CFA Level 1 Random Deck 1 Flashcards
those that have failed are not included in the results
Survivorship bias - hedge funds
arises if a study uses information that was not available on a test date
Look ahead bias
arises if a test is based on a certain time period
time -period bias
the formulate used to calculate a point estimate
Estimator
uses sample data to calculate the range of possible (or probable) values that an unknown paramount can take, with a given probability (1-level of significance)
confidence interval
Refers to the degree of confidence that the relevant parameter will lie in the computed interval
Level of significance
degrees of freedom
sample size minus 1 (n-1)
When the variance of a normally distributed population is not know, we use the _____ to construct confidence interval.
t-distribution
Desirable properties of an estimator
- Unbiasedness; 2. Efficiency; 3: Consistency
When is the t-value used?
Normal/non-normaul distribution with unknown variance (note if sample is small it can’t be done)
Rejecting the null hypothesis when it is actually true
Type I Error
Failing to reject the null hypothesis when it is actually false
Type II Error
The ____ represents the probability of making a Type II Error
significance level (1-level of significance)
The power of a test is the
probability of correctly rejecting the null hypothesis when it is false. Power of a test = 1 - P(Type II Error)
What is shortfall risk?
Risk that the portfolio will fall below some minimum acceptable level over some time horizon.
A parametric test has as least one of two characteristics:
Features: 1) Concerned with parameters, or defining features of a distribution 2) Definite set of assumptions
Test to see if the variance amongst two independent populations is equal (normally distributed population)
F-Test (one tail - right - rejection area)
test to see if the variance of a single normally distributed population is different
Chi-Square Test (two tail - reject null if outside interval)
Key Rate Duration
measures a bond’s sensitivity to a shift at one or more maturity segments of the yield thrive which results in a change to the yield curve shape
Modified and Effective duration mention a bond’s sensitivity to _______ shifts in the entire curve
Parallel - all rates change by the same amount in the same direction
What the only difference in the formulas used to calculate modified and effective duration?
Modified uses Change in YIELD in the Denominator; Effective uses Change in CURVE
What effect does a put option have on a bond’s duration?
reduces effective duration - most likely you’ll get your cash back sooner.
Money Duration is calculated as the _______ times the ______
annual modified duration x full price
Convexity measure the ______ order effect.
Second order effect on a bond’s percentage price change given a change in the YTM.
Duration measures the ______ order effect.
First order effect - change in the bond’s price given a change in YTM
Define Convexity
Convexity adjusts the percentage price change estimate provided by modified duration to better approximated the true relationship between a bond’s price and its yield to maturity which is a curve line (convex).
CFR
Corporate Family Rating - based on the overall creditworthiness of the issues. Typically based on the issuer’s senior unsecured debt
CCR
Corporate Credit Rating - applies to a specific financial obligation of the issuer and is based on factors such the issue’s relative seniority ranking in priority of claims and covenants.
Four C’s of Credit Analysis
- Capacity
- Collateral
- Covenants
- Character
Key components of credit risk
risk or probability of default AND loss severity in the event of default (product of the two equals the expected loss)
Arbitrage plays an important role in market efficiency
- Help to determine “correct” price; 2. Improve market efficiency (accurate pricing)
What is tenor?
Certain period of time over which a series of cash flows are exchanged in a SWAP
Swap settlement amount formula
settlement amount = (fixed - (LIBOR + Spread) x (portion of time) x (principal or notional amount) Note. The rates will be the clue as to which party is getting the payment. Lower rate receives settlement payment.
The worst possible loss for a holder of a put option is:
Easy - it’s just the price of the Put Option. They are not obligated to do anything else.
The worst possible loss for a holder of a call option is:
Easy - it’s just the price of the Call Option. They are not obligated to do anything else.
