2020

CFA® EXAM REVIEW

Critical
concepts
for the
CFA EXAM

Wiley’s CFA ®

Program Level I
Smartsheets
Fundamentals For CFA Exam Success
WCID184
 Expected Return
outcome is 1/6. on a Portfolio
The Continuous Uniform Distribution
The Continuous NUniform Distribution
E(R ) = ∑ wi E(R i ) = w1E(R1 ) + w 2 E(R 2 ) + + w N E(R N )

Wiley’s CFA Program Exam Review

® A continuousp uniform distribution is described by a lower limit, a, and an upper limit, b.
The Time Value of money  i =1
The Time Value of money 
A continuous
These uniform
limits serve distribution
as the parameters is of
described by a lower
the distribution. Thelimit, a, and an
probability ofupper limit, b.
any outcome
These limits serve as the
or range of outcomes outside
where: parameters of theisdistribution.
this interval The probability
0. Being a continuous of any outcome
distribution, individual
The Time
The Time Value
Value of
of Money 
Money 
QM
or range ofalso
outcomes
QM outcomes have a outside this of
probability interval
0. Theisdistribution
0. Being a continuous distribution,
is often denoted individual
as U(a,b).
Market value of investment i
Effective Annual Rates outcomes also have
Weight of asset i = a probability of 0. The distribution is often denoted as U(a,b).
Effective Annual Rates
The Time Value of money  The probability thatMarket value of portfolio
the random variable will take a value that falls between x1 and x2, that
The
bothprobability thatrange,
lie within the the random
a to b, variable will take of
is the proportion a value thatarea
the total fallstaken
between x1 the
up by andrange,
x2, that
EAR = (1 + Periodic interest rate) N − 1
EAR = (1 + Periodic interest rate) N − 1 both
x1 to lie
x2.within
Portfolio Variancethe range, a to b, is the proportion of the total area taken up by the range, pRobabiliT
The Time Value of Money  x1 to x2. QUANTITATIVE METHODS
The Future Value of a Single Cash Flow
The Future Value of a Single Cash Flow
Effective Annual Rates N N
P (x1 ≤p )X= ≤∑xreturn
ExpectedVar(R
∑
Return on a Portfolio wx – x1 ,R )
ETHICAL AND QUANTITATIVE METHODS • Expected on
w2 Cov(R
2 ) = ix j – x a portfolio
N
FVN = PV (1 + r) N i j
The median FVN is=the (1 + r)of the middle item of a data set once it has been sorted into an
PVvalue
N P (x1 ≤ XN≤i =x1 2j=)1 = 2b-a 1
EAR = (1 + Periodic interest rate) − 1 b-a
PROFESSIONAL STANDARDS Time Value of Money ascending
The
The
Present
PresentorValue
descending
Value order.Cash
of a Single
of a Single The advantage
Cash Flow
Flow of using the median is that, unlike the mean,E(R p ) = ∑ wi E(R i ) = w1E(R1 ) + w2 E(R 2 ) + + w N E(R N )
it is not sensitive to extreme values. However, the median does not use all the information
The Future Value FVof a Single Cash Flow
FVmagnitude
Variance of a 2 Asset
Remember that P(X
Portfolio
i =1 3 x) is the same as P(X > x) or this distribution because it is a
about thePVPV = and
size of the observations and only focuses on their relativeRemember
positions. that
continuous P(X 3 x)where
distribution is the same
P(X =asx)P(X > x)zero.
equals or this distribution because it is a
= (1 + r) N
N
Ethics in the Investment Profession FV =(1PV
• Present
N
+ r)(1 + r) N
value (PV) and future value (FV) of a single cash where: • Var(R
continuous p ) = wof
Variance
distribution
2 2
A σa (R
2-asset
where w2B σ=
A ) +P(X
2
) + 2w zero.
(R Bequals
portfolio
x) A w B Cov(R A ,R B )
The mode of a data set is simply its most frequently occurring value. A data set that Thehas
BinomialQUANTITATIVE
Distribution
MarketMETHODS
value of investment i
The
one mode
flow
The Present
Present
and Future Value of an Ordinary Annuity
and
said Future
is Value ValueCash
toofbea unimodal,of an Ordinary
while one thatAnnuity
has two modes is said to be bimodal. Weight
The Binomial =
It of asset iDistribution
• Challenges to ethical behavior: overconfidence
QUANTITATIVEbias,
The
METHODS
Present
is also possible for a
Single
data set to have
Flow
no mode, where all values are different and no value
Var(R p ) = wMarket
2 2 value of
2 portfolio
2
A σ (R A ) + w B σ (R B ) + 2w A w Bρ(R A ,R B )σ (R A )σ (R B )
PVAnnuityFV: # periods N; % interest per period I/Y; amount FV or amount PMT → PV A binomial random variable is the number of successes (X) from a Bernoulli trial that is
situational influences, focusing on the immediate ratheroccurs more
PVAnnuity : # periods
PV =frequently
% interest
N; others.
than Forper period I/Y;
grouped amount
data, FV or interval
the modal amount PMT →interval
is the APVbinomial random variable is the number of successes (X) from a Bernoulli trial that is
FV : # periods N; % interest per period I/Y; amount FV or amount PMT → carried
FV out “n” times. A Bernoulli experiment is an experiment that has only 2 possible
than long-term outcomes/consequences. The
withmedian
the FV is (1
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value
+:frequency.
#r) of N;
periods the%middle
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→ FVan
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a 3 Asset
Variance times.Portfolio
highest
Annuity The is
Quantiles
ascending
measure
or descending
tendency that can beout
carried
data. order. The advantage of using the median is that, unlike the
Binomial Distribution
A Bernoulli experiment is an experiment that has only 2 possible
outcomes
mean,
which are labeled “success” and “failure.” Further, these two outcomes are
• General ethical decision-making framework: identify, used
The
The
with nominal
Present
Present
it is not
The Present
and
• sensitive
PV and
and Future
andFuture
toFV
Future
extreme Value
ofValue
Value of
ordinary an
of an
values.
of
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annuity
anHowever,
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Annuity
Due
and
Annuity
the
Due median
outcomes
annuity
which areand
mutually exclusive
does notdue
labeled “success”
collectively
use all the information
and “failure.” Further, these two outcomes are
exhaustive.
N2 σ N 2 (R ) + w 2 σ 2 (R ) + w 2 σ 2 (R )
consider, decide and act, reflect. mutuallyVar(R p) = w
exclusive andA collectively B exhaustive.
• Var(R p ) = ∑ ∑of
A QM B C C
A quantile
about the sizeis aand
value at, or below
magnitude of the which a stated and proportion of theonobservations inpositions.
a data Probability wixwsuccesses
jCov(R i ,R j ) in n trials (where the
The weighted mean is calculated byobservations
assigning differentonlyweights
focuses their relative
toamount
observations in theprobability
The of x
+ successes in n trials is given by:
PV : # periods N; % interest per period I/Y; amount FV or PMT → PV 2w =1A w B Cov(R A ,R B ) + 2w B w C Cov(R B ,R C ) + 2w C w A Cov(R C ,R A )
• CFA Institute Professional Conduct Program sanctions: set lie. Examples
PVAnnuity
data set toPVaccount
of quantiles
Annuity Due
Annuity Due for
= PVOrdinary
= PV
the
include:
disproportionate
Ordinary Annuity
× (1 + r)
Annuity × (1 + r)
effect of certain observations on the arithmetic
The probability
probability of
i
x
=1 j
of
successes success,
in n p,
trials is
is equal
given for
by: all trials) is given by:
The mode FV
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= FV N; % interest ×per
(1 +period
r) I/Y; amount or amount
FV value. PMTset→that
FV has
public censure, suspension of membership and use of mean. The FVof a data
Annuity
arithmetic set
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is Ordinary
FV simply its equal
most
Annuity
assigns
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r)
weights to occurring
every observation A in
data
the data set, Formula
Bayes’
one •
mode quartiles,
is said which
to be divide
unimodal, the distribution
while one inhas
that quarters
two or fouris equal
modes said parts.
to be Variance
bimodal. It of a 2 Asset Portfolio x
P(X = x) = nCx (p) (1 – p) n–x
the CFA designation, and revocation of the CFA charter which makes it very sensitive to extreme values.
The • Present
quintiles,
and which
Future divide theandistribution into fifths.
is also
Present • possible
Value
PV ofof offor a dataValue
aaa perpetuity
Perpetuity set toof have Annuity
no mode, Due
where all values are different and no valueP(X = x) = nCx (p)x (1 – p)n – x
(but no monetary fine). Present
• moreValue
deciles, Perpetuity
which divide the data into tenths.data, the modal interval is the interval Var(R ) = w2 σ 2 (R ) + w P 2(Information Event) × P (Event)
occurs
The geometric frequently
meanPMT than to
is used others.
averageFor grouped
rates of change over time or to calculate the • • The Expected
expected
P(Event value
p Information)
A valueA and σ 2 (R B ) +random
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variable Brandom
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= PMT
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ofthe
central tendency that can
• beThe expected value of a binomialP random (Information)
variable (X) is given by:
Standards of Professional Conduct growth PV
PV of a variable
Due
Perpetuity =data.
Perpetuity
I/Y
a
Ordinary period.
Annuity In calculate geometric mean for variable
used with nominal
FV
returns data,Annuity
we must =
Due I/Y FV
addOrdinary
1 to each × (1 + r)
return observation (expressed as a decimal) and then Var(R
Annuity E(x) = n × p2 2 2 2
Measures of Dispersion Counting Rulesp ) = w A σ (R A ) + w B σ (R B ) + 2w A w Bρ(R A ,R B )σ (R A )σ (R B )
Continuous
subtract 1 from
Continuous
Compounding
the result. and
Compounding
and Future Values
Future Values different weights to observations in the
E(x) = n × p QM
I. Professionalism QM Present Statistical Concepts
The weighted
Dispersion
Value of mean is calculated
a Perpetuity
is the variability
data set toFVaccount
by assigning
or spread of a random effect ofvariable around its central •
The number
on thetendency.
Variance
The variance
of aof3different
of
ways that the krandom
Asset Portfolio
a binomial tasks can variable
be doneisequals
given nby:
1 × n2 × n3 × … nk .
PVefor
N = PVe
s r ⋅N the disproportionate
r ⋅N
certain observations arithmetic
• The variance of a binomial random variable is given by:
A. Knowledge of the Law N==  n (1 +PMT
FVGarithmetic
R 1 ) × (1
Rmean + R 2 ) ×…× (1 + R n ) to
− 1every observation in the data set,
s

mean. The assigns equal weights

= the most basic measures of variability of data. It is simply the
The •
range PVis
Data one scales:
Perpetuityof
which makes it very sensitive I/Y Nominal (lowest),
to extreme values. Ordinal, Interval, Ratio Combinations
σ 2
Var(R
= n × p × 2 (l-p)
2 2 2 2 2
p ) = w A σ (R A ) + w B σ (R B ) + w C σ (R C )
B. Independence and Objectivity difference(highest)
between the highest and lowest values in a data set. Normal
2
Distribution
σ = n × p × (l-p)
Important Relationships
Continuous Compounding Between theValues
and Future Arithmetic Mean and Geometric Mean + 2w w Cov(R ,R ) + 2w w
n A n!B C Cov(R B ,R C ) + 2w C w A Cov(R C ,R A )
C. Misrepresentation The geometric mean ismean: used to average   A B B
• Arithmetic simplerates of change over time or to calculate the
average n Cr =   =
n − r )!( r!)
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for • Formula lie in the interval µ ± (2/3)σ
D. Misconduct returns• Geometric
s

mean return: used to average rates of change

• data, we must add
The geometric mean1 toequals
each return observation
the arithmetic mean(expressed
only whenasall
a decimal) and thenare
the observations• 68%
1(or growth) over time Remember: Theofcombination
all observationsformula islie in the
used wheninterval 1σ the items are
the orderµin±which
II. Integrity of Capital Markets subtractidentical.
from the result. z‐Score
P (Information Event) × P (Event)
The difference between the geometric and arithmetic mean increases as the • ofP(Event
The• mean absolute deviation (MAD) is the average of the absolute values of assigned 90%
deviations the labels is NOT
of Information)
all important.
observations= lie in the interval µ ± 1.65σ
A. Material Nonpublic Information observations in a data set from values their mean. 38 P (Information) © 2018 Wiley
dispersion
R G =  n (1in+ observed
R1 ) × (1 + R 2 ) ×…×increases.
(1 + R n )  − 1 38 • z95%
Permutations= (observed value − populationlie
of all observations mean)/standard
in the interval µ ±= 1.96σ
deviation (x − µ)/σ
© 2018 Wiley
B. Market Manipulation common pRobabiliTy Dis
The harmonic mean n is used in the investment management arena to determine the • 99% ofn!all
average
Roy’s Safety‐First
Counting Rules
observations lie in the interval µ ± 2.58σ
Criterion
III. Duties to Clients Pr =
Important
cost of• shares
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shares
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= iof
purchased over time Minimize P(RP< RT)
to its magnitude. z‐Score
A. Loyalty, Prudence, and Care normally distributed random variable
c03.indd 38 7 March 2018

• The geometricnmean is always less than, or equal to the arithmetic mean.

Combinations
© Wiley 2018
B. Fair Dealing • The geometric mean equals the arithmetic mean only when all the observations where: areall Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
N z = (observed
return value − population mean)/standard deviation = (x − µ)/σ
identical.
Harmonic
The variance is the mean:
averageX Hof=theN squared deviations around the mean. The standard RP = portfolio
C. Suitability 1geometric and arithmetic mean increases as the  n n!
• The difference between
deviation is the positive square root∑ xof the variance. While the variance has no units,
the RT = target return
n Cr =   =
• Roy’s safety-first
the
Roy’s Safety‐First ( n − r )!( r!criterion:
r Criterion ) used to compare shortfall risk
D. Performance Presentation dispersion in observed values
i =1 i increases.
standard deviation has the same units as the random variable. Shortfall of portfolios (higher SF ratio indicates lower shortfall risk)
Ratio
Minimize P(R < R )
E. Preservation of Confidentiality • Variance:
The harmonic
Mathematically,
Population mean
unless
Variance isaverage
used
and
ofinvestment
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in observations
all the the
Standard
squared
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value),
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assigned the labels is NOT important. E (RP ) − RT
IV. Duties to Employers 22 cost
the of2018
harmonic
© Wiley mean
shares purchased
mean
all Rights over
will always
Reserved. any time. It may
be less
unauthorized thanbeor
copying viewed
the geometric
distributionas
willaconstitute
special
mean, an type
which ofitself
weighted
infringement ofwill mean
be lessShortfall ratio (SF Ratio) =
copyright.
where:
© Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
wherethe
than thearithmetic
weight ofmean.an observation is inversely proportional to its magnitude. R σP
P = portfolio return
Permutations QUANTITATIVE METHODS
A. Loyalty n
RT = target return
N
∑ (X i − µ)2 n! Continuously Compounded Returns
B. Additional Compensation Arrangements σ = mean: X H = N 2i =1
Harmonic Pr =
Shortfall nRatio ( n −r r )!
Sample Variance and n Standard Deviation1
∑ x copying or distribution will constitute Sampling
EAR = e −1 Theory
rcc = continuously compounded annual rate
cc

C. Responsibilities of Supervisors 2 © Wiley 2018 all Rights Reserved. any unauthorized an infringement of copyright.
i =1 i sampling anD esTimaTion E (RP ) − RT
V. Investment Analysis, Recommendations, and Actions • HPR
© Wiley 2018Central
Shortfall r ×limit
all Rights Reserved.
ratio t
(SF Ratio) =
anytheorem:
unauthorized copying
σGiven
or distribution will constitute an
a population infringement
with any of copyright.
t =e −l
n cc
n
∑∑(X 2 P
Mathematically,
© 2018 Wiley (Xi −
unless all2the observations in the data set are identical (equal in value), probability distribution,
X) 21 with mean, μ, and variance,
A. Diligence and Reasonable Basis i − µ)
the harmonic 2 mean
i =1
sσ == i =1 will always be less than the geometric mean, which itself will be less
Continuouslyσ , the
2
sampling
Compounded Sampling
distribution
Returns and Estimation
of the sample mean x,
−n1 sampling anD esTimaTion
B. Communication with Clients and Prospective than the arithmeticn mean. computed from sample size n will approximately be
SamplingEAR
Error
Clients c02.indd 21 = e r − 17 March 2018r7:04
normal cc = PMcontinuously compounded annual rate
with mean, μ (the population mean), and
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C. Record Retention pRobabiliTy concepTs • Standardn deviation: positive square root of the variance variance,
Sampling
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concepTs when
mean =the
Sampling
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Estimation
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VI. Conflicts of Interest

∑ (X i − X)
• Coefficient of
2
variation: used to compare relative equal
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×t
to 30. −l cc

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s =of Variation Sampling Error
Standard Error of Sample Mean when Population Variance is known
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A. Disclosure of Conflicts Coefficient of Variation
© 2018 Wiley means is
Sampling known
error of the21 as QM
mean the standard
= Sample mean −errorPopulationof sample
mean = xmean. −µ
s σx = σ
B. Priority of Transactions 22 Coefficient of)X
= P(Xdeviation variation
1 + P(X
= n
n )X nbe less than or equal to the standard • When the population variance is known, the standard
© 2018 Wiley
The meanE(X) absolute 1 (MAD)
2 )X s2 + will
X … P(X always
deviation.Coefficient
This is because, of variation =
by squaring all deviations from the mean, the standard Standard Error of Sample Mean when Population Variance is known
C. Referral Fees X where: error of sample mean is calculated as
c02.indd 21 deviation attachesn a greater weight to larger deviations from the mean.
where: 7 March 2018 7:04 PM
VII. Responsibilities as a CFA Institute Member or CFA = ∑ P(X σ x = the standard error of the sample mean
c02.indd 22 = sampleE(X)
swhere: standard i )X i
deviation = σ2018 7:04 PM
σ7xMarch
• Sharpe ratio: used to measure excess return per unit of σ = the population nstandard deviation
Candidate sThe
X semivariance
==sample
the sample
standard
i
mean.= 1isdeviation
the average of squared deviations below the mean, while the
n = the sample size
Xsemideviation risk (higher
= the sample is
mean.the positive is better) square root of the semivariance. The target semivariance where: • When the population variance is not known, the standard
A. Conduct as Participants in CFA Institute Programs where:
Sharpe
refers toRatiothe sum of the squared deviations from a specific target return and its square root.
Xi = one of n possible outcomes. σ x = the
Standard error
Error of
standard of sample
Sample
error of theMean mean
sample when is Population
mean calculated as is not known
Variance
B. Reference to CFA Institute, the CFA Designation, Sharpe Ratio σ = the population standard deviation
Chebyshev’s Inequality r − r
and the CFA Program Variance and Standard
Sharpe
p
ratio = Deviation
f n = the sample size
sx =
s
rp s−p rf
pRobabiliTy concepTs Sharpe ratio = gives n
Chebyshev’s inequality an
2 approximate value for the proportion of observations in aError of Sample Mean when Population Variance is not known
Global Investment Performance σ 2 (X) = E{[X − E(X)]
sp
data set that fall within k standard deviations from the mean.}
Standard
where: • Positive skew: mode < median < mean where: • Confidence interval for unknown population parameter sampling anD
Standards (GIPS®) rp = mean portfolio
where: Value nreturn s x = standard s of sample mean
error
Expected • Kurtosis:
rrpf == risk‐free (X) = ∑
return leptokurtic (positive excess kurtosis), x =
sbased
n on z-statistic
within k standard deviations from mean = 1 –s 1/k = sample standard deviation.
meanσ 2
portfolio return 2
i ) [X i − E(X)]
P(X 2
Proportion of observations
• Compliance by investment management firms with GIPSsrfp == risk‐free platykurtic
standard deviation
return i =1 of(negative
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E(X) = P(X 1 )X1 + P(X 2 )X 2 + … P(X n )X n σ
is voluntary. s p = kurtosis
standard deviation as ofnormal
portfolio distribution;
returns i.e. zero excess kurtosis) Confidence
where: x ±Intervalsz α /2
Sample skewness, alsoRuleknown n sample mean
The Total Probability
advantage of Chebyshev’s forasExpected
sample relative
inequality is thatskewness,
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s x = standard
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E(X)
n
and= continuous
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also knowndata
P(X )X
as sample
regardless relative
of the skewness,
shape ofis the
calculated as:
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standard ± (reliability factor × standard error)
deviation.
basis in order to claim compliance. 1. E(X) = E(X | S)P(S) + E(X | S )P(S ) 3 i i
∑
n c c where: • Confidence interval for unknown population parameter
n (X| S i −) X)
pRobabiliTy concepTs i =1
2. E(X) = E(X | S ) × P(S ) + E(X × P(S ) + . . . + E(X | S ) × P(S ) Confidence
x = The sample
© Wiley 2018based Intervals
mean (pointanyestimate ofcopying
population mean)will constitute an infringement of copyright.
Coefficient ofVariation 1 n 1  2 2 n n where: on t-statistic
all Rights Reserved. unauthorized or distribution
• Third-party verification of GIPS compliance is optional. where: • SExpected K =
 ( n − 1)(
value and ∑ variance
i =1 (X − X)3
n n − 2 )  i =1 s3
i of a random variable (X) zPoint α/2 = estimate = value of the sample statistic that is used to estimate the population

where: using
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Point estimatenormal± random
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factor × for which
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i = one of
= theValue
unconditional
variation,
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value of X
ratio of the standard deviation of the data set to
σ lyingfactor
Reliability in either tail
= aerror is σ /based
number 2 (reliability
on the factor). distribution of the point estimate and
assumed
its mean, is used to compare the relative dispersions of data sets. A lower coefficient =ofThe standard of the sample mean.
historical performance when first claiming compliance, E(X As n becomes large, the expression
| S1) = the expected value of X given Scenario 1
Variance and Standard Deviation
reduces to the mean cubed deviation.
then level of confidence for the interval (1 − α).
where:
variation
As n1)becomesisprobability
better.
large, QUANTITATIVE METHODS
or since inception of the firm or composite if less than P(S = the
E(X) = P(Xthe ofexpression
)X Scenario 1reduces occurring
1 + P(X 2 )X 2 + … P(X n )X n
to the mean cubed deviation. Standard error = value
Point estimate the standard error ofstatistic
of the sample the samplethat statistic
is used to (point estimate)
estimate the population
five years, then add one year of compliant performance The set of events {S n 1
, S2, . . . 3, Sn} is mutually exclusive and exhaustive. parameter • Whensto use z-statistic or t-statistic
σ 2 (X) = ∑
1 si =n1
nE{[X
1
(X i −− X) E(X)] 2
} © Wiley 2018 ± Rights
xall t α Remember:
Reserved.
Reliability factor =n a number any unauthorized copying or distribution will constitute an
The based on the assumed distribution of the point estimate and infringement of copyright.
each subsequent year so that the firm eventually Covariance CV
S K ≈= ∑ (X i3− X)
3
2 CV measures risk Small Sample Large Sample
E(X) n1=X∑ P(X s i )X i the level of Whenconfidence
Sampling for
from
per unit of a: interval (1 − α).
the
return. n < 30 n > 30
presents a (minimum) performance record for 10 years. SK ≈ ii==11n 3 Standard error = the standard error of the sample statistic (point estimate)
• Nine major sections: Fundamentals of Compliance; Inputwhere: Cov(XY)∑
σ 2 (X)n = = P(X s i ) [X i − E(X)]2
E{[X − E(X)][Y − E(Y)]} where: Normal distribution with known variance z‐statistic z‐statistic
i =1 x = sample mean (the point estimate of the population mean)
where:
= sampleCov(R
swhere: standard B ) = E{[R A − E(R A )][R B − E(R B )]}
A ,Rdeviation tα
data; Calculation Methodology; Composite Construction;X = one of n possible outcomes.
Normal distribution with unknown variance
= the t‐reliability factor
t‐statistic t‐statistic*

