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ETHICAL AND PROFESSIONAL STANDARDS

ETHICAL AND PROFESSIONAL STANDARDS IV(C) Responsibilities of Supervisors Annuities

Supervisors are responsible for reasonably Annuity: a finite set of level sequential cash flows
I(A) Knowledge of the Law
preventing subordinates’ violations but are not Ordinary: cash flow at end of time period
Obey strictest law that applies. Do not associate
responsible for subordinates’ behavior. Due: cash flow at beginning of time period
with law-breakers.
Perpetuity: cash flow continues forever and starts

V(A) Diligence and Reasonable Basis
I(B) Independence and Objectivity one period from now
Exercise diligence and thoroughness. Support
Do not offer gifts that might affect someone’s PVKLM = PVN?KOPQ?R (1 + r)
actions with research and investigation.
independence and objectivity. Refuse gifts or FVKLM = FVN?KOPQ?R (1 + r)
disclose to appropriate parties. V(B) Communication with Clients and PMT
PVSM?SMTLOTR =

Prospective Clients r
I(C) Misrepresentation
Make appropriate disclosures. Distinguish between Solve using TVM keys on BA II Plus.
When using an outside source, cite it. Do not
fact and opinion when presenting investment Means
promise investment returns.

analysis and recommendations. Arithmetic:
J
I(D) Misconduct
1
V(C) Record Retention Population mean, µ = Z X O ; N = population size
Do not commit fraud. Personal issues that reflect N
Develop and maintain records to support work and O\]
poorly on professional image are a violation. P
communications with clients. 1

a = Z X O ; n = sample size
Sample mean, X
II(A) Material Nonpublic Information
n
VI(A) Disclosure of Conflicts O\]
Understand what “material” and “nonpublic” Geometric:
Disclose matters that may impair your
means. Do not act or cause others to act on a
independence and objectivity. X b = BcX] X d … X P , where X O ≥ 0 for i = 1, 2, … , n
material nonpublic information. k

VI(B) Priority of Transactions 1 + R b = c(1 + R] )(1 + R d ) … (1 + R P )
II(B) Market Manipulation Harmonic:
Execute clients’ transactions before your own.
Information-based and transaction-based N
a
Xl = , where X > 0 for i = 1, 2, … , n
manipulations are not allowed. VI(C) Referral Fees J
∑O\]
1

Disclose referral fees to clients and employer. XO
III(A) Loyalty, Prudence, and Care

Clients come first. Treat clients’ investment like VII(A) Conduct as Participants in Percentiles
y
your own but with higher priority. CFA Institute Program Location of y Tp percentile, LR = (n + 1)

100
Do not compromise CFA Institute’s reputation. If LR is not an integer, use linear interpolation.
III(B) Fair Dealing
Do not share exam details.
Treat all clients fairly. Communicate investment
Quartiles: divide distribution into quarters
recommendations and changes simultaneously. VII(B) Reference to CFA Institute, the CFA Quintiles: divide distribution into fifths

Designation, and the CFA Program Deciles: divide distribution into tenths
III(C) Suitability
Do not misrepresent or exaggerate CFA Institute
Use a regularly updated IPS during investment Mean Absolute Deviation
membership, designation, or candidacy.
decisions. Choose suitable investments in a
]
a|
MAD = ∑PO\]|X O − X
P
portfolio context.

Variance and Standard Deviation

III(D) Performance Presentation QUANTITATIVE METHODS
QUANTITATIVE METHODS J
1
Do not misrepresent past performance. Do not Population variance, σd = Z(X O − µ)d
Required Rate of Return N
promise future performance. O\]
interest rate = real risk-free rate P

1
III(E) Preservation of Confidentiality + inflation premium Sample variance, s d = a)d
Z(X O − X
n−1
Keep client’s information confidential unless: client required interest rate + default risk premium O\]

is involved in illegal activity, you are legally required interest rate + liquidity premium Standard deviation is square root of variance
required, or you have client permission. required interest rate + maturity premium Coefficient of Variation
CV = s⁄aX; measures dispersion relative to mean
IV(A) Loyalty Effective Annual Rates
Put employer’s needs first. Understand EAR = (1 + periodic rate)< − 1
responsibilities when leaving employer. Consult EAR = 𝑒𝑒 ?@ABCDBEAEF − 1

employer before taking on outside employment.

Future Value (FV) and Present Value (PV)
IV(B) Additional Compensation Arrangements FV = PV(1 + r)J
Obtain employer’s written permission before
receiving cash or perks. If applicable, obtain other
party’s permission.

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Skewness Counts ways to choose r items from n where order Data Used in the Sampling Process
1 ∑PO\](X O − Xa)x does not matter, or ways to label n items with 2 Times-series data: a sequence of returns collected
Sample skewness ≈ x

n s different labels at discrete and uniform intervals of time
Kurtosis Permutation: Cross-sectional data: observations over individual
1 ∑PO\](X O − Xa )y n! units at discrete time interval
Sample kurtosis ≈ PP? =
n s y (n − r)!
Central Limit Theorem (CLT)
Odds Counts ways to choose r items from n where
For a sample of size n ≥ 30 from a population with
P(E) order does matter.
Odds = mean µ and variance σd (population’s distribution
1 − P(E) Multinomial:
n! does not matter), the sample mean xû
Probability Rules approximately follows a normal distribution with
n] ! nd ! … nã !
P(AB) = P(A|B) × P(B) = P(B|A)P(A) Extension of combination concept; counts ways mean µ and variance σd⁄n

P(A or B) = P(A) + P(B) − P(AB) to label n items with k labels. Standard Error of Sample Mean
P(A) = P(A|S] )P(S]) + ⋯ + P(A|SP )P(SP )

Discrete Uniform Distribution Population variance is known: σçû = σ⁄√n

Independence 1 Population variance is not known: sçû = s⁄√n
p(x) = , x = x] , x d , … , x P
P(AB) = P(A) × P(B) n Properties of Estimators
P(A|B) = P(A) Binomial Distribution Unbiasedness: expected value of the estimator
n
p(x) = â ä pç (1 − p)Péç , where equals the parameter it wants to estimate
Expected Value x
P n = number of trials Efficiency: an unbiased estimator with smaller
E(X) = Z P(X O )X O p = probability of success variance compared to another
O\] E(X) = np Consistency: estimated value becomes closer to the
E(X) = E(X|S])P(S]) + ⋯ + E(X|SP )P(SP ) parameter as sample size increases

σd (X) = np(1 − p)

Variance Confidence Interval
P Continuous Uniform Distribution Point estimate ± Reliability factor × Std error
σd (X) = Z P(X O )[X O − E(X)]d 1
f(x) = , a ≤ x ≤ b Point estimate: Estimate of population parameter
O\] b−a

x−a Reliability factor: Value from distribution of point
Covariance F(x) = , a ≤ x ≤ b estimate, such as normal or t-distribution
P P
b−a

Examples: xû ± z°⁄d × σ⁄√n; xû ± t °⁄d × s⁄√n
Cov(X, Y) = Z Z P(X O , YO )[X O − E(X)][YO − E(Y)] Normal Distribution
O\] Å\] X ~ Normal(µ, σ) Significance Confidence
Cov(X, X) = σ d (X) 𝑧𝑧£⁄d
P(µ − σ < X < µ + σ) = 0.68 level interval

Expected Value & Variance of Portfolio Return P(µ − 2σ < X < µ + 2σ) = 0.95 10% 90% 1.645
P P(µ − 3σ < X < µ + 3σ) = 0.99
5% 95% 1.960
EÇR S É = Z wO E[R O ] Observed value − Population mean X − µ
Z= =
O\] standard deviation σ 1% 99% 2.575
P P
EÇR S É − shortfall level
σd ÇR SÉ = Z Z wO wÅ CovÇR O , R Å É Shortfall Ratio = Biases
σô
O\] Å\] Sample selection bias: Excluding subsets of data
Market value of investment i Lognormal Distribution
wO = because of data availability
Market value of portfolio - eö where X is normally distributed
Survivorship bias: A type of sample selection
For portfolio with 2 investments: - Used to model asset prices
bias where funds or companies that no longer
EÇR S É = wÑ R Ñ + wÖ R Ö - Positively skewed
exist are excluded
Continuously compounded return from t to t + 1:
σd ÇR SÉ = wÑd σd (R Ñ ) + wÖd σd (R Ö ) Look-ahead bias: Information needed is not
STõ]
+ 2wÑ wÖ Cov(R Ñ , R Ö ) rT,Tõ] = ln ú ù = lnÇ1 + R T,Tõ] É available on the test date
ST
where Cov(R Ñ , R Ö ) = σ(R Ñ )σ(R Ö )ρ(R Ñ , R Ö ) Time-period bias: Data is based on time period
where R T,Tõ] is the effective annual rate
Correlation that makes the results time-period specific
CovÇR O , R Å É Simulation Technique

