2012 Level 2 Mindmaps-1

ChangesinCFAlevel2curriculum2012
SosnhCFAcurriculumlevel2nm2012vinm2011thccthayichyulloibbtccphnlctrcvit
trnglphoclanman,rmr.Sloibnylmchoslngreadingscalevel2gimt70readingsnm2011
xungcn64readingsnm2012.Cnkinthcthmvonhiunhtlreading47(InvestinginHedgeFunds:a
survey)camnAlternativeInvestments.
MnAlternativeInvestments:Reading50cCommodity(hcvContango,Backwardation,rollyield)bloib,
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
bbchaimhnhkhthvl1.Franchisemodel(tnhintrinsicP/EtheotangibleP/E(1/r)vFranchiseP/E(=
franchise factor x growth factor)) v 2. cng thc tnh P/E vi s gp mt ca inflation flow through rate. Cc
readingscnlicthayinhmthaiLOSkhngngk.
MnEconomics:Reading17cExchangeratesandBalanceofPaymentbloib.Nidungnycaxung
level1(thamkholevel1reading20InternationalTradeandCapitalFlowsvreading21CurrencyExchangeRates).
MnFixedIncome:Reading54cLiquidityconundrum(ccptiMinskyhypothesisvgiithchldokhng
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
Page 2
All CFA Institute members and candidates are

required to comply with the Code and Standards
Basic structure
for enforcing
the Code and
Standards
The CFA
Institute
Bylaws
Rules of
Procedure
Structure of the CFA

Institute Professional
Conduct Program
Professional
Conduct
program
(PCP)
Fair process to
member and
candidate
Based on
two
primary
principles
Confidentiality
of proceedings
Maintains oversight
and responsibility
The CFA
Institute
Board of
Governors
Is responsible for the

enforcement of the
Code and Standards
Through the Disciplinary

Review Committee (DRC)
The CFA
Designated
Officer
Conducts professional
conduct inquiries
Directs Professional
Conduct Staff
An inquiry can be prompted

by several circumstances
a1.
Requesting a written
explanation from the
member or candidate
1. Code Of
Ethics And
Standards
Of
Professional
Conduct
The Professional
Conduct staff
conducts an
investigation that
may include
Process for the
enforcement of
the Code and
Standards
The member or candidate

Interviewing
Complaining parties
Third parties
Collecting documents
and records in support
of its investigation
When an
inquiry is
initiated
Conclude the inquiry with

no disciplinary sanction
Issue a cautionary letter
Upon reviewing the
material obtained during
the investigation, the
Designated Officer may
Continue
proceedings to
discipline the
member or
candidate
If finding that a
violation of the
Code and
Standards
occurred, the
Designated Officer
proposes a
disciplinary
sanction
Accepted by
member
Rejected by
member
Six components of
the Code of Ethics
a2.
Seven Standards of
Professional Conduct
b. Ethical
responsibilities
Page 3
The matter is
referred to a
hearing by a
panel of CFA
Institute
members
Guidance
A.
Knowledge
of the law
Recommended procedures for compliance (RPC)

Application
Maintain independence and objectivity in professional activities

Gifts
Invitations to lavish functions

Tickets
By benefits
Favors
Job referrals
External
pressures
Allocation of shares in oversubscribed

IPOs to investment managers
....
From public
companies
May try to pressure sell-side analysts
From Buy-side clients
How to cope
with external
and internal
pressures
e.g. to issue favorable research

reports/recommendations for certain companies
From their
own firms
Internal
pressures
Guidance
To issue favorable reports
-->Modest gifts and entertainment are

acceptable but special care must be taken
B. Independence
and objectivity
to issue favorable research on current or

prospective investment-banking clients
Investment-banking
relationships
Conflicts of interest
-->must disclose to employers
-->Best practice: reject any offer of gift,..threatening independence and objectivity

convey true opinions
-->
-->Recommendations must
free of bias from pressures

be stated in clear and unambiguous language
-->Portfolio managers must respect and foster honesty of sell-side research

Is fraught with conflicts
Must engage in thorough, independent, and unbiased analysis
Must fully disclose potential conflicts, including the nature of compensation
Issuer-paid
research
-->Analysts
Must strictly limit the type of compensation they accept for conducting research
Best practice
Accept only flat fee for their work prior to writing the report
W/O regard to conclusions or reccomendations
Protect integrity of opinions

Create a restricted list
2.1 Standard I
PROFESSIONALISM
Restrict special cost arrangements

RPC
Limit gifts
Equity IPOs
Restrict employee investments
Private placements
Review procedures
Written policies on independence and objectivity of research
any untrue statement or omission of a fact
Definition of
"Misrepresentation"
or any fasle or misleading statement
Must not knowingly make

misrepresentation or give
false impression in
oral representations, advertising

electronic communications
written materials
qualifications or credentials, services
Must not misrepresent any

aspect of practice, including
Guidance
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
employers
C. Misrepresentation
associates
Standard I(C) prohibits plagiarism in
preparation of material for distribution to
clients
prospects
general public
Written list of available services, description of firm's qualification

Designate employees to speak on behalf of firm
RPC
Prepare summary of qualifications and experience, list of services capable of performing

Maintain copies
To avoid plagiarism
Attribute quotations
Attribute summaries
Address conduct related to professional life

Any act involving lying, cheating, stealing, other dishonest conduct that reflects adversely on
member's professional activities would be violation
Guidance
Violations
D.
Misconduct
Conduct damaging trustworthiness or competence

Abuse of the CFA Institute Professional Conduct Program
Develop and/or adopt a code of ethics

RPC
Disseminate to all employee a list of potential violations

Check references of potential employees
Page 4
Definition of "Material
nonpublic information"
Must be particularly aware of info
selectively disclosed by corporations
Analysis of Public info +
nonmaterial nonpublic info -->
Investment conclusion
Guidance
Mosaic Theory
Analysts are free to act on

this collection of info w/o
risking violation
Analysts should save and
document all their research
Make reasonable efforts to achieve

public dissemination of material info
A. Material
nonpublic
information
(MNI)
If public dissemination
is not possible,
RPC
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
adopt compliance procedures
preventing misuse of MNI
2.2 Standard II
INTEGRITY OF
CAPITAL
MARKET
Encourage
firms to
develop & follow disclosure policies

to ensure proper dissemination
use "firewall"
Prohibition of all proprietary trading while firm

is in possession of MNI may be inappropriate
Definition
Transactions that artificially
distort prices or volume
can be
related to
B. Market
manipulation
Standard II(B)
not meant to
transactions that deceive

market participants
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
prohibit legitimate trading strategies

prohibit transactions done for tax purposes
The intent of action is critical to determining

whether it is a violation of this Standard
Page 5
duty to
exercise
reasonable
care
Prudence
require cautions
and discretion
act with care, skill, and diligence

follow the investment parameters set forth
by clients & balancing risk & return
Understand & adhere

to fiduciary duties
Responsibility
to a client
includes
Guidance
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
duty of
loyalty
Put their obligation to client first in all dealings

Avoid all real or potential conflicts of interest
A. Loyalty,
prudence,
and care
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"
Submit to clients at least quarterly itemized statements
Separate assets
RPC
Review investments periodically

Establish policies & procedures with respect to proxy voting and the use of client brokerage
Encourage firms to address some topics
Do not discriminate against any clients

"Fairly" vs "equally
Standard III(B) addresses the manner of disseminating investment
recommendations or changes in prior recommendations to clients
Ensure fair opportunity to act on
Encourage firms to design equitable system to prevent
selective, discriminatory disclosure
Investment
recommendations
Guidance
2.3
Standard
III
DUTIES
TO
CLIENTS
B. Fair
dealing
Material changes should be

communicated to all current clients
Clients who don't know changes
and therefore place orders contrary
to a current recommendation
particularly clients may have acted on

or been affected by earlier advise
should be advised of the
changed recommendation
before the order is accepted
Treat all clients fairly in light of their

investment objectives & circumstances
Investment
actions
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
Be sure to gather client info in the form of an IPS and make suitability
analysis prior to making recommendation/taking investment action
Guidance
In investment
advisory
relationships
Inquiry should be repeated at least annually/prior to material changes

If clients withhold info
Risk analysis
C. Suitability
Fund managers
In case of unsolicited trade requests unsuitable for client
RPC
Standard III(D) prohibits misrepresentaions of past performance

or reasonably expected performance
--> Provide credible performance info
Guidance
D. Performance
presentation
-->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
Standard III(E) is applicable when members receive info

Guidance
Comply with applicable laws

When in dout
E. Preservation of
confidentiality
-->consult with compliance department/outside counsel before disclosing
Standard III(E) does not prevent cooperating with an investigation by CFAI PCP
RPC
Page 6
In matters related to their employment, members

and candidates must not engage in conduct that
harms the interests of the employer
Employeremployee
relationship
-->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
Abstain from independent competitive activity

that could conflict with employer's interests
Independent
practice
Provide notification to employer, obtain
consent from employer in advance
Planning to leave, must continue

to act in employer's best interest
Must
A. Loyalty
2.4 Standard IV
DUTIES TO
EMPLOYERS
Firm records or work performed on behalf

of firm stored on a home computer should
be erased or returned to employer
engage in activities conflicting with
duty until resignation effective
Leaving an
employer
Must not
contact existing clients/potential

clients prior to leaving for soliciting
take records of files to a new

employer without written permission
Free to make arrangements/preparations
provided that not breaching duty of loyalty
Applicable non-compete agreement
Whistleblowing
Nature of employment
Guidance
B. Additional
compensation
arrangements
RPC
Obtain written consent from employer before accepting

compensation or other benefits from third parties...
Should make an immediate

written report to their employers
C. Responsibilities of
supervisors
Page 7
investment philosophy followed

role of member in the
investment decision-making
process
The application of Standard

V(A) depends on
support and resources

provided by employer
Must make reasonable efforts to cover all pertinent
issues when arriving at recommendation
Guidance
A. Diligence and
reasonable basis
Provide or offer to provide supporting info to clients when

making recommendations/changing recommendations
-->must make reasonable &diligent efforts to
determine whether 2nd/3rd party research is sound
Using secondary or
third-party research
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
Standard V(B) addresses conduct with respect to communicating with clients

Communication is not confined to written
form but via any means of communication
Developing and maintaining clear, frequent, and
thorough communication practices is critical
2.5
Standard V
INVESTMENT
ANALYSIS,
RECOMMENDATIONS
& ACTIONS
distinguish clearly between facts & opinions

present basic characteristics of the analyzed
security in preparing research report
Must
adequately illustrate to clients & prospective clients the manner

of conducting investment decision-making process
keep them informed with respect to changes
to the chosen investment process
Guidance
B. Communication
with clients and
prospective clients
-->must be supported by background

report or data on request
Brief
communications
-->should notify clients that additional info and

analyses are available from the producer of the report
Capsule form
recommendations
Investment advice
based on quantitative
research and analysis
-->must be supported by readily

available reference material
-->in a manner consistent with previously applied
methodology or with changes highlighted
Should outline known limitations, consider

principal risks in investment analysis, report
RPC
In hard copy or electric form
Guidance
Fulfilling regulatory requirements may

satisfy the requirements of this Standard
C. Record retention
Absence of regulatory guidance,
Must explicitly determine

whether it does
CFAI recommends
maintaining records for at
least 7 yrs
RPC
Page 8
is a critical part of working in investment industry

Managing
conflicts
Best practice is to avoid conflicts

of interest when possible
can take
many forms
If not, disclosure is necessary
prominent
Disclosures
must be
made in plain language

in a manner to effectively communicate the info to clients
between member or
their firm and issuer
Relationships
Guidance
Disclosure
to clients
A. Disclosure
of conflicts
All matters
may impair
objectivity
investment banking
underwriting and financial
relationships
Broker/dealer market-making activities

Material beneficial ownership of stock
Investment personnel also serves as a director
should disclose material beneficial ownership
interest in securities/investment recommended
-->Sell-side
members
Disclosure of
conflicts to
employers
What?
How?
Same circumstances with clients

Any potential conflict situation
Enough info
Other requirements
2.6
Standard VI
CONFLICTS
OF INTEREST
Clients & employers' transactions have priority

-->personal investment positions
or transactions should never
adversely affect client investments
Co-investment
may occur
client is not disadvantaged by the trade
Conflicts of
interests
-->make sure
investment professional complies with

applicable regulatory requirements
Guidance
B. Priority of
transactions
investment professional does not benefit

personally from trades undertaken for clients
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
should be treated like other accounts
Family accounts (that
are client accounts)
if member has
beneficial ownership
-->may still be subject to

pre-clearance or reporting
requirements
employer
whom
client
prospective client
compensation
Inform
C. Referral fees
what
consideration
benefit
received from, or paid to, others
how
before entry into any formal agreement

nature of the consideration or benefit
Page 9
Cheating on CFA exam or any exam
Prohibiting any conduct that

undermines the integrity of
the CFA charter
A. Conduct as
members and
candidates in
the CFA
program
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
2.7 Standard VII

RESPONSIBILITIES
AS CFA MEMBER /
CANDIDATE
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
B. Reference to
CFA Institute, the
CFA Designation
and the CFA
program
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)
Page 10
are voluntary standards for Members
To give a clear guidance to investment managers on what products and

services are appropriate for a manager to purchase with client brokerage
Research
To clarifiy the manager's duty to clearly justify the use of

client brokerage to pay a portion of mixed-use product
Mixed-used products
Soft Dollar
Standards (SDS)
To enable all parties dealing with SD practices to have a

common understanding of all of the different aspects of SD
Definitions
focus on 6
key areas
To obligate
investment
managers to
Disclosure
Record keeping
clearly disclose their SD practices

give detailed info to each client when requested
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
Investment Manager directs transactions to a Broker, in exchange for which