Key components of the CFA Institute Code of Ethics (6 bullets pg 6 Wiley)
act with integrity, competence, diligence, respect, place integrity of investment profession and clients above self, reasonable care, maintain and improve their professional competence
Seven Standards of Professional Conduct
- Professionalism 2. Integrity of Capital Markets 3. Duties to clients 4. Duties to Employers 5. Investment Analysis, Recommendations and Actions 6. Conflicts of interest 7. Responsibilities as a CFA Institute Member or Candidate
Standard 1: Professionalism
A. Knowledge of the Law B. Independence and Objectivity C. Misrepresentation D. Misconduct
What is “applicable law”?
law that governs the member’s or candidate’s conduct. Local Law.
Regarding compliance to laws, members should follow the -
“more strict law”, be it applicable law or the Code and Standards
Name two types of market manipulation:
Information-based AND Transaction-based
Standard 2: Integrity of Capital Markets
A. Material Nonpublic information B. Market Manipulation
Standard 3: Duties to Clients
A. Loyalty, Prudence and Care B. Fair Dealing C. Suitability D. Performance Presentation E. Preservation of Confidentiality
Standard 4: Duties to Employers
A. Loyalty B. Additional Compensation Arrangements C. Responsibilities to Supervisors
Standard 5: Investment Analysis, Recommendations, and Actions
A. Diligence and Reasonable Basis B. Communication with Clients and Prospective Clients C. Record Retention
Standard 6: Conflicts of Interest
A. Disclosure of Conflicts B. Priority of Transactions C. Referral Fees
Standard 7: Responsibilities as a CFA Institute Member or CFA Candidate
A. Conduct as members and candidates in the CFA program B. Reference to CFA Institute, the CFA designation, and the CFA program
The standard in the investment management industry is to express returns on a _________.
Time-weighted basis: - not affected by cash withdrawals or contributions to portfolio - averages holding period return over time
Measurement Scales
NOIR (Nominal, Ordinal, Interval, Ratio)
Measurement Scales: N
Nominal - weakest level of measurement; count of data but no rank
Measurement Scales: O
Ordinal - sort of data ranked according to a certain characteristic
Measurement Scales: R
Ratio - strongest level of measurement, money
Measurement Scales: R
Ratio - strongest level of measurement, money
Chebyshev’s Inequality
Method of calculating an appropriate value for the proportion of observations in a data set that lie with a given number (k) of standard deviations from the mean. 1 - (1/k2)
Coefficient of Variation
CV=Allows for the comparison of relative dispersion. Standard deviation / sample mean. Or in otherwords, if speaking about investment returns, risk per unit of total return. Scale free measure. Can be used when data sets of significantly different means and units of measurement.
s/x = CV
Sharpe Ratio
Measure excess return per unit of risk.
Mean Portfolio Return - Risk Free Return
Standard deviation of portfolio returns
Mean Standard Deviation (MAD)
average of all absolute values (AV) of deviations in a data set. Recall that the sum of deviations from the arithemtic mean equal zero. Therefore, AV are used.
Semivariance
average of squared deviations below the mean (note still used (n-1) in the denominator). Semideviation is simply the square root of the semivariance.
Describe a postively skewed distribution
skewed to the right (this means skinny side stretched to the right - long tail on the right). Bulk of data pushed to left.
Mode < Median < Mean
Described a negatively skewed distribution
skewed to the left (this means skinny side stretched to the left- long tail on the left). Bulk of data pushed to right. Mean is pulled down by the lower outliers in the skinny tail.
Mean < Median < Mode
Negative (left) Skewed distribution - sample skewness is _______
Sample skewness is negative - numerator is formula will be a negative number because the average number of devations below the mean is large than the average of deviations above the mean.
Positive (right) Skewed distribution - sample skewness is _______
Skinny tail on right. Sample skewness is positive - numerator is formula will be a positive number because the average number of devations abover the mean is larger than the average of deviations below the mean.
Kurtosis
measures the extent to which a distribution is more or less peaked than a normal distribution. A normal distribution has a kurtosis of 3.
