CFA Flashcards
6 components of the Code of Ethics:
+Act with integrity, competence, diligence, respect and 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 Professional
Conduct:
+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
A Priori Probability
Comes from a formal reasoning
and inspection process; an
objective probability
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
A change in accounting
estimates…
Is a change due to new
information and does not require
old statements to reflect it
Accelerated Depreciation
Applies depreciation more at the
beginning of an assets life
A change in accounting
principles…
Requires restatement of prior
financial statements
Accelerated Sinking Fund
Allows the issuer the choice of
retiring more than the amount of
bonds specified in the sinking fund
requirement
Accounting Information Flow
- Journal record every transaction by order of date
in the general journal - The general ledger sorts the entries in the
general journal by account - An initial trade balance is prepared at the end of
the period to show the balance of each account
and adjustments are then made - Financial statements are made from the
adjusted trial balances
Action lag
Time it takes governments to vote
on and enact policy
Accounting Warning Signs
+Aggressive revenue recognition
+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
Active crawling peg
When the adjustments are
periodic, announced and
implemented
Acquisition Method of Accounting
for Business Combinations
When the purchase price is
allocated to the identifiable assets
and liabilities of the acquired firm
based on fair value and the rest is
recorded as goodwill
Addition of Probability
P(A or B) = P(A) + P(B) - P(AB)
Adjustments to Compare Firms’
Financial Statements
+Accounting of investment
securities
+Inventory cost methods
+Depreciation schedules
+Off-balance-sheet financing
+Treatment of goodwill and other
intangible assets
Adverse auditor’s opinion
The statements are not presented
fairly or don’t conform to
standards
Administrative Steps to Capital
Budgeting
*Idea generation
*Analyzing project proposals
*Create firm-wide capital budget
*Monitoring decisions and
conducting a post-audit
Affirmative Covenants
When the borrower promises to do
certain things
After-Tax Nominal Return
The return after tax liability is
deducted
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
After-Tax Yield =
Taxable Yield * (1 - Marginal Tax
Rate)
Advantages of NPV and IRR
NPV: A direct measure of the
expected increase in the value of a
firm
IRR: A percentage and shows
return on each dollar invested
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
American Option
Exercisable at any time;
Will never have a smaller
premium than a European option;
More flexible
All or Nothing Orders
Trades that execute only if the
entire lot can be bought
Amortization
Only done on assets with finite
lives and is done the same as
depreciation
Alternative Hypothesis
What is concluded if null is
rejected
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
American Depository Receipts
Receipts denominated in US
Dollar and trade in the US;
The security it is based on is called
the American Depository Share
Approaches to Calculating Cost of
Equity
+CAPM
+Dividend Discount Model
+Bond Yield
+ Risk Premium
Appropriations Backed
Obligations
When the state isn’t the issuer but
can act as a back up if the issuer
defaults;
General obligation
Arbitrage-Free Treasury Spot
Rates
The rates for different time
periods that correctly value a
Treasury bond;
Discount rates for a zero-coupon
bond
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
Arithmetic Mean
Average of every period’s return
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
Arms Index (or TRIN)
A measure of funds flowing into
advancing and declining stocks;
Calculated by (Number of advancing
shares\Number of declining shares) *
(Volume of declining shares\Volume of
increasing shares);
Greater than 1 indicates money going into
declining shares, the opposite means it’s
going into increasing shares
Arbitrage Free Valuation
When a bond has each of its cash flows
discounted 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
Ascending price (English) auction
Bidders can bid amounts greater
than the previous bid, and the
bidder that first offers the highest
bid wins the item and pays the
amount
Asset Backed Securities
Represent a claim to a portion of a
pool of assets and the return is
passed through to investors with
different tranches having different
levels of risk and return
Asset’s Carrying Value
The value reported on the
financial statements net of
depreciation
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
Asset’s Tax Base
Amount that will be deducted on
the tax return in the future as
economic benefits are realized
Asset Beta
= Equity Beta * [1/1 +
(Debt/Equity)(1 - Tax Rate)]
Assumptions of Gordon Growth
Model
*Dividends are appropriate to
measure shareholder wealth
*Dividend growth rate and
required return never change
*Required return is greater than
the dividend growth rate
Asset Returns and Correlation
Prefer correlations of asset returns within an asset class are significantly greater than correlations of asset class returns
Attitude/Rationalization
A mindset that fraudulent behavior is justified;
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
