Adapt CFA® Level I

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ETHICAL AND PROFESSIONAL STANDARDS

ETHICAL AND PROFESSIONAL STANDARDS IV(C) Responsibilities of Supervisors Annuities

Supervisors are responsible for reasonably Ordinary: cash flow at end of time period
I(A) Knowledge of the Law
preventing subordinates’ violations but are not Due: cash flow at beginning of time period
Obey strictest law that applies. Do not associate
responsible for subordinates’ behavior. Perpetuity: cash flow continues forever
with law-breakers.
PVJKL = PVM>JNOP>Q 1 + r

V(A) Diligence and Reasonable Basis
I(B) Independence and Objectivity FVJKL = FVM>JNOP>Q 1 + r
Exercise diligence and thoroughness. Support
Do not offer gifts that might affect someone’s PMT
actions with research and investigation. PVRL>RLSKNSQ =
independence and objectivity. Refuse gifts or r
disclose to appropriate parties. V(B) Communication with Clients and Solve using TVM keys on BA II Plus


Prospective Clients
I(C) Misrepresentation Money-Weighted & Time-Weighted Returns
Make appropriate disclosures. Distinguish between
When using an outside source, cite it. Do not Money-weighted return: IRR on a portfolio.
fact and opinion when presenting investment
promise investment returns. Calculate using worksheet and IRR function on
analysis and recommendations.

BA II Plus
I(D) Misconduct

V(C) Record Retention Time-weighted return: Product of (1 + holding

Do not commit fraud. Personal issues that reflect
Develop and maintain records to support work and period yield) over entire measurement period
poorly on professional image are a violation.
communications with clients.

Holding Period Yield
II(A) Material Nonpublic Information
Ending + Interest Received
VI(A) Disclosure of Conflicts
Understand what “material” and “nonpublic” HPY = − 1
Disclose matters that may impair your Beginning
means. Do not act or cause others to act on
independence and objectivity. Effective Annual Yield
material nonpublic information.
\]^

VI(B) Priority of Transactions EAY = 1 + HPY S − 1
II(B) Market Manipulation
Execute clients’ transactions before your own.

Information-based and transaction-based Bank Discount Yield

manipulations are not allowed. VI(C) Referral Fees Dollar discount 360
r_` = ×
Disclose referral fees to clients and employer. Face value Days to maturity
III(A) Loyalty, Prudence, and Care

Clients come first. Treat clients’ investment like VII(A) Conduct as Participants in Money Market Yield (CD Equivalent Yield)
your own but with higher priority. CFA Institute Program 360 360 × r_`
rff = HPY × =

Do not compromise CFA Institute’s reputation. Days to maturity 360 − t × r_`
III(B) Fair Dealing
Do not share exam details.
Treat all clients fairly. Communicate investment
Bond Equivalent Yield
h.^
recommendations and changes simultaneously. VII(B) Reference to CFA Institute, the CFA BEY = 2 1 + EAY −1


Designation, and the CFA Program
III(C) Suitability Type of Measurement Scales
Do not misrepresent or exaggerate CFA Institute
Use a regularly updated IPS during investment Nominal: Only differentiates between objects
membership, designation, or candidacy.
decisions. Choose suitable investments in a Ordinal: Allows for rank order

portfolio context. Interval: Allows for degree of difference


Ratio: Has meaningful zero value
III(D) Performance Presentation QUANTITATIVE METHODS
QUANTITATIVE METHODS

Do not misrepresent past performance. Do not

Means
Required Rate of Return
promise future performance. Arithmetic:
nominal risk-free rate = real risk-free rate I
III(E) Preservation of Confidentiality nominal risk-free rate + expected inflation rate 1
Population mean, µ = X N ; N = population size
Keep client’s information confidential unless: client required interest rate = nominal risk-free rate N
Nno
O
is involved in illegal activity, you are legally required interest rate + default risk premium 1
Sample mean, X = X N ; n = sample size
required, or you have client permission. required interest rate + liquidity premium n
Nno
required interest rate + maturity risk premium
IV(A) Loyalty
Geometric:
Effective Annual Rates
A
Put employer’s needs first. Understand Xs = Xo X t … X O , where X N ≥ 0 for i = 1, 2, … , n
;
responsibilities when leaving employer. Consult EAR = 1 + periodic rate − 1 1 + Rs =
y
1 + Ro 1 + R t … 1 + R O
employer before taking on outside employment. EAR = 𝑒𝑒 >?@ABCAD@DE − 1 Harmonic:

N
IV(B) Additional Compensation Arrangements Future Value (FV) and Present Value (PV) Xz = , where X > 0 for i = 1, 2, … , n
I 1
Obtain employer’s written permission before FV = PV 1 + r I Nno X
N
receiving cash or perks. If applicable, obtain other
party’s permission.

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Percentiles Expected Value Binomial Distribution
y O n ä
S}
Location of y percentile, LQ = n + 1 p x = p 1 − p Oãä , where
100 E X = P XN XN x
If LQ is not an integer, use linear interpolation. Nno n = number of trials
E X = E X So P So + ⋯ + E X SO P SO p = probability of success
Mean Absolute Deviation
E X = np
Variance
MAD =
o
O
O
Nno XN − X O σt X = np 1 − p

σt X = P XN XN − E X t
Binomial Model
Variance and Standard Deviation
Nno Describes asset price movements. Price either
I
1 moves up with probability p or down with
Population variance, σt = XN − µ t Covariance
N O O probability 1 − p
Nno

O
1 Cov X, Y = P X N , YN X N − E X YN − E Y Continuous Uniform Distribution
Sample variance, s t = XN − X t Nno Ñno
n−1 1
Nno Cov X, X = σt X f x = , a ≤ x ≤ b
Standard deviation is square root of variance
b−a
x−a

Expected Value & Variance of Portfolio Return F x = , a ≤ x ≤ b
Chebyshev’s Inequality O b−a

For any distribution with finite variance, the E RR = wN E R N Normal Distribution
proportion of observations within k standard Nno
X ~ Normal µ, σ
O O
deviations of the arithmetic mean is at least P µ − σ < X < µ + σ = 0.68
σt R R = wN wÑ Cov R N , R Ñ
1 − 1 k t for all k > 1 Nno Ñno P µ − 2σ < X < µ + 2σ = 0.95

Coefficient of Variation Market value of investment i P µ − 3σ < X < µ + 3σ = 0.99

wN =
Market value of portfolio Observed value − Population mean X − µ
CV = s X; measures dispersion relative to mean Z= =
For portfolio with 2 investments: standard deviation σ
Sharpe Ratio E R R = wÖ R Ö + w_ R _ E R R − shortfall level
Shortfall Ratio =
mean portfolio return − risk-free return σì
S} = σt R R = wÖt σt R Ö + w_t σt R _
standard deviation of portfolio returns

+ 2wÖ w_ Cov R Ö , R _ Lognormal Distribution

Measures excess return per unit of risk
where Cov R Ö , R _ = σ RÖ σ R_ ρ RÖ , R_ - eî where X is normally distributed
Skewness
- Used to model asset prices
Correlation
Positive (right) skew: - Positively skewed
Cov R N , R Ñ
- Many outliers in right tail ρN,Ñ = Corr R N , R Ñ = Continuously compounded return from t to t + 1:
σ RN σ RN
- Mean > Median > Mode SSïo
−1 ≤ ρN,Ñ ≤ 1 rS,Sïo = ln = ln 1 + R S,Sïo
Negative (left) skew: SS

