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
Global Macro Fund
Speculates on changes in
international interest rates and
currency rates, often using
derivatives and leverage
Going Concern Assumption
The company will remain in
operation for the foreseeable
future
Golden Cross
When the short term average
crosses above the long term
average;
Indicate uptrend
Gross Profit
Amount that remains after the
direct costs of producing a good
are subtracted from revenue
Golden Parachute
A rich severance package for
managers who lose their jobs after
a takeover
Gross Profit Margin =
Gross Profit/Revenue
Gordon Growth Model
Assumes annual growth rate of
dividend is constant;
Stock value equals the dividend
divided by the difference of the
required return and the dividend
growth rate
Gross Return
Total return in a security before
fees and expenses
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
Gross Revenue Reporting
When the cost of goods sold and
sales revenues are reported
separately;
Sales are higher than under Net
Revenue Reporting
Growth Stage
When industry is growing rapidly;
Rapid growth;
Limited competitive pressures;
Falling prices;
Increasing profitability
Headline inflation
Measures inflation of all goods
Heckschler-Ohlin model
Takes into account a country’s
labor and capital;
Assumes capital receives more
income than labor
Guarding Against Inflation
When policy rate is less than the
neutral interest rate
Hedge Fund Indices Problems
*Self-selection bias
*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
Harmonic Mean
The mean of n numbers expressed
as the reciprocal of the arithmetic
mean of the reciprocals of the
numbers
Hedge Funds
Pools of investor funds that are
not regulated to the same extent
as mutual funds
Head and Shoulders Pattern
Suggests that demand drove the uptrend
but it is fading;
More telltale if the highs are hit on
declining volume;
Range between the head and the neckline
is how far the trend is supposed to
decrease past the right “shoulder”
54b
Hedonic index
Adjusts a price index for the
quality of goods used in basket
Holder-Of-Record Date
The date that share holders on
record are owed the dividend
Herfindahl-Hirschman Index
Adds up the sum of the squares of
the largest firms in the market
Holding Period Return =
(Price Change + Dividend)/(Initial
Price)
Hidden Orders
Orders where only the broker
knows the trade size
Holding Period Yield
Holding Period Return = (ending
value/beginning value) - 1
OR
= (ending value - beginning value
+ cash flow received)/(beginning
value) - 1
High Willingness to Bear Risk,
Low Ability to Bear Risk
The low ability will win out in an
advisor’s assessment
Identifiable Tangible Asset
Capable of being separated from
the firm, controlled by the firm
and expected to provide future
economic benefit
If Company Redeems Bonds
A gain or loss is recognized by subtracting
the redeem 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
IFRS Treatment of Impaired
Assets
*Assets must be evaluated annually
*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
IFRS Inventory Requirements
When inventory purchased or sold
is recorded directly in the
inventory account;
Inventory is written down if net
realizable value is less than cost
and written back up if necessary
Impact lag
Time it takes for fiscal policy to
produce change once out into law
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
Implications of Gordon Growth
Model
*If the gap between the discount
and dividend growth rates grows,
stock price falls and vice versa
*Small changes in rates can
change stock price significantly
IFRS Qualifications for a Finance
Lease from the Lessee’s & Lessor’s
Perspective
*All rights and risks of ownership are transferred to the lessee
*Title is leased asset is transferred to lessee at end of 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
In verification, a third-party
attests that:
+The firm has complied with all GIPS
requirements for 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
In-Kind Creation and Redemption
When authorized participants ensure an efficient
and 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
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
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
Income Tax Expense
Is a non-operating item that is
reported within “income from
continuing operations”
Incidence of tax
Who ends up bearing the cost of a
tax
Increased Collection Period
Indicates that customers are
taking longer to pay their
outstanding accounts;
Represents a drag on the
company’s liquidity
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
Increases to Producer Surpluses
Import quotas, tariffs and
volunteer export restraints
Increasing Required Rate of
Return and Decreasing Dividend
Payout
Reduce a company’s PE
Independence Test
Events are independent if P(A|B)
= P(A)
Incremental Cash Flow
Does not include financing costs
Index Amortizing Notes
Structured Note with fixed
coupons but pay back some
principal early based on a
reference rate
Indecent entry floating exchange
rate
Market determined and only
influenced by monetary
authorities to slow the rate of
movement, not keep them at a
certain level
Index Fund
Match returns of a particular
index
Independence and Objectivity
Specifically addresses the
requirement of disclosure of the
nature of any compensation from
the subject company
Indexed Commodity Strategy
An active investment because rolling risk
and investing 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
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
Inflation Risk
Uncertainty of future inflation
rates and decreased real return
rates
Indirect Cash Flow Method
Converts net income into operating cash by
making 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
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
Indirect Cash Flow Method
Process
- Begin with net income
- Subtract gains or add loses from financing or
investing cash flows - Add back all noncash charges to income and
subtract all noncash components of revenue - Subtract increases in operating assets and add
back decreases - Add increases in operating liabilities and
subtract decreases
Informational Efficiency
Prices reflect all information associated
with 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
Indirect quote
The amount of foreign currency
that can be bought for one unit of
home currency
Initial Margin
The money deposited in a futures
account before trading begins;
Typically around one day’s
maximum price movement
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
Integrity of Capital Markets:
+Material Nonpublic Information
+Market Manipulation
Interest Coverage
Assesses the company’s ability to
pay back it’s debt;
IC = EBIT/Interest Payments
Insurance Companies
Collect insurance premiums in
return for providing risk reduction
to the insured
Interest Coverage
Measures the firms ability to meet
its interest obligations;
IC = (CFO + Interest Paid + Taxes
Paid)/Interest Paid
Insurance Contract
Security that pays a cash amount
if a future event occurs;
Used as a hedge
Interest Expense
The book value of the bond times
the market rate of interest when
the bond was issued
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
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 Swap
When floating rate interest
payments are exchanged for fixed
rate payments
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
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
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 Theories
+Pure Expectations Theory
+Liquidity Preference Theory
+Market Segmentation Theory
Interest Rate Risk
The effect of changes in bond rates
on bond values
Interest Rate Tools of the Fed
+Discount rates
+Open market operations
+Bank reserve requirements
+Persuading banks to change
credit policies
Interest Rates and Financial
Capital Relationship
If the demand for financial capital
rises, interest rates also rise
Inventory Turnover
Measures a firms efficiency with
inventory;
IT = Cost of Goods Sold/Average
Inventory
Interpretations of Duration
+Duration is the slope of the price-yield
curve at the 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
Inventory Valuation Methods
+Specific Identification
+First-in, first-out
