Ift Study Notes Vol 4 PDF

2019 CFA® Exam Prep
IFT Study Notes
Volume 4
Corporate Finance
Portfolio Management
Equity
Document Version: 1.0

Publish Date: May 30, 2018
Errata information can be found at https://goo.gl/3Z8NyS
This document should be read in conjunction with the corresponding reading in the 2019 Level I
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2018, CFA Institute. Reproduced and republished with permission from CFA Institute.
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Volume 4 2019 Level I Notes
Table of Contents
R33 Corporate Governance and ESG - An Introduction ............................................................6

1. Introduction ..................................................................................................................................................6
2. Corporate Governance Overview ..........................................................................................................6
3. Company Stakeholders .............................................................................................................................6
4. Stakeholder Management ..................................................................................................................... 10
5. Board of Directors and Committees.................................................................................................. 13
6. Factors Affecting Stakeholder Relationships and Corporate Governance ......................... 15
7. Corporate Governance and Stakeholder Management Risks and Benefits ....................... 17
8. Analyst Considerations in Corporate Governance and Stakeholder Management......... 18
9. ESG Considerations for Investors ...................................................................................................... 20
Summary .............................................................................................................................................................. 22
Practice Questions ............................................................................................................................................ 25
R34 Capital Budgeting ....................................................................................................................... 29

1. Introduction ............................................................................................................................................... 29
2. The Capital Budgeting Process............................................................................................................ 29
3. Basic Principles of Capital Budgeting ............................................................................................... 30
4. Investment Decision Criteria ............................................................................................................... 31
Summary .............................................................................................................................................................. 40
R35 Cost of Capital .............................................................................................................................. 48

1. Introduction ............................................................................................................................................... 48
2. Cost of Capital ............................................................................................................................................ 48
3. Costs of the Different Sources of Capital ......................................................................................... 52
4. Topics in Cost of Capital Estimation ................................................................................................. 56
Summary .............................................................................................................................................................. 61
R36 Measures of Leverage ............................................................................................................... 70
1. Introduction ............................................................................................................................................... 70
2. Leverage....................................................................................................................................................... 70
3. Business and Financial Risk ................................................................................................................. 71
© IFT. All rights reserved 1

Summary...............................................................................................................................................................77
Practice Questions ............................................................................................................................................79
R37 Working Capital Management ............................................................................................... 83

1. Introduction ................................................................................................................................................83
2. Managing and Measuring Liquidity ...................................................................................................83
3. Managing the Cash Position .................................................................................................................85
4. Investing Short-Term Funds ................................................................................................................85
5. Managing Accounts Receivable ...........................................................................................................87
6. Managing Inventory ................................................................................................................................90
7. Managing Accounts Payable .................................................................................................................91
8. Managing Short-Term Financing ........................................................................................................92
Summary...............................................................................................................................................................94
Practice Questions ............................................................................................................................................98
R38 Portfolio Management Overview....................................................................................... 102

1. Introduction ............................................................................................................................................. 102
2. A Portfolio Perspective on Investing ............................................................................................. 102
3. Investment Clients ................................................................................................................................ 103
4. Steps in the Portfolio Management Process................................................................................ 104
5. Pooled Investments .............................................................................................................................. 105
Appendix............................................................................................................................................................ 108
Summary............................................................................................................................................................ 110
Practice Questions ......................................................................................................................................... 113
R39 Portfolio Risk and Return Part I ........................................................................................ 116
1. Introduction ............................................................................................................................................. 116
2. Investment Characteristics of Assets ............................................................................................. 116
3. Risk Aversion and Portfolio Selection ........................................................................................... 123
4. Portfolio Risk........................................................................................................................................... 128
5. Efficient Frontier and Investor’s Optimal Portfolio ................................................................. 130
Summary............................................................................................................................................................ 133
R40 Portfolio Risk and Return Part II ....................................................................................... 142

1. Introduction ............................................................................................................................................. 142

2. Capital Market Theory......................................................................................................................... 142

3. Pricing of Risk and Computation of Expected Return ............................................................. 147
4. The Capital Asset Pricing Model ...................................................................................................... 150
5. Beyond the Capital Asset Pricing Model........................................................................................... 157
Summary ........................................................................................................................................................... 159
R41 Basics of Portfolio Planning and Construction ............................................................. 169

1. Introduction ............................................................................................................................................ 169
2. Portfolio Planning ................................................................................................................................. 169
3. Portfolio Construction ......................................................................................................................... 172
Summary ........................................................................................................................................................... 177
R42 Risk Management - An Introduction ................................................................................ 183

1. Introduction ............................................................................................................................................ 183
2. The Risk Management Process ........................................................................................................ 183
3. Risk Governance .................................................................................................................................... 185
4. Identification of Risks .......................................................................................................................... 186
5. Measuring and Modifying Risks ...................................................................................................... 188
Summary ........................................................................................................................................................... 191
R43 Fintech in Investment Management ................................................................................. 196

1. Introduction ............................................................................................................................................ 196
2. What is Fintech?..................................................................................................................................... 196
3. Big Data ..................................................................................................................................................... 196
4. Advanced Analytical Tools: Artificial Intelligence and Machine Learning ..................... 197
5. Data Science: Extracting Information from Big Data............................................................... 199
6. Selected Applications of Fintech to Investment Management............................................. 199
7. Distributed Ledger Technology ....................................................................................................... 202
Summary ........................................................................................................................................................... 205
R44 Market Organization and Structure ................................................................................. 212

1. Introduction ............................................................................................................................................ 212

2. The Functions of the Financial System.......................................................................................... 212

3. Assets and Contracts ............................................................................................................................ 214
4. Financial Intermediaries .................................................................................................................... 217
5. Positions.................................................................................................................................................... 220
6. Orders ........................................................................................................................................................ 224
7. Primary Security Markets .................................................................................................................. 226
8. Secondary Security Market and Contract Market Structures............................................... 228
9. Well-Functioning Financial Systems .............................................................................................. 230
10. Market Regulation ................................................................................................................................ 230
Summary............................................................................................................................................................ 231
R45 Security Market Indexes ....................................................................................................... 241

1. Introduction ............................................................................................................................................. 241
2. Index Definition and Calculations of Value and Returns ........................................................ 241
3. Index Construction and Management ........................................................................................... 242
4. Uses of Market Indexes ....................................................................................................................... 248
5. Equity Indexes ........................................................................................................................................ 248
6. Fixed Income Indexes .......................................................................................................................... 249
7. Indexes for Alternative Investments.............................................................................................. 250
Summary............................................................................................................................................................ 252
R46 Market Efficiency .................................................................................................................... 261

1. Introduction ............................................................................................................................................. 261
2. The Concept of Market Efficiency ................................................................................................... 261
3. Forms of Market Efficiency ................................................................................................................ 262
4. Market Pricing Anomalies .................................................................................................................. 263
5. Behavioral Finance ............................................................................................................................... 264
Summary............................................................................................................................................................ 266
R47 Overview of Equity Securities ............................................................................................. 271

1. Introduction ............................................................................................................................................. 271
2. Equity Securities in Global Financial Markets ............................................................................ 271

3. Types and Characteristics of Equity Securities ......................................................................... 271

4. Private versus Public Equity Securities ........................................................................................ 272
5. Investing in Non-Domestic Equity Securities ............................................................................. 273
6. Risk and Return Characteristics of Equity Securities.............................................................. 275
7. Equity Securities and Company Value .......................................................................................... 276
Summary ........................................................................................................................................................... 278
R48 Introduction to Industry and Company Analysis ......................................................... 284

1. Introduction ............................................................................................................................................ 284
2. Uses of Industry Analysis ................................................................................................................... 284
3. Approaches to Identifying Similar Companies .......................................................................... 284
4. Industry Classification Systems ....................................................................................................... 285
5. Describing and Analyzing an Industry .......................................................................................... 287
6. Company Analysis ................................................................................................................................. 295
Summary ........................................................................................................................................................... 298
R49 Equity Valuation ...................................................................................................................... 307

1. Introduction ............................................................................................................................................ 307
2. Estimated Value and Market Price ................................................................................................. 307
3. Major Categories of Equity Valuation Models ............................................................................ 307
4. Present Value Models: The Dividend Discount Model ............................................................ 308
5. Multiplier Models .................................................................................................................................. 314
6. Asset-Based Valuation ......................................................................................................................... 318
Summary ........................................................................................................................................................... 320

R33 Corporate Governance and ESG - An Introduction 2019 Level I Notes
R33 Corporate Governance and ESG - An Introduction

1. Introduction
This reading gives an overview of corporate governance, the stakeholders of a company,
describes how companies manage various stakeholders, the role played by the board of
directors, the risks in a corporate governance structure, what corporate governance issues
are relevant for investment professionals, and environmental and social considerations for
investors.
2. Corporate Governance Overview

The curriculum defines corporate governance as “the system of internal controls and
procedures by which individual companies are managed.” Corporate governance defines the
rights, roles and responsibilities of various groups within an organization and how they
interact. One of the goals of a good corporate governance system is to minimize the conflict
of interests between the stakeholders within a company and external shareholders.
Corporate governance practices differ from country to country, and even within a country,
several governance systems may be practiced. Most corporate governance systems are
based on one of these two theories or a combination of both: stakeholder theory and
shareholder theory.
Shareholder theory is based on the premise that the goal of a company is to maximize
shareholder returns.
Stakeholder theory is based on the premise that a company’s focus is not restricted to
shareholders, but extends to other stakeholders as well such as its customers, employees,
suppliers etc.
3. Company Stakeholders
A corporate governance system considers the needs of several stakeholder groups, some of
whom may have conflicting interests. This section covers the various stakeholder groups in a
corporation and the possible conflicts across these groups.
3.1. Stakeholder Groups
The primary stakeholder groups of a corporation include shareholders, creditors, managers
and employees, board of directors, customers, suppliers, and governments/regulators. We
look at each group in detail now.
Shareholders
Shareholders own shares in a corporation and are entitled to certain rights, such as the right
to receive dividends and to vote on certain corporate issues.

There are two types of shareholders in a company:

• Controlling shareholders who hold a significant percentage of shares in a company,
which gives them the power to control how the board of directors is elected. They
also have the power to not vote in favor of a resolution; due to a lack in the majority,
the resolution may not be passed. Examples of a resolution put to vote include: the
number of shares to buyback, merger of a company, winding up of a division etc.
• Non-controlling shareholders are minority shareholders who hold a relatively smaller
proportion of a company’s outstanding shares. They have limited voting rights.
Creditors
Creditors are suppliers of debt financing to a company such as bondholders and banks. Some
of the key characteristics and rights of creditors are listed below:
• Unlike equity shareholders, they do not have voting rights.
• They have limited influence over a company’s operations.
• They may impose restrictions on what a company can and cannot do through
covenants.
• In return for the capital provided, they expect to receive periodic interest payments
and repayment of principal at the end.
• Unlike equity shareholders, they do not directly benefit from a company’s strong
performance and prefer stability in a company’s cash flows.
Managers and Employees
Senior managers and employees are compensated for their work at a company through
salary and bonuses linked to individual and company performance, stock options etc. Lower
level employees seek fair salary, career development through training, good working
conditions, promotion etc. Managers and employees are directly affected by a company’s
performance. They can expect to receive a good payout when the company does well and
similarly face layoffs when the performance is poor. They have conflicting interests with
other stakeholders in situations like a takeover.
Board of Directors
A company’s board of directors is elected by the company’s shareholders to protect their
interests, monitor the company’s operations and performance of the management, and
participate in strategic discussions about the company. Directors are experienced
individuals and often experts in their fields who enjoy a good reputation in the business
community. They must keep a tab on the company’s operations to ensure shareholders’
interests are protected. There are two types in which a board is often structured:
• One-tier structure comprises a single board of directors. Executive directors
(internal) are either employees or senior managers of a company. Non-executive
directors (external) are not employees of the company. This type of board structure is

often found in India, the United States, and the United Kingdom.
• Two-tier comprises two boards: a supervisory board of primarily non-executive
directors, and a management board of executive directors. The supervisory board
monitors the management board. This type of board structure is often found in
Germany, China, Finland etc.
Customers
Customers expect to receive products and services of good quality for the price paid. They
also expect after-sales service, support and guarantee/warranty for the period promised. In
return, companies strive to keep their customers happy as this has a direct effect on its
revenues. Of all the stakeholders, customers are least concerned about a company’s
performance.
Suppliers
A supplier's interest in a company is limited to being paid for the products and services
supplied to a company. Some suppliers are keen to maintain a good long-term relationship
with companies as it is recurring business. Suppliers are primarily concerned that a
company has a good operating performance and steady cash flow so as to pay their dues.
Governments/Regulators
Government is a stakeholder as it collects taxes from companies. It is in the interest of
governments and regulators to pass laws and regulations to ensure the interests of the
investors are protected. The state of a country’s economy, output, import/export,
employment, and capital flows are all affected by how well companies function in a country.
3.2. Principal-Agent and Other Relationships in Corporate Governance
A principal-agent relationship arises when a principal hires an agent to carry out a task or a
service. An agent is obliged to act in the best interests of the principal and should not have a
conflict of interest in performing a task. However, in reality, there are several conflicts of
interest that arise in a principal-agent relationship and we look at a few of them in this
section.
Shareholder and Manager/Director Relationships
In this relationship, shareholders are the principals and managers/directors are the agents.
Shareholders elect the board of directors and assign them the responsibility to act in their
best interests by maximizing equity value. Examples of situations that may lead to a conflict
of interest between shareholders and managers/directors are as follows:
• Firm value versus personal benefits of managers: Investors want the firm value to be
maximized, whereas managers are more interested in maximizing their
compensation.

• Levels of risk tolerance: Investors with diversified portfolios may have the ability to
tolerate higher levels of risk taken by a specific company in their portfolio as the risk
will be diversified. Managers and directors, however, tend to play safe and avoid
taking risky decisions so as to protect their employment.
• Information asymmetry: Managers have greater access to information, and they may
leverage this knowledge to make decisions that are not necessarily aligned with the
best interests of the shareholders.
• Insider influence: If insiders exert influence over directors which prevents them from
exercising control or monitoring properly, then this leads to a conflict of interest.
• Preferential treatment of shareholders: If directors are biased towards certain
powerful investors, then it will not be fair to the other shareholders.
Controlling and Minority Shareholder Relationships
Controlling shareholders are shareholders with a controlling stake and significant authority
to influence decision making in a company. Minority shareholders, on the other hand, have
limited or no control over the management. Situations where the two ownership structures
lead to a conflict of interest are as follows:
• Electing board of directors: Controlling shareholders have greater representation and
influence in electing the board of directors that use straight voting. As a result,
minority shareholders do not have much representation on the board.
• Impact on corporate performance: Corporate decisions taken by controlling
shareholders impact the performance of a company, and consequently, shareholders’
wealth. Controlling shareholders exercise their influence on significant decisions such
as takeover transactions.
• Related-party transactions: When a controlling shareholder enters into a financial
transaction between the company and a related third-party supplier that is not in the
best interests of the company, it leads to conflicting interests for the minority
shareholders. For example, if the third party supplier is a relative/spouse of the
controlling shareholders who supplies products at above-market prices, then the
controlling shareholder stands to gain at the expense of the company/minority
shareholders.
• Difference in voting powers: An equity structure with multiple share classes tends to
assign superior voting powers to one class and limited voting rights to other classes
leading to a conflict of interest.
Manager and Board Relationships
The management of the company is primarily responsible for the operations of a company
and has access to all information about the company. Since the board relies on the
management for information, its powers and monitoring ability is limited if information is

withheld by the management or only selective information is passed.

Shareholder versus Creditor Interests
There is a conflict of interest between the two suppliers of capital to a company under the
following circumstances:
• Distribution of dividends: Creditors are concerned if a company pays excess dividends
to shareholders that may impair its ability to service debt.
• Risk tolerance: Shareholders have a higher risk tolerance and prefer a company takes
on more risk to generate higher returns. Better the performance of a company, the
higher is the return shareholders can expect. Creditors are conservative and prefer a
stable operating cash flow over higher returns as they do not have a claim to residual
income.
• Increased borrowing: When a company increases its borrowing and fails to generate
returns to service the debt, then the default risk faced by the creditors increases.
Other Stakeholder Conflicts
Examples of other conflict of interests among other stakeholders are as follows:
• Conflict between customers and shareholders: When a company charges higher prices
for its products but lowers its safety features.
• Conflict between customers and suppliers: When a company offers lenient credit terms
to customers that affects its ability to pay suppliers.
• Conflict between shareholders and governments/regulators: When a company uses
reporting practices to reduce its tax burden that benefits shareholders.
4. Stakeholder Management
Stakeholder management deals with identifying, prioritizing, communicating, effectively
engaging and managing the interests of various stakeholder groups and their relationships
with a company.
4.1. Overview of Stakeholder Management
A stakeholder management framework to balance the interests of various stakeholder
groups consists of the following:
• Legal infrastructure: This defines the rights allowed by law and the course of action
one can take for violation of these rights.
• Contractual infrastructure: This defines the contractual agreement a company and its
stakeholders enter into with the objective that the rights of both the parties are
defined and protected.
• Organizational infrastructure: This defines the internal systems, procedures, and
processes a company follows to manage its relationships with its stakeholders.

• Governmental infrastructure: This refers to the regulations imposed on companies.

4.2. Mechanisms of Stakeholder Management
Though governance practices for managing the interest of all stakeholders may vary from
company to company and across countries, there are some common control elements and
practices that are listed below:
1. General Meetings
General meetings provide an opportunity to shareholders to exercise their vote on major
corporate issues. There are typically two types of general meetings:
• Annual general meetings: These are usually held within a certain period after the end
of the fiscal year. During an AGM, a company’s annual performance is presented and
discussed, and shareholders’ questions are answered.
• Extraordinary general meetings: These can be called anytime during the year either by
the company or shareholders whenever a major resolution has to be passed such as
an amendment to a company’s bylaws, mergers or acquisitions, or the sale of
businesses.
Number of votes required may be one of the following two types based on the type of
resolution to be passed:
• For simple decisions, a simple majority of votes is sufficient.
• For material decisions, a supermajority vote is required, i.e. 75% of the votes must be
in favor of a resolution to be passed.
Proxy voting allows shareholders to authorize another individual to vote on their behalf at
the AGM. In cumulative voting, shareholders may accumulate their votes to vote for one
candidate in an election that involves more than one director.
2. Board of Director Mechanisms
The board is the bridge between shareholders and the management of the company. Since
shareholders cannot be involved in every decision or day to day operations of the company,
they exercise their voting rights to elect a board of directors that will participate in strategic
decisions, oversee operations, perform audits, monitor management’s actions, and ensure
governance systems are in place.
3. The Audit Function
The audit function refers to the controls, systems and processes in place to ensure the
company’s financial reporting/records are accurate. The objective is to prevent fraudulent
reporting of financial information. There are two types of audits: internal and external.
Internal audits are performed by an independent internal audit department, while external
audits are conducted by independent auditors not associated with the company. The board

of directors reviews the auditors’ reports for fairness and accuracy before presenting the
financial statements to shareholders at the AGM.
4. Reporting and Transparency
Shareholders have access to all audited financial information of a company, its strategy,
governance policies, remuneration policies and other information through the company’s
financial statements, website, press releases etc. They use this information to assess a
company’s performance, evaluate whether to buy or sell the shares of a company, and vote
on key corporate issues.
5. Policies on Related-party Transactions
Policies on related-party transactions require directors and managers to disclose any
transactions they have with the company that is a conflict of interest. Any transaction with a
potential conflict of interest must be cleared by the board excluding the director who has an
interest.
6. Remuneration Policies
Remuneration packages have evolved from including variable components such as options
and profit sharing to more restrictive ones such as granting shares that can be vested only
after several years or remuneration only after certain objectives are met. The objective is to
align the interests of executives with the interests of shareholders and prohibit them from
taking excessive risks for personal gains.
7. Say on Pay
Say on pay is what the term literally means; that is, the shareholders may express their
views and vote on the remuneration of executives. First introduced in the United Kingdom in
the early 2000s, it is now a widely accepted concept worldwide. Of course, whether the
board accepts the shareholders’ views on pay varies from country to country, and is non-
binding in many countries such as Canada, the United States, South Africa etc.
8. Contractual Agreements with Creditors
There are laws that often vary by jurisdiction, to protect creditors’ interests. Some of the
most common provisions are:
• Indenture: It is a legal contract that defines the bond structure, the obligations of the
issuer and the rights of the bondholders.
• Covenants: These are terms specified within a bond indenture that state what a bond
issuer may and may not do. The objective is to limit the risk of bondholders.
• Collaterals: These are financial guarantees that may be used to repay bondholders if
an issuer defaults on periodic payments.
• Periodic information: Creditors expect the company to provide periodic financial

information to monitor the risk exposure and ensure covenants are not violated.
9. Employee Laws and Contracts
Standard rights of employees in any country such as hours of work, pension and retirement
plans, vacation and leave are defined in labor laws. Companies strive to manage
relationships with its employees to protect their best interests and avoid legal repercussions
on violation of these rights. Employees form unions in many countries to collectively
influence the management on issues they may face. Individual employee contracts define an
employee’s rights and responsibilities, remunerations and other benefits such as ESOPs.
Companies might establish a code of ethics which defines the ethical behavior expected of
employees.
10. Contractual Agreements with Customers and Suppliers
Companies enter into contracts with both customers and suppliers that define the products,
services, guarantee if any, after-sales support, payment terms etc. It also defines the course
of action in case one party violates the contract.
11. Laws and Regulations
Governments and regulatory agencies pass laws to protect the interests of consumers or
specific stakeholders. Sensitive industries such as banks, health care and food manufacturing
companies have to comply with a rigorous regulatory framework.
5. Board of Directors and Committees

In this section, we look at the functions and responsibilities of a company’s board of
directors.
5.1. Composition of the Board of Directors
There is no standard structure or composition for the board of a company. It varies by
company size, complexity of operations and geography. Some common board structures are
discussed below:
• One-tier structure: It is a mix of executive (internal) and non-executive (external)
directors.
• Two-tier structure: Consists of two tiers, a supervisory board and a management board.
Members serving on one board are generally restricted from serving on other board, or
there is a limit on members that can serve on both boards.
• CEO Duality: CEO duality is when the CEO also serves as the chairperson. The roles are
usually kept separate in most countries to maintain independence. If there is no CEO
duality, then as an alternative, a lead independent director is appointed to oversee the
functioning of independent directors.
Staggered board is a commonly followed practice where directors are divided into three

groups and elected into office in consecutive years, so that all of them are not replaced
simultaneously.
5.2. Functions and Responsibilities of the Board
Two primary responsibilities of the board are:
• Duty of care: Requires board members to act on a fully informed basis, in good faith,
with due diligence and care.
• Duty of loyalty: A board member must act in the best interests of the company and
shareholders, and not act in their own self-interest.
Other responsibilities of the board are as follows:
• Guides and approves the company’s strategic direction.
• Evaluates the performance of senior executives.
• Ensures effectiveness of audit and control systems.
• Ensures that an appropriate enterprise risk management system is in place.
• Reviews proposals for corporate transactions and changes.
5.3. Board of director Committees
The board of directors delegate specific functions to individual committees that, in turn,
report to the board on a regular basis. The number of committees and their composition may
vary based on jurisdiction and industry. Some committees such as the audit is a regulatory
requirement in most jurisdictions.
Audit Committee
The functions of the audit committee are as follows:
• Oversee the audit and control systems.
• Monitor the financial reporting process.
• Supervise the internal audit function.
• Appoint the independent external auditor.
Governance Committee
The functions of the governance committee are as follows:
• Develop and oversee implementation of good corporate governance policies and code
of ethics.
• Periodically review and update the policies for any regulatory changes.
• Ensure compliance of the policies.
Remuneration or Compensation Committee
The functions of the remuneration committee are as follows:
• Develop remuneration policies for directors and executives, and present them to the
board for approval.

• Set performance criteria for managers and evaluate their performance.

• Oversee implementation of employee benefit plans, pension plans and retirement
plans.
Nomination Committee
The functions of the nomination committee are as follows:
• Identify and recommend qualified candidates who can serve as directors.
• Establish nomination procedures and policies to keep the board independent as per
good governance principles.
Risk Committee
The risk committee is responsible for defining the risk policy and risk appetite of the
company. It monitors the implementation of risk management, periodically reviews, reports,
and communicates its findings to the board.
Investment Committee
The functions of the investment committee are as follows:
• Review investment plans proposed by the management, such as new projects,
acquisitions and expansion plans, and divestitures.
• Formulating the investment strategy and policies for a company.
6. Factors Affecting Stakeholder Relationships and Corporate Governance

6.1. Market Factors
Among the market factors that affect stakeholder relationships in a company, we focus on
shareholder engagement, shareholder activism, and competitive forces.
Shareholder Engagement
Companies engage with shareholders periodically through events such as annual general
meetings and analyst calls to primarily discuss financial performance and any strategic
issues. However, companies see a benefit in interacting with them more often to counter
negative recommendations.
Shareholder Activism
Shareholder activism refers to the tactics used by shareholders to influence companies to act
in their favor. Often, their primary objective is to increase shareholder value. The strategies
used by shareholders include shareholder derivative lawsuits, proxy battles, proposing
shareholder resolutions and publicity on issues of contention.
Competition and Takeovers
Shareholders prefer corporate takeover if the management of a company underperforms.

The commonly used methods for corporate takeovers are as follows:

• Proxy contest: A group attempting to take a controlling position on a company’s board
of directors influences shareholders to vote for them.
• Tender offer: An offer by a group seeking to gain control to purchase a shareholder’s
shares.
• Hostile takeover: One company tries to acquire another company by bypassing the
management and directly going to the company’s shareholders.
6.2. Non-market Factors
This section focuses on non-market factors that affect stakeholder relationships, such as a
company’s legal environment, media’s role, and the corporate governance industry.
Legal Environment
The rights of stakeholders depend on the law of the country the company operates in. There
are primarily two law systems.
• Common law system: This is considered to offer better protection for stakeholders as
laws can be created both by legislature and judges. This system is found in the United
Kingdom, United States, India etc.
• Civil law system: This is considered restrictive for stakeholders as laws can be
created only by passing legislation.
Creditors are more successful in winning legal battles when the terms of indenture are
violated. In contrast, shareholders find it difficult to prove in court that a manager/director
has not acted in their best interests.
The Media
Regulators are keen on introducing corporate governance reforms or pass new laws to
protect the stakeholders, especially in the aftermath of 2008-09 financial crisis. Social media
is a low-cost, effective tool used by stakeholders to protect their interests, garner support on
corporate issues or use it for negative publicity against a corporate.
The Corporate Governance Industry
The corporate governance industry is a concentrated one. The genesis for the demand for
external corporate governance services was a rule introduced by the Securities and
Exchange Commission (SEC) in 2003. The SEC mandated that all US-registered mutual funds
must disclose their proxy voting records annually. As a result, institutional investors hire
experts to help them with proxy voting and corporate governance monitoring.

7. Corporate Governance and Stakeholder Management Risks and

Benefits
7.1. Risks of Poor Governance and Stakeholder Management
In this section, we analyze the risks a company faces due to poor governance structure.
Weak Control Systems
Weak control systems and poor monitoring can affect a company’s performance and value.
One example is that of Enron where auditors failed to uncover fraudulent reporting that
ultimately affected many stakeholders.
Ineffective Decision Making
Poor decisions include managers avoiding good investment opportunities to maintain a low
risk profile or taking on excessive risk without properly evaluating potential investments.
Both decisions are not in the interests of shareholders. Such decisions may result from:
• Information asymmetry: When managers have access to more information than board
members/shareholders.
• Outsized remuneration: High remuneration not aligned with long-term strategic goals
may result in managers taking excessive risks for personal gains.
• Related-party transactions: Transactions in which managers have a material interest
and is not in the interest of the company, will affect the value of the company.
Legal, Regulatory, and Reputational Risks
Improper implementation and monitoring of corporate governance procedures may result in
the following risks:
• Legal: Stakeholders such as shareholders, creditors, employees may file lawsuits
against the company if their rights are violated.
• Regulatory: Government/regulator may choose to take action if the applicable laws
are violated.
• Reputational: Company may be subjected to negative publicity by investors/analysts
if there is an improperly managed conflict of interest.
Default and Bankruptcy Risks
Poor corporate governance may affect the company’s performance, which in turn may affect
the company’s ability to service its debt. If creditors’ rights are violated and they choose to
take legal action on defaulting debt, the company may be forced to file for bankruptcy.
7.2. Benefits of Effective Governance and Stakeholder Management
The benefits of good corporate governance and balancing the interests of managers, board
members, company’s stakeholders and shareholders are as follows:
• Operational efficiency: Good governance structure ensures all employees of a

company have a clear understanding of their responsibilities and reporting

structures. The operational efficiency of a company is improved when good
governance structure is combined with strong internal control mechanisms.
• Improved control: Good governance implies improved control at all levels to help a
company manage its risk efficiently. Control can be improved with a good audit
committee, complying with laws and regulations, and introducing procedures to
handle related-party transactions.
• Better operating and financial performance: A company’s operating and financial
performance can be improved with good governance practices. Proper remuneration
for management, mitigation of lawsuits against the company, and improving the
decision making of its managers to make the right investments are ways that will help
in improving the performance of a company.
• Lower default risk and cost of debt: A company’s cost of debt and default risk can be
reduced by protecting creditors’ rights, ensuring proper audits are conducted, and
there is no information gap between the company and its creditors.
8. Analyst Considerations in Corporate Governance and Stakeholder

Management
In the aftermath of several corporate scandals in the early 2000s and global financial crisis of
2008-09, fundamental analysts have now begun focusing on corporate governance issues as
part of their analysis of a company. In this section, we look at the areas analysts focus on
when assessing a company’s corporate governance and stakeholder management system.
8.1. Economic Ownership and Voting Control
Analysts must examine the voting structure of publicly traded companies. Any structure
where voting power is not equal to the percentage of shares owned or one vote for one share
results in risks for investors. Examples of voting structures where economic ownerships are
separate from control are as follows:
• Dual-class structures: In this structure, there are two classes where one class has a
superior voting power than the other. For example, one class may carry one vote per
share, whereas another may carry several votes per share.
• Electing board members: Another mechanism is where one class of stock has the
power to elect a majority of the board, while another class has the right to elect only a
minority of the board.
8.2. Board of Directors Representation
Analysts assess whether the experience, tenure, diversity and skills of current board of
directors match the current and future needs of the company. The curriculum cites the
example of a European pharmaceutical company going through financial distress. The
company’s performance turned around for the better when non-executive directors with

financial expertise were added to the board. Several years later, when a medical crisis hit the
company, the company failed to respond by bringing in someone with medical expertise to
the board. The shares fell as they continued to retain the previous directors.
8.3. Remuneration and Company Performance
If information on executives’ remuneration is available, then analysts must assess whether
the remuneration plans are aligned with the performance drivers of the company. Some of
the warning signs analysts must look out for are as follows:
• Plans such as cash payout and no equity, offer little alignment with shareholders.
• Performance-based plans that have a full payout irrespective of a company’s
performance.
• Plans that have an excessive payout relative to comparable companies with a
comparable performance.
• Remuneration plans or payouts that are based on achieving specific strategic
objectives. Analysts must assess whether these are also aligned with company’s long-
term objectives. For example, FDA approval for a drug, or cost savings on a
production process.
• Plans based on incentives from an earlier period in the company’s life cycle. For
example, remuneration plans for executives in a company that is currently in mature
phase is still based on revenue growth as earlier.
8.4. Investors in the Company
Analysts must assess the composition of investors in a company. They must examine, in
particular, if the following types of investors are present as it can affect the outside
shareholders:
• Cross-shareholdings where a large publicly traded company holds a minority stake in
another company.
• Affiliated stakeholder can protect a company from results of voting by outside
shareholders.
• Activist shareholders have the ability to change the shareholder composition in a short
span of time.
8.5. Strength of Shareholders’ Rights
Analysts must assess whether the shareholder rights of a company are strong, average or
weak relative to investors’ right of other comparable companies. They must assess if
shareholders have the rights to remove the directors from a board or support/resist external
initiatives.
8.6. Managing Long-Term Risks
Analysts must assess the management quality of the company to understand how it manages

long-term risks. There are several instances where poor management of long-term risks has
resulted in a fall of share prices and negatively impacted the company’s reputation. Poor
management may result in repeated fines, lawsuits, regulatory investigations etc.
9. ESG Considerations for Investors

The curriculum defines ESG integration as the practice of considering environmental, social,
and governance factors in the investment process. Some of the terms related to ESG
integration are defined below:
• Sustainable investing and responsible investing: These terms are used interchangeably
with ESG integration.
• Socially responsible investing: This refers to the practice of excluding investments that
are against the moral values of investors such as investing in tobacco companies.
• Impact investing: This refers to the practice of investing in companies with an
objective of meeting social or environmental targets along with financial returns.
9.1. ESG Market Overview
There is a growth in awareness about ESG related issues among investors because of huge
losses as a result of environmental disasters and class action lawsuits in recent times. The
curriculum cites the example of the 2010 explosion of the Deepwater Horizon oil rig in the
Gulf of Mexico, which resulted in a loss of life, and tens of billions of dollars in fines to BP plc.
9.2. ESG Factors in Investment Analysis
The environmental and social factors considered in investment analysis are listed below:
Environmental factors
• Natural resource management.
• Pollution prevention.
• Water conservation.
• Energy efficiency and reduced emissions.
• Existence of carbon assets.
• Compliance with environmental and safety standards.
Social factors
• Human rights and welfare concerns in the workplace: staff turnover, employee
training and safety, keeping the morale of employees high and employee diversity are
factors that can potentially affect a company’s competitive advantage.
• Product development.
• Minimizing social risks is beneficial to a company as it can lower company’s costs.
9.3. ESG Implementation Approaches
Some of the methods for implementing ESG are as follows:

• Negative screening: This is the practice of avoiding certain sectors or companies

that violate accepted environmental and social standards. For example, companies
engaged in fossil fuel extraction or garment companies employing child labor.
• Positive screening and best-in-class: Positive screening strategy focuses on
companies that follow good ESG principles in their operations. For instance, these
companies may have policies focusing on the well-being and safety of its employees,
and strive towards protecting employee rights. Best-in-class approach does not
exclude any industry; instead, it identifies investments based on the highest ESG-
scores.
• ESG integration or ESG incorporation: This refers to the integration of qualitative
and quantitative ESG factors into traditional security and industry analysis. The focus
is to determine if a company is properly managing its ESG resources.
• Thematic investing: This strategy picks investments based on a theme or single
factor, such as energy efficiency or climate change. An increasing trend world over is
the increasing demand for energy and water. Companies that provide solutions to
these socio-economic problems make for attractive investments.
• Impact investing: As we saw earlier, impact investing combines social and
environmental objectives with generating economic profit. Though there are many
ways of executing impact investing, two common approaches are through venture
capital investing and purchase of climate bonds and green bonds.

Summary
LO.a: Describe corporate governance.
Corporate governance refers to the system of controls and procedures by which individual
companies are managed. It outlines the rights and responsibilities of various groups and
how conflicts of interest among the various groups are to be resolved.
LO.b: Describe a company’s stakeholder groups and compare interests of stakeholder
groups.
The primary stakeholders of a company includes:
• Shareholders
• Creditors
• Managers and employees
• Board of Directors
• Customers
• Suppliers
• Government/Regulators
LO.c: Describe principal–agent and other relationships in corporate governance and
the conflicts that may arise in these relationships.
A principal-agent relationship arises when a principal hires an agent to carry out a task or a
service. An agent is obliged to act in the best interests of the principal and should not have a
conflict of interest in performing a task. However, such relationships often lead to conflicts
among stakeholders in a corporate structure. Examples of relationships that lead to such
conflicts include:
• shareholder and manager/director.
• controlling and minority shareholder.
• manager and board.
• shareholder and creditor.
• customers and shareholders.
• customers and suppliers.
• shareholders and governments/regulators.
LO.d: Describe stakeholder management.
Stakeholder management deals with identifying, prioritizing, communicating, effectively
engaging and managing the interests of various stakeholder groups and their relationships
with a company. A stakeholder management framework to balance the interests of various
stakeholder groups consists of a legal, contractual, organizational, and governmental
infrastructure.

LO.e: Describe mechanisms to manage stakeholder relationships and mitigate

associated risks.
Mechanisms to manage stakeholders may include general meetings, a board of directors, the
audit function, reporting and transparency, policies on related-party transactions,
remuneration policies, say on pay, contractual agreements with creditors, employee laws
and contracts, contractual agreements with customers and suppliers, and laws and
regulations.
LO.f: Describe functions and responsibilities of a company’s board of directors and its
committees.
A company’s board of directors is elected by the company’s shareholders to protect their
interests, monitor the company’s operations and performance of the management, and
participate in strategic discussions about the company. The board of directors is the bridge
between shareholders and the management. The structure and composition of the board
vary by company size, complexity of operations and geography. The two primary
responsibilities of the board are duty of care and duty of loyalty. A company’s board of
directors delegates specific functions to individual committees that, in turn, report to the
board on a regular basis. The number of committees and their composition may vary based
on jurisdiction and industry. But, some committees are standard such as the audit
committee, governance committee, remuneration committee, nomination committee, risk
committee, and investment committee.
LO.g: Describe market and non-market factors that can affect stakeholder
relationships and corporate governance.
Stakeholder relationships and corporate governance are affected by a number of market and
non-market factors. Market factors include shareholder engagement, shareholder activism,
and competitive forces. Non-market factors include legal environment, the media, and the
corporate governance industry.
LO.h: Identify potential risks of poor corporate governance and stakeholder
management and identify benefits from effective corporate governance and
stakeholder management.
The risks of poor corporate governance include weak control systems, ineffective decision
making, legal, regulatory, and reputational risks, and default and bankruptcy risks. Benefits
include operational efficiency, improved control, better operating and financial performance,
and lower default risk and cost of debt.
LO.i: Describe factors relevant to the analysis of corporate governance and
stakeholder management.
Key factors considered by analysts in corporate governance and stakeholder management

include economic ownership and voting control, board of directors representation,

remuneration and company performance, investor composition, strength of shareholders’
rights, and the management of long-term risks.
LO.j: Describe environmental and social considerations in investment analysis.
ESG integration is the practice of considering environmental, social, and governance factors
in the investment process. Several terms used interchangeably and associated with ESG
integration are sustainable investing, responsible investing, socially responsible investing,
and impact investing.
LO.k: Describe how environmental, social, and governance factors may be used in
investment analysis.
Four often used ESG methods in investment analysis are negative screening, positive
screening and best-in-class, thematic investing, and impact investing. Negative screening
excludes certain industries or sectors that violate ESG standards. Positive screening favors
investments that follow good ESG principles. Thematic investing picks investments based on
a theme or single factor, such as energy efficiency or climate change. Impact investing
combines social and environmental objectives with generating economic profit.

Practice Questions
1. Which of the following is the most appropriate definition of corporate governance?
A. A system of defined roles for management and the majority shareholders.
B. A system of checks and balances to minimize the conflicting interests among
shareholders.
C. A system of internal controls and procedures by which individual companies are
managed.
2. Which group of stakeholders is least likely to benefit from an increase in the market value
of a company?
A. Company management.
B. Customers.
C. Shareholders.
3. A company is making a takeover bid on a rival firm and the valuators have proposed a
bid at a premium of 50% to the target's share price. The company is currently owned
70% by a majority shareholder and the remaining ownership is fragmented among small
shareholders. The above scenario can result in a conflict between:
A. controlling shareholder and management.
B. shareholders and the government.
C. controlling shareholder and minority shareholders.
4. Which of the following is not a stakeholder management infrastructure?

A. Legal infrastructure.
B. Environmental infrastructure.
C. Contractual infrastructure.
5. Which of the following is least likely to be done at an extra-ordinary general meeting?

A. Amendments to a company's bylaws.
B. Voting on a merger transaction.
C. Approval of financial statements.
6. Which of the following is a mechanism to protect the rights of creditors?

A. Proxy voting.
B. Regulations to protect the environment.
C. Collateral to secure a loan.
7. Which of the following committees is most likely responsible for establishing criteria for
appointment of board of directors and search process?

A. Nominations committee.
B. Governance committee.
C. Remuneration committee.
8. Shareholder activism is most likely facilitated by:

A. staggered boards.
B. cross-shareholdings.
C. cumulative voting.
9. Following information is provided for a publicly listed company.

• The company has an 8-person board of directors.
• The board is chaired by the chief executive officer (CEO) of the company.
• All members of the audit committee are outside directors with relevant financial and
accounting experience.
Which of the following changes will significantly improve the corporate governance of
this company?
A. The company’s Vice President of Finance should be a member of the audit
committee.
B. The board of directors should have an odd number of directors to preclude tied
votes.
C. The chairman of the board should be an independent director.
10. Which of the following can create a divorce between ownership and voting control?
A. A skewed shareholding structure where one shareholder owns majority of the
company's shares.
B. Dual class of shares with different voting rights.
C. Equal voting power of all outstanding shares.
11. Considering a single factor in investment, such as energy efficiency or climate change is
known as:
A. best in class.
B. thematic investing.
C. impact investing.

Solutions
1. C is correct. Corporate governance is the system of internal controls and procedures by

which individual companies are managed.
2. B is correct. An increase in market value of a company can benefit management because

their compensation is likely to be linked with company value. Shareholders directly
benefit from higher market value. Customers are least likely to benefit from an increase
in market value of the company.
3. C is correct. In the given ownership structure the controlling shareholder would have
more influence than minority shareholder and can use this position to the disadvantage
of minority shareholders.
4. B is correct. The stakeholder management framework includes legal infrastructure,

contractual infrastructure, organizational infrastructure and governmental
infrastructure.
5. C is correct. Approval of financial statements requires simple majority and is done at

ordinary general meetings and do not require an extra-ordinary general meeting.
6. C is correct. Collateral to secure a debt is used to protect creditors.
7. A is correct. The nomination committee establishes criteria for the board of directors and
the search process.
8. C is correct. Cumulative voting facilitates shareholder activism because it allows

shareholders to accumulate and vote all their shares for a single candidate in an election
involving more than one candidate. Minority shareholders, who may be activist
shareholders, are more likely to successfully elect a board member in this way.
9. C is correct. To ensure good governance practices, the chairman of the board and the CEO
of the company should be independent. Otherwise, if the chair of the board is a CEO of
the company, it may hamper the efforts to undo the mistakes made by him as a chief
executive.
10. B is correct. Dual share classes with different voting rights can create a divorce between
ownership and voting control.

11. B is correct. Thematic investing strategies typically consider a single factor, such as
energy efficiency or climate change.

R34 Capital Budgeting 2019 Level I Notes
R34 Capital Budgeting

1. Introduction
Capital budgeting is the process that companies use for decision making on long-term
projects.
Capital budgeting is important because:
• It helps decide the future of many corporations. Most capital investments require
huge investments that are not easy to reverse.
• It can be adopted for many other corporate decisions such as investment in working
capital, leasing, and mergers and acquisitions.
The valuation principles used in capital budgeting are used in security valuation and
portfolio management. These principles deal with projecting and then discounting cash
flows to determine if the project adds value. Capital budgeting decisions are consistent with
the management goal of maximizing shareholder value.
2. The Capital Budgeting Process
Steps in Capital Budgeting Process
The steps in the capital budgeting process are as follows:
Step 1 - Generating ideas: Most important step in the process. Investment ideas can come
from anywhere within the organization, or outside (customers, vendors etc.). What projects
can add value to the company in the long term?
Step 2 - Analyzing individual proposals: Gathering information to forecast cash flows for
each project and then computing the project’s profitability. Output of this step: List of
profitable projects.
Step 3 - Planning and capital budgeting: Do the profitable projects fit in with the company’s
long-term strategy? Is the timing appropriate? Some projects may be profitable in isolation
but not so much when considered along with the other projects. Scheduling and prioritizing
of projects is important.
Step 4 - Monitoring and post audit: Post-audit helps in assessing how effective the capital
budgeting process was. How do the actual revenues, expenses and cash flows compare
against the predictions? Post-auditing is useful in three ways:
• If the predictions were optimistic or too conservative, then it becomes evident here.
• Helps improve business operations. Puts the focus on out-of-line sales and costs.
• Helps in identifying profitable areas for fresh investments in the future, or scale down
in non-profitable ones.
Categories of Capital Budgeting Process
Capital budgeting projects may be divided into the following categories:

• Replacement projects: Analyzing whether the replacement of existing equipment

would be profitable.
• Expansion projects: Constructing a new plant or expanding capacity of the existing
one.
• New products and services: Diversifying current business operations to maintain a
competitive edge.
• Mandatory projects: Regulatory, safety and environmental laws mandated by a
governmental agency or an insurance company.
• Other projects: Pet projects of senior management or high-uncertainty projects like
R&D projects that are difficult to analyze using the traditional methods.
3. Basic Principles of Capital Budgeting
The following are the five key principles of capital budgeting:
1. Decisions should be based on incremental cash flows (not on accounting income as it
is based on accrual basis):
• Exclude sunk costs: For example, already incurred costs like preliminary
consulting fees should not be included in the analysis.
• Include externalities - Both positive/negative externalities should be considered
in the analysis. For example, negative impact of a new diet soda product launch on
the sales of existing soda products.
• A project has conventional cash flows, if the sign of cash flows changes only once
during the life of the project; while an unconventional cash flow project has more
than one sign change.
2. Timing of cash flows is vital: Due to time value of money, cash flows received earlier
are more valuable than cash flows received later.
3. Cash flows are based on opportunity cost: For example, if you plan to use an existing
office space rather than renting it out, then rental income from an office space is an
opportunity cost.
4. Cash flows are analyzed on an after-tax basis: Shareholder value increases only on the
cash that they have earned. Hence, any tax expenses must be deducted from the cash
flows.
5. Financial costs are ignored: Financial costs are already included in the cost of capital
(discount rates) used to discount cash flows to arrive at the present value. Hence, to
avoid double-counting, they must not be deducted from the cash flows.
Independent projects vs. mutually exclusive projects: Independent projects are
unrelated projects that can be analyzed separately, while mutually exclusive projects
compete with each other. Two independent projects can both be executed if they
individually meet the criteria. If two projects are mutually exclusive, then either of the two

can be undertaken, not both.

Project sequencing: Certain projects are linked through time, i.e. completion of one project
creates an opportunity to invest in another project later based on its profitability.
Unlimited funds vs. capital rationing: A firm can undertake all profitable projects if it has
access to unlimited funds. A company having limited capital however, must prioritize and
allocate funds to projects that maximize shareholder value.
4. Investment Decision Criteria
4.1. Net Present Value
Net present value is the present value of the future after tax cash flows minus the investment
outlay.
CF1 CF2 CF3
NPV = CF0 + [ 1
]+ [ 2
]+ [ ]
(1 + r) (1 + r) (1 + r)3
Decision rule:
For independent projects:
If NPV > 0, accept.
If NPV < 0, reject.
For mutually exclusive projects:
Accept the project with higher and positive NPV.
Example
Compute NPV for projects A and B given the following data:
Cost of capital = 10%
Expected Net after Tax cash flows
Year Project A (in $) Project B (in $)
0 -1,000 -1,000
1 500 100
2 400 300
3 300 400
4 100 600
Solution:
Project A:
500 400 300 100
NPV = -1000 + + 1.12 + 1.13 + 1.14 = 78.82
1.1
On the exam, you can save time by using the calculator to solve for NPV instead of using the
above formula. The key strokes are given below:
Key strokes Display
[CF][2nd][CLR WORK] CF0 = 0
1000 [+|-] [ENTER] CF0 = -1000

[↓] 500 [ENTER] C01 = 500

[↓] F01 = 1
[↓] 400 [ENTER] C02 = 400
[↓] F02 = 1
[↓] 300 [ENTER] C03 = 300
[↓] F03 = 1
[↓] 100 [ENTER] C04 = 100
[↓] F04 = 1
[NPV] 10 [ENTER] I = 10
[↓] CPT NPV = 78.82
Project B:
100 300 400 600
NPV = -1000 + + 1.12 + 1.13 + 1.14 = 49.18
1.1
4.2. Internal Rate of Return (IRR)

IRR is the discount rate that makes the present value of future cash flows equal to the
investment outlay; we can also say that IRR is the discount rate which makes NPV equal to 0.
Decision rule:
For independent projects:
If IRR > required rate of return (usually firms cost of capital adjusted for projects
riskiness), accept the project.
If IRR < required rate of return, reject the project.
For mutually exclusive projects:
Accept the project with higher IRR (as long as IRR > cost of capital).
Example
Compute IRR for projects A and B given the following data.
Cost of Capital = 10%; Expected Net After Tax Cash Flows
Year Project A (in $) Project B (in $)
0 -1,000 -1,000
1 500 100
2 400 300
3 300 400
4 100 600
Solution:
Project A:
A very tedious method is to set up the equation below and solve for r using trial and error.
500 400 300 100
1000 = 1 + r + (1 + r)2 + (1 + r)3 + (1 + r)4 r = 14.49%
A much faster method is to use the calculator:
Key strokes Display

[CF][2nd][CLR WORK] CF0 = 0

1000[+|-] [ENTER] CF0 = -1000
[↓] 500 [ENTER] C01 = 500
[↓] F01 = 1
[↓] 400 [ENTER] C02 = 400
[↓] F02 = 1
[↓] 300 [ENTER] C03 = 300
[↓] F03 = 1
[↓] 100 [ENTER] C04 = 100
[↓] F04 = 1
[IRR][CPT] 14.49
Project B:
100 300 400 600
1000 = 1 + r + (1 + r)2 + (1 + r)3 + (1 + r)4 r = 11.79%
4.3. Payback Period

The payback period is the number of years it takes to recover the initial cost of the
investment.
Advantages:
• Easy to calculate.
• Easy to explain.
• Indicator of project liquidity. A project with two-year payback is more liquid than one
with a longer payback period as the initial investment is recovered more quickly.
Drawbacks:
• Does not consider cash flows after payback period.
• It does not consider the time value of money as the cash flows are not discounted at
the project’s required rate of return.
• Does not consider the risk of a project.
4.4. Discounted Payback Period
Discounted payback method uses the present value of the estimated cash flows; it gives the
number of years to recover the initial investment in present value terms.
Drawbacks of discounted payback method:
• Does not consider any cash flows beyond the payback period.
• Poor measure of profitability as there may be negative cash flows after the
discounted payback period which may result in a negative NPV.
Example 3
Compute the payback period and the discounted payback period assuming a rate of 10%.

Year 0 1 2 3 4
Cash flows -800 340 340 340 340
Solution:
Year 0 1 2 3 4
Cash flows -800 340 340 340 340
Cumulative -800 -460 -120 220 560
Cash flows
Discounted -800 309.1 280.99 255.45 232.22
Cash flows
Cumulative -800 -490.9 -209.91 45.54 277.76
Discounted
Cash flows
Payback period = Last year with negative cumulative cash flow + unrecovered cost at the
beginning of the next year/ cash flow in the next year
120
Payback period = 2 + 340 = 2.35 years
209.91
Discounted payback period = 2 + 255.45 = 2.82 years
The discounted payback period is always going to be greater than the payback period, as
long as the interest rate is positive. If the interest rate is 0%, both payback periods will be
the same.
4.5. Average Accounting Rate of Return
The average accounting rate of return (AAR) can be defined as:
Average net income
Average accounting rate of return = Average book value
4.6. Profitability Index

Profitability Index is the present value of a project’s future cash flows divided by the initial
investment.
PV of future cash flows
Profitability Index PI = Initial Investment
NPV
Profitability Index PI = 1 + Initial investment
Investment decision rule for PI:

Invest if PI > 1.
Do not invest if PI < 1.
Difference between PI and NPV
Consider two projects A and B. Project A has an initial investment of $1 million and an NPV

of 0.1 million. Project B has an initial investment of $1 billion and an NPV of 0.2 million. If
projects A and B are mutually exclusive, then project B would be chosen because of higher
NPV. But, if you consider the profitability index, it gives a different picture.
PI of project A = 1 + 0.1/1 = 1.1
PI of project B = 1 + 0.2 /1000 = 1.0002
Based on PI, project A is more profitable than project B.
4.7. NPV Profile
NPV profile is a graph that plots a project’s NPV for different discount rates. The NPV is
shown on the y-axis with the discount rates on the x-axis. Given the data below, create the
NPV profile for project X.
Year 0 1 2 3 4
Project -400 160 160 160 160
Discount rate NPV (in $ million)

0 240
5 167
10 107
22 0
Two important points on the graph:

1. The point where the profile goes through the Y-axis (250) is the NPV of the project
when the discount rate is 0. This is equal to the sum of the undiscounted cash flows.
2. The point where the profile goes through the X-axis (22) is where the discount rate is
equal to the IRR of the project.
Example 4
Draw the NPV profiles for projects X and Y. Discuss the significance of crossover point.

Year 0 1 2 3 4
Project X -400 160 160 160 160
Project Y -400 0 0 0 800
The NPV profile for projects X and Y at different discount rates is tabulated below. Based on
these values, the NPV profiles are depicted graphically.
Note: The values are computed for each discount rate using the calculator.
Discount Rate (in %) NPV for Project X NPV for Project Y
0 240 400
5 167.35 258.16
10 107.17 146.41
15 56.79 57.40
18.92 22.82 0
20 14.19 -14.19
21.86 0 -37.22
Let us plot the NPV profile for both the projects now.
NPV Profile for Projects X and Y

500
400
NPV in $ millions
300
200
100
0
0 5 10 15 20 25
-100
Discount rate in %
NPV for Project X NPV for Project Y
The point at which the NPV for both projects intersect is called the crossover point.
If X and Y are mutually exclusive, the discount rate is used to decide which project is better.
At lower discount rates; i.e. to the left of the crossover point, Project Y is better. At higher
discount rates; i.e. to the right of the crossover point, Project X is better. For example, at a
discount rate of 10%, Project Y is better, whereas at a discount rate of 20%, Project X is
better.
4.8. Ranking Conflicts between NPV and IRR
For single and independent projects with conventional cash flows, there is no conflict
between NPV and IRR decision rules. However, for mutually exclusive projects the two
criteria may give conflicting results. The reason for conflict is due to differences in cash flow
patterns and differences in project scale.

Example (Ranking conflict due to differing cash flow patterns)

The cash flow associated with Project X and Project Y is shown below:
Year 0 1 2 3 4
Project X -400 160 160 160 160
Project Y -400 0 0 0 800
1. Which project do you select according to the NPV rule using a rate of 10%?
2. Which project do you select according to the IRR rule?
3. Show the NPV profile for both projects.
Solution:
Let us first calculate the NPV and IRR for the two projects.
NPV (in $ millions) IRR (in %)
Project X 107.17 21.86
Project Y 146.4 18.92
1. Based on the NPV rule, the project with the highest NPV, project Y is selected.
2. Based on the IRR rule, the project with the highest IRR, project X is selected.
3. We saw the NPV profile for both projects in the previous example (crossover point).
Whenever NPV and IRR rank two mutually exclusive projects differently, you must
always choose the one with the higher NPV – in this case, project Y.
Reasons for going with NPV instead of IRR:
1. IRR incorrectly assumes that intermediate cash flows can be reinvested at the IRR rate.
Just because project X gives a return of 21.86%, it does not mean the intermediate cash
flows can be reinvested at that rate.
2. NPV uses a realistic discount rate assumption of 10%. It is the opportunity cost of funds.
You can easily find other projects to invest that will give a return of 10%. Hence it is safe
to assume that the intermediate cash flows can be reinvested at this rate.
Besides differences in cash flow patterns, there can be ranking conflicts due to differences in
project size as well. Consider two projects one with an initial outlay of $1 million and
another project with an initial outlay of $1 billion. It is possible that the smaller project has a
higher IRR, but the increase in firm value (NPV) is small as compared to the increase in firm
value (NPV) of the larger project.
4.9. The Multiple IRR Problem and No IRR Problem
If a project has unconventional cash flows, it can have multiple IRRs i.e. there are more than
one discount rate that will produce an NPV equal to zero. The NPV profile of a project with
multiple IRRs intersects the x-axis at more than one point.

Some projects do not have an IRR, i.e. there is no discount rate that results in a zero NPV. No
IRR projects may have positive NPVs and can be good investments, however because of
unconventional cash flows, mathematically no IRR exists. The NPV profile of a project with
no IRR does not intersect the x-axis.
Comparison between NPV and IRR

NPV IRR
Advantages Advantages
Direct measure of expected increase in value Shows the return on each dollar invested.
of the firm.
Theoretically the best method. Allows us to compare return with the
required rate.
Disadvantages Disadvantages
Does not consider project size. Incorrectly assumes that cash flows are
reinvested at IRR rate. The correct
assumption is that intermediate cash flows
are reinvested at the required rate.
Might conflict with NPV analysis.
Possibility of multiple IRRs or no IRR for a
project.

4.10. Popularity and Usage of the Capital Budgeting Methods

The following points are based on a survey conducted across five countries to find out the
popularity of different capital budgeting methods and how often they were used:
• NPV and IRR are more likely to be used at larger firms and where the management
has MBA degrees.
• Companies in the US prefer NPV and IRR, whereas European firms use payback
method more than NPV and IRR.
• Private companies use payback method more than their public counterparts.
Relationship between NPV and Stock Price
• The value of a company can be measured as the existing value plus the present value
of its future investments. NPV is a direct measure of the expected change in the firm’s
value from undertaking a capital project.
• A positive NPV project should cause a proportionate increase in a company’s stock
price. But if the project’s profitability is less than expectations, then the stock price
may be negatively impacted.
Example
A company is undertaking a project with an NPV of $500 million. The company currently has
100 million shares outstanding and each share has a price of $50. What is the likely impact of
the project on the stock price?
Solution:
NPV of the project = $500 million. The overall value of company should increase by $500
million because of the project. Since there are 100 million shares outstanding, each share
should go up by 500/100 = $5. The share price should increase from $50 to $55.

