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CFA Level 1 Quicksheet 2023

Corporate Finance (The University of Hong Kong)

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LEVEL I
C r it ic a l C o n c e pt s f o r t h e 2 0 2 3 CFA® E x a m
^ ETHI CAL AND PROFESSI ONAL
.STANDARDS
I Professionalism
| Required Rate of Return
Components:
1. Real risk-free rate (RFR).
2. Expected inflation rate premium (IP).
Correlation and Covariance
C orrelation: covariance divided by product of the
two standard deviations.
C O V (R i,R j)
1(A) Knowledge of the Law. 3. Risk premium. cor r ^ Rp Rj j =
a ( R [) a ( R ])
1(B) Independence and Objectivity. E(R) = (l + RFRreal)(l + IP)(l + RP) - 1
1(C) Misrepresentation. E x pected return, variance o f 2-stock portfolio:
1(D) Misconduct. Approximation formula for nominal required rate:
II Integrity of Capital Markets E(R) = RFR + IP + RP E(Rp) = w AE(Ra ) + w b E ( R b )
11(A) Material Nonpublic Information.
11(B) Market Manipulation. Means V a r ( R p ) = w Af f 2 ( R A ) + w B ^ 2 ( R B)
III Duties to Clients A rithmetic mean: sum of all observation values in +2wAw Bcr(RA)(7(RB)p (R A,R B)
HI (A) Loyalty, Prudence, and Care. sample/population, divided by # of observations.
III(B) Fair Dealing. G eometric mean: used when calculating investment Normal Distributions
III(C) Suitability. returns over multiple periods or to measure N ormal distribution is completely described by its
III(D) Performance Presentation. compound growth rates. mean and variance.
III(E) Preservation of Confidentiality. G eometric mean return: 68% of observations fall within ± la .
IV Duties to Employers
90% fall within ± 1.65a.
IV(A) Loyalty. R g = [(l + R ,) x ...x ( l + RN) f - l
IV(B) Additional Compensation Arrangements. 95% fall within ± 1.96a.
IV(C) Responsibilities of Supervisors. N 99% fall within ± 2.58a.
H armonic mean = N
V Investment Analysis, Recommendations, 1 Computing Z-Scores
and Actions E Z-score: “standardizes” observation from normal
V(A) Diligence and Reasonable Basis. i=i
distribution; represents # of standard deviations a
V(B) Communication with Clients and T rimmed mean (x%): Exclude highest and lowest given observation is from population mean.
Prospective Clients. x/2 percent of observations.
V(C) Record Retention. W insorized mean (x%): Substitute values for highest observation —population mean x —fi
VI Conflicts of Interest and lowest x/2 percent of observations. standard deviation a
VI (A) Disclosure of Conflicts.
VI (B) Priority of Transactions. Variance and Standard Deviation Binomial Models
VI(C) Referral Fees. V ariance: average of squared deviations from mean. B inomial distribution: assumes a variable can take
VII Responsibilities as a CFA Institute n one of two values (success/failure) or, in the case of
Member or CFA Candidate E (x i- x )2 a stock, movements (up/down). A binomial model
VII(A) Conduct as Participants in CFA Institute
sample variance = s2 = i=l can describe changes in the value of an asset or
Programs. n —1 portfolio; it can be used to compute its expected
VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program. Standard deviation: square root of variance. value over several periods.
Global Investment Performance Standards Target Downside Deviation Sampling Distribution
D efinition o f firm : Corporation, subsidiary, or Sampling distribution: probability distribution of
etarget ( X j - target) all possible sample statistics computed from a set of
division held out to clients as a business entity.
All fee-paying discretionary portfolios must be n —1 equal-size samples randomly drawn from the same
included in at least one composite. population. The sampling distribution o f the mean is
V erification: Optional, but if chosen it must be Holding Period Return (HPR) the distribution of estimates of the mean.
carried out by an independent third party. Central Limit Theorem
R c = P[~Pc 1+ D c or Pt+C>t - 1 C entral limit theorem: when selecting simple
GIPS standards fo r firms:
P.-1 Pt-i random samples of size n from population with
1. Fundamentals of Compliance
2. Input Data and Calculation Methodology Coefficient of Variation mean p and finite variance a 2, the sampling
3. Composite and Pooled Fund Maintenance C oefficient o f variation (CV): expresses how much distribution of sample mean approaches normal
4. Composite Time-Weighted Return Report dispersion exists relative to mean of a distribution; probability distribution with mean p and variance
5. Composite Money-Weighted Return Report allows for direct comparison of dispersion across equal to a 2In as the sample size becomes large.
