All CFA I nst it ut e m em ber s and candidat es ar e
r equir ed t o com ply wit h t he Code and St andar ds
St r uctur e of t he CFA
I n st it ut e Pr ofessional
Conduct Pr ogr am
a.
1 . Code Of Et hics And
St a nda r ds Of
Profe ssion a l Con du ct
Pr ocess for t he enfor cem ent
of t he Code and Standar ds
Six com ponent s of
t he Code of Et hics
b,c.
Seven St an dar ds of
Pr ofessional Conduct
1. Code Of Ethics And Standards Of Professional Conduct - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
The CFA I nst it ut e Bylaw s
Basic st ruct ure for en for cing
Based on t w o Fair process t o m em ber and candidat e
t he Code and St andards
prim ary principles
Rules of Pr ocedure Confident ialit y of proceedings
Maint ains ov ersight and responsibilit y
The CFA I n st it ut e I s r espon sible for t he
Board of Governors enfor cem ent of t he
Thr ough t he Discip linary
Professional Conduct Review Com m it t ee ( DRC) Code and St andards
program ( PCP)
The CFA Designat ed Conduct s pr ofessional
Officer Direct s pr ofessional conduct st aff conduct inquiries
Selfdisclosure
Writ t en com plaint s
An in q uiry can b e p r om pt ed
Ev idence of m isconduct
by sev er al circum st ances
Report by a CFA ex am pr oct or
Analysis of exam m at erials and m onit or ing
of social m edia by CFA I nsit ut e
Request ing a w rit t en ex planat ion
The Pr ofessional from t he m em ber or candidat e
Conduct st aff conduct s
The m em ber or candidat e
an in v est ig at ion t hat
m ay include I nt erv iewing Com plaining part ies
Thir d part ies
Collect ing docum ent s and records in support of it s inv est igat ion
Conclude t he inquir y w it h no disciplinary sanct ion
I ssue a caut ionary let t er
Wh en an
inq uir y is I f fin d ing t hat a v iolat ion of
Up on r ev iewing t he t he Cod e and St and ards
init iat ed
m at er ial ob t ained d u r ing occur r ed, t he Designat ed Accept ed by m em ber
t he invest igat ion, t he Officer p r op oses a
Designat ed Officer m ay The m at t er is refer red t o a
disciplinar y sanct ion hearing by a panel of CFA
Cont inue proceedings I nst it ut e m em bers
Rej ect ed by m em ber
t o discipline t he
m em ber or candidat e
condem nat ion by t he m em ber's peers
I f sanct ion is im posed suspension of candidat e's cont inued
part icipant in t he CFA program
Act w it h in t egrit y , com p et ence, d ilig ence,
respect and in an et hical m anner
I n t egrit y of inv est m ent pr ofession &
int erest of client s above per sonal int erest
Care & j udgm ent
Pract ice et hics & encour age ot hers t o pr act ice
I nt egrit y & v iabilit y of t he global capit al m arket s
Professional com pet ence
Professionalism
I nt egrit y of Capit al m ar ket s
Dut ies of Client s
Dut ies t o Em ployers
I nv est m ent analysis, Recom m endat ions & Act ions
Conflict of int erest
Resp on sib ilit ies as a CFA I nst it ut e
m em ber or CFA Candidat e
 Understand and com ply w ith
applicable law s and regulations

Code and Standards vs. Local law Follow stricter law and regulation

Responsible for violations in w hich they

know ingly participate or assist
D isso ciate fr o m illeg al,
unet hical activities Leave em ployers ( in ext rem e case)

At t em p t t o stop t he b eh av ior b y b r in g ing it t o t he at t en t io n o f

Guid a nce em ployer through a supervisor or com pliance departm ent
Participation or association
May consider directly confronting
w ith violations by others
t he involved individuals
I nt erm ediat e st eps
I f n o t su ccessful,- - > st ep aw ay an d Rem oving t heir nam e from w ritt en report s
dissociate from the activity by
Asking for a different assignm ent

A. Know ledge I naction w ith continued association m ay be construed as know ing participation
of t h e law Not required reporting violations to governm ent, CFAI ,
but advisable in som e cases or required by law s in others

Stay inform ed
Review procedures
Mem ber s an d Maintain current files
candidat es
When in d o ubt, seek ad v ice o f
com pliance personnel or legal counsel
W h en d isso ciating fr o m v io lat ions, - - > D o cu m ent
Re com m e nd ed any violations and urge firm s to stop them
p r o ce du re s f or
co m plia nce ( RPC) Develop and/ or adopt a code of ethics
Make available t o em ployees info t hat
Firm s highlights applicable law s and regulations
Establish w ritten procedures for reporting suspected
violation of law s, regulations or com pany policies
Ap plica t ion

Maint ain independence and

objectivity in professional activities
Gifts, I nvitations to lavish
fu nct ions, Tick ets, Fav ors, Job r efer r als,
By benefits Allocation of shares in oversubscribed I POs. ..
Ex t er n al
pressures
From public com panies To issue favorable reports

Fr o m Bu y side clients May t r y t o p r essure sellside analysts

Fr o m t h eir e. g. to issue favorable research reports/

ow n firm s recom m endat ions for cert ain com panies

I n t er n al
pressures t o issue f av o r able r esearch o n cu r r ent o r
I n v est m ent b an k in g p r o sp ective in v est m en tb an k in g clients
How t o cope w ith external an d
relationships
internal pressures Conflicts of interest

Modest gifts and ent ert ainm ent are

accept able but special care m ust be t aken m ust disclose to em ployers

Best practice: rej ect any offer of gifts,

t hreatening independence and obj ect ivity
Guidance
convey true opinions
--> free of bias from pressures
Recom m endations m ust
be stated in clear
B. I n d e p e n d e n ce and unam biguous language
an d obj ect ivit y Portfolio m anagers m ust respect and
fo ster ho nesty o f sellside research

I s fraught w ith conflicts

2 .1 St a n d a r d I Must engage in thorough,
PROFESSI ON ALI SM independent , and unbiased analysis
Must fully disclose potential conflicts,
including the nature of com pensation
I ssuer paid research Must strictly lim it the type of com pensation
Analyst s they accept for conducting research
Accept only flat fee for their
w ork prior to w riting the report
Best practice Without regard to conclusions
or recom m endations

Protect integrity of opinions

Create a restricted list
Restrict special cost arrangem ents
Lim it gifts
Equity I POs
RPC Rest rict em ployee invest m ent s
Privat e placem ent s
Review procedures
Wr it t en p o licies o n in d ep end ence
and obj ectivity of research

D ef in it ion o f any untrue statem ent or om ission of a fact

"Misrepresent ation"
or any false or m isleading st at em ent

Mu st n o t k n o w in gly m ak e
m isr ep r esen t ation o r g iv e
false im pression in
oral represent ations, advert ising
electronic com m unications
w rit ten m aterials

qualifications or credentials, services

perform ance record
Mu st n o t m isr ep r esent Without regard to conclusions or
Guid a nce any aspect of practice, including recom m endat ions
characteristics of an investm ent
any m isrepresent at ion relating t o
C. Misre pre se n t at ion m em ber's professional act ivit ies
Must not guarantee clients specific return
on investm ents that are inherently volatile
St an d ar d I ( C) p r o h ibits p lagiar ism in p r ep ar at ion
o f m at er ial for distribution t o em p lo y ers, asso ciates,
clients, prospects, general publish

Writ ten list of available services, description of firm 's qualification

Designate em ployees to speak on behalf of firm
Prepare sum m ary of qualifications and experience,
list of services capable of perform ing
RPC
Maintain copies
To avoid plagiarism Attribute quotations
At tribut e sum m aries

Address conduct related to professional life

An y act in v o lv ing ly in g, ch eat ing, st ealing, o t h er d ish o nest co n duct t h at
reflect s adversely on m em ber's professional act ivit ies w ould be violat ion
Conduct dam aging trustw orthiness or com petence ( include behaviour m ay
not be illegal but negat ively affect a m em ber t o perform responsibility such
Guid a nce as abusing alcohol during lunch hours)
Violations
D . Miscon du ct Abuse of the CFA I nstitute Professional Conduct Program
I nvolved in personal bankruptcy is not autom at ically assum ed t o be in violation but
bankruptcy involve fraudulent or deceit ful business conduct m ay be a violation

Develop and/ or adopt a code of ethics

Dissem inate to all em ployee a list of potential violations
RPC
Check references of pot ent ial em ployees

2.1 Standard I PROFESSIONALISM - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

A. M a t e r ia l n on - pu blic
in for m a t ion ( M N I )
2 . 2 St a n d a r d I I
I N T EGRI TY O F
CAPI TAL M ARKETS
B. M a r k e t
m a n ipu la t ion
2.2 Standard II INTEGRITY OF CAPITAL MARKETS - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
it s significant im pact t o t he pr ice
of secur it y if it is disclosed
Reasonable invest or s w ould like
Definit ion of " Mat erial Mat er ial infor m at ion
t o know for m aking decision
nonpublic inform at ion"
The r eliabilit y of t he infor m at ion
dissem inat ed t o t he m ar ket place and
Non- public unt il
effficient t im e for invest or s t o r eact
Mu st be par t icular ly aw ar e of in fo
Guidance select ively disclosed by cor por at ions
Analysis of Public info + nonm at erial
nonpub lic info - - > I nv est m ent conclusion
Mosaic Analyst s ar e free t o act on t his collect ion
Theor y of info w it hout r isking violat ion
Analyst s should save and
docum ent all t heir r esear ch
Mak e r easonable ef fort s t o achiev e
public dissem inat ion of m at er ial info
Must com m unicat e t he info only t o t he designat ed
I f pu blic dissem in at ion super visor y and com pliance per sonnel w it hin t he fir m
is not possible,
Must not t ake invest m ent act ion on t he basis of t he info
Must not k now ingly engage in cond uct
inducing insider s t o pr ivat ely disclose MNI
RPC adopt com pliance pr ocedur es
pr event ing m isuse of MNI
dev elop & follow disclosur e policies
Encour age fir m s t o
t o ensur e pr oper dissem inat ion
use "fir ew all"
Pr ohibit ion of all pr opr iet ar y t r ading w h ile f ir m
is in possession of MNI m ay be inappr opr iat e
Dist or t pr ices or ar t ificially inflat e t r ading volum e
wit h t he int ent t o m islead m arket part icipant s
Definit ion
Tr an sact ions t hat ar t if icially
dist or t pr ices or volum e
t r ansact ions t hat deceive
m ar ket par t icipant s Secur ing a cont r olling, dom inant posit ion in a
financial inst r um ent t o ex ploit and m anipulat e
pr ice of a r elat ed der ivat ive/ or under lying asset
can be relat ed t o
dissem inat ion of false includ ing spr eading false r um or s
or m isleading info t o induce t r ading by ot her s
pr ohibit legit im at e t r ading st r at egies
St andar d I I ( B) not m eant t o pr ohibit t r ansact ions done for t ax pur poses
The int ent of act ion is crit ical t o det erm ining
whet her it is a violat ion of t his St andard
To be continued…
For MORE CFA® Mind Maps, please go to:
to:http://www.e-junkie.com/ecom/gb.php?cl=274078&c=ib&aff=283565
 D e scr ibe lim it a t ion s of r e gre ssion a n a ly sis
A sa m ple cova ria n ce, a sa m ple corre la t ion coe fficien t a n d a sca t t er plot

