CFA Level 1

Ethics and Professional Standards

1. Ethics and Trust in Investment Profession, 2. Code of Ethics & Standards of Professional Conduct

Basics:

• Ethics: Set of moral principles / rules of conduct providing guidance for behavior

• Moral / ethical principles: beliefs on good / acceptable / obligatory VS bad / unacceptable / forbidden

• Ethical conduct: behavior following moral principle / balances self-interest w in/direct consequences on other

• Code of Ethics: Established general guide on org’s value / overall expectation regarding member behavior

• Standards of Conduct: Established minimally acceptable / benchmark behaviors required by group enhancing Code of Ethics

• Profession (1) are subject to license / technical standard (2) aim to serve society, set / enforce professional conduct

• Professions build trust as they (1) normalize practitioner behavior (2) provide service (3) are client focused [fiduciary duty acting in best interest for another party] (4) have high entry std (5) possess expert knowledge [knowhow & synergy] (6) encourage continuing education (7) monitor conduct (8) are collegial / respectful (9) recognize oversight bodies (10) encourage member engagement (11) evolve (12) are professional (13) trust investment mngmnt [full disclosure]

• Client interest < market interest

• CFA Institute Global Body of Investment Knowledge (GBIK) and Candidate Body of Knowledge (CBOK) are updated thru practice analysis (interaction w practicing investment mngmnt professionals) to maintain body of knowledge relevant

• CFA charterholders and CFA Program candidates are required to adhere to Code and Standards and to sign annually a statement attesting to that continued adherence

• Investors w low levels of trust are less willing to accept risk and will likely demand a higher return for use of their capital

• Investment management profession and investment firms must be interdependent to maintain trust

Challenges: 

• Overconfidence: too much emphasis on internal trait / intrinsic motivation

• situational influence: money, prestige, loyalty

• Must consider LT consequences

• Compliance approach can develop ethical culture but may oversimplify decision marking and become a reason for situational influence

• Legal vs ethical: Ex. trading w material nonpublic info - ok legally, unethical in CFA

Ethical Decision-Making Framework

• Identify: Relevant facts (fact / opinion / bias) stakeholders and duties owed, ethical principles, conflicts of interest

• Consider: Situational influences, additional guidance, alternative actions

• Decide and act

• Reflect: Was the outcome as anticipated? Why or why not?

Guidance:

• Standards of Practice Handbook (Handbook) guides ethical dilemmas which all members must adhere to

• CFA Institute Bylaws and Rules of Procedure for Professional Conduct (Rules of Procedure) structure the Code and Standards 

• CFA Institute Board of Governors oversee Professional Conduct Program (PCP). PCP and Disciplinary Review Committee (DRC) enforces Code and Standards. DRC reviews conduct and partners with Professional Conduct (PC) staff to establish / review professional conduct policies. PC division enforces test policies and professional conduct of Certificate in Investment Performance Measurement (CIPM). CFA Institute Standards of Practice Council evaluates Code and Standards and Handbook, ensuring they are effective (representative of high standards, relevant, applicable, comprehensive, enforceable, testable) 

PC inquiries: 

• Source: (1) self disclosure on annual PC Statement - litigation, investigation (2) written complaint received by PC staff (3) media, regulatory notice, public source (4) proctors monitoring test (5) score analysis to detect disclosure of confidential exam info

• Conduct interviews / investigation

• Result: no disciplinary action, issue cautionary letter, continue proceedings to discipline member

• Rejection or acceptance by members. If rejected, matter referred to DRC

• Sanctions include public censure, suspension of member / use of CFA design, revocation of CFA

Code of Ethics:

• Act w integrity, competence, diligence, respect and ethically w public, clients, prospective clients, employers, employees, colleagues in investment profession, other participants in global capital markets

• Place integrity of investment profession, interests of clients above own personal interests

• Use reasonable care, exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, engaging in other professional activities

• Practice, encourage others to practice professional, ethical manner reflecting credit on themselves,  profession

• Promote integrity, viability of global capital markets for the ultimate benefit of society

• Maintain, improve professional competence, strive to maintain, improve competence of other investment professionals

Standards of Professional Conduct: (Revisions of 11th version underlined) in Standards of Practice Handbook

1. Professionalism

1. Knowledge of the Law
   Members must understand / comply w all applicable laws, rules, regulations (Code & Standard) of any gov, regulatory organization, licensing agency, professional association governing their professional activities. In event of conflict, Members must comply with the more strict law, rule, regulation. Members must not knowingly participate / assist in and must dissociate from any violation of such laws, rules, or regulations.
   → (1) attempt to stop behavior by bringing it to attention of employer thru supervisor / compliance department. (2) members dissociate from activity (removing own name in written reports, asking for dif assignment, refusing to accept new client / continue current)
   → if using photocopy of paid textbook, both user and provider are in violation

2. Independence and Objectivity (VS VI (A) Disclosure of Conflict)
   Members must use reasonable care, judgment to achieve, maintain independence and objectivity in professional activities. Members must not offer, solicit, accept any gift, benefit, compensation, consideration that reasonably could be expected to compromise their own or another’s independence and objectivity.
   → allocation of shares in oversubscribed IPOs to investment managers for their personal accounts is prohibited
   → If possible, disclose gifts before accepting, and if impossible, disclose to employer benefits
   → To miniminze pressure from IB, use (1) enhanced firewall: separate reporting structures for personnel on research & IB side (2) good compensation for research analysts (3) comp’s regular policy review to safeguard analysts
   → If pressure by comp to change rating, place comp on restricted list, give facts only ab comp

3. Misrepresentation
   Members must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, other professional activities. 

4. Misconduct
   Members must not engage in any professional conduct involving dishonesty, fraud, deceit or commit any act that reflects adversely on professional reputation, integrity, competence.

2. Integrity of Capital Markets

1. Material Nonpublic Information
   Members who possess material nonpublic info that could affect the value of investment must not act or cause others to act on the info
   → Mosaic theory: use non/material non/public info to create larger picture, and conclusion becomes material after assembled
   → Build firewall to keep material nonpublic info
   → If hear material nonpublic info on security, place it on restricted list - you can not act on it even if personal account

2. Market Manipulation
   Members must not engage in practices that distort prices, artificially inflate trading volume w intent to mislead market participants.

3. Duties to Clients:

1. Loyalty, Prudence, and Care
   Members have a duty of loyalty to their clients, must act with reasonable care and exercise prudent judgment. Members must act for the benefit of their clients, place their clients’ interests before their employer’s or their own interests.
   → soft commission policy: members are required to only use client brokerage to the benefit of the clients

2. Fair Dealing
   Members must deal fairly, objectively w all clients when providing investment analysis, making investment recommendations, taking investment action, engaging in other professional activities. 

3. Suitability

1. When Members are in an advisory relationship with a client, they must: 

1. Make a reasonable inquiry into a client’s or prospective client’s investment experience, risk and return objectives, financial constraints prior to making any investment recommendation, taking investment action and must reassess, update this info regularly. 

2. Determine that an investment is suitable to the client’s financial situation and consistent with the client’s written objectives, mandates, constraints before making an investment recommendation or taking investment action. 

3. Judge the suitability of investments in the context of the client’s total portfolio. 

2. When Members are responsible for managing a portfolio to specific mandate, strategy, style, they must make only investment recommendations or take only investment actions that are consistent with the stated objectives and constraints of the portfolio.

4. Performance Presentation
   When communicating investment performance info, Members must make reasonable efforts to ensure it is fair, accurate, complete.
   → Standards do not require compliance with GIPS, auditing, verification requirements

5. Preservation of Confidentiality
   Members must keep info about current, former, prospective clients confidential unless:

1. Info concerns illegal activities of prospective / client,

2. Disclosure is required by law,

3. Prospective / client permits disclosure of the info.

→ in case illegal activity detected: seek guidance from employer → legal counsel → resign

4. Duties to Employers

1. Loyalty
   In matters related to their employment, Members must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential info, or otherwise cause harm to their employer.
   → In case member enters into independent biz while still employed, members must notify and earn consent of employer, describe type of service rendered, expected education of service, compensation for the services
   → soliciting clients is strictly prohibited when leaving a comp unless the solicited is unemployed

2. Additional Compensation Arrangements
   Members must not accept gifts, benefits, compensation, consideration that competes with or might reasonably be expected to create a conflict of interest with their employer’s interest unless they obtain written consent from all parties involved.

3. Responsibilities of Supervisors
   Members must make reasonable efforts to ensure that anyone subject to their supervision or authority complies w applicable laws, rules, regulations, Code and Standards.
   → if member cannot fulfill supervisory responsibilities due to absence of compliance system, member should decline in writing to accept supervisory responsibility until firm adopts reasonable procedures to allow member to exercise responsibility

5. Investment Analysis, Recommendation, and Actions

1. Diligence and Reasonable Basis
   Members and Candidates must:

1. Exercise diligence, independence, thoroughness in analyzing investments, making investment recommendations, taking investment actions.

2. Have a reasonable, adequate basis, supported by appropriate research, investigation, for any investment analysis, recommendation, action.
   → Selecting External Sub/advisor: (1) reviewing adviser’s established code of ethics, (2) understanding adviser’s compliance, internal control procedures, (3) assessing qual of published return information, (4) reviewing the adviser’s investment process and adherence to its stated strategy.

2. Communication with Clients and Prospective Clients
   Members and Candidates must:

1. Disclose to prospective / clients the basic format and general principles of investment processes they use to analyze investments, select securities, construct portfolios and must promptly disclose any changes that might materially affect those processes.

2. Disclose to prospective / clients significant limitations, risks associated w investment process.

3. Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations, actions and include those factors in communications with prospective / clients.

4. Distinguish between fact, opinion in presentation of investment analysis, recommendations.

3. Record Retention
   Members must develop, maintain appropriate records to support their investment analyses, recommendations, actions, other investment-related communications with prospective / clients.

6. Conflicts of Interest

1. Disclosure of Conflicts
   Members must make full and fair disclosure of all matters that could impair their independence and objectivity or interfere with respective duties to their prospective / clients, employer. Members must ensure that such disclosures are prominent, are delivered in plain language, communicate the relevant info effectively.
   → If my senior is a board of subsidiaries of comp I write a research on, I disclose the relationship
   → If I write a research about comp A, and my comp holds stock of A, I need to disclose. No need to disclose I purchsed A stocks, or my brother is a supplier to A

2. Priority of Transactions
   Investment transactions for clients and employers must have priority over investment transactions in which a Member is the beneficial owner.

3. Referral Fees
   Members must disclose to their employer, prospective / clients, as appropriate, any compensation, consideration, benefit received from or paid to others for the recommendation of products or services.
   → disclosure allows client / employer to evaluate (1) any partiality shown in any recommendation of service (2) full cost of service.

7. Responsibilities as a CFA Institute Member / Candidate 

1. Conduct as Participants in CFA Institute Programs
   Members must not engage in any conduct that compromises the reputation or integrity of CFA Institute or the CFA designation or the integrity, validity, security of CFA Institute programs.

2. Reference to CFA Institute, the CFA Designation, and the CFA Program
   When referring to CFA Institute, CFA Institute membership, the CFA designation, or candidacy in the CFA Program, Members must not misrepresent or exaggerate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the CFA Program.

→ O: I enrolled in the CFA Program to obtain the highest set of credentials in the global investment management industry.” “I Passed level 3 CFA exam”
→ “Chrissy is a CFA,” partial designation, “I got the highest score in the test”

** Party / nonmember / fim can claim compliance w CFA Institute Code & Standard once they have ensured that their code and ethics meets the principles of the Code and Standards.

4. Global Investment Performance Standards (GIPS)

Mission: promote ethics and integrity and instill trust through the use of the GIPS standards by achieving universal demand for compliance by asset owners, adoption by asset managers, support from regulators for the ultimate benefit of the global investment community.

Objective:

1. Promote investor interests, instill investor confidence. 

2. Ensure accurate, consistent data. 

3. Obtain worldwide acceptance of a single standard for calculating, presenting performance. 

4. Promote fair, global competition among investment firms.

5. Promote industry self-regulation on a global basis.

Any firm that manages actual asset may comply. Firm must create, maintain composites for all strategies which firm manages segregated accounts. Firm must include all actual fee-paying, discretionary segregated accounts in at least one composite defined by (the same) investment mandate, objective, or strategy. Pooled funds must also be included in any composite for which the pooled fund meets the composite definition. This prevents cherry-picking
→ no non-discretionary segregated account, non-feepaying account

Verification: must be performed firm-wide. Compliance is claimed by comp, but verification by 3rd party 

Composition (FICCDPRPW)

1. Fundamentals of compliance: Use “in accordance,” “in compliance,” “consistent.” Provide a compliant description of the past 12 months to all prospective clients. The firm may select its sub-advisor, but all total firm assets must be assigned to the sub-advisor

2. Input data

3. Calculation methodology

4. Composite construction

5. Disclosure: Performance / policies adopted by firm

6. Presentation and reporting 

7. Real estate: not including publicly traded real estate securities, CMBS, private debt investment, frequency of external valuation

8. Private equity

9. Wrap Fee / Separately Managed Account (SMA) portfolios

** 6~9 are not under required provisions

• The minimum effective compliance date for a wrap fee composite is 1 January 2006

• • 1 January 2006 for real estate and private equity composites and pooled funds, as well as wrap fee composites.

• • 1 January 2000 for all other composites and pooled funds.

• Firm must maintain a list of composite descriptions and include terminated composites on this list for at least 5 years after the composite termination date. A complete list of pooled fund descriptions for limited distribution pooled funds is also required. A complete list of broad distribution pooled fund names only, but not the descriptions, is required. Firms are not required to include terminated limited or broad distribution pooled funds on the list.

Requirements: 

• The firm must present GIPS compliant record of a min 5 yrs of annual investment performance. If existent for less than 5, must present performance since inception. Afterwards, present additional year performance for each year to min 10 yrs

• Firms may internally self-regulate, but should hire a 3rd party to perform legitimate composite testing and have local sponsoring org for effective investment performance standards.

• Must comply to consistent data import and have blackout period (3 days employees not allowed to make alterations to a big retirement / investment plan), pre-clearance (obtain clearance – approval – before making the trade)

• Recommend to input office locations, not overcrowd participation in IPO

Quantitative Methods

1. Rates and Returns

• Market Determined Interest (Int) rate = Required Rate of Return (ROR) or yield = market discount rate = opportunity cost (Cost forgone from alternative actions) = time value of money
  = Real Risk Free (Rf) interest rate [Rreal] + inflation prem + default prem + maturity prem + liquidity prem
  = Nominal Rf interest rate (ex. T bill) [Rnom] + prems

• Fisher effect: Rnom = Rreal + πe

• Rnom = Rreal + inflation prem
  AND
  (1 + Rnom) = (1 + Rreal) (1 + inflation prem)

• ** Sunk cost: Cost already incurred, cannot be changed

• Returns and Portfolio Performance:

• Holding period Return (HPR):

• 1 yr: (end - beg + additional income)/beg

• Multiple yr: (1+r1)(1+r2).. -1 [[NO root]]

• Money weighted return = Internal Rate of Return (IRR) = Discount rate where PV of future after-tax CF = 0, Rate making NPV = 0 to find Return on Investment (ROI)
  (1) Find CF for equal periods , including reinvested div (2) input in calc to find IRR (3) * If interim CF occurred in 4M interval, solve for 4M IRR, then annualize by ×3 or ^3
  Timing matters, Money weight does not matter

• Time weighted return:
  (1) Find HPR at each year’s value. Includes div even if it isn’t reinvested (2) multiply HPR periods OR Geom if more than 1 yr
  Timing does not matter (does not incorporate months of HPR)

• Continuous compounding return: 

• If time 0 ~ t
  R = ln(1+r)

• If time t ~ t+1
  Rt, t+1 =  ln (1+ rt+1 / rt)

• Gross vs Net return: Sales - COGS, Trading expense = Gross return -  Selling, General, and Administrative (SG&A) = Operating income - tax, int = Net return
  Gross return is good measure for evaluating mngmnt efficiency since doens’t include SG&A

• Real ROR: 

• (1 + nom return on risky asset) = (1 + real return on risky asset)(1 + inflation prem)
  ** for int rates: (1 + Rnom) = (1 + Rreal) (1 + inflation prem)

• (1 + real return on risky asset) = (1 + real Rf rate or Tbill)(1 + risk prem)

• Leverage return: RL = generated return + (D/E)(generated return - D int)
  Ex. Equity portfolio is financed by 40% equity, 60% debt

• Annualizing & Comparing

• Annualizing: Rannual = (1+Rannual)c -1
  Ex. If 15 months since inception, c = 12/15

• NOM Nominal: int rate measured per annum (p.a.), stated w compounding period

• EFF Effective (EAY): int rate measured p.a. compounded yearly (ex. 3% annually)

• C/Y Compounding Periods per Year = c: times the int is compounded

2. Time Value of Money

• ROR = YTM = I/Y, discount rate = int rate, coupon = PMT

• Annuity [finite, level CF / PMT]: 

• Ordinary annuity: CF indexed at t = 1 (end of payment period, usual format)

• Annuity due: CF indexed at t = 0 

• ** Change calc setting to 2nd BGN 2nd SET

• Continuous compounding: FV = PV erN with N standard 1 year

• Perpetual bond [infinite]: PV = PMT/(rs/m)

• Constant dividend: PVt = Dt/r

• Constant / Gordon Growth DDM Model : [Same as Cost of Equity’s V0]
  PVt = Dt(1+g)r-g = D1r-g

• r = required return

• g = b × ROE

• b = Earnings Retention Rate = (1 – Div Payout Ratio)

• Assumptions: (1) Div is correct metric for valuation (2) Div growth / Required ROR forever (3) Div growth rate < Required ROR

• For insensitive to biz cycle, mature growth phase
  Ex. electric utility serving a slowly growing area or a producer of a staple food product

• * Cost of Equity V0 = D0(1+g)r-g = D1r-g

• * WACC: re = D1P0 (1-f) + g

• Multi-stage growth model:
  PVt =(1) i=1nDt (1+gs)i(1+r)i + (2,3) E(St+n)(1+r)n where E(St+n) = Dt+n+1 (r-gl)
  (1) ST Div Cost: find ∑(individual ST Div cost)
  (2) LT Div Cost: find E(St+n) = terminal value = stock value of the stock in n periods: [Dt+1 (1 + LT growth)] / (r-gl)
  (3) (2) / (1+r)n
  (4) add (1) and (3) 

• For rapidly growing companies

• * Cost of Equity V0 = t=1nD0(1+gs)t(1+r)t + Vn(1+r)n , where Vn Dn+1r-gL , Dn+1 = D0 (1+gs)(1+gL)

• Price to Earning ratio

• Price to Earning ratio = pr-g, p = Div Payout Rate
  As PVt = Dt (1+g)r-g=> PVtEt = Dt (1+g) / Etr-g 

• Forward price to earning ratio: = Expected div payout ratior-g
  As PVtEt+1 = Dt+1 (1+g) / Et+1r-g

• Different CF: Find NPV, and compare to other investment’s PV

• Two Rf bonds: F1,1 = (1+r2)2/(1+r1) -1
  As FV2 = PV0(1+r2)2 = PV0(1+r1)(1+F1,1)

• Options
  V0 = (hedge ratio) S0 - c0 = Vu1+r =  Vd1+r 

• Hedge ratio: Proportion of underlying offsetting risk associated with a deriv position = Units that investor is buying

• Portfolio value = V

• Vu, Vd= (hedge ratio)(up side of binomial) - (Up’s contract value) = (hedge ratio)(down side of binomial) - (Down’s contract value)

3. Statistical Measures of Asset Returns

Parameter: Descriptive measure of a population characteristic

• Measures of Central Tendency: 

• Mean

• Geom Mean: 1/n√(1+r1)(1+r2).. -1 × 100
  -1 is imp for negative answers

• Harmonic Mean: Xh = n∑(1+Xi)
  Outlier influence much smaller, and used to average ratios

• Harmonic < Geom < Arith
  If no variability in observation, Geom = Arith
  Arith × Harmonic = (Geom)2

• Trimmed mean: trim % off each extremes

• Winsorized mean: replace extreme values at both ends w nearest

• Median: odd: (n+1)/2 nd number OR even: mean of n/2nd and (n+2)/2, always in middle

• Mode: most frequent

• Measures of Dispersion: 

• Absolute dispersion: range,

• Mean Absolute Deviation MAD = (∑|Xi-X̄|) / n

• Variance, std dev, 

• Target semideviation with target B (X≤B): same formula as std dev w (Xi-B)

• Relative dispersion: 

• Coefficient of variation: CV = s/X̄ = std dev or risk per man or reward 

• Measures of Shape Distribution:

• Positive / right skew ヘ : mode < med < mean 

• Preferred by investors as more upsides), 0.5~

• Kurtosis: Combined weight of tails relative to other distribution

• Leptokurtic (fat tailed): kurtosis > 3, larger deviation from mean, higher peak, lower degrees of freedom
  * equity returns are mostly lepto

• Mesokurtic (normal): kurtosis = 3, excess kurtosis is 0

• Platykurtic (thin tailed): kurtosis < 3 (negative excess = less dev from mean) lower peak, platty's no fatty, probability density lowest 

• Measures of Location: Quantile

• Percentile: 10th percentile = 0~10% upper bound

• Interquartile range (IQR) = Q3-Q1

• Yth percentile (Py) using linear interpolation. Ex. 2nd quartile: y = 50%

• Ly = (n+1) (y/100) = location of yth percentile

• Py = Xn + (Ly ‘s percent part) × (Xn+1 - Xn)

• Box and whisker plot’s middle point = median

• Measure of relationship:

• Correlation: measures linear relationship between two random variables, -1~1, 0 no relationship

• Downsides: spurious correlation, outliers

• Covariance: measures joint variability between two random variables

• If cov positive, cor positive

	Measure of Loc	Population	Sample
Central tendency	Observed	Parameter	Sample
	Mean	μ	X̄
Dispersion	Variance	σ2 , uses n
	Standard deviation	σ, uses n
Relationship	Correlation Corr(X,Y)	ρ = σXY / σXσY	r = sXY / sXsY
	Covariance Cov(X,Y)	σXY = ρσXσY	sXY = ρsXsY

4. Probability Trees and Conditional Expectations

• Expected Values (All have same weight)

• Expected value of X = E(X) = i=1n P(Xi)  (Xi)

• Variance of X: σ2(X) = E[X-E(X)]2 = i=1n P(Xi)  (Xi - E(X))2

• Conditional expected value: E(X|S) = expected value of X given S

• Total Probability Rule of Expected Value: 

• E(X) = E(X|S) P(S) + E(X|SC) P(SC)

• E(X|S) = P(X1|S)X1 + P(X2|S)X2 + … + P(Xn|S)Xn

• Mutually exclusive & exhaustive scenarios

• Outcomes are mutually exclusive, but not independent / unconditional at each node

• Problem worked backward to form expected value today

• Probability of given scenario estimated to forecast ending values 

• Bayes’ formula: P(A|B) = P(B|A)P(A)/P(B)

• A: New info

• B: Event

• P(A|B) = Updated probability of event given new information

5. Portfolios Mathematics (Different weights)

• Expected return of portfolio: E(RP) = w1E(R1)+w2E(R2)+…+wnE(Rn)

• Variance: σ2(RP) =  E [{RP-E(RP)}2] = i=1nj=1nwiwj Cov(Ri,Rj)

• Total n variances 

• Ex. σ2(Rp) = w12σ12(R1) + w22σ2(R2) + 2w1w2 Cov(R1,R2)

• Ex. σ2(Rp) = w12σ12(R1) + w22σ2(R2) + w32σ2(R3) + 2w1w2 Cov(R1,R2) + 2w1w3 Cov(R1,R3) +  2w2w2 Cov(R2,R3)

• Covariance: Population Cov(Ri,Rj) = E [(Ri-ERi)(Rj-ERj)]

• Total n(n − 1)/2 covariances

• Shows how co-movements of returns affect aggregate portfolio variance, directions

• -∞ ~ ∞

• Positive = Returns on 2 assets on same side of expected value at the same time

• 0 = Independent

• Lower covariance = more diversification benefit

• Cov(Ri,Rj) = ρ(Ri,Rj) [σ(Ri)σ(Rj)] 

• ** Covariance with itself: used to find std dev by rooting

• Correlation: ρ(Ri,Rj) = Cov(Ri,Rj)/[σ(Ri)σ(Rj)]

• ** σXY = ρσXσY

• -1 ~ 1, shows strength and direction

• 0 = unrelated, most diversification benefit

• Joint probability function P(X,Y): Cov(RA,RB) = ij P(RA,i,RB,j) (RAi-ERA) (RBj-ERB) 

• In other words, find probability for both cases, subtract that from the percentages, multiply together, multiply w probability

• Probability of joint occurrences of values of X and Y

• ER = Expected return = Σ (Probability × RA)

• R = Return 

• Ex.
  

• Independence: if P(X,Y) = P(X)P(Y)
  * Stronger than uncorrelated

• Uncorrelated: if E(XY) = E(X)E(Y) 

• Modern Portfolio Theory: Mean-variance analysis, 

• Safety-first ratio = [E(RP) - RL] / σP 

• higher SF 🙂

• = Distance from TH / sd = units of deviation

• Measures downside risk, RL = Threshold, assumes normal distribution 

• Stress testing, scenario analysis: set of techniques for estimating losses in extremely unfavorable combinations of events or scenarios

• Value at risk (VaR): money measure of the min value of losses expected over a time period at a given level of probability

6. Simulation Methods

• Lognormal Distribution

• Continuously compounded return = Ln (End / Beg)

• Skewed right, lower bound of 0

• Parameter: mean, std of its normal distribution 

• Current stock’s continuously compounded return is normally distributed → future stock is lognormally distributed

• Assumes: Independently and identically distributed (i.i.d.): Random  variables that are independent of each other but follow the identical probability distribution

• If not normally distributed, sum is normal due to central limit theorem 

• More suitable as probability model for asset price, not suitable for asset return (both pos & neg) 

• Monte Carlo simulation: Inverse transformation method to convert ‘randomly generated uniformly distributed number → ‘simulated value of random variable of desired distribution.’ However, it is an estimate that can not specify cause-and-effect relationship. For predicting modeling, quantifying risk

• Resampling: Resampling from single sample for the statistical parameters / estimates like std error, confidence intervals, robustness

• Bootstrap method: replace the observed

• Jackknife method: no replace, sample size = n = repetition time

7. Estimation and Inference

• Probability sampling (random):

• Simple random sampling, systematic sampling (kth),

• Stratified sampling: divide into strata / subpopulations / index, then simple random sampling from each strata

• Cluster sampling: divide into clusters, clusters chosen by simple random sampling

• Non-probability sampling: convenience sampling, judgemental sampling

• Central limit theorem: larger sample around 30 allows

• Normal distribution, similar mean

• Sample variance = σ2 / n

• Sample std dev / std error : σx̄  = σ/√n 

• ** Std dev: dispersion of data from mean

• ** Std error: measure of inaccuracy of population parameter estimate vs sampling

8. Hypothesis Testing, 9. Parametric and Non-Parametric Tests of Independence

• Purpose: reject null = yes relationship, significance ≠ 0, not due to chance

• Null hypothesis: H0, no relationship, want to reject 

• Alternative hypothesis: Ha, yes relationship

• Critical value: Rejection threshold - if statistic > critical value, reject H0

• P value: Smallest level of significance at which the null hypothesis can be rejected

• Test types:

Testing subject	Test statistic	DoF	Info
	Z = (X-μ) / (σ-√n)		Known population variance, large / normal sample,  σ 68, 2σ 95, 3σ 99% 90% confidence intervals: z0.05 = 1.65  2σ 95% confidence intervals: z0.025 = 1.96  3σ 99% confidence intervals: z0.005 = 2.58 n stocks, n means, n variances, (n(n-1)) / 2 correlations
Single mean	t = X̄- μ0s/n	n-1	Unknown sample or pop variance, large sample Not normal (2 random variables of sample mean, std dev), becomes normal as sample ↑
Dif btw means		n1 + n2 - 2	2 independent samples, 1 sided test H0: μ1- μ2 = 0, so rightside of top = 0 sp2 = (n1-1)s12+ (n2-1)s22n1 + n2 - 2 = pooled estimate of variance IF unequal and unknown pop variance. sp is replaced with s1 and s2
Mean of dif	t = đ- μd0sd / √n Paired comparison test	n-1 đ	2 dependent samples approx normal dist, unknown but assumed equal variance  sđ = sd / √n  sd = standard deviation difference  đ = mean difference = 1ni=1ndi H0: μd0 = 0, so rightside of top = 0
Single variance or std dev	𝛘2 = (n-1)- s2σ02	n-1	1 sided test (asymm), normal distribution σ02 = trigger level ↑n = pdf shape becomes bell curve
Dif variance	F = s2Befores2After	n1 - 1, n2 - 1
Pearson / Bivariate Correlation	t = r n-21-r2	n-2	R = sample correlation
Independence		(r-1)(c-1)	Categorical, discrete data using contingency / two-way table, 1 side rejection region H0: size and type are not related / are independent  M: num of cells in table O: observed frequency E: expected number of observation assuming independence

• Test errors:

Result \ Reality	True H0	False H0
Fail to reject H0 (Accept H0)	:) 1-α = Confidence level	False negative, Type 2 error = β
Reject H0	False positive = False Discovery Rate (FDR, worse), Type 1 error α = significance level	:) 1-β = Power of test

• ↓ significance level = ↓ Type 1 error = ↑ Type 2 error [False Discovery approach]

• ↑ sample size = ↓ any error

• Non-parametrics: For (1) data does not meet distributional assumptions, (2) there are outliers, (3) data is given in ranks / uses ordinal scale, (4) relevant hypotheses does not concern a parameter. Types include:

• Single mean (z, t) → Wilcoxon signed-rank test

• Dif btw means (t) → Mann-Whitney U test

• Mean differences (t) → Wilcoxon signed-rank test, Sign test

• Spearman rank correlation coefficient: rs 

• Rank observation large (1) to small (n), [if tied, av of joint ranks 3.5]

• Calculate dif di between ranks for each pair for X, Y, and find di2 

• rs = 1 - 6 6i=1ndi2n(n2-1)

10. Simple Linear Regression (SLR)

• SLR: method to estimate relation in/dependent variable. Requires minimizing of Sum of Squares Error (SSE, residual sum of squares)
  Yi = b0 + b1Xi + εi,   i = 1, . . . , n.

