CFA Exam Level 1

2018 Cram Notes

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Cram Notes for CFA® Level 1 – 2017
Copyright © 2017 by Go Study LLC® All Rights Reserved. Published in 2018

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Contents
Ethics .......................................................................................................................................................... 3
GIPS............................................................................................................................................................. 4
Quantitative Methods................................................................................................................................. 5
Microeconomics ....................................................................................................................................... 12
Macroeconomics ...................................................................................................................................... 14
Fiscal and Monetary Policy / Trade Unions ....................................................................................... 17
Currencies ......................................................................................................................................... 18
Financial Statement Analysis .................................................................................................................... 19
Corporate Finance .................................................................................................................................... 26
Portfolio Management.............................................................................................................................. 31
Equity ........................................................................................................................................................ 34
Equity Valuation .................................................................................................................................... 37
Fixed Income ............................................................................................................................................. 38
Derivatives ................................................................................................................................................ 42
Alternatives ............................................................................................................................................... 44

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Ethics
Principles for answering questions
1. Everyone has to comply with the Code and Standards. So …does the action uphold the profession?
2. If you were the client would you agree with the course of action?
3. Would a moral person, or leader, follow this course of action?
4. When in doubt err towards the more strict guideline/regulation
5. Differences between requirements and recommended guidelines are frequently tested

Summarizing the Code of Ethics -PEJMAR

Priority - Your client's interests always come first (then your employer, then you).
Encourage - Practice and encourage others to act professionally and ethically to reflect credit on yourself/profession.
Judgment - Use reasonable care and judgment when performing all professional activities.
Maintain - Keep your knowledge up to date and encourage other professionals to do the same.
Actions - Employ integrity, competence, diligence, and respect in an ethical manner with everyone.
Rules - Promote the integrity of capital markets by following the rules.

Priority of Actions: Capital Market Integrity  Clients  Employer  Yourself

Reference to CFA Charter: Don’t overstate importance of the designation or use it to indicate superiority or better
investment returns. Always use CFA after your name or use it as an adjective NOT as a noun

Standards of Professional Conduct

1. Professionalism
a. Knowledge of the Law: Have to know them, comply with stricter of CFA, local, home law
b. Independence and Objectivity: Reasonable care, compensation ??s/issuer paid research
c. Misrepresentation: Knowingly misrepresenting/omitting information, commit plagiarism
d. Misconduct: Fraud, Negative light on profession. Distinction btwn personal/professional
2. Integrity of Capital Markets
a. Material nonpublic information: Can’t trade on it or cause others too. MOSIAC theory
b. Market Manipulation: Artificially distort price or volume with intent to deceive
3. Duties to Clients
a. Loyalty, prudence, and care: Act for benefit of client above employer/you. Fiduciary duty
b. Fair Dealing: Fair and objective. Disclose different levels of service (OK w/ no negative)
c. Suitability: In context of Risk constraints from IPS. Evaluate on portfolio level vs. risk of just 1 security
(prudent investor rule)
d. Performance and Presentation: Fair, accurate, fact vs. opinion. Recommend keep records for 7 years
e. Preservation of Confidentiality: Always for past/present clients unless illegal, required, or for CFA
institute investigation
4. Duties to Employers
a. Loyalty: Employer before you. Questions around quitting and taking client info/models often get tested
b. Additional Compensation Arrangements: Disclose first. Written consent from all parties is required.
c. Responsibilities of Supervisors: Reasonable effort to detect/disclose violations. 2015 has moved to slightly more
proactive duty to educate.
5. Investment Analysis, Recommendations, and Actions
a. Diligence and Reasonable Basis: Cover basis for investment, thorough, disagreeing on a group
recommendation is OK
b. Communications with clients/ prospective clients: Would you want to know something if you were the
client? If yes, then disclose it.
c. Record retention: Electronic OR paper OK. Recommendation: Keep records for 7 years
6. Conflicts of Interest
a. Disclosure of Conflicts: Disclose anything that would interfere with independence and objectivity
b. Priority of Transactions: Clients > Employers > You. Treat paying family the same as other clients.
c. Referral Fees: Full disclosure so clients can judge potential biases. Often in SD context.
7. Responsibilities as a CFA Institute Member/Candidate
a. Conduct: Don’t cast negative light on profession or capital markets via your actions

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GIPS
What is it:
A set of voluntary ethical and professional standards for the
evaluation and presentation of investment results. GIPS seeks to
establish a minimum set of performance presentation standards
that will facilitate the comparison of cross-manager
performance. The modern standards took effect Jan 1, 2011.
When in doubt remember that the standards have become
stricter over time.
Key Characteristics of GIPS
1. Voluntary, minimum standards
2. Mix of requirements and recommendations, must be
adhered to with the goal of full disclosure and fair
representation (which likely requires going beyond the
minimum GIPS requirements)
3. Only investment firms can claim compliance (NOT
individuals)
4. Compliance must be on a firm-wide basis, NO partial
compliance is allowed
5. Full disclosure is mandated (no cherry-picking
performance)
6. Composites must include ALL fee-paying, discretionary
portfolios
7. It covers all asset classes
8. Data integrity is paramount to the process
9. Provides standards where regulated industry standards are
still lacking
10. The GIPS is constantly evolving
9 Major Sections of GIPS – Fundamentals of compliance,
input data, calculation methodology, composite construction,
disclosures, presentation and reporting, real estate, private
equity, wrap fee/Separately managed accounts
Definition of a Firm - A firm is defined as “an investment firm,
subsidiary, or division held out to clients or potential clients as a
distinct business entity." The term ‘business entity’ is defined as
a separate unit, division, or department that is organizationally
or functionally separate from other units AND which has
autonomy and discretion over the assets it manages.
Signs a Division = Firm: It represents itself as such to clients, it
depends on its own personnel/administration/resources or has its
own P/L, it follows a distinct investment process, its managers
have discretion over asset allocation, and it serves a distinct
client base.
Defining a discretionary portfolio: A portfolio is discretionary
when there is latitude to manage its assets. In other words, the
manager is not so constrained by the client that they can’t
pursue their stated mandate.
Signs a portfolio is NOT discretionary: Client has veto power
over trades, manager cannot change asset allocation/risk
exposure, client frequently withdraws large amounts of cash, or
client relationship is “advisory” only.
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GIPS Combats these Reporting Issues
 Representative Accounts: The tendency for an investment
firm to put their performance in the best possible light by
presenting only top performing accounts
 Survivorship bias: Excluding dead or weak performing
accounts (this is a particularly common problem with
hedge fund performance reporting)
 Manipulating time periods to only show performance for
strong periods
Basic Principles of Compliance
 Compliance must be firm wide!!
 No false or misleading data should be presented
 Firms who are not GIPS compliant should not state that
they are
 Firms need to produce a GIPS compliant report every 12
months and give it to prospective clients on demand
 All fee-paying discretionary portfolios should be in
composites created according to a similar strategy and
investment objective
 Each composite that is included must have its own
description which must be given to clients when requested
 A firm must present at least 5 years of GIPS compliant
data (or since inception if <5 years old) and must then add
annual performance each year up to 10 years minimum to
meet GIPS standards
o Firms may link years of noncompliant data, but all post-
2000 data must be compliant
 Firms must use the prescribed calculation and presentation
methods including required disclosures
 All policies must be documented to ensure existence and
ownership of client assets
 There are additional GIPS requirements for private equity
and real estate which need to be used when dealing with
those asset classes
What is a composite: A composite is the aggregation of all the
discretionary portfolios that represent a particular investment
strategy or objective. Each composite must be included when
presenting investment results. Remember, claiming to be GIPS
compliant is an all or nothing proposition applied on a firm wide
basis.
Requirements of composite construction:
Composites are defined based on investment strategy or
objective and can only include assets managed by the firm.
Actual fee-paying discretionary portfolios need to be in at least
one composite. Nondiscretionary accounts must NOT be
included in a composite. New discretionary accounts should be
added to composites in a timely manner and closed accounts
should be kept in the composite until the last measurement
period in which they were under management. Switching
accounts from one composite to another should only happen if
client objectives have changed and its historical record stays
with the old composite. Carve outs not allowed post 2010 unless
separately managed. Cannot link model/simulated performance.
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Quantitative Methods
Time Value of Money

𝐹𝑉
𝐹𝑉 = 𝑃𝑉(1 + 𝑟)𝑛 or 𝑃𝑉 = (1+𝑟)𝑛

Calculate TVM using your calculator:

1. Convert the given interest rate (r) and time period (N) into the same units as the compounding frequency.
2. Input the FV or PV that was given.
3. If there is an annual payment (PMT), you would enter that, usually with a negative sign.
4. Hit CPT and the key for the variable that is missing.

3 Interpretations of an interest rate Components of the interest rate

 Required rate of return –The minimum rate of return at
which an investor or saver is willing to lend their funds
 Discount rate –The rate at which an investment should be
discounted back to the present. If you can earn 5% on your
money, that is the rate at which you should discount any
future dollar to get the equivalent present value 1.
 Opportunity cost – An opportunity cost reflects a trade-off 2.
between activities and is usually defined as the most valuable
foregone alternative.
Calculating Effective Annual Yield (EAR) 3.
(𝐸𝐴𝑅) = (1 + 𝑠𝑡𝑎𝑡𝑒𝑑 𝑟𝑎𝑡𝑒⁄𝑚)𝑚 − 1
4.
Where:
M = number of compounding periods in one year, m↑, EAR ↑ 5.
Stated rate = the periodic (annual) interest rate given.
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
= 𝑟𝑒𝑎𝑙 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
+ 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑟𝑖𝑠𝑘 + 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
+ 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
The real risk free rate – The theoretical rate of return
assuming no risk and no inflation
Expected inflation – Generally we expect inflation to
increase prices, thereby decreasing the value of a dollar in
the future. The sum of the risk free rate and expected
inflation is the NOMINAL risk-free interest rate
Default-risk – The risk that a borrower will not pay on
time (or at all)
Liquidity-risk - The risk of receiving less than fair value if
you have to sell quickly
Maturity risk – The longer you borrow for, the more risk
there is

Annuities
Annuity - A set of equal cash flows that occur at regular Ordinary Annuity Equation
intervals over a given period of time
Ordinary annuity –Where cash flows occur at the end of each (1+𝑟)𝑁 −1
period with the first CF happening in one period at t=1. Most 𝐹𝑉𝑁 = 𝐴[ ]
𝑟
common form. Examples: mortgages & loans
Annuity due - An annuity that has a cash flow that occurs The term in brackets is the future value annuity factor. It gives
immediately at t = 0 and at the beginning of each period us the FV of a $1 ordinary annuity per period.
Perpetuity – A perpetual annuity or a set of even never-ending
sequential cash flows with the first CF at t=1 Where:
A = the amount of the annuity
Calculate Ordinary Annuity Due r = the interest rate
To calculate the FV of an annuity set the PV = 0 and input the N = the number of periods
other variables (you will have 4 out of 5). To calculate the PV,
we set the FV equal to zero. Can also be calculated using the If asked to calculate the present value of an annuity that starts in
equation to the right. a year or two you would calculate the PV of the annuity at its
start date and then discount that value to the present day. Note
Annuity Due Calculation: Think of the value of an annuity due that when your calculator is set to END (the default) it will
(CF at t=0) as the lump sum received today + the ordinary return the present value one period before the annuity begins
annuity. So can calculate the annuity due the same way we did (i.e. a period before you get your first cash flow).
with an ordinary annuity and then multiply the resulting value
by (1+I/Y) to get the correct value Calculating a Perpetuity

Alternatively you can adjust your calculator from END mode to 𝑃𝑀𝑇 𝐴
𝑃𝑉𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = or
BGN to deal with the difference in timing. From there the 𝑟 𝑟
calculation is the same.
Where PMT is the periodic payment to be received and r is the
interest rate.
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Net Present Value
NPV is the PV of future cash flows minus the initial cash outlay. Formally, the NPV of an investment is the sum of present values of
all expected cash inflows for a given project minus the PV of the projects expected cash outflows discounted at the cost of that capital.

NPV Formula Solving NPV on your Calculator

(We undertake a project if NPV > 0 and reject if NPV < 0)
𝑁
𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑ − 𝐶𝐹0 1. Identify all the benefits (inflows) and costs (outflows)
(1 + 𝑟)𝑡
𝑡=0 2. Determine the right discount rate to use
3. Discount each cash flow using the discount rate. When
IRR Formula (“Don’t” need to memorize) inputting the cash flows, inflows are positive and outflows
are negative
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁 4. The NPV is the sum of each discounted cash flows (DCF).
𝐼𝑅𝑅: 0 = 𝐶𝐹0 + + +⋯
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)2 (1 + 𝐼𝑅𝑅)𝑁 5. Make a decision on the capital budget project - accept a
project if NPV > 0 and reject if NPV < 0*
*IRR calculations on the calculator are identical to NPV problems. The only difference is that we hit [IRR][CPT] to calculate the IRR (and no external r is needed)

Internal Rate of Return

IRR is defined as the discount rate that makes the NPV of all cash flows from a period equal to zero. In other words it is the rate of
return that makes the PV of a project’s benefit equal the PV of its costs. Solving for IRR is actually a process of guesswork—you
guess a given interest rate and then calculate the IRR and move the interest rate until it equals zero. It does not depend on market
interest rates. IRR is sort of a proxy for the rate of growth a project is supposed to generate. The bigger the IRR the better.

NPV vs. IRR & Decision Rules

We undertake a project if NPV > 0 and reject if NPV < 0. We undertake a project where IRR > a hurdle rate, usually defined as cost of
funds. Note if IRR = r then NPV = 0. If they give contradicting answers always go with NPV.
Net Present Value Internal Rate of Return
-Considers TVM and all CFs
-Is less subjective since doesn’t depend on
-Directly measures increase in value of firm
Advantages external r
-Assumes CF reinvested at OC of capital
-Easy to understand & widely accepted
-Shows return as a % on $ invested
-Based on market-determined discount rate (r)
Limitations -Assumes r stable over time -Assumes that cash flows reinvested at IRR
-Doesn’t consider NPV against size of project
NPV is preferred over IRR for mutually exclusive projects. For independent projects they will give
Decision Rule
same answer (IRR > opportunity cost of capital then NPV > 0 and vice versa).
-Different cash flow reinvestment rates and cash flow patterns
Reasons for different rankings -Size (IRR Works better with smaller opportunities)
-Timing of Cash Flows – more CF in early years favors IRR

(𝑃1 −𝑃0 )+𝐷1

Holding Period Return (HPR): 𝐻𝑃𝑅 = Where P1/P0 are prices, D1 are dividends or CFs received over the period
𝑃0

Time Weighted Rate of Return (TWRR) and Money Weighted Rate of Return (MWRR)
TWRR MWRR
(1 + 𝑟1 )(1 + 𝑟2 )(1 + 𝑟𝑖 ) − 1 𝑇
𝐶𝐹
Calculation ∑ 𝑡 = 0
Each CF-free sub-period is chained together (1 + 𝐼𝑅𝑅)
𝑡=0
Measures actual rate of return earned by manager Only requires an account to be valued at BGN & end
Advantages
Not sensitive to external CFs Cheaper and easier to compute
Requires an account/portfolio value at time of each CF
Disadvantages MWRR hugely impacted by external cash flows
Can be expensive and time consuming to compute
Portfolio manager does NOT have discretion over Portfolio manager has discretion over deposits and
Appropriate When
deposits and withdrawals made by clients withdrawals made by clients
Performance  If large CFs come in before strong performance MWRR > TWRR
differences  If those CFs come in before poor performance, however, MWRR < TWRR.

Descriptive statistics refer to ways to summarize large sets of data.

Inferential statistics is making forecasts on a population (or large set of data) using a smaller sub-set, or sample, of that data.
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Measurement Scales (NOIR) & Graphical Representations of Data
Nominal Scales: Refer to randomly assigning numbers to Absolute, Relative, & Cumulative Frequencies of Returns
different groups to act as a descriptive category. There is no Cumulative Cumulative
numerical significance or relationship between the groupings Absolute Relative
Interval Absolute Relative
so nominal scales contain the least amount of information. Frequency Frequency
Frequency Frequency
Ordinal Scales: Each group now has an ordered relationship 0≤R
with one another. For example, we could assign the best 10% 1 5% 1 5%
< 20 %
of managers the number one, the second best 10% the number 20 ≤–
two and so on. However the intervals separating the ordinal 2 10% 3 15%
40%
groupings are not comparable. 40 ≤–
Interval Scales: Have the same ranking information as ordinal 7 35% 10 50%
60%
groups, but also introduce the idea of equal differences in 60 ≤ R
value so we understand how much bigger or smaller a value is. 5 25% 15 75%
< 80%
A key example would be temperature. 80 ≤ R
Ratio Scales: Ratio scales not only order categories and have 5 25% 20 100%
< 100%
defined differences in value but also have a zero point. A key
example here is weight or money. Because there is a true zero
In addition to knowing how to read the above table you should be
point we can compute ratios and add and subtract amounts comfortable with interpreting the graphical representations of
within the scale.
each (as well as histograms & frequency polygons).

Measures of Central Tendency

Arithmetic mean - The sum of all the data divided by the # of observations, n. Most common measure of Comparing the
central tendency. Key disadvantage is the large impact of outliers. Measures

Median - The midpoint of a data set when you arrange its values from smallest to largest (half the When the observations
observations are above the median and half are below it). Outliers do not have a large impact on the are the same:
median. When odd # of observations, median = (n+1)/2.
arithmetic mean =
Mode - The observation that occurs the most frequently, so .can take multiple values. Only measure that geometric mean =
can be used with nominal data harmonic mean

Geometric mean - 𝑅𝑡 = 𝑛√(1 + 𝑋1 ) ∗ (1 + 𝑋2 ) ∗ (1 + 𝑋3 ) − 1 Usually used to calculate the average When different:
compound growth rate of an asset. It is always less than or equal to the arithmetic mean, with the
difference growing as the dispersion of observations gets larger. Arithmetic mean >
Geometric mean >
Harmonic mean - Used for calculating the average purchase price of shares purchased over time for Harmonic mean
equal periodic investments, the harmonic mean is a unique weighted mean observation where each
𝑁 Skew
observation’s weight is inversely proportional to its magnitude. It’s calculated as: 𝑁 1 where there are
∑𝑖=1
𝑋𝑖
If a distribution is
N values of Xi. positively skewed the
mean > median > mode
Weighted average = 𝑤1 𝑅1 + 𝑤2 𝑅2 + ⋯ 𝑤𝑛 𝑅𝑛 . The return for a portfolio is always the weighted average
of its individual assets. The weights must always sum to 1, and a positive weight corresponds to a long If a distribution is
position whereas a negative weight is a short position. negatively skewed the
mode > median > mean

Variance, Standard Deviation, Semivariance

∑𝑁
𝑖=1(𝑋𝑖 −𝜇)
2 ∑𝑁 ̄ 2
𝑖=1(𝑋𝑖 −X)
Population variance: 𝜎2 = Sample variance: 𝑠2 =
𝑁 𝑛−1

∑𝑁
𝑖=1(𝑋𝑖 −𝜇)
2 𝜎 is the square root of variance and is easier to interpret because it is expressed in
Standard Deviation 𝜎 = √ the same unit of measurement as the observations. The n-1 in the denominator is
𝑁
known as degrees of freedom.
2
(𝑋𝑖 −X̄ ) Semivariance is the avg squared deviation for values below the mean, i.e. we
Semivariance= ∑𝐹𝑜𝑟 𝑎𝑙𝑙 𝑋𝑖 ≤X̄ usually only care about downside risk. Semivariance <𝜎, which implies that 𝜎
𝑛−1
actually overestimates total risk.

