CFA Level 1 Flashcards
Describe Primary and Secondary source of liquidity
Primary sources of liquidity refer to funds that are readily accessible to a company at a relatively low cost. They can be held as cash or cash equivalents, and include:
* Cash available in bank accounts;
* Short-term funds, such as lines of credit and trade credit; and
* Cash flow management.
Secondary sources of liquidity include:
* Negotiating debt contracts to reduce the burdens of high- interest payments or principal repayment;
* Liquidating assets; and
* Filing for bankruptcy protection and reorganization.
Using secondary source of liquidity may impact a company’s financial and operating position.
How do you calculate Inventory Days on Hand?
Inventory Days on Hand = (Average Inventory for the Year / Cost of Goods Sold) X 365
What is Proprietary Trading?
Proprietary trading refers to a financial firm or commercial bank that invests for direct market gain rather than earning commission dollars by trading on behalf of clients.
Also known as “prop trading” and leverage is commonly used.
Should financing cost be included in NPV calc?
Not in discounting cash flows but in determining the WACC (discount rate)
What is project sequencing?
It is the evaluation and seleciton of capital projects wherein the finance manager decised whether or not to invest in a future proect based on the outcome of one or more currect projects. It is a timing option
How do you calculate Cash Conversion Cycle?
Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding
How do you calculate Days Sales Outstanding??
DSO = (Account Receivable/Total Credit Sales) * Number of Days in The Period
How do you calculate Days Payables Outstanding??
DPO = (Accounts Payable/Purchases) * Number of Days
OR
DPO = (Accounts Payable/COGS) * Number of Days
Is financing rollover risk greater for short or long-term obligations
Rollover risk is greater for short-term obligations. Short-term however is usually a cheaper source of financing.
Is financing cost included in calculating the operating break evenpoint (Q_OBE)?
No, but it is included in the (total) break evenpoint (Q_BE)
What is the formula for determing the price in which a margin call will be sent out?
Margin = Equity / Market vale =
[Initial deposit + (P - Initial Price)] / P
How does a limit buy order work?
The order gets filled at best price as long as the price is lower than the limit price
What is the disposition effect?
The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value.
Why is cumulative voting good for small shareholders?
Cumulative voting allows shareholders to direct their total voting rights to specific candidates, as opposed to having to allocate their voting rights evenly among all candidates.
Reasons to why a company must raise capital to ensure it can continue as a going concern:
Fulfill regulatory requirements (banks & capital adequacy ratios) or ensure debt covenants are met
Name the 5 stages in the industry life cycle model:
- Embryonic
- Growth
- Shakeout
- Mature
- Decline
When should you use 3-stage, 2-stage or 1-stage DDM?
1 stage is just the ordinary Gordon Growth Model
3 stage - for most public companies facing three stages, growth, transition and maturity
2 stage - for older companies that have already experienced the growth
1 stage - for really old mature companies
What is commonly found in synthethic CDOs?
Credit default swaps and other derivatives like options.
What is the relation between market liquidity risk and issuer size?
The less debt an issuer has outstanding, the less frequently it trades and the higher the market liquidity risk
Name two purposes of the derivatives market
Risk management and price discovery
Does private equity invest more in startups or established cash-generating companies?
The majority of private equity involves LBOs of established profitable and cash-generating companies with solid customer bases, proven products and high quality management.
What is committed capital in Private Equity?
It is the total funds promised by investors to private equity funds. This is also what the management fee is based on.
Do you get indirect equity exposure to real estate via Commercial MBS?
No, since in Commercial MBS you get exposure to indirect debt investment opportunities. In Real Estate Investment Truts, you get indirect exposure.
What are the three stages one can invest in alternative investments? You generally start with the first “f”…
First fund investing, the co-investing and finally direct investing. The due diligence and knowledge needed grows in each of these steps.
With co-investing, an investor contributes to a pool of investment funds (as with fund investing) but also has the right to invest directly alongside the fund manager in the assets in which the manager invests. So you do fund investing to some degree
What is the slope of the Security Market Line?
The slope is the Market Risk Premium. SML is a graphical representation of CAPM so Beta is the X-axis and the expected return is the Y-axis. The intercept is the risk free weight.
How can you handle cognitive errors?
By obtaining better information, education and advice
How can you handle emotional biases?
You can’t. You can only acknowledge their presence and adapt to it.
What is portfolio risk budgeting?
It allocates the total risk tolerance (based on 1 or many risks) to different components. This hopefully leads to investments in assets with the highest returns per unit of risk
Describe the three degrees of price discrimination
- First degree (or perfect price discrimination), each consumer is charged the maximum he is willing to pay
- Prices varies across different units sold. Quantity discounts on bulk purchases
- Prices varies across different consumer groups. Discounts for students and seniors, this is the most common price discrimination.
What is the neutral rate in monetary policy?
Neutral rate = trend growth + inflation target
If the central bank’s policy rate is below the neutral rate, then it is expansionary. If above contractionary and if equal then it is neutral.