D e scr ibe t h e u se of a n a ly sis of v a r ia n ce ( AN OV A) in r e gr e ssion a n a ly sis,

in t e r pr e t AN OV A r e su lt s, a n d ca lcu la t e a n d in t e r pr e t t h e F- st a t ist ic
Lim it a t ion t o correla t ion a n a lysis

Ca lcu la t e a n d in t e r pr e t a con fide n ce in t e r v a l for

t h e pre dict e d v a lu e of t h e de pe n de n t va r ia ble Uses of corre la t ion An a lysis

9 . Cor re la t ion a n d
Ca lcu la t e t h e pr e dict e d v a lu e for t h e de pe n de n t v a r ia ble , giv e n a n For m u la t e a t e st of t h e h y pot h e sis t h a t t h e popu la t ion
e st im a t e d r e gr e ssion m ode l a n d a v a lu e for t h e in de pe n de n t v a ria ble
Re gr e ssion - An Ove r vie w cor r e la t ion coe fficie n t e qu a ls ze r o a n d de t e r m in e w h e t h e r
t h e h y pot h e sis is r e j e ct e d a t a give n le v e l of sign ifica n ce

For m u la t e a n u ll a n d a lt e r n a t iv e h y pot h e sis a bou t a popu la t ion v a lu e of

a re gr e ssion coe fficie n t a n d de t e r m in e t h e a ppr opr ia t e t e st st a t ist ic a n d D ist in gu ish be t w e e n t h e de pe n de n t a n d
w h e t h e r t h e n u ll h y pot h e sis is r e j e ct e d a t a giv e n le v e l of sign ifica n ce in de pe n de n t v a r ia ble s in a lin e a r r e gre ssion

Ca lcu la t e a n d in t e r pr e t t h e st a n da r d e r ror of D e scr ibe t h e a ssu m pt ion s u n de r lyin g lin e a r

e st im a t e , t h e coe fficie n t of de t e r m in a t ion , a n d a r e gre ssion a n d in t e r pre t re gr e ssion coe fficie n t
con fide n ce in t e r v a l for a r e gr e ssion coe fficie n t

9. Correlation and Regression - An Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 A graph that show s the relationship betw een the observations for tw o data series in tw o dim ensions

Sca t t e r Plo t s

Each observat ion in t he scat ter plot is represent ed as a point , and the point s are not connect ed
The scatter show s only the actual observation of both data series plotted as pairs

Correlation analysis expresses t he sam e relationship ( bet w een t w o dat a series) using a single num ber
The correlation coefficient m easures t he direct ion and ext ent of linear associat ion bet w een t w o variables
A correlation coefficient less than 0 indicates a negative linear association

A sa m ple co v a ria nce, a sa m ple

co rrela t ion co efficie nt a nd a sca t t er plo t

A correlation coefficient can

have a m axim um value of 1
Correla t ion Ana ly sis and a m inim um value of - 1

A correlation coefficient
greater than 0 indicates a
positive linear association

A scatter plot of tw o variables w ith a correlation of 0; they have no linear relation - > the value of A tells us nothing about the value of B

The sam ple covariance of X and Y, for a sam ple of size n

Ca lcula t e t he Correla t ion Coefficie nt The expression for t he sam ple variance of X, is

The sam ple correlation coefficient

9 . Cor r e la t ion a nd
Re gr e ssion - Pa rt 1

Tw o variables can have a strong nonlinear

Correla t ion m a y be a n
relation and still have a very low correlation
unrelia b le m ea sure w he n
Lim it a t ion t o co rrela t ion a na ly sis

Out liers are present in one or bot h of t he series.

Outliers are sm all num bers of observations at
either ext rem e ( sm all or large) of a sam ple

correlat ion bet w een t w o variables t hat reflect s chance relat ionship in a part icular dat a set
correlation induced by a calculation that m ixes each of t w o variables w ith a third
Spurious correla t ion correlat ion bet w een t w o variables arising not from a direct
relation betw een them but from their relation to a third variable

I n investm ent decision- m aking ( for exam ple: inflat ion forecast)
Uses of correla t ion Ana ly sis Correlation of stock m arket tells us how successfully the assets can be com bined to diversify risk
Used in a financial stat em ent set ting

H0: the correlation in the population is 0 ( p = 0)

Ha : the correlation in the population is different from 0 ( p # 0)

Form ula t e a t e st of t he hy po t hesis t ha t t he

po pula t ion co rrela t ion co efficie nt equa ls ze ro
a nd de t erm ine w het he r t he hy po t hesis is
rej ect ed a t a g iv en le v el o f significa n ce
Th e for m u la for t h e t - t e st This test statistic has a t-distribut ion w ith n- 2
degrees of freedom if t he null hypot hesis is t rue
Sam pling from the sam e population, a false null hypothesis H0: is m ore likely to be rej ected as
w e increase sam ple size. The result w het her H0 is rej ect ed also depends on significance level

Linear regression w ith one independent variable ( or sim ple linear regression)
Dist inguish be t w een t he de pe nde nt a nd m odels the relationship bet w een tw o variables as a straight line
inde pe nde nt v a ria bles in a line a r regression Linear regression provides a sim ple m odel for forecasting the value of one variable, know n as the
dependent variable, given t he value of t he second variable, know n as t he independent variable

9. Correlation and Regression - Part 1.mmap - 4/28/2016 - Mindjet

 Y: dependent variable b0, b1 are the regression coefficients
X: independent variable
b0: the intercept
b1: a slope coefficient
Slope coefficient The estim ated slope coefficient is interpreted as the change
in t he dependent variable for a 1- unit change in the
independent variable
Th e r e gr e ssion e qu a t ion

The int ercept t erm

The intercept is an est im ate of the dependent variable w hen t he independent variable takes on a value of zero

error t erm ( represent s t he port ion of t he dependent variable that cannot be explained by t he independent variable

The relationship bet w een t he dependent variable, Y, and t he independent variable, Critical for a valid linear regression. I f the relationship
D e scr ibe t h e a ssum pt ion s bet w een t he independent and dependent variables is
und er ly ing line a r re gre ssion a nd X is linear in the param eter b0 and b1. b0 and b1 are raised to the first pow er only
and that neither b0 nor b1 is m ultiplied or divided by another ( for exam ple, b0/ b1) . nonlinear in t he param et ers, t hen est im at ing t hat relation
int e r pr e t r e gr e ssion coe fficie nt w ith a linear regression m odel w ill produce invalid results
The requirem ent does not exclude X from being raised to a pow er other than 1

The independent variable, X, is not random

En su r e t h at lin e a r r e gr e ssion
pr odu ce s t h e cor r e ct
The expected value of the error term is 0 e st im a t e s

Six cla ssic norm a l lin ea r The variance of the error term is the
r e gr e ssion m ode l a ssum pt ion s sam e for all observations:

u se t h e line a r r e gr e ssion m ode l t o de t e r m in e

t h e dist r ibu t ion of t h e e st im a t e d pa r a m e t e r s
The error t erm is uncorrelated across observations.
a n d a n d t h us t e st w h e t h e r t hose coe fficie nt s
Consequently, E( ei,j ) = 0 for all i not equal to j .
ha v e a pa r t icula r v a lue
The error term is norm ally distributed

The form ula for the standard error of estim ate ( SEE) for a The different betw een the actual and predicted values
linear regression m odel w ith one independent variable is of t he dependent variable is t he regression residual
Ca lcu la t e a n d in t e r pr e t t h e st a n da r d
e r r or of e st im a t e , t h e coe fficie nt of
defined as t he percent age of t he t ot al variation in t he dependent variable explained by t he independent variable
de t e r m in a t ion , a n d a con fide n ce
int e r va l for a r e gr e ssion coe fficie nt The coefficient of determ ination ( R^ 2) R^ 2 = r^ 2 for a regression w ith one independent variable

Confidence interval spans the range

Regression coefficient confidence int erval

A confidence interval is an int erval of values t hat w e believe includes t he t rue param et er value, , w ith a given degree of confidence

the estim ated param eter value

9 . Correla t ion a n d
Re gression - Pa rt 2
A hypothesis test using the confidence interval approach if w e know the hypothesized value b0 or b1
a confidence int erval around t he est im at ed param eter
Form ula t e a null a nd a lt er na t iv e h y pot he sis a b out a
popula t ion v a lue of a re gre ssion coefficie nt a nd det er m ine
t h e a ppr opr ia t e t e st st at ist ic a n d w h e t h e r t h e n ull
hy pot he sis is re j ect e d a t a g iv en lev el of significa nce
I n practice, the m ost com m on w ay to test a hypothesis using a regression m odel is
w ith a t- test of significance. To test the hypothesis, w e can com pute the statistic
This t est statistic has a t- distribution w ith n- 2 degrees of freedom . Rej ect H0 if t> + tcritical or t < - tcritical
The appropriate test structure for the null and alternative hypothesis: H0: b1 = 0 versus Ha: b1 # 0

Ca lcu la t e t h e pr e dict e d v a lu e for t h e de pe n de n t

va r ia ble , give n a n e st im a t e d r e gr e ssion m ode l I f w e know
a nd a v a lue for t h e in dep en den t v a r ia b le

Where sf = standard eror of the forecast

Th e pr e dict ion in t e r va l for a r e gr e ssion e qu a t ion for a
pa r t icu la r pr e dict e d va lu e of t h e de pe n de n t va r ia ble Y tc is tw o- tailed critical t- value at the desired level of significance w ith df = n- 2

Ca lcu la t e a n d in t e r pr e t a con fide n ce in t e r va l for

t h e pr e dict e d va lu e of t h e de pe n de n t va r ia ble
variance of the residuals = the square of the standard error of estim ate

The form ula t o ca lcu la t e sf variance of the independent variable

X value of the independent variable for w hich the forecast w as m ade

Analysis of variance ( ANOVA) is a statistical procedure for dividing the total variability of a variable into com ponents that can be attributed to different sources
Use ANOVA t o det erm ine t he usefulness of t he independent variable or variables in explaining variation in t he dependent variable
The F- t est t est s w het her all t he slope coefficient s in a linear regression are equal t o 0
The null hypothesis H0: b1 = 0
The alternative hypothesis Ha: b1 # 1

SSE ( The sum of squared errors or residuals)

Form ula for t he F- st a t ist ic in a re gre ssion RSS ( The regression sum of squares)
De scrib e t he use of a na ly sis of va r ia nce ( AN OVA) w it h one ind ep en den t v a r ia b le is
in r e gr e ssion a na lysis, in t e r pr e t AN OVA r e su lt s, TSS = SSE + RSS
a n d ca lcu la t e a n d in t e r pr e t t h e F- st at ist ic I f there are n observations, the
F- test for the null hypothesis that
the slope coefficient is equal to 0
is hear denot ed

Ca lcula t e R^ 2 a n d SEE

Regression relations can change over tim e- > the issue of param eter instability
De scrib e lim it a t ions of
Public know ledge of regression relationships m ay negate their future usefulness
re gre ssion a na ly sis
I f the regression assum ptions are violated, hypothesis t ests and predictions based on linear regression w ill not be valid

9. Correlation and Regression - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 I nt r oduct ion

Va lue D e finit ion a nd

2 9 . Equ it y Va lu a t ion : Va lua t ion Applica t ion s

Applica t ion s a n d Pr oce sse s -

An Ove r vie w
Com m u nica t ing Va lu a t ion Re sult s

The Va lua t ion Pr oce ss

29. Equity Valuation. Applications and Processes - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 The estim ation of an asset’s value based on vari ables perceived to be related to future investm ent
returns, on com parisons w ith sim ilar assets, or on estim ates of im m ediate liquidation proceeds
V a lu a t ion

What is value?
I n t rod u ct ion
Who uses equi ty valuations?

