Professional Documents
Culture Documents
ETHICS
Code of Ethics (Separate from Code of Standards)
Act with integrity competence diligence and respect in an ethical manner with everyone
Place integrity of investment profession and interest of clients above personal interest
Use reasonable care and independent professional judgment wrt investment analysis, action, recommendation
Page 2 of 44
Practice and encourage others to be professional, ethical, which reflects credit on themselves and profession
Promote the integrity and viability of global capital markets for ultimate benefit of society
Maintain and improve professional competence for yourself and others
Standards of Professional Conduct (Code of Standards)
Ok to compete against employer for additional compensation when working for them if you have written
CONSENT
Notify employer of services rendered, duration of services and compensation for services
Cant solicit current clients to join new firm if you still work at old firm. You can prepare to go into
competitive business before leaving work as long as it doesnt breach employees duty of loyalty
You can solicit current clients of old firm after youve left (unless theres a non-compete clause)
Cant take old work from old employer to new employer without written CONSENT of previous employer
Analyst not prevented from writing research report because of relationship between employer and target
company, DISCLOSURE
Doesnt matter that brokerage firm provides research that is not used by account generating commission if
account isnt paying for it
Best thing to do is to pay for accommodations, accepting not necessarily a violation if it doesnt impede
objectivity
Reward for strong past realized return from clients ok if other clients are treated the same DISCLOSURE
Rewards based on future performance: must receive written permission from employer
Ok to own same investments as clients. Responsibility to clients, then employer, then yourself.
Employees should disseminate public material information if it doesnt breach duty
You must attempt to make everyone (not just direct reports) adhere to laws, rules and regulations
Responsibility of supervisors: are held accountable for their employees actions.
Supervisory duties may be delegated but that doesnt relieve supervisors from responsibility
If block trades occur at different prices they must be allocated pro rata across all accounts with no
preferential treatment.
Acceptable to base a recommendation, in part, on an expectation of future events, even if is uncertain
EX: a politician is fighting for subsidies to an industry and believes that said subsidy will pass
Candidates cant say they received highest score on CFA exams b/c scores are broken in to <50, 50-70,
70< score sections. You dont know your actual score, just if you passed/failed.
CFA logo cant be incorporated into company name or logo. CFA logo used only to identify charterholders not
candidates
Allocate IPOs to suitable clients pro rata directly, not ok to allocate to managers who then have discretion to
allocate to their clients
Oversubscribed issues: forgo sales to yourself and immediate family(unless theyre regular accts), prorate
remaining amongst clients
Present outcomes from models or statistical estimates as opinions not fact and with qualifying statements
and caveats
Plagiarism includes: using experts either verbatim or with slight changes in wording w/o acknowledgement,
specific quotations to vague sources (leading analysts, Investment experts), using charts/graphs without
citing sources, copying spreadsheets or algos without seeking cooperation or authorization of creators.
You can use previous research done by another analyst even if they have left the firm. You cannot reissue
previously released report solely under your name. Firm can issue research if analyst is gone too.
Citing direct source or intermediary source: best obtain complete study from original author and cite author
preferred, or use both intermediary and source and cite both sources.
An influential analyst with the ability to move markets is considered material. But since this analyst is not a
company insider a report written by them is not considered MNPI and dont have to be publicly
disseminated. If you want access you can pay them.
If 10 largest shareholders are told something at a meeting. Analyst cannot use this information because it is
not public, it has not been widely publicly disseminated
Investment decisions made in context of the whole portfolio, consider the investments place in the overall
portfolio
Page 3 of 44
A family members account is a regular fee paying account comparable to all clients. Dont disadvantage
them or any other specific client because of overcorrecting notion of fairness due to this special
relationship
Dissemination should be fair(equal dissemination at same time for everyone too hard), cant discriminate
with selective dissemination
Higher fee paying clients get more service and attention but not to detriment to others
Using Quant Models: dont have to know every technical aspect but you should understand assumptions and
limitations
Developing quant models: understand technical aspects. Thorough testing of model and resulting analysis
should be completed
CFA institute recommends maintaining records for at least 7 years
If you issue a recommendation give ample time for clients to receive message and for them to act before
you or your firm trades in an effort to prevent front running
No need to dissociate yourself from report if you disagree with consensus group opinion if you believe
opinion has reasonable basis.
If market makers are in possession of MNPI, they should be passive market participants. Outright prohibition
of market making might be construed as a tip to outsiders
Exempt from best execution brokerage if client expressly prohibits best execution and is aware of the impact
on their account
MNPI violated if you act or cause other to act on MNPI received a mere outlook (promising,negative)
does not violate this
Diligence and reasonable basis not violated if no formal recommendation is made
All clients participating in a block trade should be given same execution price and pay same commission
Receive trade allocation request (what clients would like to own) notification from clients before receiving
stock from IPO
Whistleblower status granted if you dont have anything to gain personally
If client is trying to set up investment trust for kids, then the kids are the actual clients (trust beneficiaries),
consider kids risks and investment objectives
Suitability isnt an issue when recommending to general clients. Suitability may be issue if recommending
investment for specific client
Cant say date or time frame of receiving charter. Say: CFA charter received when Ive completed required
work experience after passing 3 levels
If influential analyst tells you about recommendation before going on TV it is considered MNPI if you act on
it.
Research Objectivity:
All communication btwn IBD and research should take place through compliance or legal. Draft should be
submitted beforehand. Communication should be only to verify factual info or conflicts of interest.
No communication btwn IBD and brokerage
Research cant share any part of recommendation with IBD or CorpFin
Research cant participate in marketing activities, if they are they should be disclosed.
Cant link research analyst compensation to specific IBD project. Although, compensation can be linked to
overall IBD department performance.
Cant trade against firm recommendation unless theres extreme financial hardship (different from
Standard Priority of transactions where firm should be notified of opposing trade and as long as trade
doesnt disadvantage clients)
Rating recommended to have: 1) recommendation or rating category 2) time horizon categories 3) risk
categories
Recommended restricted trading periods of at least 30 days before and 5 days after recommendation to
prevent client front running
Recommended quiet period: 30 days before IPO, 10 days before secondary offering
Research reports should be updated ideally quarterly. Also should be updated when theres a major event
Final research report should be issued if coverage is being discontinued. This report should explain reasons
for discontinuing coverage
Page 4 of 44
QUANTITATIVE METHODS
Cov
b^ 1= 2 xy =
(x x )( y y )/ ( n1 ) = Cov (x , y ) b = y b^ x plug y x
Estimated Slope coefficient = Var ( x) 0 1
X ( xx )2 /( n1 )
b^ 1b 0
t-test for significance: t stat = , REJECT if tstat > tcrit. Conclude: coefficient is significant in
sb1
CONFIDENCE INTERVALS
[
2 2
s =SEE standard error of estimate measures varianceof residuals
]
2
1 (xx )
^y t c s f where : s f = s2 1+ +
n ( n1)s x 2
SEE= MSE=
2
SSE
( n k1 )
'
sx isthe independent variabl e s variance
.
where ^y =b^ 0+ b^ 1 x
If Fstat > Fcrit then reject. Group of independent variable variation describes dependent variation
Effects of misspecification: Regression coefficients are biased and inconsistent, lack of confidence
in hypothesis tests of the coefficients or in the model predictions.