• Variables: 

• Y: dependent variable, explained variable, [Calc: Needs to be inputted in second]

• Yi: observation

• Ŷi: Expected value of Y, Ŷi = b̂0 + b̂1 Xi  

• Ȳ: mean

• X: independent variable, explanatory variable

• b0: intercept, regression coefficient, [Calc: as a]

• b̂0: Expected value of slope
  = Ȳ- b̂1X̄ 

• b1: slope coefficient, regression coefficient [Calc: as b]

• b̂1: expected value of slope coefficient
  = Cov(Y, X) / Var X = i=1n(Yi - Ȳ)(Xi-X̄)i=1n(Xi-X̄)2 (X here is X̄) 

• εi: error / residual = Yi - Ŷ. Least squares RL should have εi = 0

• r: correlation = cov (Y,X) / SY SX

• Cov(Y,X) = i=1n(Yi - Ȳ)(Xi-X̄)n-1 (X here is X̄), top: Sum of cross-products of deviations from the mean

• SY = i=1n(Yi - Ȳ)2n-1

• SX = i=1n(Xi - X̄)2n-1 (X here is X̄)

• Sum of Squares Total (SST): Variation of Y
  = i=1n(Yi - Ȳ)2  = SSE + SSR

• Sum of Squares Regression (SSR): explained variation in Y
  = ∑(Ŷi - Ȳ)2
  = expected - mean

• Sum of Squares Error (SSE): Unexplained variation / error / residual in Y
  = i=1n(Yi - Ŷi)2 =  i=1n[Yi - (b̂0 + b̂1 Xi)]2 =  i=1nei2
  = observed - expected

• Assumption:

• Linearity: Relationship between X & Y is linear

• Homoskedasticity: Variance of regression residuals are same for all observations

• Independence: Observed pairs of X and Y are independent, and regression residuals are uncorrelated across observations 

• Normality: normally distributed regression residual (not variable)

• Measures of Goodness fit:

• Coefficient of determination (R2): % of variation of dependent variable (Y) explained by indep variable (X)

= SSR / SST
** If slope is positive, correlation (X,Y) = √R2

• F-statistic to compare 2 variance (F):
  = MSR / MSE

• Significance of slope coefficient

• Hypothesis;

• LR: H0 = b1 = … bn = 0 

• SLR: H0 = 0 

• Mean Square Regression (MSR) = SSR / k

• k = number of independent variables. For SLR, 1, thus MSR = SSR

• Mean Square Error (MSE) = SSE / n-k-1

• For SLR, n-k-1 = n-2

• T-statistic to test regression coefficient (t):
  = (b̂1 - B1) / sb̂1

• b̂1: expected value of slope coefficient

• B1 = hypothesized population slope

• sb̂1= std error of slope coefficient   

= se /  √i=1n(Xi-X̄̄)2

• se = Standard error of the estimate = √MSE = standard deviation of the regression residuals. Measure of the distance between the observed values of the dependent variable and those predicted from the estimated regression

• Two sided

• Standard Error of Slope Coefficient (tintercept)
  

• Standard Error of forecast (Sf)

=
Prediction interval: Ŷf ± tcritical for 𝛂/2  sf

• Indicator / dummy variable: 0 or 1

• Intercept: av of dependent variable when indicator variable is 0 (before the shift in policy)

• Slope: difference in the mean of the dependent variable from before to after the change in policy

• Non-linear Regression (1 sided)

• Log-lin model: LnYi = b0 + biXi

• Lin-log model: Yi = b0 + b1lnXi

• Log-log model: LnYi = b0 + b1lnXi 

11. Introduction to Big Data Techniques

Fintech: technology-driven innovation occurring in the financial service industry

Big Data: collection of large quantities of financial data from a variety of sources in multiple formats

Expert system (computer if-then) → neural networks (brain) → machine learning (train / validate / test. Can seem like “black box” or opaque = not fully understandable outcome. Has downsides of overfitting [too cognizant], underfitting. Techniques include supervised learning [only data] / unsupervised learning [labeled] / deep learning [neural networks to find patterns])

Data science: interdisciplinary field harnessing advances in computer science (ML), statistics to extract info from big data. Processing methods include:

1. Capture: Data collection / formatting for analysis. Needs low latency systems for real time calculation

2. Curation: Ensure data quality thru cleaning. 

3. Storage: Data record / archive / access 

4. Search: Querying requested data

5. Transfer: Move storage location to analytical tool

Data visualization: tag cloud (text size = importance), text analytics (large unstructured text like company filings- for ST trends), Natural Language Processing (interpreting human language / translation)

Economics

1.  Firm and Market Structures

Perfectly competitive

• Perfectly elastic (horizontal) demand curve: P = MR

• Supply = MC

• Average Rev (AR) = price per unit

• TR = (P)(Q)

• Break even: P (= MR) = AR  [TR = TC or AR = ATC]

• TR = TVC < TR: Stay ST, leave LT

Monopolistic Competition 

• Characteristic: competitive, unique product, lower barrier to entry, advertising helps profit

• Profit Maximization: MR = MC

• Ideal level of output: P* (where MC = MR, trace up to D)

• Negatively sloped demand curve: P = f(Q), P > MR, P = AR

• No supply function

• TR = f(Q) × Q

• Break even: P (= AR) = ATC  [TR = TC or AR = ATC] [3rd pic]

Oligopoly: 

• Characteristic: Few sellers, standard product, advertising a lot. Attracts collusion

• Profit Maximization: MR = MC

• No supply function

• Pricing strategy: 

• Pricing interdependence:
  

• Competitors will lower prices to match a price reduction, but will not match a price increase

• Can’t determine prevailing price, explains stable prices (red)

• Cournot assumption: Firm determines profit maximizing production lvl assuming other firm does not change output. In LT equilibrium, output / price are stable, no increase profits either 

• QD = q1 + q2

• Nash equilibrium: Collusion / cartel allows higher prices. collusion more likely if (1) small number of firms / one dominant firm, (2) homogenous product (3) similar cost structure (4) frequent and small order size (5) less likeliness for retaliation (6) high external competition

• Stackelberg model: A prominent model of strategic decision making in which firms are assumed to make their decisions sequentially.

• If dominant decreases price, smaller comp will leave market rather than sell below cost, thus market share of price leader (dominant comp) will increase. In LT, market share of dominant comp decreases as profits are shared by more participants

Monopoly: 

• Characteristic: One seller, unique product, advertising does not help profit

• Profit Maximization: Max (TR-TC = π)

Others:

• Constant returns to scale: same cost per unit (↑ X input = ↑ X Output) 

• Economics of scale: ↓ cost per unit 

• Market power: concentration ratio (0~100, ≠ market power, unaffected by merger), HHI (Σ Comp market share2, Use full number, not the percentage) 

2. Understanding Business Cycles

Business cycles: recurrent expansions & contractions in economic activity (mostly GDP) affecting economy

• Types:

• Classical cycle: Level of economic activity measured by GDP volume terms. Contraction phase (between peaks / troughs) short, expansions large

• Growth cycle: Economic activity by LT potential / trend growth level to see how actual economic activity does vs potential

• Growth rate cycle: Growth rate of economic activity (GDP growth rate). Peaks and troughs recognized earlier

• Phases: 

• Recovery (trough):

• Below av: output worst (vs potential), economic activity (consumer / biz spending, start to increase), low int rate, 

• Above av: unemp rate

• Decrease: negative output gap, layoff, decline in sale, inventory - sales ratio (sales increase faster than production)

• Situation: moderate inflation, biz overtime (vs hire), capital spending (excess capacity / low utilization, CAPEX focus on efficiency / light product like software, systems, hardware - high rate of obsolescence)

• When expansion is expected: Risky assets repriced upward, corps incorporate higher profit expectations into corp bond / stock prices

• Expansion (boom):

• Above av: growth rate, activity measures (but decelerating), sales  production

• Increase: Recovery, consumer spending, company, price / int rate, positive output gap, inflation, capacity utilization 

• Situation: Employment: overtime / temp → hiring, unemp stabilize / falls, capital spending (new orders focus on heavy / complex equipment, warehouse. factory), stable inventory-sales ratio, Shortage in factors of production, overinvestment in productive capacity may lead to reduce further investment spending

• Late stage: biz experience a decrease in qualified workers, productive capacity limits ability to respond to demand

• Slowdown (peak): 

• Above av: activity measures (decelerating), inflation (accelerate), output (vs potential output), consumer optimism, interest rate

• Below av: rate of growth

• Increase: inventory-sales ratio (weakening economy, sale slows)

• Decrease: Growth rate (vs potential output growth), positive output gap, inflation, price level, hiring pace, factors of production (D>S), unemp rate (slower rate)

• Situation: stable hiring (slower, rely on overtime), healthy CF, order cancellation

• Contraction:

• Below av: economic output (vs potential economic output), activity measures, growth

• Increase: negative output gap

• Decrease: demand, profit, CF, capital spending (CF, short lead time tech / equipment → heavy construction cut off), consumer / biz confidence, comp cost (overtime and hires), absolute economic activity (recession / depression), inflation (lag), employment (cut hours / eliminate overtime / freeze hire / layoff, unemp rate rise), inventory-sales ratio (falls to normal)

• Situation: biz produce at rates below sales volumes necessary to dispose unwanted inventory

• Economic Indicators

• Leading: stock market (S&P), house price, retail sales, interest spread (10 Y treasury yield & overnight borrowing rate - federal fund. Bigger 🙂), building permits for new private housing units, consumer expectation, av weekly hours (manufacturing), manufacturer’s new orders for non-defense capital goods (excluding aircraft), av weekly initial claims to unemp insurance, ISM (Institute of Supply Management, indexes for manufacturing orders, output, emp. Bigger 🙂), LCI (Leading Credit Index, leading financial indicators showing strength of financial system)

• Coincident indicators: industrial production index (industrial production reflects current state better than services), real personal income (on non-agri payroll), manufacturing / trade sales 

• Lagging: Av duration of unemp, inventory to sales ratio (good to maintain 10-20%, Smaller 🙂), change in unit labor cost, inflation (index includes stable service components), ratio of consumer installment debt to  income (consumers borrow more when confident), commercial and industrial loans outstanding

• Diffusion index: % of index’s components moving consistently w overall index. Reflects consensus change

• Nowcasting: real-time monitoring of economic and financial variables to continuously assess current conditions and provide an estimate of the current state.

Credit cycle: Fluctuation of credit measured through liquidity of priv sector (loans, investment, real estate). Strong economy = loose credit (may contribute to asset price and real estate bubbles and subsequent crises)\

3-4. Policies

Policies: Stable / positive growth, stable / low inflation

Fiscal Policy: Influence on Taxation, Spending to control growth / GDP. Affects overall Aggregate Demand (AD) and activity, distribution of wealth / income, resource allocation

• AD: amount companies and households plan to spend. Fiscal policy influences AD

• Keynesians: Fiscal 🙂 on AD, output, esp if substantial spare capacity (considerate unemp) in economy 

• Monetarists: only temp effect on AD, monetary policy more effective to restrain / boost inflation 

• *Debt

• Ok: debt may be owned by citizens or used for capital investment, private sector may offset fiscal deficits by increasing savings foreseeing increased taxes (Ricardian equivalence - reason to choose Monetary policy, future impact of fiscal are fully discounted by economic agents)

• Not ok: high debt → high tax disincentivizing economy by reducing labor effort / entrepreneurship, lose confidence in gov → print money to finance deficit / high inflation, gov borrowing diverts private sector investment (crowding out - gov borrowing ↑ → private sector investment ↓, ↑ int)

• Tools: 

• Transfer payments: Ex. comprise payments for state pensions, housing benefits, tax credits - not included within GDP / gov spending on G&S

• Current gov spending: Regular spending on G&S. Impacts country’s skill lvl, labor productivity 

• Capital expenditure: Infra - adding to nations’ capital stock / affect potential for economy

• Cyclically adjusted budget deficits are appropriate indicators of fiscal policy in full employment

• Government revenue: Direct tax (national insurance, property / inheritance tax. Slow, powerful results), indirect tax (G&S, excise duties on fuel, alcohol, gambling, VAT. Quick results)
  * Excise: tax on certain objects
  * Tax is desirable due to simplicity, efficiency (limit interference), fairness (similar situation - horizontal equity, rich pay more - vertical equity), Rev sufficiency 

• Model: 

• Symbols:

• G: Government spending

• T: Taxes including in/direct taxes on expenditures

• B: Transfer benefits

• NT: Net Taxes

• Y: National income or output

• YD: Disposable Income

• t: Net tax rate, proportional to Y

• Multiplier: △ equilibrium output / △autonomous spending that caused the change

• Fiscal multiplier: △ gov spending / △ national income

• c: Marginal Propensity to Consume (MPC) = Consumption / YD

• s: Marginal Propensity to Save (MPS) = Saved / YD

• NT = T - B 

• Budget surplus / deficit: G-T+B = Net impact of gov sector on AD 

• YD = Y – NT = (1 – t) Y

• Household spending = cYD = C(Y-NT) = c(1-t)Y

• Fiscal multiplier = 1/[1 – c(1 – t)]

• c + s = MPS + MPC = 1

• ** If ↑ gov spending on domestic goods financed by equivalent ↑ tax,  ↑ AD  bc MPS < 1 thus every dollar less in disposable income, spending falls by $c. ↓ Aggregate spending amount < ↑ tax rise by factor of c. Additional output leads to ↑ income, output thru multiplier effect

• ** Contractionary always involves fall in budget deficit / rise in surplus. Sometimes gov spending can accompany bigger fall in taxation, making it expansionary

• Types: Automatic stabilizer (income tax, VAT, social benefit - fiscal stimulus reducing multiplier size, don’t require policy changes), discretionary fiscal adjustments (tax changes, spending cuts)

• Difficulties: 

• Lags: Recognition, action, impact lag

• Focuses more on inflation than on unemployment

• Private sector unknown / changes over time

• * Cyclically adjusted budget deficits (full employment) are appropriate indicators of fiscal policy

Monetary Policy: Influence Q of Money, Credit for price stability (Faster than Fiscal)

• Bank role: Banker to gov and bankers’ bank, lender of last resort, regulator and supervisor of the payments system, conductor of monetary policy, supervisor of the banking system

• Sole supplier of the domestic currency: God standard → fiat money (as legal tender -something offered in exchange for goods)

• Tools: 

• Open market operations (Quantitative Easing): Purchase (↑ reserves, expansionary) /sale of gov bonds from/to commercial banks/designated market makers

• Official interest / policy / refinancing / repo / discount / fed funds rate: influence S/LT int rate, and real economic activity. ↑ Int → ↑ Base rate (ref rate banks base lending on). Interest rate works through ST int rate, changes in key asset prices, exchange rate, expectation of economic agents, in order to influence inflation

• Contractionary: When gov believes ↑inflation, ↑int rate, ↓liquidity [↔ Expansionary]

• Neutral rate of interest = Real trend of growth + LR expected inflation

• If demand shock (people feeling good for spending), tightening monetary policy is suitable
  If supply shock (oil cost), tightening may be worse for situation

• Reserve requirements: requirement for banks to hold reserves in proportion to the size of deposits

• Inflation targeting framework: Credibility, transparency (reporting), independence - includes

• Operational independence: Bank’s independence to execute monetary policy, set int rate to meet inflation target

• Target independence: Bank’s independence to define inflation target, rate of inflation, horizon of target

• Exchange rate targeting: can “import” inflation experience of econ whose currency is being targeted

• Setting: Domestic country A sets currency exchange rate target to align with USD

• Change: A develops rapidly, A domestic inflation above US, A currency fall against USD

• Protect A: gov sells foreign currency reserve, buys own currency = reduce domestic money supply, increase ST interest

• Monetary tightening: exchange rate rise against dollar 

• Shortfalls:

• Bond market vigilantes: Bond market participants may reduce D for LT bonds, pushing up yield

• Liquidity trap: Money demand completely elastic (horizontal), thus money injection does not help lower int or affect real activity

Monetary & Fiscal Policy [Assumption: Wage, P are rigid]

Fiscal (Gov rev) / Monetary (MS)

• Easy F / tight M:
  ↑ Int rate (↓ priv sect), ↓ tax, ↑ gov spending, ↑Aggregate Output / ↓ MS

• Tight F / easy M:
  ↓ Int rate (↑ priv sect), ↓ public sector

• Easy F / easy M:
  ↓ Int rate (↑ priv sect), ↑ AD (↑ public sect)

• Tight F / tight M:
  ↑ Int rate (↓ priv sect), ↓ AD (↓ public sect), ↑ tax / ↓ gov spending 

Tight F: ↓ public sector, gov less spending // Tight M: ↑ int, ↓ priv sector 

5. Introduction to Geopolitics

• Geopolitics: Study of how geography affects politics and international relations. Actors (Indiv, org, comp, national gov carrying out political, economic, financial activities) influence and include state actor (national gov, political org, country leaders exerting direct authority over national security / resource) / non-sate actor (on-governmental organizations (NGOs), multinational companies, charities)

• Globalization: Trade of G&S, Capital flow, currency exchange, cultural / informational exchange
  ↔ Nationalism
  In order to lessen the extreme impact, nations (1) Reshore essentials [pandemic - relocating back to own country, use domestic / existing capacity more intensely], (2) Reglobalizing production [fortify / duplicate supply chains abroad], (3) Doubling down on key markets [strengthen focus on risky]

• International organizations

• IMF: stabilize exchange rate, assist reconstruction of the international payment system. More specifically, it enhances lending facilities, improves monitoring of global / regional / country economies, helps resolve global economic imbalances, analyzes capital market developments, assesses financial sector vulnerabilities 

• World Bank: help developing countries fight poverty and enhance environmentally sound economic growth

• WTO (World Trade Organization): provide legal and institutional foundation of the multinational trading system

Archetypes of Globalization & Cooperation

	Globalization	Nationalism / Anti-globalization
Cooperation	Multilateralism: mutually beneficial trade, extensive rule harmonization Multilateral trade agreements (WTO) Economy and Monetary Union (EMU) Common market (EU) Cabotage: right to transport passengers / goods	Bilateralism / regional: leveraged regional trade, bias against globalization Trading blocks (USMCA, MERCOSUR) NATO (North Atlantic Treaty Org)
Non-cooperation	Hegemony: Countries using political / economic influence on other to control resources Nationalization of key export firms / industries (Pemex. PDVSA, Rosneft) Foreign investment restrictions Economic and financial sanctions (US, EU vs Venezuela) Export subsidies (Boeing, Airbus)	Autarky: Political self-sufficiency w no trade, state owned enterprises control strategic domestic industries Tariffs, quotas Voluntary Export Restraints (VER) Domestic content requirements Espionage Terrorism Armed conflict

• Geopolitical risks: Event (date driven), exogenous / black swan (sudden - uprising), thematic risk (overtime - climate, migration, cyber threat). Must check event likelihood, impact velocity (speed), and impact size / nature. Signpost is a indicator risk is going up / down. Highly collaborative, interconnected countries are vulnerable to geopolitical risk, high geopolitical risk results in tangible macroeconomic effects

6. International Trade

• Traditional models: Ricardian model and the Heckscher–Ohlin model: focus on specialization and trade according to comparative advantage arising from differences in technology and factor endowments, respectively

• Trade protection / restrictions: Limit the openness of goods markets. ↓ consumer surplus, ↑ producer surplus

• Embargo, domestic content requirements (Stipulate that _% if value added / components used in production is domestic), export subsidy 

• Tariff: Protects domestic goods, ↓ trade deficit, tariff revenue collected by gov, Small country (price taker)
  

• Price P* → Pt, Import Q1~Q4 → Q2~Q3

• Consumer loss: - (A+B+C+D)

• Producer surplus: +A

• Tariff Rev / quota rent / gov gain: +C 

• National welfare deadweight loss: -(B+D)
  ** May increase if large country

• Quota: Restriction of Q imported w Q set thru import license

• Quota rent / profit captured by domestic OR foreign gov: C

• National welfare loss: -(B+D+C)

• National welfare of foreign country captures quota rent by auctioning import license: -(B+D)
  ** May increase if large country

• Voluntary Export Restraints (VER): Quota / trade restriction by exporting country → ↓ imported goods → ↑ import good price → VER affects / benefits foreign country → greatest welfare loss for importing country bc domestic pays more for same product

• Capital restrictions: controls placed on (1) foreigners’ ability to own domestic assets (2) domestic residents’ ability to own foreign assets. Limits the openness of financial markets 

• Trading bloc / Regional Trading Agreement (RTA):

• Free Trade Area (FTA): Free movement of G&S 

• Customs Union: FTA + common trade policy for non-members 

• Common Market: Customs Union + free movement of factors of production

• Economic Union: Common Market + common economic institution, policies

• Monetary Union: Economic Union + common currency

• Others:

• Trade creation: $ imports from nonmember replacing $$ domestic production

• Trade diversion: $$ imports from member replacing $ imports from nonmember 

7. Capital Flows and the FX Market, 8. Exchange Rate Calculation

• Exchange rate:

• Nominal / Spot exchange rate: Sd/f
  = Price / Base = cost of 1 unit of base currency in terms of price currency
  = A/B = number of units of currency A that 1 unit of currency B will buy
  = USD/EUR exchange rate of 1.17 = 1 euro will buy 1.1700 US dollars = 1 euro costs 1.1700 US dollars, direct quote for European citizens

• ↓ exchange rate from 1.17 to 1: euro costs less of USD = fewer USD are needed to buy one euro = USD is appreciating against the euro = EUR is depreciating against the USD = deflation, ↓ price level

• Real exchange rate d/f : Rd/f = Sd/f × (Pf/Pd) 

• Nominal adjusted for inflation, assess changes in the relative purchasing power of one currency compared with another

• Uses Direct quote d/f

• Purchasing power parity (PPP): LT equilibrium of nominal exchange rates

• A wants to purchase from foreign country B. A buys fewer goods if nominal spot exchange rate for foreign currency appreciated / foreign price level increased. ↑ real exchange rate = ↓ foreign goods purchasable, ↓  A’s relative purchasing power compared to B  

• S (Nominal) does not affect Purchasing power

• Sd/f × Pf  = Foreign price level in domestic currency

• Ex) British wants to buy EUR goods [GBP as Price, not base]
  Real exchange rateGBP/EUR = SGBP/EUR * (CPIEUR/CPIGBP)
  Nominal spot exchange rate GBP/EUR ↑10%, EUR price level ↑%5, UK price level  ↑%2
  Change in real exchange rate = (1+10%) * [(1+5%)/(1+2%)] -1 = 13%
  Real exchange rate ↑13%, costs more to buy EUR goods
  == ↑ real exchange rate, ↓relative purchasing power

• If Real exchange rate =↑ 5%, Real purchasing power ↓5%

• Market participants

• Sell side: large FX trading banks (Citigroup): 

• Buy side: Those using sell side undertake FX transactions. Includes: Corporate accounts (cross-border purchase / sales of G&S, investment), Real money account (unleveraged funds managed by insurance / mutual fund / pension / endowment / ETF), Leveraged account (leveraged professionals managed by hedge funds / proprietary trading shop / commodity trading advisors CTA / high frequency algorithmic trader / proprietary trading desks at banks), Retail, Gov (military purchase), Central banks (influencing domestic exchange rate), Sovereign wealth funds (SWF, gov entities for investmentpurpose rather than public policy)

• Market products: FX swaps (Spot + forward FX transaction), Spots (immediate delivery), Forwards (customizable future delivery vs futures), Option

• Quotation 

• Bid: price bank buys currency
  = number of units of the price currency client receives from dealer for 1 unit of base currency

• Offer: price bank sells currency
  = number of units of the price currency client sells to dealer for 1 unit of base currency

• Ex. CHF/EUR = 1.1583 - 1.1585:
  Client receives CHF 1.1583 (Bid) for selling EUR1
  Client pays CHF 1.1585 (Offer) to dealer to buy EUR 1

• Dep of A 10% relative to B, (1/1-0.10)-1 % relative to A

• % Appreciated exchange rate = % Appreciation of base currency * initial exchange rate

• Appreciation of A against B = expected spot / spot -1

• Currency regimes: 

• Ideals: (1) Credibly fixed exchange rate - no currency related uncertainty, (2) Fully convertible currencies - unrestricted capital flow, (3) Fully independent monetary policy. 

• Regimes: Independently floating rates, Fixed parity with crawling band,

• No legal tender: (1) Dollarization, (2) Monetary union (EUR)

• Currency Board System (CBS): domestic only issued w foreign currency reserves against the domestic monetary base. Bank is not lender of last resort. Best if (1) wages flexible, (2) non-traded sectors are small (2) global supply of reserve asset grows at a slow, steady rate consistent with LR growth, stable prices. Can earn seigniorage - profit by paying little / no in on its liability (monetary base) to earn market rate on its asset (foreign currency reserves). Ex. HKD

• Fixed parity: Currency pegged at currency / basket with (1) no legislative commitment to maintaining parity, (2) target level of foreign exchange level optional

• Target zone: Fixed parity w larger band: more freedom / discretion in monetary policy

• Active / passive crawling peg: Pegs against single currency, updated periodically

• Fixed parity + Crawling bands

• Managed / dirty float: Rate based on target policy

• Independently floating rates: Rate based on market

• Trade balance:

• X − M = (S − I) + (T − G),

• X = Exports,M = Imports

• S = Private Savings, I: Investment

• T: Taxes net of transfer, G: Gov expenditure

• Investors anticipate change in exchange rate → Sell currency expected to depreciate, buy currency expected to appreciate. Asset prices, exchange rates adjust so potential flow of financial capital is mitigated, actual capital flow remains consistent w trade flow. Thus, capital flow (potential + actual) determine exchange rate movements in ST to intermediate term

• In order to stop capital flight (foreign investment in liquid domestic asset suddenly decrease), restrict foreign investment in liquid domestic asset & encourage foreign direct investment. 

