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Contents

ETHICAL AND PROFESSIONAL STANDARDS..........................................................................5

QUANTITATIVE METHODS .........................................................................................................6

Hypothesis Testing ....................................................................................................................6

Test Population Means ..............................................................................................................6

Difference in means test for independent samples Equal Variance..........................................6

Unequal Variance : ....................................................................................................................6

Mean differences test for dependent samples...........................................................................6

Variance Tests............................................................................................................................6

Correlation Coefficient, r ..........................................................................................................7

Multiple Regression ..................................................................................................................7

Regression Analysis Problems ..................................................................................................7

ECONOMICS ...................................................................................................................................8

Growth Accounting Equation....................................................................................................8

Neoclassical Growth Theory.....................................................................................................8

Endogenous Growth Theory .....................................................................................................8

Factors Promoting Economic Growth.......................................................................................8

Purchasing Power Parity ...........................................................................................................8

International Fisher Relation.....................................................................................................8

Uncovered interest Rate Parity..................................................................................................9

Interest Rate Parity....................................................................................................................9

Asset Market Approach.............................................................................................................9

Currency Arbitrage....................................................................................................................9

Real Exchange Rate Risk ..........................................................................................................9

Foreign Currency Risk Premium (FCRP) ...............................................................................10

International CAPM................................................................................................................10

Currency Exposure..................................................................................................................10

Product Life Cycle ..................................................................................................................10

Regression to Mean.................................................................................................................10

PORTFOLIO MANAGEMENT .....................................................................................................11

Measuring Risk .......................................................................................................................11

Portfolio Risk and Return .......................................................................................................11

Efficient Frontier and Optimal Portfolio .................................................................................11

Systematic Risk vs. Unsystematic Risk ..................................................................................11

Capital Market Line(CML) .....................................................................................................12

SML and CAPM .....................................................................................................................12

SML vs. CML .........................................................................................................................12

Arbitrage Pricing Theory(APT) ..............................................................................................12

Testing CAPM.........................................................................................................................12

Multifactor Models .................................................................................................................13

Portfolio management Planning Process.................................................................................13

FINANCIAL STATEMENT ANALYSIS .......................................................................................14

Inventory Analysis ..................................................................................................................14

CFA Level II

Off-Balance Sheet Debt ..........................................................................................................14

Lease Classification ................................................................................................................14

Effect of Classification on Lessor ...........................................................................................15

Marketable Securities Classification.......................................................................................15

Account for Inter-corporate Investments ................................................................................15

Business Combinations ...........................................................................................................15

Purchase Method: Constructing Consolidated Statements......................................................15

Effect of Pension Plan Assumptions .......................................................................................16

Pension Calculations ...............................................................................................................16

Pension Adjustments ...............................................................................................................16

Multinational Operations ........................................................................................................17

Cash Flow Measures ...............................................................................................................17

Basic and Diluted EPS ............................................................................................................17

Most Critical Ratios ................................................................................................................17

3-component DuPont: .............................................................................................................18

5-component DuPont: .............................................................................................................18

Sustainable Growth Rate.........................................................................................................18

CORPORATE FINANCE ...............................................................................................................19

Weighted Average Cost of Capital ..........................................................................................19

Capital Budgeting Expansion Project .....................................................................................19

Operating Leverage.................................................................................................................19

Financial Leverage..................................................................................................................19

Total Leverage.........................................................................................................................19

Optimal Capital Structure .......................................................................................................19

Dividend Signaling Hypothesis...............................................................................................19

Good Reasons for Mergers......................................................................................................19

Bad Reasons for Mergers ........................................................................................................19

NPV of Merger........................................................................................................................20

Takeover Defense Measures ...................................................................................................20

EQUITY INVESTMENTS .............................................................................................................21

Alpha.......................................................................................................................................21

Taxes and International Investing ...........................................................................................21

Methods to Reduce Execution Costs.......................................................................................21

American Depository Receipts (ADRs)..................................................................................21

Franchise Value and Growth Process ......................................................................................21

Inflation Effects on Valuation .................................................................................................21

Valuation in Emerging Markets...............................................................................................21

Porters Five Forces ................................................................................................................22

Generic Competitive Strategies...............................................................................................22

Industry Analysis.....................................................................................................................22

Discounted Cash Flow (DCF) Methods..................................................................................22

Gordon Growth Model (GGM)...............................................................................................23

Present Value of Growth Opportunities ..................................................................................23

CFA Level II

H-Model..................................................................................................................................23

Solving for Required Return ...................................................................................................23

Strengths of multistage growth models:..................................................................................23

Limitations of multistage models:...........................................................................................24

Free Cash Flow to Firm (FCFF)..............................................................................................24

Free Cash Flow to Eqauity (FCFE).........................................................................................24

Single-Stage FCFF / FCFE Models ........................................................................................24

Two Stage FCFF / FCFF Models .........................................................................................24

