2012 Level 2 Mindmaps (All)
-
Upload
fabulousbaongoc -
Category
Documents
-
view
47 -
download
5
description
Transcript of 2012 Level 2 Mindmaps (All)
Changes in CFA level 2 curriculum 2012
So sánh CFA curriculum level 2 năm 2012 với năm 2011 thì các thay đổi chủ yếu là loại bỏ bớt các phần lúc trước viết
trùng lặp hoặc lan man, rườm rà. Sự loại bỏ này làm cho số lượng readings của level 2 giảm từ 70 readings năm 2011
xuống còn 64 readings năm 2012. Còn kiến thức thêm vào nhiều nhất là ở reading 47 (Investing in Hedge Funds: a
survey) của môn Alternative Investments.
Môn Alternative Investments: Reading 50 cũ‐ Commodity (học về Contango, Backwardation, roll yield…) bị loại bỏ,
có lẽ là do nội dung này sẽ được covered đầy đủ hơn ở level 3. Reading mới số 47 (Investing in Hedge Funds: a
survey) thay thế reading 51 cũ (Evaluating performance of Hedge Funds) và reading 52 cũ (Buyer Beware: evaluating
and managing the many facets of risks of hedge funds).
Môn Equity: Bỏ hẳn 2 readings là reading 36 và 38 cũ. Reading 36 cũ‐ Equity, Markets and Instruments‐ là một
reading khá dài và nhiều chữ bàn luận về các loại thị trường, các công cụ và vấn đề về thuế khi đầu tư ra nước ngoài,
ADR‐ American Depository Receipts, ETFs, country funds…. Reading 38 cũ‐ Equity concepts and Techniques‐ gồm
nhiều nội dung bị lặp trong các readings khác, như country analysis, industry analysis. Tuy nhiên trong reading 38 đã
bị bỏ có hai mô hình khá thú vị là 1. Franchise model (tính intrinsic P/E theo tangible P/E (1/r) và Franchise P/E (=
franchise factor x growth factor)) và 2. công thức tính P/E với sự góp mặt của inflation flow through rate. Các
readings còn lại có thay đổi nhỏ một hai LOS không đáng kể.
Môn Economics: Reading 17 cũ‐ Exchange rates and Balance of Payment‐ bị loại bỏ. Nội dung này được đưa xuống
level 1 (tham khảo level 1 reading 20‐ International Trade and Capital Flows và reading 21‐ Currency Exchange Rates).
Môn Fixed Income: Reading 54 cũ‐ Liquidity conundrum (có đề cập tới Minsky hypothesis và giải thích lý do khủng
hoảng nhà đất của Mỹ vài năm trước…) bị loại bỏ, có lẽ là do các thông tin này giờ đã out‐of‐date.
Môn Corporate Finance: Bỏ một LOS nho nhỏ về lịch sử các antitrust legislations ở Mỹ (trong reading 32‐ M&A).
Năm môn còn lại‐ Ethics, Quantitative analysis, Derivatives, Portfolio management, FRA giữ nguyên.
Người tổng hợp: Lê Trọng Tuấn Anh & Nguyễn Hoài Phương, AFTC.
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 1
CFA LEVEL 2
ETHICAL & PROFESSIONAL
STANDARDS
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 2
1. Code OfEthics AndStandards
OfProfessional
Conduct
a1.
All CFA Institute members and candidates arerequired to comply with the Code and Standards
Structure of the CFAInstitute ProfessionalConduct Program
Basic structurefor enforcingthe Code andStandards
The CFAInstituteBylaws
Rules ofProcedure
Based ontwoprimaryprinciples
Fair process tomember andcandidateConfidentialityof proceedings
ProfessionalConductprogram(PCP)
The CFAInstituteBoard ofGovernors
Maintains oversightand responsibility
Through the DisciplinaryReview Committee (DRC)
Is responsible for theenforcement of theCode and Standards
The CFADesignatedOfficer
Directs ProfessionalConduct Staff
Conducts professionalconduct inquiries
An inquiry can be promptedby several circumstances
Process for theenforcement ofthe Code andStandards
When aninquiry isinitiated
The ProfessionalConduct staffconducts aninvestigation thatmay include
Requesting a writtenexplanation from themember or candidate
InterviewingThe member or candidateComplaining partiesThird parties
Collecting documentsand records in supportof its investigation
Upon reviewing thematerial obtained duringthe investigation, theDesignated Officer may
Conclude the inquiry withno disciplinary sanctionIssue a cautionary letter
Continueproceedings todiscipline themember orcandidate
If finding that aviolation of theCode andStandardsoccurred, theDesignated Officerproposes adisciplinarysanction
Accepted bymember
Rejected bymember
The matter isreferred to ahearing by apanel of CFAInstitutemembers
a2.
Six components ofthe Code of Ethics
Seven Standards ofProfessional Conduct
b. Ethicalresponsibilities
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 3
2.1 Standard IPROFESSIONALISM
A.Knowledgeof the law
Guidance
Recommended procedures for compliance (RPC)
Application
B. Independenceand objectivity
Guidance
Maintain independence and objectivity in professional activities
How to copewith externaland internalpressures
Externalpressures
By benefits
GiftsInvitations to lavish functionsTicketsFavorsJob referralsAllocation of shares in oversubscribedIPOs to investment managers....
From publiccompanies
To issue favorable reports
From Buy-side clients May try to pressure sell-side analysts
Internalpressures
From theirown firms
e.g. to issue favorable researchreports/recommendations for certain companies
Investment-bankingrelationships
to issue favorable research on current orprospective investment-banking clientsConflicts of interest
-->
-->Modest gifts and entertainment areacceptable but special care must be taken
-->must disclose to employers
-->Best practice: reject any offer of gift,..threatening independence and objectivity
-->Recommendations mustconvey true opinionsfree of bias from pressuresbe stated in clear and unambiguous language
-->Portfolio managers must respect and foster honesty of sell-side research
Issuer-paidresearch
Is fraught with conflicts
-->Analysts
Must engage in thorough, independent, and unbiased analysisMust fully disclose potential conflicts, including the nature of compensationMust strictly limit the type of compensation they accept for conducting research
Best practiceAccept only flat fee for their work prior to writing the reportW/O regard to conclusions or reccomendations
RPC
Protect integrity of opinionsCreate a restricted listRestrict special cost arrangementsLimit gifts
Restrict employee investmentsEquity IPOsPrivate placements
Review proceduresWritten policies on independence and objectivity of research
C. Misrepresentation
Guidance
Definition of"Misrepresentation"
any untrue statement or omission of a factor any fasle or misleading statement
Must not knowingly makemisrepresentation or givefalse impression in
oral representations, advertisingelectronic communicationswritten materials
Must not misrepresent anyaspect of practice, including
qualifications or credentials, servicesperformance recordcharacteristics of an investmentany misrepresentation relating to member's professional activities
Must not guarantee clients specific returnon investments that are inherently volatile
Standard I(C) prohibits plagiarism inpreparation of material for distribution to
employersassociatesclientsprospectsgeneral public
RPC
Written list of available services, description of firm's qualificationDesignate employees to speak on behalf of firmPrepare summary of qualifications and experience, list of services capable of performing
To avoid plagiarismMaintain copiesAttribute quotationsAttribute summaries
D.Misconduct
Guidance
Address conduct related to professional life
Violations
Any act involving lying, cheating, stealing, other dishonest conduct that reflects adversely onmember's professional activities would be violationConduct damaging trustworthiness or competenceAbuse of the CFA Institute Professional Conduct Program
RPCDevelop and/or adopt a code of ethicsDisseminate to all employee a list of potential violationsCheck references of potential employees
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 4
2.2 Standard IIINTEGRITY OF
CAPITALMARKET
A. Materialnonpublicinformation(MNI)
Guidance
Definition of "Materialnonpublic information"Must be particularly aware of infoselectively disclosed by corporations
Mosaic Theory
Analysis of Public info +nonmaterial nonpublic info -->Investment conclusionAnalysts are free to act onthis collection of info w/orisking violationAnalysts should save anddocument all their research
RPC
Make reasonable efforts to achievepublic dissemination of material info
If public disseminationis not possible,
Must communicate the info only to thedesignated supervisory andcompliance personnel within the firmMust not take investmentaction on the basis of the info
Must not knowingly engage in conductinducing insiders to privately disclose MNI
Encouragefirms to
adopt compliance procedurespreventing misuse of MNIdevelop & follow disclosure policiesto ensure proper disseminationuse "firewall"
Prohibition of all proprietary trading while firmis in possession of MNI may be inappropriate
B. Marketmanipulation
Definition
can berelated to
transactions that deceivemarket participants
Transactions that artificiallydistort prices or volumeSecuring a controlling,dominant position in a financialinstrument to exploit andmanipulate price of a relatedderivative/or underlying asset
dissemination of false ormisleading info
including spreading false rumorsto induce trading by others
Standard II(B)not meant to prohibit legitimate trading strategies
prohibit transactions done for tax purposes
The intent of action is critical to determiningwhether it is a violation of this Standard
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 5
2.3Standard
IIIDUTIES
TOCLIENTS
A. Loyalty,prudence,and care
GuidanceResponsibilityto a clientincludes
duty toexercisereasonablecare
Prudencerequire cautionsand discretion
act with care, skill, and diligencefollow the investment parameters set forthby clients & balancing risk & return
duty ofloyalty
Understand & adhereto fiduciary duties
Determine identity of "client"Must be aware of whether they have"custody" or effective control of client assets
Manage pool of assets in accordancewith terms of governing documentsPut their obligation to client first in all dealingsAvoid all real or potential conflicts of interestForgo using opportunities for their own benefit at the expense of clientFollow any guidelines set out by client for the management of assetsJudge investment decisions in context of total portfolioVote proxies in an informed & responsible manner
"Soft dollars"
RPC
Submit to clients at least quarterly itemized statementsSeparate assetsReview investments periodicallyEstablish policies & procedures with respect to proxy voting and the use of client brokerageEncourage firms to address some topics
B. Fairdealing
Guidance
Do not discriminate against any clients"Fairly" vs "equally
Investmentrecommendations
Standard III(B) addresses the manner of disseminating investmentrecommendations or changes in prior recommendations to clientsEnsure fair opportunity to act onEncourage firms to design equitable system to preventselective, discriminatory disclosure
Material changes should becommunicated to all current clients
particularly clients may have acted onor been affected by earlier advise
Clients who don't know changesand therefore place orders contraryto a current recommendation
should be advised of thechanged recommendationbefore the order is accepted
Investmentactions
Treat all clients fairly in light of theirinvestment objectives & circumstancesDisclose to clients &prospects writtenallocation procedures
duty of fairness and loyalty to clients can never be overridenby client consent to patently unfair allocation procedures
Should not take advantage of their position in the industry to the detriment of clientsRPC
C. Suitability
GuidanceIn investmentadvisoryrelationships
Be sure to gather client info in the form of an IPS and make suitabilityanalysis prior to making recommendation/taking investment actionInquiry should be repeated at least annually/prior to material changesIf clients withhold infoRisk analysisFund managers
In case of unsolicited trade requests unsuitable for clientRPC
D. Performancepresentation
Guidance
Standard III(D) prohibits misrepresentaions of past performanceor reasonably expected performance--> Provide credible performance info-->Should not state or imply that clients will obtain orbenefit from rate of return generated in the past
Research analysts promoting the successof accuracy of their recommendations
--> ensure that their claims arefair, accurate, and complete
If the presentation is brief, must make available toclients and prospects the detailed info upon request
RPC GIPS
E. Preservation ofconfidentiality
Guidance
Standard III(E) is applicable when members receive infoComply with applicable laws
When in dout -->consult with compliance department/outside counsel before disclosing
Standard III(E) does not prevent cooperating with an investigation by CFAI PCPRPC
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 6
2.4 Standard IVDUTIES TO
EMPLOYERS
A. Loyalty
Employer-employeerelationship
In matters related to their employment, membersand candidates must not engage in conduct thatharms the interests of the employer
-->Comply with policies and procedures established byemployers that govern employer-employee relationship
Standard IV(A) does not require to place employerinterests ahead of personal interests in all matters
The relationship imposes duties andresponsibilities on both parties
Independentpractice
Abstain from independent competitive activitythat could conflict with employer's interests
Provide notification to employer, obtainconsent from employer in advance
Leaving anemployer
Must
Planning to leave, must continueto act in employer's best interestFirm records or work performed on behalfof firm stored on a home computer shouldbe erased or returned to employer
Must not
engage in activities conflicting withduty until resignation effective
contact existing clients/potentialclients prior to leaving for soliciting
take records of files to a newemployer without written permission
Free to make arrangements/preparationsprovided that not breaching duty of loyalty
Applicable non-compete agreement
Whistleblowing
Nature of employment
B. Additionalcompensationarrangements
Guidance Obtain written consent from employer before acceptingcompensation or other benefits from third parties...
RPC Should make an immediatewritten report to their employers
C. Responsibilities ofsupervisors
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 7
2.5 Standard V
INVESTMENTANALYSIS,
RECOMMENDATIONS& ACTIONS
A. Diligence andreasonable basis
Guidance
The application of StandardV(A) depends on
investment philosophy followedrole of member in theinvestment decision-makingprocesssupport and resourcesprovided by employer
Must make reasonable efforts to cover all pertinentissues when arriving at recommendation
Provide or offer to provide supporting info to clients whenmaking recommendations/changing recommendations
Using secondary orthird-party research
-->must make reasonable &diligent efforts todetermine whether 2nd/3rd party research is sound
Group researchand decisionmaking
If member does not agreewith the independent andobjective view of the group
-->Not necessarily have todecline to be identified ifbelieving consensus opinion hasreasonable & adequate basis-->Should document member'sdifference of opinion with group
RPC
B. Communicationwith clients andprospective clients
Guidance
Standard V(B) addresses conduct with respect to communicating with clients
Communication is not confined to writtenform but via any means of communication
Developing and maintaining clear, frequent, andthorough communication practices is critical
Must
distinguish clearly between facts & opinionspresent basic characteristics of the analyzedsecurity in preparing research reportadequately illustrate to clients & prospective clients the mannerof conducting investment decision-making processkeep them informed with respect to changesto the chosen investment process
Briefcommunications
-->must be supported by backgroundreport or data on request
Capsule formrecommendations
-->should notify clients that additional info andanalyses are available from the producer of the report
Investment advicebased on quantitativeresearch and analysis
-->must be supported by readilyavailable reference material-->in a manner consistent with previously appliedmethodology or with changes highlighted
Should outline known limitations, considerprincipal risks in investment analysis, report
RPC
C. Record retention
Guidance
In hard copy or electric form
Fulfilling regulatory requirements maysatisfy the requirements of this Standard
Must explicitly determinewhether it does
Absence of regulatory guidance,CFAI recommendsmaintaining records for atleast 7 yrs
RPC
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 8
2.6 Standard VICONFLICTS
OF INTEREST
A. Disclosureof conflicts
Guidance
Managingconflicts
is a critical part of working in investment industry
can takemany forms
Best practice is to avoid conflictsof interest when possibleIf not, disclosure is necessary
Disclosuresmust be
prominentmade in plain languagein a manner to effectively communicate the info to clients
Disclosureto clients
All mattersmay impairobjectivity
Relationships
between member ortheir firm and issuerinvestment bankingunderwriting and financialrelationships
Broker/dealer market-making activitiesMaterial beneficial ownership of stockInvestment personnel also serves as a director
-->Sell-sidemembers
should disclose material beneficial ownershipinterest in securities/investment recommended
Disclosure ofconflicts toemployers
What?Same circumstances with clientsAny potential conflict situation
How? Enough info
Other requirements
B. Priority oftransactions
Guidance
Clients & employers' transactions have priority
Co-investment-->personal investment positionsor transactions should neveradversely affect client investments
Conflicts ofinterests
may occur
-->make sure
client is not disadvantaged by the tradeinvestment professional does not benefitpersonally from trades undertaken for clientsinvestment professional complies withapplicable regulatory requirements
Having knowledge of pending transactions, assess to info duringnormal preparation of research recommendations
-->Must notconvey such info
May undertake personal transactions after clients & employershave had adequate opportunity to act on recommendation
Family accounts (thatare client accounts)
should be treated like other accounts
if member hasbeneficial ownership
-->may still be subject topre-clearance or reportingrequirements
C. Referral feesInform
whomemployerclientprospective client
what
compensationconsiderationbenefitreceived from, or paid to, others
howbefore entry into any formal agreementnature of the consideration or benefit
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 9
2.7 Standard VII RESPONSIBILITIESAS CFA MEMBER /
CANDIDATE
A. Conduct asmembers andcandidates inthe CFAprogram
Prohibiting any conduct thatundermines the integrity ofthe CFA charter
Cheating on CFA exam or any exam
Not following rules andpolicies of the CFA program
Giving confidential info on the CFAProgram to candidates or the public
.....
