2019

CFA® EXAM REVIEW

Critical
concepts
for the
CFA EXAM

Wiley’s CFA ®

Program Level I
Smartsheets
Fundamentals For CFA Exam Success
WCID184
 Wiley’s CFA Program Exam Review
®
The Time Value of money 
The Time Value of money 

The Time
The Time Value
Value of
of Money 
Money 
Effective Annual Rates
Effective Annual Rates
The Time Value of money 
EAR = (1 + Periodic interest rate) N − 1
EAR = (1 + Periodic interest rate) N − 1
The Time Value of Money 
The Future Value of a Single Cash Flow
The Future Value of a Single Cash Flow
Effective Annual Rates sTaTisTica

ETHICAL AND QUANTITATIVE METHODS • Standard deviation: positive square root of the variance
N
FVN = PV (1 + r) N pRobabiliTy concepTs sTaTisTica
FVN = PV (1 + r)
EAR = (1 + Periodic interest rate) N − 1 • Coefficient of variation: used to compare relative
PROFESSIONAL STANDARDS Time Value of Money The Future Value
The Present Value of a Single Cash Flow
The Present Value of a Single Cash Flow
FVof a Single Cash Flow
Coefficient
Expected
CoefficientValue
of Variation of data sets (lower is better)
dispersions
of Variation
PV = FV N
PV = (1 + r) N s
Ethics in the Investment Profession • Present
FV N =(1PV + r)(1 + r) N
value (PV) and future value (FV) of a single cash Coefficient of variation =
E(X) = P(X1 )X1 + P(X 2 )XX s2 + … P(X n )X n
Coefficient of variation =
The Present
The Present flow and
and
Future
Future
Value
Value
of
of
an
an
Ordinary
Ordinary
Annuity
Annuity X
• Challenges to ethical behavior: overconfidence bias, The Present Value of a Single Cash Flow where: n

situational influences, focusing on the immediate rather PVAnnuityFV : # periods N; % interest per period I/Y; amount FV or amount PMT → PV = sampleE(X) = ∑ P(X i )X i
PVAnnuity : # periods N; % interest per period I/Y; amount FV or amount PMT →swhere: PV standard deviation
PV = : # periods
FV N; % interest per period I/Y; amount FV or amount PMT → X FV = the • Sharpe
sample i =1 ratio: used to measure excess return per unit of
mean.
than long-term outcomes/consequences. (1 +: #r)periods N; % interest per period I/Y; amount FV or amount PMT →sFV
Annuity
FVAnnuity
N = sample standard deviation
X = the sample risk (higher mean. is better)
• General ethical decision-making framework: identify, The The Present
The Present • PV and
Present and
and Future
andFuture FV ofValue
Future Value
ordinary
Value of
of an
of
an Annuity
annuity
an Annuity
Ordinary Due
and annuity due
Annuity
Due
where:
Sharpe Ratio
X i = oneRatio of possible
n floW outcomes.
consider, decide and act, reflect. DiscounTeD
Sharpe cash applicaTions
PV : # periods N; % interest I/Y; amount FV or amount PMT →Variance rp − rf
• CFA Institute Professional Conduct Program sanctions: PVAnnuity
Annuity Due = = PVOrdinary Annuity ××per
(1 +period
r) PV and Standard
Sharpe ratio = Deviation
PVAnnuity Due PV Ordinary Annuity (1 + r) rp s− rf
Discounted
FVAnnuity: #Dueperiods
FV = FVOrdinary N; % interest Cash (1 +Flow
×per period
r) Applications
I/Y; amount FV or amount PMT → FV Sharpe ratio = p
public censure, suspension of membership and use of FVAnnuity
Annuity Due = FVOrdinary Annuity × (1 + r)
Annuity pRobabiliTy concepTs
sp
the CFA designation, and revocation of the CFA charter The Net Present Value σ 2 (X) = E{[X − E(X)] 2
}
Present andofaaFuture Value of an Annuity Due where: • Positive skew: mode < median < mean
Present• Value
Present Value
PV ofof Perpetuity
(but no monetary fine). a perpetuity
Perpetuity r
DiscounTeD cash floW applicaTions
= mean portfolio return
where:
= ∑Due
N
CF
PMT
Expected
p
•
rrpf == risk‐free
Value n leptokurtic (positive excess kurtosis),
Kurtosis:
2 return return
meanσportfolio (X) = ∑ P(X i ) [X i − E(X)]2
t
NPV
PV
PV = PV
=(1PMT Ordinary Annuity × (1 + r)
Standards of Professional Conduct PV
Annuity
Perpetuity
t=0 = +I/Yr )t
Discounted Cash× (1 +Flow Applications srfp == risk‐free
standard platykurtic
deviation
return of(negative
portfolio returns excess kurtosis), mesokurtic (same
Annuity Due =
FVPerpetuity FVOrdinary Annuity r) E(X) = P(X i =1 )X + P(X )X + … P(X )X
I/Y
kurtosis
sp = standard deviation as
1
ofnormal
1
portfolio 2
distribution;
2
returns n
i.e. zero excess kurtosis)
n
Continuous
Net Present Value Compounding and Future Values Sample skewness, alsoRule known
I. Professionalism
where:
Continuous Compounding and Future Values The Total Probability forasExpected
sample relative Value skewness, is calculated as:
Present Value of a Perpetuity
CFt = the expected net cash flow at time t Discounted Cash Flow Applications n
Probability Concepts
Sample skewness, also known as sample relative skewness, is calculated as:
1. E(X) = E(X | ∑
FVN = PVe N r ⋅N E(X) = P(X i )X i n c
A. Knowledge of the Law N = the investment’s CF
rprojected
⋅N t life + E(X | S )P(Sc) 3
s
QUANTITATIVE METHODS
FV
NPV N == PVe ∑=(or1PMT r )present
t
s

pRobabiliTy
QUANTITATIVEconcepTs
S)P(S)
i =1 ∑n (X| Si 2−) X)
B. Independence and Objectivity • PVPerpetuity
r = the discount
Positive rate
t=0 net +appropriate
I/Y
cost of capital
value (NPV) projects increase METHODS 2. E(X) = E(X
• SExpected
 | S1) ×nP(S1) + iE(X
value ∑ =1 (X − X)3 2
× P(S ) + . . . + E(X | Sn) × P(Sn)
K =  ( n − 1)( )  and variance
i3 of a random variable (X)
Internal shareholder wealth. where:
= Uniform
n n − 2  i =1 s
C. Misrepresentation where: Rate
Continuous of Return and Future Values
Compounding where:
The S
Discreteusing probabilities Distribution

Xi = one of n possibleK
( n − 1 )( outcomes.
n − 2 ) s 3

D. Misconduct
CFt = the • For
expectedmutually net cashexclusive flow at time projects,
t choose the project with Expected E(X) = theValue
The Discrete
As n| becomes

unconditional
Uniform expected
large, the value

Distribution
expression
value of X
reduces to the mean cubed deviation.
rn⋅N CFt life NPV. E(X S1) =and the expected of Xisgiven Scenario
theN =highest
N = the investment’s
FV 0PVe
projected positive which 1the probability of each of the possible
r = the discount rate ∑
NPV= =
s
A discrete
Variance uniform
Standard distribution
Deviation one in pRobabiliT
II. Integrity of Capital Markets ( ) t As
P(S n1)becomes
= the large,
probability
= the of expression
Scenario
+ 1reduces
occurring to the)X mean cubed deviation.
or 1 +
appropriate
IRR cost of capital A discrete E(X)
outcomes is identical. uniform P(X
n 1 The
)X
distribution P(X )X
is
best2 example 2+ …
one P(X
in which
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• Projectst=0for which the IRR exceeds the required rate of The set of events , S2The
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Snfrom
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σ (X) =∑
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distribution 2is of
identical.
the − examplethe roll of ofa uniform
a fair die,distribution
for which is
the the probability
probability of each
A. Material Nonpublic Information Internal return willprocess haveusing positive NPV. nE{[X (X X)
i − E(X)] }
Solved asRate of Return
an iterative calculator TVM functions. distribution
outcomeSReturn
Expected is of1the
1/6. ∑
i =non outcomes
1 (X − X)3 from the roll of a fair die, for which the probability of each
ai Portfolio
K ≈
B. Market Manipulation • For mutually exclusive projects, use the NPV rule if the outcomeSE(X)
Covariance
is 1/6. n1= ∑ P(X
i =1n s i
3 )X
i
n
CFt K2 ≈ i =1
Bank Discount Yield
0 = ∑IRR rulest conflict. The σ (X) = ∑
Continuous n Uniform
s 3
Distribution
III. Duties to Clients NPV and
NPV=
E(R p ) = ∑
Cov(XY)
N
=w P(X
E{[X i ) −[X i − E(X)]
= w1E(R−1 )E(Y)]}
E(X)][Y
2

t=0 (1 + IRR ) where:

The Continuous i= 1 i E(R i ) Distribution
Uniform + w 2 E(R 2 ) + + w N E(R N )
A. Loyalty, Prudence, and Care D 360 where:
s =
where: sample Cov(R
A continuous uniform standard ,Ri = 1 ) =
deviation E{[R
distribution − E(R )][R B − E(R
isAdescribed byB )]}
a lower limit, a, and an upper limit, b.
B. Fair Dealing DiscounTeD cash floW Solved
applicaTions as
rBD = ×
an iterative
F process
t
Yields for US Treasury bills
using calculator TVM functions.
Xi = one of n possible outcomes.
sAThese• limits
The= sample
continuous
Total standard
Covariance
Probability
A
uniform
serve as the
B
deviation
Ruledistribution
and for
A

correlation
parameters Expected is described
of the Value of by a lower
returns
distribution. The limit, a, and an
probability ofupper limit, b.
any outcome
where:
Sample
Correlation
These Kurtosis
limits Coefficient
serve uses as standard
the parameters deviations of to the
the fourth power.
distribution. TheSample
probabilityexcessofkurtosis is
any outcome
or
Variance range of
and outcomes
Standard outside
Deviation this interval is 0. Being a continuous distribution, individual
C. Suitability • BankYield
Bank Discount
where: discount yield QM calculated
Sample
1.
or E(X) of
range
outcomes
as:
Kurtosis
=also
E(X
outcomes |  uses
S)P(S) Market
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outside E(X
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c
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) Theisdistribution
investment
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distribution, is
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E(X ihave
| = ) ×aP(S
S
probability
) + E(X
of
| S
0.
) × P(S ) + . . . + E(X
is often denoted
| S ) × P(S )
as U(a,b).
D. Performance Presentation r =
Effective
BD the annualized
Annual Yield yield on a bank discount basis outcomesCorr(R 2also have
σ (X) =A E{[X ,R
1 a) probability
Market
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A }B
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B ) is often denoted as U(a,b).
n n
D = the dollar discount D 360(face value – purchase price)
E. Preservation of Confidentiality rBD = × 365/ t
The probability
where: 
that the random variable ∑n (X(σi −Awill X)σ4Btake
)(
will

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IV. Duties to Employers ascending or descending order. The advantage of using the median is that, unlike the both
x mean,
E(X S1• to
|  lie
x .within
σ 2 (n −range,
 =the
∑ 1)(nn(n−+2)(n 1)to−b,3)isi =the
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Period Yield period
to extreme yield However,
values. the median does not use all the information x1 to) =x2the
P(S . probability  (nion =−11)(n
N of
− 2)(n − 3)
N Scenario 1 occurring 
s 4
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their relative Thepositions.
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B. Additional Compensation Arrangements tD==numbers
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days remaining (face value till maturity
– purchase price) 2 – x1
P1 − P0 + D1 P1 + D1 The TotalPProbability (x1 ≤ XN ≤i =1xRule j2=)1 = for Expected Value
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The mode of a data set of the bill = − 1
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C. Responsibilities of Supervisors P Covariance E(R
t = number
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+METHODS
0
one modeHPY = (1to EAY)
be unimodal, − 1 while one that has two modes is said to be bimodal. 1.
Variance E(X)
It of = E(Xa 2 Asset | S)P(S)
i =1 Portfolio | Sc)P(Sc)
V. Investment Analysis, Recommendations, andMETHODS
QUANTITATIVE Actionswhere: is also •
Holding possible
Money
Period formarket
Yield a data setyield to have no mode, where all values are different and2.Remember E(X)Cov(XY)
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2 Money
© Wiley Market
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Variance of
32 x)a 2-asset
A. Diligence and Reasonable Basis P 0 = initial
occurs more price of the investment.
frequently than others. For grouped data, the modal interval is the where: interval
Remember that P(X is 2 portfolio
The median is the value of the middle item of a data set once it has been sorted into continuous
where:an Cov(R distribution
pA) ,R =w B )A= σ E{[R(Rthe
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instrument
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continuous Market where
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B. Communication with Clients and Prospective D ascending HPYoror =dividend
descending 360 × receivedBD = The
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advantage of using the median is that, unlike the E(X)
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Covariance experiment is an experiment that has only 2 possible
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VII. Responsibilities as a CFA Institute Member or CFA Measures of Dispersion 1 Correlation P(XCoefficient
= x) = nC2x (p) x
(1 – p)QMn–x
subtract 1 from
where:  ratethe
n result.  n
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HPY =Statistical yield t  Concepts
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B A B A B
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A. Conduct as Participants in CFA Institute Programsdata set to account
Dispersion
t = numbers of
t
days
= 1 for the disproportionate
is the variability
remaining
=  n (1 + Rmean
or spread of a random
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mean. The assigns weights • The expected ( σ )( σ )
value of a binomial random variable (X) is given by:
variable
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2 2 2 2 A B
B. Reference to CFA Institute, the CFA Designation, The
which • makes
range Data
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as the Normal Distribution
2
© Wiley
The 2018 all Rights360 − (t ×any
Reserved. rBDunauthorized
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ofofdeviations n
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increases.
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Bayes’ Formula r ( n − r )!( r!)
  • 50% of all observations lie in the interval µ ± (2/3)σ
is voluntary. R MM = HPY × (360/t)
Remember: The combination formula is used when the× order
• Comply with all requirements of GIPS on a firm-wide The harmonic mean
Important
n is used in the investment management arena to determine the average
Relationships Between • 68% of all observations lie in the
P (Information interval
Event) µin±which
P (Event) 1σ the items are
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shares
where theMADweight purchased over time proportional to • 90% of all observations lie in the interval µ ± 1.65σ
• The = iof
=1 an observation
geometric
is inversely its magnitude.
38 arithmetic mean.Permutations
• Third-party verification of GIPS compliance is optional. nmean −is1]always
× 2 less than, or equal to the © 2018 Wiley
0.5
© Wiley •
BEY = [(1 + EAY) 10 z‐Score
Counting 95%
Rules ofReserved.
all observations lie inor distribution
the interval µ ±an1.96σ
• The geometric mean equals the arithmetic mean only38when all the observations 2018
are all Rights any unauthorized copying will constitute infringement of copyright.
© 2018 Wiley
• Present a minimum of five years of GIPS-compliant N n! common pRobabiliTy Dis
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squared deviations around the mean. The standard ( n − r )! value population mean)/standard
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c03.indd
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38
the variance
increases as the
has no units, the • A z-score is used to standardize a given observation of a 7 March 201

or since inception of the firm or composite if less than dispersion in observed i =1 i increases.
standard deviation has the same units as the random variable.
38 Combinations
Roy’s
z‐Score normally
Safety‐First distributed
Criterion random variable
7 March 2018

five years, then add one year of compliant performance © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
• Variance:
The harmonic
Mathematically, mean
unlessisaverage
used
all the ofinvestment
the squared
in observations
the deviations
in management
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wherethe thearithmetic
weight ofmean.an observation is inversely proportional to its magnitude. where:
• Nine major sections: Fundamentals of Compliance; Input n • Roy’s
Roy’s Safety‐First
RP = portfolioThe
safety-first
return
Criterion criterion: used to compare shortfall risk
Remember: combination formula
SF is usedindicates
when the order in which the items are
data; Calculation Methodology; Composite Construction; ∑ (X i − µ)2 N RT = target
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is NOT important.
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Harmonic mean: X H = N risk)P T
Disclosures; Presentation and Reporting; Real Estate; σ 2 = i =1 1
Private Equity; and Wrap Fee/Separately Managed
n ∑x Shortfall Ratio
Permutations
where:
4 Sample Variance
© Wiley 2018 and Standard
all Rights Reserved. i =1Deviation
any unauthorizedi copying or distribution will constitute an infringement of copyright.
RP = portfolio return
Account (SMA) Portfolios. R = target return n! E (RP ) − RT
Mathematically,
T
n unless all the observations in the data set are identical (equal in value), n Pr =
Shortfall ratio (SF Ratio) 21 =
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s = n © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
7 March 2018 7:04 PM E ( R P ) − R T
c02.indd 21
n −1
Shortfall ratio (SF Ratio) =
EAR = e r − 1 rcc = continuously
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cc
compounded annual rate

n Continuously Compounded Returns

∑ (X i − X)2 HPR t = e r × t − l cc
Wiley © 2019
i =1
s= EAR = e r − 1 cc
r = continuously compounded annual rate
© 2018 Wiley n −1 21cc
QM
 Wiley’s CFA Program Exam Review
®