What is the basic formula for GDP?
GDP = C + I + G + (X-M)
C = Consumer spending
I = Gross Private Domestic Investment
G = Goverment expenditures on finished goods and services
X = Exports
M = Imports
What is the basic formula for Savings? (Economics)
S = I + (G-T) + (X-M)
What is meant by that the balance sheet is “classified”?
The statement distinguish on non-current vs current assets and liabilities
What is the formula for debt-to-capital ratio?
debt-to-capital = Total Debt / (Total Debt + Shareholder’s Equity)
Formula for Financial Leverage
Financial Leverage = Average Total Assets / Average Shareholder’s Equity
What is own-price elasticity?
It is the ratio of the percentage change in demand for a percentage change in price. If abs(elasticity) > 1 then it is elastic, small price changes have big impact on demand
How does substitutes goods impact own-price elasticity?
Many and good substitutes makes the demand very elastic. If there are no substitutes you demand is inelastic, you will pay much more since you have no alternative.
What is income elasticity of demand?
It is the ratio of percentage change in demand to the percentage change of income
What is the difference between normal goods and inferior goods?
- Normal goods have positive income elasticity => an increase in income increases demand
- Inferior goods have negative income elasticity => an increase in income decreases demand. Like instant noodles, bought by poor students but not by rich people.
Contrast complements and substitutes (cross price elasticity)
- Substitutes have positive cross price elasticity. If you increase the price of good X the demand of price Y will go up. People buy Y instead of X.
- Complements have negative cross price elasticity. If you increase the price of good X, the demand of good Y will decrease. Think like gasoline cars and gas, if the price of gas goes up, people will buy less gasoline cars and more electic car instead
What is a veblen good?
It is a good for which a higher price makes the good desirable. I.e., Gucci bag. The higher price means status. The price elasticity is positive, the higher price the higher quantity (up to a limit of course)
What is the GDP deflator?
The GDP deflator is a price index that can be used to convert nominal GDP into real GDP, taking out the effects of changes in the overall price level.
GDP deflator = Nominal GDP_t / Real GDP_t
Where Real GDP_t uses the prices as of the base year but the production as of year t
What is the Capital Consumption Allowance CCA?
A captail consumption allowance (CCA) measures the depreciation of physical capital from the production of goods and services over a period. CCA can be thought of as the amount that would have to be reinvested to maintain the productivity of physical capital from one period to the next. It is used in calculating GDP:
GDP = National Income + CCA + statistical discrepancy
What does the Aggregate Demand curve (AD) illustrate?
The AD curve illustrate the negative relationship between the price level and the level of real output demanded by consumers, businesses, and government.
What are the three effects that explains the negative slope of the AD Curve?
- The wealth effect
- The interest rate effect
- The real exchange rate effect
When plotting the AD Curve, AD is on the x-axis and price level on the y-axis
Explain the wealth effect (AD Curve)
A decrease in the price level increases the purchasing power of existing nominal wealth so that consumers will demand more goods and services.
Explain the interest rate effect (AD curve)
The interest rate effect refers to the changes that occur in behaviors such as spending and borrowing after a change in the interest rate.
When the interest rate decreases, individuals and businesses well generally borrow more money and invest and spend, increasing the AD. And vice versa. If price level goes up interest rates will go up to combat inflation and then AD will go down.
Explain the real exchange rate effect (AD Curve)
When the domestic price level increases, the real price increases for foreigners which reduces demand for export. So (X-M) will become lower and hence the Y (AD Curve) will also decrease. Y = C + I + G + (X-M)
What does the Aggregate supply curve (AS curve) describe?
The aggregate supply (AS) curve describes the relationship between the price level and the quantity of real GDP supplied, when all other factors are kept constant. That is, it represents the amount of output that firms will produce at different price levels.
What is the VRAS, very short aggregate supply curve?
It is the AS curve in the very short run. It is horizontal since firms will adjust its output without changing price by adjusting labor hours and intensity of use of plant and equipment,
What is the SRAS (short-run aggregate supply curve?
When output prices increase, the price level increases, but firms see no change in input prices in the short run. Firms respond by increasing output in anticipation of greater profits from higher output prices. The result is an upward-sloping SRAS curve. So the higher output prices, the higher output.
What is the Long-run aggregate supply curve?
All input costs can vary in the long run, and the LRAS curve in is perfectly inelastic (it is vertical, no change in price level will impact the output). In the long run, wages and other input prices change proportionally to the price level, so the price level has no long-run effect on aggregate supply. We refer to this level of output as potential GDP or full-employment GDP.
Name some factors that can cause the AD curve to shift to the right
GDP = C + I + G + (X-M)
* Increased consumer spending
* Increased business expectations (invest more)
* Expansionary monetary policy / expansionary fiscal policy (increase G)
Name some factors that can cause the SRAS curve to shift to the right
- Labor productivity
- Lower input prices
- Taxes and government subsidies
Name some factors that can cause the LRAS curve to shift to the right
- Increase in supply and the quality of labor
- Increase in the supply of natural resources
- Technology
Describe the three categories of unemployment
- Frictional unemployment, when you quit to seek new opportunities. It always exist
- Structural unemployment, it is caused by long-run changes in the economy that eliminate some jobs while generating other type of jobs for which the unemployed workers are not qualified.
