Salt Cfa Level 1 Formulasheet 2024

CFA® Level I
Formula Sheet – 2024 Syllabus
QUANTITATIVE METHODS Leveraged Return STATISTICAL MEASURES

STATISTICAL MEASURES OF
OFASSET
ASSETRETURNS
RETURNS
QUANTITATIVE METHODS
V< Measures of Central Tendency
R : = R ; + (R ; − r>)
RATE AND
RATES ANDRETURNS
RETURNS V= Sample mean:
-
Required Rate of Return 1
THE TIME VALUE OF MONEY IN FINANCE C=
X Z X + ; n = sample size
Interest rate = Real risk-free rate FINANCE n
+)!
+ Inflation premium Fixed-Income Instruments and the Time Value
required inter + Default risk premium of Money Median:
-A!
required inter + Liquidity premium Discount instruments/zero-coupon bonds: - If n is odd: Median = S Tth term
#
required inter + Maturity premium - No coupons; investors pay discounted value of
- If n is even:
bond at inception - -A#
Nominal Risk-free Rate Median = average of S Tth and S Tth terms
Coupon instruments: # #
(1 + Nominal risk-free rate)
PMT! PMT# PMT5 + FV5
= (1 + Real risk-free rate)(1 + Inflation premium) PV = + + ⋯+ Mode:
(1 + r)! (1 + r)# (1 + r)5
- The most frequently occurring value
Nominal risk-free rate Perpetual bonds/perpetuity:
≈ Real risk-free rate + Inflation premium PMT Dealing with Outliers
PV =
r 1. No adjustments
Holding Period Return Annuity instruments: 2. Remove all outliers with a trimmed mean
P! − P" 1 − (1 + r)65 3. Replace outliers with a winsorized mean
R= +I PV = A W X
P" r
Measures of Location
R = [(1 + R! )(1 + R # ) … (1 + R$ )] − 1 Equity Instruments and the Time Value of Interquartile range (IQR):
Arithmetic Mean Return Money IQR = Q B − Q!
∑' R Constant dividends: y
C % = ()! &
R D Location of y (0 percentile, LC = (n + 1)
T PV = 100
r If LC is not an integer, use linear interpolation.
Geometric Mean Return Constant dividend growth rate:
Distributions may be divided into quarters
!
R *+ = F∏'()!(1 + R (+ ) − 1 D! D" (1 + g)
PV = = (Quartiles), fifths (Quintiles), or tenths (Deciles)
r−g r−g
Harmonic Mean Return (Cost Averaging) E.g., 50th percentile = 2nd quartile = 5th decile
Changing dividend growth rate:
n
C
X, = , where X + > 0 for i = 1, 2, … , n -
Range
- 1 D" (1 + g 7 )+ E(S- )
∑+)! PV = Z + Range = Maximum value − Minimum value
X+ (1 + r)+ (1 + r)-
+)!
C./+(0. > X
If returns are volatile, X C*23. > C
X ,4/. where E(S- ) =
>#$%
Mean Absolute Deviation
/6?&
-
C ./+(0.) × (X
(X C ,4/. ) = (X
C *23. )# 1
Implied Return for Fixed-Income Instruments MAD = C|
Z|X + − X
n
Money-Weighted Return (MWR) +)!
Discount bond implied return:
- IRR derived from all cash inflows and returns
FV5 !/5
Sample Variance and Sample Standard
- Can be skewed by timing/value of cash flows r=] ^ −1
PV Deviation
- Appropriate if manager controls timing of CFs
Sample variance:
Equity Instruments, Implied Return, and -
Time-Weighted Return (TWR) 1
Implied Growth s# = Z(X + − C
X)#
- Geometric mean of sub-period returns n−1
Equity required rate of return: +)!
- Compound growth for an initial $1 investment D! Sample standard deviation is square root of the
- Unaffected by timing/value of cash flows r= +g
PV sample variance
Forward price-to-earnings ratio:
Future Value (FV) and Present Value (PV)
D! /E! Downside Deviation and Coefficient of
FV5 = PV(1 + r)5 ⇔ PV = FV5(1 + r)65 PV/E! =
r−g Variation
r7 85 r7 685
FV5 = PV S1 + T ⇔ PV = FV5 S1 + T Sample target semideviation:
m m
∑D E<(X + − B)#
Continuously Compounded Returns s'4/?2( = g '
n−1
FV5 = PVe/"5
Real Returns Coefficient of variation measures dispersion

