2012 Level 2 Mindmaps (All)

ChangesinCFAlevel2curriculum2012
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trnglphoclanman,rmr.Sloibnylmchoslngreadingscalevel2gimt70readingsnm2011
xung cn 64 readings nm 2012. Cn kin thc thm vo nhiu nht l reading 47 (Investing in Hedge Funds: a
survey)camnAlternativeInvestments.
Mn Alternative Investments: Reading 50 c Commodity (hc v Contango, Backwardation, roll yield) b loi b,
c l l do ni dung ny s c covered y hn level 3. Reading mi s 47 (Investing in Hedge Funds: a
survey)thaythreading51c(EvaluatingperformanceofHedgeFunds)vreading52c(BuyerBeware:evaluating
andmanagingthemanyfacetsofrisksofhedgefunds).
Mn Equity: B hn 2 readings l reading 36 v 38 c. Reading 36 c Equity, Markets and Instruments l mt
readingkhdivnhiuchbnlunvccloithtrng,cccngcvvnvthukhiutrancngoi,
ADR American Depository Receipts, ETFs, country funds. Reading 38 c Equity concepts and Techniques gm
nhiunidungblptrongccreadingskhc,nhcountryanalysis,industryanalysis.Tuynhintrongreading38
b b c hai m hnh kh th v l 1. Franchise model (tnh intrinsic P/E theo tangible P/E (1/r) v Franchise P/E (=
franchise factor x growth factor)) v 2. cng thc tnh P/E vi s gp mt ca inflation flow through rate. Cc
readingscnlicthayinhmthaiLOSkhngngk.
Mn Economics: Reading 17 c Exchange rates and Balance of Payment b loi b. Ni dung ny c a xung
level1(thamkholevel1reading20InternationalTradeandCapitalFlowsvreading21CurrencyExchangeRates).
Mn Fixed Income: Reading 54 c Liquidity conundrum (c cp ti Minsky hypothesis v gii thch l do khng
hongnhtcaMvinmtrc)bloib,clldoccthngtinnygioutofdate.
MnCorporateFinance:BmtLOSnhonhvlchsccantitrustlegislationsM(trongreading32M&A).
NmmncnliEthics,Quantitativeanalysis,Derivatives,Portfoliomanagement,FRAginguyn.
Ngitnghp:LTrngTunAnh&NguynHoiPhng,AFTC.
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 1
CFALEVEL2
ETHICAL &
PROFESSIONAL
STANDARDS

1. Code Of
Ethics And
Standards
Of
Professional
Conduct
a1.
All CFA Institute members and candidates are
required to comply with the Code and Standards
Structure of the CFA
Institute Professional
Conduct Program
Basic structure
for enforcing
the Code and
Standards
The CFA
Institute
Bylaws
Rules of
Procedure
Based on
two
primary
principles
Fair process to
member and
candidate
Confidentiality
of proceedings
Professional
Conduct
program
(PCP)
The CFA
Institute
Board of
Governors
Maintains oversight
and responsibility
Through the Disciplinary
Review Committee (DRC)
Is responsible for the
enforcement of the
Code and Standards
The CFA
Designated
Officer
Directs Professional
Conduct Staff
Conducts professional
conduct inquiries
An inquiry can be prompted
by several circumstances
Process for the
enforcement of
the Code and
Standards
When an
inquiry is
initiated
The Professional
Conduct staff
conducts an
investigation that
may include
Requesting a written
explanation from the
member or candidate
Interviewing
The member or candidate
Complaining parties
Third parties
Collecting documents
and records in support
of its investigation
Upon reviewing the
material obtained during
the investigation, the
Designated Officer may
Conclude the inquiry with
no disciplinary sanction
Issue a cautionary letter
Continue
proceedings to
discipline the
member or
candidate
If finding that a
violation of the
Code and
Standards
occurred, the
Designated Officer
proposes a
disciplinary
sanction
Accepted by
member
Rejected by
member
The matter is
referred to a
hearing by a
panel of CFA
Institute
members
a2.
Six components of
the Code of Ethics
Seven Standards of
Professional Conduct
b. Ethical
responsibilities
2.1 Standard I
PROFESSIONALISM
A.
Knowledge
of the law
Guidance
Recommended procedures for compliance (RPC)
Application
B. Independence
and objectivity
Guidance
Maintain independence and objectivity in professional activities
How to cope
with external
and internal
pressures
External
pressures
By benefits
Gifts
Invitations to lavish functions
Tickets
Favors
Job referrals
Allocation of shares in oversubscribed
IPOs to investment managers
....
From public
companies
To issue favorable reports
From Buy-side clients
May try to pressure sell-side analysts
Internal
pressures
From their
own firms
e.g. to issue favorable research
reports/recommendations for certain companies
Investment-banking
relationships
to issue favorable research on current or
prospective investment-banking clients
Conflicts of interest
-->
-->Modest gifts and entertainment are
acceptable but special care must be taken
-->must disclose to employers
-->Best practice: reject any offer of gift,..threatening independence and objectivity
-->Recommendations must
convey true opinions
free of bias from pressures
be stated in clear and unambiguous language
-->Portfolio managers must respect and foster honesty of sell-side research
Issuer-paid
research
Is fraught with conflicts
-->Analysts
Must engage in thorough, independent, and unbiased analysis
Must fully disclose potential conflicts, including the nature of compensation
Must strictly limit the type of compensation they accept for conducting research
Best practice
Accept only flat fee for their work prior to writing the report
W/O regard to conclusions or reccomendations
RPC
Protect integrity of opinions
Create a restricted list
Restrict special cost arrangements
Limit gifts
Restrict employee investments
Equity IPOs
Private placements
Review procedures
Written policies on independence and objectivity of research
C. Misrepresentation
Guidance
Definition of
"Misrepresentation"
any untrue statement or omission of a fact
or any fasle or misleading statement
Must not knowingly make
misrepresentation or give
false impression in
oral representations, advertising
electronic communications
written materials
Must not misrepresent any
aspect of practice, including
qualifications or credentials, services
performance record
characteristics of an investment
any misrepresentation relating to member's professional activities
Must not guarantee clients specific return
on investments that are inherently volatile
Standard I(C) prohibits plagiarism in
preparation of material for distribution to
employers
associates
clients
prospects
general public
RPC
Written list of available services, description of firm's qualification
Designate employees to speak on behalf of firm
Prepare summary of qualifications and experience, list of services capable of performing
To avoid plagiarism
Maintain copies
Attribute quotations
Attribute summaries
D.
Misconduct
Guidance
Address conduct related to professional life
Violations
Any act involving lying, cheating, stealing, other dishonest conduct that reflects adversely on
member's professional activities would be violation
Conduct damaging trustworthiness or competence
Abuse of the CFA Institute Professional Conduct Program
RPC
Develop and/or adopt a code of ethics
Disseminate to all employee a list of potential violations
Check references of potential employees
a
2.2 Standard II
INTEGRITY OF
CAPITAL
MARKET
A. Material
nonpublic
information
(MNI)
Guidance
Definition of "Material
nonpublic information"
Must be particularly aware of info
selectively disclosed by corporations
Mosaic Theory
Analysis of Public info +
nonmaterial nonpublic info -->
Investment conclusion
Analysts are free to act on
this collection of info w/o
risking violation
Analysts should save and
document all their research
RPC
Make reasonable efforts to achieve
public dissemination of material info
If public dissemination
is not possible,
Must communicate the info only to the
designated supervisory and
compliance personnel within the firm
Must not take investment
action on the basis of the info
Must not knowingly engage in conduct
inducing insiders to privately disclose MNI
Encourage
firms to
adopt compliance procedures
preventing misuse of MNI
develop & follow disclosure policies
to ensure proper dissemination
use "firewall"
Prohibition of all proprietary trading while firm
is in possession of MNI may be inappropriate
B. Market
manipulation
Definition
can be
related to
transactions that deceive
market participants
Transactions that artificially
distort prices or volume
Securing a controlling,
dominant position in a financial
instrument to exploit and
manipulate price of a related
derivative/or underlying asset
dissemination of false or
misleading info
including spreading false rumors
to induce trading by others
Standard II(B)
not meant to
prohibit legitimate trading strategies
prohibit transactions done for tax purposes
The intent of action is critical to determining
whether it is a violation of this Standard
2.3
Standard
III
DUTIES
TO
CLIENTS
A. Loyalty,
prudence,
and care
Guidance
Responsibility
to a client
includes
duty to
exercise
reasonable
care
Prudence
require cautions
and discretion
act with care, skill, and diligence
follow the investment parameters set forth
by clients & balancing risk & return
duty of
loyalty
Understand & adhere
to fiduciary duties
Determine identity of "client"
Must be aware of whether they have
"custody" or effective control of client assets
Manage pool of assets in accordance
with terms of governing documents
Put their obligation to client first in all dealings
Avoid all real or potential conflicts of interest
Forgo using opportunities for their own benefit at the expense of client
Follow any guidelines set out by client for the management of assets
Judge investment decisions in context of total portfolio
Vote proxies in an informed & responsible manner
"Soft dollars"
RPC
Submit to clients at least quarterly itemized statements
Separate assets
Review investments periodically
Establish policies & procedures with respect to proxy voting and the use of client brokerage
Encourage firms to address some topics
B. Fair
dealing
Guidance
Do not discriminate against any clients
"Fairly" vs "equally
Investment
recommendations
Standard III(B) addresses the manner of disseminating investment
recommendations or changes in prior recommendations to clients
Ensure fair opportunity to act on
Encourage firms to design equitable system to prevent
selective, discriminatory disclosure
Material changes should be
communicated to all current clients
particularly clients may have acted on
or been affected by earlier advise
Clients who don't know changes
and therefore place orders contrary
to a current recommendation
should be advised of the
changed recommendation
before the order is accepted
Investment
actions
Treat all clients fairly in light of their
investment objectives & circumstances
Disclose to clients &
prospects written
allocation procedures
duty of fairness and loyalty to clients can never be overriden
by client consent to patently unfair allocation procedures
Should not take advantage of their position in the industry to the detriment of clients
RPC
C. Suitability
Guidance
In investment
advisory
relationships
Be sure to gather client info in the form of an IPS and make suitability
analysis prior to making recommendation/taking investment action
Inquiry should be repeated at least annually/prior to material changes
If clients withhold info
Risk analysis
Fund managers
In case of unsolicited trade requests unsuitable for client
RPC
D. Performance
presentation
Guidance
Standard III(D) prohibits misrepresentaions of past performance
or reasonably expected performance
--> Provide credible performance info
-->Should not state or imply that clients will obtain or
benefit from rate of return generated in the past
Research analysts promoting the success
of accuracy of their recommendations
--> ensure that their claims are
fair, accurate, and complete
If the presentation is brief, must make available to
clients and prospects the detailed info upon request
RPC
GIPS
E. Preservation of
confidentiality
Guidance
Standard III(E) is applicable when members receive info
Comply with applicable laws
When in dout
-->consult with compliance department/outside counsel before disclosing
Standard III(E) does not prevent cooperating with an investigation by CFAI PCP
RPC
a
2.4 Standard IV
DUTIES TO
EMPLOYERS
A. Loyalty
Employer-
employee
relationship
In matters related to their employment, members
and candidates must not engage in conduct that
harms the interests of the employer
-->Comply with policies and procedures established by
employers that govern employer-employee relationship
Standard IV(A) does not require to place employer
interests ahead of personal interests in all matters
The relationship imposes duties and
responsibilities on both parties
Independent
practice
Abstain from independent competitive activity
that could conflict with employer's interests
Provide notification to employer, obtain
consent from employer in advance
Leaving an
employer
Must
Planning to leave, must continue
to act in employer's best interest
Firm records or work performed on behalf
of firm stored on a home computer should
be erased or returned to employer
Must not
engage in activities conflicting with
duty until resignation effective
contact existing clients/potential
clients prior to leaving for soliciting
take records of files to a new
employer without written permission
Free to make arrangements/preparations
provided that not breaching duty of loyalty
Applicable non-compete agreement
Whistleblowing
Nature of employment
B. Additional
compensation
arrangements
Guidance
Obtain written consent from employer before accepting
compensation or other benefits from third parties...
RPC
Should make an immediate
written report to their employers
C. Responsibilities of
supervisors
a
2.5
Standard V
INVESTMENT
ANALYSIS,
RECOMMENDATIONS
& ACTIONS
A. Diligence and
reasonable basis
Guidance
The application of Standard
V(A) depends on
investment philosophy followed
role of member in the
investment decision-making
process
support and resources
provided by employer
Must make reasonable efforts to cover all pertinent
issues when arriving at recommendation
Provide or offer to provide supporting info to clients when
making recommendations/changing recommendations
Using secondary or
third-party research
-->must make reasonable &diligent efforts to
determine whether 2nd/3rd party research is sound
Group research
and decision
making
If member does not agree
with the independent and
objective view of the group
-->Not necessarily have to
decline to be identified if
believing consensus opinion has
reasonable & adequate basis
-->Should document member's
difference of opinion with group
RPC
B. Communication
with clients and
prospective clients
Guidance
Standard V(B) addresses conduct with respect to communicating with clients
Communication is not confined to written
form but via any means of communication
Developing and maintaining clear, frequent, and
thorough communication practices is critical
Must
distinguish clearly between facts & opinions
present basic characteristics of the analyzed
security in preparing research report
adequately illustrate to clients & prospective clients the manner
of conducting investment decision-making process
keep them informed with respect to changes
to the chosen investment process
Brief
communications
-->must be supported by background
report or data on request
Capsule form
recommendations
-->should notify clients that additional info and
analyses are available from the producer of the report
Investment advice
based on quantitative
research and analysis
-->must be supported by readily
available reference material
-->in a manner consistent with previously applied
methodology or with changes highlighted
Should outline known limitations, consider
principal risks in investment analysis, report
RPC
C. Record retention
Guidance
In hard copy or electric form
Fulfilling regulatory requirements may
satisfy the requirements of this Standard
Must explicitly determine
whether it does
Absence of regulatory guidance,
CFAI recommends
maintaining records for at
least 7 yrs
RPC
2.6
Standard VI
CONFLICTS
OF INTEREST
A. Disclosure
of conflicts
Guidance
Managing
conflicts
is a critical part of working in investment industry
can take
many forms
Best practice is to avoid conflicts
of interest when possible
If not, disclosure is necessary
Disclosures
must be
prominent
made in plain language
in a manner to effectively communicate the info to clients
Disclosure
to clients
All matters
may impair
objectivity
Relationships
between member or
their firm and issuer
investment banking
underwriting and financial
relationships
Broker/dealer market-making activities
Material beneficial ownership of stock
Investment personnel also serves as a director
-->Sell-side
members
should disclose material beneficial ownership
interest in securities/investment recommended
Disclosure of
conflicts to
employers
What?
Same circumstances with clients
Any potential conflict situation
How?
Enough info
Other requirements
B. Priority of
transactions
Guidance
Clients & employers' transactions have priority
Co-investment
-->personal investment positions
or transactions should never
adversely affect client investments
Conflicts of
interests
may occur
-->make sure
client is not disadvantaged by the trade
investment professional does not benefit
personally from trades undertaken for clients
investment professional complies with
applicable regulatory requirements
Having knowledge of pending transactions, assess to info during
normal preparation of research recommendations
-->Must not
convey such info
May undertake personal transactions after clients & employers
have had adequate opportunity to act on recommendation
Family accounts (that
are client accounts)
should be treated like other accounts
if member has
beneficial ownership
-->may still be subject to
pre-clearance or reporting
requirements
C. Referral fees
Inform
whom
employer
client
prospective client
what
compensation
consideration
benefit
received from, or paid to, others
how
before entry into any formal agreement
nature of the consideration or benefit
2.7 Standard VII
RESPONSIBILITIES
AS CFA MEMBER /
CANDIDATE
A. Conduct as
members and
candidates in
the CFA
program
Prohibiting any conduct that
undermines the integrity of
the CFA charter
Cheating on CFA exam or any exam
Not following rules and
policies of the CFA program
Giving confidential info on the CFA
Program to candidates or the public
.....