+Weighted average cost
+Last-in, first-out
Inventory Cost Changes
Must be changed retrospectively on all past
financial 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
Inverse Floater
Structured note increase when
reference rates decrease and vice
versa
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
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
Investing and Financing Ratio
Measures the firms ability to
purchase assets, satisfy debts and
pay dividends;
IF = CFO/Investing and Financing
Cash Outflows
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 Analysis,
Recommendations and Actions:
+Diligence and Reasonable Basis
+Communications with Clients
+Record Retention
Investment Property Transfers
If from owner-occupied to investment property,
treat as 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;
Investment Bank’s IPO Conflict of
Interest
As an agent, they should set a high
price to maximized the funds
raised for the issuer but, as
underwriters, they want the price
to be low so the whole issue sells
Investor’s Utility Function
Represents the investor’s
preference in terms of risk and
return
Investment Constraints
+Liquidity
+Time horizon
+The tax treatment
+Legal and regulatory constraints
+Ethical or personal preferences
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
Issue Specific Credit Factors
*Priority of claim being rated
*Value/quality of collateral
pledged to issuance
*Covenants of issuance
*Any third-party guarantees or
insurance
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
Issuing an Investment
Recommendation Report
All clients of a firm must be given
it at the same time
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
Jensen’s Alpha =
Portfolio Return - Portfolio’s
CAPM;
Most appropriate when a fund has
multiple managers and only has
systematic risk
Lagging economic indicators
Average duration of unemployment
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
Joint Probability
P(AB) = P(A|B) \* P(B) P(A|B) = P(AB)/P(B)
Lags of fiscal policy
+Recognition lag
+Action lag
+Impact lag
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
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
Later Stage Financing
Financing when marketable goods
are in production and sales are
underway
Leptokurtic
Bigger peak and smaller tails than
a normal distribution (k>3)
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
Leverage
Amount of fixed costs a firm has
Leading economic indicators
Average hours worked weekly
Weekly unemployment claims
New manufacturer orders
Index of supplier deliveries
New building permits
Stock prices
Money supply
Interest rate spreads
Consumer expectations index
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
Leveraged Equity Real Estate
Ownership
Investor the same entitlements of
outright ownership but must meet
conditions of the loan
LIBOR
The rate paid on negotiable CDs
by banks and bank branches
located in London;
Most important reference rate for
floating-rate debt
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
LIFO
*GAAP only
*Values inventory at a historical
cost basis
*In an inflationary/deflationary
environment, earnings are
lower/higher
Leveraged Return
A return that is a multiple of the
return on the underlying asset
Limit Move
When a future exceeds its limit
and trading does not take place
Liability’s Tax Base
The carrying value of the liability
minus any amounts that will be
deducted on the tax return in the
future
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 “Behind the Market”
A buy order below the best bid or a
sell order above the best ask
Limitations of Ratio Analysis
*Not useful when viewed in isolation
*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
Limit Order “Far From the
Market”
A buy considerably lower than the
best bid or a sell considerably
higher than the best ask
Limited Tax General Obligation
Bonds
Subject to a statutory limit on
taxes that may be raised to pay off
the obligation;
General obligation
Limit Order “Making the Market”
A buy order at the best bid or sell
at the best ask
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
Limitation of Yield to Maturity
Doesn’t tell the compounded rate
of return that will be realized on a
fixed income security;
Assumes reinvestment at the yield
to maturity
Liquidity Drag
Delay or reduce cash inflows or
increase borrowing costs
Liquidity Preference Theory
Both short-term rate expectations and a liquidity
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
Locked Limit
When trading stops due to a limit
move
Liquidity Pull
Accelerate cash outflows
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
Liquidity Risk
Chance a bond will be sold at less
than market price due to a lack of
liquidity
Long Lived Assets: IFRS v. GAAP
Disclosures are more extensive
under GAAP
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
Long Position
When an investor owns, or has the
right to own, an asset
Long-Term Fixed Income
Securities that have maturities
more than 5 years;
Usually called bonds
Low Willingness to Bear Risk,
High Ability to Bear Risk
Advisor can try to educate client,
but it is not his responsibility to
force client to take on more risk
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
Lower Bound of American Put
The maximum of 0 and the
present value of the strike price
minus the stock price
Long/Short Fund
Buy securities that are expected to
outperform the market and sell
those that are expected to
underperform
Lower Bound of European Put
The maximum of 0 and the
present value of the strike price
Longitudinal Data
Observations over time of multiple
characteristics of the same entity
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
M1
Sum of currency in circulation and
overnight deposits
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
M2
M1 plus deposits with maturity up
to two years and deposits
redeemable at notice up to three
months
Managed floating exchange rate
When the monetary authority tries
to influence exchange rates in
response to specific economic
indicators
M3
M2 plus repo agreements, money
market funds and debt with
maturity up to two years
Margin Debt
An increase in the number
indicates bullish sentiment;
Sentiment indicator
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
Margin Percentage
The percentage of security value
that is owed
Marginal Cost of Capital Break
Points
Show changes in the cost of capital
Market Anomaly
Something that would lead to a
rejection of the hypothesis that
markets are efficient
Marginal cost of capital slopes
____, investment opportunity
schedule slopes ____
upward, downward
Market Cap Index Value =
(Current Total Market Value of
Stocks/Base Year Total Market
Value of Stocks) * Base Year Index
Value
Marginal cost pricing
Forces the monopoly to reduce
price to the point where the firms
marginal cost curve intersects the
market demand curve
Market Model
Single factor model where the only
factor is excess return on the
market portfolio
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
Market Order
Instructs broker to execute trade
immediately at best possible price
Market Premium
Difference between the risk free
rate and the market return
Market-Neutral Fund
Long/short funds where the short
exposure nets out the long
Market Segmentation Theory
The supply of bonds and demand for
bonds determine equilibrium yields for
various maturity ranges;
Different investors may have strong
preferences for maturity ranges that
closely match their liabilities
Markets for Commodities
+Spot
+Futures
+Forwards
Market Weighting Index
Weightings based on the market cap of each stock
as a 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
Marshall-Lerner condition
The demand for exports plus the demand for imports is 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
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
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
Maximum Price for American Put
Put’s strike price
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
Maximum Price for European Put
Present value of option’s strike
Mental Accounting
When investors classify different
investments into separate mental
accounts rather than viewing
them as one portfolio
Maximum Price of a Call Option