(1 + r9 )(1 + Risk premium) relative to mean:
(1 + Real return) = 𝑠𝑠
1 + Inflation premium CV =
C
X
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Skewness Total Probability Rule for Expected Value Continuously Compounded Rates of Return
E(X) = E(X|S!)P(S!) + ⋯ + E(X|S- )P(S- ) Continuously compounded return from 0 to T:
S'
Conditional Expected Values and Conditional r",' = ln ] ^
S"
Variances
Conditional expected value:
INFERENCE
ESTIMATION AND INFERENCE
E(X|S) = P(X! |S)X! + ⋯ + P(X - |S)X -
Sampling Methods
Conditional variance:
Simple random sampling: Subset of population is
σ# (X|S) = [X! − E(X|S)]# P(X! |S) + ⋯
chosen at random
+ [X - − E(X|S)]# P(X -|S)
Systematic sampling: Every kth observation is
Bayes’ Formula chosen until desired sample size is achieved
P(Info|Event) Stratified sampling: Simple random samples are
P(Event|Info) = × P(Event)
P(Info) drawn from each subpopulation (strata)
Prior probabilities are updated to become Cluster sampling: Sample set is divided into mini-
posterior probabilities based on new information
representations of the population (cluster)
Convenience sampling: Samples are selected based
PORTFOLIO MATHEMATICS
PORTFOLIO MATHEMATICS
on accessibility
Expected Value & Variance of Portfolio Return
-
Judgmental sampling: Samples are selected based
EoR H p = Z w+ E[R + ] on researchers’ knowledge and expertise
+)!
Sampling error = Sample mean − Population mean
CovoR + , R I p = Eq(R + − E[R +])oR I − EqR I rpr
1 ∑-+)!(X + − C
X) B - - Central Limit Theorem (CLT)
Skewness ≈ ] ^
n sB σ# oR Hp = Z Z w+ wI CovoR + , R I p For a sample of size n ≥ 30 from a population with
+)! I)!
mean µ and variance σ# , the sample mean XC
Kurtosis (Excess Kurtosis = Kurtosis – 3)
An asset’s covariance with itself is its variance approximately follows a normal distribution with
Distribution 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 Peaked Kurtosis
Correlation: mean µ and variance σ#⁄n
Leptokurtic Fatter More >3
CovoR + , R I p
ρoR + , R Ip = ρ+,I = Standard Error of Sample Mean
Mesokurtic Normal Normal 3 σ(R +)σoR I p
Population variance is known: σNO = σ⁄√n
Platykurtic Thinner Less <3
For portfolio with 2 investments: Population variance is not known: sNO = s⁄√n
EoR H p = w. R . + w< R <
Bootstrapping and Empirical Sampling
Cov(R . , R < ) = σ(R .)σ(R < )ρ(R . , R <) Distributions
Bootstrap: Replace each drawn sample with an
σ# oR Hp = w.# σ# (R . ) + w<# σ# (R < ) identical element for the next draw
+ 2w. w< Cov(R . , R < ) Jackknife: Draw each sample by leaving out one
Forecasting Correlation of Returns observation at a time without replacement
If X and Y are independent:
P(XY) = P(X)P(Y) HYPOTHESIS TESTING
HYPOTHESIS TESTING
1 ∑-+)!(X + − C
X) F
Excess kurtosis, K = ≈ ] ^ −3 E(XY) = E(X)E(Y) The Process of Hypothesis Testing
n sF
1. State hypotheses (null and alternative)
Roy’s Safety-First Ratio
Sample Covariance 2. Identify test statistic
C)(Y+ − Y
C) EoR H p − R :
∑-+)!(X + − X SFRatio = 3. Specify significance level
sDG = σ;
n−1 4. State decision rule
where R : is the threshold level
Sample Correlation Coefficient 5. Collect data; calculate test statistic
sDG P(R ; < R : ) = N(−SFRatio) 6. Make decision regarding hypothesis
rDG =
sD sG
Hypothesis Test Results
SIMULATION METHODS
SIMULATION METHODS Reject 𝐻𝐻! if test
PROBABILITY TREES
PROBABILITY TREES AND
ANDCONDITIONAL Type Hypotheses
Lognormal Distribution statistic is
CONDITIONAL
EXPECTATIONS EXPECTATIONS
- If Y follows a lognormal distribution, then ln(Y) One-tailed H! : µ ≤ µ!
Expected Value and Variance follows a normal distribution > critical value
(upper) H" : µ > µ!
Expected value: - Used to model asset prices
- One-tailed H! : µ ≥ µ!
- Positively skewed < critical value
E(X) = Z P(X + )X + (lower) H" : µ < µ!
+)! Mean and variance of Y: < lower critical
Variance: ( Two- H! : µ = µ!
-
µG = eKA".LM value or > upper
( ( tailed H" : µ ≠ µ!
σ# (X) = Z P(X + )[X + − E(X)]# σ#G = e#KAM oeM − 1p critical value
+)! where µ and σ# are the mean and variance of ln(Y)
= E(X # ) − [E(X)]#
Hypothesis Testing Decision Errors PARAMETRIC AND
PARAMETRIC AND NON-PARAMETRIC
NON-PARAMETRICTESTS F-statistic:
TESTS
OF OF INDEPENDENCE
INDEPENDENCE MSR SSR/k
Decision 𝐻𝐻" is True 𝐻𝐻" is False F= =
Tests Concerning Correlation MSE SSE/(n − [k + 1])
Do not reject H" Correct Type II (b)
𝑟𝑟√n − 2 Standard error of regression:
Reject H" Type I (a) Correct t-statistic =
√1 − r# Ñ+ p#
∑-+)! oY+ − Y
df = n − 2 s2 = √MSE = g
Power of a test = 1 − P(Type II error) = 1 − b n−2
To use the Spearman rank correlation coefficient,
p-value: smallest value of a at which H" is rejected
substitute the following value into the t-statistic Hypothesis Testing of Individual
Test Concerning a Single Mean calculation: Regression Coefficients
A t-test can be used if the sample: 6 ∑-+)! d#+ To test a hypothesis about the slope:
rR = 1 −
- Has a large size (from any population with n(n# − 1) bÉ! − b!
t=
unknown variance); or sTU%
Tests of Independence Using Contingency Table
- Is approximately normal s2
Data sTU% =
- (X C)#
F∑+)! + − X
C − µ"
X 8
oO+I − E+I p
#
t-statistic = χ# = Z To test a hypothesis about the intercept:
s⁄√n E+I
df = n − 1 bÉ" − b"
O+I − E+I t=
Standardized residual = sTU)
Test Concerning Differences between Means FE+I
1 C )#
(X
Normal populations with unknown variances that sTU) = gMSE Ö + - Ü
LINEAR REGRESSION
SIMPLE LINEAR REGRESSION n ∑+)! (X + − C
X) #
are assumed equal:
C! − C
(X X # ) − (µ! − µ# ) Estimating the Parameters of a Simple Linear
t-statistic = Prediction in the Simple Linear Regression
Regression
s# s# Model
g H+ H Y: Dependent variable/explained variable
n! n# Estimated variance of the prediction error for Y:
X: Independent variable/explanatory variable
1 (X − CX) #
(n! − 1)s!# + (n# − 1)s## s9# = s2# W1 + + X
sH# = Y = b" + b! X + ϵ, n (n − 1)sN#
n! + n# − 2
where b" is the intercept, b! is the slope coefficient,
df = n! + n# − 2 Functional Forms for Simple Linear Regression
and ϵ is the error term
Common functional forms:
Test Concerning Mean Differences
The parameters can be estimated by: - Log-lin model
Normal populations with unknown variances:
Cov[Y, X] ∑-+)! (Y+ − C
Y)(X + − CX) - Lin-log model
d| − µP" bÉ! = =
t-statistic = Var[X] C )#
∑-+)! (X + − X - Log-log model
sPQ
df = n − 1 bÉ" = C
Y − bÉ! C
X
INTRODUCTION TO BIG
INTRODUCTION TO BIGDATA
DATA TECHNIQUES
TECHNIQUES
Cov[Y, X]
Test Concerning a Single Variance r= Fintech and Big Data
Normal population: FVar[Y]FVar[X]
Characteristics of big data:
(n − 1)s # - Volume
χ# = Assumptions of the Simple Linear Regression
σ#" Model - Velocity
-
1 - Linear relationship between X and Y - Variety
s# = Z(X + − x|)#
n−1 - Homoscedasticity (i.e., constant variance of
+)! Sources of alternative data:
df = n − 1 residuals) - Individuals (e.g., unstructured data)
- Independence between X and Y - Business processes (e.g., corporate information)
Test Concerning the Equality of Two Variances
- Normality of the residuals - Sensors (e.g., smartphones and satellite data)
Normal populations:
s!# Analysis of Variance Types of Machine Learning
F= #
s# Sum of squares error (SSE): - Supervised learning
df! = n! − 1 - Unexplained variation in Y - Unsupervised learning
#
df# = n# − 1 - SSE = ∑-+)! oY+ − Ñ
Y+ p - Deep learning
Nonparametric Tests Sum of squares regression (SSR):
Test that is not concerned with parameter and is - Explained variation in Y
implemented in situations such as: # ECONOMICS ECONOMICS
Ñ+ − Y
- SSR = ∑-+)! oY Cp
- Data do not meet distributional assumptions
- Data are subject to outliers Sum of squares total (SST): FIRMS AND MARKET STRUCTURES
STRUCTURES
- Data are given in ranks - Total variation in Y Profit maximization: MR = MC
- Hypothesis does not concern a parameter C)#
- SST = SSE + SSR = ∑-+)! (Y+ − Y
Economic profit:
Coefficient of determination: Revenue > Explicit costs + Implicit costs
SSR
R# = Normal profit: Economic profit = 0
SST
= r # (if there is only one independent variable)
Shutdown Decision (Short-term vs. Long-term) Slowdown
Short-Term Long-Term - Economy: Going through a peak
TR ≥ TC Stay Stay - Activity level: Decelerating
TVC < TR < TC Stay Exit market - Employment: Hiring slows
TR < TVC Shut down Exit market - Inflation: Accelerating
Economies of Scale - Capital spending: Strong capital spending, but
Each stage of expansion has its own short-run ATC inventory starts building up as sales growth
curve. Minimum efficient scale is the low point on slows
the long-run average total cost curve.
Contraction
- Economy: Weakens and may go into a recession
- Activity levels: Below potential
Kinked demand curve: A price increase will impact - Employment: Hiring freezes, then layoffs
sales more than an equivalent price decrease
- Inflation: Decelerating, but with a lag
Cournot assumption: Competitors will maintain - Capital spending: New orders halted and existing
current output levels if one firm changes its price
orders canceled, scale back on maintenance
Game theory: If one firm changes its prices,
competitors will adjust to maximize their profits, Economic Indicators
resulting in a Nash equilibrium Leading: Stock indexes, building permits
Price collusion is more likely to happen if: Coincident: Real income, industrial production
- Few firms or one dominant firm Lagging: Unemployment rate, prime lending rate
Perfect Competition
- Products are relatively similar
- Firms: Many
- Products: Homogeneous - Firms have similar cost structures FISCAL POLICY
POLICY
- Barriers to entry: Very low - Orders are frequent and relatively small Fiscal Policy: Spending Tools
- Credible threat of retaliation for breaking pact Transfer payments: Redistribution of wealth (e.g.,
- Pricing power of firms: None
- The threat of external competition is high unemployment benefits)
- Non-price competition: None
Monopoly Current spending: Spending on goods and services
Monopolistic Competition
- Firm: One Capital spending: Spending on infrastructure
- Firms: Many
- Products: Unique Fiscal Policy: Revenue Tools
- Products: Differentiated
- Barriers to entry: Very high Direct taxes: Tax on income (e.g., income taxes,
- Barriers to entry: Low
- Pricing power of firm: Considerable corporate taxes, capital gains taxes)
- Pricing power of firms: Some
- Non-price competition: Advertising and product - Non-price competition: Advertising Indirect taxes: Tax on goods and services
differentiation Market Power Measures Fiscal Multiplier
N-firm concentration ratio: Sum of market share 1
of the N largest firms in the industry = , where MPC = marginal
1 − MPC(1 − t)
propensity to consume; t = tax rate
Herfindahl-Hirschman Index (HHI): Sum of squared
market share of the N largest firms Difficulties Executing Fiscal Policy
Recognition lag: Government must see need
UNDERSTANDINGBUSINESS
UNDERSTANDING BUSINESSCYCLES
CYCLES Action lag: Time needed to choose policy
Business Cycle Phases Impact lag: Policies do not have immediate impact
Recovery
- Economy: Going through a trough MONETARY POLICY
- Activity level: Below potential but start to increase Roles of Central Banks
Oligopoly - Employment: Layoffs slow, but firms prefer - Supplier of currency
- Firms: Few extending overtime to rehiring full-time - Banker to government and bankers’ bank
- Products: Homogeneous - Inflation: Moderate - Lender of last resort
- Barriers to entry: High - Capital spending: Low but increasing, with a focus - Regulator of payments system
- Pricing power: Some or considerable on efficiency rather than capacity - Conductor of monetary policy
- Non-price competition: Advertising and product Expansion - Supervisor of banking system
differentiation - Economy: Enjoying an upswing - Maintain foreign currency reserves and gold
- Activity level: Above-average growth rates reserves
- Employment: Full-time rehiring, more overtime
Monetary Policy Tools
- Inflation: Moderate, but increasing
Expansionary monetary policy measures:
- Capital spending: Focused on capacity expansion
- Open market operations: Buy bonds from
commercial banks
- Policy rate: Set policy rate below neutral level
- Reserve requirement: Reduce reserves for
commercial banks
INTRODUCTIONTO
INTRODUCTION TOGEOPOLITICS
GEOPOLITICS Impact of Trade Restrictions Trade Balance
National Governments and Political X − M = (S − I) + (T − G)
Cooperation A trade surplus must be reflected in excess private
State actors possesses the authority to deploy a savings or fiscal surplus
country’s national security resources
EXCHANGE RATE
EXCHANGE RATE CALCULATIONS
CALCULATIONS
Non-State Actors and the Forces of
Globalization Cross-Rate Calculations
Non-state actors participate in global political, S.⁄< = S.⁄X × SX⁄<
economic, or financial affairs but do not control a Forward Rate Calculations
country's national security resources Forward exchange rateP⁄9 1 + iP
=
Assessing Geopolitical Actors and Risk Spot exchange rateP⁄9 1 + i9
Forward exchange rates in points:

- Price increases from P ∗ to P(
- Unit of points is last decimal place in the rate
- Domestic production increases from Q! to Q #
quote (e.g., 1.5301 to 1.5302 is a 1-point increase)
- Domestic consumption falls from Q F to Q B
- Imports fall from (Q F − Q! )to (Q B − Q # )
- Loss of consumer surplus = (A + B + C + D)
The Tools of Geopolitics CORPORATECORPORATE
ISSUERSND ANALYSIS
ISSUERS
- National welfare loss = (B + D)
National security tool: Military force, espionage - Increase in producer surplus = A
Economic tools: Currency union, nationalization - Tariff revenue/Quota rent = C ORGANIZATIONAL FORMS,
FORMS,CORPORATE
CORPORATEISSUER
Financial tools: Currency markets, sanctions, FEATURES,
ISSUER AND OWNERSHIP
FEATURES, AND OWNERSHIP
Regional Trading Blocs
capital controls Sole Proprietorship
Free trade area (FTA): Free trade among members
- Extension of owner
Incorporating Geopolitical Risk into the Customs union (CU): FTA + common trade policy
- Operated by owner
Investment Process Common market (CM): CU + free movement of
- Business liability is retained by owner
Types of geopolitical risk: factors of production within bloc
- Business profits are owned by owner and taxed
- Event risk Economic union (EU): CM + common economic
as personal income
- Exogenous risk institutions and coordination of economic policies
- Owner is the main source of capital
- Thematic risk Monetary union (MU): EU + common currency
Assessing Geopolitical Threats General Partnership