Not precluded from expressing opinion
regarding the CFA Program or CFAI
B. Reference to
CFA Institute, the
CFA Designation
and the CFA
program
Preventing promotional efforts that
make promises or guarantees tied
to the CFA designation
Over-promise the
competence of an
individual
Over-promise future
investment results
Applies to any form of
communication
To maintain CFAI
membership
Remit annually to CFAI a completed
Professional Conduct Statement
Pay applicable CFAI membership
dues on an annual basis
Using the CFA designation
(see Curriculum)
Referencing candidacy in the CFA
program (see Curriculum)
Proper using of the CFA marks
(see Curriculum)
a
3.1 CFA Institute
Soft Dollar
Standards
Soft Dollar
Standards (SDS)
are voluntary standards for Members
focus on 6
key areas
Definitions
To enable all parties dealing with SD practices to have a
common understanding of all of the different aspects of SD
Research
To give a clear guidance to investment managers on what products and
services are appropriate for a manager to purchase with client brokerage
Mixed-used products
To clarifiy the manager's duty to clearly justify the use of
client brokerage to pay a portion of mixed-use product
Disclosure
To obligate
investment
managers to
clearly disclose their SD practices
give detailed info to each client when requested
Record keeping
To ensure that client can
receive assurances that what investment managers are
doing with client brokerage can be supported in an "audit"
receive important info on request
Client-directed
brokerage
To clarify the manager's role and fiduciary responsibilities to clients
a1. Define "Soft Dollar"
Arrangements
Investment Manager directs transactions to a Broker, in exchange for which
Broker provides brokerage and research services to the Investment Manager
include
Proprietary Research
Arrangements
Third-party Research Arrangements
Not include Client-directed Brokerage Arrangements
a2. Some definitions
Agency trade
A transaction involving the pmt of a commission
Principal trade
A transaction involving a "discount" or a "spread"
Soft dollar
practices
involve the use of client brokerage by an investment manager to obtain products
and services to aid the manager in investment decision making process
Brokerage
The amount on any trade retained by a broker
to be used directly or indirectly as pmt for
Research
Servies and/or products provided by a broker, the primary use of which must
directly assist the investment manager in its investment decision making process
Types
Proprietary research
Third-party research
Mixed-Use
Services and/or products,
provided to an investment
manager by a broker through
a Bokerage Arrangement
used for both
Investment decision making process
Management of the
investment firm
Client-directed
brokerage
arrangement
An arrangement whereby a client directs that trades
for its account be executed through a specific broker
in exchange for which the client receives a
benefit in addition to execution services
a3. General principles of
Soft Dollar Standards
2 key principles
of SDS
1. Brokerage is the
property of client
2. Investment managers
have a duty to
obtain best execution
minimize transaction costs
use client brokerage to benefit clients
CFAI SDS are
intended to ensure
Full and fair disclosure of the investment
manager's use of a client's brokerage
Consistent presentation of info->all parties
clearly understand brokerage practices
Uniform disclosure and record keeping
High standards of ethical practices
within the investment industry
a
3.2 CFA Institute
Soft Dollar
Standards (cont.)
b. Critique company SD
practices and policies
I. General
II. Relationships with clients
III. Selection of brokers
IV. Evaluation of research
V. Client-directed brokerage
VI. Disclosure
VII. Record keeping
c. Permissible
research guidance
Level 1- Define the Product/Service
Level 2- Determine Usage
Level 3- Mixed Use Analysis
a
4. CFA Institute
Research
Objectivity
Standards
CFAI-ROS are
intended to be
specific, measurable standards
for managing and disclosing conflicts of interest
that may impede a research analyst's ability to conduct independent research and make objective recommendations
a. Objectives of Research Objectivity Standards (ROS) (p.104)
b
Definitions
Compliance and legal department
Corporate issuer
Covered employee
Immediate family
Investment advisory relationship
Investment banking
Investment manager
Personal investments and trading
Public appearance
Quiet period
Research analyst
Research report
Restricted period
Subject company
Supervisory analyst
Requirements
and
recommended
compliance
procedures
1. Research objective policy
2. Public appearances
3. Reasonable and adequate basis
4. Investment banking
5. Research analyst compensation
6. Relationships with subject companies
7. Personal investments and trading
8. Timeliness of research reports and recommendations
9. Compliance and enforcement
10. Disclosure
11. Rating system
a
5.6.7 Case Studies
5. The Glenarm Company
Case outline
Case results
6. Preston Partners
Case outline
Case results
7. Super Selection
Case outline
Case results
a
8. Trade Allocation:
Fair Dealing And
Disclosure
a. Trade allocation
practice critique
b. Appropriate response
to inadequate trade
allocation practices
a
9. Changing
Investment
Objectives
a. Critique disclosure of
investment objectives
and basic policies
b. Appropriate
response to
inadequate
disclosure
procedures
a
10. Prudence In
Perspective
Warm-up: The Old
Prudent Man Rule
a. Basic
principles
of the New
Prudent
Investor
Rule
1. Diversification is fundamental to risk minimization
2. Trustees must base an investment's appropriateness on risk/return profile
3. Trustees have a duty to avoid fees, transaction costs,
and other expenses that are not justified
4. The fiduciary's duty of impartiality requires a
conscious balancing of current income and growth
5. Trustees may have a duty, as well as the
authority, to delegate as prudent investors would
b. General
Fiduciary
Standards
A trustee must
exercise
Care
Skill
Caution
Loyalty
Impartiality
c. Differentiate
The Old PMR
The New PIR
Use of total return
Risk management
Evaluation in a portfolio context
Security restrictions
Delegation of duty
d. Key
factors
should be
considered
when
investing
and
managing
trust assets
1. Economic conditions
2. Effect of inflation and deflation
3. Impact of investment decisions on the beneficiary's tax liability
4. How each investment contributes to risk/return of the overall trust portfolio
5. Expected total return from income and capital appreciation
6. Other resources of beneficiaries
7. Needs for
liquidity
regularity of income
preservation or appreciation of capital
8. Whether any assets have a special relationship to
the requirements of the beneficiary or the trust
a
CFALEVEL2
QUANTITAVE
ANALYSIS

EXAMPLE READING 11: (Excel output) Observation X Y
1 12 50
Regression Statistics 2 13 54
Multiple R 0.47512 3 10 48
R Square 0.22574 4 9 47
Adjusted R Square 0.12896 5 20 70
Standard Error 15.05668 6 7 20
Observations 10 7 4 15
8 22 40
ANOVA 9 15 35
df SS MS F Significance F 10 23 37
Regression 1 528.77 528.77 2.33 0.17
Residual 8 1,813.63 226.70
Total 9 2342.4
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 25.5586 11.5324 2.2163 0.0575 -1.0351 52.1523 -1.0351 52.1523
X 1.1883 0.7780 1.5272 0.1652 -0.6059 2.9824 -0.6059 2.9824
RESIDUAL OUTPUT PROBABILITY OUTPUT
Observation Predicted Y Residuals Standard Residuals Percentile Y
1 39.8176 10.1824 0.7173 5 15
2 41.0059 12.9941 0.9154 15 20
3 37.4411 10.5589 0.7438 25 35
4 36.2529 10.7471 0.7571 35 37
5 49.3236 20.6764 1.4565 45 40
6 33.8764 -13.8764 -0.9775 55 47
7 30.3116 -15.3116 -1.0786 65 48
8 51.7001 -11.7001 -0.8242 75 50
9 43.3824 -8.3824 -0.5905 85 54
10 52.8884 -15.8884 -1.1192 95 70
11.1.
Correlation
And
Regression
a.
Sample covariance
Sample correlation coefficient
Scatter plot
b. Limitations to
Correlation analysis
Outliers
Spurious correlation
Nonlinear relationships
c. Hypothesis testing of
correlation coefficient
d. Variables in a
linear regression
Dependent (Y)
Explained variable
Endogeneous variable
Predicted variable
Independent (X)
Explanatory variable
Exogenous variable
Predicting variable
e1. Assumptions
underlying linear
regression
linear relationship
independent variable uncorrelated with residuals
expected value of residual term = 0
variance of residual term is constant
residual term is independently distributed
residual term is normally distributed
e2. Simple linear
regression model
Sum of Squared Errors (SSE)
Odinary Least Squares (OLS)
e3. Regression
coefficients
Slope coefficient
Intercept
a
11.2.
Correlation
And
Regression
f1. SEE (Standard
Error of Estimate)
f2. Coefficient of
determination (R^2)
f3. Regression coefficient
confidence interval
g. Regression coefficient
t-test: b1=0
h. Predicted value of
the dependent variable
Y=
Confidence intervals
i. ANOVA
(Analysis
Of
Variance)
SST (Total Sum of Squares)
RSS (Regression Sum of Squares)
SSE (Sum of Squared Errors)
R^2 and SEE
F-Statistic
Multiple regression
Simple regression
j. Limitations of
regression analysis
Parameter instability
Limited use if others aware
and act the same
Invalid assumptions
Heteroskedastic
Autocorrelation
a
12.1. Multiple
Regression &
Issues In
Regression
Analysis
Warm-up: Multiple regression basics
a. Multiple
regression
Equation
Interpretation
Intercept term
Partial slope
coefficients
b. Regression
coefficient testing
Hypothesis
Statistical significance
Interpreting p-values
Other tests of the regression coefficients
c1. Confidence intervals for
regression coefficient b
c2. Predicted
value for Y
d. Multiple regression
assumptions
Linear relationship Y -- X
Independent variables X
Not random
No linear relation X -- X
Error term
Expected value = 0
Variance is constant
Not correlated with one another
Normal distribution
e. F-statistic
f. Coefficient of
Determination
R2 vs. Adjusted R2
g. ANOVA tables
h. Dummy
variables
Independent variables is
binary in nature
To quantify impact of
qualitative events
Coefficients in a Dummy
variable regression
a
LOS 12 i,j: Assumption violations
Assumption
Violation
Heteroskedasticity Serial Correlation (Autocorrelation) Multicolinearity
Phng sai khng ng nht T tng quan a cng tuyn
Definition
2 types:
. Unconditional:
. Conditional:
(esp. in time series)
2 types:
. Positive:
. Negative:
Detecting . Residual plots ( th phn d):
. Breusch-Pagan test:
. Residual plots:
. DW (Durbin-Watson) test:
. High R
2
, reject F-test but not any t-tests
. Rule of thumb:
Effects on
regression
analysis
. Standard errors:
. t-test:
. F-test:
. Positive: data cluster standard errors
too. t-stat too .. ..
. Negative: data diverge
. F-test: unreliable
Correcting . Adjust standard errors:
Robust std. errors
White-corrected std. errors
Heteroskedasticity-consistent std. errors
recalculate t-stats
. Adjust standard errors:
Hansen-White std. errors
(correct both heteroskedasticity & autocorrelation)
Serial correlation consistent
recalculate t-stats
. Improve specification (include seasonal terms)
. Omit 1 or more variables (not easy, must
use stepwise regression)
NOTES: . Regression analysis tests (t-tests, F-tests):H
0
: bad model (Reject H
0
good model)
. Assumption tests:H
0
: no violation (Fail to reject H
0
good model)
12.2. Multiple
Regression &
Issues In
Regression
Analysis
Warm-up: Why multiple
regression isn't easy as it looks
Assumption
violations
i1. Heteroskedasticity
What is it?
Unconditional
Conditional
Effects on regression analysis
Detecting heteroskedasticity
Correcting heteroskedasticity
i2. Serial correlation
(autocorrelation)
What is it?
Positive
Negative
Detecting
Correcting
j. Multicollinearity
is
Detecting
Correcting
Warm-up: Model specification
k. Model
misspecification
Subcategory 1: Misspecified
functional form
Misspecification 1: Omitting a variable
Misspecification 2: Variables should be transformed
Misspecification 3: Incorrectly pooling data
Subcategory 2: explanatory
variables correlated with error term
Misspecification 4: use lagged Y as X
Misspecification 5: Forecasting the past
Misspecification 6: Measuring
independent variables with error
Subcategory 3: misspecifications resulting in nonstationarity
l. Models with qualitative
dependent variables
Probit and logit models
Discriminant models
m. Interpreting regression results
a
13.1. Time-
Series
Analysis
Trend
models
a. 2 models
Linear trend model
Log-linear trend models
b1. Which model is best?
b2. Limitations of
trend models
Autocorrelation
Autoregressive
(AR) models
d. Structure of an AR
model of order p
Forecasting with an
autoregressive model
e. Autocorrelation & Model fit
l. Seasonality
Definition
Detecting
Correcting
Forecasting with an AR
model with a seasonal lag
g. In-sample and
out-of-sample
forecasting
In-sample forecasts
Out-of-sample forecasts
Root mean squared
error criterion (RMSE)
h. Regression coefficient instability
c. Covariance
stationarity
3 conditions
Constant and finite expected value
Constant and finite variance
Constant and finite covariance
with leading or lagged values
Significance of a series
not being stationary
a
13.2. Time-
Series
Analysis
f.
Mean reversion
Calculate a
mean-reverting level
i. Random walks
Random walk
Random walk with a drift
Covariance stationarity
j. Unit roots
First differencing
k,n. Nonstationarity
and cointegration
Unit root test for
nonstationary
Cointegration
m. Autoregressive conditional
heteroskedasticity (ARCH)
o. Choosing the correct model
a
CFALEVEL2
ECONOMICS

14. Economic
Growth
Warm-up: Economic
growth (EG)
Estimating EG
Rule of 70
a1. Sources of EG
Land
Capital goods
Labor
Entrepreneurial ability
a2. Preconditions for
E.G.- Incentive system
Markets
Property rights
Monetary exchange
The
productivity
curve (PC)
Labor productivity
=Real GDP per labor hour
Definition
of PC
2 properties of PC
1. Growth in capital per labor hour --> movement along PC
2. Technological growth --> shift PC upwards
Law of
diminishing
returns
b. The ONE-THIRD Rule
c. Faster
economic
growth
Three ways
Increasing the growth of physical capital
Technological advance
Investment in human capital
-->Suggestions
Stimulate saving
Stimulate R&D
Target high-technology industries
Encourage international trade
Improve the quality of education
d. Growth
theories
(GT)
Classical GT
Growth in GDP: not permanent
When real GDP per person above subsistence level --> population explosion -->
real GDP per person back to subsistence level
Figure
Neoclassical GT
Technological change --> increased saving & investment -->
capital per labor hour increase --> long term growth in GDP
Different from classical
GT: population growth
Independent of econ. growth (or real wage rate or real GDP)
But influenced by opportunity cost to women for entering workplace
Technological growth
Not influenced by economic growth
Occur through trial & error (R&D)
New GT
Based on 2 properties of market economies
Discoveries are the result of choices
Discoveries lead to profit & competition eliminates profit
Technological
change
driven by profit
there is ongoing search to discover technologies
2 other key
assumptions
Discoveries are public capital goods
Law of diminishing returns does
not apply to knowledge capital
--> no mechanism to stop economic growth
a
15. Regulation And
Antitrust Policy In A
Globalized Economy
Warm-up: Natural monopolies
a.