What does the following statement mean: P (AB)
Joint probability - what is the probability of both A and B occuring?
What does the following statement mean: P (A | B)
Conditional probability - the probability of event A occuring give that event B has occured.
P( A | B) = P (AB)/P(B)
Multiplication rule for probability
P (AB) = P( A | B) x P(B)
Addition rule for probabilities
P (A or B) = P(A) + P(B) - P(AB)
Calculates the probability of at least one of A and B occuring.
Covariance
measures how a random variables varies with another random variable
Limitations of Covariance
- Difficult to compare covariance across data sets that have different scales
- difficult to interpret as it can take on extreme values
- does not tell us anything about the strength of the relationship between variabes
Describe Covariance Formula
Cov(RA,RB) = Σ Probability * (RA - E(RA)) * (RB - E(RB))
Correlation Coefficient
COVA,B/σ(RA)σ(RB)
Covariance divided by product of standard deviations of variables
When is the Combinations Formula used?
nCr is used when the order in which the items are assigns the labels in NOT important.
Example: 20 people try out for a team. 11 are chosen. How many different ways can the eleven member team be chose from the 20 aspirants?
20! / (9!)(11!)
When is the Permutations formula used?
nPr is used when the order in which the items are assigned to two groups is an important considerations.
Example: 20 people try out for a team. 11 are chosen AND must be ranked according to skill level. How many different ways can the eleven member team be chose from the 20 aspirants?
20! / (20-11)!
n! / (n - r)!
Should result is a greater number than Combinations because, like a padlock, the order of numbers matters. For example, the actual combinations of numbers I use to unlock my padlock (1,3 = 3,1) is much less than the acutal number or unique sequences that could be used to unlock the paddlock.
When would we use the Labeling formula?
When we are working with three or more groups of predetermined size and each item must be labled as a member of one of the groups.
In this scenario we need to elimate the counting of redundances.
Refer to page 203 Wiley for example.
12! / 6! x 4! x 2!
Probability estimated from data as a relative requency of occurrence is an ______.
Empirical Probability
A probability drawing on personal or subjective judgement is a ___________.
Subjective probability.
A probability based on logical analyis is an ____.
an a priori probability
The unconditional probability of an event A is denoted by __
P(A)
Unconditional probabilities are also called ____
marginal probabilities
The probability of an event A given and event B is denoted as
P(A | B)
Number of unique covariances depending on ‘n’
n (n - 1) / 2
Shortfall Risk
The probability that a portfolio’s value or return E(Rp), will fall below a particular target value or return (RT) over a given period.
Roy’s safety first criterion states….
that an optimal porfolio minimized the probablity that the actual portfolio return, Rp, will fall below the target return, RT
Define: Binomial Random Variable
defined as the number of success in n Bernoulli trials (which are trials that produce one of two outcomes). Binomial distribution is used to make probability statemtns about a crecord of successes and failures or about anything with binary (twofold) outcomes.
Binomial Distribution
P(X=x) = nCx(p)x(1-p)n-x
p = probability of success
1-p = probabilty of failure
nCx = number of possible outcomeshave x success in n trials
Variance of a Binomial Random Variable
σ2 = n x p x (1-p)
Standard Error
Amout by which our sample statistic differs from our population statistic
standard error typically = standard deviation of sample / square root of number of observations
we don’t use standard deviation of population in the numerator because we often do not know it.
Desirable Properties of Estimator:
- Unbiasedness
- Efficiency
- Consistency
t-Distribution used in the following scenarios:
- to construct confidence intervals for a normally (or approx. normal) distributed population whose variance is unknown when the sample size is small (n < 30)
- non-normally distributed population whose variance is unknown if the sample size is large (n >= 30)
When the population is normally distributed we ___.
use the z-statistic if the population variance is known
use the t-statistic if the population variance is unknown
When the population is non-normally distributed we ___.
selection of the appropriate statistic depends on the sample size and whether the population variance is known
- if population variance is known and sample size is large (n>30) we use z-statistic
- if population variance is unknown and sample size is large (n>30) we use z-statistic or t-statistic. A t-statistic will give more conservative answer
The probability (1 – α) is referred to as the confidence level while α refers to ___________.
the significance level
Normal Good
a good that is consumer in greater quantities as income increases
Inferior good
as income rises, spend less on good. income elasticity is less than zero (negative).
