Professional Documents
Culture Documents
JuiceNotes 2023
INDEX
Quantitative Methods
1 Basics of Multiple Regression & Underlying Assupmtions 05
2 Evaluating Regression Model Fit and Interpreting Model Results 06
3 Model Misspecification 09
4 Extensions of Multiple Regrission 13
5 Time-series Analysis 15
6 Machine Learning 22
7 Big Data Projects 31
Economics
1 Currency Exchange Rates: Understanding Equilibrium Value 39
2 Economic Growth and The Investment Decision 46
3 Economics Of Regulation 51
Quantitative Methods
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Regression
k RSS MSR = RSS/k
(explained)
Error
n−k−1 SSE MSE = SSE/n − k − 1
(unexplained)
R² and adjusted R²
R2: % variation of dependent variable explained by % variation of all the independent variables
R2 = RSS/SST
Adjusted R2 = 1− ]) n−1
n−k−1 ) ]
× (1 − R2)
k=8 n = 30 R2 = 75%
Adjusted R21 = 1− ]) 30 − 1
30 − 6 − 1 )
× (1 − 0.732) ] 41.1%
Adjusted R22 = 1− ]) 30 − 1
30 − 8 − 1 )
× (1 − 0.752) ] 39.58%
Adding two more variables is not justified because adjusted R22 < adjusted R21
For evaluating a regression model, regression output may include the Akaike's
information criterion (AIC) and the Schwarz's Bayesian information criteria (BIC).
Both AIC and BIC evaluate the quality of model fit among competing models for the
same dependent variable
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For evaluating a regression model, regression output may include the Akaike's
information criterion (AIC) and the Schwarz's Bayesian information criteria (BIC).
Both AIC and BIC evaluate the quality of model fit among competing models for the
same dependent variable
AIC is used if the goal is to have a better forecast, while BIC is used if the goal is a
better goodness of fit.
AIC = n
x
(
1 n SSE)2 ( K + 1 ) n=30
n +2
x
BIC = n
x
(
1n SSE
n )
+ 1 n (n) ( K + 1) LN ( 30 ) = 3.40
3.40
Where:
K = number of independant variables
In addition to AIC and BIC, we can use a formal F-test to evaluate nested models.
Nested models are models such that one model, called the full model or unrestricted
model, has a higher number of independent variables while another model
called the restricted model, has only a subset of the independent variables.
Consider a full model with three independent variables that is evaluated relative to
a more parsimonious restricted model, which includes only the first variable as the
independent variable.
unrestricted model: Yi = b0 + b1 X1 + b2 X2 + b3 X3 +Σ i
restricted model: Yi = b0 + b1 X1 + Σ i
( SSER – SSEU ) / q
F= with q and (n-k-l) degree of freedom
( SSEU ) / ( n-k-1)
where:
Model Misspecification
Calculate and interpret a predicted value for the dependent variable, given the estimated
regression model and assumed values for the independent variables.
Where:
n = the number of observation
2
R resid = R2 from a second regression ( of the squared residuals from the
The first regression ) on the independent variables
K = the number of independent variables
This is a one-tailed test, because heteroskedasticity is only a problem if the R2 and the BP
Test statistic are too large.
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Residual serial correlation at single lag can be detected using the Durbin-Watson (DW)
Statistic. A more general test (which can accommodate serial correlation at multiple lags)
Is the Breusch-Godfrey (BG) test. The BG test regresses the regression residuals against
The original set of independent variables, plus one or more additional variables
Representing lagged residual(s):
We then test whether each of the slope coefficients of the lagged residuals is statistically
Significantly different from 0.
H0: p1 = 0 vs . H2: p1 = 0
More formally, we can quantify multicollinearity using the variance inflation factor (VIF)
For each of the independent variables. We start by regression one of the independent
2
Variable “J” against the remaining independent variables. The Rj from that equation is
Then used to calculate the VIF of that variable.
VIFj = 1 / (1 - Rj2 )
High values of Rj2 signal that the variable is well explained by other variables, and
Indicates that the variables will have a high VIF. A VIFj value of 1 (i.e., R2 = 0) indicates
that the variable j is not highly correlated with other independent variables. VIF values
2
Greater than 5 (i.e., R > 80%) warrant further investigation, while values above 10
2
(i.e.,R > 90%) indicates severe multicollinearity.
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High-leverage points are the extreme observations of the independent (or 'X') variables.
High Leverage points - would be identified using a measure called leverage (Lij) which
can be provided by statistical packages.
Leverage: Distance between variable and sample mean, scaled to be between 0 and 1
The higher the value of leverage, the greater the distance—and hence the higher the
potential influence of the observation—on the estimated regression parameters.
If a variable's leverage is higher than three times the average, [3(k + 1) / n], it is
considered potentially influential.
We can identify outliers using the studentized residuals. The steps below outline the
procedure:
Perform this sequentially, for all observations, deleting one observation at a time.
Compare the actual Y value of the deleted observation i to the predicted Y-values using
the model parameters estimated with that observation deleted.
* *
Ei = Yi – Yi
The studentized residual is the residual in step 2 divided by its standard deviation.
*
ei*
t = i
si*
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We can then compare this studentized residual to critical values from a t-distribution
with n – k – 2 degrees of freedom, to determine if the observation is influential.
Cook's distance (Di) is a composite metric (i.e., it takes into account both the leverage
and outliers) for evaluating if a specific observation is influential.
