2023 CFA L2 Book 3 Equity FI Derivatives AI

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FinTree
JuiceNotes 2023
Equity | Fixed Income| Derivatives

| Alternative Investments
Chartered Financial Analyst - Level II
INDEX
Equity Valuation
Name of Reading
1 Equity Valuation: Applications and Processes 6
2 Return Concepts 9
3 Industry And Company Analysis 13
4 Discounted Dividend Valuation 17
5 Free Cash Flow Valuation 22
6 Market-Based Valuation:Price And Enterprise Value Multiples 25
7 Residual Income Valuation 31
8 Private Company Valuation 35
Fixed Income
Name of Reading
9 The Term Structure And Interest Rate Dynamics 41
10 The Arbitrage-free Valuation Framework 50
11 Valuation And Analysis: Bonds With Embedded Options 55
12 Credit Analysis Models 62
13 Credit Default Swaps 66
Derivatives
Name of Reading
14 Pricing and valuation of forward commitments 71
15 Valuation of contingent claims 78
Alternative Investments
Name of Reading
16 Real Estate Investments 85
17 Private Equity Investments 94
18 Introduction to commodities and commodity derivatives 99
Equity Valuation
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1
Equity Valuation: Applications and Processes

LOS a
Valuation: Estimation of an asset's value based on certain variables
Intrinsic Value: Value of an asset given a hypothetically complete
understanding of the asset's investment characteristics
Steps in valuation process

Step 1: Understand the business
Step 2: Forecast company performance
Step 3: Select the appropriate valuation model
Step 4: Convert forecasts to a valuation
Step 5: Apply the valuation conclusions
Sources of perceived mispricing

VE – P = (V – P) + (VE – V)
Estimated Intrinsic Valuation

value value error
Market price
Mispricing: Difference between market price and estimated intrinsic value
Eg. Estimated value: $200 Intrinsic value: $150 Market price per share: $125
VE – P = (V – P) + (VE – V)
200 – 125 = (150 – 125) + (200 – 150)
75 = 25 + 50
LOS b & c
Going Liquidation Fair market Investment

concern value value value value
Value of a company if Price at which an

Value of a company it were to be asset would change
Value to a specific
under going concern dissolved and its hands between a
buyer
assumption assets were to be willing buyer and a
sold individually willing seller
Most relevant value for public company valuation: Intrinsic value

Most relevant value for acquisition decision: Investment value
6
LOS d Applications of equity valuation
èSelecting stocks èEvaluating business strategies and models
èInferring market expectations èCommunicating with analysts and shareholders
èEvaluating corporate events èValuation of private business
èRendering fairness opinions èShare-based payment
LOS e Industry and competitive analysis
Porter’s strategies for achieving

Porter’s five forces
above-average performance
Œ Rivalry among existing competitors

Œ Cost leadership
Threat of entry
Product differentiation
Ž Threat of substitutes
Ž Focus
Power of buyers
Power of suppliers
Quality of earnings analysis: Includes scrutiny of financial

statements to evaluate both sustainability and accuracy
Factors that may signal possible future negative surprises

Poor quality of accounting disclosures Material non audit services performed by audit firm
Existence of related-party transactions Changes in auditors
Existence of excessive employee loans Management compensation tied to profitability
High management turnover Loss of market share
Excessive pressure on company to make revenue or Management pressure to meet debt covenants
earnings targets
A history of reporting violations
LOS f
Absolute valuation models Relative valuation models
Models that specify an asset’s

intrinsic value Asset’s value is estimated in
relation to that of another asset
Eg. PV (DCF) model, DDM,
FCFE/FCFF model, Residual Typically implemented using
income model, Bond valuation price multiples such as P/E
and Asset-based valuation
Both models incorporate going concern assumption
7
LOS g
SOTP valuation: Valuation done by adding the estimated values of each of
company’s businesses as if they were independent
Sum-of-the-parts value is also called as breakup value/private
market value
Most useful when the company operates in different industries
Conglomerate discount: Investors apply a discount to a company’s stock that operates

in different unrelated industries compared to a company’s
stock that operates in a single industry
Explanations for conglomerate discount:
Inefficiency of internal capital markets (ineffective capital allocation)
Endogenous factors (to hide poor operating performance)
Research measurement errors (conglomerate discounts do not

actually exist, but they are a result of incorrect measurement)
LOS h Criteria for choosing an appropriate

approach for valuing a company
Valuation model must be consistent with the characteristics of the company being valued
(Dividend paying, intangible assets etc.)
Valuation model must be appropriate based on availability and quality of data
Valuation model must be consistent with the purpose of valuation

(Controlling interest: FCF, Minority interest: DDM)
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8
Return Concepts
LOS a
Realized holding period return: Return based on past prices and cash flows
Expected holding period return: Return based on forecasts of future prices and cash flows
Required return: Minimum return an investor requires given the asset’s risk
Discount rate: Rate used to find PV of FCF
Internal rate of return: Rate that equates PV of FCF to asset’s price
Expected alpha (ex ante alpha) = Expected return − Required return
Actual alpha (ex post alpha) = Actual return − Contemporaneous required return
Return from convergence of price to intrinsic value

V0 − P0
Expected return = Required return +
P0
LOS b Equity risk premium
Historical estimate Forward-looking estimate
Gordon growth Macroeconomic Survey

model model estimates
Ibbotson-Chen
ERP estimate:
GGM ERP model ERP
estimate: estimate:
Average return on
broad-market
[(1 + expected
equity index –
RFR ) )
D1
P0
+g – RFR inflation) × (1 +
expected growth
rate in real EPS) ×
Asking experts
what they expect
the ERP to be
Using AM instead
(1 + expected
of GM and/or
RFR: Long-term growth rate in
T-bills instead of
government bond P/E) – 1] +
T-bonds will result
yield Expected income
in upward bias
– Expected RFR
ª Issues with historical estimates: They make the assumption of stationarity and are
affected by survivorship bias
ª An issue with GGM is that it makes the assumption of stable growth rate of
earnings, dividends and prices
ª Macroeconomic models are more reliable when public equities represent a large
portion of the economy (seen in developed countries). They are also called supply-
side models
ª There can be a wide disparity between estimates obtained in surveys

9
LOS c Required return on equity investments
Capital asset pricing

Multifactor models Build-up method
model (CAPM)
Required return:
RFR + (β × ERP)
Required return for private
Unadjusted/regression beta: companies:
Estimated using ordinary RFR + ERP + Size premium +
least squares regression line Specific company premium
Actual values of beta Required return for public

estimates are influenced by companies (Bond yield + risk
these two choices: premium approach):
Index used to represent the YTM of the bond + Risk
market portfolio and; premium
The length of data period and
frequency of observations
Arbitrage pricing Fama–French Macroeconomic/

theory (APT) model BIRR model
Required return:
A set of risk premiums
RFR + (βRMRF × RMRF) Confidence risk
are added to the RFR
+ (βSMB × SMB) Time horizon risk
+ (βHML × HML) Inflation risk
Risk premium:
Business cycle risk
Factor beta × Factor
Baseline values: Market timing risk
risk premium
βRMRF: 1, βSMB & βHML: 0
SMB: Return on small cap must be greater than return on large cap
HML: Return on value stock must be greater than return on growth stock
Pastor-Stambaugh model: It adds a liquidity factor (baseline value: 0) to the Fama-French model
LOS d Beta estimation

For public companies
Adjusted beta = (2/3)(Unadjusted beta) + (1/3)(1)
For thinly traded stocks and nonpublic companies
(Unlever) (Relever)
Beta of a comparable Project beta
Asset beta
company Divide Multiply (Equity beta)
D/E of D/E of
comparable our
company company
1 + D/E (1 − t)
10
LOS e Strengths and weaknesses of methods used to
estimate the required return on equity investments
Model Strengths Weaknesses
Ÿ Choosing the market

CAPM Ÿ Simple to calculate index
Ÿ Low explanatory power
Ÿ Higher explanatory
Multifactor models Ÿ Complex and expensive
power
Ÿ They are simple

Ÿ Use of historical values
Build-up models Ÿ Can be used for closely
as estimates
held companies
LOS f International considerations in required return estimation
Two main issues that concern an analyst:

Exchange rates, and
Data and model issues in EM
Two approaches to calculate ERP:

Country spread model: ERP = ERP for developed markets + Country premium
Country risk rating model: Regression based estimate of ERP based on
developed market equity return and risk ratings
LOS g Weighted average cost of capital
Capital Component cost Weighted

Amount Weight
component (effective) average
Equity 1000 20% 20% 4%
Preferred stock 2000 15% 40% 6%
Debt 2000 10% 40% 4%
Total 5000 100% 14%
Marginal cost of capital = Weighted average cost of capital WACC
LOS h Appropriateness of using a particular rate of return

CF Discount rate
FCFF WACC
FCFE Ke
Nominal CF Nominal rate

Real CF Real rate
11
12
Industry And Company Analysis

LOS a
Top-down analysis Bottom-up analysis Hybrid analysis
Macro analysis
Micro analysis
Combines elements of
Eg. Revenue forecasted
Eg. Revenue forecasted both top-down and
based on relationship
based on historical bottom-up analysis
b/w GDP growth and
revenue growth
revenue growth
LOS b
Growth relative to GDP growth Market growth and market share
GDP growth % + x%
Œ Estimate industry sales (market
Eg. Expected GDP growth is 5% growth)
& company’s revenue will grow
15% faster Estimate company’s revenue as
= Forecasted company’s growth a percentage of industry sales
rate = 5 + 15% = 5.75% (market share)
LOS c Evaluate whether economies of scale are present in an industry

ª Economies of scale: A situation in which average costs per unit of good
fall as volume rises
ª Company with economies of scale will have lower COGS and SGA, and
higher operating margins as production volume increases
ª Sales volume and gross and operating margins are positively correlated
LOS d Forecasting COGS, SGA, financing costs, depreciation and income taxes
COGS: Forecasted as a % of sales
SGA: Forecasted as a % of sales
Financing cost: Forecasted using debt level and interest rate
Depreciation: Forecasted using depreciation schedule and historical depreciation
Income taxes: Forecasted using effective rate (Tax expense/PBT)
LOS e Balance sheet modeling

Accounts receivable: Forecasted sales/ARTR
Inventory: Forecasted COGS/ITR
PPE: Based on analyst’s judgement
Capital structure: Forecasted using leverage ratios. However
historical company practice, management's
financial strategy, and capital needs in the
future should also be considered
13
ª Maintenance capital expenditure: Expenditure necessary to sustain current business
ª Growth capital expenditure: Expenditure necessary to expand the business
ª Maintenance capital expenditure forecasts should normally be higher than depreciation

because of inflation
ª Analyst should use sensitivity analysis or scenario analysis to estimate the effect of
changes in assumptions on company's valuation
LOS f Relationship between ROIC and competitive advantage
Return on invested NOPLAT EBIT − Actual taxes

=
capital (ROIC) Invested capital Operating assets − Operating liabilities
Return on capital Operating profit

=
employed (ROCE) Debt + Equity
ª ROIC is a return to both equity and debt holders
ª It is a better measure of profitability than ROE because it allows comparison across

firms with different capital structures and tax rates
ª ROEC is suitable for comparison of companies with different tax rates
ª High ROIC is a sign of competitive advantage
LOS g Effect of competitive factors on prices and costs

Revenue growth, profitability, WC investment, capital expenditure are all
based on an estimate of company’s future competitive strength
LOS h Effect of competitive factors on prices and costs
Œ Rivalry among existing competitors: Low intensity of rivalry → More pricing power
Threat of entry: Low threat of new entrants → More pricing power
Ž Threat of substitutes: Few substitutes → More pricing power
Power of buyers: Low bargaining power of buyers → More pricing power
Power of suppliers: Low bargaining power of suppliers → More pricing power
LOS i Forecasting industry and company sales and costs

when they are subject to price inflation or deflation
Increasing prices because of inflation can decline sales volume in the short-term. The decline
depends on price elasticity of demand, reaction of competitors and availability of substitutes
Analyst should incorporate price fluctuations more slowly for a company that
uses forward contracts or derivatives to hedge the risk of increase in costs
Each item of cost should be forecasted by making an

assessment about impact of potential inflation/deflation
Vertically integrated company’s profitability will be less subjected to
fluctuation in input prices
14
LOS j Effects of technological developments on
demand, selling prices, costs, and margins
When a technological development results in a new product that could

cannibalize an existing product, analyst should use a cannibalization factor
to estimate its impact on future demand
When technological development results in lower manufacturing costs, the

supply curve shifts to the right
When technological development results in substitute products, the

demand curve shifts to the left
LOS k Considerations in the choice of an explicit forecast horizon
LOS m Sales-based pro forma company model

Step 1: Forecast revenue
Step 2: Forecast COGS
Step 3: Forecast SGA
Step 4: Forecast financing costs
Step 5: Forecast income tax expense
Step 6: Model the B/S
Step 7: Construct pro forma CF statement
using pro forma I/S and B/S
After forecasting financial statements, analyst estimates a terminal value

It is estimated using relative valuation approach or DCF approach
Multiple used should be consistent with the long-run growth rate and required return
Determine whether terminal free CF needs to be normalized
Determining how future long-term growth rate will differ from historical growth rate
Analyst should also take inflection points such economic environment, business cycle
stage, regulation and technology into consideration
LOS l Analyst’s choices in developing projections

beyond the short-term forecast horizon
ª Investment strategy: For most professionally managed equity accounts forecast horizon is
simply the average holding period for a stock (eg. forecast horizon of portfolio with 25%
turnover will be 4 years)
ª Cyclicality of the industry: Forecast horizon should be long enough to allow the business to
reach an expected mid-cycle level of sales and profitability
ª Company specific factors: In case of recent M&A or restructuring activities, forecast horizon
should be long enough to reflect expected benefits that can be realized
ª Employer’s preferences: Forecast horizon is specified by the analyst’s employer
15
16
Discounted Dividend Valuation

LOS a Inputs to DCF models
Dividends FCF Residual income
Suitable when:
Suitable when:
Company is not dividend-paying
Suitable when:
Company is dividend-paying, or or is dividend-paying but
dividends significantly differ
Company is not dividend-paying,
Dividend policy has consistent from FCFE, or
or
relationship with profitability, or
FCFs align with profitability, or
Expected FCFs are −ve
Asset is valued from minority
shareholder’s perspective Asset is valued from controlling
shareholder’s perspective
LOS b Dividend discount model (DDM)

D1 P1
One-year holding period DDM = +
(1 + Ke)1 (1 + Ke)1
D1 D2 P2
Two-year holding period DDM = 1
+ 2
+
(1 + Ke) (1 + Ke) (1 + Ke)2
Eg. P1 = 15 P2 = 21 D0 = 1.5 Expected dividend growth = 5% Required rate of return = 13.5%

D1 1.5 × (1 + 0.05) 1.575
One-year holding period DDM: 1
= = = 1.39
(1 + Ke) (1 + 0.135)1 1.135
+ P1 15 15
= = = 13.215
(1 + Ke)1 (1 + 0.135)1 1.135
14.605
D1 1.5 × (1 + 0.05) 1.575