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Measuring risk and risk-adjusted returns
Coefficient of Variation 𝑠𝑥 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 CV measures the risk/variation per unit of
𝐶𝑉 = =
(CV) X̄ 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 return/mean.
R p − rf Measures portfolio returns per unit of excess risk.
Sharpe ratio is appropriate if the distribution of
Sharpe ratio σP returns is normal, it may be overstated if returns
Higher = better risk-adjusted performance. are asymmetric.
𝐸(𝑅𝑃 ) − 𝑀𝐴𝑅 Allows investors to determine whether a given
Roy’s Safety First Criteria asset or portfolio has too much risk of declining
𝜎𝑃
(RSF) MAR = minimum acceptable return beyond a certain point (i.e. is too volatile for
The higher the better the risk-adjusted performance. them)

The Normal Distribution, Skew & Kurtosis

Key Characteristics of the
Normal Distribution


Mean = median = mode

Skewness = 0

Kurtosis = 3 (At Kurtosis =3,
we say excess kurtosis = 0)
 When the standard deviation
increases (decreases) the curve
flattens (steepens)
 The normal distribution is
completely described by its
mean and standard deviation
 The range is infinite (as it is a
A normal distribution is a return distribution that is symmetrical about its mean. We can continuous probability
fully describe a normal distribution using just its mean and standard deviation. For distribution)
example: “X is normally distributed with a mean of 𝜇 and std dev of 𝜎.  It is symmetrical
 68% of observations fall
Positive skew, or a right skewed distribution, is a return distribution that has a long right tail within ± 1 𝜎 , 95% of
and skewness > 0. It has many outliers in the right, upper region and is named after its long observations fall within ±2 𝜎,
right tail. It reflects an investment scenario where frequent small losses are normal with the 99% fall within ±3𝜎
occasional extreme gain (option payoffs have positive skew).  The tails of the normal
distribution extend without
Negative skew, or a left skewed distribution, is a return distribution that has a long left tail limit to the left and right
and skewness < 0. It has many outliers in the left, negative region and is named after its without touching the X axis.
long left tail. In an investment context, negative skew reflects a scenario of frequent small However, as we extend out
gains and occasional large, catastrophic losses. they asymptotically approach
the axis
Leptokurtic describes a curve that is more peaked (higher) & with fatter
Kurtosis measures the height or “peak” of the curve. tails than normal. Its excess kurtosis > 0. Fatter tails = more risk.
Platykurtic refers to a distribution that is less peaked, or flatter, than a
normal curve with thinner tails. Its kurtosis < 3, and its excess kurtosis < 0.
Remember plat sounds like flat.

Provided n > 100, any excess kurtosis with a value > 1.0 would indicate
significant kurtosis, where excess kurtosis = sample kurtosis – 3

Any sample skewness with an absolute value > 0.5 indicates significant
skewness.

Z-score: Standardizes observations from normal distribution to give us # of

standard deviations a given observation is from population mean:

𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛 − 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑚𝑒𝑎𝑛 𝑥− 𝜇

𝑧= =
𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝜎
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Probability
Joint Probability - Refers to a calculation of how likely both events are to happen. Probability of A & B: 𝑃(𝐴𝐵) = 𝑃 (𝐴 | 𝐵) 𝑥 𝑃(𝐵).
Probability of at Least one Event occurring: 𝑃(𝐴 𝑜𝑟 𝐵) = 𝑃 (𝐴) + 𝑃(𝐵) − 𝑃(𝐴𝐵)
Joint probability for independent & dependent events - When calculating joint probability for independent events AND =
multiplication and OR = addition.

We can express the probabilities as:

𝑃(𝐴 𝑎𝑛𝑑 𝐵 𝑎𝑛𝑑 𝐶 ) = 𝑃(𝐴𝐵𝐶 ) = 𝑃(𝐴) 𝑥 𝑃(𝐵) 𝑥 𝑃(𝐶)

𝑃(𝐴 𝑜𝑟 𝐵 𝑜𝑟 𝐶 ) = 𝑃(𝐴𝐵𝐶 ) = 𝑃 (𝐴) + 𝑃(𝐵) + 𝑃(𝐶)

Expected value: The expected value of a distribution or population is calculated as its probability weighted average. The equation is
very similar to any generic weighted average:

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 = ∑ 𝑃(𝑥𝑖 )𝑥𝑖 = 𝑃(𝑥1 )𝑥1 + 𝑃 (𝑥2 )𝑥2 + 𝑃(𝑥𝑛 )𝑥𝑛

Binomial Models & Tree Diagrams

A binomial distribution assumes a variable can only take 1
of 2 values (success/failure or up/down). We can use it to
describe changes in asset values over multiple periods.
Most commonly we use a tree diagram to do so. Note we
multiply along the branches and add down them 

Covariance & Correlation

Covariance measures how two assets move relative to one
another. Correlation (ρ) is similar to covariance as it helps
indicate the degree to which two variables are related. It
measures the linear relationship between two variables.

𝐶𝑜𝑣(𝑅𝑖 𝑅𝑗 )
𝐶𝑜𝑟𝑟(𝑅𝑖 𝑅𝑗 ) =
𝜎 (𝑅𝑖 ) ∗ 𝜎(𝑅𝑗 )
Variance of a 2 asset portfolio
Properties of Correlation
 -1 ≤ ρ ≤ 1  ρ is between -1 and 1, with 1 being a 𝑉𝑎𝑟(𝑅𝑝 ) = 𝑤𝐴2 𝜎𝐴2 𝑅𝐴 + 𝑤𝑏𝐵
2
𝜎𝐵2 𝑅𝐵
perfect linear relationship and -1 being a perfect inverse + 2𝑤𝐴 𝑤𝐵 𝜎𝐴 𝜎𝐵 𝑐𝑜𝑟𝑟(𝐴, 𝐵)
relationship.
 When ρ < 0 relationship is negative, when ρ > 0 it is From a portfolio perspective we reduce our overall risk by
positive, when ρ = 0 there is no linear relationship increasing the diversification of our portfolio (i.e. we don’t
between the variables want to put all our eggs in one basket). The smaller the
 If ρ = 1 a one unit change in one variable causes a one covariance or correlation between assets the more
unit change in the other diversification benefits there are.

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Monte Carlo Simulation (MCS)

MCS is the process of simulating a portfolio’s performance thousands of times to generate a probability distribution of outcomes.
 Pros: Considers path dependency, can incorporate any assumption and model patterns, does not assume normal distribution
 Cons: Complex, Purely statistical method so it is not as analytical as some measures, output only as good as the inputs

Historical Simulation
A historical simulation involves using past data to model potential changes to each variable.
 Pros: Uses actual historical data
 Cons: Assumes that future similar to the past, may not capture changing market conditions/infrequent events, cannot model
“what if” scenarios

The Central Limit Theorem

The central limit theorem states that, for a population distribution with mean = μ and a finite variance σ 2, the sampling distribution
will approximate a normal distribution (regardless of the underlying population distribution). This leads to three important
characteristics as the sample size becomes large (n ≥ 30):

1. The sample mean will be equal to the population mean (μ)

2. The sample mean will be approximately normally distributed (regardless of the distribution of the underlying population)
3. The sample variance will be equal to the population variance (σ 2) divided by the size of the sample (n).

Standard Error
The standard error of the sample mean is the standard deviation of the distribution of means. As the sample size up (↑) SE down ↓:

𝜎
𝜎x̄ =
√𝑛
Constructing a Confidence Interval
To construct a confidence interval we take a point estimate of the mean and then add and subtract a value to find the given range. The
more confident we want to be that a parameter falls within our confidence interval, the wider we have to make that interval. This takes
the form of the equation:

𝐶𝐼 = 𝑝𝑜𝑖𝑛𝑡 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 ± (𝑟𝑒𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟 ∗ 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑒𝑟𝑟𝑜𝑟)

Where:
Point estimate = estimate of the underlying population parameter (usually a mean)
Reliability factor = will be given, depends on sampling distribution of the point estimate
Standard error = standard error of the point estimate
𝜎
With known variance this becomes: 𝐶𝑜𝑛𝑓𝑖𝑑𝑒𝑛𝑐𝑒 𝑖𝑛𝑡𝑒𝑟𝑣𝑎𝑙 = x̄ ± 𝑧𝑎⁄2
√𝑛

Selecting the Appropriate Test Statistic

Type of Distribution Sample size < 30 Sample Size > 30
Normal distribution with known variance Z statistic Z statistic
NON-normal distribution with known variance Not possible Z statistic
Normal distribution with unknown variance T statistic T Statistic (Z OK but less conservative)
NON-normal distribution with unknown variance Not possible T statistic

The T-Statistic
If we DON’T know the population variance we abandon the z-score and use the t-statistic. To find the confidence interval using the t-
statistic the first thing to do is identify the degrees of freedom (DOF).

Degrees of Freedom
 The degrees of freedom = n-1, so if a sample size = 40, DOF = 39.
 From there we find the appropriate level of significance and look up the t-statistic from a table (much like we did with the Z-
scores). Again, when looking up the value in a table keep in mind whether we want a one or two-sided test (note that for
confidence intervals it will always be two sided).
 Unlike the Z-table, the levels of significance on a t-table show one-tailed probabilities.
 The student t-distribution is approximately normal except it is less peaked and has fatter tails.

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Types of Data Biases
Type of Bias What it is
Mining the same dataset to find a pattern or rule that appears to be true. A bias can occur if the result
Data Mining Bias
might be statistically significant but not reflective of what’s actually going on in real life.
Excluding a certain part of a population just because the data is not available. The result is that the
Sample Selection Bias sample is not truly random as it depends on only a subset of the population data.
Self-reporting from only successful/surviving funds. Can skew the data since surviving funds are
Survivorship Bias
more likely to be more successful than a truly random sampling of all funds.
Involves using variables that were not available at a given point in time but with the assumption
Look Ahead Bias that they were.
Refers to non-stationarity of data. If we use a time period that is too long we risk those economic
Time Period Bias variables no longer being relevant or at least shifting in terms of their specific relationship. If the
time period is too short we risk that information not being relevant to longer periods.
Potential issues with large
Very costly to construct the sample. May inadvertently sample from more than one population.
sample sizes

Hypothesis Testing
Null hypothesis, H0, is the hypothesis that is 7 Steps of a Hypothesis Test
actually being tested. Think of it as the 1. Formulate the null and alternative hypothesis
hypothesis a researcher wants to reject or as 2. Determine which test statistic is appropriate and find the probability
the statement that represents the status quo distribution
3. Decide on the required level of significance
Alternative hypothesis, HA, is a contradictory 4. Articulate the decision rule (if tc > ts)
statement to the null hypothesis that we only 5. ID the value of the test statistic (which will be based on the sample size)
accept if we fail to reject HO. 6. Reject or Fail to Reject the Null Hypothesis
7. Translate the statistical test into an economic decision

The Three Null and Alternate Hypotheses The Three Rejection Areas for the Null Hypotheses
H0: 𝜇 = 𝜇0
Ha states that 𝜇 ≠ 𝜇0

H0: 𝜇 ≥ 𝜇0
Ha states that 𝜇 < 𝜇0

H0: 𝜇 ≤ 𝜇0
Ha states that 𝜇 > 𝜇0

The null hypothesis will always contain an ‘equals’ sign

whereas the alternative will always be framed as an
inequality.

Note a one-tailed test gauges whether a number is

greater or less than a value whereas a two-tailed test
whether a value is equal or not equal to the value

Use t-test when evaluating the mean, the Chi-Squared

test for population variance, and the F-statistic for Reject the null hypothesis if our computed test statistic (z or t) falls outside
comparing two different population variances. the range (i.e. is more extreme) than the critical value.

Type I and II Errors

Within hypothesis testing we face two risks—one risk is rejecting a true null hypothesis and the other is failing to reject a null
hypothesis that is false. These are “mutually exclusive” errors.

 Type I error – Rejecting a null hypothesis that is actually true

 Type II error – Failing to reject a null hypothesis that is false

The significance level is the probability of making a type I error. So a 5% sig level gives us a 5% chance of rejecting a true null
The P-value is the probability of making a Type I error. Formally: if P-value ≤ α, Reject H0 and if P-value ≥ α, Fail to reject H0

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Technical Analysis
Types of Charts: Line charts, bar charts,
candlestick charts, point-and-figure charts
Reversal Patterns: Head & shoulders,
Inverse H&S, Double/Trip Top & bottom
Continuation Patterns: Triangles,
Rectangles, Pennants, & Flags
Price-based Indicators: Moving
averages, Bollinger bands, momentum
oscillators (MACD, RSI, stochastic, rate
of change)
Key Facts about Technical Analysis
Sentiment indicators: opinion polls,
 Technical analysis works better in trending markets. put/call ratio, VIX, margin debt, short
 An up move in price accompanied by high trading volume is more bullish than the interest ratio
same price increase on weak volume. Flow of Funds Indicators: TRIN, Margin
 With a Double/Triple Top or Head and Shoulders Pattern we expect the size of debt, mutual fund cash position, new or
the up/down move to be equal to the height of the pattern (set “price target”) secondary equity issuances

Microeconomics
Supply & Demand
Demand depends on: Price of good, Income, Price of related
goods (substitutes and complements)

Supply depends on: Price of good, price of inputs (labor,

capital), price of related goods

Market equilibrium occurs when the quantity supplied

equals the quantity demanded. Graphically it is the
intersection of the supply and demand curves. We solve for
market equilibrium by setting the supply and demand
functions equal to one another.
Movements along the supply/demand curve reflect changes in the quantity supplied/demanded as a result of changes in price. Shifts
in the curves reflect (non-price) related changes such as changes in input costs or technology or related goods.

Substitute Goods are goods we could use instead of the original good
Complementary Goods are goods which have an inverse relationship with demand of the original product

 The LOWER the price of substitute goods, the LOWER the demand for my product
 The LOWER the price of complementary goods, the HIGHER the demand for my product

Elasticity
Elasticity is a measure of responsiveness between one variable and another. It is defined as the percentage change in a dependent
variable caused by a percentage change in an independent variable. The greater the elasticity the greater the responsiveness
between the variables.

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Types of Elasticity

%∆𝑄𝐷
𝑂𝑤𝑛 𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 =
%∆𝑃𝑟𝑖𝑐𝑒

 Absolute value >1, Demand is elastic

 Absolute value <1, Demand is inelastic

%∆𝑄𝐷
𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 =
%∆𝐼𝑛𝑐𝑜𝑚𝑒

 Positive value indicates a normal good

 Negative value indicates an inferior good

%∆𝑄𝐷 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑋 At relatively high prices where demand is elastic (the upper half of the
𝐶𝑟𝑜𝑠𝑠 𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = demand curve), total revenue will increase (decrease) when prices decrease
%∆𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝑌
(increase) since the percentage growth in quantity demanded will outweigh
 Positive value: related good = substitute the percentage decline in price. On the lower half of the demand curve where
 Negative value: related good = complement we have inelastic demand the opposite is true. The midpoint of the demand
curve, (unit elastic demand) is point of maximum total revenue.

Normal/Inferior Goods
Substitution effects refer to how we shift our allocation across a
range of goods depending on their relative prices.

Income effects measure how changing prices impact our overall

ability to afford an item based on our real income. A normal
good is one for which income effect is positive. An inferior good
is one for which the income effect is negative

Substitution and Income Effects & Determining Type of Good

 The substitution effect is always positive: PX ↓ QX ↑
 The income effect can be either positive (normal good) or
negative (inferior good)
 A Giffen good is a type of inferior good where the income effect
is negative AND larger than the substitution effect
 A Veblen good is where QD↑ when P↑ (think status symbols like
Gucci handbags)

Factors of production (a firm’s production resources) include land, labor, capital and materials. In economic analysis we can
simplify this into a production function which only considers labor and capital. That is: 𝑄 = 𝑓(𝐾, 𝐿)

In the production function if you hold one of the factors (K or L,) constant, at some point the other will exhibit diminishing marginal
returns – i.e. the more units of labor we add holding capital constant, the less and less productive each additional unit of labor
becomes. At some point an additional unit of labor could even result in a decrease in production.

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Revenues
What
Total Revenue (TR)
Average Revenue (AR)
Marginal revenue (MR)
change in revenue from
selling one more unit
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Macroeconomics
Equation Comment
TR is the entire area under Total Revenue is
𝑇𝑅 = 𝑃 ∗ 𝑄 the demand curve up to maximized where
the quantity sold. MR = 0 (and where
elasticity = -1).
𝐴𝑅 = 𝑇𝑅⁄𝑄 Average revenue/units =
Price
Profit max when
𝑀𝑅 = ∆𝑇𝑅⁄∆𝑄 -In PC: MR = AR = price MR=MC
-With Downward sloping
demand: MR < price

Defining the Different Types of Costs

MC declines at first then begins to increase (when the marginal productivity of

labor begins to decrease). MC intersects AVC and ATC at their minimum
points (i.e. it intersects it from below). Up until the intersection each additional
unit’s cost of production is lower than AVC/ATC and is “driving” those curves
lower. Once it intersects the reverse is true.

Market Structures
 Economies of Scale – Occur
when a firm’s cost of
production decreases the larger
they get
 Diseconomis of Scale – Reflect
higher costs as size increases. If
we added 20% to our inputs we
would expand production by <
20%.
 Constant Returns to Scale - No
advantage or disadvantage to
scale
Elasticity and Market Structure
A high elasticity implies close to perfect competition
whereas a low elasticity indicates monopoly-like conditions.
The N-Firm concentration ratio is calculated as the sum of
or percentage market shares of the largest N firms in the
market.

Market Structures and Economic Profit

Perfect competition:
 Price = marginal revenue = marginal cost (in equilibrium)
 Perfectly elastic demand, zero economic profit in
equilibrium.
Monopolistic competition:
 Price > marginal revenue = marginal cost (in equilibrium).
 Zero economic profit in long-run equilibrium.
Oligopoly:
 Price > marginal revenue = marginal cost (in equilibrium).
 May have positive economic profit in long-run equilibrium, but
moves toward zero over time.
Monopoly:
 Price > marginal revenue = marginal cost (in equilibrium).
 May have positive econ. profit in LR equilibrium
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Determining a Firm’s Shutdown Points
Shutdown Criteria in Short & Long Run
Revenue–Cost Short-run Long-run
Relationship
TR > TC Stay in market Stay in market
TR > TVC but
TR < TC, i.e. AVC < AR Stay in market Exit market
(and AR < ATC)

TR < TVC Shut down, pay fixed

Exit market
i.e. AR <VC costs

Marginal Product /Marginal Revenue Product & Profit Maximization – Firms maximize revenue with a mix of inputs where the
additional output per dollar spent on each unit is equal:

𝑀𝑃1 𝑀𝑃2 𝑀𝑃𝑁 𝑀𝑃1 ∗𝑀𝑅1 𝑀𝑃2 ∗ 𝑀𝑅2 𝑀𝑃𝑁 ∗𝑀𝑅𝑁

= =⋯ and = =⋯
𝑃1 𝑃2 𝑃𝑁 𝑃1 𝑃2 𝑃𝑁

Determining Ideal Firm Size

The long-run average total cost (LRATC)

curve shows the minimum average total cost for
each level of output assuming that the plant size
(scale of the firm) can be adjusted.