Disclosures; Presentation and Reporting; Real Estate; Correlation =i sample

sThe •
Total
Sample Kurtosis
standard deviation
Covariance
Probability
Coefficient
Ruleand forcorrelation
Expected Value of returns
uses standard deviations to the fourth power. Sample excess kurtosissis = standard
2
Non-normal distribution with known variance not available z‐statistic
error of the sample mean
Private Equity; and Wrap Fee/Separately Managed Variance
calculated
Sample
1. E(X)Kurtosis
and Standard Deviation
=as:E(X | S)P(S) uses standard+ E(X | S deviations
c)P(Sc) to the fourth power. Sample excess kurtosis nis Non-normal distribution with unknown variance not available t‐statistic*
Account (SMA) Portfolios. s = sample standard deviation
2. E(X) =as:E(X | S1) × P(S1) + E(X | S2)Cov(R
calculated × P(SA2),R + .B.). + E(X | Sn) × P(Sn)
B) = − ρE(X)]
Corr(R 2 )=
σ 2 (X) =A ,R E{[X (R A ,R }B n (σ )(σ4 ) * Use of z‐statistic is also acceptable

where:  n(n + 1)
∑ n (X i −
A X) B
 3(n − 1) 2
E(X) = the E =
 n
K unconditional
(n − 1)(n
expected value
n(n−+2)(n
∑
i =1 (X − X) 
1) − 3) i =1 2 s4
ofi X  −
4
− 1)−2 3)
− 2)(n
Sample Biases
Wiley © 2020
E(X
© 2018 | SWiley
1) =
K
2
σthe(X) = ∑ P(X
E =expected i ) [Xof
value i −XE(X)]given Scenario
4
 (n3(n
 1− (n − 2)(n − 3) Data‐Mining Bias 23
 (n − 1)(n −
P(S1) = the probability of Scenario 1 occurring
i =1 2)(n − 3) s 
 
The set of events  {S1, S2, . . . , Sn} is mutually exclusive  and exhaustive. Data mining is the practice of extensively searching through a data set for statistically
 Sample statistic − Hypothesized value
Test statistic =
Standard error of sample statistic

Power of a Test economicS

Wiley’s CFA Program Exam Review

Power of a test = 1 − P(Type II error) ®
• The point of intersection of the AD curve and the SRAS curve defines the
Decision Rules for Hypothesis Tests
economy’s short run equilibrium position. Short‐run fluctuations in equilibrium
Decision H0 is True H0 is False real GDP may occur due to shifts in either or both the AD and SRAS curves. Short
Do not reject H0 Correct decision Incorrect decision run equilibrium may be established at, below or above potential output. Deviations
Topics in DemanD anD supply analysis
Type II error of short run equilibrium from potential output result in business cycles.
Reject H0 Incorrect decision Correct decision ○ In an expansion, real GDP is increasing, the unemployment rate is falling
Type I error Power of the test and capacity utilization is rising. Further, inflation tends to rise during an
Total, Average, Marginal, Fixed, and Variable Costs
Significance level = = 1 − P(Type II error) expansion.
P(Type I error)
Table: Summary of Cost Terms ○ In a contraction, real GDP is decreasing, the unemployment rate is rising
Confidence Interval Costs Calculation and capacity utilization is falling. Further, inflation tends to fall during a
contraction.
 sample   critical   standard    population   sample   critical   standard  
Hypothesis Testing  statistic −  value   error   ≤  parameter  ≤  statistic +  value   error  
    Shutdown
Total fixed cost (TFC)
Analysis
Sum of all fixed expenses; here defined to include all • Shift
Factors causing a shift in aggregate demand (AD)
in Aggregate Demand
opportunity costs
x − (z α /2 ) (s n) ≤ µ0 ≤ x + (z α /2 ) (s n)

oThesis TesTing • One-tailedSummary

versus two-tailed tests • Total variable cost (TVC)
Profits are maximizedSum of all variable expenses, or per unit variable cost
when the difference between total
times quantity; (per unit VC × Q)
An Increase in the
Following Factors Shifts the AD Curve Reason
Null Alternate Fail to reject revenue (TR) and total cost (TC) is at its highest. The level
Type of test hypothesis hypothesis Reject null if null if P‐value represents Total costs (TC) Total fixed cost plus total variable cost; (TFC + TVC)
One tailed H0 : μ ≤ μ0 Ha : μ > μ0 Test statistic > Test statistic ≤ Probability that lies of output at which this occurs is the point where: Stock prices Rightward: Increase in AD Higher consumption
Hypothesiscritical
Testing Average fixed cost (AFC) Total fixed cost divided by quantity; (TFC / Q)
• Marginal revenue (MR)
(upper tail) critical value value above the computed test
test statistic. equals marginal cost (MC); and Housing prices Rightward: Increase in AD Higher consumption
Average variable cost (AVC)
Test StatisticH0 : μ ≥ μ0
One tailed
(lower tail)
Ha : μ < μ0 Test statistic <
critical value
Test statistic ≥
critical value
Probability that lies
below the computed test
• MC is not falling Total variable cost divided by quantity; (TVC / Q) Consumer confidence Rightward: Increase in AD Higher consumption

test
Sample statistic − Hypothesized value
statistic.
• Average total cost (ATC)
Breakeven occurs when Total cost divided by quantity; (TC / Q) orEC(AFC + AVC)
TR = TC, and price (or average Business confidence Rightward: Increase in AD Higher investment
: μ = μ0 =Ha : μ ≠ μ0
Two‐tailed TestH0statistic Test statistic <
Standard error
lower
Lower critical
of sample
critical value ≤ statistic
test
Probability that lies
above the positive
revenue)
Marginal equals average
cost (MC) Changetotal
in total cost (ATC)
cost divided at thein breakeven
by change quantity; Capacity utilization Rightward: Increase in AD Higher investment
(ΔTC / ΔQ)
value
Test statistic >
statistic ≤
upper critical
value of the computed
test statistic plus the
quantity of production. The firm is earning normal profit. Government spending Rightward: Increase in AD Government spending a component
Power of a Test upper critical
value
value probability that lies
below the negative
• Breakeven,
Short-run and long-run
Shutdown, operating decisions
and Exit Points
of AD

value of the computed Taxes Leftward: Decrease in AD Lower consumption and investment
Power of a test = 1 − P(Type II error) test statistic. Revenue/ Cost Relationship Short-run Decision Long-run Decision
Bank reserves Rightward: Increase in AD Lower interest rate, higher
TR = TC Continue operating Continue operating investment and possibly higher
• Decision
Type I Rules
versus
forType II errors
Hypothesis Tests
TR > TVC, but < TC Continue operating Exit market
consumption
16 © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. Exchange rate (foreign Leftward: Decrease in AD Lower exports and higher imports
Decision H0 is True H0 is False TR < TVC Shut down production Exit market
currency per unit
Do not reject H0 Correct decision Incorrect decision domestic currency)
Type II error
Global growth Rightward: Increase in AD Higher exports
Reject H0 Incorrect decision
Type I error
Correct decision
Power of the test
Market Structures economicS

Significance level = = 1 − P(Type II error) • Shift

Factors causing a shift in aggregate supply (AS)
P(Type I error) • Perfect competition
hypoThesis TesTing
in Aggregate Supply

• Minimal barriers to entry, sellers have no pricing power. An Increase in Shifts SRAS Shifts LRAS Reason

• Confidence
Hypothesis Intervaltest concerning the mean of a single hypoThesis TesTing Supply of labor Rightward Rightward Increases resource base
t‐Statisticpopulation • Demand curve faced by an individual firm is perfectly Supply of natural resources Rightward Rightward Increases resource base
 sample   critical   standard    population   sample   critical   standard  elastic (horizontal).
 statistic −  value   error   ≤  parameter  ≤  statistic +  value   error  
Chi Squared x − µ0
 Test‐Statistic    Supply of human capital Rightward Rightward Increases resource base
t-stat = • Average revenue (AR) = Price (P) = MR. 94 © 2018 Wiley
x s −n (z α /2 ) (s n) ≤ µ0 ≤ x + (z α /2 ) (s n) hypoThesis TesTing Supply of physical capital Rightward Rightward Increases resource base

2 ( n − 1) s2 • In the long run, all firms in perfect competition will Productivity and technology Rightward Rightward Improves efficiency of inputs
χ
where: • Summary = make normal profits.
Hypothesis σ 20 test concerning the variance of a normally c04.indd 94
Nominal wages Leftward No impact Increases labor cost 7 March 2018 7:05 PM

xChi = sample mean

Squared
μ0 = hypothesized
Test‐Statistic
distributed
Null population population
Alternate mean Fail to reject • Monopoly Input prices (e.g., energy) Leftward No impact Increases cost of production

Type of test where:hypothesis P‐value represents • High barriers to entry, single seller has considerable
s = standard deviationhypothesis
2of the sample Reject null if null if Expectation of future prices Rightward No impact Anticipation of higher costs and/or
n = sample2size( n − 1) s
H0 :χμsize
≤= μ0 2 Ha : μ > μ0
perception of improved pricing
One tailed n2= sample Test statistic > Test statistic ≤ Probability that lies pricing power.
s = sample variance σ0 power
upper tail)σ 2 critical value critical value above the computed test
est 0 = hypothesized value for population variance
z‐Statistic statistic. • Product is differentiated through non-price strategies. • taxes
Business Reduce exposureLeftward
25
to equities inNoanticipation
impact of a decline
Increases in output and profit
cost of production economicS

anD anD supplywhere:

analysis © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. margins coming Rightward
under pressure.
• Hypothesis test related to the equality of the variance of • Demand curve faced by the monopoly is the industry Subsidy No impact
• Increase investments in commodities and/or commodity‐oriented companies
Lowers cost of production
EC

One tailed n = sample ≥ μ0

H0 : μsize Ha : μ < μ0 Test statistic < Test statistic ≥ Probability that lies
lower tail)s2 z-stat
= sample
two
Test‐Statisticx − µfor 0populations
the F‐Test
critical value
x − µ0
below the computed test demand curve (downward sloping).
• Reduce
Exchange rate
because
exposure to equities
theirunder
Rightwardin anticipation
prices
No impact of a decline in output
Lowers and profit
cost of production
and profits are likely to rise (due to higher prices).
= variance Topics in Demand andz-stat
Supply =
critical value
Analysis margins coming pressure.
σ n value for population variance
σ 20 = hypothesized s n
est
s12
statistic. • An unregulated monopoly can earn economic profits •
• Conclusions
Impact
Increase investments
oftheirchanges
in commodities
inprofits
AD are and
and/or commodity‐oriented
ASto rise (due to higher prices).
companies
Cycles on
Business because AD andand
prices AS likely
The demand
Two‐tailed where:
F = function
H0 : μ = sμ20
captures the effect of all where:
Ha : μ ≠ μ0 Test statistic <
these factors on demand for a good.
Lower critical Probability that lies in the long run.
x = sample mean 2
lower critical x = sample mean
value ≤ test above the positive • Monopolistic competition Conclusions
Fluctuations in on AD
aggregate and
demandAS and aggregate supply in the short run explain whyAggregate
Unemployment short Level
Test‐Statistic for the F‐Test
μ = hypothesized
Demand population mean μ = hypothesized population mean run real GDP deviates from potential GDP. These deviations of actual GDP from full‐
function: QD x = f(P x , I, Py , …) … statistic
value (Equation ≤ 1) value of the computed employment GDP form phases of Real GDP Rate Aggregate Level of Prices
where:
σ = standard deviation of the population s = standard deviation of the sample • Low barriers to entry, sellers have some degree of
the business cycle.
Unemployment

ECONOMICS
2
2 Test statistic
s1 sample drawn from Populationn1= sample size > upper critical test statistic plus the Real GDP Rate of Prices
s1n = Variance
sample
F =size of upper critical value probability that lies pricing power. Investment Applications of an Increase in AD Resulting in an Inflationary Gap
An increase in AD Increases Falls Increases
2 Topics
2
sEquation 1 is sread 2 as “the quantity demanded
2 = Variance of sample drawn fromvalue Populationof2Good X (QDX) dependsbelow on thethe price of in DemanD anD supply analysis
negative An
A increase
decrease datainsuggest
inAD ADthat Increases Falls FallsanIncreases Increases Falls
Tests
Goodfor Means
X (P ), when
consumers’ Population
incomes Variances
(I) and the are
price Assumed
of Good Equal
Y (P ), etc.” • Product is differentiated through advertising and other
If economic
increase
A decreasein AD,in going
AD forward:
the economy is undergoing expansion caused by an
value of the computed in AS Falls Increases Increases Falls Falls
Demand Elasticities An increase Falls
X Y
Hypothesis
where: tests concerning the variance test statistic. non-price strategies. An• increase
A decrease in AS
Corporate inprofits
AS will Increases
be expected to
Falls rise. Falls
Increases
Falls
Increases
sIncome
2 Elasticity
= Variance
1Hypothesis t = Test
(xof − xof
1 sample
Demand
2 ) − (drawn
µ1 − µ 2from ) Population 1
• Demand curve faced by each firm is downward sloping. aggRegaTe ouTpuT,
A decrease
pRice,
• Commodity
anD economic
in ASprices will beFalls
gRoWTh
Increases
expected to increase. Increases
The own‐price Concerning
elasticity of1/2demand is calculated Appropriate
as: Test Statistic • Interest rates will be expected to rise.
2
sIncome • elasticity
Own-price
2 = Variance of sample
2
sof elasticity

s2pdrawn ofthe
from Populationdemand 2 is calculated as: • Effect
Effect of combined changes
• Inflationary pressures will build in the economy.
in AD ADand AS
Variance of a single, p demand
 n +normally 
measures
distributed responsiveness
Chi‐square of statdemand for a particular good • In the long run all firms will make normal profits. Effect ofofCombined
Combined Changes
Changes in ASin andASADand
to a change in income,
population  %1∆QD nholding
2 all other things constant. Aggregate Output, Price, And Economic Growth
Hypothesis tests
EDPx = concerning x the variance
… (Equation 6) • Oligopoly
Topics in DemanD anD supply analysis Effect on Real on Real
Effect Effect on Aggregate
Effect on Aggregate
%∆ofPxtwo independent, Same as coefficient Change inin ASAS Change in ADin AD GDP GDP Price Level Price Level
6 Equality of variance
Hypothesis
where: © Wiley Test 2018Concerning
F‐stat
all Rights Reserved. any unauthorizedAppropriate
normally distributed populations
Test Statistic
copying or distribution Nominal
will constitute an infringement • GDP
High
of copyright. costs
on I inrefers
market
demand function
to theofvalue
entry, sellers
of goods and enjoy
servicessubstantial
included in GDP pricing
measured at Change Change
Variance of a2 single, normally ∆QD distributed Chi‐square stat current prices.
power.
(Equation 11) Increase Increase Increase Uncertain
Income • 1)sIf the
(n −Elasticity +% (n∆of absolute
QD
− 1)s 2
Demand
x2
x
value
QDx of price ∆QDx elasticity
 I  of demand Increase
© 2018 Wiley
Decrease Increase
Decrease DecreaseIncrease Uncertain Uncertain
95
spopulation
2
= 1 ED I1 = 2 =
∆I is
=   … (Equation 8)
 divided • Product GDPis differentiated onYear quality, features,
Ifp we express n1equals
+the %2∆1, I demand
n 2 −percentage change X as the
I in said ∆toI change
be  QDunitx X
in elastic. by the value of X, Nominal = Quantity produced in t × Prices in Year t Decrease
Increase Decrease
Decrease UncertainDecrease Decrease Uncertain
Equation
Income 6 can
Equalityelasticity
of variance
• distributed
Ifin the
beofexpanded
demand to the following
measures
of two independent,
absolute value
form:
the responsiveness
F‐stat of demand for a particular good marketing and other non-price strategies. Increase
Decrease Decrease
Increase Uncertain Uncertain Increase Decrease
otherof price elasticity of demand
c04.indd 95 7 March 2018 7:05 PM

sto a change
2normally income,
1 = variance of the first sample
holding all
populations things constant. Decrease Increase Uncertain Increase
lies between
% change 1, demand is said to be relatively Real GDP• refers
0 anddemanded
in quantity Pricing to the strategies:
value of goods pricing interdependence
and services included in GDP measured (kinkedat Economic Growth
mand 2
s2 = variance E I =of the second sample
inelastic. % change∆in base‐year demand
Same as coefficient
prices. curve), Cournot assumption, game theory Business Cycles
QDincome on I in market
Economic
Economic growth Growth may be calculated as:
n1 = number of observations
• %∆QDx ∆in QD firstx
sample ∆QDx   Px 
x QD xof price
(Nash equilibrium), Stackelberg model (dominant
demand function
EDIfPxthe =%∆absolute
QDx = ∆value QDx = ∆QDx elasticity of(Equation
demand 7) is
n (Equation 11)

n2 = number EDgreater
of = % ∆
observationsP = in P
second =
sample  ∆ P 
I  …
  QD  … (Equation 8)
Real GDP = Quantity produced in Year t × Base-year prices
firm). • Phases:
• The annual
Economic trough,
growth mayexpansion,
percentage change in real
be calculated peak,
as:GDP, which contraction (or the
tells us how rapidly
%∆Ithan 1,∆demand  is∆Isaid
x   to be
  QDx x relatively elastic.
nd I x x
I Px
Cross‐Price Elasticity of Demand I • Firms always maximize profits at the output level where recession)economy is expanding as a whole; or
degrees• ofIncomefreedom =elasticity n1 + n2 −2 of demand is calculated as: • The annual change in real per capita GDP. Real GDP per capita is calculated as
• The annual percentage change in real GDP, which tells us how rapidly the
GDP Deflator MR = MC • Theories total real GDP divided by total population. It is a useful indicator of the standard
Cross
Arc elasticity
elasticity is of demand as:
calculated measures the responsiveness of demand for a particular good to ofeconomy
living in a is expanding as a whole; or
country.
a change EinI price
=
% change
of another in quantity demanded
good, holding all other things constant. • Identification of market structure
Value of current year output at current year prices
• Neoclassical
• The annual change (Say’sinLaw). real per capita GDP. Real GDP per capita is calculated as
% change in income = × 100 The total
Production real GDP
Function divided
and Potentialby totalGDP population. It is a useful indicator of the standard
(Q 0 - Q1 )
× 100
GDP
• N-firm
Same deflator
concentration
as coefficient
on PY in market Value of current ratio.
year output at base year prices • Austrian of living
(misguided
in a country.
government intervention).
% change in quantity demanded % ∆ Q d (Q 0 + Q1 )/2
•
demand function The production function asserts that an increase in an economy’s potential GDP can be
EP =
• Positive for a ∆normal
QD
% change in price good. =
 ∆ PPy 
=
(P - P ) • HHI
(Equation (add
11) up the squares of the market shares of each Keynesian (advocates government intervention during
QDx  ∆QD%
x caused
aggRegaTe ouTpuT, pRice, by:
anD economic gRoWTh
x 
0 1
%∆QD × 100 The aProduction
recession). Function and Potential GDP
Cross‐Price Elasticity
Py =
• EDNegative
ofx Demand
= =  (P…+(Equation
P )/2 9) of the largest NominalN companies
GDP in the market).
%∆Pyfor an∆Pinferior y good.
∆Py   QDx  0 1 GDP deflator = × 100 • An increase in the quantity of inputs used in the production process (e.g., capital
measuresPythe
Real GDP • Monetarist
The production
and labor). function (steady growth
asserts that an rateincrease of money supply).
in an economy’s potential GDP can be
• Cross-price
Cross elasticity of demand elasticity of responsiveness
demand is calculated of demand for as: a particular good to
Aggregate Supply and Demand
a change in price of another good, holding all other things constant. Household saving = Personal disposable income • • New
caused Anby:increase
Classical in the productivity of these inputs with the application of better
(business cycles have
technology. Improving technology enables an economy to produce more output
real causes, no
% change in quantity demanded The Components of GDP − Consumption expenditures
Same as coefficient government intervention).
EC =
% change in price of substitute or complement aggRegaTe ouTpuT, pRice, anD economic • gRoWTh
Components
on PY in market of− GDP
Interest paid by consumers to businesses • using the same quantity
An increase of inputs. of inputs used in the production process (e.g., capital
in the quantity
© Wiley 2018 all Rights Reserved. any ∆ unauthorized
QDx copying or distribution will constitute an infringement of copyright.
demand function
Based on the(Equationexpenditure11) 17 approach,
− Personal GDP transfer
may be payments
calculated to foreigners
as: … (Equation 5) • Neo-Keynesian
and labor). (prices and wages are downward
%∆QDx QDx  ∆QDx   Py  • Expenditure approach •
sticky, government
An increase intervention
in the productivity of theseisinputsuseful withinthe eliminating
application of better
•
ED Py =
Positive for =substitutes.
∆ P
=   … (Equation 9)
%∆Py any unauthorized
© Wiley 2018 all Rights Reserved. y  ∆
copying y   QDwill
orPdistribution x constitute an infringement of copyright.
Income ApproachGDP = C + I + 19 G + (X − M) technology. Improving technology enables an economy to produce more output
unemployment and restoring macroeconomic
Py
• Negative for complements. Business sector saving = Undistributed corporate profits using
© 2018equilibrium).
Wiley
the same quantity of inputs. 97
GDP+ Capitalandconsumption
prices mayallowance … as:(Equation 6)
• Normal good: substitution and income effects reinforce Under • theIncome
C = Consumer income approach,
spending on final
approach at
goods market services be calculated
% change in quantity demanded I = Gross private domestic investment, which includes business investment in capital goods • Unemployment: natural rate vs frictional vs structural
E C = another.
© Wiley 2018one all Rights Reserved.in
% change anyprice
unauthorized copying or
of substitute ordistribution
complement will constitute an infringement of copyright. (e.g. plant
GDP and = National 19income
equipment) and+changes in inventory (inventory
Capital+ Total
consumption allowance investment) c04.indd 97 vs cyclical. 7 March 2018 7:

GDP = Household consumption private sector saving + Net taxes

• Inferior good: income effect partially mitigates the G = Government+spending Statisticalondiscrepancy
final goods and services … (Equation 1) • Prices indices: using a fixed basket of goods and
substitution effect. X = Exports © 2018 Wiley
M = equality
Imports of expenditure and income services to measure the cost of living results in an
The
• Giffen good: inferior good where the income effect National • Equality
income equals of Expenditure
the sum of incomes andreceived
Income by all factors of production used to upward bias in the computed inflation rate due to
outweighs the substitution effect, making the demand generate final output. It includes: substitution bias, quality bias and new product bias.
Expenditure S = IApproach
+ (G − T) + ( X − M) … (Equation 7) c04.indd 97
curve upward sloping. • Economic indicators
• Employee compensation
• Veblen good: status good with upward sloping demand Under • • the
Toexpenditure
finance
Corporate approach, GDP
a fiscal deficit
and government at market
enterprise (Gprofits
–T prices
0),may
>before the be calculated
private
taxes, as:
sector
which includes: • This
Leading (used to predict economy’s future state).
© Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. The IS Curve ○ (Relationship
Dividends paidbetween Income and the Real Interest Rate) equation is just
curve. must save more to households
than onit invests (S > I) and/or imports
GDP○ =Corporate
Consumer spending
profits retainedgoods
by and services
businesses • aexpression
Coincident for GDP (used to identify current state of the
breakdown of the

must
Disposable +exceedincome
Business exports
= GDP
gross fixed (M
−to the>government
Business X).saving − Net taxes
investment economy).
we stated in the
Profit Maximization, Breakeven and ○ Corporate
• Interest income
taxes
+ Change in inventories
paid previous LOS, i.e.
GDP = C + I + G +
(X − M).
+ Government spending on goods and
• Rent and unincorporated business net income (proprietor’s income): Amountsservices
S − I = (G − T) + ( X − M
+ Government (Equation
) …fixed
gross investment 7)
earned by unincorporated
+ Exports − Imports
proprietors and farm operators, who run their own Wiley © 2020
businesses.
The LM Curve + Statistical discrepancy
• Indirect business taxes less subsidies: This amount reflects taxes and subsidies that
Quantityare included
theory in the final
of money: MV =price PY of a good or service, and therefore represents the
 cuRRency exchange RaTes

Monetary And Fiscal Policy

Wiley’s CFA Program Exam Review

® Forward Premium/(Discount)
Required reserve ratio = Required reserves / Total deposits
Fiscal policy Using the previous relationship between forward and spot rates, the forward premium/
(discount) approximately equates to the price currency (foreign) interest rate versus base
Money multiplier = 1/ (Reserve requirement) currency (domestic) interest rate.
Monetary And Fiscal Policy
Quantity Theory of Money FP B
Required reserve ratio = Required reserves / Total deposits (1 + rP )
= UndeRstanding the Balance sheets
SP B (1 + rB )
M = PY / V
FP B Understanding the Balance Sheets
Money multiplier = 1/ (Reserve requirement) (1 + rP )
−1 = −1
Where: • Lagging (used to identify the economy’s past • + rB ) are expressed using the convention Gains and Losses on Marketable Securities
Exchange
SP B (1 rates
M = Money
Quantity condition).
supplyof Money
Theory A/B; i.e.=number
(1 + rP ) (1of
−
+ runits
B) r of
= P B
− rcurrency A (price currency) Held‐to‐Maturity
Securities Available‐for‐Sale Securities Trading Securities
V = velocity of transactions
P = price level
required(1to+ rpurchase
B ) (1 + rB ) one(1 + unit
rB ) of currency B (base Balance Sheet Reported at cost or Reported at fair value. Reported at fair value.

Monetary and Fiscal Policy

M = PY / V
Y = real output currency). USD/GBP = 1.5125 means that it will take
amortized cost.
Unrealized gains or losses due
cuRRency exchange RaTes
1.5125 USD to purchase 1 GBP. This can be different from
A higher base currency (domestic) interest rate results in a forward discount of
to changes in market values are
reported in other comprehensive
Where: • Quantity
Quantity Equation oftheory
Exchange of money market
approximately conventions
the interest differentialso care needs
percentage, totobebase
leading taken when
currency (domestic)
income within owners’ equity.
M = Money supply
dealing
appreciation of that with
Currency
familiar
percentage.
Exchange
currency Rates
pairs.
Items recognized Interest income. Dividend income. Dividend income.
on the income
V = velocity of
MV = PYtransactions statement Realized gains and Interest income. Interest income.
P = price level • Real rate
Real exchange exchange
This relationship must hold orratearbitrage will take place to realign spot and forward prices
losses.
Realized gains and losses. Realized gains and losses.
•
Y = real output
Contractionary monetary
The Fischer effect states that the policy
nominal interest rate(reduce money
(RN) reflects the realsupply with the ratedifferential. However, the expected spot exchange rate may differ from the
interest rate Unrealized gains and losses
(R ) and
Quantity
R and
the increase
expected rate interest
of
Equation of Exchange inflation rates)
(IIe
). is meant to rein in an forward exchange
Real rate.
exchange rate DC/FC = SDC/FC × (PFC /PDC )
due to changes in market
values.
overheating economy. Expansionary monetary policy The forward rate may be calculated as:
R N ==RPY
(increase
MV
e
R + Πmoney supply and reduce interest rates) is where:• Forward exchange rate (arbitrage-free)
• Common-size
Liquiditybalance
Ratios sheet: expresses each balance
meant to stimulate a receding economy SDC/FC = Nominal spot exchange rate sheet as aLiquidity % ofratios
total assets
indicate toability
a company’s allow to meetanalysts to compare
current obligations.

The Fiscal
The Fischer Multiplier
• Limitations of monetarye policy: N
effect states that the nominal interest rate (R ) reflects the real interest PFC = Foreign price level quoted in terms of the foreign currency
rate firms
formulaof different sizes Current assets
This version of the
is perhaps
PDC = Domestic 1 (1 + rDC )in terms of the domestic(1 + rDC ) Current ratio =
FDC/FC =price level × quoted or FDC/FC = SDC/FC × currency
easiest to remember
(RR) and the expected rate of inflation (II ). Current liabilities
Ignoring •
because it contains
Central
taxes, bank cannot
the multiplier can also becontrol
calculatedamount
as: of savings. SFC/DC (1 + rFC ) (1 + rFC )
Cash Flow
the DC term in Quick ratio
=
Cash + Marketable securities + Receivables
Relative Currency Movement numerator for all (acid test) Current liabilities
R• NCentral
= R R + Πbank
e
cannot control willingness of banks to three components:
FDC/FC, SDC/FC and Cash + Marketable securities
Cash ratio =
extend 1 loans.1
= = 10
Where• P Exchange rate regimes:
is the price currency dollarization,
(or quote currency) monetary
and B is the union,
base currency: • CFO (direct method)
(1 + rDC) Current liabilities
○
The Fiscal (1 − MPC)bank
• Multiplier
Central (1 −may
0.9) lack credibility. fixedareparity,
Forward rates target
sometimes zone,ascrawling
interpreted pegs,
expected future fixed
spot rates.parity • Step 1: Start
Solvency with
Ratios sales on the income statement.

• Contractionary fiscal policy (reduceas:as: spending and/

with
FtE=(%S∆
crawling E ( SPbands,
B) managed float, independently • Step 2: Go through
Solvency each
ratios indicate income
a company’s statement
financial leverage account
and financial risk.
Ignoring
Assuming taxes,
taxes,the
themultiplier
multipliercan canalso bebecalculated
also calculated 1 P B) =
t +S −1
or increase taxes) is used to control inflation in an floating rates. SP B
and adjust it for changesTotal inL-T alldebtrelevant working capital
L-T debt-to-equity =
expansion.
1
1
Expansionary
1
fiscal policy (increase spending (St +1 ) (r − r ) accounts on the balance Total sheet. equity

and/or − t)]= taxes)

reduce = 10 − 1 = ∆%S(DC/FC)t +1 = DC ofFCprice currency.
(1 − 0.9) is used to raise employment and Premium when
− MPC(1 Total debt
○[1
(1 − MPC) S E(S) > S; expect depreciation (1 + rFC ) • Step 3: Check whether Debt-to-equity =
changes
Total equity in these working
output in a recession
FINANCIAL REPORTING
Discount when E(S) < S; expect appreciation of price currency.
capital accounts indicate Total debt = a debt
Total source or use of cash.
• Fiscal
Assuming multiplier
taxes, the multiplier can also be calculated as:
Currency
ExchangeCross
RatesRates • Step 4: IgnoreFinancial all non-operating
Total assets
items and non-cash
AND ANALYSIS
and the Trade Balance leverage =
Total assets

1 charges. Total equity

Marshall-Lerner condition: ω x ε x + ω M (ε M − 1) > 0

[1 − MPC(1 − t)] P1 P2 P1 B P1
÷ = × = • CFO (indirect method)
where:
Financial
B B B P2Reporting P2 Basics 40• Step 1: Start© Wiley 2018with net any
all Rights Reserved. income.
unauthorized copying or distribution will constitute an infringement of copyright.
• Limitations of fiscal policy: recognition, action and ωx = Share of exports in total trade
impact lags Arbitrage• Types
ωM = Share of audit
Relationship
of imports in totalopinions:
trade unqualified, qualified, adverse, • Step 2: Go up the income statement account and
εx = Pricedisclaimer.
elasticity of demand for exports remove the effect of all non-cash expenses and gains
• Relationships between monetary and fiscal policy Forward
εM = Price pricing is based
elasticity on a sum
of demand forof money invested domestically in the base currency
imports from net income.
• Easy fiscal policy/tight monetary policy – results in spot • Accruals:
at the domestic interestunearned or deferred
rate, rB, as equivalent to the revenue
same sum of (liability),
money converted at the
rate unbilled
for P units of price (foreign) currency, invested
or accrued revenue (asset), prepaid expenses at the foreign rate rP for the same • Step 3: Remove the effect of all non-operating activities UndeRstanding cash FloW
higher
© Wiley 2018 all output
Rights Reserved. and higher
any unauthorized copyinginterest
or distributionrates (government
will constitute an infringement of copyright.
time, and converted back to domestic currency at a forward price set at the beginning of from net income.
expenditure would form a larger component of © Wiley
the term. (asset),
2018 accrued
all Rights Reserved. expenses
any unauthorized (liability).
copying or distribution will constitute an infringement of copyright. 35
UndeRstanding cash FloW
UndeRstanding cash FloW stateMents • Step 4: Make Financial adjustments Analysis forTechniques
changes in all working
national income). • Qualitative characteristics of financial information: capital accounts. UndeRstanding cash FloW
• Tight fiscal policy/easy monetary policy – private relevance, faithful representation,
 1  comparability, Activity Ratios Financial Analysis Techniques
sector’s share of overall GDP would rise (as a result (1 + rB ) = SP B (1timeliness,
verifiability, + rP )   understandability (first two are Free •
Cash Free
Flowcash
to the flow
Firm to the firm (FCFF) UndeRstanding cash FloW
 FP B  Activity Ratios Financial Analysis Techniques
© Wiley 2018 all
ofRights
lowReserved.
interestany unauthorized
rates), copying
whileor distribution
the public will constitute
sector’s shareof copyright. fundamental
an infringement qualitative characteristics).
(1 + rP ) FCFF = NI + NCC + [Int Cost
* (1 of
− goods
tax sold
rate)] − FCInv − WCInv UndeRstanding cash FloW
FP B = SP B Inventory turnover =
would fall. • General features
(1 + rB ) of financial statements: fair Activity Ratios Financial Average Analysis
inventoryTechniques
Cost of goods sold
• Easy fiscal policy/easy monetary policy – this would presentation, going concern, accrual basis, materiality Activity Ratios Inventory
FCFF = CFO [Int *=(1Average
turnover
+ Financial − tax Analysis
rate)] − FCInv
inventoryTechniques
UndeRstanding cash FloW

lead to a sharp increase in aggregate demand, loweringThe last term and1/F aggregation, no offsetting, frequency of reporting,
P/B in the first equation can also be written FB/P or Fd/f. Inventory turnover =
Cost of goods sold UndeRstanding cash FloW
interest rates and growing private and public sectors. comparative information, consistency. Activity
Free Cash• Ratios
Free
Flowcash
to Equity
Financial
flow to Average
equity
Cost of
Analysis
(FCFE)Techniques
inventory
goods=sold
365
Days of inventory on hand (DOH) UndeRstanding cash FloW
• Tight fiscal policy/tight monetary policy – this would Inventory turnover = Inventory turnover
Income Statements Activity Ratios
FCFEof = CFO −Financial
FCInv on +hand
Average
Net of Analysis
inventoryTechniques
borrowing
goods=sold
365
lead to a sharp decrease in aggregate demand, higher Days inventory
Inventory turnover =
Cost (DOH)
Inventory turnover
UndeRstanding cash FloW
Activity Ratios Financial Average Analysis
inventoryTechniques
interest rates and a decrease in demand from both DaysRatios
of inventory on hand Cost of goods=sold
(DOH)
365
private and public sectors. • Revenue recognition methods: percentage of Performance
Activity Financial
Inventory
Ratios
turnover
Financial =
Analysis Analysis Techniques
Inventory
Techniques turnover
Average inventory
Revenue 365
completion, completed contract, installment method, Receivables
Days turnover
of inventory on hand=Cost of goods=sold
(DOH)
Inventory turnover = Average receivables Inventory turnover
International Trade 34 cost recovery method. Activity
Receivables
Days
Ratios
© Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. • Activity ratios
of CF turnover
inventory on =
Cost of
hand CFO
Average
goods=sold
(DOH)
inventory
Revenue 365
Inventory to revenue
turnover ==
• Discontinued operations: reported net of tax as a Average receivables
Net Revenue
Average inventory
Revenue
Inventory turnover
365
• Comparative advantage: a country’s ability to produce separate line item after income from continuing Receivables
Days
Inventory
turnover
of inventory
turnover on
==
=
Cost
hand of goods
(DOH)
Average CFO =sold
receivables
Cash return on assets Inventory 365turnover
a good at a lower opportunity cost than its trading operations. Days of salesturnoveroutstanding Average
(DSO
Average inventory
Revenue
= assets 365
)total
Receivables
Days of inventory on hand = (DOH) =Receivables turnover
partners Average receivables
Inventory 365turnover
• Unusual or infrequent items: listed as separate line Revenue
)=
CFO 365
on = ÷
Days
Cash of of saleson
return outstanding
equity (DSO
• Ricardian model: labor is the only variable factor of items, included in income from continuing operations,
Receivables
Days turnover
inventory = Average
hand (DOH) =Receivables
shareholders'
Average receivables Inventory
turnover
equity
365turnover
production and differences in technology are the key reported before-tax. Days of
Receivables
Days ofCash
sales outstanding
turnover
inventory on = =
hand
( Revenue
DSO )
CFO = 365
(DOH) =Receivables turnover
to income
source of comparative advantage. Payables turnover
Average
= Operating
receivables
PurchasesincomeInventory 365turnover
• Accounting changes Days of sales
Receivables outstanding
turnover = (DSO
Average
Revenue
) = payables
trade
• Heckscher-Ohlin model: capital and labor are variable CF per share =
( CFO
Purchases
Average −Receivables
receivables 365
turnover )
Preferred dividiends
factors of production and differences in factor Financial RepoRting and analysis • Change in accounting principle (applied Payables
Days of sales
Receivables
turnover =
outstanding
turnover Average(DSO
= Number
Revenue
)of= common
trade payables shares outstanding
Receivables turnover
endowments are the primary source of comparative retrospectively). Payables turnover =
Average receivables
Purchases
Revenue 365
Days of sales
Receivables outstanding
turnover = (DSO
Average ) = payables
trade
advantage. If• Change
a company in an
declares accounting
a stock split or a stockestimate
dividend during (applied
the year, the calculation of CoverageNumber Ratios of days of payables Average
=
Receivables
365
receivables
Purchases turnover
Payables turnover = 365
• Effect of tariffs, import quotas, export subsidies and prospectively).
the weighted average number of issued shares outstanding is based on the assumption that Days of sales outstandingAverage(DSO ) = payables
Payables
trade turnover
the additional (newly issued) shares have been outstanding since the date that the original UndeRstanding incoMe stateMents Purchases Receivables
365 turnover
Number of days of payables = 365
voluntary export restraints • Correction
shares were outstanding offrom.
prior-period errors (restate all prior- Payables
Days of sales turnover =
outstanding ( DSO ) =
Payables
CFO trade payables
Average turnover
Debt coverage
Debt coverage = = Receivables
365 turnover
• Price, domestic production and producer surplus period
A complex financial
capital statements).
structure includes
Understanding Income
securities thatStatements
can be converted into common Number
Payables
Days of sales
of days of =payables
turnover
outstanding
Total Purchases
=
debt
Total(DSO
debt ) = payables
Payables
365
turnover
increase. stock (e.g., convertible bonds, convertible preferred stock, warrants and options). These Average
CFO + trade
Interest
CFO =+Purchases Revenue
paid +
365+ Taxes paid
Receivables Taxes turnover
• securities
Basic are EPSpotentially dilutive so companies with complex capital structures are Working
Number Debtcapital
Payablesof
coverage
days of
turnover
turnover
=
Interest paid
=
=payables Average
paid
Basic EPS working capital
• Domestic consumption and consumer surplus inTeRnaTional TRaDe anD capiTal FloWs
required to report basic and diluted EPS. A dilutive security is one whose conversion into Average trade
Interest
Payables paid
payables turnover
Revenue
365
shares of common stock would result in a reduction in EPS. EPS calculated after taking Working
Number capital
of turnover = Purchases
days of =payablesAverage CFO
= CFO working capital
decrease. Net income
into account all dilutive securities in the−capital
Preferred dividends
structure is known as diluted EPS.
Payables turnover
Reinvestment = Average trade Payables turnover
International Trade And Capital Flows Basic EPS = Cash paid for payablesRevenue
L-T assets
• Balance of payments components Weighted average number of shares outstanding Working capital
Number
Payablesof days of
turnover
turnover =Purchases
=
=payables Average
365
working
CFO capital
In determining which potentially dilutive securities should be included in the calculation
Average Payables
Revenue
trade CFO
payables turnover
=
• Payment
Balance of CurrentComponents
account (merchandise trade, services, income of diluted EPS, each of the securities must be evaluated individually and independently to Fixed
Working
Number
Debt
asset payment
turnover
capital
of days of
=Cash=paid for L-T365
turnover
payables
Average
Revenue
= fixed working debt repayment
assets
determine
Diluted• EPS whether they are dilutive. Any anti-dilutive securities must be ignored from the Average capital
receipts and unilateral transfers).
A country’s balance of payments is composed of three main accounts: Diluted
diluted EPS (taking into account all dilutive securities)
EPS calculation. Fixed asset turnover =
Payables
Revenue
CFO 365
turnover
Revenue
Working
Dividend
Number capital
of payment
days of =
turnover
payables = = fixed assets
• Capital account (capital transfers and sales/purchases
• The current account balance largely reflects trade in goods and services.
Convertible  Convertible  Fixed asset turnover =
Average
Cash paid for
Average dividends
working
Payables turnover
Revenue capital
• Theof capital account balance non-financial
mainly consists of assets).
capital transfers and net sales of Revenue
365
non-produced,   Preferred  Convertible  Convertible
income−− Preferred  ++ preferred

preferred+  +  debt debt× (1 − t)× (1 − t )  Number
Workingof capital
days of turnover
payables = = fixed CFO
Average assets capital
non‐produced, non‐financial assets.  NetNet
income
dividends 
dividends 
UndeRstanding cash FloW stateMents
Investing/financing = Average
Revenue
Payables
Revenue working
turnover
 Cash outflows for investing/financing
• Financial
• The account
financial account (financial
measures net capitalassets abroad
flows based and
on sales andforeign-
purchases of Diluted EPS