To assess geopolitical risk, consider: CAPITAL FLOWS AND THE FX
FX MARKET
MARKET - Set by partnership agreement
- The likelihood of occurrence The Foreign Exchange Market and Exchange - Operated by partners
- The velocity (speed) of impact Rates - Business liability is retained and shared by
- The size and nature of impact CPI9 partners
Real ex. rateP⁄9 = Nominal ex. rateP⁄9 × ] ^
CPIP - Business profits are shared by partners and taxed
TRADE AND
INTERNATIONAL TRADE AND CAPITAL
CAPITAL FLOWS
FLOWS as personal income
“A/B”: How many units of currency A can be
purchased by one unit of currency B - Partners are the main source of capital
Benefits and Costs of International Trade
- Partners’ resources and risk appetite limit
Benefits: Ideal Currency Regime business growth
- Gains from exchange 1. Exchange rates are credibly fixed
- Greater economies of scale 2. Fully convertible currencies, free capital flows Limited Partnership
- Greater product variety 3. Countries pursue independent monetary policies - Set by partnership agreement
- Increased competition - Operated by GP
- More efficient allocation of resources Such an ideal currency regime is NOT possible
- Business liability is limited for LPs and unlimited
Exchange Rate Regimes for GP
Costs:
Dollarization: Adopt another country’s currency - Business profits are shared by partners and taxed
- Income inequality
Monetary union: Adopt a common currency as personal income
- Job losses
Currency board: Commitment to exchange - Partners’ resources, risk appetite, and GP’s
Trade Restrictions domestic currency at fixed exchange rate competence/integrity limit business growth
Tariffs: Taxes on imported goods Fixed peg: Currency is pegged to foreign currency
Quotas: Limits on quantity of imported goods (or basket of currencies) within ±1% margin Limited Liability Partnership
Export subsidies: Payments to exporters Target zone: Fixed peg with wider margin - Set by partnership agreement
Minimum domestic content requirements Crawling peg: Peg rate is periodically adjusted - Operated by LPs and there is no GP
Voluntary export restraints: Self-imposed Crawling bands: Margin increases over time, - Business liability is limited for LPs
limitations by foreign producers usually to transition from fixed peg to floating - Business profits are shared by partners and taxed
Managed floating: Monetary authority intervenes, as personal income
but no official target exchange rate
Limited Companies
Independently floating: Market sets exchange rate
- Legal identity is separated from owners
- Operated by management team voted by
shareholders
- Limited business liability for shareholders
- Financed by equity and debt
Private limited companies: Controlling shareholder vs. minority shareholder Factors relevant to corporate governance and
- Profits are taxed at the personal level - Dispersed ownership: Controlled by many stakeholder management analysis:
- Subject to restrictions on the number of owners minority shareholders - Economic ownership and voting control
- Votes are needed to transfer ownership interest - Concentrated ownership: Controlled by a single - Board of directors representation
shareholder - Remuneration and company performance
Public limited companies:
- Multiple-class share structures: Disproportionate - Investors in the company
- Double taxation: once at the corporate level and
voting power to certain shareholder classes - Strength of shareholders’ rights
once at the personal level (for dividend income)
- Management of long-term risks
- No restrictions on the number of owners Shareholder vs. creditor
- Ownership interest can be transferred anytime - Equity owners prefer growth and have a higher
risk tolerance WORKING CAPITAL AND LIQUIDITY
Publicly vs. Privately Owned Corporate Issuers Cash Conversion Cycle
- Creditors prefer stability and limited downside
Private placement memorandum (PPM) is used by Cash conversion cycle = DOH + DSO − DPO
risk
private companies to raise capital in primary
market Corporate Governance Mechanisms Trade credit:
Shareholder: EAR of supplier financing
Private companies can go public by: BYL
- Corporate reporting and transparency d ;4C82-( H2/+3P6>+7Z3[-( H2/+3P
- Initial public offering (IPO) = ã]1 + ^ å−1
- Shareholder meetings (cumulative voting, proxy 1−d
- Direct listing (DL)
voting)
- Acquisition where d is the discount percentage
- Shareholder activism
Public companies can go private by: - Derivative lawsuits Working capital = Current assets
- Leveraged buyout (LBO) - Corporate takeovers (proxy contests, tender − Current liabilities
offers, hostile takeovers)
Liquidity
INVESTORSAND
INVESTORS ANDOTHER
OTHERSTAKEHOLDERS
STAKEHOLDERS Creditor: Primary sources of liquidity:
Financial Claims of Lenders and Shareholders - Bond indentures, collateral, and trustees - Free cash flows
Risk vs return characteristics of equity and debt: - Corporate reporting - Ready cash balances (bank accounts)
Equity Debt - Creditor committees - Short-term funds (lines of credit)
Upside Limited to - Cash flow management (centralized collection)
Unlimited Board and management:
potential payments
- Audit committee CFO
Maximum Cannot be more than the
- Governance committee = Cash received from customers
loss investment value
- Remuneration committee + Interest and dividends from investments
Investment Higher Lower
- Nomination committee − Cash paid to employees
risk
- Risk committee − Cash paid to suppliers
Investment Maximize Timely
- Investment committee − Cash paid to government for tax obligations
interest company repayment
− Cash paid to lenders for interest obligations
value Employee:
- Labor laws Free cash flow (to equity)
Corporate Stakeholders and Governance
- Code of ethics and compliance department = CFO − Investments in long term assets
- Whistleblower protections
Secondary sources of liquidity:
- Employee contracts
- Negotiating debt contracts
Customer and supplier: - Liquidating assets
- Commercial contracts - Filing for bankruptcy
- Public reputation and social media
Drag on liquidity: Delayed cash inflows, such as
Government: uncollected receivables and obsolete inventory
- Laws and regulations Pull on liquidity: Accelerated cash outflows, such as
- Corporate governance codes settling payables earlier
CORPORATEGOVERNANCE:
CORPORATE GOVERNANCE:CONFLICTS,
CONFLICTS, - Common law and civil law systems
Current assets
MECHANISMS,
MECHANISMS,RISKS,
RISKS,AND
ANDBENEFITS
BENEFITS Current ratio =
Corporate Governance Risks and Benefits Current liabilities
Stakeholder Conflicts and Management
Operational risks of poor stakeholder governance: Marketable
Shareholder vs. manager/director Cash + + Receivables
- Weak control systems that do not treat all Quick ratio = securities
- Entrenchment: Managers avoid justifiable risks to Current liabilities
stakeholders fairly
avoid losing their positions Cash + Marketable securities
- Ineffective decision-making process
- Empire building: Making unjustified acquisitions Cash ratio =
- Inadequate board scrutiny Current liabilities
to increase company size and compensation
- Diminished operating performance
- Excessive risk taking: Taking unjustifiable risks to
maximize returns on stock-based compensation Financial risks of poor stakeholder governance:
- Agency costs reduce the potential for exploitation - Higher default and bankruptcy risks
in an agency relationship - Higher borrowing costs
- Poor equity returns
Working Capital Management BA II Plus NPV Worksheet Function Determinants of the Costs of Debt and Equity
Conservative approach: - Cash inflows are positive; outflows are negative Issuer-specific factors:
Advantages: - F01, F02, etc. refer to cash flow frequencies - Sales risk
- Low rollover risk - CPT + NPV to compute NPV; CPT + IRR for IRR - Profitability risk: operating leverage
- Greater cash flow certainty - Financial leverage and interest coverage
Return on Invested Capital
- Low risk of inventory shortages - Asset type (tangible, fungible, and liquid)
Return on invested capital (ROIC):
- Flexibility to adapt to adverse market conditions
After-Tax Net Profit Modigliani and Miller Propositions
ROIC =
Disadvantages: Average BV of Invested Capital MM Proposition I: A firm's capital structure would
- High borrowing costs (1 − Tax Rate) × Operating Profit have no effect on its value, assuming:
=
- High cost of equity and shareholder dilution Average (LT Liabilities + Equity) 1. Investors have homogeneous expectations
- Less flexibility to borrow on an as-needed basis Capital Allocation Pitfalls 2. No market frictions (e.g., transaction costs, taxes,
- Longer lead times - Internal forecasting errors or costs of financial distress)
- More covenants - Ignoring costs of internal financing 3. No agency costs
- High risk of obsolete inventory 4. Investors can borrow and lend at risk-free rate
- Inconsistent treatment of inflation
5. Investing/financing decisions are independent
Aggressive approach: - Inertia
MM Proposition II: Cost of equity increases with the
Advantages: - Basing decisions on earnings metrics
- Pet projects debt-to-equity ratio.
- Low financing costs under an upward-sloping
yield curve - Failing to consider alternatives Without Taxes
- Great flexibility to borrow only as needed Real Options Firm value V: = V\
- Short-term borrowing involves less rigorous - Timing option: Option to delay the investment D
Cost of Equity r2 = r" + (r" − rP ) ] ^
credit analysis - Sizing option: Option to expand, grow, or abandon E
Disadvantages: - Flexibility option: Option to alter operations, With Taxes