ρO,Å = CorrÇR O , R Å É = Steps in Hypothesis Testing

σ(R O )σÇR Å É Monte Carlo simulation: Generation of a large
1. State hypotheses (null and alternate)
−1 ≤ ρO,Å ≤ 1 number of random samples from a specified
2. Select test statistic
distribution to represent the risk in the system
Bayes’ Formula 3. Specify significance level
Historical simulation: Sample from a historical
P(B|A) × P(A) 4. State decision rule
P(A|B) = record of returns to simulate a process
P(B) 5. Collect data; calculate test statistic

Counting Rules Sampling 6. Make decision regarding hypothesis

Factorial: Simple random sampling: Subset of population is 7. Make economic or business decision
n! = n(n − 1)(n − 2) … 1 chosen at random

Test Statistic (General)

Combination: Systematic sampling: Every kth observation is
Sample statistic − Hypothesized value
n n! chosen until desired sample size is achieved
Standard error of sample statistic
PC? = â r ä = Stratified sampling: Simple random samples are
(n − r)! r!

drawn from each subpopulation (strata)

Sampling error: Difference between quantity
calculated from sample and its true value

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Errors Degrees of freedom = n − 1 Profit Measures

Decision 𝐻𝐻¶ True 𝐻𝐻¶ False Accounting profit = Total revenue
Tests Concerning Two Variances
− Total accounting costs
Do not reject H¶ Correct Type II (b) Normal populations:
P¨ Economic profit = Total revenue
Reject H¶ Type I (a) Correct s]d 1 d − Total economic costs
F = d, sÅd = ZÇxOÅ − xûÅ É for j = 1, 2
Power of a test = 1 − P(Type II error) = 1 - b sd nÅ − 1 Economic profit = Accounting profit
O\]
p-value: smallest value of a that allows the Degrees of freedom 1 = n] − 1 − Total implicit costs
rejection of the null hypothesis Degrees of freedom 2 = nd − 1 Normal profit occurs when economic profit equals

zero, where total revenues match total costs
Hypothesis Test Results Tests Concerning Correlation

Type Hypotheses Reject null if 𝑟𝑟√n − 2 Revenue Terms

t-statistic = Total revenue (TR): Price times quantity; P × Q
One-tailed H¶ : µ ≤ µ¶ Test statistic > √1 − r d
(upper) HQ : µ > µ¶ critical value Nonparametric Tests Average revenue (AR): TR⁄Q
Test that is not concerned with parameter and is Marginal revenue (MR): ΔTR⁄ΔQ
One-tailed H¶ : µ ≥ µ¶ Test statistic <
implemented in situations such as: data do not Cost Terms
(lower) HQ : µ < µ¶ critical value
meet distributional assumptions, data are given in Total fixed cost (TFC): Sum of fixed costs
Test statistic <
ranks, or when hypothesis does not concern a Total variable cost (TVC): Sum of variable costs
H¶ : µ = µ¶ lower or >
Two-tailed parameter Total costs (TC): TFC + TVC
HQ : µ ≠ µ¶ upper critical

value
Average fixed cost (AFC): TFC⁄Q
ECONOMICS ECONOMICS Average variable cost (AVC): TVC⁄Q


Tests Concerning a Single Mean Own-Price Elasticity of Demand Average total cost (ATC): AFC + AFV or TC⁄Q
Population is normal with known variance: %ΔQKç Marginal cost (MC): ΔTC⁄ΔQ
xû − µ¶ ESKØ =

z-statistic = %ΔPç Shutdown & Breakeven

σ⁄√n where QKç is the quantity demanded of some good X Perfect competition:
Large sample from any population with unknown Pç is the price per unit of good X AR = ATC: Break even
variance (2 choices):
≥ESKØ ≥ > 1: elastic AR ≥ ATC: Stay in the market
xû − µ¶
t-statistic = , degrees of freedom = n − 1 ≥ESKØ ≥ < 1: inelastic AVC ≤ AR < ATC: Stay in short run; exit in long
s⁄√n
xû − µ¶ ≥ESKØ ≥ = ∞: perfectly elastic AR < AVC: Shut down in short run; exit in long
z-statistic = Imperfect competition:
s⁄√n ≥ESKØ ≥ = 0: perfectly inelastic
Small sample from normal population with Income Elasticity of Demand TR = TC: Break even
unknown population variance: %ΔQKç ΔQKç I TC > TR > TVC: Continue operation in short run;
xû − µ¶ EµK = =∂ ∑ ú K ù shutdown in long run
t-statistic = , degrees of freedom = n − 1 %ΔI ΔI Qç
s⁄√n TR < TVC: Shutdown in short and long run
where I is consumers’ income
Tests Concerning Differences between Means Productivity
EµK > 0: normal good
Normal populations with unknown variances that Marginal revenue product (MRP) of labor:
EµK < 0: inferior good
are assumed equal: Change in TR⁄Change in quantity of labor
(xû] − xûd) − (µ] − µd) Cross-Price Elasticity of Demand Profit maximization:
t-statistic = MRP] MRPP
sSd sSd
]⁄d %ΔQKç ΔQKç PR
ú + ù ESK∏ = =∂ ∑ ú ù =⋯= = 1
n] nd %ΔPR ΔPR QKç Price of input 1 Price of input n
(n d
] − 1)s] + (nd − 1)sd
d
where PR is the price per unit of another good Y Profit maximized for each product when:
d
sS = MRP = Price of input
(n] − 1) + (nd − 1) ESK∏ > 0: substitutes
Degrees of freedom = n] + nd − 2 Perfect Competition
ESK∏ < 0: complements
Normal populations with unknown variances that - Many firms

are assumed unequal: Income and Substitution Effects - Identical products

(xû] − xûd) − (µ] − µd) Price of Good X decreases: - Very low barriers to entry
t-statistic =
s]d sdd
]⁄d
Substitution Consumption - Firms have no pricing power
ú + ù Income effect Profit maximization:
n] nd effect of Good X
d
sd sd - P = MR = MC
ú ] + dù Positive Positive Increase
n] nd - P > ATC implies economic profit
Degrees of freedom = d
(s] ⁄n])d (sdd ⁄nd )d Negative - P < ATC implies economic loss
n] + nd Positive (smaller than Increase

substitution) Monopolistic Competition
Tests Concerning Mean Differences
Negative - Many firms
Normal populations with unknown variances:
Positive (larger than Decrease - Differentiated products (via advertising)
dû − µK¶
t-statistic = , degrees of freedom = n − 1 substitution) - Low barriers to entry
sKa

- Firms have some pricing power
Tests Concerning a Single Variance Normal good: Positive income effect Profit maximization:
Normal population: Inferior good: Negative income effect - MR = MC
(n − 1)s d
P Giffen good: Negative income effect larger than

d d
1
χ = , s = Z(xO − xû)d positive substitution effect
σd¶ n−1
O\]
Veblen good: Higher price increases demand

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Oligopoly IS and LM Curves Inflation
- Few firms IS curve: Negative relationship between real Deflation: Negative inflation rate
- Similar products (close substitutes) interest rates and real income (goods market) Disinflation: Declining inflation rate
- High barriers to entry LM curve: Positive relationship between real Hyperinflation: Extremely high inflation rate
- Firms have some or considerable pricing power interest rates and income (money market) Cost-push: From decrease in aggregate supply
(price collusion possible) Quantity theory of money: MV = PY Demand-pull: From increase in aggregate demand
Profit maximization: M = real money supply; V = money velocity Laspeyres index: Use base consumption basket
- MR = MC P = price level; Y = real GDP Paasche index: Use current consumption basket

