L2 FinQuiz Smart Summary 2019

2019, Study Session # 1, Reading # 1
“CODE OF ETHICS AND STANDARDS OF PROFESSIONAL CONDUCT”
Los1.a
M&C = Members & Candidates CFAI PCP ⇒ covered by CFAI Bylaws & Rules of Procedures for Proceeding CFAI = CFA Institute
COE = Code of Ethics Related to Professional Conduct. PCP = Professional Conduct
SOPC = Standards of PCP is based on principles of fairness to M&C & confidentiality of Program
Professional conduct proceedings. DRC = Disciplinary Review
BOG=Board of Governors DRC of CFAI BOG ⇒ responsible for PCP & enforcement of code & standards. Committee
PDP=Professional Development PCS = Professional Conduct
Program Statement
Circumstances Which Can Prompt Inquiry
Self disclosure by member/candidate on PCS which

comprehensively questions professional conduct such as
involvement in civil litigation, criminal investigation or any complaint
(written) against the member/candidate etc.
Written complaints about member/staff received by professional conduct

staff.
Evidence of misconduct by member/candidate received by professional
conduct staff through public source.
A report by CFA proctor of a possible violation during examinations.
CFAI designated officer conducts inquiries.
Professional conduct staff (in writing) may request explanation from subject
member/candidate & may:
Interview the subject member/candidate.
Interview the complainant / third party.
Collect relevant document & records.
Designated officer may decide:
Disciplinary sanctions are not required.
Issue a cautionary letter.
To discipline the member/candidate.
If disciplinary sanction is proposed, the subject member/candidate may
accept the sanction.
If sanction is rejected ⇒ matter may be referred to CFAI panel for hearing.
Sanctions may include.
Condemnation by member’s peers.
Suspension of candidate’s continued participation in CFAI program.
Los1.b
Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients,
employers, employees, colleagues’ in the investment profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients above their own personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment
recommendations, taking investment actions, and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the
profession.
Promote the integrity of and uphold the rules governing capital markets.
Maintain and improve their professional competence and strive to maintain and improve the competence of other investment
professionals.
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Standards of Professional Conduct
1. Professionalism 2. Integrity of Capital Markets 3. Duties to Clients 4. Duties to Employers 5. Investment Analysis,
Recommendations & Actions
6. Conflicts of Interest 7. Responsibilities as a CFAI Member or CFAI Candidate
Los1.c 1. Professionalism
A. Knowledge of Law B. Independence & Objectivity C. Misrepresentation D. Misconduct
2. Integrity of Capital Markets
A. Material Non-Public Information B. Market Manipulation
3. Duties to Clients
A. Loyalty, B. Fair Dealing C. Suitability D. Performance E. Preservation of

Prudence, and Care Presentation Confidentiality
4. Duties to Employers
A. Loyalty B. Additional Compensation C. Responsibility of

Arrangements Supervisors
5. Investment Analysis, Recommendations & Actions
A. Diligence & Reasonable B. Communication with C. Record Retention

Basis Clients & prospective
Clients
6. Conflicts of Interest
A. Disclosure of conflicts B. Priority of Transactions C. Referral Fees
7. Responsibilities as a CFAI Member or CFAI Candidate
A. Conduct as Members and Candidates in B. Reference to CFA Institute, the CFA

the CFA Program Designation, and the CFA Program

“GUIDANCE FOR STANDARDS I-VII”

M&C = Members & CFAI = CFA Institute
Candidates 1. Professionalism PCP = Professional
COE = Code of Ethics Conduct Program
SOPC = Standards of 1 A. Knowledge of Law DRC = Disciplinary
Professional conduct Review Committee
BOG=Board of M&C must understand & comply with all applicable laws, rules & regulations (including COE & SOPC). PCS = Professional
Governors These rules & regulations pertain to any govt., regulatory organization, licensing agency or professional Conduct Statement
PDP=Professional association governing their professional activities.
Development Must comply with more strict law in case of conflict.
Program M&C must not knowingly participate or assist & must dissociate from any violation of laws.
Guidance ⇒ Code & Standards VS Local Law
Members must know laws & regulations related to their professional activity in all countries
where they conduct business.
Adhere to more strict rule while deciding b/w local laws & Codes & Standards of CFAI.
Must comply with local laws related to professional activity.
Never violate Codes & Standards even if activity is otherwise legal.
Guidance ⇒ Participation in or Association with Violation by Others
Members must dissociate or separate themselves from any ongoing client or employee
activity which is illegal or unethical.
In extreme case they may have to leave the employer.
May, at first, confront the individual involved.
Approach supervisor or compliance department.
Inaction with continued association may be construed as knowing participation.
Recommended Procedures for Compliance-Members
Members must make themselves updated with applicable laws, rules & regulations.
Compliance laws must be reviewed on an ongoing basis in order to ensure that they address
prevailing laws, CFAI standards & regulations.
Members should maintain current reference material for employees in order to keep up-to-
date on laws, rules & regulations.
In doubt members should seek advice of counsel or their compliance department.
Members must document any violation when they disassociate from prohibited activity.
Members must encourage their employers to end such activity.
Under some circumstances it may be advisable or otherwise required by the law to report
violations to governmental authorities.
Standards (CFAI) do not require members to report violations to governmental authorities.
CFAI encourages members, clients & public to submit written report against a CFA member
or candidate involved in violation of the CFA Code & Standards
Recommended Procedure for Compliance-Firms
Members should encourage their firms to:

Develop and/or adopt a code of ethics.
Highlight applicable laws and regulations to employees.
Establish written procedures for reporting suspected violation of laws, regulations or company
policies.
Members incharge of supervision, creation and maintenance of investment services should:
Be aware of and comply with regulations and laws in their country of origin.
They must be aware of and comply with regulations of countries where products/services will be
sold.

1 B. Independence & Objectivity
M&C must use reasonable care & judgment to achieve & maintain independence &
objectivity in professional activities.
Not accept any gift, or any type of consideration that may compromise their own or
another’s independence & objectivity.
Guidance
Investment process must not be influenced by any external sources.

Modest gifts by clients are permitted.
Allocation of shares in oversubscribed IPO to personal accounts is not permitted.
Distinguish b/w gifts from clients & entities seeking influence to the detriment of the client.
Gifts must be disclosed to the member’s employer either prior to acceptance or
subsequently.
Guidance-Investment Banking Relationships
Do not get pressurized from sell-side analyst to issue favorable research on current or
prospective investment-banking client.
Disclose conflicts and manage these appropriately while working with investment bankers
in “road shows”.
Ensure effective “firewalls” b/w research/investment management & investment banking
activities.
Guidance-Public Companies
Do not limit research to discussions with company management.

Use sources like:
Suppliers
Customers
Competitors
Analyst must not be pressured to issue favorable research by the companies they follow.
Guidance-Buy Side Clients
Responsibility of portfolio managers to respect and foster intellectual honesty of sell side
research.
Portfolio managers must not pressure sell side analysts.
They may have large positions in particular securities; rating downgrade may
adversely affect portfolio performance.
Guidance-Fund Manager Relationships
Members responsible for selecting outside managers should not accept gifts,
entertainment or travel that might be perceived to impair member’s independence and/or
objectivity.
Guidance-Credit Rating Agency
Members employed by credit rating agencies make sure they prevent undue influence by
security issuing firms.
Members using credit ratings must be aware of potential conflicts of interest & therefore
may consider independent validation of the rating granted.

Guidance-Issuer Paid Research
Analyst’s compensation for such researches should be limited.

Preference is flat fee.
No reward must be attached with report’s recommendation.
Guidance-Travel
Best practice ⇒ analysts should pay for their own commercial travel while
attending information events or tours sponsored by the firm being analyzed.
Recommended Procedures for Compliance
Protect the integrity of opinions (unbiased opinion of the analyst) & design proper compensation systems.
Create a restricted list (remove the controversial company from research universe).
Restrict special cost arrangements (limit the use of corporate aircraft to situations in which commercial
transportation is not available).
M&C should pay for commercial transportations & hotel charges.
Limit the acceptance of gratuities and/or gifts to token items only.
Develop formal policies related to employee purchases of equity or equity related IPOs (strict limits on private
placements).
Effective supervisory & review procedures.
Ensure that research analysts are not supervised or controlled by any department that could compromise the
independence of analyst.
Appoint a senior officer with oversight responsibilities for compliance with firm’s COE & all regulations
concerning its business.
1 C. Misrepresentation
M&C must not knowingly make any misrepresentations relating to investment

analysis, recommendation, actions or other professional activities.
Guidance
Misrepresentation causes mistrust.

Don’t give false impressions in oral, written & electronic communication.
Misrepresentation includes.
Guaranteeing investment performance.
Plagiarism.
Plagiarism ⇒ using someone else’s work without giving him credit.
Misrepresentation also includes deliberately omitting information that could
affect investment decision.
Models and analysis developed by others at firm are the property of firm-
members can use them.
A report written by another analyst employed by the firm cannot be released as
another analyst’s work.
Recommended Procedure for Compliance
Firms should provide employees who deal with clients a written list of firm’s
available services and its qualifications.
Employee qualification should be accurately presented as well.
To avoid plagiarism firm must keep record of all sources and cite them.
Generally understood and factual information need not to be cited.
Members should encourage firms to establish procedures for verifying
marketing claims of third parties whose information the firm provides to
clients.

1 D. Misconduct
M&C must not engage in dishonesty, fraud, deceit or commit any act that reflects adversely on
their professional reputations, integrity or competence.
Guidance
CFAI discourages unethical behavior in all aspects of members’ and candidates’

professional lives.
Do not abuse CFAI PCP by seeking enforcement of this standard to settle personal,
political or other disputes not related to professional ethics.
Firms are encouraged to adopt these policies and procedures to:

Develop and adopt a code of ethics and make clear that unethical behavior will
not be tolerated.
Give employees a list of potential violations and sanctions including dismissal.
Check references of potential employees.
2. INTEGRITY OF CAPITAL MARKETS
2 A. Material Nonpublic Information
M&C must not act or cause others to act on the

information that is material nonpublic (affect the value of
investments).
Guidance
Material information ⇒ if disclosure would impact price of security.

If reasonable investor would want the information before making an investment decision.
Nonpublic information ⇒ not available to the marketplace.
Analyst conference call is not public disclosure.
Selective disclosing causes insider-trading.
Prohibition against acting on material nonpublic information extends to securities, swaps, and option contracts.
Guidance-Mosaic Theory
No prohibition on reaching an investment decision through public and nonmaterial

nonpublic information.
Make reasonable efforts to achieve public dissemination of information.

Encourage firms to adopt procedures to prevent misuse of material nonpublic information.
Use a “firewall” within the firm with
Substantial control of relevant interdepartmental communication  through a clearance like compliance/legal
department.
Review employee trades  maintain watch, rumor, and restricted lists.
Monitor & prohibit proprietary trading-if a firm is in possession of material non-public information.
Prohibiting all proprietary trading may send a signal to the market  firm should take the contra side of only
unsolicited customer trades.

2 B. MARKET MANIPULATIONS
M&C must not engage in practices that mislead

market participants (distort prices or artificially
inflate trading volume).
Guidance
Spreading false rumors is prohibited (which can distort market).

Standard applies to transactions that deceive market.
By distorting the price-setting mechanism of financial investments.
Securing a controlling position in a financial instrument to manipulate the price
of a related derivative or the asset.
3. DUTIES TO CLIENTS
3 A. Loyalty, Prudence & Care
M&C:
Have a duty of loyalty to clients & must act with reasonable care & exercise prudent judgment.
Must act for benefit of clients & place their clients’ interests before their employer’s or own interests.
Guidance
M&C must exercise same level of prudence, judgment & care as in management & disposition of their own interests in similar
circumstances.
M&C should manage pool of assets in accordance with the terms of governing documents (e.g. trust documents).
Determine the identity of “client’” to whom duty of loyalty is owed. (May be an individual or plan beneficiaries in case of
pension plan or trust).
M&C must follow any guidelines set by their clients for the management of their assets.
Investment decisions are judged in context of total portfolio rather than individual investments.
Conflict arises when “soft dollars” are not used for benefits of clients.
Cost-benefit analysis may show that voting all proxies may be not a beneficial strategy for clients.
Recommended Procedures of Compliance
M&C with control of client assets should submit to each client at least quarterly, a statement showing funds & securities.
In doubt, M&C should disclose the questionable matter in writing to client & obtain client approval.
M&C should address & encourage their firms to address the following regarding duties to client;
Follow all applicable rules & laws.
Establish the investment objectives of the clients.
Consider all the information when taking actions.
Diversify investments to reduce risk of loss.
Carry out regular reviews.
Deal fairly with all clients with respect to investment actions.
Disclose conflict of interest & compensation arrangements.
Maintain confidentiality & seek best execution.

3 B. Fair Dealing
M&C must deal fairly & objectively with clients (when providing investment analysis,
making recommendations, taking action or engaging in other professional activities).
Guidance
No discrimination among clients while disseminating recommendations or taking investment

decision.
Fairly does not mean equally ⇒ difference in timings of emails & fax received by clients are
normal course of business.
Different services levels are okay as far as they do not adversely affect any client.
Disclose different levels of services to all clients and prospects.
Premium services should be available to all those who are willing to pay for them.
Guidance-Investment Recommendation
All clients must be given fair opportunity to act upon every recommendation.
Clients unaware of change in recommendation  should be advised before the order is accepted.
Guidance-Investment Actions
Clients must be treated fairly in the light of their investment objectives and circumstances.
Both institutional and individual clients must be treated in a fair & impartial manner.
Member/candidates should not take advantage of their position to disadvantage clients
(e.g., in IPOs).
Firms are encouraged to establish compliance procedures to treat customers & clients fairly.
Communicate recommendations simultaneously within the firm & to customers.
M&C should consider the following:
Limit the no. of people who are aware that a recommendation is going to be disseminated.
Shorten the time frame b/w decision & dissemination.
Publish guidelines for pre-dissemination behavior.
Simultaneous dissemination (treat all clients fairly).
Maintain a list of clients & their holdings.
Develop & document trade allocation procedures.
Disclose trade allocation procedures (must be fair & equitable).
Establish systematic account review (no preferential treatment to any client or customer).
Disclose level of services (different levels of services are possible for same or different fees).
3 C. SUITABILITY
2. M&C are in advisory relationship 1. When M&C are responsible for a portfolio
with a specific mandate, strategy or style,
they must take actions according to stated
Make inquiry into Determine Judge investment objectives & constraints of portfolio.
client’s investment investment’s suitability in
experience, risk & suitability with context of client’s
return objectives, reference to total portfolio.
financial client’s objective &
constraints & constraints &
reassess & update mandate.
this information
regularly.

Guidance
Develop IPS at beginning of the relationship.

Consider client’s needs, circumstances & risk tolerance.
Consider whether use of leverage is suitable for the client or not.
Make sure to abide by the stated mandate.
Develop written IPS of each client & take the following into consideration:
Client identification.
Investor objectives.
Investor constraints.
Performance measurement benchmark
Objectives & constraints should be maintained & reviewed periodically to reflect any changes in
clients’ circumstances.
Suitability test policies.
3 D. Performance Presentations
M&C must communicate fair, accurate & complete investment performance information.
Guidance
Members must avoid misstating performance or misleading clients about investment performance
of themselves or their firms.
Members should not misrepresent past performance or reasonably expected performance.
Members should not state or imply the ability to achieve a rate of return similar to that achieved in
the past.
Brief presentations should be supplemented with information that detailed report is available on
request.
Apply GIPS standards.

Consider the knowledge of audience to whom performance presentation is addressed.
Performance of composite rather single account.
Include performance history of terminated accounts.
Disclosures that fully explain the performance results being reported.
Maintain data & records used to calculate the performance being presented.
3 E. Preservation of Confidentiality
M&C must keep information about current, former &

prospective clients confidential unless:
Information concerns illegal activity.
Disclosure is required by law.
Client or prospective client permits disclosure.

Guidance
If a client is involved in illegal activities  members may have an

obligation to report to the authorities.
This standard extends to former clients as well.
Standards do not prevent members from cooperating with CFA PCP
investigation.
Avoid disclosing information received from client except to authorized

colleagues working for the same client.
Follow firm’s procedures for storing electronic data.
Recommend adoption of such procedures if they are not in place.
4. Duties to Employers
A. Loyalty
M&C:
Must act for the benefit of their employer.
Not deprive employer of the advantage of their skills &abilities, divulge confidential
information or otherwise cause harm to their employer.
Guidance
Do not indulge in the activities that may injure the firm  deprive it of profit or
advantage of employee’s abilities & skills.
Though client’s interests are priority than firm’s but one should consider the effects
of conduct on firm’s integrity and sustainability.
A careful balance b/w managing interests of employer & family  manage such
obligations with work obligations.
Guidance-Employer Responsibility
Should not have incentive or compensation system that encourages unethical

behavior.
Members are encouraged to give their employers a copy of Code & Standards.
Guidance-Independent Practice
Independent practice for compensation is allowed.

Provide employer notification fully describing all aspects of service.
Compensation details
Duration
Nature of activities
Employer’s consent is required.

Guidance-Leaving an Employer
Continue to act in employer’s best interest until resignation is effective.

Activities that may constitute a violation include:
Misappropriation of trade secrets
Misuse of confidential information
Soliciting employer’s client prior to leaving
Self-dealing
Misappropriation of client lists.
Employer records on home computers, PDA, cell phones or any other medium
are property of firm.
After leaving the organization, simple knowledge of names and existence of
former clients is not confidential.
Member/candidate can use the experience or knowledge gained with former
employer at any other organization.
Guidance Whistle-blowing
In exceptional cases, duty to the employer may be violated in order to protect

a client or upholding the integrity of capital markets.
Whistle- blowing cannot be done for personal gains.
Guidance-Nature of Employment
If members/candidates are independent contractors, they still have duty to abide

by the terms of the agreement.
Recommended Procedures for compliance
Competition policy (employer restrictions on offering similar services outside

the firm).
Termination policy (how termination is disclosed to clients & staff).
Incident-reporting procedures.
Employee classification (e.g. full time, part time).
4 B. Additional Compensation Arrangements
M&C must not accept gifts, benefits, compensation, or consideration that competes
with or might reasonably be expected to create a conflict of interest with their
employer’s interest unless they obtain written consent from all parties involved.
Guidance
Compensation includes both direct & indirect form.

Additional benefits are also included.
Written consent from employer also includes email communication.
Immediately report to employer in written form detailing any

proposed compensation and services.
Performance incentives should be verified by the offering party.

4 C. Responsibility of Supervisors
M&C must make efforts to detect & prevent violations of applicable

laws, rules & regulations and Code & Standards by any one subject to
their supervision or authority.
Guidance
Members must take steps to prevent subordinates from violating

laws, rules, regulations or code & standards.
Make reasonable efforts to detect violations.
Members with supervisory responsibility must ensure that policies
regarding investment or non-investment behavior are enforced
equally.
Guidance-Compliance Procedures
Members with supervisory responsibility must bring an inadequate

compliance system to the firm’s attention and recommend
corrective action.
While investigating a violation it is appropriate to limit suspected
employee’s activities.
Unless adequate procedures are adopted by the firm, a member
must decline in writing from accepting supervisory responsibility.
M&C should recommend to their employers to adopt a COE.

Separate the COE from compliance procedures.
Adequate compliance procedures:
Clearly written & accessible manual.
Designate a compliance officer to implement compliance procedures.
Implement system of checks & balances.
Describe the hierarchy of supervision.
Outline scope of procedures & permissible conduct.
Once a compliance program is in place, a supervisor should:
Disseminate program contents to appropriate personnel & educate them regarding
compliance procedures.
Professional conduct evaluation as part of employee’s performance review.
Review employee’s actions & identify violation.
Once a violation is discovered, supervisor should respond promptly, conduct thorough
investigation & increase supervision.

5. Investment Analysis, Recommendations and Actions
5 A. Diligence & Reasonable Basis
2. M&C must exercise diligence, 1. M&C must have a reasonable &

independence & thoroughness in adequate basis for investment
investment analysis, analysis, recommendation or action
recommendations & actions. (supported by research &
investigation).
Guidance-Reasonable Basis
Level of research for due diligence depends on product/service offered.

Prior to making recommendation or investment action consider;
Firm’s financial results, operating history & business cycles stage.
Mutual fund’s fee & past performance.
Limitation of any quantitative methods used.
Appropriateness of peer group comparisons.
Guidance-Using Secondary or Third-Party Research
To periodically review quality of third party research use the following:

Review assumptions used.
How rigorous was the analysis.
How timely the research is.
Evaluate objectivity & independence of recommendations.
Guidance-Quantitative Research
Able to explain the nature of quantitative methods used.

Consider scenarios which are not typically used to assess downside risk.
Ensure that both positive & negative results have been used.
Guidance-External Advisers
Ensure advisors have adequate compliance and internal controls.

They present correct return information.
Do not deviate from stated strategies.
Guidance-Group Research & Decision Making
If a conclusion or recommendation derived from group research has a

reasonable basis, do not refuse to be identified with the report merely
on the basis of disagreement with the consensus view.
Policy requiring that research reports, credit ratings & investment recommendations have a reasonable & adequate basis.
Develop written guidance for analysts, supervisory analysts & review committees.
Develop measureable criteria for research report quality assessment.
Written guidance for computer-based models used in developing rating, &, evaluating financial instruments.
Develop measurable criteria for assessing outside providers.
Standardized set of criteria for evaluating the adequacy of external advisers.

5 B. Communication with Clients and Prospective Clients
M&C must:
Disclose to clients & prospective clients the basic format & general principals of
investment processes & disclose any change that materially affects those
processes.
Identify important factors (related to investments) & communicate with clients &
prospective clients.
Distinguish b/w fact & opinion (in investment analysis & recommendations).
Guidance
Always include basic characteristics of security identified.

Distinguish b/w facts and opinions.
Illustrate investment decision making process utilized.
All means of communication should be included not only the research reports.
Communicate any specific risk factors associated with securities.
Clearly communicate potential gains & losses.
Failing to illustrate model’s limitations may be considered as violation.
Able to supply additional information if requested  maintain

relevant information.
5 C. Record Retention
M&C must develop & maintain appropriate records that support investment analysis,
recommendations, actions & other investment related communications with clients &
prospective clients.
Guidance
Maintain records that support conclusion or any investment action.

Such records are property of the firm.
In the absence of regulatory requirements, keep records for 7 years.
Members who change firms must recreate analysis related
documentation – not rely on memory or material created at previous
firms.
Record-keeping is generally firm’s

responsibility.

6. Conflicts of Interest
6 A. Disclosures of Conflicts
M&C must:
Make full & fair disclosure of all matters that impair independence & objectivity or interfere
with respective duties to clients, prospective clients & employers.
Disclosures should be prominent, delivered in plain language & communicate information
effectively.
Guidance-Disclosure to Clients
Disclose all potentially conflicting areas to existing and prospective clients to let them judge
any potential bias themselves.
If servicing as a board member  disclose.
Disclosure of broker/dealer market making activities is included.
Disclosure of holdings in companies that member recommends or clients hold.
Members’ compensation structure, should be disclosed if based on the recommendation
issued or security sold.
Guidance –Disclosure of Conflicts to Employers
Give employers enough information to judge the impact of conflict.

Take reasonable steps to avoid conflict  report promptly if they occur.
Special compensation arrangements (bonus, commission etc) should be disclosed.
6 B. Priority of Transaction
Investment transaction priority flow:

Clients
⇓
Employers
⇓
Employees
Guidance
Prioritize client’s transactions over personal transactions & those made on behalf of the member’s firm.
Personal transactions may be undertaken after clients and member’s employers have been given
adequate opportunity.
Personal transaction – member is a “beneficial owner”.
Family member accounts should not be disadvantaged to client accounts.
Information about pending trades should not be disclosed to any other person if deemed material
nonpublic.

Limited participation in equity IPOs by investment personnel.

Restrictions on private placements for investment personnel.
Establish blackout/restricted periods for investment personnel.
Reporting requirements for investment personnel.
Disclosure of holdings in which the employee has a beneficial interest.
Provide duplicate confirmations of transaction.
Preclearance procedures.
Disclosure of policies regarding personal investing.
6 C. Referral Fees
M&C must disclose to employer, clients & prospective clients, as appropriate, any
compensation, consideration or benefit received from or paid to others for
recommendation of products & services.
Guidance
Must inform employers, clients and prospects of benefits received for referrals of
customers and clients.
All types of consideration must be disclosed.
Encourage firms to adopt clear procedures regarding compensation for referrals.

M&C should update the employer (at least quarterly) regarding nature and value
of referral compensation received. The clients should also be notified about
approved referral fee programs.

7. Responsibilities as a CFAI Member or CFAI Candidate
7 A. Conduct as Members and Candidates in the CFA Program
M&C must not:

Engage in any conduct that compromises the
reputation or integrity of CFAI or CFA designation.
Violate integrity, validity or security or the CFA
examinations.
Guidance
Must not engage in any activity that undermines the integrity of CFA charter.
Standard applies to:
Cheating in CFA or any exam.
Revealing anything about the contents & topics of exam.
Not following exam related rules & polices of CFA program.
Disclosing confidential exam related information to candidates or to public.
Improperly using the designation.
Misrepresenting information on PCS or CFAI in the Continuing Education Program.
Members can express their opinion regarding the CFA exam or program but without disclosing
actual exam specific information.
Members voluntarily participating in the administration of the CFA exam must not solicit or
reveal information about:
Exam question
Deliberation related to the exam process
Scoring of question
7 B. Reference to CFA Institute, the CFA Designation, and the CFA Program
M&C must not misrepresent or exaggerate the meaning or implication of

membership in CFA institute, holding the CFA designation or candidacy in CFA
program.
Guidance
Do not over-promise individual competence.

Do not over promise future investment result.
Sign PCS annually.
Pay CFAI membership dues annually.
Do not misrepresent or exaggerate the meaning of the designation.
No partial designation exists.
Acceptable to state candidate successfully completed the program in 3 years ⇒ claiming
superior ability is not permitted.
In written/oral communications.
The Chartered Financial Analyst and CFA marks must be used as adjectives or after the
charterholder’s name.
Prohibited to be used as nouns.

Trade Allocation: Fair Dealing and Disclosure
FinQuiz Team recommends reading

‘Trade Allocation: Fair Dealing and
Disclosure’ directly from the CFA
Institute’s curriculum.

Changing Investment Objectives
FinQuiz Team recommends reading

‘Changing Investment Objectives’
directly from the CFA Institute’s
curriculum.

“FINTECH IN INVESTMENT MANAGEMENT”

1. INTRODUCTION
Fintech (finance + technology) is playing a major role in the fields of:

• investment management industry
• investment advisory services
• financial record keeping, blockchain and distributed ledger technology (DLT)
2. WHAT IS FINTECH
Some salient fintech developments related to the investment industry include:

Analysis of large data sets:
o traditional data sources include economic indicators, financial statements
o non-traditional data sources (such as social media, sensor networks) to generate
profits.
Analytical tools: artificial intelligence (AI) helps identifying complex, non-linear
relationships among gigantic datasets.
Automated trading: lower transaction costs, market liquidity, secrecy, efficient trading
etc.
Automated advice: Robo-advisors or automated personal wealth management are low-
cost alternates for retail investors.
Financial record keeping: DLT provides advanced and secure means of record keeping
and tracing ownership of financial assets on peer-to-peer (P2P) basis.
3. BIG DATA
Traditional Non-traditional (alternate)
Sources Institutions, Businesses, Sources Social media, Sensor networks Company-

Government, Financial Markets used data, Electronic devices, Smart phones,
Cameras, Microphones, Radio-frequency
identification (RFID)
Forms of Data Annual reports, Regulatory Forms of Data Posts, Tweets, Blogs, Email, Text messages,
filings, Sales & earnings, Web-traffic, Online news sites
Conference calls, Trade prices &
volumes
Big data typically have the following features:

Volume
Velocity
Variety
continue

3.1 Sources of Big Data 3.2 Big Data Challenges
Main sources of alternative data are data generated by: In investment analysis, using big data is
challenging in terms of its:
1. Individuals: Data in the form of text, video, photo, • quality (selection bias, missing data,
audio or other online activities (customer reviews, outliers)
e-commerce). • volume (data sufficiency)
2. Business processes: data generated by • suitability
corporations or other public entities e.g. sales
information, corporate exhaust.
3. Sensors: data connected to devices via wireless
networks.
4. ADVANCED ANALYTICAL TOOLS: ARTIFICIAL

INTELLIGENCE AND MACHINE LEARNING
Artificial intelligence (AI) technology in computer systems is used to perform tasks that involve
cognitive and decision-making ability similar or superior to human brains.
Machine learning (ML) algorithms are computer programs that perform tasks and improve their
performance overtime with experience.
ML divides data into two sets:

• Training data: that helps ML to identify relationships between inputs and outputs through
historical patterns.
Validation data: that validates the performance of the model by testing the relationships
developed (using the training data).
4.1 Types of Machine Learning
Two main types of machine learning are:
Supervised leaning: uses labeled training data and process that information to find the
output. Supervised learning follows the logic of ‘X leads to Y’.
Unsupervised learning: does not make use of labelled training data and does not follow
the logic of ‘X leads to Y’. There are no outcomes to match to, however, the input data
is analyzed, and the program discovers structures within the data itself.
Deep Learning Nets (DLNs): Some approaches use both supervised and unsupervised
ML techniques. DLNs use neural networks often with many hidden layers to perform
non-linear data processing.

5. DATA SCIENCE: EXTRACTING

INFORMATION FROM BIG DATA
5.1 5.2
Data Processing Data Visualization
Methods
Five data processing methods are: Data visualization refers to how data will be formatted
and displayed visually in graphical format. Data
i) Capture: Data capture refers to how data is visualization for:
collected and formatted for further analysis. • traditional structured data can be done using
ii) Curation: Data curation refers to managing tables, charts and trends.
and cleaning data to ensure data quality. • non-traditional unstructured data can be
iii) Storage: Data storage refers to archiving and achieved using new visualization techniques such
storing data. as:
iv) Search: Search refers to how to locate o interactive 3D graphics
requested data. o visualization techniques using colors,
v) Transfer: Data transfer refers to how to move shapes, sizes etc.
data from its storage location to the o tag cloud,
underlying analytical tool. o mind map
6. SELECTED APPLICATIONS OF FINTECH TO

INVESTMENT MANAGEMENT
6.1 6.2 6.3 6.4

Text Analytics and Robo-Advisory Services Risk Analysis Algorithmic Trading
Natural Language
Processing
Text analytics is a use of Robo-advisory services provide Advanced AI techniques are Computerized trading of
computer programs to online programs for investment helping managers in financial instruments based
retrieve and analyze solutions without direct interaction performing scenario analysis on some pre-specified rules
information from large with financial advisors. i.e. hypothetical stress and guidelines.
unstructured text or voice- scenario, historical stress
based data sources. Two types of robo-advisory wealth event, what if analysis, Benefits:
management services are: portfolio backtesting etc. • Execution speed
Natural language processing • Fully Automated Digital Wealth • Anonymity
(NLP) is a field of research Managers Stress testing and risk • Lower transaction
that focuses on development • Advisor-Assisted Digital Wealth assessment measures require costs
of computer programs to Managers wide range of quantitative and
Limitations of Robo-advisors qualitative data. High-frequency trading
interpret human language.
• The role of robo-advisors (HFT) is a kind of algorithmic
NLP field exists at the dwindles in the time of crises. Big data and ML techniques trading that execute large
intersection of computer • The rationale behind the may provide intuition into real number of orders in
science, AI, and linguistics. advice of robo-advisors is not time to help recognize fractions of seconds.
fully clear. changing market conditions
• The trust issues with robo- and trends in advance.
advisors may arise specially
after they recommend some
unsuitable investments.
• As the complexity & size of
investor’s portfolio ↑, robo-
advisor’s ability to deliver
detailed & accurate services ↓.

7. DISTRIBUTED LEDGER TECHNOLOGY
Distributed ledger technology (DLT) – advancements in financial record

keeping systems – offers efficient methods to generate, exchange and track
ownership of financial assets on a peer-to-peer basis.
DLT advantages:
i) Accuracy
ii) transparency iii) secure record keeping
iv) speedy ownership transfer
v) peer-to-peer interactions
Limitations:
i) excessive energy consumption
ii) not fully secure technology
Three basic elements of a DLT network are:

i. Digital ledger – a digital database to record & store transactions
ii. A consensus mechanism - mechanism which ensures that entities
verify the transactions and agree on the common state of the
ledge
iii. Participant network – a peer-to-peer network of nodes.
A distributed ledger is a digital database where transactions are recorded,

stored and distributed among entities in a manner that each entity has a
similar copy of digital data.
Blockchain is a digital ledger where transactions are recorded serially in

blocks that are then joined using cryptography
7.1 7.2
Permission and Application of Distributed Ledger
Permissionless Networks Technology to Investment Management
7.2.1 7.2.2 7.2.3 7.2.4

Cryptocurrencies Tokenization Post-trade Compliance
clearing and
settlement
DLT networks can be permissionless a digital currency helps in DLT provides near-real advanced & automated
or permissioned. that works as a authenticating & time trade verification, compliance &
medium of verifying reconciliation and
Permissionless networks are open exchange to regulatory reporting
ownership rights settlement using single
to new users. Participants can see facilitate near-real- to assets on digital procedures provide
distributed record
all transactions and can perform all time transactions ledger by creating ownership among greater transparency,
network functions. between two a single digital network peers, operational efficiency
parties without record. therefore reduces & accurate record-
Permissioned networks are closed involvement of any complexity, time, costs, keeping.
networks where activities of intermediary. trade fails and need for
participants are well-defined. Only 3rd party facilitation and
pre-approved participants are verification.
permitted to make changes.

2019, Study Session # 3, Reading 7
“CORRELATION & REGRESSION”

t = t-test Calculated n(X) = No. of Independent Variables
r = Correlation Coefficient 1. INTRODUCTION R2 = Coefficient of Determination
= Critical t-value , = Correlation Coefficient (x, y)
= Degree of Freedom CI = Confidence Interval
= Null Hypothesis Broadly, to analyze relationship b/w S.E = Standard Error
= Alternative Hypothesis two/more financial variables, correlation SSE = Sum of Squared/Residual Sum of Squared Errors
= Intercept RSS = Regression Sum of squares

= Slope Coefficient (Regression Coefficient)
& regression tools are used.
k = No. of Slope Parameters
ℰ = Error Term
2. Correlation Analysis
2.1 Scatter Plots
A graph that shows relationship b/w two data-series

observations in two dimensions.
Each observation is a point & not connected.
Data (observations) shown in pairs.
Relationship depicted graphically.
2.2 Correlation Analysis
Relationship expressed using single number.

Correlation coefficient ⇒ measures the direction & magnitude of linear
relation b/w two variables.
= −1 ≤
≤ 1.
Correlation coefficient > 0
Positive relationship.
Both variables move in same direction.
X Y & X Y.
Correlation coefficient < 0.
Negative relationship.
Both variables move in opp. direction.
XY & X Y.
Correlation coefficient = 0.
No linear relationship.
Correlation of 1 does not mean for every unit of x, y changes with 1 unit.
2.3 Calculating & Interpreting the Correlation Coefficient
, =

∑೙
೔సభ೔ ೔

మ

= =
∑೙
೔సభ೔ష

Sample standard deviation= = √ .

Positive square root of sample variance.
Sample correlation coefficient:
(, )
=

Covariance of x, y divided by product of sample s.d of x, y.
Correlation coefficient:
Number without any units attached
Valid if means, variances and covariances of x, y finite and constant.

2.4 Limitations of Correlation Analysis
Results may not be always reliable.

With very low correlation, two variables can have non-linear relationship.
Outliers can (extreme observations) make correlation an unreliable measure.
At times, correlation that includes outliers may make more sense.
Generally a comparison b/w correlation, with and without outliers is made
and decision is taken.
Correlation does not imply causation.
Spurious Correlation
Correlation based on chance.

Induced correlation through mixing 3rd variable in both variables.
Correlations arising indirectly through relationship with 3rd variable.
Spurious correlations may suggest investment strategies that appear
profitable but actually would be not.
2.5 Uses of Correlation Analysis
See examples 1 to 6, Reading 7, Volume 1
2.6 Testing the Significance of the Correlation Coefficient
Significance tests ⇒ conduct to check relationships between random variables

exists or is based on chance.
=
√
√
మ
Test statistic ⇒ t-distribution with (n-2) df.
⇒ Correlation in population = 0 i.e no correlation (p=0).
⇒ Correlation in population ≠ 0 i.e. there is correlation (p≠0).
Two variables if normally distributed ⇒ we can test to determine hypothesis-
using r.
Magnitude of r to reject as n .
As n df .
As n absolute value of .
As n increases, absolute value of numerator and thus t-statistic
increases.
Decision rule Reject if
− > >
interpretation: correlation exists ⇒ p ≠ 0.

3. LINEAR REGRESSION
3.1 Linear Regressions with One Independent Variable
Linear regression ⇒ allows us to use one variable to make predictions about

another.
Test significance about relationship.
Quantify the strength.
Y ⇒ dependent variable ⇒ we seek to explain.
X⇒ independent variable ⇒ we use to explain Y
Example: using growth in money supply (X) to explain inflation (Y).
Linear regression assumes linear relation between depend & independent
variable.
= +
+
where i = 1, …, n
Two principal types of data used
Cross-sectional ⇒ involve many observations from diff. entity for same
time period.
Time series ⇒ involve many observations for same entity from different
time periods.
Linear regression computes regression line that best fits the observations.
Values of &
are chosen that minimize the sum of squared vertical
distance b/w observations and regression line.
Regression Residual ⇒ distance b/w actual observation & regression line
Estimated ^ &
^ are used for regression line & used for prediction.
Analysts typically use spreadsheet or statistical package to perform linear
3.2 Assumptions of the Linear Regression Model
The relationship between the dependent variable, Y, and the independent

variable X, is linear in the parameters b0 & b1.
X is not random.
Expected value of E(ℰ) = 0.
Variance of error term (ℰ) is same for all observation.
ℰ is uncorrelated across observations.
ℰ is normally distributed.
3.3 The Standard Error of Estimate
మ
⁄
=
∑೙ ^ ^
೔సభ೔ బ భ ೔

! "
∑೙
೔సభε
భ మ
=

SEE measures s.d of ∈# (the residual term).
SEE is much similar to s.d for single variable.
Regression residual (∈#
) = actual observation (Y) – predicted value$% &.
'
Where Y = b + b
^ X
^
n-2 is:
used as there are two parameters $% & %
&.
also called degrees of freedom.
used to ensure SEE as unbiased.

3.4 The Coefficient of Determination
Measures fraction of total variation in Y explained by X.

= 1; = ,

⇒ When n(x) > 1 this method cannot be used.

+ > 1; =
!"

=
(
)
*

(

=1−
Total variation = ∑ #
$ − &

Unexplained variation = ∑ #
$ − % &

Explained variation = ∑ #
$% − &

3.5 Hypothesis Testing
It is believed that CI contains true
CI approach requires:
% , %
Hypothesized b0 or b1
Confidence interval
CI requires level of significance ⇒ for %
= %
± $భ
Where t % = critical value of t.
df = no of observations – no. of estimated parameters.
S&'భ = standard error of estimated coefficient.
Decision criteria: if CI includes %
⇒ do not reject .
=
$భ – భ
(್෡
భ
t-statistic ⇒ (n-2) df
f |t| > t % reject H
Choice of significance level is judgmental.

Significant level type I error probability type II error probability.
P-value ⇒ smallest level of significance for which H can be rejected.
Stronger regression ⇒ S.E of parameter & tighter CI.
3.6 Analysis of Variance (ANOVA) in a Regression with One Independent
Statistical procedure for dividing total variability of a variable into components.

Helps determine usefulness of the independent variable in explaining the variation in
the dependent variable.
F-statistic test whether all slope coefficients are = 0.
To conduct F-statistic we need:
Total observations (n).
Total no. of parameters.
SSE ⇒ ∑ #
$
− % & (unexplained).

RSS ⇒ ∑ #
$% − . & (explained).

TSS = SEE +RSS

)*.+!*!,, ,- ,.!,
F-Statistic ⇒
)*.(- ,.!" !,
+(( ⁄/
= where k = no. of slope parameters.
((0 ⁄( /
)

3.7 Prediction Intervals
An interval around the estimated parameters in which it will fall.

Confidence interval is created through knowing variance of the prediction
errors$ &.
= !1 + +
( మ "

1మ
ೣ
Where
S2 = squared standard errors of estimate.
n = no. of observations.
. = estimated mean of X.
= variance of independent variable.
Four steps to determine the CI

Make the prediction.
Compute
Choose level of significance (/)& determine critical value .
Compute % ±
where % = % + %

3.8 Limitations of Regression Analysis
Parameters instability ⇒ regression relations can change over time.

Sampling from more than one population in both cross-sectional and time-
series data is problematic.
Specific to investment context, public knowledge of regression relationship
may negate their usefulness.
If regression assumptions are violated results may not be valid.

“MULTIPLE REGRESSION AND ISSUES IN REGRESSION ANALYSIS”

MSR = Mean Regression Sum of Squares 𝐹Z = Critical F taken from F
MSE = Mean Squared Error 1. INTRODUCTION Distribute Table
RSS = Regression Sum of Squares 𝐻) = Null Hypothesis
SSE = Sum of Squared Errors/Residuals 𝐻∝ = Alternative Hypothesis
α = Level of Significance Multiple linear regression models are more X = Independent Variable
ML = Machine Learning sophisticated. Y = Dependent Variable
They incorporate more than one independent F = F Statistic (calculated)
variable.
2. MULTIPLE LINEAR REGRESSIONS
Allows determining effects of more than one independent variable on a particular dependent variable
𝑌= = 𝑏) + 𝑏" 𝑋"= + 𝑏$𝑋$= + ⋯ 𝑏' 𝑋' + 𝐸=
Tells the impact on Y by changing X1 by 1 unit keeping other independent variables same.
Individual slope coefficients (e.g. b1) in multiple regressions known as partial regression/slope coefficients.
2.1 Assumption of the 2.2 Predicting the 2.3 Testing Whether All 2.4
Multiple Linear Dependent Variable in a Population Regression Adjusted
Regression Model Multiple Regression Model Coefficients Equals Zero R2
Relationship b/w Y Obtain estimates of 𝐻) Þ All slope coefficients are R2 á with addition of
and 𝑋" , 𝑋$ , 𝑋% , … 𝑋' is regression parameters. simultaneously = 0, none of the independent variables
linear. 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑠 = X variable helps explain Y. (X) in regression
Independent variables $
𝑏)^ , 𝑏"^ , 𝑏)^ , … 𝑏'^ To test 𝐻) F-test is used. 𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑅$ J𝑅 K =
are not random and 𝑟𝑒𝑔𝑟𝑒𝑠𝑠𝑖𝑜𝑛 𝑝𝑎𝑟𝑎𝑚𝑒𝑡𝑒𝑟𝑠 T-test cannot be used. '4"
no exact linear = 𝑏) , 𝑏" , 𝑏" , … 𝑏2 ,-. 1−J K (1 − 𝑅$ ).
'424"
𝐹= $
,-/
relationship exists b/w Determine assumed .--/2 When k ≥ 1 Þ 𝑅$ > 𝑅
2 or more values of 𝑋<"= , 𝑋<$= … 𝑋<2 =--//('4(25")) $
𝑅 can be –ve but R2 is
independent Compute predicted value Where
' always +ve.
variables. of 𝑌< using 𝑌<= = 𝑏<) + $ $
𝑅𝑆𝑆 = 9:𝑌<= − 𝑌? If 𝑅 is used for
Expected value of 𝑏<"𝑋<"= + 𝑏<$𝑋<$= + ⋯ +
error terms is 0.
=@" comparing regression
𝑏<2 𝑋<2= '
Variance of error term $ models.
To predict dependent 𝑆𝑆𝐸 = 9:𝑌= − 𝑌<= ?
is same for all Sample size must be
variable: =@"
observations. Decision rule Þ reject 𝐻) if F > the same
Be confident that
Error term is FC (for given α). Dependent variable
assumptions of the
uncorrelated across It is a one-tailed test. is defined in the
regression are met.
observations. df numerator =k same way.
Predictions regarding X $
Error term is normally must be within reliable df denominator =n-(k+1). á𝑅 Does not
distributed. range of data used to For k and n the test statistic necessarily indicate
estimate the model. representing H0, all slope regression is well
coefficients are equal to 0, is specified.
𝐹2,'4(25")
In F-distribution table
𝑓) 𝐹2,'4(25") where K
represents column and n-(k+1)
represents row.
Significance of F in ANOVA
table represents ‘p value’.
á F-statistic â chances of Type
I error.
1
3. USING DUMMY VARIABLES IN REGRESSION
Dummy variable Þ takes 1 if particular condition is true & 0 when it is false.

Diligence is required in choosing no. of dummy variables.
Usually n-1 dummy variables are used where n= no. of categories.
4. VIOLATIONS OF REGRESSION ASSUMPTIONS
4.1 Heteroskedasticity 4.2 Serial Correlation 4.3 Multicollinearity

4.4 Summarizing
the Issues
Variance of errors differs Occurs when two or more
Regression errors
independent variables (X) are
across observations Þ correlated across
heteroskedastic highly correlated with each other.
observations.
Regression can be estimated but
Variance of errors is similar Usually arises in
result becomes problematic.
across observations Þ time-series
Serious practical concern due to
homoskedastic regression.
commonly found approximate
Usually no systematic
linear relation among financial
relationship exists b/w X &
variables.
regression residuals.
If systematic relationship is
present Þ heteroskedasticity On page 3
can exist.
On page 4
4.1.3 Correcting for

4.1.1 The Consequence of 4.1.2 Testing for
Heteroskedasticity
Heteroskedasticity Heteroskedasticity
It can lead to mistake in inference. Does not Breush-Pagan test is widely used. Robust Generalized
affect consistency. Regression squared residuals of Standard Errors Least Squares
F-test becomes unreliable. regression on independent
Due to biased estimators of standard errors, variables.
Independent variables Corrects standard Modify original
t-test also becomes unreliable.
explain much of the variation error of estimated equation.
Heteroskedasticity effects may include:
coefficients. Requires
underestimation of estimated of errors Þ conditional
Also known as economic
standard errors heteroskedasticity exists.
heteroskedasticity expertise to
inflated t-statistic 𝐻) = no conditional
consistent implement
Ignoring heteroskedasticity leads to heteroskedasticity exists.
standards errors correctly on
significant relationship that does not exist 𝐻\ = conditional
or white-corrected financial data.
actually. heteroskedasticity exist
standards errors.
It becomes more serious while developing Under Breush-pagan test statistic =
investment strategy using regression nR2
analysis. R2: from regression of squared
Unconditional heteroskedasticity Þ when residuals on X
heteroskedasticity of error variance is not Critical value Þ calculated χ2
correlated with independent variables in distribution.
the multiple regression. df = no. of independent variables
Create major problems for statistical Reject 𝐻) if test-static > critical
inference. value.
Conditional heteroskedasticity Þ when
heteroskedasticity of error variance is
correlated with the independent variables.
It causes most problems.
Can be tested & corrected easily
through many statistically software
packages.
2
4.2 Serial Correlation
4.2.2 Testing for 4.2.3 Correcting for

4.2.1 The
Serial Correlation Serial Correlation
Consequences of
Serial Correlation
Incorrect estimate of regression coefficient standard

Adjust the coefficient Modify regression
errors
standard errors. equation.
Parameter estimates become inconsistent & invalid
→ Recommended method Extreme care is required.
when Y is lagged onto X under serial correlation.
Hansen’s method Þ most May lead to inconsistent
Positive serial correlation Þ positive (negative) errors
prevalent one. parameters estimates.
á chance of positive (negative) errors
Negative serial correlation Þ positive (negative)
errors á chance of negative (positive) errors
It leads to wrong inferences
If positive serial correlation:
Standard errors underestimated
T-statistic & F-statistics inflated
Type-I error á
If negative serial correlation
Standard errors overestimated
T-statistics & F-statistics understated
Type-II error á
4.1.2 Testing for Heteroskedasticity

Variety of tests, most common → Durbin-Watson test
∑` < <
abc (/a 4/ade )
c
𝐷𝑊 = ∑` <c
abe /a
Breush-Pagan
Where 𝐸<ftest is widely residual
= regression used. for period t.
Regression
For largesquared
sample residuals
size DWofstatistic
regression on independent variables.
is approximately.
» 2(1-r)variables explain much of the variation of errors Þ
Independent
→DW
conditional
→where r = heteroskedasticity
sample correlation exists.
b/w regression residuals of t and t-1
𝐻) = no conditional
Values of DW can heteroskedasticity
range from 0 to exists.
4.
𝐻\ = DW
conditional
= 2 Þ r=0heteroskedasticity exist
Þ no serial correlation.
Under Breush-pagan test statistic = nR2
DW = 0 Þ r=1 Þ perfectly positively serially correlated.
R2: from regression of squared residuals on X
DW = 4 Þ r = -1 Þ perfectly negatively serially correlated.
Critical value Þ calculated χ2 distribution.
For positive serial correlation:
df = no. of independent variables
𝐻) Þ No positive serial correlation
Reject 𝐻 if test-static > critical value.
𝐻)\ Þ Positive serial correlation
𝐷𝑊 < 𝑑𝑙 Þ reject 𝐻)
𝐷𝑊 > 𝑑𝑢 Þ do not reject 𝐻)
dl ≤ 𝐷𝑊 ≤ 𝑑𝑢 Þ inconclusive.
For negative serial correlation:
𝐻) Þ No negative serial correlation.
𝐻\ Þ Negative serial correlation.
𝐷𝑊 > 4 − 𝑑𝑙 Þ Reject 𝐻) .
𝐷𝑊 < 4 − 𝑑𝑢 Þ do not reject 𝐻)
4 − 𝑑𝑢 ≤ 𝐷𝑊 ≤ 4 − 𝑑𝑙 Þ inconclusive.
3
4.3 Multicollinearity
4.3.1 The 4.3.2 Detecting 4.3.3 Correcting

Consequences of Multicollinearity Multicollinearity
Multicollinearity
Difficulty in detecting significant Multicollinearity is a matter of degree Exclude one or more

relationships. rather than the presence / absence. regression variables.
Estimates become extremely á Pair wise correlation does not necessarily In many cases,
imprecise & unreliable though indicate presence of Multicollinearity experimentation is done to
consistency is unaffected. â Pair wise correlation does not necessarily determine variable causing
F-statistic is unaffected. indicate absence of Multicollinearity Multicollinearity
Standard errors of regression can á. With 2 independent variables Þ correlation
Causing insignificant t-tests is a useful indicator.
Wide confidence interval á R2 significant, F-statistic significant,
Type II errorá insignificant t-statistic on slope coefficients
Þ classic symptom of Multicollinearity
4.4 Summarizing
the Issues
Problem How to detect Consequences Possible

Corrections
(Conditional) Plot residuals or Wrong Use robust
Heteroskedasticity use Breusch– inferences; standard errors or
Pagan test incorrect GLS
standard errors
Serial correlation Durbin-Watson Wrong Use robust
Test inferences; standard errors
incorrect (Hansen’s method)
standard errors or modifying
equation
Multicollinearity High R2 and Wrong Omit variable
significant F- inferences;
statistic but low t-
statistic
4
5. MODEL SPECIFICATION AND ERRORS IN SPECIFICATION
Model specification Þ set of variables included in regression.

Incorrect specification leads to biased & inconsistent parameters
5.2 Misspecified 5.3 Times-Series 5.4 Other Types

5.1 Principles of Misspecification of Time-Series
Functional Form
Model Specification (Independent Variables Misspecification
Correlated with Errors)
Model grounded on One or more variables are Including lagged Non-stationarity:

economic reasoning. omitted. If omitted variable is variables (dependent) variable
Functional form of variables correlated with remaining as independent with properties, e.g.
compatible with nature of variable, error term will also be serial correlation. mean, are not
variables correlated with the latter and the: Including a function of constant through
Parsimonious Þ each result can be biased & the dependent variable time.
included variable should inconsistent. as an independent In practice non-
play an essential role estimated standard errors of variable. stationarity is a
Model is examined for the the coefficients will be Independent variables serious problem.
violation of regression inconsistent. measured with error
assumptions. One or more variables may
Model is tested for the require transformation.
validity & usefulness of the Pooling of data from different
out of sample data. samples that should not be
pooled.
Can lead to spurious results.
6. MODELS WITH QUALITATIVE DEPENDENT VARIABLES
Qualitative dependent variables Þ dummy variables used as

dependent instead of independent.
Probit modelÞ based on normal distribution estimates the
probability:
of discrete outcome, given values of independent variables
used to explain that outcome.
that Y=1, implying a condition is met.
Logit model:
Identical to Probit model.
Based on logistic distribution.
Both Logit and Probit models must be estimated using maximum
likelihood methods.
Discriminate analysis Þ can be used to create an overall score
that is used for classification.
Qualitative dependent variable models can be used for portfolio
management and business management.
5
7. MACHINE LEARNING
7.1 Major Focuses 7.2 What is 7.3 Types of 7.4 Machine 7.5 Supervised Machine
of Data Analytics Machine Learning? Machine Learning? Learning Algorithms Learning Training
Six focuses of data ML uses statistical Two broad categories of ML are: Some simple steps to train the ML models
analytics: techniques that 1. Supervised learning: uses labeled are:
i. Measuring training data and process that info. to 1. Define the ML algorithm.
give computer
correlations find the output. Supervised learning 2. Specify the hyperparameters used in
systems the ability
ii. Making predictions follows the logic of ‘X leads to Y’. the ML technique.
iii. Making casual to act by learning
3. Divide datasets in two major groups:
inferences from data without 2. Unsupervised learning: does not • Training sample
iv. Classifying data being explicitly make use of labelled training data • Validation sample
v. Sorting data into programmed. and does not follow the logic of ‘X 4. Evaluate model-fit through validation
clusters leads to Y’. There are no outcomes to sample and tune the model’s
vi. Reducing the match to, however, the input data is hyperparameters.
dimension of data analyzed, and the program discovers 5. Repeat the training cycles for some
structures within the data itself. given number of times or until the
required performance level is achieved.
7.4.1 Supervised 7.4.2 Unsupervised

Learning Learning
7.4.1.2
7.4.1.1 Penalized 7.4.1.3 Random
Classification & 7.4.1.4 Neural
Regression Forests
Regression Trees Networks
• computationally- CART model is ensembles multiple • also known as artificial neural

efficient method to • is represented by a binary tree decision trees together networks, or ANNs.
solve prediction • computationally efficient • are appropriate for nonlinear
based on random selection
problems. • adaptable to complex datasets statistical data and for data with
of features to produce complex connections among
• imposes penalty on the • useful for interpreting how
accurate and stable variables.
size of regression observations are classified
coefficients to address • works on a pre-classified prediction. Splitting a node • contain nodes that are linked to the
overfitting issue. training data. in random forests is based arrows.
• improves prediction in A classification tree is formed by on the best features from a • ANNs have three types of
large datasets by splitting each node into two random subsets of n interconnected layers:
shrinking the no. of distinct subsets, and the process a) an input layer
features therefore, each
independent variables of splitting the derived subsets is b) hidden layers
tree marginally varies from c) an output layer
and handling model repeated in a recursive manner.
complexity. other tress. • Deep learning nets (DLNs) are neural
Process ends when further
splitting is not possible. networks with many hidden layers
(often > 20 ).
7.4.2.1 Clustering 7.4.2.2 Dimension

Algorithms Reduction
Clustering algorithms discover the K-means Algorithm is a • reduces the no. of random
inherent groupings in the data without type of bottom-up variables for complex datasets
any predefined class labels. clustering algorithm where • Principal component analysis
Two clustering approaches are: data is divided into k- (PCA) is an established method
• Bottom-up clustering: Each clusters based on the for dimension reduction. PCA
observation starts in its own cluster, concept of two geometric reduces highly correlated data
and then assembles with other clusters ideas ‘Centroid’ (average variables into fewer, necessary,
progressively based on some criteria in position of points in the uncorrelated composite variables.
a non-overlapping manner. cluster) and ‘Euclidian’ • Dimension reduction techniques
• Top-down clustering: All observations (straight line distance b/w are applicable to numerical,
begin as one cluster, and then split into two points). textual or visual data.
smaller and smaller clusters gradually.
6
“TIME-SERIES ANALYSIS”
t = Time Independent Variable ௧ = Value of Time Series at t

௧ = Expected Value of Time Series 1. INTRODUCTION TO TIME-SERIES ANALYSIS ଴ = Y-intercept
OLS = Ordinary Least Squares Model ଵ = Slope Coefficient
RMSE = Root Mean Squared Error ௧ = A random Error Term
GLS = Generalized Least Squares Time series ⇒ set of observations on a variable’s T = time (independent variable)
outcome in different times.
Time-series models are used to explain the past or
predict the future.
2. CHALLENGES OF WORKING WITH TIME SERIES
Presence of serial correlation in errors in autoregressive time

series causes estimates to be inconsistent.
Regression results are invalid if mean and variance of time
series changes over time.
Time-series models are transformed to counter these
problems.
3. TREND MODELS
3.1 Linear Trend Models
Simplest trend model

Dependent variable changes at constant rate with time.
௧ = ଴ + ଵ + ௧
3.2 Log-Linear Trend Models
Works well in fitting time series with exponential

growth.
௧ = ௕బ ା௕భ ௧ , = 1,2 …
Exponential growth ⇒ at constant rate ௕భ − 1 with
continuous compounding
The natural log of the time series can be modeled using
a linear trend.

௧ = ଴ + ଵ + ௧
3.3 Trend Models and Testing for Correlated Errors
Regression error for one period must be uncorrelated

with regression error for all other periods.
D-W test carried on residuals.
D.W should not differ significantly from 2.0.
The presence of serial correlation in trend models
suggests that a better forecasting model can be built
using time series.