- Risk of having to refinance at higher such as changing prices or substituting inputs Firm value V: = V\ + tD
short-term rates - Fundamental option: Option to alter decisions D
Cost of Equity r# = r! + (r! − r$ )(1 − t) 8 ;
- Potential difficulty rolling over short-term debt based on future events (e.g., drill based on price E
with market turmoil of oil, continue R&D depending on initial results)
r! = cost of capital for a firm financed only by equity
- Possible need to rely on expensive trade credit
Analyzing Projects with Real Options
- Tight customer credit terms Optimal and Target Capital Structure
- Use the discounted cash flow (DCF) analysis
Static trade-off theory balances costs of financial
Liquidity and Short-Term Funding Needs without considering real options
distress with tax shield benefits from using debt:
Factors influencing a company’s short-term - Adjust the stand-alone DCF analysis by including
V: = V\ + tD − PV(costs of financial distress)
borrowing strategy: the present value of the expected costs and
- Size and creditworthiness benefits options
- Legal and regulatory considerations - Use option pricing models
- Sufficient access - Use decision trees
- Flexibility of borrowing options
CAPITAL STRUCTURE
STRUCTURE
CAPITAL INVESTMENTS
CAPITAL INVESTMENTSAND
ANDCAPITAL Weighted Average Cost of Capital (WACC)
CAPITAL ALLOCATION
ALLOCATION WACC = wP rP(1 − t) + wH rH + w2 r2
Types of Capital Investments wP = percentage of debt in capital structure
Business maintenance: wH = percentage of preferred stock
- Going concern projects w2 = percentage of common stock To estimate a company’s target capital structure:
- Regulatory/compliance projects t = tax rate - Assume the company will main its current capital
Business growth: rP = cost of debt structure
- Expansion projects rH = cost of preferred stock - Infer target weights the company is moving
- Pet projects/high-risk investments r2 = cost of equity toward
- Use the industrial average
Net Present Value (NPV) Determinants of the Amount and Type of
Pecking order theory: Since managers have an
Sum of present values of expected future cash Financing Needed
asymmetric information advantage, they prefer
inflows, net of initial cash outlay Company life cycle:
-
capital sources that reveal the least amount of
CF( information:
NPV = Z − Outlay
(1 + r)( 1. Internally generated earnings (best option)
()!
Accept a project if NPV > 0 2. New debt
3. New equity (least attractive for managers)
Internal Rate of Return (IRR)
IRR is r such that NPV = 0
Accept a project if its IRR > required return
BUSINESSMODELS
BUSINESS MODELS Auditor’s reports: ANALYZING BALANCE SHEETS
BALANCE SHEETS
Business Model Features - Unqualified Non-Current Assets
- Target customers - Qualified - Intangible assets
- Product/service offering - Adverse - Goodwill
- Channel strategy - Disclaimer - Financial instruments
- Traditional channel
INCOMESTATEMENTS
STATEMENTS Non-Current Liabilities
- Direct sales ANALYZING INCOME
- Long-term financial liabilities
- Drop shipping Revenue Recognition
- Deferred tax liabilities
- Omnichannel strategy Revenue must not be recognized unless:
- Pricing strategy - Risks of ownership have been transferred
ANALYZING STATEMENTS OF CASH
CASHFLOWS
FLOWS
- Amount of revenue can be reliably measured
Pricing and Revenue Models Relationship between Financial Statements
- Customer is likely to pay
Price discrimination: Ending AP
- Transaction is unlikely to be reversed
- Tiered pricing = Beginning AP
Service revenue may be recognized as earned
- Dynamic pricing + (Ending inventory − Beginning inventory)
Allowance for doubtful accounts: Contra-asset
- Value-based pricing − Cash paid to suppliers + COGS
account, estimated based on historical experience
- Auction/reverse auction models
Expense Recognition Ending inventory
Pricing for multiple products: = Beginning inventory
Matching principle: Expenses must be recognized
- Bundling + (Ending AP − Beginning AP)
in the same period as associated revenue
- Razors-and-blades pricing + Cash paid to suppliers − COGS
- Add-on pricing Capitalizing vs. expensing:
- Capitalizing increases assets on the balance sheet ΔAP + Cash paid to suppliers
Pricing for rapid growth: = ΔInventory + COGS
and investing cash outflows
- Penetration pricing
- Expensing reduces net income by the after-tax
- Freemium pricing CFO Direct Method
expenditure amount in the period it is incurred
- Hidden revenue business model - Convert each accrual-based item in the income
Income Statement Line Items statement to cash inflow/outflow
Alternatives to ownership: - CFO is net of cash inflows and outflows
Revenue
- Subscription pricing
− Cost of goods sold (COGS)
- Leasing CFO Indirect Method
Gross Profit - Start with net income
- Licensing
− Selling, General & Admin. (SG&A) - Add noncash expenses (e.g., Depreciation)
- Franchising
EBITDA - Subtract gains/add losses
- Fractionalization
− Depreciation and Amortization - Add increases in current liabilities
Value Chain EBIT (Operating profit) - Subtract increases in (non-cash) current assets
Value chain: Systems and functions within the firm − Interest
that create value for its customers Beginning accounts receivable
EBT (Earnings before taxes)
Supply chain: Series of steps and processes needed + Revenue
− Taxes
to prepare a product to be sold to the consumer − Ending accounts receivable
Net Income (NI)
Unit economics: The quantitative analysis of a Cash collected from customers
company's revenues and costs on a per unit basis Separately Reported Items
Cost of goods sold
- Unusual or infrequent items (US GAAP only)
Business Model Types - Discontinued operations
+ Increase in inventory
- Private label manufacturers - Non-operating items Purchases from suppliers
- Licensing arrangements − Increase in accounts payable
- Value added resellers Basic Earnings per Share
Cash paid to suppliers
- Franchise models Net income − Preferred dividends
Weighted average of shares outstanding Differences Between IFRS and US GAAP
- Network effects
- Crowdsourcing Diluted Earnings per Share Item IFRS US GAAP
Convertible Convertible Operating
Net Preferred (1 − 𝑡𝑡)
− + preferred + debt Interest received Operating
income dividends or investing
dividends interest
FINANCIAL STATEMENT
FINANCIAL ANALYSISND
STATEMENT ANALYSIS
ANALYSIS Weighted Shares from Shares from Shares issuable Operating
average + preferred + convertible + from stock Interest paid Operating
shares shares debt options or financing
INTRODUCTIONTO
INTRODUCTION TOFINANCIAL
FINANCIALSTATEMENT Operating
ANALYSIS Diluted EPS must be equal to or less than basic EPS Dividends received Operating
STATEMENT ANALYSIS or investing
Regulated Sources of Information Operating
IOSCO: International body of regulatory authorities Dividends paid Financing
or financing
SEC: US capital markets regulator Part of cash
Bank overdrafts Financing
equivalents
Free Cash Flow (FCF) IFRS Pension Plans
Free cash flow to the firm (FCFF): Cash available to - Assets are tested annually for impairment Defined benefit (DB): Firm makes periodic
equity owners and debt holders. - Impaired if carrying value > recoverable amount payments to employee after retirement.
FCFF = NI + NCC + I × (1 − t) − FCI − WCI - Impaired asset’s value is written down to
Components of the change in the net pension asset
FCFF = CFO + I × (1 − t) − FCI recoverable amount and a loss is recognized
or liability under IFRS:
- Loss can be reversed if asset value recovers, but
Free cash flow to equity (FCFE): Cash flow available (1) Employees’ service cost (income statement)
only up to pre-impairment carrying value
to common shareholders (2) Net int. expense/income (income statement)
FCFE = CFO − FCI + Net Borrowing Derecognition (3) Remeasurement (OCI)
Long-lived assets are derecognized if:
Components of the change in the net pension asset
ANALYSIS OF
ANALYSIS OFINVENTORIES
INVENTORIES (1) the asset is disposed of
or liability under US GAAP:
Inventory Valuation (2) there are no expected future benefits from use
(1) Current service cost (income statement)
IFRS: Lower of cost or net realizable value or disposal
(2) Interest expense (income statement)
US GAAP: Lower of cost or market value
(3) Expected return on plan assets (income
Reversals of inventory write-downs are allowed TOPICSIN
TOPICS INLONG-TERM
LONG-TERMLIABILITIES
LIABILITIESAND statement)
under IFRS, but not under US GAAP EQUITY
AND EQUITY
(4) Past service cost (OCI; amortized in income
Lease Classification
Inventory Valuation Methods and Systems statement)
Conditions requiring a lease to be a finance lease:
US GAAP IFRS (5) Actuarial gains/losses (income statement;
- Ownership of the leased asset is transferred to
FIFO Allowed Allowed amortized in OCI)
the lessee
LIFO Allowed N/A Share-Based Compensation
- Lessee has the option to purchase the asset and
Weighted will likely do so - Stock grants (outright or restricted)
Allowed Allowed
average - Lease term covers most of asset's useful life - Stock options
Specific - The present value of lease payments at inception - Stock appreciation rights (SARs)
Allowed Allowed
Identification is close to the asset’s fair value - Phantom shares
- The leased asset is so specialized that only the
Impact of Inventory Valuation Method lessee can use it without modification ANALYSIS OF INCOME
INCOMETAXES
TAXES
If prices are rising FIFO LIFO Temporary Differences
Ending Inventory Lessee Accounting
Higher Lower Deferred tax liabilities (DTL): Created when taxes
US GAAP
COGS Lower Higher payable is less than income tax expense
Finance lease:
Net income Higher Lower Deferred tax assets (DTA): Created when taxes
- Lessee purchases the asset, financed by the lessor
Income Tax Expense Higher Lower payable exceeds income tax expense
- Lessee's periodic lease payments have separate
Operating cash flow Lower Higher Tax base of assets: Amount that will be deducted on
depreciation and interest components
the tax return as asset’s benefits are realized
ANALYSIS OF
ANALYSIS OFLONG-TERM
LONG-TERMASSETS
ASSETS Operating lease (like a rental agreement): Tax base of liabilities: Carrying value of liability
- Single lease expense, not separated into different minus amount that will be deductible
Impairment of Property, Plant, and Equipment
components for depreciation and interest
Property, plant, and equipment (PP&E): Asset carrying amount > Tax base DTL
- The value of an operating lease payment is
IFRS Asset carrying amount < Tax base DTA
calculated as a straight-line allocation of total
- Both cost model and revaluation model allowed Liability carrying amount > Tax base DTA
payments over the term of the lease
- Impairment loss Liability carrying amount < Tax base DTL
= Carrying amount − Recoverable amount IFRS require all leases to be treated in the manner
- Recoverable amount is greater of: that is prescribed by US GAAP for finance leases. Impact of tax rate changes
(1) fair value less selling costs, and If tax rate increases, DTA and DTL will increase
Lessor Accounting If tax rate decreases, DTA and DTL will decrease
(2) value in use (PV of asset’s future cash flows)
- For operating leases (under both IFRS and US
- Loss recoveries are allowed Valuation Allowance
GAAP), the lessor retains the leased asset on its
US GAAP balance sheet and incurs the associated Contra account used if it is unlikely that future
- Only cost model is allowed depreciation expense. Lease income from the profits will be sufficient to use DTAs and credits
- Loss recoveries not allowed lessee is recorded as revenue. Corporate Income Tax Rates
- Impairment loss - For finance leases (under both IFRS and US Statutory tax rate: Corporate income tax rate in
= Carrying amount − Fair value GAAP), the lessor removes the leased asset from domestic market
its balance sheet and creates an asset with a Effective tax rate: Reported income tax expense as
Impairment of PP&E and Intangible Assets
value equal to the lease receivable and any a share of EBT
US GAAP
residual value. Cash tax rate: Actual income tax expense as a share
- Asset tested for impairment only when firm may
- Lease payments are recognized as an operating of EBT
not recover carrying value through future use
inflow on the lessor’s cash flow statement (for
- Asset is impaired when carrying value exceeds
both operating leases and finance leases)
asset’s future undiscounted cash flows
- Impaired asset’s value is written down to fair
value and a loss is recognized and cannot be
subsequently reversed
FINANCIAL REPORTING
FINANCIAL REPORTINGQUALITY
QUALITY Liquidity Ratios DuPont Analysis
Spectrum of Financial Reporting Quality Current assets Net income Assets