Fisher index: cLaspeyres × Paasche
Monopoly Factors Increasing Aggregate Demand (AD)

- One firm - Increased consumer wealth Monetary Policy
- Highly differentiated product - Optimistic business expectations Required reserves
Required reserve ratio =
- No close substitutes for product - Expectations of higher consumer income Total deposits
- Significant barriers to entry - High capacity utilization Money multiplier = 1⁄Reserve requirement
- Firm has considerable pricing power - Expansionary policies (monetary and fiscal) Fisher effect: R PN<OPQª = R ?MQª + πM
(price discrimination) - Depreciating exchange rate

Central Bank Roles

Profit maximization: - Increased global economic growth
- Sole currency supplier
- MR = MC

Factors Increasing SR Aggregate Supply (AS) - Bank of banks and government
Market Power Measures - Increased labor productivity - Regulate and supervise payments system
N-firm concentration ratio: Sum of market share - Decreased input prices - Lender of last resort
of the N largest firms in the industry - Expectations of higher output prices - Gold and foreign exchange reserves holder
Herfindahl-Hirschman Index (HHI): Sum of squares - Decrease in business taxes/increase in subsidies - Operate monetary policy
of market share of the N largest firms - Appreciating exchange rate

Tools to Implement Monetary Policy

Gross Domestic Product (GDP) Factors Increasing LR Aggregate Supply (AS) Policy rate: Expansionary when less than neutral
Nominal GDP: GDP in terms of current prices - Increased supply and quality of labor interest rate; contractionary otherwise
Nominal GDPT = PT × Q T - Increased supply of natural resources Reserve requirement: Increase/decrease funds
Real GDP: GDP in terms of base-year prices - Increased stock of physical capital available for lending and money supply
Real GDPT = PÖ × Q T - Technological improvements Open market operations: Buy/sell government
GDP deflator: (Nominal GDP⁄Real GDP) × 100
bonds to increase/decrease money supply
Business Cycle Phases
GDP = C + I + G + (X − M)

Trough (lowest point) Fiscal Policy: Spending Tools

C = consumption; I = investment
Expansion (comes after trough) Transfer payments: Redistribution of wealth (e.g.
G = government spending
Peak (highest point) Social Security and unemployment benefits)
X = exports; M = imports
Contraction (comes after peak) Current spending: Spending on goods and services
National Income
Business Cycle Theories Capital spending: Spending on infrastructure
Sum of:
Neoclassical: Free market; “invisible hand”

- Employee compensation Fiscal Policy: Revenue Tools

Austrian: Similar to Neoclassical; government
- Corporate and government pretax profit Direct taxes: Tax on income (e.g. income taxes,
intervention causes market fluctuations
- Interest income corporate taxes, capital gains taxes)
Keynesian: Advocate government fiscal policy
- Unincorporated business net income Indirect taxes: Tax on goods and services
Monetarist: Maintain steady money supply growth
- Rent

New classical: Applies microeconomic analysis Fiscal Multiplier

- Indirect business taxes, less subsidies
to macroeconomics 1
Personal Income = , where MPC = marginal
Unemployment 1 − MPC(1 − t)
= National income − Indirect business taxes
Unemployed: Jobless people who are seeking jobs propensity to consume; t = tax rate
− Corporate income taxes
Labor force: People with a job or unemployed Gains from Trade
− Undistributed corporate profits
Unemployment rate: Unemployed⁄Labor force Absolute advantage: Can produce at lower cost
+ Transfer payments
Type Result of Comparative advantage: Opportunity cost of
Personal Disposable Income (PDI) producing good is lower
Frictional Temporary transitions
= Personal income – Personal taxes

Household Saving = PDI Structural Long-run changes in economy Trade Restrictions

- Consumption Expenditures Cyclical Changes in economic activity Tariffs: Taxes on imported goods
- Interest paid by consumers to business

Quotas: Limits on quantity of imported goods

Economic Indicators Export subsidies: Government payment to
- Personal transfer payments to foreigners
Leading: Turning points precede those of the exporting firms
Expenditure and Income Equality overall economy Minimum domestic content: Minimum domestic
(G − T) = (S − I) − (X − M) Coincident: Turning points occur along with those product requirement in goods
G − T = fiscal balance of the overall economy Voluntary export restraint: Voluntarily limiting
S − I = savings minus domestic investment Lagging: Turning points occur after those of the exports, often to avoid tariffs or quota
X − M = trade balance overall economy

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Regional Trading Blocs FINANCIAL REPORTING
FINANCIAL REPORTING AND ANALYSIS Balance Sheet Components
Free trade area (FTA): No barriers to flow of goods
Accounts receivable: Reported at net realizable
Elements of Financial Statements
and services among members value based on bad debt expense. Bad debt
Assets: Resources controlled by the company that
Customs union (CU): FTA + common trade policy expense increases allowance for doubtful accounts,
are expected to produce future benefits
among non-members which contras accounts receivables.
Common market (CM): CU + free movement of Liabilities: Creditors’ claims on the resources of a
Inventory:
factors of production among members company
IFRS – LIFO not permitted; inventories reported at
Economic union (EU): CM + common economic Equity: The residual interest in the assets after
lower of cost or net realizable value.
institution and coordination of economic policies subtracting the liabilities
U.S. GAAP – LIFO permitted; inventories reported
Monetary union (MU): EU + common currency Income: Increase in economic benefits in the form
at lower of cost or market.

of inflows or decrease in liabilities that result in an
Balance of Payments Components Property, plant, and equipment (PP&E):
increase in equity
Current account: Merchandise and services, income IFRS – can be reported using cost model or
Expenses: Outflows of economic resources or
receipts, unilateral transfers revaluation model; recoverable amount is greater
increases in liabilities that result in decreases in
Capital account: Capital transfers, non-financial of (1) fair value less selling costs, and (2) value in
equity
assets sales/purchases use (PV of asset’s future cash flow stream); loss
Financial account: Government-owned assets Accounting Equation recoveries are allowed.
abroad, foreign-owned assets in the country Basic: Assets = Liabilities + Owners’ equity U.S. GAAP – only cost model is allowed; loss

Exchange Rate Calculations Expanded: Assets = Liabilities + Contributed capital recoveries not allowed.

CPIΩ + Beginning retained earnings + Revenue
Real ex. rateK⁄Ω = Nominal ex. rateK⁄Ω × ú ù Cash Flow Statement Components
CPIK – Expenses - Dividends
U.S. GAAP:
Forward exchange rateK⁄Ω 1 + iK
= Accrual Accounting Item Classification
Spot exchange rateK⁄Ω 1 + iΩ
Cash movement before accounting recognition: Dividends paid Financing
Cross rate: SÑ⁄Ö = SÑ⁄æ × Sæ⁄Ö
- Unearned revenue: Liability; cash received before Interest paid Operating
Forward exchange rates in points:
good or service provided Dividends received Operating
- Unit of points is last decimal place in spot
- Prepaid expenses: Asset; cash paid before
exchange rate quote Interest received Operating
expense incurred
- Example: If spot exchange rate is quoted in 4 All taxes Operating
Cash movement after accounting recognition:
decimal places, each point is 0.0001

- Accrued revenue: Asset; cash not yet received IFRS:

Exchange Rate Regimes after good or service provided Item Classification
Formal dollarization: No own currency; adopt - Accrued expenses: Liability; cash not yet paid for Dividends paid Operating/Financing
another country’s currency expenses incurred Interest paid Operating/Financing
Monetary union: Adopt common currency

FASB, IASB, and IOSCO Dividends received Operating/Investing

Currency board: Commitment to exchange
FASB: Sets forth Generally Accepted Accounting Interest received Operating/Investing
domestic currency for specified foreign currency at
fixed exchange rate Principles (GAAP) in the U.S. Income taxes Operating
Fixed peg: Currency is pegged to foreign currency IASB: Establishes International Financial Reporting Tax expense from
Investing
(or basket of currencies) within ±1% margin Standards (IFRS) outside the U.S. investing transaction
Target zone: Fixed peg with wider margin FASB-IASB Convergence: In May 2014, FASB and Tax expense from
Crawling peg: Exchange rate is pegged and IASB each issued converged standard for Financing
financing transaction
adjusted periodically revenue recognition.