Summary
LO.a: Describe the capital budgeting process, including the typical steps of the process,
and distinguish among the various categories of capital projects.
Capital budgeting is the process that companies use for decision making on long-term
projects. In simple terms, it is the method used by companies to decide which projects are
worth pursuing.
The steps in the capital budgeting process are as follows:
Following are the categories of capital budgeting projects:

• Replacement projects.
• Expansion projects.
• New products and services.
• Mandatory projects.
• Other projects: These may be pet projects of someone in the company, or too risky to
be analyzed using the traditional methods.
LO.b: Describe the basic principles of capital budgeting, including cash flow
estimation.
1. Decisions are based on incremental cash flows.
2. Timing of cash flows is crucial.
3. Cash flows are based on opportunity costs.
4. Cash flows are analyzed on an after-tax basis.
5. Financing costs are ignored.
LO.c: Explain how the evaluation and selection of capital projects is affected by
mutually exclusive projects, project sequencing, and capital rationing.
Independent projects versus mutually exclusive projects: If projects are independent, they
can all be undertaken, provided that they individually satisfy the decision rules. In the case
of mutually exclusive projects, the projects compete with each other. If projects A and B are
mutually exclusive, it means that either A or B can be undertaken, but not both.
Project Sequencing: Projects are sequenced through time. That is, completion of one project
creates an opportunity to invest in another project later, based on the financial results of the
earlier project.
Unlimited funds versus capital rationing: Under unlimited funds, funding is not a constraint,
so a company may invest in all profitable projects. However, if the company has limited
funds for investment, then the company must allocate funds such that they maximize

shareholder value.
LO.d: Calculate and interpret the results using each of the following methods to
evaluate a single capital project: net present value (NPV), internal rate of return (IRR),
payback period, discounted payback period, and profitability index (PI).
Net present value (NPV) is the present value of the future after tax cash flows, minus the
investment outlay (cost of the project). For independent projects - accept all projects with
positive NPV. For mutually exclusive projects - accept the project with the higher NPV.
Internal rate of return (IRR) is the discount rate which makes NPV equal to 0. For
independent projects, if IRR is greater than opportunity cost (required rate of return), accept
the project; otherwise reject the project. For mutually exclusive projects, accept the project
with the higher IRR as long as the IRR is greater than the opportunity cost.
Payback period is the number of years it takes to recover the initial investment.
Discounted payback period is the number of years it takes for the present value of the
estimated cash flows to equal the initial investment.
Profitability Index is the present value of a project’s future cash flows divided by the initial
investment.
LO.e: Explain the NPV profile, compare the NPV and IRR methods when evaluating
independent and mutually exclusive projects, and describe the problems associated
with each of the evaluation methods.
NPV profile is a graph that plots a project’s NPV for different discount rates. A sample is
shown below.
NPV Profile for Projects X and Y

500
400
NPV in $ millions
300
200
100
0
-100 0 5 10 15 20 25
Discount rate in %
NPV for Project X NPV for Project Y
The intersection point (15%) is the crossover rate. For mutually exclusive projects, at
discount rate less than 15%, Project Y should be selected but at discount rate greater than
15%, project X should be selected.
For mutually exclusive projects, the NPV and IRR methods can have conflicting results. This

can happen due to the differences in initial investment or timings of cash flows. IRR method
assumes that cash flows are reinvested at IRR rate which is practically not always correct.
When there is a conflict, always select the project with the higher NPV.
Projects with unconventional cash flow pattern can have more than one IRR. It is also
possible that a project doesn’t have an IRR.
LO.f: Describe expected relations among an investment’s NPV, company value, and
share price.
NPV is a direct measure of the expected change in the firm’s value from undertaking a capital
project. A positive NPV project should cause a proportionate increase in a company’s stock
price. But if the project’s profitability is less than expectations, then the stock price might be
negatively impacted.

Practice Questions
1. Helix Corporation is evaluating an investment to enhance the safety at its manufacturing
facility to meet the new government standards. The project is most likely a:
A. new product or market development.
B. mandatory project.
C. replacement project.
2. Which of the following statements regarding capital budgeting is most likely to be true:
A. Opportunity costs must be factored in the cash flows.
B. Interest costs must be factored in the cash flows.
C. Cash flows should not factor in taxes.
3. Ecosense Industries is analyzing three projects for investment. The initial investments
are $60 million, $50 million and $40 million for projects A, B, and C, respectively. All
three projects generate profits that are twice of the initial investment. However, the
company can select a max of two investments as the investment amount is capped at
$100 million. The restriction is most likely a result of:
A. project sequencing.
B. capital rationing.
C. mutually exclusive projects.
4. A capital project with an initial investment of $200 generates after-tax cash flows of $50,
$100 and $ 150 in years 1, 2 and 3 respectively. The required rate of return is 8 percent.
The net present value is closest to:
A. $51.11.
B. $62.11.
C. $40.80.
5. A capital project with an initial investment of $100,000 generates after-tax cash flows of
$50,000, $0 and $150,000 in years 1, 2 and 3 respectively. The cost of capital is 15
percent. The internal rate of return is closest to:
A. 32.97 percent.
B. 33.79 percent.
C. 34.13 percent.
6. Calculate the payback period and discounted payback period for the following cash flows
of a capital project. The required rate of return is 20 percent.

Year 0 1 2 3
Cash flow -12,000 5,000 8,000 10,000
The payback period is:
A. 1.12 years shorter than the discounted payback period.
B. 0.51 years shorter than the discounted payback period.
C. 0.51 years longer than the discounted payback period.
7. A capital project with an initial investment of $50,000 will create a perpetual after-tax
cash flow of $5,000. If the required rate of return is 12 percent, the project’s profitability
index is closest to:
A. 0.83
B. 1.20
C. 0.76
8. The NPV and IRR for two mutually exclusive projects are as shown below:
Year NPV IRR(%)
Project A 60 30
Project B 80 20
If the required rate of return for both the projects is 10 percent; the appropriate
investment decision would be?
A. Invest in Project B because it has higher NPV.
B. Invest in Project A because it has higher IRR.
C. Invest in both projects.
9. With regard to an NPV profile of a project, which of the following combination is most
likely to be true?
Y-intercept X-Intercept
A. Sum of the undiscounted cash flows IRR
B. Initial Investment IRR
C. IRR Sum of undiscounted cash flows
10. The crossover rate for NPV profiles of two projects is best described as the discount rate
at which:
A. Both project’s NPV becomes positive.
B. Both projects have the same IRR.
C. Both projects have the same NPV.
11. Apex Industries is investing in $500 million in a new capital project. The present value of

the future after-tax cash flows resulting from the project is $600 million. Apex currently
has 40 million outstanding shares trading at a market price of $82 per share. What is the
theoretical effect of the new capital project on Apex’s stock price most likely to be:
A. Increase to $81.5.
B. Decrease to $79.5.
C. Increase to $84.5.

Solutions
1. B is correct. Mandatory projects are required to address safety or environment related=

concerns. New product or market development would involve entering new market
places. Replacement projects can be undertaken to replace obsolete machinery or reduce
costs.
2. A is correct. Opportunity costs must be included in the incremental cash flows, as the
decision to make the investment should factor in the next best use of the capital
employed. Financing or interest costs are built into the discount rates or cost of capital
that is used to discount the cash flows. Including interest costs in the cash flows would
result in double counting. Taxes should be factored in the capital budgeting decision.
3. B is correct. Capital rationing limits the total amount that can be invested. Hence, if the
total amount of all the possible projects exceeds this limit, certain projects have to be
shelved.
4. A is correct. (On the exam, use the CF function of your calculator)

50 100 150
NPV = −200 + + 2
+ = $51.11
1.08 1.08 1.083
5. B is correct.
The IRR calculated using the financial calculator is 33.79%
6. B is correct.
Year 0 1 2 3
Cash flow -12,000 5,000 8,000 10,000
Cumulative cash flow -12,000 -7,000 1,000 11,000
Discounted cash flow -12,000 4,166.67 5,555.55 5,787.04
Cumulative DCF -12,000 -7,833.33 -2,277.78 3,509.26
The payback period is 1 year plus 7,000 / 8,000 = 0.88 of the second year cash flow =
1.88 years.
The discounted payback period is two years plus 2,277.78/5,787.04 = 0.39 of the third
year cash flow = 2.39 years.
The discounted payback period is 2.39 – 1.88 = 0.51 years longer than payback period.
Note: The discounted payback period will always be longer than the payback period as
long as the discount rate is positive (because it includes discounted cash flows).

7. A is correct.
5,000
The present value of the future cash flows is PV = = 41,666.67
0.12
PV 41,666.67
The profitability index is PI = = = 0.83
Investment 50,000.00
8. A is correct. While investing in mutually exclusive projects, the decision should be based
on NPV method as it uses the opportunity cost of funds as the discount rate. NPV
correctly assumes that the intermediate cash flows are reinvested at the cost of capital or
the opportunity cost of funds. IRR wrongly assumes that the intermediate cash flows for
Project A are invested at 30% while that for Project B are invested at 20%.
9. A is correct. In an NPV profile;

The Y-intercept of the NPV profile is NPV value when the cost of capital is 0 i.e. it is the
sum of undiscounted cash flow.
The X-intercept is the NPV profile is IRR value i.e. when the NPV becomes zero.
10. C is correct. Crossover rate is the discount rate at which the NPV profiles of two projects
intersect. It is the only point where the NPVs of the projects are the same.
11. C is correct. In theory, the stock price must increase by the NPV of the new capital project
divided by the outstanding share base.
NPV of the new capital project =$600 million - $500 million = $100 million.
On a per-share basis, the addition adds value of = $100 million / 40 million = $2.5.
Therefore, the new share price should be = $82 + $2.5 = $84.5.

R35 Cost of Capital 2019 Level I Notes
R35 Cost of Capital

1. Introduction
This reading defines what is cost of capital, methods to estimate the cost of capital, and why
estimating the cost of capital accurately is important, both for decision making by a
company’s management and for valuation by investors. Estimating the cost of capital is a
complex process which requires many assumptions.
2. Cost of Capital
Cost of capital is the rate of return that the suppliers of capital require as compensation for
their contribution of capital. Assume a company decides to build a steel plant and needs
money or capital for it. Investors such as bondholders or equity holders will lend this capital
to the company. Suppliers of capital will be motivated to part with their money for a certain
period of time if the money invested can earn a greater return than it would earn elsewhere.
In short, investors will invest if the return (IRR) is greater than the cost of capital.
Riskier projects will have a higher cost of capital. A company has access to several sources of
capital such as issuing equity, debt, or instruments that share characteristics of both debt
and equity. Each source becomes a component of the company’s funding and has a specific
cost associated with it called the component cost of capital.
The cost of capital is the rate of return expected by investors for average-risk investment in a
company. One way of calculating this cost is to determine the weighted average cost of
capital (WACC), which is also called the marginal cost of capital. It is called marginal
because it is the additional or incremental cost a company incurs to issue additional debt or
equity.
Three common sources of capital are common shares, preferred shares and debt. WACC is
the cost of each component of capital in the proportion they are used in the company.
WACC = wd rd (1 − t) + wp rp + we re
where
wd = proportion of debt that the company uses when it raises new funds
rd = before-tax marginal cost of debt
t = company’s marginal tax rate
wp = proportion of preferred stock the company uses when it raises new funds
rp = marginal cost of preferred stock
we = proportion of equity that the company uses when it raises new funds
re = the marginal cost of equity
Example
IFT has the following capital structure: 30 percent debt, 10 percent preferred stock, and 60
percent equity. The before-tax cost of debt is 8 percent, cost of preferred stock is 10 percent,

and cost of equity is 15 percent. If the marginal tax rate is 40 percent, what is the WACC?
Solution:
WACC = (0.3) (0.08) (1 - 0.4) + (0.1) (0.1) + (0.6) (0.15) = 11.44 percent
Note: Before-tax cost of debt is given. Do not forget to calculate the after-tax cost.
Example
Machiavelli Co. has an after-tax cost of debt capital of 4 percent, a cost of preferred stock of 8
percent, a cost of equity capital of 10 percent, and a weighted average cost of capital of 7
percent. Machiavelli Co. intends to maintain its current capital structure as it raises
additional capital. In making its capital budgeting decisions for the average risk project, what
is the relevant cost of capital?
Solution:
The relevant cost of capital is 7%. The WACC using weights derived from the current capital
structure is the best estimate of the cost of capital for the average risk project of a company.
2.1. Taxes and the Cost of Capital
Notice that in the equation for WACC, we consider taxes only for debt. This is because
payments to equity shareholders in the form of dividends are not tax-deductible. On the
other hand, interest costs are tax-deductible; they pass through the income statement and
provide a tax- shield. Let us see the effect on net income in the example below.
A company pays 10% interest on capital raised. On the left hand side of the table below, you
see that the interest is tax deductible. On the right hand side, the interest is not tax
deductible. So the tax expense on the LHS is 16, which is 4 less than that on the RHS. The
savings on taxes consequently reflect in the net income as well. The actual cost of debt is 6%
when it is tax-deductible instead of 10%.
Calculation of net income assuming Calculation of net income assuming
interest is tax-deductible interest is not tax-deductible
Revenue 100 Revenue 100
Operating Expenses 50 Operating Expenses 50
Interest 10 EBT 50
EBT 40 Tax expense (40%) 20
Tax Expense (40%) 16 Interest Expense 10
Net Income 24 Net Income 20
After-tax cost of debt = Before-tax cost of debt x (1 - tax rate)
2.2. Weights of the Weighted Average
Any company raising capital always has a target capital structure and raises capital in line
with this structure. This information is typically internal to a company, and not available to

an analyst. In such cases where the information is not available, an analyst should use the
market values of debt and equity as a proxy for the target capital structure (instead of using
book values).
Let us take a simple scenario where the capital structure consists of only debt and equity. So,
the WACC is wd rd (1 − t) + we re . In the table below, you can see the book value and market
value of debt is the same. But for equity they are different. While computing WACC, you
should use the market values for the weights and ignore the book values. So the weight of
debt is 0.2 and the weight of equity is 0.8.
Book Value Market Value
Debt 20 20
Equity 40 80
Weights should be based on:
• Market values.
• Target capital structure: when data is given for the current capital structure and
target capital structure, use the target capital structure as this is the proportion the
company is striving to achieve.
In the absence of explicit information about a firm’s target capital structure, one may
estimate it using one of the following approaches:
• Current capital structure based on market value weights for the components (most
common method).
• Trend in the firm’s capital structure or statements made by management regarding
capital structure policy.
• Average of comparable companies’ capital structures as the target capital structure.
Example
You gather the following information about the capital structure and before-tax component
costs for a company. The company’s marginal tax rate is 40 percent. What is the cost of
capital?
Capital Book value (in Market Value (in Component cost
component 000) 000)
Debt $100 $90 8%
Preferred stock $20 $20 10%
Common stock $100 $300 14%
Solution:
Use the market value to calculate the weights of each component.
wd = 90/410 = 0.22
wp = 20/410 = 0.05
we = 0.73

WACC = 0.22 (8) (0.6) + 0.05 (10) + 0.73 (14) = 11.78%

2.3. Applying the Cost of Capital to Capital Budgeting and Security Valuation
A company’s marginal cost of capital may increase when additional capital is raised.
Similarly, the return on investment decreases as a company invests in additional
opportunities. Assume a company has borrowed money from a bank for a project. When it
borrows additional money, the cost of capital increases as the riskiness of the company or
the investment goes up.
This relationship between investment opportunity schedule (IOS) and marginal cost of
capital (MCC) is depicted in the graph below. The following points can be inferred:
• The return on investment is greater than the cost of capital to the left of the optimal
point; in this area, it is prudent for the company to borrow more money to invest in
projects.
• The return is less than the cost of capital to the right of the optimal capital budget i.e.
in this area; it is not profitable for the company to raise more money.
• The optimal capital budget is the amount of capital at which the marginal cost of
capital is equal to the marginal return from investing, or the point at which IOS
intersects MCC schedule.
How WACC or MCC is used in capital budgeting:

WACC or MCC is used as the discount rate to compute NPV for average risk projects.
NPV = present value of inflows – present value of outflows
This assumes the target capital structure stays constant and the project has the same risk as
that of the company. Adjustments to the cost of capital are necessary when a project differs
in risk from the average risk of a firm’s existing projects. The discount rate should be
adjusted upwards for higher risk projects and downwards for lower risk projects.

3. Costs of the Different Sources of Capital

Each source of capital has a different cost because of differences in seniority, contractual
commitments, and potential value as a tax shield. Three primary sources of capital are:
• Debt
• Preferred equity
• Common equity
3.1. Cost of Debt
Cost of debt is the cost of financing to a company using debt instruments such as bank loan,
or issuing a bond. In simpler terms, it is the effective interest rate a company pays on its
current debt. Two methods to estimate the before-tax cost of debt are:
• The yield to maturity (YTM) approach
• Debt rating approach
Yield to Maturity Approach
YTM is the annual return an investor earns if the bond is purchased today and held until
maturity. It is the rate at which the present value of all future cash flows equals the market
price of the bond.
PMTt FV
P0 = ∑nt=1 [ r t
]+ r n
(1 + d ) (1 + d )
2 2
where
P0 = the current market price of the bond
PMTt = interest payment in period t
rd = the yield to maturity
n = number of periods remaining to maturity
FV = maturity value of the bond
Example
A company issues a 10-year, 8% semi-annual coupon bond. Upon issuance, the bond sells for
$980. If the marginal tax rate is 30%, what is the after-tax cost of debt?
Solution:
First, calculate the before-tax cost of debt by entering the following values:
N = 20 because it is a semi-annual coupon bond, so there are 10 x 2 = 20 periods.
PV = -980; the price at which the bond is current selling
FV = 1000; the face value of the bond that will be repaid at maturity (the face value of the
bond is not explicitly given but assume it is the nearest round figure.)
PMT = (0.08/2) * 1000 = 40 (Coupons are always paid on the face value)
Compute I/Y = 4.15 %
Annual I/Y = 4.15 x 2 = 8.30 = before-tax cost of debt

After-tax cost of debt = 8.30 (1 - 0.3) = 5.8%

Debt Rating Approach
This method is used when the company’s debt doesn’t have a YTM as it is not publicly
traded. In such case, the approach is as follows:
• Determine the current market rates for comparable bonds with similar ratings and
maturities (using matrix pricing).
• Analyze the company characteristics like covenants, seniority etc. to get before-tax
cost of debt.
• Apply the marginal tax rate to arrive at the after-tax cost of debt.
3.2. Cost of Preferred Stock
The cost of preferred stock is the cost that a company has committed to pay to preferred
stockholders in the form of preferred dividend. Preferred stock has the characteristics of
both debt and equity. Unlike common dividend which is variable, preferred dividend is
usually fixed and paid before common shareholders. The cost of preferred stock can be
computed as:
Dp
Pp =
rp
where
Pp = the current preferred stock price per share
Dp = the preferred stock dividend per share
rp = the cost of preferred stock
Example
A company issues preferred stock with par value $100 that is currently valued at $125 per
share. The preferred dividend is $5 per share. The marginal tax rate is 33 percent. What is
the cost of preferred stock?
Solution:
Cost of preferred stock = 5/125 = 4%
Note: We ignore taxes, because unlike interest payments, dividends are not tax deductible.
3.3. Cost of Common Equity
Cost of common equity, or cost of equity, is the rate of return required by a company’s
common shareholders. It is the return expected by investors for the risk they undertake.
Unlike debt and preferred stock, estimating the cost of equity is challenging because of the
uncertain nature of future cash flows.
Three commonly used methods to estimate the cost of equity are:
• Capital asset pricing model
• Dividend discount model

• Bond yield plus risk premium method

Capital Asset Pricing Model (CAPM) Approach
According to this method, the cost of equity is equal to the risk free rate plus a premium for
bearing the security’s market risk. The premium is the beta for the security multiplied by the
equity risk premium.
re = RFR + β [E(R mkt ) – RFR]
where
re = the cost of equity
RFR = risk-free rate of an asset
β = the sensitivity of a stock’s return to changes in market return
E(R mkt ) = expected return on the market
[E(R mkt ) – RFR] is also called the equity risk premium because it is the premium that
investors expect for investing in the market relative to the risk-free rate.
Example
In a developing market, the risk free rate is 10% and the equity risk premium is 6%. The
equity beta for a given company is 2. What is the cost of equity using the CAPM approach?
Solution:
re = 0.1 + 2 [0.06] = 22%
To estimate the risk free rate, we use the yields on long term government bonds. To estimate
the equity risk premium we use historical returns. Historical equity risk premium is a good
indicator of expected equity risk premium.
Dividend Discount Model (DDM) Approach
Before going deeper into DDM, let us understand a few basic concepts first.
Present value of a perpetuity: Assume an investment gives a cash flow of $10 at the end of
each period forever. This is called a perpetuity, as the cash flow continues forever. If the
discount rate is 5%, the present value of this infinite cash flow can be calculated as 10/0.05 =
200. PV0 = cash flow/interest rate.
Present value of a growing perpetuity: Now assume the cash flow for every successive
period grows at a rate of 2%. $10 in period 1, $10.2 in period 2, $10.404 in period 3 and so
on. The present value of a growing perpetuity can be computed as:
PMT1 10
PV0 = = 0.05 – 0.02 = 333.33
r−g
Note that the denominator for a growing perpetuity is smaller than a normal perpetuity as
the cash flow is increasing every period. Consequently, the present value is greater in this
case than a normal perpetuity. If the growth rate is higher, the present value is even higher.

Having understood these basic concepts, let’s move to the DDM model. The dividend
discount model states that the intrinsic value of a financial asset, such as a stock, is the
present value of future cash flows (dividends). Gordon growth model is one example of a
DCF model. It is also called the constant-growth dividend discount model. If the dividends
grow at a constant growth rate g, then the price of the stock can be written as:
D1
P0 = r
e −g
where:
D1 = dividend at end of each period
P0 = intrinsic price of stock
re = cost of equity
Therefore, rearranging the equation we get:
D
re = P 1 + g
0
In the above equation, one needs to estimate D1 , the dividend for the next period, and g, the
constant growth rate of dividends. If the company has a stable dividend policy, then D1 can
be easily estimated. There are two ways to estimate the growth rate:
• Use a forecasted growth rate from a published vendor.
• Use the following relationship between the growth rate, the retention rate, and the
return on equity:
D
g = b x ROE = (1 – EPS) x ROE
where:
g = sustainable growth rate
b = earnings retention rate
D
= dividend payout rate
EPS
ROE = return on equity
If you are given D0, you can calculate D1 as D0 (1 + g).
Example
You have gathered the following information about a company and the market:
• Current share price = 30
• Most recent dividend paid = 2
• Expected dividend payout rate = 40%
• Expected ROE = 15%
• Equity beta = 1.5
• Expected return on market = 15%
• Risk free rate = 8%

Using the DCF approach, what is the cost of retained earnings?

Solution:
Since the dividend payout rate is 40%, the retention ratio, b, is 1 – 0.4 = 0.6
g = b * ROE = 0.6 * 0.15 = 0.09
D
re = P 1 + g
0
D0 ∗ (1 + g) 2 x 1.09
re = +g= + 0.09 = 0.1627 = 16.27%
P0 30
Bond Yield plus Risk Premium Method

In this method, we add a risk premium to the yield on the firm’s long term debt. The
assumption here is that the return on a company's equity will be greater than the return on
the company's bond, as equity is riskier than the bond.
re = bond yield + risk premium
Example
A company’s interest rate on long term debt is 8%. The risk premium of equity is estimated
to be 5%. What is the cost of equity?
Solution:
re = 8% + 5% = 13 %
4. Topics in Cost of Capital Estimation
This section focuses on the risk factors considered in calculating risk-free rate, equity risk
premium and beta.
4.1. Estimating Beta and Determining a Project Beta
A firm’s beta is used to estimate its required return on equity. Beta is a measure of risk;
riskier firms will have higher betas, whereas less risker firms will have lower betas. Beta is
estimated by regressing a stock’s returns with overall market returns.
At times, we need to estimate the beta for a project or a company that is not publicly traded.
In this case we use the pure-play method.
Pure-Play Method
This method has three steps:
Step 1: Shortlist comparable publicly traded companies.
Step 2: Derive unlevered beta or comparable asset beta for the project using comparable
company’s D/E and tax rates:

1
βasset = βequity ∗ (1−t)D
1+ E
Asset beta removes the effects of financial leverage and reflects the business risks of assets
of the comparable company.
Step3: Get the equity levered beta for the project using project specific D/E and tax rate:
(1 − t)D
βequity = βasset ∗ (1 + )
E
Equity beta adjusts the asset beta for the capital structure of the company or project that is
the subject of our analysis.
Example
AA Corp. is a large conglomerate and wants to determine the equity beta of its food division.
This division has a D/E ratio of 0.7. The tax rate is 40%. A comparable publicly traded food
company has an equity beta of 1.2 and a D/E ratio of 0.5. What is the equity beta of AA’s food
division?
Solution:
Using the pure play method, we can calculate the equity beta of AA’s food division as:
1
1. Unlevered beta of publicly traded food company = 1.2 * 1 + 0.6 (0.5) = 0.923
2. Levered equity beta of AA’s food division = 0.923 [1 + 0.6 x 0.7] = 1.31
Inference: Since AA’s food division has more debt than the publicly traded company, it is
riskier and has a higher beta value.
4.2. Country Risk
The general assumption so far has been that an investor is investing in a developed country.
But what happens when an investor invests in emerging economies? Here the CAPM is
modified to adjust for additional risk in a developing market by adding country risk
premium (CRP) to market risk premium.
re = RFR + β [E (R m ) − RFR + CRP]
The country risk premium is computed as:
σequity
Country ERP = Sovereign yield spread * σsovereign bond
where:
σequity = Annualized standard deviation of equity index
σsovereign bond = Annualized standard deviation of the sovereign bond market in terms of
the developed market currency

For example, assume you are a U.S. based investor investing in Indian securities. The risk-
free rate is 3% and the beta for a stock is 1.5. The market risk premium is 6% and CRP for
India is 3%. The cost of equity is 3 + 1.5[6+3] = 16.5%.
4.3. Marginal Cost of Capital Schedule
Marginal cost of capital schedule is a graph that plots the cost of raising additional capital.
MCC schedule plots the weighted average cost of each dollar of additional capital on the y-
axis to the amount of new capital raised on the x-axis. As a company raises more funds, the
costs of capital from different sources change.
The marginal cost of capital is upward sloping because when a greater amount of capital is
raised, the cost of equity and debt financing increase. We calculate a break point using
information on when the different sources’ costs change and the proportions that the
company uses when it raises additional capital:
amount of capital at which the source′ scost of capital changes
Break point =
proportion of new capital raised from the source
Let us understand this concept through an example.
Example
A company’s target capital structure is 60 percent equity and 40 percent debt. The cost and
availability of raising various amounts of debt and equity capital is shown below:
Amount of new debt Cost of debt Amount of new equity Cost of equity
(in millions) (after tax) (in millions)
≤4 14% ≤ 9.0 20%
> 4.0 16% > 9.0 22%
What is the WACC for raising the following amounts of capital: 5, 10, 15, and 20?
Solution:
• If the company raises debt less than or equal to 4 million, then the cost is 14%. But if it is
more than that, the cost goes up to 16%. Similarly, in the case of equity, if it is less than 9
million, then the cost is 20%. If the amount of equity is greater than 9 million, the cost
goes up to 22%. After-tax cost of debt is given, so do not calculate the cost as (1-t) * cost
of debt in WACC.
Steps:
12. Calculate the proportion of debt and equity for each amount of capital raised.
Amount Debt Equity Cost of debt Cost of equity WACC
of capital (40%) (60%) (in %) (in %) (in %)
5 0.4 * 5 = 2 0.6 * 5 = 3 0.4 * 14 = 5.6 0.6 * 20 = 12 17.6
10 0.4 * 10 = 4 0.6 * 10 = 6 0.4 * 14 = 5.6 0.6 * 20 = 12 17.6
15 0.4 * 15 = 6 0.6 * 15 = 9 0.4 * 16 = 6.4 0.6 * 20 = 12 18.4

20 0.4 * 20 = 8 0.6 * 20 = 12 0.4 * 16 = 6.4 0.6 * 22 = 13.2 19.6
13. Note that the cost of capital changes when the amount of capital is greater than 10
million and 15 million.
14. There are two break points – at 10 million and at 15 million because the cost of debt and
cost of equity change at these points for any new amount of capital.
15. You can calculate the break points using Equation 13 as 4/0.4 = 10 and 9/0.6 = 15.
4.4. Floatation Costs
Floatation costs are the fees charged by investment bankers when a company raises external
capital. There are two approaches to deal with floatation costs:
Approach 1: Incorporate flotation costs into the cost of capital. This will increase the cost of
capital.
Di
re = +g
(P0 − F)
For example, consider a company that has a current dividend of $5 per share, a current price
of $100 per share and an expected growth rate of 10%. The cost of equity without
considering floatation costs would be:
$5 × 1.1
re = + 0.1 = 0.155 or 15.5%
$100
If the floatation costs are 3% of the issuance, the cost of equity considering the floatation
costs would be:
$5 × 1.1
re = + 0.1 = 0.1567 or 15.67%
$100 − $3

However, the problem with this approach is that floatation costs are not an ongoing expense,
they are a cost that the firm incurs at the start of the project. Hence, we should not be
discounting all future cash flows at a higher cost of capital. The correct way to treat
floatation costs is to use approach 2.
Approach 2: We adjust the initial cash flow by the amount of floatation costs. We do not
adjust the discount rate.
Let’s say in the above example, the company raised $100,000 for a project by issuing new
shares. The floatation costs would be 3% of $100,000 i.e. $3,000. In this approach we
increase the initial cash outlay of the project to $103,000. The cost of equity, however,
remains unchanged at 15.5%.
4.5. What do CFOs do?
In this reading, we saw several methods to estimate the cost of capital for a company or
project. A survey of a large number of US company CFOs to understand the methods they use
to estimate the cost of capital revealed the following:
• The capital asset pricing model is the commonly used model. The single-factor capital
asset pricing model is the most popular one.
• Few companies use the dividend cash flow model.
• Publicly traded companies were more likely to use the capital asset pricing model
than private companies.
• Most companies used a single cost of capital across projects, while some used risk
adjustments for individual projects.

Summary
LO.a: Calculate and interpret the weighted average cost of capital (WACC) of a
company.
WACC represents the overall cost of capital for the firm and is the appropriate discount rate
to use for projects having a similar risk profile as that of the firm.
LO.b: Describe how taxes affect the cost of capital from different capital sources.
Interest costs on the debt component are tax deductible, while dividends paid to preferred
and common stock holders are not tax deductible. To arrive at the after-tax cost of capital,
we multiply only the cost of debt by (1-t).
LO.c: Explain alternative methods of calculating the weights used in the WACC,
including the use of the company’s target capital structure.
Weights should be based on the firm’s target capital structure. In the absence of explicit
information about a firm’s target capital structure, use:
• Current capital structure based on market values.
• Trend in the firm’s capital structure or statements made by management regarding
capital structure policy.
• Average of comparable companies.
LO.d: Explain how the marginal cost of capital and the investment opportunity
schedule are used to determine the optimal capital budget.
A company’s marginal cost of capital may increase when additional capital is raised.
Similarly, the return on investment decreases as a company invests in additional
opportunities. This relationship is depicted in the graph below. The point of intersection
shows the optimal capital budget (the amount of investment that undertakes all positive
NPV projects).

LO.e: Explain the marginal cost of capital’s role in determining the net present value of
a project.
WACC (MCC) is used in following ways:
• The calculation of NPV assumes that the target capital structure stays constant and
the project has the same risk as that of the company. Adjustments to the cost of
capital are necessary when a project differs in risk from the average risk of a firm’s
existing projects. The discount rate should be adjusted upwards for higher risk
projects and downwards for lower risk projects.
• To value a security using any of the discounted cash flow models.
LO.f: Calculate and interpret the cost of debt capital using the yield-to- maturity
approach and the debt-rating approach.
Cost of debt is the cost of financing a company using debt instruments. Two methods of
estimating the cost of debt are:
YTM approach: It is the annual return that an investor earns if he purchases the bond today
and holds it till maturity.
Debt rating approach is used if the market YTM is not available. First estimate the before-tax
cost of debt based on comparable bonds with similar ratings and similar maturities. Analyze
rated firms with similar financial/valuation characteristics, debt seniority, and security. The
company’s marginal tax rate is then used to compute the after-tax cost of debt.
LO.g: Calculate and interpret the cost of noncallable, nonconvertible preferred stock.
preferred dividend
Cost of preferred stock =
current stock price
LO.h: Calculate and interpret the cost of equity capital using the capital asset pricing
model approach, the dividend discount model approach, and the bond-yield-plus risk-
premium approach.
CAPM:
re = RFR + β [E (R mkt ) − RFR]
Dividend discount model:
Di
re = +g
P0
Where g = (1 – payout rate) * ROE
Bond yield plus risk premium:
re = bond yield + risk premium
LO.i: Calculate and interpret the beta and cost of capital for a project.

Pure play method is commonly used to estimate the beta of a private company. This method
has three steps:
1. Identify comparable publicly traded company.
2. Determine comparable asset beta or unlevered beta for the project using the formula:
1
βasset = βequity ∗ (1−t)∗D
1+ E
3. Get the equity levered beta for the project using the formula:
(1 − t) ∗ D
βequity = βasset ∗ (1 + )
E
LO.j: Describe uses of country risk premiums in estimating the cost of equity.
When investing in a developing market, country risk premium is added to the market risk
premium when calculating the cost of equity using CAPM.
re = RFR + β [E (R m ) − RFR + CRP]
LO.k: Describe the marginal cost of capital schedule, explain why it may be upward-
sloping with respect to additional capital, and calculate and interpret its break-points.
Marginal cost of capital schedule is a graph that plots the cost of raising additional capital.
The marginal cost of capital is upward sloping because when a greater amount of capital is
raised, the cost of equity and debt financing increase. We calculate a break point using
information on when the different sources’ costs change and the proportions that the
company uses when it raises additional capital:
amount of capital at which the source′ scost of capital changes
Break point =
proportion of new capital raised from the source
LO.l: Explain and demonstrate the correct treatment of flotation costs.
Floatation costs are the fees incurred by a company when it raises new capital such as
issuing new equity or debt. The correct method to account for floatation costs is to increase
a project’s initial cash outflow by the floatation cost attributable to the project.

Practice Questions
1. A firm has the following capital structure: 20% debt, 10% preferred stock, and 70%
equity. The before-tax cost of debt is 6%, cost of preferred stock is 8%, and the cost of
equity is 12%. The firm’s marginal tax rate is 30 percent. The WACC is closest to:
A. 10 percent.
B. 9 percent.
C. 12 percent.
2. John Clark is evaluating the weighted average cost of capital for a company. John has
collected the following information regarding the company:
Current year($) Forecasted next year($)
Book of value of debt 150 150
Market value of debt 162 178
Book value of shareholder’s equity 75 85
Market value of shareholder’s equity 262 256
Which of the following combinations of the weight components should John use in
determining WACC:
A. 𝑤𝑑 = 0.67; 𝑤𝑒 = 0.33.
B. 𝑤𝑑 = 0.64; 𝑤𝑒 = 0.36.
C. 𝑤𝑑 = 0.41; 𝑤𝑒 = 0.59.
3. An optimal capital budget occurs when the marginal cost of capital:

A. is above the project’s rate of return.
B. is below the investment opportunity schedule.
C. intersects the investment opportunity schedule.
4. Which of the following is the least appropriate method for an external analyst to estimate
a company’s cost of debt?
A. Bond yield plus risk premium Approach.
B. Yield-to-Maturity Approach.
C. Debt Rating Approach.
5. Helios Industries has issued a seven-year maturity bond having a face value of $1,000 at
$850. The bond pays a 10 percent semi-annual coupon. If Helios’s marginal tax rate is 35
percent, its after-tax cost of debt is closest to:
A. 8.4 percent.
B. 8.9 percent.
C. 8.7 percent.

6. Crayon Corporation issued a fixed-rate perpetual preferred stock having a dividend of $2

per share. The stock was issued at $40 per share. If the company would decide to issue
preferred stock today, the yield would be 6 percent. The stock’s current value is:
A. $40.00.
B. $33.33.
C. $28.50.
7. Which of the following is the least appropriate method for an external analyst to estimate
a company’s cost of equity?
A. Bond yield plus risk premium approach.
B. Dividend discount model approach.
C. Debt rating approach.
8. Donald Hall is evaluating a project of a company that is expanding its operations in China.
He has gathered the following information for this investment:
Project beta 1.5
Risk-free interest rate 3%
Market risk premium 8%
Country risk premium for China 2.6%
The cost of equity is closest to:
A. 18.9 percent.
B. 14.40 percent.
C. 10.40 percent.
9. Matrix Industries is paying out a dividend of $4.50. The stock of the company currently
trades at $85. Matrix has a payout ratio of 20 percent and a return on equity (ROE) of 20
percent. What is its cost of equity using the dividend discount model?
A. 25.29 percent.
B. 21.29 percent.
C. 13.29 percent.
10. Sandra Johnson has gathered the following information:

Tax rate (%) Debt/Equity Equity Beta
Private company 25 1.8 NA
Comparable public company 30 1.2 1.8
Using the pure-play method, the estimated equity beta for the private company is closest

to:
A. 2.30.
B. 0.98.
C. 1.81.
11. Kent Clark has gathered the following information about capital markets in the United
States and Paraguay.
Yield on US 10-year Treasury bond 3.5 percent
Yield on Paraguay 10-year government bond 11.2 percent
Annualized standard deviation of Paraguay stock index 38 percent
Annualized standard deviation of Paraguay dollar- 22 percent
denominated government bond
Estimated country equity premium for Paraguay is closest to:
A. 12.16 percent.
B. 13.32 percent.
C. 14.23 percent.
12. David Jones has estimated the following cost schedule for Gayle Industries:
Amount of new After-tax cost of Amount of new Cost of equity
debt (in millions) debt equity (in millions)
$0 to $99 6.0 percent $0 to $199 10.0 percent
The company currently has assets on its balance sheet of $300 million that are financed
with 80% equity and 20% debt. In his analysis, David Jones makes the following
statements:
Statement 1: If Gayle Industries maintains its capital structure of 80% equity and 20%
debt, the break point at which its cost of equity will increase to 12.0% is $200 million in
new capital.
Statement 2: If Gayle Industries wants to finance total assets of $700 million, its marginal
cost of capital will increase to 12.4%.
Are David Jones Statements 1 and 2 most likely:
Statement 1 Statement 2
A. Incorrect Correct
B. Correct Incorrect
C. Correct Correct

13. Which of the following is the most appropriate treatment for floatation costs incurred by
the company while raising additional capital?
A. Ignore the costs because they are sunk costs.
B. Increase the project’s initial outlay by the amount of floatation costs.
C. Incorporate flotation costs into the cost of capital.

Solutions
1. A is correct.
WACC = (0.2) (0.06) (1 - 0.3) + (0.1) (0.08) + (0.7) (0.12) = 10.04 %
2. C is correct.
wd = $178/($178 + $256) = 0.41.
we = $256/($178 + $256) = 0.59.
Weights used in determining the cost of capital should be based on the capital structure
that the company is likely to arrive at in the future. Hence, target capital structure should
be used.
The cost of capital should factor in the marginal cost of sources of capital i.e. borrowing
additional units from henceforth. Hence, weights should be based on the market values.
3. C is correct. An optimal capital budget occurs when the marginal cost of capital intersects
the investment opportunity schedule
4. A is correct. Bond yield plus risk premium is used to calculate the cost of equity. The
other two are approaches to calculate the cost of debt.
5. C is correct.
Solve for i.
FV = $1,000; PMT = $50; N = 14; PV = -$850
The six month yield is 6.68%.
YTM = 6.68% * 2 = 13.36%
𝑟𝑑 (1 − 𝑡) = 13.36% (1 − 0.35) = 8.68%
6. B is correct.
The company can issue preferred stock at 6 percent.
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 2
𝑃𝑟𝑖𝑐𝑒𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 = = = $33.33
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑖𝑒𝑙𝑑 0.06
7. C is correct. Debt rating approach is used to estimate the cost of debt.
8. A is correct.
𝑘𝑒 = R𝑓 + 𝛽[𝐸(𝑅𝑀𝐾𝑇 ) − R𝑓 + 𝐶𝑅𝑃]
𝑘𝑒 = 0.03 + 1.5[0.08 − 0.03 + 0.026] = 18.9%

9. B is correct. First, calculate the growth rate using the sustainable growth calculation:
g = (1 − dividend payout ratio)(ROE) = (retention ratio)(ROE)
g = (1 − 0.20)(20%) = 16%
Now, using the dividend discount model:
𝐷1 4.5
𝑟𝑒 = ( ) + 𝑔 = ( ) + 0.16 = 21.29%
𝑃0 85
10. A is correct.
Asset beta for the public company:
1.8
Unlevered beta = = 0.98
[1 + (1 − 0.3)(1.2)]
Relevering to target debt ratio of the private firm: levered beta = 0.98 * [1+ (1-0.25)(1.8)]
= 2.30
11. B is correct. The country equity premium can be estimated as the sovereign yield spread
times the volatility of the country’s stock market relative to its bond market.
Paraguay’s equity premium is (11.2% – 3.5%) × (38%/22%) = 7.7% × 1.73 = 13.32%.
12. A is correct.
Statement 1 is incorrect.
The break point at which the cost of equity changes to 12.0% is:
amount of capital at which the component′ s cost of capital changes
break point = weight of the component in the WACC
$200 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
break point = = $250 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
0.80
Statement 2 is correct.
If Gayle Industries wants to finance $700 million of total assets, the firm has to raise $700
-$300=$400 million in additional capital. Using the target capital structure of 80% equity
and 20% debt, the firm will need to raise 0.80 * $400 = $320 million in new equity and
0.20 * $400 = $80 million in new debt. Looking at the capital schedule, the cost associated
with $80 million in new debt is 6% and the cost associated with $320 million of new
equity is 14%. The marginal cost of capital at that point will be (0.8 * 14%) + (0.2 * 6%) =
12.4%.
13. B is correct.
The correct treatment of floatation costs is to increase the project’s initial outlay by the
amount of floatation costs.

R36 Measures of Leverage 2019 Level I Notes
R36 Measures of Leverage

1. Introduction
The total costs of a company can be broken down into two parts: fixed costs and variable
costs. Fixed costs do not vary with output (the number of units produced and sold); whereas,
variable costs vary with output.
Leverage is the use of fixed costs in a company’s cost structure. It has two components:
• Operating leverage: Fixed operating costs such as depreciation and rent create
operating leverage.
• Financial leverage: Fixed financial costs such as interest expense create financial
leverage.
For highly leveraged firms, that is firms with a high proportion of fixed costs relative to total
costs, a small change in sales will have a big impact on earnings.
2. Leverage
Let’s look at an example to understand the impact of leverage.
Example
Consider two companies, HL and LL, with the same revenue and net income but a different
cost structure.
Operating Performance Income Statement
HL LL HL LL
No. of units sold 100 100 Revenue 100 100
Sales price per unit 1 1 Operating costs 70 75
Variable cost per unit 0.2 0.6 Operating Income 30 25
Fixed operating cost 50 15 Financing Expense 10 5
Fixed financing cost 10 5 Net Income 20 20
How is the cost structure different?
What is the impact on net income if sales numbers change?
Solution:
Net income for different units of sold
HL LL HL LL HL LL
No. of units sold 100 100 0 0 120 120
Fixed operating costs 50 15 50 15 50 15
Variable costs 20 60 0 0 24 72
Operating costs 70 75 50 15 74 87
Operating Income 30 25 -50 -15 46 33
Interest expense 10 5 10 5 10 5
Net Income 20 20 -60 -20 36 28

Let us plot the net income for different levels of sales (units sold) for HL and LL.
Net Income for different no. of units sold

60
40
20
Net Income
0
0 20 40 60 80 100 120 HL
-20
LL
-40
-60
-80
Number of units sold
As you can see, the loss is magnified when revenue is zero and the profit is also magnified
when revenue increases by a marginal amount for HL relative to LL. When 100 units are
sold, the net income is the same for both the companies. The effect of both loss and profit is
higher for a high leverage firm.
Leverage increases volatility of a company’s earnings and cash flows and also increases the
risk of lending to or owning a company. The valuation of a company and its equity is affected
by the degree of leverage. The higher a company’s leverage, the higher is its risk, which
requires a higher discount rate to be applied in valuation.
3. Business and Financial Risk

3.1. Business Risk and Its Components
Business risk is the risk associated with operating earnings. All firms face the risk that
revenues will decline, which will in turn, affect operating earnings. Business risk consists of
two components: sales risk and operating risk.
Business risk and its two components are depicted in the picture below:

3.2. Sales Risk

Sales risk is the variability in profits due to uncertainty of sales price and volume (product
demand and revenue uncertainty).
3.3. Operating Risk
Operating risk is the risk due to operating cost structure. It is greater when fixed operating
costs are higher relative to variable operating costs.
Degree of operating leverage is a quantitative measure of operating risk. It is the ratio of
the percentage change in operating income to the percentage change in units sold. It
measures how sensitive a company’s operating income is to changes in sales. For example, a
DOL of 2 means that a 1 percent change in units sold results in a 2 percent change in
operating income.
Percentage change in operating income
DOL = Percentage change in units sold
Q(P−V)
It can be shown that DOL = Q(P−V)–F
where:
Q = number of units
P = price per unit
V = variable operating cost per unit
F = fixed operating cost
P - V = per unit contribution margin
Q (P - V) = contribution margin
Example
Given the following data, compute DOL for HL and LL.
HL LL
Number of units sold 100 100
Sales price per unit 1 1
Variable cost per unit 0.2 0.6
Fixed operating cost 50 15
Fixed financing cost 10 5
Solution:
For HL:
Q = 100; P = 1; V = 0.2; F = 50
100 ∗ 0.8
DOL for HL: 100 ∗ 0.8 − 50 = 2.67
For LL:
Q = 100; P = 1; V = 0.6; F = 15

100 ∗ 0.4
DOL for LL: 100 ∗ 0.4 − 15 = 1.6
3.4. Financial Risk

Financial risk is the risk associated with how a company finances its operations. A company
may choose to finance using debt or equity. Greater the use of debt, greater is the company’s
financial risk.
Degree of financial leverage is a quantitative measure of financial risk. For example, if DFL
is 2, then a 5 percent increase in operating income will most likely result in a 10 percent
increase in net income.
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞
DFL =
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐢𝐧𝐜𝐨𝐦𝐞
Q(P−V)−F
It can be shown that DFL = Q(P−V)–F−C
where
Q = number of units
P = price per unit
C = fixed financial cost
P-V = per unit contribution margin
Example
Given the following data, compute DFL for HL and LL.
HL LL
Solution:
For HL:
Q = 100; P = 1; V = 0.2; F = 50; C = 10
100 ∗ 0.8−50
DFL for HL: 100 ∗ 0.8 − 50 − 10 = 1.5
For LL:
Q = 100; P = 1; V = 0.6; F = 15; C = 5
100 ∗ 0.4 − 15
DFL for LL: 100 ∗ 0.4 − 15 − 5 = 1.25

Effect of Financial Leverage on NI and ROE

Higher leverage leads to higher ROE volatility and potentially higher ROE levels. This is
illustrated through a simple example. Consider two firms with the same operating income
(EBIT), but different capital structures. While Firm 1 has no debt, capital structure of Firm 2
comprises 50% debt and 50% equity. The table below computes ROE for different levels of
EBIT.
ROE = NI / equity
Firm 1: Assets = 200; Equity = 200 Firm 2: Assets = 200; Equity =
Debt = 0; Tax = 0% 100; Debt = 100, Interest = 10%
EBIT NI ROE NI ROE
0 0 0 -10 -10%
20 20 10% 10 10%
40 40 20% 30 30%
60 60 30% 50 50%
80 80 40% 70 70%
Some inferences about the effect of financial leverage on NI and ROE:
• For lower levels of EBIT, NI and ROE are negative for the high leverage firm.
• Higher EBIT leads to potentially higher ROE levels, as seen in Firm 2 (high leverage
firm).
• ROE of firm 2 (high leverage firm) has a higher volatility and variability (-10% to
70%) relative to firm 1 (0 to 40%).
3.5. Total Leverage
Total leverage gives us the combined effect of both operating leverage and financial leverage.
Degree of total leverage (DTL) measures the sensitivity of net income to changes in the
number of units produced and sold.
Percentage change in net income
DTL = Percentage change in units sold
Q(P−V)
It can be shown that DTL = DOL * DFL = Q(P−V)–F−C
where
Q = number of units
P = price per unit
P-V = per unit contribution margin

Example
Given the following data, compute DTL for HL and LL.
HL LL
Solution:
For HL:
Q = 100; P = 1; V = 0.2; F = 50; C = 10
100 ∗ 0.8
DTL for HL: 100 ∗ 0.8 − 50 − 10 = 4
For LL:
Q = 100; P = 1; V = 0.6; F = 15; C = 5
100 ∗ 0.4
DTL for LL: 100 ∗ 0.4 − 15 − 5 = 2
3.6. Breakeven Points and Operating Breakeven Points

Breakeven point
Breakeven point is the number of units produced and sold at which net income is zero, the
point at which revenues are equal to costs.
F+C
Breakeven point QBE = P−V
where:
F = fixed operating costs
V = variable cost per unit
P = the price per unit
Operating breakeven point
Operating breakeven point is the number of units produced and sold at which operating
income is zero.
F
Operating breakeven point QOBE = P−V
Example
Given the following data, compute the breakeven and operating breakeven points for HL and
LL.

HL LL
Solution:
For HL:
F = 50; C = 10; P = 1; V = 0.2
F+C 50 + 10
QBE = P − V = = 75
1 − 0.2
F
QOBE = = 50/0.8 = 62.5
P−V
For LL:
F = 15; C = 5; P = 1; V = 0.6
F+C 15 + 5
QBE = P − V = 1 − 0.6 = 50
F
QOBE = P − V = 15/0.4 = 37.5

Summary
LO.a: Define and explain leverage, business risk, sales risk, operating risk, and
financial risk, and classify a risk, given a description.
Leverage is the use of fixed costs in a company’s cost structure. Leverage has two
components: operating leverage and financial leverage. Fixed operating costs such as
depreciation and rent create operating leverage. Fixed financial costs such as interest
expense create financial leverage.
Business risk is the risk associated with operating earnings. All firms face the risk that
revenues will decline, which in turn will affect operating earnings. Business risk consists of
two components: Sales risk and operating risk.
Sales risk is the variability in profits due to uncertainty of sales price and volume.
Operating risk is the risk due to the operating cost structure. Operating risk is greater when
fixed operating costs are higher relative to variable operating costs.
Financial risk is the risk due to debt financing.
LO.b: Calculate and interpret the degree of operating leverage, the degree of financial
leverage, and the degree of total leverage.
Degree of operating leverage (DOL) is a measure of operating risk. It is the ratio of the
percentage change in operating income to the percentage change in units sold. It can be
calculated using the following formula:
Q(P − V)
DOL =
Q(P − V) − F
Degree of financial leverage (DFL) is a quantitative measure of financial risk. It is the ratio of
percentage change in net income to percentage change in operating income.
Q(P − V) − F
DFL =
Q(P − V) − F − C
Degree of total leverage (DTL) measures the sensitivity of net income to changes in the
number of units produced and sold. It is the ratio of percentage change in the net income to
the percentage change in the number of units sold.
Q(P − V)
DTL = = DOL ∗ DFL
Q(P − V) − F − C
Where Q is the number of units, P is the price per unit, V is the variable cost per unit, F is the
fixed operating cost and C is the fixed financial cost.
LO.c: Describe the effect of financial leverage on a company’s net income and return
on equity.

Higher leverage leads to higher ROE volatility and potentially higher ROE levels:
• For lower levels of EBIT, NI and ROE are negative for the firm with the higher
leverage.
• Higher EBIT leads to potentially higher ROE levels.
• ROE of a high leverage firm has higher volatility and variability.
LO.d: Calculate the breakeven quantity of sales and determine the company's net
income at various sales levels.
Breakeven quantity of sales is the quantity of units sold to earn revenue equal to the fixed
and variable costs i.e. for net income to be 0.
F+C
Q(BE) =
P−V
Where F is the fixed cost, C is the financial cost, V is the variable cost per unit and P is the
price per unit.
LO.e: Calculate and interpret the operating breakeven quantity of sales.
Operating breakeven quantity of sales ignores the fixed financing costs i.e. quantity sold for
operating income to be 0.
F
Q(OBE) =
P−V
Where F is the fixed cost, V is the variable cost per unit and P is the price per unit.

Practice Questions
1. Business risk is best described as a combination of:
A. operating risk and sales risk.
B. financial risk and sales risk.
C. financial risk and operating risk.
2. Apex Industries has a unit contribution margin for a product of $10. Apex has fixed
operating cost of $400,000. The degree of operating leverage (DOL) is most likely the
lowest at which of the following production levels (in units)?
A. 200,000.
B. 300,000.
C. 400,000.
3. Nancy Scott, CFA is analyzing the income statement for Matrix Corporation.
$ millions
Revenues 28.6
Variable operating expenses 19.2
Fixed operating expenses 7.1
Operating income (EBIT) 2.3
Interest 0.7
Taxable income 1.6
Tax 0.7
Net income 0.9
Its degree of financial leverage is closest to:
A. 1.44.
B. 1.78.
C. 1.59.
4. Donald Hall has gathered the following information for Orion Enterprises.
EBIT $240,000
EBT $198,000
Tax rate 35%
Given that the degree of total leverage is 2.51, the degree of operating leverage is closest
to:
A. 1.21.
B. 2.07.
C. 2.86.

5. Michael Carter has gathered the following information for two companies.
Company A Company B
DOL 1.30 DOL 1.30
DFL 2.50 DFL 1.10
DTL 3.25 DTL 1.43
Which of the following combination is most accurate for a 10 percent increase in unit
sales?
A. Operating income and net income for both companies will increase by 10%.
B. Operating income for both companies will remain same, while net income for
Company A will increase by 25% and for Company B by 11%.
C. Operating income for both companies will increase by 13%, while net income for
Company A will increase by 32.5% and for Company B by 14.3%.
6. Andrew Smith has collected the following information on a company that manufactures
tires:
Retail price of tires $115
Variable cost per tire $75
Operating fixed costs $380,000
Fixed interest charges $58,000
Marginal tax rate 35%
The quantity of items that the company should manufacture and sell to break-even is
closest to:
A. 11,200.
B. 9,200.
C. 10,200.
7. Atlanta Manufacturing has a unit contribution margin for a product of $25. The company
has fixed costs of $45,000, interest costs of $11,000, and a tax rate of 35%. The operating
breakeven point (in units) for the company is closest to:
A. 2,240.
B. 1,800.
C. 1,360.

Solutions
1. A is correct. Business risk is linked with a firm’s operating income. It is a combination of

sales risk and operating risk. It reflects the uncertainty in the firm’s total revenue and the
expenditures incurred to produce those revenues.
2. C is correct. The degree of operating leverage measures the elasticity of operating

earnings with respect to the number of units produced and sold.
DOL = (quantity x contribution margin) / (quantity x contribution margin – fixed costs)
Using trial and error method, we find DOL for all the options:
DOL (200,000 units) = ($10 x 200,000) / ($10 x 200,000 – 400,000) = 1.25
DOL (300,000 units) = ($10 x 300,000) / ($10 x 300,000 – 400,000) = 1.15
DOL (400,000 units) = ($10 x 400,000) / ($10 x 400,000 – 400,000) = 1.11
The DOL is lowest at the 400,000 unit production level.
3. A is correct. DFL = (Operating income) ÷ (Operating income – Interest expense) or

operating income divided by pretax earnings = $2.3 ÷ $1.6 = 1.44.
4. B is correct.
Step 1: Compute the degree of financial leverage.
EBIT EBIT 240,000
Degree of financial leverage = = = = 1.21
EBIT − I EBT 198,000
Step 2: Compute the degree of operating leverage
Degree of total leverage = Degree of financial leverage × Degree of operational leverage
2.51 = 1.21 × Degree of operational leverage
Degree of operational leverage = 2.07
5. C is correct. The degree of operating leverage shows the sensitivity of operating income
to the change in units sold; while the degree of total leverage shows the change in the net
income to changes in unit sold. Since both the companies have the same DOL at 1.30;
their operating income will increase by 13% for a 10% increase in unit sales. DTL for
Company A is 3.25; hence, its net income will increase by 32.5% for a 10% increase in
unit sales. DTL for Company B is 1.43; hence, its net income will increase by 14.3% for a
10% increase in unit sales.
6. C is correct. Breakeven quantity = (Fixed operating costs + fixed financial costs) ÷ (price
per unit – variable cost per unit)
= (350,000+ 58,000) ÷ (115 – 75) = 10,200

7. B is correct. The operating breakeven point is:

𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 / c𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 = $45,000 / $25 = 1,800

R37 Working Capital Management 2019 Level I Notes
R37 Working Capital Management

1. Introduction
Working capital management is a measure of the operational liquidity of a business. It
involves managing the relationship between a firm’s short term assets and its short term
liabilities. The goal of effective working capital management is to ensure that a company has
adequate ready access to the funds necessary for day to day operating expenses.
There are several factors that impact working capital needs:
Internal Factors:
• Company size and growth rate: Large and fast growing companies have high working
capital needs.
• Organizational structure: Decentralized companies have high working capital needs
as liquidity is managed by each business unit.
• Sophistication of working capital management: Sophisticated companies will do a
better job at keeping the working capital low and still meet the short term
obligations.
• Borrowing and investing positions, activities and capacities: Companies that can
borrow easily will have low working capital needs.
External Factors:
• Banking services: Economies with developed banking systems will have low working
capital needs as borrowing is easy.
• Interest rates: High interest rates lead to high working capital.
• New technologies and new products: New technologies that make it easier to manage
working capital will lead to low working capital needs.
• The economy: Depends on the industry and the state of the economy. In a downturn,
companies maintain low inventory and are high on cash as it becomes difficult to
borrow money.
• Competitors: In a highly competitive industry, working capital requirements will be
relatively high.
2. Managing and Measuring Liquidity
Liquidity is the extent to which a company is able to meet its short term obligations using
assets that can be readily converted into cash (by selling or financing).
2.1. Defining Liquidity Management
Liquidity management refers to the ability of an organization to generate cash when and
where needed.
Two sources of liquidity for a company are:

1. Primary sources:
• Cash sources used in day-to-day operations.
• For example, cash balances, trade credit, lines of credit from bank etc.
2. Secondary sources:
• For example, liquidating assets, filing for bankruptcy, negotiating debt agreements
etc.
• The main difference between the two is that using primary sources has no effect
on the operations of a company while using secondary sources may negatively
impact a company’s financial position.
A company’s liquidity position is affected by cash receipts and the amount of cash it has to
pay.
Drags on liquidity reduce cash inflows. For example, bad debts, obsolete inventory,
uncollected receivables etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues
etc.
2.2. Measuring Liquidity
Liquidity contributes to a company’s creditworthiness. Creditworthiness is the perceived
ability of the borrower to pay what is owed in a timely manner despite adverse conditions. A
high creditworthy company is one that has the ability to make interest payments on a loan as
they come due.
High creditworthiness allows a company to:
• Obtain lower borrowing costs.
• Obtain better terms for trade credit.
• Have greater flexibility.
• Exploit profitable opportunities – as a company can raise money relatively quickly to
invest in profitable projects.
Liquidity ratios
Liquidity ratios measure a company’s ability to meet short-term obligations. In the reading
on financial ratios, we discussed all the ratios listed here.
In financial reporting and analysis, the turnover ratios were classified as activity ratios. But,
here we consider them as a measure of liquidity as well because of the effect (drag/pull)
they have on the liquidity of a company.
Liquidity ratios
Ratio Formula
Current ratio Current assets ÷ Current liabilities
Quick ratio (Cash + Marketable securities + Receivables) ÷ Current liabilities

Receivable turnover Credit Sales ÷ Average receivables

Number of days of 365 or days in period ÷ Receivable turnover
receivables
Inventory turnover Cost of goods sold ÷ Average inventory
Number of days of 365 or days in the period ÷ Inventory turnover
inventory
Payables turnover Average day’s purchases ÷ Average trade payables
Number of days of 365 or days in the period ÷ Payables turnover
payables
(Net) Operating Cycle
Operating cycle is the time needed to convert raw materials into cash from a sale. It does not
consider payments to suppliers.
Operating cycle = Number of days of inventory + Number of days of receivables
Net operating cycle is a more accurate measure which measures the time from paying
suppliers for raw materials to collecting cash from customers. The shorter the cycle, the
better is the cash-generating ability of a company.
Net operating cycle = Number of days of receivables + Number of days of inventory
- Number of days of payables
3. Managing the Cash Position
The purpose of managing a firm’s daily cash position is to make sure there is sufficient cash
(target balance). A company does not want low or negative balances because it is expensive
to borrow cash on short notice. However, it does not want an unnecessarily high cash
balance either because interest income is forgone by not investing the cash.
Companies should recognize the major sources of cash inflows and outflows in order to
precisely forecast cash flows and maintain a minimum cash balance. Some common sources
of cash inflows and outflows are listed below:
Examples of Cash Inflows and Outflows
Inflows Outflows
Receipts from operations Payments to employees
Fund transfer from subsidiaries Payments to suppliers
Maturing investments Other expenses
Other income Investments
Tax refunds Debt payments
Money from loans Taxes
4. Investing Short-Term Funds
Short-term funds are a temporary store of surplus funds that are not necessarily needed in a

company’s daily transactions. If a significant part of a company’s working capital portfolio is

not needed for daily/short-term transactions, then the money can be invested in a longer-
term portfolio. Short-term working capital portfolios consist of securities that are highly
liquid, less risky and shorter in maturity than other types of investment portfolios.
Generally working capital portfolios consist of short term government securities, and short
term bank and corporate obligations. These are investments that can be converted into cash
within 2-3 working days.
Yield on Short-term Investment
The yields on short-term investments are measured by:
F−P 360
Discount-basis yield = x
F T
F−P 360 360
Money market yield = ∗ = Holding period yield x
P T t
F−P 365 365
Bond equivalent yield = ∗ = Holding period yield x
P T t
where:
F = face value
P = purchase price
T = number of days to maturity
Instructor’s tip: We have covered these yield measures in quantitative methods. The
formula for bond equivalent yield below is different than the one we have seen in Quant
which was BEY = 2 * semi-annual yield.
Example
A 90-day $100,000 U.S. T-bill was purchased at a discount rate of 4%. Calculate the money
market yield and bond equivalent yield.
Solution:
Face value = $100,000; T = 90; discount rate = 4%
Using Equation 3:
F−P 360 100,000 − P 360
∗ = ∗ = 0.04
F T 100,000 90
Solving for P, we get P = 99,000

F−P 360 100,000 − 99,000 360
Money market yield = ∗ = ∗ = 4.04%
P T 99,000 90
F−P 365 100,000 − 99,000 365
Bond equivalent yield = ∗ = ∗ = 4.097%
P T 99,000 90

Strategies and Evaluation

The objective of investing in short-term funds is to earn a reasonable return while taking on
limited credit and liquidity risk.
Companies must create an investment policy statement to achieve this objective. An IPS
usually has the following structure:
• Purpose: Describes the purpose of the portfolio, strategy to be followed, and
acceptable instruments.
• Authorities: Names the executives who will oversee the portfolio managers
responsible for making investments.
• Limitations: Lists the generic types of investments that can be included in the
portfolio, and any restrictions on the amount of each security.
• Quality: To ensure funds are safe, references to credit ratings from agencies such as
Moody’s or S&P are made.
Short term investing strategies can be either active or passive. Passive strategies focus on
rules; safety and liquidity are prioritized. Active strategies are more aggressive and require
constant monitoring. The different types of active strategies are as follows:
• Matching strategy: A conservative strategy that uses many of the same instruments as
in passive strategy. In this strategy, the maturity of the current assets matches the
maturity of the current liabilities.
• Mismatching strategy: This is riskier than matching strategy as it requires accurate
and reliable cash forecasts. Invests in liquid securities that can be sold if need arises.
Maturity of the current liabilities does not match with the maturity of current assets.
• Laddering Strategy: Involves purchasing bonds with multiple maturities that are
spread out equally over the term of the ladder. Reduces interest rate and
reinvestment risk. It can be an effective short-term strategy.
When evaluating a company’s short-term investment policy, one must see if the policy
strategy meets the goals of the investment and if the credit ratings are neither restrictive nor
liberal.
5. Managing Accounts Receivable
Accounts receivable gets recorded when a company sells a good or service to its customers
on credit i.e. customers do not pay for it at the time of sale. There is a tradeoff between
increasing sales by granting credit and uncollectible accounts (when the amount owed by
customers is never paid back). If the credit terms are strict, then it hurts sales.
Three primary activities in accounts receivable management are:
• Establishing credit terms; granting credit and processing transactions. A company can
offer multiple terms. An example of a credit term is 2/10 net 45. This means a
customer must pay back within 45 days, but he will get a 2 percent discount if the
entire amount is paid within 10 days.