[ ]
2
ei hii
Di = 2
(1 – hii )
k x MSE
Where:
ei = residual for ith observation
k = number of independent variables
MSE = mean square error of the regression model
hii = leverage value for ith observation
Di values greater than √k/n indicate that the ith observation highly likely to be an
Influential data point. Generally, a value greater than 1 indicates high likelihood of an
Influential observation, while values above 0.5 merit further investigation.
Once influential observation are identified, we need to determine whether this was the
Result of an input error (in which case, the error should be rectified or the observation
deleted), or if the observation is valid but the model is incomplete (i.e., important
independent variables are omitted).
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A dummy variable can be an intercept dummy, a slope dummy, or a combination of the two
Y = b0 + d0 D + b1X + Σ
Y = b 0 + b1 X + d1 ( D x X ) + Σ
Y = b0 + d0 D + b1X + Σ
This regression becomes:
And the regression then becomes:
Y = b 0 + b1 X + Σ (if D=o)
Financial analysis often calls for the use of a model that has a qualitative dependent
variable—a binary or dummy variable, which takes on a value of either zero or one.
In this case, the dependent variable may take on a value of one in the event of default
and zero in the event of no default.
An ordinary regression model is not appropriate for situations that require a qualitative dependent
variable, because the forecasted values of y using the model can be less than 0 or greater than 1,
which are illogical values for probability.
Returns on *
Nifty = 5% + 1.2 GDP growth + Σ
Prob.of Bankruptcy
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Instead, we transform the probability values of the dependent variable into odds: p / (1 – p).
For example, if probability = 0.80, then odds = 0.80 / 0.20 or 4 to 1.
A logistic transformation involves taking the natural log of the odds: ln [p / (1 – p)].
Logistic regression (logit) models use log odds as the dependent variable.
In ( 1-p
P
) = b0 + b1X1 + b2X2 + … + Σ
The coefficients of the logit model are estimated using the maximum likelihood estimation methodology.
The slope coefficients in a logit model are interpreted as the change in the “log odds” of the
event occurring per one unit change in the independent variable, holding all other independent
variables constant.
Once the coefficients are estimated, using the regression equation, the predicted value
Λ
Of y (i.e., y) can be calculated from the values of the X variables. The odds are then
Calculated as:
Λ
y
odds = e
Similar to the joint F-test to evalute nested models, a likelihood ratio (LR) test is used
For logistic regression.
While traditional R2 is not available for logit models, software packages often report
Pseudo-R2 values. These Pseudo-R2 values should only be used to compare competing
Models using the same dependent variable.
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Time-series Analysis
LOS a Predicted trend value for a time series
y y
x x
Eg. Xt = b0 + b1 Xt−1
Xt = 5 + 0.5 Xt−1
Xt − 1 = 6 Xt = 8 Xt − 1 = 20 Xt = 15
Xt − 1 = 8 Xt = 9 Xt − 1 = 15 Xt = 12.5
Xt − 1 = 10 Xt = 10
b0 5
Mean of the time series = = = 10
1 − b1 1 − 0.5
Most economic and financial time series relationships are not stationary
If the error terms have significant serial correlation (autocorrelation), the AR model
used is not the best model to analyze the time series
Test used to know if the autocorrelations are significantly different from zero: t-test
Autocorrelation
t statistic (DoF: n-2) =
Standard error
Standard error = 1/ √ n
n = Number of observations
200 - - - -
1004.41
215 - - -
632
Equation: Equation:
Xt = Xt − 1 + εt Xt = b0 + Xt − 1 + εt
ª They are not covariance stationary because they do not have a finite mean
ª To use standard regression analysis, we must convert this data to covariance stationary.
This conversion is called ‘first differencing’
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LOS j & k Unit root test of nonstationarity
Autocorrelation Dickey-Fuller
approach test
First differencing
Eg. Sales Lag 1 First difference
∆ sales ∆ sales
- -
(current year) (previous year)
230 - - -
270 230 40 -
290 270 20 40
310 290 20 20
340 310 30 20
^ ^ ^
Equation: y = 30 − 0.25x Equation: y = 30 − 0.25(340) y = (55)
Forecasted sales: 340 − 55 = 285
If time series is a random walk then we must convert this data to covariance stationary.
