Ethical and Professional Standards Study Session 1 - 2: Weighting 10%

1
Ethical and Professional

Standards
Study Session 1 – 2
Weighting 10%
Overview of Level II Ethics 2
Study Session 1
Standards of CFA Institute CFA Institute

Code of
Professional Soft Dollar Research
Ethics
Conduct Standards Objectivity
Standards
Study Session 2
Ethics Cases: Other topics:

- Glenarm - Fair dealing & disclosure
Company - Changing investment objectives
- Preston Partners - Prudence in Perspective
- Super Selection
Overview of the Code and Standards 3
Code of Ethics Standards of Professional Conduct
I: Professionalism V: Investment Analysis,

• Act in an ethical A.Knowledge of the Law Recommendations, and
manner B.Independence and Objectivity Actions
Integrity is C.Misrepresentation A. Diligence and Reasonable Basis
paramount and D.Misconduct B. Communications with Clients and
clients always Prospective Clients
come first II: Integrity of Capital Markets C. Record Retention
A.Material Nonpublic Information
• Use reasonable B.Market Manipulation VI: Conflicts of Interest
care and be A. Disclosure of Conflicts
independent III: Duties to Clients B. Priority of Transactions
A.Loyalty, Prudence, and Care C. Referral Fees
• Be a credit to the B.Fair Dealing
investment C.Suitability VII: Responsibilities as a CFA
profession D.Performance Presentation Institute Member or CFA
E.Preservation of Confidentiality Candidate
• Uphold capital A. Conduct as Members and
market rules and IV: Duties to Employers Candidates in the CFA Program
regulations A.Loyalty B. Reference to CFA Institute, the
B.Additional Compensation CFA Designation, and the CFA
• Be competent Arrangements Program
C.Responsibilities of Supervisors
Standards of Professional Conduct 4
Standard I: Professionalism
I(A): Knowledge of the Law I(B): Independence and Objectivity

• Understand and comply with all laws, rules, • Use reasonable care, judgment to
regulations (including Code & Standards) achieve, maintain independence in
governing professional activities professional activities
• Comply with more strict law, rule, regulation • Do not offer, solicit, accept any
• Do not knowingly assist in violation, otherwise compensation that could compromise
dissociate from activity independence, objectivity
Guidance
Guidance
• Most strict
• Modest gifts OK
• First – notify supervisor or
compliance • Distinguish between gifts from clients and gifts
• May confront wrongdoer directly from entities trying to influence
• Dissociate if necessary • May accept gift from clients – must disclose to
• Inaction may be construed as employer – must get permission if gift is for
participation future performance
• No requirement to report violations • Investment banking relationships – do not bow
to governmental authorities, but this to pressure to issue favorable research
may be appropriate in certain cases • For issuer-paid research, flat fee structure is
preferred
Standard I: Professionalism
I(C): Misrepresentation I(D): Misconduct

• Do not make misrepresentations • Do not engage in any professional
relating to investment analysis, conduct involving dishonesty, fraud,
recommendations, actions or other deceit, or commit any act that reflects
professional activities adversely on professional reputation,
integrity, or competence
Guidance
• Standard covers oral, written, or Guidance
electronic communications This Standard covers conduct
• Do not misrepresent qualifications, that may not be illegal, but
services of self or firm, or performance could adversely affect a
record, characteristics of an investment member’s ability to perform
• Do not guarantee a certain return duties
• No plagiarism – written or oral
communications
Standard II: Integrity of

Capital Markets
II(A): Material Nonpublic Information II(B): Market Manipulation

• Members in possession of nonpublic • Do not engage in practices that
information that could affect an distort prices or artificially inflate
investment’s value must not act or trading volume with intent to
cause someone else to act on the mislead market participants
information
Guidance Guidance
• “Material” – if disclosure of information would • Do not engage in transaction-
impact a security’s price or if reasonable based manipulation – give false
investors would want the information before impression of activity / price
making an investment decision movement; gain dominant
• Information is “nonpublic” until it has been position in an asset to manipulate
made available to the marketplace price of the asset or a related
• Information made available to “analysts” is derivative
considered nonpublic until it is made available • Do not distribute false, misleading
to investors in general information
• Mosaic Theory
Standard III: Duties to Clients
III(A): Loyalty, Prudence, and Care III(B): Fair Dealing

• Act with reasonable care and exercise Deal fairly, objectively with all clients
prudent judgment when:
• Act for benefit of clients and place their • Providing investment analysis
interests before employer’s or own interests • Making investment recommendations
• Determine and comply with any applicable • Taking investment action
fiduciary duty
• Engaging in other professional activities
Guidance Guidance
• Take investment actions in client’s best interests • Different levels of service okay as
• Exercise prudence, care, skill, and diligence long as disclosed, and does not
• Follow applicable fiduciary duty disadvantage any clients
• Manage pools of client assets according to terms • Investment recommendations:
of governing documents all clients must have fair chance
• Make investment decisions in context of total to act on every recommendation
portfolio • Investment actions: treat all
• Vote proxies responsibly and disclose proxy clients fairly – consider
voting policies to clients investment objectives,
• “Soft dollars” must benefit client circumstances
III(C): Suitability
• Know client’s risk and return
objectives, and financial constraints III(D): Performance Presentation
• Update information regularly • When communicating investment
• Make investment recommendations or performance information, ensure
take investment actions that are that information is fair, accurate,
consistent with the stated objectives and complete
and constraints
• Look at suitability in a portfolio context
Guidance Guidance
• When in advisory relationship, gather • Do not misstate performance or
client information at the outset and mislead clients about investment
prepare IPS performance
• Update IPS at least annually • Do not state or imply ability to
achieve returns similar to those
• Consider whether leverage (derivatives)
achieved in the past
is suitable for client
• If managing a fund to an index or other
mandate, invest according to mandate
III(E): Preservation of Confidentiality

Keep current and prospective client information confidential, unless:
• Illegal activities are suspected
• Disclosure is required by law
• Client or prospect allows disclosure of the information
Guidance
• In some cases it may be required by law to report activities
to relevant authorities
• This Standard extends to former clients
• Exception: May provide confidential information to CFA
Institute for an investigation under Professional Conduct
Program
Standard IV: Duties to

Employers
IV(A): Loyalty
• Must act for the benefit of their employer
Guidance
Loyalty – Independent practice:
• If planning to engage in independent practice, notify employer of services provided,
expected duration, and compensation
• Do not proceed without consent from employer
Loyalty – Leaving an employer:
• If seeking new employment, act in best interest of employer until resignation is effective
• Do not take records or files without permission
• Simple knowledge of names of former clients is OK
• No prohibition on use of experience or knowledge gained at former employer
Loyalty – Whistleblowing:
• Permitted only if it protects client or integrity of capital markets
• Not permitted for personal gain
Standard IV: Duties to

Employers
IV(B): Additional Compensation Arrangements IV(C): Responsibilities of

Do not accept gifts, benefits, compensation, Supervisors
consideration that competes with, or creates a • Must make reasonable efforts to
conflict of interest with, employer’s interest unless detect and prevent violations
written consent is obtain from all parties involved
Guidance Guidance
• Compensation and benefits covers • Supervisors must take steps to
direct compensation by the client prevent employees from violating
and other benefits received from laws, rules, regulations, or the
third parties Code and Standards
• For written consent from “all parties • Supervisors must make
involved,” email is acceptable reasonable efforts to detect
violations
Standard V: Investment Analysis, Recommendations, and Actions
V(A): Diligence and Reasonable Basis V(B): Communication with Clients and
Prospective Clients
• Exercise diligence, independence, and
thoroughness • Disclose the basic format and general principles
of investment processes and promptly disclose
• Have a reasonable and adequate basis, any changes that might affect those processes
supported by appropriate research, for materially
any investment analysis,
recommendation, or action. • Identify important factors and include them in
communications with clients/prospective clients
Guidance • Distinguish between fact and opinion in the
• Make reasonable efforts to cover presentation of investment analysis and
all relevant issues when arriving at recommendations
an investment recommendation
• Determine soundness when using Guidance
secondary or third-party research
• Distinguish between facts and opinions
• Group research and decision
• Include basic characteristics of the security
making: As long as there is
• Inform clients of any change in investment
reasonable basis for opinion,
processes
member does not necessarily have
to agree with the opinion • Suitability of investment – portfolio context
• All communication covered, not just reports
Standard V: Investment Analysis, Recommendations, and Actions
V(C): Record Retention

• Develop and maintain appropriate records to support
their investment analysis, recommendations, actions,
and other investment-related communications
Guidance
• Maintain records to support research, and the
rationale for conclusions and actions
• Records are firm’s property and cannot be
taken when member leaves without firm’s
consent
• If no regulatory requirement, CFA Institute
recommends retention period of 7 years
Standard VI: Conflicts of Interest
VI(A): Disclosure of Conflicts

• Must make full and fair disclosure to clients, prospects or employer of all
matters that could reasonably be expected to impair their independence
and objectivity or interfere with respective duties
Guidance
Disclose to clients:
• All matters that could impair objectivity – allow clients to judge motives, biases
• For example, between member or firm and issuer, investment banking relations,
broker/dealer market-making activities, significant stock ownership, board
service
Disclose to employers:
• Conflicts of interest – ownership of stock analyzed/recommended, board
participation, financial and other pressures that may influence decisions
• Also covers conflicts that could be damaging to employer’s business
Standard VI: Conflicts of Interest
VI(B): Priority of Transactions

• Investment transactions for clients and VI(C): Referral Fees
employers must have priority over investment • Must disclose to
transactions in which a Member or Candidate employer, clients, and
is the beneficial owner prospective clients
Guidance Guidance
• “Beneficial owner” – has direct / • Disclosure allows clients and
indirect personal interest in the employers to evaluate full cost of
securities service and any potential biases
• Client, employer transactions take • Disclosure is to be made prior to
priority over personal transactions entering into any formal agreement
(including beneficial ownership) for services
• Family member accounts that are • Disclose the nature of the
client accounts must be treated as consideration
other client accounts
Standard VII: Responsibilities as a CFA

Institute Member or CFA Candidate
VII(A): Conduct as Members and Candidates in the CFA Program

• Must not engage in any conduct that compromises the reputation or
integrity of CFA Institute or the CFA designation or the integrity, validity,
or security of the CFA examinations.
Guidance
Conduct includes:
• Cheating on the exam
• Disregarding rules and policies or security measures related to
exam administration
• Giving confidential information to candidates or public
• Improper use of CFA designation to further personal and
professional objectives
• Misrepresenting the CFA Institute Professional Development
Program or the Professional Conduct Statement
Standard VII: Responsibilities as a CFA

Institute Member or CFA Candidate
VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program
• Must not misrepresent or exaggerate the meaning or implications of membership in
CFA Institute, holding the CFA designation, or candidacy in the CFA program
Guidance
CFA Institute membership:
• Complete PCS annually Failure to comply with results in an inactive
• Pay membership dues annually member status
Using the CFA designation:
• Don’t misrepresent or exaggerate the meaning of holding the CFA designation
Reference to the CFA program:
• May reference participation but no partial designation
• OK to say “passed all levels on first attempt,” but do not imply superior ability
Improper use of the CFA marks:
• The “Chartered Financial Analyst” and “CFA” marks must always be used either
after a charterholder’s name or as adjectives, not as nouns
CFA Institute Soft Dollar Standards 18
Definitions
General Appendix: Permissible
Principles research guidance
Soft Dollar Standards
I. General
II.Relationship
with clients VII. Record keeping
III. Selection of V. Client-directed

brokers brokerage
VI. Disclosure
IV. Evaluation of
research
Soft dollar practices

• The use of client brokerage by investment manager to obtain products/services to aid
manager in investment decision making process
Two fundamental principles

• Client property
• Duty to minimize transaction costs, obtain best execution & use client brokerage to
benefit clients
General
• Soft dollar practices must benefit client, whose interests always come first
• Allocation of client brokerage – must not be based on amount of client referrals
investment manager receives from broker
Relationship with clients
• Disclose involvement in soft dollar
• OK to use brokerage from agency trades to obtain research – client should receive
some benefit
• OK to use client brokerage obtained from principal trades to benefit other client
accounts, as long as disclosed
Selection of brokers
• Consider trade execution capabilities
CFA Institute Soft Dollar Standards34 20
Evaluation of research
• Meet definition of Standard
• Benefit client
• Documentation of basis
• Disclosure and consent obtained if benefit other clients
• Investment manager pays for research if doesn’t meet criteria
• Mixed-use research – allocate
Client-directed brokerage
• Cannot use brokerage from another client to pay
• Manager: Disclose duty of best execution
• Disclose to client that client’s selection may adversely affect execution and adequacy
of research
Disclosure
• Disclose types of third-party research received
• To comply with Soft Dollar Standards, send client statement of practices annually
• On client request, provide description of product / service obtained through client
brokerage generated by client’s account
• Provide total amount of brokerage paid from all accounts (where manager has
discretion)
Record keeping
Manager must maintain records
• Document arrangements obligating manager to generate specific dollar amount of
brokerage
• Document client arrangements re: client brokerage
• Document brokerage arrangements
• Document basis for allocations – mixed use brokerage
• Show how products / services obtained assist in investment process
• Show compliance with CFAI Soft Dollar Standards, responsible party
• Include copies of disclosures / authorizations from clients
Permissible research: 3 level analysis

• Level I: define the product or service
• Level II: determine usage
• Level III: mixed-use analysis – investment manager makes proper allocation
CFAI Research Objectivity Standards 22
Objectives Procedures for

compliance
Research
objectivity
Rating system
policy
Public Disclosure
appearances Investment
banking
Compliance
Personal and
Reasonable
investments enforcement
and adequate
basis and trading
Timeliness of research
Relationships reports and
Research
with subject recommendations
analyst companies
compensation
Objectives of the Standards
• Prepare research, recommendations, investment action – clients always first

• Full, fair, meaningful disclosures of conflicts
• Promote effective policies/procedures – minimize conflicts affecting
independence/objectivity
• Support self-regulation – adhere to specific, measurable standards, promoting
independence, objectivity
• Provide ethical work environment
Required Compliance Procedures
Research objectivity policy

• Provide written policy on research independence and objectivity
• Have supervisory procedures that ensure compliance
• Have a senior officer who attests to the firm’s implementation and adherence
Public appearances
• Require covered employees to disclose both personal and firm conflicts of interest to
the interviewer/host and, if possible, to the audience
Reasonable and adequate basis

• Appoint a supervisory analyst or a review committee to evaluate and approve
research report recommendations
Investment banking
• Separate research analysts from the investment banking division
• Research analysts are not supervised by or report to the investment banking
• Investment banking or corporate finance divisions are unable to modify, review,
approve or reject research recommendations and reports
Research analyst compensation

• Compensation should reflect the quality and accuracy of the recommendations made
• Compensation should be not be connected to the analyst’s involvement with
investment banking or corporate finance activities
Relationships with subject companies

Research analysts are not allowed to:
• Share research report with a subject company prior to the publication of the research
report
• Promise a favorable report or a certain price target to a subject company or corporate
issuer
Personal investments and trading

• Firm should have policies to ensure covered employees’ personal investment
dealings are properly managed
Timeliness of research reports and recommendations

• Reports should be issued on a timely and regular basis
Compliance and enforcement

• Effective compliance procedures should be in place
• The compliance procedures should be supervised and audited & maintain internal
audit records
Disclosure
• Firm to provide full disclose of conflicts of interest
Rating system
• Rating system should be helpful to investors in their decision-making process
Recommended Procedures for Compliance
Research objectivity policy

• Identify and describe covered employees
• Covered employees to be trained regularly and indicate in writing their adherence to the
policy annually
• Disclose conflict of interest that covered employees face
• Identify factors on which research analysts’ compensation is based
• Disclose the terms for the purchase of research reports by clients
Public appearances
• Ensure that the audience of a presentation has enough information to make informed
judgments
• Be prepared to disclose conflicts of interest
• Firm should require research analysts that are participating in public appearances to
disclose investment banking relationship with the subject company and whether the
analyst has participated in marketing activities for the subject company
• Research reports on the companies discussed should be provided to the audience for a
reasonable fee
26
Reasonable and adequate basis

• Develop written guidance for judging what constitutes reasonable and adequate basis
• Provide or offer to provide supporting information, and disclose current price of the
security
Investment banking
• Prohibit research analysts from communicating with the investment banking or corporate
finance department prior to the publication of a research report
• Investment banking or corporate finance personnel may review reports for factual
accuracies or to identify possible conflicts
• Implement quiet periods for IPOs and secondary offerings
• Analysts not be allowed to participate in marketing roadshows for IPOs and secondary
offerings
Research analyst compensation

• Compensation should be based on measurable criteria
• Direct link of analysts’ compensation with investment banking and corporate finance
activities is not allowed but firm should disclose to what extent analysts’ compensation
depends on investment banking revenues
27
Relationships with subject companies

• Implement policies that govern analysts relationship with subject companies
• Implement guidelines that only those sections of the report related to factual information
that could be verified by the subject company is shared before publication
• Compliance and legal departments get a copy of the draft report before it is shared with
the subject company
Personal investments and trading

• Approval required prior to trading in securities in the industries assigned to the analyst
• Should have procedures to prevent employees from trading ahead of investing client
trades
Restricted period of at least 30 days prior and 5 days after a report is issued
• Analysts permitted to sell contrary to their recommendation when in extreme financial
hardship
• Covered employees to provide a list of personal investments
• Establish policies to prevent short-term trading of securities
28
Timeliness of research reports and recommendations

• Reports and recommendations should be issued at least quarterly
• If the coverage of a firm is discontinued, a “final” research report should be issued
Compliance and enforcement

• Distribute a list of activities that constitute violations and the disciplinary sanctions
Disclosure
• Disclose investment banking or other corporate finance relationships & conflicts of
interests
• Provide information on their recommendations and ratings
• Disclose the valuation methods used to determine price targets, including risk factors
Rating system
• Rating systems should include recommendation and rating categories, time horizon
categories, and risk categories
• Absolute or relative recommendations are allowed
• Employees should be prohibited from communicating a recommendation contrary to
the current published one
29
Ethics and Professional Standards 30
Study Session 2 topics
Case Studies Applications

of Standards
The Glenarm Super

Trade Allocation: Fair Prudence in
Company Selection
Dealing and Perspective
Disclosure
Changing Investment
Preston Objectives
Partners
31
Quantitative Methods
Study Session 3
Weighting 5 – 10%
Overview of Level II Quant 32
Study Session 3
Correlation and Multiple Time-Series

Linear Regression Regression Analysis
Covariance & Correlation 33
Covariance Correlation
n
¦ ª¬R t,1 R1 Rt,2 R2 º¼ r1,2
Cov1,2
cov1,2 t 1
V 1V 2
n 1
• may range from +ve to –ve infinity • standardised measure of relationship
• units are squared hence less meaningful • bounded by -1 and +1
• the closer to absolute 1, the stronger the
relationship
Significance of correlation coefficient Limitations to correlation analysis
H0: ² = 0 Ha: ² Į 0 •outliers affect the coefficient

•spurious correlation: linear relationship
but no economic explanation
r n2
t= •a nonlinear relationship exists which
1 r2 cannot be captured by correlation
Two-tailed test
Degrees of freedom are n – 2
Linear Regression 34
Basic idea: a linear relationship between two variables, X and Y. Note that the standard
error of estimate (SEE) is in the same units as ‘Y’ and hence should be viewed relative to
‘Y’.
Y, dependent Mean of Hi values = 0

variable
Standard deviation of Hi =
Yi x
standard error of the
Hi error term x x
estimate (SEE)
or residual x
Yˆi x
x
x
x
x
x
Yˆi bˆ0 bˆ1 X i
x
x
x
Least squares regression finds the straight
x x
x line that minimises the SEE by minimising:
¦ ˆ i ( sum of the squared errors, SSE)
2
x
x x
X, independent
variable
Xi
Significance of coefficients 35
Hypothesis Tests on a Regression Coefficient Predictions for the dependent

To test statistical significance: variable
H0: bi = 0 Ha: bi Į 0 Given the estimated regression

coefficients and an assumed value
Other tests are possible, for example: for the independent variable(s) we
H0: bi ı 1 Ha: bi < 1 can predict the value of the
dependent value using:
b̂i bi
Test statistic, ti Ŷ i b̂ 0 b̂ 1 X̂ 1
si
Where : s i standard error of b̂i