• Monitoring credit balances.

• Measuring performance of the credit function.
5.1. Key Elements of the Trade Credit Granting Process
Credit terms offered by a company depend on the type of customer, customer’s
creditworthiness, and credit terms offered by competitors. A customer’s creditworthiness is
usually determined using a credit scoring model based on different factors such as prior late
payments, ready cash, history of bankruptcy etc. A company’s credit policy defines what
types of credit to offer to what kind of customers.
The different types of credit terms available to customers include:
• Ordinary terms: Terms are set forth using formats such as net t or d/t1 net t2 where t
is the time before which the customer must pay the invoice, t1 is the time before
which if the invoice is paid, a discount is applicable, and t2 is the same as t. For
example, 1/10 net 30 means the customer gets a 1 percent discount if the invoice is
paid within 10 days or else the entire invoice must be paid within 30 days.
• Cash before delivery: Invoice must be paid before shipment is made.
• Cash on delivery: Payment must be made at the time of delivery.
• Bill-to-bill: The previous bill must be paid before any new shipment.
• Monthly billing: Payments to be made on a monthly basis. For example, 1/10 net 30
means the customer gets a 1 percent discount if the invoice is paid within 10 days of
the next month or else the entire invoice must be paid within 30 days of the next
month.
5.2. Managing Customers’ Receipts
This section addresses the different ways in which customers make payments.
• Electronic funds transfer: Money is transferred electronically from customer’s
account to the company’s bank account through a network. An electronic collection
network is fast and efficient in terms of collecting payments and information about
the customer. Forms of electronic payment include debit/credit card, or electronic
checks.
• Lockbox: This is used when payments cannot be converted to electronic payments.
Customers mail payments to a post office box and the bank collects this several times
a day and deposits the payment into company’s accounts.
• Float factor is a good measure for check deposits. It measures the time between
checks deposited by customers and when funds are available for use by the company.
A high float factor indicates there is a lot of money in transition.
5.3. Evaluating Accounts Receivable Management
There are several ways of measuring accounts receivable performance; most deal with how
effectively outstanding receivables can be converted into cash. A simple measure is number
of days of receivables, but this does not consider the age distribution within the outstanding

balance.
Earlier in this reading, we saw that receivables turnover = credit sales/average receivables
and days of receivables = 365/receivables turnover. The problem with this approach is it
does not indicate how much of receivables has been outstanding for how long i.e. age
distribution. For example, a company may have 50 percent of accounts receivable
outstanding for 30 - 60 days while the other 50 percent may be outstanding for more than
90 days.
A common report used to monitor accounts receivable is the aging schedule. Aging schedule
is a method of breaking down accounts receivable into different time periods for which they
have been outstanding. That is, it lists accounts receivable into various groups of days
outstanding like < 31 days, between 31 and 60 days, more than 60 days and so on.
The advantage of this technique is that it helps the company in estimating how much of
receivables is potentially going to turn into bad debt, and for each time period how much
money will not be collected at all. The longer a receivable is due, the higher the probability
that it will never be collected.
The table below shows the aging schedule of accounts receivable for a company for three
months: Jan – Mar. In part a), it is expressed in absolute terms and in part b), it is expressed
as a percentage.
a) Aging schedule (in $ millions) b) Aging expressed as a percentage
Days Jan Feb Mar Days Jan Feb Mar
outstanding outstanding
< 31 days 2000 2120 1950 < 31 days 40% 39% 40%
31-60 days 1500 1650 1400 31-60 days 30% 31% 28%
61-90 days 1000 900 920 61-90 days 20% 17% 19%
> 90 days 500 700 660 > 90 days 10% 13% 13%
The table below calculates the weighted average collection days for January given the
average collection days for each grouping. The number of average collection days is
multiplied by the weight to get the overall days for each grouping.
Weighted Average Collection Period
Days outstanding Avg. collection days % weight Days x weight
< 31 days 15 40% 6
31-60 days 45 30% 13.5
61-90 days 75 20% 15
> 90 days 120 10% 12
Weighted average collection period for Jan = ∑ days * weight = 46.5. Remember that in the
above table, data for average collection days under each grouping must be given in order to
calculate the weighted average collection period. The challenge is that it is often not readily

available.
6. Managing Inventory
Inventory represents a significant cost for many companies and needs to be managed
effectively. Inventory levels that are too low will result in loss of sales due to stock-outs,
whereas a high inventory level means excess capital is tied up in inventory. The appropriate
inventory balance depends on the type of product sold and the complexity of the production
process i.e. how long it takes to make the final product.
Approaches to Managing Inventory Levels
There are two basic approaches for managing the level of inventory: economic order
quantity and just-in-time.
Economic order quantity is the optimal amount of inventory to be ordered that minimizes
total inventory costs. Reorder point refers to the level of inventory at which new inventory is
ordered.
It is tricky to balance ordering costs and carrying costs. Ordering inventory several times can
be inefficient as it would mean the company incurs transaction, communication and
transportation costs every time it orders; at the same time setting aside a large sum for a
large inventory order will decrease ordering costs but increase carrying costs. This is also
inefficient as capital is tied up (opportunity cost of capital) that could have been used
elsewhere. So, what is the optimal point at which inventory must be ordered so that the total
inventory costs are minimized? This is determined by the EOQ method.
The diagram above illustrates how EOQ method works. Inventory level is plotted against
time. The arrows show the reorder point, the level of inventory at which an order is placed.
If the level of inventory goes below this point, then the company runs a risk of going out of

stock. Economic order quantity in the diagram represents the order size that should be
placed every time the inventory levels reach the reorder point.
Just-in-time inventory: Unlike economic order quantity, just-in-time involves placing
smaller, more frequent inventory orders. It minimizes the inventory levels. It is a demand
driven inventory system where materials are ordered only when current stocks of material
reach a reorder point, which in turn, is determined by historical demand.
Just-in-time strategy strives to improve efficiency and reduce inventory carrying costs.
Production planning and inventory management have to be integrated which is done using a
manufacturing resource planning system.
Evaluating Inventory Management
The most common way to evaluate inventory management of a company is to calculate its
inventory turnover ratio and number of days of inventory. A decrease in inventory turnover
may mean:
• More inventory is on hand and products are not being sold.
• Company is storing additional inventory to prevent stock-outs.
A high inventory turnover ratio results in low days of inventory. This may indicate that a
company’s products are being sold quickly, and it is maintaining a low inventory. However,
to get the right picture, the changes in inventory turnover ratio and days of inventory should
be compared over time and relative to the industry average.
7. Managing Accounts Payable
Accounts payable is the amount a company has not yet paid to suppliers of goods and
services. It represents an important source of funds and should be managed well. Companies
take advantage of trade credit to delay the payment. For example, the terms may be such as
2/10 net 30, which means if the payment is made within 10 days, the company will get a 2
percent discount else the entire payment must be made within 30 days.
• Paying too early is costly unless the company can take advantage of discounts.
• Late payment may impact a company’s perceived credit-worthiness.
The Economics of Taking a Trade Discount
It is important for a company to evaluate when to pay its suppliers: within the discount
period, or within the maximum time allowed. To make this decision, a company should
calculate the cost of trade credit, which is the annualized cost of not availing a trade
discount. If a company’s payment terms are 2/10, net 40, the cost of not availing the 2%
discount and instead making the payment on day-40 can be calculated using the formula
below:
discount 𝑛
Cost of trade credit = (1 + ) –1
1−discount
where: n = 365 / number of days beyond discount period

This is further illustrated in the below example.

Example
Compute the cost of trade credit if terms are 2/10, net 40 and the account is paid on the 40th
day.
Solution:
Assume the item is for $100. If payment is made by Day-10 we only pay $98. Hence we can
say the actual price is $98. If payment is made on the 40th day, we pay $100. To hold our
money for 30 days beyond the discount period we pay an extra $2 over the actual price of
$98. The rate is 2/98 = 0.0204. To compute the cost of trade credit we need to annualize
this number:
(1 + 0.0204)365/30 – 1 = 27.85%. In other words, the annualized cost of not taking the trade
credit is 27.85%. If a company’s short-term borrowing cost is less than 27.85%, it should
avail the trade credit and pay the supplier within 10 days.
The key point is that a company should avail discounts made available by suppliers if the
cost of trade credit is higher than the company’s short-term borrowing cost.
8. Managing Short-Term Financing
The objectives of a short-term borrowing strategy for companies are to:
• Ensure sufficient capacity to handle peak cash needs.
• Maintain sufficient sources of credit.
• Ensure rates are cost-effective.
Short-term borrowing could be from banks or from non-bank sources. Large companies that
are financially strong use lines of credit. Companies with weaker credit terms have to use
collateral for bank borrowings. Smaller firms with poor credit terms may approach nonbank
finance companies for short term borrowings. Large creditworthy companies may issue
commercial paper.
Computing the Costs of Borrowing
One of the key tasks for a company is to decide which form of short-term borrowing will be
the most cost-effective. For comparison purposes, the company must calculate the total cost
of the form of borrowing and divide it by the total amount of loan borrowed. For example,
costs for three forms of borrowing are given below:
Interest + Commitment fee
Cost of line of credit = Loan amount
For an all-inclusive interest rate where the amount borrowed includes interest (banker’s
acceptance):
Interest Interest
Cost = Net proceeds = Loan amount − Interest

When amount borrowed includes dealer’s fee and a backup fee:

Interest + Dealer′ s commission+Backup costs
Cost = Loan amount−Interest
These costs are further illustrated in the below example.

Example
You need to borrow $1 millio20n for one month and have three options shown below. Which
one represents the lowest cost?
1. Drawing down on a line of credit at 5.5% with a 0.5% commitment fee on the full
amount. Note: 1/12 of the commitment fee is allocated to the first month.
2. A banker’s acceptance at 5.75%, an all-inclusive rate.
3. Commercial paper at 5.15% with a dealer’s commission of 0.125% and a backup line cost
of 0.25%, both of which would be assessed on the $1 million commercial paper issued.
Solution:
We begin by calculating the cost of borrowing for each option.
1. Line of credit:
Loan amount = 1 million
Interest amount + commitment fee = [0.055 x 1 million x 1/12 + 0.005 x 1 million x 1/12] x
12
Cost of line of credit = [0.055 x 1 million x 1/12 + 0.005 x 1 million x 1/12] x 12 / 1 million =
6%
2. Banker’s acceptance:
1
0.0575 x 1 x
Cost = 12
1 x 12 = 5.78%
1 − (0.0575 x 1 x )
12
3. Commercial paper with a dealer’s fee and a backup fee

1 1 1
[0.0515 x 1 x + 0.00125 x 1 x + 0.0025 x 1 x ] x 12
Cost = 12 12
1
12
= 5.55%
1 − 0.0515 x 1 x
12
Therefore, we can conclude that commercial paper represents the lowest cost.

Summary
LO.a: Describe primary and secondary sources of liquidity and factors that influence a
company’s liquidity position.
Two sources of Liquidity:
1. Primary sources:
• Cash sources used in day-to-day operations.
• For example, cash balances, trade credit, lines of credit from bank etc.
2. Secondary sources:
• Impacts the day-to-day operations and alters the financial structure. May
indicate deteriorating financial condition.
• For example, liquidating assets, filing for bankruptcy, negotiating debt
agreements etc.
Factors influencing company’s liquidity position
Internal Factors:
• Company size and growth rate: Liquidity requirements are high for faster and larger
organizations.
• Organizational Structure: Decentralized companies have higher liquidity
requirements.
• Sophistication of working capital management: Liquidity requirements are low for
better managed operations.
• Capital market access: Ease of access lowers working capital needs.
External Factors:
• Banking Services: Countries having developed banking systems will have low
liquidity requirements.
• Interest Rates: High cost of borrowing will compel more liquidity.
• State of the economy: Downturns make borrowing difficult.
• Competitors: In a highly competitive industry, working capital requirements will be
relatively high.
Drags on liquidity delay cash inflows. For example, bad debts, obsolete inventory,
uncollected receivables etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues etc.
LO.b: Compare a company’s liquidity measures with those of peer companies.
Liquidity ratios
Ratio Formula
Current ratio Current assets
Current liabilities

Quick ratio Cash + short term marketable securities + receivables

Current liabilities
Receivable Credit sales
turnover Average receivables
Number of days of 365 or days in period
receivables Receivable turnover
Inventory turnover Cost of goods sold
Average inventory
Number of days of 365 or days in the period
inventory Inventory turnover
Payables turnover Average day ′ s purchases
Average trade payables
Number of days of 365 days or days in the period
payables Payables turnover
The ratios by themselves are meaningless. They should be compared with peer companies,
keeping the industry norm in view.
LO.c: Evaluate working capital effectiveness of a company based on its operating and
cash conversion cycles, and compare the company’s effectiveness with that of peer
companies.
Operating cycle is the time needed to convert the raw materials into cash from a sale.
Operating cycle = Days of inventory + Days of receivables
Cash conversion cycle is a more accurate measure which measures the time from paying
suppliers for raw materials to collecting cash from customers. The shorter the cycle, the
better is the cash-generating ability of a company.
Cash conversion cycle = Average days of receivables + Average days of inventory - Average
days of payables
LO.d: Describe how different types of cash flows affect a company’s net daily cash
position.
Daily cash position refers to cash balances required for routine expenses. Major sources of
cash inflows and outflows should be accurately forecasted to maintain a minimum cash
balance. The common sources of cash inflows and outflows are:
Inflows Outflows
Receipts from operations Payments to employees
Fund transfer from subsidiaries Payments to suppliers
Maturing investments Other expenses
Other income Investments
Tax refunds Debt payments

Money from loans Taxes

LO.e: Calculate and interpret comparable yields on various securities, compare
portfolio returns against a standard benchmark, and evaluate a company’s short-term
investment policy guidelines.
F−P 360
Discount basis yield = ∗
F T
F−P 360
Money Market yield = ∗
P T
F−P 365
Bond equivalent yield = ∗
P T
LO.f: Evaluate a company’s management of accounts receivable, inventory, and
accounts payable over time and compared to peer companies.
Accounts Receivable:
To evaluate a company’s management of accounts receivable, a simple measure the ‘number
of days of receivables’ does not consider the age distribution within the outstanding balance.
A common report used to monitor accounts receivable is the aging schedule.
Aging Schedule for Jan
Days Accounts
weight Avg. collection days Days x weight
outstanding receivable
< 31 days 2000 40% 15 6
31-60 days 1500 30% 14 13.5
61-90 days 1000 20% 75 15
> 90 days 500 10% 120 12
The table above shows a sample aging schedule for the month of January. The days
outstanding, aging schedule (in $ millions) and average collection days will be given. Weights
will be calculated by dividing accounts receivable by total accounts receivable.
Weighted average collection period for Jan = ∑ days * weight = 46.5
Inventory:
• Ratios to monitor: Inventory turnover ratio and number of days of inventory,
compared over time and relative to peer group average.
• Decreasing inventory turnover ratios indicates rise in inventory levels and less
products being sold or the company building inventory to avoid stock-outs.
Accounts Payable:
The cost of trade credit must be calculated to see if the company benefits by investing funds
in the short term or availing the trade credit period to make the payment.

365
Discount number of days beyond discount period
Cost of trade credit=[1 + (1−Discount) ]− 1
If the cost of trade credit > short-term investment rate, then it is beneficial to use trade
credit as the return is higher.
Ratios to monitor: Payables turnover and number of days of payables.
Evaluate number of days of payables with the credit terms offered to check if payables are
being paid too soon or too late.
LO.g: Evaluate the choices of short-term funding available to a company and
recommend a financing method.
Large companies that are financially strong use lines of credit. Companies with weaker credit
terms have to use collateral for bank borrowings. Smaller firms with poor credit terms may
approach nonbank finance companies for short term borrowings. Large creditworthy
companies may issue commercial paper.

Practice Questions
1. Which of the following is least likely considered to be a secondary source of liquidity?
A. Increasing the efficiency of cash flow management.
B. Filing for bankruptcy.
C. Liquidating short-term or long-lived assets.
2. Which of the following is most likely to be considered a factor that influences a low
liquidity requirement?
A. A fast growth rate of sales.
B. Decentralized organizational structure.
C. Ease of access to capital markets.
3. Which of the following is least likely considered a ‘drag’ on liquidity?

A. Obsolete inventory.
B. Uncollected receivables and bad debt.
C. Paying vendors sooner.
4. Adam Smith has gathered the following financial information for Suzlon Industries:
Year 1 (in $ ,000s)
Cash and marketable securities 800
Receivables 1,200
Inventories 500
Total Current Assets 2,500
Fixed Assets 5,500
Total Assets 8,000
Payables 700
Short-term debt 500
Current portion of long-term debt 400
Total Current Liabilities 1,600
Long-term liabilities 2,400
Total Liabilities 4,000
Total Equity 4,000
Total Liabilities and Equity 8,000
The best estimate of year 1 cash ratio and quick ratio is closest to:
Cash Ratio Quick Ratio
A. 1.14 2.86
B. 0.50 1.25

C. 0.67 0.50
5. Rebecca is analyzing Turbo Industries, which operates in the auto ancillary segment. She
collects the following information on the company and the industry:
Company Industry average
Accounts receivable turnover 5.1 times 6.5 times
Inventory turnover 2.9 times 3.4 times
Payables turnover 10.1 times 12.5 times
Rebecca would be right in stating that relative to the industry, the company’s operating
cycle:
A. is longer, but its cash conversion cycle is shorter.
B. is shorter, but its cash conversion cycle is longer.
C. and cash conversion cycle are both longer.
6. For an 181-day $100,000 T-bill which is being sold at a discounted rate of 7.81%, the
money market yield is closest to:
A. 7.81%.
B. 8.13%.
C. 8.24%.
7. A company uses trade credit terms of 4/10 net 60. If the account is paid on the 50th day,
the cost of trade credit is closest to:
A. 64.32 percent.
B. 34.72 percent.
C. 45.13 percent.
8. Catherine Jones, a treasury manager in a company has to borrow $500,000 for a month to
meet an unforeseen short-term expense. Which of the following borrowing facilities
would be the best alternative?
A. A commercial paper at 6.25% with a dealer’s commission of 1/5% and a backup line
cost of 1/4%, both of which would be assessed on the $500,000 of commercial paper
issued.
B. A banker’s acceptance at 6.50%, an all-inclusive rate.
C. A line of credit at 6.75% with a ½ % commitment fee on the full amount with no
compensating balances.

Solutions
1. A is correct. Increasing the efficiency of cash flow management is a primary source of

liquidity.
2. C is correct. Liquidity requirements are high for faster and larger organizations.
Decentralized companies have higher liquidity requirements. Ease of access lowers
working capital needs.
3. C is correct. Drags on liquidity include: uncollected receivables, obsolete inventory and

bad debt. Paying vendors sooner is a pull on liquidity.
4. B is correct. Liquidity ratios are as follows:

Cash + Mkt Secr. +Recv. 800 + 1,200
Quick Ratio = = = 1.25
Current Liabilities 1,600
Cash + Mkt Secr. 800
Cash Ratio = = = 0.50
Current Liabilities 1,600
5. C is correct. The operating cycle = number of days of inventory + number of days of

receivables.
The cash conversion cycle = operating cycle – number of days of payables.
Company Industry
Number of days receivables 365/5.1 = 72 days 365/6.5 = 56 days
Number of days inventory 365/2.9 = 126 days 365/3.4 = 107 days
Operating cycles 72 + 126 = 198 days 56 + 107 = 163 days
Number of days payable 365/10.1 = 36 days 365/12.5 = 29 days
Cash conversion cycle 198 - 36 = 162 days 163 - 29 = 134 days
Therefore, the operating cycle and cash conversion cycle are both longer for the
company.
6. B is correct. Money- market yield = [(face value – purchase price) / Purchase price] x
(360/ days to maturity)
Purchase price = 100,000 – [0.0781 x (181/360) * 100,000] = $96,073.31
Therefore, Money market yield = [(100,000 – 96,073.31)/ 96,073.31] x (360/181) =
8.13%
7. C is correct. Cost of trade credit = {[1 + Discount/ (1 – Discount)](365/Days past discount period) }
– 1= {1 + (0.04 ÷ (1 – 0.04)} (365 ÷ (50 -10)) – 1 = 45.13%

8. B is correct.
Commercial Paper Cost:
Commercial paper cost = [(Interest + dealer’s commissions + backup costs) ÷ net
proceeds] x 12
Interest = (0.0625/12) x 500,000 = 2,604.17
Dealer’s commissions = (0.0020/12) x 500,000 = 83.33
Backup costs = (0.0025/12) x 500,000 = 104.17
Net proceeds = 500,000 – 2,604.17 = 497,395.83
Commercial paper cost = [(2,604.17 + 83.33+ 104.17) ÷ 497,395.83] x 12 = 6.74%
Banker’s Acceptance Cost:
Banker’s acceptance cost = (interest ÷ net proceeds) x 12
Interest = (0.0650/12) x 500,000 = 2,708.33
Net proceeds = 500,000 – 2,708.33 = 497,291.67
Banker’s acceptance cost = (2,708.33 ÷ 497,291.67) x 12 = 6.54%
Line Cost:
Line of credit cost = [(interest + commitment fee) ÷ usable loan amount] x 12
Interest = (0.0675/12) x 500,000 = 2,812.5
Commitment fee = (0.005/12) x 500,000 =208.33
Line of credit cost = [(2,812.5+ 208.33) ÷ 500,000] x 12 = 7.25%

R38 Portfolio Management Overview 2019 Level I Notes
R38 Portfolio Management Overview

1. Introduction
In this reading, we will see the importance of portfolio approach to investing, investment
needs of different types of investors, steps in the portfolio management process, and how to
compare various types of pooled investments.
2. A Portfolio Perspective on Investing
Portfolio approach means evaluating individual investments based on their contribution to
the investment characteristics of the portfolio. Assume an investor’s portfolio has three
stocks A, B, and C. He is evaluating whether to add another stock D to the portfolio or not. In
a portfolio approach, the investor will analyze what will happen to the risk and return of the
portfolio with and without stock D; whereas, in an isolated approach, he will only look at the
merits and demerits of the stock D.
Diversification helps investors avoid disastrous outcomes. For instance, many Enron
employees held all of their retirement funds in Enron shares. When the share tumbled from
$90 to zero between January 2001 and 2002, it completely ruined their financial wealth; this
emphasizes the need to diversify one’s portfolio. Instead, if the Enron employees had held
shares of other companies or other products, the consequence would not have been as bad.
Diversification also helps investors reduce risk without compromising their expected rate of
return. A simple measure of diversification risk is the diversification ratio. Let’s take the
example of the same portfolio consisting of three stocks: A, B and C with each stock
belonging to a different industry. There is a high probability that the movements of A, B, and
C are not correlated with each other i.e. when A moves up, B may move down or C may move
down. The benefit of diversification is that the movements of individual stocks cancel each
other out to some extent.
The benefits of diversification in risk reduction for an equally weighted portfolio is
measured by diversification ratio.
Risk of equally weighted portfolio of n securities
Diversification ratio = Risk of single security selected at random
The composition of the portfolios also matters for the risk-return tradeoff. The table below
shows two portfolios with different compositions of A, B and C.
Two portfolios with same stocks but different compositions
Weight of each stock
Portfolio Stock A Stock B Stock C Expected Standard
Return Deviation
Portfolio 1 33% 33% 33% 11% 13.1%
Portfolio 2 50% 25% 25% 11% 14%

As you can see both the portfolios have the same expected return, but Portfolio 1 has a better
risk-return trade-off than Portfolio 2 as the risk assumed is lower for the same return.
However, an important point to note is that portfolios do not provide guaranteed downside
protection. Although portfolio diversification reduces risk, the level of risk reduction is not
the same at times of financial crises. The benefits of risk reduction from diversification are
best seen under normal market conditions.
3. Investment Clients
The investment needs of different client types are given in the following table:
Investment Risk Tolerance Income Needs Liquidity
Horizon Needs
Individual Depends on Depends on the Depends on Depends on
Investors individual ability and rationale behind the
goals. willingness to take investment. individual.
risk.
Banks Short Low Pay interest on High, to meet
deposits. the daily
withdrawals.
DB pension Long, depends High for longer High for mature Low
plans on the investment horizon. funds (payouts are
employee closer), low for
profile. growing funds.
Endowments Long High Meet spending Low
and obligations.
foundations
Insurance Short Low Low High

Companies
(P&C)
Insurance Long Low (because of high Low High
Companies liquidity needs).
(Life)
Mutual Funds Varies by Varies by fund. Varies by fund. High to meet
fund. redemptions.
Instructor’s Note:
The two types of pension plans are:
Defined Contribution Plan: Company contributes an agreed-upon amount to the plan. The
agreed-upon amount is recognized as a pension expense on the income statement and the

contributed amount is treated as an operating cash outflow.

Defined Benefit Plan: A company makes promises of future benefits to be paid to the
employees.
4. Steps in the Portfolio Management Process
The three steps in the portfolio management process are: planning, execution, and feedback.
Step One: The Planning Step
In this step, the portfolio manager needs to understand a client’s needs and develop an
investment policy statement (IPS). IPS is a written document that states the client’s
objectives and constraints. Objectives are return and risk objectives which may be stated in
absolute terms or relative terms. Constraints may include liquidity, unique circumstances,
time horizon, legal, and taxes.
Step Two: The Execution Step
Based on the IPS, a portfolio is constructed in this step. Under execution, the first activity is
asset allocation. Here the portfolio manager decides what asset classes must be included in
the client’s portfolio and in what proportion. Stocks, bonds and alternative investments are
examples of different asset classes. As an example, a client’s asset allocation may consist of
60% equities, 30% fixed-income securities and 10% alternative investments.
Asset allocation is followed by security selection which is the analysis and selection of
individual securities. In other words, the specific securities to be purchased are identified.
For example, if 60% is allocated to equities, the analyst will identify what specific stocks to
purchase.
Once the securities are selected they are purchased through a broker or dealer. This is called
portfolio construction.
Step Three: The Feedback Step
A portfolio manager’s responsibility does not end with constructing a portfolio. The portfolio
also needs to be monitored and rebalanced at regular intervals. For example, if the stock
market performs very well in a particular period, the asset allocation drifts away from the
intended levels. In this case the portfolio needs to be rebalanced. The frequency at which
performance is measured is pre-decided – for instance, it could be on a monthly or quarterly
basis.
The feedback step also involves performance measurement and reporting. Analysis must
include how the portfolio performed over time, were the objectives met, what assets
attributed to the good/poor performance, how the portfolio performed against the
benchmark, and so on.

5. Pooled Investments
Pooled investments are where money is collected from several individual investors to be
invested in a large portfolio. As the name implies, it is pooling money together for an
investment. The funds where this collected money is invested could range from mutual
funds to private equity depending on the risk, capital required, strategy, and how it is
managed. The different types of investment products generally available to investors are
listed below:
Investment Products by Minimum Investment
Investment Product Minimum Investment
Mutual Funds $50 +
Exchange Traded Funds (ETFs) $50 +
Separately Managed Accounts $100,000 +
Hedge Funds $1,000,000 +
Private Equity Funds $1,000,000 +
In the rest of this section, we understand what a mutual fund is, the different types of mutual
funds and how other investment products are different from mutual funds.
5.1. Mutual Funds
A mutual fund is a comingled investment pool in which each investor has a pro-rata claim on
the income and value of the fund.
Consider the following example: An investment firms raises $100,000 for a stock-based
mutual fund from five investors and issues 10,000 shares. Each share has a value of $10.
There are three individual investors and two institutional investors. The number of shares is
based on the amount invested relative to the total amount.
Investor Amount Invested % of Total Number of Shares
John $4,000 4% 400
Jill $6,000 6% 600
Joe $10,000 10% 1,000
Jones Co. $50,000 50% 5,000
Widget Co. $30,000 30% 3,000
Assume the $100,000 is invested in various stocks and it grows to $150,000. The value of
each share goes up by 50% to $15. The advantage of this structure is that the investment
firm can have one or two managers managing this entire pool of money and each individual
investor need not hire a manager to manage his relatively small amount of money. This is a
cost effective way of managing money.
In the context of mutual funds, it is important to understand the following terms:
• Net asset value: Net asset value = value of assets – liabilities. The value of a mutual
fund is called the net asset value. It is calculated on a daily basis based on the closing

price of the stocks held in the fund’s portfolio. The NAV per share is calculated as:
NAV/number of total shares. The NAV per share in our previous example was
$100,000/10,000 = $10 per share
• Open-end fund: A mutual fund with no restrictions on when new shares can be issued
or when funds can be withdrawn. The fund accepts new investment money and issues
additional shares at a price equal to the net asset value at the time of investment.
Similarly, when an investor redeems shares, the fund sells the underlying
assets/securities to retire so many shares at the current net asset value. Because of
this, an open-end fund trades close to NAV. NAV is based on closing prices. They can
be bought/sold only once during the day. They are also called evergreen funds.
• Closed-end fund: Unlike open-end fund, in a closed-end fund, no new investment
money is accepted. Shares of closed-end funds trade in the secondary market. A new
investor may invest in the fund if an existing investor is willing to sell his shares. So,
the outstanding shares stay the same. Since there is no liquidation of underlying
assets and the share base is unchanged, the NAV may trade either at a premium or
discount to net asset value based on the demand for shares. The units issued by
closed-end funds trade like regular shares – they can be bought or sold on margin,
shorted etc.
Mutual funds can also be classified into:
• No-load fund: Most mutual funds have an annual fee for managing the fund, which is a
percentage of the fund’s net asset value. In a no-load fund, only an annual fee is
charged, but there is no fee for investment or redemption.
• Load fund: A percentage is charged for investment or redemption or both (called
entry and exit load) in addition to the annual fee.
5.2. Types of Mutual Funds
Funds can be categorized based on types of assets they invest in:
• Money market – taxable or non-taxable: They invest in high quality, short-term debt.
Taxable money market bonds invest in corporate debt and federal government debt,
while tax-free bonds invest in state and local government debt.
• Bond mutual funds – taxable or non-taxable: They invest in a portfolio of individual
bonds and preference shares.
• Stock/index mutual funds – domestic or international: They invest in a portfolio of
stocks or index funds.
• Hybrid/balanced funds – They invest in both stocks and bonds.
Funds can be categorized as actively managed or passively managed:
• With actively managed funds, the manager tries to identify securities which will
outperform the market; these funds have high fees relative to passively managed
funds.
• With passively managed funds, the manager purchases the same securities as a

benchmark index. This helps ensure that the performance of the fund is similar to the
performance of the benchmark.
5.3. Other Investment Products
Exchange Traded Funds
Like mutual funds, ETFs are a pooled investment vehicle, often based on an index. With
index mutual funds, investors buy shares directly from the fund. With ETFs, investors buy
shares from other investors.
How ETFs work
A fund manager creates the ETF by determining what assets the ETF will hold. Once the
securities are decided, the fund sponsor contacts an institutional investor who owns those
securities. The institutional investor deposits the basket of securities with the fund sponsor
(held through a custodian), and in return, receives creation units for the deposited securities.
The creation units typically represent 50,000 to100,000 ETF shares.
It is important to note that the weight of securities deposited is often in the proportion of
what it is trying to represent. For example, the weight of Athena Health in iShares Russell
2000 Growth Index Fund is 0.61%, and it is roughly the same as in Russell 2000® Growth
Index. The institutional investor then sells the creation units as ETF shares to the public;
investors buy shares from other investors, so it works like a closed mutual fund. The
institutional investor may redeem the original securities by returning the ETF creation units.
How ETFs are Similar to Mutual Funds
ETFs combine features of close-end and open-end funds:
• Trade like closed-end mutual funds; can be shorted and bought on margin.
• Because of unique redemption procedure, their prices are close to net asset value like
open-end funds.
• Expenses tend to be low relative to mutual funds but brokerage fee needs to be paid.
• Unlike mutual funds, ETFs do not have capital gains distributions.
Separately Managed Accounts
• A separately managed account is an investment portfolio managed privately for an
individual or institution by a brokerage firm or individual investment professional
(financial advisor).
• The investment must be substantial to qualify as a separately managed account,
usually between $100,000 and $500,000.
• The advantage is that the portfolio is managed exclusively to meet the client’s needs
with respect to objectives, risk tolerance, and constraints.
• Also called managed account, wrap account and individually managed account.
SMA differs from a mutual fund in the following ways:
• In a SMA, the investor owns the individual underlying share whereas in a mutual

fund, the investor owns a unit/share in a pool of underlying securities which are
owned by the mutual fund.
• Since the investor owns the shares, he has more control over when the securities are
bought and sold, and their timing.
• Tax implications are considered when buying or selling as it meets the specific needs
of the investor.
Hedge Funds
• Started out as a hedge against long-only stock positions i.e. creating a portfolio of
short positions to offset the long positions in stocks. The industry has grown
considerably since the 1940s and now encompasses several strategies.
• They tend to use high leverage which leads to high risk.
• Most hedge funds are exempt from reporting requirements of a typical public
investment company. For instance, in U.S. hedge funds do not have to register with
SEC if there are 100 or less investors.
Private Equity
• As the name implies, these are privately held and actively managed equity positions.
With a private equity investment, a firm makes an investment in a company and then
is actively involved in the management of that company.
• The equity they hold is private and not traded in public markets. The intention is to
exit out of the investment in a few years.
• Buyout funds and venture capital funds are collectively termed as private equity.
• Buyout Funds: Make a few large investments in established private companies with
the goal of increasing cash flow. Idea is to buy public companies, make them private,
restructure and then sell it or take it public again. They make few large investments.
• Venture Capital Funds: VC funds make small investments in startup companies unlike
buyout funds that invest in established companies. They actively participate in the
invested business providing advice and closely monitor the operations. They make
several small investments as the belief is that a small number of the companies will
succeed.
Appendix
This reading introduces the following terms which a Level I candidate should be familiar
with:
Top-down analysis: While performing asset allocation, analysts may select securities either
based on top-down analysis or bottom-up analysis. In a top-down analysis, macroeconomic
conditions (for different countries) are analyzed first, followed by industry and markets, and
then specific companies within the industry. For example, consider this top-down analysis in
early 2010. Analysts may have forecasted the Australian economy to grow above a certain
rate, the mining industry to do particularly well in Australia, and within mining selected Rio

Tinto plc.
Bottom-up: In a bottom-up analysis, the focus is exclusively on company-specific
circumstances, and not from an economy or industry perspective.
Buy-side firms: Investment management companies like mutual funds that use the services
of sell-side firms.
Sell-side firms: A broker or dealer that sells securities to and provides investment research
and recommendations to investment management companies.

Summary
LO.a: Describe the portfolio approach to investing.
Portfolio approach means evaluating individual investments by their contribution to the risk
and return of an investor’s portfolio.
Diversification helps investors reduce risk without compromising their expected rate of
return. A simple measure of diversification risk is the diversification ratio. The lower the
ratio, the better the diversification.
Risk of equally weighted portfolio of n securities
Diversification ratio =
Risk of single security selected at random
LO.b: Describe types of investors and distinctive characteristics and needs of each.
The investment needs of each client type are given in the following table:
Investment Risk Tolerance Income Needs Liquidity
Horizon Needs
Individual Depends on Depends on the Depends on Depends on
Investors individual ability and rationale behind individual
goals willingness to take investment
risk
Banks Short Low Pay interest on High, to meet
deposits the daily
withdrawals
DB pension Long, depends High for longer High for mature Low
plans on the investment horizon funds (payouts are
employee closer), low for
profile growing funds
Endowments Long High Meeting spending Low
and obligations
foundations
Insurance Short Low Low High

Companies
(P&C)
Insurance Long Low (because of high Low High
Companies liquidity needs)
(Life)
Mutual Funds Varies by fund Varies by fund Varies by fund High to meet
redemptions
LO.c: Describe defined contribution and defined benefit pension plans.

Defined Contribution Plan: Company contributes an agreed-upon amount to the plan. The
agreed-upon amount is recognized as a pension expense on the income statement and the
contributed amount is treated as an operating cash outflow.
Defined Benefit Plan: A company makes promises of future benefits to be paid to the
employees.
LO.d: Describe the steps in the portfolio management process.
The three steps in the portfolio management process are:
1. Planning • Understanding the client’s needs.
• Preparing an Investment policy statement.
2. Execution • Asset allocation.
• Security analysis.
• Portfolio construction.
3. Feedback • Portfolio monitoring and rebalancing.
• Performance measurement and reporting.
LO.e: Describe mutual funds and compare them with other pooled investment
products.
A mutual fund is a comingled investment pool in which each investor has a pro-rata claim on
the income and value of the fund. In the context of mutual funds, it is important to
understand the following terms:
Net asset value: Net asset value = value of assets – liabilities.
The value of a mutual fund is called the net asset value.
Open-end fund: A mutual fund with no restrictions on when new shares can be issued or
when funds can be withdrawn.
Closed-end fund: Unlike open-ended fund, in a closed-end fund, no new investment money is
accepted.
No-load fund: Only an annual fee is charged, but there is no fee for investment or
redemption.
Load fund: A percentage is charged for investment or redemption or both, in addition to the
annual fee.
Funds can be categorized based on the types of investments (money market, bond mutual
funds, stock mutual funds, index funds).
Like mutual funds, exchange traded funds (ETFs) are a pooled investment vehicle, often
based on an index. With index mutual funds, investors buy shares directly from the fund.
With ETFs, investors buy shares from other investors.
ETFs combine features of closed-end and open-end funds.

• Track NAV like open-end funds.

• Trade like close-end funds (continuously traded, can buy on margin, can short sell).
• Expenses are lower compared to mutual funds, but brokerage fee needs to be paid.
• Unlike mutual funds, ETFs do not have capital gains distributions.
Separately Managed Accounts (SMA)
• Also called “managed account”, “wrap account”, “individually managed account.”
• The investor owns individual (underlying) shares.
• Tax implications are considered when buying or selling.
• Requires high minimum investment.
Hedge Funds
• Started out as a hedge against long-only stock positions; the industry has grown
considerably and now encompasses several strategies.
• High use of leverage (and therefore high risk).
• Most hedge funds are exempt from the reporting requirements of a typical public
investment company.
Private Equity (buyout funds and venture capital)
• Privately held and actively managed equity positions.
• Buyout funds make a few large investments in established private companies.
• VC funds make several small investments in startup companies.

Practice Questions
1. Which of the following portfolios is most likely appropriate for an investor that has a low-
risk tolerance?
Portfolio Fixed Income (%) Equity (%) Alternative Assets (%)
1 30 60 10
2 55 35 10
3 20 65 15
A. Portfolio 1.
B. Portfolio 2.
C. Portfolio 3.
2. The institution that will have the highest risk tolerance for investments among the
following is:
A. Endowments.
B. Banks.
C. Non-life Insurance.
3. The institution that will most likely have the shortest investment horizon among the
following is:
A. Endowments.
B. Life insurance.
C. Non-life Insurance.
4. Which of the following statements about defined contribution plan is most accurate?
A. The employee assumes the investment risk.
B. The employer assumes the investment risk.
C. The employer promises a predetermined retirement income to participants.
5. With respect to portfolio management process, portfolio rebalancing decisions are made
in the:
A. planning step.
B. execution step.
C. feedback step.
6. Which of the following financial products is most likely to trade at their net asset value
and least likely to have capital gain distribution?
Trades at net asset value Does not have capital gain distribution
A. Open-end mutual funds Exchange traded funds

B. Exchange traded funds Closed-end mutual funds

C. Closed-end mutual funds Open-end mutual funds
7. The key difference between a venture capital fund and a buyout fund is most likely to be:
A. use of leverage.
B. have short investment horizon typically three to five years.
C. provides advice and expertise to the management team.

Solutions
1. B is correct. Sorting asset classes by their risk profile: Fixed income < Equity <
Alternative assets.
Portfolio 2 has the highest proportion of fixed income and the lowest proportion of
alternative assets and equity. Hence, it has the lowest risk profile. The portfolio that has
the highest risk profile is Portfolio 3.
2. A is correct. Among the three, the institution that has the highest risk tolerance is
Endowments. Banks have the lowest risk tolerance among the three.
3. C is correct. Among the three, the institution that has the shortest investment horizon is
non-life insurance. Between, a life and non-life insurance firms, life insurance has a
longer investment horizon as the claims or liabilities are typically longer in duration.
4. A is correct. In defined contribution plan, the employer makes no promise regarding the
future value of plan assets. The employer contributes a certain sum each period to the
employee’s retirement account. The employee assumes all the investment risk.
5. C is correct.
Planning step: Client needs and circumstances are determined to form the investment
policy statement (IPS). IPS is periodically reviewed and updated. IPS also needs to be
changed whenever there is a major change in the client’s objectives or constraints.
Execution step: Suitable asset allocation is determined. Client portfolio is then
constructed by selecting lucratively priced securities within an asset class.
Feedback: Portfolio is monitored and rebalanced to adjust asset class allocations in
response to the market performance.
6. A is correct. Open-end mutual funds trade at their net asset value per share, while closed-
end mutual funds and exchange traded funds can trade at a premium or a discount to
their net asset value.
Exchange traded funds do not have capital gain distributions as they are passively
managed.
7. A is correct. Venture capital funds make several small investments in start-up companies
and actively participate in the invested businesses providing advice. VC funds avoid the
use of leverage. Buyout funds use leverage to buyout a public company and take it private
by taking on debt. The company is restructured and the debt is eventually paid down.
Both, VC funds and Buyout funds typically have similar investment horizon.

R39 Portfolio Risk and Return Part I 2019 Level I Notes
R39 Portfolio Risk and Return Part I

1. Introduction
This reading covers:
• Investment characteristics of assets in terms of their return and risk.
• How to determine what assets are appropriate for a portfolio?
• How to construct an indifference curve and use it in the selection of an optimal
portfolio using two risky assets?
• How to construct an optimal risky portfolio?
2. Investment Characteristics of Assets
2.1. Return
Return can come in two forms:
• Periodic income through interest payments or dividends.
• Capital gains when the price of the asset you hold increases.
We now look at the various types of return measures and their applicability.
Holding Period Return
Holding period return is the return earned on an asset during the period it was held. It is
calculated as a sum of capital gain (price appreciation) and dividend yield (periodic income).
PT − P0 + DT
HPR = P0
where:
PT - P0 = capital gain component
DT = dividend or income earned during period T
PT = price at end of period
P0 = price at beginning of period
Arithmetic or Mean Return
Arithmetic return is a simple arithmetic average of returns. Assume you have three stocks A,
B, C with returns of 10%, 20% and 30% respectively. The collective return from the three
stocks is (10 + 20 + 30)/3 = 20%.
Geometric Mean Return
Geometric mean return is the compounded rate of return earned on an investment.
1
Geometric mean return = [(1 + R i1 ) ∗ (1 + R i2 ) ∗ … . .∗ (1 + R iT )]T − 1
Assume you have a stock A which returns 10%, 20% and 30% in years 1, 2, and 3
respectively.
What is the mean return earned?

Geometric mean return = [(1.1) (1.2) (1.3)]0.333 – 1 = 19.7%

Money-weighted Return or Internal Rate of Return
Money-weighted return is the internal rate of return on money invested that considers the
cash inflows and cash outflows, and calculates the return on actual investment.
Money-weighted return is a useful performance measure when the investment manager is
responsible for the timing of cash flows. This is often the case for private equity fund
managers.
Example
Given the data below, compute the holding period return, arithmetic mean return, geometric
mean return, and money-weighted return. Assume no withdrawals except at the end of year
3.
Year Assets under management at start of year (millions of $) Net return
1 30 10%
2 33 -5%
3 35 15%
Solution:
Holding period return:
Holding period = 3 years
Return = 1.1 x 0.95 x 1.15 = 1.20175 = 20.175%
Arithmetic mean:
Return = (10 – 5 + 15)/3 = 6.67%
Geometric mean:
Return = (1.1 x 0.95 x 1.15)1⁄3 − 1 = 6.317%
Money-weighted return:
To calculate the money-weighted return, we must know the net cash flows (cash inflows and
outflows) for every year. So, let us draw a table and fill in the values and derive some others
(in italics) to get the values for CF0, CF1, CF2, and CF3.
Year 1:
It is straightforward. The investment at the start of Year 1 is 30, return for year is 10%,
balance at the end of year = 30 * 1.1 = 33. Gain = 3.
Year 2:
Assets at start of year = 33; end of year = 35; return = -5%
To calculate the investment made during the year, enter these values:

FV = 35; N = 1; I/Y = -5; CPT PV. PV = 36.842

So new investment in Year 2 = 36.84 – 33 = 3.84
Loss in Year 2 = 35 - 36.84 = -1.84
Year 3:
Assets at start of year = 35; no new investment;
Calculate assets at end of Year 3: PV= 35; I/Y = 15%; N = 1; CPT FV
FV = 40.25
Gain = 40.25 – 35 = 5.25
Year 1 Year 2 Year 3
Balance from previous year 0 33 35
New investment by investor 30 3.84 0
Withdrawal by investor 0 0 0
Net balance at start of year 30 36.84 35
Investment return for year 10% -5% 15%
Investment gain (loss) 3 (1.84) 5.25
Balance at end of year 33 35 40.25
Now that we have the cash flows for the three years, let’s use the financial calculator to
calculate IRR. CF0 = -30; CF1 = -3.84; CF2 = 0; CF3 = 40.25
IRR = 6.187%
Annualized Return
Annualized return converts the returns for periods that are shorter or longer than a year, to
an annualized number for easy comparison.
c
Annualized return = (1 + rperiod ) − 1
Where c = number of periods in year
Portfolio Return
A portfolio is usually composed of more than one asset in different proportions. Portfolio
return is the weighted average of the returns of the individual investments.
Assume you have three different stocks A, B, and C in your portfolio with weights of 50%,
25% and 25% respectively. The returns on A, B, and C are 20%, 10%, and 10% respectively.
The portfolio return is the weighted average return of three stocks: 0.5 x 20 + 0.25 x 10 +
0.25 x 10 = 15% .
2.2. Other Major Return Measures and Their Applications
Gross Return
Gross return is the return earned by an asset manager prior to deducting management fees

and taxes. It measures the investment skill of a manager.

Net Return
Net return is the return earned by the investor on an investment after all managerial and
administrative expenses have been accounted for. This is the measure of return that should
matter to an investor.
Assume an investment manager generates $120 for every $100, and charges a 2% fee for
management and administrative expenses. The gross return, in this case, is 20% and the net
return is 18%.
Pre-tax and After-tax Nominal Return
The returns we saw till now were pre-tax nominal returns i.e. before deducting any taxes or
any adjustments for inflation. This is the default, unless otherwise stated.
After-tax nominal return is the return after accounting for taxes. The actual return an
investor earns should consider the tax implications as well.
In the example we saw above for gross and net return, 18% was the pre-tax nominal return.
If the tax rate for the investor is 33.33%, then the after-tax nominal return will be 18(1 -
0.3333) = 12.0006%.
Real Return
Real return is the return after deducting taxes and inflation.
(1 + r) = (1 + rreal)(1 + π)
where
rreal = real rate
π = rate of inflation
r = nominal rate
In the previous example, the after-tax nominal return was 12%. Assume the inflation rate for
the period is 10%. What is the real rate of return?
Using the above formula, (1 + 0.12) = (1 + r) (1 + 0.1). Solving for r, we get 1.818%.
Instructor’s tip: If the answer choices are close to each other, use this formula to determine
the correct answer. Else, you may use an approximation to solve for r quickly as nominal rate
= real rate + inflation.
Leveraged Return
In cases, where an investor borrows money to invest in assets like bonds or real estate, the
leveraged return is the return earned by the investor on his money after accounting for
interest paid on borrowed money.
2.3. Variance and Covariance of Returns
Variance, or risk, is a measure of volatility or dispersion of returns. It is measured as the

average squared deviation from the mean. The standard deviation of returns of an asset is
the square root of the variance of returns.
Example
Given the following annual returns data: 10%, -5%, 10%, 25%, what is the population and
sample standard deviation?
Solution:
It is better to use the calculator on the exam than using the formulas for calculating variance
and standard deviation. The key strokes are given below:
Keystrokes Explanation Display
[2nd][DATA] Enter data entry mode
[2nd][CLR WORK] Clear data registers X01
10 [ENTER] X01 = 10.000
[↓][↓] [5][+/-][ENTER] X02 = - 5.000
[↓][↓] [10] [ENTER] X03 = 10.000
[↓] [↓] [25] [ENTER] X04 = 25.000
[2nd][STAT][ENTER] Puts calculator into stats mode
[2nd][SET] Press repeatedly till you see 1-V
[↓] Number of data points N=4
[↓] Mean X = 10
[↓] Sample standard deviation Sx = 12.25
[↓] Population standard deviation 𝜎x = 10.61
Variance describes the risk of a single variable. In portfolio management, we are equally
concerned with how two variables vary relative to each other.
Covariance is a measure of how two variables move together.
• Values range from minus infinity to positive infinity.
• It is difficult to interpret. If the covariance is 50, it is difficult to say the degree to
which the variables move together and if it is a high or low covariance.
Correlation is a standardized measure of the linear relationship between two variables with
values ranging between -1 and +1.
How to interpret correlation
• If correlation = 1, then there is a perfect positive correlation between two assets. The
returns of the two assets move together in equal amounts.
• If correlation = 0, then there is no correlation between the two assets.
• If correlation = -1, then there is perfect negative correlation between two assets. The
returns of the two assets move in opposite directions in equal amounts.

The formula linking covariance and correlation is given below:

Cov (Ri, Rj) = ρ(Ri, Rj) * 𝜎(Ri) * 𝜎(Rj)
where
Ri = return on asset i
Rj = return on asset j
Cov (Ri, Rj) = covariance of returns on assets i and j
ρ(Ri, Rj) = correlation between two returns
𝜎 (Ri) = standard deviation of returns of asset i
𝜎 (Rj) = standard deviation of returns of asset j
Portfolio Expected Return and Variance
For a two asset portfolio, the expected return and variance can be computed as:
E(RP) = w1R1 + w2R2
𝜎p2 = w12 𝜎12 + w22 𝜎22 + 2 w1 w2 𝜎1 𝜎2 ρ
Example
My portfolio consists of two stocks X and Y. X represents 60% of the portfolio and Y the
remaining 40%. X has an expected return of 12% and a standard deviation of 16%. Y has an
expected return of 20% and a standard deviation of 30%. The correlation is 0.5. What is the
expected return and risk of my portfolio? How does the return/risk change when the
weights of X and Y change?
Solution:
E(R P ) = w1 R1 + w2 R 2
E(R P ) = 0.6 x 12 + 0.4 x 20 = 15.2%
We can calculate the portfolio variance:
𝜎p2 = (0.6)2 (0.16)2 + (0.4)2 (0.3)2 + 2 (0.6) (0.4) (0.16) (0.3) (0.5) = 0.0351
𝜎p = 0.1874 = 18.74%
To understand how return/risk change when the weights of X and Y change, we will
calculate the risk and return for different weights and plot a curve as shown in the graph
below.
• Point X represents 100% of the portfolio invested in stock X with return of 12% and
standard deviation of 16%.
• Point Y represents 100% of the portfolio invested in stock Y with expected return of 20%
and a standard deviation of 30%.
• The curve between X and Z (to the left of X) represents the region where amount
invested in stock X is decreased while the weight of Y is increased. This region is where
the benefit of diversification is seen i.e. expected return increases while risk goes lower.
• Beyond the Point Z, when weight of Y is increased till the point Y where 100% is invested

in Y, there is no diversification benefit. For any point between Z and Y, the risk and return
increase.
The graph below plots portfolio risk and return for a two-asset portfolio and shows the
impact of correlation of assets on portfolio risk. As you can see, there is no risk-return
tradeoff when 100% is invested either in X or Y.
2.4. Historical Return and Risk

Historical return is the return actually earned in the past, while expected return is the return
one expects to earn in the future.
Historical data shows that higher returns were earned in the past by assets with higher risk.
Of the three major asset classes in the U.S., namely stocks, bonds and T-bills, it has been
observed that stocks had the highest risk and return followed by bonds, and T-bills had the
lowest return and lowest risk.
Asset Class Annual Average Return Standard Deviation (Risk)
Small-cap stocks High High
Large-cap stocks
Long term corporate
bonds
Long term treasury bonds Low Low
Treasury bills
2.5. Other Investment Characteristics
In evaluating investments using mean and variance, we make the following two

assumptions:
• Assumption 1: Distributional characteristics
Returns are normally distributed. If this assumption does not hold, then consider
skewness and kurtosis. These concepts have been covered earlier in quantitative
methods.
• Assumption 2: Market characteristics
Markets are informationally and operationally efficient. If markets are not
operationally efficient, then it leads to: 1) high transaction costs 2) wide bid-ask
spreads and 3) larger price impact of trades.
3. Risk Aversion and Portfolio Selection
3.1. The Concept of Risk Aversion
Risk aversion refers to the behavior of investors preferring less risk to more risk.
Risk tolerance is the amount of risk an investor is willing to take for an investment. High
risk aversion is the same as low risk tolerance. Three types of risk profiles are outlined
below:
• Risk Seeking: A risk seeking investor prefers high return and high risk. Given two
investments, A and B, where both have the same return but investment A has higher
risk, he will prefer investment A.
• Risk Neutral: A risk neutral investor is concerned only with returns, and is indifferent
about the risk involved.
• Risk Averse: A risk averse investor will prefer an investment that has lower risk, all
else equal. Given two investments, A and B, where both have the same return but
investment A has higher risk, he will prefer investment B.
3.2. Utility Theory and Indifference Curves
The utility of an investment can be calculated as:
Utility = E(r) – 0.5 x A x 𝜎2
where:
A = measure of risk aversion (the marginal benefit expected by the investor in return for
taking additional risk. A is higher for risk-averse individuals.
𝜎2 = variance of the investment
E(r) = expected return
While using this formula, use only decimal values for all parameters.
Example
An investor with A = 2 owns a risk-free asset returning 5%. What is his utility?