- Many outliers in left tail Bayes’ Formula where R S,Sïo is the effective annual rate
- Mean < Median < Mode P B A × P A

P AB = Sampling
Zero skewness: P B
Simple random sampling: Subset of population is
- Distribution is symmetrical (e.g. normal)

Counting Rules chosen at random

- Mean = Median = Mode
Factorial: Systematic sampling: Every kth observation is
1 ONno X N − X \
Sample skewness ≈ n! = n n − 1 n − 2 … 1 chosen until desired sample size is achieved
n s\
Combination: Stratified sampling: Simple random samples are
Kurtosis n n! drawn from each subpopulation (strata)
Measure of “peakedness” of distribution relative O C> = =
r n − r ! r! Sampling error: Difference between quantity
to a normal distribution Counts ways to choose r items from n where order calculated from sample and its true value
Leptokurtic: More peaked than a normal does not matter, or ways to label n items with 2

Platykurtic: Less peaked than a normal Central Limit Theorem (CLT)

different labels
Mesokurtic: Same kurtosis as a normal For a sample of size n ≥ 30 from a population with
Permutation:
Excess kurtosis: Kurtosis minus 3 (kurtosis of a mean µ and variance σt (population’s distribution
n!
OP> = does not matter), the sample mean x
normal distribution is 3) n−r !
1 ONno X N − X Ç Counts ways to choose r items from n where approximately follows a normal distribution with
Sample kurtosis ≈ mean µ and variance σt n
n sÇ order does matter.

Multinomial: Standard Error of Sample Mean
Probability Rules
n!
P AB = P A B ×P B = P B A P A Population variance is known: σä = σ n
no ! nt ! … nâ !
P A or B = P A + P B − P AB Population variance is not known: sä = s n
Extension of combination concept; counts ways
P A = P A So P So + ⋯ + P A SO P SO
to label n items with k labels.
Independence

Discrete Uniform Distribution

P AB = P A ×P B
1
P AB =P A p x = , x = xo , x t , … , x O
n

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Confidence Interval Tests Concerning a Single Mean Trends
Point estimate ± Reliability factor × Std error Population is normal with known variance: Support: Low price range where buying is
Point estimate: Estimate of population parameter x − µh sufficient to stop further decline
z-statistic =
Reliability factor: Value from distribution of point σ n Resistance: High price range where selling is
estimate, such as normal or t-distribution Large sample from any population with unknown sufficient to stop further increase
Examples: x ± zó t × σ n; x ± t ó t × s n variance (2 choices):

x − µh Reversal Patterns
t-statistic = , degrees of freedom = n − 1 Head and shoulders (H&S): Indicate an upcoming
Significance Confidence s n
𝑧𝑧ô t
level interval x − µh downtrend following a preceding uptrend
z-statistic = Inverse H&S: Indicate an upcoming uptrend
10% 90% 1.645 s n
5% 95% 1.960 Small sample from normal population with following a preceding downtrend
1% 99% 2.575 unknown population variance: Price target = Neckline − Head − Neckline
x − µh Double/Triple tops: When an uptrend reverses
Biases t-statistic = , degrees of freedom = n − 1
s n two/three times at about the same high
Sample selection bias: Excluding subsets of data
Double/Triple bottoms: When a downtrend
because of data availability Tests Concerning Differences between Means reverses two/three times at about the same low
Survivorship bias: A type of sample selection Normal populations with unknown variances that

are assumed equal: Continuation Patterns

bias where funds or companies that no longer
xo − xt − µo − µt Ascending triangle: Highs form horizontal line;
exist are excluded t-statistic =
o t lows form uptrend
Look-ahead bias: Information needed is not sRt sRt
+ Descending triangle: Highs form downtrend;
available on the test date no nt
n − 1 s t
+ nt − 1 stt lows form horizontal line
Time-period bias: Data is based on time period sRt =
o o

no − 1 + nt − 1 Symmetrical triangle: Highs form downtrend;
that makes the results time-period specific
Degrees of freedom = no + nt − 2 lows form uptrend
Steps in Hypothesis Testing Normal populations with unknown variances that Rectangle: Highs and lows form horizontal lines
1. State hypotheses (null and alternate) are assumed unequal: Flag: Parallel trend lines over short period
2. Select test statistic xo − xt − µo − µt Pennant: Converging trend lines over short period
3. Specify significance level t-statistic = o t

sot stt Price-Based Indicators
4. State decision rule +
no nt
Moving average: Average closing price over a
5. Collect data; calculate test statistic sot stt
t
+ specified number of periods
6. Make decision regarding hypothesis no nt
Degrees of freedom = t Golden (Dead) cross: When short-term moving
7. Make economic or business decision so no t st n t
+ t t average crosses long-term moving average from
no nt
Test Statistic (General)
below (above)
Sample statistic − Hypothesized value Tests Concerning Mean Differences
Bollinger bands: Lines representing moving
Normal populations with unknown variances:
Standard error of sample statistic average and moving average +/ − set number of

d − µJh standard deviations from average price
Errors t-statistic = , degrees of freedom = n − 1
sJ

Decision 𝐻𝐻h True 𝐻𝐻o False

Momentum Oscillators
Do not reject Hh Correct Type II Tests Concerning a Single Variance
Rate of Change (ROC) Oscillator:
Reject Hh Type I Correct Normal population:
M = V − Vx × 100
O
Power of a test = 1 − P Type II error n − 1 st 1 V = last closing price
χt = , st = xN − x t

σth n−1 Vx = closing price x days ago, typically 10
Hypothesis Test Results Nno
Degrees of freedom = n − 1 ROC oscillator crossing 0 in the same direction as
Type Hypotheses Reject null if
the trend direction is buy/sell signal
One-tailed Hh : µ ≤ µh Test statistic > Tests Concerning Two Variances
Relative Strength Index:
(upper) HP : µ > µh critical value Normal populations:
Oû
100 Σ Up changes
One-tailed Hh : µ ≥ µh Test statistic < RSI = 100 − , RS =
sot 1 t 1 + RS Σ Down changes
(lower) HP : µ < µh critical value F= , sÑt = xNÑ − xÑ for j = 1, 2
stt nÑ − 1 Stochastic Oscillator:
Nno
Test statistic < Last closing price − Low in past 14
Degrees of freedom 1 = no − 1 %K = 100
Hh : µ = µh lower or > High in past 14 − Low in past 14
Two-tailed Degrees of freedom 2 = nt − 1
HP : µ ≠ µh upper critical %D = average of last 3 daily %K values
value Technical Analysis: Charts Moving-average convergence/divergence (MACD)

Bar chart: Shows open, close, low, and high price oscillator: Consists of MACD line and signal line
Candlestick chart: Shows open, close, low, and high MACD line is the difference between two
price. White body means close > open; dark body exponentially smoothed moving averages (12 and
means close < open 26 days). Signal line is the exponentially smoothed
average of MACD line (9 days)

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Sentiment Indicators Normal good: Positive income effect Monopolistic Competition
Put/call ratio: Volume of put options traded Inferior good: Negative income effect - Many firms
divided by volume of call options traded Giffen good: Negative income effect larger than - Differentiated products (via advertising)
CBOE Volatility Index (VIX): Measures near term positive substitution effect - Low barriers to entry
market volatility calculated by the CBOE Veblen good: Higher price increases demand - Firms have some pricing power
Short interest ratio: Number of shares sold short
Profit maximization:
Profit Measures
divided by the average daily trading volume - MR = MC
Accounting profit = Total revenue -