0 dL du ~2 4- du
4- dL 4
Positive serial correlation: SE underestimated, t-
stat larger
Negative serial correlation: SE overestimated, t-
stat smaller
Multi-Collinarity: high correlation High pairwise correlation Stepwise regression: omit one or more
between 2 or more independent High R2, high standard errors (low t- of collinear variables
variables. stats), indep coefficient t-stats are not
significant
Yt = ebo + b1t ln(yt) = b0 + b1X Regress natural log of dependent variables on independent variables
Root=non-cov stationary
Var(observations) constant, finite
Cov(Times series) constant, finite
NO unit root (series trends up or down). Correct with first differencing (described in ARCH
section below)
Test with dickey fuller. Unit root exists if b 1 1=0 (it is non-stationary)
AR test for residual correlation for time series models (if times series has
autocorrelation it is not covariance stationary) :
Detect: t-test for auto correlation in residuals:
autocorrelation( btwn error terror tkth laggedterm )
>t crit
1
standard error= reject null, CONCLUDE: serial/autocorrelations significantly
of observations
different from 0.
Page 6 of 44
Fix: Include additional lags for AR(p) model (p increasing) so theres no auto correlation
(t-stat declines to 0)
Testing for ARCH and non-stationarity for AR models **Remember: if non-stationary then AR is
invalid**
If b1 = 1, then the process has a unit root and is non-covariance-stationary from x t = b0 + b1 xt-1 + et
Random Walk is NON covariance stationary (no finite mean-reverting level)
If first differenced b0 = 0 and b1 =0 and theres not auto correlation between residuals
then AR is NOT random walk and IS covariance stationary
DICKEY FULLER TEST (first differencing method)
(xt - xt-1)= b0 + (b1 -1) xt-1 + et where g1 = b1 - 1
H0: g1 = 0 Time series has unit root and g1 will equal 0 (b1 = 1): accept null non-stationary
H1: g1 < 0 Time series doesnt have unit root and is covariance stationary
FIX non-stationarity First differencing: model change in value of dependent variable x t ,rather
than the variable itself xt
EX: run regression on ln(salest) = ln(salest) ln(salet-1)
Time series auto correlations significantly different from 0 at all lags. re-estimate model using
generalized least squares.
Test for ARCH is based on a regression of the squared residuals on their lagged values:
1) Square residuals from autoregressive model
2) Regress squared residuals against squared residuals from previous period
Seasonality
Detecting Seasonality:
Page 7 of 44
lnxt = b0 + b1 (lnxt-1) + et
if residual lag 4
Fixing Seasonality:
lnxt + b0 + b1 (lnxt-1) + b2 (lnxt-4) + et
Add lagged 4th term
Page 8 of 44
if Engle-Granger critical values rejects null hypothesis unit root. CONCLUDE: covariance stationary, 2
series are co-integrated
ECONOMICS
Price Currency USD
, rule for investors PRICE: buy @ bid , sell@ ask
= BASE: buy @ ask ,sell @ bid
Base Currency AUD
Converting:
PriceCurrency PriceCurrency
up the bid & multiply
down the ask & divide
Base Currency Base Currency
( CA ) =( AB ) x ( CB ) ( CB ) =
1
C
bid bid bid bid
( )
B Offer
Triangular Arbitrage
Market: USD EUR GBP USD Set all to bid or ask with inverting depending on
Bid Ask
strategy
USD/EUR 1.271 - 1.272
USD 1 EUR 1
EUR/GBP 1.249 -
USD/GBP 1.6 - 1.601
1.250
USD x x
EUR ask GBP ( ) ( ) x ( USD
ask GBP ) bid
Becomes:
USD x ( EUR
USD ) x(
GBP
EUR
bid
) x(
USD
GBP )
bid bid
1 1
$1 x ( 1.272 ) x ( 1.250
bid
) x ( 1.61 )
bid bid
=$ 1.006289> $ 1
Page 9 of 44
[
actual
]
Calculate forward premium (discount) = Forward f spot f =spot f
d d d
( 1+i d
360
[
actual
360 ] ) ( i f id )
Carry trade for arbitrage opportunities: borrow in lower yielding currency and invest (lend) in
higher yielding one. Then net any profit after borrowing costs and exchange rate movements.
(rd rf) < (Forward Spot) / Borrow Domestic Invest Foreign
Spot
(rd rf) > (Forward Spot) / Borrow Foreign Invest Domestic
Spot
EX: Borrow in USD, translate to Euros, Lend Euros, translate to USD, Repay in USD
Euro
Gross Return=( USD Notional ) x ( USD )
Current
x ( LIBOR Euro ) x ( USD
Euro ) Future
LIBOR USD (return funding cost )
*FPt, R and days are in terms of the number of days remaining in contract
EX: originally 90-day forward, 60 days have passed (30 days remain). FPt, R and days use 30 day
inputs
t
Interest Rate Parity: exchange rates change so that risk-adjusted returns on investments in
any currency will be equal. Investors are risk neutral
Page 10 of 44
days
1+r F (
)
360
1) Covered interest rate parity:
Forward(F / D)t = Spot(F / D )t investors earn same profit,
days
1+r D ( )
360
derives no-arb forward rate
Forward f spot f
d d
Forward premium ( discount ) as = R f R d
spot f
d
Derives no arbitrage forward rate. Interest rates and exchange rates will
adjust so the risk adjusted return on assets between any 2 countries and
their associated currencies will be the same (premiums and
discounts will offset). Real interest rate differentials would result in capital flows to the higher real
interest rate country, equalizing rates over time.
2) Uncovered Interest Rate Parity: Forward is unbiased predictor of expected future spot rates.