4. AUTOREGRESSIVE (AR) TIME-SERIES MODELS
A time series regressed on its own past values.

th-order auto regression ௧ = ଴ + ଵ ௧ିଵ +
ଶ ௧ିଶ + ⋯ + ௣ ௧ି௣ +௧
4.1 Covariance-Stationary Series
Covariance stationary ⇒ mean & variance do not change over

time.
Three principles
y௧ constant & finite
Variance of time series ⇒constant & finite.
Covariance of time series with itself in the past or future
for a fixed number of time periods ⇒ constant & finite.
4.2 Detecting Serially Correlated Errors in an Autoregressive Model
Autocorrelation of time series ⇒ correlation with own past values.

t-test involving residual autocorrelation residual and standard error of
residual is used.
DW test cannot be used.
Standard error of residual correlation = 1⁄√
t-statistic = autocorrelation/standard error.
t-statistic > 2 ⇒ autocorrelation ≠0 ⇒ residual serially correlated
⇒OCS cannot be used.
Adding more lags ⇒ can remove serial correlation.
4.3 Mean Reversion
Mean reversion:
Time series tends to move towards mean.
If time series level > mean ⇒ falls to mean.
If time series level < mean ⇒ rises to mean.
௕బ
Mean reverting level = ௧ =
ଵି௕భ
4.4 Multiperiod Forecasts and the Chain Rule of Forecasting
Next period’s predicted value is used to predict value two

periods ahead. (Chain rule of forecasting)
௧ାଶ = ଴ + ଵ ௧ାଵ
More uncertain than single period forecast.
4.5 Comparing Forecast Model Performance
Forecast error variance, accuracy of model.

Residuals within a sample period ⇒ in-sample forecast errors
Residuals outside sample periods ⇒ out-of-sample forecast errors.
RMSE ⇒ used for out-of-sample forecast errors.
RMSE, accuracy of model.
RMSE of in sample data does not guarantee model has RMSE for out-of
sample data.

4.6 Instability of Regression Coefficients
Nonstationarity: estimated coefficients of one period differ

from another period.
Periods statistical reliability ⇒ stability.
Periods statistical reliability ⇒ stability.
Sample selected must be covariance stationary.
5. RANDOM WALKS AND UNIT ROOTS
5.1 Random Walks
Without Drift With Drift
௧ = ௧ିଵ + ௧ ௧ = ଴ + ଵ ௧ିଵ + ௧
Best predictor of time series is current value + error term. ଴ ≠ 0 ଵ = 1
Error term has ⇒ 0 mean. First difference:
Constant variance ௧ = ௧ − ௧ିଵ = ଴ + ௧
Uncorrelated with previous value (terms)
Special case of AR(1) with ଴ = 0 ଵ = 1
AR (1) & standard regression analysis cannot be used with
random walk.
Correcting Random walk Consequence of Random Walk
By taking first difference R2 significantly.

௧ = ௧ − ௧ିଵ = ௧ Statistical results ⇒ invalid.
5.2 The Unit Root Test of Nonstationarity
ଵ < 1 ⇒ 1 model is covariance stationary.

With random walk:
t-test ⇒ invalid.
Standard errors in AR model ⇒ invalid.
Method I Method II
Examining autocorrelations of the AR model Using Dickey-Fuller test

If non-stationary ௧ − ௧ିଵ = ଴ + ଵ௧ିଵ + ௧
Serial correlations do not with no. of lags ଵ = ଵ − 1
Serial correlation of all lags ≠ 0 If ଵ = 1, ଵ = 0 ⇒ Time series has unit root.
଴ = ଵ = 0
ଵ = ଵ < 0
t-test with revised set of critical values is used.

6. MOVING-AVERAGE TIME-SERIES MODELS
Avg. of successive observations in time series.

Contains lagged values of residuals.
6.1 Smoothing Past Values with an n-Period Moving Average
௫೟ ା௫೟షభ ା⋯ା௫೟షሺ೙షభሻ

௡
Not the best predictor of future.
Gives equal weights to observations.
6.2 Moving-Average Time-Series Models for Forecasting
MA (q) ⇒ first q autocorrelation will be different from 0

After q observations serial correlation falls to 0
Autocorrelations of most AR(P) decline gradually
7. SEASONALITY IN TIME-SERIES MODELS
Seasonality: a pattern repeated by time series

variable at regular intervals.
Non-constant means ⇒ not covariance
stationary.
Detection & Correction
Autocorrelation differ by season.

Seasonal autocorrelation of the error term ≠0; t-test is
used for detection.
Adding seasonal lags solve seasonality problem.
R2 with seasonal lag ⇒ accuracy of model.
8. AUTOREGRESSIVE MOVING-AVERAGE MODELS
Combines autoregressive lags of dependent variable and

moving average errors.
Limitations:
Unstable parameters.
Choosing right ARMA model ⇒ quite difficult.
Data set is required.

9. AUTOREGRESSIVE CONDITIONAL HETEROSKEDASTICITY MODELS
Used to test existence of heteroskedasticity

If a > 1 ARCH (1) time series ⇒ variance of an error depends on size of
squared error in previous period.
Squared residuals (previously estimated) are regressed on constant &
first lag of the squared residuals.
If coefficients are significant ⇒ time series is ARCH (1).
Variance of errors in t+1 can be estimated through the formula.
εଶ୲ = ଴ + ଵ εଶ୲ିଵ + ⋯ + ௣ εଶ୲ି௣
Consequences
Standard errors of regression parameters ⇒ incorrect

Method to correct heteroskedasticity can be applied
Using ARCH implies AR cannot be used but variance of
residuals can be estimated
10. REGRESSIONS WITH MORE THAN ONE TIME SERIES
Scenario I Scenario II
Independent & dependent time series One time series has unit root ⇒
do not have a unit root. cannot use linear regression.
Use linear regression
Scenario III Scenario IV
Both time series have unit root but not Both time series are cointegrated and have unit
cointegrated. root.
Cannot use linear regression Linear regression can be used.
Cointegration:
Two time series are cointegrated if they
share common after trend
Testing cointegration:
Estimate ௧ = ଴ + ଵೞ೟ + ௧
Test whether error term has a unit root
using the Dickey-Fuller test using Engle
Granger critical values.
If ଴ that error term has unit root is not
rejected ⇒ no cointegration.
If ଴ rejected that error term has a unit root
cointegration exists.

11. OTHER ISSUES IN TIME SERIES
Uncertainty of time series models increases the level of

due diligence required.
Both uncertainties of estimated parameters and error
term need to be considered.
Evaluating uncertainty is complex.
12. SUGGESTED STEPS IN TIME-SERIES FORECASTING
Determine your goal whether attempting to model relationship with same variable or other variables or with time.
If using time series then plot variable on y-axis with time on x-axis.
o Look for nonstationarity characteristics e.g. heteroskedasticity, non-constant mean, seasonality, and structural
change.
o Structural change: indicated by significant shift & data is divided into two or more distinct patterns.
If no seasonality or structural shift → use trend model.
o If data plot on straight line → use linear trend model.
o If data plot on curve→ use log-linear model.
Test for serial correlation using Durbin-Watson test.
o Serial correlation not detected → Model Trend can be used, if detected use other model e.g. AR.
If residuals have serial correlation & it is not stationary use the AR model:
o Time series has a linear trend → use first differential.
o Time series has an exponential trend → use first differential of natural log of data.
o If structural shift → run two different models.
o If seasonality effect → add another lag in the AR model.
After taking first differential if series is covariance stationary run AR(1) and test for seasonality & serial correlation
o No remaining serial correlation → use the model.
o If serial correlation detected → incorporate additional lags until any serial correlation is removed.
Test for ARCH:
o If coefficient not significantly different from zero → use the model.
o Else use GLS or other method to correct for ARCH
Use sample RMSE for determining the better of two statistically developed models.

2019 Study Session # 3, Reading # 10
“EXCERPT FROM “PROBABILISTIC APPROACHES: SCENARIO

ANALYSIS, DECISION TREES, AND SIMULATIONS””
INTRODUCTION
2. SIMULATIONS
Simulations provide a way of examining the consequences to continuous risk.

Simulation generates hundreds of possible outcomes to provide a fuller picture
of the risk in an asset or investment.
2.1 Steps in Simulation
As compared to scenario analysis, simulations allows for more flexibility in how we deal with uncertainty.
Steps associated with simulation includes:
i. ⇒ Determine probabilistic
probabilistic,variables
variables⇒ ⇒no noconstraint
constrainton onnumber
numberof ofvariables
variablesallowed
allowedininaasimulation
simulation&&we wecan
candefine
define
portability
probabilitydistribution
distribution inin each
each && every
every input
input in
in aa valuation.
valuation.
ii. ⇒ Define probability
probab_______distribution
⇒ mostfor difficult
these variables⇒
step in the analysis
most difficult
& comprise
step inofthe
following
analysisthree
& comprise
steps: of following three
steps:
i. Historical data ⇒ for variables with long history, historical data is used to develop distributions.
ii.i. Historical
Cross data data
sectional ⇒ for⇒variables
substitutewith
datalongonhistory, historical
differences data isvariable
in specific used toacross
develop distributions.
existing investments that are
ii. similar to investment
Cross sectional data ⇒being analyzed
substitute data on differences in specific variable across existing investments that are
iii. similar to investment being
Statistical________⇒ whereanalyzed
historical & cross sectional data will be insufficient / unreliable, a statistical
iii. distribution
Statistical that best capture
distribution⇒ wherethe variability
historical in input
& cross estimate
sectional the
data parameters
will for that
be insufficient distribution.
/ unreliable, a statistical
iii. distribution
Check for ______⇒ that
after thebest capture the
distribution havevariability in inputitestimate
been specified the parameters
is important for that distribution.
to check correlations across variables (can be
iii. estimated by looking atacross
Check for correlations past).variables⇒ after the distribution have been specified it is important to check correlations
iv. across
Run thevariables
_____ ⇒(candrawbeone
estimated
outcome by from
looking at past).
each distribution & compute the value based upon those outcomes (process
iv. Run
can be
therepeated
simulation⇒
as many
draw times
one as
outcome
desired). from
Theeach
number
distribution
of simulation
& compute
can bethe determined
value basedfrom
uponthethose
following:
outcomes
(process d) canNobeofrepeated as many
probabilistic inputs times
⇒ asthe
desired).
number Theofnumber
inputs,ofthesimulation
number can be determined from the following:
of simulations.
a) Characteristics
e) Number of probabilistic inputsdistribution
of probability ⇒ the number of inputs,
⇒ the greater the number
the diversity of simulations.
of distribution, the the required
b) Characteristics of probability distribution ⇒ the greater the diversity of distribution, the the required
number of simulations.
f) numberofofoutcome
Range simulations.
⇒ the the potential range of outcomes, the the number of simulations required.
Two impediments c) to Range
goodof simulations:
outcome ⇒ the the potential range of outcomes, the the number of simulations required.
Two
i. impediments
Estimatingto distributions
good simulations:
of values for each input into a valuation is difficult to do (informational).
ii.i. Estimating
Too time &distributions of values
resource intensive for for
theeach input
typical into a(computational).
analysis valuation is difficult
Bothtothese
do (informational).
constraints have eased in recent years.
ii. Too time & resource intensive for the typical analysis (computational). Both these constraints have eased in recent years.
2.2 An Example of a Simulation
2.3 Use in Decision Making
In ideal simulations, analysts will examine both the historical & cross sectional
data on each input variable before making a judgment on distribution &
parameters.
Ideal simulation yields a distribution for expected values rather than a point
estimate.

2.4 Simulations with Constraints
2.4.1 Book Value Constraints 2.4.2 Earnings and Cash Flow Constraints
BV of equity is an accounting construct & by itself, means These constraints may be internally or externally imposed.
little. Simulation can be used to assess the likelihood that these
Two types of restrictions on BV of equity that may call for risk constraints will be violated.
hedging:
Regulatory capital restriction
Negative BV for equity
2.4.3 Market Value Constraints
Simulation can be used to qualify the likelihood of distress & can also be used to build in the
cost of indirect bankruptcy into valuation.
2.5 Issues
Garbage in, garbage out ⇒ simulation output is input dependent so input should be based
upon analysis & data rather than guess work.
Real data may not fit distributions.
Non-stationary distributions (means & variance estimated from historical data for an input
that is normally distributed may change over time).
If correlations b/w input variables change over time, it becomes far more difficult to model
them.
2.6 Risk-Adjusted Value and Simulations
In simulations, the cash flows that we obtain are expected cash flows & are not risk adjusted
(discount at risk adjusted rate).
Variance of the simulated values around the expected value indicates that the estimation is
in an uncertain environment.
3. AN OVERALL ASSESSMENT OF PROBABILISTIC RISK ASSESSMENT APPROACHES
3.1 Comparing the Approaches
Decision of choice b/w scenario analysis, decision trees & simulations depends on the followings:
i. Selective v/s full risk analysis ⇒ scenario analysis is best for selective risk analysis (usually 3 scenarios) while decision
trees & simulations are used for full risk analysis.
ii. Type of risk ⇒scenario analysis & decision trees ⇒ discrete outcomes in risky events. Simulations ⇒ for continuous risk.
iii. Correlation across risks ⇒ if various investment risks are correlated ⇒ simulation is best.
Table 6.4. Risk Type and Probabilistic Approaches
Discrete/Continuous Correlated/Independent Sequential/ Concurrent Risk Approach
Discrete Independent Sequential Decision tree
Discrete Correlated Concurrent Scenario analysis
Continuous Either Either Simulations
Reference: Level 2 Reading 10

3.2 Complement or Replacement for Risk-Adjusted Value
Decision tree & simulations ⇒ used as either complements to or substitutes for risk adjusted values.
Scenario analysis ⇒ always used a complement to risk adjusted value.
All three approaches use expected rather than risk adjusted cash flows & the discount rate that is used should be a risk adjusted
discount rate.
3.3 In Practice
With the surge in data availability & computing power, the use of probabilistic approaches has become more common.
The ease with which simulations can be implemented has allowed its use in variety of new markets including;
i. Deregulated electricity market.
ii. Commodity companies.
iii. Technology companies.

“CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE”

IRP = Interest Rate Parity PPP = Purchasing Power Parity
DC = Domestic Currency BOP = Balance of Payment
FC = Foreign Currency EM = Emerging Markets
IR = Interest Rates ER = Exchange Rate
E(R) = Expected Return
2. FOREIGN EXCHANGE MARKET CONCEPTS
Two points about bid-offer quotes:

Offer price is always > bid price.
Counterparty who inquires price quote will have the option to deal at either the bid or offer
price quoted to them by the dealer.
Size of bid-ask spread depends on the following factors.
The currency pair involved ⇒ more liquid currency pairs, bid-offer spread.
The time of day ⇒ the interbank FX markets are the most liquid when the major FX trading
centers are open ⇒ low spreads.
Market volatility ⇒ uncertainty about the factors influencing price, wider bid-ask spreads.
Size of transaction ⇒ larger the transactions, wider the spread (greater difficulty the dealer
faces in laying off the foreign exchange risk).
Relationship b/w the dealer & the client can also affect the size of the bid-offer spread.
2.1 Arbitrage Constraints on Spot Exchange Rate Quotes
Two arbitrage constraints to avoid riskless arbitrage opportunities:

The bid (offer) shown by a dealer cannot be higher (lower) than the current interbank offer
(bid).
The cross rate bids (offers) posted by a dealer must be lower (higher) than the implied cross-rate
offers (bids) available in the interbank market.
Forwards ⇒ agreements to exchange one currency for another on a future date at an exchange rate
agreed on today.
Forward rates must satisfy an arbitrage relationship that equates the investment return on two
alternative but equivalent investments.
An investor with one unit of DC to invest for one year faces two alternatives:
Invest cash for one year at the domestic & at the end of year, investment would be worth
1 +
Convert the DC to FC at spot rate⁄ , invest for one-year & at the end of year the
investor would have ⁄ 1 + . Undertake a forward at the start of the investment at to

convert foreign investment into DC. At the end of year the investment would be worth
⁄ 1 +
1 +

1 + = 1 +

Covered IRP⇒ =

Covered IR differential b/w two markets is zero.
Forward premium or discount⇒ − = −

Factors that determine spot bid-ask spread (e.g. liquidity, transaction size etc.) also determine bid-
offer spread for forward swap.
Mark-to-market value of forward ⇒ profit/loss that would be realized from closing out the position at
the current market price.

3. A LONG-TERM FRAMEWORK FOR EXCHANGE RATES
Trading decision in FX markets lays a view on future market prices & conditions.
Decision to be fully hedged implies that future market conditions are very
uncertain.
International parity conditions ⇒ determine long run movements in exchange
rates, IR & inflation.
Following concepts must be clearly understood:
Long run v/s short run.
Real v/s nominal values.
Expected v/s unexpected changes.
Relative movements.
3.1 International Parity Conditions
Key international parity conditions rarely hold in either the short or medium
term.
Two reasons to study international parity conditions:
Each condition reflects economic forces that should not be ignored
altogether.
Currency positions offer profitable opportunities only when parity
conditions fail to hold.
3.1.1 Covered Interest Rate Parity
An investment in a foreign money market (completely hedged against exchange

risk) should yield exactly the same return as an otherwise identical domestic
money market investment.
If this parity does not hold, arbitrage profit is possible.
Assumptions ⇒ no transaction costs, identical instruments.
3.1.2 Uncovered Interest Rate Parity
The expected return on an uncovered FC investment should be equal to the

return on a comparable DC investment.
Expected exchange rate differential = yield differential.
%∆ ⁄ = −
Country with IR is expected to see the value of its currency depreciate.
This parity relationship works better over very long term horizons.
3.1.3 Forward Rate Parity
If both covered & uncovered IR parity hold, forward exchange rate will be an
unbiased forecast of the future spot exchange rate.
Forward exchange rates are poor predictors of future spot exchange rates.
Without using any current information to predict future spot rates, the random
walk prediction can be slightly biased.

3.1.4 Purchasing Power Parity
Law of one price ⇒ identical goods should trade at the same price across
countries when valued in terms of a common currency.
Absolute versions of PPP ⇒ equilibrium exchange rate b/w two countries is
determined entirely by the ratio of their national price levels.
Due to significant transaction costs, this relationship does not hold.
Relative version of PPP⇒ % ∆ in spot rate will be completely determined by the
diff. b/w the foreign & domestic inflation rates.
Ex-ante version of PPP ⇒ expected changes in the spot exchange rate being
entirely driven by expected differences in national inflation rates.
3.1.5 The Fisher Effect & Real Interest Rate Parity
International fisher effect:

− = −
Foreign – domestic yield spread = foreign-domestic expected inflation
differential, assuming real IR are equal across markets.
Fisher effect examines how ER, IR, & inflation rates interact.
4. CARRY TRADE
FX carry trade ⇒ it involves taking long positions in high yield currencies & short
positions in low yield currencies (funding currencies).
The idea behind this trade is that the high-yield currencies on avg. have not
depreciated, & low yield currencies have not appreciated to the level predicted
by IR differentials.
During periods of low volatility, carry trades tend to generate +ve excess
returns, (prone to significant crash risk in turbulent times).
Valuation overlay approach to manage downside crash risks ⇒ high yielders will
be overweighted & low yielders will be underweighted when ER lie inside
prescribed PPP bands.
Dangers of carry trade:
Create ER misalignment around the world.
Can cause a serious currency or financial crises.

5. THE IMPACT OF BALANCE OF PAYMENTS FLOWS
Current a/c balance ⇒ sum of all recorded transactions in traded goods,

services, income & net transfer payments in a country’s overall BOP.
Countries that run persistent current a/c deficits (surpluses) often see their
currencies depreciate (appreciate) over time.
The current a/c must be matched by an equal & opposite balance in capital a/c
(to balance BOP account).
Financing decisions are usually the dominant factors in determining ER
movements
There are four reasons for this:
Prices of real goods & services adjust more slowly than ER & other asset
prices.
Production of real goods & services takes time.
It reflects financing of current expenditures & also reallocation of existing
portfolios.
Expected ER movements can induce very large short-term capital flows.
5.1 Current Account Imbalances & the Determinations of Exchange Rates
5.1.1 The Flow Supply/Demand Channel
Purchases & sales of internationally traded goods & services require the
exchange of domestic & foreign currencies.
Countries with persistent current a/c surpluses would see their currencies
appreciate over time & vice versa.
The amount by which ER must adjust to restore current accounts to balanced
positions depends on a no. of factors:
Initial import & export gap.
Response of import & export prices to ∆ in ER.
Response of import & export demand to ∆ in import & export prices.
5.1.2 The Portfolio Balance Channel
Current a/c imbalances ⇒shift financial wealth from deficit nations to surplus
nations ⇒ lead to shifts in global asset preferences ⇒ exert an impact on the path
of ER.
5.1.3 The Debt Sustainability Channel
Persistent current a/c imbalances ⇒ for deficit nations, ever-rising net external
debt levels as a % of GDP ⇒ steady downward revision in market expectations of
the currency’s real long-run equilibrium value.
5.2 Capital Flows & the Determination of Exchange Rates
Excessive surges in capital inflow to EM may cause economic or currency crises

by contributing to:
An unwarranted real appreciation of the EM currency.
A huge buildup in external indebtness by EM Govt., businesses or banks.
Property market or financial asset market bubble.
A consumption binge & overinvestment in risky projects.

5.2.1 Equity Market Trends & Exchange Rates
The relationship b/w equity market performance & ER is not stable.

Judgments on possible future currency moves, based solely on expected equity
market performance is difficult.
6. MONETARY AND FISCAL POLICIES
6.1 The Mundell-Fleming Model
Changes in monetary & fiscal policy ⇒ affect the level of IR & economic activity ⇒
leads to changes in the direction & magnitude of trade capital flows ⇒ change in
the ER.
Expansionary Monetary Policy
With Flexible ER With Fixed ER
Domestic IR ⇒ capital flow to higher Monetary authority will have to buy its own
yielding market ⇒ value of DC. currency to prevent depreciation.
In currency value will net exports. Result ⇒ tight domestic credit conditions to
offset the intended expansionary monetary
policy.
Expansionary Fiscal Policy
With Flexible ER With Fixed ER
Upward pressure on domestic IR ⇒ inflow of Monetary authority will have to sell its own
capital from lower-yielding markets ⇒ upward currency in the FX market to prevent DC
pressures on DC. appreciation.
Some insights of this model:

Objectives of independent monetary policy, free capital flows & to defend fixed ER cannot be satisfied at same time.
Degree of capital mobility is critical to the effectiveness of monetary & fiscal policy in an open economy.
Monetary-Fiscal Policy Mix & the Determination of Exchange Rates under Conditions of High
Capital Mobility
Expansionary Monetary Restrictive Monetary

Policy Policy
Expansionary Fiscal Domestic currency

Ambiguous
Policy appreciates
Domestic currency
Restrictive Fiscal Policy Ambiguous
depreciates
Reference: Level II Curriculum, Volume 1, Reading 11, Exhibit 5.

Monetary-Fiscal Policy Mix & the Determination of Exchange Rates under Conditions of Low
Capital Mobility
Expansionary Monetary Restrictive Monetary

Policy Policy
Expansionary Fiscal Domestic currency

Ambiguous
Policy depreciates
Restrictive Fiscal Domestic currency

Ambiguous
Policy appreciates
6.2 Monetary Models of Exchange Rate Determination
Under these models output is fixed & monetary policy affects ER

through the price level & the rate of inflation.
The Monetary Approach with Flexible Prices
An extension of the classical quantity theory of money to an open economy.

According to quantity theory ⇒ money supply ∆ are the primary determinant of price
level ∆ (PPP holds).
In a pure monetary approach model, a change in the money supply future growth rate
would have no immediate impact on the current ER.
The Dornbusch Overshooting Model
Shortcoming of pure monetary approach ⇒ assumption that PPP holds at all times (PPP
rarely hold in short or medium run).
Dornbusch model ⇒ assumes that output prices exhibit limited flexibility in short run but
are fully flexible in the long run.
Long run price level flexibility ensures that an in domestic money supply will give rise
to a proportional in domestic prices & contribute to a depreciation of DC in long run.
If domestic price level is assumed to be inflexible in the short run ⇒ the ER is likely to
overshoot its long run PPP path in the short run.

6.3 Portfolio Balance Approach
Role of monetary policy in determining ER ⇒ expansionary (restrictive) monetary policy

downward (upward) pressure on DC value.
Impact of fiscal policy on ER ⇒ ambigious.
Mundell-Fleming model ⇒ short-run model of ER determination.
Portfolio balance approach ⇒ global investor will hold a diversified portfolio of domestic
& foreign assets including bonds.
A steady in the supply of domestic bonds outstanding ⇒ continued widening of
the Govt. budget deficit ⇒ compensated in the form of E(R).
E(R) could come from
IR / risk premium
Immediate depreciation of the currency to a level sufficient to generate
anticipation of gains from subsequent currency appreciation.
Govts. that run large budget deficits on a sustained basis could eventually see their
currencies in value.
Combination of Mundell-fleming & portfolio balance models ⇒ expansionary fiscal policy
may be +ve for a currency in short run but –ve in the long run.
The Short- and Long-Run Response of Exchange Rates to Changes in Fiscal Policy
Increase in Real
Currency
Interest Rate
Appreciates
Differential
Short-Run Response
Expansive
Fiscal Policy
Central Bank
Long-Run Response Monetizes Debt
Government Currency
Debt Depreciates
Buildup
Fiscal Stance
Turns Restrictive
7. EXCHANGE RATE MANAGEMENT: INTERVENTION AND CONTROLS
Capital inflows ⇒ blessing ⇒ if they enable growing economies to bridge the gap b/w domestic investment &
savings.
Capital inflows ⇒ Curse ⇒ if they fuel boom like conditions, asset price bubbles & overshooting of the currency
into overvalued territory.
↑ in Capital inflows are caused by combination of pull and push factors.
Push Factors: +ve developments that attract overseas capital into the economy [relaxed regulations, liberal mkts.
Flexible exchange rates, privatization of state-owned entities etc.]
Pull Factors: developments in other economies that cause capital to flow to a particular economy [attract high
yielding economies become attractive amid low interest rates policies or ultra low interest rates in developed
economies].
Governments directly intervene to resist excessive inflows and to avoid currency bubbles.

8. WARNING SIGNS OF CURRENCY CRISES
Two school of thoughts with respect to currency crises anticipation

1. Deteriorating & weak economic conditions are warning sign for currency crises.
2. No particular factor as crises can occur out of the blue
To anticipate crises some factors are highly interrelated and often one factor leads to another.
Domestic currency
depreciates, initially • Primary Action: Increase
interest rates to stem
capital outflows but it If Govt. is unable to
may worsen banking intervene
• large foreign • banks trouble industry & slow down
capital inflows servicing short-term economy.
• domestic banks debt • Secondary Action: In FX
• capital outflow
borrow in FC . • Foreign investors market, buying own and speculative
withdraw capital currency that lowrs FC attacks increase
reserves.
Libralized Financial • speculators short
Markets currency
• Currency declines If Govt. intervenes:
further

“ECONOMIC GROWTH AND THE INVESTMENT DECISION”

FI = Fixed Income ICT = Information, Computers &
EG = Economic Growth 1. INTRODUCTION Telecommunications
Equity prices reflect expectations of the future stream of earnings, which

depend on expectation of future economic activity.
Shorter term ⇒ relationship b/w actual & potential growth is a key driver of FI
return.
Over long periods of time ⇒ the actual growth rate of GDP should equal the
rate of in potential GDP.
2. GROWTH IN THE GLOBAL ECONOMY: DEVELOPED VS. DEVELOPING COUNTRIES
Economic growth = annual % ∆ in real GDP or in real per capita GDP.

Growth in real GDP reflects how rapidly the total economy is expanding while
real per capita GDP reflects the avg. standard of living in each country.
Using market exchange rate to reflect GDP into another currency has two
problems:
Market exchange rates are very volatile.
Market exchange rates are determined by financial flows & flows in traded
goods & services (ignore consumption for non-trade-able goods &
services).
2.1 Savings & Investments
Problem of developing countries:

Savings ⇒ investment ⇒ GDP growth ⇒ income ⇒ savings.
2.2 Financial Markets & Intermediaries
Role of financial sector ⇒ channel funds from savers to investment projects.

Financial markets can promote growth in at least three ways:
By screening those who seek funding & monitoring those who obtain
funding
By creating attractive investment instruments.
Existence of well developed financial markets.
2.3 Political Stability, Rule of Law & Property Rights
Key ingredients for EG:

An effective & stable govt.
A well developed legal & regulatory system.
Clearly established property rights.
2.4 Education & Health Care Systems
Brain drain & inadequate education are major impediments to growth for many
developing countries.
Allocation of education spending among different type & levels of education is a
key determinant of growth.
Poor health is another hindrance to growth in the developing countries.

2.5 Tax & Regulatory Systems
Limited regulation ⇒ entrepreneurial activity & the

entry of new companies ⇒ production level.
2.6 Free Trade & Unrestricted Capital Flows
Open economy ⇒ world savings can finance domestic

investment ⇒ domestic income, savings &
investment.
Foreign investment can occur in two ways:
Foreign direct investment.
Indirect investment through purchase of
securities.
3. WHY POTENTIAL GROWTH MATTERS TO INVESTORS
Potential GDP ⇒ maximum amount of output an economy can sustainably produce without
inducing an in inflation rate.
If the ratio of corporate profits to GDP is trending upward ⇒ earning growth > GDP growth but
it’s not sustainable.
The relationship b/w EG & stock price can be examined through an equation:

1 % ∆ = 1 %∆ + 1 % ∆ + 1 % ∆

where
T = Time Horizon
%∆P = % ∆ in stock market value
E = Earnings
Short to intermediate horizon interpretation:
All three factors contribute to appreciation or depreciation of the stock market.
Long-run interpretation.
Growth rate of GDP dominate.
2nd & 3rd terms of equation must be approximately zero.
EG estimation is also relevant for global FI investors.
If current GDP> potential GDP ⇒ inflationary pressure ⇒ pressure on nominal IR & bond prices.
Potential GDP ⇒ improved credit quality.
FI investors must closely monitor the output gap & growth rates of actual & potential GDP to
assess the likelihood of a ∆ in central bank policy.
Credit rating agencies use potential GDP growth to evaluate the credit risk of sovereign debt.

4. DETERMINANTS OF ECONOMIC GROWTH
4.1 Production Function
Production function ⇒ Y= AF (K,L)

where
Y = level of aggregate output
L = labour quantity
K = capital stock
A = total factor productivity
Unless stated otherwise, the level of technology should be interpreted as referring to TFP.
Cobb-Douglas production function:
( , ) =
where
α = share of output paid by companies to capital & labor (value b/w 0 & 1).
Properties of Cobb-Douglas function:
Constant returns to scale.
Diminishing marginal productivity with respect to each individual input.
If value of α close to zero ⇒ diminishing marginal returns to capital are very
significant.
4.2 Capitals Deepening vs. Technological Progress
Capital deepening ⇒ an in the capital-to-labor ratio.

The ratio will as long as growth rate of capital > growth rate of labor.
When marginal product of capital = marginal cost ⇒ profit maximizing producers will stop
adding capital.
Sustained growth in per capita output requires progress in TFP.
4.3 Growth Accounting
The growth accounting equation:

∆ = ∆A + α∆K + 1 − α ∆L
A K L
It states that growth rate of output equals rate of technological ∆ + α times the growth rate
of capital plus (1-α) times the growth rate of labor.
Data on output, labor, capital & elasticity are available in developed countries but data on
technological ∆ must be estimated.
Growth accounting equation has a no. of uses:
It estimates the technological contribution progress to EG.
Used to empirically measure the sources of growth in an economy.
Used to measure potential output.
Alternative method of measuring GDP:
Labor productivity growth accounting equation.
Growth rate in potential GDP = long term growth of labor force + long term growth of
labor productivity.
Disadvantage ⇒ TFP & capital deepening are difficult to analyze & predict over long
run.

4.5 Natural Resources
Renewable Resources Non-Renewable Resources
Resources that are replenished, Finite resources that are

such as a forest. depleted once they are
consumed.
These resources eventually
limit growth.
Ownership & production of natural resources is not necessary for a country to achieve a
high level of income.
Presence of natural resources may restrain growth mainly due to two reasons:
Countries with natural resources may fail to develop economic institutions
necessary for growth.
Dutch disease ⇒ currency appreciation driven by strong export demand for
resources making other segments of economy globally uncompetitive.
4.6 Labor Supply
Labor force = working age population (16 to 64 years) that is either

employed or available for work.
Following are four factors that contribute to growth in labor input.
4.6.1 Population Growth
It is determined by fertility rates & mortality rates.

Long term labor supply is largely determined by the growth of the
working age population.
The age mix of population is also important (% of population > 65 years
& <16 years is a key consideration).
It has no affect on growth of per capita GDP.
4.6.2 Labor Force Participation
% of the working age population in the labor force.

In the short run, differences in labor force and population growth rates
may be due to changes in the participation rate.
An in the participation rate may the growth of per capita GDP.
4.6.3 Net Migration
Immigration is a possible solution to the slowing labor force growth being

experienced by many developed countries (low birth rates).
4.6.4 Average Hours Worked
Avg. hours worked is highly sensitive to the business

cycle.
Long-term trend ⇒ shorter workweek in advanced
countries.

4.7 Labor Quality: Human Capital
Human capital ⇒ accumulated knowledge & skills that workers

acquire from education, training or life experience.
Better educated & more skilled worker ⇒ more productive &
more adaptable to changes in technology.
Investment in education & on-the-job training, significant
return on that investment.
4.8 Capital: ICT & Non-ICT
If gross investment less Dep. of capital is > 0, the physical

capital stock from year to year.
The correlation b/w eco. growth & investment is high & +ve.
Network externalities ⇒ computers allow people to
interconnect through the internet & by e-mail, enabling them
to work more productively.
No of people in network ⇒ greater the potential
productivity gains.
High level of capital spending on non-ICT should eventually
result in capital deepening & thus have less impact on potential
GDP growth.
4.9 Technology
Technology ⇒ the most important factor affecting growth of per capital GDP
is technology.
Technology results in upward shift in the production function.
Technological change can be embodied in human capital &/or in new
machinery, equipment & software.
Innovation is possible through investment in ICT goods or through
expenditure on R&D.
TFP estimates are very sensitive to the measurement of the labor & capital
inputs.
Level of productivity depends on accumulated stock of human & physical
capital.
Permanent in rate of labor productivity growth, sustainable EG,
upper bound for earnings growth, potential return to equity & vice versa.
4.10 Public Infrastructure
Public capital ⇒ roads, bridges, municipal water dams & electric grids (in
some countries).
The full impact of govt. infrastructure investment may extend well beyond
the direct benefits of the project.

5. THEORIES OF GROWTH
5.1 Classical Model
Referred as Malthusian theory ⇒ focused on the impact of a growing population in a

world with limited resources.
Production function ⇒ labor input with land as a fixed factor.
Key assumption ⇒ population growth accelerates when the level of per capita income
rises above the subsistence income (minimum income needed to maintain life).
The labor input faces diminishing marginal returns so the additional output to
zero & per capita income returns back to subsistence level.
Constant standard of living & no growth in per capital output in the long run.
According to this model, the adoption of new technology results in a larger but not
richer population in the long run.
The prediction from model failed for two reasons:
As the growth of per capital income, population growth slowed rather than
accelerating as predicted by classical model.
Growth in per capita income has been possible (as rapid technological progress
offset the impact of diminishing returns).
5.2 Neoclassical Model
Objective of neoclassical growth model ⇒ determine the long-

run growth of output per capita.
Cobb-Douglas production function is the heart of this theory.
5.2.1 Balanced or Steady State Rate of Growth
Steady state rate of growth ⇒ occurs when output-to-capital ratio is constant.

The growth rate of output per worker:
∆ ∆
= +
∆

Equilibrium output-to-capital ratio, denoted by the constant Ψ
1
= + + = ∆
1−
where
= growth rate of TFP
s = saving

= growth rate of labor productivity

n = growth rate of labor
δ = depreciation rate
In the steady state, capital-to-labor ratio (k) & output per worker (y) grow at the same rate,
given by

Marginal product of capital = real interest rate.
Capital deepening has no effect on the growth rate of economy or on the marginal product of
capital once the steady state has reached.
Factors (saving rate, labor force growth rate & Dep. rate) ∆ the level of output but do not
permanently ∆ the growth rate of output per worker.
If the economy has not yet reached the steady state it can experience either faster or slower
growth relative to steady state.
If the output-to-capital ratio > its equilibrium level, the growth rates of output per capita
& the capital-to-labor ratio are above the steady state (vice versa in case of output-to-
capital ratio < its equilibrium).

5.2.2 Implications of the Neoclassical Model
Four Major Groups of Conclusions
Capital Accumulation Capital Deepening vs. Technology
Capital accumulation affects the level of output but not the Rapid growth that is above the steady state rate of growth
growth rate in the long run. occurs when countries first begin to accumulate capital; but
Regardless of its initial capital-to-labor ratio or initial level growth will slow as the process of accumulation continues.
of productivity, a growing economy will move to a point of Long-term sustainable growth cannot rely solely on capital
steady state growth. deepening investmentthat is, on increasing the stock of
In steady state, the growth rate of output equals the rate of capital relative to labor. If the capital-to-labor ratio grows
labor force growth plus the rate of growth in TFP scaled by too rapidly (i.e., faster than labor productivity), capital
labor’s share of income + . The growth rate of

becomes less productive, resulting in slower rather than

faster growth.
output does not depend on the accumulation of capital or
More generally, increasing the supply of some input(s) too
the rate of business investment.
rapidly relative to other inputs will lead to diminishing
marginal returns and cannot be the basis for sustainable
growth.
In the absence of improvements in TFP, the growth of labor
productivity and per capita output would eventually slow.
Because of diminishing marginal returns to capital, the only
way to sustain growth in potential GDP per capita is
through technological change or growth in total factor
productivity. This results in an upward shift in the any given
mix of labor and capital inputs.
Convergence Effects of Savings on Growth
Given the relative scarcity and hence high marginal The initial impact of a higher saving rate is to temporarily
productivity of capital and potentially higher saving rates in raise the rate of growth in the economy. In response to the
developing countries, the growth rates of developing higher saving rates, growth exceeds the steady state growth
countries should exceed those of developed countries. rate during a transition period. However, the economy
As a result, there should be a convergence of per capita returns to the balance growth path after the transition
incomes between developed and developing counties over period.
time. During the transition period, the economy moves to a
higher level of per capita output and productivity.
Once an economy achieves steady state growth, the growth
rate does not depend on the percentage of income saved or
Reference: Volume 1, Reading 12.
invested. Higher savings cannot permanently raise the
growth rate of output.
However, countries with higher saving rates will have a
higher level of per capita output, a higher capital-to-labor
ratio, and a higher level of labor productivity.

5.2.3 Extension of the Neoclassical Model
Criticism on neoclassical growth theory:

Lack of explanation for economic determinants of TFP.
Model predicts that the steady state rate of EG is unrelated to the rate of saving
& investment.
Critiques of neoclassical model led to two lines of subsequent research on EG.
Augmented Solow approach ⇒ adds human capital to the production function
& enables us to measure the contribution of technological progress.
Endogenous growth theory.
5.3 Endogenous Growth Theory
These models focus on explaining technological progress rather than treating it as

exogenous.
Self-sustaining growth concept with no necessary convergence to a steady state rate
of growth.
No diminishing marginal returns to capital for the economy as a whole.
In this model human capital & R&D spending are factors of production & have to be
paid for through savings.
The production function in the endogenous model is a straight line.
the saving rate, the EG rate.
Market failure ⇒ due to +ve externalities, the private companies invest too low on
R&D & knowledge capital.
According to this model the incomes of developing & developed countries should not
converge.
5.4 Convergence Debate
Convergence ⇒ countries with low per capita incomes should grow at a faster rate
than countries with higher per capita incomes.
Types of convergence under neoclassical growth theory:
Absolute convergence ⇒ convergence of per capita growth rates among all
countries but not the level of per capita income.
Conditional convergence ⇒convergence to same level of per capita output as
well as the same steady state growth rate is conditional on the countries having
same saving rate, population growth rate & production function.
Club convergence ⇒ only rich & middle-income countries that are members of
the club are converging to the income level of the richest countries.
Non-convergence trap ⇒ occurs if necessary institutional reforms will not be
implemented.
Convergence b/w developed & developing countries can occur in two ways.
Convergence takes place through capital accumulation & capital deepening.
By adopting technology that is widely used by advanced countries.
Endogenous model makes no prediction that convergence should occur.

6. GROWTH IN AN OPEN ECONOMY
Opening up an economy can significantly affect growth for following reasons:

Funding from global markets.
Countries can take benefit of law of comparative advantage.
Companies can exploit any economies of scales.
Technological progress.
Competition leads to better products.
Opening up the economy should the rate at which countries’ capital-to-labor
ratios converge.
Endogenous growth models ⇒ more open trade policy will permanently raise the
rate of EG.
Developing countries have pursued two strategies for economic development:
Inward-oriented policies ⇒ focus on developing domestic industries by
restricting imports.
Outward-oriented policies ⇒ attempt to integrate domestic industries with
those of the global economy (exports is a key driver of growth).

“ECONOMICS OF REGULATION”
1. INTRODUCTION
Regulations have macro as well as micro (companies & individual level) effects.
Regulation may develop either proactively (in anticipation of consequences of
changes in environment) or reactively (in response to some occurrences).
Significant challenge on the financial regulation ⇒ how to deal with systematic
risk.
2. OVERVIEW OF REGULATION
Regulations may impose restrictions on how

businesses interact with others & how
businesses operate internally.
2.1 Classification of Regulations and Regulators
Classification of regulations:
Statutes ⇒ laws enacted by legislative bodies.
Administrative law ⇒ rules issued by Govt. agencies or other
regulators.
Judicial law ⇒ interpretations of courts.
Advantage of independent regulators ⇒ immune from political influence &
pressure (to some extent) but may be subject to pressure from their
members.
Regulations address a broad range of issues & can be classified by their
objectives.
Substantive law ⇒ focuses on the rights & responsibilities of entities &
relationship among entities.
Procedural law ⇒ focuses on the protection & enforcement of substantive
laws.
2.2 Economic Rationale for Regulation
Informational frictions result in a variety of issues:

Adverse selection ⇒ private information in the hands of some which
affects the consumption of goods or services.
Moral hazard ⇒ incentive conflicts that arise from delegation of
decision making.
Asymmetrical information.
Externality issue (provision of public goods).
Because there are shared benefits for consuming the public good,
market will not produce the optimal amount of these goods.

2.2.1 Regulatory Interdependencies
Regulatory capture ⇒ regulation often arises to capture the interests of those regulated.
Regulatory competition ⇒ regulators may compete to provide a regulatory environment
designed to attract certain entities.
Regulatory arbitrage ⇒ entities may identify & use some aspect of regulation and
exploiting differences in regulatory interpretations or jurisdictions for their benefit.
The reason behind the interdependencies across jurisdictions is to recognize the reality &
implications of diverse trade-offs.
Evidence exists that govt. recognize the necessity for global regulatory cooperation &
coordination.
Regulation by different regulators even with seemingly similar objectives can lead to very
different regulatory outcomes.
2.3 Regulatory Tools
Regulatory & Govt. policies should be predictable & effective in achieving objectives.
Negative externalities:
Systematic risk ⇒ risk of failure of a major financial institution.
Financial contagion ⇒ situation in which financial shocks spread from their place of
origin to other locales.
The regulator should have comprehensive enforcement powers.
Difficulties to prosecute settlements with individual violators include:
Violations are difficult to detect.
Strong incentives to fight in order to protect reputation & livelihood.
3. REGULATION OF COMMERCE
IOSCO developed a framework of matters to be addressed in the domestic laws to

facilitate effective securities legislation. Regulatory & Govt. policies should be predictable
& effective in achieving objective.
Negative externalities:
Systematic risk ⇒ risk of failure of a major financial institution.
Financial contagion ⇒ situation in which financial shocks spread from their place of
origin to other locales.
The regulator should have comprehensive enforcement powers.
Difficulties to prosecute settlements with individual violators include:
Violations are difficult to detect.
Strong incentives to fight in order to protect reputation & livelihood.
4. REGULATION OF FINANCIAL MARKETS
Securities regulation focuses on such goals as protecting investors, creating confidence in

markets & enhancing capital formation.
Key focus of regulators ⇒ maintaining the integrity of the markets & acting as a referee
for its fairness.
The disclosure framework is wide-ranging & has high potential importance.
Monitoring & supervision are important aspects of the regulations.
Benefits of regulations generally come up with associated costs.

5. COST-BENEFIT ANALYSIS OF REGULATION
Regulatory burden ⇒ costs of regulation for the regulated entity.

Net regulatory burden = private costs of regulation – private benefits of regulation.
Regulators must distinguish b/w implementation costs (unanticipated) & indirect costs
(unintended consequences).
Regulatory benefits & costs are difficult to assess on a prospective basis compared with a
retrospective basis.
Sunset provisions ⇒ implemented regulation would be automatically removed after a
no. of years.
Regulatory judgments should reflect economic principal & full consideration of costs &
benefits rather than the preferences of the current decision makers.
6. ANALYSIS OF REGULATION
Effect of regulations ⇒ both micro & macro effects.

Using a framework, an analyst identifies & focuses on areas that potentially have
significant effects on the industry or entity being analyzed.
The advocates of the principle of network neutrality argue that there should not be any
restriction on access to networks.
6.1 Effects of Regulations
Regulation may affect a no. of sectors to varying degrees or designed for a particular sector.
Net regulatory burden to the entity of interest is an important consideration for an analyst.

HFT =Held-for-Trading PV = Present Value
HTM =Held-to-Maturity “INTERCORPORATE INVESTMENTS” HC = Historical Cost
AFS =Available-for-Sale VIE = Variable Interest Entity
I.S=Income Statement T.C = Transaction Cost
C.A =Contingent Assets B.S: Balance Sheet CF =Cash Flow A&L = Asset & Liability
C.L = Contingent Liabilities FV: Fair Value CV = Carrying Value R&E = Revenue & Expense
N.I = Net Income R.E = Retained Earnings G/W =Goodwill SPE = Special Purpose Entity
B.C = Business Combinations R&D = Research & Development DFV =Designated at Fair Value T.A =Total Assets
B.V = Book Value F.G = Financial Guarantee P.P = Purchase Price T.L= Total Liabilities
JCE = Jointly Controlled Entities D&E = Debt & Equity P/L = Profit or Loss MV: Market Value
G/L=Gain & Loss JCO = Jointly Controlled Operations CFO = Cash Flow from Operations OCI = Other Comprehensive Income
FVPL = Fair Value through Profit JCA = jointly Controlled Assets QSPE = Qualifying Special Purpose Entity FVOCI = Fair Value through Other
& Loss Comprehensive Income
FA = Financial Assets
1. INTRODUCTION
2. BASIC CORPORATE INVESMENT CATEGORIES
Financial assets Investment in associates Business combinations Joint venture

No significant control Significant influence over investee’s Control over investee’s Shared control
(ownership < 20%) operations (ownership 20%-50%) operations (ownership > 50%)
Ownership % is only a guideline; ultimate category is based on investor’s ability to influence.
3. INVESTMENTS IN FINANCIAL ASSETS: STANDARD IAS 39 (AS OF DECEMBER 2012)

IFRS⇒HTM, AFS, FV Through P/L, loans & receivables
3.1 Held-to-Maturity 3.5 Reclassification of Investments
IFRS U.S. GAAP

Debt Securities Balance Sheet Income
Long term Amortized cost Statement Cannot be reclassified into & out of DFV & out of From AFS HFT = cumulative
initially FV (IFRS) (original cost ± Interest HFT. or unrealized G/L in I.S
Price paid (U.S.GAAP) Discount/premium). income. IFRS⇒not permitted to classify HTM if company
sold significant HTM investment during current or
two preceding years (certain exceptions).
3.2 Fair value through Profit or Loss
AFS debt to HTM, with FV at B.S & difference b/w Debt security of AFS into HTM
fair & maturity value & G/L in other ⇒ cumulative G/L amortize
IFRS ⇒ Include securities held for trading & designated at FV. comprehensive income amortized over security over security life.
U.S. GAAP ⇒similar classification (except for some financial life.
assets).
HTM to AFS, with FV at B/S & difference b/w fair HTM to AFS = unrealized G/L
& CV is in other comprehensive income. to comprehensive income.
Debt instruments from HFT or AFS to loans &
3.2.1 Held for Trading
Receivables (foreseeable future holding)
Short term debt & equity securities. 3.2.2 Designated at Fair Value
Reported at FV.
Unrealized G/L in I.S. Investment initially recognized at FV (under both IFRS &
Interest & dividend received in I.S U.S.GAAP) that might otherwise be classified as AFS or HTM.
Accounting treatment is similar to HFT.
3.3 Available-for-Sale
D&E Securities Balance Sheet Income Statement

Neither HTM Fair value, Realized G/L.
nor FVPL unrealized Foreign currency
Initial & later G/L in equity. unrealized G/L (Debt
recog at FV Sec IFRS).

3. INVESTMENTS IN FINANCIAL ASSETS: STANDARD IAS 39 (AS OF DECEMBER 2012)

IFRS⇒HTM, AFS, FV Through P/L, loans & receivables
3.4 Loans & Receivables 3.6 Impairments
Non – derivative financial assets with fixed or determinable

IFRS U.S. GAAP
payments.
Evaluate HTM & AFS securities for Evaluate HTM & AFS securities for
IFRS ⇒ at amortized cost (unless designated as AFS or FVPL).
impairment. impairment.
U.S. GAAP ⇒ if meet the definition of debt security, then
classified as HFT, AFS or HTM Debt security is impaired if one loss event Security is impaired if decline is not
occurred, equity security is impaired if FV < temporary.
CV.
HTM & loans & receivables investment AFS⇒ Subsequent increase is
impaired, B/S value is PV of future C.F, loss reported in OCI.
in I.S & reversal is allowed.
AFS security impaired, unrealized loss in I.S.
equity cannot be reversed.

4. INVESTMENTS IN FINANCIAL ASSETS: IFRS 9 (AS OF DECEMBER 2012)
IASB has updated standard IFRS 9 (financial instruments).

Effective date is Jan 1 ’15 (early adoption permitted).
Terms AFS & HTM no longer appear in IFRS 9.
Financial assets must meet two criteria to be measured at amortized cost.
Business model test.
Cash flow characteristic test.
4.1 Classification and Measurement
All FA measured at FV when initially acquired.

Subsequent treatment ⇒ FV or amortized cost.
FA meeting above two tests of sec 4, are generally measured at amortized
cost (management can choose FVPL).
Equity investment HFT must be measured at FVPL.
Other equity investments, FVPL or FVOCI (irrevocable choice).
Derivatives are measured at FVPL (except hedging instruments).
Debt Equity
Yes
Yes
Yes
Is the business objective for financial Held for Trading
assets to collect contractual cash
No
flows? And No
Are the contractual cash flows solely
Yes
for principal and interest on Designated at FYOCI?
principal?
Yes No
Yes
Designated at FVPL?
No
Amortized Cost Changes in fair Changes in fair value

value recognized in recognized in OCI.
P/L.
Reference: Level II Curriculum, Volume 2, Reading 18.
4.2 Reclassification of Investments
Reclassification of equity instruments is not permitted.

Debt instrument reclassification ⇒ FVPL to amortized cost (vice versa) ⇒
only if objective for holding FA significantly affects operations.
No restatement of prior periods.
From amortized cost to FVPL ⇒ assets FV, G/L in P&L.
From FVPL to amortized cost ⇒ FV become carrying value.

6. BUSINESS COMBINATIONS
5. INVESTMENTS IN ASSOCIATES AND JOINT VENTURES
IFRS U.S.GAAP
Joint venture ⇒ ventures undertaken & controlled by two or
No distinction among B.C Merger A+B=A
more parties.
Acquisition A+B=A+B
Equity method of accounting is required (Both, IFRS &
Consolidation A+B=C
U.S.GAAP).
Characteristics of JVs (IFRS)
Contractual arrangement b/w two or more ventures. Two – component consolidation model (U.S.GAAP).
Joint control. Variable interest component (consolidate VIE regardless
of voting interest).
Control component.
5.1 Equity Method of Accounting: Basic Principles Acquisition method replaces the purchases method &
differences b/w IFRS & U.S.GAAP.
Initial investment Investee’s earnings Dividends received 6.1 Pooling of Interests and Purchase Methods
At cost as Increase investment Decrease Term
noncurrent asset. A/C, non operating investment A/c. U.S.GAAP IFRS
income & vice versa Pooling of interests Uniting of interests
in case of loss. Assets & liabilities at B.V, pre comb. R.E included.
No new accounting basis & continuity of ownership.
Purchase method: Net assets @ FV, Add.Dep., lower reported earnings.
5.2 Investment Costs That Exceed the Book Value of the
Investee
Excess of purchase price over book value is allocated to 6.2 Acquisition Method
FV of A&L, any remainder is G/W. Both IFRS & U.S. GAAP require the acquisition Method.
IFRS U.S.GAAP
FV or HC (less Acc.Dep.) HC only (less Acc.Dep.) 6.2.1 Recognition and Measurement of Identifiable Assets and Liabilities
Identifiable assets & liabilities at F.V.
Acquirers recognize A&L not previously recognize by acquiree (e.g. brand
5.3 Amortization of Excess Purchase Price name).
Investor recognizes expense based on excess amounts &
consistent with investee’s expense recognitions. 6.2.2 Recognition and Measurement of Contingent Liabilities
Acquirer recognize contingent liability if
Present obligation arise from past events
5.4 Fair Value Option
Measured reliably
Investment A/c at FV through irrevocable election.
IFRS U.S.GAAP
U.S. GAAP all entities, IFRS restricted.
Fair value can be reliably measured. Probable & reasonably estimated.
No prop. Share in B/S.
No goodwill, G/L, Div.in B/S.
6.2.3 Recognition and Measurement of Indemnification of Assets
Acquirer recognize assets If acquiree indemnifies.
5.5 Impairment
FV < CV investment is impaired, B/S fair value, loss I.S, reversal not 6.2.4 Recognition and Measurement of Financial Assets and Liabilities
allowed. Acquirer can reclassify financial A&L of acquiree on basis of certain
conditions.
5.6 Transactions with Associates 6.2.5 Recognition and Measurement of Goodwill

Profit from upstream (investee to investor) or downstream must IFRS U.S.GAAP
be deferred until confirmed through use or sale to a third party. Partial G/W (PP-Acquirer’s share of FV). Full G/W
Full G/W (FV of acquisition-FV of ident.net assets).
5.7 Disclosure
About A&L & results of equity method. 6.2.6 Recognition and Measurement When Acquisition Price Is Less than Fair
Value
Contingent consideration at FV & subsequent changes in I.S.
5.8 Issues for Analysts IFRS U.S.GAAP
Difference b/w PP & F.V of Treatment is same as IFRS.
acquired net assets immediately
Higher earnings Ratios impact C.F. problem in I.S.
Dividend payout Improves certain Earnings may not
is < 100%. ratios. in form of C.F.

6.3 Impact of the Acquisition Method on Financial Statements, Post-Acquisition 6.6. VARIABLE INTEREST AND SPECIAL PURPOSE ENTITIES
Financial statements continue to be affected. To accommodate specific needs of the sponsor.
Transfer A & L from sponsoring company’s B.S. as sale.
6.4 The Consolidation Process Improve certain ratios of sponsor by avoiding consolidation.
Combine the results of operations IFRS U.S.GAAP
Intercompany transactions are eliminated to avoid double Revise the definition to More general term VIE as compare to
counting encompass many SPEs SPE (IFRS).
Difference b/w IFRS & US GAAP must be considered to avoid IFRS 10 is applicable from VIE includes other entities besides
inconsistency Jan1’13 SPEs.
SPEs involved in structured Primary beneficiary must consolidate
6.4.1 Business Combination with Less than 100 Percent Acquisition financial transaction will VIE if controls (certain indicators).
Merger or consolidation ⇒ Acquire 100% equity. require an evaluation of Entity absorb losses must consolidate
Acquisition < 100% (parent, subsidiary relationship). purpose, design and risks. (if other entity will receive residual
return).
NCI in VIE also be shown in I.S & B.S.
6.4.2 Non-controlling (Minority) Interests: Balance Sheet
Subsidiary’s equity held by third parties.
Separate component of equity (both IFRS & U.S.GAAP converged)
6.6.1 Illustration of an SPE for a Leased Asset
Measurement SPE borrow debt ⇒ buy asset ⇒ lease it to repay debt & return to
IFRS U.S.GAAP equity holders.
Full G.W method Full G.W method Sponsor bear default risk, asset ownership, so consolidate.
Partial G.W method
6.6.2 Securitization of Assets

6.4.3 Non-controlling (Minority) Interests: Income Statement Example
A line item reflecting allocation of P&L.
Intercompany transactions are eliminated in full.
Impact on ratios would be diff. under full G/W & partial G/W.
6.7 Additional Issues in Business Combinations That Impair Comparability
Value of noncontrolling interest on parent’s B/S will change.
6.7.1 Contingent Assets and Liabilities

6.4.4 Goodwill Impairment
IFRS U.S.GAAP
Impairment test ⇒ annual or more frequent.
Cost of acquisition Contractual contingent A&L at FV at
Written down G/W. cannot be later restored. allocated to F.V of A,L & acquisition
Impairment loss is separate line item in I.S (both IFRS & U.S.GAAP). contingent L. Non-contractual recognize only if
G/W assignment & impairment Test C.L at F.V ( Initially) meet the def. of A or L at acquisition.
IFRS U.S.GAAP > of amount recognized& Subsequently
Assignment ⇒Cash- Assignment ⇒ Reporting unit amount req. to settle C.L ⇒> of initial amount or estimate
generating unit (subsequent) of loss.
Impairment test (one step) Impairment test (2step) Contingent assets not C.A⇒< F.V or future settlement
Rec. amount < C.V= loss C.V> F.V= impairment occurred. recognized. amount.
Loss reduced G/W & other [C.V – implied FV] of Goodwill =
assets when G/W = 0. amount of impairment Loss. 6.7.2 Contingent Consideration
Loss reduced G/W but not other May negotiated as part of acquisition price.
assets. Initially measured at F.V either A,L or Equity (both IFRS &
U.S.GAAP)
6.5 Financial Statement Presentation Subsequent to the Business Can also classify as asset (U.S.GAAP). Subsequent changes in I.S.
Combination Not remeasured equity classified.(both IFRS & U.S.GAAP)
Presentation is similar under IFRS & U.S.GAAP.
6.7.3 In-Process R&D
A separate intangible asset at FV (both IFRS & GAAP).
Subject to amortization or impairment.
6.7.4 Restructuring Costs

Expense in the period the costs are incurred.
Not a part of cost of acquisition (both standards).