Confidence interval for the
prediction of Y
Degrees of freedom = n – (k + 1)
Ŷ r critical t - value u sf
Confidence interval for the population value of a
regression coefficient n – 2 degrees of freedom
ª 1 ( X Xˆ )2 º
b̂i r critical t value u s i sf2 SEE 2 «1 2 »
¬ n (n 1)sx »¼
Components of Variation 36
Y
Yi
Ŷi b̂0 b̂1Xi Y - Ŷ o SSE
2
Y - Y
i i 2
o SST
Ŷ - Y o SSR
i
2
i
Y
b̂0
X
Total variation = sum of squared totals (SST) = actual - expected

Explained variation = sum of squared regressions (SSR) = predicted – expected
Unexplained variation = sum of squared errors (SSE) = actual – predicted
ANOVA, SEE and R-squared 37
Analysis of Variance Table

Source of Degrees of Sum of Squares Mean Square
Variation Freedom
Regression 1=k Regression sum of squares (RSS) Mean sum of
(explained) squares (MSR) =
RSS/k
Error n – (k + 1) = n - 2 Sum of squared errors Mean squared error
(unexplained) (SSE) (MSE) = SSE/(n – 2)
Total n-1 Sum of squares total (SST)
Coefficient of determination Standard Error of Estimate

n
R2 = explained variation in y
¦i 1
ˆ i
SSE
SEE MSE
total variation in y n k 1 n k 1
R2 is the proportion of the total

variation in y that is explained Interpretation
by the variation in x’s When correlation is strong (weak, i.e. near to zero)
•R2 is high (low)
RSS
R2 = r2 for linear regression •Standard error of the estimate is low (high)
SST
Multiple Regression 38
General form of model: Independent

variables Error term,
Dependent residual
variable
Yi b0 b1 X1 b2 X2 .... bk Xk H i
Y-intercept Partial slope coefficients
Predicting the dependent variable
Ŷi b̂ 0 b̂ 1X̂ 1 b̂ 2 X̂ 2 .... b̂ k X̂ k

where :
b̂ 0 , b̂1 , ...., b̂ k are estimates for the regression parameters b 0 , b1 , .... b k
X̂1 , X̂ 2 , ..... X̂ k are the assumed values of the independen t variable s
Significance of coefficients 39
Hypothesis tests on individual Determining the collective significance

regression coefficients of the independent variables
To identify which independent variables are Perform an F-test:
individually important in a multiple
H0: None of the independent variables
regression we perform a t-test on each
significantly explain the dependent variable.
slope coefficient with bi = 0. (seen earlier)
b1 = b2 = b3 = …… = bk = 0
b̂i bi Ha: At least one of the independent
Test statistic, ti variables significantly explains the
si dependent variable. At least one bi Į 0
Where : si standard error of b̂i Reject H0 if computed F > F-critical
Test statistic:
Degrees of freedom = n – (k + 1)
Regression sum of squares
F k
Looking up the critical F- Sum of squared errors
value (n - k 1)
Use table corresponding to the Mean regression sum of squares
significance level of test (D) i.e. Mean squared error
(one-tailed!!!!)
MSR
Numerator dof = k (data from ANOVA table)
MSE
Denominator dof = n – (k + 1)
Other Issues in Multiple Regression 40
Interpreting p-values
Adjusted R2
• A p-value is the smallest
• As you incorporate more variables R2 can significance level (ө) at which we
only go up, even if some of the new can reject H0
variables are statistically insignificant
• Hence in multiple regression we use Qualitative independent factors
adjusted R2. This measure of fit does not • These are variables that attain
automatically increase when another discrete states, rather than taking
variable is added. values from a range.
R2
ª

1 « 1 R2
n 1 º

• We use Dummy Variables for these
¬ n k - 1»¼ •
factors.
To distinguish between n categories,
No calculations are required we need n-1 dummy variables.
Qualitative dependent variables with binary outcomes

• Logit models - estimate the probability that the event will occur based on logistic
distribution
• Probit models - as with logit, except based on normal distribution
• Discriminant models - based on regression analysis, but producing a score which
can then be used to assess likelihood of event (e.g. credit scoring)
Assumptions, Limitations, Violations 41
Assumptions of a multiple regression Limitations of regression analysis

model 1. Regression relations change over
1. The relationship between the time (non-stationarity)
dependent variable, Y, and the 2. If assumptions are not valid, the
independent variable, X, is linear interpretation and tests of
2. Expected value of the error term is 0 hypothesis are not valid
3. The variance of the error term is the
same for all observations
(homoskedasticity)
Violations of regression assumptions
4. The error term is normally distributed
1. Heteroskedasticity – error term has
5. The error term is uncorrelated across
non-constant variance
observations (i.e. no serial correlation)
2. Serial correlation – error terms are
6. No linear relationship exists between
correlated with each other
two or more independent variables
(i.e. no multicollinearity) 3. Multicollinearity – linear relationship
between independent variables
Heteroskedasticity 42
Effect on statistical inference

Description
• Estimated standard errors of the
• Variance of the error term is non- regression coeffs. are likely to be wrong.
constant.
• With financial data they are likely to be
• Unconditional: Not related to too small, hence actual t-stats too high,
independent variables Æ causes no so coefficients might appear significant
major problems. when they are not (Type I error).
• Conditional: related to independent
variable Æ this is a problem.
Detection
Correction •Scatter diagrams (plot residual against each
• Compute robust standard errors independent variable and against time).
(aka White-corrected standard •Breusch-Pagan test: regress the residuals2
errors) used to recalculate the t against the independent variables, then test the
statistics significance of the resulting R2 using a one-
tailed chi-square test. A significant value is
evidence of heteroskedasticity.
Serial Correlation 43

Description • Positive autocorrelation can lead to too
• Autocorrelation (serial correlation) low estimates of coefficient standard
arises when the residuals are errors, hence too large t-stats, causing
correlated with one another Type I errors.
• Usually arises with time series data • Negative autocorrelation can cause the
standard errors to be overstated,
• Autocorrelation may be positive or
causing Type II errors.
negative
Detection (if not autoregressive model)

Correction
•Scatter plot of residual errors
• Adjust the coefficient
standard errors, e.g. using •Calculate the Durbin-Watson Statistic, DW Ĭ 2(1 - r).
the Hansen method (which Where r = sample correlation coefficient between
also corrects for consecutive residuals
conditional
heteroskedasticity) 0 dL dU 2 4-dU 4-dL 4
• Improve the specification ambiguous
ambiguous
Evidence of Evidence of
Test is
Test is
of the model. positive No evidence of negative
autocorrelation autocorrelation autocorrelation
Multicollinearity 44

Description • Inflates SEE and coefficient standard
Two or more independent variables are errors leading to lower computed t-stats
mutually correlated, making the • As a result, the null is rejected less
interpretation of the regression output frequently leading to Type II errors
problematic.
Correction Detection
Remove one or more of the • Conflicting t- and F-tests: significant F-statistic
offending independent combined with insignificant individual t-statistics
variables • High correlation coefficient between two
Alternatively perform a more independent variables (rule of thumb: > 0.7 but
advanced technique such works only if no more than two independent
as stepwise regression variables are present)
• When dealing with more than two independent
variables, low pair correlations could still lead to
multicollinearity
• Signs on the coefficients that are opposite to
what is expected
Model Specification Issues 45
Model Misspecification Examples of misspecification:

causes: • Omitting a variable
• Failing to transform a variable
[e.g. using market cap as an independent
variable instead of ln(market cap)]
biased and inconsistent • Incorrectly pooling data
regression coefficients [e.g. using data spanning two distinct monetary
policy regimes when building a model to
Leading to:
predict inflation]
• Using the lagged value of the dependent
variable as an independent variable
Unreliable hypothesis testing • Forecasting the past
and inaccurate predictions [using variables measured at the end of a
period to predict a value in the period]
• Errors in the measurement of the independent
variables
Types of Time-Series Models 46
Trend Models Autoregressive (AR) Moving-Average (MA)

Variable is a models models
function of time Variable is a function of Variable is a function of
earlier value(s) of itself weighted average of
previous error terms
Autoregressive Conditional Autoregressive Moving-

Heteroskedasticity (ARCH) models Average (ARMA) models
Used when variance of the error term A hybrid approach
is dependent on the size of earlier
errors
Trend Models 47
Linear trend model Log-linear trend model

Value of time series in period t, The natural log of the value of time series in
period t,
yt = b0 + b1t + Ht
ln(yt) = b0 + b1t + Ht
Average change in y is
constant in absolute terms = b1 Exponential trend: average rate of change in y
is constant = eb1 – 1
Might be a better model to use if a linear trend
y Observation
model produces serially correlated errors.
Trend
y
data series
straight line
Limitations of trend model of best fit
• The one independent variable may be
insufficient to explain changes in the dependent t
variable.
• Model errors are often serially correlated (use
DW to detect) and hence assumption violated.
Autoregressive Models 48
E.g. AR(p):
xt = b0 + b1xt-1 + b2xt-2 + … + bpxt-p + et
Covariance
stationarity Mean reversion
Time series has tendency to
converge to its mean:
Exists if time series Series has: b0
For AR(1) :
data is well-behaved, • constant mean 1 b1
so process can be • constant variance
represented with a • constant covariance
relatively simple with itself over time
model (e.g. AR)
No finite
mean- Necessary
If not covariance First differencing reverting level condition for
stationary then might help a time not parameters to be
regression results, both series achieve covariance estimated by AR
statistically & financially, covariance stationary regression
are meaningless methods
stationarity
Autoregressive Models cont. 49
Chain rule of forecasting

Inputs used in multi-period xt = b0 + b1xt-1 + b2xt-2 + … + bpxt-p + ¦t
forecasts are themselves
forecasts
Serial correlation
• Serial correlation within an AR model
Random walks causes estimates of the regression
Value in one period is equal to the coefficients to be inconsistent o big
value in previous period plus a random problem.
error: • Cannot test for it using the DW statistic.
xt = b0 + xt-1 + ¦t • Instead use a t-test to see whether any of
If b0Į 0 then random walk with drift the residual lag autocorrelations differ
significantly from zero.
This is an AR(1) model • If some are significant then the model is
with b1 = 1 incorrectly specified.
No finite
mean- Known as a unit root • Increase the order of the model by
reverting level hence the mean incorporating the offending lags.
not reverting level is • In case of seasonality, add xt-4 for quarterly
covariance undefined data, and xt-12 for monthly data
stationary
Moving Average Models 50
ARMA models
Qth order moving average model, MA(q) Combines both autoregressive lags of the
dependent variable and moving-average
errors.
xt = Ht + T1Ht-1 + T2Ht-2 + … + TqHt-q
Problems:
• Parameters can be very unstable - slight
• A time series will be well represented changes in data sample or initial
by a MA(q) model if the first q guesses of parameters can give very
autocorrelations of that time series are different final estimates
significantly different from 0, while
subsequent autocorrelations equal 0 • Choosing the right model is more art
(the autocorrelations drop suddenly to than science
0 after the first q) • Model may not forecast well - in most
• With most AR time series the cases a much simpler AR model will do
autocorrelations start large and decline as good a job
gradually as the lags increase. • Require large amounts of data (at least
80 observations)
ARCH Models 51
Autoregressive Conditional
Heteroskedasticity
Description of heteroskedasticity • Variance of error terms in one time period is
• Variance of the error term is non- dependent on the variance of the error terms
constant. in another period.
• Unconditional: Not related to • SEs of the regression coefficients in models
independent variables Æ causes will be incorrect and hypothesis tests will be
no major problems. invalid.
• Conditional: Is related to • ARCH(1) detected by performing following
independent variable Æ this is a regression:
problem.
Hˆt2 a0 a1Hˆt2-1 ut
Correction
(ut is an error term)
• Compute robust/corrected standard
• If a1 is statistically different from zero then the
errors (aka White-corrected
series is ARCH(1).
standard errors) or
• Can then use ARCH model to predict variance
• Use an ARCH model to forecast
of errors with the following equation:
the variance of the error term
Vˆ t21 a0 a1Hˆt2
Other Issues in Time Series 52
The Dickey-Fuller (DF) Test for a Unit Root

• Test is based on a transformed version of the AR(1) model xt = b0 + b1xt-1 + Ht
• Subtracting xt-1 from both sides produces:
xt - xt-1 = b0 + (b1 – 1)xt-1 + Ht or xt - xt-1 = b0 + g1xt-1 + Ht where g1 = (b1 – 1)
• If there is a unit root in the AR(1) model, then g1 will be 0 in a regression where the
dependent variable is the first difference of the time series and the independent
variable is the first lag of the time series.
• DF test: H0: g1 = 0, time series has a unit root and is nonstationary
Ha: g1 Ћ 0, time series does not have a unit root
• Test is conducted by calculating a t-statistic for g1 and using a revised set of
critical values computed by DF.
In-sample vs Out-of-sample forecast errors

• In-sample forecasts are for values within the estimation period. Can use the SEE to
compare the in-sample errors of competing models.
• Out-of-sample forecast errors represent the differences between actual and predicted
values of the time series outside of the period used to construct the model.
• Can use the RMSE (Root Mean Squared Error, i.e. the square root of the average
squared forecast error) to judge which model is most accurate.
Multiple Time Series 53
With a simple regression the following scenarios are possible:

1. Neither time series Can safely use linear regression
has a unit root
2. One or other time Error term in the regression will not be covariance stationary
series has a unit o one or more regression assumptions violated o
root regression coefficients might appear significant when not
3. A) Both time series As with 2. above
have a unit root but
are not cointegrated
3. B) Both time series Error term in the linear regression will be covariance
have a unit root but stationary but we should be very cautious in interpreting the
are cointegrated regression results. The regression estimates the long-term
relation between the two series but may not be the best
model of the short-term relation.
Cointegration
• Two time series are cointegrated if a long-term financial or economic relationship
exists between them such that they do not diverge from each other without bound in
the long run (e.g. they share a common trend)
Time Series - Summary 54
rt
Sta
55
Economics
Study Session 4
Weighting 5 – 10%
Overview of Level II Economics 56
Study Session 4
Measuring Economic
Economic Growth Activity
Regulation and Antitrust Policy Foreign Exchange Parity Relations

In a Globalized Economy
Trading with the World Currency Exchange Rates

Economic Growth 57
Rule of 70: a country’s economic activity will double every (70/growth rate) years
Real GDP = measure of inflation-adjusted income and output

Standard of living = level of real GDP per labor hour = level of labor productivity
Economic growth = % change in real GDP per labor hour = growth in labor productivity =
improvement in standard of living
Economic Growth 58
PRECONDITIONS FOR
ECONOMIC GROWTH
• Saving and investment in new

• Markets For economic growth
capital
• Property rights
• Investment in human capital
• Monetary exchange to continue • Discovery of new technologies
PRODUCTIVITY
One Third Rule Methods for Increasing Economic Growth
At a given level of technology, on • Encourage savings

average, a 1% increase in capital per • Encourage basic R&D
labor hour results in a one third of 1% • Stimulate international trade
increase in real GDP per labor hour • Improve the quality of education
Theories of Economic Growth
Classical Growth Theory GDP growth will be driven back to the subsistence level
Neoclassical Growth Theory LT GDP growth requires technological change
New Growth Theory Discovery of new products and techniques is down to luck
Regulation and Antitrust Policy 59
Based upon
Social regulation
Product quality
Government Product safety
regulation Employee safety
Negative Side Effects

Creative response Natural Monopolies
Feedback effect Economic
Cost-of-service regulation
regulation
Rate-of-return regulation
Regulator Behavior Theory
Capture Theory Share-the-gains, Share the Pains

Industry controls Theory
regulator Legislators
Customers
Regulated firms
Trading with the World 60
Comparative advantage refers to the lowest opportunity cost to produce a product.

Law of comparative advantage: trading partners can be made better off if they specialize
in producing goods for which they are the low-opportunity-cost producer and trade for the
goods for which they are the high-opportunity-cost producer
Restrictions on Trade
Tariff is a tax imposed on imported goods
Quota is a limitation on the quantity of goods imported
Voluntary export restraints (VERs) are agreements by exporting countries to limit the
quantity of goods they will export to an importing country
Two primary forces underlying trade restrictions:
¾ Governments like tariff revenue
¾ Domestic producers affected by lower-cost imports use political means to gain
protection from foreign competition
Currency Exchange Rates 61
Foreign Exchange Quotations
£:$ £ base $ quoted Direct Quotes Indirect Quotes

£/$ $ base £ quoted • DC/FC • FC/DC
• Usual method of
quoting currencies
Triangular Arbitrage
Profit is calculated by “going around

the triangle”.
USD ė GBP ė CHF ė USD or
USD USD ė CHF ė GBP ė USD

0
1. D/G
86 SD
US
Choose the way > 1

56 B
4
1. F/U
00 P
CH £/$ x CHF/£ x $/£ or

CHF/$ x £/CHF x $/£
CHF GBP Always sell the base currency and by
2.3182 CHF/GBP the quoted!
Triangular Arbitrage 62
Bid and Ask
“BID” $ “ASK”
means means
turning turning
€ into $
€ $ into €
D
1.
US
35
SD
/
1 .3
HF
00
/U
51
0C
US
HF
0U
D/
00
0C
G
1. 5
SD
BP
01
/G
1.5
BP
Ask rate = ?.???? CHF/GBP

CHF GBP
Bid Rate = ?.???? CHF/GBP
Currency Exchange Rates 63
Bid – Ask Spread Fwd Pm Fwd – Spot 360

or Disc = x
Spot Contract Days
£/$ 0.7113 – 0.7116 Factors affecting spread: Forward Contracts

• Volume Premium – base
• Volatility currency buys more
Bid (lower) Ask (higher)
• Dealers long/short position future quoted
Bank sells £ Bank sells $ • Term (forward contracts
Discount – base
only)
Bank buys $ Bank buys £ currency buys less
future quoted
Triangular Arbitrage
1. Choose a direction and formulate equations:
£/$ x CHF/£ x $/CHF
USD 2. Check examiner has given the quotes for the
right base and quoted combinations.
If not you will need to take reciprocals noting
that the bid and ask swap when you do
3. Using the bids move round the triangle selling
CHF GBP the base and buying the quoted currency
4. Did you get > 1? If not take the reciprocal of
the ask quotes to move the opposite direction.
Foreign Exchange Parity Relations 64
Factors That Cause a Currency to Appreciate/Depreciate
Differences in income growth: Country with rapid income growth has more demand for imports and
foreign currency, domestic currency depreciates
Differences in inflation rates: Higher inflation means exports more expensive, imports cheaper,
domestic currency depreciates
Differences in real interest rates: Country with higher real rates will attract foreign investment,
increased demand for domestic currency so it appreciates
Other Exchange Rate Regimes
A fixed rate system has a set rate of exchange to another currency

A currency board creates domestic currency only in exchange for the other currency, held in
bonds and other liquid assets. The currency board promises to redeem the domestic
currency at the fixed exchange rate into dollars
A pegged exchange rate system is based on a commitment to use monetary policy to
keep exchange rates within a band
Monetary Policy and Exchange Rates

Expansionary monetary policy leads to:
Rapid economic growth (increases imports)
Higher inflation (decreases exports)
Lower real interest rates (increase investment to abroad)
All three cause the domestic currency to depreciate
Fiscal Policy and Exchange Rates
Unanticipated restrictive fiscal policy leads to:

Slower growth (decreases imports) appreciation
Lower inflation (increases exports) appreciation
Lower real interest rates (increases investment abroad)
depreciation
Financial capital is more mobile, so third effect dominates in
short run
Expansionary policy ė Short run appreciation
Purchasing Power Parity

Based on the “Law of One Price”
Absolute PPP: Same basket of goods will cost the same everywhere, after
adjusting for exchange rates
Relative PPP: Changes in exchange rates will just offset changes in price levels
(i.e., differences in inflation)
Covered Interest Rate Parity

• Forward rates are arbitrage free rates set using interest rate differentials.
International Fisher Relation

• Inflation differentials between countries are the prime drivers of interest rate differentials
• Key = real interest rates the same in every country!
Uncovered Interest Rate Parity

• Countries with high interest rates (and high inflation rates) should have currency values that
fall over time
• Assumes PPP and Fisher hold
• Assumes constant real exchange rate
The forward rate is the best unbiased predictor of the future spot rate
Forward Future Spott

Spot Spot 0
t
rit res
Pa nte
y
Interest Purchasing
te d I
Ra ere
Rate Power
Parity ov
c
Parity
Un
1 + INT Q (1+ INFQ )(1+ REAL)

