All Merged Final KRD Cfal1 Quick Revision 2023

CFA Level 1 – QUICK NOTES - INDEX
TOPIC PAGES
Quantitative Methods 23
Financial Statement Analysis 44
Economics 54
Ethics 23
Corporate Issuers 25
Equity Investments 28
Fixed Income 37
Derivatives 14
Alternative Investments 12
Portfolio Management 23
PROFESSOR’S NOTE:
This Notes are For Free Distribution To Candidates Appearing For CFA Level 1 For 2023
Exams.
I Would Like To Dedicate This Note To My Daughter – Yaira Doshi, Who Has Been My Sole
Motivation Of All The Hard work That I Put Into Making This Notes And Many more.
My Sincere Good Wishes To You For Appearing For CFA Exam And For The Future.
No Education Is Ever Waste And In fact This Is the only Asset Which Is Never Depreciated,
Amortized Or Tested For Impairment and has perpetual cash flows.
ALL THE BEST ONCE AGAIN AND HAVE A GREAT FUTURE.
– KUNAL DOSHI, CFA
YouTube Channel: Prof. Kunal R Doshi 0

CFA Level 1 – Quick Notes by KRD - QM
TIME VALUE OF MONEY

Components of Interest Rates:
Nominal Risk-Free Rate = Real risk-free interest rate + Inflation premium
Set of Risk Premiums = Default risk premium + Liquidity premium + Maturity premium
Simple Interest Compound Interest

Interest is calculated on the Principal Interest is calculated on the Principal as
amount only well as Interest accrued earlier
Does not consider Reinvestment of interest Considers Reinvestment of Interest
Important Notes:
• The Future Value Calculated using Compound is always higher than Simple Interest
• More the period of compounding, the larger will be the difference between the
value calculated using Compounding and Simple Interest
Compounding Frequency
In an Annualized Compounding, the frequency of compounding is only Once a year.
However, there can be situations where the Frequency of Compounding can be more than
once a year. These Frequencies can be:
• Discrete i.e., Countable frequencies - Annual, Semi-annual, quarterly, monthly, etc.
• Continuous i.e., infinite frequencies
Annuity
• An annuity is a series of the same amount of cash flow for a particular period at the
same frequency.
• In practice, annuities occur during events like Pension payments, Insurance premiums,
loan instalments, recurring deposits, SIP, rent or lease payments, coupons in bonds,
etc.
Annuities are of various types:

• Ordinary Annuity - Cash flows assumed to occur at the end of the period.
• Annuity Due - Cash flows are assumed to occur at the beginning of the period.
• Perpetuity - Cash flows occur forever i.e., for an infinite period (only used in PV).
Amortization
• A loan is paid in instalments and each instalment consists of interest payment (INT)
and repayment of principle (PRN)
• This process of principal being paid along with each instalment is called amortization
of principal, which can be calculated using the calculator function Amortization.

ORGANIZING, VISUALIZING, AND DESCRIBING DATA

Statistics
The Methods that we apply to Collect & analyze the data are called as Statistics.
Data Types
Quantitative aspect Data Numerical Data - Discrete and Continuous
Qualitative aspect Data Categorical Data - Nominal and Ordinal
Arranging of Data Time Series, Cross Sectional and Panel Data (Variable and
Observation)
Data based on Organizing Structured (Market, Fundamental and Analytical data) v/s
Unstructured Data
How is the Data Organized?

Data are typically organized into arrays for quantitative analysis.
One- • It represents a single variable like the time series data.

dimensional • Here a new data can be added without affecting the existing data.
array Sequentially ordered data are used to identify trends, cycles, and
other patterns in the data that can be useful for forecasting
Two- • A.k.a. Data table, it represents two variables like the Panel Data
dimensional • It is one of the most popular forms for organizing data for processing by
array computers or for presenting data visually for consumption by humans.
• Like the structure in an Excel spreadsheet, a data table is comprised of
columns and rows to hold multiple variables and multiple observations,
respectively
Summarizing of Data
Single Variable Using Frequency Distribution - Absolute & relative
Multiple Variable Using Contingency Table and Confusion Matrix (two)
Guidelines for Selecting Among Visualization Types:

Relationships Scatter plots, scatter plot matrices, and heat maps

Comparisons Bar charts, tree maps, and heat maps for comparisons among
categories; line charts, dual-scale line charts, and bubble line charts for
comparisons over time
Distributions Histograms, frequency polygons, and cumulative distribution charts for
numerical data; bar charts, tree maps, and heat maps for categorical
data; and word clouds for text data
Source: CFAI
Measures of Central Tendency:

• It is the use of Quantitative measures that explains the Characteristics of data.
• It specifies where the data is centred.
• More widely used than another statistical measure
• Can be computed and applied easily.
Parts under Central Tendency:

1. Population vs Sample Mean
2. Arithmetic vs Geometric Mean
3. Weighted Mean vs Harmonic Mean
∑ "! $%&$'&$(&⋯..&$+
Arithmetic Mean: x" = =
# #
"
Geometric Mean: [(1 + R1) × (1 + R2) × (1 + R3) × … × (1 + Rn)]# − 1
2 , = 3- 4- + 3. 4. + 3/ 4/ … + 30 40
Weighted Mean: R
2 1 = $ $ 2$
Harmonic Mean: 5 $
3% &% &% &⋯&% 4
$ & ' (

Adjusting the Outliers

An extreme value or outlier in a financial data set represents a rare value in the
population; therefore, the arithmetic mean could be misleading.
There are three options for dealing with extreme values:

Option 1 Do nothing; use the data without any adjustment
Option 2 Exclude the extreme outliers - Trimmed Mean
Option 3 Replace the outliers with another value - Winsorized Mean
Location of data:
• Helps in identifying values at or below which a specified Proportion of data lies.
• Statisticians use the word - Quantiles (or Factile) as the most general term for value
5
at or below which the stated fraction of data lies. Location: 65 = (7 + 8) 9 :
677
Interquartile Range: Box and Whisker chart

It is one of the ways to visualize the dispersion of data across quartiles.
Box It represents the lower bound of the second quartile and the upper bound
of the third quartile, with the median or arithmetic average noted as a
measure of central tendency of the entire distribution
Whiskers They are the lines that run from the box and are bounded by the fences
Fences They represent the Outliers - lowest and highest values of the distribution
Interquartile It is the difference between the lowest value in the second quartile and
range the highest value in the third quartile
Source: CFAI
Measure of Dispersion

Dispersion is the variability around the Central tendency & it addresses the risk.
Absolute Dispersion -
It is a standalone variability without comparison to a reference point or benchmark.
1. Range
2. Mean Absolute Deviation
3. Population variance & Standard - deviation
4. Sample variance & Standard - deviation
5. Target Semi - variance & Standard - deviation
Relative Dispersion -
It is a ratio and amount of dispersion related to a reference point or benchmark.
7. Co-efficient of Variation
Range Maximum - Minimum Value

Mean Absolute ∑+89%?X 8 − X ?
Deviation MAD =
n
Sample Variance # ( '
'
∑ 89% X 8 − µ)
S =
N−1
Sample Standard
Deviation ∑+89%(X 8 − µ)'
S= D
N−1
Semi-variance '
∑+"8 ; " FX 8 − XG
s' =
n−1
Coefficient of s standard deviation risk
Variation CV = = =
X mean return
Mean (Arithmetic Mean) Median Mode

Meaning Average of Sum of Observation in the Most Frequently
observation divided by the Middle of the item set occurring observation
number of observations that is arranged in an in the distribution
order
Formula ∑ <! Odd number: Middle A distribution can
Population Mean: μ = #
∑ "!
value of (n+1)/2 either have one
Sample Mean: x" = Even number: Middle mode (unimodal), or
#
value between n/2 & two modes (bimodal),
(n+2)/2 or many or even no
mode

Properties of Normal Distribution

• It is completely described by two parameters: the mean and the standard deviation.
• It is symmetric i.e., equally distributed above and below the Mean. (Normal distributions
are symmetrical, but not all symmetrical distributions are normal)
• It has a Skewness of 0 & Mean=Median=Mode
• For Normal distribution, Kurtosis, which measures the flatness of distribution = 3
• Therefore, Kurtosis = 3 (Mesokurtic) and Excess Kurtosis = 0
• A linear combination (portfolio) of Normally distributed Random variables (stock) is also
Normally distributed.
• The probability of outcome further & above the mean gets smaller & smaller but does
not go to zero.
Skewness & Kurtosis

We investigate the degree of symmetry in the distribution of returns by analyzing its:
Skewness & Kurtosis
Skewness: A distribution that is not symmetrical is called skewed.

Positively skewed distribution Negatively skewed distribution
• Long tail (outliers) on the Right side • Long tail (outliers) on the Left side
• Frequent small losses (unlimited) • Frequent small gains (unlimited)
• Few extreme gains (limited) • Few extreme losses (limited)
• Mean>Median>Mode. • Mean<Median<Mode.
• More desirable • Less desirable
Kurtosis:
• Measures the thickness of the tail ends of a distribution in relation to the tails of the
normal distribution.
• It basically tells us the Proportion of total probability that is in the tail.
• Concludes whether the distribution is peaked than the Normal distribution.
Mesokurtic Leptokurtic Platykurtic

Distribution Identical to ND More peaked than ND Less peaked than ND
Tails Evenly Large dispersion Fewer dispersion (thin tails)
dispersed (Fatter tails)
Outliers Normal Extreme large Outliers Very Few Outliers (Fixed
(equity) Income)
Kurtosis 3 >3 <3
Excess Kurtosis 0 >0 <0

PROBABILITY DISTRIBUTION
The two Defining properties of probabilities are: -
1. The probability of any Event E is a number between O & 1 i.e. 0 < P( E ) < 1
2. The sum of probabilities of any set of Mutually Exclusive & Exhaustive Events is = 1
To Calculate Probability, we would need:

A. Set of all distinct possible outcomes
B. The probability distribution - Probability of all possible outcomes of a Random
Variable
• Mutually Exclusive Events = Only one of the Events can occur at a time
• Exhaustive Events = Those events which cover all possible outcomes
There are three ways/approaches to estimate the probabilities of any random variable:
1. Empirical Probability
2. Subjective Probability
3. A Priori Probability
Important Note:
Priori & Empirical = Objective Probabilities,
because both don’t vary from person to person like the subjective Probabilities
Converting Odds into Probability Probability into Odds

Odds For a =(?)
P(E) = Event A =
(a + b) [%B =(?)]
Odds Against b [1 − P(E)]

P(E) = Event A =
(a + b) P(E)
DEFGHI JK LMFHN JK O JPPEIM2Q

P(A) = RJLST 2EFGHI JK UJNNMGTH JELPJFHN
Unconditional probability P(A) = A

Conditional probability P(A B)
P(A | B) =
P(B)
The Multiplication Rule P(A B) = P(A | B) × P(B)
The Addition Rule P(A or B) = P(A) + P(B) − P(AB)
The Total Probability Rule P(A) = P(AS1) + P(AS2) +...+ P(ASn)

Bayes Formula =(V+WXYZ[\8X+ / ?^_+\)

P(Event/Information) = = (V+WXYZ[\8X+)
× P(Event)
Why do we use Bayes Formula?

• When we make decisions involving investments, we often start with viewpoints
based on our experience and knowledge.
• These viewpoints may be changed or confirmed by new knowledge and
observations.
• Therefore, we use Bayes’ formula which is a rational method for adjusting our
viewpoints as we confront new information.
Things required for Solving Bayes Formula:

1. Prior Probabilities
2. Conditional Probabilities
3. A flip of what is asked.
Z[\[7][7^ _`[7^ a7][\[7][7^ _`[7^

Conditional =(` a) P(A | B) = P(A)
P(A | B) =
Probability =(a)
Joint Probability P(A B) = P(A | B) × P(B) P(A B) = P(A) × P(B)
Probabilities usage in Investments:

Expected ErP= ∑ P(Xi) × Xi
Value/Return
Variance σ' (X) = ∑ P(X 8 )[X 8 − E(X)]'
Standard deviation c (X) = d∑ P(X 8 )[X 8 − E(X)]'
Covariance Cov (Ri,Rj) = ∑Pi[(Ri−ERi)(Rj−ERj)]
Correlation cX^d$! ,$) f
ρFR 8 , R b G =
g($! ) gd$) f
Portfolio Return ErP= W1*Er1 + W2*Er2 +…………... Wn*Ern

Portfolio Risk σ2P= [W12 × σ12] + [W22 × σ22] + [2× W1× W2 × COV12]
Counting Problems:
Factorial Arrange N!

Labelling Arrange with Label n!

n% ! n' ! … … . . nh !
Combination Permutation
When to Order of Selection is NOT Order of Selection is important
Use important
Worlds Choose Arrange (in order or like Ranks)
Include
Formula !! !!
!"! = !)! =
(! − ')! '! (! − ')!
COMMON PROBABILITY DISTRIBUTION

Probability Distribution: probabilities of all possible outcomes of a random variable.
What is Probability Function & Cumulative Distribution Function?

Probability function P(X) Cumulative distribution function F(X)
Meaning Probability of a Random Probability that a Random Variable
Variable taking some specific can take on a value Less than or equal
value to
Denotation Specific Value denoted as: Cumulative Value denoted as:
P(X) = P(X = x) F(x) = P(X ≤ x)
The Nature of the Outcome decides whether a probability is Discrete or Continuous:

Discrete random variable Continuous random variables
Probability Denoted as p(x) Denoted as f(x)
function PF = Probability Function PDF = Probability Density Function
Cumulative Denoted as F(x) = P(X ≤ x) Denoted as F(x) = P(X ≤ x)
distribution CF = Cumulative Function CDF = Cumulative Distribution
function Function
Discrete Uniform Distribution

Discrete = Finite or countable (specific) number of the possible outcome

Uniform = Each outcome has an equal probability
Example of DUF:
Tossing of Coin - 2 outcomes with each outcome having an equal probability of 1/2 = 0.5
Rolling of Dice - 6 outcomes with each having an equal probability of 1/6 = 0.1667
Probability Function : PF Cumulative Distribution Function : CF
% F(X) = n × P(X)
P(X) = i
Binomial Uniform Distribution

Assumptions of Binomial Distribution:
• Probability is constant for all trials.
• Trials are independent.
Important Points:
• The binomial distribution is symmetric when the probability of success on a trial is
0.50, but it is asymmetric or skewed otherwise.
Calculating Probabilities: P(x) = nCx*× px × (1−p)n-x

Mean Variance
Bernoulli trail B(1, P) P P × (1-P)
Binomial Distribution B(N, P) N × P N × P × (1-P)
Continuous Uniform Distribution

Discrete random variable Continuous random variables
Probability Denoted as p(x) Denoted as f(x)

function PF = Probability Function PDF = Probability Density Function
Cumulative Denoted as F(x) = P (X ≤ x) Denoted as F(x) = P (X ≤ x)
distribution CF = Cumulative Function CDF = Cumulative Distribution Function
function
Probability Function (PDF)

If f (X)
a<X<b %
jB[ Cumulative Distribution Function (CDF)
a>X>b 0 If F (X)

X<a 0
X>b "B[
jB[
a<X<b 1
Let a = lower bound & b = upper bound
Standard Normal Distribution:

• There are many Normal distributions for different mean & variances.
• For simplicity, we refer all Probability Statements to a Single Normal distribution
known as Standard Normal Distribution
• Standard Normal Distribution is a Normal Distribution with µ = 0 & i = 1
The Z Value:
• To standardize an observation from a given Normal distribution, we must
• calculate the Z value, also known as Z score or Z statistic.
• Z value denotes the number of standard deviations the given observation is away
from the population mean
!"#
The formula for standardizing a random variable: Z =
$
X = observation or the target value
µ = Mean
c = Standard deviation
Note:
While looking out for probability from the distribution table based on Z score, remember
that it always gives you the Cumulative probability from the Extreme left side .i.e : -∞ to x
Univariate Normal Distribution Multivariate Normal Distribution

Distribution of A Single random variable 2 or more random variable
Defined by Mean (N) Mean (N)
Parameters Standard deviation (N) Standard deviation (N)
#× (#B%)
Correlation Pairs ( ' )
Note:
• Correlation indicates the strength of the relationship between the pair of random
variables.
• It is the feature that distinguishes a multi-variate from a univariate normal
distribution.

What is Shortfall Risk?

It is the risk that the portfolio value will fall below some minimum Acceptable level (RL) over
some time period.
Roy's Safety-First Ratio:

The safety-first rule focuses on the downside risk known as shortfall risk.
RL = Minimum acceptable level/threshold level
p_(l U ) − l k q
jk lm^no =
rU
E(RP) − RL is the distance from the mean return to the shortfall level.
Dividing this distance by σp gives the distance in units of standard deviation.
• Assuming returns are normally distributed for the portfolio, select the one with the
highest SF ratio.
• The higher the SFR, the lower the shortfall risk
The concept of Shortfall risk with Normal Distribution also plays an important role in
financial risk management while using: VAR, Stress Testing, Scenario Analysis, etc.
Log Normal Distribution:

• The lognormal distribution has been found to be a useful accurate description of the
distribution of prices for many financial assets.
• The log-normal distribution is closely related to the normal distribution.
• Like the normal distribution, the lognormal distribution is completely described by
two parameters - mean and variance.
The two most noteworthy observations about the lognormal distribution are:
• it is bounded below by 0 and
• it is skewed to the right (it has a long right tail)
HPR LN (P1/P0)
Mean LN (P2/P1) + LN(P3/P2) + LN(P4/P3)…
Variance σ' × T
Standard deviation σ × √T
What is Monte Carlo Simulation:

• It is a computer-based technique used in finance to represent complex scenarios
• It considers thousands of different scenarios and gives a probability Distribution
based on large number of Random Variables

Uses of Monte Carlo Simulation:

• To Simulate outcome of trading strategies
• To Calculate Value of Portfolio with assets having non-normal distribution
• To Calculate Value-at-risk (VAR)
Demerits of Monte Carlo simulation:

• Fairly Complex
• Answer No better than assumptions.
• Only statistical focus, less analytical
Historical Vs Monte Carlo Simulation:

Historical Simulation Monte Carlo Simulation
Uses Historical data (actual) to simulate Uses the probability distribution based
process on assumptions of Analyst
Reflects only those risks which have occurred in Reflects imaginary, what if scenarios too
past
T-distribution
• The T distribution is like the normal distribution, just with fatter tails.
• Both T & Z, assume a normally distributed population.
• The T distributions have higher kurtosis than normal distributions.
• The probability of getting values very far from the mean is larger with a T
distribution than with a normal distribution.
Properties of T-Distribution:
• It has a symmetrical probability distribution.
• It is defined by a single parameter known as degree of freedom (unbiased
estimator of sample variance) df = n- 1
• It has Fatter tails than the Z distribution i.e. more probability in the tails
• Fatter tails mean more observations away from the Centre of the distribution i.e.,
more outliers.
• The confidence Interval for T-distribution is wider when the df is less.
• As the df increases, the tails of the distribution become less Fat, and the T-distribution
approaches the Z distribution (standard Normal distribution)
Factors that affect the width of a confidence interval:

• the choice of statistic (t or z),
• the choice of degree of confidence
• the choice of sample size

Note: The choice of statistic (t or z) and the degree of confidence (level of significance)
determines the reliability factor
What happens when the sample size increases?

As we increase the sample size, the standard error and width of the confidence interval
both decrease.
Chi-Square & F-Distribution
Chi-Square F-Distribution
Why is it It is used to test Variance of a It is Test of equality of variances of
Used? Normally Distributed Population two normally distributed populations
from two independent random samples
Test (n − 1)s ' s%'
Statistic χ' = F= '
σ'l s'
Degree of n-1 Df1 = n1–1
Freedom Df2 = n2–1
Common Properties of both Chi-Square & F-Distribution:
1. Unlike the normal and t-distributions, they both are asymmetrical.
2. Bounded below by Zero.
3. As the DF increases, they approach Normal Distribution.
Note:
Under F-Distribution, as a convention, or usual practice, is to use the larger of the two ratios
s12 / s22 or s22 / s12 as the actual test statistic.
SAMPLING
Sample Subset of Population
Sampling a subset studies to infer conclusion about the population itself
Sampling Plan A set of rules used to select a Sample
Parameter a quantity computed from or used to describe the Population
Statistic a quantity computed from or used to describe the Sample
What is Sampling Error?

• It is the difference between the observed value of a statistic (sample mean) and the
quantity it is intended to Estimate (population mean)
• Any difference between the sample mean & population mean is called sampling
Error
Method 1 - Probability Sampling Methods

Simple random Created in such a way that each element of the population has an
sampling Equal probability of being selected in the subset
Systematic It is used when we cannot code or even identify all the members of the
sampling population. Hence, we select every Kth member until we have a
sample of the desired size
Stratified Population is first divided into subpopulation (Strata)
random Then Simple random samples are drawn from each Strata in the
sampling population in sizes proportional to the relative size of the strata in the
population.
These samples are then pooled together to form a stratified random
sample.
It is often used in Bond indexing because of the difficulty of the cost of
completely replicating the entire population of bonds.
Cluster Cluster sampling is also based on subsets of a population.
Sampling However, it assumes that each subset (cluster) is representative of the
overall population with respect to the item being sampled.
In one-stage cluster sampling, a random sample of clusters is
selected and all the data in those clusters comprise the sample.
In two-stage cluster sampling, random samples from each of the
selected clusters comprise the sample.
Contrast this with stratified random sampling where random samples
are selected from each subgroup (cluster)
Clustered vs Stratified Sampling:
Disadvantages compared to Stratified Sampling

• Cluster sampling will have greater sampling error than simple random sampling
• Also, the Two-stage cluster sampling can be expected to have greater sampling
error than one-stage cluster sampling.
Advantages Compared to Stratified Sampling

• Lower cost and less time required to assemble the sample
• It may be most appropriate for a smaller pilot study
Method 2 - Non-Probability Sampling Methods

Convenience It refers to selecting sample data based on its ease of access, using
sampling data that are readily available.
Because such a sample is typically not random, sampling error will be
greater.
It is most appropriate for an initial look at the data prior to adopting a
sampling method with less sampling error.
Judgmental It refers to samples for which each observation is selected from a larger
sampling data set by the researcher, based on her experience and judgment.
However, the researcher bias (or simply poor judgment) may lead to
samples that have excessive sampling error.
In the absence of bias or poor judgment, judgmental sampling may
produce a more representative sample or allow the researcher to focus
on a sample that offers good data on the characteristic or statistic of
interest
What is Central Limit Theorem?

• It helps us understand the sampling distribution of the mean which is used to estimate
how closely the sample mean can be expected to match the population mean
• It allows us to make Precise Probability statements about the population mean using
the sample mean, whatever the distribution of the population (but with finite variance
as long as the sample size is Large (n>30)
Where is the concept used?

1. Construction of confidence Intervals
2. Testing of Hypothesis
Important properties of the Central Limit Theorem include:

According to Central Limit Theorem, when we sample from any distribution, the distribution
of the sample mean will have the below-listed properties as long as the sample size is
Large:-
1. The distribution of sample mean 2 X will be approximately Normal (N>30)

2. The Mean of the distribution of all possible samples will be equal to the mean of the
population from which the samples are drawn.
3. The Variance of distribution of the sample mean will be equal to the variance of the
&
population divided by the sample size i.e. m
n
What is Confidence Interval?

Confidence Interval estimates result in a range of values within which the actual value of
the parameter will lie, given the probability of 1-α

α = level of significance = 5%
1 - α = degree of confidence = 95%
Confidence Interval = Point Estimate + [Reliability Factor × Standard Error]

CI α Z Value
90% 10%/2=0.05 +1.65
95% 5%/2=0.025 +1.96
99% 1%/2=0.005 +2.58
Standard Error:
Important properties :
• The Value of the Standard Error of the sample mean decreases as the sample size
increases {As sample size goes to ∞, Standard Error = 0}
• This is because, as the sample size increases the sample mean gets closer on
average to the population mean.
• The standard deviation of the means of multiple samples is less than the standard
deviation of the single observation.
Depends on whether the Population Variance is known or unknown.

wx[7 r y7oz7 wx[7 r {7y7oz7
σ s
σx = sx =
√| √|
Criteria for selecting appropriate Test statistic is based on :

• Whether the distribution is Normal or Non Normal
• Whether the Population variance is known or unknown
• Whether the sample size is large (n>30) or not
T or z - the Test Statistic?
When Sampling From Small Sample Size Large Sample Size

N<30 N>30
Normal distribution with Known Variance Z Z
Normal distribution with Unknown T Z or }#
Variance

Non-Normal distribution with Known Not applicable Z

Variance
Non-Normal distribution with Unknown Not applicable Z or }#
Variance
# - Preferably " t "
Resampling
It is used to estimate the sampling distribution of a statistic.
However, there are also two alternative methods of estimating the standard error of the
sample mean which involve resampling of the data using Jackknife and Bootstrap
Methods
Jackknife It calculates multiple sample means, each with one of the observations
removed from the sample.
Bootstrap To estimate the standard error of the sample mean, we draw repeated
method samples of size n from the full data set (replacing the sampled observations
each time).
It can be used to estimate the distributions of complex statistics, including
those that do not have an analytic form
Properties of Estimator:
Unbiasedness If the expected value of the sample mean is equal to the population
mean, then we say that the sample mean "~"2 is an unbiased Estimator of
the "µ".
Efficiency An Unbiased Estimator is Efficient if no other Unbiased Estimator of the
same parameter has a sampling distribution with a smaller variance.
Consistency A consistent estimator tends to produce more accurate estimates of the
parameter, as we increase the sample size. As the sample size increases,
the standard error falls and as "n" approaches infinity, the standard
Error approaches "0".
Note: Unbiased ness & Efficiency are two properties of an estimator's sampling distribution
that should hold for any sample size.
Four types of Sampling bias:

Data mining bias, Sample selection bias, Look ahead bias & Time period bias.
I. Data mining bias

• The significance of the pattern is overestimated.

• There is overuse of the same or related data which leads to errors that arise from
misuse of such data.
• They often result in unsuccessful Investment strategies.
Solution or measures to avoid data mining bias:

• Conduct out-of-sample tests.
II. Sample Selection bias

• It occurs due to the unavailability of data or when the data is systematically
excluded from the analysis.
• This leads to the observed sample being not random and any conclusion drawn
from this sample cannot be applied to the population.
• The most common type of Sample selection bias is Survivorship bias - which
includes only those observations which are currently in existence.
III. Look ahead bias

• It is a bias where we use information that was not available on the test date.
IV. Time period bias

• If the test is based on time period that makes the result that is time period
specific.
• This happens when we use either too long or too short a time period.
• In too long a period, the data can be divided into two sub-samples.
HYPOTHESIS
What is Hypothesis Testing?
• It is part of the branch of statistics whereby a researcher or analyst tests an
assumption regarding a population parameter (mean, variance, correlation)
• The test provides evidence/validity of the statement at a given significance level
Steps in Hypothesis Testing:

1. Stating the Hypothesis - Null & Alternate Hypothesis
2. Identifying the appropriate Test statistic - 4 different types of test.
3. Specifying the level of significance - the probability at which we want to test the
Hypothesis.
4. Stating the Decision Rule - Accept/Reject decision.
5. Collecting the data & calculating the test statistic
6. Making the Statistical Decision - by Comparing the Test Statistic & the critical value

7. Making the Economic or Investment Decision - practical Interpretation
Formation of Hypothesis:
Two tail tests H0 : θ = θ0 Ha : θ ≠ θ0
One tail test H0 : θ ≤ θ0 Ha : θ > θ0
One tail test H0 : θ ≥ θ0 Ha : θ < θ0
Type I and Type II Errors in Hypothesis Testing True Situation True Situation
Decision Null (H0) is true Null (H0) is false
Do not reject Null (H0) Correct Decision Type II Error
Reject Null (H0) (accept alternative Ha) Type I Error Correct Decision
Note:
• If you try to reduce the probability of Type terror I, then you increase the
probability of making Type II Error
• The only way to seduce the probability of both Errors is to increase " N" (sample
size)
Power of Test = 1 - Probability of Type II Error

= 1 - Probability of Failure to reject a false null
= Probability of Successfully rejecting a false null
Note :
• Therefore, Power of test is Correctly rejecting a Null when its False
• Hence, if we reject the Null at the lowest level of significance, we have the strongest
evidence that the Null is false
P Value
• It is the smallest α (level of significance) at which the Null is rejected
• The smaller the P value the stronger is the evidence against H0 and in favor of Ha
• The P value can be used as an alternative to the rejection print
• Therefore, if P < α, we reject the Null
The formula for Test Statistics:

(Sample Statistic − Value of population parameter under HX )
Test Statistic =
Standard error of the sample statistic
Test (MEAN) Sub Test Test - Statistic DF

Single Mean T or Z FX − µl G n-1

t +B% = (If T-Test)
Üsá à
√n
Differences in mean Unknown variance Given Given
(Independent assumed equal.
Sample) Unknown variance Given Given
assumed unequal.
Differences in mean Paired Comparison test. d" − µpl n-1
(Dependent t=
spq
Sample)
Test (VARIANCE) Sub Test Test - Statistic DF
Single Variance Chi-square Test (n − 1)s ' n-1
χ' =
σ'l
Equality/inequality F-distribution test s%' Df1 = n1–1
of variance F= ' Df2 = n2–1
s'
Test T-Test Y ∗√+B' n-2
(CORRELATION) √%Bt *
Non-Parametric Run Test

Test Spearman Rank
Correlation Coefficient
Test of Independence
• It is for testing the hypothesis when faced with categorical or discrete data to
conclude whether two characteristics are independent of each other.
• Since the classification of investment type may be discrete (like Investment type vs
market cap used in the contingency table below) then correlation cannot be used to
assess the relationship between these two variables.
• Here a Chi-Square Distributed test statistic is used to test for the independence of
two categorical variables.
• This nonparametric test compares Actual Frequencies with those Expected on the
basis of independence.
LINEAR REGRESSION
Dependent vs Independent Variable

Dependent The variable whose variation we are seeking to explain

variable Also called as Explained Variable, Endogenous Variable or the
Predicted Variable
Independent the variable whose variation we are using to explain changes in the
variable dependent variable
Also called as Explanatory Variable, Exogenous Variable or the
Predicting Variable
Ordinary Least Square Regression (OLS)

• The goal is to fit a line to the observations on Y and X to minimize the squared
deviations from the line; hence it is called as least squares regression
• Because of its common use, linear regression is often referred to as ordinary least
squares (OLS) regression.
Simple Linear Regression Model

Yi= b0+ b1Xi+ Ɛi, i = 1,. . , n
Yi Dependent Variable i
b0 Intercept
b1 Slope Coefficient
Xi Independent variable
εi The error term, or simply the error, represents the difference between the
observed value of Y and that expected from the true underlying population
relation between Y and X
Linear regression assumes the following:
• A linear relationship between X and Y
• X uncorrelated with the residuals (error term)
• The expected value of the error term = 0
• The variance of the error term is constant (Homoskedastic)
• The error term is independently distributed
• The error term is normally distributed
Note:
Homoskedasticity - the case where prediction errors all have the same variance
Heteroskedasticity - the situation when the assumption of homoskedasticity is violated
ANOVA Table
Source of Variation Degree of Freedom Sum of Squares Mean Sum of Squares

Regression (Explained) k RSS $uu

MSR =
v
Error (Unexplained) n-k-1 SSE uu?

MSE = +BvB%
Total n-1 SST
SEE (Standard Error SEE for a regression is the standard deviation of its residuals.
of Estimate) The lower the SEE, the better the model: SSE = √MSE
Coefficient of SEE does not tell us how well the independent variable explains
Determination (r ' ) variation in the dependent variable.
r ! does this by measuring the fraction of the total variation in Y
$uu
that is explained by X: R' =
uuw
Model Dependent Independent Slope Interpretation Model Output

Variable Variable
Log- Logarithmic Linear Relative change in DV for an ln Yi= b0+ b1Xi+ Ɛi
Lin absolute change in the IV
Lin- Linear Logarithmic Absolute change in DV for a Yi= b0+ b1ln(Xi)+ Ɛi
Log relative change in IV
Log- Logarithmic Logarithmic Relative change in DV for a ln Yi= b0+ b1ln(Xi)+ Ɛi
Log Relative change in IV

CFA Level 1 – Quick Notes by KRD - FSA
INTRODUCTION TO FINANCIAL STATEMENTS

What is Audit?
• Independent review of an entity’s financial statements
• The objective is to enable the auditor to provide an opinion on the fairness and
reliability of the financial statements.
Types of Opinion by Auditors:

1. Unqualified opinion: the statements are free from material omissions and errors.
2. Qualified opinion: For any exceptions to the accounting principles
3. Adverse opinion: If the statements are not presented fairly or are materially
nonconforming with accounting standards.
4. Disclaimer of opinion: If the auditor is unable to express an opinion.
Key Audit Matters:

• An audit report must also contain a section called Key Audit Matters (international
reports) or Critical Audit Matters (U.S.)
• It highlights accounting choices that are of greatest significance to users of
financial statements including those that require significant management judgments
and estimates, how significant transactions during a period were accounted for, or
choices the auditor finds especially challenging or subjective and which therefore
have a significant likelihood of being misstated.
Describe the steps in the financial statement analysis framework.

Step 1: State the objective and context
Step 2: Gather data
Step 3: Process the data (calculate ratios)
Step 4: Analyse and interpret the data
Step 5: Report the conclusions or recommendations
Step 6: Update the analysis

FINANCIAL REPORTING STANDARDS

Objectives of financial reporting:
Provide information about the firm - to current and potential investors and creditors -
that is useful for making their decisions - about investing in or lending to the firm.
Standard-setting bodies Regulatory authorities

Professional organizations of accountants and Government agencies that have the
auditors that establish financial reporting legal authority to enforce compliance
standards. with financial reporting standards.
FASB in USA Securities and Exchange Commission
IASB for outside USA (SEC) in USA
IAS - older IASB standards Financial Conduct Authority in the UK
Some of the major Filings required by SEC are as below:

Form Purpose
S-1 Registration statement filed prior to the sale of new securities to the public.
10 - Q Required Quarterly filing (however, not required to be audited)
6- K Required semi-annually filing Non-US companies
DEF-14A Filed with SEC along with proxy statement (filed prior to the annual
meeting or other shareholder vote)
8-K Required filing to disclose material events like:
• Significant asset acquisitions and disposals
• changes in management or corporate governance
• Matters related to its accountants, its financial statements, or the
markets in which its securities trade.
144 Notification to SEC when company issues securities to certain qualified
buyers (no registering required)
3, 4, & 5 It involves the disclosure of beneficial ownership of securities by a
company’s officers and directors.
IASB's conceptual framework:

The conceptual framework for Financial reporting consists of IASB standards

The conceptual framework details:

A. Qualitative characteristics of financial statements
B. Constraints on Financial Reports
Qualitative Characteristics
There are two fundamental characteristics that make financial information useful:
Relevance
• FS are relevant if the information in them can influence users’ economic decisions or
affect users’ evaluations of past events or forecasts of future events.
• Information should have predictive value, confirmatory value (confirm prior
expectations), or both to be relevant. Materiality is an aspect of relevance.
Faithful representation
• Information that is faithfully representative is complete, neutral and free from error.
There are four characteristics that enhance the relevance and faithful representation:
Comparability Should be consistent among firms and across time periods
Verifiability Using the same methods, obtain similar results
Timeliness Information is available to decision makers before the
information is stale
Understandability Users with a basic knowledge should be able to readily
understand the information the statements present & Useful
information should not be omitted just because it is complicated.
Cost-benefit trade-off
• The benefit that users gain from the information should be greater than the cost of
presenting it.
Not everything can be captured
• The non-quantifiable information about a company like its reputation, brand
loyalty, capacity for innovation, etc cannot be captured directly in FS
Assumptions: Accrual accounting
• Assumes that FS should reflect transactions in the period when they actually occur,
not necessarily when cash movements occur regardless of when the cash is received
Assumptions: Going concern
• Assumes that the company will continue in business for the foreseeable future.
Companies with the intent to liquidate or materially curtail operations would
require different information for a fair presentation

Measurement Base:
The amounts at which items are reported in the financial statement elements depend on
their measurement base. Measurement bases include:
Historical cost the amount originally paid for the asset
Amortized cost Historical cost (-) Accumulated Depreciation/amortization, etc.
Current cost the amount the firm would have to pay today for the same asset
Net realizable value Estimated selling price of the asset – Estimated selling cost
Present value The discounted value of the asset's expected future cash flows
Fair value The price at which an asset could be sold, or a liability
transferred, in an orderly transaction between willing parties
INCOME STATEMENT
The five steps in recognizing revenue:
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
Expenses are subtracted from revenue to calculate net income.

• Matching principle: Match the revenue and cost (Which are tied to revenue) in the
same accounting period.
• Few costs like administrative costs are expensed in the period in which it is incurred;
these are called Period Costs.
Non-Operating Items Below EBIT but above the Line
Income from Discontinued Operation Below the line but net of taxes
Changes in Accounting Estimates Prospective
Changes in Accounting Policies Retrospective
Earnings per share

• A simple capital structure is one that contains no potentially dilutive securities.
Firms with simple capital structures report only basic EPS

• A complex capital structure contains potentially dilutive securities such as options,

warrants, or convertible securities. All firms with complex capital structures must
report both basic and diluted EPS.
!"# %&'()" *+","--". .%/%."&.0
Basic EPS = 1"%23#". 4/"-52" &6)7"- (, '())(& 035-"0 (6#0#5&.%&2 (94:;)
Diluted
=>??>@ABCDC?EFBCGCA F@EHIC – K?CLC??CM MFNFMC@M O K?CLC??CM MFNFMC@MO P@AC?CBA (Q*A)
EPS = (RSTU O SMMFAFH@>V EHIIH@ BW>?CB FBBXCM H@ Y?CLC??CM
BW>?CB EH@NC?BFH@O SMMFAFH@>V EHIIH@ BW>?CB FBBXCM H@ MCZA EH@NC?BFH@O
>MMFAFH@>V EHIIH@ BW>?CB FBBXCM H@ CDEC?EFBC HL HKAFH@B H? =>??C@AB)
Common size income statement

• Presented in terms of percentage of net revenue.
• It is used for time series and cross-sectional analysis and highlights the differences in
the company’s strategy
Comprehensive income includes all changes in owners’ equity except for owners’
contributions and distributions.
Comprehensive income = Net income + other comprehensive income (OCI)

Other comprehensive income includes:
1. Foreign currency translation gains and losses
2. Adjustments for minimum pension liabilities
3. Unrealized gains and losses from hedging derivatives
4. Unrealized gains and losses from available-for-sale securities

BALANCE SHEET
Balance Sheet: Assets = Liabilities + Equity
Classified balance sheet:

Under this format of the balance sheet, the firm is required to report current and non-
current assets as well as current and non-current liability separately.
Both IFRS and US GAAP require this format
Liquidity-based format:
Under this format, assets and liabilities are presented in the order of liquidity, with most
liquid ones as first followed by less liquid ones.
Allowed only under IFRS. This format is mostly used in the banking industry
Current Assets
• Includes cash and other assets which will be converted into cash or used up within one
year or one operating cycle, whichever is greater. Most liquid assets are presented
first in the Current asset list.
Current Liabilities
• These are obligations that will be satisfied within one year or one operating cycle,
whichever is greater.
Working Capital:
Working Capital Current asset - Current liability
If too much Inefficient use of resources
If too little Liquidity risk
Non-Current Assets
• PPE
• Investment Property
• DTA
• Intangible Assets
Calculation of Goodwill
• When one company acquires another company, the transaction is accounted for
using the acquisition method of accounting.
• The additional amount paid beyond the Fair Value of Net Assets is Goodwill
• Goodwill is not amortized but tested for impairment annually.
• If goodwill is impaired, the amount of impairment loss will reduce the balance sheet
value of goodwill and loss is recognized in the income statement which will reduce
the net income.

Financial assets are classified into three categories as below:

Asset type Value in the Un-realized Realized
balance sheet gain/loss gain/loss
Amortized Cost / Held Amortized cost No effect Income statement
till maturity (Debt)
FVOCI / Available for Fair value OCI Income statement
sale (Debt or Equity)
FVPL / Held for trading Fair value Income statement Income statement
(Debt or equity)
Non-Current Liabilities
• Long-term financial Liabilities / Debt
• Pension Liabilities
• DTL
Equity
It is the owner’s residual claim on the company’s assets after subtracting its liabilities. Equity
includes funds directly invested in the company by the owners, as well as earnings that
have been reinvested over time.
Contributed capital
(+) Preferred shares
(-) Treasury shares
(+) Retained earnings
(+) Accumulated other comprehensive income (OCI)
(-) Non-controlling interest/minority interest
Ending Retained Earnings = Beginning Retained Earnings + Net Income – Dividend.
Vertical Common-Size Balance Sheet:
• Expresses each item of the balance sheet as a percentage of total assets.
• The format standardizes the balance sheet by eliminating the effects of size.
• Allows for comparison over time (time-series analysis) and across firms (cross-
sectional analysis).
CASH FLOW STATEMENT
The importance of Cash flow statement

• Provides information about a company’s cash receipts and cash payments during
an accounting period.
• Information contrasts with the accrual-based information from the income statement
• Provides information about the company's Operating, Financing, and investing
activities.
• It helps to assess firms’ liquidity, solvency, and financial flexibility.
This information allows the analyst to answer such questions as:

• Does the company generate enough cash from its operations to pay for its new
investments?
• Does the company pay its dividends to common stockholders?
• Is the firm’s business sustainable?
• Is the firm able to repay the existing Debt or any unexpected obligations?
• Can it take advantage of new opportunities?
The classifications used in the cash flow statement under both IFRS and US GAAP and
are described as follows:
Cash flow CFO (Operating Cash CFI (Investing Cash Flow) CFF (Financing Cash
type Flow) Flow)
Majorly Company's Current asset Company's Non-Current Company's Non-
related to and Current liabilities Assets current liabilities and
Equity
Differences between IFRS and US GAAP

IFRS US GAAP
Interest received CFO or CFI CFO
Interest paid CFO or CFF CFO
Dividend received CFO or CFI CFO
Dividend paid CFO or CFF CFF
Tax paid *Generally, CFO Or CFI/CFF CFO
Non-cash Transactions:
• A non-cash transaction is any transaction that does not involve an inflow or outflow
of cash
• Since they do not involve any cash receipt or payment, they are not reported in any
of the cash flow statements.
• However, any transactions that may affect a company’s capital or asset structures or
any other significant non-cash transaction are required to be disclosed in footnotes,
either in a separate note or a supplementary schedule to the cash flow statement

Various types of non-Cash transactions may include:

• Exchanging one non-monetary asset for another non-monetary asset where no
cash is involved.
• A company issuing common stock either for dividends or in connection with the
conversion of a convertible bond or convertible preferred stock.
CFO: Operating Cash Flow

There are two acceptable formats for reporting CFO:
1. The direct method (encouraged under both IFRS & US GAAP)
2. The indirect method
Common rule:
Increase Decrease
Current Asset Outflow Inflow
Current Liability Inflow Outflow
The Direct Method:

CF Statement Component
Cash collected Revenue
from customer (+/-) change in accounts receivable.
(+/-) change in unearned revenue.
Cash paid to - COGS
supplier (+/-) change in Inventory.
(+/-) change in accounts payable.
Cash paid for - Operating expenses.
operating (+/-) change in prepaid operating expense (+/-) change in
expenses operating expense payable.
Cash paid for - Interest expense.
interest (+/-) change in interest payable.
Cash paid for - Tax expense.
taxes (+/-) change in tax payable.
The Indirect Method:

Net income
(+) Depreciation/other NCC

(-) Gain on sale of asset/Debt

(+) loss on sale of asset/Debt
(+) Decrease in current assets / Increase in current liability
(-) Increase in current assets / Decrease in current liability
CFI: Investing Cash Flow

Investing cash flow can include the purchase or sale of PPE and other investments.
Historical Cost of Accumulated Book value of Cash received
Equipment Sold Depreciation on equipment from sale of
Equipment Sold Equipment
Beginning Beginning balance Historical cost of Book Value of
balance accumulated equipment sold. Equipment Sold
equipment depreciation
(+) equipment (+) depreciation (-) accumulated (+) gain or (-) loss
purchased. expense depreciation on on sale of
equipment sold Equipment
(-) Minus ending (-) ending balance
balance accumulated
equipment depreciation
CFF: Financing Cash Flow

Net cash flows from creditors New borrowings (−) principal amounts repaid
Net cash flows from New equity issued (−) share repurchases (−) cash
shareholders dividends paid
Common-Size Analysis of the Statement of Cash Flows

• In a common-size analysis of a company’s income statement, each income and
expense line item is expressed as a percentage of net revenues (net sales)
• For the common-size balance sheet, each asset, liability, and equity line item are
expressed as a percentage of total assets.
Free cash flow

The excess of operating cash flow over capital expenditures:
FCFF (Free Cash Flow Cash flow available FCFF = NI + NCC + Int.(1 – Tax rate) –
to Firm) to the company’s FCInv – WCInv
suppliers of debt FCFF = CFO + Int.(1 – Tax rate) – FCInv
and equity capital

FCFE (Free Cash Flow Cash flow available FCFE = CFO – FCInv + Net borrowing
to Equity) to equity capital Net borrowing = Borrowing –
owners only Repayment
CASH FLOW Ratios:

For any ratios, replace the Net income with CFO.