- Cyclical unemployment is caused by changes in the general level of economic activity
Structural and frictional unemployment is always present
How do you calculate the unemployment rate?
Unemployment rate = Number of people unemployed / labor force
Labor force is the sum of unemployed + employed. Those who are voluntarily unemployed are not part of labor force
What is underemployed?
It is a person who is employed part-time but wants a full-time position or being stuck at ICA with an engineering degree. IT IS NOT UNEMPLOYED!
What is the participation ratio?
Participation ratio = labor force / working age population
Why is unemployment rate a lagging indicator?
Early in an expansion when hiring prospects begin to improve, the number of discouraged workers who re-enter the labor force is greater than the number who are hired immediately.
What is the Laspeyres index?
It is the price index with constant (old) basket of goods and services
Laspeyers -> Paasche -> Fischer
What is the Paasches index?
It is the price index that uses the current consumption weights.
Laspeyers -> Paasche -> Fischer
What is the Fischer index?
It is the price index that is the geometric mean of Laspeyers and Paasche index.
Laspeyers -> Paasche -> Fischer
What is cost push inflation?
Inflation can result from an initial decrease in aggregate supply caused by an increase in the real price of an important factor of production, such as wages or energy. Cost-Push Inflation is when e.g. wages increase so that the supply decreases which causes the price level to increase.
What is demand-pull inflation?
Demand-pull inflation can result from an increase in the money supply, increased government spending or any other change that increases aggregate demand. In demand-pull inflation the economy is already at full-employment equilibrium so when the demand increases, the GDP will increase to an unsustainable level. Unemployment falls bnelow its natural rate and put upward pressure on real wages which reduces SRAS and a new equlibrium is found at a higher price level
What is demand-pull inflation?
Demand-pull inflation can result from an increase in the money supply, increased government spending or any other change that increases aggregate demand. In demand-pull inflation the economy is already at full-employment equilibrium so when the demand increases, the GDP will increase to an unsustainable level. Unemployment falls bnelow its natural rate and put upward pressure on real wages which reduces SRAS and a new equlibrium is found at a higher price level
What is GDP? How does it compare to GNP?
- GDP = The total value of goods and services produced within a country’s borders
- GNP = The total value of goods and services produced by the labor and capital of a country’s citizen (regardless where they produce it, Canada, US, doesn’t matter)
What means with absolute advantage?
A country has an absolute advantage if it can produce a good at a lower resource cost than the other country.
What means with comparative advantage? (Global trade)
A country has comparative advantage if it the opportunity cost for producing a good is lower than the other countries.
By specilization the total output among to countries can increase!
What are the BOP (Balance of payments)
It includes the current account, which mainly measures the flows of goods and services; the capital account, which consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets; and the financial account, which records investment flows.
What is the current account (BOP and trade)
The current account focus on the flow of goods and services. Like raw materials, manufactured goods and services like transportation.
What is the capital account (BOP and trade)
The capital account includes financial assets. It measures the net change of assets and liabilities during a particular year.
It includes purcases of rights to natural resources.
What is the financial account (BOP and trade)
It include gold, foreing currencies. For a country with a trade deficit, it must be balanced by a net surplus in the capital and financial accounts.
Contrast Other Comprehensive Income and Comprehensive Income
Comprehensive Income incldues all items that impact owners’ equity. Some of these items are included in the calculation of Net Income and some in “Other Comprehensive Income”. When comprehensive income is presented in two statements, the statement
of comprehensive income begins with the profit or loss from the income statement and then presents the components of OCI.
Name four common items treated as Other Comprehensive Income
- Foreign currency translation adjustments (translating subsidaries’ balance sheet assets and liabilities at current exchange rates)
- Unrealized gains or losses on derivatives for hedges
- Unrealized holding gains and losses on available-for-sale securities (US GAAP)
- Certain costs of a company’s defined benefit post-retirement plans
What are the two options of denominator in construction a common-sized cash flow statement?
- The first approach is to express each line item of cash inflow (outflow) as a percentage of total inflows (outflows) of cash
- The second approach is to express
each line item as a percentage of net revenue.
What is free cash flow?
Free cash flow is the excess of operational cash flow over capital expenditures
What is Free Cash Flow to the Firm? FCFF
FCFF is the cash flow available to the firm’s supplier of debt and equity capital
FCFF = NI + NCC + Int(1-Tax rate) - FCInv - WCInv
FCFF = CFO + Int(1-Tax rate) - FCInv
We need to add back the interest paid since that belongs to debt supplie
CFO = NI + NCC - WCInv where WCInv is working capital expenditures
What is Free Cash Flow to Equity (FCFE?)