Solution:
Utility = 0.05 - 0.5 x 2 x 0 = 0.05
Now, he is considering an asset with 𝜎 = 10%. At what level of return will he have the same
utility?
0.05 = E(r) – 0.5 x 2 x 0.12. Solving for E(R) we get 0.06 or 6.00%.
Given a choice between a risk-free asset and stock with an expected return of 10% and 𝜎 =
20%, what will he prefer?
U = 0.1 - 0.5 * 2 * 0.22 = 0.06. Since the utility number of 0.06 is higher than 0.05, the investor
will prefer this investment over the previous one.
Indifference Curves
The indifference curve is a graphical representation of the utility of an investment. An
indifference curve plots various combinations of risk-return pairs that an investor would
accept to maintain a given level of utility. If the combinations of risk-return on a curve
provide the same level of utility, then the investor would be indifferent to choosing one. Each
point on an indifference curve shows that the investor is indifferent to what investment he
chooses (risk/return combination) as long as the utility is the same.
To understand the indifference curve, let us plot all these numbers - expected return,
standard deviation and utility - on a graph.
The key points to note are:

• The indifference curves run from south-west to north-east. This is intuitive because

for taking on higher risk (going east), investors expect to be compensated with higher
expected return (going north).
• The utility of points A and B are 0.05. This means that the investor will be indifferent
about choosing an investment with E(r) of 5%, 𝜎 = 0 versus another with E(r) of 6%, 𝜎
= 10% as both have the same utility. Similarly, for assuming higher levels of risk, the
investor is compensated with higher return as shown in the 0.05 utility curve. Along
this curve, the investor is indifferent about choosing one point (investment) over the
other.
• As the investor moves north-west, he is happier as his utility increases, in this case
from 0.05 to 0.06. Risk is compensated with higher returns and it signifies higher risk
aversion.
We now consider the indifference curves for different types of investors.
The exhibit above shows the indifference curves for different types of investors with
expected return on y-axis and standard deviation on x-axis. Note the following:
• Risk-neutral investor: For a risk-neutral investor, the utility is the same irrespective of
risk as the investor is concerned only about the return. The expected return is
constant.
• Risk-averse investor: For a risk-averse investor, the curve is upward sloping, as the
investor expects additional return for taking additional risk. Finance theory assumes
that most investors are risk averse, but the degree of aversion may vary. The curve is
steeper for investors with high risk-aversion.
• Risk-seeking investor: The curve is downward sloping as the expected return
decreases for higher levels of risk. It is not commonly seen.
3.3. Application of Utility Theory to Portfolio Selection
Now that we have seen utility theory and indifference curves for various investors, let us see

how to apply it in portfolio selection. The simplest case is when a portfolio comprises two
assets: a risk-free asset and a risky asset. For a high risk averse investor, the choice is easy,
to invest 100% in the risk-free asset but at the cost of lower returns. Similarly, for a risk-
lover it would be to invest 100% in the risky asset. But is it the optimal allocation of assets,
or can there be a trade-off?
Example
Consider a simple portfolio of a risk-free asset and a risky asset. Plot the expected return of
the portfolio against the risk of the portfolio for different weights of the two assets.
Risk-free asset Risky asset
Rf = 5% Ri = 10%
𝜎=0 𝜎i = 20%
Solution:
A portfolio’s standard deviation is calculated as:
𝜎p =√w12 ∗ σ12 +w22 ∗ σ22 + 2 ∗ w1 ∗ w2 ∗ ρ1,2 ∗ σ1 ∗ σ2
Given that 𝜎1 = 0, the terms 𝑤12 ∗ 𝜎12 and 2 ∗ 𝑤1 ∗ 𝑤2 ∗ 𝜌1,2 ∗ 𝜎1 ∗ 𝜎2 become zero as the
correlation between a risk-free asset with risky asset is zero.
So, the equation becomes 𝜎p = w2 * 𝜎2. For different weights of the risky asset, let’s calculate
the values for risk and return and plot portfolio risk-return on a graph. Note that the
expected return is a weighted average of the two assets.
Weight of risky asset = 𝜎p (portfolio risk) = w2 * Rp (Portfolio return) = w1* Rf +
w2 𝜎2 w2 * Ri
0 0 5%
0.25 5% 6.25%
0.5 10% 7.5%
1 20% 10%
Capital allocation line with two assets: a
risky asset and a risk-free asset
12% 10%
Expected Return
10%
7.50%
8% 6.25%
5%
6%
4%
2%
0%
0 0.05 0.1 0.15 0.2 0.25
Portfolio Standard Deviation (in %)

Graph interpretation:
• What you get by plotting risk and return values for different weights of the risky and
risk-free asset is a straight line (linear).
• As you move north-east, the weight of the risky asset increases. The lowest point on the
left corner, intersecting the y-axis with expected return of 5%, represents 100% in the
risk-free asset. Similarly, the topmost point on the right corner represents 100% in the
risky asset with expected return of 10%.
• The straight line you see in the chart above is called the capital allocation line which
represents the portfolios available to the investor as each point on the line is an
investable portfolio.
• So, how does an investor decide which portfolio to invest in? The answer is by combining
an investor’s indifference curves and CAL to determine the optimal portfolio. We look at
it in detail in the next section.
What is the Optimal Portfolio?
We get the optimal portfolio by combining the indifference curves and the capital allocation
line. The utility theory gives us the indifference curves for an individual, while the capital
allocation lines give us a set of feasible investments. The optimal portfolio for an investor
will lie somewhere on the capital allocation line i.e. some combination (weight) of the risky
asset and risk-free asset. Using an investor’s risk-aversion measure A, we can use the utility
theory to plot the indifference curves for an individual. Assume the indifference curves for
this investor look as shown in the exhibit below:
Some key points about the graph:

• Curves 1, 2, 3 and 4 are various indifference curves for an individual. The indifference
curves cannot intersect each other.
• Curve 1 lies above the CAL. Curve 2 is tangential to the CAL at point b. Curve 3
intersects CAL at two points: d and e. Curve 4 lies below the CAL.
• Curve 1 has the highest utility while Curve 4 has the lowest utility. As we discussed

before, the investor is happier when we move north-west. Of the four curves, he will
be happiest with curve 1. But, as curve 1 lies outside the CAL, it is not possible to
construct a portfolio at any point on this curve with the available assets.
• Points on curve 3 may be attainable with the two assets. To achieve the utility level of
curve 3, the investor may choose to invest at points d and e where it intersects with
CAL.
• However, curve 2 is preferred over curve 3, as it provides a higher utility. To achieve
this utility level, the investor may choose to invest at point b, where the indifference
curve is tangential to the capital allocation line
• This point - Point b represents the optimal portfolio.
If another investor has a higher level of risk aversion, where will his optimal portfolio lie?
With a higher risk aversion level, the indifference curves will be steeper. The tangential point
will be closer to the risk-free asset, so it will be to the south-west of point b.
4. Portfolio Risk
Portfolio risk depends on:
• Risk of individual assets.
• Weight of each asset.
• Covariance or correlation between the assets.
4.1. Portfolio of Two Risky Assets
Risk of a two-asset portfolio is given by:
𝜎p =√w12 x σ12 +w22 x σ22 + 2 x w1 x w2 x ρ1,2 x σ1 x σ2
𝜎p =√w12 x σ12 +w22 x σ22 + 2 x w1 x w2 x Cov1,2
Covariance = Cov1,2 = ρ1,2 x σ1 x σ2

where: ρ1,2 = correlation coefficient that gives the correlation between returns R1 and R2.
Impact of correlation on portfolio risk
As correlation decreases, the diversification benefit increases i.e. the risk of the portfolio
decreases.
Example
Let us revisit our portfolio of X and Y. Earlier, we considered the impact of changing weights
of the two assets. Now, we will also consider the impact of different correlations. The
relevant data is reproduced here. X has an expected return of 12% and a standard deviation
of 16%. Y has an expected return of 20% and a standard deviation of 30%. What is the
expected return and risk of the portfolio for different weights assuming the following

correlations: -1, -0.5, 0, 0.5, and 1?

Solution:
Rp = wx Rx+ wy Ry 𝜎p2 = 𝑤𝑥2 σ2x + wy2 σ2y + 2wx wy ρxy 𝜎𝑥 𝜎𝑦
Rx = 12%, 𝜎x = 16%; Ry = 20%; 𝜎y = 30%
Weight of X Portfolio Portfolio risk when correlation between X and Y is:
(%) return
-1 -0.5 0 0.5 1
0 20 30 30 30 30 30
20 18.4 20.8 22.5 24.2 25.7 27.2
50 16 7 13 17 20.2 23
60 15.2 2.4 10.9 15.4 18.7 21.6
70 14.4 2.2 10.28 14.3 17.5 20.2
100 12 16 16 16 16 16
This chart is not exhaustive. It is plotted only for the weights used above.
Impact of correlation on portfolio risk with changing

weights of assets
25
20
Expected Return
-1
15
-0.5
10 0
0.5
5
1
0
0 10 20 30 40
Portfolio Standard Deviation
• Consider the line represented with a correlation of 1. As the weight of X is reduced and
weight of Y is increased the risk and return both increase. There is no diversification
benefit.
• Consider a correlation of 0. As the weight of X is reduced and weight of Y is increased the
risk initially decreases and the return increases. Hence there is clearly a diversification
benefit.
• The diversification benefit increases as correlation decreases.
• With a correlation of -1, there is certain weight of X and Y when the risk is zero.

4.2. Portfolio of Many Risky Assets

In the previous example, we saw how a two-asset portfolio’s risk reduces as the correlation
between the assets decreases. To be more generic, for a portfolio with more than two assets,
the variance is given by:
σ2 N − 1
σ2P = + ∗ Cov
N N
where:
σ2P = portfolio variance
σ2 = average variance
Cov = average covariance
N = number of assets in the portfolio
Instructor’s tip:
The probability of being tested on this formula is low.
4.3. The Power of Diversification
When creating a diversified portfolio, the choice of assets and the correlation among assets
is important. Adding perfectly positively correlated assets to a portfolio does little to reduce
the portfolio’s risk. Similarly, assets that have lower correlations will reduce risk. When two
assets with a correlation of -1.0 are combined to form a portfolio, risk can be reduced to
zero.
5. Efficient Frontier and Investor’s Optimal Portfolio
5.1. Investment Opportunity Set
Consider the universe of risky, investable assets available to an investor. These can be
combined to form many portfolios; when plotted together they form a curve. This set of
portfolios is called the investment opportunity set as shown in the exhibit below.

5.2. Minimum Variance Portfolios

At any given level of return in the investment opportunity set, there will be a portfolio with
minimum variance i.e. minimum risk for a given level of return. The line combining such
portfolios with minimum variance is called the minimum variance frontier.
In the exhibit above, points M, N and O have the same expected return. But, investors will
prefer point M over N or O because it has lower risk. The curve stretching from A to B
through Z is called the minimum variance frontier.
Global Minimum-Variance Portfolio: the portfolio with the lowest risk or minimum
variance among portfolios of all risky assets is called the global minimum-variance portfolio.
It is represented by point Z in the exhibit above. It is not possible to hold a portfolio of risky
assets that has less risk than that of the global minimum-variance portfolio.
The efficient frontier is the part of the minimum variance frontier that is above the global
minimum variance portfolio. It represents the set of portfolios that will give the highest
return at each risk level. Remember that the efficient frontier consists of only risky assets.
There is no risk-free asset. Consider points L and M on the minimum variance frontier. Both
the portfolios have the same level of risk but portfolio L has a higher return than M.
Investors will prefer the portfolio with higher return.
5.3. A Risk-Free Asset and Many Risky Assets
One of the constraints of the efficient frontier is that it comprises only risky assets. We
overcome this drawback with the capital allocation line: a combination of risky assets and
risk-free asset. The addition of a risk-free asset makes the investment opportunity set much
richer than the investment opportunity set consisting only of risky assets. A portfolio of risky
assets and a risk-free asset results in a straight line represented by the capital allocation
line.

Interpretation of the diagram:

• CAL-P and CAL-Z are capital allocation lines formed by combining risky portfolios P
and Z with the risk-free asset respectively.
• Portfolio P is the optimal risky portfolio. It is the point at which the capital allocation
line is tangential to the efficient frontier of risky assets. CAL-P is the optimal capital
allocation line.
• The optimal risky portfolio is based on the market, and not the investor’s risk
preferences. Along CAL-P, the weight of risk-free assets and portfolio P varies. For
instance, it is 100% in the risk-free asset at y-axis, 100% in risky portfolio P at the
point P, and a mix of both in between.
5.4. Optimal Investor Portfolio
To identify the optimal investor portfolio, we must consider the investor’s risk preferences.
The utility of each investor is best represented by his indifference curves. The optimal
investor portfolio is the point at which the investor’s indifference curve is tangential to the
optimal allocation line. Portfolio C in the exhibit below is the optimal investor portfolio.

Summary
LO.a: Calculate and interpret major return measures and describe their appropriate
uses.
Returns can come in the form of income (interest payment and dividend) and capital gains.
Holding period return is the return earned on an asset during the period it was held.
PT − P0 + DT
HPR single period =
P0
Arithmetic return is a simple arithmetic average of returns.
Geometric mean return is the compounded rate of return earned on an investment.
1
GM = [(1 + R1 ) ∗ (1 + R 2 ) ∗ … . .∗ (1 + R T )]T − 1
Money-weighted return is the internal rate of return on money invested that considers the
cash inflows and cash outflows, and calculates the return on actual investment. It is
synonymous with internal rate of return (IRR).
Annualized return converts the returns for periods that are shorter or longer than a year, to
an annualized number for easy comparison.
Portfolio return is the weighted average of the returns of the individual investments.
Gross return is the return earned by an asset manager prior to deducting management fees
and taxes. It measures investment skill.
Net return accounts for all managerial and administrative expenses; this is what the investor
is concerned with.
Pre-tax nominal return is the return before accounting for inflation and taxes; this is the
default, unless otherwise stated.
After-tax nominal return is the return after accounting for taxes.
Real return is the return after accounting for taxes and inflation.
Leveraged return is the return earned by the investor on his money after accounting for
interest paid on borrowed money.
LO.b: Describe characteristics of the major asset classes that investors consider in
forming portfolios.
Asset Class Annual Average Return Standard Deviation (Risk)
Small-cap stocks High High
Large-cap stocks
Long term corporate bonds
Long term treasury bonds
Low Low
Treasury bills

LO.c: Calculate and interpret the mean, variance, and covariance (or correlation) of
asset returns based on historical data.
Variance is a measure of volatility or dispersion of returns for a single variable.
Covariance is a measure of how two variables move together. It is difficult to interpret.
Correlation is a standardized measure of the linear relationship between two variables with
values ranging between -1 and +1. It can be calculated using the formula:
ρ(Ri, Rj) = Cov (Ri, Rj)/σ(Ri)σ(Rj)
LO.d: Explain risk aversion and its implications for portfolio selection.
A risk-averse investor prefers less risk to more risk. In contrast, a risk seeking investor
prefers more risk to less risk. If expected returns of two assets are same, a risk-averse
investor will prefer asset with lower risk.
LO.e: Calculate and interpret portfolio standard deviation.
The standard deviation of a portfolio of two risky assets can be calculated using the
following formula:
𝜎p =√w12 ∗ σ12 +w22 ∗ σ22 + 2 ∗ w1 ∗ w2 ∗ Cov1,2
LO.f: Describe the effect on a portfolio’s risk of investing in assets that are less than
perfectly correlated.
The above graph of risk and return shows the benefits of diversification. When the
correlation of assets in a portfolio decreases, the risk of the portfolio decreases.

LO.g: Describe and interpret the minimum-variance and efficient frontiers of risky
assets and the global minimum-variance portfolio.
Consider the universe of risky, investable assets. These can be combined to form many
portfolios; when plotted together they form a curve. This set of portfolios is called the
investment opportunity set.
At any given level of return in the investment opportunity set, there will be a portfolio with
minimum variance. The line combining such portfolios with minimum variance is called the
minimum variance frontier.
The portfolio with the lowest risk or minimum variance among portfolios of all risky assets
is called the global minimum-variance portfolio.
The efficient frontier is the part of the minimum variance frontier that is above the global
minimum variance portfolio. It represents the set of portfolios that will give the highest
return at each risk level.
Remember that the efficient frontier consists of only risky assets. There is no risk-free asset.
The graph below shows these points:
LO.h: Discuss the selection of an optimal portfolio, given an investor’s utility (or risk
aversion) and the capital allocation line.
To identify the optimal investor portfolio, we must consider the investor’s risk preferences.
The utility of each investor is best represented by his indifference curves. The optimal
investor portfolio is the point at which the investor’s indifference curve is tangential to the
optimal allocation line. Portfolio C in the exhibit below is the optimal investor portfolio.

CAL (P) is based on the market, not the investor’s risk preferences; it represents the most
efficient portfolio for each level of risk.

Practice Questions
1. An analyst has gathered the annual returns on a hedge fund:
Year Return (%)
Year 1 26
Year 2 -12
Year 3 3
The fund’s holding period return over the three-year period and its annual geometric
mean return is closest to:
Holding period return Geometric mean return
A. 14.21% 4.53%
B. 14.21% 5.67%
C. 12.35% 4.53%
2. David has made investments in three securities. The returns data is as follows:
Security Time since investment Return since inception (%)
A 122 days 5.56
B 7 weeks 2.12
C 19 months 16.32
The security with the highest annualized rate of return is:
A. Security B.
B. Security C.
C. Security A.
3. Amy makes the following transactions in a hedge fund, which performs as given below
over a three year period:
New investment at the beginning of the year $18,000 $24,500 $32,000
Investment return for the year -12% 15% 20%
Withdrawal by investor at the end of the year $0 $16,000 $0
The money-weighted return that Amy will earn in this hedge fund is closest to:
A. 12.67%.
B. 7.67%.
C. 10.67%.
4. Gerald observes that the historic geometric returns for US equity market are 15% while
the inflation is at 3% and the treasury bills are at 3.5%. The real rate of return and the

risk premium for US equity market is closet to:

Real rate of return Risk premium
A. 12.65% 11.11%
B. 11.65% 11.11%
C. 10.65% 12.22%
5. Tim Jones has compiled the historical information for two stocks, Apex and Orion:
Variance of returns for Apex 0.0653
Variance of returns for Orion 0.0927
Correlation coefficient between Apex and Orion 0.5300
The covariance calculated between Apex and Orion is closet to:
A. 0.0412.
B. 0.0386.
C. 0.0468.
6. According to utility theory, a relatively risk-averse investor will have an indifference

curve that will have:
A. higher slope coefficient.
B. lower slope coefficient.
C. higher convexity.
7. Financial planner has gathered the following information:

Investment Expected return (%) Expected standard deviation (%)
A 16 8
B 18 2
C 26 8
D 22 35
Susan has a risk-aversion measure of -3 while Alex has a risk aversion measure of 3. If
the investor’s utility function is given by 𝑈 = 𝐸(𝑟) − 0.5 ∗ 𝐴 ∗ 𝜎 2 , the investment that
Susan and Alex are most likely to select is:
Susan Alex
A. Investment D Investment C
B. Investment B Investment C
C. Investment C Investment D
8. The following two shares are included in a portfolio:

Clement Corporation Telnet Corporation

Expected returns 15% 11%
Std dev of returns 38% 52%
Portfolio weights 65% 35%
Correlation of returns 0.46
The standard deviation of returns of the portfolio formed with these two stocks is closet
to:
A. 0.2980.
B. 0.3320.
C. 0.3680.
9. The portfolio that most likely falls below the efficient frontier is:
Portfolio Expected return (%) Expected std dev (%)
A 8 9
B 12 18
C 14 15
A. Portfolio B.
B. Portfolio A.
C. Portfolio C.
10. Amy has a higher risk aversion coefficient than Susan. Given that both Amy and Susan
have selected the same risky portfolio, the optimal portfolio on the capital allocation line,
for Susan will have:
A. higher expected return than Amy’s optimal portfolio.
B. lower expected return than Amy’s optimal portfolio.
C. same expected return as that of Amy’s optimal portfolio.

Solutions
1. A is correct.
Holding period return:
[(1 + 0.26)(1 − 0.12)(1 + 0.03)] – 1 = 14.21%
Geometric mean return:
[(1 + 0.26)(1 − 0.12)(1 + 0.03)]1/3 – 1 = 4.53%.
.
2. C is correct.
365
Annualized return of Security A = 1.0556(122) − 1 = 17.57%
52
Annualized return of Security B = 1.0212( 7 ) − 1 = 16.86%
12
Annualized return of Security A = 1.1632(19) − 1 = 10.02%
3. A is correct.
Starting balance ($) 0 15,840 30,391
New investment ($) 18,000 24,500 32,000
Balance at the beginning of the year ($) 18,000 40,340 62,391
Investment return for the year -12% 15% 20%
Investment gain/loss ($) -2,160 6,051 12,478.2
Withdrawal by investor at the end of 0 16,000 0
the year ($)
Balance at the end of the year ($) 15,840 30,391 74,869.2
CF0 = -18,000
CF1 = -24,500 (new investment at the beginning of year 2)
CF2 = -16,000 (withdrawal of 16,000 at the end of year 2, -32,000 new investment at the
beginning of year 3)
CF3 = 74,869.2 (balance at the end of year 3)
4. B is correct.
Real rate of return = (1 + 0.15)/ (1 + 0.03) - 1 = 11.65%
Risk premium of return = (1 + 0.15)/ (1 + 0.035) - 1 = 11.11%
5. A is correct.
Covij= σi * σj * rij = Sqrt (0.0653) × Sqrt (0.0927) × 0.5300 = 0.0412
6. A is correct. The more risk-averse an investor is, the higher the slope of the indifference
curve. An investor with less steep indifference curves has a lower level of risk aversion i.e

higher risk tolerance.
7. A is correct.
Using the utility function,
Susan’s utility Alex’s utility
Expected Expected std
Investment function; function;
return (%) dev (%)
A=-3 A=3
A 16 8 0.1696 0.1504
B 18 2 0.1806 0.1794
C 26 8 0.2696 0.2504
D 22 35 0.4038 0.0363
Susan would opt for Investment D, while Alex would opt for Investment C.
Susan is a risk-seeking investor while Alex is a risk-averse investor.
8. C is correct.
𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = √(0.65)2 (0.38)2 + (0.35)2 (0.52)2 + 2(0.65)(0.38)(0.35)(0.52)(0.46)
𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 0.3680
9. A is correct. Portfolio B must be the portfolio that falls below the Markowitz efficient
frontier as it has lower return and higher risk than Portfolio C.
10. A is correct. Susan has a low-risk aversion coefficient, therefore, a high-risk tolerance.
The indifference curve will intersect the capital allocation line at a higher level, giving an
optimal portfolio that has a higher expected return than Amy’s optimal portfolio.

R40 Portfolio Risk and Return Part II 2019 Level I Notes
R40 Portfolio Risk and Return Part II

1. Introduction
In this reading, we will discuss:
• The capital market line (CML).
• The two components of total risk: systematic and nonsystematic risk.
• The capital asset pricing model (CAPM) and the security market line (SML). The
primary objective of this reading is to identify the optimal risky portfolio using CAPM.
2. Capital Market Theory
2.1. Portfolio of Risk-Free and Risky Assets
This is a repetition of what we have seen in the previous reading. When a risk-free asset is
combined with a risky asset, it results in higher risk adjusted returns because the risk-free
asset has zero correlation with the risky asset. This leads to the capital allocation line.
Investors have different views of the market (and different levels of risk aversion) which
means the individual risky assets (e.g. securities) they choose to form their portfolio are
different. Combining the capital allocation line with an investor’s indifference curve leads to
different optimal risky portfolios, as illustrated in the exhibit below.
We now explore whether a unique optimal risky portfolio exists for all investors. The answer
is yes, if there is homogeneity of expectations.
What is homogeneity of expectations?
• It means that all investors have the same economic expectations for an asset.

• For example, assume there are two securities. With homogeneity of expectations, all
investors have the same views on risk, return, price, cash flows, and the correlation
between the two assets. This means the calculation to arrive at optimal risky portfolio
for all investors would be the same.
2.2. The Capital Market Line
Since all investors have the same expectations, they will construct only one efficient frontier.
If there is one efficient frontier, there will be only one capital allocation line. The point where
this capital allocation line is tangential to the efficient frontier is called the market portfolio.
This is the optimal risky portfolio when all investors have the same expectations. The CML is
a special case of the CAL where the efficient portfolio is the market portfolio.
Now, let us derive the equation for CML. We will use a basic equation of the form: Y = C + mX
where:
Y= Rp (portfolio return)
C = Rf (risk-free rate)
m = slope = (Rm - Rf) / 𝜎m
X = portfolio standard deviation = 𝜎p
The equation for CML can be written as
Rm − Rf
Rp = Rf + ( ) ∗ σp
σm
Any point along the CML is a combination of the risk-free asset and the market portfolio. At
the point where the CML intersects y-axis, 100% is invested in the risk-free asset and its
weight decreases as we go up along the CML.

What is the market?

Theoretically, the market includes all risky assets or anything that has value. Examples
include stocks, bonds, real estate etc.
The market portfolio should contain as many assets as possible, but it is not practical to
include all assets in a single risky portfolio because not all assets are tradable and not all
tradable assets are investable. Examples of non-tradable assets include the Eiffel Tower and
human capital. Examples of tradable assets that are not investable include Class A shares on
the Shanghai Stock Exchange that are not available for foreign investors.
Practically we use major stock market indices as a proxy for the market. This reading uses
the S&P 500 index as the market’s proxy as it represents approximately 80% of the U.S stock
market capitalization and U.S. markets account for nearly 32 per cent of the world markets.
Example
Majid Khan wants to build a portfolio using T-bills and an index fund which tracks the KSE
100 Index. The T-bills have a return of 10%. The index fund has an expected return of 16%
and a standard deviation of 30%. Draw the CML. Show the point where the investment in the
market is 75%. What is the risk and return at this point?
Solution:
Risk and return when the investment in the market is 75%:
σp = wm ∗ σm = 0.75 * 30 = 22.5% (Note: Risk of T-bills is zero)
R p = wrf x R f + wm x R m = 0.25 x 10 + 0.75 x 16 = 14.5%
Let us now plot these values on the CML.
When the return on the portfolio is 10%, Majid is holding 100% of the T-bills and 0% of the
market portfolio. As he increases his weight in the market portfolio to 75%, we see that the
return has changed to 14.5% but his risk has also gone down to 22.5%. When he has
invested 100% in the market portfolio, the risk and return are the same as the market

portfolio.
Leveraged Portfolios
Our focus so far has been on the portfolios between the points Rf , the risk-free asset, and M,
the market portfolio, on the CML, where an investor is holding some combination of the two
assets. The portfolios on this stretch between Rf and M are called lending portfolios because
the investment in the assets comes from the investor’s own wealth. He is lending (investing)
his wealth at the risk-free rate.
The dotted line in the exhibit below stretches beyond M on the CML represents the
borrowing portfolios. This means that the investor is able to borrow money at the risk-free
rate to invest more in the market portfolio.
• A portfolio beyond point M is a combination of investor’s own wealth and borrowed

money at the risk-free rate.
• As we go up north-east beyond M on the CML, the investment in the market portfolio
increases and so is the amount of borrowed money.
• Beyond point M, there is a negative investment in the risk-free asset, and the risky
portfolio is called the leveraged portfolio. More risk leads to higher expected return.
• How much money the investor borrows to invest in a portfolio beyond M depends on
his risk-return preferences, in other words, his utility function.
Rm − Rf
• The slope of the line between Rf and M is given as .
σm
Different lending and borrowing rates

Often, investors are not able to borrow money at the risk-free rate. If the borrowing rate is
higher than the risk-free rate, the CML is no longer a straight line. The slope of the line to the
Rm − Rb
right of M is given by: . Hence, there is a ‘kink’ in the CML. This is illustrated in the
σm
exhibit below. Using the data from the previous example, the slope of CML when borrowing

16 − 10
rate is the same as lending rate, we get slope as = 0.2. Now, assume the borrowing rate
30
16 − 12
is higher at 12%. The slope in this case will be = 0.133, which is less than 0.2.
30
When the borrowing rate is higher than the lending rate, the return per unit of risk is less
relative to when the borrowing rate is equal to the lending rate.
Example
After a successful initial foray into the stock market, Majid Khan gets a little greedy and
decides to build a leveraged portfolio. He invests 100,000 of his own money and 50,000 of
borrowed money in the index fund. He expects to pay 10% on the borrowed money. The
index fund has an expected return of 16% and a standard deviation of 30%. Calculate his
expected risk and return.
Solution:
w1 = Weight of the risk-free asset = Weight of borrowed money = -50,000/100,000 = -0.5
w2 = Weight in risky asset = 150,000/100,000 = 1.5
Total weight = w1 + w2 = 1.5 - 0.5 = 1
Expected return with -50% invested in T-bills = w1Rb + w2Rm = -0.5 (10) + 1.5 (16) = 19%.
Standard deviation with -50% invested in T-bills is w2 x 𝜎m = 1.5 x 30 = 45%.
This example shows us that leverage amplifies both expected return and risk.
Example
Calculate the expected return and risk if Majid actually needs to pay 12% on the borrowed
money. All other numbers are the same.
Solution:
The standard deviation or risk of the portfolio remains the same. But the expected return

must be lower as the borrowing rate has increased. Let us calculate the slope of the
Rm − Rb 16 − 12
borrowing part of the CML as = = 4/30.
σm 30
Expected return = 12% + (16 - 12)/30 * 45 = 18%.

Or, expected return with -50% invested in T-bills = w1Rb + w2Rm = -0.5 (12) + 1.5 (16) =
18%.
Standard deviation with -50% invested in T-bills 𝜎p = w2 * 𝜎M =1.5 * 30 = 45%.
3. Pricing of Risk and Computation of Expected Return
We have seen repeatedly that high returns come with high risk. But does all high risk lead to
high returns? No. Total risk can be decomposed into systematic and nonsystematic risk.
Total variance = Systematic variance + Nonsystematic variance
3.1. Systematic Risk and Nonsystematic Risk
Systematic risk is non-diversifiable or market risk that affects the entire economy and
cannot be diversified away. Investors get a return for systematic risk.
Examples of systematic risk are interest rates, inflation, natural disasters, unrest/coup
attempts such as events in Middle East/Africa since 2011 and political uncertainty.
It is tough to avoid systematic risk. However, the effects can be minimized by selecting
securities with low correlation to the rest of the portfolio.
Nonsystematic risk is a local risk that affects only a particular asset or industry. There is no
compensation for nonsystematic risk as it can be diversified away.
Examples of nonsystematic risk are oil discoveries, non-approval for a drug, new regulations
for telecom industry.
Nonsystematic risk may be avoided by diversifying a portfolio to include assets across
countries, industries and asset classes. Nonsystematic risk does not earn a return.
Pricing of risk: Pricing an asset is equivalent to estimating its expected rate of return; price
and return are often used interchangeably. For example, if we know the cash flows for a
bond, its price can be computed using the discount rate. Pricing of risk is this rate of return
which reflects the systematic risk.
Instructor’s Note
Systematic risk or market risk is the only risk for which investors get compensated. It cannot
be eliminated with diversification.
A risk-free asset has zero systematic risk and zero nonsystematic risk.
Example
Describe the systematic and nonsystematic risk components of the following assets:

• A six-month Treasury bill.

• An index fund based on the S&P 500, with total risk of 18%.
Solution:
• A six-month Treasury bill: For a T-bill, we know how much an investor would get paid at
the end of six months. The systematic risk and nonsystematic risk are both zero; the total
variance is therefore zero.
• An index fund based on the S&P 500, with total risk of 18%: S&P 500 represents the
market. There is no nonsystematic risk in a market portfolio. So, the total risk of 18% is
systematic risk.
Example
Consider two assets X and Y. X has a total risk of 25% of which 15% is systematic risk. Asset
Y is the S&P index fund mentioned above with a total risk of 18%, all of which is systematic
risk. Which asset will have a higher expected rate of return?
Solution:
Based on total risk, asset X seems an obvious choice because higher risk results in higher
return. However it is more appropriate to compare the systematic risk of the two assets as
only systematic risk earns a return. Asset Y will earn a higher expected return as its
systematic risk of 18% is higher than asset X’s 15%. An investor will not be compensated for
assuming nonsystematic risk in asset X as it can be eliminated.
3.2. Calculation and Interpretation of Beta
Return-Generating Models
Return-generating models provide an estimate of the expected return of a security given
certain input parameters called factors. If the model uses many factors, it is called a multi-
factor model. If it uses one factor, it is a single-factor model.
Multi-factor Models
The three commonly used multi-factor models are: macroeconomic, fundamental, and
statistical models. These models use factors that are correlated with security returns.
• Macroeconomic models use economic factors such as economic growth, interest rate,
unemployment rate, productivity etc.
• Fundamental models use input parameters such as earnings, earnings growth, cash
flow, market capitalization, industry-specific inputs, financial ratios like P/E, P/B,
value/growth etc.
• In the statistical models, there is no observable economic or fundamental connection
between the input and security returns. Unlike a macroeconomic or fundamental
model, there are also no pre-determined set of factors. Instead, historical or cross-
sectional security returns are analyzed to identify factors that explain variance or

covariance in returns.
Single-factor Models
In a single-factor model, only one factor is considered. A classic single factor model is the
market model which is given by this equation:
R i = αi + βR m + ei
where: Ri is the dependent variable and Rm is the independent variable.
According to the market model, a stock’s return can be decomposed into:
• αi – Excess returns of the stock (difference between expected and realized returns).
• β – Systematic risk of a security or the stock’s sensitivity to the market. For instance,
how the stock’s return varies when the market return moves up or down by 1%.
• Rm – Return on the market.
• ei – Error term that affects stock returns due to firm-specific factors. There is an error
term because not all of a stock’s returns can be explained by market returns.
Calculation and Interpretation of Beta
Beta is a measure of systematic (or market) risk. Beta is a number and has no unit of
measure. It tells us how sensitive an asset’s return is to the market as a whole. Beta
determines the amount by which a stock’s return is expected to move for every 1 per cent
increase or decrease in the market return. Beta is the ratio of the covariance of returns of
stock i with returns on the market to the variance of market return.
Cov(i,M) ρiM ∗ σi
β= =
σ2M σM
Interpretation of beta values:

• β > 0: Return of the asset follows the market trend.
• β < 0: Return of the asset moves in an opposite direction to the market trend
(negatively correlated with the market).
• β = 0: An asset’s return has no correlation with the market. For example, a risk-free
asset has a beta of zero.
• β = 1: Beta of market is equal to 1. If a stock has a beta of 1, it means it has the same
volatility as that of the market.
How do we estimate beta:
Beta is estimated using a statistical method called linear regression analysis where stock
returns are regressed against market returns. Historical security returns and historical
market returns are used as inputs in this method. Let’s say, we consider a stock’s returns for
the past 100 months. The pairs (security, market return) are plotted to get a scatter plot.
Each point on the graph represents a month. A regression line is drawn though the scatter
plot that best represents the data points. The point where the line intercepts the y-axis is α

(or excess returns). The slope of the line is equal to its beta.
A portfolio beta is calculated as the weighted average beta of the individual securities in the
portfolio.
Example
Assuming the standard deviation of market returns is 20%, calculate the beta for the
following assets:
• 6-month T-bill.
• A commodity with 𝜎 = 15%, and zero correlation with the market.
• A stock with 𝜎 = 25% and correlation with the market = 0.6.
Solution:
• 6-month T-bill: beta for a T-bill is zero as there is no correlation between a risk-free asset
and the market.
• A commodity with 𝜎 = 15%, and zero correlation with the market: using equation 7, we
can conclude that beta is zero if correlation with the market is zero.
0.6 ∗ 0.25
• A stock with 𝜎 = 25% and correlation with the market = 0.6: β = = 0.75
0.2
4. The Capital Asset Pricing Model

The capital asset pricing model is a model used to calculate the expected rate of return of
a risky asset, and gives the relationship between a security’s return and risk. CAPM states
that the expected return of assets reflects only their systematic risk, which is measured by
beta. Systematic or market risk cannot be diversified. It means that two assets with same
beta will have the same expected return irrespective of their individual characteristics.
re = R f + β [E (R mkt ) − R f ]
where:
re = expected return

R f = risk − free rate

β = systematic risk of security
E (R mkt ) = expected return of market
E (R mkt ) − R f = market risk premium; it is the compensation for assuming market risk.
4.1. Assumptions of the CAPM
We will now take a look at the assumptions for arriving at CAPM:
1. Investors are risk-averse, utility maximizing, rational individuals.
Risk aversion means investors expect to be compensated for bearing risk. Different
investors have different levels of risk aversion or risk tolerance. Utility maximizing
means investors prefer higher returns to lower returns. Individuals are rational means
that all investors have the ability to gather and process information to make logical
decisions. In reality, however, this is not true for most investors as personal biases and
experiences shroud their judgment.
2. Markets are frictionless. There are no transaction costs and no taxes.
Investors can borrow and lend as much as they want at the risk-free rate. One important
assumption here is that there are no costs or restrictions on short-selling, which is not
true in reality. This limits the CAPM.
3. All investors plan for the same, single-holding period.
CAPM is based on a single period instead of multiple periods because it is easy to
calculate.
4. Investors have homogenous expectations.
All investors analyze securities using the same probability distribution to arrive at
identical valuations. This means all investors use the same estimates for expected
returns, variance, and correlation between assets. Since the expected returns and
standard deviation for all investors is the same, they will arrive at the same optimal risky
portfolio, or the market portfolio in the CML.
5. Investments are infinitely divisible.
Investors can hold a fraction of any asset. It means that they may invest as much as or
little in any asset.
6. Investors are price takers.
CAPM assumes that there are many small investors who cannot influence the security
prices. They are price takers.
Example
FFC’s standard deviation of returns is 25% and its correlation with the market is 0.6. The
standard deviation of returns for the market is 20%. The expected market return is 10% and
the risk free rate is 3%. What is FFC’s expected return?

Solution:
ρiM ∗ σi 0.6 ∗ 0.25
β= = = 0.75
σM 0.2
re = R f + β[E(R mkt ) − R f ]
re = 0.03+ 0.75[0.1 - 0.03] = 0.0825
re = 8.25%
4.2. The Security Market Line
The security market line (SML) is a graphical representation of the capital asset pricing
model and applies to all securities, whether they are efficient or not. The graph has beta on
the x-axis and expected return on the y-axis.
SML intersects y-axis at the risk-free rate.

Rm – Rf
Slope of the line = = R m – R f as β = 1 for the market. So, slope of the line is the
β
market risk premium.
What is the difference between CML and SML?
Differences between CML and SML
CML SML
Does not apply to all securities; applies to Applies to any security. It may include
only efficient portfolios. inefficient portfolios as well.
Only systematic risk is priced. So
CAL/CML can only be applied to those
portfolios whose total risk is equal to
systematic risk.
X-axis has the standard deviation of the X-axis has beta of the asset or portfolio.
portfolio.

Rm −Rf re = R f + β[E(R mkt ) − R f ]

Rp = Rf + ( ) * 𝜎p
σm
where β is the systematic risk. SML is just a
where 𝜎p is the total risk of the portfolio.
graphical representation of CAPM.
Slope of the CML is the Sharpe ratio: Slope of the SML is the market risk
Rm − Rf premium: E(R mkt ) − R f
σm
Similarities between CML and SML

Both CML and SML have expected portfolio return on the y-axis.
The line stretches from the risk-free asset to the market portfolio in both the cases.
Example
Ricky Ponting invests 10% in the risk-free asset, 40% in a mutual fund which tracks the
market and 50% in a high-risk stock with a beta of 2.5. The risk-free rate is 5% and the
expected market return is 10%. What is the portfolio beta and expected return?
Solution:
Risk-free asset: w = 0.1 r = 5% β=0
Mutual fund: w = 0.4 r = 10% β=1
High risk stock: w = 0.5 r = ? β = 2.5
Portfolio beta = weighted average beta of all assets = 0.1 x 0 + 0.4 x 1 + 0.5 x 2.5 = 1.65
Portfolio return = rf + β (rm − rf ) = 0.05 + 1.65 [0.1 - 0.05] = 0.1325 = 13.25%
Alternative method:
First determine the return of the high-risk stock using its beta.
Expected return of high-risk stock = 0.05 + 2.5[0.1 - 0.05] = 0.175 = 17.5%
Portfolio return= weighted average return of all assets = 0.1 x 5 + 0.4 x 10 + 0.5 x 17.5 =
13.25%
4.3. Applications of the CAPM
The CAPM is important both from a theoretical and practical perspective. In this section, we
will look at some of the practical applications of CAPM in capital budgeting, performance
appraisal, and security selection.
Estimate of Expected Return
Given an asset’s systematic risk, the expected return can be calculated using CAPM.
• To estimate the current price of an asset, we discount future cash flows at the
required rate of return calculated using CAPM.
• The required rate of return from the CAPM rate is also used in the capital budgeting
process and to determine if a project is economically feasible.

Portfolio Performance Evaluation

Before selecting an investment manager, it is important for investors to understand the
performance of a manager and the cost structure involved. In this section, we look at four
measures that are commonly used in performance evaluation. These are:
Sharpe Ratio Portfolio risk premium
=
Rp − R f
Portolio total risk σp
M-Squared (R p − R f )σm
M2 = − (R m − R f )
σp
Treynor Ratio Portfolio risk premium
=
Rp − Rf
beta risk βp
Jensen’s Alpha Actual portfolio return – expected return = R p − [R f +
β(R m − R f )]
Sharpe Ratio
Sharpe ratio is the excess return of the portfolio over the risk-free rate divided by the
portfolio risk. It is the excess return per unit of risk. The higher the Sharpe ratio the better,
all else equal.
Limitations of Sharpe ratio
• The Sharpe ratio uses total risk; not systematic risk.
• The ratio itself is not informative. The Sharpe ratio of one portfolio must be compared
with another to see which one is better. For instance, if a portfolio has a Sharpe ratio
of 0.7, the number does not convey anything. But if there is another portfolio with a
Sharpe ratio of 0.9, then we know it is superior to the one with 0.7.
Treynor Ratio
Treynor ratio is the excess return of the portfolio over the risk-free rate divided by the
systematic risk of the portfolio. The numerator must be positive for meaningful results. It
does not work for negative beta assets.
Limitations of Treynor ratio
• The ratio itself is not informative. When two portfolios are compared, we know which
one is superior but we do not know if its performance is better than the market
portfolio.
• There is no information about the amount of underperformance or over performance.
For instance, assume there are two portfolios A and B with Treynor ratios of 0.6 and
0.7 respectively. Though B is better than A, we have no information as to how much
B’s performance is better than A.
M-Squared
If M-Squared return is greater than zero, the manager (portfolio) has positive risk-adjusted
return. One way to get a positive M-Squared is when the risk is same as the market but RP is

greater than RM. Another way is when the return is same as the market but at a lower risk. If
M-Squared is zero, then the manager (portfolio) has the same risk-adjusted return as the
market. If M-Squared return is negative, the manager (portfolio) has a lower risk-adjusted
return than the market.
Limitation: A limitation of this measure is that it uses total risk and not systematic risk.
Jensen’s Alpha
Jensen’s alpha is the difference between the actual return on a portfolio and the CAPM
calculated expected or required return. In other words, it is the plot of the excess return of
the security on the excess return of the market. The intercept is Jensen’s alpha and beta is
the slope.
Like the Treynor ratio, it is based on systematic risk. Alpha is used to rank different
managers and their portfolios. Since Jensen’s alpha uses systematic risk, it is theoretically
superior to M-Squared.
Interpreting Jensen’s Alpha
• If Jensen’s alpha > 0, the manager (portfolio) has positive risk-adjusted return.
• If Jensen’s alpha = 0, then the manager (portfolio) has the same risk-adjusted return
as the market.
• If Jensen’s alpha < 0, the manager (portfolio) has a lower risk-adjusted return than
the market.
Sharpe ratio and M-squared are total risk measures. Use these measures when a portfolio is
not fully diversified.
Treynor ratio and Jensen’s alpha are based on beta risk and should be used when a portfolio
is well diversified.
Security Characteristic Line

The SCL is a plot of the excess return of a security over the risk-free rate on the y-axis against
the excess return of the market on the x-axis. We saw earlier that the SML’s intercept on the
y-axis is the alpha and the line’s slope is its beta. Similarly, SCL’s slope is the security’s beta.
The SCL is obtained by regressing excess security return on the excess market return.
SCL: R i − R f = αi + βi ∗ (R m − R f )
where:
R i − R f = excess security return
R m − R f = excess market return
αi = Jensen’s alpha or excess return
Security Selection
In CAPM, we assumed that investors have homogeneous expectations and assign the same
value to all assets. So, all the investors arrive at the same optimal risky portfolio, the market
portfolio. But, in reality, it does not actually happen.
The SML can also be used for security selection. Investors can plot a security’s expected
return and beta against the SML. The security is undervalued if it plots above the SML. The
security is overvalued if it plots below the SML. The security is fairly priced if it plots on the
SML.
As you can see in the exhibit below, security X is undervalued as it plots above the SML. At a
risk level of β = 0.5, the return of X is greater than the security that plots on the SML.
Similarly, Y must not be bought because the security on SML at a risk level of β = 0.7 has a
higher return than Y.
Constructing a Portfolio
Theoretically, investors should hold a combination of the risk-free asset and the market
portfolio but it is impractical to own the market portfolio as it has a large number of
securities. For example, S&P 500 is a good representation of the market as it has 500 stocks.

But, it can be shown that holding as few as 30 stocks can diversify away the non-systematic
risk.
Interpretation of the exhibit below:
• It shows how variance decreases, nonsystematic risk in particular, as stocks are
added to the portfolio.
• Much of the non-systematic risk is diversified away with 30 stocks. As more stocks
are added, the non-systematic risk progressively decreases approaching the
systematic risk for 30 stocks.
• It is important that these stocks are not correlated with each other and must be
randomly selected from different asset classes.
5. Beyond the Capital Asset Pricing Model

Note: there is no explicit learning outcome associated with this section.
In this reading, we saw one return-generating model; the CAPM. But, there are more models
to estimate the return of an asset.
5.1 The CAPM
CAPM is popular because of its simplicity to estimate the expected return. However, there
are several theoretical and practical limitations because of its unrealistic assumptions.
5.2 Limitations of the CAPM
Theoretical limitations of the CAPM are as follows:
• Single–factor model: Only systematic or market risk is priced. This assumption is
restrictive as no other investment characteristic is considered.
• Single-period model: One of the assumptions of the model is that all investors hold assets
for a single period, which is practically not true.
Practical limitations of the CAPM are as follows:

• Market Portfolio: A market portfolio must comprise all assets, including non-investable
assets like Eiffel Tower, human capital etc.
• Proxy for a Market Portfolio: When a true market portfolio comprising all assets
cannot be created, a proxy such as S&P500 is used. But different analysts may use
different proxies for the same asset based on country. For example, one analyst may use
S&P 500 as the proxy for equity while another may use DAX.
• Estimation of beta risk: Beta is an important input for the CAPM model. If not estimated
correctly, the expected return will not be accurate as well. Beta is estimated using a long
history of returns, which may vary according to the period used. For example, beta
calculated using daily returns will be different than a one-year or five-year beta.
Similarly, the risk of a company in the past may not represent its current or future risk.
• CAPM does not predict returns accurately: Studies have shown that actual returns do
not reflect predicted returns.
• Homogeneity in investor expectations: CAPM assumes that all investors have the same
expectations for securities that result in one optimal risky portfolio, the market portfolio.
If investors have different views, then it will result in multiple optimal risky portfolios
and SMLs.
5.3 Extensions to the CAPM
Other models are considered because of the limitations of CAPM. Of course, these models,
too, come with their own limitations. The models can be broadly categorized into theoretical
and practical models.
Theoretical models
In principle, theoretical models are similar to the CAPM but with additional risk factors. One
example is the arbitrage pricing theory (APT) which takes the following form:
𝐄(𝐑 𝐩 ) = 𝐑 𝐅 + 𝛌𝟏 𝛃𝐩 + . . . + 𝛌𝐊 𝛃𝐩,𝐤 where k is the number of risk factors, 𝛌𝟏 is the risk
,𝟏
premium and 𝛃𝐩,𝐤 is the sensitivity of the portfolio to factor k.
The drawback of this model is that it is difficult to identify risk factors and estimate
sensitivity to each factor.
Practical Models
The Fama-French three-factor model and four-factor model have been found to predict asset
returns better than the CAPM, which considers only beta risk. The three factors included in
the Fama French model are relative size, relative book-to-market value and beta of the asset.
The four-factor model adds one more momentum factor to the three-factor model. These
models have limitations too: they cannot be applied to all assets and there is no certainty
that these will work in the future.

Summary
LO.a: Describe the implications of combining a risk-free asset with a portfolio of risky
assets.
A combination of the risk-free asset and a risky asset can result in a better risk–return trade-
off than an investment in only one type of asset because the risk-free asset has zero
correlation with the risky asset. The risk of a portfolio is calculated using the following
formula:
σp = √w12 ∗ σ12 +w22 ∗ σ22 + 2 ∗ w1 ∗ w2 ∗ Cov1,2
As risk-free asset has zero standard deviation and zero correlation of returns with a risky
portfolio, it results in the following reduced equation:
σp = w1 ∗ σ1
LO.b: Explain the capital allocation line (CAL) and the capital market line (CML).
Investors have different views of the market, which means the individual risky assets (e.g.
securities) they choose to form their portfolio are different. This leads to different optimal
risky portfolios, as illustrated in the figure below:
A unique optimal risky portfolio exists for all investors if there is homogeneity of
expectations.
If there is one efficient frontier, there will be only one capital allocation line. The point where
this capital allocation line is tangential to the efficient frontier is called the market portfolio.
This is the optimal risky portfolio when all investors have the same expectations. The CML is
a special case of the CAL where the efficient portfolio is the market portfolio.

Rm − Rf
Rp = Rf + ( ) ∗ σp
σm
LO.c: Explain systematic and nonsystematic risk, including why an investor should not
expect to receive an additional return for bearing nonsystematic risk.
Systematic Risk: It is non-diversifiable or market risk that affects the entire economy and
cannot be diversified away. Investors get a return for systematic risk. (Interest rates,
inflation rates, natural disaster, political situation etc.)
Nonsystematic Risk: It is a local risk that affects only a particular asset or industry. There is
no compensation for nonsystematic risk as it can be diversified away. (Oil discoveries, non-
approval for a drug, new regulations for telecom industry etc.)
LO.d: Explain return generating models (including the market model) and their uses.
Return-generating models provide an estimate of the expected return of a security given
certain input parameters called factors.
Multi-factor models include macroeconomic, fundamental, and statistical models.
In a single-factor model, only one factor is considered. A classic single-factor model is the
market model which is given by this equation:
R i = αi + βR m + ei
LO.e: Calculate and interpret beta.
Beta is a measure of systematic (or market) risk. It is calculated using the following
equation:
Cov(i, M) ρiM ∗ σi
β = 2 =
σM σM
• β > 0: Return of the asset follows the market trend.

• β < 0: Return of the asset moves in an opposite direction to the market trend
(negatively correlated with the market).
• β = 0: An asset’s return has no correlation with the market. For example, a risk-free
asset has a beta of zero.
• β = 1: Beta of the market is equal to 1. If a stock has a beta of 1, it means it has the
same volatility as that of the market.
LO.f: Explain the capital asset pricing model (CAPM), including its assumptions, and
the security market line (SML).
LO.g: Calculate and interpret the expected return of an asset using the CAPM.
CAPM: re = R f + β[E(R mkt ) − R f ]
The assumptions of CAPM are:
• Investors are risk-averse, utility maximizing, rational individuals.
• Markets are frictionless. There are no transaction costs and no taxes.
• All investors plan for the same, single-holding period.
• Investors have homogeneous expectations.
• Investments are infinitely divisible.
• Investors are price takers.
The security market line (SML) is a graphical representation of the capital asset pricing
model and applies to all securities, whether they are efficient or not.
Differences between CML and SML

CML SML
Does not apply to all securities; applies to Applies to any security. It may include
only efficient portfolios. inefficient portfolios as well.
Only systematic risk is priced. So CAL/CML
can only be applied to those portfolios
whose total risk is equal to systematic risk.

X-axis has the standard deviation of the

X-axis has beta of the asset or portfolio.
portfolio.
Rm −Rf re = R f + β[E(R mkt ) − R f ]
Rp = Rf + ( )* 𝜎p
σm
Where β is the systematic risk. SML is just a
where 𝜎p is the total risk of the portfolio.
graphical representation of CAPM.
Slope of the CML is the Sharpe ratio: Slope of the SML is the market risk
Rm − Rf premium: E(R mkt ) − R f
σm
Similarities between CML and SML
Both CML and SML have expected portfolio return on the y-axis.
The line stretches from the risk-free asset to the market portfolio in both the cases.
LO.h: Describe and demonstrate applications of the CAPM and the SML.
LO.i: Calculate and interpret the Sharpe ratio, Treynor ratio, M2, and Jensen’s alpha.
The four measures commonly used in performance evaluation are:
Sharpe Ratio Portfolio risk premium
=
Rp −Rf
portolio total risk σp
M-Squared (R p − R f )σm
M2 = − (R m − R f )
σp
Treynor Ratio Portfolio risk premium
=
Rp −Rf
beta risk βp
Jensen’s Alpha Actual portfolio return – expected return = R p − [R f +
β(R m − R f )]

Practice Questions
1. Jeff Thomas only invests in risky assets; while Lisa Jones invests in a combination of risky
and the risk-free asset. Which of the following is most accurate?
A. At any given level of risk, the maximum return for both Jeff and Lisa would be
denoted by the efficient frontier.
B. At any given level of risk, Jeff’s maximum return is denoted by the CAL and Lisa’s
maximum return is denoted by the efficient frontier.
C. At any given level of risk, Jeff’s maximum return is denoted by the efficient frontier
and Lisa’s maximum return is denoted by the CAL.
2. The capital market line (CML) plots the risk and return of portfolio combinations
consisting of risk-free asset and:
A. the market portfolio.
B. any risky asset.
C. the leveraged portfolio.
3. If the borrowing rate is higher than the lending rate:

A. the slope of the borrowing segment of CML will be less than the slope of the lending
segment of the CML.
B. the slope of the borrowing segment of CML will be equal to the slope of the lending
segment of the CML.
C. the slope of the borrowing segment of CML will be greater than the slope of the
lending segment of the CML.
4. Which of the following is most likely to be synonymous with firm-specific risk?

A. unsystematic risk.
B. systematic risk.
C. non-diversifiable risk.
5. With respect to return-generating models, the intercept term and the slope term of the
market model is:
Intercept Slope
A. alpha systematic risk
B. beta nonsystematic risk
C. variance total risk
6. An analyst gathers the following information:

Stock Expected annual Expected standard Correlation between stock

return (%) deviation (%) and market
A 12 20 0.6
B 9 15 0.7
C 16 25 0.3
Market 6 10 1.0
The stock that has the highest total risk and market risk are:
Total risk Market risk
A. Stock B Stock C
B. Stock C Stock A
C. Stock A Stock B
7. Which of the following statements about the Security Market Line is least accurate?
A. SML prices securities based on total risk.
B. SML assists in identifying mispriced securities.
C. The slope of SML equals the market risk premium.
8. Which of the following is least likely an assumption of the Capital Asset Pricing Model
(CAPM)?
A. There are no transaction costs, taxes and other hurdles in trading.
B. Investments can be made in fractions.
C. Investors plan for multiple holding periods.
9. An analyst has compiled the following data:

Risk-free rate 5%
Expected market return 12%
Beta of stock ABC 1.3
Current price of stock ABC $20
Year-end forecasted price of stock ABC $22
Dividend anticipated to be paid over the year $2
Based on his price and dividend forecast, the analysts should:
A. buy the stock.
B. sell the stock.
C. stay neutral.
10. Carol Davis, a portfolio manager is analyzing three securities A, B, and C for an
investment opportunity. She has compiled the following data:

Stock A B C
Expected Return 10.68% 16.30% 12.16%
Beta 1.3 1.6 0.8
The risk-free rate is 3.5% and market return is 11.5%. In her analysis, Carol makes the
following statements:
Statement 1: “Security A is overvalued.”
Statement 2: “Security C is undervalued.”
Which of her statements is most likely true?
A. Statement 1.
B. Statement 2.
C. Both statement 1 and statement 2.
11. George Baker, a portfolio manager, earned a return of 15% on his portfolio over the past
year. The market return over the same period was 8.5% and the risk-free rate was 2%.
The portfolio had a beta of 0.75.
Jensen’s alpha for George’s portfolio is closest to:
A. 6.5%.
B. 8.1%.
C. 6.9%.

Solutions
1. C is correct. Since Jeff only invests in risky assets, the maximum return that he is likely to
get at any given level of risk is denoted by the efficient frontier. As Lisa invests in a
combination of risk-free and risky assets, the maximum return at any given level of risk
that she is likely to get would be denoted by the capital allocation line (CAL).
2. A is correct. The capital allocation line includes all possible combinations of the risk-free
asset and any risky portfolio.
The capital market line is a special case of the capital allocation line, which uses the
market portfolio as the optimal risky portfolio.
3. A is correct. The CML is divided into two parts: lending part and borrowing part. The
point that divides the CML into the lending part and borrowing part is the market
portfolio.
If the borrowing rate is higher than the risk-free rate, then the additional return for each
additional unit of risk for the borrowing portfolio will be lower than the additional return
for each additional unit of risk for the lending portfolio.
Hence, if the borrowing rate is higher than the risk-free rate, the slope of the borrowing
segment will be lower than the lending segment.
4. A is correct. The firm-specific or industry-specific risk is known as unsystematic risk.

Unsystematic risk can be diversified, unlike the systematic or market risk. The sum of
systematic variance and nonsystematic variance equals the total variance of the asset.
5. A is correct. In the market model, Ri = αi + βiRm + ei, the intercept, α𝑖, and slope
coefficient, β𝑖, are estimated using historical security and market returns. The security
characteristic line plots the excess return of the security on the excess return of the
market. In this graph, Jensen’s alpha is the intercept and the beta is the slope.
6. B is correct.
Total risk:
Total risk is defined by total variance.
Total variance of stock A = 0.202 = 0.04
Total variance of stock B = 0.152 = 0.0225
Total variance of stock C = 0.252 = 0.0625
Stock C has the highest total risk.
Market risk:
Market risk is defined by beta.

ρim σi σm
β=
σ2m
0.6 × 0.20
βStock A = = 1.2
0.10
0.7 × 0.15
βStock B = = 1.05
0.10
0.3 × 0.25
βStock C = = 0.75
0.10
Stock A has the highest market risk.
7. A is correct. The total risk for a security is a combination of market risk and firm-specific
risk. The security market line is only based on the market risk or systematic risk, as the
firm-specific risk is diversifiable. The slope of SML is the market premium and SML can
also assist in identifying fairly priced securities.
8. C is correct. The assumptions of CAPM are:

• Risk-aversion: With greater risk, investors require greater returns.
• Frictionless markets: There are no transaction costs, taxes and other hurdles in
trading.
• Utility maximizing investors: Investors select investments according to their
preferences that maximize their utility.
• One-period horizon: All investors have the same one-period time horizon.
• Divisible assets: All investments are infinitely divisible.
• Competitive markets: Market prices cannot be influenced.
• Homogenous expectations: All investors have same expectations on assets.
9. A is correct.
Using CAPM,
Required return for stock ABC = 0.05 + 1.3 ∗ (0.12 − 0.05) = 14.1%
Forecasted return for stock ABC = (22 − 20 + 2)/20 = 20.0%
Based on this, the stock ABC plots above SML and hence is undervalued. The analyst
should buy the stock.
10. C is correct.
For a stock to be undervalued, its expected return should be greater than the required
return (from CAPM).
Using CAPM,
Required return for stock A = 0.035 + 1.3 ∗ (0.115 − 0.035) = 13.9%
Required return for stock B = 0.035 + 1.6 ∗ (0.115 − 0.035) = 16.3%
Required return for stock C = 0.035 + 0.8 ∗ (0.115 − 0.035) = 9.9%

Thus,
Stock A is overvalued.
Stock B is on par with its value.
Stock C is undervalued.
11. B is correct.
Jensen′ s alpha = αp = R p − [R f + βp (R m − R f )]
Jensen’s alpha = 0.15 – [0.02 + 0.75(0.085 – 0.02)] = 0.081 or 8.1%.