Ba sic qu e st ion s What is the im portance of i ndustry know ledge?

How can the analyst effectively
com m unicate his analysis?

The value of the asset given a hypothetically com plete

understanding of the asset’s investm ent characteristics
Reflects investor 's view of the “ true” or “ real” value of an asset
Market price and intrinsic
val ue are identical
I nvest ors will not rat ionally in cur t he expenses of
Gr ossm an- Stiglitz par adox gat hering inform at ion u nless t hey expect t o be
Rational efficient rew arded by h igher gross ret urn s com pared w it h
m arkets form ulation t he free alt ernat ive of accept ing t he m arket price

Com m on stock
Difficult to determ ine especially Trading costs exist
Further room exists for price to diverge from value

A difference bet ween t he est im at ed int rinsic

Analysts often vi ew m arket prices both
w ith respect and w ith skepticism
Seek to identify m ispricing value and t he m arket price of an asset
Rely on price eventually converging to intrinsic value
Recognize distinctions am ong the levels
of m a rk e t e fficie n cy or tiers of m arkets

I ntrinsic Value Uncertainty is Revaluat e by lookin g for t he presence of a

Valuation is an inherent part to attem pt positive e x ce ss constantly present part icular m arket or corporat e ev ent ( cat alyst )
r isk a dj u st e d re t u rn s ( a bn orm a l re t u rn or a lph a )

The error in t he est im at e of t he int rinsic value

( V E - V ) : t he difference bet ween t he valuat ion
est im at e and t he t rue but unobservable int rinsic value

VE = estim ated value

V E - P = ( V - P) + ( V E - V) P = m arket pri ce
D e fin it ion V = intrinsic value

Cont ribut e t o t he abnorm al ret urn

( V- P) : t he t rue m ispricing, t he difference bet ween t he t rue b ut
unobservable int rinsic value V an d t h e observed m arket price P

Manager’s expect at ions m ust differ from

consensus expect at ions and be correct
Com bine accurate forecasts and Act ive securit y select ion
A useful estim ate appr opr iate valuation m odel
of intrinsic value
Expectational inputs used in valuation m odels

value m axim izing using asset s

The assum pt ion t hat t he com p any w ill cont inue
it s business act ivit ies int o t he foreseeable fut ure accessin g it s opt im al sources of financing
not appropriat e for a com pany in financial dist ress
Going- concern assum ption
Th e valu e added by asset s w orkin g t oget her an d by h um an capit al applied t o m an agin g
V a lu e D e fin it ion a n d t hose asset s m akes est im at ed going concern value great er t han liq uidat ion value
V a lu a t ion Applica t ion s Going - Concern Value and Liquidation Value

Orderly liquidation value

Liquidation value
Different tim e fram e for liquidating causes different assets value of a com pany

is the price at w hich an asset ( or liability) w ould change hands betw een a w illing buyer and a w illing seller
w hen t he form er i s not under any com pul sion t o buy and the latter i s not under any com pul sion t o sell
Fair m arket val ue includes an assum ption that both buyer and seller are inform ed of all m aterial aspects of the underlying investm ent
Fair Market Value and I nvestm ent Value often used in valuation related to assessing taxes

The concept of value to a specifi c buyer taking account of potential

I nvestm ent value synergies and based on the investor’s requirem ents and expectations

Selecting stocks Prim ary use

evaluate the reasonableness of the expectations

I nferring ( extracting ) m arket expectations
as a benchm ark or com parison value of the sam e characteristic for another com pany

A m erger the general term for the com bination of tw o com panies

a com bination of tw o com panies, w i th one of the com panies

identified as the acquirer, the other the acquired
An acquisition the acquiring com pany’s ow n com m on stock
is often used as currency for the purchase
2 9 . Equit y Va lua t ion:
affects a com pany’s future cash flow s - > equity
Applica t ions a nd Processes Evaluating corporate events A divestiture a com pany sells som e m aj or com ponent of i ts business

- Pa r t 1
the com pany separates one of its com ponent businesses and transfers
A spin- off the ow nership of the separated business to its shareholders
V a lu a t ion Applica t ion s
an acquisition involving significant leverage [ i.e., debt] , w hich is
A lever aged buyout often collateralized by the assets of the com pany being acquired.)

The parties to a m erger m ay be required to seek a fairness opinion on

Rendering f airness opinions the term s of the m erger from a third party, such as an investm ent bank

Com panies concerned w ith m axim izing shareholder value

evaluate the effect of alternative strategies on share value
Evaluating business st rat egies and m odels

Com m unicating w ith analysts and shareholders

E. g acquisit ions or buy- sell agreem ents for the transfer of equity
for transactional purposes interests am ong ow ners w hen one of them dies or retires, I PO, ...
Appraising private businesses

Sh are based paym ent ( com pensation)

the basis for com puting the target

When a research report states a
inform ation on the uncertainty of reaching the target
target price for a stock, it should
clarify a tim e fram e for reaching the target

An update on the com pany’s

financial and operating results

Sell- side analyst’s report: The key assum ptions and A description of relevant aspects of the
investm ent recom m endation expectations underlying t hat current m acroeconom ic and industry context
Kind of infor . intended readers seek to gain
Persuasive supporting The intrinsic value estim ated intrinsic value An analysis and forecast for
argum ents of the security the industry and com pany
Detailed historical descriptive statistics
about the industry and com pany

May be accom panied by an explanation of the underlying rationale

Specifi c forecasts
Con t e n t s of a Re se a rch Re port
A description of the valuation m odel
Key valuation input s
Usual contents
A di scussion of qualitative factors and other considerations that aff ect valuation
Obj ectively address t he uncertainty associated w ith investing i n the security,
and/ or the valuation input s invol ving the greatest am ount of uncertainty

Contains tim ely inform ation

is w ritten in clear, incisive language
is obj ective and w ell researched, w ith key assum ptions clearly identified The requirem ents are m ore specific i n som e situations. For e.g,
di stingui shes clearly betw een facts and opi nions regulations governing disclosures of conflicts and potential conflicts
An effective research report of interest vary across countries, investm ent recom m endations are
contains analysis, forecasts, valuation, and a recom m endation that are internally consistent affected by policies of the firm em ploying an analyst
Com m un ica t ing Va lu a t ion Result s presents sufficient inform ation to allow a reader to critique the valuation
states the key risk factors invol ved in an i nvestm ent in the com pany
discloses any potential conflicts of interests faced by the analyst

Form a t of a Re se a rch Re port

All analysts have an obligation to provide substantive and Analy st s w ho are CFA I nst it ut e m em bers, how ever, have an add it ional and overriding responsibilit y t o adhere t o
m eaningful content in a clear and com prehensive report form at t he Code of Et hics and t he St andards of Professional Conduct in all act iv it ies pert aining t o t heir research report s

Re se a rch Re port in g Re spon sibilit ie s

Th e a n a lyst m u st h ol d h im se lf a ccou n t a ble t o bot h st a n da rds of com pe t e n ce a n d st a n da rds of con du ct

29. Equity Valuation. Applications and Processes - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 Sell- side analyst : Analyst s Valuat ion j udgm ent s t o dist ribut e t o current and
who work at brokerage firm s prospect ive ret ail and inst it ut ional brokerage client s

I nvest m ent discipline ( securit y is t o un derst and t he basic charact erist ics of t he m arket s served by a com p any and t he econom ics of t he com p any
select ion) and quant it at ive Valuat ion j ud gm ent s t o a port folio m anager or t o an
giv e appropriat e at t ent ion t o t o organize t hought s about an indust ry and t o bet t er underst and a com p any’s
invest m ent disciplines invest m ent com m it t ee as input t o an invest m ent decision
Bu y - side analy st s t he m ost im port ant econom ic prospect s for success in com pet it ion w it h ot her com panies in t hat indust ry
The purposes and t he int ended drivers of a business
consum er of t he valuat ion t o highlig ht t he great est challenges and opp ort unit ies need m ore sensit iv it y analysis ?
Bot h corporat e analyst s and invest m ent bank analyst s m ay also Applying t he V aluat ion Con clusion : Usefuln ess
ident ify and value com panies t hat could becom e acquisit ion t arget s Th e Analyst ’s Role and Respon sibilit ies
Analyst s at ind ependent vendors of financial inform at ion u sually offer How at t ract ive are t he in dust ries in w hich
Try t o underst and t he indust ry st ruct ure
valuat ion inform at ion and opinions in publicly dist ribut ed research report s t he com pany operat es, in t erm s of offering
prospect s for sust ained profit abilit y Port er 5 forces
Help t heir client s ach ieve t heir invest m ent obj ect ives St ay current on fact s and news concerning all t he indust ries
Cont ribut e t o t he efficient fun ct ioning of capit al m arket s I nvest m ent analyst s play a crit ical role in collect ing, organizing, analyzing,
and com m unicat ing corporat e inform at ion, and in som e cont ext s, What is t he com p any’s The level and t rend of t he com pany’s m arket sh are in dicat e
Benefit t he suppliers of capit al, including shareholders, w hen
recom m ending app ropriat e inv est m ent act ions based on sound analy sis I ndust ry a nd Use various relat ive com pet it ive posit ion it s relat ive com pet it ive posit ion wit hin an indust ry The t erm “ business m o del” refers
t hey are effect ive m onit ors of m anagem ent ’s perform ance
Com pet it iv e Analysis fram ew orks w it hin it s indust ry, and w hat Cost leadership generally t o how a co m pany m akes
is it s com pet it ive st rat egy m o ney
How is a useful Corporat e st rat eg ies Different iat ion
E.g w hen assess how a change in assum pt ions about a com p any’s
fut ure growt h or analyze how different com p et it ive responses fram ew ork? Focus Focus
t o det erm ine how changes in an assum ed on t hese quest ions
would affect t he forecast ed financials and t he est im at ed valuat ion inp ut would affect t he out com e Sensit ivit y analysis
Analy zing t he com p any’s financial
report t o evaluat e t he com pany's Looking annual report s
Hist orical analysis t o have
t he value of a st ock in vest m ent st r at egic obj ect iv es' perform ances for 10 , 5, 2 years prior
con t rol prem ium s it s insig ht s t hrough t im e
and develop expect at ions t o it
How well has t he com pany
t he v alue of nonpublicly t raded st ocks Convert ing Forecast s execut ed it s st rat egy and what are
lack of m arket abilit y discount s im port ance of qualit at iv e ( non- num eric fact ors)
Tw o im p ort ant asp ect s t o a V aluat ion it s prospect s for fut ure execut ion
2 caveat s m erit m ent ion avoid sim ply ext rapolat ing past operat ing
t he prices of shares wit h less dept h t o t heir m arket s
Sit uat ional adj ust m ent s result s w hen forecast ing fut ure perform ance
an invest or wishes t o sell an am ount of st ock t hat is large relat ive t o t hat st ock’s
t rading v olum e ( assum ing it is not large enough t o const it ut e a cont rolling ow nership) m ost relevant for evaluat ing a com pany’s Financial rat io analysis is useful for est ablished com panies
illiquidit y discount s
The price t hat would be lower t han t he success in im plem ent ing st r at egic choices I ndividual drivers of profit abilit y for m erchandising and m anufact uring com panies
m arket price for a sm aller am ount of st ock Analysis of Financial Report s can be ev alu at ed again st t he com pany ’s st at ed st rat egic obj ect iv es
b lockag e fact or

