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Contents
ETHICAL AND PROFESSIONAL STANDARDS..........................................................................5
QUANTITATIVE METHODS .........................................................................................................6
Hypothesis Testing ....................................................................................................................6
Test Population Means ..............................................................................................................6
Difference in means test for independent samples Equal Variance..........................................6
Unequal Variance : ....................................................................................................................6
Mean differences test for dependent samples...........................................................................6
Variance Tests............................................................................................................................6
Correlation Coefficient, r ..........................................................................................................7
Multiple Regression ..................................................................................................................7
Regression Analysis Problems ..................................................................................................7
ECONOMICS ...................................................................................................................................8
Growth Accounting Equation....................................................................................................8
Neoclassical Growth Theory.....................................................................................................8
Endogenous Growth Theory .....................................................................................................8
Factors Promoting Economic Growth.......................................................................................8
Purchasing Power Parity ...........................................................................................................8
International Fisher Relation.....................................................................................................8
Uncovered interest Rate Parity..................................................................................................9
Interest Rate Parity....................................................................................................................9
Asset Market Approach.............................................................................................................9
Currency Arbitrage....................................................................................................................9
Real Exchange Rate Risk ..........................................................................................................9
Foreign Currency Risk Premium (FCRP) ...............................................................................10
International CAPM................................................................................................................10
Currency Exposure..................................................................................................................10
Product Life Cycle ..................................................................................................................10
Regression to Mean.................................................................................................................10
PORTFOLIO MANAGEMENT .....................................................................................................11
Measuring Risk .......................................................................................................................11
Portfolio Risk and Return .......................................................................................................11
Efficient Frontier and Optimal Portfolio .................................................................................11
Systematic Risk vs. Unsystematic Risk ..................................................................................11
Capital Market Line(CML) .....................................................................................................12
SML and CAPM .....................................................................................................................12
SML vs. CML .........................................................................................................................12
Arbitrage Pricing Theory(APT) ..............................................................................................12
Testing CAPM.........................................................................................................................12
Multifactor Models .................................................................................................................13
Portfolio management Planning Process.................................................................................13
FINANCIAL STATEMENT ANALYSIS .......................................................................................14
Inventory Analysis ..................................................................................................................14
CFA Level II
CFA Level II
CFA Level II
Put-Call Parity.........................................................................................................................32
Caps and Floors.......................................................................................................................32
Binomial option Pricing Model...............................................................................................32
Black-Scholes Option Pricing Model......................................................................................32
Delta........................................................................................................................................33
Delta Neutral Hedging ............................................................................................................33
Gamma....................................................................................................................................33
Currency Swaps ......................................................................................................................33