Broker provides brokerage and research services to the Investment Manager
a1. Define "Soft Dollar"

Arrangements
include
Proprietary Research
Arrangements
Third-party Research Arrangements
Not include Client-directed Brokerage Arrangements
Agency trade
A transaction involving the pmt of a commission
Principal trade
3.1 CFA Institute

Soft Dollar
Standards
Soft dollar
practices
Brokerage
a2. Some definitions
Research
A transaction involving a "discount" or a "spread"
involve the use of client brokerage by an investment manager to obtain products

and services to aid the manager in investment decision making process
The amount on any trade retained by a broker
to be used directly or indirectly as pmt for
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
Mixed-Use
Proprietary research
Third-party research
Services and/or products,

provided to an investment
manager by a broker through
a Bokerage Arrangement
used for both
Client-directed
brokerage
arrangement
Investment decision making process

Management of the
investment firm
An arrangement whereby a client directs that trades

for its account be executed through a specific broker
2 key principles
of SDS
in exchange for which the client receives a

benefit in addition to execution services
1. Brokerage is the
property of client
obtain best execution
2. Investment managers
have a duty to
minimize transaction costs

use client brokerage to benefit clients
a3. General principles of

Soft Dollar Standards
Full and fair disclosure of the investment

manager's use of a client's brokerage
CFAI SDS are
intended to ensure
Consistent presentation of info->all parties

clearly understand brokerage practices
Uniform disclosure and record keeping
High standards of ethical practices
within the investment industry
Page 11
I. General
II. Relationships with clients
III. Selection of brokers
b. Critique company SD
practices and policies
IV. Evaluation of research

V. Client-directed brokerage
VI. Disclosure
VII. Record keeping
Level 1- Define the Product/Service
c. Permissible
research guidance
Level 2- Determine Usage

Level 3- Mixed Use Analysis
3.2 CFA Institute

Soft Dollar
Standards (cont.)
Page 12
specific, measurable standards
CFAI-ROS are
intended to be
for managing and disclosing conflicts of interest
that may impede a research analyst's ability to conduct independent research and make objective recommendations
a
a. Objectives of Research Objectivity Standards (ROS) (p.104)
Compliance and legal department
Corporate issuer
Covered employee
Immediate family
Investment advisory relationship
Investment banking
Investment manager
Definitions
Personal investments and trading

Public appearance
Quiet period
Research analyst
Research report
Restricted period
Subject company
Supervisory analyst
1. Research objective policy
2. Public appearances
Requirements
and
recommended
compliance
procedures
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
4. CFA Institute
Research
Objectivity
Standards
Page 13
a
Case outline
5. The Glenarm Company
Case results
Case outline
5.6.7 Case Studies
6. Preston Partners
Case results
Case outline
7. Super Selection
Case results
Page 14
a. Trade allocation
practice critique
8. Trade Allocation:
Fair Dealing And
Disclosure
b. Appropriate response
to inadequate trade
allocation practices
Page 15
a. Critique disclosure of
investment objectives
and basic policies
9. Changing
Investment
Objectives
b. Appropriate
response to
inadequate
disclosure
procedures
Page 16
Warm-up: The Old

Prudent Man Rule
1. Diversification is fundamental to risk minimization

2. Trustees must base an investment's appropriateness on risk/return profile
a. Basic
principles
of the New
Prudent
Investor
Rule
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
Care
Skill
A trustee must
exercise
b. General
Fiduciary
Standards
Caution
Loyalty
Impartiality
10. Prudence In
Perspective
The Old PMR
Use of total return
Risk management
c. Differentiate
The New PIR
Evaluation in a portfolio context

Security restrictions
Delegation of duty
1. Economic conditions
2. Effect of inflation and deflation
3. Impact of investment decisions on the beneficiary's tax liability
d. Key
factors
should be
considered
when
investing
and
managing
trust assets
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
liquidity
7. Needs for
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
Page 17
CFALEVEL2
QUANTITAVE
ANALYSIS
Page 18
EXAMPLE READING 11: (Excel output)
Observation
1
2
3
4
5
6
7
8
9
10
12
13
10
9
20
7
4
22
15
23
50
54
48
47
70
20
15
40
35
37
Regression Statistics
Multiple R
0.47512
R Square
0.22574
Adjusted R Square
0.12896
Standard Error
15.05668
Observations
10
ANOVA
df
1
8
9
Regression
Residual
Total
SS
528.77
1,813.63
2342.4
Coefficients Standard Error

25.5586
11.5324
1.1883
0.7780
Intercept
X
MS
528.77
226.70
t Stat
2.2163
1.5272
F
2.33
P-value
0.0575
0.1652
RESIDUAL OUTPUT
Observation
1
2
3
4
5
6
7
8
9
10
Significance F
0.17
Lower 95%
Upper 95% Lower 95.0% Upper 95.0%
-1.0351
52.1523
-1.0351
52.1523
-0.6059
2.9824
-0.6059
2.9824
PROBABILITY OUTPUT
Predicted Y
39.8176
41.0059
37.4411
36.2529
49.3236
33.8764
30.3116
51.7001
43.3824
52.8884
Residuals
Standard Residuals
10.1824
0.7173
12.9941
0.9154
10.5589
0.7438
10.7471
0.7571
20.6764
1.4565
-13.8764
-0.9775
-15.3116
-1.0786
-11.7001
-0.8242
-8.3824
-0.5905
-15.8884
-1.1192
Percentile
5
15
25
35
45
55
65
75
85
95
Y
15
20
35
37
40
47
48
50
54
70
Page 19
Sample covariance
Sample correlation coefficient
a.
Scatter plot
Outliers
b. Limitations to
Correlation analysis
Spurious correlation
Nonlinear relationships
c. Hypothesis testing of
correlation coefficient
Dependent (Y)
11.1.
Correlation
And
Regression
Explained variable
Endogeneous variable
Predicted variable
d. Variables in a
linear regression
Independent (X)
Explanatory variable
Exogenous variable
Predicting variable
linear relationship
independent variable uncorrelated with residuals
e1. Assumptions
underlying linear
regression
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
e3. Regression
coefficients
Sum of Squared Errors (SSE)

Odinary Least Squares (OLS)
Slope coefficient
Intercept
Page 20
f1. SEE (Standard

Error of Estimate)
f2. Coefficient of
determination (R^2)
f3. Regression coefficient

confidence interval
g. Regression coefficient
t-test: b1=0
11.2.
Correlation
And
Regression
h. Predicted value of
the dependent variable
Y=
Confidence intervals
SST (Total Sum of Squares)

RSS (Regression Sum of Squares)
i. ANOVA
(Analysis
Of
Variance)
SSE (Sum of Squared Errors)

R^2 and SEE
F-Statistic
Multiple regression
Simple regression
Parameter instability
j. Limitations of
regression analysis
Limited use if others aware

and act the same
Invalid assumptions
Heteroskedastic
Autocorrelation
Page 21
Warm-up: Multiple regression basics

a
Equation
a. Multiple
regression
Interpretation
Intercept term
Partial slope
coefficients
Hypothesis
b. Regression
coefficient testing
Statistical significance
Interpreting p-values
Other tests of the regression coefficients
c1. Confidence intervals for

regression coefficient b
c2. Predicted
value for Y
12.1. Multiple
Regression &
Issues In
Regression
Analysis
Linear relationship Y -- X
Independent variables X
Not random
No linear relation X -- X
d. Multiple regression
assumptions
Expected value = 0
Error term
Variance is constant
Not correlated with one another
Normal distribution
e. F-statistic
f. Coefficient of
Determination
R2 vs. Adjusted R2
g. ANOVA tables
Independent variables is
binary in nature
h. Dummy
variables
To quantify impact of
qualitative events
Coefficients in a Dummy
variable regression
Page 22
LOS 12 i,j: Assumption violations

Assumption
Violation
Heteroskedasticity
Phng sai khng ng nht
Multicolinearity
T tng quan
a cng tuyn
(esp. in time series)
Definition
Detecting
Serial Correlation (Autocorrelation)
2 types:
. Unconditional:
2 types:
. Positive:
. Conditional:
. Negative:
. Residual plots ( th phn d):
. Residual plots:
. Breusch-Pagan test:
. DW (Durbin-Watson) test:
. Standard errors:
. Positive: data cluster standard errors

too. t-stat too .. ..
. High R2, reject F-test but not any t-tests

. Rule of thumb:
Effects on
regression
analysis
. t-test:
. F-test:
. Negative: data diverge
. F-test: unreliable
Correcting
NOTES:
. Adjust standard errors:

Robust std. errors
White-corrected std. errors
Heteroskedasticity-consistent std. errors
recalculate t-stats
. Adjust standard errors:

Hansen-White std. errors
. Omit 1 or more variables (not easy, must

use stepwise regression)
(correct both heteroskedasticity & autocorrelation)
Serial correlation consistent

recalculate t-stats
. Improve specification (include seasonal terms)
. Regression analysis tests (t-tests, F-tests):H0: bad model (Reject H0 good model)
. Assumption tests:H0: no violation (Fail to reject H0 good model)
Page 23
Warm-up: Why multiple

regression isn't easy as it looks
What is it?
Unconditional
Conditional
Effects on regression analysis
i1. Heteroskedasticity
Detecting heteroskedasticity
Correcting heteroskedasticity
What is it?
Assumption
violations
Positive
Negative
i2. Serial correlation

(autocorrelation)
Detecting
Correcting
12.2. Multiple
Regression &
Issues In
Regression
Analysis
is
j. Multicollinearity
Detecting
Correcting
Warm-up: Model specification

Subcategory 1: Misspecified
functional form
Misspecification 1: Omitting a variable

Misspecification 2: Variables should be transformed
Misspecification 3: Incorrectly pooling data
k. Model
misspecification
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
Probit and logit models
l. Models with qualitative

dependent variables
Discriminant models
m. Interpreting regression results

Page 24
a. 2 models
Linear trend model
Log-linear trend models
Trend
models
b1. Which model is best?

b2. Limitations of
trend models
Autocorrelation
d. Structure of an AR
model of order p
Autoregressive
(AR) models
Forecasting with an
autoregressive model
e. Autocorrelation & Model fit
13.1. TimeSeries
Analysis
Definition
Detecting
Correcting
l. Seasonality
Forecasting with an AR
model with a seasonal lag
In-sample forecasts
g. In-sample and
out-of-sample
forecasting
Out-of-sample forecasts
Root mean squared
error criterion (RMSE)
h. Regression coefficient instability

Constant and finite expected value
3 conditions
c. Covariance
stationarity
Constant and finite variance

Constant and finite covariance
with leading or lagged values
Significance of a series
not being stationary
Page 25
Mean reversion
f.
Calculate a
mean-reverting level
Random walk
i. Random walks
Random walk with a drift

Covariance stationarity
j. Unit roots
13.2. TimeSeries
Analysis
First differencing
k,n. Nonstationarity
and cointegration
Unit root test for

nonstationary
Cointegration
m. Autoregressive conditional
heteroskedasticity (ARCH)
o. Choosing the correct model
Page 26
CFALEVEL2
ECONOMICS
Page 27
Warm-up: Economic
growth (EG)
Rule of 70
Estimating EG
Land
Capital goods
a1. Sources of EG
Labor
Entrepreneurial ability
Markets
a2. Preconditions for

E.G.- Incentive system
Property rights
Monetary exchange
Labor productivity
=Real GDP per labor hour
Definition
of PC
The
productivity
curve (PC)
1. Growth in capital per labor hour --> movement along PC
2 properties of PC
2. Technological growth --> shift PC upwards

Law of
diminishing
returns
b. The ONE-THIRD Rule
14. Economic
Growth
Increasing the growth of physical capital

Three ways
Technological advance
Investment in human capital
c. Faster
economic
growth
Stimulate saving
Stimulate R&D
-->Suggestions
Target high-technology industries

Encourage international trade
Improve the quality of education
Growth in GDP: not permanent

When real GDP per person above subsistence level --> population explosion -->
real GDP per person back to subsistence level
Classical GT
Figure
d. Growth
theories
(GT)
Technological change --> increased saving & investment -->

capital per labor hour increase --> long term growth in GDP
Neoclassical GT
Different from classical

GT: population growth
Technological growth
Independent of econ. growth (or real wage rate or real GDP)

But influenced by opportunity cost to women for entering workplace
Not influenced by economic growth
Occur through trial & error (R&D)
Based on 2 properties of market economies
New GT
Technological
change
2 other key
assumptions
Discoveries are the result of choices

Discoveries lead to profit & competition eliminates profit
driven by profit
there is ongoing search to discover technologies
Discoveries are public capital goods
Law of diminishing returns does
not apply to knowledge capital
--> no mechanism to stop economic growth
Page 28
Warm-up: Natural monopolies

a
Economic regulation of
natural monopolies
Rationale for
a.
15. Regulation And

Antitrust Policy In A
Globalized Economy
b. Social
regulation
Social regulation of
nonmonopolistic industries
Potential
benefits
Possible
negative
side effects
Creative
response
Feedback
effect
Capture
hypothesis
Conform to the letter (the words),

but not to the intent
is a typical example of
creative response
New regulation changes consumers'
behavior --> undermine the original intent
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
c.
Regulators'
behavior
Share-the-gains,
share-the-pain
theory
Legislators
Regulators try to
satisfy all 3 parties
Customers
Regulated firms
Page 29
Comparative
advantage
Concept
Specialize in low-opportunity-cost goods --> export
Law of comparative
advantage
Import high-opportunity-cost goods
a.
How countries can gain
from international trade
Warm-up: Consumer
and producer surplus
a
Tariffs
--> increase price of imported goods --> reduce imports --> benefit domestic producers
tariff=tax --> benefit government
higher price
License to import a limited
amount --> reduce supply -->
Quotas
b. Barriers
to trade
Voluntary
export
restraints
(VERs)
less foreign competition -->

benefit domestic producers
firms with import licenses get the gains
deadweight loss
Non-tariff
barriers
lower equilibrium domestic quantity
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.
16. Trading With

