CFA brainscape Flashcards
Residual Dividend Model
- Calc cap needs
- Pick cap structure
- Calc new cap needs from equity
- (Earnings - equity cap investment needed) = div
5 reasons to repurchase shares
- Tax advantage
- Share price support / signaling
- Added flexibility (vs. div)
- Offsetting dilution from employee stock options
- Increasing financial leverage , change cap structure
Is it good to repurchase shares
- earnings yld = EPS / stock price
- EPS after buyback = (earnings - cost of borrowing) / (existing shares - buy back shares)
- Is New EPS > old EPS, then repurchase good
- Good if borrowing cost < earnings yld
- Div payout ratio
- Div coverage ration
- FCFE coverage ratio
- Div payout ratio = divs / NI
- Div coverage ratio = NI / divs
- FCFE coverage ratio = FCFE / (divs + repurchases)
3 Investor div preference theories
- MM’s div irrelevance
- ‘Bird in the hand’
- Tax aversion
2 Goals of corporate governance
- Eliminate/reduce conflicts of interest, especially between management and shareholders
- Use company’s assets in best interest of investors and shareholders
4 Elements of a good corporate governance system (core attributes)
- Defined rights of shareholders/stakeholders
- Defined ovesight responibilities of managers/directors
- Fair treatment between managers/directors/shareholders
- Transparency of operations, risk, performance
Corporations: proportion of all businesses, proportion of revenue
20% of businesses
90% of revenue
Board of directors risk as agents of shareholders
- Lack of independence
- Personal relationships w/management
- Director has business relationship with firm
- Interlinked boards
- Over compensation
Good corp governance traits for board (8/14)
- > 75% BOD are independent
- Chairman & CEO split
- Good qualifications
- Annual, non-staggered elections
- BOD self assessments
- BOD only meetings (no mng)
- Independent audit cmmtt
- Independent nominating cmmtt
Good corp governance traits for board (6/14)
- Compensation cmmtt (?)
- Independent BOD legal consel
- Statement of governance policies
- Disclosure & transparency
- Insider transactions approved by BOD
- Responsiveness to shareholder proxy votes
4 risks from bad corporate goverance
- Financial disclosure risk
- Asset risk
- Liability risk
4.
M&A | merger
one company buys ALL of another company
acquirer and target
2 dimensions of M&A
- Forms of integration: how companies physically come together
- Type of merger: how the companies’ businesse activities relate to each other
M&A | 3 forms of integration
- Statutory merger: one company ceases to exit
- Subsidiary merger: parent + subsidiary
- Consolidation: both companies cease to exist >> completely new company
M&A | 3 types of mergers
- Horizontal: similar businesses
- Vertical: along supply chain (raw materitals/backwards, consumer/forwards)
- Conglomerate: separate industries
Reasons for M&A
- Synergy
- Rapid growth
- Market power
- Gain unique capabilities
- Diversification
- Bootstrapping EPS
- Personal benefits to mng
- Tax benefits
- Hidden value
- Int’l business goals
M&A | Bootstrapping
- Increasing EPS by M&A wo/ increase in earnings
- High PE co. buys low PE co.
- No new economic value
- EPS increase b/c per dollar of mkt cap you get more earnings
M&A and industry life cycle
- prioneer/dev: congomerate, horizontal
- rapid growth: conglomerate, horizontal
- mature: horizontal, vertical
- stabilization: horizontal
- decline: all 3
2 technical forms of acquisition
- Stock purchase
- Asset purchase
M&A | Stock purchase and asset purchase
SP|AP - 1. Payment: sharehoder|company
- Approval: maj of shareholders|company unless > 50% of assets
- Taxes: shareholder pay cap gains| co. pays cap gains
- Liabities: buyer assumes liabilities|does not assume liabilities
- Notes: buy 100% of co. | buy some assets
M&A | Anti-trust & HHI
HHI past merger|Change|Anti-trust action - 1. < 1000 | doesn’t matter | no action
- 1000-1500 | > 100 | possible
- > 1500 | > 50 | yes
M&A | Post offer defense mechanism
- Just say no
- Litigation
- Greenmail
- Share repurchase
- Leveraged recapitalization
- Crown jewel defense: possibly legal
- Pac-man
- White knight: winner’s curse
- White squire
Herfindahl - Hirschmann Index
- If change > 100, then anti-trust issue
- HHI = ∑ (MS x 100)2 from 1 to n, MS = mkt share, n = firms in industry
- < 1800 is competitive
M&A| Discounted cash flow (DCF) analysis steps
(similar to FCFE), Calc FCF: 1. Decide on FCF mode
- Dev pro forma financial estimates
- calc FCF using estimates
- discount FCF using WACCadjusted
- Determine terminal value then discount
- Add all PV FCF together
M&A| Discounted cash flow (DCF): calc FCF
NI + Net interest after tax | unlevered NI +- deferred tax change | net op profit less adj taxes (NOPLAT) + non-cash charges (NCC) +- ∆NWC - cap ex| FCF, NWC = CA(- cash) - CL(- ST debt)
M&A|Discounted cash flow (DCF): 2 terminal value methods
- Constant growth: term val = FCFT(1+g) / (WACCadj - g)
- Market multiple: term val = FCFT x (P/FCF), P = projected price
M&A| 3 valuation of target company methods
- Discounted cash flow (DCF) analysis
- Comparable company analysis
- Comparable transaction analysis
M&A| Comparable transaction analysis for target valuation
Similar to comparable company analysis, but only mergers 1. Find comparable companies that were acquired
- Calc relative value metrics based on deal price
- Create descriptive metrics (avg, median, etc)
M&A | Empirical results
- Target get 30% premium
- Acquirers: ST ↓1-3%, LT after 3yrs ↓ 4% and 60% underperform peer group
PE | committed vs paid-in capital
committed = promised
paid-in (invested) = actually received
Convertible bonds: premium payback period
PPP = mkt conv permium / favorable income diff fid = (coupon - (conv ratio x div))/conv ratio
PE | corporate governance of PE firm
- key man clause
- performance disclosure & confidentiality
- clawback
- distribution waterfall
- tag along - drag along
- no-fault divorce: fire GP w/75% of LP
- removal for cause: fire GP
- investment restrictions
- co-investment
PE | distribution waterfall
- deal by deal
- total return: a.paid back > committed capital b. paid back > invest capital
PE | 6 ways to determine NAV
- at cost - adj for later financing
- at min of cost or mkt
- revaluing with each new financing
- at cost with no adj until exit
- discount factor for restricted securities
- illiquidity discounts to comparable public firms
PE | type of investors in PE
qualified investors
PE | PE risks
- liquidity
- unquoted
- competitive environment
- agency
- capital
- regulatory
- tax
- valuation
- diversification 10. market
PE | PE costs
- transaction
- investment vehicle fund setup
- administrative
- audit
- management (2/20)
- dilution
- placement (up to 2%)
PE | gross IRR v. net IRR
gross: portfolio co. > PE firm
net: PE firm > LPs
PE | quantitative performance measures
- PIC (paid in capital) - cap utilizied by GP
- DPI*(distributed to PIC) - LP’s realized return: aka cash-on-cash return
- RVPI*(residual value to PIC) - LP’s unrealized return
- TVPI*(total value to PIC) - DPI + RVPI
* net of mng fee & carried interest
Fixed Asset Turnover
Activity Ratio
Rev / Avg Net Fixed Assets
Rev/Ass
Avg Net Fixed Assets = Fixed Assets - Dep
Common Equity Accounts (Balance Sheet)
Common stock
Add paid-in capital
Treasury stock
Non-control subsidiary
Retained earnings
Accum other comp income
Common Asset Accounts (Balance Sheet)
Cash
Acc Rec
Inv
PPE
Prepaid exp
Investments (bonds)
Intangible
DTA
Pension
Receivables turnover ratio
Activity ratio
Rev / Avg acc rec
Rev / Ass
Common Liability Accounts (Balance sheet)
Acc pay
Accru exp
Unearned rev
Debt
Captial leases
Pension
DTL
Operating cash flow | Direct vs Indirect Method
Direct:
redo income statement based on cash
not accrual
subtract out CFI p/l
Indirect:
start with accrual income statement and net income and adjust for cash basis
subtract CFI p/l
Current Ratio
Liquidity ratio
Current Assets / Current Liabilities
Cash to Income Ratio
Performance ratio
CFO / Operating Income
Cash return on equity ratio
Performance ratio
CFO / Avg total equity
EBIT
Operating profit
Multi-step income statement format
Rev - COGS = Gross Profit - SGA - Dep = Op Profit - Int = EBT - taxes = EAT - p/l discont ops = Net Income
Operating Cash Flow (CFO)
Cash flow that affects net income
Number of days of payables
Activity ratio : 365 x avg acct pay / purchases : 365 x liab / exp
total asset turnover
activity ratio : rev / avg assets : rev / asset
harmonic mean
n / (1/x1 + 1/x2 + 1/x3)
geometric mean
[(1 + r1) x (1 + r2) + (1 + r3)] ^ 1/n : less than arithmetic mean
three statistical frequencies
absolute, relative, cumulative
NOIR
nominal (no particular order), ordinal (ordered), interval (diff equal), ratio (true zero)
Holding period yield/return
