CFA Level 1 Complete 1,905 terms mccauley04

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Private value auctions Value is subjective and different to each bidder

Ascending price Bidders can bid amounts greater than the previous bid,
(English) auction and the bidder that first offers the highest bid wins the
item and pays the amount

Sealed bid auction Each bidder submits one bid, which is unknown to the
other bidders and the bidder with the highest bid wins
the item and pays the price;
The reservation price is the highest price that a bidder is
willing to pay;
The optimal bid for the bidder with the highest
reservation price is just slightly above the bidder with
the second highest reservation price;
Bids are not necessarily equal to reservation price
Second sealed bid The bidder with the highest bid wins the item but pays
auction (Vickrey the price bid by the second highest bidder;
auction) No reason for a bidder not to bid his reserve price;
Similar to a an ascending price auction, the winning
bidder tends to pay one increment of price more than
the bidder who values the time the second most
Descending price Begins with a price greater than what any bidder will pay
(Dutch) auction and the price is reduced until a bidder agrees to pay it;
If there are multiple units available, each bidder and
specify how many they want to buy;
Can be modified so that winning bidders all pay the
same price

Price elasticity How responsive the quantity demanded is to a change in

price

Elasticity of demand A measure of how consumers respond to price changes;

Perfectly elastic is when the demand curve is horizontal;
Perfectly inelastic is when the demand curve is perfectly
vertical

Unstable equilibrium When a supply curve intersects a demand curve more

than once, the unstable equilibrium is an equilibrium
where supply can increase towards another equilibrium
that results in a lower price;
Caused by a nonlinear supply function

Statutory incidence Who is legally responsible for paying a tax

Incidence of tax Who ends up bearing the cost of a tax

Substitution effect Always acts to increase the consumption of a good that

has fallen in price

Income effect Either increase or decrease a good that has fallen in

price;
Typical of normal good to have a positive income effect;
Typical of inferior good to have negative substitution
effect

Positive substitution, Consumption increases

positive income

Positive substitution, Consumption increases

negative income
smaller than positive
substitution

Positive substitution, Consumption decreases

negative income
greater than positive
substitution
Causes of demand Income
changes Increases as prices of substitute goods increase
Decreases as the prices of complement goods increases

Causes of supply Rises if technology increases;

changes Rises if input prices decrease

Giffen good An inferior good for which the income effect outweighs
the substitution effect so that the demand curve is
positively sloped (higher the price, higher the demand)

Relationship cost AFC slopes downward

curves Vertical distance between ATC and AVC equals AFC
MC initially declines, then rises
MC intersects AVC and ATC at their minimums
ATC and AVC are u-shaped
The MC above the AVC is the firm's short-rum supply
curve

Average Revenue > Firm continue production

AVC

Average Revenue < Firm should shut down

AVC

Average Revenue > Firm should stay in business for long-run

ATC

Profit maximized Producing up to but not over MR=MC;

Producing quantity where TR-TC is at a maximum

Perfect competition Many firms compete with identical products, low

barriers to entry, and the only way to compete is on
price;
Perfectly elastic demand curves for each firm;
A firm will continue to expand production until marginal
revenue equals marginal cost, which maximizes profit or
where MR = MC;
Economic loss occurs when marginal revenue is less than
marginal cost;
Firm can't make economic profit in long-run;
Long-run equilibrium output is where marginal revenue
equals marginal cost equals average total cost ;
 An increase/decrease in market demand will
increase/decrease both equilibrium price and quantity;
Short-run supply curve is the marginal cost curve above
the average variable cost
Monopolistic Many firms that compete with differentiated products;
competition Demand curve is downward sloping and is highly elastic;
Quality, Price and Marketing are key differentiators ;
Low barriers to entry;
Firms must advertise and innovate;
In short run maximize economic profits by producing
where marginal revenue equals marginal cost ;
In long run, price equals average total cost and
economic profits are 0

Oligopoly Only a few firms compete and each must consider the
actions of others when setting price and strategy;
High barriers to entry;
Demand is less elastic than monopolistic competition

Monopoly Only one seller in the market and there are no good
substitutes;
High barriers to entry;
Maximize profit, not price;
Profit maximized when marginal revenue equals marginal
cost when demand curve is above ATC

Natural monopoly When the average cost of production is falling over the
relevant range of demand and having two or more
producers would lead to hire production costs and hurt
the consumer

Marginal cost pricing Forces the monopoly to reduce price to the point where
the firms marginal cost curve intersects the market
demand curve

Oligopoly models -Kinked demand curve

-Cournot duopoly
-Nash equilibrium
-Dominant firm model

Kinked demand curve Based on the assumption that an increase in a firm's

product price will not be followed by its competitors,
but a price decrease will;
 Firms assume that demand is more elastic above a
certain price than below it;
Firms produce the quantity at the kink, assuming if they
increase production, their revenues will be eroded by
decreased prices and if they decrease production the
price won't go up much;
Model doesn't account for cause of kinks
Cournot duopoly One firm will look at the other's price and production
and adjust accordingly until both firms meet at an
equilibrium of the same price and quantity

Nash equilibrium When the choice of all firms are such that there is no
other choice that makes any firm better off;
Each decision maker will unilaterally choose what's best
for himself

Dominant firm model When a firm with the vast majority prices smaller firms
out of the market over time by lowering prices to the
point where it falls below the average total cost of
smaller competitors

Concentration Nth firm indicator

measures Herfindahl-Hirschman Index

Nth firm indicator How much market share is held by the top N firms in the
market;
Isn't affected by two large companies merging

Herfindahl-Hirschman Adds up the sum of the squares of the largest firms in

Index the market

Oligopolists and There is an incentive to cheat and raise your share of the
Collusion Agreements joint profit

Tax Burden Falls on the party with less elastic curve

Discrete Random Variable where the number of outcomes can be counted

Variable and each outcome has a measurable and positive
probability

Continuous Random Variable where the number of possible outcomes is

Variable infinite, even if upper and lower bounds exist

Discrete Uniform Variable where all possible outcomes for a discrete

Random Variable random variable are equal
Binomial Random Variable may be defined as the number of successes in a
Variable given number of trials where the outcome can be either
a success or failure;
Expected value = (probability of success) * (number of
trials);
Variance = (expected value) * (1 - probability of success)

Bernoulli Random Binomial random variable with only one trial

Variable

Z-Value of Normal The number of standard deviations away a random

Distribution variable is from the population mean ;
z = (variable - population mean)\(standard deviation)

Roy's Safety First The optimal portfolio minimizes the probability that the
Criterion return of the portfolio falls below A minimum acceptable
level;
= (Historical Return - Return Threshold)/(Volatility)
Shortfall risk is the probability of being to the left of the
minimum return

Lognormal Distribution The function e^x where x is normally distributed;

Positively skewed;
Bound to the left by 0
;Price relative is the ending price divided by the starting
price

Simple Random Completely random, systemic sampling is picking every

Sampling nth member of a population;
Sampling error is the difference between the sample
statistic and the population's statistic

Stratified Random When a population is divided up into smaller groups

Sampling based on distinguishing characteristics;
Proportions of groups in sample same as in population

Longitudinal Data Observations over time of multiple characteristics of the

same entity

Panel Data Observations of the same characteristic of multiple

entities over time

Central Limit Theorem For simple random samples of size n from a population
with a mean u and a finite variance o, the sampling
distribution of the sample mean x approaches a normal
 distribution with mean u and a variance equal to the
population variance divided by the number of sample
observations

Standard Error Dividing the sample variance by the square root of the
number of observations since the populations standard
deviation is rarely known

Properties of Unbiased - Low sampling error

Estimators Efficient - Small variance
Consistent - Accuracy increases as sample size increases

Point Estimates Single values used to estimate population parameters

Confidence Interval A range of values the population parameter is expected

to fall under;
When a distribution has a known population variance,
found by:
(sample mean) (+\-) (z-statistic) * (standard error);
When distribution population variance is not known,
found by:
(sample mean) (+\-) (t-statistic) * (standard error)

T-Distribution A bell shaped distribution symmetrical about its median

used to make confidence intervals with small samples
(<30) and unknown population variance;
Degrees of freedom = # of Observations - 1

Process for Testing +State Hypothesis

Hypothesis +Select Test Statistic
+Specify Level of Significance
+State Decision Rule Regarding Hypothesis
+Calculate Sample Statistics
+Make a Decision about Hypothesis
+Make a Decision Based on Test

Null Hypothesis What you are testing

Alternative Hypothesis What is concluded if null is rejected

Type I Error Rejecting the null when it is true;

Significance level is probability of Type I error

Type II Error Not rejecting a false null

Power of Test Probability of correctly rejecting the null;

 Found by subtracting the probability of a Type II error
from 1

Z-Test Used to calculate a mean when population is known to

be normally distributed

T-Test Used to compare two means when population is known

to be normally distributed

Chi-Squared Test Used to test hypothesis about one variance

F-Test Used to compare two variances

Parametric Tests Rely on assumptions regarding the distribution of the

population and are specific to population parameters

Nonparametric Tests Do not make any assumptions about the population and
are used when parametric tests cannot be

Spearman Rank Order all of the data and examine its correlation to see if
Correlation Test there is any relationship at the extremes ;
Used when data isn't normal

Point and Figure Chart Shows price movement by having price on the vertical
axis and the number of changes in direction on the
horizontal axis;
X = increase one box size
O = decrease one box size

Relative Strength The asset's price charted against the index price

Reversal Pattern When a trend approaches a range of prices but fails to

continue beyond that range

Sentiment Indicators Discern the potential views of buyers and sellers

Put/Call Ratio Put volume divided by the call volume;

The higher the ratio, the more negative the sentiment;
Sentiment indicator

Volatility Index (VIX) Measures the volatility of options on the S&P 500 index;
The higher the level, the more scared the market;
Sentiment indicator

Margin Debt An increase in the number indicates bullish sentiment;

Sentiment indicator

Short Interest Ratio The short interest divided by the average daily trading
 volume;
Can indicate a bearish sentiment but also an upcoming
spike from shorts closing positions;
Sentiment indicator

Mutual Fund Cash Ratio of a mutual fund's cash to its total positions;
Position Increases in a down market, decreases in an up market

Cycle Theory +Presidential Cycle = 4 years

+Decennial Cycle = 10 years
+Kondratieff Wave = 54 years

F-Test Statistic Examines two sample variances, with the larger in the
denominator and smaller in the numerator

Test's Significance The probability that a true null hypothesis will be

rejected by chance

Coefficient of Variation Standard deviation divided by the mean

Contents of Footnotes +The basis of presentation such as the accounting period

+Information about the accounting methods used
+Additional information about extraordinary events

Contents of +The basis of presentation such as the accounting period

Management +Information about the accounting methods used
Discussion and +Additional information about extraordinary events
Analysis

Contents of Auditor's +Independent view of the firms financial statements

Opinion +Generally accepted accounting policies were used and
judgements were reasonable
+Explanation when accounting policies change from
year to year

Auditor's Opinions +Unqualified opinion

+A qualified opinion
+An adverse opinion
+A disclaimer opinion

Unqualified auditor's Indicates the auditor believes the statements are fine
opinion

Qualified auditor's There is an exception to accounting principles

opinion
Adverse auditor's The statements are not presented fairly or don't conform
opinion to standards

Disclaimer auditor's When the auditor cannot issue an opinion

opinion

Steps of Financial +State the objective and context

Statement Analysis +Gather data
Framework +Process data
+Analyze and interpret data
+Report conclusions and recommendations
+Update analysis

Accounting 1. Journal record every transaction by order of date in

Information Flow the general journal
2. The general ledger sorts the entries in the general
journal by account
3. An initial trade balance is prepared at the end of the
period to show the balance of each account and
adjustments are then made
4. Financial statements are made from the adjusted trial
balances

Objectives of +Protect investors

International +Ensure market fairness, efficiency and transparency
Organization of +Reduce systemic risk
Securities
Commissions

SEC Forms +S-1

+10-K
+10-Q
+DEF-14A
+8-K
+144
+Forms 3, 4, 5

Form S-1 Filed before sale of a new security

Form 10-K Annual report

Form 10-Q Quarterly report

Form DEF-14A Proxy statement

Form 8-K Discloses material events

Form 144 Notice to the SEC of a sale of non-registered securities

Forms 3, 4, 5 Notices of insider ownership

Qualities of useful Relevance and faithful representation

financial statements

Enhancements of +Comparability
relevance and faithful +Verifiability
representation +Timeliness
+Understandability

Elements of IFRS' +Assets

Conceptual +Liabilities
Framework +Equity
+Income
+Expenses

Going Concern The company will remain in operation for the

Assumption foreseeable future

Required Financial +Balance sheet

Statements +Income statement
+Cash flow statement
+Owner's equity
+Footnotes

Features of preparing +Fair presentation

financial statements +Going concern basis
+Accrual basis
+Consistency
+Materiality
+Aggregation of only similar items
+No offsetting of assets against liabilities or revenues
against expenses unless explicitly stated by a standard
+Reporting frequency is annual

Differences between +IASB lists income and expenses as elements related to

IFRS and GAAP performance, GAAP includes revenues, gains, loses and
comprehensive income
+GAAP defines an asset as having future economic
benefit, IASB defines an asset as a resource for which a
 future economic benefit is probable
+GAAP doesn't allow for the upward valuation of most
assets
Characteristics of a +Transparency
coherent financial +Comprehensiveness
framework +Consistency

Barriers to Creating a +Valuation

Coherent Financial +Standard setting
Framework +Measuring value at a point in time versus it's movement
over a period of time

Responsibilities of Professional organizations to establish financial

standard-setting reporting standards
bodies

Responsibilities of Government agencies with legal authority to enforce

regulatory authorities compliance with financial reporting standards

Why Firms Support Would reduce the cost and the time spent on reporting
One Set of Reporting
Standards

Long Lived Assets: Disclosures are more extensive under GAAP

IFRS v. GAAP

Unrealized Included in net income

Gains/Losses on Held
For Trading Securities

Unrealized Included in comprehensive income

Gains/Losses on
Securities Available For
Sales

Bond Indenture The contract that specifies all the rights and obligations
of the issuer and the owners of a fixed income security

Zero-Coupon Bonds Do not pay periodic interest;

Sold at a discount and pay par value at maturity

Step-Up Notes Coupon rates increase over time at a specified rate

Deferred-Coupon Initial coupon payment is delayed;

Bonds Interest accrues and is paid as a lump sum;
Coupons paid regularly after the first
Floating-Rate Bonds Coupon payments are based on another rate or index;
Reference rate is the underlying rate;
Payment is a specified spread applied to the reference
rate;
Indenture lists schedule of rate changes

Cum Coupon When the buyer is entitled to the next couponn

Ex-Coupon When the buyer does not get the next coupon

Non-Amortizing Pays interest until maturity, then principal is repaid

(Bullet) Bonds

Amortizing Bonds Pay periodic interest and principal payments over the life
of a bond;
Payments are equal with the proportion of interest and
principal changing with each payment

Non-Refundable Can be called but cannot use borrowed money to buy

Bonds back bonds;
Can be called but not refunded

Sinking Fund Provisions provide the repayment of principal through a

series of payments over the life of the issuance;
In a cash payment, the issuer can deposit the required
cash amount annually to a trustee, who will randomly
call a portion of the issuance back;
In a delivery of securities, the issuer purchases bonds
with a total par value equal to the amount that is to be
retired in that year in the market and deliver them to the
trustee who will retire them;

Accelerated Sinking Allows the issuer the choice of retiring more than the
Fund amount of bonds specified in the sinking fund
requirement

Special Redemption Redemption prices from a sinking fund or government

Prices mandated sale

Repo Agreement An arrangement by which an institution sells a security

with a commitment to buy it back at a later date for a
higher price

Term Repo Repo lasting longer than a day

Risks of Bonds +Interest rate risk

 +Yield curve risk
+Call risk
+Reinvestment risk
+Credit risk
+Liquidity risk
+Exchange rate risk
+Inflation risk
+Volatility risk
+Event risk
+Sovereign risk

Interest Rate Risk The effect of changes in bond rates on bond values

Yield Curve Risk Possibility of a change in the shape of the yield curve

Call Risk As interest rates fall, an issuer is more likely to call its
bonds and refinance at a lower rate

Reinvestment Risk Not being able to reinvest money at the same rate of
return if interest rates fall and issuers call bonds or
prepay loans

Credit Risk Chance the creditworthiness of an issuer will decrease

Liquidity Risk Chance a bond will be sold at less than market price due
to a lack of liquidity

Exchange Rate Risk Uncertainty about the value of foreign currency cash
flows to an investor in terms of his domestic currency

Inflation Risk Uncertainty of future inflation rates and decreased real

return rates

Volatility Risk Chance of increased interest rate volatility causing

prepayments

Event Risk Effects from factors outside of financial markets

Sovereign Risk Credit risk of a sovereign bond outside of the investor's

home market

Par Bond When the bond's coupon rate equals the market yield;
Bonds are typically issued near par value

Discount Bond Bond priced below its par value;

Yield required in the market rises, causing prices to fall

Premium Bond Bonds priced above the bond's par value;

 Yield required in the market decreased, causing prices
to rise

Duration Bond's interest rate sensitivity;

The ratio of the percent change in price to the percent
change in yield;
= (- Percent Change in Bond Price)/Yield Change in
Percent;
Longer maturities have longer durations;
Lower coupon rates have higher duration;
Callable bonds have lower duration;
Putable bonds have less duration risk

Reasons Floating Rate *Placing a cap on a floating rate can increase the interest
Might Reset at Par rate risk
*There is time until the next reset
*If the spread in indenture no longer reflects the credit
and liquidity risk of the bond

Parallel Shift Shift in the curve is when the entire curve shifts by the
same amount

Non-Parallel Shift When not all maturities change by the same amount

Disadvantages of +Uncertainty about cash flow stream

Callable Bonds +Principal tends to be returned at times when the
possibilities for reinvestment are less attractive
+Capital appreciation potential is less than an option-
free bond

Factors Increasing +Coupon is higher so interest cash flows are higher

Reinvestment Risk +A call feature
+Is amortizing
+Contains prepayment option

Types of Event Risk +Disasters

+Corporate Restructuring
+Regulatory Issues

Ways to Issue *Single price, regular auction cycle

Sovereign Debt *Multiple price, regular auction cycle
*Ad hoc auction services
*Tap system
Single Price, Regular Debt is auctioned periodically according to a cycle and
Auction Cycle the highest price (lowest yield) at which the entire issue
to be auctioned can be sold and is awarded to all
bidders

Multiple Price, Regular Winning bidders receive bonds at the price each bidder
Auction Cycle bid

Ad Hoc Auction Method where central government auctions new

Services securities when market conditions are advantageous

Tap System When issuance and auction of bonds identical to the

previously issued bonds

Types of Treasury +Treasury Bills

Securities +Treasury Notes and Bonds
+TIPS

Treasury Bills Maturities of less than a year and do not make explicit
interest payments;
Sold at a discount to par and pay out par value at
maturity;
The implied interest rate is called the implicit interest
rate;
Either 28 day (4 week), 91 day (3 month) or 182 day (6
month) maturities;
Sometimes offer cash management bills with very short
maturities

Treasury Notes and Bonds pay semi-annual coupons at a rate fixed at

Bonds issuance;
Notes have maturities of 2, 3, 5, and 10 years;
Until 1984, were callable every 5 years;
Bonds have maturities of 20 or 30 years

Bond Pricing Prices quoted in percent and 32nds of a percent;

102-5 is equal to $102.16 per bond

TIPS Inflation protected 5 and 10 year notes and 20 year

bonds;
Make semi-annual coupon payments at a rate fixed at
issuance;
Par value starts at $1,000 and is adjusted semi-annually
 for changes to the CPI;
COUPON IS PAID ON ADJUSTED PAR VALUE;
Bond holder gets the greater of $1,000 or the final
adjusted par value at maturity;
The par value increase is taxed as income in that year

On The Run Issues Most recently auctioned treasury issues;

More actively traded than other issuances;
Provide best information

Treasury Strips Treasury securities that are sold in bulk to large dealers,
who then strip out the coupons from principal,
repackage the cash flows, and sell them separately as
zero-coupon bonds;
Coupon strips are strips created from coupon payments
stripped from the original security;
Principal strips refer to principal payments with the
coupons stripped off;
Taxed on their implicit interest rate

Agency Bonds Securities issued by various agencies and organizations

of the Federal government;
Most aren't guaranteed by US Government explicitly, but
it is implicit;
Federally related institutions are owned by the US
Government and are exempt from SEC rules and are
guaranteed by US Gov't;
Government sponsored enterprises are privately owned
but publicly chartered organizations and were created
by Congress but not guaranteed by US Gov't

Federally Related +Tennessee Valley Authority

Institutions Not +Private Export Funding Corporation
Guaranteed

Mortgage Backed Backed by pools of mortgage loans that provide both

Securities collateral and cash flow;
Self-amortizing and can be paid early;
Issued by Ginnie Mae, Fannie Mae and Freddie Mac;
Cash flows are of periodic interest, scheduled principal
repayments, and unscheduled principal payments;
Mortgage pass through securities pass payments made
 on a pool of mortgages through proportionally to each
security holder;
Collateralized mortgage obligations are derivatives of
mortgage passthroughs;
Stripped mortgage-backed securities are either
principal or interest portions of a mortgage backed
security

Tax Backed (General Backed by the full faith, credit and taxing power of the
Obligation) Bonds issuer

Limited Tax General Subject to a statutory limit on taxes that may be raised to
Obligation Bonds pay off the obligation;
General obligation

Unlimited Tax General Backed by unlimited taxing power of the issuer;

Obligation Bonds General obligation

Double-Barrel Bonds Backed by both taxes but also special charges that are
collected outside of the general fund;
General obligation

Appropriations Backed When the state isn't the issuer but can act as a back up if
Obligations the issuer defaults;
General obligation

Debt Supported by An explicit guarantee that the bond is backed up by the

Public Credit state or federal government;
Enhancement General obligation

Revenue Bonds Supported by revenues from a specific project that is

funded by the proceeds of the issuance;
Only required to pay interest and back principal if the
project generates a sufficient amount of revenue

Insured Bonds Carry a third-party guarantee that cannot be cancelled

and is good for the life of the bond;
Usually raises rating to AAA;
More common for a revenue bond than general
obligation

Prefunded Bonds Bonds for which Treasury securities have been

purchased and placed in escrow to make all of the
remaining required bond payments;
 Income and principal from Treasuries must be enough to
cover remaining payments until maturity or next call
date;
Have little credit risk
Firm Specific Credit *Past payment history
Factors *Quality of management and their ability to adapt to
changing conditions
*Industry outlook and firm strategy
*Overall debt level of firm
*Operating cash flow and ability to service debt
*Sources of liquidity
*Competitive position, regulatory environment and union
history
*Financial management and controls
*Susceptibility to event and political risk

Issue Specific Credit *Priority of claim being rated

Factors *Value/quality of collateral pledged to issuance
*Covenants of issuance
*Any third-party guarantees or insurance

Secured Debt *Personal property

Collateral *Real property
*Financial assets

Debenture Unsecured bond

Unsecured Debt Credit *Third-party guarantees

Enhancements *Letters of credit that a bank will advance the issuer for
the service of its debt
*Bond insurance

Characteristics of +Shelf-registered and they do not need to be all sold at

Medium-Term Notes once
+Provide a range of maturities and yields the issuer
would like to sell
+A best-effort issuance and agent does not buy bonds
unsold
+No typical structure or terms

Structured Note Debt security combined with a derivative

Step-Up Note Structured note with coupon rates that raise on a set
schedule
Inverse Floater Structured note increase when reference rates decrease
and vice versa

Deleveraged Floater Structured note that has coupon rates that equal a
fraction of the reference rate plus a constant margin

Dual Index Floater Structured note that has two reference rates

Range Notes Floaters that equal the reference rate if it is within a

specific range or zero if it is outside the range

Index Amortizing Structured Note with fixed coupons but pay back some
Notes principal early based on a reference rate

Characteristics of +Maturities of 270 days or less

Commercial Paper +Pure-discount security
+Typically issued by corporations with strong credit
ratings
+Directly placed paper is sold to large investors without
going through a broker
+Dealer placed paper is sold to purchasers through a
commercial paper dealer

Certificates of Deposit Issued by banks and sold to their customers;

A promise by the bank to repay a certain amount plus
interest;
Issued in specific denominations and for specified
periods of time that can be of any length;
Penalty if funds are withdrawn earlier than the maturity
date

Banker's Acceptance Guarantees by a bank that a loan will be repaid;

Part of a commercial transaction;
Gives assurance to counterparty that financing is secure
for the trade;
Counterparty can sell the acceptance in a secondary
market or hold until it is paid;
Credit risks are the borrower does not repay or the
acceptance bank does not pay

Collateralized Debt Debt instrument where the collateral for the promise to
Obligation pay is an underlying pool of other debt obligations;
Tranches are created for seniority of cash flows
Arbitrage CDO Created by a sponsor seeks to profit from the spread
between the rate earned on the underlying assets and
the rate promised to CDO holders

Balance Sheet CDO Created by a bank to reduce its loan exposure on its
balance sheet

Underwritten Issues When a banker purchases the entire issue and resells it;
Arrangement is called a firm commitment;
Deal is called a bought deal;
Typically a syndicate of other banks is put together to
help sell issue;
Goal is to presell as much of the debt as possible

Best Efforts Sale When the banker agrees to sell as much of the issue as
possible;
Not liable for the debt left over

Negotiated Offering When the price is determined between the lead

investment bank and the issuer

Auction Process When the issuer determines the size and terms of the
issue and several banks bid on the interest rate required
to sell it;
Lowest interest rate bid wins the deal

Private Placement When an issue is sold to a small group of investors and is

not required to be registered with the SEC;
Issue can be better tailored for the investors' needs;
Buyers will require a slightly higher interest rate since
issue can not be resold to the public

Interest Rate Tools of +Discount rates

the Fed +Open market operations
+Bank reserve requirements
+Persuading banks to change credit policies

Shapes of Yield Curve +Normal (upward sloping)

+Inverted (downward sloping)
+Flat
+Humped

Interest Rate Theories +Pure Expectations Theory

+Liquidity Preference Theory
+Market Segmentation Theory
Pure Expectations The yield for a particular maturity is an average of the
Theory short term rates that are expected in the future;
If rates are expected to rise, yields on longer maturities
will be higher than on shorter maturities

Pure Expectations ~Short term rates expected to rise in future = normal

Theory Yield Curve curve
Ramifications ~Short term rates expected to fall in future = inverted
curve
~Short term rate expected to rise then fall = humped
curve
~Short term rate expected to remain constant = flat
curve

Liquidity Preference Both short-term rate expectations and a liquidity

Theory premium determine yields;
Consistent with longer maturities having higher yields;
Size of liquidity premium will depend on how much
additional compensation investors require to take on the
greater risk of longer maturity bonds;
Liquidity premium can distort information coming from
the yield curve

Market Segmentation The supply of bonds and demand for bonds determine
Theory equilibrium yields for various maturity ranges;
Different investors may have strong preferences for
maturity ranges that closely match their liabilities

Arbitrage-Free The rates for different time periods that correctly value a
Treasury Spot Rates Treasury bond;
Discount rates for a zero-coupon bond

Yield Spreads +Absolute yield spread

+Relative yield spread
+Yield ratio

Absolute Yield Spread The difference between yields on two bonds;

= Higher Bond Yield - Lower Bond Yield;
Most commonly used;
Shortcoming is it may always remain constant even as
yield rise or fall
Relative Yield Spread The absolute yield spread as a percentage of the
benchmark bond's yield;
= Absolute Yield Spread/Yield on Benchmark Bond

Yield Ratio The ratio of the yield on the subject bond to the yield on
the benchmark bond;
= Subject Bond Yield/Benchmark Bond Yield;
= 1 + Relative Yield Spread

Credit Spread The difference in yields between two issues that are
similar in all respects except credit rating;
Decline in an expanding economy;
Increase during economic contractions

After-Tax Yield = Taxable Yield * (1 - Marginal Tax Rate)

LIBOR The rate paid on negotiable CDs by banks and bank

branches located in London;
Most important reference rate for floating-rate debt

Funded Investor Investor who borrows to finance an investment position

Capital Budgeting identifying and evaluating capital projects....projects

process where the cash flow to the firm will be received over a
period longer than a year.

Capital Budgeting 1) idea generation

Steps 2) analyzing project proposals
3) create the firm-wide capital budget
4) monitoring decisions and conducing a post-audti

Cap Budgeting 1) decisions based on cash flows, not accounting income

Principals 2) Cash flows based on opportunity costs & taxes
3) timing of cash flows is important
4) Cash flows are analyzed on a after-tax basis
5) financing costs are reflected in the projects required
rate of return

Externalities effects the acceptance of a project may have on other

firm cash flows.

Cannibalization when a new project takes sales from an existing product

Conventional Cash sign on the cash flows changes only once, with one or
Flow Patter more cash outflows followed by one or more cash
inflows
Unconventional Cash more than one sign change.
flow patter

NPV decision rule accept any project with positive NPV and to reject any
(independent projects) project with a negative NPV

Internal rate of return discount rate that makes the PV of the expected
incremental after-tax cash inflows just equal to the initial
cost of the project.
PV (inflows) = PV (outflows)

IRR decision rule determine required rate of return for given project.
IRR > required rate return, accept
IRR < required rate return, reject

Payback period number of years takes to recover initial cost of

investment

Payback period = full years until recover + (unrecovered cost at beginning

of last year / cash flow during last year)

Discounted payback uses present values of the projects estimated cash flows.
period Number of years takes a project to recover its initial
investment in a PV term and must be greater than the
payback period without discounting.

Profitability Index (PI) PV of a projects future cash flows divided by the initial
cash outlay

PI = PV of future cash flows / CFo

also
1+ (NPV / CFo)

PI Decision Rule PI > 1, accept project

PI < 1, reject project

Crossover rate NPV's are equal

Key advantage of NPV direct measure of the expected increase in the value of
the firm. main weakness doesn't take consideration of
project size

Key advantage of IRR measures profitability as a %, showing the return on each

dollar invested. Provides info on margin of safety that
NPV does not.
 Disadvantages -
1) possibility of producing rankings of mutuall exclusive
projects different from NPV analysis
2) possibility are multiple IRRs or no IRR for project

Weighted Average marginal cost of capital (MCC) - discount rate

Cost of Capital
cost of financing firms assets. View as opportunity cost.

Kd rate at which the firm can issue new debt

Kd (1-t) After-tax cost of debt. t is firms marginal tax rate. The

after tax component cost of debt, Kd (1-t) is used to calc
WACC

Kps Cost of preferred stock

Kce Cost of common equity. Required rate of return on

common stock and is generally difficult to estimate

WACC = (Wd)[Kd(1-t)] + (Wps)(Kps) + (Wce)(Kce)

Wd = % of debt in cap structure

Wps = % preferred stock in cap structure
Wce = % C/S in cap structure

Optimal Capital intersection of investment opportunity schedule with the

Budget marginal cost of capital curve identifies amount.

After-tax cost of debt interest rate at which firms can issue new debt net of the
(Kd) tax savings from the tax deductibility of interest.

kd (1-t)

Kps = Dps / P

Preferred dividends / market price preferred

Cost of equity capital required rate of return on the firms common stock.

Capital Asset Pricing 1) Estimate RFR. yield on default risk-free debt such as
Model U.S Treasure notes are usually used.
2) Estimate stocks beta, B. Risk measure
3) Estimate the expected rate of return on market
4) CAPM to estimate the required rate of return
 Kcs = RFR +B [E(Rm) - RFR]
Dividend Discount Po = D1 / Kce - g
Model Kce =
Kce = (D1 / Po) + g

(D1 / Po) +g

Bond yield + risk Bond yield + Risk Premium

premium Kce =

Pure-play equity beta of a publicly traded firm that is engaged in a

business similar to, and with risk similar to, project under
consideration.

Beta Asset = Bequity x [ 1 / 1 + ((1-t) D/E) ]

D/E: comparable company's debt-to-equity ratio

t : marginal tax rate

Beta Project = Basset [ 1 + ((1-t) D/E) ]

Beta -estimated using historical returns data

-estimate is affected by which index is chosen to
represent market return
-revert toward 1 over time, and estimate may need to be
adjusted for this tendency
-estimates for small-cap firms may need to be adjusted
upward to reflect risk inherent in small firms

Country Risk Premium added to market risk premium when using CAPM

Sovereign yield spread general risk of developing country. Difference in yields

between the developing countrys government bonds
and T bonds of similar maturity.

Revised Capm with Kce = Rf + B [E (Rmkt) - Rf + CRP]

country risk premium

Country Risk Premium Sovereign Yield Spread x (annualized std of equity index
= of developing country / annualized std of sovereign
bond mkt in terms of developed mkt currency)

Marginal Cost of cost of the last new dollar of capital a firm raises. As firm
Capital raises more and more capital, the costs of difference
sources of financing will increase. Raising additional
capital increases WACC.

Shows WACC for differenc amounts of financing

Break Points occur at any time the cost of one of the components of
the company's WACC changes

Break Point = amount of capital at which components cost of capital

changes / weight of component in capital structure

Flotation Costs fees charged by investment bankers when a company

raises external equity capital.

incorrect treatment increase the WACC by a fixed

percentage and will be a factor for the duration of the
project because future project cash flows are
discounted at this higher WACC to determine NPV

Flotation costs are a cash outflow that occurs at the initiation of a

project and affect the project NPV by increasing the
initial cash flow. Correct way to account for flotation
costs is to adjust the initial project cost.

Leverage amount of fixed costs a firm has.

ex) operating expenses, building, equipment leases
-Greater leverage leads to greater variability of the firms
after-tax operating earnings and net income

Business risk risk associated with firms operating income and is result
of uncertainty about a firms revenues and expenditures
necessary to produce those revenues.

Sales Risk uncertainty about firms sales

Operating Risk additional uncertainty about operating EARNINGS

caused by fixed operating costs.

Financial Risk additional risk that a firm's common stockholders must

bear when a firm uses fixed cost (debt) financing. LT
leases also introduce risk.

DOL = percentage change in EBIT / percentage change in sales

Q (P-V) / Q (P-V) - F
 -------------------------------------------

S - TVC / S - TVC - F
S - sales
DFL = ratio of the percentage change in net income (or EPS) to
the percentage change in EBIT

% change in EPS / % Sales

or

EBIT / EBIT - interest

DTL = combines the degree of operating leverage and financial

leverage. DTL measures the sensitivity of EPS to change
in sales

= DOL x DFL

= (%ΔEBIT/%Δsales) x (%ΔEPS / %ΔEBIT) = (%ΔEPS /

%Δsales)

Look back at formulas Convince yourself if no fixed costs, DOL = 1 and if no

for DOL and DFL interest cost DFL = 1. Values of 1 mean no leverage.

Leverage & ROE ROE is higher using leverage than without. Also increases
the rate of change for ROE. ROE varies directly with the
change in EBIT.

Breakeven quantity of quantity of sales for which revenues equal total costs, so
Sales net income is zero.

Contribution margin difference between price and variable cost per unit, is
available to help cover fixed costs.

Qbe (break even (fixed operating costs + Fixed financing costs) / (Price -
quantity) = variable cost per unit)

Operating Breakeven Consider only fixed operating costs and ignore fixed
Quantity of Sales financing costs.
Qobe = fixed operating costs / (price - variable cost per
unit)
Special Dividends favorable circumstances allow the firm to make a one-
time cash payment to shareholders, in addition to any
regular dividends the firm pays.