Sampling Theory Technical Analysis Market Structures

esTimaTion
• Central limit theorem: Given a population with any • Reversal patterns: head and shoulders, inverse head • Perfect competition
probability distribution, with mean, μ, and variance, and shoulders, double top and bottom, triple top and • Minimal barriers to entry, sellers have no pricing power.
σ2, the sampling Sampling and Estimation
distribution of the sample mean x, bottom.
esTimaTion • Demand curve faced by an individual firm is perfectly
computed
Sampling Error
from sample size n will approximately be • Continuation patterns: triangles (ascending/descending/ elastic (horizontal).
normal with mean, μ (the population mean), and symmetrical), rectangles, flags and pennants. • Average revenue (AR) = Price (P) = MR.
variance,
Sampling σ2of/n,
error when
mean =the
Sampling
the sample
and
Sample −size
Estimation
mean is greater
Population mean =than
x − µ or
• Price-based indicators: moving averages, Bollinger • In the long run, all firms in perfect competition will
equal to 30.
Sampling Error
Standard Error of Sample Mean when Population Variance is known bands, momentum oscillators (rate of change, relative make normal profits.
• The standard deviation of the distribution of sample strength index, stochastic, moving average convergence/
means is known as the standard
= Sample mean −error of sample
mean = xmean.
−µ
• Monopoly
Sampling
σx = σ
error of the mean Population divergence).
n • High barriers to entry, single seller has considerable
• When the population variance is known, the standard • Sentiment indicators: opinion polls, put-call ratio, VIX, pricing power.
Standard Error of Sample Mean when Population Variance is known
where: error of sample mean is calculated as margin debt levels, short interest ratio.
σ x = the standard error of the sample mean
• Product is differentiated through non-price strategies.
σx = σ
σ = the population nstandard deviation
• Flow of funds indicators: Arms index, margin debt, • Demand curve faced by the monopoly is the industry
n = the sample size mutual fund cash positions, new equity issuance, demand curve (downward sloping).
where: • When the population variance is not known, the standard Topics in DemanD anD supply analysis secondary offerings.
error oferror
σ x = the standard
Standard Error of sample
Sample meanmean
Mean when
of the sample is calculated as
Population Variance is not known • An unregulated monopoly can earn economic profits
σ = the population standard deviation
• Cycles: Kondratieff (54-year economic cycle), 18-year in the long run.
(real estate,Topics in Demand
equities), and Supply
decennial (bestAnalysis
DJIA performance
n = the sample size
sx =
s • Monopolistic competition
n The demand function captures the effect of all these factors on(third
in years that end with a 5), presidential demandyear
for a has
good.
Standard Error of Sample Mean when Population Variance is not known the best stock market performance). • Low barriers to entry, sellers have some degree of
where: • Confidence interval for unknown population parameter sampling anD esTimaTion pricing power.
Demand function: QDx = f(Px, I, Py , …) … (Equation 1)
s x = standard s of sample mean
s x = erroron • Product is differentiated through advertising and other
s = samplebased z-statistic
n deviation.
standard
σ
ECONOMICS
Equation 1 is read as “the quantity demanded of Good X (QDX) depends on the priceTopics
non-price strategies.
of in DemanD anD supply analysis
• Demand curve faced by each firm is downward sloping.
aggRegaTe ouTpuT, pRice, anD econo
Confidence
where: x ±Intervals z α /2 Good X (PX), consumers’ incomes (I) and the price of Good Y (PY), etc.”
s x = standard error of n sample mean
Demand Elasticities • Aggregate
In the long run Output,all firms Price, willAnd make normal profits.
Economic Growth
s = samplePoint standardestimate ± (reliability factor × standard error)
deviation. Income Elasticity of Demand
where: • hypoThesis
Confidence interval for unknown population parameter The own‐price elasticity of demand is calculated as: • Oligopoly
•
TesTing
Own-price elasticity of demand is calculated as: Nominal GDP refers to the value of goods and services included in GDP measured at
Confidence
x = The sample
where: based Intervals
meanon (point
t-statistic estimate of population mean) Income elasticity of demand measures the responsiveness of demand for a particular good • High costs of entry, sellers enjoy substantial pricing
current prices.
α/2 = estimate
zPoint The standard normal
of therandomsamplevariablestatisticfor which theTesting
toprobability of population
an observation to a change in income,
= value that is used
Hypothesis estimate the %∆QDholding
x
all other things constant. power.
parameterlying in
Point either
estimate tail ± is σ / 2 (reliability
(reliability factor ×
factor).
standard error) ED = … (Equation 6) Topics in DemanD anD supply analysis
• Product
Nominal GDP
is= Quantity produced in Year t × Prices in Year t
Px
σ Test Statistic %∆Px Same as coefficient differentiated on quality, features,
Reliability factor = a number
= The standard error of the sample mean. based on the assumed distribution of the point estimate and on I in market
then level of confidence for the interval (1Sample
where: Test statistic =
− α).statistic − Hypothesized value ∆QDx marketing
demand function
(Equation 11)
and other non-price strategies.
Standard
Point estimateerror = value the standard
of the sample error ofstatistic Standard
the sample error of
that statistic sample
is used to statistic
(point
estimate estimate)the population Income Elasticity of Demand •
QUANTITATIVE METHODS
If the % ∆absolute
QD value
QD of
= 
price
∆ QD x elasticity
 I  of demand Real GDP • refers
Pricing to the strategies:
value of goods pricing interdependence
and services included in GDP measured (kinkedat
• Whensto use
x x
z-statistic or t-statistic ED I = =   … (Equation 8)
 divided
equals %∆1, I demand ∆I is X as the
I in said ∆toI change
be unit
 QD x Xelastic. by the value of X,
parameter If we express the percentage change in
x ± tα
Reliability factor
Power of a Test
=n a number based on the assumed distribution of the point estimate and
Equationelasticity
Income 6 can beofexpanded demand to the following
measures form:
the responsiveness of demand for a particular good
base‐year prices. demand curve), Cournot assumption, game theory
the level of When
2
confidence
Sampling for fromthe interval
a:Power (1= −
of a test 1 −α).
P(Type II error)
Small Sample
n < 30
Large Sample
n > 30 to a change • Ifin theincome, absolute
holding all value
otherof price
things elasticity of demand
constant. (Nash equilibrium), Stackelberg model (dominant
Real GDP = Quantity produced in Year t × Base-year prices
Standard error = the standard error of the sample statistic (point estimate) lies between
% change 0 anddemanded
in quantity 1, demand is said to be relatively firm).
where: Normal distribution Decision Rules for Hypothesis Tests Slope of demand
E = Same as coefficient
x = sample mean (the point
with known variance
estimate of the population mean)
z‐statistic
function. z‐statistic I
inelastic. % change∆in QDincome • Firms always maximize profits at the output level where
on I in market
Decision H0 is True H0 is False x demand function
tα Normal distribution with unknown variance t‐statistic
Coefficient on t‐statistic*
• If the ∆QDx ∆QDvalue
%absolute x QD xof price   Px  of demand is
∆QDxelasticity GDP Deflator MR = MC11)
(Equation
= the t‐reliability factor Do not reject H 0 Correct decision Incorrect decision
own‐price in EDPx =%∆QDx = QD = ∆QDx    I   … (Equation 7)
2
%∆Px = ∆ P x
=   is∆said
P   QDx  … (Equation 8)
I =
EDgreater
Type II error
%∆Ithan 1,∆demand  ∆I x   QD to xbe  relatively elastic. • Identification
market demand x
s Non-normal distribution with known variance
= standard error of the Rejectsample
H0 mean Incorrect decision
not available
Correct decision function
z‐statistic I Px
I Valueof market
of current structure
year output at current year prices
Cross‐Price Elasticity of Demand GDP deflator = × 100
n Non-normal distribution with unknown
s = sample standard deviation
Type I error
variance
Significance level = = 1
Power of the test
− not available
P(Type II error) t‐statistic* • Income elasticity of demand is calculated as: • N-firm concentration Value of current ratio.
year output at base year prices
P(Type I error) Cross
Arc elasticity
elasticity is of demand as:
calculated measures the responsiveness of demand for a particular good to
* Use of z‐statistic is also acceptable
a change EinI price % change in quantity
ofQManother demanded
good, holding all other things constant.
• HHI (add up the squares of the market shares of each
aggRegaTe ouTpuT, pRice, anD econo
Confidence Interval =
% change in income (Q - Q )
of the largest Nominal N companies
GDP in the market).
Sample Biases  sample   critical   standard    population   sample   critical   standard   0 1 GDP Samedeflator
as =
coefficient × 100
×
Hypothesis Testing    −      ≤   ≤   
 statistic  value   error    parameter   statistic  value   error  
+     
% change in quantity demanded % ∆ Q d (Q 0 + Q1 )/2
100 on P Y in market Real GDP
Data‐Mining Bias x − (z α /2 ) (s n) ≤ µ0 ≤ x + (z α /2 ) (s n) EP =
• Positive %for a∆normal
change QDin xprice good.
=
 ∆QD%
=
 ∆ PPy  (P0 - P1 ) × 100
Aggregate Supply and Demand
demand function
(Equation 11)
Household saving = Personal disposable income
Cross‐Price %∆QD
Elasticity x DemandQD x
of x 
oThesis TesTing • Data
One-tailed
mining is the versusof two-tailed
practice
Summary extensively searching tests through a data set for statistically EDPy =
• Negative %∆Py for=
an ∆ inferior
P
=
good. 
 ∆Py   QDx 
 (P…0 + (Equation
P1 )/2 9) The Components of GDP − Consumption expenditures
significant relationships till aAlternate
pattern “that works” is discovered. In the process of data
y
• gRoWTh
Components of− GDP Interest paid by consumers to businesses
measuresPythe
aggRegaTe ouTpuT, pRice, anD economic
mining,
Type oflargetest numbers
Null
hypothesis of hypotheses
hypothesis about Rejecta single
Fail to reject
null if data set null areif tested inP‐valuea veryrepresents • Cross-price
short time Cross elasticity of demand elasticity of responsiveness
demand is calculated of demand for as: a particular good Basedto on the expenditure approach,
• Expenditure −approach Personal GDP transfer
may be payments
calculatedto foreigners
as: … (Equation 5)
© Wiley 2018
byOnealltailed
Rights Reserved.
searching : μ ≤anyμ0 unauthorized
forH0combinations Ha : of μ0 copying
μ >variables Test thator distribution
might
statistic > showTest will constitute
a correlation.
statistic an infringement
≤ Probability a change in price of another good, holding all other things constant.
that lies of copyright.
(upper tail) Hypothesis
critical value Testing
critical value above the computed test % change in quantity demanded GDP Same as coefficient
= C + I + G + (X − M)
test
Warning signs that data mining bias might exist are: statistic. EC = Income Approach on PY in market
% change in price of substitute or complement Business sector saving = Undistributed corporate profits
demand function
Test StatisticH0 : μ ≥ μ0 Ha : μ < μ0 Test statistic < Test statistic ≥ Probability that lies
One tailed ∆QDx (Equation 11)
• tail)
Too much digging warning sign.critical value   Under the income approach, GDP+ Capital
at andconsumption
market prices mayallowance
be calculated … as:(Equation 6)
© Wiley 2018
(lower
testall
• Rights Reserved.
No story, any unauthorized
no future warning sign.
critical value
copying or distribution will constitutestatistic.
below the computed test
an infringement of copyright. ED = % ∆ QD x
=
QD x
=
∆ QD x  P y  C = •
ConsumerIncome spending approach on final goods services
Sample statistic − Hypothesized value • Positive
Py
%∆Pfory
substitutes.
∆Py  
 ∆Py   QDx 
 … (Equation 9) I = Gross private domestic investment, which includes business investment in capital goods
Two‐tailed Test : μ = μ0 =Ha : μ ≠ μ0
H0statistic Test statistic < Lower critical Probability that lies P (e.g. plant and equipment) and changes in inventory (inventory investment)
economicS GDP = National income + Capital+ Totalconsumption allowance
The best way to avoid data‐mining
relationships” on “out‐of‐sample” data to
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Standard is to test of
error thesample
critical
check whether
“apparently test statistically
value ≤ statistic significant
above the positive
they ≤hold. value of the computed
• Negative for complements. y
GDP
G = Government+spending
= Household consumption
Statisticalondiscrepancy
final goods and services
private sector saving + Net taxes
value statistic … (Equation 1)
Power Selection
Sample of a TestBias
Test statistic >
upper critical
upper critical
value
test statistic plus the
probability that lies
• Normal good: substitution
% change in quantity demanded
and income effects reinforce X = Exports
• The point of intersection of the AD curve and the SRAS curve defines the
value below the negative one
E C = another.
M = Imports
The equality ofeconomy’s expenditure short and income position. Short‐run fluctuations in equilibrium
run equilibrium
Sample selection bias results from the exclusion of certain assets fromtest
value of the computed
a study due to the
% change in price of substitute or complement National • Equality
income equals
real GDP ofmay Expenditure
the sumdue
occur shiftsand
oftoincomes in eitherIncome
received bythe
or both allADfactors of production
and SRAS curves. Shortused to
Power of a test = 1 − P(Type II error)
unavailability of data.
statistic. • Inferior good: income effect partially mitigates the generate final output. It includes:
run equilibrium may be established at, below or above potential output. Deviations
substitution effect. Expenditure S = IApproach
+ (short
of G − run T) +equilibrium
( X − M) from … potential
(Equation 7) result in business cycles.
output
• Some
Type
Decision I Rules
databasesversususefor Type
historical
Hypothesis II errors
information Testsand may suffer from a type of sample selection
• Giffen good: inferior good where the income effect Under
• Employee○ compensation
the expenditure
In an expansion, real GDP is increasing, the unemployment rate is falling
andapproach,
capacity utilization
GDP atismarket
rising. Further,
prices inflationbetends to rise during
as: an
bias known as survivorship bias. Databases that only list companies or funds currently in • • To
Corporate finance and a fiscal
government
expansion. deficit
enterprise (Gprofits
–T 0),may
>before the calculated
private
taxes, sector
which includes:
existence
16
Decision
suffer from this bias.
© Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
H0 is True H0 is False outweighs the substitution effect, making the demand The IS Curve
Topics in DemanD anD supply
(Relationship
Dividends
○ analysis
must save
○ In a more paidbetween
contraction,to households
than
Income and the Real Interest Rate)
itgoods
real GDP invests
is decreasing,(S >theI)unemployment
and/or imports rate is rising
This equa
a breakdo
GDP = Consumer spending on and services
Look‐Ahead
Do not reject BiasH0 Correct decision Incorrect decision curve upward sloping. ○ Corporate
must +exceed
profits
and capacity
exports
retainedis by
utilization
(M
businesses
falling.
>government
Further, inflation tends to fall during a
X).saving − Net taxes
expression
Disposable
○ Corporate income
Business = GDP
gross
taxes
contraction. fixed
paid −toBusiness
investment
the
we stated

An analyst may not have complete information at the time of testing. Look‐ahead bias
Type II error • Veblen
Total, Average,
good: status
Marginal, Fixed,
good
and
with
Variable
upward
Costs
sloping demand • • Interest
Factors
+ Change
income causing
in inventories
a shift in aggregate demand (AD)
previous L
GDP = C
Reject 22 © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. Shift in Aggregate + (X − M).
arises if theHanalyst
0 uses anIncorrect
assumed figure decisioninstead. The actual Correct decision
figure may be different curve. Government Demand spending on goods
• Rent and unincorporated business net income (proprietor’s income): Amountsand services
from the one used in the study.Type I error Power of the test Table: Summary of Cost Terms S − I = (G − T ) + ( X −
+ Government gross fixed investment
M ) … (Equation 7)
earned
An Increase
by unincorporated
in the − Imports
proprietors and farm operators, who run their own
Significance level = = 1 − P(Type II error) + Exports
Time‐Period Bias P(Type I error) Profit Maximization, Breakeven and
Costs
hypoThesis TesTing
Calculation businesses.
The LMFollowing
Curve +Factors Shifts the AD Curve
Statistical discrepancy Reason
• Indirect business taxes less subsidies: This amount reflects taxes and subsidies that
Time‐period bias arises if the sample data is drawn from a certain time period. The results Shutdown Analysis Total fixed cost (TFC) Sum of all fixed expenses; here defined to include all
are
Stock included
prices in the final price
Rightward: of a good
Increase inorAD service,
Higherand therefore represents the
consumption
• obtained
Hypothesis
Confidence from theInterval testof concerning
study such a data set willthe mean of a single
be time‐specific. hypoThesis TesTing opportunity costs Quantity theory of money: MV = PY
portion of national income that is directly paid to the government.
t‐Statistic
© Wiley 2018population
all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. • Total variable cost15 (TVC) Sum of all variable expenses, or per unit variable cost Housing prices Rightward: Increase in AD Higher consumption
 sample   critical   standard    population   sample   critical   standardProfits  are maximized when the difference between totalThe quantity theory equation can also be written as:
times quantity; (per unit VC × Q)
 Wiley  −  value   error   ≤  parameter  ≤  statistic +  value   error revenue
©2018   45 (TR) and total cost (TC) is at its highest. The levelthat occurs
The capitalConsumer consumption
confidence allowance Rightward:(CCA) Increaseaccounts
in AD Higher for the wear and tear or depreciation
consumption
Chi Squared  statistic x − µ0
Test‐Statistic    in capital
t-stat = Total costs (TC) Total fixed cost plus total variable cost; (TFC EC + TVC) M/P and MDstock /P = kY during the production process. It represents the amount that
x s −n (z α /2 ) (s n) ≤ µ0 ≤ x + (z α /2 ) © Wiley (s 2018n)ofallhypoThesis
output
Rights Reserved.at which
TesTing this copying
any unauthorized occurs is the will
or distribution point where:
constitute an infringement of copyright.
must Business
© Wileybe2018 confidence
all Rights
reinvested Reserved.
by the 23company
any Rightward:
unauthorized
in theIncrease
copying orindistribution
business ADto maintain
Higher
willinvestment
constitute
currentan infringement
productivity of copyright.
levels.
Average fixed cost (AFC) Total fixed cost divided by quantity; (TFC / Q)
c03.indd 45
χ2 =
( n − 1) s2 • Marginal
7 March 2018 7:05 PM
revenue (MR) equals marginal cost (MC); and where: You should Capacitythink of profits + Rightward:
utilization CCA as the amount
Increase in AD earned by capital.
Higher investment
where: • Summary
Hypothesis σ0 2
test concerning the variance of a normally Average variable cost (AVC)
xChi= sample
Squared mean Test‐Statistic • MC is not falling Total variable cost divided by quantity; (TVC / Q) k = I/V Government spending Rightward: Increase in AD Government spending a component
Personal income = National income
distributed
Null population
Alternate Fail to reject Average total cost (ATC) Total cost divided by quantity; (TC / Q) or (AFC + AVC)
M = Nominal money supply of AD
Type of test
μ0 = hypothesized
where: hypothesis
population mean • Breakeven occurs when TR = TC, and price (or average MD = Nominal money demand − Indirect business taxes
s = standard deviationhypothesis
2of the sample Reject null if null if P‐value represents
n = sample2size( n − 1) s revenue)
Marginal cost (MC)equals averageChangetotalin total cost (ATC)
cost divided at
by changethe in breakeven
quantity; MD/P isTaxes referred to as real money − Leftward:
Corporate
demandDecreaseandinM/P
income AD is Lower
taxes consumption
real money supply. and investment
One tailed n2= sample H0 :χμsize
s = sample ≤= μ0 2 Ha : μ > μ0
variance
Test statistic > Test statistic ≤ Probability that lies (ΔTC / ΔQ) − Undistributed corporate profits
upper tail)σ 2
σ0
critical value critical value above the computed test
© Wiley 2018 quantity of production.
all Rights Reserved. Theorfirm
any unauthorized copying is earning
distribution will constitutenormal profit.
an infringement of copyright.
Equilibrium
Bank reserves
in the money
Rightward: Increase in AD Lower interest rate, higher
23 market
+ Transfer payments
requires that money supply and money demand
= hypothesized
z‐Statistic
0 value for population variance investment… (Equation
and possibly higher be equal.
2)
est
where: • Hypothesis test related to the equality of the variance of
statistic. • Breakeven,
Short-run and long-run
Shutdown, and Exit Points operating decisions consumption
Money market equilibrium: M/P = RMD
One tailed n = sample H0 : μsize≥ μ0 Ha : μ < μ0 Test statistic < Test statistic ≥ Probability that lies Revenue/ Cost Relationship Exchange rate (foreign Leftward: Decrease in AD Lower exports and higher imports
Test‐Statistic
lower tail)s2 z-stat
= sample
two
x − µfor 0populations
the F‐Test
critical valuez-stat critical
x − µ0
below the computed test
Short-run Decision Long-run Decision
Personal perdisposable income = Personal income − Personal taxes … (Equation 3)
= variance = value currency
Solow (neoclassical) unitgrowth model
est σ n value for population variance
σ 20 = hypothesized s n statistic. TR = TC Continue operating Continue operating domestic currency)
2
s
F= 1
Two‐tailed where: Test statisticwhere: Y = growth
TR > TVC, but < TC Continue operating Exit market Global
PersonalAF(L,K) disposable Rightward: Increase in AD
income = Household Higher exports
consumption + Household saving
H0 : μ = sμ20 Ha : μ ≠ μ0 < Lower critical Probability that lies
x = sample mean 2
lower critical x = sample valuemean ≤ test above the positive TR < TVC
Test‐Statistic for the F‐Test Shut down production Exit market
μ = hypothesized population mean value μ = hypothesized
statistic ≤ population mean
value of the computed where: • Factors causing a shift in aggregate supply (AS) … (Equation 4)
where:
σ = standard deviation of the populationstatistics =
s12 sample drawn fromTest > standard
upperdeviation
critical of test the sample
statistic plus the Y = Aggregate output
s1n2 = Variance
sampleF= 2 of
size Population n1 = sample size
s2 sample drawn fromvalue
upper critical value probability that lies L = Quantity of labor Wiley © 2019
s22 = Variance of Population 2 below the negative K = Quantity of capital
Tests for Means when Population Variances are Assumed Equal value of the computed A = Technological knowledge or total factor productivity (TFP)
Hypothesis
where: tests concerning the variance test statistic.
 MV = PY

Wiley’s CFA Program Exam Review

®
The Fischer effect states that the nominal interest rate (RN) reflects the real interest rate
(RR) and the expected rate of inflation (IIe).

