2019

CFA® EXAM REVIEW

Critical
concepts
for the
CFA EXAM

Wiley’s CFA ®

Program Level II
Smartsheets
Fundamentals For CFA Exam Success
WCID184
 Multiple Regression and Issues in Regression Analysis
QUANTITATIVE METHODS
Multiple regression equation Time‐Series Analysis

Wiley’s CFA Program Exam Review

®
Linear Trend Models Time‐Series Analysis
Predicting the dependent
Multiple Variable
regression equation = Yi = b0 + b1 X1i + b2 X 2ii + . . . + bk X ki + εi , i = 1, 2, . . . , n
• Obtain estimates for bˆ0 , bˆ1 , bˆ2 ,…, bˆk of regression parameters b0, b1, b2,. . ., bk. Linear Trend
yt = bModels
0 + b1t + ε t , t = 1, 2, . . . , T
•
Yi =Determine the assumedofvalues
the ith observation for independent
the dependent variables
variable
ˆ ˆ ˆ
Y X1 , X 2 ,…, X k . Time‐Series Analysis
• Compute the value of the dependent variable, Yˆ1 using the equation yt = b0 + b1t + εt , t = 1, 2, . . . , T
Xji = the ith observation of the independent variable Xj, j = 1,2,…, k where:
b0 = ˆthe intercept of the equation Linear
yt = the Trend value ofModels the time series at time t (value of the dependent variable)
Y = bˆ + bˆ1 Xˆ 1i + bˆ2 Xˆ 2i +…+ bˆk Xˆ ki where:
b1, . . ., bk =i the0slope coefficients for each of the independent variables b0 = the y‐intercept term
ybt ==the yt = of b0 the + b1time t + εt series
, t = 1at, 2time , . . . ,tT(value of the dependent variable)
εi = the error term for the ith observation 1 thevalue
slope coefficient/trend coefficient
All then =independent
the number variables in the regression equation (regardless of whether or not their
of observations bt 0==time, the y‐intercept
the independent term or explanatory variable
estimated slope coefficients are significantly different from 0), must be used in predicting the b
εt1 == athe
where: slope coefficient/trend
random‐error term coefficient

ETHICAL AND Multiple Regression (2 or more

value of the dependent variable. the including
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independent variables)
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PROFESSIONAL STANDARDS
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εˆ i = Yi − Yi = Yi − (b0 + b1 X1i + b2 X 2i + . . . + bk X ki ) ˆ b1 = the slope coefficient/trend coefficient
Log‐Linear the Trend
variables with error; nonstationarity).
• The relationship between the dependent variable and the independent variables is tA=series time, that grows Models
independent exponentiallyor explanatory can be variabledescribed using the following equation:
• Confidence
linear. interval for regression coefficients: use n – εt = a random‐error term
Standards of Professional Conduct • TheIntervals
Confidence
(k+1)
independent variables are not random and no linear relationship exists between A series that
two or more degrees independent of freedom
variables.
Time Series Analysis
yt =grows e b + b t exponentially can be described using the following equation:
0 1

Log‐Linear Trend Models

• The expected value of the error term is zero. Multiple regression and yt =issues e b +inb tregression analysis Time‐Series Analysis
0 1

• The ˆ variance
b j ± (tc × sbˆ ) of the error term is the same for all observations. where: • Linear trend model: predicts that the dependent variable
I. Professionalism • The error term is uncorrelated across observations. A series that grows exponentially can be described using the following equation:
j
yt = the value
Linear Trend grows of the
Models bytime a constant
series at time amount
t (value ofinthe each period
dependent variable)
A. Knowledge of the Law • The Multiple
error term
estimated is Regression
regressionnormally distributed.
coefficient ±and Issues
(critical in Regression
t -value)(coefficient standard error) where:
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ybt ==the y = e
thevalue of the time series at time t (value of the dependent variable)
0 1
t
slope
y = bcoefficient
+ b t + ε , t = 1 , 2 , . . . , T
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Hypothesis regression
tests on equation regression Coefficients
1
b0==time =1,
t
the y‐intercept 0
2, 3, …
1term t
,T
Multipletregression and issues in regression analysis
C. Misrepresentation F‐statistic• Hypothesis test on each regression coefficient: use n – bwhere: 1 = the slope coefficient
The test statistic for each regression coefficient is calculated as:
(k+1)
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II. Integrity of Capital Markets MSE SSE /[n − ( k + 1)]
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A. Material Nonpublic Information Xji = the ith observation of the independent variable Xj, j = 1,2,…, k t = time, the independent or explanatory variable
Results from Regression with Two Independent Variables ε = a ln
random‐error y = b + b
term t + ε , t = 1,2, .sides . . , T of the equation to arrive at the equation for the
B. Market Manipulation
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A. Diligence and Reasonable Basis estimated

ˆ regression coefficient ± (critical t -value)(coefficient standard error) Mean
AuTOREgRESSIVE
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b j ± (tc ×MSR
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TIME‐SERIES
B. Communication with Clients and Prospective F -stat = bˆ = A time series shows
x• t =Mean-reverting mean reversion if it tends to fall when it lies above its mean and tends to
level of AR(1) model
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error of the estimate (SEE) =QM√MSE using MSE Multiperiod T = Number of observations in the time series
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Hfrom0 : b1 = bthe = …ANOVA table 0
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VI. Conflicts of Interests HFa:-statAt least = one slope = coefficient does not equal zero
Multiperiod
© Wiley 2018 all rights
Forecasts
reserved.
and
any unauthorized 1Rule b1 of orForecasting
−copying distribution will constitute an infringement of copyright.
A. Disclosure of Conflicts • Coefficient
R 2 = MSR
MSE
Total variation of determination
SSE /[ n − ( k +
RSS / kthe F‐test
1 )]
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C. Referral Fees • Total number of regression coefficients (k + 1). Detecting
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VII. Responsibilities as a CFA Institute Member or CFA sum=of1−squares SST − SSE RSS s ) = 0 if t ≠ s
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The first difference of two periods
of the random walk equation is given as: forecasts uncertain than single period
Correlation and Regression Testing for Heteroskedasticity‐ forecasts. covariance stationary (mean reverting level of 0)
where:
B. Reference to CFA Institute, the CFA Designation, • Adjusted
Adjusted2 R 2 QUANTITATIVE 2 METHODS
R = R = 1−   n −1  2 Standard error y = x − x = x
of residual autocorrelation =1/ T + ε − x = ε , E( ε ) = 0, E( ε 2
) = σ 2
, E( ε ε ) = 0 for t ≠ s
 (1 − R ) ytt = xtt − xtt−−11 = xt −t −11+ εt t− xt −t1−1= εt ,t E(εt ) t= 0, E(εt2 ) t= σ 2 , E(εt ε s t) =s 0 for t ≠ s
and the CFA Program χ2 = nR2 with k degrees of k − 1
n −freedom. TComparing
= Number ofForecast
observations Model in Performance
the time series
n 2 2  n −1  2
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Uses of Correlation
Sample covariance = Cov(X,Y) = ∑ (X i − X)(Yi − Y)/(n − 1)
analysis  n − k − 1 • Walk AR(1) model hasforecast a uniterror root if the slope
n = Number of observations. The Breusch‐Pagan (BP) Test
Random
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QUANTITATIVE METHODS
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the time series walk. regression.
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proxies t 0 t 1 t
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cash flow in financial statement analysis. R 2 = Coefficient of determination of the second regression (the regression when the squared • Out‐of‐sample forecasts are made using data from outside the test period. These
Υ (or big data). © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. forecasts of2018the 5:41 PM error term
are used to evaluate 5 willhow bewell significantly
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b n ± tC sb their •
root ARCH
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average squared error.
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rights reserved. any unauthorized QM copying or distribution will constitute an infringement of copyright.
of the error in one 5 period depends on the variance
s X sY The
The unit Root
Root Testof Test ofNonstationarity
Nonstationarity
H0 : ρ = 0 • Conditional: heteroskedasticity is correlated with
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• The of the smaller error the RMSE,in previous 5 the more periods
accurate (if theARCH
model as errors are tool.
a forecasting
F-Statistic
Ha : ρ ≠ 0 the independent variables (causes F-test for overall found,
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xxt −− xxt −1 ==bb0 ++bb1 xxt −1 −−xxt −1 ++εtε
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Mean squared error
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where k = the number of slope coefficients (b values) • Serial correlation: regression errors are correlated the dependent variable have a unit root
• Using longer time periods brings greater statistical reliability, but there is a greater chance
n = Number of observations
rSample
= Sample deviation = sX = sX2
correlation
standard
across observations (could be positive or negative and Seasonality Seasonality
• Ifunderlying
that neitherfundamentals of the timemay series has a unit
have changed over the root,
longer linear
time period. Judgment
ANOVA Table
n – 2 = Degrees of freedom has same effect on statistical inference as conditional andregression experience play can an important
be usedrole tointest determining how to model a time series.
the relationships
Source of Variation Degrees of Freedom Sum of Squares Mean Sum of Squares heteroskedasticity) xt = b0 + b1 xt −1 + b2 xt − n + εt
xt = between
b + b 1 t −1 the
x + b 2 two
x + εtime series.
• Standard error of the estimate (smaller SEE indicates as sample QUANTITATIVE METHODS
0 t −n t
Test
The statistic
value of sample correlation (r) required to reject the null hypothesis decreases RSS RSS • Multicollinearity: two or more independent variables
Regression better fit of regression
(explained) k model) RSS MSR = = = RSS Where n =• number If either of periods of them in thehas seasonal a unit patternroot, linear regression
size (n) increases: k 1 (or combinations of independent variables) are highly Where n = number 36
cannot of periods
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−2 correlated
• As n increases, rthendegrees
 =n t = ˆ 2nˆ − (k2 +
Test-stat of1/2
freedom also increase,
 1)  n
1/2
2  SSE
which results in the absolute
MSE =
SSE • If both of them have unit roots and if they are
 ∑ (Y(ti crit
Error (unexplained)
critical value − 1b) 0−for
−r bthe
1 X i test  ∑ (εˆ i ) 
)  falling. n−2 • Makes regression coefficients inaccurate and t-test cointegrated, the regression coefficients and standard
• The
SEEabsolute
=  i =1 value of the numerator  =  i(in
=1 calculating
 the test statistic) increases with for the significance of each regression coefficient
c03.indd 36 7 March 2018


Total higher values of nn,−which
2 nresults n − 2t‐values.
− 1 inhigher  SST errors will be consistent and they can be used to
unreliable.
Where: 






 8 © Wiley 2018
exCerpt froM “probabilistiC Allconduct
Rights
approaChes: Reserved.
sCenario
hypothesis
AnydeCision
analysis, unauthorized tests.
copying or distribution will constitute an infringement of copyright.
trees, and siMulation”
= Number of observations
nNote:
k = the number of slope coefficients in the regression. • Difficult to isolate the impact of each independent
8 © Wiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
r = Sample correlation
variable on the dependent variable. Risk Types
Excerpt and Probabilistic
from “Probabilistic Approaches: Scenario Analysis,
• • All
Prediction
other factorsinterval
constant,around
a false null the predicted
hypothesis (H0: ρvalue
= 0) isof thelikely to be
more
Predictiondependent
the Coefficient
Intervals
rejected of we
as variable
determination
increase the sample size. • Model specification errors Approaches Decision Trees, and Simulation”
Linear Regression with One Independent Variable
• The smaller the size of the sample, the greater the value of sample correlation required • Misspecified functional form (omitting important Table 2-1: Risk Types and Probabilistic Approaches
The coefficient
to rejectofthe determination
null hypothesis (R2)oftells
zerouscorrelation.
how well the independent variable explains
• When
the variation =
2 inthe
sRegression
s
 1 ( X − X)2 
1 + +
2therelation
dependent variable.
between two It measures
variables is the fraction
very strong, of
a the total
false nullvariation in
hypothesis the
variables; variables may need to be transformed; Discrete/ Correlated/ Sequential/
 model equation  = Yi = b0 + b1 X i + εi , i = 1,…
…, n Continuous Independent Concurrent Risk Approach
dependent
f
n isbe
: ρ =0) that
(H0variable may −rejected
1)sx2  with
(nexplained by the independent
a relatively variable.
small sample size. pooling data incorrectly).
QM
Discrete Independent Sequential Decision tree %
• With large sample sizes, even relatively small correlation coefficients can be • Time-series misspecification (including lagged Discrete Correlated Concurrent Scenario analysis
Calculating the Coefficient
significantly differentoffrom
determination
zero. Continuous Either Either Simulations
• b1 ˆand b0 are the regression coefficients.
Y ± tc s f
dependent variables as independent variables in
• b1 is2 the slope coefficient. regressions when there is serial correlation of errors;
1. R = r 2
• b0 is the intercept term.
The coefficient of determination equals the correlation coefficient squared. This
• ε is the error term that represents the variation in the dependent variable that is not
calculation only works in linear regression i.e., when there is only one independent
explained by the independent variable.
variable.
Wiley © 2019
Explained variation Total variation − Unexplained variation
2
© Wiley
2. 2018 All = Reserved. Any unauthorized
RRights = copying or distribution will constitute an infringement of copyright.
Total variation Total variation
 Wiley’s CFA Program Exam Review
®

ECONOMICS • A restrictive (expansionary) fiscal policy under

floating exchange rates will result in depreciation
rates, population growth rates and production
functions.
(appreciation) of the domestic currency. • Convergence should occur more quickly for an open
Currency Exchange Rates
• If monetary and fiscal policies are both restrictive or economy.
• Exchange rates are expressed using the convention both expansionary, the overall impact on the exchange
p/b, i.e. number of units of currency p (price currency) rate will be unclear. Economics of Regulation
eConomiC groWth and the inVestment deCision
required to purchase one unit of currency b (base • Mundell-Fleming model with low capital mobility (trade eConomiC groWth and the inVestment deCision
currency). USD/GBP = 1.5125 means that it will take flows dominate) • Economic rationale for regulatory intervention:
1.5125 USD to purchase 1 GBP Economic(expansionary)
Growth And The Investment informational frictions (resulting in adverse selection
• A restrictive monetary policyDecisionwill lower and moral hazard) and externalities (free-rider problem)
Economic Growth And The Investment Decision
• Exchange rates with bid and ask prices (increase) aggregate demand, resulting in an increase
Relationship between economic growth and stock prices
(decrease) in net exports. This will cause the domestic • Regulatory interdependencies: regulatory capture,
• For exchange rate p/b, the bid price is the price at Relationship between economic growth and stock prices
regulatory competition, regulatory arbitrage
which the client can sell currency b (base currency) to currency E to appreciate
P = GDP  E   P 
P (depreciate).
the dealer. The ask price is the price at which the client •
P =A GDP  GDP  E
restrictive (expansionary) fiscal policy will lower • Regulatory tools: price mechanisms (taxes and
 GDP   E 
can buy currency b from the dealer. P = (increase)
Aggregate price aggregate demand, resulting in an increase
or value of earnings. subsidies), regulatory mandates/restrictions on
P == Aggregate
E Aggregate price
(decrease) inornet
earnings. value of earnings.
exports. This will cause the domestic behaviors, provision of public goods/financing for private
ange rates: understanding• equilibrium
The b/p Value ask price is the reciprocal of the p/b bid price. E = Aggregate earnings.
currency toexpressed
appreciate (depreciate). projects
• The b/p bid price is the reciprocal of the p/b ask price. This equation can also be expressed in terms of growth rates: This equation can also be in terms of growth rates:
• Costs of regulation: regulatory burden and net regulatory
• If monetary and fiscal stances are not the same, the
• Cross-rates
Currency with bidRates:
Exchange and ask prices
Understanding Equilibrium Value  ∆Poverall = ∆(GDPimpact) + ∆(E/GDP on) +the∆(P/E )
exchange rate will be unclear. burden (private costs – private benefits)
∆P = ∆(GDP) + ∆(E/GDP) + ∆(P/E)
• Bring the bid‒ask quotes for the exchange rates into
Currency Cross Rates • Monetary models of exchange rate determination • Sunset provisions: regulators must conduct a new cost-
a format such that the common (or third) currency Production Function
(assumes
Function output is fixed) benefit analysis before regulation is renewed
For example, given the USD/EUR and JPY/USD exchange rates, we can calculate theProduction cross rate
cancels out if we multiply the exchange rates
between the JPY and the EUR, JPY/EUR as follows: Y• =Monetary
AKαα L11−α−α
approach: higher inflation due to a relative
Y = AK L equilibrium Value 
CurrenCy exChange rates: understanding
JPY
=
JPY USD
×
Y = Level
increase in domestic money supply will lead to
Y = Level ofdepreciation
aggregate output in the
of aggregate output of
economy.
theeconomy.
in the domestic currency. FINANCIAL REPORTING
AND ANALYSIS
EUR USD EUR L = Quantity of labor.
Covered Interest Rate Parity L = Quantity • of labor.
Dornbusch overshooting model: in the short run, an
K = Quantity of capital.
K = Quantity of capital.
A = Total factor increase in domestic
productivity. Total factormoneyproductivity supply(TFP)will lead
reflects the to higher
general level of
Cross Rate • Multiply bid
Calculations with
1 +prices Bid‐Ask
(iPC × to obtain
Actual Spreads
360) the cross-rate bid price.
A = Total factor
productivity
productivity.
or technology
inflation and the
Total factor
in the
productivity
economy. TFP
domestic
(TFP) reflects
is a scale factor
currency
the general level of
i.e., an increase
to ininTFP TFP
Intercorporate Investments
FPC/BC = SPC/BC × productivity or technology in the economy. TFP is a scalewill factordecline
i.e., an increase
• Multiply
USD/EURbid ask 1=+1.3802(iBC × Actua
prices l
to obtain
360) the cross-rate USD/EUR askaskprice.
= 1.3806 implies a implies
α = Share of GDP
a proportionate
level lower
a proportionate
paid
increase
out to than
in output for any combination
capital.its PPP value; in the long run, as
increase in output for any combination of inputs.
of inputs.
α = Share ofdomestic
GDP paid outinterest
to capital.rates rise, the nominal exchange rate • Investments in financial assets (usually < 20% interest)
• Triangular the pricearbitrage is possible if• theRepresents dealer’s cross-rate 1 − α = Share of GDP paid out to labor.
The• forward
Represents premium of EUR (base be expressedthe as aprice of EUR α = Share of GDP paid out to labor.
1 −as:
currency).bid (ask)(discount)
price isonabove the base currency can
(below) the • interbank
An investor can
percentage
buy EUR with USD will recover and approach its PPP value.
market’s α 1−α α
under IAS 39
• An investor implied cross-rate askat(bid)FPC/BC price. = Y/L
yy = Y/L == A(K/L) (L/L)1−α ==Ak
A(K/L)α (L/L) Akα
can sell EUR for USD − SPC/BC at this price. • Held-to-maturity (debt securities): reported at
thisForward
price (aspremium
• byMarking
it is the bid (discount)
price quoted as a % = Economic Growth amortized cost using the effective interest method;
the dealer).to market a position on a currency forward
SPC/BC
yy =
= Y/L
Y/L = Output per
= Output per worker
worker or or labor
laborproductivity.
productivity.
• Create kk =
= K/L
K/L = Capital per per worker
worker or or capital‐labor
capital‐laborratio.
ratio. interest income and realized gains/losses are
The forward premiuman equalon
(discount) offsetting
the base currency forward can be position
estimatedtoas:the • =Growth
Capital
accounting equation (based on Cobb-Douglas
Determininginitial the EUR/USDforward position. recognized in income statement.
bid cross rate: production function)
• Determine
Forward premiumthe all-inasforward
(discount) a % ≈ PC
F / BC − SPC / BC FPC / BC
rate for the=offsetting
Cobb‐Douglas
− 1 ≈ exChange
CurrenCy
Cobb‐Douglas production
iPC − iBC
production function
function(Growth
rates: understanding equilibrium Value 
(GrowthAccounting
AccountingEquation) Equation) • Fair value through profit or loss (held for trading
EUR/USD
forward bid = l/(USD/EURask)
contract. SPC / BC SPC / BC
∆Y/Y
Y/Y == ∆ ∆A/A
A/A ++ αα∆∆K/K
K/K++((11−−αα))∆∆L/LL/L
and investments designated at fair value): initially
∆
recognized at fair value, then remeasured at fair value
Uncovered
Covered
• Interest
Calculate
Interest RateRate
theParity
Parity
profit/loss on the net position as of the
with unrealized and realized gains/losses, interest
Determining the EUR/USD ask cross rate:
settlement date. Potential • Labor
GDP (Labor
(Labor Productivity
productivity Growthaccounting
growth AccountingEquation) Equation)
equation
Expected future spot ask exchange rate: Actual
Potential GDP Productivity Growth Accounting income and dividend income reported in income
• Calculate the
EUR/USD = 1/(USD/EUR
1 + (iPV PC ×
of the )
bid profit/loss.
360)
CurrenCy exChange rates: understanding equilibrium Value 
CurrenCy exChange rates: understanding equilibrium Value  statement.
FPC/BC = SPC/BC × GDP==Long-term
Forward • Covered
Sexchange
e
= S
interest
rates 1(F)
×
+(1(‐i+BCOne× Actua
rate
iFC ) year l
parity:
Horizom
360 ) currency with the higher Growth rate in in potential
potential GDP Long-termgrowth growthrate rateofoflabor
laborforce
force
• Available-for-sale (AFS): initially recognized at fair
FC/DC FC/DC ++Long-term
Long-termgrowth growthrate rateininlabor
laborproductivity
productivity
Covered risk-free
Interest Rate rateParitywill(1 + trade
iDC ) at a forward discount value, then remeasured at fair value with unrealized
Covered
The forward Interest
premium Rate(discount)
Parity (1 + iFCon ) the base currency can be (expressed 1 + iPC ) as a percentage as:
FFC/DC = SFC/DC × FPC/BC = SPC/BC × gains/losses recognized in equity (other comp. income)
The expected percentage change (1 + iDC in)the spot exchange rate can(1be + icalculated
BC ) as:
11 + Actual
× Actual 360)) F Labor • Supply while realized gains/losses, interest income and
F = S × + ((iiPC
PC × 360 PC/BC − SPC/BC Classical growth model (Malthusian model)
Forward premium
PC/BC = SPC/BC × 1(F) (discount) as a % = dividend income are recognized in income statement.
Forward Fexchange ‐ AnyActua l
PC/BC PC/BC
1+ + ((iiBC ×
rates Investment )) Horizom SePC/BC − SPC/BC
Expected % change inBCspot exchange
× Actual 360 360rate
SPC/BC
= %∆SePC/BC =
• Growth
Total number in
number of real
of hours GDP
hoursavailable per
available forcapita
for work==Labor
work is temporary:
Labor forcece××Average
for Average once hoursworked
hours workedper perworker
worker
Actual
SPC/BC it rises above the subsistence level, it falls due to a • Difference between IFRS and US GAAP: unrealized
1 + (iFC × base 360 ) estimated as:
The
The forward
forward premium
premium
FFC/DC = SFC/DC
(discount)
(discount)
×
on
on thethe base currency
currency can can bebe expressed
expressed as as aa percentage
percentage as: as: population explosion. gains/losses on AFS debt securities arising from
The expected percentage change 1 + (iin theActua
spot lexchange rate can be estimated as:
DC × 360F)FPC / BC− −S SPC / BC FPC / BC exchange rate movements are recognized in income
Forward
Forward premium (discount)Actual as = ≈ FPC/BC − SPC/BC
PC/BC PC/BC = − 1 ≈ iPC − iBC • In the long run, new technologies result in a larger (but
Forward premium
Expected % change(discount)
1 in+ (spot
iPC ×exchangeas aa %%360 =rate ) ≈SPC/BC S%PC∆S e
PC/BC ≈ iPC − /iBC statement under IFRS (other comp income under US
FPC/BC = SPC/BC × SPC/BC / BC SPC BC not richer) population.
1 + (iBC × Actual 360) GAAP).
Purchasing Power Parity (PPP) the base currency can be estimated as: • Neoclassical
© Wiley 2018 all rights reserved.
reserved.anygrowth
any unauthorized
unauthorizedmodel
copyingoror(Solow’s
copying distribution
distributionwillmodel)
constitute
will constituteananinfringement copyright. • Investments in15financial
infringementofofcopyright. 15
The
Uncovered• Uncovered
The forward
forward premium
Interest
premiumRate (discount)
Parity on
interest
(discount) on rate
the base parity:currency expected appreciation/
can be estimated as: assets under IFRS 9
depreciation of Xthe currency offsets the yield differential • Both labor and capital are variable factors of
Currencies
Expected Law
Trading at a Forward
futureofspot one exchange
price : P FC rate:
Premium/Discount
X
= P DC × SFC/DCF FPC / BC − − SSPC / BC F
= FPC / BC
− production and suffer from diminishing marginal • All financial assets are initially measured at fair value.
Forward premium
Forward premium (discount) (discount) as a % ≈
as a % ≈ PC / BC PC / BC 1 ≈
= S PC / BC − 1 ≈ iPC i − i
PC − iBC
BC
Law of one price : P(1XPC + i=
P(XiFC
BC −× iSDC ) × Actual
SSPC / BC
PC / BC SPC / BC
PC / BC productivity. • Debt instruments are subsequently measured at
FC) 360
PC/BC
SFeFC/DC − S FC/DC =×SFC/DC
FC/DC = SFC/DC  amortized cost, fair value through other comp income
Absolute
Uncovered Purchasing
Interest PowerParity
Rate Parity ) 1 + (iDC PPP)
(1 + iDC(Absolute × Actual
360)  • In the steady state, both capital per worker and output
Uncovered Interest Rate Parity per worker are growing at the same rate, θ/(1 – α), (FVOCI) or fair value through profit or loss (FVPL).
 (iPC − iBC ) × Actual 
Expected
The expected
Expected future
SFFC/DC
future
PC/BC
spot
=− GPL
percentage
spot exchange
SPC/BC FC =/ GPL
change
exchange SPC/BC rate:
in the spot exchange rate
DC
rate: Actual
360can be calculated as:
 where θ is the growth rate of total factor productivity • Equity investments held for trading must be measured
• Relative
SPC/BC = GPL purchasing
PC / GPL BC
1 + (iBC ×parity:360
 power high
)  inflation leads to
and α is the elasticity of output with respect to capital. at FVPL; other equity investments can be measured at
currency depreciation ((11 +
+ iiFC ) SePC/BC − SPC/BC
S e
eFC/DC = SFC/DC × FC )
= ∆ e
= • Marginal product of capital is constant and equal to the FVPL or FVOCI.
S FC/DC = %
Expected change
SFC/DC × (1in+spot ) exchange rate % S
(1 + iiDC
PC/BC
Relative Purchasing Power Parity (Relative
DC )
PPP) SPC/BC
© Wiley 2018equilibrium
ange rates: understanding All Rights Reserved.
Value  Any unauthorized copying or distribution will constitute an infringement of copyright. real interest rate. • Investments in associates (20-50% interest, significant
The
The expected
expected percentage
percentage change
change
T
in
in the
the0 spot
spot exchange
 1 + π FC rate
exchange
T
rate can
can bebe calculated
estimated
calculatedas: as:
as: • Capital deepening has no effect on the growth rate of influence): use equity method
Relative PPP: E(S FC/DC ) = S FC/DC 
Expected of % change in spot exchange rateDC
 1 + π 
≈ %∆SePC/BC ≈SiePC − i output in the steady state, which is growing at a rate of • Investment is initially recognized on the investor’s
Ex Ante Version PPP
SePC/BC − SPC/BC
BC
Expected % change
change in in spot
spot exchange
exchange rate rate ==% %∆ ∆S
e
SePC/BC =
=
PC/BC − SPC/BC θ/(1 – α) + n, where n is the labor supply growth rate. balance sheet at cost (within a single line item);
Where π =Expected
inflation % rate. S
Purchasing Power eParity (PPP) e e
PC/BC
SPC/BC
PC/BC
• Endogenous growth model investor’s proportionate share of investee earnings
Ex ante• Fisher
PPP: % ∆ S
and ≈ π
international − π Fisher effects: if there is real
The expected percentage
FC/DC
change
FC
in the
DC
spot exchange rate can be estimated as: (less dividends) increases carrying amount of
The expectedinterest
Ex ante PPP:
Law %
percentage
of∆one
e
rate
S PC/BC change
price≈parity,
eX in the
: πP PC
e X spot exchange rate can be estimated as:
− πthe foreign-domestic
FC = P BC DC × SFC/DC
nominal yield • Capital is broadened to include human and knowledge investment.
spread
© Wiley 2018Expected will
all rights reserved.
% be
changeany determined
unauthorized
in
X spot
spot exchange
copyingby orrate the
distribution
≈
≈% foreign-domestic
∆willePC/BC
∆S
constituteiPC
S PC/BC ≈
e an infringement
≈ iPC − − iiBC
of copyright. capital and R&D. 13
Expected
Law of one % change
price : P in exchange
X
PC = P BC × SPC/BC
rate % BC • Investor’s proportionate share of investee earnings is
The Fisher expected
Effect inflation rate differential • R&D results in increasing returns to scale across the reported within a single item in income statement.
Purchasing Power
Power Parity Power(PPP)
Purchasing
Absolute Purchasing Parity (PPP)
Parity (Absolute PPP) entire economy.
Fischer Effect: i = r + π e • Excess of purchase price over book value (if any) is first
Law
S of
of =one
GPL price :P
FC /: GPL
X
XFCDC
X
= P XDC × ×S
• Saving and investment can generate self-sustaining allocated to specific assets whose fair value exceeds
Law one price FC = P(iDC
P effect: SFC/DC ) = (πeFC − πeDC)
FC/DC
International Fisher FC − iDC
SPC/BC
Law = GPL PC /: GPL
X
= X
FC/DC
XBC × SPC/BC
growth at a permanently higher rate as the positive book value: excess related to inventory is expensed
Law of of one
one price
price :P P XPCPC
BC
= P
P BC × S PC/BC externalities associated with R&D prevent diminishing while excess related to PP&E is depreciated over an
Figure• 1:Purchasing
Absolute
Relative
Absolute Purchasing
FXSpot carry
Purchasing ExchangePower
Power
PowerParity
trade: Parity
Rates,taking
Parity (Absolute
(Relative
Forward longPPP)
(Absolute PPP)
positions
Exchange
PPP) in high-yield
Rates, and Interest Rates marginal returns to capital. appropriate period of time (investor adjusts carrying
currencies
S FC/DC = GPL
and short positions in low-yield
FC // TGPL  1 + π FC 
T currencies • Convergence amount of investment on its balance sheet by reducing
S
(return
Relative =
FC/DC PPP: GPL
distribution GPL
E(S FC/DCDC
DC
) =is S peaked
0
around the mean with
S PC/BC = GPL
FC
PC // GPL
FC/DC 
 1 + π DC  • Absolute: regardless of their particular characteristics, its share of investee profits in the income statement)
S
negative = GPL skew GPL and BC
BC fat tails)
PC/BC PC
output per capita in developing countries will and any remaining amount is treated as goodwill (not
Where • π =Mundell-Fleming
inflation rate. Paritymodel amortized but subject to annual impairment test).
Relative
Relative Purchasing
Purchasing Power Power Parity (Relative (Relativewith PPP) high capital mobility
PPP) eventually converge to the level of developed
• A restrictiveT(expansionary) monetary
 1 + π FC 
T
T policy under countries. • Fair value option: unrealized gains/losses arising from
S00FC/DC will
) = rates 1 + πresult changes in fair value as well as interest and dividends
floating
Relative
Relative PPP:exchange
PPP: E(S
E(STFC/DC FC/DC ) = S FC/DC   11or+ π
FC 
 will in appreciation • Conditional: convergence 13
in output per capita is
© Wiley 2018 all(depreciation)
rights reserved. any unauthorized copying +distribution
π DC constitute an infringement of copyright. received are included in the investor’s income.
of the domestic DC currency.
dependent upon countries having the same savings
Where
Where π
π== inflation
inflation rate.
rate.
Wiley © 2019