• Forward rate calculation: (indirect format)
  In Derivative : 4. Arbitrage, Replication, Cost of Carry in Pricing Derivatives

8. Exchange Rate Calculation

Forward rate calculation: (indirect format)

• Basics:

• Forward premium / discount = Forward - Spot
  If base currency is trading at forward prem, price currency is trading at forward disc

*** Sf/d × (1 + Forward points as a percentage) = Ff/d

• Swap Financing Definition:

• rd = Domestic Risk-free (Rf) rate

•  rf = Foreign Rf rate

• τ = fractional period // ** If full year, ignore τ

• 1 pip = 1 point = 0.0001

• Spot & Forward Exchange Rate

• Option 1: Hold domestically
  * 1+rd =Amount held at end of period 

• Option 2: (1) Convert domestic currency to foreign currency using Sf/d, (2) invest one period at foreign Rf rate, (3) convert back to domestic currency
  * Sf/d(1+ rf) = Amount held at end of period
  * 1/Ff/d = Units of the domestic currency for each unit of foreign currency sold forward.

• Option 1 = Option 2:
  1+rd = Sf/d(1+ rf) (1/Ff/d)
  Ff/d = Sf/d 1+ rfτ1+rdτ
  Ff/d - Sf/d  = Sf/d  (rf - rd1+rdτ )τ

** Ff/d / Sf/d = 1+ rfτ1+rdτ : Forward Premium for base currency (F > S) if int rate in price currency > base currency (rf > rd)

Portfolio Management I

1 ~ 2. Portfolio Risk and Returns 

• 1+ E(R) = (1+rrF) [1+E(π)][1+E(RP)]

• E(R): Expected return / nominal return

• rrF : Real Risk-Free Interest Rate 

• E(π): Expected inflation 

• E(RP): Expected Risk Prem

• σ 68, 2σ 95, 3σ 99%

• Risk-return relationship:Aversive: positive

Two Risky Assets Calculation for Return & Variance

• Portfolio Return

• Rp = i=1nwiRi, i=1nwi = 1

• If 2 assets,
  E(Rp) = w1R1 + (1-w1)E(R2)

• Portfolio variance

• σP2 = Var(RP) = Var(i=1nwiRi)
  = i=1nwi2Var(Ri) + i,j=1, i≠jnwiwjCov(Ri, Rj)

• Cov(Ri,Rj) = ρijσiσj

ρ -1~1
If ρ = 1, no reduction in risk

If ρ <1, little bit of diversification perks

If ρ = -1, portfolio can be made RF

• If 2 assets:
  σP2 = w12σ12+w22σ22 + 2w1w2Cov(R1, R2)

• ** ↑ correlation = ↑ volatility of portfolio as ↓ diversification benefits

Multiple assets:

σP2 = σ bar 2N + N-1N Cov bar

Where σ and Cov bar are average

= As ↑ N in equally-weighted portfolio, ↓ contribution of each individual asset’s variance to volatility of portfolio.

If N is large, Cov has largest impact on variance

Indifference Curve: combinations of risk–return pairs investor would accept to maintain given level of utility 

• Utility Theory: 

• U = E(r) - 12Aσ2

• A: Risk aversion

• U: Utility

• Calculate in decimals

• For identical portfolio, investors with higher risk aversion would calculate a lower utility (U)
  If RF asset, variance = 0

• Definition: Measure of relative satisfaction from consumption of various G&S / portfolio
  Expected return OR negative term based on the portfolio risk weighted by risk aversion 

• Conclusions: (1) utility unbounded on both sides (2) higher return = higher utility (3) , higher variance reduces utility, reduction amplified by risk aversion coefficient (4) utility ≠ satisfaction 

• Loving: exponential, Neutral: linear, Aversive: logarithmic

Different Indifference Curves Different utilities for risk aversive indiv

Capital Allocation Line (CAL): portfolio of risky assets + RF assets

• E(Rp) = Rf +  E(Ri)- Rfσiσp

• ** E(Ri)- Rfσp : Slope variability / Sharpe Ratio

• RF asset has 0 risk, return Rf
  Risky asset has σi risk, expected return E(Ri)

• E(Rp) = w1Rf + (1-w1)E(Ri)

• σp =  (1-w1)σi

Different Utilities of 1, 2, 3 for high aversive Different Risk Aversions of A = 2, 4. 2 has higher expected return

Efficient / Min Variance Frontier of Risky Assets: min var achievable for given level of expected return

• Global Minimum Variance Frontier: portfolio of lowest possible portfolio volatility for a number of underlying assets

• Markowitz efficient frontier: Portfolio of risky assets w highest expected return for a given level of risk OR lowest amount of risk for a given level of return. Global min variance frontier ~ up / right.

CAL + Efficient Frontier

CAL (P) = dominant CAL combining RF asset + optimal risky asset portfolio

It has higher rates of return for levels of risk because of the investor’s ability to borrow at RF rate

CAL + Efficient Frontier + Indifference Curve

Optimal Risky Portfolio = CAL + Efficient Frontier 

Optimal Investor Portfolio = CAL + Indifference Curve

CML: Line w intercept as RF, tangent to efficient frontier of risky assets. RF + market portfolio (risky assets)

CML w dif lending rates: 

• When w1≥0 (lending), E(Rp) = Rf +  E(Rm)- Rfσmσp

• When w1<0 (borrowing), E(Rb) = Rf +  E(Rm)- Rbσmσp

Return Generating Model: Model providing estimate of expected return of security given certain parameters

• For Single-Index Model,
  E(Ri) - Rf  = βi [E(Rm) - Rf] 

• For Market Model,
  Ri = αi + βiRm + ei 

• αi : Intercept 

• βi : Slope coefficient, Systematic / market Risk

• Fundamental factor model: bases on earning growth, CF generation

• Total variance = Systematic β variance + Nonsystematic variance
  σi2 = βi2 σm2 + σe2 

• Systematic / non-diversifiable / market risk β: risk affecting entire market / econ. According to Capital Market Theory, Systematic risk is priced

• Nonsystematic risk: risk to single comp / industry

• Covariance dropped bc any non-market return is uncorrelated with the market

• βi: Measure of how sensitive an asset’s return is to the market as a whole, market / systematic risk
  = Cov(Ri, Rm)σm2 = ρi,m  σiσm 

• Positive: follows same trend

• 0: RF asset

• Market weight of portfolio: total $ / owning $

Capital Asset Pricing Model (CAPM): E(Ri) = Rf + βi [E(Rm) - Rf], 

Assumptions:

1. Investors are risk-averse, utility-maximizing, rational individuals

2. Markets are frictionless- no transaction costs / taxes

3. Investors plan for the same single holding period

4. Investors have homogeneous expectations / beliefs - allows for the existence of the market portfolio

5. All investments are infinitely divisible

6. Investors are price takers

Security Market Line (SML): CAPM on graph

(Above SML: Undervalued / Under SML: Overvalued)

• Slope: R m-Rf  or [E(Rm) - Rf]: Market risk premium 

• Portfolio beta = w1β1 + w2β2

• Above SML: Undervalued, Under SML, overvalued.
  * CAPM finds the Require Rate of Return, E(Ri), which is the amount justified according to its risk within CAPM model. If the ROR < Expected return, it lies above SML, and position shows that security offers a greater return against its inherent = risk is undervalued

• Limitations: Single factor / period model, Market portfolio (noninvestable assets), Proxy for market portfolio, Estimation of Beta risk, Poor predictor of returns for CAPM, Homogenigy of investor expectation

Security Characteristic Line: 

Ri - Rf  = αi + βi (Rm - Rf)

• Excess return of a security on the excess return of the market

• From Jenson’s αp = Rp - {Rf + βp [E(Rm) - Rf]}

• heterogeneity in beliefs of investor, but they are price takes

• Jensen’s alpha is the intercept and the beta is the slope.

Performance Evaluation: Measurement / assessment of outcomes of investment mngmnt decisions

** When portfolios are fully diversified, only systematic risk matter

• Sharpe / Reward-to-variability Ratio (SR)
  = [E(Rm) - Rf] /  σp = Risk premium / risk 

• Excess return per unit of risk. Similar to CAL slope

• Adjusts Total Risk, which is for portfolios not fully diversified

• Justified ex ante/ post basis 

• High Sharpe ratio = best risk adjusted performance

• Limitations: (1) Adjusts for Total Risk when only systematic is priced, (2) Comparative only (3) Must be positive numerators- neg → incorrect rankings

• Treynor Ratio (TR)
  = [E(Rp) - Rf] /  βp

• Excess return on investment w no diversifiable risk

• Uses systematic risk beta, which is for fully diversified portfolio

• Justified ex ante/ post basis

• Limitations: Comparative only (2) Must be positive numerators- neg → incorrect rankings

• M2 : Risk Adjusted Performance (RAP):
  = [E(Rp) - Rf] σmσp + Rf = SR * σm +  Rf

• Adjusts Total Risk risk using Standard Deviation to reflect std dev of market, which is for portfolios not fully diversified

• Shows what portfolio wouldve returned if it took on total risk as market index. Compare return premiums of adjusted VS market index portfolio

• Jenson’s Alpha αp:
  = Rp - {Rf + βp [E(Rm) - Rf]}

• (actual portfolio return) - (calculated risk-adjusted return) = Abnormal return over the theoretical expected return. Measure of portfolio’s performance relative to market portfolio

• αp > 0: Outperform market

• Justified ex ante/ post basis

• Uses systematic risk beta, which is for fully diversified portfolio

Portfolio Management II 

1. Portfolio Management, 2. Portfolio Planning and Construction, 3. Behavioral Biases of Individuals    

Basics:

• Diversification ratio: SD of equally weighted portfolio / SD of randomly selected security 

• Portfolio reduces risk more increasing returns

• Investment needs: Bank has highest need for liquidity, Endowment has longest term

• When defining asset class, (1) assets within a specific asset class have high paired correlations and low correlations with other asset classes. (2) mutually exclusive, add up to approximation of relevant investable universe

• Tactical Asset Allocation: deliberate deviation from IPS

IPS Process:

• Planning Step:  Understanding the client’s needs, Preparation of an investment policy statement (IPS)

• Execution Step: Asset allocation, Security analysis, Portfolio construction

• Feedback Step: Portfolio monitoring and rebalancing. Performance measurement and reporting

IPS Specifics: Introduction, Statement of purpose, Statement of duties and responsibilities, Procedures, Investment objectives / constraints / guidelines (“distinctive needs”), Evaluation and review, Appendices (strategic asset allocation, rebalancing policy) 

Asset mngmnt: 

• Buy-side: investment mngmnt comp using services of broker dealer

• Sell-side: broker/dealer selling security, research, recommendation

Mutual fund: commingled investment pool where investor in fund have pro-rata claim on income / fund value

• Open-end fund: trade at NAV, have capital gain distributions

• Close-end fund: have capital gain distributions

• No-load fund: no fee for investing / redeeming fund share, annual fee based on % of fund NAV

• Load-fund: Annual fee + % fee to invest in fund / redemptions 

• ETF: do not have capital gain distributions

Risk & Return: 

• Absolute risk: variance / standard deviation, value at risk (money measure of min value of loss expected during time at X probability)

• Subjective risk: tracking risk / error (std dev of dif btw portfolio return / benchmark return)

Behavioral Finance: 

• Cognitive 

• Illusion of control (over uncontrollable): restrict model to imp variables 

• Conservatism: review flexible model regularly

• Representativeness bias (classifying w standard, not comp specific): Result in under-diversified portfolios. take both into perspective

• * Base rates: attributes of reference class, neglect would ignore it in favor of other opinion

• Base rate neglect, sample size neglect

• Confirmation bias: Result in under-diversified portfolios. incorporate other opinions, seek guidance

• Hindsight bias: “history was predictable”

• Anchoring / adjustment bias: relying on prev to judge next

• Mental accounting bias: looking at everything singularly rather than synergy

• Framing bias: asking framed questions

• Availability bias: near me

• Availability + regret = Momentum anomaly

• Emotional

• Risk aversion: sensitive to loss than gain thus show disposition effect (investor reluctant to dispose of losing investment, sell when gain too quickly = inefficiency)

• Overconfidence: share all forecasts, scenario analysis. “Don’t confuse brains with a bull marke / bubbles” to reduce self-attribution, halo-effect (good now, may make good decision on something else later), ST over incentivization may lead to bubble

• Self-control bias: forget ab LT goals bc ST 

• Status-quo bias: do nothing

• Endowment bias: more value when asset owned

• Regret-aversion bias: do nothing bc fear regret

4. Risk Management

** Establish risk tolerance → risk budgeting → risk exposure 

Risk mngmnt: Process where org / indiv establishes defines / measures lvl of risk to be taken and adjusts to maximize comp or portfolio’s value / indiv’s overall satisfaction / utility. Comprises all decisions / actions needed to best achieve orgal / personal objectives while bearing tolerable risk level

• Framework: Risk governance, Risk identification / measurement (quant / qual assessment), Risk infra (database - Risk identification, measurement, monitoring), Defined policies / processes, Risk monitoring / mitigation / management, Communications, Strategic analysis / integration

• Good risk governance: Top-down guidance which directs risk mngmnt activities to support overall enterprise. Governance proceeds enterprise wide (not in isolation), determines org’s risk tolerance / provide max loss org can absorb

• Factor to be considered: competitive position
  Factors not considered in risk tolerance: personal motiv / belief / agenda of BOD, comp size, market environment stability, ST pressure, mngmnt compensation 

Risk budgeting: how and where risk is taken and quantifies / allocates tolerable risk by specific metrics

Risk types:

• Financial risk: Risk from comp’s capital structure like lvl of debt. Includes Market, Credit, Liquidity risk

• Non-financial risk: Risk from external financial market change like accounting rule / legal environment / tax rate change. Includes settlement risk (default risk when settling payments before default), legal risk (sued, contract not upheld by law), compliance risk (regulatory, accounting,tax risk), model risk (wrong model), tail risk (outlier), operational risk (terrorism, WC), solvency risk (bankruptcy)

Risk measuring: 

• Market risk: SD (not for non-normal, overestimates risk), beta (market risk), value at risk (VaR, tail size to find min loss expected, sensitive to inputs), CVar (Conditional VaR to find max loss expected, can understate risk) scenario loss, delta (small changes in deriv), gamma (large changes in deriv), vega (deriv’s underlying), rho (int for deriv), duration (sensitivity to int). Means thru scenario analysis, stress testing (loss in scenario analysis)

• Credit risk: liquidity / solvency / profitability / leverage, strength / cyclicality of macro / industry. Ex. Credit VaR, prob of default, expected loss given default, prob of credit rate change

What to do with risk:

• Risk acceptance: bear risk, self-insurance by setting reserve fund to cover loss, diversification

• Risk transfer: insurance = surety bond

• Risk shift (change distribution): use deriv (forward & contingent claim)

Corporate Issuers

Business Structures:

• Sole Proprietorship: Indiv (does not have to be legal identity) controls biz op with unlimited liab, profits taxed as personal income

• Partnerships

• General Partnership: Legally / vocally share unlimited control / liab of biz op

• Limited Partnership: Share limited liab & no control over biz. Typically a pass-through entity (do not pay entity-level taxes on income / loss), GP + LP structure

• Limited Liability Partnership: All LPs structure

• Limited Companies

• Private: Limited liab for all owners, ownership divided into tradable shares. Owners (shareholder / member)  elect board of directors manage / authorize profit distribution

• Public / corporations: No restriction to share #, taxed at biz + personal level most.  business level and again at the personal level if profits are distributed to shareholders. 

Governance:

• During legal claim, stakeholder (debtholder) → creditors (int /principal), supplier (account payable), gov (tax), employee (wage) → shareholder (Equityholder)

• Equity: loss limited to equity investment 

• Climate change considerations: (1) physical risk - climate risks that may be insured / diversified (2) Transition risk- transition to lower carbon. Ex. stranded assets (unviable asserts) 

• Stakeholder conflicts:

• Principal - Agent (agency) relationship: principal hiring agent to perform task 

• Managers interest can diverge (1) insufficient effort (2) inappropriate risk appetite (3) empire building (4) entrenchment - retain job (5) self-dealing - corruption

• Debtholders prefer equity raising to limit SH distribution, SH prefers greater leverage. SH distribution than dilutive equity

• SH meetings:

• Annual General Meeting (AGM): board member elections, independent auditor appointment, FS / dividend  director auditor compensation approval, nonbinding vote on compensation plan

• Extraordinary GM: special board member election proposed by SH, bylaw / article amendments, M&A / takeover / asset sales, capital increase, voluntary firm liquidation

• SH activism protects interest by increasing SH value. May lead to litigation / lawsuit: proxy contest (group persuading SH to vote for group), tender offer, hostile takeovers. Comps can defy with SH Rights Plan / poison pills

• Creditors (bondholder / private lenders) protects interest by bond indenture (contracts), creditor / ad hoc committees

• Audit committee: Monitors financial reporting process (selection / implementation of accounting policies), supervises internal audit function / independence / competence, recommends independent external auditor and proposing its remuneration

Working Capital Liquidity:

• Operating Cycle: Company’s acquisition of goods / raw materials ~ collection of cash from sales.
  Cashflow may not happen at same time as activity

• Inventory: Cost of products produced or purchased for sale

• Recognized when issuer takes ownership of materials, goods, supplies

• Derecognized when product is sold to customer

• Account Receivable (AR, BS ST asset): $ to be collected for products sold. 

• Recognized when product is sold to customer on credit

• Derecognized when cash is received from customer

• Account Payable (AP, BS ST liab): $ owed to suppliers for products received

• Recognized when product is received, issuer defers / delay payment to supplier

• Derecognized when cash is paid to supplier

• **2/10 net 30 : 2% discount if account paid within 10 days, and otherwise full amount due in 30 days

Secondary Liquidity: (1) suspend / reduce div for SH (2) delay / reduce capital expenditure (3) issuing equity (share issuing provides cash but dilutes exiting SH cost) (4) renegotiation contract terms (ST debt, debt covenants) (5) selling asset (6) bankruptcy

Factors affecting Liquidity:

• Drag on liquidity (inflow): event reducing available funds / delays cash inflows

• Uncollected AR: Measured by av # of days receivables are outstanding, level of customer payment delinquencies as a percentage of receivables

• Obsolete (out of date) inventory: If finished goods held too long in inventory, may mean no more demand / products only sold at discount

• Borrowing constraints: ST debt more expensive / unavail when credit conditions tighten 

• Pull on liquidity (outflow): event accelerating cash outflows or trade credit availability is limited, requiring companies to expend funds before they receive proceeds from sales that could offset the liability

• Early payments: w out benefits = comp forgoes fund use

• Reduced credit limit: when comp pays late often, supplier can cut credit

• Limit on ST lines of credit: by bank / gov mandate / market related

• Low liquidity positions: liquidity shortage due to industry condition / weak financial position. May be exacerbated w aggressive WC mngmnt (more cash, ST, cheaper)

Capital Investments and Capital Allocation

• Capital Investment / Projects: 

• 1~ investments, initially recorded at cost (like most assets) 

• IS: Expenditure not recorded, Non-cash dep / amort over asset life recorded

• BS: Expenditure recorded, Subsequent periods presents net basis (cost - accumulated dep / amort) to 0 or salvage value 

• CF Statement: Cash capital spending reported as incurred 

• Project types: (1) Going concern / maintenance [operation] (2) regulatory/compliance projects [3rd party required] (3) Expansion (4) Other [high risk new initiative]

• Capital Allocation - Investment analysis (time-value-of-money concepts.)

• Net Present Value (NPV):
  = t=0TCFt(1+r)t

= PV of investment CF inflow - PV of CF outflow 

• Invest if NPV ≥ 0 

• Internal Rate of Return (IRR)
  t=0TCFt(1+IRR)t = 0
  = Disc rate making NPV = 0

• Required Rate of Return = Hurdle Rate: Preferred / min return return on investment that a fund must reach before a GP receives carried interest

• Multiple IRRs exist if cash flow signs (+/–) change more than once

• Return on Invested Capital (ROIC) or Return on Capital Employed (ROCE)
  = After-tax Op ProfittAv Invested Capital = (1-Tax rate) Op profittAv total LT L&E Invested Capitalt-1, t 

• = After-tax Op  profitSales × SalesAv Invested Capital
  = After-tax OPM × Capital or Asset Turnover

• Capital or Asset Turnover = how much invested capital is generating in Sales

• Av LT liab, equity includes LT D, Share Capital, Retained Earning

• Aggregate measure to gauge firm’s ability to create value across all investment

• Comparing to ROR, if ROIC > ROR, 🙂

• 🙁Accounting, not cash-based method, backward looking

• If two mutually exclusive project, can only undertake one

• Key principles: After tax CF, Incremental CF only (ignore sunk cost), CF timing

• Pitfalls:

• Cognitive (calculation): Internal forecasting error, ignorance of internal financing (CFO vs external financing through debt - CFO is cheaper? no), inconsistency / ignorance of inflation (real / nominal)

• Behavioral (judgment): inertia, investment decisions on accounting measures (EPS, NI, ROE), pet project bias, ignorance of alternative investment 

• Real options: 

• Right, but not obligation, for mngmnt to make decision for capital investment. Only pursue / exercise a real option if it is value enhancing

• Ex. Includes timing, sizing (abandonment / growth), flexibility (price-setting - $ / production flexibility - Q), fundamental (supply costs) options

• Approach: (1) Investment analysis w out options (2) NPV w options: Project NPV = NPV w out options - option cost + option value (3) decision tree 

Capital Structure

** ** Calculate WACC: Cost of Debt = int cost (=min ROR) VS Cost of Equity = DDM or CAPM

• Cost of Capital (COC): WACC
  = (Cost of debt × Weighting of debt) + (Cost of equity × Weighting of equity)
  = Cost of financing comp = Opportunity cost of fund for suppliers = Required ROR suppliers of capital require as compensation for capital = measured by Weighted Average CC (WACC)

• Lowest WACC 🙂

• Weight: * D/(D + E) = D/E (1 + D/E)

• Moldigliani and Miller (MM) Proposition: ??????????????????????
  Comp’s choice of capital structure does not affect its value (value = PV of firm’s expected future CF, discounted by its WACC). Future CF is most imp

• Assumptions: (1) homogeneous expectations of future earning/CF, (2) Perfect capital market [no tax / transaction cost / bankruptcy cost, symmetric info], (3) RF rate lending / borrowing, (4) No agency cost (5) Independent decisions
  V = Market Value 

• Proposal 1 (w/out tax): Capital Structure Irrelevance:
  keep in mind RF lending rate + arbitrage possible,

• VL = VU :: Value of levered comp = Value of unlevered comp

• Value of comp determined by expected future CF 

• WACC unaffected by capital structure

• Proposal 2 (w/out tax): Higher Financial Leverage Raises the COE:

• ↑ leverage = ↑COE, but firm value & WACC unaffected

• ↑ COE exactly offsets lower COD

•  ↑ debt / financial leverage = ↑ bankruptcy risk = ↑ COE
  “Debt is cheaper” is wrong, required returns match ↑ risk from leverage
  re = r0 + (r0 - rd) DE
  

• Definitions:

• r0 = COC only financed with equity

• re  = COE

• rd = COD

• Proposal 2 (w tax): Firm Value with Taxes:

• Profitable company can ↑ value (V) by using debt

• ↑ tax rate, ↑ benefit of using debt in the capital structure

• Assumption: In presence of corp tax (not personal tax)

• VL = VU + tD

• tD = debt tax shield = tax * debt value

• 

• Proposal 2 (w tax): COC:

• ↑ debt = ↑ COE but at slower rate than in no-tax case

• ↑ debt = ↓ WACC, ↑ value

• Debt is value enhancing, 100% debt optimal

• Assumption: In presence of tax, no financial distress

• Cost of financial distress
  VL = VU + tD - PV
  

• D* maximized firm value, Associated equity = optimal capital structure

• static trade-off theory of capital structure: ↑ leverage = ↓ firm value, PV of financial distress > tax benefits 

• ↑ business risk. = ↑ Value-reducing impact of financial distress / bankruptcy

• Target Capital Structure: mngmnt’s desired D/E proportion, stated in book value / indirectly using financial leverage metric (net or gross debt to EBITDA, credit rating, etc). This is because market value fluctuates substantially, mngmnt’s concern is amount / type of capital investment by comp (not in comp), policies aligned to measure used by 3rd parties

• Example:

• rWACC = after-tax CF (1-t) / MV of firm

• Pecking Order Theory: Managers, incorporating consumer views, prefer decisions least visible (internal equity) over most visible (equity)

Business Model

• Pricing model: 

• Simple products: (1) Tiered - dif P for each buyer / volume / product feature (2) Dynamic - dif P for time / customer depending on avail supply ie. hotel (3) Value-based - value /effectiveness received by customer ie. pharmaceutical (4) Auction - bidding 

• Complex products: (1) Bundling (2) Razor, razorblad pricing - low qual P on initial purchase + high margin on its equipment (3) Add-on pricing - optional service ie. league skins

• Penetration pricing: lower price to penetrate market

• For digital models: (1) Freemium biz model - certain lvls free (2) hidden rev biz model - ads

• Alternatives: (1) Subscription (2) Leasing, licensing, franchising

• Biz model:

• Contract manufacturer: branded products w manufacturers

• Value-added reseller: add customization / installation / support 

• Licensing: use brand for loyalty

Financial Statement Analysis

Financial Reporting Quality:

• Earning quality good = sustainable, FS quality good = well represented

• Within GAAP (biased choice) > Within Gaap (EM) > Outside Gaap (conservative choice)

• Aggressive = higher income bias

• Conservative = higher sustainability of earning

• Motivation for low qual FS: (1) beat benchmark (2) career or incentive [unexpected biz strength banked for next per]

• Condition for low qual FS: (1) opportunity [poor in/external control, min consequence, gov cutbacks on financial regulator] (2) pressure / motivation [bonus] (3) rationalization

Spectrum of Quality:

• GAAP, decision-useful, sustainable, adequate return

• Principle-conforming, Decision-useful info [= relevance + faithful representation, Enhancing characteristics (= Comparability, verifiability, timeliness, understandability)]

• GAAP, decision-useful, unsustainable

• GAAP, biased choice (unintentional): Aggressive / conservative accounting, Earning smoothing (underestimate volatility)

• GAAP, Earnings mngmnt (EM = intentional)

• Non-compliance accounting

• Fictitious transaction

FS Quality Discipliners:

1. Market Regulatory Authorities

• Ex. International Organization of Securities Commissions (IOSCO): 

• Global standard setter for the securities sector [Technically not a regulatory authority and standard setting]. Thus Establishes objectives and principles to guide securities and capital market regulation

• Aims to protect investors, ensure a fair / efficient / transparent market, reduce systemic risk 

• Promotes cross-border cooperation and uniformity in securities regulation

• Ex. SEC: Securities / capital market regulator

• Statutes enforces include ① Securities Act of 1933 (registration of all public issuance of securities, inform properly), ② Securities Exchange Act of 1934 (create SEC, enforcing periodic reporting and authority over industry), ③ Sarbanes-Oxley Act of 2002 (create Public Companies Accounting Oversight Board, or PCAOB to oversee auditors, addressing auditor independence, enforcing mngmnt / auditor to report effectiveness of internal control)