Rationale for
Economic regulation of
natural monopolies
Social regulation of
nonmonopolistic industries
b. Social
regulation
Potential
benefits
Possible
negative
side effects
Creative
response
Conform to the letter (the words),
but not to the intent
Feedback
effect
is a typical example of
creative response
New regulation changes consumers'
behavior --> undermine the original intent
c.
Regulators'
behavior
Capture
hypothesis
regulators are selected from industry experts --> have relationships
--> sometimes decisions influenced/controlled by the industry
at regulatory hearing: consumers less prepared and
less persuasive than industry members
Share-the-gains,
share-the-pain
theory
Regulators try to
satisfy all 3 parties
Legislators
Customers
Regulated firms
a
16. Trading With
The World
a.
Comparative
advantage
Concept
Law of comparative
advantage
Specialize in low-opportunity-cost goods --> export
Import high-opportunity-cost goods
How countries can gain
from international trade
Warm-up: Consumer
and producer surplus
b. Barriers
to trade
Tariffs --> increase price of imported goods --> reduce imports --> benefit domestic producers
tariff=tax --> benefit government
Non-tariff
barriers
Quotas
License to import a limited
amount --> reduce supply -->
higher price
lower equilibrium domestic quantity
less foreign competition -->
benefit domestic producers
deadweight loss
firms with import licenses get the gains
Voluntary
export
restraints
(VERs)
are agreements by exporting countries to voluntarily limit the quantity of goods
firms with export permits get the gains (different from quotas)
Government officials who choose firms may receive some gain.
c. Critque
the
arguments
for trade
restrictions
Arguments with
some support
Infant-industry
argument
Argument:
infant industries should be protected while they get
up to world standards of productivity and quality
Critiques:
Benefits not the whole economy but to firms &
workers in those industries
Tariff or quota is market distorting --> Government subsidy is better
Dumping
argument
--> Anti-dumping law:
Exporters should be prohibited from selling
goods abroad at less than production cost
Critiques:
Difficult to estimate
production costs
price lower than in foreign firms'
market is not evidence of dumping
drive domestic firms
out of business -->
still have competition from
other countries
those domestic firms could re-enter
when foreign firms raise prices
National
security
argument
Argument
Industries associated with national defense should be
protected so they will exist domestically in case of war
Critiques:
almost all industries contribute or potentially
contribute to national defense
government should choose strategic industries to
subsidize rather than impose trade restrictions
Arguments with
very little support
Trade barriers protect jobs
Trade restrictions create jobs
Trade with low-wage countries depresses
wages in high-wage countries
a
17. Currency
Exchange Rates
a. Methods of
FX quotations
Direct
Indirect
b. Spreads
Calculation
Affected by
Market conditions
Bank/dealer's positions
Trading volume
c. FX cross rates
d. Triangular arbitrage
e. Distinguish
Spot markets
Forward markets
f. Spreads in the
forward market
Calculation
Affected by
Market conditions
Bank/dealer's positions
Trading volume
Maturity/length of contract
g,i. Forward premium/discount
h
Interest
rate parity
interest differential ~ forward differential
formula calculating Forward rate from Spot rate:
Covered
interest
arbitrage
exploits mispricing between spot & forward --> zero-cost but guaranteed profit
=money market hedge
a
18. Foreign
Exchange
Parity
Relations
a. Exchange rate
determination in a
floating system
b. BOP accounts
Current account (CA)
Financial (capital) account (FA)
Official reserve account
c. How deficit or
surplus in CA & FA
affects an economy
d. Factors that affect
currency movements
e. Effects of
Monetary
policy
on
BOP
Exchange rate
Fiscal
policy
on
BOP
Exchange rate
f. Other exchange
rate systems
Fixed
Pegged
g,h. Purchasing
power parity (PPP)
Absolute PPP
only requires that the law of one price is correct on average
Relative PPP
Expected spot exchange rate after t years =
i,j. International
Fisher relation
Interest rate differential = Expected inflation differential
Assumption: real interest rates
stable over time
equal across international boundaries
Exact formula:
Linear approximation:
k. Uncovered interest
rate parity
= combine PPP & international Fisher
Formula: expected spot exchange rate after n days=
l,m. Foreign exchange
expectation relation
Forward rate = unbiased predictor of expected future spot rate -->
no reward for bearing foreign currency exposure (but empirical
evidence suggests forward rate is not unbiased predictor)
Forward discount/premium = unbiased predictor of expected change in spot e/r
a
19 . Measuring
Economic Activity
a. Measures of
economic activity
GDP
GNI
NNI
b.
GDP at
Market prices
Factor cost
Adjustments
c
Prices
Current prices
Constant prices
GDP deflator
a
CFALEVEL2
FINANCIAL
REPORTING
ANALYSIS

20.
Inventories:
Implications
For FS &
Ratios
a. Effect of inflation &
deflation of inventory
costs
e. Effects of different
inventory valuation
methods
Inflation -->LIFO: ___ COGS; ___NI; ___tax; ___CF;
___Inventory, ___Current asset; ____ profitability; ___solvency,
____liquidity
Change in methods -->retrospective
Inventory
systems
Periodic
Inv.&COGS determined end
of accounting period
Perpetual
Inv. & COGS
continuously updated
b,c. LIFO
LIFO reserve
LIFO conformity rule
c. Adjust FS from
LIFO to FIFO
LIFO inventory
LIFO COGS
LIFO equity
LIFO tax liability
LIFO liquidation
d.
Implications
of valuing
inventory at
NRV
IFRS
write down
min(cost, NRV)
NRV=
write up: up to original cost
USGAAP
write
down
min (cost, market)
market=mid(replacement cost, _____, ________
write up: no
Except: Commodity-like products
f. Issues to
consider
Service
Merchandising
Manufacturing
3 accounts
Raw materials
WIP
Finished goods
Analysis
RM or WIP increased -->
FG increased when RM, WIP decreased -->
sales g <FG g -->
21.
Long-lived
Assets:
Implications
For FS &
Ratios
a. Capitalizing
vs. Expensing
Define asset:
Effects of capitalizing
Interest cost:
Intangible assets:
developed internally
Normally -->Expensed
Except
R&D
IFRS
R: expensed; D: Capitalized
USGAAP
Not software: like normal (expense R&D)
Software
for sale: like IFRS
(technological feasibility)
for use: capitalize R&D
b. Different
depreciation
methods for
PPE
affect COGS of SG&A
Methods
Straight live
DDB (early)
Usage-based
Change in methods -->
c. Impairment &
revaluation
Impairment
(write down)
IFRS
2 options
Sell -->=(Fair value-Selling cost)
Use -->Value in use (=PV of future CFs)
Recoverable amount=max (2 options)
If carrying value >recoverable amount -->
USGAAP
Step 1: Recoverability test
Step 2: Loss measurement
Revaluation
(write up)
Asset held for sale: up to original cost
(both IFRS & USGAAP)
Asset held
for use
USGAAP: no up
IFRS: up to original cost (except
revaluation model)
d. Disclosures
related to
long-lived
assets
BS:
IS:
CF:
Notes:
Average age=
Average depreciable life=
Remaining life=
e. Leasing vs.
Purchasing
5 motivations for leasing: less costly; less risk of obsolescence;
less restrictive provisions; OBS financing; tax advantage
f. Finance
vs.
Operating
lease
Lessor vs.
lessee
4 criteria
Transfer of title
Bargain purchase option
Lease period >=75% economic life
PV(lease pmts) >=90% fair value of asset
Reporting
by lessee
Operating lease
Finance/Capital lease
Financial statements & ratios effects
Lease
disclosures
USGAAP: Yr1:..; Yr2:...; Yr3, Yr4,Yr5; Aggregate Yr6 onward
IFRS: Yr1:...; Sum Yr2 to Yr 5, Sum Yr6 onward.
Reporting
by lessor
Operating lease
Finance
lease
Sales type
lease
Gross profit=PV(lease pmts)-BV
BS: lease receivable
IS: Gross profit for 1st year;
Interest revenue each year
CF:
Direct
financing
lease
similar to sales type lease
except for gross profit
22.
Intercorporate
Investments
1.
Investments
in financial
assets
(minority
passive)
4 types
Held-to-maturity
Held for trading
Available for sale
Designated at fair value: intention HTM or AFS but treated like HFT
Reclassification of investments in
financial assets
HTM, AFS ---------------------------------- HFT, DFV
AFS----------------------------------------------------HTM
Impairments of
financial assets
Under US GAAP
impaired if decline in value is not temporary
Under IFRS
impaired if at least one loss event has occurred &
its effect on future CF can be estimated reliably
Both USGAAP & IFRS require to evaluate each accounting period
Reversals of
impairment
Debt
Equity
Analysis of investments
in financial assets
2.
Investments
in associates
Equity
method
initially
equity investment is recorded
at cost on the investor's BS
In
subsequent
periods
the proportionate share of the
investee's earnings/loss
increases/decreases the investment
account on the investor's BS
is recognized in the investor's IS
dividends received
from the investee
are treated as return of capital
--->reduce the investment account
are not recognized in the investor's IS
Excess of purchase price over BV acquired
Impairments of Investments in associates
Transactions with the investee
Analytical issues for investments in associates
3. Business
combinations
Categories
Under IFRS
Under US GAAP
The pooling of interests method
Under the acquisition method
4. J oint
ventures
Under IFRS
Under US GAAP
5. SPE and VIE
c. Effects on
financial ratios
Items
Net income
Equity
Assets & Liabilities
Sales
Ratios
Leverage
Net profit margin
ROE
ROA
23. Employee
Compensation:
Post-retirement
And Share-based
a. Types of
post-employment
benefit plans
Defined-contribution plan
Defined-benefit plan
Other post-employment benefits
b. Measures of a
defined benefit
pension plan's
liability/asset
3 measures
Projected benefit obligation (PBO)
Accumulated benefit obligation (ABO)
Vested benefit obligation (VBO)
PBO=
(+) Beginning PBO
(+) Current service cost
(+) Interest cost
(+) Plan amendments
(+)/(-) Actuarial gains/losses
(-) Benefit paid
c. Net pension expense =
(+) Current service cost
(+) Interest cost
(-) Expected return on assets
(-)/(+) Amortization of deferred gains/losses
(+) Amortization of past service cost
d. Impact
of a DBP's
assumptions
Discount rate
increase
PBO_____, ABO_____, VBO_____
Current service cost _____, Interest cost _____,
Expected return _____, Pension expense ____
Rate of compensation
growth decrease
PBO_____, ABO_____, VBO_____
Expected rate of
return increase
PBO_____, ABO_____, VBO_____
e. Presentation
& footnotes
Funded status=
Under US. GAAP
Net pension asset/liability =Funded status
Other comprehensive income in Equity
Under IFRS
Net pension asset/liability =Funded status - Other comprehensive income
g. Evaluate the underlying
economic liability (or asset)
Reasons
for netting
Employer largely controls plan
assets & obligation -->bear risk
Decisions regarding funding & accounting are
affected by net pension obligation, not gross
f. Cash flow
information
Funded pension plan: contributions =CFO-
Unfunded plan: benefits paid =CFO-
For analytical purpose: might be CFF-, if contributions
largely differ from economic pension expense
h.
Economic pension expense
not "smoothed"
actual return instead of
expected return
Reclassifying for analytical purpose
Interest cost & Actual return: should be non-operating
Share-based
compensation
i. Accounting
issues
What is share value (esp. if shares are not traded publicly)
Expense should be spread over service period
j.
Stock
grant
Outright
stock
grants
Without conditions
Restricted stocks: can't be sold till end of vesting
Performance stocks (e.g.. ROA, ROE, IN... -->manipulation)
Stock appreciation rights
Condition: share price increase over a threshold
Payment: cash or equity or both
Phantom stocks: stock appreciation rights for privately held/ highly
illiquid firms -->based on performance of hypothetical stock
Stock
options
In the past: intrinsic value method (recognize an expense if market price
>exercise price on grant date). Problem: usually no intrinsic value
Current: Fair value method (using Black Scholes Merton or binomial
models to calculate value of option -->amortize over service period=grant
date to vesting date). Problem: very subjective
24.
Multinational
Operation
a. Distinguish
Local currency
Functional currency
Presentation (reporting) currency
b. Impact of changes in exchange rates on the translated
sales of the subsidiary and parent company
c.
If foreign currency
appreciates
All-current method
Net assets exposure -->
Net liabilities exposure -->
Temporal method
Net monetary assets exposure -->
Net monetary liabilities exposure -->
d. Compare 2 methods
Income before translation G/L
Translation G/L
Net income
Total assets
e. Affecting the
parent company's
financial ratios
Temporal vs. All current
(parent currency
depreciated -->)
ROA__; ROE__; TATO___; Invt TO___; A/R TO___
All current vs. Original
Pure BS or Pure IS ratios
Mixed BS/IS ratios
(using end-of-period BS)
f. Subsidiaries
operating in
hyperinflationary
economies
Define hyperinflation
USGAAP: 3-year accumulative infl >100% (i.e. 26% per year)
IFRS: no definition
Treatment
USGAAP: Functional =Presentation & use temporal method
IFRS
Non-monetary
Asset & Liab
adjust using price index between
acquisition date & balance sheet date
Shareholders'
equity
adjust using price index from date of contribution or
from year of beginning, whichever is later
Monetary Asset & Liab.
no adjustment
Net purchasing power Gain /Loss -->Income statement
Analyzing foreign currency disclosure : Difficulty: little requirement for disclosure. 1 parent may have many
subsi using diferrent methods -->solution: add delta CTA to Net income (clean surplus accounting)
25. The
Lessons
We Learn
Lesson 1: Understand
what you are looking at
a. Distinguish
among various
definition of
earnings
EBTDA, Operating income, EBT,
Income from continuing operations,
Income before extraordinary items,
Income before effect of changes in
accounting principles, net income
Lesson 2: Read the fine print
Lesson 3: If it's too good to be true, it may be
Lesson 4: Follow the money
b. Trends in CFO more reliable than trends in earnings
c. Lesson 5:
Understand the risks
To hedge
Not Effective
Purpose Unrealized G/L Realized G/L Unrealized G/L
Fair value hedge To hedge A/L
CF hedge
To hedge
future CF of trx
Net investment hedge
in foreign subsidiary
Foreign subsidiary
Effective
To speculate
Realized & Unrealized G/L -->
26.
Evaluating
Financial
Reporting
Quality
a.
Contrast
Cash-basis
Accrual-basis: provide more timely & relevant info. to users
Why accounting discretion
with accrual basic?
Revenue recognition, Depreciation estimates, Inventory cost flow,
Impairment, GW, Valuation allowances for DTA, pension assumptions,
stock option valuation to compute compensation expense
b. Relation between the level of accruals
and the persistence of earnings
c.
Opportunities and motivations for management to
intervene in the external financial reporting process
Influence capital markets
Satisfy contractual provisions (loan covenants, executive compensation)
Mechanisms disciplining mgmt
Independent audit, BoD, Certification by senior mgmt,
Class action litigation, Regulators, General market scrutiny
d.
Earnings
quality (EQ)
persistent & sustainable
Measures
of EQ
NOA=
Balance
sheet
approach
Accruals =
Accrual ratio =
CF statement
approach
Accruals =
Accrual ratio =
2 approaches are conceptually equivalent.