1 + INT B (1+ INFB )(1+ REAL)
International Fisher Effect
Parity Relationships
Purchasing Power Parity Interest Rate Parity (covered) Uncovered Interest Rate
Parity
(1+Iquoted)T (1+Rquoted) (1+Rquoted)
E(ST) = So x Fwd = So x E(ST) = So x
(1+Ibase)T (1+Rbase) (1+Rbase)
International Fisher Effect

Exact Methodology:
1+r = (1+real r)(1+E(i))
Foreign Exchange
Expectation Relation
Linear Approximation:
r = real r + E(i) E(S) = F
Where:
E(%S) = F - So
r = nominal interest rate So
real r = real interest rate
E(i) = expected inflation
Measures of Economic Activity 69
Gross Domestic Gross National Net National

Product (GDP) Income (GNI) Income (NNI)
Total market value Total goods and GNI less
of all final goods services produced depreciation.
and services by the citizens of a
provided in a country
country over a Amount of resources utilized or
stated period of time worn out by the production process
(1yr)
GDP
Output Expenditure Income + net property
income from
Value of production Consumption Wages and salaries abroad
- cost of inputs + Investment + Self-employment income GNI
GDP Total domestic expenditure + Company trading profits - Depreciation
+ Exports of goods and services + Government and NNI
Total final expenditure enterprise
- Imports of goods and services trading surpluses
GDP + Rental income
GDP
Can be expressed in current or constant prices
GDP at market prices – indirect taxes + subsidies = GDP at factor prices
70
Financial Reporting &

Analysis
Study Sessions 5, 6 & 7
Weighting 15 – 25%
Overview of Level II FSA34 71
Study Session 5
Inventories Long-Lived Assets
Study Session 6
Intercorporate Employee Multinational

Investments Compensation Operations
Study Session 7
The Lessons We Learn Financial Reporting Integration of Financial

Quality Statement Analysis
Techniques
Inventories 72
Inventory methods
Perpetual vs. Periodic
With inflation and LIFO, Systems
COGS is higher and end.
Perpetual: updates inv.
inv. is lower.
after each purchase/sale.
With deflation and LIFO,
Periodic: records
COGS is lower and end. inv.
purchase/sale in
is higher.
"Purchases" account ,
Weighted average cost is in inv./COGS determined at
between FIFO and LIFO. period end.
LIFO liquidation LIFO reserve Inventory valuation

Under LIFO, inv. purchased LIFO reserve will increase Under IFRS: Lower of cost
last is treated as if it’s sold with rising prices and or NRV, NRV = sales price
first. stable/increasing inv. - selling cost
LIFO liquidation occurs inv FIFO = inv LIFO + LIFO Under US. GAAP: Lower of
when a company appears reserve . cost or market
to sell the inventory it COGS FIFO = COGS LIFO – (replacement cost), NRV <
purchased first. LIFO reserve. Market < NRV – Normal
NI = LIFO reserve h profit margin
(1-t).
Long-lived assets 73
Impairment Long-lived assets

IFRS: Annually, CV vs. disclosure
recoverable amount (FV-selling Fixed asset useful life,
cost), can be reversed Fixed asset SV,
Depreciation method,
US. GAAP: Tested, two steps: Useful calculations
recoverability test, then measuring regarding a firm’s FA:
the loss, loss recoveries are average age, average
prohibited depreciable life, remaining
useful life
Impact of Impairment Revaluation to FV

US GAAP: upward revaluation is
In the year of impairment: NI prohibited, except for long lived assets
lower, ROA & ROE will held for sale
decrease
IFRS : permitted
In subsequent year: lower
depreciation, NI higher, ROA Upward revaluation: A & E increase, D/E
& ROE will increase decrease, subsequent periods: Higher
depreciation, Lower ROA and ROE
Leases 74
Capital lease criteria

transfer title
bargain purchase option
75% of the asset’s economic life
90% of the fair value of the leased asset
Lessor: capital vs. operating Lessee: capital vs. operating

Capital lease: lease lease
Relative to operating leases, capital
Sales-type lease: Manufacturer, leases will make assets higher,
dealer, PV of the lease liabilities higher, net income (early
payments is greater than years) lower, CFO higher, CFF lower,
carrying value of the leased total cash flow the same, EBIT higher
asset (COGS)
Direct financing lease
Intercorporate Investments 75
<20% votes 20 – 50% votes > 50% votes

shares are a genuine small shares are to ensure a shares are to take
investment for significant influence is over and control the
dividend/capital gains exerted over the other company
purposes company (but NOT
outright control)
“Subsidiary”
Secondary market? “Affiliate/Associate” Consolidate (Purchase
Equity Account method)
No Yes
Pooling (Merger method)
B/S Historic Cost
I/S Dividends/Int Held-to-maturity Available-for- Trading securities
securities sale securities
Debt securities
which the May be sold to satisfy company Acquired for the purpose of
company needs selling in the near term
intends to hold Debt or equity Carried in the balance sheet
to maturity Current or non-current as current assets at market
Securities are Carried in the balance sheet at value
carried at market value Income statement includes
amortized cost Income statement same as cost dividends, realised &
method unrealised gains/losses
Equity Accounting 76
Equity Accounting: Significant Influence Purchase Price > Book Value

“One line consolidation” Investment initially recorded at cost
Initially recorded at purchase price (cost) However within cost: $m
Subsequent periods:
% Net Assets Acquired X
B/S: Cost + earnings pickup – dividends
%FMV adjustments X
' B/S = %Share x ' Retained earnings
Goodwill X
I/S: Earnings pickup (% share of NI)
Cost paid X
Adjust earnings for up/down stream
inter group unearned profits
FMV adjustments impact
Upstream Downstream future earnings
Profits recognized in Profits recognized in
investee I/S investor I/S Impairments
Unconfirmed profits – Unconfirmed profits – Carrying value > Fair value
eliminate pro-rata share eliminate pro-rata share
Decline considered permanent
Fiscal years beginning post Nov 2007 IFRS 159
No reversal (US GAAP)
Can elect to hold investment at fair value with
changes in fair value taken to the I/S Reversal allowed (IAS)
Convergence with IAS 28/39
Joint Ventures 77
Joint Ventures
•Equity account: Required US GAAP Permitted IAS
“one line consolidation”
•Proportional consolidation recommended by IAS
“line by line proportional consolidation
• Report pro-rata share of all accounts, net

out intercompany transfers
• Interest cover - overstated • Make both sides of intercompany
• Return on assets - overstated adjustments in joint venture accounts
• No minority interest (consolidated on the
• Debt ratios skewed basis of ownership not control)
• The rest is as per a normal consolidation
Stockholders equity, Net Assets and NI

same under both methods
Total asset and total liabilities differ
Big impact on ratios
Consolidation (Purchase Method) 78
•Control of subsidiaries decisions: Operating/Financing/Investing

•Share ownership > 50%
•Reflect control not ownership
Steps 5. Eliminate inter-company transactions

1. Record any finance raised in parent 6. Add together assets and liabilities 100%
company’s balance sheet regardless of ownership
2. Record investment in subsidiary in 7. Eliminate investment in parent
parent’s balance sheet. company’s books
(Investment recorded at purchase price) 8. Include Common Stock and Additional
3. Adjust subsidiary identifiable net assets Paid in capital of parent only
to fair market value (IAS 100% of FMV 9. Include parents reserves and % share of
adjustments, US GAAP parents share of any post acquisition retained earnings in
FMV adjustments) the subsidiary (unlikely)
4. Calculate goodwill on acquisition 10. Calculate Minority Interest
Proceeds X Minorities % share of Net Worth of sub (at
% Identifiable Net Assets (X) FMV IAS, at book value US GAAP)
Goodwill X 11. Total Balance Sheet

Goodwill 79
Business Combination – with Less

100% Interests
Full goodwill Partial goodwill

Allowed in both US GAAP and Only allowed under IFRS
IFRS
= consideration – fair value of net
= consideration / % of interests assets X % of interests acquired
acquired – fair value of net assets
MI is stated (% of MI shareholders
MI is stated (% of MI shareholders own) X FV of net assets
own) h (consideration / % of
interests acquired)
Business Combinations 80
Purchase Method Pooling of Interests Method
US: required under SFAS 141 US: no longer permitted (since 2001)
– Business Combinations
IAS: no longer permitted (since 2003)
IAS: required under IFRS 3 –
Business Combinations
Still studied, as move from pooling to purchase
has been prospective, not retrospective
Treats transaction as acquisition of
target by buyer
Treats transaction as
merger of equals
Goodwill
Minority Interests No goodwill
Fair value adjustments No minority interest
Post acquisition earnings No fair value adjustment
Restate prior periods
Goodwill on consolidation
Post and pre acquisition
Purchase consideration 10
earnings pooled
% FMV (assets – liabilities) (8)
Combine equity
Goodwill 2
Impact on Accounts 81
Cost vs.. Equity Consolidation vs. Equity

If sub earnings > 0 and sub dividend
Assets and liabilities are different, but equity
payout < 100%, parent results are more
is the same
favorable under equity method:
Revenues and expenses are different
Parent earnings larger
(operating income), but net income is the
Parent cash flows the same same
Interest coverage and return on Reported cash flows are different
investment ratios higher
Equity method includes only capital
Capital ratios lower flows between parent and sub
Cost method preferred if sub is not Consolidation method includes all cash
profitable flows except between parent and sub
Financial ratios different
Proportionate Consolidation vs. Equity Method

Equity, net income and ROE are the same under both methods
Most other accounts and ratios change
Equity method overstates ROA
Equity method hides liabilities
Equity method hides footnote info
Impact on Accounts 82
Purchase vs.. Proportionate vs. Purchase vs. Pooling

Equity A/C Assets
Current Ratio Purchase > Pooling
Consolidated > Proportionate > Equity Equity
Assuming investee ratio > parents Purchase > Pooling
Leverage Assuming purchase is funded by
Consolidated > Proportionate > Equity issuing equity
Net Profit Margin Net Income
Equity > Proportionate > Consolidated Purchase < Pooling
Gross Margin Profit Margins
Consolidated > Proportionate > Equity Purchase < Pooling
Assuming investee ratio > parents ROA and ROE
Return on Assets ROA Purchase < Pooling
Equity > Proportionate > Consolidated
Group Accounting 83
Impairment of goodwill Bargain Purchase (-ve goodwill)

Identification: Price < % FMV of identifiable net assets
Carrying value of
Fair value of Reassess FMV of identifiable net assets
reporting unit + > reporting unit
goodwill US GAAP- reduce non current assets
Measurement: - take remainder to I/S as an
Carrying value of Implied fair value extraordinary gain
goodwill > of goodwill
IAS - take as gain to I/S
Convergence Project
Fair value of reporting unit –
FMV adjustments for 100% of net assets not
fair value of identifiable net
just purchased element
assets
Minority interest calculated using FMV
US GAAP & IFRS Differences In-process R&D capitalized
In-process R&D Contingent consideration recognized at
acquisition date
Contingent liabilities
Minority interests in equity
Contingent consideration Remaining Differences:
US GAAP full goodwill
IFRS full or partial goodwill
Special Purpose Entities 84
A separate legal entity established by asset VIE Criteria Fin 46R

transfer to carry out some specific purpose 1. Equity interest less than
10% of total assets
Purpose Access capital or manage risk 2. Equity investor lacks:
Uses Securitized loans, synthetic • Decision making ability
leases, sale of accounts • Obligation to absorb
receivable, R&D costs losses
• Right to receive
Characteri Thinly capitalized, lack of
residual returns
-stics independent management,
A VIE must be consolidated in a
servicing agreements
company’s accounts if the
Prior to Fin 46R consolidation company is the primary beneficiary
Issue
was based on voting rights not (Previously only if controlled via
risk and reward of ownership voting rights)
Variable Interests: Qualifying SPEs US GAAP only

Guarantees of debt
Not consolidated if SPE:
Subordinated debt instruments •Independent and legal separate from sponsor
Lease residual interest guarantees •Has total control over asset
Participation rights •May only hold financial assets
Asset purchase options •Sponsor must have limited financial risk
Pension Plans 85
PBO (Projected Benefit

Defined Obligation)
Defined Benefit
Contribution Present value of all future
Employer carries the Employee carries pension payments earned to
Risk date based on expected salary
risk the risk
increases over time. Assumes
Asset Employee owns employee works until
ownership Employer owns assets assets, employer retirement. Estimate of liability
acts as agent on a going concern basis
Asset ABO = Accumulated Benefit
Employer will appoint Employee directs Obligation
manageme
an investment manager investment policy VBO = Vested Benefit
nt
Obligation
Income Statement = Pension expense Income Statement = Employer

Contribution
Balance Sheet - Asset/Liability = Cumulative
payments into plan less cumulative pension Balance Sheet - Asset/Liability =
expense SFAS 87 & IAS19 excess or shortfall in payments
Post 2006 SFAS 158 Asset/Liability = Funded relative to specified contribution level
status
No major analyst issues
Major issue for analysts
Pensions 86
X BEGINNING PBO Fair value of plan assets at start of year X
+ Service cost
Actual return on plan assets +
+ Interest cost
Employer contributions +
-/+ Actuarial gains or losses
Prior service cost Plan participant contributions +

-/+
Benefits paid Expenses -
-
= ENDING PBO Benefits paid to retirees -
Reconciliation disclosed in foot notes Fair value of plan assets at end of year =
(SFAS 132)
Reconciliation disclosed in foot notes
(SFAS 132)
Pensions 87
Pension Expense FV of Plan Assets – PBO = Funded Status
Actual Events FV > PBO = Overfunded
Service Cost + FV < PBO = Underfunded

Interest Cost + Funded Status = Economic Position of Plan
Smoothed Events (SFAS 87) Funded Status Į B/S Asset/Liability SFAS 158
Expected Return on Plan Assets -
Amortisation of gains/losses +/-
Amortisation of prior service costs +/- Funded Status +/-
Amortisation of transition asset or +/-
liability +/- Actuarial (Gain)/Loss
Prior Service Cost +/-
Other Events
Net Transition Asset +/-
Curtailment/Settlements/ +/-
Termination Balance Sheet (Liability)/Asset +/-
Reported Pension Cost X
Actuarial Assumptions 88
Lower wage
Actuarial Higher discount Higher Expected Return
rate
Assumptions rate on Assets
increases
PBO Lower Lower No change
ABO Lower No change No change

Pension
Lower Lower Lower
Expense
Delayed Events
3 main delayed events Net of:
Actuarial gains & losses Plan Assets
Prior service adjustments Actual vs.. Expected return
Transition assets & liabilities
Plan Liabilities
Amortised if net gain or loss > 10% of PBO due to actuarial assumptions
opening PBO or Market related plan
assets value
Post 2006 SFAS 158 89
SFAS 158 Impact on Financial Statements

Income Statement same as SFAS 87
Balance Sheet = Funded Status
Adjust balance sheet asset/liability to funded status
Adjust deferred tax asset
Adjust comprehensive income (equity)
Assuming net actuarial losses the new standard will
increase the pension liability and reduce equity
Analyzing Pension Disclosures 90
Balance Sheet:
Replace accounting asset/liability with funded status take any change to equity
NB only required for SFAS 87 not 158
Income Statement:
Adjusted pension expense = service cost + interest cost – actual return on plan assets
Alternatively = funded status + employer contribution
Improvement in funded position reduced economic expense
Worsening of funded position increases economic expense
Required for both SFAS 87 and 158
Cash Flow Statement

Cash flow = employer contribution into fund (ĘCFO)
Contribution > Economic Expense = Principal repayment Ę CFF Ė CFO Analyst
Contribution < Economic Expense = Source of funding Ė CFF Ę CFO Adjustment
Analyst should adjust CFO and CFF for after tax amounts
Employee Compensation 91
Employee compensation: Share based compensation

Salary Advantages:
Bonus
Reduces agency problem
Share based compensation
Managerial compensation disclosure: No cash outlay
US GAAP - Proxy statement to SEC Disadvantages:
IAS – Accounting disclosure Dilution of EPS
Employees limited influence over share
Stock Based Appreciation Rights price
Payments linked to share value performance Ė ownership Ė risk aversion
No shares held Stock options Ė risk taking
Advantages: Dilution of existing shareholders
Avoids dilution
Avoids Ė risk aversion
Disadvantages:
Cash outflows
Expense spread over service life
Stock Compensation Plans 92
Stock Options Stock Purchase Plans

Prior to June 2005 Enable employees to purchase stock at a
Account APB 25 discount to market value
Footnote Disclosure SFAS 123 Recognize expense over life of option if
Post June 2005 compensatory (5% rule)
Account SFAS 123 Service Based Awards
APB 25 Intrinsic value at grant date Compensation linked to length of service
SFAS 123 Fair value at grant date Recognize expense over vesting period
(similar to IFRS 2)
Performance Based Awards
Non price related and price related
Fair value Recognize over estimated time to meet criteria
Market premium of similar option or Can lead to accounting manipulation
valuation model:
BSM All models require 6 inputs:
Binomial 1. Exercise price
Monte Carlo 2. Stock price at grant date
3. Volatility
Disclosure 4. Risk free rate
Nature and extent of arrangement 5. Expected term (time to expiry)
Method of determining fair value 6. Dividends
Impact on periods income
Foreign Currency Translation 93
Local currency Functional currency Reporting currency

The currency of the The currency in which the
The currency of the primary economic multi-national firm prepares
country in which the environment in which its final, consolidated
foreign subsidiary is the firm generates and financial statements. For
located expends cash flows. exam purposes, most likely
to be the US$
Temporal method of translation Current Rate method of translation

aka “Remeasurement” aka “Translation”
Temporal method if amount of liabilities Net asset position and depreciating local
exposed to current rate exceeds exposed currency - reduces $ value of net assets
assets – (net liability position) a negative translation adjustment under
depreciating currency makes this liability current rate method
smaller
SFAS 52 Hyperinflation = cumulative 3 year inflation rate > 100%

Use temporal method – prevents book value of PP&E falling
Temporal/Remeasurement 94
Temporal Liabilities (current) X

Common Stock (historic) X
1. Produce top of Balance Sheet
(Total Assets) Retained earnings (ß) X
Liabilities + Equity X
2. Produce Shareholders Funds and
Liabilities (retained earnings = plug
figure to ensure that the balance
sheet balances)
Opening retained earnings X
3. Produce reconciliation of retained X
earnings Net income (ß)
Dividends (X)
4. Net Income in the Income X
Closing Retained earnings
Statement will be different from NI
in retained earnings. The
difference is the exchange Monetary assets/liabilities = current rates
gain/(loss) which is taken to the
(cash, AR, AP, STD,LTD)
income statement
Non monetary assets/liabilities = historic
rates
SFAS 52 Hyperinflation = use Temporal
IAS 21 Hyperinflation = use indexing
Current/Translation 95
All Current Approach

1. Produce Income Statement – translating Opening retained earnings X
at average rate NI (from income statement) X
2. Derive closing retained earnings Dividends (X)

Closing Retained earnings X
3. Compute Balance Sheet
4. Top and bottom of the balance sheet will

not balance. The difference is the
translation gain/(loss)
5. Force the balance sheet to balance by

including the adjustment on the balance
sheet in the equity section
All assets/liabilities = current rates
Impact on Ratios 96
Translation/All Current (Compared to LC) Remeasurement/Temporal

No change from translation using all- (Compared to LC)
current method for pure income statement Even pure ratios may be distorted
and balance sheet ratios due to mix of current and historic
Mixed ratios are distorted in B/S or average and historic in
FX rate changes affect consolidated ratios, I/S
even when no “real” change occurs Mixed ratios now a blend of
current, average and historic!
Comparing Temporal and All Current

Process:
Step 1: LC appreciating or depreciating?
Step 2: Examine numerator
Translated at which rate? (current, avg,
historic, etc.)
Will numerator be larger or smaller?
Step 3: Examine denominator
Same as numerator
Step 4: Determine impact on ratio
IAS & Transaction Risk 97
IAS 21 Similar to SFAS 52

Exceptions
Integral subsidiaries – temporal method
Foreign entities – all current
Revaluations – historic rate at time of revaluation
Hyperinflation – indexing
Goodwill – current or historic rate
Losses resulting from the acquisition of an asset invoiced in an overseas
currency can be expensed (SFAS 52) or added to capitalized cost
Transaction Gains/(Losses)
Transaction recorded at spot rate
Receipt or payment at a later date
Issue = movements in spot rate between entering and settling a contract
Gains and losses reported in income statement (no guidance to where)
• Within SGA reduces
• Non-operating income/expense comparability
The Lessons & Derivatives 98
The lessons we learn