FINANCIAL RATIO ANALYSIS

Common Size Analysis
The common-size analysis creates a ratio between every financial statement item and the
base item (total assets or revenue)
A. Vertical common size balance sheet:
• expresses all balance sheet accounts as a percentage of total assets and
• all income statement items as a percentage of sales.
B. Horizontal Common size balance sheet: Prepared by computing the increase or
decrease in percentage terms of each balance sheet item from the prior year or
prepared by dividing the quantity of each item by the base year quantity of the
item, highlighting the change in item.
Use of Graphs as an Analytical Tool

• Comparison of performance and financial structure over time
• Provide the analyst (and management) with a visual overview of risk trends in a
business.
• Used to effectively communicate the analyst’s conclusions regarding the financial
condition and risk management aspects.
There are various types of graphs used for different purposes:

1. Pie graphs - are most useful to communicate the composition of the total value.
2. Line graphs - are useful when the focus is on the change in amount for limited items
over a longer time period.
3. Stacked Column graphs - are used when the composition and amounts, as well as
their change over time, are all important.
Activity Ratio Numerator Denominator

Inventory turnover Cost of sales or COGS Average inventory
Days of inventory on Number of days in period Inventory turnover
hand (DOH)
Receivables turnover Revenue Average receivables
Days of sales outstanding Number of days in period Receivables turnover
(DSO)
Payables turnover Purchases Average trade payables

Number of days of Number of days in period Payables turnover

payables
Working capital turnover Revenue Average working capital
Fixed asset turnover Revenue Average net fixed assets
Total asset turnover Revenue Average total assets
Liquidity Ratio Numerator Denominator

Current ratio Current assets Current
liabilities
Quick ratio Cash + Short- term marketable investments + Current
Receivables liabilities
Cash ratio Cash + Short- term marketable investments Current
liabilities
Defensive interval Cash + Short- term marketable investments + Daily cash
ratio Receivables expenditures
Cash conversion cycle DOH + DSO – Number of days of payables
(Net operating cycle)
Solvency – Debt Ratio Numerator Denominator

Debt- to-assets ratio Total debt Total assets
Debt- to-capital ratio Total debt Total debt + Total shareholders’
equity
Debt- to-equity ratio Total debt Total shareholders’ equity
Financial leverage ratio Average total assets Average total equity
Debt- to-EBITDA Total debt EBITDA
Solvency – Coverage Ratio Numerator Denominator

Interest coverage EBIT Interest payments
Fixed charge coverage EBIT + Lease Interest payments + Lease
payments payments

Profitability Ratio – Sales Numerator Denominator

Gross profit margin Gross profit Revenue
Operating profit margin Operating income Revenue
Pretax margin EBT Revenue
Net profit margin Net income Revenue
Profitability Ratio – Investment Numerator Denominator

Operating ROA Operating income Average total assets
ROA Net income Average total assets
Return on total capital EBIT Average short- and long-
term debt and equity
ROE Net income Average total equity
Return on common equity Net income – Average common equity
Preferred dividends
The DuPont Analysis:

Normal Net income
ROE Average equity
Two Net income Average total assets
Way x
Average total assets Average equity
ROE ROA 6 Financial Leverage
Three Net income Revenue Average total assets
Way x x
Revenue Average total assets Average equity
ROE Net Profit Margin 6 Asset Turnover ratio 6 Financial Leverage
Five Net income EBT EBIT Revenue Average total assets
Way x x x x
EBT EBIT Revenue Average total assets Average equity
ROE Tax Burden 6 Interest Burden 6 EBIT Margin 6 Asset Turnover ratio 6 Financial
Leverage.
Multiplier's Ratio Numerator Denominator

P/E Price per share Earnings per share

P/CF Price per share Cash flow per share
P/S Price per share Sales per share
P/BV Price per share Book value per share
Per Share Ratio Numerator Denominator

Basic EPS Net income (-) preferred Weighted average number of
dividends ordinary shares outstanding
Diluted EPS Adjusted income available for Weighted average number of
ordinary shares, reflecting ordinary and potential ordinary
conversion of dilutive securities shares outstanding
Cash flow per Cash flow from operations Weighted average number of
share shares outstanding
EBITDA per EBITDA Weighted average number of
share shares outstanding
Dividends per Common dividends declared Weighted average number of
share ordinary shares outstanding
Weighted average consists of the number of ordinary shares outstanding at

number of shares for the beginning of the period, adjusted by those bought
BASIC EPS back or issued during the period, multiplied by a time-
weighting factor
Weighted average weighted average number of shares for basic EPS, plus
number of shares for those that would be issued on conversion of all
DILUTED EPS potentially dilutive ordinary shares
Dividend related Ratio Numerator Denominator

Dividend payout ratio DPS EPS
Retention rate (b) 1-DPS EPS
Sustainable growth rate b × ROE
There are various indicators of the variation in and the uncertainty about a firm’s
performance.

The coefficient of variation for a variable is its standard deviation divided by its
expected value.
Ratio Numerator Denominator

Coefficient of variation of Standard deviation of Average revenue
revenues Revenue
Coefficient of variation of Standard deviation of Average operating income
operating income operating income
Coefficient of variation of Standard deviation of Average net income
net income net Income
A business segment is a portion of a larger company that:

• Accounts for more than 10% of the company’s revenues, assets, or income
• Is distinguishable from the company’s other lines of business in terms of the risk
and return characteristics of the segment.
Techniques Used to Forecast:

A. Sensitivity analysis: Aka ‘what If’ analysis shows the range of possible outcomes as
specific assumptions are changed.
B. Scenario analysis: Shows the changes in key financial quantities that result from
given (economic) events, such as loss of customers, loss of supply sources etc.
C. Simulation analysis: This is a computer-generated sensitivity or scenario analysis
based on probability models for the factors that drive the outcomes.

INVENTORY
COGS = Beginning Inventory + Purchases - Ending Inventory
Capitalizing vs Expensing (same under IFRS & US GAAP):

Capitalized Product Costs Expensed Period Costs
Purchase Additions: Abnormal Abnormal costs incurred
Cost Purchase price, import and Costs because of waste of
tax- related duties, transport, materials, labor or
insurance during transport, other production
handling, and other costs directly conversion inputs
attributable to the acquisition of
finished goods, materials, and
services
Subtractions:
Trade discounts, rebates
Conversion Costs directly related to the units Storage any storage costs
Cost produced, such as direct labor & Costs unless required as part
fixed and variable overhead costs of the production
process
All other Costs incurred in bringing the Other all administrative
Cost inventories to their present Costs overhead and selling
location and condition costs
There are total of four types of Inventory Valuation Methods:

Methods Assumption COGS includes Ending Inventory
includes
FIFO Item purchased first is the item Fist purchased Latest Purchases
sold first
LIFO Item purchased last is the item Last Purchased Earliest Purchases
sold first
Weighted Items sold are mix of purchases Average cost Average cost of all
Average of all items items
Specific Goods that have been produced - -
Identification and segregated for specific
projects

Effect of Inventory Method under RISING PRICES

Effect on FIFO LIFO
COGS ↓ ↑
Gross Profit ↑ ↓
EBIT ↑ ↓
Tax Paid ↑ ↓
Net Profit ↑ ↓
CFO (due to taxes) ↓ ↑
Ending Inventory ↑ ↓
Current Asset, Working Capital, Current Ratio, Total Assets ↑ ↓
Periodic vs Perpetual Inventory System

Periodic inventory system Perpetual inventory system
Inventory & determined at the end of the are updated continuously
COGS accounting period
Recording No detailed records of inventory Inventory purchased and sold is
are maintained recorded directly in inventory when
the transactions occur
Purchase inventory acquired during the Purchases account is not necessary
Account period is reported in a Purchases
account
Impact of Inventory FIFO Specific Identification LIFO Weighted

System on Method Average
Ending Inventory & COGS Same Same Different Different
LIFO Reserve:
• It is the amount by which LIFO inventory is less than FIFO inventory.
• LIFO reserve = FIFO inventory - LIFO inventory

Converting LIFO to FIFO

FIFO Inventory LIFO Inventory + LIFO reserve
FIFO Retained Earnings LIFO Retained Earnings + LIFO reserve × (1-Tax rate%)
FIFO Cash LIFO Cash – LIFO reserve × Tax rate%
FIFO COGS LIFO COGS – Change in LIFO reserve
FIFO NI LIFO NI + Change in LIFO reserve × (1-Tax rate%)
FIFO Tax LIFO Tax + Change in LIFO reserve × Tax rate%
LIFO Liquidation
A LIFO liquidation occurs when a LIFO firm’s inventory quantities decline as they sell more
than what they purchase.
What is the Impact of LIFO Liquidation?

COGS Decrease
Operating margins, Increase
Profit margins,
Income taxes,
Operating cash flow
Gross profit due to Number of units liquidated ×
LIFO liquidation [the replacement cost of the units liquidated - historical
purchase cost]
What should Analysts look for?

Analysts must, therefore, look to the LIFO reserve disclosures in the footnotes to see if the
LIFO reserve has decreased over the period, which would indicate the possibility of a LIFO
liquidation that requires adjustment of profit margins if its impact has been significant.
Inventory Method Changes

IFRS • A change in method is acceptable only if the change results in the financial
statements providing reliable and more relevant information.
• If the change is justifiable, then it is applied retrospectively
USGAAP • It requires companies to thoroughly explain why the newly adopted

inventory accounting method is superior and preferable to the old method.
• If the change is justifiable, then it is applied retrospectively.

Exception • No retrospective application applies when a firm changes to LIFO from

another cost flow method.
• The change is applied prospectively; no adjustments are made to the
prior periods.
Inventory Measurement
IFRS Lower of Cost or NRV,
If below Cost: B/S = down, I/S = Write down Loss, Reversal allowed
USGAAP Lower of Cost or Market/Replacement Cost
If below Cost: B/S = down, I/S = Write down Loss, Reversal Not allowed
NRV Estimated Selling Price – Selling Cost – Completion Cost
Replacement Upper limit: NRV
Cost Lower limit: NRV – Normal profit margin
Effect of Write Down on Inventory Ratios:

Category of Ratio Effect in the Write Effect in the period
Ratio down period subsequent to Write down
Liquidity Current Asset, Current Decrease Increase
ratio
Quick ratio Unaffected Unaffected
Solvency Debt to asset, Debt to Increase Decrease
Equity ratio
Equity, Total Assets Decrease Increase
Activity COGS, Inventory & Asset Increase Decrease
Turnover ratios
Profitability Margins (Gross, OP, Net, Decrease Increase
ROA, ROE
Inventory Disclosures:
• The Accounting policies adopted.
• The Total carrying amount of inventories.
• The carrying amount of inventories carried at fair value less costs to sell on B/S and on
I/S as COGS

• The amount of any write-down of inventories recognized as an expense in the period

and reversal of write-down (only for IFRS) and the circumstances or events that led to
the reversal of a write-down of inventories.
• the carrying amount of inventories pledged as security for liabilities.

LONG-LIVED ASSET
Tangible Assets
Asset During the Acquisition year Subsequent years
PPE Recorded on the Balance sheet at Cost/fair Capitalized if benefit is
value (+) all expenses necessary to make the above one year or
asset ready to use Expensed
Carrying Value = Historical cost - Depreciation
Impact of Capitalizing an Expenditure:

Item Initial Years Later Years
Balance Sheet - Asset Value Increases Decrease
Income Statement - profit No Impact Decrease
Cash Flow Statement Outflow (CFI) No Impact
Impact of Expensing instead of Capitalizing:

Item Initial Years Later Years
Balance Sheet - Asset Value No recognition No impact
Income Statement - profit Decrease No impact
Cash Flow Statement Outflow (CFO) No impact
Effect of Capitalizing vs Expensing on Financial Statements

Capitalizing Expensing
Total assets, Shareholders’ equity, CFO Higher Lower
Income variability, Debt ratio/ DE ratio, CFI Lower Higher
Net income/ROE/Interest Coverage (first year) Higher Lower
Net income/ROE/Interest Coverage (subsequent years) Lower Higher
Accounting for an intangible asset:

For Intangible Assets Created Internally: IFRS US GAAP
Costs to create intangible assets Expensed Expensed

Research costs Expensed Expensed

Development costs Capitalized Expensed
Software for Sale (before feasibility established) Expensed Expensed
Software for Sale (development) Capitalized Capitalized
For Intangible Assets Purchased from another party:

Capitalized - Recorded at Fair Value on the Balance Sheet at Acquisition
For Intangible Assets Obtained in a Business Combination:

Goodwill is said to be an unidentifiable asset that cannot be separated from the
business itself and therefore it is Capitalized.
The treatment of construction Interest is similar under U.S. GAAP and IFRS
Capitalized It is the interest that accrues during the construction period.
interest (B/S) It is not reported in the income statement as interest expense.
Expensing The interest cost is allocated to the income statement through
(I/S) Depreciation (construction done for own use) or COGS (construction
done for selling).
Cash Outflow USGAAP: Capitalized (CFI), Expensed (CFO)
IFRS: Capitalized (CFI), Expensed (CFO/CFI/CFF)
Depreciation:
SLM ( [\]^*_`]abcde fdec`)
Depreciation = g]`hce eah` \h d]]`^
DDB i
Depreciation = g]`hce eah` X (Cost – accumulated Depreciation)
Units of (U?FjF@>V EHBA – B>VN>jC N>VXC)

Depreciation = x output units in the period
Production kah` al \c^mc^ cla^]
Life of Asset:
Total Useful Life Gross PPE
Depreciation expense
Average Age Accumulated depreciation

Remaining Life Net PPE

Effect of choice of depreciation method DDB SLM

Depreciation expense (Earlier years) Higher Lower
Depreciation expense (Later years) Lower Higher
EBIT, NI & Profitability ratios (Earlier years) Lower Higher
EBIT, NI & Profitability ratios (Later Years) Higher Lower
Effect of choice of Useful Life & Salvage Longer Shorter
Depreciation expense per year Lower Higher
Component Method:
Under IFRS require companies to use a component method of depreciation
Under USGAAP the component method of depreciation is allowed but is seldom used
in practice
Models for Valuation & Reporting of LLA

Cost Model Revaluation Model
Balance sheet Carrying amount at Carried at Fair Value of LLA
Historical Cost (-) Acc. Dep.
Changes in Allows only decrease compared Allows increase & decrease
Value with Historical Costs compared to Historical Costs
IFRS Allowed Allowed (rarely used)
US GAAP Required Not Allowed
Effects of Revaluation on the Carrying Amount:

Carrying Value Recognition
First Decrease Loss = Income statement
Later Increase Gain = Income statement (till initial loss)
Extra gain = OCI directly (as Rev Surplus under Equity)
First Increase Gain = OCI (as Rev Surplus under Equity)

Later Decrease Loss = OCI (decrease the Rev Surplus)

If loss take value below carrying value = Income
statement
Impairment of assets:
• Unexpected Decline in the Value of Assets.
• Impairment losses are recognized when assets carrying value is not recoverable.
Impairment Effect:
Income statement Loss recognized
Balance Sheet Assets carrying value written down to: Fair Value (-) Selling Cost
Cash Flow No effect
Impairment Criteria:
IFRS US GAAP
Impairment Carrying Value > Recoverable amount Step 1: Recoverability Test -
Condition Carrying Value > Undiscounted
Future Cash Flow
Impairment Carrying Value (-) Recoverable Step 2: Loss measurement -
Loss amount Carrying Value (-) Fair Value
Recoverable Amount is higher of: If fair value not available, then
i. Fair Value (-) Selling cost or Value in Use (discounted Future
ii. Value in Use (discounted Future cash flow) to be considered
cash flow)
Impairment Frequency:
Assets Frequency Remarks
PPE Not tested Tested only if there is indication of impairment.
annually Like, evidence of obsolescence, decline in demand for
products, or technological advancements etc.
Intangible Not tested Tested only if significant events suggest, like
(finite Life) annually decrease in market prices, adverse change in legal or
economic factors.
Intangible Tested at least Example - Goodwill
(indefinite Life) annually

Assets held for Tested at the If the carrying amount at the time of reclassification
sale time of exceeds the fair value less Selling cost, an impairment
reclassification loss is recognized, and the asset is written down to fair
value (-) selling cost.
Asset ceases to be in use or management decides to
sell it and No dep/amt applicable once the asset held
for sale ceases to be in use
Reversals of Impairments of Long-Lived Assets.

Under IFRS US GAAP
Permitted if the recoverable amount of an asset For assets held for sale, if the
increases, IFRS permit the reversal of fair value increases after an
impairment (losses only) for assets held impairment loss, the loss can be
for sale or use (both) reversed
Not Does not permit the revaluation to the For assets held for use,
Permitted recoverable amount if the recoverable reversal of an impairment loss
amount exceeds the previous carrying is not permitted
amount
Derecognition: The assets are removed from the balance sheet after their use:
Effect On Sale Exchange Abandonment
Balance Asset removed from Remove Carrying value of asset Asset is reduced
Sheet balance sheet given up and add fair value of by the carrying
asset replaced amount
Income Gain/loss = Sale price Difference between Carrying Loss = Carrying
statement (-) Carrying value value and Fair value recognized value
Financial reporting of Investment Property (only under IFRS)

Cost Model Carrying Value = Historical Cost (-) Acc. Depreciation
Fair Value All changes in the fair value of the asset whether above or below the cost
must be adjusted in income statement
Disclosures and Presentations:

There are many differences in the disclosure requirements for tangible and intangible
assets under IFRS and U.S. GAAP. However, firms are generally required to disclose:
• Carrying values for each class of asset.

• Accumulated depreciation and amortization.

• Title restrictions and assets are pledged as collateral.
• For impaired assets, the loss amount and the circumstances that caused the loss.
• For revalued assets (IFRS only), the revaluation date, how fair value was
determined, and the carrying value using the historical cost model.

INCOME TAXES
Tax Terminologies Financial Reporting Tax Reporting
EBT Accounting Profit Taxable Income
(-) Tax Income Tax Expense Income Taxes Payable
Balance Sheet Value of Asset Carrying Value Tax Base
DTL vs DTA:
DTA is created DTL is created
Is created Tax base of an asset > Carrying Tax base of an asset < Carrying value
when value
Or when Tax base of a liability < Carrying Tax base of liability > Carrying value
value
Or when Taxes payable > Income tax Taxes payable < Income tax expense
expense
Occurs Revenues are taxable before Revenues are recognized in income
when recognizing in Income statement. statement before included in tax return.
Expenses are recognized in income Expenses are tax deductible before
statement before being tax recognized in the income statement.
deductible.
• DTLs and DTAs are presented on the balance sheet separately, not netted.
• Deferred Tax Asset/liability is due to a temporary difference & it is therefore
expected to be reversed in future.
• IFRS: DTL and DTA are always non-current assets/liabilities.
• US GAAP: DTL and DTA can be current or non-current depending on reversal.
Tax loss carry forward (DTA):

• They are available to reduce the future taxable income.
• Subject to tax rules, tax losses of prior years’ might be used to reduce taxable
income in later years, resulting in differences in accounting and taxable income.
Current vs Deferred Tax

Current Tax Asset Deferred Tax Asset
Co-Expects to receive a refund for some Taxes that have already been paid but
portion of previously paid as Taxes, the not yet recognized in the is Income
statement is called DTA

amount recoverable, is called Current Tax

Asset
Current Tax Liability Deferred Tax Liability
Amount to be paid in taxes based on Taxes not paid but reflected in the
current taxable income financial account
Permanent Difference:
It is Difference in amount Tax base (TR) & carrying value (FR) of asset & liability that will
not be reversed in the future. Therefore, NO DTA/DTL is recognized. Typically Includes :
• Income/expense items not allowed by tax legislation.
• Penalty, etc.
• Tax credit received for some expenditures like interest received on exempted
bonds.
!"#$%& ()* &*+&",&
Result: Effective tax rate ≠ statutory tax rate. Effective tax rate = -.&*()* 0"#$%&
Changes in Tax rates:

• The measurement of DTA or DTL is based on the current tax rate.
• But if the tax law or rates change then, DTA or DTL must be adjusted to reflect this
change.
• Along with the carrying value of DTA or DTL, it also affects the income tax expense
in the year of change.
Income tax expense Income Tax payable + △ #$% − △ #$(
Effect of a change in Tax rate:

If tax rate ↑ DTA ↑ Benefit ↑ Income tax expense ↓
DTL ↑ Loss ↑ Income tax expense ↑
If tax rate ↓ DTA ↓ Benefit ↓ Income tax expense ↑
DTL ↓ Loss ↓ Income tax expense ↓
The net effect depends on the relative sizes of DTL and DTA:
1&2 ()* .)(&
New DTA/DTL = Old DTA/DTL x
345 ()* .)(&
Unused tax losses and tax credits: This leads to the creation of DTA, provided there is a
possibility of sufficient profits in future.

IFRS (IAS Allows the recognition of unused tax losses and tax credits only to the
12) extent that it is probable that in the future there will be taxable
income against which the unused tax losses and credits can be applied
US GAAP •A deferred tax asset is recognized in full but is then reduced by a
valuation allowance if it is more likely (50% or more probability)
that not some or all of the deferred tax asset will not be realized.
• However, If there are concerns regarding the company's profitability
then DTA may not be recognized until realized.
• The Higher the history of Tax loss, the greater the concern
regarding company's ability to generate future taxable profit.
Valuation Allowance:
Reserve against deferred tax assets that may not reverse in the future.
Recognition of a Valuation Allowance

• DTAs must be assessed at each balance sheet date.
• If there is any doubt, then the carrying amount should be reduced to the expected
recoverable amount.
• Under U.S. GAAP, DTA is reduced by creating a valuation allowance.
• Should circumstances change, the reduction in DTA may be reversed.
• The overall process involves subjective judgement and hence an analyst should be
careful of such changes if any.
Effects of Valuation allowance Effect of reversal
DTA ↓ DTA ↑
Income tax expense ↑ Income tax expense ↓
and Income ↓ and Income ↑
Recognition of Current and Deferred Tax Charged Directly to Equity :

Whenever it is determined that DTL will not be reversed, DTL will be reduced and should
be taken directly to equity.
Required Deferred Taxes Disclosures:

• Deferred tax liabilities/assets, any valuation allowance, and net change in the
valuation allowance.
• Unrecognized deferred tax liability for undistributed earnings of subsidiaries and
joint ventures.
• Current-year tax effect of each type of temporary difference.
• Components of income tax expense.
• Tax loss carry-forwards and credits.
• Reconciliation of difference between income tax expense as a % of pre-tax and
statutory tax rate.

Analyst Treatment of Deferred Tax Liabilities

• When differences are expected to reverse and result in future tax payments, treat
DTL as debt in calculating leverage ratios.
• When differences are not expected to reverse and result in no future tax payments,
treat DTL as equity in calculating leverage ratios.

LONG TERM LIABILITIES

Calculation of Interest Expense:
Interest Carrying value of the bond at the beginning × Market rate of interest (YTM)
expense
Interest Interest payment (coupon) + Amortization of Discount (-) Amortization of
expense Premium
Impact on Financial statement at issuance:

Balance sheet Asset & Liability both increases Asset increases due to cash
by the amount of issue inflow. Liability increases due
to future cash outflow.
Par Value bond Book value = Face value Will same over the time
Premium bond Book value > Face value Will decrease over time
Discount bond (ZCB) Book value < Face value Will increase over time
Income statement Interest expense is recorded Amortization
over the life of the Bond
Par Value bond Interest expense = Coupon No Amortization
Premium bond Interest expense < Coupon Amortization of Premium
Discount bond (ZCB) Interest expense > Coupon Amortization of Discount
Amortization = Difference between Interest expense & Coupon
Cash Flow Statement:

Issue amount CFF Inflow
Coupon CFO (US GAAP) & CFO or CFF (IFRS)
Repayment amount CFF Outflow
Amortization No effect
There are two methods to account for the Amortization of Discount or premium:
i. Effective interest rate method (required in IFRS and Preferred under US GAAP)
ii. Straight line method.
Effective interest rate method:

When bonds are issued at -

Discount YTM > Coupon Interest expense > Discount is ADDED to the
Interest payment bond liability every year
Premium YTM < Coupon Interest expense < Premium is SUBTRACTED
Interest payment from the bond liability every
year
Straight Line method:

Equally Amortizing the premium/discount of the bond over the life of the bond much like
the SLM Depreciation method.
Fair Value reporting:

• The book value of a bond liability is based on its market yield at issuance.
• So, as long as the bond’s yield does not change, the bond liability represents fair
(market) value.
• However, if the yield changes, the balance sheet liability is no longer equal to fair
value, i.e., Book Value ≠ Fair Value
The fair value reporting of bonds is acceptable under both IFRS and US GAAP but is
irrevocable. IFRS and US GAAP require fair value disclosure in the financial statement
unless: Fair value = Book value or Fair value cannot be reliably measured.
If yields Fair Value Value of liability Income statement
Increase Decrease Decrease Gain is reported
Decrease Increase Increase Loss is reported
Changes in Fair Value:

• Changes in fair value can result from changes in Market rates or due to changes in
credit quality.
• Accounting standards require companies to present changes in Fair value due to
market rates and credit quality separately.
Changes in Market rate Reported in Income statement
Changed in credit quality Reported in OCI
When Companies redeem the bond on Maturity:

Income no gain or loss is recognized by the issuer and at maturity, any original
Statement discount or premium has been fully amortized;
Balance Sheet The book value of a bond liability and its face value are the same

Cash Flow The cash outflow to repay a bond is reported as CFF
However, when Companies redeem the bond before Maturity they can do so either by:
• Calling it back or
• Purchasing from open markets
Carrying amount = Cash paid to redeem the bond (+) gain on redemption or (-) loss on
redemption
The financial impact of Derecognition:

Income Gain or loss on redemption is recognized and any unamortized cost is
Statement written off and included in the gain loss calculation.
Balance Sheet Liability account reduced by the carrying amount of the redeemed
bond.
Cash Flow CFO: adjust gain/loss on redemption while doing indirect method.
CFF: cash paid for redemption is cash outflow from financing.
Debt issuance cost (floating cost):

• Includes legal & accounting fees, printing costs, sales commissions, underwriting fees, etc.
• Under IFRS and U.S. GAAP, the initial bond liability on the balance sheet (the proceeds
from issuing the bond) is reduced by the amount of issuance costs, increasing the bond’s
effective interest rate.
• Issuance costs are treated as an unamortized discount.
Effect on Treatment
Balance sheet Netted against bond proceeds: Bond Liability (-) Issue cost
Income statement Treated as Unamortized discount - Increase effective interest rate.
Cash flow Reported as CFF (Outflow)
Debt issuance cost:

IFRS US GAAP
Included in the carrying Accounted separately from bonds payable and is amortized
amount yearly
After derecognition no After derecognition, unamortized issuance cost must be written
adjustment is required off in the income statement
Disclosure:

The firm separately discloses more detail about its long-term debt in the footnotes:
• The nature of the liabilities.
• Maturity dates.
• Stated and effective interest rates.
• Call provisions and conversion privileges.
• Restrictions imposed by creditors.
• Assets pledged as security.
• The amount of debt maturing in each of the next five years.
Leasing
A Lease is a form of financing that enables the lessees to Finance the purchase or the use
of a leased asset.
Leasing is better than purchasing the Asset due to following reasons:

• Less costly financing and No Down payment.
• Fewer restrictions compared to Borrowing.
• No risk of obsolesce, residual valve or disposition of Asset.
Criteria for classification as Finance Lease (similar under IFRS and US GAAP):
Transfer of ownership of Asset to lessee IFRS & US GAAP
by the end of lease term
Includes a bargain purchase option at IFRS & US GAAP
substantially low value
Lease term IFRS : major term of economic life
US GAAP : 75% or more of useful life
At Inception the present value of lease IFRS : substantial
payments is US GAAP : 90% or more
Financial reporting of leases:

Reporting from the Lessee's perspective:
Type Balance Sheet Income statement Cash flow
statement
IFRS Finance and Asset = Right of Use Amortization on Reduction of lease
Operating lease and (ROU) as asset = PV of Right of use (ROU) liability
US lease payments asset = SLM (repayment of
GAAP Finance leases: lease) is CFF
Liability = Lease I/S = Interest outflow.
liability expense on lease

(Asset and Liability Equity = Unchanged liability + Interest portion of

differ over time but at Amortization lease payment:
the end becomes Zero) CFF or CFO (IFRS)
CFO (US GAAP)
US GAAP Operating Asset = Right of Use Amortization on Reduction of lease
leases (ROU) as asset = PV of Right of use (ROU) liability
lease payments asset = by the (repayment of
amount of lease) is CFF
Liability = Lease decrease in outflow.
liability liability each
period Interest portion of
Equity = Unchanged lease payment:
I/S = Interest CFF or CFO (IFRS)
expense on lease CFO (US GAAP)
liability +
Amortization
Exceptions: short- term No effect Report rent Rent payment is
leases and, under IFRS, expense CFO Outflow
leases where leased
asset is low value
Reporting from the Lessor's perspective:

Type Balance Sheet Income statement Cash flow
statement
Finance lease (USGAAP & Derecognize: Over life of lease: Interest and
IFRS) Leased asset Principle portion
Revenue = Interest of lease
Recognize: portion of lease payment:
Lease payments CFO (if primary
receivable = PV business) or CFI
of Lease COGS = Net book inflow
Payments value of leased asset
P/L = Lease receivable

– Book Value of Asset
Operating lease (IFRS & No effect: Over life of lease: Entire lease
US GAAP) Leased asset received is CFO
inflow

Remains on the Revenue = lease

Balance sheet payment
Expense =
Depreciation and other
lease costs
Pension :
A pension is a form of deferred compensation earned over time through employee service.
The most common pension arrangements are:

Defined contribution plan Defined benefit plan
Meaning retirement plan in which the firm Retirement plan in which
contributes a sum each period to the the firm promises to make
employee’s retirement account periodic payments to employees
after retirement
Contribution contribution can be based on any benefit is usually based on the
or benefit is number of factors, including years of employee’s years of service and
based on service, the employee’s age, the employee’s compensation at,
compensation, profitability, or even a or near, retirement
percentage of the employee’s
contribution
Investment the employee assumes all the the employer assumes the
risk investment risk investment risk
Financial Income statement: Income statement:
reporting Pension expense = employer’s change in the net pension asset
contribution or liability.
Balance sheet = No future obligation Balance sheet:
Asset - If overfunded or
Liability - if underfunded
For defined benefit plan:

Overfunded plan fair value of the plan’s assets > the estimated pension obligation
Underfunded plan fair value of the plan’s assets < the estimated pension obligation

FINANCIAL REPORTING QUALITY

Financial Reporting Quality vs Earning Quality
Part A: Financial reporting quality
• It refers to the characteristics of a firm’s financial statements like adherence to
generally accepted accounting principles (GAAP) in the jurisdiction in which the firm
operates.
• However, compliance with GAAP by itself does not necessarily result in financial
reporting of the highest quality due to the variety of estimates, and specific
treatment of many items.
Two characteristics of decision-useful financial reporting are:

1. Relevance - information presented must be material in knowledge and must be
useful in making decisions.
2. Faithful representation - reports should have qualities of completeness, neutrality,
and the absence of errors.
Part B: Earnings Quality

• The most important quality is the sustainability of the earnings - earnings that can
be expected to continue in the future.
• High-quality earnings are expected to add more value to a company than low-
quality earnings.
Describe a spectrum for assessing financial reporting quality:

A possible categorization of the quality levels of financial reports, from best to worst:
Scenario/Rank Financial Reporting Quality Earnings Quality Choices and Estimates
1 Compliant Sustainable Unbiased
2 Compliant Low Unbiased
3 Compliant Low Biased
4 Compliant Managed Biased
5 Non-Compliant Actual numbers Biased
6 Non-Compliant Fictitious Biased
Aggressive vs Conservative Accounting

Criteria Conservative accounting Aggressive accounting

Tendency to Decrease the company’s reported Increase the company’s reported

earnings and financial position (on earnings and financial position (on
the balance sheet) for the current the balance sheet) for the current
period period
Results in Increased earnings in future periods Decreased earnings in future
periods
Adjustments Upwards of Accrued liabilities, Recognizing revenues early,
reduce the reported earnings, lowering estimates of bad debts,
higher depreciation lower depreciation, deferring R&D
expenses
Note: Accounting standards have inbuilt conservatism.
Examples of Bias in the Application of Accounting Standards:

"Big bath" restructuring charges:
• Both US GAAP and IFRS provide for the accrual of future costs associated with
restructurings.
• But in some instances, companies use the accounting provisions to estimate “big”
losses in the current period so that performance in future periods will appear
better.
"Cookie jar" reserve accounting
• Both US GAAP and IFRS require accruals of estimates of future non-payment of
loans.
Three factors that typically exist in cases where management provides low-quality
financial reporting are motivation, opportunity, and a rationalization of the behavior.
Motivation Career, Stock Performance linked Compensation, Seeking Market
confidence, Avoiding Debt Covenants.
Opportunity Weak internal controls, Inadequate board of directors’ oversight,
Loopholes in Applicable accounting standards, inconsequential
penalties in the case of accounting fraud.
Rationalization This includes rationalization by management for less-than-ethical
of behavior actions. Whereby they try to justify breaking the rules.
Requirements to comply with Securities regulations typically include:

• Registration
• Disclosure
• Audit
• Management assessment of the effectiveness of the firm’s internal controls (USA)
• POI signed statement.

• Review process registration
Non-Compliance with Securities regulations may lead to:

• Enforcement actions like fines, suspension, and public disclosure of the results of
disciplinary proceedings.
• Regulators may also pursue criminal prosecution of fraudulent or otherwise illegal
activities.
Limitation of Audit reports:

• The auditor is selected and paid by the firm being audited.
• It is based on a review of information given by the company.
• Based on Sampling.
• An unqualified or “clean” audit opinion is not a guarantee that no fraud has
occurred but only offers reasonable assurance that the financial reports have been
“fairly reported” with respect to the applicable GAAP .
The solution to the Problem - Private Contracting:

• The counterparties to private contracts with the firm have an incentive to see that
the firm produces high-quality financial reports.
• Private contracts with lenders - often specify strict measures in the loan covenants.
Detecting Financial reporting qualities:

• Recognizing revenue too early.
• Using Non-recurring transactions to increase profits.
• Deferring expenses.
• Measuring and reporting Assets high and liabilities low.
Presentation Choices that Influence Analyst's Opinion:

Various reasons given by management for non-GAAP measures whereby Items are
excluded include:
• They are one-time or nonoperating costs that will not affect operating earnings
going forward.
• They are non-cash charges.
• Excluded to improve comparability with companies.
In the United States, companies that report non-GAAP measures in their financial
statements are required to:
• Display the most comparable GAAP measure with equal prominence.
• Provide an explanation by management as to why the non-GAAP measure is
thought to be useful.
• Reconcile the differences between the non-GAAP measure and the most
comparable GAAP measure.
• Disclose other purposes for which the firm uses the non-GAAP measure.

• Include, in any non-GAAP measure, any items that are likely to recur in the future,
even those treated as nonrecurring, unusual, or infrequent in the financial statements.
IFRS require that firms using non-IFRS measures in financial reports must:
• Define and explain the relevance of such non-IFRS measures.
• Reconcile the differences between the non-IFRS measure and the most comparable
IFRS measure.
Overall, the supposition is that firms use non-GAAP measures to control the metrics on
which they are evaluated and to reduce the focus of analysts and investors on GAAP
measures.
Methods used to manage financial reporting:

Effect of Accounting Choices on Earnings and Balance Sheet:
• Change in shipping terms to FOB shipping point from FOB destination to recognize
revenue early.
• Inventory cost flow assumptions like FIFO, LIFO etc.
• Estimate of recoverability of accounts receivables which can be managed,
• DTA and valuation allowance.
• Choice of depreciation methods.
• Amortization and Impairment of assets.
• Capitalization and expensing of cost at acquisition.
Effect of Accounting Choices on Cash Flow Statement:

• Stretching accounts payable credit period to show artificially stronger cash flow
• Financing accounts payables by using third-party financial institutions to pay
vendors.
Below is a list of several warning signs that analysts should look for:
Revenue • Changes in revenue recognition methods.
Recognition • Use of bill-and-hold transactions.
• Use of barter transactions.
• Use of rebate programs that require estimation of the impact of
rebates on net revenue.
• Lack of transparency with regard to how the various
components of a customer order are recorded as revenue.
• Revenue growth out of line with peer companies.
• Receivables turnover is decreasing over multiple periods.
• Decreases in total asset turnover, especially when a company is
growing through acquisition of other companies.
• Inclusion of nonoperating items or significant one-time sales in
revenue.

Inventories • Declining inventory turnover ratio.

• LIFO liquidations
Capitalization • Firm capitalizes costs that are not typically capitalized by firms
Policies in their industry.
Relationship of • The ratio of operating cash flow to net income is persistently
Revenue and less than one or declining over time.
Cash Flow
Other Warning • Depreciation methods, estimated asset lives, or estimates of
Signs salvage values are out of line with those of peer companies in
the industry.
• Fourth-quarter earnings show a pattern (either high or low)
compared to the seasonality of earnings in the industry or
seasonality of revenue for the firm.
• The firm has significant transactions with related parties
(entities controlled by management).
• Certain expenses are classified as nonrecurring but appear
regularly in financial reports.
• Gross or operating profit margins are noticeably higher than
are typical for the industry and peer companies.
• Management typically provides only minimal financial
reporting information and disclosure.
• Management typically emphasizes non-GAAP earnings
measures and uses special or nonrecurring designations
aggressively for charges.
• Growth by purchasing a large number of businesses can
provide many opportunities to manipulate asset values and
future depreciation and amortization and make comparisons to
prior period earnings problematic.
Analyst Perception:
• Analysts should consider adjusting prior-period earnings when large restructuring or
impairment charges are recognized.
• Recognizing impairment (correction) is also considered by Analysts sometimes as
good news because they anticipate future performance especially when poorly
performing assets are disposed of.
• Also, by spreading these costs across prior periods and restating prior earnings
gives a more realistic picture of true earnings trends.

APPLICATIONS OF FINANCIAL STATEMENT ANALYSIS

Evaluating the Company’s past performance and business strategy
Past Performance can be analyzed using:

• Ratio Analysis - whereby we assess a company’s profitability, leverage, solvency,
and operational efficiency.
• Trend Analysis - evaluate trends in ratios, as well as their levels.
• Peer Group Analysis - evaluate the competitors or industry averages.
Conclusion:
• Both cross-sectional and trend analysis can provide information for evaluating the
quality and performance of a company’s management.
• The results of an analysis of past performance provide a basis for reaching
conclusions and making recommendations.
Forecasting a company’s future net income and cash flow

The main objective behind Forecasting a company’s future net income and cash flow, is to
determine the value of a company or its equity component
Part A: To estimate future Net Income:

Analysts often take a top-down approach to projecting a company’s sales:
• Projected Sales based on their historical relationship with some macroeconomic
indicators, such as GDP, etc.
• Project the subject company’s market share.
• Estimate and calculate the company’s sales as:
Co's projected market share x projected total industry sales.
• Now, the analyst can choose among various methods for forecasting income & cash flow.
Part B: To estimate future Cash flows:

• Make assumptions about future sources and uses of cash
• Estimate changes in working capital, capital expenditures on new fixed assets,
issuance or repayments of debt, and issuance or repurchase of stock.
• Assume items like noncash working capital and interest expense remain constant.
Part C: Projecting Multiple-Period Performance (the purpose)

• They are needed in valuation models that estimate the value of a company or its
equity by discounting future cash flows.
• This value is then compared with its current market price as a basis for investment
decisions.
• Projections of future performance are also used for credit analysis as they help in
assessing a borrower’s ability to repay interest and principal of debt obligations.

Credit Quality:
The role of financial statement analysis in assessing the credit quality of a potential
debt investment: The 3 Cs used in credit analysis are like the gold standards:
Character professional reputation and the history of debt repayment
Collateral The ability to pledge specific collateral reduces lender risk
Capacity The ability (financial strength) to repay the obligation
Screening for potential equity investments:

• Screening is the application of a set of criteria to reduce a set of potential
investments to a smaller set having certain desired characteristics.
• A security selection approach incorporating financial ratios may be applied whether
the investor uses top-down analysis or bottom-up analysis.
• Screens can be used by: Growth investors, Value investors or Market-oriented
investors (those who cannot be clearly categorized as value or growth)
Analyst adjustments to a company’s financial statements for appropriate comparison:

• An analyst must be prepared to adjust the financial statements of one company to
make them comparable to those of another company or group of companies.
• Differences between U.S. GAAP and IFRS require an analyst to conduct several
adjustments to improve the comparability of firms’ financial statements and ratios.

CFA Level 1 – Quick Notes by KRD - ECO
DEMAND & SUPPLY ANALYSIS
DEMAND ANALYSIS: THE CONSUMER

Economics is the study of production, distribution, and consumption.
Macroeconomics Deals with aggregate economic quantities, such as national
output and national income
Microeconomics Deals with decision making by individual entities such as consumers
and businesses
Demand Analysis: The Consumer

Demand Quantity of a good/service consumers are willing and able to purchase at
a given price
Law of In general, as the price of good rises, consumers demand less of it
Demand
Demand Function: Captures buyer behavior.

Qdx = f (Px, I, Py),
Where
Qdx = the quantity demanded of some good X
Px = the Price per unit of good X (Own Price),
I = Income Level of Consumers,
Py = Price of another good Y (it can be a Substitute or Complementary product to X)
Demand curve (Graph of Inverse Demand Function): Price is expressed as a function of

∆"
quantity demanded. Slope of demand curve = ∆#
Elasticity
Measure of the responsiveness of the quantity demanded to a change in own price,
income, price of other goods.
Price Elasticity %"# "#/#' %' "# Always Negative
= = ×
%"% "%/%' (' "%
Income %"# "#/#' )' "# Normal Goods = Positive
Elasticity = = × Inferior Goods = Negative
%") ")/)' (' ")

Cross Price %"#* "#*/#*' %+' "#* Substitute = Positive

Elasticity = = × Complimentary = Negative
%"%+ "%+/%+' (,' "%+
Elasticity Interpretation Impact on Total

Expenditure
Infinite Demand is perfectly elastic, represented A small increase in price leads
by horizontal demand curve to demand becoming zero
Zero Demand is perfectly inelastic represented Demand does not change no
by vertical demand curve matter what the price is charged
>1 Demand is elastic i.e., more sensitive to Increase in price reduces total
changes in price expenditure
<1 Demand is inelastic i.e., less sensitive to Increase in price increases total
changes in price expenditure
=1 Demand is unitary elastic i.e., % change in Change in price does not change
quantity demanded is same as % change in total expenditure
price
Factors affecting elasticity:

Availability of When one or more goods are very good substitutes (few of no
substitutes good) for the good in question, demand will tend to be very elastic
(inelastic)
Portion of budget The larger the proportion of income spent on a good, the more
spent on the good elastic an individual’s demand for that good.
Response time for Elasticity of demand tends to be greater the longer the time period
change in price since the price change.
Necessities or For necessities (salt) the demand will be highly inelastic while
Luxuries very elastic for luxuries (Cars)
Calculating Elasticity
∆$
Slope of Demand Function = ∆%
The term is the slope of a demand function that (for a linear demand function) takes the
form: quantity demanded = A + B × price where B is the slope of the line
Substitution and Income Effects

Substitution When a good becomes cheaper more of it gets substituted for other
Effect goods

Income Effect When price of a good declines, real income goes up because more can
be bought with the same income
Based on this analysis, there can be 3 outcomes of a decrease in the price of good X:
Substitution effect Income effect Consumption of Good X
Positive Positive Increase
Positive Negative but smaller than the Increase
substitution effect
Positive Negative and larger than the Decrease
substitution effect
Exceptions to Law of Demand: Giffen goods and Veblen Goods

Giffen Giffen goods have larger and negative income effect which makes total effect
Goods negative. At lower prices, a smaller quantity would be demanded as a result
of the dominance of the income effect over the substitution effect. Example:
Rice to Meat.
Veblen High priced or high-status goods, the consumers may buy to derive utility.
goods Such goods have a positively sloped demand curve for some individuals over
some range of prices. It is argued that by increasing the price of a Veblen good,
the consumer would be more inclined to purchase it, not less. Example: GUCCI,
PRADA
Note: Both Giffen and Veblen have Upward sloping demand curve
SUPPLY ANALYSIS: THE FIRM

Factors of production - are the resources a firm uses to generate output and include:
Land Place where the business facilities are located
Labor Includes all workers from unskilled laborers to top management
Capital Sometimes called physical capital or plant and equipment to distinguish it
from financial capital. Refers to manufacturing facilities, equipment, and
machinery
Materials Refers to inputs into the productive process, including raw materials, such as
iron ore or water, or manufactured inputs, such as wire or microprocessors
Production Function:
• For economic analysis, we often consider only two inputs, Capital, and Labor
• The quantity of output that a firm can produce can be thought of as a function of the
amounts of capital and labor employed. Such a function is called a production
function.

Terms Calculation
Total Sum of the output from all inputs during a time period; usually illustrated as
product the Total output (Q) using Labor quantity (L)
Average Total product divided by the Quantity of a given input; measured as total
product product divided by the number of worker hours used at that output level
(Q/L)
Marginal The amount of additional output resulting from using one more unit of
product input assuming other inputs are fixed; measured by taking the difference in
total product and dividing by the change in the quantity of labor ∆&⁄∆'
Diminishing Marginal returns

• Increasing Marginal Productivity
• Diminishing Marginal Productivity
Breakeven and Shutdown Analysis

Short run: Some factors of production are fixed.
Long run: All factors of production (costs) are variable.
Accounting Profit Total revenue – Total accounting costs
Economic Profit Total revenue – Total economic costs
Economic costs Includes Opportunity costs
Total revenue TR = (P*Q), is the same from both an accounting and an economic
standpoint
Market Structures Perfect Competition Imperfect Competition

Firms Price Takers because no control Price searchers as Some control
over price over price
Shape of demand Horizontal Downward sloping
curve
Shutdown and Breakeven Under Perfect Competition:

Under perfect competition, Price = marginal revenue = average revenue
AR < AVC in The firm should shut down and also called as short run shut down point
the short run
AR < ATC in The firm should shut down and called as Long-run shut down point
the long run
AR = ATC TR = Total economic cost and called as Break-even point

AR ≥ ATC the firm should stay in the market in both the short and long run
AR ≥ AVC, but the firm should stay in the market in the short run but will exit the market
AR < ATC in the long run
Short Run and Long Run Decisions to Operate or Not

Revenue–Cost Relationship Short-Run Decision Long-Term Decision
TR = TC Stay in the Market Stay in the Market
TR > TVC but < TC Stay in the Market Exit the Market
TR < TVC Shut Down the Production Exit the Market
Marginal Revenue, Marginal Cost and Profit Maximization

Average Total Cost (ATC) Average Variable Cost (AVC) Average Fixed Cost (AFC)
ATC = TC/Q AVC = TVC/Q AFC=TFC/Q
Or AFC + AVC
Initially declines, reaches Initially declines, reaches at a When output increases,

at a minimum and minimum and then increases AFC falls
then increases.
The difference between

ATC and AVC at any
output quantity is the AFC
Marginal Revenue and Marginal Cost

The marginal cost of production and marginal revenue are economic measures used to
determine the amount of output and the price per unit of a product that will maximize
profits.
Marginal Revenue
• MR =ΔTR /ΔQ
• MR represents the change in revenue for every additional unit sold.
• MR curve differs under Perfect Competition and under Monopoly and is affected by
the same factors as demand curve.
Marginal Cost
• MC =ΔTC /ΔQ OR ΔTVC /ΔQ
• MC represents the cost of producing an additional unit.
• MC curve intersects both the ATC and AVC at their respective minimum points.