=
 dividends
dividends  interest

 interest 
 Total asset
Fixed asset turnover
turnover
 Working capital turnover
==
=
Average total
Revenue
IFRS requires theDiluted EPS = Shares from Average fixedassets
assets capital
owned
domestic and financial assets
foreign financial in the reporting country). use
assets. of a similar Weighted
conversion of
Shares from Shares
Total asset turnover ==
Average
Revenue
Revenue working
Revenue
method, but does
average + Shares from Sharesoffrom
+ conversion + issuable from Shares Fixed
Working asset turnover
capital turnover =
Average total
Weighted convertible fixedassets
Current •
not refer to it convertible
Current account surplus or deficit.
Account as the Treasury shares
average +
conversion of
preferred shares
+ debt
conversion ofstock+options Liquidity Ratios
issuable from• Liquidity ratios =
AverageAverage
Revenue
RevenueRevenue
assets capital
working
stock method.
convertible convertible Total asset
1 Fixed asset turnover
turnover =
The proceeds of
shares stock options Working capital turnover =
Average total assets
option exercise are
preferred shares debt Average fixed
Revenue assets
Average working capital
assumed to be used Both U.S. GAAP and IFRS require the presentation of EPS (basic EPS and their diluted Current
== assets Revenue
CA = X – M = Y – (C + I + G) to repurchase shares
at the average Balance Sheets
EPS) on the face of the income statement.
Total asset
© Wiley 2018Current
Fixed
all Rights
turnover
ratio
asset = any unauthorized
turnover
Reserved.
CurrentAverage
copying
liabilities
Average total or distribution will constitute an infringement of copyright.
fixedassets
assets
market price and Revenue
Revenue
these shares are Total
© Wiley 2018Fixed asset
asset turnover
turnover ==
Currency Exchange Rates known as inferred
shares. The excess
Treasury Stock
Comprehensive Income Method
• Accounting for gains and losses on marketable securities 42 © Wiley 2018
all Rights
all Rights
Reserved.
Reserved.
any unauthorized
any Average
Average
unauthorized
copying
total
fixed
copying
Revenue
Revenue
orassets
or
distribution
assets
will constitute an infringement of copyright.
distribution will constitute an infringement of copyright.
of new issued shares
over inferred shares In the calculation of diluted EPS, stock options and warrants are accounted for by using © Wiley 2018Fixed Total asset
asset
all Rights turnover
turnover
Reserved. ==
any unauthorized copying orassets
distribution will constitute an infringement of copyright.
is added to the Net income + Other comprehensive income = Comprehensive
the treasury stock method (required under U.S. GAAP). The treasury stock method income Cash + Average
Average
Short-term total
fixed assets
marketable investments + Receivables
weighted average Quick ratio = Revenue
number of shares assumes that all the funds received by the company from the exercise of options and
© Wiley 2018Total asset
all Rights turnover
Reserved. =
any unauthorized Current
copying orassets liabilities
distribution will constitute anWiley
infringement of copyright.
outstanding.
warrants are used by the company to repurchase shares at the average market price. The Average total © 2020
FRA Ending resulting
Shareholders’ Equity Revenue
net increase in the number of shares equals the increase in shares from exercise Total asset turnover =
of options and warrants minus the decrease in the number of outstanding shares from © Wiley 2018 all Rights Reserved. any unauthorized
Average copying
totalorassets
distribution will constitute an infringement of copyright.
Ending shareholders’ equity = Beginning shareholders’ equity + Net income +
repurchases. Revenue
Total asset turnover =
g cash FloW stateMents
Current ratio =
Liquidity Ratios
Current ratio =
Liquidity Ratios
Current ratio =
UndeRstanding cash FloW stateMents
Current
Currentliabilities
assets
Per Share Ratios
Current
Currentliabilities
assets UndeRstanding cash FloW stateMents

Wiley’s CFA Program Exam Review

ging
cash FloW Liquidity
stateMents Ratios Per Share Ratios Cash flow from operations
cash FloW stateMents Current
Currentliabilities
assets ® Cash flow per share =
Current ratio = Average number of shares outstanding
g cash FloW stateMents Cash +
Current Short-term
Currentliabilities
assets marketable investments + Receivables Per ShareCash Ratios
Cash flow from operations
Quick ratio
Current ratio = = Current assets Current liabilities flow per share =
Cash + Short-term
liabilitiesmarketable investments + Receivables Average number of shares outstanding
= = Current liabilities
Liquidity Current
Liquidity Ratios ratio
Ratios ratio Current Cash flow fromEBITDA operations
Quick Cash flow per = =
Cash + Short-term marketable investments + Receivables
Current liabilities EBITDA pershare
share Average number of shares
Ratios ratio =
Liquidity Quick Average number of outstanding
shares outstanding
+ Short-term Current liabilities EBITDA
Quick ratio
Current ratio
CashCurrent
== = Current assetsassets marketable investments + Receivables EBITDA per share =
Current ratio Average EBITDA
number of shares outstanding
Cash
Cash
Current++Short-term
Current Short-term
liabilities
liabilities marketable
marketable investments
Current liabilities
investments + Receivables EBITDA per share = Common dividends declared
Cash
Quickratio ratio == Cash Current assets marketable = number of shares outstanding
Average
Current
Quick ratio ratio = ++Short-term
=Cash
Short-term
Current liabilities
marketable
investments + Receivables
investments
Current liabilities
Dividends per share
Weighted averagedividends
number ofdeclared
ordinary shares
Cash ratio = Current liabilitiesCurrent liabilities Common
Cash + Short-term Currentmarketable
liabilities investments Dividends per share = Common dividends declared
Cash ratio = Cash + Short-term marketable investments + Receivables Dividends per share = Weighted average number of ordinary shares
Current liabilities investments Dividend-Related Measures Weighted average number of ordinary shares
Quick ratio = Cash Cash++Short-term
Short-term marketable
marketable investments + Receivables
Cash
Quickratio ratio== Cash
Current
Current liabilities
+liabilities
Short-term marketable investments + Receivables • Dividend-related measures amount, the increase goes directly to equity.
Defensive Cash
Cash+
interval +ratio
Short-term
+Short-term
Short-term
= marketable
Current
marketable investments
liabilities
investments + Receivables Dividend-Related
Dividend-Related Measures
Measures Common share dividends
Cash ratio = Cash marketable investments Dividend payout ratio =
Quickratio
Cash ratio==
Defensive interval ratio =Current liabilities
Cash +liabilities
Current Short-term Daily
Current liabilities
cash expenditures
marketable investments + Receivables Net income
Common Common attributable to common
share dividends
share dividends shares • Impairment of property, plant and equipment
Cash + Short-term investments + Receivables Dividend Dividendpayout payout ratio = =
ratio
Defensive interval ratio = marketable investments
Cash + Short-term
Daily cash expenditures
marketable Net income attributable
Net income to common
attributable to shares
common shares • IFRS: asset is impaired when its carrying amount
Cash ratio = + Short-term Daily cash expenditures
investments + Receivables
Defensive Cash +ratio Short-term
Current
=
Cash marketable
liabilities marketable
investments exceeds its recoverable amount (impairment loss is the
Cash ratiointerval
=
Cash conversion Cashcycle+ratio = DSO
Short-term Cash
Current +
+marketable
DOH − Number
Short-term
liabilities Daily cash
marketable
of
investments
expenditures
days payables + Receivables
investments
of Net income attributable to common shares − Common share dividendsdifference between these two amounts).
Defensive
Cash interval
=
ratiointerval = Cash + Short-term marketable investments + Receivables Retention Rate =
Net income attributable to common shares − Common share dividends
Defensive ratio= =DSO Daily of cash expenditures
Cash conversion cycle Current + DOH − Number
liabilities days of payables
Daily cash expenditures
Retention Rate =
Retention Rate =
Net income Net income
Net attributable
income attributable toattributable
common
to common
to common
shares − Common
shares
sharesshare dividends • US GAAP: asset is impaired when its carrying value
Cash
Ratiosconversion
Solvency Defensive cycle==Cash
interval ratio DSO+ +Short-term
DOH − Number marketable of investments
days of payables+ Receivables
Net income attributable to common shares exceeds the total value of its undiscounted expected
Daily cash expenditures
Solvency Cash Ratiosconversion cycle = DSO Cash + DOH − Number
+ Short-term of days of
marketable payables + Receivables
investments future cash flows (impairment loss is the difference
Defensive interval ratio = Sustainable
Sustainable growth
growth raterate = Retention
= Retention rate × ROErate × ROE
Solvency CashRatiosconversion cycle =Total
Debt to-assets
-conversion ratio
DSO Cash + DOH
debt − Number
+ Short-term Daily
= = =DSO + DOH − Number of days of payables
cash
of
marketable expenditures
days of payables + Receivables
investments between the asset’s carrying value and its fair value).
Defensive
Cash interval ratio
cycle Sustainable growth rate = Retention rate × ROE
Solvency Ratios Total
Totalassetsdebt Daily cash expenditures
Debt -conversion
to-assets ratio cycle == DSO + DOH − Number of days of payables Credit Analysis Ratios
Cash
Solvency Ratios
Debt -to-assets ratio =
Total
Totalassetsdebt Inventories
Credit Analysis Ratios
Deferred Taxes
Solvency • Cash
Solvency
Ratios ratios
conversion cycle Total
Ratios-to-assets ratio =
Solvency Debt
=Total
DSO assets
debt
+ DOH − Number of days of payables Credit Analysis Ratios
EBIT interest coverage =
Gross
EBIT
EBIT (due to temporary differences)
Total
Total assets
debt Total debt • LIFO EBITvs interest
FIFO with coverage = interest
rising prices and stable inventory levels
Cash
Debt--conversion
Debt to--assets
to capitalratio cycle
ratio == = DSO
Total
+ DOH − Number of days of payables
debt
debt +Total
Gross
EBIT interest
EBIT
Solvency DebtDebt
Ratios to--capital
--to assets ratio =
ratioTotal
Totalassets
Total
= debt
Shareholders’
debt equity EBITDA interest coverage =
EBIT interest coverage =
Gross EBIT
interest • A deferred tax liability (asset) arises when:
Debt -to-assets ratio = Total assets
Total debt +Total Shareholders’
debt equity EBITDA interest coverage = Gross interest
FFO +Gross paid − operating lease adj
Solvency DebtRatios -to-capital ratioTotal = assets FFO1 interest coverage =
interestinterest
EBIT • Taxable income is lower (higher) than pretax
Total debt +Total Shareholders’
debt equity EBITDA1 interest coverage = FFO +Gross interest
interest paid − operating lease adj
Debt
Debt --to to--capital
assets ratioratio== Total debt FFO interest coverage = Gross interestEBIT accounting profit.
Total Total
debt +
debtShareholders’
Total debt equity Return on capital = Gross interest
Debt -to
Debt
Debt---to
to-capital
equity ratio
to---capital
assets ratioratio===Total Totalassetsdebt Total debt UndeRstanding cash FloW1stateMents
UndeRstanding cash FloW stateMents
FFO ++interest
Avg (equity non-current paid − operating
deferred taxes + lease
debt) adj • Taxes payable is lower (higher) than income tax
Debt ratio = Shareholders’
Total Total Total
debt debt
+ equity
debt
Shareholders’ equity UndeRstanding cash FFO
FloW interest coverage =
stateMents EBIT
Debt
Debt-to -to-capital
-equityratio ratio= = Total assets UndeRstanding cash FloW stateMents =
FFO
TotalTotal debt debt + Shareholders’
+ Shareholders’
equity equity
equity Return
FFO1 to
UndeRstanding cash FloW stateMents ondebt
capital
= Gross interest expense.
Shareholders’
Total debt debt (equity + non-current
Total Avg EBIT
deferred taxes + debt)
Debt -to-equity ratio =
Shareholders’
Total debt
EBIT Total
equity
+ Lease debt payments
UndeRstanding cash FloW stateMents
Return on capital
=
Adj=CFOFFO − capex
Avg (equity + non-current deferred taxes + debt)
• If a company has a DTL, a reduction (increase) in tax rates
UndeRstandingFree cash Operating CF to debt
1
=Total
Debt--to
Debt
Fixed charge to--capital
equity ratio
coverage ratio =
ratio == EBIT
Average + Lease
+Shareholders’
total payments FFO
FloW stateMents to debt debt would reduce (increase) liabilities, reduce (increase)
Fixed
Fixed charge
Financial
charge
Debt -
coverage
coverage
to - leverage
equity ratio
= Shareholders’
ratioratio
=
Total
Interest
=Total
EBIT
Total
EBIT
debt debt
+
+Total
payments Lease
equity
Lease +assets
debt
payments
payments
Lease equity
payments Total
CFO − capex
debt
FFO− dividends paid
Fixed charge coverage Interest Totaldebt
EBIT +
debt
payments Lease + payments
Lease payments FFO 1
to debt = Adj CFO − capex income tax expense, and increase (reduce) equity
Debt
Debt---toto
Debt
Fixed charge to --capital
-equity
equityratio
coverage ratio
ratio = == Shareholders’
Interest
InterestAveragepayments
payments total
equity +
equity
+ Lease payments
assets
Lease payments long-lived assets
UndeRstanding cash Discretionary CF
FloW stateMents to debt
Free Operating CF to debt = Total
=
Financial leverage ratio Total
= EBIT
Shareholders’ debt
Shareholders’ ++Shareholders’
equity Lease
equity payments
+assets equity debt
Total debt
Fixed charge coverage ratio = Interest Average
Averagepayments total Lease
total equity payments
FFO −Adj Total debt
dividends
CFO − capex • If a company has a DTA, a reduction (increase) in tax rates
Profitability Ratios leverage ratioInterest
Financial = EBIT + Lease
payments + payments
Lease payments Free Net CF toCF
Operating capex
to =
debt =
Fixed charge
Profitability coverage ratio =
Ratios Average total equity Long-Lived
CFO
capex Assets paid
− capex − dividends
would reduce (increase) assets, increase (reduce) income
Profitability
Profitability Ratios
Ratios leverage ratioInterest = Total debt
payments +assets
Lease payments • LIFO Discretionary CF to debt =
to FIFO conversion
Total debt
Financial
Debt
Profitability -to-equity ratio = Gross
Ratios profit
EBIT +total
Lease payments Total debtwith rising Total debt prices and stable or
Gross
Fixed charge profit
coverage margin
ratio Gross Average
Average
= Shareholders’
Average EBIT
profittotal total
equityequity
assets assets Financial Debt to EBITDA
Statement = of CFO
Effects − capex versus
Capitalizing − dividends paid
Expensing tax expense, and reduce (increase) equity
Interest
Financial
Profitability
GrossRatios
Financial
Debt -to
Gross
coverage
profit leverage
-equity
profit margin
leverage ratio
ratio
ratio=
ratio
margin
=
Gross
=
==Interest
Gross Total
profit
Average
Revenue profit
Interest
debt
payments total
payments assets
+ Lease payments rising inventory
Discretionary CF to
Net CF to capex =
quantities
debt =
EBITDA FFO − dividends
Financial
Gross profit leverage
margin ratio = Average
= Shareholders’
Average
Gross
= Revenue EBIT
total
profit total
equity
equity equity Total debt
• DTA carrying value should be reduced to the expected
Profitability Ratios
Interest coverage
Gross profit margin = Revenue ratio Revenue
Gross
Average
Interest
profit
EBIT
total
payments
equity • Inventory under FIFOFFO capex
= Inventory
−Effect
dividends underStatements
on Financial LIFO + LIFO
recoverable amount using a valuation allowance
Interest
Gross coverage
profit margin ratio= =Revenue 1 Net=CF
FFO (free funds to operations)
reserve
to capex
net income = Total
+ non-cash charges
debtNoncurrent assets increase.
•
• Gross
Profitability
Profitability Ratios
profit margin ratios =
Gross profit
Interest
Revenue EBITpayments
Average total assets
Initially when
Debt thetocost
EBITDAis = capex
Interest
Financialcoverage leverageratio ratio== capitalized
•
EBITDA • Cash flow from investing activities decreases.
© Wiley 2018Interest
all Rights
Operating
Interest coverage
Reserved.
profit
coverage ratio
any = Gross
RevenueEBIT
Interest
Operating
Average
= = Average
unauthorized
margin
ratio
EBIT
profit payments
total
EBITtotal
copying
Operating
profit
equity
orprofitassets will constitute an infringement of copyright.
distribution
COGS under
© Wiley 2018 all Rights Reserved. FIFO
Debtanytounauthorized
EBITDA = COGS
Total under
debt LIFO – Accounting for Bonds
Change in
= or distribution will constitute an infringement of copyright.
copying LIFO 47
Gross profit margin = Interest reserve EBITDA
==
Financial
Operating leverage
profit ratio
margin = Operating
payments
Operating
Revenue profit
profit
© Wiley 2018
Interest
Operating
Operating
coverage
profitany
profit
all Rights Reserved.
ratio
margin
margin =Interest
Revenue
=
unauthorized Average
Operating
payments
Revenue
copying total equity will constitute an infringement of copyright.
or profit
distribution
In future periods when the asset is • Noncurrent assets decrease.
Interest payments
Revenue 1
FFO (free depreciated
funds to operations) = net income + non-cash charges
© Wiley 2018
Operating profit margin =
all Rights Reserved.
Revenue
Operating
Revenue orprofit
• Net income under FIFO =• Net
or amortized • Net income decreases.
income under LIFO + • Effective interest method required under IFRS and
Operating profitany unauthorized
margin = copying distribution will constitute an infringement of copyright. Retained earnings decrease.
preferred under US GAAP
Operating
EBITorprofit
Revenue Change in LIFO reserve ו (1charges
1FFO (free funds to operations) = net income + non-cash
– taxdecreases.
Equity rate)
© Wiley 2018 all Rightscoverage
Operating
Interest Reserved.
profitany margin
ratio
EBT = = copying
unauthorized
(earnings copying
before distribution
tax, but will constitute
after interest) an infringement of copyright.
© Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 47
© Wiley 2018
© Wiley 2018
all Rights Reserved.
Pretax
all Rights
Pretax
margin
Reserved.=
margin
anyEBT
=any
unauthorized
EBT
Interest
(earnings
(earnings
unauthorized
or
Revenue
EBIT
distribution
payments
before
before
Operating
copying
tax, will
tax, but
or profit
constitute
but after
distribution after
an infringement
interest)
interest)
will constitute
of copyright.
an infringement of copyright. • Equity under FIFO = Equity under LIFO + LIFO reserve ×
When the cost is expensed • Net income decreases by the entire after‐tax • Interest expense for a given period is calculated as
Interest
Pretax
Operating coverage
margin profit =anyEBT
ratio
margin =
(earnings
=Interest before
Revenue tax, but after interest) 47
© Wiley 2018 all Rights
Pretax Reserved.
margin = EBTunauthorized
(earnings copying
before or
Revenue
payments
Revenue
Revenue
distribution
tax, but will
after constitute
interest) an infringement of © Wiley
copyright. 2018 all
(1Rights
– Reserved.
tax rate) any unauthorized copying or amount ofwill
distribution the cost. an infringement of copyright.
constitute the book value of the liability at the beginning of the
Pretax margin = Revenue • No related asset is recorded on the balance
Pretax margin =
EBT (earnings before Revenue tax, but after interest)
• Liabilities under FIFO = Liabilities sheet andunder therefore,FIFO + LIFO or
no depreciation period multiplied by market interest rate at bond
EBT (earnings before tax, but after interest)
Pretax margin = Net profitcopying
Revenue
reserve × tax rate amortization expense is charged in future issuance.
© Wiley 2018Netall Rights
profitReserved.
margin any=unauthorized
Net profit or distribution will constitute an infringement of copyright.
Revenue periods.
© Wiley 2018
Net
Net
Pretax
profit
profitmargin
margin
margin
Net profit margin = Net
all Rights Reserved. =
EBT
any
==
Net
Net
Revenue profit
(earnings
profit before tax, but after interest)
unauthorized
Revenue profit copying or distribution will constitute an infringement of copyright. • Operating cash flow decreases.
• Coupon payments are classified as cash outflows.
Return on
Net profit margin = Revenue
Investment Ratios
Revenue
Net profit
Revenue Long-lived Assets • Expensed costs have no financial statement • Book value of the bond liability at any point in time is
Return Net
on profit margin
Investment Ratios = Revenue impact in future years.
Return on
Return on Investment
Net
Investment Ratios
profit margin
Ratios Net
= Revenue
profit the PV of the bond’s remaining cash flows (discounted
Return on Investment
ROA =
Net
Net
Net
income
Ratios
income
income Revenue • Capitalizing vs expensing at the market interest rate at issuance).
Return on ROA
ROA =
Investment
= AverageNet income
totalNet
Ratios assets profit
ROA
Net profit = Averagemargin
Net income = assets
total
Return onROA = Average
Investment Average total
Ratios
total assets
assets
Revenue
Net income
ROA = Average total assets
  Leases
Capitalizing Expensing
Net income Net income (first year) Higher Lower
Return on ROA = Average
Investment total
Ratios Net assets
income + Interest expense (1 − Tax rate)
+ −
AdjustedAverage ROA =total Net income + Interest expense (1 − Tax rate)
Adjusted
Adjusted
Adjusted
ROA
ROANet =
=
Net assets
income
Net income Average
income
= Net income Average
Interest
+ Interesttotal
+ Interesttotal
expense
expense (1 Tax
assets(1 − Tax rate) rate)
(1 − Tax rate)
Net income (future years) Lower Higher
• Lease accounting from lessee’s perspective: All leases
ROA = ROA ROA =total assets Average
expense
total assets
assets Total assets Higher Lower
Adjusted Average Net income Average + Interesttotal
Average expense
total
assets(1 − Tax rate)
assets
need to be recorded at lease inception on balance sheet
Adjusted ROA = Shareholders’ equity Higher Lower
Net income Average + Interesttotal expenseassets(1 − Tax rate) Cash flow from operations Higher Lower
as right-of-use asset with associated lease liability.
Adjusted ROA = Operating income or EBIT
Operating ROA = Operating Operating income
Averageor
income EBIT
ortotal
EBIT assets Cash flow from investing Lower Higher Ongoing lease acccounting standards are:
Operating
Operating ROA
ROA =
= Operating
Net Average
income income
+ total
Interest or
assetsEBIT
expense (1 − Tax rate)
Operating
Adjusted ROA
Operating ROA =
ROA== Operating Average
Average
Average
income
total
total assets
total
Average
or EBIT
assets
assets
total assets
Income variability Lower Higher • IFRS requires lessee to record depreciation expense
Operating
Average income
total assetsor EBIT
Operating ROA = Debt-to-equity Lower Higher against the asset and interest expense based on the
Operating income
Average total assets or EBIT
Operating ROA =
Average total assets EBIT lease repayment
long-lived assets rate (lease principal repayment is a
Return on total capital = EBIT
Return
Return
Operating on
on total
total
ROA
Operating
capital
=
capital =
=
income debt
Short-term or EBIT EBIT
+ Long-term
EBIT debt + Equity • Depreciation expense financing cash flow; lease interest can be operating or
long-lived assets
Return on total capitalAverage = Short-term debt + Long-term
EBIT debt + Equity long-lived assets
Return on total capital = Short-term Short-term debt +
debt
total assets + Long-term
Long-term debt debt + + Equity
Equity • Straight line long-lived assets financing cash flow)
EBIT
Return on total capital = Short-term debt + Long-term debt + Equity Original cost − Salvage value • US GAAP requires lessee of finance lease to record as
Short-term debt + Long-term EBIT debt + Equity Depreciation expense = Original cost − Salvage value
Return on total capital =Net income
Return on equity = NetShort-term
income debt + Long-term debt + Equity Depreciation expense = Original Depreciable life
− Salvage
per IFRS (interest must be operational cash flow)
Return on equity = Average Net
Net income
income
total equity EBIT − cost
Original costDepreciable
Salvage valuelife value
Return on equity = Depreciation expense = =
g cash FloW stateMents Return on equity total capital
= Average
Average
=Net income
total
total equity
equitydebt + Long-term debt + Equity
Depreciation expense
Depreciable
Depreciable life life • US GAAP requires lessee of operating leases to to
g cash FloW stateMents Return on equity = Average Short-term
total
Net income equity
Return on equity = Average total equity • Double declining balance (DDB) record a single lease expense (operational cash flow)
Average Net income
total equity
nding cash FloW stateMents Return on equity =
DuPont Decomposition of ROE Average Net
total income − Preferred
equity − Preferred dividends dividends DDB depreciation in Year X =
2
2
× Book value at the beginning of Year • X Short-term leases can be treated without any balance
Return on common equity =income
Net income Depreciable life × Book value at the beginning of Year X
Net Average−
Net income Preferred dividends sheet reporting, with lease payments termed as rent
Net= 2
DuPont Decomposition
Return
Return on common of ROE equity
= income = income −common
Preferredequity dividends DDBdepreciation
DDB depreciation in Year
in Year X= X= 2 × Book value at the beginning of Year X
Return on on common
equityNet
common equity
equity = Net income
Average
Average − Preferred
common
common dividends
equity
equity DDB depreciation in Year X = Depreciable
Depreciable life life × Book value at the beginning of Year X
Return
DuPont Decomposition
ROE = on common of ROENet Average
equity = total Average
income Net
equity common equity
income −common
Preferredequity dividends Depreciable life expenses. Under IFRS, low value leases can be reported
ROE = Average shareholders’
equity = equity equity Average Depreciation Components
Return on common
Average Net shareholders’
income
= on common equity = Net income Average−common Preferredequity dividends in the same fashion.
ROE
• Dupont
Return
DuPont decomposition
shareholders’ equity of ROE •
Depreciation
Depreciation Depreciation
Components
Components components
2‐Way
© Wiley 2018
2‐Way Dupont
Average
Decomposition
all Rights Reserved. any unauthorized Net
Decomposition copying
Average common equity
or distribution
income − will constitute
Preferred
Depreciation
an infringement of copyright.
dividends
Components
Estimated useful 45 lifeGross
=
Gross investment in fixed assets
investment in fixed assets • Lease accounting from lessor’s perspective:
© Wiley 2018 all Rights Reserved. any unauthorized
equity = copying or distribution will constitute an Estimated useful life 45 = Gross investment in fixed assets
© Wiley
©2‐Way Return
Wiley 2018 all
all Rights
Dupont
2018 on common
Reserved.
Decomposition
Rights Reserved. any
any unauthorized
unauthorized copying
copying or
or distribution
totalwill
distribution will constitute
constitute an infringement
infringement
infringement of
of copyright.
of copyright. Estimated useful 45 = Annual
45 life Annual depreciation
depreciation expense expense • Under IFRS, lessor’s can deem a lease agreement to be
© Wiley 2018ROE
all Rights
= Reserved.
Net income
any unauthorized copying
×Average
Average
Average
or common
distribution
totalwill
assetsequityan
constitute
copyright.
an infringement of copyright. 45 life = Gross Annual investment
depreciation in fixed assets
expense
NetNet income Average assets Estimated useful
ROE
© Wiley 2018ROE == Average
all Rights
income
Reserved. total
any assets
×
unauthorized × copying
Average total
or
assets
shareholders’
distribution will
50
equityan infringement
constitute of copyright. © Wiley 2018 all Rights 45 Reserved. any unauthorized
Annual depreciation expense will constitute an infringement of copyright. either a finance lease or an operating. Under US GAAP,
copying or distribution
Average
Average totaltotal
assetsassets Average Average shareholders’
shareholders’ equity equity
© Wiley 2018 all Rights Reserved. any ↓ unauthorized copying or distribution ↓ will constitute an infringement of copyright. 45 lessors can deem a lease to be a sales-type lease (same
↓ ↓ ↓ ↓ Accumulated depreciation
ROA Leverage Average age of asset =
Average age of45assetAnnual
Accumulated
= Accumulated
depreciation as finance lease), operating lease or a direct financing
© Wiley 2018 all Rights Reserved. ROA ROAany unauthorized copying Leverage orLeverage
distribution will constitute an infringement of copyright. depreciation expensedepreciation
Average age of asset = Annual depreciation expense lease (generally where rights and exposure to the asset
3‐Way
3‐Way Dupont Decomposition
Dupont Decomposition Accumulated
Annual depreciationdepreciation
expense
3‐Way Dupont Decomposition Average age of asset = and its residual lie with a third party)
Annual depreciation expense
Net income
ROE = Net income
ROE = Revenue Net income ×
×
Revenue Revenue×
Revenue
Average total
× shareholders’
assets total assets
Average
Average total assets Net investment in fixed assets • Finance and sales-type leases require assets to be
Average total assets Average equity Remaining useful life =
ROE = Revenue × Average total assets × Average shareholders’ equity Netdepreciation
Annual investmentexpense in fixed assets removed from the balance sheet and replaced with a
Revenue
↓ Average ↓ total assets Average ↓ shareholders’ equity Remaining useful life = Net investment in fixed assets
↓ ↓ ↓ Remaining useful life = Net Annual depreciation expense lease asset. Sale profits might be recorded at inception
↓
Net profit margin Asset turnover ↓ Leverage ↓ investment in fixed assets
Net profit margin Asset turnover Leverage Remaining useful life = Annual depreciation expense and interest revenue is recorded ongoing (operating
Net profit margin Asset turnover Leverage Annual depreciation expense
5‐Way Dupont Decomposition Gross investment in fixed assets Accumulated depreciation Net investment in fixed assets cash flow under US GAAP, operating or investing cash
5‐Way Dupont Decomposition Annual• Revaluation
depreciation expense of long-lived = +
assets expense Annual depreciation expense flow under IFRS; lease principal repayment is treated
Annual depreciation
Interest burden Asset turnover
5‐Way Dupont Decomposition
↓ ↓ • IFRS allows
Gross investment in fixedrevaluation
assets
=
Accumulated
model ordepreciation
cost model (only +
Netcost
investment in fixed as an assets
investing cash flow)
Gross investment
Annual depreciation in fixed assets
expense Accumulated depreciation Net investment in fixed assets
Interest burden
Net income Interest
EBT burden
Asset turnover
Asset turnoverAverage total assets model in under US GAAP).= Annual depreciation expense + Annual depreciation •
expense
US GAAP direct financing leases are generally treated
ROE = × ×
EBIT
×
Revenue Gross
Annual investment
depreciation fixed assets
expense Accumulated
Annual depreciation
depreciation expense Net
Annualinvestment
depreciation in fixed assets
expense
EBIT ↓ ↓ × Avg. shareholders’ equity Estimated useful or depreciable = Average age of asset +
Remaining useful life
EBT ↓Revenue Average total assets
↓ Annual• depreciation
If revaluation
life expenseinitiallyAnnual
decreases the asset’s
depreciation expense carryingAnnual depreciationthe same as the above sales-type leases, but require
expense
Net↓income EBT EBIT Revenue Average total assets
ROE = Net income × EBT × EBIT ↓
× Revenue × ↓ Average total The assets amount,
historical the decrease
cost of an asset
Annual depreciation
isnumber
times the recognized expense The
of years thatas a loss
book value
on the
by annual
of the asset divided
depreciation expense
lessors to also remove asset from balance sheet, but to
ROE =Tax burden
EBT × EBIT ×EBIT margin× Average total assetsLeverage
Revenue × Avg. shareholders’ equity
Estimated useful or depreciable Average age of asset Remaining useful life
EBT EBIT Revenue Average total assets Avg. shareholders’ divided byincome
equity its useful lifestatement.
equals the asset has been in use equals equals the number of years the asset replace it with a lease receivable.
Estimated
annual useful
depreciation lifeexpense
or depreciable
under Average
accumulated age of asset has remaining in itsRemaining
depreciation. useful life. useful life
↓ ↓ ↓ value of•
Valuation Ratios ↓ ↓ ↓Estimated • line
the straight Ifuseful
revaluationTherefore, initially
lifeor depreciable
method. increases
Annual
Average
Therefore, theofasset’s
depreciation
age
accumulated expense carrying
asset The bookRemaining theAn
useful operating
asset
lifedivided lease requires the lessor to retain the
Tax burden EBIT margin LeverageThe historicalcost
the historical cost
life of anbyasset
divided times
Annual
depreciation thedepreciation
number
divided of years
by annual that
expense bybook
The annual depreciation
value of the assetexpense
divided
P /E =
Taxper
Price burden
share EBIT margin Leverage annual
divided
The depreciation
by
historical costexpense
its useful oflife
anequals
asset depreciation
the
times
Annualequals
asset
thehasthe
numberaverage
been in
of use
depreciation equals
years that
expense equals
bybook
The the value
annual number of of
theyears
depreciation the
expense
asset asset
divided
The historical cost of an asset times the number of years that by annual depreciation expense
Earnings per share equalsdepreciation
the estimated useful
Valuation Ratios annual
divided by its useful
The historical anlife.
costexpense
oflife under
equals
asset age
the of the asset. depreciation.
accumulated
asset
times thehas been in
number of use equals
years that hasannual
equals
by remaining
the numberinofitsyears
depreciationuseful
thelife.
expenseasset Wiley © 2020
Valuation Ratios the straight
annual
divided byline
its method.
depreciation expense
useful lifeTherefore,
under
equals Therefore,
theaccumulated
asset has beenaccumulated
depreciation.
in use equals has remaining
equals the numberinofitsyears
useful
thelife.
asset
Price per share the the historical
straight
annual costexpense
line method.
depreciation divided by
Therefore,
under depreciation
Therefore,divided
accumulated by annual
accumulated
depreciation. has remaining in its useful life.
P /E = Price pershare
Price per share annual
the the depreciation
historical
straight expense
cost divided
line method. by
Therefore, depreciation
depreciation
Therefore, equals
divided the
byaverage
annual
accumulated
P E == Earnings
P//CE per share
 Measures of Leverage
Degree of Operating Leverage