Crawling bands: Margin increases over time, IOSCO: Not a regulatory authority but CFO Direct Method
usually to transition from fixed peg to floating members regulate most of the world’s - Convert each accrual-based item in the income
Managed floating: Monetary authority intervenes financial capital markets statement to cash inflow/outflow
to manage exchange rate without a target level - CFO is net of cash inflows and outflows
Independently floating: Exchange rate is Income Statement Components

Gross profit: Revenue less direct costs to produce CFO Indirect Method
market determined
good or service - Start with net income
Operating profit: Gross profit less selling, general, - Add noncash expenses
and administrative expenses - Subtract gains/adding losses from financing or
investing cash flows
Earnings per Share - Add/subtract asset and liability adjustments
Net income − Preferred dividends
Basic = based on accrual accounting
Weighted average of shares outstanding
Diluted =
Convertible Convertible
Net Preferred (1 − 𝑡𝑡)
− + preferred + debt
income dividends
dividends interest
Weighted Shares from Shares from Shares issuable
average + preferred + convertible + from stock
shares shares debt options
Only include potentially dilutive security in
calculation after checking that it is dilutive.

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Free Cash Flow (FCF) Solvency Ratios Perpetual vs. periodic inventory system:
Measures cash available for discretionary purposes Total debt - Perpetual system matches each unit sold with
Debt-to-equity =
Free cash flow to the firm (FCFF): Cash available to Total shareholders' equity immediate prior purchases
equity owners and debt holders. Total debt - Periodic system matches total units sold for the
Debt-to-capital =
FCFF = NI + NCC + I × (1 − t) − FCI − WCI Total shareholders' period with total purchases for the same period
Total debt +
equity
FCFF = CFO + I × (1 − t) − FCI Under FIFO, ending inventory and COGS are the
Total debt
NI = net income Debt-to-assets = same for periodic or perpetual. Under weighted
Total assets
NCC = noncash charges (e.g. depreciation) Average total assets average cost and LIFO, they may be different.
I = interest expense Financial leverage = LIFO reserve: Must be reported by firms using LIFO
Average total equity
FCI = fixed capital investment EBIT method; used to adjust LIFO COGS and ending
Interest coverage =
WCI = working capital investment Interest payments inventory (EI) to FIFO-equivalent values.
Free cash flow to equity (FCFE): Cash flow available Fixed EBIT + Lease payments EI¡µ¡¬ = EI√µ¡¬ + LIFO Reserve
to common shareholders charge = COGS¡µ¡¬ = COGS√µ¡¬ − ΔLIFO Reserve
coverage Interest payments + Lease payments
FCFE = CFO − FCI + NB
Income tax¡µ¡¬ = Income tax√µ¡¬
NB = net borrowing = debt issued − debt repaid Profitability Ratios + ΔLIFO Reserve × t

Net income LIFO liquidations:
Common-Size Analysis Net profit margin =
Revenue - Caused when units sold exceed units purchased
Vertical: Gross profit
Gross profit margin = for LIFO company
- Represent each item on income statement as Revenue - May result in higher gross profit than otherwise
percentage of revenue. EBIT
Operating profit margin =
- Represent each item on balance sheet as Revenue Depreciation Methods
percentage of total assets. EBT Straight-line:
Pretax margin =
- Represent each item on cash flow statement as Revenue Cost − Salvage value
Net income Depreciation =
percentage of total cash inflows/outflows. Return on assets (ROA) = Depreciable life
Average total assets
Horizontal: Double-declining balance (DDB):
EBIT
- Express each item relative to its value in a Return on total capital = 2
Average total capital DepreciationT = ú ù × Book valueT
common base period Depreciable life
Net income
Return on equity (ROE) = Units-of-production:
Average total equity
Activity Ratios Cost − Salvage
Annual sales DepreciationT = × Output unitsT
Receivables turnover = Valuation Ratios Total output
Average receivables Dividends declared Intangible Assets
Days of sales 365 Dividend payout ratio =
= NI available to common Purchased: Record at fair value (assumed equal to
outstanding Receivables turnover Retention rate (RR) = 1 − Dividend payout ratio purchase price)
Cost of goods sold Sustainable growth rate (g) = RR × ROE
Inventory turnover = Developed internally:
Average inventory Price per share
P/E Ratio = IFRS
Days of inventory 365 Earnings per share
= - Research expenditures are expensed
on hand Inventory turnover DuPont Analysis
Purchases - Development expenditures are capitalized
Payables turnover = Net income Assets
Average trade payables ROE = ú ùú ù GAAP
Assets Equity
Number of days 365 - Generally, both research and development costs
= Return on Leverage
of payables ROE = â äâ ä are expensed
Payables turnover Assets ratio
Revenue Net income Revenue Assets Acquired in business combination:
Total asset turnover = ROE = ú ùú ùú ù
Average total assets Revenue Assets Equity Acquirer allocates purchase price to each
Revenue Net profit Asset Leverage asset acquired on fair value basis; excess
Fixed asset turnover = ROE = ú ùâ äâ ä
Average net fixed assets margin turnover ratio recorded as goodwill
Revenue NI EBT EBIT Revenue Assets
Working capital ROE = ú ùú ùú ùú ùú ù
= EBT EBIT Revenue Assets Equity Capitalizing vs. Expensing
turnover Average working capital
Tax Interest EBIT Asset Financial - Capitalizing increases assets on the balance sheet
ROE = â äâ äú ùâ äú ù
burden burden margin turnover leverage
Liquidity Ratios and increases investing cash outflow on the
Current assets Inventory Valuation Methods and Systems statement of cash flows
Current ratio =
Current liabilities Specific identification: - Expensing reduces net income by the after-tax
Marketable
Cash + + Receivables - Each unit sold is matched with its actual cost expenditure amount in the period it is incurred
Quick ratio = securities
Current liabilities - Permissible under U.S. GAAP and IFRS
Cash + Marketable securities Weighted average cost:
Cash ratio =
Current liabilities - Average cost/unit is cost of goods available for
Marketable
Cash + + Receivables sale divided by quantity available for sale
Defensive securities
= - Permissible under U.S. GAAP and IFRS
interval Average daily expenditures
Cash Days of Days of Number First-in, first-out (FIFO):
conversion = sales + inventory − of days - Assume first item purchased is first item sold
cycle outstanding on hand payables - Permissible under U.S. GAAP and IFRS
Last-in, first-out (LIFO):
- Assume last item purchased is first item sold
- Permissible under U.S. GAAP but not IFRS

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Impairment of PP&E and Intangible Assets Operating lease: CORPORATE FINANCE
CORPORATE FINANCE
U.S. GAAP: - Rental arrangement

Capital Budgeting
- Asset tested for impairment only when firm may - There is a single lease expense that is not
The allocation of funds to relatively long-range
not recover carrying value through future use separated into different components for
projects or investments
- Asset is impaired when carrying value exceeds depreciation and interest expense.
Steps:
asset’s future undiscounted cash flows - The value of an operating lease payment is
- Generating ideas
- Impaired asset’s value is written down to fair calculated as a straight-line allocation of total
- Analyzing individual proposals
value and a loss is recognized payments over the term of the lease
- Planning the capital budget
- Loss recoveries are not permitted Conditions requiring a lease to be a finance lease:
- Monitoring and post-auditing
IFRS: - Ownership of the leased asset is transferred to
Categorization:
- Asset tested for impairment annually. the lessee at the end of the lease term
- Replacement
- Asset is impaired when carrying value exceeds - The lessee has the option to purchase the asset
- Expansion
recoverable amount. for less than its expected fair value
- New products and services
- Impaired asset’s value is written down to - The lease term covers most of the asset's
- Regulatory, safety, and environmental
recoverable amount and a loss is recognized. expected useful life

