1.

COMPARE PRIVATE EQUITY AND PUBLIC EQUITY IN TERMS OF LIQUIDITY AND

RETURNS TO INVESTORS?
EXPLAIN YOUR ANSWER.

2. DISTINGUISH THE METHODS FOR INVESTING IN NON-DOMESTIC EQUITY

SECURITIES?
 Investments in non-domestic equity securities can be made directly or through depositary
receipts, global registered shares, or baskets of listed depository receipts.

Direct Investment

Direct investing involves buying and selling securities directly in foreign markets, meaning that
all the transactions are in the company’s, not the investor’s, domestic currency. Investing directly
in foreign securities may result in less transparency and more volatility as audited financial
information may not be provided, and the market may be less liquid.

Depository Receipts

A depository receipt is a security that trades like an ordinary share on a local exchange and
represents an economic interest in a foreign company. A depository receipt is created when
foreign equity shares are deposited in a bank that then issues receipts representing the deposited
shares.

Depository receipts sponsored by the issuing company grant investors the same rights as direct
owners in common shares and are usually more regulated, while unsponsored receipts do not
give investors voting rights. There are two main types of depository receipts:

 Global Depository Receipt (GDR): issued outside the company’s home country and
outside the United States. GDRs are not subject to foreign ownership and capital flow
restrictions that the issuing company’s home country may impose. The majority of GDRs
are denominated in US dollars.
 American Depository Receipt (ADR): a US dollar-denominated security that trades like a
common share on US exchanges. There are four primary types of ADRs, with each type
having different levels of corporate governance and filing requirements.

Global Registered Share (GRS)

A global registered share is a common share traded on different stock exchanges around the
world in different currencies. GRSs are more flexible than depository receipts because they
represent an actual ownership interest and can be traded anywhere without currency conversion.

Basket of Listed Depository Receipts (BLDR)

A BLDR is an exchange-traded fund that represents a portfolio of depository receipts. These
securities can allow investors to gain broader exposure to a foreign market and easily implement
hedging or arbitrage trading strategies.

3. WHICH CAUSES OF AN INCREASE IN RETURN ON EQUITY ARE MOST LIKELY A

POSITIVE/NEGATIVE SIGN FOR A FIRM’S EQUITY INVESTORS? EXPLAIN YOUR
ANSWER.

* Negative sign:
It's reasonable to wonder why an average or slightly above-average ROE is preferable rather than
an ROE that is double, triple, or even higher than the average of its peer group. Aren’t stocks
with a very high ROE a better value?

Sometimes an extremely high ROE is a good thing if net income is extremely large compared to
equity because a company’s performance is so strong. However, an extremely high ROE is often
due to a small equity account compared to net income, which indicates risk.

Inconsistent Profits
The first potential issue with a high ROE could be inconsistent profits. Imagine that a company,
LossCo, has been unprofitable for several years. Each year’s losses are recorded on the balance
sheet in the equity portion as a “retained loss.” These losses are a negative value and reduce
shareholders' equity.

Now, assume that LossCo has had a windfall in the most recent year and has returned to
profitability. The denominator in the ROE calculation is now very small after many years of
losses, which makes its ROE misleadingly high.

Excess Debt
A second issue that could cause a high ROE is excess debt. If a company has been borrowing
aggressively, it can increase ROE because equity is equal to assets minus debt. The more debt a
company has, the lower equity can fall. A common scenario is when a company borrows large
amounts of debt to buy back its own stock. This can inflate earnings per share (EPS), but it does
not affect actual performance or growth rates.

Negative Net income

Finally, negative net income and negative shareholders' equity can create an artificially high
ROE. However, if a company has a net loss or negative shareholders’ equity, ROE should not be
calculated.

If shareholders’ equity is negative, the most common issue is excessive debt or inconsistent
profitability. However, there are exceptions to that rule for companies that are profitable and
have been using cash flow to buy back their own shares. For many companies, this is an
alternative to paying dividends, and it can eventually reduce equity (buybacks are subtracted
from equity) enough to turn the calculation negative.
In all cases, negative or extremely high ROE levels should be considered a warning sign worth
investigating. In rare cases, a negative ROE ratio could be due to a cash flow-supported share
buyback program and excellent management, but this is the less likely outcome. In any case, a
company with a negative ROE cannot be evaluated against other stocks with positive ROE
ratios.