© 13
© Wiley
Wiley 2018
2018 all
all rights
rights reserved.
reserved. any
any unauthorized
unauthorized copying
copying or
or distribution
distribution will
will constitute
constitute an
an infringement
infringement of
of copyright.
copyright. 13
 suppliers, customers, and
competitors.
•  Company site visits (e.g., to
production facilities or retail

Wiley’s CFA Program Exam Review

® stores).
3. Process input data, •  Data from the previous phase. •  Adjusted financial statements.
as required, into •  Common‐size statements.
analytically useful data. •  Forecasts.
4. Analyze/interpret •  Input data and processed data. •  Analytical results.
the data.
5. Develop and •  Analytical results and previous •  Analytical report answering
communicate reports. questions posed in Phase 1.
conclusions and •  Institutional guidelines for •  Recommendations regarding
recommendations published reports. the purpose of the analysis,
(e.g., with an such as whether to make an
analysis report). investment or grant credit.

• Joint ventures (shared control): use equity method • IFRS: current service costs, past service costs and Integrated
6. Follow‐up.
Financial Statement
•  Information gathered by
periodically repeating above
•  Update reports and
recommendations.
• Business combinations (controlling interest): use net interest expense/income recognized in P&L Analysis steps as necessary to determine

acquisition method (remeasurement refers to items in OCI). whether changes to holdings

or recommendations are

• All assets (at fair value), liabilities (at fair value), • US GAAP: current service costs, interest expense, • ROE decomposition necessary.
(extended DuPont analysis)
revenues and expenses of acquiree are combined with expected return on plan assets, amortization of past DuPont Analysis

those of parent/acquirer. service costs and amortization of actuarial gains

ROE = Tax Burden × Interest burden × EBIT margin × Total asset turnover × Financial leverage Capital Bud
and losses recognized in P&L (past service costs and
• Transactions between acquirer and acquiree are NI EBT EBIT Capital Revenue Budgeting  Average Asset
actuarial gains/losses are usually recognized in OCI ROE = × × × ×
eliminated. EBT EBIT Revenue Capital
AverageBudgeting 
Asset Average Equity
Capital Budgeting 
before subsequent amortization to P&L). Expansion Project
• Acquiree’s equity accounts are ignored. employee compensatIon: post‐employment and share‐based
• Impact of key assumptions on net pension liability and Initial Expansion Project
Expansion © WileyProject
investment2018 all outlay for any
a new investment = FCInv + NWCInv
• If acquirer owns less than 100% equity interest in rights reserved. unauthorized copying or distribution will constitute an infringement of copyright. 29

acquiree, it must create a non-controlling interest

periodic pension cost
Impact of Key Assumptions on Net Pension Liability and Periodic Pension Cost
NWCInv CORPORATE FINANCE
Initial investment outlay for a new investment = FCInv + NWCInv
Initial investment outlaycurrent
= ΔNon‐cash for a new investment
assets = FCInv
− ΔNon‐debt + NWCInv
current liabilities
NWCInv = ΔNon‐cash current assets − ΔNon‐debt current liabilities
account on consolidated balance sheet and income Impact of Assumption on Impact of Assumption on Periodic

Capital Budgeting
Assumption Net Pension Liability (Asset) Pension Cost and Pension Expense NWCInvafter‐tax
Annual = ΔNon‐cash current
operating cashassets
flows−(CF)
ΔNon‐debt current liabilities
statement to reflect proportionate share in acquiree’s Annual after‐tax operating cash flows (CF)
Higher discount rate Lower obligation Pension cost and pension expense will
net assets and net income that belongs to minority CF = (S −CC−−D)D)
both typically be lower because of lower Annual after‐tax
CF = (S −operating
− +t)  D
(l t) 
(l −cash
+  Dor (CF)
flows orCF =CF = (S − C) (l − t) + tD
(S − C) (l − t) + tD
shareholders. opening obligation and lower service • Initial investment outlay
costs. TerminalCF = after‐tax
year (S − C − D) (l − t)  +  D cash
non‐operating or CF flow=(TNOCF):
(S − C) (l − t) + tD
• Full goodwill method: goodwill equals the excess • New investment
Terminal year after‐tax non‐operating cash flow (TNOCF):
Higher rate of Higher obligation Higher service and interest costs will
of total fair value of acquiree over fair value of its compensation increase periodic pension cost and
TNOCF
TerminalTNOCF ==Sal
Sal
year after‐tax
TT + NWCInv
NWCInv − t (−Sal
+ non‐operating − BV
t (cash
Sal
Capital
T −TBV
T flow T)
) Budgeting 
(TNOCF):
identifiable net assets. increase pension expense. Initial investment for a new investment = FCInv + NWCInv
TNOCF
Expansion = Sal + NWCInv − t (Sal T − BVT )
Project
Replacement Project
Replacement ProjectT
• Partial goodwill method: goodwill equals the excess Higher expected No effect, because fair value Not applicable for IFRS.
• Replacement project
of purchase price over fair value of the acquirer’s return on plan of plan assets are used on
Intercorporate Investmentsbalance sheet
assets
No effect on periodic pension cost under Investment outlays:
U.S. GAAP.
Initial investment
Replacement
Investment outlay for a new investment = FCInv + NWCInv
Project
outlays:
proportionate share of acquiree’s identifiable net Lower periodic pension expense under Initial investment for a replacement project = FCInv + NWCInv − Sal 0 + t(Sal 0 − BV0 )
U.S. GAAP. NWCInvInitial
Investment = outlays:
ΔNon‐cash current
investment for a assets − ΔNon‐debt
replacement = FCInvliabilities
project current + NWCInv − Sal 0 + t(Sal 0 − BV0 )
assets.
Adjusted Values Upon Reclassification of Sale of Receivables:
Annual• after‐tax
Annual after-tax a operating cash=flows
FCInv (CF)
Annual after‐tax operating cash flow:
• Goodwill is not amortized
CFO Lower
but subject to annual Annual after‐tax
Initial operating
investment
operating cash
for
cash flows (CF) project
replacement
flow: + NWCInv − Sal 0 + t(Sal 0 − BV0 )
CFFimpairment test. Higher Multinational Operations CF = (S − C) (l − t) + tD
CF = (S − C − D) (l − t)  +  D or CF = (S − C) (l − t) + tD
Total cash flow Same Annual after‐tax
CF = (S operating
− C) (l − t)cash
+ tDflow:
• Difference between IFRS and US GAAP: IFRS permits full Terminal year after‐tax non‐operating cash flow:
Current assets
and
Current
Higher
partial goodwill methods
liabilities Higher (US GAAP requires use of • For independent subsidiary • CF
Terminal
Terminal
year after‐taxyear
Terminal
= after‐tax
year
non‐operating
(S − C) (l non‐operating
tD
cash
− t) +after-tax
cash
flow (TNOCF): cash flows (TNOCF)
non-operating
flow:
TNOCF = Sal T + NWCInv − t (Sal T − BT )
fullratio
Current goodwill method).Lower • Local currency (LC) = functional currency (FC) ≠ TNOCF = Sal T + NWCInv − t (Sal T − BVT )
(Assuming it was greater than 1) TerminalTNOCF year after‐tax= Sal T non‐operating
+ NWCInv − t (cash − BT )
Sal T flow:
• Impact of different accounting methods on financial parent’s presentation currency (PC). Mutually Exclusive Projects with Unequal Lives
ratios • Use current rate method to translate accounts from Mutually Replacement
1. • Least
TNOCF
Inflation Project
Exclusive
= Sal
CommonProjects
+
reduces
T NWCInv
Multiple with of the
−
Lives
t (Sal
value
Unequal T −B
Approach ofT )depreciation tax savings: if
Lives
Impact of Different Accounting Methods on Financial Ratios
LC to PC. inflation
Investment outlays: is higher (lower) than expected, the profitability
Equity Method Acquisition Method
• Income statement at average rate. Mutually
1. LeastInExclusive
ofthis approach,
Common
the Projects
project Multiple
will with
both projects of Unequal
beLivesare repeated
lower Lives
Approach until their “chains” extend over the same
(higher)
time horizon. Given equal time horizons, the NPVs of the two project chains are
than expected
Initial investment for a replacement project = FCInv + NWCInv − Sal 0 + t(Sal 0 − BV0 )
Leverage Better (lower) as liabilities are
lower and equity is the same
Worse (higher) as liabilities are
higher and equity is the same
• Assets and liabilities at current rate. 1. • Least
Mutually
compared
In this Common and exclusive
approach, theMultiple
project
both ofprojects
with
projects the are
Lives higher
Approachwith
chain NPV
repeated unequal
until istheir
chosen. lives extend over the same
“chains”
time horizon. Given equal time horizons, the NPVs of the two project chains are
• Capital stock at historical rate. Annual •
2. Equivalent Least
after‐tax
this common
operating
Annual
approach, Annuity
both multiple
cashprojects
flow:
Approach are of
(EAA) lives
compared and the project with the higher chain NPV is chosen. extend over the same
In repeated approach:
until their “chains” choose
Net Profit Better (higher) as sales are lower Worse (lower) as sales are higher
Margin and net income is the same and net income is the same • Dividends at rate when declared. time
This
project
approach
with
Givenhigher
horizon.calculates equal time
the annuity
NPV.horizons,
payment the NPVs
(equal annualof payment)
the two project
over thechains are
project’s
CF = (S − C) (l − t) + tD
• Translation gain/loss included in equity under • Equivalent
compared
2. Equivalent
life and the Annuity
Annual
that is equivalent project
annual
in present with
Approach
valuethe(PV)
annuity higher
(EAA)
to chain
(EAA)
the NPV NPV.
approach:
project’s is chosen.
Thechoose
project with the
ROE Better (higher) as equity is lower Worse (lower) as equityemployeeis higher compensatIon: post‐employment and share‐based higher EAA is chosen.
and net income is the same and net income is the same cumulative translation adjustment (CTA). Terminal year
2. Equivalent
This project
after‐tax
approach with
Annual higher
non‐operating
Annuity
calculates the EAA
Approach
annuity (annuity
cash flow: (EAA) (equal
payment payment annualover payment) theover the project’s
SML lifeproject’s that is equivalent life with in presentsame NPV
value (PV) astoproject’s
the project’s NPV).
NPV. The project with the
ROA Better (higher) as net income is Worse (lower) as net income is
• Exposure = net assets. TNOCF
This =
approachSal + NWCInv
isT calculates
− t (
the annuitySal T − B )
payment
T (equal annual payment) over the project’s
Reconciliation of the Pension the same Obligation:
and assets are lower the same and assets are higher • For well-integrated subsidiary • Rhigher
Capital EAA[E(R
i = R F + β irationing:
chosen.
M ) − R F ] if budget is fixed, use NPV or
life that is equivalent in present value (PV) to the project’s NPV. The project with the
Mutuallyhigher
SML profitability
Exclusive EAA Projects
is chosen.index with (PI)Unequal to rank Lives projects
Pension obligation at the beginning of the period • LC ≠ FC = PC. Ri = Required return for project or asset i
+ Current service costs • RProject
RF = Risk‐free i =R
ofdiscount
returnM ) − Rrate
F + β i [E(R
rate
Multiple Fof] Lives Approach
using CAPM
Accounting
+ Interest costs for Defined Benefit employee compensatIon:• post‐employment Use temporal method to translate accounts from LC SML
and share‐based 1. Least Common
βi = Beta of project or asset i

Pension Plans
+ Past service costs to PC.
employee compensatIon: post‐employment and share‐based [E(R )
Ri = Required
− R ] = Market
approach,
risk
M R i F= R F + β i [E(R M ) − R F ]
In thisreturn
premium
both projects
for project or assetare i repeated until their “chains” extend over the same
+ Actuarial losses © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 23
Reconciliation of the Pension Obligation: • Monetary assets and liabilities at current rate. RF = Risk‐freetime horizon.
rate of returnGiven equal time horizons, the NPVs of the two project chains are
− Actuarial gains
• Pension obligation components Capital Budgeting  Rii == Beta
β • Real
Required
compared
of project options:
return orfor
and the
asset timing,
projecti or with
project sizing
assetthe i higher(abandonment
chain NPV is chosen. and
Reconciliation of the Pension
− Benefits paid Obligation:
Pension obligation at the beginning of the period
• Nonmonetary assets and liabilities at historical rate. [E(R −expansion),
= MRisk‐free
R©FWiley )2018 =rate
RallF]RightsMarketof return
Reserved. flexibility,
any
risk unauthorized
premiumcopying fundamental
or distribution will constitute an infringement of copyright.
Pension obligation at the end of the period
Pension obligation
+ Current serviceat the beginning of the period
costs • Capital stock at historical rate. βi =2.BetaEquivalent
Economic
of projectAnnual
• Economic
Income
or assetAnnuity
income
i Approach (EAA)
+ Current
+ Interest service
costscosts [E(R M) − RF] = Market risk premium
The fair value of assets
+ Interest costsheld
+ Past service
in the pension trust (plan) will increase as a result of:
costs
• Revenues and expenses at average rate, except for This approach calculates the annuity payment (equal annual payment) over the project’s
•  A+positive actual dollar return earned on plan assets; and expenses related to nonmonetary assets (e.g. COGS, © Wiley 2018life Economic income = After‐tax operating cash flow + Change in market value
Past service
+ Actuarial costs
losses allthat
EconomicRightsisincome
equivalent
Reserved. =any
in presentcopying
unauthorized
After‐tax
value (PV)
operating cashorflow
to thewill
distribution
+ (Ending
project’s
constitute NPV. The project
an infringement
market value − Beginning
with the
of copyright.
•  Contributions
+ Actuarial made by the employer to the plan.
losses higher EAA is chosen. Capital StRuCtuRe
− Actuarial gains depreciation) which are translated at historical rates. market value)
− Actuarial
− Benefits gains
paid will decrease as a result of: © Wiley 2018 Cross‐Reference
all Rights Reserved. any unauthorized to CFA copyingInstitute
or distributionAssigned
will constituteReading #22of copyright.
an infringement
The fair value of plan
− Benefits
Pensionpaid
paid assets
obligation at the end of the period
• Dividends at rate when declared. SML OR
•  Pension
Benefits obligation to employees.
at the end of the period Economic income = After‐tax operating cash flow − (Beginning market value − Ending
• Translation gain/loss reported in income statement. the Capital i =R
Rmarket F + β i [E(R
Structure
value) M ) − RF ]
decision
The fair value of assets held in pension
the pension trust (plan) will increase as a result of:
The • value
Reconciliation
fair Fair of
ofvalue the
assets Fair
held
of plan Value of Plan
in the assets Assets:
trust (plan) will increase as a result of: • Exposure = net monetary asset or liability.
• • A A positive
positive actual
actual dollar
dollar return
return earnedearned on plan
on plan assets; assets;
and and R =
Economic income = After‐tax cash flows − Economic depreciation
Required return for
Ai company’s capital structure refers project or asset to thei combination of debt and equity capital it uses to
• • Contributions
Contributions
Fair value of made made
plan by employer
byassets
the theatemployer to thetoplan.
the beginning the plan.
of the period • Net asset (liability) exposure and appreciating foreign Rfinance F = Risk‐free
itsEconomic
business.rate ofThe return goal is to determine the capital structure that results in the minimum
+ Actual return on plan assets currency = translation gain (loss) β
Economic• Profit profit
The fair value of plan assets will decrease as a result of:plan i = Beta of
weighted projectcost
average or asset
of capitali and consequently, in the maximum value of the company.
The fair value+ of plan assets
Contributions will
made decrease
by theasemployer
a result of:
to the [E(RM) −Economic
RF] = Market profit =risk [EBIT premium
(l − Tax rate)] − $WACC
• • Benefits
Benefitspaidpaid
− Benefits to employees.
to paid
employees.
to employees • Ratios (originally in LC versus current rate method) Economic Dprofit =  E[EBIT (1 - Tax rate)] - $WACC

rWACC = profit =rDNOPAT (1 − t) + r
Fair value of plan assets at the end of the period
Reconciliation
Reconciliation of the
of the FairFairValueValue of Plan
of Plan Assets:
Assets: • Pure income statement and balance sheet ratios Economic
 V
− $WACC
 V E
unaffected. Economic profit
NOPAT = Net operating profit after tax = NOPAT - $WACC
Balance Sheet2018Presentation of Defined
(orBenefit Pensionwill Plans 19
• ©Fair
Wiley
Balance
value
Fair
allof
value
rights
sheet
plan reserved.
of plan assets anyat
assets
unauthorized
liability the copying orof
at beginning
the asset)
beginning
distribution
equals
theofperiod
constitute an infringement of copyright.
funded status
the period
• If foreign currency is appreciating (depreciating),
©
MM Wileyassumptions
2018 all Rights
$WACC Reserved.
= Dollar costanyofunauthorized
capital = Cost copying or distribution
of capital will constitute
(%) × Invested an infringement of copyright.
capital
+ Actual
+ Actual
• +Negative
returnreturnon plan
funded on planassets
assets
status = plan is underfunded = net • Claims valuation
Funded status
Contributions = Fair
made value
by of
the plan assets
employer
+ Contributions made by the employer to the plan to– Pension
the plan obligation mixed ratios (based on year-end b/sheet values) will be Under this approach,
• Investors
a project’s NPV is calculated as the sum of the present values of economic
−pension
Benefits
− Benefits paid liability.
to employees
paid to employees smaller (larger) after translation. • Separate
profit earned
have homogeneous
cash flows
over its life discounted
• Capital markets are perfect.
at the cost
expectations.
available
of capital. to debt and equity
Fair
Where pension value
• Fair value of plan
offunded
obligation
Positive
assets
planis assetsat
either the end
at the=end
pension
status
of the
plan
period
of the
benefit period (US GAAP)
isobligation
overfunded = netor the present value of holders.
• Investors can borrow and lend at the risk‐free rate.
• Hyperinflationary economies NPV =are
∞
∑them
EP t
the defined benefit obligation (IFRS).
Balance Sheet pension
Presentation asset. of Defined Benefit Pension Plans • There• Discount MVA no=agency costs.
t =1 (1 + WACC)
at their
t respective required rates of
Balance Sheet Presentation of Defined Benefit Pension Plans • US GAAP: use temporal method. • Thereturn financing decision
(debt cash flows and the investment
discounted decisionatare independent
cost of debt, of each other.
•  If Pension obligation > Fair value of plan assets:
Funded status = Fair value of plan assets – Pension obligation
FundedPlan status Fair value of→plan
is =underfunded Negative
assets –funded
Pension status → Net pension liability.
obligation
• IFRS: (1) restate subsidiary’s foreign currency accountsMM proposition Residual equity
Income cash flows
i without taxes:discounted
Capital Structure at cost of equity).
irrelevance
•  If Pension obligation < Fair value of plan assets: Financial RepoRting andfor inflation; (2) translate using current exchange rate;
analysis
• t Add
RI = NI t −PVsre Bt −1of the two cash flow streams to calculate total
Where pension obligation
Where pension
is either pension
Plan is overfunded benefitfunded
→ Positive obligation (US→
status GAAP) or the present
Net pension asset. value of (3) gain/loss in purchasing power recorded on income Given the assumptions company/asset value.
listed above and no taxes, changes in capital structure do not affect
the •
defined benefitobligation
Periodic obligation
pension
is either pension benefit obligation (US GAAP) or the present value of
(IFRS).
cost calculation (same for IFRS and US company value.
the defined
•  benefit obligation
Calculating Periodic Pension Cost
Employer contributions. (IFRS). statement. Where
GAAP)
• •  IfBenefits
Pensionpaidobligation
to employees> Fairreduce
value the
of plan assets:
pension obligation and the fair value of plan Capital Structure
RIt = residual
LV =income
U V in period t
•  assets
Priodic
If Pension
Plan
so
pension
isobligation
they underfunded
have
cost =shown
no impact
Ending
→
> Fair value
onNegativeoffunded
the overall
funded status
plan
funded
−assets:
status.→ Net pension liability.
assets:
status
Beginning funded status – Employer contributions Evaluating Quality of Financial NIt = net income in period t
reBt-1 = equity charge against beginning book value
• •  IfWe
Periodic
Pension obligation
Plan
have already Ending
< Fair
is underfunded net→ofNegative
value
that employer plan Beginning
funded
contributions havestatus →toNet
nothing go pension liability.
with periodic
•  pension
If cost.isobligation
Plan
Pension overfunded
pension the=periodic <
pension → Positive
Fair value funded
of plan status
– a company’sassets:
net pension → Net + Employer
pension asset. Reports • MM Prop
MM proposition ii without taxes:
I without Higher
taxes: Financial
given leverage Raisesand
MM assumptions the Cost of equity
The RI approach calculates value from the perspective of equity holders only. Therefore, future
•  Therefore,Plan pension cost of DB pension contributions
plan equals
no taxes, changes in finance.
capital structure dotonot
cost
the increase
is overfunded
inPensionliability
the pension
→ Positive funded
liability status → Net pension asset. residual
Debt income
finance is ischeaper
discounted
thanat the required
equity rate of return onincreased
However, equity use affect
calculate NPV. leads to an
of debt
Calculating Periodic
Periodic pension =obligation
costCost (excluding
Current service the+impact
costs of costs
Interest benefits paid to
+ Past service costs • Beneish model: the higher the M-score (i.e. the less
employees) minus actual earnings on plan assets.
Calculating Periodic Pension Cost + Actuarial losses − Actuarial gains − Actual return on plan assets
increase in company value
the required
∞
rate of return on equity. The higher required return on equity is exactly
RI
cost = Ending status −costs negative the number) the higher the probability of offset by NPV
• cost ∑ (1 + IIcost
the cheaper
MMof=Prop
t of debt and therefore, there is no change in the company’s weighted
rE )without taxes: higher costfinancial
of capital isleverage raises
Priodic Periodic
pension pension fundedservice
cost = Current Beginning
+ Interestfunded
costs +status – Employer
Past service costs contributions t

earnings manipulation average capital.