FCFE is the cash available to the company’s common shareholders
FCFE = CFO - FCInv - Net debt repayment
US GAAP
dividends payed is financing
the rest is operating
US GAAP cash flow classification, which item is not classified as operating?
Dividens paid is a financing activity
Interest received, interest paid, dividends received and taxes paid are all operation
IFRS - How do you classify cash flows such as interest received, interst paid, dividends received and dividends paid?
- Financing: Dividends paid & Interest paid
- Investing: Interest received & Dividends received
All four can also be operating. IFRS allows for more flexibility
What is the 2 stage DuPont-formula?
RoE = RoA * Financial Leverage
(Net Income / Assets) * Assets / (Equity)
What is the 3-stage DuPont-formula?
RoE =
Net profit margin * Total asset turnover * Financial leverage =
Net Income / Sales * Sales / Assets * Assets / Equity
Which item do you split from 1 to 3 items in the Dupont Formula?
Net profit margin = Net Income / Sales
= (Net Income / EBT) * (EBT / EBIT) * (EBIT / Sales)
Tax burden * Interest Burden * EBIT margin (operating profit margin
Tax & Interest burden is the lower the quotient, the higher burden
In times of inflation, which inventory method gives larger profit, FIFO or LIFO?
In inflationary environment, FIFO will give higher gross profit. COGS for LIFO will be higher and hence result in lower gross profit
Explain the LIFO reserve?
The LIFO reserve is the amount by which LIFO inventory is less than FIFO inventory. The LIFO reserve will increase when prices are rising and inventory quantities are stable or increasing.
How can the LIFO reserve decrease? (LIFO liquidation)
If a firm is liquidating its inventory, or if prices are falling, the LIFO reserve will decline.
Management could use a LIFO liquidation (draw down inventory) to artificially inflate current period earnings
LIFO liquidation is a decrease in the quantity of inventory
How is the value of the inventory reported on the balance sheet?
In IFRS and US GAAP (except for LIFO ) the investory is reported on the balance sheet at the lower of cost or net realizable value (NRV)
NRV is expected sales price - cost of selling
LIFO is the lowest of cost or market (replacement cost)
What happens if the Net Realizable value is lower than whats reported on the balance sheet (inventories)?
IFRSThe inventory is written down to the Net Realizable Value and the loss is recognized on the income statement.
If the value increases, the values can be written up by reducing COGS in the income statement. Inventory can never be written up more than what was previously done.
US GAAP - No write-up is allowed under US GAAP.
This doesn’t apply for LIFO in US GAAP
What is the quick ratio?
Quick ratio = (Cash + Short-term marketable securities + receivables) / current liabilities
The quick ratio is one ratio to assess a company’s liquidity position
What is the cash ratio?
Cash ratio = (Cash + Short-term marketable securities) / current liabilities
The cash ratio is one ratio to assess a company’s liquidity position
What is the current ratio?
Current ratio = current assets / current liabilities
The Current ratio is one ratio to assess a company’s liquidity position
How do you determine if an long-lived asset is impaired in IFRS?
An asset is impaired if:
carrying value > recoverable amount
Recoverable amount = max(fair value less cost to sell, value in use)
where value in use is the present value of future cash flows. The loss is then carrying value - recoverable amount
Assets must be tested for impairment anually. Fair value is market price
How do you determine if an long-lived asset is impaired in US GAAP?
Determining (1) and calculating (2) is different in US GAAP
- carrying value > undiscounted cash flow
- carrying value - fair value (or pv of cash flows)
Assets must only be tested for impairment if it is likely
Are you allowed to capitalize interest?
Yes, when a firm constructs an asset the interest that accrues during the construction period is capitalized and then part of the depreciation the following years.
The treatment is similar under IFRS and US GAAP
Under IFRS, can you capitalize reserach and/or development costs?
In IFRS, you are allowed to capitalize development costs, but not reseach costs.
A firm must show that it can complete the asset.
Under US GAAP, can you capitalize research and/or development costs?
Under US GAAP, research and development costs are generally expensed as incurred. For software that you intend to sell, you can capitalize development costs when you can show technological feasibility.
A firm must show that it can complete the asset.
When is a deferred tax liability created?
When the income tax expense is greater than taxes payable due to temporary differences
E.g., accelerated depreciation is used on calculating tax return
How do you reconcile Income tax expense, change in DTL and tax payable?
DTL = Deferred tax liability
Income tax expense = change in DTL + taxes payable
For DTA it is -change in DTA. So if DTA increase income tax is lower
How does MM Proposition 1 with taxes look like?
The formula
V_Lev = V_unlev + tD
Value levered = Value unlevered + marginal tax rate * debt debtTaxshield
What does MM Proposition 2 with taxes say?