R N = R R + Πe

The Fiscal Multiplier

economicS

Ignoring taxes, the multiplier can also be calculated as:

Shift in Aggregate Supply

An Increase in Shifts SRAS Shifts LRAS Reason

expansion. Expansionary fiscal policy (increase spending
1
=
○ and/or reduce
1
(1 − MPC) (1 −taxes)
= 10
0.9) is used to raise employment and
FINANCIAL REPORTING
AND ANALYSIS
Supply of labor Rightward Rightward Increases resource base
output in a recession
Supply of natural resources Rightward Rightward Increases resource base

Supply of human capital Rightward Rightward Increases resource base

• Fiscal
Assuming multiplier
taxes, the multiplier can also be calculated as:

Supply of physical capital Rightward Rightward Increases resource base 1

Financial Reporting Basics
Productivity and technology Rightward Rightward Improves efficiency of inputs [1 − MPC(1 − t)]
Nominal wages Leftward No impact Increases labor cost
• Types of audit opinions: unqualified, qualified, adverse,
• Limitations of fiscal policy: recognition, action and disclaimer.
Input prices (e.g., energy) Leftward No impact Increases cost of production

Expectation of future prices Rightward No impact Anticipation of higher costs and/or impact lags economicS • Accruals: unearned or deferred revenue (liability),
perception of improved pricing
• Relationships between monetary and fiscal policy unbilled or accrued revenue (asset), prepaid expenses
power
(asset), accrued expenses (liability).
• taxes
Business Reduce exposureLeftward to equities inNoanticipation
impact of a decline
Increases in output and profit • Easy
cost of production economicS fiscal policy/tight monetary policy – results in

Subsidy
margins coming Rightward under pressure. No impact Lowers cost of production
EC
higher output and higher interest rates (government • Qualitative characteristics of financial information:
• Increase investments in commodities and/or commodity‐oriented companies
• Reduce exposure to equities expenditure would form a larger component of relevance, faithful representation, comparability,
Exchange rate Rightwardin anticipation
No impact of a decline in output
Lowers and profit
cost of production
because
margins theirunder
coming prices and profits are likely to rise (due to higher prices).
pressure.
national income). verifiability, timeliness, understandability (first two are
• Increase investments in commodities and/or commodity‐oriented companies
• Conclusions
Impact of changes in AD and AS fundamental qualitative characteristics).
because
Business Cycles on AD
their and
prices AS
and profits are likely to rise (due to higher prices). • Tight fiscal policy/easy monetary policy – private
sector’s share of overall GDP would rise (as a result • General features of financial statements: fair
Conclusions on AD and
Fluctuations in aggregate demand ASand aggregate supplyUnemployment
in the short run explain whyAggregate
short Level © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. presentation, going concern, accrual basis, materiality
run real GDP deviates from potential GDP. These deviations of actual GDP from 32
employment GDP form phases of Real GDP
full‐
Rate Aggregate Level of Prices of low interest rates), while the public sector’s share
the business cycle.
Unemployment
would fall. and aggregation, no offsetting, frequency of reporting,
Investment Applications of Real GDPin AD Resulting
an Increase Rate in an Inflationary of Prices
Gap comparative information, consistency.
An increase in AD Increases Falls Increases
An
A increase
decrease
If economic datainsuggest
inAD
ADthat Increases Falls
the economy FallsanIncreases
is undergoing Increases
expansion caused by an Falls
• Easy fiscal policy/easy monetary policy – this would
increase
A in AD,in
decrease
An increase in AS
going
AD forward: Falls
Increases Increases Falls Falls Falls lead to a sharp increase in aggregate demand, lowering Income Statements
An• increase
A decrease
Corporate inprofits
AS Increases to rise. Falls
in ASwill be expected Falls Increases
Falls
Increases interest rates and growing private and public sectors.
A decrease
• Commodity in ASprices will beFalls Increases
expected to increase. Increases
• Interest rates will be expected to rise. • Tight fiscal policy/tight monetary policy – this would • Revenue recognition methods: percentage of
• Effect
Effect
Effect of
ofofCombinedcombined
Combined Changes
Changes changes
• Inflationary pressures will build in the economy.
in ASin andASADand in AD ADand AS lead to a sharp decrease in aggregate demand, higher completion, completed contract, installment method,
Effect on Real on Real Effect on Aggregate
interest rates and a decrease in demand from both cost recovery method.
Effect Effect on Aggregate
Change inin
Change ASAS ChangeChangein ADin AD GDP GDP Price Level Price Level private and public sectors. • Discontinued operations: reported net of tax as a
Increase Increase Increase Uncertain separate line item after income from continuing
© 2018Increase
Wiley
Decrease Increase
Decrease DecreaseIncrease Uncertain Uncertain
95 International Trade operations.
Decrease
Increase Decrease
Decrease UncertainDecrease Decrease Uncertain
c04.indd 95 Increase
Decrease Decrease
Increase Uncertain Uncertain Increase
7 March 2018 7:05 PM
EC
Decrease• Comparative advantage: EC a country’s ability to produce
• Unusual or infrequent items: listed as separate line
Decrease Increase Uncertain Increase
a good at a lower opportunity cost than its trading items, included in income from continuing operations,
Economic Growth reported before-tax.
Business Cycles partners
Economic
Economic growth Growthmay be calculated as:
• Ricardian model: labor is the only variable factor of • Accounting changes
• Economic
Phases:
• The annual trough,
growth mayexpansion,
percentage change in real
be calculated peak,
as:GDP, whichcontraction (or the
tells us how rapidly production and differences in technology are the key • Change in accounting principle (applied
Financial RepoRting and analysis

recession)economy is expanding as a whole; or

source of comparative advantage. retrospectively).
• The annual change in real per capita GDP. Real GDP per capita is calculated as
• The annual percentage change in real GDP, which tells us how rapidly the
• Theories total real GDP divided by total population. It is a useful indicator of the standard • Heckscher-Ohlin model: capital and labor are variable •
If a company declares a stock split or a stock dividend during the year, the calculation of
Change in an accounting estimate (applied
ofeconomy
living in a is expanding as a whole; or the weighted average number of issued shares outstanding is based on the assumption that
country.
• • Neoclassical
The annual change (Say’sinLaw). real per capita GDP. Real GDP per capita is calculated asfactors of production and differences in factor prospectively).
the additional (newly issued) shares have been outstanding since the date that the original UndeRstanding incoMe
shares were outstanding from.
The Production
• Austrian total real GDP divided
Function
(misguided by total
and Potential GDP
government population. It is a useful indicator of the standard
intervention). endowments are the primary source of comparative • Correction of prior-period errors (restate all prior-
of living in a country. advantage. Understanding Income thatStatements
•
The production function asserts that an increase in an economy’s potential GDP can be
Keynesian (advocates government intervention during period
A complex financial
capital statements).
structure includes securities can be converted into common
stock (e.g., convertible bonds, convertible preferred stock, warrants and options). These
caused by:
TheaProduction
recession). Function and Potential GDP • Effect of tariffs, import quotas, export subsidies and • securities
Basic EPS Basic are EPS potentially dilutive so companies with complex capital structures are
voluntary export restraints required to report basic and diluted EPS. A dilutive security is one whose conversion into
• • Monetarist
The
An increase in the quantity of inputs used in the production process (e.g., capital
production (steady
and labor). function growth
asserts that an rateincreaseof money supply).
in an economy’s potential GDP can be shares of common stock would result in a reduction in EPS. EPS calculated after taking
Net income − Preferred dividends
• Price, domestic production and producer surplus into account
Basic EPSall = dilutive securities in the capital structure is known as diluted EPS.
• • New
caused by:increase
An
Classical in the productivity of these inputs with the application of better
(business cycles have real causes, no
technology. Improving technology enables an economy to produce more output increase.
Weighted average number of shares outstanding
government
• using
intervention).
the same quantity
An increase of inputs. of inputs used in the production process (e.g., capital
in the quantity
In determining which potentially dilutive securities should be included in the calculation
• Domestic consumption and consumer surplus inTeRnaTionalofTRaDe anD capiTal
diluted EPS, each FloWsof the securities must be evaluated individually and independently to
• Neo-Keynesian
and labor). (prices and wages are downward Diluted determine
EPS whether they are dilutive. Any anti-dilutive securities must be ignored from the
•
sticky, government intervention is useful in eliminating
An increase in the productivity of these inputs with the application of better decrease. • Diluted
diluted EPS
EPS calculation. (taking into account all dilutive securities)
International Trade And Capital Flows
technology. Improving technology enables an economy to produce more output
unemployment and restoring macroeconomic • Balance of payments components  Preferred 
Convertible  Convertible 
using the same quantity of inputs. − Preferred  ++ Convertible 
preferred  +Convertible × (1 − t ) 
© 2018equilibrium).
Wiley Balance of• Current
Payment97 account
Components (merchandise trade, services, income cuRRency exchange  NetNetincome
RaTes income − dividends preferred +   debt debt× (1 − t) 
Fiscal policy  
 dividends 
  dividends  interest
dividends  interest  
• Unemployment: natural rate vs frictional vs structural A country’sreceipts and unilateral transfers).
balance of payments is composed of three main accounts: IFRS requires the
use of a similar
Diluted
Diluted EPS = EPS =
Weighted Shares from Shares from Shares
Shares from Shares from
c04.indd 97 vs cyclical.Monetary And Fiscal Policy • •
The Capital
current
Forward Premium/(Discount) account
account
7 March 2018 7:05 PM balance (capital
largely transfers
reflects trade and
in sales/purchases
goods and services. method, but does
not refer to it Weighted average +
conversion of
convertible
conversion of
+ conversion of + issuable from Shares
convertible
conversion ofstock+options
• Theof capital account balance non-financial
non-produced, mainly consists of assets).
capital transfers and net sales of average shares+ + debt issuable from
• Prices indices: using a fixed basket of goods and preferred shares
as the Treasury
stock method. convertible convertible
Using thenon‐produced, non‐financial
previous relationship between
97
assets.
forward and spot rates, the forward premium/ The proceeds of shares stock options1
©Required
2018 Wiley
services to measure
reserve ratio = Required the reserves
cost of/ living results in an
Total deposits • The
(discount)• approximately
Financial
financial account account
equates to (financial
measures the net capital
price assets abroad
flows(foreign)
currency based and
oninterest
sales and
rateforeign-
option
purchases
versus
exercise
assumed to bebase
are
of
used
preferred shares
Both U.S. GAAP and IFRS require the presentation of EPS (basic EPS and their diluted
debt
upward bias in the computed inflation rate due to owned
currencydomestic
(domestic) financial
andinterest
foreignrate. assets
financial in the reporting country). toat the
assets. repurchase shares
average Balance
EPS) on the face of Sheets the income statement.
UndeRstanding the Balance sheets
substitution
Money multiplier = bias,
1/ quality
(Reserve bias
requirement) and new product bias. • Current account surplus or deficit.
market price and
Comprehensive
these shares are
Income
c04.indd 97 Current Account 7 March 2018 7:05 PM known as inferred Treasury Stock Method
• Economic indicators FP B (1 + rP ) shares. The excess
of new issued shares • Accounting for gainsUnderstanding and losses the onBalance
marketable Sheets securities
= over inferred shares InNet
the calculation
income +Gains of diluted
Other EPS, stock options
andcomprehensive incomeand warrants are accounted
= Comprehensive for by using
income
Quantity Theory of Money
• Leading (used to predict economy’s future state). CA S=PXB – M (1 =+YrB )– (C + I + G) is added to the
weighted average
Losses on Marketable Securities
the treasury stock method (required under U.S. GAAP). The treasury stock method
assumes that all the funds received by the company from the exercise of options and
• MCoincident FP B Held‐to‐Maturity
(used to identify current state of the (1 + rP ) number of shares

= PY / V −1 = −1 outstanding.
Ending warrants
Shareholders’are used by theSecurities
Equity Available‐for‐Sale
company to repurchase sharesSecurities
at the average Trading
market Securities
price. The
Currency (1 + rB )Exchange Rates
FRA
economy). SP B Balance Sheet
resulting net increase Reported
in theatnumber
cost or ofReported
shares at fair value.
equals the increase in Reported
sharesatfrom
fair value.
exercise
amortized cost.
of options and warrants minus the decrease in the number of outstanding shares from
(1 + rP ) (1 + rB ) rP − rB
Where: • Lagging (used to identify the economy’s past = − = Ending shareholders’ equity = Beginning
repurchases.
Unrealized gains or losses due equity + Net income +
shareholders’
M = Moneycondition).
supply • Exchange(1rates + rB ) are(1 + rBexpressed
) (1 + rB ) using the convention to changes in market values are
Other comprehensive income − Dividends declared
reported in other comprehensive
Common-size income statements
V = velocity of transactions A/B; i.e. number of units of currency A (price currency) percentage
Items recognizedof sales.Interest
They income.
present
incomeeach
facilitate financial
item
within
Dividendstatement
on the
owners’ income statement as a
equity.
income. analysis as Dividend
the dataincome.
can be used to
P = price level cuRRency exchange RaTes
Monetary and Fiscal Policy required to purchase one unit of currency B (base on the income
conduct time-series (across time periods) and cross-sectional (across companies) analysis.
Y = real output A higher base currency (domestic) interest rate results in a forward discount of statement Realized gains and Interest income. Interest income.
currency). USD/GBP
approximately the interest differential = 1.5125 means
percentage, leading that it will take
to base currency (domestic) losses.

toCurrency
purchase 1Exchange Rates Realized gains and losses. Realized gains and losses.
• Quantity
Quantity Equation oftheory Exchange of money 1.5125
appreciation of thatUSDpercentage. GBP.
Unrealized gains and losses
• Real exchange rate
Real exchange rate
This relationship must hold or arbitrage will take place to realign spot and forward prices
due to changes in market
values.
MV = PY
with the ratedifferential. However, the expected spot exchange rate may differ from the
forward exchange rate. rate DC/FC = SDC/FC × (PFC /PDC )
Real exchange • Common-size
Liquiditybalance
Ratios sheet: expresses each balance
• Contractionary
The Fischer monetary
effect states that the policy
nominal interest rate(reduce money
(RN) reflects the realsupply
interest rate sheet as aLiquidity
% ofratios
total assets
indicate toability
a company’s allow to meetanalysts to compare
current obligations.
(RR) and and increase
the expected interest
rate of inflation rates)
(IIe). is meant to rein in an The forward rate may be calculated as: 168
firms of different sizes Current assets © 2018 Wiley
overheating economy. Expansionary monetary policy where:• Forward exchange rate (arbitrage-free) Current ratio =
Current liabilities
= + Π e SDC/FC = Nominal spot exchange rate
(increase
R N R R money supply and reduce interest rates) is PFC = Foreign price level quoted in terms of the foreign currency c07.indd 168 Cash Flow
This version of the Quick ratio
=
Cash + Marketable securities + Receivables
7 March 2018 8:04 PM

meant to stimulate a receding economy PDC = Domestic price1level (1 + rDC )in terms of the domestic
quoted (1 +currency
rDC )
formula is perhaps
easiest to remember
(acid test) Current liabilities

The Fiscal Multiplier FDC/FC = × or FDC/FC = SDC/FC × because it contains Cash ratio =
Cash + Marketable securities
• Limitations of monetary policy: SFC/DC (1 + rFC ) (1 + rFC ) • CFO (direct method)
the DC term in Current liabilities
Relative Currency Movement numerator for all
Ignoring • Central
taxes, bank cannot
the multiplier can also becontrol amount
calculated as: of savings. • Step 1: Start with sales on the income statement.
three components:
FDC/FC ,S DC/FC
Solvency Ratios
and
Where• P Exchange rate regimes:
is the price currency dollarization,
(or quote currency) monetary
and B is the union,
base currency: (1 + r )
• Central bank cannot control willingness of banks to • Step 2: Go
DC
through
Solvency each
ratios indicate income
a company’s statement
financial leverage account
and financial risk.

extend
1 loans.1 fixedareparity,
Forward rates target
sometimes zone,ascrawling
interpreted pegs,
expected future fixed
spot rates.parity with and adjust it for changesTotal inL-Talldebtrelevant working capital
○ = = 10 crawling bands, E ( SP B )managed float, independently floating L-T debt-to-equity =
(1 − MPC)bank
• Central (1 −may
0.9) lack credibility. S∆ accounts on the balance Total sheet.
equity
FtE=(% 1 P B) =
t +S −1 1Option warrant
conversion uses treasury stock method; i.e., as if company used option value to repurchase
rates. SP B Total debt
• Contractionary
Assuming taxes, the multiplierfiscal policy
can also (reduce
be calculated as: spending and/
• Step 3: Check whether changes
Debt-to-equity
shares at average market price during the =
period. Convertible Total equity in these working
preferred and debt shares are ‘if-converted’ at
beginning of period.
or increase taxes) is used to control inflation in an (St +1 ) (r − r ) capital accounts indicate
Total debt = a debt
Total source or use of cash.
Premium when − 1 = ∆%S(DC/FC)t +1 = DC ofFCprice currency. Total assets
1 S E(S) > S; expect depreciation
(1 + rFC ) Total assets
= or distribution will constitute an infringement of copyright.
Discount when E(S) < S; expect appreciation of price currency. © Wiley 2018 all Rights Reserved. any unauthorized copying
Financial leverage
Total equity
[1 − MPC(1 − t)]
Wiley © 2019
Currency
ExchangeCross
RatesRates
and the Trade Balance
40 © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
Marshall-Lerner condition: ω x ε x + ω M (ε M − 1) > 0
P P P B P
 UndeRstanding cash FloW stateMents
UndeRstanding
UndeRstanding cash FloW stateMents
UndeRstanding cash
cash FloW
FloW stateMents
stateMents
UndeRstanding cash FloW stateMents