Analyst s can com pare t he in form at ion p rovid ed d irect ly

by com panies t o t h eir own independent research
used t o produce an est im at e of value t hat can
be com pared w it h t he asset ’s m arket price Regulat ory requirem ent s concerning disclosures and filings vary int ernat ionally
Def. a m odel t hat specifies an asset ’s int rinsic value Sources of I nform at ion
Be aware when regu lat ions ( e.g., Regulat ion FD in t he Unit ed St at es) prohibit com p anies from disclosing
m at erial nonpublic inform at ion t o analyst s w it hout also dissem inat ing t hat inform at ion t o t he public
The value of an asset t o an invest or m ust be relat ed t o t he
ret urns t hat invest or expect s t o receive from hold ing t hat asset . Also requ ire careful scrut iny of
The scrut iny of all financial st at em ent s, including t he balance sheet ,
Defines cash flow net of t o evaluat e bot h t he su st ainabilit y of t he com panies’ perform ance account ing st at em ent s, foot not es,
Free cash flow
paym en t s t o providers of debt and how accu rat ely t he report ed inform at ion reflect s econom ic realit y and ot her relevant disclosure
t o equit y m odel

Free cash flow
Defines cash flows b efore t hose paym ent s t o t he firm
Based on accrual account ing
earnings in excess of t he opp ort unit y
cost of generat ing t hose earnings Residual incom e m odel
it s CFs and discount rat e
N e e d se n sit ivit y
need t o address ot her issu es, such as
a n a lysis
t he value of corporat e cont rol or t he
value of un used asset s
A st ream of cash p aym ent s sp ecified in
a legal cont ract ( t he bo nd inde nt ure )
A discount rat e can usually be based on
m arket int erest rat es and bond rat ings
Can provid e an ind ependent est im at e of value
Underlying idea: sim ilar asset s should sell at sim ilar prices
Analy st s frequent ly Eq uit y analyst s: develop bet t er insight s int o a com pany and im prove forecast accuracy
define cash flows at Qualit y of earnings analysis Sust ainabilit y of perform ance: ident ify aspect s of report ed nonrecurring perform ance
t he com pany level The fundam ent al
approach t o com p arison of a com pany’s net
I dent ify report ing decisions t hat m ay result in a level
For com m on equit y valuat ion incom e wit h it s operat ing cash flow
of report ed earnings t hat are unlik ely t o cont inue
st ock: Dividend
discount m odels
Present v alue m odels Po o r qualit y o f account ing disclo sures, such as segm ent info rm at io n, acquisit io ns,
Absolu t e V aluat ion M odels U nde rst a nding t he busine ss account ing po licies and assum pt io ns, and a lack o f discussio n o f negat iv e fact o rs.
( discou nt ed CF m odels)
Ex ist ence o f relat edpart y t ransact io ns
Great er uncert aint y t han
Ex ist ence o f ex cessiv e o fficer, em plo y ee, o r direct or lo ans
t he case wit h b ond s due t o
High m anagem ent or direct or t urnover
2 9 . Equ it y V a lu at ion :
Ex cessiv e pressure o n co m pany perso nnel t o m ak e rev enue o r earnings t arget s,
Applicat ion s an d Pr oce sse s - part icularly w hen co m bined w it h a do m inant , aggressive m anagem ent t eam o r individual
Par t 2 : Th e V alu a t ion Pr ocess A workin g select ion of risk fact ors ( AI CPA 2 00 2) ( in case growt h in Mat erial no n- audit services perfo rm ed by audit firm
an asset account at a m uch fast er rat e t h an t he growt h rat e of sales
Not as uncert ain as com m on st ock Applied t o bond valuat ion Repo rt ed ( t hro ugh regulat o ry filings) disput es w it h and/ o r changes in audit o rs
M anagem ent and/ o r direct o rs’ co m pensat io n t ied t o pro fit abilit y o r st o ck price
( t hro ugh o w nership o r co m pensat io n plans) . Alt ho ugh such arrangem ent s are
usually desirable, t hey can be a risk fact o r fo r aggressive financial repo rt ing.
Values a com p any on t he basis of t he m arket
Eco no m ic, indust ry , o r co m pany specific pressures o n pro fit abilit y ,
value of t he asset s or resources it cont rols such as lo ss o f m ark et share o r declining m argins
A sset - based valuat ion
Managem ent pressure t o m eet debt co venant s o r earnings expect at io ns
Def. est im at e an asset ’s value relat ive t o t hat of anot her asset A hist o ry o f securit ies law vio lat io ns, repo rt ing vio lat io ns, o r persist ent lat e filings

Undervalue rat ios of st ock price t o a fund am ent al

P/ E
Relat ively undervalue such as cash flow per share Con siderat ion s in U sing
using price m ult iples Acco unt ing I nform a t ion
How ?
rat ios of t he t ot al value of com m on st ock and debt net of cash and short t erm invest m ent s
t o cert ain of a com pany’s operat ing asset s t o a fund am ent al su ch as operat ing earning s ent erprise m ult iples
Select ing t he Appropriat e V aluat ion M odel
The m ore conservat ive invest ing st rat eg ies involve overweight ing ( underweight ing)
relat ively undervalued ( overvalued) asset s, wit h reference t o benchm ark weight s Relat iv e V aluat ion M odels

Pairs t rading: buy ing t he relat iv ely undervalued Relat ive value invest ing ( or relat ive spread
st ock and selling short t he relat ively overvalued st ock The m ore aggressive st rat eg ies allow short
invest ing , if using im plied d iscount fact ors)
selling of perceived overvalued asset s

do es no t specify int rinsic v alue w it ho ut m aking t he furt her

assum pt ion t hat t he com parison asset is fairly v alued
being sim ple, relat ed t o m arket prices, and
grounded in a sound econom ic principle
The m et hod of com p arables is ch aract erized by
a w ide range of possible im plem ent at ion choices Frequent ly inv olv e a group
of com parison asset s

Breakup value or Sum s t he est im at ed values of each of t he

The value derived using a
privat e m arket value com pany ’s b usinesses as if each business
sum - of- t he- part s valuat ion
were an independent going concern

Value a com p any wit h segm ent s in d ifferent ind ust ries
t hat have different valuat ion charact erist ics
evaluat e t he value t hat m ight be unlocked in a rest ruct uring t hrough When t o use
a spinoff, split off, t rack ing st ock , or equit y ( I PO) carv eout

The m arket applies a disco unt t o t he st o ck o f a co m pany Sum - of- t he- part s
o perat ing in m ult iple, unrelat ed businesses co m pared t o valuat ion V aluat ion of t he To t al En t it y
t he st o ck o f co m panies w it h narro w er fo cuses a nd I t s Com p one nt s
inefficiency of int ernal capit al m arket s
Cong lom e ra t e disco unt
en dogen ous fact ors Alt ernat ive explanat ion
research m easurem ent errors
Approach m oves from int ern at ional and nat ional m acroeconom ic forecast s
A break up v alu e in ex cess of a com pany ’s un adj ust ed g oin gconcern t o ind ust ry forecast s and t hen t o ind ivid ual com p any and asset forecast s
v alu e m ay prom pt st r at egic act ions su ch as a div est it ure or spin - off Top - dow n forecast ing
The econom ic environm ent
For ecast in g Com pa ny Perform an ce Bot t om - up forecast ing Ap proach aggregat es forecast s at a m icr o level t o larger scale forecast s, und er specific assum pt ions
underst anding t he nat ure of it s asset s and having a good und erst anding Tw o perspect ives
how it uses t hose asset s t o creat e value consist ent w it h t he charact erist ics
of t he business
of t he com pany being valued Consider qualit at ive as well as quant it at ive fact ors
Crit eria for m odel select ion are The com p any’s ow n operat ing and financial charact erist ics
t hat t he valuat ion m odel be
appropriat e given t he availabilit y and qualit y of dat a
I ssues in M odel Select ion
consist ent w it h t he purpose of valuat ion, including t he analy st ’s perspect iv e and I nt erp ret at ion
Professionals frequent ly use m ult iple valuat ion
m odels or fact ors in com m on st ock select ion

29. Equity Valuation. Applications and Processes - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
To be continued…
F or M O R E C F A ® M ind M aps, please go to:
to:http:/ / www. e - junkie . com / e com / gb. php?cl=2 7 4 0 7 8 &c=ib&a ff=2 8 3 5 6 5
 I N TROD UCTI ON
PRI VATE M ARKET REAL ESTATE D EBT

REAL ESTATE I N V ESTM EN T: BASI C FORM S

I N DI CES

REAL ESTATE: CH ARACTERI STI CS AN D CLASSI FI CATI ON S

VALUATI ON I N AN I N TERN ATI ON AL CON TEX T
3 9 . Pr iva t e Re a l
Est a t e I n vest m e n t s:
D UE D I LI GEN CE An Ove r vie w PRI VATE M ARKET REAL ESTATE EQUI TY I N V ESTMEN TS

TH E COST AN D SALES COM PARI SON APPROACH ES TO VALUATI ON

RECON CI LI ATI ON

OV ERVI EW OF TH E V ALUATI ON
TH E I N COM E APPROACH TO V ALUATI ON
OF COMM ERCI AL REAL ESTATE

39. Private Real Estate Investments - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 o ft en i ncluded in t he p ort folios of i nvest ors w it h long- t erm i n v est m ent
horizons and wit h t he abilit y t o t olerat e relat ively lower liquidit y
Privat e equit y invest m ent : som et im es
I N TRODUCTI ON referred to as direct ownership

suit able for invest ors wit h short invest m ent horizons and higher liquidit y needs
Publicly t raded debt invest m ent :
som et im es referred t o as indirect lending

The first dim ension: whet her t he invest m ent

is m ade in the pr ivate or public m arket
I n v e st m ent in real est ate has been d efined fr om a capit al m arket p erspect ive The second dim ension: whet her t he invest m ent
in t he cont ext of quadr ant s which are a r esult of t wo dim ensions of invest m ent is m ade in the pr ivate or public m arket

REAL ESTATE I N VESTM EN T:

BASI C FORM S

Four quadr ant s

Privat e r eal est at e invest m ent , com pared wit h publicly t raded real est at e invest m ent , t ypically
involves lar ger invest m ents because of the indivisibilit y of r eal est at e pr oper t y and is m or e illiquid
Publicly t raded r eal est at e invest m ent allows t he real est at e pr opert y t o
rem ain undivided but t he ownership or claim on t he pr opert y t o be divided
Equit y invest ors generally expect a higher rat e of ret urn t han lenders ( debt invest ors) because t hey t ake on m ore risk
Debt invest ors in real est at e, whet her t hrough pr ivat e or public m arket s, expect t o receive t heir ret urn fr om
pr om ised cash flows and t ypically do not part icipat e in any appreciat ion in value of t he underlying real est at e

Het erogeneit y and fixed locat ion

High unit value
Managem ent int ensive
High t r ansact ion cost s
Charact erist ics Depr eciation
Need for debt capit al
I lliquidit y :
Pr ice det er m inat ion

Single- f am ily p r oper t ies m ay be

REAL ESTATE: CH ARACTERI STI CS
AN D CLASSI FI CATI ON S Re side n t ial prope r t ie s: single- fam ily houses
and m ult i- fam ily pr oper t ies, pr opert ies t hat
pr ovide housing for individuals or fam ilies
owner - occupied or rent al propert ies
Mult i- f am ily p r oper t ies ar e r ent al p r oper t ies even if
t he owner or m anager occupies one of t he unit s
Mult i f am ily h ousing is u sually d i fferent iat ed
by locat ion and shape of st ruct ure
Propert ies p urchased w it h t he
Com m ercial real est ate propert ies int ent t o let , lease, or rent

Classificat ions
Office
I ndust rial and warehouse
N on - re side n t ial prope r t ie s include com m er cial pr oper t ies
ot her t han m ult ifam ily pr opert ies, farm land, and t im berland Ret ail
Hospit alit y
Ot her t ypes

Current incom e
Pr ice appr eciat ion ( capital appr eciat ion)
I nflat ion hedge
Mot ivat ions
Diver sificat ion
Tax Benefits

Business condit ions

Long lead t im e for new developm ent
Cost and availabilit y of capital
Unexpect ed inflat ion
Dem ographics
Charact erist ic sources of risk or risk
factors of real estate investm ent Lack of liquidit y
Risk Fa ct ors Environm ent al
Availability of infor m at ion
Managem ent
Leverage
3 9 . Pr iva t e Re a l Est a t e Ot her risk fact ors
I n ve st m e n t s - Pa rt 1
Risk and ret urn of equit y real est at e invest m ent s is affect ed by t he charact erist ics of
real est at e and t he risk fact ors, st ruct ure of leases bet ween t he owner and t enant s
PRI VATE M ARKET REAL ESTATE Rea l Est a t e Risk a nd Ret urn
EQUI TY I N VESTM EN TS Rela t iv e t o St ock s a nd Bond s

The dem and for office depends heavily on em ploym ent growth
The average length of an office building lease varies globally
“ net lease” requires t he t enant t o be
An im port ant considerat ion in office leases is whether t he responsible for paying operat ing expenses
Office
owner or t enant incurs t he risk of operat ing expenses “ gross lease” requires t he owner
t o pay t he operat ing expenses
Not all office leases are str uctur ed as net or gr oss leases
There are differences in how leases are st ruct ured over t im e and in different count ries

The dem and for indust rial and warehouse space is heavily dependent on t he overall st rengt h
I ndust rial and Warehouse of t he econom y and econom ic gr owt h and on im port and export act ivit y in t he econom y
Com m ercia l Rea l Est a t e
The dem and depends heavily on t rends in consum er spending. Consum er spending, in t urn,
depends on t he healt h of t he econom y, j ob gr owt h, populat ion gr owt h, and savings rat es
“ Percent age lease” : t he requirem ent t hat t he t enant s pay addit ional r ent once t heir sales reach a cert ain level
Ret ail
The lease will typically specify a “ m inim um rent” that m ust be paid r egar dless of t he tenant’s sales
and t he basis for calculat ing percent age rent once t he t enant ’s sales reach a cert ain level or breakpoint

The dem and fo r m ult i - fam ily populat ion gr owt h, especially for t he age segm ent m ost likely t o rent apart m ent s
space depends on how t he cost of rent ing com pares wit h t he cost of
Mult i- Fam ily owning- t hat is, t he rat io of hom e pr ices t o rent s

The cost approach involves est im at ing t he value of t he building( s) based on adj ust ed replacem ent cost
The replacem ent cost is adj usted for different types of depr eciation ( loss in value) to arrive at a de p re ciat e d r e pla ce m e n t cost
curable: fixing the pr oblem will add value that
Phy sica l d et eriora t ion relat ed t o t he age is at least as gr eat as the cost of the cure
of t he pr opert y because com ponent s of t he
pr operty wear out over tim e. Two types incurable: Fixing a st ruct ural pr oblem wit h t he foundat ion
of t he building m ay cost m ore t o cure t han t he am ount
that it would increase the value of the pr operty if cured
The Cost Approach
Fu n ct ion a l obsole sce n ce : a loss in value due to a design that is different from that of a
Types of depreciat ion new building const ruct ed wit h an appropr iat e design for t he int ended use of t he pr opert y

Ex t e r n a l obsole sce n ce : due t o eit her t he locat ion of Loca t ion a l obsole sce n ce result s when
t he pr opert y or econom ic condit ions, result s w hen t he locat ion is not opt im al for t he pr opert y
t he locat ion is not opt im al for t he pr opert y Econom ic ob sole scen ce result s when new const ruct ion
is not feasible under current econom ic condit ions

The sales com parison approach im plicit ly assum es t hat t he value of a propert y
TH E COST AN D SALES COM PARI SON
depends on what ot her com parable pr opert ies are selling for in t he current m arket
APPROACH ES TO VALUATI ON The Sales Com parison Approach

Advant ages and Disadvant ages of t he

Cost and Sales Com parison Approaches

Appraisals ( est im at es of value) are crit ical for such infrequent ly t raded and unique asset s as real est at e pr opert ies
Market value: can be thought of as the m ost probable sale pr ice. I t is what a t ypical investor is willing t o pay for the pr operty
I nvest m ent value: t he value t o a part icular investor, could be higher or lower than m arket
Appr aisals Value value depending on t he part icular invest or’s m ot ivat ions and how well t he pr opert y fit s int o t he
There are other definitions of value invest or’s port folio, t he invest or’s risk t olerance, t he invest or’s t ax circum st ances, and so on.
that differ from m arket value
Value in use: t he value t o a part icular user
OVERVI EW OF TH E VALUATI ON The incom e approach considers what pr ice an investor would pay based on an
OF COM M ERCI AL REAL ESTATE expect ed rat e of ret urn t hat is com m ensurat e wit h t he risk of t he invest m ent
Th e cost a p p roach considers what it would cost t o buy t he land and const ruct a new pr opert y on t he sit e t hat
Three different approaches has t he sam e ut ilit y or funct ionalit y as t he pr opert y being appraised ( referred t o as t he subj ect pr opert y )
I nt roduct ion t o
The sa les com p a rison approach considers what sim ilar or com parable
Valuat ion Approaches
propert ies ( com parables) t ransact ed for in t he current m arket

Highest and Best Use Highest and best use: t he use t hat would result in t he highest value for t he land