t =1 Basically, the company’s not determined by its capital
Priodic
Under the pension
corridorcost = Ending
method, funded
+ Actuarial
if the losse
net status − Beginning
s − Actuarial
cumulative funded
gains − of
amount Actual status
return
unrecognized on–planEmployer
assets contributions
actuarial gains and structure the cost
but by of equity
business risk. but no change in WACC
losses at the beginning of the reporting period exceeds 10% of the greater of (1) the defined• Altman bankruptcy protection model: higher z-score is Claims Valuation
Periodic pension cost = Current service costs + Interest costs + Past service costs
benefit• obligation
Periodic Pension Cost Under IFRS and U.S. GAAP
Periodicorpension + cost
(2) the fair value reported
Actuarialof plan
lossesassets,in then
P&Lgains
− Actuarial (also
the excess known
− Actual returnas
is amortized the better
overassets
on plan rE = r0 +
• Separate cash
D
− rD )available to debt and equity holders
(r0flows
expected periodic
While totalPeriodic
average pension
pension
periodic remaining
pension cost
cost =expense)
working
is the Current
samelives service
under the costs
ofIFRS + Interest
employees
and U.S. costs
participating
GAAP, the + Past
manner service
the plancosts
ininwhich and included E
• Discount them at their respective required rates of return.
total pension cost is divided between
as a component of periodic pension the+ Actuarial
P&L and
expense onOCIlosses
is − Actuarial gains − Actual return on plan assets
different
the P&L. under the two sets of standards. ○ Cash flows available to debt holders are discounted at the cost of debt.
Under the corridor method, if the net cumulative amount of unrecognized actuarial gains and ○ Interest
Cash flowsEBIT − Interest
available to equity holders are discounted at the cost of equity.
UnderatIFRS,
losses periodic pension
the beginning cost is divided
of the reporting periodinto three components.
exceeds 10% of the Two of them
greater of (1)are
the defined V =the present +
• Add values of the two cash flow streams to calculate total company/asset value.
©recognized
Under in P&L,
corridor
theall while
theone
(2)method, is value
recognized
if theofnet in OCI.
cumulative amount willofconstitute
unrecognized actuarial gains and 21 rD rE
Wileyobligation
benefit 2018 rights
or reserved. any
fair unauthorized copying
plan or distribution
assets, then the excess an infringement
is amortized over of copyright.
the Wiley © 2019
losses ataverage
expected the beginning
remaining ofworking
the reporting
lives ofperiod exceeds 10%
the employees of the greater
participating of (1)
in the plan andthe defined
included
1. Service costs: Both current and past service costs are recognized as an expense on the 32
asbenefit obligation
a component or (2) pension
of periodic
P&L under IFRS.
the fair value
expenseofonplan
theassets,
P&L. then the excess is amortized over the Relaxing
© Wiley 2018the assumption
All Rights of no taxes
Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
expected
2. Netaverage
interest remaining working
expense/income: lives ofexpense/income
Net interest the employeesis participating
also recognizedinonthe
theplan and included
 FCFF is these
estimated by:
inaccuracies flow through to the estimates of target company value.
• A lack of recent and relevant transaction data for companies in the same industry may
force the Net income
use of data from related sectors. As a result, the value derived for the target

Wiley’s CFA Program Exam Review

® may not be
+ accurate.
Net interest after tax
• = It is difficult to incorporate
Unlevered any anticipated target capital structure changes and merger
net income
synergiesChanges
+ into the analysis.
in deferred taxes
= NOPLAT (net operating profit less adjusted taxes)
Bid evaluation
+ Net noncash charges (depreciation)
uRe
− Change in net working capital
Target shareholders’ gain = Premium = Price paid for the target company – Pre‐merger value
− Capital expenditures (capex)
dividendS and ShaRe RepuRChaSeS of the target company
uRe Relaxing the Assumption of no Taxes Free cash flow to the firm (FCFF)
Acquirers’ gain = Synergies – Premium
Net interest after tax = (Interest expense − Interest income) (l − tax rate)
Analysis of Dividend Safety
Working capital =value
Current assets (excl. cash and equivalents) − Current
as:liabilities (excl.
• MM
Relaxing Prop I with
VL =Assumption
the VU + tD taxes:
of no Taxesdebt results in tax savings, so (BVPS): when market price is higher (lower) than BVPS, • Post-merger
The post‐merger
short‐term debt)
of the combined
value company
of the can be calculated
combined company
company value would be maximized with 100% debt (no BVPS will
Dividend decrease
payout (increase)
ratio = (dividends / net after repurchase
income)

The WACC
costs VUof+calculated
VLis=then financial
tD as:
distress) • Dividend
Dividend safetyratio
coverage measure
= (net income / dividends)
VA* = VA + VT + S – C
Comparable Company Analysis
• MM Prop II with taxes: higher financial leverage raises the VA* (DP
= Post‐merger
− SP) value of the combined company
FCFE coverage ratio = FCFE / [Dividends + Share repurchases]
cost of equity and lowers WACC (WACC is minimized at TPV=A = Pre‐merger value of the acquirer
SP
The WACC is thencalculated
D as: E
100%
rWACC =debt) r (1 − t) +   rE VT = Pre‐merger value of the target company
  D V   V S = Synergies created by the business combination
D E
Business Ethics TP = Takeover
C =premium
Cash paid to target shareholders
rWACC =   rD (1 − t) +   rE
DP = Deal price per share
And the cost  V is calculated V
of equity as: SP = Target’s stock price per share
• Friedman doctrine: only social responsibility is to When evaluating a merger offer, the minimum bid that target shareholders would accept is the
increase profits as long as the company
CF stays “within the • market
pre‐merger
Bid Takeover
Evaluation value premium and acquirer’s
of the target company, gain amount that any acquirer
while the maximum
And the cost of equity is calculated Das: rules of the game” would be willing to pay is the pre‐merger value of the target plus the value of potential synergies.
rE = r0 + (r0 − rD ) (1 − t)  
 E Target shareholders’ gain = Takeover premium = PT − VT
• Utilitarian ethics: best decisions are those that produce
D
rE = r0 + (r0 − rD ) (1 − t)  
the greatest good for the greatest number of people Acquirer’s gain = Synergies − Premium
• Agency
Modigilani and Miller Propositions
costs: using  E more
 debt reduces net agency costs • Kantian ethics: people should be treated154 as ends and = S − (PT − VT) © 2018 Wiley
of equity Without Taxes With Taxes never purely as means to the ends of others S = Synergies created by the merger transaction
• Pecking
Proposition
Modigilani and order
I Miller theory
VL = VU (information asymmetry):
Propositions VL = VU + tD • Rights theories: people have certain fundamental rights
managers prefer internalTaxesfinancing and debt over equity
c08.indd 154 7 March 2018
Without D With Taxes that take precedence over a collective good The post‐merger value of the combined company is composed of the pre‐merger value of
• Static
Proposition rE = r0 + (r0 − rD )
III trade-offVtheory (optimal capital rE = r0 + (r0 − rD ) (1 − t)
structure):
 D  • Acquirer
the acquirer, prefers
the pre‐merger value cash offer and
of the target, if confident
the synergiesof synergies
created by the merger. These
Proposition L = VU E VL = VU + tD  E  • Justice theories: just distribution of economic goods andsources of value are adjusted for the cash paid to target shareholders to determine the value of the
and/or target’s value.
increase debt up to the point where further increases in services (veil of ignorance and differencing principle) combined post‐merger company.
D  D
value
Proposition II from tax savings
rE = r0 + ( r0are
− rD offset
) by additional costs of
rE = r0 + (r0 − rD ) (1 − t)
E  E
EQUITY INVESTMENTS
VA* = VA + VT + S − C
financial
The Optimal Capitaldistress
Structure: The Static Trade‐Off Theory Corporate Governance
Next year’s dividend RetuRn ConCe
Required
VA* = Value ( IRR ) =
return company
of combined + Expected dividend growth rate
Dividends and Share Repurchases
VL = VU + tD − PV(Costs of financial distress) • Objectives: reduce conflicts of interest (manager- Market price
The Optimal Capital Structure: The Static Trade‐Off Theory
shareholder and director-shareholder conflicts) and
Equity Valuation Models
C = Cash paid to target shareholders

• VDividend policy ensure company’s assets are used in the best interests of© Wiley 2018 all Rights Required return ( IRR ) =
Next year’s dividend
D Market price + Expected dividend growth rate
L = VU + tD − PV(Costs of financial distress) • Absolute Reserved. k e (any
valuation:
IRR unauthorized
) = 1estimate + gcopying or distribution
asset’swillintrinsic constitute anvalue, infringement of copyright.
e.g.,
• MM: with perfect capital markets, dividend MeRgeRSpolicy
and aCquiSition investors and stakeholders
dividend discount model
P 0

does not matter because shareholders can create • dividendS

Desirable characteristics of an effective board of k e ( IRR ) = 1 + g
D

homemade dividends. directors:

and ShaRe RepuRChaSeS Equity• Risk Relative Premium valuation: estimate
P0 asset’s value relative to that
rEturn concEpts of another asset, e.g., price multiples
• Bird-in-hand argument: even with perfect capital Industry Life
• 75% of Industry
the board independent. Types of
Required Return
Equity Risk (CAPM)
Premium
Description Motives for Merger Merger
markets, shareholders
Dividends and prefer
Share current dividends over Cycle Stage
Repurchases • CEO and Chairman roles separate. Return
Required Return (CAPM) Concepts
future capital gains. Stabilization • Increasing • To achieve economies of scale in • Horizontal r = r + β (r − r ) Return Concepts
The expected decrease in share price when it goes ex‐dividend can be calculated usingand • Annual
the market re-election of whole
capacity research,board or staggered
production, and marketing board.
i f i,M M f

following• equation: • Holding period return

ri = r f + βi , M (rM − r f )
Tax argument: if higher tax on dividends vs capital maturity constraints to match low costs and prices of
gains, investors prefer earnings reinvestment and • Self-evaluation
• Increasing
and meeting
competitors.
without management at Holding Period Return
Where
1 − TD least competition.
annually. Where
PWshare
− PX =repurchases over cash dividends. • Large companies may buy smaller ri = required return on an individual P −asset P0 + DH
×D = requiredperiod
riHolding return on = H asset
an individual
return
1 − TCG
• Signaling effect: dividend initiations or increases usually • Independent audit, nominations and compensation f = the nominal
companies to improve management r rf = the nominal risk-free risk-freeraterate P0
and provide a broader financial base. βi,M = the βi,Msensitivity
= the sensitivity of stock of stock i toi to
changes
changes in theequity
in the equity market
market
taken as positive signals (unless overvalued company) Deceleration committees. (rM – rf)(r=M the – rf)market
= the market risk risk
premium;
premium;i.e., i.e.,extra amount
extra amount required
required for investors
for investors to hold to hold equities
equities
• Overcapacity. • Horizontal mergers to ensure • HP
orizontal
Pw = Share price with the right to receive the dividend
• Agency
Px = Share costs:
price without theshareholders
right to receive theprefer
dividend cash dividends to of growth • Access to independent
• Eroding profit
or expert
survival.
legal counsel. H = Price at
• Vertical • Required
the rather
rather thanofthan
end a the a risk-free
holding
risk-free
return
assetasset
period
P0 = Price at the beginning of the period
D = Amount prevent managers investing in negative NPV projects;
of dividend and decline• Statement margins.of governance policies.
• Vertical mergers to increase rEturn concEpts • Conglomerate
D H = Dividend
Required
Required Return (Buildup Approach)
• Return
Minimum (Buildup level of return on an asset required by an
Approach)
TD = Taxbondholders
rate on dividends often restrict dividends through covenants efficiency and profit margins.
ri = r f + equity risk premium + other risk premiums/(discounts)
©TWiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. investor.
CG = Tax rate on capital gains
• Factors affecting dividend policy: investment Mergers and Acquisitions • Conglomerate mergers to exploit
ri = PrHf +− equity
P 0 D risk premium + other risk premiums/(discounts)
+ H return is higher (lower) than required
CORPORATE FINANCE
synergy. rEturn concEpts Wherer• = If expected
36 Other riskP0premiums P0are used primarily in describing compensation for the additional risk of
opportunities,
Double Taxation System expected volatility of earnings, © Wiley 2018 All Rights Reserved. Any unauthorized• copying or distribution
Companies willindustry
in the constitute an infringement of copyright.
may EINFLclosely = Expected
return,
held stockthe Inflation asset is undervalued or liquidity)(overvalued).
© Wiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. • Mergers and industry lifecycle acquire companies in young rEturn concEpts =premiums
=Capital gain(e.g., yieldlack of marketability
+ Dividend inyield
while discounts describe a reduction in
financial flexibility, tax considerations, flotation costs, Other
EGREPS risk
compensation Expected forare usedover
earnings
control primarily
growth
the business in describing
rate compensation
real situations.
and other earnings per share for the additional risk of
ETR = CTR + [(l − CTR ) × MTR D ]
contractual/legal
• Imputation: earnings that are distributed as dividends are taxed only • Pioneering development: conglomerate and
A company’srestrictions
industries. closely
Where
EGPE • held
=Equity stock risk
Expected (e.g.,growth premium
lackrate of marketability
in the (ERP)
P/E ratio or liquidity) while discounts describe a reduction in
EINFL
compensation Gordon
= Growth
Expected
for control Model
Inflation over (GGM)the Estimatesand other situations.
business
Required• Return
EINC = Expected income component (e.g., dividends and reinvestment)
tax rate (ETR) when given corporate tax rate for and Corporatehorizontal. Additional return required
in rate realby investors to invest in
once, at the shareholder’s marginal tax rate. Source: Adapted from J. Fred Weston, Kwang S. Chung, and Susan E. Hoag, Mergers, Restructuring,
ETR =• Effective
Effective tax rate Control (New York: Prentice Hall, 1990, p.102) and Bruno Solnik and Dennis McLeavy,
EGREPS
Where = Expected
ERFR = Expected earnings
Gordon Growthrisk-free Model (GGM) rategrowth
Risk Premium Estimate
earnings per share
earnings
CTR = Corporate tax distributed
rate as dividends (CTR ) and investor’s • Rapid
International accelerating
Investments, growth:
5th edition (Boston: Addisonconglomerate and
Wesley, 2004, p. 264–265). When
EINFL
EGPE
Gordon theGrowth
equities
== Expected
Expected
investor’s Model estimate
rather
Inflation
growth rate inthan
(GGM) of
the
intrinsic
P/E
Estimates risk-free
ratio
value
asset.
(V0) is per different from the current market price (P0),
ETR = CTRtax EGREPS
EINC = = Expected
Expected incomeearnings growth
component in rate
(e.g., real earnings
dividends and share
reinvestment)
D +rate
[(1 –onCTR D) × MTRD]
D
horizontal. =• Expected
Gordon growth
D1 has model
MTRD = marginal
Investor’s marginal
tax rate dividends
on dividends (MTRD) the EGPE
investor’s
ERFRGrowth
Gordon
= expected
ExpectedERPGGM
Model
growth =return
risk-free rate
(GGM) gin
+ ratee1 +two
−the
Y YTM ofestimate
P/Ecomponents:
ratio 20-year of ERP
maturity T-bonds
= Risk(e.g., Premium Estimate
LTGB
EINC = Expected Expected inflation
income Pcomponent dividends and reinvestment) −1
• Matureofgrowth:
0
payout • Tax
Double
policies
Split‐Rate System taxation and split-rate Major Differences Stock versus horizontal
Asset Purchases and vertical. 1.
ERFRThe requiredrisk-free
= Expected return rate (rT) earned1 + YTM on of the20-year
asset’s maturity
current market TIPS price; and
1 + YTMofofprice 20-year maturity T-b−oP nds
• Stabilization and
Stock Purchase market maturity: horizontal.
Asset Purchase
2. The Where
ERP return from
Expected=inflation
D1 convergence
+ ge=− YLTGB to value [(V 0 0 )/P
−1 0 ].
ETR = CTR
Stable Dividend PolicyD + [(l − CTR D ) × MTR D ]
D1/P0 =GGM current P market dividend 1 + YTM yield of 20-year maturity TIPS
The Fama‐French 0Model1 + YTM of 20-year maturity T-bonds
Payment• Deceleration
= growth Next rate year’s dividend + Expected
Targetof growth and decline: horizontal, vertical Expected inflation −1
shareholders receive Payment
rEturnis made
concEpts selling geRequired
to the Expected =
Alpha long-term earnings
return ( IRR 1)+=YTM of 20-year maturity TIPS dividend growth rate
and conglomerate. YLTGB = yield on long-term government Marke bonds t price
Companies • attempt
Imputation:
CTRD = Corporate to pay
tax ETR
rateaon
regular = stream
earningsMTR of dividends
distributed (unaffected by short‐term earnings
as dividends. compensation in exchange for company rather than directly The toFama‐Frenchri = RF + βModel
mkt
RMRF + βi SMB + βi
size value
HML
volatility) and increase dividends only when D
forecasts suggest that the increase will be
• Pre-offer takeover their shares.
defense mechanisms: shareholders.
poison pills, D1/P
Where • Supply-side
E ( α ) Side
Supply =market
E (Estimate
i
estimate
) −(Ibbotson-Chen) (Ibbotson-Chen) of ERP
• Payout
sustainable.
Stable Dividend Companies policy
Policy following this policy usually set a target payout ratio based on long‐
Approval Shareholder approval required. Shareholder approval might
The=Fama‐French
Where
0
not
current
beri = RF
riModel
, HP dividend
+ βi RMRF
mkt
ri yield
+rate
size
βiD1 SMB + βi
value
HML
• Stable
term sustainable earnings and make
dividend dividend increases accordingly.
policy poison puts, incorporation in a state with restrictive laws, g e =
RMRF long-term =
Equity R earnings
– R
Mrisk premium ; the
F mkt RMRFk growth
( IRR
market
e = {[(1 ) =risk
+ size + g
premium
EINFL) (1 + EGREPS) value (1 + EGPE) − 1] + EINC} − Expected RF
required. EINFL =yield i = RF + βi Inflation
rExpected + βi PSMB + βi HML
staggered board of directors, restricted voting rights, Expected Y βmkt = Market alpha on long-term
isbeta
also earningsknowngovernmentasgrowth
ex-ante0 bonds or expected abnormal return. Expected return for
inalpha
LTGB
The expected increase in dividends is calculated as: EGREPS ==period
RExpected rate real earnings per share
Tax: Corporate No corporate‐level taxes. Target company pays taxes the βRMRF
on any
size •
holding= Company M – RFwill ; theexceed
size market required
beta risk premium return when perceived
Expected increase in dividends = (Expected earnings × Target payout ratio supermajority voting provisions, fair price amendments, EGPERMRF =SideEstimating
Expected
= RM RF; growth
– beta the
the(Ibbotson-Chen)
market rate required
riskinpremium
the P/E ratio return on equityvalue is greater than
to discount cash market price.
Expected dividend increase = (Expected earnings × Expected payout ratio − Previous
capital gains. βββvalue
Supply
Equity mkt == Market
=Risk Value Estimate
beta
Premium
– Previous dividend) × Adjustment factor dividend)golden parachutes EINC
βsize
mkt == flows
Market
Expected
Company tosize
beta equity
income beta component (e.g., dividends and reinvestment)
× Adjustment factor Tax: Shareholder Target company’s shareholders No direct tax consequence Realized
for
β target
= Alpha
Company size beta
ERFR size =
βvalue = Expected
Value betarisk-free +rate
Constant •
• Post-offer takeover are taxed ondefense
their capital mechanisms:
gain. litigation,
company’s The
Equity
shareholders.Required • Value
βvaluePastor‐Stambaugh
=riskReturn premium
CAPM beta(CAPM) = {[(1model EINFL) (PSM) (1 + EGREPS) (1 + EGPE) − 1] + EINC} − Expected RF
Constant
Dividend Payout dividend
Ratio Policy payout ratio policy: payout is a Liabilitiesgreenmail, Acquirer share repurchase,
assumes the target’s leveragedAcquirer recapitalization,
generally avoids the Realized alpha = HPR
The Pastor‐Stambaugh model − (PSM)
ri , HP 4
Expected dividend = Previous dividend © Wiley 2018 All Rightsmkt
The Pastor‐Stambaugh Reserved.
model Any
1 + YTM ofcopying
unauthorized
(PSM) 20-year or distribution will constitute
maturity liqan infringement of copyright.
constant % of +net income. HML +T-b βi onds
size value
This policy is followed by companies that want
(Expected earnings × Expected
to reflect the cyclical ratio − Previous
payout nature of their business
dividend) “just say no,” “crown jewel,” “Pac‒man,”
liabilities. white knight
assumption of liabilities. ri ri==r fR+F β+inflation
Expected β
i , Mi (rM − r
RMRF =f ) + βi SMB + βi LIQ− 1
mkt + size
1βsize YTM of+value
20-year
value maturity liqTIPS
• Residual
in the payment dividend
of dividends. policy:
× Adjustment
They aim payout
to payfactor onlypercentage
out a constant if there of is net income as and white squire defenses Realized alpha r = R is +
alsoβ mkt RMRF +
known as ex-post
rii = R FF+ βi i RMRF + βi i SMB + βi i HML + βi LIQ SMB alpha, β and HML
equals +
liq β actual
i LIQ holding period return HPR less
dividends. sufficient cash after investment in positive NPV required
“SMB return. = small minus big” CR “HML = high minus low
• Herfindahl-Hirschman
Herfindahl‐Hirschman Index (HHI) Index (HHI) Where
β“SMB
The liq
• small
Fama‐French
= Liquidity Fama-Frenchbeta Model model
Adjustment projects.
factor = l/N ri =“SMB
Internalrequired == small
Ratereturn
minus
minus
ofbeta onbig”
Return
big”CR
an CR “HML
individual “HML = high
=asset
high minus minus low low
Residual Dividend Policy ββliq
liq
= Liquidity
Liquidity beta
N = Number of years over which the adjustment is expected to occur rf =MeRgeRS
the nominal risk-freemkt rate
• Share repurchases n 
Sales or output of firm i 
2
© BIRR
Wiley model
and
2018r aCquiSition
=
All Rights
RF + β
Reserved. RMRF Any + β
size
unauthorized SMB +
copying β orvalue
i distribution
HMLmarket will constitute an infringement of copyright.
Companies following this policy pay out dividends only if there is sufficient cash after ∑  Total sales or output of market × 100 βi,MBIRR
BIRR= themodelisensitivityi of stock i to changes
model
i
Next year’s in the equity
expected dividend
EPS Effects• All of else
SharebeingBuyback equal, impact of share repurchase i (rM – rf) =Intrinsic the market Value risk = premium; i.e., extra amount required for investors to hold equities
RMRF =rr• iiiR
−
==Pastor-Stambaugh model: adds a liquidity
accounting for investment opportunities in positive NPV projects. r = T‐bill
rather rate + (Sensitivity
Required to
return confidence
Expected risk ×
dividendConfidence growthfactor rate to the
risk)
on shareholder wealth is the same as that of cash HHI Concentration Levels and Possible Government Response – Rthan
T‐bill
MT‐bill
rate the+a+(Sensitivity
F;rate
risk-free
market asset
risk topremium
confidence risk × Confidence risk) risk)
+(Sensitivity
(Sensitivity to confidence
to time horizon risk ×risk
Confidence
× Timerisk) horizon risk)
• after dividends.
Thisbuyback (Earnings
policy results − After-tax cost of funds)
in significant fluctuations in the amount of dividends paid. Post‐Merger HHI Concentration Change in HHI Government Action βmkt = Market Fama-French
beta ++(Sensitivity (Sensitivity
+ (Sensitivity
model. to time
to timehorizon
horizon
to inflation
risk × Time
risk × horizon
Time
risk × Inflation horizon
risk) risk)
EPS = Required
βsize = Company Returnsize (Buildup + (Sensitivity
beta DApproach) to inflation risk × Inflation risk)
• To smooth theirShares
• Reasons to outstanding after
dividend
preferpayments,
buyback usually forecast earnings and capitalLess than 1,000
companies
share repurchase: potential tax
Not concentrated Any amount No action • Macroeconomic V+0+(Sensitivity
(Sensitivity
1
+= (Sensitivity to
to inflation risk × Inflation risk)
multifactor
to business
business cycle risk models:
cycle risk × use
× Business cycleeconomic
Business risk)cycle risk)
Between l,000 and 1,800 Moderately concentrated 100 or more Possible challenge βvalue = Value beta k e − g to to
+ (Sensitivity
+ (Sensitivity
business
market
cycle
timingtiming
risk × Business
risk × Market timing
cycle
risk)
risk)
expenditure requirements for a number of years in the future. This helps them
advantages, share price support, managerial flexibility, More than 1,800 Highly concentrated 50 or more Challenge
variables
ri = r f + equity+risk + as factors.
(Sensitivity
premium
(Sensitivity
to market
to+market
other risk timing
risk ×
premiums/(discounts) Market
risk × Market timing risk)
timing risk)
determine residual dividends, which are then paid evenly over the forecast period.
offset dilution from employee stock options, higher Build‐up
Assuming • efficient
The Pastor‐Stambaugh Build-up
method
model (PSM)
method for private business
FCFF is estimated by: Build‐up
Build‐up methodpricing (i.e. the market price equals its intrinsic value), IRR equals required
method
financial leverage. 38 budget × Equity©percent Wiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
Other
return riskequity.
on premiums Therefore, are used IRR primarily in describing
cansizebe estimated as: compensation for the additional risk of
Dividend = Residual earnings = Earnings – (Capital • Target company Net income valuation closely held ri == Risk‐free
R + β
mkt
rateRMRF+ Equity +marketability
βrisk SMB + β
i premium
value
HML +while
+ iSize premium
liq
β+i Specific‐company
LIQ premium
= stock (e.g.,rate lack of or liquidity) discounts describe a reduction in
F i
in capital structure), or zero, whichever is greater.
© Wiley • Effect
all Rightsof share anyrepurchase
unauthorized copyingon EPS will constitute an infringement of copyright. • DCF + Net interest35
after tax rrii = Risk‐free
Risk‐free rate ++Equity Equity riskrisk premium
premium + Size
+ Size premium
premium + Specific‐company
+ Specific‐company premiumpremium
2018 Reserved. or distribution analysis based on FCFF. compensation for control over the business and
For companies with publicly‐traded debt, the bond‐yield plus risk premium approach can be used
other situations.
• If
SHaRe RepuRCHaSeS funds used for share repurchase are generated
=
+
Unlevered net income
• Comparable company analysis: relative valuation
Changes in deferred taxes 42 © “SMB
Wiley
to
For =
2018
calculate
For companies
•
small
All
companies with
Bond
Rights
the minus
cost yield
Reserved.
of big”
equity:
withpublicly‐traded
plus
AnyCR “HMLrisk
unauthorized
publicly‐traded =premium
debt, high
copying
debt, thethe minus
or (BYPRP)
low
distribution
bond‐yield
bond‐yield will
plusplus
approach
constitute
risk risk an
premium
with
infringement
premium of copyright.
approach
approach can becan be used
used
Gordon
βliq =calculate Growth Model (GGM) debt
publicly-traded Estimates
internally, EPS will increase if the funds would not have =
measures market value of target, then toto calculate
NOPLAT (net operating profit less adjusted taxes) Liquidity thebeta
the cost
costofofequity: equity:
+ Net used to estimate
noncash charges (depreciation) BYPRP cost of equity = YTM on the company’s long‐term debt + Risk premium
earnedoccurs
A share repurchase the when
cost aofcompany
capitalbuys if retained.
back its own shares. Shares that are
add − takeoverChange inpremium.
net working capital Gordon
BIRR model Growth
BYPRPModel cost (GGM)= Risk Premium Estimatelong‐term debt + Risk premium
repurchased by the company are known as Treasury shares and once repurchased, are not BYPRP costofofequity equity =YTM YTM onon thethe company’s
company’s long‐term debt + Risk premium
considered • for
If borrowing
dividends, voting used to finance
or calculating shareper
earnings repurchase,
share. EPS will −
• Comparable
Capital expenditures (capex)
transaction analysis: recent merger
Adjusting Beta for Beta Drift
Free cash flow to the firm (FCFF) DBeta
fall (rise) if after-tax cost of borrowing is higher (lower) transactions used to estimate fair acquisition price for Adjusting
Adjusting• iAdjusted
r =
ERP T‐bill
AdjustingBeta
Betabeta
GGM
rate
for
=for=Beta 1+ (Sensitivity
beta
(2/3) −for
Drift
+ ge Drift YLTGB
(Unadjusted to
betabeta) confidence
drift + (1/3) (1.0)
P0+ (Sensitivity to time horizon risk × Time horizon risk)
risk × Confidence risk)
than earnings
Share Repurchases versus Cashyield.Dividends Net interest after tax = (Interest expense − Interest income) (l − tax rate)
target (takeover premium built into transaction prices). Adjusted beta = (2/3) (Unadjusted beta) + (1/3) (1.0)
Adjusted beta+=(Sensitivity to inflation beta)risk × Inflation
(1.0) risk)
Working capital = Current assets (excl. cash and equivalents) − Current liabilities (excl.
(2/3) (Unadjusted + (1/3)
• • Just
Affect of share repurchase
authorizes aon book value itper doesshare
short‐term debt)
because a company share repurchase, not necessarily mean• Merger bid evaluation Where
+ (Sensitivity to business cycle risk × Business cycle risk)
that the company is obligated to go through with the purchase. For cash dividends, + (Sensitivity to market timing risk × Market timing risk)
Comparable Company Analysis 44 D1/P = current
© 0Wiley market
2018 All Rights dividend
Reserved. yieldcopying or distribution will constitute an infringement of copyright.
Any unauthorized
once a company announces a dividend, it is committed to paying them. CF ge = long-term earnings growth rate
• Cash dividends are distributed to shareholders in proportion to their ownership (DP − SP) Wiley © 2019
TP =
SP 44 YBuild‐up= 2018
© Wiley
LTGB method
yield
Allon long-term
Rights government
Reserved. Any bondsor distribution will constitute an infringement of copyright.
unauthorized copying
percentage. However, repurchases generally do not distribute cash in such a 44 © Wiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright.
manner. TP = Takeover premium Supply rSide Estimaterate
i = Risk‐free (Ibbotson-Chen)
+ Equity risk premium + Size premium + Specific‐company premium
 Estimating the Asset Beta for the Comparable Publicly Traded Firm: • Estimate dividends for each year during the first stage of growth and then discount
them to the present.
BASSET reflects only
business risk of the
 business
BEQUITY reflects
and
 • Apply the H‐model to the second and third stages to obtain an estimate of value as of markEt‐basEd Valuation: pricE and EntErp
 financial 1risk 