This conversion is called first differencing
Seasonality is present if the autocorrelation of error term is significantly different from zero
Correction: Adding a lag of dependent variable (corresponding to the same period in previous year)
to the model as another independent variable
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LOS m Autoregressive conditional heteroskedasticity (ARCH)
ARCH exists if the variance of error terms in one period is
dependent on the variance of error terms in previous period
Testing: Squared errors from the model are regressed on the first
lag of the squared residuals
^2 ^2
Equation: εt = a0 + a1 εt − 1 + μt
Intercept Predicted
error term of
last period
Possible scenarios:
Œ Both time series are covariance stationary (linear regression can be used)
Only the dependent variable time series is covariance stationary (linear regression
should not be used)
Ž Only the independent variable time series is covariance stationary (linear regression
should not be used)
Neither time series is covariance stationary and the two series are not cointegrated
(linear regression should not be used)
Neither time series is covariance stationary and the two series are cointegrated (linear
regression can be used)
Cointegration: Long term economic or financial relationship between two time series
ª If you have decided to use a time-series model plot the values to see whether the time series looks
covariance stationary
ª If you find significant serial correlation in the error terms, use a complex model such as AR model
ª If the data has serial correlation, reexamine the data for stationarity before running an AR model
ª If you find significant serial correlation in the residuals, use an AR(2) model
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Machine Learning
LOS a Machine Learning makes no assumptions about distribution of underlying data
Machine learning : Machines display intelligent decision making ability through activities such
as sensing, reasoning, and understanding
Surpervised Unsupervised Deep
learning learning learning
ML Algorithm Type
Supervised Unsupervised
Variables
(Target Variable) (No Target Variable)
Dim
STEP 1 en
Complex Database sio
nR
ed
uct
ion
Simple Database
STEP 2
Classification Numerical
STEP 3 Problem Prediction Problem
Data is Non-linear /
Linear Complex Data
Supervised Unsupervised
Classification Classification No of Categories
Known
Linear K-Means
STEP 4
No. of Categories
Complex unknown
Linear Non-Linear Non-Linear Hierarchal Clustering
Data Data
KNN à CART
Neural
SUM à Random Forests
Network
à Neural Network
Over Fitting
ª Large number of features (i.e., independent variables) are included in the data sample
ª Overfit models do not generalize well to new data (i.e. out-of-sample R-squared will be low)
Training datasets
Machine learning
Algorithm learns
the relationship Validation datasets
Input Output
Produces
in Sample Test Sample
Errors
Applied
On
Input Output
In Sample errors
Out of
Sample Errors
Bias Error à Model with poor fit
Variance à Out of Sample errors
Error à Due to over fitted
models
Base Error à Residual errors due to
random noise
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A learning curve plots the accuracy rate (i.e. - error rate) in the validation or test
sample versus the size of the training sample
Accuracy
Rate
Size of
test Sample
Sample Size
Out of sample
In sample
ª Variance error increases with model complexity, while bias error decreases with complexity
ª Data scientists often express this as a tradeoff between cost and complexity.
ª An optimal level of complexity minimizes the total error and is a key part of successful model
generalization.
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Data Scientists use the following methods to reduce the problem of overfitting
Complexity Cross
Reduction Validation
ª In a k-fold cross validation the sample is randomly divided equally into k part.
ª This process is repeated k times, and the average in-sample and out-of-sample error
rates are compiled
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LOS c Supervised machine learning algorithms - including penalized regression,
support vector machine, k-nearest neighbour, classification and regression
tree, ensemble learning and random forest-and determine the problems for
which they are best suited.
ª Penalized regression
ª LASSO
å ( Y i - Y1 ) 2 + l å b$ k
i=1 k =1
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ª Category 2: An aggregation of
homogeneous learners
Bootstrap Aggregating
Voting Classifiers Random Forest
(Bagging)
Advantages:
Unsupervised ML
è Does not use labelled data
è Algorithms include:
ª Hierarchical clustering
Principal Component
Clustering
Analysis (PCA)
PCA is a statistical method for reducing highly Cluster Contains a subsed of observations from
correlated features into a few main, uncorrelated the data set which are similar
composite variables.
PCA involves two key concepts : Investment uses of clustering :
ª Eigenvectors : New, mutually uncorrelated
ª For grouping companies based on financial
composite variables that are linear
statement items or financial ratios
combinations of the original features
ª Eigenvalue : Proportion of total variance in the ª Improving portfolio diversification
initial data that is explained by each
Popular clustering approaches include:
eigenvector
Drawback of PCA: Principal components cannot ª K-means clustering
be easily labelled or directly interpreted by the
analyst ª Hierachical clustering
Hierarchical Clustering:
K-Means Clustering Dendrograms
Agglomerative and Divisive
Difference between big data and traditional data sources rests on 3 V’s
Steps in Executing a Data Analysis Project : Financial Forecasting with Big Data
ª Useful when a project requires generic data ª Useful when a project requires internal data
Invalidity error : Where the data are outside of a meaningful range, resulting in invalid data.
Inconsistency error : Is where data conflicts with corresponding data points or reality
ª Extraction
ª Aggregation
ª Filtration
ª Selection
ª Conversion
Outliers can be detected using: Standard deviation: A data value outside 3 standard deviation from
the mean may be an outlier.
Scaling: The process of adjusting the range of a feature by shifting and adjusting the scale of data.
Two common ways of scaling include:
X i - X min
X i ( normalized ) =
X max - X min
èStandardization: The process of centering and scaling the variables.
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LOS e Preparing, wrangling and exploring text-based data for financial forecasting
Text processing : Transforming unstructured data into structured data and includes two task :
cleansing and preprocessing.
Text Preparation (Cleansing) : Involves cleaning text to remove non-useful elements from raw data.
ç Bag-of-words (BOW), a procedure for analyzing text using a collection of a distinct set of tokens
from all the texts in a simple dataset
. BOW is memory efficient and easy to handle for text analyses but does not capture the position or
ç
sequence of words present in the text.
è Structure of a DTM:
ª Columns = # of tokens from the BOW that is built using all the documents in a
sample dataset.
è Drawback of BOW : Does not represent word sequences or positions limiting its use for
advanced ML training applications.
Unstructured Data :
Structured Data
Text Exploration
Terms frequency=
Numbers
‚ N-grams:
ƒ Name entity recognition (NER)
„ Part of speech (POS)
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ML model training includes the three tasks which may be repeated several
times until desired ML model performance is attained:
ª Method selection
ª Performance evaluation
ª Tuning
A good model fit performs well and can be validated using out-of-sample data.
Types of model fitting:
ª Overfit model may generate no errors with respect to the training data and has best
accuracy, it fits training data too well and is unlikely to perform on future test cases
ª Underfit model does not fit the training data well and it produces misclassification errors.