They still may differ because of
Acquisitions
Divestitures
Exchange rate G/L
Inconsistent treatment
e. Mean reversion in earnings
Extreme earnings -->not continue forever but revert back to normal level
Accruals increase -->mean reversion faster
f. Problems
with quality
of FS &
warning
signs
Revenue
recognition
Misstating revenue
Accelerating revenue
Bill-and-hold arrangement
Channel stuffing
Barter transactions
Abnormal sales growth
Disproportionate 4th quarter revenues for a non-seasonal firm
Misclassifying nonrecurring or nonoperating
Detection
techniques
Large changes in A/R & UR
Increased DSO
Compare rev & actual cash collected
Expense
recognition
Undestating expense
Delaying expense
Misclassifying expenses as nonrecurring or nonoperating
Detection
techniques
Large changes in fixed assets & inventory
Increased DOH
LIFO liquidation
Compare depreciation expense to other companies
Core operating margin =(sales-COGS-SG&A)/ sales
BS
OBS financing
e.g..: operating lease
Goodwill
Techniques
Capitalize operating leases
Look for lack of GW impairment
CFS
Misclassifying CF
e.g..: "park" cash in LT investment -->CFF
Ignoring CF
e.g..: lease
Managing CF
Techniques
Compare growth of operating leases with growth of asset
Be alert for a decrease in discretionary spending, esp. near year-end
27.
Integration
Of FS
Analysis
Techniques
a.b.
Framework
for the
analysis
of FS
Primary purpose: identify potential outcomes, good or bad, that could affect an investment decision
Figure 1:
Framework
for Analysis
Focus on
Sources of earnings & ROE
Internal or External (remove
equity income to reduce bias)
Dupont ROE =
Asset base
Common size BS
Capital structure
Divide by total LT capital
Working capital ratios
Capital allocation decisions
Assets, Capex, Rev, EBIT by
Business segments
Geographic segments
Earnings quality & CF analysis
Accrual ratios & CF/Operating income
Mkt value decomposition
standalone value of parent, P/E multiple
OBS financing
Anticipating changes in accounting standards
c. Adjustments for differences in accounting
rules, methods & assumptions
d. Predict the impact on financial
statements and ratios of changes
in accounting standards
Eliminate operating lease
Eliminate QSPE
e. Effects of
BS modifications
Earnings normalization
CF-statement-related
modifications
FRAlevel2examples
30%
3 Note:PP=BV
TABLE1:
Parent Subsidiary
Equity
method
Explanation
Acquisitionmethod
(purchasemethod/
consolidationmethod)
Explanation
Proportionate
consolidation
method
Explanation
Cash 20 10 17 PaycashtobuyS 27 addupsub&paycash 20 addupPARTOFsub&pay$
A/R+Inventory 28 6 28 unchanged 34 addupsub 29.8 addupPARTOFsub
InvestmentinS 3 PartofS'sequity
Fixedassets 32 8 32 unchanged 40 34.4 addupPARTOFsub
Totalassets 80 24 80 101 84.2
Totalliabilities 40 14 40 unchanged 54 addupsub 44.2 addupPARTOFsub
Commonstock 28 6 28 unchanged 28 unchanged 28 unchanged
Retainedearnings 12 4 12 unchanged 12 unchanged 12 unchanged
Minorityinterest 7 Others'share
BSofParentafteracquisitionasat1/1/2009 BSbeforeacquisitionasat1/1/2009
%PurchasedofSubsidiary
Purchasedprice
y
TotalEquity 40 10 40 47 40
Totalliab.&equity 80 24 80 101 84.2
TABLE2:
Parent Subsidiary
Equity
method
Explanation
Acquisitionmethod
(purchasemethod/
Explanation
Proportionate
consolidation
method
Explanation
Revenues 60 20 60 unchanged 80 addupsub 66 addupPARTOFsub
Expenses 40 16 40 unchanged 56 addupsub 44.8 addupPARTOFsub
EquityinincomeofS 1.2 P'sshare
Minorityinterest 2.8 Deductothers'share
Netincome 20 4 21.2 21.2 21.2
Dividend 0 1
Retainedearnings 20 3
ISfortheyearending31/12/2009 ISofParentfortheyearending31/12/2009
FRA examples & exercises Page 1
FRAlevel2examples
TABLE3:
Assumption:allyearendBS
itemsofP&Sarethesameas
1/1/09,exceptforcashwhich
increasesby(NIDiv)
Parent Subsidiary
Equity
method
Explanation
Acquisitionmethod
(purchasemethod/
Explanation
Proportionate
consolidation
method
Explanation
Cash 40 13 37.3
+REofP
+PartofDivfromS 50.3
+REofP+PartofDiv
fromS+allREofS 41.2
+REofP+PartofDiv
fromS+partofREofS
A/R+Inventory 28 6 28 34 29.8
InvestmentinS 3.9
+PartofNIofS
PartofDivfromS
Fixedassets 32 8 32 40 34.4
Totalassets 100 27 101.2 124.3 105.4
Totalliabilities 40 14 40 54 44.2
Commonstock 28 6 28 28 28
Retainedearnings 32 7 33.2
+REofP
+PartofNIofS 33.2
+REofP
+PartofNIofS 33.2
+REofP
+PartofNIofS
Mi it i t t 9 1 h ' h
"Ifnotacquisition"BSasat31/12/2009 ConsolidatedBSofParentasat31/12/2009
Minorityinterest 9.1 +Other'sshareinRE
TotalEquity 60 13 61.2 70.3 61.2
Totalliab.&equity 100 27 101.2 124.3 105.4
FRAlevel2examples
30% FullGW(100%): 7.33 FairvalueofS: 23.33
7 Note:PP#BV PartialGW30%: 2.20
TABLE4:
Parent Subsidiary
FairValue
ofSubsi.
Equity
method
Explanation
Acquisitionmethod
PartialGW(IFRS)
Acquisitionmethod
FullGW(USGAAP&
IFRS)
Poolingof
interest
Explanation
Cash 20 10 10 13 PaycashtobuyS 23 23 30
A/R+Inventory 28 6 6 28 34 34 34 addupBV
InvestmentinS 4.8 PartofS'sfairequity
Goodwill 2.2 =PPPartofFairV 2.20 7.33
Fixedassets 32 8 14 32 46 46 40 addupBV
Totalassets 80 24 30 80 105.2 110.33 104
Totalliabilities 40 14 14 40 54 54 54
Commonstock 28 6 28 28 28 34 addupBV
Retainedearnings 12 4 12 12 12 16 addupBV
Minority interest 11 2 16 33
%PurchasedofSubsidiary
Purchasedprice
BSbeforeacquisitionasat1/1/2009 BSofParentafteracquisitionasat1/1/2009
Minorityinterest 11.2 16.33
TotalEquity 40 10 16 40 51.2 56.33 50
Totalliab.&equity 80 24 80 105.2 110.33 104
TABLE5:
Parent Subsidiary
Equity
method
Explanation
Acquisitionmethod
PartialGW(IFRS)
Acquisitionmethod
FullGW(USGAAP&
IFRS)
Revenues 60 20 60 80 80
Expenses 40 16 40 56 56
ShareinS'sincome 1.2
Additionaldepr. 0.6 SLD3years 0.6 0.6
EquityinincomeofS 0.6
Minorityinterest 2.8 2.8
Netincome 20 4 20.6 20.6 20.6
Dividend 0 1
Retainedearnings 20 3
ISfortheyearending31/12/2009 ISofParentfortheyearending31/12/2009
FRAlevel2examples
TABLE6:
Assumption:allyearendBS
itemsofP&Sarethesameas
1/1/09,exceptforcashwhich
increasesby(NIDiv)
Parent Subsidiary
Equity
method
Explanation
Acquisitionmethod
PartialGW(IFRS)
Acquisitionmethod
FullGW(USGAAP&
IFRS)
Cash 40 13 33.3
A/R+Inventory 28 6 28
InvestmentinS 5.1
+PartofNIofS
AddDepr.
PartofDivfromS
Goodwill 2.2
Fixedassets 32 8 32
Totalassets 100 27 100.6 0 0
Totalliabilities 40 14 40
Commonstock 28 6 28
+REofP
"Ifnotacquisition"BSasat31/12/2009 ConsolidatedBSofParentasat31/12/2009
Retainedearnings 32 7 32.6
+PartofNIofS
AddDepr.
Minorityinterest
TotalEquity 60 13 60.6
Totalliab.&equity 100 27 100.6 0 0
Pensionexercise1:
Expectedreturnonplanassetsis80
Amortizationofactuariallossis30
Amortizationofpriorservicecostis10
Calculate
Netperiodicbenefitexpense
Economicpensionexpense

Pensionexercise2:
CalculatePensionexpenseandmakeadjustmentsforanalyticalpurposes.
FRA2MultinationaloperationsEg.2
U$/LC 31/12/2008 31/12/2009
INCOMESTATEMENT2009
Allcurrent
method
Currentex/rate 0.5000 0.4545 LC $ $ Explanation
Averageex/rate 0.4762 Revenues 5,000 2,381.00 2,381.00 Average
Historicalex/rate 0.0000 COGS 3,300 1,571.46 1,595.22 Historical
ForCOGS 0.4834 Grossmargin 1,700 809.54 785.78
ForDepr.Exp. 0.4878 Otherexpenses 400 (190.48) (190.48) Average
ForFixedassets 0.4881 Depr.Expenses 600 (285.72) (292.68) Historical
Foraccum.Depr. 0.4896 302.62 IncbfremeasureG/L
Forend.inventory 0.4762 48.01 RemeasurementG/L
Forequity 0.5000 NetIncome 700 333.34 350.63
BALANCESHEET
Allcurrent
method
BALANCESHEET
Allcurrent
method
LC $ LC $ $ Explanation
Cash 100 50.00 Cash 100 45.45 45.45 Current
A/R 500 250.00 A/R 650 295.43 295.43 Current
Inventory 1,000 500.00 Inventory 1,200 545.40 571.44 Historical
CurrentAssets 1,600 800.00 CurrentAssets 1,950 886.28 912.32
FixedAssets 800 400.00 FixedAssets 1,600 727.20 780.96 Historical
Accum.Depr. 100 (50.00) Accum.Depr. 700 (318.15) (342.72) Historical
Netfixedassets 700 350.00 Netfixedassets 900 409.05 438.24
Totalassets 2,300 1,150.00 Totalassets 2,850 1,295.33 1,350.56
Accountspayable 400 200.00 Accountspayable 500 227.25 227.25 Current
Currentdebt 100 50.00 Currentdebt 200 90.90 90.90 Current
Longtermdebt 1,300 650.00 Longtermdebt 950 431.78 431.78 Current
Totalliabilities 1,800 900.00 Totalliabilities 1,650 749.93 749.93
Commonstock 400 200.00 Commonstock 400 181.80 200.00 Historical
Retainedearnings 100 50.00 Retainedearnings 800 363.60 400.63 Plugnumber
Totalequity 500 250.00 Totalequity 1,200 545.40 600.63
Totalliab.&equity 2,300 1,150.00 Totalliab.&equity 2,850 1,295.33 1,350.56
Temporal
method
31/12/2008 31/12/2009
Temporal
method
U$/LC 31/12/2008 31/12/2009
INCOMESTATEMENT2009
Allcurrent
method
Currentex/rate 0.5000 0.4545 LC $ $ Explanation
Averageex/rate 0.4762 Revenues 5,000 2,381.00 2,381.00 Average
Historicalex/rate 0.0000 COGS 3,300 1,571.46 1,595.22 Historical
ForCOGS 0.4834 Grossmargin 1,700 809.54 785.78
ForDepr.Exp. 0.4878 Otherexpenses 400 (190.48) (190.48) Average
ForFixedassets 0.4881 Depr.Expenses 600 (285.72) (292.68) Historical
Foraccum.Depr. 0.4896 302.62 IncbfremeasureG/L
Forend.inventory 0.4762 48.01 RemeasurementG/L
Forequity 0.5000 NetIncome 700 333.34 350.63
BALANCESHEET
Allcurrent
method
BALANCESHEET
Allcurrent
method
LC $ LC $ $ Explanation
Cash 100 50.00 Cash 100 45.45 45.45 Current
A/R 500 250.00 A/R 650 295.43 295.43 Current
Inventory 1 000 500 00 Inventory 1 200 545 40 571 44 Historical
Temporal
method
31/12/2008 31/12/2009
Temporal
method
Inventory 1,000 500.00 Inventory 1,200 545.40 571.44 Historical
CurrentAssets 1,600 800.00 CurrentAssets 1,950 886.28 912.32
FixedAssets 800 400.00 FixedAssets 1,600 727.20 780.96 Historical
Accum.Depr. 100 (50.00) Accum.Depr. 700 (318.15) (342.72) Historical
Netfixedassets 700 350.00 Netfixedassets 900 409.05 438.24
Totalassets 2,300 1,150.00 Totalassets 2,850 1,295.33 1,350.56
Accountspayable 400 200.00 Accountspayable 500 227.25 227.25 Current
Currentdebt 100 50.00 Currentdebt 200 90.90 90.90 Current
Longtermdebt 1,300 650.00 Longtermdebt 950 431.78 431.78 Current
Totalliabilities 1,800 900.00 Totalliabilities 1,650 749.93 749.93
Commonstock 400 200.00 Commonstock 400 181.80 200.00 Historical
Retainedearnings 100 50.00 Retainedearnings 800 363.60 400.63 Plugnumber
Totalequity 500 250.00 Totalequity 1,200 545.40 600.63
Totalliab.&equity 2,300 1,150.00 Totalliab.&equity 2,850 1,295.33 1,350.56
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
A B C D E
AdjustmentsforinflationunderIFRS
Priceindices
Dec.31.2009 100
Dec.31.2008 150
Averagefor2009 125
INCOMESTATEMENT
2009
Adjustment
factor
Inflation
adjusted
Revenues 15,000 1.20 18,000
Expenses 12,000 1.20 14,400
NetpurchasingpowerG/L 6,900
NetIncome 3,000 10,500
BALANCESHEET 2008 2009
Adjustment
factor
Inflation
adjusted
Cash 5,000 8,000 8,000
Supplies 25,000 25,000 1.50 37,500
Totalassets 30,000 33,000 45,500
Accountspayable 20,000 20,000 20,000
Commonstock 10,000 10,000 1.50 15,000
Retainedearnings 0 3,000 10,500
Totalliab.&equity 30,000 33,000 45,500
CFALEVEL2
CORPORATE
FINANCE

28.1. Capital
Budgeting
Warm-up: Basics
Project
categories
Replacement to maintain biz --> no detailed analysis
Replacement for cost reduction --> fairly detailed analysis
Expansion --> very detailed
New product/ market --> detailed
Mandatory (required by Govt. or insurance such as safety or environmental projects)
Other (pet projects or high risk like R&D)
Principles
Incremental CF, not accounting income
Timing of CF --> TVM
After tax
Notes
Exclude
Sunk cost
Financing costs
Include
Externalities
Opportunity costs
MACRS= Modified Accelerated Cost
Recovery System (for tax purpose)
Half-year convention
No salvage
a. Capital budgeting
project evaluation
Expansion
project
analysis
Initial investment outlay=
After-tax O.CF=
T.NO.CF=
Replacement
project
analysis
Initial investment outlay=
After-tax O.CF=
T.NO.CF=
b. Inflation effects (if
actual inflation higher
than expected)
Principle
Nominal CF --> use nominal discount rate
Real CF --> use real discount rate
__________ project profitability
__________ tax savings from depreciation
__________ value of payments to bondholders
Affects Revenues and Costs differently --> CF may be worse or better
c1. Projects
with different
lives
Least common multiple
of lives approach
(replacement chain)
Equivalent annual annuity
(EAA) approach
c2. Capital rationing= insufficient
capital --> violate market efficiency
Hard rationing: allocated funds cannot be increased
Soft rationing: allocated funds can be increased
d. Project
risk
analysis
Sensitivity analysis: Base case, then change ONLY 1 variable up/down
Scenario analysis: Base case, then change MANY variables --> Worst case, Best case --> Risk analysis
Simulation analysis (Monte Carlo): Probability distribution of NPV
e. Determine discount rate
CAPM --> WACC
When risk of project # overall risk --> CANNOT use WACC
a
28.2. Capital
Budgeting (cont.)
f. Evaluating
projects with
real options
Types
of real
options
Timing options: option to delay investment
Abandonment options: abandon if NPVexit > NPVcontinue (=put option)
Expansion options: option to have additional investment (=call option)
Flexibility options
(operational)
Price-setting: demand increase --> increase price (oil)
Production-flexibility: e.g..: pay overtime, use # inputs, # products...