Profit maximization occurs:
- difference between TR and TC is greatest
- MR = MC
- MRP (marginal revenue product) equals the resource cost for each type of input
Economic profit
Economic Profit = Accounting Profit - Total Opportunity Costs
Accounting Profit
bascially financial statement net income
Accounting Profit = Economic Profit + Normal Profit
Normal Profit
is the level of accounting profit needed to just cover the implicit opportunity costs ignored in accounting costs. Cost of equity is a typical example.
In the long run, all inputs to a firm are ________
variable - they can be changed. Adjusted. You can sell an asset, leave a business line, etc. Short term is a different story.
Factors the affect the chances of successful collusion:
- Number and size distribution of sellers
- The similiarity of products
- Cost Structure
- Order size and frequency
- The strength and severity of retaliation
- the degree of external competition
Marginal Product
(aka: marginal return) equals the increase in total product brought about by hirign one more unit of labor, while holding quantiies of all other factors of production the same
Total Product
Labor X Quantity
GDP Deflator
Value of current year output at current year prices / Value of current year output at base year pricies
x 100
GDP Equation
C + I + G + (X-M)
- C= consumer spening on final goods/services
- I = gross private domestic investment
- G = Governement spending
- (X-M) = net exports
Steps in financial statement analysis:
- articuate the purpose and context of the analysis
- collect input data
- process data
- analyze/interpret proceced data
- develop and communicate conclusions and recommendations
- follow up
Characteristics of useful information: Fundemental
- relevance
- faithful representation
Characteristics of useful information: Enchancing
- comparability
- verifiability
- timeliness
- understandability
Characteristics of effective Financial Reporting Framework
- transparency
- comprehensiveness
- consistency
Guidelines for gross reporting
- the company is the primary obligor under the contract
- bears inventory and credit risk
- can choose its supplier
- has reasonable latitude to establish price
if not met - company should report net revenues
Basic EPS
Net Income - Preferred Dividends
Weighted average # of shares outstanding
Diluted EPS
Net Income / (weighted average # of shares outstanding + new common shares that would have been issued at conversion)
Diluted EPS (if converted)
(Net income + After-tax interest on convertible debt -preferred) / (Weighted average # of shares outstanding + additional common shares that would have been issued at conversion)
Net profit Margin
Net Income / Revenue
Gross Profit Margin
Gross Profit / Revenue
Operating Margin
operating income / revenue
pretax margin
earnings before taxes / revenue
ROA
Operating income / Average Total Assets
ROE (basic formula)
Net income / Average Equity
Activity Ratios
Measure how efficiently a company performs day-to-day taks, such as the collection of receivabes and management of inventory (example: AR Turnover, Inventory Turnover)
Liquidity Ratios
meausre the company’s ability to meet its short term obligations
Solvency Ratios
measure a company’s ability to meet long-term obligations. Subsets of these ratios are also known as “leverage” and “long-term debt” ratios.
Profitability Ratios
measure the company’s ability to generate profits from its resources (assets).