• PCAOB promotes auditing standards for public comp in US

• Regulatory regimes affect FS thru Registration / Disclosure / Auditing requirements, Management commentaries, Responsibility statements, Regulatory review / filing

• Standard setting bodies (IASB, FASB): Private sector, self-regulated org w board members as experienced accountants, auditors, academics. Sets standards

• Regulatory authorities (SEC): Legally enforce (thru fines, suspending market participants, criminal prosecutions) financial reporting requirements

2. Auditors: Unqualified - Qualified - Adverse - Disclaimer of opinion

3. Private Contracting: Loan agreement covenants

FS Issue Detection: 

• Can inflate performance thru: recognize rev / expense prematurely / late, use non-recurring transactions to increase profit, adjusting EBITDA [(Rental payments for OL to result in EBITDAR with R as rentals, Equity-based compensation as it is non-cash expense, acquisition related charges, imp charges for goodwill / LLA, litigation cost, debt extinguishment), reduce uncollectible AR

• SEC prohibits exclusion of charges or liab requiring cash settlement from any non-GAAP liquidity measures other than EBIT and EBITDA

• CFS may improve if (1) increased AP credit period (2) not applying non-cash discount amort against int capitalized [= lower cash outflow] (3) Shifting classification of interest paid from CFO to CFF

• Channel stuffing: Overloading distribution channel w more product than it is normally capable of selling. Overstates my revenues, AR (corrected when product is returned next period), understates my inventory in current period

• Premature rev recognition - ↑ DSO

• CFO / NI < 1.0. If not, may be aggressive accrual accounting policies

• If large restructuring charge in earning, make pro forma adjustments to prior years’ earnings to reflect those prior years a reasonable share of current period's restructuring / imp charges

FS Example Files used for Financial Analysis: 

• Common: ① Securities Offerings Registration Statement (1933 Act - required info includes disclosures of securities being offered, relationship of new / other securities, annual filings info, recent audited FS, risk factors), ② Form 10-K, 20-F, 40-F (full required annual FS files for US SEC / CAD / non-US registrants. 10-K includes footnotes, MD&A, auditor’s report) ③ Annual report (comp annual report for investors, not required by SEC), ④ Proxy Statement / Form DEF 14A (Proxy required by SEC, info for casting votes once a year - proposals requiring SH vote, security ownership details, biographical info of directors, executive compensation  ⑤ Forms 10-Q and 6-K (interim files, including unaudited FS, Management Discussion & Analysis, or MD&A, nonrecurring events)

• Footnotes (in 10-K): 

• Basis of preparation for FS: accounting policy / method / estimates, unit, rounded minor discrepancies (cost allocation of dep), consolidated basis, segment reporting,  biz acquisition or disposal, contractual obligations, financial instruments and its risks, legal proceeding, related party transaction

• Operating segment: Part that needs disaggregated full FS. Part that engages in activities that generate rev / create expense, which results regularly reviewed by senior mngmnt, which discrete financial info is avail

• Comp must disclose all Operating segments that constitute 10% or more of combined operating segments’ rev / asset/ profit. Segments must  [segments for 75% of total comp rev]

• 75% of total comp rev must be reported, including operating segments and others

• Each reportable segments must include: rev, measure of profit / loss / asset / liab, interest rev / expense, cost of PPE / intangible assets required, dep / amort expense, other on-cash expense, income tax expense / income, share of net profit / loss of investment accounted for under equity method 

• MD&A (Management Discussions & Analysis or Management Commentary, in 10-K): 

• Includes: nature of the business, past results, outlook

• Unaudited

• IASB framework: “decision-useful mngmnt commentary”: (1) nature of biz (2) mgnmnt’s objectives / strategies; (3) comp’s significant resources, risks, relationships (4) results of operations (5) critical performance measures

• SEC requirements: un/favorable trends, significant events, uncertainties affecting comp liquidity / capital resource / operation results, effects of inflation, changing P, off-balance-sheet obligations, contractual commitments (purchase obligations), 

• Auditor’s report (in 10-K): 

• Audit opinion: 

• By independent accounting firm

• International standards on auditing (ISAs) developed by International Auditing and Assurance Standards Board (IAASB). Under ISA, auditor must obtain reasonable assurance if whole FS is free from material misstatement (fraud / error), and express opinion if FS is prepared in all material aspects in accordance w FS framework and report FS, communicate

• Opinions: 

• Unqualified / unmodified / clean opinion: true, fair view with applicable accounting standards

• Qualified: some scope limitation / exception 

• Adverse: not fairly represented

• Disclaimer of opinion: auditor unable to issue opinion

• Key (International) / Critical (US) Audit Matters: imp issues by auditor ie. those w/ higher risk of misstatement / involve significant mngmnt judgment (subjectivity), significant transactions

• Other sources:

• Issuer sources: Earning call, press release, interviews, comp website

• Public 3rd party source: Industry whitepaper / analyst report, economic indicators from gov, news, SNS

• Proprietary 3rd party source: analyst report (credit rating), Platform reports / data (Bloomberg) / consultancies

• Proprietary primary research: survey, product comparison

FS Analysis Framework

1. Articulate analysis’ purpose / context:
   Thru evaluation, communication, and guidelines,
   Produce analysis’ objective, target Q, reporting contents, timetable / budget

2. Collect input data:
   Thru FS / questionnaires / data, discussion w related parties, comp site visit
   Produce organized FS, questionnaires

3. Process data:
   Thru data,
   Produce adjusted FS, common size statements, ratios, graphs

4. Analyze/interpret the processed data
   Thru input / processed data (including ratios), 

Produce analytical results, forecasts, valuations

5. Develop / communicate conclusions / recs in analysis report
   Thru analytical results / prev reports, institutional guidelines,
   Produce report answering target Q, recommendations

6. Follow-up
   Thru periodically gathered info / repetition,
   Produce comparison of actual / expected results, revised forecasts, updated report / suggestions 

FS Modeling: 

• IS: Forecast for: Rev → Op Expense (COGS, SG&A) → Pro Forma EBIT (Segments forecast check) → Non-op Expense (Int exp, Inc tax, Shares outstanding) → Pro Forma IS

• CFS: (CFO) NI, Shared based compensation, WC, Dep & Amort. (CFI) CAPEX. (CFF) Share repurchase & issuance, Div, Debt issuance & Repayment

FS Analysis types:

• Sensitivity analysis: what-if, assumption changed

• Scenario analysis: Key financial Q changed

• Simulation: Computer-generated sensitivity / scenario analysis based on probability

Incorporating Competitor impacts: Porter’s Five Force model finds relative profit potential of comp. Includes industry competition, Potential for new entrants, Supplier power, Customer power, Substitute product threat 

Incorporating In/deflation:

• Industry sales: ↑ P / inflation may have bad impact on volume if Demand is Price Elastic, cheaper substitutes avail. ↓ P may also start downward price competition 

• Comp sales: ↑ impact:

• Price inelastic demand (Elasticity < 1): Rev benefits from inflation

• Price elastic demand (Elasticity > 1):  Rev declines

• ∆%Revenue =  (1+ ∆%P for rev)(1+∆%Volume) -1

• ∆%COGS = (1+∆%Volume)(1+∆%Input cost) -1

• Total Rev - COGS = Gross Profit

Financial Statements : IS, BS, CFS

1. Income Statement, Statement of comprehensive income / operations, P&L

Financial performance as flowing statement

General principle: Accrual accounting - Rev recognized / reported on IS when earned, so comp’s record reflect rev from sale when risk and reward of ownership is transferred 

• Transfer time: G&S delivery

• AR created if G&S first (on credit), cash received later 

• Unearned / Def Rev created if cash first, G&S later (delivery) ie. subscription payment

Converged accounting standards (IASB + FASB) May 2014: Aims to provide principle based approach to revenue recognition 

* Incremental costs of obtaining contract / certain costs incurred to fulfill a contract must be capitalized 

Revenue recognition: 

Framework: (1) identify contract w customer (2) identify distinct performance obligations in contract, (3) determine transaction price (4) allocation transaction price to performance obligation in contract (5) recognize rev when entity satisfies performance obligation

• (2) G&S is distinct if customer can benefit from it /  promist to transfer can be separated from other promises

• If Rev may not be recognized, record minimal amount of Rev upon sale, recognize refund liability and “right to returned goods” asset on BS as carrying amount of inventory - cost of recovery

• (5) transferring control of G&S is when entity has present right to payment, customer has legal title / physical possession / significant risk & reward of ownership / accepted G&S

** Net Rev: Rev for goods sold - return, allowances, discounts

Examples: Pizzahut

• Selling own food:
  + Sales for selling food
  - Cost of sales to make food

• Selling food as agency made by others:
  + Sales for agency fee

• Franchise royalties: (gives others license to operate)
  + Rev for franchise royalty (not Sales)
  - Upfront fee for opening new unit as Def Rev (amortized to Rev in SL basis)

• Selling license for tech they invented: 

• Rev recognized over time of license if

• Seller continues to undertake activities (upgrade / enhancements)

• Customers are positively / negatively impacted from those activities

• Activities don’t result from transfer of G&S

• If not, rev recognized at beginning when license is transferred

• Selling LT contract: recognized over time if 1 of below conditions are met:

• Customer routinely benefits 

• Entity’s performance creates / enhances asset enhances asset 

• Entity’s performance does not create alternative use

• Bill and hold arrangement: billed but holding for reason (ex. can’t move equipment yet / storage issue) if all of below is met

• Reason for arrangement is substantive (customer asked for it)

• Product identified separately to belong to customer

• Product ready for physical transfer to customer

• Entity can not use product / direct it to another customer

• Selling at gallery through consignment basis: Rev recognized when gallery sells. Risk and reward is transferred and Rev is measurable

• Selling when collectability concern: Rev recognize when remits payment for the pizza

• Selling to 3rd party directly: Rev recognized when receives the pizza

• Service Rev: Rev recognized as completion of work ie. construction

Expense Recognition: (Capitalizing VS Expensing)

Recognition models:

• Matching principle: Expense recognized at the same period when associated revenues from sale of goods are recognized

• Expensing as incurred: Period costs are costs that can not be directly matched with the timing of rev, thus are expensed immediately ie. executives’ salaries

• Capitalization with subsequent dep or amort:
  First, expenditures capitalized on BS (Asset), and CFS (investing cash outflow)
  Later, comp expenses the capitalized amount over asset’s useful life as dep or amort expense (excludes nondepreciating assets like land, unamortzable assets like intangibles w indefinite life). Expense ↓ NI on IS and ↓ assets on BS. Bc dep and amort are non-cash expenses, so no impact on CFS (excluding impact on taxable income, taxes payable)

Expenditure: 

Capitalizing: ST 🙂:

• Beg years:
  ↑ NI, profitability, profitability ratios (ROE, NPM), BV for assets (Costs recorded as Asset on BS then depreciated), taxable income (expense is smaller) and tax paid,
  ↓ expense, CFO (if higher taxes paid), total asset turnover (Sales / Total Assets bc assets are bigger)

• ** Overall: ↑ CFO as long as capital expenditures > dep expense

Interest cost: either capitalized (on BS) or expensed (IS)

• Capitalized int appears as CFI Outflow

• Expensed int ↓ CFO

• If int arises from constructing asset for

• Comp’s own use: Capitalized int on BS as LLA, expensed over time as property depreciates as dep expense

• For sale: Capitalized int on BS as Inventory, expensed as Cost of Sales when asset is sold

Internal Development Costs:

• Capitalize after product’s feasibility is established, reported as CFI outflow 

• If expensed, 

• ↑ Net CFI, market multiples

• ↓ Operating income, EPS, CFO (by CFI outflow), historical profits, EBITDA

• ↓ NI as long as (current development expense > amort expense that would have resulted from amortizing prior period’s capitalized development costs), = usually when comp’s development costs are increasing

• No amort of prior years’ software cost

• Comp that capitalizes VS expenses: analyst can adjust a capitalizing comp by
  (1) IS - include software development cost as expense, exclude amort of prior years software development cost
  (2) BS - exclude capitalized software [decrease asset and equity]
  (3) CFO - decrease CFO, cash used in investing by the amount of the current period’s development cost
  ** EBITDA: include developmental cost and exclude amortization of prior expense

Non-recurring Items:  Ex. Restructuring charges (costs to close plants, employee termination) gain / loss from selling comp asset for more / less than carrying value 

Changes in Accounting Policy

• Change within policy: Adopt Prospectively (in future) or Retrospectively (restate as standard existed in past)

• Change from one accounting method to another: Adopt Retrospectively

Income Tax

Carrying Value Standard, Should pay: (IS) Accounting profit or Book Profit = income before tax (EBT or Pretax Income), Income Tax Paid, Reported on FS earning, No provision for Income Tax Expense Accrual basis

Tax Base Actual paid: (BS change) Taxable income / profit, Basis for Income Tax Payable (L) / Recoverable (A - Tax credit),  Cash Basis

Taxable Differences:

• Permanent: 

• Dif w no reverse in future

• Treat DTL as 

• Equity if reversal possibility

• Nothing if timing / amount unsure

• Ex. Div receivable, Donation, Loans, Income / expense items not allowed by tax legislation (Penalties, Fines), Tax credits directly reducing tax (encourage solar power use / EV)

• Temporary: Recognized only if likely to be settled

• DTA: ↓Accounting profit, amount expensed, ↑Taxable income

• DTL 🙁= Pay less tax now, pay more in the future

• ** More depreciation = less taxable income 

Calculations:

• Tax Expense or Provision (IS)
  = Income Tax Payable / Recoverable + ∆ DTL - ∆ DTA
  = EBT or Pretax Income × Tax Rate
  = tax expense + Δ Tax Expense + Δ Def Tax 

• NI = EBT or Pretax Income - Income Tax Expense or Provision
  ∆ NI = ΔDTA - ΔDTL - Δvaluation allowance

• EBT or pretax income = Expected income tax expense from continuing operation × Tax Rate 

• Income Tax Payable = Taxable income × Tax rate

• Deferred tax = Temp Dif × Tax rate

• Effective Tax Rate = Total Provision for Income Tax/ EBIT 

Balance Sheet Item	Carrying Amount vs. Tax Base	Result / Temp Dif Type
Asset	Carrying Amount > Tax Base	DTL, Taxable Temp Dif (TTD)
	Carrying Amount < Tax Base	DTA, Deductible Temp Dif (DTD)
Liab	Carrying Amount > Tax Base
	Carrying Amount < Tax Base	DTL, Taxable Temp Dif (TTD)

Corporate Income Tax

• Effective tax rate: 

• = Reported Income Tax Expense (IS) / Pre-tax Income

• For projecting tax expense / earning on IS

• Cash tax rate

• = Tax Paid in Cash / Pre-tax Income

• For forecasting cash taxes, CF 

• Statutory tax rate: Domestic Corporate Income Tax rate 

• Dif btw Statutory tax rate & Effective Tax Rate can be because Tax credit, Withholding tax on div, Adjustments to prev yrs, Non-deductible expenses for tax purpose, when comp is active outside domiciled country

2. Balance Sheet, Statement of Financial Position 

Financial position at point in time

Asset Impairment

Impairment: Carrying amount > Recoverable amount (=Carrying amount not recoverable) = Writedown carrying reduces Asset (BS) and NI (IS). Non-cash item

** Impairment loss: insufficient dep expense was recognized in prior years, NI was overstated in prior years. NPM will be higher later

** Impairment write-downs: ↑ D/E Total Asset Turnover (TAT = Rev / Av Total Asset) ↓ Equity, Asset

Current Asset: Inventory

• Analysis: 

• Inventory write-down high for industries w tech obsolescence of inventories

• Comp using LIFO less likely to incur write-down

• ↓ allowance for obsolescence => ↑ cost of sales => ↓ profit margin

• Inventory is divided into Cost of sales (sold) and Ending inventory (not sold)

• In ↑ inventory unit cost, ↓ inventory quantity

• FIFO: (old / cheaper items sold first)
  ↑ ending inventory (BS)

↓ cost of sales (IS)

• LIFO
  ↑ cost of sales (IS), Inventory turnover (efficiency)
  ↓ ending inventory (BS), profit, gross / op profit / IBT (profitability), Current ratio (liquidity)
  * cost of sales similar to current replacement cost of inventory

Current or Non-current Asset: Financial Assets

Recognition can be at: 

• At initial acquisition: Entity becomes party to contractual provision of instrument

• Subsequent to acquisition:

• Amort Cost (= Cost Model):
  held to maturity (HTM), loans and notes receivable, unquoted equity instruments (where Fair Value is not reliable, cost is a proxy). 

• No affect on IS or BS, gains / losses recognized only when realized

• Fair Value: Unrealized / Holding Period Net Changes in Fair Value are recognized are, (Unrealized = assets that have not been sold / is still owned at end or period)

• OCI (BS), bypassing IS: 

• if Available-for-Sale (USGAAP) = contractual CF & sell financial asset (IFRS) = debt investments consisting solely of principal and interest, occurring on specific dates 

• IFRS: + if comp makes irrevocable election to measure so

• USGAAP: No exception to others

• Profit / loss (IS & BS): 

• IFRS: Any other than those mentioned in OCI + Allows comp to make irrevocable election at acquisition to elect this measurement

• USGAAP: all equity + trading securities (debt securities to sell rather than holding it to collect int or principal payment)

**

• Fair Value: $ that would be received to sell an asset / paid to transfer a liab in an orderly market transaction

• Amortized Cost: ($ A/L is initially recognized) - (principle repayments) ± (amort of discount / premium) - (reduction for impairment)

• ** OCI = (1) Foreign currency translation adjustment (2) Unrealized gain / loss on deriv contracts accounted for hedges (3) Unrealized holding gains / loss on avail for sale debt securities / securities designated as fair value thru OCI (4) comp’s post retirement

Non-Current Asset: PPE: 

• Impairment

• Check indications (obsolescence / demand decline / tech advancements) of asset impairment 

• IFRS vs USGAAP below

• Disclosure:

• Measurement basis, Dep method, Useful life (Dep rate), Gross carrying amount, Accumulated dep at beg / end of period, Reconciliation of carrying amount at beg / end period, Restrictions on title / pledges as security, Contractual agreements to acquire PPE

• When Revaluation model is used: How fair value is obtained, Carrying amount under cose model, Revelation surplus, Dep expense for period, Balances of major classes of depreciable assets, Accumulated dep by major class / total, General description of dep method used to compute dep expense 

Non-Current Asset: LLA: 

• When LLE is first purchased, ↑ Dep Expense (IS), Asset (BS)

• Impairment: LLA Held for Sale:
  When Assets are decided to be held for sale, Asset reclassified from (PPE) Held for use → (Non-current Asset) Held for Sale, and tested for impairment. Impaired if (Carrying amount > Fair value - Cost to sell), Asset written down to (Fair Value - Cost to sell). LLA Held for Sale is not dep / amort

• Reversal: IFRS vs USGAAP below

• Derecognition: Remove from FS when asset no longer provides future benefits from use / disposal 

• Sale: 

• Gain / Loss on sale of LLA = Sales Proceed - Carrying Amount

• Carrying amount = Net Book Value = Historical cost – Accumulated dep

• Gain / Loss disclosed in IS as (1) Other gains and loss OR (2) Separate line if material

• Other methods than sales:

• Held for Use (continue dep / test imp) until disposal or classified as Held for Sale / Distribution

• Retired or abandoned: Asset reduced by Carrying Amount of Asset, Loss: Asset’s Carrying amount 

• Exchanged: (-carrying amount of given up)(+fair value of acquired) reported as gain / loss. Use Fair Value unless no reliable measure (Carrying amount of Asset given up - no gain / loss).

• Spin-off: cash generating unit of comp and its asset spun off

• Disclosure: (IFRS) 

• Nature of expense method: Comp aggregates dep expense according to nature (dep, purchase of material, transport cost, employee benefit, advertising cost..) w no relocation

• Function of expense method: Comp classifies dep expense according to function (cost of sales, SG&A..)

Non-current Asset: Intangible Assets

• Definition: non-monetary assets without physical substance. Must be:

• 1) Identifiable: Capable of being separated from entity / arising from contractual or legal rights

• 2) Under control of comp

• 3) Expected to generate future econ benefits

• 4) Probable of expected future econ benefit of the asset will flow in comp

• 5) Cost of Asset can be reliably measured

• Measuring Model:

• IFRS: Cost Model or Revaluation Model (if active market for intangible asset exists)

• USGAAP: Cost Model

• Assessment: 

• Finite life: Amortized on systematic basis over best estimate of useful life
  Amort method and Useful life estimation reviewed at least annually

• Impairment principles same as PPE

• Indefinite life: Not amortized
  Reasonableness of assuming indefinite life reviewed, Asset tested for impairment

• Impaired when Carrying amount > Fair Value

• Identifiable Intangibles: Ex. Patent, license, trademark, customer list

• IFRS: Assets recognized on BS if probable of future economic benefits, cost of asset is measurable

• Internally Created: 

• IFRS: Research phase (Expensed), Development (Capitalized if tech feasibility met)

• USGAAP: Most Expensed, Capitalize SW development w tech feasibility (cost of employee)

• Expensed for both: Internally generated brands / mastheads / publishing titles / customer list, start-up / training / admin and overhead / redundancy / termination cost, advertising / promotion, relocation / reorganization expense

• As generally expensed, recognizes lower Asset amount than comp obtaining thru external purchase

• CFS classified as CFO  

• Purchased: 

• Capitalized

• Reported as Separately Identifiable Intangible if they arise from contractual rights (license), legal rights (patents), or have the ability to be separated and sold (customer list)

• CFS classified as CFI

• Acquired in Biz Combo (not including Goodwill)

• Biz combo accounted w Acquisition Method, Acquiree’s Identifiable A&L and Contingent Liabilities measured by Fair Value. Difference between the two = Net Identifiable Assets Acquired 

• USGAAP: To not be Goodwill,

• Item arising from contractual / legal right

• Item separable from acquired comp (Exclusive rights: patents, internet domain names, audiovisual materials)

• Non-identifiable Intangibles: Goodwill:

• Definition: (Net Identifiable Assets Acquire) - (Acquired Company) 

• Assessment: 

• Capitalized, Not amortized, Tested for impairment annually

• If Goodwill impaired, Impairment Loss charged against Income, ↓ Earnings, Total Assets, ↑ ROA in future periods. 

• Non-cash Item

• Recognition: Goodwill arising from purchase = Cost of comp - Net Identifiable Assets Acquired

• Disclosure: Acquisition date Fair Value of the total cost to purchase comp, acquisition date amount recognized for each major class of A&L, qualitative description of goodwill recognized

• Disclosure: IFRS vs USGAAP below

Non-current Liabilities: LT Financial Liab

• Amort Cost (BS): Loans / Bond Payable
  At maturity, Amort Cost of bond (Carrying Amount) = Face Value of bond
  Ex. Today: cop, issues $10 bonds at 9.75% of par value (discount) = bonds reported as $9.75 at issue date, discount of 2.75 amortized, bond will report liab of $10 at maturity

• Fair Value: Bonds issued by comp held for trading / deriv, non-deriv hedged by deriv

Non-current Liabilities: Lease

Lease: contract conveying right to use in exchange for fee. Contract must (1) identify underlying asset, (2) give customer right to obtain econ benefit from asset over contract term (3) give customer ability to direct how / what asset’s objective is

• Lessee = Using asset, borrower, Pays fee = Customer
  Similar to acquiring asset w note payable

• Lessor = Owns asset, lender, Grants rights for use, Receives fee
  Similar to installed payment investment

Advantage

• Lessee: Less cash needed uptfront, cost effective (secured borrowing = lower int rate), convenience / lower risk (like obsolescence)

• Lessor: interest earned

Classification: 

• Finance Lease (FL): Like purchase. If any of below met:

• Lease transfers ownership of underlying asset to lessee

• Lessee may purchase underlying asset 

• Lease term is major part of useful life

• PV of lease payment sum ≥ Fair value

• Underlying asset has no alternative use to the lessor

• Operating Lease (OL): All other than Finance Lease. Like rent

Reporting [(Initial Recording) - (Subsequent Recording)]

For Lessee (borrower, fee payer)

• IFRS:
  Same for FL, OL

• BS: 

• Lease Payable Liab: (PV of future lease payment) - (Principal Repayment)

• Principal Repayment uses effective interest method [Use PV & int]

• Rights-Of-Use: (PV of future lease payment) - (Accum Amort) [SL]

• IS: Interest Expense on lease liability, Amortization Expense related to ROU. Reported separately

• CFS: 

• CFF Outflow: Principal repayment (of lease pay)

• CFO or CFF: Interest expense

• ** Lease Payment = Principal Repayment + Interest Expense (Int × Last year Lease Liab) 

• USGAAP: (FL: Same as above)
  OL:

• BS: 

• Lease Payable Liab, ROU: Both initially record PV of future lease payment, [reduce balance of liab by lease payment, recognize Int Expense??]

• Subsequently, ROU amort expense = Lease Payment - Interest Expense , [record dep expense]

• IS: Lease Expense (Interest expense on lease liab + Amort expense for ROU) single line

• CFS: CFO outflow 

• ** Lease Liability = ROU asset (principal repayment and amort calculated the same)

• ** When using OL (vs FL), ↑ Asset, ↓ EBITDA margin, Asset Turnover, CFO

• Disclosure (FL + OL): Carrying amount of ROU asset and end of period by class, Total cash outflow for lease, Int expense on lease liab, Dep charge for ROU by class, Addition to ROU asset, 

• + Maturity / quantitative / qualitative analysis: Nature of lessee’s leasing activity, Future CF lessee is potentially exposed to but not reflected, Restriction / covenants, Sale / leaseback transactions 

Lessor (lender)

Identical IFRS, US GAAP

• FL:

• BS: (Lease Receivable [= PV of future lease payment]) - (Principal Proceeds) = resid val,
  Asset removed replaced with Lease Receivable (no asset to Dep)

Rev = Value of leased asset, COGS = Carrying value of asset

• IS: Interest income report as Rev (prim biz)

• CFS: CFO reports cash receipt

• OL (= rental)

• BS: No affect, continue recognize Leased Asset at (Cost - Accum Dep)

• Expense: Interest expense + Amort expense

• Interest expense = Lease payment × Int rate 

• Amort expense = PV of future lease payment / Years

• IS: Lease Rev on SL basis, continue recognize Dep expense

• CFS: CFO reports cash receipt 

• * Int Rev not recognized as transaction is not financing 

• Disclosure: Nature of lessor’s leasing activities, how lessor manages risks 

• FL: Amount of selling profit / loss, Finance income on net investment in lease, Income relating to variable lease payments not included in measurements of lease
  + Qualitative / quantitative info: Signif changes in carrying amount of net investment, Maturity analysis of lease payment receivables (undiscounted lease payments to be received on annual basis for first 5 yrs / total remaining yrs)

• OL: Lease income w separate section for income related to variable lease payments
  + Disaggregated info of each class PPE subject to OL, Maturity analysis of lease payment  (undiscounted lease payments to be received on annual basis for first 5 yrs / total remaining yrs)

Non-Current Asset: Post Emp, Share-Based Compensation Plans

When employee earns salary / bonus, comp records

• Expense record at Fair Value of compensation

• Cash outflow / accrued compensation liability 

However, Def Compensation earns compensation now but receive consideration in future. Ex:

Defined Contribution Pension Plan (DCPP): 

• Comp contributes defined amount (= Pension expense) in plan 

• CFS (CFO: Pension Expense), BS [↓ cash, (if not paid in period, ↑ Compensation Liab)] 

• Disclosure: 

• IFRS: Amount recognized on IS

• US SEC: File separate annual report (Form 11-K) including plan FS, description of plan structure / holdings

Defined Benefit Pension Plan (DBPP)

• Company contributes undefined future benefits after retirement, funded thru pension trust fund. Estimated future amounts discounted to PV, discount rate = high quality corp bond. 

• Pension expense for

• Production employee: inventory, expense thru COGS 

• Non-production employee: salaries and other admin expense, no impact on IS 

• IFRS, USGAAP similar accounting. 