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
Available for Sale Securities
Listed at fair value but
unrealized gains and loses are not
reported
Average Collection Period
Average number of days it takes
for a customer to pay its bills;
ACP = 365/Receivables Turnover
Auditor’s Opinions
+Unqualified opinion
+A qualified opinion
+An adverse opinion
+A disclaimer opinion
Average Inventory Period =
365/Inventory Turnover
Austrian
Business cycles are caused by the
government
Average Revenue < AVC
Firm should shut down
Autarky
Closed economy
Average Revenue > ATC
Firm should stay in business for
long-run
Balance Sheet CDO
Created by a bank to reduce its
loan exposure on its balance sheet
Average Revenue > AVC
Firm continue production
Bank Discount Yield
= ((face value - market
value)/(face value)) * (360/days
until maturity)
Backfilling Bias
When past performance of an
index is inflated because funds
with poor performance in the past
is not included
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
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
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
Barriers to Creating a Coherent
Financial Framework
+Valuation
+Standard setting
+Measuring value at a point in
time versus it’s movement over a
period of time
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)
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
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
Basic EPS
(Net Income - Preferred
Dividends)/(Weighted Average of
Shares Outstanding)
Benefits of a Lease
+Less costly financing
+Reduced risk of obsolescence
+Less restrictive provisions
+Off-balance-sheet financing
+Tax reporting advantages
Benefits of Derivatives
+Provide price information
+Allow risk to be managed and
shifted among market participants
+Reduce transaction costs
Basis Swap
Trading one floating rate payment
for another
Benefits of Funds of Funds
*Gives access to investors with
limited capital resources
*Greater diversification
*Fund of fund managers have
expertise in picking managers
Best Efforts Sale
When the banker agrees to sell as
much of the issue as possible;
Not liable for the debt left over
Benefits of Intermediaries
*Savers fund entrepreneurs
*Companies share risk
Beta
Measure of systematic risk
Bernoulli Random Variable
Binomial random variable with
only one trial
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
Best Efforts IPO
When a bank agrees to distribute
shares but if undersubscribed,
bank does not buy unsold portion
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
Biased Fund
Either stays net long or net short
always
Board Member Qualifications
+Make informed decisions about the firm’s future
+Have made public statements indicating their
ethical stance
+Have 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
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
Bollinger Bands
Charting 1 standard deviation
above and below the closing price
for a certain amount of days
Binomial Random Variable
Variable may be defined as the number of
successes in a 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)
Bond Equivalent Yield
= 2 * (semiannual discount rate)
OR
= HPR * (365/days until maturity)
Block Brokers
Trade large lots
Bond Equivalent Yield =
[(1 + Annual YTM) ^ (1/2) - 1] * 2;
Referred to as the semiannual
yield to maturity or semiannualpay
yield to maturity
Bond Indenture
The contract that specifies all the
rights and obligations of the issuer
and the owners of a fixed income
security
Book Building
When investment banks solicit
indications of interest from
market participants and adjust the
offering price accordingly
Bond Legal and Issuance Costs
GAAP: Capitalized
IFRS: Subtracted from book value
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
Bond Pricing
Prices quoted in percent and
32nds of a percent;
102-5 is equal to $102.16 per bond
Bootstrapping
Method of constructing a Treasury
yield curve using the yield to
maturities of different maturities
Bond Yield + Risk Premium
Cost of Equity = Risk Free Rate +
Risk Premium
Break Even Quantity of Sales
Quantity of sales for which
revenues equal total costs so net
income is zero;
= (Fixed Operating Costs + Fixed
Financing Costs)/(Price - Variable
Costs per Unit)
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
Business Risks
Risks associated with a firms’
operating income and is the result
of uncertainty about a firm’s
revenues and expenditures
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
Bringing About Disinflation
When policy rate is above the
neutral interest rate
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
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
Call Option
The right to buy
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
Call Option
The right to buy an asset at a
certain price by a certain date;
Counterparty has the obligation to
sell the asset
Callable Shares Risk ___
Common Shares Risk
More than
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
Capital account components
-Capital transfers
-Sale and purchase of nonfinancial
assets
Call Risk
As interest rates fall, an issuer is
more likely to call its bonds and
refinance at a lower rate
Capital Allocation Line
Represents the combinations of a
risky portfolio and a risk free asset
Callable Common Shares