Not precluded from expressing opinionregarding the CFA Program or CFAI
B. Reference toCFA Institute, theCFA Designationand the CFAprogram
Preventing promotional efforts thatmake promises or guarantees tiedto the CFA designation
Over-promise thecompetence of anindividual
Over-promise futureinvestment results
Applies to any form ofcommunication
To maintain CFAImembership
Remit annually to CFAI a completedProfessional Conduct Statement
Pay applicable CFAI membershipdues on an annual basis
Using the CFA designation(see Curriculum)
Referencing candidacy in the CFAprogram (see Curriculum)
Proper using of the CFA marks(see Curriculum)
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 10
3.1 CFA InstituteSoft DollarStandards
Soft DollarStandards (SDS)
are voluntary standards for Members
focus on 6key areas
DefinitionsTo enable all parties dealing with SD practices to have acommon understanding of all of the different aspects of SD
ResearchTo give a clear guidance to investment managers on what products andservices are appropriate for a manager to purchase with client brokerage
Mixed-used productsTo clarifiy the manager's duty to clearly justify the use ofclient brokerage to pay a portion of mixed-use product
DisclosureTo obligateinvestmentmanagers to
clearly disclose their SD practicesgive detailed info to each client when requested
Record keeping To ensure that client canreceive assurances that what investment managers aredoing with client brokerage can be supported in an "audit"receive important info on request
Client-directedbrokerage
To clarify the manager's role and fiduciary responsibilities to clients
a1. Define "Soft Dollar"Arrangements
Investment Manager directs transactions to a Broker, in exchange for whichBroker provides brokerage and research services to the Investment Manager
includeProprietary ResearchArrangementsThird-party Research Arrangements
Not include Client-directed Brokerage Arrangements
a2. Some definitions
Agency trade A transaction involving the pmt of a commission
Principal trade A transaction involving a "discount" or a "spread"
Soft dollarpractices involve the use of client brokerage by an investment manager to obtain products
and services to aid the manager in investment decision making process
Brokerage The amount on any trade retained by a brokerto be used directly or indirectly as pmt for
ResearchServies and/or products provided by a broker, the primary use of which mustdirectly assist the investment manager in its investment decision making process
TypesProprietary researchThird-party research
Mixed-Use
Services and/or products,provided to an investmentmanager by a broker througha Bokerage Arrangementused for both
Investment decision making processManagement of theinvestment firm
Client-directedbrokeragearrangement An arrangement whereby a client directs that trades
for its account be executed through a specific brokerin exchange for which the client receives abenefit in addition to execution services
a3. General principles ofSoft Dollar Standards
2 key principlesof SDS
1. Brokerage is theproperty of client
2. Investment managershave a duty to
obtain best executionminimize transaction costsuse client brokerage to benefit clients
CFAI SDS areintended to ensure
Full and fair disclosure of the investmentmanager's use of a client's brokerageConsistent presentation of info->all partiesclearly understand brokerage practicesUniform disclosure and record keepingHigh standards of ethical practiceswithin the investment industry
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 11
3.2 CFA InstituteSoft Dollar
Standards (cont.)
b. Critique company SDpractices and policies
I. General
II. Relationships with clients
III. Selection of brokers
IV. Evaluation of research
V. Client-directed brokerage
VI. Disclosure
VII. Record keeping
c. Permissibleresearch guidance
Level 1- Define the Product/ServiceLevel 2- Determine UsageLevel 3- Mixed Use Analysis
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 12
4. CFA InstituteResearch
ObjectivityStandards
CFAI-ROS areintended to be
specific, measurable standardsfor managing and disclosing conflicts of interest that may impede a research analyst's ability to conduct independent research and make objective recommendations
a. Objectives of Research Objectivity Standards (ROS) (p.104)
b
Definitions
Compliance and legal departmentCorporate issuerCovered employeeImmediate familyInvestment advisory relationshipInvestment bankingInvestment managerPersonal investments and tradingPublic appearanceQuiet periodResearch analystResearch reportRestricted periodSubject companySupervisory analyst
Requirementsandrecommendedcomplianceprocedures
1. Research objective policy2. Public appearances3. Reasonable and adequate basis4. Investment banking5. Research analyst compensation6. Relationships with subject companies7. Personal investments and trading8. Timeliness of research reports and recommendations9. Compliance and enforcement10. Disclosure11. Rating system
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 13
5.6.7 Case Studies
5. The Glenarm Company
Case outline
Case results
6. Preston Partners
Case outline
Case results
7. Super Selection
Case outline
Case results
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 14
8. Trade Allocation:Fair Dealing And
Disclosure
a. Trade allocationpractice critique
b. Appropriate responseto inadequate tradeallocation practices
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 15
9. ChangingInvestmentObjectives
a. Critique disclosure ofinvestment objectivesand basic policies
b. Appropriateresponse toinadequatedisclosureprocedures
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 16
10. Prudence InPerspective
Warm-up: The OldPrudent Man Rule
a. Basicprinciplesof the NewPrudentInvestorRule
1. Diversification is fundamental to risk minimization
2. Trustees must base an investment's appropriateness on risk/return profile
3. Trustees have a duty to avoid fees, transaction costs,and other expenses that are not justified
4. The fiduciary's duty of impartiality requires aconscious balancing of current income and growth
5. Trustees may have a duty, as well as theauthority, to delegate as prudent investors would
b. GeneralFiduciaryStandards
A trustee mustexercise
Care
Skill
Caution
Loyalty
Impartiality
c. Differentiate
The Old PMR
The New PIR
Use of total returnRisk managementEvaluation in a portfolio contextSecurity restrictionsDelegation of duty
d. Keyfactorsshould beconsideredwheninvestingandmanagingtrust assets
1. Economic conditions
2. Effect of inflation and deflation
3. Impact of investment decisions on the beneficiary's tax liability
4. How each investment contributes to risk/return of the overall trust portfolio
5. Expected total return from income and capital appreciation
6. Other resources of beneficiaries
7. Needs forliquidityregularity of incomepreservation or appreciation of capital
8. Whether any assets have a special relationship tothe requirements of the beneficiary or the trust
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 17
CFA LEVEL 2
QUANTITAVE ANALYSIS
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 18
EXAMPLE READING 11: (Excel output) Observation X Y1 12 50
Regression Statistics 2 13 54Multiple R 0.47512 3 10 48R Square 0.22574 4 9 47Adjusted R Square 0.12896 5 20 70Standard Error 15.05668 6 7 20Observations 10 7 4 15
8 22 40ANOVA 9 15 35
df SS MS F Significance F 10 23 37Regression 1 528.77 528.77 2.33 0.17 Residual 8 1,813.63 226.70 Total 9 2342.4
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept 25.5586 11.5324 2.2163 0.0575 -1.0351 52.1523 -1.0351 52.1523X 1.1883 0.7780 1.5272 0.1652 -0.6059 2.9824 -0.6059 2.9824
RESIDUAL OUTPUT PROBABILITY OUTPUT
Observation Predicted Y Residuals Standard Residuals Percentile Y1 39.8176 10.1824 0.7173 5 152 41.0059 12.9941 0.9154 15 203 37.4411 10.5589 0.7438 25 354 36.2529 10.7471 0.7571 35 375 49.3236 20.6764 1.4565 45 406 33.8764 -13.8764 -0.9775 55 477 30.3116 -15.3116 -1.0786 65 488 51.7001 -11.7001 -0.8242 75 509 43.3824 -8.3824 -0.5905 85 54
10 52.8884 -15.8884 -1.1192 95 70
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 19
11.1.Correlation
AndRegression
a.
Sample covarianceSample correlation coefficient
Scatter plot
b. Limitations toCorrelation analysis
Outliers
Spurious correlationNonlinear relationships
c. Hypothesis testing ofcorrelation coefficient
d. Variables in alinear regression
Dependent (Y)Explained variableEndogeneous variablePredicted variable
Independent (X)Explanatory variableExogenous variablePredicting variable
e1. Assumptionsunderlying linearregression
linear relationship
independent variable uncorrelated with residualsexpected value of residual term = 0
variance of residual term is constantresidual term is independently distributed
residual term is normally distributed
e2. Simple linearregression model
Sum of Squared Errors (SSE)Odinary Least Squares (OLS)
e3. Regressioncoefficients
Slope coefficientIntercept
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 20
11.2.Correlation
AndRegression
f1. SEE (StandardError of Estimate)
f2. Coefficient ofdetermination (R^2)
f3. Regression coefficientconfidence interval
g. Regression coefficientt-test: b1=0
h. Predicted value ofthe dependent variable
Y=
Confidence intervals
i. ANOVA(AnalysisOfVariance)
SST (Total Sum of Squares)
RSS (Regression Sum of Squares)
SSE (Sum of Squared Errors)
R^2 and SEE
F-Statistic Multiple regressionSimple regression
j. Limitations ofregression analysis
Parameter instability
Limited use if others awareand act the same
Invalid assumptions HeteroskedasticAutocorrelation
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 21
12.1. MultipleRegression &
Issues InRegression
Analysis
Warm-up: Multiple regression basics
a. Multipleregression
Equation
InterpretationIntercept termPartial slopecoefficients
b. Regressioncoefficient testing
HypothesisStatistical significanceInterpreting p-valuesOther tests of the regression coefficients
c1. Confidence intervals forregression coefficient b
c2. Predictedvalue for Y
d. Multiple regressionassumptions
Linear relationship Y -- X
Independent variables X Not randomNo linear relation X -- X
Error term
Expected value = 0Variance is constantNot correlated with one anotherNormal distribution
e. F-statistic
f. Coefficient ofDetermination
R2 vs. Adjusted R2
g. ANOVA tables
h. Dummyvariables
Independent variables isbinary in natureTo quantify impact ofqualitative eventsCoefficients in a Dummyvariable regression
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 22
LOS 12 i,j: Assumption violationsAssumption
Violation Heteroskedasticity Serial Correlation (Autocorrelation) Multicolinearity
Phương sai không đồng nhất Tự tương quan Đa cộng tuyếnDefinition
2 types:. Unconditional:
. Conditional:
(esp. in time series)
2 types:. Positive:
. Negative:
Detecting . Residual plots (Đồ thị phần dư):
. Breusch-Pagan test:
. Residual plots:
. DW (Durbin-Watson) test:
. High R2, reject F-test but not any t-tests
. Rule of thumb:
Effects on regression analysis
. Standard errors:
. t-test:
. F-test:
. Positive: data cluster → standard errors too……. → t-stat too …….. → ……..
. Negative: data diverge →
. F-test: unreliable
Correcting . Adjust standard errors: Robust std. errors White-corrected std. errors Heteroskedasticity-consistent std. errors→recalculate t-stats
. Adjust standard errors: Hansen-White std. errors(correct both heteroskedasticity & autocorrelation) Serial correlation consistent→recalculate t-stats. Improve specification (include seasonal terms)
. Omit 1 or more variables (not easy, must use stepwise regression)
NOTES: . Regression analysis tests (t-tests, F-tests):H0: bad model (Reject H0 →good model)
. Assumption tests:H0: no violation (Fail to reject H0 → good model)
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 23
12.2. MultipleRegression &
Issues InRegression
Analysis
Warm-up: Why multipleregression isn't easy as it looks
Assumptionviolations
i1. Heteroskedasticity
What is it?UnconditionalConditional
Effects on regression analysis
Detecting heteroskedasticity
Correcting heteroskedasticity
i2. Serial correlation(autocorrelation)
What is it?PositiveNegative
Effects on regression analysis
Detecting
Correcting
j. Multicollinearity
is
Effects on regression analysis
Detecting
Correcting
Warm-up: Model specification
k. Modelmisspecification
Subcategory 1: Misspecifiedfunctional form
Misspecification 1: Omitting a variable
Misspecification 2: Variables should be transformed
Misspecification 3: Incorrectly pooling data
Subcategory 2: explanatoryvariables correlated with error term
Misspecification 4: use lagged Y as X
Misspecification 5: Forecasting the past
Misspecification 6: Measuringindependent variables with error
Subcategory 3: misspecifications resulting in nonstationarity
l. Models with qualitativedependent variables
Probit and logit models
Discriminant models
m. Interpreting regression results
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 24
13.1. Time-Series
Analysis
Trendmodels
a. 2 models Linear trend modelLog-linear trend models
b1. Which model is best?
b2. Limitations oftrend models Autocorrelation
Autoregressive(AR) models
d. Structure of an ARmodel of order p
Forecasting with anautoregressive model
e. Autocorrelation & Model fit
l. Seasonality
Definition
Detecting
Correcting
Forecasting with an ARmodel with a seasonal lag
g. In-sample andout-of-sampleforecasting
In-sample forecasts
Out-of-sample forecasts
Root mean squarederror criterion (RMSE)
h. Regression coefficient instability
c. Covariancestationarity
3 conditionsConstant and finite expected valueConstant and finite varianceConstant and finite covariancewith leading or lagged values
Significance of a seriesnot being stationary
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 25
13.2. Time-Series
Analysis
f.
Mean reversion
Calculate amean-reverting level
i. Random walks
Random walk
Random walk with a drift
Covariance stationarity
j. Unit roots
First differencing
k,n. Nonstationarityand cointegration
Unit root test fornonstationary
Cointegration
m. Autoregressive conditionalheteroskedasticity (ARCH)
o. Choosing the correct model
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 26
CFA LEVEL 2
ECONOMICS
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 27
14. EconomicGrowth
Warmup: Economicgrowth (EG)
Estimating EGRule of 70
a1. Sources of EG
Land
Capital goods
Labor
Entrepreneurial ability
a2. Preconditions forE.G. Incentive system
Markets
Property rights
Monetary exchange
Theproductivitycurve (PC)
Labor productivity =Real GDP per labor hour
Definitionof PC
2 properties of PC 1. Growth in capital per labor hour > movement along PC
2. Technological growth > shift PC upwards
Law ofdiminishingreturns
b. The ONETHIRD Rule
c. Fastereconomicgrowth
Three waysIncreasing the growth of physical capital
Technological advance
Investment in human capital
>Suggestions
Stimulate saving
Stimulate R&D
Target hightechnology industriesEncourage international trade
Improve the quality of education
d. Growththeories(GT)
Classical GT
Growth in GDP: not permanent
When real GDP per person above subsistence level > population explosion >real GDP per person back to subsistence level
Figure
Neoclassical GT
Technological change > increased saving & investment >capital per labor hour increase > long term growth in GDP
Different from classicalGT: population growth
Independent of econ. growth (or real wage rate or real GDP)
But influenced by opportunity cost to women for entering workplace
Technological growthNot influenced by economic growth
Occur through trial & error (R&D)
New GT
Based on 2 properties of market economiesDiscoveries are the result of choicesDiscoveries lead to profit & competition eliminates profit
Technologicalchange
driven by profit
there is ongoing search to discover technologies
2 other keyassumptions
Discoveries are public capital goods
Law of diminishing returns doesnot apply to knowledge capital
> no mechanism to stop economic growth
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 28
15. Regulation AndAntitrust Policy In AGlobalized Economy
Warmup: Natural monopolies
a.