Wiley’s CFA Program Exam Review

® WoRking Capital ManageMent
Percentage change in operating income
DOL =
Percentage change in units sold
Working Capital Management
WoRking Capital ManageMent
Q × (P − V)
Liquidity DOL =
Measures
WoRking Capital ManageMent
MeasuRes of leveRage Q × (P − V) − F
Working
CurrentCapital
assets Management
where: Current Ratio =
QLiquidity
= NumberMeasures Working
of units sold Capital Management
Current liabilities
Measures of Leverage
PLiquidity
= Price Measures
per unit
V = Variable operating Current
cost per assets
unit
asset on the balance sheet and to report lease income Degree • Degree
ofCurrent
Operating
F = FixedQuick
of
Ratio operating
Cash
=Leverage + Short
= Current liabilities
Ratiocost
operating
leverage
term marketable(DOL) investments + Receivables • Price-weighted index: value equals the sum of the
Current assets Current liabilities
(operating cash flow) as well as asset depreciation Q × (P − V)Current Ratio =
= Contribution margin (the amount that units sold contribute to covering fixed security prices divided by the divisor (typically set to the
Current liabilities
Percentage change in operating income
=
DOLcosts) Cash + Short term marketable investments + Receivables number of securities in the index at inception).
Financial Reporting Quality (P − V) =Quick Ratio =Percentage
Contribution margin per
Accounts receivable
change
unit in
turnover
Cash + Short
units sold sales
Credit
=Current liabilities
term marketable investments + Receivables • Equal-weighted index: each security is given an identical
Quick Ratio = Average receivables
Degree• ofDegree
Financial of financial
Leverage Current liabilities
leverage (DFL) weight in the index at inception (over-represents
• Conditions conducive to issuing low quality financial Q × (P − V)
DOL = receivable turnover =
Accounts
Credit sales securities that constitute a relatively small fraction of the
reports: opportunity, motivation, rationalization Q × (P − V) − F Average receivables
Accounts receivable
in=Credit sales
target market
leveRage and requires frequent rebalancing).
ting  Accounts
Number ofPercentage
receivable
days of change
turnover =
receivables net income
DFL = MeasuRes of
• Mechanisms that discipline financial reporting where:
Average
Percentage change in operating
receivables
Average days sales on credit
income
• Market-capitalization weighted index: initial market
quality: markets, Capital
regulatory authorities, registration Accounts receivable
Budgeting  Q = Number of units
Number soldof receivables =
of days Accounts receivable
= Accounts value is assigned a base number (e.g. 100) and the
requirements, auditors, private contracting Degree • ofNumber
P = Price Degree
Total
per of total
unitLeverage
of [Q(P
days of
− V) −leverage (DTL)
Average
F](1 −=t)Average
receivables Sales
daysreceivable
sales on credit
on−credit
[Q(P / 365
− F]
V) on
WoRking Capital ManageMent
Net Present Value (NPV) V = Variable =
DFLoperating cost per unit = days
Accounts
sales
receivable
credit change in the index is measured by comparing the new
[Q(P − V) − F − C](1 −= t) [Q(P − V) − F − C] market value to the base market value (stocks with larger
F = Fixed operating costPercentage change in on
Accounts
Sales net income
receivable
credit / 365
DTL = = goods sold

CORPORATE FINANCE
n Short-term
Q × (P − V) Investment Cost(the
Returnschange
= Contribution of market values have a larger impact on the index).
CFt turnovermargin
Percentage
Inventory = amount
in Sales
the that
on credit
number units
unitssold
of/ 365 soldcontribute to covering fixed
∑ NPV = t − Outlay where:
costs) Average inventory
t =1 (1 + r) Q = Number of units sold = Cost of goods sold
(P − V) =Inventory
Contribution
P = Price Inventory
per unit
= market
margin
turnover
= =
×yield
per
Cost of unit
 Face
Average goods
value − price   360 
sold
inventory  360  Market Efficiency
Corporate Governance DTL
Money turnover
DOL DFL   ×  = Holding period yield × 
where: V = Variable operating cost per  unit inventory
Average Price Days 
Inventory  Days 
Degree ofNumber
Financial
of Leverage
days of inventory =
CFt = after‐tax cash flow at time, t. F = Fixed operating cost
• Breakeven quantity of Average
sales = day’s costoperating
(Fixed
Inventory of goods soldcosts + • Weak form EMH: current stock prices reflect all security
• Key
r = required rateareas
of return
of for the investment.
interest: This is ownership
economic the firm’s cost and
of capital
votingadjustedCfor
= FixedNumber
financial Q
cost
of days× (P − V)
of inventory =
DTL
Fixed
Number = of Percentage
financial
days change
costs)
of inventory Face ÷value
Inventory
in net−income
Contribution
= Average day’s cost of
Inventory
price  margin
goods
365 sold per unit
 sold  365  market information. Abnormal risk-adjusted returns
the risk inherent in the project. DFL
t = Tax rate = [Q(P − V) − F − C]
control, board of directors representation, remuneration Bond equivalent
Percentageyield
change
Average
=  in operating
=
Price
day’s cost × of goods
  sold
of income
= Holding period yield × 
Days/365  Days  cannot be earned by using trading rules and technical
Outlay = investment cash outflow at t = 0.
and company performance, investors in the company, where: • Operating CostInventory
goods
breakeven = quantity Inventory of sales = Fixed operating analysis.
= Cost of goods sold / 365
Internal Ratestrengthof Return of shareholders’
(IRR) rights, managing long-term Q = Number of units costs ÷ Contribution margin
Cost of goods per sold unit
/ 365
ANCE DFL =
[Q(Pproduced
− V) − F](1 and −sold
Face
t)
value =
Purchases −
[Q(P − V) − F]
price  360   360  • Semi-strong form EMH: current stock prices reflect
risks P = Price Discount
per unit[Q(P
Payables turnover
basis V) −=F
− yield = − C](1 − t) [Q(P − V)
×
− F − C]= % discount ×  all security market information and other public
n
CFt n
CFt Working
V = VariablePayables turnover
operating cost Capital
== per
Purchases
 Purchases
unitFacetrade
Average Management
value payables Days  Days 
∑ (1 + IRR)t = Outlay ∑ (1 + IRR)t − Outlay = 0 Payables turnover Average trade payables information. Abnormal risk-adjusted returns cannot be
Capital
t =1 Budgeting t =1
If the project being evaluated has a higher risk than the average risk of the firm’sCexisting
F = Fixed operating cost Average trade payables
where:
earned by using important material information after it
projects, the WACC is adjusted upwards. If the project has less risk than the average
• Sources
= Fixed
Q = Number
risk % of unitsof
financial cost liquidity:
Face
sold value − Price primary Accounts (e.g.payables
cash balances and
Discount =
Number of days of payables =Accounts Accountspayables
payables has been made public.
Payback
of • Consider
Period
the firm’s existing incremental
projects, the WACC after-tax cashdownwards.
is adjusted flows, externalities Breakeven short-term
P = Price Number
per unitof
Number of days of funds) Price and
payables
point days of payables = Average
= secondary
Average day’s (e.g. purchases negotiating
Averageday’s day’spurchases
purchases
and opportunity costs. Ignore sunk costs and financing F = Fixeddebt
V = Variable operating contracts, cost perliquidating
unit
Accounts
assets, payables
filing for bankruptcy • Strong form EMH: current stock prices reflect all public
operating VQcost Accountspayablespayables
Payback period
estimating
costsCostandof discounted
fromdebt
calculations payback period have the same formula, but discounted
of operating cash flows CWorking
protection).
PQ BE =Effectiveness
= FixedCapital
financial
BE + F + C
cost Measure== = Purchases / 365
Accounts and private information. Abnormal risk-adjusted returns
payback uses cash flows discounted by the appropriate rate: Purchases
Purchases / 365
/ 365 Market OrganizatiOn and Structure 
t = Tax• rateAdditional liquidity measures cannot be earned (assuming perfect markets where
• For mutually
Yield-to-Maturity Approachexclusive projects, use the NPV rule if the where:
information is cost-free and available to all).
Cost of goods sold
NPV and IRR nrules conflict
n P = Price Inventory
per unit turnover
Market = Organization and Structure 
The bond’s yield to maturity ∑ CF(YTM) n +1 − ∑is CFthe
n IRR of an investment in the bond, assuming Q = Number Purchases
Purchases
Purchases
of units ===Ending
Ending
Ending
produced inventory
inventory
inventory++inventory
and sold
Average COGS
COGS + COGS − −Beginning
− Beginning
Beginning inventory
inventory inventory
• Behavioral biases that may explain pricing anomalies:
• purchased
that it is
Payback
Payback=atperiod nthe 0 ignores
+ t =current markettime
t =0
price value
and held oftill
money,
maturity.risk
It isof V that
the yield = Variable
Leveraged cost per
Position unit
Metrics loss aversion, herding, overconfidence, information
period n
equates the thepresent
project value and of a∑ cash CFn +flows
bond’s that occur after the payback F = FixedOperating
1 expected future cash flows to its current market price.
operatingcycle
Operating costs==Number
cycle Number ofofdays
days ofofinventory
inventory ++ Number
Number of of
days
daysof receivables
of receivables
constitute an infringement of copyright. cascades, representativeness, mental accounting,
62 Operating cycle = Number of days of inventory Inventory+ Number of days of receivables
period is reached t =0 C©=Wiley 2018
Fixed allLeverage
RightsofReserved.
financial
Number cost any
days ofPosition
inventory = copying
unauthorized
size P0 Qor0days
distribution
1 ofwillgoods
Debt Rating Approach = Average
= = cost sold conservatism, narrow framing.
• Discounted payback period ignores cash flows that occurThe breakeven Net ratio cycleEquity
Net operating
numbercycle
operating of units
Net operating cycle−−=Number
cansize
==Number
Number
Number
P0 Q
beofofcalculated
days
days ofof M 0as: M+0 Number
0inventory
inventory
Inventory
+ Number of of
daysdaysof receivables
of receivables
n n
= ofofofdaysdays
of of inventory + Number of days of receivables
ofpayables
after the
When a reliable current market payback n
period
price for ∑ is
theCFreached
n +1 − ∑ CFndebt is not available, the before-
company’s
Number
− Number
days
Costofofdaysgoods
payables
ofsold / 365
payables Risks of Equity Securities
F+C
tax
where n• =of
cost Average
#debt can Accounting
of periods bethat ∑ CFn <by0Rate
estimated usingtof
and = 0the yieldt =on
Return
n (ratio ofpartial
is the year (in year n+1) • Q
project’s
0 similarly-rated bonds that have
Trade
BE = discounts
% Equity
= M = (e.g. “2/10 net
Equity per share
365 30” means a 2% discount
64 P − V
terms to maturity that are tsimilar
=0
average net income to its average to the company’s ∑ CFn+1book value) is based
existing debt. 64 © Wiley 2018
is2018
© Wiley margin
all
availableRights Reserved. any
if the
all Rights Reserved. amount
Price =
unauthorized
per
any unauthorized copying
share or
owed
copying
Inventory
distribution will
is paid
orturnover
distribution constitute an
within
will constitute infringement of
10 days,
an infringementcopyright.
of copyright. • Preference shares are less risky than common shares.
l
Issues in on accounting
estimating Cost ofnumbers
debt
=0
and tignores the time64value of Note © Wiley 2018 all Rights Reserved.
that otherwise full amount
taxes are not considered
any unauthorized
is due
in breakeven
copyingbyorthe
analysis
distribution
30thwill
because
constitute an infringement of copyright.
day)
there is no taxable income. • Putable common shares are less risky than callable or
CF required moneyto recover the remaining investment amount.
Return using Equity after disposal  365  non-callable common shares.
OperatingImplicit
breakeven =  Discount   Number of days
• • Fixed-rate
Profitability versus floating-rate
index (PI): PI debt: The cost
exceeds 1 of floating-rate
when NPV isdebt is reset
positive margin rate point
= Cost ofInitial Equity=  1 +

  beyond discount period − 1
Required
Profitability
Return on
Index
a Stock
periodically based on a reference rate (usually LIBOR) and is therefore, more
trade credit
1 − Discount • Callable common and preference shares are more risky
Capital Asset
difficult Pricing Model than the cost of fixed-rate debt.
to estimate PQ OBE = VQ OBE P + D − C − P0 (1 − M 0 )(1 + r CM )
= +t F than their non-callable counterparts.
PV of future cash flows NPV P M + C
• Debt PI = with option like features:= If 1 +option-like features are 62expected to be removed
© Wiley 2018 all Rights Reserved. any unauthorized 0 copying
0
Accounts payablewill constitute an infringement of copyright. • Cumulative preference shares are less risky than non-
or distribution
r = R + β [E(R
Initial )
investment− R ] Initial investment Number of days of payables =

