2012 CFA L2 Mindmaps

ChangesinCFAlevel2curriculum2012
SosnhCFAcurriculumlevel2nm2012vinm2011thccthayichyulloibbtccphnlctrcvit trnglphoclanman,rmr.Sloibnylmchoslngreadingscalevel2gimt70readingsnm2011 xung cn 64 readings nm 2012. Cn kin thc thm vo nhiu nht l reading 47 (Investing in Hedge Funds: a survey)camnAlternativeInvestments. Mn Alternative Investments: Reading 50 c Commodity (hc v Contango, Backwardation, roll yield) b loi b, c l l do ni dung ny s c covered y hn level 3. Reading mi s 47 (Investing in Hedge Funds: a survey) thay th reading 51 c (Evaluating performance of Hedge Funds) v reading 52 c (Buyer Beware: evaluating andmanagingthemanyfacetsofrisksofhedgefunds). Mn Equity: B hn 2 readings l reading 36 v 38 c. Reading 36 c Equity, Markets and Instruments l mt readingkhdivnhiuchbnlunvccloithtrng,cccngcvvnvthukhiutrancngoi, ADR American Depository Receipts, ETFs, country funds. Reading 38 c Equity concepts and Techniques gm nhiu ni dung b lp trong cc readings khc, nh country analysis, industry analysis. Tuy nhin trong reading 38 b b c hai m hnh kh th v l 1. Franchise model (tnh intrinsic P/E theo tangible P/E (1/r) v Franchise P/E (= franchise factor x growth factor)) v 2. cng thc tnh P/E vi s gp mt ca inflation flow through rate. Cc readingscnlicthayinhmthaiLOSkhngngk. Mn Economics: Reading 17 c Exchange rates and Balance of Payment b loi b. Ni dung nyca xung level1(thamkholevel1reading20InternationalTradeandCapitalFlowsvreading21CurrencyExchangeRates). Mn Fixed Income: Reading 54 c Liquidity conundrum (c cp ti Minsky hypothesis v gii thch l do khng hongnhtcaMvinmtrc)bloib,clldoccthngtinnygioutofdate. MnCorporateFinance:BmtLOSnhonhvlchsccantitrustlegislationsM(trongreading32M&A). NmmncnliEthics,Quantitativeanalysis,Derivatives,Portfoliomanagement,FRAginguyn. Ngitnghp:LTrngTunAnh&NguynHoiPhng,AFTC.
CFA MINDMAPS 2012- LEVEL 2- AFTC copyright
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CFALEVEL2
ETHICAL & PROFESSIONAL STANDARDS
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All CFA Institute members and candidates are required to comply with the Code and Standards The CFA Institute Bylaws Based on two primary principles Fair process to member and candidate Confidentiality of proceedings
Basic structure for enforcing the Code and Standards Structure of the CFA Institute Professional Conduct Program Professional Conduct program (PCP)
Rules of Procedure
The CFA Institute Board of Governors
Maintains oversight and responsibility Through the Disciplinary Review Committee (DRC) Directs Professional Conduct Staff Is responsible for the enforcement of the Code and Standards Conducts professional conduct inquiries
The CFA Designated Officer An inquiry can be prompted by several circumstances
a1.
Requesting a written explanation from the member or candidate The Professional Conduct staff conducts an investigation that may include Process for the enforcement of the Code and Standards The member or candidate Interviewing Complaining parties Third parties Collecting documents and records in support of its investigation When an inquiry is initiated Conclude the inquiry with no disciplinary sanction Issue a cautionary letter Upon reviewing the material obtained during the investigation, the Designated Officer may If finding that a violation of the Code and Standards occurred, the Designated Officer proposes a disciplinary sanction Accepted by member The matter is referred to a hearing by a panel of CFA Institute members
1. Code Of Ethics And Standards Of Professional Conduct
Continue proceedings to discipline the member or candidate
Rejected by member
Six components of the Code of Ethics
a2.
Seven Standards of Professional Conduct
b. Ethical responsibilities
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Guidance
A. Knowledge of the law
Recommended procedures for compliance (RPC) Application
Maintain independence and objectivity in professional activities Gifts Invitations to lavish functions Tickets By benefits External pressures Favors Job referrals Allocation of shares in oversubscribed IPOs to investment managers .... From public companies How to cope with external and internal pressures Guidance Internal pressures To issue favorable reports May try to pressure sell-side analysts
From Buy-side clients
e.g. to issue favorable research reports/recommendations for certain companies From their own firms Investment-banking relationships to issue favorable research on current or prospective investment-banking clients Conflicts of interest -->must disclose to employers
-->Modest gifts and entertainment are acceptable but special care must be taken
B. Independence and objectivity

-->
-->Best practice: reject any offer of gift,..threatening independence and objectivity convey true opinions -->Recommendations must free of bias from pressures be stated in clear and unambiguous language -->Portfolio managers must respect and foster honesty of sell-side research Is fraught with conflicts Must engage in thorough, independent, and unbiased analysis Issuer-paid research Must fully disclose potential conflicts, including the nature of compensation -->Analysts Must strictly limit the type of compensation they accept for conducting research Best practice Protect integrity of opinions Accept only flat fee for their work prior to writing the report W/O regard to conclusions or reccomendations
2.1 Standard I PROFESSIONALISM