- Loss can be reversed if asset value recovers, but - The present value of lease payments at inception Net Present Value (NPV)
J
only up to carrying value before impairment loss is close to the fair value of the asset CFT
was recognized. - The leased asset is so specialized that only the NPV = Z − Outlay
(1 + r)T
T\]
lessee can use without modification
Income Taxes Ignore sunk costs.
IFRS do not permit companies to classify leases as
Deferred tax assets (DTA): Created when taxes Use worksheet function on BA II Plus:
operating leases. Instead, all leases must be treated
payable exceeds income tax expense due to - Cash inflows are positive; outflows are negative
in the same way that is prescribed for finance
temporary differences. Examples: - F01, F02, etc. refer to cash flow frequencies
leases under US GAAP.
- Asset’s tax base > carrying amount
- CPT + NPV to compute NPV; CPT + IRR for IRR
- Liability’s carrying amount > tax base Lessor Accounting NPV decision rules:
Deferred tax liabilities (DTL): Created when taxes - IFRS allow lessors to treat a lease as either an - Accept projects with positive NPV
payable is less than income tax expense due to operating lease or a finance lease. - Reject projects with negative NPV
temporary differences. Examples: - Under US GAAP, lessors may choose to classify a - If only one of multiple mutually exclusive projects
- Asset’s carrying amount > tax base lease as operating, sales-type, or direct can be accepted, accept project with highest NPV

- Liability’s tax base > carrying amount financing. If any of the criteria for lessees are
Internal Rate of Return (IRR)
Tax base of assets: Amount that will be deducted on met (i.e.,ownership transfers automatically at
IRR is r such that NPV = 0.
the tax return as asset’s benefits are realized. the end of the lease term) and it is likely that
IRR decision rules:
Tax base of liabilities: Carrying value of liability lease payments will be made, the lessor will
- Accept if IRR > required rate of return
minus amount that will be deductible on the treat the lease as a sales-type lease.
- Reject if IRR < required rate of return
tax return. - For operating leases (under both IFRS and US
- Go with NPV decision if IRR decision does not
Impact of tax rate changes: GAAP), the lessor retains the leased asset on its
match NPV decision
Income tax = Taxes payable + ΔDTL − ΔDTA balance sheet and incurs the associated

depreciation expense. Lease income from the Payback Period
Bonds
lessor is recorded as revenue. - Number of years required for cumulative cash
Premium bond: Coupon rate > yield at issuance
- Finance leases (IFRS) and sales-type leases (US flows to equal initial investment
Discount bond: Coupon rate < yield at issuance
GAAP) have similar requirements. The lessor - Does not take into account time value of money
Zero-coupon bond: Bond with no coupons
removes the leased asset from its balance sheet
Issuance costs: U.S. GAAP – capitalized as an asset; Discounted Payback Period
and creates an asset with a value equal to the
IFRS – reduces initial bond liability Number of years required for cumulative
lease receivable and any residual value.
Derecognition of debt: If an issuer redeems a bond discounted cash flows to equal initial investment
- Under a direct financing lease, the lessor
before maturity, a gain/loss (book value minus
removes the asset from its balance sheet and Average Accounting Rate of Return (AAR)
redemption price) is recognized
creates an asset for the lease receivable. Average net income
Debt covenants: Affirmative – borrower promises AAR =

Average book value
to do certain things; negative – borrower promises Pension

to refrain from certain things Defined contribution: Firm periodically contributes

to employee’s retirement account during Profitability Index (PI)
Lessee Accounting PV of future cash flows NPV
employment. Employer contribution is expensed in
U.S. GAAP PI = =1+
period incurred. CF¶ CF¬
Finance (Capital) lease: Accept if PI > 1; reject if PI < 1
Defined benefit: Firm makes periodic payments to
- Purchase of asset by the lessee with the financing
employee after retirement. Over- (under-) funded Crossover Rate
provided by the lessor.
plan recognized as asset (liability). - Rate at which NPV profile of two projects cross
- The lessee's periodic lease payments have a
- Calculated as IRR of difference in cash flows
depreciation component and an interest
component

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Weighted Average Cost of Capital (WACC) Factors Affecting Working Capital Needs Security Markets
WACC = wK rK(1 − t) + wSƒ rSƒ + w≈M r≈M Internal factors: Primary market: The market where securities are
wK = percentage of debt in capital structure - Company size and growth rates first sold and the issuers receive the proceeds
wSƒ = percentage of preferred stock - Organizational structure Secondary market: The market where securities are
w≈M = percentage of common stock - Sophistication of working capital management traded among investors

t = tax rate - Borrowing and investing
Roles of Market Regulation
rK = cost of debt positions/activities/capacities
- Control fraud
rSƒ = cost of preferred stock = DSƒ ⁄P External factors:
- Control agency problems
r≈M = cost of common stock - Banking services
- Promote fairness
k ≈M = D] ⁄P¶ + g (dividend discount model) - Interest rates
- Set mutually beneficial standards
k ≈M = R ¡ + β[E(R < ) − R ¡ ] (CAPM) - New technologies and new products
- Prevent undercapitalized firms from exploiting
k ≈M = R ¡ + β[E(R < ) − R ¡ + CRP] (revised CAPM) - The economy
their investors
r≈M = rK + Risk Premium - Competitors
- Ensure that long-term liabilities are funded
(Bond Yield plus Risk Premium) Working Capital Management

Positions
Pure-Play Method Project Beta Primary sources of liquidity: Sources from normal
Long positions are owned and benefit from
Delevered asset beta for comparable company: daily operations (e.g. cash balances, short-term
price appreciation
funding, collections/payments management)
⎡ ⎤ Short positions are owned and benefit from
1 Secondary sources of liquidity: Sources that may
βQƒƒMT = βM«LOTR ⎢ ⎥ price depreciation
⎢1 + Ç1 − t D ≈N<SQ?QÀªM ⎥ change a company’s financial and operating
≈N<SQ?QÀªM É E

⎣ ≈N<SQ?QÀªM ⎦
positions (e.g. asset liquidation, renegotiation of Leveraged Positions
Relevered project beta for subject firm: debt, bankruptcy protection, reorganization) Position
DƒLÀÅM≈T Leverage ratio =
βS?NÅM≈T = βQƒƒMT œ1 + Ç1 − t ƒLÀÅM≈T É – Drag on liquidity: Delayed cash inflows Equity
EƒLÀÅM≈T Maximum initial leverage ratio
Pull on liquidity: Accelerated cash outflows

Cost of trade credit (CTC): Cost of not taking the 1
Country Equity Premium =
discount for early payment Intial margin requirement
Country equity premium =
x⁄€
(Sovereign yield spread) x %discount KQRƒ SQƒT KOƒ≈NLPT Margin Call Price
CTC = ú1 + ù − 1
⎡ ⎤ 1 − %discount P¶ (1 − Initial margin)
Annualized standard deviation
⎢ ⎥ 1 − Maintenance margin
⎢ of equity index ⎥ Corporate Governance

⎢ Annualized standard deviation ⎥ - Board should be independent of management. Orders

⎢of the sovereign bond market in terms⎥ - Audit committee should resolve conflicts Execution instruction: How to fill the order
⎣ of the developed market currency ⎦
between auditor and management in a way that (e.g. market order, limit order)
Dividend Discount Model favors shareholders Validity instruction: When the order may be filled
𝐷𝐷] - Compensation committee should (e.g. day order, fill or kill)
𝑟𝑟— = + 𝑔𝑔
𝑃𝑃¶ provide shareholders with executive Clearing instruction: How to settle the trade
𝐷𝐷 compensation information

𝑔𝑔 = ú1 − ù 𝑅𝑅𝑅𝑅𝑅𝑅 Price Return Index
𝐸𝐸𝐸𝐸𝐸𝐸 - Firms should have strong code of ethics.