Give the firm the right to repurchase the
stock at a pre-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
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
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
Cash Flow Earnings Index
A way to measure the relationship
between the operating cash flow
and earnings;
CFEI = Operating Cash Flow/Net
Income
CAPM =
Risk Free Rate + (Beta * Excess
Market Return)
Cash Flow per Share
A variation of earnings per share
but using cash flow;
CFPS = (CFO - Preferred
Dividends)/Weighted Average
Number of Common Shares
Cash Flow to Revenue
Measures the amount of operating
cash flow generated per dollar of
revenue;
CFTR = CFO/Net Revenue
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)
Cash Conversion Cycle
The length of time it takes to turn
the firms cash invested in
inventory back into cash;
CCC = Days Sales Outstanding +
Days of Inventory on Hand -
Number of Days of Payables
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
Cash Ratio =
(Cash + Marketable
Securities)/Current Liabilities
Cash-Settled Forward Contract
When the party with a negative
value pays the party with the
positive value in cash
Categories of Capital Budgeting
Projects
+Replacement projects to maintain the
business
+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
Cash Return on Assets
Measures the return of operating
cash flow attributed to all
providers of capital;
CROA = CFO/Average Total
Assets
Causes of demand changes
Income
Increases as prices of substitute
goods increase
Decreases as the prices of
complement goods increases
Cash to Income
Measures the ability to generate
cash from the firms operations;
CTI = CFO/Operating Income
Causes of Low Quality Earnings
+Selecting legal accounting measures
that don’t 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
Causes of supply changes
Rises if technology increases;
Rises if input prices decrease
Characteristics of a coherent
financial framework
+Transparency
+Comprehensiveness
+Consistency
Central bank tools
+Policy rate
+Reserve requirements
+Open market operations
Characteristics of Commercial
Paper
+Maturities of 270 days or less
+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
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
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
Characteristics of Medium-Term
Notes
+Shelf-registered and they do not
need to be all sold at 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
Clearinghouses
Provide escrow services,
guarantees of contract completion,
assurance margin traders have
necessary capital, and limits on
orders;
Reduce counterparty risk
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
Closed End Fund
Traded through secondary
markets;
Initially sell for a small premium
to the value of the underlying
assets
Chi-Squared Test
Used to test hypothesis about one
variance
Classified Balance Sheet
Separates asset and liabilities into
current and non-current
categories;
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
Charges an ongoing management
fee
Coefficient of Variation
Standard deviation divided by the
mean
Clearing Instructions
Specify how to settle a trade
Coincident economic indicators
Employees on nonfarm payroll
Personal income
Industrial production
Manufacturing sales
Commercial Paper
A short-term debt security that
can be sold directly to investors or
through dealers
Collateralized Commodities
Futures Positions
Require buying a specific futures contract and
buying government securities, with a market value
equal to the 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
Committed Line of Credit
When a bank commits to lending a
certain amount over a certain
period of time
Collateralized Debt Obligation
Debt instrument where the
collateral for the promise to pay is
an underlying pool of other debt
obligations;
Tranches are created for seniority
of cash flows
Common market
All benefits of a customs union;
All barriers to the movement of
labor and capital goods among
member countries are removed
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;
Combinational Ordering
Formula to find the number of
possible ways of selecting r items
from a set of n items;
C = (n!) \ {(n - r)! * r!}
Common Size Income Statement
Shows each category of the income statement as a
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
Components of Credit Rating
+Scale and diversification
+Operational efficiency
+Margin stability
+Leverage
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
Components of Direct Cash Flow
Method
+Cash collected from customers
+Cash used in production of goods
and services
+Cash operating expenses
+Cash paid for interest
+Cash paid for taxes
Complying to Preservation of
Confidentiality
Best way is to only share
information with someone in the
company working with that client
Components of Net Daily Cash
Position
*Treasury bills
*Short term agency securities
*CDs
*Banker’s acceptances
*Time deposits
*Repo agreements
*Commercial paper
*Money market funds
*Adjustable rate preferred stock
Components of an Order
+Bid-ask spread
+Execution order
+Validity instructions
+Clearing instructions
Comprehensive Income
Accounts for all changes in equity except
for owner contributions or distributions;
Includes foreign currency gains/loses,
pension liability adjustments, cash from