Fundamental options: project itself = option (e.g.: copper mine)
Evaluating
approaches
If NPV without option >0 --> Project will be more valuable with option
NPV = NPV without option + option value - option cost
Decision tree
Option pricing models
g. Common
capital
budgeting
pitfalls
Failing to incorporate economic responses: e.g..: profitable but low entry barriers --> competitors
Misusing standardized templates, which are not an exact match
Pet projects of senior management: less analysis
Basing investment decisions on EPS or ROE --> avoid projects with high NPV but low EPS or
ROE in the short run (especially when management compensation is tied to EPS or ROE)
Using IRR for project decision: for mutually exclusive projects, should use NPV instead
Poor CF estimation: double count or omit a CF. E.g..: inflation
Mis-estimation of overhead costs (e.g..: management time, IT support): difficult to quantify
Using the incorrect discount rate: WACC or should adjust?
Politics involved with spending the entire capital budget: e.g.. :management tries to spend
all budget to ask for more next year
Failure to generate alternative investment ideas: most important step ("good" is the enemy of "better")
Improper handling of sunk and opportunity costs
h. Measures
of income
and valuation
models
ECONOMIC
INCOME
= CASHFLOW minus ECONOMIC DEPRECIATION
Economic Depreciation year t = Beginning market value minus Ending market value for year t
Market value year t = sum of PV of all CF left
ACCOUNTING
INCOME
From Income statement
# economic income
Depreciation based on original cost, not market value
Deduct interest expense
i. Other
valuation
models
ECONOMIC
PROFIT (EP)
= NOPAT - WACC in dollars
To bond and equity holders
Sum of EP discounted at WACC = MVA (Market Value Added) = NPV
RESIDUAL
INCOME
= ACCOUNTING NET INCOME minus EQUITY CHARGE
To equity holders
Sum of RI discounted at cost of equity = NPV
Claims
valuation
Free cash flows to company (debt and equity holders) --> discount at WACC
Free cash flows to equity (shareholders) --> discount at cost of equity
a
29. Capital
Structure &
Leverage
a1. Capital
structure
theory
Capital structure objective
Maximize Firm Value
MM Proposition I
Minimize WACC
MM Proposition II
No taxes
MM Proposition I
MM Proposition II
With taxes
MM Proposition I
MM Proposition II
a2. Costs and their
potential effect on
the capital structure
Costs of financial
distress --> lower Debt
Costs
Probability
Agency costs of equity
--> higher Debt
Monitoring costs: supervising, reporting (corporate governance)
Bonding costs: insurance premiums, non-compete agreements
Residual losses: other costs
Costs of asymmetric information:
(managers vs. creditors and owners)
--> increase required rate of return
a3. Implications for
managerial
decision making
MM's propositions with no taxes: Capital structure is irrelevant
MM's proposition with taxes: optimal capital structure is 100% debt (highest tax shield, max value, min WACC)
Pecking order theory: order of raising funds: Internally generated equity --> Debt --> External Equity
Static trade-off theory
Firm value:
Optimal capital structure achieved when:
Marginal Tax Benefit = Marginal Cost of Financial Distress
b. Target capital
structure (optimal)
2 reasons for actual capital
structure to fluctuate around
target capital structure
Opportunities in a
financing source
E.g.: temporary increase in stock price
Market value
fluctuations
D, E = market value
c. Role of debt ratings
Moody's; S&P's
d. Capital structure
policy and valuation
Factors to
consider
Changes in capital structure overtime
Competitors with similar business risk
Agency costs (corporate governance)
e. International
differences in
leverage
International
differences
Total debt: Japan, France: more debt than UK, US
Debt maturity: US longer than JP
Emerging market differences: emerging market less and shorter debt
Factors
Institutional
and legal
factors
Strength of legal system: strong --> reduce agency cost--> less and longer debt
Information asymmetry: increase debt (auditors, analysts
help reduce info asymmetry --> decrease debt)
Taxes: high --> increase debt. Tax on dividend: high --> decrease debt
Financial
markets and
banking
system factors
Liquidity of capital markets (debt market): high --> longer debt
Reliance on banking system --> increase debt
Institutional investor (shareholders) presence -->
decrease information asymmetry --> decrease debt
Macroeconomic
factors
Inflation --> less, shorter debt
GDP growth --> longer debt
a
30. Dividends
& Dividend
Policy
a. Schools of
thought on
dividends
Dividend irrelevance: MM (homemade dividend)
Dividend
preference
Bird in the hand theory (Myron Gordon & John Lintner)
Impact of dividend initiation
on stock value and P/E
Higher dividend --> _____ Risk -->
_____ Cost of Equity --> _____ P/E
Higher dividend --> _____ stock value
Tax aversion
Clientele
d. Factors
affecting
dividend
payout
policy
b. Signaling
effect
Information
conveyed by
Dividend initiations
ambiguous: sharing wealth or lack of
profitable reinvestment opportunities
Dividend increases
Strong future
Unexpected Dividend
decreases / omissions
Business in trouble or more
investment opportunities
Country differences: US # Asia in perception
e. Taxation
of dividends
Tax-on-dividend
systems
Double taxation
Split rate
Imputation
c. Clientele
effect
Tax considerations
Requirements of institutional investors
Individual investor preference
c2. Agency
issues
Restrictions
on dividend
payments
"Impairment of capital" rule
Debt covenants
Cash flow
Industry life cycle
Flotation costs on new issues vs. cost of retained earnings
Shareholder preference for current income vs. capital gains
f. Dividend policy
approaches
Residual dividend model
Longer-term residual dividend
e.g.:
forecast capital budget for 5 years,
Leftover = total net income 5 years minus capital budget for 5 years.
Dividend each year = Leftover/5
Dividend stability:
steady dividend payout (taking into account inflation)
--> dividend growth rate g = company's long term growth rate
Target payout ratio
Payout ratio = constant
Payout ratio moves toward the target
g. Share
repurchase
Compare with cash dividend
EPS
effect
If Cost of Debt < Earning yield --> EPS_____
If Cost of Debt > Earning yield --> EPS_____
Book
value
effect
If Price > BVPS --> BVPSnew ______
If Price < BVPS --> BVPSnew ______
Methods
Buy in the open market
Buy a fixed number of shares at a fixed price: tender offer: P > Pmarket
Repurchase by direct negotiation: to avoid price decrease (e.g.: greenmail premium)
Rationales
Capital structure
Prevent EPS dilution from employee stock options
Supplement to cash dividend --> residual dividend policy
Management is viewing stocks as strong
Good future outlook signal
h. Global trends
i. Dividend coverage
ratios based on
Net income
FCF
j. Symptoms of not being able
to sustain cash dividend
a
31. Corporate
Governance
Warm-up: conflicts of
interest in a corporation
Multiple owners vs managers
Directors
Creditors, Employees, Customers
a. Corporate
governance
(Sarbanes-Oxley)
Definition: system of
Principles & Policies
Procedures
Responsibilities & Accountabilities
Objectives Eliminate or reduce CONFLICTS of interest (esp. mgmt vs. shareholders)
Use ASSETS in best interests of investors and other stakeholders
Attributes of
effective CG
RIGHTS of shareholders & stakeholders
Oversight RESPONSIBILITIES of managers and directors
Fair and equitable TREATMENT
Transparent & accurate DISCLOSURES about operations, performance, risk and financial position
b. Business forms
Sole proprietorship
no owner vs. manager conflict. Just creditors, suppliers, customers...
Partnerships
no owner vs. manager conflict. Just creditors, suppliers, customers...
Corporations
(US: 20% in number but account for 90% revenue)
c. Conflicts
in agency
relationships
Manager >< Shareholder
Expand firm
to increase power, security, compensation
Excessive compensation and perquisites (e.g.. lavish jet)
Invest in risky ventures (succeed --> benefit from stock options, fail --> not share the loss)
Not taking enough risk
Director >< Shareholder
Lack of independence
Personal relationship btw board - management
Board: consulting/ other biz with firm
Interlinked boards
2 companies
Directors are overcompensated
d,e. Board
of Directors
Responsibilities
(check and balance)
Institute corporate values & CG --> proficient, ethical, fair biz conduction
Ensure compliance: with all legal & regulatory requirements
Create long-term strategic objectives
Determine management's responsibilities (need to be able to measure performance)
Hire, compensate, evaluate CEO
Require complete and accurate information from management
Meet regularly
Ensure board members are adequately trained
Points to
assess Board
Composition and independence
recommend at least 3/4
Chairman independent or not
should be CEO or not
Directors qualifications
skills, experience, strategic planning, risk
management, commitment, attitudes, ethics
Board election method
all or staggered? Staggered: keep board continuity
but limit shareholders' power & slow down changes
Board self-assessment practices
annually
Frequency of separate sessions for independent directors
annually, quarterly
Audit committee and audit oversight
only independent directors, with expertise
Nominating committee
all independent
Compensation committee
Use of independent or expert legal counsel
internal counsel --> weak CG
Statement of
governance
policies
f. Statement
of CG
policies
Codes of ethics
Directors' oversight, monitoring and review responsibilities
Management's responsibilities to the board
Reports of directors' oversight and review of management
Board self assessments
Management performance assessments
Director training
Disclosure and transparency
Insider or related-party transactions
Responsiveness to shareholder proxy votes
g. Valuation
implications of
Corporate
Governance
Strong/effective CG system
--> higher measures of profitability & returns for shareholders
Weak/ineffective
CG system
Financial disclosure risk
incomplete, misleading, materially misstated disclosure
Asset risk
e.g..: too high perks
Liability risk
e.g..: OBS obligations
Strategic policy risk
e.g..: M&A
a
32.1. Mergers
& Acquisitions
Background
Bidder/ Acquirer vs. Target company
Mergers
entire target
--> 1 company ceases
Acquisitions
part of target
e.g..: assets, biz segment
a. Categorize M&A
Forms of integration
(how physically come
together)
statutory merger
acquire all A&L --> target not exist
subsidiary merger
e.g.: P&G bought Gillette (good brand)
consolidation
both cease to exist --> new company
Types of mergers
(how activities
are related)
horizontal
same industry
vertical
in the supply chain
Forward vs. Backward integration
conglomerate
no relation
b. Merger
motivations
Synergies
More rapid growth
More market power
Access to unique capabilities
Diversification
Bootstrapping EPS
c. Bootstrapping
Personal benefits for managers
Tax benefits
loss carryforwards
Unlocking hidden value
Achieving
international
business goals, by
Taking advantage of market inefficiencies (e.g..: cheap labor force)
Working around disadvantageous government policies
Use technology in new markets
Product differentiation
Provide support to existing multinational clients
d. Motivations
for mergers and
industry life
cycles
Pioneer/ development phase
Need capital, management --> H or C
Rapid growth
Need capital, management --> H or C
Mature growth
Need operational efficiency (from economies of scale) --> H or V
Stabilization
Need to cut costs (from economies of scale) --> H
Decline
H or V or C
e. Merger
transaction
characteristics
Form of
acquisition
Stock purchase
Asset purchase
Method of
payment
Methods
Securities offering
Cash offering
Mixed offering
Factors to
consider
Risk & reward for acquirer vs. target
Relative valuations of companies
Changes in capital structure
Attitude of target
management
Mgmt happy --> Friendly merger offers
Mgmt unhappy
--> Hostile merger offers
Bear hug
(propose
to BoD)
If Bear hug is
unsuccessful -->
Tender
offer
Buy shares from
target shareholders
Proxy
battle
Replace BoD
a
32.2. Mergers
& Acquisitions
(cont.)
f. Takeover
defense
mechanisms
Pre-offer
defense
mechanisms
Poison pill
Rights for current SHDs to purchase shares at big discount, triggered with 1 SHD holds > threshold (10%)
Forms
Flip-in pill
Flip-over pill
Dead-hand provision: BoD's right to redeem the pill, in a friendly merger offer
Poison put
Bondholders' right to demand immediate repayment if there is a hostile takeover
States with restrictive takeover laws
Ohio & Pennsylvania: most protection
Staggered board
e.g.: 3 groups of BoD, each is elected for 3 year-term -->
need at least 2 years to gain majority control of the board
Restricted voting rights
Ownership > threshold (20%) --> loss of voting rights --> prevent
tender offer --> bidder must negotiate with BoD directly
Supermajority voting provision for mergers
e.g..: at least 2/3 or 80%, not 51% as usual
Fair price amendment
determined by some formula or independent appraisal
Golden parachutes
lucrative cash payouts to managers if they leave after a merger
Post-offer
defense
mechanisms
"Just say no" defense
Litigation
lawsuit (anti-trust or violation of securities law)
Greenmail
agreement that allows target to repurchase its shares from
acquirer at premium price (rare after 1986: 50% tax)
Share repurchase (target's tender
offer for its own shares)
--> acquirer increases bid & leverage --> less attractive
Leveraged recapitalization
borrow to buy shares
Crown jewel defense
sell a major asset/ subsidiary
Pac-man defense
counter offer
White knight defense
--> bidding war --> good price --> winner's curse
White squire defense
(squire = junior knight)
sell a minority stake but big
enough to block acquirer
g. HHI
Herfindahl-Hirschman Index
Formula:
If post-merger HHI
< 1000: Merger ok
From 1000 to 1800
If increase in HHI <100: merger ok
If increase in HHI >=100: merger NOT ok
> 1800
If increase in HHI <50: merger ok
If increase in HHI >=50: merger NOT ok
h,i,j. Methods
for valuing a
target
company
DCF analysis
Comparable company analysis
Comparable transaction analysis
k. Evaluating
a merger bid
Post-merger value of an Acquirer
Gains accrued to the Target
Gains accrued to the Acquirer
Cash payment versus Stock payment
l. Effects of
Price
Payment
method
Cash offer
Stock offer
m. Distribution of
merger benefits
Target gains 30%
Acquirer lose stock value 1-3% (winner's curse, mgmt hubris)
3 years after merger
acquirer return = -4%
60% acquirers lag peer group (fail to capture synergy)
n. Downsizing
operations
through
corporate
restructuring
Divestitures
(dispose asset)
o. Reasons for
divestitures
Not fit long term strategy
Lack of profitability
Individual parts are worth more than the whole
Infusion of cash
Equity carve-outs
create new, independent company --> issue shares to OUTSIDE SHDs (public)
Spin-offs
create new, independent company --> issue shares to EXISTING SHDs
Split-offs
exchange shares of parent for shares of division
Liquidations
a
CFALEVEL2
EQUITY

34. Equity
Valuation:
Applications
& Process
33. A Note On Asset
Valuation
Classic works by Graham &
Dodd and J.B. Williams
a.
Define
Valuation
Intrinsic value
Possible sources of
perceived mispricing
b. Contrast
Going concern value
Liquidation value
c. Uses of
equity
valuation
Stock selection
Reading the market
Projecting the value of corporate actions
Fairness opinions
Planning & consulting
Communication with analysts and investors
Valuation of private business
Portfolio management
Planning
Executing the investment plan
d.