Expected spot price is not market traded and thus UIRP does not hold by arbitrage. Expected
appreciation/depreciation offset by int rt differential
Spot
days
1+r F (
)
360
E( (F / D) t)= Spot ( F / D)t
days
1+r D ( )
360
E(Spot f )spot f
d d
Expected change spot FX rate= Rf Rd
spot f
d
Fisher Relation: Countrys nominal interest rates should be similar to expected inflation differences
Rnominal = R real + E(inflation) R nomA-RnomB = E(InflationA) - E(InflationB)
1+ Rnominal = (1+ R real )[E(inflation)]
Macroeconomic Balance Approach: estimates how much current exchange rates must adjust to
equalize a countrys expected current account imbalance and sustainable current account
imbalance
External sustainability approach: estimates how much current exchange rates must adjust to
force a countrys
external debt (asset) relative to GDP towards its sustainable level
Reduced form econometric model approach: finds equilibrium path of FX movements based on
patterns in several macroeconomic variables, such as trade balance, net foreign asset/liability
and relative productivity
Mundell Fleming Model: monetary and fiscal policy impact on interest rates and exchange rates
Expansionary Monetary: pump money into economy int rts lower capital moves out
(domestic depreciates)
Expansionary Fiscal: lower taxes/ higher spending more gov borrowing int rts higher
capital moves in
Monetary Models:
Pure Monetary Models: PPP holds, output is constant
- Expansionary monetary/fiscal: prices, value of currency
- Restrictive monetary/fiscal: prices, value of currency
Dornbush Overshoot Model: prices are inflexible and dont reflect changes in policy immediately *think of
oversteering a car on ice
EX: expansionary monetary: prices, real interest rates depreciation of domestic currency due
to capital outflow
In Short term: depreciation of currency > depreciation implied by PPP. Depreciation is higher than it
should be.
In long term: FX rts gradually increase (appreciate) toward their normal long run PPP implied values.
Growth Economics:
Classical: Growth in real GDP is temporary and is limited by a subsistence level, new technologies result in
larger but not richer population
Neoclassical: Tech (TFP) improvement labor productivity resulting in upward shift of production function
curve.
in K (capital deepening) and L doesnt change growth in output per worker perm only amt of production
(movement on production curve)
Sustainable growth comes from population growth. Labors share of income increases from technological
advancement (treated as exogenous variable). after trade opens up and savings reallocated economies
converge at same growth rate as there is no permanent increase in growth rate. Diminishing marginal
productivity of capital but constant marginal product of capital. Savings and investment have temporary impact
on growth
In steady state, marginal product of capital (MPK) is equal to rental price of capital:
MPK =Y/ K = (capital's share of total output as % x output)/total capital = capital's share of total
output/total capital.
GDP growth rate = (growth rate in total factor productivity / (1-) labor's share of total factor cost) + growth in labor force
Endogenous: Technology leads to better labor productivity, capital deepening, knowledge capital and R&D
leads to social and other technological benefits and externalities for everyone. Saving and investment can
generate selfsustaining growth at a permanently higher rate as the positive externalities associated with R&D
prevent diminishing marginal returns to capital from setting in. Differs from neoclassical because endogenous
says capital investment has constant returns while neoclassical says K investment is diminishing.
GDP growth = TFP(tech) growth + (LT growth rate of capital) + (1- )(LT labor growth)
TFP(tech) growth = Growth in labor productivity Capital deepening
Stock market growth = GDP Growth + Capital growth + P/E multiple growth rates
*In LR stock growth depends only on GDP growth
Stock Market = GDP *(E/GDP)*(P/E) = GDP * corporate share of earnings in GDP * market P/E ratio
Regulations necessary b/c of information frictions (information asymmetry, moral hazard, adverse selection) &
externalities
Page 12 of 44
Regulatory Arbitrage: companies exploit difference between economic substance and interpretation of a
regulation.
Regulatory Capture: regulatory body gets influenced by regulated industry and advance interest of regulated
(eg. banks)
Regulatory Competition: regulators compete to provide best environment
Coase Theorem: When property rights are involved, people will make efficient decisions that are mutually
beneficial
FRA: INVENTORIES AND LONG-LIVED ASSETS
Inventories LR= LIFO RESERVE (lifo to fifo)
FIFO inventory = LIFO inventory + LIFO reserve (writedown charges)
FIFO COGS = LIFO COGS (LREnd - LRBegining) + (writedown charges)
COGS
Inventory Turnover Ratio=
Avg Inventory
LIFO to FIFO Conversion change amount:
Net Income. = + (LREnd - LRBeg) x (1- tax rate)
Current Assets = + (LIFO reserve)(1-tax rate)
Inventory.. = + (LIFO reserve)
Cash.. = (LIFO reserve) x (tax rate)
Liab (d. taxes) = + (LIFO reserve) x (tax rate)
Equity (RE). = + (LIFO reserve) x (1 tax rate)
LIFO results in higher cash flows because with lower reported income, income tax will be lower
LIFO Liquidation: COGS > Purchased, goods held in Beginning Inventory are included in COGS
Firm allows inventory to decrease. Lower COGS. Leads to unsustainable temporary increase in
net income.
Inventory Write Downs:
IFRS: min(cost, NRV = sales price selling & completion costs)
(may be written back up too to extent of loss)
GAAP: min(cost, market replacement cost) NRV Normal profit < market < NRV
(cant be written back up. Exception: agriculture, mining, forestry with active market can be reflected in IS as G/L )
Write down process: COGS, results in: Net Income
Long-Lived Assets COMPARISON Capitalizing Expensing
Capitalize as asset on balance sheet: NI 1st yr Higher Lower
1) Initially: noncurrent asset , CFI (similar to investing in asset) NI (future) [b/c depex] Lower Higher
2) Future: noncurrent asset , NI , RE , Equity (all because of T. Assets Higher Lower
depex) Equity Higher Lower
Expense cost in income statement CFO Higher Lower
Initially: NI by (cost)(1-tax), OCF no future costs CFI Lower Higher
Income Variability Lower Higher
Intangible capitalize/expense treatment: D/E Ratio Lower Higher
IFRS: R&D research expensed
Development (to bring to market) capitalized
GAAP: R&D research - expensed
Software development: establishing feasibility cost viewed as R&D costs expensed
When feasibility is established: costs capitalized as inventory
Internally developed software is expensed. Then capitalized when software
used as intended.
Patent & copyright dev: capitalized when purchased from outside
Expensed when developed internally
Investment in financial assets detail level (amount on parents financial statements proportionate to
B/S: GAAP & IFRS I/S: GAAP I/S: IFRS difference
FV through profit or loss Market FV (fair value) Interest, Divd none
- HFT(designated at
FV) Realized/unrealized
G/L
AFS FV: Interest, Divd Unrealized FOREX
IFRS: unrealized G/L in OCI Realized G/L G/L recognized in IS
GAAP: ALL unrealized G/L in OCI Reversed out of OCI in Realized
HTM -Initially recorded @ FV Interest
Reclassification adj including none
-Subsequently reported at amortized amort.
cost using effective interest method Realized G/L
Cost of debt + discount premium
thats been amortized
ownership % [0-20%]):
FV = market value if available Unrealized gain= FV Investment Beginning amt
discount
FV=par, n=time remaining, I/Y=rate/period, PMT=coupon/period, PVFV in BS
Effective Interest Method: (any diff between par & FV is amortized over term)
Par > FV (effective interest rate > stated coupon) securities trade at a discount
Par < FV (effective interest rate < stated coupon) securities trade at a premium
CarryingValue1 = CarryingValue0 + FairValue(mkt int rt) Par(Coupon)
*Use market for FV if available
Amortization of the discount/premium results in the carrying value of securities as it converges towards par as time
passes
Comprehensive income (CI=NI +OCI): Change in equity, net assets from non-owner sources.