Flow-of-Funds Indicators − Total accounting costs Oligopoly

Arms index (or TRIN): Measures relative extent to Economic profit = Total revenue - Few firms
which money is moving into and out of rising and − Total economic costs - Similar products (close substitutes)
declining stocks Economic profit = Accounting profit - High barriers to entry
Mutual fund cash position: Percentage of mutual − Total implicit costs - Firms have some or considerable pricing power
fund assets held in cash Normal profit occurs when economic profit equals (price collusion possible)

zero, where total revenues match total costs Profit maximization:
Cycles
- MR = MC
Kondratieff wave: 54-year long economic cycles Revenue Terms -

Total revenue (TR): Price times quantity; P × Q Monopoly
Elliott Wave Theory
Average revenue (AR): TR Q - One firm
Market moves in regular, repeated waves
Marginal revenue (MR): ΔTR ΔQ - Highly differentiated product
Wave sizes: grand supercycle, supercycle, cycle,
- No close substitutes for product
primary, intermediate, minor, minute, minuette, Cost Terms
- Significant barriers to entry
and subminuette Total fixed cost (TFC): Sum of fixed costs
- Firm has considerable pricing power
Market waves follow ratios of numbers in Total variable cost (TVC): Sum of variable costs
(price discrimination)
Fibonacci sequence Total costs (TC): TFC + TVC
Profit maximization:
Average fixed cost (AFC): TFC Q
- MR = MC
Average variable cost (AVC): TVC Q

ECONOMICS ECONOMICS Average total cost (ATC): AFC + AFV or TC Q Market Power Measures

Marginal cost (MC): ΔTC ΔQ N-firm concentration ratio: Sum of market share
Own-Price Elasticity of Demand
of the N largest firms in the industry
%ΔQJä Shutdown & Breakeven
ERJ• = Herfindahl-Hirschman Index (HHI): Sum of squares
%ΔPä Perfect competition:
of market share of the N largest firms
ERJ• > 1: elastic AR = ATC: Break even

ERJ• < 1: inelastic AR ≥ ATC: Stay in the market Gross Domestic Product (GDP)
AVC ≤ AR < ATC: Stay in short run; exit in long Nominal GDP: GDP in terms of current prices
ERJ• = ∞: perfectly elastic
AR < AVC: Shut down in short run; exit in long Real GDP: GDP in terms of base-year prices
ERJ• = 0: perfectly inelastic

Imperfect competition: GDP deflator: Nominal GDP Real GDP ×100
Income Elasticity of Demand TR = TC: Break even GDP = C + I + G + X − M
%ΔQJä ΔQJä I TC > TR > TVC: Continue operation in short run; C = consumption; I = investment
E©J = = G = government spending
%ΔI ΔI QJä shutdown in long run
E©J > 0: normal good TR < TVC: Shutdown in short and long run X = exports; M = imports

E©J < 0: inferior good Productivity National Income

Cross-Price Elasticity of Demand Marginal revenue product (MRP) of labor: Sum of:
%ΔQJä ΔQJä PQ Change in TR Change in quantity of labor - Employee compensation
ERJ™ = = Profit maximization: - Corporate and government pretax profit
%ΔPQ ΔPQ QJä
MRPo MRPO - Interest income
ERJ™ > 0: substitutes =⋯= = 1
Price of input 1 Price of input n - Unincorporated business net income
ERJ™ < 0: complements Profit maximized for each product when: - Rent

MRP = Price of input - Indirect business taxes, less subsidies
Income and Substitution Effects
Price of Good X decreases: Perfect Competition Personal Income
Substitution Consumption - Many firms = National income − Indirect business taxes
Income effect
effect of Good X - Identical products − Corporate income taxes
Positive Positive Increase - Very low barriers to entry − Undistributed corporate profits
Negative - Firms have no pricing power + Transfer payments
Positive (smaller than Increase Profit maximization:

Expenditure and Income Equality

substitution) - P = MR = MC
G−T = S−I − X−M
Negative - P > ATC implies economic profit
G − T = fiscal balance
Positive (larger than Decrease - P < ATC implies economic loss
S − I = savings minus domestic investment
substitution)
X − M = trade balance

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IS and LM Curves Inflation Regional Trading Blocs
IS curve: Negative relationship between real Deflation: Negative inflation rate Free trade area (FTA): No barriers to flow of goods
interest rates and real income (goods market) Disinflation: Declining inflation rate and services among members
LM curve: Positive relationship between real Hyperinflation: Extremely high inflation rate Customs union (CU): FTA + common trade policy
interest rates and income (money market) Cost-push: From decrease in aggregate supply among non-members
Quantity theory of money: MV = PY Demand-pull: From increase in aggregate demand Common market (CM): CU + free movement of
M = real money supply; V = money velocity Laspeyres index: Use base consumption basket factors of production among members
P = price level; Y = real GDP Paasche index: Use current consumption basket Economic union (EU): CM + common economic

Fisher index: Laspeyres × Paasche institution and coordination of economic policies
Factors Increasing Aggregate Demand (AD)
Monetary union (MU): EU + common currency
- Increased consumer wealth Monetary Policy

- Optimistic business expectations Required reserves Balance of Payments Components

Required reserve ratio =
- Expectations of higher consumer income Total deposits Current account: Merchandise and services, income
- High capacity utilization Money multiplier = 1 Reserve requirement receipts, unilateral transfers
- Expansionary policies (monetary and fiscal) Fisher effect: R OM;NOP¨ = R >LP¨ + πL Capital account: Capital transfers, non-financial
- Depreciating exchange rate
assets sales/purchases
Central Bank Roles
- Increased global economic growth Financial account: Government-owned assets
- Sole currency supplier
abroad, foreign-owned assets in the country
Factors Increasing SR Aggregate Supply (AS) - Bank of banks and government

- Increased labor productivity - Regulate and supervise payments system Exchange Rate Calculations
- Decreased input prices - Lender of last resort CPIÆ
Real ex. rateJ Æ = Nominal ex. rateJ Æ ×
- Expectations of higher output prices - Gold and foreign exchange reserves holder CPIJ
- Decrease in business taxes/increase in subsidies - Operate monetary policy Forward exchange rateJ Æ 1 + iJ
=
- Appreciating exchange rate Spot exchange rateJ Æ 1 + iÆ
Tools to Implement Monetary Policy Cross rate: SÖ = SÖ Ø × SØ _
_
Factors Increasing LR Aggregate Supply (AS) Policy rate: Expansionary when less than neutral Forward exchange rates in points:
- Increased supply and quality of labor interest rate; contractionary otherwise - Unit of points is last decimal place in spot
- Increased supply of natural resources Reserve requirement: Increase/decrease funds exchange rate quote
- Increased stock of physical capital available for lending and money supply - Example: If spot exchange rate is quoted in 4
- Technological improvements Open market operations: Buy/sell government

decimal places, each point is 0.0001
bonds to increase/decrease money supply
Business Cycle Phases
Exchange Rate Regimes
Trough (lowest point) Fiscal Policy: Spending Tools Formal dollarization: No own currency; adopt
Expansion (comes after trough) Transfer payments: Redistribution of wealth (e.g.
another country’s currency
Peak (highest point) Social Security and unemployment benefits)
Monetary union: Adopt common currency
Contraction (comes after peak) Current spending: Spending on goods and services