1. Read all info including MDA and Footnotes
2. Be sceptical – persistently higher than average growth rates
3. Understand what you are looking at: pro-forma information
4. Follow the money (cash flow and earnings divergence)
5. Understand the risks (business & financial)
Derivative Accounting
B/S fair value
Fair Value Hedge Speculatively held – gains/losses I/S
Hedging asset/liability value Hedging purposes – location per SFAS 133
Gains and losses I/S
Cash flow hedge Hedging foreign currency

exposure
Hedging the future cash flows of a transaction
All current – gains/losses to
Unrealized gains/losses to comprehensive income
comprehensive income
Accumulated gains/losses released to I/S when the
Temporal - gains/losses to I/S
transaction affects earnings
Financial Reporting Quality 99
Accrual vs.. Cash Accounting 1. Revenue Recognition:

Cash: • % completion method
• Earnings activities
Transaction recorded on payment/receipt
complete
Advantages: No subjectivity/Easy to verify • Assurance of receipt
Accrual: • Bill and hold
Revenue/Expense triggered by earnings • Unearned income
process 2. Depreciation Choices:
• Method (S/L vs accel’)
Advantages: Timely and relevant
information/Indication of value creating activities • UEL
• Salvage value
Disadvantages: Subjective
measurement/earnings management 3. Inventory Choices
• FIFO/LIFO/AVCO
6. Pension Accounting • Normal cost
• Discount rate • LOCOM rules
• Expected returns 4. Goodwill
• Salary growth • Fair value measurement
7. Assets held at FMV • Impairments
8. Stock Options 5. Deferred Tax
9. Provisions • Valuation allowance
Financial Reporting Quality 100
Manipulation Incentives: Disciplining Mechanisms:

Analyst Expectations External Auditors
Remuneration (Bonus/Stock Option) Internal Audit/Committee
Debt Covenants Management Certification
Financing (raising further funds) Class Action Law Suits
Earnings: Regulators
Quality = persistence/sustainability Market Scrutiny
Mean reversion
Calculations:
Cash flow and accruals elements
Aggregate = Accrual based - Cash based
Accruals element – not sustainable Accruals earnings NI earnings
Accruals – naturally self correct B/S based aggregate accruals
Richardson, Tuna, Wu – companies Aggregate = NOA - NOA
t t-1
restating earnings have highest Accruals
accruals
Cash flow based aggregate accruals
Net Aggregate = NI – (CFO- t + CFIt)
Operating = Total assets - - Total liabilities – Accruals
Assets cash total debt
NOA
Earnings Management 101
Revenue Recognition Problems: Accelerating Revenue Recognition

Range of problems: Range of problems:
Recognition of sale before completion of Recognition of sale before completion of
earnings process earnings process (assessing the
Recognition of sale without assurance of completion date)
receipt Lowering credit standards
Estimates: Cut off issues (moving sales between periods)
Credit sales Warning signs:
Deferred/Unearned revenue Bundled products
Warranty provisions Management vested options ITM
Sales returns Pressure to meet earnings forecasts
Warning Signs: Raising additional finance
Large Ė AR Large Ė AR
Large Ę Unearned Revenue Large Ę Unearned Revenue
Lower future cash-flows and accounting Disproportionate revenue in last ¼
rates of return
Recognizing revenue to early:

Bill-and-hold sales
Lessor use of sales type vs.. direct financing leases
Recording sales prior to acceptance by customer (sales of equipment prior to installation)
Incorrectly using % completion method for long term contracts
Classification of non operating Expense Recognition:

earnings as operating: Range of problems:
Range of problems: Discretion over depreciation and amortization
1.Investment income Impairment recognition
2.Divestiture of non current assets Application of lower of cost and fair value
NB. No accrual or deferral reversal in rules
later periods Warning signs:
Warning signs: of methods or lives – depreciation
Temporary inconsistency of items (disclosed in footnotes)
included within definition of operating Conference calls – additional information
income LIFO liquidations
Inventory obsolescence
Classification of operating expenses

as non operating
Deferring Expenses:
Range of problems:
Range of problems:
Incorrect classification reduces COGS
Capitalization of operating expenses
or SG&A
Warning signs:
Warning signs:
Ė Net non current assets (B/S broad
Company’s with genuine special items
measure accruals)
that can be piggy backed
Consider asset growth in the context of
Changes in operating profit margin or
expected sales and margin growth
gross margin accompanied by spikes in
Software development costs - discretion
special items
Big Bath Provisions

Goodwill:
Range of problems:
Range of problems
1. Impairments – future I/S
improvements via Ę depreciation FMV adjustments on acquisition
2. Restructuring or impairment charges Future impairments
reversed in subsequent periods
3. Use of high or low bad debt reserves Warning signs:
out of line with peers Goodwill reported and not impaired for
companies where market cap < book value
Off Balance Sheet Items
Range of problems: IASB & FASB move to fair value accounting
1.Assets and liabilities avoiding Issues:
recognition: Some assets have readily identified fair values
e.g. listed equity
Operating leases
Some assets don’t have readily identified fair
Sale of AR with recourse values (assets with no actively traded
Take or pay/through put secondary markets)
agreements e.g. unlisted equity
Equity accounted SPVs e.g. specialized equipment
Valuation models = discretionary inputs
Warning signs:
SEC obligations to report future cash flow
obligations of operating leases – analyst
may discount to PV and restate
Modifying the Balance Sheet 104
Unrecorded Items Recorded Items

Special Purpose Entities Marketable securities
Operating Leases Accounts receivable
Guarantees Inventory
Contingent liabilities Proportional vs.. equity a/c
Property Plant and Equipment
Capitalized interest
Comprehensive Income $
Goodwill
Net Income X
Intangibles (R&D)
Pension adjustments X
Redeemable Pref/Convertible Debt
US GAAP
Unrealised gains and losses on

X Long term debt
available for sale securities
Pension Liabilities (SFAS 87!)
Cumulative foreign currency
translation adjustments X Stock Option plans (Pre SFAS 123R)
Comprehensive Income X Deferred Income Taxes
Adjustments (not required by US GAAP) COGS LIFO – FIFO

Capitalized interest reversal Capitalization of operating leases
Off Balance sheet items Reversal of deferred tax assets/liabilities
Funded status of pension plan Mark to market LTD
Normalized Earnings 105
Normalizing Operating Earnings

Discretionary accounting changes Adjust COGs to LIFO
Regulated accounting changes Litigation or gov’t actions
Realised capital gains/losses Discontinued ops
Gains/losses on repurchase of debt LIFO liquidations
Catastrophes Capitalize Op leases
Insurance settlements Capitalized interest
Strikes Economic cost of pension
Impairment or restructuring plan
Temporal gains/(losses)
Cyclical Firms Inter-firm comparisons International

Remove the impact for (adjustments) comparisons
valuation: Inventory methods LIFO prohibitions
1. Averages over the
business cycle Depreciation Extraordinary items
assumptions/methods
2. Average ratios applies Capitalized R&D
to current sales or Pension plan/Stock option
Accelerate Depn
equity assumptions
3. Regression model Asset revaluation
Capital/operating leases
approach Acquisition a/c
106
Corporate Finance
Study Sessions 8 – 9
Weighting 5% – 15%
Overview of Level II Corp Fin 107
Study Session 8
Capital Capital Structure Dividends and

Budgeting and Leverage Dividends Policy
Study Session 9
Corporate Mergers and

Governance Acquisitions
Capital Budgeting (1) 108
Use cash not accounting profit Comparing projects with

Incremental cash flows only unequal lives
– Ignore sunk costs Least common multiple of lives
– Use opportunity costs approach – look at NPVs over a
–Include net working capital increases/decreases common life
Cash flows based on opportunity costs Equivalent Annual Annuity – find
Cash flow timing is important (time value of money) the annuity (PMT) that equates
Analyze after-tax cash flows the NPVs at the cost of capital
Financing costs reflected in required return
Inflation and capital budgeting

Expansion vs. Depreciation methods Real (or nominal) CF
replacement (see and cash flows discounted using real discount
next slide) Accelerated methods rate (or nominal)
Expansion – provide higher tax Inflation increases company’s
investment to savings and hence real taxes
increase the business better cash flows in the Higher than anticipated inflation
Replacement – earlier years compared decreases the worth of interest
replacement of to straight line methods payments to bondholders
existing equipment
Example of accelerated Inflation does not affect sales
with newer
method – MACRS and expenses equally
alternatives
Expansion vs. replacement projects 109
Expansion Projects – investment to increase the business
1. Initial cash outflow = FCInv + NWCInv
2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax
rate) + Depn
3. Terminal year non-operating cash flow = Cash proceeds from sale of FCInv + NWCInv
– tax rate x (Cash proceeds – BV of FCInv Termination)
Replacement projects – replacement of existing equipment with newer alternatives
1. Initial cash outflow = FCInv + NWCInv – Cash proceeds of old asset + tax rate x (Cash
proceeds – book value of old asset)
2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax
rate) + Depn
3. Terminal year non-operating cash flow = (Cash proceeds from sale of FCInv + NWCInv
– tax rate x (Cash proceeds – BV of FCInv Termination)
Using SML in Capital budgeting (Based on £)

Stand-alone – the project’s
individual risk Kproject required return = KRF + (Kmkt – KRF) £project
Kproject required return = discount rate to discount project
cash flow
Sensitivity to e.g. assumed Use of project beta to calculate required return when
sales
project risk is different from the company
Best/worst scenario
analysis Real Options
Monte Carlo simulation Real options are options that allow managers to make
– random lots of scenarios decisions at a later date where these decisions are
– generate probability dependent upon future events or information
distribution for NPV and Examples: Timing options; sizing options; flexibility
IRR options and fundamental options
Real option analysis
Capital rationing
Work out the NPV without including the real options.
Management constraint If the NPV is positive, accept the project. There is no
on the size of the capital need to consider the real options if these options
budget enhance the project value.
Optimal choice is to select Work out the NPV based on estimated future cash
investments that flows. Then add the value of the real options. This
maximize the overall NPV approach is useful when the NPV is negative.
within the capital budget
Economic versus accounting income

Economic income = cash flow + change in market value
NB: Change in MV = Ending MV – Beginning MV
or
Economic income = cash flow – economic depreciation
Accounting income differs from economic income in the following ways:

Accounting depreciation is based on initial cost of the investment and reflects the decline
in the book value. Economic depreciation reflects the decline in the market value of the
investment.
Interest expense is included in accounting income but ignored in economic income.
Other valuation models

Economic profit (EP) = NOPAT - $WACC = EBIT(1 – t) – [WACC x Capital]
NPV = MVA = sum of PV of all future EPs discounted at WACC
Residual income: RIt = NIt – reBt-1
NPV = sum of PV of all future RIs discounted at cost of equity
Claims valuation – looks at the cash flows to debt holders and equity holders. The sum of
the PV of these cash flows equal project NPV
Capital structure 112
Objective of capital structure decision is to maximise firm value and minimises the WACC
MM Proposition without taxes Taxes and its impact on value of the firm & re
Proposition I: Capital structure Interest are tax deductible, debt capital provides a
decision does not affect the tax shield that increases the value of a company.
company’s market value Proposition I (with taxes): value is maximised at
MM assumed no taxes and no cost 100% debt
of bankruptcy Value of a leveraged firm = value of an
Value of ungeared firm = value of a ungeared firm + value of the tax shield
leveraged firm Proposition II (with taxes): WACC is minimised at
Proposition II: The cost of equity is 100% debt
§D · §E·
linearly related to the firm’s debt to With tax, WACC is ra ¨ ¸rd 1 t ¨ ¸re
equity ratio ©V ¹ ©V ¹
Without taxes, WACC is §D ·
Cost of equity is re ra (ra rd ) ¨ ¸ 1 t
§D· §E· ©E¹
ra ¨ ¸rd ¨ ¸re
©V ¹ ©V ¹
Cost of capital
Cost of capital
§D· re
Cost of equity is re ra (ra rd )¨© E ¸¹ re
As D/E increases, cost of equity
WACC
would increase
rd WACC
rd
D/E D/E
MM no tax MM with taxes
Debt financing: other issues (1) 113
In reality, the value of a leveraged firm is affected by factors other than the interest on the debt.
These factors are:
Financial distress Agency costs Cost of asymmetric

costs Agency costs of equity – conflicts information
Costs of financial between equity owners and managers Managers of the firm
distress and who managed the company. have better information
bankruptcy can The net agency costs of equity include: compared to outsiders.
be direct or Monitoring cost – incurred by Valuation implications:
indirect costs. shareholders to supervise the Stock offering
Probability of managers. negative signal
bankruptcy Bonding costs – incurred by Debt offering positive
Higher operating management to assure signal
or financial shareholders that they are working Pecking order theory
leverage leads to for shareholders’ interests. says that mangers
higher probability Residual loss – incurred even choose financing
of financial though there is monitoring and methods that are the
distress bonding systems in place as these least observable signals
systems are not flawless to the most apparent
Theory says that if a firm uses more signals. Manager prefers
debt, it would reduce the net agency to use internally
costs of equity. generated funds, then
debt and finally equity.
Static trade-off theory 114
Under the static trade-off theory, as Cost of financial

higher proportion of debt is being used, Max firm value distress
there exist a point where the benefit
arising from the use of debt (i.e. tax
shield) is offset by the costs of financial
distress. VLeveraged
MV of firm
An optimal capital structure exists where PV tax

the value of the firm is maximized. shields
The optimal capital structure is a function Vungeared
of many factors
Implications for managers’ decisions

Debt ratio
MM I (No Taxes): Capital structure
Optimal Debt ratio re
irrelevant
MM I (With Taxes): 100% debt maximizes
Cost of capital
value Between 0% and

Pecking order theory: Capital structure is WACC 100%
by-product of individual financing choices rd
Static trade-off theory: Trade off cheaper
debt financing with costs of financial D/E ratio
distress; optimal capital structure between
Optimal D/E ratio
0% and 100%
Debt financing: other issues (2) 115
Target Capital Structure Capital Structure and Valuation

Used when making decisions on raising new finance Analyst considerations:
For managers maximizing firm value target = optimal Changes in capital structure over
capital structure time
Practice – fluctuation around target: Capital structure of competitors
Exploitation of opportunities in a specific financing with similar business risk
source Factors effecting agency cost –
Fluctuating debt/equity markets affecting corporate governance
weightings
Debt Rating Agencies International Difference in Leverage

Cost of capital tied to debt ratings Japan/France more debt than US/UK
Goals for achieving certain ratings may Debt maturity – longer in US than Japan
effect capital structure Developed markets have more total debt
and longer maturity than emerging markets
Financial Markets/Banking
Institutional/Legal Factors Macroeconomic
System
• Strength of legal system Factors
• Liquidity
• Information asymmetry • Inflation
• Reliance on banking system
• Taxes • GDP growth
• Institutional Investor presence
Dividends and dividend policy (1) 116
Factors affecting dividend payout policy Residual dividend model

Taxation of dividends Dividend = actual earnings
Flotation costs of a new issue minus the equity portion of
Restrictions on dividend payments firm’s capital budget
Signalling effects Advantages: simple to use;
Clientele effects investment opportunities
considered independent of
Signalling effect: the dividend
• Dividend initiation – mixed view Disadvantages: unstable
• Unanticipated dividend increase – dividend payments;
signal strong future prospects uncertainty as to dividend
• Unanticipated dividend decrease – increases investors
negative signal assessment of risk
Taxation of dividends:
Double taxation and split rate systems:
Effective tax rate
= corporate tax + (1 – corp tax) x individual tax
Split tax rate – use corporate tax rate for
distributed income
Imputation system – div taxed only at
shareholders’ rate
Residual Longer-term Dividend Target

Dividend residual stability payout ratio
dividend
Easy to use Longer term Focus on Pay a
BUT forecast of steady $ specific % of
Investors capital payout – total
may prefer budget is even though earnings
stable determined – earnings over long-
dividends excess may be term
earnings volatile
over this In practice
period are this
then spread increases
more evenly with the long
each year term rate of
growth of the
company
Dividend using the target payout approach:

ª§ expected · § target · º
§ previous · «¨ ¸ u ¨ payout ¸ u ¨§ adjustment ¸· »
expected dividend = ¨ ¸ + increase
© dividend ¹ «¨ in EPS ¸ ¨ ratio ¸ © factor ¹ »
¬© ¹ © ¹ ¼
Dividend irrelevance The bird-in-the-hand theory The tax aversion theory

theory
Dividends can be Evidence shows Ks decreases Investors will prefer
manufactured – sell a as payout ratio increases – NOT to receive
little bit of stock to get the investors are rewarding the dividends due to their
cash you want. certainty of near term higher tax rates.
Theory requires a number dividends with a lower level of Low dividend payout
of assumptions. risk. policy will be rewarded.
Policy has NO effect on Higher dividend payout policy
value. will be rewarded.
Rationales for stock repurchases

Signal that future outlook is good Dividend initiation
Share dilution due to exercise of stock Based on dividend preference theory
options Dividend initiation
Distribute cash Lower risk
Company views its own stock as good Lower cost of equity
investment Higher PE ratio
Change the capital structure
Corporate governance (1) 119
Definition:
The system of principles, policies, procedures and clearly defined responsibilities
and accountabilities used by stakeholders to overcome conflicts inherent in the
corporate form” (McEnally and Kim)
Objectives:
Eliminate or reduce conflicts of interest
Use the company’s assets properly
An effective system will:

Define the rights of shareholders (and other important stakeholders)
Define and communicate to stakeholders the oversight responsibilities of
managers and directors
Provide fair and equitable treatment in all dealings between managers,
directors and shareholders
Have complete transparency and accuracy in disclosures regarding
operations, performance, risk, and financial position
Conflicts of Interest
Sole Proprietorship Partnership Corporations
Owned and operated by a Two or more owner Distinct legal entities –
single individual managers managers act as agents of
co.
Since owners and Similar to sole Corporate shareholders
managers are one in the proprietors – conflicts have no input in the day to
same no conflict exists between partners are dealt day mgmt of the firm – this
here. Conflicts mainly with by implementing a lack of control can create
involve creditors and partnership agreement conflict between managers
suppliers and shareholders
Agency Relationships
Managers and shareholders Directors and shareholders

Management may act in their best Directors may align more closely with managers
interests not those of the shareholders than shareholders
Using funds to expand the size of the Lack of independence
firm Board members with personal relationships
Granting excessive compensation and with managers
perquisites Board members having consulting or other
Investing in risky ventures business agreements with the firm
Not taking enough risk Interlinked boards
Directors are over compensated
Determining the effectiveness of the Board
Composition of board: 75% of directors independent

Independent chairman on board (not CEO)
Qualifications of directors
How board elected (annual elections)
Board self-assessment practices
Frequency of separate sessions for independent directors (annually)
Audit committee and audit oversight (only independent directors)
Nominating committee (only independent directors)
Compensation committee and management compensation (mostly performance-based)
Use of independent and expert legal counsel
Statement of governance policies
Disclosure and transparency (more disclosure is better)
Insider or related-party transactions (board approval for related-party transactions)
Responsiveness to shareholder proxy votes
Board Of Directors
The board of directors have a responsibility to:
Institute corporate values
Ensure firm complies with all legal and regulatory requirements
Create long term strategic objectives
Determine management’s responsibilities
Evaluate the performance of the CEO
Require management to supply the board with complete and accurate information
Meet regularly
Ensure board members are adequately trained
Investors and analysts should assess the Corporate Governance and Company
following policies of corporate governance: Value
Codes of ethics
Firms with strong/effective governance
Directors’ oversight, monitoring and review
responsibilities systems exhibit:
Management’s responsibility to the board Higher measures of profitability
Reports of directors’ oversight and review of Higher returns for shareholders
management
Weak/ineffective governance system:
Board self-assessments
Management performance assessments Increased risk to investors
Directors’ training Reduced value
Extreme cases: bankruptcy
Mergers and acquisitions 123
Acquisition: One company buys only part of Types of Merger

another company
Merger: One company absorbs another Backward
Hops Farms Conglomerate
integration
company entirely
Training
Acquirer Horizontal
Forms of integration Brewery Another Brewery
Statutory merger: target company ceases to
exist
Subsidiary merger: target company becomes a Forward
Pubs
integration
subsidiary of the acquirer
Consolidation: acquirer and target form a
completely new company
Merger motivations
Bootstrapping EPS
Synergies
Achieving more rapid growth A way of packaging earnings from
Increased market power two companies after a merger
Gaining access to unique capabilities Increase in earnings per share
Diversification Real economic gains are not
Bootstrapping necessarily achieved
Personal benefits for managers Occurs when a firm with a high P/E
Tax benefits ratio acquires a firm with a low P/E
Unlocking hidden values ratio
Achieving international business goals
Industry life cycle and common mergers 124