Rationale for
Economic regulation ofnatural monopolies
Social regulation ofnonmonopolistic industries
b. Socialregulation
Potentialbenefits
Possiblenegativeside effects
Creativeresponse
Conform to the letter (the words),but not to the intent
Feedbackeffect
is a typical example ofcreative responseNew regulation changes consumers'behavior > undermine the original intent
c.Regulators'behavior
Capturehypothesis
regulators are selected from industry experts > have relationships> sometimes decisions influenced/controlled by the industryat regulatory hearing: consumers less prepared andless persuasive than industry members
Sharethegains,sharethepaintheory Regulators try to
satisfy all 3 parties
LegislatorsCustomersRegulated firms
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 29
16. Trading WithThe World
a.
Comparativeadvantage
ConceptLaw of comparativeadvantage
Specialize in lowopportunitycost goods > exportImport highopportunitycost goods
How countries can gainfrom international trade
Warmup: Consumerand producer surplus
b. Barriersto trade
Tariffs > increase price of imported goods > reduce imports > benefit domestic producers
tariff=tax > benefit government
Nontariffbarriers
Quotas
License to import a limitedamount > reduce supply >
higher pricelower equilibrium domestic quantity
less foreign competition >benefit domestic producers
deadweight loss firms with import licenses get the gains
Voluntaryexportrestraints(VERs)
are agreements by exporting countries to voluntarily limit the quantity of goods
firms with export permits get the gains (different from quotas)Government officials who choose firms may receive some gain.
c. Critquetheargumentsfor traderestrictions
Arguments withsome support
Infantindustryargument
Argument:infant industries should be protected while they getup to world standards of productivity and quality
Critiques:Benefits not the whole economy but to firms &workers in those industriesTariff or quota is market distorting > Government subsidy is better
Dumpingargument
> Antidumping law:
Exporters should be prohibited from sellinggoods abroad at less than production cost
Critiques:
Difficult to estimateproduction costs
price lower than in foreign firms'market is not evidence of dumping
drive domestic firmsout of business >
still have competition fromother countriesthose domestic firms could reenterwhen foreign firms raise prices
Nationalsecurityargument
ArgumentIndustries associated with national defense should beprotected so they will exist domestically in case of war
Critiques:
almost all industries contribute or potentiallycontribute to national defense
government should choose strategic industries tosubsidize rather than impose trade restrictions
Arguments withvery little support
Trade barriers protect jobs
Trade restrictions create jobs
Trade with lowwage countries depresseswages in highwage countries
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 30
17. CurrencyExchange Rates
a. Methods ofFX quotations
Direct
Indirect
b. Spreads
Calculation
Affected byMarket conditions
Bank/dealer's positions
Trading volume
c. FX cross rates
d. Triangular arbitrage
e. Distinguish
Spot markets
Forward markets
f. Spreads in theforward market
Calculation
Affected byMarket conditions
Bank/dealer's positions
Trading volume
Maturity/length of contract
g,i. Forward premium/discount
h
Interestrate parity interest differential ~ forward differential
formula calculating Forward rate from Spot rate:
Coveredinterestarbitrage exploits mispricing between spot & forward > zerocost but guaranteed profit
=money market hedge
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 31
18. ForeignExchange
ParityRelations
a. Exchange ratedetermination in afloating system
b. BOP accounts
Current account (CA)
Financial (capital) account (FA)
Official reserve account
c. How deficit orsurplus in CA & FAaffects an economy
d. Factors that affectcurrency movements
e. Effects of
Monetarypolicyon BOP
Exchange rate
Fiscalpolicyon BOP
Exchange rate
f. Other exchangerate systems
Fixed
Pegged
g,h. Purchasingpower parity (PPP)
Absolute PPP only requires that the law of one price is correct on average
Relative PPP Expected spot exchange rate after t years =
i,j. InternationalFisher relation
Interest rate differential = Expected inflation differential
Assumption: real interest rates stable over timeequal across international boundaries
Exact formula:Linear approximation:
k. Uncovered interestrate parity
= combine PPP & international Fisher
Formula: expected spot exchange rate after n days=
l,m. Foreign exchangeexpectation relation
Forward rate = unbiased predictor of expected future spot rate >no reward for bearing foreign currency exposure (but empiricalevidence suggests forward rate is not unbiased predictor)
Forward discount/premium = unbiased predictor of expected change in spot e/r
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 32
19 . MeasuringEconomic Activity
a. Measures ofeconomic activity
GDP
GNI
NNI
b.
GDP at
Market prices
Factor cost
Adjustments
c
Prices Current prices
Constant prices
GDP deflator
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 33
CFA LEVEL 2
FINANCIAL REPORTING ANALYSIS
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 34
20.Inventories:Implications
For FS &Ratios
a. Effect of inflation &deflation of inventorycostse. Effects of differentinventory valuationmethods
Inflation --> LIFO: ___ COGS; ___NI; ___tax; ___CF;___Inventory, ___Current asset; ____ profitability; ___solvency,____liquidity
Change in methods --> retrospective
Inventorysystems
PeriodicInv.&COGS determined endof accounting period
PerpetualInv. & COGScontinuously updated
b,c. LIFO
LIFO reserve
LIFO conformity rule
c. Adjust FS fromLIFO to FIFO
LIFO inventory
LIFO COGS
LIFO equity
LIFO tax liability
LIFO liquidation
d.Implicationsof valuinginventory atNRV
IFRS write down min(cost, NRV) NRV=
write up: up to original cost
USGAAPwritedown
min (cost, market)
market=mid(replacement cost, _____, ________
write up: no
Except: Commodity-like products
f. Issues toconsider
Service
Merchandising
Manufacturing
3 accounts
Raw materials
WIP
Finished goods
Analysis
RM or WIP increased -->
FG increased when RM, WIP decreased -->
sales g < FG g -->
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 35
21.Long-lived
Assets:Implications
For FS &Ratios
a. Capitalizingvs. Expensing
Define asset:
Effects of capitalizing
Interest cost:
Intangible assets:developed internally
Normally --> Expensed
ExceptR&D
IFRS R: expensed; D: Capitalized
USGAAP
Not software: like normal (expense R&D)
Softwarefor sale: like IFRS(technological feasibility)
for use: capitalize R&D
b. Differentdepreciationmethods forPPE
affect COGS of SG&A
MethodsStraight live
DDB (early)
Usage-based
Change in methods -->
c. Impairment &revaluation
Impairment(write down)
IFRS
2 optionsSell --> =(Fair value-Selling cost)
Use --> Value in use (=PV of future CFs)
Recoverable amount= max (2 options)
If carrying value > recoverable amount -->
USGAAPStep 1: Recoverability test
Step 2: Loss measurement
Revaluation(write up)
Asset held for sale: up to original cost(both IFRS & USGAAP)
Asset heldfor use
USGAAP: no up
IFRS: up to original cost (exceptrevaluation model)
d. Disclosuresrelated tolong-livedassets
BS:
IS:
CF:
Notes:
Average age=
Average depreciable life=
Remaining life=
e. Leasing vs.Purchasing
5 motivations for leasing: less costly; less risk of obsolescence;less restrictive provisions; OBS financing; tax advantage
f. Financevs.OperatingleaseLessor vs.lessee
4 criteria
Transfer of title
Bargain purchase option
Lease period >= 75% economic life
PV(lease pmts) >= 90% fair value of asset
Reportingby lessee
Operating lease
Finance/Capital lease
Financial statements & ratios effects
Leasedisclosures
USGAAP: Yr1:..; Yr2:...; Yr3, Yr4,Yr5; Aggregate Yr6 onward
IFRS: Yr1:...; Sum Yr2 to Yr 5, Sum Yr6 onward.
Reportingby lessor
Operating lease
Financelease
Sales typelease
Gross profit=PV(lease pmts)-BV
BS: lease receivable
IS: Gross profit for 1st year;Interest revenue each year
CF:
Directfinancinglease
similar to sales type leaseexcept for gross profit
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 36
22.IntercorporateInvestments
1.Investmentsin financialassets(minoritypassive)
4 types
Held-to-maturity
Held for trading
Available for sale
Designated at fair value: intention HTM or AFS but treated like HFT
Reclassification of investments infinancial assets
HTM, AFS ---------------------------------- HFT, DFV
AFS----------------------------------------------------HTM
Impairments offinancial assets
Under US GAAP impaired if decline in value is not temporary
Under IFRSimpaired if at least one loss event has occurred &its effect on future CF can be estimated reliably
Both USGAAP & IFRS require to evaluate each accounting period
Reversals ofimpairment
Debt
Equity
Analysis of investmentsin financial assets
2.Investmentsin associates
Equitymethod
initiallyequity investment is recordedat cost on the investor's BS
Insubsequentperiods
the proportionate share of theinvestee's earnings/loss
increases/decreases the investmentaccount on the investor's BS
is recognized in the investor's IS
dividends receivedfrom the investee
are treated as return of capital --->reduce the investment account
are not recognized in the investor's IS
Excess of purchase price over BV acquired
Impairments of Investments in associates
Transactions with the investee
Analytical issues for investments in associates
3. Businesscombinations
Categories Under IFRS
Under US GAAP
The pooling of interests method
Under the acquisition method
4. Jointventures
Under IFRS
Under US GAAP
5. SPE and VIE
c. Effects onfinancial ratios
Items
Net income
Equity
Assets & Liabilities
Sales
Ratios
Leverage
Net profit margin
ROE
ROA
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 37
23. EmployeeCompensation:Post-retirement
And Share-based
a. Types ofpost-employmentbenefit plans
Defined-contribution plan
Defined-benefit plan
Other post-employment benefits
b. Measures of adefined benefitpension plan'sliability/asset
3 measuresProjected benefit obligation (PBO)
Accumulated benefit obligation (ABO)
Vested benefit obligation (VBO)
PBO=
(+) Beginning PBO
(+) Current service cost
(+) Interest cost
(+) Plan amendments
(+)/(-) Actuarial gains/losses
(-) Benefit paid
c. Net pension expense =
(+) Current service cost
(+) Interest cost
(-) Expected return on assets
(-)/(+) Amortization of deferred gains/losses
(+) Amortization of past service cost
d. Impactof a DBP'sassumptions
Discount rateincrease
PBO_____, ABO_____, VBO_____
Current service cost _____, Interest cost _____,Expected return _____, Pension expense ____
Rate of compensationgrowth decrease
PBO_____, ABO_____, VBO_____
Current service cost _____, Interest cost _____,Expected return _____, Pension expense ____
Expected rate ofreturn increase
PBO_____, ABO_____, VBO_____
Current service cost _____, Interest cost _____,Expected return _____, Pension expense ____
e. Presentation& footnotes
Funded status=
Under US. GAAP Net pension asset/liability = Funded status
Other comprehensive income in Equity
Under IFRS Net pension asset/liability = Funded status - Other comprehensive income
g. Evaluate the underlyingeconomic liability (or asset)
Reasonsfor netting
Employer largely controls planassets & obligation --> bear risk
Decisions regarding funding & accounting areaffected by net pension obligation, not gross
f. Cash flowinformation
Funded pension plan: contributions = CFO-
Unfunded plan: benefits paid = CFO-
For analytical purpose: might be CFF-, if contributionslargely differ from economic pension expense
h.
Economic pension expensenot "smoothed"
actual return instead ofexpected return
Reclassifying for analytical purpose Interest cost & Actual return: should be non-operating
Share-basedcompensation
i. Accountingissues
What is share value (esp. if shares are not traded publicly)
Expense should be spread over service period
j.
Stockgrant
Outrightstockgrants
Without conditions
Restricted stocks: can't be sold till end of vesting
Performance stocks (e.g.. ROA, ROE, IN... --> manipulation)
Stock appreciation rightsCondition: share price increase over a threshold
Payment: cash or equity or both
Phantom stocks: stock appreciation rights for privately held/ highlyilliquid firms --> based on performance of hypothetical stock
Stockoptions
In the past: intrinsic value method (recognize an expense if market price> exercise price on grant date). Problem: usually no intrinsic value
Current: Fair value method (using Black Scholes Merton or binomialmodels to calculate value of option --> amortize over service period=grantdate to vesting date). Problem: very subjective
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 38
24.Multinational
Operation
a. Distinguish
Local currency
Functional currency
Presentation (reporting) currency
b. Impact of changes in exchange rates on the translatedsales of the subsidiary and parent company
c.
If foreign currencyappreciates
All-current methodNet assets exposure -->
Net liabilities exposure -->
Temporal methodNet monetary assets exposure -->
Net monetary liabilities exposure -->
d. Compare 2 methods
Income before translation G/L
Translation G/L
Net income
Total assets
e. Affecting theparent company'sfinancial ratios
Temporal vs. All current(parent currencydepreciated -->) ROA__; ROE__; TATO___; Invt TO___; A/R TO___
All current vs. OriginalPure BS or Pure IS ratios
Mixed BS/IS ratios(using end-of-period BS)
f. Subsidiariesoperating inhyperinflationaryeconomies
Define hyperinflation USGAAP: 3-year accumulative infl > 100% (i.e. 26% per year)
IFRS: no definition
Treatment
USGAAP: Functional = Presentation & use temporal method
IFRS
Non-monetaryAsset & Liab
adjust using price index betweenacquisition date & balance sheet date
Shareholders'equity
adjust using price index from date of contribution orfrom year of beginning, whichever is later
Monetary Asset & Liab. no adjustment
Net purchasing power Gain /Loss --> Income statement
Analyzing foreign currency disclosure : Difficulty: little requirement for disclosure. 1 parent may have manysubsi using diferrent methods --> solution: add delta CTA to Net income (clean surplus accounting)
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 39
25. TheLessonsWe Learn
Lesson 1: Understandwhat you are looking at
a. Distinguishamong variousdefinition ofearnings
EBTDA, Operating income, EBT,Income from continuing operations,Income before extraordinary items,Income before effect of changes inaccounting principles, net income
Lesson 2: Read the fine print
Lesson 3: If it's too good to be true, it may be
Lesson 4: Follow the money
b. Trends in CFO more reliable than trends in earnings
c. Lesson 5: Understand the risks
To hedge
Not Effective
Purpose Unrealized G/L Realized G/L Unrealized G/L
Fair value hedge To hedge A/L
CF hedgeTo hedge future CF of trx
Net investment hedge in foreign subsidiary
Foreign subsidiary
Effective
To speculate Realized & Unrealized G/L -->
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 40
26.EvaluatingFinancialReporting
Quality
a.
Contrast Cash-basis
Accrual-basis: provide more timely & relevant info. to users
Why accounting discretionwith accrual basic?
Revenue recognition, Depreciation estimates, Inventory cost flow,Impairment, GW, Valuation allowances for DTA, pension assumptions,stock option valuation to compute compensation expense
b. Relation between the level of accrualsand the persistence of earnings
c.
Opportunities and motivations for management tointervene in the external financial reporting process Influence capital markets
Satisfy contractual provisions (loan covenants, executive compensation)
Mechanisms disciplining mgmt Independent audit, BoD, Certification by senior mgmt,Class action litigation, Regulators, General market scrutiny
d.