DR = Discount Rate
PVDBO = Present Value of the “EMPLOYEE COMPENSATION: POST- DC
DB
= Defined Contribution
= Defined Benefits
Defined Benefit BS = Balance Sheet
OPB
Obligation
= Other Post
EMPLOYMENT AND SHARE-BASED” FV
ABO
= Fair Value
= Accumulated Benefit
Employment Benefits Obligation
VBO = Vested Benefit
Obligation
1. INTRODUCTION
Aspects of Employee Compensation
Post-Employment Benefits Share-Based Compensation
Examples: Examples:
Pension Stock options.
Other post employment benefits. Stock grants.
Value of employee compensation is difficult to determine due to various factors (e.g.

benefits are earned during service period and paid after service.
2. PENSION AND OTHER POST-EMPLOYMENT BENEFITS
2.1 Types of Post-Employment Benefits Plans
Assumptions required estimating & recognizing future

benefits can have a significant impact on the
company’s reported performance & financial position.
Comparability across companies may be affected due
to difference in assumptions.
Types of Post Employment Benefits Plans
DC Pension Plans DB Pension Plans Other Post-Employment Benefits

(OPB)
Specific contributions by employer. Employer promises to pay a defined These include life insurance premiums &
Investment risk is borne by employee. amount of pension in the future. health care insurance.
The agreed upon amount is pension Future pension payments represent a OPB are typically classified as DB plans
expense. liability of the sponsoring company. but more complex reporting
Employees may also contribute to the Various actual assumptions & requirement.
plan. computations are required to measure Future benefit depends on plan
Plan impact on company’s financial pension obligation. specifications & types of benefit.
statements can be easily assessed. Multi-employer plans (IFRS only) Þ plans Companies typically do not prefund OPB.
to which many different employers
contribute on behalf of their employees
(e.g. industry association pension plan).
Overfunded (underfunded) plan Þ
pension assets > (<) pension liabilities.
Sponsor bears the investment risk.

2.2 Measuring a Defined Benefit Pension Plan's Obligations
Pension Obligation
IFRS U.S.GAAP
Obligation is called PVDBO. Obligation is called PBO.

PVDBO Þ PV of expected future PBO Þ the actuarial PV as of a date of all benefit
payments required to settle the attributed by the pension benefits formula to employee
obligations arising from employee service rendered prior to that date.
service in the current & prior periods U.S. GAAP also identifies two other measures of pension
(without deducting any plan assets). liability including VBO & ABO.
Pension obligation depends upon a number of actuarial assumptions (e.g. discount rate,
future salary increase etc.).
2.3 Financial Statement Reporting of Pension Plans and Other Post-Employment Benefits
2.3.1 Defined Contribution Pension Plans
Contribution into the plan is recorded as an expense on the income statement.

Liability is recognized at the end of the reporting period only for any unpaid contributions.
2.3.2 Defined Benefit Pension Plans
2.3.2.1 Balance Sheet Presentation 2.3.2.2 Periodic Pension Cost
Both IFRS & U.S.GAAP require a Periodic pension cost Þ D in the net
pension plan’s funded status to be pension liability or asset adjusted for
reported on the BS. the employer’s contribution.
Funded status = PV of the defined The periodic pension cost is recognized
benefit obligation – FV of the plan in profit or loss &/or in OCI.
assets.
Underfunded (overfunded) plan Þ net
pension liability (asset). Periodic Pension Cost
IFRS U.S.GAAP
Service cost Þ amount by which a company’s pension obligation Current service cost is recognized in P&L.
increases as a result of employees’ service in the current period. Past service costs are reported in OCI in the period in which cost occurs
Past service costs Þ amount by which a company’s pension obligations (amortized to P&L over the avg. service life of employees).
relating to employees’ service in prior periods changes as a result of plan Periodic pension cost for P&L includes interest expense & return on plan
amendment or a plan curtailment. assets (similar to IFRS).
Both current & past service costs are recognized as an expense in P&L. Interest expense & return on plan assets are not netted & expected
Net interest expense/ income Þ calculated by multiplying the net return on plan assets is used rather actual return on plan asset.
pension liability /assets by the DR used in determining the PV of the Difference b/w expected & actual return is a source of actuarial G/L.
pension liability. All actuarial G/L can be reported either in P&L or in OCI.
Net interest expense/income is recognized in P&L. Corridor approach:
Remeasurement Þ it includes Þ Net cumulative unrecognized actuarial G/L at the beginning of the
Actuarial G&L. reporting period are compared with DBO & the FV of plan assets at
Diff. b/w actual return on plan assets & the amount included in the the beginning of period.
net interest expense/ income calculation. If unrecognized G/L > 10% of the greater of the DBO or the FV of
Remeasurement amounts are recognized in OCI (no subsequent plan assets, the excess is amortized (component of periodic pension
amortization to P&L). expense in P&L) over the expected avg. remaining working lives of
the participating employees.

2.3.2.2 Periodic Pension Cost
Some amount of pension costs may qualify for capitalization as part of the costs of self
constructed assets (e.g. inventories).
These costs are recognized in P&L as part of COGS.
IFRS Þ do not specify where companies presents the various components of periodic pension
cost beyond the components presented in P&L & OCI.
U.S.GAAP Þ all components of net periodic pension cost that are recognized in P&L to be
aggregated & presented as a net amount within the same line item on I.S.
2.3.3 More on the Effect of Assumptions and Actuarial Gains and Losses on Pension and Other Post-Employment
Benefits Costs
Pension obligations are based on many estimates & assumptions (e.g. employee turnover, length of service, DR
etc.).
An á (â) in pension obligation resulting from D in actuarial assumptions is considered an actuarial loss (gain).
Estimates related to plan assets also affect annual pension cost (mainly under U.S.GAAP because expected rather
than actual return on plan asset is used).
IFRS use projected unit credit method to measure the DB obligation.
PUCM gives rise to an additional unit of benefit during each period of service to which the employee is
entitled at retirement.
Objective Þ to allocate the entire expected retirement costs over the employee’s service periods.
OPB also requires assumptions & estimates.
2.4 Disclosures of Pension and Other Post-Employment Benefits
Comparative financial analysis using ratios can be affected due to several reasons e.g.
Difference in key pension assumptions.
Funded status is reported on BS rather than gross amounts. Gross amounts can D certain
financial ratios.
IFRS & U.S.GAAP differ in their provisions about cost recognized in P&L v/s in OCI.
Periodic pension costs in P&L may not be comparable (pension cost is single line item under
U.S.GAAP, various line items under IFRS).
CF information may not be comparable.
2.4.1 Assumptions
In order to assess conservative or aggressive biases, assumptions must be compared over time &
across companies.
DR assumption is based on the market IR of high-quality corporate fixed income investments of
similar maturity to timing of future pension payments.
Assumptions must be internally consistent.
Higher expected return assumptions (U.S.GAAP only) presumably reflect riskier investments.
Under OPB following assumptions would result in á(â) benefit obligations & a á(â) periodic
costs:
A á(â) near-term increase in health care costs.
A á(â) assumed ultimate health care trend rate.
A later (an earlier) year in which the ultimate health care trend rate is assumed to be
reached.
2.4.2 Net Pension Liability (or Asset)
Funded status is reported on the BS under both IFRS & U.S.GAAP.

Footnotes can be used for gross amount of pension plan assets & liabilities which reflect
underlying economic liabilities & assets of a company.
If gross benefits obligations is > company’s total assets, a small change in pension liability can
have a significant financial impact on the sponsoring company.

2.4.3 Total Periodic Pension Costs
Net periodic pension cost = ending funded status – employer contributions – beginning funded
status.
Total periodic cost in a given period can also be calculated by summing the periodic components
of cost.
Payment of cash out of a DB plan to a retiree does not affect the net pension liability or assets
(reduce plan assets & obligations by an equal amount).
2.4.4 Periodic Pension Costs Recognized in P&L vs. OCI
IFRS & U.S.GAAP differ in their provisions about which periodic pension costs are recognized in P&L
v/s in OCI.
Analyst adjustment in U.S.GAAP company’s P&L to make it similar to an IFRS company:
Include (exclude amortization of) past service costs arising during the period (previous
periods).
Return on plan assets at a DR rather than the expected rate.
Alternatively:
Analyst could use comprehensive income as the basis for comparison.
2.4.5 Classification of Periodic Pension Costs Recognized in P&L
Periodic pension costs are generally treated as operating expense.

To better reflect the operating performance an adjustment can be made as:
Add back the full amount of pension costs to operating income & then subtract only the
service costs.
The interest expense component would be added to the company’s interest expense.
Return on plan assets would be treated IFRS & U.S.GAAP differ in their provisions about which
periodic pension costs are recognized in P&L v/s in OCI.
Analyst adjustment in U.S.GAAP company’s P&L to make it similar to an IFRS company:
Include (exclude amortization of) past service costs arising during the period (previous
periods).
Return on plan assets at a DR rather than the expected rate.
Alternatively:
Analyst could use comprehensive income as the basis for comparison.
as non-operating income.
IFRS Þ return on plan assets2.4.6 Cash Flow
is calculated Information
using DR used to determine PV of pension
liability.
Cash U.S.GAAP
flow impact Þofexpected
pension return on plan of
is the amount assets is included
contribution as ato
made component of periodic
fund the plan pension
or the amount
cost.
of benefits paid (for unfunded plans).
Undercontributions
If periodic either set of >standards, an adjustment
(<) total pension canexcess
costs, the incorporate the actual
(shortage) can bereturn
viewed(adjustment
as a
may introduce
reductions of pensionearnings volatility).
obligation (source of financing).
If amounts of benefit obligations are material, the analyst may adjust the CFs in statement of CF.

3. SHARE-BASED COMPENSATION
Form of deferred compensation (no initial cash outlay). Several important dates
Both IFRS & U.S.GAAP require disclosure of management compensation. Grant date Day options are granted
Align managers’ interest with shareholders. Service period Period b/w grant date & vesting date
Recipient has no influence over MP. Vesting date Date employee can first exercise options
Ownership of existing owners is diluted (in case of stock grants & stock Exercise date Actual options exercise date
options).
3.1 Stock Grants 3.2 Stock Options 3.3 Other Types of Share-Based
Compensation
Outright transfer Fair value method

With restrictions or contingent on Option pricing model (Binomial or Black Stock grants & stock options (equity
performance. – Scholes) is used to measure fair value settled) Þ allow the employee to
Restricted stock of employees’ stock options. obtain direct ownership in the company.
Cannot sell until vesting. Inputs are important, some are known, SARs & phantom stock (cash settled) Þ
Performance stock others are subjective (e.g. volatility). compensate an employee based on D in
Contingent on meeting performance. ÓVolatility Óestimated lifeÓRF ÞÓFV value of shares (no need to hold shares).
Accounting numbers manipulation e.g. while Ó D.YÔ FV. SARs are valued at fair value &
earnings, ROA. Compensation expense is reported at compensation expense is allocated over
Compensation expense fair value (both IFRS & U.S. GAAP). the service period of the employee.
Fair value at grant date allocated over Option expense is recognized over the Phantom share Þ compensation is
service life. relevant vesting period (Ô retained based on performance of hypothetical
earnings & the offsetting entry is an Ó in stock rather than company’s actual
paid-in capital, no net impact on total stock.
equity). Used by private companies, private
units or by highly illiquid
companies.

“MULTINATIONAL OPERATIONS”
FC = Foreign Currency R/E = Retained Earnings R&E = Revenue & Expense
A&L = Assets & Liabilities COGS = Cost of Goods Sold C.R = Current Rate
PPL = Purchasing Power Loss HC = Historical Cost H.R = Historical Rate
G/L = Gain & Loss FV = Fair Value P.P.G = Purchasing Power Gain
IS = Income Statement CV = Current Value FIFO = First-in-First-Out
BS = Balance Sheet LIFO = Last-in-First-Out
AR = Accounts Receivable FASB = Financial Accounting Standard Board
AP = Accounts Payable 1. INTRODUCTION IASB = International Accounting Standard Board
I/E = Income or Expense CTA = Cumulative Translation Adjustment
F.S = Financial Statements
Two types of F.C activities
Transactions denominated in F.C.
Invest in foreign subsidiaries.
2. FOREIGN CURRENCY TRANSACTIONS
Companies decide currency in international trade.

FC transactions are denominated in currency other than company’s functional currency.
Different types of currencies
Presentation currency Functional currency Local currency
In which financial stat. amounts are presented. Currency of primary eco. environment Where the company operates
Mostly, located country’s currency. Entity generates & expends cash.
2.1 Foreign Currency Transaction Exposure to Foreign Exchange Risk
Company may expose to exchange rate on transaction (transaction exposure).

∆ in value of FC assets or liab. from FC transaction ⇒ G/L in IS (both IFRS & U.S.GAAP)
Transaction Exposure
Import Purchase Export Sale
FC may appreciate at payment date. FC may depreciate at payment date.

More functional currency to buy FC. Less functional currency units after conversion.
2.1.1 Accounting for Foreign Currency Transactions with Settlement before Balance Sheet Date
Basic principal⇒ all transactions at spot rate on transaction date.
FC risk when transaction & payment date differ.
2.1.2 Accounting for Foreign Currency Transactions with Intervening Balance Sheet Dates
BS date fall b/w transaction date & settlement date.
FC transaction unrealized G/L in I.S. at BS dates. Transactions
BS date to transaction date G/L are recognized.
G/L of both periods must equal to total actual G/L.
Export Sale Import Purchase
∆ Exchange rate causes F.C. transaction G/L as;
Asset (AR) Liability (AP)
Strengthens Weakens Strengthens Weakens
Gain Loss Loss Gain

2.2 Analytical Issues 2.3 Disclosure Related to Foreign Currency Transaction Gains and Losses
Neither standard indicate where in IS, FC transaction G/L should be placed. It is useful for companies to disclose.
Two most common treatments Amount of FC transaction G/L (both standards require).
Other operating I/E Presentation alternatives (no specific requirement).
Non-operating I/E, part of net financing cost (some cases). Companies often neglect to disclose location or amount of G/L (if
Operating profit margin affected by the placement (no guidance from immaterial).
standards). Several reasons for immaterial G/L (e.g. limited transaction, G/L offsetting,
Comparison may distort b/w companies. hedging activities).
Analyst also concern about unrealized F.C transaction G/L in I.S. ∆ in F.V of undesignated hedges in other income (amounts not disclosed).
3. TRANSLATION OF FOREIGN CURRENCY FINANCIAL STATEMENTS 3.2 Translation Methods
Companies have operations in foreign countries. Two Approaches

Consolidated financial statements under both standards (require
currency translation).
Both IASB & FASB have very similar rules for translation.
Current rate method Monetary/Nonmonetary method
3.1 Translation Conceptual Issues All A & L at current rate Variation

While translating two questions must be addressed.
Appropriate exchange rate for translation.
How is BS brought back into balance. Temporal Method
Two approaches for translation A&L Measurement basis preserved.

A&L at FC BS at CR translated at CR
All A&L at current Monetary A&L at CR A&L at FC BS at HR translated at HR
exchange rate Nonmonetary A&L at HR
Appropriate method depends on funct. currency.
Certain indicators to determine funct. currency (similar under both
3.1.1 All Assets and Liabilities Are Translated at the Current standards).
Exchange Rate If indicators are mixed than management judgment.
FC balance Sheet accounts are revalued in term of functional Three step translation approach (both standards).
currency at current exchange rate. Identify funct. currency ⇒ Translate F.C. balances to funct.
Negative translation adjustment not results in cash outflow. currency⇒ use current rate to translate into parents’ presentation
Issue whether unrealized translation G/L in I.S. or equity. currency.
3.1.2 Only Monetary Assets and Monetary Liabilities Are Translated 3.2.1 Foreign Currency Is the Functional Currency
at the Current Exchange Rate
Funct. currency ⇒ different from parent presentation currency ⇒C.R
Only monetary assets & liabilities are at current rate.
method.
Same issue as in 3.1.1 (translation adjustment is unrealized,
All A&L at CR ⇒ equity at HR⇒ R&E at Avg rate.
whether G/L to IS or equity).
CTA keep BS balance under CR method.
Entire investment exposed to translation G/L.
3.1.3 Balance Sheet Exposure CR method results in net assets exposure (except negative equity case).
A&L translated at current rate ⇒ exposed to translation When FC in value⇒ positive CTA & vice versa.
adjustment.
Net asset BS exposure ⇒ A> L (translated at current rate).
Net liabilities BS exposure ⇒ L> A (translated at current rate).
Effects of currency fluctuations on BS exposure are same as in
2.1.2.
After initial period CTA is required to keep B.S. balance.

3.2.2 Parent’s Presentation Currency Is the Functional Currency

Temporal method.
Term “re-measurement” under U.S.GAAP (local currency to funct. currency).
Temporal method Procedure
Balance Sheet Income Statement
Monetary A&L Nonmonetary A&L R&E related to R&E not related to

nonmonetary Assets nonmonetary Asset
Current rate Measured at H.C translated at HR

Measured at current value, C.V Rate used for assets Avg. rate
determination date rate.
Re-measurement G/L in IS (assume the G/L will be realized in near future).

Monetary liabilities often exceed monetary assets, so net liability exposure.
HR differs with cost flow assumption as.
FIFO LIFO AVG.
Inventory COGS Inventory COGS Inventory COGS
Recent Rate when Older exchange Rate when inv. sold Weighted Weighted
exchange rate inventory sold rate Avg. rate Avg. rate.
3.2.4 Highly inflationary Economies

3.2.3 Translation of Retained Earnings
Cumulative three-year inflation rate> 100% (U.S.GAAP, similar guidance IFRS).
Equity translated at H.R under both methods, create
Cease to be highly inflationary then the funct. currency must be identified to
somewhat problem in translating retained earnings
determine the suitable method for translating the entity’s F.S.
(different rates).
R/E = accumulated previous years income – dividends.
Approaches for Translation
U.S.GAAP IFRS
3.3 Illustration of Translation Methods
(Excluding Hyperinflationary Economies)
Temporal method Inflation – restated financial statements
then current rate method.
Avoid “disappearing plant problem”.
3.4 Translation Analytical Issues
Two translation methods result in very different amounts due to.

Different translation adjustment.
Different translation rates.
Financial ratios differ significantly (except receivable turnover).
Pure ratios (B/S or I/S) are similar before and after translation under C.R method.
Mixed ratios are distorted by translation under C.R. method.
Translation using temporal method distorts all ratios.
Not possible to generalize direction of distortion across ratios.
Foreign Currency Strengthens
Current Rate Method Temporal Method
Income, revenue, A&L, total equity & Revenue, A&L, net Income, equity
vice versa. & vice versa.

3.5 Translation when a foreign Subsidiary operates in a Hyperinflationary Economy

Temporal method (U.S.GAAP).
First restatement of financial statement then C.R. method (IFRS).
Restatement Procedure
Balance Sheet Income Statement
Monetary A&L Non monetary A&L Equity Restated from item recording date to BS date.
Net purchasing power G/L in IS
No restatement HC adjusted for ∆ in Restated by applying ∆ in

price index if items are price level from beg. of
at HC. period or contribution date
Restated from date of if later.
revaluation if carried at
revalued amount.
Holding monetary assets during high inflation ⇒ PPL monetary liability ⇒ PPG.
Results can be very similar under two different methods. (Similar exposure).
Same result if %∆ in exchange rate= ∆ in general price index in high inflation.
3.6 Companies use Both Translation Methods at the Same Time

A parent company uses temporal & C.R methods at same time (under both standards).
Firms under same industry can use different translation methods (judgment in funct. currency).
CTA to net income for comparability.
3.7 Disclosures Related to Translation Methods

Both standards require two types of disclosures.
Amount of exchange difference in net income.
Amount of CTA along with reconciliation.
Disclosure of CTA amount from equity to income at disposal of entity (U.S.GAAP).
No separate transaction & translation disclosure (under both standards).
Dirty-Surplus accounting ⇒ income items as part of equity rather G/L in I.S (e.g. CTA adjustment).
Disclosures provide detail to move from dirty-surplus to clean-surplus.
4. MULTINATIONAL OPERATIONS AND A COMPANY'S EFFECTIVE TAX RATE
Multinational companies incur income tax in the country of profit origin.

Transfer prices ⇒ price change on intercompany transactions.
Companies set transfer prices such that a higher portion of profit is allocated to lower tax
rate regime.
Analyst can obtain information about the effect of multinational operations from
companies’ disclosure on effective tax rate.
∆ in effective tax rate could be caused by ∆ in applicable tax rate &/or ∆ in profit mix.

5. ADDITIONAL DISCLOSURES ON THE EFFECTS OF FOREIGN CURRENCY
5.1 Disclosures Related to Sales Growth
Companies make disclosures about foreign currency effect on sales growth in MD&A section.
Growth in sales from volume & price is more sustainable than sales growth that comes from
∆ in exchange rate for a multinational company.
5.2 Disclosures Related to Major Sources of Foreign Exchange Risk
Sensitivity analysis is often used in disclosures about the effects of currency fluctuations.
Analyst can use sensitivity analysis disclosure with own forecast of exchange rate when
developing forecast of profit & CFs.

“EVALUATING QUALITY OF FINANCIAL REPORTS”
2. Quality of Financial Reports
2.1 Conceptual Framework for Assessing the Quality of Financial Reports
Exhibit 1. Relationships between Financial Reporting Quality and Earnings Quality

Financial Reporting Quality
Low High
High HIGH financial reporting
quality enables assessment.
HIGH earnings quality
Earnings increases company value.
(Results) LOW financial reporting
Quality quality impedes assessment
of earnings quality and impedes HIGH financial reporting
valuation. quality enables assessment.
LOW earnings quality
Low decreases company value.
The presence of high-quality financial reporting is a necessary condition to evaluate results quality.
High quality earnings provide an adequate level of return on investment & are sustainable.
Company that provides GAAP-compliant, decision-useful information about low quality earnings would appear lower
on quality spectrum.
Problem with biased accounting choices ⇒ impedes an investor’s ability to correctly assess a company’s past
performance.
Aggressive (conservative) ⇒ () companies reported performance in the current period & may () reported
performance in later period.
Reference: Level II, Volume 2, Reading 21.
2.2 Potential Problems that Affect the Quality of Financial Reports
2.2.1 Reported Amounts and Timing of Recognition
Aggressive, premature & fictitious revenue recognition ⇒ overstated profit ⇒ overstated

equity ⇒ usually accounts receivable are also overstated.
Conservative revenue recognition ⇒ understated income; equity & understated assets.
Omission & delayed recognition of expense ⇒ understated expense ⇒ overstated income,
equity & assets ⇒ understated liabilities.
Contingent liabilities understatement ⇒ overstated equity resulting from understated
expenses & overstated income & overstated other comprehensive income.
Overstatement (understatement) of financial assets (liabilities) reported at fair value are
associated with overstated equity resulting from overstated unrealized gains or understated
unrealized losses.
CFO may by deferring payables, inventory purchases & other operation related
expenditures or by accelerating payments from customers.

2.2.2 Classification
Exhibit 4. Accounting Warning Signs

Potential Issues Possible Actions/Choices Warning Signs
Overstatement or Contingent sales Growth in revenue
non-sustainability of with right of return, higher than that of
operating income “channel stuffing” industry or peers
and/or net income (the practice of
Overstated or inducing customers Increase in
accelerated to order products discounts to and
revenue they would returns from
recognition otherwise not order customers
Understated or order at a later Higher growth rate
Expenses date through in receivables than
generous terms), revenue
“bill and hold” sales
Misclassification Large proportion
(encouraging
of revenue, gains, of revenue in final
customers to order
expenses, or quarter of year for
goods and retain
losses a non-seasonal
them on seller’s
business
premises)
Lessor use of Cash flow from
finance (capital) operations is much
leases lower than
operating income
Fictitious Inconsistency over
(fraudulent) revenue time in the items
included in
Capitalizing operating revenues
expenditures as and operating
assets expenses
Lessee use of Increases in
operating leases operating margin
Classifying Aggressive
non-operating accounting
income or gains as assumptions, such
part of operations as long,
depreciable lives
Classifying Losses in
ordinary expenses non-operating
as non-recurring or income or other
non-operating comprehensive
income and gains
in operating
income or net
income
Compensation
largely tied to
financial results
Misstatement of Choice of models Models and model
balance sheet items and model inputs to inputs that bias
(may affect income measure fair value fair value
statement) measures
Over- or Classification from Inconsistency in
understatement current to model inputs when
of assets non-current measuring fair
Over- or Over- or value of assets
understatement understating compared with
of liabilities reserves and that of liabilities
allowances
Misclassification Understating Typical current
of assets and/or identifiable assets assets, such as
liabilities and overstating accounts
goodwill receivable and
inventory,
included in

Exhibit 4. Accounting Warning Signs

Potential Issues Possible Actions/Choices Warning Signs
Allowances and
reserves that
fluctuate over time
or are not
comparable with
peers
High goodwill
value relative to
total assets
Use of special
purpose vehicles
Large changes in
deferred tax assets
and liabilities
Significant
off-balance-sheet
liabilities
Overstatement of cash Managing activities Increase in
flow from operations to affect cash flow accounts payable
from operations and decrease in
Misclassifying cash accounts
flows to positively receivable and
affect cash flow inventory
from operations
Capitalized
expenditures in
investing activities
Sales and
leaseback
Increases in bank
overdrafts
Reference: Level II, Volume 2, Reading 21.
2.2.3 Quality Issues and Mergers and Acquisitions
Mergers & acquisitions provide opportunities & motivations to manage financial results.
Acquisitions can provide a one-time boost to CFO that may or may not be sustainable.
Investor cannot reliably assess whether or not the acquirer’s CF problems are worsening as no
required post-acquisition” with or without acquisition” disclosures.
Acquisitions complicate a company’s financial statements & this can conceal previous accounting
misstatements.
Acquisitions also provide opportunities that affect the initial consolidated balance sheet & income
statement in future.
The acquirer may understate the value of amortizable intangible when recording an acquisition.
2.2.4 Financial Reporting that Diverges from Economic Reality Despite Compliance with Accounting Rules
Financial reporting must also reflect economic reality.

An analyst should adjust the reported information to better reflect his/her view of economic reality.
Analyst must evaluate whether restructuring/impairment charges occur regularly & would be the part
of normalize earnings or not.
Revisions to remaining economic lives of assets may lead an analyst to question whether an earlier
change in estimate would have been more appropriate.
Sudden in reverse & allowances could call into question whether the prior estimates resulted in
overstatement of prior period’s earnings.

3. Evaluating the Quality of Financial Reports
3.1 General Steps to Evaluate the Quality of Financial Reports
Followings are same steps an analyst can choose to evaluate the quality of financial
reports.
Develop an understanding of company & its industry.
Learn about management.
Identify significant accounting areas.
Make time series & cross sectional financial & ratio analysis.
Check the warning signs of possible issues.
Check exposure to geographic region or product segment in multinational firms.
Use quantitative tools to assess the likelihood of misreporting.
3.2 Quantitative Tools to Assess the Likelihood of Misreporting
3.2.1 Beneish Model 3.2.2 Other Quantitative Models
Model to assess the probability of misreporting. Researchers have identified other variables for accounting
− = −4.84 + 0.92 + 0.528 manipulations.
+0.404 + 0.892 Some variables are auditor change, market to book value
+0.115
1 − 0.172 etc.
+4.67 − 0.327
⇒ DSR ⇒ Days Sales Receivable in relationship b/w receivable &
sales could indicate inappropriate revenue recognition.
⇒ AQI ⇒ Asset Quality Index in % of asset other than PPE & CA 3.2.3 Limitations of Quantitative Models
could indicate excessive expenditure capitalization.
⇒ SGI ⇒ Sales Growth Index Financial models based on accounting numbers are only
⇒ DEPI ⇒ Depreciation Index dep. rate could indicate capable of establishing association’s b/w variables.
understated deprecation as a means of manipulating earnings. Manipulators are just as aware as analysts of the power of
⇒ SGAI ⇒ selling, general & admin Exp. Index an in SGA expense quantitative models.
suggests admin & marketing efficiency.
⇒ Accruals ⇒ higher accruals can indicate earnings manipulation.
⇒ LEVI ⇒ Leverage Index ⇒ Increasing leverage could predispose
companies to manipulate earnings.

4. Earnings Quality
4.1 Indicators of Earnings Quality
High quality earnings ⇒ represent returns equal to or in

excess of the company’s cost of capital and are sustainable.
Indicators of Earning Quality
4.1.1 Recurring Earnings 4.1.2 Earnings Persistence and Related Measures of Accruals
Earnings that are expected to recur in the future. Earning persistence ⇒ sustainability of earnings excluding
Discontinued & other non-recurring items are separated. items that are obviously non-recurring & persistence of
Determination of whether an item is non-recurring involves growth in those earnings.
judgment. Components of earing:
Cash components.
Accrual components.
Cash component is more persistent than accrual component.
4.1.3 Mean Reversion in Earnings
If a firm reports positive net income but negative operating
CFs ⇒ earrings quality is questionable.
Mean reversion in earnings ⇒ extreme earnings (high or
low) tend to revert to normal levels over time.
Mean reversion is a natural attribute of competitive
markets.
In constructing analyst forecast of future earnings, analysts
need to develop a realistic CF model & realistic estimates of
accruals.
Indicators of Earning Quality
4.1.4 Beating Benchmarks 4.1.5 External Indicators of Poor-Quality Earnings
A company that consistently reports earnings that exactly These indicators include:
meet or nearly beat benchmarks can raise questions about Enforcement actions by regulators.
earnings quality. Restatement of financials.
These indicators are relatively less useful to an analyst.
4.2 Evaluating the Earnings Quality of a Company (Cases)
4.2.1 Revenue Recognition Case: 4.2.2 Revenue Recognition Case: 4.2.3 Cost Capitalization Case:
Sunbeam Corporation MicroStrategy, Inc. WorldCom Corp.
Example Example Example

4.3 Bankruptcy Prediction Models
4.3.1 Altman Model 4.3.2 Developments in Bankruptcy Prediction Models
Model use ratio analysis to identify likely failures. Shortcomings in Altman model:
It incorporates numerous ratios into a single mode. Single period, static nature
Model overcomes the limitation of viewing ratios independently. ⇒ Hazard model addressed this shortcoming by
Ratios in model reflect liquidity, profitability leverage & activity. incorporating all available years’ data.
Altman’s Z-score is calculated as: It incorporates the going concern assumption rather than one
! $
− = 1.2 # + 1.4 #
that might be failing solution ⇒ use market-based
" " bankruptcy prediction model.
%" & ' (
+3.3 # + 0.6 #
" % & )

+1.0 #
"
5. Cash Flow Quality
5.1 Indicators of Cash Flow Quality
Operating CFs ⇒ CF component that is generally most important for assessing a

company’s performance & valuing its securities.
High quality CF is a desirable trail and enhances company’s value.
Corporate life cycle & industry profile affect CF & must be considered when analyzing
CFs.
Reported CFs should be relevant & faithfully represent the economic reality of the
company’s activities.
Large difference b/w earnings & operating CF can be indication of earnings manipulation.
Timing & classification of CF are major issues in CF reporting.
5.2 Evaluating Cash Flow Quality
Operating CFs is less subject to manipulation than earning & thus used to identify areas of
potential earnings manipulation.
A shift in CF classification does not change the total amount of CF but affect investor’s
expectations regarding CFs.
IFRS permits to classify interest paid as operating or as financing & interest received &
dividend received as operating or investing.
US GAAP required interest paid/received & dividend received as operating CF.
Analyst must have to make adjustments when comparing CFs under US GAAP & IFRS.

6. Balance Sheet Quality
High financial reporting quality of balance sheet (BS) is indicated by completeness,

unbiased measurement & clear presentation.
High financial results quality ⇒ indicated by adequate liquidity, optimal amount of
leverage & successful asset allocation.
Completeness ⇒ significant amount of off-balance sheet obligations could be a concern
for an analyst.
Unbiased measurement ⇒ particularly important for asset & liabilities for which
valuation is subjective.
Clear presentation ⇒ it includes specification of many aspects of what appears on the BS.
7. Sources of Information about Risk
7.1 Limited Usefulness of Auditor’s Opinion as a Source of Information about Risk
An auditor’s opinion is unlikely to be an analyst’s first source of information about a

company’s risk.
A change in auditor especially multiple changes in the auditor can signal possible reporting
problem.
7.2 Risk-Related Disclosures in the Notes
Notes to the financial statements typically contain information that is useful in understanding
a company’s risk.
Disclosures also emphasize the uncertain timing & amount.
Financial instruments disclosure provides information about credit, liquidity & market risk.
7.3 Management Commentary (Management Discussion and Analysis, or MD&A)
Purpose of management commentary ⇒ to help users of financial statements in

understanding company’s risk exposures, approach to manage risks & risk management
effectiveness.
Five elements that should be contained in the commentary:
Nature of the business.
Objectives & strategies.
Resources, risks & relationships.
Results & prospects.
Performance measures & indicators.
7.4 Other Required Disclosures
Other required disclosures that are specific to an event can provide important information
relevant to assessing risk.
Examples include capital raising, management changes, non-timely filing of financial reports
etc.
7.5 Financial Press as a Source of Information about Risk
Financial press can be a useful source of information about risk when reporter unveils an issue
that has not previously been recognized.
Source of any particular news article is important.
Further investigation of initial idea from a news article is essential.

“INTEGRATION OF FINANCIAL
STATEMENT ANALYSIS TECHNIQUES”
1. INTRODUCTION M.V = Market Value

T.A = Total Assets
I.S = Income Statement
B.S = Balance Sheet
A&L = Assets & Liabilities
ROE = Return on Equity
The 6 step framework can be used in various C.F.O = Cash Flow from Operation
ROA = Return on Assets
objectives. (e.g. equity ownership, lending decision). QSPE = Qualifying Special Purpose Entity
2. CASE STUDY 1: LONG-TERM EQUITY INVESTMENT
DuPont Analysis
DuPont decomposition exposes effects of weaker operations that are masked by the effects of stronger operations.
Component analysis of ROE ⇒ helps identify potential operational flaws.
If equity income from associates is significant, remove equity income from DuPont analysis.
Reduce total assets by the carrying value of investment.
N.P margin & ROA will be recalculated after removing associate’s effect.
Financial leverage ratio adjustment = subtract investment in associate from T.A & equity (if financing is unknown).
Asset Based Composition
Require an examination of changes in the composition of B.S assets over time.

in intangible assets ⇒ may be due to successful acquisitions.
Capital Structure Analysis
Support management’s strategic objectives and allow the firm to honor its future obligations.
current ratio, quick ratio, defensive interval, working capital is a concern.
Segment Analysis/Capital Allocation
Based on segments (geographic areas of greatest importance).

Segment is the portion of larger company that accounts for more than 10% of company’s
revenues or assets & distinguished risk and return.
Segmentation is not purely geographical ⇒ analyst make judgments about allocation of capital.
Capital exp. allocation should be based on profitability.
Accruals & Earnings Quality
Analyst is concerned if consistency is result of earnings management.

Check fluctuations & level of accruals B.S & C.F.
Cash Flow Relationships
Most pressing concern ⇒ are operating earnings backed by C.F.?

Add interest & tax to CFO for comparison with operating income.
C.F. interest coverage ratio, C.F to total debt ratio, positive signs.
Decomposition and Analysis of the Company’s Valuation
Implied value = parents’ MV – parents’ pro-rata share of associate’s MV.

More complicated to remove earnings of associate if accounting standards differ.
Associate’s stock on foreign stock exchange, convert MV of the associate to the parent’s reporting currency.

3. CASE STUDY 2: OFF-BALANCE SHEET LEVERAGE FROM OPREATING LEASES
Analyst will treat operating lease as finance lease.

Significant hidden leverage (operating leases) is a concern for analyst.
In early years, depreciation & interest expense will exceed the rental expense.
Capitalizing the operating lease financial leverage is increased and interest coverage decreased.
Analytical treatments for other off-balance-sheet financing (e.g. debt guarantees, take-or-pay agreements)
are similar to operating lease.
4. CASE STUDY 3: ANTICIPATING EFFECTS OF CHANGES IN ACCOUNTING STANDARDS
Near term efforts at FASB to change accounting for securitizations.

Currently company can remove assets from its B.S. and place it in an QSPE (improve financial leverage).
Analyst will treat the securitization as secured borrowings with Assets remaining on B.S. and including securitization
liabilities as well.
Although interest income, provision for loan losses &other income may change, net income is unaffected.
Over the next few years, significant accounting changes are expected as U.S.GAAP & IFRS converge.

“CAPITAL BUDGETING”
r =Required rate of return T = Tax rate.

NPV =Net Present Value CF = after tax operating Cash Flow
IRR =Internal Rate of Return EAA = Equal Annual Annuity
TVM =Time Value of Money 1. INTRODUCTION CAPM = Capital Asset Pricing Model
SalT =Cash proceeds from sale of fixed capital at APT = Arbitrage Pricing Theory
Termination date Important for long term projects MRP = Market Risk Premium
BT = Book value at Termination date Principles adapted for other corporate MV = Market Value
FCInv = Fixed Capital Investment decisions PV = Present Value
NWCInv = Net Working Capital Investment Valuation principles similar to these used NOPAT = Net Operating Profit After tax
S = Sales in security analysis MVA = Market Value Added
C = Cash operating expenses Focus on maximizing shareholder value D = Depreciation
TNOCF = Terminal year after tax non-op cash flow
2. THE CAPITAL BUDGETING PROCESS
Steps
1. Generating Ideas 2. Analyzing Individual 3. Planning the Capital 4. Monitoring & Post-
Most important step Proposals Budget auditing
Gathering information Organize profitable Actual results compared
Forecasting cash flows proposals with projections
Evaluating profitability
Project Categories
1. Replacement projects 2. Expansion Projects 3. New product & services 4. Regulatory, safety, and 5. Other Projects
Easier decisions Increase size of business ↑ uncertainty environmental projects Can escape project
Can be normal More uncertain Complex & involve Frequently required by analysis
replacement of Carefully considered more people in decision external party Pet projects (can be)
equipment or replacing making process May generate no Some R&D decisions
with technology revenue (can be)
Mandatory
3. BASIC PRINCIPLES OF CAPITAL BUDGETING
Common Assumption & Principles Some Important Concepts Project Interactions
1. Decision based on cash flows Sunk cost: Already incurred, do not affect capital Independent projects: Cash flows independent of
2. Timing of cash flow crucial budgeting each other
3. Cash flows based on opportunity cost Opportunity cost: What resource is worth in next Mutually exclusive projects: That compete
4. After-tax cash flows analyzed
best use. Considered in capital budgeting directly with one and other
5. Financing costs are ignored → reﬂected in
required rate of return Incremental cash flow: Cash flow with decision – Project sequencing: Done through time to create
cash flow without that decision option to invest in future project
Externality: Effect of investment on other things Unlimited funds environment: Company capable
beside investment e.g. cannibalization of raising funds for all profitable projects
Conventional Cash flow: Initial outflow followed Capital rationing: limited funds → allocated to
by series of inflows achieve maximum shareholder value subject to
Nonconventional cash flow: Cash flows can flip funding constraints
from +ve to –ve, or even multiple times

4. INVESTMENT DECISION CRITERIA
4.1 Net Present Value (NPV) 4.2 Internal Rate of Return
‫ݐܨܥ‬ ‫ݐܨܥ‬
݊ ݊
ܸܰܲ = ෍ − ‫ݕ݈ܽݐݑ݋‬
ሺ1 + ‫ݎ‬ሻ‫ݐ‬ ෍ = ‫ݕ݈ܽݐݑ݋‬
‫=ݐ‬1 ሺ1 + ‫ܴܴܫ‬ሻ‫ݐ‬
Invest if NPV > 0
‫=ݐ‬1
Invest if IRR > r
Do not Invest if NPV < 0 Do not invest if IRR < r
4.3 Payback Period 4.4 Discounted Payback Period
No. of years required to cover the original investment No. of years taken by cumulative discounted cash flows to equal
Cash flows are not discounted → major drawback the original investment
Does not measure profitability ↑ than payback period
Indicator of project liquidity Usually – NPV projects → No discounted payback period
No decision rule due to lack of economic viability Ignores cash flows after payback period reached
– NPV but + discounted cash flow can happen
4.5 Average Accounting Rate of Return (AAR) 4.6 Profitability Index (PI)

Easy to understand & calculate Invest if PI>1.0
Based on accounting not on cash flow →practical limitation Do not invest if PI < 1.0
TVM not accounted for PI → indicates value received against 1 unit invested
No conceptual criterion of distinguishing between profitable & Used as guide in capital rationing
non-profitable project investments Also known as benefit-cost ratio
4.7 NPV Profile 4.8 Ranking Conflicts between NPV and IRR
Shows NPV as function of discount rates Conflicts arise in mutually exclusive projects
y-axis ⇒ NPV, x-axis ⇒ Discount rates in % Choose project based on ↑NPV
Projects with different scale can also create conflicts
4.9 The Multiple IRR Problem and the No IRR Problem 4.10 Popularity and Usage of the Capital Budgeting Methods
Unconventional cash flows can cause multiple IRR problem Larger companies usually use NPV/IRR techniques
No IRR problem → No discount rate at which NPV is 0 European countries usually use payback period
No IRR project → good investment MBA’s prefer using discounted cash flow techniques
NPV criterion most directly related to stock prices
Typically value of company = Existing investment + NPV of
future investments
Impact of investment on stock price is based on expectations
Management’s capital budgeting process can demonstrate
quality of management and degree to which management ↑
shareholders’ wealth.

5. CASH FLOW PROJECTIONS
5.1 Table Format with Cash Flows 5.2 Table Format with Cash Flows 5.3 Equation Format for Organizing
Collected by year Collected by Type Cash Flows
Cash flows from conventional expansion project See Volume III, Reading 22, Table 15. Initial outlay = FCInv + NWCInc
grouped as Another way of organizing cash flows Annual after-tax op. cash flow = (S-C-D)(1-T) + D
o Investment outlay Cash flows accumulated by type TNOCF = SalT + NWCInv – T(SalT – BT)
o After-tax operating cash flows over project’s
life
o Terminal year after-tax non-operating cash
flows
See Volume III, Reading 22, Table 14.
6. MORE ON CASH FLOW PROJECTIONS
6.1 Straight Line and Accelerated 6.2 Cash Flows for a 6.3 Spreadsheet 6.4 Effects of Inflation on Capital
Depreciation Methods Replacement Project Modeling Budgeting Analysis
Accelerated depreciation generally Incremental cash flows are used Capital budgeting usually done on Nominal CF ⇒ includes effects of
improves NPV compared to Outlay= FCInv + NWCInv –Sal0 computers using spreadsheets inflation
straight-line depreciation +T(Sal0 –B0) Real CF ⇒ adjusted ↓ to remove
Modified Accelerated Cost CF= (S –C –D) (I–T) + D See Volume III, Reading 22, effects of inflation
Recovery System (MACRS) is TNOCF= SalT + NWCInv – Example 7. Nominal CFs discounted at
generally used for tax reporting T(SalT – BT) nominal discount rate
Assets under MACRS are classified Real CFs discounted at real
into 3,5,7 or 10 year classes discount rate
Each year’s depreciation 1+Nominal rate= (1+Real
calculated through given rate)(1+Inflation rate)
percentage. With inflation WACC↑, NPV↓,
Under MACRS depreciation period IRR↓
is assumed to start at middle of If inflation > expected →
year profitability ↓ than expected
See Volume III, Reading 22, Table ↑ inflation ↓ deprecia
on tax
17. saving ↑ wealth transfer from tax
payers to government
Higher than expected inflation, ↑
wealth transfer from bondholders
to issuers
Unequal effect of inflation on
revenues & costs
o After-tax cash flows will be
better or worse depending on
how sales outputs and cost
inputs are affected.

7. PROJECT ANALYSIS & EVALUATION
7.1 Mutually Exclusive Projects with 7.2 Capital Rationing 7.3 Risk Analysis of Capital
Unequal Lives Investments – Stand-Alone Methods
7.1.1 Least common 7.1.2 Equivalent Done when company has 7.3.1 Sensitivity 7.3.2 Scenario 7.3.3 Simulation
multiple of lives annual annuity constrained budget Analysis Analysis (Monte Carlo)
approach approach Allocation is done in choosing Analysis
projects that ↑ shareholders’
Life of projects Annuity payment = wealth 1 variable is Several variables Procedure of
with unequal lives NPV is calculated Projects chosen within budget changed at a time changed at a time estimating
is made equal for each project with ↑ NPV. to check in NPV to gauge in probability
using LCM Project with ↑ EAA Individual ↑ NPV projects → not Useful in analyzing NPV. distribution of
Project with ↑ is chosen necessarily chosen most influential Three scenarios outcomes.
NPV is selected Project with -EAA is PI is used, IRR is not used variable may be used Good estimate
chosen if – NPV Misallocation of resources; Variables are built by
(pet projects) potential disadvantage of capital plotted on graphs simulating results
rationing This analysis is hundreds/thousa
Hard Capital Rationing: fixed used to establish nd of times.
budget, managers cannot go the most influential
beyond it. variables on See Volume III
Soft capital rationing: fixed budget project’s success or Reading 22,
but managers are allowed to over- failure. Example 8.
7.4 Risk Analysis of Capital
spend it under profitable
Investments – Market Risk Methods
opportunities.
Pessimistic Optimistic Most likely
Discount rate should be adjusted for ↑Costs ↑revenues Base case
market risk ↓ revenues ↓ costs scenario
Market risk measure depends on how ↑ r (used to calc. ↓ r (used to Project inputs
projected cash flows correlate with NPV). calc. NPV). costs, revenues
market returns & r are used to
CAPM & APT are used to estimate MRP calc. NPV
CAPM divides total risk into

7.5 Real Options 7.6 Common Capital Budgeting Pitfalls
Systematic risk Unsystematic
Related to risk
market Unrelated to Capital budgeting options allow flexibility regarding future
decisions i. Failure to incorporate economic
Can’t be market
Like financial options but with underlying real assets response into investment
diversified Can be
Contingent on future events, option not compulsion analysis
diversified ii. Using standardized capital
budgeting templates for unique
For diversified If project riskiness projects
Timing options: Sizing Flexibility Fundamental Options iii. Using normal analysis for pet
firm total risk ↑ avg. company’s
option to delay option options Whole investment is projects, overly estimating
measurement is riskiness – use forecasts or undertaking no
the investment an option
inappropriate project r not R&D projects are analysis
timing
Asset beta is used company’s WACC most likely iv. Using short term profitability
to measure Using WACC for ↓ fundamental options measures like ROE, NI, EPS
Abandonment option: Whole venture instead of NPV, (long term
systematic risk (↑) beta project
opportunity to decision is based on measure)
SML is used to overstate abandon project
underlying assets v. Using IRR for mutually exclusive
determine r (understate) r when profitable to do projects
which is used as If publically data so vi. Bad accounting for cash flows
discount rate unavailable → use Growth/ Expansion vii. Over estimating overhead costs
Price setting option to ↑price when
Using r → NPV > pure play method option: ability to viii. Using WACC instead of r for
undertake additional demand > supply (capacity) project with risk different than
0 & IRR > r → to estimate beta.
accept project investments when company’s avg. risk
profitable Production Flexibility option to add ix. Spending entire capital budget
more shifts, working overtime when just because it is available
Approaches to evaluate capital budgeting projects with demand ↑ in production x. Not focusing on alternative
projects which could be
i. NPV +ve without real options → go ahead no need to value option, they add value
profitable
ii. Project NPV= NPV (without options) + value of options – cost of option
xi. Mishandling opportunity and
iii. Use decision trees
sunk costs
iv. Use option pricing models to evaluate the options

8. OTHER INCOME MEASURES & VALUATION MODELS
8.1 The Basic Capital Budgeting Model 8.2 Economic & Accounting Income 8.3 Economic Profit, Residual
Income & Claims Valuation
See Volume III, Reading 22, Table 28. Economic Income = Cash flow + in MV 8.3.1 Economic Profit
in MV = Ending MV – Beg. MV EP = NOPAT - $ WACC
in MV is also termed as economic depreciation NOPAT = EBIT (1 – TAX)
MV at any point in time= PV of future CF $WACC = Capital x WACC
Interest is ignored

Economic rate of return is used to calculate MV
NPV = MVA
Accounting Income
8.3.2 Residual Income
Measured as Revenue - Expense
RIt = NIt – ECt–1
Depreciation based on original cost not MV
ECt = r x Bt-1
Interest is adjusted while calculating it

Value of company = Original BV of debt
& equity + PV of RI
8.3.3 Claim Valuation

Estimates value of liabilities / equity
claims against assets.
Value of company = Liabilities value +
equity value
Value of liabilities = PV of interest &
principal proceeds at rd
Value of equity = PV of cash flows at re
In principal EP, RI and claim valuation
results in same valuation
Only measure value of company
Real world complications

Pension liability adjustments
Financial instruments MV
Gains/losses (exchange rate)
Adjustments → deferred tax, goodwill,
inventories, lease

“CAPITAL STRUCTURE”
WACC = Weighted Avg. Cost of D = Debt Value
1. INTRODUCTION
Capital E = Equity Value
= Marginal Cost of Equity V = Company Value
= WACC Importance of the capital structure decision depends on the assumptions about = Marginal Cost of Debt
I = Interest Cost capital markets & agents operating in them. T = Marginal Tax Rate
= Asset Beta Possible to have an optimal level of debt in capital structure ⇒ level of debt
= Equity Beta where company value is maximized.
= Debt Beta
2. THE CAPITAL STRUCTURE DECISION
Capital structure ⇒ debt & equity mix company uses to finance it business.
Goal of capital structure ⇒ mix that value & WACC.
WACC = 1 − +

V = D+E
Marginal cost capital ⇒ cost of raising additional capital.
2.1 Proposition I without Taxes: Capital Structure Irrelevance
MM ranged under certain assumption choice of capital structure does not affect
company’s value.
Assumption:
Investors have homogenous expectation for cash flows
No transaction, taxes, bankruptcy costs ⇒ perfect capital markets
Investors can borrow/lend at risk free rate
No agency costs ⇒ mergers always act to shareholders wealth
Financing & investing decisions ⇒ independent of each other
Value of company levered = value of company unlevered .
WACC unaffected by capital structure
Value of company ⇒ solely determined through cash flows.

= =

2.2 Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity
The cost of equity is a linear function of the company’s debt/equity ratio.

Company debt ⇒ linearly, & WACC remains constant.
Assumptions:
No financial distress costs
Cost of debt < cost of equity
Business risk ⇒ determines cost of capital.
Financial risk ⇒ determined by capital structure.
WACC (ignoring taxes) = × + ×

= + − ×

Cost of equity ⇒ linear function of D/E ratio.
Company’s asset beta = weighted avg of debt & equity beta

=
+

debt ratio ⇒

2.3 Taxes, the Cost of Capital, and the Value of the Company
After tax = × 1 −
Factors affecting value of levered company
Tax issues.
Cost of financial distress.
Agency costs.
Asymmetric information.
Debt adds value to company depending on:
Corporate tax rate.
Personal tax rate on interest income.
Personal tax rate on dividend income.
Personal tax rate in interest income > personal tax
rate on dividends ⇒ , company’s value.
MM Proposition I: with taxes MM Proposition II: with taxes
WACC at 100% debt = + − 1 −

Company’s value maximum at 100% debt.
=
+ ×

WACC of levered company < WACC of unlevered.

=

WACC (with taxes) 1 − +

debt-tax shield = t×D as D but not as fast as with no-tax case.
= +
= +
= [{( – ) (1 – )} / ]
+ ( / )
Assumption:
No financial distress cost.
No bankruptcy cost.
2.4 Costs of Financial Distress
Cost associated with company’s financial distress uncertainty of meeting debt obligations.
Financial distress cost.
Actual bankruptcy & financial distress cost.
Probability of occurrence of financial distress & bankruptcy.
Direct cost of financial distress ⇒ legal & admin fee, actual cash expense.
Indirect cost of financial distress ⇒ impaired ability to conduct business, customers loss etc.
Companies with assets having a ready secondary market⇒ financial distress cost.
Companies with intangible assets ⇒ financial distress cost.
probability of bankruptcy:
Financial leverage.
Business risk.
Management quality.
Financial distress (expected) preferred debt level in capital structure.
2.5 Agency Costs
Conflict of interest b/w management & providers of capital.

Comprise of:
Monitoring cost: borne by owners to monitor mangers.
Bonding cost: cost to align their interest with organization.
Residual loss: costs incurred despite sufficient bonding & monitoring.
Corporate governance agency costs.
Debt in capital structure agency cost.

2.6 Costs of Asymmetric Information
Unequal distribution of information.

Asymmetry
High-tech companies.
Companies with transparent financial statements.
Companies with institutional ownership.
Companies with E as compared to D.
Asymmetry agency costs return demanded by capital providers.
The Pecking Order Theory
Managers prefer to make financing choices that are least likely to be visible.
1st choice retained earnings, 2nd choice debt, 3rd choice external equity.
Use of debt financing ⇒ reflects management’s confidence to generate cash.
2.7 The Optimal Capital Structure according to the Static Trade-Off Theory
= + − (Cost of financial distress).

Capital structure is chosen in a way that costs of financial distress be
exactly offset by tax shield benefit.
Assumption of no taxes & no financial distress costs are removed.
Target Capital Structure
Capital structure the firm uses over time while making decision about
raising funds.
Value maximized if target = optimal capital structure.
Actual structure may vary from target due to.
The market value of securities may fluctuate.
Management may exploit short-term opportunities in financing
sources.
3. PRACTICAL ISSUES IN CAPITAL STRUCTURE POLICY
3.1 Debt Ratings
Leverage ⇒ ratings agencies may ratings.

Ratings ⇒ credit risk (perceived) ⇒ return demanded by equity & bond investors.
Firms strive to maintain debt rating ⇒ chances of financial distress, value of firm.
3.2 Evaluating Capital Structure Policy
Consider how capital structure changes over time.

Analyze the capital structure of competing firms
with similar business risk.
Consider⇒ company specific factors.
Need for financial flexibility.
Company’s cash flow volatility.
Industry analysis.

3.3 Leverage in an International Setting
Capital structure of a company depends upon ⇒ quality of assets

profitability, chance of bankruptcy, growth opportunities &
company’s industry affiliations.
Financial leverage across counties differ by ⇒ traditions,
regulations, tax, polices.
While doing cross country comparison consider macroeconomic
factors, environmental issues, financing & banking sector,
institutional & legal environment.
Institutional framework
D/E ratio & larger debt if ⇒ efficient law & legal system,
auditors & analysts, taxes favoring equity.
Banking systems. Financial markets.
Longer debt maturity if active bond & stock market
Large institutional investors ↓D/E ratio
D/E if bank-based financial system.
Macroeconomic environment.
Inflation ⇒D/E, shorter maturity debt.
GDP growth ⇒D/E, longer maturity debt.

