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CFALEVEL1

STUDYSESSION01

ETHICAL &
PROFESSIONAL
STANDARDS

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All CFA Institute members and candidates are required to comply with the Code and Standards
The CFA Institute Bylaws

Basic structure
for enforcing
the Code and
Standards

Rules of Procedure

Fair process to member and candidate

Based on two
primary principles

Confidentiality of proceedings

Maintains oversight and responsibility

Structure of the CFA
Institute Professional
Conduct Program

Professional
Conduct
program
(PCP)

The CFA Institute

Board of Governors

The CFA
Designated
Officer

Through the Disciplinary

Review Committee (DRC)

Directs Professional
Conduct Staff

Is responsible for the

enforcement of the
Code and Standards

Conducts professional
conduct inquiries

Self-disclosure
An inquiry can be prompted
by several circumstances

a.

Written complaints
Evidence of misconduct
Report by a CFA exam proctor

Requesting a written explanation from the member or candidate

1. Code Of
Ethics And
Standards
Of
Professional
Conduct

Process for the

enforcement of
the Code and
Standards

The Professional
Conduct staff conducts
an investigation that
may include

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

Act with integrity, competence, diligence, respect and in an ethical manner

Six components of
the Code of Ethics

Integrity of investment profession & interest of clients above personal interest

Care & judgment
Practice ethics & encourage others to practice
Integrity & rules of capital markets
Professional competence

b,c.

Professionalism
Integrity of Capital markets
Seven Standards of
Professional Conduct

Duties of Clients
Duties to Employers
Investment analysis, Recommendations & Actions
Conflict of interest
Responsibilities as a CFA Institute member or CFA Candidate

If finding that a violation of

the Code and Standards
occurred, the Designated
Officer proposes a
disciplinary sanction

Accepted by member
Rejected by member

The matter is referred to a

hearing by a panel of CFA
Institute members

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Understand and comply with applicable laws and regulations

Follow stricter law and regulation

Code and Standards vs. Local law

Responsible for violations in which they

knowingly participate or assist

->Leave employers (in extreme cases)

Dissociate from illegal, unethical activities

Guidance

Participation
or
association
with
violations by
others

Attempt to stop the behavior by bringing it to the attention of

employer through a supervisor or compliance department
Intermediate
steps

May consider directly confronting the involved individuals

If not successful,-> step away and
dissociate from the activity by

A.
Knowledge
of the law

Removing their name from written reports

Asking for a different assignment

Inaction with continued association may be construed as knowing participation

Not require reporting violations to government, CFAI, but...
Stay informed
Review procedures
Recommended
procedures for
compliance (RPC)

Members and
candidates

Maintain current files

When in doubt,->seek advice of compliance personnel or legal counsel
When dissociating from violations,-> Document any violations and urge firms to stop them

Develop and/or adopt a code of ethics

Firms

Make available to employees info that highlights applicable laws and regulations
Establish written procedures for reporting suspected violation of laws,...

Application

Maintain independence and objectivity in professional activities

Gifts, Invitations to lavish functions, Tickets, Favors, Job referrals,
Allocation of shares in oversubscribed IPOs...

By benefits
External
pressures

To issue favorable reports

From public companies

From Buy-side clients

May try to pressure sell-side analysts

e.g. to issue favorable research reports/recommendations for certain companies

How to cope with
external and
internal
pressures

From their
own firms

Internal
pressures

Guidance

Investment-banking
relationships

to issue favorable research on current or

prospective investment-banking clients
Conflicts of interest

-->Modest gifts and entertainment are acceptable

but special care must be taken

-->must disclose to employers

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

convey true opinions

-->
-->Recommendations must

B. Independence
and objectivity

free of bias from pressures

be stated in clear and unambiguous language

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

2.1 Standard I
PROFESSIONALISM

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
Without regard to conclusions or recommendations

Protect integrity of opinions

Create a restricted list
Restrict special cost arrangements
RPC

Limit gifts
Restrict employee investments

Equity IPOs
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

oral representations, advertising

Must not knowingly make

misrepresentation or give
false impression in
Guidance

electronic communications
written materials
qualifications or credentials, services

Must not misrepresent

any aspect of practice,
including

performance record
characteristics of an investment
any misrepresentation relating to member's professional activities

C. Misrepresentation

Must not guarantee clients specific return on investments that are inherently volatile
Standard I(C) prohibits plagiarism in preparation of material for
distribution to employers, associates, clients, prospects, general publich
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

Conduct damaging trustworthiness or competence

Abuse of the CFA Institute Professional Conduct Program

D. Misconduct

Develop and/or adopt a code of ethics

RPC

Disseminate to all employee a list of potential violations

Check references of potential employees

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Definition of "Material
nonpublic information"
Must be particularly aware of info
selectively disclosed by corporations
Guidance
Analysis of Public info + nonmaterial nonpublic info --> Investment conclusion
Mosaic
Theory

Analysts are free to act on this collection

of info without 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)

Must communicate the info only to the designated

supervisory and compliance personnel within the firm

If public dissemination
is not possible,

RPC

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
Encourage
firms to

2.2 Standard II
INTEGRITY OF
CAPITAL
MARKETS

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
deceive market
participants

Transactions that artificially

distort prices or volume
Securing a controlling, dominant position in a
financial instrument to exploit and manipulate
price of a related derivative/or underlying asset

can be
related to
dissemination of false
or misleading info

B. Market
manipulation

Standard II(B)
not meant to

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

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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

Determine identity of "client"

Must be aware of whether they have
"custody" or effective control of client assets
Manage pool of assets in accordance with terms of governing documents
Put their obligation to client first in all dealings
Avoid all real or potential conflicts of interest
Forgo using opportunities for their own benefit at the expense of client
Follow any guidelines set out by client for the management of assets
Judge investment decisions in context of total portfolio
Vote proxies in an informed & responsible manner
Understand & adhere
to fiduciary duties

Responsibility
to a client
includes

Guidance
A.
Loyalty,
prudence,
and care

duty of
loyalty

"Soft dollars"
Submit to clients at least quarterly itemized statements
Separate assets
Review investments periodically
Establish policies & procedures with respect to proxy voting and the use of client brokerage
Encourage firms to address some topics (p. )

RPC

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
particularly clients may have acted on
Material changes should be
communicated to all current clients or been affected by earlier advise

Guidance
B. Fair dealing

Clients who don't know changes and therefore

place orders contrary to a current
recommendation

Investment
actions

2.3 Standard III

DUTIES TO
CLIENTS

should be advised of the changed

recommendation before the order is
accepted

Treat all clients fairly in light of their

investment objectives & circumstances
duty of fairness and loyalty to clients can
Disclose to clients &
never be overridden by client consent to
prospects written
patently unfair allocation procedures
allocation procedures
Should not take advantage of their position in the industry to the detriment of clients

RPC (p.

Guidance

In
investment
advisory
relationships

Be sure to gather client info in the form of an IPS and make suitability
analysis prior to making recommendation/taking investment action
Inquiry should be repeated at least annually/prior to material changes
-->suitability analysis must be
If clients
withhold info done based on info provided
Risk analysis
Fund managers

C. Suitability

In case of unsolicited
trade requests
unsuitable for client

Be sure investments are consistent with the stated mandate

-->refrain from making trade or seek affirmative statement

from client that suitability is not a consideration

Written IPS
Investors' objectives and constraints should be maintained and reviewed
periodically to reflect any changes in clients' circumstances

RPC

Guidance
D. Performance
presentation

Standard III(D) prohibits misrepresentations of past

performance or reasonably expected performance
--> Provide credible performance info
-->Should not state or imply that clients will obtain
or benefit from rate of return generated in the past
--> ensure that their claims are
Research analysts promoting the success
fair, accurate, and complete
of accuracy of their recommendations
If the presentation is brief, must make available to
clients and prospects the detailed info upon request

RPC

GIPS
on the basis of their special ability to conduct a
portion of clients' business or personal affairs
arising from or is relevant to that portion of clients' business
that is the subject of special or confidential relationship
Comply with applicable laws
When in doubt -->consult with compliance department/ outside counsel before disclosing
Standard III(E) is
applicable when
members receive info

Guidance
E. Preservation
of confidentiality

Standard III(E) does not prevent cooperating

with an investigation by CFAI PCP
RPC

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6
In matters related to their employment, members and candidates
not engage in conduct that harms the interests of the employer
-->Comply with policies and procedures established by
employers that govern employer-employee relationship

Employer-employee
relationship

Standard IV(A) does not require to place employer

interests ahead of personal interests in all matters
The relationship imposes duties and responsibilities on both parties

Independent
practice

Abstain from independent competitive activity

that could conflict with employer's interests
Provide notification to employer, obtain consent from employer in advance

Guidance

A. Loyalty
Planning to leave, must continue to act in employer's best interest
Must

Leaving an
employer

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

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
Whistle blowing
Nature of employment

2.4 Standard IV
DUTIES TO
EMPLOYERS

Obtain written consent from employer before accepting

compensation or other benefits from third parties...

Guidance

B. Additional
compensation
arrangements

RPC

Should make an immediate

written report to their employers

Must have in-depth knowledge of the Code & Standards

Apply knowledge in discharging supervisory responsibilities
Delegation of supervisory duties does not
relieve members of supervisory responsibility

-->Instruct subordinates methods

to prevent and detect violations

Make reasonable efforts to detect violation of laws, rules, regulations, and Code & Standards
Must understand what constitutes an adequate compliance system
Make reasonable efforts to see that appropriate
compliance procedures are established, documented,
communicated to covered personnel and followed

Guidance
-->Establish
and
implementing
Compliance
procedures

C. Responsibilities
of supervisors

Bring an inadequate compliance system to senior

managers's attention & recommend corrective action
If clearly cannot discharge
responsibilities 'cos of absence
of compliance system,
In case of
employee's
violation,

-->decline in writing to
accept responsibilities

promptly initiate investigation

take steps to ensure no repetition

Recommend employer to adopt a code of ethics

Respond promptly
RPC

If there is
a violation

Conduct a thorough investigation

Increase supervision or place appropriate limitations on
the wrongdoer pending the outcome of the investigation

investment philosophy followed

The application of
Standard V(A)
depends on

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role of member in the investment

decision-making process
support and resources
provided by employer

Must make reasonable efforts to cover all pertinent

issues when arriving at recommendation
Provide or offer to provide supporting info to clients when
making recommendations/changing recommendations
Guidance
-->must make reasonable &diligent efforts to
determine whether 2nd/3rd party research is sound

Using secondary or
third-party research

A. Diligence and
reasonable basis

If member does
not agree with the
independent and
objective view of
the group

Group research and

decision making

-->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 (p. )

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

C. Record
retention

Fulfilling regulatory requirements may

satisfy the requirements of this Standard

Absence of
regulatory
guidance
RPC

Must explicitly determine

whether it does

CFAI recommends maintaining records for at least 7 yrs

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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

investment banking
underwriting and financial relationships

Broker/dealer market-making activities

Material beneficial ownership of stock
between duties to clients and to
shareholders of the company

All matters
may impair
objectivity
Investment
personnel
also serves
as a director

Disclosure
to clients

Guidance

poses
conflicts
of interest

may receive option to

purchase securities of the
company as compensation
MNI

-->members providing investment

services also serving as directors
should be isolated from those
making investment decisions

A. Disclosure
of conflicts
-->Sell-side
members

should disclose material beneficial ownership

interest in securities/investment recommended

-->Buy-side
members

should disclose procedures for reporting

requirements for personal transactions

What?
Disclosure of
conflicts to
employers

How?

by firewalls

Same circumstances with clients

Any potential conflict situation
Enough info
Must comply with employer's restrictions regarding conflict of interest

2.6
Standard VI
CONFLICTS OF
INTEREST

Other
requirements

Must take reasonable steps to avoid conflicts

If conflicts occur inadvertently, must report them promptly

Should disclose special compensation arrangements with employer that might conflict with client interest
RPC

Document request & may consider dissociating from the activity if firm
does not permit disclosure of special compensation arrangements
Disclose to clients info that fee based on a share of capital gains
Disclose as a footnote to research report published if members have
outstanding agent options to buy stocks as a part of compensation package

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
Guidance

-->make sure

investment professional does

not benefit personally from
trades undertaken for clients
investment professional
complies with applicable
regulatory requirements

B. Priority of
transactions

Having knowledge of pending transactions,

assess to info during normal preparation of
research recommendations

-->Must not convey such info

May undertake personal transactions after clients & employers

have had adequate opportunity to act on recommendation
Family accounts (that
are client accounts)

should be treated like other accounts

if member has beneficial ownership

RPC (p. )

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

-->may still be subject to pre clearance or reporting requirements

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Cheating on CFA exam or any exam

A.
Conduct
as
members
and
candidates
in the CFA
program

Prohibiting any conduct

that undermines the
integrity of the CFA
charter (p. )

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

Preventing promotional
efforts that make promises
or guarantees tied to the
CFA designation

2.7 Standard VII

RESPONSIBILITIES
AS CFA MEMBER /
CANDIDATE

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

Over-promise the
competence of an individual
Over-promise future
investment results

Applies to any form of

communication

To maintain
CFAI
membership

Remit annually to CFAI a completed

Professional Conduct Statement
Pay applicable CFAI membership dues
on an annual basis

Using the CFA designation

(p. Curriculum)

Referencing candidacy in the CFA program

(p. Curriculum)

Proper using of the CFA marks

(p. Curriculum)

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a1. Why were the GIPS Standards created?