∑J
O\] nO PO
Flotation Costs - Confidential voting and remote proxy voting Vô‹µ =
D
Correct way to account for flotation costs is to promote shareholder interests

adjust initial investment, not to increase WACC Takeover defenses (provisions to make Price Return over Single Period

company less attractive to hostile bidder) harm PO] − PO¶
Measures of Leverage PR O =
shareholder interests PO¶
Degree of operating leverage (DOL): J
Vô‹µ] − Vô‹µ¶
%Δ Operating income Q(P − V) PR µ = = Z wO PR O
DOL = = V􋵶
%Δ Units sold Q(P − V) − F O\]
EQUITY EQUITY Total Return over Single Period
Degree of financial leverage (DFL):
PO] − PO¶ + IncO
%Δ Net income Q(P − V) − F The Financial System: TR O =
DFL = = PO¶
%Δ Operating income Q(P − V) − F − C - Save money for the future J
Degree of total leverage (DTL): - Borrow money for current use Vô‹µ] − Vô‹µ¶ + Incµ
TR µ = = Z wO TR O
%Δ Net income Q(P − V) - Raise equity capital Vô‹µ¶
DTL = = O\]
%Δ Units sold Q(P − V) − F − C - Manage risks

DTL = DOL × DFL Price Return Index over Multiple Periods

- Exchange assets for immediate and future
Vô‹µ› = Vô‹µ¶ (1 + PR µ] )(1 + PR µd ) … (1 + PR µ›)
deliveries

Breakeven - Trade on information Total Return Index over Multiple Periods

F+C V›‹µ› = V›‹µ¶ (1 + TR µ] )(1 + TR µd ) … (1 + TR µ› )
Breakeven: Q ÖŸ = Financial Intermediaries
P−V Those who help entities achieve their financial
F
Operating breakeven: Q ¬ÖŸ = goals.
P−V
Q = quantity; P = price; V = variable cost/unit
F = fixed operating cost; C = fixed financial cost

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Weighting Industry Life Cycle Putable Bonds
PO Embryonic VôLTQÀªM ÀNPK = VNon-putable bond + VôLT
Price wOô =
∑J
Å\] PÅ Slow growth, high prices, high failure risk,

Convertible Bonds
1 significant investment required
Equal wOŸ = Conversion price: Price per share at which bond
N Growth
fO Q O PO can be converted into shares
Market capitalization wOfi = Rapidly increasing demand, improving
∑J Conversion ratio: Number of common shares
Å\] fÅ Q Å PÅ profitability, falling prices, low competition
FO each bond can be converted into
Fundamental wO¡ = Shakeout
∑J Conversion value: Current share price ×
Å\] FÅ Slowing growth, intense competition,
Conversion ratio
declining profitability Conversion premium: Convertible bond’s price −
Forms of Market Efficiency Mature Conversion value
Market Prices Reflect: Little or no growth, industry consolidation,

Past market Public Private high entry barriers Short-Term Funding Alternatives
Form
data info info Decline Additional funding alternatives, which have short
Weak ✔ maturities, that are available to large financial
Negative growth, excess capacity,
Semi-strong institutions include:
✔ ✔ high competition
- Retail deposits
Strong ✔ ✔ ✔

Dividend Discount Model (DDM) - Central bank funds
fl
Market Anomalies DT - Interbank funds
V¶ = Z
Changes in the price or return of a security that are (1 + r)T - Certificates of deposit
T\]
not associated with known information about the P - Repurchase agreement (a form of collateralized
DT PP
market V¶ = Z + loan)
(1 + r)T (1 + r)P
T\]

Behavioral Finance Perpetual preferred stock; constant dividend: Bond Pricing with Spot Rates
D¶ PMT PMT PMT + FV
- Loss aversion: Dislike losses V¶ = PV = + + ⋯+
r (1 + z] )] (1 + zd )d (1 + zJ )J
- Overconfidence: Overconfident in abilities
Gordon constant growth model: CR: Coupon Rate; MDR: Market Discount Rate
- Representativeness: Rely too much on current fl
D¶ (1 + g) T
D¶ (1 + g) D] CR = MDR Price = Par Value Par
state when assessing probabilities V¶ = Z = =
- Gambler’s fallacy: Estimate future probabilities (1 + r)T r−g r−g CR < MDR Price < Par Value Discount
T\]
based on recent outcomes g = (Earning retention rate) × ROE CR > MDR Price > Par Value Premium

- Mental accounting: Keep track of gains and losses g = (1 − Dividend payout ratio) × ROE Flat Price, Accrued Interest, and Full Price
separately for different investments Multistage DDM:
PV ¡Lªª = PV ¡ªQT + AI = (PV)(1 + r)T⁄›
- Conservatism: Slow to make changes P
DT PP AI = (t⁄T) × PMT
- Disposition effect: Avoid realizing losses and seek V¶ = Z +
(1 + r)T (1 + r)P
T\]
to realize gains Yield Measures
DPõ]
- Narrow framing: Focus on issues in isolation PP = Annual cash coupon payment
r − g√ Current yield =
Flat price
Uses of Industry Analysis DPõ] = D¶ (1 + g ‡ )P (1 + g √ )
Annual cash Amortized
+
- Understand a company’s business and business coupon payment gain/loss
Price Multiples Simple yield =
environment Flat price
P¶ D] /E]
- Identify active equity investment opportunities = Yield-to-call (YTC) = IRR assuming the bond is
E] r−g
- Portfolio performance attribution Price per share called early at the stated call price
P ⁄B = Yield-to-worse = min[YTC, yield-to-maturity]
Book value per share
Porter’s Five Forces Framework
Price per share
- Threat of substitute products P⁄CF = Yield Measures for Money Market Instrument:
Cash flow per share
- Bargaining power of customers Discount Rate (DR) Basis
Price per share
- Bargaining power of suppliers P ⁄S = Days
Net sales per share PV = FV × ú1 − × DRù
- Threat of new entrants Year
Enterprise value (EV)
- Intensity of rivalry Yield Measures for Money Market Instrument:
= MV(Common equity) + MV(Preferred stock)
+ MV(Debt) − (Cash + Short term investments) Add-on Rate (AOR) Basis
Days
PV = FV‚ú1 + × AORù
Year

FIXED INCOME FIXED INCOME Implied Forward Rate (IFR)

ÖéÑ
Bond Markets (1 + zÑ )Ñ × Ç1 + IFR Ñ,ÖéÑÉ = (1 + zÖ )Ö

Primary bond markets: Markets in which issuers Yield Spreads over Benchmark Yield Curve
initially sell bonds to investors to raise capital PMT PMT PMT + FV
PV = + + ⋯+
Secondary bond markets: Markets in which existing (1 + z] + Z)] (1 + zd + Z)d (1 + zJ + Z)J
bonds are subsequently traded among investors OAS = Z-spread − Option value (in basis points)

Callable Bonds
VæQªªQÀªM ÀNPK = VNon-callable bond − VæQªª

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Asset-Backed Securities Convexity Forwards vs. Futures
Securitization Process (PVé ) + (PVõ) − [2 × (PV¶)] Compared to forwards, futures are:
ApproxCon =
- A special purpose vehicle (SPV) buys assets from (ΔYield)d (PV¶) - standardized contracts traded on an exchange
the seller firm and issues asset-backed securities %ΔPV ¡Lªª = −AnnModDur × ΔYield - guaranteed by clearinghouse
(ABS) against the assets 1 - marked-to-market and settled daily
+ (AnnConvexity)(ΔYield)d
- A servicer (could be same entity as seller) collects 2 - regulated
(PVé ) + (PVõ) − 2(PV¶ )
funds and performs other related responsibilities EffCon =
(ΔCurve)d (PV¶ ) Contingent Claims
Residential Mortgage Loans
Duration gap = Macaulay duration Derivatives in which the payoffs occur if a specific
- Interest: fixed, adjustable, convertible
− Investment horizon event occurs
- Amortization: full, partial, interest-only
Credit Analysis
- Prepayment: penalty, no penalty Forward Commitments
E[Loss] = Pr(Default) × Loss severity
- Foreclosure: non-recourse, recourse Derivatives that allow to lock in a price to transact
Loss severity = 1 − Recovery rate
Residential Mortgage-Backed Securities
in the future at a previously agreed-upon price
- Agency RMBS issued by government agencies and Credit Ratings Swaps
must have conforming loans Investment grade: Baa3/BBB- and above Two parties exchange a series of cash flows.