Stock’s current price
Mesokurtic
Kurtosis equal a normal
distribution (k=3)
Mean Absolute Deviation
Average of the absolute values of
each deviation
Mezzanine Financing
Financing enables the company
the financing to go public
Minimum Option Price
0
Money Market Fund
Invest in short-term debt
securities and provide interest
income with low risk;
NAV is set at $1.00
Modified Duration
Similar to Macaulay but takes into
account YTM;
= (Macaulay Duration)/(1 +
Periodic Market Yield)
Money Market Yield
= HPR * (360/days until maturity)
Monetary union
Countries use a shared currency;
Can’t make their own monetary
policy but participate in making
the policy of the union
Money Markets
Markets for debt securities with
maturities of one year or less and
capital markets are for longer term
debt securities and equities
Monetary union
All benefits of an economic union;
Member countries adopt a single
currency
Money neutrality
The belief that real variables (real
GDP and velocity) are not affected
by monetary variables (money
supply and prices)
Money Weighted Return
Same as IRR
Mortgage Backed Securities
Backed by pools of mortgage loans that provide both 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
Money-Weighted Return
IRR of a portfolio
Mortgages
Receives monthly principal and
interest payments paid by a
borrower;
If borrower defaults, investor gets
ownership
Monopolistic competition
Many firms that compete with differentiated
products;
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
Moving Average
Convergence/Divergence (MACD)
Lines drawn by smoothing moving average curves
and putting more weight on recent observations;
Difference between two moving average lines;
Signal Line is the smooth moving average of the
MACD line;
The crossing of the MACD line above the Signal
Line is a buy signal, the opposite is a sell signal;
Oscillator
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
Multi-Step Format
Gross profit is included
Multi-Year Dividend Discount
Model
Add each year’s dividends discounted by
each years 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
Mutual Fund Cash Position
Ratio of a mutual fund’s cash to its
total positions;
Increases in a down market,
decreases in an up market
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
Mutual Termination
One party pays the other to end
the swap
Multiple Price, Regular Auction
Cycle
Winning bidders receive bonds at
the price each bidder bid
Narrow Framing
When investors see events in
isolation
Mutual Fund
Pooled investments where each
investor owns shares representing
ownership of a portion of the
portfolio
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
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
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
Negative Covenants
When the borrower promised to
refrain from certain activities than
can adversely affect the lenders
position
Net Asset Value
Total net value of its assets divided
by the shares outstanding
Negative Skew
Long tail to the left and Mean <
Median < Mode
Net Operating Income
Gross operating income minus
estimated vacancy, collections and
other operating expenses
Negotiated Offering
When the price is determined
between the lead investment bank
and the issuer
Net Profit Margin =
Net Income/Revenue
Net Return
The return of a security after fees
and expenses are paid
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
Net Revenue =
Revenues - ordinary expenses +
other income - other expenses +
gains - losses
New Keynesian
Modify Keynesian by saying all
inputs of productivity are
downward sticky, not just labor
Net Revenue Reporting
Reports the difference between the
two figures
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
Neutral Interest Rate
Sum of the real growth rate and
the target inflation
Non-accelerating inflation rate of
unemployment (NAIRU)
The natural weight of
unemployment
Non-Amortizing (Bullet) Bonds
Pays interest until maturity, then
principal is repaid
Non-Cyclical Sectors
+Healthcare
+Utilities
+Telecom
+Consumer staples
Non-controlling/Minority
Interests
In the equity section of the
balance sheet; Represents the
portion of the subsidiary that is
not owned by the reporting firm
Non-Parallel Shift
When not all maturities change by
the same amount
Non-Current Assets
+Plants, Property, and Equipment
+Investment Property
+Intangible Assets
+Goodwill
+Financial Assets
Non-Refundable Bonds
Can be called but cannot use
borrowed money to buy back
bonds;
Can be called but not refunded
Non-Current Liabilities
+Long-Term Financial Liabilities
+Deferred Tax Liability
Nonparametric Tests
Do not make any assumptions
about the population and are used
when parametric tests cannot be
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
Objectives of International
Organization of Securities
Commissions
+Protect investors
+Ensure market fairness,
efficiency and transparency
+Reduce systemic risk
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
Objectives of Regulation
*Protect unsophisticated investors
*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
Null Hypothesis
What you are testing
Officer can decide:
+No sanctions
+Cautionary letter
+Issue sanction
Number of Days Payable
Average time it takes for a
company to pay its bills;
DP = 365/Payables Turnover
Ratio
Officer can do:
+Request written response
+Interview subject
+Interview complainant
+Collect documents relevant to
the investigation
Offsetting Contracts
Open a swap with an opposite
exposure with the same terms
with the same counterparty
On The Run Issues
Most recently auctioned treasury
issues;
More actively traded than other
issuances;
Provide best information
Oligopolists and Collusion
Agreements
There is an incentive to cheat and
raise your share of the joint profit
One-Year Holding Period Dividend
Discount Model
Equal to the current year’s
dividend in present value plus the
present value of the stock’s
expected price at the end of the
year
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
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
Oligopoly models
- Kinked demand curve
- Cournot duopoly
- Nash equilibrium
- Dominant firm model
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
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
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
Operating Break Even Cost of
Sales
= Fixed Operating Costs/(Price -
Variable Cost per Unit)
Operating Profit
When operating expenses are
subtracted from gross profit;
Profit before financing costs,
income tax and nonoperating
items
Operating Cash Cycle
The average number of days that it
takes to turn raw materials into
cash proceeds;
= Days of Inventory + Days of
Receivables
Operating Profit Margin =
EBIT/Revenue
Operating Cycle
The time it takes to produce or
purchase inventory, sell it, and
collect the cash
Operating Return on Assets =
EBIT/Average Total Assets
Operational Efficiency
Market with low trading costs;
Will make markets more
informationally efficient because
low trading costs encourage
trading on new information
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
Operational independence
When the central bank can
independently set the policy rate
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 average of the bid-ask quotes
from the exchange
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
Oscillators
tools that move between a set
range (example: 0-100);
Convergent when the oscillator
and the price chart look the same;
divergent when they don’t;
Convergence means trend will
continue
Outright Ownership of Real Estate
Holder has full ownership rights
for an indefinite time period
Option Adjusted Spread
The spread to the Treasury spot
curve that the bond would have if
it were option-free
Outside Compensation and
Benefits
Require written consent from
employer
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
Paasche index
Weights its basket based on
current consumption
Parallel Shift
Shift in the curve is when the
entire curve shifts by the same
amount
Panel Data
Observations of the same
characteristic of multiple entities
over time
Parametric Tests
Rely on assumptions regarding
the distribution of the population
and are specific to population
parameters
Par Bond
When the bond’s coupon rate