Liquidating dividends when a company goes out of business and distributes

the proceeds to shareholders. Treated as a return of
capital and amounts over the investors tax basis are
taxed as capital gains

Stock Splits divide each existing share into multiple shares, thus
creating more shares. No change in wealth

After splits or - stock prices tend to rise after

dividends - trend - price increases appear because splits are taken as a
positive signal from mgmnt about future earnings
-If no good earning report, stock prices revert to
original levels
-tend to reduce liquidity due to higher percentage
brokerage fees on lower-priced stocks

Create more shares but do not increase shareholder

value

Reverse Stock Splits opposite of stock splits. Fewer shares outstanding but
higher priced stock.

Declaration Date date the board of directors approves payment of the

dividend

Ex-dividend date first day a share of stock trades without a dividend.

Occurs two business days before the holder-of-record
date. If buy a share on or after the ex-dividend date, you
will not receive the dividend

Holder-of-record date date on which the shareholders of record are

designated to receive the dividend.

Payment Date Date the dividend checks are mailed out - sent
electronically

Share repurchase transaction in which a company buys back shares of its

own common stock.

Buy in open market companies may repurchase stock in open market at the
 prevailing market price.
Buy a fixed number of Company may repurchase stock by making a tendor
shares at a fixed price offer to repurchase a specific number of shares at a
price that is usually at a premium to the current market
price.

Repurchase by direct companies may negotiate directly with large shareholder

negotiation to buy back a block of shares, usually at a premium to
the market price. Will reduce number of shares out, and
increase EPS

Share repurchase if share repo will increase company's EPS (vice versa)
after-tax cost of
borrowing is less than
earnings yield (vice
versa)

EPS after buyback = (total earnings - after-tax cost of funds) / shares

outstanding after buyback

BVPS BVPS will decrease if the purchase price is greater than

the original BVPS and increase if the repo price is less
than the original BVPS

Primary source of sources of cash it uses in its normal day-to-day

Liquidity operations.

Secondary sources of include liquidating short-term or long-lived assets,

liquidity negotiating debt agreements or filing for bankruptcy
and reorganizing the company.

Drag on liquidity delay reduce cash inflows, or increase borrowing costs

-uncollected receivables and bad debts, obsolete
inventory

Pulls in liquidity accelerate cash outflows.

-paying vendors sooner

Cost of trade credit = (1 + (% discount / 1 - % discount)) ^ (365/days past

discount) - 1

# days of payables = Accounts Payable / Average days purchases

Average days Annual purchases / 365

purchases =
Uncommitted line of bank extends an offer of credit for certain amount but
credit may refuse to lend if circumstances change

Committed (regular) bank offers credit that it "commits to" for some period of
line of credit time.

Revolving line of credit more reliable source of short-term financing than a

committed line. Typically for longer terms than
committed, sometimes as long as years.

Bankers acceptances used by firms that export goods. Guarantee from bank
of firm that has ordered goods stating that a payment
will be made upon receipt of goods

Factoring Actual sale of receivables at a discount from their face

values. Size of discount will depend on how long it is
until the receivables are due, creditworthiness of firms
credit customers, and firms collection history on
receivables.

Nonbank finance smaller firms or firms with poor credit use for short-term
companies funding

Commercial paper large creditworthy companies can issue short-term debt

securities called commercial paper. Firm sells paper
directly to investors (direct placement) or sells through
dealers (dealer-placed paper), interest costs slightly less
than rate can get from bank

Pro-forma balance forward-looking financial statements that are

sheets / IS constructed based on specific assumptions about future
business conditions and firm performance. (don't
confuse with proforma financial statements)

Constructing Sales 1 - estimate relation tween changes in sales and changes

Driven Pro Forma in sales-driven income statement and bal sheet items
Financial 2 - Estimate future tax rate, i rate on debt, lease
payments
3 - Forecast sales for period of interest
4 - Estimate fixed operating costs and fixed financial
costs
5 - Integrate these estimates into pro forma financial
statements for period of interest
Surplus difference between projected growth in assets and
projected growth in liabilities and stockholders equity

Corporate governance set of internal controls, processes, and procedures by

which firms are managed.

Net Profit Margin = NI / Sales

= EBT x (1 - t) / Sales

The Compensation 1) Link compensation with LT objectives

Committee should ...

How to determine if if after-tax cost of debt < earnings yield = EPS increases
shr repurchase will if after-tax cost of debt > earnings yield = EPS decreases
cause EPS to
increase/decrease

DBY (discount-basis (Face - purchase price / Face) x 360 / DTM

yield) DTM = days to maturity

Forward Commitment An agreement between two parties. Buyer agrees to buy

(or Forward Contract) an asset from a seller at a future date and price
established at the start. It is a completely customized,
OTC, product and includes forwards, futures and swaps.

Contingent Claim Options - Give a buyer the right but not obligation to
buy/sell a security at a predetermined price and date.
Includes OTC and exchange traded options.

Purpose and Criticism Purposes:

of Derivative Markets
Price discovery - often the contract closest to expiration
serves as a proxy for the price of the underlying asset.

Hedging - Companies want to lock-in a certain price for

a good they either rely on or produce in order to better
forecast their prices/costs.

Criticisms:
Too complex, fail to do their job, legalized gambling

What role does Arbitrage keeps prices in line across markets, products.
Arbitrage play in If arbitrage opportunities are available, they will be taken
determining prices and
promoting market advantage of until the prices converge - "The Law of
efficiency? One Price"

What is a swap? A forward contract that is equivalent to a series of

forwards. Usually, one cash flow is fixed, the other is
variable and tied to another rate (exchange rate, stock
price, commodity price). They are private transactions.

Explain default risk for The contract is not settled unless both parties deliver on
both long and short their side of the contract. Default risk is counter-party
positions in a forward risk in this case.
contract

Discuss how forward To terminate a forward prior to expiration, an off-setting

termination contract must be established. This exposes the investor
alternatives prior to to credit risk from both parties.
expiration can affect
credit risk.

Differentiate between A dealer will take the other side of a forward contract
a dealer and an end but will attempt to off-set the risk with another contract.
user of a forward An end user is using the forward either to speculate or
contract hedge their exposure to an asset.

Describe the Equity forward contract: The promise to deliver a certain

characteristics of stock, stock portfolio or stock index at a certain
equity forward price+date.
contracts

What is LIBOR? The rate of eurodollars, LIBOR (London Interbank Offer

Rate) is the rate at which London banks lend USDs to
other London banks.

What is a Eurodollar? Eurodollar: USD time-deposits outside of the US. Banks

Describe the borrow dollars from other banks by issuing Eurodollar
characteristics of the time deposits, which are essentially unsecured loans. The
Eurodollar time rate of the loans is LIBOR (London Interbank Offer Rate)
deposit market, and - the rate at which London banks lend USDs to other
define Eurobor London banks.

Eurobor: Euro time-deposits. The cost of borrowing

 Euros from another bank. Quotes issued by the ECB

How do you calculate (European

$10,000 x (1Central Bank).
+ .0525(30/360)) = $10,043,750 in 30 days.
the cost of a $10,000, The convention is to use 360 days. The quoted interest
30 day, 5.25% over 360 days is pro-rated and then added to the face
Eurodollar deposit? value. called "add-on interest."

What is a FRA? FRA = interest rate forward contract. You calculate the
Describe the gain/loss by determining the present value of the
characteristics and agreed upon rate and the present value of the market
calculate the gain/loss rate at expiration and determine the difference.
of forward rate
agreements (FRAs)

calculate and interpret 10,000,000(((.06-.055)(180/360))/(1.06(180/360))) =

the payoff of an FRA, $24,272
and explain each of Long makes money in this case.
the component terms.
Notional principal ((Underlying rate at Exp. - Forward
FRA expiring in 90 Contract Rate)(Days in underlying
days on the 180 day rate/360))/(1+Underlying rate at exp.(Days in underlying
LIBOR, quoted at 5.5%. rate/360))
Face value = $10M.
Real rate ends up FRA notation:
being 6%. 1 X 3 : Contract expires in 1 Month, underlying rate is 60
day LIBOR (3 b/c it is total time, including contract time
What does 1 X 3 and 12 included)
X 18 mean for an FRA?
12 X 18 : Contract expires in 12 months, underlying rate
180 day LIBOR

What is a Currency An agreement to buy/sell a certain amount of a currency

Forward Contract? at a certain time for a certain rate. Cash or delivery
Describe the settlement.
characteristics of
currency forward
contracts

What does it mean to Long = Buyer

be long vs. short in a Short = Seller
forward contract?
What are the methods Delivery = Seller delivers the good to the buyer
of settlement for a Cash Settlement.= Buyer and Seller exchange the net
forward contract? cash value at the settlement date.

Cash is much more common

What is a non- An exclusively cash settled forward.

deliverable forward
(NDF)?

Describe the Agreement to buy/sell a certain bond for a certain price

characteristics of at a certain date.
forward contracts on
zero-coupon and
coupon bonds

differentiate between Futures margins vs. Securities margin: For securities,

margin in the securities federal regulators set the margin. For Futures, the
markets and margin in clearinghouse sets the margin. Margin for futures is
the futures markets, expressed in dollar terms instead of as a percent as in
and explain the role of the securities market. Futures initial margin is usually
initial margin, much lower than securities market initial margin.
maintenance margin,
variation margin, and Initial margin - a minimum amount deposited to
settlement in futures demonstrate a commitment to pay the full value.
trading.
Maintenance margin - an amount lower than the initial
margin. If the balance of the margin account drops
below the maintenance margin, the account holder is
required to deposit enough money to return the account
to the initial margin level or close the position and settle
the loss.

Settlement price - the avg. of the final few trades of the

day.

Variation margin: additional margin posted to meet initial

margin after losing more than the maintenance margin.

describe price limits Limits: Absolute price change over the previous day
and the process of allowed for a specific futures contract. If price hits a limit,
marking to market, and the futures contract has made a limit move. Limit up, limit
calculate and interpret down. If a transaction cannot take place because of a
the margin balance, limit, it is called locked limit.
given the previous
day's balance and the Marking to market: The clearinghouse can mark to
change in the futures market, intraday and collect losses, distribute gains
price. through daily settlement to keep loses from getting out
of hand.
describe how a futures Via off-setting. If a buyer has purchased a certain future,
contract can be it offers for sale the same security.
terminated at or prior
to expiration

describe the Treasury bill futures: Not very popular. Calculated as

characteristics of the $1,000,000[1-rate(90/360)]
following types of
futures contracts: Eurodollar futures: Much more popular. Same calculation
Treasury bill, as Tbill.
Eurodollar, Treasury
Bond, stock index and Treasury Bond: Many choices on what bond can be
currency delivered so the exchange declares a hypothetical or
standard bond. Thus, if the short delivers a bond with
lower interest than the hypothetical bond, they will have
to pay additional money and vice versa. Thus, at
settlement, the futures price is multiplied by a
conversion factor which attempts to balance out the
value. Since different bonds cost different amounts to
buy in the open market and get multiplied by different
conversion factors, the seller is still able to deliver the
"cheapest to deliver" bond which fulfills their obligation.
Thus, it is assume that the cheapest to deliver bond
underlies the future.

Stock Index futures: Quoted in the same magnitude as

the index (1187 for the S&P which is trading at 1185 etc.)
but then is multiplied by a standard amount ($250 for
S&P) to determine the actual price. S&P futures expire
March, June, Sept, and Dec. on the Thursday before the
third Friday of the month. Cash settled.
 Currency Futures: A much smaller market than currency
forwards. Euro face value * conversion rate = price

Difference between 1) Futures are not private transactions

forwards and futures? 2) Futures are traded on a futures exchange
3) Futures are standardized
4) Futures have a secondary market
5) Futures are guaranteed against credit losses resulting
from a counter-party's ability to pay.
6) Futures contracts are regulated at the federal level

What types of options Stock options, index options, bond options (primarily
exist? OTC), interest rate options, currency options, options on
futures, commodity options, weather options, real
options

Define interest rate Interest rate cap: a series of interest rate calls, expiring
caps, floors and on the floating loan reset dates.
collars Interest rate floor: a series of interest rate puts, expiring
on the floating loan reset dates.
Interest rate collar: Long cap, short floor or Short cap,
long floor. The short offsets the cost of the long -- a
zero cost collar.

Define intrinsic value Intrinsic value is what an option is worth if exercised at

and time value, explain expiration in the current conditions.
their relationship.
Time value: the difference between intrinsic value and
the market price of the option.

As it gets closer to expiration, time value goes to zero

and all that is left is intrinsic value.

explain how option Higher the exercise price, lower the price of a call,
prices are affected by higher the price of a put and vice versa
the exercise price and
the time to expiration The greater the time till expiration, the higher the price
of the bought option.

Describe the An agreement between two parties to exchange a series

characteristics of swap of future cash flows
contracts and explain -initially, no cash is exchanged
how swaps are -payment is made at the settlement date through netting
terminated (reading unless the swap is initiated in two different currencies
72) -The final payment is made on the termination date
-The original time to maturity of the swap is called the
tenor of a swap
-Swaps are subject to default risk and can be tricky to
untangle. If A misses a payment to B but A's swap (after
being discounted to present) is worth more than B's, the
value of the swap will be used to settle the existing
liability.
*swaps are completely OTC

Swap Termination:
1) Can terminate the swap ahead of time, discount the
cash flows and pay the net difference. This can only
happen if both parties agree to do so in advance or if
both parties agree to at the time.
2) Terminate by setting up an off-setting swap. Exposes
you to dual default risk. Most likely, the off-setting swap
won't be perfect but at least the floating rate risk is no
longer present.
3) Exercise an off-setting swaption -- an option to enz
ter into a sway at terms that are established in advance

Chapter 7 versus Ch. 7 = protection for liquidation

Chapter 11 bankruptcy Ch. 11 = protection for reorganization
protection

Describe the sources Sources of return:

of return and risk for a 1) Collateral yield - the return on the cash used as margin
commodity investment 2) Roll Yield - the return from rolling forward the
maturity
3) Spot price - changes to the price

Contents of Footnotes +The basis of presentation such as the accounting period

+Information about the accounting methods used
+Additional information about extraordinary events

Contents of +The basis of presentation such as the accounting period

Management +Information about the accounting methods used
Discussion and +Additional information about extraordinary events
Analysis

Contents of Auditor's +Independent view of the firms financial statements

Opinion +Generally accepted accounting policies were used and
judgements were reasonable
+Explanation when accounting policies change from
year to year

Auditor's Opinions +Unqualified opinion

+A qualified opinion
+An adverse opinion
+A disclaimer opinion

Unqualified auditor's Indicates the auditor believes the statements are fine
opinion

Qualified auditor's There is an exception to accounting principles

opinion

Adverse auditor's The statements are not presented fairly or don't conform
opinion to standards

Disclaimer auditor's When the auditor cannot issue an opinion

opinion

Steps of Financial +State the objective and context

Statement Analysis +Gather data
Framework +Process data
+Analyze and interpret data
+Report conclusions and recommendations
+Update analysis

Accrual Accounts +State the objective and context

+Gather data
+Process data
+Analyze and interpret data
+Report conclusions and recommendations
+Update analysis

Accounting 1. Journal record every transaction by order of date in

Information Flow the general journal
2. The general ledger sorts the entries in the general
journal by account
 3. An initial trade balance is prepared at the end of the
period to show the balance of each account and
adjustments are then made
4. Financial statements are made from the adjusted trial
balances
Objectives of +Protect investors
International +Ensure market fairness, efficiency and transparency
Organization of +Reduce systemic risk
Securities
Commissions

SEC Forms +S-1

+10-K
+10-Q
+DEF-14A
+8-K
+144
+Forms 3, 4, 5

Form S-1 Filed before sale of a new security

Form 10-K Annual report

Form 10-Q Quarterly report

Form DEF-14A Proxy statement

Form 8-K Discloses material events

Form 144 Notice to the SEC of a sale of non-registered securities

Forms 3, 4, 5 Notices of insider ownership

Qualities of useful Relevance and faithful representation

financial statements

Enhancements of +Comparability
relevance and faithful +Verifiability
representation +Timeliness
+Understandability

Elements of IFRS' +Assets

Conceptual +Liabilities
Framework +Equity
 +Income
Going Concern The company will remain in operation for the
+Expenses
Assumption foreseeable future

Required Financial +Balance sheet

Statements +Income statement
+Cash flow statement
+Owner's equity
+Footnotes

Features of preparing +Fair presentation

financial statements +Going concern basis
+Accrual basis
+Consistency
+Materiality
+Aggregation of only similar items
+No offsetting of assets against liabilities or revenues
against expenses unless explicitly stated by a standard
+Reporting frequency is annual

Differences between +IASB lists income and expenses as elements related to

IFRS and GAAP performance, GAAP includes revenues, gains, loses and
comprehensive income
+GAAP defines an asset as having future economic
benefit, IASB defines an asset as a resource for which a
future economic benefit is probable
+GAAP doesn't allow for the upward valuation of most
assets

Characteristics of a +Transparency
coherent financial +Comprehensiveness
framework +Consistency

Barriers to Creating a +Valuation

Coherent Financial +Standard setting
Framework +Measuring value at a point in time versus it's movement
over a period of time

Responsibilities of Professional organizations to establish financial

standard-setting reporting standards
bodies
Responsibilities of Government agencies with legal authority to enforce
regulatory authorities compliance with financial reporting standards

Why Firms Support Would reduce the cost and the time spent on reporting
One Set of Reporting
Standards

Long Lived Assets: Disclosures are more extensive under GAAP

IFRS v. GAAP

Unrealized Included in net income

Gains/Losses on Held
For Trading Securities

Unrealized Included in comprehensive income

Gains/Losses on
Securities Available For
Sales

Closed End Fund Traded through secondary markets;

Initially sell for a small premium to the value of the
underlying assets

Open End Fund Issues and redeems new shares based on that day's
closing value;
May charge an upfront sales fee called a load
Sometimes there are back-end loads;
Annual fees are charged to cover management fees,
administrative expenses, distribution fees

Style Describes the basic characteristics of the underlying

assets

Sector Strategy Have its investments concentrate in a specific industry

Index Fund Match returns of a particular index

Global Fund Invests in strategies all over the world

Stable Value Fund Invests in short term government securities or other

investments that can provide timely principal payments
and a set interest rate

Exchange Traded Fund A fund that invests in a portfolio of stocks and bonds in
efforts to mimic an index;
Traded like a stock
In-Kind Creation and When authorized participants ensure an efficient and
Redemption orderly market;
Can create new shares by depositing with a trustee a
portfolio of stocks that track the index;
Can redeem shares with the trustee for underlying
portfolio;
Keeps market price close to NAV;
No capital gains to fund, resulting in no tax liability

Advantages of ETFs +Efficient diversification

+Traded like a stock
+Better risk management by having options and futures
markets
+Investors know the exact composition of the fund
throughout the day
+Low expense ratios
+No worry about trading a a premium or discount to
NAV
+Dividends can be reinvested immediately
+Low capital gains tax liability

Disadvantages of ETFs +Few indices for ETFs to track

+Intraday trading might not matter for long-term
investors
+Low volume may result in inefficient markets
+Institutions can get same exposure with lower expenses
and tax consequences by investing directly in the index

Risks of ETFs +Exposed to market risk

+Only invest in only a portion of the market, opening up
investor to asset class and sector risk
+If market isn't liquid enough, won't stick to NAV
+If doesn't replicate index exactly, there is tracking error
risk
+Can be levered and opened to credit risk by using
derivatives
+Can be exposed to country or currency risk

Outright Ownership of Holder has full ownership rights for an indefinite time
Real Estate period

Leveraged Equity Real Investor the same entitlements of outright ownership but
Estate Ownership must meet conditions of the loan
Mortgages Receives monthly principal and interest payments paid
by a borrower;
If borrower defaults, investor gets ownership

Real Estate Investing in a pool of real estate assets

Aggregation Vehicles

Ways to Value Real +Replacement cost

Estate +Comparable sales
+Income method
+Discounted after-tax cash flow model

Net Operating Income Gross operating income minus estimated vacancy,

collections and other operating expenses

Stages of Venture *Seed stage

Capital *Start-up financing i
*First stage financing
*Formative stage
*Later stage financing
*Second stage investing
*Third stage investing
*Mezzanine financing

Seed Stage Providing capital in the earliest stage of business;

Helps fund research and development

Start-Up Financing Funding used for completion of product development

and fund initial marketing efforts

First Stage Financing The funding used during the transition to commercial
production and sales of products

Formative Stage Spanning seed stage to first stage financing

Financing

Later Stage Financing Financing when marketable goods are in production and
sales are underway

Second Stage Investing in a company producing and selling a product

Financing that isn't generating income yet

Third Stage Financing Investing is when a company is going through a major

expansion
Mezzanine Financing Financing enables the company the financing to go
public

Venture Capital *Illiquidity

Investment *Long-term investment horizon
Characteristics *Difficult to value
*Limited information
*Good entrepreneurs don't always make good managers
*Market conditions play a big role in venture capital
returns
*Require extensive operations analysis
*Most implant factors are expected payoff at exit, timing
of exit, and probability of failure

Long/Short Fund Take long and short stock positions;

Largest category;
Not market neutral since they try to profit more from
their long positions than their short positions

Market-Neutral Fund A type of long/short fund that attempts to make money

despite what the general market is doing;
Long and short positions net themselves out

Global Macro Funds Make bets on the direction of a market, currency,

interest rate or some other factor;
HIghly levered through the use of derivatives

Event Driven Funds Strive to capitalize on some unique opportunity in the

market

Benefits of Funds of *Gives access to investors with limited capital resources

Funds *Greater diversification
*Fund of fund managers have expertise in picking
managers

Drawbacks of Funds of *Fees are higher than investing in a hedge fund by

Funds yourself
*Returns can be lowered by diversification

Ways Hedge Funds *Borrow through a margin account

Use Leverage *Borrow externally
*Utilize derivatives that do not require trading in cash

Risks of Hedge Funds +Illiquid

 +Hard to value underlying assets
+Counterparty credit risk
+Short squeezes
+Margin calls
Self Selection Bias When the only information available for reporting is from
managers who had good enough performance to want
to report it

Backfilling Bias When past performance of an index is inflated because

funds with poor performance in the past is not included

Smoothed Pricing Occurs because there is not daily pricing of hedge fund
assets

Hedge Fund Indices *Self-selection bias

Problems *Backfilling bias
*Survivorship bias
*Smoothed pricing
*Return measures do not account for unlimited downside
with limited upside with options
*The incentive fees give the manager reason to take
extra risk since they have nothing to lose

Distressed Securities When companies are about to or have filed for

bankruptcy;
Company sometimes tries to negotiate a restructuring
outside of court;
Debt holders try to get equity stakes;
Illiquid with long investment horizons

Reasons to Invest in +Exposure to economic growth

Commodities +Hedge against inflation
+Diversification

Collateralized Require buying a specific futures contract and buying

Commodities Futures government securities, with a market value equal to the
Positions contract value of the futures contract;
Any gains from the futures contract would be used to
buy more government securities and cover margin calls
by selling them;
Total return is the change in commodities' prices plus the
interest from the government securities
Contango When a future price is above the spot price;
Caused by companies wanting to lock in future rates to
match future liabilities

Backwardation When a futures price is below the spot price;

Caused by hedgers to insure against price declines in
the future;
Some markets are described as having normal
backwardation

Sources of Commodity +Collateral yield

Returns +The price return
+Roll yield

Indexed Commodity An active investment because rolling risk and investing

Strategy on the futures curve require active management;
Weights of various commodities and blocks can change
over time and must be managed;
Collateral must be managed

Common Shares ownership interest. Residual claim (what's left after debt
holders and preferred stockholders)

Proxy having someone else vote as they direct them on their

behalf

Statutory Voting each share held is assigned one vote in the election of
each member of the board of directors.

Cumulative voting shareholders can allocate their votes to one or more

candidates as they choose. Benefits shareholders.

Callable common firm the right to repurchase the stock at a pre-specified

shares call price

Putable common shareholder the right to sell the shares back to the firm
shares at a specific price. places a floor under the share value.

Preference Shares no voting rights usually, fixed periodic payments.

Cumulative preferred promised fixed dividends and any dividends that are not
paid must be made up before common shareholders
can receive dividends.

Non-cumulative do not accumulate over time when they are not paid but
preferred dividends for any period must be paid before common
 shareholders can recieve.
Participating receive an extra dividend if firm profits exceed a
preference shares predetermined level and may receive a value greater
than par of preferred stock if firm is liquidated.

Non-participating claim equal to par value in the event of liquidation and

shares do not share in firms profits.

Convertible can be exchanged for common stock at a conversion

preference shares ratio determined when the shares are originally issued.

Convertible - Preferred dividend is higher than common dividend

Preference Shares - firm is profitable, the investor can share in profits by
advantages converting their shares into common stock
- Conversion option becomes more valuable when the
common stock price increases
- Preferred shares have less risk than common shares
because the dividend is stable, and they have priority
over common stock in receiving dividends and in the
event of liquidation of the firm.

Private equity usually issued to institutional investors via private

placements.
-less liquidity, no public market
-share price negotiated between firm and investors
-More limited firm financial disclosure, no gov't
exchange
-Lower reporting costs
-potentially weaker corporate governance
-greater ability to focus on long-term prospects, no
public short term pressure
-potentially greater return once goes public

Venture Capital capital provided to firms early in their life cycles to fund
their development and growth. Illiquid and investors
often have to commit funds to three to ten years before
they can cash out.

Leveraged Buyout investors buy all of firms equity using debt financing
(LBO) (leverage). If LBO is firms current management it's a
management buyout. (MBO).

Private Investment in public firm that needs capital quickly sells private equity
Public Equity (PIPE) to investors.
Direct Investing in securities of foreign companies simply refers to buying
a foreign firms securities in foreign markets.

Direct Investing - investment and return are in foreign currency

Obstacles - foreign stock illiquid
-reporting requirement of foreign stock less strict
-investors must be familiar with the regulations and
procedures of each market in which the invest.

Depository Receipts represent ownership in a foreign firm and are traded in

the markets of other countries and local market
currencies. Bank deposits shares of the foreign firm and
then issues receipts representing ownership of a specific
number of the foreign shares.

Depository banks act as a custodian and manages dividends, stock splits,

and other events. Investor does not have to convert to
the foreign currency, the value of the DR is affected by
exchange rate changes as well as firms fundamentals,
economic events and other factors

Sponsored DR firm is involved with the issue. Provides investor voting

rights and usually subject to greater disclosure
requirements. Unsponsored, depository bank retains
voting rights

Global Depository issued outside the US and issuers home country. Most
Receipts traded in London and Luxembourg exchanges.

American Depository denominated in US dollars and trade in the US.

Receipts

4 types of ADR's (chart -OTC

page 268 bk 4) -NYSE, NASDAQ, AMEX
-NYSE, NASDAQ, AMEX
-Private

Global Registered traded in different currencies on stock exchanges

Shares around the world

Basket of listed exchange-traded fund (ETF) that is a collection of DRs.

depository receipts ETF shares trade in markets just like common stock.
(BLDR)

book value of equity value of the firms assets and the balance sheet minus it's
 liabilities
Market value of equity total value of a firms outstanding equity shares based on
market prices and reflects the expectations of the
investors about the firms future performance.

Accounting return on calculated as net income available to common (NI - PF

equity (ROE) div) divided by the average book value of common
equity over period

ROE = NI / Average BV

Price-to-book ratio market value of a firms equity divided by the book value
of it's equity

Value Stock low price-to-book

Growth Stock higher price-to-book

cost of equity expected equilibrium total return (including dividends)

on it's shares in the market. Using dividend discount
model or capM. Decrease in share price will increase the
expected return on the shares and increase in share
price will decrease expected returns. Increase in
required return used to discount future cash flows will
decrease intrinsic value. Vice versa

Industry Rotation overweighting or underweighting industries based on

current phase of business cycle

Sector Classification Global Industry Classification Standard (GICS)

Russell Global Sectors (RGS)
Industry Classification Benchmark

Cluster analysis Historically group firms by highly correlated returns

Cluster limitations -high correlations may not be same as future

-groupings may differ over time
-grouping is sometimes non-intuitive
-method is susceptible to a central issue in statistics

Commercial Sector, industry, sub-industry

classifications GICG by S&P
MSCI Barra
Russell Global Sectors
Industry classification benchmark by Dow Jones and
FTSE
Basic materials building materials
chemicals
paper and forest products
containers and packaging

Consumer cyclical - selling goods and services in industries

discretionary -automotive
-apparel

Consumer Staples firms are less cyclical and sell goods and services
-food
-beverage
-tobacco

Energy energy
refining
production

Financial Services banking

insurance
real estate

Health Care Pharmaceuticles

Biotech

Industrial and produce capital goods for commercial services

producer durables industries
-heavy machinery
-aerospace
-defense

Technology Firms -Computers

-Software
-Semiconductor

Telecommunications wired and wireless service providers

International Standard Produced by United Nations in 1948 to increase global

Industrial Classification comparability of data
of All Economic
Activities (ISIC)

Statistical Classification similar to the ISIC, but is designed for Europe

of Economic Activities
Autralian and New jointly developed by those countries
Zealand Standard
Industrial Classification

North American jointly developed by the US, Canada and mexico

Industry Classification
System (NAICS)

Cyclical Firm one whos earnings are highly dependent on the stage of
the business cycle. High earnings volatility and high
operating leverage
ex) autos, housing, technology

Non-cyclical produces goods and services for which demand is

relatively stable over the business
ex) health care, utilities, and food and bev

Defensive industries those that are least affected by the stage of the business
cycle and include utilities, consumer staples, and basic
services.

Growth Industries demand so strong they are largely unaffected by the

stage of the business cycle

Peer group set of similar companies an analyst will use for valuation
comparisons

Experience curve shows the cost per unit relative to output

Macroeconomic cyclical or structural (Longer-term) trends, most notably

factors economic outputs as measured by GDP or some other
measure.

Technology
Demographic
Governments
Social Influence

Industry Life Cycle should be a component of an analysts strategic analysis.

-embryonic
-growth
-shakeout
-mature
-decline
Embryonic Stage Slow growth
high prices
large investment required
high risk failure

Growth Stage rapid growth

limited competitive pressures
falling prices
increasing profiability

Shakeout Stage Growth has slowed

Intense competition
Increasing Industry overcapacity
Declining profitability
Increased cut costing
Increased failures

Mature Stage Slow growth

Consolidation
High barriers
Stable Pricing
Superior Firms Gain Market Share

Decline Stage Negative Growth

Declining prices
Consolidation

Industry Concentration -Absolute market share may not matter as much as firms
market share relative to competitors
-if industry products are undifferentiated and
commodity-like, then consumers will switch to lowest-
priced producer
-industry is capital intensive, therefore costly to enter or
exit, overcapacity can result in intense price competition

Intrinsic Value rational value investors would place on asset if they had
full knowledge of assets characteristics

Invest based on 1) larger % diff tween mkt prices and estimated values,
differences between the more likely the investor is to take a position based on
market prices and the estimate of intrinsic value.
intrinsic 2) more confident investor is about the appropriateness
of the valuation model used, the more likely the investor
 is to take an investment position in a stock that is
identified as overvalued or undervalued
Invest based on 3) More confident the investor is about the estimated
differences between inputs used in valuation model, more likely the investor is
market prices and to take an investment position in a stock that is identified
intrinsic as overvalued/undervalued.
4) even if assume mkt prices sometimes deviate from
intrinsic values, market prices must be treated as fairly
reliable indications of intrinsic value.
5) position in stock identified as mispriced in mkt, an
investor must believe that the mkt price will actually
move toward its estimated intrinsic value and that it will
do so to a significant extent within the investment time
horizon

Discounted cash flow stocks value is estimated as the PV of cash distributed to

models shareholders (DDM) or the PV of cash available to
shareholders after the firm meets its necessary capital
expenditures and working capital expenses (FCF to
Equity Model)

Multiplier model can be used to estimate intrinsic values.

1) ratio of stock price to such fundamentals as earnings,
sales, bk value, cash flow per share
2) enterprise value

Enterprise Value market value of all a firms outstanding securities minus

cash and short-term liabilities.
common stock value estimated by subtracting the value
of liabilities and preferred stock from an estimate of
enterprise value.

Asset-based models intrinsic value of common stock is estimated as total

asset value minus liabilities and preferred stock.

Dividend Discount based on rationale that intrinsic value of stock is the PV

Model of future dividends
Vo = SUM (Dt / (1+ke)^t)
Vo - current stock value
Dt - dividend at time t
Ke- required rate of return on common equity
One-year holding Value of stock today is PV of any dividends during the
period DDM year plus the PV of the expected price of the stock at
the end of the year (terminal value).

One year holding Value = (dividend to be rec'd / (1+Ke) ) + (year end price /
period DDM = (1+Ke))

Multiple year HP DDM sum PV of estimated dividends over holding period.

value = D1 / (1+Ke),,,,,

Free Cash Flow to often used in discounted cash flow models instead of
Equity dividends because it represents the potential amount of
cash that could be paid out to shareholders. Firms
capacity to pay dividends. Defined as cash remaining
after a firm meets all debt obligations and provides for
the capital expenditures necessary to maintain existing
assets and to purchase new assets needed to support
the assumed growth of the firm.

FCFE = Net Income

+ depreciation
- increase working capital
- fixed capital investment (FCInv)
- debt principal repayments
+ new debt Issues

FCFE = CFO
- FCInv
+ Net borrowing

Net borrowing increase in debt during the period and is assumed to be

available to shareholders.

DDM in terms of FCFE Vo = SUM FCFEt / (1+Ke) ^t

=

CAPM estimate of required rate of return (ki) for security i as

function of its systematic risk (bi) and risk-free rate (Rf)
and the expected return on the market [E(Rmkt)]

CAPM Ki = Rf + Bi[E(Rmkt) - Rf]

Preferred Stock pays dividend that is usually fixed and indefinite maturity.
When fixed the stream of dividends is infinte:

Dp/(1+Kp)^1.....
Gordon growth model assumes annual growth rate of dividends, ge, is constant

Vo = Do (1+Gc)^1 / (1+Ke).....

uses single constant growth rate of dividends and is

most appropriate for valuing stable and mature, non-
cyclical, dividend-paying firms

Gordon Model Vo = D1 / Ke - Gc
simplified
Valuation model for preferred stock is the same as the
constant growth model with no growth (g = 0)

Gordon Assumptions - dividends are the appropriate measure of shareholders

wealth
- Constant dividend growth rate, Gc, and RR on stock,
Ke, are never expected to change
-Ke must be greater than Gc

look for words like "forever, indefinitely, infinitely,

foreseeable future"

Ke and Gc relationship - difference between widens, stock value falls

- difference narrows, stock rises
- small changes in difference can cause large changes in
stock value

Estimate growth rate 1) historical growth in dividend for the firm

on div, three methods 2) median industry in dividend growth rate
3) estimate the sustainable growth rate

Sustainable growth (1 - dividend payout ratio) x ROE

rate =
rate of which equity, earnings and dividends can
continue to grow indefinitely assuming that ROE is
constant, the dividend payout ratio is constant, and no
new equity is sold.