hedging and unrealized gains/loses from
available-for-sale securities
Concentration measures
Nth firm indicator
Herfindahl-Hirschman Index
Conservatism
When investors react slowly to
change
Conditional Probability
When one event’s probability
affects the other events
*P(A|B) = The probability of A
given B
Considerations of Firm Voting
Policy
*Whether it is a classified board
(staggered multi-year terms) or annual
elections
*Whether Board filled a vacancy without
shareholder approval
*Whether shareholders can remove
member
*Whether the Board is the proper size
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)
Considerations When Electing
Board
*Majority of Board is comprised of independent
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
Conflicts of Interest:
+Disclosure of Conflicts
+Priority of Transactions
+Referral Fees
Contango
When a future price is above the
spot price;
Caused by companies wanting to
lock in future rates to match future
liabilities
Continuation Patterns
Suggest a pause in an uptrend
rather than a reversal
Contents of Auditor’s Opinion
+Independent view of the firms
financial statements
+Generally accepted accounting
policies were used and judgements
were reasonable
+Explanation when accounting
policies change from year to year
Continuous Markets
Trades occur any time a market is
open
Contents of Footnotes
+The basis of presentation such as
the accounting period
+Information about the
accounting methods used
+Additional information about
extraordinary events
Continuous Random Variable
Variable where the number of
possible outcomes is infinite, even
if upper and lower bounds exist
Contents of Investment Policy
Statement
+Description of Client
+Statement of Purpose of IPS
+Statement of Investment Manager’s Duties and
Responsibilities
+Procedures to Update IPS
+Investment Objectives
+Investment Constraints
+Investment Guidelines
+Evaluation of Performance
+Appendices
Contents of Management
Discussion and Analysis
+The basis of presentation such as
the accounting period
+Information about the
accounting methods used
+Additional information about
extraordinary events
Contraction/Recession
Real GDP is decreasing
Rates of spending, investment and
employment remain positive while
inflation accelerates
Contribution Margin
Difference between price and
variable cost per unit
Convertible Debt
Debt an investor can exchange for
a specified number of equities in
the issuing firm
Conventional Cash Flow Pattern
Signs of cash flows only change
once
Convertible Preferred Stock
Can be exchanged for common stock at a
predetermined exchange ratio;
Dividend is usually higher;
Investor has upside potential;
Conversion option holds value over
regular preferred stock;
Less risk than common stock
Conventional fixed peg agreement
When a country pegs its currency
to within a certain margin of
another currency or to a basket of
currencies of is trading partners
Convexity
Makes so a bond’s rate of
devaluation fall the more yields
rise
Convexity
The curvature of the price-yield
curve;
The more convexity, the worse the
duration estimate will differ from
actual change
Convertible Bond Arbitrage
Takes long and short positions in
convertible bonds and equity
shares to benefit from relative
mispricing
Core inflation
Headline inflation - food & energy
Cost of Goods Sold
= Beginning Inventory +
Purchases - Ending Inventory
Corporate Governance
The set of internal controls,
processes and procedures by which
firms are managed and defines the
rights, roles and responsibilities of
management
Cost of Preferred Stock
Equals the dividend yield of the
preferred stock
Cost Method Ratio Effects
+FIFO/LIFO produces higher/lower
profitability measures
+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
Cost-push inflation
Caused by a decrease in supply
Cost of Debt
Equals the market’s yield to
maturity
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)
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
Credit Default Swap
Form of insurance pays if an issuer
defaults on its bonds
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
Credit Risk
Chance the creditworthiness of an
issuer will decrease
Covered Call Option P/L
*If stock closes below strike price, the call expires
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
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
Crawling bands
When the width of the bands of
permissible exchange rates is
increased over time
Criteria for Capital Budgeting
Method
+Location (Europeans use payback period a lot
more)
+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)
Criticisms of Derivatives
+Too risky for investors with
limited knowledge
+High leverage and high payoffs
liken them to gambling
Cumulative Preferred Stock Risk
___ Non-Cumulative Preferred
Stock Risk
Less than
Cross rate
The exchange rate between two
currencies implied by both their
exchange rates to a third currency
Cumulative Voting
Shareholders can allocate their
votes to one or more candidates
and lets minority shareholders
have proportional representation
on the board
Cum Coupon
When the buyer is entitled to the
next couponn
Currency board
Explicit commitment to exchange
domestic currency for a specified
foreign currency at a fixed
exchange rate;
Cannot set its own monetary
policy
Cumulative Preferred Stock
Has promised fixed dividends and