Price to Earnings (P/E) Ratio ..................................................................................................24

Justified P/E ............................................................................................................................24

Normalization Methods: .........................................................................................................25

Price to Book (P/B) Ratio .......................................................................................................25

Price to Sales (P/S) Ratio ........................................................................................................25

Price to Cash Flow Ratios.......................................................................................................25

Method of Comparables..........................................................................................................26

Residual Income (RI)Valuation...............................................................................................26

Economic Value Added ...........................................................................................................26

Growth Duration Model..........................................................................................................26

DEBT INVESTMENTS .................................................................................................................27

Credit Analysis........................................................................................................................27

Bond Price Yield Relationship ................................................................................................27

Duration and Convexity ..........................................................................................................28

Yield Curve(Term Structure ) Shifts .......................................................................................28

Theories of the Term Structure................................................................................................28

Key Rate Duration ..................................................................................................................28

Valuing Option Free Bonds.....................................................................................................28

Value Bond with Embedded Option........................................................................................29

Option Adjusted Spread ..........................................................................................................29

Convertible Bonds...................................................................................................................29

MBS Prepayment Risk............................................................................................................29

CMO prepayment Risk ...........................................................................................................30

ABS Prepayment Risk ............................................................................................................30

MBS /ABS spread Analysis ....................................................................................................30

DERIVATIVES ...............................................................................................................................31

Forwards-No Arbitrage Pricing...............................................................................................31

Equity Forward .......................................................................................................................31

Forward on Fixed Income securities .......................................................................................31

Forward Rate Agreements.......................................................................................................31

Currency Forward(Interest Rate Parity ).................................................................................31

Futures Price ...........................................................................................................................31

Futures Arbitrage.....................................................................................................................32

Treasury Bond Futures ............................................................................................................32

Equity Futures .........................................................................................................................32

CFA Level II

Put-Call Parity.........................................................................................................................32

Caps and Floors.......................................................................................................................32

Binomial option Pricing Model...............................................................................................32

Black-Scholes Option Pricing Model......................................................................................32

Delta........................................................................................................................................33

Delta Neutral Hedging ............................................................................................................33

Gamma....................................................................................................................................33

Currency Swaps ......................................................................................................................33

Interest Rate Swaps.................................................................................................................33

Equity Swaps ..........................................................................................................................33

Swap Pricing and Valuation ....................................................................................................33

Swptions..................................................................................................................................34

CFA Level II

I Fundamental Responsibilities

I(A) Comply with laws Code/Standards

I(B) Do noe participate/assits in violations

II Responsibilities to Profession

II (A ) Use of Professional designation

II(B) professional nisconduct

II(C) prohibition against plagiarism

III Responsibilities to Employer

III (A) Inform employer of Code/Standards

III (B) duty to employer

III (C) disclosure of conflicts to employer

III (D)Disclosure of additional compensation

III (E) Responsibilities of supervisors

IV Responsibilities to Clients

IV (A.1) Reasonable basis and represent tations

IV (A.2) Research reports

IV (A.3) Independence and objectivity

IV(B.1) Fiduciary duties

IV(B.2) Portfolio recommendations/actions

IV(B.3) Fair dealing

IV(B.4) Priority of transactions

IV(B.5) Preservation of confidentiality

IV(B.6) Prohibition against misrepresentation

IV(B.7) Disclosure of conflicts to clients

IV(B.8) Disclosure of referral fees

V Responsibilities to Public

V(A) Dont use material nonpublic info

V(B) Performance presentation

CFA Level II

QUANTITATIVE METHODS

Hypothesis Testing

Type I error Rejecting H 0 when true

Type II error Failing to reject H 0 when false

a=probability of Type 1 error

Test Population Means

z=

x 0

x 0

;t =

, n 1, df

s/ n

s/ n

n<30

Z

n30

Z

Normal distribution

Known variance

Normal distribution

t

t or z

Unknown variance

Difference in means test for independent samples Equal Variance

t=

( x1 x2 ) ( 1 2 )

1/ 2

s 2p s 2p

+

n n

2

1

, n1 + n2 2 df

s =

n1 + n2 2

2

p

Unequal Variance :

t=

( x1 x2 ) ( 1 2 )

1/ 2

s12 s22

+

n1 n2

t=

d

, n 1 df

sd / n

Variance Tests

Population variance x 2 =

(n 1) s 2

Equality of variances : F =

02

, n 1 df

s12

, n1 1, n2 1 df s12 > s 22

s 22

CFA Level II

Correlation Coefficient, r

Measure of strength of linear relationship (correlation ) between two variables

r1, 2 =

cov(1,2)

s1 s2

Test H 0 :=0:

t stat =

r n2

1 r 2

, n 2 df

Multiple Regression

Yi = bo + (b1 X li ) + (b2 X 2i ) + (b3 X 3i ) + i

t = b / sb , n k 1 df

SST=SSR+SSE

MSR=SSR/k

MSE=SSE/(n-k-1)