Currency board: Commitment to exchange
Capital spending: Spending on infrastructure
Business Cycle Theories
domestic currency for specified foreign currency at
Neoclassical: Free market; “invisible hand” Fiscal Policy: Revenue Tools fixed exchange rate
Austrian: Similar to Neoclassical; government Direct taxes: Tax on income (e.g. income taxes, Fixed peg: Currency is pegged to foreign currency
intervention causes market fluctuations corporate taxes, capital gains taxes) (or basket of currencies) within ±1% margin
Keynesian: Advocate government fiscal policy Indirect taxes: Tax on goods and services Target zone: Fixed peg with wider margin
Monetarist: Maintain steady money supply growth Crawling peg: Exchange rate is pegged and
Fiscal Multiplier
New classical: Applies microeconomic analysis adjusted periodically
1
to macroeconomics = , where MPC = marginal Crawling bands: Margin increases over time,
1 − MPC 1 − t

usually to transition from fixed peg to floating
Unemployment propensity to consume; t = tax rate
Managed floating: Monetary authority intervenes
Unemployed: Jobless people who are seeking jobs
Gains from Trade to manage exchange rate without a target level
Labor force: People with a job or unemployed
Absolute advantage: Can produce at lower cost Independently floating: Exchange rate is
Unemployment rate: Unemployed Labor force
Comparative advantage: Opportunity cost of market determined
Type Result of
producing good is lower
Frictional Temporary transitions

Structural Long-run changes in economy Trade Restrictions

Cyclical Changes in economic activity Tariffs: Taxes on imported goods

Quotas: Limits on quantity of imported goods
Economic Indicators Export subsidies: Government payment to
Leading: Turning points precede those of the exporting firms
overall economy Minimum domestic content: Minimum domestic
Coincident: Turning points occur along with those product requirement in goods
of the overall economy Voluntary export restraint: Voluntarily limiting
Lagging: Turning points occur after those of the exports, often to avoid tariffs or quota
overall economy

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 FINANCIAL REPORTING & ANALYSIS
FINANCIAL REPORTING AND ANALYSIS Earnings per Share CFO Indirect Method

Net income − Preferred dividends - Start with net income
Accrual Accounting Basic =
Weighted average of shares outstanding - Add noncash expenses
Cash movement before accounting recognition:
Diluted = - Subtract gains/adding losses from financing or
- Unearned revenue: Liability; cash received before Convertible Convertible
Net Preferred investing cash flows
good or service provided − + preferred + debt 1 − 𝑡𝑡
income dividends - Add/subtract asset and liability adjustments
- Prepaid expenses: Asset; cash paid before dividends interest
Weighted Shares from Shares from Shares issuable based on accrual accounting
expense incurred average + preferred + convertible + from stock

Cash movement after accounting recognition: shares shares debt options Free Cash Flow (FCF)
- Accrued revenue: Asset; cash not yet received Only include potentially dilutive security in
Measures cash available for discretionary purposes
calculation after checking that it is dilutive.
after good or service provided
Free cash flow to the firm (FCFF): Cash available to
- Accrued expenses: Liability; cash not yet paid for Balance Sheet Components equity owners and debt holders.
expenses incurred Accounts receivable: Reported at net realizable FCFF = NI + NCC + I × 1 − t − FCI − WCI

value based on bad debt expense. Bad debt FCFF = CFO + I × 1 − t − FCI
FASB, IASB, and IOSCO
expense increases allowance for doubtful accounts, NI = net income
FASB: Sets forth Generally Accepted Accounting
which contras accounts receivables. NCC = noncash charges (e.g. depreciation)
Principles (GAAP) in the U.S.
Inventory: I = interest expense
IASB: Establishes International Financial Reporting
IFRS – LIFO not permitted; inventories reported at FCI = fixed capital investment
Standards (IFRS) outside the U.S.
lower of cost or net realizable value. WCI = working capital investment
FASB-IASB Convergence: In May 2014, FASB and
U.S. GAAP – LIFO permitted; inventories reported Free cash flow to equity (FCFE): Cash flow available
IASB each issued converged standard for
at lower of cost or market. to common shareholders
revenue recognition.
Property, plant, and equipment (PP&E): FCFE = CFO − FCI + NB
IOSCO: Not a regulatory authority but
IFRS – can be reported using cost model or NB = net borrowing = debt issued − debt repaid
members regulate most of the world’s
revaluation model; recoverable amount is greater
financial capital markets Common-Size Analysis
of (1) fair value less selling costs, and (2) value in

Vertical:
Income Statement Components use (PV of asset’s future cash flow stream); loss
- Represent each item on income statement as
Gross profit: Revenue less direct costs to produce recoveries are allowed.
percentage of revenue.
good or service U.S. GAAP – only cost model is allowed; loss
- Represent each item on balance sheet as
Operating profit: Gross profit less selling, general, recoveries not allowed.
percentage of total assets.
and administrative expenses

Cash Flow Statement Components - Represent each item on cash flow statement as
Revenue Recognition Methods U.S. GAAP: percentage of total cash inflows/outflows.
Percentage-of-completion: Item Classification Horizontal:
- Used under IFRS and U.S. GAAP when outcome of Dividends paid Financing - Express each item relative to its value in a
long-term contract can be reliably measured Interest paid Operating common base period

- Revenue, expense, and profit are recognized Dividends received Operating Activity Ratios
based on percentage of completion Interest received Operating Annual sales
- Percentage of completion is cost incurred to date Receivables turnover =
All taxes Operating Average receivables
divided by total expected cost
Days of sales 365
Completed contract: IFRS: =
outstanding Receivables turnover

- Used under U.S. GAAP when outcome of long- Item Classification Cost of goods sold
Inventory turnover =
term contracts cannot be reliably measured. Dividends paid Operating/Financing Average inventory
- Revenue, expense, and profit are recognized only Interest paid Operating/Financing Days of inventory 365
=
when the contract is complete Dividends received Operating/Investing on hand Inventory turnover
- Under IFRS, revenue is recognized to the extent of Interest received Operating/Investing Purchases
Payables turnover =
contract costs, which means profit is recognized Income taxes Operating Average trade payables
at completion Tax expense from Number of days 365
Investing =
Installment & Cost recovery: of payables Payables turnover
investing transaction
- Under U.S. GAAP, if collectivity is certain, revenue Revenue
Tax expense from Total asset turnover =
is recognized at time of sale. Profit is cash Financing Average total assets
financing transaction
Revenue
collected multiplied by expected profit as Fixed asset turnover =
CFO Direct Method Average net fixed assets
percentage of revenue
- Convert each accrual-based item in the income Working capital Revenue
- If collectivity is uncertain, use the cost recovery =
turnover Average working capital
method, where profit is only recognized when the statement to cash inflow/outflow
project cost is recovered - CFO is net of cash inflows and outflows

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Liquidity Ratios Inventory Valuation Methods and Systems Capitalizing vs. Expensing
Current assets Specific identification: - Capitalizing increases assets on the balance sheet
Current ratio = and increases investing cash outflow on the
Current liabilities - Each unit sold is matched with its actual cost
Marketable statement of cash flows
Cash + + Receivables - Permissible under U.S. GAAP and IFRS
Quick ratio = securities - Expensing reduces net income by the after-tax
Current liabilities Weighted average cost:
expenditure amount in the period it is incurred
Cash + Marketable securities - Average cost/unit is cost of goods available for
Cash ratio =
Current liabilities sale divided by quantity available for sale Impairment of PP&E and Intangible Assets
Marketable - Permissible under U.S. GAAP and IFRS U.S. GAAP:
Cash + + Receivables
Defensive securities
= First-in, first-out (FIFO): - Asset tested for impairment only when firm may
interval Average daily expenditures
- Assume first item purchased is first item sold not recover carrying value through future use
Cash Days of Days of Number
conversion = sales + inventory − of days - Permissible under U.S. GAAP and IFRS - Asset is impaired when carrying value exceeds
cycle outstanding on hand payables Last-in, first-out (LIFO): asset’s future undiscounted cash flows