equals the market yield;
Bonds are typically issued near par
value
Participating Preferred Stock
Preferred stock that gets an increased
dividend if profits 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
Passive crawling peg
When an exchange rate is adjusted
periodically to adjust for higher
inflation versus the currency it is
pegged to
Peak
Real GDP stops increasing and
starts decreasing
Inventory to sales ration increases
Payables Turnover
Measures the firms use of trade
credit;
PT = Purchases/Average Trade
Payable
Percentage of Completion Revenue
Recognition
The percentage of total cost is how
much revenue can be recognized;
Revenue is recorded faster, more
subjective and better matches
revenues and expenses
Payment Date
The date dividend checks are sent
out
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
Payment of Interest Rate Option
Based on a stated nominal amount
and the difference between the
reference rate and the strike rate
times the fractional interest period
Performance Presentation
Statements about performance
must be accurate, fair and
complete.
Period Costs
Costs that are expensed in the
period incurred;
Abnormal waste of materials,
labor or overhead;
Storage costs;
Administrative overhead;
Selling costs;
Perpetual Inventory System
When inventory purchased or sold
is recorded directly in the
inventory account
Periodic Inventory System
When inventory values and COGS are
determined at the 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
Personal disposable income
Personal income - personal taxes
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
Personal Income
National income + transfer
payments to households - indirect
business taxes - corporate income
taxes - undistributed corporate
profits
Permutational Ordering
A specific ordering of a group of
objects and answers the question
of how many different groups of
size r in specific order can be
chosen from n objects;
P = (n!) \ (n - r)!
Phases of business cycle
Expansion
Peak
Contraction/Recession
Trough
Plain Vanilla Interest Rate Swap
Trade fixed interest payments for floating
rate payments;
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)
Poison Pill
Giving certain rights to existing
shareholders if a certain amount
of the stock is acquired
Platykuric
Smaller peak and fatter tails than
a normal distribution (k<3)
Porter’s 5 Forces
*Rivalry among competitors;
*Threat of new entrants;
*Threat of substitute products;
*Bargaining power of buyers;
*Bargaining power of suppliers.
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
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
Point Estimates
Single values used to estimate
population parameters
Portfolio Management Process
+Planning step begins with the analysis of the
investor’s 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
Portfolio Perspective
Evaluating individual investments
by their contribution to the riskreturn
of a portfolio
Positive substitution, negative
income smaller than positive
substitution
Consumption increases
Positive Abnormal Returns By
Using Technical Analysis
No form of efficient market
hypothesis supports this
Positive substitution, positive
income
Consumption increases
Positive Skew
Long tail to the right and Mean >
Median > Mode
Power of Test
Probability of correctly rejecting
the null;
Found by subtracting the
probability of a Type II error from
1
Positive substitution, negative
income greater than positive
substitution
Consumption decreases
Precautionary demand
Money held for unforeseen future
needs;
Increases with GDP
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
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
Preferred Stock Risk ___
Common Stock Risk
Less than
Presentation of deferred taxes on
balance sheet
GAAP: Classified as current or
noncurrent based on the
classification of the underlying
asset or liability
IFRS: Netted and classified as
noncurrent
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
Pretax Margin =
EBT/Revenue
Premium Bond
Bonds priced above the bond’s par
value;
Yield required in the market
decreased, causing prices to rise
Pretax Nominal Return
Return prior to paying taxes
Price elasticity
How responsive the quantity
demanded is to a change in price
Price Value of a Basis Point
The dollar change in the
price/value of a bond or portfolio
when the yield changes by one
basis point;
= Duration 0.0001 Bond Value
Price Multiples
+Price-to-Earnings
+Price-to-Book Value
+Price-to-Cash Flow
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;
Major examples are the Nikkei and Dow Jones Industrial
Price Priority
When trades with the highest bids
and lowest asks are given the
highest priorities
Primary Dealers
Trade with central banks when
they buy and sell securities
Price Return
When an index uses only the
prices of an index’s constituency
securities
Primary Market
Market for newly issued securities
secondary market is for
subsequent sale of securities
Principles of Capital Budgeting
+Decisions are based on cash flows, not
accounting 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
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
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
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
Private Equity in Comparison to
Public Equity
*Less liquid
*Share price negotiated between firm and investor,
not 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
Private Securities
Not traded on public markets,
illiquid, and not subject to
regulation
Private value auctions
Value is subjective and different to
each bidder
Private Investment in Public
Equity
When a public firm needs capital
quick and sells private equity to
investors;
Usually at a sizable discount to the
market price
Pro-Forma Statement Steps
*Estimate relationship between changes in sales
and the 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
Profitability Index
= Present Value of Cash
Flows/Initial Investment
= 1 + NPV/Initial Cash Flow
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
Process for Testing Hypothesis
+State 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
Problems Fixed by Regulation
*Fraud and theft
*Insider trading
*Costly information
*Defaults
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
Problems with Pure Play
~Beta uses historical data and sensitive to the
length of 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
Profit maximized
Producing up to but not over
MR=MC;
Producing quantity where TR-TC
is at a maximum
Project Beta
= Asset Beta [1 + (Debt/Equity)
(1 - Tax Rate)]
Protective Put Option P/L
*Maximum loss is the premium
*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
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
Publicly Traded Securities
Traded on exchanges or through
securities dealers and are subject
to regulatory oversight
Properties of Estimators
Unbiased - Low sampling error
Efficient - Small variance
Consistent - Accuracy increases as
sample size increases
Pure Expectations Theory
The yield for a particular maturity
is an average of the 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
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 strike
price
Pure Expectations Theory Yield
Curve Ramifications
~Short term rates expected to rise in
future = normal curve
~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
Put Option
The right to sell an asset at a
certain price by a certain date;
Counterparty has the obligation to
buy the asset
Put/Call Ratio
Put volume divided by the call
volume;
The higher the ratio, the more
negative the sentiment;
Sentiment indicator
Put Option
The right to sell
Putable Common Shares
Give the shareholder the right to sell back
shares to the 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
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
Putable Shares Risk ___ Callable
Shares Risk
Less than
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
Qualified auditor’s opinion
There is an exception to
accounting principles
Qualities of central bank
+Independence
+Credibility
+Transparency
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)
Qualities of useful financial
statements
Relevance and faithful
representation
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.