Retention Rate = (1 - dividend payout ratio)

proportion of net income that is not paid out as
dividends and goes to RE thus increasing equity
Multistage dividend add the PV of dividends expected during the high-
discount model growth period to the PV of the constant-growth value of
the firm at the end of the high-growth period
Value = D1 / (1+Ke)

Terminal Stock Value Pn = Dn+1 / Ke -Gc

Steps multistage -determine discount rate Ke

model: -project size & duration of high initial dividend growth
rate
-Estimate dividends during high growth period
-Estimate Gc rate at end of high growth period
-Estimate first dividend that will grow at constant rate
-Use Gc to calc stock value at end of high growth period
-add all PV of all dividends to PV od terminal value of
stock

Price Multiple analyst compares a stock price multiple to a benchmark

value based on an index, industry group of firms, or a
peer group of firms within an industry.

Price multiples based Compare price multiple such as P/E for a firm to those of
on comparable other firms based on market prices

Price multiples based multiple based on some valuation model and therefore
on fundamentals are not dependent on the current market prices of other
companies to establish value

P/E Ratio firms stock price / earnings per share

Price-sales ratio firms stock price / sales per share

Price-book value Firms stock price divided by book value of equity per
share

Price-cash flow stock price / cash flow per share (operating or FCF)

Gordon Growth Value Po = D1 / K-G

Justified P/E assuming we have correct inputs for D1, E1, Kc and g, the
equation above will provide a P/E ratio that is based on
the PV of future cash flows. (leading PE ratio)
- serves a benchmark for the price at which the stock
should trade
Dividend displacement higher dividends will increase firm value, a lower growth
of earnings rate will decrease firm value

Law of one price asserts two identical assets should sell at the same price,
or have same multiple

Disadvantages of using 1) stock may appear overvalued by comparable but

price multiple based undervalued by fundamental
on comparable 2) different accting methods can result in price multiples
that are not comparable across firms
3) price multiples for cyclical firms may be greatly
affected by economic conditions

Enterprise Value measures total company value. Viewed as what it would

cost to acquire firm

EV = market value of CS
+ Mkt Value of debt
-cash and short-term investments

want to compare values of firms that have significant

difference in capital structure.

Asset-based models based on idea that equity value is the market or fair
value of assets minus the market or fair value of
liabilities.

Discounted Cash Flow -based on fundamental concept of discounted PV and

Model Advantages well grounded in finance theory
-Widely accepted in analyst community

Discounted Cash Flow -inputs must be estimated

Model Disadvantages -value estimates are sensitive to input values

Comparable Valuation - evidence that some price multiples are useful for
of Price Multiples predicting stock returns
advantages -price multiples widely used
-price multiples readily available
-Can be used in time series and cross-sectional
comparisons
-EV/EBITDA useful when comparing firm values
independent of cap structures or when earnings are
negative and PE can't be used
Comparable Valuation -lagging price multiple reflect past
of Price Multiples -Price multiples may not be comparable across firms
Disadvantage -for cyclical firms may be greatly affected by economic
conditions
-overvalued by comparable, under by fundamental
-Different accounting methods
-negative denominator results in meaningless ratio

Advantages of price -based on theoretically sound valuation models

multiple valuation -correspond to widely accepted value metrics
based on
fundamentals

Disadvantages of price -price multiples based on fundamentals will be very

multiple valuation sensitive to the inputs
based on
fundamentals

Advantages of asset- -provide floor values

based models -most reliable when firm has primarily tangible short-
term assets, assets with ready market values, or when
firm is liquidated
-increasingly useful for valuing public firms that report
fair values

Disadvantages of -mkt values are often difficult to obtain

asset-based models -mkt values are usually different than book values
-inaccurate when a firm has high proportion of
intangible assets or future cash flows not reflected in
asset values.
-assets can be difficult to value during periods of
hyperinflation

Cost leadership (low firm seeks to have lower costs of production in its
cost) strategy industy, offer the lowest prices, and generate enough
volume to make a superior return.

Predatory Pricing firm hopes to drive out competitors and later increase
prices. laws prohibiting , hard to prove if prices not
easily traced

Differentiation strategy firms products and services should be distinctive in

terms of type, quality, or delivery. For success, firms cost
 of differentiation must be less than the price premium
buyers place on product differentiation. Should be
sustainable over time.
Porters 5 forces that 1. Rivalry among existing competitors
determine industry 2. Threat of new entrants
competition 3. Threat of substitute products
4. Bargaining power of buyers
5. Bargaining power of suppliers

Commodity Index future prices and the roll yield

Returns reflect the
changes in ...

Maintenance/Initial Initial Margin = 1 / leverage ratio

Margin & Margin Calls
= P0 x (1 - initial margin / 1 - maintenance margin)

Capital Budgeting The process of identifying and evaluating projects where

the cash flow to the firm will be received over a period
longer than a year

Why Capital Budgeting *Involves large transactions

is Important *Same principles apply to most corporate decision
making
*Objective way to maximize shareholder value

Categories of Capital +Replacement projects to maintain the business

Budgeting Projects +Replacement projects for cost reduction
+Expansion projects
+New product or market development
+Projects mandated by governments or agencies
+Projects not easy to analyze under capital budgeting

Administrative Steps to *Idea generation

Capital Budgeting *Analyzing project proposals
*Create firm-wide capital budget
*Monitoring decisions and conducting a post-audit

Principles of Capital +Decisions are based on cash flows, not accounting

Budgeting income
+Cash flows are based on opportunity costs
*Opportunity costs need to be analyzed
+Cash flow timing is important
 +Cash flows are analyzed after taxes
+Financing costs are incorporated in the required rate of
return

Conventional Cash Signs of cash flows only change once

Flow Pattern

Project Selection Independent projects can be evaluated based on its

own profitability;
Mutually exclusive projects allow for only one to be
selected from the group;
Some projects may need to be completed in sequence,
and if the preceding project wasn't profitable, the next
might not be undertaken;
At times only a set amount of capital might be available
and rationing decisions must be made

Selection Methods -NPV

-IRR
-Payback Period
-Discounted Payback Period
Profitability Index

Discounted Payback Calculates the time it takes to get back invested capital
Period in present value terms;
Alleviates the problem of the regular payback period by
incorporating The time value of money;
Doesn't take into account payback after investment is
recouped

Profitability Index = Present Value of Cash Flows/Initial Investment

= 1 + NPV/Initial Cash Flow

NPV Profile A graph that shows a project's NPV for different discount
rates;
Discount rate on the X axis, NPV on the Y;
IRR is where the line intersects the X axis;
The point where multiple projects intersect is called the
crossover rate

Advantages of NPV NPV: A direct measure of the expected increase in the

and IRR value of a firm
 IRR: A percentage and shows return on each dollar
Drawbacks of NPV and invested
NPV: It is an absolute measure and doesn't take into
IRR account the size of the project.
IRR: It is not too useful for mutually exclusive projects
and a project could have multiple or no IRR

Criteria for Capital +Location (Europeans use payback period a lot more)
Budgeting Method +Size of company (Larger companies are more likely to
use NPV or IRR)
+Public vs Private (Private companies prefer payback
period, public companies prefer NPV or IRR)
+Management education (The more education
management has, the more they will use IRR or NPV)

Weighted Average The discount rate used in capital budgeting;

Cost of Capital = (Weight of Debt) (After Tax Cost of Debt) + (Weight of
Preferred Stock) (Cost of Preferred Stock) + (Weight of
Common Equity) * (Cost of Common Equity)

Marginal cost of upward, downward

capital slopes ____,
investment opportunity
schedule slopes ____

Cost of Debt Equals the market's yield to maturity

Cost of Preferred Equals the dividend yield of the preferred stock

Stock

Approaches to +CAPM
Calculating Cost of +Dividend Discount Model
Equity +Bond Yield + Risk Premium

CAPM Approach 1 Estimate risk free rate of government bond with

maturity closest to the life of the project
2. Estimate beta
3. Estimate the expected return of the market
4. CAPM = Risk Free Rate + (Beta) * (Estimated Market
Return - Risk Free Rate)

Dividend Discount Cost of Equity = (Expected Constant Growth Rate) +

Model [(Next Year's Dividend)/(Stock Price)]

Bond Yield + Risk Cost of Equity = Risk Free Rate + Risk Premium
Premium
Beta Measure of systematic risk

Beta Pure Play Method Looking at a publicly traded security of a company

involved directly in the business the project is engaged
in;
Company's beta is also a product of its capital structure
and must be adjusted accordingly to fit the need of the
project;
Delever the comparable beta and relever for the project
in question

Asset Beta = Equity Beta * [1/1 + (Debt/Equity)(1 - Tax Rate)]

Project Beta = Asset Beta [1 + (Debt/Equity) (1 - Tax Rate)]

Problems with Pure ~Beta uses historical data and sensitive to the length of
Play time and frequency of data
~Affected by which index is chosen to represent the
market return
~Betas are believed to revert to 1 after time and the
estimate may need to be adjusted accordingly
~Betas of smaller firms may need to be adjusted upward
to reflect risk inherent in small firms not captured by
Beta calculation

Country Risk Premium Sometimes added to Beta to capture specific country

risk;
Spread between Treasury yield and country's yield;
= Sovereign Yield Spread * (Annualized St. Dev. Of
Developing Country Equity Index)/(Annualized St. Dev.
Of Developed Country Bond Market)
CAPM = Risk Free Rate + (Beta) * (Estimated Market
Return - Risk Free Rate + Country Risk Premium)

Break Point Where the cost of one of the WACC components

changes;
= Amount of Capital at which the Component's Cost
Changes/Weight of the Component in Capital Structure

Flotation Costs Fees charged by investment banks when raising equity

capital;
Correct way to account for flotation costs is to include
them in the initial project cost
Leverage Amount of fixed costs a firm has

Business Risks Risks associated with a firms' operating income and is the
result of uncertainty about a firm's revenues and
expenditures

Financial Risk Risk that the firm's common stockholders must bear
when a firm uses fixed cost financing

Degree of Operating = (Percent Change in EBIT)/(Percent Change in Sales)

Leverage = [Quantity of Units Sold (Price per Unit - Variable
Cost)] /[Quantity of Units Sold (Price per Unit - Variable
Cost) - Fixed Cost]
= (Sales - Total Variable Costs) / (Sales - Total Variable
Cost - Fixed Costs]

Degree of Financial = (% Change in EPS)/(% Change in EBIT)

Leverage = (EBIT)/(EBIT - Interest)

Total Leverage = Degree of Operating Leverage * Degree of Financial

Leverage

Break Even Quantity of Quantity of sales for which revenues equal total costs so
Sales net income is zero;
= (Fixed Operating Costs + Fixed Financing Costs)/(Price
- Variable Costs per Unit)

Contribution Margin Difference between price and variable cost per unit

Operating Break Even = Fixed Operating Costs/(Price - Variable Cost per Unit)
Cost of Sales

Types of Dividends -Regular dividends

-Special dividends
-Liquidating dividends
-Stock dividends
-Stock splits
-Reverse stock splits

Regular Dividend When a company pays out a portion of its profits on a

regular basis;
Sign of company stability

Special Dividend Used when favorable circumstances allow a firm to make

a one-time cash payment to shareholders,in addition to
any other dividends it pays
Liquidating Dividend When a company goes out of business and distributes its
proceeds to shareholders;
Treated as a return of capital for tax reasons and not
taxed unless it is over the investor's cost basis

Stock Dividend Dividends paid as newly issued stock

Stock Split When each existing share is divided into multiple shares;
No change in owners wealth;
Share price drops accordingly;
Historically, stocks rise after a split because it is seen as
a positive sign

Dividend Dates +Declaration date

+Ex-dividend date
+Holder-of-record date
+Payment date

Declaration Date The date the board of directors approves the dividend

Ex-Dividend Date The first day the stock trades without the dividend;
If stock bought on or after, it does not receive the
dividend;
Always two business days before the holder of record
date;
Stock falls by dividend amount on the ex-dividend date

Holder-Of-Record The date that share holders on record are owed the
Date dividend

Payment Date The date dividend checks are sent out

Share Repurchase A company buys back shares of its own common stock;
Increases earnings per share;
EPS RISES IF EARNINGS YIELD > COST OF BORROWED
FUNDS;
EPS FALLS IF EARNINGS YIELD < COST OF BORROWED
FUNDS;
Purchasing with company funds reduces interest income
and earnings;
Purchasing with borrowed funds incurs interest costs;
BOOK VALUE PER SHARE WILL INCREASE/DECREASE
IF THE PURCHASE PRICE IS LESS THAN/GREATER
 THAN THE BOOK VALUE PER SHARE;
Ways for Company to Alternative tothe
+Buy stock in a cash
opendividend
market at prevailing market price
Buy Back Stock +Negotiate directly with a large shareholder to buy back
it's shares, usually at a premium to the market price
+Make tender offer to buy a certain number of shares at
a set price

Liquidity Drag Delay or reduce cash inflows or increase borrowing

costs

Liquidity Pull Accelerate cash outflows

Operating Cash Cycle The average number of days that it takes to turn raw
materials into cash proceeds;
= Days of Inventory + Days of Receivables

Components of Net *Treasury bills

Daily Cash Position *Short term agency securities
*CDs
*Banker's acceptances
*Time deposits
*Repo agreements
*Commercial paper
*Money market funds
*Adjustable rate preferred stock

Face Value Discount = (Fair Value - Price)/Face Value

Discount Basis Same as bank discount yield;

= (Face Value Discount) * (360/ Days)

Uncommitted Line of An offer of credit for a certain amount a bank extends

Credit but may refuse to lend if conditions change

Committed Line of When a bank commits to lending a certain amount over a

Credit certain period of time

Banker's Acceptances Guarantees from a bank stating that a firm has ordered
goods and a payment will be made at the receipt of the
goods, which the firm sells at a discount immediately to
generate cash

Commercial Paper A short-term debt security that can be sold directly to

investors or through dealers

Pro-Forma Statement *Estimate relationship between changes in sales and the

Steps changes in sales-driven income statement and balance
sheet items
*Estimate the future tax rate, interest rates on debt, lease
payments, etc
*Forecast sales
*Estimate fixed operating costs and financing costs
*Integrate estimates into pro forma statement
Corporate The set of internal controls, processes and procedures
Governance by which firms are managed and defines the rights, roles
and responsibilities of management

Considerations When *Majority of Board is comprised of independent

Electing Board members (not managers)
*Board meets regularly without management
*Chairman is current or former CEO
*Independent Board members have a primary or leading
Board member in cases when the chairman is not
independent
*Board members are closely aligned with suppliers,
customers, etc

Considerations of Firm *Whether it is a classified board (staggered multi-year

Voting Policy terms) or annual elections
*Whether Board filled a vacancy without shareholder
approval
*Whether shareholders can remove member
*Whether the Board is the proper size

Restrictions of Board's *The firm, it's subsidiaries, or former employees

Business Dealings *Individuals or groups with a controlling interest
*Executive management or their families
*Firm's advisors, auditors and families
*An entity with a cross directorship with the firm

Board Member +Make informed decisions about the firm's future

Qualifications +Have made public statements indicating their ethical
stance
+Have not had any legal or regulatory problems as a
result of working for or serving on a board
+Have other board experience
+Will regularly attend meetings
+Do they have significant stock positions and are
 committed to shareholders
+Have they served on the board for a long time and
become too close to management
Takeover Defenses +Golden parachute
+A poison pill
+Greenmail

Golden Parachute A rich severance package for managers who lose their
jobs after a takeover

Poison Pill Giving certain rights to existing shareholders if a certain

amount of the stock is acquired

Greenmail The right of the company to use corporate funds to buy

back the shares of a hostile acquirer at a premium to
market value

Increased Collection Indicates that customers are taking longer to pay their
Period outstanding accounts;
Represents a drag on the company's liquidity

Marginal Cost of Show changes in the cost of capital

Capital Break Points

Incremental Cash Flow Does not include financing costs

Selecting an External Responsibility of the Board's audit committee

Auditor

Require Shareholder Prevents shareholders from attending all the meetings

Attendance to Vote and therefore exercising their full voting rights
Hold Their Meetings
on the Same Day but
in Different Locations

Treatment of Float Treat as a cash outflow at project initiation rather than as

Costs a component of the cost of equity

Use of Accounts To identify trends in how well the firm is doing at

Receivable Aging collecting receivables and converting them to cash
Schedule

Role of Nominations Regularly reviewing performance, independence, skills,

Committee and experience of existing board members
Portfolio Perspective Evaluating individual investments by their contribution to
the risk-return of a portfolio

Diversification Ratio The ratio of the risk of an equally weighted portfolio of n

securities to the risk of a single random security from the
list of n securities

Types of Investors +Individual investors

+Institutions
+An endowment fund
+A bank
+Insurance companies
+Investment companies
+Sovereign wealth funds

Portfolio Management +Planning step begins with the analysis of the investor's
Process risk tolerance, return objectives, time horizon, tax
exposure,liquidity needs, income needs, and any other
preferences
+Execution step is an analysis of the risk return
characteristics to determine how the fund should
allocate (top-down analysis)
+Feedback step is rebalancing the portfolio and adjust
the investor's IPS

Mutual Fund Pooled investments where each investor owns shares

representing ownership of a portion of the portfolio

Net Asset Value Total net value of its assets divided by the shares
outstanding

Open-End Fund Allows investors to buy newly issued shares at NAV;

New cash is invested by mutual fund manager in new
securities;
Investors can redeem their shares at NAV;
Management charges an ongoing fee as a percent of
NAV

Closed-End Fund Professionally managed pools of investor money that do

not take in new money or redeem shares;
Trade like equity shares on an exchange or over the
 counter
Money Market Fund Charges an ongoingdebt
Invest in short-term management
securitiesfee
and provide interest
income with low risk;
NAV is set at $1.00

Exchange Traded Similar to closed end funds but we often passively

Funds managed and do not always trade to their NAVs
Often traded to match a particular index
Can be bought, sold short, and bought on margin intra-
day
Pay brokerage commissions on trade and bid-ask
spreads
Dividend is typically only offered as cash
Produce less capital gains liabilities since it doesn't have
to sell securities to match redemptions

Separately Managed Owned by a single investor and managed to meet their

Account needs

Hedge Funds Pools of investor funds that are not regulated to the
same extent as mutual funds

Long/Short Fund Buy securities that are expected to outperform the

market and sell those that are expected to
underperform

Market-Neutral Fund Long/short funds where the short exposure nets out the
long

Biased Fund Either stays net long or net short always

Event Driven Fund Invests in response to one corporate action

Convertible Bond Takes long and short positions in convertible bonds and
Arbitrage equity shares to benefit from relative mispricing

Fixed Income Take long and short positions in bonds to benefit from
Arbitrage mispricing while minimizing interest rate effects

Global Macro Fund Speculates on changes in international interest rates and

currency rates, often using derivatives and leverage

Buyout Funds Buy entire public companies and take them private to
restructure or resell later to gain a profit;
Company typically purchased largely from debt;
Time horizon is 3-5 years
Venture Capital Fund Invests in companies in the start-up phase with the intent
that they grow into profitable companies and the
investment is sold at an IPO

Holding Period Return (Price Change + Dividend)/(Initial Price)

=

Arithmetic Mean Average of every period's return

Geometric Mean Compounded annual rate of return for an investment

Money-Weighted IRR of a portfolio

Return

Gross Return Total return in a security before fees and expenses

Net Return The return of a security after fees and expenses are paid

Pretax Nominal Return Return prior to paying taxes

After-Tax Nominal The return after tax liability is deducted

Return

Real Return Return adjusted for inflation

Leveraged Return A return that is a multiple of the return on the underlying

asset

Global Minimum The portfolio on the efficient frontier with the least risk
Variance Portfolio

Investor's Utility Represents the investor's preference in terms of risk and

Function return

Indifference Curve A plot of the combinations of risk and return that an

investor is indifferent to;
Slope upward for risk adverse investors because they
will only take more risk if they get paid for it

Two Fund Separation All investors' optimum portfolios will be made up of

Theorem some combination of an optimal portfolio of risky assets
and a risk free asset

Capital Allocation Line Represents the combinations of a risky portfolio and a

risk free asset

Capital Market Line The same thing as a capital allocation line but the risky
portfolio is now a portfolio of all the investable assets
 available in the market
Market Premium Difference between the risk free rate and the market
return

Total Risk = Systematic Risk + Unsystematic Risk

Multifactor Model Normally take into account macroeconomic factors

along with fundamental factors and statistical factors
and estimates the sensitivity of a security to each factor

Fama-French Model Estimates a security's sensitivity to firm size, book to

market value and excess market return;
Carhart adds sensitivity to price momentum

Market Model Single factor model where the only factor is excess
return on the market portfolio

Beta The sensitivity of an asset's return to the return of the

market and is the standardized measure for the
Covariance of the asset's return with the market;
= (Covariance of Asset's and Market's Return)/(Variance
of Market);
= (Correlation of Asset and Market) * (Standard
Deviation of the Asset)/(Standard Deviation of Market);
Estimated by regressing asset returns with market
returns

Security Market Line Plot of the relationship between an asset's risk and
return;
= Risk Free Rate + (Beta *Excess Return);
Shows CAPM

Differences Between *CML plots total risk on the x-axis and only plots
Security Market Line efficient portfolios; SML plots beta on the x-axis
and Capital Market *All points on the CML, except point of tangency,
Line represent the risk-return characteristics of portfolios
formed by combining the risk free rate and market return
or borrowing at the risk free rate to invest more than
100% in the market

CAPM = Risk Free Rate + (Beta * Excess Market Return)

M-Squared = (Portfolio Return - Risk Free Rate) * (Market Standard

Deviation/Portfolio Deviation) - (Market Return - Risk
Free Rate);
 Most appropriate when portfolio holds no systematic
risk and is managed by one manager
Treynor Measure = (Portfolio Return - Risk Free Rate)/Portfolio Beta;
Most appropriate when a fund has multiple managers
and only has systematic risk

Jensen's Alpha = Portfolio Return - Portfolio's CAPM;

Most appropriate when a fund has multiple managers
and only has systematic risk

Contents of +Description of Client

Investment Policy +Statement of Purpose of IPS
Statement +Statement of Investment Manager's Duties and
Responsibilities
+Procedures to Update IPS
+Investment Objectives
+Investment Constraints
+Investment Guidelines
+Evaluation of Performance
+Appendices

High Willingness to The low ability will win out in an advisor's assessment
Bear Risk, Low Ability
to Bear Risk

Low Willingness to Advisor can try to educate client, but it is not his
Bear Risk, High Ability responsibility to force client to take on more risk
to Bear Risk

Investment Constraints +Liquidity

+Time horizon
+The tax treatment
+Legal and regulatory constraints
+Ethical or personal preferences

Strategic Asset Specifies the percentage of assets go to each asset class

Allocation

Tactical Asset When a manager varies from the strategic allocation

Allocation weights when attractive opportunities are present

Risk Budgeting Sets an overall risk limit for a portfolio and allocates the
risk to different asset classes
Asset Returns and Prefer correlations of asset returns within an asset class
Correlation are significantly greater than correlations of asset class
returns

Reasons to Overstate *Meet earnings expectations

Earnings *Remain in compliance with lending covenants
*Receive higher incentive compensation

Reasons to Understate *Obtain trade relief in the form of quotas and protective
Earnings tariffs
*Negotiate favorable terms from creditors
*Negotiate favorable labor contracts

Causes of Low Quality +Selecting legal accounting measures that don't

Earnings accurately represent the economics of a business
+Structuring transactions to get a favorable outcome
+Using aggressive or unrealistic estimates and
assumptions
+Exploiting the intent of an accounting principle

Fraud Triangle -Incentive/Pressure

-Opportunity
-Attitude/Rationalization

Incentive/Pressure Motive for fraud;

Threats to financial stability or profitability;
Excessive third-party pressures on management;
Personal net worth of management or the board of
directors is threatened;
Excessive pressure on management or operating
personnel to meet internal financial goals

Opportunity Exists when there is a weakness in internal controls;

The nature of the firms operations;
Ineffective management monitoring;
A complex or unstable organizational structure;
Deficient internal controls

Attitude/Rationalizatio A mindset that fraudulent behavior is justified;

n Inappropriate ethical standards;
Excessive participation by nonfinancial management in
the selection of accounting standards;
Violations of laws and regulations by management or
board members;
 A management obsession with maintaining or increasing
the firm's stock price or earnings trend;
Making commitments to third parties to achieve
aggressive results;
Failing to correct known reportable conditions;
Inappropriately minimizing earnings for tax purposes;
Use of materiality as a basis to justify inappropriate or
questionable accounting methods;
Strained relationship between management and the
current or previous auditor

Accounting Warning +Aggressive revenue recognition

Signs +Different growth rates of operating cash flow and
earnings
+Abnormal sales growth as compared to the economy,
industry or peers
+Abnormal inventory growth compared to sales growth
*Could be signs of obsolete products
+Boosting revenue with nonoperating income and
nonrecurring gains
+Delaying expense recognition
+Abnormal use of operating leases by lessees
+Hiding expenses by classifying them as extraordinary or
nonrecurring
+LIFO liquidations
+Abnormal gross margin and operating margin as
compared to industry peers
+Extending the useful lives of long-term assets
+Aggressive pension assumptions
+Year-end surprises
+Equity method investments and off-balance-sheet
special purpose entities
+Other off-balance-sheet financing arrangements
including debt guarantees

Cash Flow Earnings A way to measure the relationship between the

Index operating cash flow and earnings;
CFEI = Operating Cash Flow/Net Income

Daily Sales in Payables DSIP = (Accounts Payable)/(COGS) * Number of Days in

 Period;
A firm can temporarily increase operating cash flows by
delaying payment to suppliers

Components of Credit +Scale and diversification

Rating +Operational efficiency
+Margin stability
+Leverage

Adjustments to +Accounting of investment securities

Compare Firms' +Inventory cost methods
Financial Statements +Depreciation schedules
+Off-balance-sheet financing
+Treatment of goodwill and other intangible assets

Reasons to Overstate *Meet earnings expectations

Earnings *Remain in compliance with lending covenants
*Receive higher incentive compensation

Reasons to Understate *Obtain trade relief in the form of quotas and protective
Earnings tariffs
*Negotiate favorable terms from creditors
*Negotiate favorable labor contracts

Causes of Low Quality +Selecting legal accounting measures that don't

Earnings accurately represent the economics of a business
+Structuring transactions to get a favorable outcome
+Using aggressive or unrealistic estimates and
assumptions
+Exploiting the intent of an accounting principle

Fraud Triangle -Incentive/Pressure

-Opportunity
-Attitude/Rationalization

Incentive/Pressure Motive for fraud;

Threats to financial stability or profitability;
Excessive third-party pressures on management;
Personal net worth of management or the board of
directors is threatened;
Excessive pressure on management or operating
personnel to meet internal financial goals
Opportunity Exists when there is a weakness in internal controls;
The nature of the firms operations;
Ineffective management monitoring;
A complex or unstable organizational structure;
Deficient internal controls

Attitude/Rationalizatio A mindset that fraudulent behavior is justified;

n Inappropriate ethical standards;
Excessive participation by nonfinancial management in
the selection of accounting standards;
Violations of laws and regulations by management or
board members;
A management obsession with maintaining or increasing
the firm's stock price or earnings trend;
Making commitments to third parties to achieve
aggressive results;
Failing to correct known reportable conditions;
Inappropriately minimizing earnings for tax purposes;
Use of materiality as a basis to justify inappropriate or
questionable accounting methods;
Strained relationship between management and the
current or previous auditor

Accounting Warning +Aggressive revenue recognition

Signs +Different growth rates of operating cash flow and
earnings
+Abnormal sales growth as compared to the economy,
industry or peers
+Abnormal inventory growth compared to sales growth
*Could be signs of obsolete products
+Boosting revenue with nonoperating income and
nonrecurring gains
+Delaying expense recognition
+Abnormal use of operating leases by lessees
+Hiding expenses by classifying them as extraordinary or
nonrecurring
+LIFO liquidations
+Abnormal gross margin and operating margin as
compared to industry peers
+Extending the useful lives of long-term assets
 +Aggressive pension assumptions
+Year-end surprises
+Equity method investments and off-balance-sheet
special purpose entities
+Other off-balance-sheet financing arrangements
including debt guarantees

Cash Flow Earnings A way to measure the relationship between the

Index operating cash flow and earnings;
CFEI = Operating Cash Flow/Net Income

Daily Sales in Payables DSIP = (Accounts Payable)/(COGS) * Number of Days in

Period;
A firm can temporarily increase operating cash flows by
delaying payment to suppliers

Components of Credit +Scale and diversification

Rating +Operational efficiency
+Margin stability
+Leverage

Adjustments to +Accounting of investment securities

Compare Firms' +Inventory cost methods
Financial Statements +Depreciation schedules
+Off-balance-sheet financing
+Treatment of goodwill and other intangible assets

IS curve Shows the inverse relationship between the real interest

rate and income;
Decrease in real interest rates -> decrease in financing
costs -> increase in capex by businesses -> same
increase in savings as capex

LM curve Shows the combination of GDP and real interest rates;

Demand for money is inversely related to the real
interest rate;
Demand for money is positively related to real income;
At equilibrium, there is a positive relationship between
real income and real interest rates

Quantity theory of (money supply)(velocity of money)=(price level)(real

money GDP)

Shifts in aggregate Change in price level/inflation

demand curve Consumer income and wealth increases
Higher expectations for economy in the future
Expansionary monetary and fiscal policy
Favorable exchange rate movement

Shifts in short term Shifts to long run aggregate supply

aggregate supply Labor productivity
Input prices
Expectations of future output prices
Taxes and government subsidies
Exchange rates

Shifts in long run Increase in supply and quality of labor

aggregate supply Increase in supply of natural resources
Increase in stock of physical capital
Technology

Personal Income National income + transfer payments to households -

indirect business taxes - corporate income taxes -
undistributed corporate profits

Personal disposable Personal income - personal taxes

income

Phases of business Expansion

cycle Peak
Contraction/Recession
Trough

Expansion Real GDP is increasing

Increasing employment, consumer spending and
business investment
The start of each new expansion is called a recovery

Peak Real GDP stops increasing and starts decreasing

Inventory to sales ration increases

Contraction/Recession Real GDP is decreasing

Rates of spending, investment and employment remain
positive while inflation accelerates

Trough Real GDP stops decreasing and begins increasing

Inventory to sales ratio decreases

Value of final output Summing the value of all final goods and services
GDP produced

Sum of value added Summing the additions to value created at each stage of
method GDP production and distribution

Core inflation Headline inflation - food & energy

Headline inflation Measures inflation of all goods

Hedonic index Adjusts a price index for the quality of goods used in
basket

Fisher index Geometric mean of a Laspeyres index;

Used to eliminate bias from substitution

Laspeyres index Uses a constant basket of goods;

Can be biased to upward movement when old products
are replaced by newer and more expensive products,
higher quality products replacing lower quality and by
consumers using substitute goods when those in the
basket get expensive

Paasche index Weights its basket based on current consumption

Demand-pull inflation Caused by increase demand

Cost-push inflation Caused by a decrease in supply

Non-accelerating The natural weight of unemployment

inflation rate of
unemployment
(NAIRU)

Leading economic Average hours worked weekly

indicators Weekly unemployment claims
New manufacturer orders
Index of supplier deliveries
New building permits
Stock prices
Money supply
Interest rate spreads
Consumer expectations index

Coincident economic Employees on nonfarm payroll

indicators Personal income
 Industrial production
Manufacturing sales
Lagging economic Average duration of unemployment
indicators Inventory to sales ratio
Labor cost per unit of output
Average prime rate
Commercial and industrial loans
Consumer installment credit to income ratio
Consumer price index

Fisher effect Nominal interest rate equals the sum of expected

inflation and the real interest rate;
Consistent with money neutrality;
Can be modified to add a risk premium for inflationary
uncertainty

Schools of economic -Neoclassical

thought -Keynesian
-New Keynesian
-Austrian
-New Classical

Neoclassical Shifts in aggregate supply and demand are driven by

technology over time and that the economy has a strong
tendency towards full employment;
Business cycle is a temporary deviation from the long-
run equilibrium

Keynesian Demand fluctuations are due to swings in the level of

optimism of business owners and that business owners
overinvest when optimistic and underinvest when
pessimistic;
Argue that wages are "downward sticky" and it is difficult
to reduce them in times of recession;
Believe government should control expectations with
monetary or fiscal policy;
Policymakers can use the budget to diminish aggregate
demand through restrictive fiscal policy

New Keynesian Modify Keynesian by saying all inputs of productivity are

downward sticky, not just labor

Austrian Business cycles are caused by the government

New Classical Believe in Real Business Cycle Theory;
Argue that governments shouldn't try to fight business
cycles;
Emphasize the effect of external shocks and technology
on aggregate demand

Lags of fiscal policy +Recognition lag

+Action lag
+Impact lag

Recognition lag When it takes time for policy makers to recognize what is
happening in the economy and make the appropriate
decision

Action lag Time it takes governments to vote on and enact policy

Impact lag Time it takes for fiscal policy to produce change once
out into law

Transaction demand Money held to meet the need for undertaking

transactions;
Increases with GDP

Precautionary demand Money held for unforeseen future needs;

Increases with GDP

Speculative demand Money available to take advantage of investment

opportunities that arise in the future;
Rises as economic future becomes uncertain

Money neutrality The belief that real variables (real GDP and velocity) are
not affected by monetary variables (money supply and
prices)

Types of +Frictional
unemployment +Structural
*Different
+Cyclical

Frictional The time lag necessary to match employees to

unemployment employers

Structural Long-run changes in the economy that eliminate some

unemployment jobs while generating others for which unemployed
workers are not qualified
Cyclical Due to changes in the general level of economic activity
unemployment

M1 Sum of currency in circulation and overnight deposits

M2 M1 plus deposits with maturity up to two years and

deposits redeemable at notice up to three months

M3 M2 plus repo agreements, money market funds and debt

with maturity up to two years

Roles of central banks +Sole supplier of money

+Banker to the government and other banks
+Regulator and supervisor of payments system
+Lender of last resort
+Holder of gold and foreign exchange reserves
+Conductor of monetary policy

Central bank tools +Policy rate

+Reserve requirements
+Open market operations

Qualities of central +Independence

bank +Credibility
+Transparency

Operational When the central bank can independently set the policy
independence rate

Target independence When the central bank defines how inflation is

computed, sets the target inflation, and determines the
time horizon for achieving the target

Fiscal policy tools *Transfer payments (entitlement programs)

*Current spending
*Capital spending
*Direct taxes
*Indirect taxes

Interest Rates and If the demand for financial capital rises, interest rates
Financial Capital also rise
Relationship

Future Income and Increases in expected future incomes will increase the
Interest Rates equilibrium interest rate.
Relationship
Neutral Interest Rate Sum of the real growth rate and the target inflation

Guarding Against When policy rate is less than the neutral interest rate
Inflation

Bringing About When policy rate is above the neutral interest rate
Disinflation

Functions of Financial +Allow entities to save and borrow money, raise equity
System capital, manage risks and
trade assets
+Determine returns required for the supply of savings to
equate to the demand for borrowing
+Allocate capital to the most efficient uses

Debt Securities Promises to repay borrowed funds

Equity Securities Represent ownership positions

Publicly Traded Traded on exchanges or through securities dealers and

Securities are subject to regulatory oversight

Private Securities Not traded on public markets, illiquid, and not subject to
regulation