6. Pooled Fund Time-Weighted Return Report different data sets. CV is calculated by dividing Standard E rror
7. Pooled Fund Money-Weighted Return Report standard deviation of a distribution by the mean or Standard error o f the sample mean is the standard
8. GIPS Advertising Guidelines expected value of the distribution: deviation of distribution of the sample means.
CV = =
X kn own population variance: cr^ = —j=
vn
QUANTITATIVE M ETHODS Roy’s Safety-F irst Ratio
u n kn own popu lation variance: s^ =
Time Value of Money Basics rp rtarget
• F uture value (FV): amount to which investment a„ Confidence Intervals
grows after one or more compounding periods. C onfidence interval: gives range o f values the mean
• F uture value: FV = PV(1 + I/Y)N. E xpected Return/ Standard Deviation
value will be between, with a given probability (say
• Present value (PV): current value of some future E x pected return-. E(X) = ^ ^ P (x j) xn 90 % or 9 5%). W it h kn own variance, form u la for a
cash flow PV - FV/(1 + I/Y)N. E(X) = P (Xl) Xl + P (x 2)x 2 + ... + P (xn)x n confidence interval is:
• A nnuities: series of equal cash flows that occur at
evenly spaced intervals over time. Probabilistic variance-. x za/2 r~
Vn
• Ordinary annuity: cash flow at end-o$-xvcs\e.
<Cx ) = E pM h - E( x ) f 1.645 for 90% confidence intervals
period.
• A nnuity due: cash flow at beginning-of-time period. = P ( x ,) [ x 1 - E ( X ) ] 2 + P ( x 2)[x -E (X )] (significance level 10%, 5% in each tail)
• Perpetuities: annuities with infinite lives. + - + P(xn)[x„ — E(x)f 1.960 for 95% confidence intervals
PVperpetuity
. = PMT/(discount
v
rate). (significance level 5%, 2.5% in each tail)
Standard deviation: take square root of variance.
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QUANTI TATI VE M ETHODS c o n t i n u e d ... M onopoly: Single firm with significant pricing F inancial account: government-owned assets
power; high barriers to entry; advertising used to abroad; foreign-owned assets in the country.
za/2 = 2.575 for 99% confidence intervals compete with substitute products.
(significance level 1%, 0.5% in each tail) Regional Trading Agreements
In a ll market structures, profit is maximized at F ree trade area: Removes barriers to goods and
Null and Alternative Hypotheses the output quantity for which marginal revenue = services trade among members.
N ull hypothesis (H0): hypothesis that contains the marginal cost. Customs union: Members also adopt common trade
equal sign (=, <, >). Gross Domestic Product policies with non-members.
A lternative hypothesis (Ha): concluded if there is Real GDP = consumption spending + investment + C ommon mark et: Members also remove barriers to
sufficient evidence to reject the null hypothesis. government spending + net exports. labor and capital movements among members.
Savings, Investment, Fiscal Balance, and Trade E conomic union: Members also establish common
Difference Between One- and Two-Tailed Tests
Balance institutions and economic policy.
O ne-tailed test: tests whether value is greater than or
Fiscal budget deficit (G - T) = excess of saving over M onetary union: Members also adopt a common
less than a given number.
T wo-tailed test: tests whether value is equal to a domestic investment (S - I) - trade balance (X - M) currency.
given number. E quation of Exchange Foreign E xchange Rates
MV = PY, where M = real money supply, V = For the exam, FX rates are expressed as price
Type I and Type II E rrors currency / base currency and interpreted as the
velocity of money in transactions, P = price level,
• Type I error: rejection of null hypothesis when it is number of units of the price currency for each unit
and Y = real GDP
actually true. of the base currency.
• Type I I error: failure to reject null hypothesis when Business Cycle Phases
Expansion; peak; contraction; trough. Real E xchange Rate
it is actually false.
base currency CPI
E conomic Indicators nominal FX rate X
Hypothesis Tests
L eading: Turning points occur ahead of peaks and v price currency CPI
Test of: Stat d .f troughs (stock prices, initial unemployment claims,
No-Arbitrage F orward E xchange Rate
manufacturing new orders)
Mean t or z n- 1 forward 1 + price currency interest rate
C oincident: Turning points coincide with peaks
Difference in means t n- 1 and troughs (nonfarm payrolls, personal income, spot 1 + base currency interest rate
Mean differences t n- 1 manufacturing sales)
E xchange Rate Regimes
L agging: Turning points follow peaks and troughs
Variance n- 1 F ormal dollarization: country adopts foreign
x2 (average duration of unemployment, inventory/
sales ratio, prime rate) currency.