39. Private Real Estate Investments - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

TH E I N COM E APPROACH
TO V ALUATI ON
3 9 . Pr iva t e Re a l Est a t e
I n ve st m e n t s - Pa rt 2
RECON CI LI ATI ON
To verify ot her fact s and condit ions t hat m ight affect t he value of t he pr opert y and t hat m ight not have been ident ified by t he appraiser
DUE DI LI GEN CE
E. g
VALUATI ON I N AN
I N TERN ATI ON AL CON TEX T
Ap praisal- Based I ndices
I N D I CES
Tr a nsact ion- Based I ndices
PRI VATE M ARKET REAL ESTATE DEBT
39. Private Real Estate Investments - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
capit alizes t he curr ent NOI using a gr owt h im plicit capit alizat ion r at e
t he direct capit alizat ion m et hod W hen t he capit alizat ion rat e is a pplied t o t he f o recast ed f irst - year
NOI for t he p r opert y, t he i m plicit a ssu m pt ion is t hat t he f irst - year NOI
There are t wo incom e approaches is r epresentat ive of f ir st - year NOI w ould be for sim ilar pr oper t ies
a pplies an e xplicit g r owt h rat e t o co n st ruct an NOI
t he DCF m et hod str eam from which a pr esent value can be derived
I n com e can be p r oj ect ed e it her for t he e nt ire e conom ic life of t he p r opert y or for a t ypical
Gener al Ap p roach and
holding period wit h t he assum pt ion t hat t he pr opert y will be sold at t he end of t he holding period
Net Operat ing I ncom e
Rent al i n com e at full o ccupancy
+ Ot her i n com e ( such as p a rking)
= Pot ent ial g ross i n com e ( PGI )
– Va cancy and collect ion loss
= Ef f ect ive g ross i n com e ( EGI )
– Op erating e x penses ( OE)
Calculat ing NOI = Net operating incom e ( NOI )
The cap r ate is like a cu r rent yield for t he p r opert y w hereas
t he discount rat e is applied t o current and fut ure NOI
The Capit alizat ion Rat e and t he Discount Rat e
Cap r at e = Discount r at e - Growt h r at e
g oing - in cap r ate is u sed t o clar ify t hat it is b ased o n t he f ir st
year of ownership when t he invest or is going int o t he deal
Cap rat e = NOI / Value t e rm inal cap rat e is b ased o n e x pect ed i n com e for
t he year aft er t he ant icipat ed sale of t he pr opert y
Defining t he Capit alizat ion Rat e o b ser ving w hat ot her sim ilar or co m par able
Value = NOI / Cap rat e pr operties are selling for to know the cap r ate
The Direct Capit alizat ion Met hod Cap r ate = NOI / Sale pr ice of com parable
Market value = Rent / ARY ARY: all r isks yield
I f NOI is not r epr esent at ive of t he NOI of sim ilar pr opert ies because
St abilized NOI of a t em porary issue, t he subj ect propert y's NOI should be st abilized
Gr oss incom e m ult iplier : the ratio of the sale pr ice to the gr oss
incom e expect ed from t he pr opert y in t he first year aft er sale
Other Form s of the I ncom e Approach The problem of gr oss incom e m ult ipler : not explicitly
consider vacancy rat es and operat ing expenses
I f t he gr owt h r at e is const ant V = NOI / ( r – g)
The Relat ionship bet ween
Discount Rat e and Cap Rat e I f NOI is n ot e x pect ed t o g r ow at a co n st ant rat e, t hen NOI s are pr oj ect ed i nt o
t he fut ure and each period’s NOI is discount ed t o arrive at a value of t he pr opert y
The cap rat e used t o est im at e t he resale pr ice or t erm inal value
is referred t o as a t erm inal cap r at e or residual cap rat e
I t is a cap rat e t hat is select ed at t he t im e of v a luat ion t o be a pplied t o t he NOI
earned in t he first year aft er t he pr opert y is expect ed t o be sold t o a new buyer
I f i n t erest rat es are e x pect ed t o be h igher in t he
The Term inal Capit alizat ion Rat e fut ure = > t erm inal cap r at es m ight be higher
The t e rm inal cap rat e could be t he sam e, h igher, or
The Discount ed Cash lower t han t he g oing in cap rat e d e p ending o n e x pect ed The gr owt h rat e is o ft en a ssum ed t o be a lit t le
Flow ( DCF) Met hod discount and growt h r at es at t he t im e of sale lower = > a slight ly higher term inal cap r ate
Un ce rt aint y a bout w hat t he NOI will be in t he f u t ure
m ay also result in select ing a higher t erm inal cap r at e
Lease st ruct ures vary across locales and can have an effect
Adapt ing t o Different Lease St ruct ures on t he way value is t ypically est im at ed in a specific locale
The “ equivalent yield” is a single discount rat e t hat could be applied
The Equivalent Yield m at hem at ically t o bot h incom e st ream s t hat would result in t he sam e value
Project incom e from exist ing leases
Make assum pt ions Assu m pt ions also h ave t o be m ade a bout w hat will h a ppen w hen a lease
about lease renewals com es up for renewal—oft en referred t o as m arket leasing assum pt ions
Make assum pt ions about Op erat ing e x penses i n volve i t em s t hat m u st be paid b y t he o wner, such as
operating expenses pr opert y t axes, insurance, m aint enance, m anagem ent , m arket ing, and ut ilit ies
The general s teps to a DCF
analysis ar e as follows
Make assum pt ions about
capit al expendit ures such as a new heat ing and air condit ioning syst em or replacing a roof, et c. ,
Make assum pt ions about absorpt ion of any vacant space
Est im ate resale value ( reversion) how long t he pr opert y will be held by t he init ial invest or
Advanced DCF:
Lease- by- Lease Analysis Select discount r ate to find PV of cash flows
Advant age: it capt ur es t he cash flows t hat invest ors act ually care about
Advant ages and Disadvant ages
of the I ncom e Appr oach D isadvant age is t he am ount of det ailed inform at ion t hat is needed and t he need t o forecast what will happen in
t he fut ure even if it is j ust forecast ing a gr owt h rat e for t he NOI and not doing a det ailed lease- b y- lease analysis
The discount r at e does not reflect t he risk
I ncom e gr owt h is gr eat er t han expense gr owt h
Com m on Errors The t erm inal cap rat e is not logical com pared wit h t he im plied going- in cap rat e
The t erm inal cap rat e is applied t o an incom e t hat is not t ypical
The cyclical nat ure of real est at e m arket s is not recognized
Three different approaches t o valuat ion: t he incom e, cost , and sales com parison approaches m ay produce t he different answers due t o im perfect ions in t he dat a and inefficiencies in t he m arket
The appraiser needs t o r econcile t he differences and arrive at a final conclusion about t he value
The pur pose of r econciliat ion is t o decide which approach or approaches you have t he m ost confidence in and com e up wit h a final est im at e of value
I n an act ive m arket : sales com parison approach is preferred
When t here are fewer t ransact ions: incom e approach is preferred
Review t he leases for t he m aj or t enant s and review t he hist ory of r ent al paym ent s and any default s or lat e paym ent s.
Get copies of bills for operat ing expenses, such as ut ilit y expenses.
Look at cash flow st at em ent s of t he pr evious owner for operat ing expenses and revenues.
Have an environm ent al inspect ion t o be sure t here are no issues, such as a cont am inant m at erial on t he sit e.
Have a p h y si cal/ engineering i n spect ion t o be sure t here are n o st r uct ural i ssues w it h t he p r opert y
and t o check t he condit ion of t he building syst em s, st ruct ures, foundat ion, and adequacy of ut ilit ies.
Have an a t t orney or a p pr opr iat e p art y r eview t he o w n ership h i st ory t o be sure t here are n o i ssues r elat ed
t o t he seller’s abilit y t o t r ansfer free and clear t it le t hat is not subj ect t o any pr eviously unident ified liens.
Review service and m aint enance agreem ent s t o det erm ine whet her t here are recurring problem s.
Have a p r opert y su rvey t o d e t erm ine w h et her t he p h ysical i m p r o vem ent s are in t he b o u ndary
lines of t he sit e and t o find out if t here are any easem ent s t hat would affect t he value.
Verify t hat t he pr opert y is com pliant wit h zoning, environm ent al regulat ions, parking rat ios, and so on.
Verify t hat pr opert y t axes, insurance, special assessm ent s, and so on, have been paid
Ret urn = { NOI Capit al expendit ures + ( Ending m arket value Beginning m arket value ) } / Beginning m arket value
May not capt ur e t he pr ice increase unt il a quart er or m ore aft er it was r eflect ed in t ransact ions
Appraisal lag
Disadvant ages Tend t o sm oot h t he index, have lower correlat ion wit h ot hers = > allocat ion t o real est at e would likely overest im at ed
How t o adj ust : unsm oot h” t he appraisalbased or use a t ransact ionbased index when com paring real est at e wit h ot her asset classes
I n recent years, indices have been creat ed t hat are based on act ual t ransact ions rat her t han appraised values
A repeat sales index relies on repeat sales of t he sam e propert y
Two m ain ways
A hedonic index which requires only one sale
Disadvant ages I nclude random elem ent s in t he observat ions = > m ay be upward or downward m ovem ent s from quart er t o quart er t hat are som ewhat random
The m a x i m um a m o unt of d ebt t hat an i n vest or can o bt ain o n co m m ercial real e st at e is u sually l im it ed b y e it her t he rat io
of t he loan t o t he appraised value of the propert y ( loan t o value or LTV) or t he debt service coverage ratio ( DSCR)
DSCR = NOI / Debt service
The d ebt service coverage rat io is t he rat io of t he f irst year NOI t o t he loan p a y m ent
 PRI CI N G EURODOLLAR FUTURES, TREASURY BON D
FUTURES, STOCK I N D EX AN D CURREN CY FUTURES FUTURE CON TRACTS

TH E RELATI ON BETW EEN FUTU RES FUTURES PRI CE & THE VALUE
PRI CES AN D EXPECTED SPOT PRI CES
4 8 . Fut u r e s M a r k e t s a nd OF A FUTURES CON TRACT
Cont r a ct s: An Ove r vie w

M ON ETARY & N ON M ON ETARY BEN EFI TS AN D COSTS W H Y FORW ARD AN D

ASSOCI ATED W I TH H OLD I N G TH E UN D ERLYI N G FUTURES PRI CES D I FFER
ASSET AN D TH EI R EFFECTS TO FU TURES PRI CE

48. Futures Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 Deliver able cont ract s obligat e t he long t o buy and t he short t o sell a cert ain quant it y of an asset f or a cert ain price on a specified fut ure dat e
Sim ilar t o for w ar d Cash set t lem ent cont ract s are set t led by paying t he cont ract value in cash on t he expirat ion dat e
cont r act s in
Bot h forw ards and fut ures are priced t o hav e zer o value at t he t im e t he invest or ent er s int o t he cont r act

Fut ur es ar e m ar k ed t o m ar k et at t he end of ev er y t r ading day . For w ar d cont r act s ar e not m ar k ed t o m ar k et

FUTURE CON TRACTS
Fut ures cont ract s t rade on organized ex changes. Forw ards are pr ivat e cont r act s and do not t rade on organized ex changes
Differ ent fr om Fut ures cont r act s are highly st andardized. Forw ards are cust om ized cont r act s sat isf ying t he needs of t he part ies involved
for w ar d cont r act s Forw ards are cont ract s w it h t he originat ing count erpart y ; a specialized ent it y called a clearinghouse is t he count erpart y t o all fut ures cont ract s
Forw ard cont ract s ar e usually not regulat ed. The gover nm ent having legal j urisdict ion regulat es fut ures m arket s

At ex pir at ion, t he spot price m ust equal t he fut ures pr ice because t he fut ures pr ice Ar bit rage w ill force t he pr ices t o
has becom e t he pr ice t oday for deliv er y t oday , w hich is t he sam e as t he spot . be t he sam e at cont ract expirat ion

The clearinghouse guarant ees t hat t r ader s in t he fut ures m arket w ill honor t heir
obligat ions by split t ing each t r ade once it is m ade and act ing as t he opposit e
Fut ures pr ice m ust converge side of each posit ion = > To safeguar d t he clear inghouse, bot h sides of t he t r ade
Fut ures m argin is a
t o t he spot price at expirat ion Fut ure m argins and are r equired t o post m argin and set t le t heir account s on a daily basis
per form ance guarant ee
m arking t o m arket
Marking t o m arket is t he pr ocess of adj ust ing t he m argin balance in a f ut ures account each day for
FUTURES PRI CE & TH E VALUE t he change in t he value of t he cont ract fr om t he prev ious t rading day, based on t he set t lem ent price
OF A FUTURES CON TRACT
Has no value at cont ract init iat ion
Does not accum ulat e v alue changes over t he t er m of t he cont ract .
The v alue aft er t he m argin deposit has been adj ust ed for t he day 's gains and losses in cont ract value is alw ays zer o
Value of a The fut ur es pr ice at any point in t im e is t he price t hat m akes t he value of a new cont r act equal t o zer o
fut ures cont r act The v alue of a fut ur es cont r act st r ay s fr om zer o only dur ing t he t r ading per iods bet w een t he t im es at w hich t he account is m ar k ed t o m ar k et
Value of fut ur es cont r act = cur rent fut ures pr ice - previous m ar k- t o- m ar ket pr ice
I f t he fut ur es price increases, t he v alue of t he long posit ion incr eases

FP = fut ur es pr ice should be t he sam e as t hat of a for w ar d cont r act

The no- ar bit rage pr ice of a fut ures cont r act So = spot pr ice at incept ion of t he cont r act ( t = 0)
Rf = annual risk - f ree rat e
4 8 . Fut ures M a rk et s T = fut ures cont r act t erm in y ear s
a nd Cont ra ct s - Pa rt 1
I f invest ors pr efer t he m ark- t o- m arket feat ure of fut ures, fut ures pr ices will be higher t han forw ard pr ices
Cases t hat causes f ut ures and I f invest or s w ould rat her hold a for w ar d cont r act t o av oid t he m ar king t o m ar ket
for w ar d pr ices t o be differ ent of a fut ures cont r act , t he for w ar d pr ice w ould be higher t han t he fut ures pr ice

W H Y FORW ARD AN D
FUTURES PRI CES D I FFER

A cash- and- carry arbit rage consist s of buy ing t he asset , st oring/ holding t he
asset , and selling t he asset at t he fut ures pr ice w hen t he cont r act ex pir es
Bor row m oney for t he t er m of t he cont r act at m ar ket int er est rat es
At t he init iat ion of t he cont r act Buy t he under ly ing asset at t he spot price

St eps Sell ( go shor t ) a fut ures cont r act at t he cur rent fut ur es price
Cash- and- car r y ar bit r age
Deliv er t he asset and r eceiv e t he fut ur es cont r act pr ice
At cont ract ex pirat ion
Repay t he loan plus int er est
I f t he fut ur es cont r act is ov er priced = > generat e a r isk less pr ofit
Fut ur e ar bit r age The fut ur es cont r act is overpriced if t he act ual m ark et pr ice is gr eat er t han t he no- arbit rage price