• BS: △Net Pension Asset / Liab = (Fair Value - PV of expected pension obligation) Single line

• IFRS:

• IS Pension Expense: 

• (1) Emp Service Cost
  = PV of △ Pension Benefit earned by employee by providing 1 more service year. Includes changes in plans (= past service cost)

• (2) Net Interest Expense OR Income accrued on Beg Net Pension A / L:
  △ PV of Net Defined Pension A/L = Net Pension A / L × Discount Rate 

• (3) BS OCI: △ Net Pension Asset / Liab remeasurement include: (1) Actuarial gain / loss (2) Actual return on plan Asset - return included in net interest expense / income

• Actuarial gain / loss: △ from change in assumptions 

• Actual return on plan asset: includes int, div, other income derived from plan asset (ie. un/realized gain / loss)

• Remeasurements not amorted

• ** OCI = (1) Foreign currency translation adjustment (2) Unrealized gain / loss on deriv contracts accounted for hedges (3) Unrealized holding gains / loss on avail for sale debt securities / securities designated as fair value thru OCI (4) comp’s post retirement

• US GAAP: 

• IS

• (1) Emp service cost for period

• (2) Int expense accrued on beg pension obligation

• (3) Expected return on plan asset (reduction in expense amount)

• BS OCI

• (4) Past service cost, subsequently amort into pension expense over future service period 

• (5) Actuarial gain / loss, subsequently amort into pension expense over time

• * no immediate recognition of (4), (5) under US GAAP

• Disclosure: 

• Principles: Explain DBPP and its risk, Amounts in FS from DBPP, how DBPP affects future CF

• Specifics: 

• Nature of benefits provided, regulatory framework, governance of plan, risk to plan

• Reconciliation of opening ~ closing balance of Net Pension A/L, of plan assets, and PV of defined benefit obligation, showing service cost, int income / expense, remeasurements, past service cost, contributions to plan, other changes

• Sensitivity analysis of differing inputs, how they would effect FS

• Composition of plan assets by category (equity / fixed income securities etc)

• Effect of DBPP on future CF

Share-based Compensation (SBC, Equity Settled): 

• For senior-level emp, aligns interest of emp w SH, requires no cash outlay

• Estimate Fair Value of SBC at grant date for Compensation Expense, ratably recognized over plan. Decreases Earnings even when no cash changes hands. Any changes in stock price after grant date does not affect financial reporting

• 🙁 Issuing shares dilutes EPS, Recipient has limited influence over comp’s market value thus less incentive for reward / punishment, Increased ownership may lead to Risk Aversive managers

• Types:

• Stock Grants (ownership):

• Outright stock grant, Restricted stock grant, Performance Shares: All reported on Fair Value of Stock / Shares Issued on grant date (=MV), compensation expense allocated over service period

• Restricted stock grant: Return shares if conditions are not met (employment period, goals)

• Performance shares: Shares granted on meeting performance goals

• Stock Options Grants (ownership): 

• Definitions:

• Grant date: Day option granted to employee

• Vesting date: Day employees can exercise stock options

• Service period: Grant date ~ Vesting date

• Exercise date: Day employee exercises option and converts to stock

• Report at Fair Value estimated as Compensation Expense. No cash exchanged upon grant. Offsetting account for expense is Additional Paid In Capital

• Grant date Fair Value recognized over vesting period (same for conditional options) 

• Upon exercise (alike stock issuance), (+) Equity by Fair Value of option on grant date + Cash provided by employee upon exercise. (+) common stock for par value of stock issued, (+) Additional paid-in capital by [stock par value - sum of fair value of option at grant date and cash received]

• Lead to both extremes of Extreme / Adverse risk taking

• Stock Appreciation Rights / Phantom stock: 

• Compensate for change in share value, don’t hold share

• Risk aversive w limited downside risk / unlimited upside potential, SH ownership not diluted

• Valued at Fair Value, Compensation expense allocated over service period

• Disclosure: (IFRS) Description of each SBC payment (terms & conditions, vesting requirements, max term of options granted, settlement method), Number & weighted av exercise price of options (number outstanding at beg of period, granted / forfeited / exercised / expired during period, outstanding / exercisable at end of period)

3. Cash Flow Statement

CFO Direct method 

(Has CFO, CFI, CFF all separately)

Direct CFO = Cash Collected from Customers - (Cash Paid to Suppliers + Cash Paid to Employees + Cash Paid for Other Operating Expense + Cash Paid for Interest + Cash Paid for Income Tax)

• Cash Collected from Customers = Rev - ΔAR 

• BS Beg AR + IS Rev - CFS Cash Collected from Customers = BS End AR

• Cash Paid to Suppliers = COGS + ΔInventory - ΔAP 

• ↑ Inventory = Purchases during the year > COGS

• COGS + ΔInventory = Purchase from Suppliers

• Beg AP + Purchase - Cash Paid to Suppliers = End AP

• Cash Paid to Employee = Salary and Wages (S&W) - ΔS&W Payable

• Beg S&W Payable + S&W Expense - Cash Paid to Employees = End S&W Payable

• Cash Paid for Other Operating Expense = Other Operating Expense + Δ Prepaid Expense - Δ Other Accrued Liab

• Cash Paid for Interest = Interest Expense - Δ Interest Payable

• Beg Interest Payable + Int Expense - Cash Paid for Int = End Interest Payable

• Cash Paid for Income Tax = Income Tax Expense - Δ Income Tax Payable 

CFO Indirect method

(Starts from NI  and deducts)

NI Adjusted for (1) non-cash expenses (2) non-operating activities (3) ΔOperating WC [Add anything bad]

• Non cash item

• + Dep expense of tangible A, Amort expense of intangible A, Depletion expense of natural resources, Amort of bond discount

• - Non-cash item (amort on premium bond)

• Non-operating loss: 

• + Loss on ① sale / writedown of A, ② retirement of debt, ③ investment accounted for under equity method

• - Gain on ① sale of A, ②③ “”

• + Increase (decrease) in DTL 

• Δ Operating WC accruing from: higher (lower) amount for Expense (vs cash payment), lower (higher) amount for Rev (vs cash receipt)

• Decrease (increase) in current operating asset (AR, inventory, prepaid expense)

• Increase (decrease) in current operating liability (AP, accrued expense liability)

CFO Indirect → Direct Method

Comp usually disclose Indirect CFO only, so use below to convert Indirect → Direct CFO

1. Disaggregate NI into Total Rev, Total Expense

2. Remove Non-operating (Ex. Non-operating gain on sale of equipment), Non-cash items (Non-cash dep expense)

3. Convert accrual amount of Rev and Expense to CF amounts of receipts and payments by adjusting changes in WC account

Direct CFI 

• Historical Cost of Equipment Sold = Equipment Purchased (Note) - Δ Equipment (BS)

• Accumulated Dep on Equipment Sold = Dep Expense (IS) - Δ Accum Dep (BS)

• Cash Received from Sale of Equipment = Hist Cost of Equipment Sold - Accum Dep of Equipment Sold (OR Book Value of Equipment Sold = underlined) + Gain on Sale of Equipment (IS)

Direct CFF: 

• Div = NI - ΔRetained Earning

• (From) Beg RE + NI - Div = End RE

• Issued stock = Δ Common stock change + Δ additional paid in capital stock

CFO Evaluation

1. Source of CF: Source for mature comp: CFO. CFO should cover CFI / F

2. CFO: Check AR, inv, AP. NI < CFO desirable due to non-cash expenses of dep / amort. If high NI but low CFO, poor earnings quality or aggressive accounting choices. Check variability 

** Link between Statements 

• BS Beg Cash (t)
  ± CFS Cash Inflow (Outflow) for CFO/I/F activities
  = BS End Cash (t+1)

• NI → CFO
  NI + Div paid + Dep - ∆AR+ ∆AP - ∆Inventory = CFO

• NI = ∆ Retained Earning

Equity Investments

1. Market Org and Structure

Financial system:

• Purpose: (1) saving (2) borrowing money to use now (3) raise equity capital (4) manage risk (5) exchange asset for immediate [spot] / future [option] delivery (6) trade on info

• Function: (1) achieve Purpose (2) discover ROR equating aggregate saving / borrowing (3) allocate capital to most productive use

• Equilibrium interest rate at Supply & Demand of Money

Traditional VS Alt investment:

• Traditional: D&E, Equity swaps (Exchange of fixed cash pay that depend on stock / index return)

• Alt Inv: hedge fund, PE, commodities, real estate security, securitized D, OL, machinery, collectibles, precious gems

Products: Commodities (carbon credits), Equity (warrant)

• Securities: Fixed Income (Bond, note, bill, Certificate of Deposit COD, Commercial Paper CP, Repo, loan agreement, mortgage) Pooled Inv (ETF = Net Asset Value, in-kind payment - portfolio, among Authorized Participants AP, created by financial intermediaries  Ex. S&P)

• Real assets: Held by Operating Comp (Real estate developer, manufacturers, loggers), created by financial intermediary (REIT, Master Limited Partnership MLP) Ex. lumber stands

• Contracts: Forward (customizable. counterparty / liquidity risk, no cash outlay),

• Futures: Clearing house (1) Requires initial margin posted when entering contract (2) Settles margin on daily basis: Deducts / Adds from margin if loss / profit (3) if drop below maintenance margin, participant replenishes account. If not, broker trades to offset position

• Variation margin: Current margin required - Current collateral price in Repo

Financial intermediaries: Ex. commercial, mortgage, IB, credit unions, credit card companies, brokers (fill orders), exchanges (regulated dealers), dealers (broker using own money, provide liquidity), arbitrageur, clearinghouses, depositories (raise fund from depositor, lend), mutual / hedge funds, insurance comp, Alternative Trading Systems [(ATS) = electronic communications networks (ECN) = multilateral trading facilities (MTFs), usually dark pools (no display of orders clients send): trading venues w no regulatory authority]

++ Derivative: 2. Forward Commitment and Contingent Claim Features and Instruments:  Option section

* (Financial) Leverage: Use of D in capital structure.

• Option Leverage: 

• Trader’s Equity + Borrowed = Total Purchase

• Trader’s Equity: Portion of security price buyer must supply

• Borrowed = Margin Loan = Loan traders borrow to purchase security w Call Money Rate (Int, low bc securitized)

• Actual Equity Investment requires Purchase /Sales Commission, actual loan requires Call Money Rate

• Definitions:

• IMR = Initial Margin Requirement = MR on 1st day of transaction, any day additional margin funds must be deposited = Min E% of total purchase price purchase, set by gov / exchange / clearinghouse

• MMR = Maintenance Margin Requirement = MR for all other. If E falls below Maintenance MR, buyer receives Margin Call (Request for additional E)

• * Max Leverage Ratio = 1/IMR
  IMR 40% means 40% is initially invested in equity 

• * Margin Call Price = Initial Purchase Price × 1 - IMR1 - MMR, subsequent P

• * MMR = Equity per sharePrice per share = Initial E p share + Margin Call P - Current Stock PMargin Call P

• * Remaining Equity
  = Initial Investment (Outflow) + Purchase and Sales Commission Paid (Outflow) + Trading Gain / Loss + Margin Int Paid (Outflow) + Div Received = Remaining Equity  OR
  = Proceeds on Sale + Payoff Loan (Outflow) + Margin Int Paid (Outflow) + Div Received + Sales Commission Paid (Outflow)

** First Initial Inv includes Commission**

• Option Orders

• Execution instruction: How to fill 

• Definition: Bid (Willing to buy P), Ask / Offer (Willing to sell P), Bid-ask spread: Ask or Offer - Bid = Cost of trading. Best ask~bid = market

• Bid × (1+ bid ask spread percentage) = ask

• Market order: Best price immediately avail. Expensive but will execute

• Limit order: Best price immediately avail but no higher (lower) P than specified limit P when buying (selling). (Stop trading!) Less expensive. Can guarantee price but may not execute

• Marketable Limit order: Limit P above (below) best offer (bid). Fill right away

• Validity instruction: When to fill 

• Day order: valid until end of biz day 

• Good-till-canceled order (GTC): valid until ordering person cancels or 60 days 

• Immediate or cancel order (IOC): valid upon receipt by broker / exchange, allows partial fill (Fill or kill does not allow partial fill, but is similar)

• Good / Market-on-close: fill only at end / beginning of trading day. Mutual funds like good on market close orders as portfolios are valued at closing price

• Stop / -loss order: (Start trading!) (1) stop price condition met → (2) order turns to market order filling at best possible price. Advantageous for constant trading / traders who can't be on desk, believes security is undervalued but willing to trade only w market confirmation

• Stop-buy used to limit loss on short position, used when asset undervalued

• Stop-sell used to limit loss on long position

• Clearing instruction: How to arrange final settlement  

• Market regulation: FInancial regulators act to level playing field for market participants, define minimum standards of competence of agents, and require that regulated firms maintain minimum levels of capital

Pim & Secondary Markets:

• Primary: includes private placement, shelf registration (Multiple public issuance w master agreement)

• Secondary: 

• Trading type: (1) Call market - specific time / price & liquid (2) Continuous market - any time

• Execution: 

• Quote / price driven / dealer / OTC market: Most

• Order driven market: Rules to match buy to sell

• Order Matching: (1) $ (2) time (3) display status: Hidden orders 🙁

• Trade Pricing: (1) Uniform pricing - call market, executed at same P (2) Discriminatory pricing - continuous market, time determines P (3) Deriv pricing - crossing network, P derived from other market

• Brokered market: unique assets

Financial Systems: 

• Allocationally efficient: allocate capital to most productive / valuable

• Informationally efficient: asset P reflect all avail info

• Operationally efficient: low trade arranging costs

Market regulation objectives: control fraud / agency problems, promote fairness, set mutually beneficial standards, prevent undercapitalized financial firms from exploiting investors by making risky investments, ensure LT liab are funded

2. Security Market Indexes  

Security Market Index (SMI) 

• Definition: Proxies for security market, market segment, asset class in asset allocation models. Calculated w constituent securities (indiv securities within index). There are 2 versions of the same index: (TRI > PRI in LT) 

• Purpose: (1) gauges of market sentiment (2) proxies for measuring / modeling returns, systematic risk, risk-adjusted performance (3) proxies for asset classes in asset allocation models (4) benchmarks for actively managed portfolios [Irrelevant to passive investors] (5) model portfolios for investment products ex. index funds, ETFs

• SMI Construction:

1. Target market, Security selection (investment universe)

2. Index weighting of securities 

3. Index mngmnt: 

1. Rebalance: adjust weight to maintain consistency with the index’s weighting method

2. Reconstitution: Rebalance + security. Dramatically affects P of current / prospective constituents

** Calculation:

• Value of Price Index
  = VPRI = i=1NniPiD 

• Divisor chosen at inception (usually 1,000)

• * Before split of Period 1 must maintain same VPRI by finding the new divisor
  Ex.
  P before split Period 1: X 10, Y 20, Z 60
  P after split Period 2:    X 12, Y 19, Z 22
  > Period 1:
  VPRI = 30 = (10 + 20 + 60) /3
  Find adjusted divisor of Period 1: 30 = (10 + 20 + 20) / X
  X = 1.67
  > Period 2:
  VPRI = 31.7 = (12 + 19 + 22) / 1.67

• Price Return Index (PRI): Only reflects P change. 

• % ∆ in VPRI
  PRI =  VPRI1 - VPRI0VPRI0

• Weighted av P return of constituent securities
  PRI = i=1NwiPRi

• Total Return Index (TRI): Reflects revinvestment (div, int)

• TRI = VPRI1- VPRI0 + InciVPRI0

• TRI = i=1NwiTRi 

• Multiple Period (Same for PRI, TRI):
  VTRIT = VTRI 0(1 + TRI 1)(1 + TRI 2)…(1 + TRIT) 

** Weighting Measures 

• Price weighting: wiP= Pii=1NPi 

• PRI = ∆%(total index) [총]

• Weights arbitrarily determined by market prices

• No need for share number

• Needs rebalancing only after split, with adjustment to divisor 

• Equal weighting: wiE= 1N

• PRI = (∑∆% Each Security) / n [각각]

• Weights assigned by index provider

• No need for share number

• ** requires an adjustment to the divisor after a stock split

• Needs 多 rebalancing for equal weighting (P change keeps changing weight), Securities w largest fraction underrepresented / smallest fraction overrepresented.

• Market capitalization / Value weighting: wiM= QiPij=1NQjPj

• PRI = % ∆(Index’s market cap) [총]

• Float adjusted market capitalization weighting: wiM= fiQiPij=1NfjQjPj

• fi = fraction of shares outstanding in the market float / investing public

• Div not included in Index

• Constituent securities held in proportion to their value in the target market

• Momentum bias: ex. overweighting stocks rising in price

• Fundamental weighting: wiF= Fij=1NFj

• Weight based on earnings etc

• Value tilt: fundamentally weighted index has ratios of BV, earnings, dividends, to market value that are higher than its market-capitalization-weighted counterpart

• Contrarian effect: Opposite of momentum: Shift away from stocks rising in price

** If Equal-weighted index price > market-cap-weighted index, comprised of the same securities : Outperformance of small-market-cap due to Contrarian Effect

Equity Indexes:

• Broad market index (BMI): 90% of E market

• Multi-market index (MMI): Dif country / region in economic / geographics

• Fundamental weighting in multi-market indexes: Weights for each MMI

• Sector indexes (SI): economic sectors (consumer goods, healthcare). ∑ SI  = BMI. (1) Provides if portfolio manager is more successful bc of stock selection / sector allocation (2) Serves as model portfolio for sector specific ETF

• Style indexes: 

• Market capitalization: large / mid / small cap securities

• Value / Growth classification

Fixed Income Indexes: 

• Issues: (1) large, less regulated (2) dealer market, illiquid

• Classification types: issuer, financing, currency of payment, maturity, credit qual, absence / presence of inflation protection

• Category:  Broad market / market sector / style / economic sector / specialized Index

Alt investments:

• Commodity index: Same commodities can have dif weighting methods. Reflects commodities’ futures price and roll yield

• REIT index: Illiquid, calculated continuously. Include Appraisal, Repeat sales, REIT Index

• Hedge fund indexes: (1) Values determined by (voluntary cooperation of) constituents rather than index providers (2) Biased upward: survivorship bias as reporting is not mandatory

3. Market Efficiency

Efficient markets reflect (Intrinsic / Fundamental Value) prices quickly, only passive investments work, only P only reacts to unexpected changes.

• Market Value: Value asset can currently be bought / sold

• Intrinsic / Fundamental Value: Value determined by investor if they completely understand investment. Estimate only

Factors that affect market efficiency: Market participants, informational availability & financial disclosure, limits to trading (allow shortselling!), transaction cost (exploit inefficiencies / arbitrages) and info acquisition cost

Forms of Market Efficiency:

• Inefficient / weak form (Reflects Market): No active trading / abnormal return (passive > active mngmnt). Market adjusts slowly to unexpected news, Market val & Intrinsic val discrepancies 

• Semi-strong-form (Reflects Market + Public): No active trading / abnormal returns (passive > active mngmnt)

• Strong-form (Reflects Market + Public + Private)

• Technical analyst examining historical data to look for patterns / exploit trading rules) assumes Weak form inefficient, Fundamental analyst assumes Semi-strong inefficient (find intrinsic val w public info to see if mispriced)

Market pricing anomalies: Inefficiencies that are consistent (not due to data mining / snooping)

• Time-series: Momentum / overreaction (depending on loss-aversion = nonsymmetrical compared to risk aversion) anomalies, Calendar anomalies: [Small firm / Turn of the year / January effect (returns higher to reduce tax liability / window dressing), Day-of-the week effect (Monday worst return), Weekend effect (weekends worse returns), Turn-of-the-month effect (End / beg of month high returns), Holiday effect (before holiday high return)]

• Cross-sectional: Contradicts semi-strong market efficiency. Ex. Book to market ratios, P/E ratio effect, Value Line enigma

• Size effect: small-cap comp outperforming large cap comp on risk adjusted basis

• Value effect: Value stocks (stocks with low P/E and Market to Book ratio, high div yield) outperform growth stocks

• Others: Ex. Distressed securities effect, Stock splits, Super Bowl, Earning surprise

• Closed-end fund discount: traded at discounted prices of NAV, not NAV (bc mngmnt fee, tax burdens from unrealized capital gains, liquidity)

• IPO: underpriced as underwriters tend to price them

* Net Asset Value = total market value of the fund’s security holdings less any liabilities

4. Equity Securities

Basics:

• Statutory voting: 1 share = 1 vote, Cumulative voting: accumulate & vote all shares into 1 candidate

• Div on Pref Share (PS): Cumulative, Non-cumulative (if not given, forfeited), participating (std div + incentive div), non-participating

• PE investments: no secondary market, regulatory costs are cheaper. Types include VC, Leveraged / Management Buy Out LBO/ MBO (have undervalued assets, high CF, to restructure and make public again), Private investment in PE (PIPE, public comp selling some ownership to investor in exchange of quick capital)

• Non-domestic Equity Securities: Foreign restrictions exist to limit foreign investor control on domestic comp, provide opportunities to domestic investors, reduce capital flow volatility in/out of E market. However, emerging markets have benefited from foreign investment as there is less concern with capital constraints, lack of liquidity in the domestic market, cheaper financing cost, higher transparency / reporting quality. Investing types include:

• Direct investing: Pay in foreign currency, investment process must be familiarized, less transparent, more volatile 

• Depository Receipts (DR): Trades like ordinary share on local exchange but represents interest in foreign comp. DR is subject to company fundamentals, market conditions, analysts’ recommendations, exchange rate movements. Depository receipt created when foreign comp E is deposited in depository bank
  (custodian / registar: div pay, stock split, transfer agent). Depository issues receipts representing deposited.

• Types depending on comp involvement:

• Sponsored DR: foreign comp directly involved w process 

• Unsponsored DR: foreign comp not involved. Depository buys shares from domestic market and issues receipt thru brokerage. Depository retains voting rights

• Types  depending on area:

• Global DR (GDR): Issued outside comp’s home country / US (can be privately placed), bank in country of exchange, not subject to foreign ownership & capital flow restrictions

• American DR (ADR): USD security trading like common share on US exchange enabling foreign comp to raise capital from US investors

• Basket of Listed Depository Receipts (BLDR): ETF of DR portfolio 

• Global Registered Share (GRS): Common share traded on dif stock exchanges in dif currencies. No currency conversion needed to purchase / sell as identical shares are quoted / traded. Higher flexibility than DR as an actual ownership of interest, traded anywhere  

Risk and Return of Equity Securities:

• Return: Rt =Pt - Pt-1+ Dt Pt01

• DR also includes Foreign Exchange Gain / Loss

• Risk: uncertainty of its expected (or future) total return / CF

• Use E’s av historical return, std dev of return

• Pref shares less risky than common share as pref share div fixed (including liquidation at par) / certain / comes before common share

Comp Value:

• mngmnt’s goal: Maximize Book Value (= SH equity on BS = total A - L, impactable, increase when NI is retained) of comp & Market Value of E (not impactable, depends on impalpable criterias like expectations)

• ROE using BV, Price/Market-to-book ratio

Company and Industry Analysis Framework

5. Industry and Comp Analysis ~ 6. Industry and Competitive Analysis ~ 7. Company Analysis: Forecasting 

(1) Industry and Comp Analysis

Research Report includes

• Front Matter: Issuer name / security identifier, Analyst rec / target buy or sell P, Disclosure / disclaimer

• Recommendation: Analyst rec, Summary of key reasons

• Comp Description: Biz model / strategy, Explanatory chart / figure

• Industry Overview & Competitive Positioning: Industry size / growth / key driver / market share trend / profitability - historical and outlook, Competitive analysis - Porter’s Five Forces (relative profit potential of comp), Analysis or external industry influences - political / econ / societal / tech / legal / environmental (PESTLE: industry themes), Evaluation of comp’s position / strategy in industry

• Financial Analysis: Evaluation of key drivers of rev / cost / profitability / CF / issuer’s use & source of capital, Forecast of key drivers / supporting discussion, Historical / forecasted FS

• Valuation: Estimates of comp / security value w target P, Relative / present value approach, Discussion of key inputs / scenario / sensitivity analysis

• ESG Considerations: Eval of ESG / risk, Ownership structure / mngmng composition, Execution compensation

• Risk: Eval of material down/upside risk and discussion of how they are considered in financial analysis 

Basics: 

• Revenue analysis: Commodization =Competing products become interchangeable commodities 

• First step to reviewing Capital investment is to identify  

• Source: CFO (include net WC, if negative), debt / equity issuance, asset disposal

• Use: Cash and investments on hand, net WC (if positive), capital expenditures & addition to intangibles, acquisitions, debt paydown, div & share purchase

(2) Industry and Competitive Analysis

• Classification by country: Ex. country where issuer is incorporated, country of primary listing of its E securities, location of its headquarters, market perception

• Performance of comp w cyclical demand is most variable / dependent on econ conditions

• Industry growth

• Cyclical & mature: crude oil, natural gas, freight transportation

• Cyclical & growth: semiconductors, fintech, digital ad

• Defensive & mature: utilities, beverage, pharmaceutical

• Defensive & growth: biotech, software, game

• Profitability measures: Time series of ROIC (public comp), assuming public / private competitors are similar

• Lower industry concentration w small competitors in market has high degree of competitive intensity unless the industry is service-oriented, is local in nature, or has high product differentiation

• Innovator’s dilemma: firm can (1) investin disruptive innov, declining existing biz but not losing market share or (2) ignore innov and lose market share while continuing strong profit for existing.