HPY/HPR : = (end value - begin value) / begin value = (P1 - P0 + D1) / P0 = [BDY x (t/360)] / [1 - BDY x (t/360)]
money weighted return v. time weighted return
MWR uses cash flows and IRR : TWR calcs return for each period then multiplies the geometric mean
annual percentage rate APR
no compounding : lower than APY : calculator CPT I/Y then multiply by # of periods
annual percentage yield APY
yes compounding : higher than APR : ( end value / begin value ) ^ # periods
bond equivalent yield BEY
semi-annual rate (compunded if necessary) x 2
money market yield / CD equivalent yield
MMY = HPY x (360/dtm) = 360 x BDY / [360 - (dtm x BDY)]
effictive annual yield (EAY)
EAY = (1 + HPY) ^ (365/t) - 1
bank discount yield (BDY)
’= ( face - price ) / face x 360 / dtm
standards of professional conduct
(7) professionalism, integrity of cap mkts, duties to clients, duties to employers, analysis+recommendations+actions, conflict of interest, responsibilities of CFA
standards / resposibilities to CFA
- conduct
- referencing CFA
standards / conflicts of interest
- disclosure
- priority or transactions
- referral fees
standards / analysis, recommendations, actions
- diligence + reasonable basis
- comms w clients + prospects
- record retention
standards / duties to employers
loyalty, outside compensation, surprise well
standards / duties to clients
loyalty, fair dealing, suitability, performance presentation, confidentiality
standards / integrity of markets
material non-public info, market manipulation
standards / professionalism
- knowledge of law
- independence + objectivity
- misrepresentation
- misconduct
code of ethics
(6) act w integrity w/public,clients,employer, client/profession above self, use care when managing money, practice + encourage, promote integrity of mkts, maintain + improve self
important Z values
- 59 = 0.5%,
- 33 = 1%, 1.96 =
- 5%, 1.65 = 5%, 1.28 = 10%
GIPS
(9) fundamentals of compliance, input data, calculation methodology, composite construction, disclosures, presentation + reporting, real estate, private equity, wrap fee / separately managed accounts (SMA) portfolios
coefficient of variation
standard deviation / mean = s / Xbar
diluted EPS
(NI - pref div) + (conv pref divs) + (conv debt int)x(1 - tax) / (weight avg shares) + (conv pref shares) + (conv debt shares) + (stock opt shares)
basic EPS
NI - pref divs / weighted avg shares
Dupont equation - original
ROE = return on equity = NI/sales x sales/assets x assets/equity = net profit margin x asset turnover x leverage ratio
Dupont equation - extended
ROE = return on equity = NI/EBT x EBT/EBIT x EBIT/sales x sales/assets x assets/equity = XXX
common size cash flow ratios
basing cash flow statement on % of sales : X/sales
common size balance sheet ratios
basing balance sheet accts on % of assets : X/total assets
common size income statement ratios
basing income statement accts on % of sales : X/sales
return on equity ROE
net income / avg equity
return on total capital
net income / (avg debt + avg equity)
return on assets w interest ROA
(net income + (int x ( 1 - tr )) / avg assets
return on assets no interest ROA
net income / avg assets
pre-tax margin
EBT / sales
EBITDA
Sales - COGS - SGA
Bayes Formula
P(A | B) = P(B | A) x P(A) / P(B)
price index vs return index
price index = includes just price, no divs or int : return index = includes div and int
portfolio variance
o^2 = Wa^2 x Oa^2 + Wb^2 x Ob^2 + 2WbWaCovab = Wa^2 x Oa^2 + Wb^2 x Ob^2 + 2WbWaPabOaOb
correlation coefficient
Pab = Covab / (Oa x Ob) : Pab x Oa x Ob = Covab : -1 <= 1
covariance
Covab = Pab x Oa x Ob = E[(Ai - Abar)(Bi - Bbar)] : range is pos to neg infiniti
covariance of A and A
Covaa = Oa^2
fact
P(A) = P(AB) + P(ABc) where A can only occur if B or Bc, B and Bc are mutually exclusive and exhaustive
probability addition rule
P(A or B) = P(A) + P(B) - P(AB)
probability multiplication rule
P(AB) = P(A|B) x P(B) = P(B”A) x P(A)
skewness
Sk = 1/n x E(Xi - Xbar)^3 / s^3, s=sample std dev : norm dist = 0, right skew > 0, left skew < 0
kurtosis
K = 1/n x E(Xi - Xbar)^4 / s^4, s=sample std dev : leptokurtic (more) > 3, norm dist = 3, platykurtic (less) < 3
sharpe ratio
S = Ri - Rf / O, O = std dev of portfolio
chebyshev’s inequality
percentage of observations that lie within k std devs, regardless of distribution, is at least >= 1 - 1/K^2 for k > 1
variance
O^2 = E(Xi - Xbar)^2 / n if Xbar is pop mean OR
mean absolute deviation
MAD = E | Xi - Xbar | / n
variance of binomial random variable
O^2 = n x p x (1 - p)
probability of x successes in n binomial trials
p(x) = n! / [(n - x)! x!] * p^x * (1 - p)^(n - x)
VAR on bonds
VAR looks at both how changes in yield affects bond/portfolio values and how yield volatility affects bond/portfolio values
price value of basis point
= duration * .0001 * notional : it’s the $ change / 1 bp change
bond valuation with duration and convexity
= ( - duration x Δy ) + ( convexity x Δy^2) x 100, where Δy = change in yield in decimal form
portfolio duration
= W1D1 + W2D2 + … + WnDn, where W is $ portion of whole portfolio
Macaulay Duration
weighted average of time until cash flows arrive, where weights are % of total bond value that cash flow represents : does not work with embedded options :
Modified Duration
Macaulay Duration / (1 + YTM) : does not work with embedded options
effective duration
(V- - V+) / (2 x V x Δy), where Δy is in decimal form
forward rate notation
length of loan ‘f’ years until loan starts : 1 f 2 >> one year loan that starts in 2 years
option adjusted spread
z spread if the bond had no options : used to compare to option free bonds : if no options then z spread = OAS
z spread v. YTM spread
steeper spot curve >> greater diff between z and YTM spreads : upward sloping spot >> z > YTM : downward sloping z < YTM : earlier principal paid >> wider diff between z and YTM
z spread, zero volatility spread
the identical yield that must be added to each risk free spot rate to correctly value a risky bond
5 bond related rates
(5) coupon rate, current yield, YTM (= IRR), spot rates, forward rates
arbitrage free bond valuation approach
use spot rates : value each cash flow : make sure it sums to bond value : arb by b/s pieces and s/b whole
what is YTM like
IRR
spot rate
the correct discount rate for a single cash flow in the future
arbitrage CDO vs balance sheet CDO
arb CDO done for profit by arb diff between cash inflow and outflow : balance sheet CDO done to reduce risk on balance sheet from loans
what debt maturities are exempt from SEC regulation
<= 270 days
what is more risky? Revenue or general obligation bonds
revenue
stripped mortgage backed securities & risk
PO wins from prepayment : IO losses from prepayment
3 maturity cycles for T-bills
30 day, 90 day, 180 day
effect of yield levels on duration and reinvestment risk
Yield down > duration up, reinvestment down : yield up > duration down, reinvestment up
different coupon structures
zero, step-up, deferred, regular, floating
list of fixed income risk
(12) interest rate, yield curve, call, prepayment, reinvestment, credit, liquidity, exchange rate, unexpected inflation, volatility, event, sovereign
bond interest rate sensitivity
maturity longer > duration up : coupon up, call, put, yield up > duration down
Is duration calced with %Δyield or Δyield
Δyield
variation margin
in a futures account, the amount of margin needed to be added when margin falls below maintenance and needs to be increased to initial
3 types of options
financial, futures, commodity
features futures for T-bills, T-bonds, stock index
T-bills - $1mm denominations : T-bonds - $100k denominations : stock index - S&P most popular ($250 x index value)
forward rate agreement terminology
when the loan begins ‘by’ when it ends ‘FRA’ : 2 by 5 FRA starts in 60 days and ends in 150 days and loan length is 90 days (150 - 60)
how are forward contract prices determined for discount bonds, coupon bonds, FRAs
discount - % off of face (eg 4% >> (1 + (96% x dtm/360)) x notional : coupon - YTM : forward rate agreement - cash settle, based on rate when loan would BEGIN in the future but discounted by length of loan because the profit wouldn’t occur until the end of the loan
forward rate agreement
pl = (realized rate - forward rate) x (dtm/360) x notional / (1 + (realized rate x (dtm/360))
cumulative distribution function (cdf)
aka ‘distribution function : sum of probabilities for the outcomes up to and including a specified outcome
of cells in top triangle in matrix
n x (n-1) / 2
combination formula
nCr = n! / ( (n-r)! x n! ) = ‘n choose r’ : calc n [2nd][nCr] r
permutation formula
of permutations of r objects from n objects (order counts) : = n! / (n-r)! : calc n {2nd][nPr] r
label n items with k labels with ni items per label
n! / (n1! x n2! x … x nk!)