Current ratio = ROE = ] ^] ^
(1) GAAP, decision-useful, sustainable, and Current liabilities Assets Book Value of Equity
adequate returns Marketable Leverage
Cash + + Receivables = (ROA) S T
(2) GAAP, decision-useful, but sustainable? Quick ratio = securities ratio
Current liabilities
(3) Biased accounting choices NI Revenue Assets
Cash + Marketable securities =] ^] ^] ^
(4) Within GAAP, but “earnings management” Cash ratio = Revenue Assets Equity
Current liabilities
(5) Departures from GAAP
Net profit Asset Leverage
Marketable =] ^S TS T
Depreciation Methods Cash + + Receivables margin turnover ratio
Defensive securities
=
ABCDEFGHIGJK IGHLK interval Average daily expenditures NI EBT EBIT Revenue Assets
Straight-line: = =8 ;8 ;8 ;8 ;8 ;
MKNOKPQGRHK HQSK EBT EBIT Revenue Assets Equity
Cash Days of Days of Number
Double-declining balance (DDB): conversion = sales + inventory − of days ="
Tax
,"
Interest
,0
EBIT
6"
Asset
,0
Financial
6
cycle outstanding payables burden burden margin turnover leverage
Book value( on hand
Depreciation( = ] ^×2
Depreciable life
Solvency Ratios INTRODUCTION TO FINANCIAL
INTRODUCTION TO FINANCIALSTATEMENT
Units-of-production: MODELING MODELING
Total debt STATEMENT
Cost − Salvage Debt-to-equity =
Depreciation( = × Output units( Total shareholders' equity Behavioral Finance and Analyst Forecasts
Total output
Total debt - Overconfidence
Debt-to-capital = - Illusion of control
FINANCIAL Total shareholders'
FINANCIAL ANALYSIS
ANALYSISTECHNIQUES
TECHNIQUES Total debt +
equity - Conservatism bias
Common-Size Analysis
Total debt - Representativeness bias
Vertical: Debt-to-assets =
Total assets - Confirmation bias
- State income statement items as % of revenue
- State balance sheet items as a % of total assets Average total assets Michael Porter’s Five Forces
Financial leverage =
- State each cash flow statement item as a % of Average total equity - Threat of substitutes
total cash inflows/outflows - Intensity of rivalry
Total debt
Horizontal (Trend) Analysis: Debt-to-EBITDA = - Bargaining power of suppliers
EBITDA
- State each item relative to its base-year value - Bargaining power of customers
EBIT - Threat of new entrants
Activity Ratios Interest coverage =
Interest payments
Revenue Fixed
Total asset turnover = EBIT + Lease payments
Average total assets charge =
coverage Interest payments + Lease pmts EQUITY CORPORATE ISSUERS
Revenue
Fixed asset turnover =
Average net fixed assets Profitability Ratios MARKET ORGANIZATION
CORPORATE STRUCTURESAND STRUCTURE
AND OWNERSHIP
Net income
Revenue Net profit margin = Functions of the Financial System
Working capital Revenue
= - Saving
turnover Average working capital
Gross profit - Borrowing
Cost of goods sold Gross profit margin =
Inventory turnover = Revenue - Raising Equity Capital
Average inventory
EBIT - Managing Risks
Annual sales Operating profit margin =
Revenue - Exchanging Assets
Receivables turnover =
Average receivables - Information-Motivated Trading
EBT
Pretax margin =
Purchases Revenue Securities Markets
Payables turnover =
Average trade payables Net income - Spot vs. Forward Markets: Spot market trades are
Return on assets (ROA) =
365 Average total assets settled within 3 days.
Days of inventory
= - Primary vs. Secondary Markets: Primary market
on hand Inventory turnover EBIT(1 − t)
Return on invested capital = transactions are done directly with the issuer,
Days of sales 365 ST & LT debt & equity
= while secondary market trades take place on
outstanding Receivables turnover Net income organized exchanges.
Return on equity (ROE) =
Number of days 365 Average total equity - Capital vs. Money Markets: Money markets are
=
of payables Payables turnover used for securities with maturities of less than
one year, while longer-dated securities are traded
in capital markets.
Positions
Long positions: Benefit from price appreciation
Short positions: Benefit from price depreciation
Leveraged Positions Complete Markets Types of Equity Market Indexes
Position - Facilitate savings/investment - Broad market indexes: Covers one equity market
Leverage ratio =
Equity - Facilitate lending to creditworthy borrowers - Multi-market indexes: Covers equity markets in
1 - Allow risk exposures to be hedged multiple countries
Maximum initial leverage ratio =
Intial margin - Facilitate exchange of currencies/commodities - Sector indexes: Important for assessing a
Maintenance margin: minimum amount of equity An ideal financial system is complete (see above), manager’s performance (selection vs. allocation)
required operationally efficient (low transaction costs), and - Style indexes: Large/small cap; Value/growth
Margin call is triggered if the equity falls below the informationally efficient (prices reflect all info.)
maintenance margin. Additional equity will be MARKET EFFICIENCY
requested to bring the account balance back to the SECURITY MARKET
SECURITY MARKET INDEXES
INDEXES Forms of Efficient Market Hypothesis (EMH)
initial margin. Price Return over Single Period Market Prices Reflect:
5
Execution Instructions (How to fill) P+! − P+" Past
PR + = PR ] = Z w+ PR + Public Private
- Market: Fill immediately at market price P+" Form market
+)! info info
- Limit: Buy below maximum price or sell above data
Total Return over Single Period
minimum price specified in order Weak ✔
5
- All-or-nothing: Cancel order if not fully filled P+! − P+" + Inc+ Semi-
TR + = TR ] = Z w+ TR + ✔ ✔
- Hidden: Visible to brokers and exchanges, but P+" strong
+)!
invisible to other traders Strong ✔ ✔ ✔
Price Return Index over Multiple Periods
- Iceberg: Only a fraction of order amount is visible
V;^]' = V;^]" (1 + PR ]! )(1 + PR ]# ) … (1 + PR ]' ) Implications of EMH
Validity Instructions (When to fill) - If weak form holds, investors will not earn
- Day orders: Cancelled if unfilled at end of day Total Return Index over Multiple Periods
abnormal profits from technical analysis
- Good-till-cancelled: No set expiry date V'^]' = V'^]" (1 + TR ]! )(1 + TR ]# ) … (1 + TR ]' )
- If markets are semi-strong efficient, investors
- Good-on-close: Filled at end of day Price-Weighted Indexes must have a comparative advantage to earn
- Stop-loss: Sell if prices fall below specified level P+ abnormal profits from fundamental analysis
w+; = 5
∑I)! PI
Clearing Instructions Market Anomalies
Settlement/clearing typically done by brokers for - Like buying one share of each stock
Changes in a security’s price that are not
retail trades; brokers or custodians for - Advantage is simplicity
attributable to known information
institutional trades - Disadvantage is arbitrary weights
- A stock’s weight is halved due to a stock split, Selected Behavioral Biases
Primary Market Transactions
requiring an adjustment to the divisor - Loss aversion: Disliking losses more than liking
- Initial Public Offerings (IPOs)
equivalent gains
- Private placements Equally Weighted Indexes
- Information Cascades: Those who act first will
- Shelf registrations: Part of issue is held back to be 1
w+= = convey information that influences others
sold directly to secondary market investors later N
- Like investing the same amount in each stock - Representativeness: Rely too much on current
- Dividend reinvestment plans (DRIPs): Investors
- Advantage is simplicity state when assessing probabilities
can roll over dividend payments to purchase new
- Disadvantages are that the impact of large - Mental accounting: Keep track of gains and losses
shares, possibly at a discount
companies is underrepresented and frequent separately for different investments/goals
- Rights offerings: Current shareholders gain right
rebalancing is required - Conservatism: Failing to incorporate new
to purchase additional shares at below-market
information in a timely manner
price; dilutes value of existing shares Capitalization-Weighted Indexes
- Narrow framing: Focusing on certain issues in
Market Structure Q + P+
w+_ = 5 isolation
∑I)! Q I PI
Quote-driven: Investors trade with dealers
- Like holding all stocks in proportion to their OVERVIEW
Order-driven: Exchanges use order matching rules OVERVIEW OF
OF EQUITY
EQUITY SECURITIES
SECURITIES
Brokered: Trades arranged by brokers market values
Common Share Voting Methods
Call markets: Conduct periodic single price - Float adjustment may be used to reflect the
Statutory: One vote per share
auctions, otherwise completely illiquid number of shares that may be actively traded
Cumulative: Votes can be bundled
Continuous Trading markets: Allow trades - Advantage is that the asset classes’ performance
Example: 10 board positions
whenever market is open, may use call market is well-represented
Statutory: 1 share votes for 10 different candidates
auction at beginning and/or end of each day - Disadvantage is that returns are heavily driven by
Cumulative: 10 votes may go to 1 candidate
large-cap (possibly overvalued) firms
Trade Pricing Rules Cumulative method advantages small shareholder
Uniform pricing rules: Used by call markets, all Fundamentally Weighted Indexes
Preference Shares
trades executed at the price that maximizes total - Built like price-weighted indexes, but using a - Cumulative: Accrue dividends if payments missed
quantity traded fundamental measure such as sales or cash flows - Non-cumulative: Missed dividends do not accrue,
Discriminatory pricing rules: Used by continuous - Contrarian effect of rebalancing by selling off top but no common dividends allowed if preferred
markets, fills most aggressively priced orders first performers and buying underperforming stocks shareholders do not receive their dividend
Derivative pricing rules: Used by crossing networks produces a value tilt - Participating: May receive additional dividend if
to trade at midpoint of quotes from other markets firm is profitable or in the event of liquidation
- Non-participating: No compensation beyond
dividends and face value in a liquidation
Private Equity Securities INDUSTRY ANDAND COMPETITIVE
COMPETITIVE ANALYSIS
ANALYSIS FIXED INCOME FIXED INCOME
- Venture capital (VC): Start-up, early-state, or Industry and Competitive Analysis Steps
mezzanine financing with IPO as exit strategy (1) Define industry FIXED-INCOME FEATURES,CASH
FIXED-INCOME FEATURES, CASHFLOWS,
FLOWS,
- Leveraged buyouts (LBO): Debt-financed deals to (2) Industry survey ISSUANCE, ANDTRADING
ISSUANCE, AND TRADING
take undervalued listed companies private (3) Industry structure Fixed-Income Cash Flow Structures
- Private investment in public equity (PIPE): (4) External influences - Bullet Bonds: Full principal repaid at maturity
Companies can raise new capital quickly, (5) Competitive analysis - Fully Amortized Loan: Equal annuity-like
investors can negotiate discounts payments contain a mix of interest and principal
External Influences on Industry Growth
- Partially Amortized Loan: Some principal is
Depository Receipts (DRs) - Political influences
amortized, remainder repaid as a lump sum at
Sponsored DRs: Issued directly by foreign - Economic influences
maturity
company; Investors receive same voting rights and - Social influences
- Sinking Funds: Certain percentage of principal
dividends as other common shareholders - Technological influences
retired each year
- Legal influences
Unsponsored DRs: Foreign company not involved; - Floating-Rate Notes (FRNs): Reference rate +
- Environmental influences
Depository bank purchases shares, issues DRs, and spread
retains voting rights - Step-Up Bonds: Coupon rate increases on schedule
COMPANY ANALYSIS:
COMPANY ANALYSIS: FORECASTING
FORECASTING
- Sustainability-Linked Bonds: Coupon rate
Global DRs: Issued outside company’s home Forecasting Revenues
increases if fails to meet environmental targets
country to avoid limits on capital flows; May be Top-down approaches
- Credit-Linked Notes: Coupon rate increases if
denominated in any currency, but USD is common; - Growth relative to GDP growth
issuer is downgraded, reduced if upgraded
Cannot be listed on US exchanges, but US investors - Market growth and market share
- Payment-In-Kind (PIK) Bonds: Coupons may be
can purchase them via private placements
Bottom-up approaches paid with more bonds rather than cash
American DRs: USD-denominated GDRs that can be - Volume and average sale price - Indexed-Linked Bonds: Coupons are tied to a
traded on US exchanges; Underlying securities, - Product-line or segment revenues specific index
American depository shares, trade in issuer’s - Capacity-based measures - Deferred (Split) Coupon Bonds: No coupons in
domestic market - Returns- or yield-based measures early years, high coupons in later years
Global Registered Shares: Traded on multiple Fixed-Income Contingency Provisions