Economies of Scale and Diseconomies of Scale

The long-run average total cost (LRATC) curve
• The LRATC curve is drawn for many different plant sizes or scales of operation.
• Each point along the curve represents the minimum ATC for a given plant size or scale
of operations.
• LRATC curve is U-shaped.
• ATC first decrease with larger scale and eventually increase.
• The lowest point on the LRATC corresponds to the scale or plant size at which the
ATC of production is at a minimum - called the minimum efficient scale.
Economies of The downward-sloping segment of the LRATC indicates that

Scale economies of scale (or increasing returns to scale) are present
Economies of scale result from factors such as labor specialization,
mass production, and investment in more efficient equipment and
technology.
Diseconomies of The upward-sloping segment of the LRATC curve indicates that
Scale diseconomies of scale are present.
Diseconomies of scale may result as the increasing bureaucracy of
larger firms leads to inefficiency, problems with motivating a larger
workforce, and greater barriers to innovation and entrepreneurial
activity
Constant returns There may be a relatively flat portion at the bottom of the LRATC
to scale curve that exhibits constant returns to scale. Over a range of
constant returns to scale, costs are constant for the various plant sizes

The Firm And Market Structure

Factors that determine the type of market structure are as follows:
1. The number and relative size of firms supplying the product.
2. The degree of product differentiation
3. The power of the seller over pricing decisions
4. The relative strength of the barriers to market entry and exit
5. The degree of non-price competition
Factors Perfect Monopolistic Oligopoly Monopoly

Competition Competition
Number of Many Firms Many Firms Few Firms Single Firm
Sellers
Nature of Identical Products are slightly Almost identical No substitutes
Products products differentiated but available
sometimes,
differentiated
Barriers to Very low Low High Very High
Entry
Demand Horizontal, Downward Downward sloping. Downward
Curves i.e. Sloping, but the Elasticity can be sloping
the demand is demand is more or less than
perfectly elastic firms in
elastic Monopolistic
competition
Nature of Price Only Price, marketing Price, marketing Advertising
Competition features features
Pricing None. Some Some to Significant. Significant.
Power
Firms are Companies set Firms can choose
“Price Takers” their own prices. the price, making
them “Price
Make abnormal Makers.”
profits in the long
run Objective is
to maximize
profits
Examples Wheat Industry Toothpaste Industry Automobile, Airline, Power Distribution
Oil Industry

Why MC = MR??
Marginal Revenue and Marginal Cost
• The company maximizes its profit at a point where MR = MC
• When MR < MC of production, a company is producing too much and should decrease
its quantity supplied until MR = MC of production
• When, on the other hand, the MR > MC, the company is not producing enough
goods and should increase its output until profit is maximized.
Perfect Competition
Price = Marginal Revenue (MR) = Average Revenue (AR)
A profit maximizing firm will produce the quantity, Q*, when MC = MR
Equilibrium in a Perfectly Competitive Market:

• In a perfectly competitive market, firms will not earn Economic Profits for any
significant period of time as new firms will enter the industry to earn economic profits,
increasing market supply and eventually reducing market price. Hence, Price = ATC
• In equilibrium, each firm is producing the quantity for which P = MR = MC = ATC,
hence, no firm earns economic profits and each firm is producing the quantity for which
ATC is a minimum (the quantity for which ATC = MC)
Short run supply curve

Firm level: Each firm will produce a quantity as long as P > AVC and will be along
the MC.
Long-Run Adjustment to an Increase in Demand Under Perfect Competition:

• A firm’s long-run adjustment may be either to alter the size of its plant or leave the
market entirely.
• Various firms have increased their plant sizes to increase output in response
to increasing market demand while firms, such as Ford and GM, have decreased plant
size to reduce economic losses referred to as downsizing.
Permanent Change in Demand:

• It leads to the entry of firms to, or exit of firms from, an Industry.
• Each firm earns a normal profit, and economic profit is zero i.e., MC = MR = P, and
ATC is at its minimum
• Now, if industry demand permanently increases causing the industry demand
curve to shift towards right, at the new Market Price and industry output and At the
new price, firms realize an economic profit because Price > ATC.
• Positive economic profits will cause new firms to enter the market and increase total
industry supply and the market price will decline back to P0 where the industry will
now produces more but with an increased number of firms in the industry, each firm

produces output at the original quantity, Q0 and the individual firms no

longer enjoy an economic profit as ATC = P0 at Q0
Monopolistic Competition
Monopolistic competition has the following market characteristics:
• Large number of independent sellers
• Selling close substitute products that are differentiated through quality and features.
• Firms compete on price, quality and marketing.
• Their demand curves are highly elastic because competing products are perceived by
consumers as close substitutes.
Short-Run and Long-Run Output Under Monopolistic Competition:
Short Run Output:

• Firms in monopolistic competition maximize economic profits by producing where
MR=MC and by charging the Price for that quantity from the demand curve, D
• Here the firm earns positive economic profits because price, P*, exceeds ATC
• Due to low barriers to entry, competitors will enter the market in pursuit of these
economic profits.
Long Run Output:

• The entry of new firms shifts the demand curve faced by each individual firm down to
the point where P* = ATC*, such that economic profit is zero
• At this point, there is no longer an incentive for new firms to enter the market, and
long-run equilibrium is established.
• The firm here continue to produce at the quantity where MR = MC but no longer earns
positive economic profits
Comparison with Perfect Competition

Perfect Competition Monopolistic Competition
P = MC (No product differentiation) P > MC
This reflects a markup in pricing due to
differentiation
Price is slightly higher as compared to perfect
competition
ATC is minimum ATC is not minimum (excess capacity)

Common Strategies by Firms in Monopolistic Competition:

Advertising This informs the consumers about the key features of firm’s products and
to distinguish their products from other products.
Advertising expenses are high and result in increase in ATC curve for the
firm. As output increases, the proportion of advertising expenses decrease in
the ATC cost curve
Product This is an important activity as innovative products result in less-elastic
Innovation demand curves for firm’s products.
Product innovation increases firm’s costs, and the firm must weigh the extra
cost with the additional revenues that it generates.
Brand A brand name associated with a product result in higher sales.
Names Firms spend a high portion of their advertising budget in building a brand
image.
Oligopoly
• An oligopoly market has higher barriers to entry and fewer firms.
• The firms are interdependent.
There are four models on Oligopoly:

1. Kinked demand curve model
2. Cournot duopoly model
3. Nash equilibrium model (prisoner’s dilemma)
4. Stackelberg dominant firm model
Kinked Demand Curve Model

This Model assumes that:

• An increase in a firm’s product price will not be followed by its competitors, but a
decrease in price will be followed by competitors.
• Each firm believes that it faces a demand curve that is more elastic (flatter) above
a given price (the kink in the demand curve) than it is below the given price
• The kink price is at price PK, where a firm produces QK. A firm believes that if it
raises its price above PK, its competitors will remain at PK, and it will lose market
share because it has the highest price.
• Above PK, the demand curve is considered to be relatively elastic, where a small
price increase will result in a large decrease in demand.
Shortcomings of the Model:

It is incomplete because what determines the market price (where the kink is located)
is outside the scope of the model.
Cournot Duopoly Model

In the Cournot assumption, each firm determines its profit- maximizing production
level by assuming that the other firms’ output will not change.
Assumptions:
• Only two firm’s competition
• Both firms have same and constant marginal costs of production
• Each firm knows the quantity supplied by the other firm and can predict their quantity
supplied in the next period.
Analysis:
• By knowing the quantity supplied of other firm, the firm can subtract this
quantity from market demand curve and arrive at their own demand curve, MC
curve and determine profit maximizing quantity.
• A long-run equilibrium is reached when both firm selects the same quantity and there
is no scope to earn economic profit by changing quantity.

• The resultant price is less than the profit maximizing price of Monopolist firm but
higher than the marginal cost (MC) of firm in perfect competition.
• As number of firms increase in the market, the market equilibrium price
falls towards marginal cost, limiting the firms from further entry.
Nash Equilibrium
• Nash equilibrium considers interdependent actions by oligopoly firms.
• No collusion is expected.
• Each firm tries to do the best, considering the actions of their rivals leading to
equilibrium.
An example of the Nash equilibrium is explained below:

• Honoring implies charging higher price, whereas.
• Cheating implies charging lower price.
Prisoners Dilemma (Game):

Two prisoners, A and B, are believed to have committed a serious crime. However, the
prosecutor does not feel that the police have sufficient evidence for a conviction. The
prisoners are separated and offered the following deal:
Prisoner B is silent Prisoner B confesses
Prisoner A is silent A gets 6 months. A gets 10 years
B gets 6 months B goes free
Prisoner A confesses A goes free. A gets 2 years.
B gets 10 years B gets 2 years
Confess is the Nash equilibrium since neither prisoner can unilaterally reduce his
sentence by changing to silence.
Case of Nash Equilibrium - Two firm oligopoly game:

• Nash equilibrium is that Firm A and Firm B charge the lower price, and this
is point from where neither firm can change its action to improve profits.
• The greatest value is found when both firms charge high prices and make $300
each. But both firms will be motivated to increase their value from $300 to $400 by
cheating (i.e., charging low prices).
Firm B Honors Firm B Cheats
Firm An Honors Firm A earns $300 Firm A earns $100
Firm B earns $300 Firm B earns $400
Firm A Cheats Firm A earns $400 Firm A earns $200
Firm B earns $100 Firm B earns $200
Collusive Agreements:

If firms can enter into and enforce an agreement to restrict output and charge higher
prices, and share the resulting profits, they are better off. There are, however, laws (anti-
trust laws) against such collusive agreements to restrain competition to protect the interests
of consumers. The OPEC oil cartel is an example of such a collusive agreement,
but evidence is common that cartel members regularly cheat on their agreements to share
the optimal output of oil.
In general, collusive agreements to increase price in an oligopoly market will be more
successful (have less cheating) when:
• There are fewer firms.
• Products are more similar (less differentiated)
• Cost structures are more similar.
• Purchases are relatively small and frequent.
• Retaliation by other firms for cheating is more certain and more severe.
• There is less actual or potential competition from firms outside the cartel.
Dominant Firm Oligopoly/ Stackelberg model

Unlike Cournot model where decision making is assumed to be simultaneous,
in Stackelberg model decisions are assumed to be made sequentially.
• The leader firm makes the output decisions first followed by the weaker firm
• The first mover advantages lie with the leader firm.
• The optimal price and output are where MR = MC
• The price followers follow the leader’s price.
Monopoly
Monopoly Pricing and Strategy
• A monopoly faces a downward-sloping demand curve for its product, so profit
maximization involves a trade-off between price and quantity sold if the firm sells at
the same price to all buyers.
• Assuming a single selling price, a monopoly firm must lower its price in order to sell a
greater quantity.
• The firm must determine (Price Searchers) what price to charge, hoping to find the price
and output combination that will bring the maximum profit to the firm
Two pricing strategies that are possible in Monopoly:

• To maximize profit, monopolists will expand output until MR=MC
• Due to high entry barriers, monopolist profits do not attract new market entrants.
Therefore, long-run positive economic profits can exist.
Important Note:
Monopolists do not charge the highest possible price because monopolists want to
maximize profits, not price.

Therefore, to Maximize Profits, Monopolists use two Pricing Strategies:

Single price When price discrimination isn’t possible, the monopoly
will charge a single price. Example: Fuel or Vaccines
Price If the monopoly’s customers cannot resell the product to each other, the
discrimination monopoly can maximize profits by charging different prices to different
groups of customers. Example: Movie or Airline Tickets
A. Single Price Strategy:

• When MR = MC, it is profiting maximizing quantity/price
• The firms don’t charge the highest price, since their focus is to maximize profits and not
price.
• At this point, P > MR and P > ATC; this implies that monopolist make economic profits.
• The economic profits are sustainable since no other firm can enter into the market.
B. Price Discrimination strategy:

• In this strategy, the firms charge different prices to different customers.
• The goal is to capture additional customer surplus as compared to single price strategy.
Price discrimination will work when:

• Monopolist is facing downward sloping demand curve.
• Monopolist can identify two different set of customers who have different price
elasticities.
• Monopolist can stop customers paying lower prices to resell the product to customers
paying higher prices.
• As long as these conditions are met, firm profits can be increased through price
discrimination.
There are three degrees of price discrimination:

First degree Each consumer is charged the price they are willing to pay
Second degree Prices vary across units but not people
Third degree consumers are segregated into different categories based on
demographics or other traits. Prices are determined by demand of each
group.
Effect of Price Discrimination strategy on Output and Operating Profit:

Assumption: There are no fixed costs and constant variable costs, so that MC = ATC
Perfect Price Discrimination:

• An extreme (and largely theoretical) case of price discrimination is perfect price
discrimination.

• If it were possible for the monopolist to charge each consumer the maximum, they are
willing to pay for each unit, there would be no deadweight loss because a monopolist
would produce the same quantity as under perfect competition
• With perfect price discrimination, there would be no consumer surplus. It would all
be captured by the monopolist.
• The important thing to note here is that when compared to a perfectly competitive
industry, the monopoly firm will produce less total output and charge a higher price.
Natural Monopoly - occurs when:

• When the average cost of production for a single firm is falling throughout the
relevant range of consumer demand, we say that the industry is a natural
monopoly (ex. Utility Co.)
• The entry of another firm into the industry would divide the production between two
firms and result in a higher average cost of production than for a single producer .
• Thus, large economies of scale in an industry present significant barrier to entry
• An unregulated natural monopoly will produce less than optimal quantity, which is why
the government regulates these monopolies to improve allocation of resources by
increasing quantity and reducing price.
How regulators manage monopoly?

• Regulators often attempt to increase competition and efficiency through efforts to
reduce artificial barriers to trade, such as licensing requirements, quotas, and tariffs
• Because monopolists produce less than the optimal quantity (do not achieve efficient
resource allocation), government regulation may be aimed at improving resource
allocation by regulating the prices monopolies may charge.
This may be done through average cost pricing or marginal cost pricing:
Average The method reduces price (equal to ATC), increase output, increase social
Cost Pricing welfare, and ensure monopolist earns normal profit
Marginal This method is referred to as efficient regulation. This produces quantity
Cost Pricing where P = MC, where P < ATC. Monopolists makes economic losses but
the government provides subsidy so that the firm can make normal profit
As previously explained, the supply function can only be determined for perfect
competition. Supply curve is the marginal cost curve above the AVC. There is no well-
defined supply function for monopolistic competition, oligopoly, and Monopoly
Measuring market power or Market concentration

When examining the pricing power of firms in an industry, we would like to be able to
measure elasticity of demand directly, but that is very difficult.
• Regulators often use percentage of market sales (market share) to measure the degree
of monopoly or market power of a firm.

• Often, mergers or acquisitions of companies in the same industry or market are not
permitted by government authorities when they determine the market share of the
combined firms will be too high and, therefore, detrimental to the economy.
• Rather than estimate elasticity of demand, concentration measures for a market or
industry are very often used as an indicator of market power.
N Firm Concentration ratio:

• Is calculated as the sum or the percentage market shares of the largest N firms in a
market. While this measure is simple to calculate and understand, it does not directly
measure market power or elasticity of demand.
• One limitation of the N-firm concentration ratio is that it may be relatively
insensitive to mergers of two firms with large market shares.
• This problem is reduced by using an alternative measure of market concentration,
the Herfindahl-Hirschman Index (HHI)
Herfindahl-Hirschman Index (HHI):

• The HHI is calculated as the sum of the squares of the market shares of the largest firms
in the market.

Aggregate Output Prices & Economic growth

Macroeconomics: It is study of aggregate behavior of households, firms and markets.
Aggregate output Value of all the goods and services produced in a specified period
Aggregate income Value of all the payments earned by the suppliers of factors used in
the production of goods and services
Aggregate Total amount spent on the goods and services produced in the
expenditure (domestic) economy during the period
Aggregate output = Aggregate income = Aggregate expenditure
Gross Domestic Product (GDP)- GDP Measures:

• Market Value of goods and services produced within an economy over a given period.
• GDP measures the flow of output and income in the economy.
• GDP represents the broadest measure of the value of economic activity occurring within
a country during a given period.
To ensure consistency across countries and across time, the following criteria are used:
• Only count goods and services produced during the measurement period.
• Count goods and services whose value can be determined by being sold in the market
• Use market value of final goods and services.
Things included and excluded in the GDP calculation:

Included in GDP computation Excluded in GDP computation
All goods and services produced during the Items produced in previous periods.
measurement period.
Goods and services whose value can be Transfer payments from the
determined by being sold in the market. government sector to individuals
Only the market value of final goods and services Capital gains that accrue to
(those that are not resold) individuals when their assets
appreciate in value.
Goods included at imputed values however, Non-market activities like Activities

Owner-occupied housing and government for one’s own benefit, such as
services, however, are two examples of services cooking, cleaning, and home repair
that are not sold in the marketplace but are still and Activities in the underground
included in the measurement of GDP economy are excluded

Calculating Gross Domestic Product:

The Income Computes GDP as the total income earned by households, businesses
approach and the government in each period
The Expenditure It is based on calculating the total amount spent on goods and services
approach produced in a country in a given period.
Also called as Value-of-final-output approach where GDP is calculated
by summing the values of all final goods and services produced during
the period
Sum-of-value-added approach - where GDP is calculated by summing the additions to

value created at each stage of production and distribution.
Stage of Production Sales Value ($) Value Added ($)
Raw Materials 100 100
Manufacturing 250 150
Retail 325 75
Sum of Value Added 325
Note: Reliability of official GDP data varies considerably across countries

Potential problems in GDP calculation:
• Failure to capture a significant portion of activity.
• Poor data collection practices
• Unreliable statistical methods within the official accounts
Nominal and Real GDP

Nominal Values goods and services at their current prices and includes the
GDP inflation effect in it
Real GDP Measures current-year output using prices from a base year; eliminates
inflation effect
Per capital Real GDP divided by the size of the population; a measure of the average
real GDP standard of living in a country
Difference between Nominal and real GDP

The main difference is that real values are adjusted for inflation, while nominal values
are not. As a result, nominal GDP will often appear higher than real GDP
GDP Deflator:

The GDP Deflator is a price index that can be used to convert nominal GDP into real
GDP by removing the effects of changes in prices. This Changes in the deflator provide a
useful gauge of inflation within the economy.
GDP Deflator = (Nominal GDP / Real GDP) x 100
The Components of GDP

Part A: The expenditure approach:
GDP = C + I + G + (X – M)
C = consumption spending
I = business investment (capital equipment, inventories)
G = government purchases
X = exports
M = imports
We may also express this equation as:

GDP = (C + GC) + (I + GI) + (X – M)
GC = government consumption
GI = government investment (capital goods, inventories)
Part B: The income approaches:

GDP = National income + Capital consumption allowance + Statistical discrepancy
National income - It is the sum of the income received by all factors of production that go
into the creation of final output.
National income = Compensation of employees (wages and benefits)

+ corporate and government enterprise profits before taxes
+ interest income
+ unincorporated business net income (business owners’ incomes)
+ rent
+ indirect business taxes – subsidies (taxes and subsidies that are included in final prices)
Capital consumption allowance (CCA) - It measures the depreciation.
The statistical discrepancy - It is an adjustment for the difference between
GDP measured under the income approach and the expenditure approach because
they use different data.
Personal Income and Personal Disposable Income
Personal income National income− Indirect business taxes−Corporate income
taxes − Undistributed corporate profits + Transfer payments
Personal/Household Personal Income – Personal Taxes
Disposable Income

Combining Income & Expenditure approach

Fundamental relationship among saving, investment, the fiscal balance, and the trade
balance:
Combining the Income and Expenditure Approaches to Measure GDP

Total Expenditure GDP = C + I + G + (X – M)
Total Income GDP = C + S + T
Total Income must = Total Expenditure
C + S + T = C + I + G + (X – M)
S = I + (G – T) + (X – M)
Private savings = Private investment (+) Government borrowing or (-)
Government savings (-) the trade deficit or (+) the trade surplus
(G – T) = the fiscal balance; difference between government spending and tax receipts
(X – M) = net exports, or the trade balance
Aggregate Demand, Aggregate Supply and Equilibrium

Aggregate demand (AD)
It represents the quantity of goods and services that households, businesses,
government, and foreign customers want to buy at any given level of prices
Aggregate supply (AS)

It represents the quantity of goods and services producers are willing to supply at any
given level of prices. It also reflects the amount of labor and capital that households are
willing to offer into the marketplace at given real wage rates and cost of capital
Aggregate Demand Curve

The AD Curve is an like an Ordinary Demand Curve which shows the quantity of real
output demanded at different price levels provided two conditions much be satisfied :
• Aggregate income and planned expenditure must be balanced (IS curve)
• Equilibrium in the money market (LM curve)
Why AD Curve is downward Sloping?

The aggregate demand curve slopes downward because higher price levels (holding the
money supply constant) reduce real wealth, increase real interest rates, and
make domestically produced goods more expensive compared to goods
produced abroad, all of which reduce the quantity of domestic output demanded.

Aggregate Supply Curve

The aggregate supply (AS) curve describes the relationship between the price level and
the quantity of real GDP supplied, when all other factors are kept constant. It represents
the amount of output that firms will produce at different price levels.
We need to consider three aggregate supply curves with different time frames:
• the very short run aggregate supply (VSRAS) curve,
• the short-run aggregate supply (SRAS) curve, and
• the long-run aggregate supply (LRAS) curve
1. In the very short run, firms will adjust output without changing price by adjusting
labor hours and intensity of use of plant and equipment in response to changes in
demand. We represent this with the perfectly elastic very short run aggregate
supply (VSRAS) curve
2. In the short run, the SRAS curve slopes upward because some input prices will
change as production is increased or decreased and change proportionally to
the price level but that at least some input prices are sticky, meaning that they do
not adjust to changes in the price level in the short run. When output prices increase,
the price level increases, but firms see no change in input prices in the short run.
Firms respond by increasing output in anticipation of greater profits from higher
output prices. The result is an upward-sloping SRAS curve.
3. All input costs can vary in the long run, and the LRAS curve in is perfectly inelastic. In
the long run, wages and other input prices change proportionally to the price level,

so the price level has no long-run effect on aggregate supply. We refer to this level
of output as potential GDP or full employment GDP
Shifts in Aggregate demand & supply curve.

Shifts in the Aggregate Demand Curve: factors can cause the AD curve to shift to the
right:
• Increase in consumers’ wealth.
• Business expectations
• Consumer expectations of future income
• High-capacity utilization
• Expansionary monetary policy
• Expansionary fiscal policy
• Exchange rates
• Global economic growth
Shifts in the Short-Run Aggregate Supply Curve: factors can cause the SRAS curve to
shift to the right:
• Labor productivity
• Input prices
• Expectations of future output prices
• Taxes and government subsidies
• Exchange rates
Shifts in the Long-Run Aggregate Supply Curve: Factors that will shift the LRAS curve to
shift to the right:
• Increase in the supply and quality of labor.
• Increase in the supply of natural resources.
• Increase in the stock of physical capital.
• Technology
Movement Along Aggregate Demand and Supply Curves

In contrast with shifts in the aggregate demand and aggregate supply curves, movements
along these curves reflect the impact of a change in the price level on the quantity
demanded and the quantity supplied. Changes in the price level alone do not cause shifts
in the AD and AS curves.
Effects on fluctuations in AD & AS on GDP

Short-Run Macroeconomic Effects:
Type of Change Named as Real GDP Price Level Unemployment
Decrease in AD Recessionary Gap Decrease Decrease Increase
Increase in AD Inflationary Gap Increase Increase Decrease

Decrease in AS Stagflation Decrease Increase Increase

Increase in AS Decrease in input price Increase Decrease Decrease
Combined effect of AD & AS on economy

Effect of combined changes in aggregate supply and demand on the economy:
Aggregate Demand Aggregate Supply Real GDP Price level (Inflation)
Increase Increase Increase Depends
Decrease Decrease Decrease Depends
Increase Decrease Depends Increase
Decrease Increase Depends Decrease
Measures of Sustainable growth - Sources of Economic growth:

• Labor supply
• Human capital
• Physical capital stock
• Technology
• Natural resources
Sustainability of Economic Growth:

One way to view potential GDP is with the following equation:
Potential GDP = Aggregate hours worked × Labor productivity
Or, stated in terms of economic growth:

Growth in potential GDP = Growth in labor force + Growth in labor productivity
Production Function
Production function approach to analyzing the sources of economic growth :
A production function describes the relationship of output to the size of the labor force, the
capital stock, and productivity.
Y = A × f (L, K)
Y = aggregate economic output
L = size of labor force
K = amount of capital available
A = total factor productivity
The production function can be stated on a per-worker basis by dividing by L:

Y/L = A × f (K/L)
Y/L = output per worker (labor productivity)
K/L = physical capital per worker

Input growth vs growth of total factor productivity

Input growth and growth of total factor productivity as components of economic
growth
The Solow model or neoclassical model of the contributions of technology, labor, and
capital to economic growth is:
Growth in Growth in technology + WL (growth in labor) + WC (growth in
potential GDP capital)
WL and WC = labor’s percentage share of national income and capital’s percentage
share of national income
Sometimes the relationship between potential GDP, improvements in technology, and

capital growth is written on a per-capita basis as:
Growth in per-capita potential Growth in technology +
GDP WC (growth in the capital-to-labor ratio)

UNDERSTANDING BUSINESS CYCLES

The business cycle is characterized by fluctuations in economic activity.
In duration, business cycles vary from more than one year to 10 or 12 years.
Key determinants of current phase of business cycles are:
• Real Gross Domestic Product (Real GDP)
• Rate of Unemployment
Activity in Business Cycles

Expansion Peak Contraction Trough
Economic Accelerating rate Slow Outright decline Turns
Activity of growth down rate of from negative to posi
growth tive
but stays at
positive
Level of Unemployment Business slows Business first cuts Layoffs slow but new
Employment level falls to low its rate of hours, freezes hiring does not occur
levels due to full hiring but hiring, but, yet & unemployment
activity the unemploy unemployment rate rate remains
ment rate continuous to fall high. Overtime and t
continues to emporary employees
fall to meet rising product
demand initially
Consumer Spending Increase Capex Cutback Upturn often
Spending s and business expands appears most in most pronounced in
begins to order rapidly but industrial productio housing, consumer
heavy equipment growth rate of n, consumer durables and orders
and engage spending starts durables for light producer
in construction to slow down and orders for new equipment
heavy
equipment followe
d with a lag in
other forms of
capex spending
Inflation Inflation picks Inflation Inflation decelerate Inflation
up modestly further acceler s but with a lag remains moderate &
ates may continue to fall
The interaction of this gauge with the cycle develops in three distinct stages:
Sta State of Effect
ge Economy

1 Peak/Top of Sales fall or slow, businesses may lag in cutting back on new
Economic Cycle production and inventories increase, increase in inventory–sales
ratios all lead to weakening economy, leading to order
cancellations and layoffs, cut in final sales further and
deepening cyclical corrections
2 Production rate Dispose of unwanted inventories, inventory–sales ratios begin to
below sales fall back toward normal; indicators return to acceptable levels and
volume businesses will raise production levels, resulting in improved
economic situation, minor increase in production levels, layoffs
may slow or stop and demand for other inputs may also increase
3 Sales business may initially fail to keep production on pace with sales,
begin cyclical which causes it to lose inventory to the initial sales increase leading
Upturn to fall in inventory–sales ratios, later there is surge in
production not only to catch up with sales but also to replenish
depleted inventories, however, there is lag between increased sales
and production may be longer than in other cycles. This later on
marks a turn in hiring patterns and for a time can
markedly exaggerate the cyclical strength
Fluctuations in the sectors due to the cyclical swings and its effect on the overall
economic activity
Theories of Business Cycle

School of Thought Belief Recommended Policy
Neoclassical School All markets reaching equilibrium because Do Nothing
of the “invisible hand, or free market,”
AD/AS curve shifts due to change in
technology

Lower interest rates and lower

wages will enable economy to come back
to equilibrium
Austrian School Misguided government Do Nothing
intervention (through monetary
policy) causes the business cycle
Therefore, advocated limited
government intervention in the economy
Keynesian School & Fluctuations are primarily due Increase AD directly,
to swings in the level of optimism of those through monetary policy
who run businesses or through fiscal policy
New Wages are “downward sticky"
Keynesian School Added the assertion that the prices of
productive inputs other than labor are
also “downward sticky",
presenting additional barriers to the
restoration of full-employment
equilibrium
Monetarist School Variations in AD are due to variations in the central bank should
the rate of growth of the money supply, follow a policy of steady
likely from inappropriate decisions by and predictable
the monetary authorities increases in the money
supply
New Classical Expansion & contractions represent Do nothing
School efficient operation of the economy in
response to external real shocks
Types of Unemployment
Unemployment can be divided into three categories:
Types Frictional Structural unemployment Cyclical unemployment
unemployment
Cause Time lag necessary Caused by long-run Caused by changes in the
to match changes in the general level of
employees who seek economy that eliminate economic activity
work with employers some jobs while
needing their skills generating others for
which unemployed
workers are not qualified
Effect Always Unemployed workers do Positive when the economy
present as employees not currently have the is operating at less than full

move, are fired, or quit to skills needed to perform capacity, negative when an
seek other opportunities the jobs that are available expansion leads
to employment temporarily
over the full employment
level
Important Jargons on Unemployment:

Unemployed A person who is not working and if is actively searching for work
Long-term Those seeking work unsuccessfully for several months
unemployed
Labor force All people who are either employed or unemployed
Voluntarily People who choose not to be in the labor force
unemployed
Underemployed People who have a job but have qualifications to work
in significantly higher paying job
Discouraged Person who has stopped looking for a job, available for work but
worker are neither employed nor actively seeking employment
Unemployment rate Percentage of people in the labor force who are unemployed,
except voluntarily unemployed
Ratios
Unemployment Rate Number of unemployed / Labor force
Activity (participation) ratio Labor force / Total population of working age
(Those between 16 and 64 years of age)
Inflation
It is the percentage increase in the price level, typically compared to the prior year
Hyperinflation Disinflation Deflation Stagflation
Inflation Out of Control Decreasing but Negative High Inflation + Slow
Situation above 0 growth
Causes Overprinting Slowdown in Austerity, Supply Shock, Bad
economy Spiral policies
Examples Zimbabwe, EU, US, UK Japan, PIGS USA in 1970s
Venezuela
CPI vs WPI Inflation Indexes

Price Index:

A price index measures the average price for a defined basket of goods and services
used to calculate a rate of inflation
Consumer price index (CPI)

• The CPI basket represents the purchasing patterns of a typical urban household.
• CPI is the best-known indicator of U.S. inflation and is used by many countries.
&'() '+ ,-(./) -) &011/2) 314&/(
CPI = &'() '+ ,-(./) -) ,-(/ 3/14'5 314&/( × 100
Wholesale price index (WPI)

• Also called as Producers Price Index (PPI)
• Instead of using consumer (retail prices) it uses more stable prices at wholesale
level (producers’ level)
• Analysts can observe the PPI for different stages of processing (raw materials,
intermediate goods, and finished goods) to watch for emerging price pressure
Headline vs Core Inflation

Headline inflation refers to price indexes for all goods
Core inflation refers to price indexes that exclude food and energy as they are
typically more volatile than those of most other goods.
More useful measure of the underlying trend in prices.
Inflation Measurement
Laspeyres index
This index uses a constant basket of goods and services. Most countries calculate
consumer price inflation using Laspeyres index. Quantity is same but price is new
(change in price).
A Paasche indexes.
This index uses the current consumption weights, prices from the base period, and prices
in the current period. Different/New quantity and Change in Price.
Note: The Paasche index is less than Laspeyres index because, compared to the base
period, consumers have substituted away from the two goods gasoline and Phone.
Three factors cause a Laspeyres index of consumer prices to be biased upward as a

measure of the cost of living:
New goods Older products are often replaced by newer, but initially more expensive,
products. New goods are periodically added to the market basket, and the
older goods they replace are reduced in weight in the index
Quality If the price of a product increases because the product has improved, the
changes price increase is not due to inflation but still increases the price index

Substitution Even in an inflation-free economy, prices of goods relative to each other

change all the time. These changes can make a Laspeyres index’s fixed
basket of goods a less accurate measure of typical household spending
Fisher index can be used to adjust for the bias from substitution. A Fisher index is
the geometric mean of a Laspeyres index and a Paasche index.
Cost Push Inflation

Inflation which results from an initial decrease in aggregate supply caused by an increase
in the real price of an important factor of production, such as wages or energy. Also,
called as Wage push inflation because labor is the most important cost of production.
Demand Pull
It results from an increase in the money supply, increased government spending, or any
other change that increases aggregate demand.
Economic Indicators
Leading Known to change direction before peaks or troughs in the business cycle like
indicators Supply Management new orders index; building permits for new
houses; S&P 500 equity price index; Leading Credit Index; 10-year Treasury
to Fed funds interest rate spread; and consumer expectations
Coincident Change direction at roughly the same time as peaks or troughs like
indicators Employees on nonfarm payrolls; real personal income; index of industrial
production; manufacturing and trade sales
Lagging Don’t tend to change direction until after expansions or contractions are
indicators already underway. Average duration of unemployment; inventory-sales
ratio; change in unit labor costs; average prime lending rate; commercial and
industrial loans; ratio of consumer installment debt to income; change in
consumer price index (Inflation)

MONETARY POLICY
Monetary refers to the central bank’s actions that affect the quantity of
policy money and credit in an economy in order to influence economic activity
Fiscal policy refers to a government’s use of spending and taxation to influence
economic activity
Money has three primary functions:

Medium of exchange accepted as payment for goods and services
Unit of account prices of all goods and services are expressed in units of money
Store of value money received for work or goods now can be saved to
purchase goods later
Narrow is the amount of notes (currency) and coins in circulation in an Currency +

money economy plus balances in checkable bank deposits Bank Deposits
Broad includes narrow money plus any amount available in liquid NM + Liquid
money assets, which can be used to make purchases assets
Money definition as per Federal Reserve Bank of New York:

M1 M2
Currency in circulation ! !
Travelers’ checks ! !
Demand deposits ! !
Other deposits against which checks can be written ! !
Savings accounts !
Time deposits of under $100,000 !
Balances in retail money market mutual funds !
Money creation process

Fractional reserve banking - In a fractional reserve banking system, a bank holds a
proportion of deposits in reserve. In most countries, banks are required to hold a minimum
percentage of deposits as reserves.
Money Multiplier - When cash is deposited in a bank, the portion that is not required to be
held in reserve can be loaned out.
Money created = New deposit / Reserve req
Money Multiplier = 1/reserve req

Relationship of Money & Price Level & Fisher Effect

Money supply × Velocity = Price × Real output (MV = PY)
Price × real output = Total spending
Money Decided by the monetary policymakers

Supply
Velocity Average number of times per year each unit of money is used to buy
goods or services
Price Level Inflation
Real Output Real GDP
Money Neutrality
• Monetarists believe that velocity and the real output of the economy change only
slowly. Assuming that velocity and real output remain constant, any increase in
the money supply will lead to a proportionate increase in the price level.
• This belief that real variables (real GDP and velocity) are not affected by monetary
variables (money supply and prices) is referred to as money neutrality.
The Fisher effects

It states that the nominal interest rate is simply the sum of the real interest rate and
expected inflation: R Nom = R Real + E[I]
R Nom = nominal interest rate
R Real = real interest rate
E[I] = expected inflation
The demand for and supply of money

There are three reasons for holding money:
Transaction demand To pay for goods and services, it is useful for conducting daily
transactions
Precautionary To meet the emergencies
demand
Speculative demand To earn profit from volatility of asset prices
The supply of money

It is determined by the central bank (the Fed in the United States) and is independent of
the interest rate.
Money Demand and Supply Curve

• The money supply curve, is vertical (perfectly inelastic) because we assume that there is
a fixed nominal amount of money circulating at any one time
• On the other end, the money demand curve (MD) is downward sloping because
as interest rates rise, the speculative demand for money falls
Equilibrium interest rate - It is the interest rate where the supply of money is equal to
the demand for money i.e. where the MS intersects MD
Interest rate & Money Supply Securities Prices of Interest rates
Equilibrium rate securities
I-high Excess Supply Purchase Increase Decrease
I-Low Excess Demand Sell Decrease Increase
Roles & Objective of Central Bank

Central banks can affect short-term interest rates by increasing or decreasing the
money supply.
An increase in the money supply:
• Will shift of the money supply curve to the right.
• Put downward pressure on interest rates.
• Firms and households buy securities, increasing securities prices.
• Interest rate will decrease until the new lower equilibrium interest rate is achieved.
Effect of Increase in the Money Supply: The Roles of Central Banks

• Monopoly supplier of the currency
• Banker to the government and the bankers’ bank,
• Lender of last resort,
• Regulator and supervisor of the payments system,
• Conductor of monetary policy
• Supervisor of the banking system
The objective of a central bank:

Primary Objective - Control inflation to Promote Price stability.
In addition to price stability, some central banks have other stated goals, such as :
• Stability in exchange rates with foreign currencies
• Full employment
• Sustainable positive economic growth
• Moderate long-term interest rate
Problems of High Inflation

High inflation is not conducive to a stable economic environment leading to menu costs
& shoe leather costs.

Menu Cost Cost to businesses of constantly having to change their prices

Shoe Costs to individuals of making frequent trips to the bank so as to minimize
leather their holdings of cash that are depreciating in value due to inflation
Costs
Costs of expected inflation:
• The cost of holding money rather than interest-bearing securities is higher because its
purchasing power decreases steadily.
Costs of Unexpected inflation:
• Transfer wealth between borrowers and lenders inequitably
• Information about supply and demand from changes in prices becomes less reliable
• Increases the magnitude or frequency of business cycles
• Make borrowing rates and the prices of other assets higher due to higher inflation risk
premium.
Monetary Policy Tools

Policy Rate Generally, the rate at which central banks lends to commercial banks.
Increase in rate indicates tightening of money supply and decrease in
rate indicates increasing money supply.
Also called as US Federal Funds Rate; ECB-Refinancing Rate; UK-
REPO rate, etc.
Open Market Purchase (Sale) of Government securities is done to Increases
Operations (decrease) bank reserves and Increase (decrease) money supply
Reserve Increase (decrease) in reserve
Requirements requirements indicates tightening (easing) of monetary policy. It is
rarely used in developed markets.
The Monetary transmission mechanism

It refers to the ways in which a change in monetary policy, specifically the central bank’s
policy rate, affects the price level and inflation. Considering the effects of a change to
a Contractionary Monetary Policy implemented through an increase in the policy rate.
Effect on Interest rate
Banks’ short-term lending rate Increase
Bond prices, equity prices, and asset prices Decrease
Consumers and businesses expenditure Decrease
Expectations for future economic growth Decrease
Domestic currency Appreciate
Exports Decrease

Qualities of effective central banks - For a central bank to succeed in its

inflation-targeting policies, it should have three essential qualities:
Independence Free from political interference

Operational independence means that the central bank is allowed to
independently determine the policy rate (most have this)
Target independence means the central bank also defines how inflation
is computed, sets the target inflation level, and determines
the horizon over which the target is to be achieved (ECB has both)
Credibility Central banks should follow through on their stated intentions.
In order to be able to implement monetary policy objectively, the central
bank should be credible among economic agents because when
economic agents believe that the central bank will hit the target,
the belief itself could become self-fulfilling.
Transparency In order to be able to implement monetary policy objectively, the central
bank should be transparent in its goals, objectives and decision making
Transparent central banks periodically report their views on the
economic indicators and other factors they consider in their interest rate
setting policy
Note: Central banks do not target current inflation; rather, they focus on inflation two
years ahead.
Exchange rate targeting

Dollarization occurs when a country adopts the US dollar as their functional currency. This is
stronger than pegging to the dollar (USD replaces the existing currency)
Countries Pegged to Dollar Saudi Arabia, UAE, Qatar, Hong Kong, Lebanon, etc.
Countries Dollarized Panama, Ecuador, East Timor, El Salvador, etc.
Rationale to use Exchange rate Targeting:

To import the inflation experience of the low inflation economy by tying Domestic
economy’s currency to the currency of an economy with a good track record on inflation
Drawback of using exchange rate targeting:

Due to exchange-rate targeting, domestic interest rates and money supply can become
more volatile.
Expansionary vs Contractionary Monetary policy & Limits

Contractionary monetary When central bank policy rate is above neutral rate of interest
policy
Expansionary monetary When central bank policy rate is below neutral rate of interest
policy
Neutral rate of interest Real trend rate of Growth + Expected (or target) inflation
The Sources of the Shock to the Inflation Rate:

The monetary authority must first try to identify the source of the shock to the inflation
rate before adopting a contractionary or expansionary monetary policy
There are two sources of the shock to the Inflation Rate:

Demand When inflation increases due to increase in consumption and investment
shock growth rates resulting from increase in the confidence of consumers and
business leaders, it is referred to as demand shock. When inflation rises due
to demand shock, it is appropriate to use tight monetary policy
Supply When inflation increases due to increase in the costs of production (e.g. costs
shock of inputs), it is referred to as supply shock. When inflation rises due to supply
shock, it is not appropriate to use tight monetary policy because increasing
interest rates further reduce profits and consumption and eventually
further increase unemployment
Limitations of Monetary Policy

• When the central bank’s policy is credible and investors believe that the inflation target
rate will be maintained over time, this effect on long-term rates will be small.
• If an economy is experiencing deflation even though money supply policy has
been expansionary, liquidity trap conditions may be present.
• In a deflationary environment, monetary policy needs to be expansionary. However, the
central bank is limited to reducing the nominal policy rate to zero. Once it reaches
zero, the central bank has limited ability to further stimulate the economy.
Liquidity trap
Liquidity trap occurs when the demand for money becomes infinitely elastic (money
demand curve is horizontal) i.e., demand for money balances increases without any
change in the interest rate
Once interest rates are at 0%, central bank can use following two approaches to
stimulate economy:
1. Convincing market participants that interest rates will remain low for a long time
period even if the inflation picks up leading to lower interest rates along the yield
curve

2. Increasing the money supply- Quantitative easing (QE) by purchasing

government or private securities (through the central bank) from the private sector
and financing those purchases by printing money. Operationally, it is similar to
open market purchase operations but conducted on a much larger scale.
FISCAL POLICY
Fiscal policy – It refers to a government’s use of spending and taxation to meet
macroeconomic goals.
Discretionary fiscal policy vs Automatic stabilizers
Discretionary refers to the spending and taxing decisions of a national government that
fiscal policy are intended to stabilize the economy.
Automatic They are built-in fiscal devices triggered by the state of the economy, For
stabilizers example, during a recession, tax receipts will fall, and government
expenditures on unemployment insurance payments will increase. Both of
these tend to increase budget deficits and are expansionary.
Objectives of fiscal policy may include:

• Influencing the level of economic activity and aggregate demand.
• Redistributing wealth and income among segments of the population.
• Allocating resources among economic agents and sectors in the economy
Tools of fiscal policy & Advantages-Disadvantages

Fiscal policy tools - Spending tools and Revenue tools
Spending Tools
Transfer Also known as entitlement programs, redistribute wealth, taxing some and
payments making payments to others. Examples include Social Security and
unemployment insurance benefits. Transfer payments are not included in
GDP computations.
Current Government purchases of goods and services on an ongoing and routine
spending basis
Capital Government spending on infrastructure, such as roads, schools, bridges, and
spending hospitals. Capital spending is expected to boost future productivity of the
economy
Revenue Tools
Direct Levied on income or wealth. These include income taxes, taxes on income for
taxes national insurance, wealth taxes, estate taxes, corporate taxes, capital gains

taxes, and Social Security taxes. Some progressive taxes (such as income and
wealth taxes) generate revenue for wealth and income redistributing.
Indirect Levied on goods and services. These include sales taxes, value-added taxes
taxes (VATs), and excise taxes. Indirect taxes can be used to reduce consumption of
some goods and services (e.g., alcohol, tobacco, gambling)
Advantages of fiscal policy tools:

• Social policies, such as discouraging tobacco use, can be implemented very quickly via
indirect taxes.
• Quick implementation of indirect taxes also means that government revenues can be
increased without significant additional costs.
Disadvantages of fiscal policy tools:

• Direct taxes and transfer payments take time to implement, delaying the impact of
fiscal policy.
• Capital spending also takes a long time to implement and the economy may
have recovered by the time its impact is felt
Fiscal Multiplier
• The fiscal multiplier determines the potential increase in aggregate demand resulting
from an increase in government spending
• The fiscal multiplier is a Keynesian idea first proposed by John Maynard Keynes's
student Richard Kahn in 1931
Disposable income Income × (1-tax rate)
Additional Spending Disposable income × MPC
Fiscal multiplier 1
1 − #$%(1 − '() +(,-)
Ricardian Equivalence
Government Debt, Deficits and Ricardo Equivalence:
When the government has insufficient tax revenues to meet expenditures, it needs to
borrow from the public. When outstanding stock of debt falls (rises), budget surplus rises
(falls)
Total size of the outstanding debt of Cumulative quantity of net borrowing +
government Fiscal (or budget) deficit in the current
period
A country’s debt ratio is the ratio of aggregate debt to GDP:

6771/7-)/ 8/,)
Debt ratio =
GDP

Arguments for being concerned with the size of fiscal deficit:

• Higher deficits lead to higher future taxes.
• If markets lose confidence in the government, investors may not be willing to refinance
the debt.
• Crowding-out effect because government borrowing is taking the place of private
sector borrowing.
Arguments against being concerned with the size of fiscal deficit:

• If the debt is primarily being held by domestic citizens, the scale of the problem is
overstated.
• If the debt is used to finance productive capital investment, future economic gains will
be sufficient to repay the debt.
• Fiscal deficits may prompt needed tax reform.
• Deficits would not matter if private sector savings in anticipation of future tax liabilities
just offsets the government deficit.
• Deficits can aid in increasing GDP and employment.
Difficulties in Executing Fiscal Policy & Interaction of Policy

Fiscal policy cannot completely stabilize aggregate demand as predicted by the multiplier
due to following time lags associated with executing and implementing fiscal policy
Recognition lag Policymakers do not have complete information on how the economy
functions; hence, it takes time to collect economic statistics and data. In
addition, data are subject to substantial revision
Action lag or When necessary, policy changes are decided on, it may take many
Execution lag months to implement a policy response
Impact lag Even if policy changes are implemented, it may take additional time to
impact the economy
Additional macroeconomic issues may hinder usefulness of fiscal policy:

• Misreading economic statistics
• Crowding-out effect
• Supply shortages
• Limits to deficits
• Multiple targets
Interaction of monetary and fiscal policy

Monetary policy and fiscal policy may each be either expansionary or contractionary, so
there are four possible scenarios:

Expansionary fiscal In this case, the impact will be highly expansionary taken
and monetary policy together. Interest rates will usually be lower (due to monetary
policy), and the private and public sectors will both expand
Contractionary fiscal In this case, aggregate demand and GDP would be lower,
and monetary policy and interest rates would be higher due to tight monetary policy.
Both the private and public sectors would contract
Expansionary fiscal In this case, aggregate demand will likely be higher (due to fiscal
policy + policy), while interest rates will be higher (due to increased
Contractionary government borrowing and tight monetary policy). Government
monetary policy spending as a proportion of GDP will increase
Contractionary fiscal In this case, interest rates will fall from decreased government
policy + Expansionary borrowing and from the expansion of the money supply, increasing
monetary policy both private consumption and output. Government spending as
a proportion of GDP will decrease due to contractionary fiscal
policy. The private sector would grow as a result of lower interest
rates.