5 elements of
industry structure
Threat of new entrants
Threat of substitutes
Bargaining power of buyers
Bargaining power of suppliers
Rivalry among existing competitors
3 generic
strategies
Cost leadership
Product differentiation
Focus
Quality of financial info.
e. Contrast
Absolute
valuation
models
Relative
valuation
models
f. Criteria for choosing
an approach
35. Return
Concepts
a. Concepts
HPR
Realized and Expected return
Required return (RR)
Return from convergence
of price to intrinsic value
Discount rate
IRR
b. Equity risk
premium
Explain equity risk premium
Use in required return determination
Major methods of estimating
equity risk premium
Historical estimation
Forward-looking estimation
c,e. Methods of
estimating the
RR on equity
investment
CAPM
Multifactor
model
Farma-French model
Pastor-Stambaugh model
Macroeconomic multifactor model
Build-up
model
Bond-yield plus risk
premium model
d. Estimating
beta for
Public co.
Thinly traded public co.
Nonpublic co.
f. International
consideration in
RR estimation
Country spread model
Country risk rating model
g. WACC
h. Appropriate discount rate
36. The Five
Competitive
Forces That
Shape Strategy
Warm-up
a.b. Porter's five
forces. Drivers of
industry profitability
Threat of new entrants
Threat of substitutes
Bargaining power of buyers
Bargaining power of suppliers
Rivalry among existing competitors
c. Common factors
that affect the five
forces
Industry growth rate
Innovation and technology
Govt policies
Complementary products
d. Changes in industry structure and their effects on the
industry's profit potential
e. Strategic
alternatives
Altering the firm's
existing position
Capitalizing on changes
in the industries
Creating changes in the
industry structure
Steps in using the forces
in an industry analysis
Example: Wal-Mart
37. Industry
Analysis
a. Components
in industry
analysis model
Industry classification
External factor review
Demand analysis
Supply analysis
Profitability analysis
International competition & markets review
Industry
classification
b. Life cycle of a
typical industry
1. Pioneer
2. Growth
3. Mature
4. Decline
Warm-up:
Business cycle
c. Effects of
business cycles
on industry
classification
Growth
industry
stocks
Defensive
industry
stocks
Cyclical
industry
stocks
d. External
factors
Technology
Govt
Social changes
Demography
Foreign influences
e1. Demand
analysis
e2. Supply
analysis
f. Profitability
analysis
Product
segmentation
Industry
concentration
Ease of
industry entry
Supply
input price
38. Valuation
In Emerging
Markets
Warm-up: Real and
nominal valuation
CF
estimation
a. Effects
of inflation
Income taxes
NWC
Capital expenditures
b. Calculate nominal
and real-term financial
projections
5-step
approach
1. Operating results- real
2. Operating results- nominal
3. NOPLAT- real
4. Free CF- real & nominal
5. Firm value- real & nominal
c. Account for
emerging
market risks
Adjust CFs, b/c
Country risks are
diversifiable
Companies respon
differently to country risk
Country risk is one-sided risk
Identifying CF effects aids
in risk management
Rather than adjusting r
d. Estimating
cost of capital
Ke
Rf
Beta
Market risk premium
Kd (1-t)
Kd
t
Capital structure weights
39. Discounted
Dividend
Valuation
a. Measures of CF
Dividends
FCF
Residual income
DDM
Appropriateness
b.
One-period
Two-period
Multi-period
Warm-up: General DDM
i,l. Multistage
growth models
Assumptions
Selection of
Two-stage DDM
H-model
Three-stage DDM
Spreadsheet modeling
j. Business
phases
Initial growth
Transition
Maturity
k. Terminal value
GGM
c. Assumptions
d. Implied growth rate
f. Justified P/E
Justified leading P/E
Justified trailing P/E
h.
Strengths
Limitations
e. PVGO
g. Value of
preferred stock
m. Calculate
expected
return with
GGM
H-model
Two-stage DDM
n. Sustainable growth rate
o. Use of spreedsheet modeling
To forecast dividends
To value common shares
p. Over/Fairly/Undervalued
40. Free
Cash Flow
Valuation
a. Interpret &
compare
FCFF
FCFE
b,f. Ownership perspective
& recognition of value
FCFE, FCFF
DDM
c,d. Calculate
FCFF
FCFE
e. Forecasting
FCFF and FCFE
Historical free cash flow
Components of free cash flow
g. FCFF & FCFE
affected by
Dividends
Share repurchases
Share issues
Changes in leverage
h. Critique the use of NI and
EBITDA as proxies for CF
i. Models
Single stage
Multistage
How many variations are there?
Model assumptions &
Firm characteristics
j. Calculate the value of
a company
k. Sensitivity analysis
l. Terminal value
FCFF is preferred to
FCFE when
41.1.
Market-based
Valuation
Types of valuation
indicators
Price multiples
Enterprise value multiples
Momentum indicators
a. Two
methods
Method of comparables
Method based on
forecasted fundamentals
b. Justified price multiple
c,d,g. Price
multiples
P/E
Trailing P/E
Leading P/E
P/B
P/S
P/CF
c,d,g. Dividend
yield (D/P)
Trailing D/P
Leading D/P
e. Underlying earnings
(persistent, continuing,
core); Normalized EPS
Exclude nonrecurring components
(G/L from asset sales, write-downs...)
Method of historical
average EPS
Method of
average ROE
f. Earnings yield (E/P)
h. Calculate
Justified P/E
Justified P/B
Justified P/S
Justified P/CF
Justified EV/EBITDA
Justified D/P
EQUITY LEVEL 2, READING 41
44. c,d,h,n
Multiples
(LOS c,d)
Advantages Disadvantages Notes Justified
(LOS h)
P/E +Popular
+Earnings power (EPS) is the primary
determinant of inv. Value
+Proved by empirical evidence
- EPS might be <0 -->P/E is meaningless
- Earnings have 1 portion that is volatile & transitory -
>difficult to interpret
- Earnings can be distorted by mgmt -->lower
comparability
* Trailing P/E: not useful for
forecastin & valuation
* Leading P/E: not relevant if
earnings are too volatile
P/B +Usually BV>0, more stable
+Firms that primarily hold liquid assets -->BV~V
E
+Useful in valuing companies expected to go out
of biz.
- Not reflect intangible assets (human capital)
- Misleading due to differences in asset size (eg.:
outsource vs. not outsource)
- Different accounting standards -->affect
comparability (eg.: R&D is expensed in US)
- BV #MV b/c of inflation or technological change
Adjustments to BV:
. Exclude intangible assets (GW,
patent)
. Adjust for OBS
. Adjust to reflect fair value
. Adjust for #accounting policies
(eg.: LIFO vs. FIFO)
P/S +S is always >0, even when E,B<0 -->P/S
meaningful for distressed firms
+Not as easy to manipulate/ distort
+Not as volatile -->estimate is more reliable
+Appropriate for start-up companies,
mature&cyclical industries, investment mgmt
companies
- High sales growth -->not mean high operating
profit -->not as meaningful as P/E & P/CF
- Not capture cost differences
- Can still be distorted (eg.: bill-and-hold)
P/CF +CF is harder to manipulate
+P/CF is more stable than P/E
+Avoid "quality of earning" problem of P/E
- If CF=NI+NCC -->ignore NCRev. & WC
- FCFE is preferred to CFO but more volatile
D/P +D/P (with capital gain) contributes to R
investment
+Div less risky than capital gain
- Ignores capital appreciation -->incomplete focus
- "Div displacement of earnings" concept: trade-off
btw div & future earnings (current & future CF)
. Used to value index
. Distinguish:
Trailing D/P=
Leading D/P=
EV/EBITDA
(LOS n)
+Useful when comparing firms with different
leverage and capital intensive (high DA)
+EBITDA usually >0
- When WC increases, EBITDA overstates CFO
- Ignore how revenue recognition affects CFO
- CAPEX #Depr ->EBITDA not capture CAPEX -->
#FCFF -->not linked with valuation theory
41.2
Market-based
Valuation
(cont.)
i. Predicted
P/E ratio
j. Evaluate stock by
method of comparables
k. PEG ratio
l. Use of price multiples in determining
terminal value in a multistage DCF model
m. Alternative definitions of CF
used in price multiples
n. EV/EBITDA
o. Sources of differences in
cross-border valuation comparisons
p. Momentum indicators
q. Over/Fairly/Undervalued
r. Central tendency of a
group of multiples
Arithmetic mean
Harmonic mean
Weighted harmonic mean
Median
42. Residual
Income
Valuation
a. Calculate
RI =
EVA =
MVA =
b. Use of RI models
c. FV of RI
d. Fundamental
determinants of RI
e. Relation
between
RI valuation
Justified P/B ratio
f. Single-stage &
multistage RI model
g. Calculate implied
growth rate (g)
h.
Continuing
RI
is.....
Persistent
factor
Assumptions
RI persists at
current level forever
RI drops
immediately to zero
RI declines over
time to zero
RI declines to LR level
in mature industry
i. Compare
RI
DDM
FCFE
j. RI models
Strengths
Weaknesses
k. Justify the
selection of RI model
l. Accounting
issues
Violations of the clean
surplus relationship
Variations from fair value
Intangible assets effects on BV
Nonrecurring items and other
aggressive accounting practices
International accounting differences
m. Over/Fairly/Undervalued
43.1 Private
Company
Valuation
a. Private
company
valuation
vs. public
Company-specific factors
Stage of lifecycle
Size
Quality & depth of mgmt
Mgmt/SHD overlap
ST investors
Quality of financial & other info.
Taxes
Stock-specific factors
Liquidity
Restrictions on marketability
Concentration of control
b. Uses of private
business valuation
Transaction- related
valuations
Venture capital financing
IPO
Sale in an acquisition
Bankruptcy proceedings
Performance-based
managerial compensations
Compliance- related
valuations
Financial reporting
Tax purposes
Liquidation- related
valuations
c. Definitions
of value
Fair market value
Fair value for financial reporting
Fair value for litigation
Market value
Investment value
Intrinsic value
d. Valuation
approaches
f. Income
approach
Free CF method
Capitalzed CF method
Excess earnings method
Market
approach
Asset-based
approach
43.2 Private
Company
Valuation
(cont.)
e. Estimate
Normalized earnings
CF
g. Elements of
discount rate
Size premiums
Availability and cost of debt
Acquirer vs. target
Projection risk
Lifecycle stage
h. Estimate ke
CAPM
Expanded CAPM
Build-up method
i. Market
approaches
GPCM (Guideline public
company method)
GTM (Guideline
transactions method)
PTM (Prior transaction method)
j. Asset- based
approach
k. Use of discounts
& premiums
Discount for
lack of control
Discount for lack
of marketability
l. Role of
valuation
standards
CFALEVEL2
ALTERNATIVE
INVESTMENTS

44.
Investment
Analysis
a. RE Investment
characteristics
Valuing real
estate
investments
c. Calculate
CFAT
=NOI - debt service - taxes payable
EART
=selling price - selling costs - mortgage balance - taxes on sale
b. Evaluate a real estate
investment using NPV, IRR
d. Potential
problems
with IRR
Multiple IRRs
Ranking conflicts
45. Income
Property
Analysis
And
Appraisal
a. Capitalization rate
vs. discount rate
b. Determine
cap rate by
Market-extraction
method
band- of-
investment
method
built-up
method
c.
Direct
capitalization
approach
Gross income
multiplier technique
d. Contrast
Limitations of the direct
capitalization approach
Selecting the appropriate cap rate
Application to income-producing property
Limitations of the
gross income
multiplier approach
Discontinuous pricing
Lack of information
Gross rent vs. NOI
Distorted selling prices
Unique or non-income
producing properties
46.1. Private
Equity
Valuation
Background: Private equity (PE)
a. Sources of value
creation in PE
1. Re-engineering
2. Favorable debt financing
3. Superior alignment of
interests (also see los b)
b. Aligning
managerial and
ownership interests
in PE firms
Incentives
Compensation
Tag-along, drag-along clauses
Effective
structuring of
investment
terms
Board representation
Noncompete clauses
Priority in claims
Required approvals
Earn-outs
c. Characteristics of
Venture Capital
Buyout Investments
d. Valuation
issues
e. Exit routes in PE
IPO
Secondary market sale
MBO
Liquidation
g. Investing
in PE firms
Risks
Specific risks
General risks
Costs
a
46.2.
Private
Equity
Valuation
(cont)
f. PE
Fund
Structures
Company limited by shares
Limited partnership (Most)
LPs
GP
Most are closed-end
2 businesses
raising fund
managing PE investments
Terms
Should
focus on
aligning
the
interests
of GP &
LPs
Economic
terms
Management fees
Transaction fees
Carried interest
Ratchet
Hurdle rate
Target fund size
Vintage
Terms of the fund
Corporate
governance
terms
Key man clause
Performance disclosure &
confidentiality
Clawback
Distribution waterfall
Tag-along, drag-along clauses
Removal for cause
No-fault divorce
Investment restrictions
Co-investment
Only vailable for "qualified" investors
Fund prospectus
Valuation
NAV
Ways to
determine
NAV
1. At cost, adjusting for subsequent financing and devaluation
2. The minimum of cost or market value
3. By revaluing a portfolio company anytime there is new financing
4. At cost with no adjustment until exit
5. By discounting for restricted securities
6. Less frequently, marked to market by reference to a peer group of
public companies, applying illiquidity discounts to public comparables
Issues in
calculating
NAV
Stale NAV
No definitive method
Undrawn LP capital
Comparison between PE funds
GP usually
values
-->Now, more and more independent parties value
Due diligence of PE
fund investments
PE funds tend to exbihit a strong persistence of returns over time
The performance range between funds is extremely large
Liquidity in PE is typically very limited and thus LPs are locked for the long term
a
46.3. Private
Equity
Valuation
(cont.)
h.
Evaluation
of PE
fund
performance
Quantitative
measures
IRR
Gross IRR
Net IRR
Multiples
PIC
DPI
RVPI
TVPI
i. Calculating
performance
measures
management fees
carried interest
NAV
Multiples
PIC
DPI
RVPI
TVPI
Other analyses
Benchmarks
Components of
performance
from an LBO
Earning growths
Increase in price multiples
Debt reduction
Exit value = investment cost + earnings growth +
increase in price multiple + reduction in debt
j. VC method
1.1. Valuation for a single
financing round
1.2. Valuation for multiple
financing rounds (11 steps)
2. IRR methodology
k. Accounting
for risk when
valuing VC
Adjusting the discount rate (r*)
= (1 + r)/(1 - q) - 1
Adjusting the Terminal Value
using scenario analysis
a
47.1.
Investing
In Hedge
Funds: A
Survey
a. Hedge
fund vs.
Mutual fund
Leverage
Use of derivatives
Disclosure requirements
and practices
Lockup periods
Fee structures
b. Hedge
funds
strategies
Arbitrage-based
Convertible
bond arbitrage
Equity market
neutral
Event driven
Risk arbitrage,
merger arbitrage
Fixed-income
arbitrage
Medium volatility
Global macro
Long-short equity
Managed futures (Commodity
trading advisers - CTAs)
Multi-strategy
Directional hedge
Dedicated short bias
Emerging market
c. Hedge fund
databases and
performance
biases
Hedge fund
database
Variety of databases exist
No database is complete
Own methodology
Reporting to databases is voluntary
Performance
biases
Selection bias (backfill bias)
Survivor bias
a
47.2.