“DIVIDENDS AND SHARE REPURCHASES: ANALYSIS”

SH = Shareholders
= Cost of Equity
FCInv = Fixed Capital Investment

1. INTRODUCTION
= Cost of Debt
WCInv = Working Capital Investment
EPS = Earnings per Share
= EX-Dividend Price
Payout policy: principles by which company = Earning Yield
= Purchase Price
distributes cash to common shareholders by = Marginal Tax Rate on Capital
= Marginal Tax on Dividends
means of cash dividends & share repurchase. Gains
D = Dividends
BOD = Board of Directors
2. DIVIDENDS FORMS & EFFECTS ON SHAREHOLDER WEALTH & ISSUING COMPANY’S FINANCIAL RATIOS
2.1 2.2 2.3 2.4 2.5

Regular Cash Extra or Special Liquidating Stock Stock Splits
Dividends (Irregular) Dividends Dividends Dividends
Distributing cash to SH on Dividends paid by Dividends paid by • Are similar to stock

regular basis companies that do not companies that go out of dividends.
Signal of company’s growth pay regular dividends or business or sell some • Common splits are 2
& profit sharing practice. paying extra dividends on portion of their business for 1 & 3 for 1.
↑ in regular dividends some special on cash. • Total SH’s equity
affects share price +vely. circumstances. remains same under
stock splits & stock
2.1.1 dividends.
Dividends Reinvestment • stock splits does not
Plans (DRPs) Non-cash form of dividends (bonus affect equity whereas,
shares). under stock dividends,
SH’s cost per share ↓, keeping their ↓ R.E, ↑ contributed
3 types of programs
proportionate ownership or total cost capital,
a) Open mkt. DRP
basis unchanged.
b) New issue DRP
Without spending real money,
c) Plans that permit either a or b.
companies issue & SH receive
Advantages:
additional shares.
• Low transaction costs for SH
Stock dividends: ↑ share outstanding,
• Low floatation costs for company.
↑ shares owned, ↓ EPS, ↓ stock price,
Disadvantages:
keeps P/E, total mkt. value &
• SH require extra record keeping.
ownership value unchanged.
• ∆ the cost basis for SH.
• SH have to pay tax on cash
dividends even when dividends are Diff. b/w Cash Dividends
reinvested. & Stock Dividends
Cash Dividends Stock Dividends

• ↓ Cash, ↓ Equity • ↓ R.E, ↑ contributed capital,
• ↓ Cash ratio, ↓ • Total equity, liquidity ratios &
Current ratio financial ratios remain
• ↑ D/E, ↑D/A unchanged

3. DIVIDENDS POLICY & COMPANY VALUE THEORY
3.2 Dividend Policy 3.3 Dividend 3.4 Other 3.5 Dividend

3.1 Dividend Policy Matters: The Bird in Policy Matters: Theoretical Theory: Summary
Does Not Matter the Hand Argument The Tax Argument Issues
Dividend irrelevance theory ⇒ Even under prefect Dividend tax rate > Demonstrating exact
dividend policy irrelevant for market conditions capital gains tax ⇒ relationship b/w dividends
shareholders. investor prefers cash investors prefer low & value of a company ⇒
Decisions related to FCInv & dividends over potential dividend paying many variables affecting
WCInv affect shareholders capital gains. stocks. value.
wealth. Dividends are considered If growth Research suggests ⇒ tax
Theory similar to MM proposition I less risky. opportunities exist rates results dividends
⇒ under perfect capital markets Ex-dividend price ⇒ share ⇒ earnings in excess payout. Empirical support
assumption ⇒ dividend policy has price when share first of cost of capital for bird in the hand theory
zero impact on cost of capital or trades without right to reinvested. For analysts ⇒ consider
shareholders wealth. receive an upcoming If no growth whether a company’s
Homemade dividends ⇒ An dividend. opportunities exist dividend policy matches:
investor desiring to earn income can MM states ⇒ paying or ⇒ excess earnings Reinvestment
sell his/her shares. dividend ⇒ Ex- distributed through opportunities.
In case of avoiding income ⇒ divided price of share but share repurchase. Client preferences.
one can purchase share from does not affect risk of Legal/financial
dividend income. future cash flows. environment.
When perfect market conditions do
not hold: 3.4.1 Clientele Effect
Companies & individuals incur
transaction cost in
selling/buying shares.
Investors’ preferences for dividend policies vary.
Shareholders pay taxes on
• Young workers ⇒ time horizon (investment), prefer
Company’s BOD & management posses
low or zero dividend payout ratios.
information ⇒ can send signals through
3.4.2 The • Retired investors prefer dividend payout ratios.
dividends regarding company’s performance.
Information • Some institutional investors only invest in dividend paying
Dividend initiation ⇒ conveys positive message, Content of stocks.
represents future earnings ⇒ share price. Dividend Actions:
• Investors marginal tax rate on dividend > marginal tax
Dividend omission ⇒ conveys negative message Signaling
⇒ represents future earnings problems. rate on capital gains, prefer investing in or zero
Dividend payout for companies: dividend paying stocks.
R&D requirements • If demands by clienteles for various dividend policies are
Capital intensive satisfied by various companies ⇒ dividend market in
Business risk
equilibrium ⇒ changing dividend policy has no effect on
share price (dividend irrelevance theory).
• Marginal investors: investors expected to be a part of next
Dividend payment may overinvestment agency trade ⇒ important in setting price.
problem. •

ವ
3.4.3 Agency
಴ಸ
By paying dividend management is left with cash
Costs and Drop in share price is:
to spend & agency problem Dividends as a = dividend amount if
Growing companies in cyclical industries hold cash & Mechanism to
< dividend amount if
pay or no dividends. Control Them
> dividend amount if
Mature companies in non-cyclical industries ⇒
payout ratios.
Dividends default risk ⇒ cash cushion to
bondholders.
Dividends ⇒ underinvestment in profitable
projects.

4. FACTORS AFFECTING DIVIDEND POLICY
4.1 Investment 4.2 The Expected 4.3 4.4 Tax 4.5 4.6
Opportunities Volatility of Future Financial Considerations Flotation Contractual
Earnings Flexibility Costs and Legal
Restrictions
Investment Earnings ⇒ volatile, Extremely useful Fee paid to Net value of

opportunities ⇒ companies cautious in during economic investment remaining
or zero dividends changing frequency & contractions. bankers, attorneys, balance sheet
paid by a company. size of dividend Companies may securities assets at least
Internally generated increases. change dividend regulators & equal to some
funds ⇒ important Managers determine policy to maintain auditors etc. by specified amount
for high tech target payout based on financial flexibility. companies for ⇒ impairment of
companies. long-term sustainable Financial flexibility issuing shares. capital rule.
Utility companies earnings and are can be achieved for smaller Companies are
usually have reluctant in dividends through share companies which required to
investment when increase in repurchase. issue few shares. maintain certain
opportunities ⇒ earnings is temporary. Make raising new ratios ⇒ bond
dividend payout equity capital indentures.
ratios. expensive, re Common stock
compared to using dividends cannot
internally be paid unless
generated funds. preferred stock
dividends are
All else equal investor prefer dividends when dividends tax rate < paid.
capital gains tax rate.
Some investors prefer capital gains even when dividends taxed.
Capital gains tax not paid unless shares are sold.
Tax basis stepped up to fair value at date of decedent’s death &
shares received by a beneficiary.
Tax-exempt institutions like pension funds ⇒ indifferent about
dividend income or capital gains
4.4.1 Taxation Methods
Dividend Imputation Split-Rate Tax

Double Taxation Tax System System
System

Dividends effectively taxed at Corporate earnings distributed as
shareholder’s rate. dividends taxed at rate.
1 Earnings taxed at corporate level then Retained earnings taxed at rate.
%
!""#$ shareholders receive tax credit. Effective Tax Rate = Corporate tax
Double taxation once at corporate Marginal tax rate of shareholder < rate + {(1 – Corporate tax rate)
level & once at shareholders level. corporate tax rate ⇒ shareholder (Individual tax rate)}
receive tax credit = diff. of two rates.
Marginal tax rate of shareholder >
corporate tax rate ⇒ shareholder pays
tax = diff. of two rates.

5. PAYOUT POLICIES
5.1 Stable 5.2 Constant Dividend 5.3 Residual

Dividend Policy Payout Ratio Policy Dividend Policy
Rarely used in practice.

Regular dividends paid based on long-run Fixed % of NI ⇒ paid as Funds in excess of current capital
expected sustainable earnings. dividends. expenditures are used to pay
Most common dividend policy. Dividends affected by dividends.
Uncertainty in level of future short-term volatility. Management can focus on positive
dividends. Not frequently used in investment opportunities.
Dividends may even when earnings. practice. Uncertainty of future dividends (due
Dividends at lower rate than earnings to fluctuation) ⇒ disadvantage.
in boom years. Investor demand return on equity.
Expected increase in dividend = increase
in earnings × target payout ratio ×
adjustment factor.
&"'#()! 1 *
+( ,#" "'#()!.
6. SHARE REPURCHASES
• Transaction where company buyback its own shares

• Treasury Shares: issued earlier and later repurchased by the company.
• Canceled Shares: issued earlier, later repurchased by the company and then retired (cannot be reissued).
6.1 Share Repurchases Methods 6.2 Financial 6.3 Valuation 6.4 The Dividend
Statements Effects Equivalence of VS Share
of Repurchases Cash Dividends & Repurchase
Four methods listed below in order of importance Share Decision
Repurchases: The
Baseline
1 2
Buy in the Open Market→ Buyback a Fixed # of Shares at Fixed Balance Sheet:
co. purchase shares in the Price→ co. repurchase specific shares a) Repurchase with surplus cash:
open mkt. at fixed price, typically, at premium. assets ↓ , equity ↓ , leverage (debt
• Common method • Adding fixed date makes it time ratios) ↑.
• Company has no legal efficient b) Repurchase with debt: debt ↑,
obligation (provides • Co. uses pro rata basis if # of equity ↓ , leverage (debt ratios) ↑.
flexibility) shares are ↑. Debt ratios even worsen more.
Income Statement:
3 4 Repurchases may increase, decrease
or have no effect on EPS depending
Dutch Auction Repurchase by Direct Negotiation
on how the repurchase in financed
• A tender offer to existing • Co. negotiates with a major
share holders by providing shareholder to repurchase (internally or externally).
them acceptable price range shares.
• Each shareholder indicates • Reasons behind such
the # of shares & min. price transactions may include
Shareholders’ wealth remains
they are willing to sell. preventing:
unaffected whether co.
• Co. starts with the lowest bid large block of shares from
repurchase shares or pay cash
price & continue to qualify overhanging the mkt.
dividends (of equal amount),
bids for higher price until activist shareholder getting
assuming other things constant.
reaches the desired no of control over the board.
shares. hostile takeover attempt.

Rationale for Share Repurchase VS Cash

Dividends
6.2.1 Changes in EPS 6.2.2 Changes in Book Compared to cash dividends, share
Value Per Share repurchases:
has tax advantage when tax on capital gain is
↓ than cash dividends.
If repurchases financed
are considered to be commenced when
internally, post- repurchase After Share
shares are undervalued.
EPS will be ↑ than pre Repurchase
are not long-term commitment (provides
repurchase EPS if rate of return When mkt. BVPS will ↓
flexibility to mgmt.).
on retained earning is ↓ than price per
are used to offset EPS dilution due to
cost of capital. share > BVPS
exercise of employee stock options.
For repurchases with borrowed When mkt. BVPS will ↑ can be used to change the capital structure
funds (financed externally), price per of the company i.e. when shares are
post-repurchase EPS will be ↑ share < BVPS repurchased, leverage ↑.
than pre repurchase EPS if
earning yield is ↑ than cost of
borrowing.
Generally, when economy is strong

(recession) → repurchases ↑ (↓) in value.
Repurchases by borrowing funds
↑ EPS when post tax debt cost < Earnings
yield of the shares (before the repurchase)
↓ EPS when post tax debt cost > Earnings
yield of the shares before the repurchase
It will not change EPS when
After-tax cost of debt = Earnings yield of the
shares before the repurchase
7. Global Trends in Payout Policy
Compared to European companies, less no. of U.S. companies

pay dividends.
In developed countries ⇒ fraction of companies paying cash
dividends is while share repurchases have increased.
8. ANALYSIS OF DIVIDEND SAFETY

Dividend payout ratio =

Ratio risk of dividend cut.

Dividend coverage ratio =

Ratio risk of dividends cut.

FCFE coverage ratio =
Ratio =1 ⇒ co. returning all cash to shareholders.
Ratio > 1 ⇒ co. liquidity.
Ratio < 1 ⇒ co. paying out more cash, therefore decreasing its
liquidity.
Financial leverage ⇒ risk of dividends cut.
Dividends yield ⇒ difficult to sustain.
Stable or dividend ⇒ positive signal.
Dividends cut in past ⇒ negative signal.

“DIVIDENDS AND SHARE REPURCHASES: ANALYSIS”

SH = Shareholders
= Cost of Equity
FCInv = Fixed Capital Investment

1. INTRODUCTION
= Cost of Debt
WCInv = Working Capital Investment
EPS = Earnings per Share
= EX-Dividend Price
Payout policy: principles by which company = Earning Yield
= Purchase Price
distributes cash to common shareholders by = Marginal Tax Rate on Capital
= Marginal Tax on Dividends
means of cash dividends & share repurchase. Gains
D = Dividends
BOD = Board of Directors
2. DIVIDENDS FORMS & EFFECTS ON SHAREHOLDER WEALTH & ISSUING COMPANY’S FINANCIAL RATIOS
2.1 2.2 2.3 2.4 2.5

Regular Cash Extra or Special Liquidating Stock Stock Splits
Dividends (Irregular) Dividends Dividends Dividends
Distributing cash to SH on Dividends paid by Dividends paid by • Are similar to stock

regular basis companies that do not companies that go out of dividends.
Signal of company’s growth pay regular dividends or business or sell some • Common splits are 2
& profit sharing practice. paying extra dividends on portion of their business for 1 & 3 for 1.
↑ in regular dividends some special on cash. • Total SH’s equity
affects share price +vely. circumstances. remains same under
stock splits & stock
2.1.1 dividends.
Dividends Reinvestment • stock splits does not
Plans (DRPs) Non-cash form of dividends (bonus affect equity whereas,
shares). under stock dividends,
SH’s cost per share ↓, keeping their ↓ R.E, ↑ contributed
3 types of programs
proportionate ownership or total cost capital,
a) Open mkt. DRP
basis unchanged.
b) New issue DRP
Without spending real money,
c) Plans that permit either a or b.
companies issue & SH receive
Advantages:
additional shares.
• Low transaction costs for SH
Stock dividends: ↑ share outstanding,
• Low floatation costs for company.
↑ shares owned, ↓ EPS, ↓ stock price,
Disadvantages:
keeps P/E, total mkt. value &
• SH require extra record keeping.
ownership value unchanged.
• ∆ the cost basis for SH.
• SH have to pay tax on cash
dividends even when dividends are Diff. b/w Cash Dividends
reinvested. & Stock Dividends
Cash Dividends Stock Dividends

• ↓ Cash, ↓ Equity • ↓ R.E, ↑ contributed capital,
• ↓ Cash ratio, ↓ • Total equity, liquidity ratios &
Current ratio financial ratios remain
• ↑ D/E, ↑D/A unchanged

3. DIVIDENDS POLICY & COMPANY VALUE THEORY
3.2 Dividend Policy 3.3 Dividend 3.4 Other 3.5 Dividend

3.1 Dividend Policy Matters: The Bird in Policy Matters: Theoretical Theory: Summary
Does Not Matter the Hand Argument The Tax Argument Issues
Dividend irrelevance theory ⇒ Even under prefect Dividend tax rate > Demonstrating exact
dividend policy irrelevant for market conditions capital gains tax ⇒ relationship b/w dividends
shareholders. investor prefers cash investors prefer low & value of a company ⇒
Decisions related to FCInv & dividends over potential dividend paying many variables affecting
WCInv affect shareholders capital gains. stocks. value.
wealth. Dividends are considered If growth Research suggests ⇒ tax
Theory similar to MM proposition I less risky. opportunities exist rates results dividends
⇒ under perfect capital markets Ex-dividend price ⇒ share ⇒ earnings in excess payout. Empirical support
assumption ⇒ dividend policy has price when share first of cost of capital for bird in the hand theory
zero impact on cost of capital or trades without right to reinvested. For analysts ⇒ consider
shareholders wealth. receive an upcoming If no growth whether a company’s
Homemade dividends ⇒ An dividend. opportunities exist dividend policy matches:
investor desiring to earn income can MM states ⇒ paying or ⇒ excess earnings Reinvestment
sell his/her shares. dividend ⇒ Ex- distributed through opportunities.
In case of avoiding income ⇒ divided price of share but share repurchase. Client preferences.
one can purchase share from does not affect risk of Legal/financial
dividend income. future cash flows. environment.
When perfect market conditions do
not hold: 3.4.1 Clientele Effect
Companies & individuals incur
transaction cost in
selling/buying shares.
Investors’ preferences for dividend policies vary.
Shareholders pay taxes on
• Young workers ⇒ time horizon (investment), prefer
Company’s BOD & management posses
low or zero dividend payout ratios.
information ⇒ can send signals through
3.4.2 The • Retired investors prefer dividend payout ratios.
dividends regarding company’s performance.
Information • Some institutional investors only invest in dividend paying
Dividend initiation ⇒ conveys positive message, Content of stocks.
represents future earnings ⇒ share price. Dividend Actions:
• Investors marginal tax rate on dividend > marginal tax
Dividend omission ⇒ conveys negative message Signaling
⇒ represents future earnings problems. rate on capital gains, prefer investing in or zero
Dividend payout for companies: dividend paying stocks.
R&D requirements • If demands by clienteles for various dividend policies are
Capital intensive satisfied by various companies ⇒ dividend market in
Business risk
equilibrium ⇒ changing dividend policy has no effect on
share price (dividend irrelevance theory).
• Marginal investors: investors expected to be a part of next
Dividend payment may overinvestment agency trade ⇒ important in setting price.
problem. •

ವ
3.4.3 Agency
಴ಸ
By paying dividend management is left with cash
Costs and Drop in share price is:
to spend & agency problem Dividends as a = dividend amount if
Growing companies in cyclical industries hold cash & Mechanism to
< dividend amount if
pay or no dividends. Control Them
> dividend amount if
Mature companies in non-cyclical industries ⇒
payout ratios.
Dividends default risk ⇒ cash cushion to
bondholders.
Dividends ⇒ underinvestment in profitable
projects.

4. FACTORS AFFECTING DIVIDEND POLICY
4.1 Investment 4.2 The Expected 4.3 4.4 Tax 4.5 4.6
Opportunities Volatility of Future Financial Considerations Flotation Contractual
Earnings Flexibility Costs and Legal
Restrictions
Investment Earnings ⇒ volatile, Extremely useful Fee paid to Net value of

opportunities ⇒ companies cautious in during economic investment remaining
or zero dividends changing frequency & contractions. bankers, attorneys, balance sheet
paid by a company. size of dividend Companies may securities assets at least
Internally generated increases. change dividend regulators & equal to some
funds ⇒ important Managers determine policy to maintain auditors etc. by specified amount
for high tech target payout based on financial flexibility. companies for ⇒ impairment of
companies. long-term sustainable Financial flexibility issuing shares. capital rule.
Utility companies earnings and are can be achieved for smaller Companies are
usually have reluctant in dividends through share companies which required to
investment when increase in repurchase. issue few shares. maintain certain
opportunities ⇒ earnings is temporary. Make raising new ratios ⇒ bond
dividend payout equity capital indentures.
ratios. expensive, re Common stock
compared to using dividends cannot
internally be paid unless
generated funds. preferred stock
dividends are
All else equal investor prefer dividends when dividends tax rate < paid.
capital gains tax rate.
Some investors prefer capital gains even when dividends taxed.
Capital gains tax not paid unless shares are sold.
Tax basis stepped up to fair value at date of decedent’s death &
shares received by a beneficiary.
Tax-exempt institutions like pension funds ⇒ indifferent about
dividend income or capital gains
4.4.1 Taxation Methods
Dividend Imputation Split-Rate Tax

Double Taxation Tax System System
System

Dividends effectively taxed at Corporate earnings distributed as
shareholder’s rate. dividends taxed at rate.
1 Earnings taxed at corporate level then Retained earnings taxed at rate.
%
!""#$ shareholders receive tax credit. Effective Tax Rate = Corporate tax
Double taxation once at corporate Marginal tax rate of shareholder < rate + {(1 – Corporate tax rate)
level & once at shareholders level. corporate tax rate ⇒ shareholder (Individual tax rate)}
receive tax credit = diff. of two rates.
Marginal tax rate of shareholder >
corporate tax rate ⇒ shareholder pays
tax = diff. of two rates.

5. PAYOUT POLICIES
5.1 Stable 5.2 Constant Dividend 5.3 Residual

Dividend Policy Payout Ratio Policy Dividend Policy
Rarely used in practice.

Regular dividends paid based on long-run Fixed % of NI ⇒ paid as Funds in excess of current capital
expected sustainable earnings. dividends. expenditures are used to pay
Most common dividend policy. Dividends affected by dividends.
Uncertainty in level of future short-term volatility. Management can focus on positive
dividends. Not frequently used in investment opportunities.
Dividends may even when earnings. practice. Uncertainty of future dividends (due
Dividends at lower rate than earnings to fluctuation) ⇒ disadvantage.
in boom years. Investor demand return on equity.
Expected increase in dividend = increase
in earnings × target payout ratio ×
adjustment factor.
&"'#()! 1 *
+( ,#" "'#()!.
6. SHARE REPURCHASES
• Transaction where company buyback its own shares

• Treasury Shares: issued earlier and later repurchased by the company.
• Canceled Shares: issued earlier, later repurchased by the company and then retired (cannot be reissued).
6.1 Share Repurchases Methods 6.2 Financial 6.3 Valuation 6.4 The Dividend
Statements Effects Equivalence of VS Share
of Repurchases Cash Dividends & Repurchase
Four methods listed below in order of importance Share Decision
Repurchases: The
Baseline
1 2
Buy in the Open Market→ Buyback a Fixed # of Shares at Fixed Balance Sheet:
co. purchase shares in the Price→ co. repurchase specific shares a) Repurchase with surplus cash:
open mkt. at fixed price, typically, at premium. assets ↓ , equity ↓ , leverage (debt
• Common method • Adding fixed date makes it time ratios) ↑.
• Company has no legal efficient b) Repurchase with debt: debt ↑,
obligation (provides • Co. uses pro rata basis if # of equity ↓ , leverage (debt ratios) ↑.
flexibility) shares are ↑. Debt ratios even worsen more.
Income Statement:
3 4 Repurchases may increase, decrease
or have no effect on EPS depending
Dutch Auction Repurchase by Direct Negotiation
on how the repurchase in financed
• A tender offer to existing • Co. negotiates with a major
share holders by providing shareholder to repurchase (internally or externally).
them acceptable price range shares.
• Each shareholder indicates • Reasons behind such
the # of shares & min. price transactions may include
Shareholders’ wealth remains
they are willing to sell. preventing:
unaffected whether co.
• Co. starts with the lowest bid large block of shares from
repurchase shares or pay cash
price & continue to qualify overhanging the mkt.
dividends (of equal amount),
bids for higher price until activist shareholder getting
assuming other things constant.
reaches the desired no of control over the board.
shares. hostile takeover attempt.

Rationale for Share Repurchase VS Cash

Dividends
6.2.1 Changes in EPS 6.2.2 Changes in Book Compared to cash dividends, share
Value Per Share repurchases:
has tax advantage when tax on capital gain is
↓ than cash dividends.
If repurchases financed
are considered to be commenced when
internally, post- repurchase After Share
shares are undervalued.
EPS will be ↑ than pre Repurchase
are not long-term commitment (provides
repurchase EPS if rate of return When mkt. BVPS will ↓
flexibility to mgmt.).
on retained earning is ↓ than price per
are used to offset EPS dilution due to
cost of capital. share > BVPS
exercise of employee stock options.
For repurchases with borrowed When mkt. BVPS will ↑ can be used to change the capital structure
funds (financed externally), price per of the company i.e. when shares are
post-repurchase EPS will be ↑ share < BVPS repurchased, leverage ↑.
than pre repurchase EPS if
earning yield is ↑ than cost of
borrowing.
Generally, when economy is strong

(recession) → repurchases ↑ (↓) in value.
Repurchases by borrowing funds
↑ EPS when post tax debt cost < Earnings
yield of the shares (before the repurchase)
↓ EPS when post tax debt cost > Earnings
yield of the shares before the repurchase
It will not change EPS when
After-tax cost of debt = Earnings yield of the
shares before the repurchase
7. Global Trends in Payout Policy
Compared to European companies, less no. of U.S. companies

pay dividends.
In developed countries ⇒ fraction of companies paying cash
dividends is while share repurchases have increased.
8. ANALYSIS OF DIVIDEND SAFETY

Dividend payout ratio =

Ratio risk of dividend cut.

Dividend coverage ratio =

Ratio risk of dividends cut.

FCFE coverage ratio =
Ratio =1 ⇒ co. returning all cash to shareholders.
Ratio > 1 ⇒ co. liquidity.
Ratio < 1 ⇒ co. paying out more cash, therefore decreasing its
liquidity.
Financial leverage ⇒ risk of dividends cut.
Dividends yield ⇒ difficult to sustain.
Stable or dividend ⇒ positive signal.
Dividends cut in past ⇒ negative signal.

“CORPORATE PERFORMANCE,
GOVERNANCE, AND BUSINESS ETHICS”
Stakeholders and Corporate Performance
Stakeholders ⇒ individual or groups with an interest, claim or stake in the

company.
Internal stakeholders’ ⇒ stockholders & employees.
External stakeholders ⇒ all other individuals & groups that have some claim on
the company.
Exchange relationship exists b/w the company & all stakeholders.
Stakeholders may withdraw their support if a company fails to account for their
claims when formulating strategies.
Stakeholder Impact Analysis
Company may face conflict of interest issue when satisfying the claims of all
stakeholders.
Stakeholders impact analysis follows these steps:
Identify stakeholders.
Identify stakeholders’ interest & concerns.
Resultantly, identify the claims of stakeholders on the organization.
Identify most important stakeholders from organization’s perspective.
Identify the resulting strategic challenges.
The Unique Role of Stockholders
Stockholders are legal owners & the providers of risk capital. That’s why they
are usually put in a different class from other stakeholder groups.
Management is obligated to pursue strategies that maximize the return in order
to reward stockholders for providing the company with risk capital.
Profitability, Profit Growth, and Stakeholder Claims
Forms of stockholders return:

Dividend
Capital appreciation
Return on invested capital (ROIC) ⇒ It tells managers the resources of company
Too much emphasis on current profitability at the expense of future profitability
can make an enterprise less attractive to shareholders.
Claims of other stakeholders must also be taken into account when maximizing
return to stockholders.
Abiding of law & societal expectations must also be taken care of when
maximizing long-run profitability.

Agency Theory
Agency problem ⇒ it can arise in a business relationship when one person

delegates decision-making authority to another.
Managers do not always act in the best interest of stakeholders & might
sometimes behave unethically or illegally.
Principal–Agent Relationships
Principal ⇒ the person delegating the authority.

Agent ⇒ the person to whom authority is delegated.
Relationship b/w senior management & stockholders is a classic example of
agency relationship.
The Agency Problem
Agency problem ⇒ agency problem may arise if agents & principals have
different goals.
Agents can take advantage of any information asymmetry (agents have more
information regarding resources than principal) & maximize their own interests
at the expense of principal.
Principals can put mechanisms to monitor agents (BOD is one example).
Challenge for principals include:
Shaping the behavior of agents so that they act in accordance with the
goals set by principals.
Reducing the information asymmetry.
Developing mechanisms for removing misleading agents.
Ethics and Strategy
Business ethics ⇒ accepted principles of right or wrong governing the conduct

of business people.
Many accepted principles of right & wrong are not only universally recognized
but also codified into law.
Managers must act legally while seeking to maximize the long run profitability
of the enterprise.
Ethical Issues in Strategy
Ethical issues usually arise due to a potential conflict b/w the goals of managers
& the fundamental rights of important stakeholders.
Self-dealing ⇒ it occurs when managers find a way to feather their own nests
with corporate monies.
Information manipulation ⇒ it occurs when mangers use their control over
corporate data to distort or hide information in order to enhance their own
financial situation.
Anti-competitive behavior ⇒ it covers actions that harm actual or potential
competitors most often by using monopoly power & thereby enhancing the
long-run prospects of the firm.
Environmental degradation ⇒ it occurs when the firm takes actions that directly
or indirectly result in pollution or other forms of environmental damage.
Corruption ⇒ it arise when managers pay bribes to gain access to lucrative
business contracts.

The Roots of Unethical Behavior
Five root causes of unethical behavior:

Poor personal ethics leads to weak business ethics.
Faculty processes that do not incorporate ethical considerations into
business decision making.
Organizational culture that de-emphasize business ethics & considers all
decisions to be purely economic ones.
Management pressure to meet unrealistic goals.
Unethical leadership.
Philosophical Approaches to Ethics
The Friedman Doctrine Utilitarian and Kantian Ethics
Doctrine ⇒ the only social responsibility of Doctrine ⇒ moral worth of actions or practices is
business is to increase profit by staying within the determined by their consequences.
rules of law. Utilitarianism is committed to the maximization of
No social expenditure beyond those mandates by good & minimization of bad.
law. Drawbacks:
Friedman does not state that businesses should Measurement of benefits, costs & risks of a
behave in an ethical manner & not engage in course of action is difficult.
deception & fraud. Ignore justice
Kantian ethics ⇒ people should be treated as
ends & never purely as means to the ends of
others.
Rights Theories Justice Theories
These theories recognize that human beings have These theories focus on the attainment of a just
fundamental rights & privileges. distribution of economic goods & services.
Rights establish a minimum level of morally Most famous theory by john Rawls ⇒ all
accepted behavior. economics goods & services should be distributed
It is pertinent to note that along with rights come equally unless unequal distribution would work to
obligations. everyone’s advantage.
Two fundamental principles of justice:
Each person should be permitted the
maximum amount of basic liberty for others.
Inequality in basic social goods is to be
allowed only if it benefits everyone.

“CORPORATE GOVERNANCE”
BOD = Board of Directors MV = Market Value
ESG = Environmental, 1. INTRODUCTION CGS = Corporate
Social, Governance Governance Systems
Corporate governance is the system of, principles, policies,

procedures & clearly defined responsibilities.
Used by stakeholders to overcome conflicts of interest
inherent in the corporate form.
2. CORPORATE GOVERNANCE: OBJECTIVES AND GUIDING PRINCIPLES
Corporate Governance Objectives
Eliminate or conflict of interest b/w shareholders & management.

Ensure a company’s asset used in best interest of stakeholders &
investors.
Effective Corporate Governance System: Core Attributes
Delineation of rights of shareholders & other stakeholders.

Clearly defined responsibilities of manager & directors to stakeholders.
Accountability for performance of responsibilities clearly identifiable & measureable.
Fairness & equitable treatment in dealings between managers, directors &
shareholders.
Complete transparency & accuracy in disclosures regarding risk, financial position,
operations & performance.
3. FORMS OF BUSINESS AND CONFLICTS OF INTEREST
Source: Level II, Volume III, Reading 27, Table 1.

4. SPECIFIC SOURCES OF CONFLICT: AGENCY RELATIONSHIPS
4.1 Manager-Shareholder Conflicts
Managers can:
Invest in projects which benefit them & not the shareholders.
May become extremely-risk averse or risk takers at instances to protect their
interests.
May utilize funds to increase company’s size contrary to shareholders’ interest.
May grant themselves excessive compensation & perquisites that are treated as
ordinary business expenses.
4.2 Director-Shareholder Conflicts
BOD responsible for.

Acting as intermediary b/w shareholders & management.
Monitoring activities of managers & approve strategies & policies which are in
the best interest of shareholders.
Approving mergers & acquisitions.
Approving audit contracts.
Reviewing audit & financial statements.
Setting managers’ compensation.
Disciplining or replacing poorly performing managers.
When board acts in favor of management ⇒ conflict occurs.
Board not considered independent when
Board members have consulting agreement with company.
Board members are major lenders to the firm.
Board members in family circle of management.
Overly excessive compensation paid to directors.
One/more senior mangers serve as a director in the company of their own
board members.
5. CORPORATE GOVERNANCE EVALUATION
5.1 The Board of Directors
Responsibilities Characteristics Objectives
Ensure management work in the best interest of 1. Independence: at least To ensure company’s assets used in best-
shareholders ⇒ primary objective. the majority (75%) should long-term interests of shareholders.
Establish values to ensure business is conducted in an ethical, be independent. To ensure managements policies, plans &
fair, competent & professional manner. practices designed to achieve objective.
Ensure firm complies with legal & regulatory requirements
on a timely manner. 2. Experience: appropriate &
Establish long-term strategic objectives with goal that relevant expertise to the
shareholders’ best interests come first. business.
Defining responsibilities of managers, establish system of
accountability & performance measurement.
Hire CEO, determine appropriate compensation packages & 3. Resources: authority to
periodic evaluation of performance. hire external consultants,
Ensure board receives sufficient info to make timely & auditors without
informed decisions. management approval /
Meet regularly & arrange extraordinary sessions if necessary. intervention.
Have adequate training to be able to perform their duties.

5.1.1 Board Composition and Independence
At least 75% of board members should be independent.

Factors indicating lack of independence.
Former employment with the company.
Any business relation.
Business interests of board members.
Personal relationships
Interlocking directorships.
Ongoing banking or other credit relationships.
5.1.2 Independent Chairman of the Board
CEO & Board chairman, if same person, can adversely affect

corporate governance practices & impair independence of the
board.
Unitary board system: single board of directors.
Tiered hierarchy of boards: comprise of management &
supervisory board.
Management board ⇒ oversees management strategy etc.
Supervisory board ⇒ monitoring & reviewing
management’s decisions, & making decisions where conflict
of interest in management board impairs independence.
5.1.3 Qualifications of Directors
BOD must possess adequate skills to perform their duties.

At least they should be.
Independent.
Possess relevant expertise in the industry.
Know about principal technologies.
Be aware of financial operations.
Understand legal matters.
Accounting & auditing.
Indicate ethical soundness.
Possess experience in strategic planning & risk
management.
Board experience with companies with sound governance
practices.
Not serve on more than a few boards simultaneously.
Excellent attendance record.
Limit other business commitments that require time.
Committed to investors’ needs.
5.1.4 Annual Election of Directors
Annual elections compared to staggered elections ⇒ global

corporate governance best practice.
Annual basis ⇒ each member is elected every year.
Staggered basis ⇒ only a portion of BOD is elected every
year.
Information regarding directors’ terms and election
frequency found in regulatory filings.

5.1.5 Annual Board Self-Assessment
At least once on annual basis assessment of board must be done.

Board carries out its own assessment.
Review should include ⇒ an assessment of board’s effectiveness.
Individual members’ evaluation performance.
Assessment on boards’ committees.
Assessment of board’s effectiveness in overseeing their functions.
Evaluation of board’s current qualities vs. required future qualities.
A report on board self assessment.
Self assessment helps board & company performance.
Enables directors to their understanding of role.
Communication b/w board members.
Board Cohesiveness.
5.1.6 Separate Sessions of Independent Directors
Independent members (board) must meet separately at least annually &

preferably quarterly, without management’s presence.
If separate meetings done infrequently → it may signal board is not working
in the best interest of the shareholders.
5.1.7 Audit Committee and Audit Oversight
Functions Characteristics of Audit Committee
Independent oversight of company’s financial Consist of only independent directors.

reporting. At least two members shall have relevant
Evaluation of internal controls & compliance accounting & auditing experience.
systems of the company. Committee must have sufficient expertise in
Provide independent oversight of the company’s financial, accounting, auditing & legal matters.
non-financial disclosures. Oversee internal audit function.
Internal audit staff to report directly to committee.
Have sufficient resources.
Authority of investigations.
Authorized to hire external auditor.
Meet auditors independently at least annually.
Full authority to review audited financial
statements.
5.1.8 Nominating Committee
Comprise of only independent directors.

Establish criteria for nominations.
Identify candidates for board & committee.
Establish criteria for nominees for senior management positions in the company.
Review qualification of nominees of board & of individual committees.
Identify candidates for management positions.
Review nominee’s qualifications.
Documentation of the reasons for the selection of candidates.

5.1.9 Compensation Committee
Compensation should include incentives to meet long term goals.

Compensation should act as a tool to attract, retain & motivate highest
quality & most experienced managers for the company.
Compensation should not be excessive.
Salary should constitute portion of the total compensation.
Bonuses should be based on exceeding expected performance.
Grants of stock options subject to shareholders’ approval.

.
ℎ ℎ =

Re-pricing of stock options ⇒ not considered in best interest of
shareholders.
5.1.10 Board's Independent Legal and Expert Counsel
BOD ⇒ possess ability & resources to hire

independent counsel ⇒ best practice.
5.1.11 Statement of Governance Policies
Companies with strong commitment to GG supply statement of corporate

governance policies in regulatory filing or on websites.
Statement comprise of:
Code of ethics.
Statement of oversight, monitoring & review responsibilities of directors.
Management performance assessments.
Prior to board meetings statement of management’s responsibilities must
be provided.
Management’s performance assessments.
Training provided prior to joining the board & periodically thereafter.
5.1.12 Disclosure and Transparency
Hiding or misrepresenting financial information can lead to mispricing of

securities → efficiency & effectiveness of capital markets.
Financial statements should have quality, clarity, completeness & information
should have provided in timely manner.
Related party transaction should require prior approval of BOD.
Non-financial disclosers include.
Governance policies & procedures.
Organizational structure.
Competitive threats.
Compensation policies.
Changes to governance structure.
5.1.13 Insider or Related-Party Transactions
Analyst should assess company’s polices regarding related-

party transactions.
Prior approval required by BOD for any such transaction.
Financial disclosure ⇒ source for analysts.

5.1.14 Responsiveness of Board of Directors to Shareholder Proxy Votes
Managements’ responsiveness to proxy maters ⇒ representative of

management’s willingness to act in shareholders’ best interests.
If voting results ignored by management ⇒ indicates both BOD &
management not working in shareholders’ interest.
6. ENVIRONMENTAL, SOCIAL, AND GOVERNANCE FACTORS
Investors should consider potential effects of ESG on

companies.
Legislative & Regulatory Risk Legal Risk
The risk that changes in government laws & regulations Risk associated with failure of company management
may change and have a significant adverse impact on to effectively manage ESG factors.
profitability & long-term sustainability.
Operating Risk Reputational Risk
Companies operations may be affected by ESG factors Risk of MV & reputation ⇒ due to ineffectively
negatively. managing ESG.
Financial Risk
ESG risk factors can result in significant losses to

company & its shareholders.
7. VALUATION IMPLICATIONS OF CORPORATE GOVERNANCE
Strong CGS profitability & shareholders wealth company’s

wealth & vice versa.
Ineffective CGS leads to:
Accounting risk ⇒ financial disclosures are incomplete,
misleading, or materially misstated.
Assets risk ⇒ risk that firm’s assets not used in the best interest
of shareholders as director and/or management misappropriate
them.
Liability risk ⇒ mangers may enter into excessive obligations
committed on behalf of shareholders.
Strategic policy risk: managers may take up projects or
transactions not favorable long-term best interest of
shareholders.

“MERGERS AND ACQUISITIONS”

M&A = Merger & Acquisition N = No. of Shares Target Received EV = Enterprise Value
DP = Deal Price/Share PAT = Price after Manager Announcement CF = Cash Flow/Share

SP = Stock Price/Share C = Cash Paid to Target P = Price/Share

FCF = Free Cash Flow = Price Paid for Target BV = Book Value/ Share

NI = Net Income = Pre Merger Targets Value E = Earnings per Share.
WACC = Weighted Avg. Cost of = Pre Merger Value of Acquirer’s Stock S = Sale per Share
∗
Capital S = Value of Synergies EBITDA = Earnings Before
NCC = Non-Cash Charges. = Post Merger Value of Combined Company Interest, Tax
Investment MP = Market Price Depreciation
CapEX = Capital Expenditure Amortization WCInv = Working Capital
Investment
1. INTRODUCTION
Companies may enter into M&A activities for variety of reasons.

Important for corporate executives & analysts to understand both
motives, operational & financial consequences of mergers.
2. MERGERS AND ACQUISITIONS: DEFINITIONS AND CLASSIFICATIONS
Acquisitions: purchase of some portion of one company by another.

Merger: absorption of one company by other.
Statuary merger: acquirer acquires all target’s assets & liabilities.
Subsidiary merger: target becomes subsidiary after purchase.
Consolidation: both cease to exist to become a new company.
Target Company: one being acquired.
Acquiring company: company acquiring target.
Hostile transaction: potential business combinations without
management & board’s consent.
Friendly transaction: business combinations approved by
management of both companies.
Horizontal merger: merging companies in same kind of business.
Vertical merger: companies at different position in same value chain.
Backward integration: acquirer purchases target ahead of it in value
chain.
Forward integration: acquirer purchases target further down the
value chain.
Conglomerate merger: Acquirer purchases target unrelated to its
core business.

3. MOTIVES FOR MERGER
3.1 Synergy 3.2 Growth
Cost synergies: M&A transaction cost. Organic growth: company growing internally.
Revenue synergies: M&A transaction External growth: company growing through
revenue. acquiring resources externally; less risky.
3.3 Increasing Market Power 3.4 Acquiring Unique Capabilities and Resources
Horizontal merger market power by Through M&A transaction acquirer can acquire
competition. specific competencies which may otherwise be
Vertical merger also market power by costly to create.
dependence on outside suppliers.
3.5 Diversification 3.6 Bootstrapping Earnings
One of management’s motives for M&A may be In company’s earnings due to M&A
diversification but it is not in best interests of transaction not due to increased economic
shareholders. benefits.
Current EPS at expense of future growth
& EPS.
Occurs when shares of acquirer trade P/E
3.7 Managers' Personal Incentives
ℎ

=
than target & P/E does not after merger.

Larger company represents greater power &
− ℎ
=

ᇲ

prestige ⇒ managers may engage in M&A
transaction to company size. −
′ ℎ +

ℎ

– =

ᇲ ᇲ
.
3.8 Tax Considerations
Under efficient markets ⇒ post merger P/E
adjusts to weighted average of two companies’
If a company has accumulated tax losses ⇒ contributions to the merged company’s
⁄ =
acquiring it can be beneficial. earnings.
Regulators typically disallows offset of losses

with gains if primary motive is tax avoidance.
3.9 Unlocking Hidden Value
Potential target is underperforming & acquirer believes by acquiring at

value < breakup value, it can unlock hidden values through reorganization,
synergy or better management.
Breakup value ⇒ achieved if company’s assets are divided & sold
separately.

3.10 Cross-Border Motivations
3.10.1 Exploiting Market Imperfections 3.10.2 Overcoming Adverse Government Policy
Enable companies to take advantage of market Facilitate to take advantage of govt. policy e.g.
imperfections. tariffs.
3.10.3 Technology Transfer 3.10.4 Product Differentiation
Company can either acquire a company to Highly differentiated products can be introduced in
introduce technology or to gain superior new markets.
technology.
3.10.5 Following Clients
Company may engage in cross border M&A

transactions to follow or support domestic clients.
Mergers and the Industry Life Cycle
See Example 4 Level II Curriculum, Volume 3, Reading 28, Example 4.
4. TRANSACTION CHARACTERISTICS
4.1 Form of Acquisition
Stock Purchase Asset Purchase
Acquirer gives target’s shareholders some Acquirer purchase target company’s assets
combination of cash & stocks to get their directly from them (the target company).
shares of stocks.
See Exhibit 1 Level II Curriculum,

Volume 3, Reading 28.

4.2 Method of Payment
Cash Offering Securities Offering Mixed offering
M&A paid for with cash. M&A in which target shareholders are A combination of both cash
given acquirer’s shares. & securities offering.
Exchange ratio: No. of shares target
shareholders receive of acquirer in
exchange for their shares.
Acquirer’s cost = exchange ratio × target’s
outstanding shares × value of stock given to
target shareholders.
No. of shares target’s shareholders receive
= owned share of target × exchange ratio.
Form of Payments Impact
In stock offering ⇒ target’s shareholders

share a portion of reward & risk.
Stock offering more appropriate if
acquirer’s share considered over-valued.
Borrowing funds to raise funds for a cash
offering can acquirer’s leverage & risk.
Issuing new common shares can dilute
ownership interest of existing shareholders.
4.3 Mind-Set of Target Management
4.3.1 Friendly Mergers 4.3.2 Hostile Mergers
Potential business combination approved by managers of both Potential business combinations against the wish of target’s
companies. managers.
Due diligence required & done by both parties. Bear hug: proposal directly submitted to target’s BOD by
DMA ⇒ contract that clarifies transaction details covering terms, acquirer’s management.
warranties, termination details etc. Tender offer: public offer by acquirer to target’s shareholders to
Proxy statement: contains all material facts concerning voting. tender their shares at price proposed in tender offer. Tender
Payment made after deal is closed with approval of shareholders offer can be made with cash, shares of acquirer’s stock, other
& regulators. securities, combination of both.
Proxy fight: individual or company seeks to take control of
organization through shareholder vote.

5. TAKEOVERS
Target’s management under hostile attempt can sell the company

or use defensive measures to resist & remain independent.
Defensive measures ⇒ help in delaying transaction,
Negotiate better deal with acquirer, or
Keep company independent.
5.1 Pre-Offer Takeover Defense Mechanisms 5.2 Post-Offer Takeover Defense Mechanisms
Shark repellants ⇒ changes to the corporate charter & right- Just say no defense: management lobbies BOD &
based defenses. shareholders to decline offer.
Flip-in pill: right given to target’s shareholders to buy target’s Litigation: target can file a lawsuit against the acquirer.
shares at substantial discount ⇒ cost of potential acquirer. Greenmail: agreement allowing target’s management to
Flip-over pill: right given to target’s shareholders to buy purchase back shares from acquirer at premium.
acquirer’s shares at discount ⇒ dilution to all existing acquirer Share repurchase: target can repurchase its shares from
shareholders. shareholders to make target attractive by cost for
Dead hand provision: target board’s right to cancel poison pill acquirer.
by vote of continuing director. Leverage recapitalization: using amount of debt to
Poison puts: right of target’s bondholders to sell bonds back to finance share repurchases.
target at pre-specified price. Crown jewel defense: target can decide to sell a subsidiary
State law can be target friendly ⇒ give target companies or asset to a third party.
power for defending against hostile takeover attempts. Pac-man defense: target defends itself by making a counter-
A portion of board seats are due for election each year ⇒ offer to acquire the hostile bidder.
target become attractive. White-knight defense: target seeks a third party to acquire
Restricted voting rights: restrict stockholders that have itself.
purchased large block of shares. White squire defense: target seeks third party to purchase
Supermajority voting provision: no. of votes required for substantial minority stake, enough to block a hostile
M&A approval, commonly a vote of 80% as opposed to 51%. attempt.
Fair-price amendments disallow merger if offer < threshold
price.
Golden parachutes: allow executives to receive attractive
payout if they leave target company following a change in
corporate control.
6. REGULATION
6.1 Antitrust
Antitrust law intend to stop M&A which impede competition.

Sherman Antitrust Act of 1890: Act to maintain competition by restraining attempts to monopolize an industry.
Clayton Antitrust Act of 1914: Act passed to clarify & strengthen The Sherman Antitrust act.
Celler-Kefauver Act of 1950: Act passed to cover up loophole of pervious act.
Hart-Scott-Rodino Antitrust Improvements Act of 1976 made necessary for M&A to be reviewed and approved
= ∑ ℎ

% !
in advance.
∑ "
೔
× 100#


6.2 Securities Laws
Williams Act ⇒ cornerstone of securities legislation for M&A

activities.
Ensures fairness of tender offer through disclosure requirements
& formal tender offer procedures.
Disclosure: section 13(d) requires public disclosure whenever a
company acquires 5% or more of target’s outstanding common
stock.
Section 14 creates tender offer process by establishing various
rules & restrictions.

7. MERGER ANALYSIS
7.1 Target Company Valuation
7.1.1 Discounted Cash Flow Analysis
Determine cash flow model to be used.

Develop pro-forma financial estimates.
Calculate FCF using pro forma estimates.
NI (unlevered) = NI + net interest (after tax).
NOPLAT = NI (unlevered) + ∆ in deferred taxes
FCF = NOPLAT + NCC - ∆ in WCInv - CapEX
Discount FCF using appropriate discount rate.
Adjust WACC according to target.
Determine terminal value.
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Using constant growth ⇒
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Using market multiple ⇒
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Add FCF (discounted) of first stage to terminal present value of
value to get value of firm.
Advantages Disadvantages
Estimated value based on When -FCF ⇒ difficult to apply.

forecasted fundamentals. Forecasting involves uncertainty.
Customizable model. Estimates sensitive.
∆ in capital structure can be Large Portion represented by
incorporated easily in cash flows terminal values ⇒ Dramatically
and WACC. affected by minor changes in WACC
or g.

7.1.2 Comparable Company Analysis
Identify comparable firms.

Calculate relative value measure for these firms.
&'()
% '
%

*
(
'
) &
&'
%
⁄%$
⁄
,

⁄
⁄+
Calculate descriptive statistics of relative value metric & apply to target firm.
Value = EPS × (P/E)
Mean, median & range can be calculated for relative value measures.
Estimate takeover premium.
× 100
Takeover premium = deal price/share of target - current stock price of target.
(
Takeover premium in % =

Estimate takeover price of target
Estimated stock price + estimated takeover premium.
Based on economic principle of law Method sensitive to market

of one price. mispricing.
Estimation based on actual market Fair takeover premium ⇒
data. estimated separately.
Data required for estimation is Difficult to incorporate specific
easily available. plans for the target.
Past data may not be timely.
Difficult to apply on financially
distressed company.
7.1.3 Comparable Transaction Analysis
Identify set of recent transactions.

Sample of recent transactions must include M&A activities of
companies in same industry as target.
Calculate relative measures.
P/CF, P/E etc.
Calculate descriptive statistics for relative value measure.
Value = EPS x (P/E)
No need to separately estimate If previous takeovers mispriced ⇒

takeover premium. technique may be inadequate.
Value based on actual market data. If few comparable transaction have
Face litigations risk. occurred ⇒ difficult to apply.
Difficult to incorporate specific
plans for the target.
Difficult to apply to a firm
experiencing financial distress.

7.2 Bid Evaluation
Target shareholders’ gain = −

Merger if creates economic value ⇒ combined firm value > sum of two separate firms.
Acquirer’s gain = − − !

∗ = + + − %
⇒ Minimum bid target’s shareholders should accept.

+ ⇒ Maximum bid acquirer wants to pay.

If acquires pays > + ⇒ ∗ <

More managers are confident about expected synergies:
Acquirer mangers ⇒ prefer to pay cash
Target managers ⇒ prefer to receive stocks
Stocks of acquirer paid ⇒ risk and benefits shared by target.
Cash offer ⇒ target’s profit = takeover premium.
= ×
Stock offer ⇒ premium determined by value of combined firm.
8. WHO BENEFITS FROM MERGERS
Target Acquirer
Empirically ⇒ short run benefits Acquirer’s SP 1-3%.

gained. In long run acquirer have
On avg. 30% premium realized over empirically underperformed.
pre-announcement MP Avg. returns –4.3%.
61% acquirers lagging behind
industry peers.
Managerial hubris⇒ managers
over-estimating synergies ⇒
transfer wealth to target’s
shareholders.
Strong buyers, premiums, no. of bidders & favorable initial

market reaction ⇒ create value in M&A.
9. CORPORATE RESTRUCTURING
Divestiture: decision of company to sell, liquidate,

spin-off a division or a subsidiary.
Reasons for Divestiture Ways to divest Assets
Change in strategic focus. Equity carve-out.

Poor fit. Spin-off
Reverse synergy. Split-off.
Financial / cash flow needs. Liquidation.

“EQUITY VALUATION: APPLICATION AND PROCESSES”

MP = Market Price FCFE =Free Cash Flows to the Equity
IV = Intrinsic Value 1. INTRODUCTION FCFF = Free Cash Flows to the Firm
C.F = Cash Flows PV= Present Value
FSA = Financial Statement Analysis Valuation is the estimation of asset’s value based on DCF =Discounted Cash Flow
DDM = Dividend Discount Model Variables affecting future returns.
Comparisons with similar assets.
Estimates of immediate liquidation proceeds.
2. VALUE DEFINITIONS AND VALUATION APPLICATIONS
Context of valuation ⇒ determines def. of value & affects selection of

valuation approach.
2.1 What is Value?
Several perspectives on value ⇒ foundation for

valuation models.
2.1.1 Intrinsic Value
Intrinsic value ⇒ value of asset given complete understanding of investment characteristics.

If MP = I.V, market is efficient.
Rational efficient markets formulation = returns generated by information processing are higher than cost of
gathering information.
Active mangers attempt to produce excess risk adjusted returns (Alpha).
Two possible sources of mispricing.
V୉ − P = V − P + (V୉ − V)
(V-P) = intrinsic value – market price = true mispricing
(V୉ − V) = estimated value – intrinsic value = estimation error
Mispricing may remain even after correct forecasts and valuation models (e.g. due to market conditions).
2.1.2 Going Concern Value and Liquidation Value
Going concern value = value of a company assuming operations continue for the foreseeable future.
Liquidation value = value of a company in financial distress.
Going concern value is normally greater then liquidation value.
2.1.3 Fair Market Value and Investment Value
Fair market value = price at which willing & informed buyer & seller ready to exchange asset or liability.
Investment value = value to a buyer after considering synergies & investor’s expectation.
2.1.4 Definitions of Value: Summary
Intrinsic value under going concern assumption is important for equity valuation.
2.2 Applications of Equity Valuation
Valuation concepts & models are used for

Stock selection & extracting market expectations.
Evaluating corporate events & business strategies.
Fairness opinions & communication with analysts & shareholders.
Appraising private businesses & share-based payment.

3. THE VALUATION PROCESS
3.1 Understanding the Business
Evaluate company’s performance in economy & industry context.
3.1.1 Industry & Competitive Analysis
Industry analysis is important because similar economic and technological factors affect all companies in industry.
Various frameworks for industry & competitive analysis to organize thoughts about an industry.
Sensitivity analysis to recognize aspects of company in which opportunity exist.
Industry structure ⇒ industry’s economic & technical characteristics (porter’s analysis).
Consider qualitative factors & avoid extrapolating past results in strategic execution.
Porter’s three generic strategies
Cost leadership Differentiation Focus
Lowest cost producer Unique product or services Competitive advantage within

Priced at or near industry avg. Premium prices a segment or segments.
Cost or differentiation focus.
3.1.2 Analysis of Financial Reports
The relevant aspects of financial report vary across companies & industries.
Established Companies ⇒ ratio analysis.
Newer companies or products ⇒ nonfinancial measures.
3.1.3 Sources of Information
Analyst can compare information provided by company to their own research.

Company provided information ⇒ regulatory filings, press releases & investor relation material.
Analyst can use third party sources of information.
3.1.4 Considerations in Using Accounting Information
Analysts rely on accounting information to forecast future performance.

Quality of earnings analysis ⇒ evaluate economic reality.
Nonrecurring events ⇒ low quality earnings.
Compare company’s net income with operating C.F.
Growth of assets > growth of sales = aggressive accounting.
Analysts must be careful about future negative surprises.
3.2 Forecasting company Performance
Two perspectives
Economic environment Company’s own operating & financial

Forecasting Approaches characteristics
Top-down forecasting approach Bottom-up forecasting approach
Economy to industry to company. Company to industry to economy.

Macro to micro. Micro to macro.
Analysts combine industry & competitive analysis with FSA to forecast certain items.

3.3 Selecting the Appropriate Valuation Model
Absolute & relative valuation models ⇒ going concern assumption.
3.3.1 Absolute Valuation Models
Specifies an asset’s intrinsic value (PV models).
PV or DCF Model
Shareholder-level Company-level
DDM
Free C.F Asset based valuation Residual Income
PV of dividends
FCFE FCFF MV of assets Earnings in excess of
or resources opportunity cost of
C.F net of C.F before generating those
payment to payments to earnings.
providers of debt debt providers
PV approach can also applied for valuing bonds & has less uncertainty than common stocks.
3.3.2 Relative valuation Models
Asset’s value relative to another asset.

Use price or enterprise multiples (method of comparables).
Similar assets should sell at similar prices.
Pairs trading ⇒ utilize pairs of closely related stocks (buy undervalued, sell overvalued).
3.3.3 Valuation of the Total Entity and Its Components
Sum-of-the-parts valuation (breakup value or private market value) ⇒ estimated values of each of the company’s businesses
(each business is independent).
Conglomerate discount ⇒ market applies a discount to the stock of company operating in multiple, unrelated businesses.
3.3.4 Issues in Model Selection and Interpretation
Consistent with the characteristics of the company being valued.

Appropriate given the availability and quality of data.
Consistent with the purpose of valuation, including the analyst’s perspective.
3.4 Converting Forecasts to a Valuation
Aspects of converting forecasts to valuation
Sensitivity analysis Situational adjustments
Sensitivity of output to an input. Control Premiums Lack of marketability Discount Illiquidity discounts
Some sensitivity analysis is
common to most valuation. Controlling value Extra return for lack Prices of shares
higher than otherwise of public market. with less depth
non-controlling
position.
Blockage factor ⇒ price for a stock block trade is less than the MP for a smaller amount of stock.

3.5 Applying the Valuation Conclusion: The Analyst’s Role and Responsibilities
Sell-Side Analysts Buy-Side Analysts Analysts at Corporations Analysts at Independent Vendors
Analysts work at Analysts provide May perform some Provide input to publicly
brokerage firms input to portfolio valuation similar to buy- distributed research reports.
manager or side analysts. Some focus solely corporate
investment Identify & value information.
committee for acquisition targets.
investment
decisions.
4. COMMUNICATING VALUATION RESULTS
Research reports share several common elements.
4.1 Contents of a Research Report
Consider the intended purpose of report reader.

Assumptions and expectations are important for intrinsic value.
Superior reports address the uncertainty associated with investing.
Focus should be on “good investment” rather “good company”.
4.2 Format of Research Report
Research report may be presented in several ways.

Analyst’s firm may specify a fixed format for consistency & quality
control.
4.3 Research Reporting Responsibilities
Analysts have obligation to provide substantive & meaningful content

in their research reports.
Analysts who are CFA Institute members will adhere Code of Ethics &
professional conduct standards.

“RETURN CONCEPTS”
ERP = Equity Risk Premium WACC = Weighted Avg. Cost of Capital
RR= Required Return 1. INTRODUCTION MVD = Market Value of Debt
RF = Risk Free Rd = Return on Debt
AM = Arithmetic Mean Investors compare expected return with fair return. MVCE = Market Value of Common
GM = Geometric Mean Analysts specify the discount rate. Equity
FFM = Fama-French Model
2. RETURN CONCEPTS
2.1 Holding Period Return
Return earned over a specified time period.

Consider dividend reinvestment if received b/w holding period.
Return Components
Investment Income Price Appreciation
ౄ ౄ ో ౄశ ౄ
r= + or
ో ో ో
ౄ
= Dividend yield or investment income.
ో
ౄ ో
= capital gains or price appreciation.
ో
2.2 Realized & Expected (Holding Period) Return
Returns
Realized Return Expected Return
Holding period in the past. Expected dividend & selling price.

Selling price & dividend are known. Price valuation models.
Different investors have different expected returns.
2.3 Required Return
Minimum level of expected return an investor requires given the asset’s riskiness.
It is opportunity cost for investing in the asset.
If expected return > required return = security undervalued (positive ex- ante
alpha) & vice-versa.
Realized or ex- post alpha = actual holding period return-required return.
Estimates of required return are essential for present value models.
2.4 Expected Return Estimates from Intrinsic Value Estimates
When an asset is mispriced, price convergence takes place.

When investor’s value estimate is more accurate than market ⇒ return has
two components ⇒ required return & return from convergence.
ో ో ో ో
ER ≈ r + where is convergence return.
ో ో
Convergence component of E(R) is quite risky (e.g. time horizon problem or
inaccurate estimates).