(3) Company Analysis: Forecasting 

Forecasting

• Objects: Drivers of FS line, Individual FS line, Summary measures, Ad hoc objects. (regularly reported)

• Aapproach for FS objects: Historical results / Base rate & convergence, Management guidance (more accurate forecasts for CAPEX), Analyst's discretionary forecast (econ forecasts, cyclical, undergoing fundamental change)

• Rev:

• Top-down objects: (Comp) Growth relative to (Nominal) GDP growth, (Comp) Market growth / share

• Bottom-up (aggregated to total rev): Volume & av selling price, Product-line / segment revenue, Capacity-based measure, return / yield based measure

• COGS: Forecast as % of sales (Gross margin): crosscheck good, not comparable w dif biz model

• Capital investment: Maintenance CAPEX forecast depends on hist dep / amort. Growth CAPEX tied to mngmnt expansion plan / rev growth. Check hist comp practice, mngmnt’s financial strategy, capital req. If no mngmnt guidance or pattern, check PPE capacity  

* Variable Cost estimate = %∆ (Cost of revenue + Operating expenses)/%∆ revenue

8. Equity Valuation

Equity valuation tries to find intrinsic / fundamental value of security. (* No holding period consideration) Models to find it includes:

1. PV / Discounted CF Model:
V0 = PV of future expected benefits

• Div discount model (DDM):
  Use Calc
  Expected Cash / Div to be distributed to SH, cash including Cash div, Share repurchase / buyback

• Needs prediction of timing / amount of 1st div & other div, div growth thereafter 

• Buyback can be due to (1) comp believes shares are undervalued / want to support share price (2)  flexibility in amount / timing of distributing cash to SH (3) tax efficiency [tax rate on div > tax rate on capital gain] (4) ability to absorb increases in outstanding shares bc of exercise of employee stock option

• Cash div payout  

• Declaration day: Comp issues statement declaring div

• Ex-dividend date: 1st day share trades w out div. Price drops amount of foregone div on this day as buyers on this date do not receive div anymore

• Holder of record date: Day where SH listed on comp’s book has ownership of shares
  * Ex-div date ~ Holder of record date = 2 days, linked to trade settlement cycle 

• Payment date: Day div is transferred

• Irrelevant to valuation: Stock div / bond issues of share, Reverse / stock split

• Terminal stock value = Expected value of share at end of inv horizon / selling price 

• Free CF to Equity (FCFE) model:
  V0 = t=1∞FCFE(1+r)t
  Div paying capacity. CF avail to be distributed to SH after meeting CAPEX, WC needs 

• Preferred method, can also use for non-dividend-paying stock

• FCFE: Measure of CF generated in period avail for distribution to common SH
  = CFO + Net Borrowing – FCInv

• CFO = NI + NCC - WCInv [In Appendix below]

• Required ROR i = Current expected risk - Rf + βi (Market Risk Prem)

In other words, Cost of Equity = re  = E(Ri)  = RF + βi [E(RM) - RF]

* Perpetual Preferred Stock Valuation

• PV of perpetuity:
  V0  = D0r

• Expected Annual Div = Issue of A% × Par value

• R = ROR for similar issues

• Par value:
  V0 = t=1∞Dt(1+r)t + F(1+r)t

• F = Preferred stock par value

* Constant / Gordon Growth DDM:
V0 = D0(1+g)r-g = D1r-g

• * Time Value of Money: PVt = Dt(1+g)r-g = D1r-g 

• * WACC: re = D1P0 (1-f) + g

• Mature comp

* Two-stage: growth → mature stage

* Multi-stage DDM:

V0 = t=1nD0(1+gs)t(1+r)t + Vn(1+r)n , where Vn = Dn+1r-gL , Dn+1 = D0 (1+gs)(1+gL)

• Growth comp

• CF0  = 0, Final CF = Vt + Dt (1+gs)t  and find NPV

• Selling included at last year t

• Find CF for only until 1 year before perpetuity starts

• * Time Value of Money: PVt = i=1nDt (1+gs)i(1+r)i + E(St+n)(1+r)n where E(St+n) = Dt+n+1 (r-gl)

2. Multiplier / Market Multiple Model: 

V0 = Share P or Enterprise Value (EV) multiple on forward / trailing basis. For similar comps

• Share Price Multiples (= screening mechanism):
  Ex. P/B, P/S, P/CF

• Higher = Overvalued

• Advantage: 

• Allow relative comparison cross-sectional / time series within sector

• Can be stated in forward basis (forecasted EPS) or trailing basis (EPS of most recent  yr)

• Using fundamental variable (rev, earnings, CF, BV) takes into account future expectations

• Disadvantage: stock may be undervalued compared w benchmark, overvalued when compared w intrinsic val estimation. Cyclical comp influenced by current econ conditions

• ** Justified Forward PE = P0E1 =  D1 / E1r-g = pr-g, p = Div Payout Ratio, E = Earning

• Enterprise Value EV Multiples (= cost of takeover):
  Ex. (EV) / (EBITDA or Total Rev): 

• EV = Market Cap + Market Value of Pref Stock + Market Value of Debt - Cash and investments 

• Market Cap = Market Value of Equity or EBITDA (EV multiple) or Op Inc

• Higher = Overvalued = investors are willing to higher prem for each EBITDA

• Advantage: Useful when comparison different capital structure

• Disadvantage: May be hard to get MV of D

3. Asset Based Valuation Model: 

V0 = Fair Val or Intrinsic Val of A&L = [MV for A (cash, AR, inv, net fixed asse) - L(AP, Note Payable : no LT debt or equity)] / shares, multiply any Market Value to each section

• Advantage: For comps w high CA, CL. For private comps

• Disadvantage: MV,  fair val hard to estimate for inflationary times. Not for comps w high intangibles, PPE

Fixed Income (FI)

1~5. Features, Types, Issuance, FI for Corp & Gov

Basics:

• Bond indenture = legal contract

• Source of repayment: Gov (tax, infra), comp (CFO, security / lien / pledge / collateral)

• Covenant: 

• Affirmative: Use of proceeds from bond issue, timely FS, allow bondholders to redeem bond at prem to par if issuer is acquired pari passu, cross-default. No additional cost

• Negative: Investment limitation, debt issuance senior to existing, asset disposal. restrictive

• Yield Curve: YTM of bonds from same issuer across maturities

FI Types: (1) Bullet bond, 

• (2) Amortizing debt: Loan / debt w periodic int pay + principal repay. Ex. mortgate loan

• ↑ near-term CF, ↓ credit risk (↓ liab)

• Holds risk of reinvesting higher CF at prevailing market int over instrument life (can decline)

• Periodic Payment Amount = A = rPrincipal1-(1+r)-N

• Input N, I/Y. 2nd AMORT. PRN = Principal, INT = int, PRN + Int = PMT

• Partially Amort debt, Principal → (Principal - PV of balloon payment)

• 

In Bullet Pay, the int would remain as the first picture’s 4.8

• Sinking Fund: Reduce credit risk by requiring issuer to retire part of bond’s principal each year

• Waterfall Structures: Distribution order for CF & risk to dif tranches

• (3) Variable Int

• Floating Rate Note FRN coupon = Market Rate Note MRN + Credit spread

• Step-up bonds: Adjust coupon depending on event (credit qual), protects investor

• Payment in Kind PIK: Coupon as additional issuance / added to the principal amount

• Capital or Int-indexed bonds: index-linked bond, changes in index captured with changes in principal or int pay

• (4) Zero-coupon bond = discount bond, for funding fixed future obligations

FI Contingency Provisions: Clause in legal doc allowing action if event / circumstance occurs. Ex. Option

• Call: Right to Buy underlying / Put: Right to Sell underlying

• Convertible:

• Conversion ratio = Convertible bond par value/Conversion price

• Conversion value = Conversion ratio × Current share price

• Warrant: Holder has option to call at fixed exercise price until expiration date

• Contingent Convertible Bonds (CoCos): Bonds that automatically convert to equity if specific event occurs

• Fixed Price Call Provision: Issuer can call back bond at predetermined P in future

• Make-whole Call: Issuer can call bond at price (YTM of sovereign bond of similar maturity + spread)

FI Types- Area (A: Domestic)

• Foreign bond: Bonds sold in A, dominated by A currency, issued by B

• Small emerging markets: usually domestic bond issuance (sovereign + local financial intermediary)

• Euro / bearer bonds: Bonds issued in B, dominated by B currency. Registered (clearing system: serial number / name)

• Global bonds: Bonds issued in Eurobond market and domestic country simultaneously

Issuance and Trading:

• Investment grade: BBB- or higher

• Fallen angels: Investment grade → high yield (new comp) / speculative / junk bonds

• FI index is dif from Equity index as (1) single issuer can have multiple FI securities outstanding = larger # of bonds (2) finite maturity / higher frequency of new issuance = monthly rebalancing (3) weighted by market value of debt outstanding (like Market Cap of Equity Value)

• FI markets are quote-driven or OTC markets

• Debut issuer: Issuer approaching bond market for 1st time involves a transfer from private to public ownership to replace bank loans with bonds

FI Markets for Corporate Issuers

• ST Funding

• LOC (Line of Credit):

• Uncommitted LOC: Unsecured, most flexible, cheapest, least reliable (bank can deny). Require minimal capital reserves until drawn down  

• Committed LOC: ST liab, unsecured, has risk of renewal at maturity, pay upfront fee

• Revolvers: multiyear commitments, lenders seek covenants requiring certain borrower actions

• Secured Loan: Pledge recorded in FS. Can use Factoring arrangement (comp selling AR to lender / factor assuming responsibility for credit-granting, collection process)

• Deposit (banks): Retail checking accounts or institute operational deposits. Saving Deposits include CD - non-negotiable CDs have penalty for early withdrawal, negotiable can be sold in open market

• Interbank market (gov): for reserve mngmnt. Ex. Repo

• CP: For bridge financing (financing for until permanent financing), rolled over, usually unsecured, secured version is Asset Backed CP

• * SPE backed financing beneficial to issuer (financing not recorded on BS), to bank / SPE sponsor / backup credit provider (cash received when CP issued, reduce capital costs by providing undrawn backup liquidity instead of holding the ST loans to maturity), to investors (purchase liquid, ST note w int + principal pay that is hard to have direct access to)

• Rollover risk mitigated through Liquidity Enhancement / back-up LOC so comp can fully repay maturing CP if a rollover is not possible

• * Repo Agreements: Secured ST lending w annual int / repo rate + agreement to buy back from investor at maturity / repurchase date. General collateral repo allows specific group of securities as eligible collateral

• Initial Margin:
  = Security P0Purchase P0

• 100% = fully collateralized, over 100%= overcollateralization

• Haircut = Security P0 - Purchase P0Purchase P0

• Variation Margin: Addresses collateral value changes by granting contract participants right to request additional collateral to maintain a security int equal to original initial margin terms
  = (IM × Purchase Pricet) - Security Pricet 

• Repurchase Price = Purchase Price × [1+ repo rate %  × days360]

• Used to (1) Finance the ownership of a security (2) Earn ST income by lending funds on a secured basis (3) Borrow a security in order to sell it short

• Risks: Default risk, Collateral risk, Margining risk (timeliness of collateral valuation & variation margin in liquidation), Legal risk, Netting / settlement risk 

• LT Funding:

• High-yield issuers face more restrictions when issuing debt (like less market availability) thus thus prefer issuing equity. If issuing, they seek to retain financial flexibility by borrowing under leveraged loans with prepayment features or issuing bonds with contingency features. For example, issuers believing their creditworthiness will improve choose callable debt as value of contingency feature rises as firm’s borrowing cost falls

• High-yield investors benefit from higher bond prices as issuer specific credit falls, but for callable debt, gains are capped at call price

FI Markets for Gov Issuers

• Public sector vary, use cash-based accounting, exclude dep of fixed public goods (federal highway)or accrual of unfunded liab (gov pension obligation) 

• Under Recardian (+MM) equivalence, taxpayers expect gov debt to be offset by higher future taxes thus sovereign gov should be indifferent between collecting taxes today VS raising debt of any maturity based

• Sovereign bond is issued thru public auction led by national treasury. Once auction announced, investors can submit competitive (specify acceptable P & #) and non-competitive (accept P determined thru action). All non-competitive bids are accepted and competitive bids are ranked w lowest yield (=highest bond P). Single price auctions have all winning bidders to receive same P, coupon. It results in lower cost of fund, broader distribution. Multi-price auction has dif P for each bidder. It results in narrower distribution of large bids bc investors must accept bonds at their bid price

• On-the-run: most recently issued bonds used for benchmark yield analysis

• Investors have varying non-economic objectives (Ex. reserve requirement)

• General Obligation bonds: Non-sovereign gov authorities issuing to repay from local tax CF

• Revenue bonds: Non-sovereign gov authorities issuing for specific project. They have maturities matching the expected life of matching project CF

• Supranational issuers target bond investors in major currencies using global bond markets. They are agencies, sponsored and owned by multiple sovereigns

6. FI Bond Valuation ~ 8. Yield & Yield Spread Measures for Fixed / Floating Rate Bonds

Bond Valuation

• Market Discount Rate MDR (i/y or r, ROR required by investors given risk of bond) = Required Yield = Require ROR = = YTM (IRR on CF where when future CF discounted at this rate, sum PV = bond P) 

• Discount: PV < FV, PMT < Market Discount Rate

• Coupon → PMT

• PVFull = PVFlat + AI

• AI = Accrued Interest  = tT × PMT

• PVFlat = Clean price [On calc, PRI. PRI + AI = Full]

• Relation between Bond P: Greater Δ%P if smaller coupon, rising,

• Coupon effect: Low Coupon (PMT) makes greater Δ%P (from MDR change)

• Maturity effect: LT bond makes greater Δ%P (from MDR change)

• ** exception: LT low coupon bond trading at discount

• Convexity effect: |MDR %Δ increase| > |MDR %Δ decrease|

• Bond P & characteristic (more volatile if MDR falling, coupon smaller, LT = higher risk)

• Inverse effect: ↑ Int rate = ↑ Inflation = ↑MDR = ↓ bond price 

• ** exception: low coupon LT bond trading at discount

• ** low coupon rate has more interest rate risk as bond value comes at repayment of face value (end)

• Matrix pricing: Using similar credit quality, maturity, use their MDR average to find PV

Fixed Rate Bond Measures

• Basics:

• Yield measure usually annualized. If more that 1 yr maturity, annualized + compounded 

• Effective Annual Rate (EAR) has periodicity / compounding of 1 (right side of pic)
  
  Ex. Q. A bond issued by RTR pays a quarterly coupon of 3.25%, has three years to maturity, and is currently trading at 97.28. The semiannual bond basis yield is closest to:
  PV= -97.28, FV= 100, n=12, PMT = 0.8125, CPT I/Y,
  Quarterly Yield I/Y=1.055
  Quarterly Yield annualized:4.22 = 1.055*4
  Annualized quarterly yield → Semiannual bond:
  2nd ICONV NOM = 4.22, C/Y = 4, EFF compute:
  EFF = 4.287
  Change C/Y to 2, CPT NOM = 4.242

• Conventions

• Current Yield (CY) = Annual coupon / Bond P

• Street convention: Yield neglecting holidays, weekends 

• True yield: Yield including holidays, weekends

• Government equivalent yield: Yield restating YTM based on 30/360 to actual/actual

• Simple yield: Sum of coupon payments +SL amortized share of the gain / loss, divided by flat price

• Spreads: 

• G-spread: yield spread over gov bond

• I-spread: yield spread over standard swap rate w same tenor / currency. Issuers use to determine fixed-rate bonds VS floating-rate alternatives. Investors use to measure of bond credit risk

• Z-spread: zero-volatility, constant yield spread over gov / swap curve, showing amount that needs to be added to each benchmark spot rate to make PV of bond’s CF equal to price

• Option adjusted spread: Z-spread adjusted for embedded option value
  = OAS = Z-spread – Option value in basis points per year.

• When accounting for multiple discount rates, calculate individually

Floating Rate Measures

• Structure: 

• Interest = Market Reference Rate (MRR) + Quoted Margin (QM)

• Required Margin (RM or Discount Margin DM)= Yield spread of a floating rate so FI priced at par value on rate reset date

• Can change due to credit risk, liquidity, tax status

• Pricing model:
  

• r = (MRR + DM)/m

• Coupon PMT = (MRR + QM)*100/m

• Assumes 

• PV is as of a rate reset date when there are N evenly spaced periods to maturity. No accrued int thus flat P = full P

• 30/360 day count convention

• same MPR is used for all CF

• * Quoted margin (QM) > Discount / Required margin (R/DM) = premium

• Money Market Yield Measures:

• Discount Rate: interest rate used to calculate PV, interest included in face value

• PV = FV (1- Days360 × DR)

• DR = (360Days) × (FV - PVFV) , FV = 100

• FV - PV = interest earned on the T-bill during maturity

• Understates ROR to investor, cost of borrowed funds to issuer

• Ex. CP, Treasury bills, bankers’ acceptances

• Add-on Rate AOR = Bond Equivalent Yield BEY = Investment Yield i/y: interest added to principal

• PV = FV / (1 + Days365 × AOR)

• AOR = (365Days) × (FV - PVPV) , PV = 100

• Ex. Bank certificates of deposit, repos, market reference rate indexes

• ** Difficult to analyze as instruments are quoted in (1) discount rate basis OR add-on rate basis (2) 360 OR 365. Further, “amount” quoted is for MMI, face value paid at maturity; for add-on rate basis, price at issuance

• Higest ROR: Change all Day Convention from DR → AOR

• 1 + EAY = (1+BEY/2)2 

• EAY = YTM

9. Interest Rate’s Term Structure: Spot, Par, Forward Curve

* Bonds may have different YTM due to credit risk, dif currency, liquidity, tax dif, periodicity assumption, and different times to maturity. Maturity Term Structure of Interest Rates are formed thru recent zero coupon bonds & spot rates (YTM of zero coupon rate).

Use of Spot Rates: 

• Determine Par Rates: YTM or coupon making PV of bond’s CF = par when differing spot rate per yr

• Finding Bond Price

• PV formula with r as each year’s differing spot rate. Spot rate must also be divided by 2 if semiannual

• Implied Forward Rate or Forward Yield: 

• 

• IFR: Breakeven reinvestment rate = Int rate over future period implied by current term structure of int rate. Links ST &LT zero coupon bond

• Convention: 2y5y = 2 years forward into 5 year maturity

• First #: length of forward period in years from today (~ in 2 years)

• Second #: bond tenor or time to maturity (5Y forward rate ~)

• When calculating 2y5y with spots, you are finding  5y’s IFR

• (1+ZA)A × (1+IFRA, B-A)B-A = (1+ZB)B 

• Ex. (1+2yrs spot) (1+IFR)3 =(1+5yr spot)

• ZA = Spot Rate 

• ZB = LT / Total Spot Rate

• IFR = Implied Forward Rate

• B-A = tenor

• Ex. Find PV when Forward rates of 0y1y, 1y1y, 2y1y given to find 3 yr spot rate:

• (1+ZA)A × (1+IFRA, B-A)B-A = (1+ZB)B to find Z2 then Z3

• (1) Implied rate: Calculate each year’s implied spot rate: 0y1y * 1y1y = (1+Z2)2, 0y1y * 1y1y * 2y1y = (1+Z3)3 , PV = sum pPMT / (each year’s implied rate)n]

• (2) Forward rate approach: 

• Spot rate = (each yr’s forward rate multiplied)1/n

• PV = sum (PMT / each yr’s forward rate multiplied) 

• Spot, Par, Forward Curve
  

• Upward sloping: Par < Spot < Forward

• Flat Term Structure: Par = Spot = Forward

• Downward sloping / Inverted Structure: Par > Spot > Forward

10. Int Rate Risk & Return ~ 11. Yield-Based Bond Duration Measures & Properties

How does Int Rate change affect coupon payment’s reinvestment & bond P if sold prior to maturity?

• Horizon Yield (Realized ROR): Investor’s total ROR on FI over holding period, including reinvested coupon = IRR expressed in annualized rate. Horizon Yield = original YTM if (1) Coupon pay reinvested at same int rate as original YTM (2) Bond is sold at P on constant-yield price trajectory (p on trajectory = carrying value) = no capital gain / loss when sold
  r = (FVPV)1T-1

• FV = YTM or Future value of reinvested coupon + Sale price in X years (PV usually 100 unless change in interest + sold. If so, recalculated to find PV by n= Total year 

• YTM = coupon + interest on reinvestment of coupon

• Carrying Value
  = Purchase Price + Amort Amount of Discount if purchased at P below par value
  = Purchase Price - Amort Amount of Prem if purchased at P above par value

Ex.

• A buys bond 10 yr 6.2 annual coupon, HTM, YTM = 6.2:
  I/Y = 6.2, N = 10, PV = 0, PMT = 6.2
  FV of Coupons = 82.493
  Redemption Value or Sale Price = 100
  r = 0.062 = 82.493 + 100100110 -1

• A buys same bond but sells after 4 yrs
  I/Y = 6.2, N=4, PV = 0, PMT = 6.2
  FV of Coupons = 27.203
  Redemption Value or Sale Price = 100
  r = 0.062 = 27.203 + 10010014 -1

• A buys same bond, int increases to 7.2
  I/Y = 7.2, N = 10, PV = 0, PMT = 6.2
  FV of Coupons = 86.475
  Redemption Value or Sale Price = 100
  r = 0.0643 = 86.475+100100110 -1

• A buys same bond, int increases to 7.2, sells after 4 yrs
  I/Y = 7.2, N=4, PV = 0, PMT = 6.2
  FV of Coupons =27.609
  Change in int affects bond P
  I/Y = 7.2, N=6, FV =100, PMT = 6.2

Redemption Value or Sale Price= PV = 95.263
r = 27.609 + 95.26310014 -1
Notice the power ¼

** Change 100 if bought for discount / prem 

As seen above, Fixed Rate Bond’s investment horizon is key to understanding Int Rate Risk & Return. Offsetting types of interest rate risk that affect bond investor is:

1. Reinvestment risk: Risk is the lower Int Rate. ↓ Rate = ↑ Future val of reinvested coupon payment
   Definition- Risk of not matching the  bond's yield to maturity (ROR) when reinvesting
   Buy&hold investors, LT, higher coupon rate have higher reinvestment risk

** Zero coupon is not exposed to reinvestment risk as there is no CF until maturity

2. Price risk: Risk is the higher Int Rate. ↑ Rate = ↓ Sale price of bond that matures after horizon date
   In other words, if investor wishes to sell bond prior to maturity, sale price will be lower if rates are higher
   Sell before maturity, ST have higher price risk

** Macaulay duration (years): 

= =

• Definition: 

• Bond’s sensitivity to int rate change

• PV weighted av time / holding period to receipt of CF, which balances Reinvestment risk & Price risk for a 1 time instantaneous parallel shift in yield curve

• Relationship:

• Lower duration if (Inverse relationship w): Increase in Coupon Rate (c), YTM (r), Fraction for current coupon period that has elapsed (t/T)

• Higher duration if (Direct relationship w): Increase in Time to Maturity (T)

• ** For discount bonds, for a given coupon rate, LT discount bond can have lower duration esp when long remaining number of period, Coupon rate < YTM (discount)

• Calculation

1. Period, Time to Receipt, CF, PV (of CF), Weight (/100), Time to Receipt × Weight

2. Period & Time to Receipt: 

1. If calculation is done at issuance or on coupon date, they are equal

2. If not, Time to Receipt = n - (t/T) where t =days since per started

3. CF: CF or PMT / (1+r)Time to Receipt  

1. **  Time to receipt be careful esp if not full number!!)

2. PV = CF all CF (= PMT) and last as 100+CF, then calculate NPV. 100-NPV = PV 

4. Weight: CF amount / PV: PV is 100 if to par. If not, YTM > Coupon = Discounted Full Price

5. ∑ (Time to Receipt × Weight)

• Graph:
  

• Panel A: ↑Int rate → ↓Price. As time passes, bond price pulled to par, increase in future val of reinvested coupon payment starts small but builds over time. At macaulay duration, offsetting: gain on reinvested coupon = loss from increase in int rate

• Others:

• Prem bond has higher coupon thus has lower macaulay

• Duration gap = Macaulay duration – Investment horizon

• Duration gap of 0 is immunized

	Dominant Risk	Source of Int Rate Risk
Investment Horizon > Macaulay Duration	Reinvestment Risk (neg gap)	Falling Int Rate
Investment Horizon = Macaulay Duration	Same risk
Investment Horizon < Macaulay Duration	Price Risk (pos gap)	Rising Int Risk

• Macaulay of 

• Zero coupon bonds = Time to Maturity

• Perpetuity = 1+rr

• FRN = T-tt

• interest rate risk arises only between reset dates

• T: Days in period

• t: Days passed since beg of period

** Annualized Modified Duration (AnnModDur): 

= Mac Dur(1+r) = (PV-) - (PV+)2 (∆Yield) PV0 : 

• Definition: First deriv of bond’s P w respect to yield. Estimates %∆P for given ∆YTM

• ** Use previous r before change

• %ΔPVFull ≈ – AnnModDur × ΔAnnYield

• If high ModDur, steep in Price-Yield graph

** Money Duration (MonDur): 

= AnnModDur × PVFull 

• Definition: Estimates ∆P given ∆YTM in currency units (∆Market Val), stated per 100 of par val / actual position size

• %ΔPVFull ≈ - MoneyDur × ΔAnnYield

** Price Value of a Basis Point (PVBP): 

= (PV-) - (PV+) 2

• Definition: Estimates ΔP given Δ1 bp YTM

• Convention: PVBP = PV01 (Price val of an 01) =  Present val of 01(=1bp) 

12. Yield-Based Bond Convexity and Portfolio Properties

Convexity: 

• Description for curved, non-linear shape of the price/yield relationship of FI instrument

• Complimentary risk metric for second-order (=non-linear) effect of Δyield on P for option-free rate bond

13. Curve-Based & Empirical FI Risk Measures

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14. Credit Risk

Credit Risk is the risk for borrower to default. The C’s of Credit Analysis include: 

• Bottom-up Factors: Covenants, Capacity (ability to repay on time), Capital (Resource avail to reduce debt reliance), Collateral (Asset qual), Character (mngmnt quality)

• Top-down Factors: Conditions, Country, Currency

Ex. Corporate CF from (1) Biz op, Inv / financing activity (2) Asset sale, divestiture (subsidiary selling), D/E issuance. Sovereign CF from (1) Tax, tariff, fee (2) Debt issuance, sale of public asset / privatization
Loss Calculation:

EL ($): Expected Loss = LGD × POD ≈  Credit Spread = Probability-weighted amount of loss

• LGD ($): Loss Given Default = EE × (1-RR)

• EE ($): Expected Exposure: Total projected exposure under EOD. Subtract if any collateral

• RR (%): Recovery Rate: % of loss recovered in default

• * Loss Severity = 1-RR 

• POD (%): Probability of Default: Conditional probability of borrower default, assuming no prior default

• Driven by Profitability (high 🙂), Coverage (enough CF, high 🙂), Leverage (low 🙂)

** If Credit Spread > POD × LGD, fairly compensated for assuming credit risk

Credit Ratings

• Credit Migration / Downgrade Risk: Risk where issuer’s creditworthiness deteriorates, migrates lower, making investors believe risk of default is higher

• Credit Ratings seeks to assess expected loss 

• Market pricing of credit risk for distressed bonds focuses on default timing, expected recovery rate

• Credit rating outlooks are more aligned with market conditions than credit ratings

Factors impacting Yield: Credit spread risk is the risk of greater expected loss bc change in credit condition. Factors:

• Bond Yield (r or I/Y): 

• Yield Spread:

• Liquidity Spread: PV as bid & ask price, finding r then their differences

• Credit Spread: r - Benchmark yield - Liquidity spread

• Benchmark Yield 

15 ~ 16. Credit Analysis for Gov Issuers & Corp Issuers

Sovereign Issuers: Creditworthiness depends on 

• Qualitative: 

• Gov institution & policy: Stable, predictable executive, legislative, judicial institutions and policies. Willingness to pay. Rule of law

• Fiscal flexibility: Ability to adjust revenue, expenditure. Fiscal discipline. Prudent use of debt

• Monetary effectiveness: Policy credibility. Exchange rate regime. Financial system, debt market development

• Economic flexibility: Economic diversification. Competitiveness. Adaptability to shocks 

• External status: Global currency status. Access to external funding. Geopolitical risk

• Quantitative:

• Fiscal strength: 

• Debt burden: (Debt to GDP or rev): shows relative solvency

• Debt affordability (Interest to GDP or rev): shows relative debt coverage

• External stability: Balance of payments, 

• External debt burden: External Debt Burden (LT External Debt / GDP), External Debt Due (External Debt Due in 12 m / GDP)

• Currency reserves: FX reserves to GDP or External Debt

• * sovereign gov is creditworthy if domestic currency is a reserve currency (one fully convertible, held by foreign central bank, investors)

• Economic growth and stability: Cyclicality,

• Economic growth and volatility: Av RGDP growth, Real GDP growth volatility (SD)

• Size / income level: econ size (GDP in PPP terms)

• Per capita GDP: GDP / Population 

Non-sovereign credit depends on issuer: Agencies (quasi-gov), public banks, supranationals, regional governments. In US, municipal issuers (state / local gov) are rated individually and issue:

• General Obligation (GO): Unsecured bond backed by general rev of non-sov gov supported by taxing authority to issuer. Used to finance specific project financing

• Revenue bonds: Issued to finance specific projects, has higher risk than GO as CF dependent on single source of rev. Analysis similar to corp analysis, w key credit measure of Debt Service Coverage Ratio (rev avail to cover principal, int after op exp)

Corporate issuers depend on: 

• Qualitative: 

• Corporate governance: Appropriate use of proceeds, treatment of debtholder / legal, tax, account, covenant compliance

• Business model: Demand / rev / margin stability & predictability, Asset quality

• Industry & competition: Structure, concentration, competitive forces, LT growth & demand

• Business risk: Deviations from expected demand, rev, margin

• Quantitative: 

• Macro (top down) approach: Macro (GDP growth, cyclicality), Industry (Addressable market, market share), Event risk (Scenario analysis, external shock)

• Issuer specific (bottom up) approach: BS - Liquidity leverage, profitability. IS - Rev growth, op profit. CFS - Debt service or Int coverage

• Creditworthiness ratios: Profitability (EBIT margin), Coverage (EBIT to Int Expense), Leverage [Debt to EBITDA, RCF to Net Debt (Retained CF / {Debt - Cash, MS})] 

Seniority ranking: (in priority of claim order)

• Secured Trench w direct claim: 1st lien / Mortgage (asset / property pledged) → Senior secured → Junior secured

• → Unsecured Trench w general claim: Senior unsecured → Senior subordinated → Subordinated → Junior subordinated

• → Equity

• * In case of default, absorb from equity up

Corp Debt has Rating agencies provide 

1. Issuer credit rating (Corporate Family Rating): Apply to senior unsecured debt, address obligor’s overall creditworthiness

2. Individual issue rating (Corporate Credit Rating): Specific financial obligation of issuer, takes factors like seniority into account

POD for issuer & issue may be same, but LGD may differ due to seniority, subordination, source of repayment (= notching). Notching is usually done for lower rated seniority

17~19. FI Securitization, ABS & MPS Market Features

Order: Assert transfer from Originator to SPE (Original source of asset → Pooled assets w similar feature → Bank sells to SPE) → SPE issues ABS to investors (SPE → ABS → ABS investors)

• SPE & originator signs purchase agreement + prospectus (structure of securitization), trustee safeguards assets

• SPE is not affected by the bankruptcy of the seller of the collateral

ABS examples:

(1) Covered Bond (CB): 

• Collateral: Commercial / Residential mortgage, public sector assets. Remains on BS = Not full securitization

• Consist of 1 bond per cover pool (unlike ABS)

• Dual recourse nature: Ringfenced loans in cover pool, Unencumbered assets on issuing institution

• Lower credit risk & yield compared to other ABS due to recourse nature, strict eligibility criteria, dynamic cover pool, redemption regimes in EOD

• Investor risk mitigated thru Overcollateralization, Set LTV (Loan to Value), 3rd party monitoring

• Ex:

• Hard-bullet covered bond: If delayed pay, bond default triggered, payment accelerated

• Soft-bullet covered bond: If delayed pay, bond default and accelerated payment delayed until new final maturity date (= 1 yr after maturity date)

• Conditional pass-thru covered bond: If delayed pay, convert to pass-thru securities after original maturity date

(2) Collateralized Debt Obligation (CDO): security backed by diversified pool of 1 or more debt obligation. Leveraged transaction, where equity tranche holders use borrowed / issued funds to generate a return above the funding cost. Ex: CBO (Bond), structured finance CDO (other CDO)

• CLO (Loan): CF CLO (CF from int, principal redistributed into tranch), MV CLO (MV affects value accruing to tranch), Synthetic CLOs (portfolio of credit default swap for other structured securities). 