multiples’ of equity valuation models
1) P/E, P/CF, P/S, P/BV : 2) EV/EBITDA
enterprise value
all a firm’s outstanding securities (debt + equity) minus cash and short term investments
justified P/E
a PE not based on stock price but some other valuation model
discounted cash flow : equity valuation models
dividend discount - Gordon constant growth V = D1/(k-g), multi-stage : Free cash flow V = E (FCFEi /(1 + r)^i
Gordon constant growth rate model
V = D1 / ( k - g)
infinite return model
E X / (1 + r)^i = X / i
3 equity valuation models
discounted cash flow model : multiplier model : asset based model
equity valuation model - asset based
asset - liabilities - pref stock, where assets and liabilities are valued at fair value
5 external effects on industries
(5) macroeconomic, technology, demographic, governmental, social
3 types of market efficiency
weak - incorp all past info, no tech analysis : semi-strong - incorp all past + public, includes weak and no fundamental analysis : strong - incorp all past, public and private, includes weak, semi-strong and no active analysis
5 index weighting types
(5) price, equal, market cap, float adj mkt cap, fundamental
index - total return vs price return
price does not include cash flows (div + int), just index price : total includes all cash flows
complete market efficiency
operational efficiency + informational efficiency = allocational efficiency
3 types of secondary markets
quote driven - investors w dealers (OTC) : order driven - rules match buyers and sellers (exchanges) : brokered - brokers locate counter parties
margin call price
P0 x (1 - initial margin %) / (1 - maintenance margin %) : think of cap structure margin loan = debt, cash = equity, losses go to equity, when equity = maint margin % of capital then margin call
call money rate
interest rate charged on margin loan
3 functions of the market
allocate capital efficiently, determine returns that put savings and borrowings in equilibrium, allow entities to save, borrow, manage risk, trade assets now and in the future
Markowitz portfolio theory
CAPM
IPS - investment guidelines
permitted asset types, leverage
IPS - (7) investment constraints
(7) risk, return, time horizon, tax situation, liquidity, legal, unique (RRTTLLU)
(9) IPS contents
description of client, state of purpose, state of duties/responsibilities, procedures, investment objectives, investment constraints, investment guidelines, eval of performance, appendices
Beta
B = Cov(im)/o^2m = corr(im)/o^2m : B is the slope of the least squares line of Ri-Rf vs Rm-Rf : E(Ri) = Rf + B[E(Rm) + Rf)]
Jensen’s Alpha
a of portfolio = (Rp - Rf) - Bp(Rm - Rf) : % of the SML line : associated with SML
Treynor’s value
(Rp - Rf) / Bp : associated with the SML
CML vs SML statistics
CML - Sharpe Ratio, M^2 : SML - Treynor, Jensen’s alpha
M squared risk measure
m^2 = (Rp - Rf)Om/Op - (Rm - Rf) : similar to sharpe ratio but % terms : associated with CML
slope of capital markets line (CML line)
is the Sharpe ratio = Rm - Rf / om
security market line (SML)
systemic risk : E(Ri) vs systemic risk, where systemic risk = Cov(im) : E(Ri) = Rf + Cov(im)/o^2m x [E(Rm) + Rf]
capital market line (CML)
total risk : optimal capital allocation : E(Rp) = Rf + [(E(Rm) + Rf) / om] x op
fact
concept of systemic risk applies to individual securities as well as portfolios
capital allocation line
line of optimal portfolios of risk free + risky assets : theoretically all investors have the same risky asset and CAL
minimum variance portfolio
for a given expected return, the portfolio (weights) with the lowest std dev : global min var portfolio = portfolio with the minimum std dev of all portfolios
portfolio variance of two assets
O^2p = WaO^2a + WbO^2b + 2WaWbCov(ab) : O^2p = WaO^2a + WbO^2b + 2WaWbCorr(ab)OaOb
covariance
Cov(ab) = E (Xa - Xbar a)(Xb - Xbar b) / n - 1 : Cov(ab) = PabOaOb
variance
O^2 = E (Xi - Xbar)^2 / n, if population, O^2 = E (Xi - Xbar)^2 / n - 1, if sample
money weighted rate of return
= IRR
3 types of lines of credit
uncommitted, committed, revolving
Receivables - factoring
selling off the receivables through securitization : factor = the buyer of the security
acc pay management - cost of trade credit
COTC = (1 + % discount/(1-%discount))^(365/# days paid past discount)
BDY vs MMY vs BEY
BDY = (F - P) / F x 360/dtm : MMY = (F - P) / P x 360/dtm : BEY = (F - P) / P x 360/dtm, this is not the normal BEY!
BDY vs MMY
Only difference is divisor is face for BDY and price for MMY
operating cycle in days formula
days of inventory + days of receivables, this is part of the cash conversion cycle
effect of share repurchase on book value
If P > BV, decrease in BV : If P < BV, increase in BV
effect of share repurchase on EPS
If E/P = cost of borrowing, no effect on EPS : if E/P > cost of borrowing, EPS will increase : if E/P < cost of borrowing, EPS will decrease
breakeven quantity of sales
Qbe = (fixed op cost + fixed financial cost) / (unit price - variable cost per unit) : contribution margin = (unit price - variable cost per unit)
degree of total leverage
DTL = DOL x DFL = %ΔEBIT / %Δsales x %ΔEPS / %ΔEBIT =%ΔEPS / %Δsales = Q ( P - V) / (Q (P - V) - F - I) = (S - TVC) / ((S - TVC) - F - I)
degree of financial leverage
DFL = %ΔEPS / %ΔEBIT = EBIT / (EBIT - I) ???