Test statistical significance of regression

F=MSR/MSE with k and n-k-1 df(1-tailed )

Standard error of the estimate (SEE=MSE ) smaller SEE means better fit

Coefficient of determination(R2=SSR/SST).% of variability of Y explained by

Xs ;higher R2 means better fit

Regression Analysis Problems

Heteroskedasticity: Non-constant error variance Detect with Breusch-Paen test

Autocorrelation: Correlation among error terms Detect with Durbin Watson test

positive autocorrelation if DW< d1

Multicollinearity: High correlation among Xs. Detectif F-test significant t-tests

insignificant

CFA Level II

ECONOMICS

Growth Accounting Equation

Total economic output growth=(labor share labor input growth)+(growth of total

factor productivity ) (a,k,a technological progress )

(Percapita economic output growth)=( capital share)(capital-labor ratio

growth )+(growth of total factor productivity )

Neoclassical Growth Theory

z Assumes diminishing marginal product of capital (MPC) and curved savings

function Predicts that an increase in savings rate will

Increase the level of per capita output

Not change long-run growth in total output which equals population growth

in long-run

Not change growth rate in per capita output withch equals technological

progress in long-run

Endogenous Growth Theory

z Assumes constant MPC to society and a straight line savings curve but

diminishing MPC to individual firms

Predicts that an increase in savings rate will increase long run growth in per

capita output

Factors Promoting Economic Growth

z High savings/capital investment

z Human capital development

z Balanced budgets tight monetary policy

z Free trade

z Adequate legal system

z Low population growth

z Technological advancement and sharing

Purchasing Power Parity

Law of one price a single clearly comparable good should have same real price in all

countries Relative PPP Countries with high inflation rates should see their currencies

depredate

s1 1 + iFC

=

, Sin FC / DC

s0 1 + iDC

International Fisher Relation

Assumes real interest rates are equal across borders so interest differential equals

inflation differential

CFA Level II

1 + rFC 1 + E (iFC )

=

1 + rDC 1 + E (iDC )

rFC rDC E (iFC ) E (iDC )

Countries with high minimal interest rates should see their currencies depreciate

E ( s1 ) 1 + rFC

, S _ in FC / DC

=

s0

1 + rDC

%S rFC rDC

Countries with high minimal interest rates will have their currencies sell at forward

discount to prevent arbitrage

F 1 + rFC

=

, Sand F in FC / DC

S 0 1 + rDC

F S0

rFC rDC

S0

Asset Market Approach

Money supply increase will cause:

z Short-run DC depreciation form inflation Increase and rate decrease.

z Long-run DC appreciation to PPP level.

z Overall, DC depreciates from initial level PPP level.

Currency Arbitrage

2-currency arbitrage

bid-ask midpoint range =

1

1

1

2

S f S f (1 TC )

S f

FC1

DC bid

DC

FC

2 bid

FC2

1

FC

1 bid

Real exchange rate (X) is:

P

X = S FC

PDC

, S in DC/FC

CFA Level II

Real exchange rate is possibility of nominal exchange rate changes not explained by

inflation differentials.

Expected foreign currency appreciation less interest rate differential:

FCRP = E (%S ) (rDC rFC ) , S in

DC/FC

International CAPM

DC return =FC interest rate +FC appreciation = DC interest rate + FCRP.

E ( R ) = RF + ( G MRPG ) + ( 1 FCRP1 ) + ( 2 FCRP2 )

= FC + 1

Currency Exposure

Exporters are hurt ad importers are helped by domestic currency appreciation.

Traditional model predicts domestic currency depreciation will improve

competitiveness and increase equity prices (negative currency exposure).

Money demand model predicts positive currency exposure; decreased LR economic

activity causes currency depreciation and lower equity prices.

Product Life Cycle

Development

Expansion

Maturity

Decline

Regression to Mean

Industry competition drives margins to long-run normal level; economic profit = 0.

10

CFA Level II

PORTFOLIO MANAGEMENT

Measuring Risk

From expectation data

N

i=1

E (rp ) = wa E (ra ) + Wb E (rb )

2

ab

= ( wa2 a2 ) + ( wb2 b2 ) + (2wa wb pab a b )

Efficient Frontier and Optimal Portfolio

Efficient portfolios have highest return for given level of risk or lowest risk for given

level of return

Optimal portfolio is intersection of efficient frontier with I curves

E(RP)

Risk P

Systematic risk cannot be diversified away ;relevant risk for security measured with

beta

i =

cov(stock , market )

var(market )

11

CFA Level II

E (rM ) rf

E (rp ) = rf + p

E(RP)

Efficient Frontier

Market Portfolio

Risk P

E (ri ) = rf + { i [ E (rm ) r f ]}

Security market line

E(RP)

E(RM)

Market Portfolio

Rf

Risk P

1

Risk measure for CML is total risk only market portfolio and risk-free asset plot on