Wiley’s CFA Program Exam Review

comparable company.
Therefore it is used as β ASSET = β EQUITY  of comparable®  the beginning of the second stage. Then discount this estimated value to the present.
D
a proxy for business
+  (1 − t)  
 1company. • Add up the present values of the dividends over the first stage, and the present value of
risk of the project
being studied.
  E   value obtained from applying the H‐model to the second and third stages. Justified P/E Multiple Based on Fundamentals
RetuRn ConCepts
the Sustainable Growth rate Justified leading P/E multiple
where:
D/E = debt‐to‐equity ratio of the comparable company. The sustainable growth rate (SGR) is defined as the growth rate of dividends (and earnings) D1
BASSET reflects t =only
marginal tax rate of the comparable company. The unlevering V =
business risk of the   BEQUITY reflects thatrelevering
and the company can sustain for a given return on equity, assuming that the capital structure 0 (r − g)
comparable company.  1  business and remains
beta formulasunchanged over time, and no new equity is issued. The long‐term sustainable growth
Therefore, it is used as
Adjust the asset beta =ofßthe
ß ASSET comparable
 for the capital structure (financial risk) of the presented
financial risk project here
orbeare markEt‐basEd Valuation: pricE and EntErp
EQUITY D  rate can incalculated as earnings retention rate times return on equity: Free Cash Flow Valuation
1 +   
a proxy for business of comparable the ones found
company being evaluated:
risk of the project company. most textbooks, P D /E (1 − b)
being studied.   E  RetuRn
where itConCepts
is assumed Justified Freeleading
discountEd Cash FlowP/E
diVidEnd Valuation
= 0 = 1 1=
Valuation
• Estimating
BPROJECT reflects beta for non-public company using the pure-areComputing
FrEE cash FloW Valuation that debt levels
constant. The FCFF from CFO earnings. E1 r−g r−g
g = b × ROE Justified P/E Multiple Based on Fundamentals
play method
business and
financial risk of the β PROJECT = β ASSETbusiness
BASSET reflects D
1 + (1 risk−oft) 
formulas presented
in the curriculum • Free Cash Flow Valuation
Useful for financial sector companies with liquid
project. 
project. E  Computing
do Table:
not multiply
Basic IFRS =FCFF
b the Earnings
versus from
U.S. GAAPCFOTreatment
retention rate, calculated of lnterest asand
1 −Dividends
Dividend payout ratio
bt‐to‐equity
reflects only ratio of the comparable company. ratio DuPont
The unlevering Analysis Justified leading
(1 assets.
P/E multiple
IFRS Free Cash Flow Valuation
SSET D/E by (1‐t)
iness risk of the   BEQUITY reflects and relevering
as they assume that U.S. GAAP − b) is the payout ratio.
mparable company.  1  business and beta formulas
Table: levels IFRS versusfrom U.S. GAAP Treatment ofCFO lnterest and Dividends dividend (earnings) growth• Misleading
terefore,
the assetit is usedbeta
as of the comparable
ß ASSET = ßEQUITY for the  capital structure (financial
financial risk risk) of the project or presented
debt
Computing
over here
• On
Interest
time.are
change
The
receivedFCFF
higher the CFO
return
CFO oron CFI equity, the higher the sustainable D1 when there are non-tangible factors and
where: D  Net income Sales Assets
the
FCFF/FCFE V0 =
+  subject
roxy for business of comparable the ones foundlookinout
yk ofbeing evaluated,
the project we use the following
D/E = debt‐to‐equity ratio of  1formula:
the  company. company. Equity
exam,
most the
Interest
textbooks, rate.
ROE
paid
for = CFO IFRS or× CFF × CFO U.S. GAAP size r −P/E
(Free differences.
) multiple
gCash Flow Valuation
  E   Equity assumptions
Table: • TheIFRS versus Sales
U.S.
higher the earnings GAAP Assets
Treatment Shareholders’
of lnterest equity
and Dividends Justified trailing
ng studied. where it
that is assumed
Interest
applies; received CFO orretention CFI rate, the higher CFO the sustainable dividend (earnings)
displacement of earnings. • Affected by accounting choices.
t = marginal tax rate of the subject company. that debt levels use the ∞
otherwise growth =rate.
Profit This margin ×CFI
FCFF
relationship
IFRS Asset turnover
is referred × Financial
toCFO leverage
as dividend
U.S. GAAP
presentedFirmValue = ∑
Dividend
are constant.
Interest The
frompaid
received CFO CFO or t
or CFF CFO
1 −0 (b1)+ g)big/ E 0 (1 − b)(1 + g)
formula the
BPROJECT reflects
D formulas P D1 /E /E 0 (D
• Inflation/technology
t
 BASSET reflects ( 1 + orWACC ) P0 = D 1 may 1 = cause differences
P/E == E0 = =
business andCountry Spread Model Dividends
curriculum.
Interest paid
received CFO CFO CFF
or CFI CFF CFO Justified trailing P/E
ßPROJECT = ß ASSET 1 +  business risk in the curriculum
Forecasting
Computing FCFFfrom
FCFF t
and CFO= 1
FCFE Justified leading =
 E Forecasting FCFF and FCFE E01MV.rr −− gg r − gr − g r−g
financial risk of do not multiply the
o‐equity
the project.ratio of the comparable company.
of project. PRAT
D/E ratioInterest model
paid
Dividend received
by (1‐t) CFO
CFO or CFI or CFF CFO
CFO between BV and
ERP estimate = ERP for a developed market + Country eq premium
as they assume
Table: Free Cash Flow
•
that
IFRSFCFFversus
Calculate
• Calculate
= CFO the + Int
U.S. (1GAAP
current − Tax
MV ( Debt
level − FCInv
Treatment
rate )of
) free of
cash lnterest
flow and and
apply Dividends
a MV
specific ( Equity
growth )rate assuming
r • P/B Justified MultipleP/B
eq Dividends
debt levels change
WACC paid = the current CFOlevel or CFF of free cash rd (1flow CFF
− Tax andRaapply
te) + a specific growth rateJustified assuming
e asset beta of the• comparable Weighted for average
the capital cost structure of (financial
capital (WACC) risk) of theto project
discountor cash
over time. On the that free cashcash flow will grow at aa constant
constant growth rate,MV and(Debt
that thethe historical Based on Fundamentals
Dividend
exam, look out forthat greceived
=free
b × ROE MVflow (Debt IFRS
CFO will) +or MV
growCFI (Equity
at ) U.S. GAAP
CFO
growth rate, and that ) + MV (Equity)
historical
ing evaluated, we use the following formula:
bt‐to‐equity ratio of flows
the subjectto the firm
company. Computing
the assumptions
Interest
Dividends • relationship
Use FCFF from
relationship
received
paid free between
cash EBIT free
between CFO flow free
or
cash
for flow
flow and
cashvaluation
CFI
CFF and fundamental
when:
fundamental
CFO
CFF
factors
factors is is expected
expected to continue. (1 − b) is the payout ratio.
to continue.
Weighted Average Cost of Capital (WACC) that applies;
• the Forecast
• Forecast
FCFF NetCFO
= =Value
income
the
the + Int−(dividends
individual
individual 1 − Tax components
rate
components − FCInv
)ROE
×Market of free
of free cash
cash flow.
flow. For For example,
example, analystsanalysts may may P0 ROE − g
=
otherwise use
Interest paid
• Company
Equity = income
FirmCFOValue
does or
rate) not
CFF −pay value
dividends CFO
of deb t
orin
OJECT reflects
formula from the forecast FCFF
forecast = EBIT
EBIT,
EBIT, Net
(1 −net Tax
net non‐cash
non‐cash + Depcharges,− FCInv
charges, −investments
WCInv
investments inpays
fixed dividends
fixed capital,
capital, and working
and working capital capital B0 r−g
le 2-7: and Calculation of a project’s Beta
MVD Dand WaCC BASSET reflects
MVCE curriculum.
Justified trailing P/E multiple
= + andthat deviate significantly
to calculate freefrom FCFE.
iness ß ß 1
WACC =ASSET  E  rd (1of−project.
PROJECT Tax rate) +
business risk r and
FCFF use = these
use theseCFO figures
+ Int
figures (1 −toTaxcalculate
rate ) − free
FCInv cash
cash flow. flow.
ncial risk of
MVD + MVCE MVD + MVCE Computing FCFF from EBIT
project. Dividend
Computingreceived FCFF from EBITDA ∞CFO or CFI
FCFE t CFO
acompany
Inc. isanalysis
considering an investment in the confectionaries business. Rukaiya has a D/E • paid
Free cash
EquityValue =∑ flow istCFF
related to profitability. ROE = Return on equity
• Justified
Price to P D /E D (1 + g) / E 0 (1 − b)(1 + g)
onsales (P/S)
= 0 ratio
Important
Dividends
Important Net= income CFO(1 + rrateor
e) CFF Sales = 1 0 = 0 =
1.5, a before‐tax cost of debt of 6% and a marginal tax rate of 35%. Tastelicious Foods Computing FCFF FCFF EBITfrom (1(t1–− 1Dividends
=EBIT
−Tax ))++×
Net−income
Dep rate) −−×
FCInv WCInv Total assets r = required return trailing equity P/E
company analysis MVD = Market value of the company’s debt
licly‐traded company that operates only in the confectionaries industry, has a D/E
• =Investor
gFCFF = EBITDA
Net income takes Tax a control
rate Dep (Tax perspective.
Sales
FCInv − WCInv ×
Total assets Shareholders’ equity g = Sustainable • Sales growth less rateaffected
E0
by
r−g
accounting
r−g r−g
choices than earnings
o‐equity
f 2, and an
r
ratio
d =
equity Industry and Company Analysis
Required
of the beta subjectrate of
of 0.7.company.
return on debt
The risk‐free rate is 4.5% and the expected return on the Computing
•
• •
Dividends,
Dividends,
Free
FCFF FCFF cash
= CFO
EBIT
share
share
from flow
+( 1 −
Int
repurchases,
repurchases,
Net (1
Tax to
− Taxthe
rate
Income ) + firm
rate
and
and
)
Dep − −
share
share
(FCFF)
FCInv
FCInv
issues
issues
− WCInv
have
have no
no effect
effect on
on FCFF
FCFF and
and FCFE.
FCFE.
and book value.
MVCE = Market value of the Industry
company’s and common Companyequity Analysis Computing • Changes
Computing
• Changes FCFFin
FCFE in leverage
from
fromleverageFCFF EBITDA have aa minor
have minor effect effect on on FCFE
FCFE and and no no impact
impact on on FCFF.
FCFF. Justified P/S Multiple Based on Fundamentals
P/B Multiple Based on Fundamentals
is 11%. Calculate the appropriate WACC that Rukaiya should use to evaluate the risk of
g-7: theCalculation
r = Required rate of return on equity
confectionaries
Growth • aRelative
of Projecting
business.
project’s to Beta
GDP future
andIndustry
Growth WaCCsales Approach
and Company Analysis
growth net income
income FCFF as== =aFCFF
NI + −NCC
Proxy ((11+
for Int(1rate
Cash
−−Cash −Flow
Tax
) +) Net Rate ) − FCInv − WCInv • Sales positive even when earnings are negative and
Computing
net FCFE
FCFF FCFF
as from
aEBITDA
Proxy EBIT
Intfor
EBITDA Tax
Tax rate Flow + Dep borrowing
(Tax rate) − FCInv − WCInv P00 more E /S−
== 0 stable
(ROE 0 )(g1 − b)(than 1 + g) earnings.
n: Growth
c. is considering an ginvestment
• Growth
Relative to GDP relative Growth to GDP
Approach growth approach B00 r−g r−g
= β S ,GDP in × gthe confectionaries business. Rukaiya has a D/E Net
Net
Investmentincomein
income
Computing FCFF
isfixed
is
FCFE aa=poor
poor
EBIT proxy
proxy
capital
from
EBITDA 1 −FCFF
(Net forrate
1 for
((FCInv)
Tax − Tax
Income
FCFE
FCFE ) + Dep
rate
for use
)for
+ Dep
use in valuation
(in
− FCInv Tax −
valuation
rateWCInv because it:
because
) − FCInv
it:
− WCInv
S
• Useful for mature, cyclical and loss-making companies.
, a before‐tax cost of Sdebt of 6% and GDP
a marginal tax rate of 35%. Tastelicious Foods Computing FCFE from
ey‐traded
calculate Tastelicious
company gS =
that Foods’
β S ,GDP(the
operates × gGDP
only reference company’s) unlevered
in the confectionaries industry, (asset)has a D/E beta, which
•
• Includes = =NIthe effects of
of non‐cash charges like
fromdepreciation that
that should
assets be be added back • to Sales ≠ profits and does not reflect cost structure.
tes
andthe animpact
equity of
betafinancial
A company’s of 0.7. salesrisk,growth
The and only
risk‐free rate reflects
ratebasedis 4.5% thesensitivity
on business
and the expected risk
of itsof growth
the confectionaries
return 180 on the
rate to the country growth Computing • Includes
rate.FCInv
FCFE
Free
compute
FCFE
compute FCFF
FCFE cashthe
= FCFF
+ NCC
Capital
from
cash
cash
effects
flow −expenditures
−EBITDA
flow
flow FCFF
FCInv
(to
non‐cash
available
Intavailable
− WCInv
1 − equity
Tax rate
charges
− Proceeds
+ Net Borrowing
)(FCFE)
to equity
to + Netholders.
equity
like
holders.
borrowing
depreciation
sale of long-term should EROE
added
1r©=−2018
0=
0/Sback = Return
Net
b =Wiley
required
to profit
• Sales
Payout
on equity
return
ratioon
margin
may equity be distorted due to revenue recognition
y.1%. Calculate the appropriate WACC that Rukaiya should use to evaluate the risk of
A company’s sales growth rate based on sensitivity of its growth rate to the country growth • rate.
• Ignores cash
Ignores cash outflow for for investment
investment in in fixed
fixed and and working
working capital.
capital.
• Market FCFE fromoutflow gMomentum
= Sustainable growth rate
choices.
Valuation indicators
and growth and Approach market share approach
e confectionaries business. Computing CFO
Market Growth Market Share Investment
• FCFF in
Ignores working
==cash
EBITDA capital
inflow−
• Ignores cash inflow from net borrowings.
FCFE FCFF (
Int1 −( 1(WCInv)
from
Tax
− Taxnet
rate borrowings.
)
rate + )Dep
+ Net( Tax rate
borrowing ) − FCInv − WCInv Justified P/CF Multiple Based on Fundamentals
  Computing FCFE from Net Income
Marketon
return 1 andCapital
Invested
Growth Market Share Approach FCFE = CFO − FCInv + Net borrowing Justified
Unexpected
• P/S
JustifiedMultipleP/S
earnings isBased on Fundamentals
the difference between a company’s reported earnings and its expected
ß ASSET = ßEQUITY  g = (1 + g )(1 + g ) − 1 c10.indd 180
EBitDa
EBitDaWCInv as
asFCFE = Change
aa Proxy
Proxy for
forFCFF Cash
in working
Cash Flow
Flow capital over the year
7 March 2018 5:44 PM

1 +
S  D

M MS Computing
Computing FCFE FCFE = NIfromfrom
+ NCC Net− IncomeFCInv − WCInv + Net Borrowing earnings.V = FCFE 0 (1 + g)
Return
lculate Tastelicious Foods’ on invested
gS =E(1(the capital
+ gMreference (ROIC)
)(1 + gMS )company’s)
−1 measures the profitability
unlevered (asset) beta, which of capital invested by the company.
Computing FCFE from EBIT 0
P0 (E 0(/S r 0 )(
− g 1) − b)(1 + g)
EBITDA is
EBITDA is aa poor
poor proxyproxy for FCFF FCFF for for use use in in valuation because because it: it: =
he impact A of company’s
financial risk, and only reflects the on business
marketrisk of theand confectionaries Working capital =for Current assets (exc.valuation
cash) − Current liabilities (exc. short-term debt)S0 UEt = EPS r − g − E(EPS )
sales growth rate based growth growth of the company’s share in FCFE FCFE == NI
that FCFF − Int−(1FCInv − Tax rate) + Net borrowing
• Return
 1 ROIC
market.
measure
= NOPLAT / Invested capital Computing FCFE = EBIT
FCFE +(1NCC
from − Tax CFO rate) − Int−(1WCInv − Tax rate + )Net
+ Dep Borrowing
− FCInv − WCInv + Net borrowing t t