Wiley’s CFA Program Exam Review

®
UndeRstanding cash FloW stateMents
EBIT + Lease payments UndeRstanding cash FloW stateMents
Fixed charge coverage ratio = EBIT
EBIT +
+ Lease payments long-lived assets
Fixed charge coverage ratio = Interest EBIT + Lease
payments Lease payments
+ Lease
payments payments
Fixed
Fixed charge
charge coverage
coverage ratio ratio = = Interest EBIT + Lease
payments +
+ payments
Lease payments
Fixed charge coverage ratio = Interest payments Interest payments + Lease
Lease payments
payments UndeRstanding cash FloW stateMents
EBIT + Lease payments
Fixed charge coverage ratio = Interest payments + Lease payments Long-Lived Assets
Profitability Ratios Interest EBIT + Lease
payments + payments
Lease payments
Fixed charge
Profitability
Profitability coverage ratio =
Ratios
Profitability Ratios
Ratios Interest payments + Lease payments Financial Statement Effects of Capitalizing versus Expensing
Profitability Ratios Gross EBIT profit+ Lease payments
Fixed charge
Profitability
Grosscoverage
Ratios
profit margin ratio = Gross Gross profit
profit
Gross profit margin = Gross
Revenue
Interest profit
payments + Lease payments
Profitability
Gross
GrossRatios
profit margin =
profit margin = Gross
Revenue
Revenue profit Effect on Financial Statements
Gross profit margin = Revenue Initially when the cost is • Noncurrent assets increase.
Gross profit
Gross profit margin = Revenue capitalized • Cash flow from investing activities decreases.
• Step 4: Ignore all non-operating items and non-cash Profitability • Gross
Profitability
Ratios
profit margin ratios Gross profit
= Revenue • COGS under FIFO = COGS under LIFO – Change in LIFO
charges. Revenue
Gross Operating
profit profit profit reserve
In future periods when the asset is • Noncurrent assets decrease.
Operating
Gross profit profit
margin margin = = = Operating
Operating profit
• CFO (indirect method) Operating
Operating profit
Operating profit margin
profit marginRevenue
margin = Operating
=
Revenue
Operating
Revenue
profit
profit • Net income
depreciated or amortized under FIFO =• Net Netincome
income decreases.
under LIFO +
• Retained earnings decrease.
Operating profit margin = Revenue
Revenue
• Step 1: Start with net income. Operating
Revenue profit Change in LIFO reserve ו (1Equity – taxdecreases.
rate)
Operating profit margin =
• Step 2: Go up the income statement account and Operating profit margin EBT (earnings =
Operating
Revenue profit
before tax, but after interest)
• Equity
When the cost under
is expensedFIFO = Equity • under
Net income LIFO + LIFO
decreases reserve
by the ×
entire after‐tax
Revenue amount of the cost.
remove the effect of all non-cash expenses and gains Pretax margin = EBT
Pretax margin = EBT (earnings
EBT (earnings
(earningsOperatingbefore
before
before
tax,
tax, but
profit
Revenuetax, but after
but after interest)
after interest)
interest)
(1 – tax rate)
Pretax
Operating margin
profit = margin = • No related asset is recorded on the balance
Pretax margin = EBT (earnings before
Revenue tax, but after interest)
from net income. Pretax margin =
EBT (earnings before
Revenue
Revenue
Revenuetax, but after interest)
• Liabilities under FIFO = Liabilities sheet andunder therefore,FIFO + LIFO or
no depreciation
Revenue
• Step 3: Remove the effect of all non-operating activities Pretax margin =
EBT (earnings before Revenuetax, but after interest) reserve × tax rate amortization expense is charged in future
UndeRstandingPretax
cash FloW stateMents
margin = periods.
from net income. Net profit Revenue • Operating cash flow decreases.
Net profit margin = Net profit
g cash FloW stateMents • Step 4: Make adjustments forTechniques
changes in all working
UndeRstandingNetcashprofit
Net
Pretax
Net FloWmargin
profit
profit
margin
stateMents
margin
margin = =
= Net
EBT Net
= Net
Revenue
Revenue
profit
(earnings
profit before tax, but after interest)
profit
Long-lived Assets • Expensed costs have no financial statement
Financial Analysis Net profit margin = Revenue Revenue Revenue impact in future years.
capital accounts. Return on Investment Ratios Net
Revenueprofit
Financial Analysis Techniques
UndeRstanding
Return
Return on
cash
Net FloW
profit
on Investment
stateMents
margin
Investment Ratios Ratios Net
=
profit • Capitalizing vs expensing
Activity Ratios
• Free cash flow to the firm (FCFF)
Return
Return
on
onNetInvestment
profit margin
Investment Net
Ratios = Revenue
income
Ratios
Free Cash Flow to the Firm UndeRstandingROAcash FloW= stateMents
Net
Net income
income Revenue
Activity Ratios Financial Analysis Techniques Return on ROA
ROA =
Investment Net
Average
= Average income
RatiostotalNet assetsprofit
ROA
Net profit= margin
Net income = assets
total   Capitalizing Expensing
FCFF = NI + NCC + [Int Cost
* (1 of
− goods
tax sold
rate)] − FCInv − WCInv Return onROA
UndeRstanding Investment
cash FloW
Average
= Average Ratios
stateMents
total
total assets
assets
Revenue
Inventory turnover = Net income
Average total assets Net income (first year) Higher Lower
Activity Ratios Financial Analysis
Average inventory Techniques ROA =
Net income Net income (future years) Lower Higher
Inventory turnover
Cost of goods sold
=(1 − tax rate)] − FCInv
Return on
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total assets
assets
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flow to Average
equity
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inventory
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Days of inventory on hand (DOH) UndeRstanding cash FloW stateMents Net income + Interest expense
Average total assets (1 − Tax rate)
Inventory turnover = Inventory turnover Adjusted ROA = Operating income or EBIT Cash flow from investing Lower Higher
Activity Ratios
FCFE = CFO − Financial
FCInv + Average
Net Analysis
inventoryTechniques
borrowing 365 Operating ROA = Operating income
Average or EBIT
total assets Income variability Lower Higher
Operating income or EBIT
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Days of inventory on hand
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Cost of goods=sold
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=
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total assets
assets
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income ortotal
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Performance
Performance Days of
Ratios inventory
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Financial Analysis Techniques
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inventoryTechniques 365
turnover
Operating ROA =
Operating income
Average total assets or EBIT
• Depreciation expense long-l
Receivables
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on handCost of goods=sold
(DOH) Average total assets EBIT EBIT long-l
Inventory turnover = Average receivables Inventory turnover Return on total capital Operating = income or EBIT EBIT
Activity Ratios
• Receivables
Activity ratios
turnover =
Average
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inventory
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goods=sold 365
Return
Return
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total
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=
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=
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= Short-term debt
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+ Long-term
EBIT
debt + Equity
debt + Equity • Straight line long-lived assets
Days
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to revenue
turnover on== hand (DOH)
Average receivables Inventory turnover Return on total capital = Short-term Short-term debt +
debt
total assets + Long-term
Long-term debt debt + + Equity
Equity Original cost − Salvage value
EBIT Depreciation expense = Original cost − Salvage value
Receivables turnover
Net Revenue
Average
=Cost of
inventory
Revenue 365 Return on total capital = Short-term debt + Long-term debt + Equity Depreciable life
Days of inventory on hand goods
(DOH) CFO =sold Short-term debt + Long-term EBIT debt + Equity Depreciation expense = Original − Salvage
Inventory turnover == Average receivables
Inventory Return on total capital =Net income − cost
Original costDepreciable
Salvage life value
value
Cash return on assets Average inventory
Revenue 365turnover Return on equity = Short-term
Net income debt + Long-term debt + Equity Depreciation
Depreciation expense
expense = =
Days of salesturnover
Receivables outstanding = (DSO)total
Average = assets 365 Return on equity = Net
Net income
income EBIT Depreciable
Depreciable life life
Days of inventory on hand (DOH) =Receivables turnover Return on equity
total =
capitalAverage = total equity
Average receivables
Inventory 365turnover Return on equity = Average Net income
total equity
Revenue
)=
CFO 365
UndeRstanding cash FloW stateMents
÷UndeRstanding cash FloW stateMents Return on equity = Average
Average total
total equity
Short-term equitydebt + Long-term debt + Equity • Double declining balance (DDB)
on =
Days
Cash of
Receivablesof saleson
return outstanding
equity
turnover (DSO
= Average Net income
Days inventory hand (DOH) =Receivables turnover Average total equity 2
Average shareholders'
receivables
Inventory equity
365turnover
Return on equity =
Net income DDB depreciation in Year X = × Book value at the beginning of Year X
Revenue UndeRstanding cash FloW stateMents Return on equity =
Average total equity Depreciable 2 life × Book value at the beginning of Year X
Days of salesturnover
Receivables outstanding = (DSO CFO)= 365 Net income − Preferred dividends DDBdepreciation
depreciation X= X=
in Year 2
Days ofCash inventory
to income on = hand (DOH) =Receivables turnover DuPont Decomposition of ROE Average total equity − DDB in Year
Depreciable 2 × Booklife
value at the beginning of Year X
Average receivables Return on common equity = Net income Preferred dividends =
Depreciable life × Book value at the beginning of Year X
Average−
Purchases Inventory 365turnover DuPont Decomposition of ROE Net=incomeNet
Net income Preferred dividends DDB depreciation in Year X
Payables
Days of sales turnover = Operating
outstanding Revenue
income
) = payables
Return
Return
Return on
on common
on common
equityNet equity
equity =
= income
equity income −common
Preferredequity dividends Depreciable life
Receivables turnover = (DSO
Average ( trade
CFO −Receivables
Preferred turnover
dividiends ) Return on
common
common Average
equity
= total
= equity −common
Net Average
income
Average
Average
Preferredequity
common
common
dividends
equity
equity Depreciation Components
Purchases
Average receivables 365 DuPont ROE =
Decomposition of ROENet income
Payables CF
turnoverper share= = Number Revenue ROE
Return = onAverage
common shareholders’
equity = equity Average−common
Net income Preferredequity dividends Depreciation• Depreciation
Depreciation Components components
Components
Days of sales outstanding = (DSO )of= common shares outstanding Average Net shareholders’
income equity Gross investment in fixed assets
Receivables turnover Average trade payables
Receivables turnover ROE = on common equity = Net income Average−common Preferredequity dividends Depreciation Components
Estimated useful lifeGross = Gross
investment in fixed assets
Payables turnover =
Average
Purchases
Revenue
receivables
365 2‐Way • Return
DuPont
Dupont
Averagedecomposition
shareholders’ equity of ROE
Decomposition Average common equity Estimated useful life =
Estimated useful Annual
= Gross
45 life Annual
investment
depreciation
depreciation
in fixed assets
expense expense
Days of salesturnover
Receivables outstanding = (DSO
Average ) = payables
trade © Wiley 2018
2‐Way all Rights
Dupont Reserved. any unauthorized Net
Decomposition copying or distribution
income − will constitute
Preferred an infringement of copyright.
dividends 45 investment in fixed assets
Receivables
365 turnover © Wiley 2018 all
ReturnRights Reserved.
on common any unauthorized
equity = copying or distribution will constitute an infringement of copyright. Estimated useful 45 life = Annual depreciation expense
Ratios of days of payablesPurchases
CoverageNumber Average
=
receivables ©
© Wiley
2‐Way
Wiley 2018
2018 all
Dupont
all Rights
Rights Reserved.
Decomposition
Reserved. any
any unauthorized
unauthorized copying
copying or
or distribution
distribution will
will constitute
constitute an
an infringement
50
infringement of
of copyright.
copyright. © Wiley 2018 all 45Reserved. any
Rights unauthorized copying or distribution
Payables turnover = 365 © Wiley 2018 all Rights
Net
Reserved.
income
any unauthorized copying
Average
Average
or
total
common
distribution
assets
will equity
constitute an infringement of copyright. 45 Annual depreciation expense will constitute an infringement of copyright.
Days of sales outstanding ( DSO =
Payables
)
Average trade payables turnover ROE = Net
Net income income × Average total assets
Receivables
365 turnover ROE
© Wiley 2018ROE == Average
all Rights Reserved. total
any assets
×
unauthorized ×Average
Average
copying
total assets
shareholders’
or distribution equityan infringement of copyright.
will constitute 45
Number
Payables of days of =payablesPurchases
turnover = 365 Average
Average totaltotal
assetsassets Average Average shareholders’
shareholders’ equity equity
Days of sales outstanding AverageCFO(DSO ) = payables
Payables
trade turnover © Wiley 2018 all Rights Reserved. any ↓ unauthorized copying or distribution ↓ will constitute an infringement of copyright. Average age of asset 45 = Accumulated
Accumulated depreciation
depreciation
Debt coverage = Receivables
365 turnover ↓ ↓ ↓ ↓ Average age of assetAnnual = Accumulated
depreciation expensedepreciation
g cash FloW stateMents Number of days of payables
Total Purchases
=
debt 365 Average age of asset = Annual depreciation expense
Payables
Days of sales turnover =
outstanding ( DSO ) =
Payables turnover ROA Leverage 45 Accumulated depreciation
Average trade payables © Wiley 2018 all Rights Reserved.
ROA ROAany unauthorized copying
Leverage or distribution
Leverage will constitute an infringement of copyright. Annual depreciation expense
g cash FloW stateMents Working CFO =+ Interest Revenue
365+ Taxesturnover
Receivables
paid paid Average age of asset =
Number Debtof capital
coverage
days turnover
of =
payables Purchases
= 3‐Way
3‐Way Dupont
Dupont Decomposition
Decomposition Annual depreciation expense
Payables turnover = Average
Interest
Payables working
paid
turnovercapital 3‐Way Dupont Decomposition UndeRstanding cash FloW stateMents
g cash FloW stateMents Average trade payables Revenue Net investment in fixed assets
Liquidity Working
Ratios of capital turnover =Purchases 365 Net income Revenue Average total assets total assets Remaining useful life =
g cash FloW stateMents Number
Payables days of
turnover ==payables = CFO working capital
Average ROE = Net income × Revenue× Average Netdepreciation
Annual investmentexpense in fixed assets
Reinvestment Average Payables
trade turnover ROE = Revenue Net income ×
Average Revenue
total assets Average × shareholders’
Average total assets
equity UndeRstandingRemaining
cash FloW stateMents
useful life = Net investment in fixed assets
Liquidity Ratios Cash paid for payables
Revenue
L-T 365assets ROE = Revenue × Average total assets × Average shareholders’ equity Annual depreciation expense
Workingof
g cash FloW stateMents Number capital turnover =Purchases Remaining useful life = Net
Liquidity Payables
g cash FloW stateMents Ratios turnover days of =payables
Current assets=
Average CFO working capital Per Share Ratios Revenue ↓ Average ↓ total assets Average ↓ shareholders’ equity
Annualinvestment
depreciationin fixed assets
expense
Current Debt ratio =
payment = Average Payables
Revenue
trade payables
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Fixed
Ratiosasset
Liquidity Number
Working turnover
capital Current
Current
turnover=Cash liabilities
=paid
assets 365 ↓
Net profit margin Asset turnover ↓ Leverage ↓ Annual depreciation expense
Current ratio of days= of payables Average = for
AveragefixedL-T debt repayment
assets
working capital
Per Share RatiosNet profit margin
Cash flow per share =
Cash
Assetflow from operations
turnover Leverage Gross investment in fixed assets Accumulated depreciation Net investment in fixed assets
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capital
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= of
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=
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assets Payables
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= = fixed assets
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flow from of shares Leverage
outstanding
operations Annual • Revaluation
depreciation expense
=
of long-lived assets expense + Annual depreciation expense
Annual depreciation
cash FloW stateMents Number of daysCurrent payables
ging
cash FloW stateMents Average
liabilities Per ShareCashRatios flow per share =
Current assets
Current ratio =
Cash paid for dividends
Average
Payables
RevenueRevenue working
turnovercapital
5‐Way Dupont Decomposition Interest burden Average number Asset of shares outstanding
turnover
Gross • IFRS allows revaluation
investment in fixed assets
=
Accumulated depreciation
model or cost model (only +
Netcostinvestment in fixed as
g cash FloW stateMents Fixed asset turnover Cash += Short-term marketable 365 investments + Receivables 5‐Way Dupont Decomposition Gross investment
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= Annual depreciation expense + Annual depreciation expe
Working capital Current
turnover
Current liabilities
= = fixed
assets CFO Cash flow from operations
EBITDA
Number
Quick of
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Investing/financing
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= = of =payables
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assets assets capital
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liabilities for investing/financing
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Quick asset
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= Current = Average = Net income Interest
EBT burden Asset turnoverAverage total assets Annual• depreciation
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× = ×↓
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capital + Receivables ROE =
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Current assets
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or depreciable
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assets
assets
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Current
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© Wiley 2018Current
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all Rights ratio
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turnover
Reserved. Cash == Currentmarketable
= any+unauthorized
Short-term copying
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liabilities
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distribution will constitute an infringement of
Valuation Ratios
copyright. ↓43 ↓ amount,
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Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 43
© Wiley 2018Quick
all Rightsratio = any unauthorized
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+total
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all Rights
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conversion any unauthorized
cycle =Average
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expenditures = =
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Cash conversion = cycle==Cash + +Short-term marketable
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= Retention
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© Wiley 2018Cash
all Rights Reserved. any unauthorized copying or − Daily cash
distribution expenditures
will 43 © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 51
Solvency Ratios conversion cycle = DSO Cash + DOH
+ Short-term Number ofconstitute
days of
marketable anpayables
infringement
investments of copyright.
+ Receivables
Defensive interval ratio = Sustainable growth rate = Retention rate × ROE
Solvency Ratios
Cash
© Wiley 2018Debt conversion
all Rights Reserved. cycle
any ratio =
Total
unauthorizedDSOCash
= = =DSOcopying
+
debt +
DOH −
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Number cash
of days
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of payables
investments + Credit
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or distribution will constitute an infringement of copyright. Analysis
Credit Analysis Ratios Ratios 43 Deferred Taxes
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to-assets
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+ DOH − Number of days of payables
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unauthorized copying − Number of days
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percoverage EBIT
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Ratios-to-assets ratio =
Solvency Debt
Total debt
conversion cycle = DSO + DOH − Number of days of payables EBITDA interest coverage =
Gross interest
EBIT
EBIT © Wiley 2018 Rights Reserved. anyliability
unauthorized (asset) ariseswill
copying or distribution when:
constitute an infringement of copyright.
Total assets Total debt EBIT interest coverage Gross= interest EBIT © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
Cash
Debt--conversion
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to capitalratio cycle
ratio == =
Total
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Total
debt
+ DOH − Number of days of 46
debt
debt +Total
Totalassets Shareholders’ equity
payables © Wiley 2018EBITDA interest
all Rights Reserved. coverage
any unauthorized = +Gross
copying
FFO
interest
or distribution
interest
Gross paidwill
interest
constitute anlease
− operating infringement
adj of copyright. • Taxable income is lower (higher) than pretax
© Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
Debt -to -assets ratio = Total debt FFO 1
Price
interest per
coverage =
share
Solvency CashRatios
Debt -conversion
to-capital ratio
Debt -to-assets ratio = Total
cycle = = DSO
Total debt + DOH − Number of days of payables /BV = interest
PEBITDA Price per share = FFOEBIT
coverage Gross interest accounting profit.
Totalassets
debt +TotalShareholders’
debt equity P /BV FFO = 1Book value
interest per share
coverage
+ interest paid − operating lease adj
= Gross interestEBIT
Solvency DebtRatios -to-capital ratioTotal = assets Book
Return value
on per= share
capital Grossdeferred
interest • Taxes payable is lower (higher) than income tax
Total debt +Total Shareholders’
debt equity Avg FFO
(equity + + interest
non-current paid − operating
taxes + lease
debt) adj
Solvency DebtRatios
Debt --to
to--capital
assets ratio ratio== Total debt FFO1 interest coverage = EBIT expense.
TotalTotaldebt debt+Total
Shareholders’
debt equity Return
FFO1 to ondebt
capital =
FFO Gross interest
Debt--to
Debt
Debt -
to--capital
to -
equity ratio
assets ratio===Total
ratio
Totalassetsdebt Total debt
=
Total Avgdebt (equity + non-current deferred taxes + debt) • If a company has a DTL, a reduction (increase) in tax rates
Debt--toto-capital
-capital ratio = Shareholders’
Total Total
debtTotaldebt
+ equity
debt
Shareholders’ equity EBIT
Debt
Debt -to-equityratio ratio= = TotalTotal
Total assets
debt
debt + Shareholders’ equity46 Return on capital Adj = CFO −
FFO capex
Debt -to-assets ratio =Total debt
Shareholders’
Total + Shareholders’
debt equity equity © Wiley 2018Freeall Rights Reserved.
Operating CF any
to unauthorized
1debt = Avg
=Total copying or distribution
(equity will constitute
+ non-current an infringement
deferred of copyright. would reduce (increase) liabilities, reduce (increase)
taxes + debt)
Debt -to-equity ratio = Total assets
46 © Wiley 2018 all Rights Reserved. FFO anyto debt
unauthorized copying
debt or distribution will constitute an infringement of copyright.
Total debt income tax expense, and increase (reduce) equity
Shareholders’
Total debt equity 1 CFO − capex FFO− dividends paid
Debt - to - equity ratio = Total debt Discretionary CF FFO to debt
to debt = = Adj CFO − capex
Debt -to-capital ratio = Shareholders’
Financial
Debt -to--capital leverage
equity ratio ratio Total
= Total =
Average
Total
debt debt total
equity
+Total assets equity
Shareholders’
debt
Free Operating CF to debt = Total
FFO −Adj
Totaldebt
Total
debt
debt • If a company has a DTA, a reduction (increase) in tax rates
Totaldebtdebt dividends
CFO − capex
Debt
Debt---toto
Debt to-equity
-equityratio ratio
ratio = == Shareholders’
Average total
equity equity
assets Free OperatingNet CF toCF capex =
to debt = capex
CFO − capex − dividends paid would reduce (increase) assets, increase (reduce) income
Financial leverage ratio Total
= debtequity
Shareholders’ +Total
Shareholders’
debt equity
Debt -to-capital ratio = Shareholders’ Average
Average total
equity
total equity
assets Discretionary CF to debt =
• LIFO toDebt FIFO conversion
Total debt
Total debtwith rising Total debt prices and stable or tax expense, and reduce (increase) equity
Financial leverage ratioTotal = debt + Shareholders’ equity to EBITDA = CFO − capex − dividends paid
Average total
Total debt assets equity rising inventory
Discretionary CF toquantities
debt = FFO − dividends
EBITDA • DTA carrying value should be reduced to the expected
Financial
Debt -to-equity leverage ratioratio= = Average EBIT total equity
Net CF to capex = Total debt
Interest coverage
Financial
Financial leverage
leverage ratio
ratio
ratio
Average
Shareholders’
=Average
Totaltotal
= Average
== Average
total
debt equity
assets assets
total assets • Inventory under FIFOFFO capex
= Inventory
− dividends under LIFO + LIFO recoverable amount using a valuation allowance
Debt -to-equity
Financial leverage ratio ratio =Interest
Average EBITpayments
total equity Net=CF
1FFO (free funds to operations) to capex
net income = Total
+ non-cash charges
debt
Interest coverage ratio Shareholders’ = Average
total
Total debt
equity
equity
total equity reserve Debt to EBITDA = capex
Debt -to-equity ratio = Interest EBITpayments EBITDA
Interest coverage ratioShareholders’ = equity Total debt 47
Interest payments Debtanytounauthorized
© Wiley 2018 all Rights Reserved. EBITDA = or distribution will constitute an infringement of copyright.
copying
Average EBIT total assets EBITDA Wiley © 2019
Interest
Financialcoverage leverageratio ratio==Interest EBIT payments
Interest coverage ratio = Average
Average EBIT total
total equity
assets 1FFO (free funds to operations) = net income + non-cash charges
© Wiley 2018 all Rightscoverage
Interest
Financial Reserved.
leverage any unauthorized
ratio
ratio ==
Interest copying
EBITor distribution will constitute an infringement of copyright.
payments
Interest coverage ratio = Interest Average payments
total equity
© Wiley 2018 all Rights Reserved. any unauthorized Interestcopying assets will constitute an infringement of copyright.
or distribution
payments 1FFO (free funds to operations) = net income + non-cash charges
 re = Expected return on stock (cost of equity).
CORPORATE FINANCE
Dividend Discount Model

Wiley’s CFA Program Exam Review

®
2. Dividend D1 Model (DDM)
P0 Discount
=
re − g
The dividend discount model asserts that the value of a stock equals the present value of
its expected future dividends.
where:
P0 = current market value of the security.
D1 = next year’s dividend.
re = required D
re =rate1 of
+ greturn on common equity.
P0
g = the firm’s expected constant growth rate of dividends.