Equal variances F n, - 1, n2- 1 M onetary union: members adopt common currency.
Factors Affecting Aggregate Demand F ix ed peg: ±1% margin versus foreign currency or
Correlation t n —2
Consumers’ wealth; business expectations; basket of currencies.
Independence x2 (r - U (c - l) consumers’ income expectations; capacity Target zone: Wider margin than fixed peg.
Regression slope: utilization; monetary and fiscal policy; exchange C rawlingpeg: Pegged exchange rate adjusted
Significance rates; global economic growth. periodically.
F 1, n - 2
Value t n- 2 Factors Affecting SR Aggregate Supply C rawling bands: Width of margin increases over
Input prices; labor productivity; expectations for time.
output prices; taxes and subsidies; exchange rates; M anaged floa ting: Monetary authority acts to
all factors that affect LR aggregate supply. influence exchange rate but does not set a target.
ECONOMICS Factors Affecting LR Aggregate Supply Independentlyfloa ting: Exchange rate is market-
Size of labor force; human capital; supply of natural determined.
E lasticity resources; stock of physical capital; level of technology.
%A quantity demanded
Own price elasticity Types of Unemployment
%A price F rictional: time lag in matching qualified workers FI NANCI AL STATEMENT ANALYSIS
If absolute value > 1, demand is elastic. with job openings.
Revenue Recognition
If absolute value < 1, demand is inelastic. Structural: unemployed workers do not have the
Two requirements: (1) completion of earnings
On a straight line dema nd curve, total revenue is skills to match newly created jobs.
process and (2) reasonable assurance of payment.
maximized where price elasticity = —1. C yclical: economy producing at less than capacity
Five-step revenue recognition model:
%A quantity demanded during contraction phase of business cycle.
Income elasticity 1. Identify contracts
%A income Policy Multipliers 2. Identify performance obligations
If positive, the good is a normal good. 3. Determine transaction price
money multiplier = -------------------------
If negative, the good is an inferior good. reserve requirement 4. Allocate price to obligations
. . . . %A quantity demanded 5. Recognize when (as) obligations are satisfied
Cross price elasticity = -------- -----------------------
%A price of related good fiscal multiplier = ------------------- Unusual or Infrequent Items
l- M P C (l- t) • Gains/losses from disposal of a business segment.
If positive, related good is a substitute.
If negative, related good is a complement. where MPC = marginal propensity to consume, • Gains/losses from sale of assets or investments in
Breakeven and Shutdown t = tax rate. subsidiaries.
Break even: total revenue = total cost. E xpansionary and Contractionary Policy • Provisions for environmental remediation.
Operate in short run if total revenue is greater than M onetary policy is expansionary when the policy • Impairments, write-offs, write-downs, and
total variable cost but less than total cost. rate is less than the neutral interest rate (real trend restructuring costs.
Shut down in short run if total revenue is less than rate of economic growth + inflation target) and • Integration expenses associated with businesses
total variable cost. contractionary when the policy rate is greater than recently acquired.
Market Structures the neutral interest rate. Discontinued Operations
Perfect competition: Many firms with no pricing F iscal policy is expansionary when a budget To be accounted for as a discontinued operation, a
power; very low or no barriers to entry; deficit is increasing or surplus is decreasing, and business—assets, operations, investing, financing
homogeneous product. contractionary when a budget deficit is decreasing activities—must be physically/operationally distinct
M onopolistic competition: Many firms; some or surplus is increasing. from rest of firm. Income/losses are reported net of
pricing power; low barriers to entry; differentiated Balance of Payments tax after net income from continuing operations.