A downward-sloping segment of an LRATC

curve indicates economies of scale (increasing
returns to scale). Over such a segment, increasing
the scale of the firm reduces ATC

Herfindahl-Hirschman Index (HHI) is the sum of the squared % market share of the top 50 largest firms in a market. An HHI = 1
would indicate a perfectly competitive industry.

GDP
𝐺𝐷𝑃 = 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 + (𝐸𝑥𝑝𝑜𝑟𝑡𝑠 − 𝐼𝑚𝑝𝑜𝑟𝑡𝑠)
GDP Deflator = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃⁄𝑟𝑒𝑎𝑙 𝐺𝐷𝑃
Private Saving, Investment, and Fiscal Balance: (𝐺 − 𝑇) = (𝑆 − 𝐼 ) − (𝑋 − 𝑀). If (G-T) > 0, either trade deficit or excess priv
savings. A negative (positive) G-T indicates a government surplus (deficit)
Quantity Theory of Money: 𝑀𝑉 = 𝑃𝑌 where V=velocity, M=money supply, P=prices (M/P is the real money supply), Y=GDP.

Aggregate Demand - 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋

Factors increasing AD: Increases in consumer wealth, More

business investment, Consumers expect future income to
increase, High capacity utilization, Expansionary
fiscal/monetary policy, Decrease in exchange rate (NX ↑),
Global GDP growth (exports ↑)

Factors increasing Aggregate Supply (Shifting SRAS right):

Greater labor productivity, Decrease in input costs including
wages, Expectations of higher future prices, Decrease in taxes,
Increase in subsidies, Increase in exchange rate (NX ↓)

Inflationary Gap - Where rGDP > Potential GDP

Deflationary Gap - Where rGDP < Potential GDP
Be able to compare/contrast change in GDP, Price Level, and Stagflation - Combination of lower output & higher prices
unemployment based on simultaneous shifts in AD/AS

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Impact of Shift in AD/AS on Economy
Type of Change Real GDP Unemployment Price Level
Increase in AD ↑ ↓ ↑
Decrease in AD ↓ ↑ ↓
Increase in AS ↑ ↓ ↓
Decrease in AS ↓ ↑ ↑

Aggregate Supply Aggregate Demand Change in rGDP Change in Prices

Increase Increase Increase Indeterminate
Increase Decrease Indeterminate Decrease
Decrease Increase Indeterminate Increase
Decrease Decrease Decrease Indeterminate

Cobb Douglas Production Function - 𝑌 = 𝐴𝐾 α 𝐿𝑏 where α is the output elasticity of capital and b is (1-α) and α + β = 1
∆𝑌 ∆𝐴 ∆𝐾 ∆𝐿
% Change in GDP (production function) = 𝑌 ≅ 𝐴 + α 𝐾 + (1 − α) 𝐿
Solow Residual – is A from Cobb Douglas (represents ∆Tech, Laws etc) = %∆𝑇𝐹𝑃 = %∆𝑌 − α(%∆𝐾 ) − (1 − α)%∆𝐿
Sources of LR Economic Growth (shifts LRAS): ↑ labor supply, ↑ Human Capital, ↑ physical capital stock, better technology, ↑
natural resources Estimate of sustainable growth = growth in labor force + growth in productivity

Phases of the Business Cycle

 Expansion (real GDP increasing, Unemployment
decreasing, capital invest. Increases, inflation and imports
likely to rise)
 Peak (real GDP flatlines, hiring slows, consumer spending
and biz. Invest starts to slow, inflation up)
 Contraction/Recession (rGDP decreasing, unemployment
increasing, consumer spending, housing construction and
biz invest decrease, inflation and imports decrease)
 Trough (rGDP stops decreasing-starts increasing, high
unemployment, decreasing inflation, increased spending on
housing and consumer durables)  Leading indicators have turning points before peaks or
troughs in the business cycle. They can be used ahead of
When Output ↑: Employment, Consumption, Investment, time to identify turns
and inflation increasing  Lagging indicators, or confirming indicators, have a
When Output ↓: Employment, Consumption, Investment, turning point after a change in the business cycle
and inflation decreasing  Coincident indicators occur at the same time as the
business cycle
Business Cycle Theories
 Neoclassical – Business cycles are temporary and driven by changes in technology. Adjustments to prices will automatically
move economies back into equilibrium.
 Keynesian – Cycles are caused by excessive optimism or pessimism and can persist due to sticky wages (don’t adjust
downward). They recommend direct monetary or fiscal intervention to restore equilibrium.
 Monetarists – Believe inappropriate monetary intervention, i.e. changes to the money supply, cause business cycles. Solution
is to keep the money supply growing at a predictable rate
 Austrian-school – Cycles are caused by government intervention in the economy which drive interest rates to artificially low
levels and cause misallocation/bubbles
 Real Business Cycle – Cycles are explained by utility-maximizing individual actors responding to real economic shocks (not
monetary variables). Also do NOT advocate for government intervention.

Unemployment
Frictional Unemployment: Caused by timing it takes to match employers and 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒
employees with the necessary skill. Frictional unemployment will always exist
regardless of market conditions 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Structural Unemployment: Structural unemployment refers to long-run mismatches =
𝐿𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒 𝑃𝑎𝑟𝑡𝑖𝑐𝑖𝑝𝑎𝑛𝑡𝑠
in the type of jobs available and the skills of workers. Caused by changes in
technology and combatted with job training etc. 𝑃𝑎𝑟𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜
Cyclical Unemployment: Caused by changes in the level of economic activity. 𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒
Positive when the economy is operating at less than full capacity and can be negative =
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐴𝑔𝑒 (𝑒𝑙𝑖𝑔𝑖𝑏𝑙𝑒) 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
if temporary inflationary gap causes employment to exceed the full employment level.
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Money
Functions: Medium of exchange, store of value, unit of account 1
𝑚𝑜𝑛𝑒𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
Measures:M1/M2/M3 – M3 is broadest, then M2, M1 narrowest 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡

The Fisher Effect - 𝑅𝑁𝑜𝑚𝑖𝑛𝑎𝑙 = 𝑅𝑅𝑒𝑎𝑙 + 𝑒(𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛). Consistent with money neutrality, the Fisher effect states that real rates are
relatively stable and changes in the nominal rate are driven by inflation.

Fiscal and Monetary Policy / Trade Unions

Monetary Policy is policy enacted by the central bank. It affects the money supply and interest rates and through this economic
activity. Expansionary monetary policy is when the central bank increases money supply (reduces interest rates). Restrictive monetary
policy is contractive and involves decreasing the money supply (increasing r).

𝑛𝑒𝑢𝑡𝑟𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑟𝑒𝑎𝑙 𝑡𝑟𝑒𝑛𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑔𝑟𝑜𝑤𝑡ℎ + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑡𝑎𝑟𝑔𝑒𝑡

 If the policy rate is ABOVE the neutral rate, monetary policy is contractionary
 If the policy rate is BELOW the neutral rate, monetary policy is expansionary

Tools of Monetary Policy

 Reserve Requirement – The percentage of each deposit banks are required to retain. The lower the reserve requirement the higher
the money multiplier and the higher the money supply. Raising the reserve requirement thus decreases overall money supply.
 Policy rate – The policy rate is the rate at which banks can borrow from the Fed (usually overnight). The lower the rate the more
expansive monetary policy as the lower cost of funds incents banks to lend more.
 Open Market Operations – This is buying or selling bonds on the open market. Buying bonds introduces new money and is
expansionary. Selling bonds takes money out of the system and is contractionary.

Fiscal policy refers to government spending and taxation policies. A balanced budget is when tax receipts = government expenditures.
A surplus occurs when tax receipts are greater than expenditures, and a deficit is when expenditures are higher than taxes.

Fiscal Policy Tools

Spending Tools Revenue Tools

 Transfer payments – Entitlement programs, redistribute
wealth (social security)
 Current spending – Ongoing / recurring / routine government
spending
 Capital spending – Spending on infrastructure, boosting
future productivity
Expansionary or Contractionary Fiscal Policy?
We focus on CHANGES to the fiscal surplus or deficit to
determine whether fiscal policy is expansionary or
contractionary.
 An INCREASE in surplus is contractionary
 A DECREASE in surplus is expansionary
 An INCREASE in deficit is expansionary
 A DECREASE in deficit is contractionary
 Direct taxation – Income or wealth taxes
 Indirect taxation – Taxes on goods and services. Sales tax,
VAT etc
 Indirect taxes are quicker to implement
Fiscal Multiplier
Changes in government spending are magnified because people
whose incomes go up because of the stimulus will in turn
increase their spending and on and on. The degree of this
multiplier depends directly on the marginal propensity to
consume (MPC) and indirectly on the tax rate (t).
1
𝐹𝑖𝑠𝑐𝑎𝑙 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
1 − 𝑀𝑃𝐶(1 − 𝑡)
Fiscal vs. Monetary Policy
Fiscal policy generally thought to be slower than monetary
policy due to political (implementation) lag and time lag for the
capital spending to trickle through economy.

Interaction of Fiscal and Monetary Policy

Monetary Fiscal Outcome
Expansionary Expansionary Highly expansionary. Lower interest rates and expanding public and private sectors
Interest rates ↓ from both fiscal/monetary action, increasing private consumption and
Expansionary Contractionary
output. Gov spending as % of GDP will fall.
Likely to have higher AD due to fiscal impact with higher interest rates due to
Contractionary Expansionary
monetary action. Gov spending as % of GDP will rise.
AD and GDP will fall and interest rates will rise. Both public and private sectors will
Contractionary Contractionary
shrink.

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Trade
Comparative Advantage - Happens when a country has a lower opportunity cost of producing a good in terms of another good. Even if
a country has the absolute advantage in producing two given goods, the law of comparative advantage states they should still
specialize in producing the good for which they have the lowest opportunity cost and trade with others for mutual benefit.

Types of Trading Agreements / Zones - All different types of trade agreements among companies designed to reduce trade barriers

Free trade area – No barriers to importing and exporting goods between the countries (NAFTA)
Customs Unions – No barriers to import/export between members, establish a common set of restrictions against non-members
Common Market – Everything above plus they allow free movement of factors of production among members (e.g. labor)
Economic Union – Everything above plus they establish common institutions and coordination of economic policies (EU)
Monetary Union – All the above and adopting a common single currency (Euro zone)

Motivations for restricting trade include: protecting an infant industry in order to allow it to mature, ensuring industries relevant to
national security survive, protecting domestic jobs, and guarding domestic industries.
Tools to restrict trade include: tariffs on imports, quotas on the amount of imports, export subsidies, min. domestic content and
voluntary export restraints.
Capital restrictions serve to: protect domestically important or strategic industries, keep domestic interest rates low, protect a
currency peg, and reduce the volatility of domestic asset prices.

Currencies
Balance of Payments
The BOP measures the difference in total (transactions) payments into and out of a country. Any surplus (deficit) in the current
account must be offset by a deficit (surplus) in the capital or financial accounts

At equilibrium the BOP = Components of BOP

Current Account – Measures the flow of goods & services,
𝑋 − 𝑀 = 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 + (𝐺𝑜𝑣 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 including merchandise & services, foreign income on dividends
− 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡) & bonds, and unilateral transfers (remittances). A current
or account deficit (surplus) means a country’s imports are greater
(𝑋 − 𝑀) = (𝑆 − 𝐼 ) + (𝑇 − 𝐺 ) (less than) its exports

(1) Lower private savings, (2) a larger government deficit, or (3)
high private investment will all increase the current account
deficit.
In other words, foreign capital is required to bridge any gap
between private investment and low private or government
savings
Capital Account – Measures long term capital transfers & the
sale/purchase of non-financial assets such as patents
Financial Account – Measures government owned assets abroad
and foreign-owned assets domestically including securities,
foreign direct investment, and currency holdings

Exchange rates
An exchange rate is the price of one currency (domestic [DC] or foreign [FC]) in terms of another. The denominator is referred to as
the base currency and the numerator is the price currency. We always price the base in terms of the numerator. So we buy or sell
the BASE currency in pricing terms given by the numerator. And it is always a two-way transaction. If we sell the base that means we
are buying the numerator/price and vice versa. To keep things simple always use DC/FC even if you have to take the inverse.

Nominal vs. Real Exchange Rates

The nominal exchange rate gives us the cost to purchase goods using today’s exchange rates. The real exchange rate gives us the
cost of purchasing the same unit of goods and services based on the new/current exchange rate and the relative change in price levels.

𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 (𝐷𝐶⁄𝐹𝐶 )  Inflation in the FC/denominator increases the real
𝐷𝐶 𝐶𝑃𝐼𝑓𝑜𝑟𝑒𝑖𝑔𝑛 exchange rate
= 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 (
𝐹𝐶
)∗(
𝐶𝑃𝐼𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐
)  Inflation in the DC/numerator decreases the real
exchange rate

Direct/Indirect Quote
𝐷𝐶
A Direct quote is a foreign exchange rate quoted as the domestic currency per unit of the foreign currency =
𝑃𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝐹𝐶

An Indirect quote is the reciprocal/inverse of the direct quote. It gives the amount of foreign currency required to buy or sell one unit
of domestic currency.

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Cross Rates - The exchange rate of two currencies as implied by their exchange rates with a common, third currency. Cross rates are
needed when there is no real FX market for the two currencies.

£ € £
You may need to take inverses to do so: = ∗
𝑈𝑆𝐷 𝑈𝑆𝐷 €

Spot and Forward Exchange Rates

No Arbitrage Forward FX Rate: Forward Discount/Premium

The forward discount or premium for the base currency is the
𝑓𝑜𝑟𝑤𝑎𝑟𝑑 (𝐷𝐶/𝐹𝐶) (1 + 𝑟𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 ) percentage difference between the forward price and the spot
= price.
𝑠𝑝𝑜𝑡 (𝐷𝐶/𝐹𝐶) (1 + 𝑟𝑓𝑜𝑟𝑒𝑖𝑔𝑛 )

You can rearrange this equation to solve for the necessary 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 =
variable. 𝑆𝑝𝑜𝑡 𝑝𝑟𝑖𝑐𝑒

If the spot/forward are given as DC/FC then the domestic If the forward > spot price it will take more of the numerator to
interest rate is in the numerator (as above). If the spot/forward buy the base, so we can say that the base appreciated relative to
are given as FC/DC then the foreign interest rate should be in the pricing currency or that the numerator depreciated relative
the numerator instead. to the base.

Financial Statement Analysis

Balance Sheet
The balance sheet reports a firm’s financial position at a specific point in time. It’s used to determine a firm’s liquidity, solvency, and
ability to make distributions to shareholders and includes Assets, Liabilities, and Shareholders’ Equity where A = L + E.

Expanded Accounting Equation

Assets =
Liabilities
+ contributed capital
+ beginning period retained earnings
+ retained earnings over period
+ revenue
- expenses
- dividends

 Balance sheet elements reported using a mix of

historical cost, amortized cost, and fair value
 Current assets (liabilities) are those expected to
be used (come due) within 1 year
 Under IFRS Research is expensed as incurred &
development is capitalized while under GAAP
both R&D are expensed.

Capitalization vs. Expensing

Vertical/Horizontal Financial Statements: A vertical common size balance
sheet expresses each line item as a % of total assets. For the exam be able to
interpret the different percentages and the ability of a firm to manage its capital
efficiently while remaining solvent/liquid. A horizontal common size balance
sheet shows each line item relative to its value in a base period, which is
helpful to assess growth trend in different line items. Can also be built for the
income statement (where vertical = each line as a % of sales).
Capitalization smooths out costs over time and will
cause higher net profits in early years and lower
profitability in later years. Also increases assets and
equity which can impact various ratios. Expensing
will have the opposite effect.

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The Income Statement
The Income statement shows the financial performance of a firm over a period of time. In other words it tells us if the firm made or
lost money in the form of net income. It consists of revenues from ordinary operations, expenses, and other gains/losses (G/L).

Revenue Recognition - Revenue is recognized when the earnings

process completes or there is reasonable assurance of payment.
For long term contracts:

 Percentage-of-completion method - Appropriate when the

outcome of a long term contract can be reliably estimated.
Revenue and expenses are recognized as the work is performed
where the % = the total cost to-date/total expected cost.
 Completed-contract method - Used when the outcome of a
contract cannot be reliably measured. Revenue and expenses
are only recognized when the contract is over.
 Installment Sales – Used when a firm finances a sale. Profit is
recognized when cash is collected.
 Cost recovery method – Used if collectability is very uncertain.
Profit only recognized when $ collected > costs

Gross profit is the profit after subtracting out direct expenses 𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒−𝐶𝑂𝐺𝑆
Gross profit margin = =
= 𝑠𝑎𝑙𝑒𝑠 − 𝐶𝑂𝐺𝑆 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
Operating income/profit (EBIT) Operating profit margin =
𝑟𝑒𝑣𝑒𝑛𝑢𝑒
= 𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 − 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
Net profit margin =
Net Income (NI) = 𝐸𝐵𝐼𝑇 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 & 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
Extraordinary Items – Items not expected to re-occur. Should be accounted for when considering future profitability. Includes G/L
from sale of business, assets, or investments, impairments, write-offs, write-downs, and restructuring or integration costs.
The income statement makes use of accrual accounting, which means that revenue is recognized when it is earned and expenses are
recognized when they are incurred (vs. when they are actually paid). As such, firms can choose accounting methods that delay or
accelerate the recognition of expenses in order to manipulate net income for a particular period of time.

Cash Flow Statement

Cash flow statement reports a company’s cash receipts & payments. It links the firm’s net income to cash inflows/outflows. Includes:

 Operating cash flows (CFO) – CFs from transactions involving the normal business of the company (affecting net income)
 Financing cash flows (CFF) – CFs from the issuance or retirement of debt and equity, including dividends
 Investing cash flows (CFI) – CFs that from sale or acquisition of PPE, CFs from a subsidiary or investments in other firms,
and CFs from securities or investments

Classifying Cash Flows with IFRS vs. GAAP

IFRS treats interest and dividends received as inflows in CFO or CFI and dividends paid as outflows in CFO or CFF. Income taxes are
CFO unless associated with an investing or financing transaction. GAAP treats interest/dividends RECEIVED and interest PAID as
inflows/outflows in CFO and dividends paid as outflows in CFF.