degree of operation leverage
DOL = %ΔEBIT / %Δsales = ΔEBIT/EBIT / Δsales/sales = Q(P-V) / (Q(P-V) - F) = (S - TVC) / ((S - TVC) - F)
cost of capital - 3 ways to calculate common equity
CAPM approach, Kc = Rf - B[E(Rm) - Rf + country risk] : Div discount model, Kc = D1/P0 + g, P0 = D1 / (k -g), g = growth rate = RR X ROE : Bond yield + risk premium (3-5%)
cost of capital - pure play method with B
2 step Beq a >> Bass a >>> Beq b : Bass a = Beq a / [1 + (1 -t)debt/equity], then Beq b = Bass a [1 + (1 - t)debt/equity]
leverage - 2 types of risk
business risk (sales and operating), financial
leverage - business risk
sales, operating
marginal cost of capital break point
BP = amount of capital at which the components cost of cap changes / weight of component in capital structure
cost of capital - country risk
CRP = sovereign yld spread x (O of developing equity mkt / O of developing bond mkt in foreign currency)
cost of capital - pref stock
Kp = Dp / P, Dp = pref div, P = mkt price of pref stock
fact
cost of capital - WACC = MCC
NPV IRR PI commonality
if one is true, all true - NPV > 0, IRR > RRR, PI > 1
profitability index (PI)
PI = PV of future cash flows / CF0 = NPV/CF0 + 1
credit - 4 Cs and 4 other measures
character, collateral, capacity, covenants, scale & diversification, operational efficiency, margin stability, leverage & coverage
‘debt’ in ratios exludes…
non-interest bearing liabilities - acc pay, acc liabilities, DTL
pension costs
service cost, interest cost, expected return on plan assets, actuarial p/l, prior service costs
2 types of capital leases
sales - PV > carrying value, lease rec = PV of lease payments, PV = rev, carrying value = COGS, int = CFO, principal = CFI (same as all amortizing loans) : direct financing/capital - no profit recog, lease rec created, int = CFO, principal = CFI
lease payment cash flows and income statement
cash flow - int is CFO, prin is CFI : income state for cap lease - depreciation is op exp, int is int exp
finance/capital lease
is a financial purchase : add to both ass and liab w/dep & int for lessee, for lessor int = CFO, prin = CFI
operating lease
rental, no balance sheet, rev = PV of cash flow, COGS = carrying value, PV > carrying, for lessor int = CFO, prin = CFI
lease is a capital lease if…
GAAP, any of these are true - title transferred, bargain purchase option, lease period >= 75% of asset life, PV of lease >= 90% of fair value
bond issuing costs
GAAP - capitalized as asset (deferred charge), expensed over life of bond, BOND + CHARGE = PROCEEDS: IFRS - reduce bond liability by costs >> increases effective rate
bonds on the balance sheet
present value of cash flows using effective rate (YTM) : effective rate = mkt rate at purchase : premium - expense + amort = coupon (this reduces liab), discount - exp = coupon + amort (this increases liab)
what happens to internally generated intangible assets
All expensed except - IFRS - dev costs past R&D capitalized, IFRS&GAAP - software dev past initial stage caped for all uses, GAAP - all software for internal use
intangible assets have two characteristics
finite/indefinite, identifiable/unidentifiable
inventory period costs
abnormal waste, storage, admin, selling are expensed not capitalized
summary of income statement
Net sales - COGS = gross profit - op exp = op profit (EBIT) - interest = EBT - taxes = EAT - below the line items adj for taxes = net income +/- other comp income - pre div = income available to common
financial leverage
assets / equity
ratio pairs
rec turnover > days of sales outstanding, pay turnover > number of days of pay, inv turnover > days of inventory on hand
types of ratios
activity, performance, liquidity, solvency/coverage, profitability, valuation
cash flow per share
CFO - pref div / weighted avg shares
income statement - single step vs multi-step
single step - rev and costs aggregated separately, multi - includes gross profit (COGS)
interest coverage ratio
coverage : CFO + int paid + taxes paid / interest paid
cash ratio
cash + mkt securities / curr liab
financing cash flow
cash flow that affects capital structure, issuing/repaying debt, issuing/buying back stock, etc
investing cash flow
cash flow from purchasing/disposing of long term assets and certain investments (like leases)
cash flow to revenue ratio
CFO / net revenue
inventory turnover ratio
COGS / avg inv : exp / asset
quick ratio
liquidity : cash + mkt securities + rec / curr liab : acid test
debt liability interest expense
market rate at purchase x balance sheet value of liab at beginning of period
deferred taxes
DTL is a liab that is what your balance sheet says you SHOULD have paid : DTA is what you should NOT have paid : income tax expense = taxes payable + DTL - DTA : ite is internal, itp is what the govt wants
cash return on assets
performance : CFO / avg assets
defensive interval
liquidity : cash + mkt securities + rec / daily expenditures
debt coverage ratio
coverage : CFO / total debt
DDB depreciation
double declining : 2 x (cost - accum dep) / useful life
fact
cost & production - when MP max, MC min : when AP max, AVC min and MP intersects AP
fact
cost - MC intersects AVC and ATC at each curves minimum point
costs - AFC, AVC, ATC
AFC = TFC / Q, AVC = TVC / Q, ATC = AFC + AVC
marginal cost (MC)
ΔTC / ΔQ
market concentration - Herfindahl-Hirschman Index (HHI)
sum of squared % mkt share of 50 largest firms : > 1800 not competitive
market concentration - 4-firm concentration ratio
sum of % of industry sales of four largest firms : >40 not competitive
fact
gov’t multiplier is GREATER than autonomous tax multiplier >> balanced budget multiplier is positive
Ricardo-Barro effect
bigger gov’t deficit ? People to save more in prep for higher future taxes > people buy the gov’t debt with savings > no crowding out effect
Phillips curve
Inflation vs UE : long term is 100% elastic, short term slopes down
equation of exchange
MV = PY
Federal Reserve money multiplier
1 + c / r + c, c = currency / deposits, r = required reserve ratio
debt payment ratio
coverage ratio : CFO / cash for long term debt repayment
reinvestment ratio
coverage ratio : CFO / cash paid for long term assets
payable turnover ratio
activity ratio : purchases / avg acc pay : exp / ass
days of sales outstanding
365 / rec turnover : 365 x avg acc rec / sales
income statement - unusual or infrequent items v. extraordinary items
unusual or infrequent - included in continuing ops and reported before taxes : extraordinary - unusual and infrequent, reported after taxes (net of taxes), not allowed in IFRS
cash flow - taxes
GAAP - all taxes in CFO : IFRS each tax goes to its section, CFO/CFI/CFF
cash flow - interest & dividends
GAAP/IFRS : int rec CFO - CFO/CFI, int paid CFO - CFO/CFF, div rec CFO - CFO/CFI, div paid CFF - CFO/CFF
items on cash flow statement come from…
1) income statement items 2) changes in balance sheet accounts
change of accounting method or estimate requires
method - retro : error - retro : estimate - pro
comprehensive income
net income + other comp income (unreal pl from currrency, pension adj, hedges, unreal pl from avail for sale securities), NO DIVS (pref or common) included
held to maturity
debt, reported at amort cost (initial proceeds), amort cost = face - unamort discount or + unamort premium, fair value ignored subsequently, realized pl on income statement
available for sale securities
debt & equity, reported on balance sheet at fair value, unrealized pl reported in other comp income, realized pl on income statement
trading securities
debt & equity, reported on balance sheet at fair value, unrealized pl reported in income statement, realized pl on income statement
gross revenue reporting vs net revenue reporting
gross = all rev + all costs, net = rev - costs : can use gross if primary obligator, bear investment + credit risk, able to choose supplier, latitude to establish price
installment sales
revenue is recognized 1) immediately - very certain payment 2) as cash comes in - % rev = % profit 3) cost recovery - profit when accum cash > accum cost
IASB vs FASB
IASB more emphasis on going concern : FASB - relevance, reliability, IASB - comparability, understandability : FASB0 bi adj of asset values upwards
accounting boards & standards
FASB > GAAP : IASB > IFRS
flow of accounting information
journal entries (in a general journal) > general ledger > initial trial balance (end of period) > adjusted trial balance > financial statements
main accounting equation
A = L + E : A = L + contributed cap + beginning retain earn + revenue - expenses - dividends
4 types of revenue and expense accruals
unearned rev (L), accrued exp (L), accrued rev (A), prepaid exp (A)
are financial statement notes audited
yes
McCallums monetary fed rul
something to do with monetarism and MV = PY
Taylor’s fed funds rate rule
Fed funds rate = 2% + actual inflation + .5*(actual inflation - 2%) + .5(output gap)
technology efficiency vs economic efficiency
technology = fewest inputs economic = lowest cost
economic profit
includes explicit & implicit opportunity cost
normal profit of an individual
an individual’s opportunity cost
opportunity cost
the return on a resource that could have been earned in its next most valuable use
marginal benefit & marginal cost
marginal benefit (MB) = demand curve marginal cost (MC) = supply curve
price elasticity of supply
%Δ quantity supplied / %Δ price of good
inelastic vs elastic
inelastic < 1
elastic > 1
perfect inelastic = 0
perfect elasticity = infinity
income elasticity of demand
%Δ quantity demanded / %Δ income
normal necessity 0-1
normal luxury > 1
inferior < 0
elasticity & greatest total revenue
when elasticity = -1, P*Q = max;
total revenue test:
if ΔPup > Δ(P*Q)up, then demand is inelastic
ΔPup > Δ(P*Q)down, then demand is elastic
cross elasticity of demand
%ΔQ / %ΔPsubstitute
if positive > substitute
if negative > compliment
price elasticity of demand
%ΔQ / %ΔP where %Δ = (Xt - X0) / [(Xt - X0)/2]
vertical demand line = inelastic
horizontal demand line = elastic
elasticity
%ΔX / %ΔY
technical analysis - change in polarity
breached resistence > support and vice versa
technical analysis - non price based
- put/call ratio
- VIX
- margin debt
- short interest ratio
- flow of funds
- mutual fund cash position
- equity issuance
technical analysis oscillators
- rate of change, Pt - P0
- relative strength, Pup/Pdown
- moving avg, 2 moving avg lines
- stochastic, Pt vs high/low prices in last X days
technical analysis - moving average and Bollinger bands
- moving avg = avg of last X closing prices
- Bollinger bands = std dev of X closing prices around moving avg
technical analysis - chart
- bar chart
- candlestick chart
- point and figure chart
- volume chart
parametric and non-parametric
- parametric: more assumptions regarding distribution of population
- non-parametric: few assumptions about population (Spearman rank correlation test)
variance testing - equality of 2 normally dist populations
are the two variances the same? both normal, independent : F test statistic, F = s1^2/s2^2, where s1^2 > s2^2 and df = n1 - 1 and n2 - 1 (2 dfs)
variance testing - variance of norm dist population
is variance same as null hypo variance? normal, Chi-square statistic : X2n-1 = (n-1) x s^2 / O2o, where O2o = null hypo value and df = n-1
mean difference test
are the means of two pops diff? both normal, DEPENDENT, remember returns of 2 steel companies : t statistic = (dbar - pop mean) / std error of d, where dbar = 1/n*E di, where di = difference in means
equality of pop means test with unknown but assumed unequal variances
are the pop means the same? Both norm, independent : t stat = (x1bar - x2bar) / (s1^2/n1 + s2^2/n2)^1/2 where df is really complicated
equality of pop means test with unknown but assumed equal variances
are the pop means the same? Both norm, independent : t stat = (x1bar - x2bar) / (sp^2/n1 + sp^2/n2)^1/2 where sp^2 = ((n1 -1)s1^2 + (n2-1)s2^2) / (n1 + n2 -2)
hypothesis test p-value
probability of obtaining a test statistic that rejects the null hypothesis when it is true, use Z table to find it
critical value
z,t,X,F value (eg 1.96)
power of hypothesis test
probabilty of correctly rejecting the null hypothesis when it is false : often decreases when alpha is small : = 1 - P(type II error)
hypo test - type I and type II error
- type 1: reject the null when true = significance level = alpha
- type II: failure to reject null when false
test statistic
(sample statistic - null hypo value) / standard error
hypopothesis testing procedure (7)
- state hypothesis
- select test statistic
- specify sig level
- state decision (rejection) rule
- collect sample and calc sample statistic
- make a decision re hypo
- make a decision based on test results
z vs t test statistic
- normal, known var = z
- normal, unknown var = t, non-norm, known 30 z
- non-norm, unknown: 30 t
the 2 n-1s
sample variance and degrees of freedom
roys safety first criterion (SF ratio)
max (E(Rp) - Rl) / Op OR min P(Rp<Rl), where Rl is the minimum threshold
continuous compounding formula
e^r where r is rate of return (eg 0.06)
working capital turnover
activity ratio = rev / (avg curr ass - avg curr liab)
days of inventory on hand
365 / inventory turnover = 365 x avg inv / COGS
bond sinking fund provisions
- repayment of principle through series of repayments
- cash payment: borrower pays cash > trustee > retires at par
- delivery of securities: borrower buys bonds > trustee > retires those bonds (worse when bonds over par)
free cash flow to equity
= CFO - FCI + net borrowing
free cash flow to firm
= CFO - FCI + int exp(1 - t) = NI + non cash charges + int exp(1-t) - FCI - working capital
investing and financing ratio
coverage ratio : CFO / cash outflows from investing and financing activities
bonds - calls & puts
- call: good for issuer/borrower, call protection > currently calleable, refundable vs non-refundable, rates down
- put: good for lender/buyer, rates up
bullet vs amortizing security
- bullet: principle repaid at end
- amortizing: principle paid along side interest
what happens when a bold is sold inbetween coupon payments
- cum coupon (normal) = seller will receive accrued interest for buyer up to sale date
- dirty price (full price) = clean price + accured int, if bond is in default trades without accrued interest : ex-coupon - next coupon goes to seller
dividend payment ratio
coverage ratio = CFO / dividends paid
cash flow stucture
Operating + investing + financial = change in cash balance + beginning cash balance = ending cash balance
cash conversion cycle
days of sales outstanding + days of inventory on hand - days of payables
split rate corporate tax
corporate retained earnings are taxed at a higher rate than earnings paid out as dividend
old prudent man vs new prudent investor rule
- total return old: income + preserve principle, new: income + cap growth
- risk old: no risk, new: risk vs return
- portfolio old: each investment by itself, new: investment part of portfolio
- security restrictions old: yes, new: no
- delegation of duty old: no, new: duty to delegate
new prudent investor: main points
- economic conditions
- inflation + deflation
- investments + tax liability
- investment effect on portfolio
- total return (income + cap growth)
- other resources of beneficiary
- liquidity, income, cap preservation
- special relationship of assets to beneficiary
PE | NAV after distribution
= NAVbefore - carried int - distributions
PE | VC post money value
= PV(exit value) = pre + inv
PE | VC ownership calc at time of investment
- f = inv/post = PV(inv)/exit value
- VC shares / other shares = f / 1-f
- price = inv / VC shares
PE | adjusting discount rate for probability of failure
r* = (1+r / 1-q) - 1, r* = adj, r = unadj
EV | residual income model
- aka economic profit for equity
- = NI - equity charge, equity charge = equity x rr
- equity charge measures shareholders opportunity cost
cash flow accrual ratio
- NI - CFO - CFI = accrual
- accrual / net op assets = cash flow accrual ratio
** EV | Four Valuation Models**
- dividend discount (DDM)
- free cash flow (FCF)
- market multiple models
- residual income model
EV | economic value added
- EVA = NOPAT - (wacc x invested cap)
- inv cap = NWC + fixed assets = book debt + book equity
- NOPAT = EBIT(1-t)
- EVA = economic profit to debt + equity
ABS | early amort trigger
- protects lender from credit quality decline
- eg. 3 months avg excess spread = 0 >> trigger
ABS | CDO
• 3 layers
senior: variable rate: 70-80% of CDO
mezzanine: fixed rate
subordinate (equity tranche)
• pool contains mix of variable + fixed rate but not in same proportion as investor layers. Swaps are used to adjust
ABS | Cash flow CDO
- goal is to repay senior + mezz
- 3 phases
1) ramp up: 1-2 mo: put together portfolio
2) reinvest: reinvest payments
3) paydown: 3-5 yrs: get paid
- if ‘coverage test’ is passed then mezz and equity get paid interest, otherwise all to senior
- principal >> senior >> mezz >> equity
ABS | Market Value CDO
more freedom to manager than cash flow CDO
ABS | Synthetic CDO
- contract, not asset
- senior + junior ‘sections’
- junior pays in as protection for senior
- then sell a credit default swap (CDS) on a notional amount tied to some other instrument
- derivative: after junior is depleted, senior is on the hook
ABS | CDO motivations
- arbitrage (majority)
2.balance sheet
◎ sell an asset without selling it and same with buying
Mortgages | SMM & prepayment calculation
prepayment(m) = SMM(m) x (mortgage balance at beginning of month - scheduled principal repayment)
Mortgages | prevailing mortgage rates
- spread between current rate and original mortgage rate
- path of mortgages
◎ refinancing burnout when rates go up and down and everyone has refied already
Mortgages | 3 factors of prepayment
- prevailing mortgages rates
- housing turnover
- characteristics of mortgage
Mortgages | 2 types of prepayment risk
- contraction risk
◎ negatie convexity (call)
◎ reinvestment risk - extension risk
Mortgages | CMO
collateralized mortgage obligation
◎ tranches
Mortgages | CMO tranche types
- sequential pay tranche
- accrual tranche
- planned amort class tranche
- support tranche
Mortgages | principal pay down window
• in a CMO, the time it takes to pay down the principal in a particular tranche
Mortgages | Z - tranche
- aka accrual tranche
- last tranche to receive principal
- interest goes to paying off other tranches. Z-tranche balance increases (accrues)
- Z or Accrual bond
ABS | CDO debt includes:
- junk bonds
- MBS & ABS (structured)
- emerging mkt bonds
- corp loans made by commercial banks
- special situation loans
Mortgages | PAC tranche
• ‘planned amortization class’
• amorted based on sinking fund schedule
• initial PAC collar: prepay speed
• guaranteed lower PSA schedule
◎ min of 2 payment speeds
• PAC window: principal repay time
• a prepay collar
Mortgages | support tranche
- paired with a PAC tranche
- more guaranteed PAC >> more risky the support
- support takes excess or provides when too little
- if support is paid off then PAC no longer supported >> ‘busted’ PAC
Mortgages | effective collar
a PAC’s PSA range
Mortgages | PAC I and PAC II
• PAC I is normal PAC
• PAC II (aka scheduled tranche)
◎ support for PAC I
◎ also has a schedule
◎ higher prepay risk, but more prepay protection than support wo/schedule
Mortgages | why were CMO’s set up?