products; large advertising expense. C urrent account: merchandise and services; income Compute Cash Flows From Operations (CFO)
Oligopoly: Few firms that may have significant receipts; unilateral transfers. D irect method: start with cash collections (cash
pricing power; high barriers to entry; products may C apital account: capital transfers; sales/purchases of equivalent of sales); cash inputs (cash equivalent of
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FI NANCI AL STATEM ENT ANALYSIS c o n t i n u e d -

_ . operating profit EBIT Basic and Diluted E PS
cost of goods sold); cash operating expenses; cash operating profit margin = ---------- -------- — Basic E PS calculation does not consider effects of
revenue net sales
interest expense; cash taxes. any dilutive securities in computation of EPS:
Indirect method: start with net income, subtracting net income
net profit margin = net income —preferred dividends
back gains and adding back losses resulting from revenue basic EPS =
wtd. avg. no. of common shs. outstanding
financing or investment cash flows, adding back all R eturn on assets [return on total capital (ROTC)]:
noncash charges, and adding and subtracting asset ,, , „ adj. income avail, for common shares
return on assets _ EBIT diluted EPS = ---- ------------------------------------------—
and liability accounts that result from operations. wtd. avg. common shares plus potential
(total capital) average total capital
Free Cash Flow common shares outstanding
F ree cash flow (FCF) measures cash available for D ebt to equity ratio a nd total debt ratio: Therefore, diluted EPS is:
discretionary purposes. It is equal to operating cash total debt
flow less net capital expenditures. debt-to-equity ratio =
total equity net _ pfd convertible convertible debt
Critical Ratios income div + dividends
preferred +
interest
0 -t)
C ommon-size fina ncia l statement analysis: total debt
total-debt-ratio = wtd shares from sh ’ s from shares
• Common-size balance sheet expresses all balance total assets avg + conversion of + conversion + issuable from
sheet accounts as a percentage of total assets. Interest coverage a nd fix ed charge coverage: sh’s conv. pfd. sh’s Vconv. debt / stock options
• Common-size income statement expresses all
income statement items as a percentage of sales. EBIT Long-Lived Assets Capitalizing vs. E xpensing
interest coverage = 7
• Common-size cash flow statement expresses each interest C apitalizing: lowers income variability and
line item as a percentage of total cash inflows EBIT + lease payments increases near-term profits. Increase assets, equity.
fixed charge coverage = 7 E xpensing: opposite effect.
(outflows), or as a percentage of net revenue. interest + lease payments
H orizontal common-siz e fina ncia l statement analysis: Depreciation
expresses each line item relative to its value in a G rowth rate (g): g = RR x ROE cost —residual value
common base period. Straight-line: ---------------------------
dividends declared useful life
L iquidity ratios: retention rate = 1 —
operating income after taxes D ouble declining balance:
current assets / ^ \
curren t ratio = ---------- 7— 7-7-7—
current liabilities L iquidity ratios indicate company’s ability to pay its
(cost —accum. depreciation)
short-term liabilities. useful life /
cash + marketable securities + receivables V
quick ratio — Operatingperforma nce ratios indicate how well
current liabilities Units o f production:
management operates the business.
cash + marketable securities DuPont Analysis cost —salvage value
cash ratio = X output units
current liabilities T raditional D uPont equation: useful life in units
cash + mkt. sec. + receivables net income sales assets Revaluation of Long-Lived Assets
defensive interval = return on equity =
daily cash expenditures „ sales , assets, , equity, IFRS: revaluation gain recognized in net income
only to the extent it reverses previously recognized
R eceivables, inventory, payables turnover, a nd days
You may also see it presented as: impairment loss; further gains recognized in equity
supply ratios— a ll o f which are used in the cash
as revaluation surplus. (For investment property,
conversion cycle: net profit asset equity
return on equity = all gains and losses from marking to fair value are
annual sales margin turnover multiplier
receivables turnover = recognized as income.)
average receivables E x tended D uPont equation further decomposes net U.S. GAAP: revaluation is not permitted.
cost of goods sold profit margin: Deferred Taxes
inventory turnover =
average inventory • Created when taxable income (on tax return) ^
net income v EBT' v ' EBIT '
ROE = A A pretax income (on financial statements) due to
purchases EBT EBIT, V,revenue /
payables turnover ratio = temporary differences.
average trade payables revenue avg. total assets
x v
A • D eferred tax liabilities are created when taxable
avg. total assets} avg. equity income < pretax income. Treat DTL as equity if
365
days of sales outstanding = not expected to reverse.
receivables turnover You may also see it presented as: • D eferred tax assets are created when taxable income
ROE = tax burden x interest burden x > pretax income. Must recognize valuation
365
days of inventory on hand = 7 EBIT margin x asset turnover x leverage allowance if more likely than not that DTA will
in ven tory turn over
Marketable Security Classifications not be realized.
_______ 365_______ H eld-for-trading: fair value on balance sheet; Long-Term Liabilities
number of days of payables =
payables turnover ratio dividends, interest, realized and unrealized G/L • Premium bond: coupon rate > market rate at
recognized on income statement. issuance.
days of inventory A vailable-for-sale: fair value on balance sheet;
cash conversion cycle = • D iscount bond: coupon rate < market rate at issuance.
on hand dividends, interest, realized G/L recognized • Interest expense equals book value at the beginning
days of sales number of days on income statement; unrealized G/L is other of the year multiplied by the market rate of interest
+ outstanding of payables comprehensive income. at the time the bonds were issued.