Rearranging the above equation gives us a formula to calculate the required return on
Accounting for Bonds equity:
3. • Dividend
Bond Yield discount
plus Risk Premium model
Approach Risk Management
The bondr yieldD1plus risk premium approach is based on the basic assumption that the cost
• Effective interest method required under IFRS and e = +g • Financial risks: market, credit (default or counterparty
of capital for P
riskier cash flows is higher than that of less risky cash flows. Therefore, we
preferred under US GAAP 0
calculate the return on equity by adding a risk premium to the before-tax cost of debt.
risks), liquidity (or transaction cost risk)
• Interest expense for a given period is calculated as • Bond yield plus risk premium • Non-financial risks: settlement, legal, compliance
the book value of the liability at the beginning of the (including regulatory, accounting and tax risks), model,
Sustainable Growth Rate
re = rd + risk premium Cost of Capitalsolvency
period multiplied by market interest rate at bond operational,
Cost of Capital
PoRtfolio Risk and Re
issuance. MeasuRes of leveRage • Methods of risk modification: risk prevention/avoidance,
• Project

g = 1−
Dbeta
 × ( ROE ) PoRtfolio Risk and RetuRn: PaRt ii
• Coupon payments are classified as cash outflows.  for
Unlevered beta
estimating Betas EPS 
a comparable asset risk acceptance (self-insurance and diversification), risk
Unlevered• beta
unleveraged
for a comparable betaasset
for a comparable asset transfer,ofrisk
Standard Deviation shifting/modification
a Portfolio of Two Risky Assets
• Book value of the bond liability at any point in time is Where (1 − (D/EPS)) = Earnings Measures of Leverage
retention rate Portfolio Risk and Return: Part II
the PV of the bond’s remaining cash flows (discounted • Beta can be calculated  by regressing
 period


the company’s stock returns against market
at the market interest rate at issuance).
returns over a given
Degree ofβOperating
= β EQUITY 
Leverage
1 of time.
 Portfolio
σ p = w1 σ1 + w2 σ 2Risk
2 2 2 2
+ 2w1w2 σand
1σ 2 ρ1,2 Return
or w12 σ12 + w22 σ 22 + 2w1w2 Cov1,2
D   to estimate the beta of a particular project
1 Capitalor
Allocation Line
β ASSET =use
• Analysts β the pure-play method ASSET EQUITY   1 + (1 − t ) 
Bond Yield plus Risk Premium  (Approach
D
WoRking Capital ManageMent of a company thatis
1 +not − t ) E   traded. This
1publicly method involves the adjustment of a
Leases DOL =
Percentage change  E  
in operating income The CAL
Utility • Function
Utility
has an interceptfunction of RFR and a constant slope that equals:
re = rd + comparable
risk premium, publicly-listed
where rd is thecompany’s
required returnbeta for differences in financial leverage.
sold on debt. asset releveraged
Beta for a• project
Percentage change in units
○Beta First for
using
finda aproject
a comparable using asset a comparable
company re-leveredthat faces for similar
target company
business risks as the com- [E(R i ) − RFR]
1
Beta for a project usingWorking a comparable asset re-levered for target company
• Lease accounting from lessee’s perspective: treating a
WoRking Capital ManageMent
forpanytarget company
or project underCapitalstudy and Management estimate the equity beta of that company. U = E(R) σ i − Aσ
2
2

lease as a finance lease (compared to an operating lease)Liquidity βDOL ○ To remove Q × ( P −all V )elements
 Dof financial
 risk from the comparable’s beta “unlever”
Measures = = β ASSET 1 +  (1 − t ) D  
results in: WoRking Capital ManageMent β PROJECT the ×β( ASSET
Q=beta. P −The +F (1 − t ) Ebeta
V )1−unlevered   reflects only the business risk of the comparable
E   where: • The
Expected Return higher
on portfolios the correlation
that lie on CML between the individual assets,
MeasuRes of leveRage
 asasset beta.
PROJECT
and is known Working Capital Management
• Higher assets, current liabilities, long-term liabilities, Country where: Current
Risk Finally,
○ Premium Current assets
Ratio =adjust the unlevered beta of the comparable for the level of financial
U = Utility the
E(R of an higherinvestment the portfolio’s standard deviation and the
p ) = w1R f + (1 − w1 ) E(R m )
EBIT, CFO, leverage ratios. Country
QLiquidity
= Number Risk
Measures of Leverage
Measures Premium
of risk Working
units(leverage)
sold Current Capital
liabilities Management
in the project or company under study.
Measures of Leverage PoRtfolio Risk and RetuRn: PaRt
E(R)
σ2 =
= Expected
ii Variance of returns
return
lower the diversification benefits (no diversification
• Lower net income (early years), CFF, asset turnover, Business PLiquidity
= Price rMeasures
per= unit
e R F + β [E(R M ) − R F + CRP] A = Additional
Variance
benefits with
return required
of portfolios
a correlation
that lie onbyCML
coefficient of +1)
the investor to accept an additional unit of risk.
60 V = rrisk
Variable = operating
R + Reserved.
versus β [E(RFinancial
cost ) −+unauthorized
Current
per R + CRP]
assets
risk
unit
current ratio, ROA (early years), ROE (early years). Degree• ofCurrent
© Wiley 2018 e all
Degree Rights
F
Operating Ratio of any
=operating leverage (DOL)
Cash
M
=Leverage
Short
F term copying or
marketable distribution will
investments +
constitute an infringement
Receivables of copyright.
• The Markowitz efficient frontier contains all the possible
F = FixedQuick operating Ratio cost Current
Currentliabilities
assets Current liabilities Portfolio Risk and Return: Part II
• Same total cash flow. Business Current
Q × (P − Country
V) Ratio =
risk=comprises
Contribution
equityCurrent margin
of sales
risk risk(theandamount
Sovereign
liabilities operating
yieldthat risk.
unitsSales
sold contribute
Annualizedrisk refers to
to covering
standard the fixed
unpredictability
deviation of equity σ 2
= w1 σ f +in
portfolios
index
2 2
(1 −whichw1 ) σ mrational,
2 2
+ 2w1 (1 − wrisk-averse
1 )Cov(R f , R m )investors will
Country Percentage
equity riskrisk change
= Sovereignin operating yield income × Annualized standard deviation of equity index Line
of revenues DOL and =operating
costs)
premium Cash + Short =refers term tomarketable
the company’s
spread × operating
investments cost structure.
+ Receivables
Annualized standard deviation Capital consider
Allocation
of sovereign investing
Quick premium
Ratio Percentage
= change in units
spread Creditsold sales Annualized standard deviation of sovereign
Financial Reporting Quality (P − V) = Contribution margin per unit Current liabilities bond market in terms of the developed market
Accounts receivable
FinancialQuick risk Ratio
Cash + Short
refers= to the uncertainty
turnover =
term marketable
Average
of profits
investments + Receivables
receivables
and cash bondflows market in terms
because ofofthe
Equation
theusedeveloped
The • of
ofCAL has
Optimal
CML
market an intercept capital of RFR allocation
and a constant line: linethat
slope drawn
equals:from the risk-
currency
Degree• ofDegree
fixed-cost Financial
financing ofLeverage
× financial
( P − V )such leverage
sources
Current
as debtCredit
liabilities
and(DFL) leases. currency free asset to E(Ramportfolio
) − Rf on the efficient frontier, where
Q sales The greater the use of debt financing, [E(R )i )=−RRFR]
• Conditions conducive to issuing low quality financial the greaterAccounts DOL = receivable turnover =
Q × ( P −risk
the financial V ) −of F the firm.
E(R p f + × σ
the portfolio isσ mat the point of tangency. The optimal CAL
p
Amount of =capitalAverage
in=Credit
at which receivables
Accounts
sales a component’sreceivable cost of capital changes σi
ting 
reports: opportunity, motivation, rationalization Accounts
Number
Break
DFL =point ofPercentage
receivable
days
= Amountofturnover change
receivables
of capital
Average
net income
at receivables
which a component’s cost of capital changes MeasuResthe
offers best risk-return tradeoff to an investor
of leveRage
Break point =
Percentage Proportion
change ofAverage
in operating newincome days raised
capital sales on fromcredit
the component
• Mechanisms that discipline financial reporting where: Proportion of new capital raised from the component where: • The point where an investor’s indifference (utility) curve
Accounts receivable Expected Return on portfolios that lie on CML
Q = Number Number of units
of sold
days of receivables = Accounts receivable
quality: markets, Capital regulatory authorities, registration
Budgeting  • ofNumber
Degree of total = Accounts receivable y‐interceptis=ManageMent
tangent
Rf = risk‐free to the rate optimal CF CAL indicates the investor’s
−leverage (DTL)
Average days sales on credit WoRking Capital
Degree
P = Price Total
per unitLeverage
of [Q(P
days of
− V) F](1 −=t)Average
receivables Sales [Q(P on−creditV) on / 365
− F]
requirements, auditors, private contracting V = Variable =
DFLoperating = days sales credit optimal
E(R p ) = w1portfolio
R + (1 − w ) E(R m )
E(R mf) − R f 1
Net Present Value (NPV) [Q(P −cost V) −per F −unit C](1 −= t)Accounts [Q(P receivable
− V) − F − C] slope = = market price of risk.
F = Fixed operating costPercentage change
DTL = Cost of
Accounts
Sales
= goods
in onnet income
receivable
credit / 365 • With homogenous σm expectations, the capital market line
QShort-term
× (P − V)Investment
= Contribution
PercentageReturns margin
change (the in Sales
theamount onsold
number that
credit units
unitssold
of/ 365 soldcontribute to covering Variance fixed
CORPORATE FINANCE where: Inventory turnover = Average inventory
n of
(CML)portfolios becomes that lie on a CMLspecial case of the optimal CAL, where
CFt
NPV = ∑ t − Outlay
costs)
t =1 (1 + r)
Q
© =
(P2018
Number
− V)Wiley
of
=Inventory
units
Contribution
sold
margin
Cost
=Costper
of goods sold Systematic the and tangent
Nonsystematic portfolio
267 Risk is the market portfolio
P = Price Inventory
per unit
turnover of unit
 Face
Average goods
value
inventory − price   360 
sold  360  σ 2 = w12 σ 2f + (1 − w1 )2 σ 2m + 2w1 (1 − w1 )Cov(R f , R m )
= market
turnover×yield= =
 Days  • CML equation (slope of line is called the market price
DTL
Money DOL DFL × = Holding period yield × 
 unit inventory  Inventory
Days 
where: Corporate Governance V = Variable
Degree ofNumber operating
Financial cost per
Leverage
Average
days of inventory =
ofcost
Price
Total Risk = Systematic risk + Unsystematic risk
F = Fixed operating
• Number
Breakeven Average of goods soldcosts + Equation of risk)
day’s costoperating
CFt = after‐tax cash flow at time, t. c10.indd 267
C = Fixed financial Q × quantity
cost
of days of − V)
(Pinventory =
of sales =Inventory
(Fixed
Inventory
of CML 7 March 2018 7:14 PM

• Key
r = required rateareas
of return of for the investment.
interest: economic This is ownership
the firm’s cost and of capital
voting adjusted for DTL = of Percentage change in net−income
t = Tax rate Fixed
Number
DFL = financial
[Q(P
Bond equivalent
days
− V) −
yield Fcosts)
of inventory
=−  Face
C] ÷
= Average
Average
=
Contribution
value day’s
day’s cost
cost of
Inventory
price  ×
365 margin
goods
of goods sold =
sold per unit
Holding period yield ×
 365 
Return‐Generating ModelsE(R m ) − R f
the risk inherent in the project. Percentage change 
 in operating     
control, board of directors representation, remuneration • Operating breakeven= quantity Price of income
CostInventory goods  soldDays/365  Days  E(R p ) = R f + × σp
Outlay = investment cash outflow at t = 0. Inventoryof sales = Fixed operating k σm k
and company performance, investors in the company, where: costs ÷ Contribution = Cost of goods sold / 365
margin
Cost of goods per soldunit
/ 365 E(R i ) − R f = ∑ βij E(Fj ) = βi1[E(R m ) − R f ] + ∑ βij E(Fj )
Internal Rate strength of Return of shareholders’
(IRR) rights, managing long-term Q = Number DFL
of units
=
[Q(Pproduced
− V) − F](1 and −sold t) [Q(P − V) − F]
value=− price   360 
Face Purchases  360  where:
j=1 j= 2
ANCE
risks P = Price Discount
per unit
Payables turnover
basis V) −=F
− yield = − C](1 − t) [Q(P − V) × − F − C]= % discount ×  • Complete diversification of a portfolio eliminates
n n V = Variable Working Capital Management
Payables
[Q(P
operating
Payables turnover
turnover cost== per
Purchases
 Purchases
unitFacetrade
Average valuepayables Days   Days  y‐intercept = Rf = risk‐free rate
CFt
∑ (1 + IRR)t = Outlay
CFt
∑ (1 + IRR)t − Outlay = 0 F = Fixed operating cost
Averagetrade
Average tradepayables
payables The Market unsystematic
Model risk. A well-diversified investor expects to
Capital Budgeting
If the project t =1
being evaluated has a higher t =1
risk than the average risk of the firm’sC
where:
• Sources
= Fixed
Qexisting
= Number of unitsof
financial cost liquidity:
Face
sold value − Price primary Accounts (e.g.payablescash balances and be
slope =
R i = α i + βi R
E(R m ) − R f
compensated + ei
for taking
= market price ofon risk.systematic risk
% Discount
Number of =days of payables =Accounts σm
•
Accountspayables payables m
projects, the WACC is adjusted upwards. If the project has less risk than the average P = Price short-term
risk Number
per unitof
Number of days
daysof funds)
of Price and
payables
payables == Average secondary
Average day’s (e.g. purchases negotiating Beta captures an asset’s systematic risk (relative to the
Payback
of • Consider
the firm’s Periodexisting incremental
projects, the WACC after-tax cashdownwards.
is adjusted flows, externalities V = Variable Breakeven
debt
point
contracts,
operating unit Average day’s
cost perliquidating day’spurchases
assets,
purchases
filing for bankruptcy Calculation riskof of the market)
Systematic and Beta
Nonsystematic Risk
and opportunity costs. Ignore sunk costs and financing F = FixedPQ operating
protection). VQcost
Accounts
Accounts payablespayables
BE =Effectiveness
BE + F + C == = Purchases / 365
Accounts payables
Payback period
estimating Costandof discounted
debt payback period have the same formula, but discountedCWorking = Fixed Capital
financial cost Measure Cov(R i ,R m ) ρi,m σ i σ m ρi,m σ i
costs from calculations of operating cash flows Purchases
Purchases / 365
/ 365
βi = = =
payback uses cash flows discounted by the appropriate rate: t = Tax• rate
where: Additional liquidity measures Total Riskσ = 2 Systematic
σrisk
2 + Unsystematic
σm risk
• For mutually
Yield-to-Maturity Approachexclusive projects, use the NPV rule if the
per unit turnover = Cost of goods sold
P = Price Inventory
m m

NPV and IRR nrules conflict

n Purchases
Purchases
Purchases ===Ending
Ending
Ending inventory
inventory
inventory + + COGS
COGS + COGS− − −
Beginning
Beginning inventory
inventory
Beginning inventory
The bond’s yield to maturity ∑ CF(YTM) n +1 − ∑is CFthe
n IRR of an investment in the bond, assuming
Q = Number of units producedAverage and sold inventory
• The capital
Return‐Generating Models asset pricing model (CAPM) is used to PoRtfolio Risk and Ret
that it is• purchased
Payback
Payback =period
n + t = 0 ignores markettime
t =0
price value oftill
money,
maturity.risk
It isof
V = Variable
© Wiley cost per
2018 all Rights unit any unauthorized copying or distribution will constitute an infringement of copyright.
Reserved. calculate an 61
k asset’s required returnk given its beta (the
61
period at the current n and held the yield F that
© Wiley
= 2018Operating
Fixed all Rights Reserved.
operating any
costs==Number
cycle unauthorized
ofofdays copying or distribution
ofofinventory ++ Numberwill constitute
of of
days an infringement
of receivables of copyright.
thepresent
project and of a∑ cash CFn +flows that occur after62the payback Operating cycle Number
Operating cycle = Number of days of inventory days inventory Number days of receivables
Inventory+ Number of days of receivables © Wiley 2018E(R all Rights = ∑ βany
Reserved.
i ) − R f market ij E(F j ) = β i1[E(R m ) − R f ] + ∑ β ij E(Fj )
unauthorized copying or distribution will constitute an infringement of copyright.
equates the value bond’s 1 expected future cash flows to its current market price.
C©=Wiley 2018
Fixed all RightsofReserved.
financial
Number days ofany
cost unauthorized
inventory = copying or distribution will constitute an infringement of copyright. security line)
period is reached t =0 Average days cost of goods72 sold The Capital
© Wiley 2018 allAsset Pricing
Rights Reserved.
j=1 Model j= 2
any unauthorized copying or distribution will constitute an infringement of copyright.
Debt Rating Approach Net operating
Net operating cycle = Number of days of inventory + Number of days of receivables
• Discounted payback period ignores cash flows that occur The breakeven numbercycle
Net operating of
cycle
= Number
units = can
Numberbeofcalculated
days of inventory
of days as:inventory
Inventory
of
+ Number of days of receivables
+ Number of days of receivables
−−Number
Number = ofofdays daysofofpayablespayables E(R i ) = R f + β i [E(R m ) − R f ]
n n The Market Model
after the
When a reliable currentpayback
market period
price for ∑ is
theCFreached
n +1 − ∑ CFndebt is not available, the before-
company’s
− Number Costofofdays goods ofsold / 365
payables
F+C
tax
wherecostn• =of
Average
#debt can Accounting
of periods bethat
n
∑ CFn <by0Rate
estimated usingofthe
and t = 0
Return =
yield on(ratio
t 0
ofpartial
is the project’s
similarly-rated bonds (in that
year have • Trade
Q = discounts (e.g. “2/10 net
365 30” means a 2% discount R = α i + βi R m + ei PoRtfolio Risk and Ret
64year n+1) BE
© Wiley
Wiley 2018 all P − VReserved. any unauthorized = copying or distribution will constitute an infringement of copyright.Sharpe• ratio
If ian asset’s expected return using price and dividend
allRights
n
terms to maturity
averagethat net areincome
tsimilar
=0 totothe itscompany’s ∑ CFn+existing
average debt. 64 © is2018available if the
Rights Reserved. amount
any unauthorized Inventoryowed
copying is paid
orturnover
distribution within
will constitute 10 days,
an infringement of copyright. PoRtfolio Risk and Ret
1book value) 64is based © Wiley 2018 all Rights Reserved. any unauthorized copying byorthe distribution
30 will constitute an infringement of copyright.forecasts is higher R − R (lower) than its CAPM required return, PoRtfolio Risk and Ret
the time value of Note that otherwise full amount is due day)
th p f
=0 Sharpe ratio =
Issues in on accounting Cost ofnumbers and tignores taxes are not considered in breakeven analysis because there is no taxable income. Calculation of Beta
estimating debt The Capitalthe asset is undervalued
Asset Pricing σ Model
p (overvalued).
CF required money to recover the remaining investment amount.  365  Capital Asset
The Cov(R Pricing,R m ) Model ρ σ i σ m ρi,m σ i
PoRtfolio Risk and Ret