R41 Basics of Portfolio Planning and Construction 2019 Level I Notes
R41 Basics of Portfolio Planning and Construction

1. Introduction
This reading addresses the following topics:
• What is an investment policy statement (IPS) and what does it contain?
• The portfolio construction process.
• How is asset allocation done for a client?
2. Portfolio Planning
2.1. The Investment Policy Statement
Portfolio planning can be defined as a program developed in advance of constructing a
portfolio that is expected to satisfy the client’s investment objectives. The written document
governing this process is the investment policy statement (IPS). It defines a plan for
investment success given the client’s situation and requirements. The IPS should be
reviewed on a regular basis.
2.2. Major Components of an IPS
The major components of an IPS are:
• Introduction: Describes the investment objectives, circumstances and state of client.
• Statement of Purpose: Covers the scope of the IPS.
• Statement of Duties and Responsibilities: Applies to investment manager, client and
other parties involved.
• Procedures: Methodologies to tackle various circumstances and updating the IPS.
• Investment Objectives: Desired rate of return and the amount of risk client is willing
to take.
• Investment Constraints: Liquidity, legal, taxes, time horizon and other unique
constraints.
• Investment Guidelines: Specifies permitted classes, selection of asset classes, use of
leverage, asset allocation and rebalancing etc.
• Evaluation of performance: Specifies the benchmark portfolio to compare investment
results with, the frequency of evaluation, and other related information.
• Appendices: Contains information on specific guidelines like permitted deviations,
strategic asset allocation, rebalancing strategies etc.
Risk Objectives
A client’s risk tolerance is generally expressed qualitatively as high, moderate, or low. Two
factors determine the overall risk tolerance: ability and willingness to take risk:
• Ability to take risk is based on wealth, time horizon, expected income etc. It is
relatively easy to determine. Risk tolerance is usually expressed in both terms: ability
and willingness. For example, a salaried person close to retirement with modest

savings has low ability to take risk.

• Willingness to take risk is more subjective and is based on the client’s psychology. For
example, a client who has recently lost his job may not be willing to take risk even
though he has the ability to do so, as job loss has a huge psychological impact.
For some clients, the risk objective might be defined quantitatively. Quantitative risk
objectives can be expressed in absolute or relative terms.
• Absolute risk objective example: Portfolio should not suffer more than a 5% loss in
any 12-month period. Practically, this could be stated as: with 95% probability,
portfolio should not lose more than 5% value in any 12-month period. Absolute risk
measure is not related to market performance. They are expressed in terms of
standard deviation, variance, or value at risk.
• Relative risk objective example: For example, return should be within 4% of the S&P
500 index return. The risk objective is expressed relative to a benchmark.
Example
Your client has a portfolio worth 10 million. He cannot handle losing more than 1 million
over the next 12 months. Is this an absolute or relative risk objective? How can this be stated
in practical terms?
Solution:
This is an absolute risk objective. In practical terms, it can be stated as: with 95%
probability, portfolio should not lose more than 10% in the next 12 months.
Example
Another client specifies a risk objective of achieving returns within 4% of the BSE 100. Is this
an absolute or relative risk objective? Identify a measure for quantifying the risk objective.
Solution:
This is a relative risk objective as it is relative to BSE 100 (market) performance. A measure
for tracking a relative risk objective is tracking risk.
Return Objectives
Return objectives can be stated on an absolute or a relative basis.
• Absolute: Absolute return is the return a portfolio must achieve over a certain period
of time. For example, a client wants to achieve a return of 9% or inflation-adjusted
(real) return of 2%. The objective is to deliver a positive return over time, irrespective
of how good or bad the market performance is. No index or benchmark is used to
measure the performance. Many strategies may be employed to generate absolute
return, the success of which depends on the skills of the manager.
• Relative: A relative return objective will be stated relative to a benchmark. Examples:

return 3% greater than 12-month LIBOR or return equal to the S&P500 index return.
The return objective can be stated before or after fees, and pre- or post-tax. The fee structure
must be clear and understood by both the parties: investment manager and the client. If
there is a required return that must be met for the client to meet a specific goal, such as
down payment of $100,000 for a house next year or $20,000 for college education for a child
next year, then it must be mentioned.
Stated risk and return must be compatible. For example, it would be unrealistic to expect a
very high return with low risk tolerance.
Example
Your client is 35 and wishes to retire in 30 years. His salary meets current and expected
future expenses. He has 100,000 in savings of which he wants to put aside 10,000 as an
emergency fund to be held in cash. You estimate that 300,000 in today’s money will be
sufficient to fund your client’s retirement income needs. Expected inflation is 2% over the
next 30 years. How much money must your client have in nominal terms to fund his
retirement? What is the required return objective?
Solution:
First, let us calculate how much money the client must have in nominal terms after 30 years,
at his retirement. You can solve it two ways:
Using the formula: 300,000 to grow at 2% for 30 years = 300,000 ∗ (1.02)30 = 543,408
Using a financial calculator: N = 30; I/Y = 2; PV = -300,000, PMT = 0, CPT FV. FV = 543,408
To calculate the return objective, we have the following data.
The client is investing 90,000 now after keeping aside 10,000 for emergency in cash. This
90,000 must grow to 543,408.47 in 30 years. To compute the interest rate, we enter the
following values in the calculator:
FV = -543,408.47, PV = 90,000, N = 30, PMT = 0, CPT I/Y. Interest rate = 6.18%
Note: If the client is saving a particular amount every year, then key in that number for PMT.
Investment constraints
The five major investment constraints are:
• Time Horizon:
o Longer the time horizon, greater is the ability to take risk and lower are the
liquidity needs in the portfolio.
• Tax Concerns:
o Investors tax status, jurisdiction of investments and tax treatment of various
types of investment accounts should be considered.
• Liquidity:

o Ability to convert invested assets into cash without suffering significant price
erosion.
o Cash requirement varies from client to client and may require certain portion
of assets to be invested in highly liquid investments.
• Legal and Regulatory:
o Restrictions on investments and percentage allocation in certain assets for
investors like insurance firms, trusts etc.
• Unique Circumstances:
o Factors influenced by religion, ethical preferences, government policies or
investor circumstances.
You can use the acronym ‘LLTTU’ to remember these five constraints.
2.3. Gathering Client Information
It is important for portfolio managers and investment advisers to know their clients; they
must find all facts about the client at the start of the relationship. This includes collecting
information about the client’s current circumstances, spending requirements, return
objectives, goals etc. Some of the important data gathered include:
• Family situation: Married or not, does the spouse work, any additional dependents,
how many children, their education plans etc.
• Employment situation: Client’s salary, sources of income, industry the client is
working in, stability of job etc.
• Financial information: Level of savings, other investments such as real estate etc.
Adequate information on financial position will help in evaluating the client’s risk
tolerance.
3. Portfolio Construction
We have defined the IPS with return and risk objectives, and five constraints. Now, using the
points in the IPS as a guideline, we need to construct the portfolio.

Portfolio construction consists of three steps:

• Strategic asset allocation
• Tactical asset allocation
• Security selection
3.1. Capital Market Expectations
Capital market expectations are the investors’ expectations about the return and risk of
various asset classes. Capital market expectations include return for each asset class an
investor may invest in (e.g. stock market, bond market, alternative investments, real estate
etc.), standard deviation of returns for each asset class (risk), and correlation between the
asset classes.
3.2. The Strategic Asset Allocation
The long-term capital market expectations and investor’s risk-return objectives are
combined into a strategic asset allocation. This is accomplished through optimization and/or
simulations on computer systems.
Strategic asset allocation is a strategy to allot a certain percentage of the portfolio, each to
different IPS-permissible asset classes in order to achieve the client’s long-term goals. Using
this method, the portfolio manager decides how much of the client’s money should be
invested in equities, bonds, or any other asset class to meet the client’s long-term goals.
Strategic asset allocation is important because:
• Most of a portfolio’s returns come from its systematic risk as nonsystematic risk is
diversified away.
• The returns of assets in an asset class reflect exposure to certain systematic factors.
This information can be used to select asset classes that match an investor’s risk and
return objectives.

How are asset classes defined:

The classification of asset classes is somewhat subjective. Furthermore, an asset class can be
divided into sub-asset classes as illustrated below.
Criteria to define asset classes:

• All assets in an asset class must be homogeneous, and not correlated to other asset
classes.
• Correlations of assets with an asset class should be high.
• Risk and return expectations of assets within an asset class must be similar.
• All the asset classes combined should account for the universe of all investable assets.
When defining the SAA, it is important to consider the asset class correlation matrix. When
the correlation between asset classes is low, the diversification benefit will be high. This
concept has been discussed in detail in earlier readings.
Example
Given the matrix below, identify which asset class is most sharply distinguished from
equities?
Historical correlation (May 31, 2005 to April 30, 2009)
Equities Fixed Hedge Real Private Commoditi Currencies
Income Estate Equity es
Equities 1.00
Fixed Income -0.35 1.00
Hedge 0.64 -0.35 1.00
Real Estate 0.88 -0.21 0.58 1.00
Private 0.88 -0.30 0.65 0.92 1.00
Equity
Commodities 0.38 -0.37 0.60 0.29 0.45 1.00
Currencies 0.18 0.16 0.19 0.16 0.16 0.26 1.00
Source: FT Alphaville
Solution:
The question asks us to identify the asset class with the lowest correlation with equities. As

you can see from the table, fixed income has the lowest correlation with equities while real
estate and private equity have the highest correlation with equities.
Once the asset allocation is done, it is possible for this asset allocation to drift from the target
allocation with time. For example, let us assume the target asset allocation is 60 percent in
stocks and 40 percent in bonds. If equities do well the following year, the asset allocation
drifts to 90 percent in equities and 10 percent in bonds. This calls for rebalancing the
portfolio as the drift is substantial. By rebalancing, we mean sell equities and buy bonds to
bring the portfolio back to the target asset allocation. The amount of allowable drift and
rebalancing policy should be defined in the IPS appendix. This material will be covered in
detail at Level III.
3.3. Steps toward an Actual Portfolio
Portfolio construction involves the following steps:
1. Define IPS:
a. Capture the investor’s requirements and constraints.
2. Determine the strategic asset allocation:
a. Define the investable asset classes for the portfolio and gather historical data
on their risk, return and correlation.
b. Combine the IPS and the risk/return profile of various portfolios derived from
the above step, to decide on a strategic asset allocation for the portfolio. Until
this step, investment decisions are entirely passive i.e. returns are primarily
generated by investing in asset class indices.
3. Tactical asset allocation:
a. This is the first step of active management where asset classes are selected.
b. Determine whether there are any short-term opportunities that warrant a
deviation from the strategic asset allocation.
c. The weights of asset classes are altered from the strategic allocation weights.
d. For example, a top-down analysis shows that given the economic cycle,
commodities might outperform. Based on this premise, you alter the weight
for the commodity asset class.
4. Security selection:
a. This is second step of active management where particular securities are
selected.
b. Identify the relatively strong securities within the favored asset class.
c. Increase weights of these securities from the weights used in index
construction, to outperform the benchmark.
d. For example, in your analysis you decide to go overweight on the base metals
securities.
Some additional terms you should know:
• Passive versus active investing: Passive investing is a strategy in which investors

invest based on a pre-defined benchmark. One example would be an investment in a

fund that tracks the S&P 500.
• Active investing: It is a strategy to identify (buy) underpriced and (sell) overpriced
stocks. The objective is to earn a return higher than the benchmark.
• Rebalancing policy: The process of restoring a portfolio’s original exposures to
systematic risk factors is defined in rebalancing policy.
• Core-satellite approach to investing: In this approach, the portfolio is divided into two
parts: core and satellite. A majority of the portfolio simply tracks a benchmark. A small
part of the portfolio called the satellite is invested in mispriced securities to generate a
return higher than the benchmark.

Summary
LO.a: Describe the reasons for a written investment policy statement (IPS).
IPS is the starting point of the portfolio management process. Before constructing a portfolio
or choosing assets for a client, it is important to understand the client’s objectives. How
much risk is he willing to take, how much can he actually take, how much return does he
expect from the portfolio, what are his current circumstances? It defines a plan for
investment success given the client’s situation and requirements.
LO.b: Describe the major components of an IPS.
The major components of an IPS are:
• Introduction: Describes the investment objectives, circumstances and state of client.
• Statement of Purpose: Covers the scope of the IPS.
• Statement of Duties and Responsibilities: Applies to investment manager, client and
other parties involved.
• Procedures: Methodologies to tackle various circumstances and updating the IPS.
• Investment Objectives: Desired rate of return and the amount of risk client is willing
to take.
• Investment Constraints: Liquidity, legal, taxes, time horizon and other unique
constraints.
• Investment Guidelines: Specifies permitted asset classes, selection of asset classes,
use of leverage, asset allocation and rebalancing etc.
• Evaluation of performance: Specifies the benchmark portfolio to compare investment
results with, the frequency of evaluation, and other related information.
• Appendices: Contains information on specific guidelines like permitted deviations,
strategic asset allocation, rebalancing strategies etc.
LO.c: Describe risk and return objectives and how they may be developed for a client.
Risk objective might be defined quantitatively. Quantitative risk objectives can be expressed
in absolute or relative terms.
• Absolute risk objective example: Portfolio should not suffer more than a 5% loss in
any 12-month period. Practically, this could be stated as: with 95% probability, the
portfolio should not lose more than 5% value in any 12-month period. The absolute
risk measure is not related to market performance. They are expressed in terms of
standard deviation, variance, or value at risk.
• Relative risk objective example: Return should be within 4% of the S&P 500 index
return. The risk objective is expressed relative to a benchmark.
Return objectives can be stated on an absolute or a relative basis.
• Absolute: Absolute return is the return a portfolio must achieve over a certain period
of time.

• Relative: A relative return objective will be stated relative to a benchmark.

LO.d: Distinguish between the willingness and the ability (capacity) to take risks in
analyzing an investor’s financial risk tolerance.
Two factors determine the overall risk tolerance: ability and willingness to take risk:
• Ability to take risk is based on wealth, time horizon, expected income etc. It is
relatively easy to determine. For example, a salaried person close to retirement with
modest savings has a low ability to take risks.
• Willingness to take risk is more subjective and is based on the client’s psychology. For
example, a client who has recently lost his job may not be willing to take risks, even
though he has the ability to do so, as job loss has a huge psychological impact.
LO.e: Describe the investment constraints of liquidity, time horizon, tax concerns,
legal and regulatory factors, and unique circumstances and their implications for the
choice of portfolio assets.
The five major investment constraints are:
• Time Horizon:
o Longer the time horizon, greater is the ability to take risk and lower are the
liquidity needs in the portfolio.
• Tax Concerns:
o Investors tax status, jurisdiction of investments and tax treatment of various
types of investment accounts should be considered.
• Liquidity:
o Ability to convert invested assets into cash without suffering significant price
erosion.
o Cash requirement varies from client to client and may require certain portion
of assets to be invested in highly liquid investments.
• Legal and Regulatory:
o Restrictions on investments and percentage allocation in certain assets for
investors like insurance firms, trusts etc.
• Unique Circumstances:
o Factors influenced by religion, ethical preferences, government policies or
investor circumstances.
LO.f: Explain the specification of asset classes in relation to asset allocation.
The classification of asset classes is somewhat subjective. Furthermore, an asset class can be
divided into sub-asset classes as illustrated below.

• All assets in an asset class must be homogeneous, and not correlated to other asset
classes.
• Correlations of assets with an asset class should be high.
• Risk and return expectations of assets within an asset class must be similar.
• All the asset classes combined should account for the universe of all investable assets.
LO.g: Discuss the principles of portfolio construction and the role of asset allocation in
relation to the IPS.
Using the points in the IPS as a guideline, a portfolio is constructed.
Strategic asset allocation is a strategy to allocate a certain percentage of the portfolio, to each
of the different asset classes in order to achieve the client’s long-term goals. Using this
method, the portfolio manager decides how much of the client’s money should be invested in
equities, bonds, or any other asset class to meet the client’s long-term goals.
Tactical asset allocation is an active investment strategy that attempts to profit from short-
term mispricing. The strategy involves deviating from the intended weights of asset classes
in the short-term.
Security selection is the process of determining which securities to include in a portfolio so
that the portfolio generates a return higher than the benchmark.

Practice Questions
1. Which of the following is least likely to be a reason for having a written investment policy
statement?
A. Having a written IPS ensures the client’s risk and return objectives can be achieved.
B. The IPS may be required by the regulation.
C. Having a written IPS is part of the best practice for a portfolio manager.
2. Jane Hall has an investment policy statement that states the return objective of
outperforming the NYSE composite index by 200 basis points. Such a return objective is
best characterized as having a(n):
A. arbitrage-based return objective.
B. relative return objective.
C. absolute return objective.
3. Which of the following is best described as a relative risk objective?

A. The fund will not lose more than $3 million in the coming 12-month period.
B. The fund would not underperform the FTSE by more than 400 basis points.
C. Value at risk will not exceed $5 million.
4. Alex Smith is 34 years old male with a secure job that pays USD 300,000 annually, which
is three times his family annual expense needs. He has no outstanding debt payments
and owns his own house. There are no foreseeable major cash outflows in the future.
Despite this, Smith is reluctant to invest in the stock market because he believes that
stock market returns are very volatile. Based on this information which of the following
statements is most accurate?
A. Smith has a low ability to take risk but a high willingness to take risk.
B. Smith has a high ability to take risk but a low willingness to take risk.
C. Smith has a high ability to take risk and a high willingness to take risk.
5. Which of the following is least likely to be discussed in the constraints section of an

investment policy statement (IPS)?
A. Tax Concerns.
B. The level of risk aversion.
C. Liquidity.
6. With regards to strategic asset allocation, assets within a specific asset class are most
likely to have:
A. high correlations with other asset classes.
B. high paired correlations.

C. low paired correlations.
7. Adam Clarke, a portfolio manager has just gathered the investment requirements of a
client. He has now decided to allot percentages of the portfolio to the different asset
classes in order to achieve the client' long-term goals. This decision is most likely an
example of:
A. strategic asset allocation.
B. rebalancing.
C. tactical asset allocation.
8. Investing majority of the portfolio passively and minority of the portfolio actively is best
described as:
A. the top-down approach.
B. the core-satellite approach.
C. the bottom-up approach.

Solutions
1. A is correct. A written IPS is consistent with best practices to be followed by a portfolio

manager. Depending on the circumstances, a written IPS or its equivalent may be
required by law. A written IPS however doesn’t ensure that risk and return objectives
will in fact be achieved.
2. B is correct. Since the return objective specifies a target return relative to a benchmark
the NYSE Composite Index, the objective is best described as a relative return objective.
3. B is correct. Since the risk objective makes reference to the FTSE Index, the objective is
best described as a relative risk objective. Value at risk (VaR) establishes a minimum
value of loss expected during a specified time period at a given level of probability and
hence option C is a type of absolute risk objective. A statement of the maximum allowed
absolute loss of $3 million is also an absolute risk objective.
4. B is correct. Given the high income and savings, Alex’s ability to take risk is high.
However, his attitude towards the stock market and fear of losing money indicates that
his willingness to take risk is low. Measuring willingness to take risk is not as objective as
measuring the ability. Ability to take risk is based on relatively objective traits such as
expected income, time horizon, and existing wealth relative to liabilities. Here, Alex has a
high ability to take risk but his willingness is low.
5. B is correct. The five constraints registered in an investment policy statement are -

Liquidity, Legal, Time horizon, Tax, Unique circumstances.
6. B is correct. Asset classes are so defined that the paired correlations of assets should be
relatively high within an asset class and low with assets of different asset classes. This is
done with the intention of achieving better diversification.
7. A is correct. After having determined the investor objectives and constraints, a strategic
asset allocation is developed which specifies the percentage allocations to the included
asset classes. Tactical asset allocation attempts to take advantage of temporary
conditions in the market. Hence, the weights of portfolio assets are deviated for a short
duration from the predetermined levels arrived at in the SAA.
8. B is correct. In core-satellite approach of constructing a portfolio, a majority of the assets

are invested passively or in a low risk asset, while minority is invested in the high-risk
and actively managed assets.

R42 Risk Management - An Introduction 2019 Level I Notes
R42 Risk Management - An Introduction

1. Introduction
Investors often assume higher risk in the pursuit of higher returns. Businesses and investors
manage risk, whether consciously or not, in every investment decision they make. This
reading lays the fundamentals of risk management from the perspective of both businesses
and individuals.
Some of the important concepts addressed in this reading include:
• What is risk management and why is it important?
• How businesses and individuals manage risk?
• The principles behind both enterprise and portfolio risk management.
• How an entity’s goals are affected by risk and how risk management decisions
produce better results?
• Identifying the various risks and the tools used by an organization to manage risk.
2. The Risk Management Process
Risk is the exposure to uncertainty.
Risk exposure is the extent to which an entity is sensitive to underlying risks.
Risk management is the process by which an organization or individual defines the level of
risk to be taken (risk tolerance), measures the level of risk being taken (risk exposure), and
adjusts the latter toward the former, with the goal of maximizing the company’s or
portfolio’s value or the individual’s overall satisfaction or utility. Ideally, risk exposure
should roughly be equal to risk tolerance. Risk management is not about minimizing risk,
but about actively managing risks to achieve goals. The focus is on risk management (as
opposed to return management) because it is possible to manage risk, but it is not always
possible to manage returns.
Risk Management Framework
A risk management framework is the infrastructure, processes, and analytics needed to
support effective risk management in an organization. Any risk management framework
should include the following factors:
• Risk governance: This top-down process lays the foundation for risk management in
an organization. Good governance ensures that the risk tolerance level is set for an
organization and provides risk oversight.
• Risk identification and measurement: This is the quantitative and qualitative
assessment of all sources of risk to an organization.
• Risk infrastructure: This refers to the people and the systems required to track risk
exposures and to perform risk analysis.
• Defined policies and processes: These are limits, requirements, constraints and

guidelines to ensure that an organization’s risky activities are within its risk tolerance
levels.
• Risk monitoring, mitigation, and management: This primarily involves identifying,
measuring and continuously monitoring risk exposure of an organization. If risk
exposure is not aligned with pre-defined risk tolerance, then necessary action is taken
to restore balance between the two.
• Communications: Critical risk issues must be continually communicated across all
levels of an organization. Risk tolerances must be communicated to managers. Risk
metrics must be reported in a timely, easy-to-understand manner. A feedback loop
with the governance body should be present to ensure that risk guidance is validated
and communicated to the rest of the organization.
• Strategic analysis or integration: The objective of this analysis is to use risk
management to increase the overall value of the business.
The diagram below shows the risk management framework in an enterprise context.

3. Risk Governance
3.1. An Enterprise View of Risk Governance
Risk governance is a top-down process that defines risk tolerance and provides guidance to
align risk with enterprise goals; includes guidance on unacceptable risks and worst losses
that can be tolerated.
An enterprise risk management perspective deals with the whole organization. The
governing body drives the risk framework in the following ways:
• It determines the goals of the organization.
• It is responsible for providing risk oversight to ensure the value is maximized.
• It determines the risk tolerance level, which risks are acceptable, what risks to
mitigate, and what risks are unacceptable. The process includes guidance on worst
losses that can be tolerated for every scenario.
Elements of good risk governance are as follows:
• To provide a forum where management can discuss the risk framework and key
issues that come up during execution.
• Form a risk governance committee to oversee the implementation of the framework
at an operational level relative to the high level oversight by the governance body.
• Appoint a chief risk officer (CRO) to build and implement the risk framework for the
entire enterprise.
3.2. Risk Tolerance
Risk tolerance identifies the extent of losses an organization is willing to experience. Risk
tolerance focuses on the appetite for risk of an organization in its pursuit of achieving goals
and maximizing value. The process involves defining:
• Which risks are acceptable and which risks are not acceptable?
• How much risk can the entity be exposed to?
The risk tolerance decision begins with two different analyses:
• Inside view: What shortfalls within the organization will cause it to fail or not achieve
certain goals?
• Outside view: What uncertain forces are the organization exposed to?
Using these two views in conjunction, the board will:
• Define what risks to take and what risks not to take.
• Determine the risk appetite: how much of these risks to take.
• Communicate risk tolerance before a crisis.
• Provide a high-level guidance to management in strategizing and choosing activities.
There are no standard formulas to determine the risk tolerance of a company. Some of the
factors that will help a board determine its risk appetite are as follows:
• Company’s areas of expertise and goals.

• Ability to respond dynamically to adverse events: The higher the ability, the higher
the level of risk tolerance.
• The amount of loss a company can bear without impacting its status as a going
concern.
• The company’s position in the industry and how it fares relative to its competitors.
• Government and regulatory landscape where the company operates.
• Quantitative analyses such as scenario analyses, macro analyses etc.
Once risk tolerance is determined, the objective of the overall risk framework should be to
align risk exposure with the enterprise’s risk appetite.
3.3. Risk Budgeting
Risk budgeting helps determine how or where risks are taken and quantifies tolerable risks
by specific metrics; risk budgeting should drive hedging strategies (not the other way
round).
Risk budgeting allocates investments or assets by their risk characteristics rather than by a
common classification of asset class such as stocks, bonds, real estate etc. For example, the
risk view of a portfolio might be that it is driven 70% by global equity returns, 20% by
domestic equity returns, and 10% by interest rates, or a portfolio that has 45% illiquid and
55% liquid securities.
How risk budget is measured
• It can be a complex, multi-dimensional measure that evaluates risks based on their
asset classes such as equity, commodities, real estate and then allocates investment
by their asset class.
• It can also be a simple, one-dimensional risk measure such as standard deviation,
beta, and value at risk and scenario loss.
• Risk factor approaches are also used in which exposure to various factors is used to
determine risk premiums.
• Example: portfolio beta is limited to 1.
One of the biggest benefits of the risk budgeting process is that it forces a firm to consider
risk tradeoffs. By adopting risk budgeting, it helps a business to:
• Choose the project with the highest return per unit of risk.
• Choose between doing less risky investments and more risky investments whose
risks have been hedged?
• Compare active versus passive strategies. This helps businesses make decisions to
add active value while staying within the risk tolerance levels.
4. Identification of Risks
There are two categories of risks: financial risks and non-financial risks.

4.1. Financial Risks

Financial risks are the risks that originate from financial markets, such as changes in interest
rates or prices. There are three primary types of financial risks:
• Market risk: This risk arises from movements in stock prices, exchange rates,
interest rates and commodity prices. Any changes in fundamental economic
conditions, events in the industry or economy, give rise to market risk.
• Credit risk: This is the risk that a counterparty will not pay an amount owed on an
obligation, such as a bond, loan, derivative, to another party.
• Liquidity risk: This is the risk that, as a result of degradation in market conditions or
the lack of market participants, one will be unable to sell an asset without lowering
the price to less than the fundamental value. Liquidity risk is also known as
transaction cost risk. Liquidity risk arises when the market for a specific asset
becomes less liquid or the size of a position increases.
4.2. Non-Financial Risks
Non-financial risks are risks that arise from sources outside the financial markets such as
actions within an entity, environment, community, suppliers and customers. These risks also
have a monetary impact on the organization. The various types of non-financial risks are
discussed below:
• Operational risk: This risk arises from within the operations of an organization and
includes both human and system or process errors. All the internal risks in an
organization are collectively called operational risk. Examples of operational risk
include employees, programming errors, making an organization susceptible to
hackers, rogue trader in a brokerage firm, natural disasters that interrupt operations,
and terrorist attacks.
• Solvency risk: This risk arises when the entity does not survive or succeed because it
runs out of cash to meet its financial obligations. One example of solvency risk is what
happened to Lehman Brothers in 2008 because of taking on excessive leverage.
• Settlement risk: This is the default risk that occurs just before payments are to be
settled.
• Legal risk: Any risk related to the law is a legal risk. For instance, an entity may be
sued by another over a transaction, or what it does or does not do as per the contract.
• Regulatory, accounting and tax risk: The three risks are collectively known as
compliance risk. This risk arises when an entity fails to comply with laws, regulations,
policies set by the government or regulatory authorities.
• Model risk: This is the risk of a valuation error that arises from improperly using a
model. For instance, using the DDM (dividend discount model) to value a company
whose growth is not constant.
• Tail risk: This risk arises when there are more events in the tail of the distribution.

• Sovereign or political risk.

Individuals face many of the same organizational risks outlined here, in addition they also
face health risk, mortality or longevity risk, and property and casualty risk.
4.3. Interactions between Risks
Risks are not independent of each other and there is no clear distinction between the various
risks as one risk may lead to another. For example, market risk leads to credit risk, which in
turn leads to settlement risk and legal risk.
Risk interactions can be non-linear and harmful. The combined risk faced is worse than the
sum of the risks of the separate components. This was seen during the 2008 crisis when
many investment firms were forced to shut down because of their high leverage and
insolvency. Most risk models do not take into account the interactions between risks.
5. Measuring and Modifying Risks
5.1. Drivers
Basic drivers of risk arise from:
• Global macroeconomics: The economic policies adopted by foreign governments and
central banks have a significant impact on domestic companies.
• Domestic macroeconomics: Economic activity in a country is affected by the taxes,
regulations, laws, monetary and fiscal policy introduced by government and quasi-
government agencies in a country.
• Industries: Government’s policies expose industries to risk. For example, the
government may exempt taxes on the textile industry to encourage growth in the
sector, while it may levy additional taxes on the tobacco industry.
• Individual companies: There could be an issue that is specific to the company that you
have invested in. For example, a lawsuit.
Using proper risk management, some of the risk can be managed, but not all of it. For risks
that cannot be controlled, an entity must ensure that its risk exposure is aligned with its
objective and risk tolerance.
5.2. Metrics
Risk exposure is often expressed in terms of quantitative measures. The basic metrics used
to measure market risk are as follows:
• Probability: It is a measure of the relative frequency with which an outcome is
expected to occur. For instance, the probability of a loss of 25% implies the likelihood
of incurring loss, but it does not say how much the loss would be.
• Standard deviation: It is a measure of the dispersion in a probability distribution.
That is, it gives us a range over which a certain percentage of outcomes are likely to
occur. The underlying assumption is that the returns are normally distributed. Hence,
it is not an appropriate risk measure for non-normal distributions. Standard

deviation and variance are measures of total risk, that is, both unsystematic and
systematic risk.
• Beta or duration: It is a measure of the sensitivity of a security’s returns to the
returns on the market portfolio. For instance, if beta is 1.5, then it implies that the
stock is expected to go up by 1.5% when the market goes up by 1%. Beta is generally
used for stock portfolios, while duration is used to measure the sensitivity of fixed-
income portfolios to changes in interest rates.
• Derivative measures: Delta, gamma, vega and rho are often used measures of
derivative risk. Delta is the sensitivity of the derivative price to a small change in the
value of the underlying asset. Gamma measures the sensitivity of the derivative to
changes in delta. Vega measures the sensitivity of the derivative to changes in the
volatility of the underlying. Rho measures the sensitivity of the derivative to changes
in interest rates.
• Value at risk or VaR: VaR measures and quantifies the risk of loss in a portfolio over
a specific time period. A VaR measure comprises three elements: an amount stated in
units of currency, a time period, and a probability. Let us take an example of a bank
with a portfolio value of $200 million. A VaR of $3 million at 5% for one day implies
that the bank is expected to lose a minimum of $3 million in one day 5% of the time.
Note that VaR only tells us the minimum expected loss; it does not state the maximum
loss.
• Conditional VaR or CVaR: Conditional VaR is the weighted average of all loss
outcomes in the statistical distribution that exceed the VaR loss.
• Expected loss given default: This is equivalent to CVaR for a debt security.
• Scenario analysis and stress testing: Scenario analysts evaluate what would
happen to a portfolio if a set of conditions or market movements occur. For example,
what would be the impact on a portfolio if the Fed increases interest rates and there
is a significant decline in the value of the US dollar.
5.3. Methods of Risk Modification
The objective of the risk manager in the risk modification stage is to align the actual risk with
pre-defined levels of risk tolerance. Different approaches to manage and modify risk are
discussed below.
Risk Prevention and Avoidance
The simplest approach to manage risk may be to avoid it altogether. But, it is not as simple as
it appears. For example, consider an individual who invests all his retirement savings in cash
to avoid the risk of volatility in equities. By doing so, he gives up any upside return potential
that equities offer and protection against inflation. Sometimes, boards may take a strategic
decision to avoid risks in certain business areas altogether after analyzing the risk-return
tradeoff, and rather focus on areas with a higher likelihood of adding value. In reality, it is
difficult to take a calculated risk by offsetting the risk of loss with the benefit of gain.

When actual risk exceeds the acceptable level, the following approaches are used to manage
risk.
Risk Acceptance: Self-Insurance and Diversification
Self-insurance is simply bearing the risk because the external means to eliminate the risk are
costly. For business, self-insurance means setting aside sufficient capital to cover losses. An
example of self-insurance is capital and loan loss reserves set aside by a bank.
Diversification: According to modern portfolio theory, diversification is an efficient way of
mitigating risk.
Next, we will look at two approaches to transfer or sell the undesired risk to another party.
Risk Transfer
Risk transfer is the process of passing on a risk to another party, often in the form of an
insurance policy. When a corporation buys fire insurance for its office building it pays a
standard premium and in return the insurance company covers the damage if the office
building catches fire. Hence through the insurance policy the risk of fire damage is
transferred from the corporation to the insurance company.
Risk Shifting
Unlike risk transfer where the risk is transferred from one party to another, risk shifting
refers to actions that change the distribution of risk outcomes. Risk shifting typically
involves the use of derivatives. Derivatives are classified into two categories:
• Forward commitments. Examples of forward commitments are forward contracts,
futures contracts and swaps.
• Contingent claims. Examples of contingent claims are call options and put options.
How to Choose Which Method for Modifying Risk
Choosing which risk mitigation method to use is an important step in the risk management
process. The risk-mitigation methods discussed above are not exclusive of each other. Often,
companies use all methods. Some important points to consider how to choose a method are
discussed below:
• Consider the cost and benefit of each option in light of the risk tolerance of the entity.
• Organizations should avoid the risks that provide few benefits at extremely high
costs.
• Organizations with large free cash flow may self-insure and diversify to the extent
possible.
• Insure when risks can be pooled effectively and when the cost of insurance is less
than the expected benefit.
• Risk shifting is an appropriate choice for mitigating financial risks that exceed risk
appetite.

Summary
LO.a: Define risk management.
Risk management is the process by which an organization or individual defines the level of
risk to be taken (risk tolerance), measures the level of risk being taken (risk exposure), and
modifies risk exposure in line with risk tolerance. The goal is to maximize the company’s or
portfolio’s value or the individual’s overall satisfaction or utility.
LO.b: Describe features of a risk management framework.
A risk management framework is the infrastructure, processes, and analytics needed to
support effective risk management in an organization. The factors a risk management
framework should include are risk governance, risk identification and measurement, risk
infrastructure, risk policies and processes, risk monitoring, mitigation and management,
communication, and strategic analysis and integration.
LO.c: Define risk governance and describe elements of effective risk governance.
Risk governance is the top-level foundation for risk management. The governance body is
responsible for setting risk tolerance and providing risk oversight.
The elements of effective risk governance include providing a forum where the management
can discuss about the risk framework, forming a risk governance committee, and appointing
a chief risk officer.
LO.d: Explain how risk tolerance affects risk management.
Risk tolerance identifies the extent of losses an organization is willing to experience. It
defines which risks are acceptable, which risks are not acceptable, and how much risk an
entity can be exposed to.
LO.e: Describe risk budgeting and its role in risk governance.
Risk budgeting quantifies tolerable risks by specific metrics. Risk budgeting allocates
investments or assets by their risk characteristics rather than by a common classification of
asset class such as stocks, bonds, real estate etc.
LO.f: Identify financial and non-financial sources of risk and describe how they may
interact.
The financial risks are the risks that originate from financial markets.
Three types of financial risks include market risk, credit risk, and liquidity risk.
Non-financial risks are risks that arise from sources outside the financial markets such as
actions within an entity, environment, community, suppliers and customers.
The various types of non-financial risks include operational risk, solvency risk, settlement
risk, legal risk, regulatory, accounting and tax risk, model risk, tail risk, and sovereign or

political risk.
Risks are not independent of each other and there is no clear distinction between the various
risks as one risk may lead to another.
LO.g: Describe methods for measuring and modifying risk exposures and factors to
consider in choosing among the methods.
The four factors that drive risk are global and domestic macroeconomics, industries, and
individual companies.
Common measures of market risk include probability, standard deviation, beta or duration,
derivative measures, value at risk, conditional value at risk, expected loss given default, and
scenario analysis and stress testing.
Risk can be modified by prevention, avoidance, risk transfer, or shifting.
When actual risk exceeds the acceptable level, risk can be mitigated through self-insurance
and diversification.
The best method to choose to modify risk depends on the benefits weighted against the costs
after considering the overall risk profile.

Practice Questions
1. Risk management process includes:
A. maximizing returns.
B. defining and measuring risks being taken.
C. minimizing risk.
2. The correct sequence for risk management for an enterprise is:

A. measuring risk exposures, establishing risk tolerance and performing risk budgeting.
B. establishing risk tolerance, measuring risk exposures and performing risk budgeting.
C. establishing risk tolerance, performing risk budgeting and measuring risk exposures.
3. Risk governance is best described as:

A. identification of individuals at each level of hierarchy for delegation of risk
management responsibilities.
B. aligning risk management with the goals of the entire organization.
C. evaluation of potential sources of risk in an organization at each of its business unit.
4. Which of the following is a financial risk?

A. Model risk.
B. Legal risk.
C. Liquidity risk.
5. Which of the following is a non-financial risk?

A. Operational risk.
B. Credit risk.
C. Market risk.
6. Which of the following is least likely an example of model risk?

A. Assuming tails of a distribution of returns are thin without checking.
B. Using the five-year risk-free rate to discount the face value of a five-year government
bond
C. Using standard deviation as a measure of risk in an asymmetric returns distribution.
7. Which of the following best describes an example of risk interaction?

A. Exogenous shocks impact creditworthiness of a company thereby increasing credit
risk to the company it owes money. The increased credit risk increases the legal risk
for the lender firm.
B. Terrorist attacks in Europe cause a decline in US stock market.
C. Political uncertainty in a region lowers economic prospects thereby raising the credit

spreads.
8. Value at risk (VaR) of a firm is one-month 5% value at risk of $2 million. The most
appropriate interpretation for this is:
A. 95% of the time the firm is expected to lose at least $2 million in one-month.
B. 5% of the time the firm is expected to lose at least $2 million in one-month.
C. 5% of the time the firm is expected to lose at most $2 million in one-month.
9. Which of the following best describes a method of risk shifting?

A. Buying insurance.
B. Maintaining a reserve fund.
C. Entering into a derivative contract.

Solutions
1. B is correct. Risks need to be defined and measured so as to be consistent with the

entity’s chosen level of risk tolerance and target for returns or other outcomes.
2. C is correct. Risk tolerance defines the appetite for risk for an enterprise. Risk budgeting
then determines how or where the risk is taken and quantifies risk on an enterprise level.
Risk exposures can then be measured and compared with the acceptable risk.
3. B is correct. Risk governance is determined by a top-down approach. The firm-wide risk

tolerance is determined, followed by providing risk oversight and guidance to align risk
with enterprise goals. Risk tolerance identifies the risk taking ability of the entire
organization. It is usually discussed ex-ante (before an adverse event).
4. C is correct. Financial risk originates form the financial markets. Credit risk, market risk,
and liquidity risk are financial risks.
5. A is correct. Non-financial risk can originate from within the organization or from
external sources like the society, environment, regulators, vendors and customers. It
includes regulatory risk, government or political risk, solvency risk, operational risk,
legal risk, accounting risk, model risk and tail risk.
6. B is correct. Assuming tails of a distribution are thin and assuming symmetry of returns
in asymmetric returns distribution are examples of model risk. Using the risk-free rate to
discount the government bond is usually appropriate.
7. A is correct. In situation A, a market risk impacts all the firms. But the decline in the
creditworthiness, exposes other parties to credit risk and legal risk. This is an interaction
among risks. In situation B and C, represents single events of risk.
8. B is correct. VaR measures a minimum loss expected over a holding period a certain
percentage of the time.
9. C is correct. Maintaining a reserve fund is a method of risk acceptance (self-insurance).

Buying insurance is a method of risk transfer and using derivatives is a method of risk-
shifting.

R43 Fintech in Investment Management 2019 Level I Notes
R43 Fintech in Investment Management
1. Introduction
This reading is divided into seven main sections. Section 2 covers ‘What is Fintech?’ Sections
3 and 4 cover ‘Big data’, ‘artificial intelligence’ and ‘machine learning’. Section 5 covers data
science. Section 6 covers applications of fintech to investment management. Finally section 7
covers distributed ledger technology.
2. What is Fintech?
The term ‘Fintech’ comes from combining ‘Finance’ and ‘Technology’. Fintech refers to
technological innovation in design and delivery of financial products and services.
Though the term ‘Fintech’ is relatively new, its earlier forms involved data processing and
automation. Fintech’s recent advancement include developing several decision making
applications.
The major drivers of fintech have been:
• Rapid growth in data
• Technological advances
While Fintech spans the entire finance space, this reading focuses on fintech applications in
the investment management industry. The major applications are:
• Analysis of large datasets
• Analytical tools
• Automated trading:
• Automated advice
• Financial record keeping
3. Big Data
Big Data refers to vast amount of data generated by industry, governments, individuals and
electronic devices. Characteristics of big data typically include:
• Volume: Over the last few decades, the amount of data that we are dealing with has
grown exponentially.
• Velocity: In the past we often worked with batch processing, however we are now
increasingly working with real time data.
• Variety: Historically we only dealt with structured data. However we are now also
dealing with unstructured data such as text, audio, video etc.

3.1 Sources of Big Data

Traditional data sources include annual reports, regulatory filings, trade price and volume
etc. Alternate data include many other sources and types of data. A simple classification of
alternate data sources is shown in Exhibit 2 of the curriculum.
Individuals Business Processes Sensors
Social media Transaction data Satellites
News, reviews Corporate data Geolocation
Web searches, personal data Internet of Things
Other sensors
3.2 Big Data Challenges
While big data can be a huge asset, there are also several challenges. The quality of data may
be questionable. The data may have biases, outliers etc. Volume of data collected may not be
sufficient. We might be dealing with too much data or too little data. Another concern is the
appropriateness of data. In most cases working with Big Data usually involves cleansing and
organizing the data before we start analyzing it.
4. Advanced Analytical Tools: Artificial Intelligence and Machine

Learning
Artificial intelligence (AI) computer systems perform tasks that have traditionally

required human intelligence. They exhibit cognitive and decision making ability comparable
or superior to that of human beings. An important term in this context is ‘neural networks’. It
refers to programming based on how the brain learns and processes information. There are
examples of AI all around us. For example, chess playing computer programs, digital
assistants like Apple’s Siri etc.
Machine learning (ML) is a technology that has grown out of AI. Machine learning
computer programs:
• learn how to complete tasks or predict outcomes.
• improve performance over time with experience.
Machine learning programs rely on training dataset and validation dataset. Training dataset
allows the ML algorithm to:
• identify relationships between variables
• detect patterns or trends
• create structure from data.
These relationships are then tested on the validation dataset. Once an algorithm has
mastered the training and validation datasets, it can be used to predict outcomes based on
other datasets.
Broadly speaking there are two main approaches to machine learning:
1. Supervised learning: In supervised learning, both inputs and outputs are identified
or labeled. After learning from labeled data, the trained algorithm is used to predict
outcomes for new data sets.
2. Unsupervised learning: In unsupervised learning, the input and output variables are
not labeled. Here we want the ML algorithm to seek relationships on its own.
With terms like AI and ML one might think that human judgment is not required, but that is
far from the truth. For ML to work well, good human judgment is required. Human judgment
is required for questions like: what data to use, how much data to use, what analytical
techniques are relevant in the given context. Human judgment may also be needed to clean
and filter the data before it is fed to the ML algorithm.
Some challenges associated with machine learning are:
• Over-fitting the data: Sometimes an algorithm may try to be too precise in the way it
interprets data and predicts outcomes. This leads to over-trained models and may
result in data mining bias . We try to mitigate this issue by having a good validation
dataset.
• Black box: ML techniques can be opaque or black box, which means we have
predictions that are not very easy to understand or to explain.
Despite these challenges and weaknesses, the importance of ML in finance and investment

management has been growing substantially. In the next few sections, we will look at specific
applications of AI and ML in the context of investment management.
5. Data Science: Extracting Information from Big Data

Data science leverages advances in computer science, statistics and other disciplines for the
purpose of extracting information from Big Data.
5.1 Data Processing Methods
Data processing methods include:
• Capture: Refers to how data is collected from various sources and transformed into a
format that can be used by the analytical process.
• Curation: Refers to the process of ensuring data quality and accuracy, through data
cleaning.
• Storage: Refers to how data will be recorded, archived and accessed. It also refers to
the underlying databases design. An important consideration here is whether the
data is structured, unstructured or both. We also need to be concerned whether the
analytical tools need real time access to the data or not.
• Search: Refers to how we can find what we want from the vast amount of data.
• Transfer: Refers to how data will move from the underlying source to the analytical
tools that are being used.
5.2 Data Visualization
Another aspect of data science is data visualization. This refers to how the data will
ultimately be presented to the analyst/user. Historically, data visualization happened
through graphs, charts etc. However, in more recent times tools such as heat maps, tree
diagrams and tag clouds are also being used.
An example of a heat map is a map of a city where routes with high traffic congestion are
shown in red. A tag cloud is a technique applicable to textual data. Words that appear more
often are shown in a larger font, whereas words that appear less often are shown with a
smaller font. This helps us to quickly evaluate how consumers/users are talking about a
given product.
6. Selected Applications of Fintech to Investment Management

So far we have discussed Fintech in general, now we will look at selected applications of
Fintech to investment management. There are four broad areas that we will consider:
6.1 Text Analytics and Natural Language Processing
Text analytics refers to the use of computer programs to derive meaning from large,
unstructured text or voice based data. For example, text analytics can be used to gauge the
consumer sentiment about a new product by analyzing what is being said about the product

on blogs, forums, YouTube etc. Based on this analysis we can determine if the sentiment is
very positive, positive, neutral or negative.
Natural language processing is an application of text analytics whereby computers analyze
and interpret human language. For example, NLP analysis can be used for communications
from policy makers such as the US Federal Reserve. Officials at these institutions may send
subtle messages through their choice of words and inferred tone. NLP analysis can provide
insights into these subtle messages. Such processing is possible because of access to Big Data
and processing power.
6.2 Robo- Advisory Services
This refers to providing investment solutions through online platforms. This replaces a
human advisor with an online platform. Robo-advice typically starts with an investor
questionnaire, which may include questions about income, spending, age, goals, investment
horizon etc. Based on the responses to these questions, the robo-adviser software uses
algorithmic rules and historical market data to come up with recommendations. The types
of solutions offered through robo-advisory services include:
• Automated asset allocation
• Rebalancing
• Tax strategies
• Trade execution
Robo-advisers typically have low fees and low account minimums. This has increased the
penetrating power of these services reaching mass market segments and people with
relatively low wealth can now afford these services.
Robo-advisers cover both active and passive investment styles, but passive styles tend to be
more common. They are usually more conservative in nature.
There are two major types of robo-advisory services
• Fully automated digital wealth managers: As the term implies, there is absolutely
no human involved in this model. These services offer low-cost investing solutions
and usually recommend an investment portfolio composed of ETFs.
• Adviser-assisted digital wealth managers: In addition to the online system, an
investor also has access to a human advisor over the phone. The advisor can assist by
giving a more customized advice based on the financial situation of the investor.
We need to recognize that robo-advice has its limits. There might be times, when an investor
needs to speak to a person, especially, in times of economic crises. Also, in instances where
investors have specific needs or want to invest in alternative investments robo-advice is not
useful. However, despite these limitations robo-advisory services are becoming increasingly
popular.

6.3 Risk Analysis

Stress testing and risk assessment involves a vast amount of risk data. This data can be in
different forms – for example structured or unstructured, quantitative or qualitative etc. Also
there is an increased interest in monitoring risk in real time.
Instructor’s tip: These characteristics correspond to the three V’s of big data – volume,
variety and velocity. Hence this data can be considered Big Data.
Big Data and ML techniques can provide insight into changing market conditions. This can
allow us to predict adverse market conditions and adverse tends.
Machine learning techniques can also be used to assess data quality. Faulty data, errors,
outliers etc can be identified and removed from the analysis.
Big Data and ML techniques are also used in scenario analysis. Scenario analysis helps in
evaluating the risk of a portfolio. For example, we can evaluate what would happen to our
portfolio if the 2007 financial crisis scenario were to repeat. A common term used here is
‘what if’ analysis. Here we evaluate what would happen to our portfolio under different
market conditions.
These techniques have become increasingly popular because of our ability to deal with big
data and the advanced analytical techniques that have been developed over the last few
years.
6.4 Algorithmic Trading
Algorithmic trading refers to computerized trading based on pre-specified rules and
guidelines. It can help us decide – when, where and how to trade. For example, after
analyzing lots of past data an algorithmic program might tell you that trading during a
certain time of day, on a particular exchange using limit orders is the most cost effective.
Algorithmic trading also allows us to take large orders and slice them into smaller pieces.
These smaller pieces can be executed using the most appropriate exchanges and trading
venues.
The benefits of algorithmic trading include:
• Speed of execution: Since trading is done by computer programs based on
predefined rules, the speed of execution is much faster.
• Anonymity: Since large orders can be broken into smaller pieces and traded through
different exchanges anonymity can be achieved, which may be important for some
investors.
• Lower transaction costs: As discussed above, by identifying the most cost effective
way to trade, algorithmic trading helps lower transaction costs. Also, because large
orders are broken down into several smaller orders, the market impact (which is a

significant component of the transaction costs) of the order is reduced.

High frequency trading (HFT) is one form of algorithmic trading. Here orders or trades are
automatically placed when certain conditions are met. Time is a crucial factor for such
trades. Therefore HFT takes place on ultra-high-speed, low-latency networks.
7. Distributed Ledger Technology

A distributed ledger is a database which can be shared across computer entities (or nodes)
in a network. This is illustrated in Exhibit 5 from the curriculum.
There can be thousands of nodes in a network. Every node will have a copy of the distributed
ledger. There is a consensus mechanism which ensures that all these ledgers are kept in
sync. Through the consensus mechanism all nodes agree on a new transaction and update
their ledgers. New records are considered immutable, which means once a record is created
it cannot be changed.
DLT uses cryptography, which refers to encrypting and decrypting data. Through
encryption we ensure that the data remains secure.
DLT also accommodates smart contracts. These are computer programs that self-execute
on the basis of pre-specified terms and conditions. For example, contracts that automatically
transfer collateral from the borrower to the lender in the event of default.
DLT networks allow us to create, exchange and track ownership of financial assets on a peer-
to-peer basis. There is no central authority to validate the transactions.
DLT benefits include:
• Accuracy, transparency and security in the record keeping process.
• Faster transfer of ownership.
• Peer-to-peer interactions.
Blockchain is a type of distributed ledger. Its characteristics are:
• Information is recorded sequentially within blocks.

• Blocks are chained and secured using cryptography.

• Each block contains a grouping of transactions and a secure link to the previous
block.
The following steps outline the process of adding new transactions to the Blockchain
network.
1. Transaction takes place between buyer and seller.
2. Transaction is broadcast to the network of computers (nodes).
3. Nodes validate the transaction details and parties to the transaction.
4. Once verified, the transaction is combined with other transactions to form a new
block (of predetermined size) of data for the ledger.
5. This block of data is then added or linked (using a cryptographic process) to the
previous block(s) containing data.
6. Transaction is considered complete and ledger has been updated.
7.1 Permissioned and Permissionless Networks
DLT can take the form of permissionless or permissioned networks.
Permissionless networks are open to any user who wishes to make a transaction. Once a
transaction is added, it cannot be changed. All users can see all transactions on the block
chain. These networks do not depend on a central authority.
In permissioned networks, network members may be restricted from participating in
certain network activities. Controls or permissions might be used. Different users may have
different levels of access to the ledger.
7.2 Applications of Distributed Ledger Technology to Investment Management
Cryptocurrencies:
They are also called digital currency or electronic currency. These do not have any physical
form, but allow transactions to take place between buyers and sellers. They are issued by
private individuals or organizations. There is no central authority, like a central bank
backing these currencies.
Many cryptocurrencies have a self-imposed limit on the total amount of currency they may
issue. For example, a well-known cryptocurency, Bitcoin has a self-imposed limit of 21
million.
We should also recognize the fact that with cryptocurrencies there is a lack of fundamentals
underlying the value of the currency. Hence they tend to be very volatile relative to major
currencies like the Dollar or the Euro.
An initial coin offering (ICO) is an unregulated process whereby companies sell their crypto-
tokens to investors. Through this process, investors fund the company and the tokens can be

used to buy products and services from the company at a latter point in time.
Tokenization:
It is the process of representing ownership rights to physical assets on a blockchain or
distributed ledger. Usually transactions involving physical assets such as real estate, require
substantial efforts in ownership verification and examination. DLT can streamline this
process by creating a single digital record of ownership.
Post- Trade Clearing and Settlement:
In financial securities market, the post-trade clearing and settlement process is quite
cumbersome. DLT has the ability to streamline this process by providing near-real-time
trade verification, reconciliation and settlement. This can significantly reduce the
complexity, time and cost involved with processing transactions.
Compliance:
Over the last few years regulators have made reporting requirements stricter. They also
demand greater transparency and access to data. Due to this, the cost and time associated
with compliance activities has gone up substantially. In fact, in many companies the number
of staff employed in compliance departments has gone up.
DLT can streamline the compliance process and bring down these costs. It can allow firms
and regulators to get near-real-time access to transaction data, as well as other relevant
compliance data. This will help firms and regulators to quickly uncover fraudulent activities.
DLT can also reduce compliance costs associated with know-your-customer and anti-money-
laundering regulations which require verification of the identities of clients and business
partners.
There are several challenges to DLT that need to be addressed before it is successfully
adopted by the investment industry. They include:
• There is a lack of DLT network standardization.
• There is also difficulty in integrating DLT with existing systems.
• DLT processing capabilities are expensive.
• DLT systems require substantial storage resources.
• Due to immutability of transactions, mistakes can be undone only by submitting an
equal and offsetting trade.
• DLT requires huge amounts of computational power. This results in high electricity
usage. This can be a challenge in certain countries.
• Regulatory approaches towards DLT can vary across jurisdiction.

Summary
LO.a: Describe “fintech.”
Fintech refers to the technological innovation in the design and delivery of financial products
and services.
LO.b: Describe Big Data, artificial intelligence, and machine learning.
Big Data refers to vast amount of data generated by industry, governments, individuals and
electronic devices.
Artificial intelligence (AI) computer systems perform tasks that have traditionally required
human intelligence. They exhibit cognitive and decision making ability comparable or
superior to that of human beings.
Machine learning (ML) computer programs learn how to complete tasks or predict outcomes
and improve performance over time with experience.
LO.c: Describe fintech applications to investment management.
Major fintech applications include:
• Text analytics and natural language processing.
• Robo-advisory services
• Risk analysis
• Algorithmic trading
LO.d: Describe financial applications of distributed ledger technology.
Major DLT applications include:
• Cryptocurrencies
• Tokenization
• Post-trade clearing and settlement
• Compliance

Practice Questions
1. Fintech is best described as:
A. systems that provide execution of decisions based on certain rules and instructions.
B. technological innovation in the design and delivery of financial services and
products.
C. processing of large traditional datasets with automation of routine tasks.
2. Which of the following statements on fintech’s use in the investment industry is correct?
A. Robo-advisors provide investment services to retail investors at lower cost than
human advisors.
B. DLT with the help of financial intermediaries provide secure ways to track ownership
of assets on a P2P basis.
C. Analysis of large datasets can be integrated into the portfolio’s asset allocation
process as part of investment strategies other than alpha generation.
3. The term Big Data typically means:

A. alternative data, arising from electronic devices, social media, sensor networks, and
company exhaust.
B. datasets with data volumes growing from megabytes to petabytes available on a real-
time or near- real- time basis in structured formats.
C. datasets having large volume, high velocity and a variety of formats.
4. Data generated by sensors most likely include:

A. structured data such as direct sales information, credit card data, as well as corporate
exhaust.
B. data collected from smart phones, cameras, satellites, and internet of things.
C. data produced in text, video, photo, and audio formats.
5. One of the challenges of using Big Data is most likely the:

A. dataset is structured and needs to be cleansed and organized before analysis.
B. dataset is quantitative instead of qualitative in nature.
C. dataset may have selection bias, missing data or data outliers.
6. In machine learning (ML) the computer algorithm “learns” from:

A. data by modelling inputs to outputs (if provided) or identifying underlying data
structure (if outputs are not given).
B. identifying relationships between inputs and outputs based on future patterns
expected in the data.
C. training datasets to arrive at easily understood outcomes through “black box”

approaches.
7. A “tag cloud” is a Big Data visualization technique where:

A. words that appear less frequently are shown with a larger font and words that appear
more often are displayed with a smaller font.
B. the relationship between different concepts is shown.
C. words are sized and displayed based on the frequency of the word in the data file.
8. Which of the following statements is least accurate? Natural language processing, may be
used to detect:
A. trends in aggregate output, interest rates or inflation.
B. fraud or inappropriate conduct in adherence to company policies.
C. trends and indicators about a stock by incorporating traditional data only.
9. Which of the following investment advisory services may not be provided by robo-
advisors?
A. Automated asset allocation and trade execution.
B. Tax-loss harvesting and rebalancing of portfolios.
C. Customized allocation for high-net-worth clients investing in different asset types.
10. Risk analysis using Big Data provides:

A. real-time identification of changing market conditions and adverse trends.
B. stress testing excluding qualitative data.
C. insight into future stock performance by segregating traditional and alternative data
with ML techniques.
11. The benefits of algorithmic trading are:

A. speed and anonymity but higher transaction costs.
B. best limit or market order and most appropriate trading venue.
C. seeking to earn a profit from investment decisions based on the end of day market
prices.
12. Which of the following is not a step in adding a transaction to a blockchain distributed
ledger?
A. Transaction between a buyer and seller is broadcast to a network of computers
(nodes).
B. Nodes validate the transaction details and parties to the transaction.
C. Each verified transaction forms a new block which is not linked with previous data as
the ledger updates.

13. Which of the following is a feature of cryptocurrencies?

A. Cryptocurrencies have clear fundamentals which help to stabilize volatility.
B. Cryptocurrencies have a self- imposed limit on the total amount of currency they may
issue.
C. Cryptocurrencies are government backed but not regulated.