Other comprehensive income (OCI) : SE, unrealized G/L b/c those items have NOT been settled
Ownership
Amt of control
GAAP
IFRS
20-50%: associates
Significant influence
Equity
same
50% (may vary): joint venture
Shared control
Equity
Equity or Proportionate cons
More than 50%: biz combo
Control
Acquisition (aka consolidation)
same
Equity Method:
ONE-LINE CONSOLIDATION of proportionate share of net assets and net income in B/S and I/S
respectively. Investment is listed at cost. Total value of the investment = Carrying value of investment
+ (earnings - dividends)
Goodwill Treatment:
proportion of net assets owned goodwill
absorption by PPE diff
Goodwill= Investment amount (ownership share%) x [(BV current assets + BV PPE Liab) +
(FV PPE BV PPE)]
If FV of net assets > investment amount
-Excess (negative goodwill) excluded from CV and included as income
Proportionate Consolidation (IFRS joint venture only if theres a stronger implied relationship than
equity method):
Page 15 of 44
All proportionally owned parts of B/S and I/S are included in the parents financial statement line by
line.
Acquisition Method (biz combo):
BS: assets & liab consolidated on B/S @FV, minority interest is created for portion that parent doesnt
own to balance acct eqn
IS: rev & expenses are added, minority interest is portion that firm doesnt own
Goodwill Treatment in Biz Combos:
IFRS (optional): Full goodwill = FV subsidiary FV identifiable assets
Partial goodwill = purchase price FV parents proportionate share of subsidiarys
identifiable net assets
GAAP (required): Full goodwill = FV subsidiary FV identifiable assets
GOODWILL IMPAIRMENT: recognized separately as line item on consolidated IS
IFRS: CV > recoverable amt (goodwill absorbs 1st hit of impairment, then non-cash assets, then cash units)
GAAP: CV > FV (written down to FV if impaired)
Notes on the 3 methods (assuming they all have 50% (same) ownership) :
1. All 3 have same net income
2. Equity and proportionate consolidation report same equity, ACQUISITION equity is higher
3. Assets, liabilities, sales and expenses: highest in ACQUISTION; PC is in the middle, lowest under equity
Reclassification of financial assets Its a VIE IF: insufficient at risk equity investment,
From To Unrealized shareholders lack decision making rights, dont absorb
G/L losses, dont receive residual benefits
HFT Any I/S (to VIE: Has lower cost of capital because assets and liabilities of
extent not VIE are isolated; VIEs can be in the form of a corporation,
recognized partnership, joint venture or trust. Not necessary for VIE to
) have separate management and employees.
AFS HTM Amortized
out of OCI
AFS HFT Transfer out of OCI
HT HFT I/S
M PENSION ACCOUNTING
HT AFS OCI
M *Funded status shows up in BS
different curriculums denote positive funded status= (PBObeg) x
as (Disc Rt)
Either net pension liability or asset
Affects actuarial
*A CTUARI
AL G/L IS PLUG Gains decrease PBO, losses increase PBO
*If contributions > periodic pension expense, remainder can
be viewed as a reduction in PBO
Periodic pension COST: total cost listed in either IS or OCI for GAAP/ IFRS
Periodic pension expense: periodic pension costs
recognized ONLY in IS/P&L (not OCI)
Periodic Pension Cost Treatment
Component Item IFRS GAAP Recognition
Recognition
+ Service Cost + Current Service Cost Actual Events Service Cost IS
+ Prior Service Cost IS (P&L) Past Service Cost OCI
+ Amortization of Unrecognized Subsequently
Prior Recognized in IS
Service Costs
Page 16 of 44
Multinational Operations
Presentation CR Functional Currency T Local Currency
Use CR when subsidiary is independent
Use T if subsidiary is highly integrated with parent
Temporal Method Current Rate Method *RE from IS can be plug so that the BS can balance
(aka (aka translation) **FX G/L shown on IS
remeasurement) ***If not given, equity translated @ current rate, then
Monetary A/L Current Rate Current Rate find plug to make A=L+(E+CTA)
Non monetary A/L Historical Rate Current Rate
Common stock, Divd Historical Rate Historical Rate
In highly inflationary environment
(capital stock) IFRS: restate for inflation, use current rate
Equity Mixed * RE PLUG Current Rate*** from I/S GAAP: temporal, nonmonetary A/L NOT restated for
Revenues, Expenses Average rate Average Rate inflation
COGS Historical Rate Average Rate
Depreciation Historical Rate Average Rate
G/L recorded in IS.
Net Income Mixed** = Rev - Average Rate = RE +divd Exposure example (from pov Domestic): if
Exp theres a NET ASSET and the foreign currency
Exposure Net monetary Shareholders equity is appreciating, theres a translation exposure
Exchange rt G/L assets (net asset)
Income StatementEquity *PLUG A = L + (E + GAIN
CTA ) if theres a NET
LIABILITY and the foreign currency is appreciating, theres a translation exposure LOSS
Speculative hedges
When earnings are relatively free from accruals, mean reversion will occur at a slower rate.
* NOA = A- L (exclude cash equivalent and marketable
securities and debt)
SalesCOGSSG A expenses
Core operating margin=
Sales
=EBT
N E E R Ta Te. N S A E.
Beneish model: if (M > -1.78) indicates higher than acceptable probability of earnings manipulation
CORPORATE FINANCE
NPV
WACC reflects inflation & financing charges, CFs should be adjusted to reflect inflation otherwise
NPV will be biased
Depreciation is added b/c it is a non-cash charge that expenses, income. D(1-t)+D = tD which is
the DEPEX tax shield
NWC = NWCInv = non cash current assets nondebt current liabilities
*NWCInv is cumulative NWC during project
If an asset is not being replaced: S= sales or revenue
C= operating costs
Initial investment (outlay) = FCInv + NWCInv (outflow, - for inflow) D= depreciation
CF = (S-C-D)(1-t)+D t=tax rate
= (S-C)(1-t)+tD Sal0= sale of old asset
TNOCF = SalT + NWCInv t(SalT - BT) SalT= sale of new asset
t(SalT - BT)= tax charge for gain on
CF TNOCF asset sale
NPV =outlay+ t
+ T BT = investment accum.