The World
Argument:
Infant-industry
argument
Critiques:
infant industries should be protected while they get

up to world standards of productivity and quality
Benefits not the whole economy but to firms &
workers in those industries
Tariff or quota is market distorting --> Government subsidy is better
Exporters should be prohibited from selling

goods abroad at less than production cost
Difficult to estimate
production costs
Arguments with
some support
Dumping
argument
--> Anti-dumping law:

Critiques:
price lower than in foreign firms'

market is not evidence of dumping
drive domestic firms
out of business -->
c. Critque
the
arguments
for trade
restrictions
Argument
National
security
argument
Arguments with
very little support
Critiques:
still have competition from

other countries
those domestic firms could re-enter
when foreign firms raise prices
Industries associated with national defense should be

protected so they will exist domestically in case of war
almost all industries contribute or potentially
contribute to national defense
government should choose strategic industries to
subsidize rather than impose trade restrictions
Trade barriers protect jobs

Trade restrictions create jobs
Trade with low-wage countries depresses
wages in high-wage countries
Page 30
Direct
a. Methods of
FX quotations
a
Indirect
Calculation
b. Spreads
Affected by
Market conditions
Bank/dealer's positions
Trading volume
c. FX cross rates
d. Triangular arbitrage
Spot markets
17. Currency
Exchange Rates
e. Distinguish
Forward markets
Calculation
Market conditions
f. Spreads in the
forward market
Affected by
Bank/dealer's positions
Trading volume
Maturity/length of contract
g,i. Forward premium/discount
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
Page 31
a. Exchange rate
determination in a
floating system
Current account (CA)
Financial (capital) account (FA)
b. BOP accounts
Official reserve account
c. How deficit or
surplus in CA & FA
affects an economy
d. Factors that affect

currency movements
Monetary
policy
on
BOP
Exchange rate
e. Effects of
Fiscal
policy
on
BOP
Exchange rate
Fixed
18. Foreign
Exchange
Parity
Relations
f. Other exchange
rate systems
g,h. Purchasing
power parity (PPP)
Pegged
Absolute PPP
only requires that the law of one price is correct on average
Relative PPP
Expected spot exchange rate after t years =
Interest rate differential = Expected inflation differential

Assumption: real interest rates
i,j. International
Fisher relation
stable over time

equal across international boundaries
Exact formula:
Linear approximation:
= combine PPP & international Fisher
k. Uncovered interest
rate parity
l,m. Foreign exchange

expectation relation
Formula: expected spot exchange rate after n days=
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
Page 32
a
GDP
a. Measures of
economic activity
GNI
NNI
Market prices
GDP at
19 . Measuring
Economic Activity
Factor cost
b.
Adjustments
Prices
Current prices
Constant prices
c
GDP deflator
Page 33
CFALEVEL2
FINANCIAL
REPORTING
ANALYSIS
Page 34
Inflation --> LIFO: ___ COGS; ___NI; ___tax; ___CF;

___Inventory, ___Current asset; ____ profitability; ___solvency,
____liquidity
Change in methods --> retrospective
a. Effect of inflation &

deflation of inventory
costs
e. Effects of different
inventory valuation
methods
Inv.&COGS determined end

of accounting period
Periodic
Inventory
systems
Perpetual
Inv. & COGS

continuously updated
LIFO reserve
LIFO conformity rule
LIFO inventory
LIFO COGS
c. Adjust FS from
LIFO to FIFO
b,c. LIFO
LIFO equity
LIFO tax liability
LIFO liquidation
20.
Inventories:
Implications
For FS &
Ratios
write down
IFRS
min(cost, NRV)
NRV=
write up: up to original cost
d.
Implications
of valuing
inventory at
NRV
USGAAP
write
down
min (cost, market)

market=mid(replacement cost, _____, ________
write up: no
Except: Commodity-like products
Service
Merchandising
Raw materials
f. Issues to
consider
3 accounts
WIP
Finished goods
Manufacturing
RM or WIP increased -->

Analysis
FG increased when RM, WIP decreased -->

sales g < FG g -->
Page 35
Define asset:
Effects of capitalizing
Interest cost:
a. Capitalizing
vs. Expensing
Normally --> Expensed

R: expensed; D: Capitalized
IFRS
Intangible assets:
developed internally
Not software: like normal (expense R&D)
Except
R&D
USGAAP
Software
for sale: like IFRS

(technological feasibility)
for use: capitalize R&D
affect COGS of SG&A

Straight live
b. Different
depreciation
methods for
PPE
Methods
DDB (early)
Usage-based
Change in methods -->

Sell --> =(Fair value-Selling cost)
2 options
Impairment
(write down)
IFRS
Use --> Value in use (=PV of future CFs)
Recoverable amount= max (2 options)

If carrying value > recoverable amount -->
Step 1: Recoverability test
USGAAP
c. Impairment &
revaluation
Revaluation
(write up)
21.
Long-lived
Assets:
Implications
For FS &
Ratios
Step 2: Loss measurement
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)
BS:
IS:
d. Disclosures
related to
long-lived
assets
CF:
Notes:
Average age=
Average depreciable life=
Remaining life=
5 motivations for leasing: less costly; less risk of obsolescence;

less restrictive provisions; OBS financing; tax advantage
e. Leasing vs.
Purchasing
Transfer of title
4 criteria
Bargain purchase option

Lease period >= 75% economic life
PV(lease pmts) >= 90% fair value of asset
Operating lease
Reporting
by lessee
f. Finance
vs.
Operating
lease
Lessor vs.
lessee
Finance/Capital lease
Financial statements & ratios effects
USGAAP: Yr1:..; Yr2:...; Yr3, Yr4,Yr5; Aggregate Yr6 onward
Lease
disclosures
IFRS: Yr1:...; Sum Yr2 to Yr 5, Sum Yr6 onward.
Operating lease
Gross profit=PV(lease pmts)-BV
Reporting
by lessor
Sales type
lease
Finance
lease
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
Page 36
Held-to-maturity
4 types
Held for trading

Available for sale
Designated at fair value: intention HTM or AFS but treated like HFT
Reclassification of investments in
financial assets
1.
Investments
in financial
assets
(minority
passive)
HTM, AFS ---------------------------------- HFT, DFV

AFS----------------------------------------------------HTM
impaired if decline in value is not temporary
Under US GAAP
Impairments of
financial assets
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
initially
equity investment is recorded

at cost on the investor's BS
Equity
method
In
subsequent
periods
2.
Investments
in associates
the proportionate share of the

investee's earnings/loss
dividends received
from the investee
increases/decreases the investment

account on the investor's BS
is recognized in the investor's IS
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
22.
Intercorporate
Investments
Transactions with the investee

Analytical issues for investments in associates
Categories
Under IFRS
Under US GAAP
3. Business
combinations
The pooling of interests method

Under the acquisition method
Under IFRS
4. Joint
ventures
Under US GAAP
5. SPE and VIE
Net income
Items
Equity
Assets & Liabilities
Sales
c. Effects on
financial ratios
Leverage
Ratios
Net profit margin

ROE
ROA
Page 37
Defined-contribution plan
a. Types of
post-employment
benefit plans
Defined-benefit plan
Other post-employment benefits
Projected benefit obligation (PBO)

3 measures
Accumulated benefit obligation (ABO)

Vested benefit obligation (VBO)
(+) Beginning PBO
b. Measures of a
defined benefit
pension plan's
liability/asset
(+) Current service cost

(+) Interest cost
PBO=
(+) Plan amendments

(+)/(-) Actuarial gains/losses
(-) Benefit paid
(+) Current service cost
(+) Interest cost
(-) Expected return on assets
c. Net pension expense =
(-)/(+) Amortization of deferred gains/losses

(+) Amortization of past service cost
Discount rate
increase
d. Impact
of a DBP's
assumptions
PBO_____, ABO_____, VBO_____

Current service cost _____, Interest cost _____,
Expected return _____, Pension expense ____
Rate of compensation
growth decrease
Expected rate of
return increase
PBO_____, ABO_____, VBO_____

PBO_____, ABO_____, VBO_____
Funded status=
Net pension asset/liability = Funded status
Under US. GAAP
23. Employee
Compensation:
Post-retirement
And Share-based
Other comprehensive income in Equity

Under IFRS
Net pension asset/liability = Funded status - Other comprehensive income
e. Presentation
& footnotes
Reasons
for netting
g. Evaluate the underlying

economic liability (or asset)
Employer largely controls plan

assets & obligation --> bear risk
Decisions regarding funding & accounting are
affected by net pension obligation, not gross
Funded pension plan: contributions = CFO-
f. Cash flow
information
Unfunded plan: benefits paid = CFOFor analytical purpose: might be CFF-, if contributions
largely differ from economic pension expense
Economic pension expense
not "smoothed"
actual return instead of
expected return
h.
Reclassifying for analytical purpose
i. Accounting
issues
Interest cost & Actual return: should be non-operating
What is share value (esp. if shares are not traded publicly)

Expense should be spread over service period
Outright
stock
grants
Stock
grant
Share-based
compensation
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
j.
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
Page 38
Local currency
a. Distinguish
Functional currency
Presentation (reporting) currency
b. Impact of changes in exchange rates on the translated

sales of the subsidiary and parent company
24.
Multinational
Operation
c.
All-current method
If foreign currency
appreciates
Temporal method
Net assets exposure -->

Net liabilities exposure -->
Net monetary assets exposure -->
Net monetary liabilities exposure -->
Income before translation G/L

Translation G/L
d. Compare 2 methods
Net income
Total assets
Temporal vs. All current
(parent currency
depreciated -->)
e. Affecting the
parent company's
financial ratios
All current vs. Original
Define hyperinflation
ROA__; ROE__; TATO___; Invt TO___; A/R TO___

Pure BS or Pure IS ratios
Mixed BS/IS ratios
(using end-of-period BS)
USGAAP: 3-year accumulative infl > 100% (i.e. 26% per year)
IFRS: no definition
USGAAP: Functional = Presentation & use temporal method
f. Subsidiaries
operating in
hyperinflationary
economies
Treatment
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)
Page 39
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 1: Understand
what you are looking at
Lesson 2: Read the fine print
Lesson 3: If it's too good to be true, it may be
25. The
Lessons
We Learn
b. Trends in CFO more reliable than trends in earnings
Lesson 4: Follow the money
Effective
Purpose
Fair value hedge
To hedge A/L
CF hedge
To hedge
future CF of trx
Net investment hedge

in foreign subsidiary
Foreign subsidiary
Unrealized G/L
Realized G/L
Not Effective
Unrealized G/L
To hedge
c. Lesson 5:
Understand the risks
To speculate
Realized & Unrealized G/L -->
Page 40
Contrast
Cash-basis
Accrual-basis: provide more timely & relevant info. to users
a.
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
Opportunities and motivations for management to
intervene in the external financial reporting process
Influence capital markets

Satisfy contractual provisions (loan covenants, executive compensation)
c.
Independent audit, BoD, Certification by senior mgmt,

Class action litigation, Regulators, General market scrutiny
Mechanisms disciplining mgmt
Earnings
quality (EQ)
persistent & sustainable
NOA=
Accruals =
Balance
sheet
approach
Accrual ratio =
d.
Measures
of EQ
CF statement
approach
Accruals =
Accrual ratio =
Acquisitions
26.
Evaluating
Financial
Reporting
Quality
2 approaches are conceptually equivalent.