Solutions
1. B is correct. Fintech refers to technological innovation in the design and delivery of

financial services and products. Fintech can also refer to companies (often new, startup
companies) involved in developing new technologies and their applications, as well as the
business sector that comprises such companies.
2. A is correct. Robo- advisers or automated personal wealth management services provide

investment services to retail investors at lower cost than traditional adviser models can
provide. B is incorrect because although DLT, may provide secure ways to track
ownership of financial assets on a peer- to- peer (P2P) basis but it reduces the need for
financial intermediaries. C is incorrect because large datasets can now be integrated into a
portfolio manager’s investment decision- making process for generating alpha and
reducing losses.
3. C is correct. The term Big Data refers to datasets having the following characteristics:
1. Volume: Vast amount of data collected in files, records, and tables growing from
megabytes (MB) and gigabytes (GB) to larger sizes, such as terabytes (TB) and
petabytes (PB).
2. Velocity: Data communicated at very high speed available on a real-time or near-real-
time basis.
3. Variety: Data collected in a variety of formats including structured, semi-structured
and unstructured data.
4. B is correct. Sensor data are collected from such devices as smart phones, cameras, RFID
chips, and satellites. Sensor data can be unstructured, arising from microprocessors and
networking technology that are present in most personal and commercial electronic
devices. Extended to office buildings, homes, vehicles, and many other physical forms,
this forms a network arrangement, known as the Internet of Things. A is incorrect
because data generated by business processes include structured data from corporations
and other public entities. It comprises of direct sales information, such as credit card
data, as well as corporate exhaust. C is incorrect because data generated by individuals
are often produced in text, video, photo, and audio formats.
5. C is correct. Big Data poses several challenges when used in investment analysis,
including the quality, volume, and appropriateness of the data. Key issues include dataset
with selection bias, outliers or missing data. A & B are incorrect because qualitative
dataset which is associated with unstructured data is more difficult to source, cleanse
and organize than quantitative data.

6. A is correct. In ML, the computer algorithm is given “inputs” (a set of variables or

datasets) and may be given “outputs” (the target data). The algorithm “learns” from the
data provided by finding the best way to model inputs to outputs (if provided) or how to
identify or describe underlying data structure if no outputs are given. B is incorrect
because The training dataset allows the algorithm to identify relationships between
inputs and outputs based on historical patterns in the data. C is incorrect because the ML
algorithm after mastering the training and validation datasets, predict outcomes based
on other datasets. ML techniques that arrive at unexplainable outcomes are known as
“black box” approaches.
7. C is correct. A Big Data visualization technique applicable to textual data is a “tag cloud,”
where words are sized and displayed on the basis of the frequency of the word in the
data file. A is incorrect because words that appear more often are shown with a larger
font, and words that appear less often are shown with a smaller font. B is incorrect
because “mind map” another data visualization technique shows how different concepts
are related to each other.
8. C is correct. After analyzing analyst commentary, NLP can assign sentiment ratings
ranging from very negative to very positive for each company. NLP can be used to detect,
monitor, and tag shifts in sentiment, potentially ahead of an analyst’s recommendation
change.. NLP may also be employed in compliance functions to review employee
electronic communications for adherence to company or regulatory policy, inappropriate
conduct, or fraud. Similarly, communications and transcripts from policymakers, such as
the Central Bank offer an opportunity for NLP- based analysis, to provide insights about
trending or waning interest rates, aggregate output, or inflation expectations. NLP
analysis may incorporate non- traditional information too, in an attempt to identify
trends and short- term indicators about a company, a stock, or an economic event that
might impact future performance.
9. C is correct. If the complexity and size of an investor’s portfolio grows, robo- advisers
may not be able to cater to the particular preferences and needs of the investor. For
example, extremely affluent investors who may own a greater number of asset types—
including alternative investments (e.g., venture capital, private equity, hedge funds, and
real estate)—in addition to global stocks and bonds would need customization, hence
demand human advisers rather than robo-advisers. A & B are services typically provided
by robo-advisers to mass market segments.
10. A is correct. Big Data may provide insights into real- time and changing market

circumstances to identify weakening market conditions and adverse trends in advance,

allowing managers to use risk management techniques and hedging practices. B is
incorrect because stress testing may consider qualitative information also. C is incorrect
because valuation of alternative data using ML techniques may help foreshadow
declining company earnings and future stock performance. After validation by ML
techniques, alternative data is integrated with traditional data and used in risk models.
11. B is correct. Algorithmic trading provides benefits of speed of execution, anonymity, and
lower transaction costs. Algorithms may also determine the best way to price the order
(e.g., limit or market order) and the most appropriate trading venue (e.g., exchange or
dark pool) to route for execution. High- frequency trading (HFT), is a form of algorithmic
trading which decides what to buy or sell and where to execute on the basis of real- time
prices and market conditions, seeking to earn a profit from intraday market mispricings.
12. C is correct. Once verified, the transaction is combined with other transactions to form a
new block (of predetermined size) of data for the ledger. This block of data is then added
or linked (using a cryptographic process) to the previous block(s) containing data.
Transaction is considered complete and ledger has been updated.
13. B is correct. Many cryptocurrencies have a self- imposed limit on the total amount of
currency they may issue. Although such limits may maintain their store of value, but
cryptocurrencies have experienced high levels of price volatility. A is incorrect because
cryptocurrencies lack clear fundamentals which contribute to their volatility. C is
incorrect because cryptocurrencies are neither government backed nor regulated.

R44 Market Organization and Structure 2019 Level I Notes
R44 Market Organization and Structure

1. Introduction
This reading covers the functions of the financial system, the various assets used by financial
analysts, the role of financial intermediaries, different positions one can take like short and
long, various types of orders, market participants, primary and secondary markets, and
finally the characteristics of a well-functioning financial system.
2. The Functions of the Financial System
The financial system includes markets and financial intermediaries that help transfer
financial assets, real assets and financial risk between entities, from one place to another,
and from one point in time to another.
The six purposes people use the financial system for are as follows:
• to save money for the future.
• to borrow money for current use.
• to raise equity capital.
• to manage risks.
• to exchange assets for immediate and future deliveries.
• to trade on information.
Three main functions of the financial system are to:
• achieve the purposes for which people use the financial system.
• discover the rates of return that equate aggregate savings with aggregate borrowings.
• allocate capital to the best uses.
2.1. Helping People Achieve Their Purposes in Using the Financial System
People often use a single transaction to achieve more than one of the six purposes when
using the financial system. For example, an investor who buys the stock of a bank may be
saving for the future, or trading based on research that the stock is undervalued, or trying to
benefit from the central bank’s policy to slash interest rates in the medium term. Each of the
six purposes listed earlier are discussed in detail below:
Saving
Saving is moving money from the present to the future. By saving, we choose not to spend
now, and make that money available in the future. One common example is people saving for
retirement. The financial system offers various instruments such as bank deposits, stocks,
and bonds for this purpose.
Borrowing
Entities like people, companies and governments often want to spend money now but do not
have money. People borrow to buy homes, cars, education while companies borrow to fund
new projects. Governments borrow to provide better infrastructure, rural development or

other such benefits for its citizens. The financial system facilitates borrowing by aggregating
from savers the funds that borrowers require. In simple terms, these are known as loans.
Raising Equity Capital
Companies raise money for projects by selling equity ownership interests. Instead of taking a
loan, they sell a certain percentage of ownership in the company to raise funds. The financial
system brings together the companies in need of money and entities providing money in the
form of investment banks. Investment banks help companies issue equities, analysts value
the securities that companies sell, regulators and standards setting bodies ensure
meaningful financial disclosures are made.
Managing Risk
Entities face financial risks related to exchange rates, interest rates, raw material prices and
might want to hedge these risks.
Example of financial risk management:
Consider a sugarcane producer (typically farmers) and a sugar refining firm. The sugar
refining firm purchases sugarcane from the farmers and processes them to produce sugar.
The sugarcane season typically lasts 150 days in a year but is based on a variety of factors
such as amount of rainfall, temperature, pests etc. Both the farmer and refining firm are
worried about what the prices will be when the sugarcane is ready – farmer fears it will be
lower due to overproduction, poor quality of crop, while the refining firm fears it will be
higher because of demand, global commodity prices and production worldwide. By entering
in to a forward contract (discussed in detail in derivatives reading), they eliminate the
uncertainty related to changing prices.
Exchanging Assets for Immediate Delivery (Spot Market Trading)
People often trade one asset for another if the value of the other asset is more to them.
Examples include currencies, carbon credits and gold. The financial system facilitates these
exchanges when liquid spot markets exist, which removes substantial transaction costs.
Information-Motivated Trading
Information-motivated traders aim to profit from information that they believe allows them
to predict future prices. Unlike pure investors, information-motivated traders strive to
leverage their information to earn extra return in addition to the normal return expected by
investors.
Active investment managers are information-motivated traders who after a thorough
analysis buy under-valued and sell over-valued securities. Pure investors and information-
motivated traders differ in their motives, and not so much in the risk they take. The primary
motive of the latter is to profit from the superior information they possess.
2.2. Determining Rates of Return
Saving, borrowing and selling equity are all means of moving money through time. While
savers move money from the present to the future, borrowers and issuers of equity move

money from the future to the present.

Money can travel forward in time if an equal amount of money is traveling in the other
direction. Think of it this way: the instruments in which savers invest are those created by
the borrowers. For instance, a bond or a stock that a saver invests in is issued by a
government or a company. The company is moving money to now, while the investor is
saving it for later.
How much savers save or move consumption to the future is related to the expected return
on investments. If the rates are high, investors will want to save more. Similarly, if the cost of
borrowing is less for borrowers now, they will want to move more money from the future to
the present i.e. borrow more. The total amount of money saved must equal the total amount
of money borrowed to achieve a balance. It will create an imbalance if either one of them is
too high or low. If rate of return is low, savers will want to save less now than how much
borrowers will want to borrow.
Equilibrium interest rate is the interest rate at which the aggregate supply of funds equals
the aggregate demand for funds. Different securities have different equilibrium rates based
on their characteristics which are usually a function of risk, liquidity and time. For instance,
investors demand a higher rate of return for equities than debt, long term investments than
short term investments, or illiquid securities than liquid securities.
2.3. Capital Allocation Efficiency
Primary capital markets are the markets in which companies and governments raise
capital. Economies are considered allocationally efficient when capital (money) is allocated
to the most productive uses i.e. projects with the highest NPV or internal rate of return (IRR).
Investors actively seek information on the various investment opportunities available before
making investment decisions.
3. Assets and Contracts
3.1. Classifications of Assets and Contracts
Classification
criteria:
Based on the Financial assets: Means by Real assets: Include physical
underlying which individuals hold claim assets like real estate,
on real assets and future equipment, commodities, and
income generated by these other assets.
assets. For e.g: securities like
stocks and bonds.
Based on the nature of Debt securities: Periodic Equity securities: Represent
claim by financial interest payments made on ownership positions and claim
securities borrowed funds which might on the future cash flows of the
be collateralized. business.

Based on where the Publicly traded: These Privately traded: These

securities are traded securities trade in public securities are not traded in
markets through exchanges or public markets. They are often
dealers and are subject to not subject to regulation.
regulatory oversight.
Based on delivery Spot market: Markets for Forward market: Contracts
immediate delivery of assets. that call for future delivery of
assets and include forwards,
futures and options.
Based on the Financial derivative Physical derivative contract:
underlying of the contract: These contracts These contracts draw their
derivative contract draw their value from financial value from real assets like
assets like equities, equity commodities.
indices, debt, and other assets.
Based on issuance of Primary market: Issuers sell Secondary market: Investors
security securities directly to investors. buy and sell securities among
themselves.
Based on maturity Money market: Securities Capital market: Securities that
with maturities of one year or have more than one year
less. maturity or equities that don’t
have any maturity.
Based on the type of Traditional investment Alternative investment
investment markets markets: Includes all publicly markets: Includes hedge funds,
traded debt and equities. private equity, commodities,
real estate, and precious gems
which are hard to trade and
value.
3.2. Securities
Securities can be broadly classified into:
Fixed Income:
Refers to debt securities where the borrower is obligated to pay interest and principal at a
pre-determined schedule. They might be collateralized i.e. investors have claim of certain
physical assets in case of a default.
The different types are:
• Bonds: Long-term debts.
• Notes: Intermediate-term debts.
• Bank borrowings: Long to short term involving revolving credit lines and other debt
instruments.
• Convertible: Debt can be exchanged for a specified number of equity shares.

Equity:
Refers to ownership claims by investors in companies.
The different types are:
• Common shareholders: They have a residual claim over any assets and income, after
all the senior securities have been paid.
• Preferred shareholders: They are paid scheduled dividends before the common
shareholders.
• Warrants: They give the holder a right to buy the firm’s security at a price called the
exercise price, within a specified time period. (similar to options)
Pooled investments:
Pooled investments include mutual funds, trusts, exchange traded funds (ETFs), and hedge
funds. They issue securities to represent the shared ownership in the assets. Money from
several investors is pooled together to be managed by a professional money manager
according to a specific investment strategy. The advantage of investing in pooled vehicles is
to benefit from the investment management services of managers and from diversification
opportunities. Pooled vehicles may be open-ended or close-ended.
3.3. Currencies
Currencies are monies issued by national monetary authorities. Reserve currencies such as
dollar and euro are currencies that national central banks around the world hold in large
quantities. Currencies trade in foreign exchange markets, spot markets, forward markets, or
futures markets.
3.4. Contracts
A contract is an agreement between traders to perform some action in the future which can
either be settled physically or in cash.
Based on the underlying asset, contracts can be further classified into:
• Physical contract: If contracts are based on physical assets like crude oil, wheat, gold
or any other commodity, then it is a physical contract.
• Financial contract: If contracts are based on financial assets such as indices, interest
rates, currencies, then they are called financial contracts.
Contracts for Difference (CFD) allow people to speculate on the price of an underlying
asset. The buyer benefits if the price of the underlying asset increases. These are derivative
contracts because their value is derived from the underlying asset. They are generally settled
in cash.
The major types of contracts (also termed as derivatives) are:
Forward contract:
It is an agreement to trade the underlying asset at a future date at a pre-specified price. It is

not standardized and is not traded on exchanges or in dealer markets.

Futures contract:
It is a standardized forward contract for which amount, asset characteristics and delivery
date are same. Standardization ensures higher liquidity.
Swap contract:
It is an agreement to swap payments of one asset for the other. The different types are:
• Interest rate swap: Floating rate payments are swapped for fixed-rate payments for a
specified period.
• Currency swap: Currency amount swapped for another currency for a specified
period.
• Equity swap: Returns earned on one investment are swapped for the other.
Options:
Contracts that give the holder a right, but not the obligation, to buy/sell an underlying
security at a specified price, at or before a specific date. The different types are:
• Call options: Buyer gets the right but not the obligation to buy the underlying
security; seller of the call option gets the premium upfront but has to the sell the
security if the buyer exercises his option to buy.
• Put options: Buyer gets the right but not the obligation to sell the underlying security;
seller of the put option gets the premium upfront but has to the buy the security if the
buyer exercises his option to sell.
Credit default swaps:
Contracts that offer insurance to bondholders. They make payments to a bondholder if a
borrower defaults on its bonds.
3.5. Commodities
Commodities include precious metals, energy products, industrial metals, agricultural
products, and carbon credits. They trade in spot, forward and futures markets. They are
traded in spot markets for immediate delivery and in forwards and futures markets for
future delivery.
3.6. Real Assets
Real assets are tangible assets such as real estate, machinery, and airplanes which are
normally held by operating companies. Real assets are unique, illiquid, and costly to manage.
They are attractive to investors for two reasons:
• Low correlation with other investments.
• Income and tax benefits to investors.
4. Financial Intermediaries
Financial intermediaries help entities achieve their financial goals. They provide products

and services which help connect buyers to sellers. There are several types of intermediaries:
4.1. Brokers, Exchanges, and Alternative Trading Systems
Brokers:
• They find counterparties for transactions (other entities willing to take the opposing
side in a transaction) and do not indulge in trade with their clients directly.
Block brokers:
• Provide similar services as brokers, except that their clients have large trade orders
that might potentially impact the security prices if the trade is executed without
proper care.
Investment banks:
• They provide advice for corporate actions like mergers & acquisition and help firms
raise capital by issuing securities such as common stock, bonds, preferred shares etc.
Exchanges:
• They provide places where traders can meet.
• They regulate traders’ actions to ensure smooth execution of the trades.
Alternative trading systems (ATS):
• They serve the same trading function as exchanges but have no regulatory oversight.
• ATS where client orders are not revealed are also known as dark pools.
4.2. Dealers
• They trade directly with their clients by taking the opposite side of their trades.
• They provide liquidity by buying or selling from their own inventory, earning profits
on the spread between the transactions.
4.3. Securitizers
Securitization is the process of buying assets, placing them in a pool and then selling assets
that represent ownership of the pool. One common example is that of mortgage-backed
securities or mortgage pass-through securities.
Securitization example:
Take the example of a mortgage bank that gives mortgage loans to a thousand homeowners.
Each mortgage loan is like an asset on the bank’s balance sheet. If the mortgage bank
combines the thousand individual mortgage loans into a pool and sells shares of the pool to
investors as securities, then this process is called securitization. The mortgage bank acts as
the intermediary as it connects investors who want to buy mortgages with home owners
who want to borrow money. The interest and principal payments from the homeowners are
paid to the investors of these securities.
Benefits of Securitization
• Improves liquidity in the mortgage markets as it allows investors to indirectly invest

in mortgages that they would otherwise not buy. The risks associated with MBS are
more predictable than that of individual mortgages, therefore, MBS are easier to price
and sell when investors need to raise cash.
• Reduces cost of borrowing for homeowners. Higher liquidity means that investors are
willing to pay more for securitized mortgages. This results in higher mortgage prices
and lower interest rates.
• Diversification of portfolio for individual investors who wish to invest in mortgages
but cannot service it efficiently.
• Losses from default and early prepayments are more predictable.
4.4. Depository Institutions and Other Financial Corporations
Depository institutions include commercial banks, savings and loan banks, credit unions and
similar institutions that raise funds from depositors and other investors and lend it to
borrowers. The diagram below explains the function of a depository institution as a financial
intermediary.
Deposit money Pays interest
Depositors Bank $$$$ Borrowers
Lend money
Pays interest
Depositors (or investors) deposit their money in the banks. Banks pay interest to the
depositors for using their money and offers services, such as check writing. The banks, in
turn, lend this money to borrowers in need of the money. The borrowers pay an interest to
the bank. The interest a bank earns from borrowers is usually higher than the interest it pays
to the depositors, that is how the bank makes money. Bank is a financial intermediary here
as it connects depositors with borrowers. Banks also raise funds by selling equity or issuing
bonds of the bank.
4.5. Insurance Companies
Insurance companies help people and companies offset risks by issuing insurance contracts;
the contracts make a payment to the party that buys the contracts in case an event occurs.
Examples of insurance contracts include life, auto, home, fire, medical, theft and disaster.
Example of an insurance contract:
Assume you own a car and wish to insure the car against any damages. You buy car
insurance from an insurance company and pay a premium at periodic intervals (annually).
By doing this, you have transferred the risk of car ownership to the insurance company. In
case, the car is involved in an accident, the insurance company pays for the damages.

4.6. Arbitrageurs
Arbitrageurs trade when they can identify opportunities to buy and sell identical or
essentially similar instruments at different prices in different markets.
Example of an arbitrage opportunity:
Consider a stock HLL Corp. that trades on two exchanges in a country. If a trader buys the
stock from one exchange at a lower price and sells on another at a higher price, then an
arbitrage opportunity exists as you can profit at the same time due to differences in prices. If
the same instrument (like HLL in example above) is bought and sold in different markets at
different prices, it is pure arbitrage.
If markets are efficient, pure arbitrage opportunities rarely exist. When it does happen, the
arbitrageur will engage in transactions that will quickly eliminate this arbitrage. However,
buying an instrument in one form and selling it in another form is called replication. It is
common for arbitrage opportunities to exist between similar instruments. Example: Buy
stock and sell overpriced calls for the same stock.
4.7. Settlement and Custodial Services
Clearinghouse helps clients settle their trades. In futures markets, they guarantee contract
performance, and hence eliminate counterparty risk. By requiring participants to post an
initial margin and maintain the margin, the clearinghouse ensures there are no defaults. In
other markets, they may act as escrow agents, transferring money from the buyer to the
seller while transferring securities from the seller to the buyer.
Depositories or custodians hold securities for their clients so that investors are insulated
from loss of securities through fraud or natural disasters.
5. Positions
An investor’s position in a security may either be a long position or a short position.
Long positions
• These are created when a trader owns an asset or has a right or obligation under a
contract to purchase an asset.
• Investors who are long benefit from an increase in price of the security.
• A long position can be levered or unlevered.
Short positions
• These are created when traders borrow an asset and sell it, with the obligation to
replace the asset in the future.
• Investors who are short benefit from a decrease in price of the security.

We will now look at each of these positions in detail.

5.1. Short Positions
Short positions are created when traders sell contracts or stocks they do not own. It is
similar to borrowing an asset you do not own.
How to create a short position in a security:
Borrow security Sell borrowed Close position

from long party security to other by repurchasing
Example of a short position:

Assume you research a stock – Oracle Corporation – and forecast its price to go down in the
short term. The holder of a short position benefits when the security price goes down. To
profit from this view, you borrow securities from a long party; sell the borrowed Oracle
stock to other traders when it is trading at $50. The stock falls to $40 in line with your
forecast. You then close the position by repurchasing and delivering it to the long party,
profiting $10 per share in the process.
The potential gain is bounded, in our example, to a maximum of $50. That is, the maximum
profit you can earn is $50 if the stock falls from $50 to $0. Conversely, the potential loss is
unbounded. If the stock’s price increases instead of falling, then the short seller incurs a loss
and theoretically, there is no maximum limit to the loss. This makes a short position very
risky. For a long position, the reverse happens. If you own Oracle stock and the stock’s price
increases, there is no limit to the maximum profit you can make. However, the loss if the
stock falls is limited to $50.
To secure the security loans given to short sellers, security lenders require that proceeds of
the short sale be posted as collateral ($50 in the example above). The security lender then
invests the proceeds in short term securities and pays interest on collateral to short sellers
at rates known as short rebate rates. Security lenders lend their securities because the
short rebate rates they pay on the collateral are lower than the interest rates they receive
from investing the collateral.

Short Position: sell the stock (owe the asset)

Maximum gain = 100 % of investment
Maximum loss = unbounded
Long Position: buy the stock (own the asset)
Maximum gain = unlimited
Maximum loss = 100% of investment
5.2. Leveraged Positions
In some markets, traders are allowed to buy securities by borrowing some percentage of the
purchase price. The leverage ratio is a measure of the amount borrowed relative to the total
value of the asset. It shows how many times larger a position is than the equity that supports
it.
Value of the position
Leverage ratio =
Value of the equity investment in it
The borrowed money is called the margin loan and the interest paid is called the call money
rate. Traders who buy securities on margin are subject to margin requirements. The initial
margin requirement is the minimum percentage of the purchase price that must be paid by
the trader (called trader’s equity).
Traders usually borrow money from their brokers. The advantage of buying securities on
margin is that it increases the amount of profit a trader makes if the share price goes up. If
the share price falls to a certain level (the margin call price) the trader will receive a call
from the broker (lender) and will be asked to add more money to his account. The minimum
amount of equity to be maintained in the positions is called the maintenance margin
requirement. Traders receive a margin call when equity falls below the maintenance
margin requirement.
1−Initial Margin
Margin call price = P x (1−Maintenance Margin)
Example
Your broker allows you to purchase stocks on margin. The initial margin requirement is 40%
and the maintenance margin requirement is 25%. You purchase a stock for $50 using $20 of
your money and you borrow the rest from the broker. The interest rate on borrowed money
is 5%. What is the leverage ratio? At what rate will you receive a margin call?
Solution:
You borrow $30, your equity is $20 and the total value of the asset is $50.
50
The leverage ratio is 20 = 2.5.
1 – Initial margin 1−0.4
Margin call price = Price x 1 – maintenance margin = 50 x 1 – 0.25 = 40.
If the stock price comes down to 40, you still owe the $30 and your equity has come down to

$10. This is 25% of $40 (the asset price). If the stock price falls below $40 the equity
becomes less than 25%, the maintenance margin. In this situation, the broker (lender) will
ask you to add money to your account such that your equity is at least 25%.
Example
We continue with the earlier example where your initial margin requirement is 40%. You
believe stock X will go down in price and decide to short sell 500 shares at the current price
of $30. How does the margin requirement impact you?
Solution:
Proceeds from short sale = 500 * $30 = $15,000. Just like long buyers buy on margin, even
short sellers are required to post a margin amount as a security. If the price goes up, then it
is a loss for the short seller (you); to mitigate this risk of loss, the broker requires that
margin traders to maintain a minimum amount of equity in their positions called the
maintenance margin requirement. The margin amount required here is 0.4 * 15,000 =
$6,000.
The total return to the equity investment in a levered position considers:
Profit or loss on the position
- Margin interest paid
+ Dividends received
- Sales commission
To calculate the return percentage on a leveraged position, we need to divide the total profit
by the initial investment. This is illustrated below:
Example
What is the overall return in percentage terms given the following data?
Purchase price = 30
Sales price = 32
Shares purchased = 500
Leverage ratio = 2
Call money rate = 5%
Dividend = $0.50 per share
Commission = $0.02 per share
Solution:
Total amount of investment 30
Trader’s equity = = = 15 per share
Leverage ratio 2
Initial investment: (Equity + Commission) x (Number of shares purchased) = 15.02 x 500 =

7,510
Margin interest paid = 1.05 x 500 = 525

Equity at end = (Sale price – trader’s equity – margin interest paid – commission + dividends
received) x Number of shares = (32 – 15 – 1.05 – 0.02 + 0.5) x 500 = 8,215
Total profit = equity at end – initial investment = 8,215 – 7,510 = 705

Total profit 705
Total return = Initial investment = 7510 = 9.39%
The realized gain is greater than the stock price return of (2/30) = 6.67%. The total return is
magnified here because of the leverage for the remainder 60% of the investment. The initial
investment is only 15.02 per share (or 7,510 for 500 shares) on margin which would
otherwise have been 30.02 per share (or 15,010 for 500 shares).
6. Orders
Brokers, dealers and exchanges arrange the trades between buyers and sellers by issuing
orders.
All orders specify the following basic information:
• What instrument to trade (name of the stock, ETF, bond etc.)
• How much to trade (quantity such as 500 socks of Microsoft Corp.)
• Whether to buy or sell (example: sell Oracle stock)
Most orders have additional instructions:
• Execution instruction: How to fill the order.
• Validity instruction: When the orders may be filled.
• Clearing instruction: How to arrange the final settlement.
In many markets, dealers are willing to buy/sell from traders. The dealer creates the market.
Some important terms:
• Bid and ask price: The prices at which dealers are willing to buy are called bid prices.
The prices at which dealers are willing to sell are called ask prices. The ask prices are
usually higher than the bid prices.
• Bid and ask size: Traders often trade various quantities of a stock at various prices.
The quantities for a bid offer are called bid sizes and the quantities for an ask offer are
called ask sizes.
• The highest bid in the market is called the best bid and lowest ask in the market is
called the best ask. The difference between the best bid and best offer is the market
bid-ask spread.
6.1. Execution Instructions
Execution instructions types are:
Market Orders:
• The order is immediately executed at the best price available.

• It executes the order quickly; however there can be substantial slippages in execution
price if a stock is thinly traded.
Limit Orders:
• Sets a minimum execution price on sell orders and maximum execution price on buy
orders.
• The order ensures that an investor never exceeds his price limit on a transaction.
• However, there is a possibility that the order may not execute at all, if the markets are
fast moving or there isn’t enough liquidity.
All or Nothing Orders:
• These orders will be executed only if the entire quantity can be traded.
• Are beneficial when the trading costs depend on the number of executed trades and
not on the size of the order.
Hidden Orders:
• These are large orders that are known only to the brokers or exchanges executing
them until the trades are executed.
Iceberg Orders:
• A small visible portion of a large hidden order is executed first, to gauge the market
liquidity before the entire order is executed.
From a testability perspective, it is important to note the difference between a market order
and a limit order.
Market order Limit order
Execution Executed at the best Sets a minimum execution price on sell
available market price. orders and maximum execution price
on buy orders.
Advantages Quick execution when a Avoids slippages as the orders are
trader believes that the executed at the pre-determined or
prices are volatile. better prices.
Disadvantages Quick execution can lead to In a volatile market, the order might be
unfavorable trade prices and partially filled or not filled at all, making
has trade price uncertainty. the possibility of missing out on trade.
Additional Trader sacrifices price Types of limit orders:
information certainty for immediate • Marketable or aggressively priced:
liquidity. Limit buy order above the best ask
or a limit sell order below the best
bid. It will be immediately executed.
• Making a new market or inside the
market: Limit price is between the
best bid and the best ask.

• Behind the market: Limit buy order

with limit price below the best bid
and limit sell order with limit price
above the best ask. If the limit
prices are way behind the market,
they are termed as far from the
market limit orders.
6.2. Validity Instructions
Validity instructions types are:
• Day orders: Order that expires if it is unfilled for the trading day on which it is
submitted.
• Good-till-cancelled orders: Order that lasts until the buy or sell order is executed.
• Immediate or cancel (fill or kill) orders: These orders are to be immediately filled
i.e. when they are received by the broker or exchange. If it fails to execute, the order is
canceled from the system.
• Good-on-close (market-on-close): These orders can only be filled at the close of
trading. Mutual funds often rely on this order type.
• Stop orders (also called stop-loss orders): This order comes with a trigger price.
Stop-sell order executes only if the price is at or below the stop price or trigger price.
Stop-buy order executes only if the price is at or above the stop price or trigger price.
6.3. Clearing Instructions
Clearing instructions tell brokers and exchanges how to arrange final settlement of trades.
These instructions convey who is responsible for clearing and settling the trade.
7. Primary Security Markets
Primary markets are where issuers first sell their securities to investors. For example, when
a private company goes public, its shares are issued first to the investors in the primary
market before it starts trading in the secondary market.
7.1. Public Offerings
Issuers generally contract with an investment bank to help them sell their securities to the
public. The investment bank builds the list of subscribers who will buy the security. This
process is known as book building. Investment banks attract investors by providing
investment information and opinion about the issuing company.
In an accelerated book build, issuers may issue securities with the help of an investment
bank in only one or two days.
The two major types of offerings provided by investment banks are underwritten offering
and best efforts offering.
• Underwritten offering: The investment bank guarantees the amount of shares and

the price at which they will be sold (think of it as though the issuer has sold the entire
issue to the investment bank, who then sells it to other investors through the book
building process). This price is called the offering price. Assume the investment bank
promises to sell 1,000,000 shares at $20 and only 800,000 are sold. If the entire issue
is not sold, the investment bank buys the remaining securities at the offering price, in
this case it buys the remaining 200,000 shares. The issuer pays an underwriting fee of
about 7% to the bank for these services.
• Best efforts offering: Unlike underwritten offering, in this case, the investment bank
only serves as a broker to bring investors to the issuer. Any securities not sold in an
undersubscribed issue will remain as is.
An IPO (Initial Public Offering) is where issuers sell securities to the public for the first
time.
• IPO could be oversubscribed or undersubscribed. If the offering price is low, more
investors will be interested in subscribing than the number of shares issued
(oversubscribed). Similarly, if the price is high, less number of investors will be
interested leading the issue to be undersubscribed.
• Investment banks have a conflict of interest in their dual role as agents and
underwriters in choosing the right offering price. As an underwriter, it is in the
interests of the investment bank to have the offering price as low as possible. But as
agents for issuers, the offering price should be right to raise the required amount of
money for the issuer.
A seasoned or secondary offering is where an issuer sells additional units of a previously
issued security. As an example a company might have raised $10 million through an IPO and
four years later wants to raise another $15 million through a secondary offering. Note that
the secondary offering is a transaction between the issuer and investors.
7.2. Private Placements and Other Primary Market Transactions
A private placement is where corporations sell securities directly to a small group of
qualified (sophisticated) investors as opposed to the public. Private placement requires
relatively low disclosure requirements because qualified investors are aware of the risks
involved. It is less costly than a public offering.
In a shelf registration, corporations sell seasoned securities directly to the public on a
piecemeal basis over time instead of selling it in a single transaction. They are sold in
secondary markets. Consider a publicly traded company that announces the sale of 700,000
shares to a small group of qualified investors at €0.75 per share. This is an example of a
private placement and not shelf registration because the company is not selling on a
piecemeal basis.
In a rights offering, companies distribute the right to buy new stock at a fixed price to
existing shareholders in proportion to their holdings. For example, a publicly traded Italian

company is raising new capital. Its existing shareholders may purchase 3 shares for €3.07
per share for every 10 shares they hold.
7.3. Importance of Secondary Markets to Primary Markets
Primary markets are where entities raise money. Secondary markets are markets where
investors trade (buy/sell) in securities. The cost of raising capital in primary markets is
lower for corporations and governments whose securities trade in liquid secondary markets.
In a liquid market, the transaction costs are low to buy/sell a security. Since investors value
liquidity, they are willing to pay more for liquid securities; these high prices result in lower
costs of capital for issuers.
8. Secondary Security Market and Contract Market Structures
Trading in securities takes place in a variety of structures. We will consider three aspects of
market structure:
• Trading Sessions
• Execution Mechanisms
• Market Information Systems
8.1. Trading Sessions
The two categories of securities market based on when they are traded are as follows:
1. Call markets:
• Trade takes place only at specific times of the day where all the traders are
present and all bid-ask quotes are used to arrive at one negotiated price.
• Markets are highly liquid when the market is in session and illiquid when the
market isn’t in session.
• Usually used for smaller markets or to determine the opening and closing
prices at stock exchanges.
2. Continuous markets:
• Trades can occur at any time the market is open where the prices are either
quote driven or auction driven.
The example below illustrates how a large order is filled in a continuous trading market.
Example
At the start of the trading day, the limit order book for stock X looks as follows:
Buyer Bid Size Limit Price ($) Offer Size Seller
John 150 30
Joe 80 31
Jill 100 32
33 40 Sam
34 60 Simon

35 120 Sue
Tom submits an order to buy 150 shares, limit $34. What is the impact on the limit order
book?
Solution:
Tom has placed a marketable limit order. He will buy 40 shares from Sam and 60 shares
from Simon as these satisfy the limit price criteria of at or below $34. He will not buy from
Sue as his is a limit order of $34. Only 100 shares are filled; 50 remain unfilled.
Average price = 0.4 x 33 + 0.6 x 34 = 33.6
In the limit order book, Tom is a buyer with bid size of 50 at a price of $34. Sam and Simon’s
orders are removed from the limit order book as they are filled. It looks like this:
Buyer Bid Size Limit Price (in Offer Size Seller
John 150 $)
30
Joe 80 31
Jill 100 32
Tom 50 34
33 40 Sam
34 60 Simon
35 120 Sue
8.2. Execution Mechanisms
The three categories of the securities market based on how they are traded are as follows:
1. Quote Driven Markets:
• Trade takes place at the price quoted by dealers who maintain an inventory of
the security.
• Dealers provide liquidity in these markets and gain from the difference in bid-
ask spread (high in opaque market).
• They are also called over-the-counter markets, price-driven or dealer markets.
2. Order Driven Markets:
• Trading rules match buyers to sellers, thus making them supply liquidity to
each other.
• Trading rules uses two sets of rules:
o Order matching rules: This establishes the order precedence based on
price, their arrival time and other factors.
o Trade pricing rules: This determines the price of the transaction.
3. Brokered Markets:
• Brokers arrange trades between counterparties.

• Used for instruments that are unique or illiquid like real estate or art pieces.
8.3. Market Information Systems
The two categories of the securities market based on when the information is disclosed are
as follows:
1. Pre-trade transparent: Here trade information on quotes and orders is publically
available prior to the trades.
2. Post-trade transparent: Here trade information on quotes and orders is publically
available after the trade.
9. Well-Functioning Financial Systems
Why do we need a well-functioning financial system?
• So that investors can save (move money from present to future) and obtain a fair rate
of return.
• Borrowers can borrow money easily (move money from future to present).
• Hedgers can offset their risks.
• Traders can trade currencies for commodities.
Four characteristics of a well-functioning financial system include:
• Well developed markets trade instruments that help people solve their financial
problems.
• Liquid markets with low cost of trading (operationally efficient markets) where
commissions, bid-ask spreads and order price impacts are low.
• Timely and accurate financial disclosures that allow market participants to forecast
the value of securities (support informationally efficient markets).
• Prices that reflect fundamental values (informationally efficient markets).
10. Market Regulation
The role of a market regulator is to ensure fair trading practices. Objectives of market
regulation are to:
• Prevent fraud.
• Control agency problems by setting minimum standards of competence for agents.
• Promote fairness.
• Set mutually beneficial standards such as IFRS or U.S. GAAP.
• Prevent undercapitalized firms from exploiting their investors by making excessively
risky investments.
• Ensure that long-term liabilities are funded.

Summary
LO.a: Explain the main functions of the financial system.
The curriculum outlines six purposes for why people use the financial system:
• To save money for the future.
• To borrow money for current use.
• To raise equity capital.
• To manage risks.
• To exchange assets for immediate and future deliveries.
• To trade on information.
Three main functions of the financial system are to:
• Achieve the purposes for which people use the financial system.
• Discover the rates of return that equate aggregate savings with aggregate borrowings.
• Allocate capital to the best uses.
LO.b: Describe classifications of assets and markets.
Classification criteria:
Based on the Financial assets Real assets
underlying
Based on the nature of Debt securities Equity securities
claim by financial
securities
Based on where the Publicly traded Privately traded
securities are traded
Based on delivery Spot market Forward Market
Based on the Financial derivative contract Physical derivative contract
underlying of the
derivative contract
Based on issuance of Primary market Secondary market
security
Based on maturity Money market Capital market
Based on the type of Traditional investment Alternative investment markets
investment markets markets
LO.c: Describe the major types of securities, currencies, contracts, commodities, and
real assets that trade in organized markets, including their distinguishing
characteristics and major subtypes.
Securities can be broadly classified into:
• Fixed Income
• Equity

• Pooled investments
A contract is an agreement among traders to do something in the future. Contracts can be
settled physically or in cash. Contracts can be further classified into physical or financial
contracts based on the underlying asset. Examples of contracts are:
• Forward contract
• Futures contract
• Swap contract
• Options
Currencies are monies issued by national monetary authorities. Currencies trade in foreign
exchange markets in the spot market, forward markets, or futures markets.
Commodities include precious metals, energy products, industrial metals, agricultural
products, and carbon credits. They trade in spot, forward and futures markets.
Real assets are tangible assets which are normally held by operating companies.
LO.d: Describe types of financial intermediaries and services that they provide.
Brokers, Exchanges, and Alternative Trading Systems:
• Brokers are agents who fill orders for their clients; they do not trade with their clients
but search for traders who are willing to take the other side of their clients’ orders.
• Investment banks provide advice and help companies raise capital by issuing
securities such as common stock, bonds, preferred shares etc.
• Exchanges provide places where traders can meet to arrange their trades.
• Dealers trade with their clients i.e. by taking the opposite side of their clients’ trades.
One of the primary services a dealer provides is liquidity.
• Alternative trading systems (ATS) serve the same trading function as exchanges but
have no regulatory oversight.
Depository institutions include commercial banks, savings and loan banks, credit unions and
similar institutions that raise funds from depositors and other investors and lend it to
borrowers.
Insurance companies help people and companies offset risks by issuing insurance contracts;
the contracts make a payment to the party that buys the contracts in case an event occurs.
Clearinghouse helps clients settle their trades.
Depositories or custodians hold securities for their clients so that investors are insulated
from loss of securities through fraud or natural disaster.
LO.e: Compare positions an investor can take in an asset.
Long positions are created when a trader owns an asset or has a right or obligation under a
contract to purchase an asset.

Short positions are created when traders borrow an asset and sell it, with the obligation to
replace the asset in the future.
In general, investors who are long benefit from an increase in the price of an asset and those
who are short benefit when the asset price declines.
LO.f: Calculate and interpret the leverage ratio, the rate of return on a margin
transaction, and the security price at which the investor would receive a margin call.
Leverage ratio = Value of the position / value of the equity investment in it
Margin call price = P * (1 - Initial Margin) / (1 - Maintenance Margin)
The total return to the equity investment in a levered position considers:
Profit or loss on the position
- Margin interest paid
+ Dividends received
- Sales commission
To calculate the return percentage on a leveraged position, we need to divide the total profit
by the initial investment.
LO.g: Compare execution, validity, and clearing instructions.
Execution Instructions indicate how to fill orders. The most common execution orders are:
• Market Orders
• Limit Orders
• All or Nothing Orders
• Hidden Orders
• Iceberg Orders
Validity instructions specify when an order should be executed. Different types of validity
instructions include:
• Day orders
• Good-till-cancelled orders
• Immediate or cancel (fill or kill) orders
• Good-on-close (market-on-close)
• Stop orders (also called stop-loss orders)
Clearing instructions tell brokers and exchanges how to arrange final settlement of trades.
These instructions convey who is responsible for clearing and settling the trade.
LO.h: Compare market orders with limit orders.
Market order Limit order
Execution Executed at the best Sets a minimum execution price on sell
available market price. orders and maximum execution price
on buy orders.

Advantages Quick execution when a Avoids slippages as the orders are

trader believes that the executed at the pre-determined or
prices are volatile. better prices.
Disadvantages Quick execution can lead to In a volatile market, the order might be
unfavorable trade prices and partially filled or not filled at all, making
has trade price uncertainty. the possibility of missing out on trade.
LO.i: Define primary and secondary markets and explain how secondary markets
support primary markets.
Primary markets are where issuers first sell their securities to investors. The two major
types of offerings are underwritten offering and best efforts offering.
• IPO (Initial Public Offering) is where issuers sell securities to the public for the first
time.
• Seasoned or secondary offering is where an issuer sells additional units of a
previously issued security.
Private placement is where corporations sell securities directly to a small group of qualified
(sophisticated) investors as opposed to the public.
Secondary markets are where investors trade (buy/sell) in securities. The companies do not
raise money from secondary markets. The cost of raising capital becomes low in primary
markets when securities trade in liquid secondary markets.
LO.j: Describe how securities, contracts, and currencies are traded in quote-driven,
order-driven, and brokered markets.
Quote Driven Markets: Customers trade at the price quoted by dealers. They are also called
over-the-counter markets, price-driven or dealer markets. Dealers provide liquidity in these
markets.
Order Driven Markets: Trading is based on the rules to match buyers to sellers. In order
driven markets, traders supply liquidity to each other. Orders are matched using an order-
matching system run by the trading system such as exchange, or broker.
Brokered Markets: Brokers arrange trades between customers. Used for instruments that
are unique or illiquid.
LO.k: Describe characteristics of a well-functioning financial system.
Four characteristics of a well-functioning financial system include:
• Well developed markets trade instruments that help people solve their financial
problems.
• Liquid markets with low cost of trading (operationally efficient markets) where
commissions, bid-ask spreads and order price impacts are low.
• Timely and accurate financial disclosures that allow market participants to forecast
the value of securities (support informationally efficient markets).

• Prices that reflect fundamental values (informationally efficient markets).

LO.l: Describe objectives of market regulation.
Markets are regulated to prevent fraud, control agency problems, promote fairness, set
mutually beneficial standards, prevent undercapitalized firms from exploiting their investors
by making excessively risky investments and ensure that long-term liabilities are funded.

Practice Questions
12. Which of the following is least likely a function of the financial system?
A. Determines rate of return that will equate aggregate savings to aggregate borrowing.
B. Prevents entities from utilizing information.
C. Enables efficient allocation of capital.
13. Which of the following asset classification is least accurate?

Financial Assets Real Assets
A. Commodities Securities
B. Derivatives Real Estate
C. Currencies Equipment
14. Which of the following asset classification is least likely to be correct?

Fixed Income Equity Pooled Investment
A. Warrants Commercial Paper Convertible Debt
B. Bonds Common Stock Mutual Funds
C. Notes Preferred Stock Asset-backed Securities
15. Which of the following statements regarding financial intermediaries is least likely to be
accurate?
A. Brokers, exchanges and alternative trading systems connect buyers and sellers at a
centralized location for trading.
B. Dealers provide liquidity and facilitate trading by buying for and selling from their
own inventory.
C. Insurance companies create a diversified pool of assets and sell interests in it.
16. The financial intermediary that is most likely responsible for promoting market integrity
in futures market is:
A. Securities and Exchange Commission.
B. Clearing House.
C. Futures Exchange.
17. Which of the following statements is least accurate?

A. A long position in an asset signifies current or future ownership and benefits from an
increase in the price of an asset.
B. A short position in an asset signifies borrowing an asset and selling it or an
agreement to sell an asset in future and benefits from a decrease in the price of an
asset.
C. Covering the short position signifies simultaneous borrowing and selling of securities
through a broker.

18. John Doe buys 100 shares of ABC Company on margin. John has evaluated his investment
in ABC and has come up with the following forecast assumptions:
Purchase price $100
Sale price after one year $150
Margin 30%
Call money rate 5%
Dividend per share $2
Transaction commission/share $0.2
The forecasted annual return that John is likely to make after one year is closest to:
A. 50.0%.
B. 53.9%.
C. 59.3%.
19. Clare has gathered the following information on a stock investment that she made.
Initial purchase price $50.00
Leverage ratio 2
Margin call price $31.25
The maintenance margin is most likely to be:
A. 15%.
B. 20%.
C. 25%.
20. Which of the following statements regarding order type is least accurate?
A. Stop sell orders can be used to limit losses on a short position.
B. A limit order might or might not be filled, exposing the owner to risks.
C. Day orders expire if they are unfilled by the end of the trading day.
21. Below is the limit orders book for Pritchet Corporation’s stock.
Buyer Bid Size (# of Limit Price Seller Offer Size (# Limit
shares) ($) of shares) Price ($)
1 200 27.55 1 100 29.15
2 100 27.65 2 300 29.35
3 200 27.80 3 200 29.75
4 300 28.20 4 200 30.05
5 400 28.50 5 400 30.20
Stuart places an immediate-or-cancel limit buy order for 500 shares at a price of $29.75.
The most likely average price that Stuart would pay is:

A. $29.75.
B. $29.39.
C. $29.42.
22. ClearTech is a biotechnology research company that is planning to sell 5 million of its
shares to the public. It has approached an investment banker who has guaranteed a price
for the issuance. This transaction is most likely:
A. Public sale of security in the primary capital market with the investment banker
executing an underwritten offering.
B. Public sale of security in the secondary capital market with the investment banker
executing a best-efforts offering.
C. Public sale of security in the secondary capital market with the investment banker
executing an underwritten offering.
23. Which of the following statements is least accurate?

A. In a quote-driven market, investors trade directly with the dealer that maintains
inventories of assets.
B. In order-driven markets, orders are executed using order matching and trade pricing
rules, which are necessary because traders are usually anonymous.
C. In call markets, trades occur at any time the market is open.
24. Country A has financial markets that have high costs of trading while Country B has
financial markets where prices reflect underlying fundamentals quickly. The financial
markets of both these countries are best characterized by:
Country A Country B
A. allocation inefficiency operational efficiency
B. informational inefficiency allocation efficiency
C. operational inefficiency informational efficiency
25. Which of the following is least likely an objective of market regulation?

A. Promote trading with as low as capital requirements to ensure greater market
participation.
B. Prevent trading on inside information.
C. Protect unsophisticated investors.

Solutions
1. B is correct.
A financial system has the following main functions:
• allows entities to save, borrow, exchange assets, issue capital, trade on
information and manage risks
• helps determine the rate of return that will equate aggregate savings to aggregate
borrowing
• Enables efficient allocation of capital
2. A is correct. Financial assets include securities, currencies, derivatives etc while real
assets include real estate, equipment, commodities etc.
3. A is correct. Fixed income securities include commercial paper, bonds, notes, convertible
debt, etc. Equity securities include warrants, common stock, preferred stock, etc. Pooled
investments include mutual funds, exchange-traded funds, hedge funds, asset-backed
securities, etc.
4. C is correct. Insurance companies create a diversified pool of risks and manage the risk
inherent in them by providing insurance contracts. Securitizers and depository
institutions create a diversified pool of assets and sell interests in it.
5. B is correct. Clearing houses arrange for financial settlement of trades. In futures

markets, they guarantee contract performance and reduce counterparty risk, thereby
promoting market integrity.
6. C is correct. Covering the short position signifies the repayment of borrowed security or
other asset.
7. C is correct.
Initial purchase amount = 100 x 100 = 10,000
Proceeds on sale = 150 x 100 = 15,000
Less Borrowed funds = 10,000 x (1 – 0.30) = 7,000
Less Margin interest paid = 0.05 x 7,000 = 350
Plus Dividends received = 2 x 100 = 200
Less Sales commission paid = 0.2 x 100 = 20
Remaining equity = 7,830
Initial investment = (100 x 100 x 0.30) + (0.2 x 100) = 3,020
Therefore return on investment = (7,830 – 3,020) / 3,020 = 59.3%
8. B is correct. The initial purchase price is 50 and the leverage ratio is 2. So equity is

50/Equity = 2 (amount actually contributed by investor) is 25. Hence the initial margin is
25/50 = 0.50. Now we can use the following formula: Margin Call Price = Initial Price x (1
– Initial Margin) / (1 – Maintenance Margin). So, 31.25 = 50 (1 – 0.50) / (1 – MM). Solve
for MM. You will get 0.20.
9. A is correct. Stop loss orders are used to restrict losses to a certain predetermined
amount. Stop buy orders can be used to limit losses on a short position. Stop sell orders
can be used to limit losses on an open position.
10. B is correct. The limit buy order with price of $29.75 will only be executed if the stock
can be bought at that price or lower. In the question, the order of 500 shares will be first
filled with the lowest priced limit sell order and will be followed by filling with the higher
priced limit sell orders that are needed to fill the entire 500 shares.
Average price = [(100 x $29.15) + (300 x $29.35) + (100 x $29.75)] / 500 = $29.39
11. A is correct. Since new securities are issued to public, they would be sold in the primary
market. The investment banker guaranteeing a price for the issuance of security is a type
of underwritten offering. In a best-effort offering, the investment banker acts only as a
broker and makes no guarantees.
12. C is correct. In call markets, orders are accumulated and securities trade only at specific
times with prices set either by the auction process or by dealer bid-ask quotes.
13. C is correct. Cost of trading determines the operational efficiency of a financial market. If
a market has high cost of trading in terms of dealer’s commissions, bid-ask spreads and
order price impacts, it is operationally inefficient. If the prices of securities reflect the
underlying fundamentals, then the financial markets have informational efficiency.
14. A is correct. Market regulation ensures that a minimum level of capital is maintained by
market participants so that counter-party risk is minimized and participants are careful
about their risk exposures.

R45 Security Market Indices 2019 Level I Notes
R45 Security Market Indexes

1. Introduction
An index is an indicator, sign, or measure of something. Since an index is a single measure
and reflects the performance of the entire security market, it makes it easy for investors to
measure and track performance.
Security market indexes were first introduced as a simple measure to reflect the
performance of the U.S. stock market. Dow Jones Average, the world’s first security market
index, was introduced in 1884 comprising only nine railroad and two industrial companies.
Until then, investors gathered data of individual securities to assess performance.
Now, security market indexes have multiple uses that help an investor track performance of
various markets, estimate risk, and evaluate the performance of an investment. Major
indexes include S&P 500, FTSE and Nikkei.
This reading defines what a security market index is, explains how to calculate the returns of
an index, how indexes are constructed, the need for market indexes, and the types of
indexes.
2. Index Definition and Calculations of Value and Returns
A security market index measures the value of different target markets such as security
markets, market segments, and asset classes. The index value is calculated on a regular basis
using actual or estimated prices of constituent securities. Constituent securities are the
individual securities comprising an index.
Each index often has two versions based on how the return is calculated:
• A price return index or price index measures only the percentage change in price of
the constituent securities within the index.
• A total return index considers the prices of constituent securities and the
reinvestment of all income (dividend and/or interest) since inception.
The value of both versions will be the same at inception. However, as time passes, the value
of the total return index will exceed the value of the price return index.
2.1. Calculation of Single-Period Returns
The price return and total returns for an index can be computed using the following
formulae:
Price return of an index:
PR I = (VPRI1 − VPRI0 )/VPRI0
where
PR I = price return of an index (in decimal)
VPRI1 = value of the price return index at the end of the period

VPRI0 = value of the price return index at the beginning of the period
Total return of an index:
VPRI1 – VPRI0 + Inc1
TR I = VPRI0
where
TR I = total return of the index portfolio
VPRI1 = value of the price return index at the end of the period
VPRI0 = value of the price return index at the beginning of the period
Inc1 = income from all the securities in the index over the period
2.2. Calculation of Index Values over Multiple Time Periods
Once returns are calculated for each period, the calculation of index values over multiple
periods is done by geometrically linking returns.
For example, if the value of a total return index at the start of period 1 is 100 and the total
returns over three periods are: 16%, 11% and -4%, index value at the end of period three
will be: 100 x 1.16 x 1.11 x 0.96 = 123.61.
3. Index Construction and Management
Constructing and managing an index is similar to building a portfolio of securities. The
difference is that an index is a paper portfolio but a real portfolio consists of actual
securities. The following factors must be considered when constructing a security index:
• Target market. E.g. U.S. equities.
• Security selection. E.g. large cap securities.
• Weight allocated to each security in the index.
• Index rebalancing.
• Reconstitution.
3.1. Target Market and Security Selection
The target market determines the investment universe. It can be defined broadly (for
example, all U.S. equities) or narrowly (for example, large cap telecom stocks in China). If the
target market is U.S. equities, then the constituent securities for the index will come from the
universe of U.S. equities. The target market may also be based on market capitalization, asset
class, geographic region, industries, sizes, exchange and/or other characteristics.
3.2. Index Weighting
Index weighting determines how much of each security to include in the index. This decision
impacts index value. We will see four methods to determine the weight of the securities in an
index:
• Price weighting
• Equal weighting
• Market-capitalization weighting

• Fundamental weighting
For each weighting method, there could be a price return index or a total return index.
Price Weighted Index
The weight of each security is calculated by dividing its price by the sum of all prices. One
example of a price-weighted index is the Dow Jones Industrial Average.
Sum of stock prices
Price weighted index =
Divisor (number of stocks in the index adjusted for splits)
Example
Consider three securities A, B and C comprising an index with the following beginning of
period (BOP), and end of period (EOP) values. Using a divisor of 3, compute a) the index
value, b) the price return and the total return.
Beginning of Beginning of End of period
Dividends/share
period price period weight price
A 4 20% 2 0
B 6 30% 6 1
C 10 50% 14 2
Solution:
Sum of the security values
Using the above equation, value of the index at start of the period = Divisor
20
= = 6.67
3
22
Value of index at end of the period = = 7.33
3
7.33 – 6.67
Price return = = 9.89%
6.67
Income 3
Dividend return = Beginning of period price = 20 = 15%
Total return = Price return + Dividend return ≈ 25%

To remove the impact of stock splits, security addition or deletion; the divisor is adjusted.
Example
In the previous example, if there is a 2-for-1 split in stock C during the period, what is the
impact on index value and return calculations?
Solution:
Initial divisor was 3 and end of index value = 7.33. End of period price of C is 7 after the split.
The divisor must be adjusted to prevent the stock split and the new weights from changing
the value of the index.

Sum of constituent securities 2+6+7

Value of index = =
Divisor 3
15
7.33 =
Divisor
Divisor = 2.05
Note that every time there is a stock split, the value of the divisor will decrease.
Advantage of price weighted index: Simplicity.
Limitations of price weighted index:
• Results in arbitrary weights for securities.
• If the price of a security is high, it will receive a relatively high weight, even though its
market capitalization might be low.
Equal Weighted Index
The equal weighting method assigns an equal weight to each constituent security at
inception.
An equal weighted index can be created by allocating an equal amount of money to all
securities.
Let’s say, you have $180,000 to invest. You will invest $60,000 each in shares of A, B, and C
trading at $4, $6 and $10 respectively. This would mean 15,000 shares of A, 10,000 shares of
B and 6,000 shares of C. However, at the end of the period, the index will no longer be
equally weighted as share prices may have changed. So, it requires rebalancing (buy shares
of depreciated stock, sell shares of appreciated stock) for the index to be equal weighted.
The return of an equal weighted index is calculated as a simple average of the returns of the
index stocks.
average of percentage change in prices
Equal weighted index = Initial index value ∗ (1 + )
100
Example
Given the following data, compute the price return and total return.
Beginning of period End of period
Dividend/share
Price Price
A 4 2 0
B 6 6 1
C 10 14 2
Solution:
Price return for A: -50%; B: 0%; C: 40%.
− 50+0+40 −10
Since weights are equal, price return = 3
= 3
= -3.3%.

Dividend return for A: 0%; B: 16.67%; C: 20%.

0+16.67+20 36.67
Total dividend return = = = 12.22%.
3 3
Total return = Price return + Dividend return = -3.3 + 12.22 = 8.9%.

Advantage of equal weighting: Simplicity.
Limitations of equal weighting:
• Securities with largest market value are underrepresented; those with lowest market
value are overrepresented.
• Maintaining equal weights requires frequent rebalancing. If not rebalanced
periodically, the chances of drifting away from the weights are high.
Market Capitalization Weighted Index
In this method, weight of each security is determined by dividing its market capitalization
with total market capitalization.
Market cap of the security
Weight of a security =
Total market cap of all index securities
current total market value of index stocks
Market Capitalization index = ∗ base year index value
base year total market value of index stocks
Example
The following data is given:
Shares Beginning of End of period Dividends per
outstanding period price price share
A 500 4 2 0
B 100 6 6 1
C 100 10 14 2
1. Given the data, what divisor must be used such that the initial index value is 1,000?
2. Compute the: 1) final index value 2) price return and total return.
3. Compute the price return if stock C has a market float of 40%.
Solution:
1. Sum of market capitalization of all securities = 500 x 4 + 100 x 6 + 100 x 10 = 3,600
3,600
Initial index value = 1,000 = divisor; divisor = 3.6.
Anytime in the future to calculate the index value, this value of the divisor is used.
2. The weights of the three securities are tabulated below:
Price return Market capitalization weights
A (2 – 4) / 4 = - 0.5 2,000 / 3,600 = 0.56

B (6 – 6) / 6 = 0 600 / 3,600 = 0.17

C (14 – 10) / 10 = 0.4 1,000 / 3,600 = 0.28
500 x 2 + 100 x 6 +100 x 14 3,000
Final index value = = = 833.33.
3.6 3.6
833.33 – 1000
Price return = = -16.67%.
1000
Price return can also be calculated as:

Price return = wA x PR A + wB x PR B + wC x PR C = 0.56 x (−50) + 0.17 x 0 + 0.28 x 40 = -
16.8%.
0 + 1 x 100 + 2 x 100
Dividend return = = 8.3%.
3600
Total return = -16.67 + 8.3 = ~ -8.3%.

3. Assume the remaining 60% of stock C is not available for trading as the founding family
owns them. Only 40% of shares are available for trading. To calculate the price return,
instead of using 100%, only 40% of shares are used in calculation. In this case, 40 shares.
Sum of market capitalization of all securities = 500 x 4 + 100 x 6 + 40 x 10 = 3,000
3,000
Initial index value = 1,000 = divisor; divisor = 3.
500 x 2 + 100 x 6 +40 x 14 2,160
Final index value = = = 720.
3 3
720 – 1000
Price return = = -28%.
1000
A float-adjusted market-capitalization weighted index weights each of its constituent

securities by price and the number of its shares available for public trading, i.e. by excluding
the shares held by the promoter group etc.
Advantages of market capitalization weighting: Constituent securities are correctly
represented in proportion to their value in the market.
Limitations of market capitalization weighting: Securities whose prices have risen or fallen
the most see a big change in their weights. Stocks whose prices have increased are over
weighted; similarly, stocks whose prices have fallen are underweighted.
Fundamental Weighted Index
Fundamental weighting addresses the disadvantages of using market capitalization as
weights. Instead of using a stock’s price as a measure, fundamental weighting uses measures
such as book value, cash flow, revenue, earnings and dividends to calculate the weight of
each security. For instance, a stock with higher earnings yield (earnings/price) than the
overall market will have more weight in a fundamental-weighted index than in a market-
weighted index. This weighting method is biased towards value stocks. This is sometimes
called a ‘value tilt’ and is illustrated in the example below.