(1+ r) ( 1+ r) Depreciation
FCInv = cost of machine
If an asset is being replaced (replacement project): +installation cost
=ending fixed asset - beg fixed
Initial investment = FCInv + NWCInv Sal0 + T(Sal0 B0)
CF = (S-C-D)(1-t)+ D
= (S-C)(1-t)+tD after-tax net proceeds from sale
TNOCF = (SalT Sal0) + NWCInv T[(SalT - BT) - (Sal0 B0)]
M&M Propositions:
MM Proposition NO Tax (cap structure doesnt With Tax (100% debt is best)
matter)
1 (changes in value) Capital Structure Doesnt Debt has tax shield advantages
No tax, transaction costs, Matter VL = VU + tDebt
bankruptcy VL = VU value based on OCF
2 Cost of capital not determined
(changes in WACC) by structure but rather by Cost of equity increases with more
business risk. Increasing use of debt but not enough to perfectly
relatively cheaper debt will offset cheaper debt. WACC
increase risk and cost equity. So minimized @ 100% debt
the two offset each other D
R E=Rall eqco +( Rall eqco R D )(1t )
VL = EBIT(1-t)/WACC
E
D
VU = EBT(1-t)/WACC R E=Rall eqco +( Rall eqco R D )
E
V=
Interest EBIT Interest
+ + ( EBIT Interest )(1t )
rD rE rD rE
V =
Static Trade off: VL = VU +tD PV(costs of financial distress) * theres a sweet spot for maximizing firm value
System Environment
Debt Efficie Comm Lower Favorab Active Bank Large High High
Usage nt on Law info le taxes bond and based institution inflatio GDP
Legal > Civil asymme on stock financial al n growth
Syste law try equity market system investors
m
D/E Lower Lower Lower Lower N/A Higher Lower Lower Lower
ratio
Maturit Longe Longer Longer N/A Longer N/A Longer Shorte Longer
y r r
Dividends
Double taxation:
Effective Tax = CorpTax + (1- CorpTax)(DivdTax)
= 1-(1-CorpTax)(1-DivdTax)
Imputation tax system: taxes paid out at corporate level, but attributed to shareholder: all taxes are effectively
paid at shareholder rate.
If (Marginal Tax) < (Corp Tax-paid) Investor gets tax credit = franking credit
If (Marginal Tax) > (Corp Tax-paid) Investor pays for gap
Split rate tax system: RE taxed at higher rate than profits it pays out at dividends, encourages
companies to have a lower retention ratio, and pay higher dividends, dividends taxed again @
shareholder level as ordinary income
Expected dividend = (previous dividend) + [(expected increase in EPS) (target payout ratio)
(adjustment factor)]
adjustment factor = 1 / # yrs that adjustment takes place
Price change = Pw divd Pw/o divd = (1-TD)/(1-TCG) x Divd
FCF = NI + Net interest after tax change in deferred taxes + net NCC net WC CAPEX
Unlevered net income Net Operating profit less adjusted taxes (NOPLAT)
Net interest after tax = (interest expense interest income)(1 marginal tax rate)
Net Working Capital + current assets current liabilities (excluding cash and equivalents and ST debt)
FCFE coverage = FCFE / (divd+share repurchases)
FCFE = CFO FCInv + net borrowing
Dividend Coverage Ratio = NI / Dividends
Dividend payout ratio = 1/Dividend coverage ratio = Dividend/NI
Private Equity
Bootstrapping: high P/E firm purchases low P/E firm
Current EPS is higher at the expense of lower growth prospects and lower future EPS
Equity carve out: subsidiary created and IPOd parent still retains control. Sale of equity of new co to
outsiders
Spin-off shares of new firm are distributed to parents existing shareholders on pro-rata basis
Split-off: parent and subsidiary exchange (surrender) stock. Parent wishes to draw distinction with
subsidiary.
M&A
GainTarget = Takeover premium = PT - VT HHI = Sum([Sales company/ T. SalesIndustry x 100]2)
GainAcquirer = S TP = S (PT - VT)
VAT = VA + VT + S C (cash paid to target shareholders)
M&A DCF FCFF using NOPLAT:
Income to all investors Tax savings from higher depreciation
FCFF = NI + Net Interest After Tax + Changes in deferred taxes + NCC INC_NWC FCInv
Friedman doctrine: social responsibilities of business is to increase profits within rules of the game
fair competition w/o deception or fraud
Utilitarianism: maximize positive, minimize negative outcomes. Bad: difficult to measure utility, what
may be good for larger group may come at expense of minority (eg: not providing healthcare for few
AIDS patients)
Kantian: People are different than factors of production, they must be treated with dignity and respect
Rights theories: everyone has rights and privileges, greatest good utilitarinism cannot violate the
rights of others
Justice theories (Rawls): rules are fair if you dont know your own particular characteristics.
Differencing principle: unequal division must benefit least advantaged members of society. Everyone
decides if sweatshop is lawful if you dont know if you fall under the category of working in one.
Corporate Governance
- Make sure assets used productively, mitigate conflicts of interest, ensure fairness btwn BOD,
managers, shareholders
- Risks: asset risk, liability risk, financial disclosure risk, strategic policy risk
EQUITY
Return concepts: Estimate required return:
MRP
ERP
Expanded CAPM: Req = RFR + (E(Rmkt) RFR) + Small Co. Premium + Co. Specific Risk
Premium
Fama French: market risk premium, small cap risk premium, value risk premium.
Rmarket RFR Rsmall - Rbig Rhigh book to value R low book to value
Pastor-Stambaugh model: adds liquidity factor to FF model
Chen-Ibbottson: ERP = (1+i)(1+REg)(1+PEg)-1+Y-RFR
Terms in order: inflation forecast, growth in real earnings, growth in market PE ratio, yield
on index
Yield on index=dividend and reinvestment income g real earnings=GDP-inflation
E(Inflation) forecast = (1+ YTM 20 yr t bond)/(1 + YTM 20 TIPS) -1
BIRR (Burrmeister, Roll, Ross) model (factor x Sensitivity to that factor):
RFR + 1) Confidence Risk: unexpected change in difference between return of risky corporate
and gov bond
2) Time horizon risk: unexpected change in diff btwn return of LT gov bonds and ST gov
bonds
3) inflation risk: unexpected change in lvl of inflation
4) Business cycle risk: unexpected change in level of real business activity
5) Market timing risk: equity market return not explained by other 4 factors
Build up method (betas are hard to find, also consider premiums and discounts for
control, marketability):
Return= RFR + ERP +Size Premium + Company specific premium + Industry Premium
Smaller companies have larger size premiums
Bond Yield Plus Risk Premium (BYPRP) = YTM LT debt + RiskPremium (associated with owning equity
investment over debt)
YTM includes: real int rt, inflation, default risk premium
Gordon Growth Equity Risk Premium = (divd yield) + earnings growth RFR = D/P + g earnings - RFR
Adjusted (Blume method) adj = (1/3)+(2/3) = 0 + 1
Beta Leveraging: 1 + [(1 Tax Rate) x (Debt/Equity)] OR (1+D/E)
Porters 5 forces: threat of entry, power of suppliers, power of buyers, threat of substitutes, rivalry
among existing competitors.