CML

Risk measure for SML is beta all properly priced securities and portfolios plot on

SML

Arbitrage Pricing Theory(APT)

Main advantage over CAPM is that APT requires fewer assumptions to derive APT

may be a more general model Specifically APT does not require the following

(historic ) assumptions that are requited by CAPM

Investors have quadratic utility functions

Security returns are normally distributed

All investors hold market portfolio

Testing CAPM

security betas are unstable portfolio betas are stable

Rolls Critique CAPM not testable because cannot observe market portfolio

Benchmark error problem cannot identify market portfolio empirical SML is too flat

12

CFA Level II

Multifactor Models

Macroeconomic factors Unexpected changes in inflation real GDP consumer

confidence yield curve

Microeconomic factors (Fama-French model ) Excess market returns large-cap minus

small cap returns value ninus growth returns stock return momentum

Portfolio management Planning Process

z Analyze risk constraints liquidity time horizon legal and regulatory taxes unique

circumstances

z Develop IPS client description purpose duties objectives and constraints

performance review schedule modification policy rebalancing guidelines

z Determine investment strategy passive active semi-active

z Select strategic asset allocation asset class weightings based on capital market

expectations

13

CFA Level II

Inventory Analysis

z INVEND=INVBGN + Pur-COGS

z IF Price

LIFO COGSothers(taxes, net income, inventory balances,

NWC)so determine the relevant ratios.

FIFO COGSothers(taxes, net income, inventory balances,

NWC)so determine the relevant ratios.

FIFO

COGs

LIFO

COGS

z accelerated SL depreciation: depreciationfuture net income, ROA,

ROE.

z Asset Impairment Obligation (AIO) :

todays assets, shareholders equity, net income, ROA, and ROE;

increases todays debt/equity

future depreciation expense, debt/equity; future net income, ROA ,

ROE , and asset turnover.

Off-Balance Sheet Debt

z Sale of A/R with recourse and take-or-pay contracts

parent assets, liabilities.

Lease Classification

Lease is capital lease to lessee if one holds:

z Title is transferred to lessee at end

z Bargain purchase option

z Lease period 75% of assets life.

z PV of payments > 90% of FV.

Lease is capital lease to lessor if all hold:

z If lessee regards the lease as Capital Lease

z Predictable collectability of the A/R.

z Cost can be determnined.

Sales-type (capital) lease:;

Direct financing :.

14

CFA Level II

z Sales-type

lessor is equipment dealer

Will report profits and has higher assets at the beginning; earlier profits, same

total CF, CFO(Because of Less interest revenue).

z Direct Financing

if the lessor is not the equipment dealer

Will reports no profits, no change in assets at the beginning; later profits,

same total CF, and more CFO(Because of More interest revenue)

Marketable Securities Classification

z Held to-maturity

B/S: Cost ; I/S : interest, realized gains/losses

z Available for sale

B/S: FMV, unrealized gains/losses; I/S: interest, realized gains/losses,

dividends

z Trading

B/S: FMV; I/S: interest, realized gains/losses, dividends, realized and

unrealized gains/losses

Account for Inter-corporate Investments

z Cost/market

z Equity

20% Equity ratio 50%; significant influence.

z Consolidation

Business Combinations

Under IASB GAAP pooling method:

z No identification of acquirer and acquired.

z B/S values consolidated at historical cost.

z Prior operating results restated.

Under IASB and U.S. GAAP purchase methods:

z Acquirer and acquired identified.

z Acquired firm B/S restated to FMV.

z Prior results disclosed, not restated.

z Goodwill

z In-process R&D

Purchase Method: Constructing Consolidated Statements

z Revalue all tangible assets/liability of acquired to FMV.

15

CFA Level II

z

z

z

Allocate remaining purchase price to goodwill (net of assumed liabilities).

Eliminate common equity of acquired firm; replace with MV of shares issued.

z Higher discount rate

PBO, ABO, service cost, pension expense;

funded status; interest cost.

z Lower compensation growth rate

PBO, service cost, interest cost, pension expense;

funded status.

z Higher expected return

pension expense.

z Lower healthcare cost inflation rate

decrease APBO & post-retirement benefit expense.

Pension Calculations

FV of plan assets (beginning)

+

actual ROA

+

contributions

+/- other factors

benefits paid

=

FV of plan assets (ending)

PBOt-1

+ service cost

+ interest cost

+/- actuarial losses/gains and amendments

+/- other factors

- benefits paid

PBOt

Funded status = FV of plan assets PBO funded status

+/- unrecognized actuarial losses (gains)

+ unrecognized prior service cost

+/- unrecognized prior transfer obligation (asset )

+/- amortization of actuarial losses/gains

= net pension asset (liability)

Pension Adjustments

z Adjust pension liability/asset to reflect funded status.

z Recurring cost = Service cost + Interest cost

z Gross pension cost = Recurring cost + actuarial losses + Plan amendments

z Non-smoothed cost (credit) = Gross pension cost Actual ROA

16

CFA Level II

Multinational Operations

z All-current method: condition

Local currency functional currency

z Method

assets/liabilities: current rate.

common stock: historical rate .