GEOPOLITICS & ITS CHARACTERISTICS

Geopolitics - It refers to the study of how geography affects interactions among nations
and their citizens. It also refers to interactions among nations, including the actions of:
• State actors like national governments and
• Non-state actors like corporations, non-government organizations, and individuals
Co-operative vs Non-Cooperative Country

• A country that engages with other countries on diplomatic, military, economic and
cultural matters may be considered cooperative and
• The one that does not may be considered non-cooperative, however, the extent of
cooperation actually varies along a spectrum.
Globalization
• It refers to the long-term trend toward worldwide integration of economic activity and
cultures.
• Countries that are closer to the globalization are those that more actively import and
export goods and services, permit freer movement of capital across borders and
exchange of currencies, and are more open to cultural interaction
Geopolitics Characteristic:
It is the type of behavior by countries. While individual countries rarely fit neatly into one
of these categories, the general framework within which they can be described are as
follows:
Autarky Non-cooperation Goal of national self-reliance, including producing most
and nationalism or all necessary goods and services domestically, state-
dominated society in general, government control of
industry and media Ex. North Korea
Hegemony Non-cooperation Open to globalization but have the size and scale to
and influence other countries without necessarily
globalization cooperating Ex. USA, Russia
Bilateralism Cooperation and Cooperation between two countries while tending not to
nationalism involve itself in multi-country arrangements Ex. KSA
Multilateralism Cooperation and Countries that engage extensively in international trade
globalization and other forms of cooperation with many other
countries, may exhibit regionalism, cooperating
multilaterally with nearby countries but less so with the
world at large Ex. Germany
Geopolitics & Its Characteristics

Tools of Geopolitics:
National Armed conflict, espionage, bilateral or multilateral agreements to Prevent
security arm conflicts
Tools
Economic Cooperative like free trade areas, common markets, and economic and
Tools monetary unions or non-cooperative like domestic content requirements,
voluntary export restraints, and nationalization
Financial Allowing of foreign investment and the free exchange of currencies, or non-
Tools cooperatively when they restrict these activities like Sanctions
Geopolitical risk
It is the possibility of events that interrupt peaceful international relations
Can be classified into three types:

Event risk Events about which we know the timing but not the outcome, such as national
elections.
Exogenous Unanticipated events, such as outbreaks of war or rebellion. Black swan
risk risk - the risk of low- likelihood exogenous events that have substantial
short-term effects
Thematic Known factors that have effects over long periods, such as human migration
risk patterns or cyber risks

INTERNATIONAL TRADE AND CAPITAL FLOWS

Imports Goods and services that firms, individuals, and
governments purchase from producers in other countries
Exports Goods and services that firms, individuals, and governments from other
countries purchase from domestic producers
Autarky or closed A country that does not trade with other countries
economy
Free trade A government places no restrictions or charges on import and
export activity
Trade protection A government places restrictions, limits, or charges on exports or
imports
World price The price of a good or service in world markets for those to whom
trade is not restricted
Domestic price The price of a good or service in the domestic country, which may
be equal to the world price if free trade is permitted or different in
case of restriction
Net exports The value of a country’s exports (-) the value of its imports over
some period
Trade surplus Net exports are positive; Exports > Imports
Trade deficit Net exports are negative; Exports <Imports
Terms of trade The ratio of an index of the prices of a country’s exports to an index
of the prices of its imports expressed relative to a base value of 100.
An increase in ratio means that prices of the goods it
exports have risen relative to the prices of the goods it imports since
the base period.
Foreign direct Ownership of productive resources (land, factories, natural resources)
investment in a foreign country
Multinational A firm that has made foreign direct investment in one or more
corporation foreign countries, operating production facilities and subsidiary
companies in foreign countries
GDP vs GNP The income to capital owned by foreigners invested within a country is
included in the domestic country’s GDP but not in its GNP.
The income of a country’s citizens working abroad is included in
its GNP but not in its GDP
Comparative advantage and absolute advantage

Benefits and costs of international trade

Benefits Lower Cost of goods (Imports)
Increasing employment
Increasing wages for workers
Increasing Profits from its export products
More efficient allocation of resources
Consumption of a larger bundle of goods
Specialization
Costs Borne by those in domestic industries that compete with imported goods
Loss of Job, majorly in unskilled sectors
Income inequality
However, it is observed that the benefits of trade are greater than the costs for overall
economies and there is various economic theory that supports this view including:
• The Theory of Absolute Advantage
• The Theory of Comparative Advantage
Absolute When a country can produce good at a lower resource
Advantage cost than another country
Comparative When a country has advantage with a lower opportunity cost in the
Advantage production of a good compared to another good
Ricardian Theory
• David Ricardo presented the advantage of Trade in 1817 where he analyzed that,
regardless of which country has an absolute advantage, there are potential gains from
trade as long as the countries’ opportunity costs of one good in terms of another are
different.
• He concluded that even if a country does not have an absolute advantage in producing
any of the goods, it can still gain from trade by exporting the goods in which it has a
comparative advantage.
The production possibility frontier & Models of Trade

As a country specializes and increases the production of an export good, increasing
costs and hence will increase the opportunity cost of the export good
The production possibility frontier

• It shows all combinations of goods that an economy can produce
• The slope of the frontier measures the opportunity cost of one good in terms
of another at each possible combination of both
• The slope is of -3 states that the opportunity cost of each million machines is 3 million
tons of food. If the country were to increase the production of machinery, the amount of

food production foregone would increase, as shown by the increasingly negative slope
of the frontier.
Models of Trade
The It has only one factor of production — labor
Ricardian The source of differences in production costs in Ricardo’s model is
model differences in labor productivity due to differences in technology.
Heckscher It has two factors of production — capital and labor
and Ohlin The conclusion of HO model is that the country that has more capital will
specialize in the capital intensive good and trade for the less capital
intensive good with the country that has relatively more labor and less
capital.
Trade restrictions
There are various reasons why governments impose trade restrictions.
Some have support among economists as conceivably valid in terms of increasing a
country’s welfare, while others have little or no support from economic theory.
Some of the reasons for trade restrictions that have support from economists are:
• Infant industry
• National security
Other arguments for trade restrictions that have little support in theory are:
• Protecting domestic jobs
• Protecting domestic industries
• Retaliation for foreign trade restrictions
• Government collection of tariffs (like taxes on imported goods)
• Countering the effects of government subsidies paid to foreign producers
• Preventing foreign exports at less than their cost of production (dumping)

Types of trade restrictions include:

Tariffs Taxes on imported good collected by the government
Quotas Limits on the number of imports allowed over some period
Export subsidies Government payments to firms that export goods
Minimum Requirement that some percentage of product content must be from the
domestic domestic country
content
Voluntary export A country voluntarily restricts the amount of a good that can be
restraint exported, often in the hope of avoiding tariffs or quotas imposed by
their trading partners
Overall welfare effects of quotas and tariffs for a small country:

P-World, QS1, QD1 No Restriction Global Price, Quantity Supplied and Quantity
Demanded
P-Protection, QS2, New Domestic Price, Quantity Supplied and Quantity Demanded
QD2 due to Restriction
A tariff and an equivalent quota both increase the domestic price from P-world - the
price that prevails with no trade restriction to price with Trade protection - P-protection
Effect of restrictions
• At P-world, prior to any restriction, the domestic Quantity supplied is QS1, and the
domestic quantity demanded is QD1, with the difference equal to the quantity
imported, QD1 – QS1
• Placing a tariff on imports increases the domestic price to P-protection, increases the
domestic quantity supplied to QS2, and decreases the domestic quantity
demanded to QD2

Effects of Tariffs and Import Quota

Consumer Loss The entire shaded area in represents the loss of consumer surplus in
the domestic economy
Producer Surplus The portion with vertical lines, the area to the left of the domestic
supply curve between P-protection and P-world, represents the gain in
the producer surplus of domestic producers
Government The portion with horizontal lines, the area bounded by QD2 – QS2
Revenue from and P-protection – P-world, represents the gain to the domestic
Tariff government from tariff revenue
Dead Weight The two remaining triangular areas are the deadweight loss from the
Loss restriction on free trade
Capital restrictions - Some countries impose capital restrictions on the flow of

financial capital across borders like:
• Outright prohibition of investment in the domestic country by foreigners
• Prohibition of or taxes on the income earned on foreign investments by domestic
citizens.
• Prohibition of foreign investment in certain domestic industries
• Restrictions on repatriation of earnings of foreign entities operating in a country.
Effect of Capital Restrictions

• Capital restrictions are thought to decrease economic welfare.
• Over the short term, they have helped developing countries avoid the impact extreme
inflow or outflows.
• However, the short-term benefits may not offset longer-term costs if the country
is excluded from international markets for financial capital flows
Governments sometimes place restrictions on the flow of investment capital into their
country, out of their country, or both. Commonly cited objectives of capital flow
restrictions include the following:
• Reduce the volatility of domestic asset prices.
• Maintain fixed exchange rates.
• Keep domestic interest rates low.
• Protect strategic industries.
Trading Blocks
Trading blocs, common markets, and economic unions
• There are various types of agreements among countries with respect to trade policy
• The essence of all of them is to reduce trade barriers among the countries. Economic
welfare is improved by reducing or eliminating trade restrictions.

Trading Blocs, Common Markets, and Economic Unions

Criteria Free Trade Customs Common Economic Monetary
Areas Union Market Union Union
No barriers to trade among Yes Yes Yes Yes Yes
members
trade restrictions with non- Yes Yes Yes Yes
members
No barriers to the movement Yes Yes Yes
of labor and capital
Establish common institutions Yes Yes
and economic policy for the
union
Adopt a single currency Yes
Examples NAFTA, GCC ASEAN EU Euro zone
RCEP
Balance of payments
It is the sum of all debit entries should equal the sum of all credit entries, and the net
balance of all entries on the BOP statement should equal zero.
BOP Components - Current Account, Capital Account & Financial Account
Current Account:
The current account can be decomposed into four sub-accounts:
Merchandise consists of all commodities and manufactured goods bought, sold, or given
trade away
Services include tourism, transportation, engineering, and business services, such
as legal services, management consulting, and accounting. Fees from
patents and copyrights on new technology, software, books, and movies
are also recorded in the services category
Income include income derived from ownership of assets, such
receipts as dividends and interest payments; income on foreign investments
Unilateral one-way transfers of assets, such as worker remittances from abroad to
transfers their home country and foreign direct aid or gifts
Capital Account:
The capital account consists of two sub-accounts:
Capital include debt forgiveness and migrants’ transfers, transfer of title to fixed
transfers assets and the transfer of funds linked to the sale or acquisition of fixed

assets, gift and inheritance taxes, death duties, uninsured damage to fixed
assets, and legacies.
Sales and of non-produced, non-financial assets, such as the rights to natural
purchases resources, and the sale and purchase of intangible assets, such as patents,
copyrights, trademarks, franchises, and leases.
Financial Account
The financial account comprises two sub-accounts:
Government- include gold, foreign currencies, foreign securities, reserve position in
owned assets the International Monetary Fund, credits and other long-term
abroad assets, direct foreign investment, and claims against foreign banks
Foreign-owned are divided into foreign official assets and other foreign assets in the
assets in the domestic country. These assets include domestic government and
country corporate securities, direct investment in the domestic country,
domestic country currency, and domestic liabilities to foreigners
reported by domestic banks
"Balance of Payment Should always Balance” - For a country with a trade deficit, it must
be balanced by a net surplus in the capital and financial accounts. A current account
surplus is similarly offset by purchases of foreign physical or financial assets.
How decisions by consumers, firms, and governments affect the balance of payments:
(G – T) = (S – I) – (X – M)
(G – T) = the fiscal balance; difference between government spending and tax receipts
(X – M) = net exports, or the trade balance
(S-I) = Private Savings less Private Investments
The relation between the trade deficit, saving, and domestic investment is rearranged as:
X – M = Private Savings + Government Savings – Investment
International organizations - designed to facilitate trade:

International Promoting international monetary cooperation.
Monetary Fund
World Bank Group Help developing countries fight poverty and enhance
environmentally sound economic growth.
World Trade It is the only international organization that regulates cross-border
Organization trade relationships among nations on a global scale.

CURRENCY EXCHANGE RATES

The price of a nation’s currency in terms of another currency. An exchange rate thus has
two components, the domestic currency and a foreign currency.
The Foreign Exchange Market

Base Currency Price Currency
The Currency which is Quoted The Base currency is quoted in terms of Price Currency
Direct Quote Indirect Quote

When Exchange rate is quoted in terms of When Exchange rate is quoted in terms of
Price/Base Currency with the rate of Base Price/Base Currency with the rate of Base
Currency as Foreign Currency (from the of Currency as Domestic Currency (from the of
investor in the Price Country Currency) investor in the Price Country Currency)
Appreciation Depreciation
An increase in the value of one currency A decrease in the level of a currency in a floating
in terms of another. exchange rate system due economic fundamental,
interest rate differentials, political instability, risk
aversion amongst investors and so on
Nominal and Real Exchange Rates

Nominal exchange rate Real exchange rate
The nominal exchange rate is defined as How many times more or less goods and
the number of units of the domestic services can be purchased abroad (after
currency that can purchase a unit of a converting Domestic into a Foreign
given foreign currency currency) than in the domestic market for a
given amount
It is measuring only the numerical It measures the relative purchase
exchange value, and does not power of one currency compared with
say anything about other aspects such as another
the purchasing power of that currency
9#: ,-(/ &011/2&;

Real exchange rate (P/B) = Nominal exchange rate (P/B) × 9#: 314&/ &011/2&;
Where,
P = Price Currency = Domestic Currency
B = Base Currency = Foreign Currency

Cross currency rates

Exchange rate between two currencies implied by their exchange rates with a common
third currency (Vehicle Currency)
Functions and Participants in the Forex market

• Facilitating international trade in goods and services
• Enabling capital market transactions (constitutes larger proportion of daily turnover)
• Facilitating hedging of currency risk exposures
Participants - Market participants like individuals, companies and governments enter

foreign exchange market to exchange one currency for another.
Other Participants include, Hedgers, Speculators, Sell Side and Buy Side Traders, etc.
Hedgers These participants want to hedge outstanding position in one currency
from adverse movements
Speculators These participants have an opinion about direction of market movement and
they bet on expected direction of movement
Sell Side Large FX trading banks, primary dealers in
currencies and originators of forward FX contracts are large multinational
banks
Buy side Consists of the many buyers of foreign currencies and forward FX contracts
like Corporations, Investment accounts, Governments, Retail markets
Buyers include the following:

Corporations regularly engage in cross-border transactions and hence
require hedging
Investment accounts Real money accounts like mutual funds, pension funds,
(Speculate and hedge with insurance companies, and other institutional accounts that do
currency derivatives) not use derivatives.
Leveraged accounts like various types of investment firms

that do use derivatives, including hedge funds, firms that
trade for their own accounts
Governments and SWFs, Pension funds, Central banks for policy or for
Government entities buying and selling foreign assets
Retail market (FX For tourism, cross-border investment, or speculative
transactions by households) trading

Spot vs Forward rates

A spot is the currency exchange rate for immediate delivery, which for most
exchange currencies means the exchange of currencies takes place two days after the
rate trade (T+2)
A forward A forward is actually an agreement to exchange a specific amount of one
exchange currency for a specific amount of another on a future date (e.g., 30 days, 60
rate days, 90 days, or one year) specified in the forward agreement. Also called
as Outright forward contracts
FX Swaps A combination of spot and forward (or combination of two
forward transactions) transaction in opposite direction
Forward quotations
• Expressed on a points basis or in percentage terms into an outright forward quotation
• Point Basis is the unit of points is the last decimal place in the spot rate quote
Forward Premium or Discount

Forward Premium or discount
The forward discount or premium for the base currency is the percentage difference
between the forward price and the spot price.
<=> ?@A
Annualized Forward Margin = >
× 100 × 8-;(
Interest Rate Parity – Arbitrage Free Forward rate

When currencies are freely traded and forward currency contracts exist, the percentage
difference between forward and spot exchange rates is approximately equal to
the difference between the two countries’ interest rates
AFM = Interest rate Difference
Interest rate parity: For spot and forward rates expressed as price currency/base
currency, the no-arbitrage relation is: As per IRP
BC:2)/1/() 1-)/ '+ #14&/ 9011/2&;
Forward (P/B) = Spot (P/B) × BC:2)/1/() 1-)/ '+ D-(/ 9011/2&;
Exchange rate regimes

The IMF categorizes exchange rate regimes into the following types:
• Two for countries that do not issue their own currencies and
• Seven for countries that issue their own currencies.

Countries that Do not Have their Own Currency

System Commitment Countries
Dollarization Doesn’t have its own currency Zimbabwe, Panama, Kosovo,
Montenegro
Monetary Part of union of several EU
Union countries
Countries that Have their Own Currency

System Commitment Countries
Currency board Commitment to exchange domestic currency Hong Kong, Djibouti,
arrangement for a specified foreign currency (USD) at Bulgaria, Bosnia, Brunei
a fixed exchange rate. Currency is (and may
be) only issued when fully backed by
holdings of an equivalent amount of U.S.
dollars
Conventional country pegs its currency within margins UAE, Qatar, Saudi Arabia,
fixed peg of ±1% versus another currency or a basket Nepal, Cameroon, Gabon
arrangement
Target Zone the permitted fluctuations in currency value Slovak republic, Syria
relative to another currency or basket of
currencies are wider (e.g., ±2%)
Crawling peg the exchange rate is adjusted periodically, Nicaragua, Botswana
typically to adjust for higher inflation
Managed width of the bands that identify permissible China, Ethiopia, Uzbekistan,
Crawling peg exchange rates is increased over time Armenia, Guatemala,
(bands) Argentina, Switzerland,
Tunisia, Croatia
Managed float the monetary authority attempts to influence Cambodia, Liberia, Algeria,
(dirty float) the exchange rate in response to specific Iran, Myanmar, Nigeria,
indicators Rwanda, Malaysia, Pakistan,
Russia, Sudan
Independently the exchange rate is market-determined, Australia, Canada, Chile,
floating and foreign exchange market intervention is Japan, Mexico, Norway,
used only to slow the rate of Poland, Sweden, United
change and reduce short-term fluctuations Kingdom, Somalia, United
States, Philippines, Romania,
Serbia, South Africa,
Thailand, Turkey, Uganda,
India

Exchange Rates, International Trade Balance, and Capital

Flow
The relation between the trade deficit, saving, and domestic investment is:
X – M = Private Savings + Government Savings – Investment
We know that (X-M) = (S-I) + (T-G)

where X is exports, M is imports, S is domestic savings, I is private investments, T is tax
revenues and G is government expenditure.
Situation Due to
X-M is positive Positive S-I (excess domestic savings as compared to investments) or
Positive T-G (excess government revenues over expenditure) or
Both - S-I & T-G
X-M is Government is having budget deficit (T-G is negative) and
negative Private savings is insufficient to meet private investments (S-I is negative)
and
Thus, will have to borrow externally
If exchange rate between two countries is expected to change significantly

• then investors will sell currency which is expected to depreciate and buy the currency
which is expected to appreciate
• Asset prices and exchange rate adjust so that potential flow of financial capital is
mitigated, and actual capital flows remains consistent with trade flows
Approaches to Exchange rate & Trade balance

Approaches for Effects of exchange rates on countries’ international trade and capital
flows
The elasticities approach focuses on the impact of Microeconomic view of the
exchange rate changes on relationship between exchange
the total value of imports and rates and the trade balance
on the total value of exports
(Trade)
The absorption approach focuses on the impact of Macroeconomic view of the
exchange rate changes on relationship between exchange
the Capital Flows rates and the trade balance
The Elasticities Approach

The condition that guarantees that devaluations improve the trade balance is called
the Marshall–Lerner condition
ωXεX+ωM(εM−1)>0

Where:
ωX and ωM = the shares of exports and imports, respectively, in total trade
εX and εM = price elasticities of foreign demand for domestic country
exports and domestic country demand for imports, respectively
Outcome:
Higher elastic demand (for either imports or exports) makes it more likely that the trade
balance will improve given currency depreciation.
As the initial trade deficit gets larger, elasticity of import demand becomes more
important, and the export elasticity less important.
Overall, currency depreciation will have a greater effect on the balance of
trade when import or export goods are primarily luxury goods, goods with close
substitutes, and goods that represent a large proportion of overall spending.
J-Curve
• A currency depreciation may initially worsen a trade deficit however, later
on, Importers adjust over time by reducing quantities and the Marshall-Lerner conditions
take effect and the currency depreciation begins to improve the trade balance.
• This short-term increase in the deficit followed by a decrease when the Marshall-Lerner
condition is met is referred to as the J-curve.
The Absorption Approach

Unlike Elasticity Approach which ignores capital flows, the Absorption approach, also
includes a macroeconomic technique that focuses not only on trade inflow but also on
the capital account and can be represented as:
BT = Y – E
Where:
Y = domestic production of goods and services or national income
E = domestic absorption of goods and services, which is total expenditure
BT = Balance of trade

CFA Level 1 – Quick Notes by KRD - ETHICS
ETHICS & TRUST IN INVESTMENT PROFESSION

ETHICS
• A set of shared beliefs about what is good or acceptable behavior and what is bad or
unacceptable behavior.
• Ethical conduct is a behavior that follows moral principles and is consistent with society’s
ethical expectations.
• These Stakeholders include clients of professionals, coworkers, employers, and
the investment profession as a whole.
Role of Code of ethics - Acceptable behavior

• It is a written set of moral principles that can guide behavior by describing what
is considered acceptable behavior.
Need for Ethical Standards

• Investment professionals have a special responsibility to their clients.
• Trust in investment professionals is important than in many other businesses.
• Failure to act in a highly ethical manner can damage – client’s wealth and investment
professionals’ image and overall industry
• A lack of trust in financial advisors will reduce the funds entrusted to them and increase
the cost of raising capital for business investment and growth.
Professionalism and Challenges to Ethical Behavior

Financial professionals have:
Suitability refers to the match between client return requirements and risk
standard tolerances and the characteristics of the securities recommended
Fiduciary requires professionals to use their knowledge and expertise to act in the best
standard interests of the client
Challenges to Ethical behavior

• Individuals tend to overrate the ethical quality of their behavior on a relative basis.
• The external or situational influences are a more important determinant of the ethical
quality of behavior than internal (personal) traits that influence behavior.
• One situational influence is social pressure from others.
• The prospect of acquiring more money or greater prestige can cause individuals
to engage in unethical behavior.
• Too much strict rules-based compliance procedures might lead to unethical behaviour

Ethics vs Legal
• Not all unethical actions are illegal, and not all illegal actions are unethical.
• Whistleblowing, Acts of civil disobedience, Recommending investment in a relative’s firm
without disclosure, etc.
• Ethical principles often set a higher standard of behavior than laws and regulations.
• In the past, some serious unethical behaviors have pushed for stricter laws in capital
markets like the Securities Act of 1933, the Glass-Steagall Act, the Sarbanes-Oxley laws
(followed the accounting scandals at Enron and WorldCom) and the Dodd-Frank Act
followed the 2008 financial crisis.
• Overall, ethical decisions require more judgment and consideration of the impact of
behavior on many stakeholders compared to legal decisions.

CODES OF ETHICS & STANDARDS OF PROFESSIONAL

CONDUCT
The Codes and Structure
• The CFA Institute Professional Conduct Program (PCP) is covered by the CFA Institute
Bylaws and the Rules of Procedure for Proceedings Related to Professional Conduct
• The CFA Institute Board of Governors has overall responsibility for the PCP and
its Disciplinary Review Committee is responsible for enforcing of the Code & Standards
The CFA Institute Professional Conduct staff conducts inquiries related to professional
conduct and there are various circumstances can prompt such an inquiry include:
1. Self-disclosure by members or candidates on their annual Professional Conduct
Statements of involvement in civil litigation or a criminal investigation, or that the
member or candidate is the subject of a written complaint.
2. Written complaints about a member or candidate’s professional conduct that
are received by the Professional Conduct staff.
3. Evidence of misconduct by a member or candidate that the Professional Conduct staff
received through public sources, such as a media article or broadcast
4. A report by a CFA exam proctor of a possible violation during the examination
5. Analysis of exam materials and monitoring of social media by CFA Institute
Once an inquiry has begun, the Professional Conduct staff may request (in writing) an
explanation from the subject member or candidate and may take the below steps:
1. Interview the subject member or candidate,
2. Interview the complainant or other third parties, and/or
3. Collect documents and records relevant to the investigation
The Professional Conduct staff may decide on the below actions:

1. No disciplinary sanctions are appropriate,
2. Issue a cautionary letter, or
3. Discipline the member or candidate.
In a case where the Professional Conduct staff finds a violation has occurred and proposes a
disciplinary sanction, the member or candidate may.
1. Accept or
2. Reject the sanction - If the member or candidate chooses to reject the sanction, the matter
will be referred to a disciplinary review panel of CFA Institute members for a hearing.
Sanctions imposed may include condemnation by the member’s peers or suspension of
candidate’s continued participation in the CFA Program
Codes and Standards - Part II

Code of Ethics
Members of CFA Institute [including Chartered Financial Analyst® (CFA®) charter holders]
and candidates for the CFA designation (“Members and Candidates”) must:
1. Act with integrity, competence, diligence, respect, and in an ethical manner with
the public, clients, prospective clients, employers, employees, colleagues in the
investment profession, and other participants in the global capital markets
2. Place the integrity of the investment profession and the interests of clients above their
own personal interests.
3. Use reasonable care and exercise independent professional judgment when conducting
investment analysis, making investment recommendations, taking investment actions,
and engaging in other professional activities.
4. Practice and encourage others to practice in a professional and ethical
manner that will reflect credit on themselves and the profession.
5. Promote the integrity and viability of the global capital markets for the ultimate benefit
of society.
6. Maintain and improve their professional competence and strive to maintain and
improve the competence of other investment professionals.
The Standards of Professional Conduct

I. Professionalism
II. Integrity of Capital Markets
III. Duties to Clients
IV. Duties to Employers
V. Investment Analysis, Recommendations, and Actions
VI. Conflicts of Interest
VII. Responsibilities as a CFA Institute Member or CFA Candidate

I. STANDARDS OF PROFESSIONAL CONDUCT
I(A) Knowledge of the Law

Standard I(A) Knowledge of the Law:
• Members and Candidates must understand and comply with all applicable laws, rules,
and regulations (including the CFA Institute Code of Ethics and Standards of Professional
Conduct) of any government, regulatory organization, licensing agency, or professional
association governing their professional activities.
• Don’t violate any laws, rules, or regulations that apply to your professional activities. This
includes the Code and Standards, so any violation of the Code and Standards will also
violate this subsection.
• Follow the strictest of these, or, put another way, do not violate any of the three sets of
rules and regulations.
• Strongly encourages members and candidates to report potential Violations by
Coworkers or clients.
• Complaint, disassociate or resign in extreme cases.
Recommendations for Members:

• When in doubt about legality, consult supervisor, compliance personnel or a lawyer.
• When dissociating from violations, keep records documenting the violations, encourage
employer to bring an end to the violations.
• There is no requirement in the Standards to report wrongdoers, but local law may
require it; members are “strongly encouraged” to report violations to CFA Institute
Professional Conduct Program
Recommendations for Firms

• Have a code of ethics.
• Provide employees with information on laws, rules, and regulations governing
professional activities.
• Have procedures for reporting suspected violations.
I(B) Independence and Objectivity

Standard I(B) Independence and Objectivity
• Members and Candidates must use reasonable care and judgment to achieve and
maintain independence and objectivity in their professional activities.
• Members and Candidates must not offer, solicit, or accept any gift, benefit,
compensation, or consideration that reasonably could be expected to compromise their
own or another’s independence and objectivity.
• Members should not let their analysis get influenced by pressure or inducements
otherwise it is a violation.

• Allocating shares in oversubscribed IPOs to personal accounts is a violation.

• Client gifts must be disclosed to the member’s employer prior to acceptance, if
possible.
Recommendations for Members
• Members or their firms should pay for their own travel to company events or tours when
practicable and should also limit the use of corporate aircraft to trips for which
commercial travel is not an alternative.

• Restrict employee participation in IPOs and private placements, require pre-approval
for participation.
• Appoint a compliance officer, have written policies on independence and objectivity and
clear procedures for reporting violations.
• Limit gifts, other than from clients to token items only.
I(C) Misrepresentation
Standard I(C) Misrepresentation
Members and Candidates must not knowingly make any misrepresentations relating to
investment analysis, recommendations, actions, or other professional activities.
Misrepresentation includes:
• Knowingly misleading investors
• Omitting relevant information
• Presenting selective data to mislead investors
• Plagiarism
What is Plagiarism?
• It is using of reports, forecasts, models, ideas, charts, graphs, or spreadsheets
created by others without crediting the source.
• Crediting the source is not required when using projections, statistics, and
tables from recognized financial and statistical reporting services.
• When using models developed or research done by other members of the firm, it
is permitted to omit the names of those who are no longer with the firm as long as the
member does not represent work previously done by others as his alone.
Actions that would violate the Standard include:

• Presenting third-party research as your own, without attribution to the source
• Guaranteeing a specific return on securities (except Govt Sec)
• Selecting a performance benchmark that is not comparable to the investment strategy
employed.
• Presenting performance data or attribution analysis that omits accounts or relevant
variables.

• Offering false or misleading information about the analyst’s or firm’s capabilities,

expertise, or experience
• Using marketing materials from a third party (outside advisor) that are misleading.

• Prepare a summary of experience, qualifications, and services a member is able to
perform.
• Encourage employers to develop procedures for verifying marketing materials provided
by third parties concerning their capabilities, products, and services.
• Cite the source of any summaries of materials provided by others.
• Keep copies of all reports, articles, or other materials used in the preparation of research
reports.
• Provide a list, in writing, of the firm’s available services and qualifications.
• Periodically review documents and communications of members for any
misrepresentation of employee or firm qualifications and capabilities
I(D) Misconduct
Standard I(D) Misconduct
• Members and Candidates must not engage in any professional conduct involving
dishonesty, fraud, or deceit or commit any act that reflects adversely on their
professional reputation, integrity, or competence.
• Members must not try to use enforcement of this Standard against another member to
settle personal, political, or other disputes that are not related to professional ethics
or competence.

• Develop and adopt a code of ethics and make clear that unethical behavior will not be
tolerated.
• Give employees a list of potential violations and sanctions, including dismissal.
• Check references of potential employees.

II. INTEGREITY OF CAPITAL MARKETS
II(A) Material Non-public Information

What is material information?
Information is “material” if its disclosure would affect the price of a security.
What is Nonpublic information?

Information is “nonpublic” until it has been made available to the marketplace.
Mosaic theory
Reaching an investment conclusion through perceptive analysis of public information
combined with non-material nonpublic information is not a violation of the Standard.
Recommendations for Firms:

• Use a firewall within the firm, with elements including.
• Review employee trades
• Maintain “watch,” “restricted,” and “rumor” lists
Restricting the trading:

• Monitor and restrict proprietary trading while a firm is in possession of material nonpublic
information.
• However, prohibiting all proprietary trading while a firm is in possession of material
nonpublic information may be inappropriate because it may send a signal to the market.
In these cases, firms should only take the opposite side of unsolicited customer trades.
II(B) Market Manipulation

• Members and Candidates must not engage in practices that distort prices or artificially
inflate trading volume with the intent to mislead market participants.
• Member actions may affect security values and trading volumes without violating this
Standard.
• The key point here is that if there is the intent to mislead, then the Standard is Violated
like spreading false information to affect prices or volume.

III. DUTIES TO CLIENTS
III(A) Loyalty, Prudence, and Care

Standard III(A) Loyalty, Prudence, and Care
• Members and Candidates have a duty of loyalty to their clients and must act with
reasonable care and exercise prudent judgment.
• Members and Candidates must act for the benefit of their clients and place their clients’
interests before their employer’s or their own interests.
• Do not discriminate against any clients when disseminating recommendations or taking
investment action.
Members and candidates must:

• Make investment decisions in the context of the total portfolio.
• Inform clients of any limitations in an advisory relationship (e.g., an advisor who may
only recommend her own firm’s products)
• Vote proxies in an informed and responsible manner
• Client brokerage, or “soft dollars” must be used to benefit the client only.

• Submit to clients, at least quarterly, itemized statements showing all securities in custody
and all debits, credits, and transactions.
Encourage firms to address these topics when drafting policies and procedures regarding
fiduciary duty:
• Follow applicable rules and laws.
• Establish investment objectives of client.
• Consider suitability of a portfolio relative to the client’s needs and circumstances, the
investment’s basic characteristics, or the basic characteristics of the total portfolio
• Seek best execution.
III(B) Fair Dealing

Standard III(B) Fair Dealing
Members and Candidates must deal fairly and objectively with all clients when providing
investment analysis, making investment recommendations, taking investment action, or
engaging in other professional activities.
“Fairly” does not mean “equally.”

• There will be differences in the time emails, faxes, and other communications are
received by different clients.

• Different service levels are acceptable, but they must not negatively affect or
disadvantage any clients.
• Disclose the different service levels to all clients and prospects, and make premium levels
of service available to all those willing to pay for them.
So how to treat with different clients?

• Give all clients a fair opportunity to act on every recommendation.
• Clients who are unaware of a change in the recommendation for a security should be
advised of the change before an order for the security is accepted.
• Members and candidates should not take advantage of their position in the industry
to disadvantage clients (e.g., taking shares of an oversubscribed IPO)

• Encourage firms to establish compliance procedures requiring proper dissemination of
investment recommendations and fair treatment of all customers and clients.
• Maintain a list of clients and holdings—use to ensure that all holders are treated fairly.

• Limit the number of people who are aware that a change in recommendation will be
made & shorten the time frame between decision and dissemination.
• Publish personnel guidelines for pre-dissemination—have in place guidelines.
• Disseminate new or changed recommendations simultaneously to all clients who have
expressed an interest or for whom an investment is suitable.
• Develop written trade allocation procedures—ensure fairness to clients, timely and
efficient order execution, and accuracy of client positions.
• Disclose trade allocation procedures.
• Establish systematic account review—ensure that no client is given preferred treatment
and that investment actions are consistent with the account’s objectives.
• Disclose available levels of service.
III(C) Suitability
Standard III(C) Suitability
• In advisory relationships, members must gather client information at the beginning of
the relationship, in the form of an investment policy statement (IPS).
• Consider clients’ needs and circumstances and, thus, their risk tolerance.
• Consider whether the use of leverage is suitable for the client.
Unsolicited Trade Requests

When the trade is unsuitable for the client but client request to purchase a security,

the manager should not make the trade until she has discussed with the client the reasons
(based on the IPS) that the trade is unsuitable for the client’s account even if the trade may or
may not have a material effect on the risk characteristics of the client’s total portfolio.
1. If the effect is minimal then after discussing with the client, the manager may follow his
firm’s policy about unsuitable trades. However, regardless of firm policy, the client must
acknowledge the discussion and an understanding of why the trade is unsuitable.
2. However, if there is a material impact on the risk/return profile of the client’s total
Portfolio then the manager may:
• Update the IPS so the client accepts a changed risk profile that would permit the trade.
• If the client will not accept a changed IPS, the manager may follow firm policy, which
may allow the trade to be made in a separate client-directed account.
• In the absence of other options, the manager may need to reconsider whether to maintain
the relationship with the client.

• For each client, put the needs, circumstances, and investment objectives into a written IPS.
• Review the investor’s objectives and constraints periodically to reflect any changes in
client circumstances.
III(D) Performance Presentation

Standard III(D) Performance Presentation
When communicating investment performance information, Members and Candidates must
make reasonable efforts to ensure that it is fair, accurate, and complete.
• Members must not misstate performance or mislead clients or prospects about their
investment performance or their firm’s investment performance.
• Members must not misrepresent past performance or reasonably expected performance
and must not state or imply the ability to achieve a rate of return similar to that achieved
in the past.
• For brief presentations, members must make detailed information available on
request and indicate that the presentation has offered only limited information.

• Encourage firms to adhere to Global Investment Performance Standards
• Consider the sophistication of the audience to whom a performance presentation is
addressed.
• Present the performance of a weighted composite of similar portfolios rather than the
performance of a single account.
• Include terminated accounts as part of historical performance and clearly state when
they were terminated.
• Include all appropriate disclosures to fully explain results (e.g., model results included,
gross or net of fees, etc.)
• Maintain data and records used to calculate the performance being presented.

III(E) Preservation of Confidentiality

Standard III(E) Preservation of Confidentiality
Members and Candidates must keep information about current, former, and prospective
clients confidential unless:
1. The information concerns illegal activities on the part of the client.
2. Disclosure is required by law; or
3. The client or prospective client permits disclosure of the information.
• The confidentiality Standard extends to former clients as well.
• If illegal activities by a client are involved, members may have an obligation to report the
activities to authorities.
• The requirements of this Standard are not intended to prevent members and candidates
from cooperating with a CFA Institute Professional Conduct Program (PCP) investigation.

• Members should avoid disclosing information received from a client except to
authorized coworkers who are also working for the client.
• Members should follow firm procedures for storage of electronic data and recommend
adoption of such procedures if they are not in place.

IV. DUTIES TO EMPLOYERS
IV(A) Loyalty
Standard IV(A) Loyalty
• In matters related to their employment, Members and Candidates must act for the benefit
of their employer and not deprive their employer of the advantage of their skills and
abilities, divulge confidential information, or otherwise cause harm to their employer
• There is no requirement that the employee put employer interests ahead of family and
other personal obligations; it is expected that employers and employees will discuss such
matters and balance these obligations with work obligations.
• Independent practice for compensation is allowed if a notification is provided to the
employer fully describing all aspects of the services, including compensation, duration,
and the nature of the activities and the employer consents to all terms of the proposed
independent practice before it begins.
When leaving an employer, members must continue to act in their employer’s best interests
until their resignation is effective. Activities that may constitute a violation include:
• Misappropriation of trade secrets
• Misuse of confidential information
• Soliciting employer’s clients prior to leaving
• Self-dealing
• Misappropriation of client lists
• Employer records on any medium (e.g., home computer, tablet, cell phone) are the
property of the firm.
Activities that may not constitute a violation include:

• When an employee has left a firm, simple knowledge of names and existence of
former clients is generally not confidential.
• There is also no prohibition on the use of experience or knowledge gained while with a
former employer.
• If an agreement exists among employers (e.g., the U.S. “Protocol for Broker Recruiting”)
that permits brokers to take certain client information when leaving a firm, a member
may act within the terms of the agreement without violating the Standard.

• Members and candidates must adhere to their employers’ policies concerning social
media. Best practice is to use separate social media accounts for personal and
professional communications.
• Members are encouraged to give their employer a copy of the Code and Standards.

• Employers should not have incentive and compensation systems that encourage
unethical behavior.
IV(B) Additional Compensation Arrangements

Standard IV(B) Additional Compensation Arrangements
• Members and Candidates must not accept gifts, benefits, compensation, or
consideration that competes with or might reasonably be expected to create a conflict
of interest with their employer’s interest unless they obtain written consent (includes
email communication) from all parties involved.
• Compensation includes direct and indirect compensation from a client and other
benefits received from third parties.
Additional compensation arrangement v/s a gift from a client:

Additional compensation Gift
If a client offers a bonus that depends on If a client offers a bonus to reward a member for
the future performance of her account her account’s past performance
It requires written consent in advance It requires disclosure to the member’s employer to
comply with Standard I(B) Independence and
Objectivity

• Make an immediate written report to the employer detailing any proposed
compensation and services, if additional to that provided by the employer.
• Members and candidates who are hired to work part time should discuss any
arrangements that may compete with their employer’s interest at the time they are
hired and abide by any limitations their employer identifies.

• Details of additional compensation, including any performance incentives, should
be verified by the offering party.
IV(C) Responsibilities of Supervisors

Standard IV(C) Responsibilities of Supervisors
• Members and Candidates must make reasonable efforts to ensure that anyone subject to
their supervision or authority complies with applicable laws, rules, regulations, and the
• Make reasonable efforts to detect violations.
• They have an obligation to bring an inadequate compliance system to the attention of
firm’s management and recommend corrective action.

• A member or candidate faced with no compliance procedures or with procedures he

believes are inadequate must decline supervisory responsibility in writing until
adequate procedures are adopted by the firm.
• If there is a violation, respond promptly and conduct a thorough investigation while
increasing supervision or placing limitations on the wrongdoer’s activities.
A member should recommend that his employer adopt a code of ethics & should encourage
employers to provide their codes of ethics to clients.
Once the compliance program is instituted, the supervisor should:

• Distribute it to the proper personnel.
• Update it as needed.
• Continually educate staff regarding procedures
• Issue reminders as necessary
• Require professional conduct evaluations.
• Review employee actions to monitor compliance and identify violations.

• Employers should not commingle compliance procedures with the firm’s code of
ethics—this can dilute the goal of reinforcing one’s ethical obligations.
• While investigating a possible breach of compliance procedures, it is appropriate to limit
the suspected employee’s activities.
Adequate compliance procedures should:

• Be clearly written & easy to understand.
• Designate a compliance officer with authority clearly defined.
• Have a system of checks and balances.
• Outline the scope of procedures.
• Outline what conduct is permitted.
• Contain procedures for reporting violations and sanctions.
• Structure incentives so unethical behavior is not rewarded.

V. INVESTMENT ANALYSIS, RECOMMENDATION AND

ACTIONS
V(A) Diligence and Reasonable Basis

Standard V(A) Diligence and Reasonable Basis
Members and Candidates must:
1. Exercise diligence, independence, and thoroughness in analyzing investments, making
investment recommendations, and taking investment actions.
2. Have a reasonable and adequate basis, supported by appropriate research and
investigation, for any investment analysis, recommendation, or action.
The level of research needed to satisfy the requirement for due diligence will differ
depending on the product or service offered. A list of things that should be considered prior
to making a recommendation or taking investment action includes:
• Global and national economic conditions
• A firm’s financial results and operating history, and the business cycle stage
• Fees and historical results for a mutual fund
• Limitations of any quantitative models used.
• A determination of whether peer group comparisons for valuation are appropriate.

Members should encourage their firms to adopt a policy for periodic review of the quality
of third-party research, if they have not
Examples of criteria to use in judging quality are:

• Review assumptions used.
• Determine how rigorous the analysis was.
• Identify how timely the research is.
• Evaluate objectivity and independence of the recommendations.
• Adopt a set of standards that provides criteria for evaluating external advisers and
states how often a review of external advisers will be performed
V(B) Communication with Clients & Prospective

Clients
Members and Candidates must:

1. Disclose to clients and prospective clients the basic format and general principles of the
investment processes and must promptly disclose any changes that might materially
affect those processes.
2. Disclose to clients and prospective clients’ significant limitations and risks
associated with the investment process.
3. Use reasonable judgment in identifying which factors are important to their investment
analyses.
4. Distinguish between fact and opinion in the presentation of investment analyses and
recommendations (Expectations based on statistical modeling and analysis are not facts)

• All means and types of communication with clients are covered by this Standard, not
just research reports or other written communications.
• Members must communicate significant changes in the risk characteristics.
• When using projections from quantitative models and analysis, members may violate the
Standard by not explaining the limitations of the model and the assumptions.
V(C) Record Retention

Standard V(C) Record Retention
• Members must maintain research records that support the reasons for the analyst’s
conclusions and any investment actions taken.
• All communications with clients through any medium, including emails and text
messages, are records that must be retained.
• A member who changes firms must re-create the analysis documentation supporting her
recommendation using publicly available information or information obtained from the
company and must not rely on memory or materials created at her previous firm

If no regulatory standards or firm policies are in place, the Standard recommends a seven-
year minimum holding period.

• This record keeping requirement generally is the firm’s responsibility.

VI. CONFLICTS OF INETERST
VI(A) Disclosure of Conflicts

• Members and Candidates must make full and fair disclosure of all matters that could
reasonably be expected to impair their independence and objectivity or interfere with
respective duties to their clients, prospective clients, and employer.
• Members and Candidates must ensure that such disclosures are prominent, are delivered
in plain language, and communicate the relevant information effectively.
Examples of Disclosures can be:

• Broker-dealer market making activities.
• Board service.
• Ownership of stock in companies that the member recommends or that clients hold
• Member’s compensation/bonus structure

• Members must give their employers enough information to judge the impact of a
conflict, take reasonable steps to avoid conflicts, and report them promptly if they occur.
• Any special compensation arrangements, bonus programs, commissions, and incentives
should be disclosed.
VI(B) Priority of Transactions

• Investment transactions for clients and employers must have priority over investment
transactions in which a member or Candidate is the beneficial owner.
• Personal transactions may be undertaken only after clients and the member’s employer
have had an adequate opportunity to act on a recommendation.
• Note that family member accounts that are client accounts should be treated just like any
client account; they should not be disadvantaged.
• Members must not act on information about pending trades for personal gain (Front
running)
• When requested, members must fully disclose to investors their firm’s personal trading
policies.

• Members can avoid conflicts that arise with IPOs by not participating in them.
• Members should encourage their firms to adopt the procedures listed in the following
recommendations for firms if they have not done so.

All firms should have basic procedures in place that address conflicts created by personal
investing. The following areas should be included:
• Establish limitations on employee participation in equity IPOs.
• Establish restrictions on participation in private placements.
• Establish blackout/restricted periods.
VI(C) Referral Fees

Standard VI(C) Referral Fees
• Members and Candidates must disclose to their employer, clients, and prospective
clients, as appropriate, any compensation, consideration, or benefit received from or
paid to others for the recommendation of products or services.
• Members must inform employers, clients, and prospects of any benefit received
for referrals of customers and clients, allowing them to evaluate the full cost of the
service as well as any potential partiality.
• All types of consideration must be disclosed.

• Members should encourage their firms to adopt clear procedures regarding compensation
for referrals.
• Members should provide their employers with updates at least quarterly.

• Firms that do not prohibit referral fees should have clear procedures for approval and
policies regarding the nature and value of referral compensation received.

VII. RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR

CFA CANDIDATE
VII(A) Conduct as Participants in CFA Institute

Programs
Members and Candidates must not engage in any conduct that compromises the reputation
for integrity of CFA Institute or the CFA designation or the integrity, validity, or security of
CFA Institute programs. Members must not engage in any activity that undermines the
integrity of the CFA charter.
This Standard applies to conduct that includes:

• Cheating on the CFA exam or any exam
• Revealing anything about either broad or specific topics tested, content of exam
questions, or formulas required or not required on the exam.
• Not following rules and policies of the CFA Program
• Giving confidential information on the CFA Program to candidates or the public
• Improperly using the designation to further personal and professional goals
• Misrepresenting information on the Professional Conduct Statement (PCS) or the CFA
Institute Professional Development Program.

• Members and candidates are not precluded from expressing their opinions regarding
the exam program or CFA Institute but must not reveal confidential information about the
CFA Program
• Members who volunteer in the CFA Program may not solicit or reveal information
about questions considered for or included on a CFA exam, about the grading process,
or about scoring of questions.
VII(B) Reference to CFA - Institute, Designation

Program
When referring to CFA Institute, CFA Institute membership, the CFA designation, or
candidacy in the CFA Program:
• Members and Candidates must not misrepresent or exaggerate the meaning or
implications of membership in CFA Institute, holding the CFA designation, or candidacy in
the CFA Program
• Members must not make promotional promises or guarantees tied to the CFA
designation, such as over-promising individual competence or over-promising investment
results in the future (i.e., higher performance, less risk, etc.)

• There is no partial CFA designation.

• It is acceptable to state that a candidate successfully completed the program in three
years if, in fact, he did, but claiming superior ability because of this is not permitted.
Members must satisfy these requirements to maintain membership:

• Sign the PCS (professional conduct statement) annually.
• Pay CFA Institute membership dues annually.
If they fail to do this: Members are no longer active members.

Members should be sure that their firms are aware of the proper references to a
member’s.

Global Investment Performance Standards (GIPS®)

GIPS - Meaning, need & Importance:
• GIPS are a set of ethical principles based on a standardized, industry-wide approach.
• Investment firms can voluntarily follow GIPS in their presentation of historical investment
results to prospective clients.
• These standards seek to avoid misrepresentations of performance.
• GIPS apply to investment management firms and are intended to serve prospective and
existing clients of investment firms.
• GIPS allow clients to more easily compare investment performance among investment
firms and have more confidence in reported performance.
• Main objective is to - promote global “self-regulation”.
Composites
A composite is a grouping of individual discretionary portfolios representing a similar
investment strategy, objective, or mandate. Examples of possible composites are “Large
Capitalization Growth Stocks” and “Investment Grade Domestic Bonds”, etc.
What should a composite include?

• A composite, such as International Equities, must include all fee-paying, discretionary
portfolios (current and past) that the firm has managed in accordance with particular
strategy.
• The firm should identify which composite each managed portfolio is to be included
in before the portfolio’s performance is known. This prevents firms from choosing
portfolios to include in a composite in order to create composites with superior returns.
Key Characteristics of GIPS

• To claim compliance, an investment management firm must define its “firm.” This
definition should reflect the “distinct business entity” that is held out to clients and
prospects as the investment firm.
• Include all actual fee-paying, discretionary portfolios in composites for a minimum
of five years or since firm or composite inception.
• After presenting five years of compliant data, the firm must add annual performance
each year going forward up to a minimum of 10 years.
• For firms or composites in existence less than five years, compliant performance since
inception must be presented in order to claim compliance.
• After the initial compliant performance presentation, one year of compliant performance
must be added each year to a required (minimum) performance history of 10 years.
• Firms are required to use certain calculation and presentation standards and make
specific disclosures.
• Input data must be accurate.

• GIPS contain both required and recommended provisions and firms are encouraged to
adopt the recommended provisions.
• Firms are encouraged to present all pertinent additional and supplemental information.
• There will be no partial compliance and only full compliance can be claimed.
• Follow the local laws for cases in which a local or country-specific law or regulation
conflicts with GIPS but disclose the conflict.
• Certain recommendations may become requirements in the future.
INDEPENDENT VERIFICATION
• Firms are encouraged to pursue all independent verification.
• Verification applies to entire firm.
• If decide to verification, then it should be done by Independent third party only.
• The third party must attest: the firm has complied with all GIPS requirement on a firm
wide basis and all process and procedures are established.

