11-Level 1 Smart Summaries PDF

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2017 Study Session # 1, Reading # 1
“Ethics & Trust in the investment Profession”

Mkt. = market
Invst. =
investment 1. INTRODUCTION
Diff. =
difference
Indv. =
Business & financial mkts. flourish on trust.
individuals
Top three attributes of a good invst.
manager include:
i. Transparent & open business practices
ii. Handle issue/crises wisely.
iii. Has ethical business practices

2. ETHICS
Definition: Widely Violations of CFA Institute

acknowledged Code &
Ethical Principles Standards
• Ethics or Ethical Principles: • is a community

Study of moral principles and • CFA Institute’s Standard of
Honesty, can damage
belief regarding what is good, Practice Handbook
fairness/justice, community’
acceptable or obligatory represents its code &
diligence & reputation externally
behavior. standards.
respect for the (stakeholders, gen.
• Ethical Actions: Actions • CFA Institute’s
rights of others. public) or internally
conforming to the ethical members/candidates re-
(organization may
expectations of society e.g. affirm their commitment
destroy).
telling truth. (to adhere to codes &
• Laws & regulations: Rules of standards) each year
conduct specified by a Govt. through Professional
• Diff. in laws may reflect diff. in Conduct Statement.
beliefs. • Members & candidates
• Code of Ethics: General guide for who violate the code &
how community members standard are subject to
should act. disciplinary actions.
• Standards of Conduct:
Benchmarks for the minimal
acceptable behaviors of
community members.
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3. ETHICS & PROFESSIONALISM
Characteristics of a Profession
A profession is based on
• specialized knowledge & skill.
• service to others
• & is practiced by members who share
& adhere to common code of ethics.
CFA Institute’s Codes & Standards
• are principle-based.
• apply to all candidates & members.
• apply to all professional activities.
4. CHALLENGES TO ETHICAL CONDUCT
Overconfidence Situational
Bias Influences
People are generally • Environmental or cultural

overconfident elements that shape our
therefore, overestimate behaviors.
the morality of their • These influences motivate
own behavior. indv. to act in their short-
term self-interests.
• Common influences in invst.
industries are money &
prestige.
• Large financial rewards or
loyalty to supervisors,
organization or certain group
can induce indv. to act
unethically.
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5. THE IMPORTACE OF ETHICAL CONDUCT

IN THE INVESTMENT INDUSTRY
• In invst. industries unethical actions or

decisions can cause mkt. crises, economic
difficulty, job losses for millions etc.
• Ethical behavior builds & foster trust between
investors & borrowers.
• ↑ level of trust means ↑ participation from
people in capital mkts, ↑ growth in economy,
jobs availability.
• Trust is imp. because invsts. are intangible &
are difficult to inspect or judge by investors.
6. ETHICAL VS. LEGAL STANDARDS
• Laws & regulations codify ethical actions that

leads to better outcomes for all the parties
(investors, employers, professionals).
• In some areas, ethics & laws may overlap,
however, in some other matters ethics & laws
may conflict.
Laws may not always truly Ethical Standards

reduce unethical behavior
• Laws typically follow mkt. practices & it may • Ethical conduct goes beyond legal
take significant time to eradicate a requirements & encompass
problematic practice. different jurisdictions.
• A new law may reduce/eliminate existing • To act ethically, indvs. are required
dubious practice but may create an to consider facts & situation & make
opportunity for a different problem. ethical choices even in the absence
• A new law may be vague. of clear laws & rules.
• Laws vary across countries & jurisdictions, • Ethics require judgment.
allowing questionable practices in areas that • Good ethical judgment considers
lack laws relevant to those practices. the benefits of multiple
• Mkt. participants may choose to interpret & stakeholders (clients, family,
comply laws in the most advantageous way colleagues, employers, mkt.
possible or may delay until a later date. participants)
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7. ETHICAL DECISION MAKING FRAMEWORKS
1) Identify: (facts, principles, duties owed, conflicts)
2) Consider: (situational influences, guidance, choices)
3) Decide & Act
4) Reflect: ( Was outcome as expected? why or why not?)
Trust can be ↑ by: Ethical decision-making

• focusing on development, framework:
maintenance & demonstration can help invst. professionals in
of a strong culture of integrity making decisions that can affect
within the firm. multiple stakeholders.
• exercising ethical decision-
making skills.
8. CONCLUSION
Responsible professionals in the invest.

industry must be able to recognize &
process areas that are prune to ethical
pitfalls & can impair their judgment
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2017, Study Session # 1, Reading # 2 & 3
“CFA INSTITUTE CODE OF ETHICS AND STANDARDS OF

PROFESSIONAL CONDUCT GUIDANCE FOR STANDARDS I-VII”
M&C = Members & Candidates CFAI = CFA Institute
LOS2.a
COE = Code of Ethics PCP = Professional Conduct
SOPC = Standards of Program
Professional Conduct CFAI PCP ⇒ covered by CFAI bylaws & rules for procedures for proceedings DRC = Disciplinary Review
BOG = Board of Governors related to professional conduct. Committee
PDP = Professional PC P is based on principles of fairness to M&C & confidentiality of PCS = Professional Conduct
Development Program proceedings. Statement
DRC of CFAI BOG ⇒ responsible for PCP & enforcement of code & standards.
Circumstances Which Can Prompt Inquiry
If disclosure by member/candidate on PCS of involvement in civil litigation,

criminal investigation of any complaint (written) against the
member/candidate.
Written complaints about member/staff received by professional conduct
staff.
Evidence of misconduct by member/candidate received by professional
conduct staff through public source.
A report by CFA proctor of a possible violation during examination.
CFAI designated officer conduct inquiries.
Professional conduct staff (in writing) may request explanation from subject
member/candidate & may:
Interview the subject member/candidate.
Interview the complainant / third party.
Collect relevant document & records.
Designated officer may decide:
No disciplinary sanctions are appropriate.
Issue a cautionary letter.
To discipline the member/candidate.
If disciplinary sanction is proposed, the subject member/candidate may
accept the sanction.
If sanction is rejected ⇒ matter may be referred to CFAI panel for hearing.
Sanctions may include:
Public censure.
Suspension of candidate’s continued participation in CFAI program.
LOS2.b
Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients,
employers, employees, colleagues in the investment profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients above their own personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment
recommendations, taking investment actions, and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the
profession.
Promote the integrity of, and uphold the rules governing, capital markets.
Maintain and improve their professional competence and strive to maintain and improve the competence of other investment
professionals.

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Standards of Professional Conduct
1. Professionalism 2. Integrity of Capital Markets 3. Duties to Clients 4. Duties to Employers 5. Investment Analysis,
Recommendation & Actions
6. Conflicts of Interest 7. Responsibilities as CFA Member or CFAI Candidate
Los2.c 1. Professionalism
A. Knowledge of Law B. Independence & Objectivity C. Misrepresentation D. Misconduct
2. Integrity of Capital Markets
A. Material Non-Public Information B. Market Manipulation
3. Duties to Clients
A. Loyalty, B. Fair Dealing C. Suitability D. Performance E. Preservation of

Prudence, and Care Presentation Confidentiality
4. Duties to Employers
A. Loyalty B. Additional Compensation C. Responsibility of

Arrangement Supervisors
5. Investment Analysis, Recommendation & Actions
A. Diligence & Reasonable B. Communication with C. Record Retention

Basis Clients & prospective
Clients
6. Conflict of Interest
A. Disclosure of conflicts B. Priority of Transactions C. Referral Fees
7. Responsibilities as CFAI Member or CFA Candidate
A. Conduct as Members and Candidates in B. Reference to CFA Institute, the CFA

CFA Program Designation, and the CFA Program

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1. Professionalism
1 A. Knowledge of Law
M&C must understand & comply with all applicable laws, rules & regulations (including COE
& SOPC).
These rules & regulations pertain to any govt, regulatory organization, licensing agency or
professional association governing their professional activities.
Must comply with more strict law, rule or regulation in case of conflict.
M&C must not knowingly participate or assist & must dissociate from any violation of laws,
rules or regulations.
Guidance ⇒ Code & Standards vs Local Law
Members must know laws & regulations related to their professional activity in all countries
where they work (conduct business).
Adhere to most strict rules ⇒ if have to decide b/w local laws & codes & standards of CFAI.
Must comply with local laws related to professional activity.
Never violate code & standards even if activity is otherwise legal.
Guidance ⇒ Participation or Association with Violation by Others
Members must dissociate or separate themselves from any ongoing client or employee
activity which is illegal or unethical.
In extreme case they may have to leave the employer.
May confront the individual involved first.
Approach the supervisor or compliance department if confrontation and discussion
fails.
Inaction with continued association may be construed as knowing participation.
Recommended Procedures for Compliance-Members
Members should establish procedures which ensure employees are updated with applicable
laws, rules & regulations.
Compliance laws must be reviewed on an ongoing basis in order to ensure that they address
prevailing laws, CFAI standards & regulations.
Members should maintain current reference material for employees in order to keep up-to-
date on laws, rules & regulations.
In doubt members should seek advice of counsel or their compliance department.
Members should document any violation when they disassociate from prohibited activity.
Members should encourage their employers to persuade the perpetrator(s) to end such
activity.
Under some circumstances it may be advisable or otherwise required by the law to report
violations to governmental authorities.
Standards (CFAI) do not require members to report violations to governmental authorities.
Members are strongly encouraged to report other members’ violations of the code &
standards.
Recommended Procedure for Compliance-Firms
Members should encourage their firms to:

Develop and/or adopt a code of ethics.
Provide information which highlights applicable laws and regulations and may be distributed to
employees.
Establish written procedures for reporting suspected violation of laws, regulations or company
policies.
Members in charge of supervision, creation and maintenance of investment services should:
Be aware of and comply with regulations and laws in their country of origin.
They must be aware and comply with regulations of countries where products/services will be sold.

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1 B. Independence & Objectivity
M&C must use reasonable care & judgment to achieve & maintain independence &
objectivity in professional activities.
Not accept any gift, or any type of consideration that compromise their own or another’s
independence & objectivity.
Guidance
Investment process must not be influenced by any external sources.

Modest gifts are permitted (by clients).
Allocation of shares in oversubscribed IPO to personal accounts is not permitted.
Distinguish b/w gifts from clients & entities seeking influence to the detriment of the client.
Gifts must be disclosed to the member’s employer in any case either prior to acceptance or
subsequently.
Guidance-Investment Banking Relationships
Do not get pressurized from sell-side analyst to issue favorable research on current or
prospective investment-banking client.
Disclose conflicts and manage these appropriately while working with investment bankers
in “road shows”.
Make sure of effective “firewalls” b/w research/investment management & investment
banking activities.
Guidance-Public Companies
Do not limit research to discussions with company management.

Use sources like:
Suppliers
Customers
Competitors
Analyst must not be pressured to issue favorable research by the companies they follow.
Guidance-Buy Side Clients
Responsibility of portfolio managers to respect and foster intellectual honesty of sell side
research.
Portfolio managers must not pressure sell side analysts.
They may have large positions in particular securities; rating downgrade may
adversely affect portfolio performance.
Guidance-Fund Manager Relationships
Members responsible for selecting outside managers should not accept gifts, entertainment
or travel that might be perceived as impairing independence and/or objectivity.
Guidance-Credit Rating Agency
Members employed by credit rating agencies should make sure they prevent undue
influence by security issuing firms.
Members using credit ratings must be aware of potential conflict of interest.
Consider whether independent analysis is warranted.

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Guidance-Issuer Paid Research
Analyst’s compensation for such research should be limited.

Preference is a flat fee.
No reward must be attached with report’s recommendation.
Guidance-Travel
Best practice ⇒ analysts pay their own commercial travel while attending
informative events or tours sponsored by the firm being analyzed.
Recommended Procedures for Compliance
Protect the integrity of opinions (unbiased opinion of the analyst) & design proper compensation systems.
Create a restricted list (remove the controversial company from research universe).
Restrict special cost arrangements (limit the use of corporate aircraft to situations in which commercial
transportation is not available).
M&C should pay for commercial transportations & hotel charges.
Limit the acceptance of gratuities and/or gifts to token items.
Develop formal policies related to employee purchases of equity or equity related IPOs (strict limits on private
placements).
Effective supervisory & review procedures.
Ensure that research analysts are not supervised or controlled by any department that could compromise the
independence of analyst.
Appoint a senior officer with oversight responsibilities for compliance with firm’s COE & all regulations
concerning its business.
1 C. Misrepresentation
M&C must not knowingly make any misrepresentations relating to investment

analysis, recommendation, actions or other professional activities.
Guidance
Misrepresentation causes mistrust.

Do not give false impressions in writing, oral or electronic communication.
Misrepresentation includes.
Guaranteeing investment performance.
Plagiarism.
Plagiarism ⇒ using someone else’s work without giving him credit.
Misrepresentation also includes deliberately omitting information that could
affect investment decision.
Models and analysis developed by others at firm are the property of firm ⇒
members can use them without attributing to developers.
A report written by another analyst employed by the firm cannot be released as
another analyst’s work.
Firms should provide employees, who deal with clients, a written list of firm’s
available services and description of its employees’ qualifications.
Employees’ qualification should be accurately presented as well.
To avoid plagiarism firm must keep record of all sources and cite them.
Generally understood and factual information need not to be cited.
Members should encourage firms to establish procedures for verifying
marketing claims of third parties whose information the firm provides to
clients.

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1 D. Misconduct
M&C must not involve in any professional misconduct dishonesty, fraud, deceit or commit any
act that reflects adversely on their professional reputations, integrity or competence.
Guidance
CFAI discourage unethical behavior in all aspects of M&C’s lives.

Do not abuse CFAI PCP by seeking enforcement of this standard to settle personal,
political or other disputes not related to professional ethics.
Firms are encouraged to adopt these policies and procedures to:

Develop and adopt a code of ethics and make clear that unethical behavior will
not be tolerated.
Give employees a list of potential violations and sanctions including dismissal.
Check references of potential employees.
2. INTEGRITY OF CAPITAL MARKETS
2 A. Material Non-Public Information
M&C must not act or cause others to act on the

information that is material nonpublic (affect the value of
investments).
Guidance
Material information ⇒ if disclosure would impact price of security.

If reasonable investor would want the information before making an investment decision.
Nonpublic information ⇒ not available to the marketplace.
Analysts’ conference call is not public disclosure.
Selective disclosure causes insider trading.
Prohibition against acting on material nonpublic information extends to securities, swaps, option
contracts and mutual funds.
Guidance-Mosaic Theory
No prohibition on reaching an investment decision through public and non-material

nonpublic information.
Make reasonable efforts to achieve public dissemination of information.

Encourage firms to adopt procedures to prevent misuse of material nonpublic information.
Use a “firewall” within the firm with
Substantial control of relevant interdepartmental communication  through a clearance like
compliance/legal department.
Review employee trades  maintain watch, rumor, and restricted lists.
Monitor & prohibit proprietary trading ⇒ if a firm possesses material non-public information.
Prohibiting all proprietary trading may send a signal to the market  firm should take the contra
side of unsolicited customer trades.

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2 B. MARKET MANIPULATIONS
M&C must not engage practices that mislead

market participants (distort prices or artificially
inflate trading volume).
Guidance
Spreading false rumors is prohibited (which can distort market).

Standard applies to transactions that deceive market.
By distorting the price-setting mechanism of financial instruments.
Securing a controlling position to manipulate the price of a related derivative or
the underlying asset.
3. DUTIES TO CLIENTS
3 A. Loyalty, Prudence & Care
M&C:
Have a duty of loyalty to clients & must act with reasonable care & exercise prudent judgment.
Must act for the benefits of clients & place their client’s interests before their employer’s & their own
interests.
Guidance
M&C must exercise same level of prudence, judgment & care as in management & disposition of their own interests in similar
circumstances.
M&C must manage pool of assets in accordance with the terms of governing documents (e.g. trust documents).
Determine the identity of “client’” to whom duty of loyalty is owed. (May be individual or beneficiaries in case of pension plan
or trust).
M&C must follow any guidelines set by their clients for the management of their assets.
Investment decisions are judged in context of total portfolio rather individual investments.
Conflict arises when “soft dollars” are not used for benefits of clients.
Cost-benefit analysis may show that voting all proxies may not be a beneficial strategy for clients.
Recommended Procedures of Compliance
M&C with control of client assets should submit to each client at least quarterly, a statement showing funds & securities.
In doubt, M&C should disclose the questionable matter in writing to client & obtain client approval.
M&C should address & encourage their firms to address the following regarding duties to client;
Follow all applicable rules & laws.
Establish the investment objectives of the clients, vote proxies & place client interests first.
Consider all the information when taking actions.
Diversify investments to reduce risk of loss.
Carry out regular reviews.
Deal fairly with all clients with respect to investment actions.
Disclose conflict of interest & compensation arrangements.
Maintain confidentiality & seek best execution.

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3 B. Fair Dealing
M&C must deal fairly & objectively with clients (when providing investment analysis,
making recommendations, taking action or engaging in other professional activities).
Guidance
No discrimination among clients while disseminating recommendations or taking investment action.

Fairly does not mean equally ⇒ difference in timings of emails & fax received by clients are normal
course of business.
Different services levels are okay as far as these do not adversely affect any client.
Disclose different levels of services to all clients and prospects.
Premium services should be available to all those who are willing to pay for them.
Guidance-Investment Recommendation
All clients must be given fair opportunity to act upon every recommendation.
Clients unaware of change in recommendation  should be advised before the order is accepted.
Guidance-Investment Actions
Clients must be treated fairly in the light of their investment objectives and circumstances.
Both institutional and individual clients must be treated in a fair & impartial manner.
M&C should not take advantage of their position to disadvantage clients (e.g., in IPOs).
Firms are encouraged to establish compliance procedures to treat customers & clients fairly.
Communicate recommendations simultaneously within the firm & to customers.
M&C should consider the following:
Limit the no. of people who are aware that a recommendation is going to be disseminated.
Shorten the time frame b/w decision & dissemination.
Publish guidelines for pre-dissemination behavior.
Simultaneous dissemination (treat all clients fairly).
Maintain a list of clients & their holdings.
Develop & document trade allocation procedures.
Disclose trade allocation procedures (must be fair & equitable).
Establish systematic account review (no preferential treatment to any client or customer).
Disclose level of services (different levels of services are possible for same or different fees).
3 C. SUITABILITY
2. M&C are in advisory relationship 1. When M&C are responsible for managing a portfolio
to a specific mandate, strategy or style
Make inquiry into Determine Judge investment

Take actions and make
client’s investment investment suitability in
recommendations
experience, risk & suitability with context of client’s
according to stated
return objectives, reference to total portfolio.
objectives & constraints of
financial client’s objectives,
portfolio.
constraints & constraints &
reassess & update mandate.
this information
regularly.

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Guidance
Develop IPS at beginning of the relationship.

Consider client’s needs, circumstances & risk tolerance.
Consider whether the use of leverage is suitable for the client or not.
Make sure to abide by the stated mandate.
Develop written IPS of each client & take the following into consideration:
Client identification.
Investor objectives.
Investor constraints.
Performance measurement benchmark
Objectives & constraints should be maintained & reviewed periodically to reflect any changes in
clients’ circumstances.
Suitability test policies.
3 D. Performance Presentations
M&C must communicate fair, accurate & complete investment performance information.
Guidance
Members must avoid misstating performance or misleading clients about investment performance of
themselves or their firms.
Members should not misrepresent past performance or reasonably expected performance.
Members should not state or imply the ability to achieve a rate of return similar to that achieved in
the past.
Provide reference to limited information provided on brief presentations.
For brief presentations members must make detailed information available on request.
Apply GIPS standards.

Consider the knowledge of audience to whom performance presentation is addressed.
Performance of weighted composite of similar portfolios rather a single account.
Include performance history of terminated accounts.
Disclosures that fully explain the performance results being reported.
Maintain data & records used to calculate the performance being presented.
3 E. Preservation of Confidentiality
M&C must keep information about current, former &

prospective clients confidential unless:
Information concerns illegal activity.
Disclosure is required by law.
Client or prospective client permits disclosure.

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Guidance
If a client is involved in illegal activities  members may have an

obligation to report to the authorities.
This standard extends to former clients as well.
Standards do not prevent members from cooperating with a CFA PCP
investigation.
Avoid disclosing information received from client except to authorized

coworkers working for the client.
Follow firm’s procedures for storing electronic data.
Recommend development of such procedures if they are not in place.
A. Loyalty
M&C:
Must act for the benefit of their employer.
Not deprive employer of the advantage of their skills & abilities, divulge confidential
information or otherwise cause harm to their employer.
Guidance
Do not indulge in the activities to injure the firm  deprive it from profit and
advantage of employee’s abilities & skills.
Although client’s interests are at priority than firms, M&C should consider the
effects of actions on firm’s integrity and sustainability.
A careful balance b/w managing interests of employer & family  manage such
obligations with work obligations.
Guidance-Employer Responsibility
Should not have incentive or compensation system that encourages unethical

behavior.
Members are encouraged to give their employers a copy of code & standards.
Guidance-Independent Practice
Independent practice for compensation is allowed as long as the following conditions

are met:
Provide employer prior notification fully describing all aspects of service.
Compensation details
Duration
Nature of activities
Employer’s consent is required.

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Guidance-Leaving an Employer
Continue to act in employer’s best interest until resignation is effective.

Activities that may constitute a violation include:
Misappropriation of trade secrets
Misuse of confidential information
Soliciting employer’s client prior to leaving
Self-dealing
Misappropriation of client lists.
Employer records on home computers, PDA, cell phones or any other medium
are property of firm.
After leaving the organization, simple knowledge of names and existence of
former clients is not confidential.
M&C can use the experience or knowledge gained with former employer at any
other organization.
Guidance-Whistleblowing
In exceptional cases, the duty to employer may be violated to protect any client
or for the integrity of markets.
Whistleblowing cannot be done for personal gains.
Guidance-Nature of Employment
If M&C are independent contractors, they still have a duty to abide by the terms
of the agreement.
Competition policy (employer restrictions on offering similar services outside

the firm).
Termination policy (how termination will be disclosed to clients & staff).
Incident-reporting procedures.
Employee classification (e.g. full time, part time).
4 B. Additional Compensation Arrangements
M&C must not accept gifts, benefits, compensation, or consideration that compete
with or might reasonably be expected to create a conflict of interest with their
employer’s interest unless they obtain written consent from all parties involved.
Guidance
Compensation includes both direct & indirect form.

Additional benefits are also included.
Written consent from employer also includes email communication.
Immediately report to employer in written format detailing any

proposed compensation and services.
Performance incentives should be verified by the offering party.

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4 C. Responsibility of Supervisors
M&C must make reasonable efforts to detect & prevent violations of

applicable laws, rules & regulations & code & standards by anyone
subject to their supervision or authority.
Guidance
Members must take steps to prevent from violating laws, rules,

regulations or code & standards.
Make reasonable efforts to detect violations.
Members with supervisory responsibility must ensure that policies
regarding investment or non-investment behavior are enforced
equally.
Guidance-Compliance Procedures
Members with supervisory responsibility must bring an inadequate

compliance system to the firm’s attention and recommend
corrective action.
While investigating violation ⇒ appropriate to limit suspected
employee’s activities.
Unless adequate procedures are adopted by the firm, a member
must decline supervisory responsibility in writing if faced with no
or inadequate compliance procedures.
M&C are encouraged to adopt recommendation that their employers adopt a COE.
Separate the COE from compliance procedures.
Adequate compliance procedures:
Clearly written & accessible manual.
Designate a compliance officer to implement compliance procedures.
Implement system of checks & balances.
Describe the hierarchy of supervision.
Outline scope of procedures & permissible conduct.
Once a compliance program is in place, a supervisor should:
Disseminate program contents to appropriate personnel & educate them regarding
compliance procedures.
Incorporate professional conduct evaluation as part of employee’s performance review.
Review employees’ actions & identify violations.
Respond promptly once a violation is discovered, conduct thorough investigation & increase
supervision.

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5. Investment Analysis, Recommendations and Actions
5 A. Diligence & Reasonable Basis
2. M&C must exercise diligence, 1. M&C must have a reasonable & adequate
independence & thoroughness in basis for investment analysis,
investment analysis, recommendation or action (supported by
recommendations & actions. research & investigation).
Guidance-Reasonable Basis
Level of research for due diligence depends on product/service offered.

Prior to making recommendation or investment action consider:
Firm’s financial and operating history & business cycle stage.
Mutual fund’s fee & management history.
Limitation of any quantitative methods used.
Appropriateness of peer group comparisons.
Guidance-Using Secondary or Third-Party Research
To periodically review quality of third party research, consider the following:

Review assumptions.
How rigorous is the analysis.
How timely the research is.
Evaluate objectivity & independence of recommendations.
Guidance-Quantitative Research
Able to explain the importance of quantitative research and how results

were used in decision making process.
Consider scenarios which are not typically used to assess downside risk.
Ensure that both positive & negative results have been used.
Guidance-External Advisers
Ensure advisors have adequate compliance and internal controls.

Review the quality of the published return information.
Do not deviate from stated strategies.
Guidance-Group Research & Decision Making
M&C should not decline to be identified with the

report if there is a reasonable and adequate
basis which is independent and objective.
Policy requiring that research reports, credit ratings & investment recommendations have a reasonable
& adequate basis.
Develop written guidance for analysts, supervisory analysts & review committees.
Develop measureable criteria for research report quality assessment.
Written guidance for computer-based models used in developing, rating & evaluating financial
instruments.
Develop measurable criteria for assessing outside providers.
Standardized set of criteria for evaluating the adequacy of external advisers.

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5 B. Communication with Clients and Prospective Clients
M&C must:
Disclose to clients & prospective clients the basic format & general principals of
investment processes & disclose any change that materially affect those
processes.
Identify important factors (related to investment analyses, recommendation or
actions) & include them in communications with clients & prospective clients.
Distinguish b/w fact & opinion (in investment analysis & recommendations).
Guidance
Always include basic characteristics of security identified.

Distinguish b/w facts and opinions.
Illustrate investment decision making process utilized.
The standard does not confine communication to a research report.
Communicate any specific risk factors associated with securities.
Clearly communicate potential gains & losses.
Failure to illustrate model’s limitations may be considered as violation.
Able to supply additional information if requested  maintain

relevant information.
5 C. Record Retention
M&C must develop & maintain appropriate records relating to investment analyses,
recommendations, actions & other investment related communications with clients &
prospective clients.
Guidance
Maintain records that support conclusion or any investment action.

Such records are property of the firm.
If regulatory requirements do not recommend, maintain records for
at least 7 years.
Members who change firms must recreate analysis documentation –
not rely on memory or material created in previous firms.
Record-keeping is generally firm’s

responsibility.

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6 A. Disclosure of Conflict
M&C must:
Make full & fair disclosure of all matters that impair independence & objectivity or interfere
with respective duties to clients, prospective clients & employers.
Disclosures must be prominent, are delivered in plain language & the information must be
communicated effectively.
Guidance-Disclosure to Clients
Disclose all potential & actual conflicts of interest to existing and prospective clients to let
them judge any potential bias.
If servicing as a board member  disclose.
Disclosure of broker/dealer market making activities.
Disclosure of holdings in companies that member recommends or clients hold.
Disclosure of fee arrangements including those in which the firm benefits from investment
recommendations.
Guidance –Disclosure of Conflicts to Employers
Give employer enough information to judge the impact of conflict.

Take reasonable steps to avoid conflict  report promptly if conflict occurs.
Special compensation arrangements (bonus, commission etc.) should be disclosed.
6 B. Priority of Transaction
Investment transaction priority flow:

Clients
⇓
Employers
⇓
Employees
Guidance
Prioritize client’s transactions over personal transactions & transactions made on behalf of the
member’s firm.
Personal transactions may be undertaken after clients and employer have given adequate opportunity
and time to act upon an investment recommendation.
Personal transaction – member is a “beneficial owner”.
Regular fee-paying family member accounts should not be disadvantaged to client accounts.
Information about pending trades should not be acted on for personal gains.

Page 16
Limited participation in equity IPOs by investment personnel.

Restrictions on private placements for investment personnel.
Establish blackout/restricted periods for investment personnel.
Reporting requirements for investment personnel:
Disclosure of holdings in which the employee has a beneficial interest.
Provide duplicate confirmations of transactions.
Preclearance procedures.
Disclosure of policies regarding personal investing.
6 C. Referral Fees
M&C must disclose to employer, clients & prospective clients, as appropriate, any
compensation, consideration or benefit received from or paid to others for
recommendation of products & services.
Guidance
Must inform employers, clients and prospects of benefits received for referrals of
customers and clients.
All types of consideration must be disclosed.
Encourage firms to adopt procedures regarding compensation for referrals.

Update firm at least quarterly regarding nature and value of referral
compensation received if firms do not have clear procedures for approval.

Page 17
7. Responsibilities as CFA Member or CFAI Candidate
7 A. Conduct as Members and Candidates in CFA Program
M&C must not:

Engage in any conduct that compromises reputation
or integrity of CFAI or CFA designation.
Violate integrity, validity or security or the CFA
examinations.
Guidance
Must not engage in any activity that undermines the integrity of CFA charter.
Standard applies to:
Cheating in CFA or any CFAI exam.
Revealing anything about the contents & topics of exam.
Not following the rules & polices for CFA program.
Disclosing confidential information on CFA program to candidates or to public.
Improperly using the designation.
Misrepresenting information on PCS or CFAI PDP.
Members can express their opinion on CFA institute or program.
Members volunteering CFA program must not solicit or reveal information about:
Exam questions
Deliberation related to exam process
Scoring of question
7 B. References to CFA Institute, the CFA Designation, and the CFA Program
M&C must not misrepresent or exaggerate the meaning or implication of

membership in CFA institute, holding the CFA designation or candidacy in CFA
program.
Guidance
Do not over-promise individual competence.

Do not over promise future investment results.
Sign PCS annually.
Pay CFAI membership dues annually.
Do not misrepresent or exaggerate the meaning of the designation.
No partial designation exists.
Although it is acceptable to state that candidate has successfully completed the program in 3
years ⇒ claiming superior ability is not permitted.
In written/oral communications.
The Chartered Financial Analyst and CFA marks must be used as adjectives or after
charterholder’s name.
Prohibited to be used as nouns.

Page 1
“CFA INSTITUTE CODE OF ETHICS AND STANDARDS OF

PROFESSIONAL CONDUCT GUIDANCE FOR STANDARDS I-VII”
M&C = Members & Candidates CFAI = CFA Institute
LOS2.a
COE = Code of Ethics PCP = Professional Conduct
SOPC = Standards of Program
Professional Conduct CFAI PCP ⇒ covered by CFAI bylaws & rules for procedures for proceedings DRC = Disciplinary Review
BOG = Board of Governors related to professional conduct. Committee
PDP = Professional PC P is based on principles of fairness to M&C & confidentiality of PCS = Professional Conduct
Development Program proceedings. Statement
DRC of CFAI BOG ⇒ responsible for PCP & enforcement of code & standards.
Circumstances Which Can Prompt Inquiry
If disclosure by member/candidate on PCS of involvement in civil litigation,

criminal investigation of any complaint (written) against the
member/candidate.
Written complaints about member/staff received by professional conduct
staff.
Evidence of misconduct by member/candidate received by professional
conduct staff through public source.
A report by CFA proctor of a possible violation during examination.
CFAI designated officer conduct inquiries.
Professional conduct staff (in writing) may request explanation from subject
member/candidate & may:
Interview the subject member/candidate.
Interview the complainant / third party.
Collect relevant document & records.
Designated officer may decide:
No disciplinary sanctions are appropriate.
Issue a cautionary letter.
To discipline the member/candidate.
If disciplinary sanction is proposed, the subject member/candidate may
accept the sanction.
If sanction is rejected ⇒ matter may be referred to CFAI panel for hearing.
Sanctions may include:
Public censure.
Suspension of candidate’s continued participation in CFAI program.
LOS2.b
Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients,
employers, employees, colleagues in the investment profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients above their own personal interests.
Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment
recommendations, taking investment actions, and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the
profession.
Promote the integrity of, and uphold the rules governing, capital markets.
Maintain and improve their professional competence and strive to maintain and improve the competence of other investment
professionals.

Page 2
Standards of Professional Conduct
1. Professionalism 2. Integrity of Capital Markets 3. Duties to Clients 4. Duties to Employers 5. Investment Analysis,
Recommendation & Actions
6. Conflicts of Interest 7. Responsibilities as CFA Member or CFAI Candidate
Los2.c 1. Professionalism
A. Knowledge of Law B. Independence & Objectivity C. Misrepresentation D. Misconduct
2. Integrity of Capital Markets
A. Material Non-Public Information B. Market Manipulation
3. Duties to Clients
A. Loyalty, B. Fair Dealing C. Suitability D. Performance E. Preservation of

Prudence, and Care Presentation Confidentiality
A. Loyalty B. Additional Compensation C. Responsibility of

Arrangement Supervisors
5. Investment Analysis, Recommendation & Actions
A. Diligence & Reasonable B. Communication with C. Record Retention

Basis Clients & prospective
Clients
A. Disclosure of conflicts B. Priority of Transactions C. Referral Fees
7. Responsibilities as CFAI Member or CFA Candidate
A. Conduct as Members and Candidates in B. Reference to CFA Institute, the CFA

CFA Program Designation, and the CFA Program

Page 3
1. Professionalism
1 A. Knowledge of Law
M&C must understand & comply with all applicable laws, rules & regulations (including COE
& SOPC).
These rules & regulations pertain to any govt, regulatory organization, licensing agency or
professional association governing their professional activities.
Must comply with more strict law, rule or regulation in case of conflict.
M&C must not knowingly participate or assist & must dissociate from any violation of laws,
rules or regulations.
Guidance ⇒ Code & Standards vs Local Law
Members must know laws & regulations related to their professional activity in all countries
where they work (conduct business).
Adhere to most strict rules ⇒ if have to decide b/w local laws & codes & standards of CFAI.
Must comply with local laws related to professional activity.
Never violate code & standards even if activity is otherwise legal.
Guidance ⇒ Participation or Association with Violation by Others
Members must dissociate or separate themselves from any ongoing client or employee
activity which is illegal or unethical.
In extreme case they may have to leave the employer.
May confront the individual involved first.
Approach the supervisor or compliance department if confrontation and discussion
fails.
Inaction with continued association may be construed as knowing participation.
Recommended Procedures for Compliance-Members
Members should establish procedures which ensure employees are updated with applicable
laws, rules & regulations.
Compliance laws must be reviewed on an ongoing basis in order to ensure that they address
prevailing laws, CFAI standards & regulations.
Members should maintain current reference material for employees in order to keep up-to-
date on laws, rules & regulations.
In doubt members should seek advice of counsel or their compliance department.
Members should document any violation when they disassociate from prohibited activity.
Members should encourage their employers to persuade the perpetrator(s) to end such
activity.
Under some circumstances it may be advisable or otherwise required by the law to report
violations to governmental authorities.
Standards (CFAI) do not require members to report violations to governmental authorities.
Members are strongly encouraged to report other members’ violations of the code &
standards.
Recommended Procedure for Compliance-Firms
Members should encourage their firms to:

Develop and/or adopt a code of ethics.
Provide information which highlights applicable laws and regulations and may be distributed to
employees.
Establish written procedures for reporting suspected violation of laws, regulations or company
policies.
Members in charge of supervision, creation and maintenance of investment services should:
Be aware of and comply with regulations and laws in their country of origin.
They must be aware and comply with regulations of countries where products/services will be sold.

Page 4
1 B. Independence & Objectivity
M&C must use reasonable care & judgment to achieve & maintain independence &
objectivity in professional activities.
Not accept any gift, or any type of consideration that compromise their own or another’s
independence & objectivity.
Guidance
Investment process must not be influenced by any external sources.

Modest gifts are permitted (by clients).
Allocation of shares in oversubscribed IPO to personal accounts is not permitted.
Distinguish b/w gifts from clients & entities seeking influence to the detriment of the client.
Gifts must be disclosed to the member’s employer in any case either prior to acceptance or
subsequently.
Guidance-Investment Banking Relationships
Do not get pressurized from sell-side analyst to issue favorable research on current or
prospective investment-banking client.
Disclose conflicts and manage these appropriately while working with investment bankers
in “road shows”.
Make sure of effective “firewalls” b/w research/investment management & investment
banking activities.
Guidance-Public Companies
Do not limit research to discussions with company management.

Use sources like:
Suppliers
Customers
Competitors
Analyst must not be pressured to issue favorable research by the companies they follow.
Guidance-Buy Side Clients
Responsibility of portfolio managers to respect and foster intellectual honesty of sell side
research.
Portfolio managers must not pressure sell side analysts.
They may have large positions in particular securities; rating downgrade may
adversely affect portfolio performance.
Guidance-Fund Manager Relationships
Members responsible for selecting outside managers should not accept gifts, entertainment
or travel that might be perceived as impairing independence and/or objectivity.
Guidance-Credit Rating Agency
Members employed by credit rating agencies should make sure they prevent undue
influence by security issuing firms.
Members using credit ratings must be aware of potential conflict of interest.
Consider whether independent analysis is warranted.

Page 5
Guidance-Issuer Paid Research
Analyst’s compensation for such research should be limited.

Preference is a flat fee.
No reward must be attached with report’s recommendation.
Guidance-Travel
Best practice ⇒ analysts pay their own commercial travel while attending
informative events or tours sponsored by the firm being analyzed.
Protect the integrity of opinions (unbiased opinion of the analyst) & design proper compensation systems.
Create a restricted list (remove the controversial company from research universe).
Restrict special cost arrangements (limit the use of corporate aircraft to situations in which commercial
transportation is not available).
M&C should pay for commercial transportations & hotel charges.
Limit the acceptance of gratuities and/or gifts to token items.
Develop formal policies related to employee purchases of equity or equity related IPOs (strict limits on private
placements).
Effective supervisory & review procedures.
Ensure that research analysts are not supervised or controlled by any department that could compromise the
independence of analyst.
Appoint a senior officer with oversight responsibilities for compliance with firm’s COE & all regulations
concerning its business.
1 C. Misrepresentation
M&C must not knowingly make any misrepresentations relating to investment

analysis, recommendation, actions or other professional activities.
Guidance
Misrepresentation causes mistrust.

Do not give false impressions in writing, oral or electronic communication.
Misrepresentation includes.
Guaranteeing investment performance.
Plagiarism.
Plagiarism ⇒ using someone else’s work without giving him credit.
Misrepresentation also includes deliberately omitting information that could
affect investment decision.
Models and analysis developed by others at firm are the property of firm ⇒
members can use them without attributing to developers.
A report written by another analyst employed by the firm cannot be released as
another analyst’s work.
Firms should provide employees, who deal with clients, a written list of firm’s
available services and description of its employees’ qualifications.
Employees’ qualification should be accurately presented as well.
To avoid plagiarism firm must keep record of all sources and cite them.
Generally understood and factual information need not to be cited.
Members should encourage firms to establish procedures for verifying
marketing claims of third parties whose information the firm provides to
clients.

Page 6
1 D. Misconduct
M&C must not involve in any professional misconduct dishonesty, fraud, deceit or commit any
act that reflects adversely on their professional reputations, integrity or competence.
Guidance
CFAI discourage unethical behavior in all aspects of M&C’s lives.

Do not abuse CFAI PCP by seeking enforcement of this standard to settle personal,
political or other disputes not related to professional ethics.
Firms are encouraged to adopt these policies and procedures to:

Develop and adopt a code of ethics and make clear that unethical behavior will
not be tolerated.
Give employees a list of potential violations and sanctions including dismissal.
Check references of potential employees.
2. INTEGRITY OF CAPITAL MARKETS
2 A. Material Non-Public Information
M&C must not act or cause others to act on the

information that is material nonpublic (affect the value of
investments).
Guidance
Material information ⇒ if disclosure would impact price of security.

If reasonable investor would want the information before making an investment decision.
Nonpublic information ⇒ not available to the marketplace.
Analysts’ conference call is not public disclosure.
Selective disclosure causes insider trading.
Prohibition against acting on material nonpublic information extends to securities, swaps, option
contracts and mutual funds.
Guidance-Mosaic Theory
No prohibition on reaching an investment decision through public and non-material

nonpublic information.
Make reasonable efforts to achieve public dissemination of information.

Encourage firms to adopt procedures to prevent misuse of material nonpublic information.
Use a “firewall” within the firm with
Substantial control of relevant interdepartmental communication  through a clearance like
compliance/legal department.
Review employee trades  maintain watch, rumor, and restricted lists.
Monitor & prohibit proprietary trading ⇒ if a firm possesses material non-public information.
Prohibiting all proprietary trading may send a signal to the market  firm should take the contra
side of unsolicited customer trades.

Page 7
2 B. MARKET MANIPULATIONS
M&C must not engage practices that mislead

market participants (distort prices or artificially
inflate trading volume).
Guidance
Spreading false rumors is prohibited (which can distort market).

Standard applies to transactions that deceive market.
By distorting the price-setting mechanism of financial instruments.
Securing a controlling position to manipulate the price of a related derivative or
the underlying asset.
3. DUTIES TO CLIENTS
3 A. Loyalty, Prudence & Care
M&C:
Have a duty of loyalty to clients & must act with reasonable care & exercise prudent judgment.
Must act for the benefits of clients & place their client’s interests before their employer’s & their own
interests.
Guidance
M&C must exercise same level of prudence, judgment & care as in management & disposition of their own interests in similar
circumstances.
M&C must manage pool of assets in accordance with the terms of governing documents (e.g. trust documents).
Determine the identity of “client’” to whom duty of loyalty is owed. (May be individual or beneficiaries in case of pension plan
or trust).
M&C must follow any guidelines set by their clients for the management of their assets.
Investment decisions are judged in context of total portfolio rather individual investments.
Conflict arises when “soft dollars” are not used for benefits of clients.
Cost-benefit analysis may show that voting all proxies may not be a beneficial strategy for clients.
Recommended Procedures of Compliance
M&C with control of client assets should submit to each client at least quarterly, a statement showing funds & securities.
In doubt, M&C should disclose the questionable matter in writing to client & obtain client approval.
M&C should address & encourage their firms to address the following regarding duties to client;
Follow all applicable rules & laws.
Establish the investment objectives of the clients, vote proxies & place client interests first.
Consider all the information when taking actions.
Diversify investments to reduce risk of loss.
Carry out regular reviews.
Deal fairly with all clients with respect to investment actions.
Disclose conflict of interest & compensation arrangements.
Maintain confidentiality & seek best execution.

Page 8
3 B. Fair Dealing
M&C must deal fairly & objectively with clients (when providing investment analysis,
making recommendations, taking action or engaging in other professional activities).
Guidance
No discrimination among clients while disseminating recommendations or taking investment action.

Fairly does not mean equally ⇒ difference in timings of emails & fax received by clients are normal
course of business.
Different services levels are okay as far as these do not adversely affect any client.
Disclose different levels of services to all clients and prospects.
Premium services should be available to all those who are willing to pay for them.
Guidance-Investment Recommendation
All clients must be given fair opportunity to act upon every recommendation.
Clients unaware of change in recommendation  should be advised before the order is accepted.
Guidance-Investment Actions
Clients must be treated fairly in the light of their investment objectives and circumstances.
Both institutional and individual clients must be treated in a fair & impartial manner.
M&C should not take advantage of their position to disadvantage clients (e.g., in IPOs).
Firms are encouraged to establish compliance procedures to treat customers & clients fairly.
Communicate recommendations simultaneously within the firm & to customers.
M&C should consider the following:
Limit the no. of people who are aware that a recommendation is going to be disseminated.
Shorten the time frame b/w decision & dissemination.
Publish guidelines for pre-dissemination behavior.
Simultaneous dissemination (treat all clients fairly).
Maintain a list of clients & their holdings.
Develop & document trade allocation procedures.
Disclose trade allocation procedures (must be fair & equitable).
Establish systematic account review (no preferential treatment to any client or customer).
Disclose level of services (different levels of services are possible for same or different fees).
3 C. SUITABILITY
2. M&C are in advisory relationship 1. When M&C are responsible for managing a portfolio
to a specific mandate, strategy or style
Make inquiry into Determine Judge investment

Take actions and make
client’s investment investment suitability in
recommendations
experience, risk & suitability with context of client’s
according to stated
return objectives, reference to total portfolio.
objectives & constraints of
financial client’s objectives,
portfolio.
constraints & constraints &
reassess & update mandate.
this information
regularly.

Page 9
Guidance
Develop IPS at beginning of the relationship.

Consider client’s needs, circumstances & risk tolerance.
Consider whether the use of leverage is suitable for the client or not.
Make sure to abide by the stated mandate.
Develop written IPS of each client & take the following into consideration:
Client identification.
Investor objectives.
Investor constraints.
Performance measurement benchmark
Objectives & constraints should be maintained & reviewed periodically to reflect any changes in
clients’ circumstances.
Suitability test policies.
3 D. Performance Presentations
M&C must communicate fair, accurate & complete investment performance information.
Guidance
Members must avoid misstating performance or misleading clients about investment performance of
themselves or their firms.
Members should not misrepresent past performance or reasonably expected performance.
Members should not state or imply the ability to achieve a rate of return similar to that achieved in
the past.
Provide reference to limited information provided on brief presentations.
For brief presentations members must make detailed information available on request.
Apply GIPS standards.

Consider the knowledge of audience to whom performance presentation is addressed.
Performance of weighted composite of similar portfolios rather a single account.
Include performance history of terminated accounts.
Disclosures that fully explain the performance results being reported.
Maintain data & records used to calculate the performance being presented.
3 E. Preservation of Confidentiality
M&C must keep information about current, former &

prospective clients confidential unless:
Information concerns illegal activity.
Disclosure is required by law.
Client or prospective client permits disclosure.

Page 10
Guidance
If a client is involved in illegal activities  members may have an

obligation to report to the authorities.
This standard extends to former clients as well.
Standards do not prevent members from cooperating with a CFA PCP
investigation.
Avoid disclosing information received from client except to authorized

coworkers working for the client.
Follow firm’s procedures for storing electronic data.
Recommend development of such procedures if they are not in place.
A. Loyalty
M&C:
Must act for the benefit of their employer.
Not deprive employer of the advantage of their skills & abilities, divulge confidential
information or otherwise cause harm to their employer.
Guidance
Do not indulge in the activities to injure the firm  deprive it from profit and
advantage of employee’s abilities & skills.
Although client’s interests are at priority than firms, M&C should consider the
effects of actions on firm’s integrity and sustainability.
A careful balance b/w managing interests of employer & family  manage such
obligations with work obligations.
Guidance-Employer Responsibility
Should not have incentive or compensation system that encourages unethical

behavior.
Members are encouraged to give their employers a copy of code & standards.
Guidance-Independent Practice
Independent practice for compensation is allowed as long as the following conditions

are met:
Provide employer prior notification fully describing all aspects of service.
Compensation details
Duration
Nature of activities
Employer’s consent is required.

Page 11
Guidance-Leaving an Employer
Continue to act in employer’s best interest until resignation is effective.

Activities that may constitute a violation include:
Misappropriation of trade secrets
Misuse of confidential information
Soliciting employer’s client prior to leaving
Self-dealing
Misappropriation of client lists.
Employer records on home computers, PDA, cell phones or any other medium
are property of firm.
After leaving the organization, simple knowledge of names and existence of
former clients is not confidential.
M&C can use the experience or knowledge gained with former employer at any
other organization.
Guidance-Whistleblowing
In exceptional cases, the duty to employer may be violated to protect any client
or for the integrity of markets.
Whistleblowing cannot be done for personal gains.
Guidance-Nature of Employment
If M&C are independent contractors, they still have a duty to abide by the terms
of the agreement.
Competition policy (employer restrictions on offering similar services outside

the firm).
Termination policy (how termination will be disclosed to clients & staff).
Incident-reporting procedures.
Employee classification (e.g. full time, part time).
4 B. Additional Compensation Arrangements
M&C must not accept gifts, benefits, compensation, or consideration that compete
with or might reasonably be expected to create a conflict of interest with their
employer’s interest unless they obtain written consent from all parties involved.
Guidance
Compensation includes both direct & indirect form.

Additional benefits are also included.
Written consent from employer also includes email communication.
Immediately report to employer in written format detailing any

proposed compensation and services.
Performance incentives should be verified by the offering party.

Page 12
4 C. Responsibility of Supervisors
M&C must make reasonable efforts to detect & prevent violations of

applicable laws, rules & regulations & code & standards by anyone
subject to their supervision or authority.
Guidance
Members must take steps to prevent from violating laws, rules,

regulations or code & standards.
Make reasonable efforts to detect violations.
Members with supervisory responsibility must ensure that policies
regarding investment or non-investment behavior are enforced
equally.
Guidance-Compliance Procedures
Members with supervisory responsibility must bring an inadequate

compliance system to the firm’s attention and recommend
corrective action.
While investigating violation ⇒ appropriate to limit suspected
employee’s activities.
Unless adequate procedures are adopted by the firm, a member
must decline supervisory responsibility in writing if faced with no
or inadequate compliance procedures.
M&C are encouraged to adopt recommendation that their employers adopt a COE.
Separate the COE from compliance procedures.
Adequate compliance procedures:
Clearly written & accessible manual.
Designate a compliance officer to implement compliance procedures.
Implement system of checks & balances.
Describe the hierarchy of supervision.
Outline scope of procedures & permissible conduct.
Once a compliance program is in place, a supervisor should:
Disseminate program contents to appropriate personnel & educate them regarding
compliance procedures.
Incorporate professional conduct evaluation as part of employee’s performance review.
Review employees’ actions & identify violations.
Respond promptly once a violation is discovered, conduct thorough investigation & increase
supervision.

Page 13
5. Investment Analysis, Recommendations and Actions
5 A. Diligence & Reasonable Basis
2. M&C must exercise diligence, 1. M&C must have a reasonable & adequate
independence & thoroughness in basis for investment analysis,
investment analysis, recommendation or action (supported by
recommendations & actions. research & investigation).
Guidance-Reasonable Basis
Level of research for due diligence depends on product/service offered.

Prior to making recommendation or investment action consider:
Firm’s financial and operating history & business cycle stage.
Mutual fund’s fee & management history.
Limitation of any quantitative methods used.
Appropriateness of peer group comparisons.
Guidance-Using Secondary or Third-Party Research
To periodically review quality of third party research, consider the following:

Review assumptions.
How rigorous is the analysis.
How timely the research is.
Evaluate objectivity & independence of recommendations.
Guidance-Quantitative Research
Able to explain the importance of quantitative research and how results

were used in decision making process.
Consider scenarios which are not typically used to assess downside risk.
Ensure that both positive & negative results have been used.
Guidance-External Advisers
Ensure advisors have adequate compliance and internal controls.

Review the quality of the published return information.
Do not deviate from stated strategies.
Guidance-Group Research & Decision Making
M&C should not decline to be identified with the

report if there is a reasonable and adequate
basis which is independent and objective.
Policy requiring that research reports, credit ratings & investment recommendations have a reasonable
& adequate basis.
Develop written guidance for analysts, supervisory analysts & review committees.
Develop measureable criteria for research report quality assessment.
Written guidance for computer-based models used in developing, rating & evaluating financial
instruments.
Develop measurable criteria for assessing outside providers.
Standardized set of criteria for evaluating the adequacy of external advisers.

Page 14
5 B. Communication with Clients and Prospective Clients
M&C must:
Disclose to clients & prospective clients the basic format & general principals of
investment processes & disclose any change that materially affect those
processes.
Identify important factors (related to investment analyses, recommendation or
actions) & include them in communications with clients & prospective clients.
Distinguish b/w fact & opinion (in investment analysis & recommendations).
Guidance
Always include basic characteristics of security identified.

Distinguish b/w facts and opinions.
Illustrate investment decision making process utilized.
The standard does not confine communication to a research report.
Communicate any specific risk factors associated with securities.
Clearly communicate potential gains & losses.
Failure to illustrate model’s limitations may be considered as violation.
Able to supply additional information if requested  maintain

relevant information.
5 C. Record Retention
M&C must develop & maintain appropriate records relating to investment analyses,
recommendations, actions & other investment related communications with clients &
prospective clients.
Guidance
Maintain records that support conclusion or any investment action.

Such records are property of the firm.
If regulatory requirements do not recommend, maintain records for
at least 7 years.
Members who change firms must recreate analysis documentation –
not rely on memory or material created in previous firms.
Record-keeping is generally firm’s

responsibility.

Page 15
6 A. Disclosure of Conflict
M&C must:
Make full & fair disclosure of all matters that impair independence & objectivity or interfere
with respective duties to clients, prospective clients & employers.
Disclosures must be prominent, are delivered in plain language & the information must be
communicated effectively.
Guidance-Disclosure to Clients
Disclose all potential & actual conflicts of interest to existing and prospective clients to let
them judge any potential bias.
If servicing as a board member  disclose.
Disclosure of broker/dealer market making activities.
Disclosure of holdings in companies that member recommends or clients hold.
Disclosure of fee arrangements including those in which the firm benefits from investment
recommendations.
Guidance –Disclosure of Conflicts to Employers
Give employer enough information to judge the impact of conflict.

Take reasonable steps to avoid conflict  report promptly if conflict occurs.
Special compensation arrangements (bonus, commission etc.) should be disclosed.
6 B. Priority of Transaction
Investment transaction priority flow:

Clients
⇓
Employers
⇓
Employees
Guidance
Prioritize client’s transactions over personal transactions & transactions made on behalf of the
member’s firm.
Personal transactions may be undertaken after clients and employer have given adequate opportunity
and time to act upon an investment recommendation.
Personal transaction – member is a “beneficial owner”.
Regular fee-paying family member accounts should not be disadvantaged to client accounts.
Information about pending trades should not be acted on for personal gains.

Page 16
Limited participation in equity IPOs by investment personnel.

Restrictions on private placements for investment personnel.
Establish blackout/restricted periods for investment personnel.
Reporting requirements for investment personnel:
Disclosure of holdings in which the employee has a beneficial interest.
Provide duplicate confirmations of transactions.
Preclearance procedures.
Disclosure of policies regarding personal investing.
6 C. Referral Fees
M&C must disclose to employer, clients & prospective clients, as appropriate, any
compensation, consideration or benefit received from or paid to others for
recommendation of products & services.
Guidance
Must inform employers, clients and prospects of benefits received for referrals of
customers and clients.
All types of consideration must be disclosed.
Encourage firms to adopt procedures regarding compensation for referrals.

Update firm at least quarterly regarding nature and value of referral
compensation received if firms do not have clear procedures for approval.

Page 17
7. Responsibilities as CFA Member or CFAI Candidate
7 A. Conduct as Members and Candidates in CFA Program
M&C must not:

Engage in any conduct that compromises reputation
or integrity of CFAI or CFA designation.
Violate integrity, validity or security or the CFA
examinations.
Guidance
Must not engage in any activity that undermines the integrity of CFA charter.
Standard applies to:
Cheating in CFA or any CFAI exam.
Revealing anything about the contents & topics of exam.
Not following the rules & polices for CFA program.
Disclosing confidential information on CFA program to candidates or to public.
Improperly using the designation.
Misrepresenting information on PCS or CFAI PDP.
Members can express their opinion on CFA institute or program.
Members volunteering CFA program must not solicit or reveal information about:
Exam questions
Deliberation related to exam process
Scoring of question
7 B. References to CFA Institute, the CFA Designation, and the CFA Program
M&C must not misrepresent or exaggerate the meaning or implication of

membership in CFA institute, holding the CFA designation or candidacy in CFA
program.
Guidance
Do not over-promise individual competence.