They still may differ because of
Divestitures
Exchange rate G/L
Inconsistent treatment
Extreme earnings --> not continue forever but revert back to normal level
e. Mean reversion in earnings
Accruals increase --> mean reversion faster
Misstating revenue
Bill-and-hold arrangement
Channel stuffing
Revenue
recognition
Accelerating revenue
Barter transactions
Abnormal sales growth
Disproportionate 4th quarter revenues for a non-seasonal firm
Misclassifying nonrecurring or nonoperating

Large changes in A/R & UR
Detection
techniques
Increased DSO
Compare rev & actual cash collected
Undestating expense
Delaying expense
f. Problems
with quality
of FS &
warning
signs
Expense
recognition
Misclassifying expenses as nonrecurring or nonoperating

Large changes in fixed assets & inventory
Increased DOH
Detection
techniques
LIFO liquidation
Compare depreciation expense to other companies
Core operating margin = (sales-COGS-SG&A)/ sales
e.g..: operating lease
OBS financing
BS
Goodwill
Techniques
Capitalize operating leases

Look for lack of GW impairment
Misclassifying CF
CFS
Ignoring CF
e.g..: "park" cash in LT investment --> CFF
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
Page 41
Primary purpose: identify potential outcomes, good or bad, that could affect an investment decision
Figure 1:
Framework
for Analysis
a.b.
Framework
for the
analysis
of FS
Sources of earnings & ROE
27.
Integration
Of FS
Analysis
Techniques
Internal or External (remove

equity income to reduce bias)
Dupont ROE =
Common size BS
Asset base
Capital structure
Divide by total LT capital

Working capital ratios
Focus on
Capital allocation decisions
Earnings quality & CF analysis

Mkt value decomposition
Assets, Capex, Rev, EBIT by
Business segments
Geographic segments
Accrual ratios & CF/Operating income

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
BS modifications
Earnings normalization
e. Effects of
CF-statement-related
modifications
Page 42
FRA examples & exercises Page 1
FRAlevel2examples
30%
3
%PurchasedofSubsidiary
Purchasedprice
Note:PP=BV
TABLE1:
BSofParentafteracquisitionasat1/1/2009
BSbeforeacquisitionasat1/1/2009
Parent
Cash
A/R+Inventory
InvestmentinS
Equity
Explanation
method
Subsidiary
20
28
10
6
17
28
3
PaycashtobuyS
Acquisitionmethod
(purchasemethod/
consolidationmethod)
27
34
unchanged
Explanation
Proportionate
consolidation
method
addupsub&paycash
addupsub
Explanation
20
29.8
addupPARTOFsub&pay$
34.4
84.2
addupPARTOFsub
44.2
28
12
addupPARTOFsub
addupPARTOFsub
PartofS'sequity
Fixedassets
Totalassets
32
80
8
24
32
80
unchanged
40
101
Totalliabilities
Commonstock
Retainedearnings
Minorityinterest
y
TotalEquity
Totalliab.&equity
40
28
12
14
6
4
40
28
12
unchanged
40
80
10
24
40
80
54
28
12
7
47
101
unchanged
unchanged
addupsub
unchanged
unchanged
unchanged
unchanged
Others'share
40
84.2
TABLE2:
ISofParentfortheyearending31/12/2009
ISfortheyearending31/12/2009
Parent
Revenues
Expenses
EquityinincomeofS
Minorityinterest
Netincome
Dividend
Retainedearnings
Equity
Explanation
method
Subsidiary
60
40
20
0
20
20
16
4
1
3
60
40
1.2
21.2
Acquisitionmethod
(purchasemethod/
80
56
unchanged
unchanged
Explanation
addupsub
addupsub
Proportionate
consolidation
method
66
44.8
Explanation
addupPARTOFsub
addupPARTOFsub
P'sshare
2.8
21.2
Deductothers'share
21.2
Page 43
FRAlevel2examples
TABLE3:
ConsolidatedBSofParentasat31/12/2009
"Ifnotacquisition"BSasat31/12/2009
Assumption:allyearendBS
itemsofP&Sarethesameas
1/1/09,exceptforcashwhich
increasesby(NIDiv)
Cash
A/R+Inventory
Parent
Equity
Explanation
method
Subsidiary
40
28
13
6
InvestmentinS
Fixedassets
Totalassets
37.3
28
3.9
+REofP
+PartofDivfromS
Acquisitionmethod
(purchasemethod/
50.3
34
Explanation
+REofP+PartofDiv
fromS+allREofS
Proportionate
consolidation
method
41.2
29.8
8
27
32
101.2
40
124.3
34.4
105.4
Totalliabilities
Commonstock
40
28
14
6
40
28
54
28
44.2
28
Retainedearnings
Mi it i t
Minorityinterest
t
TotalEquity
Totalliab.&equity
32
60
100
13
27
61.2
101.2
+REofP+PartofDiv
fromS+partofREofS
+PartofNIofS
PartofDivfromS
32
100
33.2
Explanation
+REofP
+PartofNIofS
33.2
9
9.1
1
70.3
124.3
+REofP
+PartofNIofS
33.2
+REofP
+PartofNIofS
+Other'sshareinRE
h ' h
61.2
105.4
Page 44
FRAlevel2examples
%PurchasedofSubsidiary
Purchasedprice
30%
7
FullGW(100%):
Note:PP#BV
PartialGW30%:
7.33
2.20
FairvalueofS:
23.33
TABLE4:
BSofParentafteracquisitionasat1/1/2009
BSbeforeacquisitionasat1/1/2009
Parent
Cash
A/R+Inventory
InvestmentinS
Goodwill
FairValue
ofSubsi.
Subsidiary
20
28
10
6
Equity
method
10
6
13
28
4.8
2.2
Acquisitionmethod
PartialGW(IFRS)
Explanation
23
34
PaycashtobuyS
Acquisitionmethod
FullGW(USGAAP&
IFRS)
23
34
Poolingof
interest
30
34
Explanation
addupBV
PartofS'sfairequity
=PPPartofFairV
2.20
7.33
Fixedassets
Totalassets
32
80
8
24
14
30
32
80
46
46
105.2 110.33
40
104
Totalliabilities
Commonstock
Retainedearnings
Minority interest
Minorityinterest
TotalEquity
Totalliab.&equity
40
28
12
14
6
4
14
40
28
12
54
34
16
40
80
10
24
16
54
54
28
28
12
12
11 2 16.33
11.2
16 33
51.2 56.33
105.2 110.33
40
80
addupBV
addupBV
addupBV
50
104
TABLE5:
ISofParentfortheyearending31/12/2009
ISfortheyearending31/12/2009
Parent
Revenues
Expenses
Equity
method
Subsidiary
60
40
20
16
ShareinS'sincome
Additionaldepr.
EquityinincomeofS
Minorityinterest
Netincome
Dividend
Retainedearnings
Explanation
Acquisitionmethod
PartialGW(IFRS)
60
40
Acquisitionmethod
FullGW(USGAAP&
IFRS)
80
56
80
56
0.6
0.6
2.8
20.6
2.8
20.6
1.2
0.6 SLD3years
0.6
20
0
20
4
1
3
20.6
Page 45
FRAlevel2examples
TABLE6:
ConsolidatedBSofParentasat31/12/2009
"Ifnotacquisition"BSasat31/12/2009
Assumption:allyearendBS
itemsofP&Sarethesameas
1/1/09,exceptforcashwhich
increasesby(NIDiv)
Cash
A/R+Inventory
Parent
Equity
method
Subsidiary
40
28
13
6
InvestmentinS
Goodwill
Fixedassets
Totalassets
Totalliabilities
Commonstock
Retainedearnings
Minorityinterest
TotalEquity
Totalliab.&equity
32
100
8
27
32
100.6
40
28
14
6
40
28
60
100
13
27
Acquisitionmethod
PartialGW(IFRS)
Acquisitionmethod
FullGW(USGAAP&
IFRS)
33.3
28
5.1
2.2
32
Explanation
32.6
+PartofNIofS
AddDepr.
PartofDivfromS
+REofP
+PartofNIofS
AddDepr.
60.6
100.6
Page 46
Pensionexercise1:
Expectedreturnonplanassetsis80
Amortizationofactuariallossis30
Amortizationofpriorservicecostis10
Calculate
Netperiodicbenefitexpense
Economicpensionexpense
Page 47
Pensionexercise2:
CalculatePensionexpenseandmakeadjustmentsforanalyticalpurposes.
Page 48
FRA2MultinationaloperationsEg.2
U$/LC
Currentex/rate
Averageex/rate
Historicalex/rate
ForCOGS
ForDepr.Exp.
ForFixedassets
31/12/2008
0.5000
31/12/2009
0.4545
0.4762
0.0000
0.4834
0.4878
0.4881
Foraccum.Depr.
Forend.inventory
0.4896
0.4762
Forequity
0.5000
Allcurrent
method
INCOMESTATEMENT2009
Revenues
COGS
Grossmargin
Otherexpenses
Depr.Expenses
LC
5,000
3,300
1,700
400
600
$
2,381.00
1,571.46
809.54
(190.48)
(285.72)
302.62 IncbfremeasureG/L
48.01 RemeasurementG/L
NetIncome
700
333.34
31/12/2008
FixedAssets
Accum.Depr.
Netfixedassets
350.63
31/12/2009
LC
100
500
1,000
1,600
$
50.00
250.00
500.00
800.00
Cash
A/R
Inventory
CurrentAssets
LC
100
650
1,200
1,950
$
45.45
295.43
545.40
886.28
Temporal
method
$
Explanation
45.45
Current
295.43
Current
571.44
Historical
912.32
800
100
700
400.00
(50.00)
350.00
FixedAssets
Accum.Depr.
Netfixedassets
1,600
700
900
727.20
(318.15)
409.05
780.96
(342.72)
438.24
Totalassets
2,850
1,295.33
1,350.56
Allcurrent
method
BALANCESHEET
Cash
A/R
Inventory
CurrentAssets
Temporal
method
$
Explanation
2,381.00
Average
1,595.22
Historical
785.78
(190.48)
Average
(292.68)
Historical
Allcurrent
method
BALANCESHEET
Historical
Historical
Totalassets
2,300
1,150.00
Accountspayable
Currentdebt
Longtermdebt
Totalliabilities
400
100
1,300
1,800
200.00
50.00
650.00
900.00
Accountspayable
Currentdebt
Longtermdebt
Totalliabilities
500
200
950
1,650
227.25
90.90
431.78
749.93
227.25
90.90
431.78
749.93
Current
Current
Current
400
100
500
200.00
50.00
250.00
Commonstock
Retainedearnings
Totalequity
400
800
1,200
181.80
363.60
545.40
200.00
400.63
600.63
Historical
Plugnumber
2,300
1,150.00
Totalliab.&equity
2,850
1,295.33
1,350.56
Commonstock
Retainedearnings
Totalequity
Totalliab.&equity
Page 49
U$/LC
Currentex/rate
Averageex/rate
Historicalex/rate
ForCOGS
ForDepr.Exp.
ForFixedassets
31/12/2008
0.5000
31/12/2009
0.4545
0.4762
0.0000
0.4834
0.4878
0.4881
Foraccum.Depr.
Forend.inventory
0.4896
0.4762
Forequity
0.5000
Allcurrent
method
INCOMESTATEMENT2009
Revenues
COGS
Grossmargin
Otherexpenses
Depr.Expenses
LC
5,000
3,300
1,700
400
600
$
2,381.00
1,571.46
809.54
(190.48)
(285.72)
302.62 IncbfremeasureG/L
48.01 RemeasurementG/L
NetIncome
700
333.34
31/12/2008
FixedAssets
Accum.Depr.
Netfixedassets
350.63
31/12/2009
LC
100
500
1 000
1,000
1,600
$
50.00
250.00
500 00
500.00
800.00
Cash
A/R
Inventory
CurrentAssets
LC
100
650
1 200
1,200
1,950
$
45.45
295.43
545.40
545 40
886.28
Temporal
method
$
Explanation
45.45
Current
295.43
Current
571.44
571 44
Historical
912.32
800
100
700
400.00
(50.00)
350.00
FixedAssets
Accum.Depr.
Netfixedassets
1,600
700
900
727.20
(318.15)
409.05
780.96
(342.72)
438.24
Totalassets
2,850
1,295.33
1,350.56
Allcurrent
method
BALANCESHEET
Cash
A/R
Inventory
CurrentAssets
Temporal
method
$
Explanation
2,381.00
Average
1,595.22
Historical
785.78
(190.48)
Average
(292.68)
Historical
Allcurrent
method
BALANCESHEET
Historical
Historical
Totalassets
2,300
1,150.00
Accountspayable
Currentdebt
Longtermdebt
Totalliabilities
400
100
1,300
1,800
200.00
50.00
650.00
900.00
Accountspayable
Currentdebt
Longtermdebt
Totalliabilities
500
200
950
1,650
227.25
90.90
431.78
749.93
227.25
90.90
431.78
749.93
Current
Current
Current
400
100
500
200.00
50.00
250.00
Commonstock
Retainedearnings
Totalequity
400
800
1,200
181.80
363.60
545.40
200.00
400.63
600.63
Historical
Plugnumber
2,300
1,150.00
Totalliab.&equity
2,850
1,295.33
1,350.56
Commonstock
Retainedearnings
Totalequity
Totalliab.&equity
Page 50
A
AdjustmentsforinflationunderIFRS
1
2
3 Priceindices
4
Dec.31.2009
5
Dec.31.2008
6
Averagefor2009
7
8
9
10
11
100
150
125
INCOMESTATEMENT
2009
15,000
12,000
Revenues
Expenses
NetpurchasingpowerG/L
12 NetIncome
Adjustment
factor
1.20
1.20
3,000
Inflation
adjusted
18,000
14,400
6,900
10,500
13
BALANCESHEET
14
15
Cash
16
Supplies
17 Totalassets
18
19 Accountspayable
20 Commonstock
21 Retainedearnings
22 Totalliab.&equity
2008
2009
5,000
25,000
8,000
25,000
30,000
33,000
20,000
10,000
0
30,000
20,000
10,000
3,000
33,000
Adjustment
factor
1.50
Inflation
adjusted
8,000
37,500
45,500
1.50
20,000
15,000
10,500
45,500
Page 51
CFALEVEL2
CORPORATE
FINANCE
Page 52
Replacement to maintain biz --> no detailed analysis

Replacement for cost reduction --> fairly detailed analysis
Project
categories
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)
Incremental CF, not accounting income
Timing of CF --> TVM
After tax
Warm-up: Basics
Principles
Exclude
Sunk cost
Financing costs
Notes
Include
Externalities
Opportunity costs
MACRS= Modified Accelerated Cost

Recovery System (for tax purpose)
Half-year convention
No salvage
Initial investment outlay=

Expansion
project
analysis
After-tax O.CF=
T.NO.CF=
a. Capital budgeting
project evaluation
Initial investment outlay=

Replacement
project
analysis
28.1. Capital
Budgeting
After-tax O.CF=
T.NO.CF=
Principle
Nominal CF --> use nominal discount rate