to redistribute contraction & extension risk
Mortgages | PAC I, PAC II, Support prepay risk
PAC I
PAC I
PAC I
PAC I
PAC II
PAC II
Support (no schedule)
Mortgages | pass through
the worst basic MBS with no bells or whistles
Mortgages | stripped MBS
- principal only (PO)
◎ prepay good - interest-only strips (IO)
◎ prepay pad
Mortgages | IO, PO, pass through: price volatility
price vol (PO,IO) > price vol (pass through)
Mortgages | 3 factors of agency underwriting standards
- max loan to value (LTV)
- payment to income
- loan amount
Mortgages | agency v non-agency CMO path
- agency: whole loan >> pass through >> CMO
- non-agency: whole loan >> whole loan CMO
Credit | treasuries used to create the theoretical spot rate curve
- all on the run
◎ most accurate priced issues
◎ large maturity gaps after 5 yrs - most on-the-run, some off
◎ reduces maturity gap
◎ repo mkt may distort prices - all treasuries
◎ includes all information - treasury strips (zero coupon)
◎ reduce maturity gap, rate = spot rate
◎ less liquid premium, diff taxes
Credit | par coupon curve
on-run-run yld curve
Credit | what does duration measure?
bond price sensitivity to parallel changes in interest rates
Credit | 3 factors that affect treasury securities returns
- changes in interest rate levels (90%)
- slope changes (8.5%)
- curvature changes (1.5%)
Volatility
- var = Σ (X1 - Xbar)^2 / T - 1
- sd = sqrt(var)
- Xt = ln(Yt / Yt-1)
- Xbar = avg yld from 1 > T and is optional
- *sqrt(time) to change time period (day > annual = *16)
Credit | what does bond yld volatility mean?
- if annual vol = .1 and yld = .08
- then 69% prob that yld will be .08 +- .008 a year from now
Bonds | 3 spread measures
- nominal yield: YTMbond - YTMgovt
- Z-spread
◎ spread at each spot rate so that CFpv = Po
◎ includes cost of imbedded option
◎ Z is constant across all spot rates
◎ exp: 104.12 = 8/(1+.04+Z) + 108/(1+.05+Z)… - OAS: spread once option cost is removed = Z - opt cost
Bonds | backward induction
- used to calc Po of bond
- start calcing at nodes N (end of tree) back node 0
Bonds | option value
- Pcall = Pnon-call bond - Pcall bond
- Pput = Pput bond - Pnon-put bond
Bonds | OAS
- aka option-adjusted spread
- rate that must be added to all of the non-option spot rates so that CFpv = Po
- rate that once added makes the binomial tree arbitrage free
- removes cost of embedded option
Credit | S&P’s debt service coverage
= (free op cash flow + interest) / (interest + annual principal repayment)
Credit | free operating cash flow
= FCFF - int(1- tr)
• does not add back in interest exp as does FCFF
Credit | operating cash flow
= CFO = NI + dep + decrease non-cash assets + increase non-cash debt +- non-cash charges
CF
= NI + dep +- other non-cash charges
• aka earning plus non-cash charges
• aka funds from operations (credit term)
Credit | financial ratios
- current (ST solvency)
- acid test (ST solvency)
- LT dept-cap (capitalization: financial leverage)
- total debt-cap (capitalization)
- EBIT - int (coverage)
- EBITDA - int (coverage)
• all ratios are better when higher
Asset Manager Code of Professional Conduct (AMCPC)
- loyalty to clients
- investment process and actions
- trading
- risk management, compliance, support
- performance & valuation
- disclosures
Asset Manager Ethics Responsibilities
- always act ethically & professionally
- acit in the best interest of the client
- act in an objective and independent manner
- perform actions using skill, competence and diligence
- communicate accurately with clients on a regular basis
- comply with legal and regulatory reqs regarding capital mkts
AMCPC | Loyalty to Clients policies (3B1 p 123)
- align incentives (no undue risk)
- client confidential info
- AML
- def of a token gift
AMCPC | Investment Process and Actions (3B1 p 124)
- never manipulate mkt prices
- deal fairly when doing ARA
- reasonable basis
- diff levels of service
- explainable strategies
- ability to cash out
- IPS
AMCPC | Trading (3B1 p 125)
- no insider trading
- priority of transactions
- soft dollars use
- best execution
- equitable share allocation
AMCPC | Risk management, Compliance, Support (3B1 p 125)
- Policies/procedures for AMCPC, SPC, regs, law
- firm-wide risk system
- compliance officer
- portfolio info is correct & reviewed by 3rd party
- record retention 7 yrs
- sufficient, qualified staff
- disaster recovery plan
AACPC | Performance & Valuation (3B1 p 126)
- see GIPS
- 3rd party valuations
AMCPC | Disclosure (3B1 p 127)
Absolutely EVERYTHING
3 Behavioral models
- Barnewall 2 way model
- Bailard, Biehl, Kaiser 5 way model
- Pompain model
Behavior models | Barnewall 2 way model
2 investor categories: active and passive
Behavior models | Bailard, Biehl, Kaiser 5 way model
• 2 investeror dimensions:
◎ confidence: confident (C) to anxious (A)
◎ method of action: careful (F) to impetuous (I)
• 5 investor categories:
◎ straigt arrow (middle)
◎ Individualist (CF)
◎ Adventurer (CI)
◎ Guardian (AF)
◎ Celebrity (AI)
Behavior models | Pompian model
• 4 step assesment
• 2 dimensions: risk tolerance / investment style
• 4 Behavior Investor Types (BITs):
◎ passive preserver
◎ friendly follower
◎ independent individualist
◎ active acumulator
Behavior models | Pompian model - 4 step assessment
- active/passive
- risk tolerance scale
- behaviorial biases
- classify investor in BITS
Behavior models | Pompian model - BITs
Behavior Investor Types: Risk tolerance (low > high) & Investment style (conservative > aggressive):
◎ Least: Passive preserver (emotional: bad)
◎ Moderate low: Friendly follower (cognative: good)
◎ Moderate high: Independent individualist (cognative: good)
◎ Most: Active accumulator (emotional: bad)
Behavior models | Pompian model biases - Passive preserver
- Emotional: endowment, loss aversion, status quo, regret aversion
- Cognative: mental accouting, anchoring and adjustment
Behavior models | Pompian model biases - Friendly follower
- Emotional: regret aversion
- Cognative: availability, hindsight, framing
Behavior models | Pompian model biases - Independent individualist
- Emotional: overconfidence, self-attribution
- Cognative: conservatism, availability, confirmation, representativeness
Behavior models | Pompian model biases - Active accumulator
- Emotional: overconfidence, self-control
- Cognative: illusion of control
Client / Adviser success measure
- Adviser understands long term financial goals of client
- Adviser maintains consistent approach with client
- Adviser acts as client expects
- Both client and advisor benefit
Analyst behavioral biases
- overconfidence
- way management presents information
- biased research
Analyst behavioral biases | self calibration
- Mitigate overconfidence
- accurately remembering forecasts and accurate self-evaluations
Analyst behavioral biases | Company management influence
- framing
- anchoring and adjustment
- availablity
Investment committee behavioral biases
- Often no better than individual
- All individual + social proof bias: person follows the group
- To counteract, need independence
Excess return anomolies that are not
- Excess return before, but not after expenses
- Excess return with too low associated risk