• • Fixed-rate versusindexfloating-rate debt: The cost of floating-rate debt

OperatingImplicit
is reset
breakeven = Cost of trade credit =  1 +
rate point
Discount  
 1 − Discount 

Number of days

beyond discount period  − 1 • E(R
The Capital
Portfolio
β i =i ) = R f +2iperformance
Asset σ Pricing β i [E(R = m )i,m
Model − R2 f ] evaluation
= measures
Profitability (PI): PI exceeds 1 when NPV is positive Treynor ratio σ σ
Profitability Index based on a reference rate (usually LIBOR) and is therefore, more • Sharpe m m m
periodically E(R i ) = R f + ratio β i [E(R(uses m ) − R f total
] risk)
PQ OBE = VQ OBE + F The Capital
difficult to estimate than the cost of fixed-rate debt. Sharpe ratio E(RAsset Pricing
i ) = R f + β i [E(R R pModel
−mR) f− R f ]
PV of future cash flows NPV 62 © Wiley 2018 all Rights Reserved. any unauthorized copying Accounts payablewill constitute an infringement of copyright. Treynor ratio =
or distribution
• Debt PI = with option like features:= If 1 +option-like features are expected to be removed Number of days of payables = Sharpe ratio E(R i ) = R f + βR βp ) − R ]
Initial Average day’s purchases i [E(R
p −R
debtinvestment
issues, an analyst Initial investment mf f
from future must adjust the yield to maturity on existing bonds Cost of F Capital Sharpe ratio Sharpe ratio =
Q OBE = Accounts payable 365 R pσ−p R f

PORTFOLIO MANAGEMENT
for their option features, and use the adjusted rate as the company’s cost of debt. P−V = Sharpe ratio =
Purchases / 365 Payables turnover 72 M‐squared
© Wiley 2018
Sharpe ratio (M 2 ) Reserved.pσ
all Rights R −
any R
p unauthorized
f copying or distribution will constitute an infringement of copyright.
• Nonrated debt: If a company does not have any debt outstanding (to be rated) or Sharpe ratio =
Cost of Capital
yields on existing debt are Cost of Capital
not available (due to lack of current price information), Net income at various levels of sales • 2Treynor Rσ
ratio
σp
) p m −(uses beta)
Treynor ratio − Rf
M
Sharpe = (Rratio −R = (R m − R )
an analyst may not be able to use the yield on similarly-rated bonds or the yield to Overview Treynor ratio
p f
Rσσppp− R f
f
Weighted • maturity
Average
Weighted Cost
approach of Capital
average cost of
to estimate thecapital
company’s (WACC)cost of debt. Net income = [Q ( P − V ) − F − C ](1 − t ) Treynor ratio Treynor ratio =
R pβ−p R f
• Leases: If a company uses leases as a source of finance, the cost of these leases Treynor ratio =
WACCbe= included
should (wd )(rd )(1in− its t) +cost
(wp )(r ) + (we )(re )
ofp capital.
• Steps in the portfolio management process: planning Jensen’s Treynor ratioalpha
Treynor ratio =
R pβ−p R f
Note that (includes
this formula developing considers taxes,IPS), unlikeexecution
the variant formula (includes for breakeven
asset point βp
(which has no taxable income). M‐squared α p(M = 2R) p − [R f + R β p (R−R m f− R f )]
where: • Cost
estimating Costofofpreferred
preferred Stock stock allocation, security analysis and portfolio construction), M‐squaredTreynor 2) ratio =
wd = Proportion of debt that the company uses when it raises new funds feedback (includes portfolio monitoring/rebalancing andM‐squaredM • 2M-squared
(M
σm β
(uses
p total risk)
(M= )(R p65− R f )
2 − (R m − R f )
d=
r© Before‐tax
Wiley 2018 dmarginal cost of debt ©©Wiley
Wiley 2018
2018 all
all Rights
RightsReserved.
performance Reserved.any unauthorized copying
measurement/reporting).
any unauthorized copying or distribution
or distribution will will
constitute an infringement
constitute of copyright.
an infringement Security Characteristic
of copyright. σ
63Line
M2 =2 (R p − R f ) mp − (R m − R f )
l
t = Company’srpall= Rights
p Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
vp
marginal tax rate M‐squaredM(M 2 ) − R ) σmp (R σ
wp = Proportion of preferred stock that the company uses when it raises new funds R i −=R(R f = α i + β iσ(R m − R f )
p f − m − Rf )
rp = Marginal cost of preferred stock Investment Policy Statement Jensen’s alpha 2
= −
σ mp
− (R m − R f )
Required
estimating
w • Cost Costofofon
Return equity
a Stock
equity
e = Proportion of equity that the company uses when it raises new funds
Jensen’s alpha
M (R p R f )
σ
α p = R p − [R f + β pp(R m − R f )]
re = Marginal
Capital •
Asset Capital asset
cost of equity
Pricing Model pricing model (CAPM) • Investment objectives: risk objectives and return Jensen’s alpha
• p Jensen’s
α = R p − [R f +alpha β p (R m (uses− R f )] beta)
1. Capital Asset Pricing Model (CAPM)
objectives Jensen’s alphaα p = R p − [R f + β p (R m − R f )]
To Transform Debt‐to‐equity Ratio into a Component’s Weight Security Characteristic Line
re = R F + β i [E(R M ) − R F ]
The capital asset pricing model (CAPM) states that the expected rate of return from a • Investment constraints: liquidity, time horizon, tax Security α Characteristic Line
p = R p − [R f + β p (R m − R f )]
stock equals
where:
D the risk-free
E = D =w
interest rate plus a premium for bearing risk. concerns, legal/regulatory factors, unique circumstancesSecurity RCharacteristic i − R f = α i + βLine i (R m − R f )
d R − R = α + β i (R m − R f )
[E(RM) − 1Rf] + D=EEquity D +risk
E premium. i f i
Security Characteristic
R i − R f = α i + βLine i (R m − R f )
RM = Expected rwe d=+Rwreturn
Fe += B ) − RF ]
on theMmarket.
1 i [E(R Wiley © 2019
βi = Beta of stock. Beta measures the sensitivity of the stock’s returns to changes in market R i − R f = α i + β i (R m − R f )
returns.
Valuation of Bonds
RF = Risk‐free rate.
 Leverage Position size PQ 1
= = 0 0 =
ratio Equity size P0 Q 0 M0 M0

Wiley’s CFA Program Exam Review

®
% Equity Equity per share
=M=
margin Price per share

Return using Equity after disposal

=
margin Initial Equity
Pt + D − C − P0 (1 − M 0 )(1 + r CM )
=
P0 M 0 + C

Where: EQUITY INVESTMENTS

P0 = initial share price
• Cumulative preference shares are less risky than non-
cumulative preference shares as they accrue unpaid FIXED INCOME
Pt = share disposal price dividends.
Market Organization and Structure
D = dividend per share during the period Basic Features of Bonds
C = commission per share Industry Analysis
• Purchasing
rCM = call money rate stock on margin (leveraged position) • Types of collateral backing: collateral trust bonds,
M0 = initial margin equipment trust certificates, mortgage-backed
• Leverage ratio is the reciprocal of the initial margin. • Porter’s five forces: threat of substitute product,
bargaining power of customers, bargaining power of securities, covered bonds
• Price
Security Price at which the Investor
at which theWould Receive
investor a MarginaCall
receives margin call equity valuatiOn: cOnceptS and BaSic tOOlS
suppliers, threat of new entrants, intensity of rivalry. • Credit enhancements
(1 − Initial margin) • Industry life-cycle analysis • Internal: subordination, overcollateralization, excess
P0 ×
(1 − Maintenance margin) Equity Valuation:
• Embryonic (slow growth, Concepts high prices, and Basic highTools risk of spread (or excess interest cash flow).
Dividend Discountfailure). Model (DDM)
• External: surety bonds, bank guarantees, letters of
• Types of orders • Growth (sales grow rapidly, improved profitability, credit.
• Execution instructions, e.g. market orders, limit orders. V0 lower
=
D1prices,Drelatively
+ 2
+  + low
D∞ competition). • Covenants
(1 + k e )1 (1 + k e )2 (1 + k e )∞ • Affirmative: requirements placed on the issuer.
• Exposure instructions, e.g. hidden orders, iceberg • Shakeout (slower growth, intense competition,
orders. declining profitability, focus on cost reduction, some • Negative: restrictions placed on the issuer.
equity valuatiOn: cOnceptS and BaSic tOOlS
• Validity instructions, e.g. day orders, good till cancelled failures/mergers).
n
• Repayment structures
Dt
V0 = ∑
orders, immediate or cancel orders, good on close • Mature (little
t =1 (1 + k e )
t or no growth, industry consolidation, Equity
• Bullet: entire principal amount repaid at maturity.
orders, stop orders. high
Equity barriers to entry,Concepts
Valuation: strong cash andflows).
Basic Tools
• Amortizing: periodic interest and principal payments
• Clearing instructions, e.g. how final settlement shouldOne Applying• Discount
year holding
Decline period:
Dividend the DDMModel is(negative
relatively growth, excess capacity, price
(DDM)difficult if the company is not currently paying out a made over the term of the bond.
be arranged (security sale orders must also indicate dividend. A competition,
company may weaker
not pay out firms
a dividend leave). because:
V =
dividend to be received year-end price
+ • Sinking fund: issuer repays a specified portion of the
whether the sale is a long sale or a short sale). • Competitive
0 D1 (1 + kstrategies:D1
+ e ) 2 investment
costD∞+ leadership,
+  + (1opportunities k e )1 product/service principal amount every year throughout the bond’s life
• ItVhas 0 = a lot of1 lucrative available and it wants to retain
• Execution mechanisms differentiation.
(1 + k e ) (1 + k e )2
profits to reinvest them in the business.
(1 + k e )∞
or after a specified date.
Multiple‐Year Holding Period DDM excess cash flow to pay out a dividend.
• Pure auction (order-driven) market: ranks buy and sell • It does not have sufficient
• Bonds with contingency provisions
orders on price precedence, then display precedence,
Equity Valuation
Even though V00 = the
n D
1 Dt
Gordon D2
growth model can Pn be used for valuing such companies, the • Callable: issuer has the right to redeem all or part of
then time precedence. ∑are 1 +t 2 + +
)n for common
forecasts• Dividend
used(1 + k+e )kdiscount
t =1 (1 generally
e)
(1 + kquite
e ) model (1 +(DDM)
uncertain. k e Therefore, analysts use stockone of the other the bond before maturity.
• Dealer/quote-driven/price-driven market: dealers valuation models to value such companies and may use the DDM model as a supplement.
• Putable: bondholders have the right to sell the bond
create liquidity by purchasing and selling against their where:
The year
One DDM
• holding
One-year
can beperiod:
extended
holding period
to numerous stages. For example:
© Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute
equityanvaluatiOn:
infringement of copyright.
cOnceptS and 75 back to the issuer at a pre-determined price on
Pn BaSic tOOlSat the end of n years.
= Price
own inventory of securities. equity valuatiOn: cOnceptS and BaSic
• tOOlS
A three-stage
dividendDDM is used to year-end
to be received value fairly priceyoung companies that are just entering specified dates.
• Brokered market: brokers arrange trades among their Infinite Period V =
the0 growthDDMphase. (Gordon
(1 + k eTheir
)1
Growth +
developmentModel)falls
(1 + k e )1 into three stages- growth (with very • Convertible: bondholders EQ have the right to convert the
clients. Multi‐StagehighDividend
growth rates), Discount Model(with decent
transition growth rates) and maturity (with a
Multi‐Stage Dividend
D (1 + g )1
Discount D (1 +
Model
g ) 2
D (1 + g ) 3
D (1 + g ) ∞ bond into a pre-specified number of common shares
• Features of a well-functioning financial system: timely Multiple‐Year lower growth
V0 = Holding0 cinto perpetuity).
Period + 0
DDM c
+ 0 c
+  + 0 c
• A• Gordon D growth
= (1 +1k eDDM
V0two-stage )1+ D 2 +model
(1
can be )2 + to
k+e used (constant
D(1 3
n+ k e )a company
value Pgrowth k e )∞ ofundergoing moderate of the issuer (can also have callable convertible bonds).
+ rate
(1currently
and accurate disclosure, liquidity (which facilitates  n +
n

V0dividends
growth, (1 +but )1 (1
Dk whose
= D11 e 1 +
+D k2e )2 rate (1
+ toDinfinity)
growth
2 2 + +
is+DPknne ) + (1to
expected e)
n
+Pknimprove (rise) to its long term • Contingent convertible bonds (CoCos): convert
operational efficiency), complete markets and external This equation V = + kk e ))1 to: + kk e ))2 +  + n
+ kk e ))n (1 + k e ) n
growth (1rate.
0 simplifies
(1 + (1 +
(1 (1 +
(1 automatically upon occurrence of a pre-specified
(or informational) efficiency. where:
e e e
event.
Valuation
where: Dn +1of Common
D (1 + gc Stock
) with
D1 Temporary Supernormal Growth
1

Indices where:
Pn =
kDe−
PPn == Price
V0 = 0
1atc the(k
n +g e − of
end
=
gc n)1 years.
k e − gc Fixed Income Markets
The
n correct valuation model to value such “supernormal growth” companies is the multi-
k e − gc
• Price-weighted index: value equals the sum of the Dstage
Infinite dividend
n = Last dividend
Period discount
DDM of the model thatgrowth
supernormal
(Gordon Growth combines
Model) the multi-period and infinite-period
period
The
D
D =long‐term
dividend
= First
Last (constant)
discount
dividend
dividend models.
of of
thethegrowth rate growth
constant
supernormal isgrowth
usually calculated as:
period
period • Public offering mechanisms: underwritten, best efforts,
security prices divided by the divisor (typically set to the n • Multi-stage
Dn+1 = First dividend
n+1
DDM auction, shelf registration
number of securities in the index at inception). D0 (1 + of gc the
)1 constant
D (1 + ggrowth
c)
2
Dperiod
0 (1 + g c )
3
D (1 + gc )∞
gVc0 ==RR(1×+ ROE
The Free‐Cash‐Flow‐to‐Equity + 0 (FCFE) + Model + + 0
k eD)11 (1 +D k 2e )2 (1 + k eD)3n Pn+ k e )
(1 ∞
• Corporate debt
• Equal-weighted index: each security is given an identicalThe Free‐Cash‐Flow‐to‐Equity
Value = + (FCFE) Model
2 + …+ +
weight in the index at inception (over-represents Where RRFCFEis the
(1 + k−e FC
=reinvestment
CFO )1 Inv(1 ++ kNet
e ) borrowing (1 + k e )n (1 + k e )n • Bank loans and syndicated loans (mostly floating-rate
This equation simplifies to: rate, or 1 – dividend payout rate.
securities that constitute a relatively small fraction of the FCFE = CFO − FC Inv + Net borrowing
where: loans).
target market and requires frequent rebalancing). Analysts may calculate
projections P =
of
DD
future
n +1 g )1
0 (1 +FCFE c
the intrinsic value of the company’s stock by discounting their
at D1required rate of return on equity.
the
• Commercial paper (unsecured, up to a maturity of one
Analysts mayV0 =calculate
n
k(ke −−ggc )the 1 =intrinsic value of the company’s stock by discounting their
• Market-capitalization weighted index: initial market k e − gc year).
projections of future e FCFE c at the required rate of return on equity.
value is assigned a base number (e.g. 100) and the Dn = Last ∞ dividend of the supernormal growth period
FCFE • Corporate notes and bonds.
change in the index is measured by comparing the new The long‐term
DV0n+1== ∑∞ First dividend
t
of the constant growth period
+ k e )t tgrowth rate is usually calculated as:
V0 = ∑ t =1 (1FCFE
(constant)
t
• Medium-term notes (short-term, medium- to long-
market value to the base market value (stocks with larger t =1 (1 + k e ) term, structured segments).
Value of a Preferred Stock
market values have a larger impact on the index). • gValuation
The Free-Cash-Flow-to-Equity
c = RR × ROE of preferred (FCFE) stock
Model
• Short-term wholesale funds: central bank funds,
Value of a Preferred Stock
© Wiley 2018
When • allNon-callable,
preferredrights reserved.
stock non-convertible
any unauthorized
is non‐callable, preferred
copying or distribution
non‐convertible, stock
haswillnoconstitute
maturity datewith
an infringement no
of copyright.
and pays 81
in itsinterbank funds, certificates of deposits
Market Efficiency Many analysts
Where
dividends
When RRatisathe
preferred
assert
fixedreinvestment
maturity
stock rate,
that a company’s
the value
is date rate,oforthe
non‐callable,
dividend-paying
1 –preferred
dividend stock
non‐convertible, payout can
has
capacity
rate.
nobematurity
should
calculated using
be reflected
the
cash flow estimates
perpetuity at formula:
instead of estimated future dividends. FCFE is date and pays
a measure of dividend• Repurchase agreements (repos)
dividends a fixed rate, the value of the preferred stock can be calculated using the
paying capacity and can also be used to value companies that currently do not make any
• Weak form EMH: current stock prices reflect all security perpetuity formula:
dividend payments. FCFE can be calculated as: • Repo: seller is borrowing funds from the buyer and
market information. Abnormal risk-adjusted returns V0 = 0
D providing the security as collateral.
cannot be earned by using trading rules and technical D r
V0 = 0
FCFE r= CFO − FC Inv + Net borrowing
• Reverse repo: buyer is borrowing securities to cover a
analysis. For a non‐callable, non‐convertible preferred stock with maturity at time, n, the value of short position.
• Semi-strong form EMH: current stock prices reflect the stock • canNon-callable,
be calculated usingnon-convertible
thepreferred
following formula:preferred stock with
For a non‐callable, non‐convertible stock with maturity at time, n, the value of • Repo margin or haircut: the percentage difference
all security market information and other public the stock canmaturity
be calculated at using
timethe n following formula:
n
Dt F
between the market value of the security and the
information. Abnormal risk-adjusted returns cannot be © Wiley 2018Vall0 =rights ∑n (1reserved. +any unauthorized copying or distribution will constitute an infringement of copyright. amount of 81 the loan.
t =1 D + tr) t (1 +Fr)n
earned by using important material information after it V0 = ∑ +
has been made public. © 2018 Wiley t =1 (1 + r)
t
(1 + r)n • Repo rate: annualized 365 interest cost of the loan.
where:
• Strong form EMH: current stock prices reflect all public where:
V0 = value of preferred stock today (t = 0)
• Any coupon income received from the bond provided
and private information. Abnormal risk-adjustedc14.indd
returns V • Price
D0t == expected
value multiples:
dividend
of preferred in price-to-earnings,
yeartoday
stock t, assumed
(t = 0) to be paid at theprice-to-sales,
end of the year price- as and
equity valuatiOn: cOnceptS security
BaSic tOOlS during the repo term belongs to the seller/

cannot be earned (assuming perfect markets where

365
Dr =t =required
expected rate
to-book, of return
dividend in on thet, stock
price-to-cash
year assumed flow.
to be paid at the end of the year borrower. 7 March 2018 7:15 PM

rF==required
par valuerateof preferred
of return on stock
the stock
information is cost-free and available to all). • Justified P/E ratio
Price Multiples
F = par value of preferred stock Fixed Income Valuation
• Behavioral biases that may explain pricing anomalies:
loss aversion, herding, overconfidence, information P0 D1 /E1
= • Bond pricing with yield-to-maturity (uses constant
cascades, representativeness, mental accounting, E1 r−g interest rate to discount all the bond’s cash flows)
conservatism, narrow framing.
• If coupon = YTM, the bond’s price equals par value.
Market price of share
• Enterprise value
ratio(EV):
= market value of the company’s • If coupon > YTM, the bond’s price is at a premium to
Risks of Equity Securities Price to cash flow
common stock plus the market value of outstanding Cash flow per share
82 © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. par.
preferred stock (if any) plus the market value of debt,
• Preference shares are less risky than common
82 shares. © Wiley 2018 all rights reserved. any unauthorized
Market price copying distribution will constitute an infringement of copyright. • If coupon < YTM, the bond’s price is at a discount to par.
per orshare
less
Price to cash
salesand short-term
ratio = investments (EV can be thought
• Putable common shares are less risky than callable or of as the cost of taking Net sales per share
over a company). • Price is inversely related to yield: when the yield
non-callable common shares. increases (decreases), the bond’s price decreases
• EV/EBITDA multiple is useful for comparing companies
• Callable common and preference shares are more risky Market value of equity
sales ratio =capital structures and for analyzing loss- (increases).
with
Price todifferent
Total net sales
than their non-callable counterparts. making companies. • Bond pricing with spot rates (uses the relevant spot rates
Current market price of share to discount the bond’s cash flows)
P/BV =
Book value per share
Wiley © 2019
Market value of common shareholders’ equity
P/BV =
Book value of common shareholders’ equity
 introduction to ASSet-BAcked SecuritieS