Pioneer/development phase: Mature growth phase:
~ Industry characteristics: ~ Industry characteristics: reduced profit
uncertain of product acceptance, margins due to new competition, but potential
low profit margins, and large still exists for above average growth
capital requirements ~ Merger motivation: efficiency, economies of
~ Merger motivation: access to scale/synergies
capital, management talent ~ Horizontal and vertical
~ conglomerate and horizontal Stabilization phase:
~ Industry characteristics: competition has
Rapid growth phase: reduced most of industry’s growth potential
~ Industry characteristics: high ~ Merger motivation: economies of scale,
profit margins, accelerating sales, reduced costs, improve management
and earnings, but still low ~ Horizontal
industry competition
Decline phase:
~ Merger motivation: access to
~ Industry characteristics: declining profit
capital, expand growth capacity
margins, overcapacity, and lower demand
~ conglomerate and horizontal due to shifts in consumer tastes
~ Merger motivation: survival, operating
efficiencies, new growth opportunities
~ Horizontal, vertical, and conglomerate
Mergers transaction characteristics 125
Comparing Forms of Acquisition

Friendly merger offers
Asset
Stock Purchase Acquirer approaches management
Purchase
Payment To shareholder To target
Negotiations and due diligence
Approval Shareholders None for “small”
Corporate taxes None Target pays CG Definitive merger agreement
S/H taxes S/H pay CG None
Public announcement and
Liabilities Acquirer Usually avoids shareholders vote
assumes assuming
Hostile merger offers

Acquirer submits proposal to board of directors
Attitude of target management
Successful Unsuccessful
Tender offer Proxy battle
Offer made to shareholders Proxy solicitation
Takeover defense & HHI 126
Pre-offer defense mechanisms Post-offer defense mechanisms

Poison pill: flip-in pill and flip-over pill “Just say no” defense
Poison put Litigation
States with restrictive takeover laws Greenmail
Staggered board Share repurchase
Restricted voting rights Leveraged recapitalization
Supermajority voting provision for mergers Crown jewel defense
Fair price amendment Pac-man defense
Golden parachutes White knight defense
White squire defense
Post merger Industry Change Antitrust

Herfindahl- HHI Concentration in HHI Action
Hirschman Index
Any
Key measure of < 1000 Not concentrated No action
amount
market power for
determining anti-trust Between 1000 100 or
Moderate Possible
violations & 1800 more
n
HHI = ¦ (MSi ? 100)2 > 1800 High
50 or Virtually
i=1 more certain
Valuing a target company (1) 127
3 methods to evaluate a target company
Discounted cash flow method Comparable company

Similar to FCFF approach in analysis
SS 12 Uses relative value metrics
Determine free cash flows from similar firms
available to investors after Adds a takeover premium
necessary expenditures to determine fair price to
Choose appropriate discount pay
rate (target company WACC
adjusted for merger effects)
Comparable transaction analysis
Discount cash flows back to
Also uses relative value metrics
the present
for comparables
Determine terminal value –
Comparables are recent takeover
constant growth or market
transactions, not just comparable
multiple
firms!
No need to calculate separate
takeover premium
Valuing a target company (2) 128
3 methods to evaluate a target company
Comparable company
Discounted cash flow Comparable transaction
analysis
method analysis
Advantages
Advantages Advantages
Easy access to data
Easy to model changes in No need to estimate a
cash flow from synergies takeover premium Estimates of value are
derived from the market
Using forecasts avoids Estimates of value are
(reduces estimation error)
biases that may exist in derived directly from
current market data recent deal prices Disadvantages
Model is easy to customize Disadvantages Assumes market is
valuing comparable firms
Disadvantages Assumes past M&A
correctly
Model is difficult to apply transactions were
accurately valued Must determine takeover
when free cash flows are
premium separately
negative (rapid growth firm) May not be enough
comparable transactions Difficult to incorporate
Estimation error – terminal
available synergies or changing
value
capital structures
Changing discount rates Difficult to incorporate
synergies or changing Historical data used to
can have large impact on
capital structures into estimate a takeover
estimate
analysis premium may not be
timely
Evaluating a merger bid 129
Post-merger value of an acquirer: VAT = VA + VT + S – C

Gains accrued to the target: GainT = TP = PT – VT
Gains accrued to the acquirer: GainA = S – TP = S – (PT – VT)
Adjustment for stock payment: PT = (N h PAT)
where: N = number of new shares target receives
PAT = price per share after merger announced
Effect of Payment
Cash offer
Acquirer assumes the risk and receives the potential reward
Gain for target shareholders is limited
If synergies more than expected, takeover premium for target is fixed, so acquirer wins
If synergies less than expected, acquirer loses
Stock offer
Some of the risks and potential rewards shift to the target firm
Target shareholders will own part of acquiring firm
Confident synergies will be realized
Acquirer wants to pay cash; target wants stock to participate in upside
Lack of confidence in synergy estimates
Acquirer wants to pay in stock to share risk; target wants cash to lock in any gains
Mergers benefits & restructuring 130
Distribution of merger benefits

Reasons for divestitures
Short-term effect on stock price
Division no longer fits into
Targets gain approximately 30% management’s long-term strategy
Acquirer’s lose between 1% and 3% Lack of profitability
Reverse synergy – individual parts are
Long-term effect on stock price worth more than the whole
Acquirers tend to underperform Infusion of cash
Failure to capture promised synergies
Corporate restructuring
Divestitures: Selling, liquidating, or spinning off a division or subsidiary
Equity carve-outs: creates a new, independent company; sell shares to outside
stockholders through a public offering
Spin-offs: create a new, independent company; distribute shares to parent company
shareholders – no cash for parent
Split-offs: existing shareholders must exchange shares for shares of new division
Liquidations: break up the firm and sell its assets piece by piece
131
Equity Investments
Study Sessions 10,11 &12
Weighting 20 -30%
Equity Investments - Overview 132
A note on Private
asset Company
valuation Valuation
Valuation Residual Income

process Valuation
Market-Based
Return concepts Valuation: Price
Multiples
Free Cash
Five competitive
Flow
forces
Valuation
Industry Analysis Valuation in Discounted Dividend

Emerging Markets Valuation
A Note on Asset Valuation 133
Graham and Dodd 1934 – 1962 John Burr Williams (1938)

Value should be independent of price Value is the present value of cash flows
Financial statement analysis, earnings at an “opportunity cost of capital”
power, growth prospects Discount rate was not clearly defined
Relative valuation methods DDM and FCF models
“Blocking and tackling” Forward-looking
Modern Portfolio Theory (1959) Modern Valuation Techniques

Harry Markowitz (Portfolio Selection): Fixed income: PV of coupons and par
Value includes growth and risk, value discounted by YTM
efficient frontier dominates other Common stock: PV of future cash flows
portfolios, covariance is key, discounted by the required return
diversification is a free lunch DDM: PV of expected dividends
William Sharpe: FCFF: discounted at WACC
Cost of capital is function of FCFE: required return on equity
systematic, non-diversifiable risk
Relative value: earnings ͪ multiplier
Unsystematic risk can be diversified
away Residual income: current book value +
PV of expected economic profit
Developed CAPM
Valuation Process 134
Valuation = the estimation of an asset’s

value
Relative – based on comparisons Absolute – based on variables Uses:

with similar assets perceived to be related to • Stock selection
future investment returns • Reading the market
Valuation Process - • Projecting the value of
Overview Inputs – should be qualitative corporate actions
1. Understand the business as well as quantitative • Fairness opinions
2. Forecast business • Planning and
performance Critical step that involves consulting
3. Select the relevant financial statement • Communications with
valuation model(s) analysis (including quality analysts and investors
4. Convert forecasts to a of earnings analysis) • Valuation of private
valuation combined with an business
evaluation of industry
5. Make the • Portfolio construction
prospects, competitive
recommendation or position and corporate and management
investment decision strategies.
Industry Competitive Analysis Importance of F/S Footnotes

Five Elements of Industry structure: Footnotes reveal management’s discretion in
Threat of new entrants, Threat of choices of accounting methods and estimates
substitutes, Bargaining power of Buyers, Analyst’s ability to accurately forecast result
Bargaining power of Suppliers, Rivalry derived from quality inputs
among Existing Competition
Greater transparency in earnings results in
Three Generic Strategies: Cost higher stock price—management’s ultimate goal
Leadership, Product Differentiation,
Focus
Accounting Shenanigans Considerations in Valuation

Accelerating or Premature Recognition Fits the Characteristics of the Company (Does
of Income it pay dividends? Is earnings growth estimable?
Reclassifying gains and non-operating Does it has significant intangible assets)
income Is appropriate based on the quality and
Expense recognition and losses availability of input data
Amortization, depreciation, and discount Is suitable given the purpose of the analysis
rates Considering only one model is not good
Off-balance sheet issues
Perceived mispricing
• = any difference between the analyst’s estimate of intrinsic value and the market price
• reflected in the abnormal return, alpha, the analyst expects to earn.
Ex ante alpha = expected holding-period return – required return
Ex post alpha is used to assess the success of the analyst’s strategy

= actual holding-period return - contemporaneous required return
Model selected must be:

• consistent with the characteristics of the company being valued;
• appropriate given the availability and quality of data;
• consistent with the purpose of valuation, including the analyst’s ownership
perspective (i.e. extent of the investor’s influence over the company).
Ownership Perspective
Marketable publicly traded minority interest—DDM approach is the benchmark value
Premiums for control—FCFE approach
Discounts for lack of marketability for non-publicly traded stocks
Discounts for lack of liquidity for publicly traded stocks
Return Concepts 137
Different Returns/Rates
• Holding Period Return, Realized Return, Expected Return, Required Return, Return from
Price Convergence, Discount Rate, Internal Rate of Return
Ways of Measuring the Required Return
CAPM:
E(r) rf u Erm rf
“equity risk premium”
• Multifactor Models
Req’d Return=(factor sensitivity)i*(factor risk premium)i + …. + (factor sensitivity)n*(factor

risk premium)n
Return Concepts 138
Fama – French Model
Req’d return on stock j = Rf + bmkt,*(Rmkt – Rf) + bSMB,j*(RSMALL-RBIG) + bHML,j*(RHBM-RLBM)
Rmkt – Rf = return on a value weighted market index minus risk free rate
RSMALL-RBIG =small cap return premium
RHBM-RLBM =value return premium
Pastor-Stambaugh Model
Builds on the Fama French Model by adding a liquidity factor
Macroeconomic Multifactor Models e.g. Burmeister, Roll and Ross Model
Uses economic variables believed to affect cash flows as factors within the model.
Return Concepts 139
Build-Up Method
Req’d return =Rf + Equity risk premium + size premiuim + specific company premium
Bond Yield Plus Risk Premium
Req’d return =YTM on long term debt + risk premium
Country Spread Model and Country Risk Rating Model
Calculates the premium to be added to the req’d return when investing in emerging mkts
Return Concepts 140
Estimating Beta
Public Companies
Use regression of company stock returns against the market

Adjust for beta drift by using adjusted beta
Adjusted beta=(2/3)*regression beta + (1/3)*1
Thinly traded/non public companies
Estimated beta for ABC=unlevered beta of similar quoted company *

(1+(debt of ABC/equity of ABC))
Unlevered beta of similar quoted company = Beta of similar co.*

1/[1+(debt of similar co/equity of similar co)]
Return Concepts 141
Estimating Equity Risk Premium using…..
Historical estimates
Strengths:
•Objective. Simple, unbiased if investors rational
Weaknesses:
•Assumes mean and variance are stationary
•Different ways of calculating mean return (geometric, arithmetic)
•Different ways of estimating risk free rate (can use long or short term bonds)
Return Concepts 142
Estimating Equity Risk Premium using…..
Forward looking / Ex Ante estimates

Strengths:
•Doesn’t depend on assumption of stationarity
3 Types…..
Gordons Growth Model Supply Side Estimates Survey Estimates

Strengths Strengths: Strengths:
Assumptions used are • Uses proven models • Uses expert opinions
reasonable and inputs to and current information and more likely to be
the model can easily be Weaknesses: reliable
sourced • Only appropriate for Weaknesses
Weaknesses developed countries • There maybe large
• This estimate will change differences of opinion
over time and needs
updating, assumes stable
growth
Industry and Company Analysis 143
Understanding the business Top-down forecasting

• How attractive are the industries in which the 1.
1. Macroeconomic
company operates, in terms of offering 2.
2. Industry
prospects for sustained profitability? 3.
3. Company
• What is the company’s relative competitive
position within its industry?
• What is the company’s competitive strategy?
Porter’s 5 forces POTENTIAL ENTRANTS
Threat of
new entrants Bargaining
power
FIRM
SUPPLIERS BUYERS
RIVALRY
Bargaining
power Threat of substitute
products or services
SUBSTITUTES
Competitive Strategies 144
Focus Narrow Target

Broad Target
Cost Low costs in all market A focuser will be an above
Leadership segments average performer if it can
• economies of scale achieve cost leadership in
• proprietary technology its chosen sub-sector
Competitive • pref. access to raw materials
Advantage
Satisfy particular consumer A focuser will be an above
needs average performer if it can
• product/delivery/marketing achieve product differentiation
Differentiation • premium pricing in its chosen sub-sector
Risks of each generic strategy

Cost Leadership
• New entrant enters market with lower cost base and/or technological breakthrough
reduces rivals production cost
Differentiator
• Consumers cease to value differentiating factor and/or rival company does it better
Niche
• Interest in niche from big players and/or smaller players target sub-sectors of niche
Business and Industry Life Cycles 145
Classification by business cycle reaction

Industry life cycle
Pioneer Growth Maturity Decline
• Growth Industry Stocks - experience
accelerating sales and high profit margins
Sales
during all phases of the business cycle

• Defensive Industry Stocks - product demand
independent of the business cycle, therefore
less cyclical than the overall market
• Cyclical Industry Stocks - product demand
Time
tends to vary directly with the business cycle
Industry life cycle phases

Pioneer - Acceptance of the product or service uncertain, implementation of business
strategy is unclear. Period of high risk with many failures.
Growth – Acceptance of the product or service established. Accelerating sales and
earnings. Industry growth faster than the general economy. Profit margins above average.
Mature – Industry growth corresponds to the growth of the general economy. Participants
compete for share in stable industry.
Decline – Demand for the industry’s product steadily decreases due to shifting tastes or
technologies. Profit margins are diminished.
Industry Analysis 146
Industry External Factors Demand analysis

• Technology An analyst is in a position to assess
• Government future demand for the industry’s output
• Social changes by developing
• Demographics • A macroeconomic forecast
• Foreign influences • An industry classification
• An external factor review
Supply analysis Two additional sources of information
• In the long term, demand will equate to supply • A study of the firm’s customers
• In the short term, there could be shortfalls in • A study of the industry’s inputs and
supply due to long lead times etc outputs
Factors influencing pricing practices and hence profitability

• Product segmentation - Firm’s ability to differentiate its product over various market
segments.
• Concentration – The greater the concentration, the greater the likelihood of collusion.
• Ease of industry entry – Greater ease of entry o prices toward the marginal cost.
• Supply input price – Changes in resource prices will have major implications of profitability.
Valuation in Emerging Markets 147
Incorporating EM risks Dealing with inflation in emerging

market valuation
Adjust the cash Adjust the required
flows in a scenario return by adding a Real Nominal valuation
analysis (preferred) country risk valuation approach
premium approach
Country Risk Premium

•No satisfactory method for
estimation
•Premium is often
overstated
DCF 148
Generic DCF model

f Consider using dividends for CF when:
CFt
V0 ¦ 1 rt • there is a dividend record to analyze;
• the dividend policy established by the board
where t 1
V0 value of the asset today (t 0) bears an understandable and consistent
CFt expected cash flow at time t relationship to the company’s profitability;
r required rate of return • the investor takes a non-control perspective.
Dividend Discount Models 149
Generic DDM Single Holding Period Holding period of n years

f
Dt D 1 P1
V0 ¦
t 1 1 r
t V0
1 r 1 V0
D1

D2 D P
... n nn
where where 1 r 1 r
1 2
1 r
V0 value of the share today (t 0) Pt share price at time t
Dt expecteddividendat time t
r requiredreturnon equity
Two-stage DDM
Expected HPR
Gordon growth model P1 P0 D1
r
D0 1 g D1 P0
V0 n
Dt Vn
r g r g
H-model
V0 ¦ 1 r 1 r
t 1
t n
D 0 1 gL D 0 u HgS gL

No growth model r gL r gL
D (or E) H = half the number of years for
V0 anticipated decline in growth
r
Present value of growth opportunities = market value of share - no growth value per
share
DCF Commentary 150
Gordon growth model Problem with two-stage model with

Strengths: constant growth in both stages
• Suitable for stable, mature, Assumption that a firm’s high growth rate will
dividend paying firms suddenly drop to a lower level overnight is
• Easily applied to indices highly unrealistic.
• Easily communicated &
explained Improvement built into H-model
• Can be used to determine Over a set time the high initial growth will
growth rates, rates of return and decline in a linear fashion to the
PVGO sustainable long-term growth rate
• Supplements other methods
Limitations: Rationale for three-stage model
• Very sensitive to inputs
• With a good product, some companies may
• Not easily applied to non-
sustain a high growth rate in the short-term
dividend paying stocks
• Unpredictable growth patterns • The business is most likely to go through a
makes using the model difficult growth phase, transitional phase, then mature
phase
Spreadsheet approach
Used when even the three-stage DVM is too simple for a real-life application
Further Aspects 151
Multi-stage models g = b x ROE

Strengths: Where: b = retention rate
• Flexibility
ROE = expected return on equity
• Can calculate implied growth rates
or required returns
• Can incorporate the impact of
different assumptions into the model Sustainable growth rate
• Relatively easy to construct using
Rate at which earnings (and dividends) can
spreadsheet software
continue to grow indefinitely, assuming that the
Limitations:
firm’s leverage is unchanged and no new equity
• Estimates are only as good as the finance is raised.
inputs used
• Model must be fully understood to
arrive at accurate estimates Estimating return on equity (ROE)
• Estimates are very sensitive to Net Income
assumptions regarding growth and ROE
Equity
the required return
Net Income EBT EBIT Sales Assets
• Formula and data input can lead to u u x x
EBT EBIT Sales Assets Equity
errors that are difficult to identify
FCF Models 152
• FCFs are not published but need to be computed from published financial statements
• Free means after fulfilling all obligations and without impacting on the future growth
plans of the company
Free Cash Flows to Equity (FCFE) Free Cash Flows to the Firm (FCFF)
= net income = net income
f non-cash items in income f non-cash items in income statement
statement + interest expense x (1 – tax rate)
- investment in working capital - investment in working capital
- investment in fixed assets - investment in fixed assets
+ net increase in debt or
or = CFO
= CFO* + interest expense x (1 – tax rate)
- investment in fixed assets - investment in fixed assets
+ net increase in debt or
= FCFE
* Assuming interest received and paid
+ interest expense x (1 - tax rate)
and dividends received have been
classified as an operating cash flow as – net increase in debt
required under US GAAP
NB: May be given EBIT or EBITDA as starting point for FCFE or FCFF calculations
FCF Models 153
f
FCFFt
f
Firmvalue ¦ 1 WACC t
FCFEt t 1
Equity
Equity value ¦ 1 r
t 1
t
Often referred to as " enterprise
value". This represents the total
value of the firm' s operations
regardless of whom is providing
Debt the capital.
Constant growth FCFE0 1 g FCFF0 1 g

Equity value Firm value
models: r g WACC g
n
FCFt FCFn1 1
Generic 2-stage
model:
V0 ¦ 1 r
t 1
t

r g 1 r n
Forecasting FCF - Apply a growth rate to most recent reported free cash flow or
forecast each component separately.
Sensitivity Analysis – OftenCalculation
utilized toof assess the impact
WACC is covered of uncertain
in Corporate Finance assumptions.
FCF Further Aspects 154
Preferred to DDM when: FCFE v FCFF models