Do not over promise future investment results.
Sign PCS annually.
Pay CFAI membership dues annually.
Do not misrepresent or exaggerate the meaning of the designation.
No partial designation exists.
Although it is acceptable to state that candidate has successfully completed the program in 3
years ⇒ claiming superior ability is not permitted.
In written/oral communications.
The Chartered Financial Analyst and CFA marks must be used as adjectives or after
charterholder’s name.
Prohibited to be used as nouns.

Page 1
2017, Study Session # 1, Reading # 4
“INTRODUCTION TO THE GLOBAL INVESTMENT

PERFORMANCE STANDARDS (GIPS®)”
3. a Historical Misleading Reporting Procedures
Representative Accounts Survivorship Bias Varying Time Periods
Top-performing portfolio Excluding weak Showing excellent

representative of firm’s performance accounts. performance of selected
overall investment results. time periods.
GIPS ⇒ set of ethical principles (standardized, industry-

wide & voluntarily followed by firms).
Clients have more confidence in reported performance &
can easily compare investment firms’ performances.
3. b
Composite ⇒ grouping of individual discretionary portfolios representing

a similar investment strategy, objective or mandate.
Provide information about investment style results & various types of
securities being managed.
Each portfolio is assigned to a composite before its performance is known
(no intentional superior composite creation).
3. c Verification
Requirements Recommendations
Performed by independent third party Firms are encouraged to pursue

(firm-wide basis). independent verification.
Verifier must attest; Disclosure language;
Firm has compiled with composite “[insert name of firm] has been verified
construction requirements. for the periods [insert dates] by [name of
Firm’s policies and procedures are verifier]. A copy of the verification report
designed to present and calculate is available upon request.”
performance in accordance with the
GIPS standards.

Page 1
“GLOBAL INVESTMENT PERFORMANCE STANDARDS (GIPS®)”

IMF = Investment
Management
Firms 4.a GIPS Objectives
CVG = Country Version
of GIPS
Global acceptance of calculation & presentation standards (fair & full
disclosure).
Consistent & accurate investment performance data in areas of reporting,
records, marketing & presentations.
To promote fair competition among IMFs & global self regulation.
Key Characteristics of GIPS
Define “firm” (reflect distinct business entity).

Ensure fair representation of results & full disclosure.
Include portfolios (fee-paying, discretionary) in composite for a minimum of five
years or since inception. Add annual performance each year to minimum of ten
years.
Use certain calculation & presentation standards & make disclosures.
GIPS contain both required & recommended provision.
Present all additional & supplemental information (encouraged).
Input data must be accurate & no partial compliance.
Follow local law in case of conflict with GIPS (disclose the conflict).
Certain recommendation may become requirements.
Private equity & real estate provisions are to be applied to these asset classes.
Fundamental of Compliance
Definition of the Firm
Requirements Recommendations
Total firm assets include total MV of Include broadest definition of the firm (all
discretionary & non-discretionary assets (fee geographical offices).
paying & non-fee paying).
If firm has discretion over sub-advisor
selection (include sub-advisor’s
performance).
Historical composite results will not change
(if firm changes its organization).
Document Polices & Procedures (requirements)
Document, in writing, polices & procedures the

firm uses to comply with GIPS.
Claim of Compliance (requirements)
The following statement must be used;

“[insert name of firm] has prepared and presented this report in
compliance with the Global investment performance standards
(GIPS®).”
No partial compliance & the statement “calculated in accordance with
GIPS” is not used for calculation methodologies & individual clients
(unless reporting portfolio results directly to that client).

Page 2
4.a Firm’s Fundamental Responsibilities (requirements)
Compliant presentation to all prospects.

List of composite descriptions to all prospects that make a request (list
discontinued composite for at least 5 years).
Separate noncompliant firms from GIPS compliant firm in case of joint
marketing.
Be aware of updates, guidance statements & the like.
4.b
Definition of firm ⇒ corporation, subsidiary or division held out to

client as a distinct business entity.
No non-compliant performance is presented for any periods after Jan
1st, 2000.
4.c
Firms may claim GIPS compliance for any CVG-compliant results prior
to Jan1, 2006.
Include CVG-compliant data to GIPS compliant until a minimum of ten
years of compliant performance is presented.
4.d Major Sections of GIPS
0. Fundamental of Compliance 1. Input Data 2. Calculation Methodology
Fundamental issues include: Should be consistent for full, fair Certain methodologies for portfolio
Firm definition & documentation & comparable presentations. return calculation & certain other for
of policies & procedures. composite return calculations.
Complying with GIPS updates. Uniformity is required for
Appropriate compliance claim & comparability.
verification statement.
3. Composite Construction 4. Disclosure 5. Presentation & Reporting
Assets-weighted composite for fair Disclosure about performance & Incorporate necessary return &
presentation. policies. disclosure information according
Composite returns are asset-weighted There are some disclosures that all to requirements of GIPS
avg of returns on the portfolios firms must make while there are standards.
included in each composite. others which are not applicable to all
circumstances for all firms.
6. Real Estate 7. Private Equity 8. Warp Fee/Separately Managed Account (SMA) Portfolios
Certain provisions in Sections 0-5 do Must be valued according to GIPS Some provisions in section 0-5 are supplemented or replaced
not apply to all real estate investments Private Equity Valuation Principles. by the provisions specified in this section.
or are superseded by provisions in this Open-end or evergreen fund follow
section. regular GIPS.

Page 1
“THE TIME VALUE OF MONEY”
Compound Interest or Interest on Time Line Discounting Compounding

Interest Diagram of the cash Moving CF to the beginning Moving cash flow to the
Growth in the value of investment flows associated with a of an investment period to end of the investment
includes, interest earned on: TVM problem. calculate PV. period to calculate FV.
N
Original principal. FV = PV (1 +i)
= N
Previous period’s interest (1 + )ே (1+i) is FV factor
earnings.
1
ܰ

(1 + )
Required = Nominal RFR. + Default risk + Liquidity risk + Maturity risk

interest premium. premium. premium.
rate on a
security. ⇓ ⇓ ⇓
Premium for the Premium for Longer-term
Real RFR + Expected inflation rate. risk that borrower receiving less bonds have
will not make the than fair value more maturity
promised for an risk, because
payments in a investment if it their prices are
Reflects preferences of timely manner. must be sold more volatile.
individuals for current vs. quickly.
future real consumption.
Loan Amortization Perpetuity Annuity

Process of paying off a loan Perpetual annuity. Stream of equal
with a series of periodic Fixed payment at set cash flows
loan payments, whereby a intervals over an infinite accruing at equal
portion of the outstanding time period. intervals.
loan amount is paid off, or ଵ
is the discounting
௥
amortized, with each
factor for perpetuity. ⇓
payment.
Annuity Due Ordinary Annuity
Two
First cash flow ⇐ ⇒ First cash flow that
Cash flow Additivity occurs types occurs one period
PV of PV of immediately. from now.
Principle annuity ordinary
>
PV of any stream of cash due. annuity.
flows equals the sum of PV
of each cash flow as long
cash flows are indexed at
the same point in time.

Page 2
Interpretations of
Interest Rate
Required rate of return.
Discount rate.
Opportunity cost.
Effective Annual Rate (EAR)

Rate of return actually being
earned after adjustments have
been made for different
compounding periods.
m
EAR = (1+ periodic rate) -1
Stated rate will be equal to the
actual (effective) rate only when it
is compounded annually.

Page 1
“DISCOUNTED CASH FLOW APPLICATIONS”

NPV = Net Present Value D.R. = Discount Rate.
NPV: IRR
For Independent Project:
PV of expected – PV of expected The D.R. at which NPV = 0. IRR / NPV rules lead to
cash inflows. cash outflows. The rate of return at which; exactly the same accept
PV inflows = PV outflows. /reject decision
NPV = It assumes reinvestment at
IRR.
Decision rule For Mutually Exclusive
D.R used is the market based opportunity Projects:
cost of capital. IRR > r ⇒ Accept Select the project with the
NPV assumes reinvestment at D.R. greatest NPV.
IRR < r ⇒ Reject
Decision rule: Problems in IRR

For mutually exclusive projects, NPV & IRR
NPV Decision Impact may give conflicting project rankings due to:
+ve (IRR> r) Accept shareholder’s wealth.

Different sizes of Differences in timings of
project’s initial cost cash flows.
Size of the company rises
0 - but shareholder’s wealth is
not affected.
-ve (IRR< r) Reject shareholder’s wealth.
Money-Weighted Return Time-Weighted Return (TWR)

(MWR) It measures compound
IRR of an investment. growth (Geometric return).
It is highly sensitive to the It is not affected by the
timing & amount of timings of cash flows.
withdrawals from & additions It is preferred over MWR.
to a portfolio. TWR cannot be calculated if
If one has complete control we do not know the period
over the timings of the cash end values of investment.
flows then it is more
appropriate.
Funds contributed Poor returns MWR < TWR

prior to a period of
relatively. High returns MWR > TWR

Page 2
Holding Period Yield or Money Market Yield Effective Annual Yield

Holding Period Return (HPR) (CD equivalent yield) rMM (EAY)
Total return an investor earns between the purchase Annualized HPY.
date & the sale or maturity date. Annualized HPY. Assumes 365-day year.
Assumes 360-day year. Incorporates effects of
− + + Does not incorporate compounding.

= = −1 365/ t
effects of compounding. EAY =(1+HPY) -1
It is the actual return an investor receives. = × 360 /
Bank Discount Yield (rBD) Converting rBD into rMM

Dollar discount from the
face (par) value as a 360 ×
=
fraction of the face value. 360 – ( × )
Based on face value.
Not based on market or
purchase price. Bond –equivalent yield
= / × 360/ (BEY)
BEY = 2 × (semi annual
effective yield.)

Page 1
“STATISTICAL CONCEPTS & MARKET RETURNS”

Population Sample Statistics
Statement of all members Subset of Refers to data &
in a group population. methods used to analyze
data.
Descriptive Statistics
Inferential Statistics
Parameter Sample Statistic Used to summarize &
Two Categories Forecasting, estimating or making
Measures a characteristic Measures a consolidate large data sets into
judgment about a large set based
of population. characteristic of a useful information.
on a smaller set.
sample.
Types of Measurement Scales
Nominal Scale Ordinal Scale Interval Scale Ratio Scale

Least accurate. Provides ranks/orders. Provides ranks/orders. Provides ranks/orders
No particular order or rank. No equal difference b/w scale Difference b/w the scales Equal differences b/w scale.
Provides least info. values. are equal. A true zero point exists as the
Least refined. Zero does not mean total origin.
absence. Most refined.
Cumulative Absolute Frequency

Constructing a Frequency Frequency Distribution
Sum of absolute frequencies starting with the
lowest interval & progressing through the
Distribution Tabular (summarized) presentation of
highest.
statistical data.
1. Define Intervals / Classes

Interval is a set of values that an Relative Frequency
2. Tally the observations Assigning
% of total observations falling in each
observation may take on. observations to their appropriate
interval.
Intervals must be, intervals.
All-inclusive.
Non-overlapping. Cumulative Relative Frequency
Mutually Exclusive. Sum of relative frequencies starting with the
3. Count the observations Count actual lowest interval & progressing toward the
number of observations in each highest.
Importance of Number of Intervals interval i.e., absolute frequency
of interval.
Modal Interval
Too few Too many
Interval with the highest
intervals. intervals. frequency.
Important Data may not

characteristics be summarized
may be lost. well enough.

Page 2
Histogram
Bar chart of continuous data that has been
grouped into a frequency distribution. Frequency Polygon
Helps in quickly identifying the modal X-axis: Mid points of each interval.
interval. Y-axis: Absolute frequencies.
X-axis: Class intervals.
Y-axis: Absolute frequencies.
Measures of Central Tendency Mean Median

Identify center of data set. Sum of all values divided by
Used to represent typical or total number of values. Midpoint of an arranged distribution.
expected values in data set. Divides data into two equal halves.
Population = =
It is not affected by extreme values;

Sample = = ̅ hence it is a better measure of central

Properties: tendency in the presence of extremely
Weighted Mean Mean includes all values of a large or small values.
It recognizes the disproportionate data set.
influence of different observations on Mean is unique for each data.
Mode
mean. Sum of deviations from Mean is
Most frequent value in the
= ; = 1
always zero i.e., Σ − ̅ = 0
Mean uses all the information data set.
about size & magnitude of
observations. No. of Modes Names of
Shortcoming: Distributions
Geometric Mean (GM)
Mean is affected by extremely One Unimodal
large & small values. Two Bimodal
Calculating multi-periods return.
Measuring compound growth rates. Three Trimodal
√X1 × X2 × … × Xn Harmonic Mean (H.M)

ಸస೙
(applicable only to non-negative values)
1+RG = n (1+R1) (1 + R2)

H.M is used:
…… (1 + Rn) When time is involved.
Equal $ investment at different
times.
= + 1

Quantiles:
For values that are not all equal
Quartiles: Distribution divided into 4 parts (quarters).

H.M < GM < AM
Quintiles: Distribution divided into 5 parts.
Deciles: Distribution divided into 10 parts.
Measures Measures
Percentiles: Distribution divided into 100 parts (percent). of Location ⇒ of Central + Quantiles
Tendency

Page 3
Dispersion Range Population Variance ‘σ 2’ Population Standard

Variability around the Max Value – Min Arithmetic average squared Deviation (S.D) ‘σ’.
central tendency. Value deviations from mean. Square root of population
Measure of risk. variance.
Σ −
Sample Variance
=
Mean Absolute
Deviation (MAD) −1
Arithmetic average of
absolute deviations
Using ‘n-1’ observations
Sample Standard Using entire number of observations ‘n’ will
Σ| − |
from mean:
=
Deviation systematically underestimate the population

⇒ parameter & cause the sample variance & S.D
=
Σ(x − x) to be referred to as biased estimator.
n−1
Relative Dispersion Coefficient of Variation Sharpe Ratio

ೣ
Amount of variability CV= i.e., risk per unit of expected return. Measures excess return per unit of risk.

relative to a reference
̅೛
೑
Helps make direct comparisons of dispersion Sharpe ratio =
೛
point. across different data sets. Higher Sharpe ratios are preferred.

Page 4
Symmetrical Distribution Skewness

Identical on both sides of the mean. Describes a non symmetrical distribution.
Intervals of losses & gains exhibit the .
same frequency. Sample Skewness
Chebyshev’s Inequality Mean = Median = Mode. Sum of cubed deviations from
Gives the % of observations that lie mean divided by number of
within ‘k’ standard deviations of the observations & cubed

mean which is at least 1 − for all standard deviation.
1 Σ(x − x )
మ
s
=
k>1, regardless of the shape of the
distribution. n s
| | > 0.5 is considered

± 1.25 36% Mean = Median = Mode.
⇒ significant level of skewness.
s.d observations.
± 1.5 s.d ⇒ 56% obs.
± 2 s.d ⇒ 75% obs.
± 3 s.d 89% obs. Negatively Skewed Positively Skewed
⇒
Longer tail towards left. Longer tail towards right.
± 4 s.d ⇒ 94% obs.
More outliers in the lower More outliers in the upper
region. region.
More – ve deviations. More + ve deviations.
Mean < Median < Mode Mean > Median > Mode.
Hint
Median is always in the center.
Mean is the direction of skew.
Kurtosis Distribution Excess Kurtosis In Leptokurtic

Measure that tells when distribution is Leptokurtic ⇒ >0 distribution there is a
more or less peaked than a normal higher frequency of
Mesokurtic ⇒ =0
distribution. extremely large
(Normal) deviations from the
Kurtosis of normal distribution is 3. Platykurtic <0
⇒ mean.
Excess kurtosis = sample
kurtosis-3
ℎ,

Greater +ve Increased
1 Σ( − ) kurtosis & ⇒ Risk.
= more – ve skewness.

A sample excess kurtosis of 1.0 or larger

is considered unusually large.

Page 1
“PROBABILITY CONCEPTS”
Random Variable Outcome Event Mutually Exclusive Events Exhaustive Events
Quantity. with An observed value A single outcome Both cannot happen at the same time. Include all possible
uncertain possible of a random or a set of P(A|B) = 0 & outcomes.
value(s). variable. outcomes. P(AB) = P(A|B) × P(B) = 0
Two Defining Properties of Probability

Probability
Empirical Probability A Priori Probability Subjective Probability

0 ≤ P(E) ≤ 1 ΣP( E i ) = 1 Based on historical facts Based on logical An informal guess.
i.e., Probability of an i.e., Total or data. analysis. Involves personal
event lies b/w 0 & 1. probability is equal No judgments involved. Random + historical. judgment.
to 1. Historical + non random.
Probability in Objective
Probability
terms of
Odds for the Odds against the

event event Unconditional Probability
Marginal probability.
Probability of occurrence of an event-regardless of the
past or future occurrence.
Probability of Probability of non-
occurrence divided by occurrence divided by
probability of non- probability of Conditional Probability; P(A|B)
occurrence. occurrence. Probability of the occurrence of an event is affected by
the occurrence of another event.
It is also known as likelihood of an occurrence.
‘|’ denotes ‘given’ or ‘conditional’ upon.
P(A|B) = P (AB)
P(B)
Mutually exclusive events P(A|B) = 0.
Multiplication Rule Addition Rule
For independent events,
(Joint Probability) Probability that at least one
P(A|B) = P(A)
Probability that both events will event will occur.
occur. P(A or B) = P(A) + P(B) - P(AB)
P(AB) = P(A|B) × P(B) ⇒ For mutually exclusive Independent Events
⇒ For mutually exclusive events;. events. Events for which occurrence of one has no
P(A|B) = 0, hence, P(A or B) = P(A) + effect on occurrence of the other.
P(AB) = 0. P(B). P(A|B) = P(A)
P(B|A) = P(B)
Total Probability Rule

It highlights the relationship b/w unconditional & conditional
probabilities of mutually exclusive & exhaustive events.
P(R) = P(RI) + P(RIc)
= P(R|I) × P(I) + P(R|Ic) × P(Ic)

Page 2
Covariance Expected Value Conditional Expected Value

Measure of how two assets move together. Probability weighted Calculated using conditional
It measures only direction. outcomes of a random probabilities.
-∝ ≤ Cov(x, y) ≤ +∝ (property). variable. Are contingent upon the
It is measured in squared units. It is the best guess of the occurrence of some other
Cov(Ri,Rj) = E {[Ri - E(Ri)] [Rj – E(Rj)]} outcome of a random event.
= Σ P(S) [Ri – E(Ri)] [Rj – E(Rj). variable.
Cov (RA,RA ) = variance (RA) (property).
Covariance Variables tend to

Correlation
+ ve ⇒ Move in same direction. Measures the direction as well as the magnitude.
It is a standardized measure of co-movement.
- ve ⇒ Move in opposite It has no units.
direction. -1 ≤ corr (Ri,Rj) ≤ + 1.
‘0’ ⇒ Asset returns are

unrelated.
Value Correlation Variables tend to
+1 ⇒ Perfectly positive ⇒ Move proportionally in the

same direction.
-1 ⇒ Perfectly negative ⇒ Move proportionally in the

opposite direction.
0 ⇒ Uncorrelated ⇒ No linear relationship.
Corr (Ri,Rj) = Cov (Ri,Rj)

σ (Ri) σ (Rj)
Portfolio Baye’s Formula

⇒ Used to update a given set of prior
probabilities in response to the arrival of
Expected Value Variance new information.

= ()
= +

Updated probability prior

Probability = of new info. × probability of the
unconditional event.
probability of
⇒ Where wi = market value of investment in asset ‘i’ new info.
market value of the portfolio

Page 3
Counting Methods
Labeling Formula Factorial [!] Permutation [nPr] Combination [nCr] Multiplication Rule
݊! Arranging a given Number of ways of Choosing ‘r’ items The number of ways k
݊ଵ ! … ݊௞ ! set of ‘n’ items. choosing r objects from from a set of ‘n’ tasks can be done is
The number of ways ‘n’ No subgroups. a total of n objects items when order (n1)(n2)(n3)…(ni).
objects can be labeled There are n! ways when order matters. does not matter.
with k different labels. of arranging ‘n’
items.

Page 1
“COMMON PROBABILITY DISTRIBUTIONS”
Probability Distribution Probability Function

Describes the probabilities of all possible Probability of a random variable being equal
outcomes for a random variable. to a specific value.
Sum of probabilities of all possible Properties:
outcomes is 1. 0 ≤ p(x) ≤ 1
Σ p(x) = 1
Discrete Continuous
Random Variable Finite (measurable) # of possible Infinite (immeasurable) # of possible
outcomes. outcomes.
P(x) cannot be 0 if ‘x’ can occur. P(x) can be zero even if ‘x’ can occur.
Distribution We can find the probability of a We cannot find the probability of a
specific point in time. specific point in time.
Probability Density Function (PDF) Cumulative Distribution Function (CDF)

It is used for continuous distribution. Calculates the probability of a random
Denoted by f(x). variable ‘x’ taking on the value less than or
equal to a specific value of ‘x’.
F(x) = P (X ≤ x)
Discrete uniform random variable All outcomes have the same probability.
Uniform Probability Distribution
Discrete Continuous
Has a finite number of specified outcomes. Defined over a range with parameters ‘b’
P(x)×k. K is the probability for ‘k’ number of (upper limit) & ‘a’ (lower limit).
possible outcomes in a range. cdf: It is linear over the variable’s range.
cdf: F(xn) = n.p(x). Properties:
P ( x ≤ a) = 0 & P (x ≥ b) = 1
௕ି௔
P( a < x < b) =
௫మ ି௫భ
Binomial Distribution Binomial Tree

Properties: Shows all possible combinations of up & down
Two outcomes (success & failure). moves over a number of successive periods.
‘n’ number of independent trials. Node: Each of the possible values along the
Probability of success remains constant. tree.
p(x) = U is up-move factor.
! D is down-move factor (1/U).
௫ (1 − )௡ି௫
− !. ! p is probability of up move.
(1-p) is probability of down move.

Page 2
Normal Distribution
Properties of Normal Distribution: Confidence Interval

Range of values around the expected value
Symmetric distribution within which actual outcome is expected to be
Mean = Median = Mode some specified percentage of time.
Skewness = 0
Kurtosis = 3 & Excess Kurtosis = 0
Range of possible outcomes lie between -∞ to + ∞
Asymptotic to the horizontal axis Confidence    %
Described by two parameters i.e. Mean and Variance or (standard deviation) Interval
When S.D ↑ (↓), the curve flattens (steepens)
Smaller the S.D, more the observations are centered around mean. x ± 1s  68.%
Not appropriate to use for options.
x ± 1.65s  90.%
Not appropriate to use to model asset prices.
x ± 1.96s  95%
Central Limit Theorem ⇒ Sum and mean of large no. of independent
x ± 2s  95.45%
variables in approximately normally distributed.
x ± 2.58s  99%
Linear combination of two or more normal random variables is also normally
x ± 3s  99.73%
distributed.
Applications of Normal Distribution
Shortfall Risk Roy’s Safety First Criterion Sharpe Ratio

Risk that portfolio value will fall below Optimal portfolio minimizes the = [E (Rp) – Rf] / σp
some minimum level at a future date. probability that the return of the
portfolio falls below some Portfolio with the highest Sharpe ratio
Safety First Rule focuses on Shortfall minimum acceptable level. minimizes the probability that its
Risk. Minimize P(RP < RL). return will be less than the Rf
SFRatio = (assuming returns are normally
[௉ ) − ௅ distributed).
σ୔
Choose the portfolio with greatest
SFRatio.
Managing Financial Risk

Lognormal
Value at risk (VAR) ⇒minimum value ofvariable
A random losses (in money terms) expected over
Distribution a specified time period at a specified
whoselevel of probability.
natural log has normal distribution
Properties
Stress testing/scenario analysis ⇒use of
cannot beset of techniques to estimate losses in
negative
extremely worst combinations of
is events or scenarios.
completely described by mean and variance
Log Normal distribution

is more appropriate to use to model asset prices
is used in Black Scholes Merton Model
Discrete:
Daily, annually, weekly, monthly compounding
Compounds Rate
of Return
Continuous
ln(S1/S0) = ln(1+HPR)
These are additive for multiple periods.
Effective annual rate based on continuous
compounding is given as:
EAR = e Rcc-1

Page 3
4. Monte Carlo Simulation
Use of a computer to generate a large number of random samples from a probability distribution
Uses
It is used to: Simulation Procedure for Stock Option Valuation
Plan and manage financial risk.
Value complex securities
Estimate VAR Step 1: Specify underlying variable
Examine model's sensitivity to changes in
the assumptions.
Step 2: Specify beginning value of underlying variable
Limitations
Complex procedure. Step 3: Specify a time period
Highly dependent on assumed distributions.
Based on a statistical rather than an
analytical method. Step 4: Specify regression model for changes in stock price
Random Number Generator Step 5: K random variables are drawn for each risk factor using
An algorithm that generates uniformly computer program/ spreadsheet
distributed random numbers between 0 and 1.
Step 6: Estimate underlying variables by substituting values of random

observations in the model specified in Step 4.
Step 7: Calculate value of call option at maturity and then discount back that
value at time period 0
Step 8: This process is repeated until a specified number of trials ‘I’ is completed.
Step 9: Finally, mean value and S.D. for the simulation are calculated
Historical Simulation or Back Simulation
Based on actual values & actual Drawbacks

distribution of the factors i.e., based on Cannot be used to perform “what if’
historical data. analysis.
History does not repeat itself.

Page 1
SE = Standard Error = Approaches to
= Rises
RV = Random Variable
“SAMPLING & ESTIMATION” df = Degrees Of Freedom
n = Sample Size
CI = Class Interval
Sample Methods of Sampling Sampling error

A subgroup of Sample – Corresponding
population. Statistic Population
Simple Random Stratified Random Systematic Parameter.
Sample Statistic Sampling Sampling Sampling
th
It describes the Each item of the Uses a classification Select every k
Sampling Distribution
characteristic of population under system. number.
Probability distribution of all
a sample. study has equal Separates the Resulting sample
possible sample statistics
Sample statistic probability of population into strata should be
computed from a set of
itself is a random being selected. (small groups) based approximately
equal size samples
variable. There is no on one or more random
randomly drawn.
guarantee of distinguishing
selection of characteristics.
items from a Take random sample Standard Error (SE) of
particular from each stratum. Sample Mean
category. It guarantees the Standard deviation of
selection of items the distribution of
from a particular sample means.
category. σ
σx =
n
If σ is not known then;
Date Time s
Data Observational Characteristics sx =
Units n
Time series Observations take
As n ; x approaches
over equally spaced Longitudinal Same Multiple
µ and
time interval Panel Multiple Same
S.E .
Cross- Single point estimate
sectional
Student’s T-Distribution
Bell shaped.
Shape is defined by df
df is based on ‘sample size’.
Symmetrical about it’s mean.
Less peaked than normal distribution.
Has fatter tails.
More probability in tails i.e., more observations are
away from the center of the distribution & more
outliers.

Page 2
Central Limit Theorem (CLT) Point Estimate (PE) Confidence Interval (CI)
For a random sample of size ‘n’ with; Single (sample) value Estimates
population mean µ, used to estimate Results in a range of values within
finite variance (population population parameter. which actual parameter value will
variance divided by sample size) Σܺ fall.
ഥ=
ܺ
σ , the sampling distribution of
2
݊ PE ±(reliability factor × SE).
sample mean x approaches a α= level of significance.
normal probability distribution Estimator: Formula used 1- α= degree of confidence.
with mean ‘µ’ & variance as ‘n’ to compute PE.
becomes large.
Desirable properties of
Properties of CLT an estimator
For n ≥ 30 ⇒ sampling distribution
of mean is approx. normal. Unbiased Efficient Consistent
Mean of distribution of all possible Expected value of If var (‫ݔ‬ଵ ) < var (‫ݔ‬ଶ ) As n , value of
samples = population mean ‘µ’. estimator equals of the same estimator
parameter e.g., parameter then ‫ݔ‬1 is approaches
E(‫ = )ݔ‬µ i.e, efficient parameter &
sampling error is than ‫ݔ‬2 sample error
zero. approaches ‘0’
e.g., As n ∝
‫ ݔ‬µ &
CLT applies only when
SE 0
sample is random.

Page 3
Distribution Variance Sample Test Statistic Issues Regarding Selection

Non Small Large of Appropriate Sample Size
Normal Known Unknown t z
normal (n<30) (n≥30) As n ; s.e. & hence C.I
becomes narrower.

Limitations of Large
* Sample Size

Large sample may Cost may

include increase more
*
observations from relative to an
more than one increase in
*The z-statistic is theoretically acceptable here, but use of the t-statistic is more population. precision.
conservative.
Biases
Data Mining Bias Sample Selection Bias Look –ahead Bias Time-period Bias
Statistical significance of Systematically excluding Using sample data that Time period over
the pattern is some data from analysis. was not available on the which the data is
overestimated because It makes the sample test date. gathered is either
the results were found non-random. too short or too long.
through data mining.
Data Mining Survivorship Bias

Using the same data to Most common form of
find patterns until the one sample selection bias.
that ‘works’ is discovered. Excluding weak
performances.
Surviving sample is not
random.
Warning Signs of
Data Mining
Evidence of testing Lack of economic

many different, mostly theory consistent
unreported variables. with empirical
results.

Page 1
∝ = Level of Significance SS = Sample Statistic
TS = Test Statistics “HYPOTHESIS TESTING” CV = Critical Value
TV = Table Value SE = Standard Error
Hypothesis Testing One Tailed Test Two Tailed Test

Hypothesis
Procedure Alternative hypothesis Alternative hypothesis
Statement about having one side. having two sides.
It is based on sample
one or more
statistics & probability Upper Tail H0: µ = µ0 vs Ha µ ≠ µ0.
populations
theory. H0:µ ≤ µ0 vs Ha: µ > µ0. Reject H0 if
It is used to determine Decision rule TS > TV or TS < –TV
whether a hypothesis is a Reject H0 if TS > TV
Null
reasonable statement or Lower Tail
Hypothesis H0 Two
not. H0:µ ≥ µ0 vs Ha: µ < µ0.
Tested for Types Decision rule
Steps in Hypothesis
possible Reject H0 if TS < TV
Testing
rejection.
Alternative 1. State the hypothesis.
Always
Hypothesis 2. Identify the appropriate
includes ‘=’
Ha test statistic and its
sign.
Hypothesis is probability distribution.
accepted 3. Specify the significance
when the null level.
hypothesis is 4. State the decision rule.
rejected. 5. Collect the data &
calculate the test statistic.
6. Make the statistical
decision.
7. Make the economic or
investment decision.
(Source: Wayne W. Daniel

and James C. Terrell, Business
Statistics, Basic Concepts and
Methodology, Houghton
Mifflin, Boston, 1997.)
Test Statistics Two Types of Significance

Hypothesis testing involves Errors Level (α )
Statistical Significance vs two statistics: Probability of
Economical Significance TS calculated from Type I Error Type II Error making a type I
Statistically significant results sample data. Rejecting a Failing to reject a error.
may not necessarily be Critical values of TS. true null false null Denoted by
economically significant. hypothesis. hypothesis. Greek letter
A very large sample size may alpha (α ).
result in highly statistically Used to identify
Decision Rule
significant results that may be critical values.
Based on comparison of TS to
quite small in absolute terms.
specified value(s).
It is specific & quantitative.

Page 2
σ 2 = Population Variance n = Sample Size df = Degree of Freedom

N.Dist = Normally Distributed n ≥ 30 = Large Sample
N.N.Dist = Non Normally Distributed n< 30 = Small Sample
Relationship b/w Confidence Intervals & p- value Power of a Test

Hypothesis Tests The smallest level of significance 1 – P(type II error).
Related because of critical value. at which null hypothesis can be Probability of correctly rejecting
C.I rejected. a false null hypothesis.
[(SS)- (CV)(SE)] ≤ parameter ≤ [(SS) + (CV)(SE)]. Reject H0 if p-value < α.
It gives the range within which parameter value
is believed to lie given a level of confidence.
Hypothesis Test
-C V ≤ TS ≤ + CV.
Range within which we fail to reject null
hypothesis of two tailed test at given level of
significance.
Testing Conditions Test Statistics Decision Rule
σ2 known x −µ 0 Ho:µ ≤ µ0 vs Ha: µ >µ0

z=
•
•
• N. dist. σ n Reject H0 if TS > TV

= or =
̅ ∗ ̅
n ≥30
/√
• Ho:µ > µ0 vs Ha: µ <µ0
Population Mean •
√
• σ2 unknown *(more conservative) Reject H0 if TS < –TV
• σ2 unknown x − µ0 • Ho:µ = µ0 vs Ha: µ ≠µ0
n<30 t n−1 = ; df = n-1
σ
•
n Reject H0 if TS > TV or TS < – TV
• N. dist.
( x1 − x2 ) − ( µ1 − µ 2 )
t( + −
=
n n 2
1 2
)
1 1
sP +
n1 n2
Unknown variances
where;
assumed equal. • Ho:µ1 - µ2 ≤ 0 vs Ha: µ1 -µ2 > 0
Equality of the ( n1 − 1) s1 + ( n2 − 1) s 2
2 2
sP = Reject H0 if TS > TV
Means of Two n1 + n2 − 2
Normally df = n1+n2 - 2
• Ho:µ1 - µ2 > 0 vs Ha: µ1 -µ2 < 0
Distributed ( x1 − x 2 ) − ( µ1 − µ 2 )
t= Reject H0 if TS < -TV
Populations based s12 s 22
+
on Independent n1 n 2
2 • Ho:µ1 - µ2 = 0 vs Ha: µ1 - µ2 ≠ 0
Samples. Unequal unknown  s12 s22 
 +  Reject H0 if TS > TV or TS < – TV
variances.
d . f =  12 2  2
n n
 s12   s22 
   
 n1  +  n2 
n1 n2

Page 3
Paired Comparisons Testing Variance of a Testing Equality of Parametric Test

Test N.dist. Population Two Variances from Specific to population
N.dist. Population parameter.
Relies on assumptions
TS
− 1
TS t(n-1 )= TS regarding the distribution of
=

=
; >

the population.

̅ = .

1 Decision Rule Non-Parametric Test

Decision Rule Do not consider a particular
Reject H0 if TS > TS
Reject H0 if TS > TV population parameter.
S Chi-Square Or
√n
S = F- Distribution Have few assumptions
Distribution

Asymmetrical. Right skewed. regarding population.
Bounded from below Bounded by zero.
∑ ( − ̅ )
=
by zero.
−1
Chi-Square values
can never be –ve.
Decision Rule
H0: µd ≤ µd0 vs Ha: µd > µd0
Reject H0 if TS > TV.
H0: µd ≥ µd0 vs Ha:µd < µd0
Reject H0 if TS <-TV
H0: µd = µd0 vs Ha: µd ≠ µd0
Reject H0 if TS > TV.

Page 1
“TECHNICAL ANALYSIS”
T.A = Technical Analysis S.D = Standard Deviations

F.S = Financial Statements 12. a M.A = Moving Average
C.F = Cash Flows M.V = Market Value
ROC = Rate of Change Study of collective market sentiment. MACD = Moving Average
RSI = Relative Strength Index Prices are determined by interaction of supply & demand. Convergence/Divergence
Key assumption of T.A is that EMH does not hold.
Usefulness is limited in illiquid markets as well as markets subject to large outside
manipulation.
Comparison
Technical Analysis Fundamental Analysis
Share price & trading volume Intrinsic value
Data is observable Use F.S & other information
Can applied on assets without C.F
12. b
Charts of price & volume.
Exponential price change ⇒ charts on a log scale.
Time interval reflects horizon of interest.
Types of price charts
Line charts Bar charts Candlestick charts Point & figure charts
Show closing prices as Opening & closing & Same data as bar ∆ in the direction of
data points on a high & low prices. charts. price.
continuous line. Use cross-hatches & Use boxes shaped as Horizontal axis reflects
vertical lines as candle’s body for no. of ∆ in price not
symbols. opening & closing time.
price. Price change
Price moves are much represents the height
more visible. which is “box size”.
Relative strength analysis Volume Chart
Assets closing price Usually included at the bottom of

Benchmark value. many charts.
in trend, asset is outperforming & vice versa. Volume on vertical axis.
12. c Trend in prices
Uptrend Downtrend
Reaching higher highs & retracing higher lows. Lower lows & retracing lower highs.
Show, demand is. Show, supply is .
Trend line connects increasing lows. Trend line connects decreasing highs.
Breakdown below uptrend line (significant price change). Breakdown above downtrend line (significant price change).
Support Level Change in polarity Resistance Level
Price range in which buying activity is Breached resistance levels become Price range in which selling activity
sufficient to stop decline in price. support levels & vice versa. is sufficient to stop rise in price.

Page 2
12. d Reversal Patterns
Signals the end of a trend

Head & shoulder patterns must be preceded by uptrend & inverse H&S must be preceded by downtrends.
Analyst use size of H&S pattern to project price target.
Double top & triple top Continuation Patterns
Indicate weakening buying pressure. (Similar to H&S). Used to predict the resumption
Selling pressure appears after resistance level. of a market trend.
Double bottom & triple bottom for downtrends.
Triangles Rectangles
Form when the range between high and low prices narrows. Form when trading temporarily range b/w support & resistance level.
Can be symmetrical, ascending or descending. Is a form of continuation pattern with one formed by connecting the high
Suggest buying & selling pressure roughly equal. prices and the other by connecting the lows.
Measuring implication: height of triangle at formation. Flags & pennants ⇒ Form over a short period of time, on a daily price chart.
12. e
Price based Indicators
Moving avg. lines
Mean of closing prices over a specified number of periods.

The longer the time-frame used to create M.A “n”, smoother the avg. line.
Uptrend price is higher then moving avg. & vice versa.
M.A for different periods can be used together.
Golden cross: Short-term M.A. crosses from underneath long-term M.A, buy signal. Dead cross: Short-term M.A crosses from
above long-term moving average, sell signal.
Bollinger bands
Based on S.D from average price over last n periods.

Analyst draw high & low bands above & below n-period M.A
Long-term investors may buy (sell) when price significantly exceeds (falls below) the upper (lower) bound.
Contrarian strategy ⇒ Buy (sell) when price reaches the upper (lower) band.
Oscillators
Tool to identify overbought or oversold market.

Based on M.P but scaled so that they “oscillate” around a value or between two values.
Charts used to identify convergence or divergence of oscillator & M.P
Convergence ⇒ same pattern as security, divergence ⇒ Oscillators demonstrate vice versa.
Examples of oscillators
ROC or Momentum RSI MACD Stochastic oscillator
100 × Diff. b/w last closing price & Ratio of = Total price Use exponentially smoothed Calculated from latest closing
closing price x days ago. Total price M.V price & highest & lowest
Buy when oscillator into crosses Oscillate b/w 0-100 . Oscillate around 0 but not prices.
positive territory & vice versa. Value> 70 ⇒ overbought. bounded. Use two lines bounded 0 &
Can be around 0 or around 100. Value < 30 oversold. MACD and signal lines used in 100.
technical analysis in three %k = diff. b/w latest price &
ways: Crossover between recent low as % of diff. b/w
signal line and the MACD; recent high & lows.
trends lines on the MACD Average of the last three %K
itself; and the MACD in or values calculated daily.
outside range.

Page 3
12. e Non-Price-Based Indicators
Sentiment indicators ⇒ to gain insight into trends.

Bullish⇒ increasing prices, bearish ⇒ decreasing prices.
Opinion polls⇒ measure investors’ sentiments directly.
a. Sentiment Indicators b. Flow of funds indicators
1. Put/Call Ratio Useful for observing changes in demand & supply of

securities.
Put/call ratio = Put volume
Call volume 1. Arms index or short-term trading index (TRIN)
Ratio ⇒ market sentiment is extremely negative; likely increase in price.
Viewed as contrarian indicator. Measure of funds flowing into or out of advancing &
Extremely high ratio ⇒ bearish outlook & vice versa. declining stocks.
. .
/.

TRIN =

.
/

2. CBOE Volatility Index (VIX)
Index value close to 1 ⇒ flowing evenly to advancing &
declining stocks.
Measure volatility of options on S&P 500 stock index.
Value > 1 ⇒ majority in declining stocks, value < 1 ⇒
High VIX ⇒fear declines in stock market.
majority in advancing stocks.
Technical analysts interpret VIX in contrarian way.
2. Margin debt
3. Margin Debt
Margin debt ⇒ investor wants to buy more stocks & vice versa.
in M.D, buying, when reach their limit, buying ,
prices , investor sell securities to meet margin calls. 3. Mutual fund cash position
M.D coincides with prices & M.D with prices.
Ratio of = fund’s cash/total assets.

4. Short Interest Ratio Uptrend ⇒ ratio & vice versa.
T.A analysts view as contrarian indicator.
Short interest is no. of shares borrowed & sold short.
Short interest ratio = short interest / Avg. daily trading volume. 4. New equity issuance
Some analysts may believe that if ratio increases market should
express decrease in price and vice versa. IPO add to supply of stocks.
Secondary issues do not increase the supply of stock but rather increase
shares available for trading.
Issuer tends to issue when market peaks, so issuance coincide with high price.
12. f
Cycle theory is study of processes that occur in cycles.
Cycle Periods
Presidential Cycles Decennial Patterns Kondratieff wave Kondratieff wave
Tied to U.S. Presidential Broken down on the basis of 54-year 18-year Cycle
elections cycle with the the last digit in the year; years
third year being prior to ending with a 0(5) have had
election year. the worst (best) performance.

Page 4
12. g Elliott wave theory 12. h

Intermarket analysis
Financial market prices ⇒ described by interconnected set of cycles.
Analysis of interrelationship among M.V of asset classes (e.g. stocks,
Waves ⇒ chart patterns, uptrend ⇒ 5 upward waves, 3 downwards &
bonds)
vice versa in downtrend.
Relative strength ratio ⇒to identify outperforming asset class, then
Ratios of the size of the subsequent wave ⇒ Fibonacci ratios.
assets within class.
Fibonacci sequence starts with the numbers 0, 1 and 1, and the each
subsequent number in the sequence number in the sequence is the
sum of the two previous numbers.
Ratio of 0.618 and 1. 618 used to project price targets.

Gen. = Generally
MR. = marginal
revenue
“TOPICS IN DEMAND &
MC. = marginal cost
Prof. max. = profit SUPPLY ANALYSIS”
maximization
Q.D = Quantity
Demanded
Pmt. = payments 1. INTRODUCTION This reading explores how buyers & sellers interact
LR= long-run to determine transaction prices & quantities.
SR=short-run
SMC=short-run
marginal cost 2. DEMAND ANALYSIS
LMC = long-run
marginal cost
MP = marginal
productivity
2.1 2.2 2.3 2.4 2.5 2.6

Demand Own-Price Income Cross-Price Substitution Normal &
Concepts Elasticity of Elasticity of Elasticity of & Income Inferior
Demand Demand Demand Effects Goods
Law of Demand: %∆ . %∆ . Two reasons why • Substitution

= =
As the price of good %∆ %∆
demand is –vely effect of a ∆ in
↑ (↓), buyers buy (other factors (other factors sloped: price of a good is
↓ (↑). constant) constant) 1) Substitution always in the
Demand Function: • income elasticity • if cross price- Effect: when price direction of
Qdx = f(Px, I, Py) can be +ve, -ve, or elasticity of two ↓, consumers buying more at a
Demand Curve: zero. goods is: purchase ↑. less price or
Highest quantity • Normal goods [+ve • +ve goods are 2)Income Effect: ↓ buying less at
purchased at given income elasticity] substitutes in price of a good more price.
price or highest price • Inferior goods [-ve • -ve goods are results in ↑ in • Same is true for
paid at given quantity. income elasticity] complements consumer’s real Income effect for
income & if it is normal goods.
normal good, • For inferior
more of it will be goods, income
%∆ .
= purchased. effect &
%∆

(other factors constant) substitution
effect work in
• when the magnitude of elasticity is:
opposite
i. >1, demand is elastic.
directions.
ii. < 1, demand is inelastic.
iii. =−1, demand is unit elastic.
Giffen Goods:
Inferior goods that
consumer more
2.2.1 2.2.2 2.2.3 (less) as price rises
Extremes of Predicting Elasticity & Total (fall) i.e. income
Price Elasticity Demand Elasticity Expenditure effect overwhelms
their substitution
effect.
Vertical Demand Curve: Gen. Own-Price Elasticity of When demand is elastic Veblen Goods:
Same Q.D regardless of Demand will be ↑ (more sensitive) (inelastic): High status goods
price (inelastic demand) for items that: • Price & total that ↑ in
Horizontal Demand Curve: • have close substitutes. expenditure (PxQ) desirablility with ↑
A slight ↑in price will cause • occupy large portion of total move in opposite in price.
0 demand (perfectly elastic budget. (same) direction.
demand). • are optional
• have longer adjustment times.
1
3. SUPPLY ANALYSIS: THE FIRM
3.1 3.2 3.3

Marginal Returns Breakeven & Understanding Economies
& Productivity Shutdown Analysis & Diseconomies of Scale
• Short-run: time period during which at least one

Increasing marginal returns: of the factors of production is variable.
• ↑ in marginal product as additional unit of • Long-run: time period during which all factors of
that input is employed. production are variable.
3.1.1 3.1.2 3.3.1 3.3.2

Productivity: The Total, Average & Short & Long –run Defining Economies &
relation b/w Marginal Product Cost Curves Diseconomies of Scale
Production & Cost of Labor
Total cost of production: Total Product is sum of the • SR avg. total cost Economies of scale:
TC = (w)(L) + (R)(K) output from all inputs. Q x L curve (SATC): Avg. • ↓ in per unit cost by ↑ in
• TC can be ↓ by ↑ Average Product: is total total cost curve when production.
productivity or by ↓ product divided by quantity of some costs are fixed. • LRAC curve with a –ve
• LR avg. total cost curve
ொ
input price & vice versa. a given input. . slope.
௅
Benefits of increased Marginal Product: additional (LATC): Avg. total cost Diseconomies of scale:
productivity output resulting from one curve when no cost is • ↑ in per unit cost by ↑ in
• ↓ business cost ∆ொ fixed. production.
additional unit of input. .
• ↑ in mkt value of equity ∆௅ • LRAC curve with a +ve
• Compared to total product,
• ↑ in worker rewards slope.
average product & marginal
• ↑ in firm’s competitive
product better gauge firm’s
On next page
position in the long-run.

productivity.
2
3.2.1 3.2.2 3.2.3 3.2.4 3.2.5 3.2.6 3.2.7

Economic MR, MC & Understanding Revenue under Profit- Breakeven The
Cost vs. Profit the interaction conditions of maximization, Analysis Shutdown
Accounting Maximization b/w Total, Perfect & Breakeven & Decision
Cost Variable, Fixed & Imperfect Shutdown Points
MC & Output Competition of Production
Accounting cost:
Monetary value of
economic resources • TC curve lies parallel to & Under perfect Firm B.E.P →TR =
used in business above TVC by the amount competition: maximizes TC, a point
activity i.e. explicit of TFC. • Demand curve is profit by where a
out-of-pocket current • MC curve intersects both horizontal. producing Q firm earns
pmts or allocation of AVC & ATC at their min. • TR curve is linear where P = normal
historical pmts for points. with slope equal to SMC & SMC economic
resources. • If MC is ↓(↑) than AC, AC price per unit. is rising. profit.
Economic Cost: The must ↓ (↑). Under imperfect
sum of total • The rate of ∆ in TC mirrors competition:
accounting costs & the rate of ∆ in TVC. • Demand curve is –
implicit opportunity • Quasi-fixed cost: Cost that vely sloped.
costs. stays same over a range • TR curve rises in the
Accounting Profit: of production & then ∆ range where MR is
Income before tax on when production moves +ve & demand is
income statement. outside of that range. elastic & then falls in
Economic Profit: • AFC ↓ throughout the the range where MR
Accounting profit – production span. is –ve & demand is
implicit opportunity inelastic.
cost.
MR =
∆்ோ
• Sunk costs must be ignored to continue to operate in the SR.
∆ொ
For a firm operating under: • A firm, covering its variable cost, should operate in the SR.
• Shutdown point→ min. AVC.
• Perfect competition→MR = P
• Breakeven point:→min.ATC.
• Imperfect competition→MR < P
∆்஼
MC =
∆ொ Rev. cost relation SR Decision LR Decision
SMC: additional incurred cost of variable TR = TC Stay in mkt. Stay in mkt.
input to ↑ 1 unit of output. TR = TVC but < TC Stay in mkt. Exit mkt.
LMC: additional incurred cost of all TR < TVC Shutdown production Exit mkt.
inputs to ↑ the level of output. Reference: Exhibit 22: CFA Institute’s curriculum Reading 14
Law of diminishing returns: additional
output must fall as more and more labor
is added to fixed capital.
For profit. maximization: firms should
produce the level of output such that:
i) MR = MC & ii) MC is not falling.
3
Page 1
“THE FIRM AND MARKET STRUCTURE”

1. INTRODUCTION
In a highly competitive market, long-run profits are decreased by the forces of competition.
In less competitive markets, large profits can persist in the long-run.
In the short-run, any outcome is possible
2. ANALYSIS OF MARKET STRUCTURE
2.1 Economist’s Four Types of Structures 2.2 Factors that determine Market Structure
Perfect Monopolistic Oligopoly Monopoly Number & Degree of Barriers to Power of Degree of
Competition Competition relative size product entry & exit sellers over non-price
of firms differentiation pricing competition
decisions
Allocative/
Market Number of Degree of Product Barriers to Pricing Power Non-Price Firm’s Non-price Long-run
productive
Structure Sellers Differentiation Entry of Firm Competition Demand competition profits
efficiency
Perfect Homogeneous/Stand Perfectly
Many Very Low None None None Highly efficient 0
Competition ardized elastic
Elastic over
Advertising and some price Less efficient than
Monopolistic
Many Differentiated Low Some Product ranges and Considerable perfect 0
Competition
Differentiation inelastic over competition.
others
Considerable
Advertising and Less efficient than
Homogeneous/Stand Some or Kinked for a
Oligopoly Few High Product perfect Positive
ardized Considerable demand differentiated
Differentiation competition.
oligopoly.
Monopoly One Unique Product Very High Considerable Advertising Inelastic Somewhat Inefficient High
3. PERFECT COMPETITION 3.3 Optimal Price and Output in Perfectly

Competitive Markets
Characteristics: Advantages: An individual firm represents a small seller among a

i) Free entry & exit to industry i) High degree of competition helps in efficient large number of firms in the industry.
ii) Homogenous Product allocation of resources Firm faces infinitely elastic demand curve
iii) Large number of buyers & sellers ii) In the long run, firm can make only normal
Price is determined by the market supply & demand,
iv) Sellers are price takers profit
v) No Price competition iii) Firms operate at maximum efficiency. which implies that shift in supply curve of a single
iv) Larger quantity of goods at the lowest price firm does not affect the market price
Total revenue increases by a constant amount
In perfect competition, Marginal Revenue = Avg.
Revenue = Price = Demand i.e. MR = AR = P = D
Short-run: In the short run, firms make economic profit/loss

Long-run: New firms enter into the industry → supply increases →
↓ P → Firms make normal profit

Page 2
3.1 Demand Analysis in a perfectly competitive Market Impact of Elasticity on Total Revenue
3.1.1 Elasticity of Demand

When Demand is elastic When Demand is inelastic:
It is the responsiveness (%Qd>%P): (% Qd < % P)
↑P → ↓TR ↓ P → ↓ TR
of quantity demanded
↓ P → ↑ TR ↑P → ↑TR
to change in price (all
else constant)
Total Revenue is Max. at point where |Ed| = 1
3.1.1 Elasticity of Demand Total Revenue is Max. at point where MR = 0
Relationship b/w MR & Price elasticity

MR = P (1 – )

Elastic Demand Unit Elastic Inelastic Effect of steepness/flatness of demand & supply curve on the price elasticity
|ED|>1 |ED| = 1 Demand o Steeper the curve at a given point, less elastic supply or demand will be
|ED|<1 o When curves are flat, demand & supply is referred as perfectly elastic i.e., Demand is
affected by P. (EP = infinity)
o When curves are vertical, supply & demand curves are referred as perfectly inelastic.
(EP = 0). Demand is not affected by P.
Determinants of Elasticity
Time Period Number & closeness Proportion of Luxury or necessity:

Longer the period of substitutes: income taken up by
greater the Greater the number the product E E
elasticity of substitutes, more Larger the
elastic the demand proportion, more
elastic the demand
3.1.2 Other Factors Affecting Demand
Income Elasticity of Cross Elasticity:

Demand:
%∆
%∆

%∆ %∆
Normal Good: Inferior Goods: Complements: Substitutes:

I↑→Q d↑ I↑→Q d ↓ ED < 0 ED > 0
I↓→Q d ↓ I↓→Q d ↑ ↑PY → Q X↓ ↑PY → Q X↑
EY > 0 EY < 0 ↓PY → Q X ↑ ↓PY → Q X ↓
3.1.3 Consumer Surplus
CS = Value Consumer places on units consumed – Price paid to buy those units
3.2 Supply Analysis in Perfectly Competitive Markets
↑P→↑QS
Market Supply: It is the horizontal sum of all

individual supplies (quantity only) at each possible
price

Page 3
4. MONOPOLISTIC COMPETITION
4.1 Demand Analysis in Monopolistically Characteristics:

Competitive Markets i) Many Buyers & sellers
ii) Differentiated Products
Monopolistic Competition firm has a iii) Low cost Entry & Exit
downward sloping demand curve due to iv) Firms have some control over price
product differentiation v) Use of advertising & other non-price strategies
Price > MC
Price = ATC → Long-run
Monopolistically Competitive Firm in the Short Run:
MR < Price Profit is maximized where MR = MC
No well defined supply schedule
Output level is determined at a point
where MR = MC
SR-Economic Profit encourages new firm to enter the market resulting SR-Economics losses encourage firms to exit the market:
in: i) Decrease in number of products offered
↑ number of products offered. ii) Increase in demand faced by remaining products.
Reduction in demand faced by firms already in the market iii) Shift the remaining firms’ demand curve to the right
Incumbent firm’s demand curve shift to the left. iv) Increase the remaining firms’ profit
Demand for incumbent firm’s products fall, & the price declines
Differences between Monopolistic Competition & Perfect Competition
In perfect competition, there is no excess capacity in For competitive firm P = MC Unlike perfect competition, in
the long-run, firms produce at their efficient scale. For monopolistically competitive monopolistic competition explicit
In monopolistic competition, output is at less than firm P > MC cost include advertising or
efficient scale of perfect competition marketing cost
5.1 Demand Analysis and Pricing Strategies 5. OLIGOPOLY
Demand depends on degree of pricing inter Characteristics:

dependence i) Few sellers
In case of price collusion, aggregate market ii) Industry dominated by small number of large firms
iii) Product offered by each seller is close substitutes for the products offered by
demand curve is composed of individual
other firms
production participants iv) Independent firms
In case of non-collusion, each firm faces an v) Barrier to entry & exit are high
individual demand curve vi) Firms have substantial control over price
vii) Products are differentiated through advertising & other non-price strategies.
Duopoly: It is an oligopoly with only two Price Collusion: An agreement among firms Cartel: A collusive agreement that are made
producers in the market. on the quantity produced and price to openly & formally
charge.
Profit increases.
Factors necessary for a collusion to be successful
Uncertainty of cash flows reduces.
i) Small number of firms in the industry
Provide opportunities to create barriers to
ii)Products produced by firms are identical/same
entry
iii)
Similar cost structure
iv)Orders received by firms are small in size & are
frequent
v) Severe threat of retaliation by other firms in the
market

Page 4
Pricing Strategies
Price interdependence: Cournot Assumption:

Firm pricing decisions depend on each other Profit maximizing output by each firm is
Firms face two demand curves i.e. kinked determined by assuming no change in other
demand curve firms’ output.
Nash Equilibrium:
Game theory: Study of how people behave in strategic situations
Nash equilibrium occurs in a non-game situation when a participant is unwilling to deviate from its
strategy having considered their opponent’s strategies.
5.2 Supply Analysis in Oligopoly Market 5.3 Optimal Price & Output in Oligopoly market
No well defined supply schedule There is no single optimum price & output
Output level is determined at point where analysis that is appropriate for all oligopoly
MR = MC market situations.
In the long run, firms either generate
Dominant firm: A firm is referred to as positive profits or breakeven
dominant when firm’s market share ≥ 40%. Reducing prices lead to decline in total
revenue for all the firms
Greater Capacity Lower cost structure First market Greater customer

advantage loyalty
6. MONOPOLY
Characteristics:
i) Single seller & product is highly differentiated
ii) Product offered by a firm has no close substitutes
iii) High barrier to entry
iv) Significant control over pricing (or output/supply)
v) Product is differentiated by the seller by using non-price strategies
Factors that allow Monopoly to exist:

i) Barrier to entry in the market in the form of patent or copyright
ii) Significant control over critical resources
iii) Natural monopolies exist in industries where the production is based on significant economies of scale & dealing with cost structures in the market
iv) Strong brand loyalty
v) Firm has greater market power due to increasing returns associated with network effects
6.1 Demand Analysis in Monopoly Markets 6.2 Supply Analysis in Monopoly Markets 6.4 Price Discrimination and Consumer Surplus
Monopolist has downward sloping i) Price is determined by the demand curve It refers to charging consumer different
demand curve ii) Optimal level of quantity is determined prices for the same good
Average Revenue Curve = Market by the intersection of MC and MR i.e. at
Demand Curve QM
Monopolist profit is maximized at iii) Profit maximizing price & output exist at First-degree Price Second-degree Third degree Price
quantity of output where MR = MC the elastic portion of demand curve Discrimination: Price Discrimination:
P = MC → Perfectly competitive firm’s Each consumer is Discrimination: Consumers are
profit-maximizing quantity of output. charged the Monopolist offers segregated by
P > MR = MC at the monopolist profit – Relationship between MR & Price
highest price that a menu of demographics or
maximizing quantity of output. elasticity in Monopoly:
he/she is willing quantity-based other traits.
MR = P × [1 - ] =
ು to pay. pricing options
Relative to competitive industry, a and consumers
monopolist: can select based
i) Produces a smaller quantity (QM < QC) on how highly
ii) Charges a higher price (PM > PC) they value the
iii) Earns economic profit. product.