ª A good fit model may fit the training data well but may not generalize well to out-of-sample
data.
ª Dataset size – small datasets may lead to underfitting as small datasets are not sufficient
to expose patterns in the data
Method Selection
Supervised or unsupervised learning
ª Supervised models bring a structure that may or may not be supported by data.
ª Image data: Neural networks and deep learning methods are better
ªNumber of instances
ªNumber of features
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Error analysis : For classification problems, error analysis involves computing four basic
evaluation metrics
‚ Receiver Operating Characteristic (ROC) : Uses a plotted curve to show trade-off between the
false positive rate (x-axis) and true positive rate (y-axis) for various cutoff points.
Robo-readers:
ª Are being used to examine how views expressed in text relate to future
company performance.
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Economics
Notice : The recipient of this publication is strictly prohibited by law to circulate. We have inserted a
concealed code in the document, which will lead to identification of the user to whom this document was
issued. If this documents is found to be circulated on internet, social media sites and other mode thereto,
the user identification will be reported to CFA Institute and strict legal action will be initiated.
Unless otherwise stated, copyright and all intellectual property rights in all the course material(s)
provided, is the property of FinTree Education Private Limited. Any copying, duplication of the course
material either directly and/or indirectly for use other than for the purpose provided shall tantamount to
infringement and shall strongly defended and pursued, to the fullest extent permitted by law.
The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute
code of Ethics. Your assistance in pursuing potential violators of this law is greatly appreciated. If any
violation comes to your notice, get in touch with us at admin@fintreeindia.com
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FinTree
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every day – going to work, walking down the street to buy stuff
or just going for a walk. Wondering how to utilize this travel
time? The geeks at FinTree have the perfect solution for you!
$3 Price currency
€ Base currency
€ - Depreciated $2 $3 $4 € - Appreciated
$ - Appreciated € € € $ - Depreciated
57
$ - Appreciated: −1 = 9.62%
52
52
ZAR - Depreciated: −1 = 8.77%
57
Bid Ask
Interbank market: Where dealers buy and sell foreign exchange among themselves
Bid-ask spread provided by a dealer to clients is wider than bid-ask spread used in
the interbank market
Eg.
Bid/Ask:
₹ = 65.1020/65.2030
$
= 1.2125/1.3135
$ €
Calculate market-implied bid-ask quote on €/ ₹
1 1
= 0.0116 = 0.0126
85.6441 78.9361
Triangular arbitrage
£ £ $
Eg. Bid/Ask: = 1.1189/1.1213 = 0.7526/0.7545 = 1.1820/1.1824
€ $ €
€ 891,822 $ 1,325,381
Price currency
Base currency
15.2
3 month forward bid rate = 1.1820 − = 1.1804
10,000
14.6
3 month forward ask rate = 1.1824 − = 1.1809
10,000
0.91
MXN premium: = 4.95%
19.26
Forward contract: Any exchange rate transaction that has a settlement date longer than T + 2
Forward premium/discount = Forward rate – Spot rate
Eg. Forward contract: 1 mln GBP Rate: 1.3000 USD/GBP Term: 6 months
Spot rate after 90 days: 1.3100/1.3105 90-day forward points : +120/+125 90-day LIBOR: 4%
USD 220,000
Mark-to-market value: = USD 217,821
1 + 0.04 × (90/360)
$1mln 10%
+ 2% int.
$1.02mln
₹55mln 53.92
55
₹55mln
53.92 1.02
(1 + Int. rate)n
Forward rate = S ×
(1 + Int. rate)n
(1 + 10%)1
Forward rate = 50 ×
(1 + 2%)1
= 53.92
(1 + Int. rate)n
₹50
F = S ×
(1 + Int. rate)n = ₹54.54
$
Expected
(1.1538)
spot rate = 50 ×
(1.0576) = ₹54.54
Real int.
