Salt Cfa Level 1 Formulasheet 2022 3

CFA® Level I
Formula Sheet – 2022 Syllabus
QUANTITATIVE METHODS Mean Absolute Deviation Sample Covariance

QUANTITATIVE METHODS
4
E|
MAD = ∑*+34|X + − X ∑*+34(X + − 𝑋𝑋a)(𝑌𝑌F − 𝑌𝑌a)
* s>E =
THE TIME VALUE OF MONEY
THE TIME VALUE OF MONEY n−1
Variance and Standard Deviation
Required Rate of Return *
Sample Correlation Coefficient
interest rate = real risk-free rate 1 s>E
Sample variance, s : = E):
F(X + − X r>E =
+ inflation premium n−1 s> sE
+34
required inter + default risk premium Standard deviation is square root of variance
PROBABILITY CONCEPTS
PROBABILITY CONCEPTS
required inter + liquidity premium
Target Downside Deviation
required inter + maturity premium Odds
∑) *+(>' ?@)(
Sample target semideviation, s2$-;%# = W '
P(E)
Future Value (FV) and Present Value (PV) *?4 Odds of E =
1 − P(E)
FV = PV(1 + r)! Coefficient of Variation
Probabilities
Effective Annual Rates CV = s⁄EX; measures dispersion relative to mean
Unconditional: P(A), probability of A
r"#$#%& '!
EAR = >1 + ? − 1 Skewness Conditional: P(A|B), probability of A given B
m
EAR ()*#+*,)," = 𝑒𝑒 -!"#"$%
− 1 Joint: P(AB), probability of A and B
Annuities Probability Rules
Annuity: Finite set of level sequential cash flows, Conditional: P(A|B) = P(AB)/P(B)
valued using calculator’s TVM function Multiplication: P(AB) = P(A|B) × P(B)
Ordinary Annuity: 1st cash flow received in one year Addition: P(A or B) = P(A) + P(B) − P(AB)
Annuity Due: 1st cash flow received immediately
Total: P(A) = P(A|S4)P(S4) + ⋯ + P(A|S* )P(S* )
Perpetuity: Ordinary annuity with payments that
012 where S4 , S: ,… S* is an exhaustive set of mutually
continue forever, PV.%-.%#,+#/ =
- exclusive probabilities

ORGANIZING, VISUALIZING,

Independence
ORGANIZING, VISUALIZING, AND DESCRIBING
AND DESCRIBING DATA
DATA If A and B are independent events,
P(AB) = P(A) × P(B)
Data Visualization
- Histogram and frequency polygon Expected Value

- Bar chart (and Pareto chart) *
- Tree-map E(X) = F P(X + )X +

+34
- Word cloud/tag cloud
E(X) = E(X|S4)P(S4) + ⋯ + E(X|S* )P(S* )
- Line chart (and bubble line chart)
- Scatter plot (and scatter plot matrix) Variance

- Heat map *

E)B σ: (X) = F P(X + )[X + − E(X)]:
1 ∑*+34(X + − X
Arithmetic Mean Return Skewness ≈ [ \ +34
* n sB
1
Covariance
E=
Sample mean, X F X + ; n = sample size
n Kurtosis (Excess Kurtosis = Kurtosis – 3) * *
+34
Distribution 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 Peaked Kurtosis Cov(X, Y) = F F P(X + , Y+ )[X + − E(X)][Y+ − E(Y)]
Geometric Mean Return +34 G34
Leptokurtic Fatter More >3
&
R 5 = I∑2#34(1 + R # ) − 1 An asset’s covariance with itself is its variance
Mesokurtic Normal Normal 3
Harmonic Mean Return (Cost Averaging) Platykurtic Thinner Less <3 Expected Value & Variance of Portfolio Return
n
E6 =
X , where X > 0 for i = 1, 2, … , n
*
1
∑*+34 ElR . m = F w+ E[R + ]
X+
+34
E7-+#8. > X
If returns are volatile, X E5%). > EX 6$-. * *

Quantiles σ: lR .m = F F w+ wG CovlR + , R G m
y +34 G34
Location of y #8 percentile, L/ = (n + 1) Market value of investment i
100
w+ =
If L/ is not an integer, use linear interpolation. Market value of portfolio
Distributions may be divided into quarters
(Quartiles), fifths (Quintiles), or tenths (Deciles)
E.g., 50th percentile = 2nd quartile = 5th decile 1 ∑*+34(X + − E
X) D
Excess kurtosis, K C ≈ [ \ D
− 3
n s
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For portfolio with 2 investments: Lognormal Distribution SAMPLING AND ESTIMATION
SAMPLING AND ESTIMATION
ElR . m = w7 R 7 + w@ R @ - e> where X is normally distributed Sampling

- Used to model asset prices Simple random sampling: Subset of population is
Cov(R 7 , R @ ) = σ(R 7)σ(R @ )ρ(R 7 , R @)

- Positively skewed chosen at random
σ: lR .m = w7: σ: (R 7 ) + w@: σ: (R @ ) Continuously compounded return from t to t + 1: Systematic sampling: Every kth observation is
S#J4 chosen until desired sample size is achieved
+ 2w7 w@ Cov(R 7 , R @ ) r#,#J4 = ln [ \ = lnl1 + R #,#J4 m
S# Stratified sampling: Simple random samples are
Correlation where R #,#J4 is the effective annual rate drawn from each subpopulation (strata)
CovlR + , R G m
Cluster sampling: Sample set is divided into mini-
ρ+,G = CorrlR + , R G m = ; min −1, max 1 Student’s t-Distribution
σ(R + )σlR G m representations of the population (cluster)

Parameters: degrees of freedom (df)
Convenience sampling: Samples are selected based
Bayes’ Formula The ratio below is t-distributed with df = n − 1:
P(Info|Event) × P(Event) E−µ
X on accessibility
P(Event|Info) = t= Judgmental sampling: Samples are selected based
P(Info) s/√n
Updates prior probabilities to give posterior on researchers’ knowledge and expertise
probabilities based on new information
Sampling error = Sample mean – Population mean
Counting Rules Central Limit Theorem (CLT)
Factorial: n! = n(n − 1)(n − 2) … 1 For a sample of size n ≥ 30 from a population with
q! mean µ and variance σ: , the sample mean XE
Multinomial: approximately follows a normal distribution with
q! !q" !…q# !
Counts ways to label n items with k labels mean µ and variance σ:⁄n

n %!

Standard Error of Sample Mean
Combination: %C$ = # & = Chi-Square Distribution
r (%($)!$! Population variance is known: σIK = σ⁄√n
Definition: Sum of squares of independent normal
Counts ways to choose r items from n if order does Population variance is not known: sIK = s⁄√n
random variables. It cannot be negative.
NOT matter
"! Properties of Estimators

Permutation: "P! = A point estimator is:
("%!)!
Counts ways to choose r items from n if - Unbiased if its value matches the value of the
order does matter parameter it estimates
- Efficient if it has the lowest variance of all
unbiased estimators
COMMON PROBABILITY DISTRIBUTIONS
COMMON PROBABILITY DISTRIBUTIONS
- Consistent if its value approaches the parameter
Discrete Uniform Distribution
as the sample size increases
1
p(x) = , x = x4 , x : , … , x * F-Distribution
n Confidence Interval
Definition: A ratio of two chi-square random
Continuous Uniform Distribution Point estimate ± Reliability factor × Std error
variables (two df’s). It cannot be negative.
1 Point estimate: Estimate of population parameter
f(x) = ; a ≤ x ≤ b
b−a Reliability factor: Value from distribution of point
x−a estimate, such as normal or t-distribution
F(x) = ; a ≤ x ≤ b
b−a E ± zL⁄: × σ⁄√n
E.g., X
Binomial Distribution
n Reliability factors for normal distributions

p(x) = > ? pI (1 − p)*?I , where Significance Confidence
x 𝑧𝑧N⁄:
n = number of Bernoulli trials level interval

p = probability of success 10% 90% 1.645
E(X) = np Simulation Techniques
5% 95% 1.960
σ: (X) = np(1 − p) Monte Carlo simulation: Generate many random
samples to produce a distribution of outcomes 1% 99% 2.575
Normal Distribution (µ = mean, σ = SD) Historical simulation: Sample from a historical

: If the population is not normally distributed

~50% of observations are within ± 𝜎𝜎 of µ record of returns to simulate a process and/or variance is unknown, the t- or z-
B
~68% of observations are within ±𝜎𝜎 of µ distributions may be used to get reliability factors.
~95% of observations are within ±2𝜎𝜎 of µ Normally Variance Small Large
~99% of observations are within ±3𝜎𝜎 of µ Distributed? known? Sample Sample
Yes Yes z z
Observed value − Population mean X − µ Yes No t t or z
Z= =
Standard deviation σ No Yes n/a z

No No n/a t or z
ElR . m − shortfall level
Shortfall Ratio = Resampling
σ0
Bootstrap: Replace each drawn sample with an
identical element for the next draw
Jackknife: Draw each sample by leaving out one
observation at a time without replacement
Biases Tests Concerning Differences between Means Assumptions of Simple Linear Regression
Data snooping bias: “Drilling” data to find any Normal populations with unknown variances that Model
statistically significant relationship are assumed equal: - Linear relationship between X and Y
Sample selection bias: Excluding unavailable data E4 − E
(X X : ) − (µ4 − µ: ) - Homoscedasticity (i.e., constant variance of
t-statistic =
Survivorship bias: Excluding the impact of failed s.: s.:
4⁄: residuals)
[ + \
funds or companies that no longer exist n4 n: - Independence between X and Y
Look-ahead bias: Information needed is not known

(n4 − 1)s4: + (n: − 1)s:: - Normality of the residuals

on the date the observation was recorded s.: =
n4 + n: − 2 Analysis of Variance
Time-period bias: Using data from an era that df = n4 + n: − 2 Sum of squares error (SSE): Unexplained variation
makes the results time-period specific
Tests Concerning Mean Differences in Y

Normal populations with unknown variances: Ñ+ m:
SSE = ∑*+34 lY+ − Y
HYPOTHESIS TESTING
HYPOTHESIS TESTING
da − µ&O Sum of squares regression (SSR): Explained
Steps in Hypothesis Testing t-statistic = , df = n − 1
s&P variation in Y
1. State hypotheses (null and alternative) :
Ñ+ − E
SSR = ∑*+34 lY Ym
2. Identify test statistic Tests Concerning a Single Variance
3. Specify significance level Normal population (df = n – 1): Sum of squares total (SST): Total variation in Y
4. State decision rule :
* SST = SSE + SSR = ∑*+34 (Y+ − EY):
(n − 1)s 1
5. Collect data; calculate test statistic χ: = , s: = F(X + − xa):
σ:O n−1 Coefficient of determination:

+34
6. Make decision regarding hypothesis SSR

Tests Concerning Two Variances R: =
SST
Test Statistic (General)
Normal populations: :
= r (if there is only one independent variable)
Sample statistic − Hypothesized value *,
F-statistic:
Standard error of sample statistic s4: 1 :
F= , sG: = Flx+G − xaG m for j = 1, 2 MSR SSR/k

s:: nG − 1 F= =
Hypothesis Test Results +34 MSE SSE/(n − [k + 1])
df4 = n4 − 1; df: = n: − 1
Reject H! if test Standard error of regression:
Type Hypotheses
statistic is Nonparametric Tests :
Ñ+ m
∑*+34 lY+ − Y
One-tailed H! : µ ≤ µ! Test that is not concerned with parameter and is s% = √MSE = Ö
> critical value n−2
(upper) H" : µ > µ! implemented in situations such as:
One-tailed H! : µ ≥ µ! - Data do not meet distributional assumptions Hypothesis Testing of Linear Regression
< critical value
(lower) H" : µ < µ! - Data are subject to outliers Coefficients
< lower critical - Data are given in ranks To test a hypothesis about the slope:
Two- H! : µ = µ! - Hypothesis does not concern a parameter bÉ4 − b4
value or > upper t=
tailed H" : µ ≠ µ! sST-
critical value Tests Concerning Correlation
s%
𝑟𝑟√n − 2 sST- =
Hypothesis Testing Decision Errors t-statistic = , df = n − 2 E):
I∑*+34 (X + − X
√1 − r :
Decision 𝐻𝐻O is True 𝐻𝐻O is False To test a hypothesis about the intercept:
To use the Spearman rank correlation coefficient,
Do not reject HO Correct Type II (b) bÉO − bO
substitute the following value into the t-statistic t=
sST.
Reject HO Type I (a) Correct calculation:
6 ∑*+34 d:+ 1 E ):
(X
Power of a test = 1 − P(Type II error) = 1 – b rQ = 1 − sST. = ÖMSE Ü + * á
n(n: − 1) n ∑+34 (X + − E
X):
p-value: smallest value of a at which 𝐻𝐻O is rejected