CFA Level 1 – Quick Notes by KRD - CORP
CORPORATE STRUCTURE AND OWNERSHIP

Types of Business Structures
Business Structure:
It refers to how businesses are set up from a legal and organizational point of view.
Sole Proprietorship - It is operated by an Individual, Generally, tends to be on a small

scale. The owner is personally responsible for claims against the business and therefore has
unlimited liability.
General Partnership - The partnership of two or more individuals. The partnership

agreement specifies the terms of sharing profits and losses. Partners have unlimited
liability.
Limited Partnership
• Involves two levels of Partners - General Partner and Limited Partner
• The Limited partner/s have liability limited to the extent of invested capital only.
• The General partners run the operations and keep a major portion of Profits.
• The partnership agreement specifies the terms of sharing of profits and losses.
• Most Hedge Funds, Legal and Accounting Firms, etc. are formed under this structure.
Public vs. Private Company

Corporation - There are two forms of Corporates:
Public • Shares sold and traded in Public Ex. Apple INC.,
Company • Primary Markets – Co. can Sell shares in open (IPO) for all to buy/sell
• Secondary Markets – Exchanges whereby the shares once listed on the
exchange can be bought or sold.
Private • Shares not sold to Public Ex. National Oil Company
Company • Hence, not subjected to the strict regulations of the SEC and have
relatively fewer reporting requirements
Ways to Convert a Private Company to a Public Company:

• IPO (Public or Private)
• Being Acquired by a Public Company
• Direct listing of Private Company’s Shares on Exchange
• SPAC (Special Purpose Acquisition Company) - A Blank Cheque Company

Ways to Convert a Public Company to a Private Company:

• LBO (MBO)
• Delisting of Shares
Financial Claims and Motivations

Debt Holders:
Debt Holders have a legal claim to interest and principal and are paid before the Equity
Owners
Equity Owners
Can be Preferred or Common Equity. They have a residual Claim. Common Equity has an
Upside potential but also has the last priority in the event of Liquidation and therefore
highest risk.

Introduction to Corporate Governance and ESG

Corporate Governance (CG):
• It is a system of internal controls and procedures by which individual companies are
managed.
• Shareholder theory: management's responsibility is to maximize shareholder returns.
• Stakeholder theory: focus broadens beyond shareholders and includes customers,
suppliers, employees etc.
Primary stakeholders:
Shareholders, creditors, managers, employees, board of directors, customers, suppliers,
government/regulators and affected community groups
Board of directors:
• In a one-tier board structure, both company executives and non-executive board
members serve on a single board of directors.
• In some countries, boards have a two-tier structure (Europe) in which the non-
executive board members serve on a supervisory board that oversees a
management board, made up of company executives.
Principal - agent and other relationships in corporate governance:

• Principal-agent relationship is created when a principal (shareholders) hires an
agent (managers) to perform a task or to provide service, Ex. Insurance agent

• The relationship involves obligations, trust and expectation of loyalty.

• Agent expected to act in the best interests of the principal.
• Conflicts arise when managers as agents do not act in the best interest of
shareholders who are the principals.
Different types of Principle Agent Conflicts are as follows:
Shareholder and Manager/Director Relationships

• Managers concerned with maximizing their own compensation.
• Managers and directors are typically more risk averse than shareholders.
• Managers have greater access to info about the business and are more
knowledgeable about operations than shareholders.
• The board is influenced by insiders or by certain influential shareholder groups.
Controlling and Minority Shareholder Relationships

• Straight voting (i.e., one vote for one share owned) controlling shareholders hurt
minority shareholders’ financial interests.
• Related-party transactions: when a controlling shareholder has a financial interest
in a transaction between the company and a third party and the transaction affects
the best interests of the company. Related-party transactions benefit the controlling
shareholder at the expense of the minority shareholder.
• Multiple classes of shares with differential voting rights: Many founders,
executives and key insiders hold ownership of shares with superior voting power
in companies.
Manager and Board Relationships

• Board’s ability to monitor company is dependent on the quantum of information
provided by the management to the board.
• Mostly impacts performance of non-executive directors since they are not
employees and not well-versed with day-to-day operations of company.
Shareholder versus Creditor Interests

• Shareholders are likely to prefer riskier projects for gaining higher returns, but
creditors would prefer stable performance and lower risk activities.
• Creditors are concerned when management increases borrowings beyond level
that could potentially lead to default (default risk).
• Distribution of high dividends from earnings by management could also impact the
potential to pay interest and principal.
Other Stakeholder Conflicts:

• Between customers and shareholders: Company increases prices or reduces safety
features to cut costs.

• Between customers and suppliers: Ability to repay suppliers affected when

company extends generous credit to customers.
• Between shareholders and governments or regulators: Adoption of accounting or
reporting practices that could reduce taxes and increase profits.
Stakeholder management:
It refers to the management of company relations with stakeholders and is based on
having a good understanding of stakeholder interests and maintaining effective
communication with stakeholders.
The management of stakeholder relationships is based on four types of infrastructures:

• The legal infrastructure identifies the laws relevant to and the legal recourse of
stakeholders when their rights are violated.
• The contractual infrastructure refers to the contracts between the company and its
stakeholders that spell out the rights and responsibilities of the company and the
stakeholders.
• The organizational infrastructure refers to a company’s corporate governance
procedures, including its internal systems and practices that address how it
manages its stakeholder relationships.
• Governmental infrastructure comprises the regulations to which companies are
subject.
Mechanisms of Stakeholder Management:
General Meetings
Participation in general meetings with the right to attend, speak, and exercise voting rights
• The Annual General Meeting (AGM) is held within a few weeks of the close of the
financial year.
• Extraordinary General Meetings (EGM) can be called at any time by management
or even shareholders to pass significant resolutions.
• Proxy voting: the ability to vote through the proxy without the physical presence of
shareholders at general meetings.
• Cumulative voting: Accumulation and use of cumulative votes for one or a limited
number of board nominees. Enhances the likelihood that interests are represented
on board.
Composition of the Board of Directors:

Depending on the company and geography a one-tier or two-tier structure is followed:
• One tier - there is a single board of directors that includes both internal (executive)
and external directors (non-executive), the Chairman and CEO can be the same.

• Two-tier - there is a supervisory board (non-executive) and the management

board (executive). Separation of Chairman & CEO.
• Staggered Boards: Generally, board membership tenure is for 3 years with the
option of simultaneous elections or staggered elections (around 1/3rd of the
board could be elected each year)
Board of Directors Committees

Committees focus on specific functions and provide recommendations to the board.
Audit Committee
• The Audit Committee is independent of management & it is a regulatory
requirement in most countries to have an audit committee.
• In most countries, the majority composition is from independent directors.
Governance Committee
• The primary role of adopting good governance practices, code of ethics, conflict of
interest policy and compliance with applicable laws and regulations.
Remuneration or Compensation Committee
• Proposes remuneration policies for Directors & key executives for approval by the
board or shareholders.
• May also be involved with remuneration and benefits packages for senior
management and employees.
Nomination Committee
• Forms policies and criteria for board nomination and election.
• Identifies candidates for director’s posts for election by shareholders.
Risk Committee
• Assists board in determining risk policy, profile and appetite for the company.
• Oversees enterprise risk management plans, monitors implementation and
supervises risk management functions.
• The risk committee is mandatory in some countries in the banking industry.
Investment Committee
• Establishing and revising the investment strategy and policies of the company.
Reviews capex/ investments in large projects.
Potential risks of poor corporate governance and stakeholder management:

• Risks of Poor Governance and Stakeholder Management (misconduct)
• Weak Control Systems (poor audit)
• Ineffective Decision Making (Management overconfidence)
• Legal, Regulatory, and Reputational Risks (regulatory investigations)
• Default and Bankruptcy Risks
Benefits of Effective Governance and Stakeholder Management

• Operational efficiency (adequate internal control mechanism)

• Improved control (early detection of risks)

• Better Operating and Financial Performance (reduces risks and avoids indirect
costs)
• Lower Default Risk and Cost of Debt
Analyst Considerations in Corporate Governance and Stakeholder Management

Annual reports, proxy statements and other reports published by companies provide useful
insights into the quality of management and sources of potential risk.
• Economic Ownership and Voting Control (Avoid dual structure shares)
• Board of Directors Representation (Qualified, Independent, experienced,
regularity)
• Remuneration and Company Performance
• Warning signs that may require scrutiny (Plans offering only cash salary with no
equity, excessive payouts in comparison with peers)
• Investors in the Company (avoid those with presence of a large, affiliated
stakeholder with the founder)
• Strength of Shareholders’ Rights (proper governance standards regarding
disclosures, board composition, shareholder rights and related issues)
• Managing Long-Term Risks (Managing environmental risks, human capital,
transparency and managing shareholder relationships)
ESG:
ESG investing is also termed sustainable investing or responsible investing and
sometimes socially responsible investing.
ESG Considerations for Investors:

• Socially Responsible Investing (SRI) is the practice of excluding companies and

industries that are in opposition to an investor’s moral or ethical values. Ex: tobacco,
gambling, weapons etc.
• Impact investing seeks to achieve targeted social or environmental objectives along
with measurable financial returns through engagement with management or by
direct investing.
There are several approaches to integrating ESG factors into the portfolio management
process.
Negative screening:
• Refers to excluding specific companies or industries from consideration for the
portfolio based on their practices regarding human rights, environmental concerns, or
corruption.
Positive or best-in-class screening:
• Under this approach, investors attempt to identify companies that have positive ESG
practices.
• A related approach, the relative/best-in-class approach, seeks to identify companies
within each industry group with the best ESG practices.
Full integration:
• It refers to the inclusion of ESG factors or ESG scores in traditional fundamental
analysis.
• A company’s ESG practices are included in the process of estimating fundamental
variables, such as a company’s cost of capital or future cash flows.
Thematic investing:
• It refers to investing in sectors or companies in an attempt to promote specific ESG-
related goals, such as more sustainable practices in agriculture, greater use of
cleaner energy sources, improved management of water resources, or the reduction
of carbon emissions.
Engagement/active ownership investing:
• It refers to using ownership of company shares or other securities as a platform to
promote improved ESG practices.
• Share ownership is used to initiate or support (through share voting) positive ESG
changes.
Green Finance Approach:
• Green finance refers to producing economic growth in a more sustainable way by
reducing emissions and better managing natural resource use.
• An important part of green finance is the issuance of green bonds - bonds for which
the funds raised are used for projects with a positive environmental impact.

Business Models and Risks

Business Model vs. Financial Plan
• Business Models - How the Company Plans to make money by offering
products/services, acquiring customers, delivering the product, etc.
• Financial Plan - Projections of revenue, expenses and other financials of the Company.
Essentials of Business Model

Identify the firms’ Cost of Acquiring customer
potential customers How to acquire and
How to Monitor their satisfaction
Describe the firm’s How it meets user’s needs?
product or service How is it different from others?
How the firm plans Direct Sales: Directly selling like TESLA, etc.
to sell Through Intermediaries: Wholesalers, Retailers, Agents,
Franchisees.
Channel Strategy: both Physical and digital channels aka
Omnichannel strategy Like D-mart, Walmart, Lenskart, etc. internet
sales and physical delivery location also
B2B: Sells to other Business.
B2C: Sells to Consumers
Key Assets and Key Asset: Patent, Software, Employee (like Scientists of Engineers)
Key Suppliers Key Suppliers: Large machinery, essential commodity, chip makers
Pricing Strategy Explains why buyers will pay the price given the competition
Pricing Strategy - Explains why buyers will pay that price for their product.
Value based Pricing Setting prices based on the Value received or perceived
Cost based Pricing Setting prices based on the Cost of Producing the goods/services
i.e., Cost + Profit
Price Discrimination - maximizing revenues where different customers have different

willingness to pay.
Tiered (level)Pricing Prices change based on Volume purchased
Dynamic Pricing Different prices at different times
Auction Pricing Establish pricing through bidding
Pricing Models for Multiple Products - Pricing models used by firms selling multiple or
complex products.

Bundling Combining multiple products/services together so that customers

buy them together
Razors and Blades Combining Low price equipment with high margin price on repeat
or complimentary product
Optional Products Buying additional service now or later along with the product
Penetration Pricing Discount pricing and sometimes selling below cost
Freemium Pricing Allows customers a certain level of usage for free and later collect
from a wider reach
Hidden Revenue Service at no charge but make revenue elsewhere
Alternatives to Outright Purchase Models - Alternative to purchasing an asset or product.

Subscription Model Enables customers to “rent” a product or service for as long as they
need it
Fractional Creates value by selling an asset in smaller units or through the use
Ownership at different times
Leasing Leasing instead of paying high capital and maintenance cost
Licensing Licensing typically gives a firm access to intangible assets
Franchising Franchising is a more comprehensive form of licensing. Here, the
franchisor typically gives the franchisee the right to sell or distribute
its product or service in a specified territory
Value Proposition, Value Chain and Supply Chain

Value Proposition What Customers Value as important feature of the Product/service
Value Chain How Company executes the Value Proposition
Supply Chain Every steps required in producing and delivering products
Other Business Models - Variations in Business Models

Private Label Manufacturers Cos. produce for others to market under their own brand
Licensing agreements Brand is used by another company on its products for Fee
Value added resellers Offers additional support like installation, Customization
Asset light Model Assets Owned by Franchise rather than Parent
Lean Start-up Outsourcing, using Technology
Pay in advance Model Reduce need of working capital
Ecommerce Models - encompassing a variety of internet-based direct sales models. The a

few key business model variations within e-commerce include:

Affiliate Marketing Type of advertising where a firm pays third-party publishers

to create traffic or leads to its products and services.
Marketplace Business Create networks of buyers and sellers without taking
ownership of the goods during the process
Aggregators Are like marketplaces, but the aggregator remarkets products
and services under its own brand
Network effects Increase in value of a network to its users as more users join
Crowdsourcing Enable users to contribute directly to a product, service, or
online content
Hybrid Business Models Combining platform and traditional “linear” businesses
Impact of External relations on Business Models

Changes in Economic Inflation, Interest rates, High Capex industries are more
Conditions affected
Changes in Demographics Consumer Tastes and preferences change - Coca Cola
Changes in Legal, Political War, Civil unrest, Change in Government
and regulatory
Macro, Business & Financial Risks faced by Companies.

Macro risks Risk to Operating Profit from factors like Economic, Political, Legal,
Demographic
Business risks Risk to Operating Profit from factors which are:
Industry Specific: Revenue Elasticity, Industry Structure, Competitive
intensity, Growth, and demand expectations, regulatory, etc.
Firm-Specific: Competitive risk, Product market risk, Capital investment
risk (M&A), ESG risk (reputation), Operating leverage
Financial risks Risk to Net Profit from factors like Capital structure (leverage) and fixed
costs related to Leases, underfunded pensions

Capital Investments
Capital Allocation Process - Identifying and evaluating Capital Projects
The capital allocation process has four administrative steps:
1. Generating idea: idea can come from anywhere from top to bottom of the
organization or from outside.
2. Analyzing individual proposals: This step includes forecasting cash flows and
profitability of the proposal and analyzing them.
3. Planning the capital budget: This step includes scheduling and prioritizing projects.
4. Monitoring and post-auditing: In a post-audit, actual results are compared to
planned or predicted results, and any differences must be explained.
Categories of Capital Investments or Capital Budgeting Projects:

• Replacement projects: These are projects to maintain the business or to reduce the
cost. The decision whether to replace the old machine is easy to analyze, may not
require detailed analysis.
• Expansion projects: Expansion projects increase the size of the business. These
expansion decisions may involve more uncertainties than replacement decisions,
and these decisions will be more carefully considered.
• New products and services or Market development: More complex and uncertain
than expansion projects, it involves more people in decision making process.
• Mandatory projects: Regulatory, safety, and environment projects: These projects
are frequently required by a governmental agency, an insurance company, or some
other external party. They may generate no revenue and might not be undertaken
by a company maximizing its own private interests.
• Other: Pet projects of management and very risky projects like R&D, they escape
conventional capital budgeting analysis like NPV or IRR which is faced by other
projects
Principles of Capital Allocation Process:

• Sunk costs are not considered in capital budgeting decisions.
• Opportunity cost (worth of a resource in its next best use) must be considered.
• Incremental cash flow is only to be considered and that too After Tax.
• Externality can be positive or negative (Cannibalization) and must be considered.
• Financing Cost (interest) to be Ignored.
• Consider timing of cash flow (Time Value of Money)
Conventional vs. unconventional cash flows:

• A conventional cash flow- an initial outflow followed by a series of inflows.
• In a Non-Conventional cash flow pattern – the initial outflow is not followed by
inflows only, but the cash flows can flip from positive to negative again or even
change signs several times.

Types Independent projects Mutually exclusive

Meaning Projects are unrelated to each Only one project in a set of possible
other & each project is evaluated projects can be accepted and
on its own profitability that the projects compete
Selection If project A & B are profitable Only one of the projects will be
accept both selected
Assumption Unlimited funds Capital rationing
Capital Allocation Pitfalls

• Failing to incorporate economic response.
• Misusing standard templates (may result in estimation errors)
• Pet projects of senior management (overly optimistic)
• Basing investment decision on EPS or ROE (instead of CFAT)
• Using IRR criterion for project decisions (instead of NPV)
• Poor Cash Flow estimation
• Misestimating overhead cost (over or underestimation)
• Using incorrect WACC
• Failure to generate alternative ideas.
• Ignoring opportunity cost & Including sunk cost
Real Options in Project

• Real options are actions that a firm can take in the invested project today.
• They are like Call and Put and are always positive.
• The Value of Options should be included in the Project's NPV
Types of Real Options include:

Timing Option Allows to delay the project investment
Abandonment Option Put Option - Can exit the Project before completion
Expansion Option Call Option - Allows to make additional investments in future
should the Co. decide to take if it thinks it can create value
Fundamental Option Project Payoffs depend on the Price of Underlying (like mining)
Flexibility Option Choices regarding operation aspect of Project
Price Setting Flexibility Allows company to change pries of the product (if the demand
is high)
Production Flexibility Allows company to change the input of the product (like
paying worker overtime, changing materials as inputs, etc.)

Net Present Value (NPV):

• NPV is the sum of the present values of all the expected incremental cash flows if a
project is undertaken. NPV = PVCI – PVCO.
• The discount rate used is the firm’s cost of capital, adjusted for the risk level of the
project.
Accept/reject Decision for independent projects:

If NPV>0 Accept
If NPV<0 Reject
If NPV=0 Indifferent
In the case of Mutually exclusive projects: Select the one with the highest NPV.
Internal Rate of Return (IRR):

• The IRR is the discount rate that makes the present value of the expected incremental
after-tax cash inflows equal to the initial cost of the project.
• The minimum IRR that a firm requires internally for a project to be accepted is often
referred to as the hurdle rate.
• Therefore, at IRR: PV (inflows) = PV (outflows) & NPV = PV (inflows) - PV (outflows) = 0
Accept/reject Decision for independent projects:

If IRR > required rate of return Accept
If IRR < required rate of return Reject
If IRR = required rate of return Indifferent
In case of Mutually exclusive projects: Select the one with the highest IRR.
Evaluation of whether Co. (Management) is creating value for its shareholders or not.
!"# %&'()# *(#"& +,- (%*+)
Return on Invested Capital =
*0"&,1" 2''3 4,56" '( +'#,5 7,8)#,5
!"# 9:;<=>?@A %&'()# *(#"& +,- [C2D+ (EF+,- %)]
Return on Invested Capital = *0"&,1" 2''3 4,56" '( +'#,5 7,8)#,5
If ROIC > WACC = Management is Increasing the Value of the Firm
If ROIC < WACC = The Value of the firm is reducing
Expected relations among an investment’s NPV, company value, and share price:
• Practically, when a company announces projects, its share value immediately sees a
rise perhaps due to the expected NPV it will achieve.
• However, it also depends on the certainty of the expected cash flows, the
company’s track record of executing the projects successfully and various other
factors.

Working Capital and Liquidity

Internal Sources of Funds:
Operating Cash Flow Net Income + Depreciation - Dividends
Accounts Receivables Collecting as soon as possible
Accounts Payables Delaying the payments
Selling Inventory Shorten production time and balance inventory
Liquid Debt Can sell short term marketable securities
Terms of Discount:
Example: 2/10 Net 40:
Pay within 10 days and get a 2% Discount or pay within 40 Days.
Cost of Delaying = 2% for 30 days, 24% Annualized.
Financial Intermediaries:
Banks Lines of Credit are used primarily by Large, Financially Sound Companies. These
Lines of Credit are as follows:
Uncommitted Line of Committed line of Credit Revolving Credit
Credit
Weakest form of bank Regular lines of credit, stronger Strongest form of
borrowing form of borrowing, verified credit and borrowers
through acknowledgement letter borrows repeatedly
Unsecured and Mostly Unsecured, effective for Used for Longer terms
effective term can be 364 days, and pre-payable (3-5 Years)
less than a year without penalty
Unstable, depends on Lender is in a legal bind to backed by formal
bank’s desire to lend provide capital to the borrower legal agreements
Only require interest as Charge Additional Fee Charge Additional
compensation Fee
Ex. Credit Card Ex. Overdraft Ex. Personal Credit
For Weaker Companies:

• They can borrow for the short term but will have to Pledge assets as Collateral.
• Banks may have a Blanket lien - they have a claim to current and future assets in
case the primary collateral is insufficient during default.
• Secured loans by Pledging assets as Collateral:

For Short-term Loan - Pledge Inventory or receivables

For long-term loans - Pledge Fixed Assets (PPE)
• Factoring - Sale of receivables to the Factor.
For Medium and Small-Scale Companies:

Web-based and non-bank lenders lend but they also charge fees with Interest.
Capital Market Sources:

Commercial Issued by Large Credit Worthy Companies and some times by
Paper lower credit ratings companies as well.
Other Options Long Term Debt, Equity
Managing and Measuring Liquidity:
Sources of Liquidity:
Primary sources of liquidity
These are the sources of cash that a company uses in its normal day-to-day operations.
They include:
1. Company's Cash balances - from selling goods and services, collecting
receivables, and generating cash from other sources such as short-term
Investments.
2. Short-term funding - includes trade credit from vendors and lines of credit from
banks.
3. Effective cash flow management - of a firm’s collections and payments can also
be a source of liquidity for a company,
Secondary sources of liquidity:

• These are sources the company uses when primary sources are unviable or
difficult to obtain.
• While using its primary sources of liquidity is unlikely to change the company’s
normal operations, resorting to secondary sources of liquidity can change the
company’s financial structure and operations significantly and may indicate
that its financial position is deteriorating.
They Include:
1. Negotiation of debt contracts
2. Liquidating assets (ST or LT)
3. Filing for bankruptcy protection and reorganization

Factors that Influence a Company’s Liquidity Position:

• A company’s liquidity position improves if it can get cash to flow in more quickly
and flow out more slowly.
Factors that weaken a company’s liquidity position are called drags and pulls on
liquidity:
1. Drags on liquidity - delay or reduce cash inflows or increase borrowing costs
Examples include uncollected receivables and bad debts, obsolete inventory (takes
longer to sell and can require sharp price discounts), and tight short-term credit due
to economic conditions.
2. Pulls on liquidity - accelerate cash outflows - Examples include paying vendors
sooner than is optimal and changes in credit terms that require repayment of
outstanding balances.
Liquidity ratios are employed by analysts to determine the firm’s ability to pay its short-
term liabilities.
Ratio Formula Remark
Current ratio Current assets / Current Higher better
liability CA < 1 = - Ve WCAP
Quick ratio or Acid Test Quick assets / Current Higher better
ratio liability
Receivables turnover Credit Sales/ Desirable to have Higher
Average receivables ratio or close to industry
standard
Days of sales outstanding 365/ Desirable to have close to
(DSO) or No. of days of Receivables turnover industry standard
receivables
Inventory turnover COGS/ Desirable to have close to
Average inventory industry standard
Days of inventory on hand 365/ Desirable to have close to
(DOH) Inventory turnover industry standard
Payables turnover Credit Purchases/ Desirable to have close to
Average trade payables industry standard
Number of days of 365/ Desirable to have close to
payables Payables turnover industry standard
Note: Quick asset = cash + short-term marketable securities + receivables

Working capital effectiveness:

Working capital effectiveness of a company based on its operating and cash conversion
cycles and comparing the company’s effectiveness with that of peer companies:
Operating cycle = DOH + DSO

It is the average number of days that it takes to turn raw materials into cash proceeds
from sales.
Cash conversion cycle = DOH + DSO - DOP

• Is the length of time it takes to turn the firm’s cash investment in inventory back
into cash, in the form of collections from the sales of that inventory.
• High cash conversion cycles are considered undesirable as they indicate the
company has an excessive amount of investment in working capital.
Analysis:
The shorter the cycles the greater the cash-generating ability of the firm (either via
effective inventory management, credit sales management or trade credit terms) which
implies a lesser need for borrowings or liquidity.
Short-Term Funding Choices Consideration:

• Co. should ensure it has sufficient borrowing capacity to meet ongoing needs.
• Co. should consider Cost while choosing Short Term Funding and Stay Up-to-date.
• Co. should consider having more than one Lender option.
• Co. should Maintain excess funds for business opportunities.

Cost of Capital
WACC = Wd × Kd(1-T) + Wp × Kp + We × Ke
What is the Weighted Average cost of capital or the marginal cost of capital (MCC)?
• The cost of each of the components of debt, preferred stock, and common equity is
called the component cost of capital.
• The WACC is the cost of financing firm assets and can also be viewed as an
opportunity cost.
A. The after-tax cost of debt:

The cost of debt is the cost of debt financing to a company when it issues a bond or takes
out a bank loan. After-tax cost of debt = interest rate − tax savings = kd × (1 − t)
There are two approaches we use for finding before-tax Kd:
YTM approach Debt rating approach / (Matrix Pricing)
To be used when CMP of debt is available To be used when CMP of debt is not
can be found using TVM function available by matching Credit rating
and Maturity
B. Cost of Preference Share Capital

For nonconvertible, non-callable preferred stock with fixed dividend no maturity date and
no adjustment for taxes:
%:
$: =
&:
Pp= current stock price,
Dp= preferred stock dividend per share,
Rp= cost of preferred stock
C. Cost of Common Equity:

The cost of (i.e., the required return on) common equity can be estimated using one of the
following three approaches:
CAPM: A model derived by Prof. William Sharpe based on systematic risk of an asset.
' ; = E(Ri)=Rf +β × [E(Rm)-Rf]
Dividend Discount Model:

The dividends are expected to grow at a constant rate, g, then the current value of the
stock is given by the dividend growth model:
%I
'; = +)
&J

D1/P0 = Forward annual dividend yield

G = sustainable growth rate
Bond yield plus risk premium approach

Analysts often use an ad hoc approach to estimate the required rate of return. They add a
risk premium (3-5% points) to the market yield on the firm’s long-term debt.
*K = bond yield + risk premium
Project Beta
• Project Beta is a measure of its systematic or market risk.
• Because a specific project is not represented by a publicly traded security, we typically
cannot estimate a project’s beta directly.
• Therefore, we use the pure-play method, whereby we estimate the beta of the project
based on the equity beta of a publicly traded firm that is engaged in a business similar
+=LL;>
The beta of a firm is a function not only of the business risks of its projects (lines of business)
but also of its financial structure.
+;NO?>P
+=LL;> =
[ - + ( ( - − / ) × %/ 3 ) ]
+MNO?>P
The Equity beta of a firm or project is the systematic risk of the firm’s equity to the risk of
the market.
+;NO?>P 56 +:<QR;S> = +=LL;> [- + (- − /) × %/3 ]
Adjusted Beta = [2/3 × Unadjusted Beta] + [1/3 × 1]
Floatation costs:
• Floatation costs are fees paid to investment bankers to raise external equity capital.
• Floatation costs can be substantial and often amount to between 2% and 7% of the total
amount of equity capital raised, depending on the type of offering.
Correct Treatment of Flotation Costs:

• Flotation costs are not an ongoing expense for the firm.
• Flotation costs are a cash outflow that occurs at the initiation of a project and affect the
project NPV by increasing the initial cash outflow.
• Therefore, the correct way to account for flotation costs is to adjust the initial project cost.
• We should calculate the dollar amount of the flotation cost attributable to the project and
increase the initial cash outflow for the project by this amount.

Capital Structure
What is Capital Structure?
• A company’s capital structure refers to how it finances its assets and operations.
• The capital structure consists of Debt and Equity
Factors that affect a Company’s Capital Structure Decision:

Internal Factors Can support higher proportions of Debt for Companies with
Characteristic of Business, which is Noncyclical, less fixed operating costs,
Business/Industry subscription-based revenue.
Existing Debt Level Higher Current ratio, Profitability ratios, Interest coverage
ratios (>2). Lower Debt to EBITDA rations (<3).
Corporate Tax rate Tax deductible Interest.
Management Based on Covenants and ratings.
Preferences
Debt ratings Higher ratings (Investment grade), Listed securities.
External Factors Can support higher proportions of Debt for Companies with
Market & Business cycle Lower Interest or Credit spread below benchmark
conditions
Regulations Many industries require Minimum Proportion of Equity (Banks)
Industry Norms In line with peers in Industry
How much of Debt and Equity?

There are various characteristics of the company that influences proportion of debt in its
capital structure which includes the following:
Characteristic Mode
High Growth and stability of revenue More Debt
High Growth and predictability of cash More Debt
Higher the Amount of business risk More Equity
Higher Amount and liquidity of company assets More Debt
Lower Cost and availability of debt More Debt

Debt-to-equity ratios of companies differ at different stages of their company’s life cycle:
Stage Start-Up Growth Mature
Revenue Growth Beginning Rising Slowing
Cash Flow Negative Improving Positive/Predictable
Business Risk High Medium low
Debt Availability Very Limited Limited/Improving High
Cost of Debt High Medium Low
Typical Mode Not accessible Secured (Fixed Unsecured (Bank and
assets or receivables) Public Debt)
Typical Capital Close to 0% 0% - 20% 20%+
Structure (%)
Modigliani Miller (MM) Models:

Proposition Without Tax With Tax
MM - I V(Levered) = V(Unlevered) V(Levered) = V(Unlevered) + Tax Shield
MM - II As DE ratios Increase, Ke As DE ratios Increases, Ke Increases and
Increases & WACC remains the WACC also increases
same
WACC At 100% Debt, WACC is same At 100% Debt, WACC = Kd × (1-T)
Cost of re = ro + (ro-rd) × (d/e) re = ro + (ro-rd) × (d/e) × (1-Tax %)
Equity
Tax Shield = Debt Amount × Tax rate %
Assumptions of MM Model I & Model II:

• No transaction costs, taxes, or bankruptcy costs (markets are perfectly competitive)
• Investors have homogeneous expectations.
• Investors can do Borrowing and Lending at a risk-free rate.
• No agency cost (No Conflict of Interest between Managers and Shareholders).
• Investment decisions (operating income) are unaffected by financing decisions (D/E
ratio).
Assumptions of MM Model II (With Taxes)

• Here, we relax some of those assumptions under the MM propositions like; earnings
are taxed and that interest payments to debtholders are tax deductible.

Optimal Capital Structure

• A firm’s Optimal capital structure is the proportion of Debt at which the value of
the tax shield from additional borrowing just offsets the increase in costs of
financial distress.
• This concept is called the static trade-off theory which seeks to balance the costs of
financial distress with the benefit of using debt.
• At this point, the WACC is minimized, and the Value of the Firm is Maximized
Therefore, after accounting for both Benefits and Costs, the Value of the Levered Firm will
be - V(L) = V(UL) + (Debt × Tax rate)- PV (Cost of Financial Distress)
Factors Affecting Capital Structure Decision

Debt ratings Lower Debt rating means higher cost of borrowing and therefore less
Debt will be used in the capital structure
Market Fluctuations in Market Values may make Debt or Equity attractive
conditions relatively
Asymmetric Managers have better information about the company than the
information owners/creditors. Here, a stock offering is considered negative (as
overvalued) while debt is considered positive (as it will brings in
discipline)
Agency costs Agency cost means conflict of interest between owners and managers.
of equity These costs are reduced with more leverage as managers have lesser
cash to misuse
Pecking Managers rank financing choices from most favored to least favored,
order theory based on their information content (signal to investors):
1. Internally generated funds (most favored)
2. Debt
3. New equity (least favored)

Measures of Leverage
Leverage
• Leverage means risk. It also refers to the amount of fixed costs a firm has. These
fixed costs may be:
• Greater leverage leads to greater variability of the firm’s after-tax operating
earnings and net income
There are two main types of risk that a company faces:
1. Business risk:
It is the risk associated with a firm’s operating income. Business risk is the combination of
sales risk and operating risk:
a. Sales risk: It is the uncertainty about the firm’s sales.
b. Operating risk: The greater the proportion of fixed costs to variable costs, the
greater a firm’s operating risk.
2. Financial risk
It refers to the additional risk that the firm’s common stockholders must bear when a firm
uses fixed-cost (debt) financing.
The greater the proportion of debt in a firm’s capital structure, the greater the firm’s
financial risk.
Types of Operating leverage Financial Leverage Total Leverage

leverage
Measure of Operating risk Financial risk Combined risk
Due to Fixed operating cost Fixed financing cost Both
(Interest)
Static 7'T#&)U6#)'T C2D+ 7'T#&)U6#)'T
DOL = DFL = C2+
DTL =
formula C2D+ C2+
Dynamic DOL = DFL = DTL =

formula
% # $%&' % Δ EBT or Net Income % Δ EBT or Net Income
% # ()*+,-./+-)* ), 01234 % Δ EBIT % Δ contribution or Sales
ROE and Leverage:

• ROE is higher using leverage than it is without leverage.
• Leverage also increases the rate of change for ROE.

• In the unleveraged scenario, ROE varies directly with the change in EBIT.
• However, In the leveraged scenario, ROE is more volatile.
Breakeven point (QBE):

• Is the number of units produced and sold at which the company’s net income is zero
• The point at which revenues are equal to total expenses (i.e. fixed operating and
financing cost + variable cost)
Fixed operating cost + Fixed financing cost F+I
Q 2C = =
per unit contribution margin (P − V)
Operating Breakeven point (QOBE):

• It is the number of units produced and sold at which operating income is zero
• The point at which revenues are equal to fixed operating cost + variable cost
Fixed Operating cost F

Q V2C = =
per unit contribution margin (P − V)

CFA Level 1 – Quick Notes by KRD - EQUITY
MARKET ORGANISATION AND STRUCTURE

Financial Intermediaries
They are institutions that help corporations, and individuals achieve their financial goals.
Broker Executes trade orders on behalf of a customer. Accepts the trade and
routes it to the exchange which fills the order and provides the
confirmation.
Block Broker Generally, large-quantity orders are hard to fill because of a lack of
liquidity. Block Brokers provide brokerage services to large traders.
Investment Help corporate clients raise capital by issuing shares or bonds in the
banks capital markets through IPO, Private Placement, M&A, etc.
Exchange It is a platform or a market where the securities are traded. They lay
down standardized regulations for trading and regulate the companies
having their securities listed on the exchange.
Alternative ATS are non-exchange trading venues that bring together buyers and
trading sellers of securities. ATSs do not exercise regulatory authority over
systems (ATSs) their subscribers and do not discipline subscribers other than exclusion
from trading.
An electronic communication network (ECN) connects major brokerages
and individual traders so that they can trade directly between
themselves without having to go through a middleman.
Dark pools are ATSs that don't display the orders which are usually
very large
Dealers Dealers execute or fill their client’s orders by trading with them. They
provide liquidity to the market. They trade with their clients to earn a
spread.
Broker Dealer Most brokerages are in fact broker-dealer firms i.e., they deal with a
customer and trade for their own proprietary accounts.
Primary Dealers with whom central banks trade when conducting monetary
Dealers policy. They Act as intermediaries between large clients and the
central bank.
Securitizers Securitization is a structured finance process that distributes risk by
aggregating assets which are pooled in an SPV/SPE. The securities are
sold to investors who share the risk and reward from those assets.
Depository They accept deposits from savers and investors and pay interest to the
Institutions & lenders. They further lend these deposits to borrowers with a mark-up
Other Financial interest. Depository institutions also provide other services such as
Corporations transaction services, credit services, etc.

Insurance Insurance provides protection for a fee against unforeseen events or

Companies circumstances. The insured entities are therefore protected from risk. In
other words, risks are transferred from these entities to the insurance
company. Insurance can also be obtained by using derivative
instruments on the exchange.
Arbitrageurs Arbitrage is the process of earning a risk-free profit from a price
difference of a same security trading on two or more markets
simultaneously. Arbitrage assumes ‘The law of one price’ holds.
Arbitrage has the effect of causing prices in different markets to
converge in a way to reduce opportunities for any risk-free gain.
Clearing A clearinghouse is a financial institution that provides clearing and
houses settlement services for financial and commodities derivatives and
securities transactions. A clearinghouse helps to avoid counterparty
risk - the risk that counterparties to a trade will not settle their trades
or obligations. They collect margins from the traders to provide the
same.
Custodians Depositories or custodians hold securities on behalf of their clients.
Financial Positions: A position in an asset is the quantity of the asset that an entity
or investor owns or owes.
Long A long position means to buy an asset or contract.
Position Long position entitles the ownership of the asset or contract.
Long positions benefit from increases in prices of assets owned.
Short A short position means to sell an asset that is not currently owned.
Positions Creating a short position requires borrowing of the stock.
Following are the steps to execute a short sale transaction:

1. The short seller borrows the stock from the owner for a specific time.
2. The short seller then hands over the stock to the broker to execute a
short position on the stock.
3. The broker keeps the sales proceeds as a margin.
4. If the broker earns any interest on the margin (short rebate rate), then
it is shared with the short seller.
5. If the stock after short sale goes down, the short seller can square off
the position and make a gain
6. After the square off, the shares are given back to the lender along
with the borrowing cost.
7. If the shares start rising, the short seller suffers a huge loss.
8. Any dividends paid on the stock belong to the lender.

Leveraged Leveraged transactions occur when investors purchase the stocks by

Positions borrowing a part of money from their brokers.
The borrowed money is called the margin loan and the broker’s charge
the investor on the amount of loan at the call money rate (slightly above
the government T-bill rate of equivalent maturity).
Stock is kept as collateral with the broker.
Trader’s equity is the amount which is paid by the investor (also called
trader). Traders who buy securities on margin are subject to minimum
margin requirements.
Initial It is the minimum fraction of purchase price that must be deposited by
Margin the investor as his initial equity.
Requirement Initial Margin Requirement set mostly by governments/ regulators/ stock
exchanges.
Maintenance It is the minimum equity which must be maintained with the broker at any
Margin given point in time during the life of a leveraged trade.
Margin call If the amount in the margin account is less than the maintenance margin,
then the investor gets a margin call whereby an additional margin is to
be added in the margin account till Initial Margin to continue with the
position.
Formulas:
Leverage ratio It indicates how many times larger a position is than the equity that
!
supports it. Leverage ratio = !
"#$%&# ' &)*+,- %
Maximum 1
Leverage ratio Maximum Leverage Ratio =
Minimum Margin Requirement
Call Price Current Market Price × ( 1 − initial margin%)
Call Price =
(1 − maintenance margin%)
There are various types of instructions given by the trader to the broker:
• Execution instructions indicate how to fill the order.
• Validity instructions indicate when to fill the order.
• Clearing instructions indicate how to arrange the final settlement of the trade.
Bid - Ask Spread
• Bid price: the price that a buyer is willing to pay for the security. The best bid is
the highest bid in the market.

• Ask price: the price that a seller is willing to accept for selling the security. Also
called the offer price. The best offer is the lowest ask price in the market.
• Bid-ask spread: the difference between the best bid and the best offer.
Execution Instructions - They indicate how to fill the order.

Market Order Indicate the priority to fill the order at the best price immediately
available when filling the order.
Limit buy order It is an order which remains pending if no trader is willing to sell at the
limit price or lower any time during the day.
Limit sell order remains pending if no trader is willing to buy at the limit price or
higher during the day.
A marketable order is a buy order with a price at or above the best offer in the
limit market or
a sell order with a price at or below the best bid in the market.
A standing is an order which is waiting to trade. The order may end up remaining
limit order unfilled if there is no trader who is willing to trade at that price.
Behind the A buy order placed below the best bid is behind the market.
market order
All-or-Nothing The order is executed only if the entire size of trade gets executed.
orders (AON)
Hidden orders There is a provision available to hide the order quantity (can only be
seen by broker placing the order). Only gets exposed when there is an
opposite trade of that size that enters the market).
Iceberg orders For large order sizes, a part of the quantity is disclosed (display size
at the displayed price) and the remaining large part of quantity
remains hidden. It progressively gets exposed when the earlier
displayed size trades at the displayed price.
Validity Instructions - They indicate when the order may be filled.

Day order (the most common) that is valid only for a trading session. If, on each
trading day, an order is not executed it gets cancelled.
Good-till- Order remains valid until canceling instructions are given by the
canceled (GTC) trader.
Immediate-or- Has a priority to fill the quantity in part or in full but immediately.
cancel (IOC)

Fill-or-kill order Has a priority to fill the total quantity instantly or the order gets
canceled
Good-on-close Can be filled only at the close of trading.
order
Good-on-open Can be filled only at the opening of the trading.
order
Stop Orders
• Stop orders are usually used to protect the trader from losses in the position.
• Stop orders are to be input into the system only after the initial trade is executed.
Stop orders are of two types:

Buy Stop order If price of underlying starts going up, short seller starts making a loss.
To restrict this loss, short sellers can use a buy stop order.
Sell Stop order If price of underlying starts going down, long trader starts making a
loss. To restrict this loss, Long could use sell stop order.
Clearing Instructions
It tells the brokers and exchanges how to arrange final settlement of trades.
Two common types of clearing instructions are:
1. Cash-settled trades and
2. Delivery settled trades.
Primary & Secondary Markets

Primary Market The primary markets are those in which new issues.
IPO = If the issuance is being done for the first time
Seasoned Offerings = Later Issues after IPO
Public Investment Banks follow a book-building process. It is the process of
Offerings determining the IPO price based on applications by institutions.
If the issuance is to be executed in just a couple of days, then
accelerated book building is used (often at discounted prices)
The investment banks follow two approaches to help companies raise

money:
Underwritten offering: The investment bank guarantees the sale.
Best effort offering: The investment bank acts only as a broker and
does not guarantee 100% sale of the issue.

Private Companies sell securities directly to small group of investors with an

Placements and assistance of an investment bank. Private placement is cheaper than
Other Primary the IPO as book-building is avoided.
Market
Transactions Shelf registration: A company does not sell all the shares in one
transaction but has choice to sell it over a period of time without
filing the prospectus again (Form S1).
Secondary Secondary markets provide liquidity for the securities issued in
markets the primary market.
Trading Sessions Here, trading for individual stocks takes place at specified times
- (Bonds). The intent is to gather all the bids and asks for the stock and
Call market attempt to arrive at a single price where the quantity demanded is
(Uniform Pricing) as close as possible to the quantity supplied.
Trading Sessions Trades occur at any time the market is open (Equity). Stocks are
- Continuous priced either by auction or by dealers:
market • In an auction market, there are sufficient willing buyers and
(Discriminatory sellers to keep the market continuous.
Pricing) • In a dealer market, enough dealers are willing to buy or sell
the stock.
Execution Mechanism
The three main types of market structures:
Quote-driven They are often called as Over the counter (OTC) or price-driven or
Markets dealer markets. Customers trade at the prices quoted by dealers. (Ex:
bonds, currencies, most spot commodities)
Order-driven They arrange trades using rules to match buy orders to sell orders
Markets
Brokered Brokers arrange trades among their clients by organizing the market.
markets Happens for unique items which are of interest only to a limited
number of people or institutions. Example: real estate properties,
intellectual properties, large blocks of securities, fine art etc.
Two sets of rules characterize order-driven market mechanisms:

• Order matching rules and
• Trade pricing rules
A. Order matching rules:

The system matches the highest-ranking buy order with the highest-ranking sell order.

• Order precedence hierarchy determines which orders go first and is first based on
the price priority rule and then on secondary precedence rules.
i. Price priority Rule: Highest-priced buy orders and lowest-priced sell orders trade
first since they are the most aggressively placed orders.
ii. Secondary precedence rules: Determine how to rank different orders that are
entered at the same price.
So complete precedence hierarchy is given by:

1. Price Priority
2. Display precedence at a given price (to avoid giving unfair priority to large but
hidden un-displayed quantities)
3. Time precedence among all orders with the same display status at a given price.
B. Trade Pricing Rules

After orders are matched, the system uses trade pricing rules to determine the trade
price. The three rules that order-driven markets use to price their trades are the uniform
pricing rule, discriminatory pricing rule and the derivatives pricing rule.
i. Uniform pricing rules: All trades are executed at the same price. The market
chooses the price that maximizes the total quantity traded (used in Call markets)
ii. Discriminatory pricing rules: The limit price of an order or quote that first arrived -
the standing order - determines the trade price (used in Continuous trading
markets).
iii. Derivative Pricing Rules: Match buyers and sellers who are willing to trade at
prices obtained from other markets i.e. price is derived from another market. The
executed price is then generally the midpoint of the best bid and best ask quotes
on those markets (used in crossing networks)
Well-functioning financial systems have the following characteristics: A well-functioning

financial system ensures capital allocation decisions are well made.
Complete markets The instruments needed to solve investment and risk management
problems are available to trade.
Liquidity As asset can be bought and sold quickly.
Operational Low transaction costs (as a percentage of the value of the trade).
efficiency
Informational (or Availability of timely and accurate information related to the price
external) efficiency and volume of past transactions.
Market Information

Pre-Trade Investors can obtain pre trade information regarding quotes and orders
Transparent
Post-Trade Investors can obtain pre trade information regarding Completed trade
Transparent prices and sizes
Market Regulation: The objectives of market regulation are to:

• Control fraud.
• Control agency problems.
• Promote fairness.
• Set mutually beneficial standards.
• Prevent undercapitalized financial firms from exploiting their investors by making
excessively risky investments.
• Ensure that long-term liabilities are funded.
SECURITY MARKET INDICES

Index Definition and Calculations of Value and Returns
• It is a means to measure the value of a set of securities.
• It can measure securities in various target markets, market segment or asset class.
• The constituent of the index should be the securities which represent the target
market.
There are usually two versions of the same index:

Price return index: It includes only the price returns and ignores any income received.
The single period price return of an index is the weighted average of price returns
1"# 21"$
of the individual securities: PR / = ∑3
045 w0 @ A
1"$
For Portfolio of Stocks: PR / = w5 PR5 + w6 PR 6 + ⋯ + w3 PR 3
Total return index includes both the price returns and income received on the investment
(dividends) - the weighted average of Total returns of the individual securities: The total
return of an index includes price appreciation and income.
1#" 21$" 7 /89"
The single period Total return of an index is: TR / = ∑3
045 w0 @ A
1$"
For Portfolio of Stocks: TR / = w5 TR5 + w6 TR 6 + ⋯ + w3 TR 3
Calculation of Index Values over Multiple Time Periods: To calculate the multiple period
returns, the single period returns should be linked geometrically.
Price Return: V1:/; = V1:/< (1 + PR /5 )(1 + PR /6 ) … (1 + PR /; )

Total Return: V;:/; = V;:/< (1 + TR /5 )(1 + TR /6 ) … (1 + TR /; )
Index Providers must decide the following:

A. Which target market should the index represent?
B. Which securities should be selected from that target market?
C. How much weight should be allocated to each security in the index?
D. When should the index be rebalanced?
E. When should the security selection and weighting decision be re-examined?
Index Weighting - Weighting method impacts the index value, Indices can be:
1. Price weighted.
2. Equal weighted
3. Market capitalization weighted or
4. Fundamentally weighted
Method Features Advantage Disadvantage Example

Price One share of Simple Biased towards high DJIA
Weighting each security No rebalancing priced securities.
Adjusting the Divisor
(in Splits)
Equal Equal amount Simple Constant Balancing HFRX
Weighting in each security High prices securities
underrepresented
Market Cap or Weights Securities in Value Tilt S&P 500
Value based on proportion to More impact by
Weighting Market Cap weights Large Caps
(Float (Float Self-Balancing
Adjusted) Adjusted)
Fundamental Fundamentals Weighting Subjective FTSE
Weighting like Book independent of RAFI**
Value, Price U.S. 1000
Dividends, etc. ETF
Index Management: Rebalancing and Reconstitution

Rebalancing
• Rebalancing is adjusting weights of constituent securities in the index.
• Price weighted index does not require any rebalancing.
• Equal weighted requires constant rebalancing.
Reconstitution
• Changing the composition of an index is called reconstitution.
• Reconstitution is to ensure the index represents the desired target market.
• Rebalancing and reconstitution create high turnover in an index.
Uses of Market Indices

• Gauges of market sentiment.
• Proxies for measuring and modeling returns, systematic risk, and risk-adjusted
performance.
• Proxies for asset classes in asset allocation models.
• Benchmarks for actively managed portfolios.
• Model portfolios for such investment products as index funds and ETFs

MARKET EFFICIENCY
Features of an Efficient Market
Informationally efficient Security prices adjust rapidly to any new information
Correctly Priced Difficult to find inaccurately priced securities
Abnormal Returns Not Possible
Type of Strategy Passive strategy to be followed to avoid trading cost
Passive & Active Investment Strategy

Criteria Passive Strategy Active Strategy
Objective Buying and holding a broad market Superior risk-adjusted returns
portfolio
Goal Closely track the Market Index Outperform the Market Index
Turnover Low High
Fees Low High
Market Efficient Inefficient
Alpha Low or zero Positive or Negative
Several factors contribute to an impact the degree of efficiency in a financial market.