The cost of equity is a linear function of the company’s debt-to-equity
ratio with an adjustment for the tax rate
What is degree of operation leverage? DOL
DOL = % change in operating income / % change in units sold
DOL = Q(P-V) / (Q(P-V) - F)
Q(P-V) is the contribution margin
DOL is different depending on the numbers of units produced
What is degree of financial leverage? DFL
DFL = % change in net income / % change in operating income
DFL = [Q(P-V) - F] / [Q(P-V) - F - C]
C is fixed financing cost
What is degree of total leverage? DTL
DTL = % change in net income / % change in units sold
DTL = DOL * DFL
DTL = Q(P-V) / [Q(P-V) - F - C]
What is a market order?
A market order instructs the broker to execute the trade immediately at the best possible price
What is a limit order?
A limit order places a minimum execution price on sell orders and a maximum execution price on buy orders. For example, a buy order with a limit of $6 will be executed immediately as long as the shares can be purchased for $6 or less.
What is a stop order?
They are not executed unless the stop price has been met
What is a stop-sell order at 45?
If the market price goes below 45, then the shares will be sold
What are depository receipts? DRs
**Depository receipts **(DRs) represent ownership in a foreign firm and are traded in the markets of other countries in local market currencies. A bank deposits shares of the foreign firm and then issues receipts representing ownership of a specific number of the foreign shares.
The depository bank acts as a custodian and manages dividends, stock splits, and other events.
What distuingish sponsored Deposit Receipts to unsponsored?
If the firm is involved with the issue, the depository receipt is a sponsored DR; otherwise, it is an unsponsored Depository Recipt.
What are Global Depository Receipts?
Global depository receipts (GDRs) are issued outside the United States and the issuer’s home country
Most GDRs are traded on the London and Luxembourg exchangesUSD is common
What are American Depository Receipts?
American depository receipts (ADRs) are denominated in U.S. dollars and trade in the United States.
What is committed capital
Committed capital (e.g., for
private equity funds) is how much money in total that LPs have committed to the fund’s future investments. Management fees are based on committed capital in PE.
LP stands for limited partners who are the investors.
Define each stage in the industry life-cycle model
- Embryonic - high prices, high risk
- Growth, rapidly increasing demand, low
- Shakeout, slowing growth, intense competition
- Mature, little or no growth, industry consolidation
- Decline, negative grotwh, excess capacity
Name some internal credit enhancements?
- Overcollateralization (collateral value greater than the par value)
- Cash reserve fund - money set aside to make up for credit losses
- Excess spread account, the yield promised on the bonds are lower than the promised yield on the assets supporting the ABS.
- Tranches with different seniority of claims
Name som external credit enhancements?
- Surety bonds, issued by insurance companies to make up any shortfall
- Bank guarantees, serve the same purpose
- Letters of credit from financial institutions, a promise to lend money to the issuing entity if it does not have enough cash
If the semi-annual BEY is 7%, what is the annual Bond Equivalent yield?
Bond equivalent yield is just 14%. So it disregards the compounding. So the Bond Equivalent Yield for a semi-annual pay bond is less than the real annual return from holding the bond till maturity since (1+2x) < (1+x)^2
EAR takes compounding into account, that doesn’t BEY do
What is a forward rate and a forward yield curve?
A forward rate shows the yield for future periods. E.g, the rate of interest on a 1-year loan that would be made two years from now is a forward rate. A forward yield curve shows the future rates for bonds or money market securities for the same maturities for annual periods in the future.
(1 + S3)^3 = (1 + S1)(1 + 1y1y)(1 + 2y1y)
What is a 3-year spot rate?
The 3-year spot rate is the YTM for a zero-coupon bond that matures in three years. So:
(1 + S3)^3 = (1 + S1)(1 + 1y1y)(1 + 2y1y)
You will earn that YTM for the next three years
What is a 3-year spot rate?
The 3-year spot rate is the YTM for a zero-coupon bond that matures in three years. So:
What is a Forward Rate Agreement? FRA?
A forward rate agreement (FRA) is a derivative contract that has a future interest rate, rather than an asset, as its underlying. The point of entering into an FRA is to lock in a certain interest rate for borrowing or lending at some future date
The long pays the fixed rate and the short the floating rate
What is the weak-form efficient market hypothesis?
In the weak-form efficient market hypothesis, security prices fully reflect all past market data
What is the semi-strong form of the efficient market hypothesis?
In a semi-strong-form efficient market, prices reflect all publicly known and available information, including historic market prices.
What is the strong form of the efficient market hypothesis?
In a strong-form efficient market, security prices fully reflect both public and private information. A market that is strong-form efficient is, by definition, also semi-strong- and weak-form efficient.
What is a G-spread?
A G-spread is the yield over a government bond. Should be the same maturity
What are I-spreads?
An alternative to using government bond yields (G-spread) as benchmarks is to use rates for interest rate swaps in the same currency and with the same tenor as a bond. Yield spreads relative to swap rates are known as interpolated spreads or I-spreads. I-spreads are frequently stated for bonds denominated in euros.
What is one disadvantage with the G- and I-spreads?
The G and I-spreads assume that the spot yield curve is flat. One can fix this with the zero-volatility spread or Z-spread.
What is the Z-spread?