Two-year holding period DDM: 1
= = = 1.39
(1 + Ke) (1 + 0.135)1 1.135
+
D2 1.5 × (1 + 0.05)2 1.65
= = = 1.28
(1 + Ke)2 (1 + 0.135)2 1.288
+ P2 21 21
= = = 16.3
(1 + Ke)2 (1 + 0.135)2 1.288
18.97
17
LOS c & d Gordon growth model
Eg. Expected dividend growth (For 4 years) = 20% Expected dividend growth (after 4 years) = 5%
D0 = 2 Ke = 13% Calculate the value of stock
D0 = Given = 2
D1 = 2 × (1 + 0.02) = 2.4
D2 = 2.4 × (1 + 0.02) = 2.88
D3 = 2.88 × (1 + 0.02) = 3.456
D4 = 3.456 × (1 + 0.02) = 4.1472
D5 = 4.1472 × (1 + 0.05) = 4.3546
D5 4.3546
P4 = = = 54.43
Ke - g 0.13 − 0.05
2.4 2.88 3.456 54.43 + 4.1472

Value of stock: + + + = 42.7
1.13 1.132 1.133 1.134
Assumptions of GGM:
Œ Dividends grow indefinitely at a constant rate, g (can be zero or −ve)
r > g
LOS e Present value of growth opportunities (PVGO)
Value of a stock
Value of the company without earnings Value of growth (PV of future

reinvestment (PV of perpetual CF) investment opportunities)
E1
PVGO
r
Justified P/E (V0/E1)
Value of P/E for no-growth Component of the P/E value

company that relates to growth
1 PVGO
r E1
Growth companies: High PVGO

Value companies: Low PVGO
18
LOS f Price-Earning multiple (P/E)
Based on fundamentals
Based on MPS
(justified)
Trailing Leading Trailing Leading
Po Po Vo Vo
E0 E1 E0 E1
D0(1 + g) / Ke − g D1/(Ke − g)
E0 E1
Payout ratio × (1 + g) Payout ratio

Ke − g Ke − g
LOS g Value of noncallable fixed-rate Dividend

perpetual preferred stock: Kp
LOS h Strengths and limitations of GGM

Strengths Limitations
Simple to use
Output is sensitive to changes in growth
rate and required rate of return
Appropriate for valuing dividend-paying
companies
Can be used to judge whether an equity

market is fairly valued or not It is characterized by single growth rate
but future growth can consist of
multiple stages
Can be used to estimate the ERP
LOS i Selection of model to value a company’s common shares

Two-stage Three-stage Spreadsheet
H-model
DDM DDM modeling
Supernormal growth Supernormal growth

Similar to Two-stage Used when it is
rate for few years rate declines linearly
DDM except there cumbersome to
followed by until it reaches
are three distinct describe models
sustainable growth sustainable growth
stages of growth using algebra
rate rate
19
LOS j
Growth phase Transitional phase Maturity phase
Company has high Growth in EPS declines,

profit margins, profit margins decline, Growth in EPS, profit
supernatural growth in +ve FCFE and dividend margins and dividend
EPS, −ve FCFE, and low payout ratio starts payout ratio stabilize
dividend payout ratio increasing
LOS k Terminal value
GGM Relative valuation
Forecated P/E ×
Vn = Dn + 1/Ke − g
forecasted earnings
LOS l & m Value of common shares
Two-stage DDM H-model Three-stage DDM
Supernormal growth rate D0 × (1 + gL) D0 × H × (gs − gL) Similar to Two-stage DDM

for few years followed by + except there are three
r − gL r − gL
sustainable growth rate distinct stages of growth
gL = Long-term growth rate H = Half life of supernormal growth period gs = Short-term growth rate
LOS n Spreadsheet modeling

ª Spreadsheet models are flexible, and analyst can use scenario analysis to see how changes in
dividends or interest rates affect valuation
ª Analysts are more likely to use spreadsheet models than two-stage/three-stage DDM or H-model
ª Because of the widespread use of spreadsheets, analysts can work together or exchange
information by sharing their spreadsheet models
LOS o Use of DuPont analysis to estimate a company’s sustainable growth rate
g = RR × ROE g = RR × Net profit margin × Asset turnover × Financial leverage ratio
20
LOS p Evaluate whether a stock is overvalued, fairly valued, or undervalued

ª If, MPS > Model price: Overvalued
ª If, MPS < Model price: Undervalued
ª If, MPS = Model price: Fairly valued
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21
Free Cash Flow Valuation

LOS a FCFF FCFE
CF available to the entire firm

(debt + stock holders)
CF available to equity shareholders
Value of the firm:
PV of future FCFF discounted @
Value of the firm’s equity:
WACC
PV of future FCFE discounted @ Ke
Value of the firm’s equity:
Chosen when the company has
Value of firm − Market value of debt
stable capital structure
Chosen when the company has −ve
FCFE or volatile capital structure
LOS b Ownership perspective in FCFE approach

ª Ownership perspective in FCFF/FCFE approach is a control perspective
ª Ownership perspective in dividend discount approach is a minority perspective
ª Analysts use FCF for valuation when:

Ÿ Company does not pay dividends, or
Ÿ Company pays dividends but they differ significantly from company's capacity to pay, or
Ÿ FCFs align with profitability within analyst’s forecasted period, or
Ÿ Investor takes control perspective
LOS c & d Calculation of FCFF and FCFE

FCFF
Using Net income Using EBIT Using EBITDA Using CFO
Net income EBIT × (1 − t) EBITDA × (1 − t) CFO
+ Interest × (1 − t) + Non cash charges + Depreciation × t + Interest × (1 − t)
+ Non cash charges ± WC investment ± WC investment ± FC investment
± WC investment ± FC investment ± FC investment
± FC investment
FCFE = FCFF − Interest (1 − t) ± Net borrowings
22
LOS e Approaches for forecasting FCFF and FCFE
Œ Applying historical growth rate to current FCF to forecast future FCF, or
Forecasting the components of FCF:

Forecasted FCFE = NI – [(1 – Debt ratio)(FC investment – Dep)] – [(1 – Debt ratio)(WC investment)]
LOS f Compare FCFE model and DDM

ª FCFE takes control perspective
ª DDM takes minority perspective
LOS g Impact of dividends, share repurchases, share

issues, and changes in leverage on FCFF and FCFE
There is no impact of dividends, share repurchases and share issues on FCFF and FCFE
Changes in leverage will have a small effect on FCFE (issuing new debt will increase
FCFE in current year and decrease forecasted FCFE in future years)
LOS h Use of net income and EBITDA as proxies for CF in valuation

EBITDA is a poor proxy for FCFF since
NI is a poor proxy for FCFE since it includes NCC it does not reflect cash taxes paid
Also, NI does not consider CFs that don’t appear on I/S It also ignores WC investment
(WC investment, FC investment and borrowings) and FC investment
LOS i & j FCF models
Single-stage Two-stage Three-stage
Value of firm: Stages of growth:

Supernormal growth rate
FCFFn × (1 + g) High growth period,
Vn = for few years followed by
WACC − g transitional period and
sustainable growth rate
stable growth period
Value of equity: Valuation is similar to
FCFEn × (1 + g) Valuation is similar to
Two-stage DDM
Vn = Three-stage DDM
Ke − g
LOS k Use of sensitivity analysis in FCFF and FCFE valuations

Two critical sources in valuation analysis
èGrowth rate and duration of growth: Growth in FCFF/FCFE depends on future profitability.
Future profitability depends on sales growth and NP margins. Sales growth and NP margins
depend on growth phase of the company and the profitability of the industry
èBase year values: Value of firm or value of equity will increase or decrease proportionately
with the base-year values used
23
LOS l Terminal value
GGM Relative valuation
Vn = Dn + 1/Ke − g Terminal value in

year n = Leading P/E
X earnings in year n+1
Or
Trailing P/E
X earnings in year n
LOS m Evaluate whether a stock is overvalued, fairly valued, or undervalued

24
Market-Based Valuation:
Price And Enterprise Value Multiples
LOS a Approaches to using price multiples in valuation
Method based on
Method of comparables
forecasted fundamentals
Valuation of stock is based on multiples Valuation of stock is based on forecasted

of similar companies fundamentals
Economic rationale: Economic rationale:

The law of one price (two similar assets Value used in the numerator is
should sell at the same price) derived from DCF model
Valuation is relative to similar companies Valuation is absolute
LOS b Justified P/E multiple
Trailing Leading
Vo Vo
E0 E1
D0(1 + g) / Ke − g D1/(Ke − g)
E0 E1
Payout ratio × (1 + g) Payout ratio

Ke − g Ke − g
25
LOS c & d Rationales and drawbacks of alternative price
multiples and dividend yield
P/B ratio P/S ratio
Advantages Disadvantages Advantages Disadvantages
ª Intangible assets such as

human capital, company’s
ª Less subject to distortion
reputation are not reflected
than other fundamentals ª High growth in sales does not
ª Used when earnings are zero in B/S
such as EPS or BV necessarily mean high
or −ve ª P/Bs may be misleading
ª Used when earnings are zero operating profits as judged
ª Meaningful than P/E when when assets used by
or −ve by earnings and CF
earnings are highly volatile comparable companies differ
ª Meaningful than P/E when ª It is a prefinancing income
ª Useful for companies that significantly
earnings are highly volatile measure, analysts often use
hold liquid assets ª Different accounting
ª Suitable for distressed firms EV/Sales
ª Useful when companies are treatments reduce the
ª Appropriate for valuing the ª Does not reflect differences
not expected to continue as comparability of P/Bs across
stocks of mature, cyclical in cost structures across
a going concern companies and countries
and start-ups companies
ª According to empirical ª Inflation and technological
ª According to empirical ª Although it is less subject to
research, differences in P/B changes can result in
research, differences in P/S distortion, revenue
are related to differences in significant differences b/w
are related to differences in recognition practices can still
long-run average returns BV and MV of assets
long-run average returns distort P/S
ª Share issues/repurchases
can misrepresent
comparisons
P/CF ratio Dividend yield
Advantages Disadvantages Advantages Disadvantages
ª Ratio may not provide

appropriate result if CFO is
defined as EPS + NCC
ª CFs are less subject to ª In theory, FCFE is preferred ª This approach is incomplete
manipulation than earnings over CFO. However, FCFE is because it ignores capital
ª Addresses the issue of more volatile than CFO appreciation
differences in accounting ª Companies can use ª Investors may trade-off
ª It is a component of total
treatments between similar accounting methods to future earnings growth to
return
companies enhance CFO (eg. receive higher current
ª Dividends are less risky
ª Meaningful than P/E when securitizing AR to speed up dividends
component of total return
earnings are highly volatile cash inflow or outsourcing ª Relative safety of dividends
than capital appreciation
ª According to empirical AP to slow down cash argument implies that MPS
research, differences in P/CF outflow) reflects differences in risk of
are related to differences in ª Different accounting dividend and capital
long-run average returns treatments reduce the appreciation in a biased way
comparability of P/CFs
among companies and
countries
26
LOS e
Underlying earnings Normalized earnings
Earnings adjusted for cyclicality of the

business cycle
Earnings that exclude non-recurring items Methods used for normalization:
Aka persistent/continuing/core earnings Œ Historical average EPS (ignores the size of

business), or
Average ROE (Avg. ROE × Current BVPS)
(preferred method)
LOS f Earnings yield (E/P)

ª Zero or −ve earnings render P/E ratios meaningless
ª Inverse of P/E can be used in such a case
ª High E/P: Cheap security

ª Low E/P: Expensive security
LOS g & h Justified P/B, P/S, P/CF, and dividend yield
Justified P/B Justified P/S
E1 × Payout ratio
V0 = E0 × Payout ratio × (1 +g)
Ke − g V0 =
Ke − g
V0/B0:
V0/S0:
ROE × (1 − RR)
NP margin × Payout ratio × (1 +g)
Ke − g
Ke − g
V0/B0:
V0/S0:
ROE − g
NP margin × Justified trailing P/E
Ke − g
Justified dividend yield Justified P/CF
D0 × (1 + g)
V0 =
Ke − g
D0/V0:
D0 FCFE1 × (1 + g)
V0 =
D0 × (1 + g)/Ke − g Ke − g
D0/V0:
Ke − g
1+g
27
LOS i Predicted P/E using cross-sectional regression on fundamentals
ª Cross-sectional regression summarizes a large amount of data in single equation
ª It is not used as a main tool because:

Ÿ Predictive power of regression for a different stocks and/or different time period is unknown
Ÿ Relationship between P/E and fundamentals may change over time
Ÿ Problem of multicollinearity
LOS j Evaluation of stock
Fed model Yardeni model
CEY = CBY − k × LTEG + ε

Stock market is overvalued when earnings yield
(E/P) on S&P 500 is less than 10-year T-bond yield
CEY: Current earnings yield
CBY: Current Moody’s A-rated corporate bond yield
Stock market is undervalued when earnings yield
k: Weight given by market
on S&P 500 is more than 10-year T-bond yield
LTEG: Consensus five-year earnings growth rate
ε: Error term
Criticism: It assumes earnings yield will be equal
to 10-year T-bond yield
Justified P/E: 1/Yardeni model (except ε)
LOS k P/E-to-growth ratio (PEG)

Tool to incorporate the impact of earnings growth on P/E
P/E
PEG:
G
Stocks with lower PEGs are more attractive than stocks with higher PEGs
Drawbacks of using PEG:
Œ PEG assumes linear relationship between P/E and growth.