H eld-to-maturity: amortized cost on balance
Total asset, fix ed-asset, and work ing capital turnover Leases
sheet; interest, realized G/L recognized on income
ratios: L essee reporting: Under IFRS, lessee recognizes asset
statement.
revenue and liability equal to PV of lease payments. Interest
total asset turnover = Inventory Accounting portion of each payment is interest expense,
average total assets In periods of rising prices and stable or increasing principal portion decreases liability.
inventory quantities: U.S. GAAP is same except that for an operating
revenue
fixed asset turnover = L IF O results in: F IF O results in:
average fixed assets lease, entire lease payment is an expense.
Higher COGS Lower COGS L essor reporting, fina nce lease: Remove asset from
revenue Lower gross profit Higher gross profit balance sheet, recognize lease receivable asset,
working capital turnover = Lower inventory Higher inventory
average working capital report interest income.
balances balances L essor reporting, operating lease: Keep asset on
Gross, operating, a nd net profit margins:
balance sheet, report lease payments as income,
r gross profit
. record depreciation expense.
gross profit m argin = —------------
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r
L. PORTFOLI O M ANAGEM ENT
FI NANCI AL STATEM ENT ANALYSI S c onti nued •••

Pensions Investment Policy Statement

D efined contribution: employer contribution Investment objectives:
expensed in period incurred. • Return objectives.
D efined benefit: overfunded plan recognized as • Risk tolerance.
asset, underfunded plan recognized as liability. Constraints:
• Liquidity needs.
• Time horizon.
CORPORATE ISSUERS • Tax concerns.
Weighted Average Cost of Capital • Legal and regulatory factors.
• Unique circumstances.
WACC = (wd) [kd(1—t)] + (wps) (kps) + (wce)(ks)
Combining Preferences with the Optimal Set of
Cost of Preferred Stock Portfolios Risk-Adjusted Returns
Markowitz efficient frontier is the set of portfolios Sharpe ratio and M -squared measure excess return
that have highest return for given level of risk. per unit of total risk.
Treynor measure and Jensens alpha measure excess
Cost of E quity Using CAPM return per unit of systematic risk .
ke = RFR + /3(Rmkl —RFR)
E(R)
Capital Allocation
CF, CR CFn
NPV = CF0 + + + ... +
( i+ k )1 a+ k) (l + k)n
IRR: discount rate that makes NPV equal to zero.
Nonpublic/ Thinly Traded Stock Beta
Delevered asset beta for comparable company:
0f asset = 0^ equity
■ Security Market Line (SML)
Investors should only be compensated for risk
relative to market. U nsystematic risk is diversified
Relevered beta for target company: away; investors are compensated for systematic risk.
D The equation of the SML is the CAPM, which is a
3 target y
asset ^
target ^3,---*
H I l(i-t)
- t l return/systematic risk equilibrium relationship.
/
total risk = systematic + unsystematic risk Behavioral Biases
Adjusted beta = 2/3 x unadjusted beta +1/3 C ognitive errors, b elief perseverance: Conservatism,
E(R)
Measures of Leverage confirmation, representativeness, control,
Total leverage: percent change in net income hindsight
from a given percent change in sales. C ognitive errors, information processing: Anchoring
Operating leverage: percent change in EBIT from and adjustment, mental accounting, framing,
a given percent change in sales. availability
F inancial leverage: percent change in net income E motional biases: Loss aversion, overconfidence,
from a given percent change in EBIT. self-control, status quo, endowment, regret
breakeven quantity of sales = aversion
T echnical Analysis
fixed operating & financing costs R eversal patterns: head and shoulders, inverse H&S,
price —variable costs per unit double/triple top or bottom.
C ontinuation patterns: triangles, rectangles,
operating breakeven quantity of sales = pennants, flags.
fixed operating costs Price-based indicators: moving averages, Bollinger
E(Ri)
price —variable costs per unit bands, momentum oscillators (rate of change, RSI,
stochastic, MACD).
Corporate Governance Sentiment indicators: put/call ratio, VIX, margin debt.
Stak eholder groups: Shareholders, board of
directors, senior managers, employees, creditors,
suppliers. ^ SECURI TI ES MARKETS
B oard committees: Audit, governance,
nominations, compensation, risk, investment. & EQUI TY INVESTMENTS
E SG in Investment Analysis Well-F unctioning Security Markets
N egative screening: Exclude companies with poor • Operational efficiency (lowest possible
ESG records. transactions costs).