any dividend not paid must be
paid before common shareholders
are given dividends
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
Currency Swap
Swapping loans in different
currencies
Current Liabilities
+Accounts Payable
+Notes Payable and Current
Portion of Long-Term Debt
+Accrued Liabilities
+Unearned Revenue
Currency Swap
One party makes payments
denominated in one currency
while the payments from the other
party are made in a second
currency
Current Ratio =
Current Assets/Current Liabilities
Current Yield
The yield from the bond’s annual
coupon payments;
Offers little information;
Current Yield = (Annual Cash
Coupon Payment)/(Bond Price)
Current account components
- Merchandise and services
- Income receipts
- Unilateral transfers
Custodians
Improve market integrity by
holding client securities and
preventing their loss due to fraud
or other events
Current Assets
+Cash and Cash Equivalent
+Marketable Securities
+Accounts Receivable
+Inventory
+Other Current Assets
Customs unions
All benefits of a free trade area;
Countries adopt a common set of
trade restrictions with nonmembers
Cyclical unemployment
Due to changes in the general level
of economic activity
Cycle Theory
+Presidential Cycle = 4 years
+Decennial Cycle = 10 years
+Kondratieff Wave = 54 years
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
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
Dead Cross
When the short term average
crosses below the long term
average;
Indicate downtrend
Cyclical Sectors
+Energy
+Financials
+Technology
+Materials
+Consumer discretionaries
Debenture
Unsecured bond
Debt Coverage
Measures financial risk and
leverage;
DC = CFO/Total Debt
Debt to Assets =
Total Debt/Total Assets
Debt Payment
Measures the firms ability to
satisfy long term debt with
operating cash;
DP = CFO/Cash Long-Term Debt
Repayment
Debt to Capital =
Total Debt/(Total Debt + Total
Shareholders Equity)
Debt Securities
Promises to repay borrowed funds
Debt to Equity
Measure of a firms fixed-cost
financing;
DE = Total Debt/Total
Shareholders Equity
Debt Supported by Public Credit
Enhancement
An explicit guarantee that the
bond is backed up by the state or
federal government;
General obligation
Decisions of an Index Maker
+What is the target market an asset is
supposed to measure
+What securities should be included
+How should securities be weighted
+How often should index be rebalanced
+When should selection and weighting be
reevaluated
Declaration Date
The date the board of directors
approves the dividend
Defensive Interval Ratio
The number of days the average cash
expenditures the firm could pay with
its current liquid assets;
DI = (Cash + Marketable Securities +
Receivables)/Average Daily
Expenditures
Declining Stage
When industry starts to shrink;
Negative growth;
Declining price;
Consolidation
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
Decreases to Consumer Surpluses
Import quotas, tariffs and
volunteer export restraints
Deferred Tax Disclosures
+Deferred tax liabilities and assets, valuations
allowance 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
Deductible Temporary Difference
Result in expected future tax
deductions
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 Liability and Asset
Adjustments
Adjusted for changes in expected
tax rates under the liability
method
Defined Contribution Pension
Expense
= Employer’s Contribution
Deferred-Coupon Bonds
Initial coupon payment is delayed;
Interest accrues and is paid as a
lump sum;
Coupons paid regularly after the
first
Degree of Financial Leverage
= (% Change in EPS)/(% Change
in EBIT)
= (EBIT)/(EBIT - Interest)
Defined Benefit Fund Status
Difference between the defined benefit obligation
and 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
Degree of Operating Leverage
= (Percent Change in EBIT)/(Percent
Change in Sales)
= [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]
Defined Benefit Pension Expense
Components
~Service cost is the present value of benefits earned
by employees during the current period
~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
Deleveraged Floater
Structured note that has coupon
rates that equal a fraction of the
reference rate plus a constant
margin
Deliverable Forward Contract
When a forward is settled with
physical delivery
Depreciation Methods
Straight-line depreciation;
Accelerated depreciation;
Units-of-Production method
Demand-pull inflation
Caused by increase demand
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
Depository Institutions
Institutions pay interest on
customer deposits and provide
transaction services
Derivative
A security that derives its value
from the value or return of
another asset or security
Derivative Contracts
Securities with values that depend
on values of other assets
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
Descending price (Dutch) auction
Begins with a price greater than what any
bidder will pay 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
Differences between IFRS and
GAAP
+IASB lists income and expenses as elements
related to 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
Development Cost Treatment
Capitalized under IFRS;
Expensed under GAAP
Differences Between IFRS and
GAAP Cash Flow Statements
+GAAP lists dividends paid under financing
activities and interest paid in operating activities.