Calculating CFO from the Indirect Method Calculating CFO from the Direct Method
1. Start with cash receipts from sales
1. Begin with net income. = 𝑆𝑎𝑙𝑒𝑠
2. Add back non-cash expenses. + 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑜𝑟
a. Depreciation & Amortization (b/c subtracted to get NI) − 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐴𝑅
3. Adjust for gains and losses on sales of assets 2. Subtract cash payments for purchases
a. Add back losses (b/c these are CFI, not CFO) = 𝐶𝑂𝐺𝑆
b. Subtract out gains (b/c these are CFI, not CFO) + 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑜𝑟
4. Account for changes in all non-cash current assets and − 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
liabilities (except notes payable and dividends payable). + 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑟
a. Accounts receivable ↑, accrual > cash, so reduce cash − 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐴𝑃
b. Accounts payable ↑, accrual > cash, so add back cash

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Notes on CFO Calculations
The ending cash flow from operations will be the same under
both direct and indirect methods.
 CFI and CFF are identical under both methods.
 There is an inverse relationship between changes in CF and
changes in assets. INCREASING assets USES up cash: A ↑,
cash ↓ and vice versa
 There is a direct relationship between liabilities and CF.
INCREASING liabilities is a SOURCE of cash: L ↑, cash ↑.
 The direct method IGNORES depreciation expense. The
indirect method ADDS BACK depreciation to net income.
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3. Subtract cash payments for operating expenses (SG&A,
R&D, wages, accounts payable)
= 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
+ 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑝𝑟𝑒𝑝𝑎𝑖𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑜𝑟
− 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑝𝑟𝑒𝑝𝑎𝑖𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
+ 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑜𝑟
− 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑠
4. Subtract cash interest, or payments made to debt holders
in cash.
5. Subtract cash payments for income taxes
= 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥𝑒𝑠 + 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑟
− 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

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Depreciation Methods

Straight-line method recognizes an equal amount of 𝐶𝑜𝑠𝑡−𝑅𝑉

Where RV is Residual or Salvage Value
depreciation each period. 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒
Double Declining Balance (DDB) Method - 2
Appropriate when the asset generates more benefits in = ∗ (𝑐𝑜𝑠𝑡 − 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)
𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
the early years. Depreciation ends when value= RV.
Units of Production Method - Calculates depreciation (𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑟𝑒𝑠𝑖𝑑𝑢𝑎𝑙/𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒)
based on asset usage instead of time. 𝑥 𝑜𝑢𝑡𝑝𝑢𝑡 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
𝑙𝑖𝑓𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡 𝑢𝑛𝑖𝑡𝑠
Intangible Assets - Most intangible assets are amortized using the same straight line method (similar to depreciation for tangible
assets). Intangible assets with indefinite lives, however, are not amortized (e.g. Goodwill). These should be tested for impairment at
least annually, & any impairment should be recognized as an expense on the income statement. Reevaluation (reversal) only
permitted in IFRS.

Cash Conversion Cycle: = 𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 + 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 − 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠

Activity Ratio Inverse Activity Ratio

𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 Days of sales 𝑎𝑣𝑔 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
Receivables turnover
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 outstanding (DSO) 𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
𝐶𝑂𝐺𝑆 Days of inventory on 𝑎𝑣𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Inventory turnover
𝑎𝑣𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 hand 𝐶𝑂𝐺𝑆
𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 365
Payables turnover # Days payable
𝑎𝑣𝑔 𝑡𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
𝑟𝑒𝑣𝑒𝑛𝑢𝑒 Close to industry avg is good. Too low = too much capital
Total asset turnover in assets, too high = future capex needed or too few assets
𝑎𝑣𝑔 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
to support sales
𝑟𝑒𝑣𝑒𝑛𝑢𝑒
Working capital turnover Working capital = current assets – current liabilities.
𝑎𝑣𝑔 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Inventory
COGS - 𝐶𝑂𝐺𝑆 = 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 − 𝑒𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 . Inventory costs are capitalized (expense recognition
is delayed until the asset is sold). The method for which we account for inventory will thus affect COGS/ending inventory and ratios
FIFO – First-in, first-out is an inventory method where the first item purchased is the first item assumed to be sold. Thus the early
inventory is what is used to calculate COGS. FIFO is most appropriate for perishables and limited shelf-life inventory.
LIFO – Last-in, first-out is an inventory method where the last item purchased is the first item assumed to be sold, i.e. the last
inventory purchased is used to calculate COGS. LIFO is most appropriate for non-deteriorating inventory. Only OK under GAAP.
Specific Identification – Only used if a firm knows which specific items are sold and which remain in inventory
Weighted Average Cost Method - Does not rely on any inventory flow. It takes the cost per unit as an average (total cost/# of units)
to determine COGS and ending inventory.

LIFO vs. FIFO

𝐹𝐼𝐹𝑂 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝐿𝐼𝐹𝑂 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝐿𝐼𝐹𝑂 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 Where the 𝐿𝐼𝐹𝑂 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 = 𝐹𝐼𝐹𝑂 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 − 𝐿𝐼𝐹𝑂 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
In an INFLATIONARY, price-rising environment (P↑)…
LIFO FIFO
 Increases COGS, net profit ↓  Decreases COGS, net profit ↑
 Income taxes ↓  Income taxes ↑
 Value of ending inventory ↓  Value of ending inventory ↑
LIFO: ↑ P, ↑ LIFO COGS, ↓ NI, ↓ ending inventory, ↓ current ratio, ↑ inventory turnover
In a DEFLATIONARY, price-falling environment (P↓)…
LIFO FIFO
 Decreases COGS, net profit ↑  Increases COGS, net profit ↓
 Income taxes ↑  Income taxes ↓
 Value of ending inventory ↑  Value of ending inventory ↓
LIFO: ↓ P, ↓ LIFO COGS, ↑ NI, ↑ ending inventory, ↑ current ratio, ↓ inventory turnover
LIFO Liquidation - When a company sells its older, lower-cost inventory while no
longer purchasing newer, higher cost inventory. Can cause a LARGE but temporary
increase in profitability (& decrease cash flow due to larger tax liabilities).

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LIFO vs. FIFO – Ratios
When we compare LIFO vs. FIFO we need to understand the impact of the assumption on both the numerator and denominator. If the
numerator ↑ while the denominator ↓ we know the ratio will INCREASE. If the numerator ↓ while the denominator ↑ we know the
ratio will DECREASE. If the changes move in the SAME direction the ultimate affect is inconclusive.

In an inflationary, price-rising environment (P↑) with stable or increasing inventories…

Profitability ratios:
 Will be LOWER under LIFO because COGS higher
Liquidity ratios:
 Lower inventory values with LIFO, meaning current assets
↓,With lower current assets, current ratio and working capital
LOWER
 The quick ratio will not be affected b/c it excludes current
assets
Activity ratios:
 Inventory turnover will be HIGHER under LIFO since COGS
is higher & inventory will be lower. Since inventory turnover
↑, days of inventory ↓ (365/inventory turnover)
Solvency ratios
 Under LIFO, total assets will be LOWER since
inventory is lower. This results in lower stockholder’s
equity (E = A- L) and will lead to HIGHER
Debt/Equity and debt ratios

Inventory Net Realizable Value

 Under IFRS inventory recorded on balance sheet at the LOWER of cost or net realizable value (NRV). If NRV < value of
inventory on BS, inventory is written down, and an impairment loss is recognized on the income statement. Subsequent
recovery allows to write back up to the original value.
 Under GAAP inventory is recorded on the balance sheet at the LOWER of cost or market value. If replacement cost > NRV,
record MV as the NRV on the BS. If the replacement cost < NRV minus a normal profit margin, then MV is NRV minus a
normal profit margin and Inventory is written down to MV on BS.

Profitability Calculations & Metrics

Profitability Ratios
Return on Assets 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
(ROA) 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 For 2nd ROA equation we add back interest expense to NI b/c it
Return on Assets 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑖𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒(1 − 𝑡) accounts for returns to both equity and debtholders
(ROA #2) 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
Operating return 𝐸𝐵𝐼𝑇 (𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒)
Includes tax and interest
on assets 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
Return on total 𝐸𝐵𝐼𝑇
If ratio is too low this is sign of trouble
capital 𝑎𝑣𝑔 𝑡𝑜𝑡𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
Return on Equity 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
If ratio is too low this is sign of trouble
(ROE) 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
Return on 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 Different than ROE b/c only measures accounting profit available
Common Equity 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 to common. Usually broken down using DuPont equation

DuPont Analysis –Breaks down the drivers of ROE to more precisely identify sources of a firm’s profitability. Notice we always
end with ROE = NI/equity.

Traditional 3-Part DuPont Model Sources of Low Profitability

Profit margin is low, asset turnover is low, and/or firm
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑠𝑎𝑙𝑒𝑠 𝑎𝑠𝑠𝑒𝑡𝑠 has too little leverage.
𝑅𝑂𝐸 = ( )( )( )
𝑠𝑎𝑙𝑒𝑠 𝑎𝑠𝑠𝑒𝑡𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
Extended DuPont Equation The Five Components of the Extended Model
1. Tax burden
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝐸𝐵𝑇 𝐸𝐵𝐼𝑇 𝑠𝑎𝑙𝑒𝑠 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 2. Interest burden
𝑅𝑂𝐸 = ( )( )( )( )( )
𝐸𝐵𝑇 𝐸𝐵𝐼𝑇 𝑠𝑎𝑙𝑒𝑠 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 3. Operating margin
4. Asset turnover
Note the first 3 terms are decomposing the 1st term from the 3 part 5. Financial leverage
model, and the last 2 terms are identical

Sustainable Growth Rate - How fast a firm can grow w/o any additional sources of capital while holding leverage constant.
𝑔 = 𝑅𝑅 𝑥 𝑅𝑂𝐸 (Where RR = the retention rate) RR is calculated in several different ways:

𝑁𝐼 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛−𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠

(1) 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 1 − 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 Or (2) 𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑁𝐼 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛
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Calculating EPS
We can use both Basic EPS and Dilutive EPS depending on the capital structure of the firm. Dilutive securities are defined as anything
that would decrease EPS if exercised. Antidilutive securities are the opposite—they would increase EPS. A simple capital structure
has no dilutive securities & contains only common stock, nonconvertible debt, & nonconvertible preferred stock. A complex capital
structure contains potentially dilutive securities such as options, warrants, and convertible securities.

Basic EPS Diluted EPS

[𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑝𝑟𝑒𝑓 ] + 𝐷𝑐𝑜𝑛𝑣 𝑝𝑟𝑒𝑓 + 𝑐𝑜𝑛𝑣 𝑑𝑒𝑏𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡(1 − 𝑡)
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑔 𝑠ℎ𝑎𝑟𝑒𝑠 + 𝑠ℎ𝑎𝑟𝑒𝑠 𝑓𝑟𝑜𝑚 𝑐𝑜𝑛𝑣 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 +
𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑔 # 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑠ℎ𝑎𝑟𝑒𝑠 𝑓𝑟𝑜𝑚 𝑐𝑜𝑛𝑣 𝑜𝑓 𝑑𝑒𝑏𝑡 + 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑎𝑏𝑙𝑒 𝑓𝑟𝑜𝑚 𝑠𝑡𝑜𝑐𝑘 𝑜𝑝𝑡𝑖𝑜𝑛𝑠

Taxes
Deferred Tax Liability (DTL) - A DTL is created if taxable income < pretax income. Treat DTL as equity if not expected to reverse.
Deferred Tax Asset (DTA) - A DTA is created when taxes payable > income tax expense. Recognize a valuation allowance if DTA
is not expected to be realized.
𝐼𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 + ∆𝐷𝑇𝐿 − ∆𝐷𝑇𝐴

Creation of DTA or DTL

 Using accelerated depreciation for tax purposes and straight-line depreciation for the financial statements – results in lower
actual taxes paid in the early years (creates a DTL)
 An impairment occurring where the write-down is recognized immediately but the deduction on taxes is not allowed until
asset sold (creates a DTA)
 Restructuring that leads to costs being recognized for financial reporting upon announcement where they are not deducted for
tax purposes until paid (creates a DTA)
 Inventory-cost flow methods (not LIFO) may cause a temporary mismatch
 Pensions and deferred compensation are recognized for financial reporting immediately but not deducted for tax purposes
until actually paid (creates a DTA)

Bond Issuance & the Balance Sheet

Effective Interest Rate = 𝐵𝑉 𝑎𝑡 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 𝑥 𝑏𝑜𝑛𝑑 ′ 𝑠 𝑦𝑖𝑒𝑙𝑑 𝑎𝑡 𝑖𝑠𝑠𝑢𝑎𝑛𝑐𝑒
Bond @ Par/Premium/Discount – At par, BV on balance sheet constant over life of bond. At discount (premium) BV will increase
(decrease) over life of bond & effective interest increases (decreases) as we amortize the discount (premium). Proceeds from issuance
are classified as CFF, the interest payments are in CFO (or CFF under IFRS), and the final payment is under CFF.
Derecognition of Debt – If a firm retires debt at maturity the book value and face value are the same and no G/L is recognized.
However, when bonds are redeemed before maturity any G/L is calculated as the BV of the liability – the redemption price,
unamortized issuance costs are written off and included in the G/L calculation, and G/L from debt redemption are included in net
income and need to be removed before calculating any metrics centered on a firm’s day-to-day operations.

Capitalizing vs. Expensing Long-Lived Assets

Capitalizing the cost of an asset

means adding it to the balance
sheet as an asset and then
allocating the depreciation cost of
the asset on the income statement
over the life of the asset. The
exception is land and goodwill
which are assumed to have
indefinite lives.

Expensing an asset means

recording it as an expense on the
income statement in the period in
which it is incurred.

Capitalizing will smooth out

earnings and lead to higher NI
in early years and lower NI in
later years. Expensing has the
opposite effect.
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Leases
Potential benefits for leasing include (1) cheaper financing, (2) lower risk of obsolescence, (3) flexible/customizable financing, it is (4)
off-balance sheet (leading to more favorable leverage ratios), and (5) possible tax advantages.

An operating lease is a rental agreement. No asset or liability is reported by the lessee (and no transfer of A/L occurs from the lessor).
The periodic interest payments by the lessee are just categorized as rental expense in the income statement. A financing lease, or
capital lease, is basically a debt-financed purchase of an asset. The lessee adds equal amounts to both their assets and liabilities on the
balance sheet. Over the life of the lease they will recognize depreciation expense on the asset and interest expense on the liability.

Classify as a Financing Lease if…

Lessee perspective: If substantially all the rights and risks of ownership are transferred to the lessee then the lease is treated as a
finance lease. A lessee generally prefers the operating classification because no liability needs to be reported.
Lessor Perspective: If any of the finance lease criteria are met, if the collectibability of lease payments is reasonably certain, and if the
lessor has substantially completed performance.

Ratios w/ Finance vs. Operating Lease:

All ratios are worse when the lease is
capitalized. Only improvements are:

 Higher EBIT (interest not

subtracted when calculating
EBIT),
 Higher CFO (because principal
repayment classified as a CFF),
 Higher net income in the later
years (int + depreciation < lease
payment).

Defined Benefit and Defined Contribution Pension Plans

Defined contribution plan - Retirement plan where firm matches the dollar contributions of employees into a retirement account.
There is zero investment risk for the company. Only Financial Statement effect is pension expense in current period.

Defined benefit plan - Firm makes periodic payments to its employees based on their years of service/ending salary etc. The liability
therefore rests with the firm, and the company is responsible for investment risk and returns. Firm records net pension asset/liability
on B.S. NPA/NPL consists of (1) Employees’ service costs (on income sheet as pension expense), (2) Net interest expense (on income
sheet as pension expense), and (3) remeasurements, which are actuarial G/L (on OCI – not amortized under IFRS).

Miscellaneous Financial Statement

Conservative vs. Aggressive Accounting - The estimates a firm uses and the way it records things on its financial statements can affect
its profitability ratios. There is usually a trade-off between recognizing income in the current period (aggressive) and deferring it for
later periods (more conservative)

Aggressive vs. Conservative Accounting Practices

Aggressive
 Using straight-line depreciation
 Capitalizing current period costs
 Lengthening estimate of useful life of
depreciable assets
 Increasing estimate of salvage values
 Delaying recognition of impairments
 Taking smaller valuation allowances on
DTAs
Conservative
 Using accelerated depreciation methods
 Expensing current period costs
 Lowering estimate of useful life of
depreciable assets
 Decreasing estimate of salvage values
 Early recognition of impairments
 Larger valuation allowances on DTAs

Management may have various motives to treat revenue and expenses a certain way including the way they are compensated and their
reputation in the industry.

Low quality or fraudulent financial reporting usually stems from a combination of motivation, opportunity, and
rationalization. This is more likely when:

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Fraud is more likely when Characteristics of A Strong Regulatory Framework
 Registrations requirements for newly traded securities
 There are weak internal company controls with an established review process
 The board of directors fails to provide oversight  Disclosure requirements including periodic reporting
 Relevant accounting standards provide significant and (management) notes
discretionary latitude  Independent auditing
 Penalties for fraud are minimal or nonexistent  Mandated management commentary on the reports &
sign-off
 Enforcement mechanisms
Private (debt) agreements can also impose discipline as these third parties will have incentive to monitor the firms quite closely
Financial Statement Warnings Signs… Aka What an Analyst Should Pay Attention To
Warning signs regarding revenue recognition Other warning signs regarding capitalization, cash flow, etc.
 Out of line revenue growth vs comparable companies  Capitalizing costs when other comparable companies
 Decreasing receivables turnover over multiple are expensing them
accounting periods  A CFO ratio < 1 or consistently declining net income
 Decreases in asset turnover, especially when a  A depreciation method / useful life estimate out of line
company is growing via acquisition with the industry
 Changes in the revenue recognition method  Classifying expenses as non-recurring
 Use of bill-and-hold transactions or barter transactions  Gross margins out of line with industry
or channel stuffing  Minimal disclosures and financial footnotes
 Inclusion of non-operating items or significant one-  Management appears fixated on earnings reports
time sales in revenue
Warning signs regarding inventory
Falling ↓ inventory turnover ratios, LIFO liquidation in order to lower COGS for the current period (during inflationary periods), or
Inventory growth that is out of line with industry benchmarks

Traditional credit analysis involves focusing on: character, collateral, capacity, & conditions. Financial statement analysis can help
with examining the capacity to pay by looking at

1. Scale & diversification – larger companies & more diverse product lines are better credit risks
2. Operational efficiency – ROA, operating margins, EBITDA margins. The higher the margins the better the debt ratings
3. Margin stability – More stable profit margins indicate a higher probability of repayment whereas margins that fluctuate make
lenders wary
4. Leverage – Coverage ratios of operating earnings, EBITDA, FCF to interest expense or total debt are the highest weighted
part of credit formulas. The higher earnings are relative to debt the lower the credit risk.