Positive screening: Invest in companies with good • Informational efficiency (prices rapidly adjust to
ESG records. new information).
The SML and E quilibrium
T hematic investing: Invest to promote a specific
Identifying mispriced stocks: Margin Purchases
ESG goal.
Consider three stocks (A, B, C) and SML. For margin transactions:
A ctive ownership: Use share voting, access to
Estimated stock returns should plot on SML. • Leverage factor = 1/margin percentage.
managers to promote ESG goals.
• A return plot over the line is underpriced. • Levered return = HPR x leverage factor.
• A return plot under the line is overpriced.. Margin Call Price
P0(l —initial margin %)
1 —maintenance margin %

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SECURITIES M ARKETS & EQUI TY I NVESTM ENTS c o n t i n u e d ... Critical relationship between k and g\ full price = PV at last coupon date x (1 +YTM)t/T
• As difference between k and g widens, value of accrued interest = coupon payment x (t/T)
Computing Index Prices
stock falls. where:
stock prices • As difference narrows, value of stock rises. t = days from most recent coupon payment to
Price-weighted Index =
adjusted divisor • Small changes in difference between k and g trade settlement
Value-weighted Index cause large changes in stock’s value. T = days in coupon payment period
Critical assumptions of infinite period DDM: Matrix pricing: For illiquid bonds, use yields of bonds
XXcurrent prices) (#shares) • Stock pays dividends; constant growth rate. with same credit quality to estimate yield; adjust for
x base value
XXbase year prices) (#base year shares) • Constant growth rate, g , never changes. maturity differences with linear interpolation.
• ke must be greater than g (or math will not work). Bond Markets
Typ es of Orders
E arnings Multiplier Model N ational bond mark et includes domestic bonds and
E xecution instructions: how to trade; e.g., market
v foreign bonds.
orders, limit orders. P0 Ej payout ratio • D omestic bonds. Domestic issuer and currency.
V alidity instructions: when to execute; e.g., stop
Ei k -g k -g • F oreign bonds. Foreign issuer, domestic currency.
orders, day orders, fill-or-kill orders.
E urobond mark et is outside any one country, with
C learing instructions: how to clear and settle; for sell
Price Multiples bonds denominated in currencies other than those
orders, specify short sale or sale of owned security.
price per share of countries in which bonds are sold.
Market Structures leading P/E =
forecast EPS next 12 mo. G lobal bonds trade in both a national bond market
Q uote-driven mark ets: investors trade with dealers. and the eurobond market.
Order-driven mark ets: buyers and sellers matched price per share
trailing P/E = Bond Issuance
by rules. EPS previous 12 mo. U nderwritten offering: Investment banks buy entire
Brok ered mark ets: brokers find counterparties.
price per share issue, sell to public.
Forms of E MH P/B = Best efforts offering: Investment banks act as brokers.
• Weak form. Current stock prices fully reflect book value per share
S helf registration: Register entire issue with
available security mark et info. Volume regulators but sell over a period of time.
price per share
information/past price do not relate to future P/S =
sales per share E mbedded Options
direction of security prices. Investor cannot
Callable: Issuer may repay principal early. Increases
achieve excess returns using tech analysis. price per share
P/CF = yield and decreases duration.
• Semi-strongform. Security prices instantly adjust
cash flow per share Putable: Bondholder may sell bond back to issuer.
to new pub lic information. Investor cannot achieve
Decreases yield and duration.
excess returns using fundamental analysis.
C onvertible: Bondholder may exchange bond for
• Strongform. Stock prices fully reflect a ll information
FI XED INCOME issuer’s common stock.
from public a nd private sources. A ssumesperfect
E mbedded warrants: Bondholder may buy issuer’s
mark ets in which all information is cost free and
Basic Features of Bonds common stock at exercise price.
available to everyone at the same time. Even with
Issuer. Household, nonfinancial corporations, Yield Measures
inside info, investor cannot achieve excess returns.
governments, financial institutions. E ffective yield depends on periodicity. YTM =
Maturity. Money market (one year or less); capital effective yield for annual-pay bonds.
EQUI TY INVESTM ENTS market (greater than one year). Semiannual bond basis: YTM = 2 x semiannual
Par value. Bond’s principal value (face value). discount rate.
Industry Life Cycle Stages Coupon. Annual percent of par; fixed or floating. C urrent yield = annual coupon / price.
E mbryonic: slow growth, high prices, large Divide by periodicity to get periodic rate. Simple yield = current yield ± amortization.
investment needed, high risk of failure. Currency. Single, dual, currency option. Y ield to ca ll is based on call date and call price.