Derivative Contracts Securities with values that depend on values of other

assets

Spot Market Market with immediate delivery

Primary Market Market for newly issued securities secondary market is

for subsequent sale of securities

Money Markets Markets for debt securities with maturities of one year or
less and capital markets are for longer term debt
securities and equities

Traditional Investment Market for debt and equity, alternative markets,

Market alternatives markets are for everything else

Short-Term Fixed Securities that have maturities less than 2 years;

Income Usually called paper or notes

Long-Term Fixed Securities that have maturities more than 5 years;

Income Usually called bonds

Repo Agreement A borrower sells a high quality asset and has both the
 right and obligation to buy it back at a higher price in the
futures
Convertible Debt Debt an investor can exchange for a specified number of
equities in the issuing firm

Warrants Give the holder the right to buy a firm's equity at a fixed
price prior to the warrant's expiration;
Similar to options

Asset Backed Represent a claim to a portion of a pool of assets and

Securities the return is passed through to investors with different
tranches having different levels of risk and return

Forward Contract Agreement to buy or sell an asset in the future at a

specified price in the contract at its inception

Future Contract Same as forward but are standardized in amount, asset

characteristics and delivery time;
Greater liquidity than forwards since they are traded on a
secondary market

Swap Contract When two parties make payments equivalent to one

asset being traded for another one

Currency Swap Swapping loans in different currencies

Interest Rate Swap When floating rate interest payments are exchanged for
fixed rate payments

Equity Swap Swapping the return on an equity index for the interest
payments on a debt instrument

Option Contract Security that gives its owners a right to buy or sell an
asset at a specified price at a specified time in the future

Call Option The right to buy

Put Option The right to sell

Insurance Contract Security that pays a cash amount if a future event occurs;
Used as a hedge

Credit Default Swap Form of insurance pays if an issuer defaults on its bonds

Markets for +Spot

Commodities +Futures
 +Forwards
Real Assets *Increasingly being held by institutions
*Provide income, tax advantages and diversification, but
also entail large management costs
*Require increased due diligence
*Illiquid
*Can be bought indirectly through REITs and MLPs
*Can get exposure by buying stock in companies that
have large real asset ownership

Block Brokers Trade large lots

Primary Dealers Trade with central banks when they buy and sell
securities

Broker Dealers Have an inherent conflict of interest because they

should seek the best prices for their clients but their goal
is to profit through the transaction;
Traders typically place limits on how their orders are
filled when working through a broker dealer

Securitizers Pool large amounts of securities or other assets and sell

interests in the pool to other investors;
The returns from the pool, net of fees, are passed
through to investors;
Cash flows are segregated by risk into traunches

Depository Institutions Institutions pay interest on customer deposits and

provide transaction services

Security (Prime) Provide loans to investors who purchase securities on

Brokers margin

Insurance Companies Collect insurance premiums in return for providing risk

reduction to the insured

Risks of Insurance ~Moral hazard when policy holders take more risk
Companies because they are insured
~Adverse selection that people who buy insurance are
the ones who are most risky
~Fraud when the insured purely causes damage to
collect a claim

Clearinghouses Provide escrow services, guarantees of contract

 completion, assurance margin traders have necessary
capital, and limits on orders;
Reduce counterparty risk
Custodians Improve market integrity by holding client securities and
preventing their loss due to fraud or other events

Long Position When an investor owns, or has the right to own, an asset

Short Position Result from borrowing an asset and selling it, with the
obligation to replace the asset at a later date;
Must borrow the securities through a broker, return the
securities at the request of the lender when the short
sale is closed out, and keep a portion of the proceeds
on deposit with the broker;
Borrower must pay lender all dividends or interest the
lender would have received;
*Collateral earns interest, some of which is returned to
the borrower at a short rebate rate

Leveraged Position When borrowed funds are used to purchase assets;

Funds are considered margin loans;
Interest paid is called the call money rate;
The initial margin requirement is the minimum amount of
equity an investor is required to provide at time of new
margin purpose;
Additional risk in portfolio is considered risk from
financial leverage

Components of an +Bid-ask spread

Order +Execution order
+Validity instructions
+Clearing instructions

Bid-Ask Spread The difference between the bid price and ask price;
Bid price is the price that a dealer will sell a security;
The ask or offer price is the price a dealer will pay for a
security;
How the dealer makes money

Types of Execution +Market order

Orders +Limit order
+All or nothing order
+Hidden order
Market Order Instructs broker to execute trade immediately at best
possible price

Limit Order Places a minimum execution price for a sale or maximum

execution price for a buy;
Not guaranteed to be filled;
Marketable or aggressively priced if buy/sell order is
above the best ask/below the best bid;
A limit between bid and ask is said to be making a new
market or inside the market;
Standing orders are limits waiting to be executed

Limit Order "Making A buy order at the best bid or sell at the best ask
the Market"

Limit Order "Behind the A buy order below the best bid or a sell order above the
Market" best ask

Limit Order "Far From A buy considerably lower than the best bid or a sell
the Market" considerably higher than the best ask

All or Nothing Orders Trades that execute only if the entire lot can be bought

Hidden Orders Orders where only the broker knows the trade size

Types of Validity *Day orders

Instructions *Good-till-cancelled orders
*Immediate-or-cancelled, or fill-or-kill, orders
*Good-on-close orders
*Stop-loss orders

Clearing Instructions Specify how to settle a trade

Book Building When investment banks solicit indications of interest

from market participants and adjust the offering price
accordingly

Underwritten Offering When the investment bank agrees to entire issue at a

negotiated price;
Bank is stuck with position if undersubscribed

Investment Bank's IPO As an agent, they should set a high price to maximized
Conflict of Interest the funds raised for the issuer but, as underwriters, they
want the price to be low so the whole issue sells

Best Efforts IPO When a bank agrees to distribute shares but if

 undersubscribed, bank does not buy unsold portion
Private Placement When securities are sold directly to qualified investors
with the help of an investment bank;
Do not require the issuer to disclose as much information
about the securities;
Issuance costs are less;
Offer price is lower since securities cannot be resold in
the public markets

Shelf Registration When a firm makes its public disclosures as a regular

offering but it then the issues the registered securities as
it needs capital or the markets are favorable

Rights Offering Existing shareholders are given the right to buy new
shares at a discount to the current market price;
Dilutes ownership unless option is exercised;
Sometimes the option can be sold

Call Market When trades can only be placed during a specific time
period;
Very liquid when in session because all traders are
present but illiquid between sessions;
All trades, bids, ands asks are declared and then one
negotiated price is set that clears the market for the
stock

Continuous Markets Trades occur any time a market is open

Quote Driven Markets Investors trade with dealers;

Dealers keep an inventory of securities;
Most securities other than stocks trade in quote driven
markets;
Trading is often electronic

Order Driven Market Rules are used to match buyers and sellers;
Traders are usually anonymous;
Order matching rules establish an order precedence
hierarchy;
*After orders are matched, trade pricing rules are used
to determine the price;
*In electronic markets, orders are batched together and
 matched at fixed points in time during the day at the
Price Priority When trades
average with
of the the highest
bid-ask quotesbids
fromand
thelowest asks are
exchange
given the highest priorities

Uniform Pricing Rules When all trades trade at the same price, which results
from where the highest volume is

Discriminatory Pricing Uses the limit price of the order that arrived first as the
trading price

Brokered Markets Where investors use brokers to locate a counterparty to

a trade;
Useful with unique or illiquid securities;
Dealers do not carry inventory;
Too few trades to trade in an order-driven market

Complete Markets Allow investors to save for the future at fair rates of
return, creditworthy borrowers obtain funds, hedgers
manage risk and traders get assets

Operational Efficiency Market with low trading costs;

Will make markets more informationally efficient
because low trading costs encourage trading on new
information

Informational Prices reflect all information associated with

Efficiency fundamental value in a timely fashion;
Allocationally efficient is capital is allocated to its most
efficient use;
Brought by traders who bid prices up and down in
response to new information;
Helped by accounting standards and financial reporting
requirements

Functions of *Organize trading venues

Intermediaries *Supply liquidity
*Securitize assets
*Manage banks, insurance firms and investment advisory
services
*Providing clearinghouses to settle trades
*Manage depositories

Benefits of *Savers fund entrepreneurs

Intermediaries *Companies share risk
Problems Fixed by *Fraud and theft
Regulation *Insider trading
*Costly information
*Defaults

Objectives of *Protect unsophisticated investors

Regulation *Promote minimum standards of performance reporting
*Prevent insider trading
*Require common financial reporting standards
*Require minimum capital levels so all participants can
honor their obligations

Security Market Index Used to represent the performance of a certain asset;

Constituent securities are those that make up an index;
Have a numerical value calculated from constituent
securities

Price Return When an index uses only the prices of an index's

constituency securities

Total Return When an index includes both price changes and income
from constituent securities

Decisions of an Index +What is the target market an asset is supposed to

Maker measure
+What securities should be included
+How should securities be weighted
+How often should index be rebalanced
+When should selection and weighting be reevaluated

Price Weighting Index The arithmetic average of the prices of securities

included in the index;
Divisor is adjusted for stock splits and changes in
composition when securities are added or subtracted;
Advantage is it is simple to compute;
Disadvantage is that a percentage change in a higher
priced stock has a greater impact than an equal
percentage increase in a lesser valued stock;
Stock splits, repurchases or dividends can change the
relative weight of a stock in the index;
Having an equal weighting of stocks to the index will
 return an identical return;
Equal Weighting Index The arithmetic average return of the index stocks;
Major examples are the Nikkei and Dow Jones Industrial
Matched by the returns of a portfolio that had equal
dollar amounts invested in each stock;
Simple to calculate;
Replication portfolio would have to be periodically
rebalanced, creating transaction costs;
Percentage increases by smaller companies equal a
proportionally larger weight in the index return;
Value Line Composition Average and Financial Times
Ordinary Share Index are major examples

Market Weighting Weightings based on the market cap of each stock as a

Index proportion of the index's market cap;
Replicated by a portfolio in which the value of each
security position is the same proportion of the security's
market cap to the index's market cap;
Not adjusted for dividends or stock splits;
An alternative is to incorporate a security's number of
shares available to the investing public, or a security's
float

Float Adjusted Market Like a market cap index but are based on the proportion
Weighting Index of each firm's share value available to investors to the
total market value of the index available to investors;
Stock with large controlling shareholders will have less
weighting in index;
Advantage is weights represent total market value;
Disadvantage is the relative impact of a stock's return on
the index;
S&P 500 is an example

Fundamental Weights are based in firms' fundamentals, like earning,

Weighting Index dividends or cash flow;
Avoids bias of market cap indices to overvalued firms;
Has a value tilt, overweighting firms with higher value-
based metrics

Market Cap Index (Current Total Market Value of Stocks/Base Year Total
Value = Market Value of Stocks) * Base Year Index Value

Uses of Market Indices +Reflection of market sentiment

 +Benchmark of manager performance
+Measure of market risk and return
+Measure of beta risk adjusted returns
+Model portfolio for index funds
Types of Equity Indices +Broad market index
+Multi-market index
+Multi-market index with fundamental weighting
+Sector index
+Style index

Factors Affecting +Number of market participants

Market Efficiency +Availability of Information
+Impediments to trading
+Transaction and information costs

Weak Form Market Current security prices fully reflect all currently available
Efficiency security market data

Semi-Strong Form Securities rapidly adjust without bias and reflect all
Market Efficiency current publicly available data;
Best for passive investing;
Suggested if fundamental analysis allows for profits

Strong Form Market Security prices fully reflect all information from both
Efficiency public and private sources

Market Anomaly Something that would lead to a rejection of the

hypothesis that markets are efficient

Market Anomalies +The January effect is that in the first five days of January,
stock returns are significantly higher than the rest of the
year
+The overreaction effect is the finding that firms with
poor stock returns over the last 5 years subsequently
have higher turns in the next period than firms that
performed well
+The momentum effect is that firms with high short-term
returns are followed by continued high returns
+The size effect is that small cap stocks outperform large
caps
+The value effect is that value stocks outperform growth
stocks
+Closed end investment funds typically deviate from
 NAV at a discount
+Positive earnings surprises are generally followed by
above average returns that last past the announcement
day and can be exploited by buying positive surprises
and selling negative surprises
+IPOs typically rise after issuance and then fall in the
long term

Behavioral Finance Investigates investor behavior, it's effect on financial

markets, how cognitive biases affect anomalies, and if
investors are rational;
Says investors have an asymmetric preference towards
risk

Traditional Finance Markets are rational even if individuals aren't

Representativeness When investors assume good companies are good

investments

Gambler's Fallacy When recent events affect investors' perceptions of

future probabilities

Mental Accounting When investors classify different investments into

separate mental accounts rather than viewing them as
one portfolio

Conservatism When investors react slowly to change

Disposition Effect When investors are willing to realize gains but not losses

Narrow Framing When investors see events in isolation

Information Cascades Uninformed traders watch the actions of informed

traders and follow when they are given a lot of unclear
information;
Consistent with investor rationality and improved market
efficiency if they stem from uninformed traders;
Said to be fragile if it does not lead towards the correct
pricing of an asset

Value Weighted No, market cap does not change

Indices Adjust for
Stock Splits?

Earnings Multiplier Same as a PE ratio

Increasing Required Reduce a company's PE
Rate of Return and
Decreasing Dividend
Payout

Special Purpose A legal entity to which the assets used as collateral in an

Vehicle ABS issue are sold. This transaction separates the assets
backing the ABS from the other assets of the company
that creates the SPV.

Positive Abnormal No form of efficient market hypothesis supports this

Returns By Using
Technical Analysis

Common Shares Represent an ownership interest, a residual claim on the

firm's assets in liquidation, and govern through voting
rights;
No obligation for firm to pay a dividend;
Can proxy their votes to others;

Statutory Voting Each share gets one vote in the election of each board
nominee

Cumulative Voting Shareholders can allocate their votes to one or more

candidates and lets minority shareholders have
proportional representation on the board

Callable Common Give the firm the right to repurchase the stock at a pre-
Shares specified price;
Benefits the firm because when the market price is great
than the call price, the firm can call shares and reissue
them at a higher price;
Allows firm to reduce its dividend payments without
changing its per-share dividend

Putable Common Give the shareholder the right to sell back shares to the
Shares company at a specific price;
Puts a floor on the share price;
Shareholders implicitly pay for put option because
putable shares sell for more than non-putable;
Raise more capital for firm when issued

Preferred Stock Hybrid between debt and equity;

Typically have fixed periodic payments to investors;
 Usually don't have voting rights;
Have a stated par value and dividend is a percentage of
that par

Cumulative Preferred Has promised fixed dividends and any dividend not paid
Stock must be paid before common shareholders are given
dividends

Participating Preferred Preferred stock that gets an increased dividend if profits

Stock exceed a predetermined level and may get more than
par value if firm is liquidated;
Used by smaller, riskier firms to attract capital by giving
investors chance for upside potential

Convertible Preferred Can be exchanged for common stock at a

Stock predetermined exchange ratio;
Dividend is usually higher;
Investor has upside potential;
Conversion option holds value over regular preferred
stock;
Less risk than common stock

Private Equity in *Less liquid

Comparison to Public *Share price negotiated between firm and investor, not
Equity the market
*No government or exchange requirement for
disclosures
*Lower reporting costs since they are less frequent
*Weaker corporate governance since there is less public
scrutiny
*Greater focus on long-term prospects since no public
pressure for short-term results
*Potential for large return once firm goes public

Venture Capital Capital provided to firms early in their life cycles to fund
development and growth;
Can be seed, early stage, or mezzanine funding;
Very illiquid;
Require 3-10 year commitment;
Profit comes from the firm's IPO

Leveraged Buyout When an investor buys an entire firm with debt financing;
 Called a managed buyout if it is the firm's management
that is taking it private;
Firms usually have cash flow to service the debt or
undervalued assets hat can be sold to pay down debt
over time
Private Investment in When a public firm needs capital quick and sells private
Public Equity equity to investors;
Usually at a sizable discount to the market price

Ways to Invest in +Direct Investing

Foreign Companies +Depository Receipts
+Global Depository Receipts
+American Depository Receipts
+Global Registered
+ETF of Depository Receipts

Direct Investing Buying a firm's securities in a foreign market;

Denominated in foreign currency;
May be less liquid than domestic markets;
May have less strict reporting procedures

Depository Receipts Represent ownership in a foreign firm and are traded in

other countries' markets at the local currency;
A bank deposits shares of the foreign firm and then sells
receipts representing ownership of a specific number of
foreign shares;
Depository bank acts as a custodian and manages stock
events such as splits and dividends;
Although conversion is not necessary, changes in
exchange rates affect price;
Sponsored DR is if the firm is involved with the issue

Global Depository Receipts issued outside both the US and the firm's
Receipts domestic market;
Usually denominated in US Dollar;
Not subject to capital flow restrictions and allow the firm
and investor greater opportunities for foreign investment

American Depository Receipts denominated in US Dollar and trade in the US;

Receipts The security it is based on is called the American
Depository Share
Global Registered Shares that trade in different currencies on exchanges
Shares around the world

Preferred Stock Risk ___ Less than

Common Stock Risk

Cumulative Preferred Less than

Stock Risk ___ Non-
Cumulative Preferred
Stock Risk

Putable Shares Risk ___ Less than

Callable Shares Risk

Callable Shares Risk ___ More than

Common Shares Risk

Book Value of Equity The value of the firm's assets on its balance sheet minus
it's liabilities; Market value of equity is a firm's market cap

Cyclical Firms Earnings highly dependent on the business cycle, a non-

cyclical firm has stable demand over economic stages;
High operating leverage and earnings volatility

Cyclical Sectors +Energy

+Financials
+Technology
+Materials
+Consumer discretionaries

Non-Cyclical Sectors +Healthcare

+Utilities
+Telecom
+Consumer staples

Steps for Forming Peer *Determine which companies are in the same industry
Group *Examine firms' annual reports to find competitors
*Examine competitors' annual reports to find more
competitors
*Use trade publications to find new competitors
*Confirm comparable firms have comparable
characteristics
 *Adjust financial statements of non-financial companies
for any financing subsidiary data they include
Elements of a Through +Evaluate the relationships between macroeconomic
Industry Analysis variables and industry trends
+Estimate industry variables using different approaches
and scenarios
+Compare with other analysts to confirm conclusion or
find instances of misvaluation due to group think
+Determine relative valuation of different industries
+Compare valuations of industries over time to
determine their volatilities over business cycles
+Analyze industry prospects based on strategic groups
+Classify industries by life-cycle stages
+Position the industry on the experience curve, which
shows cost per unit relative to output
+Consider forces that affect industries
+Examine forces that determine competition within
industries

Factors Influencing +Macroeconomic

Industries +Technology
+Demographics
+Government policies
+Social influences

Stages of Industry +Embryonic

+Growth
+Shakeout
+Mature
+Declining

Embryonic Stage When the industry has just started;

Slow growth;
High prices;
Large investment required;
High risk of failure

Growth Stage When industry is growing rapidly;

Rapid growth;
Limited competitive pressures;
Falling prices;
Increasing profitability
Shakeout Stage When growth and profitability are slowing due to strong
competition;
Growth has slowed;
Intense competition;
Increasing industry overcapacity;
Decreased profitability;
Increased cost cutting;
Increased failures

Mature Stage When there is little industry growth and firms

consolidate;
Slow growth;
Consolidation;
High barriers to entry;
Stable pricing;
Superior firms gain market share

Declining Stage When industry starts to shrink;

Negative growth;
Declining price;
Consolidation

Porter's 5 Forces *Rivalry among competitors;

*Threat of new entrants;
*Threat of substitute products;
*Bargaining power of buyers;
*Bargaining power of suppliers;

Leadership Strategy The firm seeks to have the lowest costs of production in
the industry;
Either to protect or grow market share;
Pricing can be aggressive or predatory;
Managerial incentives are to improve efficiency

Differentiation Firm's products are distinct;

Strategy Cost of differentiation must be less than the premium
customers will pay for it;
Pricing premium must be sustainable;
Require extensive market research and creative
personnel

Elements of Company *Overview of firm's operations, governance, strengths

Analysis and weaknesses
 *Industry characteristics
*Product demand
*Product costs
*Pricing environment
*Financial ratios
*Projected financial statements and firm valuations

Things to Consider *The bigger the difference between modeled and

when Comparing market valuation, the mover likely it is an investor buys
Market and Modeled stock
Valuations *The more confident an investor is in the assumptions in
his model, the more likely the investor is to buy stock
*Market values should be seen as rational indicators of
intrinsic value
*Investor must believe market price will eventually move
towards his estimated intrinsic value

Equity Valuation +Discounted Cash Flow

Models +Multiplier Model
+Asset Based Models

One-Year Holding Equal to the current year's dividend in present value plus
Period Dividend the present value of the stock's expected price at the
Discount Model end of the year

Multi-Year Dividend Add each year's dividends discounted by each years

Discount Model required return on equity to the present value of the
terminal value;
Most of the time they use an infinite holding period
model where the terminal value is calculated at some
point in time when growth rates remain constant

Free Cash Flow Represents the total amount that could be paid to
investors;
The cash remaining after a firm meets all of its debt
obligations and provides for capital expenditures
necessary to maintain existing assets or purchase new
ones;
FCF = Net Income + Depreciation - Increase in Working
Capital - Fixed Capital Investment - Debt Principal
Repayments + New Debt Issues;
 FCF = Cash Flow from Operations + Net Borrowing -
Gordon Growth Model Fixed Capital
Assumes annualInvestment
growth rate of dividend is constant;
Stock value equals the dividend divided by the
difference of the required return and the dividend
growth rate

Assumptions of *Dividends are appropriate to measure shareholder

Gordon Growth Model wealth
*Dividend growth rate and required return never change
*Required return is greater than the dividend growth rate

Implications of Gordon *If the gap between the discount and dividend growth
Growth Model rates grows, stock price falls and vice versa
*Small changes in rates can change stock price
significantly

Estimations of *Historical rate

Dividend Growth Rates *Industry average rate
*Sustainable growth rate

Steps of a Multistage *Determine required return

Dividend Growth *Project initial size and duration of high initial dividend
Model growth
*Estimate dividends during high growth period
*Estimate sustainable growth at the end of period
*Estimate first dividend that will grow at a constant rate
*Use sustainable growth to calculate stock value
*Add all present values

Price Multiples +Price-to-Earnings

+Price-to-Book Value
+Price-to-Cash Flow

Enterprise Value Measures total company value and represents what it

would cost to acquire the firm;
Appropriate when comparing firms with different capital
structures;
EBITDA is most used denominator

Asset Based Models Based on the equity value of a firm being the fair market
value of the assets minus the fair market value of the
liabilities;
Market value and intangible assets make this difficult
Derivative A security that derives its value from the value or return
of another asset or security

Exchange-Traded Derivatives that are standardized and backed by a

Derivatives clearinghouse

Forward Contract One party agrees to buy, and the counterparty to sell, a
physical asset or security at a specific price on a specific
date in the future

Futures Contract A forward contract that is standardized, traded in a

secondary market, regulated, backed by a
clearinghouse, requires daily settlement of gains and
losses, and exchange-traded

Swap A series of forward contracts where one party agrees to

pay the short-term (floating) rate of interest on some
principal amount, and the counterparty agrees to pay a
certain (fixed) rate of interest in return

Call Option The right to buy an asset at a certain price by a certain

date;
Counterparty has the obligation to sell the asset

Put Option The right to sell an asset at a certain price by a certain

date;
Counterparty has the obligation to buy the asset

Criticisms of +Too risky for investors with limited knowledge

Derivatives +High leverage and high payoffs liken them to gambling

Benefits of Derivatives +Provide price information

+Allow risk to be managed and shifted among market
participants
+Reduce transaction costs

Arbitrage An opportunity where the return that can be earned

without risk is greater than the risk-free rate;
Come from market mispricings;
If uncertain returns can be combined into a portfolio
that has certain returns, the portfolio should not exceed
the risk free rate

Forward Contract A bilateral contract that obligates one party to buy and
 the other to sell a specific quantity of an asset, at a set
price, on a specific date in the future;
No premium is paid to get into the contract ;
Used to hedge risk and speculate on prices;
Buyer has long position;
Seller has short position;
Can terminate a forward contract by entering into the
opposite position in another trade
Deliverable Forward When a forward is settled with physical delivery
Contract

Cash-Settled Forward When the party with a negative value pays the party with
Contract the positive value in cash

Forward End-User Someone looking to lock in a future price

Forward Dealer Someone who has a balanced book of positions and

make money off of the bid-ask spread

Equity Forwards Have a stock, portfolio, or stock index as the underlying

asset;
The more stocks covered by the forward, the more cost
effective it is;
Index forwards are usually cash settled;
Dividends normally are not taken into account

Short-Term Treasury Must settle before maturity date;

Forwards Price is typically the yield to maturity as of the
settlement date;
Default provisions must be worked in if there is a chance
of default by issuer;
Option provisions must be made if bond has embedded
options

Eurodollar Deposit A deposit in a large bank outside of the US but

denominated in US dollars;
LIBOR is the interest rate on Eurodollar deposits;
Euribor is the equivalent Euro interest rate

Forward Rate A forward contract to lend/borrow money at a certain

Agreement rate in the future;
Cash settled, no loan is made;
Creditworthiness is not considered;
If yield goes up, long gets paid; if yield goes down,
 short gets paid
Payment = (Nominal Principal) [(Floating Rate - Forward
Rate) (Days/360)]/[1 + (Floating Rate * Days)/360]
Currency Forward One party agrees to exchange a certain amount of one
currency for a certain amount of another at a future date;
Specifies an exchange rate where one party can buy a
fixed amount of currency;
Either delivered or cash settled

Differences Between *Futures are on exchanges, forwards are private

Futures and Forwards *Futures are standardized, forwards are customized
*Futures go through clearinghouses
*Government regulates futures

Margin Percentage The percentage of security value that is owed

Initial Margin The money deposited in a futures account before

trading begins;
Typically around one day's maximum price movement

Maintenance Margin The amount of margin that must be maintained in a

futures account;
Additional funds must be added to the margin account if
the balance falls below the maintenance margin

Variation Margin The funds that must be deposited into an account to

bring it back up to the initial margin amount

Limit Move When a future exceeds its limit and trading does not take
place

Locked Limit When trading stops due to a limit move

Ways to Terminate a +Delivery

Futures Contract +Cash settlement
+Make an offsetting trade
+Exchange for physicals

Treasury Bill Future Based on $1 million face value and 90 day maturity;
Quote is 100 minus the annualized discount rate in
percent of the bill;
Heavily influenced by monetary policy;
Eurodollar futures are more popular now;
1 tick move is equal to $25
Eurodollar Future Based on 90 day LIBOR
Cash settled;
Price quote is 100 minus the annualized interest rate of
the bill;
One tick move is equal to $25

Treasury Bond Future Traded on bonds with maturities greater than 15 years;
Deliverable contract;
Can choose a number of bonds to deliver, will choose
the cheapest;
Face value of $100,000;
Quotation in 1/32nds of percent of face value;
Conversion factor is used to adjust the long's payment at
delivery so more valuable bonds receive a higher
payment

Stock Index Futures S&P 500 Index is most popular;

Settlement is in cash and based on a multiplier of 250

American Option Exercisable at any time;

Will never have a smaller premium than a European
option;
More flexible

European Option Only can be exercised on the expiration date

Interest Rate Option Have an interest rate as the exercise price and reference
are as the underlying asset;
No deliverable asset and are only cash settled;
Mostly European options;
Long gets paid when reference rate exceeds strike
price; short gets paid when reference rate is below
strike price;
LONG RATE CALL COMBINED WITH A SHORT RATE PUT
IS THE SAME AS A LONG FORWARD RATE AGREEMENT

Interest Rate Cap A series of interest rate call options that have expiration
dates that correspond to the reset date on a floating-
rate loan;
Protect a floating-rate borrower;
Pays when rate rises above the cap

Interest Rate Floor A series of floating rate options that have expiration
 dates that correspond to the reset date on a floating-
rate loan;
Protect floating rate lenders;
Pays when rate falls below floor
Payment of Interest Based on a stated nominal amount and the difference
Rate Option between the reference rate and the strike rate times the
fractional interest period

Minimum Option Price 0

Maximum Price of a Stock's current price

Call Option

Maximum Price for Put's strike price

American Put

Maximum Price for Present value of option's strike

European Put

Lower Bound of The maximum of 0 and the present value of the strike
American Put price minus the stock price

Lower Bound of The maximum of 0 and the present value of the strike
European Put price

Put-Call Parity Based on the payoffs of two portfolio combinations, a

fiduciary call and protective put
Call with Strike X + Present Value of X = Stock Price + Put
with Strike X

Interest Rate Swap An exchange of one loan for another (typically one is a
floating rate, the other is a fixed rate);
Total loan amount isn't exchanged, just the difference
between the liabilities at the end of the period

Currency Swap One party makes payments denominated in one

currency while the payments from the other party are
made in a second currency

Tenor Length of the swap

Swap and Forward *Require no payment at initiation

Commonalities *Custom instruments
*Not traded in a secondary market
*Mostly unregulated
 *Default risk matters
Ways to Terminate *Large institutions
*Mutual terminationare the main players
Swap *Offsetting contracts
*Resale
*Swapation

Mutual Termination One party pays the other to end the swap

Offsetting Contracts Open a swap with an opposite exposure with the same
terms with the same counterparty

Resale Sell the swap to another party with the permission of the
counterparty

Swapation Buy an option to enter an offsetting swap and exercising

it would cancel the original swap

Types of Currency *Party A pays a fixed rate on Currency A received, Party

Swaps B pays a fixed rate on Currency B
* Party A pays a floating rate on Currency A received,
Party B pays a fixed rate on Currency B
* Party A pays a fixed rate on Currency A received, Party
B pays a floating rate on Currency B
* Party A pays a floating rate on Currency A received,
Party B pays a floating rate on Currency B

Steps in a Fixed-For- *Notional principal is swapped at initiation (Party A gets

Fixed Currency Swap Currency B and Party B gets Currency A)
*Full interest payments are exchanged at each
settlement date, each in a different currency
*Notional payment is returned at the final settlement
date

Plain Vanilla Interest Trade fixed interest payments for floating rate payments;
Rate Swap LIBOR is typically the floating rate used;
Zero-sum game;
Net Fixed-Rate Payment = (Swap Fixed Rate - Swap
Floating Rate) (Number of Days/360) (Notional
Principal)

Basis Swap Trading one floating rate payment for another

Equity Swap When the return on a stock, portfolio or index is paid

each period by one party in return for a fixed or floating
 rate payment
Call Option P/L +Maximum loss is the premium
+Break-even price is the premium plus the strike price
+Profit to the buyer is unlimited, loss to the writer is
unlimited
+Call holder will exercise when stock price is greater
than the strike price
+Maximum profit for the writer is the premium
+Zero-sum game between buyer and writer

Put Option P/L +Maximum loss for the buyer is the premium
+Maximum profit is the strike price minus the premium
+Maximum loss to writer is the strike price minus the
premium
+Break-even is the strike price minus the option premium
+Maximum profit for the writer is the premium
+Zero-sum game between buyer and writer

Covered Call When the writer of a call also owns the stock he is
obligated to sell;
Used to increase income in a time when you do not
expect the stock price to increase;
Can be written out of the money to add insurance that
the stock won't get called away;
Trading away chance of stock appreciating in future for
income now

Covered Call Option *If stock closes below strike price, the call expires
P/L worthless and the writer keeps the premium
*Breakeven point is the stock's price minus the call
premium
*If stock appreciates past the initial price but not as high
as the call's strike price, the writer gets the premium as
well as the stock's appreciating
*Maximum loss is the stock price minus the premium

Protective Put Buying a stock and a put on the stock to protect the
decline of a stock's price;
Can be replicated by buying a bond that pays the strike
 price minus the premium at expiration and a call with the
Protective Put Option *Maximum loss is the premium
strike price
P/L *Maximum loss occurs when the stock falls below the
strike price
*The break even point is the strike price plus the
premium amount
*Losses begin to occur when the stock falls below the
break even
*Same profit diagram as a long call

CFA designated officer +Self disclosure of civil litigation, criminal investigation,

looks into inquiries or written complaint
raised by: +Written complaints to CFA
+Media reports
+CFA exam proctor

Who enforces the The Board of Governors

Code of Standards?

Officer can do: +Request written response

+Interview subject
+Interview complainant
+Collect documents relevant to the investigation

Officer can decide: +No sanctions

+Cautionary letter
+Issue sanction

Sanctioned candidate +Reject sanction and refer it to a panel of CFA members

can: +Accept sanction

Sanctions are: +Condemnation by peers

+Suspension of CFA membership

6 components of the +Act with integrity, competence, diligence, respect and

Code of Ethics: in an ethical manner wit the public, clients, prospective
clients, employers, employees, colleagues, and all
participants in global markets
+Place integrity of profession and interest of clients
above all else
+Use reasonable care and independent professional
judgement when conducting investment analysis, making
 investment recommendations, taking investment action,
and engaging in 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, and uphold the rules of, the
capital markets
+Maintain and improve their professional competence of
themselves and others
7 Standards of +Professionalism
Professional Conduct: +Integrity of Capital Markets
+Duties to Clients
+Duties to Employers
+Investment Analysis, Recommendation and Action
+Conflicts of Interest
+Responsibilities of a CFA Member/Candidate

Professionalism: +Professionalism
+Integrity of Capital Markets
+Duties to Clients
+Duties to Employers
+Investment Analysis, Recommendation and Action
+Conflicts of Interest
+Responsibilities of a CFA Member/Candidate

Integrity of Capital +Material Nonpublic Information

Markets: +Market Manipulation

Duties to Clients: +Loyalty, Prudence and Care

+Fair Dealing
+Suitability
+Performance Presentation
+Preservation of Confidentiality (unless unlawful)

Duties to Employers: +Loyalty

+Additional Compensation Agreements
+Responsibilities of Supervisors

Investment Analysis, +Diligence and Reasonable Basis

Recommendations and +Communications with Clients
Actions: +Record Retention
Conflicts of Interest: +Disclosure of Conflicts
+Priority of Transactions
+Referral Fees

Responsibilities as CFA +Uphold reputation of CFA

Member/Candidate +Don't misrepresent CFA

Why were GIPS Discourage:

created? +Showing a top performing portfolio as representative of
a firms total performance
+Survivorship bias
+Varying time periods

In verification, a third- +The firm has complied with all GIPS requirements for
party attests that: using composites firm wide
+The firm's processes and procedures are established to
present performance in accordance with the calculation
methodology, data requirements and in the format
required by GIPS

Sections of GIPS: -Fundamentals of Compliance

-Input Data
-Calculation Methodology
-Composite Construction
-Disclosures
-Presentation and Reporting
-Real Estate
-Private Equity
-Wrap Fee/SMA Portfolios

Outside Compensation Require written consent from employer

and Benefits

Traveling for It is not required the each person pays for their own
Business/to a Client room

Issuing an Investment All clients of a firm must be given it at the same time
Recommendation
Report

GIPS Compliance with Firms may include performance figures for periods prior
CVGs to January 1, 2006, that were compliant with their
applicable CVG, together with GIPS-compliant
 performance figures for periods after that date, and
claim GIPS compliance
Front-Running Prohibited for employees at financial firms

Complying to Best way is to only share information with someone in

Preservation of the company working with that client
Confidentiality

Record Retention Requires members to maintain records of the data and

analysis they use to develop their research
recommendations.