Quantity theory of money
(money supply)(velocity of
money)=(price level)(real
GDP)
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
Quick Ratio =
(Cash + Marketable Securities +
Receivables)/Current Liabilities
Range Notes
Floaters that equal the reference
rate if it is within a specific range
or zero if it is outside the range
Rate of Change
Measures momentum by multiplying 100
by the difference between the latest
closing price and the closing price of a
certain number of periods ago;
Sell when moving negative;
Buy when moving positive;
Oscillator
Reasons Floating Rate Might
Reset at Par
*Placing a cap on a floating rate
can increase the interest 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
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
Reasons for Differences Between
an Accounting Item for Tax
Reporting and Financial
Reporting
+Timing of revenue and expense recognition may differ
on the income statement and tax return
+Some revenues are only recognized on the income
statement or tax return
+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
Real Estate Aggregation Vehicles
Investing in a pool of real estate
assets
Reasons for Differences Between
Effective and Statutory Tax Rate
+Different tax rates in different jurisdictions
+Permanent tax differences (tax credits, taxexempt
income, non deductible expenses)
+Changes on tax rates and legislation
+Tax holidays in some jurisdictions
+Deferred taxes provided on reinvested earnings
of foreign and unconsolidated domestic affiliates
Real Return
Return adjusted for inflation
Reasons to Invest in Commodities
+Exposure to economic growth
+Hedge against inflation
+Diversification
Reasons to Overstate Earnings
*Meet earnings expectations
*Remain in compliance with
lending covenants
*Receive higher incentive
compensation
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
Reasons to Understate Earnings
*Obtain trade relief in the form of
quotas and protective tariffs
*Negotiate favorable terms from
creditors
*Negotiate favorable labor
contracts
Record Retention
Requires members to maintain
records of the data and analysis
they use to develop their research
recommendations.
Receivables Turnover
Measures the turnover of accounts
receivable;
RT = Annual Sales/Average
Receivables
Rectangles
When trading creates a range
between a support level and a
resistance level;
Continuation pattern
Recognition lag
When it takes time for policy
makers to recognize what is
happening in the economy and
make the appropriate decision
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.
Regimes of countries with their
own currency
- Currency board
- Conventional fixed peg agreement
- Target zone
- Passive crawling peg
- Active crawling peg
- Crawling bands
- Managed floating exchange rate
- Indecent entry floating exchange 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
Regimes of countries without their
own currency
- Formal dollarization
- Monetary union
Relationship cost curves
AFC slopes downward
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
Regular Dividend
When a company pays out a
portion of its profits on a regular
basis;
Sign of company stability
Relative Strength
The asset’s price charted against
the index price
Reinvestment Ratio
Measures the firm’s ability to
acquire long term assets with
operating cash flow;
R = CFO/Cash Paid for Long-
Term Assets
Relative Strength Index (RSI)
Ratio of total price increases to
decreases over a set amount of
time;
Over 70 is overbought;
Under 30 is underbought;
Oscillator
Relative Yield Spread
The absolute yield spread as a
percentage of the benchmark
bond’s yield;
= Absolute Yield Spread/Yield on
Benchmark Bond
Require Shareholder Attendance
to Vote Hold Their Meetings on
the Same Day but in Different
Locations
Prevents shareholders from
attending all the meetings and
therefore exercising their full
voting rights
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
Required Financial Statements
+Balance sheet
+Income statement
+Cash flow statement
+Owner’s equity
+Footnotes
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
Required Interest Rate
= (risk free rate) + (default risk
premium) + (liquidity premium) +
(maturity risk premium)
Representativeness
When investors assume good
companies are good investments
Resale
Sell the swap to another party
with the permission of the
counterparty
Research Cost Treatment
Typically expensed
Responsibilities of Supervisors
Speaking to the employee to
determine the extent of the
violations and receiving
assurances that it will not be
repeated is not enough
Responsibilities as CFA
Member/Candidate
+Uphold reputation of CFA
+Don’t misrepresent CFA
Restrictions of Board’s Business
Dealings
*The firm, it’s subsidiaries, or former
employees
*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
Responsibilities of regulatory
authorities
Government agencies with legal
authority to enforce compliance
with financial reporting standards
Retail Inventory Method
Measures inventory at retail price
and subtracts a predetermined
profit from each unit
Responsibilities of standardsetting
bodies
Professional organizations to
establish financial reporting
standards
Return on Assets =
Net Income/Total Assets OR
[Net Income + Interest Expense
(1-t)]/Total Assets
Return on Capital =
EBIT/Average Total Capital
Revaluation of fixed and
intangible assets
GAAP: Not allowed
IFRS: Deferred tax recognized in
equity
Return on Common Equity =
(Net Income - Preferred
Dividends)/Average Common
Equity
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
Return on Equity =
Net Income/Average Total Equity
Reversal Pattern
When a trend approaches a range
of prices but fails to continue
beyond that range
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
Ricardian model
Uses the factor of differences in
labor productivity due to
differences in technology
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
Risks of Hedge Funds
+Illiquid
+Hard to value underlying assets
+Counterparty credit risk
+Short squeezes
+Margin calls
Risk Budgeting
Sets an overall risk limit for a
portfolio and allocates the risk to
different asset classes
Risks of Insurance Companies
~Moral hazard when policy holders take