Tests Concerning a Single Mean
INTRODUCTION TO LINEAR REGRESSION
INTRODUCTION TO LINEAR REGRESSION
Estimated variance of the prediction error for Y:
Population is normal with known variance: Simple Linear Regression 1 (X − EX) :
E − µO Y: Dependent variable/explained variable sU: = s%: à1 + + â
X n (n − 1)sI:
z-statistic = X: Independent variable/explanatory variable
σ⁄√n

Large sample from any population with unknown Y = bO + b4 X + ϵ,
variance (2 choices): where bO is the intercept, b4 is the slope coefficient,
E − µO
X
t-statistic = , df = n − 1 and ϵ is the error term
s⁄√n
E − µO
X The parameters can be estimated by:
z-statistic = Cov[Y, X] ∑*+34 (Y+ − E
Y)(X + − E
X)
σ⁄√n bÉ4 = =
Var[X] ∑+34 (X + − E
*
X):
Small sample from normal population with
unknown population variance: Y − bÉ4 E
bÉO = E X

E − µO
X
t-statistic = , df = n − 1 Cov[Y, X]
s⁄√n r=
IVar[Y]IVar[X]

ECONOMICS ECONOMICS Breakeven Analysis Monopolistic Competition
Economic breakeven occurs if a firm’s accounting - Firms: Many
TOPICS IN DEMAND AND SUPPLY ANALYSIS profit is enough to cover its implicit opportunity - Products: Differentiated (via advertising)
TOPICS IN DEMAND AND SUPPLY ANALYSIS
costs (i.e., normal profit). In the long run, firms
Own-Price Elasticity of Demand - Barriers to entry: Low
cannot earn positive economic profits.
%ΔQ&I ΔQ&I PI - Pricing power of firms: Some
E.&/ = =Ü á [ \ Shutdown Decision (Short-term vs. Long-term)
%ΔPI ΔPI Q&I Profit maximization: MR = MC
Short-Term Long-Term
Q&I = quantity demanded, PI = price per unit TR ≥ TC Stay in Stay in
çE.&/ ç > 1: elastic TVC < TR < TC Stay in Exit market
çE.&/ ç < 1: inelastic TR < TVC Shut down Exit market
çE.&/ ç = ∞: perfectly elastic
Economies of Scale
E.&/ = 0: perfectly inelastic Each stage of expansion has its own short-run ATC
E.&/ = −1: unit elastic curve. Minimum efficient scale is the low point on
the long-run average total cost curve.

Income Elasticity of Demand
%ΔQ&I ΔQ&I I
EV& = =Ü á [ & \
%ΔI ΔI QI
where I = consumers’ income
EV& > 0: normal good; EV& < 0: inferior good Oligopoly
- Firms: Few
Cross-Price Elasticity of Demand
- Products: Similar (close substitutes)
%ΔQ&I ΔQ&I P/
E.&0 = =Ü á [ \ - Barriers to entry: High
%ΔP/ ΔP/ Q&I
- Pricing power: Some or considerable
where P/ is the price per unit of another good Y
Profit maximization: MR = MC
E.&0 > 0: substitutes; E.&0 < 0: complements

Income and Substitution Effects THE FIRM AND MARKET STRUCTURES
THE FIRM AND MARKET STRUCTURES
Impacts of a reduction in a good’s price:
Perfect Competition
Substitution
Type of good Income effect - Firms: Many
effect
- Products: Identical
Normal Buy more Buy more - Barriers to entry: Very low
Inferior Buy less Buy more - Pricing power of firms: None

Goods with positively sloped demand curves: Profit maximization:

- Giffen goods: Negative income effect is greater - P = MR = MC
than positive substitution effect if good’s price - P > ATC economic profit, P < ATC economic loss
falls

- Veblen goods: Demand for a status symbol good Kinked demand curve: A price increase will impact
falls if its price is reduced sales more than an equivalent price decrease
Revenue Terms Cournot assumption: Competitors will maintain

current output levels if one firm changes its price
Total revenue (TR): Price times quantity; P × Q
Game theory: If one firm changes its prices,
Average revenue (AR): TR⁄Q competitors will adjust to maximize their profits,
Marginal revenue (MR): ΔTR⁄ΔQ resulting in a Nash equilibrium

Cost Terms Price collusion is more likely to happen if:

- Few firms or one dominant firm
Total fixed cost (TFC): Sum of fixed costs
- Products are relatively similar
Total variable cost (TVC): Sum of variable costs
- Firms have similar cost structures
Total costs (TC): TFC + TVC
- Orders are frequent and relatively small

Average fixed cost (AFC): TFC⁄Q
- Credible threat of retaliation for breaking pact
Average variable cost (AVC): TVC⁄Q
- The threat of external competition is high
Average total cost (ATC): AFC + AFV or TC⁄Q
Marginal cost (MC): ΔTC⁄ΔQ

Profit Measures
Accounting profit = Revenue − Accounting costs
Economic costs = Accounting costs + Implicit costs
Economic profit = Revenue – Economic costs
= Accounting profit−Implicit costs
Normal profit = Zero economic profit
Profits maximized if MR = MC and MC isn’t falling
Monopoly Relationship among Saving, Investment, the Shifts in Aggregate Supply (SRAS and LRAS)
- Firm: One Fiscal Balance, and the Trade Balance SRAS LRAS
Increase in
- Products: Unique (no close substitutes) (G − T) = (S − I) − (X − M) Shift Shift
- Barriers to entry: Very high G − T = fiscal balance Labor supply Right Right
- Pricing power of firm: Considerable (price S − I = savings minus domestic investment
Natural resources Right Right
discrimination possible) X − M = trade balance
Human capital Right Right
Profit maximization: MR = MC
Aggregate Demand (AD) Physical capital Right Right

The downward slope of the AD curve results from: Productivity/Tech Right Right
- Wealth effect: Price level ↑, real wealth ↓, quantity Nominal wages Left None
demanded ↓ Input prices Left None
- Interest rate effect: Price level ↑, interest rate ↑, Price expectations Right None
investment and consumption expenditures ↓
Business taxes Left None
- Real exchange rate effect: Price level ↑, real
Business subsidies Right None
exchange rate ↑, exports ↓ and imports ↑
Foreign currency

Right None
Aggregate Supply (AS) values

Inflationary Gap
Price discrimination by monopolists:

- 1st degree: Different price for each customer
- 2nd degree: Quantity-based menu options
- 3rd degree: Pricing for demographic groups
Market Power Measures

N-firm concentration ratio: Sum of market share
of the N largest firms in the industry
Herfindahl-Hirschman Index (HHI): Sum of squared
market share of the N largest firms

AGGREGATE OUTPUT, PRICES,
AGGREGATE OUTPUT, PRICES, AND ECONOMIC Full employment level of output: Long-run
AND ECONOMIC GROWTH
GROWTH equilibrium level of output
Gross Domestic Product (GDP)

Nominal GDP: GDP in terms of current prices Factors Increasing Aggregate Demand (AD)
- Higher household wealth Effect of Combined Changes in AS and AD

Real GDP: GDP in terms of base-year prices
- Higher business and consumer confidence Changes in
GDP deflator: (Nominal GDP⁄Real GDP) × 100 Real GDP Prices
- Higher capacity utilization AS and AD
GDP = C + I + G + (X − M)
C = consumption - Expansionary monetary and fiscal policies AS ↑, AD ↑ Increase Unclear
I = investment - Depreciating domestic currency value AS ↓, AD ↓ Decrease Unclear
G = government spending - Faster global economic growth AS ↑, AD ↓ Unclear Decrease

X = exports; M = imports AS ↓, AD ↑ Unclear Increase

GDI
= Net domestic income UNDERSTANDING BUSINESS CYCLES
UNDERSTANDING BUSINESS CYCLES
+ Consumption of fixed capital Business Cycle Phases
+ Statistical discrepancy Recovery

GDI - Economy: Going through a trough

= Compensation of employees - Activity level: Below potential but start to increase
+ Gross operating surplus + Gross mixed income - Employment: Layoffs slow, but firms prefer
+ Taxes (net of subsidies) on production extending overtime to rehiring full-time
+ Taxes (net of subsidies) on products and imports - Inflation: Moderate
- Capital spending: Low but increasing, with a focus
Personal household income on efficiency rather than capacity
= Compensation of employees
+ Net mixed income from Expansion

unincorporated businesses - Economy: Enjoying an upswing

+Net property income - Activity level: Above-average growth rates
- Employment: Full-time rehiring, more overtime
- Inflation: Moderate, but increasing
- Capital spending: Focused on capacity expansion

Slowdown MONETARY AND FISCAL POLICY
MONETARY AND FISCAL POLICY Impact of Trade Restrictions
- Economy: Going through a peak Monetary Policy
- Activity level: Decelerating Required reserves
Required reserve ratio =
- Employment: Hiring slows Total deposits
- Inflation: Accelerating Money multiplier = 1⁄Reserve requirement
- Capital spending: Strong capital spending, but Fisher effect: R *)'+*$W = R -%$W + π%

inventory starts building up as sales growth
Central Bank Roles
slows
- Sole currency supplier
Contraction - Lender of last resort
- Economy: Weakens and may go into a recession - Bank for commercial banks and government
- Activity levels: Below potential - Regulate and supervise payments system
- Employment: Hiring freezes, then layoffs - Gold and foreign exchange reserves holder
∗
- Inflation: Decelerating, but with a lag - Oversee monetary policy - Price increases from P to P#
- Capital spending: New orders halted and existing
- Domestic production increases from Q4 to Q :
Monetary Policy Tools
orders canceled, scale back on maintenance - Domestic consumption falls from Q D to Q B
Expansionary monetary policy measures: - Imports fall from (Q D − Q4 )to (Q B − Q : )
Business Cycle Theories - Policy rate: Set policy rate below neutral level - Loss of consumer surplus = (A + B + C + D)
- Neoclassical: “Invisible hand” lets markets reach a - Reserve requirement: Reduce reserves for - National welfare loss = (B + D)
natural equilibrium; government should not commercial banks - Increase in producer surplus = A
intervene - Open market operations: Buy bonds from - Tariff revenue/Quota rent = C
- Austrian: Like Neoclassical, focus on loose commercial banks
Regional Trading Blocs
monetary policy causing credit-fueled booms
Fiscal Policy: Spending Tools Free trade area (FTA): Free trade among members
- Keynesian: Countercyclical fiscal policy should be
Transfer payments: Redistribution of wealth (e.g., Customs union (CU): FTA + common trade policy
used to support aggregate demand
unemployment benefits) Common market (CM): CU + free movement of
- Monetarist: Oppose Keynesian fiscal focus, call for
Current spending: Spending on goods and services factors of production within bloc
steady growth of money
Capital spending: Spending on infrastructure Economic union (EU): CM + common economic
Unemployment institutions and coordination of economic policies
Fiscal Policy: Revenue Tools Monetary union (MU): EU + common currency
- Unemployed: Jobless people who are seeking jobs
Direct taxes: Tax on income (e.g., income taxes,
- Labor force: People with a job or unemployed Balance of Payments Components
corporate taxes, capital gains taxes)
- Unemployment rate: Unemployed⁄Labor force Current account: Merchandise and services, income
Indirect taxes: Tax on goods and services
Type Result of receipts, unilateral transfers
Frictional Temporary transitions Fiscal Multiplier Capital account: Capital transfers, non-financial
Structural Long-run changes in economy 1 assets sales/purchases
= , where MPC = marginal
Cyclical Changes in economic activity 1 − MPC(1 − t) Financial account: Government-owned assets
propensity to consume; t = tax rate abroad, foreign-owned assets in the country
Inflation
Difficulties Executing Fiscal Policy
Deflation: Negative inflation rate Recognition lag: Government must see need CURRENCY EXCHANGE RATES
CURRENCY EXCHANGE RATES
Disinflation: Declining inflation rate Action lag: Time needed to choose policy Exchange Rate Calculations
Hyperinflation: Extremely high inflation rate CPIU
Impact lag: Policies do not have immediate impact Real ex. rate&⁄U = Nominal ex. rate&⁄U × [ \
Cost-push: From decrease in aggregate supply CPI&
Demand-pull: From increase in aggregate demand Forward exchange rate&⁄U 1 + i&
INTERNATIONAL TRADE & CAPITAL FLOWS
INTERNATIONAL TRADE AND CAPITAL FLOWS =
Laspeyres index: Use base consumption basket Spot exchange rate&⁄U 1 + iU
Basics of International Trade
Paasche index: Use current consumption basket Cross rate: S7⁄@ = S7⁄Y × SY⁄@
Terms of trade: Price of exports/Price of imports
Fisher index: ILaspeyres × Paasche Forward exchange rates in points:
Autarky: No trade with other countries
- Unit of points is last decimal place in the rate
Economic Indicators Absolute advantage: Lower total cost of production
quote (e.g., 1.5301 to 1.5302 is a 1-point increase)
Leading: Stock indexes, building permits Comparative advantage: Lower opportunity cost
Coincident: Real income, industrial production Ideal Currency Regime