EQUITY INVESTMENTS
frome future
F debt
i issues,
M an
F analyst must adjust the yield to maturity on existing bonds Cost of Capital Average day’s purchases cumulative preference shares as they accrue unpaid
F
for their option features, and use the adjusted rate as the company’s cost ofWhere: debt. Q OBE = Accounts payable 365 dividends.
where: P = initial share price P−V =
• Nonrated debt: If a company does not have any debt outstanding (to be rated) 0 or Purchases / 365 Payables turnover
Cost of Capital
[E(RM) −yields
Rf] =onEquity risk premium.
existing debt are Cost of Capital
not available Pt = share disposal price
(due to lack of current price information), Market Organization and Structure
RM = Expected return on the market.
an analyst may not be able to use the yield on similarly-rated bonds or the yield to
Net= income
D dividendatper
various
share levels
during ofthe
sales
period Industry Analysis
βi = Beta of stock. Beta measures the sensitivity of the stock’s returns to changes in market
C = commission per share
Weighted• maturity
Average
Weighted Cost
approach of Capital
average cost of
to estimate thecapital
company’s (WACC)
cost of debt.
leases• Purchasing
returns. r = call money
Net rate = [Q
income stock
( P − Von − C ](1 − t(leveraged
) − Fmargin ) position) • Porter’s five forces: threat of substitute product,
• If a company uses leases as a source of finance, the cost of these CM
Leases:rate.
RF = Risk‐free M0 = initial margin
WACCbe= included
should
re = Expected
(w )(rd )(1in− its
return ond stock
t) + (wp )(r
(cost cost
) + (we )(re )
ofp capital.
of equity). • Leverage ratio is the reciprocal of the initial margin. bargaining power of customers, bargaining power of
equity valuatiOn: cOnceptS and
Note that this formula considers taxes, unlike the variant formula for breakeven point suppliers, threat of new entrants, intensity of rivalry.
• noPrice
Security Price at which theFINANCE
at income).
which
CORPORATE Investor
theWould Receive
investor a MarginaCall
receives margin call
where:
Dividend• Cost
estimating Costofofpreferred
Discount preferred Stock
Model stock (which has taxable
• Industry life-cycle analysis
wd = Proportion of debt that the company uses when it raises new funds
Equity
• Embryonic Valuation: Concepts and Basic Tools
l r©
2. d= Before‐tax
Wiley 2018
Dividend rPp0all=
dmarginal
=Rights
DiscountDp 1 Reserved.
Modelcost of
any(DDM) debt copying or distribution will constitute an infringement of copyright.
unauthorized ©©Wiley
Wiley 2018
2018Pall Rights (1 − Initial
Reserved. margin) copying or distribution will constitute an infringement of copyright.
any unauthorized
0all×Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
65 63 (slow growth, high prices, high risk of
t = Company’s vp tax rate
rmarginal (1 − Maintenance margin) failure).
e −g Dividend Discount Model (DDM)
wp = Proportion of preferred stock that the company uses when it raises new funds
The dividend discount model asserts that the value of a stock equals the present value of
rp = Marginal cost of preferred stock • Growth (sales grow rapidly, improved profitability,
its
where:
estimating •
expected
Required Cost future
Return
Cost of of equity
dividends.
on a Stock
equity • V0 lower
D1prices,Drelatively
+  + low
w e = Proportion of equity that the company uses when it raises new funds Types of orders 2 D∞ competition).
P = current market value of the security. = +
re0= Marginal
Capital= next
D1Capital
• year’s
Asset Capital
cost of equity
Pricing asset pricing model (CAPM)
Model
dividend. • Execution instructions, e.g. market orders, limit orders. (1 + k e )1 (1 + k e )2
• Shakeout (slower growth, (1 + k e )∞
intense competition,
1. Asset Pricing Model (CAPM)
D1 of return on common equity.
Tore =Transform
required
rre ==rate +g
Debt‐to‐equity Ratio into a Component’s Weight • Exposure instructions, e.g. hidden orders, iceberg declining profitability, focus on cost reduction, some
g = the firm’se RP F0 + β i [E(R
expected M ) − Rgrowth
constant F] rate of dividends. equity valuatiOn: cOnceptS and
The capital asset pricing model (CAPM) states that the expected rate of return from a
orders. failures/mergers).
n
Dt
stock equals D the risk-free interest rate plus a premium for bearing risk. V0 = ∑
Rearranging the
where: E above =
Dequation
= wd gives us a formula to calculate the required return on
• Validity instructions, e.g. day orders, good till cancelled • Mature (little
t =1 (1 + k e )
t or no growth, industry consolidation,
3.equity:
[E(R BondM) − • 1Rf]
Yield
D= Equity
+Dividend
plus
E Risk D +risk discount
EPremium
premium. model
Approach
orders, immediate or cancel orders, good on close high
Equitybarriers to entry,Concepts
Valuation: strong cash andflows).
Basic Tools
RM = Expected rwe d=+Rwreturn
Fe += B ) − RF ]
on theMmarket.
1 i [E(R
β = Beta
The bondr yield
i of stock.
D Beta measures the sensitivity of the stock’s returns
1plus risk premium approach is based on the basic assumption that the cost to changes in market orders, stop orders. One year •
holding
Decline period:
Dividend Discount Model (DDM)
(negative growth, excess capacity, price
= + g
of returns.
capital
Valuation
e
for P
riskier
of Bonds cash flows is higher than that of less risky cash flows. Therefore, we • Clearing instructions, e.g. how final settlement should competition, weaker firms leave).
RF = Risk‐free rate.
0 dividend to be received year-end price
V0 = +
calculate the return on equity by adding a risk premium to the before-tax cost of debt.
re = Expected return on stock (cost of equity). be arranged (security sale orders must also indicate • Competitive
V0 =
D1 (1 + kstrategies:
D1 cost
+ e ) 2 +  + (1 ∞+ k∞e )
D leadership,
1 product/service
• Bond  yield plus  risk premium whether the sale is a long sale or a short sale). differentiation.
(1 + k e )1 (1 + k e )2 (1 + k e )
 n Model © 2018 Wiley
Dividend Discount PMTt  M
Sustainable rd∑
rPe0 ==Growth + riskRate t +
 • Execution mechanisms Multiple‐Year Holding Period DDM
premium
 t =1  rd    rd 
n Cost of Capital
Cost of Capital Equity Valuation
D 
P0 =  1 Dbeta
1 +
2   
1 +
2 • Pure auction (order-driven) market: ranks buy and sell n D
1 Dt D2 Pn
• Project
g = 1re−− g  × ( ROE ) orders on price precedence, then display precedence,
7 March 2018 7:14 PM V00 = ∑ 1 +t + +
(1 + k e )2 model k e )n for common stock
Unlevered beta
estimating 
Betas EPS 
for a comparable asset • (1
Dividend
t =
+ k e )kdiscount
1 (1 + e)
(1 +(DDM)
where: • beta
Unlevered unleveraged
for a comparable betaassetfor a comparable asset then time precedence.
P 0 = current
where: market price of the bond. • One-year holding period
rate the company’s stock returns against market • Dealer/quote-driven/price-driven market: dealers
Where − (D/EPS)) where:
One year holding period:
• =(1Beta canpayment = Earnings
be calculated retention
by t.regressing
PMT
P0 = current interest market valuein ofperiod
the security.  Pn = Price at the end of n years.
t
returns over aongiven  period 1 of time. create liquidity by purchasing and selling against their
rDd 1==yield
next β ASSET = β EQUITY 
to maturity
year’s
β ofrate
dividend.
=ofβreturn
BEY basis.1
D
 © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. dividend 75 to be received year-end price
nrBond
e= = •
number Analysts
required
YieldASSET plus
use
periods the
EQUITY
Risk
pure-play
remaining
on
Premium
 (to
 1 +common
1 −maturity.
 (Approach
  to estimate the beta of a particular project or own inventory of securities.
t )method
equity.
D 
V0 = DDM (Gordon
Infinite Period Growth + Model) 1
M of a company that 
 1
is + 
not 1 − t )
publicly
E   traded. This method involves the adjustment of a (1 + k e )1 (1 + k e )
g ==the Parfirm’s
or maturityexpected value of thegrowth
constant bond. Erate   of dividends.
comparable publicly-listed company’s beta for differences in financial leverage. • Brokered market: brokers arrange trades among their
re = rd + risk premium, where rd is the required return on debt. D0 (1 + gc ) D0 (1 + gc )2 D 0 (1 + gc )3
1
D (1 + gc )∞
Valuation
Beta for a• of
Rearranging ○Beta
Preferred
project
the First for
using
above find aStock
aproject
a comparable
equation givesusing asset
us company a comparable
a formula re-levered
that asset
for similar
faces
to calculate target company
business
the required risksonas the com- clients.
releveraged
return V0 = Holding Period
Multiple‐Year + DDM 2 + + + 0
Beta for a project using a comparable asset re-levered for target company
equity: forpany target company
or project under study and estimate the equity beta of that company.• Features of a well-functioning financial system: timely
• Gordon(1 + k e growth
)1 (1 +model
ke ) (constant
(1 + k e )3 growth(1 + rate
k e )∞ of
○ DTop remove all   elements Dof financial
 risk from the comparable’s beta “unlever” dividends
D to Dinfinity) P
1 +  (1 − t ) D   and accurate disclosure, liquidity (which facilitates 1 2 n
p =
βVPROJECT r= β ASSET V0 =simplifies + + +
The unlevered
This equation (1 + k e )1 to: (1 + k e )2 (1 + k e )n
+ g β ASSET 1 +  (1 − t ) E
βr PROJECT Dthe1 p=beta.    reflects only the business risk of the comparable
beta
e =
P0and is known as asset beta.E   operational efficiency), complete markets and external
where: Risk
Country Finally, adjust the unlevered beta of the comparable for the level of financial
○ Premium (or informational) efficiency. where: D0 (1 + gc ) 1
D1
V0 = =
Country
Measures of Leverage
Risk
Vp = current Premium
value
risk(price) of preferred
(leverage) stock. or company under study.
in the project Pn = Price at the(kend gc n)1 years.
e − of k e − gc
Dp = preferred stock dividend per share.
= R F + β [E(R
re preferred M ) − R F + CRP]
Indices
p = cost
rBusiness of
Sustainable
r = +
e allGrowth
risk R β
versus stock.
Rate
[E(R ) −
FinancialR + CRP]
Frisk copying or distribution will constitute an infringement of copyright. Infinite Period DDM (Gordon Growth Model)
© Wiley 2018 Rights
F Reserved. any unauthorized
M
The long‐term (constant) growth rate is usually calculated as:
riskcomprises
BusinessCountry D risk of sales risk and operating
yield risk. Sales risk refers
Annualized to the
standard unpredictability
deviation of equity index D0 (1 + gc )1 D0 (1 + gc )2 D 0 (1 + gc )3 D (1 + gWiley
c)
∞
© 2020
g = 1 − equity ×risk
equity Sovereign
Country
premium
( ROE= ) Sovereign yield × Annualized standard deviation of equity index gVc0 ==RR(1×+ ROE + + + + 0
of revenues and EPS  risk=refers to spread
operating the company’s × operating cost structure.
Annualized standard deviation of sovereign k e )1 (1 + k e )2 (1 + k e )3 (1 + k e )∞
premium spread Annualized standard deviation of sovereign
bond market in terms of the developed market
refers =toEarnings
the uncertainty bondflows
market in terms
ofofthe
theuse
developed market
Financial
Where (1 −risk
(D/EPS)) retentionofrate
profits and cash because currency of Where RR is the reinvestment rate, or 1 – dividend payout rate.
 The Maturity Structure of Interest Rates
• A three-stage DDM is used to value fairly young companies that are just entering Value
Value of
of non‐callable
non‐callable bond
bond (option‐adjusted
(option‐adjusted price)
price) =
= Flat
Flat price
price of
of callable
callable bond
bond
Multi‐Stage Dividend
the growth Discount
phase. Model
TheirModel
development falls into three stages- growth (with very EQ
+ maturities.
The spot rate curve reflects spot rates for a range of+ Value of
Value of embedded
embedded call option
call option feature
The distinguishing
Multi‐Stage Dividend Discount The Maturity Structure of Interest Rates

Wiley’s CFA Program Exam Review

high growth rates), transition (with decent growth®rates) and maturity (with a of spot rates is that they are yields that have no element of reinvestment risk. Using spot
lower growth
D into perpetuity).
D D P Money rates
Market Pricing, Discount-rate basis
V = D11 1 + D22 2 +  + Dnn n + Pnn n
= (1 + k )DDM + (1 +can
Money
The spot rate curve reflects spot rates for a range ofprovides
Market a more
Pricing,
maturities. The accurate
Discount-rate relationship
basis
distinguishing featurebetween yields and terms to maturity relative
• AV00two-stage k ) be+ used
 + (1to+value
k ) +a (1company
+ k ) currently undergoing moderate to element
using yields to maturity on coupon-bearing
(1 + k ee )1 (1 + k ee )2 (1 + k ee )n (1 + k ee )n of spot rates is that they are yields that have no of reinvestment risk. Using spot Treasuries.
 Days 
growth, but whose growth rate is expected to improve (rise) to its long term PV = ×  − Days × 
rates provides a more accurate relationship between
APV = FV
yields
FV ×  11and− year × DR
terms to maturity
DR 
relative
where: growth rate. yield
to using yields to maturity on coupon-bearing Treasuries. 
curve for coupon
year bonds shows the yields-to-maturity for coupon-paying bonds
where:
Dn +1 of different maturities. To build the Treasury yield curve, analysts use only the most
P = Dn +1of Common Stock with Temporary Supernormal Growth
Valuation recently-issued and actively-traded government bonds as they have similar liquidity and
Pn = k −g A yield curve for coupon bonds shows the yields-to-maturity
n Year  for
 Year
coupon-paying
FV − PV
PV  bonds
k ee − gcc tax
DR
DRstatus.
of different maturities. To build the Treasury yield =
= YTMs
 Days
curve, × for
 ×
analysts
FV −
maturities where there are gaps can be estimated through a variety of
 useFV only the most
The= correct
D valuation
Last dividend model
of the to valuegrowth
supernormal such “supernormal
period growth” companies is the multi-   FV
 Daysmethods.
interpolation
D n
n = Last dividend of the supernormal growth period recently-issued and actively-traded government bonds as they have similar liquidity and
stage
D dividend discount
n+1 = First dividend
dividend of the model
constantthat combines
growth periodthe multi-period and infinite-period
D n+1 = First of the constant growth period tax status. YTMs for maturities where there are gaps can be estimated through a variety of
dividend discount models. A par curve represents a series of yields-to-maturity such that each bond trades at par. The
• Multi-stage DDM
The Free‐Cash‐Flow‐to‐Equity (FCFE) Model
• Corporate debt interpolation methods. Money • Money
Money Market
Market Pricing, Add-on
market
Pricing, Add-on Rate
Rate Basis
pricing on an add-on rate basis
Basis
par curve is derived from the spot rate curve.
The Free‐Cash‐Flow‐to‐Equity (FCFE) Model
• Bank loans and syndicated loans (mostly floating-rate FV
A par curve represents a series of yields-to-maturity such that
FV each bond trades at par. The
D D D P PV=
== CFO 1− FC
Value =
FCFE +Inv + 2
+ Net + …+
borrowing n
+ n loans). Forward
PV=  Curve
Days
FCFE CFO
(1 + k−e FC
)1 Inv
(1 + kNet
e)
2borrowing
(1 + k e )n (1 + k e )n par curve is derived from the spot rate curve.  11 + × AOR 
+ Days ×
• Commercial paper (unsecured, up to a maturity of one  Year AOR 
where:
Analysts may calculate the intrinsic value of the company’s stock by discounting their A forward Year rate represents the interest rate on a loan that will be originated at some point in
Analysts may calculate the intrinsic value of the company’s stock by discounting their year). Forward Curve
projections of future FCFE at the required rate of return on equity.
D n +1FCFE the future. Forward rates are used to construct the forward curve, which represents a series
projections
Pnof= future at the required rate of return on equity.
k∞e − gc • Corporate notes and bonds.
A forward rate represents the interest rate on of forward
a AOR
loan that
=
 rates,beeach
Year
 Year
will
− PV
FVhaving
 FV − PV  the same horizon. Typically the forward curve shows one-
× originated at some point in
AOR =  Days  × stated a semiannual
DV =∑
∞ FCFE t
FCFE
Last dividend of the supernormal growth period the future. Forward rates are used to constructyear
• Medium-term notes (short-term, medium- to long- the forward
forward rates
 Days
curve, PVonrepresents
PV
which bond basis
a series
V0n = ∑ t
(1 + k e )tt of forward rates, each having the same horizon. Typically the forward curve shows one-
D0n+1 =tt==11First
(1 + kdividend
e) of the constant growth period term, structured segments). Implied forward rates (also known as forward yields) can be computed from spot rates.
• Short-term wholesale funds: central bank funds,
year forward rates stated on a semiannual Yield
Yield
bond • basis
Spreads
Spreads Bond-equivalent
over the
over the Benchmark
Benchmark yield:Yieldmoney-market
Yield Curve
Curve rate stated on a
Value of a Preferred Stock 365-day year onareansemiannual add-on basis.
Value of a Preferred Stock interbank funds, certificates of deposits If the yields presented bond basis:
• Valuation of preferred
The Free-Cash-Flow-to-Equity (FCFE) stockModel Implied forward rates (also known as forward yields) can
• Forward
PV = =
PMT
PMT be
rate
computed
+
PMT
PMT from spot rates.
+ .. .. .. +
PMT
+ PMT + FVN
+ FV
When preferred stock is non‐callable, non‐convertible, has no maturity date and pays • Repurchase agreements (repos) PV + zzspot 1 + (1 + z + Z)2
1
+ Z)rate + +rate
(1 + + Z)
When preferred stock is non‐callable, non‐convertible, has no maturity date and pays
dividends • atatNon-callable,
a fixed rate, theavaluenon-convertible
of the preferred preferred
stock stock
can be calculated with
using no
the  1 + 6-mth
(1 +
(1 1 + Z)
1 + Z)2 forward
(1+1z+22 6-mth (1 zz N
N6 + Z) N
mths from now   FI 12-mth spot rate  2
If the yields presented are semiannual bond basis:  • Interest rate on   a loan originating at some point = 1+
 in the
Many analysts assert
rate,that company’s dividend-paying
stock cancapacity should be reflected in its
dividends a fixed
maturity
perpetuity formula:
the value of the preferred be calculated
dateof estimated future dividends. FCFE is a measure of dividend
using the
• Repo: seller is borrowing funds from the buyer and  2  2 2 
cash flow formula:
perpetuity estimates instead future.
paying capacity and can also be used to value companies that currently do not make any providing the security as collateral. 6-mth spot rate   6-mth forward rate •
• The6 mths
The benchmark
from now
benchmark spot

spot rates

rates zz12-mth
, z , zN spotare
are derivedrate  2 from
from the the government
government yield yield curve
11, z22, zN derived curve
 1 +   1 + To • calculate
Implied fixedthe
= interest
 on
x-period
forward 1 +rates
on interestforward ratecan rate y periods  from today,
fromsimplyspot remember the
2 be computed
(or from fixed rates rate swaps).
dividendVpayments.
V00 = r0
D
= D0 FCFE can be calculated as: • Reverse repo: buyer is borrowing securities
2 to cover a 2 (or
• following
from
Z refers
refers to to formula:
rates
the z‐spread
z‐spread Note perthat x and
period.
swaps).
It is y here
is constantrespresent
for all the periodic
all time
time periods. spot rate.
• Z rates. the per period. It constant for periods.
r short position.
To calculate the x-period forward rate Option‐adjusted y periods from today, Spread simply
(OAS) remember the
• FCFE
For a non‐callable, = CFO
Non-callable,
For a non‐callable, − FC Inv
non‐convertible
non‐convertible +preferred
preferred
non-convertible stock with
Net borrowing
stock with
maturity at time, n,
preferred
maturity atstocktime, n,
the value of
with
the value of
• Repo margin or haircut: the percentage
following formula: difference
Option‐adjustedy Spread
Note that x and y here respresent (1 + y s0 the + x fy )(OAS)
) (1periodic x
=spot(1 +rate. x+ ys0 )
x+ y
the stock can be calculated using the following formula:
the stock canmaturitybe calculated at using
timethe n following formula: between the market value of the security and the
OAS
OAS = z‐spread − Option value (bps per
= z‐spread − Option value (bps per year)
year)
n
amount of the loan. (1 + y s0 ) y (1 + x fy )x = (1 + x + y s0 )x + y
D F
V0 = ∑ D tt t + F n
n
V0 = ∑ (1 + r)t + (1 + r)n • Repo rate: annualized interest cost of the loan.
Implied Forward Rates
t =1 (1 + r) (1 + r)
t =1
• Any coupon income received from the bond provided Implied Forward Rates
equity valuatiOn: cOnceptS and BaSic tOOlS 365
© 2018 Wiley
where:
where:• Price multiples: price-to-earnings, price-to-sales, price- as security during the repo term belongs to the seller/ (1 +
(1 A
(1 +
+ zz AA )) A (1 + IFR
B− A
IFRAA,, BB−− AA )) B− A = = (1(1 +
B
+ zz BB )) B
V = value of preferred stock today (t = 0) borrower.
V00 = valueto-book,
of preferred stock today (t = 0)
price-to-cash flow. ( B− A) (1
B 
+ z ) 
Dt = expected dividend
D
Price= expected
Multiples
r =t required
in year t, assumed to be paid at the end of the year
dividend in year t, assumed to be paid at the end of the year • Yield
IFRA, Bspreads
IFR A, B −−AA =
= ( B− A) (1 + z B ) A  −
B
B
− 11
.indd 365 • Justified
r = required
rate of return
rate of return P/Eon on the stock
ratio
the stock Fixed Income 7 March 2018 7:15 PM
Valuation • G-spread:

 spread (1 +
(1 + zz AA )) A 
over government bond yield.
F = par value of preferred stock
F = par value of preferred stock
P0 D1 /E1
= • Bond pricing with yield-to-maturity (uses constant • I-spread: spread over the swap rate.
E1 r−g
interest rate to discount all the bond’s cash flows) • Z-spread: spread over the government spot rate.
introduction to ASSet-BAcked Securitie
• Enterprise value (EV): market value
Market price of share of the company’s • If coupon = YTM, the bond’s price equals par value. • Option-adjusted spread: z-spread less option value
Price to cash flow ratio = (bps per year).
common stock plusCash the flowmarket
per sharevalue of outstanding • If coupon > YTM, the bond’s price is at a 88 88
premium to © © Wiley
Wiley 2018
introduction 2018 All
to All rights
Fixed-income Introduction
rights reserved.
reserved.
VAluAtion Any unauthorized
Any unauthorized tocopying
Asset-Backed
copying or distribution
or Securities
distribution will
will constitute an
constitute an infringement
infringement of of copyright.
copyright.
preferred stock (if any) plus the market value of debt, par. • © 2018
Asset-backed
Parties toWiley
the Securitization securities
less cash and short-term investments (EV can be thought Introduction to Fixed-Income Valuation • Residential MBS: agency RMBS vs non-agency RMBS
= unauthorized copying or distribution will constitute an infringement of copyright. • If coupon < YTM, the bond’s price is at a discount to par.
Market price per share
Price to sales ratioany
of
© Wiley 2018
allas the
all rights cost
reserved. of taking
Net salesover adistribution
company). Party in
Party(require credit enhancements).
© Wiley 2018 rights reserved. any unauthorized per share
copying or will constitute an infringement of copyright. 395
Pricing Bonds• Price with isSpot
inverselyRates related © to2018 Wiley when the yield
yield: Description Illustration
• EV/EBITDA multiple is useful for comparing companies increases (decreases), the bond’s price decreases
c15.indd 395
•
Seller Mortgage pass-through
Originates the loans andsecurities
sells loans to (backed
the SPV by ABCpool of
Company
with
Price todifferent
sales ratio =capital structures and for analyzing loss-
Market value of equity PMT
PV(increases).
= +
PMT
+…+
PMT + FV Issuer/Trust
residential The SPV that buys the loans from the seller
mortgage loans):securities single monthly mortality SPV
and issues the asset-backed
making companies.Total net sales 1 2
(1 + z1 ) (1 + z 2 )c15.indd 395 (1 + z N ) N
rate (SMM). 7 March 2018 8:48 PM
• Bond pricing with spot rates (uses the relevant spot rates Servicer Services the loans Servicer
introduction to Fixed-income VAluAtion
Current market price of share to discount the bond’s cash flows)
P/BV = z1 = Spot rate for Period 1
FIXED INCOME
Prepayment in month t
z2 = Spot• rate
SMMt =
Book value per share Spot rate:2yield on a zero-coupon bond for a given
for Period Beginning mortgage balance for month t − Scheduled principal payment in month t
Introduction to Fixed-Income Valuation
zN = Spot rate maturity.
for Period N