Earningsquality (EQ) persistent & sustainable
Measuresof EQ
NOA=
Balancesheetapproach
Accruals =
Accrual ratio =
CF statementapproach
Accruals =
Accrual ratio =
2 approaches are conceptually equivalent.They still may differ because of
Acquisitions
Divestitures
Exchange rate G/L
Inconsistent treatment
e. Mean reversion in earnings
Extreme earnings --> not continue forever but revert back to normal level
Accruals increase --> mean reversion faster
f. Problemswith qualityof FS &warningsigns
Revenuerecognition
Misstating revenue
Accelerating revenue
Bill-and-hold arrangement
Channel stuffing
Barter transactions
Abnormal sales growth
Disproportionate 4th quarter revenues for a non-seasonal firm
Misclassifying nonrecurring or nonoperating
Detectiontechniques
Large changes in A/R & UR
Increased DSO
Compare rev & actual cash collected
Expenserecognition
Undestating expense
Delaying expense
Misclassifying expenses as nonrecurring or nonoperating
Detectiontechniques
Large changes in fixed assets & inventory
Increased DOH
LIFO liquidation
Compare depreciation expense to other companies
Core operating margin = (sales-COGS-SG&A)/ sales
BS
OBS financing e.g..: operating lease
Goodwill
TechniquesCapitalize operating leases
Look for lack of GW impairment
CFS
Misclassifying CF e.g..: "park" cash in LT investment --> CFF
Ignoring CF e.g..: lease
Managing CF
TechniquesCompare growth of operating leases with growth of asset
Be alert for a decrease in discretionary spending, esp. near year-end
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 41
27.Integration
Of FSAnalysis
Techniques
a.b.Frameworkfor theanalysisof FS
Primary purpose: identify potential outcomes, good or bad, that could affect an investment decision
Figure 1:Frameworkfor Analysis
Focus on
Sources of earnings & ROEInternal or External (removeequity income to reduce bias)
Dupont ROE =
Asset base Common size BS
Capital structureDivide by total LT capital
Working capital ratios
Capital allocation decisions Assets, Capex, Rev, EBIT byBusiness segments
Geographic segments
Earnings quality & CF analysis Accrual ratios & CF/Operating income
Mkt value decomposition standalone value of parent, P/E multiple
OBS financing
Anticipating changes in accounting standards
c. Adjustments for differences in accountingrules, methods & assumptions
d. Predict the impact on financialstatements and ratios of changesin accounting standards
Eliminate operating lease
Eliminate QSPE
e. Effects of
BS modifications
Earnings normalization
CF-statement-relatedmodifications
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 42
FRA level 2 examples
30%3 Note: PP=BV
TABLE 1:
Parent SubsidiaryEquity method
ExplanationAcquisition method (purchase method/
consolidation method)Explanation
Proportionate consolidation
methodExplanation
Cash 20 10 17 Pay cash to buy S 27 add up sub & pay cash 20 add up PART OF sub&pay $
A/R+Inventory 28 6 28 unchanged 34 add up sub 29.8 add up PART OF sub
Investment in S 3 Part of S's equity
Fixed assets 32 8 32 unchanged 40 34.4 add up PART OF sub
Total assets 80 24 80 101 84.2
Total liabilities 40 14 40 unchanged 54 add up sub 44.2 add up PART OF sub
Common stock 28 6 28 unchanged 28 unchanged 28 unchanged
Retained earnings 12 4 12 unchanged 12 unchanged 12 unchanged
Minority interest 7 Others' share
BS of Parent after acquisition as at 1/1/2009BS before acquisition as at 1/1/2009
% Purchased of SubsidiaryPurchased price
yTotal Equity 40 10 40 47 40
Total liab.&equity 80 24 80 101 84.2
TABLE 2:
Parent SubsidiaryEquity method
ExplanationAcquisition method (purchase method/
consolidation method)Explanation
Proportionate consolidation
methodExplanation
Revenues 60 20 60 unchanged 80 add up sub 66 add up PART OF sub
Expenses ‐40 ‐16 ‐40 unchanged ‐56 add up sub ‐44.8 add up PART OF sub
Equity in income of S 1.2 P's share
Minority interest ‐2.8 Deduct others' share
Net income 20 4 21.2 21.2 21.2Dividend 0 1
Retained earnings 20 3
IS for the year ending 31/12/2009 IS of Parent for the year ending 31/12/2009
FRA examples & exercises Page 1
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 43
FRA level 2 examples
TABLE 3:
Assumption: all year‐end BS items of P & S are the same as 1/1/09, except for cash which increases by (NI‐Div)
Parent SubsidiaryEquity method
ExplanationAcquisition method (purchase method/
consolidation method)Explanation
Proportionate consolidation
methodExplanation
Cash 40 13 37.3+RE of P+Part of Div from S 50.3
+RE of P+ Part of Div from S + all RE of S 41.2
+RE of P+ Part of Div from S + part of RE of S
A/R+Inventory 28 6 28 34 29.8
Investment in S 3.9 +Part of NI of S‐ Part of Div from S
Fixed assets 32 8 32 40 34.4
Total assets 100 27 101.2 124.3 105.4
Total liabilities 40 14 40 54 44.2Common stock 28 6 28 28 28
Retained earnings 32 7 33.2 +RE of P+Part of NI of S 33.2
+RE of P+Part of NI of S 33.2
+RE of P+Part of NI of S
Mi it i t t 9 1 h ' h
"If‐not‐acquisition" BS as at 31/12/2009 Consolidated BS of Parent as at 31/12/2009
Minority interest 9.1 +Other's share in RE
Total Equity 60 13 61.2 70.3 61.2
Total liab.&equity 100 27 101.2 124.3 105.4
FRA examples & exercises Page 2
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 44
FRA level 2 examples
30% Full GW (100%): 7.33 Fair value of S: 23.33 7 Note: PP#BV Partial GW 30%: 2.20
TABLE 4:
Parent SubsidiaryFair Value of Subsi.
Equity method
ExplanationAcquisition method Partial GW (IFRS)
Acquisition method Full GW (USGAAP &
IFRS)
Pooling of interest
Explanation
Cash 20 10 10 13 Pay cash to buy S 23 23 30A/R+Inventory 28 6 6 28 34 34 34 add up BV
Investment in S 4.8 Part of S's fair equity
Goodwill 2.2 =PP ‐ Part of Fair V 2.20 7.33
Fixed assets 32 8 14 32 46 46 40 add up BV
Total assets 80 24 30 80 105.2 110.33 104
Total liabilities 40 14 14 40 54 54 54Common stock 28 6 28 28 28 34 add up BV
Retained earnings 12 4 12 12 12 16 add up BV
Minority interest 11 2 16 33
% Purchased of SubsidiaryPurchased price
BS before acquisition as at 1/1/2009 BS of Parent after acquisition as at 1/1/2009
Minority interest 11.2 16.33 Total Equity 40 10 16 40 51.2 56.33 50
Total liab.&equity 80 24 80 105.2 110.33 104
TABLE 5:
Parent SubsidiaryEquity method
ExplanationAcquisition method Partial GW (IFRS)
Acquisition method Full GW (USGAAP &
IFRS)
Revenues 60 20 60 80 80Expenses ‐40 ‐16 ‐40 ‐56 ‐56
Share in S's income 1.2
Additional depr. ‐0.6 SLD 3 years ‐0.6 ‐0.6Equity in income of S 0.6Minority interest ‐2.8 ‐2.8
Net income 20 4 20.6 20.6 20.6Dividend 0 1Retained earnings 20 3
IS for the year ending 31/12/2009 IS of Parent for the year ending 31/12/2009
FRA examples & exercises Page 3
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 45
FRA level 2 examples
TABLE 6:
Assumption: all year‐end BS items of P & S are the same as 1/1/09, except for cash which increases by (NI‐Div)
Parent SubsidiaryEquity method
ExplanationAcquisition method Partial GW (IFRS)
Acquisition method Full GW (USGAAP &
IFRS)
Cash 40 13 33.3A/R+Inventory 28 6 28
Investment in S 5.1
+Part of NI of S‐Add Depr.‐ Part of Div from S
Goodwill 2.2
Fixed assets 32 8 32
Total assets 100 27 100.6 0 0
Total liabilities 40 14 40Common stock 28 6 28
+RE of P
"If‐not‐acquisition" BS as at 31/12/2009 Consolidated BS of Parent as at 31/12/2009
Retained earnings 32 7 32.6 +Part of NI of S‐Add Depr.
Minority interestTotal Equity 60 13 60.6
Total liab.&equity 100 27 100.6 0 0
FRA examples & exercises Page 4
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 46
Pension exercise 1:
Expected return on plan assets is 80
Amortization of actuarial loss is 30
Amortization of prior service cost is 10
Calculate
• Net periodic benefit expense
• Economic pension expense
FRA examples & exercises Page 5
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 47
Pension exercise 2:
Calculate Pension expense and make adjustments for analytical purposes.
FRA examples & exercises Page 6
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 48
FRA2‐ Multinational operations‐ Eg.2
U$/LC 31/12/2008 31/12/2009INCOME STATEMENT 2009
All current method
Current ex/ rate 0.5000 0.4545 LC $ $ ExplanationAverage ex/ rate 0.4762 Revenues 5,000 2,381.00 2,381.00 AverageHistorical ex/ rate 0.0000 COGS 3,300 1,571.46 1,595.22 Historical
For COGS 0.4834 Gross margin 1,700 809.54 785.78 For Depr. Exp. 0.4878 Other expenses ‐400 (190.48) (190.48) AverageFor Fixed assets 0.4881 Depr. Expenses ‐600 (285.72) (292.68) Historical
For accum. Depr. 0.4896 302.62 Inc bf remeasureG/L
For end. inventory 0.4762 48.01 Remeasurement G/L
For equity 0.5000 Net Income 700 333.34 350.63
BALANCE SHEETAll current method
BALANCE SHEETAll current method
LC $ LC $ $ ExplanationCash 100 50.00 Cash 100 45.45 45.45 CurrentA/R 500 250.00 A/R 650 295.43 295.43 CurrentInventory 1,000 500.00 Inventory 1,200 545.40 571.44 Historical
Current Assets 1,600 800.00 Current Assets 1,950 886.28 912.32
Fixed Assets 800 400.00 Fixed Assets 1,600 727.20 780.96 HistoricalAccum. Depr. ‐100 (50.00) Accum. Depr. ‐700 (318.15) (342.72) Historical
Net fixed assets 700 350.00 Net fixed assets 900 409.05 438.24
Total assets 2,300 1,150.00 Total assets 2,850 1,295.33 1,350.56
Accounts payable 400 200.00 Accounts payable 500 227.25 227.25 CurrentCurrent debt 100 50.00 Current debt 200 90.90 90.90 CurrentLong term debt 1,300 650.00 Long term debt 950 431.78 431.78 Current
Total liabilities 1,800 900.00 Total liabilities 1,650 749.93 749.93
Common stock 400 200.00 Common stock 400 181.80 200.00 HistoricalRetained earnings 100 50.00 Retained earnings 800 363.60 400.63 Plug number
Total equity 500 250.00 Total equity 1,200 545.40 600.63
Total liab.& equity 2,300 1,150.00 Total liab.& equity 2,850 1,295.33 1,350.56
Temporal method
31/12/2008 31/12/2009Temporal method
FRA examples & exercises Page 7
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 49
FRA2‐ Multinational operations‐ Eg.2
U$/LC 31/12/2008 31/12/2009INCOME STATEMENT 2009
All current method
Current ex/ rate 0.5000 0.4545 LC $ $ ExplanationAverage ex/ rate 0.4762 Revenues 5,000 2,381.00 2,381.00 AverageHistorical ex/ rate 0.0000 COGS 3,300 1,571.46 1,595.22 Historical
For COGS 0.4834 Gross margin 1,700 809.54 785.78 For Depr. Exp. 0.4878 Other expenses ‐400 (190.48) (190.48) AverageFor Fixed assets 0.4881 Depr. Expenses ‐600 (285.72) (292.68) Historical
For accum. Depr. 0.4896 302.62 Inc bf remeasureG/L
For end. inventory 0.4762 48.01 Remeasurement G/L
For equity 0.5000 Net Income 700 333.34 350.63
BALANCE SHEETAll current method
BALANCE SHEETAll current method
LC $ LC $ $ ExplanationCash 100 50.00 Cash 100 45.45 45.45 CurrentA/R 500 250.00 A/R 650 295.43 295.43 CurrentInventory 1 000 500 00 Inventory 1 200 545 40 571 44 Historical
Temporal method
31/12/2008 31/12/2009Temporal method
Inventory 1,000 500.00 Inventory 1,200 545.40 571.44 HistoricalCurrent Assets 1,600 800.00 Current Assets 1,950 886.28 912.32
Fixed Assets 800 400.00 Fixed Assets 1,600 727.20 780.96 HistoricalAccum. Depr. ‐100 (50.00) Accum. Depr. ‐700 (318.15) (342.72) Historical
Net fixed assets 700 350.00 Net fixed assets 900 409.05 438.24
Total assets 2,300 1,150.00 Total assets 2,850 1,295.33 1,350.56
Accounts payable 400 200.00 Accounts payable 500 227.25 227.25 CurrentCurrent debt 100 50.00 Current debt 200 90.90 90.90 CurrentLong term debt 1,300 650.00 Long term debt 950 431.78 431.78 Current
Total liabilities 1,800 900.00 Total liabilities 1,650 749.93 749.93
Common stock 400 200.00 Common stock 400 181.80 200.00 HistoricalRetained earnings 100 50.00 Retained earnings 800 363.60 400.63 Plug number
Total equity 500 250.00 Total equity 1,200 545.40 600.63
Total liab.& equity 2,300 1,150.00 Total liab.& equity 2,850 1,295.33 1,350.56
FRA examples & exercises Page 8
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 50
FRA2‐ Multinational operations‐ Eg.3
1234567
891011
12
13
141516171819202122
A B C D E
Adjustments for inflation under IFRS
Price indicesDec. 31. 2009 100Dec. 31. 2008 150Average for 2009 125
INCOME STATEMENT2009
Adjustment factor
Inflation adjusted
Revenues 15,000 1.20 18,000Expenses ‐12,000 1.20 ‐14,400Net purchasing power G/L 6,900
Net Income 3,000 10,500
BALANCE SHEET 2008 2009Adjustment
factorInflation adjusted
Cash 5,000 8,000 8,000Supplies 25,000 25,000 1.50 37,500
Total assets 30,000 33,000 45,500
Accounts payable 20,000 20,000 20,000Common stock 10,000 10,000 1.50 15,000Retained earnings 0 3,000 10,500
Total liab.& equity 30,000 33,000 45,500
FRA examples & exercises Page 9
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 51
CFA LEVEL 2
CORPORATE FINANCE
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 52
28.1. CapitalBudgeting
Warmup: Basics
Projectcategories
Replacement to maintain biz > no detailed analysisReplacement for cost reduction > fairly detailed analysisExpansion > very detailedNew product/ market > detailedMandatory (required by Govt. or insurance such as safety or environmental projects)Other (pet projects or high risk like R&D)
Principles
Incremental CF, not accounting incomeTiming of CF > TVMAfter tax
Notes
ExcludeSunk costFinancing costs
IncludeExternalitiesOpportunity costs
MACRS= Modified Accelerated CostRecovery System (for tax purpose) Halfyear convention
No salvage
a. Capital budgetingproject evaluation
Expansionprojectanalysis
Initial investment outlay=
Aftertax O.CF=
T.NO.CF=
Replacementprojectanalysis
Initial investment outlay=
Aftertax O.CF=
T.NO.CF=
b. Inflation effects (ifactual inflation higherthan expected)
Principle Nominal CF > use nominal discount rateReal CF > use real discount rate
__________ project profitability
__________ tax savings from depreciation
__________ value of payments to bondholders
Affects Revenues and Costs differently > CF may be worse or better
c1. Projectswith differentlives
Least common multipleof lives approach(replacement chain)
Equivalent annual annuity(EAA) approach
c2. Capital rationing= insufficientcapital > violate market efficiency
Hard rationing: allocated funds cannot be increased
Soft rationing: allocated funds can be increased
d. Projectriskanalysis
Sensitivity analysis: Base case, then change ONLY 1 variable up/down
Scenario analysis: Base case, then change MANY variables > Worst case, Best case > Risk analysis
Simulation analysis (Monte Carlo): Probability distribution of NPV
e. Determine discount rateCAPM > WACC
When risk of project # overall risk > CANNOT use WACC
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 53
28.2. CapitalBudgeting (cont.)
f. Evaluatingprojects withreal options
Typesof realoptions
Timing options: option to delay investment
Abandonment options: abandon if NPVexit > NPVcontinue (=put option)
Expansion options: option to have additional investment (=call option)
Flexibility options(operational)
Pricesetting: demand increase > increase price (oil)Productionflexibility: e.g..: pay overtime, use # inputs, # products...