International Trade Models
1. Exchange rates are credibly fixed
Lagging: Unemployment rate, prime lending rate Ricardian: Labor is the only factor of production,
2. Fully convertible currencies, free capital flows
comparative advantage due to labor productivity
3. Countries pursue independent monetary policies
Hecksher-Ohlin: Both labor and capital are factors,
Such an ideal currency regime is NOT possible
income redistribution is possible through trade
Trade Restrictions
Tariffs: Taxes on imported goods
Quotas: Limits on quantity of imported goods
Export subsidies: Payments to exporters
Minimum domestic content requirements
Voluntary export restraints: Self-imposed
limitations by foreign producers
Exchange Rate Regimes Income Statement Line Items UNDERSTANDING CASH FLOW STATEMENTS
UNDERSTANDING CASH FLOW STATEMENTS
Dollarization: Adopt another country’s currency Revenue Cash Flow Statement Classifications
Monetary union: Adopt a common currency − Cost of goods sold (COGS) CFO: Cash flows from regular operations
Currency board: Commitment to exchange Gross Profit CFI: Cash flows for buying/selling long-term assets
domestic currency at fixed exchange rate CFF: Financial transactions with capital providers
− Selling, General & Admin. (SG&A)
Fixed peg: Currency is pegged to foreign currency
EBITDA Item US GAAP IFRS
(or basket of currencies) within ±1% margin
− Depreciation and Amortization Dividends paid CFF CFO/CFF
Target zone: Fixed peg with wider margin
Crawling peg: Peg rate is periodically adjusted EBIT (Operating profit) Interest paid CFO CFO/CFF
Crawling bands: Margin increases over time, − Interest Dividends received CFO CFO/CFI
usually to transition from fixed peg to floating EBT (Earnings before taxes) Interest received CFO CFO/CFI
Managed floating: Monetary authority intervenes, − Taxes Tax expenses CFO CFO*
but no official target exchange rate Net Income (NI) *IFRS treat tax expenses for investing or financing
Independently floating: Market sets exchange rate transactions as CFI or CFF
Separately Reported Items
Marshall-Lerner Condition - Discontinued operations CFO Direct Method

Currency devaluation can improve a country’s - Unusual or infrequent items (US GAAP only) - Convert each accrual-based item in the income
trade balance if demand elasticities cause export - Non-operating items statement to cash inflow/outflow
receipts to increase more than import - CFO is net of cash inflows and outflows
expenditures Basic Earnings per Share
Net income − Preferred dividends CFO Indirect Method

Weighted average of shares outstanding - Start with net income

- Add noncash expenses (e.g., Depreciation)
FINANCIAL STATEMENT ANALYSISND ANALYSIS
FINANCIAL REPORTING Diluted Earnings per Share
- Subtract gains/add losses
Net Preferred
Convertible Convertible
− + preferred + debt (1 − 𝑡𝑡) - Add increases in current liabilities
FINANCIAL REPORTING STANDARDS
FINANCIAL REPORTING STANDARDS income dividends
dividends interest - Subtract increases in (non-cash) current assets
FASB, IASB, and IOSCO Weighted Shares from Shares from Shares issuable
average + preferred + convertible + from stock
FASB: Sets forth US GAAP shares shares debt options Beginning accounts receivable
IASB: Establishes IFRS + Revenue
Must be equal to or less than basic EPS
IOSCO: International body of regulatory authorities − Ending accounts receivable

SEC: US capital markets regulator Cash collected from customers
UNDERSTANDING BALANCE SHEETS
UNDERSTANDING BALANCE SHEETS
Fundamental Qualities of Financial Reports
Classified Balance Sheet Cost of goods sold
1. Relevance 2. Faithful Representation
Current Assets: To be used within one year + Increase in inventory
Enhancing Characteristics
1. Comparability 2. Verifiability - Cash and equivalents Purchases from suppliers
3. Timeliness 4. Understandability - Marketable securities − Increase in accounts payable
- Accounts receivable, net of bad debt expense Cash paid to suppliers
UNDERSTANDING INCOME STATEMENTS - Inventories
UNDERSTANDING INCOME STATEMENTS Free Cash Flow (FCF)
- Other (e.g., prepaid expenses)
Revenue Recognition Free cash flow to the firm (FCFF): Cash available to
Non-Current Assets
Revenue must not be recognized unless: equity owners and debt holders.
- Property, Plant, and Equipment (PP&E)
- Risks of ownership have been transferred FCFF = NI + NCC + I × (1 − t) − FCI − WCI
- Investment property
- Amount of revenue can be reliably measured FCFF = CFO + I × (1 − t) − FCI
- Intangible assets
- Customer is likely to pay
- Goodwill Free cash flow to equity (FCFE): Cash flow available
- Transaction is unlikely to be reversed
- Financial assets to common shareholders
Service revenue may be recognized as earned
Current Liabilities: To be settled within one year FCFE = CFO − FCI + Net Borrowing
Allowance for doubtful accounts: Contra-asset
- Accounts payable
account, estimated based on historical experience
- Notes payable
Expense Recognition - Accrued expenses
Matching principle: Expenses must be recognized - Deferred income (Unearned revenue)
in the same period as associated revenue Long-term Liabilities
- Long-term debt
- Deferred tax liabilities
Equity
- Contributed capital
- Preferred shares
- Treasury shares
- Retained earnings
- Accumulated other comprehensive income (OCI)
- Non-controlling (minority) interest

FINANCIAL ANALYSIS TECHNIQUES
FINANCIAL ANALYSIS TECHNIQUES Solvency Ratios INVENTORIES
INVENTORIES
Common-Size Analysis Total debt Inventory Valuation Requirements
Debt-to-equity =
Vertical: Total shareholders' equity IFRS: Lower of cost or net realizable value

- State income statement items as % of revenue Total debt US GAAP: Lower of cost or market value
- State balance sheet items as a % of total assets Debt-to-capital = Reversals of inventory write-downs are allowed
Total shareholders'
Total debt +
- State each cash flow statement item as a % of equity under IFRS, but not under US GAAP

total cash inflows/outflows Total debt Inventory Valuation Methods and Systems
Horizontal (Trend) Analysis: Debt-to-assets =
Total assets US GAAP IFRS
- State each item relative to its base-year value
Average total assets FIFO Allowed Allowed

Financial leverage =
Activity Ratios Average total equity LIFO Allowed N/A
Annual sales
Weighted Allowed Allowed
Receivables turnover = EBIT
Average receivables Interest coverage = average
Interest payments
Days of sales 365 Fixed Specific Allowed Allowed
= EBIT + Lease payments
outstanding Receivables turnover charge = Identification
coverage Interest payments + Lease pmts
Cost of goods sold Impact of Inventory Valuation Method
Inventory turnover =
Average inventory Profitability Ratios If prices are rising FIFO LIFO
Net income
Days of inventory 365 Net profit margin = Ending Inventory Higher Lower
= Revenue
on hand Inventory turnover COGS Lower Higher
Gross profit
Purchases Gross profit margin = Net income Higher Lower
Payables turnover = Revenue
Average trade payables Income Tax Expense Higher Lower
EBIT
365 Operating profit margin = Operating cash flow Lower Higher
Number of days Revenue
=
of payables Payables turnover
Perpetual vs. periodic inventory system:
EBT
Revenue Pretax margin = - Periodic system matches total units sold for the
Total asset turnover = Revenue
Average total assets period with total purchases for the same period
Net income
Return on assets (ROA) = - Perpetual system updates after each transaction
Revenue Average total assets
Fixed asset turnover = - Under FIFO, ending inventory and COGS are the
Average net fixed assets
Revenue EBIT same for periodic or perpetual

Working capital Return on total capital =
= Average total capital - Weighted average and LIFO will show differences
turnover Average working capital

Net income LIFO Reserve
Liquidity Ratios Return on equity (ROE) =
Average total equity Used to adjust LIFO COGS and ending inventory
Current assets
Current ratio =
(EI) to FIFO-equivalent values
Current liabilities Valuation Ratios
Marketable Dividends declared EIZVZ[ = EI\VZ[ + LIFO Reserve
Cash + + Receivables Dividend payout ratio =
Quick ratio = securities NI available to common COGSZVZ[ = COGS\VZ[ − ΔLIFO Reserve
Current liabilities
Retention rate (RR) = 1 − Dividend payout ratio TaxZVZ[ = Tax\VZ[ + ΔLIFO Reserve × t
Cash + Marketable securities
Cash ratio = Sustainable growth rate (g) = RR × ROE LIFO Liquidations
Current liabilities
- Happen when units sold exceed units purchased
Marketable Price per share
Cash + + Receivables P/E Ratio = - May result in higher gross profit than otherwise
Defensive securities Earnings per share
=
interval Average daily expenditures
DuPont Analysis LONG-LIVED ASSETS
LONG-LIVED ASSETS
Cash Days of Days of Number Net income Assets
conversion = sales + inventory − of days ROE = [ \[ \ Long-Term Assets
Assets Book Value of Equity
cycle outstanding on hand payables Property, plant, and equipment (PP&E):

Leverage IFRS
= (ROA) > ?
ratio
- Both cost model and revaluation model allowed
NI Revenue Assets - Recoverable amount is greater of:
=[ \[ \[ \
Revenue Assets Equity (1) fair value less selling costs, and
Net profit Asset Leverage (2) value in use (PV of asset’s future cash flows)
=[ \> ?> ?
margin turnover ratio - Loss recoveries are allowed
NI EBT EBIT Revenue Assets US GAAP
=/ 5/ 5/ 5/ 5/ 5
EBT EBIT Revenue Assets Equity – Only cost model is allowed
Tax Interest EBIT Asset Financial – Loss recoveries not allowed
=+ 5+ 59 ?+ 59 ?
burden burden margin turnover leverage

Depreciation Methods INCOME TAXES
INCOME TAXES Conditions requiring a lease to be a finance lease:
EFGH%IJKLJMN LJKON Temporary Taxable Differences - Ownership of the leased asset is transferred to
Straight-line: =
PNQ!NRSJTKN KSUN the lessee
Deferred tax assets (DTA): Created when taxes
Double-declining balance (DDB): payable exceeds income tax expense - Lessee has the option to purchase the asset and
Book value# Deferred tax liabilities (DTL): Created when taxes will likely do so
Depreciation# = [ \ × 2 - Lease term covers most of asset's useful life
Depreciable life payable is less than income tax expense
Units-of-production: Tax base of assets: Amount that will be deducted on - The present value of lease payments at inception
Cost − Salvage the tax return as asset’s benefits are realized is close to the asset’s fair value
Depreciation# = × Output units#
Total output Tax base of liabilities: Carrying value of liability - The leased asset is so specialized that only the

minus amount that will be deductible lessee can use it without modification
Intangible Assets
Purchased: Record at fair value (purchase price) Asset carrying amount > Tax base DTL IFRS require all leases to be treated in the manner
Developed internally: Asset carrying amount < Tax base DTA that is prescribed by US GAAP for finance leases.