EQUITY VALUATION: CONCEPTS
CONCEPTS AND BASIC
exchanges, including issuer’s domestic market; Callable Bonds
AND BASIC TOOLS
TOOLS
Denominated in multiple local currencies; Unlike May be recalled by issuer if rates fall
Dividend Discount Model (DDM)
DRs, GRS represent an actual ownership interest ` - VX4aa4Ta2 T3-P = VNon-callable bond − VX4aa
D( D( P-
V" = Z =Z +
(1 + r)( (1 + r)( (1 + r)- Putable Bonds
COMPANY ANALYSIS:
COMPANY ANALYSIS:PAST
PASTAND
ANDPRESENT
PRESENT ()! ()!
Company Research Reports May be sold back to issuer if rates rise

Perpetual preferred stock; constant dividend:
V;[(4Ta2 T3-P = VNon-putable bond + V;[(
D"
V" =
r Convertible Bonds
Gordon constant growth model (GGM): Conversion price: Price per share at which bond
` can be converted into shares
D" (1 + g)( D" (1 + g) D!
V" = Z = = Conversion ratio: Number of common shares
(1 + r)( r−g r−g
()! each bond can be converted into
g = (Retention rate) × ROE = (1 − D⁄E) × ROE
Conversion value:
Multistage DDM: Current share price × Conversion ratio
- Conversion premium:
D( P-
V" = Z + Convertible bond’s price − Conversion value
(1 + r)( (1 + r)-
()!
Warrants: Options to buy equity, lowers debt costs
D-A!
P- =
r − g: Convertible Contingent Bonds (CoCos)
Operating Profitability and Working Capital
D-A! = D" (1 + g R )- (1 + g : ) - Automatically convert to equity if a condition is
Analysis
met (e.g., capitalization ratio falls)
Operating income = [Q × (P − VC)] − FC Price Multiples
- Lender does not control if option is exercised
P" D! /E!
%ΔOperating income = - Primarily issued by financial institutions
DOL = E! r−g
%ΔSales
P⁄B = Price per share⁄Book value per share Fixed-Income Indexes and Markets
%ΔNet income P⁄CF = Price per share⁄Cash flow per share - Primary bond markets: Markets in which issuers
DFL =
%ΔOperating income P⁄S = Price per share⁄Sales per share initially sell bonds to investors to raise capital
DTL = DFL × DOL - Secondary bond markets: Markets in which bonds
Asset-Based Valuation Models
Useful for companies with natural resource or a are subsequently traded among investors; Most
large share of current assets/liabilities; Not useful trading is OTC rather than on organized
if company has a large share of PP&E/intangibles exchanges
Enterprise Value (EV)
= MV(Common equity) + MV(Preferred stock)
+ MV(Debt) − (Cash + Short term investments)
FIXED-INCOMEMARKETS
FIXED-INCOME MARKETS FIXED-INCOME VALUATION:
FIXED-INCOME VALUATION: PRICES,
PRICES,YIELDS,
YIELDS, Yield and Spread Measures for Money Market
INTEREST
INTEREST RATES,
RATES,AND
ANDTERM
TERMSTRUCTURE
STRUCTURE Instrument
External Loan Financing
Lines of credit: Bond Pricing with a Market Discount Rate Discount Rate (DR) Basis
- Uncommitted lines of credit PMT PMT PMT + FV Days
PV = + + ⋯+ PV = FV × ]1 − × DR^
(1 + r)! (1 + r)# (1 + r)5 Year
- Committed lines of credit
- Revolving credit agreements Par PMT = r PV = FV Add-on Rate (AOR) Basis
Discount PMT < r PV < FV Days
Secured loans and factoring: PV = FVî]1 + × AOR^
Year
- Secured (asset-based) loans Premium PMT > r PV > FV
- Factoring Bond Pricing with Spot Rates
Flat Price, Accrued Interest, and Full Price PMT PMT PMT + FV
External, Security-Based Financing PV b[aa = PV ba4( + AI = (PV)(1 + r)(⁄' PV = + + ⋯+
(1 + z! )! (1 + z# )# (1 + z5 )5
- Commercial paper (CP) AI = (t⁄T) × PMT
- Backup line of credit Forward Rates from Spot Rates
Relationship Between Bond Prices and Bond <6.
(1 + z. ). × o1 + IFR .,<6.p = (1 + z< )<
Repurchase (Repo) Agreements Features
Repo Purchase Repo Days - Inverse effect: Price moves opposite to yield
= × í1 + ] ^ì
price price rate 360 - Convexity effect: Falling yield has greater price
Security price impact than equivalent increase in yield
Initial margin = - Coupon effect: Yield changes have greater impact
Purchase price
on lower coupon bonds Spot, Par, and Forward Yield Curves
Security price − Purchase price
Haircut = - Maturity effect: Yield changes have greater impact
Security price Spot Curve Par Curve Forward Curve
on longer-term bonds (may not apply to low-
Below Above
Variation Initial Purchase coupon bonds trading at very deep discounts) Upward sloping
=] × ^ − Security price( spot curve spot curve
margin margin price( - Constant-yield price trajectory: Bonds trading at a Equal to Equal to
discount/premium will be “pulled to par” Flat
Factors Influencing Repo Rates spot curve spot curve
- Money market interest rates Other Yield Measures and Embedded Options Above Below
Inverted
- Collateral quality Annual cash coupon payment spot curve spot curve
Current yield =
- Repo term Flat price
- Collateral uniqueness FIXED-INCOME RISK
RISK AND
AND RETURNS
RETURNS
Annual cash Amortized
- Collateral delivery + Constant Yield Price Trajectory
coupon payment gain/loss
Simple yield =
Long-Term Corporate Debt Flat price
Yield-to-call (YTC) = IRR assuming bond is called

Yield-to-worse = min[YTC, YTM]
Yield Spread Measures for Fixed-Rate Bonds

Benchmark spread = YTM − Benchmark yield
G-spread = YTM − Government bond yield
I-spread = YTM − Swap rate
Z-spread
PMT PMT PMT + FV
PV = + + ⋯+
(1 + z% + Z)% (1 + z& + Z)& (1 + z' + Z)'
(Can only be calculated by trial-and-error)
Sovereign Debt
- Issued by national governments, zero default risk Option-adjusted spread (OAS) Macaulay Duration
- Bills mature < 1 year; Bonds mature > 1 year OAS = Z-spread − Option value (in basis points) 1+r 1 + r + N(c − r) t
D_4Z = ] − ^−
- On-the-run: Most recent issues of a given r c[(1 + r)5 − 1] + r T
Yield and Spread Measures for FRNs r: YTM
maturity; more liquid than off-the-run issues
Quoted margin (QM): Spread paid by FRN c: Coupon rate
Non-Sovereign Debt Discount margin (DM): Spread required by market N: Number of periods to maturity
- Municipal bonds (sub-national issuers) If QM > DM, FRN will trade above par t: Number of days since last coupon payment
- Quasi-government bonds (gov’t-backed agencies) FRN pricing formula: T: Number of days in each coupon period
- Supranational bonds (i.e., IMF, World Bank) (Ref + QM)(FV) (Ref + QM)(FV)
+ FV
= m m Duration Gap
! + ⋯+
(Ref + DM) (Ref + DM) 5 Duration gap = D_4Z − Investment horizon
]1 + ^ ]1 + ^
m m
- If positive: Price risk > Reinvestment risk
- If negative: Reinvestment risk > Price risk
Yield-Based Duration Measures FIXED-INCOME: CREDIT
FIXED-INCOME: CREDIT RISK
RISKAND
ANDANALYSIS
ANALYSIS Collateralized Debt Obligations (CDO)
Yield duration: Sensitivity to YTM C’s of Credit Analysis Securities backed by pool of debt obligations, such
Measures: Macaulay duration, modified duration, Bottom-up: as corporate bonds, leveraged bank loans, or credit
money duration, price value of basis point (PVBP) - Capacity default swap on securities
Curve duration: Sensitivity to benchmark yields - Capital
Mortgage Loans
(e.g., effective duration); for bonds with options - Collateral
Agency RMBS: Issued by government agencies;
- Covenants
Modified Duration must have conforming loans
D_4Z - Character
ModDur = Non-agency RMBS: Issued by private companies
1+r Top-down: and may have non-conforming loans
%ΔPV b[aa = −AnnModDur × ΔYield - Conditions
(PV6 ) − (PVA ) Features:
ApproxModDur = - Country
2(ΔYield)(PV" ) - Currency - Prepayment: penalty, no penalty
- Foreclosure: non-recourse, recourse
Money Duration Measuring Credit Risk
MoneyDur = AnnModDur × PV b[aa - Default risk: Probability of default Residential Mortgage-Backed Securities
ΔPV b[aa ≈ −MoneyDur × ΔYield - Loss severity: Loss given default (RMBS)
E[Loss] = Pr(Default) × Loss severity - Pass-through rate: MBS coupon rate
Price Value of a Basis Point (PVBP)
Loss severity = 1 − Recovery rate - Unlike pass-through securities, CMOs have
(PV6 ) − (PVA)
PVBP = tranches to redistribute cash flows and risks
2
Credit Rating Agencies and Credit Ratings - Sequential-pay CMOs have principal and
Basis point value (BPV) = MoneyDur × 0.0001
Credit migration risk: Possibility of downgrade prepayments paid to the tranches sequentially
Properties of Duration Credit ratings: - Prepayment risk: Contraction (faster-than-
- Investment grade: Baa3/BBB- and above expected); extension (slower-than-expected)
- Non-investment grade: Ba1/BB+ and below
CMO Tranches
Seniority Ranking - Z-tranches
- First Lien Loan – Senior Secured - Principal-only (PO) tranches
- Second Lien Loan – Secured - Interest-only (IO) tranches
- Senior Unsecured - Floating-rate tranches
- Senior Subordinated - Residual tranches
- Subordinated - Planned amortization class (PAC)
- Junior Subordinated
Pari passu: All creditors in the same ranking, Commercial Mortgage-Backed Securities
regardless of maturity, have the same priority (CMBS)
Bond Convexity and Convexity Adjustment
Net annual operating income (NOI)
1 DSC =
%ΔPV b[aa = −D_3P × ΔYTM + (Conv)(ΔYTM)# FIXED-INCOME SECURITIZATION:
FIXED-INCOME SECURITIZATION:ASSET-
ASSET- Debt service
2
BACKED ANDMORTGAGE-BACKED
BACKED AND MORTGAGE-BACKEDSECURITIES
SECURITIES
Rental Cash operating Replacement
T × (T + 1) × w NOI = ] × ^−
Convexity of each cash flow = Securitization Example income expense reserves
r 8
S1 + T - Firm sells equipment on credit
m Debt Annual interest Annual principal
- Firm creates bankruptcy-remote SPV = +
service payments repayment
(PV6 ) + (PVA) − [2 × (PV")] - SPV issues debt to purchase loans from firm
ApproxCon =
(ΔYield)# (PV")
- SPV creates securities backed by loans
Curve-Based Interest Rate Risk Measures - Investors purchase securities from SPV DERIVATIVES DERIVATIVES
(PV6 ) − (PVA ) - SPV collects loan payments from firm’s customers
EffDur = - SPV distributes cash flows to investors
2(ΔCurve)(PV" ) DERIVATIVE
DERIVATIVEINSTRUMENT
INSTRUMENT AND
AND DERIVATIVE
DERIVATIVE
(PV6 ) + (PVA ) − 2(PV" ) MARKET FEATURES
MARKET FEATURES
EffConv = Parties to a Securitization and Their Roles
(ΔCurve)#(PV" ) - Seller/Depositor: Originates loans (assets) Derivative Underlyings
- Issuer: Special purpose vehicle (SPV) established - Equities
to create asset-backed securities (ABS) - Fixed-income instruments and interest rates
- Servicer: Collects payments on underlying loans - Currencies
- Commodities
Covered Bonds - Credit
- Dual recourse against the issuing financial - Other (e.g., weather, crypto, longevity risk)
institution and the cover pool
- One bond class per cover pool
- Issuer must replace non-performing asset with
performing asset
Non-Mortgage ABS
- Amortizing: E.g., auto loan ABS
- Non-amortizing: E.g., credit card receivable ABS
Derivatives Markets No-Arbitrage Currency Forward Price
Gains from Gains from
OTC ETD F",9/P (T) = S",9/P e(/*6/+)e Type
Rising MRR Falling MRR
Market Market
Interest rate Short futures Long futures
Liquidity Lower Higher PRICING
PRICING AND
AND VALUATION
VALUATION OF
OF FORWARD futures contract contract
Trading costs Higher Lower FORWARD CONTACTS
CONTRACTS
Long FRA: Short FRA:
Transparency Less Greater Pricing and Valuation of Forward Forward rate
Fixed-rate Floating-rate
Commitments agreement
Standardization Lower Higher payer payer
Valuation at initiation:
Flexibility/
Higher Lower F" (T) = S" (1 + r)' Futures Contract Value
customization
MRR
Counterparty Valuation at maturity: = Notional Principal × í1 + ] ^ì
Higher Lower M
credit risk - Long party:
V'(T) = S' − F" (T) Futures Contract BPV
= Notional Principal × 0.0001 × Period
FORWARD COMMITMENT AND CONTINGENT CONTINGENT - Short party:
CLAIM FEATURES
CLAIM FEATURESAND ANDINSTRUMENTS
INSTRUMENTS V'(T) = −[S' − F" (T)] Forward Price vs. Futures Price
Types of Derivatives Valuation during the life of the contract: The relationship between forward prices and
Forward commitments: Obligation to trade on a V( (T) = S( − F" (T)(1 + r)6('6()
futures prices depends on the correlation between
specified date at a previously agreed price futures prices and interest rates:
Contingent claims: Trade may or may not occur Pricing and Valuation of Currency Forward Correlation Relationship
depending on market conditions Contracts None Futures price = Forward price
Valuation at initiation:
Positive Futures price > Forward price
Forward F",9/P (T) = S",9/P e(/*6/+)e
Contingent Claims Negative Futures price < Forward price
Commitments
Valuation during the life of the contract:
Forward contract Options
V( (T) = S(,9/P − F",9/P (T)e6(/*6/+)('6() PRICING AND VALUATION OF INTEREST
INTEREST RATES
RATES
Futures contracts Credit derivatives
AND
AND OTHER
OTHER SWAPS
SWAPS
Swaps Pricing and Valuation of Interest Rate Forward
Contracts Swap Values and Prices
DERIVATIVE BENEFITS, RISKS, Periodic settlements:
DERIVATIVE BENEFITS, RISKS,AND
ANDISSUER
ISSUER Implied forward rate:
AND
AND INVESTOR
INVESTORUSES USES !/(<6.) Periodic Settlement Value
(1 + z< )<
Derivative Benefits and Risks IFR .,<6. = W X −1 = (MRR − Swap rate) × Notional × Period
(1 + z. ).
Benefits:
Forward rate agreements: PRICING AND VALUATION
PRICING AND VALUATION OF OPTIONS
OF OPTIONS
- Risk allocation, transfer, and management
- Information discovery Option Moneyness
- Operational advantages Option Moneyness Call Put
- Market efficiency In-the-money S( > X S( < X
At-the-money S( = X S( = X
Risks:
- Potential for speculative use Out-of-the-money S( < X S( > X
- Lack of transparency Option Values
- Basis risk c' = max[0, S' − X]
- Liquidity risk p' = max[0, X − S']
- Counterparty credit risk c( = max[0, S( − X⁄(1 + r)'6( ] + Time value
- Destabilization and systemic risk
p( = max[0, X⁄(1 + r)'6( − S( ] + Time value
Net payment received by the FRA buyer:
Derivative Benefits and Risks
(MRR − Fixed IFR) × Notional principal × Period Arbitrage and Replication for Options
Issuers use derivatives to perform:
Call option:
- Cash flow hedge
PRICING
PRICING ANDAND VALUATION
VALUATION OF OF FUTURES - Lower bound (c( ) = max[0, S( − X/(1 + r)'6( ]
- Fair value hedge
FUTURES CONTACTS
CONTRACTS - Upper bound (c( ) = S(
- Net investment hedge
Pricing of Futures and Forward Contracts
Put option:
Investors use derivatives to hedge their risk Price of interest rate futures contract:
- Lower bound (p( ) = max[0, X/(1 + r)'6( − 𝑆𝑆& ]
exposures and take speculative positions f.,<6. = 100 − o100 × MRR .,<6. p
- Upper bound (p() = X
ARBITRAGE, REPLICATION,
ARBITRAGE, REPLICATION,AND ANDTHE
THECOST
COSTOF
OF CARRY
CARRY IN PRICING
IN PRICING DERIVATIVES
DERIVATIVES
No-Arbitrage Forward Price with
Benefits/Income and Costs
Annual compounding:
F" (T) = [S" + PV" (C) − PV" (I)](1 + r)'
Continuous compounding:
F" (T) = S" e(/AZ6+)e
Factors Impacting Option Values Compensation Structures Private Debt
Increase in Call Put - Soft hurdle rate: Incentive fee applies to entire - Venture debt: To complement existing equity
Value of underlying ↑ ↓ return if hurdle rate is cleared financing of start-up or early-stage companies
- Direct lending: Direct capital in the form of senior
Exercise price ↓ ↑ r < r0 → Performance fee = 0
and secured loans
Time to expiration ↑ ↑* r ≥ r0 → Performance fee = p × r
- Mezzanine debt: Debt subordinated to senior
Risk-free rate ↑ ↓ - Hard hurdle rate: Incentive fee is only paid on secured debt but senior to equity
Volatility of underlying ↑ ↑ return in excess of hurdle rate - Distressed debt: Funding provided to mature
Payments on underlying ↓ ↑ companies facing financial distress
Performance fee = max[0, p(r − r0)]
Cost of carry ↑ ↓
*Except for some deep-in-the-money put options - Catch-up clause: Allows the GP to receive 100% of REAL
REAL ESTATE
ESTATE AND
ANDINFRASTRUCTURE
INFRASTRUCTURE
the return in excess of the hurdle rate until the GP Real Estate Investment Structures
OPTION REPLICATION
OPTION REPLICATION USING
USINGPUT-CALL
PUT-CALLPARITY
PARITY catches up with their cumulative performance fee Debt Equity
Put-Call Parity Performance fee = max[0, rZ[ + p(r − r0 − rZ[ )] Mortgages, Direct ownership,
c" + X⁄(1 + r)' = s" + p" Private Construction Real estate funds,
- High-water mark clause: Reflects the highest lending Private REITs
Fiduciary call = Protective put
value used to calculate an incentive fee MBS, CMOs, Shares in RE corps.,
Put-Call-Forward Parity Public Mortgage REITs
- Clawback provision: Allows the LPs to get back REITs
c" + X⁄(1 + r)' = F"(T)⁄(1 + r)' + p"
incentive fees that have been paid if gains are
Fiduciary call = Protective put w. forward contract Real Estate Fund Structures
subsequently reversed
Infinite-life open-end funds:
Put-Call Parity Applications: Firm Value - Waterfall: Distribution method that defines the - Core real estate
V" + p" = c" + PV(D) order of allocations to the LPs and GPs - Core-plus real estate
VALUING Finite-life closed-end funds:

VALUING AA DERIVATIVE USING A ONE-PERIOD
DERIVATIVE USING ONE-PERIOD ALTERNATIVE INVESTMENT PERFORMANCE
ALTERNATIVE INVESTMENT PERFORMANCE
BINOMIAL MODEL
MODEL - Value-add
BINOMIAL RETURNS
AND RETURNS
- Opportunistic
Binomial Valuation Multiple of Invested Capital
Hedging portfolio: Realized value Unrealized value Benefits of Real Estate Investments
S T+S T
V" = hS" − c" MOIC = of investment of investment - Stable, predictable income
Total amount of investment - Price appreciation
Hedge ratio:
Alternative Investment Returns - Inflation hedging
c![ − c!P
h= Restrictions on withdrawals: - Portfolio diversification
S![ − S!P - Redemption fees - Tax benefits
Risk Neutrality - Notice periods
Infrastructure Investment Features
Risk-neutral probabilities: - Lock periods
- New (greenfield) or existing (brownfield) assets
1+r−d - Liquidity gates
π= - Economic (roads) or social (healthcare facilities)
u−d Alternative Investment Return Calculations - Direct ownership or indirect (via MLP or ETF)
Risk-neutral probability-weighted call price: R *; (52( f+(0 0[/Pa2 /4(2)
πc![ + (1 − π)c!P = (r8 × P!) + max{0, p[P!(1 − r8 ) − P"(1 + r0 )]} NATURAL RESOURCES
RESOURCES
c" =
1+r Timberland and Farmland
INVESTMENTS
INVESTMENTSININPRIVATE
PRIVATE CAPITAL: EQUITY Sources of return:
AND DEBT
EQUITY AND DEBT - Biological growth
ALTERNATIVE INVESTMENTS Private Equity: Leveraged Buyouts - Prices of timber/crops
ALTERNATIVE INVESTMENTS
- Management buyouts: Current management team
- Land price changes
ALTERNATIVE INVESTMENT
ALTERNATIVE INVESTMENT FEATURES,
FEATURES, is involved in the acquisition
METHODS,AND ANDSTRUCTURES
STRUCTURES - Management buy-ins: Current management team Commodity Investment Forms
METHODS,
is being replaced by the acquiring team Futures price:
Alternative Investments: Features & Categories
- Narrow manager specialization S" (1 + r) + Cost of carry – Convenience yield
Private Equity: Venture Capital
- Low correlation with traditional investments - Formative-stage financing: Angel investing, F" (T) = S" e(/AZ6+)'
- Large capital outlays seed-stage financing, early-stage financing
- Long investment horizons - Later-stage financing: After commercial Contango Backwardation
- Illiquidity production and sales have begun but before IPO Price curve slope Upward Downward
- Alternatives to direct investment - Mezzanine-stage financing: Prepare to go public Convenience yield Low High
- Incentive-based compensation arrangements
Private Equity Exit Strategies
- Performance appraisal challenges
- Trade sale
Alternative Investment Methods - Public listing (IPO, direct listing, SPAC)
- Fund Investing: Indirect investing - Recapitalization
- Co-Investing: Hybrid between direct investing and - Secondary sale
indirect investing - Liquidation
- Direct investing: Without the use of intermediary
HEDGEFUNDS
HEDGE FUNDS Indifference Curves Borrowing vs. Lending
Hedge Fund Strategies
- Equity hedge: Long and short positions in equity
and equity derivative securities; Bottom-up
- Event-driven: Seek to profit from
short-term events (e.g., Mergers); Bottom-up
- Relative value: Seek to profit from pricing
discrepancies between related securities
- Opportunistic: Emphasize top-down approach to
identifying global economic trends
Hedge Fund Features