However, in theory, the relationship is not linear
PEG doesn’t account for differences in risk
Ž PEG doesn’t account for differences in duration of growth
LOS l Terminal value
Based on Based on
comparables fundamentals
Trailing: Trailing:
Benchmark P/E × Earningsn Justified P/E × Earningsn
Leading: Leading:
Benchmark P/E × Earningsn+1 Justified P/E × Earningsn+1
28
LOS m CFs used in price and enterprise value (EV) multiples
Earnings + NCC: NI + Depreciation and amortization
Not a good measure because it ignores other items that affect CF
CFO: Can be found in the cash flow statement

May require adjustments while comparing with the company
that uses different accounting standards
FCFE: Has the strongest link to valuation theory

In theory, FCFE is preferred over CFO. However, FCFE is more
volatile than CFO
EBITDA: Forecasted EBIT + Forecasted depreciation and amortization

EV/EBITDA is preferred over P/EBITDA because EV includes
value of debt and EBITDA is a pre-interest and pre-tax
measure of flow to both debt and equity
LOS n EV multiples
Enterprise value:
MV of common stock + MV of preferred stock + MV of debt – Cash and investments + Minority Interest
Rationales for using EV/EBITDA: Drawbacks of using EV/EBITDA:
More appropriate than P/E for comparing EBITDA will overstate CFO, if WC is growing
companies with different levels of debt
FCFF reflects the amount of required capital
Useful in valuation of capital-intensive expenditures and is strongly linked with
businesses (because such businesses have valuation theory than EBITDA
high depreciation and amortization expenses)
EBITDA is useful only if capital expenses equal
EBITDA is usually +ve even when EPS is −ve depreciation expenses
Other EV multiples:
EV/FCFF, EV/EBITDAR (R: Rent expense), EV/Sales
Valuation metric could also be total invested capital (TIC) instead of EV
LOS o Sources of differences in cross-border valuation comparisons
ª Using relative valuation in an international context involves differences in accounting

methods, cultures, risk and growth opportunities and economic differences
ª P/CFO, P/FCFE will be least affected by international accounting differences while P/E,
P/B, P/S etc. will be affected the most
29
LOS p Momentum indicators
They relate to price or fundamentals to the time series of their own past
values or fundamental’s expected value
Earnings surprise: Reported EPS ‒ Expected EPS
Scaled earnings surprise: Earnings surprise/SD
Relative strength indicators: They compare a stock’s performance during a

time period with its own historical performance or with some group of stocks
LOS q Use of AM, HM, weighted HM, and median to describe

the central tendency of a group of multiples
Eg. A B C Total
MPS 400 600 100 1100
EPS 20 50 50 120
P/E 20 12 2 9.16
34
AM: = 11.33 ✗
3
3
HM: = 4.73 ✗
1/20 + 1/12 + 1/2
1
Weighted HM: = 9.16 ✔
(400/1100)1/20 + (600/1100)1/12 + (100/1100)1/2
Using median mitigates the risk of outliers
Using HM mitigates the impact of large outliers but not small outliers (i.e. those close to zero)
LOS r Evaluate whether a stock is overvalued, fairly valued, or undervalued

ª If, Multiple > Benchmark: Overvalued
ª If, Multiple < Benchmarke: Undervalued
ª If, Multiple = Benchmark: Fairly valued
30
Residual Income Valuation

LOS a Residual income/economic profit/Economic value added
Net income – Equity charge NOPAT – $WACC
Eg. Equity: $10,000 Ke: 15% Debt: $8,000 Kd: 12.5% Tax rate: 20%
Sales: $10,000 COGS: $2,000
Sales 10,000 NOPAT: EBIT × (1 − t) Or EAT + Interest(1 − t)

COGS 2,000
EBIT 8,000
8,000 × (1 − 0.2) 5,600 + 1,000(1 − 0.2)
Interest 1,000
EBT 7,000
Tax 1,400 6,400 6,400
EAT 5,600 $WACC: WACC × Total capital

Equity charge 1,500
RI/EP/EVA 4,100
12.78% × 18,000
2,300
RI/EP/EVA: NOPAT − $WACC
6,400 − 2,300
4,100
Adjustments to the financial statements:

Œ R&D expense, net of amortization is added back to earnings
Charges on strategic investments that are not expected to generate immediate
returns, are added back
Ž Deferred taxes are eliminated and only cash taxes are treated as an expense
LIFO reserve is added back to capital and change in LIFO reserve to NOPAT
Operating leases are treated as capital leases and nonrecurring items are adjust
Market value added (MVA):

Market value – Total capital
LOS b Uses of RI models

ª To measure internal corporate performance (managerial effectiveness)
ª To determine executive compensation
ª To measure goodwill impairment
31
LOS c Value of a common stock using RI model
RIt = Et − (r × Bt − 1)
Expected Opening
EPS BV
Forecasted Required
residual income return
Residual income valuation model
PV of expected future
Current BV of equity
residual income
V0 = B0 +
[ RI1
(1 + r)1
+
RI2
(1 + r)2
+
RI3
(1 + r)3 [
+ . . . .
RIt = Et – (r × Bt – 1) or (ROE – r) × Bt – 1
In DDM or FCFE model, terminal value represents a

substantial portion of expected intrinsic value
In RI model, current BV represents a substantial

portion of expected intrinsic value
With RI models, valuation is relatively less sensitive to

terminal value estimates. This reduces forecast error
RI model assumes clean surplus accounting
LOS d, e & f Fundamental determinants of RI

Single-stage RI valuation model
V0 = B0 +
[(ROE – r) × B0
r–g [
If ROE = r, then V0 = B0
If ROE > r, then V0 > B0 and +ve RI
Above equation represents PV of company’s expected RIs
Equity Q Tobin’s Q
Equity MV of Debt + MV of Equity
Assets - Debt Replacement cost of total assets
Relation between RI valuation and justified P/B

If ROE = r, then V0 = B, Justified P/B = 1
If ROE > r, then V0 > B, Justified P/B > 1
If ROE < r, then V0 < B, Justified P/B < 1
32
LOS g Implied growth rate in RI
g = r –
[ (ROE – r) × B0
V0 – B0 [
It can be computed with the assumption that intrinsic value is equal to the market price
LOS h Continuing residual income
èIt is RI after forecast horizon

èV0 = B0 + PV of high-growth RI + PV of continuing RI
èPV of continuing RIn − 1 = RIn/1 + r − ω
èIf RI persists at the current level forever, then ω = 1
èIf RI drops immediately to zero, then ω = 0
èIf RI declines over time to zero, then ω is between 0 and 1
èPV of continuing RI at time ‘t’ can also be calculated as: MVt – BVt
èPV of continuing RI at time ‘t – 1’: (MVt – BVt) + RIt/1 + r
LOS i Compare RI models to DDM and FCF models
RI model DDM FCF models
Measurement PV of expected dividends PV of expected CFs +

BV + PV of expected RIs
of value + Terminal value Terminal value
Required Required return on FCFE: Ke

Ke
return equity FCFF: WACC
Recognition of value in RI models occurs earlier than in DDM
In theory, value derived using DDM, FCFE and RI models should be identical
LOS j Strengths and weaknesses of RI models
Strengths Weaknesses
Terminal value doesn’t make up a

large portion of total PV
Based on accounting data that can be
manipulated by management
They use accounting data, which is
readily available
Can be applied to companies that do

Accounting data used may require
not pay dividends or that do not have
significant adjustments
+ve expected FCFs in the short run
Can be used even when CFs are

Models assume that the clean surplus
volatile
relation holds or that analyst makes
appropriate adjustments where it
Focus is on economic profitability doesn’t
33
LOS k Accounting issues in applying RI models
èClean surplus violation
èB/S adjustment for fair value
èIntangible assets
èNonrecurring items
èAggressive accounting practices
èInternational accounting differences
LOS l Evaluate whether a stock is overvalued, fairly valued, or undervalued

34
Private Company Valuation

LOS a Compare public and private company valuation
Company-specific factors
Stage of lifecycle: Private companies are less mature than public companies
Size: Private companies are smaller in size than public companies

Smaller size → High risk → High risk premium
Overlap of management In private companies, management has controlling interest

and shareholders:
Management may be able to take a longer-term perspective
than a public company
Quality and depth of Private companies have limited growth potential due to
management: which they are less attractive to management candidates
This leads to less management depth than a public company
This could increase risk and reduce growth prospects
Quality of financial and Public companies are required to make timely and detailed
other information: disclosure of financial and other information
This is not the case with private companies, therefore there
is higher uncertainty and risk which leads to lower valuation
Short-term investors Private companies do not experience short-term stock price

performance pressure as public companies do
Management may be able to take a longer-term perspective
Taxes: Reduction of corporate tax payments is more important for

private companies than public companies because of
greater benefits to owners/managers
Stock-specific factors
Liquidity: Stocks of private companies are less liquid than the stocks
of public companies since they are not traded on exchange
Concentration of Control of private companies is concentrated in few

control: shareholders, which may lead to benefits to some
shareholders at the cost of other shareholders
Restrictive agreements: Private companies may have agreements that restrict

shareholders from selling their shares which reduces their
marketability
Generally, stock-specific factors are +ve whereas company-specific factors are +ve or −ve
35
LOS b Uses of private business valuation
Transaction-related Compliance-related Litigation-related
Private financing
IPO Legal proceedings such as

Financial reporting damages, lost profits
Acquisition claims, shareholder
Tax issues disputes, divorce etc.
Bankruptcy require valuation
Share-based compensation
LOS c Private company valuation
Income approach Market approach Asset-based approach
Company is valued using price

Company is valued as the PV of
or EV multiples based on sales Assets − Liabilities
expected future income
of comparable company
Appropriate for companies in
Appropriate for companies in
Appropriate for mature early stage of lifecycle
high growth phase
companies
LOS d
Adjustments required to
CF estimation issues
estimate normalized earnings
ª Nonrecurring and unusual items ª Controlling/noncontrolling interest
ª Discretionary expenses ª Uncertainty regarding future CFs
ª Above-market (project different possible scenarios)
compensation/expenses ª Management biases such as overstating
ª Personal expenses goodwill
ª Use of real estate ª FCFF should be used when substantial
ª Non-market lease rates capital structure changes are
anticipated
In a strategic transaction, valuation of the firm is based on perceived synergies
A financial transaction assumes no synergies (when one firm buys another firm in a dissimilar industry)
36
LOS e Value of a private company using income approach
FCF method Capitalized CF method Excess earnings method
Step 1: Calculate earnings based

on required return on WC and
fixed assets
Single stage FCF model Step 2: Calculate excess earnings

Two stage FCF model (firm earnings − earnings based
Vn = FCFFn+1/WACC − g on required return)
Using price multiple to estimate
terminal value leads to Vn = FCFEn+1/Ke− g Step 3: Calculate PV of excess
inappropriate valuation because earnings (equals value of
rapid growth is incorporated FCF method is preferred over intangible assets)
twice (in CF projection and in Capitalized CF method for
price multiple) companies that are not expected Step 4: Calculate the value of
to grow at a constant rate company (WC + Fixed assets +
PV of excess earnings
Suitable for firms with

significant intangible assets
LOS f Factors that require adjustment when estimating the discount rate
èSize premiums
èAvailability of debt and Kd
èIn an acquisition, WACC should be based on target’s capital structure
èDiscount rate adjustment for projection risk
èManagement’s estimation
LOS g Models used to estimate the required return
CAPM Expanded CAPM Build-up approach
Used when guideline public

Appropriate for small private companies are not available
Version of CAPM that includes
companies that have little
premium for small size and
chance of going public or being Similar to expanded CAPM
company specific risk
acquired by a public company except that the beta is
assumed to be one
37
LOS h Value of a private company using market approach
Guideline public company Guideline transactions Prior transaction method

method (GPCM) method (GTM) (PTM)
Relative multiples are derived

Price multiples are derived from
and adjusted for differences This method considers actual
past acquisitions of private or
between subject company and transactions in the stock of the
public companies
comparable public company subject company
Transactions already reflect
Control premiums are used when Most relevant when valuing
control premium, therefore there
valuing controlling interest in a noncontrolling (minority)
is no need for additional
company (adjustments are made interest
adjustment
only to the equity portion)
LOS i Value of a private company using asset-based approach

Value of company = FV of assets − FV of liabilities
Aka cost approach
Considered weakest of the three approaches
Rarely used for valuation of going concerns
More appropriate for companies with less prospects for doing
better in the future, banks, financial companies, REITs, closed
end investment companies (CEICs) and early stage companies
LOS j Effects of discounts and premiums based

on control and marketability on valuations
DLOC: Discount for lack of control
Applied when total equity was developed on controlling interest
basis and valuation is being done for noncontrolling interest
1 − (1/1 + Control Premium)
DLOM: Discount for lack of marketability

Applied when comparables are based on marketable securities and
interest in the target company is less marketable
Control premium: Applied when total equity was developed on noncontrolling interest
basis and valuation is being done for controlling interest basis
Total discount = 1 – [(1 – DLOC) × (1 – DLOM)]
Forum Link Video Link
38
Fixed Income
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40
The Term Structure And Interest Rate Dynamics

LOS a
Spot Rate : Spot rate is the rate used to discount a single cash flow, it is the YTM of a Zero coupon bond
(single CF)
e.g. If a 5 years ZCB is trading at 75 (FV-100), then YTM of this bond will be 5.92% Hence 5th year spot
rate will be 5.92%.
Forward Rate - Interest rate on a loan to be initiated in future
YTM : Average annualized yield earned on a bond (similar to IRR)
Expected and realized returns on bonds

Expected return: Ex-ante holding period return that an investor expects to earn
Realized return: Actual return the investor earns over the holding period
Expected return = YTM when,

Œ Bond is held till maturity
Coupon and principal payments are made in full when due
Ž Coupons are reinvested at the original YTM
When the spot curve is flat, forward rate = spot rate
When the spot curve is upward sloping, forward rate > spot rate
When the spot curve is downward sloping, forward rate < spot rate
e.g. FV = 1000 C=6% semi annual M= 2 yrs
30 30 30 1030
Time Spot + + 3
+ = 930.4
1.035 1.04 2
1.045 1.054
0.5 7%
1 8%
1 3
1.5 9%
7% 9%
1+ 1+
2 10% 2 2
41
e.g. 3rd Year Spot Rate = ? YTM of 3 yrs Maturity Bond = ?
Maturity Coupon Rate MV Zero Coupon Bond

1 0 0.9125
2 0 0.8915
3 0 0.8182
4 0 0.7936
YTM of 3 yrs Maturity Bond is 6.91%

0.8182 = 0 + 0 + 1
(1+S3)3
LOS b Obtaining spot rates from the par curve by bootstrapping

Bootstrapping involves using the output of one step as an input to the next step i.e. using spot rate
(zero-coupon rate) of year-1 to calculate the spot rate (zero-coupon rate) of year-2
Par Rate : It is that Coupon rate which forces the bond to be priced at Par
e.g “Bootstrapping” Par

rate 18%
Time Par Rate Spot Rate
1 7% ? 12%
2 12% ? 7%
3 18% ?
Time
If 1 yr Par Rate is 7% then FV = 1000 C = 7% MV = 1000 M=1
1000+70
1000 = Spot1 = 7%
(1+S1)1
If 2 yr Par Rate is 12% then FV = 1000 C = 12% MV = 1000 M=2
120 1120
1000 = 1 +
(1+7%) (1+S2)2
1120
887.85 = Spot2 = 12.31%
(1+S2)2
3 year Par Rate is 18% then FV = 1000 C = 18% M = 3 MV = 1000

180 180 1180
1000 = + + 3
(1+7%)1 (1+12.31%)2 (1+S3)
1180
689.1 = Spot3 = 19.6%
(1+S3)3
42
“Formula” “Bootstrapping”
Spot Par Par Spot
Rate Rates Rates Rate
1 - Z4
Z1+ Z2+Z3+Z4
1
Z = Disc Factors e.g. Z3=
(1+S3)3
e.g. 1 Par rate for year 4 = ? 2 Verify 3 Par Curve = ?
Years Spot
1 7%
2 12%
3 15%
4 20%
1 1 1 1
1 Z1 = Z2 = Z3 = Z4 =
1.07 1.122 1.153 1.24
1 - Z4
Par4=
Z1+Z2+Z3 +Z4
= 18.03
2 Verification FV = 1000 C = 18.03% M = 4 years MV = ?
Years Spot
1 7% 180.3 180.3 180.3 1180.3

1000 = + + +
1.071 1.122 1.153 1.24
2 12%
3 15% 1000 = 180.3 (Z1+Z2+Z3+Z4)+ 1000 x Z4
4 20%
3 Par Curve
Years Spot Par
1 7% 7%
2 12% 11.7%
3 15% 14.33%
4 20% 18.03%
43
LOS c Assumptions concerning the evolution of spot rates in relation to

forward rates implicit in active bond portfolio management
Bond is undervalued (active portfolio manager will buy) if,
Expected future spot rate < Current forward rate
Bond is overvalued (active portfolio manager will sell) if,
Expected future spot rate > Current forward rate
LOS d Swap rate curve

Swap Rate = Par Rate
ª Swap rate: Fixed rate in an interest rate swap
ª Swap markets are highly liquid
ª LIBOR/swap rate curve is the most widely used interest rate curve because it
reflects the credit risk of commercial banks and swap markets are unregulated
making them comparable across countries
ª Wholesale banks use swap curves to value their assets and liabilities
ª Retail banks use a government spot curve as benchmark
LOS e Riding/rolling down the yield curve