3. Introduction
to Global
Investment
Performance
Standards
(GIPS)

a2. Who can claim compliance?

a3. Who benefit from Compliance?
b. Construction & purpose of Composites
c. Verification
The Structure of the GIPS Standards

GIPS Objectives

4a. Key characteristics of the

GIPS standards &
fundamentals of compliance

Key characteristics
Fundamentals
of compliance

Requirements
Recommendations

3+4 GIPS
Investment firm definition

b. The scope of the GIPS

Historical performance record

c1. How are GIPS standards implemented in countries

with existing standards for performance reporting

c2. Appropriate response when the GIPS

standards & local regulations conflict

d. Major sections of GIPS standards

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CFALEVEL1

STUDYSESSION02&03

QUANTITATIVE
ANALYSIS

Page 12

Required rate of return

a. Interest rate,
considered as

Discount rate
Opportunity cost

b. Interest rate

c,d. EAR

FV=

PV=

Annuity

e. CF
calculations

Ordinary
Annuity
Annuity
Due

PV of a
Perpetuity

5. TIME VALUE
OF MONEY

Uneven CF

f1. Time index

Find PMT

f2. Loan
payment
and
Amortization

Find N
Find I/Y
Amortization table

Rate of compound growth

f3. Other
applications

Number of periods for specific growth

Funding a future obligation

f4. Connection between

PV, FV & series of CF

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NPV

a,b. Calculate,
Interpret,
Decision rule

Problems
IRR

Conflict with
NPV due to

# Initial costs
# timing

c. HPR

Money
Weighted

d. Portfolio
rate of return
Time
weighted

6. DISCOUNTED
CASH FLOW
APPLICATIONS

IRR
More appropriate if manager has
complete control over cash in/out

Compound growth
Geometric mean
Not affected by cash in/out
Preferred method

Bank discount yield

Holding period yield

e. Yields of T-bills

Effective annual yield

Money market yield

f1. Convert among these yields

f2. Bond equivalent yield

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Statistical
methods

Descriptive statistics
Inferential statistics

Population vs.
Sample
Nominal scales

Types of
measurement
scales

a.

Ordinal scales
Interval scales
Ratio scales

Parameter vs.
Sample statistic
Definition

Frequency
distribution

b.

Construction of a
frequency distribution

7 steps

Absolute frequency
Relative frequency

c.

Cumulative absolute frequency

Cumulative relative frequency
Histogram

d.

Frequency polygon
Population mean vs. Sample mean
Arithmetic mean
Weighted mean
(portfolio return)
Mean

Geometric mean
(compound growth)

m. Use of arithmetic or geometric mean

when determining investment returns

e.
Measures
of central
tendency

Harmonic mean
(cost of shares)
Harmonic < geometric < arithmetic
Median

Odd number of observations

Even number of observations
No mode

Mode

Unimodal, bimodal, trimodal

Model interval

Quartiles (4)
Quintile (5)
Decile (10)

f. Quantile

Percentile (100)

Ly =(n+1)*y/100

Range
MAD

g. Dispersion
(measure of risk)

Variance &
Standard deviation

Population
Sample (use n-1)

1-1/(k^2)

h. Chebyshev's
inequality

CV (Coefficient of Variation) = StdDev / Average

i. Relative
dispersion

Sharpe Ratio / Reward-to-Variability ratio

Symmetrical

=Excess return/ StdDev

mean=median=mode
Calculate: Sample skewness =

j,k. Shape of
distribution

Nonsymmetrical (Skewness)
(b/c of outliers)

Calculate

l. Kurtosis

Positively skewed (Sk>0)

Types

mode<median<mean

Negatively skewed (Sk<0) --> more risk

Sample kurtosis =
Excess kurtosis = sample kurtosis - 3

Compared with
normal distribution

Leptokurtic: more peaked, fatter tails (excess kurtosis > 0) --> more risk
Platykurtic: less peaked (excess kurtosis < 0)
Mesokurtic: identical (excess kurtosis = 0)

mean<median<mode

Page 15

Random variable
Outcome

Floating c

Event

a.

Mutually exclusive events

Exhaustive events

2 defining
properties of
probability

0<=P(E)<=1
sum of all P(E) =1, if set of events is mutually exclusive & exhaustive
past data

Empirical
Determine
probabilities

b.

formal reasoning and inspection process

Priori

personal judgment

Subjective

c. Odds for vs. odds against the event

Unconditional probabilities

d.

Conditional probabilities

Multiplication rule

e. Probability rules

Addition rule
Total probability rule

Joint Probability

8. PROBABILITY
CONCEPTS

f. Calculate

Of 2 events
Of any number of
independent events

Probability of at least
one event will occur

g. Dependent events
vs.
Independent events

h. Total probability rule

i. Use of conditional expectation in investment applications

j. Tree diagram

k. Covariance and Correlation (-1 to 1)

Expected return

l. Portfolio

Variance and
standard deviation

m. Calculate covariance given

a joint probability function

n. Bayes' formula
Factorial
Labeling

o. Counting methods

Combination
Permutation

Page 16

Probability distribution
Random variables

Discrete
Continuous

a,b.
Discrete distribution vs.
continuous distribution

Probability function p(x)

for discrete variable

PDF- Probability density function f(x)

c,d. Functions

CDF- Cumulative distribution function F(x)=P(X<=x)

Discrete uniform

e,f,g. Discrete
random variables

Bernoulli
Binomial

h. Tracking error

i. Continuous uniform distribution

Normal distribution

9. COMMON
PROBABILITY
DISTRIBUTIONS

j,k. Normal distribution

Univariate distribution vs.

Multivariate distribution (the role of correlation)

1 --> 68%

l. Confidence intervals
(for normal distribution)

1.65 --> 90%

1.96 or 2 --> 95%
2.575 --> 99%

m. Standard normal
distribution and standardize

z=

Shortfall risk = Probability that (return < threshold)

n. Roy's safety-first criterion

SFRatio =
Compare to Sharpe

o. Lognormal distribution
Discretely compounded
EAR=

p. Compounded rate of return

Continuously compounded

From S:
HPR=

Monte Carlo simulation

q,r. Simulation

Historical simulation

Page 17

Simple random sampling

a,b. Sampling
concepts

Sampling error
Sampling distribution

Simple random sampling

c. Sampling
methods

Stratified random sampling

Time- series

d. Set of data

Cross- sectional

n>=30

e. Central limit theorem

f. Standard error of the sample mean

Point estimation

h. Estimate a population
parameter

Confidence interval estimation

Unbiased

10. SAMPLING &

ESTIMATION

g. Desirable properties
of an estimator

Efficient
Consistent

Small samples (n<30),

unknown variance

Used when

Normal (or approximately

normal) distribution

i. Student's
t-distribution

Symmetrical
Properties

Degrees of freedom df=n-1

Less peaked, fatter tails than normal
Higher n --> approach z

Non-Normal AND n<30

j. Calculate
confidence
interval

Not available

Known variance

Other situations

--> z test

Unknown variance --> t test

Sample size n
(larger is better), but

Possible mistake: Observations from a

different population may be included
Higher Cost

Data mining bias

k. Selection of sample size

Sample selection bias

Bias

if n >=30 --> t approach z --> both are ok

Survivorship bias
Look-ahead bias
Time-period bias

Page 18

Statement about
population parameter
Hypothesis

Null hypothesis
Alternative hypothesis

One-tailed and two-tailed

tests of hypotheses
1. State the hypothesis
2. Identify the test statistic
& probability distribution

3. Specifying
significance level

May follow t, z,Chi-square, F distribution

b. Significance level
and critical value

a.
Hypothesis
testing steps

b. Test
statistic

4. State
decision rule

Reject ...

c. Decision rule

5. Collect data and

calculate test statistic
6. Make statistical
decision

Statistical result

d. Distinguish

Economically meaningful result

7. Make economic/investment decision

Type I

b. Errors
Type II

11. HYPOTHESIS
TESTING

(alpha) reject null when it's true

(beta) do not reject null when it's false

=1-beta

c. The power of a test

c. The relation between confidence

intervals and hypothesis tests
e. How to use p-value
f. Mean of a normally
distributed population with

Test
means

known variance
unknown variance

g. The equality of means of 2 normally distributed

populations, based on independent random samples with
h. The mean difference of 2 normally distributed
populations (paired comparisons test)

Single population

i. Test variance

Two independent
populations

Parametric test

j.

Nonparametric test

Chi-square test

F-test

equal assumed variances

unequal assumed variances

Fundamentalists

Overview: 3 views

Page
19
Floating
Topic

Technicians
EMH advocates
TA is the study of collective
market sentiment

Principles

a. Technical
analysis

Prices are determined by the

interaction of Supply & Demand

Applications
Market price reflects both rational & irrational
investor behavior (EMH does not hold)
Assumptions

Trends & Patterns exist & tend to

repeat, can be used to forecast

Closing prices as a
continuous line

Line chart

OHLC chart

Bar chart

12.
TECHNICAL
ANALYSIS
(part 1)

b. Charts

Candlestick chart

Plot only price reversals

Point & figure chart

Scale
Volume
chart
Time intervals
Relative strength analysis

X: increases
O: decreases

Page 20

Definition: a trend approaches a range of prices

but fails to continue beyond that range

Inverse head
& shoulders

Head & Shoulders

Head &
shoulders

Reversal
patterns

Double tops
& bottoms
Definition: a pause in a trend
rather than a reversal

d. Chart
patterns

12.
TECHNICAL
ANALYSIS
(part 2)

Floating Topic

Triangles

Continuation
patterns

Rectangle

Flags & Pennants

Page 21
Floating Topic

c. Trends
breakout vs. breakdown
Trend

Support &
Resistance lines

Support & Resistance lines

Change in polarity (Polarity= phn cc, i lp)
--> to smooth fluctuations

=mean of the last

n closing prices
(n=20; 250...)

______ (smoother/less smooth) line

larger n -->

Moving
average
lines

--> trends are easier to see

ST average line
crosses LT
average line

Price-based

if overly long n --> may

obscure price trend

(obscure = hide)

above

--> golden cross --> _________ (buy/sell) signal

below

--> dead cross --> _________ (buy/sell) signal

SMA (Simple Moving Average) vs. EMA (Exponential)

(place more weigts on recent data)

Bollinger
bands

e.g.: bollinger band (20,2) means 2 standard deviations

above and below the 20-day moving average line
viewed as contrarian indicator: if price at or above upper band -->
over___ (bought/sold) market --> we should ____ (buy/sell)

12.
TECHNICAL
ANALYSIS
(part 3)

e. Common
TA indicators

closing price today & n days earlier

Momentum () oscillator (or
Rate of Change oscillator)

today / past day

Relative
strength
index

--> oscillate around 0

(today - past day) x 100

2 formulas

RSI = (1 - 1/ (1 + RS)) x 100

--> oscillate around 100

RS = Total price increases / Total price decreases

between 0 & 100

compare to 30 and 70

Oscillators
(dao ng)

Moving average
convergence/ divergence
oscillator

MACD line (e.g.: MACD (26,12): ExpMA(26)-ExpMA(12)

Signal line: ExpMA(9) of MACD
MACD line crossing above Signal line (or
divergence histogram crosses up) --> buy signal
Lines

%K line: (latest price - recent low) / (recent high - recent low)

%D line: 3-period average of %K line

If %K line crosses up %D line --> buy signal

Stochastic oscillator

Fast stochastic oscillator

Slow stochastic oscillator

Fast %K = %K basic calculation

Fast %D = 3-period SMA of Fast %K
Slow %K = Fast %K smoothed with 3-period SMA
Slow %D = 3-period SMA of Slow %K

Opinion polls (survey)

=put vol / call vol
Put/Call ratio
Calculated
statistical indices

=volatility of options on S&P 500

CBOE Volatility Index (VIX)

Sentiment
indicators

if high --> investors ____ (bearish/bullish) --> we should

be______ (bearish/bullish)

if increase --> investors are ________ (bearish/bullish) --> prices are __________ (increasing/decreasing)

Margin debt
Short
interest
ratio
Non-price-based
indicators

viewed as contrarian indicator: if very high --> __________ (bearish/bullish)

investor sentiment --> over_______ (bought/sold) market

=short interest / average daily trading volume

short interest = number of shares that

investors have borrowed and sold
short

contrarian indicator of follow the smart money indicator?