Corporate Finance
Net Present Value in Capital Budgeting - NPV is the PV of Internal Rate of Return - Solving for IRR is actually a process
future CFs minus the initial cash outlay: of guesswork. The general formula (don’t memorize) is:
𝑁 𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁
𝐶𝐹𝑡 𝐼𝑅𝑅: 0 = 𝐶𝐹0 + + +⋯
𝑁𝑃𝑉 = ∑ − 𝐶𝐹0 (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)2 (1 + 𝐼𝑅𝑅)𝑁
(1 + 𝑟)𝑡 If IRR > r accept project. Note that if IRR = r then NPV = 0.
𝑡=0

Decision Rule Any IRR you enter/return on your calculator corresponds to the
We accept a project if NPV > 0 and reject if NPV < 0. frequency of the cash flows. If you have semi-annual cash flows
the IRR you get is a semi-annual IRR.
Decision Rule- Just as you would undertake a project if it’s NPV > 0, you would undertake a project whose IRR > a hurdle rate,
where that hurdle rate is usually defined as the cost of funds. If you have to choose between mutually exclusive projects, always
select the one with the higher NPV. NPV and IRR can give conflicting answers. This is a result of different initial costs and the
timing of cash flows. The sooner cash flows occur the higher an IRR will be, even if the ultimate NPV is lower.
Compare/Contrast NPV & IRR – NPV is based on an external, market-determined discount rate (r). It assumes r stable over time
& doesn’t consider NPV relative to the size of the project. IRR is easy to understand. It assumes that cash flows reinvested at IRR.
Independent projects have cash flows that are unrelated to one another
Mutually exclusive projects are in direct competition with one another.
Project sequencing occurs when investing in a project today creates futures opportunities to invest in additional opportunities. In
case the project turns out unsuccessful today, the firm will not invest in the subsequent project.
Unlimited Funds vs. Capital Rationing – With unlimited funds a firm can undertake all positive NPV projects. With capital
rationing the firm has to prioritize projects in order to maximize NPV and thus shareholder value.
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Basic Principles of Capital Budgeting
 Decisions based on incremental CF not accounting income
 We consider after-tax cash flows based on opportunity costs
meaning we ignore sunk costs & think on the margin
 The timing of CFs is critical. 1 positive of NPV calc. is that it
considers TVM
 The discount rate in the calculation takes into consideration
the firm’s cost of capital or WACC. If a project is riskier than
avg a discount rate > WACC should be used
 Externalities are important. One such is cannibalization,
which is where a new project or product takes revenue away
from an existing product.
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Types of Capital Budget Projects
 Replacement projects – Projects to maintain the business
are usually made w/o detailed analysis (except for cost
reduction/enhancement replacement projects )
 Expansion projects – Projects to increase the size of the
business are complex and require detailed projections of
future demand
 New Product / Markets – Lots of uncertainty, detailed
analysis
 Mandatory Projects – Often mandated by
governments/insurance, these may not be revenue generating
 Other – Pet projects or moonshots

Payback Period
The payback period is the number of years it takes to recover the initial cost of an investment. The shorter the payback period the
better. The discounted payback period uses the PV of a project’s estimated CFs to recover its initial investment. It is always longer
than the payback period. Drawbacks: Does not take into account cash flows beyond the payback period and doesn’t discount them
(simple payback). Since it doesn’t take into account the terminal value it doesn’t actually measure profitability & is less directly
related to the share price. NPV is more popular in US, payback more popular in EU & with private companies. CPT-NPV and then key
down to PB and DPB and hit CPT again to see the payback period and discounted payback period.
𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑁𝑃𝑉
The profitability index (PI) is the PV of a project’s CFs ÷ by the initial cash outlay: 𝑃𝐼 = = 1+
𝐶𝐹0 𝐶𝐹0

WACC
The weighted cost of capital (WACC) measures a firm’s cost of capital. It consists of the weighted average of the various types of
capital a firm can use to finance its operations—debt, preferred stock, and equity. WACC is also used as the discount rate applied to a
firm’s cash flows within a capital budgeting project. WACC is upward sloping: the more a firm borrows the higher WACC will
become.
𝑾𝑨𝑪𝑪 = 𝒘𝒅 [𝒌𝒅 (𝟏 − 𝒕)] + 𝒘𝒑 𝒌𝒑 + 𝒘𝒆 𝒌𝒆
𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ 𝑊𝐴𝐶𝐶 𝑐ℎ𝑎𝑛𝑔𝑒𝑠
A break point happens anytime a firm’s WACC changes =
𝑤𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒
Levering & Unlevering Beta (Pure-play Method)
1. Using the marginal tax rate and D/E from a comparable company unlever that beta to get our asset beta:
1
𝛽𝐴𝑆𝑆𝐸𝑇 = 𝛽𝐸𝑄𝑈𝐼𝑇𝑌 ∗
𝐷
1 + [ (1 − 𝑡 ) 𝐸 ]
2. Re-lever the asset beta using the marginal tax rate and D/E ratio for the firm considering the project:
𝐷
𝛽𝑃𝑅𝑂𝐽𝐸𝐶𝑇 = 𝛽𝐴𝑆𝑆𝐸𝑇 [1 + ((1 − 𝑡) )]
𝐸

3. Use the CAPM to estimate the required ROE for the project & calculate the WACC using that return for the cost of equity

Cost of Debt: The interest rate we use for kd uses the bond’s yield to maturity (YTM). If the market price cannot be reliably estimated
we can also use the yield on similarly rated bonds with similar durations

Calculating Cost of Equity

𝐷𝑝𝑠
Cost of Preferred Stock: 𝑘𝑝𝑠 = Where 𝐷𝑝𝑠 = the dividends on preferred stock & P is the price of a preferred share
𝑃

Various Ways of Estimating the Cost of Common Stock

Capital Asset Pricing Model (CAPM)
𝑟𝑒 = 𝑟𝑓 + 𝛽(𝑟𝑚 − 𝑟𝑓 )
Dividend Discount Model (DDM)
𝐷𝑖𝑣0 (1 + 𝑔)
𝑃0 =
𝑘𝑒 − 𝑔
Bond Yield + Risk Premium
𝑘𝑒 = 𝑏𝑜𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
Where:
re = required return on equity; rf = risk-free rate; rm = the market return
β = The stock market beta
(rm-rf) = The equity risk premium (ERP)
Where:
P0 is the intrinsic price or value of the security
D0 is this year’s dividend (always remember D0 vs. D1
g is the sustainable growth rate and is equal to (1-dividend payout)*ROE
ke is the discount rate (cost of equity)
Historical (ERP) Method, Survey method, or multifactor model* can also be used
*𝐸(𝑅) = 𝑟𝑓 + 𝛽1 (𝑟𝑖𝑠𝑘 𝑓𝑎𝑐𝑡𝑜𝑟1 ) … 𝛽𝑁 (𝑟𝑓𝑛 )
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Country Risk Premium
If we are accounting for different company risk we can adjust the CAPM by adding in a country specific risk premium:

𝑟𝑒 = 𝑟𝑓 + 𝛽[(𝑟𝑚 − 𝑟𝑓 ) + 𝐶𝑅𝑃
Leverage
Leverage is the amount of fixed costs a firm has. Greater leverage = more variability in after-tax earnings and net income, i.e. more
risk / susceptibility to downturns and the need to use a higher discount rate.

 Operating leverage - The degree to which a company uses fixed costs in its operations. The higher the % of fixed costs, the
higher the company's operating leverage. For companies with high operating leverage, a small ∆ in company revenues will
result in a larger ∆ in operating income since most costs are fixed rather than variable.
 Financial leverage is the degree to which a company uses debt or preferred equity. The more debt, the higher the interest
payments, and the lower earnings per share. The more preferred equity the higher the preferred dividend payments, and the
lower EPS. Both mean higher risk to common equity holders.

Degree of Operating Leverage (DOL) Degree of Financial Leverage (DFL)

DOL is the %∆ in operating income (EBIT) DFL is the ratio of the %∆in net income (or EPS) from a %∆in earnings before
resulting from a given %∆ in sales. interest and taxes:

%∆𝐸𝐵𝐼𝑇 %∆𝐸𝑃𝑆 %∆𝑁𝐼 𝐸𝐵𝐼𝑇

𝐷𝑂𝐿 = 𝐷𝐹𝐿 = = =
%∆𝑠𝑎𝑙𝑒𝑠 %∆𝐸𝐵𝐼𝑇 %∆𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 𝐸𝐵𝐼𝑇 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
DOL for a given level of unit sales, Q is: or more in the weeds:
𝑄(𝑃−𝑉) 𝑆−𝑇𝑉𝐶
𝐷𝑂𝐿 = or 𝐷𝑂𝐿 = 𝑄 (𝑃 − 𝑉 ) − 𝐹
𝑄(𝑃−𝑉)−𝐹 𝑆−𝑇𝑉𝐶−𝐹 𝐷𝐹𝐿 =
𝑄 (𝑃 − 𝑉 ) − 𝐹 − 𝐶
The higher sales the lower the DOL. It has a
similar interpretation to elasticity. Companies that invest more in tangible assets have a higher DFL. If a company
is profitable, DFL ↑ , ROE ↑, and the rate of change of ROE is higher (think
about the assets/equity component of the DuPont formula)
Remember that DFL is not affected by the tax rate.
The Degree of Total Leverage measures the sensitivity of EPS to changes in sales. 𝐷𝑇𝐿 = 𝐷𝐹𝐿 ∗ 𝐷𝑂𝐿
If there are no fixed costs, DOL = 1, there is no operating leverage
If there are no interest costs, DFL = 1 (In a calculation if you plug zero in for fixed costs, DOL = 1. If you plug zero in for interest,
DFL = 1).

Breakeven Quantity of Sales - The quantity of sales at which Break Even Point
revenues equal total costs and net income is zero.

𝑓𝑖𝑥𝑒𝑑 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠 + 𝑓𝑖𝑥𝑒𝑑 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠

𝑄𝐵𝐸 =
𝑝𝑟𝑖𝑐𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

The higher the operating/financial leverage, the greater

(further right) the break-even point. The further from break-
even we go the greater the amplifying effect of the leverage.

Operating Breakeven Quantity of Sales

𝑓𝑖𝑥𝑒𝑑 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠
𝑄𝑂𝐵𝐸 =
𝑝𝑟𝑖𝑐𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Working Capital Management

Liquidity improves if a company can get its cash to flow IN faster, or OUT more slowly.

Primary Liquidity = Sources of cash used on a daily basis. These cash balances stem from selling goods, collecting receivables, &
effective cash management. Other sources of short-term funding can come from lines of credit and trade credit from other vendors.
Secondary liquidity – Comes from liquidating assets, renegotiating debt agreements, filing for bankruptcy and reorganizing the
company. Tapping into secondary sources of liquidity can indicate a deteriorating financial position / affect normal operations.

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Drags on liquidity
Things that reduce/delay cash inflows or increase borrowing
costs:
 Uncollected receivables - ↑ outstanding, ↑ collection risk.
Measured using # of days receivable and % of bad debts
 Obsolete inventory - Takes a while to move and may
require price cuts. Signs include slow inventory turnover
ratios and higher overall inventory count
 Reduction in short-term credit
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Pulls on liquidity
Factors that accelerate the outflow of cash. This can include:
 Paying vendors too early – Forgoes ability to earn interest
for full period
 Reduction in credit limit – Usually via history of late
payment
 Limits in short-term lines of credit
 Low liquidity positions - Requires secured borrowing, often
due to poor credit history/high risk factors (see SPVs)

A company’s operating cycle is the # of days it takes to turn raw materials into cash from a sale.

𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑦𝑐𝑙𝑒 = 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

The cash conversion cycle measures how long it takes for a firm to turn its inventory into cash via sales (where cash is in the form of
collections). It is also called the net operating cycle:

𝑐𝑎𝑠ℎ 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑐𝑦𝑐𝑙𝑒 = (𝑎𝑣𝑔 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠) + (𝑎𝑣𝑔 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦) − (𝑎𝑣𝑔 𝑑𝑎𝑦𝑠 𝑜𝑓 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠)

Lower cash conversion cycles are GOOD. They indicate > cash generating ability. High conversion cycles are BAD. They indicate too
much investment in working capital.

Other Signs of Strong Working Capital Management

 Strong liquidity – Look for higher current ratios, higher quick ratios
 Inventory Ratios Close to Industry Norms

There is always a tradeoff to be struck between stricter credit terms and borrower creditworthiness and the ability to make sales.
Inventory levels that are too low may hamper the ability to sell and lead to lost sales while excessive inventory will tie up capital that
could otherwise be invested. It also increases the risk of losses from obsolescence.

Cost of Trade Credit

The cost of trade credit is used to evaluate whether a company should pay a vendor early to take advantage of any discount periods,
(e.g. paying within 15 days to get a 2% discount with 2/15 net 60 terms). Cost is evaluated as an annualized rate and is basically the
same equation as converting a short-term rate to an annualized one:

% 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 365⁄
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 𝑐𝑟𝑒𝑑𝑖𝑡 = (1 + ) 𝑑𝑎𝑦𝑠 𝑝𝑎𝑠𝑡 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 − 1
1 − % 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
Corporate Governance
Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. It defines the rights, roles,
and responsibilities of management, the board, and shareholders. The primary stakeholders of a corporation include shareholders, the
board of directors, senior management, employees, creditors, and suppliers.

Good corporate governance practices look to ensure that:

 The firm acts ethically and lawfully in dealing with shareholders

 The board of directors protects shareholder interests
 The board acts independently of management
 There are proper procedures for managing day-to-day operations
 The firm’s financial, operating, and governance activities get reported to shareholders accurately and in a timely fashion

Principal-Agent Problem
First and foremost, corporate governance is about solving the principal-agent problem. The principal-agent dilemma arises as a
result of asymmetric information between managers (agents) and shareholders (principals) where managers know more about the
business than the owners but may not always have perfectly aligned goals.

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Signs of an Effective Board
An effective board is independent, experienced, and has the necessary resources to act in the shareholder’s long-term interests. This
means that most of these should hold true:

 A majority of the board are independent members & the chairman of the board is NOT the CEO or former CEO
 If the chairman is not independent, then independent board members must have a leading role
 The board meets regularly without management
 Board members should not have primary alliances with stakeholders other than shareholders (e.g. management, customers,
suppliers)

Board Elections
 The greater the frequency the better (less cronyism). Tenure > 10 years may signal board member is too closely aligned with
management to be considered independent
 Staggered boards > annually elected boards
 Vacant positions filled with shareholder consent are preferred
 Whether shareholders can remove a board member
 Whether the board is the right size for the company’s stage and circumstances

The Various Board Committees – Audit, Compensation, Nomination

Audit Committee Compensation Committee

The audit committee ensures that financial information provided Independent board members should set the executive
to shareholders is complete, accurate, reliable, relevant, and compensation and link it to long-term performance &
timely. profitability

Best Practices Investors should pay attention to whether:

 The external auditor should be free of management influence
while Internal auditors should have unrestricted access to the
audit committee
 Independent board members on the audit committee
 Shareholders vote on the approval of the board’s selection of
external auditor * control the audit budget
 Auditors should have authority over firm’s
affiliates/divisions
Voting Rights
A shareholder should be able to have a proxy vote their interests.
Policies that make this difficult (e.g. requiring attendance at
annual meeting) limits the shareholders power to express their
views.
Note Cumulative voting is considered friendly to minority
shareholders.
 Compensation is within appropriate ranges
 Loans or company property have been made available to board
members
 The compensation committee meets regularly
 Compensation details are disclosed to shareholders
 Whether the terms of the options granted are reasonable
Nomination Committee
The nominations committee is responsible for recruiting
qualified board members and preparing management succession
plans. It should also review performance, independence, skills,
and experience of existing members
Investors should: Judge the recruitment of board members over
several years, Analyze the criteria used to select new board
members, Compare the expertise of new candidates vs. existing
members, Evaluate the level of internal influence from
management in the process

Stakeholder mgmt. is managing company relations with

stakeholders and by having a good understanding of stakeholder Risks of poor governance include weak control systems, poor
interests. decision making, legal risk, reputational risk, and default risk.

Factors that affect stakeholder relationships:
 Communication and engagement with shareholders.
 Shareholder activism.
 Threat of hostile takeover and existence of anti-
takeover provisions.
 Company’s legal environment.
 Growth of firms that advise funds on proxy voting and
rate companies’ corporate governance
Good corporate governance can improve operational
efficiency and performance, reduce default risk, reduce the cost
of debt, improve financial performance, and increase firm value
ESG concerns can be integrated into portfolio construction
through negative screening, positive screening, best-in-class
investing, impact investing, and thematic investing.

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Portfolio Management
A portfolio perspective evaluates individual investments on the basis of how they impact the entire portfolio’s risk and return profile.
The key is to understand that diversification will reduce the amount of risk (standard deviation) of a portfolio.

Risk and Correlation: When adding additional assets to a portfolio the LOWER the correlation, the GREATER the diversification
benefit. If two assets have perfect negative correlation (one moves up 10% the other moves down 10%) we would eliminate all
portfolio risk. You can think about this algebraically using the portfolio standard deviation equation, where the last term demonstrates
the impact of changing correlations. So if assets were perfectly correlated (𝜌𝑎,𝑏 = 1) we’d get the max standard deviation.

𝜎𝑜𝑓 𝑎 2 𝑎𝑠𝑠𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = √𝑤𝐴2 𝜎𝐴2 𝑅𝐴 + 𝑤𝑏𝐵

2
𝜎𝐵2 𝑅𝐵 + 2𝑤𝐴 𝑤𝐵 𝜎𝐴 𝜎𝐵 𝜌𝑎,𝑏 ) 𝑤ℎ𝑒𝑟𝑒 𝐶𝑜𝑣(𝑅𝐴, 𝑅𝐵 ) = 𝜎𝐴 𝜎𝐵 𝜌𝑎,𝑏

𝑻𝒐𝒕𝒂𝒍 𝒓𝒊𝒔𝒌 = 𝒔𝒚𝒔𝒕𝒆𝒎𝒂𝒕𝒊𝒄 𝒓𝒊𝒔𝒌 + 𝒖𝒏𝒔𝒚𝒔𝒕𝒆𝒎𝒂𝒕𝒊𝒄 𝒓𝒊𝒔𝒌

Systematic risk is market-level risk (beta) that cannot be

diversified away. It is caused by things like GDP growth and
interest rate changes that affect the value of all risky securities.
The higher a company’s beta the greater its systematic risk.

Unsystematic risk, or company-specific risk, is risk that can

be diversified away in a portfolio (i.e. through diversification).
We are not rewarded for taking on specific risk because
diversification is free.

Mean Variance Optimization & Capital Asset Allocation Line

Mean Variance Optimization

For any given E(r) we can vary the weights of the portfolio to find the portfolio
that has the least amount of risk (lowest standard deviation). This portfolio is
known as the minimum variance portfolio.

The graph of all of the portfolios that have the lowest standard deviation for each
level of expected return make up the minimum variance frontier. ON the
minimum variance frontier, also known as the efficient frontier, the furthest left
point on the graph on the left is the global minimum variance portfolio.

The capital asset allocation line (CAL) represents all of the possible
combinations (weights) of a risk free asset and optimal risky-asset portfolios.
𝐸 (𝑅) = 𝑤𝐴 𝐸 (𝑅)𝐴 + 𝑤𝐵 𝐸 (𝑅)𝐵 .