Following are the prices for a 2% annual pay bond with different maturities
Assume an investment horizon of 5 years
Eg. Maturity Yield Price
5 2 100
10 3 91.46
15 4 77.76
20 5 62.61
25 5.5 53.05
30 6.5 41.24
Strategy-1 Strategy-2
Buy a 30-year bond and

Buy a 5-year bond
sell it after 5 years
When it is 25 year
Bond
53.05
(100) 2 2 2 2 102 (41.24) 2 2 2 2 +2
t0 t1 t2 t3 t4 t5 t0 t1 t2 t3 t4 t5
N=5 PV = -100 N=5 PV = -41.24

FV = 100 PMT = 2 FV = 53.05 PMT = 2
CPT I/Y=2 CPT I/Y=9.57%
Realized Yield = 2% Realized Yield = 9.57%
Assumptions:
Yield curve is upward sloping
Yield curve does not change over the investment horizon
44
LOS f Swap spread
Swap spread = Swap rate – Treasury yield
(Reflects difference in demand and supply)
I-spread (interpolated spread) = Risky bond rate – Swap rate
Yield quotes to many maturities , while US bond yield curve has on the run issues trading at
only a small number of maturities
LIBOR swap curve is the most commonly used interest rate curve. It approximately reflects the
default risk of a commercial bank
I-spread reflects only credit and liquidity risk
LOS g Short term spreads to gauge economic wide credit risk and liquidity risk
Eg. Risky bond, Face value = 1000 Coupon rate = 10% Maturity = 4 yrs Market value = 860
Spot rates (treasury): Year 1 = 10%, Year 2 = 11%, Year 3 = 12%, Year 4 = 15%
100 100 100 1100

860 = 1
+ 2
+ 3
+
(1 + 10% + z-spread) (1 + 11% + z-spread) (1 + 12% + z-spread) (1 + 15% + z-spread)4
Z-spread (zero volatility spread) is determined by trial and error method
It is a measure of credit risk and liquidity risk

It is not appropriate to use to value bonds with embedded options
TED and LIBOR-OIS spreads

Are
TED (T-bill and Eurodollar): LIBOR – T-bill rate
Reflects the risk in the banking system (more
accurately than a 10-year swap spread)
LIBOR-OIS spread: LIBOR – Overnight indexed swap rate

Considered an indicator of risk and liquidity of money market securities
Minimal counterparty risk
LOS h Traditional theories of the term structure of interest rates

Unbiased expectations theory Local expectations theory Liquidity preference theory
Similar to the unbiased

expectations theory with one Liquidity premiums should
major difference: the local exist to compensate investors
Aka pure expectations theory expectations theory preserves for interest rate risk
the risk neutrality.
Forward rate is an unbiased Premiums increase with
predictor of future spot rate Assumes that investors are maturity. They are higher
risk-neutral in the short term during economic uncertainties
Assumes that investors are It can be shown that this
risk-neutral theory does not hold because Forward rates are biased
the returns on long-term estimates of expected future
bonds over short holding spot rates
period are higher than the
returns on short-term bonds
45
Segmented markets theory Preferred habitat theory
Similar to segmented
Yields are determined by
markets theory but
demand and supply for funds
investors are willing to
Each maturity sector can be deviate from their preferred
thought of as a segmented maturities if expected
market additional returns are large
Investors have preference for
It also means that the
a particular maturity
preferred habitat theory can
Eg. Pension plans and be used to explain almost
insurance companies any yield curve shape.
LOS i Factors driving the yield curve

Shaping risk: Sensitivity of a bond’s price to change in the shape of yield curve
Effective duration: Measures the sensitivity of a bond’s price to parallel shifts in the yield curve
Key rate duration: Measures the sensitivity of bond’s price to a change in par rate
It captures shaping risk to a large extent
Sensitivity to parallel, A three-factor model that decomposes changes in the yield curve into
steepness, and curvature changes in level, steepness, and curvature.
movements:
LOS j Maturity structure of yield volatilities
The maturity structure of yield volatilities indicates the level of yield volatilities at
different maturities
It depicts yield curve risk
Short-term rates are more volatile than long-term rates
Volatility at long-maturity end: Associated with uncertainty regarding the real

economy and inflation
Volatility at the short-maturity end: Associated with risks regarding monetary policy
46
LOS k How key economic factors are used to establish a view on benchmark rates,
spreads, and yield curve changes
» Implied forward rates act as market-neutral reference points for fixed income traders
» In practice, active fixed-income market participants establish their own views on future interest
rate developments and then position their portfolios in order to capitalize on difference between
their own rate view and the market consensus
Ø Bond Risk Premium / Term Premium: The expected excess return of a long-term bond is less
than that of a similar short-term bond or the one-period risk-free rate. It is usually measured
using government bonds to capture uncertainty of default-free rates
Ø Credit, liquidity, and other risks may increase the overall risk premium for a specific bond
Macroeconomic factors influencing bond price & required returns
Other Factors such as

Economic Growth Monetary Policy
Inflation Fiscal Policy, Maturity
(GDP) (Interest Rates)
structure of Debt
& Investor Demand
Short-term and intermediate- Long-term Bond Yield

term Bond Yield Variations Variations
2/3 - Explained by inflation 2/3 - Explained by monetary policy

Remaining 1/3 - roughly equally Remaining 1/3 - largely attributable to
explained by GDP & monetary policy inflation
47
Impacts of Monetary Policy on Bond Risk Premium
During Economic Recessions

During Economic Expansion,
or anticipated recessions,
Benchmark rates
Benchmark rate
in order to control inflation
in order to boost economic
activity
Bearish Flattening
In the short-term Bond Yields
Bullish Steepening
rise more than Long-term
Short-term Bond Yields
Bond Yields,
fall more than Long-term
Leading to a Flatter Yield Curve
Bond Yields,
Leading to a Steeper
Term Structure
These monetary policy actions lead to
Procyclical short-term interest rate changes.
Other Factors influencing Bond Prices & Required Returns
Fiscal Policy Maturity Structure Investor Demand
Greater domestic and Non-

Greater budget deficits Longer government debt domestic investor demand
require more borrowing, maturity structures predict increases Bond prices and
which influences both bond greater excess bond returns. reduces the
supply and required yield. bond risk premium (Bond
This is effectively a segmented
Thus, fiscal supply-side effects Yield) and vice-versa.
market factor, wherein the
affect bond prices and yields
greater supply of bonds of
by increasing (decreasing) Pension funds and insurance
yields when budget deficits long-term companies use long-dated
rise (fall). maturity increases the yield in government bonds to match
that market segment. expected future liabilities.
Investor behavior in relation to the changing Bond Yields
During highly uncertain market periods, investors turn to government bonds in what is termed
a flight to quality. This is when investors sell higher-risk asset classes such as stocks and
commodities and buy default-risk-free government bonds. A flight to quality is often
associated with bullish flattening, in which the yield curve flattens as long-term rates fall by
more than short-term rates
48
Flattening Curve Steepening Curve
Interest rates Interest rates

Long-term
Long-term
Short-term Short-term
Maturities Maturities
Short-term interest rates Long-term interest rates

change more than long-term change more than short-term
interest rates (Flattening) interest rates (Steepening)
Traders will purchase long- Traders will purchase short-

term bonds and sell short- term bonds and sell long-
term bonds. term bonds.
Duration Neutral Portfolios protects the bond holder from changes in the level
of the term structure.
Fixed-income investors with long-only investment mandates may alternate

between portfolios concentrated in a single maturity, known as a bullet
portfolio, and those with similar duration that combine short and long
maturities, known as a barbell portfolio.
For example, an investor may seek to capitalize on an expected bullish
flattening of the yield curve by shifting from a bullet to a barbell position.
49
The Arbitrage-free Valuation Framework

LOS a Arbitrage-free valuation
Valuing securities such that no market participant can earn arbitrage in a
trade involving that security
Two types of arbitrage opportunities:

Value additivity: The value of the whole equals the sum of the values of the
parts. (Arbitrage can be earned by stripping or reconstitution)
Dominance: When a similar asset trades at a lower price than another asset
LOS b Arbitrage-free value of an option-free, fixed-rate coupon bond

Eg. Par rates: 1-year bond: 3% 2-year bond: 4% 3-year bond: 5%
Coupon: 6% Maturity: 3 years MV: $102 Compute arbitrage
Year 2 Year 3
4 104 5 5 105
100 = + 100 = + +
(1 + 0.03)1 (1 + S2)2 (1 + 0.03)1 (1 + 0.0402)2 (1 + S3)3
Spot rate2 = 4.02% Spot rate3 = 5.06%
6 6 106
Arbitrage-free value: 1
+ + = 102.78
(1 + 0.03) (1 + 0.0402)2 (1 + 0.0506)3
Arbitrage = $0.78
For option free bonds - We can use simple spot curve valuation approach
For bonds with embedded options - We will use Binomial interest rate models
( Changes in future rates affects probability of the option being exercised and impacts the bond
Cash flows)
LOS c Binomial interest rate tree framework

Eg. Two-period binomial tree
i2,UU
i1,U i × e2σ
i0 i2,UL
i1,L i × e−2σ
i2,LL
ª Binomial interest rate tree framework: It is a lognormal random walk model. It assumes that
interest rates have an equal probability of taking one of two possible values in the next period
ª Properties of binomial interest rate tree framework:
(a) Non-negative interest rates and (b) Higher volatility at higher rates
ª i = One-period forward rate
ª Adjacent forward rates are 2σ apart
ª Relationship b/w ‘i’ of each individual nodal period is a function of interest rate volatility
50
LOS d Process of calibrating a binomial interest rate tree to

match a specific term structure
The interest rate tree is generated using specialized computer software
Three rules to generate an interest rate tree:

Œ Interest rate tree should generate arbitrage-free values
Adjacent forward rates should be 2σ apart
Ž Midpoint for each nodal period should be approximately equal to the
implied one-period forward rate
LOS e Backward induction
Eg. Find the price of a 3-year bond, if coupon = 5%
7%
5%
3% 6%
4%
5%
98.13+99.05
2
Step 3 Step 2 Step 1
105/1.07 = 98.13
(98.5937 + 5)/1.05
101.5381 (99.5842 + 5)/1.03 105/1.06 = 99.05
(99.5283 + 5)/1.04
105/1.05 = 100
LOS f Pricing using the spot rate curve Vs. Pricing using an arbitrage-free
binomial lattice
Valuation of bonds using spot rate curve (zero coupon yield curve) is suitable for option-free bonds
Arbitrage-free binomial lattice (binomial interest rate tree) is suitable for bonds with embedded options
LOS g Pathwise valuation in a binomial interest rate framework

Eg. Fair value: $1000 Coupon: 10% Maturity: 2 years
6%
5%
5.5%
(1100/1.06) + 100
Path 1: 5% → 6% = 1083.5575
1.05
(1100/1.055) + 100
Path 2: 5% → 5.5% = 1088.2419
1.05
Average = 1085.8997
For a binomial interest rate tree with n periods, there will be 2 (n-1) unique paths
51
LOS h Monte Carlo forward-rate simulation
Prepayments on underlying residential mortgages affect the cash flows

of a MBS
Prepayment risk is similar to call risk in a callable bond
Unlike call risk, prepayment risk is affected not only by the level of
interest rate at a particular point in time but also by the path rates took
to get there
Binomial Model cash flows are not path dependent, therefore its not a
good model for modelling MBS type of products Cash flows
Recommended modelling techniques - Monte Carlo Simulation
Uses pathwise valuation

Uses large number of randomly generated simulated paths
Used when CFs are path dependent. Eg. MBS
Modelers often include mean reversion in their Monte Carlo estimation
The calibration process entails adding a constant to all rates when the
value obtained from the simulated paths is too high relative to market
prices. This results in a drift adjusted model
e.g. Use Binomial Model Use Monte Carlo Simulation

10 yr Housing Loans
M = 10 yr C =10%
Interest rate C =10%
If it’s callable bond @ yr 5
Prepay 10 yrs
Callable
0 5
Scenario 1
0 5 10 yrs
10%
YTM = 6% 6% Prepayment
YTM = 7% C > YTM
YTM = 8% Decision is
to call back
Scenario 2 Prepayment
will not
6% be large
It does not matter how interest rate 10%

(YTM) reached here
(we do not care about the of path of the 3% Leftover are the
interest rate) ones who cannot
prepay
large prepayment
triggered
52
Modern term structure models

LOS I LOS command word is describe - calculations not necessary
Equilibrium term Arbitrage-free

structure models models
Make use of fundamental economic variables
Cox-Ingersoll-Ross
Vasicek model Ho-lee model
model
Single variable - Interest rate Single variable - Interest rate
dr = a(b – r)dt + σ√rdz
Assumption: Calibrated, not assumed

Investor has limited capital
and has to make dr = a(b – r)dt + σdz
consumption and drt = θtdt + σdzt
investment decisions
Consumption today vs θt = Time-dependent
consumption later Captures mean reversion drift term
Two parts: Similar to CIR model The model can be

Œ Deterministic part [drift except that interest rates calibrated to market
term: a(b – r)dt]: are calculated assuming data by inferring the
Ensures mean reversion that volatility remains form of time-dependant
of interest rate toward constant drift term from market
the long-run value prices
Disadvantage:
Stochastic part [random It is possible for interest It means that the model
term: σ√rdz]: dz Follows rate to become −ve can precisely generate
random normal (theoretically) current term structure
distribution for which
mean = 0 and σ = 1. Cannot be calibrated as Generates symmetrical
Allows volatility to the parameters are limited (normal) distribution of
increase with the level of future rates
interest rate
Can be calibrated
Cannot be calibrated as the Parameters can vary
parameters are limited
53
ª Equilibrium term structure models seek to describe the changes in the term structure using fundamental
economic variables
ª Vasicek and CIR models are single factor models (short-term interest rates)
ª In arbitrage-free models, the analysis begins with the assumption that bonds trading in the market are
correctly priced
ª Arbitrage-free models do not attempt to explain the yield curve, rather they take the yield curve as given.
They are also known as partial equilibrium models
ª Arbitrage-free models of the term structure of interest rates begin with the assumption that bonds
trading in the market are correctly priced and the model is calibrated to value such bonds consistent with
their market price
54
Valuation And Analysis:

Bonds With Embedded Options
LOS a Fixed-income securities with embedded options
Simple options Complex options
Callable bonds Putable bonds
Bonds with both call and put options

Convertible bonds
Issuer has right to
call back the bond Estate Put : Allows the heirs of an
Investor has right to investor to sell the bond back to the
Investor has short sell the bond back to issuer upon the death of the
position on call option the issuer investor.
Most callable bonds Investor has long The bonds should be put only if they
have a lockout period position on put option sell at a discount that is, if the
(period during which prevailing price is below par
the issuer cannot call Otherwise, they should be sold in the
the bond) Option can be market a premium.
European, American Sinking fund bonds: Require the
Option can be or Bermudan issuer to set aside funds over time to
European, American retire the bond
or Bermudan
This provision reduces the credit risk
of the bond.
European
Excerise
Date
Bermudan
Excerise
Date
American
Exercise any time
● An extendible bond which allows the investor to extend the maturity of the bond
● An extendible bond can be seen as a putable bond with longer maturity
(i.e. the maturity if the bond is extended)
55
LOS b Values of a callable and putable bonds
Value of a callable bond = Value of a straight bond – Value of call option
Value of a putable bond = Value of a straight bond + Value of put option
LOS c & f Valuation of bonds with embedded options