• Firm pays no dividends. For firms with relatively stable leverage, FCFE
• Firm is paying dividends but is more direct and easier to use.
dividends differ significantly from the Situations where the FCFF approach is more
firm’s capacity to pay dividends – i.e. useful include:
dividends imperfectly signal the
• proposed purchase of entire firm (i.e. equity
firm’s long-run profitability.
and debt capital) with a subsequent
• Free cash flows appear to be better reorganization of the capital structure.
aligned with profitability over the
• firms where FCFE is negative.
analyst’s forecast period.
• firms with history of leverage changes –
• Investor takes a control perspective
FCFF may be more meaningful than an
since the firm is being analyzed as a
ever-changing growth pattern in FCFE.
takeover target
Free cash flow proxies

Both net income and EBITDA are regarded as fairly poor proxies since:
• both ignore the important distinction between profit and cash flow
• both ignore the reinvestment of earnings needed for growth
• EBITDA ignores the tax that the firm needs to pay before any distribution to investors
Price Multiples 155
Overview
• Price multiples are ratios of a stock’s market price to some measure of value per share.
• Method of comparables involves comparing a stock’s price multiple to a benchmark
multiple to determine whether or not the stock is appropriately valued.
• Method based on forecasted fundamentals relates multiples to company fundamentals
using a discounted cash flow model.
• A justified price multiple is a multiple justified by an analyst based on either of the
above methods.
P/E multiple
Rationales for using P/E: Drawbacks of using P/E:
• Earnings power is the primary driver • Earnings may not exist or be negative
of investment value • Need to adjust “book” earnings to
• P/E ratio is a popular measure with sustainable or recurring earnings
investors • Management discretion with
• Empirical research shows that P/Es accounting practices distort earnings
may be related to differences in long- and affect comparability of P/Es
run average stock returns across companies
Valuation using P/E 156
Value = earnings x P/E ratio
Determining earnings
P/E ratio based on fundamentals
Analyst may adjust for:
D1
• company specific transitory, P0 E1 1 b
nonrecurring components* Leading P/E
• transitory components due to E1 rg rg
business or industry cyclicality
D1(1 g)
• accounting method differences*
• potential dilution (e.g. due to Trailing P/E
P0 E1 1 b1 g
options and convertibles) E0 r g r g
Methods used to find normalized earnings

for cyclical businesses: P/E multiple increases if:
• Method of historical average EPS – use the • growth rate increases
average EPS over the most recent full • firm’s risk level decreases causing the
cycle required return to decrease
• Method of average return on equity – use • interest rates decrease causing the
the average ROE (based on the most required return to decrease
recent full cycle) multiplied by the current
• payout ratio increases (although g will
book value per share
also be negatively affected)
PEG Ratio 157
Steps for valuation using comparables

1. Select and calculate the price multiple that will be used in the comparison.
2. Select the comparison asset or assets.
3. Calculate the benchmark value of the multiple, i.e. the mean or median value of the
multiple for the comparison assets.
4. Compare the stock’s actual multiple with the benchmark value.
5. If possible, assess whether differences in the fundamental determinants of the price
multiple explain any of the difference in 4 and modify conclusions accordingly.
P/E to growth ratio

• Step 5 above could involve calculating the P/E-to-g (PEG) ratio.
• A high P/E should be justified by high growth – so this ratio should be roughly
constant for all firms in a sector.
• A high ratio may indicate an overpriced share, a low ratio an under priced share.
P/B Ratios 158
Value = book value x P/B ratio
Book value of equity is: P/B multiple increases if:

• net assets; or • growth rate increases
• shareholders’ funds • firm’s risk level decreases causing the
required return to decrease
Fundamental P/B • interest rates decrease causing the
P0 ROE g
• ROE increases
B0 r g
Rationales for using P/B: Drawbacks of using P/B:

• book value more stable than EPS • relies on consistent application of
• works with zero or negative earnings accounting standards
• for some firms, book values of assets • not good for firms with off Balance Sheet
may approximate market values human capital
• empirical evidence suggests differences • depreciated historical cost of assets may
in P/Bs may be related to differences in be different across similar firms due to
long-run average returns the age of the assets
P/S Ratios 159
Value = sales x P/S ratio
P/S multiple increases if:

Fundamental P/S • growth rate increases
• payout rate increases, but ….
§E0 ·1 b1 g
¨ S ¸ • profit margin increases
P0 © 0¹
• firm’s risk level decreases causing the
S0 r g
E/S = profit margin • interest rates decrease causing the
Rationales for using P/S: Drawbacks of using P/S:
• meaningful even if EPS is negative • fails to highlight cost control

• sales figures less subject to manipulation issues within a firm
• less volatile than P/E • does not reflect differences
• viewed as appropriate for valuing the stock of mature, in cost structures among
cyclical and zero-income companies different companies
• research suggests that differences in P/Ss may be
related to differences in long-run average returns
P/CF Ratios 160
Value = cash flow x P/CF ratio
Measures of cash flows that may be used:

Fundamental P/CF
CFO = cash flow from operations
P0 Value of equity from FCFE model
FCFE = free cash flow to equity
CF0 Chosen cash flow measure CF = earnings plus non f cash
charges or income
EBITDA = earnings before interest, tax,
depreciation and amortization
Rationales for using P/CF: Drawbacks of using P/CF:

• addresses the issue of differences in accounting • certain cash flows are
conservatism between companies (quality of ignored if proxies are used
earnings) such as EPS plus non-cash
• cash flows less subject to manipulation than earnings charges
• less volatile than P/E since CF tends to be more • FCFE is superior for
stable than earnings valuation but introduces
• research suggests that differences in P/CFs may be volatility problems and may
related to differences in long-run average returns also be negative at certain
times
Other Models 161
Enterprise Value/EBITDA Dividend yield model

• EV = MV of all equity and debt less cash Value = annualized dividend / dividend yield
& liquid investments = NPV of firm’s
earning activities Most recent quaterly dividend u 4
Trailing D/P
Market price
• EV should be a predictable multiple of
Forecasted dividends over next four quarters
EBITDA Leading D/P
Market price
Rationales for using dividend yield:

Rationales for using EV/EBITDA: • dividend yield is a component of total return
• Useful in comparing firms with different • dividends are not as risky as the capital
financial leverage appreciation component of total return
• Eliminates accounting manipulation in
depreciation & amortization Drawbacks of D/P approach:
• EBITDA more stable than other earnings
measures, and normally positive • focus on D/P is incomplete as it ignores
capital appreciation
Drawback of using EV/EBITDA:
• dividends now would displace future
• EBITDA ignores required capital and earnings, which implies a trade-off between
working capital investments current and future cash flows
Residual Income Models 162
Overview
• Residual Income = accounting profit - charge for equity capital employed
• Residual income represents returns in excess of shareholder expectations, or
“economic income”
The general model Forecasting residual income

f
RIt • This might use internal management
V0 B0 ¦ forecasts for the next few years. Problem =
1 1 r
t
t bias.
f
E t rB t 1
B0 ¦
• Could use fundamental forecasts of earnings
where:
t 1 1 r t growth and dividend policy.
Relationship with other models

V0 = value of share today
B0 = current per-share BV of equity • RI, DDM and FCF models = DCF models but
recognition of value is different in the RI
Bt = expected per-share BV at time t
model.
r = required rate of return on equity
• The total PV produced by all models should
Et = expected EPS for period t
be consistent, in theory, so long as each uses
RIt = expected per-share RI fully consistent assumptions.
Residual Income Models 163
Drivers of RI and link to P/B Multi-stage RI model – Continuing RI

Assuming a constant growth rate in • Continuing residual income is residual income
earnings, g, and a constant ROE after the forecast horizon.
and dividend payout, the residual
income valuation model simplifies • It is likely that residual income will decline in the
to: long run until the firm is making a “normal” return
ROE r (i.e. ROE = r o RI = 0).
V0 B0 B0
r g • Possible continuing RI assumptions are:
This formula is linked to: • RI continues indefinitely at a positive level
P0 ROE g ROE r • RI is 0 from the terminal year forward
1
B0 r g r g • RI declines to 0 as ROE reverts to r over time
• RI reflects reversion of ROE to some mean
Applicable RI model when RI fades over time from time T
w (fade rate) takes values between 0
V0 B0 ¦
T1
Et rBt1 ET rBT1 and 1:
w = 0 o no expectation of any future RI
t 1 1 r t 1 r Z1 r T1
w = 1 o same level of RI continuing
Terminal value of RI forever
RI Models – Further Aspects 164
Implied Growth Rate Justifying Continuing RI Persistence

Can be calculated given the P/B Factors suggesting high ¹:
ratio and the required rate of return • Low dividend payout ratios
on equity by rearranging the single-
stage RI formula: • High historical industry persistence
Factors suggesting low ¹:
• Very high rates of return (ROE)
• Large special items e.g. non-recurring items
• Large accounting accruals
Problems Applying RI Models

• violations of clean surplus: currency translation adjustments, minimum liability adjustment,
unrealised gains/losses on available-for-sale securities
• off-balance sheet items: operating leases, LIFO inventory, goodwill, assets/liabilities not at
FMV
• non-recurring items: extraordinary items, discontinued operations, accounting changes
• Differing international standards
RI Models Commentary 165
Strengths of RI models: Weaknesses of RI models:

• Terminal value doesn’t dominate • Easily manipulated by changing
estimate accounting assumptions
• Uses available accounting data • Ignore changes in reserves other than
• Useful even if firm doesn’t pay dividend, income and dividends
and not distorted by irregular dividends • Many adjustments may need to be made
• Can be used with unpredictable cash to accounting data to get comparable
flows figures
• Models focus on economic profitability,
not just accounting profitability
When to use a RI model:

RI model is most appropriate when:
• company does not pay dividends, or its dividend are not predictable
• company’s expected FCFs are negative within the analyst’s forecast horizon
• great uncertainty exists in forecasting TVs using an alternative PV approach
RI model is least appropriate when:
• there are significant departures from “clean surplus accounting”
• determinants of RI are not predictable
Value-Based Metrics 166
Alternative measures Accounting vs Economic Profitability

RI (see earlier slide) Economic profitability reflects the dollar
EVA® = NOPAT – (WACC x IC) cost of debt and equity capital used to
generate cash flow.
MVA = Market value of firm – IC
Accounting profitability (ROE) only
includes an accounting accrual related to
interest expense.
One way of assessing relative economic
profitability is to compute an EVA spread:
EVA spread = ROC – WACC
where ROC = NOPAT/Invested Capital
Methods of Increasing EVA®

• Increase Revenues
• Reduce operating expenses
• Use less Invested Capital
• Take advantage of positive NPV
projects
• Reduce WACC
Private Company Valuation 167
Private Company Specific Factors Liquidity and Marketability

• Stage of lifecycle, size, Taxes • Minority referred to Liquidity
• Quality and Depth of Management • Difficult to be sold referred to Marketability
• Management/Shareholder overlap DLOC = 1-[1/(1+control Premium)]
• Quality of financial and information Total discount = 1-[(1-DLOC)(1-DLOM)]
• Liquidity, Marketability, Control
Private Company Valuation Approaches

• Income Approach ÎPV of expected future income Î High Growth Phase Companies
• Market Approach Î Recent Transaction Price Multiples Î Mature Phase Companies
• Asset-based Approach Î Firm’s assets’ value minus liabilities Î Early Stage Companies
Scenario Comparable Data Subject Valuation Adj. to Comp. data

for control
1 Controlling Interests Controlling Interests None
2 Controlling Interests Noncontrolling Interests DLOC
3 Noncontrolling Interests Controlling Interests Control Premium
4 Noncontrolling Interests Noncontrolling Interests None
168
Alternative Investments
Study Sessions 13
Weighting 5 – 15%
SS13 Overview 169
Alternative Asset
Valuation
Investment
Income Property Private Equity Hedge Funds
Analysis
Real Estate Investments 170
Type Main Value Investment Principal Risks Likely Investor

Determinants Characteristics
Raw Land Supply/demand Passive, illiquid, Alligator! Speculators,
Location limited leverage, Uncertain developers,
no tax appreciation long-term
depreciation, CGT, investors
low current income
Apartments No of Active Startup risks due Well capitalised
households, management, both to uncertain in need of tax
incomes, current income demand, need of shelter
location, and capital gains, professional
population high liquidity and management
growth leverage, inflation
hedge
Office Business Active Startup risk, High net worth
buildings conditions, management, obsolescence, companies and
location, tenant income and capital quality of individuals in
mix gain, moderate management , need of tax
liquidity and competing shelter
leverage properties
Real Estate Investments cont. 171
Type Main Value Investment Principal Risks Likely Investor

Determinants Characteristics
Warehouses Commercial Passive, moderate Oversupply (cheap) Investors
and industrial liquidity and and obsolescence seeking high
activity, leverage, mostly cash flow,
flexibility of income minimal
design, easy management
access and and tax shelter
convenience
Shopping Population, Active The right tenant Well capitalised
centres income level, management, low mix, obsolescence, seeking tax
location, tenant liquidity, moderate competition, shelter
mix, lease leverage, both maintaining quality
terms income and capital management, high
gain, tax vacancy rates
advantages
Hotels and Level of Active Economies of Wealthy
Motels business and management, scale, quality investors or
tourist activity, limited liquidity, management, REITS
location and leverage, tax competing facilities
depreciation
Valuing Real Estate 172
Valuing Real Estate Steps in Calculating CFAT

Generally use NPV or IRR analysis Step 1: Compute taxes payable
Taxes payable = (NOI – depreciation –
CFAT1 CFATn ERAT interest) h tax rate
NPV ... EI
(1 IRR)1 (1 IRR)n (1 IRR)n Step 2: Compute cash flows after tax (CFAT)
CFAT = NOI – debt service – taxes
payable
CFAT = cash flow after taxes
Step 3: Compute equity reversion after taxes
ERAT = equity revision after tax
ERAT = selling price – selling costs –
EI = initial equity investment
mortgage balance – taxes on sale
Evaluating Real Estate

IRR Problems
• If NPV > 0, or NPV = 0, then
• Multiple or no IRR are the result of cash flow changing
purchase the property. A signs more than once - common with property
positive NPV means that the renovations
present worth of the property
• Misleading IRR decisions due to size and timing of cash
is greater than the equity cost
flows
of the investment. A zero NPV
means the investors equity • Conflicting IRR and NPV decisions for mutually exclusive
cost is unaffected projects
• If NPV < 0, don’t invest in the • Solution - use the NPV methodology and select projects
property as it destroys value with positive NPV
Property Analysis and Appraisal 173
Cap Rate and Discount Rate Methods to Estimate Cap Rate

•Discount rate (r) - the required rate of Market Extraction Method – considered the
return on a real estate investment given most accurate but depends on appraisal
the risk and uncertainty of cash flows data and comparable properties
•Cap rate (r – g) - the required return less NOI

R0 (ME) =
the expected growth of net operating MV
income (NOI)
Band-of-Investment Method – useful for
NOI1 NOI1 properties that utilise both debt and equity
MV0
rg R0 financing; uses a sinking fund factor to
Where R0 = market capitalization rate calculate the cap rate as a WACC figure;
depends on comparable property data
Limitations of Direct Income Capitalisation R0 (BOI) = (mtg weight u mtg cost)
•Selecting the correct cap rate may be difficult + (equity weight u equity cost)
due to lack of available market data, or low-
quality data
•Approach is limited to income-generating Built-up Method - Useful when comparables
properties, not owner-occupied properties with not available
non-monetary benefits R0 (BU) = pure rate + liquidity premium
•Properties that provide little or no income or + recapture premium + risk premium
benefits cannot use this method
Private Equity 174
Risks Structure and Terms VC v Buyout Characteristics

Liquidity Structure – LP Cash flow
Product
Competition Terms Asset base
Agency Management fees Management team entrepreneurial record
Capital Carried interest Leverage
Risk assessment
Regulatory Ratchet Exit strategy
Tax Hurdle Rate Operations
Capital required in growth phase
Valuation Target fund size Returns
Diversification Vintage Activity in public capital markets
Future funding
Market Valuation
Carried interest
Due Diligence
Exit Routes Value Creation

Costs
IPO Reengineer firm
Transaction Placement fee
Secondary Obtain lower cost
Fund set up Performance fee Market financing
Administrative Management fee MBO Goal alignment
Audit Liquidation
Private Equity 175
Control Mechanisms in PE Corporate Governance terms

Transactions Key man clause & performance disclosure
Compensation & Tag-along, drag-along and confidentiality
clauses Claw-back & distribution waterfall
Board representation & Non-compete Tag-along, drag-along clause & Remove for
clauses cause
Priority in claims, Required approvals, & No-fault divorce & Investment restrictions
Earn-outs
Co-investment
Valuation Methodologies Calculating Payoff Multiples and IRRs

DCF Calculating the exit value
Relative value or Market approach Calculating the claimant’s payoffs: Debt,
Real option analysis Preference shares, PE firms,
Management
Replacement cost
Calculating the total investment and total
VC method & leverage buyout method payoff, using these two can get the Payoff
Multiples for PE firms
Calculating the IRRs for PE investors and
management equity
Private Equity 176
Valuation Buyout Venture Performance Measurement

Issue Capital Multiples: Popular, simple, easy to
use and differentiates between realized
and unrealized returns, specified by
GIPS
Use of Frequently Uncertain Paid in Capital (PIC) – % of capital
DCF used cash flow used by GP
Distributed to PIC (DPI) – measures

Relative Validates No comps GP realized return, cash on cash return
Value DCF
Residual Value to PIC (RVPI) –
measures LP’s unrealized return
Use of High Low, more Total value to PIC – measures LP’s

Debt equity realized and unrealized return, sum of
DPI, and RVPI
Key EPS Pre-money

return growth, valuation, Other Valuation
drivers P/E future
VC – Single / Multiple financing rounds
expansion, dilution
debt LBO - Target IRR
reduction - Cash flow
Private Equity 177
For a Single Financing Round For Multiple Financing Rounds

Step 1: Post-Money Valuation Step 1: the compound discount rate
Step 2: Post-Money Valuation (round 2)
POST = FV /(1+r)N
POST2 = FV/ (1+ r2)
Step 2: Pre-Money Valuation Step 3: Pre-Money Valuation (round 2)
PRE = POST-INV PRE2 = POST2 – INV2
Step 3: Ownership Fraction Step 4: Post-Money Valuation (round 1)
f = INV/POST POST1 = PRE2 / (1+ r1)
Step 5: Pre-Money Valuation (round 1)
Step 4: No. of the shares to be held by
PRE1 = POST1 – INV1
the PE firm
Step 6: Ownership Fraction (round 2)
Spe = Se [f/(1-f)]
f2 = INV2 / POST2
Step 5: Price per share Step 7: Ownership Fraction (round 1)
P = INV/ Spe f1 = INV1 / POST1
Step 8: No. of the shares to be held by the PE
firm
Spe1 = Se [f1 /(1- f1)]
Step 9: Price per share after financing (round 1)
P1 = INV1 / Spe1
Step 10&11: Price per share after financing
(round 2)
Spe2 = (Se + Spe1) [f2 /(1- f2)]
P2 = INV2 / Spe2
Private Equity 178
IRR Method Target IRR Method

Ownership Fraction Target IRR must meet or exceed:
Step 1: Investor’s expected future wealth W = The cost of the LBO debt financing
INV h (1+r)N The cost of equity capital for a similar unlevered
Step 2: Ownership Fraction f = W/FV firm
Price per share
The return that the fund managers market to
client investors
Step 3: No. of the shares to be held by the PE
firm Spe = Se [f/(1-f)] terminal equity value
PV of equity investment =
Step 4: Price per share P = INV/ Spe (1+target IRR) N
Post-Money & Pre-Money Valuation
Step 5: Post-Money valuation
POST = INV/f or POST = P Equity Cash Flow Method
h(Spe+ Se)
Step 6: Pre-Money valuation Discount the future value of equity back to the
PRE = POST - INV or PRE = P present using an expected return on equity for
hSe each period that reflects the then capital
structure
Adjusting the Discount Rate The beta for equity that accounts for the financial
r* = [(1+r)/(1-q)] – 1 leverage:
r* = discount rate adjusted for probability
of failure
E Asset
r = discount rate unadjusted for E Equity E ( REquity ) R f E Equity [ E ( RMarket ) R f ]
E
probability of failure
DE
q = probability of failure in a year
Hedge Funds 179
Fee Structures Performance biases