IFRS Liability carrying amount > Tax base DTA Lessor Accounting
- Research expenditures are expensed Liability carrying amount < Tax base DTL - For operating leases (under both IFRS and US
- Development expenditures are capitalized
Impact of tax rate changes GAAP), the lessor retains the leased asset on its
US GAAP
If tax rate increases, DTA and DTL will increase balance sheet and incurs the associated
- Generally, both R&D costs are expensed
If tax rate decreases, DTA and DTL will decrease depreciation expense. Lease income from the
Acquired in business combination:
Income tax exp. = Taxes payable + ΔDTL − ΔDTA lessor is recorded as revenue.
Purchase price is allocated to each asset on fair - For finance leases (under both IFRS and US
value basis; excess recorded as goodwill Valuation Allowance

GAAP), the lessor removes the leased asset from
Contra account used if it is unlikely that future its balance sheet and creates an asset with a
Capitalizing vs. Expensing
profits will be sufficient to use DTAs and credits value equal to the lease receivable and any
- Capitalizing increases assets on the balance sheet
and investing cash outflows Deferred Tax Charges Directly to Equity residual value.
- Expensing reduces net income by the after-tax - Revaluation of PP&E (IFRS only) - Lease payments are recognized as an operating
expenditure amount in the period it is incurred - Impact of changes in accounting policies inflow on the lessor’s cash flow statement (for

- Impact of exchange rate fluctuations both operating leases and finance leases)
Impairment of PP&E and Intangible Assets
- Changes in fair value of certain investments Pensions
US GAAP
Defined benefit (DB): Firm makes periodic
- Asset tested for impairment only when firm may
not recover carrying value through future use NON-CURRENT (LONG-TERM) LIABILITIES
NON-CURRENT (LONG-TERM) LIABILITIES payments to employee after retirement.
- Asset is impaired when carrying value exceeds Long-Term Liabilities Overfunded (underfunded) plan is recognized as
asset’s future undiscounted cash flows Premium bond: Coupon rate > yield at issuance an asset (liability).
- Impaired asset’s value is written down to fair Discount bond: Coupon rate < yield at issuance
value and a loss is recognized and cannot be
Issuance costs:
subsequently reversed CORPORATE FINANCE
CORPORATE ISSUERS
US GAAP – capitalized as an asset

IFRS IFRS – reduces initial bond liability
INTRODUCTION TO CORPORATE GOVERNANCE
INTRODUCTION TO CORPORATE GOVERNANCE
- Assets are tested annually for impairment Derecognition of debt: If an issuer redeems a bond AND OTHER ESG CONSIDERATIONS
AND OTHER ESG CONSIDERATIONS
- Impaired if carrying value > recoverable amount before maturity, a gain/loss (book value minus Corporate governance can be described as:
- Impaired asset’s value is written down to redemption price) is recognized - A system of internal controls and procedures for
recoverable amount and a loss is recognized Debt covenants: Affirmative – borrower promises managing organizational business
- Loss can be reversed if asset value recovers, but
to do certain things; negative – borrower promises - A framework for defining the rights and
only up to pre-impairment carrying value to refrain from certain things responsibilities of individuals and groups within

Lessee Accounting the organization
US GAAP - An arrangement of checks, balances, and
Finance lease: incentives to minimize and manage conflicts
- Lessee purchases the asset, financed by the lessor between the interests of insiders and external
- Lessee's periodic lease payments have separate stakeholders

depreciation and interest components Shareholder theory is based on the concept that
Operating lease (like a rental agreement): the primary responsibility of corporate managers
- Single lease expense, not separated into different is to maximize returns for shareholders.
components for depreciation and interest
- The value of an operating lease payment is Stakeholder theory is a broader interpretation
calculated as a straight-line allocation of total of corporate governance. Shareholders are just
payments over the term of the lease one of the stakeholder groups whose interests
must be balanced.

Company Stakeholders Risks and Benefits of Corporate Governance Other important considerations:
- Shareholders and Stakeholder Management - Sunk costs are ignored
- Creditors Risks of poor corporate governance: - Opportunity cost is the value of a resource’s next-
- Managers and employees - Weak control systems that do not treat all best use
- Directors stakeholders fairly - Incremental cash flows reflect the cash flows
- Customers - Ineffective decision-making process realized from a decision
- Suppliers - Legal, regulatory, and reputational risks - Externalities (e.g., cannibalization) may have
- Governments and regulators - Default and bankruptcy risks unexpected negative impact the company

The frameworks that define the rights and - Conventional cash flow pattern only has one sign
Benefits of improving corporate governance:
responsibilities of various stakeholders include: change
- Operational efficiency
- Legal infrastructure
- Improved control Net Present Value (NPV)
- Contractual infrastructure
- Better operating and financial performance Sum of present values of expected future cash
- Organizational infrastructure
- Lower default risk and cost of debt inflows, net of initial cash outlay
- Governmental infrastructure *

Factors Relevant to Corporate Governance and CF#
Mechanisms for managing stakeholder NPV = F
(1 + r)#
Stakeholder Management Analysis #3O
relationships include:
- Economic ownership and voting control
- General meetings NPV Decision Rules
- Board of directors representation
- Board of directors - Accept if NPV is positive, reject if negative
- Remuneration and company performance
- Auditing - If only one of multiple mutually exclusive projects
- Investors in the company
- Reporting and transparency can be accepted, accept project with highest NPV
- Strength of shareholders’ rights
- Policies on related-party transactions - If subject to capital rationing, choose the highest
- Management of long-term risks
- Remuneration policies (e.g., say-on-pay
NPV combination of projects
provisions) ESG Considerations for Investors and Analysts - Projects that are negative NPV in isolation may be
- Contractual arrangements with creditors, Responsible investing: accepted as part of project sequencing

customers, employees, and suppliers - ESG integration
Internal Rate of Return (IRR)
- Laws and regulations - Socially responsible investing (SRI)

IRR is r such that NPV = 0
- Thematic investing
Board Composition Accept a project if its IRR > required return
- Impact investing
One-tier: Executive and non-executive directors
- NPV and IRR may give contradictory
Two-tier: Independent supervisory board oversees Green finance: Use financial instruments to support
recommendations due size and timing of CFs
management board economic growth while minimizing environmental
- If NPV and IRR are in conflict, go with NPV
Staggered: Multiple classes of directors elected at impact
different times; Replacing entire board takes years

BA II Plus NPV Worksheet Function
Sustainability linked loans: Credit facilities that
CEO Duality: When the CEO also chairs a - Cash inflows are positive; outflows are negative
incentivize specified sustainability performance
company's board - F01, F02, etc. refer to cash flow frequencies

objectives
- CPT + NPV to compute NPV; CPT + IRR for IRR
Key Board Committees
- Audit USES OF CAPITAL

USES OF CAPITAL Corporate Usage of Capital Allocation Methods
- Governance Typical Steps in Capital Budgeting Return on invested capital (ROIC):
- Remuneration/Compensation 1. Idea generation After-Tax Net Profit
ROIC =
- Nomination 2. Investment analysis Average BV of Invested Capital

- Risk 3. Capital allocation planning
Real Options
- Investment 4. Monitoring and post-audit

- Timing option: Option to delay the investment
Factors Affecting Stakeholder Relationships Principles of Capital Budgeting - Sizing option: Option to expand, grow, or abandon
and Corporate Governance Key assumptions of capital allocation: - Flexibility option: Option to alter operations,
Market factors - Decisions are based on cash flows instead of such as changing prices or substituting inputs
- Shareholder engagement through forums such as accounting concepts - Fundamental option: Option to alter decisions
AGMs and analyst calls - Cash flows are not equivalent to accounting based on future events (e.g., drill based on price
- Shareholder activism to influence a company's income or economic income of oil, continue R&D depending on initial results)

actions - Cash flows must account for opportunity costs
Analyzing Projects with Real Options
- Competition and takeovers to gain control of a - Analysis is done on an after-tax basis
- Use the discounted cash flow (DCF) analysis
company - Timing of cash flows is important
without considering real options.
Non-market factors - Financing costs are ignored

- Adjust the stand-alone DCF analysis by including
- Legal protections for stakeholders such as
the present value of the expected costs and
shareholders and lenders
benefits options.
- Media coverage of corporate activities
- Use option pricing models.
Corporate governance consultants to advise
- Use decision trees.
institutional investors and develop metrics
to rate companies based on their

governance practices
Common Capital Budgeting Pitfalls Managing and Measuring Liquidity Cost of common stock:
- Failure to consider economic responses Primary sources of liquidity: - Yield-to-maturity approach
- Misusing templates - Ready cash balances (bank accounts) r% = rU + β[r' − rU ]
- Undertaking pet projects - Short-term funds (lines of credit) - Multifactor model
- Basing decisions on earnings metrics (instead of - Cash flow management (centralized collection) r% = rU + β4(Factor4 ) + β:(Factor: )
incremental cash flows) Secondary sources of liquidity: + ⋯ + βG lFactorG m
- Basing decisions on IRR (instead of NPV) - Negotiating debt contracts - Bond yield plus risk premium approach
- Poor accounting for cash flows - Liquidating assets r% = r& + Risk Premium
- Over/Underestimating overhead costs - Filing for bankruptcy
Estimating Beta
- Errors in estimating a discount rate Drag on liquidity: Delayed cash inflows, such as
Blume’s beta adjustment formula:
- Over/Underspending capital budget uncollected receivables and obsolete inventory
2 1
- Failure to consider investment alternatives Pull on liquidity: Accelerated cash outflows, such as Adjusted β = [ \ (Unadjusted β) + [ \ (1.0)
3 3
- Improper handling of sunk costs and settling payables earlier
opportunity costs Net operating cycle (a.k.a. cash conversion cycle) = Asset beta/unlevered beta for comparable
# days of inventory + # days of receivable – # days company:
SOURCES OF CAPITAL
SOURCES OF CAPITAL of payable 1
Corporate Financing Options β` = βC ù û
Evaluating Short-Term Financing Choices D
(1 − t)
Internal sources of financing: E+1
Objectives of a short-term borrowing strategy: Levered project beta for subject firm:
- After-tax operating cash flows
- Ensure sufficient capacity to handle peak cash Da
- Accounts payable βaC = β` ü(1 − t) a + 1†
needs E
- Accounts receivable
- Have sufficient credit sources for ongoing cash
- Inventory & marketable securities Flotation Costs

needs
r% adjusted for flotation costs (amount):
External sources of financing: - Borrow at cost-effective rates
D4
- Financial intermediaries
r% = + g
Factors influencing a company’s short-term PO − F
o Uncommitted lines of credit
borrowing strategy: r% adjusted for flotation costs (percentage):
o Committed lines of credit D4
- Size and creditworthiness r% = + g
o Revolving credit PO [1 − f]
- Legal and regulatory considerations
o Secured loans
- Sufficient access
o Factoring CAPITAL STRUCTURE
CAPITAL STRUCTURE
- Flexibility of borrowing options
- Capital markets Capital Structure and Company Life Cycle

o Commercial paper
COST OF CAPITAL – FOUNDATIONAL TOPIC
COST OF CAPITAL – FOUNDATIONAL TOPIC
o Public and private debt
Weighted Average Cost of Capital (WACC)
o Hybrid securities (e.g., preferred equity and
WACC = w& r&(1 − t) + w. r. + w% r%
convertibles)
w& = percentage of debt in capital structure
o Common equity
w. = percentage of preferred stock
- Other
o Leasing w% = percentage of common stock
t = tax rate
Considerations Affecting Financing Choices r& = cost of debt
- Company size r. = cost of preferred stock = D. ⁄P
- Riskiness of assets r% = cost of common stock