2.5 Discount Rate (D.R)
Rate used to find PV of future C.F.

D.R depends on characteristics of investment.
Different D.R. for distinct expected future C.F.
2.6 Internal Rate of Return
IRR is the DR that equates PV of expected future CF to the asset’s price.

When markets are efficient ⇒ IRR is required return on equity.

Required return = + Expected dividend growth.

3. THE EQUITY RISK PREMIUM
Incremental return for holding equities rather than risk-free assets.

ERP depends on expectations.
RR on equity = current expected RF +ERP
RR on share i = current expected RF + βi (ERP).
Or
Current expected RF + ERP ± other risk premia/discounts.
3.1 Historical Estimates
Mean value of difference b/w equity index returns & govt. debt return.
No systematic errors in expectations ⇒ Avg. returns are unbiased estimates.
In developing historical ERP estimate include the selection of :
Equity index for equity market return.
Time period for computing estimate.
Type of mean calculated & proxy for RF return.
Extending the length of data ⇒increase precision but decrease assumption of stationarity.
High ERP during bad times but low during good times.
Two choices for historical mean return calculations are AM & GM.
RF rates can be long-term govt. bond or short-term govt. debt return.
3.1.1 Arithmetic Mean or Geometric Mean
GM is always less then A.M given any variability in returns.

AM returns best represent mean return in a single period.
If AM is known ⇒ expected terminal value can be found by compounding at AM.
GM is a compounded growth rate logical in multiperiod context.
ERP estimates based on GM tend to be closer to supply & demand-side
estimates from economic theory.
Thus. GM is preferred to AM.
3.1.2 Long-Term Government Bond or Short-Term Government Bills
A normal yield curve offsets the effect of the RF rate choice on RR estimate.
Inverted yield curve ⇒ ERP higher under bill-based estimate.
3.1.3 Adjusted Historical Estimates
Historical ERP may be adjusted through offsetting effect of Biases

or independent considering estimate of ERP.
Survivorship bias ⇒ inflate ERP ⇒should be adjusted downward.
Unexpected positive & negative events & surprises may require
ERP adjustment (upward or downward).

3.2 Forward-Looking Estimates
Based on expectations for economic & financial variables (ex ante estimates).
Less subject to nonstationarity or data biases.
Subject to potential behavioral biases & model errors.
3.2.1 Gordon Growth Model Estimates
Model assumptions are met in mature developed equity markets.

GGM Equity RP = expected dividend yield on index +long term growth rate-
current long-term govt. bond yield.
Multiple earnings growth stages ⇒ calculate IRR which is required return on
equity r and then subtract govt. bond yield to arrive at ERP as follows:
Equity index price = PV fast growth (r) + PV transition (r) + PV mature (r).
GGM assumes P/E ratio is constant, analyst make adjustment to reflect P/E
expansion or contraction.
3.2.2 Macroeconomic Model Estimates
More reliable when public equities represent large share of economy.

Focus on supply-side variables.
ERP = {[(1+EINFL)(1+EGREPS)(1+EGPE) -1.0]+EINC} – expected risk free return.

.
EINFL = Expected inflation ≈ −1

EGREPS = expected growth in real earnings per share ⇒ sum of labour
productivity growth & labour supply growth.
EGPE = expected growth in P/E ratio ⇒ baseline value is zero;
current P/E level show overvaluation or undervaluation.
EINC = expected income component ⇒ expected dividend yield.
3.2.3 Survey Estimates
Ask people (experts) what they expect about capital market, then premium can be inferred.
4. THE REQUIRED RETURN ON EQUITY
The choices include

The CAPM.
Multifactor models.
Build-up method.
4.1 The Capital Asset Pricing Model
Provide equilibrium required return.

Required return on share i = RF + βi (ERP).
βi is sensitivity of asset returns to the return on the “market portfolio” of risky assets.
If markets are segmented, two issues with same risk can have different required returns
if traded in different markets.
If markets are integrated ⇒ international CAPM is used.
4.1.1 Beta Estimation for a Public Company
Unadjusted or raw beta ⇒ regression of return on stock on the return on the market.
Choice of index & data period length & frequency of observations are important considerations.
Beta in future period ⇒ closer to mean value of 1.0, so we adjust raw beta as
adjusted beta = (2/3) (unadjusted beta) + (1/3) (1.0).
Infrequently traded securities ⇒ beta will be too small & required return will be underestimated.

4.1.2 Beta Estimation for Thinly Traded Stocks and Nonpublic Companies
Analysts estimate beta of nonpublic company on basis of public peer’s beta.

Consider differences in financial leverage.
Unlever the benchmark (public company) beta for beta of asset (debt is high quality)
β୙ ≈ β୉
1
1+ D/E
If subject company has debt & equity levels D’ & E’, then subject company’s equity beta is
β୉ = 1 + β୙
D′
E′
Sometimes median or avg. industry beta is used as benchmark beta.
CAPM is simple, widely accepted, theory-based method.
For individual securities ⇒idiosyncratic risk overwhelm market risk ⇒ beta may be poor indicator
of future average return.
4.2 Multifactor Models
CAPM beta describes risk incompletely; evidence suggests multiple factors drive returns.
Multifactor models are complex & expensive which does not ensure greater explanatory power.
APT models express required return as
r=Rf +(Risk premium)1 + (Risk premium)2 + ---------------- + (Risk premium)k
where
Risk premium = (factor sensitivity or beta)i × (factor risk premium)i
factor risk premium is expected return in excess of Rf.
4.2.1 The Fama-French Model
r୧ = R ୤ + β୫୩୲
୧ RMRF + βୱ୧୸ୣ
୧ SMB + β୴ୟ୪୳ୣ
୧ HML
RMRF = R ୫ − R ୊ , return of value weighted index in excess of one month T-bill.
SMB (small minus big) = Avg return of three small-cap portfolios – avg. return of three large size
portfolios.
HML (high minus low) = avg return on two high book-to-market portfolios minus Avg return on
two low book-to-market portfolios.
Each of the factors can be viewed as mean return to zero-net investment, long-short portfolio.
FFM market β could be above or below CAPM β.
FFM includes equity market factor (systematic risk) & company factors (e.g. size & value).
FFM views size & value premiums as compensation for systematic risk; practitioners believe
return premiums arise from market inefficiency.
4.2.2 Extensions to the Fama-French Model
Investors demand a return premium for illiquid assets.

Pastor-Stambaugh model adds to the FFM a fourth factor (liquidity).
r୧ = R ୤ + β୫୩୲ SMB + β୴ୟ୪୳ୣ HML + β୧ LIQ
୪୧୯
୧ RMRF + βୱ୧୸ୣ ୧ ୧
Avg. liquidity equity, liquidity β of 0. Below-Avg. liquidity, positive β & vice versa.
Liquidity is a function of the size of the interest, depth & breadth of market & ability to conduct
block trading with minimal price impact.
Marketability ⇒ relates to right to sell an asset.

4.2.3 Macroeconomic & Statistical Multifactor Models
Macroeconomic factor models ⇒ variables that affect future C.F and/or D.R to determine PV.
Statistical factor Models ⇒ statistical methods are applied to historical returns.
Five-factor macroeconomic BIRR (Burmeister, Roll, & Ross) model with factor definitions as:
1. Confidence risk (C.R): unanticipated change in return difference b/w 20 year risky corporate & Govt. bonds.
2. Time horizon risk (T.H.R): unanticipated change in return difference b/w 20 year govt. bond & 30-day T-bill.
3. Inflation risk (I.R): unexpected change in inflation rate (stocks have negative exposure to this factor).
4. Business cycle risk (B.C.R): unexpected change in level of real business activity.
5. Market timing risk (M.T.R): portion of return unexplained by first four risk factors.
Example of required return under this model is as follows:
4.3 Build-Up Method Estimates of the Required Return on Equity
r୧ = R ୊ + ERP ± one or more premia/Discount.

Specific beta adjustments not applied to factor risk premiums.
4.3.1 Build-Up Approaches for Private Business Valuation
r = R + ERP + size premium + specific company premium.

Two additional considerations (adjustment to firm value rather than R.R).
Controlling V/S minority interests.
Lack of ready marketability.
So-called modified CAPM formulation
R + β × ERP + size premium.
4.3.2 Bond Yield Plus Risk Premium (BYPRP)
Can be viewed as build-up method for companies with publicly traded debt.
BYPRP cost of equity = YTM (long term debt) + risk premium.
YTM includes real rate + inflation + Default risk premium.
Risk premium compensates for additional equity risk.
4.4 The Required Return on Equity: International Issues
Global context required return issues are exchange rates and data & model issues in emerging markets.
Exchange rate G/L from equity component not exactly offset by G/L from govt. security component of ERP.
Country spread model
ERP = ERP for developed market + country premium.
Country premium (typically sovereign bond yield spread) represents additional risk of emerging markets.
Country risk rating model ⇒ regression –based estimate of ERP (developed countries).
Used this regression-based equation for less developed markets to predict required return for those markets.

5. THE WEIGHTED AVERAGE COST OF CAPITAL
Required return of company’s suppliers of capital is usually referred to cost of capital.

Analyst can use total firm value approach for equity valuation.
Corporations may deduct net interest expense from income in calculating taxes owed (just corporate
taxes).
If suppliers of capital are creditors & common equity holders, then expression for WACC
MVD MVCE
WACC = r 1 − Tax rate +
MVD + MVCE MVD + MVCE
Marginal tax rates better reflect the future cost of fund raising compared to effective tax rates.
Analysts use targets weights instead of current market weights.
Before-tax required return on debt is typically YTM of company’s debt.
6. DISCOUNT RATE SELECTION IN RELATION TO CASH FLOWS
When discounting C.F to equity ⇒ required return to equity is appropriate.

Discounting C.F to firm ⇒ cost of capital is appropriate.
Real C.F should be discounted at real rate while nominal C.F should be discounted at nominal rate.
Nominal approach is exact for equity valuation.

“INDUSTRY AND COMPANY ANALYSIS”

AR = Accounts Receivables IS = Income Statement
AP = Accounts Payables FM = Financial Modeling
WC = Working Capital BS = Balance Sheet
TV = Terminal Value DTA= Deferred Tax Asset
DTL= Deferred Tax Liability
2. FINANCIAL MODELING: AN OVERVIEW
Starting FM from I.S is logical because most companies derive majority of their value from future
CF generation (determined from net income).
Exceptions i.e. banks & insurance companies (value of assets & liabilities on BS is more relevant).
2.1 Income Statement Modeling: Revenue
Segment disclosures in company’s reports are richest source of information to analyze revenue.
Accounting standards require separate financial information for any segment if that segment account for
10% or more of the revenue, operating income or assets of the combined company.
Geographic analysis of revenue ⇒ place revenue into various geographic “buckets”.
Useful for global companies operating in multiple countries.
Revenue analysis by segment ⇒ analyst classifies a company’s revenue into various business segments.
Revenue analysis through product line ⇒ most relevant for a company with a manageably small number
of products.
Top down approach ⇒ economy ⇒sector or industry ⇒ company
Bottom up approach ⇒ Inverse to top down approach
Hybrid approach ⇒ combines elements of both approaches ⇒ uncover errors that may arise from using
single approach.
2.1.1 Top-down Approaches to Modelling Revenue
Growth Relative to GDP Growth Market Growth & Market Share
Analyst first projects the growth rate of Analyst forecasts growth in a particular market.
nominal GDP. Company’s current market share & change in
Analyst then compares company’s the market share is next step to analyze.
growth with GDP growth.
Real GDP may be used to project
volumes, inflation to project prices.
2.1.2 Bottom-up Approaches to Modelling Revenue
Time Series Return on Capital Capacity Based Measures
Forecast based on historical growth Forecast based on BS accounts Projections based on capacity e.g. same
rate. store sales growth.
Simplest.
Can also be used in top-down analysis.

2.1.3 Hybrid Approaches to Modelling Revenue
Most commonly used approaches.

Volume & price approach ⇒ analyst makes
separate projection for volumes & avg.
selling price.
2.2 Income Statement Modelling: Operating Costs
Analyst may consider matching the cost analysis to the revenue analysis
depending upon the information availability.
Analysts can use top-down, bottom up or hybrid view of costs.
Fixed cost (FC) should pay particular attention while variable costs (VC) are
directly linked to revenue growth.
Best way to model VCs:
% of revenue or (projected unit volume × unit variable costs)
FC assumed to grow at its own rate based on future PP&E growth.
Operating & gross margins tend to be +vely correlated with sales level in an
industry that enjoys economies of scale.
Uncertainty regarding costs estimates must also be considered by analyst.
2.2.1 Cost of Goods Sold
Typically it’s the single largest cost for manufacturing & merchandising companies.
COGS & gross margin vary inversely.
COGS have a direct link with sales thus forecasting the COGS as a % of sales is
usually a good approach.
Small error in COGS forecast may have a material impact on projected operating
profits.
Companies usually do not disclose their hedging positions.
Analyst should consider the impact of company’s hedging strategy.
Gross margin differences among companies within a sector are logically related to
differences in their operations.
To estimate a realistic gross margin, competitors’ gross margins can provide a
useful cross check.
2.2.2 Selling, General, and Administrative Expenses
Another main part of operating costs.

Less direct relationship with sales as compared to COGS.
Variable component of SG&A which is usually large can be estimated as % of
sales.
Other administrative & general expenses are less variable & or gradually
over time.
In addition to historical analysis of these expenses benchmarking a company
against its competitors can be useful.
2.3 Income Statement Modelling: Non-operating Costs
These items include interest income & expense, taxes, minority interest, income
from affiliates & unusual charges.
Interest income:
Depends on amount of investment & rate of return earned on
investments.
Less significant component to most non-financial companies.
Interest expense.
Depends on level of debt on BS & interest rate associated with the debt.

2.3.1 Financing Expenses
Capital structure of a company is key variable used in projecting financing

expenses.
Notes to financial statements provide detail about the maturity structure of
debt & corresponding IR.
2.3.2 Corporate Income Tax
Large non-operating amount that affects profit substantially.

Three types of tax rate:
Statutory tax rate ⇒ tax rate applying to a company’s domestic tax base.

Effective tax rate ⇒
-

Cash tax rate ⇒

Diff. b/w cash tax & effective tax are reflected as DTA or DTL.
Effective tax rate & cash tax rate are key to forecast tax expense & cash taxes.
Difference b/w statutory tax rate & effective tax rate can arise due to following
reasons.
Tax credits.
Adjustments to previous years.
Withholding tax on dividends.
Expenses not deductible for tax purpose.
Onetime events must be adjusted while estimating tax rate.
2.4 Income Statement Modelling: Other Items
Analysts often assume that dividends grow each year by a certain $ amount or
as a proportion of N.I.
If a company holds > 50% of another company it will consolidate the affiliate‘s
results with its own & will report minority interest.
Share count is a key input in calculating intrinsic value & EPS.
Market price of a stock is an important determinant of future share count
changes.
Analysts typically exclude unusual charges from their forecasts, as these
changes are almost impossible to forecast.
2.5 Balance Sheet and Cash Flow Statement Modelling
Some BS items including AR, AP & inventory are closely linked to IS projections.
Working capital accounts can be best modeled through efficiency ratios.
Future AR can be projected by assuming # of days sales outstanding &
combining that assumption with sales projection.
Analyst can project future inventory by assuming an inventory turnover
rate & combining that assumption with COGS projection.
Analyst can modify projections through top-down & bottom up consideration.
In the absence of a specific opinion on WC ⇒ historical performance to
persist may be an assumption by analyst (bottom-up-approach).
Specific view of future WC ⇒ analysts began with a forecast for large
sector of economy (top-down approach).
Projections of PP&E are less directly tied to IS for most companies:
Net PP&E mainly depends on capex & depreciation.
Depreciation forecasts ⇒ based on historical dep. & disclosure about dep.
schedule.
Capex forecast ⇒ depends on future need for new PP&E.
Maintenance capex ⇒ to sustain current business.
Growth capex ⇒ required to expand the business.

2.5 Balance Sheet and Cash Flow Statement Modelling
Future capital structure projections:

Leverage ratios (e.g. debt to equity, debt to capital) can be useful for projecting future debt & equity level.
Return on invested capital (ROIC) & return on capital employed (ROCE) can be determined once IS & BS are
constructed.

ROIC =

Invested capital = operating assets – operating liabilities.
ROIC is better than ROE because it is not affected by degree of financial leverage.
Sustainably higher ROIC is a sign of a competitive advantage.

ROE =

Pretax measure which is useful in comparing companies with different tax structure.
Analysts usually make assumptions regarding use of future CFs (e.g. share repurchase, dividend etc.) for
projecting future CF statement.
2.6 Scenario Analysis and Sensitivity
Projections involve uncertainty, requiring scenarios to consider in addition to most likely “base case result”.
Sensitivity analysis ⇒ effect on the estimate of intrinsic value (IV) by changing one assumption at a time.
Scenario analysis ⇒ changing multiple assumptions at the same time to view impact on IV.
Large, mature, slow growing, non-cyclical businesses may have upside & downside scenarios close to the base case.
For most companies, range of possibilities will be approximately symmetrical & bell curve.
3. THE IMPACT OF COMPETITIVE FACTORS ON PRICES AND COSTS
Competition affect forecasts & incorporating competitions into financial

forecasting can be a challenging task.
Porter’s “five forces” framework can be used as a tool to think about how
competitions will affect financial results.
Porter’s Five Competitive Forces
Threat of Substitute Rivalry among Existing Companies
Substitutes & switching cost will Pricing power in industries that are
pricing power & vice versa. fragmented, growth, exit barriers,
fixed cost.
Bargaining Power of Suppliers Bargaining Power of Buyers
Profitability if suppliers have influence Profitability if buyers have greater

over price or quantity supplied. ability to demand lower prices &/or
control over quantity
Threat of New Entrants
Downward pressure on profitability if above market returns are present.

Barriers to entry, threat of new entrants.

4. INFLATION AND DEFLATION
Overall or in prices of goods & services (inflation & deflation) can

significantly affect the forecasts of a company’s performance.
Impact of inflation & deflation differs from company to company & within a
company (for revenues & costs).
4.1 Sales Projections with Inflation and Deflation
4.1.1 Industry Sales and Inflation or Deflation
Industry structure can be an important factor in determining the relationship

b/w in input cost & in price of end products.
In case of price elastic demand, company’s efforts to pass on inflation
through prices can volumes if there are cheaper substitutes available.
Inflationary environment ⇒ raising prices too late will result in profit margin
squeeze & acting too soon could result in volume loss.
Deflationary environment ⇒ lowering prices too soon will result in gross
margin & waiting too long will result in volume .
4.1.2 Company Sales and Inflation or Deflation
Revenue projections = expected volume × price development.

If demand is price inelastic (elastic) ⇒ revenues will benefit (decline) from
inflation.
To reflect different rates of the cost of inflation among countries, an
international company should take into account the geographic mix of its
operations.
If inflation of the county of export > company’s domestic inflation, pricing
gains may be wiped out by currency loss.
Likely pricing of a product is dependent on identifying products’ major input
cost.
Company strategy is also an important factor while determining price.
4.2 Cost Projections with Inflation and Deflation
4.2.1 Industry Costs and Inflation or Deflation
Following factors can influence forecasting of the industry costs:

Purchasing characteristics of an industry.
Monitoring the underlying drivers of input prices.
Competitive environment within industry participants.
4.2.2 Company Costs and Inflation or Deflation
Segmentation of industry’s cost by category & geography is helpful

in forecasting company’s cost.
Analyze whether cheaper alternatives & efficiency can be a
possibility to offset the impact of input prices.

5. TECHNOLOGICAL DEVELOPMENTS
Technological developments (TDs) have an impact on individual businesses &

industries.
If TDs result in a new product that threatens to cannibalize demand for an
existing product ⇒ unit forecast (new product) combined with an expected
cannibalization factor is used to estimate the impact on future demand for
the existing product.
If changes in technology lead to manufacturing cost, supply curve will shift
to right (more production at same price).
If technology leads to attractive substitute products, demand curve will shift
to the left.
6. LONG-TERM FORECASTING
Certain factors may influence the time horizon of forecasting including

investment strategy, cyclicality, & company specific factors etc.
Analyst’s employer preferences may be another factor that can influence
forecast time horizon.
Forecast period should be long enough to allow the business to reach an
expected mid cycle level of revenues & earnings.
Normalized earnings ⇒ expected level of mid cycle earnings of a company
(excluding usual or temporary factors).
To better represent normalized earnings, long-term projections are better
than short-term projections.
Important considerations when deriving TV based on long term projections:
Historical multiple -based approach ⇒ assumptions ⇒ past is relevant
to the future in term of growth & required return.
DCF approach ⇒ analyst should normalize terminal year CF before
using in projection.
Challenges for analyst:
Inflection point estimation.
To forecast economic disruption.
7. BUILDING A MODEL
Example

“DISCOUNTED DIVIDEND VALUATION”

RF = Risk free GGM = Gordon growth model
MP = Market Price DCF = Discounted cash flows.
FCFF = Free cash flows to firm DDM = dividend discount model
FCFE = Free cash flows to equity RIM = Residual income model
PV= Present Value
1. INTRODUCTION
DCF models ⇒view the intrinsic value of common stock as the present value of
expected future cash flows.
Four steps in applying DCF analysis to equity valuation
i. Choosing the class of DCF model.
ii. Forecasting the cash-flows.
iii. Choosing a discount rate methodology.
iv. Estimating the discount rate.
Here dividends are an appropriate definition of cash flows & class of model is DDM.
Basic objective of any DDM is to value a stock.
2. PRESENT VALUE MODLES
PV models constitute a demanding & rigorous approach for valuing assets.
2.1 Valuation Based on the Present Value of Future Cash Flows
Value of asset relates to benefits or returns we expect to receive from holding it (future cash flows).
Money has a time value (money received in future is worth less than same amount received today).
Two elements of DCF valuation.
Estimating the CF.
Discounting the CF(economic rationale)
Discount rate for RF cash flows is RF rate.
Future CFs for equity are not known with certainty (they are risky) requires two adjustments.
Discount the expected CF.
Adjust the discount rate to reflect the risk.
V0 = value of asset at time t=0

n = number of CF in the life of asset (∞ for equities)
CFt = Expected CF at time t.
r = the discount rate or required rate of return.

2.2 Streams of Expected Cash Flows
Three Types of DCF Models
Dividend Discount Model Free C.F Models Residual Income Model
Investors holding shares receive cash return A company can add to cash (or use up cash) by When impractical to apply DDM or FCF,
in the form of dividends. selling goods & services. third approach RIM.
DDM accounts for reinvested earnings. For a going concern some of CFO is not “free”. RI = earnings in excess of investor’s
Dividends are less volatile then earnings & FCFF = CF that can be withdrawn by bondholders required return on beginning investment.
other return concepts so less sensitive to and shareholders without economically In contrast to accounting income, RI
short-term fluctuations. impairing company. attempts to measure value added in excess
Company might not pay divided (no cash, Value of common equity = PV of FCFF –MV of of opportunity cost.
unprofitable, or very profitable). debt. RI model states that stock’s value is BV plus
Generally mature companies tend to pay FCFE = CFO – cap. expenditure. PV of expected future residual earnings.
dividends. FCFF is a pre-debt FCF concept; FCFE is a post RI model can be applied to both dividend-&
DDM perspective is that of minority debt FCF concept. non-dividend paying stocks.
ownership. FCFF is easier to apply in several cases such as RI model ⇒ when CF is negative.
Applying DDM to non-dividend paying leverage is expected to change significantly. RI requires a detailed knowledge of
shares is theoretical. FCF concept is very popular (can be applied to accruals.
non-dividend-paying companies). If quality of accounting disclosure is good
Appropriate for control perspective. analyst may use RI model.
Analyst may find that one model is more suitable to particular valuation problem.

3. THE DIVIDEND DISCOUNT MODEL
DDM is the simplest & the oldest PV approach to valuing stock.
3.1 The Expression for a Single Holding Period
Shareholder who buys & holds shares, the CF are dividends & MP of share.
MP should reflect expected dividends subsequent to sale.
If investor whishes to hold share for one year the value of stocks:
Where
V0 = value of stock today t= 0.
P1= Expected price per share at t =1.
D1 = Expected dividend per share for year 1.
r = required rate of return.
3.2 The Expression for Multiple Holding Periods
If investor plans hold stock for two years, the value of stock is:
For any finite holding period, the value of stock is:
If holding period extends to indefinite future, the stock value is present value of all expected future dividend
(forecasting problem).
or
Two broad approaches to simplify the forecasting problem.

Assign a growth pattern for future dividends (constant growth, two or three stages of
growth).
Finite number of dividends can be forecasted individually up to a terminal point; from this
point onwards forecast either remaining dividends through stylized growth pattern or
share price at terminal point by using some method (e.g. multiples).

4. THE GORDON GROWTH MODEL
Dividends grow indefinitely at a constant rate (this assumption is applied to general DDM).
4.1 The Gordon Growth Model Equation
Where g is constant growth rate.

For this equation r > g makes sense whereas r=g or r < g does not make sense.
Model values are very sensitive to “r” & “g”.
GGM applies to dividend-paying stocks.
GGM is most appropriate for companies with earnings growth nominal comparable to or
lower than economy’s growth rate.
Growth rate of economy is measured by growth in GDP.
If earnings growth rate is above economy’s growth rate ⇒ use multistage DDM.
Analysts have often used the GGM to value broad equity market indices.
GGM can be used to value fixed-rate perpetual preferred stock as:
Where dividend growth rate equal to zero.
4.2 The Links Among Dividend Growth, Earnings Growth, & Value
Appreciation in the Gordon Growth Model
Dividends growing at a constant rate g, stock value also grows at g as well.

“g” in GGM is the rate of value or capital appreciation.
If prices are efficient, price is indeed expected to grow at rate of g.
Another characteristic of GGM ⇒ components of total return stay constant through time.
4.3 Share Repurchases
Companies can distribute free CF to shareholders in the form of share repurchases.

Corporations do not view themselves as committed to maintain share repurchases at any specified level.
Share repurchases are harder to forecast than cash dividends.
Share repurchases are neutral in their effect on wealth of ongoing shareholders (if at market price).
DDM is a valid valuation approach even when the company being analyzed engages in share repurchases.
4.4 The Implied Dividend Growth Rate
Diff. b/w estimated values of a stock & its actual market value might be
explained by different growth rate assumptions.
Given price (V0), expected next period dividend (D1), and required
return (r) the growth rate can be inferred.
Calculation of implied growth rate provides an alternative perspective
on valuation of stocks (fairly valued, over or undervalued).

4.5 The Present Value of Growth Opportunities
Value of stock is
Value of company without earnings reinvestments.
PV of growth opportunities.
Earnings growth may increase, leave unchanged, or reduce shareholder wealth depending upon
relationship b/w g & opportunity cost of funds.
Company without positive expected NPV projects is defined as a non-growth company.
Earnings will be flat in perpetuity assuming a constant ROE.
The no-growth value per share is
The actual value per share is
The flexibility to adopt investments to new circumstances and information is valuable.

High level of managerial flexibility or good business opportunities ⇒higher value of PVGO
1/r, value of P/E for no growth company; the 2nd component of P/E value relates to growth opportunities.
Value of growth & value of assets in place generally have different risk characteristics.
4.6 Gordon Growth Model and the Price-to-Earnings Ratio
P/E expression has two uses:

When used with forecasts of the inputs to the model, the analyst obtains a justified P/E (fair,
warranted or justified on the basis of fundamentals).
To weight whether the forecasts of earnings growth built into the current stock price are
reasonable.
Trailing P/E = MP per share / trailing 12 months EPS.
Leading P/E = MP per share / next 12 month EPS.
Leading & trailing P/E can be developed from GGM.
4.7 Estimating a Required Return using Gordon growth Model
GGM can be used to estimate stock’s required return (assuming efficient prices).
r is composed of two parts; dividend yield & capital gains yield (g).
4.8 The Gordon Growth Model: Concluding Remarks
Appropriate for dividend-paying companies with stable future dividend & earnings growth rate.
Analysts use it to judge whether an equity market is fairly valued or not & for estimating equity risk premium.
Output is very sensitive to “g” & “r”.

5. MULTISTAGE DIVIDEND DISCOUNT MODELS
Constant growth under GGM is not a realistic assumption, growth falls into three stages.
Growth Stages
Growth Phase Transition Phase Mature Phase
Rapidly expanding markets. Earnings growth slows due to competition. Investments just earn opportunity
High growth in earnings. Prices, margins & sales growth slows. costs.
Often negative FCFE. Earnings growth declining towards growth Earnings growth, dividend payout &
Dividend payout is zero or very low. rate of overall economy. ROE stabilize at long-rum level.
Capital requirement declines. Dividend & earnings growth rate is
Positive FCF & increasing dividend payout called mature growth rate.
rates.
5.1 Two-Stage Dividend Discount Model
Two Versions
General two-stage Model H-Model
Stage 1 represents abnormal growth. Growth rate assumed to decline

Transition to mature growth in stage 2 from abnormal to mature rate
is abrupt. during stage 1.

Two-stage DDM is useful where supernormal growth rate for a few years, after which growth rate falls to a sustainable level.
Possible limitation ⇒ transition stage abrupt.
Analysts estimate terminal value through multiple or GGM.
Some analysts use different discount rates for different growth phases.
5.2 Valuating a Non-Dividend-Paying Company
Stock currently paying no dividends does not mean principles of DDM do not apply.
Non-dividend-paying company can use a multistage DDM in which first-stage dividend equals zero.
If it is difficult to estimate timing of initiation of dividends & dividends policy then analyst may prefer FCF or RI model.
5.3 The H-Model
Growth linearly declines through the supernormal growth period until it reaches a normal rate at the end.

Or
Where H = half life in years of the high-growth period.

In equation one the 1st term is PV of dividend stream if it grows at gL forever. The 2nd term is extra value
occurring to stock because of supernormal growth.
Longer the supernormal growth period & larger the extra growth rate (gS – gL)⇒ higher the share value.
H-model is an approximation model; for long extraordinary growth period or for a large diff. in growth rates
the analyst may abandon the approximation model.

5.4 Three-Stage Dividend Discount Models
Two versions
General three-stage model (three distinct stages of growth).
Growth rate in middle stage assumed to decline linearly.
The process of using this model involves four steps.
i. Gather the required inputs.
ii. Compute the expected dividends in first stage & find the sum of their PV.
iii. Apply the H-model to 2nd & 3rd stages to estimate their value as of beginning of 2nd stage, then find PV.
iv. Sum of values obtained in 2nd & 3rd step.
5.5 Spreadsheet (General) Modeling
Spreadsheets allow the analyst to build complicated models that would be very cumbersome to describe
using algebra.
Several analysts can work together or exchange information by sharing their spreadsheet models.
5.6 Estimating a Required Return Using Any DDM
Given current price & all inputs to a DDM except for the required return, an IRR can be calculated.
If price does not equal intrinsic value, the expected return will need to be adjusted to reflect the additional
component of return.

When short-& long-term growth rates are same H model reduces to GGM.
Analyst must find the rate of return such that the PV of future expected dividends equals the current stock price.
5.7 Multistage DDM: Concluding Remarks
Multistage DDMs accommodate a variety of patterns of future stream of expected dividends.

Multistage DDMs make stylized assumptions about growth based on a lifecycle of business.
6. THE FINANCIAL DETERMINANTS OF GROWTH RATES
Dividend growth rate (g) = earnings retention ratio (b) × return on equity (ROE).
6.1 Sustainable Growth Rate
Rate that can be sustained for a given level of ROE assuming capital structure is
constant.
Sustainable growth rate = g = b × ROE.
Lower (higher) the earnings retention ratio, the lower (higher) growth rate in
dividends ⇒ dividend displacement of earnings.
External equity is more costly than internal equity for several reasons e.g.
investment banker fees.
Continuous issuance of new stock is not a practical funding alternative.
Growth of capital through issuance of new debt can be sustained for considerable
periods.
Target % of debt to total capital ⇒need to issue debt to maintain percentage as
equity grows through reinvested earnings.

6.2 Dividend Growth Rate, Retention Rate, and ROE Analysis
DuPont Model.
1st term is profit margin, higher profit margin, higher ROE (direct relation).
2nd term is total asset turnover (company’s efficiency) which also has direct relation with ROE.
this expression
is called PRAT model P = profit margin R = Retention rate A = asset turnover, T = financial leverage.
Profit margin & asset turnover determine ROA while retention rate & financial leverage reflect financial policies.
ROE hold exactly only when ROE is calculated using beginning-of-period shareholders’ equity.
Analysts prefer to use avg. total assets in calculating ROE.
Analyst should be careful in projecting historical financial ratios into the future when using this analysis.
6.3 Financial Models and Dividends
Spreadsheets are used for more complex dividend models.

Company’s ability to pay dividend in future can be predicted using one of these models.

“FREE CASH FLOW VALUATION”

DCF = Discounted cash flow
1. INTRODUCTION TO FREE CASH FLOWS
IV = intrinsic value
PV = present value
FCF = free cash flows IV is PV of expected future CF.
WCI = working capital investment FCF ⇒ CF available for distribution to shareholders.
FCI = fixed capital investment. FCF approach is used for many reasons (e.g. no dividends.
Dividends paid significantly different from capacity to pay etc.)
Value of common equity ⇒ by using FCFE or FCFF –MV of debt.
2. FCFF & FCFE VALUATION APPROACHES
2.1 Defining Free Cash Flow 2.2 Present Value of Free Cash Flow 2.3 Single-Stage (Constant-Growth FCFF & FCFE Models
FCFF FCFE 2.3.1 Constant-Growth 2.3.2 Constant-Growth

FCFF valuation Model FCFE Valuation Model
CF to suppliers of capital after CF to common equity holders
operating expenses & necessary after operating exp., Interest & = =
investments in W.C & F.C. principle payments, investment 1 + 1 +
Capital suppliers are common in W.C & F.C.
stockholders, bondholders &
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2.2.1 Present Value of FCFF 2.2.2 Present Value of FCFE

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3. FORECASTING FREE CASH FLOW
3.1 Computing FCFF from Net Income
= + + 1 − − −

If noncash in N.I > noncash ↑ in N.I ⇒ adjustment is positive & vice versa.
After-tax interest is added back because it is CF to one of company’s capital providers
(similar treatment for preferred dividend).
represents fixed capital necessary to support current & future operations.
Cash & cash equivalents & short-term debt (notes payable & current portions of long
term debt) ignore while calculating change in WC.

3.2 Computing FCFF from the Statement of Cash Flows
= + 1 − − .

Consider treatment of interest paid, if taken out of N.I & CFO (as under U.S.GAAP), then
after-tax interest must be added back to get FCFF.
CFO = NI + NCC - .
Interest paid is considered as operating or financing activity under IFRS.
3.3 Noncash Charges
Analyst should verify the NCC to ensure that FCFF estimate provides reasonable basis for
forecasting.
If company is growing (ability to indefinitely defer tax liability) adding back deferred taxes to
N.I is warranted & vice versa in case of DTA.
Noncash Items and FCFF

Noncash Item Adjustment to NI to Arrive at FCFF
Depreciation Added back
Amortization and impairment of intangibles Added back
Restructuring charges (expense) Added back
Restructuring charges (income resulting from
Subtracted
reversal)
Losses Added back
Gains Subtracted
Amortization of long-term bond discounts Added back
Amortization of long-term bond premiums Subtracted
Added back but calls for special
Deferred taxes
attention
3.4 Computing FCFE from FCFF
= − 1 − + .

FCFE is the amount a company can afford to pay out as
dividends (often dividends differ from FCFE).
FCFE = NI + NCC - FCInv – WCInv + Net borrowing.
FCFE = CFO – FC Inv + Net borrowing.
3.5 Finding FCFF & FCFE from EBIT or EBITDA
FCFF = EBIT (1-tax rate) + Dep. – FCInv – WCInv.

FCFF = EBITDA (1- tax rate) + Dep. (tax rate) – FCInv – WCInv.
Many noncash adjustments are not required when starting with EBIT or EBITDA.
FCFE can also be calculated from EBIT & EBITDA by subtracting Int (1- tax rate) &
adding net borrowing to above FCFF equations.
Noncash charges that affect taxes must be accounted for
3.6 FCFF & FCFE on a Uses-of- Free-Cash-Flow Basis
Up till now calculation of FCF is sources based, it can also be uses based.
Uses of FCFF Uses of FCFE
Increase in cash balance + Net payment to debt Increase in cash balance + payments to equity
providers + payments to providers of equity capital. capital providers.
These uses must be equal to sources of FCFF. Uses of FCFE must equal to sources of FCFE.

3.7 Forecasting FCFF & FCFE
FCFF & FCFE forecasting
Constant growth rate Component approach
Constant growth rate to current level of free cash flows. Complex approach to forecast each component of
Appropriate if FCF grow at constant rate & relationship FCF (e.g. FCInv, WCInv, noncash charges).
between FCF and fundamental factors will continue.
For FCFE forecasting debt ratio is assumed to be constant.

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Incremental FCInv as proportion or sales =

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Incremental WCInv as proportion of sales =

FCInv has two components, to maintain existing capacity & expenditure necessary for growth.
If dep. is the only noncash charge then the equation can be:
= −
− ! −
+ .
Net borrowing = DR (FCInv – Dep.) + DR (WCInv)
so
FCFE = NI – (1-DR) (FCInv – Dep.) – (1-DR) (WCInv)
3.8 Other Issues in Free Cash Flow Analysis
3.8.1 Analyst Adjustments to CFO
Discrepancies b/w ∆ B/S accounts & ∆ CFS include acquisitions or

divestitures & nondomestic subsidiaries.
Analyst adjusts CFO by removing contaminations regarding CFF or CFI.
3.8.2 Free Cash Flow versus Dividends and Other Earnings Components
Many analysts prefer FCF valuation over DDM.

For companies paying little to no dividends, analyzing targets for takeover, FCF is appropriate measure.
Dividends, share issuance & repurchases have no impact on FCFF or FCFE while leverage charges have some
impact (affect interest tax shield) on FCF.
If inputs are known & consistent DDM & FCFE model result in identical valuation.
EBITDA is a poor proxy for FCFF (because it ignores dep. Tax shield, FCInv & WCInv. A before tax discount
rate should be used rate instead of WACC which is after tax).
EBITDA is poorer proxy for FCFE (ignores after-tax interest cost or CF from new borrowings or debt
repayments).
3.8.3 Free Cash Flow and Complicated Capital Structures
Capital Structures can be complex by adding preferred stock to debt & common
equity structure.
Preferred dividend would be added to CF to obtain FCFF (when starting with N.I).
For FCFE ⇒ issuing preferred stock P.S, FCFE & vice versa.
P.S has many same effects as debt except tax treatment of preferred dividends.

4. FCFF CASH FLOW MODEL VARIATIONS
4.1 An International Application of the Single-Stage Model 4.2 Sensitivity Analysis of FCFF & FCFE Valuation
When inflation rates are high & volatile, real valuation has Sales growth & profit margins depends on growth phase
much appeal. of company & industry profitability.
International equity investing requires incorporating different Analysts can perform a sensitivity analysis to examine
eco. Factors & dealing with varied accounting standards. sensitivity of final valuation to changes in each input
Build-up method (country real return with industry, size & variable.
leverage adjustments) is used for real discount rates.
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4.3 Two-Stage Free Cash Flow Models
Growth in 2nd stage is long-run sustainable growth rate.

Growth rate in FCF models may refer to different
variables (income, sales etc.)
4.3.1 Fixed Growth Rate in Stage I & II 4.3.2 Declining Growth Rate in Stage I &
Constant Growth in Stage II
Constant growth in each stage e.g. 20% Growth rate decline over time not
sale growth in stage I & 6% in stage II. drop precipitously.
Two Examples
Growth rate of EPS decline Declining sales growth in

in 1st stage, which affects stage I with profits,
other variables (e.g. new investment & financings.
investments, borrowings).
5. NONOPERATING ASSETS AND FIRM VALUE
If significant non-operating assets (e.g. excess cash, excess marketable

securities) then firm value:
value of firm = value of operating assets + value of non-operating assets.
Financial investments in stocks & bonds should be reflected at MV.

“MARKET-BASED VALUATION: PRICE

AND ENTERPRISE VALUE MULTIPLES”
DCF = Discounted Cash Flows NCC = Noncash Charges
FV = Fair Value WC = Working Capital
BVPS = Book Value Per Share CFO = Cash Flow From Operation
NE = Normalized Earnings DY = Dividend Yield
ROA = Return On Assets EV = Enterprise Value
ROE = Return On Equity ROIC = Return On Invested Capital
EY = Earnings Yield TIC = Total Invested Capital
IR = Interest Rate SD = Standard Deviation
RI = Residual Income HM = Harmonic Mean
1. INTRODUCTION
Valuation Tools
Price Multiples Enterprise Value Multiples Momentum Indicators
Ratio of MP to some measure of Relate with total MV of capital to a Relate with price or a fundamental to
fundamental value per share. measure of fundamental value for entire time series of its own past or expected
Intuition is to evaluate share price. company. values.
Same valuation purpose. Provide information on future pattern of
returns.
2. PRICE & ENTERPRISE VALUE MULTIPLES IN VALUATION
Methods of Multiples
2.1 The Method of Comparables 2.1 The Method Based on Forecasted Fundamentals
Valuation based on multiples benchmarked to multiples Use of multiples derived from forecasted fundamentals
of similar assets. (e.g. profitability, growth etc.).
The word relative is necessary (because asset may be DCF model based valuation is one process for
under, over or fairly valued relative to comparable forecasted fundamentals.
asset or group of assets. Justified price multiples ⇒ estimated fair Value
Economic rationale ⇒ law of one price (two identical justified on basis of comparables or fundamentals.
assets should sell at same price).

3. PRICE MULTIPLES
3.1 Price to Earnings
Ratio of MP (easily determinable) to EPS (based on complex accrual accounting rules).
Rationales & Drawbacks
Rationales Drawbacks
Earning power ⇒ chief driver of investment value. EPS can zero or negative relative to price so no economic sense
Widely recognized & used. Recurring components difficult to distinguish from transient components.
Accounting estimates & choices may distort EPS.
3.1.1 Alternative Definitions of P/E
Trailing P/E Forward P/E
Current MP divided by most recent four quarter EPS. Current price divided by next year’s expected earnings.
3.1.2 Calculating the Trailing P/E
3.1.2.1 Analyst Adjustments for Nonrecurring Items 3.1.2.2 Analyst Adjustments for Business-Cycle Influences
Nonrecurring earnings are removed by analyst. Somewhat different from company-specific effects.
Identification of nonrecurring items requires detailed Trailing EPS often depressed or negative at bottom of cycle &
analysis (I.S, footnotes etc). vice versa.
CF component of earnings should receive greater Normalized EPS ⇒ EPS expected under mid-cyclical conditions.
weight than accrual component. Normalized earnings for a loss reporting cyclical company can
also be calculated as
By multiplying total assets to long-run ROA.
By multiplying total equity to long-run ROE.
Methods of Calculating Normalized Earnings
Historical Avg. EPS Average ROE
Avg. EPS over most recent full cycle Avg. ROE (recent cycle) × BVPS.
Not account for changes in business’s size. Consider business size.
3.1.2.3 Analyst Adjustments for Comparability with 3.1.2.4 Dealing with Extremely Low, Zero, or Negative Earnings
Other Companies
Analyst may use normalized EPS if current earnings are zero
Analyst adjusts EPS for differences in accounting or negative.
methods. Inverse price ratio (earnings yield) is another solution.
Usually FSA adjustments also incorporated in P/E Ranked by highest to lowest P/E, securities are ranked
analysis. costly to cheapest & vice versa when ranked by EY.

3.1.3 Forward P/E
Forward P/E with Next Four Quarter Earnings Next 12 Months Earnings Next Fiscal Year’s Earnings
MP/ next 4 quarter earnings. MP/ estimated next 12 months EPS.

Useful in comparison of companies P/E based on mean P/E based on
with different fiscal-year ends. of analysts’ current following fiscal year
fiscal year forecasts (based entirely on
(may have actual forecasts).
EPS for some
quarters).
3.1.4 Valuation Based on Forecasted Fundamentals
3.1.4.1 Justified P / E 3.1.4.2 Predicted P/E Based on Cross-Sectional Regression
Trailing P/E Forward P/E P/E can be estimated from cross-sectional regressions of
P/E on fundamentals believed to drive security valuation.
1 − (1 + ) 1−
− −
Limitations
Where
b = retention rate, r= required return, g= Predictive power Explanatory power Problem of
growth rate. for different stocks of regression multicolinearity.
Justified P/E is inversely related to r & positively & time periods is changes over time.
related to g. not known.
3.1.5 Valuation Based on Comparables
Compare a stock’s actual price multiple with a

benchmark value of the multiple
Steps in method of comparables
Select & calculate price multiple. ⇒ Select & calculate value of ⇒ Compare the stock’s actual ⇒ Diff. b/w actual &
multiple for comparable multiple with benchmark benchmark value should
asset or assets. value. be explained by diff. in
fundamentals.
Benchmark P/E value includes avg. or median P/E value of peer

groups & industry or sector, the P/E for an equity index or avg.
historical P/E value for the stock.

P/E Benchmarks
3.1.5.1 Peer-Company Multiples 3.1.5.2 Industry and Sector Multiples
Benchmark companies in same industries. Compare stock’s multiples with median

Subject stock’s P/E is compared with mean or (insensitive to outliers) or mean multiple of
median P/E for peer group. industry.
Stocks with greatest growth rate (lowest risk) Comparison across broader segments
are, all else equal, most attractively valued. determines whether relative valuation
/

= accurately reflects intrinsic value.

Greater the number of comparison assets,
Lower PEG stocks are more attractive.
more likely the mispricing of individual assets
PEG ignores non-linear relationship between
cancel out.
P/E and growth diff. in risk & diff. in duration
of growth.
3.1.5.3 Overall Market Multiple 3.1.5.4 Own Historical P/E
Consider size diff. b/w subject stock & stocks in Past values of stock’s own P/E as basis of
selected index. comparison.
If index is market cap weighted, largest Justified price = (benchmark value of own
constituent stocks influence calculated P/E. historical P/E) × (most recent EPS).
Mid-cap stocks ⇒ use median P/E. Analyst should consider changes in business
Consider time frame for comparing avg. mix & leverage.
multiple. Inflation distorts comparison b/w two P/Es of
Fed model ⇒ market is overvalued when EY is different time periods.
less than 10 year Treasury bond yield.
Fed model ignores growth factors, inadequately
reflects inflation effects & relationship between
IR & EY in not linear.
Yardeni model ⇒ CEY = CBY - b x LTEG + residual
where CEY = current earnings yield,
CBY = Moody’s A-rated corporate bond yield, b=
earnings projection weight, LTEG = 5 year
earnings growth rate for the market index.
3.1.6 P/Es in Cross-Country Comparisons
Analyst should consider

EPS affects due to differences in accounting
standards.
Differences in macroeconomic contexts (e.g.
differences in inflation).

3.1.7 Using P/Es to Obtain Terminal Value in Multistage Dividend Discount Models
Terminal price multiples ⇒ multiples used to estimate terminal value.
Terminal Price Multiples
Based on Fundamentals Based on Comparables
Trailing Multiple Leading Multiple Trailing Multiple Based Terminal Leading Multiple Based
Value Terminal Value
By dividing both sides of Dividing both sides by EPS at = ℎ

= ℎ

GGM by EPS at time n (final time n+1.

×

×
stage begins).
Based on market data

Calls for specific estimates. Terminal value may reflect mispricing.
3.2 Price to Book Value
= ℎ

ℎ

BV is generally positive (cumulative BS amount). Ignores certain assets (e.g. human capital).
BVPS is more stable than EPS. Valuation is misleading when level of assets used by
Appropriate for liquid asset companies. companies differ significantly.
Appropriate for companies that are going out of Accounting effects & difference (e.g. R&D) may
business. impair comparability.
Inflation & technological changes create difference
b/w book value & market value.
Share issues or repurchases distort historical
comparisons.
3.2.1 Determining Book Value

−

−
=
! . ℎ

Adjustments in P/B Ratio
Tangible BVPS = common equity – Certain adjustments for enhancing B/S should be adjusted for significant off-
intangible assets. comparability (e.g. two firms with balance sheet assets & liabilities & diff. in
Exclusion of all intangibles may not different inventory accounting) accounting standards.
warranted (e.g. patents which are
separable from the entity and sold).

Assuming GGM & using expression g = b × ROE the justified PO/BO is

calculated as follows:
"# −
=
−
Large ROE in relation to r, higher justified P/B ratio.
Justified P/B based on R.I valuation is
$

= 1 +

Follow steps given in section 3.1.5.

P/B should consider ROE, risk and expected earnings growth differences.
3.3 Price to Sales
Sales are less subject to distortion than other High sales growth does not assure operating profits
fundamentals. Share price reflects the effects of debt financing
Sales can never be negative, so P/S can always be while sales are a pre-financing debt measure.
used. Ignore cost structure differences among companies.
Sales are more stable than EPS.
P/S is appropriate for stocks of mature, cyclical &
zero-income companies.
3.3.1 Determining Sales
=

Where net sales = total sales – returns & customer discounts.
Analyst should evaluate revenue recognition practices before
relying on P/S.
If questionable revenue recognition practices ⇒ avoid
investment or risk premium.
In terms of GGM

% & 1 − 1 +

=
−
P/S is an increasing function of profit margin & earnings growth rate.
We can also derive ‘g’ by restating the above equation.
3.3.3 Valuation Based On Comparables
Follow steps given in section 3.1.5.

P/S usually based on trailing sales, but can be based on forecasted sales.

3.4 Price to Cash Flows
CF are less subject to manipulation & more stable If CFO = EPS + NCC, then noncash revenues & net
than earnings. changes in WC are ignored.
Address the issue of differences in accounting FCFE is more volatile & frequently negative than CF
conservatism b/w companies. (if multiplies is P/FCFE).
Companies use accounting methods that enhance
CF measures (e.g. securitizing AR).
3.4.1 Determining Cash Flow
Cash flows definitions for calculating P/CF ratio:

Earnings-plus-noncash-charges definition of CF = EPS + dep + amortization & depletion.
Analyst can use CFO in price multiple (adjustment to CFO required for diff. in
accounting standards & non persistence).
FCFE cash flow concept captures amount of capital expenditures but more volatile than
CF & CFO concept (so trailing P/FCFE is not more informative).
EBITDA is another CF concept EV/EBITDA is often used instead of P/EBITDA because the
former considers the debt portion.
Trailing '( =

Justified P/CF = value of stock using DCF model/Cash flows.

Justified P/CF ⇒ inversely related to “r” & positively related to “g”.
Follow same steps as P/E, P/B & P/S
3.5 Price to Dividend and Dividend Yield
DY is a component of total return. Use of DY is suboptimal (explains one component).

Dividends are less risky than capital appreciation. Dividend displacement of earnings ⇒ dividend paid
now displaces earnings in future periods.
Biased reflection of difference in relative risk of
return components due to relative dividend safety.

3.5.1 Calculation of Dividend Yield
Dividend Yield
Trailing DY Leading DY

(

) !$ )

ℎ
ℎ

In the context of GGM
* −
=
1+
DY is negatively related to “g” & positively related to “r”.
Similar process as other multiples.

Consider whether diff. in “g” explains diff. in DY.
High dividend payouts relative to peers indicate less secure dividends.
4. ENTERPRISE VALUE MULTIPLES
Multiples that relate the EV of company to some measure of value.

EV multiples are less sensitive to effects of financial leverage than price multiples.
4.1 Enterprise Value to EBITDA
EV is total company value.

EBITDA is pre-interest, pretax operating CF.
EV/EBITDA is an overall company valuation indicator.
More appropriate for comparing companies with EBITDA will overestimate CFO if WC is growing &
different financial leverage (because EBITDA is pre ignores effects of differences in revenue recognition
interest). on CFO policy.
Used in capital intensive business (controls diff. in EBITDA will reflect diff. in business only if dep.
Dep. & amortization). expense matches businesses; capital spending
EBITDA is positive when EPS is negative. programs expenditure.

4.1.1 Determining Enterprise Value
EV = MV of equity + MV of preferred stock + MV of debt – cash & investments.

Nonearning assets (cash & investments) are subtracted because EV measures the net
price an acquirer would pay for the whole company.
When MV are not available use BV from B.S.
Justified EV/EBITDA positively related to growth rate in FCFF,

expected profitability & negatively related to WACC.

"#+' =

!"
Lower EV/EBITDA relative to peers indicates

relatively undervalued company.
TIC is similar to EV but does not deduct cash
and investments.
4.2 Other Enterprise Value Multiples
EBITDA Alternatives
FCFF EBITA EBIT
N.I + interest (1-t) + dep. & NI + interest exp + tax + NI + interest exp + taxes.
amortization – WCInv – FCInv amortization. Choose where neither dep. nor
Suitable for companies where amortization is a major
amortization is a major expense.
expense.
EV multiple can be based on nonfinancial

measurement (e.g. EV to subscriber in case of cable
industry).
4.3 Enterprise Value to Sale
P/S fails to recognize that for a debt financed

company, not all sales belong to equity investors.
While EV/S is suitable for companies with diverse
capital structure.
4.4 Price and Enterprise Value Multiples in a Comparable Analysis: Some Illustrative Data
Illustration

5. INTERNATIONAL CONSIDERATIONS WHEN USING MULTIPLES
Across border comparisons involve diff. in accounting methods.

Cultural, economic difference & resulting risk & growth differences.
Accounting differences affect comparability of all price multiples.

P/CFO & least affected while P/B, P/E & multiples based on EBITDA most

affected by accounting differences.
6. MOMENTUM VALUATION INDICATORS
Unexpected earnings (earnings surprise) ⇒ diff. b/w reported & expected earnings.
, = − ( )
"

=
#
$ ᇲ

- $
, =
#

Smaller the historical size of forecast errors; the more meaningful a given size of
EPS forecast error.
Relative-Strength Indicators
Compare stock’s performance with its Price momentum ⇒indicator, which Other definition ⇒ stock’s return
own past performance or performance compares stock’s performance with over a recent period to return over a
of group of stocks. its past performance, is the stock’s longer period.
compound rate of return. .
=

%

Rational ⇒ pattern of reversal
$ "

exists. If this ratio, stock price relative
to index.
Momentum indicators may provide a clue when market price converges to intrinsic value.
7. VALUATION INDICATORS: ISSUES IN PRACTICE
7.1 Averaging Multiples: The Harmonic Mean

/

(/) = 0& = ∑೙ ) )
೟సభ( (೔
Where 0 is ratio of individual holding

1ℎ ℎ

= 0*& = *೔
∑೙
೟సభ+ )( ,
೔
Where 1 are portfolio value weights & 0 > 0 for i = 1, 2------n.

HM P/E gives less weight to higher P/E & vice versa.
HM reduces impact of larger outliers while median mitigates effect of outliers.

“RESIDUAL INCOME VALUATION”
R.I = Residual Income TV = Terminal Value

1. INTRODUCTION
F.S = Financial Statements FCF = Free Cash Flows
NOPAT = Net Operating Profit OCI = Other Comprehensive
after Tax Residual income ⇒ income after considering the costs of all of the company’s capital. Income
BV = Book Value DT = Deferred Taxes
DJIA = Dow Jones Industrial MVA = Market Value Added
Average EVA = Economic Value Added
DCF=Discounted Cash Flows A&L = Assets & Liabilities
2. RESIDUAL INCOME DDM=Dividend Discount Model
Traditional F.S let the owners decide whether earnings cover their opportunity
costs.
R.I = net income – charge for common shareholders’ opportunity cost (which is
not considered in traditional accounting).
Cost of equity is marginal cost of equity (represents cost of additional equity)
also referred as required rate of return on equity.
Second approach = NOPAT – capital charge (for both debt & equity).
Two assumptions:
Marginal cost of debt is equal to current cost of debt.
Weights based on BV of debt & equity.
2.1 The Use of Residual Income in Equity Valuation
Company with positive R.I is creating value thus the R.I, the valuation.
R.I models are used to value individual stocks, DJIA & proposed as a solution to
measuring G/W impairment.
R.I is also called economic profit or abnormal earnings.
R.I models are also called discounted abnormal earnings model & Edwards-Bell-
Ohlson model.
2.2 Commercial Implementations
Economic value added = NOPAT – (C% × TC).

Where C = cost of capital & TC = total capital.
Most common adjustments to NOPAT & TC are:
R&D expenses are capitalized & amortized rather than expensed.
If strategic investments are not expected to generate an immediate
return, capital charge is suspended until a later date.
G/W is capitalized & not amortized.
D.T are eliminated & only cash taxes are considered as an expense.
Inventory LIFO reserve is added back to capital & any in LIFO reserve is
added when calculating NOPAT.
Operating leases are treated as capital leases & nonrecurring items are
adjusted.
Diff. b/w EVA & second approach to R.I is due to difference in assumptions.
MVA = MV of the company - accounting BV of total capital.
Positive economic profit means MV > BV of total capital.
Varieties of commercial R.I models are used for measuring internal corporate
performance & determining executive compensation.

3. THE RESIDUAL INCOME MODEL
Companies that earn more (less) than cost of capital should sell for more (less)
than BV.
Intrinsic value of equity is sum of two components;
Current BV of equity.
PV of expected future R.I.
= + ∑

೟ = + ∑

೟ ೟ ೟షభ
೟
Where
= value of a share of stock today (t=0)
= current per share BV of equity

= expected BV of equity at time t
r = cost of equity

= expected EPS for period t

= expected per share R.I (
−
)
When EPS > per share cost of equity, RI is positive & vice versa.
3.1 The General Residual Income Model
R.I model has a clear relationship with DDM (above model can be derived from
DDM).
Clean surplus accounting ⇒ income reflects all changes in BV of equity other
than ownership transactions.