Factor Degree of Efficiency (high)
Market Participants Greater number of active market participants
Information Availability and Information availability (e.g., an active financial
Financial Disclosure news media) and financial disclosure
Limits to trading Less limitation, allowing short selling, less regulations,
Arbitrage Trading
Transaction Costs and Less cost to trade, If returns net of Cost or low or
Information Acquisition Costs Zero, Markets are efficient

The three versions of the Efficient Market Hypothesis (EMH) differ by their notions of
what is meant by the term "all available information."
Market Efficiency and Incorporation of Information

Forms Past Market Data Public Information Private Information
Weak form √ × ×
Semi-strong form √ √ ×
Strong form √ √ √
Market Pricing Anomalies

• Anomaly means deviation or departure from the Normal (Exception)
• If markets are efficient the trading strategies designed to exploit the market
anomalies will not generate returns
• Market efficiency would be tested if any of the following anomalies result into
mispricing of securities resulting into abnormal gains.
Time Series Anomalies Cross Sectional Anomalies Other Anomalies

January Effect Size Effect Closed End Fund Discount
(turn of the Month Effect)
Day of the Week Effect, Value Effect (Market to BV ratios, Earnings Surprise, Initial
Weekend Effect, Turn of PE ratios, High Dividend Yield) Public Offerings, Stock
the Month Effect, Holiday Splits
Effect, Time of the day
Effect
Momentum, Overreaction
Predictability of Returns based on Prior Information

• Equity returns are related to prior information such as interest rates, inflations rates,
volatility, dividend yields etc. Any changes in these factors could affect equity
returns. This, however, does not imply a market inefficiency.
• Any trading based on expected changes in above factors may not result in
consistent abnormal returns.
Implications for Investment Strategies
• Researchers conclude that observed anomalies are not violations of market
efficiency but are a result of statistical methodologies used to detect the
anomalies. It is difficult to consistently earn abnormal profits by trading on them.

Behavioral Finance
• Field of financial thought that examines investor behavior and how it affects
their observations in the financial markets.
• Behavioral finance attempts to explain why individuals make the decisions that
they do, whether these decisions are rational or irrational.
Loss Aversion Investors dislike risk and are willing to assume risk only if
adequately compensated in the form of higher expected returns
Herding Occurs when investors trade on same side of market and neglect
or ignore processing/ analyzing information.
Overconfidence Investors have inflated view of their ability to process new
information.
Information Situation in which an individual imitates the trades of other market
Cascades participants and completely disregards his or her own private
information.
Representativeness Investors assess new information and probabilities of outcomes
based on similarity to the current state or to a familiar
classification
Mental accounting Investors keep track of the gains and losses for different investments
in separate mental accounts and treat those accounts differently
Conservatism Investors tend to be slow to react to new information and continue
to maintain their prior views or forecasts
Narrow framing Investors focus on issues in isolation and respond to the issues
based on how the issues are posed

OVERVIEW OF EQUITY MARKETS

Part A: Common Shares
• Common shares represent ownership in a corporation.
• They have voting rights and entitle a residual claim.
Shareholder voting can of two types:

Statutory voting Regular form of shareholder voting. One share equals to One vote
Cumulative Can direct their total voting rights to specific candidates, (by giving
voting up rights on other candidates). Cumulative voting is used to better
serve small (minority) shareholders
Common shares can be callable or putable.

Callable common shares Putable common shares
Gives issuer the right to buy back the Provides shareholders the right to sell the
shares from shareholders at a pre- shares back to the issuer at a pre-
determined price. Hence, It is a benefit for determined price. Hence, It is a benefit for
the issuer. the holder.
Part B: Preference Shares

A preferred share, also called preference share, has characteristics of both common
stock and debt securities. They have following features:
• No voting rights.
• Fixed dividend before ordinary shareholders
• Priority of claims in case of liquidation over common shares
• Can be Convertible or Non-Convertible
• Can be Callable or Putable
• Maturity can vary from few years to perpetuity.
Preferred Shares can be classified as:

Cumulative Unpaid dividends accrue over time and are paid in full before
Preference Shares dividends can be paid to common shares
Non-Cumulative Unpaid dividends for one or more period are forfeited
Preference Shares
Participating Over and above preferred dividends, additional dividends are
Preference Shares paid if company’s profits exceed a certain target level (Startups)

Non-Participating No extra pay outs apart from fixed dividends; and par value of
Preference Shares shares in event of liquidation
Convertible Preference Shares

Convertible Preferred Shares are convertible into specified number of shares based on
the conversion ratio which is decided at issuance. They have following advantages:
• Allow investors to earn a higher dividend.
• Allow investors to benefit from a rise in the price of the common shares.
• Price is less volatile.
• Have relatively limited Downside risk.
Compared to Public Securities, Privative Equity Securities are:

• Issued to institutional investors via private placements.
• Smaller than public markets
• No active secondary market
• Highly illiquid
• Require negotiations between investors for trading.
• Difficult to obtain financial information as not required by regulatory authorities to
publish this information.
There are three primary types of private equity investments:

1. Venture capital
2. Leveraged buyouts.
3. Private investment in public equity (PIPE)
The two major routes of investing in foreign securities are:

1. Direct Investing
2. Depository Receipts
Direct Investing
Investors can buy and sell securities directly in foreign markets. However, there are some
obstacles to direct foreign investments like:
• Investments and return are denominated in a foreign currency.
• The foreign stock exchange may be Less transparent, Highly Volatile and illiquid.
• Strict and complex reporting requirements of foreign stock exchanges.
• Familiarity needed with foreign laws, regulations, taxations policies, etc.
Depository Receipts
What are Domestically traded securities, representing economic claims on foreign
DRs companies

How does Equity shares of a foreign company (ex. USA) are deposited in a bank
DR Work (which acts as the depository) in the country (ex. India) on whose
exchange (NSE, BSE) the shares will trade
What's the Depositary bank acts (Citibank, Mumbai) issues receipts to DR investors
role of that represent shares deposited. The DR Banks acts as a Custodian and
Banks also manages operational process like Stock Splits, Dividend
Distribution, etc.
Foreign DRs are issued in the currency where they are listed (foreign currency),
Currency so investors don’t have to convert but they do face currency risk
A depository receipt can be sponsored or unsponsored

Criteria Sponsored DR Unsponsored DR
Involvement When foreign company (issuer) When foreign company (issuer) has
has direct involvement in the got no involvement in the issuance of
issuance receipts (does it through Bank)
Investor Investors have same rights as Depository bank retains the voting
rights common shareholders - right to rights
vote & to receive dividends
There are two types of depository receipts:

1. Global Depository Receipt (GDR)
2. American Depository Receipt (ADR)
Global Depository Receipts American Depository Receipts

(GDRs) (ADRs)
Issued Issued outside US and outside Issued and traded in USD on US

the Issuers home country exchanges (like a common stock)
Restrictions Not subject to foreign Most require U.S. Securities and
ownership and capital flow Exchange Commission (SEC)
restrictions. Mostly traded on registration, but some are privately
London, Luxembourg, placed (Rule 144A or Regulation S
Singapore markets receipts)
Denominated in USD, GBP, EUR, etc. USD

There are four primary types of ADRs, with each type having different levels of
corporate governance and filing requirements:
Level I Level II (listed) Level III (listed) Rule 144A

(Unlisted) (Unlisted)
Objectives Increase US Increase US Increase US Access QIBs
investor base investor base investor base
Trading OTC NYSE, NASDAQ, NYSE, NASDAQ, or Private
or AMEX AMEX Offerings
Listing Fees Low High High Low
SEC Full registration Fulfill SEC Fulfill SEC SEC registration
registration not required Requirements Requirements not required
Allows to Raise Capital Raise Capital & Raise Capital & Raise Capital
make acquisitions make acquisitions
Return Characteristics of Equity Securities:

The main sources of Equity securities' total return are:
• Dividend income
• Changes in market price i.e. Capital gains (or losses)
• Reinvestment income of dividends
• Currency exchange gains (or losses) for foreign investors
1521<7/5
Returns = × 100 >
1=
I ∑?+4!JK + − KL
H=
M−N
Risk of Equity Securities

• The risk of Equity securities is measured in terms of Standard Deviation
• Preference shares are less risky than common shares because of priority of
dividend income cash flow and par value on maturity.
• ‘Putable’ common or preference shares are less risky than ‘callable’ or ‘option
free’ counterparts as they can be sold back to the issuer at pre-determined price,
• ‘Non-callable’ common or preference shares are less risky than ‘callable’ common
or preference shares, since the ‘Call price’ in callable shares limits an investor’s
potential future total return.
• Cumulative preference shares are less risky than non-cumulative preference
shares, because of safeguards for unpaid dividends.

Price to Book Value ratio: Also referred to as the Market-to-Book ratio

• It indicates the Value of Company in Market as compared to its Books (financial
reporting)
• It provides an indication of investors’ expectations about a company’s future
investment and cash flow-generating opportunities.
• The larger the Price-to-Book ratio the more favorably investors will view the
company’s future investment opportunities.
Price-to-book ratio = -..$!"#$%&
(#)*% (%# +,"#%
/"01% .2 %31)&4 (%# +,"#%
Accounting Return on Equity (ROE)

ROE is Net Income available to Common Shareholders divided by Average total book
value of equity.
When Beginning and Ending Values are Available When only Beginning Values of
Equity are available
NI@ NI@ NI@
ROE@ = = ROE@ =
Average BVE@ (BVE@ + BVE@25 )⁄2 BVE@25
Management's accounting choices can have a big impact on computed ROE, therefore
an increasing ROE is ‘not always’ good, and needs careful analysis:
• ROE can increase is if net income decreases at a slower rate than shareholders’
equity.
• ROE can increase if the company issues debt and then uses the proceeds to
repurchase some of its outstanding shares which will increase the company’s
leverage and make its equity riskier.
The Cost of Equity and Investors’ Required Rate of Return: Cost of equity, is usually used
as a proxy for the Equity investors' minimum required rate of return [ Ke = E(r) ]
KE is estimated in practice using:
Dividend Discount Model A5
Ke = + g
1<
Capital Asset Pricing Model Ke = Rf + (Rm-Rf) × β
The Company’s WACC is the Minimum required rate of return on longer-term investments to
satisfy all providers of capital (Debt & Equity). Therefore, projects are selected when
Expected returns (IRR) are greater than its computed WACC.
WACC = Wd × Kd × (1-T) + Wp × Kp + We × Ke


INDUSTRY AND COMPANY ANALYSIS

Need of Industry Classification System
• A well-designed Industry Classification System often serves as a useful starting
point for industry analysis
• It allows analysts to compare industry trends and relative valuations among
companies in a group.
The two types of classifications used by the Market or Analysts are:

• Commercial Industry Classification Systems
• Government Industry Classification Systems
Commercial classification systems have an advantage over government classification

systems due to following reasons:
• Most government systems do not disclose information (prohibits) about constituents
of a particular category.
• They do not distinguish between small and large businesses, between for-profit
and not-for-profit organizations.
• Commercial systems are reviewed and updated more frequently than government
systems (5 years)
• Commercial systems only include publicly traded organizations.
Constructing a Peer Group

• A peer group is a group of companies engaged in similar business activity and
whose valuation metrics are influenced by very similar and closely related factors
• The construction of a peer group is a subjective process and the result often differs
significantly from even the most narrowly defined categories given by the
commercial classification systems
PEER GROUP
The following lists of suggested steps and questions are given as practical aids to
analysts in identifying peer companies.
Questions that may improve the list of peer’s companies.

What proportion of revenue and operating Should be higher percentage
profit is derived from business activities
similar to those of the subject company?
Does a potential peer company face a growth rates, margins, and valuations
demand environment similar to that of the exposure should be similar
subject company?

Does a potential company have a finance Need to make adjustments to the financial
subsidiary? statements to lessen the impact that the
finance subsidiaries have
In order to compete in the marketplace, a company needs to understand dynamics of the

industry and market in which it operates, this approach is called Strategic Analysis
For this Michael Porter (2008) identified five forces framework is the classic starting
point for strategic analysis that determines the nature and intensity of competition in
each industry:
Forces Features
The threat of Higher level of entry barriers helps maintaining a level of profits for
new entrants existing players. Factors Include: High Fixed Cost, Premium Pricing,
Economies of Scale
The bargaining In a high demand relative to supply market, suppliers have a strong
power of position and hence greater bargaining power. This force determines
suppliers the cost of labor, raw materials, and other inputs
The bargaining In a market with high supply relative to demand, buyers tend to
power of buyers have a strong position and hence bargaining power. This force
influences the prices that firms can charge, cost and investment
The threat of Substitutes can limit profitability. The threat of a substitute is high if
substitutes the buyer's cost of switching to the substitute is low
The intensity of Competition level between the existing players can determine the
rivalry pricing strategy and hence profitability in the market. Greater
concentration (less firms, large market share) reduces competition,
whereas market fragmentation (many firms with small share)
increases competition.
Industry Lifecycle:
• Industries, like individual companies, tend to evolve over time, and usually
experience significant changes in the rate of growth and levels of profitability
along the way
• Over the period an industry passes through various stages and industry’s stage in
the cycle has an impact on industry competition, growth, and profits
• The industry’s stage will also change over time, so the analyst must monitor the
industry on an ongoing basis

• Hence, the industry’s life-cycle position often has a large impact on its competitive
dynamics and therefore it is an important component of the strategic analysis of
an industry
Stages of the Industry Life Cycle:
Source: CFA Institute
The characteristics of all the stage are as follows:
Stage 1: Embryonic stage - The industry has just started.

Slow growth Customers are unfamiliar with the product
High prices The prices cannot be reduced as the volume necessary for economies of
scale has not been reached
Large Large investments required to develop the product
investment
High risk of Most embryonic firms fail
failure
Stage 2: Growth stage - industry growth is rapid.

Rapid Growth New consumers discover the product, Initial Craze of product
Limited Competition High growth allows firms to grow even with competition

Falling Prices Prices tend to fall now due to economies of scale

Increasing Profits Less competition, high growth, lower cost
Stage 3: Shakeout stage - Due to heavy competition, the industry growth and profitability
are slowing.
Slowing Growth The demand has saturated with only few new customers to be found
Intense competition Industry growth has slowed, so firm growth must come at the
expense of competitors
Increasing industry Firm investment exceeds increases in demand and this overcapacity
overcapacity is thus profitability
Increased cost Firms restructure to survive and attempt to build brand loyalty.
cutting High failures in the industry as weaker firms liquidate or are
acquired
Stage 4: Mature stage - Firms begin to Consolidate.

Slow Growth Markets are Saturated, demand only for replacement
Consolidation Few players left (Oligopoly Markets)
Market Share Large firms gain market share with better products and scale
High entry Surviving firms have brand loyalty and low cost structures
barriers
Stable Prices Firms try to avoid price wars, except during recessions
Stage 5: Decline stage - Growth is negative.

Negative Global Competition, Substitute availability, Preference changes of
Growth consumers reason for negative growth
Declining Prices Competition and Overcapacity leads to fall in prices
Consolidation Failures exit or Merge
Elements that Should be Covered in a Company Analysis

• Company analysis includes analysis of the company's financial position, products
and/or services, and its competitive strategy.
• The analyst should try to determine if the strategy is primarily defensive or
offensive, and how the company intends to implement the strategy.
Porter identifies two chief competitive strategies:

A low-cost strategy the firm seeks to have the lowest costs of production in its
(cost leadership) industry, offer the lowest prices, and generate enough
volume to make a superior return
A product/service firm’s try to have products and services that are distinctive in
differentiation strategy terms of type, quality, or delivery
Elements that Should Be Covered in a Company Analysis:

• Firm overview, including information on operations, governance, and strengths &
weaknesses.
• Industry characteristics
• Product demand & Product costs
• Pricing environment
• Financial ratios (ROE) time series and cross sectional
• Projected financial statements and firm valuation.
Dupont Analysis
3 way ROE = (NPM)(Asset Turnover)(Financial Leverage)
Net Income Net Sales Average Total Assets
3 Way ROE = \ ^\ ^\ ^
Net Sales Average Total Assets Average Common Equity
Spreadsheet Modeling
• Analysts often use spreadsheet modeling to analyze and forecast company
fundamentals.
• Spreadsheet modeling is used to forecast revenues, operating income, net income,
cashflows, etc.
• It is one of the most widely used tool for company analysis.
• But the Models can be too complex and may have error.

EQUITY VALUATION CONCEPTS

Split vs Reverse Spit
Split Reverse Split
Process Each Share is divided into a Opposite of Split, Shares are
multiple merged
Shares Number of Shares are increased Number of Shares are reduced
Price Price of each share falls Price of each share rises
Indicates Bullish sign, greater liquidity Red Flag, Done to boost share price
Types of Dividends: Dividend is distribution of wealth or profits with the shareholders

Cash Dividend Stock Dividend Share Repurchase or
Buyback
Cash amount is directly More shares are Shares are repurchased by
transferred to investors allocated to existing issuer and full amount is
account (regular or special) investors free of cost paid to investors
It reduces the cash by the Cash flow is unaffected Cash flow is reduced by the
amount of dividend paid amount of cash paid for
repurchase
Does not affect number of Increases number of Decreases number of shares
shares outstanding shares outstanding outstanding
Share price is affected and Share is affected but not Share price and is Market
so is Market Cap Market Cap Cap are affected
Dividend Payment Chronology

Dividend Date when the BOD approves payment of a dividend (2nd Feb)
Declaration Date
Ex-Dividend Date First Date from which the Share purchaser will NOT get dividend
Record Date Date on which shareholders receive Dividend
Payment Date The date dividend checks are mailed to or payment is made
electronically to holders as of record date

The Dividend Discount Model

• The value of an Equity share is the present value of all future expected cash flows
(dividends)
• The model assumes that the Company pays Dividend and is a Going Concern
• However, it can still be applied for a company that does not pay dividends
currently but would start paying dividend at some stage in future.
D0 Current dividend (at time 0)

D1 Dividend expected to be received at the end of next period t=1
Ke or r Cost of Equity or Required rate of return = Rf + (Rm-Rf) × β ……(CAPM)
Intrinsic value of a stock with a One-Year Holding Period horizon:
D/ + P5 D/ P5
V< = = +
(1 + r)5 (1 + r)5 (1 + r)5
Intrinsic value for a Multiple-Year Holding Period horizon:
A A A 1 E H)
%
V< = (57C)#
&
+ (57C)&
'
+ ⋯ + (57C)'
'
+ (57C) '
`< = ∑G@45 (57F)
(
(
+ (57F))
Assumptions of Gordon model:

The infinite period DDM (Gordon Model) has four assumptions:
• Dividends are the correct metric to use for valuation purposes.
• Dividends growth rate ‘g’ is assumed to remain constant for perpetuity.
• The required rate of return ‘r’ is assumed to remain constant.
• The required rate of return ‘r’ is greater than the growth rate ‘g’
The Gordon Growth Model - Singe Stage:

D< (1 + g) D5
V< = =
(r − g) (r − g)
The Gordon Growth Model – Multi-Stage:

8
D< (1 + g I )J V8
V< = a +
(1 + r)J (1 + r)8
J45
D875
V8 =
r − gK
D875 = D< (1 + g I )8 (1 + g K )

gs = short-term growth rate that lasts for ‘n’ years

Vn = terminal value estimated using the Gordon Growth model
gL = long-term sustainable growth rate
Dn+1 = dividend in Year n+1
FCFE CFO – Fixed Capital Investments + Net Borrowings

Value of Equity (VE or V0) M
FCFEJ P8
One Period VL = a +
(1 + r)J (1 + r)8
J45
Value of Equity (VE or V0) FCFE< (1 + g) FCFE5

Single Stage Model VL = =
(r − g) (r − g)
Value of Equity (VE or V0) 8
Multistage Model FCFE< (1 + g I )J V8
V< = a +
(1 + r)J (1 + r)8
J45
FCFE875
V8 =
r − gK
Preferred Stock Valuation:

Perpetual Preferred Shares Preferred Shares with limited Period
8
Value Vo = Pd/r PdJ FV
V< = a +
(1 + r)J (1 + r)8
J45
A price multiple is a ratio that compares price of a stock to some value like earnings,
sales, book value of equity or cash flows. The price multiples used are:
Ratio Price relative to
P/E ratio Earnings per share (EPS) also called the earnings multiplier
P/B ratio Book value of the share (Net Asset Value = Asset - Liability)
P/S ratio Last twelve months sales per share
P/CF ratio Cash flow generated per share
A trailing P/E (Current P/E) A leading P/E

(Forward P/E or prospective P/E)

Compares the Stock's Current Price to its Compares the stock's current Price with the
earnings during the last full fiscal year company's forecasted earnings for the
(Trailing EPS) next full fiscal year
Justified PE ratio: As per DDM: P0 = D1/ (r - g)

P< D5 ⁄E5 p
= =
E5 r−g r−g
The P/E ratio is determined by:

• The expected dividend payout ratio.
• The estimated required rate of return on the stock (r)
• The expected growth rate of dividends for the stock (g)
Enterprise Value
• Enterprise value is the value of a company.
• It determines the value for all the stakeholders including debt holders, preferred
shareholders and equity shareholders.
Enterprise Value MV of common stock + MV of preferred stock + MV of debt - Cash
and investments
MV = Market Value
Debt Holders = Long- and Short-term Debt
Importance of EV/EBITDA
• Enterprise value is an indication of company value, not equity value.
• EV/EBITDA multiple is often used when comparing two companies with different
capital structures.
• For loss making companies with negative earnings, P/E would not convey any
meaningful information.
Asset-based valuation models

NAV = Total Assets* – Total Liabilities*
* Based on Fair/Market Values
Important facts that the practitioner should realize are as follows:

• This valuation works well for the companies that do not have significant intangible
assets. Especially the ones like financial companies, natural resource companies
and the companies that are being liquidated.
• This model is inappropriate for companies with assets that do not have easily
determinable market (high tangible assets like PPE)
• Asset values may be more difficult to estimate in a hyper-inflationary environment.

CFA Level 1 – Quick Notes by KRD - FI
FIXED-INCOME SECURITIES: DEFINING ELEMENTS

Major types of issuers include the following:
Types Major Issuer
Supranational organizations World Bank, European Investment Bank
Sovereign (national) Government of USA, Japan, Saudi Arabia, India
governments
Non-sovereign (local) State of California (United States), the region of
governments Catalonia (Spain), or the City of Edmonton (Canada)
Quasi-government entities Postal Service of India, Department of Transport, UAE,
(agencies that are owned or National Highway Authority of India
sponsored by governments)
Companies (i.e., corporate Financial (bank and insurance) and Non-financial
issuers) Companies
Types Money Market Securities Capital Markets Perpetual Bonds

Securities (Consoles)
Duration 1 Year or Less More than 1 Year No Stated Maturity
Issuer Government & Corporates Corporates Sovereign Governments
Purpose Working Capital Long term Capital Social or Economic
Projects
Domestic Bonds They are bonds issued and paid in Domestic Currency only
It is aimed solely at a country’s domestic investors
Dual- currency They make coupon payments in one currency and pay the par value
bonds at maturity in another currency.
Currency Option They are combination of a single- currency bond with a foreign
bonds currency option. They give bondholders the right to choose the
currency in which they want to receive interest payments and principal
repayments. Bondholders can select one of two currencies for each
payment.

!"#$’& (##)(* +"),"# ,(-./#0

Current Yield =
!"#$’& +)11/#0 .(12/0 ,13+/
Problems with Current Yield: The current yield neglects:

• The frequency of coupon payments in the numerator and
• Any accrued interest in the denominator
• Does not consider Time value of Money.
What is Credit Enhancement?

• Provisions that can be used to reduce the credit risk of a bond issue
• Very often used in securitized bonds
There are two primary types of credit enhancements:

Internal credit relies on structural features regarding the bond issue
enhancement
External credit refers to Financial guarantees received from a third party,
enhancement often called a financial guarantor
Internal Credit Enhancement

Subordination Also known as credit trenching and is most popular credit
enhancement mechanism. This type of protection to senior debt
holders is commonly referred to as a waterfall structure.
Overcollateralization Posting more collateral than is needed to obtain or secure
financing.
Reserve accounts or Cash reserve fund: A cash deposit that can be used to absorb
Reserve funds losses from the excess spread.
External (Third Party) Credit Enhancement

Surety bond Issued by a rated and regulated insurance company. Such insurance
companies are called monoline insurance companies.
Bank Issued by a Bank. There is usually a maximum amount that is
guarantee guaranteed, called the penal sum.
Letter of credit Provided by a financial institution to reimburse any cash flow shortfalls
from the assets backing the issue.
What are Bond Covenants? Bond covenants are legally enforceable rules that borrowers
and lenders agree on at the time of a new bond issue.

Affirmative Typically, administrative in nature

Covenants Provide “to do” list for issuers
Examples Utilizing the proceeds from the bond issue
Promise of making the contractual payments
Promise to comply with all laws and regulations.
Maintain its current lines of business, insure, and maintain its assets.
Pay taxes as they come due.
Negative Restrictive in nature
Covenants Provide “not to do” list to issuers.
Examples Restrictions on issue of additional debt
Restrictions on issue of debt senior to existing debt holders (Negative
pledge)
Restrictions on converting uncollateralized assets into collateralized.
Restrictions on dividend distributions and share buy-backs
(repurchases)
Restrictions on asset disposals
Restrictions on risky investments
Restrictions on mergers and acquisitions
Legal Structure
Domestic All the bonds that are issued and traded in a specific country and
Bonds denominated in the currency of that country.
Foreign All the bonds issued by entities that are incorporated in another
Bonds country.
Euro Bonds issued and traded on the Eurobond market are called Eurobonds,
Bonds and they are named after the currency in which they are denominated.
For example, Eurodollar, Euro yen, Euro rupee, etc.
Taxes
Taxes on Income/Interest:
Ordinary income A bond pays interest to investors, which is generally taxed at the
tax rate ordinary income tax rate
Tax-exempt Interest on tax-exempt securities, such as municipal bonds issued
securities in the United States, is not taxed

The tax status of bond income may also depend on where the bond is issued and traded.
Net of Tax Interest Domestic bonds pay their interest net of income tax
Gross Interest Euro Bonds make gross interest payments
Taxes on Capital gains:

• If a bond is sold before its maturity date, the price is likely to have changed
compared with the purchase price.
• This change will generate a capital gain if the bond price has increased or a capital
loss if the bond price has decreased.
• Any capital gain or loss generated from bond investment is usually treated
differently from taxable income.
• Very often, the tax rate for long-term capital gains (generally 12 months and
above) is lower than the tax rate for short-term capital gains, and the tax rate for
short-term capital gains is equal to the ordinary income tax rate.
Bonds issued at discount or premium:

Discount Bonds - For bonds issued at a discount, an additional tax consideration is
related to the tax status of the original issue discount.
Premium Bonds - Some jurisdictions also have tax provisions for bonds bought at a
premium.
Principle Repayment
Bullet bond Also called as Plain Vanilla bond
In this case, the entire payment of principal occurs at maturity.
Most of the government or corporate bonds pay in bullet structure
Fully Amortizing It has a payment schedule that calls for periodic payments of
bond interest and repayments of principal.
It has a fixed periodic payment schedule that reduces the bond’s
outstanding principal amount to zero by the maturity date
Partially It has fixed payment schedule like fully amortized bond but only a
Amortizing bond portion of the principal is repaid by the maturity date.
Therefore, a balloon payment is required at maturity to retire the
bond’s outstanding principal amount
Sinking Fund An arrangement under which issuer must redeem the portion of the
Arrangements bond’s principal outstanding each year throughout the bond’s life or
after a specified date.

Coupon Payment
Plain VanillaA conventional bond pays a Fixed periodic coupon over a specified time
Bond to maturity.
Floating-RateCoupon rate is linked to an external reference rate, such as Libor
Notes Additional features observed in FRNs may include a floor or a cap.
An inverse orIt is also called an inverse floater; has a coupon rate inversely related
reverse FRN to the reference rate. Example: Coupon rate = 12% - Libor.
Step-Up The coupon (fixed or floating) increases by specified margins at
Coupon Bonds specified dates.
Credit-LinkedCoupon is linked to changes in the bond’s credit rating. Coupon
Coupon Bonds increases by specified amount (bps) with a subsequent credit
downgrade below the credit rating at the time of issue.
Payment-in- The issuer may pay interest in cash or in the form of additional
Kind (PIK) amounts of the bond issue. Investors demand a higher yield for
Coupon Bonds holding bonds with PIK coupons.
Deferred A deferred coupon bond, sometimes called a split coupon bond, pays
Coupon Bonds no coupons for its first few years but then pays a higher coupon than it
otherwise normally would for the remainder of its life. Common in
project financing.
Index-Linked Coupon payments and/or principal repayment linked to a specified
Bonds index such as any published variable, including an index reflecting
prices (like Inflation), earnings, economic output, commodities, or foreign
currencies.
Inflation-linked bonds
• Inflation-linked bonds reduce inflation risk to the investors by keeping real rate of
return fixed over the life of the bond.
• They offer investors protection against inflation by linking a bond’s coupon
payments and/or the principal repayment to an index of consumer prices such as the
US Consumer Price Index (CPI)
• Governments are large issuers of inflation-linked bonds, also called linkers.
The following examples describe how the link between the cash flows and the index is
established, using inflation-linked bonds as an illustration:
Zero-coupon- The principal amount to be repaid at maturity increases in line with
indexed bonds increases in the price index during the bond’s life
Interest- The inflation adjustment applies to the interest payments only
indexed bonds

Capital- Both the interest payments and the principal repayment are adjusted
indexed bonds for inflation by applying a fixed coupon rate to increasing principal in
line with inflation.
Ex: US Treasury Inflation Indexed Securities (TIIS) or Treasury Inflation
Protected Securities (TIPS) which are linked to US CPI
Indexed- Fully amortized bonds, with the annuity payment, increasing in line with
annuity bonds inflation during the bond’s life
What are bonds with Contingency provision?

• A contingency refers to some future event or circumstance that is possible but not
certain.
• For bonds, the term embedded option refers to various contingency provisions
found in the indenture.
• For bonds, a contingency provision is a clause in a legal document that allows for
some action if the event or circumstance does occur.
Callable A Callable bond gives the issuer the right to redeem all or part of the bond
bonds before the specified maturity date. The primary reason to issue callable
bonds is to protect issuers against a decline in interest rate.
Putable They are bonds which give the bondholders/investors, the right to sell the
Bonds bond back to the issuer at a pre-determined price on specified dates.
If interest rates rise after the issue date, thus depressing the bond’s price, the
bondholders can put the bond back to the issuer and get cash.
Available exercise styles on callable bonds include the following:

American- Also referred to as continuously callable, here the issuer has the right to
style call call a bond at any time starting on the First call date
European- The issuer has the right to call a bond only once on the call date
style call
Bermuda- The issuer has the right to call bonds on specified dates following the call
style call protection period. These dates frequently correspond to coupon
payment dates
Lockout period: Period till which the bond cannot be called.
Make-whole call:
• Make-whole provision acts as a “sweetener” to make the bond issue more attractive
to potential buyers resulting in a lower coupon rate.

• If such a provision exists and if bond is called before maturity, the present value of
the future coupon payments and principal repayment forgone is paid to investors
by the issuers.
Price Putable bond > Option free bond > Callable bond
Yield Putable bond < Option free bond < Callable bond
Bond will be Yield goes Price goes Price is

Called Down Up Capped (PAR)
Put Up Down Floor (PAR)
What are Convertible bonds?

§ A convertible bond is a hybrid security with both debt and equity features.
§ A combination of a straight bond (option-free bond) plus an embedded equity call
option
§ Gives the bondholder the right to exchange the bond for a specified number of
common shares in the issuing company.
Key terms for convertible bonds:

§ Conversion price: The price per share at which the convertible bond can be
converted into shares.
§ Conversion ratio: Par value divided by the conversion price.
§ Conversion value (Parity value): Current share price multiplied by the conversion
ratio.
§ Conversion premium: Convertible bond’s price less its conversion value
§ Conversion parity occurs if the Conversion value is equal to the convertible
bond’s price.
Contingent Convertibles (CoCos):

• Bonds with contingent write-down provisions are convertible on the downside.
• Several European banks have been issuing Cocos.
• Conversion is automatic if a specified event occurs—for example, if the Bank’s
capital falls below the minimum requirement set by the regulators.
• Must offer a higher yield than otherwise similar bonds.
Warrants:
• Entitles the holder to buy the underlying stock of the issuing company at a fixed
exercise price until the expiration date.
• Warrants are frequently attached to bond issues as a “sweetener.”
• Warrants are actively traded in some financial markets.

FIXED INCOME MARKETS: ISSUANCE, TRADING &

FUNDING
Primary Bond Markets

All sale of new issues occur in Primary market via:
A. Public offering (or public offer), in which any member of the public may buy the
bonds or via
B. Private placement, in which only a selected investor, or group of investors, may buy
the bonds
Public Offerings: The most common bond issuing mechanisms:

1. Underwriting Offering
2. Shelf registration
3. Auction
Underwritten Offerings - The Investment Bankers offer different services to issuers to help
them raise capital, this includes:
Underwritten Also called a firm commitment offering, here the IB guarantees the sale
offering of the bond issue at an offering price that is negotiated with the issuer
Best effort The IB only serves as a broker and only tries to sell the bond issue at the
offering negotiated offering price if it can, for a commission
Shelf Registration - Instead of issuing all bonds at once, a shelf registration gives
flexibility to authorized issuers to offer additional bonds in phases.
The issuer prepares Master Prospectus - a single, all-encompassing offering circular that
describes a range of future bond issuances, all under the same document.
Auctions - Bonds may be sold through auctions inviting bids from participants.
Auctions are helpful in providing price discovery and in allocating securities.
In many countries, most sovereign bonds are sold to the public via a public auction.
The auction process can be - Single-price auction or Multiple-price auction:

Single Price All the winning bidders pay the same price and receive the same coupon
Auction rate for the bonds, used in US
Multi Price The Process generates multiple prices and yields for the same bond issue,
Auction mostly used in the public auction process in countries like UK, Italy, India,
Sweden, Canada, and Germany

Primary Dealers
• Most US Treasury securities are bought at auction by primary dealers.
• Primary dealers are financial institutions that are authorized to deal in new issues
of US Treasury securities.
• They have established business relationships with the Federal Reserve Bank of
New York (New York Fed), which implements US monetary policy.
Sovereign Bonds
• Sovereign Bonds are issued by Government to meet their spending goals.
• Basically, it is the fiscal deficit (when tax revenues are insufficient to cover
expenditures) which is the primary reason to issue sovereign bonds.
• On the run (Benchmark) issues - Sovereign securities which are most recently issued
Non-Sovereign Government Bonds

• Issued by Governments of provinces, regions, states, and cities.
• These bonds are typically issued to finance public projects, such as schools,
motorways, hospitals, bridges, and airports.
• Non-sovereign bonds are typically not guaranteed by the national government.
• However, non-sovereign bonds still receive high credit ratings.
• Non-sovereign bonds usually trade at a higher yield and lower price than
sovereign bonds with similar characteristics.
Quasi-Government Bonds
• These are Bonds issued by organizations set up by the National Governments for
performing various functions.
• These organizations often have both public and private sector characteristics, but
they are not actual governmental entities (ITC, ADNOC, ARAMCO, ONGC, etc.)
Supranational Bonds
• Highly rated bonds are issued by supranational agencies, also referred to as
multilateral agencies
• The most well-known supranational agencies are the World Bank, the IMF, the
European Investment Bank (EIB), the Asian Development Bank (ADB), and the
African Development Bank (AFDB)
Types of Corporate Debt

Bank Loans Primary source of debt financing for small and medium-size companies.
and Also for large companies in countries with under-developed bond
Syndicated markets
Loans Bilateral loan - Loan from a single lender to a single borrower
Syndicated loan - Loan from a group of lenders (syndicate) to a single
borrower.

Bank loans can be customized to the borrower’s needs.

Commercial Short-term, unsecured promissory note Issued to public or via a private
Paper (CP) placement.
and its Issued by Large credit worthy companies through which they reduce
characteristics their funding cost.
Maturity ranges from overnight to 364 days with 90 days as most
famous ones (in US less than 270 days)
Commercial paper is often reissued or rolled over when it matures
Medium-term MTNs can have very long maturities.
note (MTN) MTNs can carry floating or fixed rates.
MTNs are offered continuously to investors by an agent of the issuer.
MTNs turn out to be lower cost option for the issuer because of cost
savings in registration and underwriting.
Corporate Notes and Bonds

Term Maturity
Short Term 5 years
Medium Term 5-12 Years
Long Term Above 12 Years
MTNs 9 months - 100 years
Structured Financial Instruments

• Structured Financial instruments represent a broad sector of financial instruments.
• Typically have customized structures that often combine a bond and at least one
derivative.
Protected These instruments offer either full or part capital protection.

Instruments Example - Guarantee Certificate which involves a package of zero-
coupon bond and call option on underlying asset.
Yield These instruments allow investors to seek higher return by increasing
Enhancement risk exposure. For example, Credit Linked Note (CLN) creates a credit
Instruments exposure for investor (who acts as a protection seller) by transferring the
exposure from the issuer of CLN (who basically is a protection buyer).
Participation These instruments allow investors to participate in return of underlying
Instruments assets. These may not offer capital protection. Floaters can be
considered as a type of participation instruments. Many structured

products sold to individuals are participation instruments linked to an

equity index. These create indirect exposure to a particular asset class
such as equity index and hence may attract those investors for whom
direct exposure is prohibited.
Leveraged These are instruments created to magnify returns and offer the
Instruments possibility of high payoffs from small investments.
Inverse Floater is an example of Leverage Instrument
Under Inverse Floater, when the reference rate decreases, the coupon
payment of an inverse floater increases.
Inverse floater coupon rate: Coupon – (Lev × Ref. rate)
Short-term funding alternatives available to banks

Banks typically have access to:
The retail Retail deposit accounts from their customers.
market Retail or Customer Deposits - Primary sources of funding for deposit-
taking banks. Retails deposits include - Demand deposits (checking
accounts), Savings accounts, Money Market Mutual Funds
The Includes Central bank funds, interbank deposits, and certificates of deposit.
wholesale A. Certificate of Deposits
market B. Central bank funds
C. Interbank funds
REPO - Repurchase and Reverse Repurchase Agreements

• A repurchase agreement or repo is the sale of a security with an agreement to buy
the security back from the purchaser at an agreed price at a future date.
• In practical terms, a repurchase agreement can be viewed as a collateralized loan
in which the security is sold and subsequently repurchased.
• Repurchase agreements are a common source of money market funding for
dealer firms in many countries.
Repo Terminologies
Repo rate The interest rate on a repurchase agreement
Repurchase Price The price at which the dealer repurchases the gilt
Repurchase Date The date when the gilt is repurchased
Overnight Repo When the term of a repurchase, agreement is one day

Term Repo When the agreement is for more than one day
Repo to Maturity An agreement lasting until the final maturity date
Reverse Repo A re-purchase agreement when viewed from the counterparty’s
point of view
Several factors affect the repo rate (rate will be Low when):
• Lower risk of collateral
• Shorter term of the repurchase agreement.
• Delivery of collateral to the lender is required.
• Scarcer a specific piece of collateral
• Lower the interest rates of alternative financing in the money market.

INTRODUCTION TO FIXED-INCOME VALUATION

Relation between Yield, Coupon & Price of Bond:
YTM > Coupon Discount
YTM = Coupon Par
YTM < Coupon Premium
The yield-to-maturity is the rate of return on the bond to an investor given three critical
assumptions:
1. The investor holds the bond to maturity.
2. The issuer makes all of the coupon and principal payments in the full amount on the
scheduled dates i.e., we assume the issuer will not default on any of the payments
3. The investor can reinvest coupon payments at that same YTM.
Relation between Bond Price & Bond Characteristics can be summarized as :

Inverse effect Price and yield are inversely related
Coupon effect lower coupon bonds are more sensitive to the yield change
Maturity effect*** Higher the maturity higher is the change in the bond price
***Exception - lower coupon bonds (Coupon < Yields)
Two bonds with same maturity and same yield - the ZCB is riskier CBB:
Convexity For the same coupon rate and time- to- maturity. The impact of change in
Effect yield and price of bond is not linear but curved (Convex). Also, the
percentage price change is greater when the market discount rate goes down
than when it goes up.
Pull to Tendency of a bond's price to approach its par value by its maturity date.
Par Effect Discount bonds that trade below par will see their value rise as maturity
approaches. Premium bonds, on the other hand, will see their value fall
towards par value as they approach maturity.
Yield Curve / Spot Curve

• The Spot rate Treasury curve is a yield curve constructed using Treasury spot rates
rather than yields.
• It’s the curve with Treasury yields for various maturities and is used widely to value
risk free bonds.

• The shape and level of the spot curve changes continuously with the market prices
of bonds.
• Ideally spot rate curve is built from on-the-run treasuries, off-the-run treasuries, or
a combination of both.
Forward rates
• The annualized interest rate on a debt to be initiated at a future period is called
the forward rate for that period.
• The term structure of forward rates is called the forward curve.
The forward curves and spot curves are mathematically related, and we can derive one
from the other.
Pricing Bonds with Spot Rates

PMT PMT PMT + FV
PV = + … … … +
(1 + z4 )4 (1 + z5 )5 (1 + z6 )6
Clean vs Dirty Price

Name Meaning Formula
Flat Price/Clean The price at which bonds are 0
Price/Quoted Price traded or quoted in the market ./ 7)** = (./) × (1 + 2)8
(on settlement date)
Accrued Interest (AI) Accrued interest - from the 5
date of previous coupon 34 = × 789:8;
6
payment date till the selling
date
Full Price/Dirty Price It is the price actually paid ./ 7)** ./ 7*(0 + AI
Matrix Pricing
• It is the process of a method of estimating the required YTM (or price) of bonds with
Maturity that are currently not available, not traded or infrequently traded.
• The procedure is to use the YTMs of traded bonds that have credit quality very
close required bond with similar in maturity and coupon.
• Interpolation is used for calculation for averaging in case if the required maturity is
not available.
Street Yield vs True Yield

Street Ignores the Considers Dividend received on the exact date

Convention weekends or (ignoring weekends or holidays)
holidays
True Yield Actuals weekends or Considers Dividend received on a date after the
holidays weekend or holidays if the due date falls on holiday
Yield Measures for Callable Bonds

• Right to the issuer to call back (buy back) the bond at some point of time in future.
• The issuer may call back if the interest rates go down.
• Bonds are called back at premium.
Option Adjusted Yield and Call Price

The value of a callable bond is equal to the value of the option free bond less the value
of the call option.
Value of Callable bond = Value of Option Free bond - Call Option Value
The option-adjusted yield is calculated by adding the value of the call option to the
bond’s current flat price.
Call Option Value = Value of Option Free bond - Value of Callable bond
The option-adjusted yield

• They are yields of callable bonds after adjusting (removing) for the effect of Call
option.
• They can be used to compare the yields of bonds with various embedded options
to each other and to similar option-free bonds.
Yield to Worst - The lowest yield realized if the bond on the Callable bond is called Yield
to Worst.
Yield Measures for Floating-Rate Notes

Coupon on FRNs:
• Value of FRNs is more stable relatively as the coupon interest rates are reset
periodically based on a reference rate like Libor/SOFR.
• Coupon is always paid in arrears but are uncertain.
• Coupon rate is the reference rate plus or minus a margin.
• Margin is based on the Credit risk of the bond relative to the Credit risk of the
reference rate instrument.

Quoted Margin and Discount Margin

Quoted Margin used to calculate the bond coupon payments is called as the
Margin Quoted margin. Quoted margin is added to the Coupon rate =
Reference rate (Libor) + Quoted margin
Discount or The Required or Discount margin is the yield spread over, or under, the
Required reference rate such that the FRN is priced at par value on the reset date
Margin The Discount Margin is added to the Yield = Reference rate (Libor) +
Discount margin
When Credit Quality of FRN QM vs DM Value of FRN

Remains Unchanged QM = DM Par
Decreases QM < DM Discount
Increases QM > DM Premium
Money Market Instruments

Bond YTM MM YTM
Yield Annualized and compounded Annualized but not compounded
Measures instead use a simple rate of interest
YTM Calculated using standard time- Often are quoted using nonstandard
Calculation value-of-money analysis and with interest rates and require different
formulas programmed into a pricing equations than those used for
financial calculator bonds
Periodicity Usually are stated for a common Have different times-to- maturity have
periodicity for all times-to-maturity different periodicities for the annual
(365 days) rate (360 or 365 days)
Quoted money market rates are either:

1. Discount rates
• T Bills, Banker's Acceptance
• Stated on 360-day basis.
2. Add-on rates
• Bank CDs, REPOs, Indexes on LIBOR, etc.
• BEY - is a money market rate stated on a 365-day add-on rate basis.