=(number of advancing issues/number of declining issues) /
(volume of advancing issues / volume of declining issues)
Arms index or TRIN
(short-term TRading INdex)

Flow of funds
indicators

Margin debt

Compare to 1:
Spikes upward = daily ____ (gain/loss)
Spikes downward = daily ______ (gain/loss)

if increase --> investors _________ (buy/sell) more

Mutual fund cash position

New equity issuance (IPO)
and Secondary offerings

= mutual fund cash / total assets

viewed as contrarian indicator
=market _________ (peak/trough) because Issuers sell new shares
when stock prices are thought to be _____ (high/low)

viewed as support or
resistance level

Page 22

Kondratieff Wave
(40 to 60 years)

f. Cycles

12.
TECHNICAL
ANALYSIS
(part 4)

18-year cycle

Decennial (10-year) pattern

4-year Presidential cycle
Upward moves: 5 waves (1,3,5=impulses; 2,4=corrective; 2=pullback
Downward moves: 3 waves (A,B,C) (A=bulltrap)

Uptrend

g. Elliott
Wave
Theory

Downtrend: downward moves (5 waves); upward moves (3 waves)

Fibonacci
numbers
Size of waves correspond with Fibonacci ratios

0,1,1,2,3,5,8,13,21...
Golden ratio: 1.618 or 0.618

Price target can be 1.618 of the previous high

Different
waves

Grand
Supercycle
(centuries)

Supercycle

Cycle

Primary

Intermediate

Minor

Minute

Minuette

Sub-Minuette
(few minutes)

Major asset classes: stocks, bonds, commodities, currencies

h. Intermarket
analysis

interrelationships (relative strength ratios) among

Equity sectors/ industries

International markets

Floating Topic

Page 23

CFALEVEL1

STUDYSESSION04,05&06

ECONOMICS

Page 24

Markets for factors

of production

a. Types
of
markets

Markets for services

and finished goods
Capital markets

b. Principles of
demand and supply
Shifts
Movement along

c,d. Demand &

Supply Curves

d. Process of
aggregating
Demand
and
Supply

Stable

e. Equilibria
Unstable

Individual and aggregate inverse

demand and supply functions

f.g. Calculate
and interpret

13. Demand
And Supply
Analysis:
Introduction

Individual and aggregate

demand and supply curves
Amount of excess demand
Amount of excess supply

Types of auctions

h.

Winning price

Consumer surplus

l. Calculate
and interpret

Producer surplus
Total surplus

i. Causes of demand or
supply imbalance

Impact of govt regulation

and intervention

j.k.

Effect of introduction and

removal of a mkt interference

Price elasticity of demand

m. Elasticity

Income elasticity
Cross- price elasticity

Page 25

Consumer choice theory

a
Consumer utility theory

Indifference curves
Use of

Opportunity sets

Budget constraints

b.c.

Calculate and interpret

a budget constraint

14. Demand
And Supply
Analysis:
Consumer
Demand

d. Consumer's equilibrium
bundle of goods

Substitution effects

e. Compare
Income effects

normal goods
Distinguish
inferior goods

f.
Giffen goods
Explain
Veblen goods

Accounting profit

Page 26

Normal profit

a. Concepts

Economic profit

Total revenue
Average revenue

b. Revenue

Marginal revenue

a
c. Factors of
production
Total costs

Average costs

Marginal costs

d. Costs

Fixed costs

Variable costs

Breakeven points

e.
Shutdown points

15. Demand
And Supply
Analysis:
The Firm

Economies of scale

f.
Diseconomies of scale

g. Determine
profit-maximizing
level of output
SR profit maximization

h. Distinguish
LR profit maximization

Decreasing-cost industries

i. Distinguish

Constant-cost Industries

Increasing-cost industries

Total

j. Product
of labor

Marginal

Average

Diminishing
marginal returns

k.l.

Profit-maximizing
utilization level of
an input

Optimal combination of
resources-->Minimize cost

Page 27

PERFECT COMPETITION

MONOPOLISTIC
COMPETITION

a.b.c.d.e

OLIGOPOLY

16. The Firm

And Market
Structures

MONOPOLY

Use

f. Concentration
measures
Limitations

g. Identify type of
market structure

Expenditure approach

a. Calculate
GDP using

Page 28

Income approach

Sum-of-value-added method

b. Compare
Value-of-final-output method

a
GDP

Nominal GDP

Compare

Real GDP

c.
GDP deflator

GDP
National income

d. Compare
Personal income
Personal disposable income

Saving
Investment

e. Fundamental
relationship among

Fiscal balance

17. Aggregate
Output, Price,
And Economic
Growth

Trade balance

IS curve

f.

LM curve
Aggregate demand curve

Aggregate
Demand
and Supply

SR

g. Aggregate
supply curve in
LR

h. Shifts and movements

along D & S curves

i. Fluctuations in aggregate D & S -->

SR changes in econ & biz cycle
Sources

j.

Measurement
Sustainability

Economic
growth

k. Production
function approach

Input growth

l. Components of
economic growth

Growth of total
factor productivity

Page 29

Biz Cycle

a. Describe
Phases of Biz Cycle

Business
cycle

b. Economy
moving
through biz
Cycle -->

Inventory levels
Labor
Physical capital
utilization levels

c. Theories
of Biz Cycle
Types

d. Unemployment

Measures

Inflation

e. Explain

18.
Understanding
Business
Cycles

Disinflation
Deflation

f. Indices used to
measure inflation
Inflation
Uses

g. Inflation
measures

Limitations

h. Factors -->
affect price levels

i. Describe
economic
indicators

Cost push inflation

Demand-pull inflation

Uses
Limitations

Economic
indicators
Past biz cycle

j. Identify

Current biz cycle

Expected future
biz cycle

Page 30

Monetary policy

a. Compare
Fiscal policy

Definition, qualities and

functions of money

Money creation process

Demand for money

c. Theories of
Supply of money

d. Fisher
effect
Roles

e. Central
banks

Objectives

f. Implementation
of monetary policy
Monetary
policy

g. Qualities
of effective
central banks
economic growth

h. Relationships
between monetary
policy and

inflation
interest
exchange rate

Expansionary
monetary policy

19. Monetary
And Fiscal
Policy

i.
Contractionary
monetary policy

j. Limitations of
monetary policy
Roles

k. Describe
Objectives

l. Tools of
fiscal policy

Fiscal
policy

Spending tools
Revenue tools

m. Being concerned with

Size of a fiscal debt

implementation
of fiscal policy

n. Explain
difficulties of
implementation

Expansionary
fiscal policy

o.
Contractionary
fiscal policy

p. Interaction of monetary
and fiscal policy

Arguments for
Arguments against

Page 31

Warm-Up:
International Trade
a
Benefits

a. International trade

Costs

Comparative advantage

b. Distinguish
Absolute advantage

Ricardian

c. Models
of trade

Heckscher-Ohlin

Trade restrictions

d. Restrictions
Capital restrictions

Trading blocs

20.
International
Trade And
Capital Flows

e. Motivations
for and
Advantages of

Common markets

Economic unions

Description

f.

Current account
Components

Capital account
Financial account

Balance of
payments
Consumers

g. Influenced by

Firms

Govt

World Bank

h. Functions and
objectives of
international
organizations

IMF

WTO

Page 32

Define an exchange rate

Nominal exchange rates

a.

Real exchange rates

Distinguish

Spot exchange rates

Forward exchange rates

Functions

b. FOREX
market

Participants

d. % change in a
currency relative to
another currency

21. Currency
Exchange
Rates

e. Currency
cross-rates

Forward quotations
Forward discount or premium

f.g.
h. Calculate and interpret
Forward rate consistent with

Countries that do not

have their own currency

i. Exchange
rate regimes

Countries that have

their own currency

International trade

j. Impact of exchange
rates on countries'

Capital flows

spot rate
and interest rate

Page 33

CFALEVEL1

STUDYSESSION7,8,9,10

FRA

Page 34

Fin position

Role of
FiR

of an entity that is useful to a wide range of users in making economic decisions

Fin performance

Provide info about

Changes in fin position

a. Roles of FR
and FSA

Use info in a company's Fin Statements

Use other relevant info
To evaluate past, current, and prospective performance and fin position
Invest in securities

Roles of FSA

Recommend to investors

To make economic decisions. E.g.:

Whether to extend trade, bank credit

Analysts: form opinions about company's ability to earn profits and generate CF

Income Statement
(financial performance)

Revenues
Expenses
Gains and Losses
Assets

Balance Sheet (financial position) (A=L+OE)

b. Role
of key FS

Liabilities
Owners' equity

Operating CF
CF statement

Investing CF

Financing CF
Statement of changes in Owners' equity

accounting methods, assumptions, estimates

FS notes
(footnotes)

Additional items:

acquisitions or disposals
legal actions
employee benefit plans
contingencies and commitments
significant customers
sales to related parties
segments of firm

are audited
Supplementary
schedules

c. Importance of

not audited
operating income or sales by region or business segments
reserves for an oil and gas company
info about hedging activities and financial instruments

assessment of financial performance and condition of a

company from the perspective of its management

22. FSA
Introduction

Results from operations, with trends in sales and expenses

Publicly held companies in US

Capital resources and liquidity, with trends in CF

General business overview

MD&A

discuss accounting policies that require significant judgements by management

discuss significant effects of trends, events, uncertainties
liquidity and capital resource issues, transactions or events with liquidity implications
Discontinued operations, extraordinary items, unusual or infrequent events
Extensive disclosures in interim financial statements
disclosure of a segment's need for CF or its contribution to revenues or profit

= independent review of an entity's FS

objective: auditor's opinion on fairness and reliability of FS, "no material errors"
Independent review though FS prepared by mgmt and are its responsibility
3 parts

d. Audits
of FS

Standard
auditor's
opinion

Reasonable assurance of no material errors (follow generally accepted auditing standards)

FS prepared in accordance with accepted accounting principles, reasonable accounting principles and estimates, consistency

Explanatory paragraph: when a material loss is probable but amount cannot be reasonably estimated. Uncertainties
may relate to the going concern assumption --> signal serious problems and need close examination by analyst
(under US GAAP): Opinion on internal controls
Unqualified opinion: auditor believes statements are free from material omissions and errors
3 types of Opinions

Qualified opinion: if statements make any exceptions to accounting principles --> explain these exceptions
Adverse opinion: if statements are not presented fairly or are materially nonconforming with accounting standards

Interim reports
SEC filings

e. Other info sources

than annual FS and
supplementary info

Quarterly or Semiannual reports (update FS and footnotes, but not audited)

from EDGAR
to shareholders when there are matters that require a shareholder vote

Proxy statements

Filed with SEC

About election of board members, compensation, management and qualifications and issuance of stock options
Corporate reports and press releases
Viewed as PR or sales materials

State the objective and context

Gather data

f. Steps in FSA
framework

Process data
Analyze and interpret data
Report the conclusions or recommendations
Update the analysis

Page 35

Assets
Liabilities

a. Fin
Statement
elements
and
accounts

5 Elements

Owners' equity
Revenue
Expenses

Basic form

b. Accounting
equation

A=L+OW

Extended forms

A=L+CC+Ending Retained Earnings

A=L+CC+Beginning RE+R-X-D

Double entry accounting

c. Recording
process

Unearned revenue

23. Financial
Reporting
Mechanics

Accruals

Accrued revenue
Prepaid expenses

d. Accruals
and other
adjustments

Accrued expenses

Other
adjustments

Historical vs Current costs --> Valuation adjustments

--> income statement or in "other comprehensive income

e. Relationship among IS, BS, CF, OE (p.23)

General Journal (Journal entries)

General ledger (sort entries by account)

f. Flow of Info in
Accounting system

Initial trial balance-->adjusted trial balance

FSs

g. Use of results of
accounting process in
security analysis

Page 36

Objective of Fin statements

a.