G rowth: rapid growth, falling prices, limited Indenture. Affirmative and negative covenants. Y ield to worst is lowest of a bond’s YTCs or YTM.
competition, increasing profitability. Price, Yield, Coupon Relationships M oney mark et yields may be on a discount or add­
Shak eout: slower growth, intense competition, Bond prices and yields are inversely related. on basis and may use a 360- or 365-day year.
declining profitability, cost cutting, weaker firms Increase in yield decreases price; decrease in yield B ond-equivalent yield is an annualized add-on yield
fail or merge. increases price. based on a 365-day year.
Mature: slow growth, consolidation, stable prices, Coupon < yield: Discount to par value. Forward and Spot Rates
high barriers to entry. Coupon > yield: Premium to par value. Forward rate is a rate for a loan that begins at a
D ecline: negative growth, declining prices, C onstant-yield price trajectory: Price approaches future date. “Iy3y” = 3-year forward rate 1 year
consolidation. par as bond nears maturity from amortization of from today.
Five Competitive Forces discounts and premiums. Capital gains and losses Example of spot-forward relationship:
1. Rivalry among existing competitors. are calculated relative to this trajectory. (1 + S2)2 = (1 + S j)(l + lyly)
2. Threat of entry. Cash F low Structures Yield Spreads
3. Threat of substitutes. Bullet: All principal repaid at maturity. G -spread: Basis points above government yield.
4. Power of buyers. F ully amortizing: Equal periodic payments include I-spread: Basis points above swap rate.
5. Power of suppliers. both interest and principal. Z-spread: Accounts for shape of yield curve.
One-Period Valuation Model Partially amortizing: Periodic payments include Option-adjusted spread: Adjusts Z-spread for effects
interest and principal, balloon payment at maturity of embedded options.
Di + Pi
V0 = repays remaining principal.
(1 + k .) (l + k„) Interest Rate Risk
Sink ingfund: Schedule for early redemption.
Be sure to use ex pected dividend in calculation. Interest rate risk has two components: reinvestment risk
F loating-rate: Coupon payments based on reference
and mark etprice risk from YTM changes. These risks
Infinite Period Dividend Discount Models rate plus margin.
have opposing effects on an investor’s horizon yield.
Supernormal growth model (multi-stage) DDM: Bond Pricing • Bond investors with short horizons are more
D Dn There are two equivalent ways to price a bond: concerned with market price risk.
n
V0 = + + + • Constant discount rate applied to all cash flows
(1 + k .) (1 + k J" (1 + k.)" • Bond investors with long horizons are more
(YTM) to find PV. This is a bond’s fla t price (does concerned with reinvestment risk.
Dn+ 1 not include accrued interest).
where: Pn = • The horizon at which market price risk and
(ke - g c ) • Discount each cash flow using appropriate spot reinvestment risk just offset is a bond’s M acaulay
rate for each. This is a bond’s no-arbitrage price. duration. This is the weighted average of times
C onstant growth model:
F ull price includes accrued interest. Government until a bond’s cash flows are scheduled to be paid.
V - Do(! + gc) _ D, bonds use actual day counts; corporate bonds use
vo — —
k e - Sc k e - gc 30/360 method. cont inued on next page...

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 lOMoARcPSD|14321585

FI XED INCOM E c o n t i n u e d ... Forward Contract Value ALTERNATI VE INVESTM ENTS

At time tr.
M odified duration is the approximate change in a Hedge Funds
V (T) = [S + PV (costs) - PV (benefits)]
bonds price given a 1% change in its YTM: - CF0(T )a + Rf)-(T-t)I E vent-driven strategies: merger arbitrage; distressed/
Futures vs. Forwards restructuring; activist shareholder; special
Macaulay duration (V_) —(V+)
F utures are standardized, exchange-traded forward situations.
~~ 0 +0 2V0(Ay) R elative value strategies: convertible arbitrage;
contracts that require daily cash settlement of
mark-to-market gains and losses. asset-backed fixed income; general fixed income;
E ffective duration is required if a bond has volatility; multi-strategy.
embedded options: Forward Rate Agreements (FRA)
E quity strategies: market neutral; fundamental
Can be viewed as a forward contract to borrow/ growth; fundamental value; quantitative
( V - ) - ( y +) lend money at a certain rate at some future date.
directional; short bias.
2V q (Acurve) Interest Rate Swaps M acro strategies: based on global economic trends.