IFRS allows them to 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
Difference Between Modified and
Effective Convexity
Modified convexity does not take
options into account and effective
convexity does
Differences Between Security
Market Line and Capital Market
Line
*CML plots total risk on the x-axis and
only plots efficient portfolios; SML plots
beta on the x-axis
*All points on the CML, except point of
tangency, 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
Differences Between Futures and
Forwards
*Futures are on exchanges,
forwards are private
*Futures are standardized,
forwards are customized
*Futures go through
clearinghouses
*Government regulates futures
Differentiation Strategy
Firm’s products are distinct;
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
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]
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
Dilutive/Anti-Dilutive Securities
Stock options, warrants, convertible bonds or
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
Direct Method -> Indirect Method
+Cash Collected from Customers
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
Direct Cash Flow Method
Converts each line item of the
accrual-based income statement
into cash receipts and payments;
Begins with cash inflows from
customers and deducts cash
outflow from purchases, operating
expenses, etc
Direct quote
The value of one unit of a foreign
currency in terms of the home
currency
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
Disadvantages of Callable Bonds
+Uncertainty about cash flow stream
+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
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
Discount Bond
Bond priced below its par value;
Yield required in the market rises,
causing prices to fall
Disclaimer auditor’s opinion
When the auditor cannot issue an
opinion
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
Discontinued Operation
Operation that management plans to get rid of, or
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
Discounted Payback Period
Calculates the time it takes to get back
invested capital 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
Discount Basis
Same as bank discount yield;
= (Face Value Discount) * (360/
Days)
Discrete Random Variable
Variable where the number of
outcomes can be counted and each
outcome has a measurable and
positive probability
Discrete Uniform Random
Variable
Variable where all possible
outcomes for a discrete random
variable are equal
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
Discriminatory Pricing
Uses the limit price of the order
that arrived first as the trading
price
Dividend Dates
+Declaration date
+Ex-dividend date
+Holder-of-record date
+Payment date
Disposition Effect
When investors are willing to
realize gains but not losses
Dividend Discount Model
Cost of Equity = (Expected
Constant Growth Rate) + [(Next
Year’s Dividend)/(Stock Price)]
Dividend Payment
Measures the firms ability to make
dividend payments from operating
cash flows;
DiP = CFO/Dividends Paid
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
Does IFRS accept LIFO?
NO!!!
Drawbacks of Funds of Funds
*Fees are higher than investing in
a hedge fund by yourself
*Returns can be lowered by
diversification
Domestic Government Collects
Full Value of Import License
Quota has same economic result
as a tariff
Drawbacks of NPV and IRR
NPV: It is an absolute measure
and doesn’t take into 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
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
Dual Index Floater
Structured note that has two
reference rates
Double-Barrel Bonds
Backed by both taxes but also
special charges that are collected
outside of the general fund;
General obligation
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)
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
Duties to Clients:
+Loyalty, Prudence and Care
+Fair Dealing
+Suitability
+Performance Presentation
+Preservation of Confidentiality
(unless unlawful)
Duration Relationships
*Higher/lower coupon means
lower/higher duration
*Longer/shorter maturity means
higher/lower duration
*Higher/lower market yield means
lower/higher duration
Duties to Employers:
+Loyalty
+Additional Compensation Agreements
+Responsibilities of Supervisors
Duration/Convexity Approach
Approximates the actual interest
rate sensitivity of the bond
Earnings Multiplier
Same as a PE ratio
Duration/Convexity Bond Pricing
[(-Duration Change in Yield) +
(Convexity Change in Yield ^ 2)]
* 100
Economic union
All benefits of a common market;
Member countries establish
common institutions and
economic policy for the union
Effective Annual Rate
= (1 + (periodic rate/compounding