Valuation of callable/putable bond is done using backward induction process
and a binomial interest rate tree framework
Value at any node where the bond is callable (putable) must be the call price
(put price) if the computed value exceeds (is below) the call price (put price)
Eg. Find the price of a 2-year bond callable in year 1 at $100, if coupon = 5%
6%
3%
4%
Step 2 Step 1
105/1.06 = 99.0566
[(99.0566 + 100)/2] + 5
101.4837
1.03
105/1.04 = 100.9615
100
( We will replace 100.9615 with 100 as bond will be called )
LOS d Effect of interest rate volatility the value of callable/putable bond
Interest rate volatility Value of call option Value of put option
Value of callable bond Value of putable bond

Interest rate volatility
(B − C) (B + P)
LOS e Effect of changes in the level and shape of yield

curve on the value of a callable/putable bond
ª When interest rates decrease call option in callable bond limits the bond’s upside potential
ª When interest rates increase, put option in putable bond hedges against the loss in value
ª Value of call option increases as the upward sloping yield curve flattens
ª Value of put option decreases as the upward sloping yield curve flattens
LOS g Option-adjusted spreads (OAS)

OAS is a constant spread that, when added to all the one-period forward rates, in the tree
makes the value of bond equal to its market price
OAS = Z-spread − Option cost
Callable bond: Option cost = +ve

Putable bond: Option cost = −ve
OAS is sensitive to interest rate volatility
OAS is used by analysts in relative valuation, bonds with similar credit risk should have the
same OAS
Think of OAS as what you earn, therefore higher OAS (than peers) indicated cheaper bond
56
LOS h
Relationship between volatility and OAS
Assumed level Value of Value of

Callable Bond straight bond OAS
of volatility call option
unaffected
Value of
Assumed level Value of
Putable Bond straight bond OAS
of volatility put option
unaffected
LOS i Effective duration of a callable/putable bond

V− − V+
Effective duration:
2 × V0 × ∆y
V− and V+ are calculated using binomial interest rate tree framework
Calculating effective duration and effective convexity for bonds with embedded options is a complicated
undertaking because we must calculate values of BV + y and BV- y. Here’s how it is done:
Δ Δ
Step 1 : Given assumptions about benchmark interest rates, interest rate volatility, and any calls and/or
puts, calculate the OAS for the issue using the current market price and the binomial model.
Step 2: Impose a small parallel shift in the benchmark yield curve by an amount equal to +Δy.
Step 3 : Build a new binomial interest rate tree using the new yield curve.
Step 4: Add the OAS from step 1 to each of the one-year rates in the interest rate tree to get a “modified”
tree.
Step 5: Compute BV +Δy using this modified interest rate tree.
Step 6 : Repeat steps 2 through 5 using a parallel rate shift of -Δy to obtain a value of BV- y
Δ
57
LOS j Effective durations of callable, putable, and straight bonds

ª Optionality of a bond will never increase the duration (interest rate risk).
However, in some cases, it will reduce the duration
ª A decrease (increase) in rates would decrease the effective duration of a

callable (putable) bond
ª Effective duration of floater ≈ Time (years) to next reset
LOS k Interest rate sensitivity of bonds with embedded options
One-sided duration: Effective duration when interest rates go up or down

Better at capturing interest rate risk when the option is near the money
Callable bonds: Lower one-sided down-duration than one-sided up-duration
Putable bonds: Higher one-sided down-duration than one-sided up-duration
Key rate duration: Aka partial durations

Measures the sensitivity of price of a bond to a change in spot rate
It captures shaping risk to a large extent
Effective duration for each maturity point is calculated individually
Key rate durations Coupon rates
Ÿ If an option free bond is trading at par, the bond’s maturity matched rate is
the only rate that affects the bond value
Ÿ Option free bonds not trading at par, the maturity matched rate is still the
most important rate
Ÿ A bond with low (Zero) coupon rate may have negative key rate duration for
horizons other than it’s maturity
Ÿ Callable bond with low coupon rates are unlikely to be called hence, there
maturity matched rate is still the most critical rate
Ÿ Keeping everything constant, higher coupon bonds are more likely to be

called & therefore time to exercise rate will tend to dominate the time to
maturity rate, (interest rates are also constant)
Ÿ Putable bonds with high coupons are unlikely to be put & are most sensitive
to their maturity matched rates.
Ÿ Keeping everything else constant, lower coupon bonds are more likely to be
put & therefore the time to exercise rate will tend to dominate maturity date.
(interest rates also constant)
58
Key Rate Durations of various 15-Year option -Free Bonds With Different Coupon
Rates
Key Rate Durations

Coupon Price
Total 2-years 3-years 5-years 10-years 15-years
1% $ 76.12 13.41 -0.05 -0.07 -0.22 -0.45 14.20
2% $88.06 12.58 -0.03 -0.05 -0.15 -0.27 13.08
3% $100.00 11.94 0.00 0 0 0 11.94
5% $123.88 11.03 0.02 0.1 0.15 0.32 10.44
8% $159.69 10.18 0.09 0.15 0.32 0.88 8.74
Key Rate Durations of various 15-Year Callable Bonds With Different Coupon Rates
Key Rate Durations

Coupon Price
1% $ 75.01 13.22 -0.03 -0.01 -0.45 -2.22 15.93
2% $ 86.55 12.33 -0.01 -0.03 -0.15 5.67 6.85
3% $ 95.66 11.45 0.00 0.00 0.00 6.40 5.05
5% $ 112.87 9.22 0.02 0.10 0.15 6.67 2.28
8% $ 139.08 8.89 0.09 0.15 0.32 7.20 1.13
Key Rate Durations of various 15-Year Putable Bonds With Different Coupon Rates
Key Rate Durations

Coupon Price
1% $ 77.24 9.22 -0.03 -0.01 -0.45 8.66 1.05
2% $ 89.82 9.90 -0.01 -0.03 -0.15 7.23 2.86
3% $ 95.66 10.50 0.00 0.00 0.00 5.12 5.38
5% $ 123.88 10.70 0.02 0.10 0.15 2.89 7.54
8% $ 159.69 10.08 0.09 0.15 0.32 0.45 9.07
59
LOS l Effective convexity
Bond price Bond price
Yield Yield
Callable bond Putable bond
(Lower duration (Lower duration
at lower yield) at higher yield)
(V− + V+) − 2V0

Convexity:
V0 × (∆y)2
LOS m Value of a capped or floored floating-rate bond
Capped floater: Protects the issuer from rising interest rates (issuer option)
Value = Value of straight bond − Value of embedded cap
Floored floater: Protects the investor from declining interest rates (investor option)
Value = Value of straight bond + Value of embedded floor
Coupon rate is determined at the beginning of the period but is paid at the end of the period
EXAMPLE : Value of capped and floored floating-rate bond

Susane Albright works as a fixed income analyst with Zedone Banks, NA. She has been asked to value a
$100 par, two-year, floating-rate note that pays LIBOR (set in arrears). The underlying bond has the
same credit quality as reflected in the LIBOR swap curve. Albright has constructed the following two-
year binomial LIBOR tree :
One-period forwar rate

Year 0 Year 1
4.5749% 7.1825%
5.3210%
How would we compute the following?
Ÿ The value of the floater, assuming that it is an option-free bond?
7.1825% = 107.1825
100
4.5749%
100 5.32.10% = 105.3210
100
Ÿ The value of the floater, assuming that it is capped at a rate of 6%. Also compute the value of the
embedded cap?
106.00
98.89
99.44
100 105.3210
95.09
Ÿ The value of the floater, assuming that it is floored at a rate of 5%. Also compute the value of the
embedded floor?
107.1825
100
105
100 105.3210
100.40
60
LOS n Convertible bond
It has an embedded convertible option

The convertible option is a call option on issuers’s common stock, which gives
bondholder the right to convert the bond into equity shares during a pre-determined
period (conversion period) at a pre-determined price (conversion price)
The conversion ratio may also be adjusted upward if the company pays a dividend in
excess of a specified threshold dividend
Other put options exercisable during specific periods may also be embedded with a
convertible option . These put options can be hard puts ( i.e., redeemable for cash) or
soft puts (i.e., the issuer decides whether to redeem the bond for cash, stock,
subordinate debentures, or combination of the three).
LOS o Components of a convertible bond’s value

Conversion value = Share price × Conversion ratio
Conversion ratio: Number of common shares for which a convertible bond can be exchanged
Market conversion price = Price of convertible bond/Conversion ratio
Market conversion premium ratio = Market conversion premium per share/Share price
Minimum value of convertible bond is greater of conversion value or straight value
LOS p Valuation of a convertible bond in an arbitrage-free framework

Value of convertible bond:
Value of straight bond + Value of call option on equity
Value of callable convertible bond:

Value of straight bond + Value of call option on equity – Value of call option on bond
Value of callable and putable convertible bond:

Value of straight bond + Value of call option on equity – Value of call option on bond
+ Value of put option on bond
LOS q Risk–return characteristics of a convertible bond
ª Busted convertible: If value of equity share falls significantly, then a

convertible bond will behave like a straight bond
ª Common stock equivalent: If value of equity share increases significantly,

then a convertible bond will behave like equity
ª When the stock’s price rises, the bond underperforms because of the
conversion premium
61
Credit Analysis Models

LOS a
Probability of default: Probability that borrower (issuer) will fail to pay interest or repay principal
Loss given default: Value an investor will lose if the issuer defaults
Expected loss: Probability of default × Loss given default
PV of expected loss: Highest price an investor would pay to an insurer to entirely
remove the credit risk of the investment
It makes two adjustments to the expected loss:
Œ Using risk-neutral probabilities, and
Including TVM
PV of expected loss = Value of risk-free bond – Value of risky bond
PV of expected loss = Expected loss + Risk premium – Time value discount
Recovery rate: 1 – Loss given default
Credit spread: YTM on risky ZCB – YTM on risk-free ZCB
LOS b Credit scoring Credit rating
Used for small businesses and

individuals
Used for companies, ABS, government
Ranks borrower’s credit riskiness and quasi-government entities
It does not provide an estimate of Investment grade:

default probability BBB– and above
Provides ordinal ranking Speculative grade (junk bonds):

Below BBB–
They do not explicitly take into
account current economic conditions Credit ratings summarize the results
of credit analysis in one simple metric
They are not percentile rankings
There is an inherent conflict of
Credit bureaus are under pressure interest in an issuer-pays model
from lenders to maintain stability in
credit scores Credit rating agencies are under
pressure from lenders to maintain
Credit scores have different stability in credit ratings
implications depending on the
borrower and nature of the loan
LOS c Strengths and weaknesses of credit ratings

Simple to understand and summarize Lower correlation with default probability

complex credit analysis
They do not explicitly depend on business
cycle whereas default probability does
Stable over time that reduces volatility in
the debt markets Issuer pays model may not provide
accurate ratings
62
LOS d Structural models of corporate credit risk
They are based on the structure of a company’s balance sheet and rely on
insights of option pricing theory
Value of risky debt:

Value of risk-free debt – Value of European put on company’s assets
Structural models can estimate probability of default, expected loss and PV of

expected loss using option pricing models
Owning company’s equity is equivalent to holding a European call option on

company’s assets
Strike price of call option = FV of company’s debt

Option is in the money if, assets > FV of debt
Important inputs in structural models:

Œ Expected return on company’s assets
Asset return volatility
Since company’s assets are not traded, above parameters are non observable.
Therefore we must use implicit assumption procedures (calibration)
LOS e Reduced form models of corporate credit risk
Reduced form model uses historical data (as against calibrated data)
as an input to the model
Basing estimates on historical data is called hazard rate estimation
LOS f Assumptions, strengths, and weaknesses of both

structural and reduced form models
1 Structural models
Assumptions
èCompany’s assets trade in a frictionless markets
èSimple balance sheet structure
èInterest rates are constant over time
èAsset’s return volatility is constant over time
Probability of default and recovery rate

Provides an option analogy to understand
depend on assumed B/S of the company
company’s probability of default and
recovery rate
Using implicit estimation procedure results
in errors in estimating credit measures
It can be estimated using current market
prices It does not explicitly consider the business
cycle
63
2 Reduced form models
Assumptions
èCompany’s ZCB trades in frictionless and arbitrage-free markets
èRFR, the state of economy and loss given default are all stochastic
(vary randomly)
èProbability of default depends on the state of the economy
èCompany’s default depends only on company-specific factors
Strengths Weakness
Historical estimation can be used
Credit risk measures reflect changing Hazard rate estimation may not be
business cycle appropriate to predict future defaults
This model does not require company’s

B/S to have a simple capital structure
Reduced form models perform better than structural models and credit ratings models
LOS g Determinants of the term structure of credit spreads

Term structure of credit spreads represents the
relationship of credit spreads to debt maturity
Credit spread for a specific maturity is estimated by

bootstrapping spot rates for both risky and risk-free bond
Computed credit spread includes a liquidity premium in

addition to default premium
LOS h PV of expected loss

ª Highest price an investor would pay to an insurer to entirely remove
the credit risk of the investment
ª PV of expected loss = Value of risk-free bond – Value of risky bond
ª PV of expected loss can be estimated from the credit spread
64
LOS i Credit analysis of ABS

ª ABS do not default but they will lose value as defaults occur in the collateral pool
ª Therefore probability of default does not apply to an ABS
ª ABS credit risk is modeled using probability of loss, loss given default, expected
loss, and PV of expected loss
65
Credit Default Swaps

Introduction
Makes periodic payments (CDS spread)
Promises to compensate in the event of default
Credit protection buyer Credit protection seller

Short Long
ª CDS provide protection against default
ª They also protect buyer against changes in market perception of

borrower’s credit quality
ª They are similar to put options
ª CDS are written on debt of companies, debt of sovereign, local

and state governments and on portfolios of loans or mortgages
LOS a Types of CDS
Single-name CDS Index CDS Tranche CDS
CDS on specific borrower
Borrower is called reference

entity
Covers a combination of
borrowers
Debt instrument is called
reference obligation
Investors can trade indexes of Covers a combination of
CDS borrowers but only up to a
Reference obligation is not
pre-specified levels of losses
only the debt covered but also
Higher the correlation of
the debt that is pari passu or
defaults, higher the price of
higher relative to the
CDS
reference obligation
Payoff is determined by
cheapest-to-deliver obligation
Features of CDS markets:
Credit protection buyer does not have to own the reference obligation
Industry convention is to use a standard coupon rate (1% or 5%) as against credit spread
Difference b/w coupon rate and credit spread is adjusted using upfront premium
66
LOS b Credit events and settlement protocols
Credit event:
It is an outcome that triggers the payment from CDS seller to CDS buyer
Three types:
Bankruptcy, failure to pay, and restructuring (not considered as a credit event in the US)
Determinations committee: Determines whether a credit event or succession event has occured
Succession event: Change in corporate structure where ultimate responsibility of debt is in

question (merger, divestiture, spinoff etc.)
CDS can be settled by physical settlement or cash settlement
Payout amount = Notional amount × Payout ratio
Payout ratio = 1 – Recovery rate
LOS c Pricing of CDS

ª Probability of default, loss given default, and coupon rate all influence the pricing of CDS
ª Expected loss = Hazard rate (aka conditional probability of default) × Loss given default
ª Hazard rate: Probability that an event will occur given that it has not already occurred
Eg. FV: $1,000 Maturity: 2 years Coupon: 6% Recovery rate: 30%