Price change estimates based on duration only are May be replicated by a series of FRAs with present Hedge fund fees:
improved by adjusting for convex ity: values at swap initiation that sum to zero. • “2 and 20”: 2% management fee plus 20%
1 Options incentive fee.
%Aprice = —duration (Ay) H— convexity (Ay) • Buyer of a call option—long asset exposure. • Hard hurdle rate: incentive fee only on return
• Writer (seller) of a call option—short asset above hurdle rate.
Asset-Backed Securities exposure. • Soft hurdle rate: incentive fee on whole return,
R esidential MBS', home mortgages are collateral. • Buyer of a put option—short asset exposure. but only paid if return is greater than hurdle rate.
Agency RMBS include only conforming loans; • Writer (seller) of a put option—long asset • High water mark: no incentive fee until value
nonagencv RMBS may include nonconforming exposure. exceeds previous high.
loans and need credit enhancement. intrinsic value of a call option = Max[0, S —X] Private Capital
Prepayment risk : contraction risk from faster intrinsic value of a put option = Max[0, X —S] L everaged buyouts: management buyouts (existing
prepayments; extension risk from slower American vs. E uropean Options managers), management buy-ins (new managers)
prepayments. A merican options allow the owner to exercise the V enture capital stages of development:
CMOs: pass-through MBS are collateral. May have option any time before or at expiration. E uropean • Formative stage: angel investing, seed stage, early
sequential-pay or PAC/support structure. options can be exercised only at expiration. stage.
C ommercial MBS : non-recourse mortgages on Factors that Affect Option Values • Later stage: expand production, increase sales.
commercial properties are collateral. • Mezzanine stage: prepare for IPO.
A uto ABS: auto loans are collateral. Increase in: Calls Puts E xit strategies: trade sale; IPO; recapitalization;
C redit ca rd ABS: credit card receivables are Asset price Increase Decrease secondary sale; write-off.
collateral. Real E state
Exercise price Decrease Increase
CDOs: Bonds, bank loans, MBS, ABS, or other Includes residential property; commercial property;
CDOs are collateral. Risk-free rate Increase Decrease
real estate investment trusts (REITs); whole loans;
Collateral and Credit E nhancement Volatility Increase Increase construction loans.
Secured bonds are backed by specific collateral and Commodities
Time to Increase Increase*
senior to unsecured bonds. expiration C ontango: futures price > spot price.
U nsecured bonds are general claims to issuer’s cash Back wardation: futures price < spot price.
flows and assets. Holding costs Increase Decrease
futures price « spot price(l + Rf) + storage costs
Internal credit enhancement: Excess spread, Holding Decrease Increase - convenience yield
overcollateralization, waterfall structure. benefits
E xternal credit enhancement: Surety bonds, letters of Infrastructure
*Except some deep-in-the-money European puts. Long-lived assets for public use, including
credit, bank guarantees.
Put-Call Parity transportation, utility, communications, social.
Credit Analysis
The put-call parity relationship for European B rownfield: Existing infrastructure.
Investment grade: Baa3/BBB- or above
options at time P. G reenfield: Infrastructure to be built.
N on-investment grade: Bal/BB+ or below
c + X(1 + Rf) T = S + p
Corporate family rating (CFR): issuer rating.
Each security in the put-call parity relationship can
Corporate credit rating (CCR): security rating.
be expressed as:
“Four Cs”: capacity, collateral, covenants, character,
S = c - p + X(1 + RfVT
default risk = probability of default
p = c - S + X(1 + RfVT
loss severity = percent of value lost if borrower
c = S + p - X(1 + RfVT
defaults
X(1 + Rf)"T = S + p - c
expected loss = default risk x loss severity
recovery rate = 1 —expected loss percentage Put-Call Forward Parity
The present value of the forward price of the
underlying asset, F0(T)(1 + Rf)~T, can be
DERIVATIVES substituted for S in any of the put-call parity
relationships at time 0.
Arbitrage and Replication
• L aw o f one price-, two assets with identical cash
flows in the future, regardless of future events,
should have the same price.
• Two assets with uncertain returns can be combined
in a portfolio that will have a certain payoff. If a
portfolio has a certain payoff, the portfolio should
yield the risk-free rate. For this reason, derivatives ISBN: 978-1-0788-2583-2
values are based on risk-neutral pricing.
Derivatives Values vs. Prices
The price of a forward, futures, or swap contract
is the forward price stated in the contract and is
9 781078 825832
set such that the contract has a value of zero at
initiation. Value may change during the contract’s
life with opposite gains/losses to the long and short.
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