Page 5
7. IDENTIFICATION OF MARKET STRUCTURE
7.1 Econometric Approaches 7.2 Simpler Measures
a) Market power can be measured by estimating the elasticity of demand i) Concentration Ratio
& supply in a market CR = Sum of sales value of the largest x firms/ Total market sales.
Highly elastic → close to perfect competition 0 ≤ CR < 100%
Inelastic → Firms have market power CR = 100% for monopoly
b) Using cross-sectional regression analysis instead of time series analysis CR = 0% for perfectly competitive industry
Complex method ii) Herfindahl-Hirschman Index (HHI):
Different specifications of explanatory variables HHI = Σ squared market share of the ith firm
HHI = 1 → Perfectly competitive industry
For M firms in the market with equal market share:
HHI = (1/M)
Not direct measure of market power
Less appropriate as a profitability measure as it ignores elasticity of
demand

Page 1
“AGGREGATE OUTPUT, PRICE AND ECONOMIC GROWTH”

Los 16.a
GDP = ∑ MV (final goods & services) produced

during a period within the country.
Approach to GDP
Expenditure Approach: Income Approach:

GDP = ∑ expenditure (cost) on goods & GDP = ∑ income earned by households
services produced in the country within & businesses in the country during a
a specific period. period.
Los 16.b Expenditure Approach
Sum-of-value added: Value-of-final output:

GDP =∑ value created at each stage of GDP = ∑ value of final goods & services
production & distribution during a produced during the period.
period.
Los 16.c GDP
Nominal GDP: Real GDP:

GDP = ∑ = ∑
Measure goods & services at their Measure current year output using
current cost. base prices.
GDP deflator: Price index that is
Per capita real GDP =

used to convert nominal GDP to
real GDP.
Los 16.d Components of GDP
Consumption (C) Investment (I) Government spending (G) Net Exports (X-M)
Income
National Income: Personal Income: Personal Disposable Income:

NI = ∑ Income received by PI = Pre-tax income received by Personal income × (1-tax rate).
factors of production used in households.
the production of final output.

Page 2
Los 16.e
(G-T) = (S-I) – (X-M)

where,
G-T = Fiscal balance.
X-M = Trade balance
Thus If;
G-T > 0
⇒X-M < 0 (Trade deficit), or
⇒S-I > 0 (Excess private savings).
Los 16.f
IS curve:
(S-I) = (G-T) + (X-M)
It shows the –ve relationship at each level of real interest rate b/w
real interest rate and levels of aggregate income.
LM Curve:
According to quantity theory of money:
MV = PY
where,
M = Nominal money supply
V = Velocity of money
P = Price level
Y = Real income/expenditure
⇒ M/P = Y × (1/V)
It shows the +ve relationship between real interest rate & level of
real income, for a given level of real Ms, at which real MD= real Ms.
Aggregate demand curve is combination of points where IS & LM

curves intersect each other for different levels of real Ms, keeping
nominal Ms Constant.
Los 16.g
Aggregate Supply Curve:

It shows the relationship b/w price level and quantity of real GDP
supplied, keeping all other factors constant.
SRAS curve is upward sloping.
VRAS curve is perfectly elastic.
LRAS curve is perfectly inelastic (vertical).
LRAS shows potential GDP.

Page 3
Los 16.h Aggregate Demand Curve
Movement: ∆ in price level causes Shift in AD curve:

movement along the curve. ∆ in household wealth.
∆ in consumer & business expectations.
Capacity utilization.
Fiscal & Monetary policy.
Currency exchange rate.
Global economic growth rates.
Aggregate Supply Curve
Movement: ∆ in price level causes Shifts in AS curve:

movement along the curve. Short-Run:
∆ in nominal wages or other input prices.
Expectations about future prices.
Business taxes & subsidies.
Currency exchange rates.
Factors affecting LRAS.
Long-Run:
∆ in labor supply & quality of labor.
∆ in physical capital supply.
Availability of natural resources.
Level of technology.
Los 16.i Gaps
Recessionary Gap: Real GDP < Inflationary Gap: Real GDP > potential
potential GDP ⇒ input prices. GDP ⇒ input prices.
Stagflation:
High unemployment and increasing inflation. (Or) weak economic growth +
high inflation (may be caused by sudden in short-run AS).
Fixed income investments.
Investment in equities.
Investment in commodities.
Los 16.j Sources of Economic Growth
Labor Supply Human Capital Physical Capital Stock
Technology Natural Resources

Page 4
Los 16.j
Potential GDP = Agg. Hours worked × labor

productivity (or)
Growth in potential GDP = Growth in labor-force +
Growth in labor-productivity.
Sustainable rate of economic growth
= f (rate of in labor force, rate of in labor
productivity).
Los 16.k
Production function:
It shows the relationship between:
Output & labor,
Capital stock.
Productivity
Total factor productivity ⇒ advances in
technology.
Los 16.L
Growth in potential GDP = Growth in technology + (growth in

labor) + (growth in capital)
where,
= Labor’s % share of national income.
= Capital % share of national income.
Growth in per-capital potential GDP = Growth in technology +
(growth in capital-to-labor ratio)

Page 1
“UNDERSTANDING BUSINESS CYCLES”

17. a
Business cycle is defined by fluctuations in the economic activity.

Real GDP & unemployment rate are the key measures used to evaluate current
phase of business cycle.
Phases of Business Cycle
Expansion: Real GDP Peak: Real GDP Begins Decreasing Contraction: Real GDP Early expansion (recovery): Real
GDP Begins Increasing
Output Output
Employment Employment
Consumption & Investment Consumptions & Investment
Inflation Inflation
17. b
Inventories are an important business cycle indicator.

Inventory/Sales ratio typically increases in later stage of expansion.
Firms try to adjust their utilization of labor & physical capital in reaction to
fluctuations in business activity.
Firm lay (add) employee during contraction (expansion) slowly as it is a high cost
activity, buying & selling plant and equipment is costly, firms adjust production
levels by their current physical capital.
Investment in new capacity is only made if expansion is likely to persist.
17. c Theories of the Business Cycle
Neoclassical Economists
Business cycles are temporary

Driven by ∆ in technology.
Economy moves toward full employment as a
result of rapid adjustment of wages & other input.
Keynesian Economists
Lowering interest rates may not reignite economic

growth and government intervention through fiscal
policy may be required.
Wages are slow to move downward ⇒ Contraction can
persist for long.
According to “New Keynesians” prices of input variables
other than labor also slowly move downward.

Page 2
17. c Theories of the Business Cycle
Monetarists
Money supply needs to grow at a moderate rate

otherwise economic downturn may be severe or
inflation may accelerate. Business cycles may occur
due to exogenous shocks or govt. intervention.
Austrian School
Government intervention that drives interest rates

to be artificially low trigger’s business cycle.
Real Business Cycle Theory
Utility maximizing factors’ response to real economic

forces explains the business cycle.
17. d Types of Unemployment
Frictional Unemployment Structural Unemployment
Results from time lag between which Results from long-term economic changes.
employees & employers find each other.
Cyclical Unemployment
Result from changes in general level of

economic activity.

=

An individual, who is actively seeking for work, is available for work
but not working is considered as “unemployed”.
Labor force includes all individuals who are working or are available for
work.

=


Page 3
17. e
Inflation: Sustained increase in price levels over a time period

referred as inflation.
భ
= −1
బ
Deflation: Sustained decrease in price level over a time period is

referred as deflation.
17. f
. & భ

=
. & .
CPI is one of the most widely used price index.

Percentage change in prices index for all goods in the economy is known
to as Headline inflation.
Percentage change in price index excluding food & energy prices is
referred as core inflation.
17. g
Laspeyres Price Index:

Price index created by keeping the composition of the consumption
basket constant.
Biases causing Laspeyres Price Index to be Biased Upward:
New goods Quality changes Substitution
Paasche Price Index:

Reduces substitution bias.
Uses current consumption weights for basket of goods/services for both
current & prior (base) period.

Page 4
17. h Types of Inflation
Cost-push inflation: Demand-pull inflation:

Real price of an important factor ⇒ Persistent in AD ⇒ P ⇒temporarily
aggregate supply. output > potential or full-employment level
Unemployment rate below which upward pressure wages is likely to develop is represented by
NAIRU (Non-Accelerating Inflation on Rate of Unemployment).
17. i Economic Indicators
Leading indicators: Coincident indicators:

They have turning points before peaks/ They have turning point at the same point as
trough in business cycle. the business cycle.
Lagging indication:
They have turning points that occur after that of
business cycle.
Limitation:
Relationship b/w various indicators & business cycle
is not exact.
Relationship varies over time.
17. j
Analysts should use variety of indicators

together rather than relying on any one
indicator.

Page 1
“MONETARY AND FISCAL POLICY”
LOS 18.a Fiscal Policy:

Use of Spending and Taxation by government to stimulate
economic activity
T – GE > 0 → Budget Surplus
T – GE = 0 → Balanced Budgets
T – GE < 0 → Budget Deficit
Monetary Policy:
It refers to central bank activities to stimulate economic activity
through quantity of money (MS) & credit in an economy.
Expansionary ↑ Contractionary ↓
Quantity of Quantity of
Money & Credit Money & Credit
LOS 18.b Money: Medium of exchange
Qualities of Money: Functions of Money:

i) Acceptance i) Medium of exchange
ii) Divisibility ii) Store of value
iii) High value relative to weight iii) Units of account
iv) Difficult to counterfeit
Fractional Reserve System:

New money created is a multiple of new excess reserves available for lending
by banks
1

=

↑ reserve requirement → ↓ Mulplier

↓ reserve requirement →↑ Multiplier
LOS 18.c Reasons for Holding Money
Transactions- Precautionary Speculative

related Demand
Central bank determines the level of money supply with the

objectives of managing inflation & economic activities
LOS 18.d
Fisher Effect:
Nominal interest rate = RReal interest rate + Expected inflation
RNOM = Real + E (I)

Page 2
LOS 18.e
Roles of Central Bank
Sole supplier of Banker to Regulator and Lender of last resort Manage country’s Conductor of
currency Government and supervisor of gold & foreign Monetary Policy
bankers’ bank payment system exchange reserves
Objectives of Central Banks
Controlling inflation Currency stability Full employment Positive sustainable Moderate interest
economic growth rates
Central Bank Tools
Policy rate Reserve Open Market

Requirements Operations
↓ Policy rate
↓ Reserve requirements ↑ MS → Expansionary Policy
LOS 18.g Essential Qualities
Independence Credibility Transparency
Los 18.h Monetary Transaction Mechanism
Market interest Asset Prices Growth Exchange rates

rates Expectations
Influence domestic and net external demand

⇒ affect economic growth & inflation
Los 18.i
Neutral interest rate = Real trend rate of economic growth + inflation target
Real trend rate ≈ Long-term sustainable real growth rate of an economy
Policy rate > Neutral rate → Contractionary Monetary Policy
Policy rate < Neutral rate → Expansionary Monetary Policy
Los 18.j Limitations of Monetary Policy
Long-term interest rates may move opposite to short-term interest rates

Greater cash holding (liquidity trap)
Unwillingness of bank to lend greater amount.
Short-term rates can’t fall below zero

Page 3
LOS 18.k Fiscal Policy: Government use of taxes &

government spending policies
Budget Surplus Budget Deficit

(T > GE) (T < GE)
Objectives of Fiscal Policy
Influence level of Distributing Resource allocation

economic activity Wealth/Income among sectors and
economic agents
LOS 18.l Fiscal Policy Tools
Spending Tools Revenue Tools

i) Transfer payments i) Direct taxation
ii) Current spending ii) Indirect taxation
iii) Capital spending
Fiscal Policy
Advantage: Disadvantage:
i) Quickly implement social policies i) Implementation time lag regarding in direct taxes
Indirect Taxes
ii) Quickly raise revenue at low cost ii) Delayed impact of changes in capital spending
LOS 18.m Size of Fiscal Deficit
Arguments for being concerned: Argument against being concerned:

i) Higher deficit leads to higher taxes i) Debt financed by domestic citizens
ii) If market loses confidence, central bank may ii) Deficit due to capital spending may increase
need to finance govt. debt. productive capacity of the economy
iii) Crowding-out effect iii) Tax reforms needed
iv) Ricardian equivalence
v) If there is unemployment in the economy, debt
can be used to increase employment; thus
crowding out effect is not triggered.
LOS 18.n Causes of Delay
Recognition lag: Action lag: Impact lag:

Unable to recognize needed Time taken by government Policy takes time to
changes in discussing, voting, & stimulate economic activity
enacting policy
LOS 18.o
↑ (↓) government budget surplus ⇒ Contractionary (expansionary) fiscal policy

↑ (↓) government budget deficit ⇒ Expansionary (contractionary) fiscal policy

Page 4
LOS 18.p
Policy Particulars
Monetary Fiscal Interest Rates Output
Contractionary Expansionary ↑ ↑
Expansionary Contractionary ↓ Variable
Contractionary Contractionary ↑ ↓
Expansionary Expansionary ↓ ↑
Particulars
Private Sector Spending Public Sector Spending
↓ ↑
↑ ↓
↓ ↓
↑ ↑

Page 1
“INTERNATIONAL TRADE AND CAPITAL FLOWS”

LOS 19.a Increase in Economic Welfare
Free trade Greater product More competition More efficient

variety allocation of
resources
Cost of free trade (losses) is borne by domestic industries that lose business to foreign
competition as less efficient producers will leave industry eventually.
⇒ ↑ unemployment
Some argue that,
Benefit of free trade > cost of free trade
LOS 19.b Advantage
Absolute Advantage Comparative Advantage

Lower cost (fewer resources) in production of good Lower opportunity cost of producing a good compared to its
compared to its trading partner trading partner
LOS 19.c Trade Models
i) Ricardian Model of Trade: Heckscher-Ohlin Model

Labor is the only factor of production There are two factors of production
Production cost & Comparative Advantage i) Capital
is derived by differences in labor ii) Labor
productivity due to difference in technology Relative amount of each factor a country
possess derives the comparative advantage
LOS 19.d Reasons for Trade Restrictions
Infant Industry National Security Protecting Protecting

Domestic Jobs Domestic
Industries
Types of Trade Restrictions
Tariffs: Quotas: Domestic Content Provisions: Voluntary Export Restrictions:

Tax on imported goods by Limiting the quantity of imported A certain % of value added or A voluntary restriction on quantity
government goods from a specific period components used in production exported by a country for a specific
should be from domestic country period
PD↑ → Q I ↓ ↑ PD
→ QD↑ → Gain Domesc Producers
→ Loss Domesc Consumer
Trade restrictions result in:
↓ Imports ↑ Price ↓ Domestic ↑ Domestic ↑ Producer

Consumption Qs Surplus
Export subsidies → ↓ PE → Benefit exporng country at the expense of imporng country government.

Page 2
LOS 19.e Trade Agreements
Free trade area: Customs union: Monetary union: Common Market: Economic union:
No barriers at all b/w Common set of Adoption of single Allowing free Common institutions &
member countries restrictions against currency movement of factors of coordination of
non-members production among economic policies
members among members
LOS 19.f Balance of Payment
Current Account: Capital Account: Financial Account:

Imports & Exports Debt forgiveness Govt. owned assets abroad.
Foreign income from dividends & Migrated assets Foreign owned assets in the country
interest Transfer of funds for sale / purchase Official reserve assets and private
Unilateral transfers of assets assets abroad
Rights to natural resources Direct investment in domestic
Patents, copyrights etc. country
Any surplus (Deficit) in current Account must be offset by deficit (Surplus) in capital & financial account
LOS 19.g
At equilibrium,
Exports – Imports = Private Savings + Government Savings – Domestic Investments
(Or)
X – M = Private Saving + Government Savings – Domestic Investments
Lower level of private savings

Larger Government Deficit Current Account Deficit
High private investment
LOS 19.h Goals of International Monetary Fund (IMF)
Provides forum for Promotes employment, Exchange rate stability Supports open system of Making resources
cooperating on economic growth and international payments. available to members
international monetary poverty reduction and experiencing BOP
problems. facilitates growth of difficulties
international trade.
World Bank Provides
Low interest loans Interest-free credits Grants to developing

countries for many
specific purposes
World trade organization (WTO)

Deals with global trading rules between nations
Ensures smooth, predictable & free trade flows

Page 1
“CURRENCY EXCHANGE RATES”

LOS 20.a
Exchange rate: The price or cost of one currency (DC or FC) in terms of another (FC or DC)
e.g.
DC/FC = Domestic currency per unit of foreign currency
$ 2.510/£ = 2.510 Dollars per one unit of pound.
Nominal Exchange Rate: $2.510/£ means one pound unit can purchase 2.510 units of U.S. dollars.
Real Exchange: It shows the dollar cost of purchasing same unit of goods/services based on
relative price levels among two countries & the current dollar/pound exchange rate.
ಷ಴
Real exchange rate (d/f) = nominal exchange rate (d/f) ×
ವ಴
All else constant:
(↓) ↑ CPIFC → (↓) ↑ real exchange rate (DC/FC)
(↓) ↑ CPIDC → (↑) ↓ real exchange rate
(↓) ↑ nominal exchange rate → (↓) ↑ real exchange rate
Spot exchange rate: The exchange rate for immediate delivery
Forward exchange rate: The exchange rate for delivery sometime in future.
LOS 20.b
Foreign Exchange Market
Functions Participants in foreign exchange market

Facilitate companies & individuals Large multinational banks are primary
that purchase or sell goods/services dealers & originators of forward contracts
denominated in foreign currencies Buyers include:
Currency risk can be reduced or i) Corporations
eliminated through forward currency ii) Investment accounts
contracts. a) Real money accounts: refer to accounts
managed mutual funds, insurance
companies and other institutional
investors that do not use derivatives
b) Leverage accounts: refer to the
professional trading community that
uses derivatives.
iii) Governments & Government entities
iv) Retail accounts
Central banks
LOS 20.c
i) Direct Quote:

Base Currency: The currency which is represented by

one unit
Price currency: The currency represented by more or
ii) Indirect Quote: less than one unit is called price currency.

Indirect Quote =
!"

Page 2
LOS 20.d
For Direct Quote:

భ
#
% ∆ Exchange rate = బ భ
−1
#
బ
If, % > 0; FC appreciated

% < 0; FC depreciated.
LOS 20.e
Cross rate:
It’s the exchange rate between two
currencies derived from a third
common currency.
£ &'( £
= ×
$% $% &'(
LOS 20.f.g Forward exchange rate is quoted in two ways
i) Unit of points: Note: ii) Percentage terms:

It’s the last decimal place in the spot If Forward rate > Spot rate, £ is Continuing with our example;
).)))*
exchange rate quote. trading at a forward premium Forward premium = × 100
+.,-
For example: If Forward rate < Spot rate, £ is = 0.0286%
).*
+10.2→ = 0.00102 trading at a forward discount or 0.029%
),)))
Suppose,
S0 =3.561 USD/£
Forward rate = 3.561 + 0.00102
= 3.56202 USD/£
LOS 20.h
Interest rate parity (for DC/FC):

./01 4೑೚ೝ೐೔೒೙
=
23 4೏೚೘೐ೞ೟೔೎
4೑೚ೝ೐೔೒೙
⇒ forward = spot ×
4೏೚೘೐ೞ೟೔೎
If,
4೑೚ೝ೐೔೒೙
Market forward rate ≠ spot rate ×
4೏೚೘೐ೞ೟೔೎
⇒ Arbitrage is possible
LOS 20.i Exchange Rate Regimes
Countries That Do not Have Their Own Currency: Countries That Have Their Own Currency:
i. Use currency of another country as its own (formal i. Currency board arrangement
dollarization). ii. Conventional fixed peg arrangement
ii. Use of a common currency (Participating in a iii. Crawling peg (active and passive)
monetary union) iv. Management of fixed exchange rate with crawling
bands
v. Managed floating exchange rates.
vi. Independently floating rates

Page 3
LOS 20.j
Exports – Imports = (Private Savings – Investment in physical capital) + (Tax

revenue – govt. spending)
X – M = (S – I) + (T – G)
Trade surplus (X > M) must be reflected in a fiscal surplus (T > G), an excess
savings (S > I) or both.
LOS 20.j
Elasticities Approach:

=

+

' =

+

Marshall – Lerner condition where depreciation of DC → ↓ Trade deficit (X –
M)
WX EX + WI (EI – 1) >0
The J-Curve:
Short-term ↑ in deficit followed by ↓ when Marshall-Lerner condition is met is
referred to as the J-Curve
Absorption Approach:
Focuses on capital account & can be represented by:
BT = Y – E
Where,
BT: Balance of Trade
Y: National Income
E: Domestic expenditure

Page 1
“FINANCIAL STATEMENT ANALYSIS: AN INTRODUCTION”

FSA = Financial G/L = Gain & Loss
21.a
Statement CF = Cash Flows
Analysis Financial reporting ⇒ The way companies show their financial performance to different parties by preparing & PPE = Property, Plant,
IASB = International presenting F.S. Equipment
Accounting Role of FSA is to use the information in a company’s F.S, along with other relevant information, to make FS = Financial
Standard economic decisions. Statements
Board IASB’S framework describes Mgmt. = Management
“The objective of F.S is to provide information about the financial position, performance & changes in
financial position of an entity that is useful to a wide range of users in making economic decisions.”
21.b Financial Statements
Income Statement Balance Sheet Cash flow Statement Statement of changes

in owner’s Equity
Revenue Expense G/L Operating CF Investing CF Financing CF
Amounts Relate to in Cash effects of Resulting from Resulting Reports the amount
charged outflows, equity or transactions acquisition or sale of from issuance & sources of ∆ in
for depletion of net assets that involve PPE, subsidiary or & retirement equity investor’s
delivery of assets and from normal business segment, securities of debt & investment
goods and incurrences peripheral of firm & investments in equity
services in of liabilities or other firms
the which incidental
ordinary decrease transactions
course of equity.
Assets Liabilities Owner’s Equity
business.
Resources Obligations Residual interest in the

a company to lenders net assets of an entity
controls. and
creditors.
21.c Financial Statement Notes
F.S notes ⇒ disclosures that provide further details about information in F.S.
Are audited & provide information about accounting methods, assumptions & estimates used by management.
Provide additional information on certain items (e.g. business acquisition or disposal, legal action etc.).
Supplementary Schedules
Are not audited & provide information regarding;

Reserves for oil & gas companies.
Information about hedging activities & financial instruments.
Operating income or sales by region or business segment.
Management Discussion & Analysis (MD&A)
Provide assessment of financial performance & condition of a company from its management’s perspective and may include
discussions regarding:
results from operations, effects of trends, capital resources, liquidity & general business overview.
accounting policies, discontinued operations, extra ordinary items, unusual & infrequent events, disclosures in interim F.S &
segments need for CF.

Page 2
21.d
Audit is an independent review of F.S with an objective to provide an opinion on fairness & reliability of F.S.
Board of directors appoint audit firms and a standard auditor’s report contain three paragraphs:
Introductory ⇒ F.S are prepared by management & auditor has performed an independent review.
Scope ⇒ Describes the nature of the audit process and provides reasonable assurance about fairness of F.S.
Opinion ⇒ Expresses the auditor’s opinion on the fairness of the audited F.S. There are three types of audit
opinions:
i. Unqualified opinion ⇒ statements are free from material omissions or errors.
ii. Qualified opinion ⇒ statements make any exception to accounting principles
iii. Adverse opinion ⇒ statements are not presented fairly or are materially nonconforming with standards.
Going concern assumption ⇒ firm will continue to operate for the foreseeable future.
Internal controls ⇒ company’s internal system to ensure that company presents accurate F.S. (auditor must state opinion on
it).
21.e
Analyst should examine quarterly or semiannual reports. (not necessarily audited).

Proxy statement ⇒ issued to shareholders about matters that require shareholders’ vote.
Corporate reports & press releases ⇒ companies provide relevant info on their websites, in
press releases & in conference calls with analysts and investors.
21.f Financial Statement Analysis Framework
Phase 1 Phase 2 Phase 3 Phase 4 Phase 5 Phase 6

State objective Gather Data Process the data Analyze & interpret Report the conclusions Follow up
& context the processed data or recommendations
Input Input Input Input

Input Input
• Nature of report • Data from the • Gather new info
• F.S & other data • Input data • Analytical results periodically by
• Apprehend report’s • Visit site & consult previous phase • Processed data • Previous reports
needs & concerns repeating previous
mgmt., suppliers, • Institutional steps to determine
• Guidelines customers etc. guidelines. changes in the
conclusion.
Output Output Output Output Output

Output
• Purpose of analysis • Organized F.S and • Adjusted F.S. • Analytical results • Analytical report
• Updated reports &
• List of questions financial data • Common-size F.S. answering
recommendations
• Nature of report tables • Ratios and graphs questions posed in
• Timeframe and • Completed • Forecasts phase 1.
budget questionnaires • Recommendations

Page 1
“FINANCIAL REPORTING MECHANICS”

OCI = Other Comprehensive Income COGS = Cost of Goods Sold IS = Income Statement
FS = Financial Statements SG&A = Selling, General & Admin BS = Balance Sheet
AR = Accounts Receivables AP = Accounts Payables MV = Market Value
CF = Cash Flows TB = Trial Balance
22.a F.S elements ⇒ major classification of assets, liabilities, owner’s equity, revenues & expenses.
Accounts ⇒ specific records within each element. Chart of accounts is a detailed list of accounts.
Contra accounts ⇒ entries that offset some part of value of another account.
Classifying Accounts into F.S Elements
Assets Liabilities Owner’s Equity Revenues Expenses
Firm’s economic Creditors’ claim on Owner’s residual Inflows of economic Outflows of economic
resources company’s resources claim on firm’s resources resources
resources
Examples are cash & Examples are AP It includes, capital, It includes sales, gains COGS, SG&A,
equivalent, AR, financial liabilities, additional paid in & investment income depreciation, tax,
inventory, financial unearned revenue capital, retained interest paid & losses.
assets, prepaid exp income tax payable earnings & OCI.
etc. etc.
22.b
Basic accounting equation

Assets = liabilities + owner’s equity.
Expanded accounting equation.
Assets = liabilities + contributed capital + beg. retained earnings + revenue – exp - dividends
22.c
Double- entry accounting ⇒ transaction has to be recorded in at least two accounts.
22.d Accruals
Unearned Revenue Accrued Revenue Prepaid Expenses Accrued Expenses
Receiving cash before Providing goods or Paying cash ahead of Owing cash for expenses
providing goods/services. services before receiving time for anticipated it has incurred.
Cash , unearned cash. Revenue, AR. expense. Cash, prepaid Expenses, accrued exp.
revenue(liability). exp. (asset). (liability) .
When unearned revenue or prepaid expense arise Cash changes hands first & revenue or expense is recorded later.
When accrued revenue or accrued expense arise Revenue or expense is recorded first & cash changes hands later.
Valuation adjustments ⇒ B.S value of certain assets to reflect their current MV.
To keep equation in balance changes in assets also change equity through I.S or OCI.

Page 2
22.e
B/S summarizes the company’s financial position at the end of the current accounting
period.
I.S, CF statement & statement of owner’s equity show changes that occurred during the
most recent accounting period.
22.f Accounting System
General journal ⇒ General ledger ⇒ Trial balance ⇒ Financial statements
Listing of all general Sorting the entries in Initial T.B ⇒ shows • Final product
entries. general journal by balance in each account • F.S are prepared based
account. adjusted T.B⇒ after on the account totals
adjusting entries. from an adjusted trial
balance.
22.g
Crucial for analysts to review footnotes & MD&A.

Due to allowable discretion of management regarding adjustments & assumptions,
possibility exists for manipulation of F.S by management.
A good understanding of accounting process is required by analysts.
Debits ⇒ money going out Credits ⇒ money coming

of the business into the business

Page 1
“FINANCIAL REPORTING STANDARDS”

FCF = Future Cash Flows FS = Financial Statements
23.a
FASB = Financial Accounting A&L = Assets & Liabilities
Standard Board G/L = Gain & Loss
F.S provides information about financial performance & ∆ in financial position.
IASB = International BS = Balance Sheet
Reporting standards ensure the usefulness of information to a wide range of users.
Accounting Standard IS = Income Statement
Board
23.b
Standard-Setting Bodies Regulatory authorities

• Govt. agencies responsible to recognize and ensure that
Professional organizations (of accountants &
companies prepare financial reports in accordance with
auditors) to establish financial reporting accounting standards.
• Regulators include Securities & Exchange Commission (SEC) in U.S
• IFRS issued by IASB and Financial Service Authority (FSA) in UK etc.
• US GAAP issued by FASB
IASB objectives include promoting: International Organization of Securities

single set of financial standards to ensure that the Commissions (IOSCO)
standards result in transparent, comparable and
decision-useful information.
convergence of national & global accounting
standards. • Not a regulatory authority but its members regulate more than 90%
FASB operates within a structure similar to IASB. of world’s financial capital markets.
• Objectives of IOSCO include:
i. To protect investors
Desirable attributes of Accounting Standards Boards ii. To ensure that markets are fair, efficient and transparent
• The organization should have clearly defined processes, iii. To reduce systematic risk
adequate authority, resources and competencies to fulfill its
• Its principles are grouped into nine categories including principles
responsibilities.
• The board should operate independently and all parties should for regulators, for enforcement, for auditing, and for issuers among
observe high professional standards with clearly defined others.
responsibilities.
Securities & Exchange Commission Filings
Form S-1 Form 10-K Form 10-Q Form DEF-14A Form 8-K Form 144 Form 3, 4, & 5
Registration Companies are Quarterly Related to To disclose Companies are Filing about
statement required to file unaudited proxy material required to file beneficial
prior to the this form filings. statement for events this form when ownership.
sale of new annually. Includes info shareholders. including issuing Form 3 is initial
securities Includes info such as MD&A, corporate securities to statement,
such as business accounting , governance, qualified form
& mgmt., legal disposals etc. buyers without
audited F.S etc. disclosures registering the
Not a substitute etc. securities to
for annual SEC.
report.
23.c
One barrier to convergence is different standard setting bodies & regulatory authorities.
Political pressure that regulatory bodies face from business groups is another barrier.

Page 2
23.d Qualitative Characteristics
Understandability Comparability Verifiability Timeliness
Users with basic knowledge of F.S presentation should be Similar conclusions could be Information is available to users
business should be able to readily consistent among firms & drawn from independent prior to making a decision.
understand the information in F.S. across time periods observers using same method.
Required Reporting Elements
An item should be recognized in F.S if future benefit is probable & can be measured reliably.
Measurement Bases
Historical cost Current cost Realizable value Present value Fair value
Amount originally paid Amount to be paid Amount for which firm Discounted value of Exchange asset or settle
for the asset today for the same could sell the asset asset’s expected FCF liability in an arm’s -length
asset transaction.
Constraints & Assumptions

Constraints
One constraint on F.S preparation is to balance b/w verifiability & timeliness.
Benefits from information should be greater than cost.
Intangible & non-quantifiable information cannot be captured directly in F.S.
Assumption
Accrual basis ⇒ reflecting transactions at time of occurrence, not necessarily when
cash is paid.
Going concern assumption ⇒ company will continue to exist for a foreseeable future.
23.e IAS # 1
Required financial statements Principles for preparing F.S Principles for presenting F.S
Balance sheet. Fair presentation Aggregation of similar items.

Statement of comprehensive Going concern; accrual basis; Classified B.S & minimum
Income. materiality and aggregation information on face of F.S.
Cash flow statement. No offsetting Comparative information for
Statement of ∆ in owner’s Frequency of reporting prior periods.
equity. Comparative information and
Explanatory notes. consistency of presentation.

Page 3
23.f Comparison of framework
FASB IASB
Not at top of GAAP hierarchy. Consider framework if no explicit standard exist.

Different objective for business & non business F.S. One objective for both.
reporting. Place more emphasis on going concern assumption.
Place less emphasis on going concern assumption. Also lists comparability & understandability as primary
Relevance & reliability are primary characteristics. characteristics.
Revenue, expense, G&L & comprehensive income as Income & expenses are elements of performance.
elements of performance. Assets are resources from which future economic
Define asset as future economic benefit. benefit is expected.
“Probable” is used to define A&L. Requires probability criterion to be met and has a
Does not allow upward movement of assets. separate recognition criterion of relevance.
23.g Coherent Financial Reporting Framework
Transparent Comprehensive Consistent
Full disclosure & fair Should include all types of Similar transactions should
presentation. transactions having financial be accounted for in similar
implications. ways.
Barriers to Coherent Financial Reporting
Valuation Standard Setting Measurement
Trade-off b/w relevance & Principle-based ⇒relies on Trade-off b/w properly

reliability. broad framework (IFRS). valuing B/S & I.S.
Rule-based ⇒specific
guidance (U.S.GAAP).
Objective-oriented⇒ Blend
of two.
23.h
Analyst should be aware of new products & innovations in financial market.

Companies disclose policies & estimates in footnotes.
Management can discuss impacts of adopting a new standard.

Page 1
“UNDERSTANDING THE INCOME STATEMENTS”

IS = Income Statement RV = Residual Value
R = Revenue I.S is sometimes referred to as “statement of operations” the “statement DO = Discontinued Operations
E = Expenses of earnings” or “profit & loss statement”. CF = Cash Flows
FV = Fair Value I.S equation= Revenue - expenses = net income. EP = Exercise Price
SL = Straight-Line AMP = Avg. Market price
AFS = Available For Sale Securities OCI = Other Comprehensive
R.E = Retained Earnings Income
24.a
Revenues ⇒ sale of goods & services in normal course of business.

Revenue less adjustment for returns = net revenue.
Expenses ⇒ outflows, depletion of assets, and incurrences of liabilities in the ordinary course of business.
Gains & losses ⇒ result from incidental transactions outside firm’s primary business activities.
Presentation Formats
Single-Step format Multi-Step format
All revenues are grouped Includes gross profit

together & all expenses (revenue-cost of goods
are grouped together. sold) as a subtotal.
Gross profit - operating expense = operating profit.

Operating income - interest & tax expense = net income (for non-financial firms).
Pro-rata share of subsidiary’s income that the firm does not own is reported in
parent’s I.S as non-controlling interest- as a negative number.
24.b Accrual method ⇒ revenue is recognized when earned & expenses are recognized when incurred.
According to FASB revenue is recognized when realized & earned. Four additional guidance are:
There is evidence of arrangement b/w buyer & seller.
The product has been delivered or service has been rendered.
The price is determined or determinable.
The seller is reasonably sure of collecting money.
Specific Revenue Recognition Applications
In some cases revenue may be recognized before delivery or even after delivery.
Long – Term Contracts
Often related to construction & long term projects.

Service contracts or licensing agreements ⇒ firm may equally recognize revenue.
Long – Term Contracts
Percentage of Completion Method Completed Contract Method
Appropriate when cost & revenue can reliably estimated. Suitable when uncertain outcomes or short term project.
R.E & profit recognized as work is performed. R.E & profit at project completion.
Measured as total cost to date divided by total project cost. Expected loss recognized immediately (either method).

Page 2
24.b IFRS ⇒ unreliable outcome, revenue is recognized to the extent of cost, cost is expensed & profit is
recognized at completion.
% of completion method is more aggressive & subjective due to cost estimates, provide smoother
earnings & better matching. C.F are same under both methods.
Installment Sales Firm finances the sale & payments are expected over extended period.
Normal Revenue Recognition Method Installment Method Cost Recovery Method
Seller has completed a significant Collectability is uncertain. Profit is recognized when cash
part of earnings process. Profit recognized is based on percentage of sales collected exceeds cost.
Collection is certain or is possible price received as cash.
to estimate the amount that

= ℎ ×
cannot be collected.
Barter Transaction Two parties exchange goods or services without cash.

Round-trip transaction ⇒ sale & simultaneously identical purchase from the same party.
Based on F.V of revenue from similar

U.S.GAAP Revenue can be recognized at F.V. only if the IFRS non-barter transactions with unrelated
company has historically received cash parties.
payments for such services.
Gross & Net Reporting of Revenue

Criteria to use gross revenue reporting
under GAAP.
Gross Revenue Reporting Net Revenue Reporting Be the primary obligor & bear
inventory & credit risk.
Reports sales & COGS separately. Difference in sale & cost is reported. Be able to choose supplier &
establish price.
Implications for Firms disclose revenue recognition policies in

footnotes.
Financial Analysis
Check conservative firms’ revenue recognition policies.
Extent to which policy requires making judgment &
estimates.
Revenue Recognition Accounting Standards Issued May 2014
Core Principle: Depict promised Contract exists if Companies are required to disclose:
goods/services in an amount to which the →collectability is contract info at year end, disaggregated into different
entity expects to be entitled. probable. categories.
5-Steps to achieve core principle: IFRS: probable means contract-related assets & liab. balances, significant ∆
Identify the contract with a customer. more likely than not. to the balances, remaining obligations with their
Identify the obligation in the contract. U.S GAAP: probable transition prices, any judgments and ∆ in judgments
Determine the transaction price. means likely to occur. related to revenue recognition.
Allocate the price to the obligation. Converged standards
Recognize revenue when entity provide guidance for
satisfies the obligation. contract modifications.

Page 3
Matching principle ⇒ accrual based ⇒ expense to generate revenue in the same period as
24.c
revenue recognized.
Period costs ⇒ expenditure not directly tied to revenue generation. Expense in period of
incurrence.
Cost of long lived assets (depreciation) also matched with revenue.
Credit sale ⇒ estimate bad debt expense.
Implication for Financial Analysis
Delayed exp. increase net income, therefore more aggressive.

Analysts must consider the reasons for a change in expense estimate.
Analyst should compare firm’s estimates with industry peers.
Firms should disclose policies & estimates in footnotes & MD&A.
24.d Depreciation
Straight-line depreciation Accelerated depreciation
Equal amount of dep. expense. More dep. exp. in early years.

In early years, lower dep. expense & higher net Same total expense.
income compared to accelerated method.
Declining balance method
SL dep. expense =

Constant rate of dep. each year
Double – declining balance
Depreciates the asset at two times the SL rate.
DDB dep. = (cost − Acc. Dep. )

No explicit RV in calculation but dep. ends once RV reached.
Inventory
Specific Identification First-in, first-out Last-in, first-out Weighted Avg. cost method
Can be used if firm can identify Item purchased first is Last item purchased is Easy to use.
which items are sold and assumed to be sold first. assumed to be sold first.
Per unit cost =
which remain in inventory. COGS is charged with early Recent purchases to COGS &
cost of available goods
purchases & inventory with earlier purchases to inventory.
recent purchases. Suitable for durable inventory. Total units
This per unit cost is used to
determine COGS & inventory
Intangible Assets
Amortization ⇒ allocation of cost of an intangible asset over its useful life.

Amortization exp. should match asset’s economic benefits.
Intangible assets with indefinite lives must be tested for impairment annually instead
of amortized.

Page 4
24.e Nonrecurring items & changes in accounting standards
Discontinued operations Unusual or infrequent items Extraordinary items Changes in accounting standards
Unusual in nature or Items that are both unusual

Management disposes of or
infrequent in occurrence & infrequent (U.S.GAAP).
plans to dispose of one of
but not both. Examples are loss from
its component operations.
Examples are G/L from asset expropriation of assets, G/L
The discontinued operation
sale, impairments & write from early debt retirement
must be physically &
offs. & uninsured losses from
operationally distinct from
These items are included in natural disaster.
the rest of the firm.
income from continuing Reported separately in I.S,
Measurement date ⇒ the
operations & reported net of tax after continuing
date at which disposal is
before tax. operations.
decided.
Analyst may review these IFRS does not allow
Phase out period ⇒ time
items to determine whether extraordinary items to be
b/w measurement period &
they should be used in separated from operating
actual disposal date.
forecasting. results.
G/L from DO is reported net
of tax after continuing
operations.
Change in accounting principle Change in accounting estimate Correction of a prior period error
∆ From one (U.S. GAAP or Result of a change in management’s judgment. Correction of a prior period error requires
IFRS) policy to another. Applied prospectively. retrospective restatement of financial statements.
Retrospective application. Do not affect C.F.
24.f
Nonfinancial firm ⇒ non operating transactions may result

from investment income & financing expenses.

Page 5
24. g & h
Earnings per Share
Corporate profitability performance measure.
Company may have simple (no potentially dilutive securities) or complex (potentially dilutive securities) capital structure.
Reported only for shares of common stock.
Basic EPS Dilutive EPS

Dilutive securities ⇒ options: warrants, convertible debt or convertible
=
.

preferred stock that decrease EPS i.e. basic EPS > diluted EPS.
Weighted Avg. number of shares ⇒ no. of shares outstanding during In case of diluted EPS numerator must be adjusted as follows:
the year, weighted by portion of the year. If convertible preferred stock is dilutive net income would be
Stock dividend ⇒ additional shares to each shareholder. increased by preferred dividends.
Stock split ⇒division of each “old” share into “specific” number of If convertible bonds are dilutive interest exp. multiplied by (1-tax
“new” shares. rate) must be added back to earnings.
Each shareholder’s proportional ownership is unchanged. If dilutive securities, denominator is adjusted for equivalent number of
Stock split or stock dividend is applied to all shares outstanding prior common shares created by conversion of all dilutive securities.
to split or dividend & to the beginning-of-period weighted avg. Dilutive stock options or warrants (EP< AMP), number of shares but no
shares. numerator adjustment.
Treasury stock method
Hypothetical funds received from options used to purchase common
shares at AMP.
Net increase in shares (shares created by option- repurchased
shares).
Net income − Preferred dividend +
convertible preferred dividends +
convertible debt interest1 − T
Diluted EPS =
weighted Avg. shares +
shares from conversion of conv. pfd. shares +
shares from conversion of conv. debt +
shares issuable from stock options
24. i Common Size IS
Vertical Common Size IS Horizontal Common Size IS
Expresses each line item as a Each line item is expressed in

percentage of sales. relation to selected base year.
24. j Margin Ratios
Gross Profit Margin Operating Profit Margin Net Profit Margin
Gross Profit OPM Net Profit

GPM = NPM =
Sales Operating Profit Sales
=
Sales

Page 6
24. k & l
Comprehensive income ⇒ all changes to equity other than owner contributions & distributions.
C.I = net income + OCI (foreign currency G/L, minimum pension liability adjustments, unrealized
G/L on derivative contracts accounted for as hedges & AFS securities).
Transactions included in OCI affect equity but not net income.
AFS securities are reported on B/S at FV and their unrealized G/L as component of OCI.

Page 1
“UNDERSTANDING BALANCE SHEETS”

CI = Comprehensive Income G/W = Goodwill GP = Gross Profit
I&E = Income & Expenses IS = Income Statement HC = Historical Cost
CA = Current Assets BS = Balance Sheet FV = Fair Value
CL = Current Liabilities A&L = Assets & Liabilities
25.a
Assets are a company’s economic resources from which future economic benefits are
expected to flow & can be created by operating, investing & financing activities.
Liabilities are obligations owed by an entity & created by operating & financing activities.
Stockholder’s equity is residual interest in assets after subtracting a firm’s liabilities & can be
created by operating & financing activities.
25.c Common Balance Sheet formats
Account Format Report Format
Assets on left hand side and liabilities Assets, liabilities & equity are
& equity on right hand side. presented in one column.
Classified balance sheet ⇒separately classifies current and non-current assets and liabilities.
25.d Assets & Liabilities
Assets Liabilities
Current assets ⇒ assets likely be converted into cash or used Current liabilities ⇒ obligations that will be satisfied within
up within one year or one operating cycle, whichever is greater. one year or one operating cycle whichever is greater.
Operating cycle ⇒ time from inventory acquisition to cash CA –CL = working capital.
collection. Noncurrent liabilities ⇒ life of more than one year & provide
Noncurrent assets ⇒ not to be converted into cash or used up information about financing activities.
within one year or one operating cycle. (Provide info about
investing activities).
IFRS requires current/ noncurrent format unless liquidity-based
presentation is more relevant and reliable.
Minority interest ⇒ pro-rata share of subsidiary’s net assets,
not owned by parent company.
25.e
Historical cost ⇒ value that was exchanged at the acquisition date. Verifiable & objective but may be less relevant.
Fair value ⇒ amount at which knowledgeable, willing parties exchange asset or settle liability in an arm’s-length transaction.
Standard costing ⇒ assigning predetermined costs to goods produced.
Retail method ⇒ measure inventory at retail price & then subtract G.P in order to reflect cost.
Long term assets with physical substance are tangible assets.
B/S value of tangible assets = HC – Accumulated Depreciation.
H.C = original costs + costs necessary to get the asset ready for use.
Intangible assets ⇒ long term assets that lack physical substance. Financial securities are not intangible assets.
Unidentifiable intangible assets cannot be purchased separately & may have infinite life (tested for impairment at least annually).

Page 2
25.e Internally created intangibles
U.S.GAAP IFRS
Expensed as incurred.
Research Stage Development Stage
Expensed Capitalized
Goodwill ⇒ excess of purchase price over acquirer’s share in the F.V of identifiable A&L acquired in acquisition.
Net income can be manipulated by allocating more of the acquisition price to goodwill & less to other assets.
Analyst should eliminate G/W impact for comparability.
Financial Assets ⇒ Investment securities (stock & bonds), derivatives, loans & receivables.
Financial Liabilities ⇒ Derivatives, notes payable & bonds payable.
Financial A&L are reported on B.S at FV (marking to market) or amortized cost.
Realized G/L for all categories are reported in IS.
Most financial liabilities are at amortized cost.
Derivatives that are liability to the company, non-derivative instruments & held-for-trading liabilities are reported at FV.
Marketable Investment Securities
Held-to-maturity Trading securities Available for sale
Debt securities (held till maturity). Debt & equity securities (short Neither held till maturity nor traded in the
B/S at amortized cost. term). near term.
Amortized cost = par value ± disc/ premium. B/S at FV. FV at B/S.
Subsequent ∆ in MV is ignored. Unrealized G/L (income statements). Unrealized G/L in OCI
25.f
Contributed capital ⇒ total amount paid in by the common & preferred shareholders.
Authorized shares ⇒ # of shares that may be sold under firm’s articles of incorporation.
Issued shares ⇒ shares actually sold to shareholders.
Outstanding shares ⇒ issued shares – reacquired shares.
Treasury stock ⇒ stock that has been reacquired rather than being cancelled.
U.S.GAAP ⇒ firms can report CI in I.S or in ∆ in equity or separate statement.
IFRS ⇒ firms can report either of the two: 1) a separate I.S and a second statement
including OCI or 2) a single statement of OCI.
25.g
Statement of ∆ in stockholder’s equity ⇒ transactions that equity accounts for the

period.
Statement includes transactions with shareholders & reconciliations of beginning &
ending equity a/c balance including capital, additional paid-in-capital, retained earnings &
accumulated OCI.

Page 1
“UNDERSTANDING CASH FLOW STATEMENTS”

CFS = Cash Flow Statement IS = Income Statement
CFO = Cash Flow from Operations BS = Balance Sheet
CFI = Cash Flow from Investing FCFE = Free Cash Flow to Equity
THE CASH FLOW STATEMENT
CFF = Cash Flow from Financing NCC = Noncash Charges
The CFS reconciles the beginning & ending balances of cash over an accounting period
NI = Net Income FCFF = Free Cash Flow to the Firm
CFO + CFI + CFF = ∆ in cash balance + beginning cash balance = ending cash balance.
BV = Book Value AR = Accounts Receivable
UR = Unearned Revenue AP = Accounts payable
Items on CFS come from two sources

26.a
I.S. items.
∆ in B.S accounts.
Cash Flow Statement Activities
CFO CFI CFF
Inflows & outflows of cash resulting from Inflows & outflows resulting from Inflows & outflows of cash resulting
transactions related to a company’s acquisition or disposal of long-term from transactions that affect a firm’s
operating activities that generate revenue. assets & certain investments. capital structure.
Investing activities include: Acquisition of debt & equity investments (other than trading securities) & loans to others.
26.b
Noncash investing & financing activities are not reported in CFS, however,
these activities must be disclosed in either footnotes or supplemental
schedules.
26.c
Key difference in CFS
U.S.GAAP IFRS
Dividend paid ⇒ financing. Interest & dividend received ⇒ operating or investing.

Interest paid ⇒ operating. Dividend or interest paid ⇒ operating or financing.
Interest & dividend received ⇒ operating. Taxes paid ⇒ operating unless specifically identifiable
All taxes paid ⇒ operating. investing or financing transaction.
26.d
Methods of Presenting CFS
Direct Method
Direct Method Indirect methodIndirect Method
Converts an accrual basis I.S into cash basis I.S Net income is converted to CFO by making adjustment for
Both methods (direct & indirect) are permittedtransactions
under IFRS that affect N.Ihowever,
& U.S.GAAP, but non cash items, non-
the use
operating
of direct method is encouraged. Difference is due items, andoffor
to presentation net changes in operating accruals.
CFO.
Direct method provides more information than indirect method.

Indirect method focuses on the difference in net income & CFO.

Page 2
26.d Disclosure Requirements
U.S.GAAP IFRS
Direct method presentation must also disclose Payments for interest & taxes must be
adjustments to reconcile N.I to CFO. disclosed.
Payment for interest & taxes can be reported in
cash flow statement or in footnotes.
26.f CFO
Direct Method Indirect Method
Cash collected from customers. Net income.

Cash used in production of goods & services. ± G/L resulted from financing or
Cash operating expenses. investing CF.
Cash paid for interest. + Noncash charges
Cash paid for taxes. – Non cash revenue.
– (for in operating assets)
+ (for in operating assets)
+ (for in operating liabilities)
CFI – (for in operating liabilities ).
Calculated by examining change in gross asset accounts that result from investing
activities.
Cash paid for new asset = ending gross asset + gross cost of old assets sold –
beginning gross assets.
Cash from asset sold = B.V of asset ± G/L on sale.
CFF
Determined by measuring CF occurring b/w firm & supplier of capital.

Net CF from creditors = new borrowings – principal amounts repaid.
Cash dividend can be calculated from an analysis of retained earnings.
CFO + CFI + CFF = total CF = ∆ in balance sheet cash.
26.g Adjust I.S item for its corresponding B.S. account & eliminate noncash as well as non operating transactions.
Illustrative conversion process of frequently used accounts is:
Cash collection Revenue Cash Received from customers
from customers • add in AR (or subtract in AR) = Beg. AR + Revenue – End. AR
• add in UR (or subtract in UR)
Cash payment = COGS + [End. Inventory – Beg. Inventory] – [End. AP – Beg. AP]
to suppliers where COGS + [End. Inventory – Beg. Inventory] = Purchases
• Other items follow the same principles.

• Cash paid for other operating expense
• SG&A + in prepaid expense - in prepaid expense. – in other accrued liabilities + in other accrued liabilities.
• Refer to FinQuiz Notes Reading 25 for detailed linkages of CFS with IS and BS

Page 3
26.h Major sources & uses of cash
Sources & uses of cash change as firm moves through its life cycle.
Over the long term, successful firms must be able to generate CFO that exceed capital
expenditure & provide a return to debt & equity holders.
Operating cash flow
+ CFO can be generated by earning related activities or by non cash working capital
(not sustainable).
CFO also provides a check of the quality of a firm’s earnings
Variability of N.I & CFO should also be considered.
Investing cash flows
capex is usually an indication of growth.

Firm may reduce capex or even sell capital assets to save cash.
Generating CFO in excess of capex is desirable.
Financing cash flows
Provide information about debt & equity (using cash to repay

debt, reacquire stock or pay dividends).
Common-size CFS
By expressing each line item as a % of revenue.

Alternatively by expressing each cash inflow as a % of total cash
inflow & each cash outflow as a % of total cash outflow.
26.i
Free CF ⇒ measure of cash that is available for discretionary purposes (after covering capex).
Under IFRS when dividends paid are classified as operating activity, they should be added back to
CFO to calculate FCFF.
Free Cash Flow
FCFF FCFE
Cash available to all investors. Cash flow available to common equity holders.
FCFF = N.I + NCC + [int(1-tax rate)] – FCInv – WCInv FCFE = CFO – FCInv + Net borrowings.
FCFF = CFO + [int × (1- tax rate )] – FCInv
Firms that follow IFRS must consider dividend &
interest classification.