Modigliani and Miller Propositions

- Assets for collateral = R Z + β[E(R ' ) − R Z ]
MM Proposition I: A firm's capital structure would
- Public vs. private equity (CAPM)
have no effect on its value, assuming:
- Asset liability management = r& + Risk Premium
1. Investors have homogeneous expectations
- Debt maturity structure (Bond Yield plus Risk Premium)
2. No market frictions (e.g., transaction costs, taxes,
- Currency risks
Costs of the Various Sources of Capital or costs of financial distress)

- Agency costs
Cost of debt: 3. No agency costs
- Bankruptcy costs
- Yield-to-maturity approach 4. Investors can borrow and lend at risk-free rate
- Flotation costs
5. Investing/financing decisions are independent
- Taxation PO = à∑*+34
012"
â+
Z_

1
]4J (% ^
" 1
]4J (%^
2
MM Proposition II: Cost of equity increases with the
- Inflation
- Debt rating approach (e.g., matrix pricing) debt-to-equity ratio.
- Government policy

- Monetary policy

Cost of preferred stock:
r. = D. ⁄P

Without Taxes Factors Affecting Capital Structure Decisions EQUITY EQUITY
Firm value V\ = V` - Capital structure policies and targets
D E - Capital investment financing MARKET ORGANIZATION AND STRUCTURE
MARKET ORGANIZATION AND STRUCTURE
WACC [ \ r& + [ \ r%
V V - Market conditions Functions of the Financial System
D - Asymmetric information - Saving
Cost of Equity r% = rO + (rO − r& ) [ \
E Pecking order theory: Since managers have an - Borrowing
With Taxes asymmetric information advantage, they prefer - Raising Equity Capital
Firm value V\ = V` + tD capital sources that reveal the least amount of - Managing Risks
D E information: - Exchanging Assets
WACC [ \ r& (1 − t) + [ \ r% 1. Internally generated earnings (best option) - Information-Motivated Trading
V V

D 2. New debt
Cost of Equity r# = r! + (r! − r$ )(1 − t) / 5 Securities Markets
E 3. New equity (least attractive for managers)
- Spot vs. Forward Markets: Spot market trades are
r! = cost of capital for a firm financed only by equity Agency Costs settled within 3 days.
Agency costs arise from conflicts between - Primary vs. Secondary Markets: Primary market
managers and owners. The interests of managers, transactions are done directly with the issuer,
shareholders, and bondholders are not always while secondary market trades take place on
aligned. organized exchanges.
- Capital vs. Money Markets: Money markets are
MEASURES OF LEVERAGE
MEASURES OF LEVERAGE used for securities with maturities of less than
Leverage one year, while longer-dated securities are traded

in capital markets.

Positions
Costs of Financial Distress Long positions: Benefit from price appreciation
Companies with negative earnings can experience Short positions: Benefit from price depreciation
financial distress, which leads to explicit and
implicit costs: Leveraged Positions

Position
- The explicit, or direct, costs of financial distress Leverage ratio =
Equity
include the legal and administrative cash
1
expenses associated with bankruptcy. Maximum initial leverage ratio =
Intial margin
- Implicit, or indirect, costs include foregone
Business Risk Maintenance margin: minimum amount of equity

investment opportunities and the loss of trust
Two components of business risk are: required
from customers, creditors, suppliers, and
- Sales risk: determined by the elasticity of demand Margin call is triggered if the equity falls below the
employees.
for products and services maintenance margin. Additional equity will be
Optimal and Target Capital Structure - Operating risk: determined by the share of fixed requested to bring the account balance back to the
Static trade-off theory balances costs of financial costs as a share of total operating costs initial margin.
distress with tax shield benefits from using debt:
Measures of Leverage Execution Instructions (How to fill)

V\ = V` + tD − PV(costs of financial distress)
Degree of operating leverage (DOL): - Market: Fill immediately at market price
%Δ Operating income Q(P − V) - Limit: Buy below maximum price or sell above
DOL = = minimum price specified in order
%Δ Units sold Q(P − V) − F
- All-or-nothing: Cancel order if not fully filled
Degree of financial leverage (DFL):
- Hidden: Visible to brokers and exchanges, but
%Δ Net income Q(P − V) − F
DFL = = invisible to other traders
%Δ Operating income Q(P − V) − F − C
- Iceberg: Only a fraction of order amount is visible
Degree of total leverage (DTL):
Validity Instructions (When to fill)
%Δ Net income Q(P − V)
DTL = = - Day orders: Cancelled if unfilled at end of day
%Δ Units sold Q(P − V) − F − C
- Good-till-cancelled: No set expiry date

DTL = DOL × DFL - Good-on-close: Filled at end of day

Breakeven - Stop-loss: Sell if prices fall below specified level

F+C Clearing Instructions
Breakeven: Q @C =
P−V Settlement/clearing typically done by brokers for
F
Operating breakeven: Q [@C = retail trades; brokers or custodians for
P−V
institutional trades
Q = quantity; P = price; V = variable cost/unit
F = fixed operating cost; C = fixed financial cost

Primary Market Transactions Price-Weighted Indexes Implications of EMH
- Initial Public Offerings (IPOs) P+ - If weak form holds, investors will not earn
w+0 = !
- Private placements ∑G34 PG abnormal profits from technical analysis
- Shelf registrations: Part of issue is held back to be - Like buying one share of each stock - If markets are semi-strong efficient, investors
sold directly to secondary market investors later - Advantage is simplicity must have a comparative advantage to earn
- Dividend reinvestment plans (DRIPs): Investors - Disadvantage is arbitrary weights abnormal profits from fundamental analysis
can roll over dividend payments to purchase new - A stock’s weight is halved due to a stock split,
Market Anomalies
shares, possibly at a discount requiring an adjustment to the divisor
Changes in a security’s price that are not
- Rights offerings: Current shareholders gain right
Equally Weighted Indexes attributable to known information
to purchase additional shares at below-market
1
price; dilutes value of existing shares w+C = Selected Behavioral Biases
N
Market Structure - Like investing the same amount in each stock - Loss aversion: Disliking losses more than liking
Quote-driven: Investors trade with dealers - Advantage is simplicity equivalent gains
Order-driven: Exchanges use order matching rules - Disadvantages are that the impact of large - Information Cascades: Those who act first will
Brokered: Trades arranged by brokers companies is underrepresented and frequent convey information that influences others
Call markets: Conduct periodic single price rebalancing is required - Representativeness: Rely too much on current
auctions, otherwise completely illiquid state when assessing probabilities
Capitalization-Weighted Indexes - Mental accounting: Keep track of gains and losses
Continuous Trading markets: Allow trades Q + P+
whenever market is open, may use call market w+1 = ! separately for different investments/goals
∑G34 Q G PG
auction at beginning and/or end of each day - Conservatism: Failing to incorporate new
- Like holding all stocks in proportion to their information in a timely manner
Trade Pricing Rules market values - Narrow framing: Focusing on certain issues in
Uniform pricing rules: Used by call markets, all - Float adjustment may be used to reflect the isolation
trades executed at the price that maximizes total number of shares that may be actively traded
quantity traded - Advantage is that the asset classes’ performance OVERVIEW OF EQUITY SECURITIES
OVERVIEW OF EQUITY SECURITIES
Discriminatory pricing rules: Used by continuous is well-represented Common Share Voting Methods
markets, fills most aggressively priced orders first - Disadvantage is that returns are heavily driven by Statutory: One vote per share
Derivative pricing rules: Used by crossing networks large-cap (possibly overvalued) firms Cumulative: Votes can be bundled
to trade at midpoint of quotes from other markets
Fundamentally Weighted Indexes Example: 10 board positions
Complete Markets - Built like price-weighted indexes, but using a Statutory: 1 share votes for 10 different candidates
- Facilitate savings/investment Cumulative: 10 votes may go to 1 candidate
fundamental measure such as sales or cash flows
- Facilitate lending to creditworthy borrowers Cumulative method advantages small shareholder
- Contrarian effect of rebalancing by selling off top
- Allow risk exposures to be hedged
performers and buying underperforming stocks Preference Shares
- Facilitate exchange of currencies/commodities
produces a value tilt - Cumulative: Accrue dividends if payments missed
An ideal financial system is complete (see above),
- Non-cumulative: Missed dividends do not accrue,
operationally efficient (low transaction costs), and Types of Equity Market Indexes
but no common dividends allowed if preferred
informationally efficient (prices reflect all info.) - Broad market indexes: Covers one equity market
shareholders do not receive their dividend
- Multi-market indexes: Covers equity markets in
SECURITY MARKET INDEXES - Participating: May receive additional dividend if
SECURITY MARKET INDEXES multiple countries
- Sector indexes: Important for assessing a firm is profitable or in the event of liquidation
Price Return over Single Period
! manager’s performance (selection vs. allocation) - Non-participating: No compensation beyond
P+4 − P+O dividends and face value in a liquidation
PR + = PR V = F w+ PR + - Style indexes: Large/small cap; Value/growth
P+O
+34 Private Equity Securities

Total Return over Single Period MARKET EFFICIENCY

MARKET EFFICIENCY - Venture capital (VC): Start-up, early-state, or
! Forms of Efficient Market Hypothesis (EMH) mezzanine financing with IPO as exit strategy
P+4 − P+O + Inc+
TR + = TR V = F w+ TR + Market Prices Reflect: - Leveraged buyouts (LBO): Debt-financed deals to
P+O
+34
Past take undervalued listed companies private
Price Return Index over Multiple Periods Public Private
Form market - Private investment in public equity (PIPE):
V0bV2 = V0bVO (1 + PR V4 )(1 + PR V: ) … (1 + PR V2) info info

data Companies can raise new capital quickly,
Total Return Index over Multiple Periods Weak ✔ investors can negotiate discounts
V2bV2 = V2bVO (1 + TR V4 )(1 + TR V: ) … (1 + TR V2 ) Semi-
✔ ✔
strong
Strong ✔ ✔ ✔
Depository Receipts (DRs) Multistage DDM: Credit Enhancements
*
Sponsored DRs: Issued directly by foreign D# P* Internal: Subordination, over-collateralization,
company; Investors receive same voting rights and VO = F + reserve accounts
(1 + r)# (1 + r)*
#34
dividends as other common shareholders D*J4 External: Surety bonds, letters of credit, guarantees
P* = from financial institutions
Unsponsored DRs: Foreign company not involved; r − g\

Depository bank purchases shares, issues DRs, and D*J4 = DO (1 + g Q )* (1 + g \ ) Bonds with Contingency Provisions

retains voting rights Price Multiples Callable Bonds
PO D4 /E4 May be recalled by issuer if rates fall
Global DRs: Issued outside company’s home =
E4 r−g VY$WW$SW% S)*& = VNon-callable bond − VY$WW
country to avoid limits on capital flows; May be
denominated in any currency, but USD is common; P⁄B = Price per share⁄Book value per share Putable Bonds
P⁄CF = Price per share⁄Cash flow per share May be sold back to issuer if rates rise
Cannot be listed on US exchanges, but US investors
P⁄S = Price per share⁄Sales per share V0,#$SW% S)*& = VNon-putable bond + V0,#
can purchase them via private placements

Asset-Based Valuation Models
American DRs: USD-denominated GDRs that can be Convertible Bonds
Useful for companies with natural resource or a
traded on US exchanges; Underlying securities, large share of current assets/liabilities; Not useful Conversion price: Price per share at which bond
American depository shares, trade in issuer’s if company has a large share of PP&E/intangibles can be converted into shares
domestic market Enterprise Value (EV) Conversion ratio: Number of common shares
= MV(Common equity) + MV(Preferred stock) each bond can be converted into
Global Registered Shares: Traded on multiple
+ MV(Debt) − (Cash + Short term investments) Conversion value:
exchanges, including issuer’s domestic market;
Current share price × Conversion ratio
Denominated in multiple local currencies; Unlike
Conversion premium:
DRs, GRS represent an actual ownership interest
FIXED INCOME FIXED INCOME Convertible bond’s price − Conversion value