Fair Dealing If a client places an order that goes against the firm's
recommendation for that security, members and
candidates should inform the client of the discrepancy
between the order and the firm's recommendation
before accepting the order.

Independence and Specifically addresses the requirement of disclosure of

Objectivity the nature of any compensation from the subject
company

Referral Fees Members and candidates must disclose to employers

and to affected clients, before entering into any formal
agreement for services, any benefits received for the
recommendation of services provided by the member.

Responsibilities of Speaking to the employee to determine the extent of

Supervisors the violations and receiving assurances that it will not be
repeated is not enough.

Performance Statements about performance must be accurate, fair

Presentation and complete.

Bond Indenture Contract that specifies all the rights and obligations of
the issuer and owners of a fixed income security.

Negative Covenants Prohibitions on the borrower.

Affirmative Covenants Actions that the borrower promises to perform.

Maturity or Term to Length of time until loan contract or agreement expires.

Maturity Remaining life of bond.

Par Value Amount borrower promises to pay on or before maturity

date.
Coupon Rate Rate when multiplied by Par Value gives amount of
annual interest payment.

Non-Amortizing Bond Characteristic of most T-Bonds and Corporate bonds.

(Bullet Bond or Bullet Pay only interest until maturity, at which time full face
Maturity) value is paid back.

Bullet Bonds Pay entire principal in one lump sum at maturity.

Serial Bonds Pay off principal thru series of pmts over time.

Amortizing Securities Make periodic principal and interest pmts (i.e., MBS &
ABS).

Sinking Fund Provide for the retirement of a bond thru a series of

Provisions predefined principal pmts over the life of the issue.

Cash Payment - issuer deposits cash with trustee who

retires applicable proportion of bonds at par using
lottery selection.
Delivery of Securities - issuer purchases the bonds with
equal total par value in the market and delivers them to
trustee who will retire them.

options which benefit Conversion features, put provisions, and floors, non-
investor callable.
FLOORRECEIVED=bondholder

options which benefit Call provisions, prepayment options, sinking fund

issuer provisions, and caps. CAPPAID=issuer

Callable Bond Issuer has right (not obligation) to retire all or part of
Provisions bond prior to maturity. There may be several call dates,
and customarily when a bond is called on the first
permissible call date, the call price is above par value.
The call price will normally decline over time according
to the schedule.

Put Provision Grants right to sell (put) the bond to the issuer at a
specified price prior to maturity.

When would it be If interest rates have risen and/or the creditworthiness of

beneficial for a the issuer has deteriorated so that the market price of
the bond has fallen below par.
bondholder to
Refunding Provisions Nonrefundable bonds prohibit premature retirement of
exercise a put option?
issue using proceeds of a lower cpn bd. Bds that carry
these provisions can be freely callable, but not
refundable.

Non-Refundable Bond Prohibit call of an issue using proceeds from a lower

coupon bond issue.

Coupon Formula Formula used to find new rate on a floating-rate security

(Floater) [New Coupon Rate = Reference Rate (+) or (-) Quoted
Margin].

Inverse Floater Cpn moves in direction opposite to reference rate

New Coupon Rate = Constant Rate (K) - (L * Reference
Rate)
Where K is the constant and L is the multiplier

Coupon Rate Cap Maximum rate paid by borrower/issuer.

Coupon Rate Floor Minimum periodic coupon interest payment received by

lender/security owner.

Coupon Rate Collar Simultaneous combination of both cap and floor.

Regular Redemption When bonds are redeemed under the call provisions
specified in the bond indenture.

Special Redemption When bonds are redeemed to comply with a sinking

fund provision or because of a property sale mandated
by government authority.

Repo Arrangement where an institution sells a security with a

commitment to buy it back at a later date at a specified
higher price.

Repo Rate The annualized percentage difference between lender's

purchase and sell back price.

Why are Repo They are not regulated by the Federal Reserve and
issuances preferred provide better collateral positions for the lenders if the
among lenders? sellers goes bankrupt. Lenders have only an obligation
to sell back the repos rather than stake a claim against
sellers' assets.

Inflation-Indexed Coupon formulas based on inflation; Coupon Formula

Bonds Ex.: 3% + annual change in CPI. Par value changes with
 chgs in CPI
Type of Risks 1) Interest rate risk 2) Yield curve risk 3) Call risk
4) Prepayment risk 5) Reinvestment risk 6) Credit risk
7) Liquidity risk 8) Exchange-rate risk 9) Inflation risk
10)Volatility risk 11) Event risk 12) Sovereign risk

Interest Rate Risk The effect of changes in the prevailing market rate of
interest on bond values. Inverse relationship btwn
interest rates and bd prices. i.e., When rate goes up,
bond prices fall.

Interest Rate Risk and Long TTM = higher int rate risk (longer time to get your
Bond Features $$)
Smaller cpns = higher int rate risk (longer time to get
your $$)

Low cpn then high price vol.

High cpn then low price vol.

LT to Mat then high price vol.

ST to Mat then low price vol.

Interest Rate Risk and When mkt int rates are high, price vol will be lower
Bond Features When mkt rates are low price vol will be higher
(Market Interest Rates)
Increase int rate then decrease vol.
Decrease int rate then increase vol.

Interest Rate Risk and Deep Disc Bd w/ low cpn relative to mkt then bd has
Bond Features increased price vol.
(Deep Discount Bonds Deep Disc Bd w/ high cpn relative to mkt then bd has
1) decreased price vol.

Interest Rate Risk and Compared w/ Bds selling at par, deep disc bds have
Bond Features greater price vol.
(Deep Discount Bonds Investors expecting declining int rates prefer zeros w/
2) long term to mat.
Decreasing Int Rates then Reinvestment Rate Decreases
and will not earn initial YTM
Int Rate Decrease then Bd Price Increases with
Increased Cap Gain.
 Investors expecting increasing int rates will not prefer
zeros w/ long term to mat.
Premium Bond Cpn Rate > Current Yld > YTM
Cpn Rate > mkt yld > par value
Premium/Price decreases to par as bd approaches mat.

Discount Bond Cpn Rate < Current Yld < YTM

Cpn Rate < mkt yld < par value
Discount/Price increases to par as bd approaches mat.

Par Bond Cpn Rate = Current Yld = YTM

Cpn Rate = required mkt yld, then bd price = par value.

What measure Duration

approximates the
interest rate risk on
bonds?

What does a bond's The interest rate risk of a bond, or parallel changes in the
duration tell us? yield curve (rate changes at every maturity).

Which call provision Call protection period.

gives investors
protection against call
risk?

Prepayment Risk Similar to Call Risk, risk of prepayment when interest

rates fall, requiring investor to reinvest at a lower rate.

What is the relationship Positive, higher volatility in rates increases probability of

between interest rate yields falling to level where bonds will be called.
volatility and Call or
Prepayment Risk?

Reinvestment Risk Bds w/ embedded call options have greater

Embedded Call reinvestment risk. All or part of principal can be repaid in
Options low int rate environment.

Do non-callable Yes, since the coupon interest payments must be

coupon bonds have reinvested, those cash flows are subject to reinvestment
reinvestment risk risk.
before maturity?

Do non-callable zero- No, since there are no cash flows to reinvest until
coupon bonds have maturity.
reinvestment risk
before maturity?
Credit Risk (1) Default Risk
Three Types (2) Credit Spread Risk
(3) Downgrade Risk

Credit Spread Risk Diff btwn a Bd's Yld and comparable Risk Free Bd's Yld.
All else equal the riskier the bd the higher the spread.

Volatility Risk Risk associated with fixed-income securities that have

embedded options, such as call options, prepayment
options, or put options. Changes in interest rate volatility
affect the value of these options.

Types of Event Risk 1) Disaster

2) Corporate Restructuring
3) Regulatory Issues.

Yield Curve Risk The possibility of changes in the shape of the yield
curve.
Relation between bond yields and maturity.
Non-parallel shift.

What do changes in Yields are changing by different amounts for bonds with
the shape of the Yield different maturities.
Curve tell investors?

Cumulative Coupon Bond traded with next coupon attached.

Bond

Ex-Coupon Bond Bond traded without right to next coupon.

Full (or Dirty) Bond Total amount paid for bond, including accrued interest.
Price

Full Price Full Price (Dirty) = Clean Price + Accrued Interest.

Sovereign Risk Risk of changes in governmental attitudes and policies

toward the repayment and servicing of debt.

Portfolio Duration The combined weighted average duration of all the

bonds in the portfolio weighted by their dollar values
(based on market value) of the bonds that make up the
portfolio. A good measure for bd price sensitivity to
parallel shifts in the yield curve.
What do changes in Yields are changing by different amounts for bonds with
the shape of the Yield different maturities.
Curve tell investors?

What does a bond's The interest rate risk of a bond, or parallel shift changes
duration tell us? in the yield curve (rate changes at every maturity).

What measure Duration.

approximates the
interest rate risk on
bonds?

Variable Rate Bond Variable Rate Bond Interest Rate Risk is highest 1 day
Interest Rate Risk after reset date.

Floating-Rate Security A floating-rate security will be much less sensitive to

Sensitivity and Market changes in market yields than a fixed-coupon bond of
Yields equal maturity and thus lesser duration.

Floating-Rate Security The longer the time period between the two reset dates
Sensitivity and Reset for a floating rate security (coupon reset period), the
Dates greater the amount of potential bond price fluctuation
and therefore greater duration, IE interest rate risk.

Effect on interest rate Interest rate risk and duration increases.

risk and duration
Maturity increases

Effect on interest rate Interest rate risk and duration decreases.

risk and duration
Coupon Increases

Do non-callable Yes, since the coupon interest payments must be

coupon bonds have reinvested, those cash flows are subject to reinvestment
reinvestment risk risk.
before maturity?

Do non-callable zero- No, since there are no cash flows to reinvest until
coupon bond have maturity.
reinvestment risk
before maturity?

Callable Bond Less Certain Cash Flow, Cap on price appreciation,

Disadvantages Reinvestment risk.
Reinvestment Risk A bond has more Reinvestment Risk when:
1) The coupon is higher so that interest cash flows are
higher
2) It has a call feature
3) It is an amortizing security
4) It contains a prepayment option.

Yield on Risky Bond Yield on Risky Bond = Yield on Default Free Bond +
Credit Spread.

Current Yield Current Yield = (annual cash coupon payment) / (market

price of bond).

This measure looks at the current price of a bond instead

of its face value and represents the return an investor
would expect if he or she purchased the bond and held
it for a year. This measure is not an accurate reflection of
the actual return that an investor will receive in all cases
because bond and stock prices are constantly changing
due to market factors.

Dollar Duration Dollar Duration = Dollar change in bond price for a 1%

change in yield.

What is the relationship Positive.

between interest rate
volatility and Call or
Prepayment Risk?

Value of a Callable Callable Bond Value = Value of Option Free Bond -

Bond Value of Call

Value of a Putable Putable Bond Value = Value of Option Free Bond + Value
Bond of Put.

How Central Govts 1) Regular Cycle Auction-Single Price

Issue Sovereign Bonds 2) Regular Cycle Auction - Multiple Price
3) Ad Hoc auction System
4) Tap System.

T-Notes 1) 2,3,5 & 10 years Maturity

2) Carry Coupon & Non-Callable
T-Bonds Bonds have maturity of more than 10 years (20 to 30
years).
Non-Callable.

On-the-run issues The most recently auctioned Treasury issue, also known
as the current issue.

Off-the-run issues Older issues that have been replaced by a more recently
auctioned issue.
Treasuries with several subsequent issues are termed
well off-the-run.

Coupon Strips Refers to strips created from coupon payments stripped

(denoted as CI) from the original security.

Principal Strips (PI) Refers to bond and note principal payments with the
coupons stripped off. Those derived from stripped
bonds are denoted (bp) and those from stripped notes
(NP).

TIPS 5 & 10 Yr Notes & 20 Yr bonds offered by US Treasury

with Inflation Protection.
Provides Real ROR w/ Semiannual Inflation Adj.
Principal adjust, but cpn is fixed.

Adjusted Par Bd Value * Cpn = Int Pmt

TIPS cpn pmt = adj principal at beg period ( 1 + i) c

Principal Adjustment OR
and Coupon adj principal at end period * c

where i = inflation rate and c = cpn rate

MBS Mtge Pass thru amortizing sec created by pooling large

number of mtges.
Shrs sold as participation certificates.
Scheduled prin pmts, prin prepmts, & int pmts passed
thru to investors after deducting admin & svce fees.

CMO Collateralized Mtge Obligation

Defines pmt structure that distributes pmt risk among
various investors.

Types of Federal 1) Federally Related Institution (GNMA, TVA)

Agencies 2) Govt Sponsored Enterprise (Federal Farm Credit
System, Fed Home Loan Bank System, FNMA, Freddie
Mae, Sallie Mae).
GSEs commonly issue debentures.
CMO Creation 1) Redistribute the prepayment risk
Motivation 2) Create security with different maturity.

Municipal Bonds Munis. Cpn Int typically exempt from federal tax in U.S.

GO Muni Bonds Backed by the full faith, credit, and taxing power of the
issuer.

Types of GO Muni 1) Limited Tax GO

Debt 2) Unlimited Tax GO
3) Double Barreled Bond
4) Appropriation Backed Obligation/Moral Obligation
Bonds.

Muni Revenue Bonds Supported only through revenues generated by projects

that are funded with the help of the original bond issue.

Taxable-Equivalent To compare tax exempt bd w/ taxable bd convert tax

Yield exempt yld to taxable equivalent.
It is the yld offered on a taxable sec to give same after-
tax yld as tax exempt.

Taxable-Equivalent Yield = Tax-Free Yield / (1 - Marginal

Tax Rate)

Corporate Bonds Credit ratings on corp bds are a function of four factors:
Credit Ratings (1) Character
(2) Capacity
(3) Collateral
(4) Covenants

Collateral Trust Bonds Bonds backed by financial assets.

Debentures Unsecured Debts.

Credit Enhancements 1) Third Party Guarantees

2) Letter of Credit
3) Bond Insurance.

Medium Term Notes 1) Register with SEC Rule 415(Shelf Registration)

2) Maturity - 9 months to 100 years
 3) Combined with Derivatives are called structured
securities
4) Agents do on best effort basis.
Type of Structured 1) Step Up Notes
Medium Term Notes 2) Inverse Floaters
3) Deleveraged Floaters
4) Dual Indexed Floaters
5) Range Notes
6) Index Amortizing Notes

Commercial Paper A short-term unsecured debt instrument used by

corporations to borrow money at rates lower than bank
rates. CP has maturities from 2 - 270 days; unregulated
by the SEC.

Directly-Placed Paper Commercial paper that is sold to large investors without

going through an agent or broker-dealer.

Dealer-Placed Paper Sold to purchasers through a commercial-paper dealer.

Certificates of deposit Issued by banks and sold to their customers.They

(CDs) represent a promise by the bank to repay a certain
amount plus interest and, in that way, are similar to other
bank deposits.

Bankers Acceptances Guarantees by a bank that a loan will be repaid. They are
created as part of commercial transactions, especially
international trade.

Asset Backed Credit Card Balances, Auto Loans, Receivables, etc.

Securities Can be securitized like residential mortgages into what
are known as asset backed securities (ABS).

Special Purpose SPV is a bankruptcy remote entity; Meaning no claim to

Vehicle SPV if Corporation goes bankrupt. Not a sub of corp,
can achieve high credit rating and borrow at lower rates
than corp.

Credit Enhancement 1) Corporate Guarantees

For ABS(CLB) 2) Letter of Credit
3) Bond Insurance

Collateralized Debt Debt securities for which the underlying collateral is

Obligations itself other debt (loans, mortgages, bonds, other CDOs,
(CDO) etc...).
1) Arbitrage CDOs - creator hopes to profit from spread
between cash flows to be received on underlying assets
and payments made by CDO
2) balance sheet CDOs - used to reduce debt exposure
on firms' balance sheets.
FED Interest Rate Tools 1) The discount rate
2) Open market operations (most often used)
3) Bank reserve requirements
4) Persuading banks to tighten or loosen their credit
policies

International Bonds (1) Foreign Bds

(2) Eurobonds
(3) Sovereign Debt

Foreign Bonds Issued in a local mkt by a foreign issuer.

Eurobonds Issued outside the legal system of a country and not

registered with regulatory agencies.

Sovereign Debt Debt of a country's govt.

Sovgn debt rating depends on govt's willingness and
ability to repay debt.

On-the-run issues The most recently auctioned Treasury issue, also known
as the current issue.

Off-the-run issues Older issues that have been replaced by a more recently
auctioned issue.
Treasuries with several subsequent issues are termed
well off-the-run.

Term Structure Of A yield curve displaying the relationship between spot

Interest Rates rates of zero-coupon securities and their term to
maturity.

Yield Curve Graphical plot of yld on a particular bd flavor against its

mat.
Differentiate btwn on-the-run and off-the-run yld
curves.

Normal Yield Curve Long-term rates are greater than short-term rates, so the
curve has a positive slope.
Flat Yield Curve The yield on all maturities are essentially the same.

Inverted Yield Curve Long-term rates are less than short-term rates, thus yield
curve a negative slope.

Humped Yield Curve Rates in the middle spectrum are higher or lower than
those for both short and long maturity bonds.

Pure Expectation States that the yield for a particular maturity is an

Theory average(not a simple average) of the short term rates
that are expected in the future.
Yld curve shape reflects investor expectations about fut
behavior of int rates.
Fwd rates that can be compounded using today's spot
rates are best guess of fut int rates.

Liquidity Preference States that investors require a risk premium, in addition to

Theory expectations about future short term rates for holding
longer term bonds.
Investors prefer greater liquidity and will demand a
premium (higher ylds) to invest in LT issues.
This is consistent with the fact that interest rate risk is
greater for longer maturity bond.

Market Segmentation States that investors and borrowers have preferences for
Theory different maturity ranges.
Mkt for debt secs is segmented across investor mat
preferences.
Thus the supply of bonds (desire to borrow) and
demand for bond (desire to lend) determine equilibrium
yields (level of int rates) for various maturity ranges
within each mkt segment.

Short term rates If ST rates are expected to rise, then LT yield will be
expected to rise and higher than ST yield, & yield curve will slope upward.
Yield Curve

Short Term Rates and 1) Short Term rates expected to rise then Upward
Yield Curve Sloping Curve
2) Short Term rates expected to fall then have a
downward Sloping Curve
3) Short Term rates expected to rise then fall then have a
Humped Yield Curve
 4) Short Term rates expected to remain constant then
have a Flat Yield Curve.
Spot Rates The appropriate discount rates for individual future
payments.

Absolute Yield Spread The difference between yields on two bonds.

Absolute Yield Spread = [yield on the higher-yield bond
- yield on the lower-yield bond]
Absolute yield spreads are usually expressed in basis
points (100ths of 1%).

Relative Yield Spread Absolute yield spread expressed as a percentage of the

yield on the lower-yield bond.
Relative Yield Spread = [Absolute Yield Shield/Yield on
lower-yield bond]
OR
[(yield on the higher yield bond / yield on the lower
yield bond) - 1]

Yield Ratio Yield Ratio is the ratio of the yields on the two bonds
(Given Security to Benchmark Security).

Yield Ratio = [yield on the higher yield bond / yield on

the lower yield bond]

After-Tax Yield The yield on a taxable bond, after adjustment for federal
income taxes, is called the after-tax yield
After-Tax Yield = (Taxable Pre-Tax Yield) × (1 - Marginal
Tax Rate)
Taxable-Equivalent Yield|Taxable-Equivalent Yield = Tax-
Free Yield / (1 - Marginal Tax Rate)

Credit Spreads Diff in spread btwn two issues that are identical in all
respects but credit rating.
Function of state of economy.

Credit Spreads Expanding economy then credit spreads decline.

Expanding Economy Corps have stronger cash flows.

Credit Spreads Economic contraction then credit spreads increase.

Contracting Economy Cash Flows are pressured, then greater possibility of
default, and required ylds on low quality issues increase.
Nominal Spread The difference in yield basis points between a non-
treasury security and similar treasury security; i.e.,
difference between YTM Corporate Bond and the YTM
of a similar Treasury Bond.

Alternative Bond ABS

Issues CCRs - Credit Card Receivables
CARS - Automobile (loans) backed Bonds

Assets w/ amortizing cash flows bundled together,

sliced up, and sold to investing public.

Basic Bond Pricing Use Constant Rate (YTM) to discount all cash flows.
[Maturity Value]/[(1+i/m)^n*m]

Bond Pricing Cpn bd can be thought as of a portfolio of zero cpns

No Arbitrage priced according to no-arb relationship.
Pricing Relationship Each individual int rate used to compute PV of single
cash flow in future is a spot rate.

Bond Pricing (1) Find PV of all fut cash flows discounting at constant
Two Methods to Price rate applied to all cash flows (YTM).
a Bond (2) Treat each cash flow as its own zero-cpn bd and find
the PV of each 'zero' using spot rate for each cash flow.

To prevent arb these two prices must be the same.

YTM must be an avg of the spot rates.

Zero Coupon Price is the PV of its Par Value.

Market convention states semi-annual compounding
used when pricing zeros.

Present Value [Maturity Value]/[(1+i/2)^n*2]

Zero Coupon Bond Where i/2 is semiannual coupon rate and n*2 is number
of compounding periods.

Accrued Interest Interest that is either payable or receivable, and that has
been recognized, but not yet paid or received.
Accrued interest occurs as a result of the difference in
timing of a security's cash flows and the measurement of
these cash flows.
Day Count Convention The notation used for day-count conventions shows the
Notation number of days in any given month divided by the
number of days in a year.
The result represents the fraction of the year remaining
that will be used to calculate the amount of future
interest owed.

Most common Day (1) 30/360

Counts Used in Bond (2) Actual/360
Markets (3) Actual/365
(4) Actual/Actual

30/360 30/360 is the easiest convention to use because it

Day Count Convention assumes that there are 30 days in every month, even
though some months actually have 31 days. For example,
the period from May 1, 2006 to August 1, 2006 would be
considered to be 90 days apart. Given the simplicity of
this day-count convention, it is often used in calculations
of accrued interest for corporate, agency and municipal
bonds. It is also commonly used by investors of
mortgage backed securities.

Actual/360 Actual/360 convention is most commonly used when

Day Count Convention calculating the accrued interest for commercial paper, T-
Bills and other short-term debt instruments that have
less than one year to expiration. It is calculated by using
the actual number of days between the two periods,
divided by 360.

Actual/365 Actual/365 convention is the same as the actual/360,

Day Count Convention except that it uses 365 as the denominator. This is used
when pricing U.S. government Treasury Bonds.

Actual/Actual Actual/Actual convention uses the actual number of days

Day Count Convention between two periods and divides the result by the actual
number of days in the year, rather than assuming that
each year is made up of 360 or 365 days. Of course, we
know that in reality there are always 365 days in a year -
with the exception of leap years - but these conventions
are standards that have developed over time and help to
ensure that everyone is on an even playing field when a
bond is sold between coupon dates.
Accrued Interest When a bd is sold btwn cpn pmt dates, part of next cpn
Bond Price belongs to seller.
This portion of cpn is called accrued int.

AI Period = # of days from LAST cpn pmt date to settle

date / # of days in cpn period
AI = AI Period * Cpn

Accrued Interest (1) Clean Price: Bd Price w/out accrued int

Clean and Dirty Prices (2) Dirty Price: Bd Price w/ accrue int

clean price = dirty price - AI

LIBOR London Interbank Offering rate. Determined each day

and published by the British Bankers' Association for
several currencies, including the U.S dollar ,Canadian
dollar, Australian dollar, the Euro, Japanese yen, British
pounds, and Swiss francs, among others.

Problem in estimation 1) Uncertainty of Principal Cash Flow

of Cash flow 2) Uncertainty of Coupon Cash Flow
3) Bond Convertible/exchangeable.

Explicit Paying Debt 1) Coupon Interest Payment

Security Returns 2) Recovery of principal along with capital gain/loss
3) Reinvestment income (from investing coupon
payments).

Yield on Risky Bond Yield on Risky Bond = Yield on Default Free Bond + Risk
Premium(Credit Spread).

Current Yield Current yield is concerned only with coupon cash flow,
but does not consider capital gains/losses or
reinvestment income.
Current Yield = Annual Cash Coupon Payment / Bond
Price.

Yield to Maturity (YTM) YTM uses a single discount rate to value the cash flows,
so it ignores the shape of the spot yield curve.
It is the annualized IRR of a bond based on its price and
cash flow. It is the most popular of all yield measures
used in the marketplace.
Realized Yield on If the reinvestment rate is < YTM, then the realized yield
Bond on the bond will be less than the YTM.
The realized yield will always be between the YTM and
the assumed reinvestment rate.

YTM YTM assumes all cpns will be automatically reinvested at

Reinvestment YTM rate to mat.
Assumption Failure to reinvest cpns at YTM will result in a different
actual yield.

Yield to call (YTC) YTC - Investors are typically interested in knowing what
the yield will be if the bond is called by the issuer at the
first possible date. This is called yield to first call or yield
to call (YTC).

Yield to Call YTC is the more conservative yld measure whenever the
Quoted Callable Bd's quoted Callable Bd's Price is greater than the Bd's Call
Price > Bd's Call Price Price.

Yield to First Par Call YTFPC is calculated in exactly the same way as YTC,
(YTFPC) except that the number of years is to first par call, and
FPC becomes par value.

Yield to put (YTP) YTP - Some bonds may be put (sold back to the issuer
prior to maturity) at the option of the holder. Investors
are typically interested in knowing what the yield will be
if the bond is put to the issuer at the first possible date.
This is called yield to put (YTP).

Yield to worst (YTW) YTW involves the calculation of YTC and YTP for every
possible call or put date, and determining which of these
results in the lowest expected return.
Least attractive yield option when bond has a call or put
option.

Cash flow yield (CFY) CFY incorporates a projection as to how these

prepayments are likely to occur. Once we have this in
hand, we can calculate CFY via an internal rate of return
measure, similar to the YTM.
Cash Flow yield (CFY) is use for MBS & other amortizing
securities.
Yield to Refunding Yield to Refunding refers to a specific situation where
the bond is currently callable & current rates make the
callable attractive to the issuer, but covenants contain
provisions against refunding until some future date.

Bond Equivalent Yield Different cpn frequencies mean that ylds cannot be
(BEY) compared directly without conversion.
and For example, annual pay bd's yld compared to
Annual Equivalent semiannual pay bd's yld.
Yield (AEY) Must convert BEY to EAY, or vice versa.

Note: BEY is synonymous w/ seminannual YTM

Bond Equivalent Yield BEY of an annual-pay bond

(BEY) BEY = [(1 + annual YTM)^1/2 - 1] * 2

Annual Equivalent AEY = [1 + (YTM/2)]^2 - 1

Yield OR
AEY = [1 + (BEY/2)]^2 - 1

Bootstrapping Spot Bootstrapping spot rates from existing cpn bds using
Rates known ST spot rates.
For example:
Know one period rate at 4%
Given two year 8% cpn bd w/ price of 100
Layout arb-free price relationship
100 = 8/(1.04)^1 + 108/(1 + Zˇ2)^1
Then compute two period zero-coupon bd spot rate
Zˇ2 = [108 / 92.3077]^0.5 - 1 = 8.167%
Solve for Zˇ3 given Zˇ1 and Zˇ3, along w/ three period
cpn bd.

Forward Rate Fwd Rate is a borrowing/lending rate for a loan to be

made at some future date.

Forward rates are calculated from spot rates of the yield

curve

N-period Spot Rate (SˇN) = [1 + ˇ1fˇ0)(1+ˇ1fˇ1) ...

(1+ˇ1fˇN)]^1/N - 1

ˇ1fˇN = [(1+ spotˇn+1)^n+1 / (1 + spotˇn)^n] - 1

Forward Rate Investors should receive the same total return from
Total Return investing in a 2 yr bd as investing in a 1 yr bd, and then
rolling the proceeds into a second 1 yr bd.
The two 1 year rates multiplied together will equal the 2
year rate squared.

Z-Spread 1) Z-Spread is the credit spread that adjusts for the

curvature of the spot rate yld curve.
2) Z-Spread is the constant spread which must be added
to each rate on the Treasury spot yield curve in order to
make the present value of the risky bond's cash flows
equal to its market price.
3) The steeper the benchmark spot rate curve, the
greater the difference between the two spread
measures.
4) The earlier bond principal is paid, the greater the
difference between the two spread measures.

Option Adjusted 1) OAS is the Z-Spread w/ the option value removed

Spread(OAS) 2) Option Removed Spread
3) OAS is used when bonds have embedded options.
3) The OAS is the spread to the Treasury spot rate curve
that the bond would have if it were option-free.
4) The OAS is the spread for non-option characteristics
like credit risk, liquidity risk, and interest rate risk.

Bond Option Cost Z-spread - OAS = Option Cost in %.

Put Option Z Spread Put Option Z-spread < OAS.

Duration Duration is a measure of the slope of the price yield

Slope Price Yield function.
Function This function is steeper at low int rates, and flatter at high
int rates.

Duration (1) Duration (int rate sensitivity) is high at low int rates,
Interest Rate Sensitivity and
Non Callable Bonds (2) Duration (int rate sensitivity) is low at high int rates.

This concept holds for non-callable bonds

Duration (1) Bd w/ smallest price ▲, given ▲ in yld, has shortest

▲ Price & ▲ Yield mat and highest cpn.
Maturity & Coupon (2) Bd w/ largest price ▲, given ▲ in yld, has longest
mat and lowest cpn.
Convexity Convexity is a measure of the degree of curvature or
convexity in price/yield relationship.
It accounts for the amt of error in estimated duration
price.
Price yield curve more convex at low yld segment.

Full Valuation The full valuation approach requires the re-valuation of a

Approach bond for a range of interest rate changes.

The The duration/convexity approach utilizes the measure of

Duration/Convexity duration combined with convexity to estimate the
approach percentage price change of a bond for a given change
in interest rates.

Coupon & YTM Cpn and YTM are inversely related to Dur.
Relationship to low cpn then longer dur.
Duration high cpn then shorter dur.

Maturity Maturity is directly related to Dur.

Relationship to Dur of zero cpn bd is equal to its mat.
Duration Cpn bds have shorter dur than zero cpn w/ same term to
mat.

Upside price With a callable or pre-payable debt the upside price

appreciation appreciation in response to decreasing yields is limited.
Callable or pre-
payable debt

Downside Price With Putable debt the downside price in response to

response to Increasing increasing yields is limited.
Yields
Putable Debt

Positive Convexity The increase in bond price when yield decreases is more
than decrease in bond price when yield increases.
Low ylds, then prices rise at an increasing rate as ylds
fall.
High ylds, then prices fall at a decreasing rate as ylds
rise.
Negative Convexity Callable or pre-payable debt, the upside price
appreciation in response to decreasing yields is limited
as once the bond reaches the call price the price wont
appreciate.

If Bd is callable and likely to be called,as ylds fall, no

one will pay a higher price than call price.
Price will not rise significantly as ylds fall; as ylds fall,
prices rises at a decreasing rate.

This is the concept of negative convexity (illustrated by

the "back bending" portion of callable bd graph).
Similarly for bonds with put option the negative
convexity phenomenon occurs at high yields.

Convexity Special features of callable bonds are that they have pos
Callable Bonds convexity when ytm is high; and
negative convexity when ytm is low.

Convexity Inverse relationship btwn cpn & convexity,if yld and mat
Coupon, Yield, and constant.
Maturity Inverse relationship btwn yld & convexity,if cpn and mat
constant.
Direct relationship btwn mat & convexity,if yld and cpn
constant.

Effective Duration Eff Dur linearly approximates change in bd price for 100
bp change in yld.
Measure of price sensitivity to changes in yld.
First derivative price/yld function.
Effective Duration = [V- - V+] / [2 V0 (▲y)^2 ]
V- : Bd price if yld decreases
V+ : Bd price if yld increases
V0: Current Bd Price
▲y : Change in yld (in decimal form)
Note: 1% = 0.01

Effective Duration is the preferred measure because it

gives a good approximation of interest rate sensitivity for
both option-free bonds and bonds with embedded
option.
Effective Convexity Measures how much bd's price yld curve deviates from
linear approximation of duration curve.
Second derivative price/yld function

Effective Duration = [V- + V+ - 2V0] / [2 V0 (▲y)^2 ]

V- : Bd price if int decreases
V+ : Bd price if int increases
V0: Current Bd Price
▲y : Change in yld (in decimal form)
Note: 1% = 0.01

Macaulay Duration Macaulay Duration is an estimate of a bond's interest rate

sensitivity based on the time, in years, until promised
cash flows will arrive. Not useful measure for bonds with
embedded options.

Modified Duration Modified Duration is derived from Macaulay Duration

and offers slight improvement over Macaulay duration in
that it takes the current YTM into account.
Measure of price vol given small changes in required
yld.

It is always neg for option free bds because of inverse

relationship btwn bd price and bd yld.

Mod Dur = Mac Dur / (1 + y/m); where m is number of cpn

pmts
%▲P = - Mod Dur * ▲y

Not useful for bonds with embedded options.

Portfolio Duration The duration of a portfolio is simply the weighted

average of the durations of the individual securities in
the portfolio

Portfolio Duration = wˇ1Dˇ1 + wˇ2Dˇ2 + ... +wˇN*DˇN

Where: w is equal to the individual security's weight and
D is equal to the individual security's duration.

Limitations of Portfolio duration:

1) limitations of portfolio duration as a measure of
 interest rate sensitivity stem from the fact that yields may
not change equally on all the bonds in the portfolio
2) Useful only for parallel changes of yield curve.
Convexity Effect 1) Convexity is a measure of the curvature of the price-
yield curve. The more curved the price-yield relation is,
the greater the convexity.
2) A straight line has a convexity of zero. If the price-
yield curve were, in fact, a straight line, the convexity
would be zero.
3) The reason we care about convexity is that the more
curved the price-yield relation is the worse our duration-
based estimates of bond price changes in response to
changes in yield are. The greater the convexity the
greater the error in price estimates based solely on
duration.

Percentage Change in Percentage Change in Price = duration + convexity effect

Price Percentage Change in Price = ( [-duration × ▲y)] +
[convexity × (▲y)^2 ] ) × 100
Note: 1% = 0.01

Effective Convexity Effective Convexity takes into account changes in cash

versus flows due to embedded options, while modified
Modified Convexity convexity does not.

The difference between modified convexity and

effective convexity mirrors the difference between
modified duration and effective duration.

Price Value of a Basis PVBP shows what happens to bd price given 1 bp

Point change in yld.
Another way of measuring bd's potential price vol.
It is an absolute value.

Price Value of a Basis Point = (duration) (.001) (bond

value)

Dollar Duration Dollar Duration Price ▲ = D/100 ▲BP/100 MV

Price ▲

Discounted Cash Flow Convert btwn a HPY, EAY, and MMY

Applications EAY and MMY are annualized version of the HPY
 HPY = (P1 - P0 + Income) / P0
Discounted Cash Flow BDY = D / F * 360 / t
Calculations where D is discount rate and F is face value

EAY = (1 + HPY)^365/t - 1

MMY = [360 BDY] / [360 - (t BDY)]

Probability distribution the probabilities of all the possible outcomes for a

random variable. Probability of all possible outcomes
must sum to 1.

Discrete random number of possible outcomes can be counted and for

variable each possible outcome there is a measurable and
positive probability.

Continuous random the number of possible outcomes is infinite, even if lower

variable and upper bounds exist.