Fundamental options: project itself = option (e.g.: copper mine)
Evaluatingapproaches
If NPV without option >0 > Project will be more valuable with option
NPV = NPV without option + option value option cost
Decision tree
Option pricing models
g. Commoncapitalbudgetingpitfalls
Failing to incorporate economic responses: e.g..: profitable but low entry barriers > competitors
Misusing standardized templates, which are not an exact match
Pet projects of senior management: less analysis
Basing investment decisions on EPS or ROE > avoid projects with high NPV but low EPS orROE in the short run (especially when management compensation is tied to EPS or ROE)
Using IRR for project decision: for mutually exclusive projects, should use NPV instead
Poor CF estimation: double count or omit a CF. E.g..: inflation
Misestimation of overhead costs (e.g..: management time, IT support): difficult to quantify
Using the incorrect discount rate: WACC or should adjust?
Politics involved with spending the entire capital budget: e.g.. :management tries to spendall budget to ask for more next year
Failure to generate alternative investment ideas: most important step ("good" is the enemy of "better")
Improper handling of sunk and opportunity costs
h. Measuresof incomeand valuationmodels
ECONOMICINCOME
= CASHFLOW minus ECONOMIC DEPRECIATIONEconomic Depreciation year t = Beginning market value minus Ending market value for year t
Market value year t = sum of PV of all CF left
ACCOUNTINGINCOME
From Income statement
# economic incomeDepreciation based on original cost, not market valueDeduct interest expense
i. Othervaluationmodels
ECONOMICPROFIT (EP)
= NOPAT WACC in dollarsTo bond and equity holdersSum of EP discounted at WACC = MVA (Market Value Added) = NPV
RESIDUALINCOME
= ACCOUNTING NET INCOME minus EQUITY CHARGETo equity holdersSum of RI discounted at cost of equity = NPV
Claimsvaluation Free cash flows to company (debt and equity holders) > discount at WACC
Free cash flows to equity (shareholders) > discount at cost of equity
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 54
29. CapitalStructure &Leverage
a1. Capitalstructuretheory
Capital structure objectiveMaximize Firm Value MM Proposition I
Minimize WACC MM Proposition II
No taxesMM Proposition I
MM Proposition II
With taxesMM Proposition I
MM Proposition II
a2. Costs and theirpotential effect onthe capital structure
Costs of financialdistress > lower Debt Costs
Probability
Agency costs of equity> higher Debt
Monitoring costs: supervising, reporting (corporate governance)Bonding costs: insurance premiums, noncompete agreementsResidual losses: other costs
Costs of asymmetric information:(managers vs. creditors and owners) > increase required rate of return
a3. Implications formanagerialdecision making
MM's propositions with no taxes: Capital structure is irrelevant
MM's proposition with taxes: optimal capital structure is 100% debt (highest tax shield, max value, min WACC)
Pecking order theory: order of raising funds: Internally generated equity > Debt > External Equity
Static tradeoff theoryFirm value:
Optimal capital structure achieved when:Marginal Tax Benefit = Marginal Cost of Financial Distress
b. Target capitalstructure (optimal)
2 reasons for actual capitalstructure to fluctuate aroundtarget capital structure
Opportunities in afinancing source
E.g.: temporary increase in stock price
Market valuefluctuations
D, E = market value
c. Role of debt ratingsMoody's; S&P's
d. Capital structurepolicy and valuation
Factors toconsider
Changes in capital structure overtimeCompetitors with similar business riskAgency costs (corporate governance)
e. Internationaldifferences inleverage
Internationaldifferences
Total debt: Japan, France: more debt than UK, USDebt maturity: US longer than JPEmerging market differences: emerging market less and shorter debt
Factors
Institutionaland legalfactors
Strength of legal system: strong > reduce agency cost> less and longer debtInformation asymmetry: increase debt (auditors, analystshelp reduce info asymmetry > decrease debt)Taxes: high > increase debt. Tax on dividend: high > decrease debt
Financialmarkets andbankingsystem factors
Liquidity of capital markets (debt market): high > longer debtReliance on banking system > increase debtInstitutional investor (shareholders) presence >decrease information asymmetry > decrease debt
Macroeconomicfactors
Inflation > less, shorter debtGDP growth > longer debt
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 55
30. Dividends& Dividend
Policy
a. Schools ofthought ondividends
Dividend irrelevance: MM (homemade dividend)
Dividendpreference
Bird in the hand theory (Myron Gordon & John Lintner)
Impact of dividend initiationon stock value and P/E
Higher dividend > _____ Risk >_____ Cost of Equity > _____ P/E
Higher dividend > _____ stock value
Tax aversion
Clientele
d. Factorsaffectingdividendpayoutpolicy
b. Signalingeffect
Informationconveyed by
Dividend initiationsambiguous: sharing wealth or lack ofprofitable reinvestment opportunities
Dividend increases Strong future
Unexpected Dividenddecreases / omissions
Business in trouble or moreinvestment opportunities
Country differences: US # Asia in perception
e. Taxationof dividends
Taxondividendsystems
Double taxation
Split rate
Imputation
c. Clienteleeffect
Tax considerations
Requirements of institutional investors
Individual investor preference
c2. Agencyissues
Restrictionson dividendpayments
"Impairment of capital" ruleDebt covenantsCash flowIndustry life cycle
Flotation costs on new issues vs. cost of retained earningsShareholder preference for current income vs. capital gains
f. Dividend policyapproaches
Residual dividend model
Longerterm residual dividend e.g.:forecast capital budget for 5 years,Leftover = total net income 5 years minus capital budget for 5 years.Dividend each year = Leftover/5
Dividend stability: steady dividend payout (taking into account inflation)> dividend growth rate g = company's long term growth rate
Target payout ratio Payout ratio = constant
Payout ratio moves toward the target
g. Sharerepurchase
Compare with cash dividend
EPSeffect
If Cost of Debt < Earning yield > EPS_____If Cost of Debt > Earning yield > EPS_____
Bookvalueeffect
If Price > BVPS > BVPSnew ______If Price < BVPS > BVPSnew ______
MethodsBuy in the open marketBuy a fixed number of shares at a fixed price: tender offer: P > PmarketRepurchase by direct negotiation: to avoid price decrease (e.g.: greenmail premium)
Rationales
Capital structurePrevent EPS dilution from employee stock optionsSupplement to cash dividend > residual dividend policyManagement is viewing stocks as strongGood future outlook signal
h. Global trends
i. Dividend coverageratios based on
Net incomeFCF
j. Symptoms of not being ableto sustain cash dividend
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 56
31. CorporateGovernance
Warmup: conflicts ofinterest in a corporation
Multiple owners vs managersDirectorsCreditors, Employees, Customers
a. Corporategovernance(SarbanesOxley)
Definition: system ofPrinciples & PoliciesProceduresResponsibilities & Accountabilities
Objectives Eliminate or reduce CONFLICTS of interest (esp. mgmt vs. shareholders)Use ASSETS in best interests of investors and other stakeholders
Attributes ofeffective CG
RIGHTS of shareholders & stakeholdersOversight RESPONSIBILITIES of managers and directorsFair and equitable TREATMENTTransparent & accurate DISCLOSURES about operations, performance, risk and financial position
b. Business forms
Sole proprietorship no owner vs. manager conflict. Just creditors, suppliers, customers...
Partnerships no owner vs. manager conflict. Just creditors, suppliers, customers...
Corporations (US: 20% in number but account for 90% revenue)
c. Conflictsin agencyrelationships
Manager >< ShareholderExpand firm to increase power, security, compensation
Excessive compensation and perquisites (e.g.. lavish jet)Invest in risky ventures (succeed > benefit from stock options, fail > not share the loss)Not taking enough risk
Director >< Shareholder
Lack of independencePersonal relationship btw board managementBoard: consulting/ other biz with firm
Interlinked boards 2 companies
Directors are overcompensated
d,e. Boardof Directors
Responsibilities(check and balance)
Institute corporate values & CG > proficient, ethical, fair biz conductionEnsure compliance: with all legal & regulatory requirementsCreate longterm strategic objectivesDetermine management's responsibilities (need to be able to measure performance)Hire, compensate, evaluate CEORequire complete and accurate information from managementMeet regularlyEnsure board members are adequately trained
Points toassess Board
Composition and independence recommend at least 3/4
Chairman independent or not should be CEO or not
Directors qualificationsskills, experience, strategic planning, riskmanagement, commitment, attitudes, ethics
Board election methodall or staggered? Staggered: keep board continuitybut limit shareholders' power & slow down changes
Board selfassessment practices annually
Frequency of separate sessions for independent directors annually, quarterly
Audit committee and audit oversight only independent directors, with expertise
Nominating committee all independent
Compensation committee
Use of independent or expert legal counsel internal counsel > weak CG
Statement ofgovernancepolicies
f. Statementof CGpolicies
Codes of ethicsDirectors' oversight, monitoring and review responsibilitiesManagement's responsibilities to the boardReports of directors' oversight and review of managementBoard self assessmentsManagement performance assessmentsDirector training
Disclosure and transparencyInsider or relatedparty transactionsResponsiveness to shareholder proxy votes
g. Valuationimplications ofCorporateGovernance
Strong/effective CG system > higher measures of profitability & returns for shareholders
Weak/ineffectiveCG system
Financial disclosure risk incomplete, misleading, materially misstated disclosure
Asset risk e.g..: too high perks
Liability risk e.g..: OBS obligations
Strategic policy risk e.g..: M&A
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 57
32.1. Mergers& Acquisitions
Background
Bidder/ Acquirer vs. Target company
Mergers entire target > 1 company ceases
Acquisitions part of target e.g..: assets, biz segment
a. Categorize M&A
Forms of integration(how physically cometogether)
statutory merger acquire all A&L > target not exist
subsidiary merger e.g.: P&G bought Gillette (good brand)
consolidation both cease to exist > new company
Types of mergers(how activitiesare related)
horizontal same industry
verticalin the supply chain
Forward vs. Backward integration
conglomerate no relation
b. Mergermotivations
Synergies
More rapid growth
More market power
Access to unique capabilities
Diversification
Bootstrapping EPS c. Bootstrapping
Personal benefits for managers
Tax benefits loss carryforwards
Unlocking hidden value
Achievinginternationalbusiness goals, by
Taking advantage of market inefficiencies (e.g..: cheap labor force)
Working around disadvantageous government policiesUse technology in new marketsProduct differentiation
Provide support to existing multinational clients
d. Motivationsfor mergers andindustry lifecycles
Pioneer/ development phase Need capital, management > H or C
Rapid growth Need capital, management > H or C
Mature growth Need operational efficiency (from economies of scale) > H or V
Stabilization Need to cut costs (from economies of scale) > H
Decline H or V or C
e. Mergertransactioncharacteristics
Form ofacquisition Stock purchase
Asset purchase
Method ofpayment
MethodsSecurities offeringCash offering
Mixed offering
Factors toconsider
Risk & reward for acquirer vs. targetRelative valuations of companiesChanges in capital structure
Attitude of targetmanagement
Mgmt happy > Friendly merger offers
Mgmt unhappy> Hostile merger offers
Bear hug(proposeto BoD)
If Bear hug isunsuccessful >
Tenderoffer
Buy shares fromtarget shareholders
Proxybattle
Replace BoD
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 58
32.2. Mergers& Acquisitions
(cont.)
f. Takeoverdefensemechanisms
Preofferdefensemechanisms
Poison pill
Rights for current SHDs to purchase shares at big discount, triggered with 1 SHD holds > threshold (10%)
FormsFlipin pill
Flipover pill
Deadhand provision: BoD's right to redeem the pill, in a friendly merger offer
Poison put Bondholders' right to demand immediate repayment if there is a hostile takeover
States with restrictive takeover laws Ohio & Pennsylvania: most protection
Staggered boarde.g.: 3 groups of BoD, each is elected for 3 yearterm >need at least 2 years to gain majority control of the board
Restricted voting rightsOwnership > threshold (20%) > loss of voting rights > preventtender offer > bidder must negotiate with BoD directly
Supermajority voting provision for mergers e.g..: at least 2/3 or 80%, not 51% as usual
Fair price amendment determined by some formula or independent appraisal
Golden parachutes lucrative cash payouts to managers if they leave after a merger
Postofferdefensemechanisms
"Just say no" defense
Litigation lawsuit (antitrust or violation of securities law)
Greenmailagreement that allows target to repurchase its shares fromacquirer at premium price (rare after 1986: 50% tax)
Share repurchase (target's tenderoffer for its own shares)
> acquirer increases bid & leverage > less attractive
Leveraged recapitalization borrow to buy shares
Crown jewel defense sell a major asset/ subsidiary
Pacman defense counter offer
White knight defense > bidding war > good price > winner's curse
White squire defense(squire = junior knight)
sell a minority stake but bigenough to block acquirer
g. HHI
HerfindahlHirschman Index Formula:
If postmerger HHI
< 1000: Merger ok
From 1000 to 1800If increase in HHI <100: merger okIf increase in HHI >=100: merger NOT ok
> 1800If increase in HHI <50: merger okIf increase in HHI >=50: merger NOT ok
h,i,j. Methodsfor valuing atargetcompany
DCF analysis
Comparable company analysis
Comparable transaction analysis
k. Evaluatinga merger bid
Postmerger value of an Acquirer
Gains accrued to the Target
Gains accrued to the Acquirer
Cash payment versus Stock payment
l. Effects of
PricePaymentmethod Cash offer
Stock offer
m. Distribution ofmerger benefits
Target gains 30%Acquirer lose stock value 13% (winner's curse, mgmt hubris)
3 years after merger acquirer return = 4%60% acquirers lag peer group (fail to capture synergy)
n. Downsizingoperationsthroughcorporaterestructuring
Divestitures(dispose asset) o. Reasons for
divestitures
Not fit long term strategyLack of profitabilityIndividual parts are worth more than the wholeInfusion of cash
Equity carveouts create new, independent company > issue shares to OUTSIDE SHDs (public)
Spinoffs create new, independent company > issue shares to EXISTING SHDs
Splitoffs exchange shares of parent for shares of division
Liquidations
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 59
CFA LEVEL 2
EQUITY
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 60
34. EquityValuation:
Applications& Process
33. A Note On AssetValuation
Classic works by Graham &Dodd and J.B. Williams
a.