Warrants: Options to buy equity, lowers debt costs
INTRODUCTION TO INDUSTRY AND
INTRODUCTION TO INDUSTRY & COMPANY
COMPANY ANALYSIS
ANALYSIS FIXED-INCOME SECURITIES:
FIXED-INCOME SECURITIES: DEFINING Convertible Contingent Bonds (CoCos)
ELEMENTS ELEMENTS
DEFINING - Automatically convert to equity if a condition is
Porter’s Five Forces Framework
- Threat of substitute products Types of Bonds met (e.g., capitalization ratio falls)
- Bargaining power of customers - Collateral Trust Bonds: Backed by financial assets - Lender does not control if option is exercised
- Bargaining power of suppliers - Equipment Trust Bonds: Backed by physical assets - Primarily issued by financial institutions
- Threat of new entrants - Covered Bonds: Backed by a segregated pool of
- Intensity of rivalry loans that are replaced if they stop performing FIXED-INCOME MARKETS: ISSUANCE,
FIXED-INCOME MARKETS: ISSUANCE, TRADING,

Principal Repayment Structures TRADING, AND FUNDING
AND FUNDING
Industry Life Cycle Stages
- Bullet Bonds: Full principal repaid at maturity Bond Markets
- Embryonic: Slow growth, high prices, high failure
- Fully Amortizing: Equal annuity-like payments - Primary bond markets: Markets in which issuers
risk, significant investment required
contain a mix of interest and principal initially sell bonds to investors to raise capital
- Growth: Rapidly increasing demand, improving
- Partially Amortizing: Some principal is amortized, - Secondary bond markets: Markets in which bonds
profitability, falling prices, low competition
remainder repaid as a lump sum at maturity are subsequently traded among investors; Most
- Shakeout: Slowing growth, intense competition,
- Sinking Funds: Certain percentage of principal trading is OTC rather than on organized
declining profitability
retired each year exchanges
- Mature: Little or no growth, industry
- Grey market: Informal forward market to gauge
consolidation, high entry barriers Coupon Structures
interest in upcoming bond issues and set prices
- Decline: Negative growth, excess capacity, - Fixed-rate bonds: Set percentage of principal
for the primary market
high competition - Floating-rate (FRNs): Reference rate + spread
- Step-up: Coupon rate increases on schedule Sovereign Debt
Key Competitive Strategies
- Credit-Linked: Coupon rate is increased if issuer is - Issued by national governments, zero default risk
- Low-cost leadership: To hold/gain market share
downgraded, reduced if upgraded - Bills mature < 1 year; Bonds mature > 1 year
- Product differentiation: To charge premium prices
- Payment-in-kind: Coupons may be paid with more - On-the-run: Most recent issues of a given

bonds rather than cash maturity; more liquid than off-the-run issues
EQUITY VALUATION: CONCEPTS AND
EQUITY VALUATION: CONCEPTS AND BASIC
BASIC TOOLS - Deferred (Split) Coupon: No coupons in early Non-Sovereign Debt
TOOLS
years, high coupons in later years - Municipal bonds (sub-national issuers)
Dividend Discount Model (DDM)
c *
Inflation-Indexed Bonds - Quasi-government bonds (gov’t-backed agencies)
D# D# P*
VO = F =F + - Supranational bonds (i.e., IMF, World Bank)
(1 + r)# (1 + r)# (1 + r)* - Zero-coupon: Principal amount is adjusted
#34 #34
- Interest-indexed: Coupons are adjusted Corporate Debt
Perpetual preferred stock; constant dividend:
- Capital-indexed: Fixed rate, adjusted principal - Commercial paper (CP) used for < 1 year, but
DO
VO = - Indexed-annuity: Amortizing bonds with annuity carries rollover risk
r
Gordon constant growth model (GGM): payments adjusted for inflation - Long-term bonds ~12+ years
c - Bilateral/syndicated bank loans are also used
DO (1 + g)# DO (1 + g) D4
VO = F = =
(1 + r)# r−g r−g
#34
g = (Retention rate) × ROE = (1 − D⁄E) × ROE
Medium-Term Notes (MTNs) Yield Measures Securitization Example
- Used to bridge gap between CP and L/T bonds Annual cash coupon payment - Firm sells equipment on credit
Current yield =
- Offered to investors through an agent in a range Flat price - Firm creates bankruptcy-remote SPV
of maturities Annual cash Amortized - SPV issues debt to purchase loans from firm
+
coupon payment gain/loss
- Lower registration/underwriting costs than Simple yield = - SPV creates securities backed by loans
Flat price
bonds, but relatively illiquid - Investors purchase securities from SPV
Yield-to-call (YTC) = IRR assuming bond is called
- SPV collects loan payments from firm’s customers
USCP vs. Eurocommercial Paper Yield-to-worse = min[YTC, YTM]
- SPV distributes cash flows to investors
USCP ECP
Yield Measures for FRNs Residential Mortgage Loans

Currency US dollar Any currency
Quoted margin (QM): Spread paid by FRN - Interest: fixed, adjustable, convertible
Maturity Overnight Overnight to
Discount margin (DM): Spread required by market - Amortization: full, partial, interest-only
to 270 days 364 days
If QM > DM, FRN will trade above par - Prepayment: penalty, no penalty
Interest Discount Interest-
FRN pricing formula: - Foreclosure: non-recourse, recourse
calculation basis bearing or
(Ref + QM)(FV) (Ref + QM)(FV)
discount + FV
= m …+ m Residential Mortgage-Backed Securities
basis (Ref + DM) 4 (Ref + DM) ! - Agency RMBS: Issued by government agencies;
[1 + \ [1 + \
Settlement T + 0 T + 2 m m

must have conforming loans
Negotiable Can be sold Can be sold Yield Measures for Money Market Instrument - Non-agency RMBS: Issued by private companies
Discount Rate (DR) Basis and may have non-conforming loans
Structured Financial Instruments
- Guarantee certificate: Zero-coupon bond with a Days - Pass-through rate: MBS coupon rate
PV = FV × [1 − × DR\
call option on the issuer’s equity Year - Prepayment risk: Contraction (faster-than-

- Credit-linked note: Seller earns a premium for expected); extension (slower-than-expected)
Add-on Rate (AOR) Basis
providing credit protection on underlying bond Days - Prepayment rates are relative to PSA benchmark
PV = FV¢[1 + × AOR\ Collateralized Mortgage Obligations (CMO)
- Participation Instruments: Coupon payments Year
based on underlying rate (e.g., FRNs)

- Unlike pass-through securities, CMOs have
Implied Forward Rate (IFR)
- Leveraged Instruments: Modify returns tranches to redistribute cash flows and risks
@?7
(1 + z7 )7 × l1 + IFR 7,@?7m = (1 + z@ )@ - Sequential-pay CMOs have principal and
Leveraged floater: 2 × (Reference rate)
Deleveraged floater: 0.5 × (Reference rate) prepayments paid to the tranches sequentially
Leveraged inverse floater: Max coupon − 2 × (RR) - Planned amortization class (PAC) CMOs have
support tranches to absorb prepayment risk
Factors Increasing Repurchase (Repo) Rates
- Higher Collateral risk Non-Mortgage ABS
Yield Spreads over Benchmark Yield Curve - Amortizing: E.g., auto loan ABS
- Longer term
G-spread= YTM − Government bond yield - Non-amortizing: E.g., credit card receivable ABS
- Delivery requirement
I-spread= YTM − Swap rate Collateralized Debt Obligations (CDO)
- Low quality collateral
- Higher rates for alternative sources of funds Z-spread Securities backed by pool of debt obligations, such
PMT PMT PMT + FV as corporate bonds, leveraged bank loans, or credit
PV = + + ⋯+
(1 + z% + Z)% (1 + z& + Z)& (1 + z' + Z)'
INTRODUCTION TO FIXED-INCOME VALUATION
INTRODUCTION TO FIXED-INCOME VALUATION default swap on securities
(Can only be calculated by trial-and-error)
Bond Pricing with Spot Rates Covered Bonds

PMT PMT PMT + FV Option-adjusted spread (OAS)
- Dual recourse against the issuing financial
PV = + + ⋯+ OAS = Z-spread − Option value (in basis points)
(1 + z4 )4 (1 + z: ): (1 + z! )! institution and the cover pool
CR: Coupon Rate; MDR: Market Discount Rate
- One bond class per cover pool
CR = MDR Price = Par Value Par INTRODUCTION TO ASSET-BACKED
INTRODUCTION TO - Issuer must replace non-performing asset with
CR < MDR Price < Par Value Discount ASSET-BACKED
SECURITIES SECURITIES performing asset
CR > MDR Price > Par Value Premium Parties to a Securitization
- Seller/Depositor: Originates loans (assets)
Bond Pricing Relationships - Issuer: Special purpose vehicle (SPV) established
- Inverse effect: Price moves opposite to yield to create asset-backed securities (ABS)
- Convexity effect: Falling yield has greater price - Servicer: Collects payments on underlying loans
impact than equivalent increase in yield
ABS Tranching
- Coupon effect: Yield changes have greater impact - Credit tranching: Certain tranches absorb credit
on lower coupon bonds losses before others
- Maturity effect: Yield changes have greater impact - Absolute priority rule: Senior claims outrank
on longer-term bonds (may not apply to low- subordinated claims in the event of a liquidation
coupon bonds trading at very deep discounts) - Time tranching: Certain tranches are exposed to
Flat Price, Accrued Interest, and Full Price prepayment risk
PV Z,WW = PV ZW$# + AI = (PV)(1 + r)#⁄2
AI = (t⁄T) × PMT

UNDERSTANDING FIXED-INCOME
UNDERSTANDING FIXED-INCOME RISK AND Convexity DERIVATIVES DERIVATIVES
RETURNS
RISK AND RETURNS (PV? ) + (PVJ) − [2 × (PVO)]
ApproxCon =
Constant Yield Price Trajectory (ΔYield): (PVO) DERIVATIVE MARKETS AND INSTRUMENTS
DERIVATIVE MARKETS AND INSTRUMENTS

1 Types of Derivatives
%ΔPV Z,WW = −D1)& × ΔYTM + (Conv)(ΔYTM):
2 Forward commitments: Obligation to trade on a
(PV? ) + (PVJ ) − 2(PVO )
EffConv = specified date at a previously agreed price
(ΔCurve):(PVO )

Contingent claims: Trade may or may not occur
depending on market conditions

Forward
Contingent Claims
Commitments
Options
Forward contract
Credit derivatives
Futures contracts
Asset-backed
Swaps
securities

Yield Duration vs. Curve Duration Forwards vs. Futures

Yield duration: Sensitivity to YTM Forward Contracts Futures Contracts
Measures: Macaulay duration, modified duration, Fully customizable Standardized

money duration, price value of basis point (PVBP)
Largely Heavily regulated
Curve duration: Sensitivity to benchmark yields Duration Gap
unregulated
(e.g., effective duration); for bonds with options Duration gap = D1$( − Investment horizon
Over-the-counter Exchange-traded
- If positive: Price risk > Reinvestment risk
Macaulay Duration (OTC)
- If negative: Reinvestment risk > Price risk
1+r 1 + r + N(c − r) t Counterparty credit Guaranteed by
D1$( = [ − \−
r c[(1 + r)! − 1] + r T risk exposure clearinghouse
FUNDAMENTALS OF CREDIT ANALYSIS
FUNDAMENTALS OF CREDIT ANALYSIS
r: YTM No cash flows until Margin deposit
c: Coupon rate Credit Risk maturity and daily mark-
N: Number of periods to maturity - Default risk: Probability of default to-market
t: Number of days since last coupon payment - Loss severity: Loss given default
T: Number of days in each coupon period E[Loss] = Pr(Default) × Loss severity BASICS OF DERIVATIVE PRICING
BASICS OF DERIVATIVE PRICING AND
Loss severity = 1 − Recovery rate AND VALUATION
VALUATION

Spread Risk The Principle of Arbitrage: Replication

- Credit migration risk: Possibility of downgrade Strategies
- Market liquidity risk: Need to sell at a discount Asset − Derivatives = Risk-free asset