Interest Rate Swaps.................................................................................................................33
Equity Swaps ..........................................................................................................................33
Swap Pricing and Valuation ....................................................................................................33
Swptions..................................................................................................................................34
CFA Level II
CFA Level II
QUANTITATIVE METHODS
Hypothesis Testing
Type I error Rejecting H 0 when true
Type II error Failing to reject H 0 when false
a=probability of Type 1 error
Test Population Means
z=
x 0
x 0
;t =
, n 1, df
s/ n
s/ n
n<30
Z
n30
Z
Normal distribution
Known variance
Normal distribution
t
t or z
Unknown variance
Difference in means test for independent samples Equal Variance
t=
( x1 x2 ) ( 1 2 )
1/ 2
s 2p s 2p
+
n n
2
1
, n1 + n2 2 df
Unequal Variance :
t=
( x1 x2 ) ( 1 2 )
1/ 2
s12 s22
+
n1 n2
d
, n 1 df
sd / n
Variance Tests
Population variance x 2 =
(n 1) s 2
Equality of variances : F =
02
, n 1 df
s12
, n1 1, n2 1 df s12 > s 22
s 22
CFA Level II
Correlation Coefficient, r
Measure of strength of linear relationship (correlation ) between two variables
r1, 2 =
cov(1,2)
s1 s2
Test H 0 :=0:
t stat =
r n2
1 r 2
, n 2 df
Multiple Regression
Yi = bo + (b1 X li ) + (b2 X 2i ) + (b3 X 3i ) + i
SST=SSR+SSE
MSR=SSR/k
MSE=SSE/(n-k-1)
Test statistical significance of regression
F=MSR/MSE with k and n-k-1 df(1-tailed )
Standard error of the estimate (SEE=MSE ) smaller SEE means better fit
Coefficient of determination(R2=SSR/SST).% of variability of Y explained by
Xs ;higher R2 means better fit
Regression Analysis Problems
Heteroskedasticity: Non-constant error variance Detect with Breusch-Paen test
Autocorrelation: Correlation among error terms Detect with Durbin Watson test
positive autocorrelation if DW< d1
Multicollinearity: High correlation among Xs. Detectif F-test significant t-tests
insignificant
CFA Level II
ECONOMICS
Growth Accounting Equation
Total economic output growth=(labor share labor input growth)+(growth of total
factor productivity ) (a,k,a technological progress )
(Percapita economic output growth)=( capital share)(capital-labor ratio
growth )+(growth of total factor productivity )
Neoclassical Growth Theory
z Assumes diminishing marginal product of capital (MPC) and curved savings
function Predicts that an increase in savings rate will
Increase the level of per capita output
Not change long-run growth in total output which equals population growth
in long-run
Not change growth rate in per capita output withch equals technological
progress in long-run
Endogenous Growth Theory
z Assumes constant MPC to society and a straight line savings curve but
diminishing MPC to individual firms
Predicts that an increase in savings rate will increase long run growth in per
capita output
Factors Promoting Economic Growth
z High savings/capital investment
z Human capital development
z Balanced budgets tight monetary policy
z Free trade
z Adequate legal system
z Low population growth
z Technological advancement and sharing
Purchasing Power Parity
Law of one price a single clearly comparable good should have same real price in all
countries Relative PPP Countries with high inflation rates should see their currencies
depredate
s1 1 + iFC
=
, Sin FC / DC
s0 1 + iDC
International Fisher Relation
Assumes real interest rates are equal across borders so interest differential equals
inflation differential
CFA Level II
1 + rFC 1 + E (iFC )
=
1 + rDC 1 + E (iDC )
rFC rDC E (iFC ) E (iDC )
E ( s1 ) 1 + rFC
, S _ in FC / DC
=
s0
1 + rDC
%S rFC rDC
F 1 + rFC
=
, Sand F in FC / DC
S 0 1 + rDC
F S0
rFC rDC
S0
Asset Market Approach
Money supply increase will cause:
z Short-run DC depreciation form inflation Increase and rate decrease.
z Long-run DC appreciation to PPP level.
z Overall, DC depreciates from initial level PPP level.
Currency Arbitrage
2-currency arbitrage
bid-ask midpoint range =
1
1
1
2
S f S f (1 TC )
S f
FC1
DC bid
DC
FC
2 bid
FC2
1
FC
1 bid
P
X = S FC
PDC
, S in DC/FC
CFA Level II
Real exchange rate is possibility of nominal exchange rate changes not explained by
inflation differentials.
DC/FC
International CAPM
DC return =FC interest rate +FC appreciation = DC interest rate + FCRP.
E ( R ) = RF + ( G MRPG ) + ( 1 FCRP1 ) + ( 2 FCRP2 )
= FC + 1
Currency Exposure
Exporters are hurt ad importers are helped by domestic currency appreciation.
Traditional model predicts domestic currency depreciation will improve
competitiveness and increase equity prices (negative currency exposure).
Money demand model predicts positive currency exposure; decreased LR economic
activity causes currency depreciation and lower equity prices.
Product Life Cycle
Development
Expansion
Maturity
Decline
Regression to Mean
Industry competition drives margins to long-run normal level; economic profit = 0.
10
CFA Level II
PORTFOLIO MANAGEMENT
Measuring Risk
From expectation data
N
Risk P
i =
cov(stock , market )
var(market )
11
CFA Level II
E (rp ) = rf + p
E(RP)
Efficient Frontier
Market Portfolio
Risk P
E (ri ) = rf + { i [ E (rm ) r f ]}
Security market line
E(RP)
E(RM)
Market Portfolio
Rf
Risk P
1
CFA Level II
Multifactor Models
Macroeconomic factors Unexpected changes in inflation real GDP consumer
confidence yield curve
Microeconomic factors (Fama-French model ) Excess market returns large-cap minus
small cap returns value ninus growth returns stock return momentum
Portfolio management Planning Process
z Analyze risk constraints liquidity time horizon legal and regulatory taxes unique
circumstances
z Develop IPS client description purpose duties objectives and constraints
performance review schedule modification policy rebalancing guidelines
z Determine investment strategy passive active semi-active
z Select strategic asset allocation asset class weightings based on capital market
expectations
13
CFA Level II
LIFO
COGS
14
CFA Level II
CFA Level II
z
z
z
Pension Adjustments
z Adjust pension liability/asset to reflect funded status.
z Recurring cost = Service cost + Interest cost
z Gross pension cost = Recurring cost + actuarial losses + Plan amendments
z Non-smoothed cost (credit) = Gross pension cost Actual ROA
16
CFA Level II
Multinational Operations
z All-current method: condition
Local currency functional currency
z Method
assets/liabilities: current rate.
common stock: historical rate .