Define ValuationIntrinsic value
Possible sources ofperceived mispricing
b. Contrast
Going concern value
Liquidation value
c. Uses ofequityvaluation
Stock selection
Reading the market
Projecting the value of corporate actions
Fairness opinions
Planning & consulting
Communication with analysts and investors
Valuation of private business
Portfolio management PlanningExecuting the investment plan
d.
5 elements ofindustry structure
Threat of new entrantsThreat of substitutesBargaining power of buyersBargaining power of suppliersRivalry among existing competitors
3 genericstrategies
Cost leadershipProduct differentiationFocus
Quality of financial info.
e. Contrast
Absolutevaluationmodels
Relativevaluationmodels
f. Criteria for choosingan approach
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 61
35. ReturnConcepts
a. Concepts
HPR
Realized and Expected return
Required return (RR)
Return from convergenceof price to intrinsic value
Discount rate
IRR
b. Equity riskpremium
Explain equity risk premium
Use in required return determination
Major methods of estimatingequity risk premium Historical estimation
Forwardlooking estimation
c,e. Methods ofestimating theRR on equityinvestment
CAPM
Multifactormodel
FarmaFrench model
PastorStambaugh model
Macroeconomic multifactor model
Buildupmodel Bondyield plus risk
premium model
d. Estimatingbeta for
Public co.
Thinly traded public co.
Nonpublic co.
f. Internationalconsideration inRR estimation
Country spread model
Country risk rating model
g. WACC
h. Appropriate discount rate
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 62
36. The FiveCompetitiveForces That
Shape Strategy
Warmup
a.b. Porter's fiveforces. Drivers ofindustry profitability
Threat of new entrants
Threat of substitutes
Bargaining power of buyers
Bargaining power of suppliers
Rivalry among existing competitors
c. Common factorsthat affect the fiveforces
Industry growth rate
Innovation and technology
Govt policies
Complementary products
d. Changes in industry structure and their effects on theindustry's profit potential
e. Strategicalternatives
Altering the firm'sexisting position
Capitalizing on changesin the industries
Creating changes in theindustry structure
Steps in using the forcesin an industry analysis
Example: WalMart
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 63
37. IndustryAnalysis
a. Componentsin industryanalysis model
Industry classificationExternal factor reviewDemand analysisSupply analysisProfitability analysisInternational competition & markets review
Industryclassification
b. Life cycle of atypical industry
1. Pioneer2. Growth3. Mature4. Decline
Warmup:Business cycle
c. Effects ofbusiness cycleson industryclassification
GrowthindustrystocksDefensiveindustrystocksCyclicalindustrystocks
d. Externalfactors
TechnologyGovtSocial changesDemographyForeign influences
e1. Demandanalysis
e2. Supplyanalysis
f. Profitabilityanalysis
ProductsegmentationIndustryconcentrationEase ofindustry entrySupplyinput price
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 64
38. ValuationIn Emerging
Markets
Warmup: Real andnominal valuation
CFestimation
a. Effectsof inflation
Income taxesNWCCapital expenditures
b. Calculate nominaland realterm financialprojections 5step
approach
1. Operating results real
2. Operating results nominal
3. NOPLAT real
4. Free CF real & nominal
5. Firm value real & nominal
c. Account foremergingmarket risks
Adjust CFs, b/c
Country risks arediversifiable
Companies respondifferently to country risk
Country risk is onesided risk
Identifying CF effects aidsin risk management
Rather than adjusting r
d. Estimatingcost of capital
KeRfBetaMarket risk premium
Kd (1t) Kdt
Capital structure weights
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 65
39. DiscountedDividendValuation
a. Measures of CF
Dividends
FCF
Residual income
DDM
Appropriateness
b.OneperiodTwoperiod
Multiperiod
Warmup: General DDM
i,l. Multistagegrowth models
Assumptions
Selection of
Twostage DDM
Hmodel
Threestage DDM
Spreadsheet modeling
j. Businessphases
Initial growthTransition
Maturity
k. Terminal value
GGM
c. Assumptions
d. Implied growth rate
f. Justified P/E Justified leading P/E
Justified trailing P/E
h. Strengths
Limitations
e. PVGO
g. Value ofpreferred stock
m. Calculateexpectedreturn with
GGM
Hmodel
Twostage DDM
n. Sustainable growth rate
o. Use of spreedsheet modelingTo forecast dividends
To value common shares
p. Over/Fairly/Undervalued
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 66
40. FreeCash FlowValuation
a. Interpret &compare
FCFF
FCFE
b,f. Ownership perspective& recognition of value
FCFE, FCFF
DDM
c,d. Calculate
FCFF
FCFE
e. ForecastingFCFF and FCFE
Historical free cash flow
Components of free cash flow
g. FCFF & FCFEaffected by
Dividends
Share repurchases
Share issues
Changes in leverage
h. Critique the use of NI andEBITDA as proxies for CF
i. Models
Single stage
MultistageHow many variations are there?
Model assumptions &Firm characteristics
j. Calculate the value ofa company
k. Sensitivity analysis
l. Terminal value
FCFF is preferred toFCFE when
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 67
41.1.Marketbased
Valuation
Types of valuationindicators
Price multiplesEnterprise value multiplesMomentum indicators
a. Twomethods
Method of comparablesMethod based onforecasted fundamentals
b. Justified price multiple
c,d,g. Pricemultiples
P/E Trailing P/ELeading P/E
P/B
P/S
P/CF
c,d,g. Dividendyield (D/P)
Trailing D/P
Leading D/P
e. Underlying earnings(persistent, continuing,core); Normalized EPS
Exclude nonrecurring components(G/L from asset sales, writedowns...)Method of historicalaverage EPSMethod ofaverage ROE
f. Earnings yield (E/P)
h. Calculate
Justified P/E
Justified P/B
Justified P/S
Justified P/CF
Justified EV/EBITDA
Justified D/P
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 68
EQUITY LEVEL 2, READING 4144. c,d,h,n
Multiples(LOS c,d)
Advantages Disadvantages Notes Justified (LOS h)
P/E + Popular+ Earnings power (EPS) is the primary determinant of inv. Value+ Proved by empirical evidence
- EPS might be <0 --> P/E is meaningless- Earnings have 1 portion that is volatile & transitory -> difficult to interpret- Earnings can be distorted by mgmt --> lower comparability
* Trailing P/E: not useful for forecastin & valuation* Leading P/E: not relevant if earnings are too volatile
P/B + Usually BV>0, more stable+ Firms that primarily hold liquid assets --> BV~VE
+ Useful in valuing companies expected to go out of biz.+ Proved by empirical evidence
- Not reflect intangible assets (human capital)- Misleading due to differences in asset size (eg.: outsource vs. not outsource)- Different accounting standards --> affect comparability (eg.: R&D is expensed in US)- BV # MV b/c of inflation or technological change
Adjustments to BV:. Exclude intangible assets (GW, patent). Adjust for OBS. Adjust to reflect fair value. Adjust for # accounting policies (eg.: LIFO vs. FIFO)
P/S + S is always >0, even when E,B<0 --> P/S meaningful for distressed firms+ Not as easy to manipulate/ distort+ Not as volatile --> estimate is more reliable+ Appropriate for start-up companies, mature&cyclical industries, investment mgmt companies+ Proved by empirical evidence
- High sales growth --> not mean high operating profit --> not as meaningful as P/E & P/CF- Not capture cost differences- Can still be distorted (eg.: bill-and-hold)
P/CF + CF is harder to manipulate+ P/CF is more stable than P/E+ Avoid "quality of earning" problem of P/E+ Proved by empirical evidence
- If CF=NI+NCC --> ignore NCRev. & WC- FCFE is preferred to CFO but more volatile
D/P + D/P (with capital gain) contributes to R investment+ Div less risky than capital gain
- Ignores capital appreciation --> incomplete focus- "Div displacement of earnings" concept: trade-off btw div & future earnings (current & future CF)
. Used to value index
. Distinguish: Trailing D/P=
Leading D/P=
EV/EBITDA(LOS n)
+ Useful when comparing firms with different leverage and capital intensive (high DA)+ EBITDA usually > 0
- When WC increases, EBITDA overstates CFO- Ignore how revenue recognition affects CFO- CAPEX # Depr -> EBITDA not capture CAPEX --> # FCFF --> not linked with valuation theory
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 69
41.2Marketbased
Valuation(cont.)
i. PredictedP/E ratio
j. Evaluate stock bymethod of comparables
k. PEG ratio
l. Use of price multiples in determiningterminal value in a multistage DCF model
m. Alternative definitions of CFused in price multiples
n. EV/EBITDA
o. Sources of differences incrossborder valuation comparisons
p. Momentum indicators
q. Over/Fairly/Undervalued
r. Central tendency of agroup of multiples
Arithmetic meanHarmonic meanWeighted harmonic meanMedian
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 70
42. ResidualIncome
Valuation
a. Calculate
RI =
EVA =
MVA =
b. Use of RI models
c. FV of RI
d. Fundamentaldeterminants of RI
e. Relationbetween
RI valuation
Justified P/B ratio
f. Singlestage &multistage RI model
g. Calculate impliedgrowth rate (g)
h.ContinuingRI
is.....
Persistentfactor
Assumptions
RI persists atcurrent level forever
RI dropsimmediately to zero
RI declines overtime to zero
RI declines to LR levelin mature industry
i. Compare
RI
DDM
FCFE
j. RI models
Strengths
Weaknesses
k. Justify theselection of RI model
l. Accountingissues
Violations of the cleansurplus relationship
Variations from fair value
Intangible assets effects on BV
Nonrecurring items and otheraggressive accounting practices
International accounting differences
m. Over/Fairly/Undervalued
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 71
43.1 PrivateCompanyValuation
a. Privatecompanyvaluationvs. public
Companyspecific factors
Stage of lifecycleSizeQuality & depth of mgmtMgmt/SHD overlapST investorsQuality of financial & other info.Taxes
Stockspecific factorsLiquidityRestrictions on marketabilityConcentration of control
b. Uses of privatebusiness valuation
Transaction relatedvaluations
Venture capital financingIPOSale in an acquisitionBankruptcy proceedingsPerformancebasedmanagerial compensations
Compliance relatedvaluations Financial reporting
Tax purposes
Liquidation relatedvaluations
c. Definitionsof value
Fair market value
Fair value for financial reporting
Fair value for litigation
Market value
Investment value
Intrinsic value
d. Valuationapproaches
f. Incomeapproach
Free CF method
Capitalzed CF method
Excess earnings method
Marketapproach
Assetbasedapproach
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 72
43.2 PrivateCompanyValuation
(cont.)
e. Estimate
Normalized earnings
CF
g. Elements ofdiscount rate
Size premiums
Availability and cost of debt
Acquirer vs. target
Projection risk
Lifecycle stage
h. Estimate ke
CAPM
Expanded CAPM
Buildup method
i. Marketapproaches
GPCM (Guideline publiccompany method)
GTM (Guidelinetransactions method)
PTM (Prior transaction method)
j. Asset basedapproach
k. Use of discounts& premiums
Discount forlack of control
Discount for lackof marketability
l. Role ofvaluationstandards
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 73
CFA LEVEL 2
ALTERNATIVE INVESTMENTS
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 74
44.Investment
Analysis
a. RE Investmentcharacteristics
Valuing realestateinvestments
c. Calculate
CFAT = NOI - debt service - taxes payable
EART = selling price - selling costs - mortgage balance - taxes on sale
b. Evaluate a real estateinvestment using NPV, IRR
d. Potentialproblemswith IRR
Multiple IRRs
Ranking conflicts
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 75
45. IncomePropertyAnalysis
AndAppraisal
a. Capitalization ratevs. discount rate
b. Determinecap rate by
Marketextractionmethod
band ofinvestmentmethod
builtupmethod
c.
Directcapitalizationapproach
Gross incomemultiplier technique
d. Contrast
Limitations of the directcapitalization approach Selecting the appropriate cap rate
Application to incomeproducing property
Limitations of thegross incomemultiplier approach
Discontinuous pricing
Lack of information
Gross rent vs. NOI
Distorted selling prices
Unique or nonincomeproducing properties
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 76
46.1. PrivateEquity
Valuation
Background: Private equity (PE)
a. Sources of valuecreation in PE
1. Reengineering
2. Favorable debt financing
3. Superior alignment ofinterests (also see los b)
b. Aligningmanagerial andownership interestsin PE firms
Incentives Compensation
Tagalong, dragalong clauses
Effectivestructuring ofinvestmentterms
Board representationNoncompete clausesPriority in claimsRequired approvalsEarnouts
c. Characteristics ofVenture Capital
Buyout Investments
d. Valuationissues
e. Exit routes in PE
IPO
Secondary market sale
MBO
Liquidation
g. Investingin PE firms
Risks Specific risksGeneral risks
Costs
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 77
46.2.PrivateEquity
Valuation(cont)
f. PEFund
Structures
Company limited by shares
Limited partnership (Most)LPsGP
Most are closedend
2 businessesraising fundmanaging PE investments
Terms
Shouldfocus onaligningtheinterestsof GP &LPs
Economicterms
Management fees
Transaction fees
Carried interest
Ratchet
Hurdle rate
Target fund size
Vintage
Terms of the fund
Corporategovernanceterms
Key man clause
Performance disclosure &confidentiality
Clawback
Distribution waterfall
Tagalong, dragalong clauses
Removal for cause
Nofault divorce
Investment restrictions
CoinvestmentOnly vailable for "qualified" investorsFund prospectus
Valuation NAV
Ways todetermineNAV
1. At cost, adjusting for subsequent financing and devaluation2. The minimum of cost or market value3. By revaluing a portfolio company anytime there is new financing4. At cost with no adjustment until exit5. By discounting for restricted securities6. Less frequently, marked to market by reference to a peer group ofpublic companies, applying illiquidity discounts to public comparables
Issues incalculatingNAV
Stale NAVNo definitive methodUndrawn LP capitalComparison between PE fundsGP usuallyvalues
>Now, more and more independent parties value
Due diligence of PEfund investments
PE funds tend to exbihit a strong persistence of returns over timeThe performance range between funds is extremely largeLiquidity in PE is typically very limited and thus LPs are locked for the long term
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 78
46.3. PrivateEquity
Valuation(cont.)
h.Evaluationof PEfundperformance
Quantitativemeasures
IRRGross IRR
Net IRR
Multiples
PIC
DPI
RVPI
TVPI
i. Calculatingperformancemeasures
management feescarried interestNAV
Multiples
PIC
DPI
RVPI
TVPI
Other analyses
Benchmarks
Components ofperformancefrom an LBO
Earning growths
Increase in price multiples
Debt reduction
Exit value = investment cost + earnings growth +increase in price multiple + reduction in debt
j. VC method
1.1. Valuation for a singlefinancing round
1.2. Valuation for multiplefinancing rounds (11 steps)
2. IRR methodology
k. Accountingfor risk whenvaluing VC
Adjusting the discount rate (r*) = (1 + r)/(1 q) 1
Adjusting the Terminal Valueusing scenario analysis
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 79
47.1.InvestingIn HedgeFunds: ASurvey
a. Hedgefund vs.Mutual fund
Leverage
Use of derivatives
Disclosure requirementsand practices
Lockup periods
Fee structures
b. Hedgefundsstrategies
Arbitrage-based
Convertiblebond arbitrage
Equity marketneutral
Event driven
Risk arbitrage,merger arbitrage
Fixed-incomearbitrage
Medium volatility
Global macro
Long-short equity
Managed futures (Commoditytrading advisers - CTAs)
Multi-strategy
Directional hedge
Dedicated short bias
Emerging market
c. Hedge funddatabases andperformancebiases
Hedge funddatabase
Variety of databases exist
No database is complete
Own methodology
Reporting to databases is voluntary
Performancebiases Selection bias (backfill bias)
Survivor bias
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 80
47.2.Investing In
HedgeFunds: ASurvey
d. Factormodels forhedge fundreturns
Alpha (manager skill) andbeta (market exposure)
Regression model
Use a multitude oftraditional market factors
e. Non-normalityof HF returns
Sources
Implications forperformance appraisal
f. Motivationsfor HGreplicationstrategies
Simple to manage thereforeoffered to investors at low fees
Simplest form vs.complex form
Separate HF betafrom HF replication
g. Difficultiesin applyingtraditionalportfolioanalysis to HG
Developing exp. return assumption: survivor, selection,stale pricing, backfill biases inherent in HF databases.