Valuation Ratios
measure the quantity of an asset of flow (e.g. earnings) associated with the ownership of a specified claim (e.g. a share or ownership of the enterprise)
Inventory Turnover
Activity Ratio
COS (COGS) / Average Inventory
Days of inventory on hand
Activity Ratio
Number of Days in Period (365) / Inventory Turnover
Receivables Turnover
Activity Ratio
Sales (Revenue) / Average AR
Days of Sales Outstanding
Activity Ratio
Number of days in period (365) / Receivables Turnover
Payables Turnover
Activity Ratio
Purchases / Average Trade Payables
Number of days of payables
Activity Ratio
Days in period (365) / Payables Turnover
Working Capital Turnover
Activity Ratio
Revenue / Average Working Capital
Working Capital = CA - CL
Fixed Asset Turnover
Activity Ratio
Revenue / Average net fixed assets
Turnover ratios will always have
An IS account in the numerator and a BS account in the denominator (usually expressed as an average)
Total Asset Turnover
Activity Ratio
Revenue / Average Total Assts
Current Ratio
Liquidity Ratio
Currernt Asset / Current Liabilities
Quick Ratio
Liquidity Ratio
(Cash + Short Term marketable instruments + Receivables) / Current Liabilites
Basically Cash (or equivalents) and AR in Numerator
Cash Ratio
Liquidity Ratio
Cash+Short-term marketable investment / Current Liabilities
Defensive Internal ratio
Liquidity Ratio
Cash + Short-term marketable securities + Receivables / Daily Expenditures
Cash conversion cycle (net operating cycle)
Liquidity Measure
DOH + DSO - Number of Days of payable
Debt-to-Assets
Solvency Ratio
Total debt / Total Assets
Debt-to-Capital Ratio
Solvency Ratio
Total Debt / Total Debt + Total Shareholders Equity
Debt-to-Equity
Solvency Ratio
Total Debt / Total Stockholders Equity
Financial Leverage Ratio
Solvency Ratio
Average Total Assets / Average Total Equity
Interest Coverage
Solvency - Coverage Ratio
EBIT / Interest Payments
Fixed Charge Coverage
Solvency - Coverage Ratio
(EBIT + Lease Payments) / (Interest Payments + Lease Payments)
Gross Profit Margin
Profitability Ratio
Gross Profit / Revenue
Operating Profit Margin
Profitablity Ratio
Operating Profit / Revenue
Pretax Margin
Profitability Margin
EBT (earning before taxes, after interest) / Revenue
Net Profit Margin
Profitability Ratio
Net Income / Revenue
Operating ROA
Profitability (ROI) Ratio
Operating Income / Average total assets
ROA
Profitability (ROI) Ratio
Net Income / Average Total Assets
ROE
Profitability (ROI) Ratio
Net Income / Average Total Equity
Return on Common Equity
Profitability (ROI) Ratio
(Net Income - Preferred Dividends) / Average Common Equity
Components of ROE (per DuPont model)
Function of: Efficiency, operating profitability, taxes, leverage
ROE (DuPont - 2 components)
ROE = ROA x Leverage
Remember ROA = Net Income / Avg Total Assets
Remember Leverage = Avg Total Assets / Avg Equity
ROE (DuPont - 3 components)
ROE = Net Profit Margin x Total Asset Turnover x Leverage
The first two components essentially create ROA
Helps to analyze ROE as a function of profitability, effeciency and leverage
ROE (DuPont - 5 components)
This breaks down Net Profit margin into 3 components - Tax Burden, Interest Burden, and EBIT Margin
Then we multiply, these 3 components by Total Asset Turnover x Leverage
Cash Conversion Cycle
DOH + DSO - Number of Days of Payables
Remember each of these requires 365 in the numberator and the associated turnover ratio in the denominator
Net Realizable Value
Estimate Selling Price in the ordinary course of busienss less the stimated costs necessary to get the inventory in condition for sale and to make the sale
Under US GAAP, inventory is measured as:
lower of cost or market. Market value is defined as current replacement cost subject to upper and lower limits.
Upper Limit: Net Realizable Value
Lower Limit: Net Realizable Value - Normal Profit Marign
Reversals of previously written down inventory is allowed under:
IFRS, but not US GAAP. The reversal is limited to the amount of the original write down.