Z-spread = Zero volatility spread
The Z-spread is the constant add-on to each benchmark spot rate that if used in discounting would equal the market price of the bond. It is the appropriate yield curve spread.
What is the option-adjusted spread?
OAS = option-adjusted spread
An option-adjusted spread (OAS) is used for bonds with embedded options. The OAS is the spread to the government spot rate curve that the bond would have if it were option-free. IT IS ADJUSTED FOR THE OPTION
Hence, option value = Z-spread - OAS
What is the relation between OAS, Z-spread and option value?
Option value = Z-spread - OAS
Describe call markets and continuous trading markets
- In a call market, trades can be arranged only when the market is called at a particular time and place. I a call market, one price clears the market for the stock.
- In contrast in a continuous trading market, trades can be arranged and executed anytime the market is open.
Describe the three types of market structures (execution mechanisms)
- In quotedriven markets, customers trade with dealers (very common for bonds, OTC markets)
- In order-driven markets, an order matching system run by an exchange, a broker, or an alternative trading system uses rules to arrange trades. Often trades with complete strangers.
- In brokered markets, brokers arrange trades
between their customers (real estate, large blocks of stocks, tänk ECM SEB)
Contrast Ordinal and Nominal data
Both Ordinal and Nominal are categorical data.
1. Ordinal -> the categories can be logically ordered, like credit ratings
2. Nominal -> cannot be organised in a logical order, like different sectors (energy vs utilities).
What relationship exist with Beta and use of leverage?
For a given set of projects, the greater a firm’s reliance on debt financing, the greater its equity beta
How do you estimate Beta of a company given a Beta of another comparable company?
- We adjust the beta from a comparable company (or group of companies) for its leverage and tax rate. We unlever it to get asset beta
- We adjust the comparable company’s asset beta (re-lever it) based on the financial leverage and the marginal tax rate of the target company.
So unlever - then relever
What is the formula to get the unlevered beta (asset beta)?
Beta_asset = Beta_equity x [1 / (1 + [1-t]D/E)]
So the higher D/E or Tax rate, the lower will the unlevered Beta be.
Asset beta = unlevered, equity beta = levered
What is the formula to get the levered beta (equity beta)?
equity beta=asset beta
* [1 + (1-t) x D/E]
What is the formula and interpretation of the market Beta?
Beta = cov(Rp, Ra) / var(Rp) where Ra is the return on the asset and Rp is the return on the market portfolio. A company having a Beta of 1.2 implies that if stock market increases by 10% the company’s share price will increase by 12%
What is a fiduciary call?
A fiduciary call is what is on the right side of the put-call-parity. It is c + X / (1+Rf)^t.
What is a protective put?
A protective put is a share of stock together with a put option on the stock.
What is the put-call-parity?
c + X / (1 + Rf)^T = S + p
It is based on the payoffs of two portfolio combinations: a fiduciary call and a protective put.
What is the put-call-forward parity?
Put-call-forward parity is derived with a forward contract rather than the underlying asset itself. We subsite F0 / (1+Rf)^t for S in the original put-call-parity.
F0 / (1 + Rf)^T + p0 = c0 + X / (1 + Rf)^T
What are the money’s three primary functions?
- Unit of account (you express prices in omney)
- You can use it to store value over time
- It serves as a medium of exchange, you can buy stuff with it
Economic output can be stated as a production function Y = A x f(L,K), what is A, L and K?
Y = A x f(L,K)
1. A is the total factor productivity (change in technology)
2. L is the labor size
3. K is the amount of capital available
What does solow’s growth model (neoclassical model) say?
growth in potential GDP = …
growth in potential GDP = growth in technology + W-L (growth in labor) + W-C(growth in capital)
W-L are and W-C are the labor’s share of national income and capital’s percentage of national income
growth potential GDP=growth in labor force+growth in labor productivity
What is the peak in a business cycle most likely associated with?
The peak phase of a business cycle represents the highest level of economic output (real GDP) reached during that cycle. Inflation pressure that built during the expansion may continue into the early part of the contraction that follows the peak. Employment declines first after the peak, it is a lagging indicator.
Is the LRAS elastic?
LRAS = Long-run aggreate supply curve
No, the LRAS is perfectly inleastic, it is vertical. Because in the long run input prices change in proportion to the price level, so even if the price level goes up, the input prices will also raise and the supply will be thesame.
x is ouput, y is price. LRAS reflect the potential GDP.
What can cause the LRAS-curve to shift?
Items that can move the LRAS to the right (incresed output) include:
1. Increased supply of labor
2. Better technolology (can also move SRAS to the right)
3. Natural resources
How does the term “credit cycles” refer to? And are they longer or shorter than business cycles?
The term “credit cycle” refers to cyclical fluctuations in interest rates and credit availability. Credit cycles tend to be longer than business cycles and they can cause asset price bubbles if the credit availability is too high
Will any firm maximiize profit at MR = MC?
Yes, maximimzing profit at MR = MC is applicable for all firms!
What is the Fischer effect?