Discrete distribution p(x) = 0 when x cannot occur, or p(x) > 0

Continuous p(x) = 0 even though x can occur. Only consider P(X1 ≤ X

distribution ≤ X2)

Probability function 0 ≤ p(x) ≤ 1

Σp(x) = 1 the sum of the probabilities for all possible

outcomes, x, for a random variable, X, equals 1

Probability density (pdf) function, denoted f(x), than can be used to

function generate the probability that outcomes of a continuous
distribution lie within a particular range of outcomes. For
a continuous distribution, it is the equivalent of a
probability function for a discrete distribution.
PDF - used to calculated the probability of an outcome
between two values

Cumulative distribution distribution function, defines the probability that a

function (cdf) random variable, X, takes on a value equal to or less than
a specific value, x. Represents the sum, or cumulative
value, of the probabilities of the outcomes up to and
including a specific outcome.
F(x) = P(X ≤ x)
Discrete uniform probabilities for all possible outcomes for a discrete
random variable random variable are equal.

Binomial distribution assumes a variable can take one of two values

(success/failure) or, in the case of a stock, movements
(up/down). A binomial model can describe changes in
the value of an asset or portfolio, it can be used to
compute its expected value over several periods

Bernoulli random binomial random variable for which the number of trials
variable is 1. Final outcome is the number of successes in a series
of n trials. Final outcome is number of successes in a
series of n trials.

p(x) = P(X = x) = (number of ways to choose x from n) pⁿ

(1-p)ⁿ-ⁿ

Expected value of X = np
E(X) =
n trials
p success

Variance of binomial np (1-p)

random =

Up move factor U - 1.01

Down move factor D = 1/1.01

Node each possible values along binomial tree

Tracking error difference between total return on a portfolio and the

total return of the benchmark against which its
performance is measured.

Continuous uniform defined over a range that spans between some lower
distribution limit, a, and some upper limit b, which serves as the
parameters of the distribution.

Normal Distribution completely described by its can and variance

68% fall w/in ±δ
90% fall w/in ± 1.65δ
95% fall w/in ±1.96δ
99% fall w/in ±2.58δ
Univariate distributions distribution of a single random variable

Multivariate Probabilities associated with a group of random

Distribution variables and its meaningful only when the behavior of
each random variable in the group is in some way
dependent upon the behavior of the others. Can be
discrete - joint prob tables
Continu - normal distribution

Confidence interval range of values around the expected outcome within

which we expect the actual outcome to be some
specified percentage of time.

Confidence Intervals: 90% -X -1.65 to X +1.65

90% CI 95% - X - 1.96 to X +1.96
95% CI 99% - X - 2.58 to X +2.58
99% CI

Z-value number of std a given observation is from the population

mean

Standardization process of converting an observed value for a random

variable to its z-value

Z score "standardizes" observation from normal distribution;

represents # of standard deviations a given observation
is from the population mean

z = (obs. - pop. mean) / STD

z = x-µ / STD

Roy's safety-first optimal portfolio minimizes the probability that the

criterion return of the portfolio falls below some minimum
acceptable level. (threshold level)

Roys Safety First Ratio SFRatio = (expected return − minimum return)/(standard

deviation of return)

the larger the better

Discretely just the compound returns we are familiar with given

compounded returns some discrete compounding period

Effective annual rate = e^Rcc - 1

Holding period yield, ln (S1/So) = ln (1 + HPR) = Rcc

calculation from price
relative
Monte Carlo based on repeated generation of one or more risk
Simulation factors that affect security values, in order to generate a
distribution of security values.

Simple random method of selecting a sample in such a way that each

sampling item or person in the population being studied has the
same likelihood of being included in the sample.

Sampling error difference between a sample statistic and its

corresponding population parameter

Sampling error of sample mean - population mean

mean =

Stratified sampling Classification system to separate the population into

smaller groups based on one or more distinguishing
characteristics. From each subgroup a random sample is
taken and results are pooled.

often used in bond indexing because of the difficulty

and cost of completely replicating the entire population
of bonds.

Time-series data observations taken over period of time at specific

equally spaced time intervals

cross-sectional data sample of observations taken at a single point in time.

Standard error of known pop. variance: σx = σ / √n

sample mean = unknown pop. variance sx = s/√n

Point estimates single values used to estimate population parameters.

x = ∑x / n

Point estimate +/- (reliability factor x standard error)

Not as reliable as confidence interval estimates.

90% z = ±1.645 for 90%, 5% in each tail

One Tail 1.28 or -1.28
95% z = ±1.960 for 95%, 2.5% in each tail
one tail +1.65 or -1.65

99% z = ±2.575 for 99%, .5% in each tail

One Tail - +2.33 or -2.33

Data mining analysts repeatedly use the same database to search for
patterns or trading rules until one that "works" is
discovered.

bias refers to results where the statistical significance of

the patter is overestimated because results were found
through data mining.

one tailed test tests whether value is greater than (greater than equal
to) or less than (less than equal to) a given number
Ho: µ≤0 verses Ha: µ>0

two-tailed test tests whether value is equal to a given number

Ho: µ = 0 versus Ha: µ≠0

Relative Strength identify intermarket relationships. How doing relative to

Analysis index. not price

Change in polarity once a support level is breached in technical analysis,

principle resistance level is Change in PP

Test Statistic (Observed value - Hypothesized value) / Standard Error

Kondratieff Wave (K Recurring cycle of various frequencies in capital markets.

Wave) Postulates a 54-year cycle to western economies

TRIN (Arm Index) ratio of two ratios: (Number of advancing issues /

number of declining issues) / (volume of advancing
issues / volume of declining issues)

P-value = lowest level of significance for which the null hypothesis

may be rejected.

Chi-Square = (n-1) * observed variance / hypothesized variance

Important properties -If sample size n is sufficiently large (n>30), sampling

of central limit distribution will be approx. normal
theorem
-mean of population, and mean of distribution of all
possible sample means are equal
 -variance of distribution of sample mean is STD^2 / n the
population variance divided by the sample size.

Desirable properties of -unbaised

an estimator are: -Efficiency
-consistence

T-distribution based on small samples N<30 from populations

unknown variance.

-symmetrical
-defined by single parameters, degrees of freedom (df),
where df are equal to the number of sample
observations minus 1. n-1 for sample means.
-more probability in tails (fatter tails) than normal
distribution
-as df (sample size) gets larger, the shape of the T
distribution more closely approaches a standard normal
distribution

Distribution is Z-stat can be used as long as sample size is larger than

nonnormal but 30
population variance is
known

Distribution is T-stat can be used as long as sample size is large (n>30)

nonnormal and
population variance is
unknown

Sample selection bias some data is systematically excluded from analysis, lack
of availability

Survivorship bias most common form of sample selection bias. Does not
include things that cease to exist

Look-ahead bias occurs when a study tests a relationship using sample

data that was not available on the test date.

Time period basis result if the time period over the data is gathered is too
short or too long.

Hypothesis Testing -state hypothesis

Procedure -select approp. test statistic
 -specific level of significance
-state decision rule regarding hypothesis
-collect the sample and calculate sample stat
-make decision regarding hypothesis
-make decision based on results of test

Parametric Test rely on assumptions regarding distribution of population

and are specific to population parameters.

Non-parametric Test 1. hypothesis test of mean value for a variable that comes
situations from a distribution
2. when data are ranks rather than values
3. Hypo not involve parameters of distribution, such as
testing whether a variable is normally distributed. Use
run tests

Future Value (FV) The amount an investment is worth after one or more
periods.
FV = PV(1 + I/Y)ⁿ

Present Value (PV) current value of some future cash flow

PV = FV(1+I/Y)ⁿ

Annuities series of equal cash flows that occur at evenly spaced

intervals over time

Perpetuities annuities with infinite lives

PV perpetuitie = PMT/(discount rate)

IP expected inflation rate premium

risk premium E(R)= (1+RFRreal)(1+IP)(I+RP)-1

approximation formula E(R)≅RFR+IP+RP

for nominal required
rate

arithmetic mean the average; the sum of a set of numbers divided by the
number of numbers in the set

geometric mean used when calculating investment returns over multiple

periods or to measure compound growth rates

coefficient of variation expresses how much dispersion exists relative to the

mean of a distribution; allows for direct comparison of
dispersion across different sets
sharpe ratio measures excess return per unit of risk
-the larger the better

probabilistic variance δ²(X) = ∑P(x)x = P(x₁)[x₁ - E(X)]² + P(x₂)[x₂ - E(X)]² +...

Probabilistic Standard Deviation would be the square

root of the above.

correlation covariance divided by the product of the two standard

deviations

expected return of 2- E(Rp) = W₁E(R₁) + W₂E(R₂)

stock portfolios
var(Rp) = w₁²δ₁² + w₂²δ₂² + 2w₁w₂δ₁δ₂p(R₁.R₂)

δ₁δ₂p(R₁.R₂) = Cov₁,₂

According to the formula:

- risk ↓ benefit is possible if correlation < + 1
- if corr = 1 → no risk reduction benefit
- ↓ correlation, ↑ diversification & risk reduction benefit
- max diversification benefit when corr = - 1 because
opposite movements ↓ volatility.

sampling distribution probability distribution of all possible sample statistics

computed from a set of equal-size samples randomly
drawn from the same population. The sampling
distribution of the mean is the distribution of estimates of
the mean

sentiment indicators opinion polls, put/call ratio, VIX, margin debt, short
interest ratio

flow of funds TRIN, margin debt, mutual fund cash position, new
indicators equity issuance, secondary offerings

continuous FV = PV x e ^ (rate * time period)

compounding

Right/positive skewed mean > median > mode. Distribution appears as if the
distribution right tail has been pulled away from the mean.

Skewness extent to which a distribution is not symmetrical

Left/negative skewed mean < median < mode. Distribution appears as if the left
distribution tail has been pulled away from the mean.
Kurtosis measure of the degree to which a distribution is more or
less peaked than a normal distribution

Kurtosis of a normal 3
distribution

Leptokurtic Distribution with positive excess kurtosis that has more

distribution returns clustered around the mean and fatter tails

Platykurtic distribution A description of the kurtosis in a distribution in which the

statistical value is negative. When compared to a normal
distribution, a platykurtic data set has a flatter peak
around its mean, which causes thin tails within the
distribution. The flatness results from the data being less
concentrated around its mean, due to large variations
within observations.

Odds for and against Find the likelihood of an outcome occuring "x out of y
times" based on its probability distribution.

Odds for: 1-to-(y-x)

Odds against: (y-x)-to-1

Power of a test The power of a statistical test is the probability that the
test will reject the null hypothesis when the null
hypothesis is actually false (i.e. the probability of not
committing a Type II error, or making a false negative
decision). The power is in general a function of the
possible distributions, often determined by a parameter,
under the alternative hypothesis. As the power increases,
the chances of a Type II error occurring decrease.

Mean, Median, Mode Mean = arthimetic average

Median = middle number (if even # of values take
average of middle two)
Mode = number which occurs most often

What does a total Returns from both capital gains and the reinvestment of
return objective current income, but is not net of inflation
consider

What does the real Returns from both capital gains and the reinvestment of
total return objective current income net of inflation
consider
What does the Putting the plan that has been devised to work. The
implementation portfolio is constructed and assets are allocated based
process of portfolio on the investment strategy and market forecasts.
management focus on

Correlation coefficient (Cov of A and B) / [(STD of A) x (STD of B)

formula

What is the most asset allocation

important decision to
be made in the
investment process?

What is the formula for (Covstock,market)/(Varmarket) -- the trick here is to

beta given covariance convert standard deviation to variance by squaring it.
and variance to the Also, the denominator only includes the variance of the
market? market; the variance of the stock itself should be
excluded if it's provided

What does an An investment policy statement identifies a benchmark

investment policy portfolio that will be used to judge the performance of
statement do? the portfolio manager.

What is the importance Expressing investment goals in terms of risk is not more
of risk and return in an appropriate than expressing goals in terms of return. The
investment policy investment objectives should be stated in terms of both
objective? risk and return. Risk tolerance will likely help determine
what level of expected return is feasible.

What is Downside dispersion is measured using semivariance

"semivariance?" (the dispersion of returns occurring below a specified
target return such as zero).

What is the definition Beta (systematic risk) is the slope coefficient of the
for "beta?" regression line (historical returns of the stock against the
historical returns of the market) and is used to construct
the SML.

What is the measure of Markowitz Portfolio Theory relies on your understanding

risk used in Markowitz of basic statistics. You need to understand and be able
portfolio theory? to calculate the mean, the standard deviation and the
correlation coefficient. The measure of risk used is the
standard deviation of the returns for an individual
investment =s = [S(R actual - ER)^2(Probability)]^1/2
In the context of the In the context of the SML, a security is underpriced if the
SML, when is a security required return is less than the holding period (or
over/under priced? expected) return, is overpriced if the required return is
greater the holding period (or expected) return, and is
correctly priced if the required return equals the holding
period (or expected) return.

How is the holding Here, the holding period (or expected) return is
period return calculated as: (ending price - beginning price + any cash
calculated? flow or dividends) / beginning price. The required return
uses the equation of the SML: risk free rate + Beta ×
(expected market rate - risk free rate).

What are some Liquidity needs, time horizon, tax concerns, legal and
common investment regulatory factors and unique needs and preferences
contstraints?

How is the expected ERportfolio = Σ(ERstock)(W% of funds invested in each

return for a portfolio of the stocks) ER = w1ER1 + w2ER2, where ER = Expected
calculated? Return and w = % invested in each stock.

What happens when With positive transactions costs, there will be rates of
the underlying return on both sides of the SML for which the cost of
assumption of zero trading will be greater than the expected gains from
transaction costs is trading. This means there is a band of expected returns
relaxed (CAPM)? for each level of systematic risk that is consistent with
efficient pricing, once transactions costs are considered.

Why is an investment The investment policy statement provides a clear

policy statement articulation of the risk a client will accept, and addresses
important? risk in the context of the client's return requirement or
expectations. Write a policy statement that specifies the
investor's goals and constraints. Then itemize the risks
the investor is willing to take to meet these goals.

What are the four 1. Write a policy statement that specifies the investor's
general steps in the goals and constraints. Then itemize the risks the investor
portfolio management is willing to take to meet these goals. 2. Develop an
process? investment strategy designed to satisfy the investor's
policy statement based on an analysis of the current
financial and economic conditions. 3. Implement the
plan by constructing the portfolio, allocating the
 investor's assets across countries, asset classes, and
securities based on the current and future forecast of
economic conditions. 4. Monitor and update the
investor's needs and market conditions. Rebalance the
investor's portfolio as needed.

What is a "preservation Capital preservation is the objective of earning a return

of capital" return on an investment that is at least equal to the inflation
objective? rate. The concern is the maintenance of purchasing
power, which means that the real rate of return must
equal the inflation rate.

What produces a One of the key assumptions of the CAPM is the ability of
kinked capital market investors to lend and borrow at the risk-free rate. This
line? assumption is necessary to produce a straight line CML.
Investors can lend all they want by buying investments at
the risk-free rate, but investors must pay a premium over
the risk-free rate to borrow. Unequal borrowing and
lending rates put a kink in the CML.

What does Markowitz Markowitz Portfolio Theory relies on your understanding

portfolio theory rely of basic statistics. You need to understand and be able
on? to calculate the mean, the standard deviation and the
correlation coefficient. The measure of risk used is the
standard deviation of the returns for an individual
investment. Downside dispersion is measured using
semivariance (the dispersion of returns occurring below
a specified target return such as zero). Beta (systematic
risk) is the slope coefficient of the regression line
(historical returns of the stock against the historical
returns of the market) and is used to construct the SML.

How is beta beta of stock A = covariance between stock and the

calculated? market / variance of the market

If borrowing/lending Yes. The introduction of a zero-beta (no systematic risk)

rates are different, is it portfolio with a return that is higher than the risk-free
still possible to have a rate can result in a straight CML even with the
straight CML? assumption that borrowing and lending rates are
different. Margin accounts represent borrowing, so
unless the margin lending rate is the same as the risk-
free rate, this does not solve the problem (a kinked CML)
 that results from unequal borrowing and lending rates in
the model.
What type of risk is Systematic. The CAPM concludes that expected returns
positively related to are a positive (linear) function of systematic risk.The risk
expected excess that cannot be diversified away is systematic risk
returns according to (nondiversifiable risk or market risk). Since the market
CAPM? portfolio contains all risky assets, it must represent the
ultimate in diversification. All the risk that can be
diversified away must be gone. Unsystematic risk
(diversifiable risk or unique risk) is the risk that can be
diversified away by adding more securities to a portfolio.

How is the CML The SML and CML both intersect the vertical axis at the
related with the SML? risk-free rate. The SML describes the risk/return tradeoff
for individual securities or portfolios, whereas the CML
describes the risk/return tradeoff of various
combinations of the market portfolio and a riskless asset.

How much of the Studies have demonstrated that approximately 90% of

variation in a single the variation in a single portfolio's returns can be
portfolio's returns can explained by its target asset allocations. It is very difficult
be explained by its to generate abnormal portfolio returns by market timing
target asset and security selection within asset classes.
allocation?

How does the return A portfolio with equal numbers of shares of each stock
on an index provide in the price-weighted index will match the performance
for dividend of the index assuming there are no stock splits, stock
reinvestment? dividends, or changes in the make-up of the index. The
return on the index does not include cash dividend
payments. Since the reinvested dividends will add to the
number of shares of those stocks that pay dividends, the
portfolio return that reinvests dividends will exceed that
of the index.

Why does the Mispricings of small company stocks can persist

mispricing of small because the small size of the positions that can be
company stocks established limits the ability to execute sufficiently
persist at times? profitable arbitrage trades. The total profit to be gained
by exploiting a mispricing may be small enough that it
does not represent a significant profit opportunity to
large funds.
How can the lack of If the reasons underlying a persistent pricing anomaly
theoretical explanation are not well understood, it is difficult to exploit.
allow mispricings to Arbitrageurs will use their funds to exploit other
persist? mispricings which they believe they understand better
and are, therefore, better able to exploit and profit from.

According to capital Capital market theory suggests that all investors should
market theory, what invest in the same portfolio of risky assets, and this
represents the risky portfolio is located at the point of tangency of the CML
portfolio that should and the efficient frontier of risky assets. Any point below
be held by all investors the CML is suboptimal, and points above the CML are
who desire to hold not feasible. The optimal portfolio for an investor is
risky assets? determined as the point where the investor's highest
utility curve is tangent to the efficient frontier.

How should investor's Premiums, loads, and redemption fees are compensation
feel about loads and for sales and marketing efforts, but they are not
transaction fees? performance incentives for the portfolio managers.
Different classes of shares can be structured with
different schedules of front-end, back-end, and
distribution fees. The optimal choice depends on the
investor's expected holding period and is not
necessarily the one with the lowest total annual fees.

What are the * Markowitz investors: All investors use the Markowitz
assumptions of capital mean-variance framework to select securities. This
market theory? means they want to select portfolios that lie along the
efficient frontier, based on their utility functions.

What shape will the Risk averse = steep. Less risk averse = flatter
indifference curve
have for risk-averse
versus less risk averse
investors?

The market portfolio in The market portfolio contains all risky assets in
the Capital Market existence. It does not contain any risk-free assets.
Theory contains which
types of investments?

What does the The efficient frontier outlines the set of portfolios that
efficient frontier gives investors the highest return for a given level of risk
outline? or the lowest risk for a given level of return. It is also the
 point at which there are no more benefits to
diversification.
On a graph of risk, The efficient set is the set of portfolios that dominate all
measured by standard other portfolios as to risk and return. That is, they have
deviation and highest expected return at each level of risk.
expected return, what
does the efficient
frontier represent?

Factors that affect 1) Time horizon

individual's ability to 2) Expected income
take risk

Factors that affect 1) Personality type

individual's willingness
to take risk

Cost of Goods Sold = Beginning Inventory + Purchases - Ending Inventory

Product Costs Costs capitalized under the Inventories account on the

balance sheet;
Purchase costs less trade discounts and rebates;
Conversion costs including labor and overhead;
Other costs necessary to bring the inventory to its
present location and condition

Period Costs Costs that are expensed in the period incurred;

Abnormal waste of materials, labor or overhead;
Storage costs;
Administrative overhead;
Selling costs;

Inventory Valuation +Specific Identification

Methods +First-in, first-out
+Weighted average cost
+Last-in, first-out

Specific Identification *GAAP and IFRS

*Each unit sold is matched with the unit's actual cost
*Most appropriate when items are not interchangeable
and when firms have a small number of costly and
distinguishable items

FIFO *GAAP and IFRS

 *Each unit sold is matched with the unit's actual cost
*Most appropriate when items are not interchangeable
and when firms have a small number of costly and
distinguishable items

LIFO *GAAP only

*Values inventory at a historical cost basis
*In an inflationary/deflationary environment, earnings are
lower/higher

Weighted Average *GAAP and IFRS

Cost of Inventory *Dividing total cost of goods available for sale by the
total quantity of goods available for sale

Periodic Inventory When inventory values and COGS are determined at the
System end of the period;
Inventory bought is put into a Purchase account, which is
added to beginning inventory to find the cost of goods
available for sale. COGS is found by subtracting the
ending inventory from goods available for sale

Perpetual Inventory When inventory purchased or sold is recorded directly in

System the inventory account

IFRS Inventory When inventory purchased or sold is recorded directly in

Requirements the inventory account;
Inventory is written down if net realizable value is less
than cost and written back up if necessary

GAAP Inventory Requires inventory be reported at the smaller of cost or

Requirements market value;
Market price is usually replacement cost but cannot be
greater than net realizable value or net realizable value
minus a normal profit margin;
Even if inventory has to be written down, it is not
allowed to be written back up

Inventory Disclosure +Cost flow method used

+Total carrying value of inventory, with carrying value by
classification if appropriate
+Carrying value of inventory recognized at fair value
minus selling costs
+Total COGS for the period
+Amount of inventory write downs during a period, as
 well as any write ups with a description of the event
+Carrying value of inventories pledged as collateral

Inventory Cost Must be changed retrospectively on all past financial

Changes statements;
IFRS requires an explanation as to why a change
provides better information;
GAAP requires an explanation as to why the cost flow
method is preferable;
IF CHANGING TO LIFO, NO CHANGES ARE MADE
RETROSPECTIVELY AND THE OLD METHOD JUST
BECOMES THE FIRST LAYER OF THE LIFO COST BASIS

Cost Method Ratio +FIFO/LIFO produces higher/lower profitability measures

Effects +FIFO/LIFO produces higher/lower Current and Working
Ratios
+FIFO/LIFO produces lower/higher Inventory Turnover
and higher/lower Days of Inventory On Hand
+FIFO/LIFO produces lower/higher solvency ratios

Identifiable Tangible Capable of being separated from the firm, controlled by

Asset the firm and expected to provide future economic
benefit

Research Cost Typically expensed

Treatment

Development Cost Capitalized under IFRS;

Treatment Expensed under GAAP

Software Development Expensed until known to be feasible, then they are

Treatment capitalized by both GAAP and IFRS

Acquisition Method of When the purchase price is allocated to the identifiable

Accounting for assets and liabilities of the acquired firm based on fair
Business Combinations value and the rest is recorded as goodwill

Depreciation Methods Straight-line depreciation;

Accelerated depreciation;
Units-of-Production method

Straight Line When an asset's value is decreased by the same amount

Depreciation each year

Accelerated Applies depreciation more at the beginning of an assets

Depreciation life
Unit of Production Depreciates the assets based on the actual usage of the
Depreciation asset

Amortization Only done on assets with finite lives and is done the
same as depreciation

Revaluation Model An alternative to the cost model and allows for long
lived assets to be reported at fair value as long as there
is an active market for the asset;
Any revaluation above historical cost is not reported on
the income statement but is an increase in the
revaluation surplus in owner's equity

IFRS Treatment of *Assets must be evaluated annually

Impaired Assets *Impaired if its carrying value exceeds its recoverable
amount
*An impaired asset must be written down on the balance
sheet and the impairment loss of the difference of the
carrying value and the recoverable amount is recorded
on the income statement
*Asset can be revalued up if the recoverable amount
rises

GAAP Treatment of *Only tested for impairment when it is deemed

Impaired Assets necessary
*First tested for recoverability then the loss is measured
*No loss recovery is allowed

Derecognition When an asset is sold, exchanged or abandoned;

When sold, the asset is taken off of the balance sheet
and the gain/loss is reported on the income statement;
If abandoned, the entire value is listed as a loss on the
income statement;
If traded, the new asset is put on the balance sheet and
the difference in values is put on the income statement

IFRS PP&E Disclosures +Historical cost

+Useful life and depreciation rates
+Gross carrying value and accumulated depreciation
+Reconciliation of carrying amounts from beginning to
end of period
+Title restrictions and assets pledged as collateral
+Agreement to acquire any PP&E in the future
GAAP PP&E +Depreciation expense by period
Disclosures +Balances of major asset classes by nature and function
+Accumulated depreciation
+General description of the methods used

Investment Property Held by a firm for the purpose of collecting rental

income and gaining capital appreciation;
ONLY DISTINGUISHED BY IFRS;
Can be valued using fair value or cost model;
Any upside revaluation is recognized as a gain on the
income statement;
Must disclose the the valuation model used

Investment Property If from owner-occupied to investment property, treat as

Transfers a revaluation and recognize gain only if it reverses a
previous loss;
If from inventory to investment property, recognize a
gain or loss if fair value is different from carrying
amount;
If from investment property to owner-occupied or
inventory, the cost basis is the property's fair value at that
date;

Taxes Payable The tax liability on the balance sheet caused by taxable
income

Income Tax Expense Income tax expense is the expense recognized on the
income statement that includes taxes payable and
changes to the deferred tax assets and liabilities
= Taxes Payable + Changes in Deferred Tax Liability -
Changes in Deferred Tax Assets

Permanent Difference Difference between taxable income and pretax income

that will not reverse in the future;
Do not create deferred tax assets or liabilities but
change the effective tax rate from the statutory tax rate

Temporary Difference Difference between the tax base and the carrying value
of an asset or liability that will result in either taxable
amounts or deductible amounts in the future

Taxable Temporary Result in expected future taxable income

Difference
Deductible Temporary Result in expected future tax deductions
Difference

Reasons for +Timing of revenue and expense recognition may differ

Differences Between on the income statement and tax return
an Accounting Item for +Some revenues are only recognized on the income
Tax Reporting and statement or tax return
Financial Reporting +Assets and/or liabilities have different carrying amounts
and tax bases
+Gain or loss recognition in the income statement differs
from the tax return
+Tax losses from periods prior may offset future taxable
income
+Financial statement adjustments may not affect the tax
return or may be recognized in different periods

Deferred Tax Liability Created when income tax expense is greater than taxes
payable;
MOST COMMON REASON IS USING DIFFERENT
DEPRECIATION METHODS ON TAX RETURN AND
INCOME STATEMENT

Deferred Tax Asset Created when taxes payable are greater than income tax
expense;
POST-EMPLOYMENT BENEFITS, WARRANTY EXPENSES
AND TAX LOSS CARRYFORWARDS ARE MOST
COMMON CAUSES;
Must be reduced if it is unlikely to be used under GAAP

Asset's Tax Base Amount that will be deducted on the tax return in the
future as economic benefits are realized

Asset's Carrying Value The value reported on the financial statements net of
depreciation

Liability's Tax Base The carrying value of the liability minus any amounts that
will be deducted on the tax return in the future

Deferred Tax +Deferred tax liabilities and assets, valuations allowance

Disclosures and the net change in the valuation allowance over a
period
+Any unrecognized deferred tax liability for
undistributed earnings of subsidiaries and joint ventures
 +Current year effects of each temporary difference
+Components of income tax expense
+Reconciliation of reported income tax expense and the
tax expense based in the statutory rate
+Tax loss carryforwards and credits

Tax Rate Increase The increase in DTL is added to taxes payable and the
Causes... increase in DTA is subtracted from taxes payable

Tax Rate Decrease The decrease in the DTL would result in lower income
Causes... tax expense and the decrease in DTA would result in
higher income tax expense

Reasons for +Different tax rates in different jurisdictions

Differences Between +Permanent tax differences (tax credits, tax-exempt
Effective and Statutory income, non deductible expenses)
Tax Rate +Changes on tax rates and legislation
+Tax holidays in some jurisdictions
+Deferred taxes provided on reinvested earnings of
foreign and unconsolidated domestic affiliates

Revaluation of fixed GAAP: Not allowed

and intangible assets IFRS: Deferred tax recognized in equity

Undistributed profit GAAP: No deferred taxes for foreign subsidiaries that

from a subsidiary meet the indefinite reversal criterion or domestic
subsidiaries if amounts are tax free
IFRS: Recognized unless the parent is able to control the
distribution of profit and it is probable that the
difference will not reverse in the future

Undistributed profit GAAP: No deferred tax for a foreign joint venture that
from a joint venture meets the indefinite reversal criterion
IFRS: Recognized unless the parent is able to control the
distribution of profit and it is probable that the
difference will not reverse in the future

Undistributed profit GAAP: Deferred taxes are recognized from temporary

from an associate firm differences
IFRS: Recognized unless the parent is able to control the
distribution of profit and it is probable that the
difference will not reverse in the future

Recognition of DTA GAAP: Recognized in full and reduced if it is more likely

 than not it won't be fully realized
IFRS: Recognized if probable that tax profit will be able
to cover the tax asset

Tax rate used to GAAP: Enacted tax rate only

measure deferred IFRS: Enacted or substantially enacted tax rate
taxes

Presentation of GAAP: Classified as current or noncurrent based on the

deferred taxes on classification of the underlying asset or liability
balance sheet IFRS: Netted and classified as noncurrent

Interest Expense The book value of the bond times the market rate of
interest when the bond was issued

Par Value Bond Effects +Assets and liabilities increase by the bond proceeds
+Interest expense is equal to the coupon payment
+Proceeds are reported as cash inflow from financing
activities and coupon payments are reported as cash
outflows from operating activities
+Repayment of principal is reported as cash outflow
from financing activities

Discount Bond Effects +Reported on balance sheet as less than face value
+Discount is amortized over time and eventually the
value of the bond liability will increase until it equals
face value at maturity

Premium Bond Effects +Reported on the balance sheet as above face value
+As the premium is amortized the book value of the
bond will decrease until it equals par value at maturity

Bond Legal and GAAP: Capitalized

Issuance Costs IFRS: Subtracted from book value

If Company Redeems A gain or loss is recognized by subtracting the redeem

Bonds price from the book value of the bond liability at the
redeem date;
GAAP requires any remaining unamortized bond
issuance costs must be written off and included in the
gain or loss calculation;
IFRS requires no write down since the legal and issuance
costs have already been deducted
Affirmative Covenants When the borrower promises to do certain things

Negative Covenants When the borrower promised to refrain from certain

activities than can adversely affect the lenders position

Fixed Income Financial +Nature of liabilities

Statement Disclosures +Maturity dates
+Stated and effective interest rates
+Call provisions and conversion privileges
+Restrictions imposed by creditors
+Assets pledged as security
+The amount of debt maturing in each of the next 5 years

Finance (Capital) Basically a purchase of an asset that is financed by debt;

Lease Lessee adds equal parts asset and liability to the balance
sheet at inception;
Lessee includes principal payments is an investing cash
outflow while the interest payment is an operating cash
outflow under GAAP;
Depreciation expense is recognized on the asset and
interest expense on the liability;
Lessor takes asset off of balance sheet and replaces it
with a lease investment account;
Leads to higher EBIT calculations and net income will be
lower in early years and higher in later years

IFRS Qualifications for *All rights and risks of ownership are transferred to the
a Finance Lease from lessee
the Lessee's & Lessor's *Title is leased asset is transferred to lessee at end of
Perspective lease
*The lessee can purchase the asset at a price
significantly lower than the fair value of the asset at some
future date
*The lease term covers a major portion of the asset's
economic life
*The present value of the lease payments is substantially
equal to the fair value of the leased asset
*The leased asset is so specialized that my the lessee
cause the asset without significant modification

GAAP Qualifications *Title of asset is transferred to the lessee at the end of

for a Finance Lease period
from Lessee's & *A bargain purchase option is available to the lessee to
Lessor's Perspective buy the asset at a price significantly below market value
at some future date
*The lease period is 75% or more of the assets economic
life
*The present value of the lease payment is 90% or more
of the assets fair market value
*Collection of lease payments is fairly certain (lessor
only)

Sales-Type Lease When the present value of the lease payments exceeds
carrying value of the asset;
Treated as if the lessor sold the asset to the buyer and
also provided them a loan for the same amount;
Typical of dealers or manufacturers;
Lessor recognizes a sale equal to the present sale of the
lease payments, cost of goo sold equal to the carrying
value, and a lease receivables account is created equal
to the present value of the lease payments;
Interest portion of each payment is the lease receivable
balance at the beginning of the period times the lease
interest rate

Direct Finance Lease When the present value of the lease payments does not
exceed the carrying value of the asset;
Typically lessor bought the asset from a third party;
Lessor removes asset from balance sheet and creates a
lease receivable account in the same amount;
The interest portion of each payment is equal to the
beginning of period lease receivables times the lease
interest rate

Operating Lease A rental agreement;

Lessee recognizes rental expense each period and an
operating cash outflow;
Lessor does not remove asset from balance sheet,
recognizes rental income and continues to depreciate
the asset

Benefits of a Lease +Less costly financing

+Reduced risk of obsolescence
+Less restrictive provisions
 +Off-balance-sheet financing
+Tax reporting advantages
Synthetic Lease When the lease is treated like ownership for tax
reporting to allow for the deduction of depreciation and
interest expenses but the lease does not appear on the
balance sheet

Lease Disclosures +General description of leasing arrangement

+Nature, timing, and amount of payments to be paid or
received in each of the next 5 years (payments can be
aggregated)
+Amount of lease revenue and expense reported in the
income statement for each period presented
+Amounts receivable and yearned revenues from lease
arrangement
+Restrictions imposed by legal agreements

Defined Contribution = Employer's Contribution

Pension Expense

Defined Benefit ~Service cost is the present value of benefits earned by

Pension Expense employees during the current period
Components ~Interest costs is the increase to the benefit obligation
due to the passage of time
~Expected return on plan assets reduces the pension
expense
~Actuarial gains or losses come from changes to
assumptions the actuary uses about future obligations
~Prior service costs are retroactive benefits awarded to
employees when the plan is initiated or amended

Defined Benefit Fund Difference between the defined benefit obligation and
Status the plan assets;
Reported on balance sheet under GAAP;
IFRS removes unrecognized actuarial gains and losses
and unrecognized prior service expenses from the
funded status and the result does not reflect economic
reality;
Firms separately disclose the components of the benefit
obligation, assets and expenses and the assumptions
used to calculate the pension expense
Deferred Tax Liability Adjusted for changes in expected tax rates under the
and Asset Adjustments liability method

GAAP Asset Book value is greater than the sum of the estimated
Impairment undiscounted future cash flows from its use and disposal

Prior Service Cost When changes in the terms of a defined benefit pension
plan increase the future benefits due employees based
on their prior employment with the company

Simple Capital Only contains common stock and nonconvertible stock

Structure

Auditor/Audit Opinion 1) Unqualified opinion (good);

2) Qualified opinion (followed GAAP except for...);
3) Adverse opinion (bad)

Must express an opinion about the effectiveness of the

company's internal control system. Are internal controls
in accordance with PCAOB (public company accounting
oversight board). This is either final paragraph or as a
separate opinion. Least likely to prepare and accept
responsibility for them.