- Assume last item purchased is first item sold - Impaired asset’s value is written down to fair
Solvency Ratios
- Permissible under U.S. GAAP but not IFRS value and a loss is recognized
Total debt
Debt-to-equity = Perpetual vs. periodic inventory system: - Loss recoveries are not permitted
Total shareholders' equity
Total debt - Perpetual system matches each unit sold with IFRS:
Debt-to-capital = immediate prior purchases - Asset tested for impairment annually.
Total shareholders'
Total debt +
equity - Periodic system matches total units sold for the - Asset is impaired when carrying value exceeds
Total debt period with total purchases for the same period recoverable amount.
Debt-to-assets =
Total assets Under FIFO, ending inventory and COGS are the - Impaired asset’s value is written down to
Average total assets recoverable amount and a loss is recognized.
Financial leverage = same for periodic or perpetual. Under weighted
Average total equity
average cost and LIFO, they may be different. - Loss can be reversed if asset value recovers, but
EBIT
Interest coverage = LIFO reserve: Must be reported by firms using LIFO only up to carrying value before impairment loss
Interest payments
method; used to adjust LIFO COGS and ending was recognized.
Fixed EBIT + Lease payments
charge = inventory (EI) to FIFO-equivalent values.
Interest payments + Lease payments Income Taxes
coverage EI≤©≤≥ = EI¥©≤≥ + LIFO Reserve

Deferred tax assets (DTA): Created when taxes
COGS≤©≤≥ = COGS¥©≤≥ − ΔLIFO Reserve
Profitability Ratios payable exceeds income tax expense due to
Net income Income tax≤©≤≥ = Income tax¥©≤≥
temporary differences. Examples:
Net profit margin = + ΔLIFO Reserve × t
Revenue - Asset’s tax base > carrying amount
Gross profit LIFO liquidations:
Gross profit margin = - Liability’s carrying amount > tax base
Revenue - Caused when units sold exceed units purchased
Deferred tax liabilities (DTL): Created when taxes
EBIT for LIFO company
Operating profit margin = payable is less than income tax expense due to
Revenue - May result in higher gross profit than otherwise
EBT
temporary differences. Examples:
Pretax margin =
Revenue Depreciation Methods - Asset’s carrying amount > tax base
Net income Straight-line: - Liability’s tax base > carrying amount
Return on assets ROA =
Average total assets Cost − Salvage value Tax base of assets: Amount that will be deducted on
EBIT Depreciation =
Return on total capital = Depreciable life the tax return as asset’s benefits are realized.
Average total capital Double-declining balance (DDB): Tax base of liabilities: Carrying value of liability
Net income 2 minus amount that will be deductible on the
Return on equity ROE = DepreciationS = × Book valueS
Average total equity Depreciable life tax return.

Valuation Ratios Units-of-production: Impact of tax rate changes:

Dividends declared Cost − Salvage Income tax = Taxes payable + ΔDTL − ΔDTA
Dividend payout ratio = DepreciationS = × Output unitsS
NI available to common Total output

Bonds
Retention rate RR = 1 − Dividend payout ratio
Intangible Assets Premium bond: Coupon rate > yield at issuance
Sustainable growth rate g = RR × ROE
Purchased: Record at fair value (assumed equal to Discount bond: Coupon rate < yield at issuance
Price per share
P/E Ratio = purchase price) Zero-coupon bond: Bond with no coupons
Earnings per share

Developed internally: Issuance costs: U.S. GAAP – capitalized as an asset;
DuPont Analysis IFRS IFRS – reduces initial bond liability
Net income Assets - Research expenditures are expensed
ROE = Derecognition of debt: If an issuer redeems a bond
Assets Equity - Development expenditures are capitalized
before maturity, a gain/loss (book value minus
Return on Leverage GAAP
ROE = redemption price) is recognized
Assets ratio - Generally, both research and development costs
Net income Revenue Assets are expensed Debt covenants: Affirmative – borrower promises
ROE = to do certain things; negative – borrower promises
Revenue Assets Equity Acquired in business combination:
Net profit Asset Leverage Acquirer allocates purchase price to each to refrain from certain things
ROE =
margin turnover ratio asset acquired on fair value basis; excess
NI EBT EBIT Revenue Assets
ROE = recorded as goodwill
EBT EBIT Revenue Assets Equity
Tax Interest EBIT Asset Financial
ROE =
burden burden margin turnover leverage

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Leases CORPORATE FINANCE
CORPORATE FINANCE Pure-Play Method Project Beta
Finance (Capital) lease:
Delevered asset beta for comparable company:
Net Present Value (NPV)
- Purchase of asset financed with debt I
CFS 1
- Lessee will recognize asset value in balance sheet NPV = − Outlay βP∂∂LS = βLπKNSQ
1+r S D∑M;RP>P∫¨L
and report depreciation expense 1 + 1 − t ∑M;RP>P∫¨L
Sno E∑M;RP>P∫¨L
Operating lease: Ignore sunk costs.
Relevered project beta for subject firm:
- Rental arrangement Use worksheet function on BA II Plus:
D∂K∫ÑL∑S
- Lessee will not recognize asset/liability on - Cash inflows are positive; outflows are negative βR>MÑL∑S = βP∂∂LS 1 + 1 − t ∂K∫ÑL∑S
E∂K∫ÑL∑S
balance sheet but will make periodic lease - F01, F02, etc. refer to cash flow frequencies

payments recognized as rental expense - CPT + NPV to compute NPV; CPT + IRR for IRR Flotation Costs
Conditions requiring a lease to be a finance lease: NPV decision rules: Correct way to account for flotation costs is to
IFRS - Accept projects with positive NPV adjust initial investment, not to increase WACC

- Title transferred to lessee at end of lease - Reject projects with negative NPV
Measures of Leverage
- Bargain purchase option available to lessee - If only one of multiple mutually exclusive projects
Degree of operating leverage (DOL):
- Lease term is majority of asset’s economic life can be accepted, accept project with highest NPV
%Δ Operating income Q P−V
- PV of lease payment is close to fair value
DOL = =
Internal Rate of Return (IRR) %Δ Units sold Q P−V −F
- Asset is so specialized that only lessee can use
IRR is r such that NPV = 0. Degree of financial leverage (DFL):
asset without significant modifications. %Δ Net income Q P−V −F
IRR decision rules: DFL = =
U.S. GAAP (lease must be treated as finance lease if %Δ Operating income Q P − V − F − C
- Accept if IRR > required rate of return
any of the following criteria are met) Degree of total leverage (DTL):
- Reject if IRR < required rate of return
- Title transferred to lessee at end of lease %Δ Net income Q P−V
- Go with NPV decision if IRR decision does not DTL = =
- Bargain purchase option available to lessee %Δ Units sold Q P−V −F−C
match NPV decision
- Lease period is ≥ 75% of asset’s economic life DTL = DOL × DFL
- PV of lease payments is ≥ 90% of fair value Payback Period