When t he fut ur es price is t oo low ( w hich present s a pr ofit able ar bit rage oppor t unit y )
Sell t he asset short
At t he init iat ion of t he cont ract Lend t he short sale pr oceeds at m arket int er est rat es
Rev erse cash- and- car ry arbit rage
St eps Buy ( go long) t he fut ur es cont r act at t he m ar k et price

Collect t he loan proceeds

At cont r act expir at ion
Tak e deliv er y of t he asset for t he fut ures pr ice and cov er t he shor t sale com m it m ent

48. Futures Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 Any posit ive cost s associat ed wit h st oring or holding t he asset in a cash and car r y ar bit r age will incr ease t he no- ar bit r age fut ur es pr ice
E.g., Financial asset s: no st orage cost s ot her t han t he opport unit y cost of t he funds
A m onet ar y benef it fr om holding t he asset
will decr ease t he no- arbit r age fut ur es pr ice
Convenience yield: The ret ur n fr om non- m onet ar y benefit s which com e fr om holding an asset in shor t supply
M ON ETARY AN D N ON M ON ETARY
BEN EFI TS AN D COSTS ASSOCI ATED W I TH
H OLDI N G TH E UN DERLYI N G ASSET AN D net cost s ( NC) = st orage cost s - convenience yield
The no- ar bit r age fut ur es pr ice count ing net cost s
TH EI R EFFECTS TO FUTU RES PRI CE FV (NC) = fut ur e value, at cont r act ex pir at ion, of t he net cost s of holding t he asset

NB = yield on t he asset + convenience yield

The no- ar bit r age fut ur es pr ice count ing net benef it s
FV (NB) = fut ur e value, at cont r act ex pir at ion, of t he net benef it s of holding t he asset

r efer s t o a sit uat ion wher e t he fut ur es pr ice is below t he spot pr ice

Backw ar dat ion t o occur , t her e m ust be a significant benef it t o holding E. g. , benefit s t o holding t he asset t hat offset t he oppor t unit y cost of
t he asset , eit her m onet ar y or non- m onet ar y holding t he asset ( t he r isk- fr ee r at e) and addit ional net holding cost s

Backwar dat ion and cont ago

r efer s t o a sit uat ion wher e t he fut ur es pr ice is above t he spot pr ice
Cont ango
happens when t her e is no benef it s t o holding t he asset , t he fut ur es pr ice will be

The fut ur es pr ice m ight be t em porar ily above or below expect ed f ut ur e

spot pr ices, but it would be an unbiased pr edict or of fut ur e spot r at es
I f bot h par t ies t o a fut ur es t r ansact ion ar e hedging exist ing r isk,
t he fut ur es pr ice m ay be equal t o expect ed f ut ur e spot pr ices

happens when t he fut ur es pr ice is lower t han t he expect ed pr ice in t he fut ur e t o com pensat e t he fut ur e buyer for accept ing asset pr ice r isk
Nor m al backwar dat ion

happens when t he fut ur es pr ice is gr eat er t han t he ex pect ed spot pr ice

Nor m al cont ango
The m ost likely sit uat ion in financial m ar ket s is nor m al backwar dat ion
sim ilar t o a forwar d r at e agr eem ent t o lend US$1,000,000 for t hr ee m ont hs beginning on t he cont r act set t lem ent dat e
TH E RELATI ON BETW EEN
FUTURES PRI CES AN D based on 90- day LI BOR, which is an add- on yield
EX PECTED SPOT PRI CES Eur odollar
t he pr ice quot es ar e calculat ed as ( 100 - annualized LI BOR in per cent )
t he m inim um pr ice change is one "t ick," which is a pr ice change of 0.0001 = 0.01 %

t r aded for T- bonds wit h a m at ur it y of 15 year s or m or e

t he cont r act is deliver able wit h a face value of $100, 000
Tr easur y Bonds
Eur odollar , Tr easur y Bonds, St ock T- bond fut ur es ar e quot ed as a per cent and fr act ions of 1 % ( m easur ed in 1/ 32nds) of face value
4 8 . Fu t u r e s M a r k e t s I ndex, and Cur r ency Fut ur es
each bond is given a conversion fact or ( m ult iplier ) t hat is used t o adj ust t he long's paym ent at deliver y
a nd Cont r a ct s - Pa r t 2 based on t he level of an equit y index
St ock index fut ur es m ost popular st ock index fut ur e is t he S&P 500
set t lem ent is in cash and is based on a m ult iplier of 250

Cur r ency Fut ur es I n t he Unit ed St at es, cur r ency cont r act s t r ade on t he eur o, Mexican peso, and y en, am ong ot her s

Tr easur y bill ( T- bill) fut ur es cont r act s ar e based on a $1 m illion face value 90- day ( 13-week) T- bill, and t hey set t le in cash
The pr ice quot es ar e 100 m inus t he annualized discount in per cent on t he T- bills
Tr easur y Bill Fut ur es Pricing
T- bill fut ur es ar e pr iced using t he no- ar bit r age pr inciple

Eur odollar f ut ur es are pr iced as a discount yield, and LI BOR- based deposit s are pr iced as an add- on yield
= > The r esult is t hat t he deposit value is not per fect ly hedged by t he Eur odollar cont r act
= > Eur odollar fut ur es can't be pr iced using t he st andar d no- arbit r age fr am ewor k
Eur odollar fut ur es

The no- ar bit r age fut ur es pr ice for a T- bond cont r act
FVC: t he fut ur e value of t he coupon paym ent s
The fut ur es pr ice t hat insures a cash- and- carr y ar bit r age would pr ovide no pr ofit is lower t han
Tr easur y Bond Fut ur es wit hout t he cash flows Because t he cost t o hold t he asset is r educed by t he asset cash f lows

T- bond fut ur es pr ices m ust be adjust ed t o confor m t o t he pr ice for

t he bond t hat is cheapest t o deliver , using it s conversion fact or ( CF)

The no- ar bit r age fut ur es pr ice adj ust ed for t he fut ur e value of
t he dividends ( FVD) or pr esent value of t he dividends ( PVD)
PRI CI N G EUROD OLLAR FUTURES,
St ock fut ur es
TREASURY BON D FUTURES, STOCK
I N D EX AN D CURREN CY FUTURES

The no- ar bit r age fut ur es pr ice

Equit y I ndex Fut ur es

The pr ice of cur r ency fut ur es DC = dom est ic cur r ency

Cur r ency Fut ur es FC = f oreign cur r ency

I n cont inuous t im e it is

48. Futures Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 AM ERI CAN / EUROPEAN OPTI ON S ON FUTURES AN D FORW ARD S PUT- CALL PARI TY FOR EUROPEAN OPTI ON S
AN D APPROPRI ATE PRI CI N G M OD EL FOR EUROPEAN OPTI ON S

SYN TH ETI C CALL/ PUT OPTI ON , BON D AN D UN D ERLYI N G STOCK

PUT- CALL PARI TY FOR FORW ARD / FUTURES OPTI ON S

ON E- AN D TW O- PERI OD BI N OM I AL M OD ELS TO
TH E H I STORI CAL AN D I M PLI ED 4 9 . Opt ion M a r k e t s a nd CALCULATE AN D I N TERPRET PRI CES OF I N TEREST
VOLATI LI TI ES OF AN UN D ERLYI N G ASSET RATE OPTI ON S AN D OPTI ON S ON ASSETS
Cont r a ct s: An Ove r vie w

EFFECT OF TH E UN D ERLYI N G ASSET'S CASH ASSUM PTI ON S UN D ERLYI N G TH E

FLOW S ON TH E PRI CE OF AN OPTI ON BLACK- SCH OLES- M ERTI ON M OD EL

TH E D ELTA OF AN OPTI ON AN D A CH AN GE I N TH E VALUE OF EACH I N PUT AFFECTS TH E OPTI ON

I TS USE I N DYN AM I C H EDGI N G PRI CE ( UN D ER TH E BLACK- SCH OLES- M ERTI ON M OD EL)

49. Option Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 A lon g posit ion in a European call opt ion w it h an ex ercise price of X t hat m at ures in T year s on a st ock ( wit h a price at t im e t of S t)

A long posit ion in a pur e- discount risk less bond t hat pay s X in T y ear s

A fidu ciar y call

PUT- CALL PARI TY FOR EUROPEAN OPTI O N S

A long posit ion in a European put opt ion wit h an ex ercise price of X t hat m at u res in T y ear s
A long posit ion in t he underly ing st ock

A pr ot ect iv e put

That t h e cost of a fiduciary call m ust be equal t o t he cost of a prot ect iv e up

Put - call par it y for Eu r opean opt ions

+ : long posit ion
- : short posit ion

Bu y ing a European put opt ion on t he sam e st ock wit h t he sam e ex ercise price ( X) an d t he sam e m at u rit y ( T)
A sy nt het ic Eur opean Buy ing t he st ock
call opt ion is form ed by Shor t ing (i.e., borr ow ing) t he present v alue of X wort h of a pur e- discount risk less bond

Buy ing a Eur opean call opt ion

A sy nt het ic Eur opean
put opt ion is form ed by
SYN THETI C CALL/ PUT OPTI ON,
BON D AN D U N D ERLYI N G STOCK
A sy nt het ic st ock
posit ion is form ed by
Sh ort ing t he st ock
Buy ing ( i.e., inv est ing in) t he discount bond
Buy ing a Eur opean call opt ion
Shor t ing (i.e., wr it ing) a European put opt ion
Buy ing ( i.e., inv est ing in) t he discount bond

Buy ing a European put opt ion

A sy nt het ic pur e- discount Buy ing t he st ock
riskless bond is creat ed by
Shor t in g ( i.e., wr it in g) a Eur opean call opt ion

To price opt ions by using com binat ions of ot her inst r um ent s w it h k now n prices
Two r easons t o cr eat e sy nt het ic
posit ions in t h e secu r it ies To ear n ar bit r age pr ofit s by ex ploit ing r elat ive m ispr icing am ong t he four secur it ies

I f put - call par it y doesn't hold ( if t he cost of a fiduciar y call does not equal t he cost of a prot ect iv e
put ) , buy ( go lon g in) t he u nder priced posit ion an d sell (go shor t ) in t h e ov erpriced posit ion
Using put - call par it y for ar bit r age

D = r isk - neut ral probabilit y of an down - m ove = 1 - U

Rf = r isk - free r at e
U = size of an up- m ov e
D = size of a down- m ove
Calcu lat ing t he pay off of t h e opt ion at m at urit y
in bot h t he up-m ove an d dow n- m ove st at es
Calcu lat e t he v alue of
On e- Per iod Binom ial Model Calcu lat ing t he ex pect ed value of t h e opt ion in one y ear as
an opt ion on t he st ock
t he probabilit y- weight ed av erage of t h e pay offs in each st at e
Discount ing t he ex pect ed value back t o t oday at t h e risk - free rat e

pr ovides t he infor m at ion r equir ed t o calculat e a hedge r at io

Ar bit r age w it h one- per iod ( t he fr actional shar e of st ock in t he ar bit r age t r ade)
binom ial m odel