=
+
−
General expression for R.I model based on the work of Edwards & Bell & Ohlson
& Feltham is stated as:

−

= +

1 −
Here ROE uses beg. BV of equity rather avg. BV in denominator.
3.2 Fundamental Determinants of Residual Income
= 1 +
బ
Justified
బ
Single stage (constant growth) R.I model ⇒ = +

If ROE = r then =
2nd term is PV of expected economic profits.

Justified is directly related to expected future RI.

&

Tobin’s q =
!"#
!$

$$
$
Although similar to P/B, Tobin’s q has some obvious differences;
Numerator includes MV of total capital & denominator uses total assets
rather equity.
Assets are valued at replacement cost (consider inflation impact) rather
than historical cost.
3.3 Single-Stage Residual Income Valuation
Assumes constant earnings growth rate & ROE.

Implied growth rate can be assessed by inputting current price into model &
solving for “g”.
Drawback ⇒ model assumes that excess ROE above cost of equity will persist
indefinitely.
Abnormally high ROE, competition, return & vice versa.
Over time, company’s ROE will revert to mean value & at some point RI will be
zero.

3.4 Multistage Residual Income Valuation
Used to forecast R.I for a certain time horizon & then estimate a terminal value based
on continuing R.I at the end of that horizon.
Continuing R.I ⇒ R.I after the forecast horizon.
R.I often models ROE fading toward the cost of equity (R.I approaches to zero).
In R.I valuation BV often captures a large portion of total value & TV may not be a large
component of total value (contrasts with other multistage approaches e.g. DDM, DCF).
One of the following assumptions is made for continuing R.I;
R.I continues indefinitely at a positive level.
R.I is zero from terminal year forward.
R.I to zero as ROE reverts to cost of equity.
R.I reflects the reversion of ROE to some mean level.
Finite horizon model of R.I valuation assumes certain premium over book value

% − % so:
(
−
) % − %
= + +
(1 + )
(1 + )%
For long forecast periods this premium may be treated as zero & for short periods
it must be calculated.
R.I model (R.I fades over time)

−
% − %
%
= + +

1 +

1 + − (1 + )%

Persistence factor (ω) represents that behavior of R.I fades over time (b/w zero & one).
Persistence factor ”1” mean R.I will not fade at all & “0” mean R.I will not continue after
initial forecast horizon.
The persistence factor, stream of R.I in final stage.
Persistence factor varies from company to company.
Lower Residual Income Persistence Higher Residual Income Persistence

Extreme accounting rates of return (ROE) Low dividend payout
Extreme levels of special items High historical persistence in the industry
(e.g., nonrecurring items)
Extreme levels of accounting accruals
4. RESIDUAL INCOME VALUATION IN RELATION TO OTHER APPROACHES
Total PV should be consistent under all valuation models (DDM, FCF or R.I) if applied
correctly.
Earlier value recognition under R.I model has a practical advantage (less sensitive to
terminal value estimate).
4.1 Strengths and Weaknesses of the Residual Income Model
Strengths Weaknesses
TV does not make up a large portion of total PV Accounting data is subject to manipulation &
relative to other models. require significant adjustments.
RI models use readily available accounting data. Model requires that clean surplus relationship
Applied to companies with negative CF or not hold.
paying dividend currently. Model assumes that cost of debt capital is
Focuses on economic profitability & can be used reflected appropriately by interest expense.
when CF are unpredictable.

4.2 Broad Guidelines for Using a Residual Income Model
R.I Model (Most Appropriate) R.I Model (Least Appropriate)
For a company that does not pay dividends, or its When clean surplus relationship does not hold.
dividends are not predictable. Significant determinates of R.I (e.g. BV & ROE) are
Firms with negative FCF forecasts. not predictable.
When greater uncertainty in forecasting TV using
alternative PV approaches.
RI models are used to establish justified market multiples such as P/E or P/B
or to assess consistency of results (used in conjunction with other models).
Different models can produce different valuations due to inconsistent
assumptions.
5. ACCOUNTING AND INTERNATIONAL CONSIDERATIONS
In order to apply RI model most accurately, analyst needs to adjust BV for

off-balance sheet items & reported N.I to obtain comprehensive income.
IFRS & U.S.GAAP permit a variety of items to bypass the I.S & reported
directly in equity (dirty surplus relation).
Growing company ⇒ ROE can continue at high levels over time (
expenditures are capitalized rather expensed).
R.I models are sensitive to accounting choices & aggressive accounting
methods.
5.1 Violations of the Clean Surplus Relationship
Clean surplus relationship violations ⇒ when accounting standards permit

charges directly to equity, bypassing the I.S.
Comprehensive income = N.I + OCI
OCI ⇒ events & transactions that result in a change to equity but are not
reported on the I.S.
Items that commonly bypass I.S include:
Foreign currency translation adjustments.
Certain pension adjustments.
Fair value changes of some financial instruments.
When items bypass I.S, the BV of equity is stated accurately but N.I is not.
Analysts assess whether amounts that bypassed the I.S are likely to be
offsetting & can assess their effects on future ROE.
5.2 Balance Sheet Adjustments for Fair Value
Reported assets & liabilities should be adjusted to fair value when possible.
Examine F.S footnotes for off-balance sheet assets & liabilities (e.g.
operating leases & use of SPE’s to remove debt & assets from B.S).
Analyst should examine the F.S & footnotes for items unique to the subject
company.

5.3 Intangible Assets
These assets can have a significant effect on BV.

Separately identifiable intangibles ⇒ appropriate to include these in determination of
BV of equity.
Intangible assets often are not recognized as assets unless they are obtained in an
acquisition (require special consideration).
For a mature company, ROE should reflect the productivity of R&D expenditures
(higher revenues to offset expenditures over time).
R&D (capitalizing v/s expensing) ⇒ significant implication for long-term ROE ⇒ analyst
should be careful.
5.4 Nonrecurring Items
Forecast of future R.I should be based on recurring items.

Misclassifications (e.g. nonoperating income to operating income) can lead to of
future R.I if no adjustments are made.
No adjustments to BV are necessary for these items (because nonrecurring G/L are
reflected in the value of assets in place).
5.5 Other Aggressive Accounting Practices
Companies may engage in activities that accelerate revenues in the current period.
Analyst should carefully examine the use of reserves when assessing R.I.
5.6 International Considerations
Measures of BV & earnings differ internationally (due to differences in international

accounting standards).
Even within a single set of accounting standards companies make choices & estimates
that can affect valuation.
Three primary considerations in applying R.I model internationally:
Availability of reliable earnings forecasts.
Clean surplus relationship hold.
Accounting rules do not result in delayed recognition of value changes.

“PRIVATE COMPANY VALUATION”

PC= Private Company CCM= Capitalized Cash Flow Methods
NE= Normalized Earnings MVIC= Market Value of Invested Capital
FCFF= Free Cash Flows To Firm 1. INTRODUCTION TO FREE CASH FLOWS CP= Control Premium
FCFE= Free Cash Flow To Equity PTM= Prior Transaction Method
DLOC= Discount For Lack Of Control
DR= Discount Rate Valuation of equity of private companies is a
DLOM= Discount For Lack Of
TV= Terminal Value major field of equity valuation. Marketability
FCF= Free Cash Flows
2. THE SCOPE OF PRIVATE COMPANY VALUATION
PCs range from single employee to large successful companies.
2.1 Private and Public Company Valuation: Similarities and Contrasts
Company-Specific factors Stock-Specific factors
Stage in life cycle Liquidity of equity interest
PCs may at earliest stage or include large, stable, or Less liquid stocks in PC so share
failed companies. price.
Public companies typically advanced in their life cycle.
Concentration of control
Size
Leads to benefit some shareholders

PC are small size, risk premium, growth
at cost of others in PC.
prospects companies.
Public company ⇒ access to capital.
Potential agreements
Overlap of shareholders & management
Agreements to restrict ability to sell
Less external pressure & agency issues & longer shares, marketability.
term perspective in PC.
Quality/depth of management
Small PC are less attractive & have lower

management depth therefore risk, growth.
Quality of financial & other information
High quality information in public company due

to detailed disclosure requirements
Limited information in PC, risk.
Limited information in PC , risk, valuation.
Pressure from short-term investors
Short-term stock price performance pressure in

public companies, longer term perspective in PC.
Tax concern
Tax reduction is more important goal for PC Stock-specific factors ⇒ negative for PC.
(greater benefit to owner) Company specific factors ⇒ can be positive or negative.

2.2 Reasons for Performing Valuations
Transaction-related Compliance-related Litigation-related
Private Financing Legal proceedings including

Financial Reporting Tax Reporting those related to damages, lost
VC investors ⇒ multiple round of financing profits, shareholder disputes &
tied to milestones. G/W impairment Reasons for valuations divorce often require valuation.
tests require include corporate &
Initial public offering business valuation individual tax
for a cash- reporting.
Key element of valuation is to identify generating unit
public companies similar to the one going (IFRS) or a
public. reporting unit
Acquisition
Valuation can be performed by

management of target, buyer or
investment banking firms.
Bankruptcy
Valuation about whether more valuable as

going concern or in liquidation.
Share-based payments (compensation)
Have accounting & tax implications to

issuer & employee.

3. DEFINITIONS (STANDARDS) OF VALUE
Specifies how value is understood.

Key elements in determining definition ⇒ status of company & use of valuation.
Major definitions of value
Fair Market Value Market Value Fair Value
Price at which property changes Estimated amount for which Financial Reporting
hands b/w hypothetical willing & property exchanges on date of
able buyer & seller at arm’s length. valuation b/w a willing buyer &
seller in arm’s length after proper IFRS U.S.GAAP
marketing.
Price received for Price received
asset or paid for to sell an asset
Fair Value (litigation) Investment Value Intrinsic Value transfer in a or paid to
current transfer a
transaction b/w liability b/w
Generally similar to definitions Value to a particular investor True “or” real value on basis of
market place participants at
of financial reporting. based on requirements & evaluation or available facts &
participants. measurement
expectations. become MV when other
date.
Focus on specific buyer rather investors reach the same
than value in a market context. conclusion.

4. PRIVATE COMPANY VALUATION APPROACHES
Income Approach Market Approach Asset based Approach
Present discounted value of Value asset based on pricing Value of PC = value of

income expected from asset. multiples. underlying assets - value of
Best for high growth company. Best to value mature Stage liabilities.
Company. Best for earliest stage company.
For small, relatively mature
private companies with limited
growth prospects.
4.1 Earnings Normalization & Cash Flow Estimation Issues
4.1.1 Earnings Normalization Issues for Private Companies 4.1.2 Cash Flow Estimation Issues for Private Companies
NE ⇒ Economic benefits adjusted for nonrecurring or unusual FCFF ⇒ use to value firm.
items to eliminate anomalies. FCFE = use to value equity.
Compensation expenses are overstated in PC, taxable income & Future CF estimation ⇒ wide range CF uncertainty (project
tax expenses. possible future scenarios).
Personal expenses may be included as expenses of PC. Discount rate should reflect risk of achieving projected CF.
Some analysts separate real estate owned by PC from operating
company (consider non-operating asset). Overall company value
If real estate is leased to PC by a related entity, lease expense
requires adjustment to market rental rate.
Further adjustment can be related to inventory accounting Probability-weighted Expected future CF
methods, depreciation assumptions & capitalizing v/s expensing. avg. of company’s should be discounted at
Reviewed financial statement ⇒ provides an opinion letter with estimated scenario a single discount rate.
assurance less than audited F.S. values.
Compiled FS ⇒ not accompanied by auditor’s opinion letter
(greater analytical adjustment). Appraiser should be aware of managerial basis (e.g. overstate value
in G/W impairment testing).
FCFF = EBIT – estimated taxes + Dep. – capex – WCInv.
FCFE = FCFF – after tax interest exp. + net new borrowing.
FCFF valuation is more robust if substantial capital structure
changes (WACC less sensitive to change in financial leverage).
4.2 Income Approach Methods of Private Company Valuation
Value is based on future income & cash flows.

Assets are probable future economic benefits (both IFRS &
U.S. GAAP provide support for this method).
Forms of Income Approach
Free CF method or Capitalized CF, capitalized income or Excess earnings method

discounted CF method capitalization of earnings method
PV of future CF by using a Value of business = value

DR reflective of risk of CF of intangible assets + value
of WC & fixed assets.

4.2.1 Required Rate of Return: Models & Estimation Issues
Application of size premiums Use of the CAPM Expanded CAPM Elements of build-up approach
Size premiums are frequently CAPM is not appropriate for CAPM + small size & company When comparable public
used in return requirement of small PC valuation (not – specific risk premium. company is not available.
PC, not in public companies. comparable to public Excludes application of β.
companies). Expanded CAPM (excluding
β) + industry risk premium.
Relative debt availability & Discount rate in an acquisition Discount rate adjustment for
cost of debt context projection risk
Less debt availability to PC, rely Use cost of capital consistent with Lesser amount of information
more on equity WACC. riskiness of targets CF (instead of concerning PC, uncertainty in
buyer’s own cost of capital). projections, DR.
Management less experienced in
forecasting future performance.
4.2.2 Free Cash Flow Method
FCF valuation may involve projecting FCF for a number of years (5year practical guideline) & a terminal value estimate.
Terminal value through price multiples or capitalized CF method.
Company in a high growth industry ⇒ rapid growth incorporated twice if multiples are used to estimate TV.
4.2.3 Capitalized Cash Flow Method
Estimates value based on value of a growing perpetuity (stable growth FCF model).
Rarely used in private & public companies, suitable for PC with no available projections.
= sustainable growth rate of FCF to the firm.
r is required return on equity.
4.2.4 Excess Earnings Method
Estimate earnings remaining after deducting amounts that reflect required returns to WC &
fixed asset.
Excess earnings are capitalized by using CCM formula to obtain estimates of value of
intangible assets.
Used to value intangible assets & very small businesses.
Value of business = value of WC & fixed assets + capitalized value of intangibles.
4.3 Market Approach Methods of Private Company Valuation
Guideline public company Guideline transaction method Prior transaction method
Value based on comparable Value based on multiples of Value based on actual stock
public co. multiples. actually acquired public or transactions of subject PC
Relative risk & growth private companies.
prospects differences are Relates to sales of entire
adjusted. companies.

Finding & assessing comparable companies is challenging.

Lack of marketability in PC create uncertainty in determining price multiples.
Mature PC, EBITDA & EBIT multiples are frequently used.
MVIC = MV of debt & equity.
Equity value = MVIC – value of debt.
Highly leveraged & volatile performance company ⇒face value of debt is not
appropriate (use matrix pricing i.e. estimate MV of debt).
Very small PC ⇒ N.I based multiples are commonly used.
Extreme small PC ⇒ revenue based multiples.
Nonfinancial metrics of valuation in certain industries (e.g. price per bed in
hospital).
4.3.1 Guideline Public Company Method
Advantages ⇒ large pool of guideline companies, financial & trading information is available.
Disadvantages ⇒ comparability & subjectivity issues in risk & growth adjustments.
Control premium CP ⇒ value of controlling interest – value of non controlling.
Factors in estimating C.P
Type of transaction Industry factors Form of consideration
CP measured before Significant stock

Strategic Transaction Financial Transaction valuation date exchange
reflects different transactions ⇒ less
environment from relevant in
Buyer that would No material synergies
that of valuation measuring control
benefit from certain for buyer
date. premiums.
synergies by owning
the target firm.
Multiples after applying CP should be assessed for reasonableness.
4.3.2 Guideline Transactions Method
Factors in Transaction – based Multiples
Synergies Contingent consideration Noncash consideration
Payments for synergies Potential future payment to Cash equivalent value of a

require consideration. seller contingent on certain large block of stock may
agreed upon occurrences. create transaction price
uncertainty.
Availability of transactions Changes b/w transaction & valuation date
Limited meaningful ∆ in marketplace result in

transactions. differing risk & growth
Time of transactions is expectations requiring
important. adjustment to multiples.

4.3.3 Prior Transaction Method
Valuation based on actual price paid or multiple implied from transaction.

More relevant in considering the value of minority equity interest.
PTM is the most meaningful evidence of value if available, timely & arm’s
length.
4.4 Assets-Based Approach to Private Company Valuation
Value of ownership = FV of assets – FV of liabilities.

Rarely used for valuation of going concerns (tangible & intangible asset
valuation difficulty).
Better approach if value in liquidation is greater than going concern value.
Also appropriate for resource, financial companies & holding companies.
Management fees, carried interest, relative growth & profit, tax effect &
diversification also affect value of an interest in a pooled investment
vehicle.
4.5 Valuation Discount & Premiums
Application of control premium & DLOC & marketability discount may is

fact-specific and estimates vary dramatically.
Timing of potential liquidity event is a key consideration (e.g. PC pursuing
IPO may receive a modest valuation discounts).
4.5.1 Lack of Control Discount
Amount or % reflects the absence of some or all powers of control.

Necessary for valuing noncontrolling interest if value of total equity is based
on a controlling interest basis.
The effect on value of the lack of control is uncertain
Data for estimating DLOC are limited & interpretations vary.

The valuation is considered to be the Controlling Interest Value, generated by
CCM & FCF methods, if CF & DR are estimated on controlling interest basis.
4.5.2 Lack of Marketability Discounts
Amount or % deducted from ownership to reflect absence of marketability.

DLOM quantified through restricted stock transactions & IPOs.
Restricted stock ⇒ identical to freely traded stocks of public company except for
the trading restrictions.
Stock sale prior to IPO, another source of marketability discount.

Key assumptions are the expected term until a liquidly event & level of company
volatility.
Put option analysis provides ability to address risk through the volatility estimates
but put options do not provide liquidity for the asset holding.
In addition to DLOC & DLOM, key person discounts, portfolio discount etc. exists.
DLOC & DLOM are multiplicative and are applied in sequence.
4.6 Business Valuation Standards & Practices
role of FV estimates ⇒ greater focus on valuation estimates, practices &

standards.
Standard compliance mostly is at the option of the individual appraiser (because
buyers & users are often not so aware of such services).

“THE TERM STRUCTURE AND INTEREST RATE DYNAMICS”
2. Spot Rates and Forward Rates
Spot curve ⇒ it represents the term structure of interest rates at any point in time.
Forward rate ⇒ interest rate that is determined today for a loan that will be initiated in a
future time period.
Forward curve ⇒ the term structure of forward rate for a loan made on a specific initiation
date.
Forward pricing model ⇒ it describe the valuation of forward contracts on no-arbitrage
argument.
∗ + = ∗ ∗ ,
2.1 The Forward Rate Model
Forward rate model is used to establish that when the spot curve is upward (downside)
sloping, the forward curve will lie above (below) the spot curve.
Two interpretations of forward rates:
Can be viewed as breakeven interest rates.
Rate that can be locked.
Par curve ⇒ it represents the YTM on coupon paying government bonds priced at par over
a range of maturities.
It can be used to construct a zero coupon yield curve.
Bootstrapping ⇒ the process of determining zero coupon rates by using the par yields.
2.2 Yields to Maturity in Relation to Spot Rates and Expected and Realized Returns on Bonds
Yield to maturity (YTM) ⇒ most familiar pricing concept in bond markets.

Principal of no arbitrage shows that a bond’s value is the sum of the present values of
payments discounted by their corresponding spot rates, the YTM of the bond should be
some weighted average of spot rates used in the valuation of the bond.
YTM is the expected rate of return for a bond that is held until its maturity (assumptions ⇒
(i) all coupon & principal payments are made in full (ii) coupon are reinvested at original
YTM).
YTM is poor estimate of expected return if
Interest rates are volatile.
Yield curve is steeply sloped.
Significant default risk.
If bond has embedded options.
2.3 Yield Curve Movement and the Forward Curve
Forward contract price remains unchanged as long as future spot rates evolve as
predicted by today’s forward curve.
The forward contract value is expected to increase if expected future spot
rate will be lower than what is predicted by the prevailing forward rate &
vice versa.

2.4 Active Bond Portfolio Management
One way to outperform the bond market’s return is to anticipate changes in

interest rate relative to the projected evaluation of spot rates reflected in
today’s forward curves.
Riding the yield curve ⇒ buying bonds with a maturity longer than that the
investment horizon to earn a total return greater than the return on a maturity-
matching strategy (assumption ⇒ no change in level & shape of yield curve over
an investment horizon).
As a bond approaches maturity, it is valued at successively lower yields & higher
prices when the yield curve slopes upward.
3. The Swap Rate Curve
3.1 The Swap Rate Curve
Swap rate ⇒ the interest rate for the fixed rate leg of an interest rate swap.
Swap rate curve ⇒ the yield curve of swap rates.
Swap market is highly liquid because:
A swap does not have multiple borrowers or lenders.
Swaps provide one of the most efficient ways to hedge interest rate risk.
3.2 Why Do Market Participants Use Swap Rates When Valuing Bonds
The investor can adjust the swap spread by using swap curve as benchmark so
that the swap would be fairly priced given the spread.
3.3 How Do Market Participants Use the Swap Curve in Valuation?
The yields on zero coupon bonds determine the swap curve which in turn can be
used to determine bond value.
3.4 The Swap Spread
Swap spread ⇒ spread paid by the fixed rate payer of an interest rate swap
over the rate of the on-the-run treasury security of the same maturity.
Swap curve is mostly used because:
It reflects the default risk of private entities.
Swap rates are more comparable across counties.
Swap market has more maturities than do govt. bond markets.
Swap rates are used for yields with a maturity of more than one year.
Z-spread ⇒ constant basis point spread that would need to be added to the
implied spot yield curve so that the discounted cash flows of a bond are equal to
its current market price (More accurate measure of credit & liquidity).

3.5 Spreads as a Price Quotation Convention
I-Spread ⇒ bond rates net of the swap rates of the same maturities.
TED spread ⇒ difference b/w LIBOR & yields on a T-bill of matching maturity.
An ↑ (↓) in TED spread is a sign that lender believe the risk of default on
interbank loan is ↑ (↓).
LIBOR – OIS spread ⇒ difference b/w LIBOR & the overnight indexed swap (OIS)
rate.
4. Traditional Theories of the Term Structure of Interest Rates
4.1 Local Expectations Theory 4.2 Liquidity Preference Theory
Pure expectations theory ⇒ it states that the forward rate is an This theory asserts that liquidity premiums exist to compensate
unbiased predictor of the future spot rate. investors for the added interest rate risk.
Broadest interpretation ⇒ bonds of any maturity are These premiums increase with maturity.
perfect substitutes for one another. The forward rate provides an estimate of the expected spot rate
Assumption ⇒ risk- neutrality that is biased upward by the amount of liquidity premium.
Conflict ⇒ investors are risk averse. Liquidity preference theory fails to completely explain the term
Local expectations theory ⇒ more rigorous version. structure.
It states that the expected return for every bond over short The existence of liquidity premiums implies that the yield curve
time periods is the risk-free rate. will typically by upward sloping.
Assumption ⇒ no arbitrage exists.
This theory differs from the unbiased expectations theory
in that it can be extended to a world characterized by risk.
No risk premiums for very short holding periods.
Theory is applicable to risk-free as well as risky bonds.
4.3 Segmented Markets Theory 4.4 Preferred Habitat Theory
SMT allows for lender & borrower preferences to influence the Similar with SMT in proposing that many borrowers & lenders
shape of the yield curve. have strong preferences for particular maturities but it does not
According to this theory, yields are solely a function of the supply assert that yields at different maturities are determined
& demand for funds of a particular maturity rather than independent of each other.
reflection of expected spot rates or liquidity premiums. Institutions will be willing to deviate from their preferred
Theory is consistent where asset/liability management maturities if additional returns justify so.
constraints exist. Theory is closer to real world phenomena.
The reflection of preferred habitat can also be seen in
quantitative easing in 2008 by Federal Reserve.
5. Modern Term Structure Models
These models provide quantitative description of how interest evolves.

Models are based on assumptions which can’t be completely accurate in
depicting the real world.

5.1 Equilibrium Term Structure Models
These are models that seek to describe the dynamics of the term structure using
fundamental economic variables that are assumed to affect interest rates.
Characteristics of these models:
They are one-factor or multifactor models.
They make assumptions about the behavior of factors.
These are more sparing with respect to the numbers of parameters that
must be estimated compared with arbitrage free term structure models.
Models
5.1.1 The Cox–Ingersoll–Ross Model 5.1.2 The Vasicek Model
This model assumes that every individual has to make An equilibrium term structure model which also capture mean
consumption & investment decision with his limited capital. reversion.
CIR model can explain interest rate movements in terms of an Unlike CIR model, interest rates are calculated assuming that
individual’s preferences for investment & consumption as well as volatility remains constant over the period of analysis.
the risks & returns of the productive processes of the economy. Disadvantage ⇒ it is theoretically possible for the interest rate to
Short term interest rates tend to move in bonded range & show become negative.
a mean reversion tendency. Investors can use these two models to determine mispricing if
parameters of the models are believed to be correct.
5.2 Arbitrage-Free Models: The Ho–Lee Model
In AFMs, the analysis starts with the observed market prices of a reference set
of financial instruments with the assumption that the reference set is correctly
priced.
These models overcome problem of finite number of free parameters as the
case with vasicek & CIR models.
Ho – Lee model:
It uses the relative valuation concept of black-Sholes option model.
Assumption ⇒ yield curve moves in a way that is consistent with a no-
arbitrage condition.
Model generates a symmetrical distribution of future rates, negative
interest rates are possible.
Modern interest rate theories are proposed for the most part to value bonds
with embedded options.

6. Yield Curve Factor Models
6.1 A Bond’s Exposure to Yield Curve Movement 6.2 Factors Affecting the Shape of the Yield Curve
Shaping risk ⇒ sensitivity of a bond’s price to the changing shape Yield curve (YC) can take any shape & the challenge for a fixed
of yield curve. income manager is to manage shape risk.
Yield curve shifts are rarely parallel. YC factor model ⇒ a model or a description of YC moments that
Active bond management ⇒ trade on a forecasted yield curve or can be considered realistic when compared with historical data.
to hedge yield curve risk Letterman & scheinkman three factor model ⇒ it states
Shaping risk also affects the value of embedded option. that YC moments are historically well described by a
combination of three independent movements including
level steepens & curvature.
Level movement ⇒ upward or downward shift in YC.
Steepness ⇒ non-parallel shifts in YC.
Curvature ⇒ movement in three segments of the YC.
Principal components analysis.
Approach to identify the factors that best explain historical
variances.
6.3 The Maturity Structure of Yield Curve Volatilities 6.4 Managing Yield Curve Risks
Two important reasons to quantify interest rate volatility: Yield curve risk ⇒ risk arising from unanticipated changes in the
Value of embedded options are crucially depend on YC.
interest rate volatility & hence value of fixed income YC risk management ⇒ it involves changing the identified
instruments with embedded options. exposures to desired values by trades in security or derivative
Fixed income interest rate risk management is an markets.
important part of any management process. Effective duration (sensitivity of bond’s price to a small parallel
Interest rate volatility is not same for all interest rates along the shift in benchmark yield curve) is one measure of YC sensitivity.
YC. Another measure ⇒ key rate duration⇒ a bond’s sensitivity to a
The uncertainty of an interest rate is measured by the annualized small change in a benchmark YC at a specific maturity segment.
standard deviation of the proportional change in a bond yield Shaping risk can be identified & managed by using one of these
over specific time interval. two measures.

“THE ARBITRAGE-FREE VALUATION FRAMEWORK”
1. INTRODUCTION
2. The Meaning of Arbitrage-Free Valuation
Arbitrage – free valuation ⇒ valuation that determines security values that are
consistent with the absence of arbitrage opportunities (riskless profits without
any net investments).
Principle of no arbitrage is an implication of the idea that identical assets should
sell at the same price.
Fundamental principle of valuation ⇒ value of any financial asset is equal to the
present value of its expected future cash flows.
Value of bond with embedded options = sum of arbitrage free bond with option
+ arbitrage free value of each of the options
2.1 The Law of One Price
Law of one price ⇒ it states that two perfectly substitute goods must sell for
the same current price in the absence of transaction costs otherwise arbitrage
opportunity will exist.
2.2 Arbitrage Opportunity
Types of arbitrage opportunities.

Value additivity ⇒ value of the whole equals the value of the parts.
Dominance ⇒ Financial asset with a risk-free payoff in the future must
have a positive price today.
2.3 Implications of Arbitrage-Free Valuation for Fixed-Income Securities
Stripping ⇒ process of separating the bond’s individual cash flow & trade them
as zero-coupon securities.
Reconstitution ⇒ process of recombining the appropriate individual zero
coupon securities & reproducing the underlying coupon treasury.
Arbitrage profits are possible when value additivity does not hold.
3. Interest Rate Trees and Arbitrage-Free Valuation
3.1 The Binomial Interest Rate Tree
First step in binomial valuation method ⇒ present the benchmark par curve by
using bonds of a particular country or currency.
For bonds with interest rate dependent CFs, interest rate volatility is a
consideration.
Lognormal interest rate model has two properties:
Non negativity of interest rates (IRs).
Higher volatility at higher interest rates.

3.2 What Is Volatility and How Is It Estimated?
Variance ⇒ measure of dispersion of a probability distribution.

Standard deviation ⇒ square root of the variance.
In a lognormal distribution, volatility is measured relative to current level of
rates,
Methods commonly used to estimate IR volatility:
By estimating historical IR volatility.
Implied volatility through market prices of IR derivatives.
3.3 Determining the Value of a Bond at a Node
Backward induction valuation ⇒ method used to value bond at a particular

node.
Value of a bond at any node will depend on future CFs.
We fill par values at maturity & work back from right to left to find value at a
desired node.
The relevant discount rate to use is the one-year forward rate at the node.
3.4 Constructing the Binomial Interest Rate Tree
First step in binomial IR tree construction is to calibrate a binomial IR tree to

match a specific term structure (to ensure model is arbitrage free).
Finding the rates in the tree is an iterative process & the IRs are found
numerically.
If we use a higher estimate of volatility the possible forward rates may spread
out on the tree.
If lower estimate of volatility, the rate should collapse to the implied forward
rates from the current yield curve.
3.5 Valuing an Option-Free Bond with the Tree
Binomial IR tree should produce the same value as

discounting the CFs with the spot rates.
3.6 Path-wise Valuation
Path-wise valuation ⇒ an alternative approach to backward induction in a

binomial tree.
Path-wise valuation calculates the PV of a bond for each possible IR path & then
takes the average of these values across paths.
The approach produces same value as the backward induction method.
Steps in path-wise valuation:
Specify all potential paths.
Determine PV along each potential path.
Calculate the avg. across all possible paths.

4. Monte Carlo Method
Monte Carlo method ⇒ method for simulating a sufficiently large number of

potential IR paths in an effort to discover how a value of a security is affected.
Monte Carlo method is often used when a security’s CFs are path dependent.
The benchmark term structure is represented by the current spot rate curve
such that the avg. PV across the scenario IR paths for each benchmark bond
equals its market value (arbitrage free valuation).
The number of paths, the accuracy of the estimate.
Monte Carlo method is input dependent.
Modelers also assume “mean reversion in IRs” in Monte Carlo simulation.

“VALUATION AND ANALYSIS: BONDS WITH EMBEDDED OPTIONS”
2. Overview of Embedded Options
Embedded options ⇒ contingency provisions found in the bond’s indenture.

These options represent rights that enable their holders to take advantage of
interest rate movements.
2.1 Simple Embedded Options
2.1.1 Call Options 2.1.2 Put Options and Extension Options
Call option ⇒ an issuer option that allows the issuer to redeem Put option ⇒ bondholder has right to exercise the option prior
the callable bond issue prior to maturity. to maturity.
Lockout period ⇒ period during which the issuer can’t call the In rising IR scenario put option is likely to exercise.
bond. No American style putable bonds.
European style callable bond ⇒ call option on this bond can only
be exercised on a single date at the end of the lockout period.
American style callable bond ⇒ continuously callable from the
end of the lockout period until maturity.
Bermudian styles call option ⇒ it can be exercised only on a
predetermined schedule of dates after end of lockout period.
2.2 Complex Embedded Options
Callable & putable bonds are most common type of bonds with embedded options while convertible bonds
are another.
Conversion option ⇒ it allows bondholders to convert their bonds into issuer’s common stock.
Death-put, estate put or survivor’s options bonds ⇒ bond’s which can redeemed at par by the heirs of a
deceased bondholder.
Sinking fund bond ⇒ it requires the issuer to set aside funds over time to retire the bond issue (reduce
credit risk).
Sinking fund bond may include the following options:
Call option + acceleration provision + delivery option.
3. Valuation and Analysis of Callable and Putable Bonds
3.1 Relationships between the Values of a Callable or Putable Bond, Straight Bond, and Embedded Option
Value of callable bond = value of straight bond – value of issuer call option.
Investor is long on bond & short on call option.
Value of callable bond is lower than value of comparable option free bond.
Value of putable bond = value of straight bond + value of investor’s put option.
Investor is long bond & on a put option.
As the value of put option , so the value of the putable bond relative to the value of the straight
bond.

3.2 Valuation of Default-Free and Option-Free Bonds: A Refresher
Future CFs of default free, option free bond should be discounted at spot rate
corresponding to CFs payment data.
Spot rates can be inferred from readily available information of on-the-run
sovereign bonds of various maturities.
3.3 Valuation of Default-Free Callable and Putable Bonds in the Absence of Interest Rate Volatility
3.3.1 Valuation of a Callable Bond at Zero Volatility
Borrower will exercise the call option when the value of the bonds future CFs is higher than the
call price.
Example.
3.3.2 Valuation of a Putable Bond at Zero Volatility
Investor will exercise the put option when the value of the bonds future CFs is lower
than the put price.
Option holders may be risk averse & may exercise early even if the option is worth
more alive than dead.
3.4 Effect of Interest Rate Volatility on the Value of Callable and Putable Bonds
3.4.1 Interest Rate Volatility
Value of any type of option will with the in volatility.

Effect of interest rate volatility on the value of bonds with options is critical.
3.4.2 Level and Shape of the Yield Curve
3.4.2.1 Effect on the Value of a Callable Bond 3.4.2.2 Effect on the Value of a Putable Bond
All else equal, value of call option as the yield curve flattens. Value of put option as yield curve moves from being upward
Value of call option further if yield curve actually inverts. sloping to downward sloping.
3.5 Valuation of Default-Free Callable and Putable Bonds in the Presence of Interest Rate Volatility
Valuation procedure of a bond with embedded option in the presence of interest rate (IR)
volatility is as under:
Generate an IR tree based on the given yield curve & IR volatility assumptions.
At each mode of the tree, determine whether the embedded options will be exercised.
Apply the backward induction valuation methodology to calculate the bond’s present value.

3.5.1 Valuation of a Callable Bond with Interest Rate Volatility
Example
3.5.2 Valuation of a Putable Bond with Interest Rate Volatility
Example
3.6 Valuation of Risky Callable and Putable Bonds
Two approaches to value bonds that are subject to default risk:

The DR above the default-free rate to reflect default risk.
By making the default probabilities explicit.
3.6.1 Option-Adjusted Spread
Two standard approaches to construct a suitable yield curve:

Use an issuer specific yield curve (more satisfactory but less convenient).
Uniformly raise the one year forward rates derived from the default free benchmark yield
curve by a fixed spread (z-spread).
When valuing risky bonds with embedded options, option-adjusted spread (OAS) is used to
construct IR tree.
OAS ⇒ A constant spread that when added to all the one-period forward rates on the IR tree
makes the arbitrage-free value of the bond equal to its market price.
Option free bond ⇒ Z-spread = OAS at zero volatility.
OAS lower (larger) than that for a bond with similar characteristics & credit quality indicates
that the bond is likely overpriced (underpriced).
3.6.2 Effect of Interest Rate Volatility on Option-Adjusted Spread
The IR dispersion on the tree is volatility dependent & so is the OAS.

Scenario analysis over a specified investment horizon is another application of valuing bond
with embedded options.
There is a trade-off b/w reinvestment of cash flows & change in the bond’s value over a
specified investment horizon.
4. Interest Rate Risk of Bonds with Embedded Options
4.1 Duration
Duration ⇒ it measures the sensitivity of bonds price to changes in the bond’s yield
to maturity.
Bonds with embedded options ⇒ effective duration is an appropriate measure.
4.1.1 Effective Duration
It indicates the sensitivity of the bond’s price to a 100 bps parallel shift to the
benchmark yield curve.
Effective duration (ED) of a callable & putable bond < ED of straight bond.

4.1.2 One-Sided Durations
One-sided duration ⇒ it is appropriate when embedded option is near the money.

Sensitivity of bonds with embedded options is not symmetrical to positive/negative
changes in interest rate of the same magnitude.
4.1.3 Key Rate Durations
ED assumes parallel shifts in benchmark yield curve which are not as neat in reality.
Key rate durations ⇒ it measures the sensitivity of the bond’s price to changes in
specific maturities on the benchmark yield curve.
Key rate duration help risk managers to identify the “shaping risk”.
4.2 Effective Convexity
Effective convexity ⇒ sensitivity of duration to changes in interest rates.

Putable bonds always have positive convexity.
Callable bonds have positive convexity at higher IRs but it turns negative when the
call option is near the money.
5. Valuation and Analysis of Capped and Floored Floating-Rate Bonds
Capped floater ⇒ it protects the issuer against rising IRs & is thus an issuer option.
Value of capped floater ⇒ value of straight bond-value of embedded cap.
5.2 Valuation of a Floored Floater
Floored floater ⇒ it protects the investor from declining IRs is thus an investor
options.
Value of floored floater ⇒ value of straight bond + value of embedded floor.
6. Valuation and Analysis of Convertible Bonds
6.1 Defining Features of a Convertible Bond
Convertible bond ⇒ a hybrid security that provides the characteristics of an option

– free bond & an embedded conversion option.
It gives the right to bondholders to convert their debt into equity during a
predetermined period (conversion period) at a predetermined price (conversion
price).
Conversion ratio ⇒ the number of shares of common stock that the bondholder
receives form converting the bond into shares.
Forced conversion ⇒ an event where the issuer of callable & convertible bond has
an incentive to call the bond when the underlying share price increases above the
conversion price (to avoid coupons).

6.2 Analysis of a Convertible Bond
6.2.1 Conversion Value

Conversion value = Underlying share price × Conversion ratio.
6.2.2 Minimum Value of a Convertible Bond
Minimum value of a convertible bond is equal to the greater of
The conversion value and
The value of the underlying option-free bond.
6.2.3Market Conversion Price, Market Conversion Premium per Share, and Market
Conversion Premium Ratio
Market conversion premium per share = Market conversion price – Underlying
share price
Market conversion price ⇒ price that investors effectively pay for the
underlying common stock if they buy the convertible bond & then
convert it into shares.
Market conversion premium ratio ⇒ premium or discount investors have to
pay as a percentage of the current market price of the shares.
6.2.4 Downside Risk with a Convertible Bond
Investors use the straight value as a measure of the downside risk of a
convertible bond.
All else equal, the the premium over straight value, the less attractive the
convertible bond.
6.2.5 Upside Potential of a Convertible Bond
Upside potential of a convertible bond depends primarily on the prospects of
the underlying common stock.
6.3 Valuation of a Convertible Bond
Value of convertible bond = Value of straight bond + Value of call option on issuer’s
stock.
Value of callable convertible bond = Value of straight bond + Value of call option on
the issuer’s bond – Value of issuer call option.
Value of callable putable convertible bond = Value of straight bond + value of call
option on issuer’s stock – Value of call option + Value of investor put option.
6.4 Comparison of the Risk–Return Characteristics of a Convertible Bond, the Straight

Bond, and the Underlying Common Stock
Busted convertible ⇒ when the underlying share price is well below the conversion
price (bond-like risk return characteristics of security).
If underlying share price > conversion price ⇒ convertible bond exhibits mostly
stock risk – return characteristics.
In between the bond & stock ⇒ hybrid instrument.
The call option component increases in value as the underlying share price
approaches the conversion price.
If the underlying share price exceeds the conversion price ⇒ rise in bond value
is at least equal to share price increase.
If the underlying share price is above the conversion price but decrease toward it,
the relative change in the convertible bond price is less than the change in
underlying share price (because convertible bond has a floor).

Reading 37 Credit Analysis Models
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Expected release date: March 12, 2019
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“CREDIT DEFAULT SWAPS”

CDS = Credit Default Swap
CC = Credit Curve 1. INTRODUCTIONS
IR = Interest Rates
Credit derivative ⇒ instrument in which the underlying is a measure of a
borrower’s credit quality.
CDS provides protection against default & from changes in the market’s
perceptions of a borrower’s quality.
2. BASIC DEFINITIONS AND CONCEPTS
Credit default swaps ⇒ a contract b/w a credit protection buyer & credit
protection seller, where buyer makes a series of cash payments to the seller &
receives a promise of compensation for credit losses resulting from default.
CDS are somewhat similar to put option (buyer wins when underlying performs
poorly).
2.1 Types of CDS
Single-Name CDS Index CDS
CDS on one specific borrower (called reference entity). Involves a combination of borrowers.
Reference obligation ⇒ designated instrument being It is possible to trade indices of CDS.
covered in agreement. Participants can take positions on the credit risk of a
Payoffs ⇒ cheapest to deliver obligation ⇒ debt combination of companies.
instrument that can be purchased & delivered at the Credit correlation is a key determinant of the value of an
lowest cost. index CDS.
Default correlation, cost to purchase protection.
Diverse companies with low correlation, protection is less
expensive.
Tranche CDS
It covers a combination of borrowers but only up to pre-

specified levels of losses.
Tranche CDS is a small portion of the CDS market.
2.2 Important Features of CDS Markets and Instruments
Notional amount ⇒ amount of protection being purchased.

Each CDS contract has an expiration date as with all
derivatives.
CDS spread ⇒periodic CDS payment from CDS buyer to CDS
seller.
2.3 Credit and Succession Events
Credit event ⇒ outcome that triggers a payment from a

credit protection seller to the credit protection buyer.

Types of Credit Events
Bankruptcy Failure to Pay
It involves the establishment of a legal procedure that It occurs when a borrower does not make a schedule
forces creditors to defer their claims. payment of principal or interest on any outstanding
If bankruptcy plan established by court fails, it’s likely to obligation after a grace period (no formal bankruptcy filing).
be a full liquidation of the company.
At liquidation, court determines the payment to various
creditors.
Company normally continues to operate until liquidation
occurs.
Restructuring
It refers to a number of possible events.

Reduction or deferral of principal or interest.
Change in seniority or priority of an obligation.
Change in currency in which payment will be made.
Restructuring must be involuntary (forced on the borrower by the
creditors).
Succession event ⇒ it arises when there is a change in the corporate
structure of the reference entity in which ultimate responsibility
become unclear.
2.4 Settlement Protocols
In case of credit event, CDs can be settled physically or through cash.

Physical settlement ⇒ less common & involves actual delivery of the
debt instrument.
Cash settlement ⇒ credit protection seller pays cash to credit
protection buyer up to loss suffered.
Payout ratio = 1 - recovery rate.
Payout amount = payout ratio × national
2.5 CDS Index Products
Market indices (CDS indices) can be classified by regions & credit quality.
Investment grade index CDS are typically quoted in terms of spread while high yield are quoted in terms
of price.
Index components are updated by every six months by creating new series.
Latest series are called on the run while older series are called off-the-run.
Use ⇒ to take positions on the credit risk of the sectors covered by indices as well as to protect bond
portfolio (similar to index components).
Index CDS are more liquid than single name CDS.
2.6 Market Characteristics
CDS trade in OTC market in a network of banks & other financial

institutions.
Credit insurance has existed for many years but insurance products
are more consumers focused than commercial focused.
Size of CDS market today is considerably less than it was just a few
years ago.

3. BASICS OF VALUATION AND PRICING
Derivatives ⇒ typically valued by constructing a hedge b/w the

derivative & the underlying that produces a risk free position.
Valuation principle is more difficult to apply on credit derivatives
than conventional derivatives.
3.1 Basic Pricing Concepts
Probability of default is most important element of CDS.

Hazard rate ⇒ probability that an event will occur given that it has
not already occurred (conditional probability).
Loss given default ⇒ amount that will be lost if default occurs.
Expected loss = amount owned – expected recovery.
Protection leg ⇒ contingent payment that protection seller may
have to made to the protection buyer.
Premium leg ⇒series of payments the protection buyer promises to
make to the protection seller.
Estimated value of protection leg depends on:
Probability of each payment.
Timing of each payment.
Discount rate.
Upfront payment ⇒ PV of protection leg – PV of premium leg.
If the result is > (<) zero, the protection buyer (seller) pays the
seller (buyer).
3.2 The Credit Curve
Credit spread ⇒ rate in excess of LIBOR that investors expect to

receive to justify holding the instrument.
Credit spread ≈ probability of default × loss given default (%).
Credit curve ⇒ credit spreads for a range of maturities of a
company’s debt.
A hazard rate can affect the credit curve:
Constant hazard rate ⇒ flatten credit curve.
Upward sloping CC ⇒ greater likelihood in later years.
Downward sloping CC ⇒ greater probability of default in
earlier years.
3.3 CDS Pricing Conventions
Spread can easily compared with IR than with prices.

PV of credit spread = upfront premium + PV of fixed coupon.
Credit spread ≈ (upfront coupon / duration) + fixed coupon.
3.4 Valuation Changes in CDS during Their Lives
CDS value fluctuates during its lifetime similar to any traded financial instrument.
Many factors can change over the life of the CDS including duration, probability of
default, the expected loss given default & shape of CC.
New market value of the CDS reflects gains/losses to the two parties.
Profit for the buyer of protection ≈ ∆ in spread in BPS × Duration × Notional.
% ∆ in CDS price = ∆ in spread in bps × duration.

3.5 Monetizing Gains and Losses
Monetizing gain/loss ⇒ opportunity to unwind the position & to

capture gain/loss.
Credit protection buyer (seller) gains if credit quality of the reference
entity deteriorates (improves).
Two ways of realizing a profit/loss on a CDS:
Exercise the CDS in response to a default.
Unwind the position by entering into a new offsetting CDS in
the market.
4. APPLICATIONS OF CDS
CDS has two uses:

To exploit an expected movement in underlying.
CDS facilitate trading opportunity in valuation differences b/w
CDS & underlying.
4.1 Managing Credit Exposures
A CDS is primarily used to or credit exposure.

Lender’s justification for using a CDS:
Illiquid bond or loan market.
Significant transaction costs.
The main justification for selling credit protection is to profit from making markets.
Naked CDS ⇒ a swap that is purchased by the party with no exposure to the reference entity.
Long/short trade ⇒ when a party takes long position in one CDS & short position in another.
Bet that credit position of one entity will improve relative to other.
Curve trade ⇒ buying a CDS of one maturity & selling a CDS on the same reference
entity with a different maturity.
A flatter (steeper) curve means that long term credit risk () relative to short term
risk.
In the short run, a curve steeping (flattening) trade is bullish (bearish).
Value of longer-term CDS will be more sensitive than those of shorter term CDS.
4.2 Valuation Differences and Basis Trading
CDS valuation disparities exist because of different assessments of the price of

credit risk
Difference in the credit spreads in bonds & CDS markets is the foundation of basis
trade.
General idea behind basis trade ⇒ mispricing is likely to be temporary & spread
should converge when market recognizes disparity.
If the credit spread is in the bond (CDS) market than the CDS (bond)
market, it is said to be-ve (+ve) basis.
Synthetic CDO ⇒ combining default free securities with a combination of CDS as
protection seller.
If synthetic CDO is lower cost than actual CDO ⇒ buy the former & sell the
latter to capture arbitrage profit.

“PRICING AND VALUATION OF

Mkt. = Market FORWARD COMMITMENTS”
Gen. = Generally
Imp. = important
Fwd. = Forward
DC = Domestic 1. INTRODUCTION
Currency
FC = Foreign
Currency Fwd. Commitment⇒ a contract where the price or rate of an underlying can
be locked in to buy or sell at some future date or series of dates.
2. PRINCIPLES OF ARBITRAGE-FREE PRICING & VALUATION OF FORWARD COMMITMENTS
Fwd. Commitment Pricing: Price/rate when initiating the

fwd. contract.
Fwd. Commitment Valuation: value of the contract after
contract initiation.
Arbitrage-free Approach: is based on law of one price.
Assumption: Prices adjust to reach at 0 arbitrage profit.
Two fundamental rules (from arbitrageurs’ perspective):

Rule 1: Do not use own money
Rule 2: Do not take price risk
Four Key Assumptions Throughout This Reading:
i. Replicating instruments are identifiable & investable.

ii. No mkt. friction.
iii. Short selling is allowed
iv. Borrowing and lending is allowed at known risk-free rate.
1
3. PRICING & VALUING FORWARD & FUTURE CONTRACTS
3.2 3.3 3.4 3.5 3.6 3.7

3.1 No Equity Interest Rate Fixed Income Currency Comparing
Our Arbitrage Forward & Forward & Forward & Forward & Forward &
Notation Forward Future Futures Contracts Futures Contracts Futures Futures
Contracts Contracts Contracts Contracts
Fwd. Contract • For stocks, No Arbitrage FRA Strategy: Carry Arbitrage for Bonds: • Fwd. value is
Value: carry benefit Step 1: Make deposit for Step 1: Buy the bond future value of
At time 0:= VT(T) is dividend h+m days. requiring S0 Cash flows. underlying
At expiration: pmts. Step 2: Borrow funds for h Step 2: Borrow funds equal adjusted for
i. For Long: • Value of days. to the cost of the bond. any carry cash
VT(T) = ST – Equity Fwd. Step 3: Borrow funds for m Step 3: Sell the futures flows.
F0(T) contact = days initiated at h. contract at F0 (T). • Future values
ii. For Short: Current Fwd. Step 4: Receive floating FRA Step 4: Borrow the arbitrage are 0 at the end
VT(T) = F0(T) Price – Initial & roll payoff at Lh(m) rate profit. of the day
– ST Fwd. Price from h to h+m) Net Cash flow because of daily
Net Cash flow mark to
Value of Bonds Futures market.
Due to mark-to-market the
Cash flows for FRA value of the bonds futures is
Valuation: the price ∆ since the
1: Receive floating FRA previous day’s settlement.
(settled in arrears) at time 0;
roll fwd. at rate Lh(m) rate
from h to h+m)
2: Receive fixed FRA (settle
in arrears) at time g; roll fwd
at rate Lh(m) rate from h to
h+m.
Net Cash flow
Carry Arbitrage with foreign

3.2.1 3.2.2 exchange:
Carry Arbitrage Model Carry Arbitrage Model is also known as covered interest
When There Are No When Underlying Has rate parity.
Underlying Cash Flows Cash Flows Strategy 1: Invest 1 currency unit
in domestic RF rate.
Strategy 2: 3 simultaneous steps.
Steps for Arbitrage Opportunity: Fwd. Pricing = F0(T) i. Convert DC into FC at spot
1) When Fwd. price is ↑ than that =FV0,T(S0+θ0−γ0) exchange rate.
determined by carry arbitrage Steps to Purchase ii. Invest FC at foreign RF rate
model: Underlying that Pays some for time T.
Step 1: Sell fwd. contract at F0(T) Cash Benefits iii. Enter into Fwd. foreign
Step 2: Purchase underlying at 0 & exchange rate to sell FC in
sell at T. Step 1: Purchase exchange to DC at time T.
Step 3: Borrow funds for underlying underlying at 0, sell at T. Arbitrage opportunity exists if
purchase. Step 2: Reinvest two strategies result in different
Step 4: Borrow the arbitrage profit distribution. value at time T
Net Cash flow Step 3: Borrow funds.
2) When Fwd. price is ↓ than that Step 4: Sell forward Value of Foreign Exchange Fwd.
determined by carry arbitrage contract. Contract is simply the PV of
model: Step 5: Borrow arbitrage difference b/w two fwd. prices.
Step 1: Buy fwd. contract at F0(T) profit.
Step 2: Sell short underlying at 0 & Net Cash flow
purchase at T.
Step 3: Lend the short sale
proceeds.
Step 4: Borrow the arbitrage profit
Net Cash flow
(All steps are done simultaneously)
2
4. PRICING & VALUING SWAP CONTRACTS
General approach to pricing & valuing swaps is using a replicating or

hedge portfolio of comparable instruments
4.1 4.2
4.3
Interest Rate Currency Swap
Equity Swap
Swap Contracts Contracts
Contracts
Cash Flows for Receive-Fixed Swap • Four major types are: fixed for fixed, • An OTC derivative contract where one
Hedge with Bonds: floating for fixed, fixed for floating & party pays equity return & another
Step 1: Receive fixed swap. floating for floating. pays either a different equity returns
Step 2: Buy floating rate bond. • Key features of currency swaps or rate or fixed series.
Step 3: Short sell fixed rate bond. include: • Key features of equity swaps include:
Net Cash flow i. Often involve an exchange of i. Equity leg can be an
Swap Value for Fixed Rate Receiver & notional principle both at individual stock, published
Floating Rate Payer= value of fixed bond initiation & at expiration. stock index or a custom
– value of floating bond. ii. Payment at each swap leg is portfolio.
• Value of fixed bond in different currency unit. ii. Equity leg can be with or
FB=C∑ , (1)+PV0,tn(1) iii. Each swap leg can either be without dividends.
• Value of floating bond assumed to fixed or floating. iii. All the interest rate swap
be 1 (at reset date) nuances exist with equity
• Swap Pricing Equation = swap that have a fixed or
,
() floating interest rate leg.
∑೙
೔సభ బ,೟೔ ()
Interest rate Swap Valuation Cash Flows for Currency Swap Hedged
For a receive-fixed interest rate swap, with Bonds:
valuation can be achieved by entering Step 1: Enter currency swap.
into an offsetting swap i.e. receive Step 2: Short sell bond in currency a. Cash Flows for Receive-fixed Equity
floating pay fixed. Step 3: Buy bond in currency b. Swap Hedged with Equity & Bonds:
Net Cash flow
Currency Swap Valuation Step 1: Enter currency swap.
Value of fixed for fixed currency swap = Step 2: Buy notional amount of equity.
difference in a pair of fixed rate bonds in Step 3: Short sell fixed rate bond.
currency A and B. Then convert currency Step 4: Borrow arbitrage profit.
B bond into currency A through a spot Net Cash flow
foreign exchange transaction.
Equity Swap Valuation
Valuing an equity swap after initiation is
similar to the pricing of a comparable
interest rate swap except that instead of
adjusting floating rate bond, we adjust
value of the notional amount of equity.
3
“Valuation of Contingent Claims”

i-rate = interest rate
pmts. = payments
Gen. = generally
1. INTRODUCTION
Contingent claim⟹A derivative instrument that provides a right but not an

obligation to its owner to payoff determined by an asset, rate or other derivative.
Option valuation models are also based on the principle of ‘No-Arbitrage’.
2. PRINCIPLES OF A NO-ARBITRAGE APPROACH TO VALUATION
Two fundamental rules (from arbitrageurs’ perspective):

Rule 1: Do not use own money.
Rule 2: Do not take price risk
Basic Principle: Law of one price
Key Assumptions for Option Valuation
i. Replicating instruments are identifiable & investable.

ii. No mkt. friction.
iii. Short selling is allowed
iv. Borrowing and lending is allowed at known risk-free rate.
Key assumption of BSM Model⟹value of the underlying

follows geometric Brownian motion, which implies
lognormal distribution i.e. underlying’s continuously
compounded return is normally distributed.
1
3. BINOMIAL OPTION VALUATION MODEL
• used to value options (path dependent).