ß ASSET = 0.7 A company’s = 0.233

sales growth rate based on market growth and growth of the company’s share • inDoes
• Does
that not account
not account for for cashcash outflow
outflow from from taxes taxes paid.paid. Justified Dividend Yield
 1 + 2 • Return on invested capital (ROIC): better measure of Table:
 Noncash
• Does Items and FCFF
return
market. on Invested Capital • • Does
FCFE
not account
not account for
=isCFO simpler −EBITDA
for the the contribution
to
contribution of
use
+ Net when capital
of the
the depreciation
depreciation tax
structure
tax shield
shield to
is stable
to FCFF.
FCFF. E0/S• 0 = Net profit margin
Standardized unexpected
Equity earnings is calculated by dividing a company’s unexpected
capital. to NI to 1 − b =• Payout
•  NOPLAT Forces = Net operating profit less adjusted taxes. Computing
Computing FCFE FCFE
FCFE from
from Net Income
FCInv
CFO borrowing Price
Porter’s Five profitability than ROE because unaffected by financial • • Ignores
Ignores cash cash outflow
outflow for investment in in fixed
fixed and and working capital. D
earnings r −tog cash flow (P/CF) ratio
ratio
•  2018
Invested  capital = Operating
1 all rights assets − or Operating liabilities. for
45ifinvestment working
Adjustment 0
= by the standard deviation of past unexpected earnings over a period of time.
SSET = ß EQUITY
© Wiley
Return  onFive
Porter’s
• leverage
invested
Forces reserved.
capitalany
 D   of substitutes
unauthorized
(ROIC) measures copying thedistribution
profitability will constitute
of capital an infringement
invested by of copyright.
theNoncash
company. • FCFF
Item
FCFE is
==EBITDA
CFO
preferred
+ NCC 1 − Tax
−(FCInv − FCInv +rate
Net
it reflects
) −−borrowing
Int (1 − Tax+rate company
Net) +Borrowing
fundamentals
Arrive at FCFF
Dep(Tax rate) − FCInv − WCInv + Net •
P Cash 1 + g flow less affected by accounting choices than
 1 +Threat FCFE NIfrom WCInv 0
Computing
Free
Free Cash
Cash better FCFE
Flow
Flow bModel
or
Model ifModels EBIT
Variations
FCFE
Variations is negative Justified P/CF Multiple Based on Fundamentals
ROIC  is Threat
•
•
a E
better
Rivalry   –measure
of
Intensityofofprofitability
substitutes
competitionthan return on equity (ROE) as it is not affected Multistage by
Depreciation Valuation orrowing
discountEd diVidEnd Valuation
Added back earnings. EPSt − E (EPSt )
the company’s ROIC = NOPLAT
financial / Invested
leverage/capital capital
of suppliers structure. Generally speaking, a sustainably Amortization high ○ SUE t =
ROIC
• Bargaining
• indicates
Rivalry a– competitive
power
Intensity of competition advantage. Single‐Stage
Computing
Single‐Stage
There
• Single-stage
canFCFE
discountEd
beFCFE = EBIT
Valuation
Valuation
many
diVidEnd Valuation
and impairment
from (1 −
different
FCFF/FCFE
Model
EBIT
CFO Tax
Model
of intangibles
rate) −of
patterns (valuation
1 − Tax
Intfuture growth
model
rate) rates
Added back
+ Depdepending
− FCInv −on WCInv + Net borrowing • Cash FCFEflow σg[EPS
0 (1 + more ) t −stable E (EPSt )]than earnings.
 1 • •  Bargaining
Bargaining
power of customers
power of suppliers Restructuring charges (expense) Added back a firm’s prospects. V0 = eq
SSET = 0.7  •
• =
1 + 2•  on
return •
0.233
NOPLAT
Threat Return
Bargaining
of =
new Net
power
on capital
operating
entrants
of
– Based
customers
employed
profit on less adjusted
profitability(ROCE): taxes.
of the pretax
market, measure
barriers to entry, However,
etc. the same discounting
Restructuring charges (income resulting from reversal) principles are applied for valuing firms
Subtracted over multiple holding • Many − g)
(r definitions of cash flow.
• Invested Capital Employed
capital =comparisons Discounted
Operating (roCE) Dividend
assetsacross− Operating Valuation
liabilities. periods. In order FCFE = EBIT
CFO
to from −
estimate( 1 −
FCInv Tax +rate
theFCFF Net
FCFF ) − Int
borrowing(1 − Tax rate ) + Dep −
value11 of the firm, we first estimate the free cash flows F C Inv − WCInv + Net borrowing
© Wiley • 2018
that all rights reserved. any
Relative‐strength unauthorized
indicators copying oradistribution
compare will constitute anduring
stock’s performance infringement of copyright.
a particular
usefulof newfor Discounted Dividend different
ofValuation countries/tax Computing FCFE EBITDA
=
at the • period,
• Threat entrants – Based on profitability the market, barriers to entry,will Losses Value
Value of
etc.be generated ofby the
thethe firm
firm = WACC Added back Enterprise value to EBITDA multiple
Return on Capital Employed firm each year
WACC −
− ggand then discount these expected cash flows Justified Dividend either Yield with its own past performance, or with the performance of a group of
Return
ROIC isona capital
One‐Period structures
DDM
better employed
measure of(ROCE)
profitability is similar
than returnto ROIC, but focuses
on equity (ROE) onaspretax operating
it is not affectedGains profit.
by Subtracted
One‐Period
Return
the
DDM
on Capital
company’s financial Employed leverage/capital structure. Generally speaking, a sustainably Amortization
appropriate
Computing
© wiley 2018FCFE
high
rate.
FCFE
all rights
from
of=reserved.
EBITDA
long‐term EBIT
EBITDA − Taxdiscounts
(1bond
any unauthorized rate
copying ) −orInt (1 − Tax
distribution rate) + Dep
will constitute (Tax back
anAdded
infringement rate ) − FCInv − WCInv + Net 51
of copyright. •
comparable
Useful stocks.
for comparing companies with different
ROIC indicates aD P Operating D + Pprofit borrowingbond FCFEpremiums D0leverage. r−g
ey ROCE
VROCE = = =competitive
D 1Operating
+ P11 1profit
advantage.
= D11 /+Capital P111 employed Amortization
Non‐operating Value147 of long‐term
assets
ofEBITDA
equity
EBIT
(e.g.,
(1 −= =(TaxFCFE
excess
rate
1cash and marketable securities)
1 ) − Int −(Tax
(1Int ) + Dep
raterate
Subtracted
− F(CTax
are separated from the
Inv − WCInv + Net borrowing
=
V00 = (1 + 1r) 1 +
operating =
assets − operating liabilities Value
FCFE =of equity 1 − Tax rate ) − 1 −
− gg are valued separately and their Tax ) + Dep rate − FCInv
is)then − WCInv
to the +• PNet 1+ g
return on (1
Capital + r) 1 (1 + r)Operating
(1 + r) 1
= Employed (roCE) Operating profit
(1 + r)profit
(1 + r) 1 Deferred taxes
company’s operating assets. They r−
r Added value back but requires
added Valuation Useful
0indicators:
forissues valuing capital-intensive firms.
in Practice
ROCE
• Operating profit is a assets pretax−measure operatingofliabilities profitability. calculated value ofbthe orrowing company’s operating assets to determine special
total attention
firm value.
• • Analysing
Capital
= operating
cash
employed competitive
+ =
cash equivalents
Debt capital position
++ net
Equity workingwith
capital. Porter’s
capital + net five
fixed forces
asssets Computing FCFE from EBITDA Average
• Multiples:
EBITDAThe is often
Harmonic
positive Mean
when earnings are negative.
Return
V = The onvaluecapital of employed
the stock today (ROCE) (t =is0)similar Operating to ROIC, profitbut focuses on pretax operating 12profit. August 2017 4:32 PM
V00 = The value of= the stock today (t = 0) General • expression
Two-stage for the FCFF/FCFEtwo‐stage FCFF valuation model: model • EBITDA is affected by revenue recognition choices.
it is• a Threat
P1 = Expected price of the stock after one year (t = 1)
P1 = Expected
Since pricecash
pretax ofof
measure, +substitutes.
the cash
stock equivalents
ROCE afterisone useful + net
year in (tworking
= 1) capital
performing + net fixedacross
comparisons asssetscompanies in
FCFE = EBITDA(1 − Tax rate) − Int(1 − Tax rate) + Dep(Tax rate) − FCInv − The WCInv P/E+for a portfolio or an index is most accurately calculated through the harmonic mean rEsidu
D
D 1 = Expected
ROCE (acountries
1 = Expected
different •
ROCE
dividend
form dividend
of=pre-tax
Rivalry Operating
with
for
ROIC)
for
(intensity
Year
Year
different
1,
profitis
1,
tax
assuming
useful
of /structures.
Capital
assuming
itcomparing
for it
competition).
will
employed
be paid
will be paid
at
companiesthe end of Year
at the endacross of Year
1 (t = 1)
countries
1 (t = 1)with b o rrowing Equity
©andWileythe2018 • Net
allEnterprise
weighted rights reserved.
harmonic value
any = MVcopying
unauthorized
mean. of common
or distribution will equity
constitute+anMV of of copyright.
infringement
rdifferent
= Required return on the stock
tax return
structures.
n
FCFFt FCFFn+1 1
rROCE
= Required on the stock 147 =∑ any + preferred stock 51 + MV of debt – Value of cash and short-
(a form of pre-tax ROIC) is useful for comparing companies across countries ©
•
with
© wiley 2018Firm
Wiley 2018 all value
all rights
rights reserved.
reserved. any+unauthorized
unauthorized
WACC)t copying
copying or
or distribution
distribution
− g) (1will
will constitute
Equitynan infringement of copyright.
constitute an infringement of copyright. 49
InFlAtIon taxBargaining
• Operating
different
Multiple‐Period
AnDprofit DEFlAtIon power of suppliers.
DDM is a pretax measure of profitability.
structures. 50 © Wiley 2018 All Rights Reserved. t =1 (1 Any unauthorized (WACC
copying or distribution + WACC)
will constitute an infringement of copyright. The Residual term
Income investments.
Model n
Multiple‐Period DDM = Debt capital + Equity capital. Simple harmonic mean: X H = n
• Capital • employed
Bargaining
Industry Sales and Inflation or Deflation power of customers. © wiley 2018 Firm value = PV of FCFF in Stage 1 + Terminal value × Discount Factor Tobin’s• qWeighted
all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. is different from harmonic the 51 P/B inmean the∑ (1 / X i )respects: P/E
i =1for portfolio
following
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The relationship
different countries r )11 +…+ (1 + r )nn +
increases in(1input+ r )ncosts and increases in the price of final products General expression for the two‐stage FCFE model: eq • It uses the market value of equity and debt (rather than just equity) in the numerator
depends on the(1following + rwith
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(as opposed to the mean) mitigates the effect of outliers.
Expression • Dividend policy is related to earnings.
for calculating Value a share of stock markEt‐basEd Single‐Stage
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• 2018
© Wiley to All
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narrow a search
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competitive environment. or Deflation • Justified P/E
have a material impact on a company’s value. Quantitative ESG-related information The • intrinsic
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the the return value of the stock would be greater than
residual income model makes the following simplifying assumptions:intrinsic
on equity (ROE) is less than the its
required book
returnvalue.
on equity (r), the
V0 = effects of (1 − b) is the
projected payout ratio.fines/penalties) is relatively easy to integrate into valuation
environmental • Wiley
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valuethe return
of the on stock equitywould (ROE) be less is lessthanthan its bookthe required
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RI t = Residual income at time t
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P/E ratio
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=
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V0 Residual ∞ Income Valuation
Justified trailing P/E = E00 = r1− g0 = 0 r − g 0 = r−g © 2018 Wiley RIt(1 + r )t E − rBt −1
gL = Long‐term sustainable growth rate
E 0 rater − g r−g r−g Justified
Justified • P/E-to-growth
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P/B Multiple Based(PEG)
P/E multiple ratio:
on Fundamentals investors prefer stocks with In the Multistage
V = B + ∑
residual
t =1
t = B0 model,
income + ∑ t the intrinsic value of a stock has three components:
gs = Short
r = required• H-model:
term
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supernormal growth
growth rate declines linearly from a short-run In the •
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high rate to long-run constant growth rate (H = half the © 2018 WileyP0 ROE − g lower PEGs
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= Length
r = required return
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V0 =of B0the + ROE stock
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book value. + (PV of continuing RI)
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CR “(1 - b) = payout rate”
growth. B0 = Current intrinsic bookvalue valueofper thesharestockofwould equitybe greater than its book value.
The H‐Model D (1 + g ) D H(g − g ) • If the
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per share of equity at any time t than the required return on equity (r), the intrinsic
V0 = 0 L
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P/B Multiple
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on Fundamentals
rClean Surplus
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stock(ROE would − r)B bet-1less Pthan − Bits book value.
© Wiley 2018 all rightsr reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 47 = Required V0 = B0of +∑ T on tequity
+ P T − BTT
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changes following
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assumptions
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the income
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pointstatement.
in time.
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r s= required return ROE = Return on equity income:
g = Long‐term sustainable growth rate P0 (E 0 /S0 )(1 − b)(1 + g) Multistage Residual Income Valuation
HL = Half‐life = 0.5 times the length of the high growth period t = EPSt –indefinitely
• ItRIcontinues (r × Bt −1 ) at a positive level.
r = required return r = required return
S0
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−g
Wiley © 2019
H = Half‐life = 0.5 times the length of the high growth period g = Sustainable growthr rate •
• ItIt continues
is zero from indefinitely
the terminal at ayear positive forward.level.
The H‐model equation can be rearranged to calculate the required rate of return as follows: In the Multistage residual income model, the intrinsic value of a stock has three components:
•
• ItItRI is zero from
declines to the terminal
zero as ROE year forward.
reverts to the cost of equity over time.
t = (ROE t – r)Bt −1
The H‐model equation can be rearranged to calculate the required rate of return as follows: Justified
E /S = Net P/SprofitMultiplemargin Based on Fundamentals •
• ItIt declines
reflects the to zeroreversion as ROE of ROEreverts toto the cost
some meanoflevel.equity over time.
0 0
 Residual income, or economic profit, recognizes the cost of equity capital. It is calculated by fixed income
deducting a charge for equity capital from net income.

Wiley’s CFA Program Exam Review

Residual income = Net income − Equity charge ® VAluATIon And AnAlySIS oF CAppEd And FlooREd
FloATInG‐RATE BondS
Equity charge = Cost of equity capital × Equity capital
Valuation of a Capped Floater

• Companies with positive RI create value as they generate more income than their cost Equity Valuing a capped floater using a binomial interest rate tree is different from valuing an
of obtaining capital. option‐free bond in the following two ways:
• Companies with negative RI effectively destroy value as they do not generate fixed income
sufficient income to cover their cost of capital. • Since it is a floating‐rate security, the coupon payment on the capped floater on the
The more sustainable a company’s competitive advantage and the brighter the industry’s next payment date is based on the interest rate today. Basically, the coupon for the
• Companies
prospects, the higherwith
the higher (lower)
persistence residual income should be associated with higher
factor. priVatE company Valuation
period is determined at the beginning of the period, but paid (in arrears) at the end of
(lower) valuations. eq VAluATIon And AnAlySIS oF CAppEd And FlooREd
the period.
T-1
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the coupon rate is capped, the coupon at each node must be adjusted to reflect
(E − rBt −1 ) E T − rBT-1
V0 = B0 + ∑ t Private + Company Valuation negative interest rates. •
the Callable
coupon bond: when
characteristics interest
of the cap. rates
The effective fall and
coupon rate forthe
the upcoming
Economic Value added (1 + r) t
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Valuation of a Capped Floater
period is the lower of (1) the current rate and (2) the cap rate.
t=1
• Vasicek: short-term rate determines the entire term embedded call option is at the money, effective
The Capitalized Cash Flow Method
EVA measures the value added for shareholders by the management of a company during a
implied Growth rate
structure, interest rates are mean-reverting, volatility Valuing a capped
Value
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floater using
convexity
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=negative
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ways:of uncapped floater – Value of embedded cap
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given year. FCFF1Value Added (EVA) constant, negative interest rates possible. capped at the call price.
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the period.
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firm for next twelve months modeled as a function of time, negative interest rates Valuation ofby Floored
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price. to reflect
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capital the coupon characteristics of the cap. The effective coupon rate for the upcoming
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period in alower
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Advantages: • Yield curve risk can be managed using: below a specified
Convertible Bondsminimum rate. Therefore, it offers investors protection against declining
Value of capped floater = Value of uncapped floater – Value of embedded cap
interest rates.
Market value FCFE
V = added1 (MVA) measures the value created by management for the company’s • Key rate duration. ValuaTIon
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and
and
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• Unlike
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economic models,
profits over the of
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the company. Conversion value = Market price of common stock × Conversion ratio
• significant
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of uncertainty for companies
associated with it) doesexperiencing
not constitute a significant • A measure based on a factor model which explains • TheValue of floored
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changes in the yield curve through level, steepness and Convertible
• • therefore
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of equity Convertible
Convertible Bonds
Convertible
Convertible Bonds
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issuer).
from current book value, which leads to earlier recognition of value relative to The procedure valuing
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the equity
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of
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ratio
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discount rate minus growth rate). Market conversion
in a floaterpremium perthe
share = Market conversion the−bond
price Current market price
flows. • Measure of yield curve risk. A floor provision
Ratchet Bonds prevents effective coupon rate on from
below a specified minimum rate. Therefore, it offers investors protection against declining
declining
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appropriate:
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interest).
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7 March 2018 5:44 PM
rateConvertible
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• Discount
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and analySIS: bondS WITh embedded opTIonS 
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• The estimates of terminal value using alternative valuation models entail a great ofConvertible
issuance is set at abond
security level
value much == higher than
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Discount Factor
Discount Factor Valuation and Analysis: Bonds With Embedded Options  • This
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Valuation bond and Analysis: Bonds With Embedded c13.indd 224 Options  bond is called, the investor can only purchase a replacement bond carrying a lower
Convertible callableand putable bond value = Straight value
7 March 2018 5:43 PM

1
11 + Control premium Valuation
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P ( T ) = [1 + r ( T )]T T bond, with one callable bond being replaced by another until the bond’s eventual
[1 + r (T )] Value of callable bond = Value of straight bond – Value of embedded call option − Value of the call option
maturity is reached. The appeal for the issuer−isValue of the
that the call
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• There
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there are no callable
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costs. == Straight
+ Value
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Value of the
the call option on on the
the stock
stock
• • P(T)
Where ItTotal discount
is isdifficult with
to predict
a discount factor the DLOC
usedmain and discount
determinants
to determine for lack
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of a payment value at
received • Putable
and Value of embedded
Convertible callable bond
bond value
bond call option = Value of straight bond – Value of callable bond Valuation of a convertible bond that is callable and putable:
value = Straight value
value + Value of
of the call option
option on the stock
Where P(T) is a discount factor used to determine the present value of a payment received at −− Value
−
− Value of
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of the call
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time
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of periods
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Value of putable bond = Value of straight bond + Value of embedded put option Credit Analysis
Convertible callableand putable bond value = Straight value © 2018 Wiley
(number of 1 + Marketability premium 
 to maturity). Value of putable bond = Value of straight bond + Value of embedded put option Valuation of
of aaaa convertible
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convertible bond that
bond that is
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putable:
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and putable:
Total discount = 1 – [(1 – DLOC)(1 – DLOM)] Valuation of convertible bond that is callable and putable:
Forward Contract Price
© 2018 WileyContract
Forward Price • Effect
Value of of interest
embedded rate volatility
199option
put = Value of putable bond – Value of straight bond • Loss given default = % of overall position lost if default
− Value of the call option on the bond
Value of embedded put option = Value of putable bond – Value of straight bond
c13.indd 224
+ Value of the put option on the bond
Convertible callableand putable bond value = Straight value
7 March 2018 5:43 PM

• Higher interest rate vol. increases value of embedded Convertible callableand

Convertible
occurs
Convertible callableand putable
callableand putablebond
putable bond value
bond value == Straight
value = Straight value
Straight value
value
1 ++ Value of the call option on the stock
++ Value
Value of
of the
the call
call option
option on
on the
the stock
stock
F (( T T )) =
*, T
T *, = 1 call option and decreases value of callable bond. Value of the call option on the stock
FIXED INCOME
Effective Duration:
F [[11 ++ ff ((TT *, T ))]T
*, T ]
T
Effective Duration: 7 March 2018 5:44 PM • Recovery rate = % of overall position −
−
recovered
−− Value
Value
Value
Value of the
of the
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• Higher interest61rate vol. increases value of embedded
.indd 199
© Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
(PV− ) − (PV+ )
occurs ++ Value
+
+ Value
Value of
Value of
of the
of the
the put
the put option
put option
put on
option on
option the
on the
on bond
the bond
the bond
bond
put option
Effective Duration and
= (PV increases
− ) − (PV ) value putable bond.
Where T*
Where Term Structure
T* is
is the
the number
number of
of periods
periods until
until initiation
initiation of
of the
the forward
forward contract,
contract, and
and f(T*,T) is the
f(T*,T) is the Effective Duration = 2 × ( ∆ Curve) ×+PV0 • Expected loss = Probability of default × loss given default
implied t-period forward rate T* periods in the future.
implied t-period forward rate T* periods in the future. • Effect of yield curve2 × ( ∆ Curve)
change:× PV0 value of embedded call (put)

ΔCurve =option increases (decreases)

shift in the as yield curve goes from • PV of expected loss = Difference between value of risky
• Forward
Forward
Forward pricing model
Pricing Model
Pricing Model the magnitude
ΔCurve =upward
the magnitude
of the parallel
of the parallel shift
benchmark yield curve (in decimal). © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
bond and value of equivalent riskless bond
6
PV– = Full price of thesloping
bond when tothe
flat to indownward
benchmark
the benchmarksloping
yield curve (in decimal).
yield curve is shifted down by ΔCurve.
P ( T * + T ) = P ( T *
P ( T * +T ) = P ( T *) F ( T *, T ) ) F ( T *, T ) PV– = Full price of the bond when the benchmark yield curve is shifted down by ΔCurve.
PV+ = • Valuation
Full of callable
price of the bond and putable
when the benchmark bonds
yield curve withupbinomial
is shifted by ΔCurve.
• Structural models (option analogy)
PV+ = Full price of the bond when the benchmark yield curve is shifted up by ΔCurve.
ValuaTIon and analySIS:
PV0 bondS interest
WITh embedded
= Current rateof tree
opTIonS 
full price the bond (i.e., with no shift). • Equity holders: comparable to holding a European call
• Forward
Forward
Forward Rate Model
Rate Model rate model PV0 = Current full price of the bond (i.e., with no shift).
• Callable bond: at each node during the call period, option on company assets.
Properties of Effective Durations of Cash and Common Types of Bonds © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 6
[[11 ++ rr ((TT ** ++TT ))]]TT **++ TT == [[11 ++ rr ((TT **))]]TT ** [[11 ++ ff ((TT *,
*, TT ))]T
T Properties of the valueDurations
Effective of the bondof Cashmust equal Types
and Common the lowerof Bondsof (1) the • Debt holders: comparable to holding a riskless bond
] Type of Bond
Type of Bond
Valuation and
value if the bond is not called Analysis:
Effective Bonds
Duration
Effective(using
With Embedded
Durationthe backward
Options 
and selling a European put option on company assets.
{{ }}
1 Cash 0
= [1
[1 ++ rr ((TT **))]]T * [[11 ++ ff ((TT *, T ))]]
T* T 1 ( T *+ T )
rr (( T
T**+ +TT )) = *, T
T ( T *+ T ) − 1
−1 Cash induction), and (2) the call 0 price.
Zero‐coupon
Zero‐coupon bond
bondValue of callable bond = Value ≈ Maturity
of straight bond – Value of embedded call option
≈ Maturity
• Model assumes that company assets trade in
Fixed‐rate• bond
Putable bond: at each node we use the higher of (1) the
< Maturity frictionless markets.
ValuaTIon and analySIS:and
bondSFixed‐rate
WITh embeddedbond
opTIonS  < Maturity
The • Riding
forward
The forward rate model
rate modelthe yield is the forward
curve:pricing
is the forward pricing
Assuming model expressed
model expressed in
an upward-sloping,terms of rates,
in terms of rates, and showsshows
Callablethe value
bond
thebond determined
of embeddedthrough backward
≤ Duration induction,
of straight bond andof(2) © Wiley
©Wiley
© 2018
Wileybond
Wiley all
2018all
2018 rights
allrights
all reserved.
rightsreserved.
rights reserved. any
reserved.any unauthorized
anyunauthorized copying
unauthorizedcopying
copyingor or distribution
ordistribution will
distributionwill constitute
willconstitute an
constitutean infringement
aninfringement ofofcopyright.
infringementof copyright.
copyright.
T-period forward rate at period T* as a function of any two spot rates. Callable
Putable bond
Value
the put price.
call option = Value
≤ Duration
≤
of of straight
straight bondbond – Value callable
© •
2018 Structure ofanytheunauthorized
balance copying
sheetor distribution
usedwill toconstitute
derive an infringement
the of copyright.
stable rate
T-period forward yield curve,
at period T* aastradera function can enhance
of any two spotyieldrates. by buying Duration of straight bond
Putable bond
Floater (Libor flat)
≤ Duration of straight bond
≈ Time (in years) to next reset model is unrealistic.
bonds
Relationship
Relationship between
between
withthe maturity
the Spot Spot Rate Rategreater
and One-Period
and
than rather
One-Period Forward
Forward
than
Rates
Rates
equal to Floater• (Libor
Option-adjusted
Valuation
Value of and
flat) spread
Analysis:
putable (OAS)
≈Bonds
bond = Value of (in
Time With
straight toEmbedded
years)bond + Value
next Options put option
reset of embedded
the liability horizon. Effective• Convexity
Constant spread that, when added to all one-year
• Only implicit estimation can be used to estimate
measures of credit risk because company asset value is
• [[Swap ]] = [[1 + r=(1Swap )][ 1,1)][ –)]]Yield
...[[1 + fon − 1,1)]]
T
1 + r ( T ) T = 1 + r (1) 1 + f (1,1) 1 + f ( 2,1) ... 1 + f ( T − 1,1) Effective Convexity
1 + r ( T )spread ][1 + f (fixed ][1 +rate f ( 2,1 ( T government Value ofValue
forwardcallable bondin=interest
rates
of embedded Value
put of straight
rate
option bondof–makes
tree,
= Value Value
putableofbond
embedded
– Valuecall
arbitrage-freeof option
straight bond
1 (PV− ) + (PV+ ) − 2(PV0 ) an unobservable parameter.
securityrr (( T
T )) = {{[[11 ++ equivalent
=with 1))][1
rr ((1 1,1))maturity
][1 ++ ff ((1,1 ][][11 ++ ff (( 2,1
2,1))]... 1,1))]}1TT −
]...[[11 ++ ff ((TT −− 1,1 ]} − 11 valueConvexity
Effective of bond equal
= (PV to+2)its
+ (PV
− )Curve)
∆
current
− 2(PV ) market price.
× PV0of0 straight bond – Value of callable bond
Effective embedded=call ((option
of Convexity • Credit risk measures do not explicitly consider changes
• z-spread = constant spread that is added to implied spot • Value
If the OAS for a bond
Effective Duration:
= 2Value
∆ Curve) × PV0 (higher) than that for a
is lower
bond with similar characteristics and credit quality, in the business cycle.
curve such that the PV of a bond’s cash flows (when Floating‐Rate Securities
discounted at relevant spot rates plus the z-spread)
Value Securities
Floating‐Rate of putable bond = Value of straight bond + Value of embedded put option
it suggests that the bond
Effective Duration =
(PV is) −relatively
(PV ) − overpriced+ • Reduced form models
equals its market price (underpriced).
Value × (uncapped
of capped floater = Value2 of ∆ Curve) floater
× PV0 – Value of embedded cap.
• Model assumes that only some of company’s debt is
Value of
Value of capped floater
embedded put=option
Value of uncapped
= Value floater –bond
of putable Value–of embedded
Value cap. bond
of straight
• TED spread = LIBOR – Yield on a T-bill with same maturity • Value
Forofaembedded
given bond price,
cap = Value the lower
of uncapped floaterthe interest
– Value
Value of embedded cap = Value of uncapped floater – Value of capped floater
of capped rate
floater traded.
ΔCurvevolatility,
Value = the
of floored the
floaterhigher
magnitude =of
Value the
the parallelOAS shiftfor
of non‐floored a callable
infloater
the + Value ofbond.
benchmark yield curvefloor.
embedded (in decimal).
• Model inputs are observable, allowing the use of
• LIBOR-OIS spread = LIBOR – overnight indexed swap rateEffectivePVValue of floored floater = Value of non‐floored floater + Value of embedded floor.
Duration:
• Effective
Value
– = Full price of
duration
of embedded the bond when the benchmark yield curve is
floor = Value of floored floater – Value of non‐floored floater shifted down by ΔCurve.
historical estimation for credit risk measures.
• Traditional theories of term structure Value of embedded floor = Value of floored floater – Value of non‐floored floater
PV+ = Full price of the bond when the benchmark yield curve is shifted up by ΔCurve.
(PV− ) − (PV+ ) • Credit risk measures consider changes in the business
• Unbiased (pure) expectations theory. PVEffective Duration = of the bond (i.e., with no shift).
0 = Current full price 2 × ( ∆ Curve) × PV0 cycle.
• Local expectations theory. 68 © Wiley 2018 All Rights Reserved.
Properties Any unauthorized
of Effective copyingof
Durations or distribution
Cash and will constitute an infringement of copyright.
•
© Wiley 2018 all rights reserved. any unauthorized copying or distribution will
68
constitute an infringement of © Wiley 2018
copyright. All Rights Reserved. Any unauthorized
65 copying or distribution willCommon Types of of
constitute an infringement Bonds
copyright. Model does not impose any assumptions on balance
© Wiley 2018• allLiquidity
rights reserved. any unauthorizedtheory.
copying or distribution will constitute an infringement of copyright.
ΔCurve =Type the magnitude 65
preference of Bond of the parallel shift in the benchmark Effectiveyield Durationcurve (in decimal).
sheet structure but needs to be properly formulated
• Segmented markets theory. PV– = Full Cash price of the bond when the benchmark yield
0 curve is shifted down by ΔCurve. and backtested, e.g. hazard rate estimation.
Zero‐coupon bond
PV+ = Full price of the bond when the benchmark yield ≈ Maturity
curve is shifted up by ΔCurve.
• Preferred habitat theory. • Credit analysis of ABS
Fixed‐rate bond
PV0 = Current full price of the bond (i.e., with no shift). < Maturity
• Modern term structure models Callable bond ≤ Duration of straight bond • Structural or reduced form model can be used.
• Cox-Ingersoll-Ross: short-term rate determines
Properties of Effective
Putable bond Durations of Cash and Common ≤ DurationTypesofofstraight
Bondsbond • ABS do not default, so probability of default replaced
Type ofFloater
Bond (Libor flat) Effective≈ Time
Duration
(in years) to next reset by probability of loss.
the entire term structure, interest rates are mean-
Cash 0
Effective Convexity
Zero‐coupon bond ≈ Maturity
Fixed‐rate bond < Maturity Wiley © 2019
(PV− ) + (PV+ ) − 2(PV0 )
Callable bond Effective Convexity = ≤ Duration of straight bond
( ∆ Curve)2 × PV0
Putable bond ≤ Duration of straight bond
 • The Gamma is always
underlying nonnegative.
instrument is liquid, meaning that it can be easily bought and sold.
value of the contingent obligation of the protection seller to the protection buyer. This is currency forward contracts
Value of
of protection
protection leg =
= between:
Credit risk
risk =
= Value
Value ofof risk‐free
risk‐free bond
bond –– Derivatives
Expected payoff
payoff on
on risky
risky bond
bond As the stocktrading
• Continuous price changesis available, and as time to that
meaning expiration
one canchanges,
trade at gamma is also changing.
every instant.
calculated
Value as the difference
leg Credit Expected
Derivatives • Short selling of the underlying instrument with full use of the proceeds is permitted.
• The present value of the hypothetical value of the bond if it had no credit risk; and Pricing a Currency Forward Contract Gamma measures
• Markets are frictionless,how sensitive delta is to changes in the price
Derivatives meaning that there are no transaction costs, regulatoryof the underlying stock. Stated