Wiley’s CFA Program Exam Review

underStAnding Fixed-income riSk
® introduction to Fixed-income VAluAtion
underStAnding Fixed-income riSk
Introduction to Asset-Backed Securities
Introduction to Fixed-Income Valuation Parties to the Securitization Money Duration underStAnding Fixed-income riSk

Pricing Bonds with Spot Rates Money Duration

Party in MoneyDur = AnnModDur × PVFull
Party Description Illustration Money Duration
MoneyDur = AnnModDur × PVFull
PMT PMT PMT + FV Seller Originates the loans and sells loans to the SPV ABC Company
PV = + +…+ The estimated (dollar) change in the price Full
of the bond is calculated as:
(1 + z1 )1 (1 + z 2 )2 (1 + z N ) N Issuer/Trust The SPV that buys the loans from the seller SPV MoneyDur = AnnModDur × PV
and issues the asset-backed securities The estimated Full
(dollar) change in the price of the bond is calculated as:
introduction to Fixed-income VAluAtion ΔPV = – MoneyDur × ΔYield
Servicer Services the loans Servicer
z1 = Spot rate for Period 1 The estimatedFull
(dollar) change in the price of the bond is calculated as:
ΔPV price of ×a ΔYield
z2 = Spot• rate
Spot rate:2yield on a zero-coupon bond for a given in = – MoneyDur
the full bond in response to a 1 bp change
for Period
zN = Spot rate
Introduction to Fixed-Income Valuation
maturity.
for Period N SMMt =
Prepayment in month t Price Value in
ΔPV ofFull
its aYTM
Basis Point
= – MoneyDur × ΔYield
Beginning mortgage balance for month t − Scheduled principal payment in month t
Price Value of a Basis Point
• Bonds
Pricing Accrued
with interest
Spot Rateswhen a bond is sold between coupon
Flat Price, Accrued Interest and the Full Price  (PV− ) − (PV+ )
payment dates • Prepayment risk: contraction risk occurs when interestPrice Value PVBP of a=Basis Point
PMT PMT PMT + FV (PV− ) −2 (PV+ )
PVBP =
Figure: Valuing
• PVFull = price: a Bond 1 + calculated
between 2 +…+as the PV
Coupon‐Payment N
Dates
of future cash flows as rates fall (leading to an increase in prepayments), while 2 (PV )
(1 + z1 ) (1 + z 2 ) (1 + z N ) (PV− ) −
of the settlement date. extension risk occurs when interest rates rise (leading Basis Point PVBP Value = (BPV) +
2
to a decrease in prepayments). • Approximate convexity: used to revise price estimates of
z1 = Spot• rate Accrued Basis Point Value (BPV)
for Periodinterest 1 (AI) included in full price: seller’s
z2 = Spot rate for Period 2 share of the next coupon, where t is the
proportional • CMOs (backed by pool of mortgage pass-through Basis Point
BPV = MoneyDur
option-free × 0.0001 (1 bps expressed as a decimal)
Value (BPV)bonds based on duration to bring them close
zN = Spot rate number for Period days N from last coupon date to the settlement securities): sequential-pay tranches (shorter-term to
BPV their actual ×values
= MoneyDur 0.0001 (1 bps expressed as a decimal)

date and T is the tranches receive protection from extension risk, longer-Annual Convexity
and number of days in the coupon period BPV = MoneyDur × 0.0001 (1 bps expressed as a decimal)
Flat Price, Accrued Interest the Full Price  Annual Convexity
(actual/actual for government bonds, 30/360 for term tranches receive protection from contraction (PV− ) + (PV+ ) − [2 × (PV0 )]
PV Full = PV Flat + AI ApproxCon =
Figure: Valuing corporate a Bond between bonds)Coupon‐Payment Dates risk); PAC/support tranches (support tranche provides Annual Convexity (PV−()∆+Yield)
2
(PV+ ) −×[2 (PV 0 ) 0 )]
× (PV
protection against contraction and extension risk to ApproxCon = 2
(PV−()∆+Yield)(PV+ ) −×[2 (PV ) )]
× 0(PV
AI = t/T × PMT the PAC tranche); floating rate tranches (floater and Price Effects ApproxCon = 0
• TheBased percentage
on Duration ( ∆change
and Convexity
Yield) 2
in 0a) bond’s full price for a
× (PV
inverse floater).
• PVFlatFull or clean or quoted price: full price less AI, or Price Effects given Based change
on Duration in yield based
and Convexity on duration with convexity
equivalently
= PV × (1 + r) t/T • Credit enhancements for non-agency RMBS: internal Price Effects adjustment
%∆PV Full
Based is estimated
≈on(−Duration
AnnModDur as follows:
× ∆Yield)
and Convexity
1
+  × AnnConvexity × ( ∆Yield)2 
(cash reserve funds, excess spread accounts,  12 
%∆PV Full ≈ (− AnnModDur × ∆Yield) +  × AnnConvexity × ( ∆Yield)2 
Semiannual bond basis yield or semiannual bond equivalent yield overcollateralization, senior/subordinate structure)  21 
Full
= PV + AI Flat
%∆PV Full 
≈ (− AnnModDur × ∆Yield) +  × AnnConvexity × ( ∆Yield)  2
PV and external (monoline insurers). Money convexity 2 
M N
 1 + SAR M  =  1 + SAR N  • Commercial MBS (backed by non-recourse commercialMoney convexity
    1
• Yield

AI = t/Tmeasures M× PMT   N 
mortgage loans): investors have significant call ∆PV Full ≈ (− MoneyDur × ∆Yield) +  × MoneyCon × ( ∆Yield)2 
Money• convexity
Effective convexity: use for bonds 12
∆PV Full ≈ (− MoneyDur × ∆Yield) +  × MoneyCon × ( ∆Yield)2 
with embedded 
• Effective annual annual rateyield
(SAR) isdepends
referred to in the on periodicity ofpercentage
the rate. We protection but are exposed to balloon risk (like
Important: What we refer to as stated curriculum as APR or annual
options instead of approximate  21 convexity. 
stated
stick to SAR to keep
PV Fullyour focus annual
= PV × (1 + r) on a statedt/T yield.
annual rate versus the effective annual rate. Just remember that if you see an annual extension risk). Effective∆convexity
PV Full 
≈ (− MoneyDur × ∆Yield) +  × MoneyCon × ( ∆Yield)  2 
FundAmentAlS oF credit AnAlySiS • Callable bonds can exhibit negative convexity when
percentage rate on the exam, it refers to the stated annual rate.
2 
• Annual-pay bond: stated annual yield for periodicity of • Non-mortgage asset-backed securities: auto-loan Effectivebenchmark
convexity
Current yield [(PV− )yields+ (PV+ )]decline.
− [2 × (PV0Putable)] bonds always exhibit
Semiannual one bond= basis effective yield orannual semiannual yield.bond equivalent yield receivable-backed securities (backed by amortizing EffCon =
Effectivepositive
convexity[(PV convexity.
()∆+Curve) 2
(PV+ )] − × [2
(PV ) 0of
× 0(PV
auto loans) and credit card receivable-backed −Fundamentals )] Credit Analysis
• Semiannual-pay M Annual cash coupon
bond: stated payment annual yield for EffCon = 2
Current SAR
 1periodicity M = 
yield SAR N  N securities (with lockout period before principal [(PV−( ∆ (PV+ )] ×
) +Curve) (PV
− [2 ) )]
×0(PV

+
M 
 = of

1 + two =
Bond
N 
semiannual
 price bond basis yield
amortizing period sets in).
Credit Analysis
Expected Loss=
EffCon
Yield Volatility ( ∆Curve)2 × (PV0 )
0

= semiannual bond equivalent yield = yield per

Yield Volatility
to Fixed-income VAluAtion semiannual period × 2. • CDOs: structured as senior, mezzanine and FundAmentAlS oF credit AnAlySiS • Two
Expected loss = Default probability × Loss severity given default
components of credit risk:1default risk (or default
%∆PV Full ≈ (− AnnModDur × ∆Yield) +  × AnnConvexity × ( ∆Yield)2 
to Fixed-income
to Fixed-income VAluAtionWhat we refer to as stated annual rate (SAR) is referred to in the curriculum as APR or annual percentage rate. We
Important:
VAluAtion
• onCurrent © Wiley subordinated bonds (or equity class). CDO manager Yield Volatility probability) and loss severity (or  12 loss given default). Loss
stick to SAR to keep your focus on a stated annual rate versus the effective annual rate. Just remember that if you see an annual
yield: annual cash coupon payment divided by 89 
× ∆Yield) +  × AnnConvexity × ( ∆Yield)2 
percentage rate the exam, it refers to the stated annual rate. 2018 All rights reserved. AnyFIXED
unauthorized
INCOME copying or distribution will constitute an infringement of copyright. Full
engages in active management of the collateral to Yield %∆aPV
on corporate ≈ (− AnnModDur
bond:1 minus
the bond price. severity equals Fundamentals theof recovery
 21
Credit rate.
Analysis 
Option‐adjusted
Option‐adjusted price
price  × AnnConvexity 2
Current yield price
Option‐adjusted generate the cash flow required to repay bondholders % ∆ PV
• Expected
Full
≈ ( − AnnModDur × ∆ Yield) + × ( ∆ Yield)
• Yield-to-call: computed for each call date. underStAnding
FIXED INCOMEFixed-income riSk And return
Duration Gap
Yield on a corporate loss bond = Real risk-free 2interest rate + Expected inflation  rate
The Maturity Structure of Interest Rates and to earn a competitive return for the equity tranche.Duration Expected Gap Loss + Maturity + Liquidity premium + Credit spread
• Current
Value
Value
Value
of non‐callable
Yield-to-worst:
of
of
non‐callable
non‐callable
yield =
Annual bond
lowest
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bond
(option‐adjusted
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cash(option‐adjusted
coupon
(option‐adjusted among
payment price) =
price)
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of
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price of
callable
callable
bond
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bond
Fixed-income riSk And return Duration gap = Macaulay duration premiumhorizon
− Investment
+ Value
Value of embedded
embedded call call option Understanding Fixed-Income Risk and Return
Interest Rates
Thevarious
spot rate curve yieldsreflects to call.
Bond rates for a range of+
spotprice Value of
+ maturities.
of embedded Interest Rate Risk
call option
option feature
The distinguishing DurationDuration
Gap gap
Expected loss==Macaulay duration −×Investment
Default probability Loss severity given default
horizon
of• spot rates is that theypricing are yields that have no element of reinvestment risk. Using Duration
spot Yield Spread:
Money Market
Money
Money
Market Pricing, market
Pricing, Discount-rate Discount-rate basis on
basis a discount rate basis Macaulay Understanding Fixed-Income Risk and Return
Basics of Basics of Derivative
Derivative Pricing ©anDPricing
Wiley Duration
anD
2018
valuation valuation
All rights gap = Macaulay
reserved. Any duration
unauthorized copying− Investment
or distribution horizon
will constitute an infringement of copyright.
Money rates Allofprovides
Market Pricing, a more accurate
Discount-rate relationship
basis orfeature between yieldsanand terms oftocopyright.
maturity relative 87 interest rate risk
spot rates for © Wiley 2018
a range rights
maturities.reserved. Any
The unauthorized
distinguishing copying distribution will constitute infringement • Two types of Yield• on
Spread
a corporate risk consists
bond:
= Liquidity of downgrade
+ Credit risk (or credit
yields that have no to element
using yields to maturity on
of reinvestment risk. coupon-bearing
Using spot Treasuries. Macaulay Duration1 + r 1 + r + [N × (c − r)]  © Wiley 2018Yield spread
All rights reserved. premium
Any unauthorized copying spread
or distribution will constitute an infringement of copyright.
 • MacDur
Reinvestment − risk: future value migration risk) and market liquidity risk.
 − (t/T)of any interim bond
Days Basics of=Derivative Pricing +and Valuation
PV = = FV FV ×  11and − Days Days × DR  = Basics of Derivative Pricing and Valuation
ate relationship between PV = FV yields ×
×  1for
−
− terms × DR
× DR 
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
relative underStAnding Fixed-income riSk And return
2018Yield on a corporate bond Real risk-free interest
willrate Expected inflation rate
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n coupon-bearing Treasuries. 
yield curve year
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 r increases
1 + r 1 + r + [N × (c − r)] 
− 1] + r  when interest rates © Wiley For small,
All rights
• Fundamental
Corporate
reserved.
instantaneous
Any unauthorized
familychanges rating
in+the
copying
(CFR):
Maturity
or distribution
yield spread, issuer
premium
constitute
the+rating.
Liquidity
return
an infringement
impactpremium
of copyright.
+ Credit
(i.e. the spread
percentage
of different maturities. To build the Treasury yield curve, analysts use only the most = − − Fundamental Value of Value
an of an
Asset Asset
rise
MacDur (decline).

Understanding c ×Matters r) N −more
1] + r  to long-term
[(1 +Fixed-Income
 (t/T)
Risk and Return investors. change in price, including accrued interest) can be estimated using the following formula:
recently-issued and actively-traded government bonds as they have similar c =liquidity
Coupon and
rate per
r
period (PMT/FV) • Corporate credit rating (CCR): rating for a specific issue.
nds shows the yields-to-maturity
DR
tax status.
 Year  for
=  Year Year YTMs  × × for
FV
FV − PV 
coupon-paying
−
− PV
FVmaturities
PV 
bonds
where there are gaps can be estimated through a variety • Market of price risk: selling price of a bond decreases Yield Spread:  impact  E(ST ) 
T )≈ −Modified
uild the Treasury yield DR
DR =
=  Days
curve,  ×  use
analysts FV only  the most Macaulay Duration • Four
Return SE(S
Cs:0 =capacity, γ −duration
θ + γ × covenants,
 (1T+ r −+ θλ+)Tcollateral, ∆Spread character.
Days FV
FV  cModified rate per period when
(increases)
Duration interest rates rise (decline). Matters S 0 =
-traded government interpolation
bonds as they
Daysmethods.
have similar liquidity and
= Coupon (PMT/FV)  (1 + r +λ)  
ies where ©there are gaps can be estimated through a variety of
more to short-term investors. • Yield spread
Return
Where:
impact= Liquidityof a premium
change + in
Credit
thespread
credit spread (includes
Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute
suchanthat
infringement Modified
of copyright. Duration  1
The== MacDur + 87r 1 + r + [N × (c − r)]  Where:
For larger changes inadjustmentthe yield spread, welarger
must also incorporate the (positive) impact of
Money
Money A
Money Market • parMoney
Market curve Pricing,
Pricing, represents
market Add-on
Add-on a series
Rate Basis
Rate
Rate Basis
pricing
of yields-to-maturity
on an add-on rate basis
each bond trades at MacDur
par.
• Macaulay
ModDur −
duration: weighted  −average
(t/T) of the time it convexity for changes)
Market Pricing,
par curve is derived from the spot rate curve.
Add-on Basis N
 1r+ r c × [(1 + r) − 1] + r  risk rfree
r =convexity = risk
intofree
rate ourrateestimate of the return impact:
would take to receive all the bond’s promised cash flows. For small,
λ risk instantaneous
= asset risk premium changes in the yield spread, the return impact (i.e. the percentage
MacDur DERIVATIVEs λ = asset premium
FV
FV ModDur = change θ =inStorage,
price, including
insurance, accrued
andcosts interest)
other can be estimated
value using the following formula:
ies of yields-to-maturity PV= such that FV each bond trades at par. The θ = Storage, insurance,
impact and other at costs
present at present
value× Convexity × ∆Spread 2 )
e spot rate curve.
PV=
Forward
PV=  1 +Curve
 1
Days
Days AOR 
× AOR cModified• Modified
= Coupon rate perhas
duration
1 + r (PMT/FV)
duration:
period
a very important estimated
application percentage
in risk management. price change It can be usedγ =
Return
γ = Convenience
toConvenience
≈ −(MDur
andbenefits
× ∆Spread)
other benefits
+ (1/2
at present
value value
+ Days × and other at present
 1 + Year Year × AOR  estimate for
the a bond
percentage in response
price change for to
a a
bond100in bps
response (1%) to achange
change inin
its yields
yield‐to‐ Return impact ≈ − Modified duration × ∆ Spread
A forward Year rate represents the interest rate on a loan that will be originatedModified at someduration
Modified
maturity. point inhas a very important application in risk management. It can be used
Duration Derivatives
to
Arbitrage
Pricingand
Arbitrage
and Replication:
versus Valuation
Replication:
the future. Forward rates are used to construct the forward curve, which represents estimate thea percentage
series price change for a bond in response to a change in its yield‐to‐
 Year
rates,be×each
Year − PV
FVhaving
 FV PV the same horizon. Typically the forward curve • Price, asAsset
For larger changes in
it relates the yield
to
+ Derivative spread,
forwards, we mustand
futures,
= Risk-free alsoswaps
incorporate
(note the
that(positive)
options are impactnot of
a
=  Year − PV at MacDur asset asset
DERIVATIVES
FV
e interest rate on of AOR
forward
AOR
a AOR
loan that
=
= will
 Days × originated
 ×
− some point in shows%
maturity. one-
∆PV Full=≈ − AnnModDur × ∆Yield
ModDur convexity
Asset + Derivative
into our estimate
= Risk-free
of the returnto impact:
year forward Days rates  PV PV  1+ r problem in this regard), refers the fixed price (that is agreed upon at contract
 Days
used to construct the forward curve, which represents a series  stated PVon a semiannual bond basis
initiation) at which the underlying transaction will take place in the future. These
PV Full ≈ −
%∆duration × ∆Yield Asset − Risk-free asset = − Derivative
g the same horizon. Typically the forward curve shows one- If Macaulay isAnnModDur
not already known, annual modified duration can be estimated Return− impact
Asset
securitiesRisk-free
do not≈− asset
(MDur
require= −an
×Derivative
∆outlay
Spread)of+cash
(1/2 ×atConvexity × ∆Spread so
contract initiation, ) there is no 2