Short term fleeting factors: industry growth rate, technology, innovation, government
Picking Corporate Strategy:
Page 21 of 44
D0 (1+ g L ) D0 H (g sg L ) D 0 ( 1+ g L ) + D 0 H (g sg L )
The H-Model: V 0= + = Growth rate declines linearly
(r g L ) (rg L ) (r g L )
D0
r ( )
P0 [
( 1+ g L ) + H ( gs g L ) ] + g L
Add back: preferred dividends to FCFF Add back: net issuance of preferred stock to FCFE
NCC = Depreciation + Amortization + Impairment + Reversal of income from restructuring
EBITDA not good proxy for FCFF and FCFE. EBITDA is looking at debt repayment strength, doesnt
consider WCInv, FCInv. Look at relationships in FCF and EBITDA derivation to see specifics.
Page 23 of 44
Market Comparables
EV = MV eq + MV Debt +minority interest + preferred shares cash & ST investments
(# preferred shares) x (Common Share Price)
Enterprise value ratio denominators:
Market Ratios
b = retention ratio = (EPS - DivPerShare)/EPS
P 0 P0 1 D1 1 D1 / E1 (1b)
Leading = = ( )=
E1 1 E1 r g E 1 rg
=
r g
P0 D 0 (1+g) / E 0 (1b)(1+ g)
Trailing = = * (1+g) multiplied b/c it negates next periods earning to current
E0 rg r g
P0 ROEg
= B0 = book value of equity = (assets - liability) preferred stock
B0 rg
P (1+ g)
= ** P/CF and D/P are the same but flipped
CF (rg)
D 0 r g
=
P0 1+ g
P Price
= = BVPS = Common Stock + Additional paid-in Capital + Retained Earnings ()
BV Book Valueof Equity
Treasury Stock + Accum. OCI
RI TO EQUITY HOLDERS
Residual Income = NI Equity charge
Equity charge = Req X BVequity
RI TO ALL CAPITAL HOLDERS
EVA = [EBIT(1-TaxRate)] (WACC% X Total invested capital)
= NOPAT - $WACC
Residual income = After Tax Operating Profit Capital Charge
= (ROIC - WACC) x Total Capital(Assets)
Capital Charge = Equity Charge + Debt Charge
= Req x BVequity + Rdebt x Debt Capital x (1-tax)
BVt = BVt-1 + earningst-1 Divdt-1
MVA = Market value of the company Book Value of Invested Capital
=([shares x stock price] + [% of par debt]) (BV eq + BVdebt)
RI t E r B t1 ( ROEt r )Bt 1
RI Value of the firm:
V 0=B0 + t
=B0 + t t
=B 0+
(1+r ) (1+r ) (1+ r)t
(ROEr)
Single Stage RI ,V 0 =B 0+ B0 RI: residual income E:earnings r:req rt B:bookValue/share
r g
g=r
[ B 0 x (ROEr )
V 0B0 ] if ROE > required return value > stock price & P/B justified > P/B
Tobins q = Market value of debt and equity / Replacement cost of total assets
Persistence factor () :
Strong persistence factor =1 : low dividend payout (firm is retaining money to grow company), RI
persists forever
Weak persistence factor =0 : high ROE (nonrecurring items, high accounting accruals make these relatively
high returns unsustainable)
Terminal value
T 1
Et r Bt1 E T r BT 1
V 0=B0 + t
+ PV(continuing residual income in yr T-1)
T =1 (1+r ) (1+ r)(1+ r)T 1
RI t
PV ( continuing residualincome year T 1 )=
1+r
ROE declines to cost of equity over time due to competitive market, so RI goes to zero
RI appropriate when terminal value is uncertain and when clean surplus relationship holds
Page 25 of 44
n
Simple harmonic mean=
1/x i
1
Weighted harmonic mean=
wi /x i w is weight, x is ratio (P/E, P/B )
ALTERNATIVE INVESTMENTS
Real Estate: (insurance, utilities, maintenance **interest and tax are NOT
included)
NOI = Rental Income + Other Income Vacancy&Collection Loss Operating Expenses
Venture Capital
Future value of VC investment = (Initial investment) x (1 + IRR rate)Years
Exit value = Investment cost + earnings growth + inc price multiples + reduction in debt
VC Ownership
shares required for fractional ownership= shares by founder ( 1%VC Ownership )
Tag along drag along: mgmt. may buy/sell stake if PE firm sells
Ratchet: mgmt or LP can increase its equity allocation depending on performance
Carried interest: GP profits from performance
Distribution Waterfall: diff investors get paid out based on hierarchy priority
Hedge Funds: Adding hedge funds will cause STD to increase, Sharpe to decrease, negative skewness and positive kurtosis
Commodities:
F0 = S0 e(RFRc + U - Y )T *continuously compounded
t
F0 = S0 (1 + RFR) - FV(Benefits) + FV(Costs) *discrete
U = Storage costs, Y=convenience yield benefit of holding asset
Backwardation: futures< spot
Normal Backwardation: futures < E(future spot rate)
T. Commodity Return =
Spot return cheaper to replace
+ Roll Return (Replace maturing with new contracts. Backwardation: + roll return, Contango: -
roll return)
+ Collateral Return (Posted collateral returns invested in t-bills)
+ Rebalancing Return (portfolio rebalancing adjustment by keeping same proportion of assets
in portfolio)
Insurance perspective: long commodities will earn + returns for supporting short hedgers
Hedging Pressure Hypothesis: risk premium earned on other side of heavy long/short
Theory of storage: difficult to store commodities. Positive convenience yield
Convenience Yield: monetary benefit of holding asset vs holding futures contract
Convenience yield is high: spot , futures & inventory is low
FIXED INCOME
Structural models of corporate credit risk: looks at BS and option of A=L+E. Default risk is constant.
Doesnt change for business cycles or changing economic variables. Assumptions: B/S is simple with
only one class of zero-coupon bond, asset is actively traded on frictionless market, RFR is constant.
Reduced forms: impose assumptions on output of structural models. Perform better than structural
models because they impose assumptions on structural models Assumptions: Theres a 0 coupon
liability traded on the market, RFR is stochastic (random, not constant), default risk depends on the
economic conditions which depend on non-constant variables varies w/ business cycle.