Wiley’s CFA Program Exam Review

The
The • premium
premium leg
legvalue of the expected payoff on the (risky) bond, ® after accounting for the
The present Derivatives differently, gamma measures
constraints, or taxes. the nonlinearity risk or the risk that remains once the portfolio is
probability, amount and timing of each payment. In order to compute this value: Plain-Vanilla Interest Rate
fixed Swaps
income as a Combination of Bonds delta• neutral.
The rPCa)TCombination of Bonds There are no arbitrage opportunities in the market.
The premium
premium ○ leg
leg refers
Firstrefers
we compute
to
to the
the series
series
the expected
of
of periodic
periodic payments that
payoffpayments
of each payment that the theonprotection
protection buyer promises
the bond bybuyer promises Plain-Vanilla F0,PC/BC Interest = S0,PC/BCRate Swaps ×
(1 + as
to make
to make to to thethe multiplying
protection seller.
protection seller.
the payment
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fixed-rate (1 +payer rBC )T(floating-rate receiver) on a plain-vanilla interest • Options are European, so they cannot be exercised prior to expiration.
rate When gamma is large, delta is very sensitive to changes in the value of the underlying
complicated by the fact that once default occurs, regardless of exactly when it occurs during •
• The continuously compounded risk-free interest rate is known and constant. Further,
complicated byprobability the fact that once default occurs, regardless of exactly when it occursswap
of survival. during
Taking is aequivalent
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fixed-rate bond (on whichreceiver) fixed on a plain-vanilla
payments must beinterest
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The
the term Credit
term of○the Curve
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protection buyer ceases ceases toofmake
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and negative.provide
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good approximation
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how much the value of the option
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the expected payoffto payments
each payment at the to protection
appropriate seller.
swap
and is As
using aequivalent
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issuing
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a fixed-rate bond (onbond
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aa result,
result, hazard
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received). proceeds to purchase (r − r a) × floating-rate
T payer can bond (on which floating
long payments will be ○ It will decrease toward –1.0 as the underlying price moves down, and increase
The credit curve ○ Then presents
we sumcredit all these spreads
amounts ontoa comecompany’s up withdebt for a range
the expected payoff of on maturities.
the bond. The In other
0,PC/BC = S0,PC/BC × e
words,PC BC the fixed-rate be viewed as being on a floating-rate
• If When gamma
the underlying
toward 0is as
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instrument
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+ r ) T payer can be viewed as being long on a floating-rate
credit spread
The upfront
The upfront payment refers
payment to the spread on top of LIBOR required by investors to hold the debt PC underlying stock
yield at an annualized rate. and can provide a reasonably good approximation of how much the
The difference between these twoand figures represents credit exposure. bond and Fshort 0,PC/BC on=aSfixed-rate
0,PC/BC × bond. T
instrument. With the evolution high degree of efficiency in the CDS market, the credit (1 + r ) Option value
delta isofalsothe option
influenced would by change
time to given
expiration.a change in the price of the underlying stock.
the forward rate is higherBCthan the spot rate, it means that the price currency
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curve for a borrower
difference in
in values
values of
of the
is essentially the protectiondetermined
protection leg
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and premium
premium ratesleglegon equals the
the amount
its obligations.
equals amount of the• If interest rates increase, the fixed-rate payer benefits, as there is a positive difference
of the the• BSm Gamma modelisfor largest when there is great Stock
non-Dividend-Paying uncertainty regarding whether the option will
upfront
Value of protection leg = Credit risk = Value of risk‐free bond – Expected payoff on risky bond • between
payment. risk-free
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rates is increase,
higher than
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thereceipts baseand
fixed-rate currency
payer
(fixed-rate) risk-free
benefits, asrate.
payments. there is a positive difference
upfront payment. • expire
If the in-the-money
underlying price orremains
out-of-the-money.
unchanged, as a call option moves toward expiration:
Credit Default Swaps (CDS)
One of the factors that influences the credit curve is the hazard rate:
• between
If the
rate
○ forward
F ○is lower
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c =○ SN(d This) implies
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thattoward
gamma1.0 will tendcall
if the to be large when an option is at-the-money
is in-the-money.
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payment = = Present
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protection leg leg –– Present
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PC BC
rates increase, butbonds,the value value
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floating-rate bond bondremainsdecreasesat par. and close
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toward 0 if the call is out-of-the-money.
as interest
Since rates increase,
the fixed-rate payerbut is long the valueon theoffloating-rate
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and short on the at par. p =○ e–rT XN(–d 2)means
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• • Protection
The premium A constant hazard
leg refers toseller rate
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earns result
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CDSpayments relatively
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compensates
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than thefrom (long
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will move andtowardclose –1.0to expiration.
if the putOn the other hand, when an option is
is in-the-money.
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default
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in
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buyer
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a negativeInterpreting thedeep-in-the-money BSM Model: Approach or 1
deep-out-of-the-money,
○ Delta will move toward 0 if the put is out-of-the-money. gamma approaches zero, as
payment to the
the protection seller (buyer). In order
order to understand
understand this, note that:during
complicated
payment to by the fact that seller
protection once default(buyer). occurs,In regardless
to of exactlythis, whennote it occurs
that: • risk-free
If interestrate
difference rates
between
is decrease,
higher than thethe
(floating-rate)
base currency
fixed-rate receipts payer andloses
risk-free out,rate.
(fixed-rate) as there is a negative
payments. • Swaptions: holder ofofathe payer (receiver) swaption hopes
the term • ofTypes the CDS, ofthe CDS: protectionsingle-namebuyer ceases to CDS, makeindex payments CDS, to thetranches
protection seller. CDSAs • Vthe
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The BSM model can be described as the present value of the expected option payoff at
Value • Changes
a result,
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hazard
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of protection
protection
rates must during
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decrease, on risk-free
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of theof the fixed-rate
floating-rate bond bond
applications
increases
remains at par.
thatofmarket Delta swap fixed rate increases (decreases) before
delta.
seller will expiration.
sellerpayment will make make to to the
the buyer.
buyer. as interest rates decrease,
FI
expiration of swaption
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like• PV
PV Settlement
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price the fixed-rate
currency risk-free payerratebut is
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used on
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bond, she payer loses out is long as aon resultthe floating-rate
of the decrease bond and short
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seller willwill make make over over the the termterm of of thethe CDS CDS is
Swap
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The optimal = number
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Pricing a Plain-Vanilla Derivatives
Interest Rate Swap: Determining the Swap Fixed Rate T where E(pT) = XN(–d2) – Se N(–d1)
• Changes
the seller
the seller in will
willthereceivecredit quality
receive aa premium
premium or perceived
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• Changes Upfront
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in duration
CDS = Present
inception. of thevalue CDSof(duration protectionshortens leg – Present through valuetime). of premium leg Pricing Plain-Vanilla Plain-VanillaInterest Rate Interest Swaps Rate Swap: Determining the Swap Fixed Rate A gamma-neutral portfolio impliesDR that gamma is zero. If we want to alter the gamma and
value at inception. fixed rate) priCing and
priCing and Valuation
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of forward CommitmentS
deltaforward
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• Changes in the probability of default, expected loss given default and in the shape of N H = −of our portfolio, our first step would be to bring gamma to an acceptable level
exposures
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is B
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© 2018 Wiley Delta
If thisPrIcIng anD (negative), ValuatIon of–– FixedforwarD ×commItmentS Swap fixed rate =  × 100
)  ×+100
the
difference creditispremiumcurve.
positive ≅ (Credit the protection buyer (seller) makes the upfront −+BB0 ((rate N ) ...(LIBOR using options as the hedging H instruments and then alter the overall portfolio’s delta by buying
Upfront
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spread Fixed coupon)
coupon) × Duration
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of CDS Net fixed
Swap fixedrate ratepayment=  B0 (t1= ) +[SwapB0 ( 21)fixed 0 3) +– + B0 ( N t–1 Spread)] * (No. of days/360)
payment to theCross-Reference
protection seller (buyer). to CFA In order Institute
to understand Assignedthis, noteReading
DR
that: #40 Valuing Valuing Currency
Swap contracts
Currency Swaps Swaps
 B0 (1) +*BNotional 0 ( 2 ) + B0principal( 3) + ... + B0 ( N )  orofselling
priCing and Valuation stock.
forward CommitmentS
The change in value
Present value of of a CDS credit for a given
spread =valuechange in
Upfront the credit
payment spread value
+ payment
Present can beofapproximated couponas:
fixed coupon Estimating the Value of an Option
• • PV Present
Price of
of protectionvalue CDS of
legcredit
represents spread the= Upfront of thepayment
contingent DR+ Present value
that theofprotection
fixed
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== B
Valuing aVVaaPlain-Vanilla Ba −− SS0 B Bb Interest Rate Swap c14.indd 255 estimating the Value of option
Introductory seller will Definitions
make to the buyer. Plain-Vanilla•
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a
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0 b
initiation
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DR
Valuing a Plain-Vanilla Interest Rate Swap
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Profit
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forCDS protection perrepresents
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per 100buyer
100 par =100
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=100
the value–– Upfront
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premium in bps%
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Where the currency
currency aa value value of of thethe swap
swap equals equals the the difference
difference between between DR the currency a fixed bond
the currency a fixed bond For calls: c − c ≅ Delta c (S − S)
and the
the
value ofathe
currency
floating-rate payments (based on the current term structure of interest
A forward protection
commitment buyer will is make to the seller.
a derivative instrument in the form of a contract that provides the V =VaNA avalue
=aBvalue*− (PSFR
S0 Bofof thethe0currency
currency
– PSFRbbt)bond. bond.
* Sum of PV factors of remaining coupon
and
is greater, at a rates)
currency
Net= fixed equals
NA *rate
thebpayment
presentt value = [Swap of fixed-rate
fixedofrate payments
PV–factors (LIBOR so that there is*zero
+ Spread)] (No.value to For calls:  c − c ≈ Delta (S
of days/360)  S) + Gamma c (S − S)2
ability • toIflock the value inprice of payments
a price or rate that
at the seller
thewhich one will
can make
buy over or sell thethe termunderlying
of the CDSinstrument V payments (PSFR 0of– tPSFR
asswap = t trate ) * Sum oft–1remaining coupon For puts: p − p ≅ Delta pc(S −−S)
•
The percentagethe Change
seller will in change
CDS
receive a in
price
premium CDSforupfront
specified future date, or exchange an agreed-upon amount of money at a specified series
cangiven
a be
so computed
that change
overall, as:
both in credit
the positions spread hold equal © 2018
© 2018
Where
of
either
Wiley
Wiley
party. This
the currency
payments
a value of the fixed
as of t = t 11 −− B

swap * Notional
equals therefore
N )) principal 
the difference
B0 (( N
representsbetween the price ofa fixed
the currency the swap.
bond 2
value at CDS inception. • Over
and the
Swap the term
currency
fixed rate =of the
a
rate value
= of theswap, as there are changes in the
currency b bond.
0 × term structure of interest rates,
100
dates. Swap fixed
where PSFR B0 ((periodic
is swap
the 1) + +B B0 ((22))swap+B B0 ((fixed
3) + rate. ... + B0 ( N )  × 100 Gamma p
the value of the B 0 1) will +
0 fluctuate. 0 3) + ... + B0 ( N )  • 
%forward
Change in CDS price = Change in spread in expiration
bps × Duration where PSFR is of thethe periodic swap rate.rate isset at a level at which the presentFor puts: p − p ≈ Delta p (S − S) + For very small changes in stock value, (S − S)2
the delta-based approximation is quite accurate.
Valuing aUpfront contract % ≅ (Credit at Initiation
spread –(t = 0)coupon)
and × Duration(tof=CDS t) • At the initiation
If fixed
interest swap, the1after Bfixed
−swap N )fixed
0 ( swap
premium Fixed ○ rate =rates increase initiation, ×the100 present value of floating-rate • However, for large changes in stock value, 2 delta-based estimates understate actual call
A forward is a contract between two parties, where one (the long position) has the obligation
Valuing a forward contract at Initiation (t = 0) and expiration (t = t) Valuing
currency • value
Value
Equity
7Swap
7 March
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
 B0 (1) on
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current term structure of interest
0 ( N ) will exceed the present value of
buy, •
Valuing Equity MarchSwaps
values. Importantly, this is the case for large increases and decreases in the price of
Long/short trade: sell= Upfront
protection payment(long sell CDS) on entity
2018
to
monetizing and the
Gains other and (the shortspread
losses position) an obligation toPresent thevalue
underlying asset Valueat currency
a specified rates) equals the present value of fixed-rate payments so that there is zero value to
at• receive-return-on-equity
time Present value long
of credit Position Value + Short of fixedPositioncoupon Swap contracts
fixed-rate
Pay-fixed, payments (based on the swap fixed rate).
This receive-return-on-equity swap
pay-fixed, receive-return-on-equity the stock.
price (established
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quality as the is
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contract) at atospecified
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as
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pay-fixed,
Pricing
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Valuing Currency Equityparty. SwapsSwap The swap fixed rate therefore represents
swap will have a positive value for the price of the swap.
the fixed-rate payer (floating- • The implication here is that delta-based estimation is not perfect, and it gets more and
of the swap, as there are changes in the term structure of interest rates,For very small changes in the stock, the delta approximation and the delta-plus-
■
inception
At initiation
• The of the
protection
Price firstofcontract).
method
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to prevent
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worsen
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[(1
pay-fixed,
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The
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fixed of
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on equity)
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The
swapa
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Notional amount]
Notional
currency
swap
fluctuate.
will
amount] –– PV
swap
be an are asset
PV of
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of the
the
the
the remaining
fixed
remaining fixed-rate
fixed-raterates on Derivative Strategies
fixed-rate payments
payments
plain-vanilla
payer and a interest
liability for
•
more
gamma
rate
the
inaccurate
approximations as the stock for callmoves valuesaway arefrom
fairlyitsaccurate.
For large changes in the value of the stock, the delta-plus-gamma-based estimate is a
initial value.
Price versus
CDS Value to via
prevent arbitrage to (T)prevent – ST arbitrage • The If the
■
interest
At expiration upon default S T – Fa0(T) cash or physical settlement (discussed F earlier). swaps ○ fixed
[(1in rates onrates
respective a currency increase
countries. swap afterare swap initiation,
amount]still – PVthe fixed the present
rates on value of floating-rate
plain-vanilla
paymentsinterest
Gammarate
• • ACurve third (least trade common)Swith upward-sloping
method occurs if therecredit is no default.curve:
0
The if– credit
parties © 2018 Wiley
simply pay-floating,
• swaps
• + Return
Pay-floating,
payments floating-rate
on equity)
must(based
receive-return-on-equity
in
* Notional
on thethe
payer.
receive-return-on-equitynew term
of the
structure)
remaining
will swap fixed-rate
exceedcurrency
the present value of more
• alone.
Managing
accurate approximation
portfolio
of
duration
the value of the call than the estimate based on delta
At expiration
The price of atheir forward/futures T – F0(T)
contract is the
F0(T) ST pay-floating,However, If thewerespective
○ receive-return-on-equity
interest adjust
rates countries.
decrease notional
afteron swap
principal initiation,in the foreign
the present value of byfloating-rate
dividing This is the case for large
Derivatives up and down moves in the stock.
• holdAt curveexpiration, ispositions
expected until
both forward to steepen,
maturity.
and Byfixed
futures then,buy price
contracts
or rate
theprotection
seller hasatcaptured
are equivalent
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to all
underlying
CDS)
a spotthe transaction
premium • However,
the notional fixed-rate
weon must
principal payments
adjust in thethe(basednotional
domestic the swap
principal
currency fixed
in
by therate).
foreign
current currency
spot rate option
by dividing
(expressed asgamma is stock
defined as theupchange in anamount,
option’sthe delta given a small change in the
transaction will occur at contract expiration. The forward/futures price is agreed upon at [(1
pay-floating, + payments
Return will
equity)
receive-return-on-equity *be lower
Notional than
amount] the – present
PV (Next value
coupon of fixed-rate
payment + payments.
Par value) • • Increase
When the moves
duration: by a
enterlarge intoelse receive delta-plus-gamma-based
fixed interest rate estimate
payments without having to make any payments to the protection buyer. [(1 notional
+ Return■on The swap
equity) *in will
Notional have
amount] a positive
– PV (Next value thefor
bycoupon the fixed-rate
payment + Par payer
value) (floating-
value ofasoverestimates
the underlyingthe stock,
• in
initiation At on theaunderlying
the long-term
ofexpiration, contract. both asset. CDS
forward
Pricing
This andis known
and sell
futures
a forward/futures protection
convergence,
ascontracts
contractaremeans (longimplying
equivalent CDS)
determining tothataon at a
spot contract
thistransaction
forward/
the
DC/FC). principal
The receiver).
swap thewill domestic
have a positive currency value for current spot
the floating-rate rate (expressed
payer (fixed- priceholding
of the call.everything
When the constant.
stock moves Option
downgammaby a largemeasures
amount, thethe
in swap or buy bond futures contracts.
■
expiration, the forward/futures price will be the same as the spot price
7 March 2018 5:43 PM
DC/FC). rate curvaturedelta-plus-gamma-based
the option price–stock price relationship.
inshort-term
theof underlying CDS asset.ofThis theissame known entity as convergence, implying that at contract [(1 + Return on
rateonequity) *
receiver). Notional amount] – PV (Next coupon payment + Par value) estimate underestimates the price of the call.
futures
Applications
aluation of forward price.
CommitmentS
[i.e., FT(T) the CdS = fTforward/futures
(T) = ST].
One-Period
For • Pay-return
Binomial
pay-return-on-one-equity-instrument,
fixed-for-floating ■ Arbitrage
The swap
currency swaps: one equity
Opportunity
will be an instrument,
asset to the
receive-return-on-another-equityinstrument fixed-rate receive-return
payer and a on
liability for the
• a Reduce
gamma ofduration: enter intoinpay fixedofinterest rateDelta stays at
expiration, price will be the same as the spot price pay-return-on-one-equity-instrument, receive-return-on-another-equityinstrument
In this case, the swap will be an asset to the floating-rate payer • and
• [i.e.,
Basis trade:
(T) = fTexposures
aFTforward/futures (T) profit ]. from
= STcontract temporary difference between For fixed-for-floating another
■
equity
floating-rate
currency instrument
swaps: payer. swap The a long or short position one share stock is zero.
swap in+1.0swap or sell bond on afutures contracts.
The value of is the amount pay-return-on-one-equity-instrument,
Indexliability foristhanthe receive-return-on-another-equityinstrument
fixed-rate payer.
•
Valuing Manage
a(1)forwardcredit credit contract
spread i.e., take
during
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c14.indd 249 7 March 2018 5:43 PM
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241 contracts. © 2018 Wiley
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futures
As a result
versus forward contracts c14.indd 250 underlying
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• Covered call = long stock + short call on stock
•
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7 March 2018 5:43 PM
priceduring
time that was itsapplied
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current futures price and the futures
underpriced. To exploit this opportunity we would buy the option c14.indd 264 7 March 2018
Valuing thataFwas Forward
0(T)applied= S0Contract
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ponly puncertain factor that affects the price of the option.
•
indd 241 7 March 2018 5:43
price the last mark-to-market
• The market value of a long position in a futures contract before marking to market
adjustment. underlying
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h
• isNoteSthat= stockunderlying
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positive for call options. Collar = long stock + long put on stock + short call on
− S S − S
• Time moves in discrete (not continuous) increments. Private real estate investments
• vThe t(T) = =ft(T)S –– [F ft–0(T). to hedge a short position on a call, we must go long on the stock
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• • An Value market of0 value
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t(T) = ft(T) – ft–(T). underlying stock, and vice versa.
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the spread = long call (or put) + short call (or put) with
the options
positionusing
carry costs or benefits (long position) willthe no-arbitrage
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Net Operating Income
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c = for
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PV(–hS − – + −c–) or c = hS + PV(–hS+ + c+)
• The was forward price is not influenced by the expected future spot price. c = hS + PV ( − hS + c )
performed.
calculating the forward Price when the underlying Has cash flows
Single-Period Put Valuation Equation • Bear spread = long call (or put) + short call (or put) with
• Forward price wheninunderlying has discrete cash flows Rental
lowerincome exercise at fullprice.
occupancy Profit if expected decrease in stock
calculating Vt (T) the=forwardPV of differences Price when forward prices = PVHas
the underlying t,T [Ftcash(T) − flowsF0 (T)]
• Note p = c
hS
+ h– is (mathematically)
that –+ c PV(–hS +– + p +–) or p =positive hS + for call+ options.
PV(–hS + p +)
+ Other income (such as parking)
F0(T) = (S0 – γ0 + θ0) (1 + r)T ph = hS + PV (− hS + p ) price materialises. DR
• This means
S +
– S– that in order to hedge a short position on a call, we must go long on the = Potential gross income (PGI)
where PVFt,T(T) ( ) means S00(1–the +γ0r)present value)(1 Tat timeTt of an amount paid in
0 = (S +T θ–0(γ ) (10 –+θr) 0 + r) Derivatives
• ©2018
© wiley
wiley
underlying stock, and vice versa.
The
2018
• allallthe hedge
rights ratio
reserved. anyforanyputs
unauthorized negative.
is copying
copying or distribution
distribution will constitute ananinfringement
infringement • −LongVacancy 77straddle
77 and collection = long losscall + long put with same strike price
T – t years (or at time T). ©
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2018
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rights
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reserved.
price
binomial call
reserved.
any option
unauthorized
unauthorized
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model, the
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values position will
for
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short call position= Effective 77
gross income (EGI)
F0(T) = S0(1 + r)T – (γ0 – θ0)(1 + r)T Value • ofloses
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a Call meansOption that in order to hedge a long position on a put, we would actually go long and expiration. Profit if expected increase in volatility
• Forward price when underlying price ishas cash as: flows π out,=underlying
risk-neutral
and vice versa.probability of UP move) − Operating expenses (OE)
With continuous compounding, the forward calculated on
c++ =no-arbitrage
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Table 1-1:
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the forward price is calculated as: the long underlying position loses out.
Single-Period
c+–a=single-period
Max(0,S+– Put– Valuation
X) = Max(0,udS Equation – X)
in πc + + setting.
(1 − π)c −for puts,
Time F0(T) = S0e(rc+θcLong c– – • Since
c = h– –is–negative 2S –aX) put is equivalent to a short position in the
–γc)T
Position Value Short Position Value
DR = Max(0,S X) = Max(0,d The Direct Capitalization Method
ALTERNATIVE INVESTMENTS
(r +θ –γc)T underlying (1and + r)Derivatives
lending– 245–out the proceeds of the +short+sale. Specifically, a long Private Real Estate Investments
©At WileyF0(T) = S0e c cZero,
initiation
2018 as the contract is Zero, as the contract is the two-Period p =
position hS +on PV(–hS
Binomial
a put can +
model
bep ) or
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lending that + phas ) been partially financed with a
Note that only carry costspriced and benefits incurred
to prevent arbitrage over the term of the forward
priced to prevent arbitragep++ = Max(0,X contract are – S++) = Max(0,X – u S), 2
Private real estate investments Cap rate = Discount rate − DR Growth rate
where:
short position inMax(0,X
shares. – udS)
included
Note
During •
thatlifeValue
in
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of carry of
preceding a forwardformulas.
the costs and benefits incurred contract during its life when
over the term of the forward contractThe p +– =
are• Max(0,X
two-period – S +–
binomial ) = model puts makes use of a recombining two-period binomial tree.
Net Operating Income
included
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contract underlying
ain the preceding
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− when
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π = means that
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+ − ratio
– rSdetermined
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) = Max(0,X
in 2018
order
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through d2S) backward induction.
to hedge a long position on a put, we would actually Private real Private Real Estate Investments
estate investments The gocaplong rate can
Rental be defined
income at full Private
asoccupancy
the current Real yield Estate Investments
on an investment:
indd 245
• Carry costs, like thet rate  (1 + r )  increase the burden  (1 + rof) carrying 
t
the underlying (u − d)
7 March 5:43 PM