• based on no-arbitrage approach.
3. 1 3. 2 3. 3 3. 4
One-Period Two-Period Interest Rate Multi-Period
Binomial Model Binomial Model Options Model
No Arbitrage Approach: • can be viewed as 3 one- • There are many • Provides a

• Up factor = u= period binomial models, 1 approaches to value natural bridge to

positioned at time 0 and 2 i-rate options. the BSM option
• Down factor = d=
positioned at time 1. • An approach used valuation model.
శ ష
• Call Hedge ratio h= ≥0 • illustrates: Self-Financing & here assumes that • Basic idea is to
శ ష
శ ష Dynamic Replication. RN probability of an slice up option
• Put Hedge ratio = ≥0
శ ష • Call hedge ration = h+= up move is 50%. expiration into
• Call Option Value (single period) శశ శష • In-the money i-rate smaller periods.
= c = hS + PV(–hS– + c–) శశ శష
call option: when • Each time step is
• Put Option Value (single-period) • Call option value = c =
current spot rate > of equal length.
= p = hS + PV(–hS– + p–) PV[π2c++ + 2π(1 – π)c+– + (1 –
exercise rate. • For T maturity &
Steps for Arbitrage Opportunity: π)2c--]
• In-the money i-rate n time steps,
writing one call hedge with h units • Put option Value = p =
put option: when each time step is
of the underlying & finance PV[π2p++ + 2π(1 – π)p+– + (1 –
current spot rate < of T/n in length.
Step 1: Write one call option π)2p--–]
exercise rate. • For American-
Step 2: Buy h underlying units. Expected terminal option
• Option valuation style options,
Step 3: Borrow or lend. payoffs:
follows the each node is
Net Cash flow • E(c2) = π2c++ + 2π(1 – π)c+– +
expectation tested whether
(1 – π)2c– –
approach but taken the option is
• E(p2) = π2p++ + 2π(1 – π)p+– +
only one-period at a more exercised
(1 – π)2p–
time. or not exercised.
Expectations Approach: Option values based on
• results in identical value as the no expectation approach:
arbitrage approach. • c = PVr[Eπ(c2)]
• differs from discounted cash flow • p = PVr[Eπ(p2)]
approach in two ways:
i. Probability is objectively
determined and is not based
on investor’s view.
ii. Discount rate is not risk
adjusted.
Formulas for this approach:
E(c1) = πc+ + (1 – π)c–
E(p1) = πp+ + (1 – π)p–
where, π = [FV(1) – d]/(u – d)
c = PVr[E(c1)]
p = PVr[E(p1)]
Put Call Parity = S + p = PV(X) + c
2
4. BLACK-SCHOLES-MERTON OPTION VALUATION MODELS
4.1 4.2 4.3

Introductory Assumptions of the BSM Model
Material BSM Model
• Introduced by Black, • Underlying follows GBM • Dynamically managed portfolio of stocks &
Scholes & Merton in (geometric Brownian motion) zero-coupon bonds with the goal to replicate
1973 in two • GSM implies continuous prices the option pay offs with stocks & bonds.
published papers. (i.e. move smoothly). • Two components for BSM model are:
• BSM model is • Underlying is liquid Stock component & Bond component
essentially a no- • Continuous trading is available • For calls value: stock component – bond
arbitrage approach • Short selling with full proceeds is component = c = SN(d1) – e–rTXN(d2)
with a continuous allowed • For puts value: bond component – stock
time process. • No market frictions component = p = e–rTXN(–d2) – SN(–d1)
(/)(/)
• No arbitrage opportunities where d1 =
d2=d1− √
√
available
• Replicating strategy cost = nSS + nBB
• Options are European style
• equivalent # of shares: nS = N(d1) > 0 for calls &
• Borrowing & lending is allowed nS = –N(–d1) < 0 for puts.
at constant risk free i-rate
• equivalent # of bonds: nB = –N(d2) < 0 for calls &
(compounded continuously).
nB = N(–d2) > 0 for puts.
• Volatility of the underlying is
• In reality hedge is imperfect because of
known & constant
assumptions used.
• If underlying pays yield, it is
• BSM model requires few adjustments to
continuous known & constant at
accommodate carry benefits
annualized rate.
• An ↑ in carry benefits will ↓ the value of call & ↑
the value of put.
• High dividends ↓ the value of d1thus ↓ N(d1) and
↓ the # of bonds to short sell for calls and ↓ the
# of bonds to buy for puts.
BSM Model Applied to Currencies

Two components are: foreign
exchange component & bond
component.
• For calls: foreign exchange
component – bond component =
(
) − ()
• For puts: bond component – foreign
exchange component =
− − (−
)
3
5. Black Option Valuation Model
Modified version of BSM model for options on underlings that are costless to carry.
5.1 5.2 5.3

European Options Interest Rate Swaptions
on Futures Options
• Assumptions: • call (put) option gains when • Right to enter a swap at a pre-agreed
o Futures prices follows reference rate ↑ (↓). swap rate.
geometric Brownian • Rates are set in advance and • Payer Swaption⟶pay fixed, receive
motion. pmts. are made in arrears. floating
o Ignoring margin • There is accrual based • Receiver Swaption⟶ receive fixed,
requirements & marking adjustment & day count pay floating
to market. convention. • Swap pmts are advanced set, settled
• For calls: c = e–rT[F0(T)N(d1) – • c= in arrears & rates are quoted on
XN(d2)] () (
) [FRA(0,tj−1, annual basis.
• For puts: p = e–rT[XN(–d2) – tm)N(d1)−RXN(d2)] • Payer swaption value: PAYSWN =
F0(T)N(–d1)] • p= PV[E(PAYSWN,T)]
• Futures option put–call parity () (
)[RXN(−d2)− • Receiver swaption value: RECSWN =
= c = e–rT[F0(T) – X] + p FRA(0,tj−1,tm)N(−d1)] PV[E(RECSWN,T)], where,
• E(PAYSWN,T) = erTPAYSWN
• E(RECSWN,T) = erTRECSWN.
Two components for BSM model are:
Swap component & Bond component
• For Payer Swaption: PAYSWN =
(AP)PVA[RFIXN(d1) – RXN(d2)]
• For Receiver swaption: RECSWN =
(AP)PVA[RXN(–d2) – RFIXN(–d1)]
Several Useful Combinations
• If exercise rate = current FRA rate then • Long a receiver swaption & short a
o long i-rate call & short i-rate put = receive payer swaption = receive fixed, pay
floating, pay fixed FRA or floating forward-swap. (assuming same
o long i-rate put & short i-rate call = receive exercise rates ).
fixed, pay floating FRA. • Long a payer swaption & short a
• i-rate cap (floor) is a series of i-rate call receiver swaption = receive floating ,
(put)options called caplets (floorlets) each with pay fixed forward swap. (assuming
the same exercise rate & sequential maturities. same exercise rates )
• Long i-rate cap & short i-rate floor = receive • If receiver & payer swaption have same
floating , pay fixed i-rate swap. (assuming same value then exercise rate = at-market
exercise rates ) forward swap rate.
• When cap (floor) is in-the-money, receive floating • Embedded call feature is similar to a
counterparty will receive (pay) identical net pmts. receiver swaption.
• Long i-rate floor & short i-rate cap = receive fixed,
pay floating i-rate swap. (assuming same exercise
rates )
• When floor (cap) is in-the-money, receive fixed
counterparty will receive (pay) identical net pmts.
• If exercise rate = swap rate, cap value = floor
value
4
6. Option Greeks & Implied Volatility
These are called static risk measures as they gauge ∆ in value

due to ∆ in one measure keeping other measures constant.
6.1 Delta 6.2 Gamma 6.3 Theta 6.4 Vega 6.5 Rho 6.6 Implied
Volatility
• ∆ in given • ∆ in given • ∆ in given • ∆ in given portfolio • ∆ in given

instrument instrument’s delta portfolio /option for a small ∆ in portfolio for a
for a small ∆ for a small ∆ in value for a small volatility. small ∆ in risk-
in value of value of stock. ∆ in time. • Vega of an option free interest
stock. • measures • Option theta is (call or put) is +ve. rate.
• Delta of long curvature in option the rate at which • Vega is based on • Rho for call is
one share is price in relation to option value future volatility, +ve.
+1 & of the stock price. declines as the which is subjective. • Rho for put is –
short one • is always non- option • Of the 5 variables in ve.
share is -1. negative. approaches the BSM, an option • Gen. influence
• Call Deltac = • Gammac = expiration. value is most of i-rate is not a
e–δTN(d1) Gammap =
షಌ౐ • Stock theta is 0 as sensitive to volatility major concern
• Put Deltap = √ stocks have no changes. for option
n(d1)
–e–δTN(–d1) expiration date. • Option values tend values.
• Optimal # of • measures non- • Time toward their lower
Hedging linearity of risk decay⟶gain or bound at extremely
Units = NH that remains if the loss of option low volatility.
portfolio is delta-
= value due to • Lower bond of a
neutral. mere passage of
− European-style Call
ಹ Delta-plus- Gemma
Delta
calendar time. option = greater of • is the BSM model
Approximation: Especially long (0 or stock minus PV volatility that yields the
Approximation: • ̂ −c ≈ Deltac option positions of exercise price).
೎ market option price.
(for forecasting ( − ) + are exposed to • Lower bond of a • is the measure of future
∆ in option
( − ) for calls
time decay. European-style Put volatility.
prices).
• ̂ −p ≈ Deltap • Speed of option option = greater of • Term structure of
• ̂ −c ≅ ೛
( − ) + value decline ↑ as (0 or PV of exercise volatility: implied
Deltac( −S)  time to expiration price minus stock). volatility with respect to
for calls ( − ) for puts ↓. time-to-expiration.
• ̂ −p ≅
• Implied volatility with
Deltap( −S)
respect to exercise price
 for puts.
is called volatility smile
or sometimes called
skew depending on the
particular shape.
• As implied volatility ↑,
hedging become more
expensive.
• To understand prices of
various risk exposures,
one can convert the
quoted price to implied
volatility.
5
“Derivative Strategies”
i-rate = interest
rate 1. INTRODUCTION There are many different ways in which derivatives are used in a
pmts. = typical investment situation.
payments An investment professional should be familiar with the understanding
Gen. = of risk-return trade-off associated with the derivatives.
generally
NP = notional
principle 2. CHANGING RISK EXPOSURES WITH SWAPS, FUTURES & FORWARDS
Mkt. = market
FC = foreign
currency
B.E.P =
Breakeven
Price 2.1 2.2 2.3
XP = exercise Interest Rate Swaps / Currency Swaps / Equity Swaps /
price Futures Examples Futures Examples Futures Examples
2.1.1 Interest 2.1.2 Interest 2.2.1 2.2.2 2.3.1 2.3.2

Rate Swap Rate Futures Currency Swap Currency Futures Equity Swap Stock Index
Futures
• Two parties • No counter- • Involves • Similar to currency • Parties agree to

exchange cash party risk. different swap but Currency trade return on the
flows at specified • Also called currencies. futures are limited stock portfolio to
dates over a bond futures • NP is by standardized another asset.
swap tenor based because exchanged at expiration dates & • Pmt.→ in series or
on fixed for underlying the beg. & fixed NP sizes. single at the end.
floating i-rate & asset is often a end of the • Fractional • If the equity
NP determined at bond. swap. contracts are not portfolio is –ve, the
initiation. • The futures allowed. party traded equity
• Pmts. are price moves • Currency forward return will receive
typically netted. fairly contracts can be other asset return
• A fixed income consistently & customized to any as well as negative
portfolio’s proportionately size or date. equity portfolio
duration can be ↓ with the yield pmt.
by entering into a that drives the
pay-fixed i-rate bond.
swap.
Cash-settled at
expiration.
To temporarily
remove mkt. risk
→sell Stock index
futures.

3. POSITION EQUIVALENCIES
Assuming XP & expiration dates are same.
3. 1 3. 2 3. 3 3. 4 3. 5 3. 6
Synthetic Synthetic Synthetic Assets Synthetic Synthetic Foreign
Long Asset Short Asset with Futures or Put Call Currency
Forwards Options
= Buying a = Selling a • Using futures or = Short = Long Stock + • If an investor has

Call + Call + forwards to Stock + Long Put FC obligation & he
Selling a put Buying a eliminate future Long Call wants protection
put price risk. Unlimited against FC
• Stock – Futures = profit potential appreciation
Rf rate without locking in
• If div. yield of exchange rate, he
stock is > RF rate, can buy Call option
future price will on FC.
be less than spot • Call will be
price. exercised when
• This strategy is spot rate at
called synthetic expiration will be
risk-free rate or below the strike
synthetic cash. rate. If FC
appreciate,
exchange rate will
↓.

4. COVERED CALLS & PROTECTIVE PUTS
• Covered Calls: Selling call options on shares owned.

• Protective Puts: Buying put options on shares owned.
4.1 4.2 4.3 4.4 4.5 4.6

Investment Investment Equivalence of Writing Cash- The Risk of Collars
Objectives of Objectives of Long Secured Puts Covered Calls
Covered Calls Protective Puts Asset/Short & Protective
Forward Puts
Position
4.2.1 Protecting Profits

• Protective put is similar • Delta measures ∆ in
to buying insurance i.e. option price as the • Writing a put
protection against loss underlying price ∆ option &
when asset fall in value. • Call (Puts) deltas range simultaneously
• Cost of insurance can be from 0 to +1 (–1) depositing money
↓ by ↑ the size of • Long (short) futures or equal to XP in an
deductible i.e. choosing forward delta is +1 (–1) account.
↓ XP. • The following three • Writing a covered
positions have same call & writing a put
deltas: are very similar to
i. At the money their risk-reward
covered call. features because
4.2.2 Profit & loss at ii. At the money of put-call parity.
expiration protective put.
• Max. profit = (ST−S0) iii. Long stock/short
−p0 = unlimited forward position.
• Max. loss = S0 − X+ p0
• B.E.P = S0 + p0
On page 4
• Expiration value = Max
(ST, 𝑋)
• Profit at expiration =
Max (ST, 𝑋) – S0 – p0
4.1.1 4.1.2 4.1.3 4.1.4

Mkt. Participant # 1: Mkt. Participant # 2: Mkt. Participant # 3: Target Profit & Loss at
Income Generation Improving on the Mkt. Price Realization Expiration
• is most common • In the money option • is hybrid of first two • Max. gain = (X−S0) + c0
motivation for premium = exercise objectives • Max. loss = S0 − c0
writing covered value + time value • writing calls with XP near • B.E.P = S0 − c0
calls. • Someone who writes the target price. • Expiration value =
• Premium for long- covered call to improve • Call writer may ST–Max (ST – 𝑋, 0)
term options is ↑. on the mkt may capture experience opportunity • Profit at expiration =
time value. loss compared to straight ST–Max (ST – 𝑋, 0) + c0
• Writer expect stock sale of the shares. – S0
price will remain stable.

4.5.1 4.5.2 Shareholder acquires

Covered Calls Protective Puts downside protection
• Call writer bears significant • Continuous purchase of through protective put
opportunity cost if underlying protective put is expensive but ↓ the cash outlay by
price ↑ sharply. strategy. writing a covered call.
• However, covered call writer • However, purchasing protective
retains option premium & losses put occasionally is a sensible risk
less compared to simply holding reducing strategy.
shares if stock price ↓.
4.6.1 4.6.2 4.6.3

Collars on an existing holding Same Strike Collar The Risk of a Collar
• At or below put XP, the collar • Investor combines same strike Risk reduction at the cost of
locks in a profit. collar with a long position in the return potential.
• At or above the call XP, the underlying
profit is constant. • Motivation: capital preservation
• Risk is completely neutralized.

5. SPREADS & COMBINATIONS
Option Spread: buying one call & writing another or buying one put & writing another with different XPs.
Option Combination: Typically uses both puts & calls e.g. Straddle.
5.1 5.2 5.3 5.4

Bull Spreads & Calendar Straddle Consequences
Bear Spreads Spread of Exercise
• A strategy in which a • Long Straddle: Buying • For option writer,

trader sells (or buys) a puts & calls [same consequences of
near-dated call & buys (or asset, same XP]. exercise can be
sells) a longer-dated one • Short Straddle: writing significant &
[same asset, same strike both puts & calls unexpected
price]. [same asset, same XP]. exercise may be
• Long calendar spread: • Directional play on the quite inconvenient.
buying longer-dated underlying volatility.
option. • Risk of long straddle is
• Short calendar spread: limited to the total
buying near-term option. option cost paid.
• Calendar spread can be
done with calls or puts.
5.1.1 5.1.2 5.1.3 5.1.4

Bull Spread Bear Spread Refining The Risk
Spreads of Spreads
• Become valuable • Become valuable when Limit upside

when price of the price of the asset ↓. return
asset ↑. • Opposite of bull spread. potential as
• Can be constructed • Investor buy ↑ XP & sell well as max.
with puts or calls. ↓ XP. loss like collars.
• Strategy: buying • B.E.P for Put Bull
one option, writing Spread = XH − (pL −pH)
another with ↑ XP.
• B.E.P for Call Bull
Spread = XL + (cL-cH)
5.1.3.1 5.1.3.2 5.1.3.3

Adding a Short Leg to a Long Multiple Strikes Spreads as a Volatility Play
Position e.g. • Spreads: directional
e.g. • initial position: Long Call play.
• initial position: Long Call • Subsequent Position: • Spread traders can take
• Subsequent Position: Writing a mix of two or advantage of ∆ in
Long Call + Short Call more options volatility level.

6. INVETMENT OBJECTIVES & STRATEGY SELECTION
Derivatives: a helpful tool to quickly adapt to changing mkt.

conditions/client needs or to create a preferred risk-return trade-off.
6.1 6.2 6.3 6.4

The Necessity Spectrum of Analytics of the Applications
of Setting an Market Risk Breakeven Price
Objective
• Users of options • Derivatives give • Variety of factors Short cases depicting

consider mkt. participants determine the derivative usages by
direction as well as many value of an option mkt. participants in
volatility. alternatives to such as: underlying multiple ways to solve
• Spreads: middle- take a single mkt. price, XP, time problem or alter risk
of-the-road position. to expiration, Risk- exposures.
strategy. • Each choice has free rate, dividends
• Straddle buyer: its own strengths paid, asset price
expects ↑ volatility. & weaknesses. volatility,
6.4.1 6.4.2.1 6.4.3 6.4.4 6.4.5 6.4.6 6.4.7 6.4.8 6.4.9

Writing Portfolio Collar/ Writing Long Long Calendar Currency interest
Covered Protection Equity Put Straddle Call Spread Forward rate
Calls Swap Options Contract Swap
6.4.2.2
Portfolio
Protection
Adjustment

“Derivative Strategies”
i-rate = interest
rate 1. INTRODUCTION There are many different ways in which derivatives are used in a
pmts. = typical investment situation.
payments An investment professional should be familiar with the understanding
Gen. = of risk-return trade-off associated with the derivatives.
generally
NP = notional
principle 2. CHANGING RISK EXPOSURES WITH SWAPS, FUTURES & FORWARDS
Mkt. = market
FC = foreign
currency
B.E.P =
Breakeven
Price 2.1 2.2 2.3
XP = exercise Interest Rate Swaps / Currency Swaps / Equity Swaps /
price Futures Examples Futures Examples Futures Examples
2.1.1 Interest 2.1.2 Interest 2.2.1 2.2.2 2.3.1 2.3.2

Rate Swap Rate Futures Currency Swap Currency Futures Equity Swap Stock Index
Futures
• Two parties • No counter- • Involves • Similar to currency • Parties agree to

exchange cash party risk. different swap but Currency trade return on the
flows at specified • Also called currencies. futures are limited stock portfolio to
dates over a bond futures • NP is by standardized another asset.
swap tenor based because exchanged at expiration dates & • Pmt.→ in series or
on fixed for underlying the beg. & fixed NP sizes. single at the end.
floating i-rate & asset is often a end of the • Fractional • If the equity
NP determined at bond. swap. contracts are not portfolio is –ve, the
initiation. • The futures allowed. party traded equity
• Pmts. are price moves • Currency forward return will receive
typically netted. fairly contracts can be other asset return
• A fixed income consistently & customized to any as well as negative
portfolio’s proportionately size or date. equity portfolio
duration can be ↓ with the yield pmt.
by entering into a that drives the
pay-fixed i-rate bond.
swap.
Cash-settled at
expiration.
To temporarily
remove mkt. risk
→sell Stock index
futures.

3. POSITION EQUIVALENCIES
Assuming XP & expiration dates are same.
3. 1 3. 2 3. 3 3. 4 3. 5 3. 6
Synthetic Synthetic Synthetic Assets Synthetic Synthetic Foreign
Long Asset Short Asset with Futures or Put Call Currency
Forwards Options
= Buying a = Selling a • Using futures or = Short = Long Stock + • If an investor has

Call + Call + forwards to Stock + Long Put FC obligation & he
Selling a put Buying a eliminate future Long Call wants protection
put price risk. Unlimited against FC
• Stock – Futures = profit potential appreciation
Rf rate without locking in
• If div. yield of exchange rate, he
stock is > RF rate, can buy Call option
future price will on FC.
be less than spot • Call will be
price. exercised when
• This strategy is spot rate at
called synthetic expiration will be
risk-free rate or below the strike
synthetic cash. rate. If FC
appreciate,
exchange rate will
↓.

4. COVERED CALLS & PROTECTIVE PUTS
• Covered Calls: Selling call options on shares owned.

• Protective Puts: Buying put options on shares owned.
4.1 4.2 4.3 4.4 4.5 4.6

Investment Investment Equivalence of Writing Cash- The Risk of Collars
Objectives of Objectives of Long Secured Puts Covered Calls
Covered Calls Protective Puts Asset/Short & Protective
Forward Puts
Position
4.2.1 Protecting Profits

• Protective put is similar • Delta measures ∆ in
to buying insurance i.e. option price as the • Writing a put
protection against loss underlying price ∆ option &
when asset fall in value. • Call (Puts) deltas range simultaneously
• Cost of insurance can be from 0 to +1 (–1) depositing money
↓ by ↑ the size of • Long (short) futures or equal to XP in an
deductible i.e. choosing forward delta is +1 (–1) account.
↓ XP. • The following three • Writing a covered
positions have same call & writing a put
deltas: are very similar to
i. At the money their risk-reward
covered call. features because
4.2.2 Profit & loss at ii. At the money of put-call parity.
expiration protective put.
• Max. profit = (ST−S0) iii. Long stock/short
−p0 = unlimited forward position.
• Max. loss = S0 − X+ p0
• B.E.P = S0 + p0
On page 4
• Expiration value = Max
(ST, 𝑋)
• Profit at expiration =
Max (ST, 𝑋) – S0 – p0
4.1.1 4.1.2 4.1.3 4.1.4

Mkt. Participant # 1: Mkt. Participant # 2: Mkt. Participant # 3: Target Profit & Loss at
Income Generation Improving on the Mkt. Price Realization Expiration
• is most common • In the money option • is hybrid of first two • Max. gain = (X−S0) + c0
motivation for premium = exercise objectives • Max. loss = S0 − c0
writing covered value + time value • writing calls with XP near • B.E.P = S0 − c0
calls. • Someone who writes the target price. • Expiration value =
• Premium for long- covered call to improve • Call writer may ST–Max (ST – 𝑋, 0)
term options is ↑. on the mkt may capture experience opportunity • Profit at expiration =
time value. loss compared to straight ST–Max (ST – 𝑋, 0) + c0
• Writer expect stock sale of the shares. – S0
price will remain stable.

4.5.1 4.5.2 Shareholder acquires

Covered Calls Protective Puts downside protection
• Call writer bears significant • Continuous purchase of through protective put
opportunity cost if underlying protective put is expensive but ↓ the cash outlay by
price ↑ sharply. strategy. writing a covered call.
• However, covered call writer • However, purchasing protective
retains option premium & losses put occasionally is a sensible risk
less compared to simply holding reducing strategy.
shares if stock price ↓.
4.6.1 4.6.2 4.6.3

Collars on an existing holding Same Strike Collar The Risk of a Collar
• At or below put XP, the collar • Investor combines same strike Risk reduction at the cost of
locks in a profit. collar with a long position in the return potential.
• At or above the call XP, the underlying
profit is constant. • Motivation: capital preservation
• Risk is completely neutralized.

5. SPREADS & COMBINATIONS
Option Spread: buying one call & writing another or buying one put & writing another with different XPs.
Option Combination: Typically uses both puts & calls e.g. Straddle.
5.1 5.2 5.3 5.4

Bull Spreads & Calendar Straddle Consequences
Bear Spreads Spread of Exercise
• A strategy in which a • Long Straddle: Buying • For option writer,

trader sells (or buys) a puts & calls [same consequences of
near-dated call & buys (or asset, same XP]. exercise can be
sells) a longer-dated one • Short Straddle: writing significant &
[same asset, same strike both puts & calls unexpected
price]. [same asset, same XP]. exercise may be
• Long calendar spread: • Directional play on the quite inconvenient.
buying longer-dated underlying volatility.
option. • Risk of long straddle is
• Short calendar spread: limited to the total
buying near-term option. option cost paid.
• Calendar spread can be
done with calls or puts.
5.1.1 5.1.2 5.1.3 5.1.4

Bull Spread Bear Spread Refining The Risk
Spreads of Spreads
• Become valuable • Become valuable when Limit upside

when price of the price of the asset ↓. return
asset ↑. • Opposite of bull spread. potential as
• Can be constructed • Investor buy ↑ XP & sell well as max.
with puts or calls. ↓ XP. loss like collars.
• Strategy: buying • B.E.P for Put Bull
one option, writing Spread = XH − (pL −pH)
another with ↑ XP.
• B.E.P for Call Bull
Spread = XL + (cL-cH)
5.1.3.1 5.1.3.2 5.1.3.3

Adding a Short Leg to a Long Multiple Strikes Spreads as a Volatility Play
Position e.g. • Spreads: directional
e.g. • initial position: Long Call play.
• initial position: Long Call • Subsequent Position: • Spread traders can take
• Subsequent Position: Writing a mix of two or advantage of ∆ in
Long Call + Short Call more options volatility level.

6. INVETMENT OBJECTIVES & STRATEGY SELECTION
Derivatives: a helpful tool to quickly adapt to changing mkt.

conditions/client needs or to create a preferred risk-return trade-off.
6.1 6.2 6.3 6.4

The Necessity Spectrum of Analytics of the Applications
of Setting an Market Risk Breakeven Price
Objective
• Users of options • Derivatives give • Variety of factors Short cases depicting

consider mkt. participants determine the derivative usages by
direction as well as many value of an option mkt. participants in
volatility. alternatives to such as: underlying multiple ways to solve
• Spreads: middle- take a single mkt. price, XP, time problem or alter risk
of-the-road position. to expiration, Risk- exposures.
strategy. • Each choice has free rate, dividends
• Straddle buyer: its own strengths paid, asset price
expects ↑ volatility. & weaknesses. volatility,
6.4.1 6.4.2.1 6.4.3 6.4.4 6.4.5 6.4.6 6.4.7 6.4.8 6.4.9

Writing Portfolio Collar/ Writing Long Long Calendar Currency interest
Covered Protection Equity Put Straddle Call Spread Forward rate
Calls Swap Options Contract Swap
6.4.2.2
Portfolio
Protection
Adjustment

“PRIVATE REAL ESTATE INVESTMENTS”

REITS = Real Estate Investment
Trusts 1. INTRODUCTION TV = Terminal Value
NOI = Net Operating Income RE = Real Estate
DSCR = Debt Service Coverage MV = Market Value
Private equity investment in real estate ⇒ direct ownership. RC = Replacement Cost
Ratio
REITS ⇒ indirect investments.
Real estate investments are usually part of the portfolios of investors with
longer investment horizon & low liquidity needs.
2. REAL ESTATE INVESTMENT: BASIC FORMS
Real estate equity investor ⇒ ownership interest.

RE debt investor ⇒ loan funds to entity acquiring the RE property or may invest in security based on real estate lending.
Publicly traded RE investment provides liquidity & diversification benefits.
Expected return of RE equity investors > return expected by debt investors.
Return components of RE equity investors:
Income stream
Capital appreciation
3. REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS
3.1 Characteristics
Heterogeneity & fixed location ⇒ no two RE properties are identical.

High unit value ⇒ unit value of RE property > bond or stock unit value.
Management intensive ⇒ active management by the property owner or manger.
High transactions cost ⇒ because of many parties involved (e.g. appraisers, lawyers etc.).
Need for debt capital ⇒ the ability to access funds & the cost of funds in credit markets are important (because
large amount required to purchase & develop RE properties).
Illiquidity & difficulty in price determination ⇒ appraised based valuation due to low volume of transactions.
3.2 Classifications
Office Industrial & Warehouse Properties
Single or multi-tenant buildings found in the central Property used for light or heavy manufacturing as
business districts. well as associated warehouse space.
Often built to suit the needs of tenants. Older buildings can be converted from one use to
another use.
Retail Properties Hospitality
Vary from large shopping centers to small stores Vary in size & amenities available.
occupied by individual tenants. Typically located near attractions that tourists visit.
Require day-to-day management.
Other Types
These include parking facilities, restaurants, country clubs etc.

Some buildings intended for one use many not easily be adapted for other uses. (e.g.
university or hospital buildings).

4. PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS
Several motivations of RE equity investors include:

To earn current income.
Capital appreciation.
Inflation hedge ⇒ both rent & RE prices rise in inflationary
environment.
Diversifications ⇒ RE performance has not typically been highly
correlated with other asset classes & it brings diversification
benefits.
Tax benefits ⇒ RE investment may receive favorable tax
treatment compared with other investments.
4.1 Risk Factors
Changes in economic conditions will affect RE investments (both current income & RE
values may be affected).
Long lead time for new development & during this time market conditions may change
dramatically.
Cost & availability of capital ⇒ shortage of capital or high interest may be an issue.
Unexpected inflation can negatively impact fixed income securities.
Demographics (e.g. size & age distribution of population) factor.
Lack of liquidity ⇒ longer time to realize cash & the risk that the market may move
against the investor.
Real estate value can be affected by environmental conditions.
Lack of informed decision-making due to non-availability of RE information.
Management risk reflects the ability of the property & asset managers to make the right
decisions regarding the operation of the property.
Higher leverage in RE investments also increases risk.
Many other risks may also exist in the RE e.g. natural disasters.
Some risks can be converted to a known $ amount through insurance.
4.2 Real Estate Risk and Return Relative to Stocks and Bonds
RE lease can be thought as giving equity RE investment a bond-like characteristic.

At the end of lease term, the uncertainty regarding renewal of lease gives equity-like
characteristic to RE investment.
The risk & return profile of real estate falls b/w risk & return profile of stocks & bonds.
4.3 Commercial Real Estate
4.3.1 Office
Demand depends heavily on employment growth.

Amount of space used per employee is important because it tends to when economy is
strong & vice versa.
Important consideration ⇒ whether the owner or tenant incurs the risk of operating
expenses.
Net (Gross) lease ⇒ tenant (owner) is responsible for operating expenses.
There are differences in how leases structured over time & in different countries.
Lease terms will affect the risk & return to the investor.
4.3.2 Industrial and Warehouse
Demand depends heavily on strength of economy & economic

growth as well as import & export activity.
Industrial leases are often net leases.

4.3.3 Retail
Demand depends mainly on trends in consumer spending.

Retail lease terms vary on the basis of quality of the property, size &
importance of tenant.
Unique aspect ⇒ tenants pay additional rent once their sales reach a
certain level (called % lease).
4.3.4 Multi-Family
The demand for multi-family space depends on population

demographics & the ratio of home prices to rents.
As home prices (), more (less) people will rent.
Higher interest rates may also home ownership & may cause a
shift toward renting.
The tenant may or may not be responsible for paying operating
expenses.
5. OVERVIEW OF THE VALUATION OF COMMERCIAL REAL ESTATE
5.1 Appraisals
Appraised value ⇒ estimated values that are critical for such infrequently
traded & unique assets as RE properties.
REIT prices can be observed as with any publicly traded share & are
available in many countries around the world.
REIT prices reflect the management performance & the value of
underlying properties.
Even when there is a transaction, an appraisal is often used as a basis for
estimating the value of the property rather than just assuming that the
agreed upon transaction price equals the value.
Appraisal is also done for performance measurement & usually
conducted on an annual basis.
5.1.1 Value
MV of property ⇒ most probable sale price.

Investment value ⇒ value to a particular investor.
Value in use ⇒ value to a particular user.
The MV may differ from the value that the potential buyer or seller
originally placed on the property & from the price that is ultimately
agreed upon.
Mortgage lending value ⇒ value of the property which may throughout
the life of the loan be expected to be generated in the event of sale.

5.2 Introduction to Valuation Approaches
Approaches Used to Estimate Value
Income Approach Cost Approach
It considers what price an investor would pay based on an This approach considers what it would cost to buy the land &
expected rate of return that is commensurate with the risk of construct a new property on the site that has same utility as the
investment. property being appraised.
Value estimated = PV of the expected future income from the Adjustments are possible.
property.
Sales Comparison Approach
It considers what similar or comparable properties transacted for

in the current market.
Adjustments are made to reflect comparables’ differences from
the subject property.
Concept ⇒ you would not pay more than others are paying for
similar properties.
The three approaches may vary significantly in their results due to

difference in assumptions & availability of data.
5.2.1 Highest and Best Use
The highest & the best use of a vacant site is the use that would
result in the highest value for the land.
6. THE INCOME APPROACH TO VALUATION
Income Approaches
Direct Capitalization Method Discounted CF Method
It estimates the value of an income-producing property It discounts future projected CFs to arrive at PV of the
based on the level & quality of its NOI property.

6.1 General Approach and Net Operating Income
NOI in RE property context is similar to EBITDA in a

financial reporting context.
Income Approaches
Direct Capitalization Method DCF Method
Uses a growth implicit cap rate. It applies an explicit growth rate to construct an NOI
Implicit assumption ⇒ 1st year NOI is representative stream from which a PV can be derived.
of what the typical 1st year NOI would be for similar The discount rate should reflect the risk
properties. characteristics of the property.
NOI = income from property – operating expenses
(property tax, insurance, maintenance, utilities &
repairs).
NOI is a before-tax unleveraged (before deducting
financing cost & federal income tax) measure of
income.
6.2 The Direct Capitalization Method
6.2.1 The Capitalization Rate and the Discount Rate 6.2.2 Defining the Capitalization Rate

Discount rate ⇒ + risk premium specific to =

investment. Going-in cap rate ⇒ rate based on the 1st year of
Cap rate ⇒ it is calculated using the current NOI ownership when the investor is going into the deal.
hence it is lower than discount rate.
=

Discount rate is applied to current & future NOI.
When income & value are growing at a constant If the sale price for a comparable company is a good
compound growth rate: indication of the value of the subject company:

=
− ℎ =

This cap rate is called all risk yield (ARY).
6.2.3 Stabilized NOI 6.2.4 Other Forms of the Income Approach
Cap rate must be applied to stabilize NOI otherwise the Gross income multiplier ⇒ ratio of sale price to the
implicit assumption that the 1st year NOI is gross income expected from the property in the 1st
representative of what the typical 1st year NOI would be year after sale.
for similar properties may violated. Problem ⇒ it does not consider vacancy rates
& operating expenses.
Gross rent multiplier is also considered a form of
direct capitalization but less reliable as compared to
using a cap rate.

6.3 The Discounted Cash Flow (DCF) Method
6.3.1 The Relationship between Discount Rate and Cap Rate 6.3.2 The Terminal Capitalization Rate
Cap rate = DR – growth rate (if same change in income & With DCF method, estimated TV is an important
value for a property). input.
When the NOI is growing, price will be & cap rate will Terminal cap rate ⇒ it is used to estimate the TV.
be. TV ⇒ PV of income to be received by the next
If growth rate is constant: investor.
= − Estimating the TV & selecting a terminal cap rate is
challenging.
If NOI growth rate is not constant, project each period NOI,
Terminal cap rate may differ from going-in cap rate.
& discount it back to arrive at a value for the property.
6.3.3 Adapting to Different lease Structures 6.3.4 The Equivalent Yield
Lease structures have an impact on an estimated Equivalent yield ⇒ single discount rate applied to
value in a specific locale. two income streams that would result in the same
Term & reversion approach: value.
Term rent ⇒ fixed passing rent. Equivalent yield is not a simple avg.
Reversion ⇒ estimated rental value.
Cap rate used for reversion is derived from
sales of comparable fully let properties.
Discount rate of term rent < reversion discount
rate.
A variation of the term & reversion approach is layer
method.
The only difference is that this method deals
with the higher income expected from the rent
review in a different way mathematically.
6.4 Advanced DCF: Leases-by-Lease Analysis
Steps to a DCF analysis include:

Forecast income from existing leases.
Assumptions about lease renewals.
Assumptions about operating expenses.
Make assumptions about capex.
Assumptions about absorption of any vacant space.
Estimate reversion (resale value).
Select discount rate to find PV of CFs.
6.5 Advantages and Disadvantages of the Income Approach
It captures the CFs that investors actually care about. Detailed information is needed.
Does not depend on current transactions from Small variations in assumptions can have a significant
comparable sales if we are able to select an impact on the value.
appropriate discount rate. Discount rate & forecasting of NOI growth rate is
difficult.

6.6 Common Errors
Common erroneous assumptions include:

The DR may not reflect the risk.
Income growth > expenses growth.
Illogical terminal cap rate & applied to an income that is
not typical.
Cyclical nature of RE market is not recognized.
7. THE COST AND SALES COMPARISON APPROACHES TO VALUATION
7.1 The Cost Approach
Estimated total value of property = estimated value of building based on

replacement cost + estimated value of land based on sales comparison approach.
The replacement cost (RC) is adjusted for different types of deprecation to arrive at
a deprecated RC:
Physical deterioration ⇒ related to age of property.
Functional obsolescence ⇒ loss in value due to a design that is different from
the new building constructed with an appropriate design.
Locational obsolescence (external) ⇒ when the location is not optimal for the
property.
Economic obsolescence ⇒ when new construction is not feasible under
current economic conditions.
7.2 The Sales Comparison Approach
Sales comparison approach ⇒ value of a property depends on what other

comparable properties are selling for in the current market.
Adjustments have to be made to each of the comparable for differences from the
subject property due to certain factors (e.g. size, location etc.).
7.3 Advantages and Disadvantages of the Cost and Sales Comparison Approaches
Cost Approach
Advantage Disadvantages
Set an upper limit on the value (investor would never Depreciation estimate of an older property may be
pay more than the cost to buy land & develop a difficult.
comparable building). The assumption made concerning investor purchase
costs may be an overstatement.
Sales Comparison Approaches
Advantage Disadvantages
Reliable approach in an active market Comparable properties are difficult to find when
market is weak.
Investor may not behave rationally in certain time
periods, (bubble in property prices).

8. RECONCILIATION
It is highly unusual to get the same answer from all three valuation approaches (income, cost &
sales comparison) because of different assumptions used by these approaches.
The appraiser needs to reconcile the differences & arrive at a final conclusion about the value.
Purpose of reconciliation ⇒ to decide in which approach(es) you have the most confidence.
9. DUE DILIGENCE
Property investors usually go through a process of due diligence to verify facts & conditions that
might affect the value of the property.
To acquire commercial RE, investors often sign a contract or letter of intent.
Conducting due diligence can be costly but lowers the risk of acquiring a property.
10. VALUATION IN AN INTERNATIONAL CONTEXT
Difference across countries will mainly be based on which approaches are emphasized & which of
the ways of applying the approach is used.
It is important to note that the general RE concepts are the same & value is derived from an
income stream that has a risk associated with it.
11. INDICES
11.1 Appraisal-Based Indices 11.2 Transaction-Based Indices
RE indices often rely on appraisals to estimates values Such index is possible by companies that collect
(insufficient transactions of the same transactions to rely information on enough transactions to create an index
on). based only on transactions.
Appraisal based indices combine valuation information Problem ⇒ same property may not sell very frequently.
from individual properties & provide a measure of market To develop an index, some econometric technique is
movement. applied on different properties selling every quarter.
The return for all the properties is calculated as: More sales, the more reliable is the index.

( .)
= Hedonic index ⇒ control for differences in the
.
characteristics of the property.
These individual property returns are then value
weighted to get the return for all properties in the Such indices require sufficient amount of data.
index.
Such index allows us to compare the performance of RE
with other asset classes.
11.3 Advantages and Disadvantages of Appraisal-Based and Transaction-Based Indices
Disadvantage of appraisal-based index.

Appraisals lag in case of sudden shifts in the market.
Index with appraisal lag is more of an issue when compared with other publicly traded asset classes.
Appraisal lag tends to smooth the index.
Two general ways of adjusting the appraisal lag.
Unsmooth the appraisal-based index.
Use a transaction-based index.
Disadvantage of transaction-based index.
Can be noisy.
Statistical techniques are used to control the noise, can be challenging.

12. PRIVATE MARKET REAL ESTATE DEBT
Investors who do use debt financing will normally expect to earn a higher rate of return on their
equity investment (positive financing leverage).
By borrowing money, the investor is taking on more risk in anticipation of higher return on
equity.
Maximum amount of debt is usually limited by either the ratio of loan to the appraised value or
DSCR.

=

Debt service includes both interest & principal payments on mortgage.

“PUBLICLY TRADED REAL ESTATE SECURITIES”

NAVPS = Net Asset Value per Share REOCS = Real Estate Operating
P = Price 1. INTRODUCTION Companies
DTL = Deferred Tax Liability AFFO = Adjusted Funds from
DDM = Dividend Discount Model Operations
Investment in commercial RE property may be either in the form of direct
ownership or indirect investment by means of equity securities.
Mostly rental rates are inflation indexed & provide an above average yield.
RE investments provide diversification benefits in many investment portfolios.
Valuation of REITS is similar in some respects to the valuation of other kinds of
equity securities.
2. TYPES OF PUBLICLY TRADED REAL ESTATE SECURITIES
REITS REOCs
Equity REITs ⇒ tax advantaged entities Ordinary taxable RE companies.

that typically own, operate & develop Suitable in the countries where no tax-
income producing RE property. advantaged REIT regime is in place.
Mortgage REITs ⇒ make loans secured by Primary cash inflows ⇒ sale of developed
RE. or improved properties rather than rental
REITs’ tax advantage ⇒ allows to deduct income.
dividends paid.
Hybrid REITs ⇒ combination of equity &
mortgage REITs.
MBS
Debt obligations that represent rights to receive CFs from portfolios of

mortgage loans.
Market cap of RE equity securities < RE debt securities.
3. PUBLICLY TRADED EQUITY REITs
3.1 Market Background
3.2 REIT STRUCTURE
Simple Structure Umbrella Partnership REITs Down/Up REITs
Holds & operates properties directly. Holds REIT properties. Up REITs ⇒ REIT has a controlling
Purpose ⇒ to avoid recognition of interest in & serves as a general
taxable income. partner.
Down REITs ⇒ REIT owns more than
one partnership & may own
properties at both the REIT &
partnership level.

3.3 Investment Characteristics
Investment characteristics of public & private REITS include:

Exemption from income taxes at the corporate level.
High income distribution as a result of distribution requirement.
Low volatility of reported income due to conservative, rental-property-focused
business models.
More frequent secondary equity offerings compared with industrial
companies.
REITs offer much greater ease of ownership in both small & larger amounts, provide
liquidity & diversification opportunities.
3.3.1 Advantages of Publicly Traded Equity Real Estate Securities
REITs or REOCs provide the following advantages:

Greater liquidity due to trading on stock exchanges rather than property markets.
Lower investment than a single commercial property.
Limited liability.
Access to superior quality & range of properties.
REITs investors’ property interests are actively managed on their behalf by professional
managers.
Diversification.
REITs offer the following advantages over REOCs:
Taxation benefits
Greater degree of earnings predictability due to contractual nature of REITS rental income.
High income payout ratios & yields.
REOCs offer the following advantage compared with the REITs.
Operating flexibility as REOCs are free to invest in any kind of real estate.
3.3.2 Disadvantages of Publicly Traded Equity Real Estate Securities
Disadvantages of publically traded RE securities include:

Taxation ⇒ REIT & REOC investing is less tax advantaged as compared to direct property investment.
Minority shareholders in REITS have less control over property decisions than do direct property owners.
Maintenance of publicly traded REITS structure is costly.
Stock market value of a REIT is more volatile than the appraised NAV of a REIT.
Structural conflicts & related costs ⇒ the use of UPREITS and DOWNREITS structures can create conflicts of interest
b/w the partnership & REIT shareholders during decision making process.
Payout, retention, reinvestment, future growth.
Potential for forced equity issuance at disadvantageous prices if management, timing, and type financial leverage is
flawed.
3.4 Considerations in Analysis and Due Diligence
When conducting due diligence of equity REITS, following should be considered:

Remaining lease terms ⇒ short remaining lease terms are +ve consideration in an expansionary economy.
Inflation protection.
Market rent analysis.
Costs of re-leasing space.
Tenant concentration.
Availability of new competitive supply.
Leverage analysis.
Review of senior management.
3.5 Equity REITs: Property Subtypes
3.5.1 Shopping Center/Retail REITs
Invest in regional shopping malls & community shopping centers.

Tenants' leases in regional malls are usually terms of 3-10 years & typically require
tenants (expect for anchor retailers).
Analysts often analyze such factors as rental rates & sales per square foot for the
rental property portfolio.

3.5.2 Office REITs
Invest in & manage multi-tenanted office properties in central business districts of

cities & suburban markets.
Lease term typically consist of 5-25 years with contractual base rent.
Tenants also share operating expenses, common area costs & property taxes.
Analysts pay particular attention to new space under construction in a REIT’s local
market, business conditions, quality of space, location & convenience etc.
3.5.3 Industrial REITs
Hold industrial properties that are used as warehouses, distribution centers & small office.
Less cyclical than hotel, health care & storage.
Stable rental income & values.
Analyst focus ⇒ trends in tenants’ requirements, strategic property locations, shifts in the
composition of national & local industrial bases & trends in new supply & demand.
3.5.4 Multi-family/Residential REITs
Rental apartments for lease to individual tenants, typically using one-year lease.
Fluctuations in rental income can occur as a result of construction competition,
regional economic strength & weakness.
Analyst focus ⇒ local demographics & income trends, age & competitive appeal,
cost & availability of ownership in local markets & the degree of Govt. control of
local residential rents.
3.5.5 Storage REITs
They own & operate self storage properties.

Gross lease agreements usually on a monthly basis.
Analyst focus ⇒ rate of construction of new competitive facilities, trends in housing
sales activity, local demographic trends, new business start-up activity & seasonal
trends in demand for storage facilities.
3.5.6 Health Care REITs
Invest in skilled nursing facilities, hospitals, medical office buildings & rehabilitation
centers.
Analyst focus ⇒ scrutinize operating trends in facilities, in Govt. funding, in litigation
settlements, insurance costs & amount of new facilities under construction.
3.5.7 Hotel REITs
Hotel REITs typically lease all their properties to taxable REIT subsidiaries & receive
passive rental income.
A minor portion of net operating CF from hotel properties may be subject to income
tax.
The hotel sector is business cycle driven.
Analyst focus ⇒ trends in occupancies, avg. room rates, & operating profit margins
by hotel type & geographical location.
3.5.8 Diversified REITs
Own & operate in more than one type of property.

Diversification benefits.
Analyst focus ⇒ analysis of management experience & degree of local market
presence of each property.

3.6 Economic Drivers
Major economic factors affecting REITS include:

Job creation
GDP growth
Retail sales growth
New space supply v/s demand
Population growth
Those sectors bear the greatest risks for REITS where occupant demand for space
can fluctuate most widely in short-term.
4. REAL ESTATE OPERATING COMPANIES
REITs & REOCs face similar operating & financial risks as private RE investments.
Despite certain advantages of REOCs (e.g. operating flexibility), the equity markets
of most countries show a REIT preference (tax advantage, high income
distributions).
REOCs are usually able to elect to convert to REIT status if they meet the general
requirement of REITs.
5. VALUATION: NET ASSET VALUE APPROACH
NAVPS ⇒ a fundamental benchmark of the value of a REIT or REOC.

Discount (premium) in REIT share price from NAVPS = indication of potential
undervaluation (indication of +ve future events).
5.1 Accounting for Investment Properties
Fair value based accounting valuation is relevant for asset-based valuation.

IFRS:
Investments property ⇒ property that is owned or leased under a capital lease
for the purpose of earning rentals or capital appreciation or both.
Companies are allowed to value investment properties using either a cost or
fair value model & it appears as a separate line item on the B.S.
Company must make additional disclosures about how it determines fair value.
U.S.GAAP:
No specific definition of investment property.
Most RE companies use historical cost method, which does not represent
economic values of assets & liabilities.
5.2 Net Asset Value Per Share: Calculation
NAVPS ⇒ diff. b/w MV of RE Company’s assets & its liabilities divided by no. of
shares outstanding.
In valuing REITs’ or REOCs’ portfolios, analysts will use appraised value or NOI.
Goodwill, deferred financing expenses & deferred tax assets will be excluded to
arrive at a “hard” economic value for total assets.
Liabilities adjustment ⇒ replace face value of debt with MV of debt & remove
deferred tax liabilities.

=
.

5.3 Net Asset Value Per Share: Application
The NAV approach is most often used by sector-focused RE investors.

Value-oriented investors tend to focus on NAV when stocks are trading at significant
discounts.
NAV analysis is important when there is significant LBO activity.
5.3.1 Important Consideration in a NAV-Based Approach to Valuing REITs
Important considerations:
Examine how NAVs are calculated.
Cap rate approach.
Applying value per square foot.
Using appraised values.
NAV reflects the value of a REIT’s asset to a private market buyer, which may
not be the same as value assigned by a private equity investor.
NAV implicitly treats a company as an individual asset or static pool of assets
(not consistent with going concern assumption).
When property markets become illiquid & few transactions are observable,
NAV estimate will be quite subjective.
5.3.2 Further Observations on NAV
Rationale for REITs or REOCs trading at premiums to underlying NAVPS.

Lower required return rate ( value) in the public market than the private
market for RE assets.
Above avg management team in public market leads to better investment
decisions.
6. VALUATION: RELATIVE VALUE (PRICE MULTIPLE) APPROACH

, , Multiples are used for valuing shares of
REITS & REOCs.
6.1 Relative Value Approach to Valuing REIT Stocks
, Multiples allow investors to quickly ascertain the

value of a given REITs shares compared with other REIT shares or with
its historical levels.
Main drivers behind the multiples of most REITs & REOCs:
Growth expectation in FF0/AFF0 ⇒ the expected growth,
the multiple.
Risk of underlying RE.
Risk associated with company’s capital structures & access to
capital.

6.2 Funds from Operations and Adjusted Funds from Operations
FFO:
Accounting NI excluding depreciation, deferred tax & gain/loss from sales of
property & debt restructuring.
Depreciation is excluded because investors believe that RE maintains its value to a
greater extent, often appreciating in value.
Deferred tax liability may not be paid for many years.
G/L & debt restructuring are excluded because they don’t represent sustainable
income.
EBITDA = NOI – general & admin expenses.
FFO = EBITDA – interest exp.
AFFO:
Also know as funds available for distribution.
AFFO ⇒ FFO adjusted to remove any non-cash rent & to subtract maintenance-
type capex & leasing cost.
Straight-line rent ⇒ avg. contractual rent over a lease term.
Non cash rent ⇒ diff. b/w straight-line rent & cash rent paid during the period.
Purpose of adjustment ⇒ to obtain more tangible, cash-focused measure of
sustainable economic income.
AFFO is superior to FFO because it takes into account the capex.
6.3 P/FFO and P/AFFO Multiples: Advantages and Drawbacks
Benefits Drawbacks
These multiples are widely accepted in evaluating May not capture the intrinsic value of all RE assets
shares across global stock markets & industries. held by REIT or REOC.
Portfolio manager can put the valuation of REITs & P/FFO does not adjust for the impact of recurring
REOCs into context with other investment capex.
alternatives Wide variations in estimates & assumptions are
Data for these multiples is readily available. incorporated into the calculation of AFFO.
Multiples can be used in conjunction with growth & Increased level of one-time items (e.g. gains &
leverage level to deepen the relative analysis. accounting charges) make P/FFO & P/AFFO more
difficult to compute & compare b/w companies.
7. VALUATION: DISCOUNTED CASH FLOW APPROACH
REITs & REOCs tend to be high dividend paying shares thus

DDM for valuation is applicable.
7.1 Considerations in Forecasting Longer-Term Growth Rates
Four key considerations:

Internal growth potential that stem from rent over time.
Investment activities have an impact on long-term growth ⇒
development-oriented companies have shown better growth.
Capital structure can have an impact on growth.
Retaining & reinvesting a portion of free CF can make a
contribution to the growth rate.

7.2 Some Perspective on Long-Term Growth Rates
Key component in DCF & DDM is required return.

A long run growth rate can be derived by adding the components
mentioned in 7.1.
Key drawback of DCF/DDM ⇒ highly sensitive to growth & discount
rates.

DCF = Discounted Cash Flow PIC = Paid in Capital
VC = Venture Capital “PRIVATE EQUITY VALUATION” DPI = Distributed to Paid in
GP = General Partner RVPI = Residual Value to Paid in
LP = Limited Partner TVPI = Total Value to Paid in
EV = Enterprise Value
MV = Market Value EBITDA = Earnings before Interest,
PE = Private Equity
HYD = High Yield Debt Tax, Depreciation, Amortization
MBO = Management Buyout
IPO = Initial Public Offering
P/E = Price-to-Earnings Ratio
1. INTRODUCTION
Reading focuses on entire asset class of equity investments not quoted on stock market.
Private Equity Classification
Venture Capital
Seed Stage Start-Up-Stage Expansion stage
Finance provided to: Financing to recently created Financing to companies:

Conduct research on business companies with well-articulated Started selling effort.
ideas business & marketing plans. May be at breakeven.
Develop prototype products Expanding production.
Conduct market research Product development.
Providing working capital.
Buyout
Acquisition Capital Leverage Buyout (LBO) Management Buyout
Financing in: LBO firm provides financing to acquire Management provides financing to
Debt, another company. acquire:
Equity, or A company,
Quasi-equity. Specific product-line, or
To acquire another company Special Situations Division (carve out)
Mezzanine Finance Distressed Securities
Subordinated debt and Financing of restricting companies.

Equity kicker in context of LBO Facing financial distress.
One-Time Opportunities Others
Financing in: Classification not exhaustive can Activist investing etc.

Changing industry trends. be of other forms as well.
New-government regulation.

2. INTRODUCTION TO VALUATION TECHNIQUES IN PRIVATE EQUITY TRANSACTIONS
Income Approach: Discounted Cash Flow
Value obtained⇒ discounting expected future cash flows at an appropriate cost of capital.
Applies across the broad spectrum to all stages.
Most relevant results when applied to companies:
with sufficient operating history and
In the expansion-to-maturity stage.
Emphasize on expected cash flows.
Relative Value:Earnings Multiples
Applicable to the earnings of a Portfolio Company.

Earnings multiple obtained from the average of a group of relevant public companies.
Applicable to companies with significant operating history & predictable stream of cash flows.
Can be applied with caution to expanding companies
Rarely applied to early stage or start-up companies
P/E, EV/EBITDA, EV/sales ⇒ commonly used multiples.
Real Option
Right to take business decision ⇒ call & put option

Judgment required about key option parameters
Applicable to business with flexibility possessed by management & shareholders in decision-making
Applicable to companies at seed or start-up phase
Replacement Cost
Estimated cost to recreate business.

Applies to early stage.
Rarely applies to mature companies
Key Considerations
Value of Control Liquidity Impact
Control premium ⇒ incremental value Cost associated with finding buyers &
associated with a block of shares⇒ speed of converting assets into cash
helps in gaining control Illiquidity with in willingness to
acquire control
Cost of Marketability Private Equity Valuation Uses
Cost associated with right to sell the Helps determine transaction price.
assets Serves as a monitoring tool to identify new
Practically, liquidity and marketability opportunities
discounts are often combined. Serves as performance reporting tool to investors

2.1 How Value is Created in Private Equity
Value is created by improving business financing,

operations, management & marketing.
In LBO value is create through restructuring.
Terms sheet, investment terms & agreements to create a
balance of rights & obligations b/w private equity firm &
management.
Contractual Clauses
Tag- along & drag-along rights: future potential acquirer to extend the offer
to all shareholders including management.
Corporate board seats: ensures private equity control in case of major
corporate events.
Noncompete clause: prevent owners from restarting same business during a
predefined time period.
Preferred dividends & liquidation preference: distribution first made to PE
firms.
Reserved matters: requires approval of PE or provides PE with veto right.
Earn-outs: price of transaction conditional on future performance.
2.2 Using Market Data in Valuation
Comparable public companies:

Value can be determined through traded company of similar scope &
industry.
Appropriate when similar companies available.
Multiples are used.
Comparable transaction.
Values implied by recent transaction.
Terminal value is estimated using perpetual growth rate assumption or using
trading multiples.
2.3 Contrasting Valuation in Venture Capital and Buyout Settings
2.4 Valuation Issues in Buyout Transactions
Buyout = buyer acquires controlling stake from seller.

Comprise of MBO, LBO, takeovers.
LBO transaction structure involves negotiation b/w providers of equity
capital, senior debt, high bond yields & Mezzanine finance.
Mezzanine finance ⇒ hybrid finance, bridge b/w equity & debt.

2.4.1 The LBO Model
Method of determining maximum price that can be paid to the seller,

capital structure & various other parameters.
LBO models not a separate valuation technique.
Inputs of LBO:
Cash flow forecast of the target company.
Expected return from the finance providers.
Amount of financing available for the transactions.
Exit value is determined using expected range of exit multiples of
comparables.
Value can be created through:
Operational improvements.
Improved corporate governance system.
Multiple expansions.
Debt reduction.
2.5 Valuation Issues in Venture Capital Transactions
DCF ⇒ difficult to apply in VC transaction due to uncertainty in future

cash flows.
Ownership diluted by additional financing rounds.
Due to unique features of start-up companies applying comparables is
difficult.
Real option method or VC approach ⇒ recommended in valuing private
equity.
2.6 Exit Routes: Returning Cash to Investors
IPO Secondary Market
Result in valuation multiples. Very common.

liquidity Represent significant proportion of exits.
Provide access to amount of capital. Absence of IPO ⇒ highest valuation multiple.
Can attract caliber managers Involves selling of equity stake to another financial
Cumbersome process. investor or private equity firm.
Flexible
Costly
Appropriate exit rout for private companies with
established operating history and excellent growth
prospects.
IPO timing ⇒ important factor
MBO Liquidation Important Decisions
Takeover by the management with Liquidation of the company by Timing of exit.

significant leverage. controlling shareholder ⇒ when Determining optimal exit route.
Helps in alignment of interests company is no longer viable.
Excessive leverage company’s Results in lowest value.
flexibility. May result in negative perception
for private equity firm.

2.7 Summary
Valuation ⇒ most critical part of equity valuation.

Investment decision making flow.
Screening investment opportunity.
Preparing a proposal.
Investment appraisal.
Structuring the deal.
Negotiating.
Valuation serves as a dual purpose:
Serving as benchmark for negotiations.
Assessing company’ ability to generate superior cash flows.
Post-investment valuation ⇒ important for investors.
3. PRIVATE EQUITY FUND STRUCTURES AND VALUATION
3.1 Understanding Private Equity Fund Structures
General Partner Limited Partners
Primary responsible for all management Limited liability & priority over GP in case of
decisions. liquidation.
Has a fiduciary duty to act in the best Possess no control over funds routine
interest of LP & fully liable. management.
Pays management fee & carried interest.
Usually closed end funds.

Typically span of 10 years with 2-3 years extension possible after LPs’ approval.
Investment period extended to 5-6 years.
Qualified investor can invest.
Private equity funds raise investments & manage private equity investments.
Investors typically commit certain amount that is subsequently drawn by the fund.
J-curve: curve that plots return generated by PE funds against time.
J-curve effect: PE funds exhibit negative returns followed by positive returns.
Economic Terms
Management Fee: annually paid to GP calculated as % of total committed capital.

Transaction fees: fees paid to GP for providing investment-banking services benefiting
the fund.
Carried interest: represents GP’s share of profits generated by PE fund.
Ratchet: mechanism of allocating equity b/w shareholders & management of PE.
Usually in percentage based on performance.
Hurdle rate: IRR PE must achieve before its GP receives any carried interest.
Target fund size: absolute amount in fund prospectus or information memorandum.
Vintage year: when PE is launched
Term of the fund: typically 10 years. If unlimited tenure ⇒ quoted on stock markets.