Yield Pricing
Discount Yield Year FV − PV Days
H Lx H L PV = FV x H1 − × DRL
Days FV Year
Annualised Rate of Return Year FV − PV FV
H Lx H L PV =
Days PV Days
R1 + × AORT
Year
Bond Equivalent Yield 365 FV − PV AOR to BEY = AOR*365/360
H Lx H L
Days PV
Yield Curve
• Yield curves is a graphical curve which plots YTM of bonds (same credit) at
different maturities.
• The slope of the yield curve gives an idea of future interest rate changes and
economic activity.
Spot Spot rate for U.S. Treasury bonds is also referred to as the Zero curve or
Curve Strip curve (because zero-coupon U.S. Treasury bonds are also called
stripped Treasuries). Spot rates can be considered as Zero Coupon YTM for
bond for every maturity.
Spot Market rate = Rates starting from today (0th year)
Par Curve A par bond yield curve, or par curve is the yield that reflects coupon rate
that would make a bond priced at par.
Alternatively, they can be viewed as the YTM of a par bond at each
maturity. Remember for a Par bond YTM and Coupon are both same.
A Par curve is constructed from the spot curve, so it is Coupon at which the
bond is valued at Par after discounting it at the respective Spot rate.
Forward A forward rate is a borrowing/lending rate for a loan to be made at some
Market future date. Forward rates can be estimated from the Spot rates.
Yield Spreads
• A yield spread, in general, is the difference in yield between different fixed
income securities.
• Fixed-rate bonds often use a government benchmark security with the same time-
to-maturity as, or the closest time-to-maturity to, the specified bond (on-the-run
security)
• A frequently used benchmark for floating-rate notes is LIBOR/SOFR.

• Yield spreads are typically quoted in basis points.

• Widening of Spread reflects high credit risk and narrowing of spread indicates low
credit risk.
G-Spread YTM Corporate Bond (-) Treasury Yield

I-Spread YTM Corporate Bond (-) Swap rate
OIS Spread Reference rate− OIS rate
Z-Spread The G-spread and I-spread each use the same discount rate for each
cash flow. Z-spread uses a constant yield spread over a government (or
interest rate swap) spot curve is known as the zero-volatility spread (Z-
spread) of a bond over the benchmark rate.
The Z-spread over the benchmark spot curve can be calculated as follows:
PMT PMT PMT + FV

PV = 4
+ 5
+ ⋯………+
(1 + S4 + Z) (1 + S5 + Z) (1 + S6 + Z)6

INTRODUCTION TO ASSET BACKED SECURITIES
Securitization
• Securities that are backed, or collateralized, by a pool (collection) of assets, such
as loans and receivables are referred to generically as Asset-backed securities
(ABS)
• Securitization is a process whereby the underlying assets which is a pool of various
assets/loans, are purchased by an entity, which then issues securities which are
supported by the cash flows of these underlying pool of assets/loans
• Assets that are typically used to create asset backed bonds are called securitized
assets and include, among others, residential mortgage loans, commercial
mortgage loans, automobile loans, student loans, bank loans, and credit card
debt.
Participants in the Securitization Transaction

Originators The Company which wants to raise funds through Securitization
Obligors Those who have been borrowers of loan with the Originator
SPE or SPV A legally independent company set up by the originator who
gets the assets transferred and is considered bankruptcy remote
from the seller of the loans
Servicer Helps in collection and transfer of amount from the obligors to
the investors
Rating Agencies Needed to rate the Securities issued by Originators
Enhancement Providers Needed to give more support to the credit issues by Originator
Investment Bankers Help in structuring the deal, pitching the securities to Financial
institutions and creating market for Securitized papers
Investors FIs like Corporates, Mutual Funds, Pension Funds, SWFs, Banks,
Insurance Companies, etc.
Others Independent accountants, lawyers/attorneys, trustees,
underwriters, etc.
Benefits of Securitization for Economies and Financial Markets

The Major objective of Securitization is to generate source of capital and liquidity at low
cost, however, there are range of benefits both for the issuers and investors in the
securitization process which are as below:

Investors Lowering or removing of the wall between ultimate investors and

originating borrowers.
Investors get to choose between variety of securities which suit their needs.
Securitization provides diversification and risk reduction compared to
purchasing individual loans (whole loans).
Borrowers Lowering of the costs paid by borrowers and enhancing the risk-adjusted
returns to ultimate investors.
Improvement of banks’ profitability by increasing loan origination more
than they would be able to do by their own finance.
Markets Creation of tradable securities with better liquidity than the original loans
on the bank’s balance sheet.
Greater efficiency and liquidity of financial markets.
Enabling of innovations in investment products.
Tranching - Creation of Classes

Time Here several classes of the ABS are created with different priority claims to
Tranching the cash flows from the underlying pool of loans. They also have different
specifications of the payments to be received if the cash flows from the
loans are not sufficient to pay all the promised ABS cash flows. Each class is
paid sequentially (Waterfall Structure)
Credit Here the bond classes are distributed based on how they will share any
Tranching losses resulting from defaults of the borrowers (from the pool) loans in a
structure called senior/subordinate structure. The purpose of this structure is
to redistribute the credit risk associated with the collateral.
Residential Mortgage Loans - Important Features

Meaning A mortgage loan is secured by the collateral of real estate property
The mortgage gives the lender the right to take possession of the
mortgaged property and then sell it in order to recover funds toward
satisfying the debt obligation, called foreclosing of loan
The higher the loan-to-value ratio (LTV), the lower the borrower’s
equity and hence greater credit risk for the lender
Maturity In the US, the typical maturity: 15-30 years
In Europe, the typical maturity: 20-40 years
It can be as long as 50-100 years
Interest Rate The interest rate on a mortgage loan is called the mortgage rate or
Determination contract rate.

The four basic ways that the mortgage rate can be specified are as
follows:
Fixed rate - Rate does not change over time (US, France, Germany)
Adjustable or variable rate - Based on Reference rate (UK, Australia,
South Korea)
Hybrid Mortgage - Fixed till initial period and then adjusted (Canada,
Denmark, Switz)
Convertible - The borrower has option to convert the Mortgage rate
later on (Japan)
Amortization In most countries, residential mortgages are amortizing loans.
Schedule There are two types of amortizing loans:
Interest-only mortgage: The borrower pays only the interest and does
not have to make any principal repayment in the initial years of the
mortgage.
Interest-only lifetime mortgage: There are no scheduled principal
repayments over the entire life of the loan, the entire original loan
amount has to be repaid in one ‘balloon’ payment at the end (Bullet
Mortgages)
Prepayments Any payment toward the repayment of principal that is more than the
scheduled principal repayment. It is an option or an early repayment
option which entitles the borrower to prepay all or part of the
outstanding mortgage principal prior to the scheduled due date
Prepayment risk It is the uncertainty in cash flows received by the lender, due to the
borrowers’ ability to alter payments, usually to take advantage of
interest rate movements
Prepayment Prepayment penalty mortgages impose penalty if prepaid
Penalties
Rights of the Recourse loan: The lender has a claim against the borrower for the
Lender in a shortfall between the amount of the mortgage balance outstanding
Foreclosure and the proceeds received from the sale of the property.
Non-recourse loan: The lender can look only to the property to
recover the outstanding mortgage balance
Strategic In a non-recourse loan, if the market value of house falls below the
default amount to be repaid at any given stage, the borrower loses incentive
to continue the mortgage payment and instead could choose to
deliberately commit a ‘strategic default’
Types of RMBS
Agency RMBS Mortgage pass through securities

CMO - Securities that are collateralized by RMBS.

The primary CMO structure includes:
• Sequential-pay tranches.
• Planned amortization class tranches (PACs), Support
tranches and
• Floating-rate tranches
Non-Agency RMBS Not guaranteed by the US government or by a GSE
Agency RMBS
If a loan satisfies the underwriting standards for inclusion as collateral for an agency
RMBS, it is called a “conforming mortgage.” These are required for agency RMBS.
Guaranteed by a The RMBS Guaranteed by a Federal Agency like Ginnie Mae which
Federal Agency are backed by full faith and credit of the US Government
Guaranteed by The RMBS Guaranteed by GSEs in US like Fannie Mae and Freddie
GSEs or Private Mac which do not carry the full faith and credit of the US government
Entities and those issued by private entities which are neither guaranteed by
a federal agency nor by GSE
Mortgage Pass-Through Securities

• Agency RMBS are mortgage pass-through securities
• Each mortgage pass-through security represents a claim on the cash flows from a
pool of mortgages of securitized mortgage
• A pool can consist of several thousand or only a few mortgages
• When a mortgage is included in a pool of mortgages that is used as collateral for
a mortgage pass-through security, the mortgage is said to be securitized
Characteristics of Mortgage Pass Through Securities

Cash Flow Cash flow consists of:
• Monthly mortgage payments representing interest.
• The scheduled repayment of principal, and
• Any prepayments
Service Fee The servicing fee is typically a portion of the mortgage rate
The monthly cash flow for a mortgage pass-through security is less
than the monthly cash flow of the underlying pool of mortgages by
an amount equal to servicing and other fees
Pass through rate A mortgage pass-through security’s coupon rate is called the pass-
through rate.

The pass-through rate needs to be lesser than the mortgage rate by

an amount equal to the servicing and other fees
A weighted WAC is found by weighting the mortgage rate of each mortgage
average coupon loan in the pool by the percentage of the mortgage outstanding
rate (WAC) relative to the outstanding amount of all the mortgages in the pool
A weighted WAM is found by weighting the remaining number of months to
average maturity maturity for each mortgage loan in the pool by the amount of
(WAM) outstanding mortgage balance
Prepayment Risk
Contraction When interest rates decline, the risk that a security will have a shorter
risk maturity than was anticipated at the time of purchase because
homeowners refinance at now-available lower interest rates
Extension Risk that when interest rates rise, fewer prepayments will occur because
risk homeowners are reluctant to give up the benefits of a contractual interest
rate that now looks low. As a result, the security becomes longer in
maturity than anticipated at the time of purchase
Prepayment Rate Measures

SMM Single monthly mortality rate
SMM = Prepayment for month ÷ (Beginning mortgage balance for month –
Scheduled principal repayment for month)
CPR Conditional prepayment rate which is a corresponding annualized rate of SMM
Collateralized Mortgage Obligations

• The cash flows of mortgage-related products are redistributed to various tranches.
• In contrast to a mortgage pass-through security, the collateral is not a pool of
mortgage loans but a mortgage pass-through security.
• The creation of a CMO cannot eliminate prepayment risk; it can only distribute the
various forms of this risk among various classes of bondholders.
The primary CMO structure includes:

• Sequential-pay tranches.
• Planned amortization class tranches (PACs), Support tranches and
Sequential-Pay Tranches
• Each class of bond (the tranches) would be retired sequentially.

• The precise amount of the principal repayment will depend on the cash flow of the
collateral, which depends on the actual prepayment rate of the collateral.
PAC SUPPORT Tranches

PAC The greater predictability of the cash flows for PAC tranches occurs because
Tranches a principal repayment schedule must be satisfied.
PAC bondholders have priority over all other tranches in the CMO structure
in receiving principal repayments from the collateral.
The greater certainty of the cash flows for the PAC tranches comes at the
expense of the non-PAC tranches, called support tranches or companion
tranches
Support Absorb the prepayment risk first.
Tranches Absorb principal repayments more than scheduled principal payments to
the PAC tranches if the prepayments are faster than expected.
Do not receive any principal until the PAC tranches receive their scheduled
principal repayment if the prepayments are slower than expected.
They thus expose investors to the greatest level of prepayment risk
Non-agency Residential Mortgage-Backed Securities

• These are not guaranteed by the US government or by a GSE that can provide
protection against losses in the pool.
• Hence, some form of internal or external credit enhancement is necessary to make
these securities attractive to investors.
Non RMBS May include.

• Prime loans and
• Subprime loans
Commercial Mortgage-Backed Securities (CMBS)

Meaning CMBS are backed by a pool of commercial mortgage loans on income-
producing property, such as multifamily properties (e.g., apartment
buildings), office buildings, industrial properties (warehouses etc.),
shopping centers, hotels & health care facilities (e.g., senior housing
care facilities)
Credit Risk Commercial mortgages are generally non-recourse loans which means the
lender can look only to the property to recover the outstanding mortgage
balance
Key Loan-to-value ratio - The amount of Loan against the Value of asset
indicators of

potential Debt-to-service-coverage (DSC) ratio - Annual NOI divided by the Debt

credit service (Interest & Principal)
performance NOI-Rental income reduced by cash operating expenses and a non-cash
replacement reserve reflecting depreciation of the facilities over time.
Basic CMBS Structure

• A credit-rating agency determines the level of credit enhancement necessary to
achieve a desired credit rating.
• Interest on principal outstanding is paid to all tranches.
• The lowest priority CMBS tranche absorbs the losses arising from loan defaults,
such tranches are usually not rated by credit-rating agencies and referred to as the
‘first-loss piece’, ‘residual tranche’ or equity tranche.
Call Protection
• With CMBS, investors have considerable call protection unlike in case of RMBS
• Hence CMBS trades in the market more like corporate bonds than like RMBS
• Call protection can be: At the structure level: Sequential pay tranches & at the
Loan Level.
At the loan level:

Prepayment Contractual agreement that prohibits any prepayments for a specified
lockouts period
Prepayment Predetermined penalties that a borrower who wishes to refinance must
penalty points pay.
(1 point = 1% of outstanding loan balance)
Yield Penalty that neutralizes the benefit to a borrower of refinancing at a
maintenance lower rate
charges
Defeasance Portfolio investment strategy using Government securities such that cash
flows from securities match interest and principal repayments as per
term of loan (like the Asset-liability matching investment strategy used
by insurance companies)
Non-Mortgage Asset-Backed Securities

Types of non-mortgage assets have been used as collateral in securitization:
Auto loan and lease receivables, credit card receivables, personal loans, and
commercial loans. Collaterals can be amortizing or non-amortizing.
Amortizing Loan Traditional residential mortgage loans and Automobile loans.

The cash flows for an amortizing loan include interest payments,

scheduled principal repayments and any prepayments, if
permissible.
Non-amortizing The loan has no schedule for paying down the principal.
Loan The prepayment issue does not affect it.
A credit card receivable is an example of a non-amortizing loan
The lockout periods.

• Also called as ‘revolving period’ is the period during which the principal received is
reinvested to acquire additional loans with a principal equal to the total principal
received from the cash flow.
• When the lockout period is over, any principal that is repaid will not be used to
reinvest in new loans but instead distributed to the bond classes
Auto Loan Receivable-Backed Securities

• Includes deals backed by auto loan and lease receivables.
• The cash flows for auto loan-backed securities consist of regularly scheduled
monthly loan payments (interest payment and scheduled principal repayments)
and any prepayments.
• Prepayments result from sales and trade-ins requiring full payoff of the loan,
repossession and subsequent resale of vehicles, insurance proceeds received upon
loss or destruction of vehicles, and refinancing of the loans at a lower interest rate.
• All auto loan-backed securities have some form of credit enhancement.
Credit Card Receivable-Backed Securities

• At the time of purchase, the credit cardholder is agreeing to repay the amount
borrowed (i.e., the cost of the item purchased) plus any applicable finance charges.
• The amount that the cardholder has agreed to pay the issuer of the credit card is a
receivable from the perspective of the issuer of the credit card.
• Credit card receivables are used as collateral for the issuance of credit card
receivable-backed securities.
• For a pool of credit card receivables, the cash flows consist of finance charges
collected, fees, and principal repayments.
• Interest is paid to security holders periodically (e.g., monthly, quarterly, or
semiannually)
• The interest rate may be fixed or floating — roughly half of the securities are
floaters.
• Certain provisions in credit card receivable-backed securities require early
amortization or rapid amortization of the principal if certain events occur.

Collateralized Debt Obligations (CDO)

A generic term used to describe a security backed by a diversified pool of one or more
debt obligations.
CBOs Backed by corporate & emerging market bonds
CLOs Backed by leveraged bank loans
Structured finance CDOs Backed by ABS, RMBS, CMBS, and other CDOs
Synthetic CDOs Backed by a portfolio of credit default swaps
Structure of a CDO Transaction

• The funds to purchase the collateral assets for a CDO are obtained from the
issuance of debt obligations.
• These debt obligations are bond classes or tranches.
• The bond classes include senior bond classes, mezzanine bond classes (bond
classes with credit ratings between senior and subordinated bond classes), and
subordinated bond classes (often referred to as the residual or equity class
Cash Inflows to Primarily include interest received from collateral.

CDO structure In addition, if any derivatives such as interest rate swaps are used in
the structure, then CDO may receive cash flows from such
arrangements
Cash Outflows Include interest paid to various tranches such as Senior tranche,
from CDO Mezzanine tranche etc.
structure It could be a fixed payment or floating payment based on
benchmark rate

UNDERSTANDING FIXED-INCOME RISK AND RETURN

YTM at the time of purchase measures the investor’s rate of return under three
assumptions:
• The investor holds the bond to maturity.
• There is no default by the issuer and
• The coupon interest payments are reinvested at YTM.
Total return (amount) on the Bonds:

• Coupons
• Reinvestment of Coupons
• Redemption Amount
Horizon yield or Realized return (Holding Period return)

• IRR between the total return (amount received) from the bond and its purchase
price.
• The horizon yield on a bond investment is the Annualized HPR.
!
79;"<
• Realized return = :9
−1
Realized returns vs YTM?

The Realized or horizon yield matches the original Yield-to-maturity if:
1. Coupon payments are reinvested at the same rate as the original yield-to-maturity
2. The bond is sold at a price on the constant-yield price trajectory, resulting into zero
capital gains or losses when the bond is sold.
Capital Gains (Losses) arise if a bond is sold at a price above (below)its constant-yield
price trajectory.
Assuming the Bond makes all the promised payments and on time and assuming that the
reinvestment occurs at YTM itself, there are five broad conclusions:
Scenario Bond Holding Period Reinvestment rate vs YTM Realized return vs YTM
1 Bond is HTM Reinvestment rate = YTM Realized return = YTM
2 Bond is not HTM Reinvestment rate = YTM Realized return = YTM
3 Bond is HTM Reinvestment rate > YTM Realized return > YTM
4 Bond is not HTM Reinvestment rate > YTM Realized return < YTM
5 Bond is HTM Reinvestment rate < YTM Realized return < YTM
6 Bond is not HTM Reinvestment rate < YTM Realized return > YTM

The result is based on the idea of a trade-off between two risks:

1. Market price risk and
2. Coupon reinvestment risk
These risks are the two offsetting types of interest rate risk that affect the bond investor:
Coupon Uncertainty about the total of coupon payments and reinvestment
reinvestment risk income on those payments due to the uncertainty about future
reinvestment rates
Market price risk Uncertainty about price due to change in market yield
DURATION
Type of Duration Indicates Helpful in
Macaulay Time it takes to recover the initial Finding the Payback time
Duration investment
Modified Sensitivity of Bond price due to change Small Changes in Yield
Duration in Yield (assumes linear relation)
Approximate Sensitivity of Bond price due to change Large Changes in Yield
ModDur in Yield (assumes Non-linear relation)
Effective Sensitivity of Bond price due to change Large Changes in Yield
Duration in Yield Curve (used for bonds with Curve
Embedded option)
Key rate Sensitivity of Bond price due to change Finding effect of non-
Duration in Yield Curve of Specific Maturity parallel shift in Yield Curve
Duration of a Bond Portfolio

Two ways to calculate the duration of a bond portfolio:
1. Weighted average of time to receipt of the aggregate cash flows (theoretically
correct but difficult to use)
2. Weighted average of the individual bond durations that comprise the portfolio
(commonly used)
Approach 1: Weighted average of time to receipt of the aggregate cash flows

• In this approach, the aggregated cash flows are identified, and IRR is obtained
(called Cash flow yield)
• Macaulay duration is then calculated as the weighted average of time to receipt of
aggregated cash flow, where the Cash flow yield is used to obtain the weights.

Approach 2: Weighted average of the individual bond durations

• Macaulay and Modified durations for the portfolio are calculated as the weighted
average of the statistics for the individual bonds.
• An advantage of this approach is that callable bonds, putable bonds, and
floating-rate notes can be included in the weighted average using the effective
durations for these securities.
• A limitation is that this measure of portfolio duration implicitly assumes a parallel
shift in the yield curve.
Note:
When the yield curve is flat, the two approaches produce the same portfolio duration.
Properties of Bond Duration for Non-callable bonds

• The duration of a bond that uses the actual/actual method to count days is slightly
different from that of an otherwise comparable bond that uses the 30/360 method.
• Macaulay duration of a zero-coupon bond is its time-to-maturity.
• Macaulay duration for a CBB, decreases smoothly as the bond approaches
maturity, which creates a “saw-tooth” pattern.
Macaulay and Modified duration statistics for a fixed-rate bond depend primarily on:
Coupon rate Higher the coupon rate, lower the duration.
Yield-to-maturity Higher the yield-to-maturity, lower the duration.
Time-to-maturity Longer the time to maturity, higher the duration with exceptions
of some bonds trading at discount.
Money Duration of a Bond

The money duration of a bond is a measure of the price change in units of the currency in
which the bond is denominated (for example dollar duration)
MoneyDur = AnnModDur × PVFull
Hence, if ModDur gives us the Percentage Change in Bond price due to duration, Money
Duration gives us the Dollar change in Bond Price
ΔPVFull ≈ − MoneyDur × Δyield
%ΔPVFull ≈ − AnnModDur × ΔYield
Money duration is sometimes expressed as Money duration per 100 of bond par value

Money Duration per 100 units of par value = Annual ModDur × PVFull per 100 of par
value
Price Value of a Basis Point (PVBP)

It is an estimate of change in the full price given a 1 basis point change in the YTM.
(PV= ) − (PV> )
PVBP = `a (PV= ) − (PV? )
2
Alternatively: If we have Money duration (per 100) we can calculate PVBP directly by
dividing it by 10,000.
@ABCD EFGHIJAB KCG 4??
PVBP = 4????
Convexity
• Convexity is a measure of the curvature of the price-yield relation
• The more curved it is, the greater the convexity adjustment to a duration-based
estimate of the change in price for a given change in YTM.
[(PV= ) + (PV> )] − [2 × (PV? )]

Approx Convexity =
(∆Yield)5 × (PV? )
EFFCON
• Callable bonds often have negative convexity at lower yields but positive convexity
at higher yields like an Option free bond.
• Putable bonds always have positive convexity like an Option free bond.
[(PV= ) + (PV> )] − [2 × (PV? )]
Effective Convexity =
(∆Curve)5 × (PV? )
Finding the value of Bond with Duration and Convexity:

1
%∆PV LFMM ≈ (−AnnModDur × ∆Yield) + i × AnnConvexity × (∆Yield)5 j
2

Duration Gap
Duration Gap = MacDur - Investment Horizon
When Duration Gap Coupon reinvestment risk vs Price risk Risk of Interest
rate
IH > MacDur Negative Coupon reinvestment risk > Price risk Falling
IH < MacDur Positive Coupon reinvestment risk < Price risk Increase
IH = MacDur Zero Coupon reinvestment risk = Price risk No risk
We can estimate the impact on a bond’s value of a change in spread:

1
%∆PV LFMM = (−Duration × ∆k:2lmn) + i × Convexity × (∆k:2lmn)5 j
2

FUNDAMENTALS OF CREDIT ANALYSIS

Default risk vs Credit risk
Default risk is the narrower term Credit risk is the broader term because it
because it addresses the likelihood of considers both the default probability and
an event of default how much is expected to be lost if default
occurs
Modelling the Credit risk: Factors considered in Modelling Credit risk of Bond are: -
Expected It is the amount of money a bond investor in a credit risky bond stands
exposure to lose at a point in time before any recovery is factored in. A bond’s
expected exposure changes over time.
Loss severity Is the percentage of amount you lose in case the bond is defaulted
Recovery rate It is the percentage of loss recovered in the event of a default.
Recovery rate is the opposite of loss severity.
For Ex. At a loss severity of 40%, the recovery rate would be 60%.
Loss given It is amount of Loss in event of default.
default (LGD) It is equal to loss severity multiplied by exposure
Probability of It is the likelihood of default occurring in a given year
default (POD)
Probability of It is 1 – the cumulative conditional probability of default
survival
Expected Loss POD × LGD
Credit This is the risk that a bond issuer’s creditworthiness deteriorates, or

migration (or migrates lower, leading investors to believe that:
downgrade) • The risk of default is higher.
risk • Causing the yield spreads on the issuer’s bonds to widen
• Price of its bonds to fall
Market This is the risk that the price at which investors can actually transact
liquidity risk (buying or selling) may differ from the price indicated in the market
Liquidity Compensation for risk that there may not be sufficient market liquidity
premium to buy or sell bonds in the quantity desired
Two main issuer-specific factors that affect market liquidity risk are:

• The size of the issuer: The amount of publicly traded debt an issuer has
outstanding.
• The credit quality of the issuer: lower credit quality – higher liquidity risk and
vice versa
Seniority Ranking
The bond's priority of claims to the issuer’s assets and cash flows is referred to as its
seniority ranking.
Typical Ranking in Order of Seniority:
Secured debt First Lien - Senior Secured
Second Lien - Secured
Unsecured debt Senior Unsecured
Senior Subordinated
Subordinate
Junior Unsecured
Pari Passu
It means that all creditors at the same level of the capital structure are treated as one
class. In the event of Bankruptcy all bond holders in a particular seniority ranking have
similar claims
Why does Priority of Claims not work always?

Due to the judge’s order the absolute priority may not be strictly enforced in the final
plan.
Issuer vs. Issue Ratings

Rating Type Also Known as Ratings for Ratings Scale
Issue rating Corporate Credit The ratings assigned to the Can be anywhere
rating various Issues by the from AAA to D
Company
Issuer credit Corporate Family Ratings assigned to the Equal to the Senior
rating rating Issuer's creditworthiness Unsecured Debt
The Concept of Notching in Credit ratings:

Notching is the practice of lowering the rating by one or more levels for more
subordinate debt of the issuer.

Credit Migration
• Credit Migration is change in Credit ratings of Bonds.
• The change in the price of the bond depends on the modified duration of the bond
and the change in spread resulting from the change in credit risk.
Risks of relying on Credit rating agencies:

• Credit ratings change over time.
• Ratings Tends to Lag markets.
• Ratings agencies may make mistakes.
• Difficult to capture all risks.
Credit Analysis
Most of the Credit Analysts use some fundamental principles to evaluate the Credit risk.
A common way to categorize the key components of credit analysis is by the four Cs.
These 4 Cs include:
Capacity Refers to Borrower’s ability repay its debt obligations on time.
Analysis of capacity is like the process used in equity analysis.
Collateral More essential for less creditworthy companies
Assessing appropriate value of Collateral is not easy
Covenants Legally enforceable rules that borrowers and lenders agree on at the time
of a new bond issue. Covenants can be Affirmative & Negative.
Character Refers to management’s integrity and its commitment to repay the loan.
Factors such as management’s business qualifications and operating record
are important for evaluating character
Financial ratios in Credit Analysis

Category Ratios Formula Interpretation Expectation
Profitability EBITDA EBIT + Dep + Amt Operating Cash flow Higher
ratios better
FFO NI from continuing CFO but excludes Higher
operations + non-cash Working Capital better
+ Deferred Taxes changes
FC before NI + Non-Cash - FC Amount available for Higher
Dividends Invest - WCAP all capital providers better
Changes
FC after FC before dividends - Amount that can be Higher
Dividends Dividends used to repay debt better

Leverage Debt to Capital Total Debt/Total Percentage of Lower

ratios Capital Capital financed by better
Debt
Debt to EBITDA Total Debt/EBITDA Signal of Operating Lower
leverage better
FFO/Debt FFO/Debt Cash flow available Higher
to pay debt better
FCF after FCF after Ability to pay debt Higher
Dividends/Debt Dividends/Debt better
Coverage EBITDA/Interest EBITDA/Interest Times of interest that Higher
ratios Expense Expense can be covered better
EBIT/Interest EBIT/Interest Expense Times of interest that Higher
Expense can be covered better
Yield on corporate bond = Real risk-free interest rate + Expected inflation rate
+ Maturity premium + Liquidity premium + Credit spread
Factors affecting spread:

• Credit cycle
• Broader Economic conditions
• Financial market performance
• Broker-dealers’ willingness to provide sufficient capital for market making.
• General market supply and demand
The price impact from spread changes is driven by two main factors:
• Modified duration & Convexity
Changes in Spreads Price Impact due to Change in Spread

Small – ModDur × Δ Spread
Large 1
(−ModDur × ∆ k:2lmn) + i × Convexity × (∆ k:2lmn)5 j
2
High Yield Bonds: also called non-investment grade debt with credit ratings
below -BBB.
Reasons for below investment grade rating:

• High leverage
• Unproven operating history

• Low or negative free cash flow

• High sensitivity to business cycles
• Low confidence in management
• Unclear competitive advantages
• Large off-balance-sheet liabilities
• Industry in decline
Special considerations
• Greater focus on issuer liquidity and Cash flow
• Detailed financial projections
• Detailed understanding and analysis of the debt structure & corporate structure
Sovereign Debt
A basic framework for evaluating and assigning a credit rating to sovereign debt includes
five key areas:
Institutional Successful policymaking, minimal corruption, culture of honoring
assessment debts
Economic includes growth trends, income per capita, and diversity of sources for
assessment economic growth
External includes the country’s foreign reserves, its external debt, and the
assessment status of its currency in international markets
Fiscal includes the government’s willingness and ability to increase revenue
assessment or cut expenditures to ensure debt service, as well as trends in debt as
a percentage of GDP
Monetary includes the ability to use monetary policy for domestic economic
assessment objectives and the credibility and effectiveness of monetary policy
Municipal Debt
Most municipal bonds can be classified as general obligation bonds or revenue bonds.
Types Features Risk and Analysis
General Unsecured bonds issued with the full faith and Same as Sovereign
obligation credit of the issuing government, typically a city, Bonds
(GO) bonds county, or state supported by its taxing power
Revenue Issued to finance specific projects, such as Same as Corporate
obligation airports, toll bridges, hospitals, and power bonds
bonds generation facilities

CFA Level 1 – Quick Notes by KRD - DERV
DERIVATIVES INSTRUMENT & MARKET FEATURES

DERIVATIVES AND FEATURES
• Financial instrument that derives its value from the performance of an underlying
asset which could be stocks, bonds, commodities, currencies, weather, livestock, etc.
• The underlying trades in the cash or spot market and the price of the underlying is
called as spot price.
• Underlying assets can be - Stock, Index, Hard Commodities (like gold and oil) or
Soft Commodifies (like cotton, coffee), weather, livestock, Currencies, Interest rate
Instruments, etc.
• Derivatives are traded either on exchange or in OTC Markets
• Contacts are either Deliverable or Cash Settled (Netting OFF)
• Hedgers either Hedge full exposure or only partially hedge
• Speculators do Cash Settlement and make either gain or loss.
There are two general classes of derivatives:
Features Exchange-Traded Derivative Markets Over-the-Counter Derivatives

Contracts Standardized Customized
Liquidity High Low
Transparency High Low
Regulated Highly Regulated Less regulated
Default risk Low High

FORWARD COMMITMENT
FORWARD COMMITMENTS
Forwards are contracts where both the parties have an obligation to engage in a
transaction at a later point in time as per the terms agreed at the initiation.
Forward Price: The price is fixed at the initiation which is to be honored when the
contracts are settled.
Types of Forward Commitment:

• Forward Contract
• Futures Contract
• Swaps
Forwards
• Being OTC contracts, Forwards, do not need any specific platform.
• In a Forward contract one party agrees (the buyer) to buy an underlying asset
from the other party (the seller) at a later date at a fixed price they agree on when
the contract is signed
• The contracts are customizable but could be illiquid (as not listed)
• Each party is subject to the possibility that the other party will default.
• However, after netting out, only one party can possibly default at any given time.
Futures contract
• The Buyer (Long) of a futures contract commits to purchase the underlying from the
Seller (Short) at a later date at a price known as the futures price
• The futures price is agreed upon at the initiation of the contract itself.
• When a futures contract is initiated, no money exchanges hands between the two
parties since there is no obligation at the start.
Futures settlement:
• The futures contracts are settled on a daily basis to minimize the risk of default. This
daily settlement process is called as marked-to-market (M2M)
• The daily settlement is undertaken at the settlement price (determined by the
exchange) and All contracts are marked daily to the settlement price.
• Accounts maintained by investors for this purpose is called a margin account.
• Participants can offset their positions by taking opposite trades before expiration
(Long Short)
• The futures market follows an important principle: “Futures prices converge to the
spot price at expiration.”

Margins in Futures
• In Futures contracts, a clearinghouse provides the credit guarantee against default.
• To ensure a smooth mark-to-market settlement, exchange requires various margins
to be deposited by the participants in the trade.
There are three types of margins:

Initial Margin This margin is needed to initiate the contract.
It is quoted as the percentage of the contract value.
Maintenance The minimum margin needed to be maintained in the account at any
Margin given point in time during the life of the contract.
It is lower than the initial margin
Variation In an event if the maintenance margin condition is not met, the
Margin (Margin participant is required to add additional margin in the account to
Call) bring it back up to the initial margin
Swaps
• A Swap is an OTC derivative contract in which two parties agree to exchange a
series of cash flows whereby one party pays a variable series, and the other party
pays a fixed or variable series on a different underlying
• Swap has the identity of underlying asset, payment dates, procedures etc. outlined
in advance.
• Only one party can default at any given time (based on netting)
Plain Vanilla Swap:

• The most commonly used swap is fixed for floating interest rate swap (aka plain
vanilla swap or just vanilla swap)
• The vanilla swap is based on a notional principal, which ordinarily matches with
the loan amount.
• No money changes hands at the initiation of vanilla swap, thus initial value of
swap is zero.
• The interest payments could be tied to a specific floating rate such as LIBOR.
Swap Settlement:
• Swap allows netting of the payments.
• Credit risk of a swap is much less than that of a loan since notional principal is
not exchanged and netting is followed for interest payment obligations.
• Credit risk of swap is managed by use of collateral between parties.
Credit Derivatives – is a contract that provides a bondholder (lender) with protection

against a downgrade or a default by the borrower.

DERIVATIVES BENEFITS, RISKS & USES

Advantage of Derivatives
Risk The risk can be traded without trading the underlying instrument
Management itself. Helps in Risk Allocation, Transfer & Management.
Information Futures, forwards, and swaps provide valuable information about
Discovery the prices of the underlying assets while Options provide
information on the price volatility (implied volatility) of the
underlying assets
Operational Lower transaction cost than the underlying and provide greater
Advantages liquidity than the spot markets. It is easier to take a short position
on the underlying asset in a derivatives market as compared to the
spot market.
Market If the prices of the underlying assets are too high, investors will
Efficiency invest in derivatives, thereby reducing the demand for the
underlying assets. As a result, the derivatives market will force the
prices of the underlying assets back to their appropriate levels.
Risks of Derivatives
Leverage As high as 20-30 times in many cases can magnify outcomes
Basis Risk Difference in the Underlying position and the Hedging instrument
used in Derivatives due to Timing or Quantity or Asset used.
Liquidity Risk Closing positions due to margin calls
Counterparty The risk of default in case of OTC transactions which operate without
Risk Clearing Houses.
Systematic Risk Market risk due to excessive speculation
Derivatives uses:
Cash Flow Hedging of Domestic Currency Value of Future receipts like
Hedge Interest or Dividends in foreign Currency.
Fair Value Hedge Hedging Changes in the Balance Sheet Value of Assets and
Liabilities.
Net Investment Hedging Volatility in the Value of Equity if Company’s Foreign
Hedge Subsidiary.

ARBITRAGE, REPLICATION & CARRYING COST
Arbitrage
• In its purest sense, arbitrage is riskless profit/gain.
• If a return greater than the risk-free rate can be earned by holding a portfolio of
assets that produces a certain (riskless) return, then an arbitrage opportunity exists.
• Arbitrage opportunities arise when assets are mispriced.
• Trading by arbitrageurs will continue until they affect supply and demand
enough to bring asset prices to efficient (no-arbitrage) levels.
ARBITRAGE PROCESS
If Forward is Overvalued Forward is Undervalued
Forwards Short Long
Spot Long Short
Money Market Borrow at RF Invest at RF
Replication – It is the creation of an asset or portfolio from another asset,

portfolio and/or derivative. A portfolio composed of the underlying asset and the risk-
free asset could be constructed to have the same cash flows as a derivative. This
portfolio is called the replicating portfolio.
Position Replication
Long Asset + Short Derivative Long Risk-Free Asset (Lending)
Long Asset + Short Risk-Free Asset (Borrowing) Long Derivative
Short Derivative + Short Risk-Free Asset (Borrowing) Short Asset
Replication is the essence of arbitrage and provides benefits by:
• Exploring pricing differentials
• Lowering transaction costs

PRICING & VALUATION OF FORWARDS
The No Arbitrage Forward Price

Assets No-Arbitrage Forward Price No-Arbitrage Forward Price
All Assets except F0(T) = S0×(1 + RF)! F0(T) = S0×(1 + RF)! = SO ×
Currency e(#! $%&)(
For Currency ()*+(!) (-.) F0(T) (P/B) = S0 (P/B)
F0(T) (P/B) = S0 (P/B) ×
()*+(!) (/.) ()*+(!) (-.)
× = SO ×
()*+(!) (/.)
(#"# $#$# )∗(
e
PV of Cost and Benefit:

We can denote the present value of any costs of holding the asset from time 0 to
settlement time T as PV0 (cost) and the present value of any cash flows from the asset
and any convenience yield over the holding period as PV0 (benefit)
Price of Forward at different time phases:

If an asset has both storage costs and benefits from holding the asset over the life of the
forward contract: F0(T) = [S0 + PV0(cost) − PV0(benefit)] × (1 + RF)!
Value of the Forward:

At Initiation 12(3) Always zero
V0(T) = S0 – (4*56)%
= 0
During the life 78(!) Without cost or benefit

Vt(T) = St – ()*#9)&'(
During the life 78(!) With cost or benefit

Vt(T) = St – [(γ − Θ) × (1 + rf): ] − ()*#9)&'(
At Expiration VT(T) = ST - F(0)T Difference can be gain

or loss
Where,
T Maturity
t Time before maturity
V Value

S0 Spot price
F Forward price
rf Risk free rate
γ Benefits like dividends or interest, plus convenience yield
Θ Cost like cost of carrying the asset
Implied Forward Rate

It is a break-even reinvestment rate. Also called as Forward Yields, they are Expected
Forward rates calculated from the Spot yields. The calculation of Implied Forward rates
leads to forward curve, which is a series of forward rates (like spot rates) each having the
same time frame.
/$;
(1 + Z; ); × 41 + IFR ;, /$; 6 = (1 + Z/ )/
Where,
Z; = Spot yield for A period (ex. 1y)
Z_B= Spot yield for B period (ex.2y)
IFR ;, /$; = IFR between A & B (ex. 1y1y)
Forward Rate Agreement

Position Swap Position Interest rate risk FRA Position
Borrower Fixed rate payer Increase Long FRA
Lender Fixed rate payer Decrease Short FRA
(=>>%$1>@ %)×(B/DE2)
FRA Payoff to the LONG = ) × FGHIGJKL MNIJOIPLQ
F4*=>>×*+,G

PRICING & VALUATION OF FUTURES

Forward vs Future Pricing and Valuation
• The pattern of cash flow in a futures contract is similar to the forward contract.
• Future contracts are, however, marked to market on a daily basis using the
settlement price determined by the exchange.
• The value of a futures contract is the accumulated gain or loss on the contract since
the previous day’s settlement.
• This value is then paid out daily into the account; the futures price thereafter gets
effectively reset to the settlement price and the value of the contract becomes zero
• Gains/losses on forward contracts are realized only at expiration, but with futures,
there could be daily gains and losses. Thus interest on interim cash flows also
assumes relevance.
Forwards Futures
Price Constant over the Life Will Change due to M2M
Value Fluctuates due to changes in UA Will Change due to M2M
Note: The change in Futures prices to the Settlement Price each day make the Value of
the Futures ZERO after settlement.
Forwards or Futures? Which one is better?

If Interest rates are Constant or Uncorrelated Futures Price = Forward Price
with Futures prices
If Interest rates are Positively Correlated with Futures Price > Forward Price
Futures prices
If Interest rates are Negatively Correlated Futures Price < Forward Price
with Futures prices

PRICING & VALUATION OF INTEREST RATE & SWAPS

Swap Pricing
• The price of the Swap is the Fixed rate (SFR) in Specified in the Swap Contract.
• The No-Arbitrage rate which gives the Swap a Zero Value at Initiation is Called
PAR SWAP RATE
PV of Floating
Payments MRR MRR MRR MRR
PV = + + +
(1 + S) )) (1 + SH )H (1 + SI )I (1 + SJ )J
PV of Fixed
Payments F F F F
PV = + + +
(1 + S) )) (1 + SH )H (1 + SI )I (1 + SJ )J
Swap Valuation
• Some Swaps could have a zero some positive or negative value.
• It is possible to find a swap price where their combined value would be zero, that
price determines the swap pricing.
• At initiation the Value of Swap is Zero and later on the Value will fluctuate as the
Future Floating rate changes.
• Value for Fixed rate payer = PV (Floating) – PV (Fixed)
Replication of Swaps
• Invest in a variable rate bond to receive a series of unknown payments in future
and finance the purchase by issuing a bond with equal fixed payments.
• Replication assists in valuing a swap, though it is not necessary to create the swap
itself. It is therefore possible to value a swap based on replication and the
principle of no arbitrage.

PRICING & VALUATION OF OPTIONS

OPTIONS BASICS
Long Option Here, the one who has bought the Option is called Long Option or
Option Holder
Short Option The one who has sold the Option is called Short Option or Option Writer
Option Purpose & Cost:

• Option act as an insurance whereby an Unfavorable financial position is protected
for the Buyer of the Option
• However, it comes at a cost to be paid by the buyer of the Option to the seller of
the Option (Upfront & Irreversible) is called Option Premium
Options terms:
S0 Spot price today i.e., at year 0
St Spot price before maturity, here, t is any time before maturity T
ST Spot price at maturity i.e., time T
X Exercise price or strike price or contract price
c0, cT value or price of the call option at time 0 and time T
p0, pT value or price of the put option at time 0 and time T
Π profit from the transaction
Based on their time of exercisability, options can be classified as:

American Options They are exercisable (i.e., they can be terminated by the
holder) anytime during the life of the contract
European Options They are exercisable only at expiration
Moneyness
Moneyness refers to whether an option is in the money or out of the money.
Types In the Money option Out of the Money Option At the money option
Call Option St > X St < X St = X
Put Option St < X St > X St = X

Option Premium = Intrinsic Value + Time Value

Intrinsic Value (IV):
• It is that part of Option Premium which represents the extent to which the Option is
in the Money (ITM)
• In case of Call Option; Intrinsic Value = St – X
• In case of Put Option; Intrinsic Value = X – St
• If the option is ATM or OTM it has no intrinsic value i.e., Intrinsic Value for
ATM/OTM = 0
Time value (TV):

• It denotes the probability/possibility that the option will expire ITM by its
maturity.
• If the Probability is higher than the time value will be higher and vice-versa
• However, if the underlying assets price does not move till maturity, then Time Value
decays/falls and can in fact fall to “0” for the options once they expire on maturity.
• Therefore, On Maturity; Time Value = 0
European and American options:

• The only difference between European and American options is that a holder of an
American option has the right to exercise prior to expiration, while European
options can only be exercised at expiration.
• The prices of European and American options will be equal unless the right to
exercise prior to expiration has positive value.
• At expiration, both types of options are, of course, equivalent and they will have
the same value, the exercise value. Their exercise value at expiration will either be
zero if they are at or OTM, or the amount that they are ITM.
CALL Option Bounds:

At Time Minimum Value Maximum Value
Time = 0 K C0 < S0
C0 > Max (0, S0-(4*LM)- )
Time = T - t K Ct < St
Ct > Max (0, St-(4*LM)-'. )
Time = T CT > Max (0, ST- X) CT < ST
PUT Option Bounds:

At Time Minimum Value Maximum Value

Time = 0 K K
P0 > Max (0, (4*LM)- − UG) P0 < (4*LM)-
Time = T - t K K
Pt > Max (0, (4*LM)-'. − UH) Pt < (4*LM)-'.
Time = T PT > Max (0, X−UV) PT < X
Factors that determine option prices:

Impact of Increase in Impact on Value of Impact on Value of Put
Parameter Call Option Option
Underlying Price (St) Increase Decrease
Exercise Price (X) Decrease Increase
Risk free interest (Rf) Increase Decrease
Volatility of the UA (W) Increase Increase
Time to Expiration (T) Increase Increase#
Cost of holding the asset (Θ) Increase Decrease
Benefit of holding the asset (γ) Decrease Increase
# Except for European PUT Option

OPTION REPLICATION & PUT CALL PARITY

Put call parity – It is an equation or Option position combined with Underlying
N
asset which gives same payoff on maturity. As per Put call parity, S0+P0 = C0+(4*>6)%
S0 + P0 Long Stock position + Long Put position
N Long Call position + Present value of X price, Investment in a
C0 + (4*>6)%
zero-coupon risk-free bond which will pay par on maturity
equal to X
When Option Payoff for a fiduciary call at Payoff for a fiduciary call at
is expiration expiration
OTM X+0=X ST - 0 = ST
ITM X + (ST − X) = ST (X – ST) + ST = X
The payoff on a protective put is the same as the payoff on a fiduciary call
• Therefore, the Price of Call & Put using PCP is also called as “No ARBRITRAGE
PRICE” or the point where payoff is same
• This parity is true only for European Options on the same stock with same strike for
call and put with similar maturity and with the assumption of No Dividend
Put call Forward Parity – The put-call forward parity relationship is derived
by substituting the synthetic asset for the underlying asset in the put-call parity relationship.
O8(P) S
+ P0 = C0 + ()*TR)/
()*QR)/
Application of Options in Corporate Finance

Value of Firm (VT) = Value of Debt (D) + Value of Equity (E)
At Time Payoff to Equity Payoff to DEBT
If VT > D VT – D D
If VT < D 0 VT
PF Max (0, VT- D) Min (VT, D)
Option Similarity Long Call Short Put

VALUATION USING ONE PERIOD BINOMIAL MODEL

∆ #$%%
HEDGE RATIO = ∆ &'()*%+,'- $..)/
HEDGE RATIO indicates the NUMBER OF SHARES needed to Hedge the OPTIONS.
Binomial Option Pricing Model

Pricing under Binomial Model:
A binomial model is based on the idea that, over the next period, some value will change
to one of two possible values (binomial)
To construct a binomial model, we need to know:

• The beginning asset value (S0)
• The size of the two possible changes (U & D)
• And the probabilities of each of these changes occurring (πU & πD)
The probabilities of an up-move and a down-move are calculated based on the size of
the moves and the risk-free rate:
)*QR$U
πU = risk-neutral probability of an up-move =
V$U
πD = risk-neutral probability of a down-move = 1-πU

Where,
Rf = risk-free rate
U = size of an up-move
D = size of a down-move
Sample

CFA Level 1 – Quick Notes by KRD - ALT
CATEGORIES, CHARACTERISTICS & COMPENSATION

STRUCTURES OF ALTERNATIVE INVESTMENTS
ALTERNATIVE FEATURES:
Compared to traditional investments, they exhibit several of the following characteristics:
• Less liquidity of assets held.
• More specialization by investment managers.
• Less regulation and transparency.
• More problematic and less available historical return and volatility data.
• Different legal issues and tax treatments.
• Relatively low correlations with returns of traditional investments.
• High fees.
• Restrictions on redemptions.
• Relatively more concentrated portfolios.
Forms of Investing:
Direct Purchasing assets by own self like real estate by individual or hiring a
Investing specialized fund manager by SWFs.
Fund Investing in a Pool of assets with other investors like Hedge Funds, PE
Investing Funds where the General Partner manages the investment.
Co- Contributes to the pool but also has right to directly invest alongside the
Investing manager like Partnerships.
Fee structure:
Management Fees Paid a percentage of AUM annually either on Beg or End fund
Value
Incentive Fees Paid on the Performance of the Fund either Net or Gross of
Management Fees.
Committed Capital Capital committed by LPs to GPs in the PE structure
Dry Powder Amount of Committed Capital not yet Withdrawn by the GP
Hurdle rate Minimum return required by the LP
Soft Hurdle When Incentive is paid on all the Gains
Hard Hurdle When Incentive is paid on the Gains only above Hurdle rate

High Watermark No incentive fee is paid until the fund breaches the highest value
till date
Catchup Clause A minimum fee paid to GP before the amount is distributed
between GP and LP
Waterfall Structure Ways in which the payments are allocated to the GP and LP
Deal by Deal Profits are distributed considering individual gain/loss - beneficial
(American) for GP
Whole of Deal Profits are distributed considering overall gain/loss - beneficial
(European) for LP
Clawback provision Incentive fees can be reversed from GP if the performance drops
later on.
FEES & RETURNS TO INVESTORS

A common fee structure in the hedge fund market is “2 and 20,” which reflects a 2%
management fee and a 20% incentive fee.
Total Fees by LP to GP mV1 + Max (0, p(V1-V0)
Rate of return to LP [+, − +.] − 01234 5667
Return % =
+.
M = Management Fee
P = Performance Fee
V0 = Beg. Investment Value
V1 = End. Investment Value

PERFORMANCE CALCULATION & APPRAISAL

Risk–Return Measures:
• The Sharpe ratio is a risk–return measure frequently reported because of its ease of
calculation and understandability but not be the appropriate risk–return measure
for alternative investments because measures of return and standard deviation may
not be relevant and reliable given the illiquid nature of the assets.
• Alternative investment returns tend to be leptokurtic, negatively skewed.
• For publicly traded securities, such as REITs and ETFs, market returns are used, and
standard deviation of risk are more applicable.
For All Alternative Investments:

Sharpe Ratio 8E(R ! ) − R " <
σ!
Sortino Ratio 8E(R ! ) − R # <
σ!$
Treynor Ratio 8E(R ! ) − R " <
βp
Calmar Ratio Average Annual Compounded return
Maximum Drawdown
Var Downside Risk which gives:
• Size of Loss
• Probability of Loss
Multiple of Invested Total Capital Returned + Value of Remaining Assets

Capital Total Capital Paid over the Life of Investment
(Money Multiple)
Due Diligence Overview:

• A manager should have a verifiable track record and display a high level of
expertise and experience with the asset type.
• The asset management team should be assigned an appropriate workload and
provided sufficient resources.
• They should be rewarded with an effective compensation package to ensure
alignment of interest, continuity, motivation, and thoughtful oversight of assets.