- Number of years required for cumulative cash Breakeven
Pension F+C
flows to equal initial investment Breakeven: Q _ª =
Defined contribution: Firm periodically contributes P−V
- Does not take into account time value of money
to employee’s retirement account during F

Operating breakeven: Q ≥_ª =
employment. Employer contribution is expensed in Discounted Payback Period P−V
period incurred. Number of years required for cumulative Q = quantity; P = price; V = variable cost/unit
Defined benefit: Firm makes periodic payments to discounted cash flows to equal initial investment F = fixed operating cost; C = fixed financial cost


employee after retirement. Over- (under-) funded Dividends
Profitability Index (PI)
plan recognized as asset (liability). - Cash dividends and stock dividends do not affect
PV of future cash flows NPV

PI = =1+ shareholder wealth.
Financial Reporting Quality Spectrum CFh CF≥
1. Compliant with GAAP; decision useful; adequate Accept if PI > 1; reject if PI < 1 - Stock splits are essentially stock dividends.
and sustainable earnings
Payment chronology:
Crossover Rate - Declaration date – company declares dividend
2. Compliant with GAAP; decision useful;
- Rate at which NPV profile of two projects cross - Ex-dividend date – two days before HOR date
inadequate and unsustainable earnings
- Calculated as IRR of difference in cash flows - Holder-of-record (HOR) date – shareholders
3. Compliant with GAAP; reporting choices biased;

inadequate and unsustainable earnings Weighted Average Cost of Capital (WACC) listed on company records will be deemed to have
4. Compliant with GAAP; earnings actively WACC = wJ rJ 1 − t + wR∂ rR∂ + w∑L r∑L ownership of shares to receive dividends
managed (increased/decreased/smoothed) wJ = percentage of debt in capital structure - Payment date – company pays dividends

5. Not compliant with GAAP; numbers presented wR∂ = percentage of preferred stock Share Repurchases
based on company’s actual economic activities w∑L = percentage of common stock Changes in earnings per share (EPS):
6. Not compliant with GAAP; numbers fictitious t = tax rate Cost of debt < Earnings yield EPS increases
or fraudulent rJ = cost of debt Cost of debt > Earnings yield EPS decreases

rR∂ = cost of preferred stock = DR∂ P Changes in book value per share (BVPS):
Aggressive vs. Conservative Accounting
r∑L = cost of common stock Stock price < BVPS BVPS increases
Aggressive Conservative k ∑L = Do Ph + g dividend discount model Stock price > BVPS BVPS decreases
Costs capitalized Costs expensed k ∑L = R ≤ + β E R ; − R ≤ CAPM

Longer useful life Shorter useful life k ∑L = R ≤ + β E R ; − R ≤ + CRP revised CAPM

Higher salvage value Lower salvage value r∑L = rJ + Risk Premium
Straight-line method Accelerated method (Bond Yield plus Risk Premium)
Delayed impairment Early impairment
recognition recognition
Smaller allowance Larger allowance for
for doubtful accounts doubtful accounts

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Working Capital Management Indifference Curve Capital Asset Pricing Model (CAPM)
Primary sources of liquidity: Sources from normal E(Ri) Assumptions:
Moderate'Risk
daily operations (e.g. cash balances, short-term High'Risk Aversion - Investors are risk-averse, utility-maximizing,
funding, collections/payments management) Aversion rational individuals
Low'Risk
Secondary sources of liquidity: Sources that may

Expected'Return
Aversion - Markets are frictionless
change a company’s financial and operating
Risk'Neutral - All investors plan for same single holding period
positions (e.g. asset liquidation, renegotiation of
- Investors have homogeneous expectations
debt, bankruptcy protection, reorganization)
- Investments are infinitely divisible
Drag on liquidity: Delayed cash inflows Risk'Seeking
Pull on liquidity: Accelerated cash outflows - Investors are price takers
Cost of trade credit (CTC): Cost of not taking the E R R = R Æ + βN E R ; − R Æ
discount for early payment 0 !i

\]^ Standard'Deviations
Security Market Line (SML)
%discount JPQ∂ RP∂S JN∂∑MKOS
CTC = 1 + − 1 Graphical representation of CAPM:
1 − %discount Minimum-Variance Portfolios SML
E(Rp)
Corporate Governance E(Rp)
- Board should be independent of management. Markowitz(EfDicient(Frontier
E(Rm) M

Expected*Return
- Audit committee should resolve conflicts !i =*!m
between auditor and management in a way that
Expected(Return
8R i
favors shareholders Rm
*=*
pe
- Compensation committee should Slo
provide shareholders with executive Minimum<Variance
Global( Frontier Rf
compensation information
Minimum<
- Firms should have strong code of ethics.
Variance
- Confidential voting and remote proxy voting 0 !i
Portfolio 1.0
promote shareholder interests Beta
0 !p
Takeover defenses (provisions to make Portfolio(Standard(Deviations

company less attractive to hostile bidder) harm

Identifying Mispriced Stocks
shareholder interests Capital Allocation Line (CAL) SML
E(Rp)
Line representing possible combinations of risk- Stock Z
free assets and optimal risky asset portfolio Stock X

Expected*Return
PORTFOLIO MANAGEMENT
PORTFOLIO MANAGEMENT E RN − RÆ
E RR = RÆ + σR
Portfolio Management Process σN
Stock Y

Planning: List objectives and constraints in IPS Capital Market Line (CML)
Execution: Asset allocation, security analysis, CAL with risky portfolio being market portfolio
Rf
portfolio construction E R; − RÆ
Feedback: Monitoring and rebalancing, E RR = RÆ + σR
σ;
0 !i
performance measurement and reporting

Borrowing vs. Lending Beta

Risk Management Based on the graph above,
Risk management framework: - Stock X is underpriced
- Risk governance - Stock Y is overpriced
- Risk identification and measurement - Stock Z is fairly priced
- Risk infrastructure

- Defined policies and processes Ratios

- Risk monitoring, mitigation, and management Sharpe RR − RÆ

Total risk

- Communications ratio σR
- Strategic analysis or integration M- σ;
RR − RÆ − R; − RÆ
Risk tolerance: Which risks are acceptable and how squared σR
much risk should be taken Treynor RR − RÆ
Systematic

Risk budgeting: How the risks should be taken

ratio βR
risk

Financial risks: Arise from financial market Beta Jensen’s
activities (e.g. market, credit, liquidity risk) Systematic risk = Non-diversifiable / market risk R R − R Æ + βR R ; − R Æ
alpha
Non-financial risks: Arise from within entity or Unsystematic risk = Diversifiable risk

from external (e.g. operational, legal, regulatory, Total risk = Systematic risk + Unsystematic risk Investment Policy Statements (IPS)
political, model, tail risk) Cov R N , R ; ρN,; σN Investment objectives: Risk objectives,
Risk measures: Standard deviation, beta, duration, βN = =
σt; σ; return objectives
delta, gamma, VaR, CVaR, etc. Constraints: Liquidity, time horizon, tax concerns,
Risk modification: By prevention and avoidance, legal and regulatory factors, unique circumstances
transfer (insurance), or shifting (derivatives)