FASB US
1) Financial Accounting Standards Board; 2) Standards
form GAAP; 3) Aims, useful, relevant, reliable, consistent
and comparable; 4) SEC deems FASB standard
authoritative

FASB F/S elements REGLC (think relic)

1) Revenues
2) Expenses
3) Gains
4) Losses
5) Comp Income

FASB - Harmonization 1) Increase comparability; 2) Reduce expense of

overseas capital; 3) Reduce the expense of producing
consolidated accounts

IOSCO EU & US
 1) Int'l Org. of Securities Commission; 2) Goal: uniform
regulation; 3) Core objectives: Protecting investor, Fair,
transparent, efficient markets, Reduction of systematic
risk
IASB EU
1) Int'l Accounting Standards Board; 2) Unified int'l
frameworks of accounting standards (IFRS); 3) Addopted
by EU in 2005

IASB - Goals 1) Development of high quality, transparent and

enforceable global standards; 2) Promote application of
standards; 3) Take into account special needs (small &
med entities & emerging markets); 4) Convergence of
nat'l and int'l standards

IAS No. 1 1) Summary of accounting policies

2) Statement of changes in OE

Roles of financial 1) Evaluating equity investments for a portfolio;

reporting & analysis 2) Evaluating potential M&A;
include: 3) Evaluating a subsidiary of a parent company;
4) Deciding on private equity/ venture cap investment
5) Determine creditworthiness - borrowing;
6) Extending credit to customers;
7) Examining compliance with covenants/contracts;
8) Assigning a debt rating;
9) Valuing a security - Equity research/reports;
10) Forecasting future earnings/cash flows;

Balance Sheet shows the financial position of a firm AT A SINGLE POINT

in time A = L + E.

Income Statement Shows the performance of the company over a

reporting period.

Sarbanes-Oxley 1) Responsibility to establish and maintain adequate

Management Report: internal controls
2) Mgmt's framework for evaluating internal controls
3) Assessment of the effectiveness of internal controls
over the last operating period
4) Statement of auditor's attestment
5) Certify that f/s are fairly presented

MD&A contains: 1) Results of operations and discussions of trend;

 2) Capital resources, liquidity, and cash flow trends;
3) General business overview based on known trends;
4) Effects of trends, events, and uncertainties;
5) Discontinued operations, extraordinary items, unusual
items;
6) Disclosure in interim f/s;
7) Segment cash flow
8) Sig accounting methods and estimates

Funded status of the US Gaap: Balance Sheet

pension plan (under IFRS:Disclosed in Footnotes
US GAAP & IFRS) is May be mentioned in MD&A if mgnt considers it
reported where? significant

Steps of F/S Analysis 1) Purpose and context

2) Data Collection
3) Data Processing
4) Analysis/Interpretation of data
5) Develop conclusions and recommendations
6) Follow-up

The objective of f/s is ensure that information in f/s is useful to a wide range of
to users. to provide econ decision mkrs w/useful info abt 1)
fin performance 2) fin position

Fundamental 1) fair presentation; 2) going concern; 3) accrual basis; 4)

principles for consistency; 5) materiality
PREPARING f/s under
IFRS: (IAS No 10)

IFRS (IAS No. 1): 1) Balance Sheet; 2) Comprehensive Income; 3) Change

Required F/S in Equity; 4) Cash Flow Statement; 5) Accounting policies
and notes.

IFRS: Presentation 1) Aggregation where appropriate; 2) No offsetting

Requirements assets against liabilities or income against exp.; 3)
Classifed B/S; 4) Minimum Info on face; 5) Minimum
disclosure; 6) Comparative info.

The 4 Qualitative 1) understandability; 2) relevance; 3) reliability; and 4)

Characteristics of IFRS comparability
No hierarchy <- shocking for Europeans

Trade-Offs Qualitative 1) Relevance vs. reliability; 2) Benefit > cost; 3) Excludes

Characteristics of IFRS intangibles and non-quantifiable info.
The 4 Qualitative 1) Relevance & Reliability
Characteristics of 2) Comparability
FASB: 3) Understandability - user specific

IFRS/US GAAP Both: purpose is to assist development & revision of

Frameworks: purpose accting stds.
of framework IASB: Firms must consider framework if no std exists
FASB: No express requirement to consider framework

IFRS/US GAAP Both: General agreement on objectives; focus on wide

Frameworks: objective range of users.
of F/S IASB: One objective for all users
FASB: Separate objectives for business entities and non-
business entities.

IFRS/US GAAP Both: Recognize going concern & accrual assumptions

Frameworks: IASB: Going concern & accruals given more prominence
underlying in framework
assumptions: FASB: Going concern assumption not well developed in
framework.

IFRS/US GAAP FASB: Asset is a future economic benefit

Frameworks: F/S IASB: Asset is a RESOURCE from which future economic
elements: benefit is expected to flow.

IFRS/US GAAP FASB: No discussion of "probables"

Frameworks: IASB: Asset, liabilities, are probable flows
Recognition of
Elements:

IFRS/US GAAP Both: Broadly consistent, lack fully developed concepts

Frameworks: FASB: Assets revaluations prohibited (except some
Measurement of financial instruments)
Elements:

Characteristics of an 1) Transparency; 2) Comprehensiveness; 3) Consistency

effective framework

Barriers to a single 1) Valuation; 2) Standard setting; 3) Measurement

framework:

IFRS Revenue 1) Risk & Reward transferred; 2) No continued control; 3)

Recognition Reliable measurement; 4) Probable flow of benefits; 5)
Cost verifiable
SEC guidance for 1) Evidence of an arrangement; 2) Completion of
Revenue Recognition earnings process; 3) Price is determined or
determinable; 4) Assurance of payment

IFRS Revenue 1) Outcome reliable: rev recognized by stage of

Recognition For completion.
Service 2) Outcome unreliable: revenue recognized but no profit

Under Completed Used when estimates of revenue or cost are unreliable

Contract Method: or short-term contracts.
(US GAAP only) Revenue, expense, and profit is
recognized at completion
(IFRS) Revenue is recognized to the extent of contract
cost, cost are expensed when incureed, and profit is
recognized at completion.

Percentage of FASB & IASB

Completion -LT projects under contract, reliable estimates of
revenue, cost and completion time.
-Rev, exp and profit are recognized in proportion to
total cost incurred to date, divided by total expected
cost.

(Total Cost Incurred / Total Cost) x Total Revenue

Sales Basis Revenue 1) installment sales (If collection is certain, rev is

Recognitions recognized at time of sale)
2) installment method: (if collection cannot be
estimated)
3) cost recovery (if collectability is highly uncertain)

Installment Method: profit recognized is the proportion of cash collected x

total expected profit.
Revenue = (COG provided to date/total COG to be
provided) x total expected revenue

Cost recovery method: profit is recognized only when it exceeds estimated total
cost.

Barter (IASB & FASB) Exchange of goods or services between two parties (no
cash)
IASB: Revenue = FMV of similar non-barter transaction
with unrelated parties
 FASB: Revenue = FMV only if the company has received
Net Reporting of cash
Showspayments
only the for such services
difference betweenin the past.
sales and cost of
Revenue goods sold
Users are usually: 1) internet-based merchandising
companies; 2) Sell prodict but never hold inventory; 3)
Arrangement for supplier to ship directly to end
customer.

Discolsure policies in footnotes

Gross Reporting of shows sales and cost of goods sold.

Revenue Under GAAP: 1) must be primary obligor under the
contract; 2) bear inventory and credit risk; 3) have the
ability to choose its supplier; 4) have reasonable latitude
to set the price.

Operating vs. Non- Financial Services Companies: Operating activities:

operating Income Interest, Dividends, G/(L) on disposal
Non-Financial Services Companies: Non-operating
activities: Interest, Dividends, G/(L) on disposal

Unusual OR Infrequent reported ABOVE the line.

items: 1) G/(L) from disposal of a business segment
2) G/(L) from sale of investment in subsidiary
3) Provisions for environmental remediation,
impairments, write-offs, write-downs, restructuring.
4) Integration expense for recently acquired business
Analyst must determine effects on future income

Extraordinary Items: reported BELOW the line.

Unusual AND Prohibited under IAS1
Infrequent items: 1) Losses from expropriation of assets.
2) Uninsured losses from natural disasters
Analyst must determine if it is really THAT extraordinary
and if should be included in forecasting

Discontinued reported BELOW the line.

Operations: Operations mgmt has decided to dispose of but:
1) has not yet done so or
2) did so in CY after it generated profit/(loss)
Must be physicallly and operationally distinct from firm.
 Analyst must determine effects on future income amd
Types of accounting 1) Change
cash flows.in accounting principle; 2) Change in
changes: accounting estimate; 3) Prior period adjustments

Types of accounting Refers to changes from one GAAP method or IFRS

changes: accounting method to another
principle IFRS & US GAAP require prior year data shown in f/s to
be adjusted.

Types of accounting Refers to change in mgmt judgement

changes: accounting Does NOT require restatement of prior pd earnings;
estimate Disclose in footnotes

Types of accounting Adjustments Involves erros or new accounting standards

changes: prior period Resate prior period
adjustments Disclose nature and effect on NI
Errors may indicate weakness in internal controls

Potentially Dillutive Stock options, Warrants, Convertible debt, Convertible

Securities preferred stock

Dilutive Securities securities that would DECREASE EPS if exercised

If X< Avg. stock price then could be exercised
If X> Avg. stock price then will not be exercised

Anti-dilutive Securities securities that would INCREASE EPS if exercised

Simple capital capital structure that contains NO potentially dillutive

structure securities
(contains only c/s, nonconvertible debt, and
nonconvertible pref. stock)

Complex Capital potentially dilutive securitites [options, warrants,

Structure convertible securities]

BASIC EPS (net income - preferred dividends) / weighted average

of common shares out

*only income from continuing operations is considered

Diluted EPS [net income - preferred dividends] + [convertible

prf.dividends] + [convertible debt int.] (1-t) / (weighted
avg. of c/s o/s) + (shares from conversion of conv. pfd.
shares) + (shares from conversion of conv. debt) + (shares
issuable from stock options)
 *only income from continuing operations is considered

Stock options: Use 1) Calculate cash raised on exercise

treasury stock method 2) Repurchase shares at avg. price
3) New Shares = exercised - repurchased

= (average mkt price - strike price)

× (# of options / strike price)

Comprehensive Change in equity from transactions from nonownership

income sources. Include:
NI,
chg in foreign currency translation adj.,
chg in pension adj to funded status,
chg unrealized gains/losses on derivatives contracts
accounted for as hedges
chng in unrealized gains/losses on available-for-sale
securities

Balance Sheet - 1) Account format (A on left and L & E on right)

formats 2) Report format ( A, L, E presented in one column)
3) Classified B/S (ordered)

Intangible Assets 1) Lack physical form (patent, copyrights etc;

2) Good will is an ex. of an unidentifiable intangible
asset, not amortized but subject to annual impairment
reviews;
3) Identifiable intangibles are amortized.
(eliminate goodwill from ratio analysis)

B/S - short-term 1) held-to-maturity: @ amortized cost (i.e Bonds)

investments 2) trading: @ fair value through P&L @ fair mkt value,
unrealized g/(l) are recognized on the I/S.
3) available-for-sale: @ fair mkt value,
unrealized g/(l) are NOT recognized on the I/S, instead
recognized on comprehensive income as part of SOE.

B/S - investments 1) Intention to hold >1 year (e.g. debt or equity) valued @
cost or mkt value
2) Equity accounted investments

B/S - Long-lived assets Held for continuing use within the business (not for
resale)
 1) investment property; 2) Assets held for sale; 3) Natural
resources; 4) PP&E
B/S - Long-lived assets 1) Land @ cost; 2) Plant & building @ historic cost less
PP&E accu'm depr; 3) Equipment @ historic cost less accu'm
depr 4) Intangible assets @ historic cost less accu'm
amort

Depreciation Methods: 1) SL; 2) Double Decline balance (accelerated); 3) Units

of production; 4) Tax code perscribed Modified
Accelerated Cost Recovery System (MACRS)

B/S - Long-term pd after more than 1 year

Liabilities notes & bonds: at PV of future CF pymets
Capital leases
Provisions
Deferred tax

B/S - Stockholders' Contributed capital = c/s @ par plus add'l paid-in capital
Equity
Treasury stock (reaquired by from but not yet retired,
contra-equity account)

R/E = Accum' NI less dividends

Minority (non-controlling) interest

Comprehensive income items = all chg in SOE not in I/S

or from issuing stock, reacquiring stock, & paying
dividends.

Cash Flow From +Cash rcvd from customer

Operations (CFO) - +Cash dividends rcvd
FASB +Cash interest rcvd
+Other cash income ((trading securities)
- Payment to suppliers
- Cash expenses (wages etc)
- Cash interest paid
- Cash taxes paid

Free Cash Flow -CFO net income + non-cash charges - working cap
investment

Free Cash Flow to the Cash Flow available for distribution to all investors
Firm - FCFF (stockholders & debt holders)
 CFO + int(1-t) - fixed capital investment
or
[FCFF calculated from NI = NI + noncash charged + (Int
exp(1-tax rate) - net cap investment - working capital
invt.]

Free Cash Flow to Cash Flow available for distribution to the c/s; after all
Equity - FCFE obligations have been paid.
CFO - fixed capital investment + net debt increase
or
CFO - net cap expenditure + net borrowings

Statement of Cash assess liquidity, solvency and financial flexibiliy

Flow - relevance:

Cash Flow From Interest Rec'd - CFO/CFI

Operations (CFO) - Divs Rec'd - CFO/CFI
IFRS Interst Paid - CFO/CFF
Divs Paid - CFF/CFO
Overdraft = cash, not CFF

Cash Flow From Includes: cash flow from interst Rec'd and Paid, and
Operations (CFO) - Dividend received.
FASB Includes all income taxes paid.

CFO - Direct method Cash collections less direct cash inputs less other cash
outfllows

CFO - Direct/Indirect Increase in an asset: deduct (use of cash)

method Increase in a liability: add (source of cash)
Decrease in an asset: add (source of cash)
Decrease in a liability: deduct (use of cash)

CFO - Indirect method 1) Start with NI

steps: 2) Sub Gains or add losses from financing or investing
CFs
3) Add non-cash charges (depr't & amort'z) & sub all non
cash revenue.
4) Add/ Sub changes to related b/s operating accounts:
Increase in an asset: deduct (use of cash)
Increase in a liability: add (source of cash)
 Decrease in an asset: add (source of cash)
Decrease in a liability: deduct (use of cash)
Cash Flow From "Assets"
Investing (USA) Cash spent on long-term assets
(Assets) Proceeds from the sale of long-term assets
Cash flow from investments in JVs, affiliates, and long-
term investments in securities (trading securities are
CFO)
[CFI = Cash additions - cash rcvd on disposal]

Cash Flow From "Equity"

Financing (USA) -Chg in debt - Cash raised from equity and debt
(Source of Cash) -Chg in c/s - Cash spent on repurchasing equity or
redeeming debt
-Dividends paid
Calculate dividend declared: NI -*Div.Declared = chg in
R/E
*Div. Declared +(-) chg in div. payable = cash dividend
paid

Calculate dividends 1st: Net Income - dividends declared = chg in R/E

declared: Then: Dividends declared +/- chg dividends payable =
cash dividends paid.

Cash Flow: Logic (A = L A: Increase = use cash (-), Decrease = source cash (+)
+ E) L: Increase = source cash (+), Decrease = use of cash (-)
E: Increase = source cash (+), Decrease = use of cash (-)

Amortization of Bond Outflow

Premium = (in/out flow) (bringing bond DOWN to par)
in the indirect method
CFO

Financial Ratio based Any I/S subtotal is expressed a margin ratio (to
on I/S: revenues).
Gross profit margin = gross profit/ revenue
Net profit margin = Net Inc/revenue
Operating profit margin = EBIT/ revenue
Pre-tax margin = EBT/ revenue

Amortization of Bond Inflow

Discount = (in/out flow) (bringing bond UP to par)
in the indirect method
CFO
Valuation allowance 1) is a contra asset account used to reduce the value of a
DTA.
2) it is used to reduce the asset when future taxable
income is deemed to be insefficient to fully use the DTA.

An Increase in the Decreases DTA -> Decreases Net Income

Valuation Allowance
Account: [Decrease in Valuation Allowance; Increase DTA and
Increases Net Income]

Tax base of an asset Amount deductible in future tax return

Tax base on a liability Carrying amount of the liability minus the amount that
will be deductible in the future.

DTA/DTL: Effect on Tax Rate down:

Net Income when Tax DTL down -> Inc. Tax Exp down -> NI up
Rate decreases: DTA down -> Inc. Tax Exp up -> NI down

Impact on the B/S of a Interest Expense = Coupon + Amortization

Discount Bond: = PV of future CF x market yield @ issuance

Impact on the B/S of a Interest Expense = Coupon - Amortization

Premium Bond: = PV of future CF x market yield @ issuance

Impact on the B/S of a Interest Expense = Amortization

Zero Coupon Bond:

Impact on the B/S of a Interest expense = Coupon rate

Par Bond:

Impact on the Cash CFO: cash interest expense

Flow of a Par Bond: CFF: increased by amount rcvd at issuance and
decreased by payment made at redemption

Impact on the Cash CFO: cash interest expense

Flow of a Premium CFF: increased by amount rcvd at issuance and
Bond: decreased by payment made at redemption
CFO is lower CFF is higher

Impact on the Cash CFO: cash interest expense

Flow of a Discount CFF: increased by amount rcvd at issuance and
Bond: decreased by payment made at redemption
CFO is higher and CFF is lower

Impact on the Cash CFO: no impact

Flow of a Zero Coupon CFF: increased by amount rcvd at issuance and
Bond: decreased by payment made at redemption
CFO is lower (b/c no impact) and CFF is higher

Bond Issuance Cost GAAP: shown as a separate prepaid asset and

under GAAP/IFRS amortized.
IFRS: Deducted from proceeds and liability therefore
effective interest rate is HIGHER under IFRS than GAAP.

Gain/(loss) on bond BV - cash paid = gain/(loss) + any unamortized issue

early retirement: costs (US only) = Gain/Loss on repurchase [I/S as
(derecognition of continuing operations)
debt)

Debt covenants part of indenture that place restrictions on the firm that
protect bondholderns and increase value of the firm's
bond.
Breach is technical default

Activity Based Divdends and share repurchases

Restrictions Production and investment
M&A
New debt issuance
Payoff pattern and liquidation priority
Maintenance of assets used as collateral

Footnote Finance Nature of liability; Maturity dates; Stated and effective

Liability Disclosure int. rates; Call and conversion features; covenants;
security pledged as collateral; Amount of Debt maturity
in each of the next 5 years; Fair value of o/s instrutments

Analysis: Market Value is more relevant than book value: Recent changes allow
of Debt more liability to be recorded at FMV (IFRS & GAAP
require disclosure of FMV)

Downward adj. in liability will Increase equity and

decrease leverage ratio.
Upward adj in liability will decrease equity and increase
leverage ration

Operating Lease Off B/S asset or liability = Footnotes disclosure

Lease payments are expensed when due via I/S
Payments are CFO outflows
Finance (capital) Lease If any ONE out of the FOUR are met must be classifed as
criteria (under US Financial Lease:
GAAP) 1) Title transfered to lessee at the end of lease;
2) Bargain purchase option at the end of the lease;
3) Lease period is at least 75% of asset's useful life;
4) The PV of least pymts is at least 90% of fmv.
(given borrowed rate and lease rate use lower of the
two)

Straight-line depreciation exp = (cost-residual value)/ useful life

depreciation (SL)

Double-decline depreciation exp = (cost - accum depre)/useful life x 2

balance (DDB)
Does NOT use residual value (salvage value) but
depreciation stops when residual value has been
reached.
* reduce EBIT, NI, Assets, Equity and decrease ROA &
ROE

Units of Production depreciation exp =

Method (cost - residual value) x (# units produced / total
expected to produce)

Measurement of A & L 1) Basis for measurement;

disclosure in footnotes 2) carrying value of inventory by category;
3) Amount of inventory carried at FV less cost to sell
4) Write-downs & reversals (discussion of circumstance
that led to reversal);
5) Inventories pledged as collateral for liabilities;
6) Inventories recognized as an expense.

Expensed Intangibles: (GAAP) Internally created intangibles

1) (R&D) are expensed
2) Advertising
3) Software (developed to establish feasibility)

Capitalized Under GAAP

Intangibles: 1) Purchased patentes, copyrights, franchises, licenses,
brands, and trademarks
2) Direct response advertising
3) Goodwill arising from transactions
(Proceeds - FMV net assets required = goodwill)
 4) Software development costs once feasibility is
established
Intangibles under IFRS: Research = Expensed
Development may be capitalized when the following
critera is met: (ie if in the Development stage and NOT
research stage)
1) process is clearly identified
2) Cost can be clearly idenfified
3) Technical feasibility established
4) Market is clearly identified
5) Frim has resources to complete

CFO Disclosure GAAP: direct method must disclose adj to reconcile NI

requirement: to CFO. reconciliation is NOT required for IFRS.

IFRS: pymts for Int & Taxes MUST be disclosed separately

in the CF Stmnt under direct or indirect. Under GAAP, this
can be reported in CF stmnt or disclosed in footnotes.

CFO Analysis: CFO = NI, means high quality of earnings but may be
affected by the stage of business cycle and firm's life
cycle
CFO > NI, means premature recognition of revenue or
delayed recognition of expenses.

CFI Analysis: Increasing CFI, may indicate growth OR

Decreasing CFI or sell capital assets to conserve or
generate cash.
May result in higher outflows in the future as older assets
are replaced or growth conts.

Measures of Operating Total assets TO = Revenue/Avg. total asset

Performance - Fixed asset TO = Revenue/ Avg. net fixed assets
Efficiency Ratios: Working Cap TO = Revenue/Avg. working captial

Return on total capital EBIT/ Avg. total capital

(ROTC): Total capital includes: debt capital, so int. is aded back to
NI

Return on Equity Return on Total Equity = NI/ Avg. Total Equity

(ROE): Return on C/E = NI - Pref. Div/ Avg. Common Equity

Return on Assets ROA: NI/Avg. Total Assets

 NI + Int (1-t) / Avg. Total Assets
Operating ROA: Operating INc/ Avg. Total Assets
Vertical Common Size I/S: Income statement account / Sales
Statements: B/S: Balance sheet account / Total Assets

Horizontal Common I/S and B/S

Size Statements: Each line is relative to base year

Traditional DuPont ROE = (NI/Sales) x (Sales/Assets) x (Assets/Equity)

Equation: or
ROE= Net Profit Margin x Asset TO x Leverage Ratio

ROE interpretation: if Means that at least ONE of the following is true:

ROE is low: Company has poor profit margin;
Company has poor asset TO;
Company is underleveraged

Extended DuPont ROE =

Equation: (NI/EBT)x(EBT/EBIT)x(EBIT/Rev)x(Rev/Asset)x(Asset/Eqty
)
or
(tax burden)x(int. burden)x(EBITmargin)x(Aset TO)x(Fin
Lvg)

Cash flow ratios same as other ratios using NI in this case substitute NI for
CFO.

Common Size 1) Show each item as a % of Net Revenue

Statement 2) Show each inflow as a % of total inflows
3) Show each outflow as a % of total outflow

Segment Reporting 1) if 50% of its revenue is earned externally

2) if a business area has at least 10% of a firm's:
Revenue; or Operating profit; or Use of asset
3) Business and geographical segments

Disclosure for each 1) Revenue (external & internal)

segment: 2) Segment results (operating profit)
3) Carrying amount of segment asset4
4) Segment liabilities (IFRS)
5) Cost of PPE and intangibles acquired
6) Depreciation and Amort expenses
7) Other non-cash expense
8) Share of profit/loss from equity accounted
 investments
9) Reconciliation bw segment data and consolidated
data
From creditor POV: Int. EBIT/ *Gross Interest
Coverage; EBITDA/ *Gross Interest
*(inc'd capitalized interest)
How many times is EBIT or EBITDA bigger than gross
interest? Higher ratio is desired. Shows ability to cover
int. payment

Cost included in 1) Purchase cost; 2) conversion costs; 3) Allocation of

Inventory on b/s: fixed production OH based on normal capacity levels;
4) Other costs necessary to bring the inventory to its
present location and condition (freight costs &
installation)

Exclude: Admin OH, Storage costs, Abnormal material

waste

Inventory Valuatoin US Gaap: lower of cost or market value

(LCM) (does NOT allow subsequent reverasals)
IFRS: lower of cost or NET realizable value
(allows subsequent reversals)

Net Realizable Value NRV =

(NRV) (IFRS) Est. selling cost - Est. cost of complition - selling costs

Market Value (GAAP): Replacement cost subject to:

Upper limit = NRV
Loewr limit = NRV - normal profit margin

Inv. Valuation reporting It is Rare, but permitted for commodity producer/dealers

Inventory ABOVE B/S = NRV
costs: I/S = unrealized gains/losses

Inventory Systems: Periodic:

Inventory and COGS determined at p/e

Perpetual: Inv. & COGS updated for each sale (no

purchase
account need)
 Cost flow method impact:
FIFO = same for both
LIFO = different
Avg. cost = different
FIFO & LIFO relationship remain
LIFO results in: I/S: COGS higher, EBT lower, Taxes: lower, NI: Lower
(assuming inflationary B/S: INV: lower, W/C: Lower, R/E: lower
period) CF: CFO: higher

FIFO results in: I/S: COGS lower, EBT higher, Taxes: higher, NI: higher
(assuming inflationary B/S: INV: higher, W/C: higher, R/E: higher
period) CF: CFO: lower

Inventory Cost Flow FIFO: EI = newest purchases

Methods: LIFO: EI = oldest purchases
Avg. Costs: EI = Available for sale/Units
Specific ID: high value items (cars, diamonds etc)

Ending Inventory = Beginning Inv. (BI) + Purchases (P) = Available for Sale
Available for sale - COGS = Ending Inventory (EI)

Inventory mangement: slow moving or obsolete inventory

Low T/O (High DOH):

Inventory mangement: Lost sales from stock outs

High T/O (low DOH)
and sales growth
below industry
average

Inventory mangement: Efficient inventory managment

High T/O (low DOH)
and sales growth
above industry
average

Asset Capitalization Assets held for continuing usage in the business NOT for
resale ( Invoice price, Sales Tax, Freight & Insurance, and
Installation costs)
1) capitalize costs that result in higher future earnings
2) expense costs that have uncertain/NO impact on
future earnings
Capitalization of 1) Capitalize interst during construction period when
Interest building its own operating facility;
2) Interest must actually be paid by the firm;
3) Specific and general debt interest is capitalized

Financial Implications Income variability lower

of Capitalizing Profitability early years (ROE, ROA & NI) is Higher
Profitability later years: lower
Total Cash Flows: Same
CFO: higher
CFI: Lower
Leverage ratios: D/E & D/A: lower
Opposite fore Expensing

Component Required by IFRS

depreciation Permited by US GAAP

Impairments Asset is impaired if carrying value > recoverable amount.

recognition (IFRS) One-step process
1) Compare carrying value to: recoverable amount = the
greater of the two.
a) Fair value - selling costs
b) Value in use = (PV of future cash flow from cont. use)
*Loss reversal is limited to original impairment loss

Impairments 2 step-process
recognition (GAAP) 1) Recoverability: carrying value > undiscounted CF from
asset's use and disposal
2) Loss measurement: Loss is the excess of carrying
value over the asset's fair market value or PV of cash
flows
*Loss reversal for held-for-use assets is PROHIBITED
*Loss reverse for held-for-sale assets is allowed

Asset Revaluation: IFRS Allows firm to report PP&E at FMV less Accm' Depr'
IFRS Must disclose carrying vlaue using historic cost model.

Revaluation below Impairment is recorded on a Contra asset account.

historic cost revalued below original cost means contra asset account
is 0
1) B/S asset reduced to FMV
 2) Loss take to I/S
3) Reversal of org. loss allowed I/S
4) Increase above org. cost to equity (comprehenive
income)
Revaluation above 1) B/S asset increased to FMV
historic cost 2) Increase above original cost to equity via revaluation
surplus account (comprehensive Income)

Financial Assets: US Unlisted instruments

GAAP/Amortized at Held-to-maturity investments
Cost Loans
Receivables

Financial Liability: US All other liabilities (e.g. bonds, notes payables, leases)
GAAP/Amortized at
Cost

Financial Assets: US Trading securities

GAAP/Fair Market Available-for-sale
Value Derivatives (standalone or embedded in non-derivative
intrument)
Assets with fair value exposure hedged by derivatives

Financial Liability: US Derivatives

GAAP/Fair Market Non-derivative investments with fair value exposure
Value hedged by derivatives

Footnote disclosure of is required under IFRS but not under GAAP

reconciliation of
opening and closing
carrying values:

Taxation: Tax Payable Tax liability based on taxable income as per TAX
Report/RETURN

Taxation: Income Tax Taxes payable + chg deferred tax as per Financial Report.
Expense Income tax expense - change in DTA + change DTL

Deferred Tax Liability: Income Tax Expense > Taxes Payable

(DTL) F/S > Tax Return
Pay less tax now but more on reversal

Deferred Tax Asset: Income Tax Expense < Taxes Payable

(DTA) F/S < Tax Return
Pay more tax now but more on reversal
Taxable Income Income subject to tax as per Tax Return

Income Tax Paid actual cash outflow for taxes paid during current period

Tax Loss Carryforward Loss that could not be deducted on the tax return in
current period but may be used to reduce taxable
income and taxes payable in future (i.e. warranty)

Valuation Allowance Contra asset account used to reduce DTA for probability
that it will NOT be realized.
Increase in valuation = decrease in DTA and NI
Decrease in valuation = increase in DTA and NI

Sources of Differences Timing differences (depreciations)

betweent F/S & T/R Permanent differences:

Effective Tax Rate Income Tax Expense/Pretax Income (EBIT)

Income Tax Exp. = Taxes payable + chg in DTA

Taxation Analyst Nonreversal DTL, therefore it is permanent = Equity.

Adjustments: therefore decrease in DTL = Increase in Equity
Reversal DTL, therefore it is temp = Liability

DTA Issues 1) will only benefit on reversal if there is sufficient taxable

earnings.
2) can only utilize loss carryforwards if we have future
profits
3) If asset cannot be utilized in full it is reduced by a
contra "valuation allowance". REDUCE DTA, REDUCE NI

Sources of 1) Timing Differences:

Differences: Temporary Accrual vs. modified cash accounting
Differences in reporting methods estimates

Sources of When Statutory tax rate does NOT equal Effective tax
Differences: rate
Permanent Tax expense does note equal pretax income x statutory
rate

Taxation Disclosure 1)DTL, DTA, valuation allowance, Net Δ in valutaion

Requirements allowance over the period
2) unrecognized DTL or undistributed earning from
 subsidiaries & JVs
3) Current yr tax effect of each type of temp diff.
4)Components of Inc Tax Expense
5)Tax loss carryforwards and credits
6) Reconciliation of reported income tax expense and
tax expense based on statutory rate (explain why there is
a permanent difference. Why effective tax rate ≠
statutory rate)

Analyzing Effective Tax 1) Diff tax rate in diff. tax jurisdictions (countries)
Rate Reconciliation (continuous)2) Permanent tax differences: tax credit, tax-
exempt income, nondeductible expenses, & tax diff
between capital gains and operating income.
(continuous)
3)Δ in tax rates and legislation
4) Deferred tax provided on the reinvested earnings of
foreign and unconsolidated domestic affiliates
5) Tax holidays in some countries (sporadic) notice
conditions such as termination dates for holidays or a
requirement to pay the accum' taxes at some point in the
future.

Implication for 1) Consider the growth rate and capital spending levels
Analysts: when determining whether temp diff due to accelerated
Be aware of depre will reverse
differences in tax 2) Look for cumulative differences due to asset
reconcilation between impairments and post-retirement benefits
periods 3) Restructuring charges can create a DTA

Analyst Treaments of 1) when differences are expected to REVERSE and

DTL results in future tax payment, treate DTL as a LIABILITY in
calculating leverage ratios
2) when differences are NOT expected to REVERSE and
result in future tax payment, treat DTL as EQUITY in
calculating leverage ratios
3) when the amount and timing of future tax payments
from reversal is uncertain, exclude from both liability and
equity.

Reasons to Lease 1) Cheaper Financing;

2) Reduce risk of obsolescence;
3) Less restrictive provisions;
 4) Off-B/S reporting;
5) Tax Reporting Advantages (treated as ownership for
tax ( deduct depreciation and interest expense)

Lessor Accounting If PV of min lease pymt < cost of asset

Capital Lease: Sales- 1) lessor is a dealer or seller of the leased equipment
Type Lease 2) at the time of lease inception, lessor recognized a
gross profit on sale. (NI, R/E, and Assests are higher)
3) Interest rev recognized over period of lease
4) PV of min. lease pymt - cost of asset = gross profit
CFO = Int. Income inflow
CFI = Reduction in lease value

Lessor Accounting If PV of min lease pymt = cost of asset

Capital Lease: Sales: 1) lessor is not a dealer of leased equipment (fin. co.)
Direct Financing Lease 2) no gross profit is recognized at time of lease
inception
3) all profit is int. revenue recognized over period of
lease.
CFO = Int. Income inflow
CFI = Reduction in lease value

Financial Lease 1) Firms adds a lease asset and a lease liability to b/s =
Reporting amounts
2) Recognize int. expense on liability and depreciation
exp on asset
*Since Int. exp + depre > lease pymt in the early years.
This decreases NI, and Profitability ratios.

Effects of Lease Assets: higher

Classification on F/S - Liabilities: Higher
Finance Lease NI (Early yrs): Lower
CFO: Higher (b/c only interest portion is classed as CFO)
CFF: Lower (b/c principal repayment portion)
Total CF: Same

*Since Int. exp + depre > lease pymt in the early years.
This decreases NI, and Profitability ratios.

Effects of Lease Assets: lower

Classification on F/S - Liabilities: lower
Operating Lease NI (Early yrs): higher
 CFO: lower (b/c entire pymt is classed as CFO)
CFF: higher
Total CF: Same
Effects of Lease Current Ratio (CA/CL): lower
Classification on Ratios Work. Cap (CA -CL): Lower
- Asset TO: (Sales/TA): Lower
Finance Lease ROA (EAT/TA): Lower
ROE (EAT/E): Lower
Debt/Equity: Higher

*Since Int. exp + depre > lease pymt in the early years.
This decreases NI, and Profitability ratios.

Effects of Lease Current Ratio (CA/CL): Higher

Classification on Ratios Work. Cap (CA -CL): Higher
- Operating Lease Asset TO: (Sales/TA): Higher
ROA (EAT/TA): Higher
ROE (EAT/E): Higher
Debt/Equity: Lower
Understates Leverage ratios (b/c not recognized as a
liability)
Overstates Coverage ratios (b/c lease pymt is NOT
treated as int. expense)
Understates Fixed Assets & No impact on CA

Finance (capital) Lease GAAP: more quantitative rules

criteria GAAP vs. IFRS IFRS: more qualitative approach based on whether the
risks and reward of the asset have tranferred.

What is the economic it is the purchase of an asset using debt finance.

substance of financial
(capital) lease?