Importance of reporting standards in security analysis and valuation

Of standard-setting bodies
(establishing standards)

IASB (International Accounting Standards Board)

US FASB (Financial Accounting Standards Board)

Of regulatory authorities
(enforcing standards)

b. Role

IOSCO (International Organization of Securities Commissions)

UK FSA- Financial Services Authority
US SEC- Securities and Exchange Commission

Status of global convergence

of accounting standards

c.

Barriers to developing one universally

accepted set of financial reporting standards

standard setting bodies

disagree

regulatory authorities

political pressures from business groups and others

Objective of financial statements
Understandability
consistent among firms and time periods

Comparability
Qualitative
characteristics

info timely and sufficiently detailed -> influence decision

Relevance

faithful representation
substance over form
neutrality
prudence and conservatism in estimates
completeness

Reliability

d. IFRS
framework

Required
reporting
elements

assets, liabilities, equity, income, expenses

Historical cost: amount originally paid for the asset
Current cost: would have to pay today for the same asset
Realizable value: amount for which firm could sell the asset
Present value: discounted future cash flows
Fair value: 2 parties in an arm's length transaction would exchange the asset

Measurement
bases

reliability and relevance (timely)

cost
Intangible and non-quantifiable info

Constraints

Accrual basis

Assumptions

Going concern
Required financial statements

BS, IS, CFS, OE, Explanatory notes (incl. accounting policies)

Fair presentation
Principles for
PREPARING

Going concern basis

Accrual basis
Consistency

24. Financial
Reporting
Standards

e. General requirements
for Financial Statements

Materiality
Aggregation
Principles for
PRESENTING

No offsetting
Classified balance sheet
Minimum information is required
Comparative information

IASB requires mgmt to consider the

framework if no explicit standard exists

Purpose of framework

IASB same objective

Objectives of financial statements

FASB different objectives for biz and non-biz

Assumptions

IASB emphasizes going concern

Qualitative
characteristics

FASB: relevance, reliability

Primary characteristics

IASB: comparability, understandability also

IASB: income+expenses

f. IFRS (by IASB) #

US GAAP (by FASB)

Performance
Financial
statement
elements

FASB: Revenues, Expenses, Gains,

Losses, comprehensive income
IASB: resource from which future
economic benefit is expected

Asset definition

FASB: future economic benefit

IASB: define criteria for recognition

"Probable"

FASB: define assets and liabilities

IASB: allow

Values of assets to be
adjusted upward

FASB: not allow

Reconciliation statement
Characteristics of a coherent
financial reporting framework

Transparency
Comprehensiveness
Consistency
Valuation

g.

Barriers to creating a
coherent financial reporting
framework

Principles-based
Standard setting

Rules-based

IFRS
relies on broad framework
FASB in the past
specific guidance how to classify trx
FASB moving now

Objectives oriented

blend the other two

Measurement
update

h. Importance of monitoring developments

in financial reporting standards

www.iasb.org
www.fasb.org

In the footnotes & in MD&A (management judgment)

i. Evaluate company disclosures of

significant accounting policies & estimates

new accounting standards

--> 3 statements

standard does not apply

will not affect the FS materially
are still evaluating the effects of the new standards

Page 37

Revenues
Components

a. IS

Expenses
Gross profit

Presentation formats

unearned revenue

Accrual accounting

IASB
FASB

General principles of

evidence of arrangement btw buyer and seller

Revenue recognition
SEC

product delivered or service rendered

price is determined or determinable
seller reasonably sure of collecting money

Percentage-of-completion method

Long term contracts

b,c. Revenue
recognition

Completed-contract method
Certain collectibility -> normal method

Installment sales

Not reasonably estimated collectibility -> installment method

Highly uncertain collectibility -> cost recovery method

Applications

Round trip transactions

Barter transactions

Gross revenue reporting

(vs. net revenue reporting)

primary obligator
bear inventory & credit risk
ability to choose supplier
reasonable latitude to establish prices

Implications for Financial Analysis

Inventories
Matching
principle

Depreciation
Long-lived assets

Depletion
Amortization

d. Expense
recognition

Bad debt, warranty expenses estimation

Period costs

25. Understanding
The Income
Statement

Admin

Implications for Financial Analysis

Discontinued operations
Nonrecurring items

Unusual or infrequent items

Extraordinary items

e. Financial reporting
treatment and analysis
of

Changes in accounting
standards

Change in accounting principle

Change in accounting estimate
Prior-period adjustment

Operating components

f. Distinguish

Nonoperating components

Simple

Capital structure

Complex
Basic EPS

Formula:
Effect of: Stock dividends and Stock splits

g. EPS
Diluted EPS

h.

Dilutive securities
Antidilutive securities

Formula:
Treasury stock method

i,j. Common size IS

& financial ratios
FX translation gains and losses
Adjustments for minimum pension liability

l. Items excluded from IS but affect

OE- other comprehensive income

Unrealized gains
and losses from

CF hedging derivatives
Available-for-sale securities

k. Comprehensive
income: e.g.. on page __

Page 38

Assets
Liabilities

a. Elements

Equity

b1. Uses of BS in financial analysis

b2. Limitations of BS in financial analysis

Account format

2 common formats

Report format

c. Formats of BS

Classified BS

Current assets
Current liabilities

Current vs.non current

Non current assets

Non current liabilities

d. Classifying
Liquidity-based presentation

Reporting noncontrolling/ minority interest

Historical cost
Bases

Fair value
Replacement cost
PV of future CF
Cash and cash equivalent
Account receivable

Current
assets

lower of cost or net realizable value

Inventories

standard costing
retail method

26. Understanding
The Balance Sheet

Marketable securities
Prepaid expenses and others
Accounts payable

e. Measurement bases
Current
liabilities

Note payables
Current portion of long term debt
Tax payables
Accrued liabilities
Unearned revenue/income
Tangible
assets

Non-current
assets

Used in operations
Not used in operation -> investment assets
Identifiable (finite period) -> amortized

Intangible
assets

Unidentifiable (infinite) -> not amortized, but

tested for impairment at least annually
Internally produced -> not recorded,
except legal costs

Contributed capital
Minority (noncontrolling) interest
Retained earnings

f. Components of OE

Treasury stock
Accumulated other
comprehensive income

BS

g. Analyse

Statement of changes in OE

h. Common-size balance sheet

i. Liquidity & solvency ratios

Goodwill

Page 39

The CF statement

a
CFO
CFI

a.
CFF

affect Net Income

affect Long term assets and
certain investments
affect capital structure

Not reported

b. Noncash investing,
financing activities

Disclosed in footnote or supplemental schedule to CF statement

US GAAP: CFF

dividends paid

IFRS: CFF or CFO

US GAAP: CFO

interest paid

IFRS: CFO or CFF

interest and
dividend
received

c. IFRS vs. US GAAP

US GAAP: CFO
IFRS: CFO or CFI
US GAAP: CFO

taxes paid

IFRS: CFO or CFF or CFI

Direct

27.
Understanding
The CF
Statement

d,e, f,g. CF methods

Total
currency
amounts

Indirect

Major sources and uses of cash

CFO
CFI
CFF

h. Analyse
and interpret

Common-size CF
statement, divided by

Free cash flow

Revenue
Total cash inflow (for inflows) and
Total cash outflow (for outflows)

to Firm: FCFF=NI+NCC+Int*(1-t)-FCInv-WCInv=CFO+Int*(1-t)-FCInv

available to

to Equity: FCFE=CFO-FCInv+NetBorrowing
CF to revenue

Performance
ratios

=CFO/net revenue

Cash return-on-asset

=CFO/average total assets

Cash return-on-equity

=CFO/average total equity

=CFO/Operating income

Cash-to-income
Cash flow per share

i.
CF ratios

Debt coverage
Interest coverage
Coverage
ratios

=(CFO-preferred dividends)/ Weighted average

number of common shares)

=CFO/Total debt
=(CFO+Interest paid+taxes paid)/interest paid

Reinvestment ratio

=CFO/cash paid for long term assets

Debt payment ratio

=CFO/cash long term debt repayment

Dividend payment
Investing and
financing ratio

=CFO/dividends paid
=CFO/cash outflows from
investing and financing activities

Stockholders
Debt holders

Page 40

EXAMPLE: CASH FLOW STATEMENT

Page 41

Page 42

Ratio analysis
Common size

a. Analyses

Balance sheet

Vertical

Income statement

Horizontal
Charts: stacked column graph, line graph

Receivables
management

Receivables T.O = annual sales/average receivables

Days of sales outstanding or average collection period = 365/ receivables T.O
Inventory T.O = COGS/average inventory

Inventory management

Activity

Days of inventory on hand = 365/inventory T.O

Payables T.O = purchases/average trade payables

Trade credit management

Number of days of payables = 365/payables T.O

Total assets management

Total asset T.O = revenue/average total assets

Fixed assets management

Fixed asset T.O = revenue/average net fixed assets

Working capital management

Working capital T.O = revenue/average working capital

Current ratio = current assets/current liabilities

Quick ratio = (cash + marketable securities + receivables)/current liabilities

Liquidity

Cash ratio= (cash + marketable securities)/ current liabilities

Defensive interval= (cash + marketable securities + receivables)/ average daily expenditures
Cash conversion cycle = days sales outstanding + days of inventory on hand - number of days of payables
Debt-to-equity = D/E

b,c. Classes
of ratios

Debt-to-capital = D/(D+E)
Use of debt financing
Debt-to-assets = D/A

Solvency

Financial leverage = A/E

Interest coverage = EBIT/Interest payments

Ability to repay
debt obligations

Fixed charge coverage= (EBIT + lease payments) / (interest payments+lease payments)

Net profit margin= Net income/ Revenue

28.
Financial
Analysis
Techniques

Gross profit margin= (Net sales - COGS)/ Revenue

Operating
profitability

Operating profit margin = EBIT/ Revenue

Pretax margin= EBT/ Revenue

Profitability

ROA
Profitability
relative to funds

Ratio
analysis

Formula 1: ROA= Net income/ Average total assets

Formula 2: ROA= (Net income + int exp (1- tax rate))/ Average total assets

Operating ROA = EBIT / Average total assets

ROTC (Return on Total Capital) = EBIT/ Average total capital
ROE = Net income/ Average total equity
Return on common equity = (Net income - preferred dividends)/ Average common equity

Valuation

Sales per share, EPS, P/CF ... (in Equity study section)

Original approach

d. DuPont analysis
Extended (5-way) DuPont

Valuation ratios
Dividends and Retention Rate
Net income per employee
and Sales per employee
Industry-specific ratios

for service and consulting firms

Growth in same-store sales

Sales per square foot

for restaurants and retail industries

for retail industry

Revenue

Equity analysis
Business risk

Coefficients of
variation of

Operating income
Net income

e. Ratios used in
Capital adequacy
VaR
For Banks, Insurance
companies, financial firms

Reserve requirements
Liquid asset requirement
Net interest margin

Credit analysis

Ratios: interest coverage ratios, return on capital, debt-to-assets, CF to total debt ...
Altman Z-score
Business segment

Segment analysis
Geographic segment

f. Model and
forecast earnings

Using ratio analysis

Using techniques: sensitivity analysis, scenario analysis, simulation

Page 43

28. Financial analysis techniques

INCOME STATEMENT

VND
3,650

Sales: 1 laptop per day, P=10m

Cost of goods sold: Cost=5m
SG&A
EBIT

(1,825)

-50.0%

(210)

-5.8%

1,615

Interest expense

(15)

EBT

1,600

Income tax

25%

Net income

400
1,200

Dividends

100%

Increase/Decrease in Retained earnings

1,200
-

BALANCE SHEET
Cash

105

Account receivable

7 days on credit

70

Inventory

5 days in store

25

Total current assets

200

Net PPE

300

Total assets

500

Account payable

10 days

50

Short-term debt

150

Long-term debt

Equity

300

Total liabilities+equity

500

2.9%

8.2%

1.4%

Page 44

Inventory cost flow methods

Inventory valuation methods

Inventory accounting

IFRS-> Lower of cost or NRV

US GAAP -> LCM=lower of cost or market

ending = beginning + purchases - COGS

a
product cost --> capitalized

a. IFRS & GAAP

rules for determining
Inventory cost

period cost --> expensed

Specification Indication
FIFO

b,c. Computing
ending inventory
and COGS

LIFO
Weighted average cost

Periodic

d. Inventory
systems

Perpetual

29.
Inventories

COGS

e. Effects of different
inventory accounting
methods on

IFRS

f. Inventory
reporting

GAAP

Inventory balances
Other FS items: taxes , net income

, working capital , cash flows

Lower of cost or NRV

Lower of cost or market
No write-up

Exception

Commodity-like products

g. FR presentation &
disclosures of inventories

Profitability

h. Effects of different
inventory accounting
methods on

Liquidity
Activity
Solvency

Page 45

Capitalize
a1. Accounting
standards

Expense

NI
Shareholders' equity

CF

CFO
CFI

a2. Effects of
capitalizing vs
expensing on
Financial
ratios

Profitability
Interest coverage ratio

Implications for analysis

30.1. Long-lived
Assets- Part1Capitalization
a3. Capitalized
interest

Interest incurred during

construction --> capitalize

required by both US GAAP & IFRS

i/r on debt related to construction

What interest
rate to use?

if no construction debt
outstanding-> based on
existing unrelated borrowings

Interest costs in excess

of project construction
-> expensed

reported in FSs

Unidentifiable:
Goodwill

GW=Purchase price -Fair value

Not amortized but impairment test

IFRS: R&D anything

b. Intangible
assets

R: Expense
D: Capitalise

Created internally -->

EXPENSED except for
Identifiable

US GAAP: R&D software

Software for sale

--> similar to IFRS
Software for use

Purchased externally --> CAPITALIZED (asset at cost)

USGAAP --> expense
Obtained in business acquisition
IFRS --> not expense

Before technical feasibility: expense

After technical feasibility: capitalize
Capitalize all

Page 46
Carrying Value (or Book value)

c1. Concepts

Historical cost
Economic depreciation

SL (Straight Line)
depr=2/n* book value
Accelerated depreciation

d. Depreciation
methods

DDB (Double Declining Balance)

or
final year: depr=book value - salvage

Units-of-production

c2. Effect on net income

c3. Useful lives and

Salvage Values

Component depreciation

e,f. Amortization of
intangible assets

Cost model

30.2. Long-lived
Assets- Part2 Depreciation And
Impairment

g. IFRS

Revaluation model
(land, buildings...)