- Low legal and regulatory restrictions
- Large investment universe
- Use of derivatives and short positions Minimum-Variance Portfolios
- Leverage
- Aggressive strategies with concentrated positions
- Limits on liquidity
- High fees Beta
Cov(R + , R 8 ) ρ+,8 σ+
β+ = =
INTRODUCTIONTO
INTRODUCTION TODIGITAL
DIGITALASSETS
ASSETS σ#8 σ8
Distributed Ledger Technology Systematic risk = Non-diversifiable (market) risk
Tokenization: Represents ownership rights to Nonsystematic risk = Diversifiable risk
physical assets on a distributed ledger Total risk = Systematic risk + Nonsystematic risk
- Non-fungible tokens (NFTs) Capital Asset Pricing Model (CAPM)
- Security tokens Assumptions:
- Utility tokens
- Investors are risk-averse, utility-maximizing,
- Governance tokens Capital Allocation Line (CAL)
rational individuals
Line representing possible combinations of risk-
Digital Asset Investment Forms - Markets are frictionless
free assets and optimal risky asset portfolio
Direct Indirect - All investors plan for same single holding period
E[R + ] − R 9
Centralized Cryptocurrency EqR H r = R 9 + Ö Ü σH - Investors have homogeneous expectations
σ+
exchanges coin trusts - Investments are infinitely divisible
Decentralized Cryptocurrency Investor’s Optimal Portfolio - Investors are price takers
exchanges futures contracts
Cryptocurrency EqR H r = R 9 + β+ [E[R 8 ] − R 9 ]
exchange-traded funds
Limitations:
Cryptocurrency stocks
- Single-factor: Only accounts for systematic risk
Hedge funds - Single-period: Does not consider multiple periods
- Inclusion of assets that are not investable, such as
human capital and assets in closed economies
PORTFOLIO MANAGEMENT
PORTFOLIO MANAGEMENT
Security Market Line (SML)
PORTFOLIORISK
PORTFOLIO RISKAND
ANDRETURN:
RETURN:PART
PARTII Graphical representation of CAPM:
Risk Aversion
Combination of ability and willingness to take risk
Risk averse: Requires a premium to take more risk
Risk neutral: Only concerned with expected return,
PORTFOLIO RISK
PORTFOLIO RISK AND
ANDRETURN:
RETURN:PART
PARTIIII
indifferent to level of risk
Risk seeking: Will pay a premium to take more risk Capital Market Line (CML)
CAL with risky portfolio being market portfolio
Utility Function
E[R 8 ] − R 9
1 EqR H r = R 9 + Ö Ü σH
U = E(r) − Aσ# σ8
2
A is the degree of risk aversion, it is >0 for risk-
averse, 0 for risk-neutral, and <0 for risk-seeking
Identifying Mispriced Stocks Asset Allocation Risk tolerance: Which risks are acceptable and how
Stocks that plot above the SML are underpriced; Strategic asset allocation: Set of exposures to IPS- much risk should be taken
stocks that plot below the SML are overpriced permissible asset classes in weights that are Risk budgeting: How the risks should be taken
Ratios consistent with the client’s long-term objectives Financial risks: Arise from financial market
Sharpe RH − R9 Tactical asset allocation: Deliberate deviations activities (e.g., market, credit, liquidity risk)
Total risk
ratio σH from policy weights based on forecasts of asset Non-financial risks: Arise from within entity or
M- σ8 class returns over the near term from external (e.g., operational, legal, regulatory,
oR H − R 9 p + R9
squared σH political, model, tail risk)
RH − R9 THE
THEBEHAVIORAL
BEHAVIORALBIASES
BIASES OF INDIVIDUALS
OF INDIVIDUALS Risk measures: Standard deviation, beta, duration,
Treynor
Systematic
βH Cognitive Errors delta, gamma, VaR, CVaR, etc.

ratio
risk
- Conservatism bias: People fail to incorporate new Risk modification: By prevention and avoidance,
Jensen’s transfer (insurance), or shifting (derivatives)
R H − qR 9 + βH (R 8 − R 9 )r information that conflicts with their opinions
alpha
- Confirmation bias: People seek “evidence” that
confirms their prior beliefs
PORTFOLIO MANAGEMENT: AN OVERVIEW
PORTFOLIO ETHICAL
- Representativeness bias: People inappropriately ETHICALAND
ANDPROFESSIONAL
PROFESSIONALSTANDARDS
STANDARDS
Portfolio Management Process
classify new information based on past similar
Planning: List objectives and constraints in IPS I(A) Knowledge of the Law
situations
Execution: Asset allocation, security analysis, Obey strictest applicable law. Disassociate
- Illusion of control bias: People overestimate their
portfolio construction immediately from any illegal or unethical activity.
ability to control or predict events
Feedback: Monitoring and rebalancing,
- Hindsight bias: People believe past events would I(B) Independence and Objectivity
performance measurement and reporting
have been predictable Do not offer or accept gifts that might impair
Institutional Investor Clients - Anchoring and adjustment bias: People rely too independence and objectivity. Gifts from clients
- DB pension plans: Younger beneficiaries increase much on initial information in their estimation may be permissible.
time horizon and risk tolerance - Mental accounting bias: People put money in
I(C) Misrepresentation
- Endowments/Foundations: Generally longer time separate mental buckets
Cite sources. Do not plagiarize or omit important
horizon, low liquidity needs, high risk tolerance - Framing bias: People answer the same question
information. Act quickly to correct any errors.
- Banks: Short time horizon, high liquidity need, differently based on how it is framed
very low risk tolerance - Availability bias: People assume outcomes that I(D) Misconduct
- Insurers: Short time horizon (longer for Life than are easier to remember are more likely Does not apply to personal behavior unless it
P&C), high liquidity needs, low risk tolerance reflects poorly on the investment profession.
Emotional Biases
- Investment companies: Time horizon and risk II(A) Material Nonpublic Information
- Loss-aversion bias: People strongly prefer
tolerance vary by mandate, liquidity needs are Do not act or cause others to act on material
avoiding losses more than achieving gains
usually high due to potential redemptions nonpublic information. Seek public dissemination.
- Overconfidence bias: People overestimate their
- Sovereign Wealth Funds: Vary by mandate
own abilities II(B) Market Manipulation
Robo-Advisors - Self-control bias: People lack self-discipline to Do not take any actions that distort prices or
- Cater to underserviced segments, “mass affluent” make decisions based on their long-term goals trading volume. Market making and legitimate
- Lower fees compared to traditional managers - Status quo bias: People are more inclined to do trading strategies are allowed.
- Relatively low barriers to entry nothing rather than make changes
III(A) Loyalty, Prudence, and Care
- Endowment bias: People value an asset more
Mutual Funds Place clients’ interest above yours. Disclose
when they hold the rights to it
- Open-end: Accept new investors after launch policies on proxy voting and soft commissions.
- Regret-aversion bias: People avoid making
- Closed-end: No new shares created after launch, III(B) Fair Dealing
decisions that could potentially turn out badly
may trade at a premium/discount to NAV Treat all clients fairly. Treat non-immediate family
- No-Load: No investing/redemption fees, funds Market Anomalies like other clients. Communicate investment
charge a percentage of NAV Factors that cause anomalies misclassifications: recommendations and changes simultaneously.
- Inappropriate asset pricing model
Exchange Traded Funds (ETFs) III(C) Suitability
- Statistical issues due to small samples
- Mutual funds only trade at the end of each day, Use a regularly updated IPS during investment
- Temporary disequilibria
ETFs can be traded at any time during the day decisions. Evaluate decisions in a portfolio context.
- Investors can sell ETFs short or buy on margin
AN
ANINTRODUCTION TO RISK
INTRODUCTION TO RISK MANAGEMENT
MANAGEMENT III(D) Performance Presentation
- ETFs do not trade at discount/premium to NAV
Risk Management Performance data should be fair, accurate, and
- ETFs distribute dividends to investors, mutual
Risk management framework: complete. Do not promise returns for risky assets.
funds reinvest dividends
- ETFs have lower minimum investment levels - Risk governance III(E) Preservation of Confidentiality
- Risk identification and measurement Keep all client information confidential unless:
BASICS OF PORTFOLIO
PORTFOLIOPLANNING
PLANNINGAND - Risk infrastructure client is involved in illegal activity, you are legally
BASICS OF
AND CONSTRUCTION
CONSTRUCTION - Defined policies and processes required, or you have the client’s permission.
Investment Policy Statements (IPS) - Risk monitoring, mitigation, and management
Investment objectives: Risk/return objectives - Communications
Constraints: Liquidity, time horizon, tax concerns, - Strategic analysis or integration
legal and regulatory factors, unique circumstances
IV(A) Loyalty BA II PLUS
BACALCULATOR TIPS
II PLUS CALCULATOR TIPS
Get permission before taking outside work (even
unpaid) that competes with employer. Abide by Basic Operations
non-compete agreement (if applicable) and do not 2ND : Access secondary functions (in yellow)
take employer’s property.
ENTER : Send value to a variable
IV(B) Additional Compensation Arrangements
2ND + ENTER : Toggle between options
Obtain written permission from all parties before
receiving any compensation for outside work. ↑ ↓ : Navigate between variables/options
STO + 0 - 9 : Store current value into memory
IV(C) Responsibilities of Supervisors
RCL + 0 - 9 : Recall value from memory
Supervisors must adequately train and monitor
subordinates. Responsibilities may be delegated.
Time Value of Money (TVM)
V(A) Diligence and Reasonable Basis For annuity, loan, and bond calculations
Exercise diligence and thoroughness. Support
N : Number of periods
actions with research and investigation.
I/Y : Effective interest rate per period (in %)
V(B) Communication with Clients and
Prospective Clients PV : Present value
Make appropriate disclosures. Distinguish between PMT : Payment/coupon amount
fact and opinion in analysis and recommendations.
FV : Future value/redemption value
V(C) Record Retention CPT + one of the above : Solve for unknown
Maintain records to support recommendations and
2ND + BGN : Toggle between ordinary annuity
decisions. 7-year retention period recommended.
and annuity due
VI(A) Disclosure of Conflicts
Disclose any matters that may impair 2ND + CLR TVM : Clear TVM worksheet
independence and objectivity, prominently Note:
and in plain language. - Always clear the TVM worksheet before
VI(B) Priority of Transactions starting a new calculation
Execute clients’ transactions before accounts - For bonds, PMT and FV should have the same
in which you have a beneficial interest. sign, and opposite signs to PV
VI(C) Referral Fees Cash Flow Worksheet ( CF , NPV , IRR )
Disclose referral fees to clients and employer, For non-level payments
including non-monetary arrangements.
Input ( CF )
VII(A) Conduct as Participants in CF0: Initial cash flow
CFA Institute Program
C01: 1st distinct cash flow after initial cash flow
Do not share confidential exam details. Expressing
opinions about CFAI policies is permissible. F01: Frequency of CO1
C0n: nth distinct cash flow
VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program F0n: Frequency of C0n
Do not misrepresent the meaning of CFA Institute Note:
membership, designation, or candidacy. - Always clear the CF worksheet before starting
a new calculation
- The use of F0n is optional. You can leave them as
1 and input repeating cash flows multiple times. If
you do so, C01 will be the cash flow at time 1, C02
will be the cash flow at time 2, and so on.
Output ( NPV , IRR )
I: Effective interest rate per period (in %)
NPV + CPT : Solve for net present value
IRR + CPT : Solve for internal rate of return

Salt Cfa Level 1 Formulasheet 2024

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CFA® Level I

Formula Sheet – 2024 Syllabus

QUANTITATIVE METHODS Leveraged Return STATISTICAL MEASURES

Real Returns Coefficient of variation measures dispersion

Forward exchange rates in points:

Assessing Geopolitical Threats General Partnership

Disadvantages: - Flexibility option: Option to alter operations, With Taxes

Global Registered Shares: Traded on multiple Fixed-Income Contingency Provisions

Company Research Reports May be sold back to issuer if rates rise

Yield-to-call (YTC) = IRR assuming bond is called

Yield Spread Measures for Fixed-Rate Bonds

VALUING Finite-life closed-end funds:

Hedge Fund Features

βH Cognitive Errors delta, gamma, VaR, CVaR, etc.

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