I/S : average rate.
z
Temporal method.
Local currency Reporting currency
Functional currency Reporting currency
sub in inflationary environment, parent currency is functional currency.
Method
B/S monetary assets/liabilities: current rate.
B/S non-monetary assets/liabilities: historical rate.
I/S sales, SG&A : average rate.
COGS& depreciation: historical rate.
Diluted EPS=
CFA Level II
z
z
z
z
z
z
3-component DuPont:
netincome sales assets
ROE =
sales assets equity
5-component DuPont:
assets
EBIT sales int erest exp ense
(1 t )
ROE =
]
assets
sales assets
equity
18
CFA Level II
CORPORATE FINANCE
Weighted Average Cost of Capital
WACC = (wd)[kd(1-t)]+(wps)(kps)+(wce)(ks), weighted by the market value.
Capital Budgeting Expansion Project
z Initial investment : Cost , changes in NWC
z Operating cash flows = (R-C) (1-t)+(Dt), D is Depreciation.
z Terminal cash flows:
after-tax salvage
return of NWC
Operating cash flows at the last period
Operating Leverage
Variable vs. fixed cost tradeoff.
DOL = (EBIT/EBIT) / (Q/Q)
DOLQ=Q(P-V) / [Q(P-V)-F]
DOLS= (S-VC)/ (S-VC-F)
Financial Leverage
Use of fixed incomes in capital structure
DFL =(EPS /EPS) / (EBIT/EBIT)
DFL = EBIT / [EBIT I]
Total Leverage
DTL = DOLDFL=(EPS /EPS) / (Q/Q)
Optimal Capital Structure
Tradeoff between tax shelter benefit from more debt and higher expected bankruptcy
costs from higher leverage.
Dividend Signaling Hypothesis
Unexpected dividend cut is bad news; dividend increase is good news.
Good Reasons for Mergers
z Economies of scale.
z Vertical integration.
z Complementary resources.
z Surplus cash.
z Eliminating operating inefficiencies.
Bad Reasons for Mergers
z Diversification.
z Lower financing costs.
19
CFA Level II
Bootstrapping
NPV of Merger
NPV (cash merger)=gain cost
=VBT-(cash price VT)
Cost of stock merger = (NPBT)-VT
Takeover Defense Measures
z Staggered boards.
z Supermajority.
z Fair price amendment
z Restricted voting rights
z Waiting period.
z Poison pill
z Litigation.
z Asset or liability restructuring .
20
CFA Level II
EQUITY INVESTMENTS
Alpha
ex ante = expected return required return from CAPM or APT
ex post = holding period return - return on similar assets.
Taxes and International Investing
Three forms of tax: transaction, capital gain, income.
Methods to Reduce Execution Costs
Program trading, Internal / external crossing, Principal trades, agency trades, futures
contract.
American Depository Receipts (ADRs)
Advantage: Reduce administration / duty costs on each transaction.
Disadvantage: Do not eliminate inherent currency / economic risks.
Franchise Value and Growth Process
Tangible P/E =1/r
Franchise P/E = franchise factor growth factor = FFG
1
1
FF =
r ROE
G=
g
rg
P0
1
=
, k is the required rate of return, I is the inflation rate, is the
E1 k + (1 ) I
inflation flow-through rate.
21
CFA Level II
CFA Level II
D1
rg
Vo =
H=
[D0 (1 + g L )] + [D0 H ( g s g L )]
r gL
t
2
r=
D1
+g
P0
CFA Level II
FCFF1
WACC g
FCFF1
rg
1 b
rg
24
CFA Level II
Trailing P / E0 =
(1 b)(1 + g )
rg
Normalization Methods:
z Historical average EPS.
z Average ROE.
Price to Book (P/B) Ratio
Advantages:
z BV almost always>0,
z BV more stable than EPS.
z Measures NAV of financial institutions.
Disadvantages:
z Size differences cause misleading comparisons.
z Influenced by accounting choices.
z BVMV due to inflation/ technology.
Justified = P / B =
ROE g
rg
PM 0 (1 b)(1 + g )
rg
25
CFA Level II
Method of Comparables
z Firm multiple > benchmark implies overvalued
z Firm multiple < benchmark implies undervalued.
z Fundamentals that affect multiple should be similar between firm and benchmark.