Real CF --> use real discount rate
__________ project profitability
b. Inflation effects (if

actual inflation higher
than expected)
__________ tax savings from depreciation

__________ value of payments to bondholders
Affects Revenues and Costs differently --> CF may be worse or better
Least common multiple

of lives approach
(replacement chain)
c1. Projects
with different
lives
Equivalent annual annuity

(EAA) approach
Hard rationing: allocated funds cannot be increased
c2. Capital rationing= insufficient

capital --> violate market efficiency
Soft rationing: allocated funds can be increased
Sensitivity analysis: Base case, then change ONLY 1 variable up/down
d. Project
risk
analysis
Scenario analysis: Base case, then change MANY variables --> Worst case, Best case --> Risk analysis
Simulation analysis (Monte Carlo): Probability distribution of NPV
CAPM --> WACC
e. Determine discount rate
When risk of project # overall risk --> CANNOT use WACC
Page 53
a
Timing options: option to delay investment
Abandonment options: abandon if NPVexit > NPVcontinue (=put option)
Types
of real
options
Expansion options: option to have additional investment (=call option)

Flexibility options
(operational)
f. Evaluating
projects with
real options
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)

If NPV without option >0 --> Project will be more valuable with option
Evaluating
approaches
NPV = NPV without option + option value - option cost

Decision tree
Option pricing models
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
g. Common
capital
budgeting
pitfalls
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?
28.2. Capital
Budgeting (cont.)
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
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
h. Measures
of income
and valuation
models
ACCOUNTING
INCOME
From Income statement

# economic income
ECONOMIC
PROFIT (EP)
Depreciation based on original cost, not market value

Deduct interest expense
= NOPAT - WACC in dollars

To bond and equity holders
Sum of EP discounted at WACC = MVA (Market Value Added) = NPV
i. Other
valuation
models
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
Page 54
MM Proposition I
Maximize Firm Value
Capital structure objective

Minimize WACC
a1. Capital
structure
theory
MM Proposition II
MM Proposition I
No taxes
MM Proposition II
MM Proposition I
With taxes
MM Proposition II
Costs of financial
distress --> lower Debt
Costs
Probability
Agency costs of equity

--> higher Debt
a2. Costs and their

potential effect on
the capital structure
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
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)
a3. Implications for

managerial
decision making
Pecking order theory: order of raising funds: Internally generated equity --> Debt --> External Equity
Firm value:
Static trade-off theory
Optimal capital structure achieved when:
Marginal Tax Benefit = Marginal Cost of Financial Distress
29. Capital
Structure &
Leverage
2 reasons for actual capital

structure to fluctuate around
target capital structure
Market value
fluctuations
b. Target capital
structure (optimal)
c. Role of debt ratings
Opportunities in a
financing source
E.g.: temporary increase in stock price

D, E = market value
Moody's; S&P's
Changes in capital structure overtime
d. Capital structure
policy and valuation
Factors to
consider
Competitors with similar business risk

Agency costs (corporate governance)
Total debt: Japan, France: more debt than UK, US

International
differences
Debt maturity: US longer than JP

Emerging market differences: emerging market less and shorter debt
Strength of legal system: strong --> reduce agency cost--> less and longer debt
Institutional
and legal
factors
e. International
differences in
leverage
Information asymmetry: increase debt (auditors, analysts

help reduce info asymmetry --> decrease debt)
Taxes: high --> increase debt. Tax on dividend: high --> decrease debt
Factors
Financial
markets and
banking
system factors
Macroeconomic
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
Inflation --> less, shorter debt
GDP growth --> longer debt
Page 55
Dividend irrelevance: MM (homemade dividend)
Bird in the hand theory (Myron Gordon & John Lintner)

Dividend
preference
Higher dividend --> _____ Risk -->

_____ Cost of Equity --> _____ P/E
Impact of dividend initiation

on stock value and P/E
a. Schools of
thought on
dividends
Higher dividend --> _____ stock value

Tax aversion
Clientele
Information
conveyed by
b. Signaling
effect
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
Double taxation
Tax-on-dividend
systems
e. Taxation
of dividends
d. Factors
affecting
dividend
payout
policy
Split rate
Imputation
Tax considerations
c. Clientele
effect
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
30. Dividends
& Dividend
Policy
Flotation costs on new issues vs. cost of retained earnings

Shareholder preference for current income vs. capital gains
Residual dividend model

forecast capital budget for 5 years,
Longer-term residual dividend
e.g.:
Leftover = total net income 5 years minus capital budget for 5 years.
Dividend each year = Leftover/5
f. Dividend policy
approaches
Dividend stability:
steady dividend payout (taking into account inflation)

--> dividend growth rate g = company's long term growth rate
Payout ratio = constant
Target payout ratio
Payout ratio moves toward the target

Compare with cash dividend
g. Share
repurchase
EPS
effect
If Cost of Debt < Earning yield --> EPS_____
Book
value
effect
If Price > BVPS --> BVPSnew ______
If Cost of Debt > Earning yield --> EPS_____
If Price < BVPS --> BVPSnew ______

Buy in the open market
Methods
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)
Capital structure
Prevent EPS dilution from employee stock options
Rationales
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
Page 56
a
Multiple owners vs managers
Warm-up: conflicts of
interest in a corporation
Directors
Creditors, Employees, Customers
Principles & Policies

Procedures
Responsibilities & Accountabilities
Definition: system of
a. Corporate
governance
(Sarbanes-Oxley)
Objectives
Eliminate or reduce CONFLICTS of interest (esp. mgmt vs. shareholders)

Use ASSETS in best interests of investors and other stakeholders
RIGHTS of shareholders & stakeholders
Oversight RESPONSIBILITIES of managers and directors
Fair and equitable TREATMENT
Transparent & accurate DISCLOSURES about operations, performance, risk and financial position
Attributes of
effective CG
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)
b. Business forms
to increase power, security, compensation
Expand firm
Manager >< Shareholder
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
c. Conflicts
in agency
relationships
Lack of independence
Personal relationship btw board - management
Board: consulting/ other biz with firm
2 companies
Interlinked boards
Director >< Shareholder
Directors are overcompensated
Responsibilities
(check and balance)
31. Corporate
Governance
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
recommend at least 3/4
Composition and independence

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
annually
Board self-assessment practices
Frequency of separate sessions for independent directors
d,e. Board
of Directors
Audit committee and audit oversight

Points to
assess Board
annually, quarterly
only independent directors, with expertise
all independent
Nominating committee
Compensation committee
internal counsel --> weak CG
Use of independent or expert legal counsel
Codes of ethics
Directors' oversight, monitoring and review responsibilities
Statement of
governance
policies
Management's responsibilities to the board
f. Statement
of CG
policies
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
Strong/effective CG system
g. Valuation
implications of
Corporate
Governance
--> higher measures of profitability & returns for shareholders
Financial disclosure risk

Weak/ineffective
CG system
Asset risk
Liability risk
incomplete, misleading, materially misstated disclosure
e.g..: too high perks

e.g..: OBS obligations
Strategic policy risk
e.g..: M&A
Page 57
Bidder/ Acquirer vs. Target company

Mergers
--> 1 company ceases
entire target
Background
Acquisitions
e.g..: assets, biz segment
part of target
Forms of integration
(how physically come
together)
e.g.: P&G bought Gillette (good brand)
subsidiary merger
both cease to exist --> new company
consolidation
a. Categorize M&A
same industry
horizontal
Types of mergers
(how activities
are related)
vertical
acquire all A&L --> target not exist
statutory merger
in the supply chain

Forward vs. Backward integration
conglomerate
no relation
Synergies
More rapid growth
More market power
Access to unique capabilities
Diversification
Bootstrapping EPS
b. Merger
motivations
Personal benefits for managers

Tax benefits
32.1. Mergers
& Acquisitions
c. Bootstrapping
loss carryforwards
Unlocking hidden value

Taking advantage of market inefficiencies (e.g..: cheap labor force)
Achieving
international
business goals, by
Working around disadvantageous government policies

Use technology in new markets
Product differentiation
Provide support to existing multinational clients
Pioneer/ development phase

Rapid growth
d. Motivations
for mergers and
industry life
cycles
Mature growth
Stabilization
Decline
Form of
acquisition
Need capital, management --> H or C
Need capital, management --> H or C

Need operational efficiency (from economies of scale) --> H or V
Need to cut costs (from economies of scale) --> H
H or V or C
Stock purchase
Asset purchase
Securities offering
Methods
Cash offering
Method of
payment
Mixed offering
Risk & reward for acquirer vs. target
e. Merger
transaction
characteristics
Factors to
consider
Relative valuations of companies

Changes in capital structure
Mgmt happy --> Friendly merger offers

Attitude of target
management
Mgmt unhappy
--> Hostile merger offers
Bear hug
(propose
to BoD)
If Bear hug is
unsuccessful -->
Tender
offer
Proxy
battle
Buy shares from

target shareholders
Replace BoD
Page 58
a
Rights for current SHDs to purchase shares at big discount, triggered with 1 SHD holds > threshold (10%)
Poison pill
Flip-in pill
Forms
Flip-over pill
Dead-hand provision: BoD's right to redeem the pill, in a friendly merger offer
Bondholders' right to demand immediate repayment if there is a hostile takeover
Poison put
States with restrictive takeover laws
Pre-offer
defense
mechanisms
Staggered board
Ohio & Pennsylvania: most protection
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
Ownership > threshold (20%) --> loss of voting rights --> prevent
tender offer --> bidder must negotiate with BoD directly
Restricted voting rights
Supermajority voting provision for mergers
determined by some formula or independent appraisal
Fair price amendment

Golden parachutes
f. Takeover
defense
mechanisms
e.g..: at least 2/3 or 80%, not 51% as usual
lucrative cash payouts to managers if they leave after a merger
"Just say no" defense

lawsuit (anti-trust or violation of securities law)
Litigation
agreement that allows target to repurchase its shares from
acquirer at premium price (rare after 1986: 50% tax)
Greenmail
Share repurchase (target's tender

--> acquirer increases bid & leverage --> less attractive
offer for its own shares)
borrow to buy shares
Leveraged recapitalization
Post-offer
defense
mechanisms
sell a major asset/ subsidiary
Crown jewel defense

Pac-man defense
counter offer
--> bidding war --> good price --> winner's curse
White knight defense
sell a minority stake but big

enough to block acquirer
White squire defense

(squire = junior knight)
Herfindahl-Hirschman Index
Formula:
< 1000: Merger ok
32.2. Mergers
& Acquisitions
(cont.)
From 1000 to 1800
If post-merger HHI
g. HHI
> 1800
If increase in HHI <100: merger ok
If increase in HHI >=100: merger NOT ok

If increase in HHI <50: merger ok
If increase in HHI >=50: merger NOT ok
DCF analysis
h,i,j. Methods
for valuing a
target
company
Comparable company analysis

Comparable transaction analysis
Post-merger value of an Acquirer

Gains accrued to the Target
k. Evaluating
a merger bid
Gains accrued to the Acquirer

Cash payment versus Stock payment
Price
l. Effects of
Payment
method
Cash offer
Stock offer
Target gains 30%
m. Distribution of
merger benefits
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)
Not fit long term strategy

Divestitures
(dispose asset)
o. Reasons for
divestitures
Lack of profitability
Individual parts are worth more than the whole
Infusion of cash
n. Downsizing
operations
through
corporate
restructuring
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
Page 59
CFALEVEL2
EQUITY
Page 60
Classic works by Graham &

Dodd and J.B. Williams
33. A Note On Asset

Valuation
Define
Valuation
Intrinsic value
a.
Possible sources of
perceived mispricing
Going concern value
b. Contrast
Liquidation value
Stock selection
Reading the market
Projecting the value of corporate actions
Fairness opinions
c. Uses of
equity
valuation
34. Equity
Valuation:
Applications
& Process
Planning & consulting

Communication with analysts and investors
Valuation of private business
Portfolio management
Planning
Executing the investment plan
Threat of new entrants

5 elements of
industry structure
Threat of substitutes
Bargaining power of buyers
Bargaining power of suppliers
Rivalry among existing competitors
d.
3 generic
strategies
Cost leadership
Product differentiation
Focus
Quality of financial info.
Absolute
valuation
models
e. Contrast
Relative
valuation
models
f. Criteria for choosing

an approach
Page 61
HPR
Realized and Expected return
Required return (RR)
a. Concepts
Return from convergence

of price to intrinsic value
Discount rate
IRR
Explain equity risk premium

Use in required return determination
b. Equity risk
premium
Major methods of estimating

equity risk premium
Historical estimation
Forward-looking estimation
CAPM
Multifactor
model
35. Return
Concepts
c,e. Methods of
estimating the
RR on equity
investment
Farma-French model
Pastor-Stambaugh model
Macroeconomic multifactor model
Build-up
model
Bond-yield plus risk

premium model
Public co.
d. Estimating
beta for
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

Page 62
Warm-up
Threat of new entrants
Threat of substitutes
a.b. Porter's five

forces. Drivers of
industry profitability
Bargaining power of buyers
Bargaining power of suppliers
Rivalry among existing competitors
Industry growth rate
Innovation and technology
36. The Five