Hazard rates: Year 1 = 3% Year 2 = 4%
Year 1: $60
96% Year 2: $1060
60
97%
4% Year 1: $60
Year 2: 1060 × 30% = $318
3%
Year 1: 60 × 30% = $18
Year 2: 1060 × 30% = $318
Probabilities of default: 3%
And 97% × 4% = 3.88%
Loss given default: (1060 × 70%) + (60 × 70%) = $784

Or 1060 × 70% = $742
Expected loss: Loss given default × Probability of default

(3% × 784) + (3.88 × 742) = $52.31
ª PV of credit spread = Upfront premium + PV of fixed coupon
ª Upfront payment = PV of protection leg – PV of premium leg
ª Upfront premium ≈ (CDS spread – Fixed coupon) × Duration
ª Profit for protection buyer ≈ Change in spread × Duration × Notional amount
67
CDS index products
Investment grade indices (CDX IG/iTraxx Main): Constituent entities = 125
High yield indices (CDX HY/iTraxx Crossover): Constituent entities = 100
CDS indices are equal weighted
Market characteristics
CDS are centrally cleared
Parties send their contracts to the clearinghouses that collect
and distribute payment and impose margin requirements
Changes in price of CDS provide an opportunity to unwind
the position (monetizing a gain/loss)
Two ways to monetize a position:
Œ Exercising a CDS in response to a default
Entering into an offsetting position
LOS d Credit curve

ª Relationship between credit spreads and maturities of company’s bonds
ª Upward sloping curve (steepening): Greater likelihood of default in later years
ª Downward sloping curve (flattening): Greater likelihood of default in earlier years
ª Flat curve: Hazard rate is constant
CDS trading strategies

Long/short trade: Buy CDS of one entity and sell CDS of another entity
Curve trade: Buy and sell CDS of different maturity of the same entity
Basis trade: Exploit the difference in credit spreads of bond market and CDS market
Mispricing is temporary. Disappears after it is recognized
LOS e Applications of CDS
Uses of CDS:
Managing credit exposure
Exploiting valuation disparities
Bond yield = RFR + Funding spread + Credit spread
RFR + Funding spread = LIBOR
Collateralized debt obligations (CDO):

Claims against a portfolio of debt securities
Synthetic CDO: Buying default free securities and selling CDS
Watch video with important

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FinTree Forum for the reading
68
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Derivatives
Pricing And Valuation Of Forward Commitments

Introduction
Forward commitments
Forwards Futures Swaps
n
è No arbitrage forward/futures price = Spot × (1 + RFR)
è Value of forward/futures at initiation is zero
è Two fundamental rules for arbitrage:

Investmment = 0
Exposure to market risk = 0
Eg. Spot price: $100 RFR: 10% Maturity: 1 year
S = 100 S = 130 Long = 110
0 0.6 1
Price of the contract (0.6): 130 × (1+10%)0.4 = $135.05
Value of the contract at expiration (1): 135 − 110 = $25.05

25
Value of the contract today (0.6): = $24.11
(1+10%)0.4
LOS a & b Pricing and valuation of forward and fututres

1 Price and value of forward and futures (with dividend)
Eg. Spot price: $625 RFR: 8% CC Maturity: 6 months Spot rate in month 2 = $630
Expected dividends: $10 (Month 1), $20 (Month 3)
S = 625 D = 10 D = 20
0 1 3 6
(20.4)
(10.34)
650.5
Price of the contract (Long): 619.76
71
S = 630 D = 20
0 2 3 6
(20.4)
647.03
Price of the new contract (Short): 626.62
Value in month 6 (626.67 − 619.76) : 6.86

−0.08 × 4/12
Value in month 2 (6.91 × e ): 6.67
2 Price and value of forward and futures (continuous dividend yield)
Eg. #1 Spot index: $2,700 RFR: 10% Dividend yield: 2% CC Maturity: 6 months
Continuously compounded rate: LN (1.1) = 9.53%
Price of the contract: 2700 × e(9.53% − 2%) × 6/12 = 2803.59
Eg. #2 Spot index: 8,780 RFR: 6.9% CC Dividend yield: 1.8% CC Maturity: 40 days
Spot index on day 10: 8,900
S = ₹8,780 S = ₹8,900
0 10 40
Price of the contract (Short): 8780 × e(6.9% − 1.8%) × 40/365 = 8829.2

Price of the new contract (Long): 8900 × e(6.9% − 1.8%) × 30/365 = 8937.8
Value of the contract (Day 40): 8829.2 − 8937.8= (108.18)
Value of the contract (Day 10): 8900 × e(6.9%) × 30/365 = (107.56)
Characteristics of US LIBOR:
ª It is a rate at which one bank lends another bank
ª For short term
ª Currency is USD
ª Issued out of US
ª It is an add-on rate
ª Different LIBOR exist for different maturities
ª 360 day convention is used
30 60
1 × 3 FRA:
60 90
2 × 5 FRA:
90 90
3 × 6 FRA:
60 120
2 × 6 FRA:
72
3 Price and value of forward rate agreement (FRA)
Eg. FRA: 4 × 5 Nominal amount: $ 10,000,000 Position: Short

LIBOR (today) LIBOR (after 90 days)
30 day 300 bps 30 day 370 bps
120 day 390 bps 120 day 520 bps
150 day 400 bps 150 day 580 bps
Price of the FRA
Formula Logic Magic

(approx.)
) 1 + (0.04 × 150/360)
1 + (0.039 × 120/360)
−1
) × 360/30
4 × 150/360
150 days
1.67
3.9 × 120/360 = 1.3% 0.37%

1.67
120 days
4 × 150/360 = 1.67%
150 days
$100 $101.67
3.9 × 120/360 = 1.3%
120 days
$100 $101.3
Rate for 30 days:

PV = −101.3 FV = 101.67 N = 1
CPT I/Y = 0.362%
0.362 ð 30 days 0.37 ð 30 days

4.34%
4.34% ð 360 days 4.44% ð 360 days
Price of new FRA (after 90 days)

30 days
120 days 30 days
Day 90
)1 + (0.038 × 60/360)
1 + (0.037 × 30/360)
−1
) × 360/30 = 3.89%
Value of the FRA

10,000,000 × (4.34% − 3.89%) × (30/360)
= $3,750
1 + (0.038) × (60/360)
73
4 Price and value of currency forward contracts
Eg. Spot price: 66.505/$ Interest rates: India = 7% USA = 2%

Position: Long Investment: $1,000,000 Maturity: 6 months
After 2 months: Spot price: 68.15/$ Interest rates: India = 6.9% USA = 1.5%
0.5
Price of the contract: 66.505 ×

) )
1.07
1.02
= ₹68.1155
4/12
Price of the new contract: 68.15 ×

) )
1.069
1.015
= ₹69.3377
1,00,000 × 1.2223
Value of the contract: = ₹1,195,342.94
1.0694/12
5 Price of cheapest-to-deliver bond futures
Eg. Full price: $1,020 Maturity: 1.4 years Coupon: 12% semi-annual RFR: 10% semi-annual
Conversion factor: 1.17
S = 1,020 C = 60 C = 60
0 0.5 1 1.4
1.4/0.5
1,020 × 1.05 60 × 1.050.9/0.5 60 × 1.05 0.4/0.5
(62.38)
(65.5)
1,169
1,041.12
Accrued interest (60 × 0.4/0.5): (48)
Future price: 993.1
Conversion factor: 1.17
Quoted future price (993.1/1.7): 848
LOS c & d Pricing and valuation of swaps

1 Price and value of swaps (spot rates)
Eg. Spot rates (today) Spot rates (after 6 months)

1 6% 0.5 8%
2 8% 1.5 8.5%
3 9% 2.5 9.7%
4 10% 3.5 11%
Maturity: 4 years Notional amount: $10 mln
74
1 − Z4 1 − 0.683
Price of the swap: = 9.74%
Z1 + Z2 + Z3 + Z4 0.9433 + 0.8573 + 0.7721 + 0.683
Z1 = 1/(1.06)1 Z2 = 1/(1.08)2 Z3 = 1/(1.09)3 Z4 = 1/(1.1)4
Value of fixed coupon bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}
[0.974 × (0.962 + 0.8848 + 0.7933 + 0.694)] + (10 × 0.694)
$10.18 mln
Z1 = 1/(1.08)0.5 Z2 = 1/(1.085)1.5 Z3 = 1/(1.097)2.5 Z4 = 1/(1.11)3.5
MV + Coupon 10 + 0.6
Value of floating coupon bond: 1−n/12
= $10.1998 mln
(1 + Spot raten) (1 + 0.08)0.5
Value of the swap (fixed rate payer): Value of floating coupon bond − Value of fixed coupon bond
Value of the swap (fixed rate payer): 10.1998mln − 10.18mln = $0.0198 mln
2 Price and value of swaps (LIBOR)
Eg. LIBOR (today) LIBOR (after 30 days)

90 day 1.5% 60 day 3%
180 day 1.8% 150 day 3.3%
270 day 1.9% 240 day 4%
360 day 2.15% 330 day 4.1%
Maturity: 1 year (quarterly pay) Notional amount: $100 mln
1 − Z4 1 − 0.9789
Price of the swap: = 0.0053 × 4 = 2.13%
Z1 + Z2 + Z3 + Z4 0.9962 + 0.991 + 0.9859 + 0.9789
Z1 = 1/{1 + [0.015 × (90/360)]} Z2 = 1/{1 + [0.018 × (180/360)]}

Z3 = 1/{1 + [0.019 × (270/360)]} Z4 = 1/1.0215
Value of fixed coupon bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}
{[100 × 2.13% × 90/360 × (0.995 + 0.9864 + 0.974 + 0.9606)] + (100 × 0.9606)}
$98.46 mln
75
Z1 = 1/{1 + [0.03 × (60/360)]} Z2 = 1/{1 + [0.033 × (150/360)]}
Z3 = 1/{1 + [0.04 × (240/360)]} Z4 = 1/{1 + [0.041 × (330/360)]}
MV + Coupon 100 + (1.5 × 90/360)

Value of floating coupon bond: = $99.87 mln
(1 + Spot rate) (1 + 0.03) × 60/360
Value of the swap (fixed rate receiver): Value of fixed coupon bond − Value of floating coupon bond
Value of the swap (fixed rate receiver): 98.46mln − 99.87mln = ($1.14 mln)
3 Price and value of currency swaps
UK LIBOR (today) US LIBOR (today)

180 day 130 bps 180 day 200 bps
270 day 150 bps 270 day 220 bps
360 day 170 bps 360 day 250 bps
UK LIBOR (after 30 days) US LIBOR (after 30 days)

150 day 100 bps 150 day 250 bps
240 day 110 bps 240 day 300 bps
330 day 120 bps 330 day 320 bps
Maturity: 1 year (quarterly pay) Notional amount: £1 mln

Spot rate: $1.5/£ Spot rate after 30 days: $1.75/£
1 − Z4
Price of the swap (UK): = 0.42 × 4 = 1.68%
Z1 + Z2 + Z3 + Z4
1 − Z4
Price of the swap (US): = 0.6175 × 4 = 2.47%
Z1 + Z2 + Z3 + Z4
Value of USD bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}
{[1.5mln × 2.47% × 1/4 × (0.9968 + 0.9896 + 0.9803 + 0.9715)] + (1.5mln × 0.9715)}
$1,493,733
76
Value of GBP bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}
{[1 mln × 1.68% × 90/360 × (0.9985 + 0.9958 + 0.9927 + 0.9891)] + (1 mln × 0.9891)}
£1,005,819 = $1,760,184 (1,005,819 × 1.75)
Value of the swap (USD receiver): Value of USD bond − Value of GBP bond
Value of the swap (USD receiver): 1,493,733 − 1,760,184 = ($266,450)
3 Price and value of equity swaps
LIBOR (today) LIBOR (after 30 days)

180 day 200 bps 150 day 250 bps
270 day 220 bps 240 day 300 bps
360 day 250 bps 330 day 320 bps
Maturity: 1 year (quarterly pay) Notional amount: ₹1.5 mln

Equity index after 30 days: ₹29,300
Equity index today: ₹27,600
1 − Z4
Price of the swap: = 0.6175 × 4 = 2.47%
Z1 + Z2 + Z3 + Z4
Value of the bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}
{[1.5mln × 2.47% × 4 × (0.9968 + 0.9896 + 0.9803 + 0.9715)] + (1.5mln × 0.9715)}
₹1,493,733
29,300
Value of the equity index: 1.5 mln × = ₹1,592,391
27,600
Value of the swap (fixed rate payer): Value of equity index − Value of bond
Value of the swap (fixed rate payer): 1,592,391 − 1,493,733 = 98,658
77
Valuation Of Contingent Claims

LOS a & b Binomial option valuation model
Eg. Spot price: 150 Strike price: 150 RFR: 10% Expiry: 6 months σ (annual): 35%
Value of option using binomial model
Up factor (U): e0.35×√0.5 = 1.2808
Down factor (D): 1/U = 0.7807
(1 + RFR) − D (1 + 0.1)0.5 − 0.7807

Risk neutral probability of U: = 53.6093%
U−D 1.2808 − 0.7807
Risk neutral probability of D: 1 − Risk neutral probability of U = 46.3907%
Value of call option: 192.12 − 150 = 42.12

3%
150 × 1.2808 = 192.12
609 Value of put option = 0 (option is out of the money)
53.
150
46.
390 Value of call option = 0 (option is out of the money)
7%
150 × 0.7807 = 117.105
Value of put option = 150 − 117.105 = 32.895
42.12 × 53.6093%
Value of call option (today): = 21.53
(1 + 0.1)0.5
32.895 × 46.3907%
Value of put option (today): = 14.55
(1 + 0.1)0.5
Value of call option using put-call parity
S+P = B+C
150 + 14.55 = 150/1.10.5 + C
Value of call option (C) = 21.53
Valuation of an option using a two-period binomial model is done using the same method:
Œ Calculate the expected spot rate at each node using up/down factor
Calculate the intrinsic value of the option at each node
Ž Calculate the value of the option today
American option: No benefit of early exercise

Deep-in-the-money put option: Benefit of early exercise
78
LOS c Arbitrage opportunity
Ou − Od
Hedge ratio/delta:
Su − S d
If the value of option > Value of the replicated portfolio, arbitrage can
be earned by selling the option and buying the replicated portfolio
If the value of option < Value of the replicated portfolio, arbitrage can
be earned by selling the replicated portfolio and buying the option
LOS d & e Interest rate option

Eg. Exercise rate: 5.2% Option: European call Maturity: 2 years Notional amount: $100 mln
10.72%
5.77%
3% 7.2%
3.89%
4.82%
Payoff: 5.52%
[(5.52 + 2)/2]/1.0577 = 3.55%
[(3.55 + 0.96)/2]/1.03 = 2.19% Payoff: 2%
(2/2)/1.0389 = 0.96%
Payoff: 0
LOS f Assumptions of the Black–Scholes–Merton option valuation model

èUnderlying follows a lognormal distribution (i.e. logarithmic
return is normally distributed)
èUnderlying is liquid
èFrictionless markets
èOptions are European
èContinuously compounded RFR, volatility of the return, and
yield on underlying asset are all known and constant
LOS g Components of BSM model