Page 1
“FINANCIAL ANALYSIS TECHNIQUES”
BS = Balance Sheet GP = Gross Profit

LTD = Long-Term Debt 27.a NP = Net Profit
SG&A = Selling, General & Admin PV = Present Value
Common size statements allow analysts to more easily compare performances.
R&D = Research & ROE = Return On Equity
Vertical common-size B.S express each line item as a % of total assets.
Development TA = Total Assets
Vertical common-size I.S expresses each line item as a % of sales.
STD = Short-Term Debt TE = Total Equity
Common size I.S ratios are useful in studying trends in costs & profit margins, I.S
RR = Retention Ratio SD = Standard Deviation
account / sales.
CV = Coefficient of Variation IS = Income Statement
B/S accounts can also be converted to common-size ratio as, B.S account/ total
EBITDA = Earnings before Interest, EBIT = Earnings before Interest
assets.
Tax, Depreciation & & Tax
Stacked column graph ⇒ shows ∆ in items from year to year in graphical form.
Amortization
Ratios are used for internal comparisons & comparisons across firms.
Their limitations are:
Different accounting treatment & divisions of one firm operating in multiple
industries.
Not useful when viewed in isolation or one set of ratios.
Need to use judgment when analyzing the results of ratio analysis.
27.b Pure B/S Ratios
Liquidity Ratios Debt Solvency Ratios
Firm’s ability to satisfy short term obligations. Measure financial risk & leverage as well as solvency.
the leverage the ratio.
Current Ratio =

if <, 1

Debt to capital ratio = total debt/(total debt + total
Quick Ratio = shareholders’ equity)
Cash + short term marketable securities + receivables Debt-to-equity ratio = total debt/ total equity.
Current liabilities Total debt ratio = total debt / total assets.
Cash Ratio = Financial leverage = total assets / total equity.
Cash + short term marketable securities
Current liabilities
Income Statement Ratios
Profitability Ratios
How good management is at turning their efforts into

profits. Higher margin ratios are desirable.
Gross profit margin = gross profit/ revenue.
Net profit margin = net income/ revenue.

Page 2
27.b Financial Ratios
Activity Ratios Liquidity Ratios Solvency Ratios Profitability Ratios Valuation Ratios
How well a firm utilizes Ability to meet Financial leverage How well a Sales per share.
various assets. short-term & ability to meet company EPS.
obligations. longer term generates profits Price to cash
obligations. on its investment. flow.
These categories are not mutually exclusive.
Activity Ratios
Receivable turnover = annual sales / average receivables, (desirable, close to industry norm).
Days of sales outstanding= 365 / receivable turnover.
Collection period too long, too much capital tied in assets, (too low, may hamper sale).
Inventory turnover = cost of goods sold / avg. inventory.
Days of inventory on hand = 365 / inventory turnover, (desirable close to industry norm).
Process period too high, too much capital tied up in inventory (obsolete inventory), if too low, inadequate stock.
Payable turnover = purchases / avg. trade payables.
Number of days of payables = 365 / payable turnover ratio
Total asset turnover = revenue / avg. total assets.
Fixed asset turnover = revenue / avg. net fixed assets.
Net refers to net of Acc. Depreciation.
Working capital turnover = revenue / avg. working capital.
Liquidity Ratios
Current, quick & cash ratio.

Defensive interval ratio = cash + marketable securities + receivable / avg. daily cash expenditures.
Daily expenditures include cash expenses for cost of goods, SG &A & R&D, add back dep. (if items taken from I.S).
Cash conversion cycle = [days sales outstanding] + [days of inventory on hand] – [number of days of payables].
High conversion cycle is undesirable (excessive amount of capital in sales process).
Solvency Ratios
Total debt is calculated differently by different analysts.

Here (interest-bearing STD and LTD).
Debt-to-capital = total debt / (total debt + total equity).
Capital = short & LTD + preferred stock & equity.
Debt -to- assets = total debt / total assets.
Interest coverage = EBIT / interest payments,(firm’s ability to repay debts).
Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments).
(Suitable for companies that lease a large portion of assets).
Profitability Ratios
Net profit margin should be based on net income from continuing operations.
See G.P & N.P margin.
Operating profit margin = EBIT / sales (EBIT = GP – SG&A (analyst should be consistent in calculation method).
Pretax margin = EBT / revenue.
Return on assets = N.I / avg. total assets
misleading, because interest excluded from N.I but total assets include debt as well as equity. Alternative calculation is:
Return on assets = [net income + interest expense (1-tax rate)] / avg. total assets.
Operating return on assets = EBIT / avg. total assets.
Return on total capital = EBIT / avg. total capital
alternative way is to include PV of operating leases as asset & liability.
Return on equity = net income / avg. total equity.
Return on common equity = (N.I – preferred dividends) / avg. common equity.
Analyst should be concerned if these ratios are low.

Page 3
27.d
DuPont system of analysis ⇒ can be used to analyze ROE (analyst can use impact of leverage, profit margins & turnover
on shareholders’ returns).
DuPont System
Original three-part approach Extended five-part system
ROE = [net income / sales] [sales / assets] [assets / equity]. ROE = [N.I / EBT] [EBT / EBIT] [EBIT / sales] [sales / T.A] [T.A
DuPont is a way to decompose ROE, to better understand / T.E].
the changes that are driving the ROE. in tax or interest burden will ROE.
More leverage does not always lead to higher ROE (as
leverage rises, so does the interest burden).
27.e
Valuation ratios ⇒used in analysis for investments in common equity.

Valuation ratios are, P/E, P/CF, P/sales, P/BV.
Per share valuation measures include EPS (basic & diluted), dividends per share, CF per share & EBITDA per share.
Total dividends on firm wide-basis ⇒ dividends declared.
N.I – dividend declared = retained earnings (to grow corporation).
Sustainable growth rate = g = RR × ROE.
Dividend payout ratio = dividends declared / N.I available to common shareholders.
R.R = 1 – dividend payout.
N.I per employee & sales per employee is used for valuation of services & consulting companies.
Growth in same store sales ⇒ restaurant & retail industries.
Sales per square foot ⇒ retail industry.
Business risk ⇒ S.D of revenue, EBIT & N.I are indicators of uncertainty of firm’s performance.
Coefficient of variation ⇒ S.D divided by variable’s expected value.
SD of Sales SD of EBIT SD of N.I

CVsale = , CVEBIT = , CVN.I = Mean N.I
Mean Sales Mean EBIT
Capital adequacy ⇒ ratio of bank’s capital to its total risk.

Business segment ⇒ portion of a larger company that accounts for more than 10% of company’s revenues, assets or profits.
Geographic segments ⇒ business environment that is different from other segments.
U.S.GAAP & IFRS require companies to report segment data.
27.f Ratio analysis can be used in preparing pro forma financial statements.
Methods of examining variability
Sensitivity Analysis Scenario Analysis Simulation
“What if” questions. Based on scenarios & yield Probability distributions for key
a range of values or variables are selected & computer
outcomes. is used for outcome.

Page 1
“INVENTORIES” FIFO = First-In-First Out

WAC = weighted average cost
Section 1: Introduction COGS = Cost of Goods Sold
I.S = income statement
B.S. = Balance sheet • Merchandisers report inventory - finished goods. CF = Cash Flows
GP = gross profit • Manufacturers classify 3 inventory types- raw material, work-in-progress & finished goods. NI = Net Income
OP = operating profit • If no inflation/deflation – choice of inventory valuation would be irrelevant. BV = Book Value
IBT = Income before tax CV = Carrying Value
NRV = Net Realizable Value
RC = Replacement Cost
HC = Historical Cost Section 2: Costs of Inventories
WC = Working Capital 28. a Under IFRS and U.S. GAAP:
CA = Current Assets Costs to include in inventories are:
LIFO = Last-In-First Out Purchase costs – purchase price, import & tax related duties, transport, handling costs, trade discounts
F.S. = Financial Statement & rebate etc.
Conversion costs - direct labor & overhead costs (both fixed & variable).
Other costs - to bring inventory to present location & condition.
Costs to exclude from inventories (recognized on I.S.as expense in the period incurred) are:
Abnormal costs occurred due to wastage of materials, labor or other production conversion inputs.
Storage, selling & administrative overhead.
Section 3: Inventory Valuation Methods

Cost flow Methods
28.b c d
US GAAP (cost flow assumption) IFRS (cost flow formula)
Specific identification. Specific identification.

First-in, First-out. First-in, First-out.
Weighted Avg. cost. Weighted Avg. cost.
Last-in, First-out.
Cost flow methods under U.S.GAAP
Specific identification method FIFO Method LIFO Method WAC Method
Unit sold is matched with 1st item purchased is the 1st Recent purchases sold 1st. Avg. cost of goods available =
unit’s actual cost. item sold. COGS measured using recent total cost / quantity.
Suitable for items not Ending inv. includes most prices. COGS = avg. cost × units sold.
interchangeable, expensive recent purchases, COGS Prices LIFO COGS > FIFO End. Inv. = avg. cost × units
unique. earliest purchases. COGS. remaining.
earnings taxes, CF.
End. Inv. at earliest cost.
LIFO method is not allowed under IFRS.

Prices, LIFO COGS, N.I, inventory, current ratio inventory turnover & vice versa under FIFO.
Inflationary periods (const. or ↑ inv. Q) More useful measures

FIFO (in comparison with WAC or LIFO): • End. Inv. → in FIFO
• In I.S. ↓ COGS → ↑ GP, ↑OP, ↑IBT • COGS → in LIFO
• In B.S. ↑ End. Inv.
Vice versa in deflationary periods (const. or ↑ inv. Q)

Page 2
Allocation of Cost-available for sale to:

Inventory Systems cost of sale and ending inventory
FIFO Specific identification
Periodic Inv. System Perpetual Inv. System

Periodic Perpetual Periodic Perpetual
Inv. values & COGS are Inv. values & COGS are Periodic Perpetual
determined at end of updated continuously.
accounting period. Inv. purchases & sold directly
Beg.inv + purchase = cost of recorded in inv., no purchase FIFO WAC. FIFO WAC.
goods available for sale. account.
COGS = cost of goods No difference No difference
(allocation is same) (allocation is same)
available – ending inv.
Purchases are recorded in a
Significantly Different
purchase account. Allocation
LIFO WAC. & FIFO
Periodic Perpetual Periodic Perpetual
Beg. Inventory + Purchase = Cost of goods available for sale Quite Different Similar
Allocation Allocation
Cost of goods available for sale = Ending inventory + cost of sale
Section 4: The LIFO Method

LIFO Reserves = FIFO Inv. value – LIFO inv. value
28. e f • To compare co. using LIFO with co. not using LIFO.
• Adj. COGS = LIFO COGS + ∆in LIFO reserve
Widely used in the U.S.
Tax savings in inflation results in ↑ CFs & ↑ Co. value.
LIFO Liquidation: when units sold > units
LIFO conformity rule: Co. using LIFO for tax purposes must also use LIFO
produced/purchased.
for F.S. purposes.
In Inflationary periods: (vice versa in deflation). • cause inventory-related ↑ in GP.
In I.S.→ ↑ Purchase Price→↑ COGS → ↓ (GP, OP, tax exp., NI) • one-time event and non-sustainable.
In B.S.→ ↓ End. Inv.→↓ WC, T.A, R.E, SH’s Eq.) Reasons (reduction in inv. levels):
↑ CFO, ↓ CR, ↑ D/E, ↓ Profitability ratios • labor strikes, eco. recession, ↓ in demand etc.
Analysts’ concerns:
Mgmt. may purposely ↓ invt. to report ↑GP and NI.
(review LIFO reserve footnote disclosures).
Section 5: Inventory Method Changes

Under IFRS:
∆ is acceptable only if justifiable and is applied retrospectively.
Under US GAAP:
28. h • Conditions are similar to IFRS but also requires co. to explain thoroughly.
• ∆ from LIFO to another method requires retrospective restatements.
• ∆ to LIFO is on prospective basis and retrospective restatement is not
required.

Page 3
Section 6: Inventory Adjustments
Inventory Adjustments
28 g
IFRS US GAAP
Lower of cost or NRV. Lower of cost or market.

NRV = expected sale price-estimated selling cost. Market is usually current cost but cannot be greater
If NRV is < BV, inventory write down to NRV & loss in than NRV or less than NRV – normal profit margin.
I.S. If cost > market, write down & loss in I.S, no write up
Subsequent recovery ⇒ “write up” & gain in I.S. allowed.
Inventory cannot be written up by more than
previous write down.
Analyst should consider ratio impact of write down or write up.

Reporting inventory above H.C is permitted in certain industries (both IFRS & U.S.GAAP).
Section 7: Presentation and Disclosure
28.i j k l
Presentation & Disclosure
IFRS provide list of disclosures from a to h (please refer curriculum).

Disclosures under US GAAP are very similar except f and g are not relevant.
US GAAP also requires inventories’ significant estimates and any material income from LIFO liquidation.
Inventory Ratios (directly impacted by co.’s choice of inventory valuation methods )
Inventory Turnover (ITO) Days of Inv. on hand (DIH) GP Margin
Other Ratios
↑ ITO, ↓ DIH → Effective inv. Mgmt. Co. from highly competitive
(indirectly impacted)
↓ ITO, ↑ DIH could reflect→ slow moving, obsolete, ind. → ↓ GPM
Inadequate Inv.or inv. write down Co. with fewer competitors • Current Ratio
Slow g. + ↑ITO → Inadequate Inv. levels → ↑ GPM • ROA
Inv. write down could reflect → poor inv. mgmt. • D/E
Companies selling staple products → ↑ ITO
Companies selling luxury products → ↓ ITO

Financial Analysis Illustrations
IFRS and US GAAP require companies to disclose either on B.S or in notes, the carrying amounts of inv. in
classifications (e.g. raw material, W.I.P, finished goods).
Analysts should compare g rate of sales to g rate of finished goods inv.
Analysts should consider MD&A and similar sections for related info.
Analysts should consider differences in choice of inv. valuation method when conducting comparisons.

Page 1
“LONG-LIVED ASSETS”
G/W =Goodwill NRV = Net Realizable Value
SL =Straight Line 29.a, c FV = Fair Value
RV =Residual Value CF = Cash Flows
BV =Book Value Expenditure can either be capitalized as an asset (investing outflow) or expensed in I.S. BC = Business
B.S =Balance Sheet Nonmonetary exchange, cost is based on F.V. Combination
PP&E =Property, Plant & If expensed then operating outflow, total CF is unaffected by expensing vs. capitalizing DDB = Double Declining
Equipment decision. Balance
SV = Salvage Value CV = Carrying Value
F.S = Financial Capitalized Interest HC = Historical Cost
statements G/L = Gain & Loss
Pmt = payment Interest cost is capitalized when an asset is constructed for own use or for resale under i-exp = interest expense
both standards.
Interest rate is based either on debt acquired to specifically finance the asset’s
construction or the firm’s existing borrowings.
Interest cost is charged to I.S through depreciation or COGS.
In CF statement, cap. Interest is an outflow from investing activities.
Income earned by temporarily investing borrowed funds reduces borrowing costs
available for capitalization (IFRS). No reduction under U.S. GAAP.
Effects of Capitalizing vs Expensing

Items Capitalizing Expensing
Total assets Higher Lower
Equity Higher Lower
Income variability Lower Higher
Net income (1st year) Higher Lower
Net income (subsequent years) Lower Higher
CFO Higher Lower
CFI Lower Higher
Debt-to-equity & debt ratio Lower Higher
Interest coverage (1st year) Higher Lower
Interest coverage (subsequent Lower Higher
years).
Analyst may reverse effect of capitalized interest & restate

financial statements & ratios.
Many analysts consider total interest expense when calculating
interest coverage ratios.
29.b
Intangible assets ⇒ long term assets that lack physical substance (e.g. brand
name, copyrights etc.).
Finite-life intangible asset ⇒ amortized; Indefinite-life ⇒ impairment test.
Intangible Assets
Identifiable Intangible assets Unidentifiable Intangible assets
Capable of being separated from firms, controlled by firms Cannot purchase separately & may have indefinite life (e.g.
& expected to provide future eco. benefit (IFRS). G/W).
Future eco. benefit must be probable & asset cost can be G/W is excess of purchase price over FV of identifiable net
measured reliably. assets.

Page 2
29.b Intangible Assets
Created Internally Purchased Obtained in B.C
Expensed as incurred except the following exceptions. Initially at FV. Acquisition method is
If part of a group, then used for B.C.
R&D Costs
purchase price allocated Purchase price is allocated
to each asset based on its to assets & liabilities of
FV. acquired firm on the basis
IFRS U.S. GAAP
Analyst is more interested of their FV, any remaining
in type of asset rather amount is G/W.
Research cost ⇒expensed Expensed
value.
Development cost⇒ capitalized. Capitalizing intangible
assets have similar effects
Software development cost as capitalizing other
expenditures.
IFRS U.S.GAAP
For sale or own use ⇒ Same treatment as IFRS

expensed until technological for sale, capitalized for
feasibility, then capitalized. own use once probability
of completion is
determined.
29. d & e Depreciation ⇒ systematic allocation of an asset’s cost over time.

Carrying value ⇒net value on B.S.
Historical cost ⇒ original purchase price + installation & transportation.
Dep. is a real & significant operating expense.
Analyst should compare the reported depreciation to eco. dep. (actual decline in value).
Depreciation Methods
Straight-line depreciation Accelerated depreciation Units-of-production
Same amount each year. More dep. in early years & less in later years. Based on asset production activity rather time.
Dep. expense = (original cost – SV) Less N.I in early years.
Dep. = × output units in period

/ useful life. DDB dep. in year X = × BV

Once CV reaches SV, no additional dep. expense.
Useful lives & salvage values
Longer useful life & higher salvage value ⇒ dep. N.I & vice versa.
∆ in estimate (useful life or SV ) affects financial statements prospectively.
Estimate involved when allocating dep. Exp. between COGS & SG&A by a manufacturing firm
(affect GP margin).

Page 3
29. d & e Component Depreciation
IFRS U.S. GAAP
To depreciate components of assets Allowed but seldom used.

separately useful life estimates are required.
Dep.exp. of each component is computed
separately.
29.f & g
Amortization is identical to the depreciation of tangible assets (same methods & estimates are used).
Indefinite life intangibles are tested for impairment at least annually.
Examples include acquired license, acquired trademark etc.
29. h The Revaluation Model
Most long-lived assets ⇒ carried at depreciated cost & no FV alternative under U.S.GAAP.
IFRS provide alternative ⇒ revaluation model (long-lived assets at FV).
FV < carrying amount ⇒ loss in I.S, income & and thus equity.
Subsequent increase ⇒ gain in I.S up to previous loss and any excess in equity.
in asset value above carrying amount ⇒ component of shareholders’ equity (revaluation surplus).
Subsequent decline ⇒ reduce surplus and remainder is recorded as loss in I.S.
Upward revaluation results in total assets & equity, dep. Exp. & profitability in periods after revaluation.
29. i Impairment
IFRS U.S.GAAP
If CV > recoverable amount then impaired. Impaired if firms are unable to recover CV through
Recoverable amount = greater of, FV – selling cost or future use.
value in use.
Value in use = PV of future CF stream.
Impairment Steps
If impaired, B.S value is recoverable amount & loss (CV
– recoverable amount) is recorded in I.S.
Loss reversal is allowed (limited to original loss).
Recoverability Loss measurement
Long lived assets held for sale Impaired if CV > Value written down
future undiscounted to FV on B.S & loss
CF. (CV –FV) in I.S.
If firm reclassify from held for use to held for sale,
Loss recovery is not
impairment test, impaired if CV > NRV, NRV at B.S &
permitted.
loss in I.S.
Loss reversal allowed under IFRS & U.S.GAAP (limited
to original impairment loss).

Page 4
29.j
Derecognition
Sold Abandoned Exchanged
Diff. b/w sale proceeds & CV ⇒ G/L No proceeds. G/L is computed by comparing CV of
in I.S. CV removed from B.S & loss in I.S. old asset with FV of old asset (or FV
G/L as part of other G/L or reported of new asset if more evident).
separately if material. CV of old asset removed & new
G/L removed from N.I when asset recorded at FV.
calculating CFO from indirect
method.
29. l & m Disclosures (PP&E Intangible assets)
IFRS U.S. GAAP
PP&E Intangible assets PP&E Intangible assets
Basis for measurement, useful life Similar as PP&E Dep. Exp. & balance of major classes Provide an estimate of
& dep. method. except, must of assets by nature & function. amortization expense for
Gross CV, Acc. Dep. & reconciliation disclose whether Description of dep. methods for next five years.
of carrying amount from beg. to useful lives are finite major asset classes. Gross carrying amount and
ending period. or indefinite. Accumulated Dep. By major classes accumulated amortization
Agreement to acquire PP&E in or total. expense in total and by
future & assets pledge as collateral. Description of impaired asset & major asset classes.
Revaluation date, CV using H.C impairment circumstances. The aggregate amortization
model & how FV is determined. How FV is determined. expense.
Carrying amount under cost model Amount & location of loss in
and revaluation surplus financial statements.
Amount & reversals of impairment
losses recognized in the period.
Circumstances & main events
leading to loss recognition in I.S.

Page 5
29. n Investment Property: Property to earn rental income or capital gains or both.
Under IFRS Under U.S. GAAP

• Such a property is called investment property • No specific definition
• Allow either cost model or fair value model • Most companies use the
• Cost Model: Property cost – Acc. Dep.–impairment losses historical cost model
• FV Model: All ∆ in the FV of the asset affect NI
• To use FV model, companies must reliably determine the
property’s FV on a continuing basis.
Reclassification of Investment Property
If chosen model:
Investment property Cost Model No ∆ in CV
reclassified as
Owner occupied property or
part of inventory
If chosen model: FV Property’s cost at FV for subsequent accounting
Owner occupied property Property will be carried at FV & ∆ from depreciated cost
If chosen model: FV to FV will be treated as revaluation surplus/loss
reclassified as
Investment property
Any difference b/w CA and FV at time of transfer is

Property as part of Inventory If chosen model: FV recognized as profit or loss
reclassified as
Investment property
L29. o The Lease vs Buy Decision
Leases:
• less costly financing

• may contain less restrictive provisions
• reduce the risk of obsolescence, residual value & disposition to the lessee
• tax benefits for lessor
• in some countries, companies may own asset for tax purposes while not
reflecting the ownership in F.S, such lease type is known as synthetic lease.

Page 6
L29. p Finance leases vs Operating leases
Finance Lease Operating Lease

Equivalent to the purchase of an An agreement allowing the lessee to
asset by the buyer (lessee) that is use the asset for a period of time
directly financed by the seller
(lessor)
Accounting and reporting by the lessee

• economically similar to borrowing money & buying • economically similar to renting as asset
an asset. • no asset or liability on B.S.
• reports asset and related debt on B.S • lease exp. on I.S.
• reports i-exp. & dep. exp. on I.S. • full lease pmt as CFO(out) on statement of CF
• On statement of CF, portion of lease pmt related to: • reports ↑ (profits & return measures) in early yrs
i. i-exp as CFO(out) • stronger solvency position
ii. lease liability as CFF(out)
• reports ↓ ROA
• reports ↑ operating CFs
an Lease disclosures (future pmts):

• under U.S. GAAAP are disclosed yr. by yr. for the 1st • under IFRS are disclosed for the 1st yr, in aggregate
5-yrs and then aggregated for subsequent yrs. for yrs 2-5 & then in aggregate for subsequent yrs.
ase will typically show higher profits in early years, higher
Accounting and reporting by the lessor

• reports lease receivables & reduces its assets • records lease revenue when earned
by the CA on B.S • reports leased assets on B.S & dep. exp. on I.S
• reports interest revenue on I.S.
an
Under U.S. GAAP, two types of non operating leases (from lessor’s perspective):
Direct Finance lease: Sales-type lease:
• when PV of leased pmts = CA of leased assets • when PV of leased pmts > CA of leased assets
ill typically show higher profits in early years,

Page 1
“INCOME TAXES”
I.T = Income Tax VA = Valuation Allowance
30. a Tax Loss Terminology
DTA = Deferred Tax Asset A&L = Assets & Liabilities
DTL = Deferred Tax Liabilities NI = Net Income
C/F = Carry Forwards FS = Financial Statement
Amount of I.T expense may differ from actual taxes owed to taxing
authorities.
Taxable income ⇒ income subject to tax based on tax return.
Taxes payables (current tax expense) ⇒ tax liability on B.S caused by taxable
income.
Income tax paid ⇒ actual CF for I.T including from prior periods payments or
refunds from received in the current period.
Tax loss carry forward ⇒ current loss to reduce future taxable income (can
result in DTA).
Tax base ⇒ amount at which the asset or liability is valued for tax purposes.
Financial Reporting Terminology
Accounting profit ⇒ pretax financial income.

Income tax expense = taxes payable + ∆ DTL - ∆ DTA.
Carrying value ⇒ net B.S value of an A or L.
Permanent difference ⇒ diff. b/w taxable income & pretax income that will
not reverse in future.
Temporary difference ⇒ diff. b/w tax base & CV of an A or L that result in
either taxable amounts or deductible amounts in future.
30. b
DTL is created when I.T expense is > than taxes payable due to temporary
differences.
DTL occurs when
Revenues in I.S before on tax return due to temporary differences.
Expenses are tax deductibles before recognizing in I.S.
DTA is created when taxes payable are > income tax exp due to temporary
differences.
Post-employment benefits, warranty expenses & tax loss C/F are causes of
DTA.
DTA occurs when
Revenues are taxable before recognizing in I.S.
Expenses are recognized in I.S before they are tax deductible.
Tax loss C/F is available to reduce future taxable income.
30. c
Tax base of assets ⇒ amount that will be deducted on tax return in future as
eco benefit of asset are realized.
Carrying value ⇒ value of asset reported on F.S, net of depreciation &
amortization.
Tax base of liabilities ⇒ CV of liability – any amount deductible on tax return
in future.
Tax base of revenue received in advance = CV – amount of revenue that will
not be taxed in future.

Page 2
30.d
Example
30. e
When tax rate, DTL & DTA & vice versa.

∆ in B.S values will affect I.T. expenses in current period.
I.T expense = taxes payable + ∆ DTL - ∆ DTA.
30. f
Permanent difference ⇒ difference b/w taxable income & pretax income

that will not reverse in future.
Permanent differences do not create DTA or DTL & will cause firm’s effective
tax rate to differ from statutory tax rate.
Statutory rate ⇒ tax rate of jurisdiction.
Effective tax rate = income tax expense / pretax income.
Temporary difference ⇒ diff. b/w tax base & CV of A or L that will result in
taxable or deductible amounts in future.
30. g
Neither DTA nor DTL are carried on B.S at discounted PV.

If > 50% probability that some or all DTA will not realized, then DTA must be
reduced by valuation allowance (reduce net B/S value of DTA) I.T expense
& N.I & vice versa. (U.S.GAAP).
Management can manipulate earnings by changing valuation allowance.
30. h
Disclosure is required for DTA & DTL.

∆ in these accounts are reflected in I.T expense.
Some examples of temporary differences may include depreciation methods.
30. i
Disclosure is about:
DTA, DTL & VA, net ∆in VA.
Any unrecognized DTL for undistributed earnings of subsidiaries & joint
ventures.
Current year tax effect of each difference.
Components of I.T expenses & tax loss C/F & credits.
Reconciliation of reported I.T provision and the I.T provision computed
using the statutory tax rate.

Page 3
30. j
Tax Accounting Differences, IFRS vs. U.S.GAAP

U.S.GAAP IFRS
Revaluation of fixed assets Not applicable, no revaluation allowed. Deferred taxes are recognized in equity.
and intangible assets
Undistributed profit from an No deferred taxes for foreign subsidiaries Deferred taxes are recognized unless the
investment in a subsidiary that meet the indefinite reversal criterion. parent is able to control the distribution of
profit and it is probable the temporary
No deferred taxes for domestic difference will not reverse in the foreseeable
subsidiaries if the amounts can be future.
recovered tax free.
Undistributed profit from an No deferred taxes for foreign corporate Deferred taxes are recognized unless the
investment in a joint JVs that meet the indefinite reversal venture is able to control the sharing of
venture (JV). criterion. profit and it is probable that the temporary
difference will not reverse in the foreseeable
future.
Undistributed profit from an Deferred taxes are recognized on Deferred taxes are recognized unless the
investment in an associate temporary differences. investor is able to control the sharing of
firm. profit and it is probable that the temporary
difference will not reverse in the foreseeable
future.
Deferred tax asset Recognized in full and then reduced if Recognized if “probable” that sufficient
recognition “more likely than not” that some or the taxable profit will be available to recover the
entire tax asset will not be realized. tax asset.
Tax rate used to measure Enacted tax rate only. Enacted or substantially enacted tax rate.
deferred taxes
Presentation of deferred Classified as current or noncurrent based Netted and classified as noncurrent.
taxes on the balance sheet on the classification of the underlying
asset or liability.

Page 1
“NON-CURRENT (LONG-TERM) LIABILITIES”

MRI = Market Rate of Interest CFS = Cash Flow Statement
CR = Coupon Rate O.L = Operating Lease
IE = Interest Expense F.L = Finance Lease
FV = Fair Value GP = Gross Profit
PV = Present Value BV = Book Value
A&L = Assets & Liabilities IS = Income Statement
CV = Carrying Value CFO = Cash Flow From Operation
BS = Balance Sheet CFF = Cash Flow from Financing
31. a Debt Issuance
Bond Issued at Par Bond Issued at Discount Bond Issued at Premium
MRI (return required by bondholders) = CR. CR < MRI = discount. CR > MRI= Premium.
PV of coupon + PV of face amount = par value. Investors pay less than Investor will pay more for
A&L by face value on B.S. face value because of attractive coupon rate.
Interest expense = coupon paid (I.S). low coupon.
Issuance proceeds as CFF inflow, coupon payment in
CFO & repayment of face value, outflow from CFF.
Under U.S. GAAP or as CFO or CFF under IFRS. B/S Impact
A & L by bond sale proceeds.

Price of the bond at issuance = PV of future cash payments.
Interest exp & Value of bond at issuance is calculated using market rate of interest at
issuance.
31. b I.E includes amortization of discount or premium at issuance if not issued at par.
I.E (effective I.R method) = BV of bond liability t–1 × MRI at issuance.
Premium bonds ⇒ I.E < coupon payment, difference is amortization of premium.
I.E as bond liability & reduces periodic premium amortization & vice versa in
case of a discount bond.
Zero Coupon Bonds
No periodic payments of interest & interest expense are implied.

Actual interest payments are included in face value.
F.S impact is qualitatively same as any other discount debt.
Issuance Cost
Bond issuance costs usually netted against bond proceeds & reported as CFF.
IFRS U.S.GAAP
Initial bond liability on B/S is reduced by Capitalize as an asset & allocate over term of
amount of issuance cost, effective I.R. bond.

Page 2
31. c Extinguishing Debt
At maturity BV & face value of liability is same so no G/L.

Firm may choose to redeem bonds before maturity due to various
reasons.
When redeemed before maturity G/L is calculated by subtracting
redemption price from BV of liability.
Unamortized issuance cost must be written off & included in G/L
calculation (U.S.GAAP). No write-off is necessary under IFRS (already
included in BV of liability).
In CFS, G/L is eliminated from N.I in arriving at CFO & cash paid to
redeem bonds is shown as an outflow from financing activities.
FV Reporting Option
If yield ∆, bond’s carrying amount no longer equal to its market value.

Yield, FV of liability & vice versa.
Option to report debt at FV (IFRS & U.S.GAAP) & G/L in I.S.
MV of debt is more appropriate then B.V.
When I.R were low at issuance, firm is better off when I.R rise (low MV
of debt, debt, equity, debt to assets & debt to equity) & vice
versa.
31. d Debt Covenants
Restrictions imposed by lender Affirmative Covenants Negative Covenants

on borrower to protect lender’s
position & to reduce default risk. Borrower promises to do certain Refrain certain activities that
things e.g. timely interest & adversely affect ability to repay
principal payment, maintain e.g. Limit paying dividends &
ratios etc. issuing more debt etc.
If technical default (covenant violated), bondholder can demand immediate repayment of principal.
31. e
Firms provide disclosure about long term debt in footnotes & MD&A.
Disclosure usually includes maturity dates, stated & effective I.R, restrictions by creditors & the
amount of scheduled debt repayments for the next five years.
Discussion in MD&A can be both quantitative & qualitative.

Page 3
31. f
Lease ⇒ contractual arrangement whereby the owner (lessor) grants lessee the right to use the asset for a particular period &
payment.
Leasing can have less costly financing, reduce obsolescence risk, less restrictive provisions, off B.S financing & tax reporting advantages.
Lease Classification
Finance lease Operating lease
In substance, purchase of asset with debt. Rental arrangement.

Equal amounts to both A&L. No A or L.
Dep. expense on assets & interest exp. to liab. Periodic payments as rental expense.
31. g Lessee’s Perspective
IFRS U.S.GAAP
If all rights & risks of ownership are transferred to Capital lease if any of following occur:
lessee, finance lease. Title transferred at lease end.
Circumstances for a finance lease include: Bargain purchase option.
Title transferred at end of lease. Lease period is 75% or more of asset’s life.
Lessee can purchase assets at significant PV of lease payment is 90% or more of FV
lower price in future. leased asset
Lease term covers major portion of asset’s
economic life.
The PV of lease payments is substantially
equal to FV of leased asset.
Specialized asset, that only lessee can use
without modifications.
Lease not meeting any of above criteria is operating lease & preferred by lessee (no Liability).
Lessor’s perspective
IFRS U.S. GAAP
If all rights & risks of ownership are transferred, If any one of lease criteria is met, & reasonably
finance lease, otherwise operating. assured cash collectability, & lessor has
substantially performed under the lease, capital
lease, otherwise operating.
Operating lease ⇒ rental income & depreciation on asset.

Capital lease ⇒ replace asset with lease investment account.

Page 4
31. h Reporting by the lessee
Operating lease Finance Lease
B.S is unaffected. A&L (lower of PV of future minimum lease

Rent expense (lease payment) in I.S. payment & FV of leased asset).
CFS, lease payment as CFO outflow. Asset is dep. in I.S & interest expense (lease
liability t–1 × lease rate) is recognized.
CFS, principal (outflow from financing), interest:
outflow from CFO (U.S.GAAP), CFO or CFF (IFRS).
Ratios & F.S effects of leases
B.S I.S CFS
Turnover ratios will be lower under EBIT for capital lease. CFO & CFF under finance lease &
finance lease. Total expense over life of lease is same. vice versa in case of O.L.
ROA, leverage ratios, current N.I in early years will be lower under Total CFs are unaffected.
ratio & working capital under capital finance lease (sum of dep. & interest is >
lease. lease payment) & higher in later years.
Reporting by the lessor
U.S.GAAP IFRS
No distinguish b/w sales-type &

Sale-Type Lease Direct Financing Lease
direct financing.
Similar treatments for sales-type
PV of lease payment > PV of lease payment = leases originated by dealers or
CV of asset CV of asset manufacturers.
Sales-type lease
Lessor (normally manufacturer or dealer) sells asset for PV of lease payment &
provides loan of same amount to buyer.
Sale = PV of lease payment, cost = CV of asset & difference is GP.
Principal portion reduces lease receivable & interest portion is recognized as
interest income.
In CFS, interest is inflow from CFO & Principal as inflow from CFI.
Direct Financing Lease
No GP is recognized, simply providing a financing function.

Remove asset from B.S & create lease receivable by same amount.
CFS treatment is similar as under sales-type.
Operating Lease
Rental income by lessor.

Keep asset on B.S & depreciate it.

Page 5
31. i
Both lessee & lessor are required to disclose useful information about leases, including ;
General description of leasing arrangement.
Timing, nature & amount to be paid or received in each of next five years & payments
after 5 years are aggregated.
Lease revenue & expense in I.S & amount receivable & unearned revenues.
Restrictions imposed by lease agreements.
I.R used in lease calculations is not always disclosed.
31. j, k Types of Pension Plans
Defined Contribution Plans (DCP) Defined-Benefit Plans (DBP)
Company contributes a defined amount into the plan More complicated than DCP.
(treated as pension expense). Company promises future benefits to be paid to
Cash flows contributed to the plan are treated as an employees during retirement.
operating cash outflows. Assumptions are made to determine future obligation.
Impact on assets & liabilities ⇒ in cash & a liability is The pension obligation is allocated over the employee’s
recognized if some portion of agreed upon amount has employment as part of pension expense.
not yet been paid.
Recognition of DBP
Most DBPs are funded through pension trust fund.

If the fair value of plan assets > (<) the PV of pension
obligation, the plan has a surplus (deficit) & the company’s
balance sheet will reflect a net pension asset (liability).
Defined Benefit Plan
IFRS U.S.GAAP
∆ in net pension asset or liability have three components. ∆ in net pension asset or liability each period is viewed as having
five components.
′
Three components are recognized in P&L in the period

/ &

incurred.
& Service costs.

Interest exp.
Employees’ service costs ⇒ PV of in the pension benefit Expected return on assets ( amount of expense
earned by the employee by providing one more year of service. recognized).
Past service costs & actuarial G/L are recognized in OCI &
Net interest expense or income ⇒ net pension asset or liability × subsequently amortized over time (smooth pension
discount rate (reflective of high quality corporate bond yield). expenses).
Remeasurements:
Actuarial G/L resulting from ∆ made to assumptions.
Actual return on plan asset – any return included in net
interest exp or income

Page 6
31. l In evaluating solvency (ability to satisfy long-term obligations), analysts look at leverage &
coverage ratios
Ratios
Leverage ratios Coverage ratios
Measure amount of debt (interest bearing obligation) in capital Sufficiency of earnings to repay interest & other fixed charges.
structure. Interest coverage = EBIT / interest payment.
Debt-to-assets ratio = total debt / total assets (% of total assets Fixed charges coverage = EBIT + lease payment / interest + lease
financed with debt). payments.
Debt-to-capital ratio = total debt / (total debt + total equity) Lower the ratios, the greater difficulty to make payments.
(total capital excludes non-interest bearing liabilities).
Debt-to-equity ratio = total debt / total equity (amount of debt
financing relative to equity base).
Financial leverage ratio = Avg. total assets / Avg total equity
(leverage used in DuPont)
Higher these ratios, higher the leverage.

Page 1
“FINANCIAL REPORTING QUALITY”
1. INTRODUCTION
Quality of financial reports can vary greatly.

High quality financial repotting ⇒ useful to analysts in assessing a company’s
performance & prospects:
Low quality financial reporting ⇒ it contains inaccurate, misleading, or
incomplete information.
2. CONCEPTUAL OVERVIEW
Exhibit 1. Relationships between Financial Reporting Quality and Earnings Quality
Financial Reporting Quality
Low High
High HIGH financial reporting

quality enables assessment.
Earnings HIGH earnings quality
(Results) LOW financial reporting increases company value.
Quality quality impedes assessment HIGH financial reporting
of earnings quality and quality enables assessment.
Low impedes valuation. LOW earnings quality
decreases company value.
Reference: Level I Reading 32
2.1 GAAP, Decision-Useful, Sustainable, and Adequate Returns
Earnings of high quality conforms to the generally accepted accounting

principles (GAAP) of the jurisdiction e.g. IFRS, US GAAP etc.
High quality financial reporting also embodies the conceptual framework.
Relevant information ⇒ information that can affect a decision & are of
material nature.
Faithful representation ⇒ complete, neutral & error free information.
Comparability, verifiability, timeliness & understandability are other
characteristics.
Superior quality earnings indicate an adequate level of return on investment &
its sustainability.
2.2 GAAP, Decision-Useful, but Sustainable?
High quality reporting does not guarantee that earnings are also of high
quality.

Page 2
2.3 Biased Accounting Choices
Biased choices in financial reports ⇒ unfaithful representation of economic

phenomena.
Problem ⇒ it negatively impact investor’s decision regarding investment.
Aggressive (conservative) choices ⇒ they increase (decrease) company’s
reported performance & financial position in current period & decrease
(increase) the same in later periods.
Another bias⇒ earnings smoothing ⇒ conservative attitude in good periods &
aggressive choices in struggling periods.
Investors may prefer conservative choices rather than aggressive ones.
2.3.1 Within GAAP, but “Earnings Management”
Earnings management ⇒ intentional choices that create biased financial reports.

Earnings can be managed upward by taking real actions or can be increased by
accounting choices.
2.4 Departures from GAAP
Financial reporting that departs from GAAP can generally be considered poor
quality.
Under this situation, assessment of earnings quality is difficult or impossible.
2.5 Differentiate between Conservative and Aggressive Accounting
2.5.1 Conservatism in Accounting Standards
Conceptual framework supports neutrality of information (lack of upward or downward bias),

which is a desirable characteristic.
Impairment
IFRS ⇒ recoverable amount < carrying value ⇒ impairment charges will be recorded.
U.S GAAP ⇒ sum of undiscounted future CFs < carrying value ⇒ impairment charge
will be recorded.
Research cost ⇒ immediate expensing in both IFRS & U.S. GAAP.
Litigation losses ⇒ both IFRs & U.S.GAAP require expense recognition when it becomes
“probable” that a cost will be incurred.
Insurance recoverable ⇒ not recognized a receivable until insurance company may not
acknowledges the validity of claimed amount.
Commodity inventories ⇒ ↑ in market prices of commodity, inventories held may not be
recognized unless they are sold.
Four potential benefits of conservatism:
It protects the contracting parties with less information & greater risk.
Conservatism reduces the possibility of litigation & litigation cost.
It protects the interest of regulators & politicians.
Tax savings.
2.5.2 Bias in the Application of Accounting Standards
Companies use the accounting provisions to estimate big losses in the current
period so the performance in future periods will appear good.
Both U.S.GAAP & IFRS require accruals of estimates of future non-payments of
loans.

Page 3
3. Context for Assessing Financial Reporting Quality
3.1 Motivations
Companies experiencing performance problems may induce a response that

inflates current earnings in exchange for lower future earnings.
Manager mark poor performance to beat market expectations & to increase
stock price.
Incentive compensation & career concerns may motivate accounting choice.
3.2 Conditions Conducive to Issuing Low-Quality Financial Reports
Three conditions for low quality financial reports:

Opportunity ⇒ it is the result of internal conditions e.g. poor internal
controls.
Motivation ⇒ it arise from pressure to meet some criteria for personal
reasons.
Rationalization ⇒ it is important because if an individual is concerned
about a choice he needs to be able to justify it to him.
3.3 Mechanisms That Discipline Financial Reporting Quality
3.3.1. Market Regulatory Authorities
National regulators & regulations that establish & enforce rules can play a
significant role in financial reporting quality.
Features of regulatory regime that affect financial reporting quality includes:
Registrations requirements.
Disclosure requirements.
Auditing requirements.
Management commentaries.
Responsibility statements
Regulatory review of filings
Enforcement mechanisms.
3.3.2. Auditors
Publically traded companies typically require their financial statements to be

audited by an independent auditor.
Auditor’s opinion provides some assurance regarding financial statement
fairness to their users.
3.3.3 Private Contracting
Loan agreements & other contractual arrangements serve as mechanisms to

discipline financial reporting quality.
Managers may manipulate reported results to avoid the financial triggers based
on these agreements.

Page 4
4. Detection of Financial Reporting Quality Issues
Manager that wants to improve Manager that wants to improve

performance in current period could: performance in later period could:
Recognize revenue premature. Save current income for a later period.

Increase profit through non-recurring transactions. Recognize future expenses in a current period.
Defer expense to later periods.
Assets (liabilities) re-measurements at higher (lower)
values.
4.1 Presentation Choices
EBITDA is widely viewed as eliminating noisy reporting signals.

Various versions of pro-forma earnings because a financial reporting staple of
the era.
4.2 Accounting Choices and Estimates
4.2.1 How Accounting Choices and Estimates Affect Earnings and Balance Sheets
Assumptions about inventory cost flows can affect financial reporting.

Under first-in-first-out (FIFO) basis, the remaining inventory reflects the most
recent costs.
FIFO cost assumption will provide a more current picture of ending inventory
value.
Weighted-avg. cost ⇒ more current costs are shows in cost of sales.
4.2.2 How Choices Affect the Cash Flow Statement
Investors mostly scrutinized the operating section of CFs as a reality check on

reported earnings.
Operating cash flow statement can be shown either under the direct or indirect
method.
Managers can improve the appearance of CFO without actually improving it e.g.
through accounts payable management.
Cash generated by operation in excess of net income signifies better quality of
earnings and vice versa.

Page 5
4.2.3 Choices That Affect Financial Reporting
Exhibit 22. Areas Where Choices and Estimates Affect Financial Reporting
Area of Choice/Estimate Analyst Concerns
Revenue recognition How is revenue recognized: upon shipment or upon

delivery of goods?
Is the company engaging in “channel stuffing”—the
practice of overloading a distribution channel with more
product than it is normally capable of selling?
This can be accomplished by inducing customers to buy
more through unusual discounts, the threat of near-term
price increases, or both—or simply by shipping goods
that were not ordered. These transactions may be
corrected in a subsequent period and may even result in
restated results. Are accounts receivable relative to
revenues abnormally high for a company relative to its
history or its peers? If so, channel stuffing may have
occurred.
Is there unusual activity in the allowance for sales
returns relative to past history?
Does the company’s day’s sale outstanding indicate any
collection issues that might indicate shipment of
unneeded or unwanted goods to customers?
Does the company engage in “bill and- hold”
transactions? In such transactions, a customer purchases
goods but requests that the goods remain with the seller
until a later date. This kind of transaction makes it
possible for a seller to manufacture fictitious sales by
declaring end-of-period inventory as “sold but held,”
with a minimum effort and phony documentation.
Does the company use rebates as part of its marketing
approach? If so, how significantly do the estimates of
rebate fulfillment affect net revenues, and have any
unusual breaks with history occurred?
Does the company separate its revenue arrangements
into multiple deliverables of goods or services? This area
is one of great revenue recognition flexibility, and also
one that provides little visibility to investors. They simply
cannot examine a company’s arrangements and decide
for themselves as to the propriety of revenue allocation
to different components of a contract. If a company uses
multiple deliverable arrangements with its customers as
a routine matter, investors might be more sensitive to
revenue reporting risks. In seeking a comfort level,
investors might ask the following questions: Does the
company explain adequately how it determines the
different allocations of deliverables and how revenue is
recognized on each one? Do deferred revenues result? If
not, does it seem reasonable that there are no deferred
revenues for this kind of arrangement? Are there unusual
trends in revenues and receivables, particularly with
regard to cash conversion? If an investor cannot be
satisfied with the answers from these questions, he or
she might be more comfortable with other investment
choices.

Page 6
Long-lived assets: Depreciation policies Do the estimated life spans of the associated assets make sense, or are
they unusually low compared with others in the same industry?
Have there been changes in depreciable lives that have a positive effect on
current earnings?
Do recent asset write-downs indicate that company policy on asset lives
might need to be reconsidered?
Intangibles: Capitalization policies Does the company capitalize expenditures related to intangibles, such as
software? Does its balance sheet show any R&D capitalized as a result of
acquisitions? Or, if the company is an IFRS filer, has it capitalized any
internally generated development costs?
How do the company’s capitalization policies compare with the
competition?
Are amortization policies reasonable?
Allowance for doubtful accounts/loan loss Are additions to such allowances lower or higher than in the past?
reserves Does the collection experience justify any difference from historical
provisioning?
Is there a possibility that any lowering of the allowance may be the result
of industry difficulties along with the difficulty of meeting earnings
expectations?
Inventory cost methods Does the company use a costing method that produces fair reporting
results in view of its environment? How do its inventory methods compare
with others in its industry? Are there differences that will make
comparisons uneven if there are unusual changes in inflation?
Does the company use reserves for obsolescence in its inventory
valuation? If so, are they subject to unusual fluctuations that might
indicate adjusting them to arrive at a specified earnings result?
If a company reports under US GAAP and uses last-in-first-out (LIFO)
inventory accounting, does LIFO liquidation (the assumed sale of old,
lower-cost layers of inventory) occur through inventory reduction
programs? This inventory reduction may generate earnings without
supporting cash flow, and management may intentionally reduce the
layers to produce specific earnings benefits.
Tax asset valuation accounts Tax assets, if present, must be stated at the value at which management
expects to realize them, and an allowance must be set up to restate tax
assets to the level expected to eventually be converted into cash.
Determining the allowance involves an estimate of future operations and
tax payments. Does the amount of the valuation allowance seem
reasonable, overly optimistic, or overly pessimistic?
Are there contradictions between the management commentary and the
allowance level, or the tax note and the allowance level? There cannot be
an optimistic management commentary and a fully reserved tax asset, or
vice versa. One of them has to be wrong.
Look for changes in the tax asset valuation account. It may be 100%
reserved at first, and then “optimism” increases whenever an earnings
boost is needed. Lowering the reserve decreases tax expense and
increases net income.
Goodwill Companies must annually assess goodwill balances for impairment on a
qualitative basis. If further testing appears necessary, it is based on
estimates of the fair value of reporting units (US GAAP issuers) or cash-
generating units (IFRS issuers), which are associated with goodwill
balances. The tests are based on subjective estimates, including future
cash flows and the employment of discount rates.
Do the disclosures relating to the goodwill testing suggest that the testing
was skewed to avoid goodwill impairment charges?

Page 7
Warranty reserves Have additions to the reserves been reduced, perhaps to make earnings
targets? Examine the trend in the charges of actual costs against the
reserves: Do they support or contradict the warranty provisioning activity?
Do the actual costs charged against the reserve give the analyst any
indication about the quality of the products sold?
Related-party transactions Is the company engaged in transactions that disproportionately benefit
members of management? Does one company have control over another’s
destiny through supply contracts or other dealings?
Do extensive dealings take place with non-public companies that are under
management control? If so, non-public companies could absorb losses
through supply arrangements that are unfavorable to the private
company, for example) in order to make the public company’s
performance look good. This scenario may provide opportunities for an
owner to cash out.

4.3 Warning Signs
Followings are warning signs for analysts or investors:

1) Pay attention to revenue.
Cheek for bill-and-hold arrangement for revenue recognition.
Barter transaction may difficult to value properly.
Rebate programs may have significant effects on revenue recognition.
Analysts may need to understand the reasons of exponential revenue growth (higher than industry).
Compare revenue with accounts receivables.
Calculate receivable turnover for several years.
Company may engage in channel stuffing activities if receivables are increasing at %of total revenue.
2) Pay attention to signals from inventories.
Compare inventory growth with competitors & industry benchmarks.
Calculate the inventory turnover ratio.
↓ Inventory turnover could suggest obsolescence problems.
Companies under U.S. GAAP may use LIFO that affects earnings in inflationary environment.
3) Pay attention to capitalization policies and deferred costs
If company is the only one that is capitalizing certain costs while other industry participants are treating
these costs as expense, a red flag is raised.
4) Pay attention to the relationship of cash flow and net income.
Cash flow from operation ⇒ if ratio is consistently below 1.0 or net income has declined repeatedly,
problem exist.
5) Other potential warnings signs.
Depreciation method & useful life.
Analyst should compare useful life & depreciation method with peer group.
Analyst should check fourth-quarter surprises.
Check for presence of related-party transactions.
Non-operating income or one-time sales included in revenue.
Classification of expenses as non-recurring.
Gross margins out of line with industry.
Minimal disclosures.
Management fixation on earnings reports.

Page 1
“FINANCIAL STATEMENT ANALYSIS: APPLICATIONS”

N.I = Net Income OP = Operating Profit
CF = Cash Flows GP = Gross Profit
FS = Financial Statements R&D = Research & Development
33.a
Trends in ratios & difference b/w firm & competitors or industry avg. indicate firm’s business strategy.
Ratio of GP/OP will higher for a firm that spends largely on R&D.
If firm going to improve EPS by cost cutting, examine operating & gross margins.
Non-U.S companies that use any accounting standards other than IFRS or U.S. GAAP & file with the U.S SEC
were previously required to reconcile their net income & equity accounts to U.S. GAAP.

33.b
Forecast of future N.I & CF begins with forecast of future sales (top down approach).
Analyst estimates company sales by multiplying projected industry sales with projected
market share.
Simple forecasting model ⇒ historical avg. or trend adjusted measure of profitability.
Complex forecasting model ⇒ each I.S & B.S item estimated based on separate assumptions
about its growth to revenue growth.
To estimate CF ⇒ make assumptions about future sources & uses of cash.
33.c “Three Cs” to credit analysis
Character Collateral Capacity to repay
Management’s professional Reduce lender risk Close examination of FS &

reputation & history of debt ratios
repayment.
Categories Considered by rating agencies
Scale & diversification Operational efficiency Margin Stability Leverage
Larger companies, wider Greater vertical Indicate a higher Greater earnings in

variety of product line & diversification, probability of relation to debt &
greater geographical efficiency with better repayment. interest expenses, less
diversification less credit debt ratings. credit risk.
risk.
33.d
Portfolio stocks from large universe of equity investments are selected based on accounting items & ratios.
Multiple criteria are used instead of single factor in order to avoid other undesirable characteristics.
Back testing ⇒ using a specific set of criteria to screen historical data to determine how portfolios will perform.

Page 2
33.e
F.S must be adjusted for different accounting methods to make them comparable.
Important differences b/w IFRS & U.S. GAAP are: effect of exchange rate changes,
treatment of internally generated intangible assets etc.