I/S : average rate.

z

Temporal method.

Local currency Reporting currency

Functional currency Reporting currency

sub in inflationary environment, parent currency is functional currency.

Method

B/S monetary assets/liabilities: current rate.

B/S non-monetary assets/liabilities: historical rate.

I/S sales, SG&A : average rate.

COGS& depreciation: historical rate.

z Traditional cash flow = net income + depreciation + change in deferred taxes.

z Cash flow from operations (CFO) = traditional cash flow net changes in non-cash

current assets and liabilities.

Basic and Diluted EPS

NI Pr ef div

Basic EPS=

WA common sharesO / S

Diluted EPS=

WA common shares + potential connom shares O/S

Internal liquidity:

z Current ratio = current assets / current liabilities.

z Quick ratio = (current assets - inventory) / current liabilities.

z Receivables turnover = sales / average accounts receivable

z Average collection period = 365/ receivables turnover.

z Inventory turnover = COGS / average inventory..

z Payables turnover = COGS / average trade payables.

z Payables payment period = 365 / payables turnover.

Evaluating operating efficiency:

z Total asset turnover = sales / average total assets.

17

CFA Level II

z

z

z

z

z

z

Gross profit margin = gross profit / sales.

Operating profit margin = EBIT / sales.

Net profit margin =net income / sales.

Return on total assets (ROA) = net income/ average total assets.

Return on total equity (ROE) = net income / average total equity.

z Debt-equity ratio = total long term debt/ total equity.

z Long term debt to total capital = long term debt / long term capital.

Note: long term capital = long term debt+ preferred stock + equity.

z Debt to assets = total debt / total assets.

Note: also called debt to total capital.

z Interest coverage = EBIT / interest expense.

3-component DuPont:

netincome sales assets

ROE =

sales assets equity

5-component DuPont:

assets

EBIT sales int erest exp ense

(1 t )

ROE =

]

assets

sales assets

equity

g = ROERR, RR=Retention Ratio.

18

CFA Level II

CORPORATE FINANCE

Weighted Average Cost of Capital

WACC = (wd)[kd(1-t)]+(wps)(kps)+(wce)(ks), weighted by the market value.

Capital Budgeting Expansion Project

z Initial investment : Cost , changes in NWC

z Operating cash flows = (R-C) (1-t)+(Dt), D is Depreciation.

z Terminal cash flows:

after-tax salvage

return of NWC

Operating cash flows at the last period

Operating Leverage

Variable vs. fixed cost tradeoff.

DOL = (EBIT/EBIT) / (Q/Q)

DOLQ=Q(P-V) / [Q(P-V)-F]

DOLS= (S-VC)/ (S-VC-F)

Financial Leverage

Use of fixed incomes in capital structure

DFL =(EPS /EPS) / (EBIT/EBIT)

DFL = EBIT / [EBIT I]

Total Leverage

DTL = DOLDFL=(EPS /EPS) / (Q/Q)

Optimal Capital Structure

Tradeoff between tax shelter benefit from more debt and higher expected bankruptcy

costs from higher leverage.

Dividend Signaling Hypothesis

Unexpected dividend cut is bad news; dividend increase is good news.

Good Reasons for Mergers

z Economies of scale.

z Vertical integration.

z Complementary resources.

z Surplus cash.

z Eliminating operating inefficiencies.

Bad Reasons for Mergers

z Diversification.

z Lower financing costs.

19

CFA Level II

Bootstrapping

NPV of Merger

NPV (cash merger)=gain cost

=VBT-(cash price VT)

Cost of stock merger = (NPBT)-VT

Takeover Defense Measures

z Staggered boards.

z Supermajority.

z Fair price amendment

z Restricted voting rights

z Waiting period.

z Poison pill

z Litigation.

z Asset or liability restructuring .

20

CFA Level II

EQUITY INVESTMENTS

Alpha

ex ante = expected return required return from CAPM or APT

ex post = holding period return - return on similar assets.

Taxes and International Investing

Three forms of tax: transaction, capital gain, income.

Methods to Reduce Execution Costs

Program trading, Internal / external crossing, Principal trades, agency trades, futures

contract.

American Depository Receipts (ADRs)

Advantage: Reduce administration / duty costs on each transaction.

Disadvantage: Do not eliminate inherent currency / economic risks.

Franchise Value and Growth Process

Tangible P/E =1/r

Franchise P/E = franchise factor growth factor = FFG

1

1

FF =

r ROE

G=

g

rg

If FF>0, higher retention ratio implies higher GF, higher franchise P/E.

Higher flow-through rate implies higher P/ E, all else equal.