Call = [Spot × N(d1)] − [Bond × N(d2)]
Put = [Bond × N(−d2)] − [Spot × N(−d1)]
LN(S/X) + {T × [(σ2/2) + RFR]}

d1 =
σ × √T
d2 = d1 − (σ × √T)
Bond = e–rT
79
LOS h Valuation of European option on equities using BSM model
Call = [Spot−qt × N(d1)] − [Bond × N(d2)]
Put = [Bond × N(−d2)] − [Spot−qt × N(−d1)]
LN(S−qt/X) + {T × [(σ2/2) + RFR]}

d1 =
σ × √T
q = Continuously compunded dividend yield
Valuation of European option on currencies using BSM model

Call = {[S0 × eInterest rate of base currency × T × N(d1)]} – [Bond × N(d2)]
Bond = e–Interest rate of price currency × T
LOS i Using Black model to value European options on futures

Call = [F × e−rt × N(d1)] − [Bond × N(d2)]
Put = [Bond × N(−d2)] − [F × e−rt × N(−d1)]
LN(F × e−rt/X) + {T × [(σ2/2) + RFR]}

d1 =
σ × √T
LOS j Using Black model to value European interest rate options and swaptions
Call = [AP × e−r(N×Actual/365)]× [FRA × N(d1)] − [X × N(d2)] × Notional amount
AP (Accrual period) = [(N − M) × 30/360]
Equivalencies (interest rate option)

Long FRA: Long interest rate call + Short interest rate put
Short FRA: Short interest rate call + Long interest rate put
Interest rate cap: A series of interest rate call options

Used by a floating rate borrower to hedge the risk of increase
in interest rates
Interest rate floor: A series of interest rate put options
Used by a floating rate lender to hedge the risk of decrease
in interest rates
Payer swap: Long interest rate cap + Short interest rate floor
Receiver swap: Short interest rate cap + Long interest rate floor
Swaptions
Swaption: Option on swap
Payer swaption: Right to pay fixed rate and receive floating rate
Receiver swaption: Right to receive fixed rate and pay floating rate
Value of payer swaption:

AP × PVA {[SFR × N(d1)] – [X × N(d2)]}× Notional amount
80
Equivalencies (swaptions)
Payer swap: Long payer swaption + Short receiver swaption
Receiver swap: Long receiver swaption + Short payer swaption
LOS k Option Greeks
Delta Vega Rho
Change in the value of option

for a given change in the
value of underlying stock
It is the slope of the

prior-to-expiration curve
($ terms) for a given change
Call option: Delta = +ve
in volatility
Put option: Delta = −ve
It is based on future volatility for a given change in RFR
In-the-money option:
Delta is close to e−qt
It is highest when the option Call option: Rho = +ve
is at-the-money and close to Put option: Rho = −ve
At-the-money option:
expiry
Delta is b/w 0 and e−qt
Call option: Vega = +ve
Out-of-the-money option:
Put option: Vega = +ve
Delta is close to 0
DeltaC = e−qt × N(d1)

DeltaP = −e−qt × N(−d1)
ΔC = ΔS × DeltaC
Gamma Theta
Change in delta for a given

change in the value of Change in value of option for
underlying stock a given change in calender
time
Measure of curvature of the
option value in relation to the It is the rate at which time
value of stock value of option declines as
the option approaches expiry
Gamma is same for both call
and put option Relationship between option
value and time to maturity is
It is highest when the option +ve
is at-the-money and close to
expiry Relationship between option
value and passage of time is
ΔC = ΔS × DeltaC + ½ −ve
Gamma × ΔS2
81
LOS l Delta hedging
ª Delta hedging refers to managing portfolio delta by entering into additional positions
ª Delta-neutral portfolio: Portfolio delta is set and maintained at zero
ª Delta-neutral portfolio needs to be rebalanced continually to maintain the hedge (aka

dynamic hedging)
ª No. of options = No. of shares/Delta
ª No. of options will be higher than the no. of shares
LOS m Role of gamma risk in options trading

ª Gamma captures non-linearity risk or the risk that
remains once the portfolio is delta neutral
ª Gamma risk: Risk of leaving a delta-hedged portfolio

unhedged because of a sudden jump in stock prices
LOS m Implied volatility
It is the volatility in BSM model that yields the market price of the option
If expected volatility > implied volatility, take long position on option

If expected volatility < implied volatility, take short position on option
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Real Estate Investments

LOS a Basic forms of real estate investments
Private market Public market
Direct investment Indirect investment
Equity investment Debt investment Equity investment Debt investment
Purchasing a Lending money to

Investing in REITs Investing in MBS
property a purchaser
Characteristics of real estate Classification of real estate
èHeterogeneity
Residential:
èHigh unit value
Single-family houses and
èActive management
multi-family apartments
èHigh transaction costs
èDepreciation
Non residential:
èNeed for debt capital
Commercial properties, farmland
èIlliquidity
and timberland
èDifficulty in price determination
LOS b & c Economic value determinants of real estate investments &

Factors affecting the demand for major property types
èCash flow is a function of rental income, operating expenses, leverage and capital spending
èThe drivers of cash flows are driven by supply & demand of spaces and other economic factors
Difficulty in price determination
85
Factors affecting the demand for Commercial property types &

their type of lease
Industrial and
Office Retail Multi-family
warehouse
Demand depends on
Demand depends on
employment growth
consumer spending Demand depends on
Demand depends on
population growth
Gross lease: the overall economy
Lease terms vary
Owner is responsible
depending on quality Demand also depends
for paying operating Demand for warehouse
of the property, size on cost of renting
expenses also depends on
and importance of the versus the cost of
import/export activity
tenant buying
Net lease: in the economy
Tenant is responsible
Percentage lease: Increase/decrease in
for paying operating Net leases are more
Tenants pay additional interest rates also
expenses common
rent once sales reach a affect demand
certain level
Net lease < Gross lease
Reasons to invest in real estate
Current income, Capital appreciation, Inflation hedge, Diversification & Tax benefits
Real estates have both bond-like (fixed income stream) and stock-like (capital appreciation) characteristics
Based on empirical data,

Risk and return of bond portfolio < Risk and return of real estate portfolio < Risk and return of stock portfolio
Percentage of debt and equity used to finance real estate does not affect property’s value
LOS d Due diligence in private equity real estate investment
è Review lease and rental history è Have an attorney review the ownership history,
clear title etc.
è Examine copies of bills for operating expenses è Review service and maintenance agreements
è Have the property surveyed to confirm the
è Review CF statement from previous owner boundaries and find out if there are any
easements that would affect the value
è Perform environmental inspection of the site è Verify that the property is compliant with zoning
laws, environmental regulations etc.
è Perform a physical/engineering inspection è Verify payment of property taxes, insurance,
special assessments etc.
86
LOS e Private equity real estate investment indexes
Appraisal-based Transaction-based
indices indices
Repeat-sales index Hedonic index
Return:
Capital Requires only one
NOI − + (End MV − Beg MV)
expenditures Relies on repeat sales sale
Beginning MV of the same property
It includes variables
This return is equivalent to IRR Regression model is such as size, age,
used to create an quality and location
Such an index allows investors to compare index of the property into
the performance of real estate with other the regression model
asset classes
Apprisal-based index tends to have less volatility and lag transaction-based index
This results in lower correlation with other asset classes
LOS f Approaches to valuing real estate properties
Income approach Cost approach Sales comparison approach
Value = PV of expected
future income from the
Value of land + Cost of
property Sale prices of comparable
constructing new property
properties are adjusted for
− Adjustments for
Two methods: differences in the subject
depreciation and
Direct capitalization property
obsolescence
method
DCF method
87
LOS g,h& i Inputs to direct capitalization and DCF methods

Income approach
Direct capitalization method DCF method
NOI1 Rent1 Using

Cap rate ARY GIM
Cap rate: Forecast NOI over

Gross income
r−g All risk yield holding period
NOI: multiplier (GIM):
(ARY): and terminal
Rental income at Sale price/Gross
Cap rate can also Rent1/Comparable value at the end
full occupancy income. It can be
be derived from sale price then discount
+ Other income derived from
comparable them back to n0
– Vacancy and comparable
transactions This valuation is
collection loss transactions
used in case of If no growth is
– Operating
Cap rate: net lease because expected, then
expense V0 = Gross income
NOI1/Comparable NOI = Rent cap rate = disc
× GIM
sale price rate
èWhen tenant pays all expenses, the rate used to value the property is ARY
èAdjustments are required when the contract rent (passing or term rent) is not equal
to current market rent (open market rent)
èSuch issue is dealt with ‘term and reversion approach’
èUnder this approach, contract rent and reversion are appraised separately using
different cap rates
èDiscount rate on contract rent < Reversion rate, because contract rent is less risky
èLayer method: Similar to ‘term and reversion approach’ except that one layer is
contract rent that is considered to be perpetual and the second layer is the increase
in rent
èThe two methods result in different valuation
èEquivalent yield: Mathematical (not simple) average of two cap rates. It is the rate
at which two methods result in same valuation
Steps for DCF analysis:

Œ Project income from existing leases
Make assumptions about lease renewals
Ž Make assumptions about operating expenses
Make assumptions about capital expenditure
Make assumptions about vacancy
‘ Estimate resale value
’ Select appropriate discount rate
Important points in cost and sales comparison approaches

Cost approach is appropriate for unusual properties for which comparables
are not easily available
It is also appropriate for new properties
Sales comparison approach is appropriate when the market is active
In theory, all approaches must produce the same outcome. However, in

practice that is not the case
Therefore, appraiser must reconcile the differences to arrive at a conclusion 88

LOS j Private real debt investments
Using debt(leverage) magnifies returns
+leverage: Investment Return > Interest Paid
With leverage, there is also an increase in risk
Financial ratios used to analyze and evaluate private real estate

investments
Debt service coverage ratio Equity dividend rate
Loan-to-value (LTV)
(DSCR) (Cash-on-cash return)
NOI Loan amount CF
Debt service Appraisal value Equity
Leveraged IRR: Consider CFs over holding period, sale price and outstanding loan
LOS k
Types of publicly traded real estate securities
Real estate investment Real estate operating Mortgage-backed

trusts (REITs) companies (REOCs) securities (MBS)
Asset-backed
securitized debt
Equity REITs: Ordinary taxable real
obligations that receive
Tax-advantaged estate ownership
CF from an underlying
companies or trusts companies
pool of mortgage loans
that own, operate and
develop income- Engage to a large
Can be commercial
producing real estate extent in the
(CMBS) or residential
development of real
(RMBS)
Mortgage REITs: estate, with an intent
Invest in loans that are to sell rather than to
MV of real estate debt
secured by real estate lease
securities > MV of real
estate equity securities
89
Types of REITs
Retail REITs Industrial REITs Storage REITs Hotel REITs
Aka shopping Invest in properties They own and They lease

center REITs that are used as operate properties to
warehouses, self-storage management
Small retailers pay distribution properties (mini- companies
greater of fixed centers, warehouses)
rent and % of sales manufacturing RevPAR:
facilities and small They are gross Avg room rate × Avg
Anchor retailers offices leases occupancy
either pay fixed
rent or own their They are long-term Rented on monthly Affected by business
premises leases basis cycle
Office REITs Residential REITs Health care REITs
Aka multi-family Invest in nursing

REITs homes, hospitals,
medical office
Invest in Invest in rental buildings etc.
multi-tenanted apartments
office properties Unaffected by
They are gross recession.
They are net leases leases However, affected
by demographics,
They are one-year government
leases funding etc.
LOS l Net asset value per share (NAVPS)

MV of assets − MV of liabilities
NAVPS =
No. of shares outstanding
If existing appraisals are not available, value of operating real estate is

estimated by capitalizing NOI (rent)
Expected NOI
Value =
Cap rate
Non-cash rent: Difference between average rent over the term of

contract and cash rent actually paid
If MPS > NAVPS then, REIT is overvalued

If MPS < NAVPS then, REIT is undervalued
Eg. Last 12-month NOI = $200k Non-cash rent = $8k Full-year adjustment for acquisitions = $2k
Next 12-month growth in NOI = 2% Cap rate = 6% Cash and equivalents = $50k
AR = $30k Land = $40k Prepaid/Other assets = $15k Debt = $1mln Other liabilities = $225k
No of shares outstanding = 48k
Last 12-month NOI: 200,000

Non-cash rent: (8,000)
Full-year adjustment for acquisitions: 2,000
Pro forma cash NOI for last 12 months: 194,000
Next 12 months growth in NOI (2%) 3,880
Estimated next 12 months cash NOI: 197,880
Cap rate: 6%
Estimated value of operating real estate: 3,298,000
Cash and equivalents: 50,000
AR: 30,000
Land: 40,000
Prepaid/other assets: 15,000
Estimated gross asset value: 3,433,000
Debt: (1,000,000)
Other liabilities: (225,000)
Net asset value: 2,208,000
No. of shares outstanding: 48,000
NAVPS: 46
91
LOS m Relative value approach to valuing REIT stocks
Funds from Adjusted funds from

operations (FFO) operations (AFFO)
More accurate measure of current

economic income
Measure of operating income of
REITs/REOCs
Aka cash available for distribution
(CAD)/funds available
Calculated as:
for distribution (FAD)
Accounting net earnings
+ Depreciation expense
Calculated as:
+/− Deferred tax expenses
FFO
+/− Gains or losses from sales of
– Non-cash rent
property and debt restructuring
– maintenance-type capital
expenditures and leasing costs
LOS n Approaches to REIT/REOC valuation
NAVPS Relative value DCF
Frequently used:
P/FFO and P/AFFO
Factors that impact these

Based on MV of assets and ratios:
Investors use two-stage/
liabilities Ÿ Expectations for growth
three-stage DDM with
in FFO/AFFO
near-term/intermediate-
Largest component of Ÿ Risk associated with
term/long-term growth
intrinsic value of a underlying real estate
forecasts
REIT/REOC Ÿ Risk associated with
company’s capital
structures and access to
capital (higher leverage
→ lower FFO/AFFO)
92
LOS o Investing in real estate through publicly traded securities
Advantages Disadvantages
Investors may be able to replace one property

Greater liquidity for a similar property without having to pay
taxes. REITs do not qualify for such benefits
Lower investment requirement Less control for minority shareholders
Limited liability High maintenance costs
Ability to invest in superior quality and range

Stock market determined price
of properties
Active professional management UPREIT/DOWNREIT conflict
Low rate of income retention, reducing future

income growth
Diversification
REITs use debt market to refinance their debt.
In periods of weak credit availability they may
have to issue equity at disadvantageous price.
Additional advantages of REITs Additional advantage of REOCs

compared with REOCs: compared with REITs:
Tax advantage Opearting flexibility
Predictable earnings
High income payout ratios and yields
93
Valuation methodologies
Real options
DCF Venture capital
Relative value Replacement cost
LBO is not a valuation technique, but a way to determine the impact of capital structure, purchase
price and other parameters on returns the PE firm expects from the deal
LOS d Valuation issues in buyout and VC transactions

Valuation issue Buyout VC
Less frequently used

Using DCF method Frequently used
(CFs are uncertain)
Using relative value Used to check the value Difficult to use (no
approach from DCF analysis comparable companies)
Level of debt High Low
Pre-money valuation (PRE): Value of a company before making investment

Post-money valuation (POST): Value of a company after making investment
VC investor’s proportionate ownership: Investment/POST
POST = PRE + INV
Required Rate of Return on VC Investments