Reversal of previous loss --> gain in IS

Above historical cost --> revaluation surplus in equity

IFRS

Recoverable amount = max (value in use, fair value - selling cost)

If carrying value > recoverable amount --> impair

Step 1: Recoverability test

US GAAP

Tangible assets
Step 2: Loss measurement

h. Impairment

Intangible assets

Reversing an
impairment loss

Asset for sale

Asset held for use

Sales --> Gains/ Losses

i. Derecognition of PPE
& intangible assets

j. FS presentation &
disclosures of PPE &
intangible assets

k. Financial reporting of
investment property

Abandoned --> no proceeds, loss=carrying value

Exchange --> equivalent to sell and buy another

IFRS
US GAAP

Value in use = PV of future CF stream

Page 47

Taxable income

TAX RETURN

Taxes payable

current tax expense

Income tax paid

actual cash flow

=past or current loss --> create DTA

Tax loss carryforward

Tax base = net amount of asset/liability used for tax reporting purposes
Income before tax

Accounting profit

Earnings before tax

Income tax expense

a. Terminology
FINANCIAL
REPORTING

=Taxes payable + change in DTL - change in DTA

= Income tax expense - Taxes payable

DTL

Cause: depreciation
=Taxes payable - income tax expense

DTA

Causes: Warranty expenses, Tax-loss carry forwards

Valuation allowance: contra account to DTA

Carrying value = net balance sheet value of asset/liability
Permanent difference
vs. Temporary difference
DTL

Income tax exp. > Current tax exp.

Revenues/Gains recognized in IS before in tax return

Expenses/Losses tax deductible before recognized in IS (depreciation)
Revenues/Gains taxable before recognized in IS

b.

DTA

Income tax exp. < Current tax exp.

Expenses/Losses recognized in IS before tax deductible (warranty

expenses, post-employment benefits)
Tax loss carryforwards

Treatment for analytical purpose: DTL not expected to reverse --> equity
Definition
Assets

31. Income
Taxes

Examples

c. Tax
base of

Depreciable equipment
R&D
AR

Definition
Liabilities

Examples

Customer advance
Warranty liability
Note payable

d. Calculation
Adjustment to FS

e. Income tax
rate changes

=Taxes payable + change in DTL - change in DTA

Impact on FS and ratios

Temporary
differences

between tax base and carrying value

will reverse
result in DTA or DTL

f. Differences

Permanent
differences

between taxable income and pretax income

not reverse
makes effective tax rate
different from statutory tax rate

effective tax rate = income tax expense / pretax income

>50% probability

g. Valuation allowance for DTA

Depreciation --> DTL (if reverse, if not --> equity)
Impairments --> DTA
Restructuring --> DTA

h. Deferred tax items

LIFO, FIFO
Post-employment benefits and deferred compensation --> DTA
Unrealized gains/losses on available-for-sale marketable securities

Analyze disclosures relating to

deferred tax items

effective tax rate reconciliation

How disclosures affect FS and ratios

j. IFRS vs. US GAAP (see table in Schweser)

Page 48

Bond terminology
a

BS

IS

Par bond
a,b.
Recognition
&
measurement

Premium bond

Discount bond (incl.

zero-coupon debt)

32.1.
Long-term
LiabilitiesPart1Financing
Liabilities

Amortization methods

IFRS: effective interest rate method

US GAAP

b.

Issuance costs

prefers: effective interest rate method

allows: straight line depreciation

IFRS: increase liability --> increase effective i/r

US GAAP: capitalize as an asset (prepaid exp.)

Fair value reporting option

c. Derecognition of debt

d. Debt covenants

e. Presentation and disclosures

CF

Page 49
Less costly financing
Reduced risk of obsolescence

f. Motivations
for leasing vs.
purchasing

Less restrictive provisions

OBS financing
Tax reporting advantages

Operating lease
Transfer of title
US GAAP: If meets
one of the criteria

Lessee

Bargain purchase option

Lease period >=75% economic life
PV(lease pmts)>=90% fair value

g. Types of
lease

Finance lease
(capital lease)

IFRS: similar to US GAAP but less specific, with 1

additional criterion: leased asset is specialized

US GAAP: like lessee

with added conditions:

Lessor

collectability of lease payments

is reasonably certain
lessor has substantially
completed performance

IFRS: like lessee with added condition: substantially all

rights & risks of ownership are transferred to lessee

Operating
lease

Finance
lease

32.2.
Long-term
LiabilitiesPart2- Leases
& Pension
Plans

h1. Reporting
by Lessee

FS & ratio effects

of finance lease
compared to
operating lease

Balance
sheet
Income
statement
Cash
flow

Finance
lease

Salestype
lease
Direct
financing
lease

h2. Reporting
by Lessor's
Operating
lease

i. Disclosures of lease
Defined
contribution
Service cost
j. Two types

Interest cost
Defined
benefit

Pension
Plans

Expected return on plan assets

Actuarial G/L
Prior service costs

k. Presentation & disclosure

l. Leverage & coverage ratios

Page 50

Meet earnings expectations

overreport earnings

Lending covenants
Incentive compensation
Trade relief (quotas, tariffs)

underreport earnings

Negotiable favorable terms from creditors

a. Incentives to

Negotiable favorable terms from labor contracts

More solvent
Manage the BS

Less solvent
Enhance performance ratios

Select acceptable accounting --> misrepresent economics of transactions

b. Activities--> Low
quality of earnings

Structuring transactions --> achieve desired outcomes

Aggressive unrealistic assumptions, estimates
Exploit intent of an accounting principle: apply narrow rule to broad range of transactions

=motives
Threats to financial stability or profitability
Incentives or pressure
risk factors

Excessive third-party pressures

Personal net worth of mgmt or BOD is threatened
Excessive pressure to meet internal financial goals

=weakness in internal control

Nature of the firm's industry or operations
Opportunity

33. Financial
Reporting
Quality: Red
Flags And
Accounting
Warning Signs

risk factors

Ineffective mgmt monitoring

Complex or unstable organizational structure
Deficient internal control

=mindset that fraudulent behavior is justified

c. "Fraud triangle"

Inappropriate ethical standards

Excessive participation by nonfinancial mgmt
in the selection of accounting standards
Known history of violations by mgmt or board members

Attitudes or
rationalization

Obsession with increasing firm's stock price or earnings trend

risk factors

Commitments to third parties

Failing to correct known reportable conditions
Inappropriately minimizing earnings for tax purposes
Use of materiality as a basis to justify inappropriate
or questionable accounting methods
Strained relationship between mgmt & auditor

Aggressive revenue recognition

CFO growth rate # Earnings growth rate
Abnormal sales growth as compared to economy, industry or peers
Abnormal inventory growth as compared to sales growth
Boosting revenue with nonoperating income and nonrecurring gains
Delaying expense recognition

d. Common
accounting
warning signs
& detecting
methods

Abnormal use of operating leases by lessees

Hiding expenses by classifying them as extraordinary or nonrecurring
LIFO liquidations
Abnormal gross margin & operating margin as compared to industry peers
Extending the useful lives of LT assets
Aggressive pension assumptions
Year-end surprises
Equity method investments & OBS special purpose entities
Other OBS financing arrangements including debt guarantees

Page 51

Stretching Accounts Payables

Financing Accounts Payables

Ways to
manipulate
CFS

Securitizing Accounts Receivables

34. Accounting
Shenanigans On
The Cash Flow
Statement

Repurchasing stock to offset dilution

Page 52

a. Past financial
performance of a
company

Evaluating

Reflecting company's strategy

b. Basic projection of
future net income and CF

Character
Three C's

Collateral
Capacity

35. FSA:
Applications

c. FSA in
assessing
credit quality
for DEBT
investment

Credit rating
agencies use
formulas that
include

Scale and diversification

Operational efficiency
Margin stability
Leverage

d. FSA in screening for

EQUITY investments

e. Adjustments for
comparing different
companies

Page 53

CFALEVEL1

STUDYSESSION11

CORPORATE
FINANCE

Capital
budgeting
process

Page 54

Step 1: Idea generation

Step 2: Analyzing project proposal
Step 3: Create firm-wide capital budget
Step 4: Monitoring decisions and conducting a post audit
To maintain business

Replacement

a.

Project
Categories

For cost reduction

Expansion
New product/market development
Mandatory
pet project

Other

high risk (R&D)

Base on
incremental CF

# accounting income
sunk cost --> exclude !
Cannibalization --> include !

externalities

b. Basic
principles

Opportunity cost --> include !

Timing of CF is important
After tax basis
Financing costs

Exclude ! because Reflected in required rate of return

Independent vs.
Mutually exclusive projects
Project sequencing

c. Interactions

36. Capital
Budgeting

Unlimited funds vs.

Capital Rationing

NPV

IRR

d. Methods

Payback period

Discounted payback period

PI

NPV profile
Advantage of NPV
Advantage of IRR

e.
Conflicting project rankings
Problems with IRR

Multiple IRR and No IRR problems

Location

Europe: PP more than IRR and NPV

Company Size

f. Which methods
are popular?

Public vs Private

Larger: NPV, IRR

Private: PP
Public: NPV, IRR

Management education

g. Relationship between NPV,

company value and stock price

More educated -> NPV, IRR

Page 55

a,b. Formula & tax effects:

c. Weights = Target
capital structure
(Market values)

If lack
information -->

use Current capital structure + Trend

or use Industry average

Yield to maturity approach

f. Cost of fixed rate debt

Debt rating approach

g. Cost of preferred stocks

(noncallable, non convertible)
WACC
Formula:
i. Pure-play method
to calculate beta of
a project
CAPM

h. Cost of
equity
capital --> 3
approaches

37. Cost
Of Capital

j. Country equity
risk premium
CRP =

Dividend Discount Model

pure play
Relationship between
asset beta & equity beta

Sovereign yield spread

x
(stddev equity/stddev bond)

g=retention rate * ROE

Bond yield plus risk premium approach

e. Role of
MCC in NPV

MCC

k. MCC schedule

Discount rate

=WACC if project same risk level

Assumption: same capital structure over the life of project

Upward sloping with

additional capital
Breakpoints

d. Optimal
capital budget

Incorrect

l. Treatment of
Flotation cost

Correct

MCC & Investment

opportunity schedule

adjust cost
of equity
adjust initial
project cost

Page 56

Leverage or Gearing

Business risk

a. Define

Sales risk
Operating risk <-- operating leverage

a
Financial risk <-- financial leverage

DOL

38. Measures
Of Leverage

b. Calculate

DFL

DTL

c. Effect of financial leverage

on Net income & ROE

d,e. Breakeven quantity

Page 57

Regular dividends
Cash dividends

Extra/ Irregular/ Special dividends

Liquidating dividends

a. Explain

Stock dividends
Stock splits
Reverse stock splits

Declaration date
Ex-dividend date

b. Dividend payment
chronology

Holder-of-record date
Payment date

39. Dividends
And Share
Repurchases:
Basics

Buy in the open market

c. Share
repurchase
methods

Buy a fixed number of

shares at a fixed price
Repurchase by direct negotiation

when the repurchase is financed with company's excess cash

d. Effects
of share
repurchase
on EPS

when the repurchase is

financed with debt

if after-tax borrowing cost > earnings yield

if after-tax borrowing cost < earnings yield

e. Effect of share
repurchase on BV per share

f. Why share repurchase is

equivalent to Cash dividend

Page 58
Cash balances (selling goods, collecting receivables, from short term investments)
Primary
sources

Short term funding (trade credit from vendors, lines of credit from banks)
Effective CF management

Sources of liquidity

Liquidating assets (short term or long lived)

Renegotiating debt agreements

Secondary
sources

a.