Inflation rate
rate = 4%
(1 + 20%)
India = = 15.38%
(1 + 4%)
(1 + 10%)
USA = = 5.76%
(1 + 4%)
Covered interest
Forced by arbitrage. It is always true
rate parity
Uncovered interest
Not forced by arbitrage. It may not be true
rate parity
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Eg. Spot rate: $1.2/€ 1-year forward rate: $1.3/€
USD interest rate: 9% Euro interest rate: 7% Determine if an arbitrage opportunity exists
Forward rate
× 1 + Euro int. rate Vs 1 + USD int. rate
Spot rate
1.3
× 1 + 7% Vs 1 + 9%
1.2
1.1591 Vs 1.09
Invest Borrow
Fisher effect:
Nominal interest rateA − Nominal interest rateB = Expected inflationA – Expected inflationB
Not forced by arbitrage and does not Forced by arbitrage and is always true
work in the short term
If uncovered interest rate parity holds, then covered interest rate parity holds
(forward exchange rate is an unbiased predictor of the future spot rate)
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LOS i Carry trade
Carry trade: Investor borrows in lower yielding currency (funding currency) and invests in
higher yielding currency and hope that high yielding currency will depreciate less than
interest rate differential
It assumes that uncovered interest rate parity does not work in the short term
Carry trade generates positive returns during the periods of low volatility
Crash risk: Probability of substantial losses due to high volatility and/or perceived risk in
financial markets
Current account deficit: Investor countries’ portfolio For deficit countries, rising
Depreciation of currency composition is dominated by Debt/GDP ratio will lead to
few investee countries depreciation of currency
Appreciation/depreciation of
currency would help eliminate If investor countries decide to For surplus countries, rising
the initial imbalance in the reduce the holdings, it can Assets/GDP ratio will lead to
long run lead to depreciation of appreciation of currency
investee countries’ currencies
Capital mobility
Monetary policy Fiscal policy
High Low
Expansionary Expansionary Indeterminate Depreciation
Expansionary Contractionary Depreciation Indeterminate
Contractionary Expansionary Appreciation Indeterminate
Contractionary Contractionary Indeterminate Appreciation
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Savings and investment: High savings High levels of investment High GDP growth
Financial markets and Ÿ Financial sector channels savings to projects that offer highest
intermediaries: risk -adjusted returns
Ÿ Financial sector encourage savings by creating financial
instruments that facilitate risk transfer and enhance liquidity
Ÿ Aggregating small amounts of savings into a larger pool
enables intermediaries to finance larger projects
Political stability, rule of Ÿ Countries that have stable and effective government, and well
law, and property rights: developed legal, regulatory and property rights system have
higher economic growth
Ÿ Factors such as wars, corruption and political instability raise
investment risk and weaken economic growth
Education and Ÿ Basic education raises the skill level of the workforce which
healthcare systems: contributes to potential economic growth
Ÿ Education can also raise growth by increasing the productivity
of existing physical capital
Ÿ Empirical studies show that poor health has resulted in slowing
down of economic growth
Tax and regulatory
systems: Limited regulations More growth and productivity
Free trade and Ÿ Foreign investments break out the cycle of low income, low
unrestricted capital flows: savings, and low investment
Ÿ It can be direct (FDI) or indirect (buying equity/debt issued by
domestic companies)
Ÿ Free trade benefits a country’s economy by providing more
goods at lower costs
Over the short and medium term all three factors contribute to increase/decrease
in stock market, but in the long-term growth rate of GDP dominates
∆P = ∆GDP
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LOS c Why potential GDP and its growth rate matter for equity and fixed
income investors
Higher potential GDP
ª Actual GDP > Potential GDP = Inflationary gap. This results in higher nominal interest rates
(restrictive monetary policy) and fiscal surplus
ª Higher potential GDP growth rate improves credit quality of fixed income securities
Absolute Relative
Y = T Kα L(1 − α)
Known as growth accounting equation
Y = GDP, T = Total factor productivity,
K = Capital, L = Labor, α = Share of capital %∆Y = %∆TFP + α × %∆K + (1 − α) × %∆L
in GDP
Capital deepening
Highly sensitive to
Population growth is business cycle
determined by fertility Labor force
rates and mortality participation rate: Long-term trend in
It is a possible solution
rates average hours worked
Labor force to declining labor force
is downwards
Working age population growth which is
Population growth may
experienced by
increase growth rate of Causes of this
Increase in this rate developed countries
the overall economy development:
may increase per capita with low birthrates
but it has no impact on Legislation, growth of
the rate of increase in GDP part-time and
per capita GDP temporary work,
wealth effect etc.
ª Physical capital: ICT (infrastructure, computers, and telecommunications equipment) and non-ICT
ª There is high correlation b/w investment in physical and human capital, and economic growth
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Economics Of Regulation
LOS a Economic rationale for regulation
Pareto Optimal : Regulation is often required when markets cannot provide efficient solution
Which means that one cannot make any participants better off without making some other
participants worse off
Externalities : Cost or benefit that affects the party that did not choose to incur that cost or
benefit. For example a polluter may not bear the full cost of their action
Social Objectives : Public good is a resource that can be enjoyed by a person without making
it unavailable to others.
Since people share in consumption, regulations are necessary to ensure an optimal level of
production of such public goods
ª Company Laws, tax laws, contract laws, ª To prevent failures of the financial system
competition laws, labour laws
ª Maintain the integrity of markets
ª Regulation may facilitate or hinder commerce.
For example, protections of intellectual property ª Objective : 3 Interelated Goals
facilitate long-term investments in research ŒProtect investors
ŽCreate confidence in the markets
ŽEnhance capital formation
Disclosure : Disclosure provide transparency (i.e, reduce information asymmetry) in financial markets
and hence promote investor confidence
Agency problems : Regulation imposing fiduciary duties seek to mitigate such agency problem
Focused on protecting small investors : Hence the relatively lax regulatory coverage of hedge funds
and private equity funds that are marketed only to qualified investors
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Regulation of Financial Institution
Prudential Supervision :
Ÿ Prudential supervision refers to the monitoring and regulation of financial
institutions to reduce system-wide risk and to protect investors
Ÿ The cost benefit analysis of financial market regulation should also include
hidden costs. For example, FDIC insurance for banks may incentivize them
with excessive risk-taking (a moral hazard problem)
Anititrust Regulation
ª Antitrust laws work to promote domestic competition by monitoring and restricting activities
that reduce or distort competition
ª Regulators often block a merger that leads to an excessive concentration of market share
Regulations
Administrative
Statutes Judicial law
regulations
Rules issued by
Laws made by government Interpretations of
legislative bodies agencies or other courts
regulators
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Regulators
Government Independent
agencies regulators
SRB’s
Enforcement Powers
ª FINRA is an SRO recognized by the SEC in the United States. FINRA’s primary objective is to
protect investors by maintaining the fairness of the U.S. capital markets. FINRA has the
authority to enforce security laws and regulations
ª However, the use of SROs in civil-law countries is not common; in such countries, formal
government agencies fulfill the role of SROs
ª In common-law countries such as the United Kingdom and the United States, SROs have
historically enjoyed recognition
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Regulator capture : The Regulatory capture is based upon the assumption that,
regardless of the original purpose behind its establishment,
a regulatory body will, at some point in time, be influenced
or even possibly controlled by the industry that is being
regulated
Regulatory competition & Arbitrage : Regulatory differences between jurisdiction can lead to
regulatory competition, in which regulators compete to
provide the most business-friendly regulatory environment
LOS h
Describe benefits and costs of regulation
LOS i
Describe the considerations when evaluating the effects of regulation on
an industry
ªRegulation can help or hinder a company or industry. Regulation may shrink the size of
one industry( e.g. if it is heavily taxed) while increasing the size of another (e.g. an
industry receiving subsidies).