1
“Corporate Governance & ESG: An Introduction”

Gen. = generally
Corp. Gov. = 1. INTRODUCTION In the invst. decision making assessment of a co.’s
corporate corp.gov. has become essential.
governance Investors have become more attentive to ESG related
Co. = company co.’s operations.
ESG =
Environmental,
social, governance Corporate Governance: System of internal control & procedures to manage a co.
Org. = organization It provides framework to define rights, duties & responsibilities of various groups.
Invst. = investment 2. CORPORATE
Corp. gov. systems may vary among countries, jurisdictions or even within countries.
Mgmt. = GOVERNANCE
OVERVIEW Shareholder Theory: Maximizing shareholders’ returns is the most imp. responsibility of a co.
management Stakeholder Theory: Broadens co.’s focus beyond shareholders towards its customers,
suppliers, employees & others.
3. COMPANY
STAKEHOLDERS
3.1 3.2
Stakeholders Principal-Agent & Other
Groups Relationships in
Corporate Governance
3.1.1 3.1.3 3.1.5 3.1.7

Shareholders Managers & Customers Governments
Employees /Regulators
3.1.2 3.1.4 3.1.6

Creditor Board of Suppliers
s Director
s
Principle-agent relationship
involves obligation, trust,
expectation & loyalty.
1
2
3.2.1 3.2.2 3.2.3 3.2.4 3.2.5

Shareholder & Controlling & Minority Manager & Board Shareholder vs Other Stakeholder
Manager/ Director shareholder relationships Creditor interests Conflicts
relationships relationships
Conflicts may arise Opinions of minority Board’s Risk-tolerance Conflicts b/w:

due to divergence in shareholders are monitoring role differences. • customers &
views with respect overshadowed by can be • Creditors prefer shareholders
to risk tolerance in the influence of compromised stable performance • customers &
invst. or corp. controlling due to limited & ↓ risk activities. suppliers
decision making, shareholders info. provided • Shareholders prefer • shareholders &
info. asymmetry, (situations such as: to them. riskier projects with govt. or regulators
insiders influence or takeover or related- strong likelihood of ↑
favoring influential party transactions, return potential.
shareholders. or multiple class
structure).
4. STAKEHOLDER MANAGEMENT
4.1 4.2
Overview of Stakeholder Management Mechanism of Stakeholder Management
Two basis of stakeholder mgmt.:

effective communication & active engagement. Stakeholder mgmt. & governance
• Legal infrastructure: practices vary across countries &
framework for rights established by law & jurisdictions.
ease of legal recourse in case of violations.
• Contractual infrastructure:
contractual arrangements to secure the
rights of stakeholders & mgmt.
• Governmental infrastructure:
regulations imposed on companies.
4.2.1 4.2.3 4.2.5 4.2.7 4.2.9 4.2.11

General The Audit Policies on Say on Employees Laws Laws &
Meetings Functions Related-Party Pay & Contracts Regulations
Transactions
4.2.2 4.2.8
Board of 4.2.4 4.2.6 Contractual 4.2.10
Directors Reporting & Remuneration Agreement Contractual Agreement with
Mechanisms Transparency Policies with Creditors Customers & Suppliers
2
3
5. BOARD OF DIRECTORS & COMMITTEES
5.1 5.2 5.3

Composition of the Functions & Board of Directors
Board of Directors Responsibilities of Committees
the Board
• Board structure vary by • Two widely established

countries & geographies. elements of directors’
• 1-tier structure: is a mix of responsibilities are duty of care
executive & non-executive & duty of loyalty:
directors • Board guides & approves co.’s
• 2-tier structure: supervisory strategic direction, review
& mgmt. boards are corporate performance &
independent from each appoint or terminate senior
other. mgmt. etc.
5.3.1 5.3.2 5.3.3 5.3.4 5.3.5 5.3.6

Audit Governance Remuneration or Nomination Risk Investment
Committee Committee Compensation Committee Committee Committee
Committee
• oversees audit & • ensures co. • specializes in • identifies & • assists the Reviews material
control systems & adopts good remuneration recommends board in invst.
financial corp. gov. matters. qualified determining opportunities (e.g.
reporting practices. • handles the members for risky policies. large projects,
processes. • reviews contracts & board • oversees acquisitions,
• recommends the policies on performances nomination. enterprise risk expansion,
appointment of regular basis. of managers • establishes mgmt. divestitures etc.)
independent • monitors co.’s & directors. board’s implementation proposed by
external auditors. compliance nomination mgmt.
• proposes with the procedures &
auditor’s applicable policies.
remuneration. laws & •
• External & regulations.
internal auditors
report to the
audit committee.
3
4
6. FACTORS AFFECTING STAKEHOLDER

RELATIONSHIPS & CORPORATE GOVERNANCE
6.1 6.2
Market Factors Non-market Factors
6.2.3
6.1.1 6.1.2 6.1.3 6.2.1 6.2.2 The Corporate
Shareholder Shareholder Competition Legal The Media Governance
Engagement Activism & Takeovers Environment Industry
Engagement Shareholders’ Corporate Takeovers: Two legal systems: • Media has The demand
of companies strategies to • Proxy contest • Common Law ability to spread for external
with compel co. to • Tender offer • Civil Law info. quickly & corp. gov. has
shareholders. act in a desired • Hostile takeover Common law shape public grown
manner. Anti-takeover offers superior opinion. considerably in
measures include protection of • Media can recent years
staggered board, interests of motivate amid ↑ in imp.
poison pills etc. shareholders & politicians & of corp. gov.
creditors. regulators to monitoring and
introduce corp. proxy voting.
gov. reforms.
7. CORPORATE GOVERNANCE & STAKEHOLDER

MANAGEMENT RISKS & BENEFITS
7.1 7.2
Risks of Poor Governance & Benefits of Effective Governance
Stakeholder Management & Stakeholder Management
7.1.1 7.1.2 7.1.3 7.1.4 7.2.1 7.2.2 7.2.3 7.2.4

Weak Ineffective Legal, Default & Operational Improved Better Lower
Control Decision Regulatory & Bankruptcy Efficiency Control Operating & Default Risk
Systems Making Reputational Risks Financial & Cost of
Risks Performance Debt
4
5
8. ANALYST CONSIDERATIONS IN CORPORATE

GOVERNANCE & STAKEHOLDER MANAGEMENT
8.1 8.2 8.3 8.4 8.5 8.6 8.7

Economic Board of Remuneration Investors Strengths of Managing Summary of
Ownership Directors & Company in the Shareholders’ Long-term Analyst
& Economic Representation Performance Company Rights Risks Considerations
Control
• Examining Board of • Examining the Understanding Assessing mgmt.’s

board’s voting directors’ composition of shareholders’ ability to tackle
structure can independence, investors & assessing rights (strong, issues such as long-
bring useful tenure, potential effects of weak, average) term environmental
insight. experience & cross-shareholding compared with risks, human capital
• Dual-class diversity can arrangements or other mgmt.
structure may bring useful sizeable affiliated companies. transparency,
involve superior invst. insight. stockholders. treatment of various
voting rights • The presence of stakeholders etc.
retained by co. activist can attract
insiders. new investors.
Some warning signs for assessing co.’s Analyzing corp.

remuneration plans may include: gov., stakeholder
• Plans offering little alignment with mgmt. & other
shareholders non-financial
• Plans exhibiting little variation sin considerations is
results over multiple years. inherently a
• Plans with excessive payouts relative subjective
to comparable companies with exercise
comparable payouts.
• Plans that may have specific strategic
implications.
• Plans based on incentives from an
earlier period in the co.’s life-cycle.
5
6
9. ESG CONSIDERATIONS FOR INVESTORS
Practice of considering environmental, social &

governmental factors in the investment process.
9.1 9.2 9.3

ESG Market View ESG Factors in ESG Implementation
Investment Analysis Methods
Investors are becoming Environmental Factors include: Negative Screening:

more conscious of Natural resource mgmt. Excluding certain sectors or
workplace, human right pollution prevention, water companies.
& environmental issues. conservation, energy efficiency, Positive Screening: :
reduced emissions etc. Adding companies that embrace
Social Factors include: human ESG related principles.
rights, welfare concerns in the Best-in-class:
workplace, product Focusing on the best co. in an
development, community industry based on ESG
impact etc. considerations.
Thematic Investing:
Focuses on a specific economic
or social trend.
Impact Investing:
Achieving targeted social or
environmental objectives along
with measureable financial
returns by direct investment in
projects or companies.
6
Page 1
“CAPITAL BUDGETING”
CB = Capital Budgeting
DR = Discount Rate
NPV = Net Present Value
IRR = Internal Rate of Return
CF = After Tax Cash flows at
DCF = Discounted Cash Flows
Time t
AAR = Average Accounting Rate of Return
r = Required Rate of Return
PI = Profitability Index
1. INTRODUCTION
CB is a process of decision making on capital projects (project with a life of a

year or more).
2. THE CAPITAL BUDGETING PROCESS
Steps in capital budgeting process
Step I Generating Ideas ⇒ Step II Analyzing Individual ⇒ Step III Planning the Capital ⇒ Step IV Monitoring & Post
Proposals Budget Auditing
Ideas can come from anywhere To forecast CF of each project & Consider profitable proposals within Post audit ⇒ actual result is
(from top or bottom of organization evaluate profitability. company’s overall strategies. compared with predicted results,
or outside the company) any difference must be explained.
Classification of CB Projects
Replacement Projects Expansion Projects New Products & Regulatory, Safety & Other Projects
Services Environmental
Projects
If replacement is to size of business. More uncertain Required by a govt. Some projects

just maintain More uncertainties than expansion agency, insurance escape capital
business, no than replacement projects. company or some budgeting analysis.
careful analysis is decisions. More complex & other external These are either
required. Decisions involve more party. pet projects or so
If replacement is to considered more people in decision May generate no risky that these are
enhance efficiency, carefully. making. revenue. difficult to analyze.
very detailed
analysis.

Page 2
3. BASIC PRINCIPLES OF CAPITAL BUDGETING
Capital budgeting assumptions:

Decisions are based on CF rather than accounting concepts. Intangible costs & benefits are
ignored.
Timing of CF is crucial.
CF are based on opportunity cost (consider incremental CF only).
CF should be analyzed on after-tax basis.
Financing costs are ignored in CF (reflected in required rate of return).
Capital budgeting CFs are different from net income due to noncash charges & interest expense.
Some Important CB Concepts
Sunk cost ⇒ cost already been incurred.

Opportunity cost ⇒ resource’s worth in its next-best use.
Incremental CF ⇒ CF with decision – CF without decision.
Externality ⇒ effect of an investment on other things beside investment itself & can be positive or negative.
Cannibalization ⇒ when an investment takes customers & sales from another part of the company.
Conventional CF ⇒ initial outflow followed by a series of inflows.
Nonconventional CF ⇒ CF can flip from positive to negative again even after initial outflows.
Independent v/s mutually exclusive projects ⇒ projects are independent if CFs are independent of each other.
Mutually exclusive projects compete directly with each other.
Project Sequencing ⇒ investing in a project creates option to invest in future projects.
Unlimited funds v/s capital rationing ⇒ if company can raise the funds for all profitable projects (unlimited funds).
If company has a fixed amount of funds (capital rationing).
4. INVESTMENT DECISION CRITERIA
4.1 Net Present Value
NPV = PV of future after tax CF – investment outlay.

౪
NPV = ∑ − outlay.
()౪
Decision rule for NPV = invest if NPV > 0 (wealth increasing).
4.2 Internal Rate of Return
DR that makes PV of future after-tax CF equal to that of investment outlay (one investment outlay).
౪
IRR = ∑ = outlay.
(
)౪
Decision rule for IRR = invest if IRR > r.
4.3 Payback Period
No. of years required to recover the original investment in a project (based on CF).
It ignores time value of money, risk of project & CF after payback period is reached.
Measure of payback & liquidity & not profitability.
Simple and very easy to explain.
No decision rule like NPV or IRR.

Page 3
4.4 Discounted Payback Period
No. of years it takes for cumulative DCF from a project to equal the original investment.
If project has negative NPV, usually no discounted payback period.
It considers time value of money & risk within discounted payback period.
Ignores CF after discounted payback period is reached.
Not a good measure of profitability & possibility of negative CF after discounted payback period.
4.5 Average Accounting Rate of Return

=
Advantage ⇒ easy to understand & calculate.
Disadvantages ⇒ based on accounting numbers, not CF, does not account for time value of
money & no sound cutoff that distinguishes b/w profitable & unprofitable investments.
4.6 Profitability Index

= = 1 +

PI is ratio of PV of future CF & initial investment while NPV is difference b/w these two.
Investment decision rule = invest if PI ≥ 1.0
Also called “benefit-cost ratio” in govt & not-for- profit organizations.
4.7 NPV Profile
Shows a project’s NPV graphed as a function of various discount rates.

When profile goes through horizontal axis ⇒ DR is IRR.
NPV declines at a decreasing rate as DR increases.
4.8 Ranking Conflicts b/w NPV & IRR
Single & independent conventional projects ⇒ no conflict b/w decision rule for NPV & IRR.
Mutually exclusive projects ⇒ criteria sometimes disagree (choose project based on NPV).
NPV assumes more realistic reinvestment rate assumption.
NPV shows amount of gain as currency amount while IRR gives a rate of return.
4.9 The Multiple IRR Problem & the No IRR Problem
Problem with IRR criterion⇒”multiple IRR problem” (nonconventional projects).

Possibility of no IRR (no DR exists that result in zero NPV).
Having two sign changes does not mean that you will have multiple IRR; it just
means that you might.
4.10 Popularity & Usage of the Capital Budgeting Methods
Several other methods instead of NPV & IRR are heavily used (e.g. in European countries, payback period).
U.S. companies are larger and companies prefer NPV & IRR over payback period.
Private companies use payback period more frequently.
Companies managed by an MBA ⇒ preference for DCF techniques.
NPV criterion most directly related to stock prices.
Value of company = value of existing investment + PV of future investments.
Impact of investment on stock price depends on whether profitability is more or less than expected.
CB process demonstrates two things about quality of management.
Degree to which management purses goal of shareholder’s wealth maximization.
Effectiveness in pursuing that goal.

Page 1
2017, Study Session #10, Reading # 36
“COST OF CAPITAL”
WACC =
Weighted Avg. Cost of Capital SYS = Sovereign Yield Spread
MCC =
Marginal Cost of Capital FC = Flotation Cost
TCS =
Target Capital Structure IB = Investment Banker
IOS =
Investment Opportunity
1. INTRODUCTION CF = Cash Flows
Schedule MP = Market Price
YTM = Yield-to-Maturity Cost of capital is important in investment decisions for PS = Preferred Stock
ERP = Equity Risk Premium management & investors. DDM = Dividend Discount Model
DDM = Dividend discount model If return is > cost of capital, company has created value.
Cost of capital estimation requires assumptions &
estimates.
Company must estimate project-specific costs of capital.
2. COST OF CAPITAL
Cost of capital ⇒ rate of return the suppliers of capital require as compensation

(opportunity cost of funds).
Marginal cost ⇒ cost to raise additional funds for potential investment projects.
WACC = wୢ rୢ 1 − t + w୮ r୮ + wୣ rୣ
Cost of capital for entire company is WACC, which is also referred as MCC.
where
wୢ = proportion of debt
rୢ = before tax cost of debt
௣ , ௘ = proportion of preferred & common equity respectively.

t = marginal tax rate
௣ , ௘ =
&
.
2.1 Taxes & Cost of Capital
In many jurisdictions interest on debt financing is a deduction to arrive at

taxable income.
Estimating the cost of common equity capital is more challenging than the cost
of debt capital and conventional preferred equity (no stated & fixed payment).
Two methods for estimating cost of equity are:
Capital asset pricing model.
Dividend discount model.
No tax adjustment in cost of equity (payment to owner is not tax deductible).
2.2 Weights of the Weighted Average
Ideally uses in project or company proportion of each source of capital that

company use.
Target capital structure ⇒ capital structure that a company is striving to obtain.
Analysts use several approaches for estimating target capital structure as:
Assume current capital structure represents company’s TCS.
Examine trends or statements by management regarding capital structure
policy to infer TCS.
Use avg. of comparable companies’ CS as TCS.

Page 2
2.3 Applying the Cost of Capital to Capital Budgeting & Security Valuation
Company’s MCC may as additional capital is raised, & returns as company makes additional
investments represented by IOS.
Optimal capital budget ⇒ amount of capital raised and invested at which marginal cost of capital
is equal to marginal return from investing.
Upward or downward adjustment to company’s WACC if systematic risk of project is above or
below the company’s risk.
NPV = PV of inflows (discounted at project’s cost of capital) – PV of outflows.
If we are using the company’s WACC to calculate project NPV, we assume:
Project has same risk as avg. risk project of company.
Constant TCS throughout useful life.
If free cash flow to firm, use weighted avg. cost of capital for company valuation.
If free CF to equity, use cost of equity to find PV of these CF.
3. COST OF THE DIFFERENT SOURCES OF CAPITAL
3.1 Cost of Debt
3.1.1 Yield-to-Maturity Approach 3.1.2 Debt-Rating Approach 3.1.3 Issues in Estimating the Cost of Debt
Yield that equates PV of Used when MP of debt is not 3.1.3.1 Fixed-Rate Debt versus Floating-Rate Debt
bond’s promised payments to available.
MP. Before-tax cost of debt = yield on Estimating cost of floating rate debt is difficult
YTM assumes reinvestment at comparably rated bonds for (depends on current & future yield).
YTM. maturities closely matching
those of company’s debt. 3.1.3.2 Debt with Option like Features
Important consideration ⇒ debt
ratings are ratings of debt issue
Cost of debt is difficult to determine if debt has
itself.
option like features (call, put etc.).
Analysts can make market value adjustments to
3.2 Cost of Preferred Stock
YTM for options.
Cost of nonconvertible, non-callable PS = ௣ =

Cost to pay preferred stock holders as preferred dividend.
஽೛
3.1.3.3 Nonrated Debt
௉೛
௣ =
Where If company does not have rated bonds,
௣ =

“synthetic” debt rating based on financial ratios is
௣ =

used, it ignores information on bond issue &
issuer.
Dividend on Ps is not tax-deductible.
Certain number of features (e.g. call option, cumulative dividends etc.) affect cost of PS & hence
3.1.3.4 Leases
require adjustment.
If company uses leasing as source of capital, the

cost of leases should be included in cost of
capital.

Page 3
3.3 Cost of Common Equity
Company may increase common equity through earnings reinvestments or issuance of new shares.
3.3.1 Capital Asset Pricing Model Approach
௜ = ௙ + ௜ ௠ − ௙
௜ = return sensitivity of stock i to changes in market return.

Where
௠ = expected return on market

௠ − ௙ = expected market risk premium. (MRP)
Selection of appropriate ௙ rate guided by duration of projected CF.
Expected MRP is the premium that investors demand for investing in market portfolio relative to ௙ .
௜ = ௙ + ௜ଵ (factor risk premium), +௜ଶ (factor risk premium)2 +---------- ௜௝ (factor risk premium)j.
Multifactor model (factors that may be other sources of priced risk).
Equity risk Premium
Historical ERP Approach DDM Based Approach Survey Approach
௘ = +
஽భ
Realized ERP is a good indicator of Ask panel of finance experts for their
௉బ
expected ERP. estimates & take mean response.
ଵ= next year dividend
Where
Use historical data for avg. return of Adjust ERP for particular project or
଴= current market value
market portfolio & avg. RFR. company by adjusting its systematic risk.
Limitations
g = growth rate.
Stock index risk level may change over ஽భ
= dividend yield.
௠ is dividend yield plus growth in
time. ௉బ
Investor risk aversion may change.
ERP is difference b/w ௠ & RfR.

Sensitive to method of estimation & dividend.
historical period covered.
3.3.2 Dividend Discount Model Approach
ଵ
௘ = +
଴
Growth rate estimation
Through published source or vendor Sustainable growth rate
= 1 −
∗ !
Where ROE = return on equity.
Assume constant capital structure.
3.3.3 Bond Yield plus Risk Premium Approach
௘ = ௗ + Risk premium
ௗ = before-tax cost of debt.

Where
Risk premium capture additional risk of stock relative to its bonds.

Page 4
4. TOPICS IN COST OF CAPITAL ESTIMATION
4.1 Estimating Beta & Determining a Project Beta
β can be estimated through market model regression (company’s

stock return against market return).
Estimation period, periodicity of return interval, selection of
appropriate market index, use of smoothing technique &
adjustments for small-capitalization stocks are important
considerations for β estimation.
Business risk ⇒ risk related to uncertainty of revenues.
Operating risk ⇒ operating cost structure risk.
Financial risk ⇒ uncertainty of N.I & net CF due to use of financing.
Pure – Play Method
Using comparable publicly traded company’s β & adjusting it for financial leverage differences.
Comparable company ⇒ company with similar business risk.
Asset (unlevered) β ⇒ β after removing effects of financial leverage.
Β adjustment for capital structure of company or project (lever the asset β to arrive equity β)
௔௦௦௘௧ = ௘௤௨௜௧௬ " #

ଵ
ವ
ଵାቄሺଵି௧ሻ ቅ
ಶ
௘௤௨௜௧௬ = ௔௦௦௘௧௦ $%1 + 1 − &'

(We assume debt has no market risk)
஽
ா
Steps in Pure-Play Method
Step I ⇒ Step II ⇒ Step III ⇒ Step IV
Select the comparable Estimate comparable’s beta Unlever the comparable’s beta Lever β for project’s financial risk
4.2 Country Risk
β does not capture country risk for companies in developing countries.

Adjust cost of equity (using CAPM) by adding a country spread to MRP.
Country Spread (country equity premium) types
Sovereign Yield Spread
Diff. b/w govt. bond yield in that If country has credit ratings but no

*
+
= ( ) .
country (denominated in developed equity markets, the expected rate of
*
,
-

market currency) & Treasury bond return is found by estimating reward
-

yield of similar maturity bond in to credit risk for a large sample of
developed market country. countries (which have both credit
ratings and equity markets) & apply
this ratio to countries without equity
markets.

Page 5
4.3 Marginal Cost of Capital Schedule
Cost of different sources of capital ∆ as more capital raised (result in MCC schedule).
Debt incurrence test ⇒ may restrict a company’s ability to incur additional debt of
same seniority.
Company can deviate from target capital structure, MCC may increase.

=

4.4 Flotation Costs
Floatation cost ⇒ fee charged by I.B based on size & type of offering.
Debt & preferred stock ⇒ ignore flotation cost (quite small amount).
Flotation cost may be substantial in equity issuance.
View about Flotation Cost
Incorporate into cost of capital Incorporated into valuation analysis as an additional project cost
FC in Monetary terms FC as % applied against price per share Adjustment to CF in valuation computation (e.g. consider initial
outflow in NPV calculation).
ଵ ଵ
௘ = / 1+ ௘ = / 1+
Preferred over cost of capital adjustment method.
଴ − 0 ଴ 1 −
f = % flotation cost as a% of issue price
Incorrect approach⇒ adjust PV of FCF by a fixed %, not initial CF.

Found in text book because:
Useful if specific project financing can’t identified
Demonstrate how costs of financing change when company
switches from internally generated equity to external equity.
4.5 What Do CFOs Do?
A survey of CFOs revealed the following:

CAPM is most popular method for estimating cost of equity &
popular in publicly traded companies.
Dividend CF model to estimate cost of equity is used by limited no. of
companies.
Majority use single company cost of capital with some type of risk
adjustment for individual projects.

Page 1
“MEASURE OF LEVERAGE”
Q = Units Sold C = Fixed Financial Cost
V = Variable Cost per Unit F = Fixed Operating Cost
DFL = Degree of Financial P = Price per Unit
1. INTRODUCTION DOL = Degree of Operating
Leverage
Leverage
DTL = Degree of Total Leverage
Leverage ⇒ use of fixed cost in company’s cost structure.
Fixed cost
Operating fixed cost Financial fixed cost
Analysts use fixed costs as leverage, leverage magnifies earnings both and .
Three reasons why analyst must understand a company’s use of leverage:
o Degree of Leverage is important in assessing company’s risk and return.
o Exact information about company’s business and future prospects about
operating and financial leverage.
o Understanding leverage helps in assessing company’s cash flows & selecting
appropriate discount rate.
Total leverage is the sensitivity to a given % change in units sold.
2. LEVERAGE
COST STRUCTURE
Fixed cost Variable cost
Same expense regardless of production / sales Fluctuate with level of production

Salaries, rent, interest on debt etc. Purchase, shipping, delivery charges etc.
Company’s valuation is affected by the degree of leverage.

Leverage risk and discount factor.
Leverage chances of significant losses in downturn ⇒ financial distress and bankruptcy.
Companies with same earnings may not have same valuation due to difference in leverage.
Reference (Curriculum level I, Volume 4, Reading 37)

Page 2
3. BUSINESS RISK AND FINANCIAL RISK
3.1 Business Risk and Its Components
Business risk
Associated with operating earnings Operating Risk
Operating earnings risk due to risky revenues Associated with cost structure
Uncertainty about prices of goods & services offered Uses fixed cost of operation
Different sales than expected Fixed cost relative to variable cost
Sales risk Operating risk
Economic condition
Industry dynamics
Government regulation
Demographics
3.2 Sales risk 3.3 Operating Risk
Associated with operating earnings. Combination of variable cost & fixed cost
Companies having same cost structure with Fixed cost, difficulties for business to adjust operating cost to ∆ in
differing sales risk will affect variability of sales.
company’s profitability. % ∆

=
% ∆
Relatively similar concept as elasticity in economics
DOL is dependent on level of units sold being considered
Operating Income = Q (P-V)-F
Per unit contribution margin = amount of each unit sold covering fixed cost
=P–V
Contribution Margin = Q ( P – V)
= Units sold × per unit contribution margin
= Revenue – Total Variable Cost
()
=

Management has more opportunity to manage & control operating risk than
sales risk.
Sales risk is usually same irrespective of what equipment is used to produce
the product.
Analysts consider how operating cost structure affects company’s risks.
Industries having operating leverage ⇒ focus on investing up front to
produce the product.
Retailers having operating leverage ⇒ more variable cost in cost of sales.

Page 3
3.4 Financial Risks
Owning Securities Variability of operating earnings
Having claims in business Cash paid to claimants
Income Assets Fixed financial cost Variable financial

cost
Creditors/lenders Shareholders
How company finances its operations
Debt or lease payments ⇒ financial risk ⇒ variability in NI
% ∆
=
% ∆ !"#$% &'!
ሾொሺ௉ି௏ሻିிሿሺଵି௧ሻ ሾொሺ௉ି௏ሻିிሿ
= ሾொሺ௉ି௏ሻିிି஼ሿሺଵି௧ሻ = ሾொሺ௉ି௏ሻିிି஼ሿ
DFL is not affected by tax rate.

DFL is different at different levels of operating income.
DFL can be managed & in control of management.
Companies with investment in tangible assets ⇒ financial leverage.
DFL ⇒ ROE (only favorable for profitable company)
DFL ⇒ Risk of ownership of stakeholders
DFL ⇒ Chances of default.
3.5 Total Leverage
It is the combined effect of operating & financial leverage.

Degree of total leverage (DTL) = DOL × DFL
It tells about the total risk associated with future cash flows.
Management considers it as it tells about how it would increase owner’s wealth.
DTL = sensitivity of cash flows to ∆ in no. of units produced & sold
% ∆
=
% ∆ (')!" * ($+ +,-
./ − 0 1./ − 0 − 2
= ×
./ − 0 − 1./ − 0 − − 32
. / − 0
=
./ − 0 − − 3
Both fixed operating & financial costs variability of earnings to owners.

Page 4
3.6 Breakeven Points & Operating Breakeven Points
QBE (Breakeven Point) ⇒ revenues - costs & NI = 0

PQ = VQ + F+ C
PQBE = VQBE +F+C
QBE = F+C / (P-V)
QOBE (Operating breakeven point) ⇒ revenues - operating cost & operating profit =0
PQ0BE = VQOBE + F
QOBE = F / (P-V)
Breakeven points for companies with Op. & Fin. leverage are less important & vice versa.
Greater total leverage ⇒ revenue to meet fixed cost (F&C).
Reference (Curriculum level I, Volume 4, Reading 37)
3.7 The Risk of Creditors & Owners
The risk of equity capital and debt capital differs.

Lenders have prior claim as compared to shareholders.
Unable to pay contractual payments may cause business to go bankrupt.
In US negotiated reorganization allow business to re-organize and continue to
exist.
Non-viable businesses are liquidated (2nd stage of bankruptcy).
Difference b/w re-organization & liquidation is often due to difference between
after to operating & financial leverage.
Operating leverage gives less flexibility in making changes.
Financial leverage ⇒ companies use bankruptcy laws and protection to
change their capital structure.
Investors / owners avoid companies going towards bankruptcy but evaluate
opportunities among companies already in bankruptcy.
Debt holders get a portion of their capital but payments are delayed (both
interest + capital) during period of bankruptcy protection.

Page 1
“DIVIDENDS & SHARE REPURCHASE”

EY = Earning Yield BVPS = Book Value per Share
1. INTRODUCTION
ATCF = After Tax Cost of Financing EPS = Earnings per Share
CFO = Chief Financial Officer MP = Market Price
DRPs = Dividend Reinvestment Dividend ⇒ payout to shareholders based upon numbers of shares owned.
Plans Board of directors declare dividend (sometime with consent of shareholders).
Company’s payout = cash dividends + value of shares repurchased
Payout policy ⇒ set of rules guiding payout.
Payment of dividends is usually discretionary.
Under some jurisdictions dividends are double taxed
Dividend payout ratio = cash dividends (on common share) / NI.
2. DIVIDENDS: FORMS
Cash Dividends Other Forms
2.1 Regular Cash Dividends 2.2 Extra or Special 2.3 Liquidating Dividends 2.4 Stock Dividends 2.5 Stock Splits
(Irregular) Dividends
2.1.1 Dividends
Reinvestment Plans (DRPs) 2.1 Regular Cash Dividends
Different markets pay dividends at different frequencies.

US & Canada ⇒ quarterly
Europe & Japan ⇒ semi-annually
Asian markets ⇒ annually
Management can use dividend announcement to shareholder’s confidence.
An in regular dividend can share price.
2.1.1 Dividends Reinvestment Plans (DRPs)
Open-Market DRP New-Issue DRP Blend of both types
Company purchases shares Called Scrip dividend

in open market of the scheme in UK.
dividend amount & Company creates (issue)
allocate to plan new shares.
participants.
DRP ⇒ automatic reinvestment plan offered by some companies.

Can be helpful for small shareholders as means to increase no. of shares (long term).
New-issue DRPs ⇒ save floatation cost.
Participating shareholders may not have to bear additional transaction cost.
Potential disadvantage ⇒ extra record keeping for tax purpose.
If share price for re-invested dividend than the original purchase price then original dividend re-
investing will avg. cost basis.
Cash dividends are fully taxed even when re-invested in the same year.
Such plans are useful in tax-deferred accounts e.g. retirement accounts.

Page 2
2.2 Extra Dividend
Extra, special, irregular ⇒ dividend paid by a company that does not pay dividends regularly.
It can be an additional (one time) payment with regular dividend.
Companies in cyclical industries may use this in strong cycles.
Companies could have stated polices for extra dividends.
Suspension ⇒Company stops paying any cash dividends.
2.3 Liquidating
It is paid when a company:

Goes out of business and net assets (adjusted for liabilities) are distributed to
shareholders.
Sells a portion of business & distributes its proceeds.
Pays dividends in excess of accumulated retained earnings (impairing stated capital).
2.4 Stock Dividends
Non-cash form of dividend also called ‘bonus issue of shares’.

Company distributes additional shares usually 2-10% of outstanding shares.
Total wealth (market value) remains same.
Cost per share is reduced.
In share price is offset by in no. of shares outstanding.
Generally not taxable.
Proportionate ownership & value of each shareholder’s ownership position remain same.
From company’s perspective shares broaden shareholder base so advantageous and
probability of more individuals owning stock.
Stock dividend can keep stock in optimal range ($20 to $80 in US).
It has no economic impact on the company.
Cash dividend can affect capital structure:
Reduce assets and equity.
Liquidity ratios can .
Financial leverage ratios can .
Stock dividends have no such effects.
2.5 Stock Splits
Similar to stock dividend in economic impact.

Apart from usually 2 for 1 or 3 for 1, unusual split like 5 for 4 etc. can occur.
Companies can announce stock split any time.
Typically it is considered a positive sign for future in stock price.
Reverse stock splits ⇒ share price, no. of shares outstanding but no
impact on market value of shareholders’ equity.
Reverse stock splits are done to price of stock to a marketable range.
Reverse stock splits are done by companies coming out of financial distress.

Page 3
3. DIVIDENDS: PAYMENT CHRONOLOGY
3.1 Declaration Date 3.2 Ex-Dividend Date 3.3 Holder-of-Record Date 3.4 Payment Date
Corporation issue First date when share Also called owner-of record Also known as payable
statement declaring trades without (ex) date, date of book closure, date.
specific dividend dividend. shareholder of record date, Date when actually
Dividend could be of any Time b/w ex-date & holder record date, and date of payment is transferred.
type. -of- record date is linked to record. It can occur on weekend
On declaration date trade settlement cycle of Typically two days after ex- and holiday
companies also announce the exchange on which dividend date.
holder-of-record and shares are listed. Determined by corporation
payment date. Investors owing share Owner of stock in company’s
till/on ex-date receive records will be deemed to
dividend. have ownership of shares for
Determined by securities receiving upcoming dividend.
exchange.
3.5 Interval between Key Dates in the Dividend Payment Chronology
Usually time b/w ex-date & record date is fixed to 2 days.

Other dates vary company to company.
Most companies follow a fairly set routine.
4. SHARE REPURCHASES
4.1 Share Repurchase Methods 4.2 Financial Statement Effects of Repurchases 4.3 Valuation Equivalence of Cash Dividends
& Share Repurchases: The Baseline
A. Buy in the open market 4.2.1 Changes in Earnings per Share
B. Buy back a fixed number 4.2.2 Changes in Book Value per Share
of shares at a fixed price
C. Dutch Auction
D. Repurchase by direct
negotiation 4. SHARE REPURCHASES
Share repurchases (buyback) ⇒ a transaction in which company buys back its own shares.
Uses corporate cash.
An alternative to cash dividends
Repurchases shares are classified as treasury shares or stock.
Not considered for voting, dividends or calculating EPS.
In many markets it is becoming increasingly common.
After amount of repurchase is authorized, companies may or may not follow.
Unlike cash dividends, buybacks are not done proportionally to ownership percentage.
Common method outside US & Canada is open market repurchase.
Not all methods are permissible according to laws.
Reasons why companies opt for buybacks

Support share price (most frequently cited in the U.S. by chief financial officers)
Flexibility in distributing cash to shareholders.
To absorb in shares outstanding resulting from stock options.
Tax efficiency in some cases where tax on cash dividends exceeds tax on capital gains.

Page 4
A. Buy in the open market
Most common method.

Company buys back its shares in open market.
Maximum flexibility for the company.
No legal obligation to honor the program.
For 1) liquidity 2) acquisition 3) capital expenditures, company may not follow through
with an announcement program.
In US open market transactions ⇒ shareholders approval is not required.
In Europe open market transactions ⇒ approval is required.
A cost effective method if competently timed to minimize price impact and to exploit
perceived undervaluation.
B. Buy back a fixed number of shares at a fixed price
A fixed price tender offer to repurchase a specific

number of shares at fixed price.
Typically it is a premium price.
C. Dutch Auction
A tender offer to existing shareholders but

company stipulates a range of acceptable prices.
A minimum price is uncovered.
Company pays the price to all qualified bids.
Can be accomplished in a short term period.
D. Repurchase by direct negotiation
In some markets company negotiate to buy back shares.

A major shareholder is involved.
Price is often premium to market.
May be done to keep block of shares after overhanging the market.
Greenmail ⇒ premium purchase of accumulated shares from a hostile
investor to prevent takeover.
Large investors may negotiate at discount to generate liquidity when in a
weak position.
4.2 Financial Statement Effects of Repurchases
Both balance sheet & income statements are affected.

Assets and equity ⇒ refinanced by cash ⇒ leverage.
Leverage magnified when repurchase is financed with debt.
4.2.1 Changes in Earnings per Share
No. of shares outstanding can EPS (assuming NI remains

constant).
Generally share repurchases may , or no effect on EPS.
Effects depend upon repurchase financed internally or externally and
their cost.
For internal financing, EPS if funds are free (idle).
For external financing, EPS ⇒ earning yield > after tax cost of
financing for repurchase.
EPS is unchanged ⇒ earning yield = after tax cost of financing.
EPS ⇒ earning yield < after tax cost of financing for repurchase.

Page 5
4.2.2 Changes in Book Value per Share
If MP > BVPS ⇒ BVPS after repurchase.

If MP < BVPS ⇒ BVPS after repurchase.
4.3 Valuation Equivalence of Cash Dividends

& Share Repurchases: The Baseline
If tax treatment is similar, both share repurchase and

cash dividends are equivalent.
If shares are repurchased at premium from one
shareholder the remaining shareholders’ wealth is
reduced.

Page 1
“WORKING CAPITAL MANAGEMENT”

WCM = Working Capital Management A/R = Accounts Receivable
LOC = Line Of Credit CGS = Cost of Goods Sold
STMI = Short Term Marketable Investments SWCP = Short Term Working Capital Portfolios
CR = Current Ratio BEY = Bond Equivalent Yield
CA = Current Assets DSO = Days Sales Outstanding
CL = Current Liabilities WADSO = Weighted Avg. Days of Sale Outstanding
1. INTRODUCTION
Effective WCM ⇒ adequate cash to fund Insufficient access to cash:

day to day necessary operations with Internal Factors External Factors Restructuring by selling of
company’s assets invested in most Company size & growth Banking services assets.
productive way. rates Reorganization via bankruptcy
Organizational structure Interest rates proceedings.
Sophistication of New technologies & new Final liquidation.
working capital products Excessive investment in cash, may
management not be the optimum use of
Borrowing & investing The economy company resources.
position / activities / A careful balance is required in
Competitors
capacities WCM.
In effective WCM
Adequate cash levels are maintained.
Converting short-term assets into cash.
Controlling outgoing payments to vendors, employees and others.
It is done by investing in:
Short term funds.
Highly liquid securities.
Maintaining credit reserves in bank lines of credit.
Issuing money market instruments like commercial paper.
It requires reliable cash flow forecasts.
SCOPE OF WCM
Transaction Relation with trading partners Analysis of WCM activities Focus
Payment for trade, To ensure smooth transactions. To formulate appropriate Global view
financing and strategies. point.
investment. Strong emphasis
on liquidity

Page 2
2. MANAGING & MEASURING LIQUIDITY
2.1 Defining Liquidity Management Liquidity ⇒ Company’s ability to meet its short term 2.2 Measuring Liquidity
obligations.
2.1.1 Primary Sources of Liquidity An asset is liquid if it can be converted into cash, either
by sale or financing, quickly.
Companies with liquidity ⇒ focus is on putting
2.1.2 Secondary Sources of Liquidity
abundant liquidity into most effective use.
In tight financial situation ⇒ effective liquidity
2.1.3 Drags & Pulls on Liquidity management required ⇒ ensures solvency.
If liquidity management is not done ⇒ bankruptcy or
possible liquidation.
2.1 Defining Liquidity Management
Ability of management to generate cash when needed.

Usually it is associated with short-term assets and liabilities to provide
cash.
Long term assets & liabilities can be used to provide liquidity but can
reduce company’s overall financial strength.
Liquidity management challenges ⇒ developing, implementing and
maintaining liquidity policy.
Company must manage key resources that include primary sources and
secondary sources.
2.1.1 Primary Sources of Liquidity
Most readily available source can be held as cash or near-cash securities.

Ready cash balance: available at banks against payment collection,
investment income, liquidation of near cash securities (maturity < 90
days) & other cash flows.
Short- term funds: trade credit, bank lines of credit, shot term investment
portfolios.
Cash flow management: effectiveness of company in cash management,
system of cash collection, cash available to use.
These funds are readily accessible at lower costs.
2.1.2 Secondary Source of Liquidity
May affect company’s normal operations and in some cases alter financial
and operating position.
Sources include:
Negotiating debt contracts: pressure of interest or principal
repayments.
Liquidating assets.
Filing for bankruptcy protection and re-organization.
Use of such sources may signal deteriorating financial health.
Bankruptcy protection may be considered a liquidity tool.
Under such protection, a company generating operating cash is liquid and
able to continue business operations until restructuring is approved.

Page 3
2.1.3 Drags & Pulls on Liquidity
Drag ⇒ when receipts lag Pull ⇒ disbursements paid quickly
Major drags include Major pulls on payments include

Uncollected receivables Making payments early
→ outstanding, risk they would not be collected at all → Paying vendors before due date results in companies forgo use of funds.
→ Indicated by no. of days receivable and bad debts. → Effective payment management means making payment when due, not early.
Obsolete inventory Reduced credit limit
→ Inventory stands than usual → History of late payments can lead to credit limit by suppliers.
→ Indication of no longer being usable → Can squeeze company’s liquidity.
→ Indicated by slow inventory turnover ratios. Limits on short term lines of credit.
Tight credit → Liquidity squeeze occur when bank LOC.
→ Economic condition not favorable → LOC restrictions can be:
→ Short term debt cost. Government mandated, market-related & company specific.
Drags controlled by strict credit & collection practices. → Over-banking ⇒ approach common in emerging as well as some developed
markets featuring unsound banking systems whereby companies establish lines
of credit in excess of their needs..
Low liquidity positions:
→ Such situation is faced by a company in a particular industry or with a weaker
financial position.
→ Secured borrowing is done by such companies.
→ Important for such companies to identify such assets for short term borrowings.
Critical to identify drags and pulls on time or before they have arisen.
2.2 Measuring Liquidity
Liquidity ensures creditworthiness ⇒ perceived ability of a borrower to make timely payments.

Creditworthiness chances to obtain credit at ↓ borrowing cost ⇒ better trade credit terms profitable opportunities.
Liquidity chances of financial distress ⇒ leads to insolvency & bankruptcy (extreme case).
Liquidity ratios ⇒ check company’s ability to meet short-term debt obligations.

=

=

Ratio chances to cover CL.

/ = .
.
→ Measures how many times A/R created & collected on avg. in one fiscal period.

=
.
→ Measure how many times inventory created / acquired & sold during one fiscal period.
Activity ratios can also be re-arranged to estimate no. of days CA or CL are on hand.
/
.
=
.
/
/ !

.
=
/ !
"
. =
" / !
Alternate name
No. of days payable Days payable outstanding Avg. days payable
No. of days inventory Avg. inventory period Inventory holding period
No. of days receivables Days sales outstanding Days in receivables
Turnover ratios tell how company is managing its liquid assets.
Ratio analysis must be done against some benchmark not in isolation.
Benchmark could be industry avg. or company’s own track record (past performance) or with peer group.

= .
+

Measure of time needed to convert raw material into cash from a sale.
Does not account for increased cash flow by deferring payment to suppliers.

= .
+ .
– .
Also called cash conversion cycle.
Cycles cash generating ability.
For many companies cash conversion cycle is a period that requires financing.

Page 4
3. MANAGING THE CASH POSITION
3.1 Forecasting Short-Term Cash Flows Ensuring net cash positions not negative. 3.2 Monitoring cash uses and levels
Negative balance is avoided as cost of borrowing is
3.1.1 Minimum Cash Balance and unacceptable.
Balance = inflows-outflows.
Managing short term portfolio ⇒ opportunity cost is
3.1.2 Identify Typical Cash Flows
considered acceptable.
To manage cash decisions are done on latest
3.1.3 Cash Forecasting System
information.
Company’s treasury function uses optimum services
and techniques associated with company’s payment
configuration to manage cash.
3.1 Forecasting Short Term Cash Flows
Necessary task.
Precision in forecasting effectiveness.
Forecast ⇒ precise may not be accurate.
External uncertainty encourages companies to
maintain minimum level of cash as a buffer.
3.1.1 Minimum Cash Balance
Provides financial flexibility or protection.

An opportunity to take advantages from attractive
opportunities.
Size of this buffer depends upon:
Variation of cash inflows & outflows.
Access to liquid sources.
Ability to raise funds with lead time.
3.1.2 Identifying Typical Cash Flows
Cash mangers using cash flow history or organizational financial history must identify cash flow elements and collect data about them
regularly.
Real cash flows should be reflected.
Elements include ;
Inflows Outflows
Receipts from operations, broken down by Payables & payroll disbursements, broken down by
operating unit, departments, etc. operating unit, departments, etc.
Funds transfers from subsidiaries, joint ventures, Funds transfer to subsidiaries.
third parties.
Maturing investments Investments made
Debt proceeds (short and long term) Debt repayments.
Other income items (interest, etc.) Interest and dividend payments
Tax refunds. Tax payments.

Page 5
3.1.3 Cash Forecasting System
Must be structured as a system to be effective.

Several aspects to be covered.
Importance of aspects varies in between forecast horizon.
Short Tem Medium Term Long Term

Data frequency Daily / weekly for 4-6 weeks Monthly for one year Annually for 3-5 years
Format Receipts & disbursements Receipts & disbursements Projected financial statements
Techniques Simple projections Projection models and averages Statistical models
Accuracy Very high Moderate Lowest
Reliability Very high Fairly high Not as high
Uses Daily cash management Planning financial transaction Long-range financial position
3.2 Monitoring Cash Uses and Levels
Financial manager in charge of managing cash position must know cash balance at real
time basis.
Monitoring cash flow ⇒ key aspects of cash forecasting system.
It involves knowing of the transactions information in time to tackle with them.
Information should be gathered from principal users and providers of cash along with
cash projections.
Minimum cash level is estimated in advance and steps are taken to determine the target
balance for each bank.
Target balance is applied to one main account (the bank where company’s transactions
are concentrated).
Large companies have more concentration banks making cash management more
complex.
Short term investments and borrowing assist in cash management.
Cyclical companies need to focus more on sources of cash in times when they produce
and stock inventory for peak seasons.
Company’s cash needs are also influenced by long term investment and financial
activities.
Predicting cyclical and non-operating activity needs is critical in managing cash.
Setting aside too much cash can be costly while setting aside too little can cause penalty
to raise funds quickly ⇒ either case would be costly; a reliable forecast is necessary.
4. INVESTING SHORT-TERM FUNDS
4.1 Short-Term Investment Instruments 4.2 Strategies 4.3 Evaluating Short Term Funds Management
4.1.1 Computing Yields On Short Term Investments
4.1.2 Investment Risks
4. Investing Short-Term Funds
Temporary store of funds not needed in daily transactions.

Extra working capital portfolio funds must be invested in long term portfolios.
SWCP include: highly liquid, less risky, and shorter maturity securities e.g. U.S
government securities & corporate obligation.
The portfolio changes as cash is needed or more cash is available for investment.

Page 6
4.1 Short-Term Investment Instruments
Instruments Typical maturities Features Risks

U.S Treasury Bills (T-bills) 13, 26, and 52 weeks Obligation of U.S government (guaranteed), issued at a Virtually no risk
discount.
Active secondary market.
Lowest rates for traded securities.
Federal agency securities 5-30 days Obligations of U.S federal agencies (e.g., Fannie Mae, Federal Slight liquidity risk;
Home Loan Board) issued as interest-bearing. insignificant credit risk.
Slightly higher yields than T-bills.
Bank certificates of 14-365 days Bank obligations, issued interest-bearing in $100,000 Credit and liquidity risk
deposit (CDs) increments. (depending on bank’s
“Yankee” CDs offer slightly higher yields. credit).
Banker’s acceptances 30-180 days Bank obligations for trade transactions (usually foreign), issued Credit and liquidity risk
(BAs) at a discount. (depending on bank’s
Investor protected by underlying company and trade flow itself. credit).
Small secondary market.
Eurodollar time deposits 1-180 days Time deposit with bank off-shore (outside United States, such as Credit risk (depending
Bahamas) on bank) very high
Can be CDs or straight time deposit (TD). liquidity risk for TDs
Interest-bearing investment.
Small secondary market for CDs, but not TDs.
Bank sweep services 1 day Service offered by banks that essentially provides interest on Credit and liquidity risk
checking account balance (usually over a minimum level). (depending on bank).
Large numbers of sweeps are for overnight.
Repurchase agreement 1 day + Sale of securities with the agreement of the dealer (seller) to Credit and liquidity risk
(Repos) buy them back at a future time. (depending on dealer)
Typically over-collateralized at 102 percent.
Often done for very short maturities (< 1 week).
Commercial paper (CP) 1-270 days Unsecured obligations of corporations and financial institutions, Credit and liquidity risk
issued at discount. (depending on credit
Secondary market for large issuers rating)
CP issuers obtain short-term credit ratings
Mutual funds and money Varies Money market mutual funds commonly used by smaller Credit and liquidity risk
market mutual funds businesses. (depending on fund
Low yields but high liquidity for money market funds; mutual manager).
fund liquidity dependent on underlying securities in fund.
Can be linked with bank sweep arrangement
Tax-advantaged securities 7, 28, 35, 49, and 90 Preferred stock in many forms including adjustable rate Credit and liquidity risk
days preferred stocks (ARPs), auction rate preferred stocks, (AURPs), (depending on issuer’s
and convertible adjustable preferred stocks (CAPs). credit).
Dutch auction often used to set rate.
Offer higher yields
Relative amounts to be invested in each type, depends upon the company.

Page 7
4.1.1 Computing Yield on Short Term Investments

= – ℎ
.
Investor pays less than face value but receives face value at maturity e.g. T-bill, banker’s
acceptance.
Interest bearing securities ⇒ investor pays face amount, receives back face amount +
interest.
Nominal rate ⇒ rate based on securities face value.
Yield ⇒ actual return if investment held till maturity.
# $% % &

= ×
% % .' ' (
⇒ Annualized using 360 days.
# )$% % !
!

= ×
" " .' ' (
⇒Annualized using 365 days
⇒ also referred to as the investment yield basis.
U.S. T-bill may be quoted on discount basis or BEY.
# )$% % &

= ×
# ) *. ' (
⇒ Though BEY is relevant for investment decisions but discount basis is often quoted.
4.1.2 Investment Risk
Type of Risk Key Attributes Safety Measures

Credit (or default) Issuer may default Minimize amount
Issuer could be adversely Keep maturities short
affected by economy, Watch for
market “questionable” names
Little secondary market Emphasize government
securities
Market (or interest rate) Price or rate changes Keep maturities short
may adversely affect Keep portfolio diverse in
return. terms of maturity,
There is no market to sell issuers.
the maturity to, or there
is only a small secondary
market
Liquidity Security is difficult or Stick with government
impossible to (re) sell. securities.
Security must be held to Look for good secondary
maturity and cannot be market.
liquidated until then. Keep maturities short.
Foreign exchange Adverse general market Hedge regularly.
movement against your Keep most in your
currency currency and domestic
market (avoid foreign
exchange).

Page 8
4.2 Strategies
Short-term investors do not want to take on substantial risk.

Strategies can be active or passive.
⇒ Passive: one or two decision rules for making daily investments.
⇒ Active: constant monitoring may involve matching, mismatching or laddering
strategies.
Company must have investment guideline policy
Passive Active
Top priority is safety & liquidity. More daily involvement & choice of
Less aggressive than active strategies. investments.
Roll over is required Active involvement with more flexible
Must be monitored against some benchmark investment policy and better forecasts.
Matching Strategy Mismatching Strategy Ladder strategy
Conservative & similar to passive strategies. Requires reliable cash forecast. In b/w passive & matching
Matching is of timing of cash outflows with Riskier, requires liquid securities (T-bill) to Schedules maturities so that investments are
investment maturities. meet liquidity needs. distributed equally over the ladder’s term.
May also be accompanied by derivatives Helpful in managing long-term portfolios
posing additional risks.
4.3 Evaluating Short Term Funds Management
For portfolios that are not large or diversified ⇒ use spread sheet models.
For diversified portfolios ⇒ more expensive treasury workstations.
Investment returns must be expressed on BEY to allow comparability.
Overall portfolio return must be weighted according to the size of the
investment.
5. MANAGING ACCOUNTS RECEIVABLE
5.1 Key Elements of Trade Credit 5.2 Managing Customer’s Receipts 5.3 Evaluating Accounts Receivable
Granting Process Management
5.3.1 Account Receivable Aging 5.3.2 The No. of Days of Receivables.

Schedule

Page 9
5. Managing Accounts Receivable
Accounts receivable management ⇒ granting credit and processing transaction,

monitoring credit balance, measuring performance of credit function.
Efficient processing and disbursement of information to concerned
departments and managers is required.
Ensuring account receivable accounts are current.
Co-ordination with treasury management function.
Preparation of regular performance measurement reports.
Captive finance subsidiary ⇒ wholly owned subsidiary established to provide
financing of the sales of the parent company.
Some companies outsource accounts receivable function while some may invest
in credit insurance.
5.1 Key Elements of Trade Credit Granting Process
Effective credit management policy is required.

Basic guidelines of such policy set boundaries for credit management function.
Credit scoring model is used to classify borrowers according to credit-
worthiness.
Such models can be used to predict late payers.
Based upon the quality of borrower the credit is granted.
5.2 Managing Customer’s Receipts
Cash collection systems are function of types of customers and the methods
they use.
Nature of business ⇒ nature of customers ⇒ methods of payment.
Common electronic methods:
Direct debit
Electronic funds transfer
POS terminals
If payments do not transfer electronically, lock box system is used.
⇒ Lockbox: customer payments are mailed to a post office box and the banking
institution retrieves and deposits these payments several times a day.
Float factor measures time it takes for checks to clear ⇒ does not measure time
it takes to receive, deposit and clear checks
. '
=
. "
total amount of check deposited
Avg. daily deposit =
no. of days.
Cash collection system must accelerate payments & information content
associated with those payments.
Cash concentration involves:
1) Consolidating deposits.
2) Moving funds (b/w company accounts or to outside points).
⇒ Best treatments for consolidating deposits & moving funds for cash
concentration may differ for.
⇒ For moving funds electronic methods are cost effective.
5.3 Evaluating Accounts Receivable Management
Accounts receivable management ⇒ how efficiently receivable converted into

cash.
Such measures can be derived from 1) general financing reports and 2) Internal
financial records.

Page 10
5.3.1 Accounts Receivable Aging Schedule
Key report used by accounts receivables managers.

It breaks down accounts into categories of days outstanding.
Can be converted into percentage for comparability.
5.3.2 The No. of Days Receivables.
Provides overall picture.

Can be compared with credit management policy to gauge
account collection performance.
Weighted average DSO gives better idea of how long it takes
to collect from customers irrespective of sales level and ∆ in
sales.
Aging schedule is used to calculate weighted avg. DSO.
Major drawback of WADSO ⇒ requires more information ⇒
comparability across companies is difficult due to lack of
information.
6. MANAGING INVENTORY
6.1 Approaches to Managing Levels of Inventory 6.2 Inventory Costs 6.3 Evaluating Inventory Management
6. Managing Inventory
Necessary for working capital management

Careful balance is required;
⇒ more inventories can lead to obsolete inventory and losses
on selling through discount ⇒ liquidity squeeze.
⇒ Fewer inventories (shortage) can lead to lost sales &
company’s inability to avoid price increase by suppliers.
Motive to hold inventory
a) Transaction motive ⇒ need for inventory as a part of
routine.
b) Precautionary stocks ⇒ amount maintained to avoid stock
out losses.
c) Speculative motive ⇒ if costs to in future then benefit
can be achieved. Assumption ⇒ storage cost < savings from
in price.
6.1 Approaches to Managing Levels of Inventory
Economic order quantity – reorder point

⇒ Traditional method
⇒ Reliable short term forecast is necessary.
⇒ Based upon expected demand and predictability of demand.
⇒ Safety stock ⇒ cushion beyond anticipated needs, helps when lead time.
⇒ Anticipation stock ⇒ Inventory in excess of anticipated demand
It fluctuates with sales level.
Just-in-time method
⇒ System to minimize in-process inventory.
⇒ Materials ordered when reach re-order level.
⇒ Can reduce inventory level to optimum level if J.I.T method is incorporated
with manufacturing resource planning method.
⇒ Careful planning is required.

Page 11
6.2 Inventory Costs
Several components ⇒ represent both opportunity & real costs.

⇒ Ordering cost: depend on orders e.g. setup, labor, freight etc.
⇒ Carrying: financing & holding costs e.g. storage, cost of capital, insurance, taxes etc.
⇒ Stock-out: affected by level of inventory e.g. lost sales, back-order costs etc.
⇒ Policy: cost of gathering data can be “soft” cost e.g. data processing, overtime, training etc.
6.3 Evaluating Inventory Management
Inventory turnover ratio is used along with no. of days of

inventory.
Comparison can be drawn with other industries or past history.
Can be different due to product mixes.
Knowing the reason for or in inventory turnover is necessary.
7. MANAGING ACCOUNTS PAYABLE
7.1 The Economics of Taking a Trade Discount 7.2 Managing Cash Disbursements 7.3 Evaluating Account Payables Management
7. Managing Accounts Payable
Trade credit ⇒ spontaneous form of credit in which purchaser finances its purchases by delaying payments.
⇒ Discount may be given by the supplier for early payment.
⇒ Usually a specific time is given in which discount can be earned.
Inefficient payable management could be costly in terms of real and opportunity cost.
Company must ensure payable practice is organized, consistent and cost-effective.
Factors need to be taken care off while devising guidelines for managing accounts payable include;
⇒ Organization’s centralization / decentralization.
⇒ Number, size & location of vendors
⇒ Trade credit, cost of borrowing.
⇒ Controls of disbursement float (time for clearing a check).
⇒ Inventory management.
⇒ E-commerce and electronic data interchange (electronic supply chain management)
Stretching payables ⇒ extending time to pay dues during grace period provided by suppliers.
Careful balance is required if paying too early is costly and delaying may deteriorate company’s perceived
credit-worthiness.
7.1 The Economics of Taking a Trade Discount

discount .