Seniority Ranking Forward Contract: Price

- First Lien Loan – Senior Secured FO (T) = SO (1 + r)2 − FV2 (benefit) + FV2 (cost)
- Second Lien Loan – Secured Forward Contract: Value
- Senior Unsecured
Initiation VO (T) = 0
- Senior Subordinated
Expiration V2(T) = S2 − FO (T)

- Subordinated
Modified Duration V# (T) = S# − PV#(benefit)
- Junior Subordinated Time t
D1$( + PV# (cost) − FO (T)⁄(1 + r)2?#
ModDur = Pari passu: All creditors in the same ranking,
1+r
regardless of maturity, have the same priority Forward Price vs. Futures Price
%ΔPV Z,WW = −AnnModDur × ΔYield
(PV? ) − (PVJ ) Credit Ratings The relationship between forward prices and
ApproxModDur = futures prices depends on the correlation between
2(ΔYield)(PVO ) Investment grade: Baa3/BBB- and above
Non-investment grade: Ba1/BB+ and below futures prices and interest rates:
Money Duration and PVBP
Correlation Relationship
MoneyDur = AnnModDur × PV Z,WW Four C’s of Credit Analysis
None Futures price = Forward price
ΔPV Z,WW ≈ −MoneyDur × ΔYield - Capacity
Positive Futures price > Forward price
(PV? ) − (PVJ ) - Collateral
Price value of a basis point = - Covenants Negative Futures price < Forward price
2
Basis point value = D1)& × 0.0001 - Character Option Moneyness

Effective Duration Corporate Bond Yield Components Option Moneyness Call Put
(PV? ) − (PVJ ) - Real risk-free interest rate In-the-money S# > X S# < X
EffDur =
2(ΔCurve)(PVO ) - Expected inflation rate At-the-money S# = X S# = X

- Maturity premium Out-of-the-money S# < X S# > X
- Liquidity premium
Yield spread
- Credit spread

Option Styles Compensation Structures Timberland and Farmland
- American: May be exercised at any time - Soft hurdle rate: Incentive fee applies to entire Sources of return:
- European: May only be exercised at expiration return if hurdle rate is cleared - Biological growth
- Hard hurdle rate: Incentive fee is only paid on - Prices of timber/crops
European Option Values
return in excess of hurdle rate - Land price changes
c2 = max[0, S2 − X]

p2 = max[0, X − S2] Common Clauses and Provisions Forms of Real Estate Investing
cO ≥ max[0, SO − X⁄(1 + r)2 ] - Catch-up clause: Allows the GP to receive 100% of Debt Equity
pO ≥ max[0, X⁄(1 + r)2 − SO ] the return in excess of the hurdle rate until the GP
Mortgages, Direct ownership,
catches up with their cumulative performance fee
American Option Values Private Construction Real estate funds,
- High-water mark clause: Reflects the highest
- The value of an American call/put must be at lending Private REITs
value used to calculate an incentive fee
least equal to the value of an equivalent European MBS, CMOs, Shares in RE corps.,
- Waterfall: Distribution method that defines the
call/put. order of allocations to the LPs and GPs Public Mortgage REITs
- American calls on dividend-paying stock or - Clawback provision: Allows the LPs to get back REITs
American puts may be exercised early. incentive fees that have been paid if gains are
subsequently reversed Infrastructure Investments
- American calls on nondividend-paying stock
- New (greenfield) or existing (brownfield) assets
should never be exercised early.
Hedge Fund Strategies - Economic (roads) or social (healthcare facilities)
Factors Impacting Option Values - Equity hedge: Long and short positions in equity - Direct ownership or indirect (via LP or ETF)
Increase in Call Put and equity derivative securities; Bottom-up - Private vehicles or public securities (uncommon)
Value of underlying ↑ ↓ - Event-driven: Seek to profit from
short-term events (e.g., Mergers); Bottom-up GAAP Investment Categorization

Exercise price ↓ ↑
- Relative value: Seek to profit from pricing - Level 1 pricing: Uses exchange-traded, publicly
Time to expiration ↑ ↑*
discrepancies between related securities traded prices
Risk-free rate ↑ ↓ - Macro: Emphasize top-down approach to - Level 2 pricing: Relies on outside broker quotes
Volatility of underlying ↑ ↑ identifying global economic trends - Level 3 pricing: Uses values computed using

Payments on underlying ↓ ↑ internal models
Private Equity: Leveraged Buyouts
Cost of carry ↑ ↓
- Management buyouts: Current management team
*Except for some deep-in-the-money put options is involved in the acquisition

- Management buy-ins: Current management team PORTFOLIO MANAGEMENT
PORTFOLIO MANAGEMENT
Put-Call Parity
is being replaced by the acquiring team
cO + X⁄(1 + r)2 = sO + pO
PORTFOLIO MANAGEMENT: AN OVERVIEW
PORTFOLIO MANAGEMENT: AN OVERVIEW
Fiduciary call = Protective put Private Equity: Venture capital

- Formative-stage financing: Angel investing, Portfolio Management Process
Put-Call-Forward Parity Planning: List objectives and constraints in IPS
seed-stage financing, early-stage financing
cO + X⁄(1 + r)2 = FO(T)⁄(1 + r)2 + pO Execution: Asset allocation, security analysis,
- Later-stage financing: After commercial
Fiduciary call = Protective put w. forward contract portfolio construction
production and sales have begun but before IPO
Binomial Valuation of Options - Mezzanine-stage financing: Prepare to go public Feedback: Monitoring and rebalancing,
πc4J + (1 − π)c4? Exit strategies: Trade sale (best price), IPO, performance measurement and reporting
cO =
1+r recapitalization, secondary sale, liquidation
Institutional Investor Clients
1+r−d
π= Private Debt - DB pension plans: Younger beneficiaries increase
u−d
J ? - Direct lending: Direct capital in the form of senior time horizon and risk tolerance
c4 − c4
h= J and secured loans - Endowments/Foundations: Generally longer time
S4 − S4?
- Mezzanine debt: Debt subordinated to senior horizon, low liquidity needs, high risk tolerance

secured debt but senior to equity - Banks: Short time horizon, high liquidity need,

ALTERNATIVE INVESTMENTS - Venture debt: To complement existing equity very low risk tolerance
ALTERNATIVE INVESTMENTS
financing of start-up or early-stage companies - Insurers: Short time horizon (longer for Life than

- Distressed debt: Funding provided to mature
Qualities of Alternatives vs. Traditional Assets P&C), high liquidity needs, low risk tolerance
companies facing financial distress
- Narrow manager specialization
- Investment companies: Time horizon and risk
- Low correlation with traditional investments Commodities tolerance vary by mandate, liquidity needs are
- Less regulation and lower transparency Futures price: usually high due to potential redemptions
- Limited historical risk and return data SO (1 + r) + Storage costs – Convenience yield - Sovereign Wealth Funds: Vary by mandate
- Unique legal and tax considerations
Contango Backwardation Robo-Advisors
- High fees
Price curve - Cater to underserviced segments, “mass affluent”
- High use of leverage Upward Downward
slope - Lower fees compared to traditional managers
- Restrictions on redemptions
Convenience - Relatively low barriers to entry
Investment Methods Low High
yield
- Fund Investing: Indirect investing
- Co-Investing: Hybrid between direct investing and
indirect investing
- Direct investing: Without the use of intermediary
Mutual Funds Minimum-Variance Portfolios Beta
- Open-end: Accept new investors after launch Cov(R + , R ' ) ρ+,' σ+
β+ = =
- Closed-end: No new shares created after launch, σ:' σ'
may trade at a premium/discount to NAV Systematic risk = Non-diversifiable (market) risk
- No-Load: No investing/redemption fees, funds Nonsystematic risk = Diversifiable risk
charge a percentage of NAV Total risk = Systematic risk + Nonsystematic risk

Exchange Traded Funds (ETFs) Capital Asset Pricing Model (CAPM)

- Mutual funds only trade at the end of each day, Assumptions:
ETFs can be traded at any time during the day - Investors are risk-averse, utility-maximizing,
- Investors can sell ETFs short or buy on margin rational individuals
- ETFs do not trade at discount/premium to NAV - Markets are frictionless
- ETFs distribute dividends to investors, mutual - All investors plan for same single holding period

funds reinvest dividends - Investors have homogeneous expectations
Capital Allocation Line (CAL)
- ETFs have lower minimum investment levels - Investments are infinitely divisible
Line representing possible combinations of risk-
- Investors are price takers
free assets and optimal risky asset portfolio
PORTFOLIO RISK AND RETURN: PART I
PORTFOLIO RISK AND RETURN: PART I E£R . § = R U + β+ [E[R ' ] − R U ]
E[R + ] − R U
Money-Weighted Return (MWR) E£R . § = R U + Ü á σ.
σ+ Limitations:
- IRR derived from all cash inflows and returns - Single-factor: Only accounts for systematic risk
Investor’s Optimal Portfolio
- Can be skewed by timing/value of cash flows - Single-period: Does not consider multiple periods
- Appropriate if manager controls timing of CFs - Inclusion of assets that are not investable, such as
Time-Weighted Return (TWR) human capital and assets in closed economies
- Geometric mean of sub-period returns Security Market Line (SML)
- Compound growth for an initial $1 investment Graphical representation of CAPM:
- Unaffected by timing/value of cash flows
Risk Aversion
Combination of ability and willingness to take risk
Risk averse: Requires a premium to take more risk
Risk neutral: Only concerned with expected return,
indifferent to level of risk
Risk seeking: Will pay a premium to take more risk

Utility Function
1
PORTFOLIO RISK AND RETURN: PART II
PORTFOLIO RISK AND RETURN: PART II
U = E(r) − Aσ:
2 Capital Market Line (CML)
A is the degree of risk aversion, it is >0 for risk- CAL with risky portfolio being market portfolio
averse, 0 for risk-neutral, and <0 for risk-seeking E[R ' ] − R U

E£R . § = R U + Ü á σ.
σ' Identifying Mispriced Stocks
Indifference Curves
Stocks that plot above the SML are underpriced;
Borrowing vs. Lending

stocks that plot below the SML are overpriced
Ratios
Sharpe R. − RU

Total risk
ratio σ.
M- σ'
lR . − R U m + RU
squared σ.
Treynor R. − RU
Systematic

ratio β.
risk
Jensen’s
R . − £R U + β. (R ' − R U )§
alpha

BASICS OF PORTFOLIO PLANNING
BASICS OF PORTFOLIO PLANNING AND INTRODUCTION TO RISK MANAGEMENT
AN INTRODUCTION TO RISK MANAGEMENT Reversal Patterns
CONSTRUCTION
AND CONSTRUCTION Head and shoulders (H&S): Indicate an upcoming
Risk Management
Investment Policy Statements (IPS) Risk management framework: downtrend following a preceding uptrend
Investment objectives: Risk/return objectives - Risk governance Inverse H&S: Indicate an upcoming uptrend
Constraints: Liquidity, time horizon, tax concerns, - Risk identification and measurement following a preceding downtrend
legal and regulatory factors, unique circumstances - Risk infrastructure

Asset Allocation - Defined policies and processes

Strategic asset allocation: Set of exposures to IPS- - Risk monitoring, mitigation, and management
permissible asset classes in weights that are - Communications
consistent with the client’s long-term objectives - Strategic analysis or integration
Tactical asset allocation: Deliberate deviations Risk tolerance: Which risks are acceptable and how
from policy weights based on forecasts of asset much risk should be taken
class returns over the near term Risk budgeting: How the risks should be taken
Financial risks: Arise from financial market