Example
Compute the price return for the following index. Weight the securities based on earnings.
Shares outstanding Beginning of Earning (in $ End of period
(in million) period price million) price
A 500 price
4 20 2
B 100 6 20 6
C 100 10 20 14
Solution:
All the three companies have earnings of $20 million and total earnings of $60 million.
Earnings yield, earnings weight and price return of the three companies:
Earnings
Earnings yield Price return
weight
A 20 / (500 x 4) = 1% 20 / 60 = 33.3% (2 – 4) / 4 = -0.5
B 20 / (100 x 6) = 3.3% 20 / 60 = 33.3% (6 – 6) / 6 = 0
C 20 / (100 x 10) = 2% 20 / 60 = 33.3% (14 – 10) / 10 = 0.4
Price return = wA x PR A + wB x PR B + wC x PR C
= 0.33 x (−50) + 0.33 x 0 + 0.33 x 40 = -3.3%.
All the three securities have equal weights here as the earnings are equal. Under the market
capitalization method, A would have highest weight and B would have the lowest weight. In
other words, a value stock like B (low P/E ratio or high earnings yield) has more weightage
in the fundamental-weighted method than it would have in the market capitalization
method.
Summary of Results
The table below compares all the weighting methods.
Number of shares BOP price EOP Price Earnings Dividends/share
A 500 4 2 20 0
B 100 6 6 20 1
C 100 10 14 20 2
Method Price Return Total Return

Price 10% 25%
Equal -3.3% 8.9%
Market Cap -16.7% -8.3%
Fundamental -3.3% 8.9%
The pros and cons of the different index weighting methods are shown below.
Method Pros Cons

Price Simple Arbitrary weights.

Equal Simple High market cap stocks are under-
represented. Requires frequent rebalancing.
Market Cap Securities held in Influenced by overpriced securities.
proportion to their value
Fundamental Value tilt Does not consider market value. Requires
rebalancing.
3.3. Index Management: Rebalancing and Reconstitution
Rebalancing
Rebalancing means adjusting the weights of constituent securities in an index to maintain
the weight of each security in the index. The weights do not remain constant as the prices of
securities change. For weighting methods like price-weighted and market-weighted index,
rebalancing is not necessary as the weight is determined by the price. However, as we saw in
the case of equal weighting method, the weights digress heavily when the price of a security
appreciates/depreciates. If rebalancing happens too often, then the transaction costs will be
high. If rebalancing does not happen often enough, then the portfolio will digress from equal
weights.
Reconstitution
Reconstitution is the process of changing the constituent securities in an index. It is part of
the rebalancing cycle. The frequency of reconstitution varies from index to index. When a
constituent security no longer meets the necessary criteria it is removed from the index and
a new security is added. For example, a stock might be part of a large-cap index but after an
erosion of over 80% of its market cap it no longer meets the large cap criteria. This stock will
be removed from the index and another one which meets the criteria will be added.
4. Uses of Market Indexes
Security indices serve the following purpose:
• Index performance serves as a proxy of market sentiment.
• Investment management performance can be better evaluated in comparison with a
suitable index that serves as a benchmark.
• Serves as a proxy for measuring and modeling returns, systematic risk and risk-
adjusted performance.
• Serves as a proxy for asset class performance in asset allocation models.
• Useful in creation of passive portfolios that track index funds and ETFs.
5. Equity Indexes
Equity indices can be classified into:
Broad market index
• Provides a proxy for the overall market performance.

• Typically, 90% of the securities in the market are represented in the index.
• Example: Wilshire 5000 index
Multi-market index
• Constructed from several indices of different countries.
• Countries included can be based on national markets, geographic region (Latin
America index), development groups (emerging market index) etc.
Sector index
• Constructed to track performance of a specific economic sector such as finance,
technology, energy, health care etc. or on a national or global basis.
Style index
Constructed to track performance of securities that are classified based on characteristics
like:
• Market capitalization: Securities are classified based on market capitalization to form
indices like large cap, mid cap and small cap indices.
• Value/Growth: Includes securities based on value/growth criteria to form growth
and value indices. (uses price-to-earnings and dividend yields to classify securities)
• Combination of market capitalization and value/growth: Includes these
combinations: Large-cap value, large-cap growth, mid-cap value, mid-cap growth,
small-cap value, small-cap growth indices.
6. Fixed Income Indexes
6.1. Construction
Compared to equity indexes, fixed income indexes are difficult to construct and replicate.
They are challenging to construct because:
• There are a large number and variety of fixed income securities ranging from zero
coupon bonds to callable and putable bonds. Pricing data is not always available.
• Many fixed income securities are not liquid i.e. not easy to replicate.
6.2. Types of Fixed Income Indexes
Like equities, fixed income securities can be classified based on the issuer, geographic
region, maturity, type of issuer, market sector, style, credit quality, currency of payments etc.
The following table illustrates how the fixed income securities can be organized based on
various dimensions.

Dimensions of Fixed Income Indexes

Market Global
Regional
Country or currency zone
Type Corporate
Collateralized/securitized/mortgage backed
Government agency
Government
Maturity Short term (e.g. < 1 year)
Medium term (e.g. 7 - 10 years)
Long term (e.g. 20 + years)
Investment grade (e.g. S&P rating of BBB or above)
Credit Quality
High yield
7. Indexes for Alternative Investments
7.1. Commodity indexes
Commodity indexes consist of futures contracts on one or more commodities such as
agricultural products (like wheat, sugar), precious metals like gold, and energy like crude oil.
It is important to recognize the following points related to commodity indexes:
• Since commodity indexes are based on futures indexes, the performance of the index
and the underlying commodities can be different.
• It is common to have multiple indexes with the same commodities but in different
proportions or weights. For example, while one commodity index may have a higher
weight for energy, the other may be overweight on agricultural products. This also
leads to a different risk return profile.
7.2. Real Estate Indexes
Real estate indexes represent markets for real estate securities (such as REITs) and the
market for actual real estate. Examples of actual real estate investments include properties
such as apartment buildings, retail malls, office buildings etc. Real estate is a highly illiquid
market with few transactions and non-transparent pricing. There are several types of real
estate indexes: appraisal indexes, repeat sales indexes, and REIT indexes. This material is
covered in detail under alternative investments.
7.3. Hedge Fund Indexes
Hedge fund indexes reflect the returns on hedge funds. Research organizations collect data
on hedge fund returns and compile this information into indexes. Since hedge funds are not
required by regulation to report their performance, the research firms rely on voluntary
cooperation of hedge funds to report returns. Here are some important points to consider
when evaluating hedge fund indexes:
• Constituents determine the index.

• Poorly performing hedge funds are less likely to report.

• Returns of hedge fund indexes are likely to be overstated/biased upward due to
survivorship bias.

Summary
LO.a: Describe a security market index.
An index is a single measure that reflects the performance of the entire security market. It
makes it easy for investors to measure and track performance.
LO.b: Calculate and interpret the value, price return, and total return of an index.
Price return index or price index measures only the percentage change in price of the
constituent securities within the index.
PRI = (VPRI1 - VPRI0)/ VPRI0
Total return index reflects the prices of constituent securities and the reinvestment of all
income (dividend and/or interest) since inception.
TRI = (VPRI1 - VPRI0 + Inc1)/ VPRI0
Calculation of index values over multiple periods is done by linking returns.
LO.c: Describe the choices and issues in index construction and management.
Index providers must consider the following:
• Which target market should the index represent? E.g. U.S. Equities.
• Which securities should be selected from that market? E.g. Large cap securities.
• How much weight should be allocated to each security in the index?
• When should the index be rebalanced?
• When should the security selection and weighted decision be re-examined?
Target market can be defined broadly or narrowly. It may also be based on asset class,
geographic region, industries, sizes, exchange and/or other characteristics.
LO.d: Compare the different weighting methods used in index construction.
Index weighting determines how much of each security to include in the index. This decision
impacts index value. Various methods used to determine the weight of the securities in an
index are:
Price Weighting: The weight on each security is determined by dividing its price by the sum
of all prices.
Equal Weighted Index: Assign equal weight to each constituent security at inception.
Market Capitalization Weighted Index: Weight of each security is determined by dividing its
market capitalization with total market capitalization.
Fundamental Weighing: Instead of using a stock’s price as a measure, fundamental weighting
uses measures such as book value, cash flow, revenue, earnings and dividends to calculate
the weight of each security.

Method Pros Cons

Price Simple Arbitrary weights.
Equal Simple High market cap stocks are under-represented.
Requires frequent rebalancing.
Market Cap Securities held in Influenced by overpriced securities.
proportion to their
value
Does not consider market value. Requires
Fundamental Value tilt
rebalancing.
LO.e: Calculate and analyze the value and return of an index given its weighting
method.
Sum of Stock Prices
Price weighted index =
No. of stocks in index adjusted for splits
Market Capitalization index
current total market value of index stocks
= ∗ base year index value
base year total market value of index stocks
average of percentage change in prices
Equal weighted index = Initial index value ∗ (1 + )
100
LO.f: Describe rebalancing and reconstitution of an index.
Rebalancing means adjusting the weights of an index’s constituent securities. The weight of
each security in an index should reflect the weighting method used. The weights do not
remain constant as the prices of securities change.
Reconstitution is the process of changing the constituent securities in an index. It is part of
the rebalancing cycle. The frequency of reconstitution varies from index to index.
LO.g: Describe uses of security market indexes.
The most important use of indexes is that they give a sense for how a particular security
market performed over a particular period. Indexes also serve as:
• Indicators (gauges) of market sentiment.
• Proxies for measuring and modeling returns, systematic risk and risk adjusted
performance.
• Proxies for asset classes in asset allocation models.
• Benchmarks to evaluate the performance of a portfolio.
• Model portfolios for index funds and ETFs.
LO.h: Describe types of equity indexes.
Equity indexes can be classified into: broad market, multi-market, sector and style indexes.
Broad market index tries to represent the entire market. Typically, 90% of the securities of

the selected market are represented in the index.

Multi-market index includes indexes from different countries as they represent multiple
security markets based on national markets, geographic region, development groups etc.
Sector index focuses on a specific economic sector such as consumer goods, finance, energy,
health care, technology etc. on a national or global basis.
Style index contains securities based on certain characteristics like market capitalization,
value, growth, or a combination of any of these.
Market capitalization index contains securities based on market capitalization such as large
cap, mid cap and small cap.
Value/Growth index contains a group of stocks based on value/growth criteria.
Market Capitalization and Value/Growth index combines the three market capitalization
groups with value/growth classification resulting in the following six basic index style
categories: Large-cap value, large-cap growth, mid-cap value, mid-cap growth, small-cap
value, small-cap growth.
LO.i: Describe types of fixed-income indexes.
Dimensions of Fixed Income Indexes
Market Global
Regional
Country or currency zone
Type Corporate
Collateralized/securitized/mortgage backed
Government agency
Government
Maturity Short term (e.g. < 1 year)
Medium term (e.g. 7-10 years)
Long term (e.g. 20+ years)
Credit Quality Investment grade (e.g. S&P rating of BBB or above)
High yield
LO.j: Describe indexes representing alternative investments.
Commodity indexes consist of futures contracts on one or more commodities such as
agricultural products (like wheat, sugar), precious metals like gold, and energy like crude oil.
Real estate indexes represent markets for real estate securities (such as REITs) and the
market for actual real estate.
Hedge fund indexes reflect the returns on hedge funds. Research organizations collect data
on hedge fund returns and compile this information into indexes.

LO.k: Compare types of security market indexes.

Security market indexes represent asset classes and target markets that can be classified
based on geographic location, sector, industry, economic growth, value stocks, growth stocks
etc. Some globally known indexes include Dow Jones Industrial average, S&P, Barclays
Capital Global aggregate Bond Index etc.

Practice Questions
1. Catherine has gathered the following information on performance of an security index:
Value of index at the end of the year 500
Interest income over the year 20
Dividend income over the year 30
Total return on index over the year 4.50%
The value of the index at the start of the year is closest to:
A. 507.20.
B. 478.50.
C. 526.30.
2. The market index that most likely requires frequent rebalancing is:
A. Price weighted.
B. Equal weighted.
C. Market-capitalization weighted.
3. The index weighting method that most likely has a contrarian effect is:
A. Equal weighting.
B. Market capitalization weighting.
C. Fundamental weighting.
4. The index weighting method that most likely requires an adjustment to the divisor for
stock splits and changes in composition of index is:
A. price weighted index.
B. equal weighted index.
C. fundamental weighted index.
5. Calculate the one-year return on an index which includes three stocks as shown below:
Stock Start Share Start Shares End Share End Shares
price Outstanding price Outstanding
A $20 5,000 $30 5,000
B $10 8,000 $15 8,000
C $300 500 $290 500
The price-weighted, equal-weighted and market capitalization weighted returns of the
above is closest to:
Price-weighted Equal-weighted Market cap-weighted
A. 25.8% 1.5% 32.2%
B. 1.5% 32.2% 25.8%

C. 32.2% 1.5% 25.8%
6. David is trying to construct a price-return float-adjusted market-capitalization-weighted

equity index which includes the three stocks as shown below:
Shares % Shares in Beg of End of Period Dividends Per
Stock
Outstanding Market Float Period Price ($) Price ($) Share ($)
A 10,000 70 20 30 2
B 20,000 80 10 5 1
C 30,000 90 50 70 5
Assuming the beginning value of the float-adjusted market-capitalization-weighted
equity index is 100, the ending value is closest to:
A. 123.1.
B. 132.1.
C. 112.7.
7. Which of the following is least likely to be a use of an index?

A. Benchmarking performance of a mid-cap manager with a broad market index.
B. Measuring market return, beta and excess returns.
C. As a reflection of market sentiment.
8. Which of the following statements regarding fixed-income indices is least likely to be

accurate?
A. Fixed income indices have broader market and a higher turnover than equity indices.
B. Fixed income indices vary in their constituent securities and are difficult and
expensive to replicate.
C. Data for fixed income securities is relatively easy to find.
9. Which of the following statements regarding indices representing alternative

investments least likely to be true?
A. In a hedge fund index, the constituents determine the hedge fund index rather than
the index providers determining the constituents.
B. Commodity indexes have issues because they have different weighting methodologies
and are based on the performance of future contracts.
C. Commodity indices track the spot market performance and are subject to upward
bias.
10. An index based that includes growth stocks is most likely a type of:
A. style index.
B. broad market index.
C. sector index.

Solutions
1. C is correct. Total return on an index uses both the price and income earned on the
security to determine the overall return earned. Thus it measures the price appreciation,
interest and dividend income over a period which is expressed as a percentage of the
beginning value of the index.
(Index valueend − Index valuestart + income earned)
Total return =
Index valuestart
(500 − Index valuestart + 20 + 30)
4.5% =
Index valuestart
(500 + 20 + 30)
Index valuestart = = 526.31
(1 + 4.5%)
2. B is correct. After the initial construction of an equal weighted index, the prices of
constituent securities change and the index is no longer equally weighted. To bring the
securities back in equal weights, frequent rebalancing has to be done to the index. Market
capitalization weighted indices generally will have a momentum “effect”.
3. C is correct. Fundamental weighting is based on factors like company earnings, revenue,

assets or cash flow. Fundamental weighting leads to indices that have a relative value tilt
i.e. a contrarian effect. In such an index, portfolio weights will shift away from securities
that have increased in relative value and towards securities that have fallen in relative
value whenever the portfolio is rebalanced.
4. A is correct. In a price weighted index, the divisor is initially equal to the number of
securities in the index. This divisor must be adjusted so the index value immediately after
the split is the same as the value immediately prior to split.
5. B is correct.
Price-weighted index:
sum of stock prices
Price − weighted index =
number of stocks in index adjusted for splits
20 + 10 + 300
Price − weighted indexstart = = 110
3
30 + 15 + 290
Price − weighted indexend = = 111.67
3
111.67 − 110
Price − weighted indexreturn = = 1.5%
110
Equal-weighted index:

Equal − weighted index = (1 + average percentage change in index stocks)

30 15 290 1
Equal − weighted index = [( − 1) + ( − 1) + ( − 1)] ( ) = 32.2%
20 10 300 3
Market capitalization-weighted index:

Total portfolio value at the start of the period:
20(5,000) + 10(8,000) + 300(500) = 330,000
Total portfolio value at the end of the period:
30(5,000) + 15(8,000) + 290(500) = 415,000
415,000 / 330,000 – 1 = 25.8%
6. B is correct. This is a price return index (not a total return index). Hence we only
consider changes in prices and ignore the dividends. In float-adjusted market-
capitalization weighting, the weight on each constituent security is determined by
adjusting its market capitalization for its market float. Per computations shown below,
the ending value of the index so computed equals 132.1.
Stock Shares % Shares in Shares Beg of Beg. Float End of Ending
Outsta Market in Period Adj. Period Float Adj.
nding Float Index Price ($) Market Price Market
Cap ($) ($) Cap ($)
(1) (2) (1) x (2) (4) (3) x (4) = (6) (3) x (6)
= (3) (5)
A 10,000 70 7,000 20 140,000 30 210,000
B 20,000 80 16,000 10 160,000 5 80,000
C 30,000 90 27,000 50 1,350,000 70 1,890,000
Total 1,650,000 2,180,000
Index 100.0 132.1
Value
Most of the global indices are market capitalization-weighted with a float adjustment.
7. A is correct. Indices are used to benchmark performance of portfolio managers. However,

the comparison should be with an appropriate benchmark. Here, a mid-cap manager’s
performance should be benchmarked with a mid-cap index.
8. C is correct. Fixed income securities are largely traded by dealers and are often illiquid.
Hence, data is more difficult to be obtained.
9. C is correct. Performance disclosures by hedge funds are voluntary and hence only better
performing hedge funds are likely to be part of an index. This causes the hedge fund
index to have an upward bias, as the performance of poor performing funds is not
captured. Commodity indexes have issues because they have different weighting

methodologies and are based on the performance of future contracts and not on the
performance of actual commodities.
10. A is correct. Style indices represent groups of securities classified according to market
capitalization, value, growth, or a combination of these characteristics.

R46 Market Efficiency 2019 Level I Notes
R46 Market Efficiency

1. Introduction
Market efficiency concerns the extent to which market prices incorporate available
information. Investors are interested in market efficiency because if prices do not fully
incorporate information, then opportunities exist to make abnormal profits. Governments
and regulators are interested in market efficiency because market efficiency promotes
economic growth.
2. The Concept of Market Efficiency
2.1. The Description of Efficient Markets
• An informationally efficient market is one in which asset prices reflect new
information quickly and rationally.
• ‘Quick’ is relative to the time a trader takes to execute an order. If it takes 15 minutes
for new information to be incorporated into security prices and trade execution time
is 30 minutes, we can say the new information is incorporated quickly.
• Market prices should not react to information that is well anticipated; only
unexpected information should move prices.
• In a perfectly efficient market investors should use a passive investment strategy
because active investment strategies will underperform due to transaction costs and
management fees.
2.2. Market Value versus Intrinsic Value
• Market value of an asset is its current price at which the asset can be bought or sold.
• Intrinsic value is the value that would be placed on an asset by investors if they had
full knowledge of the asset’s characteristics.
• In highly efficient markets, full information is available in the market and is reflected
in asset prices. Therefore, market value = intrinsic value.
• However if markets are not efficient, the two prices can diverge significantly.
2.3. Factors Contributing to and Impeding a Market’s Efficiency
The following factors affect a market’s efficiency:
• Market Participants – More participants increase efficiency.
• Information availability and financial disclosure – More information increases
efficiency.
• Limits to trading – Limitations on arbitrage and short selling decrease efficiency.
2.4. Transaction Costs and Information-Acquisition Costs
Two types of costs are incurred by traders when trading on market inefficiencies:
transaction costs and information-acquisition costs. These costs should be considered when
evaluating a market’s efficiency.

• Transaction costs – High costs decrease efficiency.

• Information-acquisition costs – High costs decrease efficiency.
3. Forms of Market Efficiency
The table below introduces three forms of market efficiency which are differentiated based
on assumptions about the level of information in security prices.
Market Prices Reflect:
Forms of Market Past Market Data Public Information Private
Efficiency Information
Weak form Yes No No
Semi-strong form Yes Yes No
Strong form Yes Yes Yes
Evidence that investors can consistently earn abnormal returns by trading on the basis of
information would challenge the efficient market hypothesis.
3.1. Weak Form
In a weak-form efficient market:
• security prices fully reflect all past market data.
• non-market public and private information is not necessarily incorporated into the
stock price.
• technical analysts cannot make abnormal returns on a consistent basis simply by
analyzing historical market information.
Tests to check whether securities markets are weak-form efficient:
• Look at patterns of prices. Is there any serial correlation in security returns? If yes,
the market is not weak-form efficient.
• Can trading rules or any technical analysis method involving historical data be used
to make abnormal profits? If yes, then it contradicts weak-form efficiency.
3.2. Semi-strong Form
In a semi-strong form efficient market:
• prices reflect all publicly known and available information. This includes financial
data such as earnings, dividends, and trading data such as closing prices, volume etc.
Weak-form is a subset of semi-strong form.
• prices adjust quickly and accurately to new public information.
• efforts to analyze publicly available information are futile.
• fundamental analysis will not lead to abnormal returns in the long run. Lots of
fundamental analysts (active investors, portfolio managers) evaluating securities to
buy/sell help the market in becoming semi-strong form efficient.

Tests to check whether securities markets are semi-strong efficient:

• Researchers test for when markets are semi-strong efficient using event studies. Most
research indicates that developed securities markets are semi-strong efficient while
developing countries’ markets may not be semi-strong efficient.
3.3. Strong Form
In a strong-form efficient market:
• prices reflect all public and private information. It encompasses semi-strong and
weak form.
• investors will not be able to earn abnormal profits by trading on private information.
Tests to check whether securities markets are strong-form efficient:
• Researchers test whether a market is strong-form efficient by testing whether
investors can earn abnormal profits by trading on non-public information.
• Most research indicates that markets are not strong form efficient as regulations
prohibit the use of private information (or insider trading).
3.4. Implications of the Efficient Market Hypothesis
We can draw the following implications of efficient markets on developed markets:
Form of Market Implication Conclusion
Efficiency
Securities Investors cannot earn abnormal Technical analysts assist
markets are returns by trading on the basis of past markets in maintaining weak-
weak-form trends in price. from efficiency.
efficient.
Securities Analyst must consider whether the Fundamental analysts assist
markets information is already reflected in markets in maintaining semi-
are semi-strong security prices and how any new strong-from efficiency.
from efficient. information affects a security's value.
Securities Investors trading on private Regulations try to prevent
markets information can make abnormal insider trading.
are NOT strong- profits.
from efficient.
The role of portfolio managers is not necessarily to beat the market, but to establish and
manage portfolios consistent with their clients’ objectives and constraints.
4. Market Pricing Anomalies
A market anomaly is something that challenges the idea of market efficiency. Some
anomalies observed in the market are:

4.1. Time Series anomalies:

• Calendar anomalies: The returns in January are higher than in any other month,
especially for small firms. This phenomenon is known as the January effect.
• Momentum and overreaction anomalies: Investors overreact to events or release of
unexpected public information.
4.2. Cross-sectional anomalies:
• Size effect: Small-cap stocks tend to perform better than large-cap stocks.
• Value effect: Value stocks tend to perform better than growth stocks.
4.3. Other anomalies:
• Closed-end fund discounts: Closed-End funds sell at a discount to NAV.
• Earnings surprise: Investors can earn abnormal profits by buying stock of companies
with positive earnings surprise and selling those with negative earnings surprise.
• IPOs: Prices rise on listing day, but underperform in the long-term.
• Predictability of returns based on prior information: Research has found that equity
returns are related to prior information such as interest rates, inflation rates, stock
volatility and dividend yields.
In practice, it is not easy to trade and benefit from anomalies. Most research concludes that
anomalies are not violations of market efficiency, but are the result of statistical methods
used to detect anomalies.
Many anomalies might simply be a result of data mining. At times researchers carefully
analyze data and form a hypothesis. This is the opposite of what should happen. Ideally, a
hypothesis should be formed and then the data should be analyzed to accept or reject the
hypothesis.
5. Behavioral Finance
Behavioral finance uses human psychology to explain investment decisions. Some irrational
behavior and biases observed in the market are:
• Loss aversion: Investors dislike losses more than they like gains of the same amount.
• Herding: In herding, investors ignore their private information and act as other
investors do.
• Overconfidence: Overconfident investors do not process information. They place too
much confidence in their ability to process and analyze information and value a
security.
• Information cascades: Information cascade is when people observe the actions of a
handful of market participants and blindly follow their decisions. The informed
participants act first and their decision influence the decisions of others.

Other behavioral Biases

• Representativeness: Investors with this bias will assess probabilities based on events
seen before, or prior experiences instead of calculating the outcomes.
• Mental accounting: Investors divide investments into separate mental accounts, they
do not view them as a total portfolio.
• Conservatism: Investors tend to be slow to react to changes.
• Narrow framing: Investors focus on issues in isolation.
Behavioral Finance and Investors
Behavioral biases affect all investors irrespective of their experience. An understanding of
behavioral finance will help individuals make better decisions, individually and collectively.
Behavioral Finance and Efficient Markets
If investors must be rational for efficient markets, the existence of behavioral biases implies
that the markets cannot be efficient. If the effect of the biases did not cancel each other out,
then the markets could not be efficient. But, since investors are not making abnormal returns
consistently, the markets can be considered efficient. Evidence supports market efficiency. In
other words, markets can be considered efficient even if market participants exhibit
seemingly irrational behavior.

Summary
LO.a: Describe market efficiency and related concepts, including their importance to
investment practitioners.
In an informationally efficient market, asset prices reflect new information quickly and
rationally. ‘Quick’ is relative to the time a trader takes to execute an order. In an efficient
market, it is not possible to consistently achieve superior abnormal returns. Prices should
only react to unexpected information. In an efficient market, passive investment strategy is
preferred over active investment strategy.
LO.b: Distinguish between market value and intrinsic value.
Market value is the price at which an asset can be bought or sold. Intrinsic value is the value
based on complete information. In highly efficient markets, complete information is available
in the market which is incorporated in the stock price. Therefore, market value = intrinsic
value.
LO.c: Explain factors that affect a market’s efficiency.
• Market Participants
• Information availability and financial disclosure
• Limits to trading
• Transaction costs
• Information-acquisition costs
LO.d: Contrast weak form, semi-strong form and strong-form market efficiency.
Forms of Market Past Market Public Private

Efficiency Data Information Information
Weak form Yes No No
Semi-strong form Yes Yes No
Strong form Yes Yes Yes
LO.e: Explain the implication of each form of market efficiency for fundamental
analysis, technical analysis, and the choice between active and passive portfolio
management.
• If markets are weak-form efficient, then technical analysts cannot make abnormal
returns on a consistent basis simply by analyzing historical market information.
• Fundamental analysis will not lead to abnormal returns in the long run if the market
is semi-strong form efficient.
• In a strong-form efficient market, investors will not be able to earn abnormal profits
by trading on private information.
LO.f: Describe selected market anomalies.
Time Series anomalies:

• Calendar anomalies: The returns in January are higher than in any other month,
especially for small firms. This phenomenon is known as the January effect.
• Momentum and overreaction anomalies: Investors overreact to events or release of
unexpected public information.
Cross-sectional anomalies:
• Size effect: Small-cap stocks tend to perform better than large-cap stocks.
• Value effect: Value stocks tend to perform better than growth stocks.
Other anomalies:
• Closed-end fund discounts: Closed-End funds sell at a discount to NAV.
• Earnings surprise: Investors can earn abnormal profits by buying stock of companies
with positive earnings surprise and selling those with negative earnings surprise.
• IPOs: Prices rise on listing day, but underperform in the long-term.
• Predictability of returns based on prior information: Research has found that equity
returns are related to prior information such as interest rates, inflation rates, stock
volatility and dividend yields.
LO.g Describe behavioral finance and its potential relevance to understanding market
anomalies.
Behavioral finance examines if investors act rationally, how investor behavior affects
financial markets, and how cognitive biases may result in anomalies.
Some of the observed irrational behaviors include:
• Loss aversion: Traditional finance assumes that investors are risk averse. Behavioral
finance suggests that humans are loss averse.
• Herding: Herding is where one set of investors follows another set of investors for no
rational reason.
• Overconfidence: The overconfidence bias explains pricing anomalies. Overconfident
investors do not process information. They place too much confidence in their ability
to process and analyze information and value a security.
• Information cascades: Information cascade is when people observe the actions of a
handful of market participants (or experts) and follow their decisions.
• Representativeness: Investors with this bias will assess probabilities based on events
seen before, or prior experiences (instead of calculating the outcomes).
• Mental accounting: Investors divide money into different buckets, they do not view
their assets as a whole but allocate based on goals.
• Conservatism: Investors tend to be slow to react to changes.
• Narrow framing: Investors focus on issues in isolation.

Practice Questions
1. The market where any new information about a security is quickly, fully and rationally
reflected in the security’s price, is best described as?
A. Allocational efficiency.
B. Operational efficiency.
C. Informational efficiency.
2. Individuals investing in an inefficient market, will most likely benefit from a(n):
A. passive investment strategy.
B. active or passive investment strategy.
C. active investment strategy.
3. Which of the following statements regarding market’s efficiency is least likely to be true?
A. Greater the number of market participants, higher would be the efficiency.
B. Greater the restrictions on arbitrage trades, higher would be the efficiency.
C. Lower the costs of trading and information gathering, higher would be the efficiency.
4. Which of the following statements regarding different types of market’s efficiency is least
likely to be true?
A. In weak-form of efficient markets, prices do not reflect all past price and volume
information.
B. In semi-strong-form of efficient markets, prices fully reflect all available public
information.
C. In strong-form of efficient markets, prices fully reflect all public and private
information.
5. Bruce has a trading strategy that is based on buying undervalued securities using
fundamental analysis to generate abnormal profits. If his trading strategy does make
abnormal returns, the market is most likely:
A. weak form efficient.
B. semi-strong form efficient.
C. strong form efficient.
6. Which of the following statements regarding market anomalies is the most accurate?
A. Neither weak-form or semi-strong form market efficiency holds.
B. Discovered anomalies are not violations of market efficiency, but a limitation of the
research methodology.
C. Weak-form market efficiency holds but semi-strong form doesn’t hold.
7. The behavioral finance theory which explains how investors place greater importance on

the recent outcomes is most accurately described as:

A. gambler’s fallacy.
B. representativeness.
C. narrow framing.

Solutions
1. C is correct. In an informationally efficient market, all the available information about any
security is immediately and rationally reflected in its price. In an efficient market, prices
should be expected to react only to the “unexpected” or “surprise” element of
information releases. Investors process the unexpected information and revise
expectations accordingly.
2. C is correct. In an inefficient market, individuals might be able to earn abnormal profits

as securities might be mispriced. On the other hand, in an efficient market a passive
investment strategy would be preferred to an active strategy as there are fewer
opportunities to earn abnormal profits.
3. B is correct. Greater the restrictions on arbitrage trading, lower will be the efficiency.
This is because arbitrageurs trade on the price differences between the same security or
similar securities trading at different locations. Their trading minimizes the price
differences across exchanges, making the markets more efficient.
4. A is correct. In weak-form of efficient markets, prices fully reflect all past price and
volume information.
5. B is correct. In weak-form of efficient markets, prices fully reflect all past price and
volume information. Hence, technical analysis does not result in abnormal profits in this
market. In semi-strong-form of efficient markets, prices fully reflect all available public
information. Hence, fundamental analysis does not result in abnormal profits in this
market. In strong-form of efficient markets, prices fully reflect all public and private
information. Hence, even trading on insider information does not result in abnormal
profits in this market and the best choice is a passive investment strategy. Since, Bruce
earns abnormal profits using fundamental analysis, the markets are weak-form efficient.
6. B is correct. Discovered anomalies are not violations of market efficiency, but a limitation
of the research methodology like inadequately adjusting for risk or data mining.
7. A is correct. Gambler’s fallacy is the behavioral finance theory in which recent outcomes
affect investor’s estimates of future probabilities. Narrow framing involves investors
focusing on issues in isolation. Representativeness involves investors assessing
probabilities of outcomes depending on how similar they are to the current state.

R47 Overview of Equity Securities 2019 Level I Notes
R47 Overview of Equity Securities

1. Introduction
In this reading, we look at the different types of equity securities, how private equity
securities differ from public equity securities, the risk involved in investing in equities, and
the relationship between a company’s cost of equity, its return on equity, and investors’
required rate of return.
2. Equity Securities in Global Financial Markets
In 2008, the U.S. contributed about 21% to the global GDP, but its contribution to the total
capitalization of global equity markets was around 43%.
Historically, equity markets have offered high returns relative to government bonds and T-
bills but at higher risk. The volatility in equity markets was high during key crises such as
World War I, World War II, Tech Crash of 2000-2002, Wall Street Crash and the most recent
credit crash of 2007-2008. In the recent crash, while the world markets fell by 53%, Ireland
was the worst hit incurring losses of over 70%.
An important point to note is that equity securities are a key asset class for global investors.
3. Types and Characteristics of Equity Securities
3.1. Common Shares
Common shares represent an ownership interest in a company and give investors a claim on
its operating performance, the opportunity to participate in decision making, and a claim on
the company’s net assets in the case of liquidation.
Statutory voting versus cumulative voting
In statutory voting each share is entitled for one vote. In cumulative voting, a shareholder
can cumulate his total votes and choose one particular candidate. For example, let’s say that
a shareholder holds 100 shares and is supposed to vote for election of three board members
position. In statutory voting, he can vote 100 votes for each position while in cumulative
voting, he can vote all the 300 votes to a single candidate; thereby increasing his likelihood
of winning. Cumulative voting is beneficial to minority shareholders.
Different classes (Class A and Class B)
A firm can have different classes of equity shares which may have different voting rights and
priority in liquidation. For example: Class A shares would have more votes than Class B
shares.
Callable & putable common shares
Common shares can also be issued with an inherent option. The two types are:
• Callable: Firms have an option to buy back shares from investors at a specified price

by a pre-determined date. The call feature favors the firm as it can buy back shares at
lower value than market value.
• Putable: Investors have an option of selling the shares back to the company at a
specified price by a pre-determined date. The put feature favors the investor as it
limits his downside risk.
3.2. Preference Shares
Preference shares are a form of equity in which payments made to preference shareholders
take precedence over payments to common shareholders.
Cumulative and non-cumulative preference shares
• Cumulative: If dividends are not paid out for year one and two, year three dividends
would be sum of the third year’s dividends plus the non-paid out dividend of years
one and two.
• Non-cumulative: If dividends are not paid out for year one and two, and the firm
decides to pay dividends in third year; it would only have to pay third year dividends.
Participating and non-participating preference shares
• Participating: As the name implies, preferred shareholders participate in the firm’s
profit. Shareholders receive extra dividends than the pre-specified rate in case of
higher profits. The shareholders also receive a higher proportion of firm’s asset than
the par value in case of liquidation.
• Non-participating: Shareholders receive only the pre-specified rate even if the firm
earns higher profits. The shareholders only receive the par value in case of
liquidation.
Convertible preference shares
• Convertible preference shares are those which can be converted to common stock
and hence have lower risk and the inherent option to gain from a firm’s future profits.
4. Private versus Public Equity Securities
Private equity refers to the sale of equity capital to institutional investors via private
placement. The key characteristics of private equity are:
• Less liquidity as shares are not publicly traded.
• Price discovery can be biased as the security is not available for valuation by a broad
base of public participants.
• Management can focus on long term value creation as it doesn’t have to worry about
reporting results to market.
• Lower reporting costs due to lesser regulatory requirements.
• Weaker corporate governance due to lesser regulatory requirements.
• Potential for generating high returns when investment is exited.

The types of private equity are:

Venture capital:
• Refers to capital provided to firms in early stages of development.
• The three stages of funding include: seed/startup capital, early stage and mezzanine
financing.
Leveraged buyout:
• Large amount of debt relative to equity is used to buy out a firm.
• The large proportion of debt, amplifies returns if the buyout turns out to be
successful.
• Leveraged buyout performed by management is termed as Management Buyout
(MBO).
• The firm acquired either has to generate the adequate cash flows or sell assets to
service the debt.
Private investment in public equity: A public company, which needs additional capital
immediately, sells equity to private investors.
5. Investing in Non-Domestic Equity Securities
A market is said to be “integrated” with global market if capital flows freely across its
borders. However, some countries place restrictions on capital flows.
The key reasons why capital flows into a country’s equity securities might be restricted is:
• To prevent foreign entities from taking control of domestic companies.
• To reduce volatility of financial markets which can rise by the constant inflow and
outflow of capital.
• To provide domestic investors the advantage of earning better returns.
The two ways to invest in the equity of companies in a foreign market are:
• Direct investing
• Depository receipts
5.1. Direct Investing
It refers to directly buying and selling securities in foreign markets. Some potential issues
associated with direct investing are:
• Along with the stock performance, the returns are exposed to the currency risk as the
trade is made in foreign currency.
• Investor must be aware of the investment environment and laws of the foreign land.
• The disclosure requirement of the foreign country might be low, impeding the
analysis process.
5.2. Depository Receipts
A depository receipt (DR) is a security that trades like an ordinary share on a local exchange

and represents an economic interest in a foreign company.

Process of creating a DR
A foreign company’s shares are deposited in a local bank, which in turn issues receipts
representing ownership of specific number of shares. The receipts then trade on a local
exchange in local currency price. For e.g. a Japanese firm’s shares are held by a UK bank,
which then issues DR representing this stock to the UK citizens. The depository bank is
responsible for handling dividends, stock splits and other events.
Based on the foreign company’s involvement, DR can either be:
• Sponsored DR: Foreign company is involved in issuance and holders of DR are given
voting rights.
• Unsponsored DR: Foreign company is not involved in issuance and the bank retains
the voting rights.
Based on the geography of issuance, DRs can either be:
• Global depository receipt (GDR):
o DRs issued outside the company’s home country and outside the U.S.
o GDRs are issued by a depository bank which is located or has branches in the
countries on whose exchanges the shares are traded.
• American depository receipt (ADR):
o USD denominated DRs that trade like common shares on U.S. exchanges.
o Some ADRs allow firms to raise capital and use shares to acquire other firms in
the US.
• Global registered shares (GRS):
o Shares traded on different stock exchanges in different currencies.
• Basket of listed depository receipts (BLDR):
o Is an ETF representing a collection of DRs.
Types of ADRs
The table below shows the four types of ADRS:
Level I Level II Level III Rule 144A
Objectives Broaden U.S. Broaden U.S. Broaden U.S. Access qualified
investor base investor base investor base institutional
with existing with existing with existing buyers.
shares. shares. shares.
Attract new
investors.
Raising capital No No Yes, through Yes, through
on U.S. public offerings. private
markets? placements or
QIBs.

SEC Required Required More Not required

Registration registration
required
Trading places Over-the- Stock Stock Private
counter (OTC) exchanges exchanges placement
Listing Fees Low High High Low
Earnings None Size constraint Size constraint None
requirements is applicable. is applicable.
6. Risk and Return Characteristics of Equity Securities

6.1. Return Characteristics of Equity Securities
There are two sources of total return for equities: capital gains (or price change) and
dividend income. That is, how much the stock appreciates in price and how much dividend is
paid by the company during that period. For investors who buy foreign securities directly or
through depository shares, there is another source of income: foreign exchange gains or
losses due to currency conversion.
6.2. Risk of Equity Securities
Risk is based on uncertainty of future cash flows. A stock’s return is from the price change
and dividends paid. Since a stock’s price is uncertain, the expected future return is uncertain.
The standard deviation of equity’s expected total return measures this risk.
The table below shows the risk characteristics of different types of equity securities.
Risk characteristics of different types of equity securities
Common shares vs. Preference Shares Common Shares
preference shares. 1. Dividends on preference shares 1. Returns are unknown
Preference shares are fixed as a percentage of the as can be from capital
are less risky. par value. gains (price
2. Dividends are paid before appreciation) and
common shares. dividends.
3. On liquidation, preference 2. On liquidation,
shareholders get par value of common shareholders
the shares. have residual claim .i.e.
they get paid after
claims of debt and
preferred shares have
been met; hence it is
unknown.
3. Foreign investments
are subject to currency
exposure risk.

Callable vs. non- 1. Callable shares are riskier as the firm has an option to
callable shares redeem at a predetermined price if the prices rise.
Non-callable shares 2. Callable shares benefit firms.
are less risky. 3. Callable shares pay higher dividend to compensate for
higher risk and lower potential payout which is limited by
the call price.
Putable vs. non- 1. Putable shares are less risky as they can be sold by
putable shares investors at a predetermined price.
Putable shares are 2. Putable shares benefit investors.
less risky. 3. Putable shares pay lower dividend to compensate for
limited downside risk.
Cumulative vs. non- 1. Any unpaid dividends are accumulated and paid before
cumulative common stock dividends are paid.
preference shares.
Cumulative shares
are less risky.
7. Equity Securities and Company Value
Companies issue equity in primary markets to raise capital and increase liquidity. A
company needs capital for the following reasons:
• to finance revenue generating activities (organic growth). The capital is used to
purchase long-term assets, invest in profit-generating projects, expand to new
territories, or invest in research and development.
• to make acquisitions (inorganic growth).
• to provide stock-based and option-based incentives to employees.
• in some cases, if the company is cash-strapped, it needs the capital to keep it a going
concern, fulfill debt requirements and maintain key ratios.
The goal of a company’s management is:
• to increase book value or shareholder’s equity on a company’s balance sheet.
Management has control over the book value as it can increase net income or sell and
purchase its own shares. If the company pays little or no dividends and retains the
earnings, then book value increases. Book value = assets - liabilities.
• to ensure the stock price rises (maximizing market value of equity). Management
cannot directly influence what price a stock trades at. It depends on investor’s
expectations, analysts’ view of the company’s future cash flows and market
conditions etc.
Book value is based on current value of assets and liabilities (historic) whereas market value
is based on what investors expect will happen in the future (intrinsic value). Book value and
market value of equity are rarely equal. A useful ratio to compute and understand this

relationship better is the price to book ratio (P/B).

7.1. Accounting Return on Equity
ROE is a key ratio to determine whether the management is using its capital effectively.
ROEt = Net Income / Average book value of equity = NIt / (BVEt + BEt−1 )/2
Sometimes beginning book value of equity is used instead of average book value.
ROE can increase over time because of the following reasons:
• Increase in business profitability that increases net income relatively to the increase
in book value of equity.
• Rapid decline in book value i.e. net income declines at a slower rate compared to the
decline in book value.
• Increase in leverage that increases net income and reduces book value of equity,
thereby increasing overall risk.
As only the first case is desirable in the above three cases, a proper analysis of the increase in
ROE should be done. DuPont formula can yield a better understanding of the sources of
growth in the ROE ratio.
7.2. The Cost of Equity and Investor’s Required Rates of Return
When investors purchase company shares, their minimum required rate of return is based
on the future cash flows they expect to receive.
Cost of equity is the minimum expected rate of return that a company must offer its
investors to purchase its shares (not easily determined).
• Cost of equity may be different from investor’s required rate of return.
• Because companies try to raise capital at the lowest possible cost, the cost of equity is
often used as a proxy for the investors’ minimum required rate of return.
• If expected rate of return is not maintained the share price falls.
Cost of equity can be estimated using methods such as the dividend discount model (DDM)
and the capital asset pricing model (CAPM). These models are discussed in detail in other
readings.

Summary
LO.a: Describe characteristics of types of equity securities.
There are two types of equity securities: common shares and preference shares.
Common shares represent an ownership interest in a company, including voting rights. In
statutory voting each share is entitled for one vote. In cumulative voting, a shareholder can
cumulate his total votes and choose one particular candidate. Common shares may be
callable or putable.
Preference shares are preferred over common shares while claiming a company’s earnings
in the form of dividends, and net assets upon liquidation. Dividends on preference shares can
be cumulative, non-cumulative, participating, non-participating or a combination of these.
Convertible preference shares are those which can be converted to common stock.
LO.b: Describe the differences in voting rights and other ownership characteristics
among different equity classes.
A firm can have different classes of equity shares which may have different voting rights and
priority in liquidation. For example: Class A shares would have more votes than Class B
shares.
LO.c: Distinguish between public and private equity securities.
Private equity refers to the sale of equity capital to institutional investors via private
placement.
The types of private equity are:
• Venture capital
• Leveraged buyout
• Management buyout
• Private investment in public equity
LO.d: Describe methods for investing in non-domestic equity securities.
There are two ways to invest in equity of companies outside the local market: direct
investing and depository receipts.
Direct Investment: Buy and sell securities directly in foreign markets in the company’s
domestic currency.
Depository receipt: A security that trades like an ordinary share on a local exchange and
represents an economic interest in a foreign company.
Based on the foreign company’s involvement a DRs can be sponsored or unsponsored.
Based on the geography of issuance, DRs can classified as
• Global depository receipt (GDR)
• American depository receipt (ADR)

• Global registered shares (GRS)

• Basket of listed depository receipts (BLDR)
LO.e: Compare the risk and return characteristics of different types of equity
securities:
Risk characteristics of different types of equity securities
Common shares vs. Preference Shares Common Shares
preference shares. 1. Dividends on preference 1. Returns are unknown as they
Preference shares are shares are fixed as a can be from capital gains
less risky. percentage of the par (price appreciation) and
value. dividends.
2. Dividends are paid before 2. On liquidation, common
common shares. shareholders have residual
3. On liquidation, claim .i.e. they get paid after
preference shareholders claims of debt and preferred
get par value of the shares have been met; hence
shares. it is unknown.
3. Foreign investments are
subject to currency exposure
risk.
Callable vs. non- 1. Callable shares are riskier as firm has an option to redeem
callable shares at a predetermined price if the price rises.
Non-callable shares 2. Callable shares benefit firms.
are less risky. 3. Callable shares pay higher dividend to compensate for
higher risk and lower potential payout which is limited by
the call price.
Putable vs. non- 1. Putable shares are less risky as they can be sold by
putable shares investors at a predetermined price.
Putable shares are less 2. Putable shares benefit investors.
risky. 3. Putable shares pay lower dividend to compensate for
limited downside risk.
Cumulative vs. non- 1. Any unpaid dividends are accumulated and paid before
cumulative preference common stock dividends are paid.
shares.
Cumulative shares are
less risky.
LO.f: Explain the role of equity securities in the financing of company’s assets.
Companies issue equity in primary markets to raise capital and increase liquidity. A
company needs capital to finance revenue generating activities, make acquisitions, and
provide stock-based and option-based incentives to employees.

LO.g: Distinguish between the market value and book value of equity securities.
Book value is based on current value of assets and liabilities (historic) whereas market value
is based on what investors expect will happen in the future (intrinsic value). Book value and
market value of equity are rarely equal. A useful ratio to compute and understand this
relationship better is the price to book ratio (P/B).
LO.h: Compare a company’s cost of equity, its accounting return on equity, and
investors’ required rates of return.
Return on equity (ROE) is an important measure to determine whether the management is
using the capital effectively. Both net income and the book value of equity in the formula
below are affected by the management’s choice of accounting methods related to
depreciation, inventory etc.
ROEt = Net Income / Average book value of equity= NIt / (BVEt+BEt-1)/2
When companies raise money by issuing debt or equity securities, there is a minimum
return that investors expect in return for their money which is called the cost of capital. Cost
of equity is the minimum expected rate of return that a company must offer its investors to
purchase its shares.

Practice Questions
1. Which of the following statements regarding the types of equity securities is least
accurate?
A. A firm issuing callable common shares is obligated to buy them at a predetermined
price.
B. Putable common shares are more favorable to investors than callable common
shares.
C. Cumulative preferred shares require payment of any dividends that were missed out
in the past before any dividend to common shareholders is paid out.
2. Which of the following statements regarding the key characteristics of preference shares
is least accurate?
A. Preference shares combine the characteristics of both debt and equity securities.
B. During liquidation, preference shareholders rank below subordinated bondholders
with respect to claims on the company’s net assets.
C. Dividends on preference shares are a contractual obligation and hence their price is
less volatile than equity securities.
3. Which of the following is least accurate about private equity securities?

A. Private equity firms have lower reporting costs compared to public companies.
B. Private equity investments are liquid investments that offer greater potential for
returns.
C. Corporate governance and disclosures are weaker at a private firm.
4. Which of the following statements regarding depository receipts is least accurate?

A. Foreign stocks that trade on U.S. exchanges and are denominated in U.S. dollars are
called as American depository receipts.
B. Investors holding sponsored depository receipts have voting rights while investors
holding unsponsored depository receipts do not.
C. Global depository receipts are issued out of the U.S. and issuer’s country and are
subject to capital flow restrictions.
5. Which of the following statements regarding the risk and return characteristics of
different types of securities is least accurate?
A. Among commons shares, putable common shares are the least risky and callable
common shares are the most risky.
B. Among preference shares, cumulative preference shares are less risky than non-
cumulative preference shares.
C. Convertible preference shares tend to exhibit more price volatility than the
underlying common shares.

6. Which of the following statements regarding the book value and market value of equity is
least accurate?
A. Book value of equity is the difference between balance sheet value of firm’s assets
and liabilities.
B. Positive retained earnings decrease the book value of equity.
C. Market value of equity is the current price of shares multiplied by the number of
outstanding shares.
7. Which of the following sources of increase in a firm’s ROE is the most favorable for an
investor?
A. Net income decreasing at a lower rate than book value of equity.
B. Net income increasing at a higher rate than book value of equity.
C. Debt is used to buy back some of the outstanding equity.

Solutions
1. A is correct. A firm issuing callable common shares has the option but not obligation to
buy them at a predetermined price.
2. C is correct. Dividends on preference shares are not a contractual obligation of the firm.
However, their price is less volatile than equity securities because they do not allow
investors to share in profits of the company and the dividends on preference shares are
fixed.
3. B is correct. Private equity investments are illiquid investments. However, they have a
long term growth prospect that offers greater potential for returns once the firm goes
public.
4. C is correct. Global depository receipts are issued out of the U.S. and issuer’s country.
However, they are not subject to capital flow restrictions. They are most often
denominated in U.S. dollars.
5. C is correct. Putable common shares are the least risky and callable common shares are
the most risky. The risk of non-callable, non-putable shares falls in between. Because of
the lower risk, putable shares will provide a lower expected rate of return. Among
preference shares, cumulative preference shares are less risky than non-cumulative
preference shares. Convertible preference shares tend to exhibit less price volatility than
the underlying common shares because the dividend payments are known and more
stable.
6. B is correct. Positive retained earnings increase the book value of equity. Book value
signifies the firms past operating performance.
7. B is correct. Net income increasing at a higher rate than book value of equity is generally
favorable for an investor. Issuing debt to buy back equity can increase ROE, but also
increase the riskiness of the stock. Net income decreasing at a lower rate than book value
of equity, will increase the ROE. However, such an increase in ROE isn’t favorable as it
signifies a contracting business.

R48 Introduction to Industry and Company Analysis 2019 Level I Notes
R48 Introduction to Industry and Company Analysis

1. Introduction
In this reading, we will focus on:
• what factors to consider when analyzing an industry.
• what advantages are enjoyed by companies in strategically well-positioned
industries.
• how to analyze the competitiveness of an industry.
• an introduction to company analysis.
2. Uses of Industry Analysis
Industry analysis is primarily used in fundamental analysis. Its uses include:
Understanding a company’s business and business environment:
Industry analysis is used in stock selection and valuation as it helps an analyst understand
the health of the industry, the issuer’s growth opportunities, and business risks. For a credit
analyst, industry analysis provides insights into how much debt companies use, if the
industry is well-positioned for the companies to service this debt, or if a company is over-
leveraged relative to its peers.
Identifying active equity investment opportunities:
Investors use a top-down approach to analyze the macroeconomic factors (which country
offers better growth prospects), then classify industries based on positive, neutral and
negative outlook, and finally shortlist stocks within those industries. Investors then
overweight, market weight or underweight industries. Or, they also attempt to outperform
the benchmark by industry or sector rotation. A sector rotation strategy involves timing
investments in industries by analyzing fundamentals to take advantage of the business-cycle
conditions. For example, when interest rates go down, stocks in the financial and housing
sectors tend to do well.
Portfolio performance attribution:
This is used to determine how a fund manager’s performance relative to a benchmark can be
attributed to different sources such as asset class selection (stock/bond mix),
industry/sector allocation, and finally, stock selection.
3. Approaches to Identifying Similar Companies
The three main methods for classifying companies are:
3.1. Products and/or services offered:
For example, firms that produce healthcare related products or provide healthcare related
services will constitute the healthcare industry.

3.2. Business cycle sensitivities:

Depending on the sensitivity to the business cycle, companies can be classified as:
• Cyclical: Earnings are highly dependent on the stage of the business cycle.
• Non-cyclical: Earnings are relatively stable over the business cycle.
Non-cyclical industries can be further divided into:
• Defensive: Industries that are least affected by the stage of the business cycle, for
example, utilities and consumer staples.
• Growth: Industries that have a very strong demand due to which they are largely
unaffected by the stage of the business cycle.
Limitations of business cycle sensitivities classification:
• Cyclical/non-cyclical is a continuous spectrum. Recession usually affects all parts of
the economy; a non-cyclical sector should be seen as a relative term. For instance, to
say that a household spends the same amount on groceries during a recession may
not be accurate. Households often tend to curtail expenses when jobs are at risk and
incomes are relatively low.
• Growth/defensive labels may be misleading. Even defensive industries may grow
when the economy is doing well and might perform poorly when the economy is
sluggish. Go through Example 1 in the curriculum.
• Different regions of the world might be at different stages of the business cycle. This
is a challenge when evaluating multinational companies.
3.3. Statistical similarities:
Firms that historically have had highly correlated returns are grouped together.
Limitations of statistical similarities classification:
• The classification is not intuitive and may change over time.
• Falsely indicating a relationship where none exists. For example, grouping together
tobacco and aerospace.
• Falsely excluding a significant relationship.
4. Industry Classification Systems
A well-designed classification system is a useful starting point for industry analysis; analysts
can compare industry trends and relative valuation among companies. The following are the
industry classification systems currently available to investors.
4.1. Commercial Industrial Classification Systems
Most index providers classify companies into industry groups using firm’s fundamentals
such as revenue. Some use three levels of classification whereas others use four levels. The
three main commercial industrial classification systems are:
• Global industry classification standard.

• Russell global sectors.

• Industry classification benchmark.
We will look at one system the Global industry classification standard (GICS) to understand
this concept better.
Global Industry Classification Standard (GICS)
This standard classifies companies based on its principal business activity. There are four
levels of classification: a company belongs to a sub-industry; sub-industry belongs to an
industry; industry belongs to an industry group and a group belongs to a sector. The diagram
below will help you remember how companies are classified in this system:
Examples:
Exxon Mobil – integrated oil & gas (sub industry) – oil gas & consumable fuels (industry) –
energy (sector)
Nike – apparel, footwear (sub-industry) – apparel & textile products (industry) – consumer
discretionary (sector)
4.2. Governmental Industry Classification Systems
Various governmental agencies organize statistical data according to the type of industrial or
economic activity; the common goal is to facilitate comparison of data over time and across
countries which use the same system. Continuity of data is an important criterion for
measurement and evaluation of economic performance over time; any change in continuity
will impact comparability of data, making it irrelevant. Some examples of governmental
industry classification systems include:
• International Standard Industrial Classification of All Economic Activities.
• Statistical Classification of Economic Activities in the European Community.
• Australian and New Zealand Standard Industrial Classification.
• North American Industry Classification System.

4.3. Strengths and Weaknesses of Current Systems

Commercial Classification System Governmental Classification System
Generally, disclose information about a Generally, do not disclose information
specific company. about a specific company. Difficult for
analysts to know all constituents for a
particular category.
Reviewed and adjusted frequently. Reviewed and adjusted relatively
infrequently – usually every five years.
Generally, distinguish between large and No distinction between large and small
small businesses. Only include for-profit, businesses, for-profit and non-profit, or
publicly traded companies. private and public companies.
A limitation of both the systems is that a company’s narrowest classification unit cannot
be assumed to be its peer group. For instance, we cannot assume all companies in the
apparel/footwear (sub-industry grouping) /consumer discretionary (sector) category to
be Nike’s peer group.
4.4. Constructing a Peer Group
A peer group is a group of companies engaged in similar business activities whose
economics and valuation are influenced by closely related factors. For instance, if you are
valuating Toyota it is appropriate to compare Toyota with other auto companies rather than
Samsung. Some examples of Toyota’s peers include Daimler, Honda, Volkswagen and General
Motors. Constructing a peer group is a subjective process.
Steps to construct a preliminary list of peer companies:
1. Use a commercial classification system as a starting point.
2. Study the subject company’s annual report to understand its competitive environment.
3. Study the competitor’s annual reports.
4. Review industry trade publications to identify comparable companies.
5. Confirm that each company derives a significant percentage of revenue from a business
activity similar to the primary business of the subject company.
A company could belong to more than one peer group. For example, Hewlett Packard could
be in the personal computer industry as well as the information technology services
industry.
5. Describing and Analyzing an Industry
Objective of Industry Analysis
The objective is to identify industries that offer the highest potential risk-adjusted returns
i.e. industries that generate high return on invested capital relative to the weighted average
cost of capital. In this context, it is important to recognize that not all industries perform well

at any point in an economic cycle. Economic fundamentals and hence economic profits can
vary substantially across industries.
Why strategic groups are important in industry analysis?
When performing an industry analysis, it is useful to consider strategic groups. Strategic
groups are groups of companies sharing distinct business models or catering to a specific
market segment. For example, consider the airline industry in the U.S. and the low cost
carriers (LCC) within it. LCC is a strategic group in the airline industry comprising of
companies such as South West airlines, JetBlue etc.
We now look at a commonly used framework for industry analysis. Designed by Michael
Porter, the framework is also known as Porter’s Five Forces.
The table below summarizes what each of these five forces means:
Porter’s Five Forces
Force Description
Threat of If substitutes to a company’s products are easily available, then the
substitute threat is high and demand for the company’s products will decrease.
products Customers may switch to alternative products if switching costs are
low.
Ex: Low priced brands are close substitutes to premium brands.
Low cost mobiles from China are substitutes to Samsung or iPhone.
If coffee prices increase substantially, coffee drinkers may switch to tea.
Or, during a recession, movie goers may prefer to watch movies at
home using substitute forms instead of going to the cinema.
If this force is strong, it will weaken the pricing power of the market
players.