Behavioral bias | Disposition effect
more willing to sell winners than losers
Behavioral bias | Biases creating excess returns
- Momentum effect
◎ Herding - Bubble and crash: panic buying/selling
- Value vs Growth
◎ Halo effect
Behavioral bias | Biases that contribute to overconfidence
- illusion of knowledge
- self-attribution
- representativeness
- availability
- illusion of control
- hindsight
Behavioral bias | Methods to avoid bias
- seek counter evidence/opinions
- defined systematic decision process
- verifiable data
- correct framing
- documenting decisions
- bayes formula
Behavioral bias | Quantitative indication of bubbles/crashes
- Bubble: 2 std dev from mean price
- Crash: 30% drop in a few months
Behavioral bias | Bubble/Crash biases
- overconfidence
- confirmation
- self-attribution
- hindsight
- regret aversion
- disposition effect
Behavioral finance | macro vs micro
- macro: mkt deviaition from traditional finance theory
- micro: individuals’ decision making process deviation from traditional finance (REM: rational economic men)
Rational economic men (REM)
The rational actor assumption in traditional finance theory
Bayes formula
P(A|B) = P(B|A) * P(A) / P(B)
Behavioral finance | Utility theory
• Foundation of traditional finance theory
• diminishing marginal utility return
◎ >> concave risk averse utility function
◎ >> convex indifference curves
Behavioral finance | Satisfice
- sufficient satisfaction, but not optimal, are sufficient
- satis+ficent = satisfice
Behavioral finance | Decision theory
• associated with traditional finance theory • process of making optimal decision when decision maker is informed, math able, rational (REM)
Behavioral finance | Bounded rationality
- associated with behavioral finance theory
- Knowledge and cognative limitations of decision maker
- Satisfice
- More constrained that prospect theory
Behavioral finance | Prospect theory
- associated with behavioral finance theory
- similar to bounded theory
- risk aversion is replaced by loss aversion
- 2 phases: Editing phase, then Evaluation phase
Behavioral finance | Prospect theory : Editing phase
First three steps
- Codification: gain/loss & prob
- Combination: Combines similar outcomes
- Segregation: separation of risk-free and risky aspect of each outcome
Behavioral finance | Prospect theory: Evaluation phase
- assign weights and prob
◎ weights and prob are based on behavioral biases
◎ >>gains < losses, large prob < tail events - calc expected utility
IPS | Situational profiling and risk tolerance
- source of wealth
◎ active (entrepreneurial) vs passive (steady accum & inherit) - measure of wealth
◎ perceived wealth vs needs >> percieved risk tolerance - stage of life
◎ foundation, accumulation, maintenance, distribution
IPS | Situational profiling: Source of wealth
- Active: more risk tol, but possible business risk vs investment risk difference
- Passive: less risk tol
IPS | Situational profiling: Stage of life
- Foundation (mod risk)
- Accumulation (highest risk)
- Maintenance [retirement] (low-mod risk)
- Distribution: old wealthy giving to others (low - high risk)
Traditional finance assumes investors have 3 traits
- risk aversion: min risk; risk is volatility
- rational expectations: unbiased view of the world
- asset integration: all investments are correlated
Traditional vs Behavioral investor traits
- risk aversion vs loss aversion
- rational expectations vs biased expectiations
- asset integration vs ass segregation
IPS | 4 Personality types
- cautious: low risk, indecisive, difficult
- methodical: conservative, lots of data
- confident, decisive
- spontaneous: high portfolio turnover, chase fads, doubt self and others
IPS | for exam, IPS = O&C (objectives & constraint section of IPS)
*only front of card*
IPS | IPS benefits to clients
- id’s and documents objectives/constraints
- dynamic in response to changes w/client or mkt
- easy to understand
- education about self and investing
- understand manager’s actions
- transferable across managers
IPS | IPS benefits to manager
- knowledge of client
- guidance for investment decisions
- resolution of disputes (signed documentation)
IPS | RRTTLLU breakdown by O&C
- O: RR
- C: TTLLU
IPS | arrving at RRTTLLU
TTLLU >> risk >> return
IPS | SAA must conform to IPS
*only front of card*
IPS | RRTTLLU abbrev for notes in test
- return: rn
- risk: rs
- time horizon: tm
- taxes: tx
- liquidity: lq
- legal: ll
- unique: u
IPS | calcing returns with inflation
add inflation in initially so that you include the inflated numbers when calcing taxes
IPS | are residences included in investment calculations?
no
IPS | remember to watch for…
- pre vs after tax
- real vs nominal
IPS | Return objective: 2 categories
required vs desired return
IPS | Risk objective: 2 categories
- ability (time horizon, wealth & outflow) vs willingness to take risk
- always state conclusion
- if they differ, pick conservative choice
IPS | assessing clients’ preferences
look at actions as well as statements
IPS | 4 Risk objective factors
- time horizon
- critical goals/expenditures
- liquidity needs
- portfolios proportion of overall wealth
IPS | Time horizon constraint assessment
- state:
◎ number of stages
◎ each stage objective
◎ # yrs in each stage - other involved people (eg giving/receiving inheritance)
- multi-generational horizon
- retirement time horizon default: 20-25 yrs
IPS | 4 Tax constraint: tax types
- income
- capital gains
- wealth transfer
- personal property (eg car, house)
IPS | 4 Tax mitigation strategies
- Tax deferral (eg cap gain investment, loss harvesting, low turnover)
- Tax avoidance: tax free securities
- Tax reduction: investments with lower tax rates (eg cap gains vs income)
- Wealth transfer timing: (eg. no sales)
IPS | Complicated tax situation
state that tax situation is complex and manager should seek qualified tax advice
IPS | 5 Liquidity constraints
- ongoing, known expense (or in return jbj)
- emergnecy reserves (if requested)
- one-off, infrequent outflows (college falls under time horizon)
- one off positive inflows
- illiquid assets: restricted from sale, illiquid (eg house)(or in unique), large tax cost (or in unique or tax)
IPS | Legal: 2 common issues
- Trust: revocable vs irrevocable
- Family foundation
IPS | Legal: notes
- If no big legal issues state there are none beyond normal Code & Standards responsibilities
- manager must follow the trust document; weigh needs of different stakeholders
- mention other legal issues or lack of
- if complex issues, state manager will seek qualified expert advice
IPS | Unique constraints
- Special investment concerns (eg social)
- Special instructions (liquidate holdings)
- Restrictions on sales
- Forbidden asset / asset classes
- Assets outside of portfolio (eg. houses)
- Bequests
- Unattainable objectives
IPS | General notes
- State what is there and what is NOT there
- Complex issues, seek qualified expert
- Re-state all the facts
- point out conflicting factors
Strategic Asset Allocation (SAA)
is the mix of asset classes that will meet the IPS objectives and constraints
IPS & SAA | important return is pre or after tax?