Cost of trade credit = 1 + − 1
1 − discount
2/10 net 30 ⇒ 2% discount in 10 days & net amount due on 30th day.
Cost of funds during discount period = 0% ⇒ beneficial to pay near to discount period’s end.
Customer’s short term investment rate < calculated rate ⇒ discount offers a better return over company’s short-term borrowing rate.
7.2 Managing Cash Disbursements
Company’s ability to delay funding bank accounts until the day checks clear.
Pay electronically when it is cost effective.

Page 12
7.3 Evaluating Account Payables Management
"
. =
.’ " .
Comparison of no. of day’s payable with credit terms is necessary.
Paying early ⇒ costly.
Paying later ⇒ deteriorating relations with suppliers.
In some industries no. of days inventory & no. of days payable are
similar to one another.
8. MANAGING SHORT-TERM FINANCING
8.1 Source of Short-Term Financing 8.2 Short-Term Borrowing Approaches 8.3 Asset-Based Loans 8.4 Computing the Costs of Borrowing
8.1 Source of Short-Term Financing
Panel A: Bank Source
Sources / Type Users Rate Base Compensation Other
Uncommitted line Large corporations None Mainly in U.S; limited

reliability
Regular line All sizes Prime (U.S.) or base rate Commitment fee Common everywhere
(other countries), money
market, LIBOR+
Overdraft line All sizes Commitment fee Mainly outside U.S.
Revolving credit Larger corporations Commitment fee +extra Strongest form (primarily
agreement fees in U.S.)
Collateralized loan Small, weak borrowers Base + Collateral Common everywhere
Discounted receivables Large companies Varies Extra fees More overseas, but some
in U.S.
Banker’s acceptances International companies Spread over commercial None Small volume
paper
Factoring Smaller Prime + + Service fees Special industries
Panel B: Nonbank Sources
Sources / Type Users Rate Base Compensation Other
Nonbank finance Small, weak borrowers Prime + + Service fees Weak credits
companies
Commercial paper Largest corporations Money market sets rate Backup line of credit, Lowest rates for short-
commissions + term funds

Page 13
8.2 Short-Term Borrowing Approaches
Effective strategy must ensure:

⇒ Sufficient capacity to handle peak cash needs.
⇒ Sufficient sources to fund ongoing cash needs.
⇒ Rates are cost effective.
Company should consider
⇒ Their size & credit-worthiness
⇒ Sufficient access
⇒ Flexibility of borrowing options
Both active and passive borrowing strategies exist. (Discussed earlier).
8.3 Asset-Based Loans
Companies with credit quality go for secured loans (asset-based

loans).
Often short term assets presents a challenge for the lender due to
uncertainty involved with such assets.
Lenders may have blanket lien ⇒ right over assets if collateral does
not pay, even if it has worth (in some cases).
Factorizing of accounts receivable can be used.
Inventory blanket lien ⇒lender can claim some or all inventory.
Requires company to certify that goods are segregated and sale
proceeds paid to the lender.
Warehouse receipt arrangement ⇒ similar to above but third party
overlooks inventory.
Cost of asset-based loans depends upon length of time it takes to sell
the goods.
8.4 Computing the Costs of Borrowing
Interest + Commitment Fee

Cost =
Loan Amount
If amount borrowed includes interest cost e.g. bankers acceptance.
Interest
Cost =
Net Proceeds
= –
.
In case of dealer’s fee & backup costs e.g. commercial paper
Interest + Dealer s commission + backup cost
Cost =
Loan amount − Interest
Cost is usually annualized and compared.

Page 1
“PORTFOLIO MANAGEMENT AN OVERVIEW”

40.a
MPT = Modern Portfolio Theory
NAV = Net Asset Value
Portfolio perspective ⇒ evaluates individual investments in a portfolio context
FI = Fixed Income
(risk & return contribution).
SD = Standard Deviation
Diversification reduces portfolio risk without necessarily reducing expected
return according to MPT.
MPT results in equilibrium expected return for securities & portfolios given
market risk.
Diversification ratio = S.D of equally weighted portfolio / S.D of a single security
from portfolio.
Computer based optimization calculates portfolio weights that produce lowest
portfolio risk.
During financial crisis correlations tend to , diversification benefit.
40.b Individual Investor
Invest for variety of reasons (purchase a house, for retirement etc.).
Defined Contribution Pension Plan
Individual makes investment decisions &

takes investment risk.
No guarantee of specific future pension
payments.
Institutional Investors
Endowment Foundation Banks Defined Benefit
Fund that provides Fund for charitable purpose Objective is to earn Obligation to provide
ongoing financial or research related to a more on investments benefits to retirees.
support for a specific particular disease. than pays to depositors. Long time horizon &
purpose. A common objective is to Investments need to be select investments that
Long horizon with high maintain real portfolio of low risk and should be match pension liabilities.
risk tolerance little value while generating relatively liquid.
liquidity needs. income to meet funding
needs
Long horizon, low liquidity
needs & high risk tolerance.
Insurance Companies Investment Companies Sovereign wealth fund
Invest premiums for Manage pooled funds of Pools of assets owned

funding customer many investors. by a govt.
claims. Mutual funds ⇒ manage
Life insurance ⇒ long- pooled funds in
time horizon. particular style (index,
Property & casualty growth etc.).
insurance ⇒ shorter
horizon than life
insurance.

Page 2
40.c Steps in Portfolio Management Process
Planning ⇒ Execution ⇒ Feedback
Analysis of objectives & constraints & Analysis of risk & return of various Monitor changes & rebalance
IPS development. asset classes. portfolios periodically.
Benchmark is selected for Top-down analysis ⇒ examines Measure portfolio performance &
performance measurement. current economic conditions & compare it with benchmark
IPS should be updated regularly or constructs a well diversified portfolio.
when circumstances dictate Bottom up analysis ⇒identify most
otherwise. attractive securities.
40.d Mutual Funds
Open-End-Fund Closed-End-Fund
Buy & redeem share at NAV. Each investor owns a portion of overall Do not take new investments into
Fund charge ongoing management portfolio. fund or redeem investor shares
fee.
(shares trade like equity)
NAV =
.

No load funds ⇒ no additional fee. Charge on-going management fees.
Load funds ⇒ charge upfront,
redemption or both fees.
Types of Mutual Funds
Money Market Funds Bond Mutual Funds Stock Mutual Funds
Invest in short term debt securities Invest in FI securities.

with low risk of value change. Differentiated by maturities, credit Index Funds Actively Managed Funds
Funds are differentiated by maturities ratings, issuers & types.
& types of securities. Passive Select securities with
investments to object to beat
match the benchmark.
performance of a Higher turnover,
particular index. management fee, tax
Other Forms of Pooled Investments
liabilities.
ETFs Separately Managed Accounts Hedge Funds
Purchase and sale of investments Portfolio owned by a single Not regulated to the extent that
between investors (similar to closed- investor. mutual funds are.
end funds). Qualified investors (normally rich
Most try to match a particular index individuals).
(passively managed).
In-kind creation and redemption
provision process keeps ETF price
Buyout Funds Venture Capital Funds
close to NAV.
Can be shorted or margined.
Less capital gain liability as compared Typically buy public companies & Invest in companies in start up
to open end fund (in kind take them private. phase with intention to sell in IPO
redemption). Use of significant leverage. or to an established firm after
Sell restructured firm in public growing the company.
offering or to another company Expertise in industries in which
after a period of time (3 to 5 years). they focus.

Page 3
40.d Hedge Fund
Long / Short Funds Equity Market-Neutral Fund Event-Driven Funds
Buy ⇒ undervalued securities. Value of long positions will exactly Invest in response to corporate events
Sell ⇒ overvalued Securities. offset the value of short positions. (e.g. mergers & acquisitions).
Profitable as long as longs
outperform shorts.
Long (short) bias ⇒ larger long
(short) position relative to short
(long) positions.
F.I Arbitrage Funds Convertible Bond Arbitrage Funds Global Macro Funds
Take positions in debt securities to Take positions in convertible bonds Speculate on exchange rates &
exploit mispricing while minimizing and related equity to profit from interest rates globally & use
interest rate risk. relative mispricing. derivatives & leverage.

Page 1
“RISK MANAGEMENT: AN INTRODUCTION”
1. INTRODUCTION
2. THE RISK MANAGEMENT PROCESS
Risk ⇒ all of the uncertain environmental variables that lead to variation in &
unpredictability of outcomes (exposure to uncertainty).
Risk exposure ⇒ extent to which underlying risks result in actual risk borne by a
business or investor who has assets or liabilities that are sensitive to those risk.
Risk management ⇒ process by which an organization or individual defines the
level of risk to be taken measures the level of risk being taken and adjust the
latter towards the former, with the goals of maximizing the company’s or
portfolio value or the individual’s overall satisfaction or utility.
Risk management is not about minimizing risk not about predicting risk (impact
of an event would not be a surprise).
Risk management is a continuous process that is always being revaluated &
revised.
Risk governance ⇒ top-down process & guidance that directs risk management
activities to align with and support the overall organization.
See Exhibit 1 Curriculum Level 1 2017
Goods risk management
To understand which risk drive better outcomes.
Less frequent surprises
More decision discipline
More awareness & active monitoring.
Fewer operational errors.
Better relations
Better image or reputation.
3. RISK GOVERNANCE
3.1 An Enterprise View of Risk Governance
Governing body has three focus areas:

Responsibility of risk oversight
Determination of organizational goals, directions & priorities.
Spelling out the risk appetite or tolerance.
Risk governance is the impact of the governing body of an organization on the
risk management framework.
Enterprise risk management ⇒ it requires that the entire economic balance
sheet of the business be considered, not just one part of business in isolation.
Considering the full spectrum of risks will result in better risk governance.

Page 2
3.2 Risk Tolerance
Risk tolerance identifies the extent to which the entity is willing to experience
losses or opportunity costs & to fail in meeting its objectives.
Two different analyses for risk tolerance:
Inside/before a crises
Outside/after a crises.
Determination of risk tolerance certainly contains no formula & it depends on
strategies of the company.
Once risk tolerance is determined, the overall risk framework should be geared
toward measuring, managing & communicating compliance with this risk
tolerance.
3.3 Risk Budgeting
Risk budgeting ⇒ it quantifies & allocates the tolerable risk by specific metrics;
it extends & guides the implementation of the risk tolerance decision.
Risk budgeting applies to both business management & portfolio management.
Risk budget can be simple, one dimension or can be complex & multi-
dimensional.
Benefit of the risk budgeting ⇒ it forces risk trade-offs & supports a culture in
which risk is considered as part of all key decisions.
4. IDENTIFICATION OF RISKS
4.1 Financial Risks
Market Risk Credit Risk
Risk that arises from movement in interest rates, stock prices, exchange Risk of loss if one party fails to pay an amount owed on an obligation.
rates & commodity prices. Route source of the risk can arise from fundamental conditions in the
Market risks are among the most obvious & visible risks faced by most economy, industry or company.
organization. Highly visible risk.
Liquidity Risk
Risk of a significant downturn valuation adjustment when selling a

financial asset.
Having to make price concessions is not necessarily unusual & does not
imply a poorly functioning market.
Liquidity risk varies over time & size of the position.

Page 3
4.2 Non-Financial Risks
Non-financial risks arise from relationship b/w the entity & counterparties,
regulators, governments, the environment, suppliers, customers and
employees.
Settlement risk ⇒ risk that arise from settlement of payments that occur just
before a default.
Legal risk ⇒ risk of being sued over a transaction or for that matter, anything an
entity does or fails to do.
Compliance risks ⇒ these include regulatory risk, accounting risk & tax risk.
Model risk ⇒ risk of a valuation error from improperly using a model.
Tail risk ⇒ risk of more events in the tail of the distribution than would be
expected by probability models.
Ignoring tail risk is a form of model risk. (Tail risk seems more of a financial
risk).
Operational risk ⇒ risk that arises from the people & processes that combine to
produce the output of an organization (external factors’ influence).
Solvency risk ⇒ risk that the entity does not survive or succeed because it runs
out of cash even though it might otherwise be solvent.
Individuals face other type of non-financial risks also and these include life
changing disaster, cheated by a financial advisor etc.
4.3 Interactions between Risks
The interactions b/w risks are numerous.

It has been said that market risk begets credit risk which begets operational risk.
The combined risk compounds the individual risks in non-linear manner during
adverse financial risk interactions.
Most risk models & systems do not directly account for risk interaction which
makes the consequences of the risk interactions even worse.
5. MEASURING AND MODIFYING RISKS
5.1 Drivers
Financial markets generate prices that fluctuate as investors absorb information

about the global & domestic state of economy, company’s industry &
characteristics of company itself.
Uncertainties of global & domestic macroeconomic & central bank policies
create risks for economies & industries that we often treat as systematic.
Investors also face unsystematic risk of individual companies.
Risk management can control some of the risk but it cannot control all of it.

Page 4
5.2 Metrics
Matrix in the context of risk ⇒ quantitative measures of risk exposure.

Most basic matric ⇒ probability ⇒ it is a measure of the relative frequency with which one would
expect an outcome not a sufficient measure of risk.
Standard deviation ⇒measure of the dispersion in a probability distribution.
Limitation ⇒ inappropriate measure for non-normal distribution.
Beta ⇒ a measure of the sensitivity of a security’s returns to the returns on the market portfolio.
Delta ⇒ it measures the sensitivity of the derivative price to a small change in the value of the
underlying.
Limitation ⇒ it measures small change only.
Gamma ⇒ it captures large changes as it is considered a second order risk (it reflects the risk of
change in delta).
Vega ⇒ first order measure of the change in the derivative price for a change in the volatility of
the underling.
Rho ⇒ it measures the sensitivity of derivatives to changes in interest rates.
Duration ⇒ it measure the interest rate sensitivity of a fixed income instrument.
Value at risk (VaR) ⇒ a measure of the size of the tail of the distribution of profits on portfolio or
for an entity.
VaR covers three elements.
Amount in unit of currency
A time period.
A probability
Limitation of VaR:
Different VaR measures can lead to highly diverse estimates.
VaR is subject to model risk.
VaR measure is input dependent.
Conditional VaR ⇒ weighted average of all loss outcomes in the statistical distribution that
exceeds the VaR loss.
VaR focuses on the left tail of the distribution & tell us the expected frequency of extreme
negative returns.
Extreme value theory ⇒ it measures the statistical characteristics of outcomes that occur in the
tails of the distribution.
Scenario analysis ⇒ a set of conditions that could occur & would put some pressure on a portfolio.
Stress testing ⇒ it involves extremely large & high pressure scenarios that would occur only rarely
but would have the potential for destabilizing the entire organization.
Operational risk is one of the most difficult risks to measure.
5.3 Methods of Risk Modification
Risk modification⇒ an analysis at risk governance stage

that defines how much risk is acceptable.
Risk modification is not strictly risk reduction.
5.3.1 Risk Prevention and Avoidance
One method of managing risk is taking steps to avoid it

altogether (not as simple as it appears).
It is unclear that every risk should be completely avoided.
Insurance companies rely heavily on the techniques of risk
prevention & avoidance.
Decision of risk avoidance is generally made at the
governance level.

Page 5
5.3.2 Risk Acceptance: Self-Insurance and Diversification
Self-insurance ⇒ notion of bearing a risk that is considered

undesirable but too costly to eliminate by external means.
Good governance ⇒ self-insurance results in risks that are completely
in line with the enterprise risk tolerance.
Self-insurance is obtained by setting a side sufficient capital to cover
losses.
5.3.3 Risk Transfer
Risk transfers ⇒ the process of passing on a risk to another party

(usually through insurance policy).
From insurer point of view, insurance almost always works on the
basis of diversification or pooling of risks.
The insurer assesses the pooled risks & charge a premium that covers
the expected aggregate losses & the insurer’s operating costs as well
as leaves a profit.
5.3.4 Risk Shifting
Risk shifting ⇒ actions that change the distribution of risk outcomes

(generally involves derivatives).
Risk shifting diverts some portion of the risk distribution to another
market participant who either bears the risk or moves it to another
party.
There are several types of derivatives (covered in derivatives portion
of CFA level 1 curriculum).
5.3.5 How to Choose Which Method for Modifying Risk
Choosing the risk mitigation method is difficult but no mutually

exclusive (many organizations use all methods to some extent).
Organizations with large amount of free cash flow may choose to self-
insure some risk.
Risk takers should identify risks that offer few rewards in light of
potential costs & avoid those risks when possible.
Risk decisions always on of balancing costs against benefits while
producing a risk profile that is constant with the risk management
objectives of the organization.

Page 1
“PORTFOLIO RISK AND RETURN: PART I”
SD = Standard Deviation CAL = Capital Allocation Line

EF = Efficient Frontier HPR = Holding Period Return
E(R) = Expected Return GM = Geometric Mean
IC = Indifference Curve AM = Arithmetic Mean
42.a
HPR ⇒ % in value of an investment over a given time period.

= − 1 × 100

.

Average Returns
Arithmetic Mean Return Geometric Mean Return Money-Weighted Rate of Return
Simple avg. of a series of periodic return. Compound annual rate. IRR based on portfolio’s cash inflows &
Unbiased estimator of true mean. GM < AM when periodic return vary from outflows.

ℎ

= period to period. Consider beg value & additional deposits as

భ మ య ⋯ ೙
GM return = inflows & withdrawal of cash, interest &
1 + R × 1 + R × … × 1 + − 1
౤
dividends & ending value as outflows.
Other Return Measures
Gross & Net Return Pretax & After-tax Nominal Return Real Return
Total return before management & Returns prior to paying tax are pre- Nominal return adjusted for inflation.
administrative fee (& net returns are tax & after paying tax are after-tax. It measures in investor’s purchasing
returns net of these fees). power.
Cost necessary to generate investment
return (commission & other) are deducted. Leveraged Return
From both gross & net return.
Calculated as G/L on investment as a % of
investor’s cash investment.
Use of derivative produce leveraged return.
42.b
Empirical research (1926-2008) shows small cap had the greatest avg. risk & return.
Real returns are more stable than nominal (inflation rate fluctuate greatly).
Return may not always follow normal distribution (negatively skewed, excess kurtosis).
Liquidity affects expected return, so it must be considered when choosing investments.

Page 2
42.c Variance (SD) of an Individual Security
Variance & SD are common measures of risk (both measure variability of return around
the mean).
Given return (Rt) for period t, total no. of periods (T) & mean (µ) mean of T returns is;
మ
∑೅
೟సభ ೟ µ
ߜ =

sample variance
∑ −

=
−1
Covariance & correlation of returns for two securities.
Covariance ⇒ extent to which two variables move together.
Positive (negative) covariance ⇒ variables move together (opposite direction).
Zero covariance ⇒ no linear relationship b/w variables.
Covariance is absolute measure & measured in return units squared.
Correlation , =
భ,మ
భ మ
Correlation Coefficient
+1 -1 0
Assets move together in the same Assets move in opposite direction Movement of one asset does not
direction 100% of the time. 100% of the time. provide any prediction regarding
movement of another asset.
42.d Risk
Risk Averse Risk Seeking Risk Neutral
Investors who prefer less risk to Risk lover investors take more risk No risk preference.
more risk given equal expected given equal expected return.
return.
Risk averse investors may seek risky investments if

appropriate compensation for additional risk is available.

Page 3
42.e
Variance P = + + 2 !",

= √
Where
W1 = weight of asset 1
1-W1 = weight of asset 2
#, = & !", = #,
భ,మ
భ మ
42.f
If two risky asset returns are perfectly positively correlated then;

= + (greatest portfolio risk).
the correlation, diversification benefit.
If asset’s return is perfectly negatively correlated, portfolio risk could be
eliminated altogether (specific set of assets’ weights).
42.g
Minimum-variance portfolio ⇒ for a given level of E(R), portfolios with lowest SD.
Minimum – variance frontier ⇒graph of minimum-variance portfolios.
Global minimum-variance portfolio ⇒farthest left portfolio (least risky on MVF).
EF ⇒ top portion of minimum-variance frontier.
All portfolios on EF provide highest level of E(R) for a given level of risk.
42. h
Utility function ⇒ investor’s degree of risk aversion in term of risk & return.
I.C ⇒ combination of risk & return among which investor is indifferent.
More risk averse investors ⇒steeper I.C.
Two fund separation theorem ⇒ investor’s optimal portfolios are made up of risky
& risk free asset’s combination.
Line representing these combinations is called CAL.
If A represents risky assets & B represent risk free then;
$ = $ +
= % =

Page 1
“PORTFOLIO RISK AND RETURN: PART II”

SML = Securities Market Line RF = Risk Free
43.a
FR = Forecasted Return CML = Capital Market Line
RR = Required Return SR = Systematic Risk
MPT = Market Portfolio Theory In previous reading we determined E (RP) & σP of combined assets (risky & RF). NSR = Non systematic
BV = Book Value Risk return tradeoff can be plotted through a line started with RF return & CAL = Capital Allocation Line
MV = Market Value extend through the risky portfolio. EF = Efficient Frontier
43.b
For an individual investor best CAL should represent best risk / return combination
(greatest utility).
MPT assumes homogenous expectations (same EF, risky portfolio (market portfolio) &
CAL).
Optimal CAL (CML) ⇒ tangent to EF.
−
= = +

where
intercept is Rf & slope is
೘ ೑
ಾ
Diff. b/w E (RM) & Rf is market risk premium.
If investors can borrow at RF, they can invest to the right of the market portfolio.
Investment Strategies
Passive Active
When investor believes markets Markets are not informationally

are efficient. efficient.
Index investment. Overweight the undervalued &
underweight the overvalued
securities to generate active
return.
43.c Not perfectly correlated assets ⇒ portfolio risk <

weighted avg. risk of portfolio’s securities.
Total risk = systematic risk + nonsystematic risk.
Types of Risk
Nonsystematic Risk Systematic Risk
Also known as idiosyncratic, Also known as non diversifiable or

diversifiable or firm specific risk. market risk.
Eliminated through diversification. Cannot be eliminated through
No need to buy all market securities diversification.
to eliminate N.S.R. Concept applies to individual
N.S.R. is not compensated in securities as well as portfolios.
equilibrium (can be eliminated for Firms highly correlated with market
free through diversification). S.R.
High total risk does not necessarily
mean expected return.

Page 2
43.d
Return generating models ⇒ to estimate E(R) on risky securities based on specific

factors (macroeconomic, fundamental & statistical).
Multifactor models ⇒ use macroeconomic statistical & fundamental factors.
− = × 1 + × 2 + … + ×
Statistical factors represent relations for specific time period.
Fama & French model consider three factors; firm size, BV/MV ratio & beta, Carhart
include 4th factor as momentum.
Market model is a single factor model
− = −
where β represent sensitivity of return of to return on market portfolio.
43.e
=
೔೘
మ
೘
! "ℎ # $
Using correlation

= %

Slope of least squares regression line (best fit) is the estimate of β.
43.f
SML ⇒ line that represent relationship b/w S.R (β) & return.
SML equation (CAPM)
= + −
Comparison b/w CML & SML
CML SML
Use total risk (only efficient Use β (all properly priced

portfolios at CML). securities & portfolios plot on
SML).
Low β stock is not necessarily low risk stock (when total risk is a consideration).

Page 3
43.g
CAPM = equilibrium model that predicts E(R) on a stock given E (Rm), β & RF.
43.h
In equilibrium, security’s E(R) is equal to its required return.

Analyst can compare forecasted return with required return if;
FR > RR ⇒ security is undervalued (plot above the SML).
FR < RR ⇒ security is overvalued (plot below the SML).
FR = RR ⇒ security is fairly valued (plot on SML).
Total Risk Adjusted Return Measure
Sharpe Ratio M-Squared
− − /0 = ( − )

ಾ
− ( − )
ℎ* = + ,

ು
*& #. ℎ* .
- * & *& #.
sharpe ratio is a relative measure & slope of CML & CAL.
Risk-adjusted return measures (β)
Treynor measure Jensen’s Alpha
& &
೛ ೑
% return in excess of those from a
ು
portfolio with same β but lies on SML.
' = − + ( − )
Excess return per unit of systematic risk.
Does not work for –ve β assets.
If portfolio is not fully diversified, total risk is more relevant and, Sharpe ratio or M2 is
appropriate measure.
If portfolio is well-diversified and diversifiable risk is negligible Treynor & Jensen’s alpha
are appropriate.
These measures are used to compare actively managed fund’s performance with passively
managed funds.

Page 1
“BASICS OF PORTFOLIO PLANNING AND CONSTRUCTION”

44.a
Understanding of client’s needs, circumstances & constraints are essential to

produce good results.
IPS begin with investor’s risk / return goals (mutually exclusive & must be
consistent).
44.b
Major components of IPS typically address;

Description of client & statement of purpose of IPS.
Statement of duties & responsibilities of manager, custodian & client.
Procedures of IPS update & investment guidelines.
Investment objectives & constraints.
Evaluation of performance & appendices.
IPS should contain clear statement of circumstances, constraints & benchmark.
44.c Investment objective
Risk objective Return objective
Absolute Risk Relative Risk Absolute Return Relative Return
For example not to in Relative to specific Can be stated in real (e.g. Relative to benchmark.
portfolio value by more benchmark. 3% > than annual inflation Bank ⇒ relative to cost
than 2% at any point rate) or nominal (e.g. of funds.
over any 12-month overall return of at least May be relative to
period. 6%) terms. return on peer groups’
Also stated in terms of portfolios.
probability of specific
portfolio results (either
% losses or $ losses).
44.d Risk
Ability to Bear Risk Willingness to Bear Risk
Based on financial circumstances other objective factors. Based on investor’s attitude & beliefs.
Investment horizon, greater assets v/s liabilities, higher Willingness is quite subjective & can be assessed
expected income, greater ability to bear investment risk. through a short questionnaire.
If ability & willingness is consistent, no problem in selecting appropriate level of risk.

If willingness is above average, ability is below average ⇒ low ability will prevail in
advisor’s assessment.
If ability is above average, willingness is below average ⇒ advisor may attempt to educate
client.
Approach will most likely conform to lower of investor’s ability or willingness to bear risk.

Page 2
44.e Investment Constraints
Liquidity Tax Situations Time horizon
Ability to turn investments into cash Overall tax rate as well as tax Generally longer the horizon, more risk
without significant price concessions. treatment of various accounts is a & less liquidity the investor can accept.
Property & casualty insurance ⇒ consideration.
significant liquidity required Expected after tax return in relation to
(unpredictable claims). Hedge funds & risk should be focused.
private equity funds are not suitable
investments.
Legal & Regulatory Unique Circumstances
Constrain how portfolio funds are Specific preferences or restrictions

invested. (ethical, religious & diversification
needs).
44.f
Strategic asset allocation ⇒ % allocation to IPS-permissible asset classes.

Correlation of return within asset class should be high & between asset
classes should be low (risk reduction)
Recently, alternative investments have gained prominence as an investable
asset class.
Asset classes, being mutually exclusive, should approximate the universe of
permissible investments specified in IPS.
Once asset classes have been specified, then return, standard deviation &
correlation for each asset class with other classes is determined.
44.g
Through efficient frontier, manager identifies portfolio which best meet

risk / return requirement of investor.
Tactical asset allocation ⇒ variation from strategic asset allocation weights
to take advantage of short term opportunities.
Security selection ⇒ deviation from index weights on individual securities.
Risk budgeting ⇒set an overall risk limit & then allocate risk b/w strategic,
tactical & security selection.
Success of security selection & tactical asset allocation depends on
manager’s skills & informational efficiency of markets.

Page 1
“MARKET ORGANIZATION AND STRUCTURE”

FI = Financial Intermediaries MP = Market Price
45.a
IB = Investment Bank NAV = Net Asset Value
People use the financial system for the following purposes:

Save & borrow money, manage risks, trade information and exchange assets &
raise equity capital.
The three main functions of financial system are:
Determine equilibrium returns (interest rates) ( rate of return, savings,
borrowings & vice versa).
Achievement of the purpose of the financial system.
Most efficient uses of capital.
Financial system works best when markets are liquid, transaction cost &
information is readily available.
Usually risk can be hedged through derivatives.
Investors weight risk/return of different investments to determine their most
preferred investments.
45. b
Financial assets ⇒ stocks, bonds, derivative contract & currencies.

Real assets ⇒ real estate, equipment, commodities & other physical assets.
Financial derivative contracts ⇒ based on debt & equity indexes or other
financial contracts.
Physical derivative contracts ⇒ derive their value from physical assets (e.g.
gold, silver etc.).
Primary market ⇒ market for newly issued securities
secondary market ⇒ where subsequent sale of securities occurred.
Money markets ⇒ markets for debt securities with maturities of one year or
less.
Capital markets ⇒ markets for debt & equity securities with longer-term
maturities.
45. c Securities
Fixed Income Securities Equity Securities Pooled Investment Vehicles
Debt securities that promise to repay borrowed

Common Stock Preferred Stock Warrants
money in future.
Short term < 1 year, medium term ⇒1-5 years, long
term longer than 5 to 10 years. Residual claim on firm’s Fixed dividend & paid Similar to options (right of
Bonds ⇒ long-term debt; notes ⇒ intermediate term assets. before common stock holder to buy a firm’s
Dividend paid after dividend. equity shares at a fixed
debt; commercial papers ⇒ short term-debt.
interest to debt exercise price).
Repurchase agreements ⇒ borrower sells an asset
holders.
with obligation to repurchase (at price) in the
future.
Convertible debt ⇒ debt that can be converted into a
specified no. of equity shares of issuing firm.

Page 2
45. c Pooled Investment Vehicles
Mutual Funds ETFs Asset-Backed Securities Hedge Funds
Investors can purchase Trade like closed-end Claim to a portion of Organized as limited
shares either from fund funds. the pool of financial partnerships (investors
itself (open-end funds) or MP close to NAV. assets (e.g. mortgages, are limited partners,
in primary & secondary car loans etc.). fund manager as
markets (closed-end Different classes of general partner).
funds). claims (tranches) with Often use leverage.
different risk & return.
Currencies
Issued by govt’s central bank

Reserve currencies ⇒ held by govt & central banks worldwide.
Spot currency markets ⇒ currencies are traded for immediate delivery.
Contracts
Forward, futures, swap & option contracts are discussed in derivative portion.
Insurance contracts ⇒ pay a cash amount if a future event occurs.
Credit default swaps ⇒ form of insurance (a payment if an issuer defaults on its bond).
Commodities
Metals, agricultural products, energy products etc.

Trade in spot, forward & futures markets.
Real Assets
Real estate, equipment & machinery etc.

Holding real assets directly provides certain benefits (income, tax,
diversification etc.) but these are illiquid & require due diligence.
45. d FI = facilitate exchange of assets, capital & risk (stand b/w buyers & sellers).
Allow greater efficiency & well functioning economy.
Financial Intermediaries
Brokers, Dealers & Exchanges Securitizers
Brokers ⇒ help clients in buying & selling securities by finding counterparties. Pool large amount of securities or
Block brokers ⇒ assist in large placements. other assets & then sell interests in
Investment banks ⇒ help corporations in selling securities. the pool to other investors.
Exchanges ⇒ venue where traders can meet (sometimes act as brokers by providing electronic order Create liquidity & economies of scale.
matching). CF from securitized assets can be
Alternative trading systems (ATS) ⇒ same trading function as exchanges but no regulatory function. segregated by risk (tranches).
Dark pools ⇒ ATS that do not reveal current client orders.
Dealers ⇒ buying for or selling from their own inventory (provide liquidity & earn spread b/w
bid/ask).
Broker-dealer ⇒ dealer also act as broker (inherent conflict of interest).
Primary dealers ⇒ trade with central bank which influences money supply.

Page 3
45. d Financial Intermediaries
Depository Institutions Insurance Companies
Include commercial banks, credit unions, savings & banks Collect insurance premium in return for providing risk
loans. reduction to the insured.
Expertise in evaluating credit quality & risk management. Moral hazard ⇒ insured may take more risk when
Payday advance corporations and factors ⇒ provide credit protected against losses.
secured by future paychecks, accounts receivables etc. Adverse selection ⇒ those with probability of losses are
the insurance buyers.
Fraud ⇒ fictitious loss claims.
Arbitrageurs Clearinghouses & Custodians
Try to exploit mispricing for similar instruments. Clearinghouse ⇒ limit counterparty risk (risk that other
Replication ⇒ similar positions using different assets. party will default).
Custodians ⇒ hold client securities (improve market
integrity) & prevent their loss due to fraud.
45. e Positions in an Asset
Long, Short & Hedger Short Sale & Positions Leveraged Positions
Long ⇒investor who owns an asset or Short seller; Use of borrowed fund.
right to purchase an asset. Simultaneously borrow & sell Margin loan ⇒ borrowing from broker.
Short ⇒borrowing an asset & selling with securities through broker. Call money rate ⇒ interest rate on
the obligation to replace it in the future Must return securities to lender. margin loan.
or party who must sell an asset. Portion of short sale proceeds as Initial margin requirement ⇒ minimum
Hedgers ⇒ use short positions to hedge collateral. fraction of purchase price that must be
existing long positions (inversely Payment-in-lieu ⇒ dividends or interest trader’s equity.
correlated assets). on short sale securities (borrower pay to Financial leverage ⇒additional risk from
the lender). the use of borrowed funds.
Short rebate rate ⇒interest earned on
collateral (paid to short seller).
45. f
Leverage ratio ⇒ value of assets/value of equity.

Maintenance margin requirement ⇒ minimum equity % the
investor must maintain to ensure that the loan is covered by the
value of assets.
Margin call ⇒ request to bring equity % back to maintenance
margin %.
Margin call price ⇒ ܲ ቂ ቃ.

In a short sale margin call will be triggered in case of in price.

Page 4
45. g,h
Make a market ⇒ traders who post bids & offers.

Take the market ⇒ investors who trade at posted prices.
Order Includes Three Things
Execution Instructions Validity Instructions Clearing Instructions
Market order ⇒ executes trade Specify when an order should be How to clear & settle a trade.
immediately at the best possible price executed. Investors can use prime brokers for
⇒ appropriate when trader wants to Day orders ⇒ expire if unfilled by the prime brokerage services & custodial
execute quickly & believes that the end of the trading day. services & other brokers for specialized
information is not reflected in market Good-till-cancelled orders ⇒ orders last execution.
prices. until they are filled.
Disadvantage ⇒ may execute at Fill or kill orders ⇒ cancelled unless filled
unfavorable price. in part or whole immediately.
Limit order ⇒ minimum execution price Good-on-close orders ⇒ only filled at the
on sell orders & maximum on buy orders. end of trading day.
Advantage ⇒ reduces price Stop orders ⇒ not executed unless stop
uncertainties. price condition has been met.
Disadvantage ⇒ order might not be Stop sell orders ⇒ triggers when price
filled. falls from specified price.
Marketable ⇒ above the best ask Stop buy orders ⇒ trigger when
or below the best bid. price is above the specified stop
Behind the market ⇒ placing a: buy price.
order below the best bid price OR Used to limit losses on a short
sell order above the best ask price. position (when price).
Standing limit orders ⇒ limit orders Stop orders reinforce market
waiting to execute. momentum.
All-or-nothing orders ⇒ execute only if Execution prices are often
the whole order can be filled. unfavorable.
Hidden orders ⇒ only the broker or
exchange knows the trade size.
Display size ⇒ some of trade is visible to
the market (also known as iceberg
orders).
Markets
45. i
Primary Capital Markets Secondary Financial Markets
Initial public offerings ⇒ first time issues (not currently publicly traded). Securities trade after their initial issuance.
Seasoned offerings ⇒ new shares issued by firms whose shares are already Provide liquidity & price/value information.
trading in the market. Better secondary markets allow firms to raise external
Primary market: public offerings capital at lower cost (due to liquidity).
Stock or bond issues are almost sold with the assistance of an investment
banking firm.
Book building ⇒process of gathering indication of interest.
Underwritten offering ⇒ IB agrees to buy the entire issue at a price that
is negotiated b/w issuer & bank.
Best effort basis ⇒ bank is not obligated to buy unsold portion.

Page 5
45. i Markets
Primary Capital Markets
Primary market: private placements & other transactions

Private placement ⇒ securities sold directly to qualified investors.
Shelf registration ⇒ firms issue the registered directly into secondary
markets when it needs capital & when the markets are favorable.
Dividend reinvestment plan ⇒ use dividends to buy new shares of the
firm at a slight discount.
Rights offering ⇒ right to buy new shares at a discount to MP by existing
shareholders.
45. j
Call markets ⇒ stock is only traded at specific times.

Very liquid when in session & illiquid b/w sessions.
Used in smaller markets & to set opening prices & prices after trading
halts on major exchanges.
Continuous markets ⇒ trades occur at any time the market is open.
Price is set by either auction process or by dealer bid-ask quotes.
Market Structure
Quote-Driven Markets Order-Driven Markets
Traders transact with dealers who post bid-ask prices. Order-driven markets ⇒ orders executed using trading rules.
Also called dealer, price-driven or over-the-counter markets. Traders are usually anonymous.
Electronic trading.
Type of trading rules
Brokered Markets
Order matching rules Trade pricing rules
Broker finds the counterparty in order to execute a trade.
Valuable for unique or illiquid securities Establish an order Used to determine the
precedence hierarchy. trade price.
Price priority ⇒ highest Uniform pricing rules &
priced buy and lowest discriminatory pricing
priced sell orders are rules.
given the highest priority.
Secondary precedence
rule⇒ Priority to non-
hidden & earliest arriving
orders (same prices).
Market Information
Pre-trade transparent ⇒ investors can obtain pre-trade

information regarding quotes & orders.
Post-trade transparent ⇒ post trade information regarding
completed trade prices & sizes.
Transactions costs are higher & bid-ask spreads are wider in
opaque markets.

Page 6
45. k
Complete markets fulfill the following:

Fair rate of return for future savings.
Creditworthy borrowers can obtain funds.
Hedgers can manage their risks & traders can obtain needed assets.
Operationally efficient markets ⇒ low trading costs.
Informationally efficient markets ⇒ security prices reflect all information
associated with fundamental value.
Allocationally efficient markets ⇒ capital is allocated to its most productive
use.
45. l
Market regulations are used to prevent fraud & theft, insider trading, defaults
& costly information.
Regulations can be provided by govt. as well as self-regulatory organizations.
When regulations fail to address problems, liquidity , new ideas go unfunded
& growth slows.

Page 1
“SECURITY MARKET INDICES”

SMI = Security Market Index
46.a
MP = Market Price
CS = Constituent Securities
FI = Fixed Income SMI ⇒to represent performance of an asset
REITS = Real Estate Investment Trusts class, security market or segment of market.
Index is numerical value calculated from MP of
constituent securities.
Index return ⇒ % in index value over a period
of time.
46.b Index Return
Price Index Return Index
Uses only the prices of the CS in Uses price & income in return
return calculations. calculation (total return).
If interim CF then total return >
price return.
Returns for a measurement period (multiple sub-periods).

ܴ௉ = ሺ1 + ܴௌଵ ሻሺ1 + ܴௌଶ ሻሺ1 + ܴௌଷ ሻ … ሺ1 + ܴௌ௄ ሻ − 1
Where
K = total no. of sub-periods, RSK = portfolio return during sub-period K
46.c
Index providers must have to decide about target

market, securities type & weight, rebalancing &
reconstitution.
Target market may be defined very broadly or
narrowly.
Selection process may be determined by an
objective rule or subjectively (by committee).
46.d Weighting Methods
Price-Weighted Index Equal-Weighted index Market cap-Weighted Index Fundamental Weighting

Page 2
47.d Price-Weighted Index
Arithmetic avg. of prices of securities included in the index.

The divisor is adjusted for stock splits & index reconstitution
(index will be unaffected).
Price Weighted Index
Advantage Disadvantage
Simple to compute Results in arbitrary weights for

each security.
Equal-Weighted index
Arithmetic avg. return of the index stocks & matched by the return of a
portfolio with equal $ invested in each index stock.
Advantage ⇒ simplicity.
Disadvantages ⇒ frequent portfolio rebalancing ( transaction cost) &
small firm bias.
Market cap-Weighted Index
Each index component is weighted according to market cap (price × no.

of shares outstanding).
Self rebalancing in case of stock splits or stock dividends.
Float-Adjusted Market Cap Weighted Index
Market float ⇒ total value of shares actually available to public for

investing.
Free float ⇒ market float - shares not available to foreign buyers.
Float adjusted index is calculated similar to value weighted (however
weights are calculated based on publicly available shares).
Market Cap Weighted Indexes
Advantage Disadvantage
Index security weights represent proportion Overvalued stocks are given higher weight
of total market value. & vice versa (large market cap bias)
Fundamental Weighting
Weights based on firm fundamentals (e.g earnings, dividends etc.), based

on single or some combination of fundamental measures.
Weights are unaffected by share prices.
Advantage ⇒ avoids the market-cap weighted index bias.
Fundamental weighted index will actually have value tilt.

Page 3
47.e
Examples
47.f
Rebalancing Reconstitution
Adjusting portfolio’s securities weight to their Adding & deleting securities that make up an
target weights. index.
Rebalancing is done on periodic basis (usually When security is added (deleted) to an index its
quarterly) & an issue for equal-weighted indexes. price ().
Addition & deletion requires other index
components’ weight adjustment.
47.g
Indexes have several uses;

Reflection of market sentiment (represent market return).
Benchmark of manager performance (benchmark should consistent with manager style).
Proxies for measuring and modeling returns
Measure of β & risk-adjusted return.
Model portfolio for index funds and ETFs.
Proxies for asset classes in asset allocation models.
47.h Types of Equity Indices
Broad Market Index Multi-Market Index
Provides a measure of market’s overall Constructed from indexes of markets in several

performance. countries.
Usually contains more than 90% of the market’s Used to measure equity return of a geographic
total value. region, stage of economic development or
entire world.
Multi-Market Index with Fundamental Weighting Sector Index
Market cap for securities with each country ⇒ Track different economic sectors on a global,
then weight the country index return in global regional. Or country-specific basis.
index by a fundamental factor (e.g. GDP). Used in cyclical analysis
Prevent a country with high stock return from Can be for a particular country or global.
being over weighted in multi-market index.
Style Indices
Measure return to market cap & value, growth

strategies or a combination of these characteristics.
Multiples are used in value & growth indexes
Turnover of style indices is higher than broad market
indices.

Page 4
47.i
Different F.I indexes are available to investors.

Several issues with the construction of F.I indexes;
Large universe of securities ⇒ high turnover in F.I indexes.
Dealer markets & infrequent trading ⇒ illiquid securities ⇒ lack of recent trades.
Indexing is difficult for portfolio managers (illiquidity, transaction cost & higher turnover).
Broad market, sector, style & other specialized indices are available.
47.j Alternative Investments Indices
Commodity Indices Real Estate Indices
Represent futures contracts on commodities (e.g. grains, Can be based on property appraisal, repeat
livestock etc.). property sales or performance of REITS.
Issues in commodity indexes; REITS offer good liquidity while constituent
Variety of weighting schemes (equal, combination of properties are quite illiquid.
liquidity measures and world production values etc.)
results in different exposures & risk & return
Hedge Fund Indices
characteristics.
Based on prices of commodity futures contracts risk-
free rate and roll yield and not spot prices of Equally weight the return of hedge funds included in index.
commodities (return on index differs from return of Performance of different indices can vary substantially (hedge
commodity itself). funds are unregulated).
Upward bias in index return (only successful funds report the
data).
47.k
Number of
Index Reflects Constituent Weighting Method Notes
Securities
Dow Jones Industrial

Large U.S. stocks 30 Price Stocks are chosen by Wall Street Journal editors
Average
Contains some illiquid stocks, price weighting and adjusted for
Nikkei Stock Average Large Japanese stocks 225 Modified price
high-priced shares
All stocks on the Tokyo

Float-adjusted Has a large number of small illiquid stocks making it hard to
TOPIX Stock Exchange First Variable
market cap replicate. Contains 93% of the market cap of Japanese equities
Section
MSCI All Country World Stocks in 23 developed Free float-adjusted

Variable Available in both U.S. dollars and local currency
Index and 22 emerging markets market cap
S&P Developed Ex-U.S. Global energy stocks Float-adjusted

Variable Is the model portfolio for the SPDR S&P Energy-Sector ETF
BMI Energy Sector Index outside the U.S. market cap
Barclays Capital Global Global investment-grade Formerly known as the Lehman Brothers Global Aggregate Bond
Variable Market capitalization
Aggregate Bond Index bonds Index
Markit iBoxx Euro High- Below investment-grade Market capitalization

Variable Represents liquid portion of market and rebalanced monthly
Yield Bond Indexes bonds and variations
FTSE EPRA/NAREIT Global Float-adjusted

Global real estate 335 Represents publicly traded REITs
Real Estate Index market cap
HFRX Global Hedge fund Contains a variety of hedge fund strategies and is weighted
Global hedge funds Variable Asset weighted
Index based on the amount invested in each hedge fund
HFRX Equal Weighted Contains same strategy funds as HFRX Global Hedge Fund Index
Global hedge funds Variable Equal weighted
Strategies EUR Index and is denominated in euros
U.S. stocks grouped by

Morningstar Style Float-adjusted Nine categories classified by combinations of cap categories and
value/growth and market Variable
Indexes market cap value/growth categories
cap

Page 1
“MARKET EFFICIENCY”
E(R) = Expected Return CM = Capital Market
47.a
TA = Technical Analysis TC = Transaction Cost
EM = Emerging Markets MV = Market Value
ME = Market Efficiency Informationally efficient CM ⇒current security price reflect fully, quickly & IV = Intrinsic Value
rationally all available information (you can’t beat the market).
Perfectly efficient market ⇒ passive investment strategy (indexing), because
active investment will underperform (transaction cost & management fees).
If time lag b/w information dissemination & information reflection in securities
prices ⇒ positive risk adjusted return is possible.
Only unexpected new information should move prices.
47.b
MV ⇒ current price.
IV = value placed on an asset based on rational investors’ understanding of its
characteristics.
If MV < IV ⇒ buy the asset & vice versa (inefficient markets).
More complex an asset’s future cash flows ⇒ more difficult is to determine its
IV.
47.c
Markets are generally in b/w perfectly efficient & completely inefficient.
Factors Affecting Degree of ME
No. of Market Participants Availability of Information
No. of asset market followers (e.g. investors, analyst etc), More information is available to investors ⇒ higher the
the market efficiency market efficiency.
Emerging markets ⇒ information availability ⇒ efficient
markets.
Access to information should not favor one party over another
(insider trading should be prohibited).
Impediments to Trading Transaction & Information Acquisition Cost
Arbitrage ⇒ buying an asset in one market & simultaneously If investors can earn superior returns, after deducting
selling it at a higher price in another market. information acquisition costs, the market is viewed as inefficient.
Impediments to arbitrage (e.g. TC), allow some price
inefficiencies.
Short selling improves ME.

Page 2
47.d Forms of ME
Weak-Form ME Semi-Strong Form ME Strong-Form ME
Current security prices fully reflect all Security prices reflect publicly known and Security prices fully reflect all public &
past security market data. available information. private information.
Price changes will be independent from Fundamental analysis will not work for No group of investor has monopolistic
one period to the next (past price & positive risk adjusted return. access to information (no one can
volume has no predictive power). achieve positive abnormal return).
Positive risk adjusted returns are not Evidence support that markets are not
possible by using technical analysis. strong-form efficient.
47.e
Abnormal Profit
>
If returns equilibrium E(R) ⇒ reject the
<
hypothesis of efficient prices.
Technical Analysis
Seeks to earn positive risk-adjusted return

by using historical prices & volume.
Evidence indicate we can’t reject the
hypothesis that markets are weak-form
efficient.
TA shown success in EM.
Fundamental Analysis
Event study test shows that developed

markets are generally semi-strong form
efficient however EM are not.
Exceptionally skilled investors can generate
abnormal profit through the use of
fundamental analysis.
Active VS Passive Portfolio Management
Invest passively if markets are semi-strong

and strong-form efficient.
Portfolio manager can add value through
establishing & implementing objectives,
diversification, asset allocation & tax
management.

Page 3
47.f
Anomaly ⇒ deviation from the common rule (an

exception to the notion of ME).
Data mining or data snooping ⇒ investigating data
until a statistically significant relation is found.
To avoid data mining find economic basis b/w
variables & stock return.
Anomalies in Time-Series Data
Calendar Anomalies Overreaction & Momentum Anomalies
January effect or turn-of-the year effect ⇒ during Overreaction Effect

first five trading days of January stock returns are
higher (especially for small firms). Firms with poor stock returns over previous three to
Possible explanations: five years have better returns.
Tax-loss selling (sells losing position in December Pattern attributed to investor overreaction to
& buys in Jan. at higher prices). unexpected good & bad news.
Window dressing (sell risky stocks).
Evidence indicates January effect is not persistent.
Other calendar anomalies Momentum Effects
Turn-of-the-month effect (returns are at month
end). High short term returns are followed by continued
Day-of-the-week effect (avg. Monday returns are high return.
negative). Both, overreaction & momentum effects violate weak
Weekend effect (Returns over the weekend lower form ME.
than weekdays).
Holiday effect ⇒ pre-holiday returns are higher.
Anomalies in Cross-Sectional Data
Size Effect Value Effect
Small-cap stocks outperform large-cap stocks Value stock (low P/E, low P/B & dividend yield)
(a random result for the time period outperform the growth stocks (vice versa multiples).
examined). Violates semi-strong form market efficiency.

Page 4
47.f Other Anomalies
Closed-End Investment Fund Discounts Earnings Surprises
Traded at a large discount to Earnings surprise ⇒ portion of announced earnings

NAV. (anomaly). that was not expected by market.
TC would eliminate any profits. Positive surprise leads to positive post announcement
return & negative surprise leads to negative return.
Initial Public Offerings Economic Fundamental
Typically underpriced. Stock returns are usually related to economic

Some believe this is not an anomaly but fundamental and this is evidence of market
result of statistical methodologies. inefficiency.
Relationship b/w stock returns & prior information
(e.g. dividend yields) is not constant over all time
periods.
Implication for Investors
Bottom line ⇒ anomalies will likely be

unprofitable (no sound economic basis).
47.g Behavioral Finance
Examines investor behavior, its effects

Loss Aversion Mental Accounting
on financial markets, how cognitive
biases may result in anomalies &
Tendency for investors to be more risk whether investors are rational. Classify different investments into
averse when faced with potential losses & Even if investor rationality is viewed as separate mental accounts instead of
less risk averse when faced with potential prerequisite for ME, there may be no viewing as a total portfolio.
gains. room for profitable arbitrage for any
mispricing.
Investor Overconfidence Conservatism
Overestimate their ability to value Information Cascades Investors react slowly to changes.
securities.
Less diversified portfolio holding. Uninformed traders watch the actions
of informed traders when faced with Disposition Effect
unclear information.
Representativeness Herding behavior (similar to
Investors are willing to realize gains
information cascades) ⇒ trading
but unwilling to realize losses.
Investors assessing probabilities of occurs in clusters (not necessarily
outcomes depending on how similar they driven by information)
are to the current state. Narrow Framing
Gambler’s Fallacy Investors view events in isolation.
Recent results affect investor’s estimate

of future probabilities.

Page 1
“OVERVIEW OF EQUITY SECURITIES”

MP = Market Price GDRs = Global Depository
CP = Call Price Receipts
PP = Put Price ADRs = American Depository
PE = Private Equity Receipts
DRs = Depository Receipts ADS = American Depository
CPS = Convertible Preferred Shares
Shares SD = Standard Deviation
BV = Book Value
MV = Market Value
48.a Types of Equity Securities
Common Shares Callable Common Shares
Represent ownership interest. Firm has right to repurchase stock at pre specified price.
Residual claim on assets in case of liquidation. When MP > CP ⇒ firm usually call.
Voting rights (board selection, mergers etc.). Allows the firm to reduce dividend payment (similar to share
repurchase).
Statutory Voting Cumulative Voting
Each share held is assigned one Can allocate votes to one

vote in the election of each or more candidates as
member of BOD. they choose.
Provides minority
shareholders a higher
level of representation
on the board.
Putable Common Shares Preference Shares
Right of shareholder to sell the shares back to firm at specific price. Features of both common stock & debt.
Put option places a floor on security value. Shares usually do not mature & shares can have put or call features.
Investors normally put the shares when MP < PP. Fixed periodic payments & usually have no voting rights.
Types
Cumulative Non-Cumulative Participating Preference Non-Participating Convertible Preference

Shares Preference Shares Shares
Cumulative dividends Dividends do not Receive extra dividend Claim equal to par
paid before common accumulate when not if firm’s profit exceed a value at liquidation.
shareholder’s dividend. paid. predetermined level. Do not share in firm’s
Dividends must be paid May receive value > par profit.
before being paid value at liquidation.
common shareholders.

Page 2
48.a Types
Convertible Preference Shares
Exchanged for common stock at a conversion ratio.

Advantages:
Preferred dividend is > common dividend.
Investor can share in profits through conversion.
Conversion option is more valuable when stock price .
PS have less risk than common shares (priorities in dividends & liquidation proceedings).
CPS often used to finance risky venture capital & private equity transactions.
48.b
Firm may have different classes of common stock.

Classes may be treated differently with respect to voting power,
seniority, dividends, stock splits & other transactions with
shareholders.
Company filings with regulators contain information regarding
ownership & voting rights of different classes.
48.c
Private equity securities ⇒ usually issued via private placements.

Private markets are smaller than public markets.
Characteristics of PE: (compared to public equity).
Less liquid & share price is not determined in market.
Limited financial disclosure & lower reporting costs.
Potentially weaker corporate governance.
Greater ability to focus on long-term prospects (no public pressure) &
potentially greater return for investors.
Main Types of PE Investments
Venture Capital Leveraged buyout (LBO) Private Investment in Public

Entity (PIPE)
Capital provided to fund Buy a public firm’s common stock Public firm sells PE to investors.
development & growth of firm’s outstanding using debt financing. Investors may buy the stock at a
life cycle stages. If buyer is firm’s current sizeable discount to MP.
VC investments are illiquid management ⇒the LBO is
(usually three to ten years). management buyout.
VC financing include seed or start Candidate firm usually generate
up capital, early stage & high levels of cash flows, used to
mezzanine financing. make interest and principal
payments on issued debt.

Page 3
48.d
Integrated market ⇒ free capital flows across borders.

World’s financial markets are becoming more integrated but global capital flow barriers still exist.
When foreign ownership restrictions , equity market performance.
Firm’s perspective ⇒ foreign stock exchange listing publicity, liquidity & transparency.
Direct Investing
Investing in the equity of companies outside of investors’ local market.

Obstacles:
Investments & returns are denominated in foreign currency.
Foreign stock exchange may be illiquid & may have less strict
reporting requirements.
Investors must be familiar with regulations & procedures of market
in which they invest.
Methods for Investing in Foreign Companies
Depository Receipts Global Depository Receipts
Deposit shares of foreign firm into bank & then issues Issued outside U.S & issuer’s home
receipts representing ownership of specific no. of foreign country.
shares. Usually $ denominated & can be sold to
Depository bank (custodian) ⇒ manages dividend U.S institutional investors.
payments, stock splits & other taxable events. Not subject to capital flow restrictions.
Value of DR is affected by exchange rate ∆ , firm
fundamentals, market conditions & any other factors. American Depository Receipts
Types $ denominated & trade on U.S. exchanges.