Correlation, volatility and beta exposurescan change significantly over time
Warning about the use of mean-varianceoptimization and Share ratios: Because standarddeviation is not a complete measure of risk for HF
Individual HF typically have a higherstandard deviation than their style index
h. Funds offunds vs.singlemanager HF
Reduce the standard deviationof a HF portfolio (diversify)
High quality managers: significant investmentskill, manager relationship, and research cost
Average performance
Take less factor riskthan a broad HF index
Longer lives andlarger asset inflows
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 81
CFA LEVEL 2
FIXED INCOME
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 82
48.General
PrinciplesOf CreditAnalysis
a. Componentsof credit risk
Default risk
=Borrower not pay
Sources of info fromrating agencies
Credit ratingRating watchRating outlook
Credit spread riskDowngrade risk
CorporateCreditAnalysis
b. Components 4 Cs
CharacterCovenantsCollateralCapacity to pay
c,d. Keyfinancial ratios
Profitability: ROE > DuPontShortterm solvencyCapitalization (financial leverage)Coverage ratios
e. Cash Flowanalysis
# CF, # FCFF, #FCFES&P uses:
CF ratios4 traditionalcoverage ratios
Funds from operations / Total debtFunds from operations / capital spending requirements(Free operating CF + Interest) / InterestDebt service coverage = (Free OCF + interest) /(Interest + annual principal repayment)
Leverage ratio = Debt payback period = Total debt / Discretionary CF
f. Analysis ofHighYield Issuers
Debt structure AnalysisCorporate structure AnalysisCovenants AnalysisEquity Analysis approach
g. Analysis ofAssetBackedsecurities
Collateral credit qualitySeller/Servicer qualityCash Flow stress andPayment StructureLegal structure
h. Analysis ofMunicipal bond
Taxbacked debt
Issuer's debt structureBudgetary policyLocal tax & Intergovernmentalrevenue availabilityIssuer's socioeconomic environment
Revenue bonds
Limits of the Basic SecurityFlow of funds structureRate, or UserCharge,CovenantsPriorityofRevenue ClaimsAdditionalBonds test
i. Analysis ofSovereign Bonds
Keyconsiderations
Economic risk(ability)
Economic and Income structureProspects for economic growthDegree of fiscal flexibilityPublic debt burdenMonetary policy and Price stabilityBOP flexibilityExternal debt and liquidity
Political risk(willingness)
2 ratings Local currency debt ratingForeign currency debt rating
j. Contrast creditanalysis
Corporate bonds vs. ABSCorporate bonds vs. Municipal securitiesCorporate bonds vs. Sovereign debt
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 83
49. TermStructure &Volatility Of
InterestRates
Warmup: Yield curve shapes
a. Yieldcurveshifts
Parallel shift
Nonparallel shift Yield curve twistButterfly shifts
b. FactorsaffectingTreasuryreturns
Changes in the level ofrates (parallel shifts)
Changes in theslope (twists)
Changes in thecurvature (butterfly)
Warmup: Spot curvesand bootstrapping
c. Treasuryspot rate curve
All ontherunTreasury securities
All ontherun andsome offtherunTreasury securities
All Treasury couponsecurities and Bills
Treasury strips
d. Swap rate curve(LIBOR curve)
What is it?
As a benchmark> reasons:
e. Termstructuretheories
Pure (Unbiased)expectations theory
Liquidity theory
Preferredhabitattheory
Warmup: Calculatingkey rate duration
f. Yieldcurverisk
Barbell portfolios
Ladder portfolios
Bullet portfolios
g1. Yield volatility
Historical yield volatility
Implied yield volatility
g2. Forecasting yield volatility
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 84
50. ValuingBonds WithEmbedded
Options
Warmup:Binomial model
Binomial interest rate trees
Constructing an arbitragefree tree
Valuing an optionfree bondwith the binomial model
Spreadmeasures
The nominal spread
The Zspread
OAS
b. Benchmarkinterest rates tocalculate spreads
Treasury securities
A bond sector
Specific issuer
c. Backward induction methodology
d. Callable bond valuation
e. Relations
Vcall =
Vput=
f. Effect of volatilityon arbitragefreevalue of an option
Warmup: How OAS is calculated
a,g. Relative value analysis
Treasury benchmark
Bond sector benchmark
Issuerspecific benchmark
h. Effective duration and convexity
i. Putable bond valuation
j. Convertiblebonds
Componentvalues
Conversion ratio
Conversion value
Straight value
Minimum value of aconvertible bond
Market conversion price
Market conversionpremium per share
Premium payback period
Valuing convertible bonds using anoptionbased valuation approach
k. Convertible bonds vs.Common stock
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 85
LOAN AMORTIZATION SCHEDULE
500,000 1%360
$5,143.06
Column 1 Column 2 Column 3 Column 4 Column 5 Column 6
Period Beginning Principal
Scheduled total pmt
Interest pmt
Scheduled principal pmt
Beg. Pr less scheduled pr. Pmt
1 500,000 5,143 5,000 143 499,857 2 499,857 5,143 4,999 144 499,712 3 499,712 5,143 4,997 146 499,567 4 499,567 5,143 4,996 147 499,419 5 499,419 5,143 4,994 149 499,270
175 433,500 5,143 4,335 808 432,692 176 432,692 5,143 4,327 816 431,876 177 431,876 5,143 4,319 824 431,051 178 431,051 5,143 4,311 833 430,219 179 430,219 5,143 4,302 841 429,378 180 429,378 5,143 4,294 849 428,529 181 428,529 5,143 4,285 858 427,671 182 427,671 5,143 4,277 866 426,804 183 426,804 5,143 4,268 875 425,929 184 425,929 5,143 4,259 884 425,046 185 425,046 5,143 4,250 893 424,153 186 424,153 5,143 4,242 902 423,252 187 423,252 5,143 4,233 911 422,341 188 422,341 5,143 4,223 920 421,421 189 421,421 5,143 4,214 929 420,492 190 420,492 5,143 4,205 938 419,554 191 419,554 5,143 4,196 948 418,607 192 418,607 5,143 4,186 957 417,650 193 417,650 5,143 4,176 967 416,683 194 416,683 5,143 4,167 976 415,707 195 415,707 5,143 4,157 986 414,721 196 414,721 5,143 4,147 996 413,725 197 413,725 5,143 4,137 1,006 412,719 198 412,719 5,143 4,127 1,016 411,703 199 411,703 5,143 4,117 1,026 410,677 200 410,677 5,143 4,107 1,036 409,641 358 15,126 5,143 151 4,992 10,134 359 10,134 5,143 101 5,042 5,092 360 5,092 5,143 51 5,092 0
Loan amountMortgage rate (per month)Number of months
Scheduled total pmt
Fixed income examples Page 1
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 86
LOAN AMORTIZATION SCHEDULE
500,000 PSA 1001% m=1 to 30: 0.2%360 m=31 or more 6%
$5,143.0686.82
Col 1 Col 2 Col 3 Col 4 Col 5 Col 6 Col 7 Col 8 Col 9 Col 10 Col 11 Col 12
Period Beginning Principal
Scheduled total pmt
Interest pmt
Scheduled principal pmt
Beg. Pr less scheduled pr. Pmt
CPR SMM Prepmt Ending principal
Weights for Macaulay Duration
Life
1 500,000 5,143 5,000 143 499,857 0.20% 0.0167% 83 499,774 0.0005 0.00052 499,774 5,143 4,998 145 499,628 0.40% 0.0334% 167 499,461 0.0006 0.00123 499,461 5,143 4,995 148 499,313 0.60% 0.0501% 250 499,063 0.0008 0.00244 499,063 5,143 4,991 152 498,910 0.80% 0.0669% 334 498,576 0.0010 0.00395 498,576 5,143 4,986 157 498,419 1.00% 0.0837% 417 498,002 0.0011 0.0057
80 291,518 5,143 2,915 2,228 289,290 6.00% 0.5143% 1,488 287,802 0.0074 0.594581 287,802 5,143 2,878 2,265 285,537 6.00% 0.5143% 1,469 284,069 0.0075 0.604882 284,069 5,143 2,841 2,302 281,766 6.00% 0.5143% 1,449 280,317 0.0075 0.615283 280,317 5,143 2,803 2,340 277,977 6.00% 0.5143% 1,430 276,548 0.0075 0.625784 276,548 5,143 2,765 2,378 274,170 6.00% 0.5143% 1,410 272,760 0.0076 0.636385 272,760 5,143 2,728 2,415 270,345 6.00% 0.5143% 1,390 268,954 0.0076 0.647086 268,954 5,143 2,690 2,454 266,501 6.00% 0.5143% 1,371 265,130 0.0076 0.657887 265,130 5,143 2,651 2,492 262,638 6.00% 0.5143% 1,351 261,288 0.0077 0.668688 261,288 5,143 2,613 2,530 258,757 6.00% 0.5143% 1,331 257,427 0.0077 0.679589 257,427 5,143 2,574 2,569 254,858 6.00% 0.5143% 1,311 253,547 0.0078 0.690690 253,547 5,143 2,535 2,608 250,940 6.00% 0.5143% 1,291 249,649 0.0078 0.701791 249,649 5,143 2,496 2,647 247,002 6.00% 0.5143% 1,270 245,732 0.0078 0.712992 245,732 5,143 2,457 2,686 243,046 6.00% 0.5143% 1,250 241,796 0.0079 0.724293 241,796 5,143 2,418 2,725 239,071 6.00% 0.5143% 1,230 237,842 0.0079 0.735694 237,842 5,143 2,378 2,765 235,077 6.00% 0.5143% 1,209 233,868 0.0079 0.747095 233,868 5,143 2,339 2,804 231,064 6.00% 0.5143% 1,188 229,875 0.0080 0.758696 229,875 5,143 2,299 2,844 227,031 6.00% 0.5143% 1,168 225,863 0.0080 0.770397 225,863 5,143 2,259 2,884 222,979 6.00% 0.5143% 1,147 221,832 0.0081 0.782198 221,832 5,143 2,218 2,925 218,907 6.00% 0.5143% 1,126 217,782 0.0081 0.793999 217,782 5,143 2,178 2,965 214,816 6.00% 0.5143% 1,105 213,712 0.0081 0.8059
140 33,822 5,143 338 4,805 29,017 6.00% 0.5143% 149 28,868 0.0099 1.3871141 28,868 5,143 289 4,854 24,013 6.00% 0.5143% 124 23,890 0.0100 1.4038142 23,890 5,143 239 4,904 18,986 6.00% 0.5143% 98 18,888 0.0100 1.4205143 18,888 5,143 189 4,954 13,934 6.00% 0.5143% 72 13,862 0.0101 1.4374144 13,862 5,143 139 5,004 8,858 6.00% 0.5143% 46 8,812 0.0101 1.4544145 8,812 5,143 88 5,055 3,757 6.00% 0.5143% 19 3,738 0.0101 1.4715146 3,738 3,775 37 3,738 - 0.00% 0.0000% - - 0.0075 1.0915
Loan amountMortgage rate (per mth)Number of months
Scheduled total pmtaverage life:
Fixed income examples Page 2
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 87
LOAN AMORTIZATION SCHEDULE
500,000 PSA 901% m=1 to 30: 0.2%360 m=31 or more 6%
$5,143.06
Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 Column 9 Column 10
Period Beginning Principal
Scheduled total pmt
Interest pmt
Scheduled principal pmt
Beg. Pr less scheduled pr. Pmt
CPR SMM Prepmt Ending principal
1 500,000 5,143 5,000 143 499,857 0.18% 0.0150% 75 499,782 2 499,782 5,143 4,998 145 499,637 0.36% 0.0300% 150 499,487 3 499,487 5,143 4,995 148 499,338 0.54% 0.0451% 225 499,113 4 499,113 5,143 4,991 152 498,961 0.72% 0.0602% 300 498,661 5 498,661 5,143 4,987 156 498,504 0.90% 0.0753% 375 498,129
80 307,999 5,143 3,080 2,063 305,936 5.40% 0.4615% 1,412 304,524 81 304,524 5,143 3,045 2,098 302,426 5.40% 0.4615% 1,396 301,030 82 301,030 5,143 3,010 2,133 298,897 5.40% 0.4615% 1,380 297,518 83 297,518 5,143 2,975 2,168 295,350 5.40% 0.4615% 1,363 293,987 84 293,987 5,143 2,940 2,203 291,784 5.40% 0.4615% 1,347 290,437 85 290,437 5,143 2,904 2,239 288,198 5.40% 0.4615% 1,330 286,868 86 286,868 5,143 2,869 2,274 284,594 5.40% 0.4615% 1,314 283,280 87 283,280 5,143 2,833 2,310 280,970 5.40% 0.4615% 1,297 279,673 88 279,673 5,143 2,797 2,346 277,327 5.40% 0.4615% 1,280 276,047 89 276,047 5,143 2,760 2,383 273,664 5.40% 0.4615% 1,263 272,401 90 272,401 5,143 2,724 2,419 269,982 5.40% 0.4615% 1,246 268,736 91 268,736 5,143 2,687 2,456 266,280 5.40% 0.4615% 1,229 265,051 92 265,051 5,143 2,651 2,493 262,559 5.40% 0.4615% 1,212 261,347 93 261,347 5,143 2,613 2,530 258,817 5.40% 0.4615% 1,195 257,623 94 257,623 5,143 2,576 2,567 255,056 5.40% 0.4615% 1,177 253,879 95 253,879 5,143 2,539 2,604 251,275 5.40% 0.4615% 1,160 250,115 96 250,115 5,143 2,501 2,642 247,473 5.40% 0.4615% 1,142 246,331 97 246,331 5,143 2,463 2,680 243,651 5.40% 0.4615% 1,125 242,527 98 242,527 5,143 2,425 2,718 239,809 5.40% 0.4615% 1,107 238,702 99 238,702 5,143 2,387 2,756 235,946 5.40% 0.4615% 1,089 234,857
140 62,994 5,143 630 4,513 58,481 5.40% 0.4615% 270 58,211 141 58,211 5,143 582 4,561 53,650 5.40% 0.4615% 248 53,403 142 53,403 5,143 534 4,609 48,794 5.40% 0.4615% 225 48,569 143 48,569 5,143 486 4,657 43,911 5.40% 0.4615% 203 43,709 144 43,709 5,143 437 4,706 39,003 5.40% 0.4615% 180 38,823 145 38,823 5,143 388 4,755 34,068 5.40% 0.4615% 157 33,910 146 33,910 5,143 339 4,804 29,107 5.40% 0.4615% 134 28,972 147 28,972 5,143 290 4,853 24,119 5.40% 0.4615% 111 24,008 148 24,008 5,143 240 4,903 19,105 5.40% 0.4615% 88 19,016 149 19,016 5,143 190 4,953 14,063 5.40% 0.4615% 65 13,999 150 13,999 5,143 140 5,003 8,995 5.40% 0.4615% 42 8,954 151 8,954 5,143 90 5,054 3,900 5.40% 0.4615% 18 3,882 152 3,882 3,921 39 3,882 - 0.00% 0.0000% - -
Loan amountMortgage rate (per month)Number of months
Scheduled total pmt
Fixed income examples Page 3
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 88
LOAN AMORTIZATION SCHEDULE
500,000 PSA 3001% m=1 to 30: 0.2%360 m=31 or more 6%
$5,143.06
Col 1 Col 2 Col 3 Col 4 Col 5 Col 6 Col 7 Col 8 Col 9 Col 10
Period Beginning Principal
Scheduled total pmt
Interest pmt
Scheduled principal pmt
Beg. Pr less scheduled pr. Pmt
CPR SMM Prepmt Ending principal PSA90
90-300 PAC tranche
1 500,000 5,143 5,000 143 499,857 0.60% 0.0501% 251 499,606 75 75 2 499,606 5,143 4,996 147 499,459 1.20% 0.1006% 502 498,957 150 150 3 498,957 5,143 4,990 153 498,804 1.80% 0.1513% 754 498,049 225 225 4 498,049 5,143 4,980 163 497,887 2.40% 0.2022% 1,007 496,880 300 300 5 496,880 5,143 4,969 174 496,705 3.00% 0.2535% 1,259 495,446 375 375 6 495,446 5,143 4,954 189 495,258 3.60% 0.3051% 1,511 493,747 450 450 7 493,747 5,143 4,937 206 493,541 4.20% 0.3569% 1,762 491,780 525 525 8 491,780 5,143 4,918 225 491,554 4.80% 0.4091% 2,011 489,543 600 600 9 489,543 5,143 4,895 248 489,296 5.40% 0.4615% 2,258 487,038 674 674