periods) ) ^ (compounding periods)
- 1
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
Effective Annual Yield
= (1 + HPR) ^ (365/days until
maturity) - 1
Elements of a Through Industry
Analysis
+Evaluate the relationships between macroeconomic 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
Effective Convexity
Takes into account changes in
cash flows from embedded options
Elements of Company Analysis
*Overview of firm’s operations,
governance, strengths and weaknesses
*Industry characteristics
*Product demand
*Product costs
*Pricing environment
*Financial ratios
*Projected financial statements and firm
valuations
Effective Duration =
(Bond Price When Yields Fall -
Bond Price When Yields Rise)/(2
Initial Price Change in Yield in
Decimal Form)
Elements of IFRS’ Conceptual
Framework
+Assets
+Liabilities
+Equity
+Income
+Expenses
Elliot Wave Theory
Financial markets can be described as a series of
cycles;
A few minutes is a subminuette cycle, centuries it
is a grand supercycle;
In uptrend, prices go up 5 waves, down 3; down 5
and up 3 in downtrend;
Size of waves thought to correspond to Fibonacci
sequence and can be used to set price targets by
convering to 0.618 and 1.618
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
Embryonic Stage
When the industry has just started;
Slow growth;
High prices;
Large investment required;
High risk of failure
Equal Weighting Index
The arithmetic average return of the index stocks;
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
Empirical Probability
Comes from past data; an
objective probability
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
Enhancements of relevance and
faithful representation
+Comparability
+Verifiability
+Timeliness
+Understandability
Equity Securities
Represent ownership positions
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
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
Equity Swap
Swapping the return on an equity
index for the interest payments on
a debt instrument
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
Equity Valuation Models
+Discounted Cash Flow
+Multiplier Model
+Asset Based Models
European Option
Only can be exercised on the
expiration date
Estimations of Dividend Growth
Rates
*Historical rate
*Industry average rate
*Sustainable growth rate
Event Driven Fund
Invests in response to one
corporate action
Excess Kurtosis
Kurtosis - 3; Significant if result is
greater than 1
Event Driven Funds
Strive to capitalize on some unique
opportunity in the market
Event Risk
Effects from factors outside of
financial markets
Exchange Rate Risk
Uncertainty about the value of
foreign currency cash flows to an
investor in terms of his domestic
currency
Ex-Coupon
When the buyer does not get the
next coupon
Exchange Traded Fund
A fund that invests in a portfolio of
stocks and bonds in efforts to
mimic an index;
Traded like a stock
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 exdividend
date
Exchange Traded Funds
Similar to closed end funds but we often passively
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
Exchange-Traded Derivatives
Derivatives that are standardized
and backed by a clearinghouse
F-Test
Used to compare two variances
Expansion
Real GDP is increasing
Increasing employment, consumer
spending and business investment
The start of each new expansion is
called a recovery
F-Test Statistic
Examines two sample variances,
with the larger in the denominator
and smaller in the numerator
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
Face Value Discount =
(Fair Value - Price)/Face Value
Extraordinary Item
Item that is both unusual and
infrequent;
Allowed only by GAAP
Factors Affecting Market
Efficiency
+Number of market participants
+Availability of Information
+Impediments to trading
+Transaction and information
costs
Factors Increasing Reinvestment
Risk
+Coupon is higher so interest cash
flows are higher
+A call feature
+Is amortizing
+Contains prepayment option
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
Factors Influencing Difference
Between Nominal and Zero-Vol
Spreads
~The steeper the benchmark spot rate
curve, the greater the difference between
the two and an upward/downward
sloping curve produces a Z spread
greater/smaller than nominal spread
~The shorter the maturity, the greater
the difference
Features of preparing financial
statements
+Fair presentation
+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
Factors Influencing Industries
+Macroeconomic
+Technology
+Demographics
+Government policies
+Social influences
Federally Related Institutions Not
Guaranteed
+Tennessee Valley Authority
+Private Export Funding
Corporation
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.