ADS ⇒ security on which ADR is based (trade in firm’s domestic market).
Sponsored DR Unsponsored DR
Level I Level II Level III Rule 144A
Trading location Over-the- NYSE, NYSE, Private
Equity issuing firm is involved Firm is not involved.
counter(OTC) Nasdaq, or Nasdaq, or
in the issue of receipts. Depository bank retains the
AMEX AMEX
Provide voting rights to voting rights.
SEC registration Yes Yes Yes No
investors & subject to greater
required
disclosure.
Ability to raise No No Yes Yes
capital in U.S.
Firm listing fees Low High High Low
Global Registered Shares Basket of Listed Depository Receipts
Traded in different currencies around the world. An ETF that is a portfolio of DRs.

Page 4
48.e Equity Securities
Returns Risks
Returns consist of price changes, dividend Risk is measured as SD of return.

payments & ∆ in exchange rates (foreign PS is less risky than common stock ⇒ pay
currency equity investment). lower avg. return than common stock.
Domestic return when foreign currency Cumulative PS has less risk than non-
appreciates. cumulative (right to receive missed dividends).
Gains from dividends & dividend reinvestment Putable shares are less risky & callable shares
have been an important part of equity are more risky than option free.
investor’s long-term returns.
48.f
Equity capital ⇒ to purchase long-term

assets, equipment & expansion into new
businesses or geographic areas etc.
Publicly traded securities provide liquidity.
48.g Equity Securities
BV of Equity MV of Equity
BV of equity = balance sheet assets – liabilities. Total of firm’s outstanding equity shares based
Positive NI & retained earnings BV. on market price.
MV & BV of equity are seldom equal.
MV reflects investor expectations about firm’s
future cash flows.
೟
48.h = = ( ೟
೟೟షభ)
೟
Alternatively
೟
=
೟షభ
⇒ First method is more appropriate when it is an industry convention to use average book values or BV is volatile.
⇒ Latter method is appropriate when examining ROE for a no. of years or when BV is stable.
ROE is generally viewed as positive for firm (reason for an should be examined e.g BV is rapidly than NI, ROE will
but not favorable).

=

⇒ Firm’s anticipated future growth, ratio.

⇒ Firms with () are considered value (growth) stocks.
Investor’s Required Return & the Cost of Equity
Cost of equity ⇒ firm’s expected equilibrium total return on its shares in the market.
⇒ Estimated through dividend discount model or CAPM
If investor’s expected return > minimum required rate of return ⇒ shares are attractive
investment.

Page 1
“INTRODUCTION TO THE INDUSTRY AND COMPANY ANALYSIS”

CA = Company Analysis
49.a
IA = Industry Analysis
ILC = Industry Life Cycle
MS = Market Share Industry analysis is important for CA because;
It provides a framework to understand the firm.
Business conditions (growth, competition, risk) the firms in an industry face.
In credit analysis industry conditions provide information about default risk.
Active management = IA identify undervalued or overvalued industries.
Industry rotation ⇒ change industry weights based on current phase of business cycle.
Performance attribution analysis ⇒ Industry classification schemes play a role in
performance attribution.
49.b
Products & services (principal business activity is one way to group companies into an
industry).
Sector ⇒ group of related industries.
Classifications by sensitivity to business cycle include cyclical & non-cyclical firms.
Statistical Methods
Group firms that have had highly correlated returns Limitations

historically. Historical correlation may not be the same in the future.
Groups formed then with low correlation b/w groups. Grouping of firms may differ over time & across countries.
Grouping may be non-intuitive.
Grouped by a relationship that occurs by chance.
Industry Classification Systems
Commercial Classification Government Classification
Several indexes provide classification of firms (three or four levels). Organize statistical data according to type of
Use fundamentals to classify firms. industrial or economic activity & to make
A description of representative sectors is as follows: comparison of data across time and among
countries.
Classifications Methodologies of govt providers differ from
commercial providers as:
Govts. Do not identify individual firms in a
Basic material & processing Consumer Discretionary group.
Govt systems are updated less frequently.
Building materials. Automotive. Govt. classification systems do not distinguish
Chemicals. Apparel. b/w small & large firms, private & public etc.
Paper and forest products. Hotels and restaurants.
Containers and packaging.
Metal, mineral and mining
companies.
Consumer Staples Firms Energy Financial Services Health Care
Food. Energy exploration. Banking & finance. Pharmaceuticals.

Beverage. Refining. Insurance. Biotech.
Tobacco. Production. Real estate. Medical devices.
Personal care products. Energy equipment. Asset management. Health care equipment.
Energy services. Brokerage services. Medical supplies.
Providers of health care services.

Page 2
49.b Classifications
Industrial & Producer Durables Technology
Heavy machinery and Computers.

equipment. Software.
Aerospace. Semiconductors.
Defense. Communication equipment.
Transportation. Internet services.
Commercial services and Electronic entertainment.
supplies. Consulting and services.
49.c
Cyclical Firms Non-Cyclical Firms
Earnings are highly dependent on Stable demand over the business

business cycle stage. cycle.
High earning volatility & operating Examples include health care,
leverage. utilities, food etc.
Normally expensive, non-necessity
products (e.g. auto, technology
etc.).
Defensive Industries Growth Industries
Least affected by stage of business Largely unaffected by business cycle

cycle. stage.
Examples include utilities, consumer
staples etc.
“growth” defensive & “cyclical” descriptors must be used with caution e.g;
Cyclical industries may include growth firms that are less business cycle
dependent.
Non-cyclical may be affected by severe recessions.
Defensive industries may not always be safe investments.
49.d
Peer group ⇒ set of similar companies which an analyst used for

comparisons.
Peer group is formed by identifying firms in same industry classification.
Analyst might include a company in more than one peer group.
Analyst follows certain steps to form a peer group.

Page 3
49.e
A thorough IA should include the following elements;

Evaluative relationship b/w macroeconomic variables & industry
trends.
Estimate industry forecasts using different approaches & scenarios.
Compare projections with other analyst projections to identify
differences.
Determine relative valuation of different industries.
Determine volatility of industry performance.
Analyze industry prospects based on strategic groups (firms that are
distinct from rest of industry).
Industry life cycle stage classification.
Experience curve (cost per unit relative to output).
Consider external factors that affect industries & determine
competition.
49.f External Factors
Macro Economic Factors Technology
Cyclical or structural trends. Introduction of new or improved

Economic output (GDP), interest rates, products.
credit availability and inflation are some Examples are computer hardware, radical
examples. improvements etc.
Demographic Factors Governments Social Influences
Age distribution, population size & Can affect business through taxes & Relates to how peoples live in society
composition. regulation. (work, play, spend money etc.).
Population aging means healthcare Examples ⇒ setting terms to industry Example ⇒ women entering into
industry’s demand increases & population entry, heavy taxes to some industries. workforce promotes day care industries.
in twenties means residential furniture &
related industries demand increases.
49.g
ILC ⇒ component of analyst’s strategic

analysis.
Industry’s stage has an impact on competition,
growth & profits & industry analysis should be
continuous process.

Page 4
49.g Stages of ILC
Embryonic Stage Growth Stage
Industry has just started. Rapid demand growth (new consumers).

Slow growth (unfamiliar product). Limited competitive pressure.
High prices (no meaningful economies of Prices & profitability (economies of
scale achieved). scales achieved).
Large investment required & high risk of
Shakeout Stage Mature Stage Decline Stage
Growth has slowed (demand saturates). Slow growth (demand is for replacement Negative growth (societal changes,
Intense competition & in overcapacity. only). substitute products etc.).
Profitability & price cuts. Consolidation (oligopoly). Price (increased competition & price
Failures (weaker firms liquidate or Barriers to entry (brand loyalty & low cost wars).
merge with others). structures). Weaker companies exit, merge or
Stable pricing (avoid price wars). redeploy capital into different products
Firms with superior products gain market and services.
share.
Growth firms focus on reinvesting CF (growth focus) while mature firms distribute CF
to shareholder (cost efficiency focus).
Analyst should be concerned if firms do not act according to their stage (mature firm
want to size).
Stage may be longer or shorter than anticipated or it may be skipped altogether.
Some firms in industry may have competitive advantage / disadvantage.
49.h IndustryIndustry
Concentration
High concentration does not guarantee pricing power.

Firm’s relative market share matters as much as their absolute market share
(firm having 50% share may have a competitor with 50% share).
Undifferentiated & commodity-like products ⇒ low pricing power.
Costly to enter & exit, overcapacity result in intense price competition.
Ease of Entry
Barrier to entry suggests industries have low pricing power.

Same firm’s dominance over no. of years may suggest entry is probably
difficult.
High barrier may not necessarily mean high pricing power (e.g. strong
competition among existing firms).
Capacity
Under capacity ⇒ demand > supply ⇒ pricing power.

Overcapacity ⇒ supply > demand ⇒ price cutting.
Capacity is fixed in short & variable in long run.
Capacity may not be physical (e.g. demand for insurance) &
reallocated to new industries more quickly.
If capacity is physical & specialized ⇒ overcapacity can exist for
an extended period.

Page 5
49.h Market Share Stability
Variable market share ⇒ competitive industry ⇒ little pricing power.

Factors affecting MS;
Barrier to entry.
New products & innovations.
Switching cost (cost of changing one firm’s product to other).
Switching cost and stable MS.
49.i Economic profit ⇒ return on invested capital –

opportunity cost of funds.
Strategic analysis ⇒ examines industry’s competitive
environment that influence a firms’ strategy
Porter’s Five Forces
Rivalry among Existing Competitors Threat of New Entrants
Fragmented industry rivalry. Barriers, premium pricing &

Slow growth leads to competition (fight competition from new comers.
for MS). Identify factors that discourage new
Fixed cost leads to price (firms try to entrants.
operate at full capacity).
Barriers to exit or undifferentiated
products, competition.
Threat of Substitutes Bargaining Power of Suppliers Bargaining Power of Buyers
Limit profit potential. Few suppliers with scarce products ⇒ Buyers power, prices & profitability.
Commodity-like products ⇒ suppliers’ power & industry’s profitability.
competition prices & vice versa in
differentiated products.
Barriers & concentration, competition.

Overcapacity ⇒ intense price competition.
Stability in MS & price sensitivity in buying decision ⇒ competition.
Industry maturity, growth.
49.j
Illustration of candy / confections industry.

Page 6
49.k Company analysis ⇒ analyzing firm’s financial

condition, products & services.
Competitive strategy ⇒ how a firm responds to the
opportunities & threats of the external environment.
Competitive Strategies
Cost Leadership Strategy Differentiation Strategy
Firm seeks to be lowest cost producer. Firm’s products & services should be
Strategy can be used defensively (protect distinctive in terms of type, quality or
market share) or offensively (to gain delivery.
market share). For success, cost of differentiation < price
Predatory pricing ⇒ firm hopes to derive premium.
out competitors & prices later. Usually outstanding research team &
Operational efficiency is required. creative personnel.
Company analysis should include:

Firm overview & industry characteristics.
Product demand & product cost.
Pricing environment.
Projected financial statements & financial ratios.
Spread sheet modeling ⇒ to analyze & forecast company fundamentals.
Problem ⇒ model complexity can make their conclusions seem precise.
Analyst must consider which factors are likely to be different going
forward & how this will affect firm’s net earnings.

Page 1
“EQUITY VALUATION: CONCEPTS AND BASIC TOOLS”

FCFE = Free Cash Flows to Equity IV = Intrinsic Value
WC = Working Capital MV = Market Value
50.a
EV = Enterprise Value DCF = Discounted Cash Flow
TA = Total Asset PV = Present Value
TL = Total Liabilities Intrinsic / fundamental value ⇒ rational value based on asset’s TV = Terminal Value
PS = Preferred Stock characteristics (derived through valuation models). FCinv = Fixed Capital Investment
GGM = Gordon Growth Model If IV ≠ MV, abnormal return is possible. DDM = Dividend Discount Model
RR = Retention Rate Perceived mispricing, appropriateness of valuation model & MDDM = Multistage Dividend
SGR = Sustainable Growth Rate inputs are important considerations in investment decision. Discount Model
MP = Market Price PMs = Price Multiples
FV = Fair Value
50.b Equity Valuation Models
DCF or PV Models Multiplier Models Asset-Based Models
DDM 1st Type IV of common stock = TA-TL &

preferred stock.
Stock value is PV of cash Ratio of stock to some

distributed to shareholders. fundamental (earnings, sales
BV, CF etc.).
FCFE Model 2nd Type
PV of cash available to Ratio of EV to EBITDA or

shareholders after capital sales.
expenditures & WC expense. EV = MV of all outstanding
securities – cash & short
term investment.
50.c DDM
One-year holding period DDM Multiple year holding periods DDM

1. Sum of the PV of estimated dividends over
= +
(1 + ) (1 + ) holding period & estimated TV.
2. For two year holding period

1 2
= + +
(1 + ) (1 + ) (1 + )
FCFE
3. It reflects firm’s capacity to pay dividends & also useful for firms not currently
paying dividends.
4. = + −

−
+
.
5. FCFE = CFO – FCinv + net borrowings (represent cash to equity holders after
meeting all obligations).
೟
1. = ∑
೟
( ೐ )
Where is obtained from CAPM or adding risk premium to publically traded
dRatio of EV to EBITDA or sales.
2. EV = MV of all outstanding securities – cash & short term investment.
3. ebt or govt bond yield.

Page 2
50.d
PS usually has indefinite maturity & fixed dividend.

ು
=
ು
50.e
GGM ⇒ assumes annual dividend growth rate is constant .

భ
= Where = cost of equity.
೐ ೎
Assumptions of GGM
Dividends are appropriate measure of shareholder
wealth.
& never expected to change.
>
When difference b/w & widens, value & vice versa.
Small changes in difference cause large changes in value.
Stock value due to dividend growth = stock value at 0%
growth rate – stock value at a positive growth rate.
Estimating Dividend Growth Rate
Use historical dividend growth rate. Median industry dividend growth rate. Sustainable growth rate
Rate at which equity earnings & dividends continue to

grow indefinitely.
Assumptions are constant ROE, dividend payout ratio &
no new equity is issued.
! = !! × !".
Firm may not be able to pay dividend currently due to
financial distress or higher reinvestment income.
Multistage Dividend Growth Models
If g > r this relationship can’t hold indefinitely (higher growth will attract competition).
Sustainable growth rate is more realistic assumption.
To determine MDDM;
Duration & size of high growth period should be projected.
Estimates of high growth period dividends & constant growth rate.
భ మ ೙ ೙
= + + ⋯ + +
( ೐ ) ( ೐ )మ ( ೐ )೙ ( ೐ )೙
where
೙

=
೐ ೎
50.f
GGM is appropriate for stable, mature & dividend-

paying firms with single growth rate.
MDDM can be two or three stages (growth, transition &
mature).
For non-dividend paying firms estimating future
dividend payments are speculative so FCFE is
appropriate.

Page 3
50.g
DDM is very sensitive to inputs so price multiple approach (comparison

of stock price multiple to a benchmark value) is used by many analysts.
PMs are used in time series & cross sectional comparisons.
Critique ⇒ reflect only the past (often historical data is used).
Multiples based on comparables ⇒ compare multiple of the firm with
other firms based on MP.
Multiples based on fundamentals ⇒ what a multiple should be based on
some valuation models.
50.h Price Multiples
P/E Ratio P/S Ratio

#

ℎ
Widely used by analysts.
P/B Ratio P/CF Ratio
#

$ % & ℎ
CF is CFO or free cash flow.
Multiples can be industry specific (e.g. cable industry

market cap is compared to number of subscribers).
Multiples
Fundamental Based Comparable Based
P భ!
భ Compare multiple with benchmarks (historical avg, stocks & industry avg.) &
Justified leading 'E = (it is justified because we assume that inputs
"# determine its valuation.
are correct & leading because it is based on next period expected earnings). Law of one price⇒ two identical assets should sell at same price.
P
This 'E serves as a benchmark at which stock should trade. Not applicable if firms are of different size, in different industries etc.

Very sensitive to inputs, (several sets of inputs for a range of justified P/E). P/S ratio is favored over P/E for cyclical firms (sales are less volatile).
D
Dividend payout 'E , g, k cause P/E.

Dividend displacement of earnings ⇒ dividend, growth so firm’s value
impact is ambiguous.
50.i
EV ⇒ total company value ⇒ cost to acquire the firm

EV = MV of common stock + MV of debt – cash & short term investments.
Acquirer’s cost for a firm is decreased by amount of target’s liquid assets (cash &
investments).
EV is appropriate for firms with different capital structure.
EBITDA is normally used as denominator of EV multiple (usually a positive number as
compared to NI & show both equity & debt owner’s earnings).
Disadvantage of EBITDA ⇒ non-cash revenue & expense.
If MV of debt is not available than comparable’s MV of debt or BV is used

Page 4
50.j Asset-Based Valuation Models
Equity value = MV or FV of assets – MV or FV of liabilities.

Problematic if large amount of intangible assets.
More reliable when short term tangible assets, assets with ready MV or
when firm is liquidating.
Often used to value private companies but increasingly useful for public
companies (FV reporting on BS).
50.k DCF Models
Advantages Disadvantages
Strong base in finance theory (concept of Inputs must be estimated.

discounted PV). Value estimates are very sensitive to
Widely accepted in analyst community. inputs.
Comparable Based Valuation
Useful for predicting stock returns. Not comparable across firms with different size, products &
Readily available & widely used by analysts. growth.
Can be used in time series & cross sectional. Lagging price multiples reflect the past.
EV/EBITDA is useful when comparing a firm’s value Cyclical firms greatly affected by eco conditions.
independent of capital structure, or when earnings are Stock may appear overvalued by comparables but undervalued
negative. by fundamental method & vice versa.
Different accounting methods distort comparability.
Negative denominator results in meaningless ratio.
Fundamental Based Valuation
Advantages Disadvantage
Based on theoretically sound valuation models. Very sensitive to inputs

Correspond to widely accepted value metrics.
Asset-Based Models
Provide floor values. MVs are difficult to obtain & usually different than BV.
Reliable when short-term tangible assets, readily Inaccurate when higher proportion of intangible assets.
measurable MV assets & in liquidation. Assets can be difficult to value during hyperinflation.
Increasingly useful to value public firms that are reported
at FV.

Page 1
“FIXED-INCOME SECURITIES: DEFINING ELEMENTS”

FI = Fixed Income
CFs = Cash Flows 1. INTRODUCTION
FI security ⇒ an instrument that allow governments, companies &

other types of issuers to borrow money from investors.
Adding FI securities to portfolio adds diversification benefits.
2. OVERVIEW OF A FIXED-INCOME SECURITY
Three important elements of bond investing:

The bonds features
Legal, regulatory & tax consideration.
Contingency provisions.
2.1 Basic Features of a Bond
2.1.1 Issuer 2.1.2 Maturity
Major types of bond issuer include: Maturity date ⇒ date when the issuer is
Supranational organizations e.g. World Bank. obligated to redeem the bond by paying
Sovereign governments e.g. UK, USA. the outstanding principal.
Non-sovereign governments. Tenor ⇒ time remaining until maturity
Quasi-govt. entities. date.
Corporate issuers. Money market securities ⇒ maturities at
Credit risk ⇒ risk of loss resulting from the issuer issuance of one year or less.
failing to make full & timely payment of Capital market securities ⇒ FI securities
interest/principal. with maturity > 1 year.
2.1.3 Par Value 2.1.4 Coupon Rate and Frequency
Principal or par value amount that the issuer Coupon/nominal rate ⇒ interest rate that
agrees to repay the bondholder on maturity date the issuer agrees to pay every year until
maturity.
Plain vanilla bond ⇒ fixed rate bond.
Floaters ⇒ bonds with floating rate
2.1.5 Currency Denomination coupon.
Zero coupon bonds ⇒ issued at discount
Dual currency bonds ⇒ pay interest in one to par & redeemed at par.
currency & principal in another currency.
Currency option bonds ⇒ single currency
bond+ foreign currency option.
2.2 Yield Measures
ᇲ

=
ᇲ

Yield to maturity (YTM) ⇒ internal rate of return on a
bond’s expected cash flows.
Lower IR scenario anticipation, lower YTM demand.

Page 2
3. LEGAL, REGULATORY, AND TAX CONSIDERATIONS
3.1 Bond Indenture 3.2 Legal and Regulatory
Trust deed (indenture) ⇒ legal contract that describe: FI securities are subject to legal & regulatory
Bond form requirements.
Issuer’s obligations. National bond market ⇒ bonds that are issued &
Bondholder’s rights. traded in a specific county.
Collateral ⇒ assets or financial guarantees above & Euro bonds ⇒ bond issued & traded on euro bond
beyond the issuer’s promise to pay. market.
Credit enhancements ⇒ provisions to reduce the Bearer bonds ⇒ trustee does not keep
credit risk of the bond issue. records of bond’s ownership.
Covenants ⇒ clauses that define bond-holder’s rights Registered bonds ⇒ ownership is recorded by
and an issuer’s actions. either name or serial number.
3.1.1 Legal Identity of the Bond Issuer and its Legal Form
3.1.3 Asset or Collateral Backing
Bond issuer is legally obliged to make contractual

payments. 3.1.3.1 Seniority Ranking
Secured bonds ⇒ backed by assets or financial

3.1.2 Source of Repayment Proceeds guarantees pledged to ensure debt repayment in
case of default.
Unsecured bonds ⇒no collateral bond.
Supranational organization ⇒ either the
Debentures ⇒ types of bond that can be
repayment of previous loans or the paid-in-capital
unsecured.
from its members.
Sovereign bonds ⇒ tax revenue & print money is
the major source of repayment. 3.1.3.2 Types of Collateral Backing
Non-sovereign govt. debt:
Tax
Collateral trust bonds ⇒ secured by securities
Cash flow of project (financed with bond
such as shares other bonds or financial assets.
issue).
Equipment trust certificates ⇒ bonds secured by
Special tax or fees.
specific types of equipment or physical assets.
Corporate bonds ⇒ issuer’s ability to generate
Mortgage-backed securities ⇒ debt obligations
CFs from operations.
that represent claims to the CFs from pools of
Securitization ⇒ CFs generated by one or more
mortgage loans.
underlying financial assets.
Covered bonds ⇒ debt backed by a segregated
pool of assets called “cover pool”
3.1.4 Credit Enhancement
3.1.5 Covenants
Credit enhancement ⇒ variety of provisions that
can be used to the credit risk of a bond issue.
3.1.4.1 Internal credit enhancement ⇒ Bond covenants ⇒ legally enforceable rules that
subordination ⇒ ordering of claim priorities for borrowers & lenders agree on at the time of a
ownership or interest in an asset. new bond issue.
Junior tranche ⇒ function as credit protection Affirmative covenants ⇒ what issuers are
for senior tranche. required to do (admin nature).
Excess spread ⇒ difference b/w CF received Negative covenants ⇒ what issuers are
from the assets used to secured issue & the prohibited from doing (costly & do materially
interest paid to investors. constrain the issuer’s potential business decision).
3.1.4.2 External credit enhancement. Examples ⇒ restrictions on debt, negative
Surety bond ⇒ issued by a rated & regulated pledges. Restriction on prior claims
insurance company. restrictions on investments etc.
Letter of credit ⇒ provided by a financial
institution.
Less common form.

Page 3
3.3 Tax Considerations
Income portions of a bond investment ⇒ taxed at

ordinary income tax rate.
Capital gain/loss if the price is likely to have changed
compared with the purchase price.
Different tax rate for long term & short term capital
gains in different countries.
4. STRUCTURE OF A BOND'S CASH FLOWS
4.1 Principal Repayment Structures
4.1.1 Bullet, Fully Amortized, and Partially Amortized Bonds 4.1.2 Sinking Fund Arrangements
Bullet bond ⇒ entire principal payment occurs at maturity. Sinking fund ⇒ an issuer’s plan to set aside funds
Amortizing bond ⇒ periodic payments of interest & over time to retire the bond.
repayment of principal. Benefit:
Partially amortized bond ⇒ fixed periodic payments until Formal plan to retire the debt.
maturity & a portion of the principal at maturity date. Disadvantage:
Balloon payment ⇒ payment to retire the bond’s Reinvestment risk
outstanding principal at maturity. Issuer may have option to repurchase bonds
at below market prices.
4.2 Coupon Payment Structures
Coupon ⇒ interest payment that the bond issuer

makes to the bondholder.
Usually coupon is paid semi-annually for sovereign &
corporate bonds.
4.2.1 Floating-Rate Notes 4.2.2 Step-Up Coupon Bonds
Coupon rate is linked to an external reference Fixed or floating coupon which by specified
rate e.g. LIBOR. margins at specified dates.
Quarterly coupons. Provides some protection against rising interest
Typical coupon rate = 3M LIBOR+---BPS (spread). rates.
Variable rate note ⇒ spread is not fixed.
Little interest rate risk.
Additional features may include a floor or cap.
Inverse floater ⇒ inverse relationship to the
reference rate.
4.2.3 Credit-Linked Coupon Bonds 4.2.4 Payment-in-Kind Coupon Bonds
Coupon rate change when bond’s credit rating Coupon is paid in the form of additional amounts
change. of the bonds issue rather than as a cash payment.
Attractive to investors who are concerned about Favored when issuer’s future cash flows will be
the future credit worthiness of the issuer. questionable.

Page 4
4.2 Coupon Payment Structures
4.2.5 Deferred Coupon Bonds 4.2.6 Index-Linked Bonds
These bonds: Coupon &/or principal repayments are linked to a

Paid no coupon for first few years & pays specific index.
higher than normal coupon for the remainder Example ⇒ inflation linked bonds.
of its life. Real interest rate = nominal interest rate –
Common in project financing. inflation.
Priced at significant discount to par. Equity-linked note ⇒ final payment is based on
the return of an equity index.
5. BONDS WITH CONTINGENCY PROVISIONS
Contingency provision ⇒ clause in legal document that allows for some

action if the event does occur.
Embedded option ⇒ various contingency provisions found in the indenture.
5.1 Callable Bonds
Callable bond ⇒ gives the issuer the right to redeem all or part of the bond before maturity date.
Provide protection to issuer in declining interest rate environment.
The yield & price compensate the bondholders for the value of the call option to the issuer.
Bermuda-style call ⇒ issuer has the right to call bonds on specified dates following the call protection period.
5.2 Putable Bonds
Put provisions ⇒ provide right to the bondholder to sell the bond back to the issuer at a pre-
determined price on specified dates.
Pre-specified selling price of put able bond provide benefit to bond holder.
Lower yield on these bonds compensate the issuer for the value of the put option to the
investor.
5.3 Convertible Bonds
Convertible bond ⇒ hybrid security with both debt & equity features (bond holder has a right to
exchange the bond for specified number of shares in issuing company).
Convertible bond may further include call provision.
Advantages for investor:
Investor can participate in equity upside.
Investor receives downside protection.
Price of convertible bond cannot fall below the price of the straight bond.
Price of a convertible bond is than the price of the bond without this provision.
Conversion price ⇒ price per share at which the convertible bond can be converted into shares.
Conversion ratio ⇒ number of common shares that each bond can be converted into.
Conversion value ⇒ current share price × conversion ratio.

Page 1
“FIXED-INCOME MARKETS: ISSUANCE, TRADING, AND FUNDING”
2. OVERVIEW OF GLOBAL FIXED-INCOME MARKETS
2.1 Classification of Fixed-Income Markets
2.1.1 Classification by Type of Issuer 2.1.2 Classification by Credit Quality
This classification include: Credit risk ⇒ risk of loss resulting from the issuer
Govt & govt related sectors failing to make full & timely payments of interest
Corporate sector &/or principal.
Structured finance sector Investment grade bonds ⇒ bonds with credit
rating of “BBB” or above by S&P & Fitch.
Junk bonds ⇒ bonds with ratings below “BBB”.
2.1.3 Classification by Maturity 2.1.4 Classification by Currency Denomination
Bonds can also be classified by the original maturity of Currency denomination of the bonds’ cash flows
the bonds when they are issued. influences which country’s interest rate affect
Money market securities ⇒ maturity range form bond price.
overnight to 1 year.
Capital market securities ⇒ maturity > 1 year
2.1.5 Classification by Type of Coupon 2.1.6 Classification by Geography
These include: These include domestic, foreign & euro bond.

Fixed coupon bonds. Domestic bonds⇒ issued & sold in a specific country
Floating rate bonds. denominated in its local currency & issued by a local issuer.
Euro bonds ⇒ issued internationally.
2.1.7 Other Classifications of Fixed-Income Markets
These include:
Inflation-linked bonds.
Municipal bonds etc.
2.2 Fixed-Income Indices
Fixed-income index ⇒ a multi-purpose tool used by investors &

investment managers to describe a given bond market or sector
& to evaluate investment managers’ performance.
Index construction (security selection & index weighting) varies
among indices.
2.2 Investors in Fixed-Income Securities
Major categories of bond investors include:

Central bank
Institutional investors.
Retail investors.

Page 2
3. PRIMARY AND SECONDARY BOND MARKETS
Primary bond markets ⇒ markets in which issuers first sell bonds to

investor to raise capital.
Secondary bond markets ⇒ markets in which existing bonds are
subsequently traded among investors.
3.1 Primary Bond Markets
3.1.1 Public Offerings
Any member of the public can buy

the bonds under this offering.
3.1.1.1 Underwritten Offerings 3.1.1.2 Shelf Registration
Under this arrangement, investment bank guarantees the It allows certain authorized issuers to offer additional
sale of bond issue at an offering price that is negotiated bonds to public without having to prepare a new &
with the issuer. separate offering circular for each bond issue.
Phases of underwriting process. Lower level of scrutiny compared with standard public
Determination of underwriting needs. offering.
Underwriter selection.
Defining transaction structure.
3.1.1.3 Auctions
Assessing market conditions & bond pricing.
To determine demand of the issue.
Issuing phase. Auction involves bidding.
Helpful in providing price discovery.
Primary dealer’s ⇒ financial institutions that are
authorize to deal in new issue.
3.1.2 Private Placements
A non-underwritten, unregistered offering of bonds that

are sold only to an investor or a small group of investors.
Typically involves institutional investors.
3.2 Secondary Bond Markets
Secondary Markets Structure
Organized Exchange Over-The-Counter (OTC) Markets
Place where buyers & sellers can Buy & sell order initiated from
meet to arrange their trades. various locations are matched
through a communication network.
Bid-ask spread ⇒ difference b/w prices at which dealer

will buy from a customer (bid) & sell to a customer (ask).
Settlement ⇒ process that occurs after the trade is made.

Page 3
4. SOVEREIGN BONDS
4.1 Characteristics of Sovereigns Bonds
Sovereign bonds have different names in different countries.

Bond names may also vary depending on the bond maturity.
On-the-run issue ⇒ securities that were most recently issued.
4.2 Credit Quality of Sovereign Bonds
Usually not backed by collateral.

Budget surplus ⇒ excess revenue is used to make interest &
principal payments.
Budget deficit ⇒ new debt to roll over existing debt.
4.3 Types of Sovereign Bonds
4.3.1 Fixed-Rate Bonds 4.3.2 Floating-Rate Bonds
Most common type of sovereign bonds. Bonds whose interest payments are linked with
These include: some reference rate.
Zero coupon bonds. Lower interest rate risk than a simple fixed
Coupon paying bonds. coupon bond.
4.3.3 Inflation-Linked Bonds
Bonds whose interest payments are linked with

some reference rate.
Lower interest rate risk than a simple fixed
coupon bond.
5. NON-SOVEREIGN GOVERNMENT, QUASI-GOVERNMENT, AND SUPRANATIONAL BONDS
5.1 Non-Sovereign Bonds
Issued by provinces, regions, states & cities.

These bonds are usually issued to finance public projects.
Tax is the main source of interest & principal repayment.
5.2 Quasi-Government Bonds
Quasi-government entities ⇒ organizations having public & private

sector characteristics but not actual govt entities.
Bonds are repaid from cash flows generated by the entity or from the
project bond issue is financing.
5.3 Supranational Bonds
Bonds issued by multilateral agencies (e.g. IME, WB).

Typically plain vanilla bonds with large size issues.

Page 4
6. CORPORATE DEBT
6.1 Bank Loans and Syndicated Loans
Bilateral loans ⇒ loan from a single lender to a single borrower.

Syndicated loans ⇒ loans from a group of lenders to a single borrower.
These loans are usually at floating rate & interest rate is based on a
reference rate plus a spread.
6.2 Commercial Paper
Commercial paper (CP)⇒ short-term, unsecured promissory note issued in

the public market that represents a debt-obligation of the issuer.
CP is a flexible, readily available & low cost source of short term financing.
Investors in CP are exposed to various level of credit risk depending on the
issuer’s creditworthiness.
“Rolling over the paper” (new issuance of CP to pay the existing one) is a
common practice.
Short-dated maturity, credit risk & no. of issuers ⇒ feature of
attractive CP.
6.3 Corporate Notes and Bonds
No universally accepted taxonomy as to what constitute short, medium &

long term maturities usually:
Short term ⇒ < 5 years.
Medium term ⇒ > 5 year but < 12 year.
Long term ⇒ > 12 years.
Serial maturity structure ⇒ maturity dates are spread out during the bond’s
life.
Term maturity structure ⇒ notional principal is paid off in lump sum at
maturity (more risk than serial maturity).
Seniority ranking is an important consideration for investors.
7. SHORT-TERM FUNDING ALTERNATIVES AVAILABLE TO BANKS
7.1 Retail Deposits
Primary source of funding for deposit taking banks.

Two main types include demand deposits & saving
accounts.
7.2 Short-Term Wholesale Funds
These funds include central bank funds, interbank funds & certificates of
deposit.
Central bank funds market ⇒ allows banks that have a surplus of funds to loan
money to banks that need funds (maturity up to one year).
Central bank funds rates ⇒ interest rates at which central bank funds are
bought or sold.

Page 5
7.3 Repurchase and Reverse Repurchase Agreements
Repurchase agreement ⇒ sale of a security with a simultaneous agreement by

the seller to buy the same security back at an agreed-on price & future date.
Several factors can affect the repo rate including:
Risk associated with collateral.
Repo term.
Delivery requirement for the collateral.
Supply & demand conditions of the collateral.
Alternative financing rate.
Reverse repurchase agreement ⇒ when repo agreement is viewed through the
lens of the cash lending counterparty, it is called reverse repo.
Credit risk is present in repo agreement for both parties.

Page 1
“INTRODUCTION TO FIXED-INCOME VALUATION”

MMI = Money Market Instruments
1. INTRODUCTION
2. BOND PRICES AND THE TIME VALUE OF MONEY
2.1 Bond Pricing with a Market Discount Rate
Bond price ⇒ PV of the promised future cash flows.

Market rate or required yield ⇒ rate of return required by investors
given the risk of investment in bonds.
Bond is described as trading at discount (premium) if price is < (>) par
value.
When the coupon rate is > (<) market rate, bond is trading at premium
(discount).
If coupon rate = market discount rate ⇒ bond is priced at par.
2.2 Yield-to-Maturity
YTM ⇒ internal rate of return that makes present value of future cash
flow equal to market price.
Assumptions regarding YTM.
Investor holds the bond to maturity.
Issuer does not default on any of the payments.
Reinvestment of coupon payments on same rate.
2.3 Relationships between the Bond Price and Bond Characteristics
Inverse relationship b/w bond price & market rate.

Convexity effect ⇒ when market discount rate goes down, % price ∆ is
greater than when the same goes up (given same maturity & coupon
rate).
Coupon effect ⇒ lower coupon bond has % price ∆ than a
coupon bond when market rate ∆ (given same time to maturity).
Maturity effect⇒ longer term bond has a greater % price ∆ than a
shorter term bond when market rate ∆ (given same coupon).
3. PRICES AND YIELDS: CONVENTIONS FOR QUOTES AND CALCULATIONS
3.1 Flat Price, Accrued Interest, and the Full Price
Full or dirty price ⇒ sum of the parts price.

Flat price ⇒ full price – accrued interest (usually quoted by dealers).
Settlement date ⇒ date on which the bond buyer makes cash
payment & the seller delivers the security.
Day-count conventions vary from market to market.

Page 2
3.2 Matrix Pricing
Matrix pricing ⇒ mechanism used to calculate market discount rate &

prices of thinly traded bonds.
Features of frequently traded comparable bonds are used in matrix
pricing (e.g. time-to- maturity, coupon rates & credit quality).
Matrix pricing is also used in underwriting new bonds to get an
estimate of the required yield spread over benchmark.
Benchmark rate ⇒ YTM on a Govt. bond having same maturity.
Term structure of credit spreads ⇒ relationship b/w the spreads over
the risk fee rates & time to maturity.
3.3 Yield Measures for Fixed-Rate Bonds
Effective annual rate ⇒ rate with just one compounding period in the year.
Semiannual bond basis yield ⇒ annual rate having a periodicity (no. of
periods) of two or yield per semiannual period times two.
Street convention ⇒ yield measures that neglect weekends & holidays.
Current yield ⇒ sum of the coupon payments received over the year divided
by the flat price.
Bonds with embedded option:
Yield-to-worst (YTW) ⇒ the lowest of the sequence of yield-to-call &
YTM is called YTW.
Option-adjusted-yield ⇒ required market rate whereby price is adjusted
for the value of the embedded option.
3.4 Yield Measures for Floating-Rate Notes
Interest payments on a floater are not fixed.

Relatively immune to interest rate risk.
Interest rate = reference rate + quoted margin.
Quoted margin compensate the investor for the difference in the
issuer’s credit risk.
Valuation of a FRN needs a pricing model.
3.5 Yield Measures for Money Market Instruments
Differences in yield measures of money market & bond market

include:
Rate of return on MMI is stated on a simple interest basis & not
compounded as the case with bond YTM.
Standard time-value-of –money analysis can not be used in MMI.
MMI have no common periodicity for all time-to-maturity.
Pricing formula for MMI quoted on discount rate basis.
= × 1 − ×

= ×

Pricing formula for MMI quoted on an add-on-rate.
=

ವೌ೤ೞ
ೊ೐ೌೝ ×
=
×


Page 3
4. THE MATURITY STRUCTURE OF INTEREST RATES
Analysis of Term structure ⇒ involves the analysis of yield curve (relationship b/w YTM & time-
to-maturity).
Maturity structure should be analyzed for bonds that have the same properties except time-
to-maturity.
Spot curve is ideal data set for a series of zero coupon govt. bonds.
Par curve ⇒ sequence of YTM such that each bond is priced at par value.
Forward market ⇒ market for future delivery.
Forward rate ⇒ interest rate on a bond or MMI traded in a forward market.
Implied forward rate (forward yields) ⇒ breakeven reinvestment rate calculated from spot rates.
Forward curve ⇒series of forward rates each having the same time frame.
Forward curve implication:
Forward rates are used to make maturity choice decisions.
They are used to identify arbitrage opportunities.
Important in derivative valuation.
Forward & spot rates are interconnected (used to value a fixed income security in the same
manner).
5. YIELD SPREADS
5.1 Yield Spreads over Benchmark Rates
Components of YTM.
Benchmark yield (often a govt. bond yield).
Spread (difference b/w YTM & benchmark).
Benchmark captures macroeconomics factor (e.g. inflation business cycle etc.) while spread capture
microeconomic factors (credit quality & liquidity etc.).
Spread Risk Premium Taxation
Liquidity
Credit Risk
Benchmark “Risk-Free" Rate of Expected Inflation

Rate
Return
Expected Real
Rate
Reference: Level I Curriculum, Volume 5, Reading 53.
Benchmark spread is usually measured in basis points.

G spread ⇒ yield spread in basis points over a govt. bond.
I spread ⇒ yield spread of a bond over the standard swap rate in that currency of the same tenor.
5.2 Yield Spreads over the Benchmark Yield Curve
Z-spread ⇒ constant spread that is added to each spot rate such that
the present value of cash flows matches the price of the bond.
Option adjusted spread (callable bond) ⇒ z spread – call option value.

Page 1
“INTRODUCTION TO ASSET-BACKED SECURITIES”
1. Introduction
Securitization ⇒ process that involves moving assets from the owner of the
assets into a special legal entity.
Asset-backed securities ⇒ that are backed by a pool of assets (loans &
receivables).
Securitized assets ⇒ assets that are used to create asset backed bonds.
Mortgage-backed security ⇒ securities backed by high quality real estate
mortgage.
2. Benefits of Securitization for Economies and Financial Markets
Securitization involves disintermediation (lessening the role of intermediates)

which in turn lowers the cost of borrowing & ↑ the risk adjusted return.
Securitization allows banks to increase the amount of funds available to lend.
Securitization originates tradable securities with better liquidity than with
typical bank loans.
Securitization enables innovations in investment products.
3. The Securitization Process
3.1 An Example of a Securitization Transaction
Seller of loans / mortgages or depositor ⇒ Issuer or trust (SPV) Securities ⇒ Investor
3.2 Parties and Their Role to a Securitization Transaction
Seller or collateral (originator or depositor).

Special purpose vehicle (SPV) or issuer or trust.
Servicer
Other parties e.g. accountants lawyer, rating agencies etc.
3.3 Bonds Issued
Prepayment risk ⇒ uncertainty that the cash flows will be different from the
scheduled cash flows as set forth in the loan agreement due to borrower’s ability to
alter payments (interest rate movement).
Time tranching ⇒ creation of bond classes.
Subordination ⇒ structure with more than one bond classes & they differ in loss
sharing resulting from borrowers default.
Credit tranching ⇒ set of bond classes to allow investors to choose the amount of
credit risk that they prefer to bear.

Page 2
3.4 Key Role of the Special Purpose Vehicle
SPV plays a pivotal role in the securitization process.

SPV protects the rights of creditors.
Absolute priority rule ⇒ principle that senior creditors are paid in full before
subordinated creditors are paid anything.
In most jurisdictions, the courts have no discretion to change seniority because
the bankruptcy of a company does not affect the SPV.
4. Residential Mortgage Loans
Mortgage loan ⇒ loan secured by the collateral of some specified real estate
property.
Foreclosure ⇒ it allows the lender to take possession of the mortgaged
property & then sells in order to recover funds.

Loan-to-value ratio (LTV) =

↑ The LTV, ↓ the borrower’s equity & vice versa.
↑ The equity, ↓ the changes of borrower’s default.
4.1 Maturity
Maturity varies from country to country ranging from 15Y to 50Y.
4.2 Interest Rate Determination
Fixed rate ⇒ mortgage rate remains the same during the life of the mortgage.
Variable or adjustable rate ⇒ mortgage rate is reset periodically based on some
reference rate or index.
Initial period fixed rate ⇒ mortgage rate is fixed for some initial period & is then
adjusted.
Convertible ⇒ initially, the rate is fixed or adjustable & at some point the
borrower has the option to convert the mortgage into a fixed or adjustable rate.
4.3 Amortization Schedule
Loan amortization ⇒ gradual reduction of the amount borrowed over time.

The last payment is said to be a “balloon” payment, which consists on the
unpaid mortgage balance.
Interest only mortgage ⇒ no scheduled principal repayment is specified for a
certain number of years.
4.4 Prepayments and Prepayment Penalties
Prepayment ⇒ payment that is in excess of the scheduled principal

repayment.
Prepayment option ⇒ option with the borrower to prepay all or part of the
outstanding mortgage principal prior to the scheduled due date.
Prepayment penalty mortgages ⇒ mortgages that stipulate some sort of
mortgage penalty to compensate the lender for difference of interest rate.

Page 3
4.5 Rights of the Lender in a Foreclosure
Recourse loan ⇒ the lender has a claim against the borrower for the shortfall
b/w outstanding loan balance & cash received from the sale of property.
Non-recourse loan ⇒ lender does not have such claim.
This feature has implications for projecting the likelihood of defaults by
borrower.
5. Residential Mortgage-Backed Securities
Residential mortgage backed securities (RMBS) ⇒ bonds created from the

securitization of mortgage loans for the purchase of residential properties.
Sectors of RMBS.
Agency RMBS (issued by Ginnie Mae, Fannie Mae & Freddie Mac
Non-agency RMBS
5.1 Mortgage Pass-Through Securities
Mortgage pass-through securities (MPS) ⇒ a security created when one or

more holders of mortgages form a pool of mortgages & sell shares in the pool.
5.1.1 Cash Flow Characteristics
Cash flows (CFs) of MPS depend on the CFs of the underlying pool of mortgages.
CFs represents interest, principal & prepayments.
Monthly CFs of MPS is less than the monthly CFs of the underlying pool of
mortgages (due to servicing & other fees).
Servicing fee is typically a portion of mortgage rate.
Weighted avg. coupon rate & weighted average rate are determined for each
MPS.
5.1.2 Conforming and Non-Conforming Loans
Conforming mortgages ⇒ a mortgage that satisfy the underwriting standards

for inclusion as collateral for RMBS e.g. loan size, loan to value ratio etc.
Non-conforming mortgages ⇒ these are used as collateral for MPS that are
privately issued (non-agency MPS).
5.1.3 Measures of Prepayment Rate
Two key prepayment rate measures.

Single monthly mortality (SMM).
Conditional prepayment rate (CPR).
SMM = prepayment for month ÷ (Beg. Mortgage balance for month – scheduled
principal repayment).
CPR is annualized SMM.
Prepayment model is used to forecast future prepayment rate.
5.1.4 Cash Flow Construction
Example

Page 4
5.1.5 Weighted Average Life
Legal maturity of MBS ⇒ date when the last scheduled principal

payment is due.
Weighted avg. maturity is widely used by market participants for MBS.
Avg. life of MPS depends on prepayment assumption.
5.1.6 Contraction Risk and Extension Risk
Future CFs of MPS depend on actual prepayments & hence not

predictable.
Components of prepayment risk:
Contraction risk ⇒ risk of shorter than expected maturity when IR
is lower & refinancing is available at lower rate.
Extension risk ⇒ longer than anticipated maturity on the back of
IR rise (home owner will enjoy existing lower rates).
5.2 Collateralized Mortgage Obligations
Collateralized mortgage obligation (CMO) ⇒ securities arising from

redistribution of CFs of mortgage – related products.
CMO distribute prepayment risk among various classes of bondholders.
5.2.1 Sequential-Pay Tranches
Sequential-pay CMOs ⇒ each class of bond would be retired

sequentially.
The principal amount will depend on the CF of the collaterall, which
depends on actual prepayments.
5.2.2 Planned Amortization Class Tranches
Planned amortization class (PAC) ⇒ common structure in CMOs ⇒ it

provide greater predictability of the CFs.
PAC tranche have priority over all other tranches in receiving principal
repayments.
CFs certainty to PAC tranche comes at the expense of support tranche.
5.2.3 Support Tranches
Support tranche reduces the extension risk of the PAC tranches by not
receiving the principal until the PAC tranche receive their scheduled
principal repayment.
Support tranches absorb any principal repayment in excess of scheduled
principal repayments to reduce contraction risk of PAC tranches.
5.2.4 Floating-Rate Tranches
Floating rate tranche can be created even though collateral pays a fixed
rate.
Floating rate tranche can be constructed through a floater & inverse
floater combination.

Page 5
5.3 Non-agency Residential Mortgage-Backed Securities
RMBS issued by any entity other than Ginnie Mae, Fannie Mae &
Freddie Mae.
Credit risk – important consideration.
Prime (subprime) loans ⇒ high (low) credit quality of the borrower.
Two important components when forecasting the future CFs.
Assumed default rate.
Recovery rate.
5.3.1 Internal Credit Enhancements
Senior / Subordinated Structure Overcollateralization
Subordinated bond class provides credit A situation in which the value of the collateral
support to senior class. exceeds the amount of the par of the
Credit protection level is set at the time of outstanding bond classes issued by SPV.
issuance.
Shifting interest mechanism ⇒ no payment to
subordinated bonds for a period of time if
credit enhancement for senior tranche
deteriorates.
Overcollateralization
Two forms
Cash reserve fund.
Excess spread amount
Cash reserve fund ⇒ a deposit of cash provided to the SPV from the proceeds of the sale of the loans pool by
the entity seeking to raise funds.
Excess spread account ⇒ it involves the allocation into an account of any amounts resulting from monthly
funds remaining after paying out the interest to the bond classes as well as servicing & other fees.
5.3.2 External Credit Enhancements
Financial guarantee by a third party to the transaction

e.g. mono line insurance companies.
6. Commercial Mortgage-Backed Securities
Commercial mortgage-backed securities (CMBS) ⇒ backed by pool

of commercial mortgage loans on income-producing properties.
6.1 Credit Risk
Each property must be viewed individually to assess credit risk.

Indicators of credit performance:
Loan-to-value ratio
Debt-to-service coverage

( )
Debt-to-service coverage =

The higher the better it is.

Page 6
6.2 Basic CMBS Structure
6.2.1 Call Protection
Call protection comes either at:

Structure level.
Loan level
Structural call protection ⇒ CMBS are structured to have sequential-pay tranches, by
credit rating.
Loan level protection ⇒ four mechanisms:
Prepayment lockouts ⇒ prohibition of prepayments during a specified period
of time.
Prepayment penalty ⇒ predetermined penalties that a borrower who wants
to refinance must pay to do so.
Yield maintenance charge ⇒ penalties paid by the borrower that makes
refinancing solely to get a lower mortgage rate uneconomical for the
borrower.
Defeasance ⇒ the borrower provides sufficient funds for the servicer to
invest in a portfolio of govt. securities that replicates the CFs that would exist
in the absence of prepayments.
6.2.2 Balloon Maturity Provisions
Many commercial loans are balloon loans that require substantial principal repayment
at maturity of the loan.
Balloon risk ⇒ risk that the borrower will not be able to make the balloon payment (a
type of extension risk).
7. Non-Mortgage Asset-Backed Securities
7.1 Auto Loan Receivable-Backed Securities
Deals backed by auto loan & lease receivables.

CFs of auto-loan-backed securities ⇒ interest + principal repayments + prepayments.
Credit enhancement through senior/subordinate structure, overcollateralization etc.
7.2 Credit Card Receivable-Backed Securities
Credit card receivables are used as collateral for the issuance of credit receivable
backed securities.
CF consist ⇒ financial charges, fees & principal repayment.
Interest rate may be fixed or floating & is paid periodically to security holders.
Credit card receivable-backed securities are non-amortizing loans & have lockout
periods.
Rapid amortization ⇒ early amortization provisions.

Page 7
8. Collateralized Debt Obligations
Collateralized debt obligation (CDO) ⇒ generic term used to describe a security

backed by a diversified pool of one or more debt obligations.
8.1 Structure of a CDO Transaction
Funds to purchase the collateral assets for CDO are obtained from the issuance
of debt obligations.
Debt obligations comprises, senior, mezzanine & subordinated bond classes.
Yield on senior & mezzanine classes is typically higher than comparable
corporate bond.
Equity class investors have the potential to earn equity-like returns.
Basic economics ⇒ fund raising through sale of bond classes ⇒ investment of
the funds ⇒ effort to generate higher return than cost of the bond classes ⇒
excess return is paid not to equity holders & CDO manager.
Classes of CDO bonds are structured to provide a specific level of risk of
investors.

Page 1
“UNDERSTANDING FIXED-INCOME RISK AND RETURN”

MD = Modified Duration
ED= Effective Duration
2. SOURCES OF RETURN
Fixed-rate bond investor has three sources of return:

Coupon & principal payments on the schedule dates.
Coupon reinvestment income.
Potential gain or loss on bond sale prior to maturity.
Bond purchased at premium / discount adds another aspect to the rate
of return.
Carrying value ⇒ purchase price + (-) amortized amount of discount
(premium).
Coupon income is the return associated with the “passage of time”
while capital gain/loss is linked with “change in value”.
3. INTEREST RATE RISK ON FIXED-RATE BONDS
3.1 Macaulay, Modified, and Approximate Duration
Bond duration ⇒ measures the sensitivity of the bond’s full price to changes in the bond’s YTM (other
variables remain constant).
Main types of bond duration:
Yield duration.
Curve duration.
Yield duration ⇒ sensitivity of bond’s price to bond’s own YTM. (Include Macaulay, modified, money & price
value of basis point duration).
Curve duration ⇒ sensitivity of the bond price with respect to benchmark yield curve (usually govt. yield
curve).
Curve duration static often used is effective duration.
Macaulay duration ⇒ weighted average of the time to receipt of the bond’s promised payments.
Weights are the share of the full price that corresponds to each of the bond’s promised future payments.

Modified duration = where r = yield per period.

It provides an estimate of the % price ∆ for a bond given a change in its YTM.
% ∆ ≈ −
× ∆ .
MD provides a linear estimate of the % price∆.
- -శ
Approx Mod Dur =
× ∆ × బ
3.2 Effective Duration
Effective duration (ED) ⇒ sensitivity of the bond’s price to a change in benchmark yield curve.
−

=
2 × ∆ ×
ED is an appropriate duration measure for bonds with embedded options & mortgage backed
securities.
3.3 Key Rate Duration
Measure of a bond sensitivity to the change in a benchmark yield curve at a specific maturity
segment.
It helps shaping risk for a bond.

Page 2
3.4 Properties of Bond Duration
Macaulay & MD depends on the day-count basis used to obtain the YTM.
Longer time-to-maturity ⇒ higher Macaulay duration.
YTM & coupon rate are inversely related to Macaulay duration.
If a bond is priced at a discount, a longer time to maturity might lead to a lower duration.
Embedded option (call or put) the ED of the bond.
3.5 Duration of a Bond Portfolio
Two ways to calculate duration of a bond portfolio:

The weighted average of time to receipt of aggregate cash flows.
The weighted average 3.5ofDuration
the individual bondPortfolio
of a Bond duration that comprise the portfolio.
First method is theoretically correct but difficult to use.
Advantage of 2nd approach ⇒ can easily used as measure of interest rate risk.
Two ways to calculate
Limitation duration
⇒ this of a assumes
measure bond portfolio:
parallel shift in the yield curve (rarely occurred).
The weighted average of time to receipt of aggregate cash flows.
The weighted average of the individual bond duration that comprise the portfolio.
First method is theoretically correct but difficult to use.
3.6 Money Duration of a Bond and the Price Value of a Basis Point
Advantage of 2nd approach ⇒ can easily used as measure of interest rate risk.
Limitation ⇒ this measure assumes parallel shift in the yield curve (rarely occurred).
Money duration ⇒ measure of the price change in units of the currency in which the bond
is denominated.
the Price Value of a Basis Point

=

3.6 Money ×
Duration of a Bond and
Price value of a basis point (PVBP) ⇒an estimate of the ∆ in the full price give 1bp ∆ in
YTM.
Money duration ⇒ measure
-శ
of the price change in units of the currency in which the bond
PVBP = -
is denominated.

=
×
Price value of a basis point (PVBP) ⇒an estimate of the ∆ in the full price give 1bp ∆ in
3.7 Bond Convexity
YTM.
-శ
PVBP = -

Duration estimates the ∆ in the bond price along the straight line while true relationship
b/w bond price & YTM is curved.
3.7 Bond
Convexity statistic is used to improve Convexity
the estimate.
% ∆ PV ≈ -Ann Mod Dur × ∆ Yield + 12 × Ann Convexity × ∆ Yield
- శ - ×బ!
ApproxCon = ∆"మ × బ
#- శ $- ×బ!
Effective convexity = ∆%మ × బ
Convexity Adjustment
Callable bond have -ve convexity.