Competitive
Forces That
Shape Strategy
c. Common factors
that affect the five
forces
Govt policies
Complementary products
d. Changes in industry structure and their effects on the

industry's profit potential
Altering the firm's

existing position
e. Strategic
alternatives
Capitalizing on changes
in the industries
Creating changes in the
industry structure
Steps in using the forces

in an industry analysis
Example: Wal-Mart
Page 63
Industry classification
External factor review
a. Components
in industry
analysis model
Demand analysis
Supply analysis
Profitability analysis
International competition & markets review
b. Life cycle of a
typical industry
1. Pioneer
2. Growth
3. Mature
4. Decline
Warm-up:
Business cycle
Industry
classification
c. Effects of
business cycles
on industry
classification
Growth
industry
stocks
Defensive
industry
stocks
Cyclical
industry
stocks
37. Industry
Analysis
Technology
Govt
d. External
factors
Social changes
Demography
Foreign influences
e1. Demand
analysis
e2. Supply
analysis
Product
segmentation
Industry
concentration
f. Profitability
analysis
Ease of
industry entry
Supply
input price
Page 64
Warm-up: Real and

nominal valuation
a. Effects
of inflation
Income taxes
NWC
Capital expenditures
1. Operating results- real
CF
estimation
b. Calculate nominal
and real-term financial
projections
2. Operating results- nominal

5-step
approach
3. NOPLAT- real
4. Free CF- real & nominal
5. Firm value- real & nominal
38. Valuation
In Emerging
Markets
Country risks are

diversifiable
Adjust CFs, b/c
c. Account for
emerging
market risks
Companies respon
differently to country risk
Country risk is one-sided risk
Identifying CF effects aids
in risk management
Rather than adjusting r
Rf
Ke
Beta
Market risk premium
d. Estimating
cost of capital
Kd (1-t)
Kd
t
Capital structure weights
Page 65
Dividends
FCF
a. Measures of CF
Residual income
Appropriateness
One-period
b.
Two-period
Multi-period
Warm-up: General DDM

Assumptions
Two-stage DDM
DDM
i,l. Multistage
growth models
Selection of
H-model
Three-stage DDM
Spreadsheet modeling
j. Business
phases
Initial growth
Transition
Maturity
k. Terminal value
39. Discounted
Dividend
Valuation
c. Assumptions
d. Implied growth rate
Justified leading P/E
f. Justified P/E
GGM
Justified trailing P/E
h.
Strengths
Limitations
e. PVGO
g. Value of
preferred stock
GGM
m. Calculate
expected
return with
H-model
Two-stage DDM
n. Sustainable growth rate

To forecast dividends
o. Use of spreedsheet modeling
To value common shares
p. Over/Fairly/Undervalued
Page 66
FCFF
a. Interpret &
compare
FCFE
FCFE, FCFF
b,f. Ownership perspective

& recognition of value
DDM
FCFF
c,d. Calculate
FCFE
Historical free cash flow
e. Forecasting
FCFF and FCFE
Components of free cash flow
Dividends
40. Free
Cash Flow
Valuation
g. FCFF & FCFE

affected by
Share repurchases
Share issues
Changes in leverage
h. Critique the use of NI and

EBITDA as proxies for CF
Single stage
How many variations are there?
i. Models
Multistage
Model assumptions &
Firm characteristics
j. Calculate the value of

a company
k. Sensitivity analysis
l. Terminal value
FCFF is preferred to
FCFE when
Page 67
Price multiples
Types of valuation
indicators
Enterprise value multiples

Momentum indicators
Method of comparables
a. Two
methods
Method based on
forecasted fundamentals
b. Justified price multiple
P/E
Trailing P/E
Leading P/E
c,d,g. Price
multiples
P/B
P/S
P/CF
41.1.
Market-based
Valuation
Trailing D/P
c,d,g. Dividend
yield (D/P)
Leading D/P
Exclude nonrecurring components

(G/L from asset sales, write-downs...)
Method of historical
average EPS
e. Underlying earnings
(persistent, continuing,
core); Normalized EPS
Method of
average ROE
f. Earnings yield (E/P)
Justified P/E
Justified P/B
Justified P/S
h. Calculate
Justified P/CF
Justified EV/EBITDA
Justified D/P
Page 68
EQUITY LEVEL 2, READING 41

44. c,d,h,n
Multiples
(LOS c,d)
P/E
Advantages
Disadvantages
Notes
+ Popular
+ Earnings power (EPS) is the primary
determinant of inv. Value
+ Proved by empirical evidence
- EPS might be <0 --> P/E is meaningless

* Trailing P/E: not useful for
- Earnings have 1 portion that is volatile & transitory - forecastin & valuation
* Leading P/E: not relevant if
> difficult to interpret
earnings are too volatile
- Earnings can be distorted by mgmt --> lower
comparability
P/B
+ Usually BV>0, more stable

+ Firms that primarily hold liquid assets --> BV~VE
+ 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
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)
Justified
(LOS h)
Adjustments to BV:
. Exclude intangible assets (GW,
patent)
. Adjust for OBS
. Adjust to reflect fair value
. Adjust for # accounting policies
(eg.: LIFO vs. FIFO)
. Used to value index

. Distinguish:
Trailing D/P=
Leading D/P=
EV/EBITDA + Useful when comparing firms with different

(LOS n)
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
Page 69
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
41.2
Market-based
Valuation
(cont.)
n. EV/EBITDA
o. Sources of differences in
cross-border valuation comparisons
p. Momentum indicators
q. Over/Fairly/Undervalued
Arithmetic mean
r. Central tendency of a
group of multiples
Harmonic mean
Weighted harmonic mean
Median
Page 70
RI =
a. Calculate
EVA =
MVA =
b. Use of RI models
c. FV of RI
d. Fundamental
determinants of RI
RI valuation
e. Relation
between
Justified P/B ratio
f. Single-stage &
multistage RI model
g. Calculate implied
growth rate (g)
is.....
Persistent
factor
42. Residual
Income
Valuation
RI persists at
current level forever
h.
Continuing
RI
Assumptions
RI drops
immediately to zero
RI declines over
time to zero
RI declines to LR level
in mature industry
RI
i. Compare
DDM
FCFE
Strengths
j. RI models
Weaknesses
k. Justify the
selection of RI model
Violations of the clean
surplus relationship
Variations from fair value
l. Accounting
issues
Intangible assets effects on BV

Nonrecurring items and other
aggressive accounting practices
International accounting differences
m. Over/Fairly/Undervalued
Page 71
Stage of lifecycle
Size
Quality & depth of mgmt
Company-specific factors
Mgmt/SHD overlap
ST investors
a. Private
company
valuation
vs. public
Quality of financial & other info.

Taxes
Liquidity
Stock-specific factors
Restrictions on marketability
Concentration of control
Venture capital financing

Transaction- related
valuations
IPO
Sale in an acquisition
Bankruptcy proceedings
Performance-based
managerial compensations
b. Uses of private
business valuation
43.1 Private
Company
Valuation
Compliance- related
valuations
Financial reporting
Tax purposes
Liquidation- related
valuations
Fair market value

Fair value for financial reporting
Fair value for litigation
c. Definitions
of value
Market value
Investment value
Intrinsic value
f. Income
approach
Free CF method
Capitalzed CF method
Excess earnings method
d. Valuation
approaches
Market
approach
Asset-based
approach
Page 72
Normalized earnings
e. Estimate
CF
Size premiums
Availability and cost of debt
g. Elements of
discount rate
Acquirer vs. target

Projection risk
Lifecycle stage
CAPM
Expanded CAPM
h. Estimate ke
Build-up method
43.2 Private
Company
Valuation
(cont.)
i. Market
approaches
GPCM (Guideline public

company method)
GTM (Guideline
transactions method)
PTM (Prior transaction method)
j. Asset- based
approach
Discount for
lack of control
k. Use of discounts
& premiums
Discount for lack

of marketability
l. Role of
valuation
standards
Page 73
CFALEVEL2
ALTERNATIVE
INVESTMENTS
Page 74
a. RE Investment
characteristics
44.
Investment
Analysis
CFAT
= NOI - debt service - taxes payable
EART
= selling price - selling costs - mortgage balance - taxes on sale
c. Calculate
Valuing real
estate
investments
b. Evaluate a real estate

investment using NPV, IRR
d. Potential
problems
with IRR
Multiple IRRs
Ranking conflicts
Page 75
a. Capitalization rate
vs. discount rate
Market-extraction
method
b. Determine
cap rate by
45. Income
Property
Analysis
And
Appraisal
band- ofinvestment
method
built-up
method
Direct
capitalization
approach
c.
Gross income
multiplier technique
Limitations of the direct

capitalization approach
Selecting the appropriate cap rate

Application to income-producing property
Discontinuous pricing
d. Contrast
Limitations of the
gross income
multiplier approach
Lack of information
Gross rent vs. NOI
Distorted selling prices
Unique or non-income
producing properties
Page 76
Background: Private equity (PE)

a
1. Re-engineering
a. Sources of value
creation in PE
2. Favorable debt financing

3. Superior alignment of
interests (also see los b)
Incentives
Compensation
Tag-along, drag-along clauses
Effective
structuring of
investment
terms
b. Aligning
managerial and
ownership interests
in PE firms
Board representation
Noncompete clauses
Priority in claims
Required approvals
Earn-outs
Venture Capital
c. Characteristics of
Buyout Investments
46.1. Private
Equity
Valuation
d. Valuation
issues
IPO
Secondary market sale
e. Exit routes in PE
MBO
Liquidation
Risks
g. Investing
in PE firms
Specific risks
General risks
Costs
Page 77
Company limited by shares

LPs
Limited partnership (Most)
GP
Structures
Most are closed-end
2 businesses
raising fund
managing PE investments
Management fees
Transaction fees
Carried interest
Economic
terms
Ratchet
Hurdle rate
Target fund size
Vintage
Terms
Should
focus on
aligning
the
interests
of GP &
LPs
Terms of the fund

Key man clause
Performance disclosure &
confidentiality
Clawback
Corporate
governance
terms
f. PE
Fund
Distribution waterfall
Tag-along, drag-along clauses
Removal for cause
No-fault divorce
Investment restrictions
46.2.
Private
Equity
Valuation
(cont)
Co-investment
Only vailable for "qualified" investors
Fund prospectus
1. At cost, adjusting for subsequent financing and devaluation
2. The minimum of cost or market value
Ways to
determine
NAV
Valuation
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
NAV
Stale NAV
No definitive method
Issues in
calculating
NAV
Undrawn LP capital
Comparison between PE funds
GP usually
values
Due diligence of PE
fund investments
-->Now, more and more independent parties value
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
Page 78
Gross IRR
IRR
Net IRR
PIC
a
DPI
Multiples
RVPI
Quantitative
measures
TVPI
management fees
h.
Evaluation
of PE
fund
performance
carried interest
NAV
PIC
i. Calculating
performance
measures
DPI
Multiples
RVPI
TVPI
46.3. Private
Equity
Valuation
(cont.)
Other analyses
Benchmarks
Earning growths
Components of
performance
from an LBO
Increase in price multiples

Debt reduction
Exit value = investment cost + earnings growth +
increase in price multiple + reduction in debt
1.1. Valuation for a single

financing round
1.2. Valuation for multiple

financing rounds (11 steps)
j. VC method
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
Page 79
Leverage
Use of derivatives
a. Hedge
fund vs.
Mutual fund
Disclosure requirements
and practices
Lockup periods
Fee structures
Arbitrage-based
Convertible
bond arbitrage
Equity market
neutral
Event driven
Risk arbitrage,
merger arbitrage
47.1.
Investing
In Hedge
Funds: A
Survey
Fixed-income
arbitrage
b. Hedge
funds
strategies
Medium volatility
Global macro
Long-short equity
Managed futures (Commodity
trading advisers - CTAs)
Multi-strategy
Directional hedge
Dedicated short bias
Emerging market
Variety of databases exist

Hedge fund
database
No database is complete
Own methodology
c. Hedge fund
databases and
performance
biases
Reporting to databases is voluntary
Performance
biases
Selection bias (backfill bias)

Survivor bias
Page 80
Alpha (manager skill) and

beta (market exposure)
d. Factor
models for
hedge fund
returns
Regression model
Use a multitude of
traditional market factors
Sources
e. Non-normality
of HF returns
Implications for
performance appraisal
Simple to manage therefore

offered to investors at low fees
f. Motivations
for HG
replication
strategies
47.2.
Investing In
Hedge
Funds: A
Survey
g. Difficulties
in applying
traditional
portfolio
analysis to HG
Simplest form vs.

complex form
Separate HF beta
from HF replication
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
Reduce the standard deviation

of a HF portfolio (diversify)
High quality managers: significant investment
skill, manager relationship, and research cost
h. Funds of
funds vs.
single
manager HF
Average performance
Take less factor risk
than a broad HF index
Longer lives and
larger asset inflows
Page 81
CFALEVEL2
FIXED INCOME
Page 82
=Borrower not pay

Credit rating
Default risk
a. Components
of credit risk
Sources of info from

rating agencies
Rating watch
Rating outlook
Credit spread risk

Downgrade risk
Character
b. Components- 4 Cs
Covenants
Collateral
Capacity to pay
Profitability: ROE --> DuPont
c,d. Key
financial ratios
Short-term solvency
Capitalization (financial leverage)
Coverage ratios
# CF, # FCFF, #FCFE
Corporate
Credit
Analysis
S&P uses:
Funds from operations / Total debt
e. Cash Flow
analysis
CF ratios
4 traditional
coverage ratios
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

Debt structure Analysis
f. Analysis of
High-Yield Issuers
Corporate structure Analysis

Covenants Analysis
Equity Analysis approach
48.
General
Principles
Of Credit
Analysis
Collateral credit quality

Seller/Servicer quality
g. Analysis of
Asset-Backed
securities
Cash Flow stress and