ªRegulation are not always costly for those that end up being regulated. If the regulator is
captive, regulation may end up benefiting the regulated entities
ªRegulation may introduce inefficiencies in the market. For example, past government
bailouts of financial institutions have conveyed a message of future implicit guarantees.
For this reason, the credit spreads on bonds issued by the financial sector may not fully
reflect their risk
StandardNormal Distribution
P (Z ::;; z) = N(z) for z ::;; 0
z
-0.5 0.3085 0.3050 0.3015 0.2981 0.2946 0.2912 0.2877 0.2843 0.2810 0.2776
-0.6 0.2743 0.2709 0.2676 0.2643 0.2611 0.2578 0.2546 0.2514 0.2483 0.2451
-0.7 0.2420 0.2389 0.2358 0.2327 0.2296 0.2266 0.2236 0.2206 0.2177 0.2148
-0.8 0.2119 0.2090 0.2061 0.2033 0.2005 0.1977 0.1949 0.1922 0.1894 0.1867
-0.9 0.1841 0.1814 0.1788 0.1762 0.1736 0.1711 0.1685 0.1660 0.1635 0.1611
-1 0.1587 0.1562 0.1539 0.1515 0.1492 0.1469 0.1446 0.1423 0.1401 0.1379
-1.1 0.1357 0.1335 0.1314 0.1292 0.1271 0.1251 0.1230 0.1210 0.1190 0.1170
-1.2 0.1151 0.1131 0.1112 0.1093 0.1075 0.1056 0.1038 0.1020 0.1003 0.0985
-1.3 0.0968 0.095'1 0.0934 0.0918 0.0901 0.0885 0.0869 0.0853 0.0838 0.0823
-1.4 0.0808 0.0793 0.0778 0.0764 0.0749 0.0735 0.0721 0.0708 0.0694 0.0681
-1.5 0.0668 0.0655 0.0643 0.0630 0.0618 0.0606 0.0594 0.0582 0.0571 0.0559
-1.6 0.0548 0.0537 0.0526 0.0516 0.0505 0.0495 0.0485 0.0475 0.0465 0.0455
-1.7 0.0446 0.0436 0.0427 0.0418 0.0409 0.0401 0.0392 0.0384 0.0375 0.0367
-1.8 0.0359 0.0351 0.0344 0.0336 0.0329 0.0322 0.0314 0.0307 0.0301 0.0294
-1.9 0.0287 0.0281 0.0274 0.0268 0.0262 0.0256 0.0250 0.0244 0.0239 0.0233
-2 0.0228 0.0222 0.0217 0.0212 0.0207 0.0202 0.0197 0.0192 0.0188 0.0183
-2.1 0.0179 0.0174 0.0170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146 0.0143
-2.2 0.0139 0.0136 0.0132 0.0129 0.0125 0.0122 0.0119 0.0116 0.0113 0.0110
-2.3 0.0107 0.0104 0.0102 0.0099 0.0096 0.0094 0.0091 0.0089 0.0087 0.0084
-2.4 0.0082 0.0080 0.0078 0.0075 0.0073 0.0071 0.0069 0.0068 0.0066 0.0064
-2.5 0.0062 0.0060 0.0059 0.0057 0.0055 0.0054 0.0052 0.0051 0.0049 0.0048
-2.6 0.0047 0.0045 0.0044 0.0043 0.0041 0.0040 0.0039 0.0038 0.0037 0.0036
-2.7 0.0035 0.0034 0.0033 0.0032 0.0031 0.0030 0.0029 0.0028 0.0027 0.0026
-2.8 0.0026 0.0025 0.0024 0.0023 0.0023 0.0022 0.0021 0.0021 0.0020 0.0019
-2.9 0.0019 0.0018 0.0018 0.0017 0.0016 0.0016 0.0015 0.0015 0.0014 0.0014
-3.0 0.0013 0.0013 0.0013 0.0012 0.0012 0.0011 0.0011 0.0011 0.0010 0.0010
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StandardNormal Distribution
P (Z :-s; z) = N(z) for z 2 0
z
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1. 4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1. 8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2. 1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
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STUDENTS T-DISTRIBUTION
Level of significance for One-Tailed Test
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df 1 2 3 4 5 6 7 8 9 10 12 15 20 24 30 40