The Fischer effect says that:
nominal interest rate = real interest rate + expected inflation
It states that in an economy, the real interest rate is stable and that changes in nominal interest rates result from changes in expected inflation.
What does The Quantity Theory of Money state?
M x V = P x Y
M is the quantity of money
V is the velocity of circulation of money in the economy
P is the price level
Y is the real output
Thus, the amount of money used to purchase goods and services in an economy, M × V, is equal to the money value of this output, P × Y.
If you increase the money supply, while velocity and output are constant, all you’re doing is creating inflation (or increasing P).
What are price takers and price searchers?
In the theory of the firm, price searchers are those firms that set their own selling price, such as a monopoly firm. A price taker, on the other hand, is a firm that takes the price as it is set by the market forces of demand and supply.
How can you express the current account deficit?
As X-M and use in the formula:
S = I + (G - T) + (X - M)
What probability rule do you use to calculate the unconditional probability?
You can use the total probability rule to calculate the unconditional probability:
P(A) = P(A|S) + P(A|S^C) where S and S^C are mutually exclusive and exhaustive.
What is the multiplication rule of probability?
P(AB) = P(A|B) * P(B)
The probability that both events will occur
What is the addition rule of probability?
P(A or B) = P(A) + P(B) - P(AB)
The probability that at least one of the two events will occur.
What is Bayes’ formula?
Start with P(AB) = P(BA) and then use the multiplication rule of probability:
P(A) * P(A|B) = P(B) * P(B|A)
and
P(A) = P(B) * P(B|A) / P(A|B)
What is the definition of marketable securities?
Marketable securities are securities that can easily be sold.
How do you calculate the double-declining balance depreciation?
You apply two times the straight-line rate, so if the asset’s life is 10 years, then you assume 1/10+ * 2 depreciation rate. And you also do not take the residual value into account, but rather just stop when residual value has been reached.
DDB depreciation = (2 / useful life) * (cost - accumulated depreciation)
Do you capitalize shipping and installation costs?
All costs incurred until an asset is ready for use must be capitalized, including the invoice price, applicable sales tax, freight and insurance costs incurred delivering equipment, and any installation costs
Cmpanies generally must capitalise interest costs associated with
acquiring or constructing an asset that requires a long period of time to get ready for ts intended use
How do you calculate the stocks variance if you have probability distribution?
variance = p1 * (R1- Rmean)^2 + p2 * (R2- RMean)^2 + p3 * (R3- Rmean)^2
What does revenue recognition say about reversal of revenue recognize?
Revenue recognition standards require that firm conclude that they will not have to reverse any cumulative revenue recognized. So if it is likely they will receive a bonus in a project, likely is not enough, they have to be certain!
What are goverment program’s automatic stabilizers?
They tend to change the government budget deficit in an opposite direction to economic growth. For xample, during a recession, tax receipts will fall, and government expenditures on unemployment insurance payments will increase. They do not require any vote from legislators.
If p is the probability that an event occurs, then the odds for that even occurring is expressed as …
odds = p / (1-p)
so if p is small, then odds will also be small. If the probability is 1 / 8, then the odds is (1 / 8) / (7 / 8) = 1 / 7, the odds is one-to-seven.
What kind of indicator is:
1. Real personal income
2. Unemployment rate
3. Building permits
- Real personal income is a coincident indicator with turning points that tend to coincide with business cycle turning points.
- The unemployment rate is a lagging indicator, here suggesting an expansion has been underway for some time. (previously discouraged workers enter the workforce)
- Building permits are a leading indicator because builders may seek permits in anticipation of an economic expansion that has not begun yet.
Will profit be the same if the firm uses periodic or perpetual inventory system and FIFO? How about LIFO?
For a firm using FIFO, gross profit is the same whether the firm uses a periodic or perpetual inventory system. For a firm using LIFO or average cost, gross profit can be different depending on the choice of inventory system.
What is a periodic inventory system?
In a periodic inventory system, inventory values and COGS are determined at the end of the accounting period. No detailed records of inventory are maintained.
FIFO COGS and ending inventory are the same whether a perpetual or periodic system is used.
What is a perpetual inventory system?
In a perpetual inventory system, inventory values and COGS are updated continuously. Inventory purchased and sold is recorded directly in inventory when the transactions occur.
What is the difference between permutation and combination?
Permutation is used if ordering matters, so it will be larger. In combination, the order doesn’t matter:
Permutation = n! / k!
Combination = n! / (k! * (n-k)!)
What is stratified random sampling?
Stratified random sampling uses a classification system to separate the population into smaller groups based on one or more distinguishing characteristics. So each strata is sampled from!
What is cluster sampling?
Cluster sampling is also based on subsets of a population, but in this case we are assuming that each subset (cluster) is representative of the overall population with respect to the item we are sampling. So we do not need to sample from all clusters (as we do in stratified random sampling)
What are the four phases in a business cycle?