Max amt bond holder wants to pay for insurance to remove credit risk = EL = ParDebt[1-e -LGD x (default
intensity) x (time to maturity)
]
Expected Loss = ParDebt x N(-e2) Asset x eE(return on assets) x time to maturity N(-e1)
PV(Expected Loss) = ParDebt x e- RFR x time to maturity N(-d2) Asset x N(-d1)
If PV(EL) > EL then risk premium dominates time value discount
Segmented mkts theory: yields on curve represent supply and demand. So yields dont reflect spot
rates or liquidity premiums.
Page 28 of 44
Preferred habitat: preferred maturities of investors, if premiums for other maturities are large enough
they will invest
Effective convexity computed using binomial model: the yield curve is shifted upward and downward
in parallel manner and binomial tree calculated each time. Resulting bond values are used to compute
effective convexity.
I spread: Risky bond yield swap rate for the same maturity
-represents credit and liquidity risk
TED spread: indicates commercial bank lending risk, perceived credit risk in economy
LIBOR treasury rate
LIBOR-OIS: Liquidity in money market securities
LIBOR(credit risk) OIS (overnight index swapfederal funds rate. Very little credit and
counterparty risk)
Low: high market liquidity
High: unwilling to lend because of concerns over credit and liquidity
Swap rate: liquid, flexible and efficient for hedging
Swap rate determination: EX find swap fixed rate for a three year interest rate swap
1) Spot1, Spot2 Spot3 are given
2) Find CouponRt3 this is the swap rate for 3 yr IRS
CouponRt 3 CouponRt 3 CouponRt 3 1
1
+ 2
+ 3
+ 3
=1
(1+ Spot 1 ) (1+ Spot 2 ) (1+ Spot3 ) ( 1+ Spot 3)
origination
CDO types
Arbitrage driven CDO: take advantage of spread between the return on collateral and funding costs
Cash flow CDO: principal and interest payments can pay tranches
Market value/Balance Sheet CDO is actively managed to generate sufficient cash flows
Term structure:
Pure expectations: forward rates are unbiased predictor of future expected rates
Yield volatility:
Annualized std= days= daily , daily = Var
2
( x t x ) yt
Variance=
N 1
, xt =100 ln
( )
y t 1
, y t = yield
If you think asset price will enter into a forward contract to buy asset (at lower price)
If you think asset price will enter into a forward contract to sell asset (at higher price)
Where g is
$ 1.2 $ 1.4 the # of
PV = (30g)/ 365
+
(1+r ) (1+ r)(100 g)/365 days after
initiation
FRA:
3 x 9 FRA: 6 (m) month libor rate, 3 (h) months from now
h = expiration in 90 days h+m m =9mo 3 mo = 180-Day LIBOR
Buy FRA effectively long loan contract price Sell FRA effectively short loan contract price
IF Floating rate > contract rate IF Contract rate > floating rate
Long borrows @ below market rt & gets paid Short loans @ below market rt & gets paid
FRA @ Initiation:
FRA on day g:
FRA=
[ 1+ L0 ( h+m )
1+ L ( h ) (
0
( h+m
360 )
h
360 )
1 (
]
360
m )
][ ]
negative of the value to
1+ Forward 0 ( 360m ) long
[
1
Value of long=
hg
1+ L g ( hg )( )
360
1+ Lg ( h+mg ) ( h+360
mg
)
FRA long payoff @ Expiration
days loan term
360
( Current Market LIBOR rateOld FRA rate )
*int rt = spot rate @
1+[ rt ( of daystheloan term/360)]
NP
expiry
Futures:
The value of a futures contract is zero when the account is marked-to-market and there is no margin call. The price of the
contract is adjusted to the new no-arbitrage value, which is theoretically the same as the settle price at the end of trading, as
long as price change limits have not been reached
Futures prices will be unbiased predictors of future spot rates
Futures Contract = Spot (1+RFR)T + FV(Costs of holding) FV(benefits from holding) *FV values are
straight , not discounted
Costs increase the price of a futures contract b/c buyer skips out on those costs by buying a
futures contract instead of the underlying asset. Which include: storage costs
Benefits decrease the price of a futures contract b/c the buyer skips out on those benefits by
buying a futures contract instead of the underlying asset. Which include: dividends, cash flows,
convenience yield
Contango: If costs of carry are greater than benefits then futures price are greater than the spot price
Backwardation: If costs of carry are less than benefits then future price is less than spot price
Normal contango: Futures price > Expected Future spot rate
Normal backwardation: Futures Price < Expected Future spot rate
Traders want normal backwardation because they can enter into contract to buy in future @ lower price
Convenience Yield:
If convenience yield> borrowing rate, futures price is below spot price and market is in
backwardation. It means that the value of the convenience of holding the asset is worth more
than the cost of funds to purchase it. The no-arbitrage cost-of-carry model will not apply. This
applies to non-financial futures contracts.
Futures vs forwards
Futures are marked-to-market forwards are not. Futures contracts trade on exchanges, no
counter party risk (margin requirements by clearing house). If mark to market is preferred then
futures price > forward price.
Differences between theoretical (no-arb) prices of forwards and futures:
If asset prices and Preferences based
interest rates
correlation is:
Positive Prefer long in futures contract to have market to market features.
Futures price > forward price. When asset increases and mark to market contract
generates cash, reinvestment opportunities tend to be better due to positive correlation of asset
values and higher interest rates. Gains from adjustments can be invested at higher level, while
losses can be financed at lower costs.
Zero No preference
Negative Prefer long in forwards contract to avoid mark to market. Gains from
adjustments are invested in lower level, while losses must be financed at a
higher cost
Value of futures contract = current futures price price when previously marked to market
Contracts marked-to-market, contract=0 @ end of trading day, contract only has value during
trading day.
C
++ down
(1+r )
Value of Call = up C
c=
2
( down)( up )C C
+
(1+ r)2
+++( up)( down )C
( up)2 C
Value of 2 period call=
Put Options:
Everything is the same as above except calls replaced with puts for:
Put value up = P+ = Max[0, x- S+]
Put value down = P- = Max[0, x- S-]
Option is Call optionmarket > call option intrinsic Put optionmarket > Put option intrinsic
overpriced Sell options, buy shares Sell options, sell shares
Option is Call optionmarket < call option intrinsic Put optionmarket < Put option intrinsic
underpriced Buy options, sell shares Buy options, buy shares
Portfolio Cost = [# shares]*[Stock0]-[# calls]*[call = [# shares]*[Stock0]-[# puts]*[put
(buy is outflow, sell is val0] val0]
inflow of cash) = (ns)(S0) (nc)(C0) = (ns)(S0) (nP)(P0)
Portfolio value Portfolio value in up move: Portfolio value in up move:
*up and down move [# shares]*[Stockup]-[# Calls]*[Call valup] [# shares]*[Stockup]-[# puts]*[put valup]
portfolio value will be = (ns)(S+) (nc)(C+) = (ns)(S+) (nP)(P+)
the same Portfolio value in down move: Portfolio value in down move:
[# shares]*[Stockdown]-[# Calls]*[Call valdown] [# shares]*[Stockdown]-[# puts]*[put valdown]
= (ns)(S-) (nc)(C-) = (ns)(S-) (nP)(P-)
Profit Portfolio Value Portfolio Cost
Hedge Ratio = H = Portfolio Hedged if: H-=H+ nS+-C+ = nS+-C-
nS-C which means:
Effect on option Call delta = N(d1) > 0 Call price Put delta = [N(d1)-1] < 0 Value ,
value if stock price N(d1) x S as stock
changes Value , as stock Put price [N(d1) -1] x S
Gamma: measures sensitivity of delta to changes in the price of underlying Gamma = delta/price
of underlying
Large (bad) when option is at money and close to expiration (more sensitive). Option value more
sensitive to changes in stock lead to large changes in delta and have frequent rebalancing of
dynamic hedges.