1 161 199 216 225 230 234 237 239 241 242 244 246 248 249 250 251
2 18.5 19.0 19.2 19.2 19.3 19.3 19.4 19.4 19.4 19.4 19.4 19.4 19.4 19.5 19.5 19.5
3 10.1 9.55 9.28 9.12 9.01 8.94 8.89 8.85 8.81 8.79 8.74 8.70 8.66 8.64 8.62 8.59
4 7.71 6.94 6.59 6.39 6.26 6.16 6.09 6.04 6.00 5.96 5.91 5.86 5.80 5.77 5.75 5.72
5 6.61 5.79 5.41 5.19 5.05 4.95 4.88 4.82 4.77 4.74 4.68 4.62 4.56 4.53 4.50 4.46
6 5.99 5.14 4.76 4.53 4.39 4.28 4.21 4.15 4.10 4.06 4.00 3.94 3.87 3.84 3.81 3.77
7 5.59 4.74 4.35 4.12 3.97 3.87 3.79 3.73 3.68 3.64 3.57 3.51 3.44 3.41 3.38 3.34
8 5.32 4.46 4.07 3.84 3.69 3.58 3.50 3.44 3.39 3.35 3.28 3.22 3.15 3.12 3.08 3.04
9 5.12 4.26 3.86 3.63 3.48 3.37 3.29 3.23 3.18 3.14 3.07 3.01 2.94 2.90 2.86 2.83
10 4.96 4.10 3.71 3.48 3.33 3.22 3.14 3.07 3.02 2.98 2.91 2.85 2.77 2.74 2.70 2.66
11 4.84 3.98 3.59 3.36 3.20 3.09 3.01 2.95 2.90 2.85 2.79 2.72 2.65 2.61 2.57 2.53
12 4.75 3.89 3.49 3.26 3.11 3.00 2.91 2.85 2.80 2.75 2.69 2.62 2.54 2.51 2.47 2.43
13 4.67 3.81 3.41 3.18 3.03 2.92 2.83 2.77 2.71 2.67 2.60 2.53 2.46 2.42 2.38 2.34
14 4.60 3.74 3.34 3.11 2.96 2.85 2.76 2.70 2.65 2.60 2.53 2.46 2.39 2.35 2.31 2.27
15 4.54 3.68 3.29 3.06 2.90 2.79 2.71 2.64 2.59 2.54 2.48 2.40 2.33 2.29 2.25 2.20
16 4.49 3.63 3.24 3.01 2.85 2.74 2.66 2.59 2.54 2.49 2.42 2.35 2.28 2.24 2.19 2.15
17 4.45 3.59 3.20 2.96 2.81 2.70 2.61 2.55 2.49 2.45 2.38 2.31 2.23 2.19 2.15 2.10
18 4.41 3.55 3.16 2.93 2.77 2.66 2.58 2.51 2.46 2.41 2.34 2.27 2.19 2.15 2.11 2.06
19 4.38 3.52 3.13 2.90 2.74 2.63 2.54 2.48 2.42 2.38 2.31 2.23 2.16 2.11 2.07 2.03
20 4.35 3.49 3.10 2.87 2.71 2.60 2.51 2.45 2.39 2.35 2.28 2.20 2.12 2.08 2.04 1.99
21 4.32 3.47 3.07 2.84 2.68 2.57 2.49 2.42 2.37 2.32 2.25 2.18 2.10 2.05 2.01 1.96
22 4.30 3.44 3.05 2.82 2.66 2.55 2.46 2.40 2.34 2.30 2.23 2.15 2.07 2.03 1.98 1.94
23 4.28 3.42 3.03 2.80 2.64 2.53 2.44 2.37 2.32 2.27 2.20 2.13 2.05 2.01 1.96 1.91
24 4.26 3.40 3.01 2.78 2.62 2.51 2.42 2.36 2.30 2.25 2.18 2.11 2.03 1.98 1.94 1.89
25 4.24 3.39 2.99 2.76 2.60 2.49 2.40 2.34 2.28 2.24 2.16 2.09 2.01 1.96 1.92 1.87
26 4.23 3.37 2.98 2.74 2.59 2.47 2.39 2.32 2.27 2.22 2.15 2.07 1.99 1.95 1.90 1.85
27 4.21 3.35 2.96 2.73 2.57 2.46 2.37 2.31 2.25 2.20 2.13 2.06 1.97 1.93 1.88 1.84
28 4.20 3.34 2.95 2.71 2.56 2.45 2.36 2.29 2.24 2.19 2.12 2.04 1.96 1.91 1.87 1.82
29 4.18 3.33 2.93 2.70 2.55 2.43 2.35 2.28 2.22 2.18 2.10 2.03 1.94 1.90 1.85 1.81
30 4.17 3.32 2.92 2.69 2.53 2.42 2.33 2.27 2.21 2.16 2.09 2.01 1.93 1.89 1.84 1.79
40 4.08 3.23 2.84 2.61 2.45 2.34 2.25 2. 18 2.12 2.08 2.00 1.92 1.84 1.79 1.74 1.69
60 4.00 3.15 2.76 2.53 2.37 2.25 2.17 2.10 2.04 1.99 1.92 1.84 1.75 1.70 . 1.65 1.59
120 3.92 3.07 2.68 2.45 2.29 2.18 2.09 2.02 1.96 1.91 1.83 1.75 1.66 1.61 1.55 1.50
00 3.84 3.00 2.60 2.37 2.2 1 2.10 2.01 1.94 1.88 1.83 1.75 1.67 1.57 1.52 1.46 1.39
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df 1 2 3 4 5 6 7 8 9 10 12 15 20 24 30 40
1 648 799 864 900 922 937 948 957 963 969 977 985 993 997 1001 1006
2 38.51 39.00 39.17 39.25 39.30 39.33 39.36 39.37 39.39 39.40 39.41 39.43 39.45 39.46 39.46 39.47