after tax
SAA process
- eliminate portfolios that violate stated or appropriate constraints
- assess return to risk ranking
◎ sharpe ratio
◎ most often you will never need to get to this stage bc/only one portfolio remains
SAA portfolio elimination process
- excess/insufficient cash equivalents
- hold/fail to hold assets specified in constraints
- violates risk constraints
4.generate insuffient return (after-tax)
5.inappropriate asset classes or weightings (even if not specificed)
◎ 60 equity/40 bond&cash is default
◎ do not ignore home ownership >> too much real estate holdings
• address concentration issues (eg. low-basis inheritance, former employer stock)
IPS & SAA | monte carlo simulation pro/cons vs deterministic method
• Pros:
1. path dependency
2. better display of risk/return by providing multiple possible outcomes
3. better tax analysis
4. better display of short-term & long-term performance (eg more ST vol, but better LT return)
5. better analysis of multi-period effects
6. can look at different points in timeline (major decision/event points)
• Cons:
1. if simplistic model of returns is used
2. if generalized asset class returns are used rather than specific investments (w/costs)
3. if simplistic tax model is used
Taxes | 3 types of taxes
- income
- wealth: assets and asset transfers
- consumption: sales & VAT
Taxes | marginal tax rate
tax rate paid on the last dollar of income
Taxes | how US taxes work in regards to different tax rates over a single income
- every one pays same rate on 1st dollar
- each dollar after is taxed on whichever tax rate basket that dollar falls into
- for example: $20K income: first $8,350 is taxed at 10%, remaining is taxed at 15%
- the overall rate (avg tax rate) is the weighted average of the different rates * the amount taxed at that rate
Taxes | 2 most common tax regimes
#1: common progressive (progressive, light on all investment) #2: LIght capital gains tax (progressive, light on cap gains)
Taxes | accrual taxes
• paid periodically (eg annually)
Taxes | FVIF - accrual tax
FVIF = [1 + R*(1 - T)]^N
R = pre-tax return
◎ or FVIF = (1 + Rart)^N
T = tax rate
N = number of investment periods
• = after-tax value of each dollar invested
Taxes | accrual (annual) tax drag % is less/more than tax rate
more, due to effect on compounding
Taxes | tax drag
- gain lost to taxes
- stated as a dollar value or %
Taxes | FVIF - deferred tax
FVIF = [(1 - T) \* (1 + R)^N + T\*B] R = investment return N = # periods T = tax rate B = % of original investment ALREADY taxed
Taxes | Tax drag: deferred vs accrual
- accrual $ and % > deferred
- deferred is constant % of total gain (horizon and return do not affect it) and equal to tax rate
- accrual $ and % grow with return and horizon
Taxes | FVIF - wealth based
FVIF = [(1 + R) \* (1 - T)]^N R = investment return N = # periods T = tax rate
Taxes | wealth tax attributes
- tax drag > tax rate
- horizon increase >> greater $ and % tax drag
- return increase >> greater $ lower % tax drag
Taxes | accrual tax attributes
- tax drag > tax rate
- horizon or return increase >> greater $ and % tax drag
Taxes | deferred tax attributes
constant % tax drag regardless of horizon or return
• tax drag % = tax rate
Taxes | annual return after realized (cummulative) taxes sans deferred taxes
Rart = R(1 - Trealized) = R[1 - (PiTi + PdTd + PcgTcg)]
Pi, Pd, Pcg = % of gain attributed to interest, div, realized cap gains
Ti, Td, Tcg = tax rate on interest, div, realized cap gains
Taxes | Tax loss harvesting
- using investment loses ot offset investment gains
- main gain reducing tax bill in near term and those saving can be invested
Taxes | HIFO
- Highest In (basis), First Out
- allowed by some govts
- Also LIFO if you believe taxes will rise
Taxes | trading activity and taxes
usually the frequent trader falls under a higher tax rate, which leads to lower returns, especially over longer horizons and higher return rates
Taxes | year end sales
- if gain, wait until next year
- if loss, sell this year to harvest the loss
Taxes | Mean variance optimization
Optimizing portfolio allocation should be done on an after tax basis using equivalent after-tax returns and risk on an after tax basis
Taxes | effective unrealized cap gains tax rate adjusting for annual taxes
Tecg = Tcg*[1 - (Pi + Pd + Pcg)] / [1 - (PiTi + PdTd + PcgTcg)]
Taxes | FVIF - all taxes
FVIFt = (1 - Tecg) * (1 + Rart)^N + Tecg - (1-B)*Tcg
• Tecg = effective cap gains adj for annual taxes
• Rart = return after realized taxes
Taxes | accrual equivalent (after tax) return
Rae = (ending balance after all taxes / beginning balance)^N
N = number of periods
• as horizon or amount deferred increases Rae approaches pre-tax return
Taxes | accrual equivalent tax rate
Tae = 1 - (Rae / Rpre-tax)
Taxes | tax deferred account (TDA)
- pre-tax income
- entire balance when withdrawn
- FVIFtda = (1 + R)^N * (1 - Tfuture)
Taxes | tax-exempt account (TEA)
- not Tea (equivalent accrual tax rate)
- after-tax income
- no tax upon withdrawl
- FVIFtea = (1 + R)^N * (1 - Tnow)
Taxes | TDA vs TEA
- if Tfuture < Tnow, then TDA is better
- if Tfuture > Tnow, then TEA is better
- if Tfuture = Tnow, then no difference
- if $ amounts are restricted and equal then compare FV’s of each, but remember to include extra taxed $ for TDA
Taxes | FVIF
Future Value Interest Factor
Taxes | List of FVIF’s
- tax deferred acct
- tax exempt acct
- all taxes
- accrued annual tax
- wealth tax
- deferred cap gains
Taxes | FVIF - deferred capital gains
FVIFcgt = (1 - Tcg)*(1 + R)^N + Tcg * B
• Tcg = cap gains tax rate
• B = cost basis PERCENT
• R = annual return
Taxes | Taxes and investment risk (volatility)
after tax risk = stan dev * (1 - T)
• govt absorbs part of variability
• tax exempt accts (TDA & TEA): investor bears all risk
Taxes | asset location
type of acct asset is located (eg tax advantaged acct)
Taxes | tax alpha
value created by effective tax management
Taxes | Taxes and trading behavior
- Traders: high turn-over, ST cap gains >> bad
- Active investors: med-turn-over, LT cap gains >> so-so
- Passive investors: LT cap gains over many years >> good
- Exempt investors: hold assets in tax-exempt accts
Estate
Every thing a person owns
• financial
• real estate (aka immovable property)
• collections (eg art)
• businesses
• non-tangible (eg trademarks, patents
Estate planning
Planning of transfer of person’s estate to other during lifetime or at death
Will
- aka testament
- legal doc that states rights of others to person’s estate
Probate
• Legal process that takes place at death
• court determines
◎ will validity
◎ decedent’s property inventory
◎ claims against decedent
◎ distributes property according to will
Intestate
Dying without a valid will
Avoiding probate
• There are ways to avoid probate
◎ joint ownership w rights of survivorship
◎ living trusts
◎ retirement plans
◎ life insurance
Estate | gifts
- aka lifetime gratuitous transfer or inter vivos transfer
- given while living
- subject to gift taxes; who pays is up to govt law
Estate | wealth transfer methods
- gifts
- bequests
Estate | bequests
- testamentary gratuitous transfer
- given after death
- estate taxe (paid by grantor/transferor); inheritance tax (paid by recipient); who pays is up to govt law
- taxes can vary based on relationship to decedent
Roman law
civil law system based on old Roman law; top down system where laws are handed down from legislative body
English law
common law system; bottom up; judges create precedents that are applied in future cases
Estate | forced heirship
- children or spouse have a right to a portion of parent’s estate
- all assets are usually included
Estate | community property rights
- each spouse entitled to half of the estate earned during mariage
- gift and inheritence can be held separately
- part of forced heirship
Estate | separate property rights
- each spouse owns their property separately
- common in civil law countries
Human capital
- aka net employment
- PV of net employment income over lifetime
Individual balance sheet
- Assets: all tangible and intangible assets including human capital and any other future income
- Liabilities: all current and future liabilities incurred by living life plus any required reserve fund (Core capital)
- Equity is anything left over (Excess capital)
Core capital
equals liabilities on Individual Balance Sheet
• sum product of expected annual spending x prob of living that long
Excess capital
equals equity on Individual Balance Sheet
Mortality table
death table (fun)
• combined prob: prob either one is alive next year
• real annual spending: living exp for coming year
• exp real spending: real annual spending * combined prob
• present value:PV of real annual spending
• total: PV of core capital required to meeting exp THROUGH the given year (row)
• 0 prob to live past 100 in table
monte carlo simulation advantage
gives a distribution of outcomes vs just a mean
longevity risk
- risk of running out of money in retirement prior to death (ruin)
- generally, retiree should spend <= 3% of assets to have 95% confidence of not outliving assets
Estate | giver and givee terms before and after death
- before death: donor, recipient
- after death: testator, beneficiary
Estate | return and tax rate symbols
- Rg, Tig = investment return and annual tax rate of recipient
- Re, Tie = investment return and annual tax rate of giver
- Te = estate tax rate paid by the estate
- Tg = gift tax rate paid by either giver, receiver
Estate | relative value of gift / bequest
RV = FVgift / FVbequest ◎ = (1 - Tg)\*(1 + Rg\*(1 - Tig))^N / (1 - Te)\*(1 + Re\*(1 - Tie))^N F = future vale
Estate | relative value of gift when donor pays gift tax
- add in + Tg*Te due to reduced estate taxes
- RVg = (1 - Tg + Tg*Te)*(1 + Rg*(1 - Tig))^N / (1 - Te)*(1 + Re*(1 - Tie))^N
Estate | relative value: generation skipping
RV = 1 / 1 - T T = wealth transfer tax
Estate | calcing generation skipping
- calc excess above core capital requirements for giver and next generation
- give excess to third generaiton