Calcu lat e t he st ock v alues at t he end of t wo per iods (t here ar e t hree possible ou t com es
4 9 . Opt ion M ar ke t s because an up-t hen- down m ove get s y ou t o t h e sam e place as a dow n- t hen- up m ov e)
a n d Con t ra ct s - Pa rt 1 Calcu lat e t hree possible opt ion pay offs at t he end of t wo per iods
Calcu lat e t he ex pect ed opt ion v alues at t he end of t wo
per iods ( t = 2) using t h e up- and dow n- m ov e pr obabilit ies
St eps t o v alue
ON E- AN D TW O- PERI OD BI N OM I AL Discou nt t he ex pect ed opt ion v alues ( t = 2) back on e per iod at t he risk - free
M OD ELS TO CALCU LATE AN D an opt ion
Two-Period Binom ial Model rat e t o find t he opt ion v alues at t he end of t he first per iod (t = 1 )
I N TERPRET PRI CES OF I N TEREST RATE
OPTI ON S AN D OPTI ON S ON ASSETS Calcu lat e t he ex pect ed opt ion v alue at t h e end of one
per iod ( t = 1) using up- and dow n- m ov e pr obabilit ies
Discou nt t he ex pect ed opt ion v alue at t h e end of one per iod (t = 1 )
back on e per iod at t he risk - free rat e t o find t he opt ion v alue t oday

is t he set of possible int erest r at e pat hs t h at are used t o v alue bonds wit h a binom ial m odel
t he v alues for on- t he-r un issues
Binom ial int er est gener at ed using an int er est r at e t r ee t he int er est r at e t r ee m ust m aint ain t he int er est
r at e t r ees t he underly ing r ule gov erning t he sh ould pr ohibit ar bit r age oppor t u nit ies rat e v olat ilit y assum pt ion of t h e under lying m odel
const r uct ion of an int er est r at e t r ee

pr ice t he bond at each node using pr oj ect ed int er est r at es

There ar e t hree basic st eps t o v aluing an opt ion
on a fix ed-incom e inst r um ent using a binom ial t r ee calculat e t he int rinsic v alue of t h e opt ion at each node at m at urit y of t h e opt ion, and
Opt ion s on Fixed calculat e t he v alue of t h e opt ion t oday
I ncom e Secur it ies

The v alue of an int erest r at e cap or floor is t he sum of t he v alues of t h e indiv idual caplet s or floorlet s

Opt ions on I n t er est Rat es: Ex pirat ion v alue of caplet

Caps and Floor s

Ex pirat ion v alue of floor let

As t h e per iod cov er ed by a binom ial m odel is div ided in t o ar bit r ar ily sm all, discr et e t im e per iods, t he m odel r esu lt s conv er ge t o t h ose of t he cont in uou s- t im e m odel

The Black -Scholes- Mert on ( BSM) m odel v alues opt ions in cont inuous t im e and is deriv ed fr om t he sam e no- arbit r age assum pt ion used t o v alue opt ions wit h t he binom ial m odel
To deriv e t h e BSM m odel, an " inst an t an eou sly " risk less por t folio is used t o solv e for t he opt ion price based on t he sam e logic
The price of t he under lying asset follows a lognorm al dist r ibut ion
The (cont inuous) r isk -fr ee
r at e is const ant and k now n Lim it at ion : The BSM m odel is not u seful for pricing opt ion s on bond prices and int erest r at es

Th e v olat ilit y of t h e under ly ing I n pract ice, t he v olat ilit y is not k now n an d m ust be est im at ed. The bigger problem is t h at
asset is const ant and k nown v olat ilit y is oft en not const ant ov er t im e and t he BSM m odel is not u seful in t hese sit uat ion s

Assum pt ions and Lim it at ions Mar ket s ar e " fr ict ionless" Model is less r ealist ic and less useful

The BSM m odel can be easily alt ered if we relax t he

The under lying asset gen erat es no cash flows assum pt ion of n o cash flows on t he under lying asset

The m odel does n ot correct ly price Am erican opt ions. Binom ial opt ion
The opt ions ar e Eur opean pr icing m odels ar e m or e appr opr iat e for pr icing Am er ican opt ions

ASSU M PTI ON S U N D ERLYI N G THE

BLACK- SCH OLES- M ERTI ON M ODEL

The for m ula for t h e BSM m odel

Use put - call par it y t o calculat e t he put value

49. Option Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
 A Gr eek is a sensit iv it y fact or t hat capt ur es t he r elat ionship bet w een each input (asset
price, asset price v olat ilit y, t im e t o ex pirat ion, and t he risk- free rat e) t he opt ion price

Delt a descr ibes t he r elat ionship bet w een asset pr ice and opt ion pr ice

Vega m easur es the sensit iv it y of the opt ion pr ice t o changes

in the v olat ilit y of r et ur ns on the under ly ing asset

A CH AN GE I N TH E V ALU E OF
EACH I N PU T AFFECTS THE
OPTI ON PRI CE ( U N D ER TH E
BLACK- SCH OLES- MERTI ON
MOD EL)

Rho m easur es t he sensit iv it y of t he opt ion pr ice t o changes in t he r isk -fr ee r at e

Ther e is a benefit t o ear ly ex er cise of opt ions on fut ur es w hen t hey ar e deep in t he m oney t het a is less than zer o: as t im e passes and t he opt ion
Ex er cising t he opt ion (eit her a put or call) ear ly w ill gener at e cash fr om t he m ar k t o m ar k et = > cash can ear n appr oaches t he m at ur it y dat e, it s v alue decr eases
Am er ican opt ions on futur es ar e m or e v aluable
int er est , w hile t he fut ur es position w ill gain or lose fr om m ov em ent s in t he fut ur es pr ice = > t hese pr ice t han com par able Eur opean opt ions because
m ov em ent s bet w een ear ly ex er cise and opt ion ex pir ation w ill m ir r or t hose of t he deep in t he m oney opt ion

Ther e is no m ar k t o m ar k et on for w ar ds, ear ly ex er cise does not acceler ate t he pay m ent of any gains
With no r eason for ear ly ex er cise, the v alue of Am er ican
and Eur opean opt ions on for w ar ds ar e t he sam e
Thet a m easur es t he sensit iv it y of t he opt ion pr ice t o t he passage of t im e
AMERI CAN / EU ROPEAN OPTI ON S
ON FU TU RES AN D FORW ARD S
AN D APPROPRI ATE PRI CI N G
MOD EL FOR EU ROPEAN OPTI ON S

The Black m odel can be used t o pr ice Eur opean opt ions on for w ar ds and fut ur es

= st andar d dev iat ion of r et ur ns on t he fu t ur es cont r act

F T = futur es pr ice

PU T- CALL PARI TY FOR

Put- call par ity for opt ions on for w ar ds and futur es is as follow s FORW ARD / FU TU RES OPTI ON S
Am er ican opt ions on fut ur es ar e m or e v aluable t han Eur opean opt ions because ear ly ex er cise pr ov ides m ar k t o m ar k et funds on the fut ur es, w hich can ear n int er est
4 9 . Op t ion M a r k e t s
Am er icans and Eur opean opt ions on for w ar d cont r act s ar e equiv alent because ther e is no m ar k t o m ar k et
a nd Con t r a ct s - Pa r t 2

St ep 1: Conv er t a tim e ser ies of N pr ices to r etur ns

St ep 2: Conv er t t he r et ur ns t o Delt a is t he change in t he pr ice of an opt ion for a one-unit change in t he pr ice of t he under ly ing secur it y C = change in t he pr ice of the call ov er a shor t t im e int er v al
cont inuously com pounded r et ur ns S = change in t he pr ice of t he under ly ing stock ov er a shor t t im e inter v al
The steps in com put ing histor ical v olat ilit y for use as an TH E H I STORI CAL AN D C N( d1) x S
input in t he BSM cont inuous-t im e opt ions pr icing m odel ar e I M PLI ED V OLATI LI TI ES OF P ( change in put pr ice) [ N( d1) - 1] x S
AN U N D ERLYI N G ASSET Use BSM m odel t o estim at e t he change in the v alue of the call
giv en t he change in t he v alue of t he st ock and the opt ion's delt a

St ep 3: Calculat e t he v ar iance and st andar d

dev iat ion of t he continuously com pounded r et ur ns

w hen used in t he Black -Scholes for m ula, it pr oduces t he cur r ent m ar k et pr ice of t he opt ion I m plied v olat ilit y is t he v alue for st andar d dev iat ion of cont inuously com pounded
r ates of r etur n that is "im plied" by the m ar k et pr ice of the opt ion

Decr ease the v alue of a call opt ion

I ncr ease the v alue of a put opt ion All else equal, the ex ist ence of cash flow s on t he under ly ing asset w ill
EFFECT OF THE U N D ERLYI N G
ASSET' S CASH FLOW S ON
THE PRI CE OF AN OPTI ON

Put -call par it y for opt ions on under ly ing asset s w it h cash flow s by adj ust ing S for t he pr esent v alue of the cash flow s (PVCF)
A call opt ion delt a is bet w een
0 and 1. I f the call opt ion is
I nt er pr et ing Delt a
A put opt ion delt a is bet w een
Out - of- t he- m oney ( st ock pr ice is less t han ex er cise pr ice) , t he call delt a m ov es
closer t o 0 as t im e passes, assum ing t he under ly ing st ock pr ice doesn't change
I n-t he-m oney (st ock pr ice is gr eat er t han ex er cise pr ice), t he call delt a m ov es
closer t o 1 as t im e passes, assum ing t he under ly ing st ock pr ice doesn't change
Out - of- t he- m oney ( st ock pr ice is gr eat er t han ex er cise pr ice) , t he put delt a m ov es
closer t o O as t im e passes, assum ing t he under ly ing st ock pr ice doesn't change

TH E DELTA OF AN OPTI ON AN D - 1 and 0. I f t he put opt ion is I n-t he-m oney (st ock pr ice is less t han ex er cise pr ice), t he put delt a m ov es
I TS USE I N D YN AM I C H ED GI N G closer t o -1 as t im e passes, assum ing t he under ly ing st ock pr ice doesn't change

The goal of a delt a- neut r al por t folio ( or delt a- neut r al hedge) is t o com bine a long posit ion in a st ock wit h a shor t
posit ion in a call opt ion so t hat t he v alue of t he por t folio does not change w hen t he v alue of t he st ock changes
Num ber of call opt ions needed t o delt a hedge = num ber of shar es hedged/ delt a of call opt ion
Num ber of put opt ions needed t o delt a hedge = num ber of shar es/ delt a of t he put opt ion
Dy nam ic Hedging
The delt a-neut r al posit ion only holds for v er y sm all changes in t he v alue of t he under ly ing st ock
costly in ter m s of tr ansaction costs
= > m ust be cont inually r ebalanced t o m aint ain t he hedge ( a dy nam ic hedge)

can be v iew ed as a m easur e of how poor ly a dy nam ic hedge w ill per for m
Gam m a m easur es t he r at e of change in delt a as t he under ly ing st ock pr ice changes w hen it is not r ebalanced in r esponse t o a change in t he asset pr ice

Call and put opt ions on t he sam e under ly ing asset w it h t he sam e ex er cise pr ice and t im e t o m at ur it y w ill hav e equal gam m as
Long posit ions in calls and puts hav e posit iv e gam m as
Gam m a is lar gest w hen a call or put opt ion is at -t he-m oney and close t o ex pir at ion

Gam a effect

49. Option Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
To be continued…
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