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Asset Allocation Behavioral Finance Multistage DDM:
Strategic asset allocation: Set of exposures to IPS- - Loss aversion: Dislike losses O
DS PO
permissible asset classes expected to achieve the - Overconfidence: Overconfident in abilities Vh = +
1+r S 1+r O
client’s long-term objectives - Representativeness: Rely too much on current Sno
DOïo
Tactical asset allocation: Decision to deliberately state when assessing probabilities PO =
deviate from policy exposures to systematic risk r − g¥
- Gambler’s fallacy: Estimate future probabilities
O
factors intended to add value based on forecasts of based on recent outcomes DOïo = Dh 1 + g ¬ 1 + g¥

near-term returns of those asset classes - Mental accounting: Keep track of gains and losses Price Multiples
separately for different investments Ph Do /Eo
- Conservatism: Slow to make changes =
Eo r−g
EQUITY EQUITY - Disposition effect: Avoid realizing losses and seek
Price per share

to realize gains P B=
Positions Book value per share
- Narrow framing: Focus on issues in isolation
Long positions are owned and benefit from
Price per share
P CF =
price appreciation Forms of Market Efficiency Cash flow per share
Short positions are owned and benefit from Market Prices Reflect: Price per share
P S=
price depreciation Past market Public Private Net sales per share
Form Enterprise value EV
data info info
Leveraged Positions
= MV Common equity + MV Preferred stock
Position Weak ✔
Leverage ratio = + MV Debt − Cash + Short term investments
Equity Semi-strong ✔ ✔

Maximum initial leverage ratio
Strong ✔ ✔ ✔
1
=

Intial margin requirement

FIXED INCOME FIXED INCOME

Porter’s Five Forces Framework

Margin Call Price - Threat of substitute products Callable Bonds

Ph 1 − Initial margin - Bargaining power of customers VØP¨¨P∫¨L ∫MOJ = VNon-callable bond − VØP¨¨

1 − Maintenance margin - Bargaining power of suppliers

- Threat of new entrants Putable Bonds
Orders - Intensity of rivalry VìKSP∫¨L ∫MOJ = VNon-putable bond + VìKS
Execution instruction: How to fill the order

(e.g. market order, limit order) Industry Life Cycle Convertible Bonds
Validity instruction: When the order may be filled Embryonic Conversion price: Price per share at which bond
(e.g. day order, fill or kill) Slow growth, high prices, high failure risk, can be converted into shares
Clearing instruction: How to settle the trade significant investment required Conversion ratio: Number of common shares

Growth each bond can be converted into

Price Return Index
I Rapidly increasing demand, improving Conversion value: Current share price ×
Nno nN PN
VìΩ© = profitability, falling prices, low competition Conversion ratio
D

Shakeout Conversion premium: Convertible bond’s price −
Price Return over Single Period Conversion value
PNo − PNh Slowing growth, intense competition,
PR N = declining profitability Bond Pricing with Spot Rates
PNh
I Mature PMT PMT PMT + FV
VìΩ©o − VìΩ©h PV = + + ⋯+
PR © = = wN PR N Little or no growth, industry consolidation, 1 + zo o 1 + zt t 1 + zI I
VìΩ©h
Nno high entry barriers CR: Coupon Rate; MDR: Market Discount Rate

Total Return over Single Period Decline CR = MDR Price = Par Value Par
PNo − PNh + IncN Negative growth, excess capacity, CR < MDR Price < Par Value Discount
TR N =
PNh high competition CR > MDR Price > Par Value Premium
I
VìΩ©o − VìΩ©h + Inc© Dividend Discount Model (DDM) Flat Price, Accrued Interest, and Full Price
TR © = = wN TR N
VìΩ©h ø
Nno DS PV ≤K¨¨ = PV ≤¨PS + AI = PV 1 + r S æ

Vh =
1+r S AI = t T × PMT
Price Return Index over Multiple Periods Sno
O
VìΩ©æ = VìΩ©h 1 + PR ©o 1 + PR ©t … 1 + PR ©æ DS PO Yield Measures
Vh = +
1+r S 1+r O Annual cash coupon payment
Total Return Index over Multiple Periods Sno Current yield =
Flat price
VæΩ©æ = VæΩ©h 1 + TR ©o 1 + TR ©t … 1 + TR ©æ Perpetual preferred stock; constant dividend:
Annual cash Amortized

Dh +
Weighting Vh = coupon payment gain/loss
r Simple yield =
PN Flat price
wNì = Gordon constant growth model:
Price I Yield-to-call (YTC) = IRR assuming the bond is
Ñno PÑ
ø
Dh 1 + g S Dh (1 + g) Do called early at the stated call price
1 Vh = = =
Equal wNª = 1+r S r−g r−g Yield-to-worse = min YTC, yield-to-maturity
Sno
N
fN Q N PN g = Earning retention rate × ROE
Market capitalization wNf = Yield Measures for Money Market Instrument:
I g = 1 − Dividend payout ratio × ROE
Ñno fÑ Q Ñ PÑ Discount Rate (DR) Basis
FN Days
Fundamental wN≤ = I
PV = FV × 1 − × DR
Ñno FÑ Year

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Yield Measures for Money Market Instrument: Convexity Option Values
Add-on Rate (AOR) Basis PVã + PVï − 2× PVh Exercise/intrinsic value of a
ApproxCon =
Days ΔYield t PVh European call = Max 0, Sæ − X
PV = FV 1 + × AOR
Year %ΔPV ≤K¨¨ = −AnnModDur × ΔYield Exercise/intrinsic value of a

Implied Forward Rate (IFR)

1 European put = Max 0, X − Sæ
+ AnnConvexity ΔYield t
_ãÖ 2

1 + zÖ Ö
× 1 + IFR Ö,_ãÖ = 1 + z_ _ PVã + PVï − 2 PVh Option Moneyness
EffCon = Option Moneyness Call Put
ΔCurve t PVh
Yield Spreads over Benchmark Yield Curve
Duration gap = Macaulay duration In-the-money SS > X SS < X
PMT PMT PMT + FV
PV = + + ⋯+ At-the-money SS = X SS = X
1 + zo + Z o 1 + zt + Z t 1 + zI + Z I − Investment horizon
OAS = Z-spread − Option value in basis points

Out-of-the-money SS < X SS > X

Credit Analysis

Asset-Backed Securities E[Loss] = Pr(Default) × Loss severity Factors Impacting Option Values
Securitization Process Loss severity = 1 − Recovery rate Increase in Call Put
- A special purpose vehicle (SPV) buys assets from
Value of underlying ↑ ↓
the seller firm and issues asset-backed securities Credit Ratings
Exercise price ↓ ↑
(ABS) against the assets Investment grade: Baa3/BBB- and above
Non-investment grade: Ba1/BB+ and below Time to expiration ↑ ↑*
- A servicer (could be same entity as seller) collects
funds and performs other related responsibilities
Risk-free rate ↑ ↓
Four C’s of Credit Analysis Volatility of underlying ↑ ↑
Residential Mortgage Loans
- Interest: fixed, adjustable, convertible - Capacity Payments on underlying ↓ ↑
- Amortization: full, partial, interest-only - Collateral
Cost of carry ↑ ↓
- Prepayment: penalty, no penalty - Covenants
*Except for some deep-in-the-money put options
- Foreclosure: non-recourse, recourse - Character

Residential Mortgage-Backed Securities

Option Boundaries
- Agency RMBS issued by government agencies and Yields and Spreads European options:
must have conforming loans Yield on a corporate bond is sum of: ch ≥ Max 0, Sh − X 1 + r æ
- Non-agency RMBS issued by private companies - Real risk-free interest rate ph ≥ Max 0, X 1 + r æ − Sh
and may have non-conforming loans - Expected inflation rate American options:
- Pass-through rate: coupon rate on the MBS - Maturity premium Ch ≥ ch ; Ph ≥ ph
- Prepayment risk: contraction (faster-than- - Liquidity premium Ch ≥ Max 0, Sh − X 1 + r æ
expected prepayments), extension (slower-than- - Credit spread Ph ≥ Max 0, X − Sh
expected prepayments) Yield spread = Liquidity premium + Credit spread