- Non-agency RMBS issued by private companies Non-investment grade: Ba1/BB+ and below
Arbitrage
and may have non-conforming loans

Four C’s of Credit Analysis The state in which one take profits from the risk-
- Pass-through rate: coupon rate on the MBS
- Capacity free manner of the market
- Prepayment risk: contraction (faster-than-
- Collateral
expected prepayments), extension (slower-than- Option Styles
- Covenants
expected prepayments) - European options can only be exercised at
- Character
- Prepayment rates are compared to the PSA expiration.
benchmark CPR Yields and Spreads - American options can be exercised at any time
Collateralized Mortgage Obligations Yield on a corporate bond is sum of: during the life of the option.
- Securities backed by pool of RMBS - Real risk-free interest rate -

- Expected inflation rate Option Values

- Structured with tranches with varying exposures
- Maturity premium Exercise/intrinsic value of a
to prepayment risks
- Liquidity premium European call = Max[0, S› − X]
- A sequential-pay CMO has principal and
- Credit spread Exercise/intrinsic value of a
prepayments paid to the tranches in sequence
Yield spread = Liquidity premium + Credit spread European put = Max[0, X − S› ]
- PAC CMO have predictable cash flows and
Return impact ≈ −Modified duration × ΔSpread

support tranches with more contraction or Option Moneyness

1
extension risk + (Convexity)(ΔSpread)d Option Moneyness Call Put
2
Collateralized Debt Obligations In-the-money ST > X ST < X
Securities backed by pool of debt obligations; such Special Considerations in Credit Analysis
At-the-money ST = X ST = X
as corporate bonds, leveraged bank loans, or credit Need to consider the additional factors when
Out-of-the-money ST < X ST > X
default swap on securities pricing these securities:

- High-yield corporate bonds (i.e. covenant) Factors Impacting Option Values
Duration
- Sovereign bonds (i.e. political risk) Increase in Call Put
MacDur
ModDur = - Non-sovereign government bonds (i.e. municipal Value of underlying ↑ ↓
1 + 𝑟𝑟
¡Lªª debt) Exercise price ↓ ↑
%ΔPV = −AnnModDur × ΔYield

(PVé ) − (PVõ ) Time to expiration ↑ ↑*
ApproxModDur =
2(ΔYield)(PV¶ ) Risk-free rate ↑ ↓
DERIVATIVES DERIVATIVES
ApproxModDur = ApproxMacDur⁄(1 + r) Volatility of underlying ↑ ↑
(PVé ) − (PVõ ) Forward Contract
EffDur = Payments on underlying ↓ ↑
2(ΔCurve)(PV¶ ) Value of 𝑇𝑇-year forward contract at: Cost of carry ↑ ↓
PortfolioDur = w] D] + wd Dd + ⋯ + wJ DJ Initiation V¶ (T) = 0 *Except for some deep-in-the-money put options
MoneyDur = AnnModDur × PV ¡Lªª Expiration V›(T) = S› − F¶ (T)

ΔPV ¡Lªª ≈ −MoneyDur × ΔYield Option Boundaries

VT (T) = ST − PVT(benefit)
(PVé ) − (PVõ ) Time t European options:
Price value of a basis point = + PVT (cost) − F¶ (T)⁄(1 + r)›éT
2 c¶ ≥ Max[0, S¶ − X⁄(1 + r)› ]
Basis point value = MoneyDur × 0.0001 Forward price of an asset:
p¶ ≥ Max[0, X⁄(1 + r)› − S¶ ]
F¶ (T) = S¶ (1 + r)› − FV› (benefit) + FV› (cost)

American options:
Exchange-Traded Derivatives vs. Over-the- C¶ ≥ c¶ ; P¶ ≥ p¶
Counter Derivatives C¶ ≥ Max[0, S¶ − X⁄(1 + r)› ]
Compared to exchange-traded derivatives, over- P¶ ≥ Max[0, X − S¶ ]

the-counter derivatives are:
Put-Call Parity
- Customized
s¶ + p¶ = c¶ + X⁄(1 + r)›
- Flexible
- More private Put-Call-Forward Parity
- Less regulated F¶ (T)⁄(1 + r)› + p¶ = c¶ + X⁄(1 + r)›
- Subject to greater risk of default

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 ALTERNATIVE INVESTMENTS
ALTERNATIVE INVESTMENTS Purposes of Due Diligence Minimum-Variance Portfolios

To assess whether: E(Rp)
General
- A potential investment is in compliance with its Markowitz(EfDicient(Frontier
Compared to traditional investments, alternative
prospectus
investments exhibit:

Expected(Return
- The appropriate organizational structure and
- lower liquidity
policies are in place
- narrow manager specialization
- low correlation with traditional investments - The fund terms appear reasonable
Minimum<Variance
- less regulation and lower transparency Global( Frontier
- limited historical risk and return data Minimum<
PORTFOLIO MANAGEMENT
PORTFOLIO MANAGEMENT Variance
- unique legal and tax considerations
- Portfolio
Hedge Funds Investment Clients 0 !p
Strategies: Individual investors: Portfolio(Standard(Deviations

- Event-driven – seek to profit from - Defined contribution pension plan (employee
Capital Allocation Line (CAL)
short-term events invests part of the wages to the fund and bears the
Line representing possible combinations of risk-
- Relative value – seek to profit from pricing investment risk)
free assets and optimal risky asset portfolio
discrepancies between related securities Institutional investors:
E[R O ] − R Ω
- Macro – emphasize a top-down approach to - Defined benefit pension plan (employer is obliged EÁR S Ë = R Ω + ∂ ∑ σS
σO
identifying global economic trends to pay a certain annual amount to its employee
- Equity hedge – take positions in equity and equity when they retire and thus, bears the investment Capital Market Line (CML)
derivative securities risk) CAL with risky portfolio being market portfolio
Hedge Fund Fees: - Endowments and foundations (provide E[R < ] − R Ω
- “2 and 20” – 2% management fee and 20% EÁR S Ë = R Ω + ∂ ∑ σS
continuing financial support for educational and σ<
incentive fee
medical purposes)

- Hard hurdle rate – incentive fee calculated on Borrowing vs. Lending

- Banks, insurance, investment companies,
returns above the hurdle rate
sovereign wealth funds
- Soft hurdle rate – incentive fee calculated on

entire return if hurdle rate is cleared Portfolio Management Process

- High water mark – incentive fee only applies to Planning: List objectives and constraints in IPS
profits after previous losses have been recovered Execution: Asset allocation, security analysis,

Private Equity portfolio construction

Leveraged buyouts: Feedback: Monitoring and rebalancing,
- “Going private” transactions performance measurement and reporting

- Management buyouts – current management Risk Aversion
team is involved in the acquisition Risk aversion: The degree of an investor’s inability
- Management buy-ins – current management team
and unwillingness to take risk
is being replaced by the acquiring team
Risk seeking: An investor who prefers to gamble Beta
Venture capital:
Risk neutral: An investor who is indifferent about Systematic risk = Non-diversifiable / market risk
- Formative-stage financing – angel investing,
the gamble and the guaranteed outcome Unsystematic risk = Diversifiable risk
seed-stage financing, early stage financing
Risk averse: An investor who prefers the Total risk = Systematic risk + Unsystematic risk
- Later-stage financing – after commercial
guaranteed outcome Cov(R O , R < ) ρO,< σO
production and sales have begun but before IPO βO = =
- Mezzanine-stage financing – prepare to go public σd< σ<
Indifference Curve
Exit strategies: E(Ri) Capital Asset Pricing Model (CAPM)
Moderate'Risk
Trade sale, IPO, recapitalization, secondary sales, High'Risk Aversion Assumptions:
write-off/liquidation Aversion - Investors are risk-averse, utility-maximizing,

Low'Risk
Expected'Return

Real Estate Aversion rational individuals

Examples: Residential property, commercial real Risk'Neutral - Markets are frictionless
estate, REIT investing, mortgage-backed securities, - All investors plan for same single holding period
timberland, and farmland - Investors have homogeneous expectations
Risk'Seeking
Real estate valuation: comparable sales, income, - Investments are infinitely divisible
and cost approaches - Investors are price takers

0 !i EÁR S Ë = R Ω + βO [E[R < ] − R Ω ]
Commodities Standard'Deviations
Limitations:
Contango: Little/no convenience yield; futures
- Single-factor (only systematic and beta risk are
price > spot price
included)
Backwardation: High convenience yield; futures
- Single-period (the model does not consider multi-
price < spot price
period implications)
Roll yield: Spot price − Futures price
- Inclusion of assets that are not investable, such as
Futures price: Spot price (1 + 𝑟𝑟) + Storage
human capital and assets in closed economies
costs – Convenience yield