Income Tax Payable
Calculated on the basis of the company’s tax base
tax expense
appears on income statement and is an aggreagte of its income tax payable and any changes in deferred tax assets and liabilities. Liabilties increase tax expense; deferred tax assets reduce tax expense.
Tax Expense < Taxes Payable
Deferred Tax Asset
Tax Expense > Taxes Payable
Deferred Tax Liability
Gain from the exstinguishment of debt is recorded…
On the income statement
Under US GAAP, what are the two types of capital leases (from lessor’s perspective)?
- Direct Financing Lease
- Sales-type Lease
Direct Financing Lease
PV of lease payments (and associated receivable) equal CV of leased asset - no profit, strictly financing.
Sales-type Lease
PV of lease payment (and associated receivable) exceed CV of leased asset - will show profit in year of sale and interest revenue thereafter
Financial Reporting Quality
pertains to quality of the information in financial reports, including disclosures in notes. Provides decision-useful information, which is relevant and faithfuly represents the economic reality of company’s activities
Earnings Quality
pertains to the earnings and cash generated by the company’s activitie, results from activities that a company will likely be able to sustain in the future and provide a sufficient return on company’s investment.
Free Cash Flow to the Firm (FCFF) - explanation
the cash flow avaiable to the company’s suppliers of capital after all operating expesnes have been paid and necessary investments in working capital and fixed capital have been made
Free Cash Flow to the Firm (FCFF) - formula
FCFF = NI + NCC + IntExp (1 - tax rate) - FCInv - WCInv
NCC = Non cash charges
IntExp = Interest expense
FCInv = Capital Expenditures
WCInv = Working Cap investment
Wilcoxon signed-rank test
Mann-Whitney U-test
most appropriate for tests of differences in means for nonparametric data such as analysts’ rankings
Relative strength index (RSI)
Relative strength index (RSI) is a momentum oscillator and provides information on whether or not an asset is overbought or oversold. An RSI greater than 70 indicates that a stock is overbought; an RSI lower than 30 suggests that a stock is oversold
Under IFRS, the costs incurred in the issuance of bonds are most likely:
included in the measurement of the bond liability.
IFRS measures inventory at the lower of cost and net realizable value.
Under IFRS, net realizable value (NRV) is defined as:
the estimated selling price less the estimated costs necessary to get the inventory ready for sale and make the sale.
A higher tax burden ratio (Net income/Earnings before tax) implies
that the company can keep a higher percentage of pretax profits; this result implies a lower tax rate and a higher ROE.
Both IFRS and U.S. GAAP allow agricultural inventories to be valued
at net realizable value.
Cash to income =
Cash to income = Cash flow from operating activities (CFO)/Operating income
Formula for Sustainable Growth Rate
Sustainable Growth Rate = Retention ratio (b) × Return on equity (ROE).
Note: The Rention ratio is the inverse of the dividend payout ratio. One states what is paid out (dividends), the other states what is retained (retained earnings).
Reminder: When faced with a diluted EPS question, first calculate the basic EPS. You have to do this in order to determine whether a convertbile security is dilutive. If Diluted EPS is lower than Basic, include the convertible security in the analysis. If Diluted EPS is greater than Basic EPS, exclude the convertible security.
You can do this!
Is convertible debt dilutive?
Maybe/maybe not. Must compare EPS under both scenarios to decide.
Are options dilutive?
Yes - always.
For recognition in the financial statements, an element must _____.
have a cost or value that can be measured with reliability.
Cash Return on Assets =
CFO / Avg. Total Assets
Margin Call Formula
Price0 x (1 - initial margin) / (1 - maintenance margin)
A dealer market is
quote-driven or price-driven
A pure auction market is
order-driven market - where participants submit their bid and ask prices to a central location. Two sets of rules:
- Order Matching: PDT (price, display, time)
- Trade Pricing (uniform, discriminatory, derivative)
See page 179 Wiley
Speaking about a company’s value: What is Book Value?
The net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities.