- Prepayment rates are compared to the PSA Put-Call Parity

Return impact ≈ −Modified duration × ΔSpread
benchmark CPR sh + p h = ch + X 1 + r æ
1
Collateralized Mortgage Obligations + Convexity ΔSpread t Put-Call-Forward Parity
2
- Securities backed by pool of RMBS
F h T 1 + r æ + ph = ch + X 1 + r æ
- Structured with tranches with varying exposures

to prepayment risks Option Strategies
DERIVATIVES DERIVATIVES Fiduciary call = Long call + Long risk-free bond
- A sequential-pay CMO has principal and
prepayments paid to the tranches in sequence Forward Contract Protective put = Long asset + Long put
- PAC CMO have predictable cash flows and Covered call = Short call + Long asset
Value of 𝑇𝑇-year forward contract at:
support tranches with more contraction or Option Strategies Profit
Initiation Vh T = 0
extension risk Long call Max 0, Sæ − X − ch
Expiration Væ T = Sæ − Fh (T)
Collateralized Debt Obligations Short call −Profit(Long call)
Securities backed by pool of debt obligations; such Time t VS T = SS − PVS benefit Long put Max 0, X − Sæ − ph
as corporate bonds, leveraged bank loans, or credit + PVS cost − Fh (T) 1 + r æãS
Short put −Profit(Long put)
default swap on securities Forward price of an asset:
Covered call Profit(Short call) − Sh
Duration Fh T = Sh 1 + r æ
− FVæ benefit + FVæ cost Protective put Profit(Long put) − Sh
MacDur

ModDur = Forwards vs. Futures

1 + 𝑟𝑟
Compared to forwards, futures are:
%ΔPV ≤K¨¨ = −AnnModDur × ΔYield
PVã − PVï - standardized contracts traded on an exchange
ALTERNATIVE INVESTMENTS


ALTERNATIVE INVESTMENTS
ApproxModDur = - guaranteed by clearinghouse
2 ΔYield PVh General
ApproxModDur = ApproxMacDur 1 + r - marked-to-market and settled daily Compared to traditional investments, alternative
PVã − PVï - regulated investments exhibit:
EffDur =
- lower liquidity
2(ΔCurve) PVh
Swaps - narrow manager specialization
PortfolioDur = wo Do + wt Dt + ⋯ + wI DI
Two parties exchange a series of cash flows. - low correlation with traditional investments
MoneyDur = AnnModDur × PV ≤K¨¨
- less regulation and lower transparency
ΔPV ≤K¨¨ ≈ −MoneyDur × ΔYield Option Styles
- limited historical risk and return data
PVã − PVï - European options can only be exercised at
Price value of a basis point = - unique legal and tax considerations
2 expiration.

Basis point value = MoneyDur × 0.0001 - American options can be exercised at any time
during the life of the option.

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Hedge Funds BA II PLUS CALCULATOR TIPS
BA II PLUS CALCULATOR TIPS CFA CANDIDATE CHECKLIST
CFA CANDIDATE CHECKLIST
Strategies: Basic Operations Source:
- Event-driven – seek to profit from 2ND : Access secondary functions (in yellow) http://www.cfainstitute.org/programs/cfaprogram/c
short-term events ENTER : Send value to a variable ourseofstudy/Pages/candidate_checklist.aspx

- Relative value – seek to profit from pricing 2ND + ENTER : Toggle between options Several Months Before Exam Day
discrepancies between related securities ↑ ↓ : Navigate between variables/options ¨ Review testing policies.
- Macro – emphasize a top-down approach to
STO + 0 - 9 : Store current value into memory ¨ Confirm international travel passport is valid.
identifying global economic trends
RCL + 0 - 9 : Recall value from memory ¨ Ensure you have the necessary travel
- Equity hedge – take positions in equity and equity
documents to get to the test center.
derivative securities Time Value of Money (TVM)

Hedge Fund Fees: For annuity, loan, and bond calculations The Month Before Exam Day
- “2 and 20” – 2% management fee and 20% N : Number of periods ¨ Review and print your exam admission ticket on
incentive fee I/Y : Effective interest rate per period (in %) clean, blank paper.
- Hard hurdle rate – incentive fee calculated on ¨ If the name on your exam admission ticket does
PV : Present value
returns above the hurdle rate not match the name on your passport exactly,
PMT : Payment/coupon amount
- Soft hurdle rate – incentive fee calculated on update your name in your CFA Institute account
FV : Future value/redemption value as soon as possible. Reprint your ticket after the
entire return if hurdle rate is cleared
- High water mark – incentive fee only applies to CPT + one of the above : Solve for unknown name change.
profits after previous losses have been recovered 2ND + BGN : Toggle between ordinary annuity ¨ Check directions to the test center and special

and annuity due instructions for travel and parking.
Private Equity
2ND + CLR TVM : Clear TVM worksheetNote: ¨ Plan travel route to the test center.
Leveraged buyouts:
- Always clear the TVM worksheet before The Week Before Exam Day
- “Going private” transactions
starting a new calculation. ¨ Plan to dress in layers as temperatures at test
- Management buyouts – current management
- For bonds, PMT and FV should have the same centers can vary.
team is involved in the acquisition
sign, and opposite signs to PV ¨ Plan your lunch.
- Management buy-ins – current management team
¨ Review instructions for filling out answer sheet.
is being replaced by the acquiring team Cash Flow Worksheet ( CF , NPV , IRR )
¨ Review the CFA exam personal belongings
Venture capital: For non-level payments
policy (link at end of section).
- Formative-stage financing – angel investing, Input ( CF )

seed-stage financing, early stage financing CF0: Initial cash flow What to Bring to the Test Center
- Later-stage financing – after commercial C01: 1st distinct cash flow after initial cash flow ¨ Valid international travel passport
production and sales have begun but before IPO F01: Frequency of CO1. ¨ Exam admission ticket
- Mezzanine-stage financing – prepare to go public C0n: nth distinct cash flow. ¨ At least one approved calculator
Exit strategies: F0n: Frequency of C0n. ¨ No. 2 or HB pencils
Trade sale, IPO, recapitalization, secondary sales, Note: ¨ Eraser
write-off/liquidation - Always clear the CF worksheet before starting ¨ Pencil sharpener

a new calculation. CFA Exam Personal Belongings Policy
Real Estate
- The use of F0n is optional. You can leave them as http://www.cfainstitute.org/about/governance/p
Examples: Residential property, commercial real
1 and input repeating cash flows multiple times. If olicies/Pages/personal_belongings_policy.aspx
estate, REIT investing, mortgage-backed securities,
you do so, C01 will be the cash flow at time 1, C02
timberland, and farmland
Real estate valuation: comparable sales, income, will be the cash flow at time 2, and so on.
and cost approaches Output ( NPV , IRR )
I: Effective interest rate per period (in %)
Commodities NPV + CPT : Solve for net present value
Contango: Little/no convenience yield; futures IRR + CPT : Solve for internal rate of return
price > spot price
Backwardation: High convenience yield; futures
price < spot price
Roll yield: Spot price − Futures price
Futures price: Spot price 1 + 𝑟𝑟 + Storage
costs – Convenience yield

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