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Security Market Line (SML) Risk Management Continuation Patterns
Graphical representation of CAPM: Risk management framework: Ascending triangle: Highs form horizontal line;
E(Rp) SML - Risk governance lows form uptrend
- Risk identification and measurement Descending triangle: Highs form downtrend;
- Risk infrastructure lows form horizontal line
E(Rm) M
Expected*Return

!i =*!m - Defined policies and processes Symmetrical triangle: Highs form downtrend;
8R i - Risk monitoring, mitigation, and management lows form uptrend
Rm
*=* - Communications Rectangle: Highs and lows form horizontal lines
pe
Slo
- Strategic analysis or integration Flag: Parallel trend lines over short period
Rf Risk tolerance: Which risks are acceptable and how Pennant: Converging trend lines over short period

much risk should be taken
Price-Based Indicators
0 !i
Risk budgeting: How the risks should be taken
1.0 Moving average: Average closing price over a
Beta Financial risks: Arise from financial market
specified number of periods
activities (e.g. market, credit, liquidity risk)
Identifying Mispriced Stocks Golden (Dead) cross: When short-term moving
Non-financial risks: Arise from within entity or
average crosses long-term moving average from
E(Rp)
SML from external (e.g. operational, legal, regulatory,
below (above)
Stock Z political, model, tail risk)
Stock X Bollinger bands: Lines representing moving
Risk measures: Standard deviation, beta, duration,
average and moving average +/ − set number of
Expected*Return

delta, gamma, VaR, CVaR, etc.

standard deviations from average price
Stock Y
Risk modification: By prevention and avoidance,

transfer (insurance), or shifting (derivatives) Momentum Oscillators

Rate of Change (ROC) Oscillator:
Technical Analysis: Assumptions
Rf M = (V − Vx) × 100
- Supply and demand determine prices
V = last closing price
- Changes in supply and demand cause changes in
0 !i Vx = closing price x days ago, typically 10
prices
Beta ROC oscillator crossing 0 in the same direction as
- Prices can be projected with charts and other
Based on the graph above, the trend direction is buy/sell signal
technical tools
- Stock X is underpriced Relative Strength Index:
- Investors are often irrational, thus preventing
- Stock Y is overpriced 100 Σ(Up changes)
market efficiency RSI = 100 − , RS =
- Stock Z is fairly priced
1 + RS Σ(|Down changes|)

Technical Analysis: Charts Stochastic Oscillator:
Ratios Last closing price − Low in past 14
Bar chart: Shows open, close, low, and high price
Sharpe RS − RΩ %K = 100 ú ù
Candlestick chart: Shows open, close, low, and high High in past 14 − Low in past 14
Total risk

ratio σS %D = average of last 3 daily %K values

price. White body means close > open; dark body
M- σ< Moving-average convergence/divergence (MACD)
ÇR S − R Ω É − (R < − R Ω ) means close < open
squared σS oscillator: Consists of MACD line and signal line
Line chart: A plot of price data, typically closing
Treynor RS − RΩ prices, with a line connecting the points MACD line is the difference between two
Systematic

ratio βS Point and Figure chart: Constructed with columns exponentially smoothed moving averages (12 and
risk

of X’s alternating with columns of O’s to reflect the 26 days). Signal line is the exponentially smoothed
Jensen’s
R S − ÁR Ω + βS (R < − R Ω )Ë number of changes in price average of MACD line (9 days)
alpha

Sentiment Indicators

Trends
Investment Policy Statements (IPS) Put/call ratio: Volume of put options traded
Uptrend: Security price reaches higher highs and
Investment objectives: Risk objectives, divided by volume of call options traded
higher lows
return objectives CBOE Volatility Index (VIX): Measures near term
Downtrend: Security price reaches lower highs and
Constraints: Liquidity, time horizon, tax concerns, market volatility calculated by the CBOE
lower lows
legal and regulatory factors, unique circumstances Short interest ratio: Number of shares sold short

Support: Low price range where buying is
Asset Allocation sufficient to stop further decline divided by the average daily trading volume

Strategic asset allocation: Set of exposures to IPS- Resistance: High price range where selling is Flow-of-Funds Indicators
permissible asset classes expected to achieve the sufficient to stop further increase Arms index (or TRIN): Measures relative extent to

client’s long-term objectives which money is moving into and out of rising and
Reversal Patterns
Tactical asset allocation: Decision to deliberately declining stocks
Head and shoulders (H&S): Indicate an upcoming
deviate from policy exposures to systematic risk Mutual fund cash position: Percentage of mutual
downtrend following a preceding uptrend
factors intended to add value based on forecasts of fund assets held in cash
Inverse H&S: Indicate an upcoming uptrend
near-term returns of those asset classes
following a preceding downtrend
Price target = Neckline − (Head − Neckline)
Double/Triple tops: When an uptrend reverses
two/three times at about the same high
Double/Triple bottoms: When a downtrend
reverses two/three times at about the same low

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Cycles BA II PLUS CALCULATOR TIPS
BA II PLUS CALCULATOR TIPS CFA CANDIDATE CHECKLIST
CFA CANDIDATE CHECKLIST
Kondratieff wave: 54-year long economic cycles Basic Operations Source:

2ND : Access secondary functions (in yellow) https://www.cfainstitute.org/programs/cfaprogram/
Elliott Wave Theory
ENTER : Send value to a variable courseofstudy/Pages/candidate_checklist.aspx
Market moves in regular, repeated waves

Wave sizes: grand supercycle, supercycle, cycle, 2ND + ENTER : Toggle between options

primary, intermediate, minor, minute, minuette, ↑ ↓ : Navigate between variables/options Several Months Before Exam Day
and subminuette STO + 0 - 9 : Store current value into memory ¨ Review testing policies.
Market waves follow ratios of numbers in RCL + 0 - 9 : Recall value from memory ¨ Confirm international travel passport is valid.
Fibonacci sequence ¨ Ensure you have the necessary travel
Time Value of Money (TVM)

documents to get to the test center.
Intermarket Analysis For annuity, loan, and bond calculations

The combined analysis of major categories of N : Number of periods The Month Before Exam Day
securities, including equities, bonds, currencies, I/Y : Effective interest rate per period (in %) ¨ Review and print your exam admission ticket on
commodities, to identify market trends and clean, blank paper.
PV : Present value
inflection points ¨ If the name on your exam admission ticket does
PMT : Payment/coupon amount
not match the name on your passport exactly,
FV : Future value/redemption value
update your name in your CFA Institute account
CPT + one of the above : Solve for unknown as soon as possible. Reprint your ticket after the
2ND + BGN : Toggle between ordinary annuity name change.
and annuity due ¨ Check directions to the test center and special
2ND + CLR TVM : Clear TVM worksheetNote: instructions for travel and parking.
- Always clear the TVM worksheet before ¨ Plan travel route to the test center.
starting a new calculation. The Week Before Exam Day
- For bonds, PMT and FV should have the same ¨ Plan to dress in layers as temperatures at test
sign, and opposite signs to PV centers can vary.

¨ Plan your lunch.
Cash Flow Worksheet ( CF , NPV , IRR )
¨ Review instructions for filling out answer sheet.
For non-level payments
¨ Review the CFA exam personal belongings
Input ( CF )
policy (link at end of section).
CF0: Initial cash flow

C01: 1st distinct cash flow after initial cash flow What to Bring to the Test Center
F01: Frequency of CO1. ¨ Valid international travel passport
C0n: nth distinct cash flow. ¨ Exam admission ticket
F0n: Frequency of C0n. ¨ At least one approved calculator
Note: ¨ No. 2 or HB pencils
- Always clear the CF worksheet before starting ¨ Eraser
a new calculation. ¨ Pencil sharpener
- The use of F0n is optional. You can leave them as CFA Exam Personal Belongings Policy
1 and input repeating cash flows multiple times. If https://www.cfainstitute.org/about/governance/
you do so, C01 will be the cash flow at time 1, C02 policies/Pages/personal_belongings_policy.aspx
will be the cash flow at time 2, and so on.
Output ( NPV , IRR )
I: Effective interest rate per period (in %)
NPV + CPT : Solve for net present value
IRR + CPT : Solve for internal rate of return

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