Small (good) when option is deep in or out the money (not sensitive) b/c changes in stock dont
affect . Dynamic hedge will perform well
Max [0, ( market ratecap rate ) x notional ] Max [0, ( floor ratemkt rate ) x notional ]
1+market rate 1+market rate
2 year cap = 2-year caplet + 1-year caplet
Value 2-year caplet. Value right 3 end nodes (red) with caplet
value. Value 2 middle nodes (blue) by using binomial method
dividing sum of 2 50% weighted nodes from right then dividing by
corresponding int rt
Fixed rate c=
1Z n
=
1
( 1+ R 4 [ ])
360
360
Z 1 + Z2 + Z n 1 1 1 1
( 1+ R1 [ ] ) ( [ ] ) ( [ ]) ( [ ] )
90
360
+
1+ R2
180
360
+
1+ R3
270
360
+
1+ R 4
360
360
90 x period
Present Value Factors 1
z (n)=
1+ raten ( 360 )
Swap Value
Fixed payment amount = (fixed rate from above) x (360/period length) x (notional)
PV(fixed rate) = Z1(days until pymt 1) x (fixed pymt) + Z2(days until pymt 2)[fixed pymt +
notional]
*Uses new term structure
EX: originally pymts made annually, now 180 days have passed
1 1
PV ( rate ) =
( 1+ R180 ( ) 180
360 ) x [ payment ] +
( 1+ R1 80
540
( )
360 ) x [ payment +notional ]
PV(floating) uses only 1st floating payment and notional for calculation
= Z1(days until pymt 1) x [(Rate pymt 1)*(period length/360)*(notional) + notional]
Use new term structure for PV factor Use initiation original old term structure for floating pymt
) [( x notional )+notional
]
1
( 360
EX : PV ( floating rate )=
( 1+ R 180 ( 180
360 )
R0 ( 360 ) x
360 )
Equity Swaps:
Pay fixed, receive float: (1+ROE) x NP PV(remaining fixed rt payments)
Pay float, receive fixed: (1+ROE) x NP PV(coupon + par)
Swaption:
Payer swaption gives holder right to enter into a swap in the future as a fixed-rate payer
If swap fixed rates increase (as interest rates increase), the right to enter the pay-fixed
side of the swap (a payer swaption) becomes more valuable, when interest rates
increase bond prices fall and put options on the bond becomes more valuable.
Receiver Swaption gives holder the right to pay floating and receive fixed.
CDS:
Payout amount = (payout ratio) x (notional) Payout ratio = 1 recovery rate
Bond spread = yield investors cost of fundingcompare w/ CDS spread
CDS asset swap spread = coupon interest rate on swap fixed
CDS spread < asset swap spread
CDS spreads are negatively related to probability of survival and recovery rate, and positively related
to probability of default and loss.
Cheapest to deliver same seniority (pari passu):
single name payoff = protection notional (par %) x (notional)
index payoff = proportional weighted notional (% of par after default) x (weighted notional)
new notional = total notional default payoff
physical settlement Cash settlement
- Discounted/defaulted reference obligation - Par-market value in cash
- Par value
CDS price (per $100 notional) = 100 upfront premium
Value protection leg = credit risk, contingent payment that may be made from CDS seller to CDS
buyer in case of default
= value of RFR bond E(payoff risky bond)
Minimum
Variance Portfolio:
Correlation = = Cov(1,2)/1 2
CAL EQN =
Based on Graph
Borrow money at RFR and invest in risky
assets. Move on line A from bottom to top
(same risk, more return)
Lend money at RFR, earn same return but less
risk. Move on line B from right to left (same
return, less risk)
Similar
CML VS CAPM:
If markets are in equilibrium risk & return will lie on SML, not CML. Risk & return combos for
individual securities will lie below CML b/c their include unsystematic risk which can be diversified
away
SML CML
Measure of Uses (systematic, market, non- Uses =stand alone risk = systematic +
risk diversifiable) unsystematic
Application Determine benchmark appropriate Asset allocation btwn RF asset and risky
returns portfolio
Definition Graph CAPM Graph efficient frontier
Slope Market risk premium ADJUSTED
Market portfolio sharpe BETA
ratio for stability, as
Assets systematic risk: it tends to gravitate towards 1
Adj i= 0+ ii OR adj 1=
where i = stock, M = market 1/3 + 2/3 i
Markowitz Decision Rule: when comparing 2 portfolios choose higher E(return) lower (R) ceterus
paribus
To fully hedge factor risk set combined weightings to 0 and solve for w.
Total active Return = [(portfolio sensitivity benchmark sensitivity) x factor return] + Asset
selection returns
= Factor tilts (AKA sum absolute contribution to active return) + individual
security return
k
b j b i COV (F j , F i)
i Active factor risk AEF A [ AEF Acov ( A , A ) + AEF Bcov ( A , B ) ]
FMCAR j= = Ex : FMCAR A =
Active risk squared Active risk squared Active Risk Squared= Active factorspecific risk
**Where AEF = Active
Exposure Factor**
Active return R pR b
=
IR = Information Ratio (mean active return per unit of risk) active risk s(R p Rb )
indicates pure stock selection ability and manager performance, independent of aggressiveness
(aggressiveness included in residual risk)
add stocks with highest IR
Residual Risk:
Residual return
Information ratio= (vs benchmark ) trade off between active return & active risk
residual risk
Nc
Information Coefficient ( IC )=2 ( picks that are correct )1=2 ( )
N
1=2
picks correct
(
total picks
1 )
Residual return
Information ratio= (vs benchmark)
IR IC x Breadth residualrisk
Optimal amount of residual risk= = =
2 2 Risk Aversion Aversion
2 2
IR IR IC x breadth
Highest Achievable Valueadded =VA = =
2 4 4