Bargaining Customers enjoy bargaining power in industries with large volumes

power of and smaller number of buyers. The price competition and profitability
customers is low as customers demand low prices.
Ex. Airlines ordering numerous aircrafts from Boeing or Airbus. Since
airlines typically order a large number of aircrafts, they have high
bargaining power.
Bargaining Suppliers enjoy pricing power in industries where suppliers are small
power of and the supply of key inputs to a company is scarce.
suppliers Ex: Consumer products companies have limited control over price.
Threat of new If barriers to entry are high, then the threat of new entrants is low.
entrants Conversely, if barriers to entry are low, then the threat of new entrants
is high.
Ex: The threat of new entrants is high in the mobile handset market.
Intensity of Industries with high fixed costs, high exit barriers, little differentiation
rivalry among in products, and of similar size experience intense rivalry.
existing Ex: Boeing and Airbus.
competitors
5.1. Principles of Strategic Analysis
We will now focus on the internal competitive forces within an industry: barriers to entry,
industry concentration, pricing, capacity, market share stability, and the stages in its
lifecycle. All these forces play an important role in an industry’s competitiveness.
Barriers to Entry
Barriers to entry is an important concept from a testability perspective. Do not confuse
barriers to entry with barriers to success. For example, in the United States, it takes an
investment of only $150,000 to start a new mutual fund. The initial capital requirement may
be low but that does not guarantee success. Will investors invest in a fund without a track
record?
Here is a simple way of looking at barriers to entry:
High barriers to Discourage new High pricing power

entry entrants
• If the barriers to entry are high, then it discourages new entrants from entering the
industry.
Example of high barriers to entry: Global credit card networks such as Visa and
MasterCard.
• Low barriers to entry implies new entrants can enter the industry.
Example of low barriers to entry: Starting a restaurant as it requires a modest amount

of capital and culinary skills.

High barriers to entry does not imply high pricing power under the following conditions:
• Price is a large percentage of the customer’s purchase decision. Consider the aircraft
manufacturing industry. The two big players in this industry are Airbus and Boeing
and the competition between these two companies is high. Major airlines buy from
either of them, but price is a big consideration in their purchase decision given the
number of aircrafts each airline buys and the price of an aircraft. So, even though the
barriers to entry are high, there is a downward pressure on pricing for the
manufacturers as airlines would otherwise switch to the other supplier if, let us say,
Boeing prices its Boeing-777 aircraft substantially higher than an Airbus A-320.
• Industry has high barriers to exit. The auto industry has high barriers to entry as the
initial capital requirement is high to set up manufacturing facilities, building a
dealership network, building the brand etc. This makes it difficult for a new company
to enter the industry. At the same time, it is not feasible for the existing players to exit
the market. Consequently, when demand is low (perhaps due to a sluggish economy),
car makers are forced to reduce prices.
Industry Concentration
• In concentrated industries, each player generally has high pricing power because
fortunes of the company are tied with the industry and they have more to gain by
keeping prices high even though cutting prices might increase market share.
• In segmented industries, each player generally has low pricing power because
companies gain more by undercutting competition in an effort to increase market
share.
• However, there are exceptions to this rule. Do not automatically assume that high
concentration leads to high pricing power, or that fragmented industries have weak
pricing power.
While industry fragmentation is a good indicator of a competitive industry with limited
pricing power, there are fewer fragmented industries with strong pricing power (the bottom
left quadrant in the table below). The following table shows the role of concentration in
pricing and competition.

Two Factor Analysis of Industries: Concentration & Pricing Power

Strong Pricing Power Weak Pricing Power
Concentrated Low capital requirements. Generally capital intensive and sell
Differentiated products. commodity like products.
Less number of players. Fierce competition between them.
Less price competition Relative market share matters more
Ex: Soft drinks (Coke, Pepsi) than absolute market share.
US Defense Little or no differentiation in
US Railroads products.
Alcoholic beverage industry Ex: Commercial aircraft (Boeing,
Airbus).
Integrated oil companies (Exxon
Mobil, BP)
Fragmented If one or two players are larger Ex: Consumer packaged goods
than the others, they compete (Procter & Gamble, Unilever)
with small players and not among Airlines
themselves. Retail
Highly price competitive. Homebuilding
Each player has a smaller Restaurants
absolute market share.
Ex: Asset Management
Companies (Fidelity)
If the customers are not price
sensitive, then the players have
high pricing power.
Home Improvement (Home
Depot– 11% and Lowe’s – 7%
market share)
Industry Capacity
• Tight or limited capacity results in high pricing power as demand exceeds supply.
• Overcapacity leads to price cuts and a very competitive environment.
When evaluating the impact of industry capacity on pricing, the following points should be
considered:
• Current capacity as well as future capacity levels must be evaluated; such an analysis
might reveal the capacity crunch is temporary.
• It is quicker to shift financial and human capital to new uses but tough to shift capital
invested in physical assets. Physical capital takes a relatively long time to establish.
Capacity is fixed in the short term, and variable in the long term – new factories may
be built to add capacity.

Market Share Stability

• Stable market share implies less competitive industries.
• Unstable market share implies highly competitive industries and limited pricing
power.
• Factors that impact market share stability include: barriers to entry, switching costs,
new product introductions, complexity of products and pace of innovation.
• If barriers to entry are high, switching costs are high and new product introductions
are low, then the market share stability will be high.
• If barriers to entry are low, switching costs are low and new product introductions
are high, and the market share stability will be low.
Price Competition
If price is a major factor in customer buying decisions, then competition will be high. Ex:
commercial aircraft industry. Price is a major factor in an airline’s purchase decision. This
weakens pricing power for Boeing and Airbus.
Industry Life Cycle Model
There are five stages in the lifecycle of any industry: embryonic, growth, shakeout, mature
and decline. The characteristics of each stage are depicted in the diagram below:
Embryonic
• Slow growth, high prices.
• Product still not positioned in the market; buyers unaware; distribution channels to
be developed.
• High investment and high risk of failure.
• Low volumes; no economies of scale.
Growth
• Rapidly increasing demand; new customers.
• Falling prices as economies of scale are achieved.

• Low barriers to entry; threat of new entrants.

• Low competition leads to increased market share and profitability.
Shakeout
• Slowing growth, intense competition, and declining profitability.
• Market is saturated; no new customers.
• Investment to add capacity leads to overcapacity. To boost demand, prices are cut
which decreases profitability.
• Focus is on reducing costs and building brand loyalty.
• Ex: deregulation of telecom companies in the 1990s.
Mature
• High barriers to entry; consolidation takes places resulting in oligopolies.
• Little or no growth.
• Market is saturated; it is a stable competitive environment.
• Companies with superior products gain market share.
Decline
• Growth is negative.
• Excess capacity leads to price cuts resulting in price wars.
• Competition increases.
• Weaker companies exit.
The life cycle model is a well-defined framework to understand any industry’s evolution. But
it is not a cookie-cutter model that all industries adhere to. There are external factors which
significantly affect how an industry evolves causing some stages to be shorter or longer than
expected. These are technological, social, regulatory and demographic changes which we will
see in detail in the next section.
Limitations of the Industry Life Cycle Model
• It is less practical for analyzing industries going through rapid changes, or periods of
economic instability.
• Not all companies in an industry will perform the same. For example, there are
consistently profitable companies even in a highly competitive industry such as
consumer goods, or retail.
Industry Comparison (Internal Factors)
The table below discusses three industries using the characteristics we have discussed so
far. Analyze and test your understanding for the reasoning behind the characteristic. For
instance, barriers to entry for branded pharma companies are high because it requires
substantial financial and intellectual capital. A new entrant would require a sizeable
investment in R&D and manufacturing facility.

Industry Comparison (Internal Factors)

Branded Pharma Oil Services Confections/Candy
Major companies Pfizer, Novartis, Schlumberger, Cadbury, Nestle,
Merck, Halliburton Hershey, Mars
GlaxoSmithKline
Barriers to Very high Medium Very high
success/entry
Level of Concentrated: small Fragmented Very concentrated:
concentration no. of companies top four companies
control majority of control most of the
the global market. global market.
Impact of Industry NA Medium/High NA
Capacity
Industry Stability Stable Unstable Very stable
Life Cycle Mature: no rapid Mature Very mature:
change in demand demand varies
year on year. according to
population growth
and pricing.
Price competition Low/medium High Low
5.2. External Influences on Industry Growth, Profitability, and Risk
The five external factors affecting an industry’s growth are macroeconomic, technological,
demographic, governmental and social influences.
Macroeconomic Factors: Demand for products and services are affected by overall
economic activity at any point in time. Economic variables that affect an industry’s revenues
and profits are GDP, level of interest rates, inflation, and how easily money is available to
businesses. Example: People cut down on discretionary spending during the festive/holiday
season if inflation is very high (emerging economies), or if the economy is in a recession
leading to job cuts.
Technological Influences: New technologies can rapidly change an industry or push them
into the decline stage faster. Examples: Invention of the microchip and the evolution of the
computer hardware industry; impact of digital imaging technology on the photographic film
industry, USBs on DVD/CD, digital music on cassette player industry.
Demographic Influences: Changes in population size, age and gender ratio.
Examples: Surge in retirement-oriented investment products in the U.S. between 1990 and
2000 to cater to the baby boomers. Impact of Japan’s aging population on local economy.
Impact of India’s young population on several sectors of the economy: education, housing,
consumer spending, hospitality, technology etc.

Governmental Influences: Tax rates and rules set by governments affect an industry’s
revenues and profits. Similarly, regulatory changes such as environmental restrictions, how
much of foreign investment is allowed in an industry, or restrictions on gold imports
influence an industry’s performance. Examples: Governments control, through regulations,
how much money financial institutions can accept from investors for issuing securities and
savings deposits. The objective is to protect investors from fraudulent practices. Patients in
developed countries can be treated and prescribed treatment only by certified doctors.
Social Influences: How people work, spend their money and leisure time pursuing hobbies,
and travel affect various industries. The curriculum cites the example of how more women
entering the workforce worldwide has spun many new industries, while boosting others.
Restaurants, work wear for women, home and child care services, and demand for more cars
are some of the effects of this trend.
Now, we analyze the impact of these external factors for the same three industries.
Industry Comparison (External Influences)
Demographic Population Low Low
Influences increasing. Demand
for drugs is high.
Government and Very high as it Medium Low
Regulatory requires govt.
Influences approval.
Social Influences N/A N/A N/A
Technological Medium/High Medium/High Low
Influences
Growth vs. Defensive Cyclical Defensive
Defensive vs.
Cyclical
6. Company Analysis
Company analysis involves analyzing a company’s financial position, products and/or
services, and competitive strategy. Porter has identified two chief competitive strategies:
low-cost strategy (also called price leadership) and a product/service differentiation
strategy.
Low-cost Strategy/Price Leadership
• In this strategy, companies price their products and services lower than their
competition to stimulate demand and gain market share.
Examples: low cost airlines, cheap alternatives of iPad/iPhone.
• It is a defensive strategy to protect market share in the near term. Companies may
then raise prices in the future to increase profits.

Example: full service airlines use this strategy to compete against low cost carriers to
protect lucrative routes.
• Usually adopted by experienced companies to lower costs; it requires tight cost
controls, efficient operating systems, continuous monitoring of the operating costs,
lower labor costs and eliminating any overheads.
• The company must have easy access to capital to invest in technology and
production-improving equipment.
• Low switching costs for customers, little to no product differentiation helps this
strategy.
Differentiation Strategy
• In this strategy, companies establish themselves as suppliers of products/services
that are unique in quality/type/distribution. Caters to a niche market with specific
needs.
Examples: Customized Maybach, Apple products (introduction of iPod, iPad), fashion
brands.
• The target customer base is usually not price sensitive.
• The higher rate of return is by selling the products at a premium. The price premium
should be greater than the costs of differentiation. Focus is on building brand
recognition and a loyal customer base.
• Focus is on market research, and R&D to understand a customer’s needs and
incorporating them in product design. These companies employ creative people to
design such products. Example: Apple.
• Companies also need to invest in marketing and sales efforts to create brand
awareness.
6.1. Elements That Should be Covered in a Company Analysis
Some of the important points that should be covered in the research report for a company
are listed below:
• Company profile: what products/services, sales composition, management strengths
& weaknesses, labor issues, legal actions etc.
• Industry characteristics: industry analysis, stage in life cycle, brand loyalty.
• Analysis of demand for products/services: sources of demand, differentiation, long
term outlook.
• Analysis of supply of products/services: sources of supply, industry/company
capacity.
• Analysis of pricing: historical relationship between demand, supply, and prices,
pricing outlook based on demand and supply, impact of raw materials and labor
costs.
• Financial ratios and measures: activity ratios, liquidity ratios, solvency ratios,
profitability ratios and other financial statistics for the previous years to forecast

performance.
6.2. Spreadsheet Modeling
Spreadsheet modeling is a widely used tool by analysts in company analysis. But it has
certain limitations:
• Most models are highly complex in nature and require a lot of assumptions. For
instance, revenue growth projections for the next five years, leverage/equity
financing, wages, inventory costs, tax rate, beta etc.
• The complexity of the model may make it appear that the conclusions or stock price
forecasts are right, when in fact they may be inaccurate.
Here is what an analyst can do to determine whether a model is valid:
• Start with the income statement. Ask what important changes have taken place since
the previous year?
• What effects do these changes have on the net income? Are they reasonable? For
instance, is a 5% growth in revenue leading to a 30% growth in net income?
• Does the financial model’s format match that of the company’s financial statements?

Summary
LO.a: Explain uses of industry analysis and the relation of industry analysis to
company analysis.
Uses of industry analysis:
• To understand a company’s business and business environment.
• To identify active equity investment opportunities.
• To create an industry or sector rotation strategy.
• For portfolio performance attribution.
Relation of industry analysis to company analysis:
• They are closely interrelated.
• Together they can provide insights about the firm’s potential growth, competition
and risk.
LO.b: Compare methods by which companies can be grouped, current industry
classification systems, and classify a company, given a description of its activities and
the classification systems.
The three main methods for classifying companies are
• Products and/or services offered: For example, firms that produce healthcare related
products or provide healthcare related services will constitute the healthcare
industry.
• Business cycle sensitivities: Companies are classified as ‘cyclical’ – earnings highly
dependent on the stage of the business cycle or ‘non –cyclical’ – earnings are
relatively stable over the business cycle.
• Statistical similarities: Firms that historically have had highly correlated returns are
grouped together.
Current industry classification systems are:
Commercial industry classification systems include:
• Global Industry Classification Standard.
• Russell Global Sectors.
• Industry Classification Benchmark.
Governmental industry classification systems include:
• International Standard Industrial Classification of All Economic Activities.
• Statistical Classification of Economic Activities in the European Community.
• Australian and New Zealand Standard Industrial Classification.
• North American Industry Classification System.
A limitation of the current classification system is that all firms in the same narrowest
industry classification do not necessarily form a peer group.

LO.c: Explain the factors that affect the sensitivity of a company to the business cycle
and the uses and limitations of industry and company descriptors such as “growth”,
“defensive” and “cyclical”.
Depending on the sensitivity to the business cycle, companies can be classified as:
• Cyclical: Earnings are highly dependent on the stage of the business cycle.
• Non-cyclical: Earnings are relatively stable over the business cycle.
Non-cyclical industries can be further divided into:
• Defensive: Industries that are least affected by the stage of the business cycle, for
example, utilities and consumer staples.
• Growth: Industries that have a very strong demand due to which they are largely
unaffected by the stage of the business cycle.
Limitations
• Cyclical industries often include growth firms.
• Non-cyclical industries can be affected by severe recessions.
• Business cycles can differ across countries so it is difficult to measure sensitivity for a
global firm.
LO.d: Explain the relation of “peer group” as used in equity valuation, to a company’s
industry classification.
A peer group is a group of companies engaged in similar business activities whose
economics and valuation are influenced by closely related factors. Peer group can be
constructed using the following steps:
1. Use a commercial classification system as a starting point.
2. Study the subject company’s annual report to understand competitive environment.
3. Study competitor’s annual reports.
4. Review industry trade publications to identify comparable companies.
5. Confirm that each company derives a significant percentage of revenue from a business
activity similar to the primary business of the subject company.
LO.e: Describe the elements that need to be covered through industry analysis.
Investment managers and analysts examine industry performance in relation to other
industries (cross-sectional analysis) and over time (time-series analysis). The objective is to
identify industries that offer the highest potential risk-adjusted returns. Not all industries
perform well at any point in an economic cycle. Economic fundamentals and hence economic
profits can vary substantially across industries.

LO.f: Describe the principles of strategic analysis of an industry.

Porter’s Five Forces
Force Description
Threat of substitute Customers may switch to alternative products if switching
products costs are low. If substitutes are easily available, then the
threat is high.
If this force is strong, it will weaken the pricing power of the
market players.
Bargaining power of Large volumes and smaller number of buyers. Customers
customers demand low prices which drives profitability low.
Bargaining power of Do suppliers have a control over pricing or restricting
suppliers supply of key inputs to a company?
Threat of new entrants If barriers to entry are high, then the threat of new entrants
is low. Conversely, if barriers to entry are low, then the
threat of new entrants is high.
Intensity of rivalry among Industries with high fixed costs, high exit barriers, little
existing competitors differentiation in products, and of similar size experience
intense rivalry.
LO.g: Explain the effects of barriers to entry, industry concentration, industry
capacity, and market share stability on pricing power and return on capital.
• If the barriers to entry are high, then it discourages new entrants from entering the
industry. But that does not mean it leads to high pricing power. This might happen if
price is a large percentage of the customer’s purchase decision or the industry has
high barriers to exit.
• In concentrated industries, each player generally has high pricing power. In
segmented industries, each player generally has low pricing power. However, there
are exceptions to this rule.
• Tight or limited capacity results in high pricing power as demand exceeds supply.
Similarly, overcapacity leads to price cuts and a very competitive environment.
• Factors that impact market share stability include: barriers to entry, switching costs,
new product introductions, complexity of products and pace of innovation.
LO.h: Describe product and industry life cycle models, classify an industry as to life
cycle phase (embryonic, growth, shakeout, maturity, and decline), and describe
limitations of the life cycle concept in forecasting industry performance.
There are five stages in the lifecycle of any industry and their characteristics are depicted in
the diagram below:

There are external factors at play which significantly affect how an industry evolves causing
some stages to be shorter or longer than expected. One of the limitations of this model is that
it is less practical for analyzing industries going through rapid changes, or periods of
economic instability. Another limitation is that not all companies in an industry will perform
the same.
LO.i: Compare characteristics of representative industries from the various economic
sectors.
Major companies Pfizer, Novartis, Schlumberger, Cadbury, Nestle,
Merck, Halliburton Hershey, Mars
GlaxoSmithKline
Barriers to Very high Medium Very high
success/entry
Level of Concentrated: small Fragmented Very concentrated:
concentration no. of companies top four companies
control majority of control most of the
the global market global market
Impact of Industry NA Medium/High NA
Capacity
Industry Stability Stable Unstable Very stable
Life Cycle Mature: no rapid Mature Very mature:
change in demand demand varies
year on year according to
population growth
and pricing
Price competition Low/medium High Low

Demographic Population Low Low

Influences increasing. Demand
for drugs is high
Government and Very high as it Medium Low
Regulatory requires govt.
Influences approval.
Social Influences N/A N/A N/A
Technological Medium/High Medium/High Low
Influences
Growth vs. Defensive Cyclical Defensive
Defensive vs.
Cyclical
LO.j: Describe macroeconomic, technological, demographic, governmental, and social
influences on industry growth, profitability, and risk.
External influences on industry growth, profitability, and risk include:
• Technology: Can dramatically change an industry through the introduction of new or
improved products.
• Demographics: This includes changes in population size, age and gender ratio.
• Government: This includes tax rates, regulations and government purchases of goods
and services.
• Social factors: Relates to how people work, play and spend their leisure time.
• Macroeconomic influences: Includes long term trends in factors such as GDP growth,
interest rates and inflation.
LO.k: Describe the elements that should be covered in a thorough company analysis.
A through company analysis includes investigation of:
• corporate profile
• industry characteristics
• demand for products/services
• supply of products/services
• pricing
• financial ratios

Practice Questions
1. Industry analysis would be least likely used in:
A. performance attribution analysis.
B. top-down fundamental investing.
C. tactical asset allocation strategy.
2. Industry classification systems provided by commercial players are most likely based on:
A. products and services delivered.
B. statistical similarities.
C. business cycle sensitivity.
3. Which of the following is least likely a limitation of the cyclical/ non-cyclical descriptive
approach to classifying companies?
A. Cyclical industries often include growth firms.
B. Business cycle timing defers across countries and regions.
C. Business-cycle sensitivity is a discrete phenomenon rather than a continuous
spectrum.
4. Which of the following statements about peer groups is most accurate?

A. A peer group is generally composed of all the companies in the most narrowly
defined category used by the commercial industry classification system. .
B. Comments from the management of the company about competitors are generally not
used when selecting the peer group.
C. Commercial industry classification systems often provide a starting point for
constructing a peer group
5. Which of the following statements regarding industry analysis is the most appropriate?
A. An analyst must not compare his estimates with that from other analysts, as this can
create a bias.
B. Industries must be positioned on the experience curve and classified based on their
life-cycle stage.
C. Industry should be analyzed in isolation without their linkages to the macroeconomic
variables.
6. Which of the following statements regarding strategic analysis using Porter’s five forces
is least appropriate?
A. Economic profit increase as rivalry among existing competitors increases.
B. Economic profit decreases as threat of substitutes increases.
C. Economic profit decreases as bargaining power of buyers increases.

7. Which of the following most accurately results in greater pricing power within an
industry?
Barriers to entry Unused Capacity Barriers to exit
A. Low Low Low
B. High Low Low
C. Low High High
8. According to the industry life-cycle model, an industry experiencing little or no growth,

facing industry consolidation, high barriers to entry and stable pricing is most likely in its:
A. growth stage.
B. maturity stage.
C. decline stage.
9. Susan is a portfolio manager and she expects a slowdown in the economy and
diminishing growth rates with respect to revenues and profits. She will most likely make
changes to the portfolio by:
A. underweighting utilities.
B. overweighting automobile stocks.
C. overweighting pharmaceuticals.
10. Which of the following is least likely to be an external influencing factor on industry
growth, profitability and risk?
A. Macroeconomic factors.
B. Demographic factors.
C. Rivalry among existing players.
11. A company with a successful cost leadership strategy is most likely characterized by:
A. creative marketing and product development.
B. reduced market share.
C. focus on operational efficiency.

Solutions
1. C is correct. Industry analysis is used in performance attribution analysis and top-down

fundamental investing. Tactical asset allocation involves timing investments in asset
classes and does not make use of industry analysis.
2. A is correct. Industry classification systems provided by commercial players like MSCI,

S&P, Russel and Dow Jones are usually based on products and services that the firm
delivers.
3. C is correct. Business-cycle sensitivity falls on a continuum and is not a discrete “either–

or” phenomenon.
4. C is correct. A limitation of current classification systems is that the narrowest

classification unit assigned to a company generally cannot be assumed to constitute its
peer group.
5. B is correct. An analyst must check his estimates with that from other analysts. However,
he should do so without letting a bias impact his analysis. Industry trends should be
analyzed by evaluating their relationships with macroeconomic variables.
6. A is correct. Economic profit decreases as rivalry among existing competitors increases.

As greater numbers of firms start competing for business, the pricing power erodes and
reduces the economic profits earned by those firms.
7. B is correct. High barriers to entry decreases competition as they allow fewer new
entrants. Increased competition translates into greater pricing power. Low unused
capacity means the industry is operating at higher utilization, which results in greater
pricing power as there is lower price competition. Low barriers to exit results in higher
pricing power.
8. B is correct. An industry experiencing little or no growth, facing industry consolidation,

high barriers to entry and stable pricing is in maturity stage.
9. C is correct. Non-cyclical companies like pharmaceuticals and utilities produce goods or

services for which demand remains relatively stable throughout the business cycle and
thus tend to be over-weighted during economic slowdowns and when revenues and
profits are expected to be under pressure.
10. C is correct. Rivalry among existing players is a factor that is internal to the industry.
External influences include macroeconomic, technological, demographic, governmental

and social influences.
11. C is correct. In a differentiation strategy, a firm tries to earn higher margins per product
through differentiation (by creative marketing and product development) to earn a
superior return. In a low-cost strategy, a firm tries to generate high sales volume at low
costs to earn a superior return.

R49 Equity Valuation 2019 Level I Notes
R49 Equity Valuation

1. Introduction
We began the equities section with a discussion on how securities markets are organized,
how efficient markets are, the different types of equity securities, and how to analyze an
industry and a company. The focus of this reading is on determining the intrinsic value of the
security.
2. Estimated Value and Market Price
Intrinsic value of a security is based on its fundamentals and characteristics. It is also called
the fundamental value or estimated value as it is based on the fundamentals such as
earnings, sales, and dividends. If the intrinsic value is different from the market price, then
you are implicitly questioning the market’s estimate of value.
Overvalued Fairly valued Undervalued

Market value > Market value = Market value <
Intrinsic value Intrinsic value Intrinsic value
Assume, Caterpillar Inc. is trading on NYSE at $84.53. An analyst estimates its intrinsic value
as $88.21. Is it overvalued, fairly valued, or undervalued? Going by the relationships given
above, the security is undervalued. In reality, making this decision is not that
straightforward. It depends on an analyst’s input values and assumptions in the model. Some
factors to consider when market value ≠ intrinsic value:
• Percentage difference between the market price and intrinsic value. Assume you
calculate the intrinsic value of a security to be $95, but it is currently trading at $180.
Since the % difference is large, it is prudent to calculate the intrinsic price once again
because the assumptions or input data to the model may be incorrect.
• Confidence in your model. High confidence means the market price will converge to
the intrinsic value over the time horizon considered. If your confidence is low, you
might see the two prices diverging substantially.
• Model sensitivity to assumptions. If many securities appear to be under- or overvalued,
analysts should check the model’s sensitivity to their inputs.
• Number of analysts. More the number of analysts covering a security, lesser the
mispricing. Recollect what we read about efficient markets. The market price, in this
case, is likely to reflect intrinsic value. Securities neglected by analysts are often
mispriced.
3. Major Categories of Equity Valuation Models
Three major categories of equity valuation model are:

Present value models

• They estimate value as present value of expected future benefits.
• Future benefits are defined as either cash distributed to shareholders (dividend
discount models) or cash available to shareholders after meeting the necessary
capital expenditure and working capital expenses (free cash flow to equity models).
Multiplier models
• They estimate intrinsic value based on a multiple of some fundamental variable.
• For example, either Stock price / earnings (or sales, book value, cash flow).
• Or Enterprise value / EBITDA (or sales).
Asset-based valuation models
• They estimate the value of equity as the value of assets less the value of liabilities.
• Book values of assets and liabilities are typically adjusted to their fair values when
using these models.
The choice of model depends on availability of information and the analyst’s confidence in
the appropriateness of the model; generally, analysts will try to use more than one model.
4. Present Value Models: The Dividend Discount Model
4.1. Dividends: Background for the Dividend Discount Model
A dividend is a distribution made to shareholders based on the number of shares owned.
Cash dividends are payments made to shareholders in cash. The three types of cash
dividends are:
1. Regular cash dividends: They are paid out on a consistent basis. Stable or increasing
dividend is viewed as a sign of financial stability.
2. Special dividends: They are one-time cash payments when the situations are
favorable (Also called as extra dividends or irregular dividends; used by cyclical
firms).
3. Liquidating dividend: This is distributed to shareholders when a company goes out of
business.
Stock dividend: Company distributes additional shares instead of cash. A stock dividend
simply divides the ‘pie’ (the market value of equity) into smaller pieces without affecting the
value of the pie. Since the market value of equity is unaffected, stock dividends are not
relevant for valuation purposes.
Stock split: Increases the number of shares outstanding. For example, in a 2 for 1 split, each
shareholder is issued an additional share for each share currently owned.
Reverse stock split: Reduces the number of shares outstanding. For example, in a 1 for two
reverse stock split, each shareholder would receive one share for every two old shares.

Stock splits and reverse stock split are similar to stock dividends. They do not change the
market value of equity hence they are not relevant for valuation purposes.
Share repurchase: This is an alternative to cash dividends, here the company uses cash to
buy back its own shares. An important point to note is that as compared to stock dividends
and stock splits, share repurchases affect the market value of equity. The effect on
shareholder’s wealth is equivalent to a cash dividend. Some key reasons why companies
engage in share repurchases instead of cash dividends are:
1. to support share prices.
2. flexibility in the amount and timing of cash distribution.
3. when tax rate on capital gains are lower than tax rates on dividends.
4. to offset the impact of employee stock options.
Dividend payment chronology
Dividend payment schedule is as follows:
1. Declaration date: Company declares the dividend.
2. Ex-dividend date: Cutoff date on or after which buyers of a stock are not eligible to
the dividend. Also is the first date when the stock trades without dividend.
3. Holder-of-record date: A record of shareholders who are eligible to receive the
dividend is made (usually two days after the ex-dividend date).
4. Payment date: Dividend payment made to the shareholders.
4.2. The Dividend Discount Model: Description
This model is based on the principle that the value of an asset should be equal to the present
value of the expected future benefits. The simplest present value model is the dividend
discount model (DDM). According to DDM, the intrinsic value of a stock is the present value
of future dividends plus the present value of terminal value.
Intrinsic value = PV of future dividends + PV of terminal value
n
Dt Pn
V0 = ∑ +
(1 + r)t (1 + r)n
t=1
Example
For the next three years, the annual dividends of stock X are expected to be 1.0, 1.1, and 1.2.
The expected stock price at the end of year 3 is expected to be $20.00. The required rate of
return on the shares is 10%. What is the estimated value?
Solution:
Calculate the present value of each of the future dividends at the reqd. rate of return of 10%.
1
PV of cash flow 1 = 1.1 = 0.909

1.1
PV of cash flow 2 = (1.1)2 = 0.909
20+1.2
PV of cash flow 3 = (1.1)3
= 15.928
Estimated value = 0.909 + 0.909 + 15.92 = 17.74

In the exam, use a financial calculator with the following keystrokes:
CF0 = 0; CF1 = 1; CF2 = 1.1; CF3 = 21.2; I = 10%, CPT NPV
NPV = 17.7
Free cash flow to equity (FCFE) is the residual cash flow available to be distributed as
dividends to common shareholders. In practice, FCFE model is often used because:
• FCFE is a measure of a firm’s dividend-paying capacity.
• It can be used for a non-dividend paying stock (unlike DDM which requires the timing
and the amount of the first dividend to be paid).
• It can also be used for a company that pays dividends which are extremely small or
the dividends being paid are not an indication of a company's ability to pay dividends.
• Not all of the available cash flow is distributed to shareholders because a company
retains some part of it for future investments as a going concern.
FCFE = CFO - FCInv + Net borrowing
where: FCInv = fixed capital investment
Net borrowing = borrowings – repayments
∞
FCFE t
𝐕𝟎 = ∑
(1 + r)t
t=1
Required Rate of Return on a share

Analysts generally use CAPM (capital asset pricing model) to calculate the required return
on a share.
Required rate of return on share = current expected risk free rate + Betai [market risk
premium]
In addition to CAPM, there are other methods to calculate the required return like the bond
yield plus risk premium method which we will see later.
4.3. Preferred Stock Valuation
For a non-callable, non-convertible perpetual preferred share paying a level dividend and
assuming a constant required rate of return, the value is given by the equation below:
Do
V0 =
r
where: V0 = present value of the perpetuity; Do = dividend and r = rate of return

Example
A $100 par value, non-callable, non-convertible perpetual preferred stock pays a 5%
dividend. The discount rate is 8%. Calculate the intrinsic value of the preferred share.
Solution:
Expected annual dividend = 0.05 x 100 = 5
Value of the preferred share = 5.00/0.08 = 62.50
Other types of preferred shares to consider are:
• Shares which mature on a given date: In the earlier example, instead of being a
perpetual share, assume the share matured after four years. To calculate the value of
this share, calculate the present value of the four dividends with the last one paid at
the end of 4thyear at the required rate of 8%. Input these values in your financial
calculator: N = 4; I = 8; PMT = 5; FV = 100; PV =? Present value of this share = 90.06.
• Callable (redeemable) shares: These shares are callable by the issuer at some point
before maturity. Assuming all the conditions are the same as the shares which mature
on a given date, will investors pay 90.06, less or more for this share? They will pay
less for this share as investors stand the risk of the issuer calling the share when it
trades above the par value.
• Shares with retraction option (putable shares): Here, the holder of the preferred stock
has an option to sell the share to the issuer at a specified price before the maturity
date. Unlike callable shares, putable shares will trade at a value above 90.06 as the
put option is valuable to investors. If the share trades below the par value, investors
can sell it back to the issuer.
4.4. The Gordon Growth Model
One of the disadvantages of the dividend discount model is that it is difficult to accurately
estimate the amount of dividends for a long period of time. The Gordon growth model
simplifies this by assuming that dividends grow indefinitely at a constant rate; it is also
called as the constant-growth dividend discount model. According to this model, the intrinsic
value of a security can be calculated as:
D
V0= r −1g
where:
g = dividend growth rate = b * ROE
b = earnings retention rate = (1- dividend payout ratio)
ROE = return on equity
In the equation above, if the growth rate is zero, then the equation reduces to the present
value of a perpetuity.

Assumptions of the Gordon Growth model:

• Dividends are the correct metric to use for valuation purposes. Dividends are a
reflection of a company's earnings.
• Dividend growth rate is perpetual.
• Required rate of return is constant throughout the life of the security.
• Dividend growth rate < required rate of return.
When is it not appropriate to use the Gordon Growth Model?
• If the company is currently not paying a dividend as it may reinvest earnings in
attractive opportunities.
• If the company is not profitable enough currently to pay a dividend. An analyst may
still use the model by assuming that the company will pay a dividend in the future.
What happens to the value if dividend value is increased?
D
Let us look at the formula again. V0= r−g
1
When dividend increases, numerator increases. If the payout ratio increases, retention rate
decreases and value of g decreases. If g decreases, the denominator increases. As a result, the
impact on value, if dividend is increased cannot be determined with certainty.
Example
Estimate the intrinsic value of a stock given the following data:
Beta =1.5; RFR = 3%; market risk premium = 5%; dividend just paid = $1.00; dividend
payout ratio = 0.4; return on equity = 15%.
Solution:
D1 D0 ∗(1+g)
V0 = =
r−g r−g
Note: the values of r, g and expected dividend are not given. So, first calculate these values.
r = RFR + Beta x market risk premium = 3+ 1.5 x 5 = 10.5%
g = b x ROE = (1 - 0.4) x 0.15 = 0.09
1.09
Applying the Gordon growth model, V0 = 1 x 0.105 – 0.09 = 72.67
Example
A company does not currently pay dividend but is expected to begin to do so in 4 years. The
first dividend is expected to be $2.00 and to be received at the end of year 4. The dividend is
expected to grow at 5% into perpetuity. The required return is 10%. What is the estimated
current intrinsic value?
Solution:

To calculate the intrinsic value, first calculate the value of dividend at the end of period 3 and
then discount it to t=0 using the Gordon growth model.
D 2
V3 = r –4g = 0.10 – 0.05 = 40
40
V0 = (1.1)3 = 30.05
Instructor’s Note: Do not forget to discount 40 to the present value. The undiscounted value is
commonly presented as one of the answer options as a trap.
4.5. Multistage Dividend Discount Models
It is an ideal situation to assume that all companies grow at a constant rate indefinitely and
pay a constant dividend; the assumption is true to an extent only for stable companies. In
reality, companies go through a finite rapid growth phase followed by an infinite period of
sustainable growth.
A two-stage DDM can be used to calculate the value of such companies transitioning from
growth to mature stage. The Gordon growth model may be used to calculate the terminal
value at the beginning of the second stage which represents the present value of dividends
during the sustainable growth phase.
n
D0 (1 + g s )t Vn
V0 = ∑ t
+
(1 + r) (1 + r)n
t=1
The first term is discounting the dividends during the high growth period. The second
term is calculating the terminal value for the second sustainable growth period and then
discounting it to the present value where Vn = terminal value at time n estimated using
the Gordon growth model.
Example
Let us understand the concept better with the help of an example. The current dividend for a
company is $4.00. The dividends are expected to grow at 20% a year for 4 years and then at
10% after that. The required rate of return is 18%. Estimate the intrinsic value.
Solution:
First draw a timeline.
We will use this formula:

n
D0 (1 + g s )t Vn
V0 = ∑ +
(1 + r)t (1 + r)n
t=1
where n = 4 (high growth period)

V D D4 (1 + gL ) 8.29 ∗ 1.1 9.12
Solve for the second term: (1+r)
n
n
;V4 = r−g
5
= = 0.18 − 0.1 = 0.08 = 114
r–g
Using the financial calculator, we can calculate the present value of dividends and terminal
value by entering the following values: CF0 = 0; CF1 = 4.8; CF2 = 5.76; CF3 = 6.91; CF4 = 8.29 +
114; I = 18; NPV = 75.48
Note: while calculating V4, you need to use 10% as growth rate since it is the long term growth
rate.
Three Stage Models
The concept of a two-stage model can be extended to as many stages as a company goes
through. Often, companies go through three stages beyond the startup phase: growth,
transition and maturity.
5. Multiplier Models
Price multiple is a ratio that uses a company’s share price with some monetary flow/value
for evaluating the relative worth of a company’s stock. Commonly used price multiple ratios
are listed below:
Price multiples
Ratio What it measures
Price-to-earnings ratio (P/E) Price per share
Trailing P/E:Trailing 12 month earnings per share
For example, price = 50, EPS = 5; P/E = 10
Forward/leading/estimated
Stock price
P/E:Leading 12 month earnings per share
Most commonly used ratio. Analysts prefer stocks with
low P/E to high P/E.
Price-to-book ratio P/E Price per share
P/B = Book value per share
Assets – Liabilities
Book value per share = Shares outstanding
Evidence suggests that companies with low P/B tend to
outperform stocks with high P/B (expensive stock).

Price-to-sales ratio Price per share

P/S = Sales per share
Like P/E ratio, this can be trailing or leading ratio. One
advantage of P/S ratio is that it can never be negative
unlike P/E as earnings can be negative. It is useful during
periods of economic slowdown or extraordinary growth.
Price-to-cash flow ratio Price per share
P/CF = Cash flow per share
One aspect to note here is what cash flow measure has
been used by the analyst. The cash flow measure may be
operating cash flow, free cash flow etc.
Common criticism: These ratios do not consider the future. When forecast of
fundamental values are used such as estimated EPS in leading P/E, the P/E value may
differ substantially from the trailing P/E. When comparing companies, the multiples
should be consistently used. For example, you cannot compare the trailing P/E of one
company with a leading P/E of another company.
For a growing company, what will be higher: the leading P/E or the trailing P/E?
The trailing P/E will be higher as the earnings are higher in the future periods. So the leading
P/E will be lower.
5.1. Relationships among Price Multiples, Present Value Models, and Fundamentals
We can link price multiple to fundamentals through a discounted cash flow model such as
Gordon Growth Model. How? By assuming that intrinsic value of a security is equal to its
market price i.e. the security is fairly valued.
D1 D1
V0 = becomes P0 = if we assume that: V0 = P0
r−g r−g
D1
P0 E1 Dividend payout ratio
Forward P/E = E = =
1 r−g r−g
The multiple you see above is related to the fundamentals as both dividend payout ratio and
growth rate represent the fundamentals of a company. Some interpretations based on the
formula:
• The forward P/E and payout ratio appear to be positively related. But, it does not
necessarily mean a higher dividend payout increases the P/E.
• A higher payout ratio may mean the company is retaining less for reinvestment,
which in turn means, a slower growth rate. Since P/E and growth rate are positively
related, if g slows (denominator increases), then P/E decreases. This is known as
dividend displacement of earnings.
• P/E is inversely related to the required rate of return.

Example
Between 2008 and 2012, a company’s dividend payout ratio has been 40% on average. In
2008, the dividend was $1.00 and has grown steadily to $1.8 for 2012. This growth rate is
expected to continue in the future. Using a discount rate of 20%, estimate the company’s
justified forward P/E.
Solution:
P Payout ratio
=
E1 r − g
The growth rate is not given. So calculate g with the information given about dividends. The
growth rate is expected to continue; so it will be the long-term constant growth rate.
1
1.8 4
g = ( ) − 1 = 0.16
1
P 0.4
= = 10
E1 0.2 − 0.16
5.2. The Method of Comparables
This method compares relative values estimated using multiples. The objective is to
determine if a stock or asset is fairly valued, undervalued or overvalued relative to the
benchmark value of the multiple. For example, if the average P/B value for private sector
banks is 1.1, and the P/B for the bank under consideration is 0.65, then it is relatively
undervalued, all else equal. This method is based on the principle that similar assets should
be priced the same: the law of one price.
For example, assume that there are two companies the data for which is given below:
Company A Company B
P 100 50
E1 10 6
P/E 10 8.3
On a relative value basis, company B is a better buy.
Primary difference between P/E multiples based on comparables and P/E multiples based
on fundamentals:
• P/E multiple based on comparables use the law of one price. For example, if the
trailing P/E of Caterpillar is 13.2, Komatsu is 15.5 and Deere is 9.6. Which one of
these is undervalued? Given this data, Deere is undervalued relative to the other
stocks.
• P/E multiple based on fundamentals is calculated as payout ratio/(r - g). With this
method we only need information about a target company.

5.3. Illustration of a Valuation Based on Price Multiples

In this section, we will see through examples how price multiples is used in cross-sectional
analysis, time-series analysis and in valuing a private company.
Example
The table below presents the current P/E ratio of a few automobile companies.
Company P/E
Volkswagen 12.01
Ferrari 24.57
Lamborghini 13.42
Pagani 14.1
Solution:
This is a cross-sectional analysis as different companies are compared at a specific point in
time. According to the data, Volkswagen is the most undervalued as it has the lowest P/E.
For every $ of earnings, we are paying $12.01. It must be noted that several other factors in
conjunction with relative value analysis must be performed before making a buy decision.
Share prices plunge if a company is on the verge of bankruptcy.
Example
The table below computes the P/E ratio for Nikon over a five period 2012 - 2016. Determine
if the stock is overvalued or undervalued relative to historic levels?
Year Price (in $) EPS P/E = Price/EPS
2012 17.52 1.71 10.25
2013 29.19 1.42 20.56
2014 35.7 1.2 29.75
2015 7.55 0.61 12.38
2016 5.42 0.48 11.3
Solution:
This is a time series analysis. The 2012 P/E level for Nikon indicates it is undervalued
relative to the historic high of 29.75 in 2014. Analysts may recommend buying the stock if it
were to return to the historic high levels provided the increase in P/E is not due to a
decrease in EPS, which is not the case here. Other fundamental factors should also be
considered such as is slowing revenues, the growing popularity of alternative cameras and
smartphones affecting Nikon’s business, slowing economy etc.
5.4. Enterprise Value
Enterprise value is used as an alternate measure for equity; it measures the market value of
the whole company (debt and equity).
Enterprise value = market value of debt + market value of equity + market value of

preferred stock – cash and investments

EV = MVE + MVD + MVP – cash and cash equivalents
Note: use estimates if market values are not available
The most commonly used EV multiple is EV/EBITDA. EBITDA is earnings before interest,
taxes, depreciation and amortization. It is a proxy for cash flow, or how much cash the
company is generating. However, it may include other non-cash expenses and revenues.
When is EV/EBITDA used?
• When earnings are negative making P/E useless. EBITDA is usually positive.
• For comparing companies with significant differences in capital structure.
• To evaluate the cost of a takeover.
A major limitation of the enterprise value model is that it is difficult to obtain the market
value of debt.
Example
The EV/EBITDA ratio for a company is 10. EBITDA is 20 million. Market value of debt is 50
million. Cash is 2 million. What is the value of equity?
Solution:
EV MVD + MVE – Cash
=
EBITDA EBITDA
50 + MVE − 2
10 =
20
MVE = 152 million
6. Asset-Based Valuation
An asset-based valuation of a company uses the estimates of the market or the fair value of
the company’s assets and liabilities. This valuation method is appropriate for companies that
have low proportion of intangible or off-the-books assets. It is commonly used for valuing
private enterprises.
Other factors to consider:
• Book values may be very different from market values.
• Some intangible assets are not reported; asset-based value could be considered a
'floor' value.
• Asset values are hard to estimate in a hyper-inflationary environment.
Some examples when this method is not appropriate:
• A hugely popular restaurant in a rented space. The restaurant is popular because of
the proprietor’s cooking skills and secret recipes. The proprietor would like to sell the
business and retire. This method is not appropriate as setting a value for the

proprietor’s cooking skills is challenging. Only the restaurant’s equipment, inventory

and furniture can be valued.
• In the case of a laundry business, the equipment and inventory can be valued at
depreciated value or at replacement cost. But intangibles such as convenience due to
location, clever marketing etc. cannot be assigned a value.
The tables below list the pros and cons of the different valuation models we have seen so far.
Comparables Valuation Using Multiples
Advantages Disadvantages
Good predictor of future returns. Lagging numbers tell about past.
Widely used. Not always comparable across firms.
Easily available. Impacted by economic conditions.
Time-series comparison. Might conflict with fundamental method.
Cross-sectional comparison. Sensitive to different accounting methods.
Allows us to identify relatively underpriced
Negative denominator.
securities.
DCF
Based on PV of future cash flows. Inputs have to be estimated.
Widely accepted and used. Estimates sensitive to inputs.
Asset-Based Model
Floor values. Market values hard to determine.
Works when assets have easily Market values often different from book
determinable market values. values.
Works well for companies that report fair Do not account for intangible assets.
values.
Asset values hard to determine during
hyperinflation.

Summary
LO.a: Evaluate whether a security, given its current market price and a value estimate,
is overvalued, fairly valued, or undervalued by the market.
Market value > Intrinsic value - Overvalued
Market value = Intrinsic value - Fairly valued
Market value < Intrinsic value - Undervalued
Factors to consider when market value ≠ intrinsic value:
• Percentage difference between the market price and intrinsic value.
• Confidence in your model.
• Model sensitivity to assumptions.
• Number of analysts.
LO.b: Describe major categories of equity valuation models.
Type of Model Characteristics
Present Value Models • Estimate intrinsic value as the present value of expected
future benefits.
• Future benefits defined as cash to be paid to shareholders,
or cash flows available to be distributed to shareholders.
• Ex: Gordon growth model, two-stage dividend discount
model, free cashflow to equity model.
Multiplier Models, • Based on share price multiples or enterprise value
also known as market multiples.
multiple models • Share price multiple model estimates intrinsic value
based on a multiple of some fundamental variable such as
revenues, earnings, cash flows or book value.
• Ex: P/E, P/S
• Enterprise value multiple models are of the form:
enterprise value/some fundamental variable. Here, the
fundamental variable is usually EBITDA or revenue.
Asset Based Models • Estimate intrinsic value based on the estimated value of
assets and liabilities.
LO.c Describe regular cash dividends, extra dividends, stock dividends, stock splits,
reverse stock splits, and share repurchases
Cash dividends are payments made to shareholders in cash. The three types of cash
dividends are:
1. Regular cash dividends are paid out on a consistent basis. Stable or increasing
dividend is viewed as a sign of financial stability.
2. Special dividends are one-time cash payments when the situations are favorable (also

called as extra dividends or irregular dividends; used by cyclical firms).

3. Liquidating dividend is distributed to shareholders when a company goes out of
business.
Stock dividends are payments made to shareholders in additional shares instead of cash.
Stock Splits divides each existing share into multiple shares.
Reverse stock splits are the opposite of stock splits and decreases the total number of
outstanding shares.
Share repurchase is when a company buys back its own outstanding shares using cash.
LO.d: Describe dividend payment chronology
Dividend payment schedule is as follows:
1. Declaration date: Board of directors approves dividend.
2. Ex-dividend date: Cutoff date on or after which buyers of a stock are not eligible to
the dividend. It is also the first date when the stock trades without dividend.
3. Holder-of-record date: An entry of shareholders eligible for the dividend is made
(usually two days after the ex-dividend date).
4. Payment date: Dividend payment made to the shareholders.
LO.e: Explain the rationale for using present value models to value equity and
describe the dividend discount and free-cash-flow-to-equity models.
This model is based on the principle that the value of an asset should be equal to the present
value of the expected future benefits. The simplest present value model is the dividend
discount model (DDM).
According to DDM, the intrinsic value of a stock is the present value of future dividends, plus
the present value of terminal value. It can be calculated using the formula:
n Dt Pn
V0 = ∑. t
+
t=1 (1 + r) (1 + r)n
Free cash flow to equity (FCFE) is the residual cash flow available to be distributed as
dividend to common shareholders. FCFE model is used because it is a measure of a firm’s
dividend-paying capacity and can be used for stocks with small dividends or no dividend.
FCFE = CFO - FCInv + Net borrowing
∞FCFE t
V0 = ∑. ∗ ( )
t=1 (1 + r)t
Required return on share = risk free rate + Betai [market risk premium]

LO.f: Calculate the intrinsic value of a non-callable, non-convertible preferred stock.

D
V=
r
where:
V = present value of the perpetuity
D = dividend and r = rate of return
LO.g: Calculate and interpret the intrinsic value of an equity security based on the
Gordon (constant) growth dividend discount model or a two stage dividend discount
model, as appropriate.
The Gordon growth model assumes that dividends grow indefinitely at a constant rate; it is
also called as the constant-growth dividend discount model.
D
V0 = r −1g
where: g = retention rate * ROE

For a multi staged dividend discount model:
n D0 (1 + g s )t Vn
V0 = ∑. t
+
t=1 (1 + r) (1 + r)n
The first term is discounting the dividends during the high growth period. The second term
is calculating the terminal value for the second sustainable growth period and then
discounting it to the present value.
LO.h: Identify characteristics of companies for which the constant growth or a
multistage dividend discount model is appropriate.
The constant growth model is appropriate for companies that pay dividends growing at a
constant rate. These are usually mature and stable firms (e.g. producer of a staple food
product).
A two-stage DDM can be used to calculate the value of companies transitioning from growth
to mature stage.
A three stage model is used for companies that go through three stages beyond the startup
phase: growth, transition and maturity.
LO.i: Explain the rationale for using price multiples to value equity and distinguish
between multiples based on comparables versus multiples based on fundamentals.
Price multiple is a ratio that uses a company’s share price with some monetary flow/value
for evaluating the relative worth of a company’s stock.
Method of comparables compares relative values estimated using multiples. The objective is
to determine if a stock or asset is fairly valued, undervalued or overvalued relative to the

benchmark value of the multiple. It is based on the law of one price.

Price multiple can be linked to fundamentals through a discounted cash flow model such as
Gordon Growth Model by assuming that intrinsic value of a security is equal to its market
price i.e. the security is fairly valued.
D1
E1 dividend payout ratio
Forward P/E = P0 /E1 = =
r−g r−g
LO.j: Calculate and interpret the following multiples: price to earnings, price to an
estimate of operating cash flow, price to sales, and price to book value.
Price-to-earnings ratio (P/E):
price per share
Trailing P/E =
trailing 12 month earnings per share
stock price
Forward P/E =
leading 12 month earnings per share
price per share
Price − to − book ratio P/B =
book value per share
price per share
Price − to − sales ratio P/S =
sales per share
price per share
Price − to − cashflow ratio P/CF =
cash flow per share
LO.k: Describe enterprise value multiples and their use in estimating equity value.
Enterprise value is used as an alternate measure for equity; it measures the market value of
the whole company (debt and equity).
Enterprise value = market value of debt + market value of equity + market value of
preferred stock – cash and investments
The most commonly used EV multiple is EV/EBITDA. It is used in the following situations:
• When earnings are negative making P/E useless.
• For comparing companies with significant differences in capital structure.
• To evaluate the cost of a takeover.
LO.l: Describe asset-based valuation models and their use in estimating equity value.
An asset-based valuation of a company uses the estimates of the market or the fair value of
the company’s assets and liabilities. This valuation method is appropriate for companies that
have low proportion of intangible or off-the-books assets. It is commonly used for valuing
private enterprises.

LO.m: Explain advantages and disadvantages of each category of valuation model.

Comparables Valuation Using Multiples
Good predictor of future returns. Lagging numbers tell about past.
Widely used. Not always comparable across firms.
Easily available. Impacted by economic conditions.
Might conflict with fundamental
Time-series comparison.
method.
Sensitive to different accounting
Cross-sectional comparison.
methods.
Allows us to identify relatively underpriced
Negative denominator.
securities.
DCF
Based on PV of future cash flows. Inputs have to be estimated.
Widely accepted and used. Estimates sensitive to inputs.
Asset-Based Model
Floor values. Market values hard to determine.
Works when assets have easily determinable Market values often different from
market values. book values.
Works well for companies that report fair
Does not account for intangible assets.
values.
Asset values hard to determine during
hyperinflation.

Practice Questions
1. An analyst determines the intrinsic value of a stock to be equal to $30. The current
market price of the stock is $35. This stock is most likely:
A. undervalued.
B. overvalued.
C. fairly valued.
2. An investor expects a share to pay dividends of $1 and $2 at the end of Years 1 and 2,
respectively. At the end of the second year, the investor expects the share to trade at $20.
If the required rate of return is 10%, then according to the dividend discount model, the
intrinsic value of the stock today is closest to:
A. $18.
B. $19.
C. $20.
3. A company has an issue of 5%, $50 par value, perpetual, non-convertible, non-callable
preferred shares outstanding. The required rate of return on similar issues is 4%. The
intrinsic value of a preferred share is closest to:
A. $44.5.
B. $50.0.
C. $62.5.
4. Which of the following assumptions is required by the Gordon growth model?

A. Constant growth rate > Required rate of return.
B. Constant growth rate < Required rate of return.
C. Constant growth rate = Required rate of return.
5. Bright industries has just paid a dividend of $5 per share. If the required rate of return is
10% per year and the dividends are expected to grow indefinitely at a constant growth
rate of 8% per year, the intrinsic value of Bright industries stock is closest to:
A. $250.
B. $270.
C. $300.
6. An analyst has gathered the following data for a company:

Return on equity 15%
Dividend payout ratio 30%
Required rate of return on shares 20%
Current year’s dividend per share $2
Using the Gordon growth model, the intrinsic value per share is closest to:

A. $20.48.
B. $21.75.
C. $23.26.
7. The constant growth model can be used to value dividend-paying companies that are:
A. expected to grow very fast.
B. in a mature phase of growth.
C. very sensitive to the business cycle.
8. Assume that a stock is expected to pay dividends at the end of Year 1 and Year 2 of $2
and $3, respectively. Dividends are expected to grow at 5% rate thereafter. If the
required rate of return is 10%, the value of the stock is closest to:
A. $56.36.
B. $58.45.
C. $60.24.
9. A firm has an expected dividend payout ratio of 40% and an expected future growth rate
of 8%. What should the firm’s fundamental price-to-earnings ratio be if the required rate
of return on similar stocks is 12%?
A. 6x.
B. 8x.
C. 10x.
10. An analyst has determined that the appropriate EV/EBITDA for a company is 10. The
analyst has also collected the following information about the company:
EBITDA = $20 million
Market value of debt = $60 million
Cash = $1 million
The value of equity for the company is closest to:
A. 139 million.
B. 141 million.
C. 145 million.
11. An asset-based valuation model would be best suited for a:

A. privately held company.
B. company with relatively high level of intangible assets.
C. company where the market value of assets and liabilities are different from the
balance sheet values.

Solutions
1. B is correct. The market price is more than the estimated intrinsic value, hence the stock
is overvalued.
2. B is correct. CF0 = 0, CF1 = $1, CF2 = $2+$20, I/Y = 10%; CPT → NPV = $19
3. C is correct. The expected annual dividend is 5% x $50 = $2.50. The value of a preferred
share is $2.5 / 0.04 = $62.5.
4. B is correct. For the Gordon growth model, the constant growth rate must be less than
the required rate of return.
D1
P0 =
k−g
5. B is correct.
D1 $5(1.08)
P0 = = = $270
k − g 0.1 − 0.08
6. C is correct. g = b x ROE; b = earnings retention rate = (1 – Dividend payout ratio)

D1 = D0 (1 + g); V0 = D1 / (r – g)
b = 1 – 0.30 = 0.70; g = 0.70 x 15 = 10.5%;
D1 = 2 (1.105) = $2.21;
V0 = 2.21 / (0.2 – 0.105) = $23.26
7. B is correct. The Gordon growth model (also known as the constant growth model) can
be used to value dividend-paying companies in a mature phase of growth because one of
the assumptions of this model is that we need stable dividend growth rates. This
assumption would be violated in options A and C.
8. A is correct. Using a two stage model, we get:

($2/1.1) + ($3/(0.1-0.05)/1.1 = $56.36
9. C is correct. The P/E ratio based on fundamentals is calculated as:

𝑃0 𝐷1 /𝐸1 0.4
= = = 10𝑥
𝐸1 𝑘 − 𝑔 0.12 − 0.08
10. B is correct.
EV = 10 x 20 million = 200 million.
Equity value = EV – Debt + Cash = 200 million – 60 million + 1 million = 141 million.

11. A is correct. Asset-based valuations are most often used when an analyst is valuing
private enterprises. Both options B and C are examples of companies where the asset-
based valuation model should not be used.

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© IFT. All rights reserved

R33 Corporate Governance and ESG - An Introduction ............................................................6

R34 Capital Budgeting ....................................................................................................................... 29

R35 Cost of Capital .............................................................................................................................. 48

© IFT. All rights reserved 1

R37 Working Capital Management ............................................................................................... 83

R38 Portfolio Management Overview....................................................................................... 102

R40 Portfolio Risk and Return Part II ....................................................................................... 142

© IFT. All rights reserved 2

2. Capital Market Theory......................................................................................................................... 142

R41 Basics of Portfolio Planning and Construction ............................................................. 169

R42 Risk Management - An Introduction ................................................................................ 183

R43 Fintech in Investment Management ................................................................................. 196

R44 Market Organization and Structure ................................................................................. 212

© IFT. All rights reserved 3

2. The Functions of the Financial System.......................................................................................... 212

R45 Security Market Indexes ....................................................................................................... 241

R46 Market Efficiency .................................................................................................................... 261

R47 Overview of Equity Securities ............................................................................................. 271

© IFT. All rights reserved 4

3. Types and Characteristics of Equity Securities ......................................................................... 271

R48 Introduction to Industry and Company Analysis ......................................................... 284

R49 Equity Valuation ...................................................................................................................... 307

© IFT. All rights reserved 5

R33 Corporate Governance and ESG - An Introduction

2. Corporate Governance Overview

© IFT. All rights reserved 6

There are two types of shareholders in a company:

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© IFT. All rights reserved 8

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withheld by the management or only selective information is passed.

© IFT. All rights reserved 10

• Governmental infrastructure: This refers to the regulations imposed on companies.

© IFT. All rights reserved 11

© IFT. All rights reserved 12

5. Board of Directors and Committees

© IFT. All rights reserved 13

© IFT. All rights reserved 14

• Set performance criteria for managers and evaluate their performance.

6. Factors Affecting Stakeholder Relationships and Corporate Governance

© IFT. All rights reserved 15

The commonly used methods for corporate takeovers are as follows:

© IFT. All rights reserved 16

7. Corporate Governance and Stakeholder Management Risks and

© IFT. All rights reserved 17

company have a clear understanding of their responsibilities and reporting

8. Analyst Considerations in Corporate Governance and Stakeholder

© IFT. All rights reserved 18

© IFT. All rights reserved 19

9. ESG Considerations for Investors

© IFT. All rights reserved 20

• Negative screening: This is the practice of avoiding certain sectors or companies

© IFT. All rights reserved 21

© IFT. All rights reserved 22

LO.e: Describe mechanisms to manage stakeholder relationships and mitigate

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include economic ownership and voting control, board of directors representation,

© IFT. All rights reserved 24

4. Which of the following is not a stakeholder management infrastructure?