more risk 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
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
Role of Nominations Committee
Regularly reviewing performance,
independence, skills, and
experience of existing board
members
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
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
Round Trip Transaction
When goods are sold to one party
with the simultaneous purchase of
identical goods from the same
party
Sanctioned candidate can:
+Reject sanction and refer it to a
panel of CFA members
+Accept sanction
Roy’s Safety First Criterion
The optimal portfolio minimizes the
probability that the 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
Sanctions are:
+Condemnation by peers
+Suspension of CFA membership
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
Scenario Analysis
Measuring interest rate risk by
plugging in different rates to the
valuation model and looking at the
outputs
Sample Skew
(1/sample size) * [(Sum of Each
Sample Deviation Cubed)/(Sample
Deviation Cubed)]; Skewness
greater than 0.5 is significant
Schools of economic thought
- Neoclassical
- Keynesian
- New Keynesian
- Austrian
- New Classical
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
Sections of GIPS:
- Fundamentals of Compliance
- Input Data
- Calculation Methodology
- Composite Construction
- Disclosures
- Presentation and Reporting
- Real Estate
- Private Equity
- Wrap Fee/SMA Portfolios
SEC Forms
+S-1
+10-K
+10-Q
+DEF-14A
+8-K
+144
+Forms 3, 4, 5
Sector Strategy
Have its investments concentrate
in a specific industry
Second sealed bid auction (Vickrey
auction)
The bidder with the highest bid wins the item but
pays the price bid by the second highest bidder;
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
Secured Debt Collateral
*Personal property
*Real property
*Financial assets
Second Stage Financing
Investing in a company producing
and selling a product that isn’t
generating income yet
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
Security (Prime) Brokers
Provide loans to investors who
purchase securities on margin
Selecting an External Auditor
Responsibility of the Board’s audit
committee
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
Selection Methods
-NPV
-IRR
-Payback Period
-Discounted Payback Period
Profitability Index
Security Market Line
Plot of the relationship between an
asset’s risk and return;
= Risk Free Rate + (Beta *Excess
Return);
Shows CAPM
Self Selection Bias
When the only information
available for reporting is from
managers who had good enough
performance to want to report it
Seed Stage
Providing capital in the earliest
stage of business;
Helps fund research and
development
Semi-Strong Form Market
Efficiency
Securities rapidly adjust without
bias and reflect all current publicly
available data;
Best for passive investing;
Suggested if fundamental analysis
allows for profits
Sentiment Indicators
Discern the potential views of
buyers and sellers
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;
Alternative to a cash dividend
Separately Managed Account
Owned by a single investor and
managed to meet their needs
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
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
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
Shapes of Yield Curve
+Normal (upward sloping)
+Inverted (downward sloping)
+Flat
+Humped
Shifts in aggregate demand curve
Change in price level/inflation
Consumer income and wealth increases
Higher expectations for economy in the
future
Expansionary monetary and fiscal policy
Favorable exchange rate movement
Shifts in long run aggregate supply
Increase in supply and quality of
labor
Increase in supply of natural
resources
Increase in stock of physical
capital
Technology
Short-Term Fixed Income
Securities that have maturities
less than 2 years;
Usually called paper or notes
Shifts in short term aggregate
supply
Shifts to long run aggregate supply
Labor productivity
Input prices
Expectations of future output
prices
Taxes and government subsidies
Exchange rates
Short-Term Treasury Forwards
Must settle before maturity date;
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
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
Simple Capital Structure
Only contains common stock and
nonconvertible stock
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
Simple Random Sampling
Completely random, systemic
sampling is picking every nth
member of a population;
Sampling error is the difference
between the sample statistic and
the population’s statistic
Single Price, Regular Auction
Cycle
Debt is auctioned periodically
according to a cycle and the
highest price (lowest yield) at
which the entire issue to be
auctioned can be sold and is
awarded to all bidders
Smoothed Pricing
Occurs because there is not daily
pricing of hedge fund assets
Single-Step Format
All expenses are grouped together
Software Development Treatment
Expensed until known to be
feasible, then they are capitalized
by both GAAP and IFRS
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;
Sources of Bond Return
+Coupon payments
+Recovery of principal at maturity
+Reinvestment income
Situations Where Estimating Cash
Flows is Difficult
+Principal repayment stream is
not known with certainty
+Coupon payments are not known
with certainty
+Bond is convertible
Sources of Commodity Returns
+Collateral yield
+The price return
+Roll yield
Sovereign Risk
Credit risk of a sovereign bond
outside of the investor’s home
market
Special Redemption Prices
Redemption prices from a sinking
fund or government mandated
sale
Spearman Rank Correlation Test
Order all of the data and examine
its correlation to see if there is any
relationship at the extremes ;
Used when data isn’t normal
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
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
Speculative demand
Money available to take advantage
of investment opportunities that
arise in the future;
Rises as economic future becomes
uncertain
Special Purpose Vehicle
A legal entity to which the assets used as
collateral in an ABS issue are sold. This
transaction separates the assets backing
the ABS from the other assets of the
company that creates the SPV.