Ÿ VC firms target an expected hurdle return.
Ÿ The failure rate of VC investments, especially early-stage VC investments, is much higher than that of
growth equity or buyouts.
Ÿ Thus, the target return on investment is 10x to 30x more as compared to the 2 to 2.5 times in the Buyout
space.
Option Pools
Ÿ To attract and incentives employees, start-ups grant their employees the option to purchase shares.
Ÿ When these options are exercised, they will naturally have a dilutive effect, so VC firms tend to calculate
the per-share price on a fully diluted basis.
Ÿ The basis of the dilution is contractually defined.
Ÿ By calculating the share price on a fully diluted basis, VC investors are effectively left untouched by the
dilution effect. Instead, the original shareholders, i.e. founders, absorb the effects of dilution.
Stage Financing
Ÿ Stage financing is a key mitigator of the risk that is fundamental to venture capital: significant uncertainty
about growth and profitability prospects.
Ÿ Because the earlier-stage investors take on higher risk, the return for those investors has to be higher.
Ÿ Valuations, specifically pre-money valuations, at which later rounds of financing are raised, provide insight
into the performance of an otherwise illiquid asset class.
Ÿ Venture capital investments tend to be minority stake investments. This is partly because the founders might
not be willing to give up control but also because entrepreneurs are essential in the initial stages of business
development. So, the dilution of initial investors through the subsequent financing rounds is common.
Ÿ It is typical to use convertible preferred equity in later-stage financing. Because the capital that comes in at
later stages is less risky than earlier-stage financing. In addition, to mitigate risk further, later-stage capital
tends to have a preferred dividend.
Ÿ If the investee company performance is as expected and the returns are high, the preference shares will be
irrelevant. However, if things do not go as planned, the accumulated dividend is treated as junior debt,
diminishing the value held by earlier equity investors while preserving the value for Preferred Dividend share
holders.
94
Private Equity Valuation

LOS a Sources of value creation in private equity
ª Ability to re-eingineer the company to generate superior returns
ª Ability to obtain favorable debt financing
ª Better alignment of interests between owners and managers of the company
LOS b How PE firms align their interests with those of the

managers of portfolio companies
ª Result driven management pay packages and contractual clauses are used to align the
interests between owners and managers of the company
ª Contractual clauses:
Ÿ Tag-along, drag-along: Potential future acquirer can not acquire control without extending
the acquisition offer to all shareholders, including company management
Ÿ Corporate board seats: PE firm is ensured control in case of major corporate event such as
takeover, IPO etc.
Ÿ Noncompete clause: Imposed on founders that prevents them from competing against the
company during a predefined period of time
Ÿ Priority in claims: PE firms receive their distributions before other shareholders and maybe
guaranteed a minimum multiple of their original investment
Ÿ Approval: Decisions of strategic importance such as change in business plan, acquisition are
subject to approval by PE firms
Ÿ Earn-outs: Acquisition price paid is tied to the portfolio company’s future performance over
a specified period of time
LOS c Buyout Venture capital
èSteady and predictable CFs èUnrealistic and unpredictable CFs

èEstablished market position èNew market with uncertain future
èSignificant asset base èWeak asset base
èStrong and experienced management èNew management team
team èLow use of debt
èHigh use of debt èUnclear risk and exit
èPredictable risk and exit èProduct is based on new technology
èEstablished product èHigh cash burn rate
èPotential for restructuring and cost èHigh WC requirements
reduction èLimited due diligence
èLow WC requirements èMonitoring: Milestones
èExtensive due diligence èHigher returns from few highly
èMonitoring: CFs, strategic and business successful investments
plan èLimited capital market presence
èLower variance across returns from èTransaction are a result of relationship
underlying investments between VCs and entrepreneurs
èActively present in capital markets èLess scalable
èTransactions are auctions èMain source of revenue to the general
èMore scalable partner: Carried interest (share in
èMain source of revenue to the general profits)
partner: Carried interest, transaction
and monitoring fees
95
LOS f PE fund structures
Most common form of PE structures is limited partnership
General partner (GP): Fund manager, liable for all debts and has unlimited liability
Limited partners (LPs): Fund investors and have limited liability
Another form is company limited by shares. It offers a better legal protection to the partners
PE fund terms
Economic Corporate governance
Key man clause:

GP is prohibited from making new investments
in case of departure of key named executives
Disclosure and confidentiality:

Financial performance of underlying funds is
disclosed but information on companies in
Management fees:
which the funds invest is not
Fees paid to the GP as a percentage of
committed capital/NAV/invested capital
Carried interest:
GP’s share of profits. Usually 20% (after
Transaction fees:
management fees)
Fees paid to the GP in his advisory capacity
when they provide investment banking
Clawback provision:
services. When these fees apply, they are
Requires GP to return capital to LPs when firm
deducted from management fees
exits highly profitable investment early in its
life but subsequent exits at less profits
Carried interest:
GP’s share of profits. Usually 20% (after
Distribution waterfall:
management fees)
Order of distribution to LPs before GP receives
carried interest (can be deal-by-deal or total)
Ratchet:
Allocation of equity b/w shareholders and
Tag-along, drag-along:
management
Potential future acquirer can not acquire
control without extending the acquisition offer
Hurdle rate:
to all shareholders, including company
IRR that the fund must achieve before GP
management
receives any carried interest
No-fault divorce:
Target fund size:
GP may be removed without cause if
Stated absolute amount in the fund prospectus
supermajority of LPs approve
Vintage year:
Removal for cause:
Year in which PE fund was launched
Allows removal of GP or termination of the
fund for cause
Term of the fund:
Life of the firm. Usually 10 years
Investment restrictions:
Impose limits such as minimum level of
diversification, borrowing limits etc.
Co-investment:
Allows the LPs to co-invest with GP in new
funds at low or no management fees
96
PE valuation
Valuation is related to the fund’s NAV
Issues with calculating NAV:

Ÿ If valuation is adjusted with new rounds of financing, NAV will be
more stale when financings are infrequent
Ÿ Value at which investment in portfolio companies is reported
Ÿ Undrawn LP commitments are not included in the NAV calculation
Ÿ Comparing PE firms that follow different investment strategies
Ÿ Equity valuations are performed by GPs
PE due diligence
Top performing funds tend to continue to outperform and poor
performing funds tend to continue to underperform
Performance range b/w funds is very large
PE investments are usually illiquid and long-term. However, duration

of investment in PE is shorter than maximum life of the fund
LOS e Alternative exit routes
Secondary Management
IPO Liquidation
market sale buyout (MBO)
Company is sold to Company is liquidated

Company’s equity is Company is sold to
another financial or if it is deemed no
offered to public management
strategic investor longer viable
Results in highest They use large
Results in second Results in lowest
valuation amounts of leverage
highest valuation valuation
97
LOS g
Risks of investing in PE Costs of investing in PE
Liquidity risk
Unquoted investments risk

Transaction fees
Competitive environment risk
Investment vehicle fund setup costs
Agency risk
Administrative costs
Risk of loss of capital
Audit costs
Regulatory risk
Management and performance fees
Taxation risk
Dilution costs
Valuation risk
Placement fees
Diversification risk
Market risk
LOS h Financial performance of PE funds from investor perspective

Gross IRR: % return earned by the firm
Net IRR: % return earned by the LPs
Paid in capital (PIC): PIC/Committed capital = % of capital called by GP
Distributed to paid-in capital (DPI): Cumulative distributions paid to LPs/Cumulative invested capital
Residual value to paid-in capital (RVPI): Value of the LPs’ holdings in the fund/Cumulative invested capital
Total value to paid-in capital (TVPI): DPI + RVPI
DPI, RVPI and TVPI are calculated net of management fees and carried interest
LOS i Evaluating a PE fund
Management fees: % fee × Total paid-in capital
Carried interest: % carried interest × Increase in NAV before distribution
NAV before distribution: NAV after distributiont−1 + capital called down − management
fees + operating results
NAV after distribution: NAV before distribution − Carried interest – distributions
98
Commodities And Commodity Derivatives:

An Introduction
LOS a Characteristics of commodity sectors
Energy Grains Industrial metals
Actively traded:
Crude oil, natural gas, and
refined products Includes wheat, rice, corn, Includes copper,
and soybeans aluminum, nickel, zinc,
Most valuable sector lead, tin, and iron
Risks: Droughts, floods,
Crude oil: Can be stored in pests and diseases Aka base metals
its natural state. Requires
processing Weather plays important Demand is associated
role in determining yield directly with GDP growth
Natural gas: Can be used
directly. Storage and Technology and politics Demand is also affected by
transportation costs are play a key role in food weather and business
high because it needs to supply and demand cycles
be liquified
Long storage period Long storage period
Refined products: Short
storage period
Livestock Precious metals Softs
Includes hogs, cattle,

sheep, and poultry Includes cotton, coffee,
Includes gold, silver, and
sugar, and cocoa
platinum
This sector is dependent
on prices of grains and Aka cash crops
Weather has no impact on
GDP per capita
availability of precious
Weather plays important
metals
Weather has impact on role in determining yield
health and weight of
Used in electronics, auto
animals Demand is associated with
parts, and jewelry
global wealth
Risk: Diseases
Long storage period
Short storage period
Long storage period
99
LOS b Life cycle of commodity sectors
Industrial/Precious
Energy Grains
metals
Œ Drilling a well
Extracted ore is smelted
Extracting oil
Œ Planting into quality metal
Ž Transporting to storage
Growth
facility
Ž Head formation There are economies of
Storing
Harvest scale in the production of
Refining
industrial/precious metals
‘ Transporting and trading
Livestock Softs
Maturity varies with

animal size
Production cycle for
Freezing allows storage for coffee:
some period after
slaughter Œ Planting
Harvesting
Ranchers and Ž Drying
slaughterhouses trade hog Transporting
and cattle futures to hedge Roasting
against processed meat ‘ Transporting to retail
locations
Demand is associated with
global wealth
LOS c Valuation of commodities

Unlike bonds and stocks, commodities do not produce CFs
PV of a commodity = Spot price + PV of storage costs − PV of benefits
100
LOS d Participants in commodity futures markets
Hedgers Exchanges Regulators
Informed investors
Operate all over the Monitor commodity
Producers or users of world markets
the commodity
Traders and
investors Analysts
Hedgers:
Informed investors
Non-market
Speculators:
participants
Informed investors or
liquidity providers
Their research affects
market behavior
Arbitrageurs:
Capitalize on
mispricing
LOS e Relationship between spot prices and expected future prices

Basis: Spot price − Futures price
Calendar spread: Near-term futures price − Longer-term futures price
Contango: Spot price < Futures price (basis and calendar spread is −ve)
Backwardation: Spot price > Futures price (basis and calendar spread is +ve)
LOS f Theories of commodity futures returns
Hedging pressure
Insurance theory Theory of storage
hypothesis
Assumption:
Market is dominated by
short hedgers (producers) Considers producer’s as
Future price = FV of spot
well as buyer’s perspective
price + FV of storage costs
Speculators take long
− FV of convenience yield
position If markets are dominated
by short hedgers:
If costs < benefits:
Futures price < Expected Backwardation
Backwardation
spot price
If markets are dominated
If costs > benefits:
Results in backwardation by long hedgers:
Contango
normally. Therefore it is Contango
also known as the theory
of normal backwardation
101
LOS g Total return for a fully collateralized commodity futures contract
Eg. Spot pricet0: 100 Futures pricet0: 95 Spot pricet1: 105 Futures pricet1: 105
Return on T-bill (collateral): 3.5%
Total return: 19.02%
Spot yield Roll yield Collateral yield
Change in spot prices Change in futures prices Return on collateral
Return: Return: Return:

(105 − 100)/100 = 5% (105 − 95)/95 = 10.52% 3.5%
LOS h Roll yield in contango and backwardation

Contango Backwardation
Long: −ve, short: +ve Long: +ve, short: −ve
LOS i Commodity swaps
Total return swap Basis swap Variance swap
Long:
Receives payment based
Payments are based on Variance buyer receives
on the change in level of
difference between the the payment if:
commodity index
prices of two commodities Actual variance >
Expected variance
Short:
One commodity has highly
Pays series of fixed
liquid futures contract and Volatility seller receives
payments
the other (used by buyer in the payment if:
production) has no futures Actual variance <
Generally used by large
contract Expected variance
institutional investors (eg.
pension plans)
Excess return swap Volatility swap
Volatility buyer receives

the payment if:
Payments are made or
Actual volatility >
received by either party
Expected volatility
based on return calculated
by the change in index
Volatility seller receives
relative to a benchmark or
the payment if:
fixed level
Actual volatility <
Expected volatility
102
LOS j How construction of commodity indexes affects index returns
Different characteristics of commodity indexes:
Ÿ Breadth and selection methodology of commodities (differences in

methodology results in returns differences)
Ÿ Weighting of the commodities (equal weighted or some other method)
Ÿ Method and frequency of rolling contracts (active/passive)
Ÿ Method and frequency of rebalancing the weights (leads to
underperformance in a trending market)
Ÿ Governance of indexes (independence of index providers)
103
FinTree
CFA® Level II JuiceNotes 2022
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Equity | Fixed Income| Derivatives

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Our Placement Team purely leverages these contacts to

Equity Valuation: Applications and Processes

Steps in valuation process

Step 2: Forecast company performance

Step 3: Select the appropriate valuation model

Step 4: Convert forecasts to a valuation

Step 5: Apply the valuation conclusions

Sources of perceived mispricing

Estimated Intrinsic Valuation

Mispricing: Diﬀerence between market price and estimated intrinsic value

200 – 125 = (150 – 125) + (200 – 150)

Going Liquidation Fair market Investment

Value of a company if Price at which an

Most relevant value for public company valuation: Intrinsic value

èSelecting stocks èEvaluating business strategies and models

èInferring market expectations èCommunicating with analysts and shareholders

èEvaluating corporate events èValuation of private business

èRendering fairness opinions èShare-based payment

LOS e Industry and competitive analysis

Porter’s strategies for achieving

Œ Rivalry among existing competitors

Quality of earnings analysis: Includes scrutiny of ﬁnancial

Factors that may signal possible future negative surprises

Existence of related-party transactions Changes in auditors

Existence of excessive employee loans Management compensation tied to proﬁtability

High management turnover Loss of market share

Models that specify an asset’s

Both models incorporate going concern assumption

Conglomerate discount: Investors apply a discount to a company’s stock that operates

Explanations for conglomerate discount:

Ineﬃciency of internal capital markets (ineﬀective capital allocation)

Endogenous factors (to hide poor operating performance)

Research measurement errors (conglomerate discounts do not

LOS h Criteria for choosing an appropriate

Valuation model must be appropriate based on availability and quality of data

Valuation model must be consistent with the purpose of valuation

Expected alpha (ex ante alpha) = Expected return − Required return

Return from convergence of price to intrinsic value

LOS b Equity risk premium

Historical estimate Forward-looking estimate

Gordon growth Macroeconomic Survey

ª There can be a wide disparity between estimates obtained in surveys

Capital asset pricing

Actual values of beta Required return for public

Arbitrage pricing Fama–French Macroeconomic/

LOS d Beta estimation

For thinly traded stocks and nonpublic companies

Model Strengths Weaknesses

Ÿ Choosing the market

Ÿ They are simple

LOS f International considerations in required return estimation

Two main issues that concern an analyst:

Two approaches to calculate ERP:

LOS g Weighted average cost of capital

Capital Component cost Weighted

Equity 1000 20% 20% 4%

Threat of entry: Low threat of new entrants → More pricing power

Power of buyers: Low bargaining power of buyers → More pricing power

Power of suppliers: Low bargaining power of suppliers → More pricing power