Residual Income (RI)Valuation
z RIt=Et-(rBt-1)
z Firm value = adjusted BV0+ PV of expected future RI.
z
ROE r
B0
rg
RI T
, is the persistence factor,
1+ r
between 0 and 1.
ln
= T ln
Cons tan tGrowthP / E
1 + gC + dC
26
CFA Level II
DEBT INVESTMENTS
Credit Analysis
Liquidity sources
z Working capital
z Cash flow.
z Back-up facilities
z Third-party guarantees.
High-yield debt
z Issuer has senior, short-term, floating bank debt.
Asset-backed debt
z Quality of collateral.
z Servicer quality
z Payment structure.
z Legal structure (VIE, SPV)
Municipal bonds
z Tax-backed: repaid with tax revenue
z Revenue: repaid with project CF.
Sovereign debt
z Local vs. foreign currency rating.
z Economic risk; ability to pay.
z Political risk: willingness to pay.
Bond Price Yield Relationship
Option free bond exhibits
positive convexity.
price
Strike price
yield
yield
27
CFA Level II
ED =
(BVY BV+Y )
2 BVO Y
BV y BV+ y (2 BVo )
2 BVo y 2
28
CFA Level II
1 nodal _ value2UU
2
1 + i1,U
nodal _ value2UD
+
1 + i1,U
1 nodalvalue2, DD
2
1 + i1, D
nodalvalue2,UD
+
1 + i1, D
1 nodal _ value1,U
2
1 + i0
nodalvalue1, D
+
1 + i0
1 nodal _ value1,U
2
1 + i0
nodal _ value1,D
+
+
1
i
0
29
CFA Level II
30
CFA Level II
DERIVATIVES
Forwards-No Arbitrage Pricing
FP = S 0 (1 + R f ) T
Vlong = S t
FP
(1 + R f )T t
Equity Forward
FP (equity ) = ( S 0 PVD ) (1 + R f )T
Vlong = S t PVDt
FP
(1 + R f )T t
FP
(1 + R f )T t
1 + L(1+ k ) 360
360
1
FR ( j , k ) =
1 + L( j ) ( j )
k
360
T
(
1 + Rdomestic )
(1 + R foreign ) T
F and S in DC/FC
Vlong =
St
(1 + R foreign )
T t
FP
(1 + Rdomestic )T t
Futures Price
FP = S 0 (1 + R f ) T
CFA Level II
Futures Arbitrage
Cash and carry: Borrow, buy spot, sell futures today deliver asset, repay loan at end
Reverse cash and carry: short spot, invest, buy futures today; collect loan, buy asset
under futures contract, deliver to cover short sale .
Treasury Bond Futures
FP = bond price (1 + R f )T FVC
Equity Futures
FP( stock ) = S 0 (1 + R f ) T FVD
FP(index) = S 0 e ( R )T
Put-Call Parity
Call+Risk-free Bond=Put+Underlying
Co +
X
= P0 + S 0
(1 + r )T
1+ R D
U D
Step 3: Discount to today at risk free rate
up =
Ct = [ S t N (d1 )] [ X e r (T t ) N (d )]
S
ln t + r + (0.5 2 ) (T t )
X
d1 =
T t
d 2 = d1 ( T t )
Pt = Ct St + (e r (T t ) X )
Effect of each variable on a call option Asset price positively related
32
CFA Level II
z
z
z
z
z
Delta
Estimates the change in value of option for a one-unit change in stock price
Call delta between o and 1 increases as stock price increases
Call delta close to 0for far out of the money calls close to 1 for fan in the money
calls
Put delta between I and 0 increases from 1 to 0 as stock price increases
Put delta =call delta -1 (all else equal )
Delta close to 0 for far out of the money puts close to -1 for fan in the money puts
Delta Neutral Hedging
#Calls for delta hedge =
# shares of stock
delta of call option
Delta neutral position only holds for very small changes in value of underlying stock
Delta neutral portfolio must be frequently (continuously) rebalanced to maintain
hedge called a dynamic hedge
Gamma
Measures rate of change in delta as underlying stock price changes largest when
option is at the money
Currency Swaps
Parties swap payments in two currencies at fixed or floating rates
Interest Rate Swaps
Plain vanilla interest rate swap trading fixed interest rate payments for floating rate
payments
Equity Swaps
Return on stock portfolio or stock index is paid each period by one party in return for
a fixed payment Return can be capital appreciation or total return including dividends
on the stock or portfolio
Swap Pricing and Valuation
Swap rate is set so PV of floating rate payments PV of fixed rte payments swap
value is zero to both parties
CN =
1 BN
B1 + B2 + L + BN
33
CFA Level II
Bn = PV of 1 on n th date
34