Defined Contribution Employer contributes specific %

Plans No guarantee on future benefits
Employee bears investment risk
Pension expense = employer contribution

Defined Benefit Plans Employer promises specific payment stream at

retirement
Payments are based on yrs of service, retirement age,
and final salary
 Employers bears investment risk
Funded by pool of assets
Complicated accounting
DBO Funded Status = Fair Value of Plan Assets - Defined Benefit Obligation
(DBO)
Fair Value > DBO: overfunded (asset on B/S, GAAP)
Fair Value < DBO: underfunded (liability on B/S, GAAP)
(Funded Status = Economic Position of Plan)

Funded Status US IFRS: Funded status is NOT on B/S Asset/Liability

GAAP & IFRS Result in a b/s that does NOT represent econ reality

GAAP: Funded status = B/S Asset/Liability

-Both disclose components of DBO, plan assets,

expenses, and assumptions used to calculate pension
expense.
-Both smooth the effect of changes in actuarial
assumptions and prior services costs over time. (less
volatile expense)

Net Periodic Benefit + Service Costs (recurring costs (actual))

Costs + Interest Costs (recurring costs (actual))
- Expected return on plan assets (smoothed event)
+/- Amort of (gains) and losses (smoothed event)
+/- Amort of prior service costs* (smoothed event)
+/- Amort of transition (asset)/liability (smoothed event)
= Pension Expense on I/S

* Prior service costs are expensed immediately under

IFRS but deferred and amortized under US GAAP.

Defined Benefit PV of future obligation or the PV of the amount owed to

Obligations (DBO) employees for future pension benefits earned to date.
Payments are determined based on expected final
salary.

Motivation to To improve liquidity and leverage ratios

Overstate
Assets/Understate
Liabilities
Motivation to Improve ROA and Asset TO Ratios
Understate Report higher aquisition goodwill
Assets/Overstate
Liabilities

Motivation to Under- Trade relief

report Earnings Contingent consideration
Union concessions

Motivation to Over- Meet Analyst Expectations

report Earnings Meet debt covenants
Incentive compensation

Not all CF increase are 1) Stretching A/P (increase in # days in payable)

Sustainable. Example = 365/(AP T/O) = 365/(purchases/ Avg. AP))
of how Mgmt can 2) Financing payables (allows to great AP as CFF)
Manipulate Cash Flow 3) Securitizing A/R: (allows to recognize gains in I/S)
Statement 4) Income Tax Benefit from stock options
5) Buybacks offset dilutive effect of employee stock
options

Low Quality Earnings is Selecting accounting principles to distort results

result of Structuring transactions to achieve a desired outcome
Using aggressive or unrealistic estimates and
assumptions
Exploiting the intent of the accounting principle

Warning Signs of Aggressive Revenue Recognition

Earnings Manipulation Diff. growth rates of operating cash flow and earnings
Abnormal comparative sales growth
Abnormal inventory growth as compared to sales
Moving nonoperating income and nonrecurring gains up
to I/S to boost revenue
Delaying expense recognition
Excessive use of off-b/s financing arrangements
including leases.
Classifying expenses as extraordinary or nonrecurring
and moving them down the I/S to boost Inc. from cont.
operations.
LIFO liquidations (decrease in inv. levels that result in
out-of-date, low cost being recognized in COGS)
Abnormal comparative margin ratios
 Aggressive assumptions and estimates
Equity method investments with little or no cash flow
Fraud Triangle 1) Incentive/Pressure (the motive to commit fraud)
2) Opportunity (exists with weak internal controls)
3) Attitude/rationalization (mindset that fraud is justified)

Fraud Triangle - 1) 1) 3rd party pressure: 1) analyst/institutional expectations;

Incentive/Pressure 2) need to obtain finance; 3) listing requirements; 4)
Debt covenants; 5) Transactions

2) Directors' Financial Position: 1) Equity interest; 2) Stock

options; 3) Personal debt guarantees.

3) Economic/Industry/Entity Conditions: 1) higher

competition, lower margins; 2) Technological change; 3)
Decline in demand; 4) Threat of hostile takeover; 5)
Negative cash flows; 6) New accounting/regulatory
requirements

Fraud Triangle - 2) 1) Nature of industry/entity operations: 3rd party

Opportunity transactions; Power of customer/supplier; Acct est
subjective; Unusual transactions; International
operations; International operations; Operations in tax
havens.

2) Opportunity complex/unstable org. structures:

Difficult to determine structure; Difficult to determine
controlling interest; Overly complex structure; High key
employee turnover

3) Insufficient internal Control: Inadequate monitoring;

High stock turnover internal aduit, IT; Ineffective
accounting and IT system.

4) Ineffective Monitoring: Dominant person/group;

Ineffective audit committee; Ineffective board of
directors.

Fraud Triangle - 3) Ineffective corp. ethical values; non-financial managers

Attitude/rationalization invovled in selection of accounting principles/estimates;
 History of violation; Focus on stock price and earning
trends; Commitment to unrealistic/aggressive forecasts;
Failure to correct known breaches quickly; Focus on tax
reduction; Materiality as justification for inappropriate
accounting policy; Strained relationships with auditors
(auditor TO, disputes, unreasonable demands, time
pressures, Limitation of 411 access, influence over
auditor's scope).
Creative Cash Flows Higher share price
Accounting: Lower borrowing cost
Motivation Higher incentive compensation

Creative Cash Flows Delay Supplier pymt: boost CFO; review days' sales in
Accounting: Technique AP; Financing of payables: use N/P to pay off AP;
manipulate timing of CFO;
Securitization of A/R: accelerates appearance of
collection, boosts CFO;
Tax benefit of stock options: lower tax paid on option
exercise;
Buybacks to offset dilution: net flows treated as CFF not
CFO.

Forecasting Financial 1) Forecast GDP

Performance: Top 2) Regress industry sales against GDP
Down Approach: 3) Forecast industry sales
4) Cosider changes to firm's mkt share
5) Forecast firms sales
6) Use hisoric margins for stable firms or forecast
individual expense items
7) Remove non-recurring items when calculating historic
margins

Forecasting Financial 1) Credit Scoring (CF Forecast)

Performance: 2) Equity Investment screening (cutoff values)
Application

4 General Categories 1) Scale & Diversification

for 2) Operational Efficiency
Creditworthiness/Capa 3) Margin Stability
city: 4) Leverage
Screening for Potential Low: P/E, P/CF, or P/S
Equity Investment: High: ROE, ROA, growth rates of sales and earnings
Criteria Low: leverage

Financial Adj to Diff. in depreciation methods/assumptions;

Facilitate Comparison: Diff. in inventory methods/assumptions;
Diff. in treatment of the effect of exchg rate chgs;
Diff. in classifications of investment securities
Goodwill:
Internally Generated DON'T capitalize,
Purchased = Capitalize
Capitalization decisions
Off B/S finance:
Operating vs. Capital Leases
Equity accounted SPEs vs. non-qualifying SPEs
Sale of A/R

Convergence IFRS/US IAS 39 Marketable securities

GAAP: IAS 2 Inventories (LIFO prohibited)
IAS 16 PP&E
JV (IFRS: proportional consolidation)
IAS 38 Intangibles
IAS 18 & 11 Contruction Contracts
Extraordinary Items: Prohibited in IFRS
Cash Flow Statement

Form DEF-14A: When a company prepares a proxy statement for its

shareholders prior to the annual meeting or other
shareholder vote, it also files the statement with the SEC
as Form DEF-14A.

Form 8-K: Companies must file this form to disclose material events
including significant asset acquisitions and disposals,
changes in management or corporate governance, or
matters related to its accountants, financial statements,
or the markets on which its securities trade.

Form 144: A company can issue securities to certain qualified

buyers without registering the securities with the SEC,
but must notify the SEC that it intends to do so.

The account format of follows the traditional ledger account, assets on the left
B/S hand side and liabilities and equity on the right hand
side.
The report format of assets, liabilities, and equity are presented in a single
B/S column.

FIFO is appropriate for inventory that has a limited shelf life

ex) Because the movies have a very limited shelf life and
will greatly deteriorate in value with age, especially after
the first year, FIFO is the most appropriate method of
accounting for the movies for sale.

LIFO is appropriate for inventory that does not deteriorate with age.

Which set of U.S. GAAP

accounting standards
requires firms to
disclose estimated
amortization expense
for the next five years
on intangible assets?

One major difference all DTA and DTL are classified as noncurrent under IFRS
between the
presentation of Under U.S. GAAP, deferred tax assets and liabilities are
deferred tax assets classified as current or non-current according to the
and liabilities under classification of the underlying asset or liability.
IFRS and under U.S. Under IFRS, deferred tax assets and deferred tax
GAAP is that: liabilities are all classified as noncurrent, with footnote
disclosure about the expected timing of reversals.

To investigate the management turnover.

stability of that
structure, Kilgore
would be best served
by looking at

The best indicator of companies should not recognize revenue from barter
overstating its profits is transactions. The additional revenue is likely to
improperly boost profits.

While an unusually high sales-growth rate may indicate

 fraud, it could also indicate good management. It's a
yellow flag, but not the best indicator of accounting
shenanigans. Rising inventory is also a dual signal. It
could be meant to overstate profits, or it could simply
reflect an actual buildup of inventory in response to
market forces or corporate operations.
Which of the following More than a third of Maxwell's total sales go to its own
characteristics should consolidated subsidiaries
be of least concern High levels of related-party transactions are worrisome,
about management's particularly when those parties are not audited. But
opportunities to transactions within the company between subsidiaries
commit fraud? consolidated in a company's audited financial statements
are neither unusual nor a particularly fertile ground for
fraud. Both remaining characteristics are legitimate risk
factors.
1) market penetration gives ability to dictate terms to
vendors
2) More than half of the revenues is generated in
emerging markets.

FIFO ending inventory = LIFO ending inventory + LIFO reserve \FIFO after-tax
profit

FIFO after-tax profit = LIFO after-tax profit + (change in LIFO reserve)(1 − t)

Cash collected from Revenues - Increase in accounts receivable.

customers If accounts rec went up, cash went out.
If accounts rec went down cash came in.

Specific Identification best matches the actual historical cost of inventory to

Method their physical flow.

General Flow in 1) Journal entries 2) general ledger 3) trial balance 4) FS

Accounting System

FS Analysis Framework S GPA RU

1) State obj/context
2) Gather data
3) Process data
4) Analyse/interpret data
5) Report conclusions/recs
6) Update analysis
Proxy Statements are 1) available on EDGAR 2) A good source of info abt the
qualifications of board members and management.

Changes in asset lives estimates and no specific disclosure are required.

and salvage values are
changes in accounting
...

Ricardian model Uses the factor of differences in labor productivity due

to differences in technology

Heckschler-Ohlin Takes into account a country's labor and capital;

model Assumes capital receives more income than labor

Trade blocs +Free trade areas

+Customs unions
+Common market
+Economic union
+Monetary union

Free trade area All barriers to import and export of goods and services
among member countries are removed

Customs unions All benefits of a free trade area;

Countries adopt a common set of trade restrictions with
non-members

Common market All benefits of a customs union;

All barriers to the movement of labor and capital goods
among member countries are removed

Economic union All benefits of a common market;

Member countries establish common institutions and
economic policy for the union

Monetary union All benefits of an economic union;

Member countries adopt a single currency

Current account -Merchandise and services

components -Income receipts
-Unilateral transfers

Capital account -Capital transfers

components -Sale and purchase of non-financial assets

Financial account -Government owned assets abroad

components -Foreign owned assets in the country
Types of trade -Tariffs
restrictions -Quotas
-Export subsidies
-Minimum domestic content
-Voluntary export restraint

Tariff Increases the domestic price;

Decreases the quantity imported and increases the
domestic quantity supplied;
The government gains by the amount of the tariff
revenues

Quota Same effect as a tariff except the government only gains

if it charges for tariff licenses (quota rents);
If the government doesn't charge quota rents, the loss to
the domestic economy is equal to the quota rents (the
difference between the gain in producer surplus and the
loss in consumer surplus)

Export subsidies Increase the good's price and decrease consumer

surplus;
In a small country, the price of the good will increase by
the amount of the subsidy. In a large country, the world
price decreases and some foreign participants also
benefit

Voluntary export Agreement by the government to limit the quantity of a

restraint good that can be exported;
The loss to the domestic economy is equal to that of an
equivalent quota with no charge for quota rents

Autarky Closed economy

Direct quote The value of one unit of a foreign currency in terms of

the home currency

Indirect quote The amount of foreign currency that can be bought for
one unit of home currency

Cross rate The exchange rate between two currencies implied by

both their exchange rates to a third currency

Regimes of countries -Formal dollarization

without their own -Monetary union
currency

Formal dollarization Using another country's currency;

Country can't set its own monetary policy

Monetary union Countries use a shared currency;

Can't make their own monetary policy but participate in
making the policy of the union

Regimes of countries -Currency board

with their own -Conventional fixed peg agreement
currency -Target zone
-Passive crawling peg
-Active crawling peg
-Crawling bands
-Managed floating exchange rate
-Indecent entry floating exchange rate

Currency board Explicit commitment to exchange domestic currency for

a specified foreign currency at a fixed exchange rate;
Cannot set its own monetary policy

Conventional fixed When a country pegs its currency to within a certain

peg agreement margin of another currency or to a basket of currencies
of is trading partners

Target zone A set range a currency is allowed to fluctuate relative to

another currency;
Larger movement range than a fixed peg

Passive crawling peg When an exchange rate is adjusted periodically to adjust

for higher inflation versus the currency it is pegged to

Active crawling peg When the adjustments are periodic, announced and
implemented

Crawling bands When the width of the bands of permissible exchange

rates is increased over time

Managed floating When the monetary authority tries to influence

exchange rate exchange rates in response to specific economic
indicators

Indecent entry floating Market determined and only influenced by monetary

exchange rate authorities to slow the rate of movement, not keep them
at a certain level
Marshall-Lerner The demand for exports plus the demand for imports is
condition greater than 1;
Under this condition, depreciation of a currency will
decrease a trade deficit;
For export elasticity, the worst case is completely
inelastic demand because the decrease in foreign
currency has no effect on the quantity demanded;
For import elasticity, the worst case is perfectly inelastic
demand because the quantity demanded remains the
same as price changes;
Overall, currency depreciation will improve the trade
deficit when either import or export demand is elastic;
Only considers trade flows and not capital flows

Quota Rents Gains to those foreign exporters who receive import

licenses under a quota if the domestic government does
not charge for the import licenses.

Domestic Government Quota has same economic result as a tariff

Collects Full Value of
Import License

Decreases to Import quotas, tariffs and volunteer export restraints

Consumer Surpluses

Increases to Producer Import quotas, tariffs and volunteer export restraints

Surpluses

Net Revenue = Revenues - ordinary expenses + other income - other

expenses + gains - losses

Single-Step Format All expenses are grouped together

Multi-Step Format Gross profit is included

Gross Profit Amount that remains after the direct costs of producing
a good are subtracted from revenue

Operating Profit When operating expenses are subtracted from gross

profit;
Profit before financing costs, income tax and
nonoperating items

Percentage of The percentage of total cost is how much revenue can

Completion Revenue be recognized;
Recognition
 Revenue is recorded faster, more subjective and better
matches revenues and expenses
Installment Sales When a firm finances a sale and payments are expected
to be received over an extended period of time;
If collection is certain, revenue is recorded at the time of
sale;
If not certain, either the installment method or cost
recovery method can be used;
In the installment method, profit is recognized as cash is
collected and equals the cash collected multiplied by
the total expected profit as a percentage of sales;
The cost recovery method only recognizes profit when
cash collected exceeds costs incurred

Barter Transaction When two parties exchange goods with no cash

payments;
GAAP says revenue can be recognized at fair value only
if the firm has historically received cash for the goods
and use the historical price to determine fair value,
otherwise the revenue is recorded at the carrying value
of the surrendered items;
IFRS says revenues must be based on fair value of
revenue from similar transactions with unrelated parties

Round Trip Transaction When goods are sold to one party with the simultaneous
purchase of identical goods from the same party

Gross Revenue When the cost of goods sold and sales revenues are
Reporting reported separately;
Sales are higher than under Net Revenue Reporting

Net Revenue Reports the difference between the two figures

Reporting

Does IFRS accept NO!!!

LIFO?

Discontinued Operation that management plans to get rid of, or

Operation already has;
The measurement date is the date management made a
plan of discontinuation;
The phaseout period is the time between the
measurement period and the actual disposal date;
 Income must be separated on the income statement,
past income statements must be restated
Extraordinary Item Item that is both unusual and infrequent;
Allowed only by GAAP

A change in Requires restatement of prior financial statements

accounting principles...

A change in Is a change due to new information and does not require

accounting estimates... old statements to reflect it

Basic EPS (Net Income - Preferred Dividends)/(Weighted Average

of Shares Outstanding)

Diluted EPS [(Net Income - Preferred Dividends) + Convertible

Preferred Dividends + Convertible Debt Interest * (1-t)] /
[Weighted Average Shares + Shares from Conversion of
Preferred Shares + Shares from Converted Debt + Shares
from Issuable Stock Options]

Dilutive/Anti-Dilutive Stock options, warrants, convertible bonds or

Securities convertible preferred stock that would
decrease/increase earnings per share if converted to
common stock;
Stock options and warrants are only dilutive when their
exercise prices are less than market value of the stock;
the treasury stock method must be used to calculate
average number of shares outstanding

Treasury Stock Method Equates the net increase in the number of shares
outstanding to the number of shares created by
exercising the option minus the number of shares
repurchased with the proceeds of the exercise;
Assumes the funds received by the company from the
exercise of the options would be used to purchase
shares of the company's common stock at the average
market price

Common Size Income Shows each category of the income statement as a

Statement percentage of revenue;
+Controls for a company's size, allowing for easier
comparison
+The effective tax rate is the amount of tax paid divided
 by pretax income
+Gross profit margin is the gross profit divided by the
total revenue
+Net profit margin is the net income divided by total
revenue
Comprehensive Accounts for all changes in equity except for owner
Income contributions or distributions;
Includes foreign currency gains/loses, pension liability
adjustments, cash from hedging and unrealized
gains/loses from available-for-sale securities

Classified Balance Separates asset and liabilities into current and non-
Sheet current categories;

Working Capital Working Capital = Current Assets - Current Liabilities

Operating Cycle The time it takes to produce or purchase inventory, sell

it, and collect the cash

Current Assets +Cash and Cash Equivalent

+Marketable Securities
+Accounts Receivable
+Inventory
+Other Current Assets

Current Liabilities +Accounts Payable

+Notes Payable and Current Portion of Long-Term Debt
+Accrued Liabilities
+Unearned Revenue

Standard Costing Assigns predetermined amounts of materials, labor, etc

Inventory to each unit produced

Retail Inventory Measures inventory at retail price and subtracts a

Method predetermined profit from each unit

Non-Current Assets +Plants, Property, and Equipment

+Investment Property
+Intangible Assets
+Goodwill
+Financial Assets
Trading Securities Listed at fair value, with unrealized gains and losses are
recognized in the income statement

Available for Sale Listed at fair value but unrealized gains and loses are not
Securities reported

Non-Current Liabilities +Long-Term Financial Liabilities

+Deferred Tax Liability

Shareholders' Equity +Owner's Equity

+Contributed Capital
+Par Value is the stated legal value, has no relationship to
fair value, and is reported separately in the statement
+Shares
+Preferred Stock
+Non-Controlling Interest
+Retained Earnings
+Treasury Stock
+Accumulated Other Comprehensive Income

Operating Activities +Cash collected from customers

+Interest and dividends received
+Sales proceeds from trading securities
+Cash paid to suppliers and employees
+Cash paid for other expenses
+Acquisition of trading securities
+Interest and taxes paid

Investing Activities +Sales proceeds of fixed assets

+Sale of debt and equity instruments
+Principal from loans made to others
+Acquisition of fixed assets
+Loans made to others
+Acquisition of debt and equity investments

Financing Activities +Principal from issued debt

+Proceeds from issued stock
+Principal paid on debt
+Payments to reacquired stock
+Dividends paid to shareholders

Differences Between +GAAP lists dividends paid under financing activities and
IFRS and GAAP Cash interest paid in operating activities. IFRS allows them to
Flow Statements be listed as either operating or financing activities
+GAAP lists dividends and interest received under
operating activities. IFRS allows them to be listed as
either operating or investing activities
+GAAP lists taxes paid under operating activities. IFRS
lists taxes as operating activities unless they are
associated with an investing or financing activity
Direct Cash Flow Converts each line item of the accrual-based income
Method statement into cash receipts and payments;
Begins with cash inflows from customers and deducts
cash outflow from purchases, operating expenses, etc

Components of Direct +Cash collected from customers

Cash Flow Method +Cash used in production of goods and services
+Cash operating expenses
+Cash paid for interest
+Cash paid for taxes

Indirect Cash Flow Converts net income into operating cash by making
Method adjustments for transactions that affect net income but
are not cash transactions;
Eliminate noncash expenses and nonoperating items;
Only presents the net of cash receipts and payments;
Focuses on the differences between net income and
operating cash flow

Indirect Cash Flow 1. Begin with net income

Method Process 2. Subtract gains or add loses from financing or investing
cash flows
3. Add back all noncash charges to income and subtract
all noncash components of revenue
4. Subtract increases in operating assets and add back
decreases
5. Add increases in operating liabilities and subtract
decreases

Direct Method -> +Cash Collected from Customers

Indirect Method 1. Start with net sales
2. Subtract/add any increase/decrease in accounts
receivable
 3. Add/subtract any increase/decrease in unearned
revenue

+Cash Payments to Suppliers

1. Begin with Cost of Goods Sold
2. Add back depreciation and amortization if they have
been included in COGS
3. Add/subtract any increase/decrease in the inventory
balance
4. Reduce/increase COGS by any increase/decrease in
the accounts payable balance
5. Subtract any inventory write off from COGS
Free Cash Flow Cash available once the firm has covered it's capital
expenditures;
= Net Income + Noncash Charges + (Interest Expense * [1
- tax rate]) - Fixed Capital Investment - Working Capital
Investment;
= Cash Flow from Operations + (Interest Expense * [1 -
tax rate]) - Fixed Capital Investment

Free Cash Flow to Cash flow that would be available for distribution to
Equity common shareholders;
= Cash Flow from Operations - Fixed Capital Investment
+ Debt Issued - Debt Repaid

Uses of Ratio Analysis *Project future earnings and cash flow

*Evaluate a firms flexibility
*Assess managements performance
*Evaluate changes in the firm and industry over time
*Compare firms within an industry

Limitations of Ratio *Not useful when viewed in isolation

Analysis *Skewed by different accounting treatments
*Difficult to find appropriate ratios when companies
compete in multiple industries
*Conclusions can't be made by looking a a single ratio
*Determining a target or comparison value of a ratio is
difficult

Use of Activity Ratios Give indications of how well a firm utilizes various assets
Use of Liquidity Ratios The ability to pay short-term obligations as they come
due

Use of Solvency Ratios Ability to pay back long-term obligations

Use of Profitability Give information about how well a company generates

Ratios operating profits and net profits from its sales

DuPont ROE Equations = Net Profit Margin Asset Turnover Leverage Ratio
= (Net Income/EBIT) (EBT/EBIT) (EBIT/Revenue)
(Revenue/Total Assets) (Total Assets) * (Total
Assets/Total Equity)
= (Tax Burden) (Interest Burden) (EBIT Margin) (Asset
Turnover) (Financial Leverage)

Sustainable Growth = Retention Rate * ROE

Non- In the equity section of the balance sheet; Represents

controlling/Minority the portion of the subsidiary that is not owned by the
Interests reporting firm

Income Tax Expense Is a non-operating item that is reported within "income

from continuing operations"

Foreign Currency Taken directly to owners' equity

Translation Loss

Steps of Valuing a +Estimate cash flows

Bond +Determine appropriate discount rate
+Calculate the present value of the estimated cash flow

Situations Where +Principal repayment stream is not known with certainty

Estimating Cash Flows +Coupon payments are not known with certainty
is Difficult +Bond is convertible

Arbitrage Free When a bond has each of its cash flows discounted
Valuation using a discount rate that is specific to the maturity of
each cash flow;
Spot rates used are required rate of returns on zero
coupon bonds maturing at a given time;
The value of a bond based on spot rates must be equal
to the value of its parts or there is an arbitrage
opportunity

Steps of Arbitrage *Value the security using spot values

Free Valuation *Compare the value to the market price
Sources of Bond +Coupon payments
Return +Recovery of principal at maturity
+Reinvestment income

Current Yield The yield from the bond's annual coupon payments;
Offers little information;
Current Yield = (Annual Cash Coupon Payment)/(Bond
Price)

Yield to Maturity The IRR of a bond's price and promised cash flows;
Stated as two times the semiannual coupon payments
implied by the bond's price

Bond Equivalent Yield [(1 + Annual YTM) ^ (1/2) - 1] * 2;

= Referred to as the semiannual yield to maturity or
semiannual-pay yield to maturity

Yield to Call The yield on callable bonds that are selling at a premium
to par;
Can be less than the yield to maturity if the bond is
trading at a premium;
Calculate the same way as yield to maturity but the call
price is used instead of par and the time period only
runs to the next call

Yield to Worst The worst yield outcome of any of the possible call
provisions

Yield to Refunding Used when a bond is callable and rates make sense for it
to be called, but the bond covenants contain provisions
giving protection from refunding until a future date;
Same calculation as yield to call but date used is the first
date refunding is allowed

Yield to Put Used if a bond has a put option and is selling at a

discount;
Calculated the same way as yield to maturity but with
the put price as the price and put date as the date

Cash Flow Yield Used for mortgage-backed securities and other

amortized asset-backed securities;
Includes assumptions on how prepayments are likely to
 occur;
Once monthly cash flow projections are made, can
calculate a CFY as a monthly IRR based on the market
price of the security;
Bond Equivalent Yield = [(1 + Monthly CFY) ^ 6 - 1] * 2
Limitation of Yield to Doesn't tell the compounded rate of return that will be
Maturity realized on a fixed income security;
Assumes reinvestment at the yield to maturity

When Bond at Par.... Coupon Rate = Current Yield = Yield to Maturity

When Bond at Coupon Rate < Current Yield < Yield to Maturity
Discount...

When Bond at Coupon Rate > Current Yield > Yield to Maturity
Premium...

Bootstrapping Method of constructing a Treasury yield curve using the

yield to maturities of different maturities

Steps of Bootstrapping *Begin with 6-month spot rate

*Set value of the 1-year bond equal to present value of
the cash flows with the 1-year spot rate divided by two
as the only unknown
*Solve for 1-year spot rate
*Use 6-month and 1-year spot rates and equate the
present value of the cash flows of the 1.5-year bond to
its price, with 1.5-year bond as the only unknown
*Solve for 1.5-year bond

Nominal Spread The difference between a bond's YTM and a similar

Treasury's YTM;
Uses a single discount rate;
Ignores the shape of the yield curve and is technically
only correct if yield curve is flat

Zero Volatility Spread The equal amount that must be added to each rate on
the Treasury spot yield curve in order to make the
present value of the risky bond's cash flow equal to its
market price;
Measures spread to Treasury spot rates necessary to
produce a spot rate curve that correctly prices a risky
bond;
 For a risky bond, the value obtained from discounting
expected cash flows at Treasury spot rates will be too
high since Treasury spot rates are lower than they would
be for a risky bond
Factors Influencing ~The steeper the benchmark spot rate curve, the greater
Difference Between the difference between the two and an
Nominal and Zero-Vol upward/downward sloping curve produces a Z spread
Spreads greater/smaller than nominal spread
~The shorter the maturity, the greater the difference

Option Adjusted The spread to the Treasury spot curve that the bond
Spread would have if it were option-free

Forward Rate Borrowing/lending rate for a loan to be made at a future

date;
Borrowing for three-years at a three year rate or for 1-
year periods, three in succession, should cost the same

Scenario Analysis Measuring interest rate risk by plugging in different rates

to the valuation model and looking at the outputs

Duration/Convexity Approximates the actual interest rate sensitivity of the

Approach bond

Duration Relationships *HIgher/lower coupon means lower/higher duration

*Longer/shorter maturity means higher/lower duration
*Higher/lower market yield means lower/higher duration

Convexity Makes so a bond's rate of devaluation fall the more

yields rise

Effective Duration = (Bond Price When Yields Fall - Bond Price When Yields
Rise)/(2 Initial Price Change in Yield in Decimal Form)

Macaulay Duration An estimate of a bond's interest rate sensitivity based on

years until promised cash flow will arrive;
Cannot be used for bonds with options

Modified Duration Similar to Macaulay but takes into account YTM;

= (Macaulay Duration)/(1 + Periodic Market Yield)

Interpretations of +Duration is the slope of the price-yield curve at the

Duration bond's current YTM
+Duration is a weighted average of the time until each
cash flow
 +Duration is the approximate percentage change in price
for a 1% change in yield
Portfolio Duration The weighted average of each bond's duration;
Best with a parallel curve shift since not all bonds will
have the same yield change

Convexity The curvature of the price-yield curve;

The more convexity, the worse the duration estimate will
differ from actual change

Duration/Convexity [(-Duration Change in Yield) + (Convexity Change in

Bond Pricing = Yield ^ 2)] * 100

Effective Convexity Takes into account changes in cash flows from

embedded options

Difference Between Modified convexity does not take options into account
Modified and Effective and effective convexity does
Convexity

Price Value of a Basis The dollar change in the price/value of a bond or

Point portfolio when the yield changes by one basis point;
= Duration 0.0001 Bond Value

Holding Period Yield Holding Period Return = (ending value/beginning value)

-1
OR
= (ending value - beginning value + cash flow
received)/(beginning value) - 1

Effective Annual Rate = (1 + (periodic rate/compounding periods)) ^

(compounding periods) - 1

Required Interest Rate = (risk free rate) + (default risk premium) + (liquidity
premium) + (maturity risk premium)

Time Weighted Return Same as annualized return

Money Weighted Same as IRR

Return

Bank Discount Yield = ((face value - market value)/(face value)) * (360/days

until maturity)

Effective Annual Yield = (1 + HPR) ^ (365/days until maturity) - 1

Money Market Yield = HPR * (360/days until maturity)

Bond Equivalent Yield = 2 * (semiannual discount rate)
OR
= HPR * (365/days until maturity)

Measurement Scales +Nominal scales are arbitrary ways of coding data

+Ordinal scales are coding data categorically based on
some sensical order that is relative
+Interval scales are coding data in an order that has an
equal distance between scale values
+Ratio scales provide ranking, equal distance between
values, and a true 0

Mean Absolute Average of the absolute values of each deviation

Deviation

Harmonic Mean The mean of n numbers expressed as the reciprocal of

the arithmetic mean of the reciprocals of the numbers

Chebyshev's Inequality The percentage of the observations that lie within k

standard deviations of the mean is at least 1 - (1/k^2)
when k > 1

Positive Skew Long tail to the right and Mean > Median > Mode

Negative Skew Long tail to the left and Mean < Median < Mode

Leptokurtic Bigger peak and smaller tails than a normal distribution

(k>3)

Platykuric Smaller peak and fatter tails than a normal distribution

(k<3)

Excess Kurtosis Kurtosis - 3; Significant if result is greater than 1

Sample Skew (1/sample size) * [(Sum of Each Sample Deviation

Cubed)/(Sample Deviation Cubed)]; Skewness greater
than 0.5 is significant

Empirical Probability Comes from past data; an objective probability

A Priori Probability Comes from a formal reasoning and inspection process;

an objective probability

Subjective Probability Comes from a personal judgement

Conditional Probability When one event's probability affects the other events
*P(A|B) = The probability of A given B
Joint Probability P(AB) = P(A|B) * P(B)
P(A|B) = P(AB)/P(B)

Addition of Probability P(A or B) = P(A) + P(B) - P(AB)

Total Probability P(A and B) = P(A) * P(B) if independent events

Independence Test Events are independent if P(A|B) = P(A)

Bayes' Formula Used to update a given set of prior probabilities for a

given event in response to new information;
(Updated Probability) = {(Probability of new information
of a given event) \ (Unconditional probability of new
information)} * (Probability of event)

Permutational A specific ordering of a group of objects and answers

Ordering the question of how many different groups of size r in
specific order can be chosen from n objects;
P = (n!) \ (n - r)!

Combinational Formula to find the number of possible ways of selecting

Ordering r items from a set of n items;
C = (n!) \ {(n - r)! * r!}

Two Assets' Dividing the covariance between returns of two assets

Correlation Coefficient by the individual standard deviations of returns of the
two assets

Days of sales = 365 / Rec TO

outstanding (DSO) = 365 / (Rev / Avg. AR)

Days of inventory on = 365 / Inv TO

hand (DOH) = 365 / ( COGS / Avg. Inv.)

Days of payables = 365 / payables TO

= 365 / (purchases / Avg. AP)

Total Asset TO = Rev / Avg Total Assets

Fixed Asset TO = Rev / Avg Fixed Assets

Inventory turnover = COGS / Avg inventory

Receivables Turnover = Annual Sales / Avg Rec

Payables TO = Purchases / Avg Trade Payables

Current ratio = CA/CL

Quick ratio = (cash + mkt sec + AR) / CL

Cash ratio = (Cash + mkt sec) / CL

Defensive interval = (cash + mkt sec + AR) / Daily Cash Exp

Long Term D-to-E = Total LT Debt / Total Equity

D-to-E = Total Debt / Total Equity

Financial leverage ratio = Total Assets/Total Equity

Total Debt Ratio = Total Debt / Total Asset

Debt-to-Capital = Total Debt/ Total Debt + SHE

Covariance of Op. Inc = std dev. EBIT/ Mean EBIT

Covariance of = std. dev Rev/ mean Rev.

Revenue

Operating Leverage = %chg in EBIT/ %chg in Sales

Int. Coverage = EBIT/Interest Expense

Fixed Charged = (EBIT+Lease Pymts) / Int. exp + Lease payments

Coverage

Funds from Operations = NI adj for non cash items/ total debt
to debt

Free operating CF to = CFO - Capex / total debt

Total Debt

Total Debt to EBITDA = total debt / EBITDA

Return on Capital = EBIT / Capital

Total debt to total debt = total debt/ total debt + equity

+ equity

Gross Profit margin = Gross profit/ revenues

LIFO = lower, FIFO = higher

Inventory TO = COGS / Avg. Inventory

LIFO = Higher, FIFO = Lower

DOH = 365/(Inv. T/O)

= 365/( COGS/ Avg. Inv.)
 LIFO = lower days, FIFO = higher days
equalibrium elastic in |ep|=1
terms of equilibrium
price

relatively inelastic 0<|ep|<1

relatively elastic |ep|>1

income elastic normal ie >1

good

income inelastic 1>ie>0

normal good

income elastic inferior ie<0

good

cross elasticity of ec<0

compliments

cross elasticity of ec>0

substitutes

imperfect competition downward sloping demand curve

in order to increase qty sold, individ producer must
reduce price
marg rev curve downward sloping and steeper than
demand curve
total revenue - increases at increasing rate above unitary
elastic curve and increases as decreasing rate below it
total rev max at unit elastic....and marg rev at unit elastic
is negative

marginal cost curve their min values

intersects avc and atc
at?

long-run equilibrium is p = atc

total product max output that a given qty of labor can produce when
working with a fixed qty of capital units

marginal cost equation change in total cost/change in total produc

marginal product change in total product/change total labor