instrument through time. Therefore, these costs are addedofincarrying the forward And puton
pricing or the callunderlying
value will be as thewell. If the value
present price of of the
the terminal
underlying value falls,
forthetheput benefits,
option. The while + Other income (such as parking)
risk-free
At• Carry
V
expiration (T) costs,
= PV like
of the
S rate
differences
– F of
(T) interest,
in forward
equation. through time. Therefore, these costs are added in the forward pricing
t T 0
increaseprices the= burden
PVF 0 (T)
t,T [F– t(T)
S T – F 0 (T)] the underlying
Two• important the
A writtenlong concepts
underlying
call is related position
equivalent
rate is used for discounting, and must be compounded over two periods.
to the to two-period
loses
selling out. the binomial
stock short option
and valuationthe
investing model
proceeds.areNet • = Net
Operating operating
Capitalization
Potential Income
gross rate =
Private
income
NOI1
income (PGI) Real Estate Investments
instrument dynamic A• replication and self-financing.
• Carry benefits decrease the burden of carrying the underlying instrument through Hedge • Ratio Since Use
written forh is process
negative
put
Puts is equivalent toputs,
for value a When
toa buying
put put
is equivalent
the applied
option
stock with toto acall
using short options:
borrowed the
position in the
funds. − Vacancy and collection Value loss
Carry • equation.
Price
time,
• benefits
Carry soandof
these
benefits
a FRA:
costs benefits forward
are accounted
decrease arethesubtracted
burden
rate
for starting
in
inofthis the forward
equation
carrying
at FRA
the in pricing expiration,
equation.
the computation
underlying instrument of the two• Dynamic
through
underlying expectations and lending out the proceeds of the short sale. Specifically, a long
approach. Net Operating =Rental
Effective income
Income grossatincomefull occupancy
(EGI)
position
the expectations + on replication
a put can be
–approach means
overinterpreted
one thatPeriod
theasportfolio
lending of thatstockhas been and borrowing
partially financeddynamically with −a+Operating
Other income (such(OE) aswe parking)
Carry Arbitrage
forward given
prices. two
Model LIBOR
When therates Underlying Has Cash Flows p – p Rearranging the above equation,
expenses can estimate the value of a property by dividing its first‐year
time, so these benefits are subtracted in the forward pricing equation. • replicates
hTwo-period
short = position the value binomial
in shares. of the callmodel through for European
the binomial lattice. stock options =NetPotentialrate. gross income (PGI)
• Value of a FRA prior toT expiration © 2018
• Wiley Self-financing S+ – S– means that if additional funds are required to purchase more NOI by Rental
shares to
=the
−
capoperating
Vacancy
income
and
at income
full occupancy
collection
(NOI)
loss
• IfF0a(T) = (S0 −payment
dividend γ 0 + θ0 ) is(1announced
+ r) between the forward’s valuation and expiration c• =Use PVr[E(c backward 1)] induction with the expectations + Other income (such as parking)
© 2018 Wiley maintain
Options the hedge, the amount of borrowed funds will automatically increase. == Effective NOIgross income (EGI)
• Calculate
dates, assuming that new theimplied
news announcement forward rate does not based change onthecurrent price of the Writing
Value of ap Put =approach.
PV r[E(p1)]
Option
The Direct ValueCapitalization
Potential = gross1 income Method (PGI)
−−Vacancy
Operating andexpenses
Cap rate
collection (OE)loss
LIBOR
underlying, rates.
the value of the original forward will fall.
or CommitmentS
aluation of forward • The mark-to-market adjustment in futures markets results in the value of a futures
the• expectations
The• price
A • Value
7written
March 2018 call approach
5:43
of call
PMis equivalent
and in aput two-Period
to options
selling the Setting
stock short and investing the proceeds. = =Effective
Cap Net rate = Discount
operating
gross incomerate −(EGI)
income (NOI) rate
Growth
• Calculate interest savings based on the this newofforward A of 7written
a callput or put option, under
is equivalent to buyingthis approach,the stockiswith calculated
borrowed directly
funds.from expected − Operating expenses (OE)
contract after settlement equaling zero. Therefore, values otherwise identical terminal coption πc +payoffs.
March 2018
+25:43
(1++ − π)c −
PM
+– 2 –– AnThe estimate
Direct of the appropriate
Capitalization cap rate for a property can be obtained from the selling price of
Method
F0 (T)
forward rate = and
Svs T
+ r) rate.
FRA
0 (1futures − contracts
( γ 0 − θ0 ) will (1 + r) T
likely be different. c = = PV[π c + 2 π (1 – π)c + (1 – π) c ] The cap• or
= Net
Direct
rate operating
can becapitalization
defined income (NOI)
as the current method yield on an investment:
(1 +++r) similar comparable properties.
Markets Where Accrued Interest Is Not Included in the Bond Price Quote the expectationsp = PV[π2approach p + 2 π (1 over– π)p one +– Period 2 – –
+ (1 – π) p ]
Interest
• Discount
rate forward
these
and futures
interest contracts
savings for a period equal to
where:
The Direct • Cap rate = Discount rate
Capitalization
Capitalization Method
NOIrate − Growth
1NOI
from rate comparable property
Valuing a Forward Contract When the Underlying Has Carry Benefits/Costs Capitalization
Cap rate = rate =
F0the (T) =number QF0 (T) × of CF(T) days andremaining
QF0 (T) = 1/ CF(T) until FRA × F0 (T) expiration c = PVr[E(c1)]
Cap rate =
Sale priceValue
Discount
of comparable property
rate − Growth rate
plus the number of days in the term of the underlying Very important: (1 + rUnder − d) this approach, the value of the option is computed based solely Theon cap rate can be defined as the current yield on an investment:
Forward Rate Agreements π== PVr[E(p1options
pAmerican )]
Vt (T) = PV of differences in forward prices = PVt,T [Ft (T) − F0 (T)] possible
© 2018 Wiley
• terminal (u −values.d) 253we can estimate the value of a property by dividing its first‐year
hypothetical loan (using appropriate LIBOR rate). Rearranging the abovebyequation, NOI
A forward F0rate
(T) =agreement PVCI(fra) ) × (1is +a r) forward
T
= [B0contract
(T + Y) where + AI 0 −the underlying is r)
anTThe price• ofAmerican
interest or put call options onapproach,
a non-dividend-paying stock
The cap rate
The
NOI
risksby
cap the • Capitalization
rate cap
derived
Value
canrate.be defined
dividing
of property rent
rateas= the current 1 by recent sales prices of comparables is known as the all
yield on an investment:
0 −
ofIt(Sainvolves PVCI 0,T ] × (1 + is a calloptions option, under this is calculated directly from expected
rate on• a deposit.
Price bond futures contract (1)when accrued interest
0,T american-Style yield (ARY). The value ofValue a property is then calculated as:
two counterparties: the fixed DR payer/floating receiver (long
terminal option willpayoffs. neverDerivatives be exercised early.
position) not
and included
(2) the floating inunauthorized
the bond
payer/fixed price
receiver quote
(short position).(convert this price to NOI1rate NOI
© Wiley 2018 All Rights Reserved. Any copying or distribution will constitute an infringement of copyright. Capitalization
= Rent= 1
The futures price of the bond is calculated as:
the quoted futures price using bond’s conversion factor)
c14.indd 253
American-Style • Early Optionsexercise and Early of American
Exercise call options on a dividend- Rearranging Value
Market the value
above
Cap =equation,
7 March 2018
rate
1 5:43 PM
Value we can estimate the value of a property by dividing its first‐year
ARY
• A long FRA position can be replicated by holding a longer-term 252 78 Eurodollar time
© Wiley 2018 All
paying
Rights
stock
Reserved. Any
and American
unauthorized copying or
put options
distribution will constitute
onanboth infringement of
NOI by the cap rate.
© 2018 Wiley
copyright.
currency forward contracts T • An American-style call option on non-dividend-paying stock will never be exercised
F0 (T) =and
deposit [B0at(Tthe + Y) same + AI 0 − shorting
time PVCI 0,T ](or × owing)
(1 + r) on − AI a shorter-term Eurodollar time dividend-paying and non-dividend-paying stocks may Rearranging • Gross the above income equation, we can estimate the value of a property by dividing its first‐year
multiplier
T
early, because the minimum value of the option will exceed its exercise value.An
Otherestimate ofofthe appropriate
NOI1 Approach cap rate formethod a property can be obtained from the selling price of
deposit. NOI byForms
theValuecap the
= Income
rate.
Pricing a Currency Forward Contract © 2018• Wiley There bemay optimal be casesinwhere some early cases.
exercise of an American-style call option on similar
a or comparable Capproperties.
rate 253
The quoted• Price futures of a
price currency
of the bond forward
is calculated as:
Think of the long position in an FRA as the party that has committed to take a hypothetical • Black-Scholes-Merton model for European options on
c14.indd 252 dividend-paying stock is
DR
optimal. Gross
7 March income
2018 NOI
5:43 PM multiplier =
Selling price
• Early exercise of American-style put options on both dividend-paying and non- Value = 1 NOIGross income
loan, and the short as the party(1that Cap rate Cap = rate
+ r has )T committed to give out a hypothetical loan, at the fixed non-dividend-paying
dividend-paying stocks may be warranted stock in certain cases. An estimate of the appropriate
Sale price ofcap rate for aproperty
comparable property can be obtained from the selling price of
FRA rate.QF F0,PC/BC = S0,PC/BC × [B (TPC+ TY) + AI − PVCI ] × (1 + r)T − AI
0 (T) = 1/CF(T) × (1 + rBC )
0 0 0,T T
c14.indd 253 similar or comparable 7 properties.
March 2018 5:43 PM

An estimate of
Value theof appropriate
subject cap
property rate
= for a property can be obtained
× Grossfrom the selling price of
FRA Payoffs no-arbitrage versus expectations approach in a multi-Period Setting The cap rate derived by dividing rentNOI by recent sales multiplier
Gross income prices of comparables income of subject
is known as theproperty
all
Currency Forward Contracts Cap rate = properties.
similar or comparable
risks yield (ARY). The Salevalue priceof of a property
comparable is then calculated as:
property
• IfFLIBOR 0,PC/BC =at S0,PC/BC
FRA expiration ×e (r − r ) × T
PC BC
is greater than the FRA rate, the long benefits. • Generally speaking, European-style options can be valued based on the expectations
approach. Under this approach, option value is determined as the present value of theCap rate = Rent1
NOI Wiley © 2019
Effectively, the long has accessSto a loan × (1 rPC )T
at +lower-than-market interest rates, while the = price
shortInterest rate parity:
is obligated F0,PC/BC
to give
0,PC/BC
out =a loan at lower-than-market interest rates. expected future option payouts, where the discount rate is the risk-free rate and Thethe capMarket
rate derived value Saleby dividing
ARY
of comparable
rent by recent property
sales prices of comparables is known as the all
• If the forward rate is higher than the(1spot + rBC )T it means that
rate, the price currency
○ Stated differently, the long benefits as the fixed payer and floating receiver. expectation is based on the risk-neutral probability measure. risks yield (ARY). The value of a property is then calculated as:
risk-free rate is higher than the base currency risk-free rate. • Both American-style options and European-style options can be valued based on the
 ARBiTRAge PRicing TheoRy

Arbitrage pricing theory (APT) describes the expected return of an asset (or portfolio) as a

Wiley’s CFA Program Exam Review

®
linear function of the risk of the asset (or portfolio) with respect to a set of factors that capture
systematic risk. APT is an equilibrium pricing model that does not indicate the identity or even
the number of risk factors.

Assumptions

1. Asset returns are described by a factor model.

2. There are many assets so investors can form well‐diversified portfolios that have zero
asset‐specific risk.
3. No arbitrage opportunities exist among well‐diversified portfolios.

Private equity valuation

of management with PE firm
• LBO transactionsPrivate real estate investments
APT equationPORTFOLIO MANAGEMENT
E(Rp) = RF + λ1βp,1 + + λKβp,K ...
• DCF method • Significant debtPrivate
used toEquity
finance purchase.
Valuation
Portfolio Management Process
E(Rp) = Expected return to portfolio p
• If NOICash • Exit value = Initial cost + Value creation from earnings
The Discounted is expected to grow
Flow Method at a constant rate
(DCF) Quantitative Measures of Return
growth + Value creation from multiple expansion +
• RPlanning
F = Risk-free rate
λj = Expected reward for bearing the risk of factor j
• PICValue
(paid increation from
capital): Ratio debt
of paid in reduction.
capital to date to committed capital.
•
βp,jIdentify riskofand
= Sensitivity returntoobjectives.
the portfolio factor j
NOI1
Value = • Venture
Private real estate investments
capital transactions
K• =Identify
Number ofinvestment
factors constraints: liquidity, time horizon,
(r − g) • DPI (distributed to paid‐in) or cash‐on‐cash return: Value of cumulative distributions paidtax concerns, legal/regulatory factors and unique
to• LPs Pre-money
as a proportion valuation
of cumulative (PRE) = agreed
invested capital.value of company • The factor risk premium (or factor price), λj, represents the expected reward for
circumstances.
bearing the risk of a portfolio with a sensitivity of l to factor j, and a sensitivity of 0
The Discounted Cash Flow Method (DCF)
The • If property
Terminal Capitalization
is expected Rate to generate income for a specific ○prior(DPI to a=round Cumulative of financing.
distributions / PIC) an inTroducTion To MulTifacTor Modelsto• all
an inTroducTion To MulTifacTor Models Create
other factors. investment Such a portfolio policyisstatement. called a pure factor portfolio (or more simply,
holding NOI1period before being sold at the end of the • Post-money valuation (POST) = value of company after
• RVPI (residual value to paid‐in): Value of LPs’ shareholdings held with the fund as a • Form capital market expectations.
the factor portfolio for factor j.
Value = NOI for the first year of ownership for the next investor the round of financing (I). • The sensitivity of the portfolio’s return to factor j, βp,j, represents the increase in portfolio
holding g)period,= value property as the sum of the PV of An Introduction to
Terminal (r −value proportion of cumulative invested capital.
• Create
return in response An Introduction
strategic to a one-unit assetincrease to Multifactor
allocation. in factor j, holding Models
Multifactor Models
all other factors constant.
income stream and sale price (use direct
Terminal capcap ratemethod • ○POSTRVPI = PRE + I. • The intercept term in the model is the risk‐free rate. It represents the rate of return if
The Terminal to Capitalization
estimate sale Rate price or terminal value) = NAV after distributions / PIC Arbitrage
Arbitrage • the Execution
Pricing
Pricing
portfolio
Theory
Theory and
and the
has 0 sensitivity the FactorFactor
to all Model
Model
risk factors (or 0 systematic risk).
• Proportionate ownership of VC investoran=inTroducTion
• TVPI (total value to paid‐in): Value of portfolio companies’ distributed (realized) and
I ÷ POST. To MulTifacTor Models
• E(RFeedback: monitoring/rebalancing and performance
Cost Approach E(R PPModel )) =
=R R FF + +λ λ11β β pp,1,1 + +… …+ +λ λKKβ β pp,K
Terminal value =
NOI for the first year of ownership for the next investor • undistributed
Exit routes: IPO (highest
(unrealized) value asvaluation),
a proportion ofsecondary cumulative invested market The carhart
an inTroducTion To MulTifacTor Models evaluation
capital. ,K

Terminal cap rate sale, An Introduction to Multifactor Models

Appraised value = Land value + Building value ○ managementTVPI = DPI + RVPI buyout, liquidation (lowest valuation)The carhart
E(Rpp)) four-factor
E(R =
= Expected
Expected return model
return on (alsothe known
the portfolio as ppthe four-factor model and the carhart
• Private equity fund performance model)
Arbitrage is
R a = commonly
Risk‐free
Pricing Multifactor Models
Theory used
rate andmultifactor
on
the Factor
portfolio
model. Model It asserts that the excess return on a portfolio
• Cost approach
Cost Approach is a function λ
RFF = Risk‐free
of: premium
Anrate Introduction to Multifactor Models
Building value = Replacement cost + Developer’s profit λjj = = Risk
Risk premium for for factor
factor jj
• Appraised value =value = Land valuevalue + Building value. • Gross IRR: based on cash flows between
NAV before distributions = Prior year’s NAV after distributions + Capital Arbitrage fund and called • βArbitrage
β E(R = P
p,jPricing
) = R
Sensitivity +
F pricing
Theory
λ ofβ
1 p,1
of and the + … +
theory
portfolio
the
λ β
K p,K
Factor to factor
Modelj j
Appraised Land value
− Curable + Building
deterioration p,j = Sensitivity the portfolio to factor
portfolio companies.down − Management Fees + Operating results 1. K Its=
K =sensitivity
Number
Number of oftofactors
the market index (RMRF) that represents exposure to the market.
factors
• Building value−=Incurable Replacement deteriorationcost + Developer’s profit 2. AE(R market ) = Rcapitalization
+ λ β + … factor
+ λ β(SMB) that represents exposure to size.
Building value = Replacement cost + Developer’s profit
– Total depreciation. • NAV Netafter IRR: based on=cash
distributions flowsdistributions
NAV before between−fund Carried and limited
interest Active E(Rp) = Expected return on the portfolio p
3. Return
– Distributions
P F 1 p ,1 K p ,K
A book-value-to-price factor (HML) that represents exposure to a value orientation.
− Functional obsolescence Active Return
R = Risk‐free rate
− Curable deterioration partners (return to investors). 4. AFmomentum factor (WML).
• Sales comparison − Recent
− Incurable approach: locational
deteriorationcalculateobsolescence
average adjusted • E(R
λCarhart
j = Risk premium
p) = Expected
four-factor for factor
return onmodel
the j portfolio p
Active return = R −
−R
comparable properties and Total Exit• Value PIC (Paid-in capital): ratio of invested capital to Rβp,j = Sensitivity
Active return rate = of Rppthe Rportfolio
B to factor j
price per square foot from
− Functional obsolescence F = Risk‐free βfactors B
K E(R = p) = RF +
Number of p,1RMRF + βp,2SMB + βp,3HML + βp,4WML
use this to − Recent
value property
locational obsolescence committed capital. λj = Risk premium for factor j
Replacement cost = Building costs psf × Total area sf βp,j = Sensitivity= of
Active the portfolio to factor+j Return from asset selection
• ExitDPIvalue = Initial cost + Earnings growth + Multiple expansion + Debt reduction
(Distributed to paid-in): ratio of cumulative Active Active return return = Return Return from from factor factor tilts tilts + Return from asset selection
• Real estate indices Effective age area sf • Return
© 2018 Wiley KActive = Number return of factors
Replacement
Incurable deterioration =cost = Building costs psf × Total × Value after curable deterioration distributions paid to LPs to cumulative invested
• Appraisal-based indices: Totalappraisal
Effective economic
age values
life lag Post‐money valuation (POST)
capital.
Active Risk
Risk
Active Return Active return = Rp − RB
Incurable deterioration = × Value after curable deterioration
transaction pricesTotal when market
economic life shifts suddenly.
• POST
c16.indd 317
RVPI = PRE(Residual
+I value to paid-in): ratio of LPs’ holdings TE
TE =
Active = S(R (R
returnp− RB)
p − R=B)Rp − RB
tate investments
tate investments
tate investments • Transaction-based
Sales Comparison Approach indices: repeat sales and hedonic held with the fund to cumulative invested capital. ActiveS return = Return from factor tilts + Return from from assetsecurity selection
selection
Sales Comparison Approach portfolio ManageMent
indices. Proportionate ownership of the VC investor portfolio ManageMent
ManageMent Where TE = tracking error
Sales price • TVPI (Total value to paid-in): sum of DPI and RVPI. portfolio Where
Active •
TE
Risk
=
Active
tracking
Active return
error
risk =isReturn the standard from factor deviation tilts + Return of fromthe active
asset selectionreturn
Loan
Loan toto• Value
to LoanSale
Value
Value to value
ratio
ratio price psf ratio= price
Sales
Loan price psf =
ratio
Sale
sf sf
• Basic
= I / POST venture capital method (in terms of NPV) Active MeASURing
risk squared = 2 And MAnAging MARkeT RiSk
2(Rp − RB)
Active Risk Active
TE MeASURing
S(Rrisk
= MeASURing p −squared
Cross-Reference RB) = S (R S
And
And − RBMAnAging
top CFA
)
MAnAging
Institute Assigned MARkeT
MARkeT Reading RiSk
RiSk #49
LTV
LTV
ratio
LTV ratio
ratio ==
Loan
Loan amount
amount
= Loan amount Post‐money • Stepvalue 1: Post-money value (POST) Cross-Reference to
Cross-Reference to CFACFA Institute Institute Assigned Assigned Reading Reading #49 #49
AdjSale
Adj SalepriceAppraised
price = Sale
Appraised
psf psf
Appraised
value
=value
value
Sale psf × (1psf
price price × (1 adj
+ %age ) × (1 +adj
+ %age ) × (1 +adjcondition
condition ) adj) Where TETE = tracking
Active = S(R risk error
p −squared
RB) = Active factor risk + Active specific risk
× (1 +×location ) ( ) Active risk squared = Active factor risk + Active specific risk
(1 + location adj) × (1 + sale date adj)
adj × 1 + sale date adj Exit value vAlUe AT RiSk (vaR)
vAlUe AT AT RiSk RiSk (vaR) (vaR)
Debt
Debt • Debt
Service
Debt Service
Service serviceratio
Coverage
Coverage
Coverage coverage ratio
ratio
ratio Post-money value =
(1 + Required rate of return) Number of years to exit
vAlUe
Where TErisk = tracking error
value at Active (vaR) risk squared describes = aSnn2minimum
(Rp − RB) loss to which a portfolio or portfolios of assets
NOI
NOI ∑
n
Adj n sale price psf p
Required wealth
value
value be
might
might be
at
at riskrisk
Active
subject
bePrivateActive
subject
(vaR)
(vaR) Market Risk
specific
Private
over
describes
overdescribes
specific risk
a particular
equity risk =∑
=
valuation
a particular
particular
aa minimum
∑
minimum
w a 2
ia σ
time
wtime
ε2 period
loss to
loss to which aa portfolio
withwhich
portfolio or
a certain degree of
i σ ε period with a certain degree of probability.
or portfolios
portfolios of assets
probability.of assets
=
i
NOI
∑
DSCR
DSCR = might subject equityover valuation a i =1 time i
period with a certain degree of probability.
DSCR = Debt p=1 Adj sale price psf p Active risk squared = iS=1(Rp − RB) 2
Debt
Avg Price service
psf
Debt service=
service • Step 2: Pre-money value (PRE): PRE = POST – The parametric Active risk method squared = Active
generates a VaR factor risk + Active
estimate based on specific
returnriskand standard deviation,Measuring and M
Avg Price
p=1 n
= Price psf × Target property psf Investment.
• VaR:
parametric
The parametric minimum
method generates generatesloss over a VaRaestimate particular based time
on return period with adeviation,
and standard
valuepsf
Appraised =Avg Required wealth = Investment × (1 + IRR) Number of years to exit The
typically
Where: from a normal method distribution.a VaR estimate based on return and standard deviation,
Ownership proportion Where: specified probability
Equity• dividend
Equity Equityrate/Cash‐on‐cash
dividend
dividend dividend ratioreturn
rate/Cash‐on‐cash
rate/Cash‐on‐cash return
return n
(cash-on-cash return) Ownership
Publiclyproportion
traded real estate securities typically
typically
w a from
fromth asset’s a normal
a normal distribution.
distribution.
Equity
• Step 3: Ownership proportion of VC investor = wii = The i asset’s active weightn in the portfolio (i.e., the difference between
a = The i
Active
th risk active
squared weight = Activein the portfolio
factor risk (i.e.,
+ the
Active difference
specific between the
risk the asset’s
asset’s weight
weight inin
Appraised value =Avg Price psf × Target property psf • zParametric Measuring
method wai σand Managing Market Risk
Appraisal‐Based Indices First year cash flow
Publicly traded real estate securities
Investment
Ownership
Ownership proportion
proportion ÷ = =
POST.Required
Required wealth
wealth / /
Exit Exit value
value
the
the
σ
portfolio
2 portfolio Active
=
and
R
and
R
−µ
−
its
its weight
specific
µ
weight riskinin=ththe ∑
the benchmark)
benchmark) 2
ε th
First year
year cash
cash flow
flow σ εε == The zresidualR σ− µ risk of the iith iasset (i.e., the variance of the iith asset’s returns that is not
i
2
Equity dividend rate
Publicly =
= First
Traded Real Estate Securities The z• =
residual
=VaR risk of the asset
=1 (i.e., the variance of the asset’s returns that is not
Equity dividend rate
Equity dividend rate = Equity investment Estimating
explained by
i
estimate based
σ factors)
VaR—Parametric nMethod on return and standard deviation,
• Step by the
i
Equity investment
investment 4: Shares to be issued to VC investor σ
from ∑
Equity explainedActive the factors) risk = wa σ 2
Appraisal‐Based NOI Publicly
Indices Traded Real
− Capital expenditures + (Ending Estate
market Securities
value − Beginning market value)
Shares
Shares to bebe issued
issued typically specific normal i ε distribution
VALUATION: Return = NET ASSET VALUE APPROACH
i