Basic
Market value of common shareholders’ equity
P/BV = Features of Bonds • Bonds
Accrued • Prepayment risk: contraction risk occurs when interest
Accruedinterest
Pricing with Spot Rateswhen a bond is sold between coupon
Book value of common shareholders’ equity Flat Price, Interest and the Full Price 
payment dates rates fall (leading to an increase in prepayments), while
PMT PMT PMT + FV extension risk occurs when interest rates rise (leading
where:• Types of collateral backing: collateral trust bonds,
Figure: Valuing = a Bond + between +…+
Coupon‐Payment Dates
• PVFull (1 price:
+ z1 )1 calculated
(1 + z 2 )2 as
(1 +thez N )PV
N of future cash flows as
equipment trust certificates,
equity = mortgage-backed to a decrease in prepayments).
Book value of common shareholders’ of the settlement date.
(Total assets – Total liabilities)
securities, covered – Preferred
bondsstock z1 = Spot• rate Accrued
for Periodinterest1 (AI) included in full price: seller’s • CMOs (backed by pool of mortgage pass-through
• Credit
Enterprise Value enhancements
Multiples z2 = Spot rate proportional
for Period 2 share of the next coupon, where t is the securities): sequential-pay tranches (shorter-term
tranches receive protection from extension risk, longer-
• Internal: subordination, overcollateralization, excess zN = Spot rate for Period
number N from last coupon date to the settlement
days
term tranches receive protection from contraction
EV/EBITDA
spread (or excess interest cash flow). date and
Flat Price, Accrued T is the
Interest and number
the Full Price  of days in the coupon period
(actual/actual for government bonds, 30/360 for risk); PAC/support tranches (support tranche provides
• External: surety bonds, bank guarantees, letters of PV Full
= PV + AIFlat
protection against contraction and extension risk to
where:
credit.
Figure: Valuing corporatea Bond betweenbonds) Coupon‐Payment Dates
EV = Enterprise value and is calculated as the market value of the company’s common the PAC tranche); floating rate tranches (floater and
• Covenants
stock plus the market value of outstanding preferred stock if any, plus the market value of AI = t/T × PMT inverse floater).
debt, less cash and short term investments (cash equivalents).
• Affirmative: requirements placed on the issuer. • Credit enhancements for non-agency RMBS: internal
• PVFlat
Full or clean or
= PV × (1 + r) t/T
quoted price: full price less AI, or (cash reserve funds, excess spread accounts,
• Negative: restrictions placed on the issuer. equivalently overcollateralization, senior/subordinate structure)
• Repayment structures and external (monoline insurers).
Semiannual bond basis yield or semiannual bond equivalent yield
• Bullet: entire principal amount repaid at maturity. PV Full = PV Flat + AI • Commercial MBS (backed by non-recourse commercial
• Amortizing: periodic interest and principal payments M
 1 + SAR M  =  1 + SAR N 
N
mortgage loans): investors have significant call
   
made over the term of the bond. • Yield

AI = t/Tmeasures
M × PMT
  N 
protection but are exposed to balloon risk (like
• Sinking fund: issuer repays a specified portion of the Important: What • Effective annual yield depends on periodicity of the
we refer to as stated annual rate (SAR) is referred to in the curriculum as APR or annual percentage rate. We
extension risk).
principal amount every year throughout the bond’s lifestick to SAR PV stated = PVannual
Fullyour focus
to keep yield.
r) t/Tannual
×on(1a +stated rate versus the effective annual rate. Just remember that if you see an annual • Non-mortgage asset-backed securities: auto-loan
percentage rate on the exam, it refers to the stated annual rate.
or after a specified date. • Annual-pay bond: stated annual yield for periodicity of receivable-backed securities (backed by amortizing
• Bonds with contingency provisions Current yield
Semiannual one
bond= basiseffective yield orannual semiannual yield. bond equivalent yield auto loans) and credit card receivable-backed
• Callable: issuer has the right to redeem all or part of • Semiannual-pay bond: stated annual yield for securities (with lockout period before principal
M Annual cash coupon payment
 + SAR
Current M  = of two
yield SAR= N
N semiannual bond basis yield amortizing period sets in).
the bond before maturity.  1periodicity  =  1 + Bond  price
© Wiley 2018• allPutable:
rights reserved. bondholders have
any unauthorized copying the right
or distribution to sellanthe
will constitute bondof copyright.
infringement
= M
semiannual 83 bondN equivalent yield = yield per • CDOs: structured as senior, mezzanine and
back to the issuer at a pre-determined price
introduction VAluAtionWhatsemiannual
to Fixed-income VAluAtion
onto Fixed-incomeImportant:
introduction period × 2. subordinated bonds (or equity class). CDO manager
we refer to as stated annual rate (SAR) is referred to in the curriculum as APR or annual percentage rate. We © Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. 89
specified dates. • Current yield: annual cash coupon payment divided by
stick to SAR to keep your focus on a stated annual rate versus the effective annual rate. Just remember that if you see an annual engages in active management of the collateral to
percentage rate on the exam, it refers to the stated annual rate.
the bond price. generate the cash flow required to repay bondholders
• Convertible: bondholders have the right to convert theOption‐adjusted Option‐adjusted price price and to earn a competitive return for the equity tranche.
Current • yield
Yield-to-call: computed for each call date.
bond into a pre-specified number of common shares
of the issuer (can also have callable convertible bonds). • Value
Value of
of non‐callable
Yield-to-worst:
non‐callable
Annual
bond
lowest
bond (option‐adjusted
yield
cash(option‐adjusted
coupon among
payment
price) =
= Flat
price) the FlatYTMprice
priceand of
of callable
the bond
callable bond
Interest Rate Risk
Current yield = +
+ Value
Value of of embedded
embedded call call option
option
• Contingent convertible bonds (CoCos): convert various yields to call. Bond price
automatically upon occurrence of a pre-specified Money
Money Market
• Money
Market Pricing,
market
Pricing, Discount-rate
pricingbasis
Discount-rate basis
on a discount rate basis • Two types of interest rate risk
event. © Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. • Reinvestment 87
risk: future value of any interim bond
 Days Days × DR  cash flows increases (decreases) when interest rates
= × −
Fixed Income Markets PV FV 1
PV = FV ×  1 − year × DR 
 year  rise (decline). Matters more to long-term investors.
• Public offering mechanisms: underwritten, best efforts, • Market price risk: selling price of a bond decreases
 Year
Year   FV FV − − PV
PV  (increases) when interest rates rise (decline). Matters
auction, shelf registration DR =
DR =  Days  × ×
 Days   FV FV  more to short-term investors.

Money
© Market
Wiley 2018 Pricing,
All rights reserved.Add-on Rate
Rate Basis
Any unauthorized copying
Basis or distribution will constitute an infringement of copyright. 87
Money Market Pricing, Add-on Wiley © 2020
FV
FV
PV=
PV=  Days
 1 + Days × AOR 
 Yield on a corporate bond = Real risk-free interest rate + Expected inflation rate
g Fixed-income riSk And return
+ Maturity premium + Liquidity premium + Credit spread
Understanding Fixed-Income Risk and Return

Wiley’s CFA Program Exam Review

Understanding Fixed-Income Risk®and
Macaulay Duration Return
Basics Basics of Derivative
of Derivative Yield
Pricing anDPricing Spread:
anD
valuation valuation

Macaulay Duration1 + r 1 + r + [N × (c − r)]  Yield spread = Liquidity premium + Credit spread

MacDur =  − BasicsBasics of Derivative
of Derivative Pricing
Pricing and Valuation
and Valuation
g Fixed-income riSk And return  − (t/T)
 r c × [(1 + r) N − 1] + r 
1 + r 1 + r + [N × (c − r)]  Fundamental
Fundamental
For small, Value ofValue
instantaneous of an Asset
an changes
Asset in the yield spread, the return impact (i.e. the percentage
MacDur =  −  − (t/T)
Understanding
r c × [(1 +Fixed-Income
c = Coupon rate per period (PMT/FV)
r) N − 1] + r  Risk and Return change in price, including accrued interest) can be estimated using the following formula:
 SE(S  ) E(S  T) 
Macaulay Duration S0 =  0 =  T  − θ +Tγ − θ + γ
T

cModified
= CouponDuration
rate per period (PMT/FV) Return + r +λ(1≈) +−rModified
 (1impact + λ)  duration × ∆Spread

1 + r 1 + r + [N × (c − r)]  Where: Where:

Modified Duration MacDur
• Macaulay
ModDur ==  duration:
MacDur − weighted
N
 1r+ r c × [(1 + r) − 1] + r 
 −average
(t/T) of the time it r =For
risklarger changes
convexity
rfree
= risk
rate free rate inadjustment
the yield spread, for welarger
must also incorporate the (positive) impact of
changes) synthetic call, put, underlying asset and bond, e.g.
convexity into our
riskestimate
premiumof the return impact:
would take MacDurto receive all the bond’s promised cash flows.λ = assetλθ risk
DERIVATIVEs = asset
premium
= Storage, insurance, andcostsother
synthetic call = long put + long underlying stock + short
ModDur = θ = Storage, insurance, and other at costs
present at present
value value
cModified• Modified
= Coupon rate perhas
duration
1 + r (PMT/FV)
duration:
period
a very important estimated
application percentage
in risk management.price change
It can be usedγ = γ Return
= Convenience
toConvenience impact
and other ≈and−(MDur other ×benefits
benefits at∆Spread)
present at present
value Convexity × ∆Spread 2 )
+ (1/2 ×value bond).
forpercentage
estimate the a bond in response
price change forto a 100
a bond bps (1%)
in response to achange
change inin its yields Derivatives Pricing versus Valuation
yield‐to‐ • Factors affecting the value of an option
Modified
Modified Durationhas a very important application in risk management. It can be usedArbitrage
maturity. duration to Arbitrage and Replication:
and Replication:
estimate the percentage price change for a bond in response to a change in its yield‐to‐ • Price, as it relates to forwards, futures, and swaps (note that options are not a Impact of an increase in: Call Put Basics of Derivative Pricing an
MacDur Asset + Asset
Derivative + Derivative
= Risk-free = Risk-free
asset asset Lowest Prices of European Calls and Puts
maturity. % problem in this regard), refers to the fixed price (that is agreed upon at contract
DERIVATIVES
∆PV Full=≈ − AnnModDur × ∆Yield
ModDur Value of the underlying Increase Decrease Basics of Derivative Pricing an
1+ r initiation) at which the underlying transaction will take place in the future. These
Full Asset − Asset
Risk-free − Risk-free
asset = asset
− =
Derivative − Derivative Exercise price Decrease XIncrease
If Macaulay%∆duration
PV ≈− isAnnModDur
not already known, × ∆Yield annual modified duration can be estimated
securities do not require an outlay of cash at contract initiation, so there is no Prices of European Calls and
Lowest c 0 ≥Puts
Max[0,S0 − ]
(1 + R F )T
Modified
estimate
• Iffollowing
using the duration
the
Macaulay
percentage
has a very
price
important
duration
formula:
change
is application
for
not known,
a bond in
in risk
response
management.
annual
to a
modified
change
It can be used to
in its yield‐to‐ •
Types of derivatives
concept of a price being paid at the beginning.
The value of
Derivativethese −contracts
Risk-free fluctuate
asset = − in response
Asset to changes in the price
Lowest Prices
of the
Risk-free of European
rate Calls and Puts Increase Decrease
If Macaulay duration
duration can is notbe estimated
already known, annual usingmodified
the following
duration can formula:
be estimated Derivative − Risk-free asset = − Asset X
maturity. underlying. cTime to expiration
0 ≥ Max[0,S 0 − X T ] Increase X Increase (except for
using the following formula: (PV− ) − (PV+ ) c 0 ≥ Max[0,S0 − (1 + R F )Tp0] ≥ Max[0,
ApproxModDur = • Forward
Forward commitments: forwards, futures, interest rate
Contract (1 + R F ) (1 + R F )T
− S0 ]in-the-money
deep
2 × ( ∆Yield) × (PV0 ) Forward Contract Payoffs:Payoffs:
(PV− )×−∆(PV swaps. European puts)
%∆PV Full ≈ − AnnModDur +)
Yield FORWARD CONTRACTS
ApproxModDur = X
2 × ( ∆Yield) × (PV0 )
We can also use the approximate modified duration (ApproxModDur) to estimate
• Contingent claims: ST > F(0,T) options,
ST > F(0,T)creditSderivatives. T < F(0,T)ST < F(0,T) pVolatility
0 ≥ Max[0, of theXPut‐Call ] Increase
− S0Forward Parity Increase
0 ≥ Max[0,
punderlying (1 + R F )T − S0 ]
If Macaulay
Macaulay duration
duration is not already known,
(ApproxMacDur) annualthe
by applying modified
followingduration can be estimated
formula: ALong
forward Long
is a position
position contract between two
ST – F(0,T) STparties,
– F(0,T)where one ST (the long
S
– F(0,T) position) has the obligation
T – F(0,T) (1 + R F )T
using
We canthealso
following
use the formula:
• Effective approximate
duration:modified measures duration
the(ApproxModDur)
sensitivity of to Derivative Pricing and Valuation
to buy, and the other (the(Positive (Positive
short position)payoff)has payoff)
an obligation
(Negative (Negative
a estimate fixed forward price (that established at the inception of the contract) at a future date.Put‐Call Benefits
sell anpayoff)
topayoff) underlying asset at a
Forwardfrom Paritythe p0 − cDecrease
0 =
[X − F(0,T)]Increase
MacaulayApproxMacDur
duration (ApproxMacDur) by applying the following formula: Put‐Call underlying (1 + R F )T
bond’s price =toApproxModDur a (PV
change − in × (1 + r)
the benchmark yield curve Short position –[ST – F(0,T)]
Short position –[ST – F(0,T)] –[ST – F(0,T)]
–[ST – F(0,T)] Forward Parity
ApproxModDur = − ) (PV + )
• Derivative pricing ispayoff)
based
(Negative on risk-neutral
payoff) pricing.
(Positive payoff) [X − F(0,T)]
pCost of carry Binomial Option Increase Decrease
(appropriate (Negative (Positive payoff)
ApproxMacDur =measure 2 × ( ∆Yield)
ApproxModDur for bonds
× (PV 0 )+ r)
× (1 with embedded options) • Typically, no cash changes hands at inception. 0 − c 0 = [X − F(0,T)] Pricing
• • Forward
Forward contracts T
Effective Duration
Forward
The long position
price: price:
benefits when the price of the underlying asset increases, whilep0 − c 0 = (1 + R F )T
• One-period (1 + R Fbinomial
) model for a call option (based on
We can also use the approximate
(PV− ) − (PVmodified duration (ApproxModDur) to estimate • Price
the short benefitsat contract when the initiation
price of the (assuming
underlying asset underlying
falls. asset +
πc + (1 − π)c −
Effective Duration +) c=
MacaulayEffDur duration = (ApproxMacDur) • If the entails
party benefits
that isSTadversely andT costs)
affected by price movements defaults on its Binomial Option risk-neutral
Pricing probability π)(1 + r)
2 × ( ∆Curve) × (PVby 0 ) applying the following formula: F(0,T) =F(0,T)
S 0 (1 += r) 0 (1 + r) Binomial Option Pricing
(PV− ) − (PV+ ) commitment, the counterparty with the favorable position faces default risk.
EffDur = • Forwards are a zero-sum game—one party’s gain is the other party’s loss. πc + + (1 − π)c −
ApproxMacDur = ApproxModDur
2 × ( ∆Curve) × (PV0 ) × (1 + r) c = πc + + (1 − π)c − (1 + r − d)
=F(0,T) = (S − γ + θT)(1 + r)T or F(0,T) = ST (1 + r)T − ( γ − θT)(1 + r)T
0 γ + θ0)(1 + r) or F(0,T) = S0 (1 + r) 0 − ( γ − θ)(1 + r)
− (1 + r)
Duration• Keyof a rate
Bond duration:
Portfolio measure of a bond’s sensitivity to a F(0,T) (S c=
(1 + r)
π=
(u − d)
Pricing and Valuation of Forward Contracts
change
EffectivePortfolio
Duration in the benchmark yield for a given maturity (used * Note that benefits (γ) and
Duration of a Bond Portfolio *
Note that benefits (γ) and costs (θ)costs (θ) are expressed
are expressed in termsinoftermspresentof present
value. value.
to assess yield= curve
duration w1D1 + w2 D2 +…+ w N D N
risk, i.e. non-parallel shifts in the The price of a forward contract is the fixed price or rate at which the underlying π =
(1 + r − d)
+
92 © Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. π = (1(u +− r −d)d) S S−
yield
EffDur curve)
Portfolio
(PV ) − (PV+ )
= duration− =Annual w1D1 +MacDurw2 D2 +…+ w N D N Value ofValue
transaction of occur
a forward
will a forward
contract: contract:
at contract expiration. The forward price is agreed upon at initiation (u − d)
Where u = 1 and d = 1
2 × ( ∆Curve)
= × (PV0 ) • Value of a forward contract during its life (long S0 S0
• Portfolio
Annual ModDur duration: 1weighted
+r average of the durations of of the forward contract. Pricing a forward
position)
contract means determining this forward price.
t + r)T − t ] S+ S−
Vt (0,T) V=t (0,T)
St − [F(0,T) / (1 + r)T/−(1
= St − [F(0,T) ]
the individual
Annual ModDur = bonds
Annual MacDur held in the portfolio, where each The value of a riSk
forward contract is the amount that a counterparty would need to pay,
Where u = S1+ and d = S1− Hedge ratio
oru = S10 and d = S10
Durationbond’s of a Bond Portfolio
weight equals 1 + rits proportion of the portfolio’s
underStAnding Fixed-income
wouldFixed-income
expect to
And return
receive,
ALTERNATIVE INVESTMENTS
Where
S0 S0
− ( γ=to−Sθtget
− ( γ+out
−r)θtof its
+ r)(already-assumed) t + r)T − forward position. c+ − c −
t t
underStAnding Vt (0,T) V
riSk t (0,T)
=AndStreturn )(1 )(1
− [F(0,T) / (1 + r)T/−(1
− [F(0,T) ] ]
market value underStAnding Fixed-income riSk And return Hedge ratio n= +
Portfolio duration = w1D1 + w2 D2 +…+ w N D N Hedge • Potential
ratio benefits of S − S− investments: low
alternative
Money• Duration Valuing
underStAnding a Forward
Fixed-income riSk AndContract
return at Expiration (t = T)
Money duration: measure of the dollar price change in
response
Money Duration to a change in yields • Value of a forward contract at expiration (long position) correlations
c+ − c −
n = c++ − c −−
with returns on traditional investments and
Lowest Prices of American Calls and Puts
Annual MacDur
MoneyDur
Annual
Money Duration ModDur = AnnModDur
= × PVFull higher
n = S+ − S returns than traditional investments
Money Duration 1 + r Full VT (0,T) = ST − F(0,T) S − S −
© Wiley 2018MoneyDur
All rights reserved. Any unauthorized
= AnnModDur × PV copying or distribution will
DR constitute an infringement of copyright. • Hedge funds C0 ≥ Max[0, S0 − X/(1 + RFR)T ]
MoneyDur = change
AnnModDur in the ×pricePVFull Lowest Prices of American Calls and Puts
The estimated (dollar)
MoneyDur = AnnModDur × PV
of the bond is calculated as:
Full
© Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
• Event-driven
Lowest Prices of American Calls and Puts strategies: merger arbitrage, distressed/
The estimated Full (dollar) change in the price of the bond is calculated as:
ΔPV(dollar) = – MoneyDur × ΔYield Forward • Forward
Contract rate Payoffs agreement
at Expiration (FRA) C0restructuring,
≥ Max[0, S0 − X/(1 activist,
+ RFR)P0 ≥T special
]Max[0, (Xsituations.
− S0 )]
• PriceFull
The estimated change
valuechange in
of a basis the price
point of the bond
(PVBP): is calculated
bond is estimates
as: the change ≥ Max[0, Svalue
• C0Relative 0 − X/(1
T
+ RFR) ] fixed income convertible
strategies:
The estimated
ΔPV
in the
(dollar)
=
full– MoneyDur
in the price
price of×aΔYield × ΔYield
of the
bond in response to a 1 bp change
calculated 94 as: 94 © Wiley ©
2018• Long
Wiley
all 2018
rights (short)
all rights
reserved. any position
reserved. any
unauthorized
ST > F(0,T) can
unauthorized
copying be
or viewed
copying or
distribution willas the
distribution will
constitute
ST < F(0,T) party
constitute
an that
an infringement
infringement of of
copyright.copyright.
ΔPV P0 arbitrage,
≥ Max[0, (X fixed − S0 )] income asset backed, fixed income
Full = – MoneyDur
Price Valuein
ΔPV ofFull
its aYTM
Basis Point
= – MoneyDur × ΔYield has committed to take (give out) a hypothetical loan.
Long position ST − F(0,T) ST − F(0,T) P0 general,
≥ Max[0, (X volatility,
− S0 )] multi-strategy.
Price Value
© Wiley ofrights
2018 Allof a Basis Point
reserved.
(PV Any unauthorized
) − (PV copying or distribution will constitute an infringement of copyright. • If LIBOR at FRA expiration
(Positive payoff)> FRA rate, the long
(Negative benefits.
payoff)
• Macro strategies: long and short positions in broad
Price Value a Basis −Point +)
Price Value PVBPof a=Basis Point
(PV ) −2 (PV ) Short position • If LIBOR at FRA−[Sexpiration T − F(0,T)]
< FRA rate,−[S the short benefits.
T − F(0,T)] markets (e.g. equity indices, currencies, commodities,
PVBP = (PV −) − (PV +) • Futures: similar(Negative to forwards payoff)but standardized, (Positive payoff)exchange-
PVBP = (PV− ) − 2 (PV+ ) etc.) based on manager’s view regarding overall macro
PVBP
Basis Point Value (BPV)= − 2 +
traded, marked-to-market daily, clearinghouse environment.
2
• Approximate
Basis Point Value (BPV) convexity: used to revise price estimates of guarantees that traders will meet their obligations • Equity hedge strategies: market neutral, fundamental
Basis Point
Basis Point
BPVValue =
option-free (BPV) × 0.0001 (1 bps expressed as a decimal)
MoneyDur
Value (BPV)bonds based on duration to bring them close
• Forward vs futures prices growth, fundamental value, quantitative directional,
to
BPV their actual ×values
= MoneyDur 0.0001 (1 bps expressed as a decimal)
432
• If underlying asset prices are positively (negatively) © 2018 Wiley short bias, sector specific.
BPV = MoneyDur × 0.0001 (1 bps expressed as a decimal)
Annual Convexity
BPV = MoneyDur × 0.0001 (1 bps expressed as a decimal) correlated with interest rates, the futures price will be • Two types of fees: management fee (based on assets
Annual Convexity
(PV− ) + (PV+ ) − [2 × (PV0 )] higher (lower) than the forward price. under management) and incentive fee (which may be
Annual Convexity
ApproxCon =
Annual Convexity (PV ()∆+Yield)
2
(PV ) −×[2 (PV 0)
× (PV )] c17.indd 432 • If futures prices are uncorrelated with interest rates subject to a ©hurdle
7 March 2018 8:49 PM
Wiley 2018rate or reserved.
all rights high water mark copying
any unauthorized provision).
or distribution will constitute an infring
ApproxCon = (PV −) + (PV +)2− [2 × (PV 0)]
− ( ∆Yield) + × (PV ) 0
ApproxCon = (PV− ) + (PV+2) − [2 × 0(PV0 )] or if interest rates are constant, forwards and futures • Private equity
ApproxCon = ( ∆Yield) 2 × (PV0 ) would have the same price. © Wiley 2018• allLeveraged
rights reserved.buyouts (LBOs):
any unauthorized copying ormanagement buyouts
distribution will constitute (MBOs)
an infringement of copyright.
• TheBased
Price Effects percentage
on Duration ( ∆change
and Convexity
Yield) in 0a) bond’s full price for a
× (PV © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
given
Price Effects Based changeon Durationin yield based on duration with convexity
and Convexity • Interest rate swaps and management buy-ins (MBIs).
Price Effects Based
adjustment
%∆PV
Price Effects BasedFull
on Duration and Convexity  1
is estimated
≈on(−Duration
AnnModDur as follows:
× ∆Yield)
and Convexity +  × AnnConvexity × ( ∆Yield)2  • The swap fixed rate represents the price of the swap • Venture capital: formative stage financing (angel
Full
 12
 2
 (swap has zero value to the swap counterparties at investing, seed-stage financing, early-stage financing),
%∆PV ≈ (− AnnModDur × ∆Yield) + 1 × AnnConvexity × ( ∆Yield) 
%∆PV Full ≈ (− AnnModDur × ∆Yield) +  21 × AnnConvexity Basics × 2  anD valuation
∆Yield)Pricing
of(Derivative swap initiation). later-stage financing, mezzanine-stage financing.
Full
≈ (− AnnModDur × ∆Yield) +2 × AnnConvexity × ( ∆Yield)  2
%∆PV
Money convexity 2  • If interest rates increase after swap initiation, the swap • Development capital: includes private investment in
Money convexity public equities (PIPEs).
Money convexity 1
∆PV Full ≈ (− MoneyDur × ∆Yield) +  × MoneyCon × ( ∆Yield)2  Moneynesswill have positive
and Exercise Value of value for the fixed-rate payer.
a Put Option
Money• convexity • If interest rates decrease after swap initiation, the swap • Distressed investing: buying debt of mature companies in
Effective
∆PV Full convexity: use for bonds
 12
≈ (− MoneyDur × ∆Yield) + 1 × MoneyCon × ( ∆Yield) 
with embedded 2