CAL is the set of all possible efficient portfolios. If investors have different
expectations of e(r), 𝜎, or 𝜌 they will each have a different CAL. The Y-intercept
is the minimum return of the risk-free asset and the line runs to the point where
the entire portfolio is invested in the risky portfolio.

𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑒𝑡𝑢𝑟𝑛

Its slope = and 𝜎𝑃 = 𝑤𝐴 𝜎𝐴
𝜎𝑃

Beta - Beta measures the sensitivity of an asset’s return to the return on a market index.
𝐶𝑜𝑣𝑖,𝑚 𝜎𝐴 𝜌𝐴,𝑀  Overall market has a beta = 1
𝛽= 2 =  Higher Beta = higher sensitivity to systematic/market factors
𝜎𝑀 𝜎𝑀  Beta often measured using least squares regression
 Since 𝐶𝑜𝑣(𝑅𝑖, 𝑅𝑚 ) = 𝜎𝑖 𝜎𝑚 𝜌𝑖,𝑚 we can substitute that in for
Be able to substitute between 𝜷, covariance, correlation Covariance
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Capital Market Line (CML) vs. Securities Market Line (SML)
Capital Market Line (CML)
The Capital market line (CML) is the specific instance of the
CAL where we define the risky portfolio as the market portfolio.
The CML shows expected portfolio return as a linear function of
portfolio risk:
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Securities Market Line (SML)
The SML models the tradeoff between systematic risk (Beta) and
expected return. The difference between the SML and CML is
that we use the SML when we are not talking about the market
portfolio. SML is built on the CAPM Model:

𝐸(𝑅)𝑀 −𝑅𝑓 𝐸(𝑅)𝑃 = 𝑅𝑓 + 𝛽 (𝐸(𝑅𝑀 ) − 𝑟𝑓 )

𝜎𝑝 : 𝐸(𝑅)𝑃 = 𝑅𝑓 + 𝜎𝑝
𝜎𝑀
The SML uses systematic risk, or Beta, on the x-axis. It is the
The CML uses total risk on the x-axis. If investors are borrowing, graphical representation of the CAPM model.
they are investing in the market portfolio using margin and the
weight of their risky portfolio will be > 100%.
Investors who believe markets are informationally efficient will tend to follow a lower-cost passive strategy (Beta)
Investors who believe markets are NOT informationally efficient will follow a higher-cost active strategy (Alpha)

Assumptions of the CAPM Model

 Investors are risk averse
 Investors are utility maximizing
 Markets are frictionless – no taxes, transaction costs (it is
free to diversify)
 All investors have the same single period time horizon
 All investors have homogenous expectations for e(r), 𝜎, and
correlation
 All investments are infinitely divisible
 Markets are competitive – Investors take price as given & no
investor has the ability to impact that market price

Overvalued & Undervalued Securities

 If the E(r) > required return, security is undervalued
 If the E(r) < required return, security is overvalued
 If the E(r) = required return the security is fairly valued

Risk Adjusted Performance Metrics

If the portfolio is fully diversified or invests across multiple managers
then systematic risk measures (Alpha, Treynor) and the SML are more
appropriate. If there is a high degree of specific risk or a fund uses
only one manager then total risk measures (Sharpe ratio, M2 ) are more
appropriate

Be able to identify portfolios that are inefficient according to CML, high and
low beta portfolios on the SML, & the types of risk on the SML/CML

Summary of Risk Adjusted Performance Metrics

Measure Formula Notes
Systematic Risk Measures
Systematic risk measure
Jensen’s ex-post alpha ∝𝑃 = 𝑅𝑎𝑐𝑡𝑢𝑎𝑙 − 𝑅𝑝𝑟𝑒𝑑𝑖𝑐𝑡𝑒𝑑
Positive alpha = plot above SML
𝑅𝑃 − 𝑅𝐹 Excess return over systematic risk
Treynor Measure = Treynor > Treynor of SML portfolios = portfolio lies above SML
𝛽𝑃 Will have same relative ranking as Jensen’s ex-post alpha.
Total Risk Measures
𝑅𝑝 − 𝑟𝑓 Measures excess returns to total risk. Appropriate if normally distributed
Sharpe Ratio = If SP > SCML it will plot above the CML
𝜎𝑃 Alpha if SP > SM
𝑅𝑝 − 𝑟𝑓 Measures the value-add or lost relative to the market if the portfolio has
Modigliani & Modigliani
= 𝑅𝐹 + ( )𝜎𝑀 the same TOTAL risk as the market
M2 𝜎𝑃 If positive value portfolio lies above the CML

Market Model: 𝑅𝑖 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑚 + 𝑒𝑖 Where: 𝑅𝑖 = return on the asset, 𝛼𝑖 = the intercept, 𝛽𝑖 is the slope, 𝑅𝑚 is the market return and 𝑒𝑖
= any abnormal return on the asset
Fama & French - Multifactor return model that uses three variables: Firm Size, Book Value/Market Value Ratio, and Excess Market
Return. The Carhat Model adds Price Momentum as a factor to the Fama & French model.

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The Investment Policy Statement (IPS)
The IPS is a living document that defines the client/advisor relationship and sets clear objectives and constraints on the portfolio in order
to develop a strategic asset allocation (SAA) that is unique to each investor. The IPS should be reviewed annually or changed whenever
a major change in circumstances could affect risk-return objectives or portfolio constraints.

Portfolio Planning and Construction

The portfolio management process involves 3 steps: Planning (creating an IPS), Execution (asset allocation and risk/return analysis),
and Feedback (portfolio monitoring and rebalancing).

Risk Governance determines the organization’s goals and
priorities, outlines a firm’s risk appetite in order to define what
types of risk are and are not acceptable, and oversees the risk
management function. Good Risk Governance:
 Establishes the maximum loss a firm could face
 Provides clear guidance to management
 Appoints a chief risk officer
 Establishes a risk management committee
Risk tolerance measures the extent to which an organization is
able and willing to suffer losses.
Risk Budgeting is about allocating firm resources to business
or investment activity based on the different risk profiles of each
activity.
Financial Risks: market, credit, and liquidity risk
Non-financial Risks: operational, settlement, model, sovereign,
regulatory, and accounting/legal/contract risk

Investment Objectives
Risk can be measured on a relative basis against a benchmark or on an absolute basis.
Risk tolerance depends on both your willingness to take risk and your ability to take risk.
1. Willingness and Ability are different.
a. Willingness is about your attitude & beliefs about asset types (it’s a more subjective criteria)
b. Ability is about your financial ability—do you have low liquidity needs, longer time horizon, a secure job, more
assets saved? If yes, that indicates a higher ability
2. When there is a conflict between the willingness and ability always go for the most conservative option.

Investment Constraints – RRTTLU

 Taxes – Investors tax rate, taxable/retirement accounts, and specific asset taxes
 Time horizon – Longer time horizon, more ability to take risk
 Liquidity – Lower liquidity/spending needs, more ability to take risk
 Legal – Any legal issues/constraints, e.g. can’t buy particular type of asset
 Unique constraints – Catch all for preferences. Can include ethical considerations, religious ones

Institutional Investors & Their IPS Constraints

Type of Investor Risk tolerance Time horizon Liquidity Needs

Individuals Depends Depends Liquidity for life events, retirement
Endowments &
High Long Little liquidity needs outside of planned spending
Foundations
High: Seeks to earn a spread between loans/investments and
Banks Low Short
deposits
Long for life
Need to fund claims as they happen, Life insurance has longer
Insurance companies Low insurance
time horizon and more risk tolerance than P&C insurers
Short for P&C
Mutual funds / Sovereign Mutual funds manage funds in accordance with a particular
Depends Depends
wealth funds style or region, SWFs are government
Defined benefit pensions Moderate-to-High Long Must meet retirement benefits of employees

Mutual Funds & Other Pooled Investments

Mutual funds combine funds from many investors into a single portfolio that is invested in a specified class of securities or to match
a specific index. Examples: money market funds, bond funds, stock funds, and balanced (hybrid) funds. Open-ended trade at NAV,
whereas closed-ended funds have a fixed number of shares that trade at a price determined by the market.
ETFs are similar to mutual funds, but investors can buy and sell ETF shares in the same way as shares of stock. Management fees are
generally low, though trading ETFs results in brokerage costs.
SMAs are portfolios managed for individual investors who have substantial assets. In return for an annual fee based on assets, the
investor receives personalized investment advice.
Hedge funds are skill-based strategies that can offer both higher absolute and risk-adjusted returns depending on the choice of
strategy. These are available only to accredited investors and are exempt from most reporting requirements.

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Buyout funds involve taking a company private by buying all available shares, usually funded by issuing debt. The company is then
restructured to increase cash flow.
VC funds invest in and provide advice plus expertise to the start-ups.

Equity
Market Organization and Structure
Markets are informationally efficient when the price of securities quickly, fully, and rationally adjusts to new information. Statistically,
we’d say that security prices are an unbiased estimator of their true value. In other words:

1. The price is right: Asset prices reflect all available info and prices adjust instantaneously to incorporate that information
2. There is no free lunch: Since prices adjust immediately it is not possible to get an informational advantage and therefore earn
above-average returns. No alpha is consistently possible

If markets are efficient there should be no risk-adjusted returns possible from trading on publically available information. Thus an
efficient market favors a passive investment strategy over a more expensive active strategy.

Factors Driving an Efficient Market

 A high number of market participants
 More Information, More Widely available
 Low barriers to trading - If a pricing discrepancy leads to an arbitrage opportunity, the ability for market participants to buy/sell
and take advantage will force prices closer to their intrinsic value
 Low Transaction / Information costs – If the cost of obtaining information or actually buying / selling securities is higher than the
potential mispricing of a security than deviation from the intrinsic price can persist

Challenges to the Efficient Market Hypothesis

Traditional finance is built on the assumptions of rational individuals, perfect information, and efficient markets that quickly absorb
new info. Behavioral finance theories modify these models by relaxing certain assumptions. BF acknowledges that people aren’t
economic machines. We are weird. We don’t always act rationally. We make mistakes in processing things. On top of that, perfect
information doesn’t exist. It’s impossible to know everything about everything at all times. This means that there are informational,
cognitive, and emotional challenges to the theory of efficient markets.

Modifications to the Efficient Market Hypothesis (EMH)

Definition Implications Significance
Prices reflect all past price and Charts/technical trading will
Weak Form Fundamental Analysis can lead to alpha
volume data not lead to excess returns
Prices reflect all past price and Charts/technical trading AND
Semi-Strong Insider info can lead to alpha, generally
volume data AND all public fundamental analysis will not
Form should favor passive strategy
information lead to excess returns
Prices reflect all past price and
Strong-Form volume data and all public AND No excess returns possible No alpha possible, favor a passive strategy
nonpublic information
Even in strong-form efficient markets a portfolio manager can add value by managing risk, asset allocation, and minimizing taxes.

Leverage
Leverage Factor = 1/margin percentage
Levered return = Holding Period Return x leverage factor
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡
Leverage ratio = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 In practice this is often the share price divided by the initial margin requirement

The margin maintenance requirement is the minimum equity percentage an investor must maintain in their position. A margin call
occurs when the investor receives a request to contribute more capital to maintain the margin requirement.

1 − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑚𝑎𝑟𝑔𝑖𝑛
𝑀𝑎𝑟𝑔𝑖𝑛 𝑐𝑎𝑙𝑙 𝑝𝑟𝑖𝑐𝑒 = 𝑃0 ( )
1 − 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑚𝑎𝑟𝑔𝑖𝑛

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 − (𝑐𝑜𝑚𝑚𝑖𝑠𝑠𝑖𝑜𝑛 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡)

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 + 𝑐𝑜𝑚𝑚𝑖𝑠𝑠𝑖𝑜𝑛

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Types of Markets
1. Quote driven: Where investors trade with dealers (OTC). These tend to have high liquidity.
2. Order-driven: Where investors trade with other investors. More competition leads to better prices
3. Brokered-Markets: Where Investors use brokers to find counter-parties. Most valuable for illiquid securities (e.g. art)

Primary markets are the markets for newly issued securities. New shares are listed here when new companies IPO or when an already
trading company issues new shares.

Secondary markets are where securities trade once they have been issued. They provide liquidity and price information. The better the
secondary market, the easier it is for firms to raise external capital in the primary market, which results in a lower cost of capital for
firms with shares that have adequate liquidity.

Types of Orders
Execution Orders – How to trade (market vs. limit). There are two types of execution orders.

 Market orders are executed at the stated market price no matter what that price is. Thus a trader placing a market order
values speed and certainty of execution over price control.
 Limit orders are where the trader sets the desired price and waits for the market to hit that price (or not). Limit orders value
price control but sacrifice certainty of execution as a result.

Validity Instructions – When to trade (stop orders, fill-or-kill orders)

Clearing Instructions – How to settle trades

Index Construction
A security market index is a basket of securities picked to represent the performance of an asset class, index, or market segment. An
index will have an actual value ($ for each point in time)
A price index calculates the return using only prices (i.e. it ignores dividends).
A total return index uses both the price and income/distributions of the securities in the index to calculate return.

A good index will (1) reflect market sentiment, (2) be useful in benchmarking manager performance (3) help in building historical
estimates of sector risk for asset allocation, and (4) can be used to measure beta and risk-adjusted (excess) returns.

Different Methods of Constructing Indices

 Price Weighted Index - The arithmetic mean of the prices of index securities (𝑃1 + 𝑃2 + 𝑃𝑁)/(# 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠). Denominator
is adjusted for stock splits and the addition/deletion of stocks. Easy to compute but biases towards high priced stocks.
 Equal Weighted Index - The arithmetic average return of an index of stocks assuming that each stock is equally weighted.
Simple to construct but portfolio requires rebalancing as prices change, & larger weighted stocks are underrepresented relative
to MV.
 Market Cap / Value Weighted Index - An index whose weights are based on the market cap of each index stock as a
proportion of the total market cap of the entire index. Higher priced stocks are not over-represented, but large cap stocks are.
Can also lead to inclusion of over-valued/mature stocks and a concentration in industries that are over-represented by large
caps. Free-Float adjusted Market Cap index subtracts out shares that are not actually publically traded. Useful in a
developing market context where many shares are held by governments, corporations, or controlling shareholders who are
not seeking to trade.
 Fundamental Weighting - Fundamental weightings use firm fundamentals such as earnings, dividends, or cash flow to weight
the index. This type of weighting is NOT affected by share price and avoids the market-cap weighted index bias towards
overvalued stocks / away from undervalued stocks. In fact it will actually have a value tilt.

Rebalancing & Reconstituting

Rebalancing is the process of adjusting the weights of a portfolio in order to restore them to the target allocations. Rebalancing is most
necessary for equal-weighted indices as the changes in price over time will cause the weights of the securities to change from the initial
target. There is a trade-off between frequency of rebalancing and the cost of doing so.

Reconstitution is the process of adding or removing securities from an index. Securities are usually only removed if they no longer meet
the criteria which can be the result of bankruptcy, delisting, or more subjective judgement. Adding a security to an index tends to cause
price increases (as demand ↑). Removing a security from an index causes price decreases (as demand ↓).

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Types of Equity Indices
 Broad market index - Overall market performance (Wilshire
5000), usually contains 90%+ of a market’s total value
 Multi-market index – Combines multiple markets to build an
index for a geographic region (MSCI Emerging Markets)
 Multi-market index with fundamental weighting - Market-cap
level weighting within a country but fundamental weighting (e.g.
GDP) to weight the countries in the index to ensure high
performing stock markets are NOT overrepresented
 Sector index – Measures the returns for an industry, e.g.
healthcare, insurance. Very helpful for cyclical analysis and
evaluating portfolio managers who follow a specific sector
 Style index – Measures returns to an investment style, like value,
growth, or large-cap / small-cap. Since stocks often move
categories (like from growth to value). Style indices tend to have
higher turnover/rebalancing
Market Anomalies
 Calendar anomalies – There is a January effect which finds that
stock returns in the first 5 days of the year tend to be higher than
for the rest of the year
 Overreaction / Momentum effects – Firms with worse results
over the preceding 3-5 years tend to have better returns over the
next periods
 Size Effect – Small-caps tend to outperform large-cap stocks
 Value Effect – Value stocks tend to outperform growth stocks
 Close-ended funds – Trading prices can sometimes deviate
from NAV
 Earnings announcements – Positive earnings surprises are
followed by periods of positive risk-adjusted post-
announcement stock returns and vice versa
 Initial Public Offerings – IPOs are typically underpriced, with
the offer price below the market price once trading begins
Industry Analysis & The Business Cycle
A cyclical firm has earnings that are highly dependent on the business cycle. They tend to have volatile earnings and high operating
leverage. Products tend to be expensive and/or non-essential (i.e. have high elasticity of demand). Industries include basic materials,
consumer discretionary, energy, financial services, industrials and tech.
A non-cyclical firm is relatively immune to the business cycle. It produces goods where demand is stable over time. Industries include
healthcare, utilities, & consumer staples.
Phases of the Business Cycle
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Creating a Fixed Income Index
There are many different types of fixed income securities and
just as many indices. These indices tend to have higher turnover
than equity indices and can be hard and/or expensive to
replicate.
Common factors / methods of building these indices include:
 By issuer
 By collateral
 Coupon
 Maturity
 Credit risk (investment risk vs. junk-bond/high yield)
 Inflation protection
Behavioral Finance Biases
 Loss aversion – when an investor feels greater pain for a loss
than pleasure at a gain of equal value
 Overconfidence bias – when you think you know more than you
do or when you have unwarranted faith in your abilities
 Herding behavior – doing what others do to avoid the
responsibility for the decision (can cause investors to over-
concentrate in low risk investments or well-known companies)
 Information cascades – when the first movers in a market
influence the subsequent actions of market participants
 Representativeness bias – using overly simple if-then or rule-
of-thumb decisions instead of thorough analysis
 Conservatism – when individuals hold onto previous
views/forecasts by inadequately incorporating new information
 Mental accounting – when individuals place wealth into
different mental buckets to meet different goals
 Narrow framing – when an investor focuses on issues in
isolation without considering the broader context
Characteristics of the Business Cycle Stages
Embryonic - Slow growth, High prices, Large investment into
product, High risk of failure
Growth - Rapid growth, low competition, falling prices,
increasing profitability
Shakeout - Slowing growth, high competition, industry
overcapacity, lowering profitability, more cost cutting, more
firms failing
Mature - Slow growth, consolidation, high barriers to entry,
stable pricing, competition over market share
Decline - Negative growth, falling prices, more consolidation
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Competitive Strategy
Porter’s Five Forces Determinants of Pricing Power