The weekend effect suggests that
returns on weekends tend to be lower than returns on weekdays.
The holiday effect suggests that returns
on stocks in the day prior to market holidays tend to be higher than other days.
The phenomena that people ignore their own preferences and follow other people’s investment decisions is referred to as:
Information Cascade
Herding is
clustered trading that may or may not be based on information.
Gambler’s fallacy is
a behavioral theory which suggests that recent outcomes affect investors’ estimates of future probabilities.
Categories of pricing anamolies:
- Time Series
- Calendar
- January Effect
- Turn-of-the month
- Day-of-the week
- Weekend
- Holiday
- Momentum and Overaction
- Calendar
- Cross-sectional
- Size Effect (small over large)
- Value Effect (value over growth)
- Other
- Closed-end Investment Fund
- Earnings Surprises
- IPO
- Predictability of Returns Based on Prior Info
Statutory Voting (elections of board of directors)
each share represents one vote
Cumulative Voting (elections of board of directors)
total voting rights are based on the number of shares owned multiplied by the number of board directors being elected. Provided a better representation of minority shareholders.
Sponsored Depository Receipt (DR)
the forgein company has direct involvement in the issuance. Investors have same rights as those enjoyed by direct owners.
Unsponsored Depository Receipt (DR)
No involvement by foreign company. Investors do not enjoy same rights as direct stock investors.
Porter identified the following five forces:
- Threat of substitute products
- Bargaining power of customers
- Bargaining power of suppliers
- Threat of new entrants
- Intensity of rivalry
Three major categories of equity valuation models:
- Present Value (discounted cash flow)
- Multiplier Models
- Asset-based valuation models
Calculation of Enterprise Value
Think of it as the cost of taking over a company. Market Value of CS + Market Value of PS + Market Value of Debt - Cash (and equivalents).
Execution Orders
indicte how to fill the order (market, limit)
Validity Instructions
indicate when the order may be filled
Clearing Instructions
indicate how the arrange the final settlement of the trade
Enterprise Value
EV = Cost of taking over company
EV = Mkt CS + Mkt Pref + Debt - Cash (equivalents)
Representativeness
Behavioral Bias - investors assessing probabilities of outcomes depending on how simlar they are to the current state
Bond: Conversion Price
the price per share at which the convertible bond can be converted into shares
Bond: Conversion Ratio
number of common shares that each bond can converted into.
Bond Par Value / Conversion Price
Bond: Conversion Value
sometimes called parity value, current share price multiplied by the conversion ratio
Conversion Parity
Occurs if the conversion value is equal to the convertible bond’s price.
Interbank Offered Rate
Used as reference rates not only for floating-rate bonds, but also for other debt instruments including mortgages, derivatives such as interest rate and currency swaps, and many other financial products and and contracts.
Commerical Paper
whether US or Eurocommercial paper - it is negotiable which means that investors can buy and sell it on secondary markets. Companies use it as source of funding working capital (CA-CL), seasonal demand for cash, but also as a source of interim financing for long-term projects.
Coupon Effect
Lower coupon bonds experience more price volatility all else being equal
Maturity Effect
Longer maturity bonds experience more price volatility all else being equal
Convexity
Price increases are greater in absolute terms than price decreases for a given +/- change in bond market discount rate.
In otherwords, if yield decreases, I’m going to expect to receive a higher price. Stingy - don’t want to let go. If yields increase, i’m only going to be willing to give up a little.
Bond duration and convexity are measure of
interest rate risk
Sources of return for a fixed-rate bond investor
- receipt of promised coupon and principal payments on scheduled dates
- reinvestment of coupon payments
- potential capital gains or losses on the sale of the bond prior to maturity
Two types of duration:
- Yield Duration = Sensativity of the bond price with respect to the bond’s own yield-to-maturity
- Curve Duration = Sensativity of the bond price (or more generally, the market value of a financial asset or liability) with respect to a benchmark yield curve
Yield Duration Statistics
Macaulay Duration, modified duration, money duration, price value of a basis point (PVBP)
Curve Duration Statistic
Effective Duration
Duration Gap (FI page 553-554)
Bond’s Macaulay duration (MD) minus the investment horizon (IH).