•Paid on quarterly or annual basis •Voluntary report to databases
•High-water mark provision •Selection bias
•Backfill bias
•Survivor bias
Hedge Fund Strategies
•Arbitrage-based funds Hedge Fund Returns
•Convertible bond arbitrage strategies •Factor models
•Equity market neutral funds •Alpha: manager skill
•Event driven funds •Beta: market exposure
•Risk arbitrage (merger arbitrage) •Hedge fund returns are often not normally
•Fixed-income arbitrage distributedǂ Sharpe ratio or other classical
•Medium volatility arbitrage ratios may be useless
•Global macro funds
•Long-short equity funds Funds of funds (FOF)
•Managed futures funds •Retailing (exposure to a large number of
•Multi-strategy funds hedge funds)
•Directional hedge fund strategies •Access to funds closed to individuals
•Dedicated short bias funds •Diversification
•Emerging market hedge funds •Expertise
•Due Diligence Process
179
Hedge Fund Risk 180
Market risks Operational risks

•Can be limited by understanding the beta •Include inadequate resources, unauthorized
exposures of individual hedge funds and trading and style drift, the theft of investor
increase the allocation to funds with lower assets, and misrepresentation of investments
market risks and performance
•Alternatively, allocate to managers with the •Can be minimized by a strict delineation of
highest alpha and hedge away the common duties
factors at the FOF level
Counterparty risk
Event risks •Arises when owed money on a swaps or
•Event driven funds, such as those following options contract and the seller of the contract
mergers and distressed or special situation fails to deliver the gains
investments
•Event driven funds have a lower correlation Leverage
with market indices, but their returns can •Can magnify market risk and counterparty
change dramatically with event risk risk
•Events may affect broader market risks •Can be gained through derivatives
180
181
Fixed Income Investments

Study Sessions 14 & 15
Weighting 5 – 15%
Overview of Level II Fixed Income 182
Study Session 14: Valuation Issues
Term Structure and Valuing Bonds with

General Principles Volatility of Embedded Options
of Credit Analysis Interest Rates
Study Session 15: Structured Securities
Mortgage-backed Valuing MBS/ABS

Sector of the
Bond Market
Asset-backed
Sector of the
Bond Market
Credit Analysis 183
Credit Risk
Default Risk
Credit Spread Risk
Key Considerations
Downgrade Risk
The 4 Cs
• Character
• Capacity
• Collateral
• Covenants
High yield issuer – Debt structure (bank
loans), corporate structure, covenants
Asset Backed Securities - Quality of
underlying collateral Key ratios
Municipal Securities – Tax/revenue- • Profitability
generating ability of the issuer • Short-term solvency
Sovereign Debt - Economic and political • Capitalization/Leverage
risk – 2 ratings (local & foreign currency • Coverage
debt)
Credit Analysis S&P Framework 184
Cash flow ratios

Net income
+ Depreciation Coverage ratios
+/ũ Other noncash items
Funds from operations Funds from operations
Total debt
ũ Increase in NWC
Operating cash flow Funds from operations
ũ Capital expenditures Capex
Free operating cash flow
– Cash dividends
Free operating CF + interest
Discretionary cash flow Interest
–Acquisitions
+Asset disposals Debt service coverage
+Other sources (uses)
Prefinancing cash flow Free operating CF + interest
Annual interest + principal
Debt payback period
Total debt
Discretionary CF
Term Structure 185
Yield Curve Shifts

Yield curve construction: 4 bond
universes
• on-the-run Treasuries
Parallel shifts Twists
• on-the-run + some off-the-run Treasuries
Yield
• all Treasuries
Yield New steepened
curve • Treasury strips
Alternative: swap rate (LIBOR) curve
Original curve
Maturity
Shape of yield curve
Maturity
Defined by “term structure” of interest
rates
Butterfly shifts
Three theories:
- pure expectations (shape shows
Yield
Yield
Original expected implied forward rates)
Positive butterfly curve
shift - liquidity theory (long-term bonds give
Megative higher yield to compensate for higher IR
butterfly
shift risk)
Original curve
Maturity Maturity
- preferred habitat (investors must be
compensated for investing in less-
preferred habitat)
Volatility of Interest Rates 186
Yield volatility
Impact of non-parallel shifts and
on price measured by Key measurement
Rate Duration
Historical Forecasting
yield volatility yield volatility
Approximate percentage
change in value in response to
a 100 basis point change in a T X
tX 2
key rate, holding all other rates

Variance ¦ T 1 Best estimate
t 1
of average X
constant is zero.
Where
Hence:
Xt 100 >ln yt yt 1 @ T
Xt2
Effective Portfolio Duration = yt the yield on day t
variance ¦T 1
t 1
Sum of Key Rate Duration Implied

volatility
Spot
Volatility
rate
derived from
option pricing
models
key rate Maturity

Bonds with Embedded Options 187
Binomial Model Backward induction Callable: call price is

1. Populate interest rate effective cap at each node
tree with rates

i1,U i1,L e2V 2. Discount from end Putable: put price is
effective floor at each node
3. At each node take
average price,
consider call/put and BV'y BV'y
add cash flow
ED
2 u BV0 u 'y
BV'y BV'y 2 u BV0
EC
2 u BV0 u 'y 2
Spread measures
Nominal spread
= YTMcorp – YTMTreas z-spread: credit, liquidity and option risks
(ignores shape of yield curve)
Zero-volatility/Z/Static spread “option cost”
- spread added to spot rates to
Treasury term
get theoretical bond price =
structure
actual bond price
Option-Adjusted Spread OAS: credit and liquidity risks only
- spread added to the interest
rate tree to get theoretical bond
price = actual bond price
Relative Value Analysis 188
Treasury Issuer
Sector Benchmark
Benchmark Benchmark
Actual Undervalued if
Undervalued if actual
actual OAS > Undervalued
OAS > 0 OAS > required OAS*
required OAS*
Actual
Overvalued Overvalued Fairly priced
OAS = 0
Actual
Overvalued Overvalued Overvalued
OAS < 0
*Relative to same benchmark

Convertible Bonds 189
1.Conversion value market price of the stock u conversion ratio

2. Market conversion price market price of CB y conversion ratio
3. Market conversion premium conversion price market price
market conversion premium per share
4. Market conversion premium ratio
market price of common stock
market conversion premium per share
5. Premium payback period
favourable income difference per share
6. Favourable income differenti al per share
coupon interest conversion ratio dividends per share
conversion ratio
Market price of bond
7. Premium over straight value 1
straight value
Convertible bond value =

Straight value + equity call option – bond call option + bond put option
“Common stock equivalent” (conversion value > straight value) vs..

“Fixed income equivalent” (conversion value < straight value)
Mortgage-Backed Securities 190
Mortgage Passthrough Securities

US Mortgage market – key
Only one class of bond investor
features
Cash flows: net interest, principal
Home loans in the form of
payments, curtailments
fixed-rate level-payment fully
amortized mortgages Mostly issued by agencies: Ginnie
Mae, Fannie Mae, Freddie Mac
principal
outstanding Mortgage 1 Investor 1
Mortgage 2 Investor 2
Pool …
…
Pass-through securities Investor N

Mortgage N backed by the pool are
t issued to investors
Non-agency MBS
Collateral can be individual loans (vs.. passthrough securities for
agency MBS)
No government guarantee
Normally have max LTV, payment-to-income and size criteria
Prepayment Rates
PSA Benchmark
Assumes the monthly
prepayment rate
CPR increases as it seasons
Factors affecting Conditional
prepayment behaviour prepayment rate
1.Prevailing mortgage rates (CPR) is the expected
annual prepayment Annual
2.Housing turnover CPR
rate.
3.Characteristics of the 7.5% 125 PSA
underlying mortgage loans Can be converted to
6% 100 PSA
SMM (single-monthly
mortality rate): 3% 50 PSA
SMM 1 1 CPR
1 /12
30 Age in
months
Contraction Risk: IR p hence prepayments n hence expected life p
Extension Risk: IR n hence prepayments p hence expected life n
Mortgage Paythrough Securities

Several classes of investors
Collateralized Mortgage Obligations Stripped MBS

Securities issued against passthrough securities Principal and interest
for which the cash flows have been reallocated payments are paid to different
to different bond classes known as tranches security holders:
Sequential Pay Planned

Tranches Amortization Class Principal Only Interest Only (IO) Strips
Each class of Tranches (PO) Strips Positively related to
bond retired Amortized based on Very sensitive mortgage rates: as IR p
sequentially a sinking fund to prepayment there is more prepayment
schedule established rates of principal leading to less
Tranche A – Most
within a range of Prices rise as cash flow for the IO strip
Contraction Risk
Tranche Z – Most prepayment speeds IR p
Extension Risk Support tranche
absorbs any excess
Commercial MBS 193
• CMBS are backed by a pool • Call Protection at the Loan Level

of commercial mortgage loans – Prepayment lockout
on income producing property
– Defeasance
• CMBS differ from residential
– Prepayment penalty points
MBS in that they are non-
recourse loans. Hence each – Yield maintenance charge
property must be assessed in • Call Protection from the actual CMBS
isolation rather than as a pool structure: as the CMBS is sequential
paying (by credit rating), the AA rated
tranche cannot be repaid before the
• Debt-to-service coverage (DSC) ratio AAA rated tranche
= ratio of net operating income to debt
service.
• Need DSC need > 1, but also check
average & dispersion.
• Loan to Value (LTV) ratio Balloon Risk
• The lower the LTV, the greater the Risk of default at end of loan,
protection afforded to the lender when most of repayment is due
• Note value estimates may vary
considerably
Asset-Backed Securities 194
ABS: Key Features
Types
Prepayment (sequential pay
credit card receivables ABS, tranches having differing
auto loans prepayment/extension risks)
home equity loans vs.
manufactured housing loans Senior-subordinate structure
Small Business Admin loans (senior tranche protected against
corporate loans default by subordinate) a.k.a.
credit tranching
bonds
Credit
other credit-sensitive receivables
Enhancements
Amortizing (e.g. auto External credit enhancements:

loans) vs.. 1. Corporate guarantee by seller
Non-amortizing 2. Bank letter of credit
(e.g. credit card loans) 3. Bond insurance
Internal credit enhancements:

1. Reserve funds
vs. 2. Overcollateralization
3. Senior/subordinated structure
Types of Asset-Backed Security 195
Home equity loans Auto Loans

• Often closed-ended HELs, • Prepaid if sold, traded in, repossessed,
fixed or floating rate destroyed (insurance proceeds), early
• Cash flows similar to MBS repayment or refinanced – but…
• Can be split into tranches: • Refinancing uncommon since collateral

NAS vs. PAC value depreciates rapidly and new car
loans often below market rates
• Prepayments are
modelled on issuer- • Prepayments: CPR & SMM
specific prospectus
prepayment curve (PPC) SBA loans
• Variable rate, 5-25
years
Manufactured housing Credit Card Receivables
loans • Prepayments
measured via CPR • Non-amortizing, with cash
• Amortizing over 15-20 yrs flows = interest, fees,
• Lower prepayments than principal
Student loans
MBS because (1) small • 3 amortization structures:
loans, (2) depreciating • Floating rate, with
deferment, grace & passthrough, controlled
collateral, (3) low credit amortization, bullet payment
quality of borrowers repayment periods
• Prepayments from defaults • Prepayment measured by
• Prepayment model: CPR “monthly payment rate”
with PPC or loan consolidations
ABSs: Other issues 196
Collateralized Debt
Obligations
Arbitrage Cash CDO CDO = ABS

transaction (underlying = backed by
(motivation: earn cash debt pool of bonds,
the spread) instruments) loans, MBSs
vs. vs. or ABSs
Balance sheet Synthetic CDO
transaction (credit
(motivation: derivatives
remove debt from create economic
B/S) equivalence to
cash instruments)
Valuing MBS/ABS 197
Techniques for valuing MBSs and ABSs
Cash flow yield analysis Monte Carlo vs. binomial Spread measures
Discount rate that makes Monte Carlo incorporates IR Nominal spread: hides
the present value of the path, so can use prepayment prepayment risk
future cash flows equal to model to produce value. Z-spread: same
the current price.
Binomial model does not have problem, but considers
Prepayment assumption
ability to value securities that y.c. shape
required.
are IR path dependent, since OAS: best measure
Can calculate bond equiv backward induction starts at
yield: end of timescale.
BEY 2 x [(1 iM)6 1]
Best spread measure for

Monte Carlo and spreads valuations
The rates in the Monte Carlo model can be “tweaked” no option (or option exercise
so that model’s resultant price of MBS/ABS = market unlikely): use Z-spread
price. embedded option, not IR path
Level of “tweak” is the OAS, since the model dependent: OAS with binomial
incorporates the prepayment option. embedded option, IR path
dependent: OAS with Monte
Hence for investing: biggest OAS = cheapest
Carlo
investment
Duration Measures MBS/ABS 198
MBS Duration Measures
Effective Duration
From Monte Carlo Empirical Duration
model. Shock yield by Use linear regression
+/-'y, reapply the model to identify how price
then plug results into changes with yields.
duration formula.
P P Cash Flow Duration

Duration
2 P0 'y Estimate CF and hence CF Coupon Curve
yield, shock yield by +/-'y, Duration
re-estimate CFs and hence Calculate duration by
new prices, then plug results changing coupon
into duration formula. instead of yield.
199
Derivative Investments
Study Sessions 16 & 17
Weighting 5 -15%
Overview of Level II Derivatives 200
Study Session 16: Derivatives Investments: Forwards and Futures
Forward Future Market

Market and and Contracts
Contracts
Study Session 17: Derivatives Investments: Options, Swap and Interest Rate
Options Credit
Market and Derivatives
Contracts Interest Rate
Swap Market
Derivatives
and Contracts
Instruments
Forward Contracts 201
Obligation to:
buy (long)
sell (short)
an asset at an agreed price on an agreed forward date
Value & Price

– Value = PV of net advantage to long from
having contract at forward price (FP) Credit risk
– Price = FP set when contract initiated, for Party with the
no-arbitrage must = cash asset price + net positive value
cost of carry faces credit risk
in that amount
Forward Contract Prices & Values 202
FORWARD PRICE VALUE (to the long at time t)

TYPE = spot price = (spot price – PV benefits)
+ net costs of carry – PV of forward price
§ FP ·
Equity
(So - PVD) x (1+Rf )T St PVD ¨¨ ¸
Tt ¸
Forwards
© 1 R f ¹
§ St · § FP ·
S0eR T
Equity Index
Forwards ¨ T t ¸ ¨ R T t ¸
©e ¹ ©e ¹
Calculate the forward
PV of difference between interest at FRA
interest rate. E.g. 4ͪ7
FRA rate and at the current forward rate for the
FRA, use fwd rate from
FRA period
time 4 to 7
(1 R f,quoted ) T § St · § F ·
Currency
S0 u ¨¨ ¸ ¨ ¸
T- t ¸ ¨ T- t ¸
Forwards (1 R f, base ) T © (1 R base ) ¹ © (1 R quoted ) ¹
Futures Contracts 203
Like forwards, but standardised, exchange

traded and subject to margining
Basis = spot price – futures price Futures price v. Forward

Contango = negative basis. Most likely price
scenario. – In principle same no-
Backwardation = positive basis. It will arbitrage price applies to
occur if benefits holding assets large both
enough – But investors preference for
Convergence Ш As maturity approaches, mark-to-market feature
basis converges to zero (due to arbitrage) (cash flow effect) could
make futures more (/less)
valuable than forwards
– Effect of mark-to-market
ignored on following slides
Value of § current · § price of futures at time ·
¨¨ ¸¸ ¨¨ ¸¸
futures contract © futures price ¹ © of last mark to market ¹
Futures pricing 204
Futures arbitrage
– Futures price (like forward) determined by arbitrage
If futures trades above theoretical FP then:
Cash and carry arbitrage
– Buy cash asset with borrowed money and sell future
If futures trades below theoretical FP then:
Reverse cash and carry arbitrage
– Short sell cash asset, invest proceeds, and buy future
Convenience Yield: Non- Generic futures pricing formula:

monetary benefits from
holding asset, e.g., holding FP = S0 ͪ (1 + Rf)T +FV(NC)-FVD
asset in short supply with NC=Storage Cost-Convenience Yield
seasonal/highly risky
production process FVD=Future Value of Cash Flow
Eurodollar deposits vs T-bills Difficulty in pricing Eurodollar futures

•Eurodollar deposits are US$ denominated •Eurodollar futures cannot be priced
deposits outside the US priced off the easily as LIBOR is an add-on interest and
LIBOR curve using 360 day convention arbitrage transaction cannot be
•While T-bills are discount instruments, constructed perfectly as is the case with
Eurodollar deposits are add-on instruments T-bill futures
Pricing Financial Futures 205
Type of Future Price
T-Bond FP = [(So x (1+Rf )T) – FV(Coupons)]/CF

S0,CF = Price, Conversion Factor of CTD bond
(Cheapest To Deliver bond gives highest implied
repo rate)
Equity & Currency Exactly the same as for forwards
Normal Backwardation Normal Contango

• Hedgers (shorts) are rejecting • Hedgers (longs) are rejecting
price risk price risk
• Speculators (longs) will require • Speculators (shorts) will require
compensation to accept risk compensation to accept risk
•Result: Futures price < expected spot •Result: Futures price >expected spot
price price
Options basics (refresher) 206
call payoff = max(0, ST – X)

call profit = max(0, ST – X) – C0
put payoff = max(0, X – ST) Call Put
put profit = max(0, X – ST) – P0
Long Short Short Long
B/E = strike + B/E = strike -

prem prem
Max profit = Max loss = Max loss Max profit

unlimited unlimited = B/E = B/E
Max profit = premium
Max loss = premium

Options Jargon (refresher) 207
– Moneyness
– Strike/exercise price (X)
– Underlying price (S) Call Put
– expiration In the money S – X = +ve; S – X = –ve
– European/American Out of the money S – X = –ve; S – X = +ve
– Intrinsic value At the money S – X = 0; S–X=0
– Time value
Intrinsic value
– Call: Max (S-X,0)
– Put: Max (X-S,0)
Time value
– Premium minus Intrinsic value
Caps, floors, collars 208
Cap Floor
– series of interest rate caplets, – series of interest rate floorlets, puts
calls with identical strikes & with identical strikes & equally-spaced
equally-spaced expiries expiries
– bought by borrower – bought by lender
Collar
– (long) collar = long cap + short floor
– zero cost if cap premium = floor premium
Put-call parity 209
Cost of fiduciary call (long call + Zero Coupon Bond): c0 + X/(1+r)T

must equal cost of protective put (long put + stock): p0 + S0
Arbitrage – If Put-call parity doesn’t hold then any of for options on futures:
the equations below tells you how to get a profit
c0 + [X - f0(T)]/(1+r)T = p0
e.g. if c0 > p0 + S0 - X/(1+r)T then sell call and buy
synthetic call (buy put & U/L & sell bond [=borrow])
Synthetics
– c0 = p0 + S0 - X/(1+r)T (synthetic call = long put + long underlying + short bond)
– p0 = c0 - S0 + X/(1+r)T (synthetic put = long call + short underlying + long bond)
– S0 = c0 - p0 + X/(1+r)T (synthetic underlying = long call + short put + long bond)
– X/(1+r)T = p0 - c0 + S0 (synthetic bond = long put + short call + long underlying)
Option pricing models 210
Discrete time – underlying asset Continuous time – underlying

is assumed to move only at asset can move at any point in
discrete points in time time
e.g. Binomial
e.g. Black-Scholes-Merton
limit of discrete time model as

period length Ш 0
Binomial option pricing 211
Option value – for no arbitrage, call price at start of a Given call value can
period: estimate put from put-call
c (1 )c 1rd parity
c
1r where: ud
Hedge ratio (delta) – a
risk-free portfolio requires
n units of stock per call,
where n (hedge ratio) =
Symbols
S = stock price at start of period c c
S+ = upper potential end-of-period stock price = S ͪ u S S
S- = lower potential end-of-period stock price = S ͪ d
(if d is not given, then assume d = 1/u)
c+ = call value at expiry if stock rises = Max(0,S+ - X) Valuing American
c- = call value at expiry if stock falls = Max(0,S- - X) options
At each point, substitute
r = risk-free rate per period
intrinsic value if larger than
‘roll-back’ value
2-period Binomial example (1) 212
Stock price = $100