Page 3
4. INTEREST RATE RISK AND THE INVESTMENT HORIZON
4.1 Yield Volatility
Term structure of yield volatility ⇒ relationship b/w the volatility of bond’s YTM & time-to-
maturity.
The importance of yield volatility in measuring interest rate risk is that bond price changes
are product of two factors:
Impact of per basis point ∆ in YTM.
Number of basis points in YTM change.
4.2 Investment Horizon, Macaulay Duration, and Interest Rate Risk
Investor faces coupon reinvestment risk as well as market price risk if the bond needs to be
sold prior to maturity.
If:
Investment horizon > Macaulay duration ⇒ reinvestment risk > market price risk.
Investment Horizon = Macaulay duration ⇒ reinvestment risk offsets market price
risk.
Investment horizon < Macaulay duration ⇒ price risk dominates reinvestment risk.
5. CREDIT AND LIQUIDITY RISK
Credit risk ⇒ it involves the probability of default & degree of recovery if default occurs.
Liquidity risk ⇒ transaction costs associated with selling a bond.
∆ In the spread of traditional fixed rate bond can result from ∆ in credit or liquidity risk.

Page 1
“FUNDAMENTALS OF CREDIT ANALYSIS”

MV = Market Value CR = Credit Risk
NOI = Net Operating Income 1. INTRODUCTION Y.S = Yield Spread
TV = Terminal Value GO = General Obligation
RC = Replacement Cost RE = Real Estate
DSCR = Debt Service Coverage REITS = Real Estate Investment
Ratio Trusts
2. CREDIT RISK
Credit risk ⇒ risk of loss resulting from the issuer of debt failing to make full &
timely payments of interest &/or principal.
Components of CR
Default Risk Loss Given Default
Probability that a borrower defaults. Portion of a bond’s value an investor lose.

As an issuer’s default risk rises, investors will Expected loss = default probability × loss
focus more on what the recovery rate might severity given default
be in the event of default.
Spread Risk
Risk that yield spread will widen & bond will underperform.
Factors Affecting Y.S
Credit Migration (Downgrade) Risk Market Liquidity Risk
Risk that a bond issuer’s credit worthiness. Risk that transaction price may differ from
Default risk, yield spreads widen, bond market price.
price. A liquidity premium in addition to credit
premium to compensate the liquidity risk.
Size of the issue & credit quality of the issuer
are main factors that affect market liquidity
risk.
3. CAPITAL STRUCTURE, SENIORITY RANKING, AND RECOVERY RATES
3.1 Capital Structure
Capital structure ⇒ the composition & distribution of a

company’s debt & equity.
Some companies have straightforward while others have
very complex capital structures.

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3.2 Seniority Ranking
Seniority ranking refers to the priority of payments.

Level of seniority can affect the value of an investor’s claim in the event of default
& restructuring.
Unsecured debt ⇒ often referred to as debentures.
Secured debt ⇒ debt-holder has a direct claim.
First mortgage debt ⇒ pledge of a specific property.
First lien debt ⇒ pledge of a certain assets.
Reason for different seniority rankings ⇒ to optimize cost of capital.
3.3 Recovery Rates
Pari-Passu ⇒ equal footing in the right of payment.

Recovery rates can vary widely by industry or depending on when they occur in a
credit cycle.
Recovery rates are average & key components of credit analysis & risk.
4. RATINGS AGENCIES, CREDIT RATINGS, AND THEIR ROLE IN THE DEBT MARKETS
Major credit agencies (Moody’s, S&P, Fitch) play a central role in the credit market.
Some factors that led to the universal use of credit ratings include:
Independent credit risk assessment.
Regulatory & statutory reliance & usage.
Huge growth of debt market & issuer payment for ratings.
Ease of comparison across bond issuers, issues & market segments.
4.1 Credit Ratings
Long-Term Ratings Matrix: Investment Grade vs. Non-Investment Grade

Investment Grade Moody’s S&P Fitch
Aaa AAA AAA
High-Quality
Aa1 AA+ AA+
Grade
Aa2 AA AA
Aa3 AA- AA-
Upper-Medium A1 A+ A+
Grade A2 A A
A3 A- A-
Low-Medium Baa1 BBB+ BBB+
Grade Baa2 BBB BBB
Baa3 BBB- BBB-
Non-Investment Low Grade or Ba1 BB+ BB+

Grade “Junk” or Speculative Ba2 BB BB
“High Yield” Grade Ba3 BB- BB-
B1 B+ B+
B2 B B
B3 B- B-
Caa1 CCC+ CCC+
Caa2 CCC CCC
Caa3 CCC- CCC-
Ca CC CC
C C C
Default C D D
Reference: Level I Curriculum, Volume 5, Reading 56, Exhibit 4.

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4.2 Issuer vs. Issue Ratings
Rating agencies provide both issuer (corporate family) & Issue (corporate credit) rating.
Cross default provisions ⇒ whereby events of default on one bond trigger default on all
outstanding debt.
Structural subordination ⇒ when a corporation with a holding company structure has
debt at both its parent & subsidiaries level.
Notching process ⇒ credit ratings on issues can be moved up or down from the issuer
rating.
The senior unsecured rating, the smaller the notching adjustment will be.
4.3 Risks in Relying on Agency Ratings
Limitations & risks to relying on credit rating agency ratings include:

Credit ratings can be very dynamic.
Rating agencies are not infallible.
Other types of so-called idiosyncratic or event risk are difficult to capture in
ratings.
Ratings tend to lag market pricing of credit.
5. TRADITIONAL CREDIT ANALYSIS: CORPORATE DEBT SECURITIES
Goal of credit analysis ⇒ to assess an issuer’s ability to satisfy its debt obligations.
The main focus in credit analysis is to understand a company’s ability to generate
CF rather than its willingness to pay debts (corporate bond contracts are
enforceable by law).
5.1 Credit Analysis vs. Equity Analysis: Similarities and Differences
The primary objective of management is to maximize shareholders wealth.

Management’s legal duty to its creditors is to meet the terms of governing
contracts.
Equity analysts are interested in the strategies & investments that will a
company’s value & grow its earnings.
Credit analysts will look more at the downside risk.
5.2 The Four Cs of Credit Analysis: A Useful Framework
Capacity Collateral
Ability of the borrower to make its debt Quality & value of the assets supporting the
payments on time issuer’s indebtness.
Covenants Character
Terms & conditions of lending agreements Management quality

that the issuer must comply with.

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5.2.1 Capacity
Industry Structure
Porter’s Framework
Power of Suppliers Power of Customers
Few suppliers, credit risk. Few buyers, credit risk.
Barriers to Entry Substitution Risk
Barriers, risk. Companies with less substitutes represent

less credit risk.
Level of Competition
Competition, credit risk.
Industry Fundamentals
Cyclical or Non-Cyclical Growth Prospects
Cyclical industry ⇒ revenue volatility, Weaker competitors in slow growth

more riskier than non-cyclical industries. industries ⇒ credit worthiness.
Published Industry Statistics
Company Fundamentals
Operating history.
Competitive position.
Management strategy & execution.
Ratio analysis.

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Ratios Analysis
Profitability & Cash Flow Leverage Ratios
Credit analysts focus on EBIT because it is useful Debt/capital ⇒ it shows the % of a company’s
to determine a company’s performance prior to capital base that is financed with debt.
cost arising from its capital structure. Capital = total debt + shareholder’s
Several measures of CF: equity.
EBITDA Debt/EBITDA ⇒ analysts use this ratio to
Funds from operation = N.I + Dep + look at trends over time.
amortization + deferred tax & other non- FFO/debt ⇒ often used by credit rating
cash items. agencies.
Free CF before dividends = N.I + Dep. &
amortization – capex - in non cash
working capital excludes nonrecurring
items.
Free CF after dividends = free CF before
dividends – dividend payments.
Coverage Ratios
EBITDA / Interest Expense EBIT / Interest Expense
The ratio, the better the credit quality is More conservative measure of interest coverage
(does not include dep. & amortization).
5.2.2 Collateral
Asset value analysis is typically emphasized more with weaker credit quality companies.
If default probability rises to a sufficient level, the analysts consider the collateral value in
the context of loss severity.
Value & quality of a company’s assets are difficult to observe directly.
A market-based signal to impute the quality of a public company is equity market
capitalization.
Key point of collateral analysis ⇒ to assess the value of the assets relative to the issuer’s
level & seniority ranking of debt.
5.2.3 Covenants
Covenants are integral to credit agreements & spell out what the issuer’s
management is obligated to do (affirmative covenants) & limited in doing
(negative covenants).
Covenants are described in bond prospectus for corporate bonds.
Strong covenants protect bond investors from the possibility of
management taking actions that would hurt an issuer’s credit worthiness.
5.2.4 Character
Management often has little ownership in a corporation so analysis of

character is different than it would be for owner-managed firm.
Judgments about management character includes:
An assessment of management strategy.
Management track record of past strategies.
Accounting policies & tax strategies.
History of fraud or malfeasance.

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6. Credit risk VS. Return: yields and spreads
Credit risk, potential return, volatility, certainty of earning return.

Credit quality, quoted yield.
Yield on corporate bonds = real Rf + expected inflation rate + maturity premium +
liquidity premium + credit spread.
Investors in corporate bonds focus primarily on yield spread (liquidity + credit
spread) relative to comparable default free bond.
Factors affecting spreads on corporate bonds include:
Credit cycle ⇒ improved credit cycle, narrower credit spread.
Broader economic conditions ⇒ weaker economic conditions, wider credit
spread.
Financial market performance ⇒ weak financial markets, wider credit spreads.
Heavy new issue supply, wider credit spreads, if there is insufficient demand.
For investment grade bonds investors mainly focus on spread risk rather default risk.
For small instantaneous ∆ in Y.S:

≈ − × ∆

For larger spread ∆:

≈ − .× ∆
+ 12 ௑ × ∆
ଶ
7. SPECIAL CONSIDERATION OF HIGH-YIELDS, SOVEREIGN, AND MUNICIPAL CREDIT ANALYSIS
7.1 High Yield
Reasons for below investment grade ratings:

Weak operating history.
Highly leveraged capital structure.
Negative FCF.
Poor management & risky financial policies.
High yield companies are usually unable to access the debt & equity markets so liquidity is a key
focus in high yield analysis.
Sources of liquidity from strongest to weakest include:
Cash on BS.
Working capital.
Operating cash flow.
Bank credit.
Equity issuance.
Asset sale.
If amount of liquidity is < debt coming due in the next 6-12 months ⇒ warning flag for bond
investors.
Forecast of future earnings & CF including several scenarios, to assess whether the issuer’s credit
profile is stable, improving or declining.
High yield companies tend to have many layers of debt in their capital structure.
The lower the ranking in debt structure, the credit rating & the expected recovery in the
event of default.
Corporate structure:
In a holding company structure, the parent’s reliance on CF from its subsidiaries means the
parent’s debt is structurally subordinated to the subsidiaries debt (lower recovery rating).
Leverage ratios should be calculated at each of the debt- issuing entities as well as on a
consolidated basis.
Covenant analysis:
Change of control put ⇒ in the event of acquisition bondholders have the right to require the
issuer to buy back their debt at par or at small premium.
Restricted payments ⇒ limitation on cash that can be paid out to shareholders over time.
Limitations on liens ⇒ limits on how much secured debt an issuer can have.

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7.2 Sovereign Debt
Debt issued by the Govts around the world.
Types of Sovereign Debt
External Debt Internal Debt
Denominated in hard currency. Denominated in local currency.

Generally weaker sovereigns can only assess Easier to service because central bank can print
international debt by issuing bonds in foreign currencies additional money.
(safer store of value).
Both external & internal debts are easy to service if govt. runs a budget & current account
surplus.
Key issues for sovereign analysis:
Govt ability to pay.
Govt willingness to pay (more important).
Specific characteristics that the analysts should expect in a top-quality sovereign credit include:
Political & economic profile.
Institutional effectiveness & political risks.
Economic structure & growth prospects.
Flexibility & performance profile.
External liquidity & international investment position.
Fiscal performance, flexibility & debt burden.
Monetary flexibility.
7.3 Municipal Debt
Debt issued by provincial & local Govts. as well as the various agencies & authorities they create.
GO bonds ⇒ unsecured bonds issued with the full faith & credit of the issuing govt.
These bonds are supported by the taxing authority of the issuer.
Some similarities to sovereign debt analysis.
Economic analysis focuses on employment, per capita income, per capita debt,
demographics & net population growth.
Revenue bonds ⇒ for specific project financing.
Risk than GO bonds (depends on single source of revenue).
Analysis of these bonds include project analysis & financial analysis.
Key credit metric ⇒ debt service coverage ratio (DSCR).
The the DSCR, the stronger the creditworthiness.

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“DERIVATIVE MARKETS AND INSTRUMENTS”
ETD = Exchange Traded Derivatives 2. DERIVATIVES: DEFINITIONS AND USES
Derivative ⇒ a derivative is a financial instrument that derives its

value from the performance of an underlying asset.
Derivatives are similar to insurance ⇒ both transfer risk from one
party to another.
Long position ⇒ the purchaser of the derivative.
Short position ⇒ the seller of the derivative.
Classes of derivative:
Forward commitments ⇒ these instruments force the two
parties to transact in the future at a previously agreed-on price.
Contingent claims ⇒ provide the right but not obligation to buy
or sell the underlying at a predetermined price.
Derivatives serves the following purposes:
Improve the performance of the markets of underlying
Used to create strategies.
Trade at lower transaction costs than spot market transaction.
3. THE STRUCTURE OF DERIVATIVE MARKETS
3.1 Exchange-Traded Derivatives Markets
ETD are standardized contracts whose terms & conditions are

precisely specified by the exchange.
Clearing ⇒ process by which the exchange verifies the execution of a
transaction & record the participant’s identities.
Settlement ⇒ process in which exchange transfer money from one
participant to another.
Margin bond ⇒ credit guarantee by clearing house by requiring a cash
deposit.
3.2 Over-the-Counter Derivatives Markets
OTC derivative markets ⇒ an informal network of market participants

that are willing to create & trade virtually any type of legal derivative.
OTC dealers typically hedge their risk by engaging in alternative
transaction.

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4. TYPES OF DERIVATIVES
4.1 Forward Commitments
4.1.1 Forward Contracts
Forward contract ⇒ an over-the-counter contract in which two parties

agree that the buyer will purchase an underlying asset from the seller
at a later date & at a fixed price they agree on.
No money changes hand when contract is initiated.
Cash-settled forwards ⇒ forward settled by exchange of cash but not
through delivery.
4.1.2 Futures
Futures contract ⇒ a standardized derivative contract created &

traded on a futures exchange.
Settlement price ⇒ average price of the final future trades of the day.
Initial margin ⇒ a required minimum sum of money to support the
trade.
Maintenance margin ⇒ amount of money that each participant must
maintain in the account after the trade is initiated.
Margin call ⇒ a request to deposit additional funds.
Price limits ⇒ a provision limiting price changes.
Limits up (down) ⇒ upper (lower) price limit of a trade.
Locked limit ⇒ occurred when the market reaches these limits &
trading stops.
The futures price converges to the spot price at expiration.
4.1.3 Swaps
Swap ⇒ an over the counter derivative contract in which two parties

exchange a series of cash flows.
Types of swaps:
Fixed for fixed (both parties pay fixed rate).
Fixed for floating.
Floating for floating.
Floating for fixed.
4.2 Contingent Claims
4.2.1 Options
Option ⇒ a derivative contract in which buyer, pays a sum of money to the seller & receive the
right to either buy or sell an underlying asset at a fixed price.
Call option ⇒ provides the right to buy.
Put option ⇒ provides the right to sell.
American-style option ⇒ can be exercised before maturity.
European-style ⇒ can be exercised only at maturity.
Exercise price ⇒ fixed price at which underlying asset can be purchased.
Option premium ⇒ sum of money paid by the option buyer.
In-the-money option ⇒ when option value is positive for buyer & S୘ > X where S୘ = price at
maturity X = exercised price.
Out- of money = S୘ < X
At the money = S୘ = X

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4.2.2 Credit Derivatives
Credit derivative ⇒ a class of derivative contracts b/w two parties, a

credit protection buyer & a credit protection seller, in which the latter
provides protection to the former against a specific credit loss.
Total return swap ⇒ in which credit protection buyer offers to credit
protection seller the total return on the underlying bond.
Credit spread option ⇒ a call option in which the underlying is the
credit spread (difference b/w yield of risky v/s yield of risk free bond).
Credit default swap (CDS) ⇒ a derivative contract in which the
protection buyer makes a series of cash payments to the seller &
receives a promise of compensation for credit losses in case of default
of 3rd party.
4.2.3 Asset-Backed Securities
ABS ⇒ a derivative contract in which a portfolio of debt instruments is

assembled & claims are issued on the portfolio in the form of tranches.
Credit risk is highest for junior tranches & lowest for senior tranches.
4.3 Hybrids
Derivatives can be combined with other derivative or underlying assets

to form hybrids. (e.g. options on futures).
4.4 Derivatives underlying
4.4.1 Equities ⇒ usually individual stocks & stock indices.

4.4.2 Fixed-income instruments and interest rates ⇒ derivative on
bonds are widely used.
4.4.3 Currencies ⇒ currency risk is a major factor in global financial
markets & currency derivative market is large.
4.4.4 Commodities ⇒ widely used to speculate in & manage risk
associated with commodity price.
4.4.5 Credit derivatives.
4.4.6 Other.
5. THE PURPOSES AND BENEFITS OF DERIVATIVES
5.1 Risk allocation, transfer, and management ⇒ derivatives allow

trading the risk without trading the instruments itself.
5.2 Information discovery ⇒ price discovery as futures price is
sometimes thought of as predictive.
5.3 Operational advantages ⇒ derivatives have lower transaction costs
than the underlying.
Greater liquidity than underlying.
5.4 Market efficiency ⇒ derivative markets offer less costly ways to
exploit the mispricing.
Investors can easily manage their risks with low cost.

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6. CRITICISMS AND MISUSES OF DERIVATIVES
6.1 Speculation and gambling ⇒ speculators are thought to engage in

price manipulation & to trade at extreme prices.
Gambling typically benefits only a limited number of
participants.
6.2 Destabilization and systemic risk ⇒ the very benefit of derivatives
results in an excessive amount of speculative trading that brings
instability to market.
Another criticism of derivatives is simply their complexity.
7. ELEMENTARY PRINCIPLES OF DERIVATIVE PRICING
7.1 storage ⇒ agricultural commodities are the oldest from of

derivatives.
Commodity storage cost can be quite expensive.
7.2 arbitrage ⇒ condition that two equivalent assets sell for different
prices, leading to an opportunity to buy at low price & sell at the high
price thereby earning RF without investing capital.
Law of one price ⇒ arbitrage leads to this law as the combined
actions of arbitrageurs bring about a convergence of prices.

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“BASICS OF DERIVATIVE PRICING AND VALUATION”
2. Fundamental Concepts of Derivative Pricing
2.1 Basic Derivative Concepts
A derivative is a financial instrument that derives its performance from the value of
an underlying asset.
Forward Commitments
Forward Contract Future Contract Swap Contract
Over-the-counter Standardized derivative Over -the-counter

derivative. contract traded on an derivative contract.
Buyer agrees to purchase exchange. Under this contract one
from seller at a later date & Daily settlement & credit party pays a variable rate
at a fixed price. guarantee through clearing while the other party pays
house. either variable or fixed rate.
Contingent claim
Option derivative contract in which buyer pays a sum of money to the seller or
writer & receive a right to either buy or sell an underlying asset at a fixed price
either at specified expiry date or before that date.
2.2 Pricing the Underlying
Main types of underlying on which derivative are based are:

Equities.
Fixed income securities/interest rates.
Currencies.
Commodities.
2.2.1 The Formation of Expectations
Assumption ⇒ no intermediate CFs (dividend or interest)
2.2.2 The Required Rate of Return on the Underlying Asset
Required rate of return (K) ⇒ rate at which to discount future cash flow.
Minimum rate is risk-free rate of interest.
Also known as opportunity cost.
2.2.3 The Risk Aversion of the Investor
Three potential types of investors.

Risk averse
Risk neutral
Risk seeking
λ is denoted for risk premium.

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2.2.4 The Pricing of Risky Assets
2.2.5 Other Benefits and Costs of Holding an Asset
Convenience yield ⇒ nonmonetary advantage of holding the

asset
Primarily linked with commodities.
Cost of carry ⇒ the holding, storing or carrying cost of an asset.
2.3 The Principle of Arbitrage
Arbitrage ⇒ a type of transaction undertaken when two assets produce identical results but sell for different prices.
Arbitrage opportunities disappear very quickly.
Exhibit 6 Arbitrage, Replication, and Derivatives

Assets + Derivative = Risk-free asset
Asset - Risk-free asset = -Derivative
Derivative - Risk-free asset = -Asset
Risk –neutral pricing ⇒ it uses the fact that arbitrage opportunities guarantee that a risk free portfolio consisting of the
underlying & the derivative must earn the risk free rate.
Arbitrage-free pricing ⇒ process of pricing derivatives by arbitrage & risk neutrality.
Principle of no arbitrage ⇒ combination of assets/ derivatives that produce the same result must sell for the same price.

2.4 The Concept of Pricing vs. Valuation
Options can be analyzed to determine their fundamental value.

Forward, futures & swap start off with the value of zero & either positive or
negative value arise as underlying moves.
Forward, future or swap price ⇒ price or rate at which the underlying will
be purchased at a later date.
Price or rate is embedded into the contract while the value will fluctuate as
market conditions change.
3. Pricing and Valuation of Forward Commitments
3.1 Pricing and Valuation of Forward Contracts
3.1.1 Pricing and Valuation of Forward Contracts at Expiration
் = ் − ଴
where
଴ ⇒ Forward price at initiation date
் ⇒ Value at expiration
The value of forward contract at expiry is the spot pricing of the underlying minus the
forward price agreed to in the contract.
Value to the short party = Value to the long party X (-1)

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3.1.2 Pricing and Valuation at Initiation Date
଴ = ଴ 1 + ்
Forward price is the spot price compounded at risk-free rate over the life of
the contract.
Forward price of an asset with benefits & costs:
଴ = ଴ 1 + ் − − 1 + ்
If benefit > costs then forward transaction would return less than the spot
transaction & vice versa.
3.1.3 Pricing and Valuation during the Life of the Contract
௧ = ௧ − ଴ 1 + ିሺ்ି௧ሻ

௧ = ௧ − − 1 + ௧ − ଴ 1 + ିሺ்ି௧ሻ
3.1.4 A Word about Forward Contracts on Interest Rates
If underlying in forward contract is an interest rate, then the contract is called

forward rate agreements (FRAs).
FRAs can combine with underlying asset to produce a hedged position.
FRAs are often based on LIBOR, which represents the rate on a Eurodollar time
deposit.
3.2 Pricing and Valuation of Futures Contracts
Forward contracts are typically private, customized transaction while futures

contracts have standard terms, heavily regulated & exchange traded.
Futures are marked to market on daily basis.
Clearing house collects & distribute cash flows from the parities on daily basis.
Value of future contracts ⇒ gain or loss on a future contract since its previous day’s
settlement.
Usually no distinction b/w futures & forward pricing.
3.3 Pricing and Valuation of Swap Contracts
Off-market forwards ⇒ a forward transaction that starts with nonzero value.

We can equate a swap to a series of forward contracts.
Swap valuation during its life again appeals to replication & the principle of no
arbitrage.
4. Pricing and Valuation of Options
Option is clearly an asset to the holder & a liability to the seller.

Buyers pay a premium & receive a right to buy (a call) or sell (a put) the underlying.
American option ⇒ can be exercised before or at maturity.
European option ⇒ allow exercise only at expiration.

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4.1 European Option Pricing
4.1.1 Value of a European Option at Expiration
The holder of call option will exercise the option if the value of underlying exceeds
the exercise price (X).
Value of call option at expiration = 0, ் −
Value of put option = 0, − ்
4.1.2 Effect of the Value of the Underlying
The value of call option cannot exceed the value of underlying & is directly related to
the value or underlying.
No upper or lower boundary is provided by the underlying for puts.
The value of European put option is inversely related to the value of underlying.
4.1.3 Effect of the Exercise Price
In-the-money option ⇒ if the underlying > the exercise price for a call (put) option
then option is in (out) the money.
At-the-money option ⇒ when the underlying is precisely at the exercise price, the
option said to be at-the-money.
Out-of-the money ⇒ exactly opposite from in-the-money.
Lower exercise price has two benefits for a call option:
There are more outcomes in which the call expires in-the money.
The lower the X, the higher the payoffs.
The effect is just the opposite for put options.
Value of European call option ⇒ inversely related to exercise price.
Value of European put option ⇒ directly related to exercise price.
4.1.4 Effect of Time to Expiration
The value of a European call option is directly related to the time to expiration.
Value of a European put option ⇒ either directly or inversely related to the time to
expiration but direct effect is more common.
4.1.5 Effect of the Risk-Free Rate of Interest
Value of European call (put) ⇒ directly (inversely) related to the risk free interest
rate.
Call option holder continues to earn interest on the money that could be expended
later in paying the exercise price upon option exercise.
4.1.6 Effect of Volatility of the Underlying
Value of European call & European put is directly related to the volatility of the
underlying.
Time value of an option ⇒ reflects the value of the uncertainty that arises from the
volatility of the underlying.
At expiration option has time value of zero.

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4.1.7 Effect of Payments on the Underlying and the Cost of Carry
A European call (put) is worth less (more) the more benefits that are paid by the
underlying & worth more (less) the more costs that are incurred in holding the
underlying.
4.1.8 Lowest Prices of Calls and Puts
Exhibit 11. Call Option vs. Leveraged (Margin) Transaction

Outcome at T
Call Expires Out-of-the-Money(ST ≤ X) Call Expires In-the-Money(ST >X)
Call 0 ST – X
Leveraged transaction
Asset ST ST
Loan –X –X
Total ST – X ST – X
Exhibit 12. Put vs. Short Sale and Bond Purchase

Outcome at T
Put Expires in-the-Money (ST < X) Put Expires Out-of-the-Money (ST ≥ X)
Put X – ST 0
Short sale and bond purchase
Short sale – ST – ST
Bond X X
Total X –ST X –ST
Lowest value of European call = greater of zero or S-PV of X Reference: Level I Reading 58
Lowest value of European put = greater of zero PV of X-S
4.1.9 Put–Call Parity
Exhibit 15. Protective Put vs. Fiduciary Call

Outcome at T
Put Expires In-the-Money (ST < X) Call Expires In-the-Money (ST ≥ X)
Protective put
Asset ST ST
Long put X –ST 0
Total X ST
Fiduciary call
Long call 0 ST –X
Risk-free bond X X
Total X ST

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4.1.10 Put–Call–Forward Parity
Exhibit 17. Protective Put with Forward Contract vs. Protective Put with Asset
Outcome at T
Put Expires In-the-Money (ST < X) Put Expires Out-of-the-Money (ST ≥ X)
Protective put with asset
Asset ST ST
Long put X –ST 0
Total X ST
Protective put with forward contract
Risk-free bond F0 (T) F0 (T)
Forward contract ST – F0 (T) ST – F0 (T)
Long put X –ST 0
Total X ST
Exhibit 18. Protective Put with Forward Contract vs. Fiduciary Call
Outcome at T
Put Expires In-the-Money (ST < X) Call Expires In-the-Money (ST ≥ X)
Protective Put with Forward Contract
Risk-free bond F0 (T) F0 (T)
Forward contract ST – F0 (T) ST – F0 (T)
Long put X – ST 0
Total X ST
Fiduciary Call
Call 0 ST – X
Risk-free bond X X
Total X ST

4.2 Binomial Valuation of Options
Binomial model ⇒ model that allows only two possible movements in the underlying
– one going up & one going down from where it is now.
గ௖భశ ାሺଵିగሻ஼భష ଵା௥ିௗ
଴ = where =
ଵା௥ ఓିௗ
Where
ଵା call price on up move
ଵି call price on down move
π & 1-π are synthetic probabilities & they produce a weighted avg. of the next two
possible call values.
Changing the C.S to P.S leads to the binomial put option pricing formula:
ଵା + 1 − ଵି
଴ =
1+

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4.3 American Option Pricing
American options possess an additional trail than European option in that they can
exercise before maturity.
If certain benefits are attached with American call option (e.g. dividends, interest)
early exercise is worth doing.
If certain costs (e.g. storage cost) are attached with the option, preference would be
given to owing the option rather to own the underlying.
The minimum value of an American put > minimum value of European put ⇒
stronger motivation for early exercise.

Page 1
“RISK MANAGEMENT APPLICATIONS OF OPTION STRATEGIES”

So = Stock Price at Time
59.a Call Option: Profit & Loss
Zero (Initial)
X = Strike/Exercise Price
OP = Option Premium Maximum loss for long on call = c0.
Breakeven = X+c0 (call price/option price).
Potential profit for long & potential loss for short is theoretically unlimited.
ST > X at expiration ⇒ holder of call will exercise the option.
For short max profit = C0.
Long profit (loss) = short loss (profit) ⇒ zero sum game.
Put Option: Profit & Loss
Maximum loss for buyer of put (long) = p0.

Maximum gain for long = X-p0.
Maximum gain for long = maximum loss for short.
Breakeven = X-p0.
Max gain for short = p0.
Long profit (loss) = short loss (profit) ⇒ zero sum game.
Underlying asset price ⇒ buyer of put (long), seller of the call (short) ⇒ profit.
Underlying asset price ⇒ long call & short put ⇒ profit.
Generally long put perceives asset price will & short put perceives asset price will .
59.b Covered Call
Buy stock and sell (write) call option.

Stock will be used for delivery.
Assumption: stock price will not go up soon.
Call premium received ⇒ increase income.
Stock’s upside potential is traded against call premium.
Upside potential (limited to) ⇒ X– So + c0.
Maximum loss = So – c0.
Protective Put
Buying a stock + buying a put (long).

Investment management technique ⇒ protects a stock from in value.
Limited downside loss against unlimited upside gain.
Breakeven = So + c0.
Stock price > breakeven ⇒ profit
Maximum loss = (So-X) + p0 paid.
Maximum loss occurs when current price < X.

Page 1
“INTRODUCTION TO ALTERNATIVE INVESTMENTS”

F.I = Fixed Income
PE = Private Equity 1. INTRODUCTION
RE = Real Estate
VC = Venture Capital
AIs are perceived to behave differently (provide diversification) from traditional
LBO = Leverage Buyout
ABS = Asset Backed Securities investments.
AIs = Alternative Investments Absolute return objective ⇒to provide +ve return throughout the economic
MBS = Mortgage Backed Securities cycle.
Relative return objective ⇒ return relative to an equity or F.I benchmark.
2. ALTERNATIVE INVESTMENTS
AIs are alternatives to long-only positions in stocks, bonds & cash.

AIs are almost always actively managed.
Characteristics common to many AIs:
Illiquid underlying investments.
Narrow manager specialization.
Correlation with traditional investments.
Less transparency & low level of regulation.
Limited historical data.
Unique tax & legal considerations.
High net worth individuals & institutions are the typical investors in AI.
HF indices may be inherently biased upwards due to survivorship & backfill biases.
Different weightings & constituents in index construction can significantly affect the indices & their
results & comparability.
2.1 Categories of Alternative Investments
Hedge Funds Private Equity Funds
Manage portfolio of securities & Generally invest in private

derivative positions using variety of companies or public companies with
strategies. the intent to take them private.
Often highly leveraged & employ Majority of PE activity involves LBOs
long & short positions. & VC investments.
Real Estate Commodities
Direct or indirect investment in Physical commodity investments or

buildings & / or land. investments in businesses engaged
Securitization structures broadened in the production of physical
the definition of RE investing. commodities.
Main vehicles ⇒ commodity futures
contracts & funds benchmarked to
commodity indices.
Others
These investments may include tangible assets (e.g.

wine, art, stamps etc.) & intangible assets (e.g. patents).

Page 2
2.2 Return: General Strategies
Ways to Achieve Returns
Passive Return Active Return
Assume that markets are efficient & Assumption ⇒ inefficiencies exist &
focus on β drivers of return. alpha return after adjusting for β
Expected alpha return is zero for risk is possible.
passive managers. Alpha returns are results of
Efficiently take on market risk. managers’ special skills in capturing
non-systematic opportunities in the
market.
Alpha Seeking Strategies
Absolute Return Market segmentation
Return independent of market Capital cannot migrate effortlessly from

returns. lower expected return areas to higher
No market index to beat. ones.
Formal performance objective ⇒ Segmentation brought on by investment
cash rate, real return target or constraints that provide an opportunity
absolute nominal return. for more flexible managers to move into
higher returning segments quickly.
Concentrated Portfolios
Concentrating assets among fewer securities, strategies

& / or managers (less diversification).
Higher return if these concentrated positions
outperform the market (alpha potential).
Risks of AIs
Risks can be considered both on stand-alone basis & within the context of
portfolio.
Risks ⇒ low liquidity, transparency & limited redemption availability.

⇒ ℎ
=

Sharpe ratio & downside risk measures ignore low correlation of AIs with
traditional investments.
2.3 Portfolio Context: Integration of Alternative Investments

with Traditional Investments
Key motivation for investing in AIs ⇒ diversification

potential.
AIs also improve portfolio’s risk-return profile.

Page 3
2.4 Investment Structures
Most common structure ⇒ partnership.

Fund is the general partner (GP) ⇒ investors are limited partners (LPs).
Less regulation.
GP runs the business & bears unlimited liability.
Management fees are based on assets under management.
Incentive fees are based on realized profits.
Fee is only earned after the fund achieves a specified return (hurdle rate).
High water marks ⇒ highest cumulative return used to calculate an incentive fee.
3. HEDGE FUNDS
Characteristics of HF:
Aggressively managed & highly leveraged portfolio of investments across asset
classes.
Fewer investment restrictions & goal of generating high returns.
Usually set up as a private investment partnership.
Often imposes restrictions on redemptions.
Funds of funds ⇒ funds that hold a portfolio of HFs.
Provide diversification.
Available for smaller investors.
Expertise in conducting due diligence on HFs.
3.1 Hedge Fund Strategies
3.1.1 Event-Driven Strategies
Seek to profit from short-term events (e.g.

acquisitions or restructuring).
Bottom-up strategy.
Subdivisions
Merger Arbitrage Distressed/Restructuring
Generally involve going long on stock of Focus on the securities of companies

Target Company & short on stock of either in bankruptcy or near to
acquiring company when merger is bankruptcy.
announced. Variety of ways to profit from distressed
Primary risk ⇒ acquisition does not securities.
occur.
Activist Special Situations
Purchase of sufficient equity in order to Opportunities in the equity of companies

influence a company’s policies or that are currently engaged in
direction. restructuring activities other than M&A
These funds operate in public equity & bankruptcy.
market.

Page 4
3.1.2 Relative Value Strategies
Seek profit from a pricing discrepancy b/w related securities.

Expectations ⇒ pricing discrepancy will be resolved in time.
Examples
Fixed Income Convertible Arbitrage Fixed Income Asset Backed
Zero β investment strategies that seek to Focus on relative value b/w a variety of
exploit a perceived mispricing b/w a ABS & MBS.
convertible bond & its component parts. Seek to take advantage of mispricing
Typically involves buying convertible across different ABS.
debt securities & selling the same
issuer’s common stock.
Fixed Income General Volatility
Focus on the relative value within the FI Use options to go long or short market
markets. volatility either in a specific asset class or
Currency dynamics & govt yield curve are across asset classes.
important considerations.
Multi-Strategy
Relative value within & across asset classes.

Looks for investment opportunities wherever
they might exist.
3.1.3 Macro Strategies
Focus on top down approach to identify economic trends evolving across the world.
Trade in FI, equity, currency & commodity markets.
Use long &/or short positions to potentially profit from a view on overall market
direction.
3.1.4 Equity Hedge Strategies
They are focused on public equity markets & take long & short positions
in equity & equity derivative securities.
Use a “bottom-up” as opposed to “top down” approach.
Examples
Market Neutral Fundamental Growth
Use fundamental &/or quantitative analysis to Fundamental analysis to identify

identify under/overvalued securities. companies expected to exhibit high
Portfolio should have a β of approximately zero. growth & capital appreciation.
Intent ⇒ profit from individual securities movement Long position in identified company
while hedging against market risk. securities.

Page 5
Examples
Fundamental Value Quantitative Directional
Fundamental analysis to identify Technical analysis to identify companies

undervalued securities that are under/overvalued.
Net long or short position depending
upon anticipated direction of market.
Short Bias Sector Specific
Technical or fundamental analysis to Exploit expertise in a particular sector.

identify overvalued equity securities. Use technical & fundamental analysis to
Net short exposure is based upon identify opportunities in the sector.
market expectations.
3.2 Hedge Funds and Diversification Benefits
HFs lack performance persistence.

Traditional view of HF ⇒ arbitrage players ⇒ seek to earn return while
hedging against risk.
HFs provides diversification benefit because of less than perfect
correlation with stock market.
3.3 Hedge Fund Fees and Other Considerations
3.3.1 Fees and Returns
Common fee structure in HF market is “2 & 20” which reflects a 2%

management fee & 20% incentive fee.
Incentive fee is calculated independent of management fees.
Hurdle rate is frequently set based on a RF rate proxy plus a premium.
Incentive fee can be based on returns in excess of the hurdle rate or on
the entire return (soft hurdle rate).
High watermark provision may also be included in fee structure.
3.3.2 Other Considerations
Leverage has the effect of magnifying gains or losses because the HF can
take a large position relative to the capital committed.
HFs normally trade through prime brokers.
The the margin requirement, the leverage is available to the HF.
Redemptions can magnify losses for HF.
When drawdown occurs, investors may decide to exit the fund or
redeem at least a portion of their shares.
Redemption fees ⇒ discourage redemption & help to recover
transaction costs.
Lock up period gives the HF manager time to implement & potentially
realize the expected result of a strategy.
FOFs may offer more redemption flexibility than afforded by direct
investment in HFs.

Page 6
3.4 Hedge Fund Valuation Issues
Valuations are important for calculating performance & meeting redemptions.

When market prices or quotes are used for valuation, funds may differ in which price
or quote they use:
Common practice ⇒ use avg. quote.
Conservative practice ⇒ use bid prices for longs & ask prices for shorts.
Any model should be independently tested, benchmarked & calibrated to industry-
accepted standards to ensure a consistency of approach.
Liquidity discounts are necessary to reflect fair value.
Trading NAV ⇒ incorporates liquidity discounts ⇒ based on the size of the position
held.
Reporting NAV ⇒ based on quoted market price.
3.5 Due Diligence for Investing In Hedge Funds
FOFs have an additional layer of fees.

Key due diligence factors include:
Investment strategy.
Investment process.
Competitive advantage.
Track record.
Size & longevity.
Management style.
Key person risk.
Reputation & plans for growth.
Systems risk management & investor relations.
4. PRIVATE EQUITY
There are different stages & types of PE investing.

The focus of PE firms may ∆ as business conditions & the availability of
financing change.
Categories of PE
Leveraged Buyouts Venture Capital
LBO funds that acquire public Invest or provide financing to private

companies or established private companies with high growth potential.
companies mainly through debt. VC can be provided at a variety of stages.
Assets of the target company serve as
the collateral for the debt.
After the buyout, the target becomes or
remains a privately owned company.
Development Capital Distressed Investing
Minority equity investments in more Buying the debt of mature companies in

mature companies that are looking for financial difficulties.
capital to expand or restructure operations Turnaround investors ⇒ buy the
company’s debt & plan to be more active
in the management & direction of the
company.

Page 7
4.1 Private Equity Structure and Fees
PE funds are typically structured as partnerships similar to HFs (outside investors

are LPs & PE firm as GP).
PE firms usually charge both a management fee & an incentive fee on a fund basis.
Management fees generally range from 1 to 3% of committed capital.
GP does not earn an incentive fee until the LPs have received their initial
investment back.
Claw back provision ⇒ requires the GP to return any funds distributed as
incentive fees until the LPs have received back their initial investment & 80%
of the total profit.
4.2 Private Equity Strategies
4.2.1 Leveraged Buyouts
Management Buyouts (MBO) ⇒ current management is involved in the acquisition.

Management buy-ins (MBIs) ⇒ current management team is being replaced & the
acquiring team will be involved in managing the company.
To a large extent potential returns in this category are due to the use of leverage.
4.2.1.1 LBO Financing
PE firms use debt to finance a significant proportion of each deal to equity

returns & no. of transactions.
Typical LBO capital structure ⇒ equity, bank debt & high yield bonds.
Mezzanine financing (MF) ⇒ debt or preferred shares with a relationship to
common equity due to a feature such as attached warrants or conversion options.
Being subordinate to senior & high yield debt MF pays a higher coupon rate.
4.2.1.2 Characteristics of Attractive Target Companies for LBOs
Some characteristics of attractive target companies for LBOs include:

Depressed stock price.
Willing management.
Inefficient companies.
Strong & sustainable CF.
Low leverage & significant amount of physical assets.
4.2.2 Venture Capital
Portfolio Company ⇒ the company that is being invested in & will

become part of the portfolio of the VC fund.
VC investors are actively involved in portfolio companies.
VC Fund Financing
Formative Financing Later-Stage Financing
Company is in the process of being formed. This financing is provided after

Angel investing ⇒ capital provided at idea stage. commercial production & sales have
Seed-stage financing⇒ supports production development & begun but before any IPO.
market research. Funds may be used for initial expansion
Early stage financing ⇒ provides to companies moving or major expansion.
toward operation but before commercial production & sales
have occurred.

Page 8
VC Fund Financing
Provided to prepare to go public.

Represents the bridge b/w the
expanding company & the IPO.
4.2.3 Other Private Equity Strategies
Several other specialties for PE firms include:

Minority equity investing.
Distressed investing ⇒ purchasing the debt of a troubled company.
Distressed debt investors are called vulture investors.
Investing in companies in specific industries.
4.2.4 Exit Strategies
Ultimate goal for PE ⇒ improve underperforming businesses & exit them at high
valuations.
Exit strategies:
Trade sale ⇒ sale of a company to strategic buyer such a competitor.
IPO ⇒ selling of shares to public investors through an IPO (highest price).
Recapitalization ⇒ not a true exit strategy.
PE firm maintains control but allows the PE investor to extract money from
the company.
Popular strategy when IR is.
Secondary sale ⇒ sale to another PE firm or group of investors.
Liquidation ⇒ occurs when transaction has not gone well.
4.3 Private Equity: Diversification Benefits, Performance, and Risk
Due to less than perfect correlation with traditional investments, PE

funds can add diversity to portfolio.
By identifying skillful PE fund managers, investors may benefit from
superior returns.
4.4 Portfolio Company Valuation
Approaches to PE Valuations
Market or Comparables Approach Discounted Cash Flow Approach
Use multiples of different measures. Values a company or its equity as the PV

Large, mature private companies ⇒ of the relevant expected future CF.

EBITDA multiple. =

Asset-Based Approach
Value of a company based on the values of its underlying assets

less the value of any related liabilities.
Value of the company to the equity holders.
Valuations can be arrived at using fair or liquidation values.
Liquidation value ⇒ net amount that will be realized if
the business is terminated.

Page 9
4.5 Private Equity: Investment Considerations and Due Diligence
IR, capital availability expectations & refinancing risk must be

considered & evaluated.
PE investments are long-term illiquid investments.
5. REAL ESTATE
Direct or indirect equity investing in RE property such as land & buildings.

Debt investing in RE includes mortgage loans or MBS investing.
Reasons for investing in RE:
Competitive long-term total return potential.
Multiple year leases with fixed rents lessen CF impact from economic shocks.
Diversification benefits.
Provide inflation hedge if rents can be adjusted quickly for inflation.
Unique features of RE compared with other investment asset classes:
Indivisibility.
Unique characteristics.
Fixed location.
5.1 Forms of Real Estate Investment
Debt Equity
Private Mortgages Direct ownership of real estate.
Ownership can be through sole
ownership, joint ventures, real estate
limited partnership, or other
commingled funds.
Public Mortgage-backed securities (residential Shares in real estate corporations
and commercial) Shares of real estate investment trusts
Collateralized mortgage obligations
Leveraged ownership ⇒ property title is obtained through an

equity purchase combined with mortgage financing.
Mortgage loans represent passive investments where the
lender expects to receive a predefined stream of payments.
5.2 Real Estate Investment Categories
5.2.1 Residential Property
Direct equity investment in a residence with the intent to occupy.

If purchase is partially financed, any () in the value of the home () the owner’s equity in the home.
Securitization provides indirect, debt investment opportunities in residential property.
5.2.2 Commercial Real Estate
Appropriate direct investment (equity & debt) for institutional funds or high-net-
worth individuals with long time horizons & limited liquidity needs.
Direct investment requires active & experienced, professional management.
Lender conducts financial analyses to establish the creditworthiness of the borrower
before providing the debt financing.

Page 10
5.2.3 REIT Investing
Mortgage REITS ⇒ risk & return characteristics similar to fixed income investments.
Equity REITS ⇒ invest primarily in commercial or residential properties & employ
leverage.
Sources of return to equity REITS= rental income – debt servicing.
5.2.4 Mortgage-Backed Securities (MBS)
MBS structure ⇒ buying a pool of assets & assigning the income & principal returns
into individual security tranches for commercial MBS.
Collection of Assets Combination of Funding Assorted Securities
Investment-Grade Last
CMBS 60%-70% Loss
Debt
Real 70%-75% High-Yield BB Rated
Estate CMBS
Asset B Rated
5%-10%
Unrated
Property
Owners’ Equity
25%-30% Property Owners’
Equity 25-30%
Pool of Pool of Commercial Mortgage-

First
Properties Loans Backed Securities
Loss
5.2.5 Timberland and Farmland
Timberland ⇒ offers an income stream based on the sale of timber products as a component of total return
(low correlation with other asset classes).
Flexible investment ⇒ harvest more trees when timber prices are up & delaying harvests when prices
are down.
Farmland ⇒ perceived to provide an inflation hedge.
Returns ⇒ related to harvest quantities & agricultural commodity prices.
Two main property types:
Row crops⇒ planted & harvested annually.
Permanent crops ⇒ grows on trees or vines.
Little flexibility in harvesting as compared to timberland.
5.3 Real Estate Performance and Diversification Benefits
RE index can generally be categorized as an appraisal index, transactions-based index

or a REIT index.
Appraisal indices ⇒ use estimates of value as inputs to the indices.
Rely on comparable sales & CF analysis techniques.
These indices understate volatility because appraisals are done periodically.
Transactions-based indices ⇒ use repeat sales of properties to construct the indices.
Sample selection bias.
Higher the no. of sales the more reliable & relevant is the index.
REIT indices ⇒ use the prices of publicly traded shares of REITS to construct the
index.
Index may not represent the properties of interest to the investor.

Page 11
5.4 Real Estate Valuation
Comparable Sale Approach Income Approach
Approximate value based on recent sales Direct capitalization approach

of similar properties. Estimates the value of an income
Adjustments are made for differences in producing property based upon the
key characteristics of property ⇒ level & quality of NOI.
condition, age, location & size. NOI ⇒ income to the property after
deducting operating exp (property tax,
insurance, maintenance utilities &
Cost Approach repairs) but before depreciation,
finance cost & income tax.

Evaluates the replacement cost of the ℎ

=

property by estimating the value of land Cap rate ⇒ discount rate-growth rate
& the costs of rebuilding using current Discounted CF approach ⇒ discounts
construction costs & standards. future projected CFs to arrive at a PV of
the property.
5.4.1 REIT Valuations
Income Based Valuation Asset Based Valuation
Typically similar to direct cap approach. This approach calculates a REIT’s NAV.
Funds from operation (FFO) & adjusted FFO REIT’s NAV = Estimated MV of REIT’s total
are used as measure of income. assets – value of its total liabilities.
FFO = NI + Dep ± gains (loss) from sale of RE REIT shares are often traded at value other
property. than NAV per share.
AFFO adjusts the FFO for recurring capex.
5.5 Real Estate Investment Risks
RE investment may fail to perform in accordance with expectations.

Other risks include:
Change in govt regulation.
Ability of fund management to select finance & manage real properties.
Leverage magnifies the impact of gains & losses.
6. COMMODITIES
Commodities ⇒ physical products.

Return ⇒ based on ∆ in price rather than on an income stream.
Most commodity investors trade in commodity derivatives to avoid storage &
transportation costs associated with holding the underlying commodity.
Commodities include precious & industrial metals, energy products & agri products.
Commodity derivatives may be attractive to investors because these investments
provide an inflation hedge & diversification benefits.
6.1 Commodity Derivatives and Indices
Commodity derivatives include futures, forwards, options & swaps.

Commodity indices typically use the price of futures contracts on the commodities included in them
rather than the prices of the commodities themselves.
Commodity indices vary in the commodities included in them & the weighting methods used.

Page 12
6.2 Other Commodity Investment Vehicles
Alternative means of achieving commodity exposure include:

ETF ⇒ suitable for investors who can only buy equity shares or seek the
simplicity of trading them.
Common stock of companies exposed to a particular commodity.
Managed futures funds.
Individual managed accounts.
Funds that specialize in specific commodity sectors.
6.3 Commodity Performance and Diversification Benefits
Arguments for investing in commodities include:

Potential for return ⇒ investors believe prices will in the short or medium
term.
Portfolio diversification ⇒ commodities behaved differently during the business
cycle from stocks & bonds.
Inflation hedge ⇒ commodity prices affect inflation calculations.
6.4 Commodity Prices and Investments
Commodity spot prices are a function of:

Supply & demand.
Cost of production & storage.
Value of users.
Global economic conditions.
The inability of suppliers to quickly respond to changes in demand levels may results
in supply levels that are too low in times of eco. growth & too high in times of eco.
slowing.
6.4.1 Pricing of Commodity Future Contracts
The price of a commodity futures contract may be approximated by the following

formula

≈

1 + + −convenience
where
r = period’s short term risk free rate.
Convenience yield ⇒ yield related to convenience of having physical possession of
the commodity.
Contango (backwardation) ⇒ futures price > (<) spot price & commodity forward
curve is upward (downward) sloping.
Source of return for commodity futures contract:
Roll yield ⇒ Diff. b/w the spot price of a commodity & the price specified in the
future contract.
Collateral yield ⇒ interest earned on the collateral posted as a good faith
deposit for the futures contract.
Spot prices ⇒ primary determinant is relationship between current supply &
demand.
7. OTHER ALTERNATIVE INVESTMENTS
Collectibles:
Tangible assets such as antiques & fine art, fine wine, rare stamps & coins,
jewelry & watches etc.
Provide no current income but potential for higher capital gains.
Highly illiquid.
No. of indices that provide information about returns to these investments.

Page 13
8. RISK MANAGEMENT OVERVIEW
8.1 Investment and Risk Management Process
The manger of an investment portfolio makes investment decisions consistent with

the portfolio’s established investment policies, taking risk into account.
Investor due diligence should be used to ensure portfolio risk is effectively managed
by the portfolio manager.
8.1.1 Risk Management Issues
Risks vary across alternative investments.

PE & HF may have long lockup periods.
Poor manager selection can create a lingering drag on the portfolio.
8.1.2 Risk Issues for Implementation
Investors should recognize that past performance is not necessarily

representative of future performance.
In case of illiquid investments, portfolio should be diversified
sufficiently to reduce the possibility of 100% loss.
8.2 Risk – Return Measures
Sharpe ratio may not be the appropriate risk – return measure for
alternative investments because measure of return & SD may not be
relevant & reliable.
Returns are overstated & volatility is understated in alternative
investments.
Alternative investment returns tend to be leptokurtic &
negatively skewed.
Downside risk measure (e.g. ) focus on the left side of the return
distribution curve & Sortino ratio uses downside deviation as
opposed to standard deviation as a measure of risk.
8.3 Due Diligence Overview
A Typical Due Diligence Process

Organization: Experience and quality of management team, compensation, and staffing
Analysis of prior and current funds
Track record/alignment of interests
Reputation and quality of third-party service providers, e.g., lawyers, auditors, prime brokers
Portfolio Management: Investment process
Target markets/asset types/strategies
Sourcing of investments
Role of operating partners
Underwriting
Environmental and engineering review process
Integration of asset management /acquisitions/ dispositions
Disposition process, including how initiated and executed
Operations and Reporting and accounting methodology
Controls: Audited financial statements and other internal controls
Valuationfrequency and approach(es)
Insurance and contingency plans
Risk Management: Fund policies and limits
Risk management policy
Portfolio risk and key risk factors
Leverage and currencyrisks/constraints/hedging

Page 14
8.3 Due Diligence Overview
A Typical Due Diligence Process

Legal Review: Fund structure
Registrations
Existing/prior litigation
Funds Terms: Fees (management and performance) and expenses
Contractual terms
Investment period and fund term and extensions
Carried interest
Distributions
Conflicts
Limited partners’ rights
Reference: Level I Curriculum, Volume 6, Reading 60, Exhibit 20.

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1

2017 Study Session # 1, Reading # 1

“Ethics & Trust in the investment Profession”

Definition: Widely Violations of CFA Institute

• Ethics or Ethical Principles: • is a community

3. ETHICS & PROFESSIONALISM

CFA Institute’s Codes & Standards

4. CHALLENGES TO ETHICAL CONDUCT

People are generally • Environmental or cultural

5. THE IMPORTACE OF ETHICAL CONDUCT

• In invst. industries unethical actions or

6. ETHICAL VS. LEGAL STANDARDS

• Laws & regulations codify ethical actions that

Laws may not always truly Ethical Standards

7. ETHICAL DECISION MAKING FRAMEWORKS

1) Identify: (facts, principles, duties owed, conflicts)

2) Consider: (situational influences, guidance, choices)

3) Decide & Act

4) Reflect: ( Was outcome as expected? why or why not?)

Trust can be ↑ by: Ethical decision-making

Responsible professionals in the invest.

“CFA INSTITUTE CODE OF ETHICS AND STANDARDS OF

Circumstances Which Can Prompt Inquiry

If disclosure by member/candidate on PCS of involvement in civil litigation,

Copyright © FinQuiz.com. All rights reserved.

Standards of Professional Conduct

6. Conflicts of Interest 7. Responsibilities as CFA Member or CFAI Candidate

A. Knowledge of Law B. Independence & Objectivity C. Misrepresentation D. Misconduct

2. Integrity of Capital Markets

A. Material Non-Public Information B. Market Manipulation

A. Loyalty, B. Fair Dealing C. Suitability D. Performance E. Preservation of

A. Loyalty B. Additional Compensation C. Responsibility of

5. Investment Analysis, Recommendation & Actions

A. Diligence & Reasonable B. Communication with C. Record Retention

A. Disclosure of conflicts B. Priority of Transactions C. Referral Fees

7. Responsibilities as CFAI Member or CFA Candidate

A. Conduct as Members and Candidates in B. Reference to CFA Institute, the CFA

Copyright © FinQuiz.com. All rights reserved.

Guidance ⇒ Code & Standards vs Local Law

Guidance ⇒ Participation or Association with Violation by Others

Recommended Procedures for Compliance-Members

Recommended Procedure for Compliance-Firms

Members should encourage their firms to:

Copyright © FinQuiz.com. All rights reserved.

1 B. Independence & Objectivity

Investment process must not be influenced by any external sources.

Guidance-Investment Banking Relationships

Do not limit research to discussions with company management.

Guidance-Buy Side Clients

Guidance-Fund Manager Relationships

Guidance-Credit Rating Agency

Copyright © FinQuiz.com. All rights reserved.

Guidance-Issuer Paid Research

Analyst’s compensation for such research should be limited.

Recommended Procedures for Compliance

M&C must not knowingly make any misrepresentations relating to investment

Misrepresentation causes mistrust.

Recommended Procedures for Compliance

Copyright © FinQuiz.com. All rights reserved.

CFAI discourage unethical behavior in all aspects of M&C’s lives.

Recommended Procedures for Compliance

Firms are encouraged to adopt these policies and procedures to:

2. INTEGRITY OF CAPITAL MARKETS