• Manager buys and sells debt obligations to (1) paying off holders of the bond classes (2) generating attractive return for equity tranche and manager

• After the ramp-up period but before underlying collateral pool loans mature, collateral manager can replace loans in portfolio as long as new assets meet portfolio selection criteria

• Recourse limited to collateral pool

• Investors in equity tranches take on equity-like risks with potential to earn returns comparable to equities. These residual tranche investors play a key role in whether a CLO is viable or not. The CLO structure has to offer competitive returns for this tranche. Facing these risk/return possibilities puts them in the position of the marginal, price-setting investors

(3) Mortgage Backed Securities (MBS):

• Collateral: Residential & Commercial mortgages

• ** Foreclosure: Allows lender to take possession and sell property to recover funds to satisfy outstanding debt

• Considerations: 

• LTV: ↓ 🙂= ↑ borrower’s equity, ↓default possibility

• DTI (Debt to Income ratio): monthly debt payments / monthly pre-tax, gross income

• Prime loan = low LTV & DTI, Subprime loan = high …

• To calculate securities value, find Prepayment Risk = (Contraction + Extension risk)

• Contraction risk: Risk that borrower repays principal / proportion in shorter time period, reducing future payment investor receives. For investors, investors must reinvest the proceeds at lower interest rates, and prepayment option reduces potential price appreciation for bond

• Extension risk: Risk that borrower repays principal / proportion in longer time period. For investors, higher int rate reduces value of CF investors receive. Payments investors receive will be discounted at a higher interest rate, and the extension stretches out the payments the investors receive

• Time Tranching aims to mitigate prepayment risk

• RMBS: 

• Collateral: Many Residential mortgage, Mortgage as Pass-thru Securities

• Contingencies: Prepayment option, recourse loan (lender can ask borrower for remaining loan if unrecoverable w house itself), non-recourse loan

• Types:

• Agency RMBS: 

• Guaranteed by a federal agency: full faith of gov. Has specific established underwriting standards

• Guaranteed by gov-sponsored enterprises (GSEs): GSE fully guarantees pay (w fee)

• Non-agency RMBS: Issued by private entities, not guaranteed

• Mortgage Pass-thru Security: pooled mortgages w CF as monthly payment of principal, int, prepayments. Mortgage is securitized. A (WAC - weighted average coupon rate from pool) - B (Pass through rate) = service fee for SPE

• WAC = ∑[i × CB / (∑CB)] 

• CB = Current Balance, OR Principal Value

• Pool removed from BS, transferred to SPE. SPE issues securities backed by pooled asset

• CMO (Mortgage): securitizes Mortgage as Pass-thru Securities. Tranching can redistribute the prepayment risk across the different tranches. Ex. Sequential Pay CMO (time tranching),

• Z tranche / accretion or accrual bond: No int until pre-set date w both principal & accrued int payment start. LT and last tranche. Benefits other tranches as it frees up CF so other tranches can distribute. No reinvestment risk

• Principal-Only (PO) securities: Only principal repayments (til face value) paid. Sensitive to prepayment & int rate. When int falls or prepayment accelerates, PO value increases

• Interest-Only (IO) securities: Only int payments. Usually hedged

• Floating-Rate tranch: linked to index / ref rate 

• Residual tranche: any remaining CF after all obligation. For LT institutional investors / hedge funds. Banks avoid as it bc capital requirements

• Planned Amortization Class (PAC): Fixed CF, any prepayment risk absorbed by support tranche

• CMBS

• Collateral: Few Commercial mortgage 

• Structure:

• Balloon loans, not fully amortizing (= down pay)

• Call Protection: Protection against early prepayment. Sequential-pay tranche allows lower level tranches to be prepaid only if seniors are retired. Principal losses are always borne by the junior tranches first. Steps: Prepayment lockout (prepay not allowed) → Prepayment w penalty → Defeasance (Borrower has to buy gov securities portfolio fully replicating remaining scheduled principal + int’s CF, including balloon loan balance. Cost to assemble afforded by issuer)

• Indicators for potential credit performance: LTV,

• Debt Service Coverage Ratio (DCSR): Net Op Inc (NOI) / Debt Service

• NOI = Rental income − Cash Operating Expenses − replacement reserves

• NOI excludes principal + int pay, CAPEZ, dep, amort 

• Cash Operating Expense includes Property tax, Insurance, Property maintenance

• Balloon risk: Risk borrower fails to make balloon pay at maturity, is in default. Lender has to extend loan to “workout period” and modify original terms. Type of extension risk 

(4) Non-MBS: 

• Collateral: Credit card receivables (non-amortizing), Solar lease / loan payment

• Lockout / revolving period: Period of no prepayment risk, and principal repaid is reinvested to acquire additional loan w principal = principal repaid. After lockout, principal start to repay

• Ex. collateralized Debt / Loan / Bond Obligation, CDO Squared

• Credit Card Receivables ABS: Generates additional fee income 

• ** Rapid Amort Provision: requirement for ealy principal amort if event occurs during revolving period

• Solar ABS: green loans collateralized by debt (mortgages, loans, receivables) that can be further collateralized by a lien pledged on the installed systems, on the property itself, or both. This would combine multiple liens to mitigate default risk

Credit Enhancement for ABS Credit Risks 

• Internal: overcollateralization, subordination / credit tranching

• Excess spread= coupon on underlying collateral - coupon paid on securities. Builds up reserves for overcollateralization

• External: financial guarantee by bank / insurance comp, LOC, cash collateral account

Derivatives

1. Deriv Instrument & Market Features, 2. Forward Commitment & Contingent Claim Features & Instruments  

Deriv Basics: Deriv transforms performance of underlying, rather than directly passing thru returns of the underlying to a 3rd party (counterparty). Includes Stand-alone & Embedded deriv (call / put). Types of Firm Commitment include forward / future / swap / contingent claim (option - one party decides when / whether)

Futures (Standard): 

• Futures contract buyer creates long exposure to underlying by agreeing to purchase underlying later. Seller creates short exposure by agreeing to sell. 

• Exchange-Trade Deriv (ETD): Market w standard futures, options avail on exchanges set by exchange. Requires Central Clearing Mandate (verification of of transaction execution, payment exchange, participant recording, MTM, collateral delivery upon inception, deposit to minimize counterparty risk). Less trade cost

• Ex. Int rate swap clearing process: Deriv trade executed on Swap Execution Facility (SEF), a swap trading platform. → SEF transaction shared w Central Counterparty (CCP) → Novation process: CCP replaces existing trade → CCP becomes counterparty for both financial intermediaries = CCP assumes credit risk → no default risk exposure for both parties

Exchange reserves may impost the below to decrease counterparty default.

• Mark to Market (MTM) / Daily Settlement: Each party must deposit Initial Margin (IM) to Futures Margin Account

• F0(T) = Today’s open price, F1(T) = Today’s close price

• MTM gain / loss = [F1(T) - F0(T)] × n

• Margin Balance1 = Margin Balance0 ± Day gain (loss).
  If Margin Balance < Initial Cash Margin, Initial Cash Margin - Margin Balance = Margin Call

• 

• Price Limit: Band relative to previous day’s settlement price within which all trades must occur. Participants require both parties’ agreement to practice outside bands OR impose circuit breaker which pauses indtradahy trading for brief period if a price limit is reached

Forwards (Custom):

• OTC: Markets w customizable deriv contracts traded by are driv end users, dealers, financial intermediaries (commercial / investment banks). Less transparent / liquidity 

• Ex. Long Forward (Forward buyer) Payoff
  

ST = Underlying Price, F0(T) = Forward Price, T = time

• Deriv price is a linear function of the underlying, thus firm commitments are linear deriv

• At time T, transaction is settled based on difference btw F0(T) and ST from the buyer’s perspective.

• Buyer Gain: ST > F0(T)

Credit Deriv

• Based on credit underlying = default risk of debt issuer(s)

• Credit Default Swap (CDS): Insurance for default. Contingent claim based on Credit Spread like Cash Bond, and Credit Spread depends on POD & LGD. Can manage risk of loss from issuer default separately from cash bond. 

Swaps. Counter party: Floating / Fixed Rate Payer

** Options

• Option types:

• Call: Right to Buy underlying

• Expect ↑ underlying’s price, Issuer 🙂

• Seeks flexibility to refinance debt if market interest rates were to fall

• If callable bond’s YTM < coupon rate, call feature more valuable

• **** ↑YTM = ↑Current Market int rate, new bonds have higher int compared to existing lower unattractive rate coupons 

• If Coupon Rate > Current market, you can call to receive higher int promised in call

• Put: Right to Sell underlying

• Expect ↓ underlying’s price, Bondholder 🙂

• If putable bond’s YTM > coupon rate, put feature more valuable

• Option positions:

• Long: = Buy / Hold / Own option = have right to exercise = must pay premium

• Unbounded gain, risk limited to premium

• Long position: Benefit  if ↑ Underlying A P

• Limited risk, Prem paid (-)

• Short: = Issue / Sell / Write option = have obligations = received premium

• Sells asset not owned

• Short exposure: Benefit if ↓ Underlying A P

• Unlimited risk, Prem received (+)

• ** Only the short can default

* Ex. Hedgers short if financial risk of instrument positively correlated to exposed risk. Ex. To hedge risk of holding copper, wire manufacturer sells short copper futures. If copper P falls, manufacturer loses copper inventories BUT gains on short position. Long position of inversely related  

Option Positions and Underlying Risk

Type

Position

Exposure to Underlying Risk

Market Expectation

Call

Long

= Long (upside risk)

Bullish P ↑

** Long Call: I hold / buy / own right to buy underlying Risk limited, premium paid (-) Strike Price < Market Spot Price: I want ↑ Underlying Market P so I can practice the buy at strike price lower than market price. If vice versa state, I skip purchase bc i can buy at lower market price outside the option

Original graph: Red Call option value at maturity: cT = max(0, ST - X) Call option buyer’s profit: Π = max(0, ST - X) - c0 Where c0 = Prem

Short

= Short (downside risk)

Bearish P ↓

Short Call: I issued / wrote / sold right to buy underlying from me  Risk unlimited, prem received (+) Strike price < Market price: Buyer will exercise, I sell Strike Price > Market Spot price: I want ↓ Underlying Market P, so that buyer passes to exercise, and I receive prem.

Original graph: Red

Put

Long

= Short (upside risk)

Bearish P ↓

Long Put: I hold / buy / own right to sell underlying Risk limited, prem paid (-) Strike Price > Market Spot Price: I want ↓ Underlying Market P I sell as I can buy at the asset at lower market price and sell at higher strike price at higher price than market price Strike price < Market price, I skip selling as I can sell at higher market price outside the option

Original graph: Red

long put option payoff: pT =max (0 , X-ST) long put option profit: Π  = max (0, X-ST) - p0

Short

= Long (downside risk)

Bullish P ↑

** Short Put: I issued / wrote / sold right to sell underlying.   Risk unlimited, prem received Strike Price < Market Spot Price: I want ↑ Underlying Market P as put option will not be exercised bc put option buyer will not exercise option = sell asset at lower strike price when they can sell at higher market P

Shot put option payoff: -pT = -max (0 , X-ST) Short put option profit: Π  = -max (0, X-ST) + p0

++ Derivative: 2. Forward Commitment and Contingent Claim Features and Instruments:  Option section

++ Derivative: 8. Pricing and Valuation of Options

• At maturity: Exercise if

• Call: (ST − X) > 0 

• Put: (X − ST) > 0

• Any time before maturity (t<T), Exercise Value is:

• Call: Max (0, St - X(1+r)-(T-t) )

• Put: Max (0, X(1+r)-(T-t) - St)

• Assuming F0(T) = X, If ST > PV(X):
  St - PV(F0(T)) = Max (0, St - X(1+r)-(T-t) )
  Forward Long Commitment at t (Vt(T)) = Call option

• Moneyness: Relation btw Option Value & Exercise Price across underlying P 

• In The Money (ITM): 

• call option w underlying Spot > Exercise P (X)

• Put option w underlying Spot < Exercise P(X)

• At the Money (ATM):

• Underlying Spot = Exercise P (X) 

• Out of Money (OTM):

• Call option w underlying Spot < Exercise P (X)

• Put option w underlying Spot > Exercise P(C)

• Call Option Time Value: ct - Max(0, St - X(1+r)-(T-t) )
  Or ct  = Max(0, St - X(1+r)-(T-t) ) + Time Value

• Put Option Time Value: pt - Max(0, X(1+r)-(T-t) - St)
  Or pt = Max (0, X(1+r)-(T-t) - St) + Time Value

• Time Value Decay: time value of an option prem is always positive but declines to zero at maturity. A purchased option declines in value bc of time value defline. A sold option increases in value bc of time value decline

• If Exercise Price = Stock Price, Exercise P of both call, put the exercise = 0, only reflect time value

• If share price > forward price by more than initial put premium, Loss on forward sale > loss on purchased put at maturity. 

3. Derivative Benefits, Risks, and Issuer and Investor Uses

Benefits:

• Risk Allocation, Transfer, Mngmnt: Allocate, trade, manage underlying exposure without trading the underlying. Create exposures unavailable in cash markets 

• Info Discovery: Deliver info regarding expected price in the future, info regarding expected risk of underlying = implied volatility (if goes up, uncertainty of general market goes up)

• Operational Advantages: Reduced cash outlay, lower transaction costs versus the underlying, increased liquidity and ability to “short” 

• Market Efficiency: Less costly to exploit arbitrage opportunities or mispricing

Risks: 

• Greater Potential for Speculative Use: High degree of implicit leverage increases financial distress

• Lack of Transparency: Added portfolio complexity w exposure w out full understanding 

• Basis risk: Possibility of dif in Expected value of deriv VS underlying. Can arise if deriv references similar P or index

• Liquidity risk: Dif in CF timing of deriv VS underlying

• Destabilization & systematic Risk: Excessive risk taking, use of leverage contributes to market stress

• Counterparty credit risk: Party using futures fail to meet margin call 

Long Call buyer faces counterparty risk

Users:

Deriv accounting standards require derive purchase / sold marked to market thru IS via Earnings unless embedded in A or L or qualifies for Hedge Accounting. Hedge Accounting allows issuer to offset hedging instruments against hedged transaction / BS items to reduce financial statement volatility. Hedge Accounting Designation types include

• CF: Absorbs variable CF of floating rate A or L. Ex. Int rate swap to fixed rate for floating rate debt, FX forward to hedge forecasted sales

• Fair Value: Offset fluctuation in Fair Value of A or L. Ex. Int rate swap to floating rate for fixed-rate debt, Commodity future to hedge inventory

• Net Investment: Designated as offsetting FX risk of equity of foreign op. Ex. Currency swap or forward

** Upfront prem = Principal at risk + Issue Premium 

4. Arbitrage, Replication, Cost of Carry in Pricing Derivatives  5. Pricing & Valuation of Forward Contracts & Underlying w Varying Maturities, 6. Of Futures Contracts, 7. Interest Rates & Other Swaps, 

Arbitrage can happen when

1.  2 assets w identical future CF trade at dif price: (S0A = S0B)

• Bond A has price of EUR 99 at time t=0: S0A = EUR 99

• Bond B has price of EUR 99.15 at time=0: S0B = EUR 99.15

• Both bonds have expected future price: S0A = S0B = 100

• At time t=0, investor can: Sell Bond B short to receive proceeds of EUR 99.15, purchase Bond A for EUR 99, Realize net cash inflow of EUR 0.15

• At time t=1, investor receives EUR 100 for ZBond A, uses this to buy Bond B for EUR 100 to cover short position. Offsetting CF at time T leaves investor w riskless profit of EUR 0.15 price dif between A&B at t=0

2. Asset w known future P that does not trade at PV of its future price determined using an appropriate discount rate: (S0 = ST(1 + r)–T).

Replication: Deriv’s CF decreased using long / short positions in underlying asset / borrow or lending cash

Cost of carry: Net of costs  & benefits related to owning underlying asset for a specific period

• Asset Class & Examples

Asset Class	Ex	Benefit (i)	Cost (r, c)
Asset w out CF	Non div paying stock		Rf rate
Equities	Div paying stocks Equity index	Div Div yield	Rf rate
Foreign Exchange	Sovereign bond (foreign) Market exchange rate		Rf - Rd
Commodities	Soft / hard commodities Commodities indexes	Convenience yield	Rf rate
Credit	Single ref entity Credit index	Credit spread	Rf rate

** Convenience Yield = A non-cash benefit of holding physical commodity versus a deriv

Initiation & Maturity is the same, Seller just Vice Versa for all equations

Forward Contract in general

• No arbitrage contract w no additional cost:

• Initiation: VT(T) =0

• F0(T) at t = 0 is F0(T) = S0 (1+r)T

• During life (t < T), MTM in Long Position: VT(T) = St - F0(T)(1+r)-(T-t) 

• PV of forward price = PVt of F0(T) = F0(T)(1+r)-(T-t) 

• Maturity: VT(T) = St - F0(T)

• r = Rf rate = Opportunity cost of holding / carrying asset, usually Q in $

• With cost & benefit, compounding

• Initiation: VT(T) =0

• During life (t < T), MTM in Long Position: Vt(T) = [St - PVt(I) + PVt(C)] - F0(T) (1+r)-(T-t)  

• PV of forward price = PVt of F0(T) = [S0 - PV0(I) + PV0(C)] (1+r)-(T-t) 

• Maturity: VT(T) = St - F0(T)

• I = Income (benefits, div) c = cost (storage, insurance), usually Q in %

• PVt(C) − PVt(I) < 0 = = Vt(T) < St − F0(T)(1 + r)-(T-t)  = = PV of cost < PV of benefit in owning  = = Forward contract has MTM < (Current spot price - PV of forward P)

• F0(T) < S0  = Opportunity and Other Cost < Benefit of holding 

Example for Forward Contract in general:

A agrees to deliver 1,000 shares in 6 months under forward contract. S0 = EUR50, Rf = 5%

• If no div (I=0)
  → F0(T) = S0(1+r)T : EUR50(1.05)0.5  = 51.23

• If div (I=EUR0.3)
  → F0(T) = [S0 - PV0(I) + PV0(C)] (1+r)T : 

• Find PV0(I) of div per share:
  → PV0(I) = EUR 0.30/(1.05)0.25 + EUR 0.30/(1.05)0.5 = 0.5892

• Substitute PV0(I) in equation
  → F0(T)  = (EUR50 - EUR0.5892)(1.05)0.5 = EUR 50.6310

• Opportunity cost of borrowing at Rf rate is EUR 1.23 p share if no div, EUR 0.63 p share if div

Continuous Compounding: 

• No additional cost:

• F0(T) = S0erT 

• With cost & benefit: 

• F0(T) = S0e(r+c-i) T 

Currency Market w Continuous Compounding:

• No additional cost:

• At initiation, Currency w lower Rf rate for forward period trades forward
  F0,f/d (T) = S0,f/d e(Rf-Rd)T 

• During Life, MTM Value of FX forward: Vt(T) = St,f/d -  F0,f/d e-(Rf-Rd)(T-t)

• ↑ Interest rate differential (Rf - Rd) = Price or Foreign currency depreciate on forward basis, Base or Domestic currency to appreciate = MTM Gain

• ↓ Spot price (S0- < S0) = MTM gain for forward contract seller. This is to satisfy no-arbitrage condition, where S0 at t=0 must equal to PV of forward price discounted at Rf

• MTM value for forward seller at settlemenT : F0(T) − ST,  seller has a loss if F0(T) < ST

• rf >  rd  = FT,f/d > S0,f/d = Foreign Currency Forward discount = FX Forward Prem

• rf <  rd = FT,f/d < S0,f/d = Foreign currency forward prem = FX forward Premium Discount

Example for Market w Continuous Compounding w no additional cost

• AUD/USD spot P S0,f/d = 1.3335

• 6M AUD Rf rate = 0.05%

• 6M USD Rf rate = 0.2%

• At time t=0

• 1) Borrow USD 1,000 at 0.2% USD Rf rate for 6M

• 2) Purchase AUD 1,333.50 at AUD/USD spot rate S0,f/d

• 3) Lend AUD 1,333.50 received at 0.05% AUD Rf rate for 6M

• At time t=1

• 4) Receive AUD loan proceeds of AUD 1,333.83 (1,333.50e(0.0005×0.5))

• 5) Exchange AUD to USD to repay USD at _ST,f/d__ 

• 6) Repay USD w interest 1,001 (1,000e0.002×0.5))

• If no arbitrage opportunity (Step 4 offset Step 6), ST,f/d = 1,3325 = AUD1,333.83 / USD 1,0001

Interest Rate Forward Contracts

• Discount Factor: 1(1+z1)i, P equiv of zero rate = PV of currency unit on future date. Can use TVM

• Forward Rates: ** Refer to Fixed Income 9. Interest Rate’s Term Structure: Spot, Par, Forward Curve: Implied Forward Rate

• Forward Rate Agreement (FRA): OTC deriv contract w agreement to apply specific int to future period time 

• IFRA,B-A  = Implied Forward Interest Rate

• MRRB-A = MRR for B-A period 

• Initiation: VT(T) =0

• Net Payment = (MRRB-A − IFRA,B-A) × Notional Principal × Period

• PV of Net Payment: Discounted - FRA settles at the beginning rather than the end of the interest period

• fA,B−A = 100 − (100 × MRRA,B−A) = futures price for MRR for B−A periods that begins in A period (MRRA,B−A)
  

• Futures Contract BPV = Notional Principal × 0.01% × Period = ∆P of futures contract given ∆1 bp in yield

Futures Contract - Mark to Market every day, Recognizes Realized MTM, Price fluctuates daily based on market changes, Daily settlement mechanism resets futures MTM = 0, variation margin is exchanged to settle difference and reduce counterparty risk, Cumulative realized MTM gain / loss = comparable forward contract

Forwards Contract - no margin deposit, Recognizes Contract MTM by difference between current spot price St and PV of forward price PV[F0(T)] and is settled at maturity = Counterparty credit risk. Forward Contract Price F0(T) remains fixed until maturity

• Shot maturity of futures & ability to borrow at Rf rates results in no distinction btw futures & forward

• Exception: Convexity bias: Dif in ∆P given ∆(yield between int rate futures, int rate forwards).
  Int rate Forwards= non-linear or convex relationships btw P & yield
  Int rate Futures= linear relationship btw P & yield

Swaps: 2 parties exchanging a series of future CF

• Pay-Fixed, Receive-Float: MRR > Agreed Fixed rate: MTM Gain (= V of dif btw fixed rate and MRR multiplied by contract notional over int period)

• Pay-float, Receive-Fixed, : MRR > Agreed Fixed rate: MTM Loss

• Has risk & return profile similar to long fixed-rate bond position

• ↑Int = Σ PV(Floating payments) > Σ PV(Fixed payments) = will owe more in future floating-rate settlements than it will receive in fixed-rate settlements = MTM loss for the client

• Swaps have price and a value: Price is a reference to the fixed-rate payment on the swap, which is constant over time. The value of a swap is zero at initiation but can change over the life of the swap as market interest rates change.

• Swap has periodic settlements at end of period (FRA has single settlement in beg of int period)

• Swap & forward both hold counterparty risk

• Interest rate swap has a constant fixed rate for which PV of fixed versus floating CF exchanges equals zero

• Swaps allow issuers to match periodic CF of specific BS liab to transform their int rate exposure profile

• Swaps enable investors to actively adjust their interest rate exposure profile w out buying / selling underlying securities

• Swaps enable both issuer / investor to avoid admin burden of entering into / managing multiple forward contracts

• Par swap rate represents fixed rate at which PV of fixed and future CF equal one another. First find Implied Forward Rate per period using zero rates, discount implied forward rate back to present using zero rate 

• Periodic settlement value = (MRR – sN) × Notional amount × Period.

9. Option Replication Using Put-Call Parity  

10. Valuing a Derivative Using a One-Period Binomial Model

(I can not do this anymore. I will come back)

Alternative Investments

1. Alternative Investment Features, Methods, Structures  

• Characteristic: LT, illiquid, larger capital outlay

• Ex: PE (mature life cycle stage / firms in decline for leveraged buyouts), Infra (built by gov or Public-Private Partnership PPP thru concession agreement)

• Means: Fund investment (just choose, no investment decisions), Co-investment, Direct investment

• Fund Investment Structure: 1) pre-commitment of funds prior to investment selection, extended period where fund is not sold, (2) higher mngmnt fees, complex fee structures, (3) less transparency on periodic returns and fund positions

• Coinvestment reasons: 1) accelerate investment timing when avail funds, expected inflows are insufficient for specific deal, 2) expand scope of avail new investments, 3) increase diversification of an existing pool of fund investment

• Management Fee: Mngmnt fee + performance fee / incentive fee / carried interest based on % of periodic fund return, levied on committed capital (amount LP provides to fund) [VS Funds: fixed % of AUM, based on invested capital]

• Subject to Min Fund Return = Hurdle Rate = Preferred Return

• Soft: Manager earns fee on annual returns in excess of hurdle

• Hard: Fee calculated on entire return when hurdle is exceeded
  rGP = max[0, p(r – rh)]

• rGP = GP’s ROR , rh = hurdle rate  rh, r = single period fund rate

• Modifications:

• Catch-up Clause:
  rGP = max[0, rcu+ p(r − rh − rcu)].
  Claus favoring GP. Ex. For a GP who earns a 20% performance fee, a catch-up clause allows GP to receive 100% of the distributions above the hurdle rate until she receives 20% of the profits generated, and then every excess dollar is split 80/20 between the LPs and GP

• High-Water Mark: Highest val net of fees that fund reaches in history, Reflects The highest cumulative return used to calculate an incentive fee. Reward managers for sustained performance, protects LPs from paying twice for the same returns

• Claw-back Provision: Requirement GP return funds distributed as incentive fee until LM have received initial investment & % of total profit

• Waterfall: 

• Deal-by-deal / American waterfalls: Advantageous to GP as performance fee collected per-deal basis, paid before LP receives initial investment / preferred ROR (=hurdle rate)

• Whole-of-fund / European waterfalls: All distribution goes to LP as deal is exited, GP receives no profit until LP receives initial investment / hurdle rate med. 