Investing In
Hedge
Funds: A
Survey
d. Factor
models for
hedge fund
returns
Alpha (manager skill) and
beta (market exposure)
Regression model
Use a multitude of
traditional market factors
e. Non-normality
of HF returns
Sources
Implications for
performance appraisal
f. Motivations
for HG
replication
strategies
Simple to manage therefore
offered to investors at low fees
Simplest form vs.
complex form
Separate HF beta
from HF replication
g. Difficulties
in applying
traditional
portfolio
analysis to HG
Developing exp. return assumption: survivor, selection,
stale pricing, backfill biases inherent in HF databases.
Correlation, volatility and beta exposures
can change significantly over time
Warning about the use of mean-variance
optimization and Share ratios: Because standard
deviation is not a complete measure of risk for HF
Individual HF typically have a higher
standard deviation than their style index
h. Funds of
funds vs.
single
manager HF
Reduce the standard deviation
of a HF portfolio (diversify)
High quality managers: significant investment
skill, manager relationship, and research cost
Average performance
Take less factor risk
than a broad HF index
Longer lives and
larger asset inflows
a
CFALEVEL2
FIXED INCOME

48.
General
Principles
Of Credit
Analysis
a. Components
of credit risk
Default risk
=Borrower not pay
Sources of info from
rating agencies
Credit rating
Rating watch
Rating outlook
Credit spread risk
Downgrade risk
Corporate
Credit
Analysis
b. Components- 4 Cs
Character
Covenants
Collateral
Capacity to pay
c,d. Key
financial ratios
Profitability: ROE --> DuPont
Short-term solvency
Capitalization (financial leverage)
Coverage ratios
e. Cash Flow
analysis
# CF, # FCFF, #FCFE
S&P uses:
CF ratios
4 traditional
coverage ratios
Funds from operations / Total debt
Funds from operations / capital spending requirements
(Free operating CF + Interest) / Interest
Debt service coverage = (Free OCF + interest) /
(Interest + annual principal repayment)
Leverage ratio = Debt payback period = Total debt / Discretionary CF
f. Analysis of
High-Yield Issuers
Debt structure Analysis
Corporate structure Analysis
Covenants Analysis
Equity Analysis approach
g. Analysis of
Asset-Backed
securities
Collateral credit quality
Seller/Servicer quality
Cash Flow stress and
Payment Structure
Legal structure
h. Analysis of
Municipal bond
Tax-backed debt
Issuer's debt structure
Budgetary policy
Local tax & Intergovernmental
revenue availability
Issuer's socioeconomic environment
Revenue bonds
Limits of the Basic Security
Flow of funds structure
Rate, or User-Charge,
Covenants
Priority-of-Revenue Claims
Additional-Bonds test
i. Analysis of
Sovereign Bonds
Key
considerations
Economic risk
(ability)
Economic and Income structure
Prospects for economic growth
Degree of fiscal flexibility
Public debt burden
Monetary policy and Price stability
BOP flexibility
External debt and liquidity
Political risk
(willingness)
2 ratings
Local currency debt rating
Foreign currency debt rating
j. Contrast credit
analysis
Corporate bonds vs. ABS
Corporate bonds vs. Municipal securities
Corporate bonds vs. Sovereign debt
49. Term
Structure &
Volatility Of
Interest
Rates
Warm-up: Yield curve shapes
a. Yield
curve
shifts
Parallel shift
Nonparallel shift
Yield curve twist
Butterfly shifts
b. Factors
affecting
Treasury
returns
Changes in the level of
rates (parallel shifts)
Changes in the
slope (twists)
Changes in the
curvature (butterfly)
Warm-up: Spot curves
and bootstrapping
c. Treasury
spot rate curve
All on-the-run
Treasury securities
All on-the-run and
some off-the-run
Treasury securities
All Treasury coupon
securities and Bills
Treasury strips
d. Swap rate curve
(LIBOR curve)
What is it?
As a benchmark
--> reasons:
-
-
-
e. Term
structure
theories
Pure (Unbiased)
expectations theory
Liquidity theory
Preferred
habitat
theory
Warm-up: Calculating
key rate duration
f. Yield
curve
risk
Barbell portfolios
Ladder portfolios
Bullet portfolios
g1. Yield volatility
Historical yield volatility
Implied yield volatility
g2. Forecasting yield volatility
50. Valuing
Bonds With
Embedded
Options
Warm-up:
Binomial model
Binomial interest rate trees
Constructing an arbitrage-free tree
Valuing an option-free bond
with the binomial model
Spread
measures
The nominal spread
The Z-spread
OAS
b. Benchmark
interest rates to
calculate spreads
Treasury securities
A bond sector
Specific issuer
c. Backward induction methodology
d. Callable bond valuation
e. Relations
Vcall =
Vput=
f. Effect of volatility
on arbitrage-free
value of an option
Warm-up: How OAS is calculated
a,g. Relative value analysis
Treasury benchmark
Bond sector benchmark
Issuer-specific benchmark
h. Effective duration and convexity
i. Putable bond valuation
j. Convertible
bonds
Component
values
Conversion ratio
Conversion value
Straight value
Minimum value of a
convertible bond
Market conversion price
Market conversion
premium per share
Premium payback period
Valuing convertible bonds using an
option-based valuation approach
k. Convertible bonds vs.
Common stock
LOAN AMORTIZATION SCHEDULE
500,000
1%
360
$5,143.06
Column 1 Column 2 Column 3 Column 4 Column 5 Column 6
Period
Beginning
Principal
Scheduled
total pmt
Interest
pmt
Scheduled
principal pmt
Beg. Pr less
scheduled pr.
Pmt
1 500,000 5,143 5,000 143 499,857
2 499,857 5,143 4,999 144 499,712
3 499,712 5,143 4,997 146 499,567
4 499,567 5,143 4,996 147 499,419
5 499,419 5,143 4,994 149 499,270
175 433,500 5,143 4,335 808 432,692
176 432,692 5,143 4,327 816 431,876
177 431,876 5,143 4,319 824 431,051
178 431,051 5,143 4,311 833 430,219
179 430,219 5,143 4,302 841 429,378
180 429,378 5,143 4,294 849 428,529
181 428,529 5,143 4,285 858 427,671
182 427,671 5,143 4,277 866 426,804
183 426,804 5,143 4,268 875 425,929
184 425,929 5,143 4,259 884 425,046
185 425,046 5,143 4,250 893 424,153
186 424,153 5,143 4,242 902 423,252
187 423,252 5,143 4,233 911 422,341
188 422,341 5,143 4,223 920 421,421
189 421,421 5,143 4,214 929 420,492
190 420,492 5,143 4,205 938 419,554
191 419,554 5,143 4,196 948 418,607
192 418,607 5,143 4,186 957 417,650
193 417,650 5,143 4,176 967 416,683
194 416,683 5,143 4,167 976 415,707
195 415,707 5,143 4,157 986 414,721
196 414,721 5,143 4,147 996 413,725
197 413,725 5,143 4,137 1,006 412,719
198 412,719 5,143 4,127 1,016 411,703
199 411,703 5,143 4,117 1,026 410,677
200 410,677 5,143 4,107 1,036 409,641
358 15,126 5,143 151 4,992 10,134
359 10,134 5,143 101 5,042 5,092
360 5,092 5,143 51 5,092 0
Loan amount
Mortgage rate (per month)
Number of months
Scheduled total pmt
Fixed income examples Page 1
500,000 PSA 100
1% m=1 to 30: 0.2%
360 m=31 or more 6%
$5,143.06
86.82
Col 1 Col 2 Col 3 Col 4 Col 5 Col 6 Col 7 Col 8 Col 9 Col 10 Col 11 Col 12
Period
Beginning
Principal
Scheduled
total pmt
Interest
pmt
Scheduled
principal
pmt
Beg. Pr less
scheduled
pr. Pmt
CPR SMM Prepmt
Ending
principal
Weights
for
Macaulay
Duration
Life
1 500,000 5,143 5,000 143 499,857 0.20% 0.0167% 83 499,774 0.0005 0.0005
2 499,774 5,143 4,998 145 499,628 0.40% 0.0334% 167 499,461 0.0006 0.0012
3 499,461 5,143 4,995 148 499,313 0.60% 0.0501% 250 499,063 0.0008 0.0024
4 499,063 5,143 4,991 152 498,910 0.80% 0.0669% 334 498,576 0.0010 0.0039
5 498,576 5,143 4,986 157 498,419 1.00% 0.0837% 417 498,002 0.0011 0.0057
80 291,518 5,143 2,915 2,228 289,290 6.00% 0.5143% 1,488 287,802 0.0074 0.5945
81 287,802 5,143 2,878 2,265 285,537 6.00% 0.5143% 1,469 284,069 0.0075 0.6048
82 284,069 5,143 2,841 2,302 281,766 6.00% 0.5143% 1,449 280,317 0.0075 0.6152
83 280,317 5,143 2,803 2,340 277,977 6.00% 0.5143% 1,430 276,548 0.0075 0.6257
84 276,548 5,143 2,765 2,378 274,170 6.00% 0.5143% 1,410 272,760 0.0076 0.6363
85 272,760 5,143 2,728 2,415 270,345 6.00% 0.5143% 1,390 268,954 0.0076 0.6470
86 268,954 5,143 2,690 2,454 266,501 6.00% 0.5143% 1,371 265,130 0.0076 0.6578
87 265,130 5,143 2,651 2,492 262,638 6.00% 0.5143% 1,351 261,288 0.0077 0.6686
88 261,288 5,143 2,613 2,530 258,757 6.00% 0.5143% 1,331 257,427 0.0077 0.6795
89 257,427 5,143 2,574 2,569 254,858 6.00% 0.5143% 1,311 253,547 0.0078 0.6906
90 253,547 5,143 2,535 2,608 250,940 6.00% 0.5143% 1,291 249,649 0.0078 0.7017
91 249,649 5,143 2,496 2,647 247,002 6.00% 0.5143% 1,270 245,732 0.0078 0.7129
92 245,732 5,143 2,457 2,686 243,046 6.00% 0.5143% 1,250 241,796 0.0079 0.7242
93 241,796 5,143 2,418 2,725 239,071 6.00% 0.5143% 1,230 237,842 0.0079 0.7356
94 237,842 5,143 2,378 2,765 235,077 6.00% 0.5143% 1,209 233,868 0.0079 0.7470
95 233,868 5,143 2,339 2,804 231,064 6.00% 0.5143% 1,188 229,875 0.0080 0.7586
96 229,875 5,143 2,299 2,844 227,031 6.00% 0.5143% 1,168 225,863 0.0080 0.7703
97 225,863 5,143 2,259 2,884 222,979 6.00% 0.5143% 1,147 221,832 0.0081 0.7821
98 221,832 5,143 2,218 2,925 218,907 6.00% 0.5143% 1,126 217,782 0.0081 0.7939
99 217,782 5,143 2,178 2,965 214,816 6.00% 0.5143% 1,105 213,712 0.0081 0.8059
140 33,822 5,143 338 4,805 29,017 6.00% 0.5143% 149 28,868 0.0099 1.3871
141 28,868 5,143 289 4,854 24,013 6.00% 0.5143% 124 23,890 0.0100 1.4038
142 23,890 5,143 239 4,904 18,986 6.00% 0.5143% 98 18,888 0.0100 1.4205
143 18,888 5,143 189 4,954 13,934 6.00% 0.5143% 72 13,862 0.0101 1.4374
144 13,862 5,143 139 5,004 8,858 6.00% 0.5143% 46 8,812 0.0101 1.4544
145 8,812 5,143 88 5,055 3,757 6.00% 0.5143% 19 3,738 0.0101 1.4715
146 3,738 3,775 37 3,738 - 0.00% 0.0000% - - 0.0075 1.0915
Loan amount
Mortgage rate (per mth)
Number of months
Scheduled total pmt
average life:
500,000 PSA 90
1% m=1 to 30: 0.2%
360 m=31 or more 6%
$5,143.06
Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 Column 9 Column 10
Period
Beginning
Principal
Scheduled
total pmt
Interest
pmt
Scheduled
principal
pmt
Beg. Pr less
scheduled pr.