- IH > MD: Coupon reinvestment risk dominates market price risk. Risk is lower interest rates. Duration gap negative.
- IH = MD: Coupon reinvestment risk offsets market price risk. Duration gap is zero.
- IH < MD: Market price risk dominates coupon reinvestment risk. Risk is higher interest rates. Duration gap positive.
Expected Loss =
Probability of Loss x Loss Severity
What is the risk that a bond issuer’s creditworthiness may deteriorate or migrate lower?
Credit Migration Risk OR Downgrade Risk
Describe what backs these types of fixed income instruments:
- mortgage-backed security
- equipment trust certificate
- collateral trust bond
- mortgage-backed security - mortgages on property
- equipment trust certificate - physical assets or equipment (plans, shipping containers, vehicles)
- collateral trust bond - securities
Incorporating both duration and convexity, the percentage change in a bond’s price =
(–Modduration × ∆yield) + (0.5 × Convex × (∆yield)2 )
Effective Cost of skipping trade payable discount
(1 + (Discount/1-Discount) (365/# days past discount period) -1
CML
Capital Markets Line - the line with an intercept point equal to the risk-free rate that is tangent to the efficient frontier of risky assets; represented the efficient frontier when a risk-free asset is available for investment.
CAL
Capital Allocation Line - a graph line that describes the combinations of expected return and standard deviation of return available to an investor from combining the optimal portfolio of risky assets with the risk-free asset.
SCL
Security Characteristic Line - a plot of the excess return of a security on the excess return of the market
SML
Security Market Line - the graph of the capital asset pricing model (CAPM). Risk free rate is the intercept, beta is the slope.
Calulation of Beta
Beta = Correlation * Standard Dev Asset / Standard Dev Mkt
OR
Covariance / Standard Dev Mkt2
βi = Cov(Ri, Rm)/σm2
A commodity market is in contango when futures prices are:
higher than the spot price.
The value at risk (VaR)of an alternative investment is best described as the:
minimum amount of loss expected over a given time period at a given probability level.
The power of a test is the
probability of correctly failing to accept the null hypothesis when it is false.
Explain flat, clean, full, dirty bond prices…
When a bond is between coupon payment dates, its price has two parts—the flat price or clean price and the accrued interest. The sum of the parts is the full price or dirty price. The full price is equal to the flat price plus the accrued interest.
The Change of Polarity Principle
The Change of Polarity Principle asserts that once the price rises above the resistance level, it becomes the new support level. Similarly, once the price falls below a support level, it becomes the new resistance level.
Which quantities does the Laspreyes index use in determined price level inflation?
Base year quantities are used - remember always to use prices from each year.
Which quantities does the Paasche index use in determining price level inflation?
Current composition of basket is used in all years. Prices from each respective year are used.
Using fixed basket of goods in a price index can give rise to biases:
- Substition Bias
- Quality Bias
- New Product Bias
CA = Sp – I + (T – G – R)
CA = Current Account balance
Sp = Private sector savings
I = Investments
T = Taxes
G = Government spending
R = Transfers
Valuation of Inventory: IRFS vs US GAAP
Under IFRS, inventory is valued at its net realizable value, whereas under US GAAP, market value is defined as current replacement.
If the p-value is _____ than the specified _______, the ______ hypothesis is rejected.
If the p-value is less than the specified level of significance, the null hypothesis is rejected.
Percentiles Formula
(n+1)y/100
RSI
Relative Strength Index - Neutral = 30-70.
Below 30, oversold
Above 70, overbought
Fiscal Multiplier Formula
1/(1-c(1-t))
c = propensity to consume (%consumption/%disposable income)
t = tax rate