If inflation flow-through <100%, higher inflation implies lower P/E, all else equal.

P0

1

=

, k is the required rate of return, I is the inflation rate, is the

E1 k + (1 ) I

inflation flow-through rate.

Adjust cash flows rather than discount rate:

z Country risks are diversifiable.

z Differing response to country risk.

z Country risk is one- sided.

z ID cash flow aids in risk management.

21

CFA Level II

1. Entry barriers(or threat of new entrants)

z function of economies of scale, product differentials, brand identity, capital

requirements, access to distribution channels, government policy, cost

advantages,

2. Threat of substitutes

z function of relative price performance of substitutes, buyer propensity to

substitute, switching cost.

3. Bargaining power of buyers

z function of bargaining leverage / price sensitivity.

4. Bargaining power of suppliers

z determined by differentiation of inputs, presence of substitute inputs, supplier

concentration, importance of volume to supplier, threat of forward

integration.

5. Rivalry among existing competitors:

z function of industry growth, fixed costs, value added, product differences,

brand identity, diversity of competitors, exit barriers, informational

complexity.

Generic Competitive Strategies

z Cost leadership

Try to be low- cost producer.

z Differentiation.

Try to set products apart from competitors products.

z Cost focus

z Differentiation focus.

Differentiate in industry segment.

Industry Analysis

z Industry life cycle:

Pioneer

Growth

Mature

Decline

z External factors: Technology, government, social change, demography, foreign

influences.

Discounted Cash Flow (DCF) Methods

Use dividend discount models (DDM) when:

z Firm has dividend history.

z Dividend policy related to earnings.

z Minority shareholder perspective.

Use free cash flow (FCF) models when:

z Firm lacks stable dividend policy.

z Dividend policy not related to earnings.

z FCF is related to profitability.

22

CFA Level II

Use residual income (RI) when:

z Firm lacks dividend history.

z FCF is negative.

Three ways to determine cost of equity:

z CAPM: r=rf+(rm-rf).

z Multifactor APT.

z Add equity risk premium to firms LT bond yield.

Gordon Growth Model (GGM)

Assumes perpetual dividend growth rate

V0 =

D1

rg

z Very sensitive to estimates of r and g,

z Difficult with non-dividend stocks.

z Difficult with unpredictable growth patterns (use multi-stage model).

Present Value of Growth Opportunities

E

Vo = 1 + PVGO

r

Step 1: Calculate dividends in high-growth period.

Step 2: Use GGM for terminal value at end of high-growth period.

Step 3: Discount interim dividends and terminal value to time zero to find stock value.

H-Model

Vo =

H=

[D0 (1 + g L )] + [D0 H ( g s g L )]

r gL

t

2

For Gordon (or stable growth) model, solving for return yields:

r=

D1

+g

P0

z Flexibility.

z Use in forward or reverse.

z Relationship between assumptions and value estimates.

23

CFA Level II

z Garbage-in, garbage-out.

z Cant determine effects of assumptions unless model is clearly understood.

z Value estimates sensitive to assumptions of growth and required return.

z Difficult to ID data / input errors.

Free Cash Flow to Firm (FCFF)

Assuming DEPreciation is only NCC:

z FCFF= NI+Dep+[Int(1-tax rate)]-FCInv-WCInv.

z FCFF = [EBIT](1-tax rate)]+Dep-FCInv WCInv.

z FCFF = [EBITDA(1-tax rate)]+(Deptax rate)-FCInv-WCInv.

z FCFF = CFO + [Int(1-tax rate)]-FCInv.

Free Cash Flow to Eqauity (FCFE)

z FCFE = FCFF [Int(1-tax rate)]+Net borrowing.

z FCFE = NI + Dep FCInv-WCInv+Net borrowing.

z FCFE = NI-[(1-DR)(FCInv-Dep)]-[(1-DR)WCInv].

z

Single-Stage FCFF / FCFE Models

z

FCFF1

WACC g

FCFF1

rg

Step 1: Calculate FCF in high-growth period.

Step 2: Use single-stage FCF model for terminal value at end of high-growth period.

Step 3: Discount interim FCF and terminal value to time zero to find stock value; use

WACC for FCFF, r for FCFE.

Price to Earnings (P/E) Ratio

Problems with P/E.

z If earnings <0, P/E meaningless.

z Volatile, transitory portion of earnings makes interpretation difficult.

z Management discretion over accounting choices affects reported earnings.

Justified P/E

Leading P / E1 =

1 b

rg

24

CFA Level II

Trailing P / E0 =

(1 b)(1 + g )

rg

Normalization Methods:

z Historical average EPS.

z Average ROE.

Price to Book (P/B) Ratio

Advantages:

z BV almost always>0,

z BV more stable than EPS.

z Measures NAV of financial institutions.

Disadvantages:

z Size differences cause misleading comparisons.

z Influenced by accounting choices.

z BVMV due to inflation/ technology.