90 Where: i =1
Beginning market value © Wiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. R − µ n
wai = The E(R izActive
= ) =factor riskweight= Active risk squared −
− Active specific
specific risk
Pσ ∑
th asset’s
nactive in the riskportfolio
squared(i.e., the difference between the asset’s weight in
Active factor n
VALUATION: NET ASSET VALUE APPROACH w irisk
R i = Active Active risk
Capitalization rateNOI − Capital expenditures + (Ending market value − Beginning market value) Proportion
REITs Proportion of venture
of venture capitalist investment
capitalist investment× Shares held byheld
× Shares theby
Where: portfolio E(Rand
E(R P ) =its
P) = ∑
∑ wi R
i =1weight
w R i in the benchmark)
Return = company
companyfounders
founders σ 2
The = The
ε = Information residual i =
risk 1 of
i i
the i th asset (i.e., the variance of the ith asset’s returns that is not
Capitalization rate Beginning Shares to be issued = w a
The ith asset’sRatio i =active
1 weight in the portfolio (i.e., the difference between the asset’s weight in and M
property market value Shares to be issued = Proportion of investment of company founders Thei Information i Ratio Measuring
NOI of a comparable Proportion of investment of company founders the explained by andthe factors)
Capitalization rate = portfolio its nweight in the benchmark)
• Net asset value Total (NAV)
NOIvalue approach
of a of comparable
comparable property
property σ 2
= The σ E(R =
residual P )RRw ∑
=p2risk −
σ
−
2R
R
w+of
BiRw i2 σ 2ith+asset
the 2w σ w
(i.e., σ ρ
the variance of the i th
asset’s returns that is not
Capitalization rate = ε P=
propertyby capitalizing Price per •
Price per share
Step 5: Price per share IR
σ = w σi22i +
wpi22ii=1 +B wj22 σ 22j + 2wi σi wj σ j ρi, j
Measuring iand j Managing
• Estimate valueTotal explainedσ IR P= σ ) jj σ=jjActive
+ 2wii σrisk i w jσ jρi, j − Active Market
specific riskRisk
i

of operating
value of comparable real estate share Active
byP the pi −
factor w
risk jsquared i, j
s(Rfactors)
s(R
p − RB)
iR B
Net Asset Value NOI (exclude
per Share non-cash rents).
© Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. Price per share = 87Amount of venture capital investment Estimating VaR—Parametric Method
Amount of venture capital investment The Information Unannualized
Active
σ P = wfactor 2Ratio 2 risk σ2Pσ=2=+2w Annual
Active σP /ρ
risk No. of days
squared
0.5
− Active
0.5 specific risk
Net Asset Value per Share
• Total NAV Price per share =Number of shares issued to venture capital investment Unannualized i σ i +wσ σj P = =j Annual i σ i wσjσ P j/ No.i, j of days0.5
Net = Value
Asset Value of operating real estate + Value of Number of shares issued to venture capital investment
Unannualized P Annual σP / No. of days
NAVPS = R − µ
other tangible
Shares assets – Value of liabilities.
outstanding
Net Asset Value Adjusted discount rate The
Note
•
NoteInformation
that:
that:
Historical
z = R pRatio − R Bsimulation: returns are ranked lowest to
NAVPS = Equity
Note IR = σ
Exposure—CAPM
that:
• NAV per share
Shares = Total NAV ÷ Number of shares
outstanding Adjusted discount rate
87 94
94 ©
© Wiley
Wiley 2018highest,
All s(R −VaR
Rights
Rights pReserved.
R B ) Any is determined
Any unauthorized copying for
or required
or distribution will confidence
will constitute an infringement of copyright.
© Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. • 2018The All parametric Reserved.
R − R B method
unauthorized
using the copying
normal distribution
distribution constitute
is easyantoinfringement
use and of copyright.
employs
VALUATION: outstanding.
RELATIVE VALUATION (PRICE MULTIPLE) APPROACH Commodities
Adjusted discount rate =
1+ r
−1
1 −1q+ r
• The
• interval
The
historical
IR
parametric
) = prfvalues
E(r=aparametric n+ β [method
method
E(r
that M )can rusing
− using ] adjusted
fbe
the normal
the normal distribution
distribution is
for reasonableness
is easy
easy to to use
use and
and employs
in any environment.
employs
historical values that can be adjusted for reasonableness in any environment.
Funds• from
VALUATION: Price RELATIVE
to funds
operations (FFO)
VALUATION
from operations ratio (PRICE MULTIPLE) APPROACH Adjusted discount rate =
1− q
− 1 • • Monte
historical
However,
• However,
E(R
However,
s(R
P ) = ∑
pvalues
it −does
Carlo
it does
R
w
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not reflect
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losses that
thatin any
result
that result
environment.
from
result from
unexercised
from unexercised
unexercised
• Spot • assumptions
options in iti=1a portfolio nottothat generate expirenonparametric a distribution of
worthless. random
Funds from operations (FFO) r = Discount rateand futures
unadjusted pricingof failure.
for probability Fixed Income
options
options
Exposure
in aa portfolio
in portfolio that
that expire worthless.
expire worthless.
• Further, the distribution changes as time value diminishes and the option value
Accounting net earnings q = Probability of failure.
• Contango: futures price >ofspot • outcomes
Further, the distribution changes as time value diminishes and the option value
r = Discount rate unadjusted for probability failure.price. 94 ©First-• and
Wiley 2018Further,
All Rightsthe
second-order
approaches distribution
Reserved.
the Any unauthorized
yield
underlying effects changes on copying
security bondas value
time value
or distribution
price: diminishes
will constituteand
at maturity. the optionof value
an infringement copyright.
Add: Depreciation charges on real estate approaches 2 2the underlying security value at at maturity.
maturity.
• • Finally,
2 2
Accounting net earnings qBackwardation
= Probability of failure. Conditional
σ P = wsensitivity
approaches i σ the jσVaR:
i +wunderlying j +2w
to average
i σ isecurity
correlation w jσ jρchanges i, jloss
value expected
between portfolio outside assets adds instability to
Add:
Add: Deferred
Depreciationtax charges
charges on real estate • Backwardation: spot price > futures price. • Finally,
• Finally, sensitivity
sensitivity to to correlation
correlation changes between
changes between portfolio
portfolio assetsassets adds
adds instability
instability to to
Add 94 © Wiley 2018 theconfidence
the ∆AllBestimate.
Rights Reserved.
estimate. ∆y limits Any ( ∆y)2 copying
1 unauthorized or distribution will constitute an infringement of copyright.
Add:(Less):
Deferred Losses (gains) from sales of property and debt restructuring
tax charges = −D + C
Funds
Add (Less):fromLosses
operations
(gains) from sales of property and debt restructuring
• Insurance
Backwardation Ft < S0 theory (theory of normal backwardation): the
Equity• Exposure—CAPMB
estimate.
Incremental 1 + y VaR: 2 (1change + y)2 in VaR if a position within the
The historical simulation method uses current portfolio weights for each asset multiplied
Funds from operations Most futures
futures
Ft <contracts
S0
market will be in backwardation normally
will be worth less than the corresponding spot rate to recognize the by The historical simulation
The historical
portfolio
its percentage
simulation method
return changes method uses
for each period.
uses currentcurrent portfolioportfolio weights
All available returns
weights for for each
representing
each asset
asset multiplied
expected
multiplied
reality
Adjusted funds from operations (AFFO) because
present value producers
of the future benefit. Futuressell prices
futures to locktoinspot
will converge prices so that
as the contract by
Delta
by
approaches
would
its percentage
its be used.
E(ra ) = rreturn
percentage f + β [for
return
Returns
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for each
the repriced ]
) − rfperiod.
period. All available
All
portfolio
available returns returns representing
are ranked lowest
representing expected
expected reality
to highest, and VaR
reality
is then
Adjusted • Price
fundsto fromadjusted
operations funds
(AFFO) from operations ratio maturity, revenues
at which time are
F = Smore
. predictable
Most futures contracts will be worth less than the corresponding spot rate to recognize the
t 0
would •
would
determined
beMarginal
be used. Returns
used.for
Returns
the
VaR:
required
for the
for change
the repriced
repriced
confidence
in VaR
portfolio
portfolio
interval.
for arearanked
are marginal
ranked lowestchange
lowest to highest,
to highest, in and VaR
and VaR is is then
then
Funds from operations determined
Fixed portfolio
Income for the ∆ positions
required
c confidence interval.
present value of the future benefit. Futures prices will converge to spot as the contract determined
approaches Deltafor Exposure
the
= required confidence interval.
Less:
FundsNon‐cash rent
from operations Contango• Hedging pressure hypothesis: if consumers (producers) ∆ S
Less:
Less: Maintenance‐type
Non‐cash rent capital expenditures and leasing costs maturity, at which time Ft = S0.
have greater demand for hedging, the futures market willNote
Note that:
Note • First-
that:
First-that:
and second-order and second-order yield effects on bond yield price:effects on bond price
Adjusted funds from operations
Less: Maintenance‐type capital expenditures and leasing costs Ft > S0
Contango be in contango (backwardation) Gamma • The historical simulation method can be adjusted by overweighting more current or
Adjusted funds from operations • The
• The historical
∆Bhistorical simulation
∆ysimulation 1 method
( ∆method 2
y)underweighting can be
can be adjusted
adjusted by by overweighting
overweighting more more current
current oror
AFFO is preferred over FFO as it takes into account the capital expenditures necessaryFutures to more =realistic
− D returns + Cwhile older or less realistic outcomes.
• contracts
Theory have
of greater
storage value than the spot price.
•
more
more B
Additionally,
realistic
realistic 1 + returns
y ∆
returns
delta
2 while underweighting
while
(1 + y)
underweighting
2 older or
older or less
less realistic
realistic outcomes.
outcomes.
maintain the economic
AFFO is preferred overincome
FFO asof a property
it takes portfolio.
into account the capital expenditures necessary to
F t > S 0
• Γ = gamma =historical simulation can accommodate options
Additionally,
historical simulation can accommodate
options
in a portfolio because it
in a portfolio because it
• uses Additionally,
outcomeshistorical that ∆Sactually simulationoccurred. can accommodate options in a portfolio because it
maintain • EV
the to EBITDA
economic ratio:
income of aEBITDA can be computed as NOI
property portfolio.
Components • Futures
of Futures price
Returns = Spot price + Storage costs –
• On
uses outcomes
uses outcomes that
the other hand,
that actually
actually occurred.
the historical
occurred.
simulation method suffers from the disadvantage of
Futures contracts have greater value than the spot price. Delta
minus G&A expenses Convenience yield.
Spot price return = (St – St-1)/ PSt-1
•
New• call
On
• representing
OnImpact the other
the other
price:
hand,
ofonly delta
hand, the
theand
historical
historical
historical gamma
reality
simulation
simulation
rather onthan method
call
methodoption
extreme
suffers
suffers from
price
from the
outcomes
the disadvantage
thatdisadvantage
can occur. Asof
of
representing only only historical
historical reality reality rather rather than than extreme
extreme outcomes
outcomes that that can
can occur.
occur. AsAs
• DCF valuation approach: use dividend discount model asComponents • Convenience
of Futures Returns yield is inversely related PM to inventory size
PM
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future appears
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appears likely
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to
Roll return = [(Near-term futures contract closing price – Farther-term PM futures contract closing reflect past results. 1
REITs pay dividends and general availability of commodity. reflect
c + ∆ c past
≈ ∆cS+results.∆ ∆ S + Γ ( ∆ S ) 2
price)/Near-term
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return = (Stclosing PSt-1 × Percentage of the position in the futures contract reflect past results.
– St-1)/price] c
2
c
© Wiley
© Wiley 2018
Wiley 2018 All
2018 All Rights
All Rights Reserved.
Rights Reserved. Any
Reserved. Any unauthorized
Any unauthorized copying
unauthorized copying or
copying or distribution
or distribution will
distribution will constitute
will constitute an
constitute an infringement
an infringement of
infringement of copyright. • Components of futures returns: price return, roll return, Gamma
being
copyright.
of copyright. rolled. Roll return is positive for markets in backwardation where the spot rate at maturity
©
Private Equity for one instrument can be rolled into a lower-priced forward for farther
Roll return = [(Near-term
collateral return futures contract closing price – Farther-term
322out expiration. Roll yield
322the new futures contractVega closing © 2018 Wiley
is negative for markets in contango as the spot price will be lower than 322
price)/Near-term futures contract closing price] × Percentage of the position in the futures contract
futures price. • Sensitivity risk measures can complement VaR because ©© 2018 2018 Wiley
Wiley
(1) they address ∆delta shortcomings of position size measures,
• Sources of value creation: reorganizing investee being • Commodity
rolled.
Collateral return Rollis return
the yield swaps:
is positive
(e.g., excess
for markets
interest return
rate) for in swap,
thebackwardation
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∆ S
company, raising higher levels of debt, aligning interests for swap,
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forward for farther
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∆σ S 7 March 2018
c16.indd 322 7 March 2018
is negative for markets in contango as the spot price will be lower c16.indd than
322 the new futures price. 7 March 2018
New call price:
© Wiley 2018 return
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reserved. any unauthorized
the yield copyingrate)
(e.g., interest or distribution
for thewillbonds
constitute
orancash
infringement
used to maintainNew
of copyright. the call price: 91
1
investor’s futures position(s). c + ∆c ≈ c + ∆ c ∆S + Γ c ( ∆S)2
c + ∆c ≈ c + ∆ c ∆S + Γ c ( ∆S)2 + vega∆σ S
12 Wiley © 2019
2
© Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. Vega 91
 The Information Ratio
E( RA )* = IC BR σ A
The information ratio measures the active return from a portfolio relative to a benchmark
per unit of active risk (which is the volatility of the active return, and also known as

Wiley’s CFA Program Exam Review

® E( R )
benchmark tracking risk). The information ratio is used to evaluate the consistency of active A = Information ratio (IR* ) = IC BR
return. σ ( RA )

Active return RA RP − RB The Full Fundamental law

portfolio ManageMent
Information ratio (IR) = = =
Active risk σ ( RA ) σ ( RP − RB )
E(RA) = TC IC BR σA
The Information Ratio
• Since active management is a zero-sum game, the realized information ratio across all
funds with
The information themeasures
ratio same benchmark
the activeshould
returnbefrom
closeatoportfolio Note that there is no * with the expected active return here because the portfolio is constructed
zero. relative to a benchmark
per •
unit If
ofan investor
active riskdoes not isexpect
(which a positiveofex
the volatility ante
the information
active ratio,
return, and sheknown
also should asjustconstrained active security weights.
with
invest in the benchmark.
benchmark tracking risk). The information ratio is used to evaluate the consistency of active
• Scenario risk measures can complement VaR because • • Rankings
return.
Break-even
based on inflation
active riskrate: difference
(standard deviationbetween yieldcan
of active return) onbeadifferent E(R )
A
(1) they can overcome any assumption of normal zero-coupon
from rankings based default-free nominal
on total risk (standard bondofand
deviation the yield on
returns). = Information ratio (IR) = TC * IC * BR
σ (R A )
distributions, and (2) a portfolio’s most concentrated a zero-coupon
• Unlike default-free
the Sharpe ratio, the realratio
information
Active return bond
RA (includes
RP − RB expected
is affected by the addition of cash or portf

positions can be stress tested leverage to a and

Information
inflation risk=Ifpremium
portfolio.
ratio (IR) cash is added =
Active riskfor uncertainty
= the information
to a portfolio,
σ ( RA ) σ ( RP −over
ratio of the
RB ) future Optimal • Amount
Independence of investment decisions
combined portfolio will fall. of Active Risk for a Constrained Portfolio
• The inflation)
information ratio is not affected by the magnitude of active weights. Independence analysis of acTive PorTfolio ManageMenT
Economics and Investment Markets ○ active
Note that an outsideisinvestor cannot change the active risk of a managed
• BRofdoes Investment
not equal Decisions N when (1) active returns between
• Since management a zero-sum game, the realized information ratio across all individual 1R*assets are correlated, or (2) forecasts are not
Active Portfolio Management
portfolio
funds with Analysis by changing
the same benchmark of Active its individual
Portfolio
should asset active
be close to zero. weights.
Management However, she
BR can
does σ
not(RA) portfolio
equal = TC
N
ManageMent
when
SR
σ (RB)
(1) the active returns between individual assets are correlated, or
• Inter-temporal rate of substitution (ITRS) • If an investor effectivelydoeschange
not expect her active risk ex
a positive exposure by taking appropriate
ante information ratio, she should positions
(2)just on independent
forecasts B
are not independent from from period
period totoperiod.
period BR can then be estimated as:
Sharpe• Ratio thethe
benchmark.
• Ratio of the marginal utility of consumption in the Sharpe
invest
The Information
in ratio
Ratio
benchmark.
• Rankings based on active risk (standard deviation of active return) can be different Maximum Value ofNthe Constrained Portfolio’s Sharpe ratio
future to the marginal utility of consumption today. CONSTRuCTING RP −THE Rbased
BR =
from rankings f OPTIMAlon total risk (standard deviation of returns).
PORTFOlIO 1 + ( N − 1)ρ
SRP = ratio measures the active return from a portfolio relative to a benchmark SP2P = SR2B + (TC)2(IR*)2
The information
• ITRS is inversely related to real GDP growth. • Unlike the Sharpe
per unit of activeSTD risk( R(which
P)
ratio, the information ratio is affected by the addition of cash or
is the volatility of the active return, and also known as
leverage to 2a portfolio. If cash is added to a portfolio, the information ratio of the
• ITRS is inversely related to the one-period real risk-freebenchmark SR2tracking
combinedP = SR B + IR2 The information ratio is used to evaluate the consistency of• active
risk).
portfolio will fall. For hedging strategies that make use of derivatives and other form of arbitrage, BR
rate.
return.
Optimal •
• The Information
Level ratio
of Risk ratio is not affected by the magnitude of active weights.
information
Ex Post will Algorithmic Trading
Performance
be much higherMeasurement
than the number of securities.
All other things ○ Note remaining
that anthe same,investor
outside an investor should
cannot changechoosethe the investment
active risk of a manager
managed •
with For arbitrage strategies, the information ratio will be quite high even for relatively
• Covariance between ITRS and expected future price of a the highest levelportfolio Active return R R − R The realizedmodest information
• willExecutionvalues of coefficient (ICR), which reflects how actual active returns correlate
IC.
algorithms:
of skillIR (as measured
by(IR)changing by individual
its her information
= asset ratio)P weights.
=active because investing
However,with she her
withcan allows us tobreak down whatlarge trades
return into
A B
Information
σ* (R ratio
) = Sharpe σ (R = realized active returns, determine realized to expect given the
risky asset is negative, resulting in a positive risk premium.produce the highest
Aeffectively
SR B change
B ) for
ratio Active
herher riskrisk
own
active σ ( RA ) by
portfolio.
exposure σ ( Rtaking
P − RBappropriate
) positions on smaller
transfer
In the fixed income sizes
coefficient. to minimize
arena, almost all bonds trading
are, at leastimpact,
to a certaine.g. VWAP,
extent, driven by interest
• The larger the negative covariance, the higher the risk Determining the Optimal Amount of Active Risk the benchmark.
rate risk and market participation,
credit risk, resulting in some implementation
correlation between shortfall
returns.
premium. • • Since
Optimal active portfolio
managementconstruction is a zero-sum game, the realized information ratioExpected across allvalue added conditional on the realized information coefficient, ICR, is calculated as:
Figure 2-1:
CONSTRuCTING The Correlation
THEsameOPTIMAlTriangle PORTFOlIO • High-frequency trading algorithms: find and execute
econoMics
invesTMenTand invesTMenT MarkeTs
MarkeTs • Real default-free interest rates are: The optimal • Sharpe
funds with
level the
of ratio
active benchmark
of combination
risk is the levelshould be close
of active risktothat
zero.yields the highest Sharpe When it comes to market-timing active management strategies:
ratio opportunistic, profitable trades, e.g. event-driven
• investor.
for the If an investor does not expect a positive ex ante information ratio, she should just E(RA
Forecasted | ICR) = (TC)(ICR) BR σA
• Positively relatedEconomics to GDP growth rate. analysis ofMarkets
and Investment acTive PorTfolio ManageMenTinvest
SR2P in the2benchmark.
= SR B + IR
Active
2 Returns
μi
• More algorithms, statistical
frequent rebalancing canarbitrage
increase the algorithms
information ratio, but only to the extent
Economics and Investment Markets • Rankings based on active risk (standard deviation of active return) can be different
• Positively related to expected volatility of GDP growth.For unconstrained from
portfolios, the optimal level of active risk (also known as the optimal
rankings basedisoncomputed total riskas: (standard deviation of returns).
• Market
The realized
that forecasts
value added
are independent
fragmentation
from an actively
form
(same oneinstrument
managed
period to the next.
portfolio can traded in down into two
be broken
• things
Optimal level • Generally speaking, there are such few opportunities to make active decisions that in
Taylor Rule amount of aggressiveness) theof active risk for unconstrained the portfolios multiple markets): liquidityactiveaggregation
return or a highcreates a “super
Taylor• Rule All •
otherUnlike remaining same, an investor should is choose
affectedthe byinvestment managercashwith
of parts:
Taylor rule for short-term interest rates The Basic
the highest
the
Fundamental
level of
Sharpe ratio,
Law the information ratio addition or order to achieve a high expected information ratio, the portfolio
leverage to askill (as measured
portfolio. If cash by her information
is added to a portfolio, ratio)thebecause
informationinvesting
ratiowith her will
of the book”must
manager of quote
have a and higherdepth across
information many markets while
coefficient.
prt = ιt + π t +*0.5(π t − π*t ) +*0.5(Yt − Yt* ) produce the * highest IR Sharpe ratio for her own portfolio. • The expected value added given the realized skill of the investor for the period,
prt = ιt + π t + 0.5(π t − π t ) + 0.5(Yt − Yt ) σ ( RA )* = portfolio
combined
Portfolio Construction: σ ( Rwill
B ) fall. Signal Quality: smart order routing introduces orders in markets offering
• Coefficient
Transfer The A ) =SR
E(Rinformation ICB BR ratioσ Ais not affected Information Coefficient of active weights.
by the magnitude E(RA | ICR).
Other practical
best limitations
prices and of the fundamental
favorable law include:
market impact
Determining the Optimal Amount of Active Risk
○ Note that an outside investor cannot change the active risk of a managed• Any noise that results from constraints that prevent the portfolio constructed from
Where
Where
prt = policy rate at time t
prt = policy rate at time t The
The Full
• Full
optimal
fundamental
Fundamental
portfolioLaw
level of active
by changing law
risk isher
its individual asset active weights. However, she can
theactive
level risk
of active risk that yieldsappropriate
the highest positions
Sharpe ratio
being optimal.
• Transaction costs and taxes are ignored.
ιt = real short-term interest rates that balance saving and borrowing effectively change exposure by taking • onThe limitations of mean-variance optimization also apply here.
ιt = real short-term interest rates that balance saving and borrowing for the investor.the benchmark. RAproblems ICR) + Noise
= E(RA | associated
π = inflation Realized • The with estimation and use of risk models (e.g., identifying the
π t = inflation*t ActiveE(RWeightsA ) = TC IC BR σ A Active Returns
π t = the inflation target wi right set of risk factors, non-linearities,
PM and non-stationary returns).
π*t = the inflation target For unconstrained portfolios, Value the
Addedoptimal level of Ractive Ai risk (also known as the optimal
*
Y and Yt = logarithmic levels of actual and potential real GDP, respectivelyEx-Post CONSTRuCTING
amount (Realized)
of aggressiveness) THE OPTIMAl is computed PORTFOlIO
as:
Yt and Yt* = tlogarithmic levels of actual and potential real GDP, respectively Risk-Weighted Correlation
© 2018 Wiley
Mean-Variance-Optimal
© 2018 WileySR* 2P = SR2IR B + IR
Active
2 Security Weights 337
σE(R( RAA)|IC= R )=(TC)(IC
σ ( RB )R ) BRs A
SR B
µi σ A
All other things
∆w*i = remaining the same, an investor should choose the investment manager with
c17.indd 339

c17.indd 337 the highest level of σ i2skill

IC (as BRmeasured by her information ratio) because investing with her will 7 March 2018 5:43 PM

produce
where: the highest Sharpe ratio for her own portfolio.

Wiley’s CFA Program Exam Review

∆w*i = Active security weight
®
Determining the forecast
μi = Active return Optimal Amount of Active Risk PM

σA = Active portfolio risk

σi = optimal
The level
Forecasted of active
volatility riskactive
of the is thereturn
level on
of active risk
security i that yields the highest Sharpe ratio
for
IC =the investor. coefficient
© 2018Information
Wiley 337
BR = Breadth
For unconstrained portfolios, the optimal level of active risk (also known as the optimal
amount
Ex-Anteof aggressiveness)
(Expected) is computed
Risk-Weighted as:
Correlation
c17.indd 337 7 March 2018 5:43 PM
IR
σ* ( RA ) = σ( R )
 R µ B
SR
IC = COR  BAi , i 
Sign up
 σi σi 
for your
© 2018 Wiley Free Trial
PM

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© 2018 Wiley 337

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