Payment Structure
Legal structure
Issuer's debt structure

Tax-backed debt
Budgetary policy
Local tax & Intergovernmental
revenue availability
Issuer's socioeconomic environment
h. Analysis of
Municipal bond
Limits of the Basic Security

Flow of funds structure
Revenue bonds
Rate, or User-Charge,
Covenants
Priority-of-Revenue Claims
Additional-Bonds test
Economic and Income structure

Prospects for economic growth
Degree of fiscal flexibility
Key
considerations
Economic risk
(ability)
Public debt burden

Monetary policy and Price stability
BOP flexibility
i. Analysis of
Sovereign Bonds
External debt and liquidity

Political risk
(willingness)
2 ratings
Local currency debt rating

Foreign currency debt rating
Corporate bonds vs. ABS
j. Contrast credit
analysis
Corporate bonds vs. Municipal securities

Corporate bonds vs. Sovereign debt
Page 83
Warm-up: Yield curve shapes

Parallel shift
a. Yield
curve
shifts
Yield curve twist
Nonparallel shift
Butterfly shifts
Changes in the level of
rates (parallel shifts)
b. Factors
affecting
Treasury
returns
Changes in the
slope (twists)
Changes in the
curvature (butterfly)
Warm-up: Spot curves

and bootstrapping
All on-the-run
Treasury securities
c. Treasury
spot rate curve
49. Term
Structure &
Volatility Of
Interest
Rates
All on-the-run and

some off-the-run
Treasury securities
All Treasury coupon
securities and Bills
Treasury strips
What is it?
d. Swap rate curve

(LIBOR curve)
As a benchmark
--> reasons:
Pure (Unbiased)
expectations theory
Liquidity theory
e. Term
structure
theories
Preferred
habitat
theory
Warm-up: Calculating
key rate duration
Barbell portfolios
f. Yield
curve
risk
Ladder portfolios
Bullet portfolios
Historical yield volatility
g1. Yield volatility
Implied yield volatility
g2. Forecasting yield volatility

Page 84
Binomial interest rate trees

Constructing an arbitrage-free tree
Valuing an option-free bond
with the binomial model
Warm-up:
Binomial model
Spread
measures
The nominal spread

The Z-spread
OAS
Treasury securities
b. Benchmark
interest rates to
calculate spreads
A bond sector
Specific issuer
c. Backward induction methodology

d. Callable bond valuation
Vcall =
e. Relations
50. Valuing
Bonds With
Embedded
Options
Vput=
f. Effect of volatility
on arbitrage-free
value of an option
Warm-up: How OAS is calculated
Treasury benchmark
a,g. Relative value analysis
Bond sector benchmark

Issuer-specific benchmark
h. Effective duration and convexity

i. Putable bond valuation
Conversion ratio
Conversion value
Straight value
Component
values
Minimum value of a
convertible bond
Market conversion price
j. Convertible
bonds
Market conversion
premium per share
Premium payback period
Valuing convertible bonds using an
option-based valuation approach
k. Convertible bonds vs.

Common stock
Page 85
Fixed income examples Page 1
LOAN AMORTIZATION SCHEDULE

Loan amount
Mortgage rate (per month)
Number of months
Scheduled total pmt
Column 1 Column 2
Beginning
Principal
Period
1
2
3
4
5
175
176
177
178
179
180
181
182
183
184
185
186
187
188
189
190
191
192
193
194
195
196
197
198
199
200
358
359
360
500,000
499,857
499,712
499,567
499,419
433,500
432,692
431,876
431,051
430,219
429,378
428,529
427,671
426,804
425,929
425,046
424,153
423,252
422,341
421,421
420,492
419,554
418,607
417,650
416,683
415,707
414,721
413,725
412,719
411,703
410,677
15,126
10,134
5,092
500,000
1%
360
$5,143.06
Column 3
Column 4
Column 5
Scheduled
total pmt
Interest
pmt
Scheduled
principal pmt
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,000
4,999
4,997
4,996
4,994
4,335
4,327
4,319
4,311
4,302
4,294
4,285
4,277
4,268
4,259
4,250
4,242
4,233
4,223
4,214
4,205
4,196
4,186
4,176
4,167
4,157
4,147
4,137
4,127
4,117
4,107
151
101
51
143
144
146
147
149
808
816
824
833
841
849
858
866
875
884
893
902
911
920
929
938
948
957
967
976
986
996
1,006
1,016
1,026
1,036
4,992
5,042
5,092
Column 6
Beg. Pr less
scheduled pr.
Pmt
499,857
499,712
499,567
499,419
499,270
432,692
431,876
431,051
430,219
429,378
428,529
427,671
426,804
425,929
425,046
424,153
423,252
422,341
421,421
420,492
419,554
418,607
417,650
416,683
415,707
414,721
413,725
412,719
411,703
410,677
409,641
10,134
5,092
0
Page 86

Loan amount
Mortgage rate (per mth)
Number of months
Col 1
500,000
1%
360
Scheduled total pmt
$5,143.06
Col 2
Col 4
Col 3
Col 5
Beginning Scheduled Interest

Period
Principal total pmt pmt
1
2
3
4
5
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
140
141
142
143
144
145
146
500,000
499,774
499,461
499,063
498,576
291,518
287,802
284,069
280,317
276,548
272,760
268,954
265,130
261,288
257,427
253,547
249,649
245,732
241,796
237,842
233,868
229,875
225,863
221,832
217,782
33,822
28,868
23,890
18,888
13,862
8,812
3,738
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
3,775
PSA
m=1 to 30:
m=31 or more
5,000
4,998
4,995
4,991
4,986
2,915
2,878
2,841
2,803
2,765
2,728
2,690
2,651
2,613
2,574
2,535
2,496
2,457
2,418
2,378
2,339
2,299
2,259
2,218
2,178
338
289
239
189
139
88
37
Col 6
100
0.2%
6%
Col 7
Col 8
Col 9
Col 10
average life: 86.82

Col 11
Col 12
Weights
Scheduled Beg. Pr less
Ending
for
principal
scheduled
CPR SMM
Prepmt
principal Macaulay
pmt
pr. Pmt
Duration
143
499,857 0.20% 0.0167%
83 499,774
0.0005
145
499,628 0.40% 0.0334%
167 499,461
0.0006
148
499,313 0.60% 0.0501%
250 499,063
0.0008
152
498,910 0.80% 0.0669%
334 498,576
0.0010
157
498,419 1.00% 0.0837%
417 498,002
0.0011
2,228
289,290 6.00% 0.5143% 1,488 287,802
0.0074
2,265
285,537 6.00% 0.5143% 1,469 284,069
0.0075
2,302
281,766 6.00% 0.5143% 1,449 280,317
0.0075
2,340
277,977 6.00% 0.5143% 1,430 276,548
0.0075
2,378
274,170 6.00% 0.5143% 1,410 272,760
0.0076
2,415
270,345 6.00% 0.5143% 1,390 268,954
0.0076
2,454
266,501 6.00% 0.5143% 1,371 265,130
0.0076
2,492
262,638 6.00% 0.5143% 1,351 261,288
0.0077
2,530
258,757 6.00% 0.5143% 1,331 257,427
0.0077
2,569
254,858 6.00% 0.5143% 1,311 253,547
0.0078
2,608
250,940 6.00% 0.5143% 1,291 249,649
0.0078
2,647
247,002 6.00% 0.5143% 1,270 245,732
0.0078
2,686
243,046 6.00% 0.5143% 1,250 241,796
0.0079
2,725
239,071 6.00% 0.5143% 1,230 237,842
0.0079
2,765
235,077 6.00% 0.5143% 1,209 233,868
0.0079
2,804
231,064 6.00% 0.5143% 1,188 229,875
0.0080
2,844
227,031 6.00% 0.5143% 1,168 225,863
0.0080
2,884
222,979 6.00% 0.5143% 1,147 221,832
0.0081
2,925
218,907 6.00% 0.5143% 1,126 217,782
0.0081
2,965
214,816 6.00% 0.5143% 1,105 213,712
0.0081
29,017 6.00% 0.5143%
149
28,868
0.0099
4,805
4,854
24,013 6.00% 0.5143%
124
23,890
0.0100
4,904
18,986 6.00% 0.5143%
98
18,888
0.0100
4,954
13,934 6.00% 0.5143%
72
13,862
0.0101
5,004
8,858 6.00% 0.5143%
46
8,812
0.0101
5,055
3,757 6.00% 0.5143%
19
3,738
0.0101
3,738
0.00% 0.0000%
0.0075
Page 87
Life
0.0005
0.0012
0.0024
0.0039
0.0057
0.5945
0.6048
0.6152
0.6257
0.6363
0.6470
0.6578
0.6686
0.6795
0.6906
0.7017
0.7129
0.7242
0.7356
0.7470
0.7586
0.7703
0.7821
0.7939
0.8059
1.3871
1.4038
1.4205
1.4374
1.4544
1.4715
1.0915

Loan amount
Mortgage rate (per month)
Number of months
Period
1
2
3
4
5
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
140
141
142
143
144
145
146
147
148
149
150
151
152
Beginning
Principal
500,000
499,782
499,487
499,113
498,661
307,999
304,524
301,030
297,518
293,987
290,437
286,868
283,280
279,673
276,047
272,401
268,736
265,051
261,347
257,623
253,879
250,115
246,331
242,527
238,702
62,994
58,211
53,403
48,569
43,709
38,823
33,910
28,972
24,008
19,016
13,999
8,954
3,882
PSA
m=1 to 30:
m=31 or more
90
0.2%
6%
$5,143.06
Scheduled total pmt

Column 1 Column 2
500,000
1%
360
Column 3
Scheduled
total pmt
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
3,921
Column 4 Column 5
Scheduled
Interest
principal
pmt
pmt
5,000
143
4,998
145
4,995
148
4,991
152
4,987
156
3,080
2,063
3,045
2,098
3,010
2,133
2,975
2,168
2,940
2,203
2,904
2,239
2,869
2,274
2,833
2,310
2,797
2,346
2,760
2,383
2,724
2,419
2,687
2,456
2,651
2,493
2,613
2,530
2,576
2,567
2,539
2,604
2,501
2,642
2,463
2,680
2,425
2,718
2,387
2,756
630
4,513
582
4,561
4,609
534
486
4,657
437
4,706
388
4,755
339
4,804
290
4,853
240
4,903
190
4,953
140
5,003
90
5,054
39
3,882
Column 6
Column 7
Beg. Pr less
scheduled pr. CPR
Pmt
499,857
0.18%
499,637
0.36%
499,338
0.54%
498,961
0.72%
498,504
0.90%
305,936
5.40%
302,426
5.40%
298,897
5.40%
295,350
5.40%
291,784
5.40%
288,198
5.40%
284,594
5.40%
280,970
5.40%
277,327
5.40%
273,664
5.40%
269,982
5.40%
266,280
5.40%
262,559
5.40%
258,817
5.40%
255,056
5.40%
251,275
5.40%
247,473
5.40%
243,651
5.40%
239,809
5.40%
235,946
5.40%
58,481
5.40%
53,650
5.40%
48,794
5.40%
43,911
5.40%
39,003
5.40%
34,068
5.40%
29,107
5.40%
24,119
5.40%
19,105
5.40%
14,063
5.40%
8,995
5.40%
3,900
5.40%
0.00%
Column 8 Column 9 Column 10

SMM
0.0150%
0.0300%
0.0451%
0.0602%
0.0753%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.4615%
0.0000%
Prepmt
75
150
225
300
375
1,412
1,396
1,380
1,363
1,347
1,330
1,314
1,297
1,280
1,263
1,246
1,229
1,212
1,195
1,177
1,160
1,142
1,125
1,107
1,089
270
248
225
203
180
157
134
111
88
65
42
18
-
Page 88
Ending
principal
499,782
499,487
499,113
498,661
498,129
304,524
301,030
297,518
293,987
290,437
286,868
283,280
279,673
276,047
272,401
268,736
265,051
261,347
257,623
253,879
250,115
246,331
242,527
238,702
234,857
58,211
53,403
48,569
43,709
38,823
33,910
28,972
24,008
19,016
13,999
8,954
3,882
-

500,000
Loan amount
1%
Mortgage rate (per month
Number of months
360
Scheduled total pmt
$5,143.06
Col 1
Col 2
Col 4
Period
Beginning Scheduled Interest