Justified = P / B =

ROE g

rg

Advantages:

z Meaningful even for distressed firms.

z Sales revenue not easily manipulated.

z Not as volatile as P/E ratios.

z Useful in valuing mature, cyclical, and start-up firms.

Disadvantages:

z High sales do not imply high profits and cash flows.

z Does not capture cost structure differences.

z Revenue recognition practices still distort sales.

Justified P / S =

PM 0 (1 b)(1 + g )

rg

Advantages:

z Cash flow harder to manipulate than EPS.

z More stable than P/E

z Mitigates earnings quality concerns.

Disadvantages:

z Difficult to estimate true CFO

z FCFE better but more volatile.

25

CFA Level II

Method of Comparables

z Firm multiple > benchmark implies overvalued

z Firm multiple < benchmark implies undervalued.

z Fundamentals that affect multiple should be similar between firm and benchmark.

Residual Income (RI)Valuation

z RIt=Et-(rBt-1)

z Firm value = adjusted BV0+ PV of expected future RI.

z

ROE r

B0

rg

RI T

, is the persistence factor,

1+ r

between 0 and 1.

EVA = NOPAT - $WACC; NOPAT = EBIT(1-t)

$WACC = WACCInvested capital; Invested capital = NWC + Net PP&E

Ways to increase EVA : Increase revenues, reduce expenses, less invested capital ,

find + NPV projects, reduce WACC.

Growth Duration Model

1 + gH + dH

High, Growh, P / E

ln

= T ln

Cons tan tGrowthP / E

1 + gC + dC

26

CFA Level II

DEBT INVESTMENTS

Credit Analysis

Liquidity sources

z Working capital

z Cash flow.

z Back-up facilities

z Third-party guarantees.

High-yield debt

z Issuer has senior, short-term, floating bank debt.

Asset-backed debt

z Quality of collateral.

z Servicer quality

z Payment structure.

z Legal structure (VIE, SPV)

Municipal bonds

z Tax-backed: repaid with tax revenue

z Revenue: repaid with project CF.

Sovereign debt

z Local vs. foreign currency rating.

z Economic risk; ability to pay.

z Political risk: willingness to pay.

Bond Price Yield Relationship

Option free bond exhibits

positive convexity.

negative convexity.

price

price

Strike price

yield

yield

27

CFA Level II

ED =

(BVY BV+Y )

2 BVO Y

Convx =

BV y BV+ y (2 BVo )

2 BVo y 2

Parallel shift

Nonparallel shift slope changes

Butterfly twist change in humped shape

Theories of the Term Structure

z Pure (unbiased) expectations Forward rates (F) function of expected future spot

rates E(S)

If up sloping, spot rates rise

If down sloping , spot rates fall

If flat, spot rates constant

z Liquidity theory

F rates reflect expectation of E(S) plus liquidity premium

z Preferred habitat theory

Imbalance between fund supply demand at maturity range induces lenders to

shift from preferred habitats to one with opposite imbalance

z Market segmentation theory

Imbalance between fund supply demand at maturity range induces lenders to

shift from preferred habitats to one with opposite imbalance

z Market segmentation theory

Yield curve shape determined by supply demand for securities at each

maturity

Key Rate Duration

% value from 100 bps in key rate

Have several key rates (5-yr, 10-yr )

Estimate effect of non-parallel yield curve shift on bond portfolio value

Valuing Option Free Bonds

To value option free bond with the binomial tree start at end and discount back though

the tree (backwards induction method ) Value 2-year option free bond

step1: Find the time one up node value

28

CFA Level II

1 nodal _ value2UU

2

1 + i1,U

nodal _ value2UD

+

1 + i1,U

nodal value 1,D =

1 nodalvalue2, DD

2

1 + i1, D

nodalvalue2,UD

+

1 + i1, D

nodal value 0 =

1 nodal _ value1,U

2

1 + i0

nodalvalue1, D

+

1 + i0

For bonds with embedded options assess whether option will be exercised at each

node New Step 3 is

Step 3 (callable bond ) Find time 0 value assuming year 1 down node calculated

value> than call price

nodal value 0 =

1 nodal _ value1,U

2

1 + i0

nodal _ value1,D

+

+

1

i

0

Option-removed spread.

Compensation for liquidity and credit risk

Spread that forces model price =marker price

z-spread =OAS+option cost

Convertible Bonds

Conversion value =stucco price x conversion ratio

Minimum value =min(straight value conversion value )

Market conversion premium=conversion price market price

Callable convertible bond=straight bond - call on stock call on bond

MBS Prepayment Risk

z Prepayment speed factors

Spread of current vs original mortgage rates.