financial distress.
options
∆ PV Full ≈ (−instead
MoneyDur ∆Yield) +  21 × MoneyCon
of×approximate convexity. × ( ∆Yield)2  will have positive
Currentvalue for Price
Market the floating-rate
(St) payer.Value Max
Intrinsic
PV Full ≈ (− MoneyDur × ∆Yield) +2 × MoneyCon × ( ∆Yield)2
∆convexity Moneyness versus Exercise Price (X) [0, (X – St)] • Exit strategies: trade sale, IPO, recapitalization,
Effective• Callable bonds can exhibit negative 2 convexity when  •
In‐the‐money
An interest rate swap can be viewed as a combination
St is less than X X – St secondary sale, write-off/liquidation.
Effectivebenchmark
convexity
[(PV− )yields
+ (PV+ )]decline.
− [2 × (PV0Putable bonds always exhibit At‐the‐money of FRAs.
Effective EffCon
convexity =
)] St equals X 0 • Valuation methods for portfolio company: market or
positive convexity.
Effective convexity[(PV ()∆+Curve) 2
(PV )] −× [2
(PV ) )]
× 0(PV • Options
Out‐of‐the‐money St is greater than X 0 comparables approach, discounted cash flow approach,
EffCon = [(PV −) + (PV +)]2 − [2 × (PV 0)]
EffCon = [(PV−−( ∆ (PV )] ×
) +Curve)
+ (PV
− [2 ) 0 )]
×0(PV • Call (put) option gives the holder/buyer the right to buy asset-based approach.
Credit Analysis
EffCon =
Yield Volatility
( ∆Curve)+ 22 × (PV0 ) 0
( ∆Curve) × (PV0 ) (sell) the underlying asset at the exercise price. • Real estate
Fiduciary Call and Protective Put Payoffs
Yield Volatility • European option: can only be exercised at the option’s • Investment categories: residential property, commercial
tAlS oF credit Yield • Two
AnAlySiSVolatility
%∆PV
components
Full of credit risk:  1default
≈ (− AnnModDur × ∆Yield) +  × AnnConvexity × ( ∆Yield) 
risk (or default 2  Security expiration. Value if ST > X Value if ST < X
Yield Volatility
probability) and loss severity (or  12 loss given default). Loss 
real estate, REITs, timberland/farmland.
%∆PV Full ≈ (− AnnModDur × ∆Yield) + 1 × AnnConvexity × ( ∆Yield)2  • American option:Scan
Call option T –X be exercised atZero any point up to • Performance measurement: appraisal indices (tend
severity Full equals 1 minus the recovery
%∆PV Full ≈ (− AnnModDurFundamentals × ∆Yield) 

of+ Credit2 rate.
1 × AnnConvexity
Analysis × ( ∆Yield) 2 
Zero coupon bond X X
∆PV
%Gap ≈ (− AnnModDur × ∆Yield) +2 × AnnConvexity × ( ∆Yield)2 the option’s expiration. to understate volatility), repeat sales indices (sample
Duration • Expected loss 2  Fiduciary call payoff ST X
selection bias), REIT indices (based on prices of publicly
Expected
Duration Gap Loss • Call (put) option is in-the-money when the stock price
Duration Duration
Gap gap = Macaulay duration − Investment horizon is higher (lower) than the exercise price. traded shares of REITs).
DurationDuration
Gap gap Put option Zero X – ST
Expected loss==Macaulay duration −×Investment
Default probability Loss severity given default
horizon
Stock • Intrinsic or exerciseSvalue: the amountSTan option is • Real estate valuation approaches: comparable sales
Duration gap = Macaulay duration − Investment horizon T
Duration gap = Macaulay duration − Investment horizon Protective in-the-money
put payoff 91 by (minimum
S value of 0).
X
approach, income approach (direct capitalization
© Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. T
Yield • on
Spread
a corporate risk bond:
consists of downgrade risk (or credit method and discounted cash flow method), cost
© Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. • Put-call parity 91 for European options (options and bond
© Wiley 2018migration risk) and market liquidity risk. approach.
All rights
© Wiley 2018Yield onreserved.
a corporate Any unauthorized
bond = Real copying or distribution
risk-free will
interest constitute
willrate
an infringement
+ Expected of copyright.
inflation rate
Put‐Call Parityhave the91 same time to expiration/maturity T)
91
All rights reserved.
• Corporate family rating
Any unauthorized copying or distribution
(CFR):premium
+ Maturity issuer +rating.
constitute an infringement of copyright.
Liquidity premium + Credit spread • REIT valuation approaches: income-based approaches,
asset-based approaches (NAV).
• Corporate credit rating (CCR): rating for a specific issue. X
Yield Spread:
c0 +
(1 + R F )T
= p 0 + S0 • Commodities
• Four Cs: capacity, collateral, covenants, character. • Investors prefer to trade commodity derivatives to
• Return
Yield spread = Liquidity
impact change+ in
of a premium Credit
thespread
credit spread (includes Combining Portfolios to Make Synthetic Securities avoid costs of transportation and storage for physical
• Put-call parity formula can be rearranged to create commodities.
For small, instantaneous changes in the yield spread, the return impact (i.e. the percentage
Consisting
change in price, including accrued interest) can be estimated using the following
Strategy of formula: Value Equals Strategy Consisting of Value Wiley © 2020
fiduciary long call + X = Protective put long put + long p0 + S0
Return impact ≈ − Modified duration × ∆Spread call long bond c0 + underlying asset
(1 + R F )T
storage, value to users, and global economic conditions. σi

• Demand for commodities depends on global manufacturing dynamics and

Expected Return on portfolios that lie on CML

Wiley’s CFA Program Exam Review

economic growth. Investors anticipate demand changes ® by looking at economic
events, government policy, inventory levels, and growth forecasts.
E(R p ) = w1R f + (1 − w1 ) E(R m )
• Supply of many commodities is relatively inelastic in the short run as a result of
the extended lead times required to increase production (e.g., to drill oil wells or to
plant crops). Variance
PoRtfolio Risk and RetuRn: PaRt ii of portfolios that lie on CML
• As a result, commodity prices tend to fluctuate widely in response to changes in
demand. Note that both demand and supply are affected by the actions of non-
σ 2 = w12 σ 2f + (1 − w1 )2 σ 2m + 2w1 (1 − w1 )Cov(R f , R m )
hedging investors (speculators). Portfolio Risk and Return: Part II
Pricing of Commodity Futures Contracts Capital Allocation
Equation of CML Line
) − R fand a constant slope that equals:
E(RofmRFR
• Price of a commodity futures contract.
The price of a futures contract on a commodity may be calculated as follows:
Technical Analysis The CAL• E(R
has an intercept
Optimal
p ) = Rf +
capital allocation
× σp line: line drawn from the risk-
σm
free
[E(R i asset
) − RFR]to a portfolio on the efficient frontier, where
Futures price = Spot price × (1 + Risk-free short-term rate)
+ Storage costs − Convenience yield • Reversal patterns: head and shoulders, inverse head the portfolio
σi is at the point of tangency. The optimal CAL
where:
and shoulders, double top and bottom, triple top and y‐interceptoffers the best risk-return tradeoff to an investor
= Rf = risk‐free rate
Holders of• commodities
When the losefutures
out onprice is higher
the interest (lower)
that they wouldthan the spot
have earned had they held bottom. • The
Expected Returnpoint wherethat
on portfolios anlieinvestor’s
on CML indifference (utility) curve
is tangent − Rthe
E(R m )to optimal
price,
cash. Further, prices
they incur arecosts
storage saidontocommodities.
be in contango (backwardation).
The long position in the futures • Continuation patterns: triangles (ascending/descending/ slope
E(R =
) = w R + (1
f
− =
w market
) E(R priceCAL
m)
indicates the investor’s
of risk.
p
σm
1 f 1
contract gains possession of the commodity in the future without investing cash at present
• Sources of return on a commodity futures contract: roll symmetrical), rectangles, flags and pennants. optimal portfolio
and avoids incurring storage costs. Therefore:
yield, collateral yield, spot prices. • Price-based indicators: moving averages, Bollinger • of
Variance With homogenous
portfolios expectations, the capital market line
that lie on Risk
CML
Systematic and Nonsystematic
• • The
Infrastructure
spot price is multiplied by (1 + r) to account for the time value of money. bands, momentum oscillators (rate of change, relative (CML) becomes a special case of the optimal CAL, where
• Storage costs are added in computing the futures price.
• Investments in real, capital intensive, long-lived assets. strength index, stochastic, moving average convergence/ the
σ 2
= tangent
w12 σ 2f + (1portfolio
− w1 )2 σ 2m +is
2wthe market portfolio
1 (1 − w1 )Cov(R f ,R m )
Total Risk = Systematic risk + Unsystematic risk
• Economic
On the other infrastructure:
hand, the buyer assets
of a futures contract such
gives up theasconvenience
transportation
of having divergence). • CML equation (slope of line is called the market price
and utility
physical possession of the assets.
commodity and having it available for use immediately. Equation of risk)
• Sentiment indicators: opinion polls, put-call ratio, VIX, Return‐Generating
of CML Models
Therefore, the futures price is adjusted for the loss of convenience. The convenience yield
• Social infrastructure: assets such as education,
is subtracted to arrive at the futures price. The futures price may be higher or lower than
margin debt levels, short interest ratio. E(R
k m ) − Rf k
E(R ip))−=RRf f =+∑ β ijσE(Fj ) =×βσi1p[E(R m ) − R f ] + ∑ β ij E(Fj )
E(R
the spot pricehealthcare
of a commodity,anddepending
correctional
on the facilities.
convenience yield. • Flow of funds indicators: Arms index, margin debt, m
j=1 j= 2
• Brownfield investments: investments in existing mutual fund cash positions, new equity issuance,
where: • Complete diversification of a portfolio eliminates
• When futures prices areassets.
infrastructure higher than the spot price (when there is little or no
convenience yield), prices are said to be in contango. secondary offerings. The Market Model
• Greenfield investments: investments in infrastructure unsystematic
y‐intercept = Rf = risk‐free rate risk. A well-diversified investor expects to
• When futures prices are lower than the spot price, prices are said to be in • Cycles: Kondratieff (54-year economic cycle), 18-year
assets to be constructed.
backwardation. be
R i =compensated
α i E(R
+ βi R m + ei for taking on systematic risk
(real estate, equities), decennial (best DJIA performance m ) − Rf
• Risk-return measures in years that end with a 5), presidential (third year has Beta=captures
• slope σm an= market price of risk.
asset’s systematic risk (relative to the
There are three sources of return on a commodity futures contract:
• Sharpe ratio is not appropriate risk-return measure since the best stock market performance). riskof of
Calculation Betathe market)
1. Roll returns
yield: Thetend to bebetween
difference leptokurtic
the spot and
price negatively
of a commodityskewed.
and the futures Systematic and Nonsystematic
Cov(R ρ Risk
σσ ρ σ
i ,R m )
βi = = i,m 2i m = i,m i
• Downside
price,
dates.
or the difference between the futures
risk measures more prices
useful,of contracts expiring
e.g. value at different
at risk Fintech σm2
σm σm
(VAR), shortfall risk, Sortino ratio.
2. Collateral yield: The interest earned on the collateral (margin) deposited to enter
Total Risk = Systematic risk + Unsystematic risk
PoRtfolio Risk and Ret
into the futures contract. • Big data can include structure or unstructured (or a mix)
• The capital asset pricing model (CAPM) is used to
3.
PORTFOLIO MANAGEMENT
Spot prices: These are influenced by current supply and demand. data sets and can come from alternative sources such Return‐Generating
as individuals (personal data), businesses (‘corporate The Capital
calculateModels
security
Asset Pricing
an asset’s required return given its beta (the
market
k Model line) k

exhaust) or physical sensors (devices data) 72 © Wiley 2018E(Rall Rights f = ∑ βany

i ) − RReserved. ij E(F j ) = β i1[E(R
unauthorized copying
m or R f ] + ∑will
) −distribution β ij constitute
E(Fj ) an infringement of copyright.
Overview E(R i ) = R f + βj=i 1[E(R m ) − R f ] j= 2
PoRtfolio Risk and Ret
• Machine learning identifies relationships between
• Steps in the portfolio management process: planning© 2018 Wiley inputted and targeted data and can be supervised The •
Market
Sharpe ratioIf anModel asset’s expected return using price and dividend
PoRtfolio Risk and Ret

(includes developing IPS), execution (includes asset (inputs and outputs are labeled externally), The Capital forecasts
Asset Pricing isRhigher Model(lower) than its CAPM required return, PoRtfolio Risk and Ret
allocation, security analysis and portfolio construction), unsupervised (data is not labeled) or deep learning R i = α i + β i R m +p − ei R f
The Capital the
Sharpe asset
Asset ratio =is undervalued
Pricing (overvalued).
(using multistage, nonlinear processing to identify E(R i ) = R f + β i [E(R σModel
p m ) − Rf ]
feedback (includes portfolio monitoring/rebalancing and 10 August 2017 2:58 AM
• Portfolio performance evaluation measures
patterns and relationships) The Capital Asset Pricing Model
performance measurement/reporting). Calculation E(R of ) =
Beta
R + β [E(R ) − R ]
Sharpe
Treynor • Sharpe
ratio
ratio
i f i m
ratio (uses total risk)
f

• Fintech applications include robo-advisory services PoRtfolioE(R

Risk and =RetuRn:
R f +i ,R
)Cov(R β m i) mρ)i,m
i [E(R
PaRt − σRifσ] m ρi,m σ i
Investment Policy Statement (low-cost, automated advice process), risk analysis (e.g. Sharpe ratio
β i =i
Treynorratio
Sharpe
σ m RR
2
ratio==
=
p p− −RR f f σm
2 =
σm
real-time alerts) and algorithmic trading (automated Sharpe ratio R pσ−β pRpf
• Investment objectives: risk objectives and return Standard Deviation of a Portfolio of Two Risky Assets
transactions).
Sharpe ratio =
R pσ−pR f
objectives M‐squared
Treynor
• (MTreynor
Sharpe
ratio 2 ratio =ratio (uses beta)
) σp
• Investment constraints: liquidity, time horizon, tax Portfolio 2 2Risk 1 2 and
1 2 1,2 Return
2 2 2 2 2 2 2 2
σ p = w σ
1 1 + w σ + 2w w σ σ ρ or w σ
1 1 + w σ
2 2 + 2w w
1 2 Cov1,2
72 Treynor ratio σpm− R f
R
concerns, legal/regulatory factors, unique circumstances © Wiley 2018
Mall
2 Rightsratio
Treynor − R=f ) any
= (R pReserved. −unauthorized
(R m − R f copying
) or distribution will constitute an infringement of copyright.
Treynor ratio Rσppβ−p R f
Utility • Utility function
Function Treynor ratio =
Risk Management R pβ−p R f
1
U = E(R) − Aσ 2 M‐squared (M2) ratio =
Treynor
Jensen’s alpha βp
2 • M-squared (uses total risk)
• Financial risks: market, credit (default or counterparty M‐squared
α (M ) 2
σ (R − R )]
Mp2 ==R(Rp −−[RRf +) β m
p −m
(R −f R )
risks), liquidity (or transaction cost risk) p f
σp
m f
where: • The higher the correlation between the individual assets,
2
M‐squared (M ) σ
M2 = (R p − R f ) m − (R m − R f )
• Non-financial risks: settlement, legal, compliance the
U = Utility higher
of an the portfolio’s standard deviation and the
investment Security Characteristic σp
Line
σ
(including regulatory, accounting and tax risks), model, E(R) = Expected M2 = (R p − R f ) m − (R m − R f )
lower return
the diversification benefits (no diversification Jensen’s alpha σp
operational, solvency σ2 = Variance of returns R i − R f = α i + β i (R m − Rf )
benefits with a correlation coefficient of +1)
A = Additional return required by the investor to accept an additional unit of risk.
Jensen’s alpha
• p Jensen’s
α = Rp − [Rf +alpha
βp (Rm (uses
− Rf )] beta)
• Methods of risk modification: risk prevention/avoidance, • The Markowitz efficient frontier contains all the possibleJensen’s alpha α p = R p − [R f + β p (R m − R f )]
risk acceptance (self-insurance and diversification), risk portfolios in which rational, risk-averse investors will Security Characteristic
transfer, risk shifting/modification α p = R p − [R f +Line
β p (R m − R f )]
consider investing Security R
Characteristic Line
i − R f = α i + β i (R m − R f )
Security Characteristic
R − R = α + βLine (R − R )
i f i i m f

R i − R f = α i + β i (R m − R f )

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