Pmt
CPR SMM Prepmt
Ending
principal
1 500,000 5,143 5,000 143 499,857 0.18% 0.0150% 75 499,782
2 499,782 5,143 4,998 145 499,637 0.36% 0.0300% 150 499,487
3 499,487 5,143 4,995 148 499,338 0.54% 0.0451% 225 499,113
4 499,113 5,143 4,991 152 498,961 0.72% 0.0602% 300 498,661
5 498,661 5,143 4,987 156 498,504 0.90% 0.0753% 375 498,129
80 307,999 5,143 3,080 2,063 305,936 5.40% 0.4615% 1,412 304,524
81 304,524 5,143 3,045 2,098 302,426 5.40% 0.4615% 1,396 301,030
82 301,030 5,143 3,010 2,133 298,897 5.40% 0.4615% 1,380 297,518
83 297,518 5,143 2,975 2,168 295,350 5.40% 0.4615% 1,363 293,987
84 293,987 5,143 2,940 2,203 291,784 5.40% 0.4615% 1,347 290,437
85 290,437 5,143 2,904 2,239 288,198 5.40% 0.4615% 1,330 286,868
86 286,868 5,143 2,869 2,274 284,594 5.40% 0.4615% 1,314 283,280
87 283,280 5,143 2,833 2,310 280,970 5.40% 0.4615% 1,297 279,673
88 279,673 5,143 2,797 2,346 277,327 5.40% 0.4615% 1,280 276,047
89 276,047 5,143 2,760 2,383 273,664 5.40% 0.4615% 1,263 272,401
90 272,401 5,143 2,724 2,419 269,982 5.40% 0.4615% 1,246 268,736
91 268,736 5,143 2,687 2,456 266,280 5.40% 0.4615% 1,229 265,051
92 265,051 5,143 2,651 2,493 262,559 5.40% 0.4615% 1,212 261,347
93 261,347 5,143 2,613 2,530 258,817 5.40% 0.4615% 1,195 257,623
94 257,623 5,143 2,576 2,567 255,056 5.40% 0.4615% 1,177 253,879
95 253,879 5,143 2,539 2,604 251,275 5.40% 0.4615% 1,160 250,115
96 250,115 5,143 2,501 2,642 247,473 5.40% 0.4615% 1,142 246,331
97 246,331 5,143 2,463 2,680 243,651 5.40% 0.4615% 1,125 242,527
98 242,527 5,143 2,425 2,718 239,809 5.40% 0.4615% 1,107 238,702
99 238,702 5,143 2,387 2,756 235,946 5.40% 0.4615% 1,089 234,857
140 62,994 5,143 630 4,513 58,481 5.40% 0.4615% 270 58,211
141 58,211 5,143 582 4,561 53,650 5.40% 0.4615% 248 53,403
142 53,403 5,143 534 4,609 48,794 5.40% 0.4615% 225 48,569
143 48,569 5,143 486 4,657 43,911 5.40% 0.4615% 203 43,709
144 43,709 5,143 437 4,706 39,003 5.40% 0.4615% 180 38,823
145 38,823 5,143 388 4,755 34,068 5.40% 0.4615% 157 33,910
146 33,910 5,143 339 4,804 29,107 5.40% 0.4615% 134 28,972
147 28,972 5,143 290 4,853 24,119 5.40% 0.4615% 111 24,008
148 24,008 5,143 240 4,903 19,105 5.40% 0.4615% 88 19,016
149 19,016 5,143 190 4,953 14,063 5.40% 0.4615% 65 13,999
150 13,999 5,143 140 5,003 8,995 5.40% 0.4615% 42 8,954
151 8,954 5,143 90 5,054 3,900 5.40% 0.4615% 18 3,882
152 3,882 3,921 39 3,882 - 0.00% 0.0000% - -
Loan amount
Mortgage rate (per month)
Number of months
Scheduled total pmt
500,000 PSA 300
1% m=1 to 30: 0.2%
360 m=31 or more 6%
$5,143.06
Col 1 Col 2 Col 3 Col 4 Col 5 Col 6 Col 7 Col 8 Col 9 Col 10
Period
Beginning
Principal
Scheduled
total pmt
Interest
pmt
Scheduled
principal
pmt
Beg. Pr less
scheduled
pr. Pmt
CPR SMM Prepmt
Ending
principal
PSA90
90-300
PAC
tranche
1 500,000 5,143 5,000 143 499,857 0.60% 0.0501% 251 499,606 75 75
2 499,606 5,143 4,996 147 499,459 1.20% 0.1006% 502 498,957 150 150
3 498,957 5,143 4,990 153 498,804 1.80% 0.1513% 754 498,049 225 225
4 498,049 5,143 4,980 163 497,887 2.40% 0.2022% 1,007 496,880 300 300
5 496,880 5,143 4,969 174 496,705 3.00% 0.2535% 1,259 495,446 375 375
6 495,446 5,143 4,954 189 495,258 3.60% 0.3051% 1,511 493,747 450 450
7 493,747 5,143 4,937 206 493,541 4.20% 0.3569% 1,762 491,780 525 525
8 491,780 5,143 4,918 225 491,554 4.80% 0.4091% 2,011 489,543 600 600
9 489,543 5,143 4,895 248 489,296 5.40% 0.4615% 2,258 487,038 674 674
10 487,038 5,143 4,870 273 486,765 6.00% 0.5143% 2,503 484,261 749 749
60 176,093 5,143 1,761 3,382 172,711 18.00% 1.6402% 2,833 169,878 1719 1,719
61 169,878 5,143 1,699 3,444 166,434 18.00% 1.6402% 2,730 163,704 1704 1,704
62 163,704 5,143 1,637 3,506 160,198 18.00% 1.6402% 2,627 157,570 1689 1,689
63 157,570 5,143 1,576 3,567 154,003 18.00% 1.6402% 2,526 151,477 1675 1,675
64 151,477 5,143 1,515 3,628 147,849 18.00% 1.6402% 2,425 145,424 1660 1,660
65 145,424 5,143 1,454 3,689 141,735 18.00% 1.6402% 2,325 139,410 1645 1,645
66 139,410 5,143 1,394 3,749 135,661 18.00% 1.6402% 2,225 133,436 1630 1,630
67 133,436 5,143 1,334 3,809 129,628 18.00% 1.6402% 2,126 127,502 1615 1,615
68 127,502 5,143 1,275 3,868 123,633 18.00% 1.6402% 2,028 121,606 1600 1,600
69 121,606 5,143 1,216 3,927 117,679 18.00% 1.6402% 1,930 115,749 1585 1,585
70 115,749 5,143 1,157 3,986 111,763 18.00% 1.6402% 1,833 109,930 1569 1,569
71 109,930 5,143 1,099 4,044 105,886 18.00% 1.6402% 1,737 104,149 1554 1,554
72 104,149 5,143 1,041 4,102 100,048 18.00% 1.6402% 1,641 98,407 1539 1,539
73 98,407 5,143 984 4,159 94,248 18.00% 1.6402% 1,546 92,702 1523 1,523
74 92,702 5,143 927 4,216 88,486 18.00% 1.6402% 1,451 87,035 1507 1,451
75 87,035 5,143 870 4,273 82,762 18.00% 1.6402% 1,357 81,405 1492 1,357
76 81,405 5,143 814 4,329 77,076 18.00% 1.6402% 1,264 75,811 1476 1,264
77 75,811 5,143 758 4,385 71,426 18.00% 1.6402% 1,172 70,255 1460 1,172
78 70,255 5,143 703 4,441 65,814 18.00% 1.6402% 1,079 64,735 1444 1,079
79 64,735 5,143 647 4,496 60,239 18.00% 1.6402% 988 59,251 1428 988
88 16,658 5,143 167 4,976 11,681 18.00% 1.6402% 192 11,490 1280 192
89 11,490 5,143 115 5,028 6,462 18.00% 1.6402% 106 6,356 1263 106
90 6,356 5,143 64 5,080 1,276 18.00% 1.6402% 21 1,255 1246 21
91 1,255 1,268 13 1,255 - 0.00% 0.0000% - - 1229 -
Loan amount
Mortgage rate (per month
Number of months
Scheduled total pmt
51.
Mortgaged-
Backed
Sector Of
The Bond
Market
a. Mortgage loans
b. Mortgage passthrough securities
d. Measuring
prepayment
speeds
CPR
PSA
c. Calculate prepayment
amount for a month
f.
Factors affecting
prepayments
Prevailing mortgage rates
Housing turnover
Characteristics of the
underlying mortgages
Types of
prepayment risk
Contraction risk
Extension risk
e. Average life of an MBS
CMOs
g. Creation and Matching
of assets and liabilities
h. Tranches
Sequential Pay
Accrual tranche
Planned Amortization
Class (PAC)
Support Tranche
i. Risks and
Performance of each
type of CMO tranche
j. Stripped MBS
k. MBS
Agency
Nonagency
Warm-up: Commercial MBS
l. CMBS vs
Residential MBS
m. CMBS: Structure
and Call protection
52. Asset-
Backed
Sector Of
The Bond
Market
a. Securitization
transaction
Structural features
Parties
Seller
Issuer/Trust
Servicer
b. Tranching
Prepayment
tranching
Credit
tranching
c. Securitization
backed by
Amortizing
assets
Non-amortizing
assets
d1. Credit
enhancements
External
Corporate guarantees
Letter of credit
Bond insurance
Internal
Reserve funds
Cash reserve funds
Excess servicing spread funds
Overcollateralization
Senior/Subordinated structure
d2. Shifting
interest
mechanism
e. Cash flow and
prepayment
charateristics for
securities backed by
Home equity loans
Manufactured housing
backed loans
Auto loans ABS
Student loan-backed securities
SBA loan-backed securities
Credit card receivable-backed securities
f. CDO
What is it?
Types
Cash flow CDO
Ramp up phase
Reinvestment phase
Pay down phase
Market value CDO
Synthetic CDO
g. Primary
motivations
for CDO
Arbitrage-driven
Balance sheet- driven
53. Valuing
MBS And
ABS
a. MBS/ABS
spread measures
Cash flow yield
Nominal spread
Zero- volatility spread
b. Monte Carlo
simulation model
Step 1:
Step 2:
Step 3:
Step 4:
Step 5:
c. Path dependency
d. OAS from a Monte
Carlo model
e. OAS analysis
f. Why effective durations reported by
various dealers & vendors may differ
g. Analysing interest rate risk with
effective duration and convexity
h. Other
MBS
duration
measures
Cash flow
duration
Coupon curve
duration
Empirical
duration
i. Spread analysis of
fixed-income securities
Nominal spread
Zero-volatility spread
OAS
CFALEVEL2
DERIVATIVES

54.
Forward
Markets
And
Contracts
Warm-up: Forward contracts
Warm-up:
Forward
contract price
determination
The no-arbitrage principle
A simple version of the Cost-of-Carry model
Cash and Carry arbitrage when the forward contract is overpriced
Reverse cash and carry arbitrage when the forward contract is underpriced
a. Forward
contract
value
At initiation
During the life
At expiration
b. Price and
Value of
Forward on
EQUITY
With discrete dividends
With continuous dividends
c1. Price & Value of
Forward on FIXED INCOME
c2. Price & Value of FRA
c3. Price & Value of
Forward on
CURRENCY
d. Credit risk
55. Futures
Markets And
Contracts
Warm-up: Futures
contracts
a. Futures/Spot
convergence
Warm-up: Futures margins and marking to market
b. Futures contract value
c. Futures vs Forward prices
d. Holding the
underlying asset
Costs
Monetary costs
Non-monetary costs
Benefits
Monetary benefits
Non-monetary benefits
e. Backwardation
vs.
Contango
f. Normal backwardation
&
Normal contango
Warm-up:
Eurodollar futures
Treasury bond futures
Stock index futures
Currency futures
Warm-up: T-Bill futures pricing
g. Difficulties in pricing Eurodollar futures
& creating a pure arbitrage opportunity
h. Calculate
price of
Treasury bond futures
Stock futures
Stock index futures
Currency futures
56. Option
Markets And
Contracts
Warm-up: Put-call parity
for European options
Fiduciary call
Protective put
a1. Using put-call
parity to create
synthetic
Call option
Put option
Bond
Underlying stock
a2. Why
synthetic?
Pricing options
Earning arbitrage profit
b. Binomial
option-pricing
model
One-period
Two-period
Warm-up: Binomial
interest rate trees
Options on Fixed Income Securities
Options on Interest rates: Caps and Floors
c. BSM model
Assumptions: Lognormal, Rf & sigma: constant & known, Frictionless market, No CF, European options.
Limitations
d. The
Greeks
DELTA
Delta
e. Interpreting
e. Use in
dynamic
hedging
GAMMA
Interpreting
f. Effect on
Option's price
Delta
Delta hedge
VEGA
Interpreting
h. Estimate
Historical
volatility
Implied
volatility
RHO
THETA
g. Effect of the underlying asset's
cash flows on option price
i. Put-call parity for options
on forwards (or futures)
j. American vs European options
on forwards and futures
57. Swap
Markets And
Contracts
a. Swap
pricing
valuation
b. Swaps =
I/r swap = FRAs
= 1 call + 1 put
c. Pricing &
Valuing a Plain
Vanilla swap
Plain vanilla swaps as combinations of bonds
Floating rate bond reprices to par at each settlement date
d. Valuing a Currency swap
e. Equity swaps
Swaptions
f. Characteristics
and uses
g. Payoffs and
cash flows
h. Value of i/r
swaption
i. Swap credit risk
j. Swap spread
58. Interest
Rate
Derivative
Instruments
a. Cap and floor
on i/r
on fixed-income
instruments
b1. Payoff for a cap
and a floor
b2. A collar
59. Using
Credit
Derivatives
To Enhance
Return And
Manage Risk
a. Credit default
swaps (CDS) vs.
Corporate bonds
b. Advantages
over other
credit
instruments
Risk management
Short positions
Liquidity
Flexibility
Confidentiality
c1. The
use of
credit
derivatives
by
Commercial banks
Investment banks
Hedge funds
Life Insurance, Property & casualty insurance,
Reinsurers & monoline companies
c2. Structured
credit products
d. Credit
derivative
strategies
Basis
trade
Curve
trade
Index
trade
Options
trade
Capital
structure
trade
Correlation
trade
CFALEVEL2
PORTFOLIO
MANAGEMENT

60. Portfolio
Concepts
a. Mean-
Variance
analysis
Assumptions
Risk averse investors, parameters are known
and used, no taxes or transaction costs
Portfolio expected return
Standard deviation
b. Frontiers
Minimum variance frontier
Efficient frontier
c. Diversification
Effect of correlation on diversification
Effect of number of assets on diversification
d. CAL and CML
Equally-weighted
portfolio risk (variance)
CAL
CML
e. CAPM
4 assumptions
Inputs needed: E(R), s, cov.
Homogeneous expectation
Borrow and lend at risk free rate
Unlimited short-selling
No trx cost, no tax
Perfect competitive market
f. SML
Market risk premium
Beta
Financial market equilibrium
CML # SML
Risk measure
Application
Definition
Slope
g. Market model
(single factor model)
2 sources of risks
3 assumptions
E(error)=0
covar (Rm, error)=0
uncorrelated unsystematic
risk across assets
Predict
Expected returns
Variances
Covariances
h. Adjusted betas
i. Instability in
the minimum
variance frontier
Reasons
Reliability
Statistical inputs are forecast
Time instability
Forecast from historical sample--> change over time
Overfitting problem
Small changes cause large change
j. Multifactor models
Macroeconomic factor models
k. Portfolio expected return
Fundamental factor models
Statistical factor models
l. Arbitrage
Pricing Model
Assumptions
APT equation
APT # Multifactor
m. Active
return and risk
Active return
(tracking error)
Active risk
(tracking risk)
Active factor risk
Active specific risk
Information ratio
Uses of factor and
tracking portfolios
n. CAPM # APT
a
61. A Note
On Harry M.
Markowitz's
" Market
Efficiency: A
Theoretical
Distinction
And So
What?"
a. CAPM
CAPM
assumptions
Borrow and
Lend at risk
free
Unlimited
short selling
CAPM
implications
Market portfolio on
efficient frontier
Linear relationship
between return and beta
b. Consequences of
restrictions on
borrowing at risk free rate
short selling
a
62.
International
Asset
Pricing
a,b. International
market integration
Integration vs.
Segmentation
Impediments to
international flow
of capital
Psychological barriers
Legal restrictions
Transaction costs
Discriminatory taxation
Political risks
Foreign currency risk
b. Factors that favor
international market
integration
Many private and institutional investors who are internationally active
Essentially all major corporations have multinational operations
Corporations and Governments borrow and lend on an international scale
Standard
CAPM
2 basic results
Separation theorem
Risk-pricing relationship
c. Assumptions
of domestic
CAPM
Risk-averse investors
Homogeneous expectations
Investors concerned with nominal returns in home currency
Risk free security available for lending and borrowing
No taxes, no transaction costs
d. Extended
CAPM
Elements
Risk-free rate = Investor's domestic risk free rate
Market portfolio = All risky assets in the world
Additional assumptions
(unreasonable)
Investors have identical consumption baskets
PPP holds exactly
ICAPM
Warm-up: domestic and foreign currency returns
e. Real e/r and domestic
currency returns
f. Calculate
Expected exchange rate
Domestic-currency HPR
on a foreign bond
g. Calculate
End-of-period real e/r
Domestic currency ex-post
return on a foreign bond
h. Calculate foreign
currency risk premium
i. ICAPM Formula
Investor's domestic risk free rate
World market risk premium
Sensitivity of asset to changes
in all foreign currencies
j. Effect of market segmentation on ICAPM
k. Currency exposure
l. Exchange rate exposure
m,n
E/R and domestic
economy/ equity
Traditional
model
J-curve effect: Trade
balance - Currency
Equity exposure
Money
demand
model
E/R and bonds
(i.e. E/R and I/R)
Free markets theory
Government intervention theory
63. Theory
Of Active
Portfolio
Management
a. Justify ACTIVE PM
b1.
Treynor-
Black
model-
steps
1
2
3
4
5
b2. Treynor-
Black
Calculations
Stock alphas
Weightings
Portfolio A
Alpha
Expected
return
Standard
deviation
forecast
Covariance A and
Market index M
b3. Treynor-Black:
Efficient market periods
vs.
Inefficient market periods
c. Measure accuracy in
forecasting alphas
a
64. PM
Process
And
Investment
Policy
Statement
Warm-up:
elements of PM
Evaluating investor and
market characteristics
Developing an investment
policy statement
Determining an asset
allocation strategy
Measuring and
evaluating performance
Monitoring dynamic investor objectives
and capital market conditions
a. Importance of the
PORTFOLIO perspective
PM
process
Step 1:
Planning
c1.
Objectives
Risk objectives
Return objectives
c2.
Constraints
Liquidity
f. Time horizon
f. Legal and
regulatory
concerns
f. Tax
considerations
f. Unique
circumstances
d. IPS
Role of IPS
Elements of IPS
e. Strategic Asset allocation:
3 common approaches
Passive
Active
Semi-active,
risk-controlled active
or enhanced index strategies
PM process Step 2: Execution
PM process Step 3: Feedback
g. Ethical conduct in managing
investment portfolios
p

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