Spot Market
Market with immediate delivery
Stable Value Fund
Invests in short term government
securities or other investments
that can provide timely principal
payments and a set interest rate
Standard Error
Dividing the sample variance by
the square root of the number of
observations since the populations
standard deviation is rarely known
Stages of Industry
+Embryonic
+Growth
+Shakeout
+Mature
+Declining
Start-Up Financing
Funding used for completion of
product development and fund
initial marketing efforts
Stages of Venture Capital
*Seed stage
*Start-up financing i
*First stage financing
*Formative stage
*Later stage financing
*Second stage investing
*Third stage investing
*Mezzanine financing
Statutory incidence
Who is legally responsible for
paying a tax
Standard Costing Inventory
Assigns predetermined amounts of
materials, labor, etc to each unit
produced
Statutory Voting
Each share gets one vote in the
election of each board nominee
Step-Up Note
Structured note with coupon rates
that raise on a set schedule
Steps of a Multistage Dividend
Growth Model
*Determine required return
*Project initial size and duration of high initial
dividend 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
Step-Up Notes
Coupon rates increase over time at
a specified rate
Steps of Arbitrage Free Valuation
*Value the security using spot
values
*Compare the value to the market
price
Steps for Forming Peer Group
*Determine which companies are in the same
industry
*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
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
Steps in a Fixed-For-Fixed
Currency Swap
*Notional principal is swapped at
initiation (Party A gets 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
Steps of Financial Statement
Analysis Framework
+State the objective and context
+Gather data
+Process data
+Analyze and interpret data
+Report conclusions and
recommendations
+Update analysis
Steps of Valuing a Bond
+Estimate cash flows
+Determine appropriate discount
rate
+Calculate the present value of the
estimated cash flow
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
Stochastic Oscillators
Calculated using the highest and lowest
closing prices over a set time period;
%K line is the difference between the
latest price and recent low divided by the
difference between the recent high and
low;
%D is a three period average of %K line;
The crossing of the %D line above the %K
line is a buy signal, the opposite a sell
Straight Line Depreciation
When an asset’s value is decreased
by the same amount each year
Stock Dividend
Dividends paid as newly issued
stock
Strategic Asset Allocation
Specifies the percentage of assets
go to each asset class
Stock Index Futures
S&P 500 Index is most popular;
Settlement is in cash and based on
a multiplier of 250
Stratified Random Sampling
When a population is divided up
into smaller groups based on
distinguishing characteristics;
Proportions of groups in sample
same as in population
Strong Form Market Efficiency
Security prices fully reflect all
information from both public and
private sources
Subjective Probability
Comes from a personal judgement
Structural unemployment
Long-run changes in the economy
that eliminate some jobs while
generating others for which
unemployed workers are not
qualified
Substitution effect
Always acts to increase the
consumption of a good that has
fallen in price
Structured Note
Debt security combined with a
derivative
Sum of value added method GDP
Summing the additions to value
created at each stage of production
and distribution
Style
Describes the basic characteristics
of the underlying assets
Sustainable Growth
= Retention Rate * ROE
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
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
Swap and Forward Commonalities
*Require no payment at initiation
*Custom instruments
*Not traded in a secondary market
*Mostly unregulated
*Default risk matters
*Large institutions are the main
players
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
Swap Contract
When two parties make payments
equivalent to one asset being
traded for another one
T-Test
Used to compare two means when
population is known to be
normally distributed
Swapation
Buy an option to enter an
offsetting swap and exercising it
would cancel the original swap
Tactical Asset Allocation
When a manager varies from the
strategic allocation weights when
attractive opportunities are
present
Takeover Defenses
+Golden parachute
+A poison pill
+Greenmail
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
Tap System
When issuance and auction of
bonds identical to the previously
issued bonds
Tax Backed (General Obligation) Bonds
Backed by the full faith, credit and
taxing power of the issuer
Target independence
When the central bank defines
how inflation is computed, sets the
target inflation, and determines
the time horizon for achieving the
target
Tax Burden
Falls on the party with less elastic
curve
Target zone
A set range a currency is allowed
to fluctuate relative to another
currency;
Larger movement range than a
fixed peg
Tax Rate Decrease Causes…
The decrease in the DTL would
result in lower income tax expense
and the decrease in DTA would
result in higher income tax
expense
Tax Rate Increase Causes…
The increase in DTL is added to
taxes payable and the increase in
DTA is subtracted from taxes
payable
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
Tax rate used to measure deferred
taxes
GAAP: Enacted tax rate only
IFRS: Enacted or substantially
enacted tax rate
Tenor
Length of the swap
Taxable Temporary Difference
Result in expected future taxable
income
Term Repo
Repo lasting longer than a day
Taxes Payable
The tax liability on the balance
sheet caused by taxable income
Test’s Significance
The probability that a true null
hypothesis will be rejected by
chance
Things to Consider when
Comparing Market and Modeled
Valuations
*The bigger the difference between modeled and
market valuation, the mover likely it is an investor
buys stock
*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
Total Asset Turnover
Measures the firms effectiveness
at creating revenue from assets;
TAT = Revenue/Average Total
Assets
Third Stage Financing
Investing is when a company is
going through a major expansion
Total Leverage
= Degree of Operating Leverage *
Degree of Financial Leverage
Time Weighted Return
Same as annualized return
Total Probability
P(A and B) = P(A) * P(B) if
independent events
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 semiannually
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
Total Return
When an index includes both price
changes and income from
constituent securities
Total Risk =
Systematic Risk + Unsystematic
Risk
Traditional Investment Market
Market for debt and equity,
alternative markets, alternatives
markets are for everything else
Trade blocs
Money held to meet the need for
undertaking transactions;
Increases with GDP
Transaction demand
Money held to meet the need for
undertaking transactions;
Increases with GDP
Trading Securities
Listed at fair value, with
unrealized gains and losses are
recognized in the income
statement
Traveling for Business/to a Client
It is not required the each person
pays for their own room
Traditional Finance
Markets are rational even if
individuals aren’t
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
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 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
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
Treatment of Float Costs
Treat as a cash outflow at project
initiation rather than as a
component of the cost of equity
Treynor Measure =
(Portfolio Return - Risk Free
Rate)/Portfolio Beta;
Most appropriate when a fund has
multiple managers and only has
systematic risk
Treasury Notes and Bonds
Bonds pay semi-annual coupons at a rate
fixed at 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
Triangles
When prices reach lower highs and higher lows;
Trendlines converge when projected forward;