3 17.44 16.04 15.44 15.10 14.88 14.73 14.62 14.54 14.47 14.42 14.34 14.25 14.17 14.12 14.08 14.04
4 12.22 10.65 9.98 9.60 9.36 9.20 9.07 8.98 8.90 8.84 8.75 8.66 8.56 8.51 8.46 8.41
5 10.01 8.43 7.76 7.39 7.15 6.98 6.85 6.76 6.68 6.62 6.52 6.43 6.33 6.28 6.23 6.18
6 8.81 7.26 6.60 6.23 5.99 5.82 5.70 5.60 5.52 5.46 5.37 5.27 5.17 5.12 5.07 5.01
7 8.07 6.54 5.89 5.52 5.29 5. 12 4.99 4.90 4.82 4.76 4.67 4.57 4.47 4.41 4.36 4.31
8 7.57 6.06 5.42 5.05 4.82 4.65 4.53 4.43 4.36 4.30 4.20 4.10 4.00 3.95 3.89 3.84
9 7.21 5.71 5.08 4.72 4.48 4.32 4.20 4. 10 4.03 3.96 3.87 3.77 3.67 3.61 3.56 3.51
10 6.94 5.46 4.83 4.47 4.24 4.07 3.95 3.85 3.78 3.72 3.62 3.52 3.42 3.37 3.31 3.26
11 6.72 5.26 4.63 4.28 4.04 3.88 3.76 3.66 3.59 3.53 3.43 3.33 3.23 3.17 3.12 3.06
12 6.55 5.10 4.47 4.12 3.89 3.73 3.61 3.51 3.44 3.37 3.28 3.18 3.07 3.02 2.96 2.91
13 6.41 4.97 4.35 4.00 3.77 3.60 3.48 3.39 3.31 3.25 3.15 3.05 2.95 2.89 2.84 2.78
14 6.30 4.86 4.24 3.89 3.66 3.50 3.38 3.29 3.21 3.15 3.05 2.95 2.84 2.79 2.73 2.67
15 6.20 4.77 4.15 3.80 3.58 3.41 3.29 3.20 3.12 3.06 2.96 2.86 2.76 2.70 2.64 2.59
16 6.12 4.69 4.08 3.73 3.50 3.34 3.22 3.12 3.05 2.99 2.89 2.79 2.68 2.63 2.57 2.51
17 6.04 4.62 4.01 3.66 3.44 3.28 3.16 3.06 2.98 2.92 2.82 2.72 2.62 2.56 2.50 2.44
18 5.98 4.56 3.95 3.6 1 3.38 3.22 3.10 3.01 2.93 2.87 2.77 2.67 2.56 2.50 2.44 2.38
19 5.92 4.51 3.90 3.56 3.33 3.17 3.05 2.96 2.88 2.82 2:72 2.62 2.51 2.45 2.39 2.33
20 5.87 4.46 3.86 3.51 3.29 3.13 3.01 2.91 2.84 2.77 2.68 2.57 2.46 2.41 2.35 2.29
21 5.83 4.42 3.82 3.48 3.25 3.09 2.97 2.87 2.80 2.73 2.64 2.53 2.42 2.37 2.31 2.2?
22 . 5.79 4.38 3.78 3.44 3.22 3.05 2.93 2.84 2.76 2.70 2.60 2.50 2.39 2.33 2.27 2.21
23 5.75 4.35 3.75 3.41 3.18 3.02 2.90 2.81 2.73 2.67 2.57 2.47 2.36 2.30 2.24 2.18
24 5.72 4.32 3.72 3.38 3.15 2.99 2.87 2.78 2.70 2.64 2.54 2.44 2.33 2.27 2.21 2.15
25 5.69 4.29 3.69 3.35 3.13 2.97 2.85 2.75 2.68 2.61 2.51 2.41 2.30 2.24 2.18 2.12
26 5.66 4.27 3.67 3.33 3.10 2.94 2.82 2.73 2.65 2.59 2.49 2.39 2.28 2.22 2.16 2.09
27 5.63 4.24 3.65 3.31 3.08 2.92 2.80 2.71 2.63 2.57 2.47 2.36 2.25 2.19 2.13 2.07
28 5.61 4.22 3.63 3.29 3.06 2.90 2.78 2.69 2.61 2.55 2.45 2.34 2.23 2.17 2. 11 2.05
29 5.59 4.20 3.6 1 ·3.27 3.04 2.88 2.76 2.67 2.59 2.53 2.43 2.32 2.21 2.15 2.09 2.03
30 5.57 4.18 3.59 3.25 3.03 2.87 2.75 2.65 2.57 2.51 2.41 2.31 2.20 2.14 2.07 2.01
40 5.42 4.05 3.46 3.13 2.90 2.74 2.62 2.53 2.45 2.39 2.29 2.18 2.07 2.01 1.94 1.88
60 5.29 3.93 3.34 3.01 2.79 2.63 2.51 2.41 2.33 2.27 2.17 2.06 1.94 1.88 1.82 1.74
120 5.15 3.80 3.23 2.89 2.67 2.52 2.39 2.30 2.22 2.16 2.05 1.94 1.82 1.76 1.69 1.61
00 5.02 3.69 3.12 2.79 2.57 2.41 2.29 2. 19 2.11 2.05 1.94 1.83 1.71 1.64 1.57 1.48
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Financial Modelling
ª Financial Modelling Skills are applied to variety of scenarios like Equity Research, Mergers and
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CFA® Level II JuiceNotes 2022
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