2. Alternative Investment Performance, Returns  

Investment Cycle: Capital Commitment( Investment selection, immediate / delayed commitment of capital =  Capital call, Neg returns) → Capital Deployment → Capital Distribution
Shows J-Curve effect

Evaluation be thru (1) IRR or (2) Multiple Of Invested Capital MOIC (3) Leveraged Returns or Cash position rL  (4) mark-to-model” valuation

• MOIC = Money Multiple: 

• Realized value of investment + Unrealized value of investmentTotal amount of invested capital

• Total value of all distribution & residual A value relative to initial total investment

• rL  = Simple Leveraged ROR
  = r (Vc+Vb) - (Vb+rb) Vc
  = r + Vb Vc (r-rb)

• r = periodic ROR, rb = borrowed periodic rate, Vc = cash investment, Vb = borrowed fund (borrowed / capital)

• Breakeven: rL = r

• Mark to Market: Returns are overstated, volatility of returns understated. Accounting valuation through fair value in different levels:

• Lvl 1: Accessible quoted P in active market for identical A/. Ex. Exchange-traded public equity securities (observed closing market P)

• Lvl 2: Inputs other Level 1 in/directly observable for A/L. Ex. OTC int rate deriv (pricing model using quoted market P)

• Lvl 3: No inputs / market activity to measure Fair Val for A/L. Ex. PE, Real estate (CF projection model w avail market participant assumption)

Returns:

• GP’s return: Mngmnt Fee + Incentive Fee structure (notation: “rm and p” structure)

• Normal return:
  RGP = (P1 × rm) + max[0, (P1 – P0) × p]

• Net of mngmnt fee:
  RGP(Net) = (P1 × rm) + max{0, [P1(1 – rm) – P0] × p}

• Net with Hurdle:
  RGP(Net with Hurdle) = (P1 × rm) + max{0, [P1(1 – rm) – P0×(1+hurdle)] × p}

• High-water Mark (in P2, PHWM = P1 - RGP ):
  RGP(High-Water Mark) = (P2 × rm) + max[0, (P2 – PHWM) × p]

• Net with High-water Mark
  RGP(Net with High-Water Mark) =  (P2 × rm) + max[0, {P2(1-rm) - PHWM} × p] 

• ** Fund value = P1 - RGP 

• Investor’s periodic ROR: ri = (P1 – P0 – RGP)/P0

• rm = GP mngmnt fee as % of AUM, p = performance fee as % of total return

• Redemption fee: Fee charged to discourage redemption, offset transaction cost for remaining investor in fund. Notice period is given in advance for investors to redeem investment. Lockup period is the minimum holding period before investors can withdraw funds. A gate provision limits redemption for a period of time at the discretion of fund manager

• Custom Fee Arrangement: include (1) Fees based on liquidity term / asset size (2) Founders shares [incentives for first investors - lower mngmnt fee structure] (3) Either/or fees [major investors can choose lower mngmnt fee or higher incentive fee]

Biases: survivorship / backfill bias

3. Investments in Private Capital: E&D, 4. Real Estate, Infrastructure, 5. Natural Resources , 6. Hedge Funds, 7. Digital Assets

Equity

• VC: Pre-seed capital / angel investing → Seed-stage (support development, marketing) financing → Early-stage / start-up (between operation - commercial production for strategic investors)  financing → Later-stage / expansion (before IPO) financing, Mezzanine: before IPO, expand

• Private Investment in Public Equity (PIPE): Private offering to select investors with fewer disclosures, lower transaction costs allowing issuer to raise capital more quickly and cost effectively

• Exit strategies: 

• Trade sale: Division of private comp sold via direct sale / auction to strategic buyer w intentions for expanding sale / biz scope
  🙂immediate / fast / simple cash exit, higher P (prem) from synergy seeking strategic buyers,
  🙁potential management opposition, limited buyers, decreased financial appeal w foregone monetization of ownership stakes / options

• Public listing: 

• IPO: for large, fast growing comp, earns market attention
  🙂highest potential share prie, likeliest mngmnt approval, PE sponsor’s fame, P appreciation from ongoing ownership stake
  🙁high transaction cost, LT, stock market volatility, much disclosure, lockup period freezing capital committed to deal

• Direct listing: Security E floated on public market directly w out underwriters to reduce complexity, cost 

• Special Acquisition Company (SPAC): “blank check” comp existing to acquire unspecified private comp w predetermined period or return capital to investors. earns market attention
  🙂extended disclosure time / ability to provide forward guidance to develop investor interest, fixed valuation / lower share P volatility, transaction structure flexibility, high-profile / seasoned sponsors involved
  🙁Capital cost dilution, valuation spread (announced / true value from dilution), deal /capital risk of potential redemption, prolonged post-merger stockholder overhand (downward pressure on share P as large blocks are sold in open market) / churn

• Recapitalization: via PE maintaining control, increase leverage & pay div out of new capital structure.

• Secondary sale: sale of comp to PE

• Write-off / liquidation: investment loses value

Debt

• Mezzanine debt: Private credit subordinate to senior secured debt, senior to equity

• Unitranche debt: Hybrid loan structure (dif tranches of un/secured) in single loan / int rate

• Vintage Yr: yr private capital fund makes first investment 

• Risk & Return: InfraD < Senior real estate D < Senior direct lending < Unitranche D < Debt mezzanine < PE co-investment

• Funds seeded during Expansion phase earn excess returns if early-stage comp
  Funds seeded during Contraction phase earn excess returns if distressed comp

Real Estate

• Debt: 

• Private - Mortgage / Mezzanine debt, construction loan

• Public - MBS / CMBS / CMO, Covered bond, Mortgage REIT / ETF

• Equity: 

• Private - Direct (sole ownership, JV, LP), Indirect (real estate fund, private REIT)

• Public - Publicly traded shares, public REIT, UCITS / Mutual fund / ETF

Direct investment: tax benefits (reduce taxable income using non-cash property dep expense, tax deductible int expense) 

Indirect investment: 

• REIT structure eliminates double corporate taxation (usually Corp + personal tax, avoid corp by distributing div) - Trades on exchanges w Master limited partnerships

• Strategy (Risk & Return): Senior Debt → Core Real Estate (strat w exposure to well-leased, high-qual comm / res real estate, offered by open-end funds) → Core-plus Real Estate → Value-add Real Estate → Opportunistic Real Estate 

• Forms: (1) Equity REIT (invest in prop thru partnership) (2) Mortgage REIT (underwrite loan to real estate) (3) Hybrid REIT (invests in both 1, 2)

Infrastructure

CF from contractual payments like (1) Availability payment [payment received to make facility avail] (2) Usage-based payment [toll], (3) Take or Pay arrangement [min purchase price to pre-agreed volume]

Infra has higher recovery rates, lower default rate

Category:

• Economic infra: (1) transportation asset (2) info and communication tech (ICT, data center) (3) utility and energy assets

• Social infra: ex. healthcare and educational facilities

Investment Stage: (Most risk & return at top)

• Greenfield investment: 1st stage of development. Develop new asset to lease / sell / hold & operate. high weighting to capital appreciation

• Brownfield investment: 3rd stage of development. Expand existing facilities, use privatization of public assets, sale leaseback of completed greenfield project. ST investment, immediate CF & op history. high weighting to current yield

• Secondary-stage investment: investment in existing that needs no development

Natural Resources  

	Raw land	Farmland	Timberland
Return drivers	Land price	Harvest Q, commodity P, land P	Biological growth, harvest Q, lumber P, land P
Rev source	P appreciation, lease	Crop sale, P appreciation, lease	Tree sale, P appreciation, lease
Value	location	Location, growth cycle, soil quality	Location, timper quality, timber proudctionphase
Risk	Alternative use	Weather, biological factors, disease
Owner	Institutional mostly	Individual mostly	Institutional mostly
Ownership structure	Direct / partnership	Direct / partnership, REIT	Direct, partnership, REIT, TIMO

* TIMO = timberland investment mngmnt organizations

Commodities: 

• No CF. Investing usually thru derivatives or funds (commodity trading advisers CTA - various futures)

• In case of carrying commodity, F0(T) = S0e(r+c–i)T

• Backwardation: Spot > Forward = downward sloping / inverted forward curve, convenience yield > 0, benefit of holding commodity > cost of carry = enhances returns of long-only investors

• Low inventories of commodity = incentive for market participants to own physical commodity rather than a derivative contract = incentive drives up spot prices relative to forward prices and lead to S > F  = backwardation 

• Carrying commodity = incurs Cost of Carry (tax, brokerage) 

• Contango: Spot < Forward = cost of ownership > benefit of convenience yield = lowers returns of long-only investors 

• Work as hedge against inflation as returns on commodity investing are driven by commodity price changes, and inflation partially reflects these changes

• High leverage, perform better during inflationary periods

Hedge Funds  

• Hedge fund:paid performance based fee, require managers to invest, barely regulated, privately owned, ST 

• Mutual fund: paid fixed compensation, no own investment, highly regulated

• Strategies: 

• Equity: long/short E (long in undervalued), short bias (short overvalued), market neutral, growth (long), value

• Event driven: merger arbitrage (long undervalued / acquired), distressed, special situation, activist

• Relative value: convertible bond arbitrage (underlying bond vs embedded call), FI arbitrage (General - sovereign, ABS - mispricings), multi-strategy

• Opportunistic: global macro, managed futures (= CTA using momentum of commodities)

• Multi-manager: Funds of Funds

• Illiquid → Liquid: LP → SMA → Close end funds → Mutual funds → ETF

• Risk & Return:

• Market beta: systematic, broad market using market index - fund / ETF

• Strategy beta: investment strategy of hedge fund 

• Alpha: manager specific returns from selection of positions 

• Expose to selection bias (voluntary reporting), survivorship bias

Digital Asset

Distributed Ledger Technology (DLT): tech development offering improvements to deliver financing service

Distributed Ledger: shared database

Consensus protocol: set of rules governing how blocks join the blockchain to resist malicious manipulation thru

• Proof of work: determines which specific block to add through computationally costly lottery by miners. Longest blockrain most secured bc computation itself is impossible to manipulate in short time 

• Proof of stake: requires participants on networks = validators to pledge capital to vouch for block's validity

Forms: Permissionless network: Network fully open to any user on DLT network. All recorded, slower, costlier, decentralized, safer (VS permissioned network)

Appendix

Recognition Models

• Fair Value: $ that would be received to sell an asset / paid to transfer a liab in an orderly market transaction

• Amortized Cost: ($ A/L is initially recognized) - (principle repayments) ± (amort of discount / premium) - (reduction for impairment)]

• Net Realizable Value (NRV): (Estimated selling price in ordinary course of biz) -  (Estimated cost to make sale & to get inventory in condition for sale)

• Market Value:
  [Equity] Value asset can be bought / sold
  [Inventory] Current replacement cost of (NRV - Normal Profit Margin ≤ MV ≤ NRV) 

• Intrinsic / Fundamental Value: Value determined by investor if they completely understand investment. Estimate only. 

• Net Asset Value = total market value of the fund’s security holdings less any liabilities

FS Ratios
Activity / Efficiency / asset utilization / operating ratio: day-to-day tasks. Turnovers higher: 🙂 Revenue = Sales
Days of Inventory on Hand (DOH)	Days in PerInventory Turnover	Av days comp takes to sell inv
Inventory Turnover	COGSEnd or Av Inv	# of times comp sells inv in yr
* Analysis:  Low DOH, High Inv Turnover: Effective inv mngmnt OR comp doesn’t carry adequate inv / comp written down inv values. Can result in lost sales, production problems for raw materials inv High DOH, Low Inv Turnover: slow-moving inv due to tech obsolescence, change in fashion
Days of Sales Outstanding (DSO)	Days in PerReceivables  Turnover	Av days comp takes to receive AR Receivable writeoff = ↓ DSO If constant ↑, premature recognition of rev
Receivables Turnover	RevEnd or Av Inv
Days of Payables Outstanding (DPO)	Days in PerPayables  Turnover	Av days comp takes to pay supplier
Payable Turnover	Purchase or COGSEnd or Av Inv	# of times paid off to supplier in yr
* Analysis:  Low DPO, High Payable Turnover: Not using avail credit facilities OR using early payment discounts High DPO, Low Payable Turnover: Not paying on time OR using lenient supplier terms. Compare w liquidity ratios: If sufficient cash to pay obligation but high DPO, latter reason
WC Turnover	RevAv WC
Fixed Asset Turnover	RevAv Net Fixed A or PPE	Rev from Fixed Asset inv.  Low ratio = capital-intensive OR  new biz (new asset w less Dep, high Carrying Value)
Total Asset Turnover (TAT)	RevAv Total A	* In Du Pont
Liquidity ratio: ST obligations. Low - reliance on CFO OR outside financing
Current	CACL	WC > 0 → Current Ratio >1
Quick / Acid test	Cash + ST MS + ARCL
Cash	Cash + ST MSCL
Defensive interval = Burn rate	Cash + ST MS + ARDaily cash expenditure	Days comp can pay daily cash expenditure w only liquid A, no additional CF. For ventures. Cash expenditure = ∑ Expense - ∑ Non-cash expense
Solvency Ratio: LT obligations. Expense = Payment * Total D = Interest bearing S/LT D. No Accrued liab, AP, Lease
Debt to Equity	Total DTotal E	MV used (not BV)
Total Debt (to Asset)	Total DTotal A
Debt to Capital	Total DTotal D + Total E
Financial Leverage	Av Total AAv Total E	* In Du Pont
Debt to EBITDA	Total or Net DEBITDA	Yrs to repay debt based on EBITDA (= Approximate of CFO)
Interest Coverage	EBITInt Expense	# of times EBIT from op inc covers int payment = times int earned
Fixed Charge Coverage	EBIT + Lease ExpenseInt Expense + Lease Expense	# of times comp earning covers int & lease payment
Profitability Ratio: Generate profits from capital invested.  Revenue = Sales, EBIT Profit = Op Profit, Earnings Before Tax (EBT) Income = Pretax Income, Profit = Income
Return on Rev, IS
Gross Profit Margin (GPM)	Gross ProfitRev	= Rev to cover op & other expense, then generate profit = % of Rev contributed to NI (Int covering Cost of Sales) Gross Profit = Rev - COGS
Op Profit Margin (OPM)	Op IncRev	Op Inc = Gross Profit - Op Cost * In Du Pont
EBT Margin	EBT IncRev	EBT = Op Profit - Int Reflects effect on profitability of leverage and other (non-operating) inc & expenses
Net Profit Margin (NPM),  Profit Margin, Return on Sales	NIRev	Net Profit = Rev - All Expense Includes non/recurring components * Du Pont: NPM = Tax burden × Int burden × OPM
Return on Investment
Operating ROA	EBITAv Total A
ROA	NIAv Total A	NI = Return to E holders Assets are financed by E holders & creditors, Interest expense (= return to creditors) subtracted in the numerator * Du Pont: ROA = Tax Burden × Int Burden × OPM × TAT
Adjusted ROA (Pre-int)	NI + Int Expense (1-Tax Rate)Av Total A
Adjusted ROA (Pre-int, Pre-tax)	EBITAv Total A	Return on all asset (liab / D / E) invested in comp
Return on Invested Capital ROIC	EBIT (1-Tax Rate)Av Total SLT D&E or Av Invested Capital = After Tax OPM × Capital or Asset Turnover	Invested Capital = Op A - Op Liab After Tax Op Profit =After-tax Op  ProfitSales Capital or Asset Turnover = SalesAv Invested Capital
** ROE	NIBeg year Total E or Av Total E	NI avail to common SH earned on E capital (minority / pref / common E) invested after Div Use BV Denominator depends on whether E is volatile (if so, use av) High ROE is not always good Ex. 🙁↑ROE if ↓NI slower rate than SH E or if comp, issues D to repurchase outstanding shares = ↑leverage, risk
Return on Common Equity	NI - DivAv Comon E
** Du Pont Analysis:  ROE  = NIAv E  = NIEBT         × EBTEBIT          × EBITRev   × RevAv total A                    × Av total AAv E  = Tax Burden × Int Burden × OPM × Total Asset Turnover × Leverage = ROA × Leverage = NetPM × Equity Turnover * Tax burden = 1 - tax rate
CF Ratios
Coverage Ratio (IS, CFS) High 🙂
Debt Coverage	CFOTotal D	Financial risk and leverage
Reinvestment	CFOCash Paid for LT A	Ability to acquire asset w CFO
Debt Payment	CFOCash Paid for LT D	Ability to pay debts w CFO
Div Payment	CFODiv Paid	Ability to pay div w CFO
Investing and Financing	CFOCFI & CFF Outflow	Ability to acquire A, pay D, make distribution to owners
Performance Ratio (CFS)
CF to Rev	CFONet Rev	Op cash generated / $ of rev
Cash Return on Asset	CFOAv Total Asset	Op cash generated  / $ of A investment
Cash Return on Equity	CFOAv SH E	Op cash generated  / $ of owner investment
Cash to Income	CFOOp Inc	Cash generating ability of op Can use change in CFO
CF per share	CFO - Pref Div# of Common Shares Outstanding	CFO on a per-share basis
Other Ratios
Valuation ratio, Price / EV Multiple: Quantity of asset / flow evaluating E
P / Earning	Price per share / EPS = pr-g	p = Div Payout Ratio g = b or (1 - Div Payout Ratio) × ROE p = EPS / Div Payout Ratio * Low P/E and P/B = undervalued
Price / Book Value	Market Price per share / BVE per share	Investors’ expectations about company’s future investment, CF-generating opportunities Higher 🙂 Compare for similar industries
Div Payout Ratio	Div / NI  = 1 - Earnings Retention Rate (b)	Price to Earning ratio = Div payout ratior-g
Retention Rate (b)	(NI - Div) / NI  = 1 - Div Payout Ratio
Div / Sustainable Growth Rate (g)	b × ROE = (1 - Div Payout Ratio) × ROE
Others
PPE Asset Age Ratio	Estimated Total Useful Life  Hist CostAnnual Dep Expense =  Estimated Age of Equipment  Accum DepAnnual Dep Expense + Estimated Remaining Life  Net PPE Annual Dep Expense	Cost model * Net PPE = PPE – Accum dep  (Don’t use the FS’ Net)
Common Size Analysis:	- IS: Everything / Rev - BS: Everything / Asset - CFS: ① Cash Inflow (Outflow) / Total Inflow (Outflow) ②Everything / Net Rev	IS: Analysis for time-series and cross-sectional comparison (compare comp w each other across time  / industry / sector) Identifies strategies BS: Identify strategies & capital structure
Earnings per Share (EPS) Basics: IFRS and USGAAP require EPS on IS for net P&L, P&L from continuing op  Ordinary share / common stock / common share: Equity shares subordinate to all other. Paid last in liquidation, benefit most when comp doing well Diluted EPS = decreased EPS Shares repurchased are (-) 2 for 1 split treated as if happened in beg. Ending WANCSO × 2 to total shares Divs: Pref Div for Non/Convertible Shares are all included (included in converted securities or not ) SH Div is NOT included Common Share issued as Stock Div are NOT weighted, and treated as if issued at beg of yr. Thus add the WHOLE number to WANCSO Basic EPS: BEPS = NI - Pref DivWANCSO = Income Avail to Common SHWANCSO WANCSO = Weighted Average Number of Common shares Outstanding Diluted EPS BEPS ≥ DEPS, if not, Antidilutive, thus always calculate options SEPARATELY Convertible Preferred Stock DEPS = NI WANCSO + NCSI at Conversion  NCSI = New Common Shares that would have been Issued NCSI at Conversion = Convertible Pref Shares × # each Pref Share is convertible into If-converted method: EPS if Convertible Pref Sec were converted at beginning of period. If converted in the beginning, 1) Convertible Pref Securities would no longer be outstanding. Instead, additional Common Stock would be outstanding. Thus WANCSO would be higher than BEPS 2) Comp would have not paid Pref Div. Thus, NI avail to Common SH would be higher than BEPS If Stock is not convertible, it is left to (-pref div) and left out of WANCSO change Convertible Bond / Debt DEPS = NI + After Tax Int for Convertible Debt - Pref DIv WANCSO +  NCSI at Conversion If-converted method: EPS if Convertible Debt were converted at beginning of period. If converted in the beginning, 1) Debt Securities would no longer be outstanding. Instead, additional Shares of Common Stock would be outstanding 2) Comp would not have paid Interest on the Convertible Debt. Thus, NI avail to Common SH increases by After Tax Int for Convertible Debt May be dilutive or anti-dilutive NCSI Bond converted = (Total Convertible Bonds / Face Value per Bond)(Common Stocks each Bond is Convertible into) Convertible Stock Option (Employee, Warrants) DEPS = NI - Pref DIv WANCSO +  (NCSI at exercise - SPCR at exercise)×(Outstanding Days/365)   Treasury stock method: EPS if  Options / Warrants have been exercised + comp uses proceeds to repurchase Common Stock at Av Market Price  SPCRUE = Shares that could have been Purchased with Cash Received  ** SPCRUE upon exercise = Proceeds from option exercise = option P × Q / Market P Comp assumed to (1) Receive cash upon exercise and in exchange, issue shares (2) Use cash proceeds to repurchase shares at Weighted Av Market Price during period No effect on net income available to common shareholders, Increase WANCSO only Always Dilutive
Cash Conversion Cycle	# of days comp takes for inventory investment → cash receipt = DOH + DSO - DPO
Operating Cycle	= DOH + DSO
Working Capital (WC)	Total Working Capital: CA - CL Net Working Capital: CA - CL, excluding cash / MS / ST debt
Cash Flow from Operations (CFO)	= Cash received from customers + Int and div received on investments - Cash paid to employees / suppliers - Taxes paid to gov - Int paid to lenders  = NI + NCC - WCInv * Does not account for capital investments that issuers make to improve operations
Free Cash Flow (FCF):	= CFO - Investments in LT assets  = Excess of operating cash flow over capital expenditures
FCF to Firm (FCFF)	= NI + NCC + Int(1 – Tax rate) – FCInv – WCInv = CFO + Int(1 – Tax rate) – FCInv = CF avail to D&E investors after all op expense (ie. income tax) are paid, investments in WC and Fixed Capital made NCC = Non-Cash Charge (Amort, Dep) FCInv = Capital expenditures (ie. equipment) Int(1 – Tax rate) = after-tax interest payments CFO = NI + NCC - WCInv Above calculates Int Paid in CFO. If Int Paid is CFF (Only IFRS), delete Int(1 – Tax rate) If Int Paid is CFI (Only IFRS), add to CFO above If Div Paid is CFO (Only IFRS), add to CFO above
FCF to Equity (FCFE)	= CFO + Net Borrowing – FCInv  = CF avail to Common Stockholders after op expense & borrowing cost (principal, int) are paid, investments in WC and FC made

IFRS VS USGAAP
	IFRS (IASB)	US GAAP (FASB)
Based on	Principles	Rules
Development Cost	Capitalized if conditions met	Expense
IS
Inventory Valuation	FIFO, Weighted av acceptable	FIFO, LIFO, Weighted av acceptable
Inventory Measurement	Lower (Cost OR NRV) * NRV Assessment done by item / groups of similar items, asses every period
		Exception: LIFO / Retail Inventory Methods: Lower (Cost OR Market), where Market Value: Current replacement cost of (NRV - Normal Profit Margin ≤ MV ≤ NRV)
Writedown Inventory < Carrying Amount (BS)	Writedown Inventory to NRV loss recorded as expense (IS) for Cost of Sale	(For LIFO method) Writedown Inventory to NRV or MV loss recorded as expense (IS) for COGS
Inventory Writedown Results	- : Profit, Carrying amount of inventory (BS), Profitability / Liquidity / Solvency ratios  +: Profitability ratios (inv / total asset turnover as asset reduces) * CFO not affected by non-cash write-down * Exception: writeup happens in y1, and y2 is reversed
Inventory Writedown Reversal	Reversal limited to original write-down, recognized as reduction in Cost of Sales (Reduction in Inventory recognized as expense) * (Difference between cost and NRVper kg) × (Inventory)	X
Inventory Exceptions	Agriculture, forest products, minerals / products, commodity broker-traders: Measured in NRV, or quoted market  price if an active market exists. Changes recognized as Profit / Loss in period of change
Inventory Disclosure	Accounting policy to measure inventory [Cost formula (inventory valuation method) Total carrying amount of inventories / in classification (merchandise, raw material..) Carrying amount of inventories carried at Fair Value - Cost to Sell  Inventory recognized as expense (Cost of Sales) Write-down of inventories recognized as expense  Reversals of any write-down recognized as reduction in Cost of Sales Circumstances leading to reversal Carrying amount of inventories pledged as security for liab	All same except 6,7, + Disclosure of LIFO liquidations’ (1) significant estimates applicable to inventories (2) any material amount of income
Non-recurring Items = Unusual / Infrequent	IS: In Continuing Operations but separately below the effect on a net basis, including per share basis BS: related A&L related as Held for Sale
BS
LLA Impairment, PPE Impairment	Impaired if Carrying Amount > Recoverable amount  * Recoverable amount = Max (Fair Value - Cost to Sell - Value in Use) * Value in use = PV of expected future CF * Impairment loss (IS) = Carrying amount - Recoverable amount	Unrecoverable if Carrying amount > Undiscounted Expected CF * If unrecoverable, Asset written down to Fair Value * Impairment loss (IS) = Fair Value - Carrying amount
LLA Reversal	Held for Use / Sale: Yes reversal if Recoverable amount increases (Only Impairment Loss, but no revaluation of Recoverable Amount if Recoverable amount > previous carrying amount)	Asset Held for Use: no reverse Asset Held for Sale: yes reverse if Fair Value increases
Intangible Asset	Cost Model or Revaluation Model (if active market for intangible asset exists)	Cost Model
Intangibles Disclosure	* Finite: Useful life (Amort rate), Amort method, Gross carrying amount, Accum amort at beg / end of period, Reconciliation of carrying amount at beg / end period * Indefinite: Carrying amount of asset, Why indefinite, Restriction on title and pledges as security, Contractual agreements to acquire intangible assets * Revaluation mode: Date of revelation, How fair value obtained, Carrying amount under cost model, Revelation surplus	Gross carrying amount, Accum amort in total / major class, Aggregate amort expense, Estimated amort expense for next 5 fiscal yrs
Imp Disclosure	Imp loss / reversal recognized, Where it is in FS, Assets affected by imp / reversal	Description of imp asset, Reason for imp, Method to determine fair value, Amount of imp loss, Where they are recognized in FS
CFS
Div / int classification	Flexible  Int / div received: CFO / CFI Int / div paid: CFO / CFF	Less flexible Int / div received: CFO Int paid: CFO Div paid: CFF
Bank overdrafts	Cash equivalents	Financing
Taxes paid	CFO with portion allocatable to CFI or CFF	CFO
Format of Statement	In/direct, direct encouraged	In/direct, direct encouraged, reconciliation of net income to CFO must be provided