Filing for bankruptcy

Reorganizing company

Factors that influence

company's liquidity position

Drags on liquidity: delay/reduce cash inflows or increase borrowing cost

Pulls on liquidity: accelerate cash outflows

Current ratio = CA/CL

Quick ratio = (Cash + ST marketable securities + Receivables) / CL
Receivables turnover = Credit sales/receivables

Receivables

Number of days of receivables = =365/receivable turnover

b. Liquidity
measures

Inventory

Inventory turnover = COGS/average inventory

Number of days of inventory = 365/inventory turnover

Payables

Payables turnover ratio = purchases/average trade payable

Number of days of payables = 365/payables turnover

Operating cycle

c. Working capital
effectiveness

turn raw materials into

cash proceeds from sales

Cash conversion cycle

or net operating cycle

=days of inventory + days of receivables

turn cash investment in inventory

back into cash collected

=Operating cycle - days of payables

US T bills

40. Working
Capital
Management

Short term federal agency securities

d. Tools to
manage net
daily cash
position
(more
details in
Fixed
Income)

Bank CD
Banker's acceptances
Time deposits
Repurchase agreements
Commercial paper
MM mutual funds
Adjustable- rate preferred stock
% discount
Discount basis yield

e1. Comparable yields

(already in Quantitative )

Money market yield

Bond equivalent yield
Purpose and objective
Guidelines

e2. Cash Management

Investment Policy

Who does that

Responsibilities
Steps to make investment
Limitations and constraints
aging schedule

Receivables
weighted average
collection period

f. Evaluate
performance of

Inventory
Accounts
payable

2/10 net 60
Trade credit
Cost of trade credit
Number of days of payables
Uncommitted line of credit
Lines of credit

Committed (regular) line of credit (overdraft)

Revolving line of credit

From banks
Short term bank loans,
collateralized by

g. Short term
funding choices

Fixed assets
Inventory
Account receivables
Blanket lien

Banker's acceptances
Factoring
Non bank

Nonbank finance companies

direct placement
Commercial paper
through dealers

Page 59

Steps to construct
sales-drven pro forma FSs

See the example on the next page

average compound growth

rate of sales over 5-10 years
economic cycles

41. FSA
(Pro Forma IS & BS)
Estimating sales

regression analysis of GDP

growth and sales growth

seasonality
new product introductions
specific events

changes in regulation
competing products

pay down debt entirely

reduce L+E
pay down debt + buy back common stocks
L+E > A --> surplus

Reconcile IS and BS
increase A

CAPEX

L+E < A --> deficit

Page 60

41. CONSTRUCTING PRO-FORMA FINANCIAL STATEMENTS

($ millions)

Yr 2011

Yr 2012 (1st trial) Yr 2012 (2nd trial)

Proportional
to sales

INCOME STATEMENT
Sales

100%
sales projected
to increase 100%

500

1,000

Cost of goods sold

(200)

-40.0%

(400)

SG&A

(100)

-20.0%

(200)

Interest expense

10%

(50)

(50)

Nonoperating income

Earnings before tax

150

350

150

350

150

350

Income tax

0%

Net income
Dividends
Increase/Decrease in Retained earnings

0%

0.0%

BALANCE SHEET
Current assets

100

20.0%

Net PPE

900

180.0%

Total assets

1,000

200
(assume full capacity)

1,800
2,000

Current liabilities

100

Long-term debt

500

500

Common stock

100

100

Retained earnings

300

650

1,000

1,450

Total liabilities+equity

20.0%

200

Yr 2012 (final)

Page 61

internal controls
Definition

processes
procedures

a. Corporate governance

Describe good CG (p.113)

Majority of BOD is independent

Meets regularly outside the presence of management
otherwise, independent board members
should have a primary or leading board
member

Chairman of BOD should not

be CEO or former CEO

Board members should not be closely aligned with supplier, customer, share-option plan, pension adviser
Able to hire external consultants without management approval

b. Independence

firm & subsidiaries, former employees, executives & their families

Individuals or groups with a controlling interest
no material
relationship with

c. Define
"independence"

Executive management & their families

Firm's advisers, auditors & their families

Effective
BOD

Entity with a cross directorship with the firm

b. Frequency of
Board Elections

annual, not 2-3 years, not staggered (classified)

Skills, experience, qualifications

Care & competence
d. Experience

Ethical stances
Other board experience
Regularly attend meetings
If served on the board for more than 10 years --> not very independent

c. Resources

Financial information
to shareholders

Audit Committee

set executive compensation, commensurate

with responsibilities and performance

Remuneration /
Compensation
Committee

42. Corporate
Governance

make sure independence

e. Board
committees

link compensation to firm

performance and profitability

Nominations
Committee

recruit new independent

board members

Other Board
Committees

f1. Provisions of a strong

corporate code of ethics
Consultancy contracts
Finder's fees for identifying M&A targets

f2. Related party transactions and

personal use of company assets
--> should discourage:

Other compensation
Related party transactions
Personal use of company's assets

Confidential voting
Voting Rules

Cumulative voting
Voting for other corporate changes

Shareowner-sponsored
proposals

Shareowner-sponsored
board nominations

proxy statement

Shareowner-sponsored resolutions

g. Evaluate
policies

Advisory or Binding Shareowner proposals

Common stock classes

dual classes of common stock

Shareowner Legal Rights

Golden parachutes
Takeover defenses

Poison pills
Greenmail

Page 62

CFALEVEL1

STUDYSESSION12

PORTFOLIO
MANAGEMENT

Page 63

a. Portfolio approach
to investing
Individual
investors

DC pension plans
DB pension plans
Endowment
Foundation

Institutional
investors

b. Types of
investors

Bank
Insurance companies
Investment companies/
Mutual funds
Sovereign wealth funds

Planning step

c. Steps in
PM process

Investment Policy Statement (IPS)

Execution step
Feedback step

What is it?
2 categories

43. PM- An
Overview

No-load funds

Open-end funds

Load funds

Closed-end funds

d1. Mutual
funds

Money market funds

Types

Bond mutual funds

Stock mutual funds

Index funds
Actively managed funds

ETF
Separately managed account
Long/Short funds
Equity market-neutral funds
Long bias, Short bias

d2. Other
forms of
pooled
investments

Hedge
funds

Strategies

Event-driven funds
Fixed income arbitrage funds
Convertible bond arbitrage funds
Global macro funds

Buyout funds (Private

equity funds)
Venture capital funds

Page 64

HPR
Arithmetic mean return

Geometric mean return

Average
returns

a. Major
return
measures

Money weighted rate of return

Gross return
Pretax nominal return
Other return
measures

After tax nominal return

Real return
Leveraged return

Asset classes with greatest average return

also have highest standard deviation
Real return much more stable
than nominal returns

b. Characteristics
of major asset
classes
considered in
Mean-Variance
portfolio theory:

44.
Portfolio
Risk &
ReturnPart 1

Returns
distributions

are negatively skewed

greater kurtosis (fatter tails
than normal distribution)

Liquidity is a major concern in emerging

markets & thinly-traded securities

Mean
Variance

c. Calculate

Covariance
Correlation

Risk averse investor

d. Risk
aversion

Risk- seeking (risk-loving)

Risk neutral

e. Portfolio
standard
deviation

f. If rho<1 --> Effect on portfolio's risk:

Minimum variance
frontier of risky assets

g. Interpret

Efficient frontier of risky assets

Global minimum variance portfolio

Investor's utility

h. Selection of an
optimal portfolio

Capital allocation line (CAL)

Page 65

Return =

a. Risk free asset + Portfolio of risky assets -->

Standard deviation =

CAL (Capital Allocation Line)

b.
CML (Capital Market Line)

Systematic

c. Risks
Nonsystematic

Macroeconomic
Types of Factors

45.
Portfolio
Risk &
ReturnPart 2

Fundamental
Statistical

Multifactor
models

d. Return
generating
models

Formula

with k factors
Factor sensitivity of Factor loading

Fama & French

three-factor model

Firm size, Firm B/P, Rm-Rf

Carhart suggest 4th factor: prior period returns

--> to measure price momentum
Market model

= covar / variance of market portfolio

e. Calculate Beta

Slope of regression of returns on market index

Equation:
Sharpe ratio

f,g,h. CAPM & SML

M-square
Treynor measure
Jensen's alpha

Page 66

a. Reasons for a written IPS

Description of Client

Circumstances & Situation

Investment objectives

Statement of the purpose of the IPS

Statement of duties &
responsibilities of

Investment manager
Custodian of assets
Client

Procedures to update IPS & to respond

to various possible situations
Absolute

Forms

c. Investment objectives

Relative

Risk objectives

(derived from communications

with the client)

d. Risk tolerance

Ability
Willingness

Return objective

Liquidity

b. Major
components
of an IPS

e. Investment
constraints

Time horizon
Tax situation
Legal & regulatory
Unique circumstances

Investment guidelines (how the policy will be

executed, asset types permitted, leverage)

46. Basics
Of
Portfolio
Planning &
Construction

Evaluation of performance (e.g..: benchmark)

Definition &
Specification

Appendices

Strategic
(baseline)
asset
allocation

Correlations within a
class should be very high
Correlations between
classes should be low
Equities

f. Asset
classes

Bonds
Cash
Categories

Real estate
Alternative

Hedge funds, PE funds,

commodity funds, artwork,
intellectual property rights

Tactical asset allocation (deviate from strategic asset allocation)

Rebalancing: how & when

Identify investable asset classes

Strategic
asset
allocation
Principles of
portfolio
construction

Risk, Return, Correlation

Efficient frontier
Identify portfolio which best meets risk &
requirement of investor (based on IPS)
to take advantage of perceived short term opportunities

Tactical asset
allocation

success depends on

g.
Security selection
Risk budgeting
Role of asset allocation

success depends on

manager's ability to identify short term opportunities

the existence of such short term opportunities
manager's skill
opportunities (mispricing or inefficiencies)

Page 67

CFA LEVEL 1
STUDY SESSION 13 & 14

EQUITY

Page 68

Saving
Borrowing

Issuing equity

Allow entities to

Risk management

a. Main functions
of financial system

Exchanging assets
Utilizing information
Supply & demand determine returns (i/r)

Equilibrium interest rate

Allocate capital to most efficient uses

Financial vs. Real assets

Public vs. Private securities
Debt vs. Equity vs. Derivative
Common stock
Equity

Preferred stock
Warrants

Fixed income
Convertible debt

Securities

b1. Classification
of assets

Mutual funds
Pooled
investment
vehicles

c. Asset
classes

ETFs and ETNs

(depositories)
ABS
Hedge funds

Currencies
Forward, Futures, Swap, Option
Contracts

Insurance

Credit default swap

Commodities
Real assets

Spot vs. Derivative markets

IPO vs. Secondary issues (or seasoned offerings)

47.1. Market
Organization &
Structure (part 1)

Primary
market

i. Primary vs.
Secondary markets

Public offerings vs Private

placements & other
transactions

Secondary market--> importance:

Securities trade after initial offerings

provide liquidity

Money vs. Capital markets

Traditional investment market (debt, equity) vs.
Alternative market (hedge funds, commodities, real estate...)
Trades occur at specific times
All trades, bids, asks are declared, and then one
negotiated price is set to clear the market for the stock

b2. Classification
of markets

Call
market

Traders/investors indicate their bids and asks

NOT a dealer or quote-driven market
in smaller markets

j1. Distinguish
used

to set opening prices and prices after

trading halts on major exchanges
Trade occur any time the market is open

Continuous
market

Price is set by

auction process
dealer bid-ask quote

Quote-driven markets (dealer markets,

price-driven markets, OTC markets)

j2. Distinguish

Order-driven markets (rules are

used to match buyers & sellers)
Brokered markets
Pre-trade transparent

j3. Market
information

Post-trade transparent

Brokers
Brokers,
Dealers &
Exchanges

Block brokers
Investment banks
Exchanges
Alternative trading systems (ATS)
Dealers

d. Financial
intermediaries

Securitizers
Depository institutions
Insurance companies
Arbitrageurs
Clearinghouses
and Custodians

Clearinghouses
Custodians

Order matching rules

Trade pricing rules

Page 69

Long position

e. Positions

Short position

Leveraged position

The investor pays for the stock with some cash

and borrow the rest through the broker
The broker keeps the stock as collateral
Leverage ratio
Margin lending rate

f. Margin
transaction

The proportion of total transaction

value that must be paid in cash

Margin requirement

Initial margin (IM)

Maintenance margin (MM)

-->margin call

Margin call price = Po * (1 - IM) / (1 - MM)

Bid-ask
Market order
Limit order
Execution
instructions

All-or-nothing order
Hidden order
Iceberg order
Stop order

g,h.