HEDGE FUNDS
A contemporary hedge fund may have the following characteristics:
• Aggressively managed portfolio - Leveraged, long-short positions, uses derivatives.
• Goal of generating high returns
• Return objectives - absolute basis or relative to benchmark.
• Private Investment partnership - Open to limited partner with large ticket
investment
• Restrictions on redemptions - lockup period, notice period.
The Four broad categories of strategies are:

Event-driven strategies
They are typically based on a corporate restructuring or acquisition that creates profit
opportunities for long or short positions in common equity, preferred equity, or debt of a
specific corporation. Subcategories are:
• Merger arbitrage : Buy the shares of a firm being acquired and sell short the firm
making the acquisition
• Distressed/restructuring: Buy the (undervalued) securities of firms in financial
distress when analysis indicates value will be increased by a successful restructuring;
possibly short overvalued security types at the same time
• Activist shareholder: Buy sufficient equity shares to influence a company’s policies
with the goal of increasing company value
• Special situations: Invest in the securities of firms that are issuing or repurchasing
securities, spinning off divisions, selling assets, or distributing capital
Relative value strategies

They involve buying a security and selling short a related security with the goal of
profiting when a perceived pricing discrepancy between the two is resolved. They include:
• Convertible arbitrage fixed income: Exploit pricing discrepancies between
convertible bonds and the common stock of the issuing companies
• Asset-backed fixed income: Exploit pricing discrepancies among various mortgage-
backed securities (MBS) or asset-backed securities (ABS)
• General fixed income: Exploit pricing discrepancies between fixed income
securities of various types
• Volatility: Exploit pricing discrepancies arising from differences between returns
volatility implied by options prices and manager expectations of future volatility
• Multi-strategy: Exploit pricing discrepancies among securities in asset classes
different from those previously listed and across asset classes and markets
Macro strategies
• They are based on global economic trends and events and may involve long or
short positions in equities, fixed income, currencies or commodities.

Equity hedge fund strategies

They seek to profit from long or short positions in publicly traded equities and derivatives
with equities as their underlying assets and include:
• Market neutral: Use technical or fundamental analysis to select undervalued
equities to be held long, and to select overvalued equities to be sold short, in
approximately equal amounts to profit from their relative price movements without
exposure to market risk.
• Fundamental growth: Use fundamental analysis to find high-growth companies.
Identify and buy equities of companies that are expected to sustain relatively high
rates of capital appreciation.
• Fundamental value: Buy equity shares that are believed to be undervalued based
on fundamental analysis. Here it is the hedge fund structure, rather than the type of
assets purchased, that results in classification as an alternative investment.
• Quantitative directional: Buy equity securities believed to be undervalued and short
securities believed to be overvalued based on technical analysis. Market exposure
may vary depending on relative size of long and short portfolio positions.
• Short bias: Employ predominantly short positions in overvalued equities, possibly
with smaller long positions, but with negative market exposure overall
Note: Many hedge funds tend to specialize in a specific strategy at first and over time
may develop or add additional areas of expertise, becoming multi-strategy funds
Funds of Hedge Funds (FOF)

• They are funds that hold a portfolio of hedge funds.
• Funds of hedge funds invest in numerous hedge funds, diversifying across fund
strategies, investment regions, and management styles.
PRIVATE CAPITAL - EQUITY

What are PE Funds?
Private EQUITY/DEBT refers to one of the ways to investment in companies.
Where do PE Funds invest in?

• In private companies
• In public companies which they intend to take private
• In the case of public companies, such financing is referred to as private investment in
public equities (PIPEs)
Leveraged Buyout funds

• Acquiring public companies or established private companies with a significant
percentage of the purchase price financed through debt

• The assets of the target company typically serve as the collateral for the debt, and
the cash flows of the target company are expected to be sufficient to service the
debt.
Types of Management LBOs:

1. Management buy-outs (MBOs) - existing management team is involved in the
purchase and
2. Management buy-ins (MBIs) - an external management team will replace the
existing management team.
Private Equity Exit Strategies:

The average holding period for companies in PE portfolios is around five years.
There are several primary methods of exiting an investment in a portfolio company:

1. Trade sale: Sell a portfolio company to a competitor or another strategic buyer.
2. IPO: Sell all or some shares of a portfolio company to the public.
3. Recapitalization: The company issues debt to fund a dividend distribution to equity
holders (the fund). This is not an exit, in that the fund still controls the company, but is
often a step towards an exit.
4. Secondary sale: Sell a portfolio company to another PE firm or a group of investors
5. Write-off/liquidation: Reassess and adjust to take losses from an unsuccessful
outcome
Venture capital funds

• VCs invest in companies in the early stages of their development.
• The investment often is in the form of equity but can be in convertible preferred
shares or convertible debt.
• While the risk of start-up companies is often great, returns on successful
companies can be very high.
• This is often the case when a company has grown to the point where it can be sold
(at least in part) to the public via an IPO.
• The company that is being invested in is often called the portfolio company
• VCs are not passive investors, but they are actively involved with the companies in
which they invest
Investment Stages of VC:

The formative stage
• It refers to investments made during a firm’s earliest period and comprises three
distinct phases.
• Angel investing refers to investments made very early in a firm’s life, often the
“idea” stage, and the investment funds are used for business plans and assessing

market potential. The funding source is usually individuals (“angels”) rather than
venture capital funds
• The seed stage refers to investments made for product development, marketing,
and market research. This is typically the stage during which venture capital funds
make initial investments, through ordinary or convertible preferred shares
• Early stage refers to investments made to fund initial commercial production and
sales
Later-stage financing (expansion venture capital) is provided after commercial

production and sales have begun but before any IPO. Funds may be used for initial
expansion of a company already producing and selling a product or for major
expansion.
Mezzanine-stage financing (mezzanine venture capital) is provided to prepare to go

public and represents the bridge between the expanding company and the IPO.
PRIVATE CAPITAL – DEBT

Refers to various forms of Debt provided by investors directly to the private entities.
Direct Lending Loans made directly to a private company
Venture Debt Loans made to a venture firms/startup
Mezzanine Debt Private debt that is subordinated to the senior debt. May have
special features like Conversion or warrants.
Distressed Debt Purchasing debt of firms in Bankruptcy
Private Capital Potential Benefits and Risks:

Benefits Risks
An immediate cash exit for the PE fund Possible opposition by management
Potential for high valuation of the asset Lower attractiveness to employees of the
Fast and simple execution portfolio company
Lower transaction costs than an IPO Limited number of potential trade buyers
Lower levels of disclosure and higher A possible lower price than in an IPO
confidentiality

REAL ESTATE
Real estate investments can be differentiated according to their underlying assets. Assets
included under the heading of real estate investments include:
a. Residential property — single-family homes
b. Commercial property — produces income.
c. Loans — with residential or commercial property as collateral, mortgages,
construction loans, etc. (MBS)
d. Real estate investment trusts (REITs):
• They issue shares that trade publicly like shares of stock.
• REITs hold mortgages, hotel properties, malls, office buildings, or other
commercial property.
• Income is used to pay dividends which is typically 90% of income must be
distributed to shareholders to avoid taxes on this income that would have to
be paid by the REIT before distribution to shareholders.
• Equity REITs, which invest primarily in commercial or residential properties
Real estate performance is measured by three different types of indices:
An It is based on periodic estimates of property values.
appraisal Prepared by the National Council of Real Estate Investment Fiduciaries
index (NCREIF) in US. Appraisal index returns are smoother than those based on
actual sales and have the lowest standard deviation of returns of the
various index methods.
A repeat It is based on price changes for properties that have sold multiple times
sales (ΔPrice✖Properties).
index The sample of properties sold included in the index is not necessarily random
but may also not be representative of the broad spectrum of properties
available (an example of sample selection bias)
REIT They are based on the actual trading prices of REIT shares, similar to equity
indices indices.
Real Estate Investment Risks:

• Property values are subject to variability based on national and global economic
conditions, local real estate conditions, and interest rate levels
• Management of the underlying properties includes handling rentals or leasing of
the property, controlling expenses, directing maintenance and improvements, and
ultimately disposing of the property.
• Leverage magnifies the impact of gains and losses, because of operations and
changes in property value, on the equity investors. As the loan-to-value ratio
increases, the risk increases.

Real Estate Investment Due Diligence:

• Property values fluctuate because of global and national economic factors, local
market conditions, and interest rate levels.
• Other specific risks include variation in the abilities of managers to select and
manage properties, and changes in regulations.
• Decisions regarding selecting, financing, and managing real estate projects directly
affect performance.
• The degree of leverage used in a real estate investment is important because
leverage amplifies losses as well as gains.
Distressed properties investing:

They have additional risk factors compared to investing in properties with sound
financials and stable operating histories.
Real estate development:

• They have additional risk factors including regulatory issues such as zoning,
permitting, and environmental considerations or remediation, and economic changes
and financing decisions over the development period.
• The possible inability to get long-term financing at the appropriate time for
properties initially developed with temporary (short-term) financing presents an
additional risk.
NATURAL RESOURCES – FARMLAND & TIMBERLAND

Timberland offers an income stream based on the sale of timber products as a
component of total return and has historically provided a return that is not
highly correlated with other asset classes
Farmland is often perceived to provide a hedge against inflation. Its returns include
an income component related to harvest quantities and agricultural
commodity prices.
Farmland consists of two main property types:

1. Row crops that are planted and harvested annually (corn, soybeans, rice, and
cotton) &
2. Permanent crops that grow on trees (Apples, berries, bananas, grapes, bushes and
shrubs palms, etc.)

INFRASTRUCTURE INVESTMENTS
Infrastructure investments include:
• Transportation assets invests in assets such as roads, airports, ports, and railways,
as well as utility assets, such as gas distribution facilities, electric generation and
distribution facilities, and waste disposal and treatment facilities.
• Other categories of infrastructure investments are communications (e.g.,
broadcast assets and cable systems) and social (e.g., prisons, schools, and health
care facilities)
• They may also be categorized by their geographic location.
Brownfield investments Greenfield investments

Investments in infrastructure assets that Investments in infrastructure assets that are to
are already constructed be constructed
Provides stable cash flows and It is subject to more uncertainty and may
relatively high yields but offers little provide relatively lower yields
potential for growth but offers greater growth potential
Investment in infrastructure can be made by:

Direct investing:
• Constructing the asset
• Purchasing the asset
• Public-private partnership
Indirect Investing: More liquid investments backed by infrastructure assets are available
through -
• ETFs
• Mutual funds
• Private equity funds or
• Master limited partnerships (MLPs)
COMMODITIES INVESTMENT
• Commodities themselves are physical goods and thus incur costs for storage and
transportation.
• Although, it is possible to invest directly in commodities such as grain and gold, the
most commonly used instruments to gain exposure to commodity prices are
derivatives.

Commodity Derivatives:
• Futures, forwards, options, and swaps are all available forms of commodity
derivatives.
• Commodity indices typically use the price of futures contracts on the commodities
included in them rather than the prices of the commodities themselves.
• As a result, the performance of a commodity index can be quite different from the
performance of the underlying commodities.
Other methods of exposures to commodities include the following:

Exchange ETFs may be suitable for investors who can only buy equity shares or seek
traded the simplicity of trading them.
funds (ETFs) ETFs may invest in commodities or futures of commodities.
ETFs may use leverage.
Like mutual funds or unit trusts, ETFs charge fees that are included in their
expense ratios, although the ETF expense ratios are generally lower than
those of most mutual funds
Managed They are actively managed investment funds
futures Professional money managers invest in the futures market on behalf of the
funds funds
Individual They are managed by chosen professional money managers with
managed expertise in commodities and futures on behalf of high-net-worth
accounts individuals or institutional Investors
Specialized Specialized funds in specific commodity sectors focus on certain
funds commodities, such as oil and gas, grains, precious metals, or industrial
metals
Potential Benefits and Risks of Commodities

Returns on commodities:
• Returns on commodities over time have been lower than returns on global stocks or
bonds.
• Sharpe ratios for commodities as an asset class have been low due to these lower
returns and the high volatility of commodities prices.
• As with other investments, speculators can earn high returns over short periods when
their expectations about short-term commodity price movements are correct, and
they act on them.
Risk & Diversification benefits

• Correlations of commodity returns with those of global equities and global bonds
have been low, typically less than 0.2, so that adding commodities to a traditional
portfolio can provide diversification benefits.
• Because commodity prices tend to move with inflation rates, holding commodities
can act as a hedge of inflation risk.
Commodity Prices and Investments:

Spot prices for commodities are a function of supply and demand.
Factors affecting Demand Factors affecting Supply
Value of the commodity to end-users Production and storage costs
Global economic conditions Speculators
Business cycles
Speculators
Commodity Valuation:
Spot and Future or Forward prices of commodities are very different due to :
Purchasing a commodity today has benefit of using it but also has storage cost and cash
tied up. An equation that considers these aspects is :
Futures price ≈ spot price (1 + risk-free rate) + Storage costs − Convenience yield
Contango If there is little or no convenience yield, futures prices will be higher
than spot prices, this situation is termed as contango (F>S)
Backwardation When the convenience yield is high, futures prices will be less than spot
prices, the situation is referred to as backwardation (F<S)
Three sources of commodities futures returns are:

1. Roll yield
• The yield due to a difference between the spot price and futures
• Futures prices converge toward spot prices as contracts get closer to expiration.
• Roll yield is positive for a market in backwardation (F<S) and negative for a market in
contango (F>S)
2. Collateral yield
• The interest earned on collateral required to enter a future contract.
3. Change in spot prices.

• The total price return is a combination of the change in spot prices and the
convergence of futures prices to spot prices over the term of the futures contract.

CFA Level 1 – Quick Notes by KRD - PM
PORTFOLIO MANAGEMENT OVERVIEW

Diversification ratio:
It is the ratio of Standard deviation of the equally weighted Portfolio to the standard
deviation of the randomly selected security.
! #$ %#&'$#()# (+,-.((/ 01)23'14)
DR = ! #$ 617-&)'/ )
Outcome: Lower the diversification ratio better it is & If ratio = 1 = no diversification.
MODERN PORTFOLIO THEORY

The main conclusion of MPT is that an investment's risk and return
characteristics should not be viewed alone but should be evaluated in terms of overall
portfolio and how it affects the overall risk and return of the Portfolio.
Risk premium = Expected return - Risk free rate

It is the return in excess of the risk-free return expected by investors as compensation for
the asset’s risk.
STEPS IN PORTFOLIO MANAGEMENT PROCESS

When establishing and managing a client’s investment portfolio, certain critical
steps are followed in the process:
Step 1: The Planning Step
Understanding Understand the client’s needs - objectives and constraints
the client’s needs
Preparation of A written planning document that describes the client’s investment
an IPS objectives and the constraints that apply to the client’s portfolio and
should be reviewed and updated regularly
Step 2: Execution
Here the portfolio manager constructs a suitable portfolio based on the IPS of the client.
Asset Decisions include the distribution between asset classes and
allocation geographical weightings within asset classes by using a Top-down or
Bottom-Up approach

Security Detailed knowledge of the companies and industries used by the

analysis analysts to assign a valuation to the security and identify preferred
investments
Portfolio Construction of the portfolio using target asset allocation, security
construction analysis, and the client’s requirements as set out in the IPS.
Decisions to be taken on Diversification like asset class weightings, sector
weightings. Managing risks as per the risk tolerance level set out in the
client's IPS
Step 3: The Feedback Step

Feedback step assists the portfolio manager in rebalancing the portfolio which can be due
to a change in, market conditions or the circumstances of the client.
Portfolio Monitoring and reviewing whether the security and asset weightings
Monitoring and have drifted from the intended levels. This can be due to the
Rebalancing market movements or due to changes in Client's needs or
circumstances, and may require some rebalancing
Performance Assessing whether the client’s objectives have been met. Analysis
Measurement and of performance may suggest that the client’s objectives need to be
Reporting reviewed and perhaps changes made to the IPS
TYPES OF INVESTORS
Part A: Individual investors – Individuals, Defined contribution plans (401K)
Part B: Institutional Investors – Defined benefit pensions plans, Endowments and
Foundations, Banks, Insurance Companies, Sovereign Wealth Funds.
POOLED FUNDS - Include:

• Mutual Funds
• Exchange Traded Funds
• Separately Managed Accounts
• Hedge Funds
• Private Equity Funds
Mutual Funds
Open- Accept new investment money and issue additional shares at a value equal to
end fund the NAV of the fund at the time of investment and also can be exited at any
time during its life by redeeming at NAV

Closed- No new investment money is accepted into the fund after its launch. Also,
end they may have exit restrictions. However, investors can buy/sell from
fund the Exchange at price which may or may not be equal to NAV
Exchange Traded Funds (ETFs)- ETFs combine features of closed-end

and open-end mutual funds. ETF is a type of security that can tracks an Index, sector,
commodity, or other asset and can also be purchased or sold on a stock exchange the
same as a regular stock. The major difference between an index mutual fund and an
ETF is that:
Mutual Funds Exchange Traded Funds
Buy/Sell Direct from the AMC On the Exchange
Value NAV Exchange price
Trading On the Close of Day Throughout the Trading Hours of
Exchange
Expense High Lower
Brokerage No Yes
Investment Passive and Active (mostly) Passively managed
Separately Managed Accounts - A fund management service for

institutions or individual investors with substantial assets (HNIs) also commonly referred
to as a “managed account, “wrap account,” or “individually managed account”.
What is the key difference between mutual fund and SMA?

The important difference is that a Mutual fund investor owns shares of a company that in
turn owns other investments, whereas in an SMA investor owns the invested assets
directly in their own name.
Hedge Funds - Hedge fund strategies generally involve a significant amount of

risk, driven in large measure by the liberal use of leverage and complexity. It
also involves the extensive use of derivatives.
PE Funds - Private equity refers to one of the ways to investment in companies:

• Private Equity Funds – LBOs
• Venture Capital Funds.

PORTFOLIO RISK AND RETURN: PART I
Returns with Single and Multi-Period

For Single Period: "# − ("# − &) + )#
!! = × &++
Holding Period (#$ − &)
Return (HPR)
For Multiple When assets have returns for multiple holding periods, it is
Period: AM & GM necessary to aggregate those returns into one overall return
Arithmetic or mean return Geometric mean return

Meaning AM assumes that the amount GM returns account for the compounding of
invested at the beginning of returns
each period is the same
Accuracy Less Accurate measure More Accurate as it reflects growth
& ! ="#$"%$"&$⋯"(
Formula % &! =
%
(
(() + %)) × () + %-) × … × () + %/) − )
Returns with multiple cash flows.

For Multiple Cash Inflows & Outflows: MWRR & TWRR
Money-Weighted Return or Internal Rate of Return

• The money-weighted return and its calculation are like the IRR and YTM
• It is sensitive to the additions and withdrawals of funds.
Time-Weighted Return or Internal Rate of Return

• It Measures Compounded growth over multiple years.
• It is not sensitive to the additions and withdrawals of funds.
• The TWRR is the preferred performance measure as it neutralizes the effect of cash
withdrawals or additions to the portfolio, which are generally outside of the control of
the portfolio manager.
All types of returns

Gross and Net Return (difference in fees)
Gross Returns Net Returns

Returns before deducting Returns after deducting Fees

Fees
Fees Include: Management expenses, custodial fees, taxes, or any other
expenses that are not directly related to the generation of
returns but rather related to the management and
administration of an investment
Pre-Tax & Post-Tax Nominal Returns (difference in tax)

Pre-tax Nominal Return After-tax Nominal Return
Returns prior to paying taxes & Returns after payment of taxes and Inflation
Inflation adjustment
Nominal returns & Real Returns

Real returns are returns after adjusting for inflation.
(1+Nominal Return) = (1+Real return)×(1+Inflation)
Leveraged Returns
There are two ways of creating a claim on asset returns that are greater than
the investment of one’s own money:
• By using leverage / borrowings Or
• By using Derivative products
Risk aversion and portfolio selection

Types of Investors:
Risk The investor is said to be risk loving or risk seeking.
seeking The investor gets extra “utility” from the uncertainty
Risk The investor is indifferent about the outcome.
neutral The investor cares only about return and not about risk, so higher return
investments are more desirable even if they come with higher risk
Risk Investor does not want to take the chance or risk of losing.
averse Investors are likely to shy away from risky investments for a lower, but
guaranteed return. They want to minimize their risk for the same amount of
return, and maximize their return for the same amount of risk
Risk & Return - Portfolio Return

Portfolio return 2) = w1 × r1 + w2 × r2 … wn × rn
Variance of a Portfolio of Assets

Using Covariance 8% 9 = w*+ σ*+ + w++ σ++ + 2w* w+ Cov*+
Using Correlation σ2p =w12σ12+w22σ22+2w1w2ρ12σ1σ2
Covariance 1 ! )(/ " 0/
∑-(/ ! 0/ 1 " )3
>?@(!A, !C) =
40#
Correlation Cov (R " , R # )
ρ-R " , R # 0 =
σ(R " ) σ-R # 0
Efficient frontier
Global Minimum-Variance Portfolio - The left-most point on the minimum-variance
frontier is the portfolio with the minimum variance among all portfolios of risky assets,
and is referred to as the Global MVP
Indifference Curves
• An indifference curve plots the combinations of risk–return pairs that an investor
would accept to maintain a given level of utility (i.e., the investor is indifferent
about the combinations on any one curve because they would provide the same
level of overall utility)
• As risk increases, an investor needs greater return to compensate for higher risk at
an increasing rate (i.e., the curve gets steeper)

For Risk Averse Higher Slope

For Risk Neutral Horizontal or Invariant
For Risk Lover Negative Slope or Inverse
Application of Utility Theory to Portfolio Selection

Capital Allocation Line with Two assets:
• If only these two assets are available in the economy and the risky asset represents
the market, the line is called the capital allocation line.
• The CAL represents the portfolios available to an investor.
• The equation of CAL can be rewritten in a more usable form:
8(9! ):(9" )
E(Rp) = Rf + ! ;!
" σp
The capital allocation line has:

• An intercept of Rf and
5(6 )0(6$ )
• A slope of D # E
7#
Which is the additional required return for every increment in risk, and is sometimes
referred to as the market price of risk
Which one of these portfolios should be chosen by an investor?

The answer lies in combining indifference curves from utility theory with
the CAL from portfolio theory:
• Utility theory gives us the utility function or the indifference curves for an
individual and the capital allocation line gives us the set of feasible investments

• Overlaying each individual’s indifference curves on the capital allocation

line will provide us with the optimal portfolio for that investor.
Investors Optimal Portfolio

Capital Allocation Line and Optimal Risky Portfolio
• All portfolios on the efficient frontier are candidates for being combined with the
risk-free asset.
• With the addition of the risk-free asset, we can narrow our selection of risky
portfolios to a single optimal risky portfolio, P, which is at the tangent of CAL(P)
and the Efficient frontier of risky assets.

PORTFOLIO RISK AND RETURN: PART II

Capital Market Theory
Highly risk-averse investors choose to invest most of their wealth in risk free asset and
earn low returns because they are not willing to assume higher levels of risk
Capital Market Line

The capital market line is a special case of the CAL, where the risky portfolio is
the market portfolio.
Risk and return characteristics of the portfolio represented by the CML can be computed
by using the return and risk expressions for a two-asset portfolio:
• E(Rp) = w1Rf + (1 – w1) E(Rm)
• σ2p = wrf2σrf2+wrm2σrm2+2.wrf.wrmCov.rf.rm
Equation of CML : 5(6% )06$ × σp

7%
• The y- intercept is the risk-free rate, and
5(6% )06$
• The slope of the line referred to as the market price of risk is
78
• The Slope of CML is always positive slope because the RM is Larger than the RF.
Systematic & Non-Systematic Risk

Total risk = Systematic Risk + Non-Systematic Risk
Systematic Risk Non-Systematic Risk
Market Specific Risk Company Specific Risk
Affects all companies/securities in Directly affects the concerned
the Sector, Economy, Industry, etc. Company/Security only
Cannot be Diversified Can be Diversified by adding more securities
Priced in the Securities' Expected Not Considered in the Expected returns or
returns or Valuation Valuation
Beta - Measure of Systematic Risk (βi)

Beta is the Measure of Sensitivity of Stock with respect to Market.
It denotes the Change in Price of Stock due to Change in market.
It is the measure of Systematic risk of an asset.
!" $%&((" , (*),&* = .", *. ,". ,*,&* = .", *. ,",*
Decomposition of Total Risk for a Single-Index Model:

Total variance Systematic variance + Nonsystematic variance

σi2 βi2σm2 + σe2
σi √ (βi2σm2 +σe2)
Pricing of risk and Computation of expected return

The Single-Index Model E(Ri) – Rf = βi [E(Rm) – Rf]
The Market Model Ri =αi + βiRm + ei
Capital Asset Pricing Model (CAPM) E(Ri) = Rf + βi[E(Rm) – Rf]
Security Characteristic Line Ri –Rf =αi +βi(Rm –Rf)
PORTFOLIO BETA
It is the weighted average beta of individual Securities belonging to the portfolio,
weights being proportion of funds invested in each Securities.
PERFORMANCE EVALUATION
Ratio Meaning Formula
Sharpe Ratio Ratio of Excess returns over Total Risk $%&$'
Sharpe Ratio = (%
Treynor Ratio Ratio of Excess returns over Systematic Treynor Ratio = $%&$'
)%
Risk
M Square Measure of portfolio return that is $! & $"
M2 (!
x σm – (Rm – Rf)
adjusted for the total risk of the
portfolio relative to that of some
benchmark
Jenson's Difference between the actual αp =Rp– [Rf +βp(Rm –Rf)]
Alpha portfolio return and the calculated
risk-adjusted return (based on CAPM)

BASICS OF PORTFOLIO PLANNING & CONSTRUCTION
Portfolio Planning
The Investment Policy Statement - The IPS is the starting point of the portfolio
management process.
Major Components of an IPS

• Introduction of the client
• Statement of Purpose: This section states the purpose of the IPS
• Statement of Duties and Responsibilities: details of duties and responsibilities of the
client
• Procedures: steps to keep the IPS current and the procedures to follow to respond to
various contingencies
• Investment Objectives & Investment Constraints
• Investment Guidelines - how policy should be executed (e.g., on the permissible use of
leverage and derivatives), specific types of assets excluded from investment, if any.
• Evaluation and Review
Objective
Risk objective - can be absolute risk objective or it can be relative risk objective:
Absolute risk Desire of not to suffer any loss of capital or not to lose more than a
objective given percent of capital. Example: No decrease in the value more than
4%
Relative risk Relates risk to one or more benchmarks perceived to represent
objective appropriate risk standards. Example: risk not more than S&P 500
risk
Matrix Ability: Below Average Ability: Above Average

Willingness: Below Average Below Average risk Resolution Needed
Tolerance
Willingness: Above Resolution Needed Above Average risk
Average Tolerance
Return objective.
• Return objective can also be stated in absolute (minimum return of 15%)
or relative (Return 4% higher than LIBOR) terms.

Constraints
Liquidity The IPS should state what the likely requirements are to withdraw
funds from the portfolio.
Higher the liquidity needs lower the risk tolerance for investor.
Time horizon Investor with a longer horizon, especially if the risky investments are
expected to have higher returns
Tax Concerns A taxable investor based in the US is also likely to consider including US
municipal bonds in her portfolio because interest income from US
municipal bonds is exempt from taxes. A tax-exempt investor, such as
a pension fund, will be relatively indifferent to the form of returns
Legal & In some countries, institutional investors such as pension funds are subject
Regulatory to restrictions on the composition of the portfolio.
Factors
Unique A client may have considerations derived from his or her religious or
Circumstances ethical values that could constrain investment choices.
Portfolio Construction
When defining asset classes, several criteria apply:
• Correlations of assets should be relatively high within an asset class
• However, it should be lower versus assets in other asset classes.
Capital Market They are the investor’s expectations concerning the risk and return
Expectations prospects of asset classes, however broadly or narrowly the investor
defines those asset classes
The Strategic SAA is the set of exposures to IPS-permissible asset classes that
Asset Allocation is expected to achieve the client’s long-term objectives given the
client’s investment constraints
Core Satellite Approach - One of the ways to address the issue of Active vs
Passive management.
The core Core is managed with low turnover to capture the long-term systematic
risk premium of its assets on a tax-optimal basis. Majorly invested in less
risky assets and passively managed
The Satellite portfolios are used generate a high active return with little regard
satellite for benchmark exposure. Majorly invested in high risky assets and actively
managed

BEHAVIORAL FINANCE
It is the research of the ways in which human behavior differs from the rationality
assumed by traditional economic models. There irrational behaviors may lead to
predictable deviations of financial markets from the Equilibrium or market inefficiency
Two forms of behavioral biases are:

Types Due to Solution
Cognitive Faulty Can often be corrected or eliminated through
Errors cognitive better information, education, and advice
reasoning
Emotional Feelings or Harder to correct as they stem from impulses and
Biases Emotions intuitions and they arise spontaneously rather than through
conscious effort
Cognitive errors are classified into two categories:

Belief Tendency to cling to one’s previously held beliefs by committing
perseverance bias statistical, information-processing, or memory errors
Processing errors Describe how information may be processed and used illogically or
irrationally in financial decision making
Cognitive errors: Belief Perseverance

• Refers to a situation where an individual holds conflicting beliefs
• It causes stress that individuals intend to reduce by letting go conflicting beliefs
Conservatism Market participants rationally form an initial view but then fail to
bias change that view as new information becomes available
Individuals overweight their prior probabilities and do not adjust them
appropriately as new information becomes available
Confirmation Market participants focus on or seek information that supports prior
Bias beliefs and avoid conflicting beliefs or view points
Consider positive but ignore negative information
Representative Error of believing that because two things that are similar in some
Bias respects they are also similar in other respects
The two forms of Representative biases are Base rate neglect and
Sample size neglect bias
Illusion of Market participants wrongly believe they can control the outcome (also
Control Bias related to emotional biases of illusion of knowledge, self attribution and
overconfidence)
Hindsight Bias Selective memory of past events, actions leading to tendency to see
things as more predictable then they really are.

Cognitive errors: Information Processing Biases

Refers to a situation where an individual wrongly process information.
It causes stress that individuals intend to reduce by letting go conflicting beliefs.
Anchoring and Basing expectations on a prior number and overweighting its
Adjusting bias importance, adjusting in relation to that number as new information
arrives
Leads to underestimating the implications of new information
Mental Viewing money in different accounts or from different sources
Accounting Bias differently when making investment decisions
Framing Bias Decisions are affected by the way in which the question or data is
framed
The framing of the information results in different choices
Availability Bias Occurs when individuals judge the probability of an event occurring
by the ease with which examples and instances come to mind
More-recent events are typically easier to recall than events further in
the past
Emotional Biases
They generally arise from emotion and feelings rather than through conscious thought.
Loss Aversion Individuals display asymmetrical responses to gains and losses.
bias Feeling more pain from a loss than pleasure from an equal gain
Overconfidence Market participants overestimate their own intuitive ability or
Bias reasoning
Self-Control Bias Individuals lack self-discipline and favor short-term satisfaction
over long-term goals
Status Quo Bias Individuals feel comfortable in exiting investment strategy and don’t
wish to change
Endowment Bias An Asset is felt to be special and more valuable simply because it is
already owned
Regret Aversion Occurs when market participants do nothing out of excessive fear
Bias that actions could be wrong.
Are more concerned with errors of commission (doing something
that turns out wrong) than errors of omission (not doing something
that turns out right). It is quite like status quo bias

RISK MANAGEMENT
The risk management process

1. Identifying the risk tolerance of the organization
2. Identifying and measuring the risk that organization faces
3. Modifying and monitoring these risks
Risk exposure - is the measure of potential future loss resulting from a specific activity or
event. The organization may increase its risk exposure if it can manage the risk by
making organization changes, buying insurance or entering into derivative contracts.
Risk Governance - Risk governance is the top-down process and guidance that
directs risk management activities to align with and support the overall enterprise.
The major areas in which risk governing body drives the risk framework are:
• Risk oversight
• Risk Tolerance
• Risk Budgeting
Identification of risks - Financial & Non-Financial

Financial Risks: are the risks which arises from the exposure to the financial markets
There are three types of financial risks:
Market Arises from movement in the interest rate, stock prices, exchange rates and
risk commodity prices
Credit Risk of loss if counter party fails to pay an obligated amount in contracts
risk such bond, loan, derivatives etc.
Liquidity Loss in value when security seller needs to reduce selling price below fair
risk value of due to less buyers available. Higher bid-ask spread is the indication
of higher liquidity risk
Non-Financial Risks: arise from the operations of the organization and from sources
external to the organization. Different types include:
Type Risk of
Regulatory Additional cost to the firm due to change in regulatory environment
risk
Accounting Incorrect accounting policies and estimates
risk

Tax risk Increase in tax liability due to increase in tax rate

Legal risk Being sued over a transaction or for anything entity does or fails to do
Model risk Asset valuation are based on incorrect analytical model
Tail risk Extreme events risk and incorrectly concluding that distribution is
normal
Operational Human error or faulty organizational process can be internal (employee
risk theft) or external (hacking)
Solvency risk Entity does not survive because it runs out of cash
Mortality risk Dying relatively younger prior to providing for family’s future needs
Longevity risk Outliving - living longer than anticipated so that assets run out
Measuring and Modifying Risks

Metrics – Measures of risk for specific asset types include:
Standard Measures a range over which a certain percentage of the outcomes would
deviation be expected to occur. It is the measure of volatility in asset price or interest
rate. However, it is not an appropriate measure of risk for non-normal
distribution
Beta Measures of sensitivity of a stock or portfolio compared to the benchmark. It
is measure of systematic or market risk of security
Duration It is the measure of sensitivity of the price of fixed income instrument to
change in interest rate
Derivative risks (Greeks) include:

Delta Sensitivity of price of derivative instrument to small change in the price of
underlying asset
Gamma Sensitivity of delta to change in the price of underlying asset
Vega Sensitivity of price of derivative instrument to change in volatility of underlying
instrument
Rho It is the sensitivity of price of derivative instrument to change in rate of interest
Theta It is the sensitivity of price of derivative instrument to time left in expiration
Tail Risk - uncertainty about the probability of extreme (negative) outcomes. It Includes:
Value at risk VaR is the minimum loss over a period of time with specific probability.
(VaR) It Measures of the size of the tail of the distribution of portfolio
A VaR measure contains three elements:
• The loss sizes

• The probability
• A time frames
For example, assume a VaR of $2 million at 5% for one day means:
the expected Daily loss is minimum of $2 million 5% of the time
Conditional VaR Conditional VaR is the expected value of loss, given loss exceeds a
(CVaR) minimum amount.
It is a common tail loss measure, defined as the weighted average of
all loss outcomes in the statistical distribution that exceed the VaR
loss
Methods of risk often used to compliment VaR:

Sensitivity Measures the effect on portfolio value given a small change in one of the
Analysis several risk factor
Scenario Measures the effect on portfolio value of significant changes
Analysis in Multiple risk factors together
Stress Testing It examines the effect on value of a scenario of extreme risk-factor
changes
Methods of Risk Modification

Once identified by the risk management team, management may decide to:
Prevent risk avoid it altogether
Accept a risk Self-insurance or excess reserve
Transfer a risk Insurance, Surety bonds, Fidelity bond
Shift a risk Using Derivatives to Hedge

TECHNICAL ANALYSIS
Technical analysis - Analysis that uses price and volume data displayed graphically.
Principles and Assumptions

• Technicians believe - market trends and patterns reflect irrational human behavior.
• Technical analysis is the study of market trends or patterns which tend to repeat
themselves and are, therefore, somewhat predictable.
Trends & Support vs resistance

Support Resistance
A low-price range in which buying activity is A price range in which selling is sufficient
sufficient to stop the decline in price. to stop the rise in price.
Change in polarity principle:

It states that once a support level is breached, it becomes a resistance level. The same
holds true for resistance levels; once breached, they become support levels.
Candlestick Chart
• A vertical line (known as wick or shadow) represents the range through which the
security price traveled during the time period.
• Shaded body of the candle represents higher opening price than the closing price,
and clear (white) body represents lower opening price than the closing price.
Construction of a Candlestick Chart
Chart Patterns - Reversal

Head and Shoulders: The prior Inverse Head and Shoulders: Pattern formed
trend must be an uptrend. upside down and acts as a reversal pattern for a
preceding downtrend.

Price target = Neckline − (Head − Neckline)
Chart Patterns - Continuation

Triangles An ascending triangle typically forms in an uptrend and typically, a
descending triangle will form in a downtrend
Rectangle Formed by two parallel trend lines, formed by connecting the high prices (at
Pattern which investors repeatedly sell shares) and low prices (at which investors
repeatedly buy shares).
Flags and These are considered minor continuation patterns because they form over
Pennants short periods of time - on a daily price chart, typically over a week. A flag
(Banners) is like rectangles. A pennant is like triangles.
Price-Based Indicators
Moving The average of the closing price of a security over a specified number of
Average periods. Moving averages smooth out short-term price fluctuations, giving
the technician a clearer image of market trend.
Bollinger Bollinger Bands consist of a higher line representing the moving average
Bands plus a set number of standard deviations from average price and a lower
line that is a moving average minus the same number of standard deviations.
Momentum oscillators (Swings) – Are constructed from price data, they

either oscillate between a high and low (typically 0 and 100) or oscillate around a number
(such as 0 or 100).
Convergence- when oscillator moves is same direction.
Divergence - when oscillator moves is different direction.
Oscillators have three main uses:
• To determine the strength of a trend
• Signaling a pending trend reversal
• In a non-trending market, oscillators can be used for short-term trading decisions.
Sentiment Indicators – (Opinion Polls, Statistical Indices, Margin debt, Margin

debt, short interest). Sentiment indicators attempt to gauge investor activity for signs of
increasing bullishness or bearishness.

Flow-of-Funds Indicators – (Arms Index, Margin Debt, Mutual Fund Cash

Position, New Equity Issuance, Secondary Offerings). Technicians look at fund flows to
gauge the potential supply and demand for equities.
Use of Cycles by Technical Analysts

Kondratieff Kondratieff was an economist in the Soviet Union who suggested that
Wave Western economies had a 54-year cycle
18-Year The 18-year cycle is interesting because three 18-year cycles make up
Cycle the longer 54-year Kondratieff Wave (for real estate).
Decennial Years ending with a 0 have had the worst performance, and years
Pattern ending with a 5 have been by far the best.
Presidential Third year after election (a year before next election) is found to be
Cycle the best for US markets
Elliott Wave Theory
The theory proposed the market moves in regular, repeated waves or cycles.
Elliott described how the market moved in a pattern of five waves moving up in a bull
market in the following pattern: 1 = up, 2 = down, 3 = up, 4 = down and 5 = up. He
called this wave the “impulse wave.” The impulse wave was followed by a corrective wave
with three components: a = down, b = up and c = down.
Intermarket Analysis
• Combines analysis of major categories of securities to identify market trends and
possible inflections in a trend.
• Can also be used to identify sectors of the equity market to invest in.
• Can help in allocating funds across national markets.

FINTECH
The term Fintech refers to the technological innovation in the design and delivery of
financial services and product.
Big Data – Big Data refers to the large amount of data generated by the
economy (industry, government, individuals) that is potentially useful
The data is sourced from traditional and non-traditional sources:
The data is sourced from traditional and non-traditional sources:
Traditional Financial Markets (e.g.: equity, fixed income, future, options, and other
Sources derivatives). Businesses (e.g.: Company financials, commercial transactions
and credit card purchases). Government (e.g.: trade, economic, employment
and payroll data)
Non- Individuals (e.g.: Credit card purchases, product reviews, internet search
Traditional logs, and social media posts). Sensors (e.g.: satellite imagery, shipping
Sources cargo information, and traffic patterns). Internet of Things (e.g.: data
generated by “smart” buildings).
Three Characteristics of Big Data:

Volume The amount of data collected has been increasing by leaps and bounds.
Velocity Refers to how quickly data is communicated.
Variety The data is available from many sources and many formats. It could be
structured data, semi-structured data (photos, HTML pages) and non-structured
data (video messages).
AI computer systems are capable of performing tasks that traditionally

Artificial required human intelligence at levels comparable (or superior) to those of
Intelligence human beings
example - “Neural networks”
Machine Seeks to extract knowledge from large amounts of data by “learning”
Learning from known examples and then generating structure or predictions. ML
“find the pattern, apply the pattern”.
Challenges of using Big Data

• Should use appropriate volume of data.
• Use high quality data, after checking for outliers, bad or missing data, or sampling
biases.

TYPES OF MACHINE LEARNING:
Challenges of Machine Learning Models:

Overfitting Occurs when the machine learns the input and output too exactly
Underfitting This occurs when model fails to capture the underlying trend
DATA SCIENCE
Data Science binds computer science, statistics, and other disciplines to extract
information from Big Data, and describes methods to process and visualize data.
Various data processing techniques include:

• Capture – collecting data and transforming into a format used by analytical process.
• Curation – refers to the process of ensuring data quality and accuracy by checking
all data and making adjustments to missing or bad data.
• Storage – archiving and accessing data.
• Search – examining stored data to find needed information.
• Transfer – moving data source or storage location to the underlying analytical tool.
Distributed Ledger Technology – A database that is shared on a network so

that each participant has an identical copy. Distributed Ledger Technology uses
cryptography to ensure only authorized participants can use the data.

Blockchain – A distributed ledger that records transactions sequentially in blocks

and links these blocks in a chain. Consensus mechanism in a blockchain requires some
computers, referred as miners, on the network to solve a cryptographic problem.
Distributed ledger could be on permission less or permissioned networks:

Permission less Networks where transactions can be viewed by all participants, with
Networks no central authority. Removes the need of trust between parties
Permissioned Networks where transactions can be viewed by few participants
Networks
Financial Applications of Distributed Ledger Technology

Crypto Electronic medium of exchange without the involvement of financial
currencies intermediary. Crypto currencies typically reside on permission less
networks.
ICO An initial coin offering (ICO) is an unregulated process whereby
companies sell their crypto tokens to investors in exchange for "at money
or for another agreed upon cryptocurrency. However, most ICOs do not
typically have attached voting rights.
Smart Are electronic contracts that be programmed to self-execute based on
Contracts terms agreed to by counterparties. Example, an options contract could
be set up to exercise automatically if certain defined conditions are met.
Post- Trade DLT can streamline existing post- trade processes by providing near-
Clearing and real- time trade verification, reconciliation and settlement; reducing the
Settlement complexity, time, and costs associated with processing transactions
Tokenization Electronic proof of ownership of physical assets, which could be
maintained in a distributed ledger.
Compliance DLT- based compliance may better support shared information,
communications, and transparency within and between firms, exchanges,
custodians, and regulators. DLT could help uncover fraudulent activity
and reduce compliance costs associated with know-your-customer and
anti-money-laundering regulations, which entail verifying the identity of
clients and business partners.

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CFA Level 1 – QUICK NOTES - INDEX

ALL THE BEST ONCE AGAIN AND HAVE A GREAT FUTURE.

– KUNAL DOSHI, CFA

YouTube Channel: Prof. Kunal R Doshi 0

TIME VALUE OF MONEY

Simple Interest Compound Interest

Annuities are of various types:

YouTube Channel: Prof. Kunal R Doshi 1

ORGANIZING, VISUALIZING, AND DESCRIBING DATA

How is the Data Organized?

One- • It represents a single variable like the time series data.

Guidelines for Selecting Among Visualization Types:

YouTube Channel: Prof. Kunal R Doshi 2

Measures of Central Tendency:

Parts under Central Tendency:

YouTube Channel: Prof. Kunal R Doshi 3

Adjusting the Outliers

There are three options for dealing with extreme values:

Interquartile Range: Box and Whisker chart

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Range Maximum - Minimum Value

Mean (Arithmetic Mean) Median Mode

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Properties of Normal Distribution

Skewness & Kurtosis

Skewness: A distribution that is not symmetrical is called skewed.

Mesokurtic Leptokurtic Platykurtic

YouTube Channel: Prof. Kunal R Doshi 6

To Calculate Probability, we would need:

Converting Odds into Probability Probability into Odds

Odds Against b [1 − P(E)]

DEFGHI JK LMFHN JK O JPPEIM2Q

Unconditional probability P(A) = A

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Bayes Formula =(V+WXYZ[\8X+ / ?^_+\)

Why do we use Bayes Formula?

Things required for Solving Bayes Formula:

Z[\[7][7^ _`[7^ a7][\[7][7^ _`[7^

Joint Probability P(A B) = P(A | B) × P(B) P(A B) = P(A) × P(B)

Probabilities usage in Investments:

Portfolio Return ErP= W1*Er1 + W2*Er2 +…………... Wn*Ern

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Labelling Arrange with Label n!

COMMON PROBABILITY DISTRIBUTION

What is Probability Function & Cumulative Distribution Function?

The Nature of the Outcome decides whether a probability is Discrete or Continuous:

Discrete Uniform Distribution

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Uniform = Each outcome has an equal probability

Binomial Uniform Distribution

Calculating Probabilities: P(x) = nCx*× px × (1−p)n-x

Continuous Uniform Distribution

Probability Denoted as p(x) Denoted as f(x)

Probability Function (PDF)

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Standard Normal Distribution:

Univariate Normal Distribution Multivariate Normal Distribution

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What is Shortfall Risk?

Roy's Safety-First Ratio:

Log Normal Distribution:

What is Monte Carlo Simulation:

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Portfolio Return ErP= W1Er1 + W2Er2 +…………... Wn*Ern