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

CFA LEVEL 2

ETHICAL & PROFESSIONAL

STANDARDS


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


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


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


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


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


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


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


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


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


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


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


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


8. Trade Allocation:Fair Dealing And

Disclosure

a. Trade allocationpractice critique

b. Appropriate responseto inadequate tradeallocation practices

a


9. ChangingInvestmentObjectives

a. Critique disclosure ofinvestment objectivesand basic policies

b. Appropriateresponse toinadequatedisclosureprocedures

a


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 LEVEL 2

QUANTITAVE ANALYSIS


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


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


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


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


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)


12.2. MultipleRegression &

Issues InRegression

Analysis

Warm-up: Why multipleregression isn't easy as it looks

Assumptionviolations

i1. Heteroskedasticity

What is it?UnconditionalConditional


Detecting heteroskedasticity

Correcting heteroskedasticity

i2. Serial correlation(autocorrelation)

What is it?PositiveNegative


Detecting

Correcting

j. Multicollinearity

is


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


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


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 LEVEL 2

ECONOMICS


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


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


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


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


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


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 LEVEL 2

FINANCIAL REPORTING ANALYSIS


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 -->


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


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


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_____


Expected rate ofreturn increase

PBO_____, ABO_____, VBO_____


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


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)


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 -->


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


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


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:





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



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)





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




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:




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




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)




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



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



Pension exercise 2:

Calculate Pension expense and make adjustments for analytical purposes.



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


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




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



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




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



CFA LEVEL 2

CORPORATE FINANCE


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


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


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


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


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


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


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 LEVEL 2

EQUITY


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


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


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


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


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


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


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


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


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


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


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


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


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 LEVEL 2

ALTERNATIVE INVESTMENTS


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


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


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


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


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


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


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 LEVEL 2

FIXED INCOME


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


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


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


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



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


Scheduled total pmt

Interest 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:




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


Scheduled total pmt

Interest 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




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


Scheduled total pmt

Interest 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



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


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


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 LEVEL 2

DERIVATIVES


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


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


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


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


58. InterestRate

DerivativeInstruments

a. Cap and floor

on i/r

on fixedincomeinstruments

b1. Payoff for a capand a floor

b2. A collar


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 LEVEL 2

PORTFOLIO MANAGEMENT


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


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


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


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


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


2012 level 2 mindmaps (all)

Documents