Stop loss orders

To prevent losses
or To protect profits

Stop-buy & Stop-sell orders

day order
Validity
instructions

good-till-cancelled
immediate or cancel order (fill or kill order)
market-on-close order

good-on-close order

47.2. Market
Organization &
Structure (part 2)

good-on-open order
Clearing instructions

Commissions
Operationally efficient

low trading costs

Bid-ask spreads
Price impact

Informationally efficient

k. Characteristics of
well- functioning
financial system

Prices that rapidly adjust to new info

The prevailing price is fair since it reflects
all available info regarding the asset

Allocationally efficient
Allowing entities to
achieve their purposes

Investors can save at fair rates of return

Creditworthy borrowers can obtain funds
Hedgers can manage risks
Traders can obtain assets they need

Having financial
intermediaries that

Without regulation
--> Problems

Fraud & theft

Insider trading
Costly information
Defaults

l. Objectives
of market
regulation

Consequences

liquidity declines, firms shun risky projects, new ideas go

unfunded, economic growth slows

Regulation can
be provided by

Governments
Industry groups
Protect unsophisticated investors --> preserve trust

Market
regulation
should

Require minimum standards of competency and

make it easier for investors to evaluate performance
Prevent insiders from exploiting other investors
Financial reporting requirements
Require minimum levels of capital

Page 70

a. Describe a security
market index

Value

b. Calculate
for an index

Price return
Total return

Which target market

Which securities

c. Index construction
& management

Weighting
Rebalancing frequency
Re-examining selection & weighting

48.1. Security
Market Indices
(part 1)

arithmetic
average

Price
weighted
index

=sum of stock prices / number of stocks adjusted for splits

-->Index movements are influenced by the
differential prices of the components

A percentage change in a high-priced stock will

have a relatively greater effect on the index
30 stocks
arithmetic
2 major
indexes

limited number of stock

DJIA
criticisms

downward bias

Nikkei Dow Jones Stock Average

large growing firms -->

splits --> lose weights

225 stocks

arithmetic average return of the index stocks

d,e. Weighting
methods

Equal
weighted
index

equivalent to a portfolio that has equal dollar

amounts invested in each stock in the index
The Value Line (VL) Composite average

1695 stock returns

Examples
Financial Times Ordinary Share Index
Market- cap
weighted index
(or value
weighted index)

=
Criticism: large company has greater impact
Float-adjusted market cap- weighted index

Fundamental weighting
(earnings, dividends, cash flow)
Example

30 stocks on LSE

Page 71

f. Rebalancing &
reconstitution

Reflection of market sentiment

Benchmark of manager performance

g. Uses of
security
market indices

Measure of market return and risk

Measure of beta and risk-adjusted return
Model portfolio for index funds

Broad market index

Multi-market index

h. Types of
equity indices

Multi-market index with fundamental weighting

Sector index

48.2. Security
Market Indices
(part 2)

Style index

Characteristics

Large universe of securities

Dealer markets and infrequent trading

i. Types of
fixed income
indices

Sectors, geographic regions, levels of country economic development, type of issuers

or collateral, coupon, maturity, default risk, inflation protection
Broad market indexes, sector indexes, style indexes & other specialized indexes

Commodity indexes

j. Indices
representing
alternative
investments

Real estate indexes

Hedge fund indexes

k. Compare & contrast types

of security market indices

Page 72

a. Concepts
a

Market value

b. Distinguish

Intrinsic value

Number of market participants

Availability of information

c. Factors affecting a
market's efficiency

Impediments to trading
Transaction and information costs

Weak form

d. Forms
of EMH

Semi-strong form
Strong-form

Fundamental analysis

e. Implications
of each form
of EMH for

Technical analysis
Choosing between active and
passive portfolio management

January effect (or turn-of-the-year effect)

Turn-of-the-month effect
Anomalies in
Time-series data

Calendar
anomalies

Day-of-the-week effect
Weekend effect
Holiday effect

49. Market
Efficiency

Overreaction and
momentum anomalies

f. Market
pricing
anomalies

Anomalies in
cross-sectional data

Size effect
Value effect

Other
anomalies

Closed-end investment funds

Earnings announcements
IPO
Economic fundamentals

Implications for investors

Loss aversion
Investor overconfidence
Representativeness
Gambler's fallacy

g. Behavioral
finance

Conservatism
Disposition effect
Narrow framing
Information cascades
Herding behavior

Page 73
Common shares
Callable common shares

a
Putable common shares

a. Characteristics of

Preference shares
Cumulative preference shares
Convertible preference shares

b. Equity classes

Public equity
securities
Characteristics

c. Distinguish

Private
equity
securities

Venture capital
3 main
types

Leveraged buyouts (LBO)

Private investment in public
equity (PIPE)

Direct investing

50. Overview
Of Equity
Securities

Depository receipts (DRs)

d. Methods for
investing in
non-domestic
equity
securities

Global depository receipts (GDRs)

American depository receipts (ADRs)
Global registered shares (GRS)
Basket of listed depository receipts (BLDR)

e. Risk and Return

characteristics of various
types of equity securities

f. Role of equity
securities in financing
company's assets &
creating company value

Market value of equity securities

g. Distinguish

Book value of equity securities

Company's accounting ROE =

Company's cost of equity

rate of return required by investors

h. Contrast
Investors' required
rates of return

depends on estimates of
firm's future CF & risk

Page 74

a. Industry analysis

Grouping
companies
by

Products & services

Sensitivity to
business cycles
Statistical methods
(cluster)

different sectors
Cyclical
Non-cyclical
firms with highly correlated returns --> same group
Limitations
GICS
Systems

RGS
Industry Classification
Benchmark by DJ & FTSE
Basic material and
processing firms

b. Industry
classification

Commercial
classifications

Industry
classification
systems

Consumer discretionary
Consumer staples
Classification

Energy
Financial services
Industrial and producer durables
Technology
Telecommunications

United Nations
Government
classifications

European Community
Australia & New Zealand
North America (US, Canada, Mexico)

51.1. Introduction
To Industry And
Company
Analysis (part 1)
Firms

Cyclical firms
Non-cyclical firms

c. Sensitivity to
business cycle

Cyclical sectors
Sectors
Non-cyclical sectors

d. Peer group

e. Elements of an
industry analysis

Macroeconomic factors

f. External
influences on
industry growth,
profitability and
risk

Technology
Demographic factors
Governments
Social influence

Defensive (stable)
Growth

Page 75

Slow growth
Embryonic stage

High prices
Large investment required
High risk of failure
Rapid growth
Limited competitive pressures

Growth stage

Falling prices
Increasing profitability
Growth has slowed
Intense competition

g. Product &
industry life
cycle

Shakeout stage

Increasing industry
overcapacity
Declining profitability
Increased cost cutting
Increased failures
Slow growth
Consolidation

Mature stage

High barriers to entry

Stable pricing
Superior firms gain market share
Negative growth

Decline stage

Declining prices
Consolidation

Industry concentration

51.2.
Introduction To
Industry And
Company
Analysis (part 2)

h. Effects
on return
on invested
capital and
pricing
power of

Ease of entry
Capacity
Market share stability

Rivalry among existing

competitors
Threat of new entrants

i. Principles of
strategic industry
analysis- Michael
Porter's five forces

Threat of substitute products

Bargaining power of buyers
Bargaining power of suppliers

j. Example of the
candy/confections industry

Financial condition
Analyze

k. Elements
of a company
analysis

Products and services

Competitive strategy

Should
include

ROE (DuPont)

Defensive vs. Offensive

Cost leadership vs. Product differentiation

Firm overview, Industry characteristics, Product demand, Product costs, Pricing

environment, Financial ratios, Projected financial statements and firm valuation

Page 76

Size of differences between market price and intrinsic value

a. Factors
to consider
when
exploiting
mispricing

Confidence about valuation model

Confidence about the inputs
Why stock is mispriced
If market price will move toward intrinsic value

c. Rationale

d. Preferred stock

Dividend
discount
models

e. Common stock

Types of
models

Discounted
cash flow
models

f. Appropriate for
companies that are

Stable & mature

Non-cyclical
Dividend-paying

Free cash flow

to equity models

52. Equity
Valuation:
Concepts And
Basic Tools

Advantages

k.
Disadvantages

b. Equity
valuation
models
g. Rationale

h. Stock price / fundamentals

Types of
models

Multiplier models
(or market multiple
models)

e. Enterprise value / EBITDA or revenue

Advantages

k.
Disadvantages

Explain

j. Assetbased
models

Advantages

k.
Disadvantages

Page 77

CFA LEVEL 1
STUDY SESSION 15 & 16

FIXED INCOME

Page 78

Rights and obligations

Covenants

a. Bond's indenture

Negative
Affirmative

Basic features of a bond

Zero coupon
Coupon rate structures

Step-up notes
Deferred coupon bonds

b.

Coupon formula
Floating-rate securities

Inverse floater
Inflation-indexed bonds
Caps and floors

Full (dirty) price = Clean Price + Accrued interest

c. Bond trades
between
coupon dates

Cum coupon
vs. Ex-coupon
Trading flat

Nonamortizing/ Bullet
bond/ Bullet maturity

Amortizing securities

Prepayment options

53. Features
Of Debt
Securities

Call provisions

d. Provisions for
redemption and
retirement of bonds

Nonrefundable bonds

Sinking fund provisions

Cash payment
Delivery of securities

Accelerated sinking
fund provision

Redemption price

Regular
Special

Security owner
(bondholders)
options

Conversion option
Put provision
Floors

e. Embedded
options

Security issuer
(borrowers)
options

Call provision
Prepayment options
Accelerated sinking
fund provisions
Caps

Margin buying

f. Methods to finance the

purchase of a security

Repo

Page 79

Interest rate risk

Yield curve risk
Call risk
Prepayment risk
Coupon
Reinvestment risk

Call feature

i. Factors affecting
reinvestment risk

Amortizing
Prepayment option

Default risk
Credit risk

a,i,j,k,l,m,n,o.
Risks

j. Forms

Credit spread risk

Downgrade risk

j. Meaning and role of credit rating

Liquidity risk

k. why important even hold to maturity

l. Exchange-rate risk
m. Inflation risk
n. Volatility risk
Disaster
o. Event risk

Corporate restructuring
Regulatory issues

Sovereign risk

54. Risks
Associated
With
Investing In
Bonds

Coupon rate
Market yield

b. Relations
among

Bond's price relative

to par value

Discount
Premium
Equal to par

Maturity
Coupon
Embedded
options

c. Effect on interest
rate risk of

Call
Put

Yield

value of option-free bond

Value =

minus
value of embedded call

d,h. Callable bond

h. Disadvantages of a
callable or prepayable
security to investors

Less certain CF- call risk/prepayment risk

Reinvestment risk
Potential price appreciation < option free securities

Interest rate risk

e. Floating
rate security

Reasons Price # Par

Cap risk
Margin

Duration =
Dollar duration =

f,g. Duration
g. Duration and Yield curve
risk for a portfolio of bonds

Page 80

Features

a
Credit risk
characteristics

a. Government
securities
(sovereign debt)

Regular cycle auction- single price

Distribution
methods

Regular cycle auction- multiple price

Ad hoc auction system
Tap system

T-bills

TREASURIES
Instruments

T- notes
T- bonds
TIPS

b,c. Treasury
securities
(Treasuries)

Two categories
(vintage)

On-the-run
Off-the-run

c. Stripped
Treasury
securities

Coupon strips
Principal strips
STRIPS

55.1
Overview
Of Bond
Sectors
And
Instruments

Federally related institutions

(owned by US Gov.)