Barriers to entry – Higher barriers prevent new entrants

and allow incumbent firms to charge higher prices while
low barriers mean new firms can easily enter the market.
If barriers to entry are high but competition is steep within
existing firms (automobile industry) then pricing power
may still not be high.
Industry concentration – Concentrated market share does
not guarantee pricing power. This depends on the degree
of market share the competition has as well as the degree
of differentiation of the product
Degree of product differentiation – The greater the
differentiation the higher the pricing power of a firm and
the higher its potential return on capital
Industry capacity – The capacity of an industry directly
affects prices (think of the supply and demand curve).
Under-capacity, where demand > supply, creates pricing
power.
Stability of market share – Stable market share over time
indicates a less competitive industry and hints at more
pricing power
Switching costs – The higher the switching costs of
changing a product the more pricing power a firm will
have
Cost Leadership – Where a firm looks to be lowest cost producer in an industry to create enough volume to generate profits. This can
be used defensively to protect market share or offensively to gain market share. Predatory pricing is the practice of lowering costs
expressly to drive out competition with the hopes of raising them again after (this is often illegal).
Product Differentiation - A firm looks to differentiate its product against others in order to charge a premium for that product. Factors
of differentiation include type, quality, and method of delivery. This strategy requires creative execution and market research.
External Influences on Industry Growth, Profitability and Risk include: macroeconomic factors, demographic influences, technological
change, governmental factors, and social influences

Equity Valuation
Peer group is a set of comparable companies used in valuation analysis. It will generally have similar: business activities, demand
factors, cost-structures, and access to capital

Discounted Cash Flow (DCF) Models

Estimates the value of a stock as the PV of cash distributed to shareholders (dividend discount models (DDM) or the PV of cash
available to shareholders (free cash flow models)

Single Period DDM - The PV of any dividends received during 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑡𝑜 𝑏𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
the period plus the PV of the expected stock price at the end of 𝑃0 = +
the period, i.e. the terminal value. (1 + 𝑘𝑒 ) (1 + 𝑘𝑒 )
Multi-stage DDM - For a multi-year period we just sum the PV 𝐷1 𝐷2 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
of each dividend and the terminal value 𝑃0 = + 2 +
(1 + 𝑘𝑒 ) (1 + 𝑘𝑒 ) (1 + 𝑘𝑒 )2
Constant Growth (Gordon Growth) Model - Assumes that
dividends will grow at a constant annual growth rate (g) and is 𝐷𝑖𝑣0 (1+𝑔) 𝐷𝑖𝑣1
thus most applicable to mature, stable companies. Always pay 𝑃0 = or 𝑃0 =
𝑘𝑒 −𝑔 𝑘𝑒 −𝑔
attention to whether you are given D0 or D1
where: 𝑔 = (1 − 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜) 𝑥 𝑅𝑂𝐸

Free Cash Flow DDM - We often use FCFE in discounted cash ∞

flow models instead of dividends as it represents the potential 𝐹𝐶𝐹𝐸𝑡
𝑃0 = ∑
cash that shareholders could receive. Obviously it is much more (1 + 𝑘𝑒 )𝑡
useful for firms that don’t pay dividends. 𝑡=1
Price of Preferred Stock – Simplifies the DDM b/c preferreds 𝐷𝑝𝑠
have a fixed dividend which is the same for each period 𝑃= Where 𝐷𝑝𝑠 = the dividends on preferred stock
𝑟

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Relationship btwn required return and growth rate in DDM Assumptions of constant Growth/infinite DDM
 The model is very sensitive to changes in either 𝑘𝑒 or g  Dividends are right way to measure shareholder wealth
 As the difference between 𝑘𝑒 and g ↑, value of the stock ↓  The growth rate of dividends and the required rate of return
 As the difference between 𝑘𝑒 and g ↓, value of the stock ↑ will remain constant forever
 That 𝑘𝑒 > 𝑔 (if not the denominator is < 0 and the math
doesn’t work)
Free Cash Flow Models
FCFE is the cash available to a firm’s equity holders after it meets all its other obligations (defined as debt obligations and capital
expenditures needed to support the firm’s growth). FCFF measures cash available to the firm and ALL of its investors (debt and
equity) for discretionary purposes.

𝐹𝐶𝐹𝐸 = 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑓𝑖𝑥𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝐹𝐶𝑖𝑛𝑣 ) – debt principal
repayments + new debt issues
𝐹𝐶𝐹𝐸 = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 − 𝐹𝐶𝐼𝑛𝑣 + 𝑛𝑒𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔
𝐹𝐶𝐹𝐹 = 𝐶𝐹 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 − 𝑛𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠
𝐹𝐶𝐹𝐹 = 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + [𝐼𝑛𝑡 𝑥 (1 − 𝑡)] − 𝐹𝐶𝐼𝑛𝑣 − 𝑊𝐶𝐼𝑛𝑣
𝑭𝑪𝑭𝑬 = 𝑭𝑪𝑭𝑭 − [𝑰𝒏𝒕 𝒙 (𝟏 − 𝒕)] + 𝒏𝒆𝒕 𝒃𝒐𝒓𝒓𝒐𝒘𝒊𝒏𝒈

Market Multiplier Models

Apply a multiple to a given calculated ratio such as the P/E or P/B. Multipliers can either use fundamentals such as earnings, sales, book
value, or free cash flow or an enterprise value ratio.

 Leading Price-to-Earnings – P/E is the stock price ÷ by
forecasted EPS over next 12 months
 Trailing Price-to-Earnings – Stock Price ÷ EPS over last 12
months
 Price-to-Sales – P/S = The stock price ÷ by sales per share
 Price-to-Book – The P/B ratio is the stock price ÷ by book
value of equity per share
 Price-to-Cash flow – the P/CF ratio is the stock price ÷ by
cash flow per share, where CF can be operating CF or FCF

Justified P/E - Uses the Gordon Growth Model to give us the benchmark price at which a stock should trade (the numerator is the
intrinsic value in the Gordon growth model and we use next year’s earnings, E 1, to make this a leading indicator).

𝐷1
⁄𝐸  Higher payout ratio should increase P/E
𝑃0
Justified P/E = = 1  Lower required return should increase P/E
𝐸1 𝑘−𝑔  Higher growth rate should increase P/E

Asset based valuation models are based on the assumption that the fair value of a firm is the market value of its assets minus the market
value of its liabilities. Market values are often difficult to obtain, so analysts start with book value and then make adjustments. Most
reliable when firm has mostly tangible short-term assets and can be problematic if a firm has a lot of intangible assets (goodwill/brand).
In the latter case the asset-based valuation is used as a floor value.
Enterprise Value (EV) is what it would cost to acquire the entire firm. EV = 𝑀𝑉 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 & 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 + 𝑀𝑉 𝑜𝑓 𝑑𝑒𝑏𝑡 −
𝑐𝑎𝑠ℎ 𝑎𝑛𝑑 𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠. EV based ratios that are typically used for valuation include: EV/EBIT and EV/EBITDA, where
EBITDA is earnings before interest, taxes, depreciation and amortization.

Fixed Income
A bond’s price equals the PV of all of its future cash flows including repayment of the principal (face value or par value) at maturity.
The market rate, or required yield, is the rate of return required by investors given the investment risk of that bond issuance. The
riskier a lender (i.e. the worse their credit rating), the higher the yield they need to offer to compensate. The Price-Yield relationship is
convex.

Yield to maturity (YTM) is the IRR that makes the PV of future cash flows equal to the current market price.
YTM assumes: the investor holds the bond to maturity, the issuer does not default, and the reinvestment rate = coupon rate.

Solving for P or I/Y: The YTM is the market rate we use to discount the bond’s cash flows. If we know YTM we can calculate the
bond price and vice versa.

Types of Bonds & Structures: (1) A plain vanilla bond is a fixed rate bond, (2) a floating bond has a floating rate coupon that adjusts
its interest rates (these may have a floor or cap), (3) a zero coupon bond is issued at a discount to par.

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Bond Structures
 Bullet structures - Periodic interest rate payments are made over the life of the bond & the final payment includes both the last
interest rate payment and the principal (sometimes also called a balloon payment). Most bonds have this structure.
 Amortizing loans - Each periodic payment includes both interest and partial repayment of the principal (student loans, mortgages).
 Sinking fund provisions – Have provisions where the principal is paid off in a series of periodic payments. This reduces credit risk
to bondholders as the principal is reduced over time but increases reinvestment risk (if r ↓)
 Negative covenants – Describe things the company is prohibited from doing such as asset sales of collateral, specific investments,
and restrictions on borrowing more. Affirmative (positive) covenants – Describe what issuers are required to do e.g. insure assets.

Bond prices have an inverse relationship with interest rates How Prices Move over Life of a Bond
The price of a bond at maturity = its face value. As a bond
approaches maturity it will converge to its principal value.

Until Maturity:
 If the bond price = par value it is priced at par
 If the bond price > par it is trading at a premium
 If the bond price < par it is trading at a discount

Price & Duration

 A LOWER coupon rate bond will be MORE sensitive to
changes in yield than a higher coupon rate bond
The longer the duration of a bond the more sensitive the price is  A LONGER duration bond is MORE sensitive to a change in
to changes in the market interest rate. yield than a shorter duration bond, all else equal

Clean/Full Price
 Accrued interest is how much of the current coupon you’ve “earned (coupon payment x % of coupon period that has elapsed)
 The full price (or dirty price) is the price of a bond that factors in accrued interest
 The flat price = full price – accrued interest, and is usually the price quoted by dealers. It is also called the clean price.
 Matrix pricing is a pricing method used to calculate the YTM for thinly traded bonds using bond features (duration, credit quality
etc.) from frequently traded comparables.

Callable & Putable Bonds

Call Options – Callable bonds give the issuer the right (but not the obligation) to buy the bond at a specified call price.

o If r↓, P ↑ & the incentive for the issuer to call the bond at par increases (the price of a callable bond will not rise as quickly)
o If r ↑, P ↓, the price of a callable bond will not fall as much as that of a non-callable bond because the call option will become
less valuable (and the bondholder is short the call option)

Put options – Putable bonds give the bondholder the right (but not the obligation) to sell the bond back to the issuer at a specified
price. Because the put has value to the bondholder, putable bonds will sell at a discount.

Convertible bonds – Give the bondholder the right to convert their bond into a specified number of shares of common stock at a
specified conversion price. The conversion ratio = (# shares / conversion price). Exhibit both debt and equity characteristics.

Spot and Forward Rates

A forward rate is the current borrowing or lending rate for a loan to be made in the future. Think of the forward interest rate as the
discount rate that takes a single payment in the future and discounts it to another (nearer) time that is also in the future. Forward rates
are derived in a way that borrowing for three years at the 2-year spot rate should cost the same as borrowing for two successive one
year periods, i.e. there are no arbitrage opportunities. So a “2y1y” is the rate for a 1 year loan made two years from now.

(1 + 𝑆2 )2 = (1 + 𝑆1 )(1 + 1𝑦1𝑦)
Repos
A repurchase agreement (repo) involves one party selling a security to a counterparty with a commitment to buy it back at a later date
for a specified higher price where the difference in prices is effectively the interest the buyer is charging the seller. A buyer, i.e. the
lender, who enters a repo agreement will gain exposure to the credit risk of the seller. This means the interest rate they charge will
depend on their perception of that risk.

 Factors that increase/have positive relationship with the repo rate: length of term, credit risk of borrower, fed funds rate
 Factors that decrease/are inversely related to the repo rate: physical delivery, quality and scarcity of collateral
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Yield Spreads
Yield spread is the difference between the yields of two bonds, measured in bps. Usually it’s used to compare a bond’s YTM with the
YTM of a benchmark (often a government yield). The idea is that the benchmark yield captures macroeconomic factors while the
spread captures micro factors like credit quality, liquidity, etc.

 The Zero-volatility spread, or z-spread, is the constant spread that is added to each point on the spot-rate treasury curve
which will make the price of a security equal to the PV of its cash flows.
 The option-adjusted spread (OAS) adjusts the z-spread to remove the call option value:
𝑂𝐴𝑆 = 𝑧 𝑠𝑝𝑟𝑒𝑎𝑑 – 𝑐𝑎𝑙𝑙 𝑜𝑝𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒. Think of it as the part of the spread above the yield on a risk-free bond that is not
attributable to the effect of embedded options. The higher volatility, the lower the OAS.

Interest Rate Risk

Interest rate risk is the risk to a bondholder from fluctuating interest rates (i.e. r ↑, P↓). It has two components. Market price risk is
the uncertainty about the bond price due to fluctuations in the market YTM. Reinvestment risk is the uncertainty about the returns
earned from reinvesting coupon payments caused by changing yields.

 Investors with a short term investment horizon: Market price risk > reinvestment risk
 Investors with a long term horizon: Reinvestment risk > market price risk

These factors impact interest rate risk:

 Maturity - Longer maturity increases interest rate risk
 Coupon rate – An increase in coupon rate will decrease interest rate risk
 YTM – An increase (decrease) in a bond’s YTM will decrease (increase) interest rate risk
 Embedded options – Both put/call provisions decrease a bond’s interest rate risk as they reduce effective duration

Duration
Bond duration is a measure of interest rate risk. It measures the sensitivity of a bond’s (full) price to a change in its yield, all else
equal. We use duration to estimate the price change of a bond or portfolio of bonds given a change in interest rates assuming a parallel
shift in interest rates.

Macaulay duration is the weighted avg of the # of years until each of the bond’s promised cash flows is to be paid where the weights
are the PV of a cash flow divided by the PV of all cash flows.
Modified duration measures the percent change in a bond’s price for a 1% change in its yield to maturity. Modified duration is a
linear approximation & does not account for convexity. Thus it is a good estimate for small ∆𝑃 caused by small ∆𝑌𝑇𝑀 but gets worse
the larger the change in price or the more convex the curve:
𝑃− − 𝑃+
𝐷𝑀𝑜𝑑 =
2 ∗ 𝑃0 ∗ ∆𝑌𝑇𝑀
Effective duration also measures the % change in a bond’s price for a 1% change in its YTM. It can also account for changes in the
bond’s cash flows. Effective duration can thus be used for bonds with embedded options (like MBS) & floating rate bonds.

%∆𝑃 ≈ −𝐷𝑒𝑓𝑓 ∗ ∆𝑌𝑇𝑀

Factors affecting duration
 Time to Maturity – Time ↑ , D ↑
 Coupon rate – As coupon rate ↑, D ↓ (decreases weighted avg time)
 YTM – As YTM ↑, D ↓ (decreases PV of distant payments A LOT, and their % of the total PV decreases)
 Call (put) options decrease (increase) the ED of a bond

Key rate duration

Key rate duration, or partial duration, tries to capture the impact of non-parallel shifts in the yield curve in order to better account for
scenarios where the yield changes a different amount depending on the maturity of the bonds. It does this by measuring the sensitivity
of the value of a bond or bond portfolio to changes in the spot rate at specific maturities.

Portfolio duration: 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝑊1 𝐷1 + 𝑊2 𝐷2 + ⋯ 𝑊𝑖 𝐷𝑖

Dollar duration: 𝐷𝐷 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑚𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 ∗ 𝑓𝑢𝑙𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑜𝑛𝑑

Convexity
Convexity measures the curvature of a bond’s yield curve. We add convexity to measures of duration in order to improve estimates of
price changes caused by a change in yield.
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Using convexity to refine price impact of duration
𝑃− + 𝑃+ − 2𝑃0
𝐴𝑝𝑝𝑟𝑜𝑥 𝑐𝑜𝑛𝑣 =
𝑃0 ∗ ∆𝑌𝑇𝑀2
1
%∆𝑃 ≈ −𝐷𝑒𝑓𝑓 ∗ ∆𝑌𝑇𝑀 + ∗ 𝐶𝑜𝑛𝑣𝑒𝑓𝑓 ∗ ∆𝑌𝑇𝑀2
2
Asset Backed Securities (ABS)
An ABS is a security backed by a pool of loans or receivables & can include credit cards, consumer loans, auto loans, commercial
assets, and home equity loans (MBS = mortgage-backed). Most ABS’s are created using a special purpose vehicle (SPV) with the
primary reason for them being the ability to move an illiquid asset off the balance sheet & monetize the assets.

Prepayment risk
Prepayments are early or excess payments of the principal by the borrowers. The risk for pass-through securities (like MBS) is that they
must put this capital back to work causing substantial reinvestment risk. Since reinvestment risk is already higher with amortizing
securities (due to the inclusion of principal repayments in each payment) this is a major source of risk.

 Extension risk – the risk that prepayments will be slower than expected. Usually occurs when r ↑ & lender cannot reinvest at
higher interest rates

 Contraction risk – the risk that prepayments will be faster than expected reducing total interest paid. Often occurs when r ↓
(e.g. mortgage refinancings)

Tranches / Securitization
Tranching is the practice of creating different classes of holder of the security with different seniority of claims. The more junior tranches
are riskier and will absorb losses first (i.e. are subordinated), but must be compensated for this extra risk with higher yield.

Types of Tranches
A sequential pay CMO retires each class of bond sequentially. The principal amount depends on the CFs of the collateral and thus
depends on actual prepayments. A short tranche receives all principal payments (planned & prepaid) offering greater protection from
extension risk, while Tranche 2 only starts receiving principal payments once Tranche 1 is retired.

A PAC tranche essentially has priority over all other support tranches when it comes to receiving exactly the amount of specified
principal payments. The greater certainty for the PAC tranche means the support tranches have greater CF uncertainty (they have both
greater extension and contraction risk).

Residential Mortgage-Backed Securities (RMBS) Commercial Mortgage-backed Securities (CMBS)

In the U.S. mortgage-backed securities can be agency or non-agency. Think
of agency as high-quality mortgages and non-agency as all the rest. Credit
risk is more important for non-agency RMBS and they will often have credit
enhancements built in as a result.
Assumptions about Prepayment Rates for MBS
SMM - Single Monthly Mortality is the % reduction in the outstanding
principal caused by prepayments over a 1 month period.
CPR – Conditional Prepayment Rate is an annualized SMM
PSA Benchmark – A monthly series of annual CPRs that assumes that
prepayments increase as the mortgage pool ages (becomes seasoned). PSA
100 is the norm. A PSA of 40 means the prepayment level is only 40% of the
benchmark.
Other Asset-backed Securities
Auto-loan ABS: Auto loans are collateral. Usually 3-5 year amortization
Credit Card ABS: Backed by pool of non-amortizing credit card debt. Have
lockout period.
CDOs: Collateralized debt obligations are any security backed by a
diversified pool of one or more debt obligations (bonds, bank loans, MBS,
ABS, or other CDOs are the collateral).
Backed by income producing real estate (apartments,
warehouses, shopping centers). Rely on tenants and
customers paying their leases to provide the CF-so the
specific risks depend on the type of tenants & their
risk factors. Most CMBSs are have significant call
protection (protection against prepayment risks).
All CMBS are nonrecourse loans. The lender can only
look to the collateral to repay the loan. Risk analysis
focuses on the credit risk of the property:
Debt-to-service coverage ratio (DSC) – The basic
CF coverage ratio. The higher the ratio the better for
the lender:
𝑛𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝐷𝑆𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝑑𝑒𝑏𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒
Loan-to-value ratio (LTV) – The lower the LTV
ratio the better for the lender
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑎𝑚𝑜𝑢𝑛𝑡
𝐿𝑇𝑉 𝑟𝑎𝑡𝑖𝑜 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑝𝑝𝑟𝑎𝑖𝑠𝑒𝑑 𝑣𝑎𝑙𝑢𝑒

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Credit Analysis
Credit risk is the risk of a borrower failing to make timely or full payments. Credit risk has two facets—default risk and loss severity.
Default risk is the probability of default; loss severity is the % of value lost if a default occurs; the expected loss = default risk x loss
severity. The recovery rate is 1 – the expected loss %.