4. IDENTIFY CHARACTERISTICS OF COMPANIES FOR WHICH THE CONSTANT

GROWTH OR A MULTISTAGE DIVIDEND DISCOUNT MODEL IS APPROPRIATE.
The Gordon (constant) growth dividend discount model is particularly useful for valuing the
equity of dividend-paying companies that are insensitive to the business cycle and in a mature
growth phase.

On the other hand, multistage models are often used to model rapidly growing companies. The
multistage DDM can be extended beyond two stages to however many stages are deemed
appropriate. For instance, the valuation of a fairly young company may benefit from a three-
stage DDM.

Question (example)

Which one of the corporations above would most likely be the best fit for a valuation using the
Gordon (constant) growth dividend-discount model?

Corporation A.

Corporation B.

Corporation C.

Solution

The correct answer is C.

Due to its insensitivity to the business cycle and a short-term growth rate that corresponds to its
long-term growth rate, Corporation C would probably be the most appropriate candidate for
valuation using the Gordon (constant) growth DDM.

A multistage model would likely be appropriate for Corporation A due to the significant variance
between short-term and long-term growth rates.

A constant growth model valuation may also be appropriate for Corporation B, but accuracy is
less likely due to the cyclical nature of its business.

5. DISCUSS THE PROS AND CONS OF USING THE PRICE MULTIPLES TO VALUE
EQUITY

The simplicity of using multiples in valuation is both an advantage and a disadvantage. It is a

disadvantage because it simplifies complex information into just a single value or a series of
values. This effectively disregards other factors that affect a company’s intrinsic value, such as
growth or decline. However, this simplicity allows a financial analyst to make quick
computations to assess a company’s value.

Meanwhile, using multiple analysis can also lead to difficulty in comparing companies or assets.
This is because companies, even when they seem to have identical business operations, may have
different accounting policies. As such, multiples may be easily misinterpreted, and comparisons
are not as conclusive. They need to be adjusted for different accounting policies.

Multiples analysis also disregards the future – it is static. It only considers the company’s
position for a certain time period and fails to include the company’s growth in its business
operations. However, there are ways to adjust for this using certain multiples that look at
“leading” ratios.

6. HOW DOES CYCLICALITY AFFECT VALUATION?

A cyclical company is likely to experience wider-than-average fluctuations in demand, high

demand in economic expansion, and low demand in economic contraction. It may be subject to
greater-than-average profit variability related to high operating leverage. Non-cyclical companies
produce goods or services for which demand remains relatively stable throughout the business
cycle.

7. WHICH TYPES OF FIRMS ARE MOST APPROPRIATE TO APPLY THE ASSET-BASED

MODEL IN VALUING EQUITY?

An asset-based valuation of a company uses estimates of the market or fair value of the
company’s assets and liabilities and, thus, is most appropriate for companies with a high
proportion of current assets and current liabilities and few/insignificant intangible assets. Asset-
based valuations are frequently used in combination with multiplier models to value private
companies or to supplement the valuation of public companies.
Not all companies own assets for which the fair value can be easily determined, and market
values can differ significantly from carrying values. Furthermore, asset valuations may be of
limited use in a hyper-inflationary environment.

8. DESCRIBE THE USE OF INTERBANK OFFERED RATES AS REFERENCE RATES IN

FLOATING-RATE DEBT. HOW ARE LIBOR RATES DETERMINED?

Floating Rate Bonds

A floating rate bond is expressed as a reference rate plus a spread or margin. The spread is
usually fixed, remains constant until maturity, and it is primarily a function of the issuer’s credit
quality. The coupon rate adjusts to the level of market interest rates depending on the reference
rate.