Ginnie Mae (Government National Mortgage Association)

TVA (Tennessee Valley Authority)

d. Types
of US Fed
agencies

GSEs (Government Sponsored Enterprises)

(privately owned, publicly chartered)
(commonly issue debentures)

Federal Farm Credit System

Federal home Loan Bank System
Federal National Mortgage Association (Fannie Mae)
Federal Home Loan Bank Corporation (Freddie Mac)
Student Loan Marketing Association (Sallie Mae)

Debentures (unsecured, not backed by collateral)

Characteristics
Periodic interest
CF

AGENCY
BONDS

Scheduled repayments of principal

Principal repayments in excess of scheduled principal payments

Instruments

Mortgage
passthrough
security

e,f. MBS
(Mortgagebacked
securities)

Tranche I
3 tranches
Types

CMOs (Collateralized
mortgage obligations)

Tranche II
Tranche III

f. Motivation for creating CMO

Stripped
mortgage-backed
securities

Tax

Page 81

Tax exempt
Taxable

Limited tax GO debt

g. MUNIS
(Municipal
securities)

Tax- backed bonds or GO

(General Obligation) bonds

Unlimited tax GO debt

Double-barreled bonds
Appropriation-backed obligations
(or Moral obligation bonds)

Instruments
Revenue bonds
Insured bonds
Prerefunded bonds

Rating agencies and Credit ratings

Secured vs. Unsecured Debt

Credit enhancements

Shelf registration (sold over time)

Medium
term
notes

55.2
Overview
Of Bond
Sectors
And
Instruments
(cont.)

Maturity ranges
Best effort underwriting

= typical bond + derivative

Purpose: get around restrictions
Step-up notes
Inverse floaters

Structured
notes

Structured
medium term
notes

Deleveraged floaters
Dual-indexed floaters
Range notes
Index amortizing notes

h,i,j,k.
CORPORATE
ISSUES

Instruments

Commercial
paper

Directly placed
Dealer placed

Negotiable CDs
Bankers Acceptances
Role of a SPV
i. Asset-backed
securities

Motivation
External credit
enhancements

Corporate guarantees
LC
Bond insurance

j. CDO (Collateralized debt obligation)

k. Bonds

Primary
market
Secondary
market

Mechanism for
placing bonds

Page 82
Discount rate
OMO

Banks borrow reserves from Fed

Buy/Sell Treasuries by Fed

Most commonly used

a. Interest rate policy tools

Bank reserve requirement

% of deposits banks must retain

Persuading banks to tighten/loosen credit policies

Normal / Upward
Inverted / Downward

b. Yield curve / Term

structure of interest rate

Flat
Humped

Pure expectation

c. Basic theories of term

structure of interest rate

Liquidity preference
Market segmentation theory

d. Define a spot rate

56. Understanding
Yield Spread

Absolute yield spread =

e. Measures

Relative yield spread =

Yield ratio =

= yield difference b/c of credit rating

f. Credit (quality) spread

Relation with the well-being

of the economy

Yield spread
g. Effect of embedded options

Issue size

h. Liquidity spread

Maturity spread

After tax yield of a taxable security

i. Tax

j. LIBOR

Tax equivalent yield of a tax-exempt security

Page 83

1. Estimate CFs

a. Steps in bond
valuation process

Coupons
Principal

2. Determine appropriate discount rate

3. Calculate present value

Defaults and potential credit problems

Embedded options -> uncertain principal repayment

b. Difficulties in
estimating CFs

Floating rate securities -> uncertain coupons

Convertible or Exchangeable bonds

57. Introduction
To The
Valuation Of
Debt Securities

Compute value of bonds

c.

Value of zero coupon bonds

d. Time and value of bond

Price-yield profile

e. Yield and value of bond

f. Arbitrage free
valuation approach

Page 84

Coupons

a. Sources of return
from investing in bond

Principal + Capital gain/loss

Reinvestment income

Current yield

d. Calculate BEY and EAY

Assumptions

CF will be reinvested at YTM

Bond will be held till maturity
Reinvestment income

YTM
Limitations

b,c,d.
Traditional
yield
measures

58. Yield
Measures,
Spot Rates
And Forward
Rates

c. Reinvestment

Reinvestment
risk increases
with

Realized yield can be different from YTM

BEY

Yield to call

Yield to worst

Yield to refunding

YTP

CFY

e. Theoretical Treasury spot rate curveBOOTSTRAPPING

Nominal spread

Zero-volatility spread (Z-spread)

f. Spreads
Option-adjusted spread (OAS)

g. Spot rates, Forward rates, Value of bonds

OAS = Z spread - Option cost

Higher
coupons
Longer
maturities

Page 85

Full valuation approach

(scenario analysis)

a. Measuring
interest rate

Duration/ convexity approach

Option-free bonds

Callable bonds

b. Price volatility
characteristics for

Prepayable bonds

Putable bonds

d,e. Effective duration

d,e. Types
of duration

Macaulay duration

Modified duration

59. Introduction
To The
Measurement Of
Interest Rate
Risk

Duration

f. Interpreting
duration
=

g. Portfolio duration
Limitations

j. PVBP
Relationship to duration

What is it?

Can be

Positive
Negative

c,h,i. Convexity

Relation to bond price and yield

h. Calculation

i. Types

Modified convexity
Effective convexity

k. Impact of yield volatility on i/r risk of bonds

Page 86

CFALEVEL1

STUDYSESSION17

DERIVATIVES

Page 87

Derivative

a.

Exchange- traded
vs. OTC

Forward contracts
Forward
commitment

Futures contracts
Swaps

b.
Calls
Contingent claim

Options
Puts
Convertible, callable bonds

60. Derivatives
Markets And
Instruments

Criticisms

c. Derivative
markets

Purposes

Law of one price

2 securities/portfolios with identical cash flows

d. Arbitrage
2 securities with uncertain returns combined in a portfolio

Page 88
Long position

a. Positions
Short position

Deliverable forward contracts

Settling

Cash settlement

b. Settling
Terminating a position
prior to expiration

Basics

with same party (offsetting)

with other party

Banks/Financial institutions

Dealer

Bid-ask prices

c. Parties
Corporations
End user

Gov. units
Non-profit

Single stocks

1. Equity
forward
(LOS d)

Portfolio of stocks
Stock index
With or without dividends

Settled before bonds mature

Quote: annualized % discount from FACE

Zero-coupon bonds (T-bills)

61. Forward

2. Bond
Forward
(LOS d)

Quote: yield to maturity

Types
Coupon bonds

Exclusive of accrued interest

Include provisions for default, embedded options
Can be on individual or portfolio of bonds

Large banks outside of US

Denominated in U$
Published daily by British Banker's Association
Eurodollar
time deposit

Compiled from quotes from large banks

E.g..: LIBOR

e. Rates

Annualized 360-day/year
Add-on rate (# T-bill)
= reference/benchmark rate

Euribor

3. Loan
forward
(FRA)

Euro lending rate, established in Frankfurt, published by ECB

Settle in cash

f. Features

No actual loan
Long=borrower

Formula:

g. Payoff
of an FRA

Term of FRA # Term of loan

Quote

4. Currency
Forward
(LOS h)

E.g.: 2x5 FRA

Off-the-run FRA

Page 89

Deliverable or cash settlement

Similar to forward

Zero value at beginning

Differ from
forward

Futures : exchange- traded >< Forwards are private, do NOT trade

Futures are highly standardized >< Forwards are customized
Futures: clearinghouse as counterparty --> reduce credit risk

a,b. Characteristics
of futures (vs.
Forward)

Futures market regulated by government

Quality, Quantity, Delivery time, manner, minimum price fluctuation

Standardization

Uniformity promotes market liquidity

Long vs. Short
Hedger vs. Speculator

# margins in securities markets

Initial margin
Types of
margins

c. Margins

Maintenance margin
Variation margin

Settlement price
How a futures trade takes place

Price limits

Limit move

Limit up
Limit down

Locked limit

62. Futures
d.
Marking
to market

adjust margin balance

on daily basis (or more frequent in chaotic situations)

Delivery
4 ways

Cash settlement
Reverse/ Offsetting/ Closing out

e. Terminate
a futures

Ex-pit transactions

Delivery options in
futures contracts

For short position

What (T-bonds), where (gold, corn), when to deliver

T-bill futures

Eurodollar futures

f.

T-bond futures

Stock Index futures

Currency futures

Page 90

Definition
Call vs. Put

a. Options
characteristics

Long vs. Short

Option premium

b. American vs.
European options

In-the-money

c. Moneyness

Out-of-the-money
At-the-money

d. Exchange-traded vs.
OTC options

63.1. Option
(part 1)
Equity
Financial options

Stock indices

Bond
Interest rate

e. Underlying
instruments

Currencies
Options on futures
Commodity options

interest rate options

f. Compare

FRAs

Cap

g. Interest rate ...

Floor
Collar

contract multiplier

Page 91

a
for a stock option

h. Option payoffs

for interest rate options

Intrinsic value

i. Option value =

+
Time value

European call
European put

j,k. Rules for minimum

values and lower bounds

American call
American put

63.2. Option
(part 2)

Exercise price
Time to expiration

l,o. Option price

affected by

Interest rate
Volatility

m. Put- Call parity

Put-Call parity

n. CF on the underlying
asset affect

Lower bounds

Page 92

Characteristics

a
Mutual
termination

a.

How swaps
are terminated

Offsetting
contract
Resale
Swaption

64. Swap
Currency swaps

b.

Plain vanilla
interest rate swaps

Equity swaps

Page 93

a
Value at expiration
Profit
Maximum profit/loss

a. Simple Call & Put

Breakeven underlying price

General shape of the graph
Market outlook of investors

b1. Covered call

b2. Protective put

Page 94

CFALEVEL1

STUDYSESSION18

ALTERNATIVE
INVESTMENTS

Page 95

Open- end vs.

Closed- end
NAV

a. Managed investment
companies (mutual funds)

Investment
company fees

one-time fees
ongoing annual fees

Style
Sector

b. Strategies

Index
Global
Stable Value

Definition

mimic an index

In-kind
process

Advantages

price
tax

Diversification

66.1.
Alternative
InvestmentsPart 1

Exchange traded
Better risk management
Advantages

Composition is known
Operating expense ratio
No trading at a discount or premium
Tax
Dividend

b,c,d. ETF

Few indices
Disadvantages

Intraday trade
Inefficient markets
Larger investors

Market risk
Asset class/ sector risk
Risks

Trading prices # NAV (depth and liquidity)

Tracking errors
Derivative risks --> credit risk
Currency and country risks

Page 96

Outright ownership

a
Types

Leveraged equity position

Mortgages
Aggregation vehicles

Characteristics

e,f,g. Real
Estate
Investment

Cost method

f,g. Approaches to the

valuation of real estate

Sales
comparison
method

Income
method

Discounted
after tax cash
flow model

Seed
stage

66.2.
Alternative
InvestmentsPart 2

R&D

Start-up
financing

Formative
stage

Initial marketing

Early
stage

Stages

First stage
financing

Balanced
stage

Later
stage

Expansion
stage
financing

Second stage
investing

Third stage
financing

Mezzanine
(bridge financing)

h,i. Venture
capital
investing
Illiquidity
Long term horizon

Difficulty in valuation
Limited data
Characteristics

Entrepreneurial /
Management mismatches
Fund Manager incentive mistakes
Timing in the
business cycle
Requirement for extensive
operations analysis

i. NPV of a venture capital project

IPO

Commercial production

Producing and selling products

Not yet generating income

Major expansion

Page 97

Absolute return

Limited partnership
Forms

Limited liability corporation

Offshore corporation
Long/short funds

Classifications

Market-neutral funds
Global macro funds
Event- driven funds

Leverage
Illiquidity
Potential for mispricing

j. Hedge
fund

l.

Counterparty credit risk

Unique risks

Settlement errors
Short covering
Margin calls

Performance
Self-selection bias
Backfilling bias

m.

Biases

Survivorship bias
Smoothed pricing
Option-like strategies
Fee structures and gaming

Effect of survivorship bias

66.3.
Alternative
InvestmentsPart 3

Fund to invest in
hedge funds

k. Fund of funds
investing

Benefits
Drawbacks

n. How legal issues affect valuation

n,o. Closely held

companies

o. Valuation
methods

Cost approach
Comparable approach
Income approach

describe

p. Distressed
securities investing

compare with VC

Commodities
Motivation for investing in

Commodities derivatives
Commodity-linked securities

q,r Commodities

Sources of return on
Collateralized commodity
futures position

Page 98

a. Relationship
between spot
prices and
expected future
prices

67. Investing
In
Commodities

Contango

Backwardation

Sources of return
b. Commodity
investment

Risk
Effect on portfolio

c. Commodity
index strategy

Active investment