- Expansion (real GDP is increasing)
- Peak (real GDP stops increasing and starts decreasing)
- Contraction, real GDP is decreasing
- Trough, real GDP stops decreasing and begins increasing
Why is inventorys an important business cycle indicator?
Firms try to keep enough inventory on hand to meet sales demand but do not want to keep too much of their capital tied up in inventory. As a result, the ratio of inventory to sales in many industries trends toward a normal level in times of steady economic growth.
What does the inventory-sales ratio about the different business cycles?
- Peak -> sales growth begins to slow and unsold inventories accumulate, the quotient increase
- Trough -> sales growth starts to increase and inventory doesn’t catch up so quotient decrease then firms will start producing inventories so the quotient reaches its normal level
What does the inventory-sales ratio about the different business cycles?
- Peak -> sales growth begins to slow and unsold inventories accumulate, the quotient increase
- Trough -> sales growth starts to increase and inventory doesn’t catch up so quotient decrease then firms will start producing inventories so the quotient reaches its normal level
Which is the correct test statistic for a test of the null hypothesis that a population variance is equal to a chosen value?
This is a test of the value of a single variance and is based on a test statistic with a performed via the chi-square distribution.
Chi-square assumes that the population is normally distributed. (so does F-statistic)
F-test is for testing equality of variances from two populations
Which is the correct test statistic for a test of the equaility of the variances of two normally distribtued populations?
The hypotheses concerned with the equality of the variances of two populations are tested with an F-distributed test statistic.
Chi-square is used for 1 variance (population variance)
Which is the correct test statistic for a test of the equaility of the variances of two normally distribtued populations?
The hypotheses concerned with the equality of the variances of two populations are tested with an F-distributed test statistic.
Chi-square is used for 1 variance (population variance)
What is factoring?
Factoring refers to the sale of receivables without recourse; that is, the risk that the firm’s customers will not pay, or will not pay in a timely manner, is borne by the factor, who purchases the receivables.
One company sells its receivables to another company. The other company nows bears the risk of the customers not paying.
What are flotation costs?
Flotation costs are the fees charged by investment bankers when a company raises external equity capital. Flotation costs can be substantial and often amount to between 2% and 7% of the total amount of equity capital raised, depending on the type of offering.
Flotation costs are a cash outflow that occurs at the initiation of a project and affect the project NPV by increasing the initial cash outflow.
What kind of return does CAPM provide?
CAPM shows the required return given the stocks Beta (its systematic risk). If the expected return calcualted by an analyst is greater, then you should buy the stock.
What are abondonment options?
Real options relevant to capital investments
Abandonment options are similar to put options (the option to sell an asset at a given price in the future). They allow management to abandon a project if the present value of the incremental cash flows from exiting a project exceeds the present value of the incremental cash flows from continuing the project.
What are abondonment options?
Real options relevant to capital investments
Expansion options are similar to call options (the option to buy an asset at a given price in the future). Expansion options allow a company to make additional investments in future projects if the company decides they will create value.
What are flexbiility options?
Real options relevant to capital investments
Flexibility options give managers choices regarding the operational aspects of a project. The two main forms are price-setting and production flexibility options.
* Price-setting options allow the company to change the price of a product. For example, the company may raise prices if demand for a product is high, in order to benefit from that demand without increasing production.
* Production-flexibility options may include paying workers overtime, using different materials as inputs, or producing a different variety of product.
What are fundamental options?
Real options relevant to capital investments
Fundamental options are projects that are options themselves because the payoffs depend on the price of an underlying asset. For example, the payoff for a copper mine is dependent on the market price for copper. If copper prices are low, it may not make sense to open a copper mine, but if copper prices are high, opening the copper mine could be very profitable.
What are fundamental options?
Real options relevant to capital investments
Fundamental options are projects that are options themselves because the payoffs depend on the price of an underlying asset. For example, the payoff for a copper mine is dependent on the market price for copper. If copper prices are low, it may not make sense to open a copper mine, but if copper prices are high, opening the copper mine could be very profitable.
What is matrix pricing of bonds?
Matrix pricing is a method of estimating the required yield-to-maturity (or price) of bonds that are currently not traded or infrequently traded. The procedure is to use the YTMs of traded bonds that have credit quality very close to that of a nontraded or infrequently traded bond and are similar in maturity and coupon, to estimate the required YTM.
You use linear interpolation of the maturities to find a suitable YTM
What is the sustainabile growth rate?
Used in DDM
The sustainable growth rate is the rate at which equity, earnings, and dividends can continue to grow indefinitely assuming that ROE is constant, the dividend payout ratio is constant, and no new equity is sold.
sustainable growth = g = (1 − dividend payout ratio) × ROE
A securities market that have low transaction costs is said to exhibit:
Operational efficiency
What is meant with an informationally efficient market?
If security prices reflect all the information associated with fundamental value in a timely fashion, then the financial system is informationally efficient
Operational efficiency contributes to informational efficiency.
What is meant with an allocationally efficient market?
In informationally efficiently markets, capital is allocated to its most productive use. That is, they are allocationally efficient