LIBOR

The London InterBank Offered Rate (LIBOR) is the reference rate for many floating bonds. For
floating-rate bonds denominated in US dollars, the reference rate is the US dollar LIBOR and 3-
month LIBOR if the coupons are paid quarterly. LIBOR rates reflect the rates at which multiple
banks believe they could borrow unsecured funds from one another. Historically, LIBOR rates
were set by the British Bankers’ Association (BBA).

9. DISTINGUISH UNDERWRITTEN OFFERING AND BEST EFFORTS OFFERING?

The term best efforts refers to an agreement made by a service provider to do whatever it takes to
fulfill the requirements of a contract. In finance, an underwriter makes a best efforts or good faith
promise to the issuer to sell as much of their securities offering as possible. While the two parties
come to an agreement for the sale of some securities, the underwriter doesn't guarantee to sell
them all.

10. COMPARE SOVEREIGN BONDS AND NON-SOVEREIGN BONDS? WHICH TYPES

OF BONDS TYPICALLY OFFER HIGHER YIELD? EXPLAIN

A sovereign bond is a debt security issued by a national government to raise money for financing
government programs, paying down old debt, paying interest on current debt, and any other
government spending needs. Sovereign bonds can be denominated in a foreign currency or the
government’s domestic currency. Sovereign bonds are a way governments raise money in
addition to tax revenue.

Provinces, regions, states, and cities issue bonds called non-sovereign bonds or non-sovereign

government bonds. These bonds are generally issued to finance schools, hospitals, highways,
bridges, etc.
The national government does not guarantee non-sovereign bonds. Still, the default rates for non-
sovereign bonds are low, and their credit ratings are relatively high. However, non-sovereign
bonds usually trade at higher yields and lower prices than their sovereign counterparts.

11. DISTINGUISH FLAT PRICE AND FULL PRICE OF BONDS.

Coupon interest is paid not daily, but monthly, semi-annually or annually. If an investor sells a
bond between coupon payments and the buyer holds it until the next coupon payment, the entire
coupon interest earned for the period will be paid to the buyer. The seller gives up the interest
from the time of the last coupon payment to the time until the bond is sold. The amount of
interest over this period that will be received by the buyer (even though it was earned by the
seller) is called accrued interest.
Accrued interest is calculated as a proportional share of the next coupon payment using either the
actual/actual or 30/360 method to count days.

The amount that the buyer pays the seller the agreed upon price for the bond plus accrued
interest is called the full price (dirty price). The agreed-upon bond price without accrued interest
is simply referred to as the flat price (clean price). Flat prices are quoted in order to not to
misrepresent the daily increase in the full price as a result of interest accruals.

Here is how to calculate the full price:

Note that the next coupon payment is discounted for the remainder of the coupon period.
An easier formula is used to to get the present value of the bond at the last coupon payment date
and find its (future) value on the settlement date.

12. IF YIELD TO MATURITY AND RISK FACTORS REMAIN CONSTANT OVER THE
REMAINDER OF A COUPON BOND'S LIFE AND THE BOND IS TRADING AT A
DISCOUNT TODAY, WHAT WOULD BE THE SIGN OF CURRENT YIELD AND
CAPITAL GAIN YIELD? (POSITIVE OR NEGATIVE) EXPLAIN YOUR ANSWER.

Positive current yield only. A coupon bond will have a positive current yield. It will not have a
capital gain because its price will increase toward par along its constant-yield price trajectory as
long as it YTM remains constant.
13. HOW DOES OPTION-ADJUSTED SPREAD DIFFER FROM ZERO-VOLATILITY
SPREAD FOR CALLABLE BONDS?

Both the option-adjusted (OAS) and the zero-volatility spread (Z-spread) are useful to calculate
the value of a security. In general, a spread represents the difference between the two
measurements. The OAS and Z-spread help investors compare the yield of two different fixed-
income offerings that have embedded options. Embedded options are provisions included with
some fixed-income securities that allow the investor or the issuer to do specific actions, such as
calling back the issue.

As an example, mortgage-backed securities (MBS) often have embedded options due to the
prepayment risk associated with the underlying mortgages.1 As such, the embedded option can
have a significant impact on the future cash flows and the present value of the MBS.