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
Finance (Capital) Lease
Basically a purchase of an asset that is financed by debt;
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
Financing Activities
+Principal from issued debt
+Proceeds from issued stock
+Principal paid on debt
+Payments to reacquired stock
+Dividends paid to shareholders
Financial account components
-Government owned assets abroad
-Foreign owned assets in the
country
Firm Specific Credit Factors
*Past payment history
*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
Financial Leverage =
Average Total Assets/Average
Total Equity
First Stage Financing
The funding used during the
transition to commercial
production and sales of products
Financial Risk
Risk that the firm’s common
stockholders must bear when a
firm uses fixed cost financing
Fiscal policy tools
*Transfer payments (entitlement programs)
*Current spending
*Capital spending
*Direct taxes
*Indirect taxes
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
Fixed Income Arbitrage
Take long and short positions in
bonds to benefit from mispricing
while minimizing interest rate
effects
Fisher index
Geometric mean of a Laspeyres
index;
Used to eliminate bias from
substitution
Fixed Income Financial Statement
Disclosures
+Nature of liabilities
+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
Fixed Asset Turnover
Measures the utilization of fixed
assets;
FAT = Revenue/Average Net Fixed
Asset
Float Adjusted Market Weighting
Index
Like a market cap index but are based on the
proportion 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
Fixed Charge Coverage =
(EBIT + Lease Payments)/(Interest Payments +
Lease Payments)
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
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
Form 10-Q
Quarterly report
Foreign Currency Translation Loss
Taken directly to owners’ equity
Form 144
Notice to the SEC of a sale of nonregistered
securities
Form 8-K
Discloses material events
Form DEF-14A
Proxy statement
Form S-1
Filed before sale of a new security
Form 10-K
Annual report
Formal dollarization
Using another country’s currency;
Country can’t set its own monetary
policy
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
Formative Stage Financing
Spanning seed stage to first stage
financing
Forward Contract
Agreement to buy or sell an asset
in the future at a specified price in
the contract at its inception
Forms 3, 4, 5
Notices of insider ownership
Forward Dealer
Someone who has a balanced book
of positions and make money off of
the bid-ask spread
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
Forward End-User
Someone looking to lock in a
future price
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
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 - Fixed Capital Investment
Forward Rate Agreement
A forward contract to lend/borrow money at a
certain 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]
Free Cash Flow to Equity
Cash flow that would be available
for distribution to common
shareholders;
= Cash Flow from Operations -
Fixed Capital Investment + Debt
Issued - Debt Repaid
Fraud Triangle
- Incentive/Pressure
- Opportunity
- Attitude/Rationalization
Free trade area
All barriers to import and export
of goods and services among
member countries are removed
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
Frictional unemployment
The time lag necessary to match
employees to employers
Front-Running
Prohibited for employees at
financial firms
Funded Investor
Investor who borrows to finance
an investment position
Functions of Financial System
+Allow entities to save and borrow
money, raise equity 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
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
Functions of Intermediaries
*Organize trading venues
*Supply liquidity
*Securitize assets
*Manage banks, insurance firms and
investment advisory services
*Providing clearinghouses to settle trades
*Manage depositories
Future Income and Interest Rates
Relationship
Increases in expected future
incomes will increase the
equilibrium interest rate.
Fundamental Weighting Index
Weights are based in firms’
fundamentals, like earning, dividends or
cash flow;
Avoids bias of market cap indices to
overvalued firms;
Has a value tilt, overweighting firms with
higher value-based metrics
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
GAAP Asset Impairment
Book value is greater than the sum
of the estimated undiscounted
future cash flows from its use and
disposal
GAAP Treatment of Impaired
Assets
*Only tested for impairment when
it is deemed necessary
*First tested for recoverability
then the loss is measured
*No loss recovery is allowed
GAAP Inventory Requirements
Requires inventory be reported at the
smaller of cost or 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
Gambler’s Fallacy
When recent events affect
investors’ perceptions of future
probabilities
GAAP PP&E Disclosures
+Depreciation expense by period
+Balances of major asset classes
by nature and function
+Accumulated depreciation
+General description of the
methods used
Geometric Mean
Compounded annual rate of return
for an investment
GAAP Qualifications for a Finance
Lease from Lessee’s & Lessor’s
Perspective
*Title of asset is transferred to the lessee at the end
of period
*A bargain purchase option is available to the
lessee to 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)
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)
GIPS Compliance with CVGs
Firms may include performance
figures for periods prior 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
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
Global Depository Receipts
Receipts issued outside both the US and
the firm’s domestic market;
Usually denominated in US Dollar;
Not subject to capital flow restrictions
and allow the firm and investor greater
opportunities for foreign investment
Global Minimum Variance
Portfolio
The portfolio on the efficient
frontier with the least risk
Global Fund
Invests in strategies all over the
world
Global Registered Shares
Shares that trade in different
currencies on exchanges around
the world