Imply buying and selling pressures have
temporarily become equal but will not impede the
trend;
A price target can be set by the difference between
the two trendlines at the beginning of the pattern
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
Trough
Real GDP stops decreasing and
begins increasing
Inventory to sales ratio decreases
Type II Error
Not rejecting a false null
Two Assets’ Correlation Coefficient
Dividing the covariance between
returns of two assets by the
individual standard deviations of
returns of the two assets
Types of Bonds
+Zero-Coupon Bonds
+Step-Up Bonds
+Deferred-Coupon Bonds
+Floating-Rate Bonds
Two Fund Separation Theorem
All investors’ optimum portfolios
will be made up of some
combination of an optimal
portfolio of risky assets and a risk
free asset
Types of Currency Swaps
*Party A pays a fixed rate on Currency A received,
Party 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
Type I Error
Rejecting the null when it is true;
Significance level is probability of
Type I error
Types of Dividends
- Regular dividends
- Special dividends
- Liquidating dividends
- Stock dividends
- Stock splits
- Reverse stock splits
Types of Equity Indices
+Broad market index
+Multi-market index
+Multi-market index with
fundamental weighting
+Sector index
+Style index
Types of trade restrictions
- Tariffs
- Quotas
- Export subsidies
- Minimum domestic content
- Voluntary export restraint
Types of Event Risk
+Disasters
+Corporate Restructuring
+Regulatory Issues
Types of Treasury Securities
+Treasury Bills
+Treasury Notes and Bonds
+TIPS
Types of Execution Orders
+Market order
+Limit order
+All or nothing order
+Hidden order
Types of unemployment
+Frictional
+Structural
*Different
+Cyclical
Types of Investors
+Individual investors
+Institutions
+An endowment fund
+A bank
+Insurance companies
+Investment companies
+Sovereign wealth funds
Types of Validity Instructions
*Day orders
*Good-till-cancelled orders
*Immediate-or-cancelled, or fillor-
kill, orders
*Good-on-close orders
*Stop-loss orders
Uncommitted Line of Credit
An offer of credit for a certain
amount a bank extends but may
refuse to lend if conditions change
Undistributed profit from a
subsidiary
GAAP: No deferred taxes for foreign
subsidiaries that 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
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
Underwritten Offering
When the investment bank agrees
to entire issue at a negotiated
price;
Bank is stuck with position if
undersubscribed
Uniform Pricing Rules
When all trades trade at the same
price, which results from where
the highest volume is
Undistributed profit from a joint
venture
GAAP: No deferred tax for a foreign joint
venture that 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
Unit of Production Depreciation
Depreciates the assets based on
the actual usage of the asset
Unlimited Tax General Obligation
Bonds
Backed by unlimited taxing power
of the issuer;
General obligation
Unsecured Debt Credit
Enhancements
*Third-party guarantees
*Letters of credit that a bank will
advance the issuer for the service
of its debt
*Bond insurance
Unqualified auditor’s opinion
Indicates the auditor believes the
statements are fine
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
Unrealized Gains/Losses on Held
For Trading Securities
Included in net income
Use of Accounts Receivable Aging
Schedule
To identify trends in how well the
firm is doing at collecting
receivables and converting them
to cash
Unrealized Gains/Losses on
Securities Available For Sales
Included in comprehensive income
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
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
Use of Profitability Ratios
Give information about how well a
company generates operating
profits and net profits from its
sales
Value of final output GDP
Summing the value of all final
goods and services produced
Use of Solvency Ratios
Ability to pay back long-term
obligations
Value Weighted Indices Adjust for
Stock Splits?
No, market cap does not change
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
Variation Margin
The funds that must be deposited
into an account to bring it back up
to the initial margin amount
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
Volatility Risk
Chance of increased interest rate
volatility causing prepayments
Venture Capital Fund
Invests in companies in the startup
phase with the intent that they
grow into profitable companies
and the investment is sold at an
IPO
Voluntary export restraint
Agreement by the government to
limit the quantity of a 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
Venture Capital Investment
Characteristics
*Illiquidity
*Long-term investment horizon
*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
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
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
Ways for Company to Buy Back
Stock
+Buy stock in the open market at
prevailing market price
+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
Ways Hedge Funds Use Leverage
*Borrow through a margin account
*Borrow externally
*Utilize derivatives that do not
require trading in cash
Ways to Terminate Swap
*Mutual termination
*Offsetting contracts
*Resale
*Swapation
Ways to Invest in Foreign
Companies
+Direct Investing
+Depository Receipts
+Global Depository Receipts
+American Depository Receipts
+Global Registered
+ETF of Depository Receipts
Ways to Value Real Estate
+Replacement cost
+Comparable sales
+Income method
+Discounted after-tax cash flow
model
Ways to Issue Sovereign Debt
*Single price, regular auction cycle
*Multiple price, regular auction
cycle
*Ad hoc auction services
*Tap system
Weak Form Market Efficiency
Current security prices fully reflect
all currently available security
market data
Ways to Terminate a Futures
Contract
+Delivery
+Cash settlement
+Make an offsetting trade
+Exchange for physicals
Weighted Average Cost of Capital
The discount rate used in capital
budgeting;
= (Weight of Debt) (After Tax Cost of
Debt) + (Weight of Preferred Stock)
(Cost of Preferred Stock) + (Weight of
Common Equity) * (Cost of Common
Equity)
Weighted Average Cost of
Inventory
*GAAP and IFRS
*Dividing total cost of goods
available for sale by the total
quantity of goods available for sale
Who enforces the Code of
Standards?
The Board of Governors
When Bond at Discount…
Coupon Rate < Current Yield <
Yield to Maturity
Why Capital Budgeting is
Important
*Involves large transactions
*Same principles apply to most
corporate decision making
*Objective way to maximize
shareholder value
When Bond at Par….
Coupon Rate = Current Yield =
Yield to Maturity
Why Firms Support One Set of
Reporting Standards
Would reduce the cost and the
time spent on reporting
When Bond at Premium…
Coupon Rate > Current Yield >
Yield to Maturity
Why were GIPS created?
Discourage:
+Showing a top performing
portfolio as representative of a
firms total performance
+Survivorship bias
+Varying time periods
Working Capital
Working Capital = Current Assets
- Current Liabilities
Yield Spreads
+Absolute yield spread
+Relative yield spread
+Yield ratio
Working Capital Turnover =
Revenue/Average Working Capital
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 Curve Risk
Possibility of a change in the
shape of the yield curve
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
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
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
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
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
Yield to Worst
The worst yield outcome of any of
the possible call provisions
Zero-Coupon Bonds
Do not pay periodic interest;
Sold at a discount and pay par
value at maturity
Z-Test
Used to calculate a mean when
population is known to be
normally distributed
Z-Value of Normal Distribution
The number of standard
deviations away a random variable
is from the population mean ;
z = (variable - population
mean)(standard deviation)