An option-adjusted spread compares the yield or return of a fixed-income product to the risk-free

rate of return on the investment. The risk-free rate is theoretical and shows the value of an
investment with all possible risk dynamics removed. Most analysts use U.S. Treasurys as the
basis of the risk-free return.2

The zero-volatility spread provides the analyst with a way to evaluate a bond's pricing. It is the
consistent spread—or difference—between the present cash flow value and the U.S. Treasury
spot rate yield curve. Z-spread is also known as the static spread because of the consistent
feature.3

The nominal spread is the most basic type of spread concept. It measures the difference in the
basis points between a risk-free U.S. Treasury debt instrument and a non-Treasury instrument.4

This spread difference is measured in basis points. The nominal spread only provides the
measure at one point along the Treasury yield curve, which is a significant limitation.

14. EXPLAIN BENEFITS OF SECURITIZATION FOR ECONOMIES AND FINANCIAL

MARKETS.

Securitization allows investors to have more direct legal claims on loans and portfolios of
receivables. Also, due to disintermediation (lessening the role of intermediaries), the costs paid
by borrowers can effectively be diminished. Banks can improve their profitability by increasing
loan origination and fees.

Investors can easily access securities matching their risk, return, and maturity needs. For
example, a pension fund with a long-term horizon can have access to long-term real-estate loans.

Further, securitization allows for the creation of tradable securities with much liquidity and
results in more efficient financial markets.

Many sovereign governments have embraced securitization. For example, the Italian government
has used securitization for privatizing public assets. In emerging markets, companies and banks
have used securitization to lower their funding costs.
15. DISTINGUISH CREDIT TRANCHING AND TIME TRANCHING. HOW DEFAULT
RISKS ARE REDISTRIBUTED DIFFERENTLY ACROSS THE TRANCHES IN EACH
TYPE?

16. EXPLAIN THE LOAN-TO-VALUE RATIO. WHAT DOES A LOW (HIGH) LOAN-TO-
VALUE RATIO INFER FOR LENDERS?

An LTV ratio is calculated by dividing the amount borrowed by the appraised value of the

property, expressed as a percentage. For example, if you buy a home appraised at $100,000 for
its appraised value, and make a $10,000 down payment, you will borrow $90,000. This results in
an LTV ratio of 90% (i.e., 90,000/100,000).

Determing an LTV ratio is a critical component of mortgage underwriting. It may be used in the

process of buying a home, refinancing a current mortgage into a new loan, or borrowing against
accumulated equity within a property.

Lenders assess the LTV ratio to determine the level of exposure to risk they take on when
underwriting a mortgage. When borrowers request a loan for an amount that is at or near the
appraised value (and therefore has a higher LTV ratio), lenders perceive that there is a greater
chance of the loan going into default. This is because there is very little equity built up within the
property. As a result, in the event of a foreclosure, the lender may find it difficult to sell the
home for enough to cover the outstanding mortgage balance and still make a profit from the
transaction.

The main factors that impact LTV ratios are the amount of the down payment, sales price, and
the appraised value of a property. The lowest LTV ratio is achieved with a higher down payment
and a lower sales price.

17. WHAT IS PREPAYMENT RISK AND HOW DOES IT AFFECT LENDERS OF

MORTGAGE LOANS AND INVESTORS OF MORTGAGE-BACKED SECURITIES?
Prepayment risk may sound counter-intuitive in that repaying a loan in a shorter period of time is
considered a risk. However, to a lender, it may be preferable to have a loan outstanding for a
longer period of time. To understand prepayment risk, we introduce an example.

Consider a loan with a face value of $1,000. The loan has a 10% interest rate on the face value of
the loan. The borrower is to make annual interest payments over a period of three years. As such,
the lender would be receiving $1,300 over the life of the loan. The loan’s payment schedule is
illustrated below:

Next, assume that the borrower has the option to repay the face value amount before the end of
three years. In this scenario, the borrower can theoretically repay the face value of $1,000 at the
end of Year 1 and end up not having to pay interest in Years 2 and 3 (due to the face value being
repaid at the end of Year 1). In doing so, the lender would only end up receiving $100 in profit
on the loan. The payment schedule in this scenario is illustrated below:

As such, prepayment risk is the risk that the borrower repays the outstanding principal amount
(or a portion of the outstanding principal amount) prematurely and, in turn, causes the lender to
receive less in interest payments.