THE BEHAVIORAL BIASES OF INDIVIDUALS activities (e.g., market, credit, liquidity risk)
THE BEHAVIORAL BIASES OF INDIVIDUALS
Non-financial risks: Arise from within entity or Price target = Neckline − (Head − Neckline)
Cognitive Errors
from external (e.g., operational, legal, regulatory, Double tops: When an uptrend reverses twice at
- Conservatism bias: People fail to incorporate new
political, model, tail risk) about the same high
information that conflicts with their opinions
Risk measures: Standard deviation, beta, duration, Price target = Valley − (Top − Valley)
- Confirmation bias: People seek “evidence” that
delta, gamma, VaR, CVaR, etc.
confirms their prior beliefs Double bottoms: When a downtrend reverses twice
Risk modification: By prevention and avoidance,
- Representativeness bias: People inappropriately at about the same low
transfer (insurance), or shifting (derivatives)
classify new information based on past similar Price target = Top + (Top − Valley)

situations
TECHNICAL ANALYSIS
TECHNICAL ANALYSIS Triple Tops/Bottoms: More significant indicators
- Illusion of control bias: People overestimate their
Technical Analysis: Principles than double tops/bottoms
ability to control or predict events
- Hindsight bias: People believe past events would - The market discounts everything Continuation Patterns
have been predictable - Prices move in trends and countertrends Triangles (Ascending and Descending)
- Anchoring and adjustment bias: People rely too - Price action is repetitive with reoccurring
much on initial information in their estimation patterns

- Mental accounting bias: People put money in Technical Analysis: Charts
separate mental buckets Line chart: A plot of price data, typically closing
- Framing bias: People answer the same question prices, with a line connecting the points
differently based on how it is framed
- Availability bias: People assume outcomes that Bar chart

are easier to remember are more likely
Triangle (Symmetrical)
Emotional Biases Narrowing = bullish; Widening = bearish
- Loss-aversion bias: People strongly prefer
avoiding losses more than achieving gains

- Overconfidence bias: People overestimate their
own abilities
- Self-control bias: People lack self-discipline to
make decisions based on their long-term goals
Candlestick chart
- Status quo bias: People are more inclined to do
White body: close > open; Dark body: close < open
nothing rather than make changes
- Endowment bias: People value an asset more

when they hold the rights to it Rectangles (Bullish and Bearish)
- Regret-aversion bias: People avoid making
decisions that could potentially turn out badly

Market Anomalies
Factors that cause anomalies misclassifications:

- Inappropriate asset pricing model
- Statistical issues due to small samples Trends
- Temporary disequilibria Uptrend: Price reaches higher highs/lows
Downtrend: Price reaches lower highs/lows
Support: Buying is sufficient to stop further decline

Resistance: Selling pressure stops further increase
Flag: Parallel trend lines over short period
Pennant: Converging trend lines over short period
Price-Based Indicators FINTECH IN INVESTMENT MANAGEMENT
FINTECH IN INVESTMENT MANAGEMENT ETHICAL AND PROFESSIONAL STANDARDS
ETHICAL AND PROFESSIONAL STANDARDS
Moving average (MA): Average closing price over a Machine Learning
specified number of periods (e.g., 7-day, 60-day) Supervised learning: Algorithm finds relationships I(A) Knowledge of the Law
Golden cross: Short-term MA crosses long-term MA among labeled training data Obey strictest applicable law. Disassociate
from below; bullish indicator Unsupervised learning: Algorithm works with immediately from any illegal or unethical activity.
Dead cross: Short-term MA crosses long-term MA

unlabeled data to create clusters/groupings I(B) Independence and Objectivity

from above; bearish indicator
Data Processing Methods Do not offer or accept gifts that might impair
Bollinger bands: Lines representing MA +/ − X
Data capture: Collecting data, transforming into independence and objectivity. Gifts from clients
standard deviations; Bullish if MA reaches lower
usable format may be permissible.
bound, bearish if MA reaches upper bound
Data curation: Cleaning data to ensure high quality I(C) Misrepresentation

Data storage: Recording, archiving, accessing data Cite sources. Do not plagiarize or omit important
Search: Finding specific information in datasets information. Act quickly to correct any errors.
Transfer: Moving data from source or storage
I(D) Misconduct
location to the analytical tool
Does not apply to personal behavior unless it
Uses of Fintech in Investment Management reflects poorly on the investment profession.
Text Analytics: Analysis of unstructured data

II(A) Material Nonpublic Information

Natural Language Processing: Interpreting human
Do not act or cause others to act on material
language (e.g., speech recognition)
nonpublic information. Seek public dissemination.
Distributed Ledger Technology (DTL) II(B) Market Manipulation

Ownership of assets is created and exchanged on a Do not take any actions that distort prices or
Momentum Oscillators peer-to-peer network trading volume. Market making and legitimate
Rate of Change (ROC) Oscillator: Smart contracts: Programmed to execute if trading strategies are allowed.
M = (V − Vx) × 100 specified conditions are met
V = last closing price III(A) Loyalty, Prudence, and Care
Blockchain: Digital ledger for blocks of linked
Vx = closing price x days ago, typically 10 Place clients’ interest above yours. Disclose
transactions validated through user consensus
ROC oscillator crossing 0 in the same direction as policies on proxy voting and soft commissions.
Permissionless networks: No centralized authority
the trend direction is buy/sell signal needed to validate transactions III(B) Fair Dealing
Relative Strength Index: Permissioned networks: Members are restricted Treat all clients fairly. Treat non-immediate family
100 Σ(Up changes) from participating in certain activities like other clients. Communicate investment
RSI = 100 − , RS =
1 + RS Σ(|Down changes|) recommendations and changes simultaneously.
Stochastic Oscillator: Uses of DTL in Investment Management
Cryptocurrencies: Allow transactions without III(C) Suitability
Last closing price − Low in past 14
%K = 100 [ \ intermediaries, such as banks Use a regularly updated IPS during investment
High in past 14 − Low in past 14
Tokenization: Represents ownership of physical decisions. Evaluate decisions in a portfolio context.
%D = average of last 3 daily %K values
MA convergence/divergence (MACD) oscillator: assets on a blockchain or distributed ledger III(D) Performance Presentation
Consists of MACD line and signal line: MACD line is Clearing/Settlement: DTL allows near real-time Performance data should be fair, accurate, and
the difference between two exponentially trade verification and reconciliation complete. Do not promise returns for risky assets.
smoothed moving averages (12 and 26 days); Compliance: Allows regulators to conduct near
III(E) Preservation of Confidentiality
Signal line is the exponentially smoothed average real-time review of all transactions
Keep all client information confidential unless:
of MACD line (9 days)
client is involved in illegal activity, you are legally

Sentiment Indicators required, or you have the client’s permission.
Put/call ratio: Volume of put options traded
divided by volume of call options traded
CBOE Volatility Index (VIX): Measures near-term
market volatility calculated by the CBOE
Intermarket Analysis
The combined analysis of major categories of
securities (equities, bonds, etc.) to identify
patterns and inflection points
- Top-down approach: Focus on global equity
markets, then narrow down to specific companies
- Bottom-up approach: Select stocks based on
a set of predefined criteria regardless of
economy and sector

IV(A) Loyalty BA II PLUS CALCULATOR TIPS
BA II PLUS CALCULATOR TIPS
Get permission before taking outside work (even
unpaid) that competes with employer. Abide by Basic Operations
non-compete agreement (if applicable) and do not 2ND : Access secondary functions (in yellow)
take employer’s property.
ENTER : Send value to a variable
IV(B) Additional Compensation Arrangements
2ND + ENTER : Toggle between options
Obtain written permission from all parties before
receiving any compensation for outside work. ↑ ↓ : Navigate between variables/options
STO + 0 - 9 : Store current value into memory
IV(C) Responsibilities of Supervisors
RCL + 0 - 9 : Recall value from memory
Supervisors must adequately train and monitor
subordinates. Responsibilities may be delegated.

Time Value of Money (TVM)
V(A) Diligence and Reasonable Basis For annuity, loan, and bond calculations
Exercise diligence and thoroughness. Support
N : Number of periods
actions with research and investigation.

I/Y : Effective interest rate per period (in %)
V(B) Communication with Clients and
Prospective Clients PV : Present value
Make appropriate disclosures. Distinguish between PMT : Payment/coupon amount
fact and opinion in analysis and recommendations.

FV : Future value/redemption value
V(C) Record Retention CPT + one of the above : Solve for unknown
Maintain records to support recommendations and
2ND + BGN : Toggle between ordinary annuity
decisions. 7-year retention period recommended.

and annuity due
VI(A) Disclosure of Conflicts
Disclose any matters that may impair 2ND + CLR TVM : Clear TVM worksheet
independence and objectivity, prominently Note:
and in plain language. - Always clear the TVM worksheet before

VI(B) Priority of Transactions starting a new calculation

Execute clients’ transactions before accounts - For bonds, PMT and FV should have the same
in which you have a beneficial interest. sign, and opposite signs to PV

VI(C) Referral Fees Cash Flow Worksheet ( CF , NPV , IRR )

Disclose referral fees to clients and employer, For non-level payments
including non-monetary arrangements.
Input ( CF )
VII(A) Conduct as Participants in CF0: Initial cash flow
CFA Institute Program
C01: 1st distinct cash flow after initial cash flow
Do not share confidential exam details. Expressing
opinions about CFAI policies is permissible. F01: Frequency of CO1
C0n: nth distinct cash flow
VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program F0n: Frequency of C0n
Do not misrepresent the meaning of CFA Institute Note:
membership, designation, or candidacy. - Always clear the CF worksheet before starting
a new calculation
- The use of F0n is optional. You can leave them as
1 and input repeating cash flows multiple times. If
you do so, C01 will be the cash flow at time 1, C02
will be the cash flow at time 2, and so on.
Output ( NPV , IRR )
I: Effective interest rate per period (in %)
NPV + CPT : Solve for net present value
IRR + CPT : Solve for internal rate of return

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CFA® Level I

Formula Sheet – 2022 Syllabus

QUANTITATIVE METHODS Mean Absolute Deviation Sample Covariance

- Histogram and frequency polygon Expected Value

- Tree-map E(X) = F P(X + )X +

- Scatter plot (and scatter plot matrix) Variance

"! Properties of Estimators

n Reliability factors for normal distributions

: If the population is not normally distributed

(n4 − 1)s4: + (n: − 1)s:: - Normality of the residuals

Tests Concerning Mean Differences in Y

σ:O n−1 Coefficient of determination:

Goods with positively sloped demand curves: Profit maximization:

Revenue Terms Cournot assumption: Competitors will maintain

Cost Terms Price collusion is more likely to happen if:

- Orders are frequent and relatively small

Aggregate Demand (AD) Physical capital Right Right

Price discrimination by monopolists:

Market Power Measures

- Higher household wealth Effect of Combined Changes in AS and AD

GDI - Economy: Going through a trough

+ Net mixed income from Expansion

unincorporated businesses - Economy: Enjoying an upswing

Coincident: Real income, industrial production Ideal Currency Regime

Marshall-Lerner Condition - Discontinued operations CFO Direct Method

Net income − Preferred dividends CFO Indirect Method

Average total assets FIFO Allowed Allowed

Revenue EBIT same for periodic or perpetual

different times; Replacing entire board takes years

- Audit USES OF CAPITAL

to rate companies based on their

- Inventory & marketable securities Flotation Costs

Modigliani and Miller Propositions

Costs of the Various Sources of Capital or costs of financial distress)

implicit costs: Leveraged Positions

Business Risk Maintenance margin: minimum amount of equity

Measures of Leverage Execution Instructions (How to fill)

Breakeven - Stop-loss: Sell if prices fall below specified level

Total Return over Single Period MARKET EFFICIENCY

Yield Measures for FRNs Residential Mortgage Loans

Bond Pricing with Spot Rates Covered Bonds

Yield Duration vs. Curve Duration Forwards vs. Futures

Spread Risk The Principle of Arbitrage: Replication

Seniority Ranking Forward Contract: Price

short-term events (e.g., Mergers); Bottom-up GAAP Investment Categorization

Exchange Traded Funds (ETFs) Capital Asset Pricing Model (CAPM)

Asset Allocation - Defined policies and processes

much on initial information in their estimation patterns

- Availability bias: People assume outcomes that Bar chart

avoiding losses more than achieving gains

- Endowment bias: People value an asset more

decisions that could potentially turn out badly

unlabeled data to create clusters/groupings I(B) Independence and Objectivity

Data curation: Cleaning data to ensure high quality I(C) Misrepresentation

II(A) Material Nonpublic Information

VI(B) Priority of Transactions starting a new calculation

VI(C) Referral Fees Cash Flow Worksheet ( CF , NPV , IRR )

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