Principal total pmt
pmt
1
2
3
4
5
6
7
8
9
10
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
88
89
90
91
500,000
499,606
498,957
498,049
496,880
495,446
493,747
491,780
489,543
487,038
176,093
169,878
163,704
157,570
151,477
145,424
139,410
133,436
127,502
121,606
115,749
109,930
104,149
98,407
92,702
87,035
81,405
75,811
70,255
64,735
16,658
11,490
6,356
1,255
Col 3
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
5,143
1,268
5,000
4,996
4,990
4,980
4,969
4,954
4,937
4,918
4,895
4,870
1,761
1,699
1,637
1,576
1,515
1,454
1,394
1,334
1,275
1,216
1,157
1,099
1,041
984
927
870
814
758
703
647
167
115
64
13
PSA
m=1 to 30:
m=31 or more
300
0.2%
6%
Col 5
Col 6
Scheduled
principal
pmt
Beg. Pr less
scheduled CPR
pr. Pmt
143
147
153
163
174
189
206
225
248
273
3,382
3,444
3,506
3,567
3,628
3,689
3,749
3,809
3,868
3,927
3,986
4,044
4,102
4,159
4,216
4,273
4,329
4,385
4,441
4,496
4,976
5,028
5,080
1,255
499,857
499,459
498,804
497,887
496,705
495,258
493,541
491,554
489,296
486,765
172,711
166,434
160,198
154,003
147,849
141,735
135,661
129,628
123,633
117,679
111,763
105,886
100,048
94,248
88,486
82,762
77,076
71,426
65,814
60,239
11,681
6,462
1,276
-
Col 7
0.60%
1.20%
1.80%
2.40%
3.00%
3.60%
4.20%
4.80%
5.40%
6.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
18.00%
0.00%
Col 8
Col 9
Col 10
SMM
Prepmt
Ending
principal
251
502
754
1,007
1,259
1,511
1,762
2,011
2,258
2,503
2,833
2,730
2,627
2,526
2,425
2,325
2,225
2,126
2,028
1,930
1,833
1,737
1,641
1,546
1,451
1,357
1,264
1,172
1,079
988
192
106
21
-
499,606
498,957
498,049
496,880
495,446
493,747
491,780
489,543
487,038
484,261
169,878
163,704
157,570
151,477
145,424
139,410
133,436
127,502
121,606
115,749
109,930
104,149
98,407
92,702
87,035
81,405
75,811
70,255
64,735
59,251
11,490
6,356
1,255
-
0.0501%
0.1006%
0.1513%
0.2022%
0.2535%
0.3051%
0.3569%
0.4091%
0.4615%
0.5143%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
1.6402%
0.0000%
90-300
PSA90 PAC
tranche
75
150
225
300
375
450
525
600
674
749
1719
1704
1689
1675
1660
1645
1630
1615
1600
1585
1569
1554
1539
1523
1507
1492
1476
1460
1444
1428
1280
1263
1246
1229
Page 89
75
150
225
300
375
450
525
600
674
749
1,719
1,704
1,689
1,675
1,660
1,645
1,630
1,615
1,600
1,585
1,569
1,554
1,539
1,523
1,451
1,357
1,264
1,172
1,079
988
192
106
21
-
a. Mortgage loans
b. Mortgage passthrough securities
d. Measuring
prepayment
speeds
CPR
PSA
c. Calculate prepayment
amount for a month
Prevailing mortgage rates
Factors affecting
prepayments
Housing turnover
Characteristics of the
underlying mortgages
f.
Types of
prepayment risk
Contraction risk
Extension risk
e. Average life of an MBS
51.
MortgagedBacked
Sector Of
The Bond
Market
g. Creation and Matching

of assets and liabilities
Sequential Pay
Accrual tranche
CMOs
h. Tranches
Planned Amortization
Class (PAC)
Support Tranche
i. Risks and
Performance of each
type of CMO tranche
j. Stripped MBS
Agency
k. MBS
Nonagency
Warm-up: Commercial MBS

l. CMBS vs
Residential MBS
m. CMBS: Structure
and Call protection
Page 90
Structural features
Seller
a. Securitization
transaction
Parties
Issuer/Trust
Servicer
Prepayment
tranching
Credit
tranching
b. Tranching
Amortizing
assets
c. Securitization
backed by
Non-amortizing
assets
Corporate guarantees
External
Letter of credit
Bond insurance
d1. Credit
enhancements
Reserve funds
Internal
Cash reserve funds

Excess servicing spread funds
Overcollateralization
Senior/Subordinated structure
52. AssetBacked
Sector Of
The Bond
Market
d2. Shifting
interest
mechanism
Home equity loans
Manufactured housing
backed loans
e. Cash flow and

prepayment
charateristics for
securities backed by
Auto loans ABS
Student loan-backed securities
SBA loan-backed securities
Credit card receivable-backed securities

What is it?
Ramp up phase
Cash flow CDO
Reinvestment phase
Pay down phase
Types
Market value CDO
f. CDO
Synthetic CDO
g. Primary
motivations
for CDO
Arbitrage-driven
Balance sheet- driven
Page 91
Cash flow yield
a. MBS/ABS
spread measures
Nominal spread
Zero- volatility spread
Step 1:
Step 2:
b. Monte Carlo
simulation model
Step 3:
Step 4:
Step 5:
c. Path dependency
d. OAS from a Monte

Carlo model
e. OAS analysis
53. Valuing
MBS And
ABS
f. Why effective durations reported by
various dealers & vendors may differ
g. Analysing interest rate risk with

effective duration and convexity
Cash flow
duration
h. Other
MBS
duration
measures
Coupon curve
duration
Empirical
duration
Nominal spread
i. Spread analysis of
fixed-income securities
Zero-volatility spread
OAS
Page 92
CFALEVEL2
DERIVATIVES
Page 93
Warm-up: Forward contracts
The no-arbitrage principle

A simple version of the Cost-of-Carry model
Warm-up:
Forward
contract price
determination
Cash and Carry arbitrage when the forward contract is overpriced

Reverse cash and carry arbitrage when the forward contract is underpriced
At initiation
a. Forward
contract
value
During the life

At expiration
54.
Forward
Markets
And
Contracts
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
Page 94
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
Costs
Monetary costs
Non-monetary costs
d. Holding the
underlying asset
Benefits
Monetary benefits
Non-monetary benefits
55. Futures
Markets And
Contracts
e. Backwardation
vs.
Contango
f. Normal backwardation
&
Normal contango
Eurodollar futures
Treasury bond futures
Warm-up:
Stock index futures

Currency futures
Warm-up: T-Bill futures pricing

g. Difficulties in pricing Eurodollar futures
& creating a pure arbitrage opportunity
Treasury bond futures
Stock futures
h. Calculate
price of
Stock index futures

Currency futures
Page 95
Fiduciary call
Warm-up: Put-call parity

for European options
Protective put
Call option
Put option
a1. Using put-call

parity to create
synthetic
Bond
Underlying stock
Pricing options
a2. Why
synthetic?
Earning arbitrage profit
One-period
b. Binomial
option-pricing
model
Two-period
Options on Fixed Income Securities
Warm-up: Binomial
interest rate trees
Options on Interest rates: Caps and Floors

Assumptions: Lognormal, Rf & sigma: constant & known, Frictionless market, No CF, European options.
c. BSM model
Limitations
Delta
e. Interpreting
DELTA
e. Use in
dynamic
hedging
56. Option
Markets And
Contracts
Interpreting
Option's price
GAMMA
f. Effect on
d. The
Greeks
Delta
Delta hedge
Interpreting
Historical
volatility
VEGA
h. Estimate
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
Page 96
pricing
a. Swap
valuation
I/r swap = FRAs
b. Swaps =
= 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
57. Swap
Markets And
Contracts
e. Equity swaps
f. Characteristics
and uses
Swaptions
g. Payoffs and
cash flows
h. Value of i/r
swaption
i. Swap credit risk
j. Swap spread
Page 97
on i/r
a. Cap and floor
58. Interest
Rate
Derivative
Instruments
on fixed-income
instruments
b1. Payoff for a cap

and a floor
b2. A collar
Page 98
a. Credit default
swaps (CDS) vs.
Corporate bonds
Risk management
Short positions
b. Advantages
over other
credit
instruments
Liquidity
Flexibility
Confidentiality
Commercial banks
59. Using
Credit
Derivatives
To Enhance
Return And
Manage Risk
c1. The
use of
credit
derivatives
by
Investment banks
Hedge funds
Life Insurance, Property & casualty insurance,
Reinsurers & monoline companies
c2. Structured
credit products
Basis
trade
Curve
trade
Index
trade
d. Credit
derivative
strategies
Options
trade
Capital
structure
trade
Correlation
trade
Page 99
CFALEVEL2
PORTFOLIO
MANAGEMENT
Page 100
Risk averse investors, parameters are known

and used, no taxes or transaction costs
Assumptions
a. MeanVariance
analysis
Portfolio expected return

Standard deviation
Minimum variance frontier
b. Frontiers
Efficient frontier
Effect of correlation on diversification
c. Diversification
Effect of number of assets on diversification

Equally-weighted
portfolio risk (variance)
CAL
d. CAL and CML
CML
Inputs needed: E(R), s, cov.
Homogeneous expectation
4 assumptions
Borrow and lend at risk free rate

Unlimited short-selling
e. CAPM
No trx cost, no tax

Perfect competitive market
Market risk premium
Beta
Financial market equilibrium
Risk measure
f. SML
CML # SML
Application
Definition
Slope
2 sources of risks
E(error)=0
3 assumptions
60. Portfolio
Concepts
covar (Rm, error)=0

uncorrelated unsystematic
risk across assets
g. Market model
(single factor model)
Expected returns
Predict
Variances
Covariances
h. Adjusted betas
Reliability
i. Instability in
the minimum
variance frontier
Reasons
Statistical inputs are forecast
Time instability
Overfitting problem
Macroeconomic factor models
j. Multifactor models
Forecast from historical sample--> change over time

Small changes cause large change
k. Portfolio expected return
Fundamental factor models

Statistical factor models
Assumptions
l. Arbitrage
Pricing Model
APT equation
APT # Multifactor
Active return
(tracking error)
Active risk
(tracking risk)
m. Active
return and risk
Active factor risk

Active specific risk
Information ratio
Uses of factor and
tracking portfolios
n. CAPM # APT
Page 101
CAPM
assumptions
Borrow and
Lend at risk
free
Unlimited
short selling
a. CAPM
Market portfolio on
efficient frontier
CAPM
implications
Linear relationship
between return and beta
61. A Note
On Harry M.
Markowitz's
"Market
Efficiency: A
Theoretical
Distinction
And So
What?"
borrowing at risk free rate

b. Consequences of
restrictions on
short selling
Page 102
Integration vs.
Segmentation
Psychological barriers
Legal restrictions
Transaction costs
Discriminatory taxation
Political risks
Foreign currency risk
Impediments to
international flow
of capital
a,b. International
market integration
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
Separation theorem
2 basic results
Risk-pricing relationship
Standard
CAPM
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
Risk-free rate = Investor's domestic risk free rate
Elements
Market portfolio = All risky assets in the world
d. Extended
CAPM
Additional assumptions
(unreasonable)
Investors have identical consumption baskets

PPP holds exactly
Warm-up: domestic and foreign currency returns
62.
International
Asset
Pricing
e. Real e/r and domestic

currency returns
f. Calculate
g. Calculate
Expected exchange rate

Domestic-currency HPR
on a foreign bond
End-of-period real e/r

Domestic currency ex-post
return on a foreign bond
h. Calculate foreign
currency risk premium
Investor's domestic risk free rate
ICAPM
i. ICAPM Formula
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
E/R and bonds

(i.e. E/R and I/R)
Traditional
model
J-curve effect: Trade

balance - Currency
Equity exposure
Money
demand
model
Free markets theory
Government intervention theory
Page 103
a. Justify ACTIVE PM
b1.
TreynorBlack
modelsteps
Stock alphas
Weightings
63. Theory
Of Active
Portfolio
Management
Alpha
b2. TreynorBlack
Calculations
Portfolio A
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
Page 104
Evaluating investor and

market characteristics
Developing an investment
policy statement
Determining an asset
allocation strategy
Warm-up:
elements of PM
Measuring and
evaluating performance
Monitoring dynamic investor objectives
and capital market conditions
a. Importance of the
PORTFOLIO perspective
c1.
Objectives
Risk objectives
Return objectives
Liquidity
64. PM
Process
And
Investment
Policy
Statement
f. Time horizon
c2.
Constraints
f. Legal and
regulatory
concerns
f. Tax
considerations
PM
process
Step 1:
Planning
f. Unique
circumstances
d. IPS
Role of IPS
Elements of IPS
Passive
e. Strategic Asset allocation:
3 common approaches
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
Page 105

2012 Level 2 Mindmaps-1

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2012 Level 2 Mindmaps-1

Uploaded by

Copyright:

Available Formats

ChangesinCFAlevel2curriculum2012

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright

All CFA Institute members and candidates are

Structure of the CFA

Is responsible for the

Through the Disciplinary

An inquiry can be prompted

The member or candidate

Conclude the inquiry with

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright

Recommended procedures for compliance (RPC)

Maintain independence and objectivity in professional activities

Invitations to lavish functions

Allocation of shares in oversubscribed

May try to pressure sell-side analysts

From Buy-side clients

e.g. to issue favorable research

To issue favorable reports

-->Modest gifts and entertainment are

to issue favorable research on current or

-->Best practice: reject any offer of gift,..threatening independence and objectivity

free of bias from pressures

-->Portfolio managers must respect and foster honesty of sell-side research

Protect integrity of opinions

Restrict special cost arrangements

Restrict employee investments

any untrue statement or omission of a fact

or any fasle or misleading statement

Must not knowingly make

oral representations, advertising

Must not misrepresent any

Must not guarantee clients specific return

Written list of available services, description of firm's qualification

Prepare summary of qualifications and experience, list of services capable of performing

Address conduct related to professional life

Conduct damaging trustworthiness or competence

Develop and/or adopt a code of ethics

Disseminate to all employee a list of potential violations

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright

Analysts are free to act on

Make reasonable efforts to achieve

Must communicate the info only to the

Must not knowingly engage in conduct

develop & follow disclosure policies

Prohibition of all proprietary trading while firm

transactions that deceive

including spreading false rumors

prohibit legitimate trading strategies

The intent of action is critical to determining

act with care, skill, and diligence

Understand & adhere

Determine identity of "client"

Manage pool of assets in accordance

Put their obligation to client first in all dealings

Review investments periodically

Do not discriminate against any clients

Material changes should be

particularly clients may have acted on

Treat all clients fairly in light of their

Disclose to clients &

duty of fairness and loyalty to clients can never be overriden

Inquiry should be repeated at least annually/prior to material changes