18. DISTINGUISH DIFFERENT TYPES OF DURATION: MACAULAY DURATION,

MODIFIED DURATION, APPROXIMATE MODIFIED DURATION, AND EFFECTIVE
DURATION
1. Macaulay Duration

Macaulay duration is a weighted average of the times until the cash flows of a fixed-income
instrument are received. The concept was introduced by Canadian economist Frederick
Macaulay. It is a measure of the time required for an investor to be repaid the bond’s price by the
bond’s total cash flows. The Macaulay duration is measured in units of time (e.g., years).

The Macaulay duration for coupon-paying bonds is always lower than the bond’s time to
maturity. For zero-coupon bonds, the duration equals the time to maturity.

The formula for the calculation of Macaulay duration is expressed in the following way:

Where:

ti – The time until the ith cash flow from the asset will be received

PVi – The present value of the ith cash flow from the asset

V – The present value of all cash flows from the asset

2. Modified Duration

Relative to the Macaulay duration, the modified duration metric is a more precise measure of
price sensitivity. It is primarily applied to bonds, but it can also be used with other types of
securities that can be considered as a function of yield.

The modified duration figure indicates the percentage change in the bond’s value given an X%
interest rate change. Unlike the Macaulay duration, modified duration is measured in
percentages.

The modified duration is often considered as an extension of the Macaulay duration. It is

supported by the following mathematical formula:

 
 

Where:

YTM – The yield to maturity of a bond

n – The frequency of compounding

3. Effective Duration

Effective duration is a measure of the duration for bonds with embedded options (e.g., callable
bonds). Unlike the modified duration and Macaulay duration, effective duration considers
fluctuations in the bond’s price movements relative to the changes in the bond’s yield to maturity
(YTM). In other words, the measure takes into account possible fluctuations in the expected cash
flows of a bond.

The effective duration is calculated using the following formula:

Where:

V–Δy  – The bond’s value if yield falls by y%

V+Δy – The bond’s value if yield rises by y%

V0 – The present value of all cash flows of the bond

Δy – The yield change

 
19. EXPLAIN WHY EFFECTIVE DURATION IS THE MOST APPROPRIATE MEASURE
OF INTEREST RATE RISK FOR BONDS WITH EMBEDDED OPTIONS.

A bond that has an embedded feature increases the doubtfulness of cash flows, thus making it
hard for an investor to determine the rate of return of a bond. The effective duration helps
calculate the volatility of interest rates in relation to the yield curve and therefore the expected
cash flows from the bond. Effective duration calculates the expected price decline of a bond
when interest rates rise by 1%. The value of the effective duration will always be lower than the
maturity of the bond.

A bond with embedded options behaves like an option-free bond when exercising the embedded
option would offer the investor no benefit. As such, the security's cash flows cannot be expected
to change given a change in yield. For example, if existing interest rates were 10% and a callable
bond was paying a coupon of 6%, the callable bond would behave like an option-free bond
because it would not be optimal for the company to call the bond and re-issue it at a higher
interest rate.

20. EXPLAIN HOW A BOND’S MATURITY, COUPON, AND YIELD LEVEL AFFECT ITS
INTEREST RATE RISK

Time to Maturity

Longer maturity bond prices are more sensitive to changes in yields than shorter maturity bonds.
As shown in the following graph, the price of the 30-year bond increases a lot more than that of
the 1-year bond in response to a decrease in interest rates.
Coupon Rate

Bonds with higher coupon rates are less sensitive to changes in interest rates. This is because one
can always reinvest the large coupon payments at the prevailing market interest rate. On the
contrary, zero-coupon bonds are the most sensitive to interest rate swings since all the interest
payments of zero-coupon bonds are accumulated and paid at maturity.