Corporate Governance Terms
Key man clause: If a key executive leaves or devotes insufficient time, this clause prohibits the GP from making
new investments until a new key executive is named.
Disclosure & confidentiality: PE firms not required to disclose financial performance. Disclosure limited to
financial performance of the fund.
Claw back provision: requires GP to return capital to LPs in excess of agreed profit split b/w GP & LPs.
Distribution to LPs waterfall: mechanism providing orderly distribution & specifies their priority of waterfalls.
Tag-along, drag-along rights: future acquirer of the company not allowed to acquire without extending
acquisition offer to all shareholders.
No-fault divorce: GP can be removed by super approval majority of LPs without cause.
Removal for cause: either removal of GP or an earlier liquidation for a cause.
Investment restriction: minimum level of diversification of funds investments, geographic or sector focus, or
limits on borrowing.
Co-investment: LPs having first right of co-investing along the GP.
3.2 What Are the Risks and Costs of Investing in Private Equity?
Equity Risk Factors
Not traded on security markets ⇒ illiquid investments.

More risky than securities quoted on exchange.
Competition exists for finding attractive investment opportunities.
Uncertainty that management will run the company in best interest of PE firm ⇒
agency risk.
Business & financial risk ⇒ loss of capital can occur.
∆ in government regulation ⇒ risk.
∆ in tax treatment ⇒ risk
Valuation is subjective ⇒ risk.
Problems in raising further investment capital if required.
Negatively affected by market conditions ⇒ market risk.
Concentrated investment portfolios ⇒ lack of diversification.
Cost of investing in Private Equity
Transaction fees: due diligence, bank financing, legal fees and sale transactions in
investee companies.
Investment vehicle setup cost: comprises legal costs, subject to amortization.
Administrative cost: custodian fee, transfer agent, accounting cost etc.
Audit cost.
Management & performance fee.
Dilution: associated with dilution of ownership.
Placement fee.
3.3 Due Diligence Investigations by Potential Investors
Due diligence required because:
Top performing funds continue to outperform while poorly performing continue

to underperform or disappear.
Performance range b/w funds ⇒ extremely large.
Liquidity ⇒ typically very limited.
Duration of investment typically shorter than maximum life of fund.
Gross IRR: measured without adjusting fee paid to GP.
Net IRR: received by LPs adjusted for fees paid.

Multiples
Measures total return to investor relative to total sum invested.

Easy to calculate.
Ignore time value of money.
Able to differentiate b/w actual proceeds & divestments as well as unrealized
portfolio subject to GP valuation.
Performance Measures

=

=

Also called cash-on-cash return.

=

presented net of management fee
= +
3.4 Private Equity Fund Valuations
Valuation generally associated with NAV

NAV = fund asset – fund liabilities.
NAV can be estimated.
At cost with subsequent adjustments (financing/deterioration)
Lower of cost or MV.
By a revaluation of the portfolio company whenever a new financing
round involving new investors takes place.
At cost without interim adjustments.
With discount (for restricted securities).
Marked to market by reference to peer group of public comparables and
applying liquidity discounts.
Insures with NAV:
NAV values based on subjective judgments.
Undrawn commitments not included in NAV.
Different valuation techniques used for different strategies.
May subject to upward bias.
May provide stale valuation ⇒ if adjusted infrequently.
3.5 Evaluating Fund Performance
IRR ⇒ annual return generated by investment.

Assumes investment is liquid, not true for significant
portion of PE funds.
Greatly affected by time.
Issues for Analysts
Apart from quantitative measures:
Analyze realized investments since inception including failures.

Analyze unrealized investments, red flags, exit time.
Cash flow forecast at portfolio company level and at aggregate portfolio.
Analysis of portfolio valuation, audited financial statements & NAV.

4. CONCEPT IN ACTION: EVALUATING A PRIVATEEQUITY FUND
A NOTE ON VALUATION OF VENTURE CAPITAL DEALS
See Appendix. Reference: Level II Curriculum, Volume 5, Reading 41.

“COMMODITITES & COMMODITY

Mkt. = Market
DERIVATIVES: AN INTRODUCTION”
Gen. = Generally
Imp. = important
Comm. = 1. INTRODUCTION • Comm. trade in physical (spot) mkts. and in futures & forwards mkts.
commodities • Key considerations include: Relation b/w spot & future prices & components of future returns.
Pmts. = payments
• Comm. have shown historically low avg. return correlation with stocks & bonds.
2. COMMODITIES OVERVIEW
• Comm. are inherently different from other asset classes.

• Value depends on their use as consumables or as inputs to the production of goods/services.
• Offer distinct set of risk exposures to investors.
2. 1 Commodity Sectors 2. 2 Lifecycle of Commodities 2.3 Valuation of

Commodities
Key lifecycle types include:

Straight-through consumption with natural gas
Input-output production lifecycle with crude oil &
Segmenting comm. gasoline, heating oils or other products.
into various Seasonal planting production with grains.
sectors. Year-round production with coffee
Features that
affect supply &
demand of each
Comm. are gen.
comm. sector
Energy Industrial / Livestock physical assets.
include:
Precious Metals Most common way to
o Comm. storage
invest in comm.is via
o Frequency/
derivatives.
timing of Steps for Energy Flexible life Fluctuations in Valuation of comm. is
consumption. Complex cycle animal availability. based on a forecast of
o Spoilage 1. Extraction (50- Large Maturity timings ↑ future prices based on
o Insurance 100 days) economies of with size e.g. factors such as supply &
o Ease of 2. Transportation scale involved o Poultry →few demand, timings, &
transportation (1-10 days) Supply & weeks storage costs etc.
on page 3
o Weather 3. Storage (days- demand o Hog →few Comm. do not generate
o Geo-political & few months) instability issue months future cash flows.
geo-economic 4. Trading (N/A) o Cattle →few yrs Some businesses use
events 5. Refining (3-5 comm. futures to hedge
days) their price risk &
6. Transportation Grains Softs uncertainty about
& trading (5-20 future comm. prices.
days)
Steps for grain • Include coffee,
production cocoa, cotton &
1) Planting sugar.
2) Growth • Coffee is
3) Pod/Ear/Head harvested
Formation somewhere all
4) Harvest around the yr.
Various Sectors of
Commodities
on next page
1
2.1.1 2.1.2 2.1.3 2.1.4 2.1.5 2.1.6

Energy Grains Industrial (Base) Metals Livestock Precious Metals Softs (Cash Crops)
Gen. have long Includes copper, Includes hogs, cattle, Unique metals Gen. cash
storage period aluminum, nickel, sheep & poultry. (gold, silver, crops.
Key Factors in zinc, lead, tin & This sector is tied to platinum etc.) Includes
food supply & iron. events in grain mkts. & Act as storage of cotton,
demand include: Used in industrial GDP per capita. values as well as coffee, sugar
o Weather production. Storage costs (keeping consumed inputs in & cocoa etc.
o Disease & Demand ∝ GDP animals alive) are tied electronics, auto Storability
pests growth. to grain prices. parts & jewelry. issue &
o Technology Can be stored in Other key factors Storability is for weather are
(genetic yrs. & are less include: ages. imp. factors.
modification, susceptible to o Weather No impact of
bio-fuel weather issues. o Diseases weather.
substitution). Demand may be o Govt.-permitted Global supply &
o Politics affected by use of drugs & demand effects
o Social stress weather & growth hormones. such as inflation
seasonal factors. o Substitute proteins expectation, funds
Other factors may o Cross-border flow, industrial
include politics, mergers & production,
environmental acquisitions. technology are
concerns etc. imp.
The most economically valuable of all the comm.

Three distinct products & value chain include the following:
Crude Oil Natural Gas Refined Products
Effectively stored Can be used directly due to vapor End-use fuels (such
underground. form. as heating oil, gas
Varied in qualities Categorized as ‘associated gas’ & oil, jet oil, propane,
Availability & ‘unassociated gas’. gasoline, bunker
affordability ‘Associated gas’ is a co-product of oil fuel).
facilitates activity. production. Have short-shelf life
Drivers of global Storage & transportation costs are ↑. Requires scheduled
demand & supply In extreme weather (colder or hotter) coordination for
include: demand ↑. adequate supplies.
technology, politics Seasonality & available supply Weather is a key
& business cycle. ∆ natural gas prices. driver.
2
3. COMMODITY FUTURES MARKET
3.1 3.2 3.3

Futures Market Spot & Futures Pricing Futures Returns
Participants
• Future • Spot Prices: Current price to

contracts are deliver a comm.
standardized • Futures Prices: Agreed on 3.3.1 3.3.2 3.3.3
as exchange price to deliver a comm. at Theories of Components Contango,
oversees future date. Futures of Futures Backwardation
trading & • Basis: diff. b/w spot & futures Returns Returns & Roll Return
margin prices.
requirements • Backwardation: when spot
• Comm. mkts. price > future price.
are net 0 in • Contango: when spot price <
terms of futures price.
aggregate • Two futures contracts can
future also be described in terms of
positions. backwardation or contango
• Following are and the price diff. is called
3.3.1.1 3.3.1.2 3.3.1.3
the no. of calendar spread.
Insurance Theory Hedging Pressure Theory of
participants in • +ve calendar spread: futures
• Proposed by Keynes. Hypothesis Storage
commodity mkts. are in backwardation.
• Also called normal • Hedging pressure occurs • The level of
future mkts. • -ve calendar spread: futures
backwardation when both producers & comm. helps
mkts. are in contango.
(theory assumes consumers hedge shapes
• Comm. futures are settled futures prices to seek comm.
futures curve is in
either as cash or physical price protection. futures price
backwardation).
delivery.
• Theory proposes • Ideally balanced curves.
• Cash settled: no value after hedging results in flat • Futures
that producers use
the maturity date. comm. curve. Price = Spot
comm. futures to
• Physical-settled comm. make their revenue • However, if one group is Price of the
futures: Title of the actual predictable by more concerned about Physical
comm. (specific quality) is locking in prices. price protection than Comm. +
transferred to the buyer by
• Such process the imbalance will Direct
the seller at a specific place & induce speculators to Storage
provides insurance
date. take on the price Costs –
to the farmer &
• Physical delivery ensures the return to the uncertainty risk. Convenience
convergence of spot & investor for • Measuring asymmetry Yield.
On next page
futures mkts. However, an providing that in hedging pressure b/w
issue of quality difference insurance. comm. buyers & sellers
may arise. is very difficult.
3.1.1 3.1.2 3.1.3 3.1.4 3.1.5

Commodity Hedgers Commodity Traders & Investors Commodity Commodity Market Commodity
• Knowledgeable 3 primary types: Exchanges Analysts Regulators
mkt. participants. i. Informed investors Found • Analysts are non- Various
• Gen. motivated by (aforementioned hedgers & throughout the mkt. participants regulatory
risk mitigation. speculators-based on info. world to meet who research on bodies
• Both long or short advantage) people’s needs info. & facilitate monitor the
positions can be ii. Liquidity providers (buy (food, energy, mkt. participants. global comm.
associated with when producers want to sell materials) from • They affect mkt. mkts.
either hedging or & sell when consumer is various parts of behavior in an
speculating. ready to buy) the world. indirect manner.
iii. Arbitrageurs (capitalize on
mispricing).
3
3.3.2
Components of Futures Returns 3.3.3
3 components of total return Contango, Backwardation & the Roll
i. Price return Return
ii. Roll Return • Contango & backwardation and the
iii. Collateral Return resulting roll return reflect

underlying supply and demand
• Price Return =

expectations and are accounting
• Roll Return = [(Near-term futures contract closing price – mechanism for commodity term
Farther-term futures contract closing price)/Near-term futures structure.
contract closing price] × % of the position in the futures
• Industrial metals, agriculture,
contract being rolled.
livestock, precious metals & softs
• Roll return is sector dependent. has statistically strong –ve mean roll
• Collateral Return is the yield (e.g. interest rate) for bonds or returns e.g. gold’s perpetual storage
cash sued to maintain investor’s future position. as an alternative to currency.
• On indexed investments cash is equal to the notional value of • Only Energy have statistical
futures and total return also includes rebalance return (return possibility of +ve mean roll return as
from rebalancing the component weights of the index) in energy is consumed in real time
addition to above three returns. basis.
4. COMMODITY SWAPS
• A legal contract involving exchange of pmts over multiple

periods of specified reference price/index of comm.
• Provides risk management, risk transfer and degree of

customization.
Swap Market Participant Structure
• Many types of swaps available because they are not
standardized e.g.
o Excess return swap-pmts. are made or received
by either party based on a return calculated by
∆ in the level of index relative to the benchmark
or fixed level.
o Total return swap-one party receives pmt.
based on the ∆ in the level of the index
multiplied by the notional amount of the swap.
o Basis swap-periodic-pmts. are exchanged based
on the values of two related comm. reference
prices that are not perfectly related.
o Variance swaps-two parties agree to
periodically exchange pmts. based on the
proportional diff. b/w agreed or proposed
variance in the comm. price levels & some fixed
variance amount established at the outset of
the contract.
o Volatility commodity swaps-very similar to
variance swaps with the exception that the Reference: CFA Institute Level II Volume 6, Reading 45, Exhibit 15.
direction & amount of pmts. are determined
relative to the observed vs. expected volatility
for a reference price comm.
4
5. COMMODITY INDEXES
Three primary roles in comm. investments: Key characteristics that differentiate indexes from each other are as
i. As a benchmark to evaluate broader follows.
moves in comm. pricing. • Breadth of coverage
ii. As an indicator to examine relation b/w • Relative weightings assigned and how the weights are determined.
comm. prices & other macroeconomic • Rolling methodology (how contracts will roll over).
variables. • Methodology & frequency for rebalancing the weights of the
iii. Act as basis to monitor ∆ that can affect individual comm., sectors & contracts in the index.
contract value. • Governance of indexes.
Five Commercially Imp. Commodity Indexes are:
5.1 5.2 5.3 5.4 5.5

S&P GSCI Bloomberg Deutsche Bank Liquid Thomson Reuters/Core Rogers International
Commodity Index Commodity Index Commodity CRB Index Commodity Index
5.6
Re-balancing Frequency
• Rebalancing is imp. if mkt is frequently mean

reverting & for indexes that rebalance more
frequently.
• In a trending mkt. frequent rebalancing can
lead to underperformance.
5.7
Commodity Index Summary
• There is no dominant index on a particular

methodology.
• Comm. indexes (like equity indexes) act in
parallel even when when their returns
frequently differ dramatically over time.
5
“THE PORTFOLIO MANAGEMENT PROCESS

AND THE INVESTMENT POLICY STATEMENT”
AUM = Assets under Management
MPT = Modern Portfolio Theory
SAA = Strategic Asset Allocation
CME = Capital Market Expectations
1. INTRODUCTION
Portfolio management process ⇒ an integrated set of steps undertaken in a

consistent way to create & maintain an appropriate portfolio to meet client’s stated
goals.
IPS ⇒ written document that clearly sets out a client’s objectives & constraints
CME ⇒ risk & return characteristics of capital market instruments (e.g. stocks &
bonds).
2. INVESTMENT MANAGEMENT
Investment management ⇒ service of professionally investing money.

Investment management firm’s size & revenue is judged by the amount of AUM.
Wealthy individuals & institutional investors are clients of investment
management firms.
Sell-side analysts ⇒ research produced by analysts employed by brokerage firms.
Buy-side analysts ⇒ analysts employed by an investment manager or institutional
investor.
3. THE PORTFOLIO PERSPECTIVE
Portfolio perspective ⇒ risk & return evaluation in the context of aggregate

portfolio rather than individual security level.
Historical roots of portfolio perspective ⇒ MPT ⇒ the analysis of rational
portfolio choices based on efficient use of risk.
4. PORTFOLIO MANAGEMENT AS A PROCESS
Portfolio management as a process ⇒ set

of activities that combine in a logical
manner to produce a desired product.
This process is dynamic & flexible.
Monitoring and rebalancing to complete
the loops of the process.

5. THE PORTFOLIO MANAGEMENT PROCESS LOGIC
5.1 The Planning Step 5.2 The Execution Step
5.1.1 Identifying & Specifying the Investor's Objectives & Constraints Portfolio selection / composition decision.
Execution step interact constantly with feedback step
(portfolio is revised as investor’s circumstances or CME ∆).
Investment objectives ⇒ desired investment outcomes (pertain to
Tactical asset allocation ⇒ responds to ∆ in short-term CME
return & risk).
rather than to investor’s circumstances.
Constraints ⇒ limitations on investor’s ability to take full or partial
Portfolio implementation decision is equally important to
advantage of particular investments.
portfolio selection decision.
5.1.2 Creating the Investment Policy Statement 5.3 The Feedback Step
Once the client has specified objectives &

5.3.1 Monitoring and Rebalancing
constraints then next task is to formulate IPS.
IPS covers objectives & constraints as well as
variety of other issues (e.g. manager fees, Use of feedback to manage ongoing
investment strategy etc.). exposure so that the client’s objectives &
Investment strategy can be indexing, active or constraints continue to be satisfied.
semi active. Investor, economic & market-related
factors are monitored.
5.1.3 Forming Capital Market Expectations

5.3.2 Performance Evaluation
Forming long-run CME that can effect risk &
return characteristics of various asset classes. Performance appraisal ⇒ evaluation of
whether or not the manager is doing the
good job.
5.1.4 Creating the Strategic Asset Allocation
Market timing ⇒ return attributable to
short-term tactical deviations from the SAA.
SAA combines the IPS & capital market
expectations to determine target asset class
weights. 5.4 A Definition of Portfolio Management
Single period (simplicity is the benefit) &
multi period (address liquidity and tax
Portfolio management is an ongoing process in which:
considerations) portfolio perspective.
Objective & constraints are identified & strategies are developed.
Portfolio composition is decided & portfolio decisions are initiated.
Portfolio performance measurement.
The Portfolio Construction Monitoring & Revision Process Investors & market conditions are monitored.
Rebalancing.
Specification and quantification of investor’s
objectives, constraints, and preferences
Monitoring investor-
related input factors
Portfolio policies and
strategies
Portfolio construction and revision Attainment of investor objectives
Asset allocation, portfolio optimization,
security selection, implementation, and Performance measurement
Capital market expectations execution
Monitoring economic and market input factors

Relevant economic, social, political
and sector considerations

6. INVESTMENT OBJECTIVES AND CONSTRAINTS
6. Objectives
6.1.1 Risk Objective 6.1.2 Return Objective
Risk can be measured in absolute terms or in relative Total return = Price appreciation + investment income.
terms. Return objective may be absolute or relative to
Examples of absolute risk objectives are SD & variance benchmark.
while relative risk objective is a specified level of tracking Desired return must be evaluated in the light of investor’s
risk (SD of difference b/w portfolio’s & benchmark’s total ability to assume risk.
returns). Required returns are more stringent than desired return.
Value at risk ⇒ probability based measure of the loss that
one anticipates, will be exceeded only a specified small
fraction of the time over a given horizon.
Investor’s willingness to take risk depends on behavioral &
personality factors.
Financial & practical limitations often limit the amount of
risk that can prudently be assumed.
If mismatch exists b/w ability & willingness to take risk,
client education is required.
TABLE 1 Risk Tolerance

Ability to Take Risk
Willingness to Take Risk Below Average Above Average
Below Average Below-average risk tolerance Resolution needed
Above Average Resolution needed Above-average risk tolerance
TABLE 2 Return Requirements and Risk Tolerances of Various Investors

Type of Investor Return Requirement Risk Tolerance
Individual Depends on stage of life, circumstances, and Varies
obligations
Pension Plans The return that will adequately fund Depends on plan and sponsor
(Defined Benefit) liabilities on an inflation adjusted basis characteristics, plan features,
funding status, and workforce
characteristics
Pension Plans Depends on stage of life Varies with the risk tolerance
(Defined of individual participants of individual participants
Contribution)
Foundations and The return that will cover annual spending, Determined by amount of
Endowments investment expenses, and expected inflation assets relative to needs, but
generally above average or
average
Life Insurance Determined by rates used to Below average due to factors
Companies determine policyholder reserves such as
regulatory constraints
Non-Life Insurance Determined by the need to price policies Below average due to factors
Companies competitively and by financial needs such as regulatory constraints
Banks Determined by cost of funds Varies

6.2 Constraints
6.2.1 Liquidity 6.2.2 Time Horizon
Need for cash in excess of new contributions or savings. Time period associated with an investment objective.
Liquidity risk ⇒ economic loss from the sale of illiquid Time horizon may be short term, medium term or long
asset to meet liquidity needs. term.
Assets with price risk are liquid, especially during Multistage horizon ⇒ combination of shorter & longer
market downturns. term time horizon.
Time horizon, risk the investor can take.
6.2.3 Tax Concerns 6.2.4 Legal and Regulatory Factors
Tax is a concern for taxable investors. External factors imposed by govt, regulatory or oversight
Tax policies ∆ that affect security prices, affect both authorities to constrain investment decision making.
taxable & tax-exempt investors. More strict constraints for institutional investors rather
individual investors.
6.2.5 Unique Circumstances
Internal factors that may constrain portfolio choices.

Examples include:
Avoid investments against which there may be
ethical or social consideration.
Avoidance of non-domestic shares.
7. THE DYNAMICS OF THE PROCESS
Work of portfolio management ⇒ taking the inputs & moving step by step to convert
this raw material into a portfolio to meet investor’s objectives & constraints.
Portfolio management is a continuous process once put into motion.
8. THE FUTURE OF PORTFOLIO MANAGEMENT
During last few decades, portfolio management has become a more science-based discipline.
Most significant market development ⇒ emergence of a broad range of new standardized derivative contracts.
9. THE ETHICAL RESPONSIBILITIES OF PORTFOLIO MANAGERS
Portfolio manager must keep in mind that he/she is in a position of trust that requires ethical conduct.
During management of investment portfolios, ethical conduct is the foundation requirement.

“AN INTRODUCTION TO MULTIFACTOR MODELS”
1. INTRODUCTION
Factor ⇒ variable or characteristic with which individual asset returns are

correlated.
Multifactor models offer increased explanatory power & flexibility when
compared with single factor model.
Comparative strength of multifactor models:
Build portfolios that replicate or modify in a desired way.
Establish desired exposures to one or more risk factors.
Preform granular risk & return attribution on actively managed portfolio.
Identify active decision relative to benchmark.
2. MULTIFACTOR MODELS AND MODERN PORTFOLIO THEORY
Modern portfolio theory (MPT) ⇒ it considers each investment in context of

portfolio rather than in isolation. (Mean return, mean variance & correlations).
Key insight ⇒ correlation of <1offers the potential for risk reduction by
means of diversification.
Capital asset pricing model (CAPM) ⇒ model for the expected return of assets
in equilibrium based on a mean-variance foundation.
Investor would expect compensation for bearing an asset’s non-
diversifiable risk/systematic risk.
3. ARBITRAGE PRICING THEORY
Arbitrage pricing theory (APT) ⇒ a framework that explains the expected return of an asset (portfolio) in equilibrium as
a linear function of the risk of the asset (portfolio) with respect to a set of factors capturing systematic risk.
R = a + b , l + bil + ____ + bi l + E
where
= return of asset
= an intercept term
= return of factor K
= sensitivity of the return to the return of factor k.
E = error term
APT makes less strong assumptions than CAPM as under:
A factor model describes asset returns.
Investor can eliminate unsystematic risk through diversification.
No arbitrage opportunities.
Carhart four factor model ⇒ also include “momentum factor” in addition to three factors of Fama & French as under:
− = + +
+ +
+
Where
− = Return of portfolio – risk free return.
= Alpha
RMRF = return on a value weighted index in excess of the one month T-bill rate.
SMB = Small minus big (size factor).
HML = High minus low book to market portfolios.
WML = winner minus losers (momentum factor).

4. MULTIFACTOR MODELS: TYPES
4.1 Factors and Types of Multifactor Models
Macro-Economic Factors Model Fundamental Factors Model
Factors are surprises in macroeconomic These factors are attributes of stocks or

variables that significantly explain returns. companies that are important in explaining
These factors include interest rate, inflation cross sectional differences in stock prices
risk, business cycle risk & credit spreads etc. e.g. P/E ratio, financial leverage etc.
Statistical Factor Model
Statistical methods are applied to historical returns of a

group of securities to extract factors that can explain the
observed return of securities in the group.
Advantage ⇒ model makes minimal assumptions
Disadvantage ⇒ interpretation of model is difficult.
4.2 The Structure of Macroeconomic Factor Models
According to macroeconomic factor models, return to each asset are correlated with solely to the surprises in some
factors related to the aggregate economy.
Surprise ⇒ actual value – predicted value.
R = a + b F + bF + ⋯ + b F + ε
R = return on asset i
a = expected return to asset i
b = sensitivity of the return on asset i to a surprise in factor K
F = surprise in factor K
ε = Error term
Exhibit 5. Growth and Inflation Factor Matrix
Inflation
Low Inflation/Low Growth High Inflation/Low Growth
• Cash • Inflation-linked bonds

• Government bonds • Commodities
• Infrastructure
Growth
Low Inflation/High Growth High Inflation/High Growth
• Equity • Real assets (real estate,

• Corporate debt timberland, farmland, energy)
Reference: Level II Curriculum

4.3 The Structure of Fundamental Factor Models
In fundamental factor model, factors are stated as “returns” rather than return “surprises” in relation to predicted values
(expected value≠ 0).
Factor sensitivities ⇒ these are attributes of the security which are expressed using a standardized beta.
.
Standardized beta =
( )
Analyst use fundamental factor models for a variety of purposes including portfolio performance attribution & risk
analysis.
Factors of model can divide into these groups.
Company fundamental factors ⇒ related to company’s internal performance.
Company share-related factors ⇒ these include valuation measure & other factors related to share price or other
trading characteristic of shares.
Macroeconomic factor ⇒ these include sector or industry membership factors.
5. MULTIFACTOR MODELS: SELECTED APPLICATIONS
5.1 Factor Models in Return Attribution
Multifactor models explain the source of a manger’s active return.

Active return = R − R
Component of active return
Factors tilt ⇒ over or underweight weights relatives to the benchmark factor sensitivities.
Security selection ⇒ ability to overweight securities that outperform the benchmark or that underperform the
benchmark.
Active return = ∑Portfolio sensitivity − Benchmark sensitivity × factor return + security seleciton.
5.2 Factor Models in Risk Attribution
Active risk ⇒ standard deviation of active returns (tracking error) stated as sR − R
౦ ా
Information ratio = IR =
!౦ ా"
In addition to focusing on active risk, these models can also be used for sourcing of total risk.
Fundamental factor models can be used to relate active risk exposures to a manager’s portfolio decisions in a fairly direct
& intuitive way
Active risk squared = s R − R or active factor risk + active specific risk.
Two components
Active factors risk ⇒ contribution to active risk resulting from the portfolio’s different-from-benchmark
exposures relative to factors specified in the risk model.
Active specific or security selection risk ⇒ risk arises due to security selection (non-factor or residual risk).
5.3 Factor Models in Portfolio Construction
Multi factor models permit the portfolio manager to make focused bets or control portfolio risk relative to benchmark
risk.
Passive management ⇒ analysts can use multifactor models to replicate an index fund’s factor exposures, mirroring
those of the index tracked.
Active management ⇒ many investment managers rely on multifactor models in predicting alpha as part of a variety of
active investment strategies (also used to establish desired risk profiles).
Rule-based active management ⇒ these strategies rely heavily on factor models to introduce international factors & style
biases v/s cap-weighted indexes (factors include size, value, quality or momentum etc.)
Factor replication portfolio can be built based either on an existing target portfolio or on a set of desired exposures.

5.4 How Factor Considerations Can Be Useful in Strategic Portfolio Decisions
Investor s should be aware of which priced risks they face &analyze the
extent of their exposure.
Multi factor approach can help investors achieve better diversified &
possibly more efficient portfolios.

“MEASURING & MANAGING MARKET RISK”

Mkt = Market
Gen. = Generally 1. INTRODUCTION Mkt. Risk →arises from ∆ in mkts to which the organization has exposure.
Std. = Standard Managing mkt risk relies heavily on the use of models.
Dev. = Deviation Effective risk mgmt. requires blending historical data with forward-looking
Expc. = Expected judgment while using models.
Dist. = Distribution
Obs. = Observations
FI = Fixed income 2. UNDERSTANDING VALUE AT RISK (VAR)
D = Duration
C = Convexity
2. 1 VaR Formal 2. 2 Estimating 2. 3 Advantages & 2.4 Extensions of VaR

Definition VaR Limitations of VaR
Min. loss that would be 1st Step: Conditional VaR (CVaR):

expected a certain % of Risk Decomposition • Avg. loss conditional on exceeding the VaR cutoff.
time over a certain 2nd Step: • How much is expected to lose if VaR exceeded.
period. Gather data history for
3 elements of VaR each risk factors. • Also known as expected tail loss or expected
statement: the frequency 3rd Step: shortfall.
of losses of a given min. Use data to make VaR • CVaR is best derived using the historical simulation
magnitude expressed in estimation. or Monte Carlo simulation.
either currency or % Incremental VaR (iVaR):
terms
• How the VaR will ∆ if the portfolio allocation will ∆.
E.g. 5% VaR of a portfolio
is $1 million over a 1-day. • IVaR is the diff. b/w new VaR & old VaR.
• Reflects the impact of anticipated ∆in portfolio.
Marginal VaR (MVaR):
• Uses formulas derived from calculus to reflect the
3 methods to calculate VaR impact of very small ∆ in the portfolio.
(step 1 & 2 are same in each method) Ex-ante Tracking Error (relative VaR):
• Measures portfolio’s performance deviation from its
benchmark.
• Computed using standard VaR models to a portfolio
with (portfolio holdings – benchmark holdings).
• Ex-ante tracking error will be 0 if portfolio perfectly
matches benchmark.
2.3.1 2.3.2
Advantages of VaR Limitations of VaR
Simple concept Subjectivity

Easily communicated concept-considerable Underestimating the frequency of extreme events.
…continue
amount of info. into a single no. Failure to take into account liquidity.
Provides a basis for risk comparison. Sensitivity to correlation risk.
Facilitates capital allocation decisions. Vulnerability to trending or volatility regimes.
Can be used for performance evaluation. Misunderstanding the meaning of VaR – taken VaR
Reliability can be verified (through backtesting). for worst case scenario
Widely accepted by regulators. Oversimplification
Disregard for right-tail events.
1
2.2.1 2.2.2 2.2.3

The Parametric Method The Historical Simulation The Monte Carlo
of VaR Estimation Method of VaR Estimation Simulation Method of VaR
Estimation
Gen. assumes normal return Reprices the current portfolio using Requires the specification of
distribution (requires only 2 actual historical ∆ during the statistical dist. of return & the
parameters expc. return & std. dev. lookback period. generation of random outcomes
For non-normal distribution Portfolio returns are arrayed lowest from that dist.
additional parameters can be used. to highest. Extremely flexible but can be
ோିఓ Limitation: All obs. are wghtd. complex & time consuming.
Std. Normal Dist. (z-dist.)=
ఙ equally & can be resolved by using E.g. a 5% VaR will be the 5th
Below the expected value:
weighting methodology (↑ wght. to percentile of simulated values.
1% VaR is 2.33 std. dev. away
recent obs. & ↓ weight. to distant Can accommodate virtually any
5% VaR is 1.65 std. dev. away.
obs.) dist.
16% VaR is 1 std. dev. away
Calculated VaR is based on actual Capable of handling the adj. of
How a 5% VaR is obtained?
values e.g. 5% VaR will be the 5th time horizon (extrapolate daily
− 1.65 (−1)Portfolio percentile of the historical values. data to annual data to calculate
Value Weakness: Past may not repeat. annual VaR).
Simple & straightforward method Suitable when lookback period Can be used when portfolio
Easy to use historical data due to returns are expected to be contain options.
normal dist. assumption. representative of future.
VaR is very sensitive to parameter Capable of handling the adj. of time
estimates horizon (extrapolate daily data to
Suitable when normal dist. can be annual data to calculate annual
applied & parameters are reliable. VaR).
Difficult to use when portfolio Can be used when portfolio contain
contain options. options.
Limitation: All obs. are wghtd.
equally.
2
3. Other Risk Measures-Sensitivity & Scenario Measures
3.1 3.2 Scenario Risk Measures 3.3 Sensitivity & Scenario

Sensitivity Risk Measures • Portfolio return estimations resulted from hypothetical Risk Measures & VaR
∆ in performance by ∆ing ∆in mkts or repeat of an historical event. • VaR→measures losses & prob. of
single risk factor. • 2 factors differentiate it from sensitivity measure: larger losses
i. use of multiple factor movements. • Sensitivity →measures ∆in asset
ii. larger size of factor movement value due to ∆ in some other
• Stress tests: assess the impacts of extreme –ve events. factors.
• VaR gives broader picture of the
risk.
• Both VaR & scenario risk measure
estimate potential loss.
3.2.1 3.2.2
Historical Scenarios Hypothetical Scenarios
• Measure the portfolio return that • Model the impact of extreme 3.3.1
would result from the repeat of a movements & co-movements Advantages & Limitations of Sensitivity
specific historical financial mkt in different mkts that have Risk Measures & Scenario Risk
event. not previously occurred. Measures
• Equities can be modeled using their • For effective results: identify Scenario & Sensitivity measures can
price histories or factor analysis. the portfolio’s most compliment VaR in the following ways:
• For FI & derivatives, valuation significant exposures. 1) They don’t need to rely on history.
models are needed. • Reverse stress testing: 2) Scenarios can be designed to
• As historical events exhibit Targeting the material • overcome normal dist.
abnormally ↑ correlation among exposures & assessing their assumptions.
asset classes thus run tests as price behavior in various • expose portfolio’s most
∆ occurs instantly. environments. concentrated position.
• One variation includes running the • Helpful in handling stress Scenario’s limitations are as follows:
scenario over multiple days. parameters. 1) Historical scenarios may not
However, it can produce smaller • Can assess –ve surprise in a necessarily repeat.
potential loss measure. given stress event. 2) Hypothetical scenarios:
• Not suitable for handling options/ • may incorrectly specify asset’s
option-embedded securities. co-movement.
• Need to sensibly model mkts. or • can be difficult to create &
securities, that didn’t exist at the maintain.
historical event. 3) It is difficult to establish appropriate
limits on scenario analysis or stress
test.
3.1.1 3.1.2 3.1.3

Equity Exposure Measures Fixed Income Exposure Measures Options Risk Measures
• is the primary equity • Primary FI exposure measures: • Options’ behavior is non-linear.
∆
exposure measure. Duration & Convexity (to assess • Delta =
∆
• E(Ri) = RF + βi[E(RM) – RF] potential losses or position for
• Call option deltas range = 0 to 1
• Expected stock return’s given ∆in i-rates).
• Put option deltas range 0 to -1
sensitivity to the equity risk • D is approx. measure of ∆
premium. sensitivity of bond piece to the i- • Gemma =
∆
• Broad mkt. = 1 rate ∆. • Vega =
∆
∆ ∆ ∆
• = − • Delta & vega are 1st order effect

• Further incorporate C, to while gemma is 2nd order effect.
accommodate longer periods & • Option measures are applicable
larger yield ∆. to options & portfolios that
∆ ∆ ∆ మ contain options.
• = − +
మ

3
4. Applications of Risk Measures
4.1
Market Participants & The Different Risk Measures They Used
3 factors influence the risk measures used by

mkt. participants
i. Mkt. participant’s leverage ratio
ii. Business’s exposure to risk factors
(equity/FI concentration).
iii. Accounting or regulatory requirements.
4.1.1 Banks 4.1.2 Asset Managers 4.1.3 Pension Funds 4.1.4 Insurers
Factors banks seek to address • Commonly regulated for fair (defined benefit plans) The mkt. risk managing measures
through their use of risk tools. treatment of investors. Main focus Important mkt. risk in property & casualty line of
• Liquidity Gap is on volatility, probability of loss, measures for pension plans business include:
• VaR underperforming the benchmark include: • Sensitivities & exposures
• Leverage etc. • Interest rate & curve • Economic capital & VaR
• Sensitivities • Each portfolio has its own risk • Scenario Analysis
• Economic Capital constraints & limits. • Surplus at risk
• Scenario Analysis • Portfolio returns can be measured • Glide path For life portfolios, mkt. risk
using backward-looking returns or • Liability hedging measures include the following:
using current portfolio to measure exposure versus return • Sensitivities
potential losses. generating exposure. • Asset & liability matching
• Scenario Analysis
4.1.2.1 Traditional Asset Managers: 4.1.2.2 Hedge Funds:

A typical sample of risk measures A typical sample of risk
used by asset managers are: measures used by hedge fund
• Position limits managers are:
• Sensitivities • Sensitivity
• Beta sensitivity • Gross exposure
• Liquidity • Leverage
• Scenario analysis • VaR
• Active share • Scenarios
• Redemption risk • Drawdown
• Ex post versus ex ante tracking
error
• VaR
4
5. Using Constraints In Market Risk Management
5.1 5.2 5.3 5.4 5.5

Risk Budgeting Position Limits Scenario Limits Stop Loss Limits Risk Management &
Capital Allocation
• Total agreed on • Limits on the mkt. • Limit on the • Requires a reduction in • Allocating capital wisely
risk appetite of a value of any given estimated loss size or complete • Capital allocation may
firm or portfolio investment or notional for given liquidation when a loss start with the
& then allocated principle for a scenario. of a particular size measurement of
to sub-activities. derivative contract. • Scenario occurs in a specified economic capital i.e.
• Risk budgeting • Address event risk and analysis without period. establishing overall risk
typically rest on single named risk such related action • A more dynamic & appetite and then
the foundations as: steps are not sophisticated subdivide this appetite
of VaR or ex ante i. Limits per issuer very helpful. alternative approach is among its units.
tracking error. ii. Limits per Drawdown Control
currency/country (Portfolio Insurance) →
iii. Limits on purchasing protective
categories options after losses of a
expected to be given magnitude.
minimized.
iv. Limits on gross
sized long-short
positions or
derivative
activities.
v. Limits on asset
ownership that
corresponds to
mkt. liquidity
measures.
5
“ECONOMICS AND INVESTMENT MARKETS”
2. FRAMEWORK FOR THE ECONOMIC ANALYSIS OF FINANCIAL MARKETS
2.1The Present Value Model
A given amount of money received in the future will be valued less today
because of sacrifice of present consumption (present value concept).
Present value equation:
~౟
౪
P = ∑

౪శ౩
౩

౪,౩
౪,౩
౪,౩
౟
Factor that typically distinguishes one financial asset class from another is the
degree of certainty that investor have about future cash flows.
1st component of discount rate in equation 1 is less which represents real return
on default free fixed income security.
2nd component in DR Q, is for inflation adjustments.

3rd component P, is to compensate other types of risks, including default risk &
liquidity risk.
2.2 Expectations and Asset Values
Information that changes expectations affects asset values & realized return.
Holding period returns may differ from expected return because of the
difference b/w actual news & expected information.
Prices may fall (rise) despite good (bad) news if expectation was for better
(worse) news.
3. THE DISCOUNT RATE ON REAL DEFAULT-FREE BONDS
An investor defers some current consumption in order to buy a financial asset.

Price of financial assets is impacted by individual’s saving & consumption
decision.
3.1 Real Default-Free Interest Rates
For a default free (unaffected by inflation) bond, investor require opportunity

cost of not consuming today.
Inter-temporal rate of substitution ⇒ ratio of marginal utility of consumption
“S” period in the future to the marginal utility of consumption today.
If the price of the bond is too low for an individual investor, he would have a
higher inter-temporal rate of substitution and vice versa in case of higher bond
prices.
Higher the return the investor can earn, the more important current
consumption becomes relative to future consumption.

3.1.1 Uncertainty and Risk Premiums
As an investor’s income or wealth increases, his absolute risk aversion is

assumed to fall.
Wealthier & poorer investors would have the same willingness to invest in risky
assets when financial markets are in equilibrium.
3.1.2 Risk Premiums on Risky Assets
Price of risky bond is established relative to the price of default-free bond.

Future price uncertainty creates a discount for risk.
During bad economic times inter-temporal rate of substitution is high (smaller
income higher marginal utility of future consumption).
Most risky assets have returns that tend to be high (low) during good (bad)
times when the marginal value of consumption is low (high).
If an asset has high return with high marginal utility of consumption ⇒ asset
would provide a hedge against bad times.
3.2 Default-Free Interest Rates and Economic Growth
An increase in real GDP growth should lead to an increase in the real default
free rate of interest (more goods & services will be available in the future
relative to today).
Process ⇒ higher real GDP ⇒ lower willingness to substitute ⇒ less savings ⇒
more borrowings ⇒ higher real rates.
Other things being equal, an economy with higher real GDP growth should
have higher real risk free rates.
Real interest rates are higher in an economy with more volatile GDP
growth (other things being equal).
3.3 Real Default-Free Interest Rates and the Business Cycle
GDP growth is not perfectly predictable.

Willingness of investor to substitute future wealth for current consumption is
inversely related to changes in real GDP growth.
3.3.1 Economic Growth and Real Yields
Inflation-linked bonds ⇒ bonds that pay real return plus a return that is linked
directly to an index of consumer prices.
Real yields on inflation indexed bonds to be higher for those countries with high
growth.
Imperial study unveils very unclear pattern b/w historical economic growth, the
volatility in that growth & short term real yields.
3.3.2 Real Default-Free Interest Rate
Real risk free rate has a close connection with the business cycle which has a
related connection with the savings.

4. THE YIELD CURVE AND THE BUSINESS CYCLE
4.1 Short-Term Nominal Interest Rates and the Business Cycle
T-bills are very short dated govt. securities to help smooth the cash flow needs
of the govt.
T-bills yields are very closely related to the central bank’s policy rate.
4.2 Treasury Bill Rates and the Business Cycle
Nominal interest rate = real interest rate + inflation.

Nominal interest rates are positively related to real interest rate, inflation &
growth volatility.
Taylor rule is used for setting policy rate;
pr = l + l 0.5l + l∗ + 0.5Y − Y∗
where pr = policy rate l = level of short term real interest rate = rate of
inflation l∗ target rate of inflation Y & Y∗ = actual and potential real GDP
respectively.
Difference b/w Y & Y∗ is “output gap”. If this gap is positive it indicates that
economy is producing beyond its sustainable capacity.
Neutral policy rate is when actual inflation is equal to targeted & output gap is
zero.
4.3 Short-Term Interest Rate Summary
Short term risk free rate ⇒ influenced by inflation ⇒ by real economic activity
⇒ by policy rate.
4.4 Conventional Government Bonds
4.4.1 Break-even Inflation Rates
Investment in T-bill is a good hedge against possible bad consumption

outcomes.
Break-even inflation rate ⇒ yield difference b/w risk–free nominal bond (zero
coupons) & zero coupon risk free real bond of same maturity.
Break-even inflation rates provide an independent view about future inflation &
include a risk premium of future inflation uncertainty.
4.5 The Default-Free Yield Curve and the Business Cycle
Maturities of bond have an impact on the way that investors price it.
Historical analysis reveals that there are no risk premium embedded in
investor’s return expectation & risk premium regarding inflation is constant over
time.
4.5.1 The Slope of the Yield Curve and Investor Expectations
Govt. yield curve ⇒ expected in short term interest rates might be

connected to expect future inflation & maturity structure of inflation risk
premium.
Variation in central bank’s policy rate can influence the shape of yield curve.

4.5.2 The Term Spread and the Business Cycle
Recession is often preceded by a flattening, or even an inversion in the yield

curve.
Later stage of business expansion is often characterized by peak in inflation &
higher short term interest rates.
4.5.3 Evidence on Risk Premiums for Default-Free Bonds
Investors prefer investment that paid off more in bad times as compared to
those that paid less in these times. Resultantly, during bad times their expected
return goes down & prices goes up.
Historical studies imply that bond risk premium vary over time.
4.5.4 Other Factors
Yield curves can also influenced by:

Trade balances of the countries.
Regulatory factors.
Demand & supply considerations.
5. CREDIT PREMIUMS AND THE BUSINESS CYCLE
Credit premium ⇒ premium demanded by bondholders given the non-zero

probability that the issuer may default on its obligation.
Recovery rate ⇒ the amount that the bondholders will receive in the event of
default.
5.1 Credit Spreads and the Credit Risk Premium
Credit spread ⇒ diff. b/w yield on a corporate bond & that on a govt. bond
(same currency, same maturity).
Credit premium tend to rise in times of economic weakness.
Expected loss = probability of default × (1-Recovery rate).
Even in a well-diversified portfolio, investor’s continue to be exposed to
considerable market risk because defaults tend to cluster around downturns in
the business cycle.
Three types of corporate bonds.
Senior secured (secured by lien or claim against assets).
Senior unsecured (no claim on company’s assets).
Subordinated debt (inferior claim on company’s assets as compared to
senior debt holders).
5.2 Industrial Sectors and Credit Quality
Spreads b/w corporate bond sectors with different ratings vary and have very
different sensitivities to the business cycle.
Lower rated corporate bonds will tend to outperform higher rated bonds when
spreads corporate bonds are narrowing relative to corporate bonds & vice versa
in case of spread widens.

5.3 Company-Specific Factors
When spread widen, the spread on bonds issued by corporations with a low
credit rating will tend to widen the most.
Company specific factors also play a part in determining the difference in the
yield of an individual corporate issuer & that of govt. bond with same maturity.
5.4 Sovereign Credit Risk
Sovereign risk premium ⇒ diff. b/w yields on bonds issued by government of

emerging market & that of US treasuries.
5.5 Credit Premium Summary
6. EQUITIES AND THE EQUITY RISK PREMIUM
Equity security is a financial instrument in which both the size & timing of cash
flows are uncertain.
Equity risk premium is higher as compared to risk premium of corporate bond
given the inferior claim of equity investors as compared to bond investors.
6.1 Equities and Bad Consumption Outcomes
Investors demand equity risk premium if consumption hedging properties of

equities are poor (equities tend not to pay off in bad times).
Equity risk premium is usually positive & quite large in bad times.
6.2 Earnings Growth and the Economic Cycle
Earnings growth slowdown during period of recession & improved at the end of
period of recession.
According to some analysts, corporate profitability to be an important leading
indicator of business cycle.
A rise in the earnings of cyclical companies after a period of decline is an
indicator of economic growth in the future.
6.3 How Big is the Equity Risk Premium?
On ex-ante basis, it is impossible to quantify the equity risk premium.

Historical data reveals that equities outperformed govt. bonds.
6.4 Valuation Multiples
Equity analyst used valuation multiples to compare equities within & among sectors.
Price to earing (P/E) ratio = this ratio tells the investors about the price they are
paying for the shares as a multiple of the company’s earnings per share.
When last year’s (current year’s) earnings are used in ratio calculation, the ratio is
called trailing (leading) P/E.
Price to book (P/B) ratio = it measures the ratio of the company’s shares price to its
net assets.
The ratio tells investors the extent to which the value of their shares is covered by
the company’s net assets.

6.5 Investment Strategy
Growth stock tends to trade at very high P/E & at very low dividend yield.
Value stocks trade in more mature markets with low prospects of substantial
earnings growth (low P/E higher D/Y).
Company size (small cap, mid cap, large cap) is another consideration for equity
investors.
Usually small cap stocks contains high equity premium relative to large-
cap.
7. COMMERCIAL REAL ESTATE
7.1 Regular Cash Flow from Commercial Real Estate Investments
Investment in commercial real estate generates cash flows in the form of rents.
Rental growth is usually associated with CPI growth.
Credit quality of a commercial property portfolio will be determined by the
credit quality of the underlying tenants.
7.1.1 The Equity Component of an Investment in Commercial Real Estate
Value of property will arguably determined by two factors:

Property’s location.
State of the underlying economy.
Cash flows from a commercial real estate portfolio have features of bond as well
as equity investment.
7.1.2. Illiquidity and Investment in Commercial Real Estate
Investment in commercial real estate is usually considered as “illiquid” due to

difficulty in selling the same.
7.2 The Pricing Formula for Commercial Real Estate
~౟
౪
P = ∑

౪శ౩
౩

౪,౩
౪,౩
౪,౩
౪,౩
౟
౟
∅౟
౪,౩ ౪,౩
~
E CF = Expected CFs from commercial real estate.

1 + l, = inflation indexation (govt. tenant).
1 + l, + θ, + π, = fixed nominal rental income (govt. tenant).
1 + l, + θ, + π, + γ, = nominal rental income (corporate tenant).
Further, risk premium for terminal value uncertainty & illiquidity is also added.
7.3 Commercial Real Estate and the Business Cycle
Nominal rental income appears to be relatively stable & immune to business

cycle while property capital values are much more sensitive to the economic
cycle.
Investor generally demands a high risk premium due to pro-cyclical nature of
commercial property prices.
Property risk premium vary over time with economic conditions & positively
correlated with risk premiums on corporate bonds & equities.

“ANALYSIS OF ACTIVE PORTFOLIO MANAGEMENT”
2. ACTIVE MANAGEMENT AND VALUE ADDED
Objective of active management ⇒ to add value in the investment process by

doing better than a benchmark portfolio.
If the investor outperforms (underperforms) the benchmarks, the value added is
positive (negative).
2.1 Choice of Benchmark
Qualities of a good benchmark:

Benchmark should representative of the assets from which investor will
make selection.
Benchmark portfolio can actually be replicated at low cost.
Benchmark weights are verifiable ex-ante, & return data are timely ex-
post.
Most common market indices are capitalization based with features of self-
rebalancing & simultaneously held by many investors.
Float adjusted market cap weights ⇒ improved from of market weight index as
it only consider securities available for general public investing.
Return on benchmark portfolio, R , return to the individual securities, R , & the
weight of each security in the portfolio W, as under
R = ∑ W, R
2.2 Measuring Value Added
Value added return = Return of portfolio – return on benchmark.

Risk adjusted return ⇒ return of portfolio after incorporating portfolio’s risk
relative to benchmark.
2.3 Decomposition of Value Added
Decomposition include:
⇒ Value addition through asset allocation (different weights to asset classes).
⇒ Value addition through security selection (security weights differ while
overall asset class weight will remain same).
3. COMPARING RISK AND RETURN
Risk – return trade-off can be represented in either absolute or relative terms.

Sharpe ratio (SR) provides an absolute reward to risk measure.
Information ratio (IR) provides a benchmark relative reward to risk measure.

3.1 The Sharpe Ratio
SR ⇒ A measure of how much the investor is receiving in excess of a risk less

rate for assuming the risk of the portfolio:
౦ ూ
SR =

౦
SR can be used as ex-ante measure or ex-post measure of risk & return.
SR ratio is unaffected by the addition of cash or leverage in a portfolio.
3.2 The Information Ratio
IR ⇒ it compares the active return from a portfolio relative to a benchmark with

the volatility of active return (active risk).
IR measures the consistency of active return.
౦ ా
IR =

౦ా
IR can be used as ex-post or ex-ante measure.
Distinction b/w SR & IR:
For a “closed-end index fund” SR is close to the benchmark while the IR of
the same fund will be closest to zero.
Unlike SR, the IR is affected by addition of cash or the use of leverage.
3.3 Constructing Optimal Portfolios
The potential improvement in an active portfolio’s expected SR compared with

the benchmark’s SR is a function of the squared IR.
Ex-ante IR is the single best criterion for constructing an actively managed
portfolio.
Ex-post IR is the best criterion for evaluating the past performance of actively
managed funds.
4. THE FUNDAMENTAL LAW OF ACTIVE MANAGEMENT
4.1 Active Security Returns
R = R − R
R = Return on asset i
R = Return on benchmark
R = Active return on asset A

Exhibit 6. The Correlation Triangle
Forecasted Active Returns
Single Quality:
Portfolio Construction: Information
Transfer Coefficient Coefficient
Active weights Realized Active Returns

Value Added
Reference: curriculum Level II
Investor with higher ability to forecast returns (higher information coefficient) will add more value over
time to the portfolio.
Another important fundamental law parameter is “breadth” which is equal to the number of
independent decisions made by investor per year in constructing the portfolio.
Breadth can be higher than the number of securities if factors in the risk model suggest that their
active returns are negatively correlated & vice versa.
4.2 The Basic Fundamental Law
Expected active portfolio return is the sum product of active security weights & forecasted
active security return as under:
= ∑ ∆
Optimal expected active return ∗ is the product of information coefficient (IC), the
square route of breadth (BR) & portfolio active risk
∗ =
ಲ
Information ratio of unconstrained optimal portfolio is
∗ =
√
4.3 The Full Fundamental Law
Full fundamental law is as under:

=
ಲ
where
TC = Transfer coefficient

4.4 Ex Post Performance Measurement
Actual performance is measured by the relationship b/w relative weights & relative returns.
|
=
ಲ
Any difference b/w the actual active return of the portfolio & the conditional expected active
return can be represented with a noise term as:
= |
+
First part ⇒ expected value added given the realized skill of the investor.
2nd part ⇒ it represents any noise that results from constraints that impinge on optimal
portfolio structure.
5. APPLICATIONS OF THE FUNDAMENTAL LAW
EXAMPLE
6. PRACTICAL LIMITATIONS
Limitation of the fundamental law.

Practical consideration ⇒ e.g. transaction costs &
taxes.
Conceptual issues ⇒ e.g. dynamic implementation
over time.
6.1 Ex Ante Measurement of Skill
Core element of fundamental law⇒ information coefficient

⇒ correlation b/w portfolio investor’s forecasts & actual
outcomes.
Forecasting ability probably differs among different asset
segments & varies over time.
The higher the uncertainty about forecasting ability, the
smaller the expected value added is likely to be.
6.2 Independence of Investment Decisions
Breadth can increase well beyond the number of securities

when fundamental law concepts are applied to hedging
strategies using derivative or other forms of arbitrage.
When the decisions are not completely independent breath
is lower than number of assets.

“Algorithmic Trading & High-Frequency Trading”

Algos. = Algorithms
HF = high frequency 1. INTRODUCTION Algorithms can process millions of pieces of data per second, make sub
millisecond decisions & take autonomous actions.
About 75% of the U.S. stocks are placed by computer algos.
Algos. are used in different asset classes such as equities, bonds, futures, FX etc.
2. THE BASICS OF ALGORITHMIC TRADING
Algorithmic Trading→Using a computer to automate a trading strategy.

There are following two types of trading algorithms.
2. 1 Execution Algorithms 2.2 High Frequency Trading Algorithms (HFT)
Execution Algos: break down large orders & • Constantly monitor real time market data & look for patterns
execute them over a period of time and to to trade on.
achieve the benchmarked price. • HFTs are about profit.
Goal is to minimize the impact of large
• HFT track streams of data directly from trading venues.
orders.
Examples include: • Streams may be in the form of Quote events, Trade events or
i. Volume weighted average price News events
(VWAP) • HFT algos. are about ‘How to trade and when to trade and
ii. Implementation shortfall even sometimes what to trade’.
iii. Market participation algos.
• Statistical Arbitrage (stat arb) algos: Detect breaks in
Parent order: All the info. provided by the
participant (instrument, order, quantity, statistically correlated instruments for trading opportunities.
algo. etc.). • Types of HFT algos for stat arb trading:
Child Order: A subset of total order. i. Pairs trading
Execution algos are about automating ii. Index arbitrage.
‘How to trade’. iii. Basket trading
iv. Spread trading
v. Mean reversion
vi. Delta neutral strategies
• In HFT strategies, low latency (time diff. b/w stimulus &
response) is important.
• Multi-legged trade: placing multiple trade as part of stat arb.
strategy.
• HFT algos. are typically used in bank proprietary trading
groups, hedge funds & proprietary trading funds.
• Other areas in which HFT algo. techniques are used include:
i. Liquidity aggregation & small order routing
ii. Real time pricing of instruments
iii. Trading on news
iv. Genetic tuning
v. Money-machine-(ultimate goal)
1
3. THE EVALUATION OF ALGORITHMIC & HIGH-FREQUENCY TRADING
Key drivers in the evolution of algo trading & HFT.

I. Market fragmentation
II. Opportunities in new asset classes
III. Opportunities in Cross-asset class trading
IV. Opportunities in new geographies
V. Opportunities in cross-border trading
4. ALGORITHMIC & HIGH-FREQUENCY TRADING PLATFORMS & TECHNOLOGIES
Key technologies integral to algo trading are:
1. Execution management systems (EMS):

• Front-end trading systems
• Broker algo access & custom algo access are integrated with EMS
2. Complex event processing
• For complex analysis & response for HF data.
• Widely used for algo trading, HFT, liquidity aggregation, small
order routing, pre-trade risk analysis, market surveillance.
3. Tick database
• Real-time time series database
• Capture & store HF market data for analysis & backtesting
2
5. RISK MANAGEMENT USES OF TRADING ALGORITHMS
5.1 5.2
Risk Management Uses of Regulating Oversight: Real Time
trading Algorithms Market Monitoring & Surveillance
Two approaches used to mitigate trading • Goal of real time monitoring is to

risks are: detect anomalous market
1. Real time pre trade risk firewall: movements. It provides early warning
• Trades can be blocked from going to system to potential market problems.
market. • Goal of real time market surveillance
• Monitoring for erroneous trades such as is to detect potential market abuse
Fat finger trade (buying 1 share at while it is happening.
$1,000 instead !,000 shares at $1). • The kinds of pattern that can be
• Useful for trading groups and brokers detected include:
offering Sponsored access (direct o Insider trading
market access for clients using the o Front running orders
broker’s exchange membership). o Painting the tape
2. Backtesting & market simulation o Fictitious orders (quote
• Testing algos. with a variety of real stuffing, layering, spoofing))
historical & pre-planned scenarios o Wash trading
before putting them to work live. o Trader collusion
6. IMPACT OF ALGORITHMIC & HIGH-FREQUENCY

TRADING ON THE SECURITIES MARKETS
Positive Impacts Negative Impacts
• Minimize market impact of • Fear of an unfair

large trades advantage
• Lower cost of execution • Acceleration &
• Improved efficiency in accentuation of market
certain markets movements
• More open & competitive • Gaming the market
trading markets • Increased risk profile
• Improved & more efficient • Algos. gone wild.
trading venues.
3

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2019, Study Session # 1, Reading # 1

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