10 487,038 5,143 4,870 273 486,765 6.00% 0.5143% 2,503 484,261 749 749 60 176,093 5,143 1,761 3,382 172,711 18.00% 1.6402% 2,833 169,878 1719 1,719 61 169,878 5,143 1,699 3,444 166,434 18.00% 1.6402% 2,730 163,704 1704 1,704 62 163,704 5,143 1,637 3,506 160,198 18.00% 1.6402% 2,627 157,570 1689 1,689 63 157,570 5,143 1,576 3,567 154,003 18.00% 1.6402% 2,526 151,477 1675 1,675 64 151,477 5,143 1,515 3,628 147,849 18.00% 1.6402% 2,425 145,424 1660 1,660 65 145,424 5,143 1,454 3,689 141,735 18.00% 1.6402% 2,325 139,410 1645 1,645 66 139,410 5,143 1,394 3,749 135,661 18.00% 1.6402% 2,225 133,436 1630 1,630 67 133,436 5,143 1,334 3,809 129,628 18.00% 1.6402% 2,126 127,502 1615 1,615 68 127,502 5,143 1,275 3,868 123,633 18.00% 1.6402% 2,028 121,606 1600 1,600 69 121,606 5,143 1,216 3,927 117,679 18.00% 1.6402% 1,930 115,749 1585 1,585 70 115,749 5,143 1,157 3,986 111,763 18.00% 1.6402% 1,833 109,930 1569 1,569 71 109,930 5,143 1,099 4,044 105,886 18.00% 1.6402% 1,737 104,149 1554 1,554 72 104,149 5,143 1,041 4,102 100,048 18.00% 1.6402% 1,641 98,407 1539 1,539 73 98,407 5,143 984 4,159 94,248 18.00% 1.6402% 1,546 92,702 1523 1,523 74 92,702 5,143 927 4,216 88,486 18.00% 1.6402% 1,451 87,035 1507 1,451 75 87,035 5,143 870 4,273 82,762 18.00% 1.6402% 1,357 81,405 1492 1,357 76 81,405 5,143 814 4,329 77,076 18.00% 1.6402% 1,264 75,811 1476 1,264 77 75,811 5,143 758 4,385 71,426 18.00% 1.6402% 1,172 70,255 1460 1,172 78 70,255 5,143 703 4,441 65,814 18.00% 1.6402% 1,079 64,735 1444 1,079 79 64,735 5,143 647 4,496 60,239 18.00% 1.6402% 988 59,251 1428 988 88 16,658 5,143 167 4,976 11,681 18.00% 1.6402% 192 11,490 1280 192 89 11,490 5,143 115 5,028 6,462 18.00% 1.6402% 106 6,356 1263 106 90 6,356 5,143 64 5,080 1,276 18.00% 1.6402% 21 1,255 1246 21 91 1,255 1,268 13 1,255 - 0.00% 0.0000% - - 1229 -
Loan amountMortgage rate (per monthNumber of months
Scheduled total pmt
Fixed income examples Page 4
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 89
51.Mortgaged
BackedSector OfThe Bond
Market
a. Mortgage loans
b. Mortgage passthrough securities
d. Measuringprepaymentspeeds
CPR
PSA
c. Calculate prepaymentamount for a month
f.
Factors affectingprepayments
Prevailing mortgage ratesHousing turnoverCharacteristics of theunderlying mortgages
Types ofprepayment risk Contraction risk
Extension risk
e. Average life of an MBS
CMOs
g. Creation and Matchingof assets and liabilities
h. Tranches
Sequential Pay
Accrual tranche
Planned AmortizationClass (PAC)
Support Tranche
i. Risks andPerformance of eachtype of CMO tranche
j. Stripped MBS
k. MBS
Agency
Nonagency
Warmup: Commercial MBS
l. CMBS vsResidential MBS
m. CMBS: Structureand Call protection
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 90
52. AssetBacked
Sector OfThe Bond
Market
a. Securitizationtransaction
Structural features
PartiesSeller
Issuer/Trust
Servicer
b. Tranching
Prepaymenttranching
Credittranching
c. Securitizationbacked by
Amortizingassets
Nonamortizingassets
d1. Creditenhancements
ExternalCorporate guaranteesLetter of creditBond insurance
InternalReserve funds
Cash reserve fundsExcess servicing spread funds
Overcollateralization
Senior/Subordinated structure
d2. Shiftinginterestmechanism
e. Cash flow andprepaymentcharateristics forsecurities backed by
Home equity loans
Manufactured housingbacked loans
Auto loans ABS
Student loanbacked securities
SBA loanbacked securities
Credit card receivablebacked securities
f. CDO
What is it?
Types
Cash flow CDO
Ramp up phase
Reinvestment phasePay down phase
Market value CDO
Synthetic CDO
g. Primarymotivationsfor CDO
Arbitragedriven
Balance sheet driven
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 91
53. ValuingMBS And
ABS
a. MBS/ABSspread measures
Cash flow yield
Nominal spread
Zero volatility spread
b. Monte Carlosimulation model
Step 1:Step 2:Step 3:Step 4:Step 5:
c. Path dependency
d. OAS from a MonteCarlo model
e. OAS analysis
f. Why effective durations reported byvarious dealers & vendors may differ
g. Analysing interest rate risk witheffective duration and convexity
h. OtherMBSdurationmeasures
Cash flowduration
Coupon curveduration
Empiricalduration
i. Spread analysis offixedincome securities
Nominal spread
Zerovolatility spread
OAS
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 92
CFA LEVEL 2
DERIVATIVES
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 93
54.ForwardMarkets
AndContracts
Warmup: Forward contracts
Warmup:Forwardcontract pricedetermination
The noarbitrage principle
A simple version of the CostofCarry model
Cash and Carry arbitrage when the forward contract is overpriced
Reverse cash and carry arbitrage when the forward contract is underpriced
a. Forwardcontractvalue
At initiation
During the life
At expiration
b. Price andValue ofForward onEQUITY
With discrete dividends
With continuous dividends
c1. Price & Value ofForward on FIXED INCOME
c2. Price & Value of FRA
c3. Price & Value ofForward onCURRENCY
d. Credit risk
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 94
55. FuturesMarkets And
Contracts
Warmup: Futurescontracts
a. Futures/Spotconvergence
Warmup: Futures margins and marking to market
b. Futures contract value
c. Futures vs Forward prices
d. Holding theunderlying asset
Costs Monetary costs
Nonmonetary costs
Benefits Monetary benefits
Nonmonetary benefits
e. Backwardation vs.
Contango
f. Normal backwardation &
Normal contango
Warmup:
Eurodollar futures
Treasury bond futures
Stock index futures
Currency futures
Warmup: TBill futures pricing
g. Difficulties in pricing Eurodollar futures& creating a pure arbitrage opportunity
h. Calculateprice of
Treasury bond futures
Stock futures
Stock index futures
Currency futures
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 95
56. OptionMarkets And
Contracts
Warmup: Putcall parityfor European options
Fiduciary call
Protective put
a1. Using putcallparity to createsynthetic
Call optionPut optionBond
Underlying stock
a2. Whysynthetic?
Pricing optionsEarning arbitrage profit
b. Binomialoptionpricingmodel
Oneperiod
Twoperiod
Warmup: Binomialinterest rate trees
Options on Fixed Income Securities
Options on Interest rates: Caps and Floors
c. BSM modelAssumptions: Lognormal, Rf & sigma: constant & known, Frictionless market, No CF, European options.Limitations
d. TheGreeks
DELTA
Delta
e. Interpreting
e. Use indynamichedging
GAMMA
Interpreting
f. Effect on
Option's price
Delta
Delta hedge
VEGA
Interpreting
h. Estimate
Historicalvolatility
Impliedvolatility
RHO
THETA
g. Effect of the underlying asset'scash flows on option price
i. Putcall parity for optionson forwards (or futures)
j. American vs European optionson forwards and futures
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 96
57. SwapMarkets And
Contracts
a. Swappricing
valuation
b. Swaps =I/r swap = FRAs
= 1 call + 1 put
c. Pricing &Valuing a PlainVanilla swap
Plain vanilla swaps as combinations of bonds
Floating rate bond reprices to par at each settlement date
d. Valuing a Currency swap
e. Equity swaps
Swaptions
f. Characteristicsand uses
g. Payoffs andcash flows
h. Value of i/rswaption
i. Swap credit risk
j. Swap spread
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 97
58. InterestRate
DerivativeInstruments
a. Cap and floor
on i/r
on fixedincomeinstruments
b1. Payoff for a capand a floor
b2. A collar
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 98
59. UsingCredit
DerivativesTo EnhanceReturn And
Manage Risk
a. Credit defaultswaps (CDS) vs.Corporate bonds
b. Advantagesover othercreditinstruments
Risk management
Short positions
Liquidity
Flexibility
Confidentiality
c1. Theuse ofcreditderivativesby
Commercial banks
Investment banks
Hedge funds
Life Insurance, Property & casualty insurance,Reinsurers & monoline companies
c2. Structuredcredit products
d. Creditderivativestrategies
Basistrade
Curvetrade
Indextrade
Optionstrade
Capitalstructuretrade
Correlationtrade
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 99
CFA LEVEL 2
PORTFOLIO MANAGEMENT
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 100
60. PortfolioConcepts
a. MeanVarianceanalysis
Assumptions Risk averse investors, parameters are knownand used, no taxes or transaction costs
Portfolio expected return
Standard deviation
b. FrontiersMinimum variance frontier
Efficient frontier
c. DiversificationEffect of correlation on diversification
Effect of number of assets on diversification
d. CAL and CML
Equallyweightedportfolio risk (variance)CAL
CML
e. CAPM4 assumptions
Inputs needed: E(R), s, cov.Homogeneous expectationBorrow and lend at risk free rateUnlimited shortsellingNo trx cost, no taxPerfect competitive market
f. SML
Market risk premiumBeta
Financial market equilibrium
CML # SML
Risk measureApplicationDefinitionSlope
g. Market model(single factor model)
2 sources of risks
3 assumptionsE(error)=0covar (Rm, error)=0uncorrelated unsystematicrisk across assets
Predict
Expected returns
Variances
Covariances
h. Adjusted betas
i. Instability inthe minimumvariance frontier
Reasons
Reliability Statistical inputs are forecast
Time instability Forecast from historical sample> change over time
Overfitting problem Small changes cause large change
j. Multifactor models
Macroeconomic factor models k. Portfolio expected return
Fundamental factor models
Statistical factor models
l. ArbitragePricing Model
Assumptions
APT equation
APT # Multifactor
m. Activereturn and risk
Active return(tracking error)
Active risk(tracking risk) Active factor risk
Active specific risk
Information ratio
Uses of factor andtracking portfolios
n. CAPM # APT
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 101
61. A NoteOn Harry M.Markowitz's
"MarketEfficiency: ATheoreticalDistinction
And SoWhat?"
a. CAPM
CAPMassumptions
Borrow andLend at riskfree
Unlimitedshort selling
CAPMimplications
Market portfolio onefficient frontier
Linear relationshipbetween return and beta
b. Consequences ofrestrictions on
borrowing at risk free rate
short selling
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 102
62.International
AssetPricing
a,b. Internationalmarket integration
Integration vs.Segmentation
Impediments tointernational flowof capital
Psychological barriersLegal restrictionsTransaction costsDiscriminatory taxationPolitical risksForeign currency risk
b. Factors that favorinternational marketintegration
Many private and institutional investors who are internationally activeEssentially all major corporations have multinational operationsCorporations and Governments borrow and lend on an international scale
StandardCAPM
2 basic results Separation theorem
Riskpricing relationship
c. Assumptionsof domesticCAPM
Riskaverse investorsHomogeneous expectationsInvestors concerned with nominal returns in home currencyRisk free security available for lending and borrowingNo taxes, no transaction costs
d. ExtendedCAPM
Elements Riskfree rate = Investor's domestic risk free rateMarket portfolio = All risky assets in the world
Additional assumptions(unreasonable) Investors have identical consumption baskets
PPP holds exactly
ICAPM
Warmup: domestic and foreign currency returns
e. Real e/r and domesticcurrency returns
f. CalculateExpected exchange rateDomesticcurrency HPRon a foreign bond
g. CalculateEndofperiod real e/rDomestic currency expostreturn on a foreign bond
h. Calculate foreigncurrency risk premium
i. ICAPM FormulaInvestor's domestic risk free rateWorld market risk premiumSensitivity of asset to changesin all foreign currencies
j. Effect of market segmentation on ICAPM
k. Currency exposure
l. Exchange rate exposure
m,n
E/R and domesticeconomy/ equity
Traditionalmodel
Jcurve effect: Tradebalance CurrencyEquity exposure
Moneydemandmodel
E/R and bonds(i.e. E/R and I/R)
Free markets theory
Government intervention theory
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 103
63. TheoryOf ActivePortfolio
Management
a. Justify ACTIVE PM
b1.TreynorBlackmodelsteps
1
2
3
4
5
b2. TreynorBlackCalculations
Stock alphas
Weightings
Portfolio A
Alpha
Expectedreturn
Standarddeviationforecast
Covariance A andMarket index M
b3. TreynorBlack:Efficient market periods vs.Inefficient market periods
c. Measure accuracy inforecasting alphas
a
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 104
64. PMProcess
AndInvestment
PolicyStatement
Warmup:elements of PM
Evaluating investor andmarket characteristics
Developing an investmentpolicy statement
Determining an assetallocation strategy
Measuring andevaluating performance
Monitoring dynamic investor objectivesand capital market conditions
a. Importance of thePORTFOLIO perspective
PMprocessStep 1:Planning
c1.Objectives
Risk objectives
Return objectives
c2.Constraints
Liquidity
f. Time horizon
f. Legal andregulatoryconcerns
f. Taxconsiderations
f. Uniquecircumstances
d. IPS Role of IPS
Elements of IPS
e. Strategic Asset allocation:3 common approaches
Passive
Active
Semiactive,riskcontrolled activeor enhanced index strategies
PM process Step 2: Execution
PM process Step 3: Feedback
g. Ethical conduct in managinginvestment portfolios
p
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 105