The 3 Components of Credit Risk The 4 Cs of Credit Analysis

1. Default risk – The risk of an issuer failing to make timely
interest or principal payments
2. Downgrade risk – The risk that a bond’s credit rating will
be downgraded, reducing its market value
3. Credit spread risk – The risk that credit spreads will widen
(narrow), decreasing (increasing) the market value of a bond
Credit Ratings (Moody’s, S&P, Fitch)
Investment Grade – Baa/BBB- or higher
Non-investment grade (junk) – Ba/BB+ or lower
Notching - Adjusting the rating on a specific bond issue relative
to the overall rating given to the issuer
 Capacity – The ability of the borrower to repay its debt
obligations. Capacity analysis focuses on (1) industry
structure, (2) industry fundamentals, and (3) company
fundamentals
 Collateral – Assessing the market value of collateral, more
important for less creditworthy issuers
 Covenants – The terms (affirmative/negative covenants)
that borrowers and lenders have agreed to
 Character – Management’s integrity, commitment, &
strategy for repaying the loan

Debt can be either secured or unsecured, both can be further ranked as senior or subordinated.

Order of seniority: First lien or first mortgage, Senior secured debt, Junior secured debt, Senior unsecured debt, Senior subordinated
debt, Subordinated debt, Junior subordinated debt. All debt in the same class is pari passu, (same priority on claims).

Internal credit enhancements include overcollateralization, excess spread, and junior tranches.
External credit enhancements include surety bonds, letter of credit, bank guarantees

Derivatives
A derivative is a security that derives its value from another security or asset. Think of a derivative like insurance. Its purpose is to
transfer risk from one party to another (they can also have lower transaction costs & other efficiencies). The buyer of a derivative is
long the position, the seller of a derivative is short the position

 Criticisms of derivatives – Risky & complex, especially for uneducated investors; highly leveraged payoffs lead some to
view them as “gambling” and subject to abuse by speculators
 Benefits of derivatives – Better info, lower costs, enhanced risk management - provides price discovery/information, allow
risk to be managed and shifted between parties, reduce transaction costs (higher liquidity & lower physical cost)
 Exchange-traded derivatives – Standardized contracts backed by a clearinghouse, and as such provide higher liquidity and
increased protection to investors
 OTC derivatives – Created via an informal network of market participants, where each participant hedges their specific risks
by finding counterparties with the opposite set of concerns and then creating offsetting transactions

The law of one price – Two assets with the same guaranteed future cash flows should have the same price due to arbitrage. With
derivatives if there is a guaranteed payoff, then the return must equal the risk free rate, i.e. we can replicate the position:

𝑙𝑜𝑛𝑔 𝑟𝑖𝑠𝑘𝑦 𝑎𝑠𝑠𝑒𝑡 + 𝑙𝑜𝑛𝑔 𝑑𝑒𝑟𝑖𝑣𝑎𝑡𝑖𝑣𝑒 = 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑒𝑡𝑢𝑟𝑛.

Forward/Futures Contracts
A forward contract is where one party agrees to buy and a counterparty agrees to sell an asset at a specified price on a specific date in
the future. Assuming no carrying or storage costs, the future price of an asset, 𝐹0 (𝑇), is the spot price (𝑆0 ) compounded at the
opportunity cost of invested funds—assumed to be 𝑟𝑓 :
𝐹0 (𝑇) = 𝑆0 (1 + 𝑟𝑓 )𝑇

The value of a futures or forward contract 𝑉0 (𝑇) at inception is zero:

𝐹0 (𝑇)
𝑉0 (𝑇) = 𝑆0 − =0
(1 + 𝑟𝑓 )𝑇
That value then fluctuates as the prices of the underlying asset change over the life of the contract. If the expected future price goes up
(↑) over the life of the forward contract, the right to buy the asset at the pre-specified lower price becomes more valuable (long has
positive value). At any given time the long or short position may have a gain equal to the other’s loss (zero-sum game). Remember
that no cash changes hands at the inception of most futures forward contracts.
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Factors affecting the futures vs. spot price: Holding an asset can have either positive or negative value to the holder.
 Negative: If you have to store an asset (like gold) it will have storage costs. Storage costs increase the futures price to reflect
a premium for avoiding the cost of holding the underlying asset.
 Positive: Holding an asset can also be convenient and this convenience yield serves to increase the value of the spot rate and
decrease the futures price. Mathematically we add or subtract the net PV cost/benefit from the spot rate.

Forward & Futures Price

A futures contract is a standardized and exchange-traded forward contract facilitated/backed by a clearinghouse. Compared to a
forward contract a futures contract: (1) is less customizable, (2) is more liquid, (3) does not face counterparty (default) risk, and (4) is
regulated by the government. Gains and losses on futures contracts are settled every day, which lead to gains and losses in the margin
account that, in the case of gains, can be withdrawn and used elsewhere. Forwards are not marked-to-market. Thus:

 If positive correlation exists between interest rates and futures prices: Futures price > Forward price
 If negative correlation: Forward price > Futures price
Swaps
A swap is an OTC contract in which two parties agree to exchange a series of CFs based on a notional principal on periodic settlement
dates for a set length of time (tenor) with no payment at the start of the contract. At each settlement date the payments are netted (only
one party is making a payment). Most swaps are used to convert fixed interest payments into floating & vice versa.

Options
Buying an option contract gives the owner the right, but not the obligation, to either buy or sell the underlying asset at a given price
(exercise/strike price) within a set amount of time. An option is said to be in the money when the option value is positive for the buyer.
It is at the money when the strike price = the market price and out of the money when it is less. Options are a zero-sum game.

 Call option – The right to buy the asset American options can be exercised at any time up to the
 Put option – The right to sell the asset expiration date. European options can only be exercised on the
 You can be either long or short a call or put. A long call is contract’s expiration date. Their values will be equal unless the
equivalent to a short put right to exercise before maturity has a positive value which is
 You buy a naked call when you expect the stock to rise (fall) only true if the underlying asset has cash flows (like dividends).
 You buy a naked put when you expect the stock to fall American call option price > European call option price on
assets with CFs
If you (1) know these facts, (2) can ±premiums, and (3) know the basic positions for each strategy (i.e. what you are long and short) that’s all you
need to answer 95% of any exam questions. Don’t freak out about the payoff diagrams & equations in the readings.

Factors Affecting an Option’s Value

Underlying Time to Holding
Increase in  Exercise Price Volatility Holding costs
price expiration Benefits
Puts Decrease Increase Increase Increase* Decrease Increase
Calls Increase Decrease Increase Increase Increase Decrease

Put-Call Parity
Put-call parity is a relationship defining how the price of a European put option and European call option on the same asset are related.
We use a protective put and fiduciary call to construct the equation, where a protective put is a long position in a stock (S0) and a
long position in a put (P0) and a fiduciary call is a long position in a call (C0) and a long position in the risk free asset (r f). We assume
the puts have the same exercise price (X) and time to expiration:
𝑋
𝑆0 + 𝑃0 = 𝐶0 +
(1 + 𝑟𝑓 )𝑡

You can rearrange the equation to solve for any variable and create a synthetic position (equivalent payoffs):
𝑋
𝑆𝑦𝑛𝑡ℎ𝑒𝑡𝑖𝑐 𝐿𝑜𝑛𝑔 𝐸𝑞𝑢𝑖𝑡𝑦: 𝑆0 = 𝐶0 − 𝑃0 + 𝑡
(1 + 𝑟𝑓 )
Put-call forward parity is a put-call parity relationship derived using a forward contract on the underlying asset rather than the asset
itself (substitute out S0 in our put-call relationship). The idea is that when the contract settles at time T the long must purchase the
asset for F0(T) and in order to guarantee they have that amount they need to invest in a discount bond at time, t = 0 that will pay F 0(T)
at maturity (T).
𝐹0 (T) 𝑋
𝑡 + 𝑃0 = 𝐶0 +
(1 + 𝑟𝑓 ) (1 + 𝑟𝑓 )𝑡

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Binomial Models
A binomial model gives us the probability of a stock moving up or down, as
well as the magnitude of the up and down moves over one period. We use
them to price the value of a call today.

Once we have/calculate those variables (the size of a down move equals 1/the
size of the up move) we can use a tree diagram to calculate the expected value
at payoff (as the probability weighted average) and then discount that value to
today at the risk free rate.

1. Calculate the size of the up / down moves

2. Find the probability weighted average using a tree diagram
3. Discount the value back to today using rf as the discount rate

Credit derivatives (credit default swaps-CDS and credit spread options) provide protection to the buyer from a downgrade or default
from a borrower.

Forward Rate Agreements (FRA)

What: An FRA is a derivative contract based on interest rates and set according to an agreed upon notional principal (NP). Think of
it as an agreement to enter into two loans in the future—one short, one long—where one is a fixed rate loan and the other is a floating-
rate loan. So a 3 x 12 FRA is an agreement to enter into two 9 month loans starting three months from now.

Why/How Used: FRAs are often used by firms to hedge risk/remove uncertainty about future borrowing and lending.

 If a firm plans to borrow in the future that means it is (most likely) taking on a future floating rate liability. Taking a long
position in an FRA (pay fixed, receive floating) will lock in a maximum interest rate.
 A firm planning on lending in the future can take a short position in an FRA (pay floating, receive fixed) to hedge their interest
rate risk. A decline in rates will reduce the return on funds loaned but the FRA payoff would offset that decline.

Payment & Solving: FRAs are netted so that only one party will pay the other based on the difference between the specified interest
rate and the market interest rate on the settlement date at the beginning of the loan period. The long FRA position receives floating,
pays fixed, the short FRA position receives fixed, pays floating

1. You are given the fixed-rate and floating-rates at the beginning of the loan period, m months from today
2. Discount the net payment from the END of the loan (n) to the beginning (n-m months from today)
3. Always discount at the market rate, which is the floating-rate
4. If rate given is LIBOR, that rate is a nominal rate, and you calculate the monthly rate as the annual rate x (n-m)/12
5. Determine if you are receiving the fixed or floating payment to determine the right sign (+,-) of the payoff.

Alternatives
Basic characteristics of alternatives:
 Low liquidity – Have a liquidity premium and > E(r).  High due diligence costs and other fees
 Diversification benefits – Low correlation with equities/fixed  Hard to benchmark performance or compare across
income. Portfolio diversification single main reason to invest. benchmarks
 Less regulation & information disclosure  May have higher use of leverage and derivatives
 Problematic historical return and volatility data  Unique legal issues and tax treatment

Bottom line: Alternatives require more due diligence and are less suitable for some investors (i.e. those who are less sophisticated or
have higher liquidity needs). Alternatives are suitable for those who have sufficient wealth, do not have any immediate liquidity needs
they cannot meet, and are sophisticated.

5 Major Alternative Asset Classes

 Real estate – Includes direct property ownership and indirect via vehicles
 Commodities – Owning physical commodities, derivatives, or equity of commodity producing firms
 Private Equity – Includes LBO funds and venture capital
 Hedge Funds – Many strategies, usually leveraged and use derivatives
 Other – Tangible assets like art or collectibles, as well as patents and intangibles
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Types of Hedge Fund Strategies
HF strategy Definition
Buy undervalued convertible securities, short stock. Earn interest based on bond yield and short-sale.
Convertible Arbitrage Benefits from greater volatility (the value of the call option on the bond increases). Managers add
leverage when yield curve is upward sloping
Distressed Securities Long only. Capitalize on inefficiency in distressed marketplace.
Emerging Markets Long only, invest in emerging market securities.
Equity-Market Neutral Uses pairs trading (buy undervalued, short overvalued) to eliminate systematic risk
Hedged Equity Similar to equity-market neutral, but manager can keep net exposure long or short
Fixed Income Arbitrage Long/Short fixed income positions based on expected changes in yield curve
Global Macro Focus on industries/region vs. individual security selection
Merger Arbitrage Focus on investing ahead of potential mergers (deal arbitrage), spin-offs, take-overs etc.
Diversify investments across multiple managers/strategies. Good beginner entry to Hedge Funds, but
Fund of Funds
extra layer of management incurs more fees. Can also be subject to style drift.

Survivorship bias is an upward bias in investment results that occurs when only surviving firms report their results (i.e. all the ones
that failed because of poor results aren’t included). This is most common with hedge funds.

Backfill bias also biases results upwards. It occurs when successful managers decide to add their investment results to a benchmark.

PE vs. VC
Private equity (PE) involves ownership in a non-publically traded private company. Buyout funds typically purchase a public company
and take it private, often financed with a significant amount of debt (leveraged buyout). The goal is to restructure & improve operating
efficiency, increase cash flow, pay down debt, issue dividends, and then resell for a higher value. Signs a company is a good target for
PE:
 Willing management  Strong and sustainable cash flows
 A depressed or low stock price  Low leverage
 Inefficient companies where restructuring is possible  High amount of physical assets

Venture Capital funds typically invest in earlier stage companies and take a minority position. The goal is the eventual IPO or sale of
the business. Compared to PE this is an even higher risk/higher reward strategy.

Fees for Hedge Funds, PE, and VC

Most GPs are paid an annual fee for committed capital of 1-2% plus performance based carried interest. Carried interest is taken as a
percentage cut, traditionally 20%, of a fund’s profit. This is the common term 2 & 20 (2% management fee, 20% performance).

As you might imagine LPs are concerned about the nature of this profit, and will often structure provisions to try to protect themselves.
One provision is setting a hurdle rate, or minimum level of return, the fund must clear before any profits are distributed to the GP.
Another common provision is a high-water mark which sets clawback provisions that force a GP to repay profits if the fund’s value
subsequently falls back below a certain threshold.

Real Estate
Real estate investments can be either direct or indirect. Direct investments include owning a home, owning commercial property, or
owning (agricultural) land. Indirect exposure to real estate is more diverse and more liquid. It can consist of owning development
companies, REITs, a commingled real estate fund (CREF), or infrastructure funds.

Pros of Real Estate Investing Cons of Real Estate Investing

 Low correlation with equities  High information costs (due diligence)
 Low volatility of returns  High commissions to purchase/sell
 Good inflation hedge  Asymmetric information (for direct)
 Can support a lot of leverage  Illiquid (especially direct strategy)
 Property expenses are tax deductible  Indivisible (geographic/political risk)
 Direct control of properties  High operating costs
 Geographic diversification is possible  Location risk (idiosyncratic risk)
Note, some of these pro/cons apply more to direct real estate (e.g. indivisible, illiquid, high purchase costs) & asymmetric info

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Valuing Direct Real Estate

Comparable sales Values real estate based on sales of recent properties, adjusted for specific characteristics like square footage,
approach age, number of bedrooms, location etc.
𝑁𝑂𝐼
Estimates the real estate value as
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒
Income approach Where Net Operating Income (NOI) = income from the property minus operating expenses (taxes, utilities, &
repairs) but before depreciation, finance cost, & income tax. Capitalization rate = discount rate - growth rate
Cost approach Estimates the replacement cost of a property as the cost of the land and today’s cost of rebuilding the home

Valuing REITS using Income-based and Asset-based valuation

Income-based valuation Asset based valuation

 Similar to direct cap approach in that we use a measure of income
divided by the cap rate  Calculates a REIT’s NAV
 We use Funds from operations (FFO) or Adjusted FFO as measure of  NAV = MV Assets – MV liabilities
net income  REIT shares may fluctuate above or below
 FFO = NI + Dep ± G/L sales of property NAV in trading
 AFFO = FFO – recurring capex (it’s basically free cash flow)

Commodities
Commodities are physical products like oil, metals, agricultural products etc. Investment can be direct via ownership of the physical
commodity or via derivatives/futures or it can be indirect which involves investing in companies whose main business is tied to
commodities. With the indirect approach you need to be careful that the firm does not fully hedge its exposure to the underlying asset;
with the direct approach you need to be aware of actual storage costs. The key benefits of commodities are: (1) high liquidit y, (2)
diversification via low correlation with stocks/bonds and (3) inflation hedge IF storable & correlated with economic activity.

Calculating a Commodity Return

𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 ≈ 𝑆𝑝𝑜𝑡 𝑝𝑟𝑖𝑐𝑒(1 + 𝑟𝑓 ) + 𝑠𝑡𝑜𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠 − 𝑐𝑜𝑛𝑣𝑒𝑛𝑖𝑒𝑛𝑐𝑒 𝑦𝑖𝑒𝑙𝑑

 The higher the storage cost the greater the benefit of not holding the asset and being able to buy it.
 The convenience yield is any non-monetary benefit that comes from holding a commodity. For example, if I am an airline
company, I may get some convenience and de-risking of my business by holding actual oil. This decreases FP.

Backwardation and Contango

Contango is where: Spot price < Futures

price (CRAP, Contango)

Backwardation is where Spot Price >

Futures price (occurs where there is a high
convenience yield)

Sources of return on a commodity futures contract

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑠𝑝𝑜𝑡 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝑐𝑜𝑙𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝑟𝑜𝑙𝑙 𝑟𝑒𝑡𝑢𝑟𝑛

The spot return is the price return on the underlying commodity over the life of the contract. In other words it is the change in the
spot price of the commodity between the time you purchased the contract and its expiration. So if you buy a 1 year futures contract
giving you the right to buy oil for $45/barrel and its spot price in 1 year is $65/barrel, the spot return is $20/barrel.

Collateral return is the risk free rate of return you earn because a futures contract does not require payment until the expiration of the
contract (this is true of all futures contracts). It’s the periodic risk free return, or the equivalent return you’d make earning cash. So just
like with cash, higher interest rates increase the collateral yield and lower interest rates decrease it.

Roll return is the return that comes from rolling a futures contract forward at expiration into a new contract. It is equal to:

𝑟𝑜𝑙𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 = ∆𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 − ∆𝑆𝑝𝑜𝑡 𝑝𝑟𝑖𝑐𝑒

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Roll return can be either negative or positive depending on the term structure of commodity prices. It will be negative when
markets are in contango, which means the futures price is greater than the spot price (think crap, contango!). Roll return will be
positive when markets are in backwardation, which is where the FP is lower than the spot price.

Infrastructure investing refers to investments in long-lived, capital intensive assets that are publically used – e.g. toll roads, bridges.
Infrastructure investments can be brownfield investments, which refers to investing in existing infrastructure or greenfield
investments, which refers to investing in infrastructure that is yet to be built.

Benefits of Investing in Infrastructure Risks of Investing in Infrastructure

 Stable income/cash flow  Uses leverage
 Low correlation with other assets  Cash flow risk
 May offer some inflation protection  Operational or construction risk
 Long-term cash streams may match the time  Regulatory risk – Often publically important
horizon of institutional investors projects are subject to heavy government
regulation

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