Each period stock either rises 25% or falls 20% (so u = 1.25, d = 0.8)
European call option expires at end of two periods, strike = $97.5
Risk free rate = 7% per period
Stock = $156.25
B er Call = $58.75
eith
A
er Stock = $125 or
Stock = eith Stock = $100
or er
$100 eith Call = $2.50
Call = ? Stock = $80 or
C Stock = $64
Call = $0
2-period Binomial example (2) 213
At all three points (because r, u, and d are the 1 r d 1 0 . 07 0 . 8

same each period): 0 .6
ud 1 . 25 0 . 8
Point B (i.e. at end of first period, assuming stock price rose):
cB
c (1 )c >0.6 u $ 58 .75 @ >(1 0 .6 ) u $2.5 @ $33.88
1 r 1.07
Point C (i.e. at end of first period, assuming stock price fell):
cC
c (1 )c >0.6 u $ 2 .5 @ >(1 0 .6 ) u $0 @ $1.40
1 r 1.07
Point A (now, using cB as c+ and cC as c-):
cA
c B (1 )c C >0. 6 u $ 33 .88 @ >(1 0 .6 ) u $1.40 @ $19.52
1 r 1.07
Valuing interest rate options 214
Binomial Model

i1,U i1,L e2V interest rates in tree will be
provided, and assume p = 0.5
Valuing an option on a bond Valuing a cap or a floor

- work backwards to value the - use rates in tree to evaluate
bond at each point in the tree payoff for each caplet/floorlet
- value option on bond using - use rates in tree to discount p-
conventional binomial weighted payoffs back to a PV
approach
Black-Scholes-Merton model 215
Assumptions of BSM
– Underlying asset price follows a geometric lognormal diffusion process
– Risk-free rate and volatility of asset known and constant over option life
– No cash flows (e.g. dividends) on the underlying
– No transaction costs or taxes
– European style options
S 0 N(d 1 ) Xe r T N(d 2 )
c
c
d1

ln S 0 X r c 2 /2 T
T
As per binomial, given call value can
d2 d1 T estimate put from put-call parity
Extensions of BSM 216
BSM Model with dividends Black’s model (options on futures)
S 0 e T N(d 1 ) Xe r T N(d 2 ) >f 0 (T)N(d 1 ) XN(d 2 ) @

c
er
c
T
c c

ln S 0 e X r c 2 /2 T
- T
d1
ln /2 T
f 0 (T)
X
2
d1
T T
Application to interest rate options –

replace f0(T) with forward interest rate
d2 d1 T from the date of expiration of option to
end of period of underlying interest rate
in the option
The Greeks 217
Relationship between change in

Factor Factor sensitivity factor and change in premium
Call Put
' option val ue
Underlying price Delta Positive Negative
' asset price
' option value
Passage of time Theta Negative Negative
' time to expiry
option val ue
Interest rate Rho Positive Negative
interest rate
' option value
Volatility Vega ' price volatility
Positive Positive
Estimating volatility: ' Delta

Historical (std. devn. of past log returns) Gamma
' asset price
Implied (by pricing model & current premium)
Delta hedging 218
A long position in a stock with a short position in call options so value of portfolio
does not change with the value of the stock.
Number of calls required = number of shares
call delta (but beware of gamma)
Intrins ic value Total value delta (right ax is )

16 1
Gamma is the 0.9

14
slope of this line,
0.8
12
it measures how
fast delta 0.7
10 changes as the
0.6 Delta is the
underlying price
slope of the
8 moves. It is 0.5
premium versus
positive, and
6
0.4
asset price line.
greatest for ATM
0.3 Call deltas vary
options
4 between 0 and +1
0.2
(since the line
2
0.1 moves from
0 0
being flat to a
450 slope)
12
14
20
22
24
30
32
34
16
18
26
28
36
Swaps and swaptions 219
Plain Vanilla Interest Rate Swap Currency Swap

• An agreement to exchange fixed rate • An agreement to exchange payments
payments for floating rate payments denominated in one currency with
• Based on a notional principal. payments in another currency.
• Payments are netted off • Principal amounts are exchanged at the
• Equivalent to issuing a fixed-coupon bond start and end of the swap.
and using proceeds to buy a floating-rate • Interest payments not netted off as they
bond are in different currencies
• Equivalent to a series of off-market FRAs • Equivalent to issuing a fixed- or floating-
• Equivalent to a series of interest rate calls rate bond in currency A, converting
and puts proceeds to currency B and buying a fixed-
or floating-rate bond in the latter currency
Equity Swap Swaptions
• An agreement to swap fixed Payer Swaption
payments for a return on a stock
An option to enter into a pay fixed swap
or stock index
As interest rates increase, the option
• If the equity returns are negative,
becomes more valuable
the fixed rate payer must also pay
the percentage decline Receiver Swaption
• Equivalent to buying/ An option to enter into a receive fixed swap.
selling equity A and selling/buying As interest rates decrease, the option
the bond/equity B becomes more valuable
Pricing and valuing swaps 220
Valuation
Pricing (setting the fixed rate)
- Difference between PVs of the two
flows
- Discount fixed cash flows at the new
Interest rate swap pricing
LIBOR rates
Use the premise that an interest
rate swap is equivalent to issuing - use fact that PV of FRN at coupon
a fixed rate bond and investing in date = par to simplify floating rate PV
a floating rate bond. - NB LIBOR at the start of each
The fixed rate must be set so that coupon period determines the
the values of the 2 bonds are the coupon paid at the end of the period
same at initiation.
At issue, the floating rate bond has
a value equal to its face value.
Therefore, the value of the fixed
1 - DF for last flow
rate must be:
F

¦ DF for i th flow
Swaption 221
Payer swaption Value of Payoff for a Payer Swaption)

Right to enter swap as fixed- PV of the difference between
rate payer (wins if rates payments based on higher existing
increase) (market) swap rate and payments
Receiver swaption based on strike rate
Right to enter swap as fixed- Discount CFs based on “spread”

rate receiver (wins if rates fall) between contract and market
Uses
Hedge anticipated floating rate
exposure in the future
Speculate on IR changes
Terminate an existing swap (i.e.,
buy the right to enter into an
offsetting position)
Interest rate options 222
Interest rate call payoff:

Notional principal ͪ
Max(0,underlying rate at expiry – exercise rate) ͪ (days in underlying rate/360)
Interest rate put payoff:
Notional principal ͪ
Max(0,exercise rate - underlying rate at expiry) ͪ (days in underlying rate/360)
For both types:
• payoff is at end of underlying notional loan period, rather than at expiry (for other
options payoff is at expiry)
• compare with FRAs
• Cap = series of interest rate calls
• Floor = series of interest rate puts
Credit Default Swap 223
Characteristics Strategies
Insurance contract on Basis trade
“reference obligation” (a specific Credit curve flattener
bond or loan) Credit curve steepener
Buyer pays seller default swap Index trade
premium (default swap spread) Options trade
Protects buyer from losses due Capital structure trade
to default Correlation trade
Swap seller is long the credit
risk only
224
Portfolio Management
Study Session 18
Weighting 5 – 15%
Overview of Portfolio Management 225
PORTFOLIO MANAGEMENT
Portfolio Management
Portfolio Concepts Process & the Investment
Policy Statement
A Note on The Theory of Active

“Market Management
Efficiency”
International
Asset Pricing
Mean and standard deviation 226
For an individual investment For a portfolio

Expected n
§ probabilit y u ·
return E (R ) ¦ ¨¨ potential return ¸¸
© ¹
E(Rport) ¦w E(R )
i 1
i i
Variance n n n
§ ·
¦wi Vi ¦¦wi wjCovij
2
¨ probu §¨ potential E(R) ·¸ ¸ V 2 port 2 2
(for standard
deviation take
V 2
¦¨ ¨ return ¸ ¸ i 1 i 1 j 1
© © ¹ ¹
square root) for iz j
e.g. for 2 assets :

If estimating an V port w12V 12 w 22V 22 2 w1 w 2 Cov 1, 2
investment’s E(R) & s Covi,j =
from time series data Most important factor when adding E[(Ri-E(Ri))㬍(Rj-E(Rj))]
then use these an investment to a portfolio that
formulae, but use contains a number of other
actual return for each investments is average covariance
period in place of Cov ij
with all the other investments Correlatio n, rij
potential, and set all V iV j
probs equal
Mean Variance Analysis 227
E(R) Assumptions:
BCD is the
efficient frontier
.D • Investors are risk-averse
• Investors know expected returns,
. C
variances, and covariances for all
assets
B . opportunity set of
• Investors use Markowitz
framework
.
• Frictionless markets: no taxes or
available transactions costs
A portfolios
V
ABCD is the minimum variance frontier
Minimum Variance Frontier--Smallest variance among all portfolios with the same expected return
Construction:
1. Estimation: Forecast expected return, E(R), and variance, Ӻ2, for each individual asset
2. Optimization: Solve for weights that minimize the portfolio Ӻ2 given target return and portfolio
weights that sum to one
3. Calculation: Calculate E(R) and Ӻ2 for all the minimum variance portfolios from Step 2
Correlation and Diversification 228
Lower correlation higher bow greater diversification
This is for a two-asset portfolio
E(r) Variance for an equal-weighted

30% portfolio:
1 n 1
20% P2 = i2 + Cov
n n
= –1 = +1
10%
= –0.3
= +0.3
0% Total Risk
0% 10% 20%
Adding in a risk-free asset 229
Combinations of a risk portfolio

and a risk-free asset will lie on a
straight line:
Expected Return
L
E(R)
All investors CM
want to be on
.
CML
M
.
.
P
.
.
RF Borrowing P
at RF RF M is the market
portfolio (optimal
Lending at RF risky portfolio)
Standard deviation
V
Hence, given assumptions on next slide: CML

(Capital Market Line)
CML vs. CAL 230
• The Capital Market Line assumes • The Capital Allocation Line assumes
homogeneous expectations heterogeneous expectations
• CML Equation • CAL Equation
ª E(RM) - RF º ª E(RT) - RF º
E(RC ) R F « »VC E(RC ) R F « »VC
¬ VM ¼ ¬ VT ¼
Security Market Line CML

Risk measure Systematic Total
Application Required return for Asset allocation for Rf and M

securities
Definition Graph of CAPM Graph of efficient frontier
Slope Market risk premium Sharpe ratio

Systematic vs. Unsystematic Risk 231
Total Risk
Total Risk = Unsystematic Risk + Systematic Risk
Unsystematic Risk
Market
Risk
Systematic Risk
Number of Stocks in the Portfolio
Using the SML 232
㱍= Expected Return – Required Return
E(Ri)
ƽ SML
RM
M
. SML shows
expected return
RF . (per CAPM)
Compare this to
Ei anticipated
EM=1
(forecast) return
E(Ri) = RF + Ei(E(RM)- RF)

• A stock that is overpriced will plot below the SML
• A stock that is underpriced will plot above the SML
• A stock that is correctly priced will plot on the SML
CAPM in The Real World 233
Two key assumptions…

1. Investors can borrow/lend at risk-free rate
2. Unlimited short-selling and access to short proceeds
…yields two implications…

1. Market portfolio lies on the efficient frontier (market portfolio is efficient)
2. Linear relationship between expected return and beta
If the 2 key assumptions are violated…

1. Market portfolio might lie below the efficient frontier (might be inefficient)
2. Relationship between expected return and its beta might not be linear
The Market Model 234
• Regression of an asset’s returns against an observable index’s returns:
R i = D i + E iR M + H i
• Expected return: E(Ri) = Di + EiE(RM)
• Variance: Vi 2 Ei VM VH
2 2 2
• Covariance: Cov ij = E iE jV M 2
Beta Instability Problem

Historical beta not necessarily a good predictor of future relationships….
Adjusted beta
Mean-reverting level of beta = 1
Adjust beta to reflect this mean-reverting level
Ӫi,t = ө0 + ө1Ӫi,t–1, where 㱍0 + 㱍1 = 1
Most popular values: 㱍0 = 1/3 and 㱍1 = 2/3
Adjustment moves beta towards 1
Adjusted beta moves toward 1 more quickly for larger values of 㱍0
LOS 71.a: discuss how the Index Model simplifies CAPM
Active Risk and Return 235
• Active return is the difference Information Ratio

between the portfolio return (P) and its Active return per unit of active risk
benchmark (B): RP – RB
(rP rB )
• Active risk (“tracking risk”) is the IR =
standard deviation of the active return s(rP rB )
• Source of active risk can be active Measures manager’s consistency in
factor risk and active specific risk generating active returns
• Factor portfolio vs. tracking
portfolio
Multifactor models/APT 236
APT (Arbitrage Pricing Theory) Multifactor models
(5L 5I EO EO EO ಹಹENON • analyst chooses

number and the
identity of the factors -
EN = sensitivity of the actual return from security i to enough so model
changes in an index representing risk factor k adequately predicts
ON = the difference between the expected return for a security returns (but
one- unit exposure to factor k and the risk-free not too many)
return
• Macroeconomic
APT assumptions: CAPM assumptions: models use underlying
• Competitive capital market economic influences
• Security returns can be
• Markowitz investors (e.g. real GDP growth,
described by a factor
• Unlimited risk-free unexpected inflation)
model
lending/borrowing • Fundamental factor
• Sufficient securities to • Homogenous expectations models use specific
diversify away the
• One-period investment aspects of the
unsystematic risk
horizons securities (e.g. P/E
• No arbitrage opportunity • Frictionless markets ratio, firm size)
International Asset Pricing 237
Real Exchange Rate Risk

The possibility of exchange rate changes that are not explained
by inflation differentials
Real exchange rate = spot rate x foreign price level

(dc/fc) domestic price level
%' real spot = %' nominal spot rate – (inflationQ – inflationB)

(dc/fc)
ICAPM 238
Form of ICAPM:
E(R) = Rf + bGMRPG + J1FCRP1…… + JkFCRPk
where
E( R) = expected return required on investment x
Rf = risk free rate in investor’s home country (domestic)
bG = the world beta of stock x (sensitivity to changes in global portfolio value)
MRPG = the world risk premium
Jk = sensitivity of stock* x to changes in real exchange levels
FCRPk = foreign currency risk premium
*in domestic currency returns

Domestic Currency Sensitivity
Foreign Currency Risk Premium
J = JLC + 1
ª E(S 1) - S 0 º
FCRP = «
¬ S0 »¼ rquoted - rbase Exporter JLC < 0
Importer JLC > 0
OR J = domestic currency sensitivity
E(S 1) - F JLC = local currency sensitivity
FCRP =
S0
Equity & Bond Exposures 239
Currency Exposures of National Economies
Equity Markets Bond Markets

Traditional Model Free Markets Theory
causes causes
Increased long-run Currency Increase in real Currency
economic activity depreciation interest rates appreciation
causes Negative causes Negative

Higher equity currency Lower bond currency
prices exposure prices exposure
Money Demand Model Government Intervention Theory

causes causes
Increased long-run Currency Government to Currency
economic appreciation decrease real appreciation
activity rates
Positive
currency Positive
causes causes
exposure Higher bond currency
Higher equity exposure
prices prices
Active Management 240
Active management and market equilibrium:

• empirical evidence:
• abnormal returns produced by some managers
• some anomalies in realized returns have persisted over prolonged periods
• if no one can beat the passive strategy, money will flow away from active managers and their
expensive analysis - prices will no longer reflect sophisticated forecasts - subsequent profit
opportunity lures back active managers who once again become successful
Treynor-Black Model:
• Only a limited number of securities are analyzed. The rest are assumed to be fairly priced.
• The market index portfolio (M) is the baseline portfolio. The expected return and the
variance of M are known.
• To create the active portfolio:
• Estimate the beta of each security to find mispricings. Those with non-zero alphas will be
put into the active portfolio with the following weights: (+ alpha + weight, - alpha -
weight) n
¦
i j
wi =
2(i ) 2
j=1 (j )
• The cost of less-than-full diversification comes from the non-systematic risks of the
mispriced stocks, Ӻ2(e), which offsets the benefit of the alphas.
• Estimates of ө, Ӫ and Ӻ2(e) are used to determine security’s weights (+ or -) in the
n n n
active portfolio
A = ¦wii A = ¦w i i ¦
2(A)= wi22()
i
i=1 i=1 i=1
Active Management 241
Treynor-Black Model (cont’d):

• The expected return and the standard deviation of the Active portfolio (A):
E(RA) = 㱍A + 㱎A{E(RM) – RF} A = 2A M2 + 2 ( A )
• Combine the active portfolio and M to create the optimal portfolio which will maximize
the Sharpe’s ratio
• When short positions are prohibited, simply discard stocks with negative alphas.
• We should adjust the alpha estimated by an analyst by his past accuracy. Therefore if a
manager has consistently overestimated alpha on a stock in the past, we have to
“discount” his analysis . That will give a smaller weight to the stock
The portfolio management process 242
Steps: Typical IPS elements:

1. Planning • Client description
• Specify investor’s objectives and constraints • Purpose of the IPS
• Create the investment policy statement (IPS) – • Identification of duties and
formal document governing all investment decision responsibilities
making, with a central role in the whole portfolio • Formal statement of objectives
management process and constraints
• Formalize capital market expectations • Calendar schedule for portfolio
• Create the strategic asset allocation performance and IPS review
2. Execution step • Performance measures and
• Construct a portfolio with the appropriate asset benchmarks
allocation • Considerations for developing
3. The feedback step the strategic asset allocation
• Monitor objectives and constraints and capital • Investment strategies and
market conditions, rebalance portfolio as needed investment styles
• Guidelines for portfolio
Objectives: Constraints: adjustments and rebalancing
• Return • Time horizon(s)
• Risk tolerance • Liquidity needs
(ability & willingness) • Taxes Importance of ethical
conduct (managers are in
Time horizon directly • Legal & Regulatory needs
a position of trust)
affects ability to take risk • Unique circumstances

Ethical and Professional Standards Study Session 1 - 2: Weighting 10%

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1

Ethical and Professional

Overview of Level II Ethics 2

Standards of CFA Institute CFA Institute

Ethics Cases: Other topics:

Code of Ethics Standards of Professional Conduct

I: Professionalism V: Investment Analysis,

Standards of Professional Conduct 4

I(A): Knowledge of the Law I(B): Independence and Objectivity

I(C): Misrepresentation I(D): Misconduct

Standards of Professional Conduct 6

Standard II: Integrity of

II(A): Material Nonpublic Information II(B): Market Manipulation

Standard III: Duties to Clients

III(A): Loyalty, Prudence, and Care III(B): Fair Dealing

Standards of Professional Conduct 8

Standard III: Duties to Clients

Standard III: Duties to Clients

III(E): Preservation of Confidentiality

Standards of Professional Conduct 10

Standard IV: Duties to

Standard IV: Duties to

IV(B): Additional Compensation Arrangements IV(C): Responsibilities of

Standards of Professional Conduct 12

Standard V: Investment Analysis, Recommendations, and Actions

Standard V: Investment Analysis, Recommendations, and Actions

V(C): Record Retention

Standards of Professional Conduct 14

Standard VI: Conflicts of Interest

VI(A): Disclosure of Conflicts

Standard VI: Conflicts of Interest

VI(B): Priority of Transactions

Standards of Professional Conduct 16

Standard VII: Responsibilities as a CFA

VII(A): Conduct as Members and Candidates in the CFA Program

Standard VII: Responsibilities as a CFA

CFA Institute Soft Dollar Standards 18

Soft Dollar Standards

III. Selection of V. Client-directed

Soft dollar practices

Two fundamental principles

CFA Institute Soft Dollar Standards34 20

Permissible research: 3 level analysis

CFAI Research Objectivity Standards 22

Objectives Procedures for

Objectives of the Standards

• Prepare research, recommendations, investment action – clients always first

Required Compliance Procedures

Research objectivity policy

CFAI Research Objectivity Standards 24

Required Compliance Procedures

Reasonable and adequate basis

Research analyst compensation

Relationships with subject companies

Required Compliance Procedures

Personal investments and trading

Timeliness of research reports and recommendations

Compliance and enforcement

CFAI Research Objectivity Standards 26

Recommended Procedures for Compliance

Research objectivity policy

Recommended Procedures for Compliance

Reasonable and adequate basis

Ŷi b̂ 0 b̂ 1X̂ 1 b̂ 2 X̂ 2 .... b̂ k X̂ k

Real GDP = measure of inflation-adjusted income and output

Comparative advantage refers to the lowest opportunity cost to produce a product.