Mortgage rate path (refinancing burnout )

Level of mortgage rates

Underlying mortgage rates

Seasonal factors

z Contraction risk occurs as rates fall prepayments rise average life falls

z Extension risk occurs as rates rise prepayments fall slow average life rises

29

CFA Level II

z PAC I tranches: low contraction and extension risk (due to PAC collar)

z PAC II tranches: somewhat higher contraction and extension risk

z Support tranches: higher contraction and extension risk

z IO strips: value positively related to interest rates at low current rates

z PO strips: negative convexity at low rates high interest rate sensitivity

ABS Prepayment Risk

z External credit enhancement corporate guarantees leers of credit bond insurance

z Internal credit enhancement reserve funds over-collateralization senior sub

structure

z Auto loan low prepayment risk small balances high depreciation

z Credit card receivable low prepayment (lockout period no prepayments on crddit

cards )

MBS /ABS spread Analysis

z Plain vanilla corporate: Z-spread

z Callable corporate: OAS (binomial model )

z MBS: OAS (Monte Carlo model )

z Credit card auto ABS: Z-spread

z High quality home equity ABS: OAS (Monte Carlo model )

30

CFA Level II

DERIVATIVES

Forwards-No Arbitrage Pricing

FP = S 0 (1 + R f ) T

Vlong = S t

FP

(1 + R f )T t

Equity Forward

FP (equity ) = ( S 0 PVD ) (1 + R f )T

Vlong = S t PVDt

FP

(1 + R f )T t

FP ( fixedincome) = ( S 0 PVD ) (1 + R f )T

Vlong = S t PVC

FP

(1 + R f )T t

Long position in FRA is party that would borrow If LIBOR at end is above forward

rate in FRA long in effect has right to borrow at below market rates and receives a

payment

FRAPriceis forward rate implied by current sport rates

j+k

1 + L(1+ k ) 360

360

1

FR ( j , k ) =

1 + L( j ) ( j )

k

360

FP (currency ) = S 0

T

(

1 + Rdomestic )

(1 + R foreign ) T

F and S in DC/FC

Vlong =

St

(1 + R foreign )

T t

FP

(1 + Rdomestic )T t

Futures Price

FP = S 0 (1 + R f ) T

Futures< forward when rates and asset values negatively correlated

31

CFA Level II

Futures Arbitrage

Cash and carry: Borrow, buy spot, sell futures today deliver asset, repay loan at end

Reverse cash and carry: short spot, invest, buy futures today; collect loan, buy asset

under futures contract, deliver to cover short sale .

Treasury Bond Futures

FP = bond price (1 + R f )T FVC

Equity Futures

FP( stock ) = S 0 (1 + R f ) T FVD

FP(index) = S 0 e ( R )T

Put-Call Parity

Call+Risk-free Bond=Put+Underlying

Co +

X

= P0 + S 0

(1 + r )T

Cap=portfolio of calls on LIBOR

Floor=portfolio of puts on LIBOR

Collar=buy cap and sell floor or sell cap and buy floor

Binomial option Pricing Model

Step 1: Calculate option payoffs at end in all stares

Step 2:Calculate expected value using probabilities

1+ R D

U D

Step 3: Discount to today at risk free rate

up =

Ct = [ S t N (d1 )] [ X e r (T t ) N (d )]

S

ln t + r + (0.5 2 ) (T t )

X

d1 =

T t

d 2 = d1 ( T t )

Pt = Ct St + (e r (T t ) X )

Effect of each variable on a call option Asset price positively related

32

CFA Level II

z

z

z

z

z

Volatility of asset price: positively related

Risk free rate: positively related

Time to expiration: positively related

Exercise price: Negatively related

Delta

Estimates the change in value of option for a one-unit change in stock price

Call delta between o and 1 increases as stock price increases

Call delta close to 0for far out of the money calls close to 1 for fan in the money

calls

Put delta between I and 0 increases from 1 to 0 as stock price increases

Put delta =call delta -1 (all else equal )

Delta close to 0 for far out of the money puts close to -1 for fan in the money puts

Delta Neutral Hedging

#Calls for delta hedge =

# shares of stock

delta of call option

Delta neutral position only holds for very small changes in value of underlying stock

Delta neutral portfolio must be frequently (continuously) rebalanced to maintain

hedge called a dynamic hedge

Gamma

Measures rate of change in delta as underlying stock price changes largest when

option is at the money

Currency Swaps

Parties swap payments in two currencies at fixed or floating rates

Interest Rate Swaps

Plain vanilla interest rate swap trading fixed interest rate payments for floating rate

payments

Equity Swaps

Return on stock portfolio or stock index is paid each period by one party in return for

a fixed payment Return can be capital appreciation or total return including dividends

on the stock or portfolio

Swap Pricing and Valuation

Swap rate is set so PV of floating rate payments PV of fixed rte payments swap

value is zero to both parties

CN =

1 BN

B1 + B2 + L + BN

33

CFA Level II

Bn = PV of 1 on n th date

Value to floating pay side=PV of fixed PV of floating

Swptions

Payer swaption value increases as rates rise

Receiver swaption value increases as rates fall

34

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