a semiannual
Implied forward rates (also known as forward yields) can be computed from
bond
Yield
Yield • basis
Spreads
Spreads over the
over the Benchmark
Benchmark
Bond-equivalent Yieldmoney-market
yield:
Yield Curve
Curve
Yield Spreads over the Benchmark Yield Curve
spot rates.
rate stated on a Modified • Iffollowing
using the duration
Macaulayhas a very
formula: important
duration is application
not known, in risk management.
annual It can be used to
modified Types
concept ofof derivatives
a price being paid at the beginning.
estimate the percentage price changeknown,
for a bond in response to a change inbeitsestimated
yield‐to‐
these −contracts = − Asset
FI
If the 365-day
yields presented year onare ansemiannual
add-on basis. bond basis: If Macaulay
maturity.
duration can
duration is notbe estimated
already using
annual the following
modified duration formula:
can • The value
DerivativeDerivative
− Risk-free
of Risk-free −asset
asset = fluctuate
Asset in response to changes in the price of the
+ FV
known as forward yields) can
PV =
• Forward
PV =
PMT
PMT
PMT be computed
+
+
PMT
PMT
PMT from spot rates.
+
+ .
. .
. .
. +
+
PMT +
PMT
PMT +
FV
FV using the following formula: (PV− ) − (PV+ )
ApproxModDur = • underlying.
Forward commitments: forwards, futures, interest rate
PV = (1 (1 + + zz11rate
+ Z)111 + (1
+ Z) (1 + + zz 22 + Z)222 + . . . + (1
+ Z) + zz NN +
(1 + + Z)
Z)NN
N
2 × ( ∆Yield) × (PV )
emiannual bond basis: 1 + 6-mth (1 + zspot
1 + Z) rate (1+ z 2 6-mth + Z) forward (1 +rate
zN 6 + Z)
mths from now   FI 12-mth spot rate Full 2
(PV− )×−∆(PV
0 Forward swaps.
Forward
Contract Contract
Payoffs:Payoffs:
 • Interest rate on   1a+ loan originating at some point  =in 1the
+ %∆PV ≈ − AnnModDur Yield+)
2 ApproxModDur
 =
future.
2 2
We can also use the
2 × ( ∆Yield) × (PV0 )
approximate modified duration (ApproxModDur) to estimate
FORWARD• Contingent
CONTRACTS claims: options,
ST > F(0,T)creditSderivatives. ST < F(0,T)
• The
• The benchmark
benchmark spot spot rates
rates zz11,, zz22,, zzNN are are derived
derived2 from
from the
the government
government yield
yield curve
curve ST > F(0,T) T < F(0,T)
•
-mth forward rate 6 mths
The from now
benchmark spot on interest
rates z12-mth
1, z2, zN spot rate  from the
are derived government yield curve
If Macaulay duration is not already known, annualthe modified duration can be estimatedLong position
Long position – F(0,T)where one
STparties, S
(or calculate
from fixedfixedthe rates = 1 + rate swaps).
swaps). Macaulay duration (ApproxMacDur) by applying following formula: T – F(0,T)
2
To
(or
(or• Implied
from
from rates
fixed rates 
x-period
forward on interest
 on interest forward
rates ratecan
rate rate
swaps).
2
y 
periods
be computed
 from today, simply
from spot remember
using
the
the following
We can• also formula:
use the approximate
A forward is a contract between S T – F(0,T)
two
(Positive Derivative Pricing and Valuation
ST (the
payoff) (Negative
– F(0,T)long position) has the obligation
(Negative payoff)
• Z
• Z refers to
• following
Z refers
rates.
refers
to the
the z‐spread
to formula:
the z‐spread
z‐spread Note per period.
perthat
per period.
x and
period.
It is
It
It is
constant
y here
is
for all time
respresent
constant
constant for
for all
time periods.
the periodic
all time periods. spot rate.
periods. Effective duration:modifiedmeasures duration
the(ApproxModDur)
sensitivity of to a estimate to buy, and the other (the(Positive payoff)has
short position) an obligation topayoff) sell an underlying asset at a
MacaulayApproxMacDur
duration (ApproxMacDur) by applying
= ApproxModDur × (1 + r) the following formula:
ward rate Option‐adjusted
y periods from today,
Option‐adjusted Spread simply
(OAS) remember the bond’s price to a change in
(PV− ) − (PV+ ) the benchmark yield curve fixed forward
Short
Short• position
price (that
position established –[S at –the inception
F(0,T)] of the contract)
–[S T F(0,T)]
– at a future date.
Option‐adjustedy Spread Spread (OAS) ApproxModDur = Derivative pricing –[ST – is based
F(0,T)]
T
on risk-neutral
–[ST – F(0,T)] pricing.
(1 + y s0 the
t x and y here respresent + x fy )(OAS)
) (1periodic x
=spot(1 +rate. x+ ys0 )
x+ y
(appropriate
ApproxMacDur =measure2 × ( ∆Yield)
ApproxModDur for bonds
× (PV 0 )+ r)
× (1 with embedded options) (Negative (Negative
payoff) payoff) (Positive(Positivepayoff) payoff)
OAS =
OAS = z‐spread
z‐spread − − Option
Option value value (bps
(bps per per year)
year)
Effective Duration • • Forward contracts
Typically, no cash changes hands at inception.
OAS = z‐spread − Option value (bps per year) • Forward
Forward The long price:
position benefits when the price of the underlying asset increases, while
ys0 )
x+ y
We can also
Effective use the approximate
Duration (PV− ) − (PVmodified
+)
duration (ApproxModDur) to estimate • price:
the Price at contract
short benefits when the initiation
price of the (assuming
underlying asset underlying
falls. asset
MacaulayEffDur
duration= (ApproxMacDur) by applying the following formula: entails benefits and
T costs) by price movements defaults on its
Implied Forward
Implied Forward Rates Rates 2 × ( ∆Curve) × (PV0 ) • IfF(0,T)
the party
= S that
F(0,T)
(1 +=is
r) 0 (1 + r)
STadversely affected
Implied Forward Rates (PV− ) − (PV+ ) 0
EffDur = commitment, the counterparty with the favorable position faces default risk.
ApproxMacDur = ApproxModDur
2 × ( ∆Curve) × (PV0 ) × (1 + r) • ForwardsF(0,T)are a zero-sum
(1
(1
+ z ) AA (1
(1 + (1 +
+ zz AA )) A (1
IFRAA,,BB−− AA )) BBB−−− AAA =
+ IFR
+ IFR )
= (1
(1 +
= (1
+ z ) BB
+ zz BB )) B • Key
Duration of a rate
Bond duration:
Portfolio measure of a bond’s sensitivity to a F(0,T) = (S − γ= +(Sθ0)(1 − γ+ +r)game—one
θT)(1
or +F(0,T)
party’s=gain
r)T or =F(0,T) (1(is
S (1 + r)ST0 −
the
+γ r) T other Tparty’s Tloss.
− ( γ+ −r)θ)(1 + r)
− θ)(1
A A, B − A B 0 0
 (1 + z ) BB 
• Yield = ((( BBB−−− AAA))) (1 + zz BB )) B  − 1
(1 + Effectivechange
Duration in the benchmark yield for a given maturity (usedPricing *and Valuation of Forward Contracts
IFRAAA,,,BBBspreads
IFR −− AA =  −1 Duration of a Bond Portfolio
IFR Portfolio
yield= curve
duration w1D1 + w2 D2 +…+ w N D N Note that benefits (γ) and (θ)costs (θ) are expressed
in termsinofterms of present
value. value.
B
−A =  + zz AA )) AAA  − 1
(1 + to assess risk, i.e. non-parallel shifts in the *Note that benefits (γ) and costs are expressed present


(1
(1 + z A )  92 © Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
• G-spread:  spread over government bond yield. yield curve) (PV ) − (PV+ )
EffDur = duration− =Annual
The price of a forward contract is the fixed price or rate at which the underlying
Portfolio w1D1 +MacDur
w2 D2 +…+ w N D N Value ofValue
transaction
of a forward
a forward
will occur contract:
at
contract:
contract expiration. The forward price is agreed upon at initiation
• I-spread: spread over the swap rate. • Portfolio 2 × ( ∆Curve)
Annual ModDur =
duration:
× (PV0 )
1weighted
+r average of the durations of of the forward • Value of a forward contract during its life (long
contract. Pricing a forward contract means determining this forward price.
• Z-spread: spread over the government spot rate. the individual position)
V (0,T) = S − [F(0,T) t + r)T − t ]
T/−(1
ModDur = bonds held in the portfolio, where each
Annual MacDur Vt (0,T) =t St − [F(0,T) t / (1 + r) ]
Annual
Durationbond’s
of a Bond Portfolio
weight equals 1 + rits proportion of the portfolio’s The value of a forward contract is the amount that a counterparty would need to pay, or
• Option-adjusted spread: z-spread less option value would expect to V (0,T)
receive, = S
to −
get( γout
− θtof
)(1its t
+ r)(already-assumed)
− [F(0,T)T/−(1 t + r)T − t
]
forward position.
(bps market value riSk=And
Vt (0,T) t St − ( γ − θ
return )(1 + r) − [F(0,T) / (1 + r) ]
rightsper year). t
© Wiley
Wiley 2018
2018 All
All reserved. Any unauthorized
unauthorized copying
copying or
or distribution
distribution will
will constitute
constitute an
an infringement
infringement of copyright. Portfolio duration = w1D1 + w2 D2 +…+ w N D N
of copyright. underStAnding Fixed-income
©
© Wiley 2018 rights
All rights reserved.
reserved. Any
Any unauthorized copying or distribution will constitute an infringement of copyright. 92 © Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
• © 2018
Asset-backed securities • Money duration: measure
395
of the dollar price change in Valuing a Forward Contract at Expiration (t = T)
Wiley
response to a change Annual MacDur in yields • Value of a forward contract at expiration (long position)
• Residential MBS: agency RMBS vs non-agency RMBS Money Duration Annual ModDur =
1+ r
(require credit enhancements). 90 395 © Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. VT (0,T) = ST − F(0,T)
Full
MoneyDur = AnnModDur × PV DR
c15.indd 395
• Mortgage pass-through securities (backed 90 by pool of © Wiley 2018 All rights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
7 March 2018 8:48 PM

residential mortgage loans): single monthly mortality • Forward rate agreement (FRA)
rate (SMM). 7 March 2018 8:48 PM • Price(dollar)
The estimated valuechange
of a in the price
basis pointof the bond is calculated
(PVBP): estimates as: the changeForward Contract Payoffs at Expiration
• Long (short) position can be viewed as the party that
94 94 © Wiley
© Wiley 2018 2018 reserved.
all rights all rights reserved. any unauthorized
any unauthorized copying orcopying or distribution
distribution will constitute
will constitute an infringement
an infringement of copyright.
of copyright.
ΔPVFull = – MoneyDur × ΔYield ST > F(0,T) ST < F(0,T)
Long position ST − F(0,T) Wiley © 2019
ST − F(0,T)
90 © Wiley 2018 Allofrights reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
Price Value a Basis Point (Positive payoff) (Negative payoff)
Short position −[ST − F(0,T)] −[ST − F(0,T)]
 Wiley’s CFA Program Exam Review
®

Basics of Derivative Pricing anD valuation

has committed to take (give out) a hypothetical loan. Impact of an increase in: Call Put • Development capital: includes private investment in
Basics of Derivative Pricing anD valuation
• If LIBOR at FRA expiration > FRA rate, the long benefits. Lowest Prices of European Calls and Puts public
Basics of Derivative Pricing equities (PIPEs).
anD valuation
Value of the underlying Increase Decrease
• If LIBOR at FRA expiration < FRA rate, the short benefits. X • Distressed investing: buying debt of mature companies in
Exercise price c 0 ≥PutsDecrease −
Max[0,S Increase
] financial distress.
Lowest Prices of European Calls and 0
(1 + R F )T
• Futures: similar to forwards but standardized, exchange-Lowest Prices Risk-freeof European
rate Calls and Puts Increase Decrease • Exit strategies: trade sale, IPO, recapitalization,
traded, marked-to-market daily, clearinghouse cTime to expiration
X
secondary sale, write-off/liquidation.
0 ≥ Max[0,S 0 − X T ] Increase X Increase (except for
guarantees that traders will meet their obligations c 0 ≥ Max[0,S0 − (1 + R F )Tp0] ≥ Max[0, − S0 ]in-the-money
deep
(1 + R F ) (1 + R F )T • Valuation methods for portfolio company: market or
• Forward vs futures prices European puts) comparables approach, discounted cash flow approach,
X
• If underlying asset prices are positively (negatively) pVolatility
0 ≥ Max[0, of theXPut‐Call ] Increase
T − S0Forward Parity Increase asset-based approach.
≥
punderlying
Max[0, (1 + R ) − S ]
correlated with interest rates, the futures price will be 0 F
(1 + R F )T
0 • Real estate
[X − F(0,T)]
higher (lower) than the forward price. Put‐Call Benefits
Forwardfrom Paritythe p0 − cDecrease
0 =
IntroductIon to AlternAtIve Investments• Investment categories: residential property, commercial
Increase
(1 + R F )T
• If futures prices are uncorrelated with interest rates Put‐Call underlying Forward Parity real estate, REITs, timberland/farmland.
[X − F(0,T)] •
or if interest rates are constant, forwards and futures pCost of carry
0 − c 0 = [X − F(0,T)]Binomial
T
Increase
Option Pricing
Decrease Performance measurement: appraisal indices (tend
Commodity Prices and Investments
would have the same price. p0 − c 0 = (1 + R F )T to understate volatility), repeat sales indices (sample
• One-period (1 + R Fbinomial
) model for −a call option (based on
+
πc + (1 − π)c Spot prices for selection
commodities bias),are REIT indices
a function (based
of supply on prices
and demand, costsofofpublicly
production and
• Interest rate swaps Binomial Option risk-neutral
Pricing probability c= π)(1 + r) storage, value traded
to users,shares
and globalof REITs).
economic conditions.
Binomial Option Pricing
• The swap fixed rate represents the price of the swap + − • Real estate valuation approaches: comparable sales
πc + (1 − π)c • Demand for commodities depends on global manufacturing dynamics and
(swap has zero value to the swap counterparties at c = πc + + (1 − π)c − approach,
c= (1 + r) π=
(1 + r − d) economic growth. income approach
Investors anticipate (direct
demand capitalization
changes by looking at economic
swap initiation). (1 + r) (u − d) events,method
governmentandpolicy,
discounted
inventorycashlevels,flow method),
and growth cost
forecasts.
• If interest rates increase after swap initiation, the swap
vative Pricing anD valuation
(1 + r − d)
• Supply approach.
of many commodities is relatively inelastic in the short run as a result of
π = (1 + r − d) the extended lead times required to increase production (e.g., to drill oil wells or to
will have positive value for the fixed-rate payer. π = (u − d)
S +
Where u = 1 and d = 1
S −
• REIT valuation approaches: income-based approaches,
plant crops).
(u − d)
• As aasset-based approaches
prices tend to(NAV).
S0 S0
Moneyness • Ifand
interest
Exerciserates
Valuedecrease after swap initiation, the swap
of a Put Option result, commodity fluctuate widely in response to changes in
will have positive value for the floating-rate payer. S+ S− • demand.
Commodities Note that both demand and supply are affected by the actions of non-
Where u = S1+ and d = S1− Hedge ratio hedging investors (speculators).
• An interest rate
Current Market Price (St)
swap can be viewed
Intrinsic Value Max
as a combination Where ALTERNATIVE
u = S10 and d = S10
INVESTMENTS • Investors prefer to trade commodity derivatives to
Moneyness versus Exercise Price (X) [0, (X – St)] S0 S0
of FRAs. c+ − c − avoid costs
Pricing of Commodity of transportation
Futures Contracts and storage for physical
In‐the‐money St is less than X X – St Hedge ratio n= +
Hedge• ratio
Potential benefits of alternative S − S− investments: low commodities.
• Options
At‐the‐money St equals X 0
Out‐of‐the‐money St is greater than X 0 correlations
c+ − c − with returns on traditional investments and • Price of a commodity futures contract.
The price of a futures contract on a commodity may be calculated as follows:
• Call (put) option gives the holder/buyer the right to buy n = c++ − c −−
higher
Lowest Prices of American Calls and Puts
returns than traditional investments
n = S+ − S Futures price = Spot price × (1 + Risk-free short-term rate)
(sell) the underlying asset at the exercise price. S −S −
• Hedge funds C0 ≥ Max[0, S0 − X/(1 + RFR)T ] + Storage costs − Convenience yield
Fiduciary Call and Protective Put Payoffs
• European option: can only be exercised at the option’s Lowest Prices of American Calls and Puts
• Event-driven
Lowest Prices of American strategies:
Calls and Puts merger arbitrage, distressed/
Security
expiration. Value if ST > X Value if ST < X C0restructuring,
≥ Max[0, S0 − X/(1 activist,
P0 ≥T special
+ RFR) ]Max[0, (Xsituations.
− S0 )] Holders of• commodities
When the lose futures
out onprice is higher
the interest (lower)
that they wouldthan the spot
have earned had they held
• American option:Scan
Call option T –X be exercised atZero any point up to ≥ Max[0, Svalue
• C0Relative 0 − X/(1 + RFR)T ] fixed income convertible
strategies: cash. Further, price, prices
they incur arecosts
storage saidontocommodities.
be in contango The long (backwardation).
position in the futures
contract gains possession of the commodity in the future without investing cash at present
Zero coupon the option’s expiration.
bond X X P0 arbitrage,
≥ Max[0, (X fixed− S0 )] income asset backed, fixed income • Sources of return on a commodity futures contract: roll
and avoids incurring storage costs. Therefore:
P0 general,
≥ Max[0, (X volatility,
− S0 )] multi-strategy. yield, collateral yield, spot prices.
Fiduciary • Call (put) option is in-the-money when the stock price
call payoff ST X
is higher (lower) than the exercise price. • Macro strategies: long and short positions in broad • • TheInfrastructure
spot price is multiplied by (1 + r) to account for the time value of money.
Put option Zero X – ST markets (e.g. equity indices, currencies, commodities, • Storage costs are added in computing the futures price.
• Intrinsic or exercise value: the amount an option is • Investments in real, capital intensive, long-lived assets.
Stock ST ST etc.) based on manager’s view regarding overall macro On the other • Economic infrastructure: assets such asconvenience
transportation
Protective putin-the-money
payoff by (minimum
ST value of 0). X
hand, the buyer of a futures contract gives up the of having
environment. and utility
physical possession of the assets.
commodity and having it available for use immediately.
• Put-call parity for European options (options and bond • Equity hedge strategies: market neutral, fundamental Therefore,• the futures price is adjusted for the loss of convenience. The convenience yield
have the same time to expiration/maturity T) Social infrastructure: assets such as education,
is subtracted to arrive at the futures price. The futures price may be higher or lower than
Put‐Call Parity growth, fundamental value, quantitative directional,
the spot pricehealthcare
of a commodity, anddepending
correctionalon the facilities.
convenience yield.
short bias, sector specific. • Brownfield investments: investments in existing
c0 +
X
= p 0 + S0 • Two types of fees: management fee (based on assets • When futures prices areassets.
infrastructure higher than the spot price (when there is little or no
(1 + R F )T under management) and incentive fee (which may be convenience yield), prices are said to be in contango.
• When • anGreenfield
futures prices investments:
are lower than the investments
spot 97 in infrastructure
price, prices are said to be in
subject to a ©hurdle Wiley 2018rate or reserved.
all rights high water mark copying
any unauthorized provision).
or distribution will constitute infringement of copyright.
assets to be constructed.
Combining Portfolios to Make Synthetic Securities backwardation.
• Put-call parity formula can be rearranged to create • Private equity • Risk-return 97 measures
synthetic call, put, underlying asset and bond, e.g. • allLeveraged
© Wiley 2018 rights reserved.buyouts (LBOs):
any unauthorized copying ormanagement buyouts
distribution will constitute (MBOs)
an infringement There are three sources of
of copyright. return on a commodity futures contract:
Consisting rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. • Sharpe ratio 97 is not appropriate risk-return measure since
synthetic call = long put + long underlying stock + short© Wiley 2018 alland management buy-ins (MBIs).
of Value Equals Strategy Consisting of Value 1. Roll returns
yield: Thetend to bebetween
difference leptokurtic
the spot andprice negatively
of a commodity skewed.
and the futures
bond). • Venture capital: formative stage financing (angel
long call + X = Protective put long put + long p 0 + S0 • Downside
price, or the difference between the futures
risk measures more prices
useful,of contracts
e.g. value expiring
at riskat different
long bond c 0 • + Factors T affecting the value of an option
underlying asset investing, seed-stage financing, early-stage financing), dates.
(VAR), shortfall risk, Sortino ratio.
(1 + R F )
later-stage financing, mezzanine-stage financing. 2. Collateral yield: The interest earned on the collateral (margin) deposited to enter
long call c0 = Synthetic call long put + long into the futures contract.
X
underlying asset p 0 + S0 − 3. Spot prices: These are influenced by current supply and demand.
(1 + R F )T
+ short bond
long put p0 = Synthetic put long call + short X
underlying asset c 0 − S0 +
(1 + R F )T
+ long bond
long S0 = Synthetic long call + long
244 © 2018 Wiley
X
g underlying underlying bond + short put c0 + − p0
(1 + R F )T
asset asset

Wiley’s CFA Program Exam Review

d long bond = Synthetic long put + long p0 + S0 – c0 ®
X r58.indd 244 10 August 201

bond underlying asset

(1 + R F )T
+ short call

© Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright.

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