RPC
Create a restricted list Restrict special cost arrangements Limit gifts Restrict employee investments Review procedures Written policies on independence and objectivity of research Equity IPOs Private placements
Definition of "Misrepresentation"
any untrue statement or omission of a fact or any fasle or misleading statement oral representations, advertising electronic communications written materials qualifications or credentials, services
Must not knowingly make misrepresentation or give false impression in
Guidance
Must not misrepresent any aspect of practice, including
performance record characteristics of an investment any misrepresentation relating to member's professional activities
Must not guarantee clients specific return on investments that are inherently volatile
C. Misrepresentation
Standard I(C) prohibits plagiarism in preparation of material for distribution to
employers associates clients prospects general public Written list of available services, description of firm's qualification Designate employees to speak on behalf of firm RPC Prepare summary of qualifications and experience, list of services capable of performing Maintain copies To avoid plagiarism Attribute quotations Attribute summaries
Address conduct related to professional life Guidance Violations Any act involving lying, cheating, stealing, other dishonest conduct that reflects adversely on member's professional activities would be violation Conduct damaging trustworthiness or competence Abuse of the CFA Institute Professional Conduct Program Develop and/or adopt a code of ethics RPC Disseminate to all employee a list of potential violations Check references of potential employees
D. Misconduct
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Definition of "Material nonpublic information" Must be particularly aware of info selectively disclosed by corporations Guidance Mosaic Theory Analysis of Public info + nonmaterial nonpublic info --> Investment conclusion Analysts are free to act on this collection of info w/o risking violation Analysts should save and document all their research Make reasonable efforts to achieve public dissemination of material info
A. Material nonpublic information (MNI)
If public dissemination is not possible,
Must communicate the info only to the designated supervisory and compliance personnel within the firm Must not take investment action on the basis of the info
RPC
Must not knowingly engage in conduct inducing insiders to privately disclose MNI adopt compliance procedures preventing misuse of MNI Encourage firms to develop & follow disclosure policies to ensure proper dissemination use "firewall" Prohibition of all proprietary trading while firm is in possession of MNI may be inappropriate
2.2 Standard II INTEGRITY OF CAPITAL MARKET
Definition Transactions that artificially distort prices or volume can be related to transactions that deceive market participants Securing a controlling, dominant position in a financial instrument to exploit and manipulate price of a related derivative/or underlying asset including spreading false rumors to induce trading by others
B. Market manipulation
dissemination of false or misleading info
Standard II(B) not meant to
prohibit legitimate trading strategies prohibit transactions done for tax purposes
The intent of action is critical to determining whether it is a violation of this Standard

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright Page 5
duty to exercise reasonable care
Prudence require cautions and discretion
act with care, skill, and diligence follow the investment parameters set forth by clients & balancing risk & return Determine identity of "client" Must be aware of whether they have "custody" or effective control of client assets
Understand & adhere to fiduciary duties Guidance Responsibility to a client includes duty of loyalty
Manage pool of assets in accordance with terms of governing documents Put their obligation to client first in all dealings Avoid all real or potential conflicts of interest Forgo using opportunities for their own benefit at the expense of client Follow any guidelines set out by client for the management of assets Judge investment decisions in context of total portfolio Vote proxies in an informed & responsible manner
A. Loyalty, prudence, and care
"Soft dollars" Submit to clients at least quarterly itemized statements Separate assets RPC Review investments periodically Establish policies & procedures with respect to proxy voting and the use of client brokerage Encourage firms to address some topics
Do not discriminate against any clients "Fairly" vs "equally Standard III(B) addresses the manner of disseminating investment recommendations or changes in prior recommendations to clients Ensure fair opportunity to act on Encourage firms to design equitable system to prevent selective, discriminatory disclosure Investment recommendations Guidance Material changes should be communicated to all current clients Clients who don't know changes and therefore place orders contrary to a current recommendation Treat all clients fairly in light of their investment objectives & circumstances Investment actions Disclose to clients & prospects written allocation procedures duty of fairness and loyalty to clients can never be overriden by client consent to patently unfair allocation procedures particularly clients may have acted on or been affected by earlier advise should be advised of the changed recommendation before the order is accepted
2.3 Standard III DUTIES TO CLIENTS
B. Fair dealing
Should not take advantage of their position in the industry to the detriment of clients RPC
Be sure to gather client info in the form of an IPS and make suitability analysis prior to making recommendation/taking investment action Guidance In investment advisory relationships Inquiry should be repeated at least annually/prior to material changes If clients withhold info Risk analysis Fund managers In case of unsolicited trade requests unsuitable for client RPC
C. Suitability
Standard III(D) prohibits misrepresentaions of past performance or reasonably expected performance --> Provide credible performance info Guidance -->Should not state or imply that clients will obtain or benefit from rate of return generated in the past Research analysts promoting the success of accuracy of their recommendations --> ensure that their claims are fair, accurate, and complete
D. Performance presentation
If the presentation is brief, must make available to clients and prospects the detailed info upon request RPC GIPS
Standard III(E) is applicable when members receive info Guidance E. Preservation of confidentiality RPC Comply with applicable laws When in dout -->consult with compliance department/outside counsel before disclosing
Standard III(E) does not prevent cooperating with an investigation by CFAI PCP
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In matters related to their employment, members and candidates must not engage in conduct that harms the interests of the employer Employeremployee relationship -->Comply with policies and procedures established by employers that govern employer-employee relationship Standard IV(A) does not require to place employer interests ahead of personal interests in all matters The relationship imposes duties and responsibilities on both parties
Abstain from independent competitive activity that could conflict with employer's interests Independent practice Provide notification to employer, obtain consent from employer in advance
Planning to leave, must continue to act in employer's best interest
A. Loyalty
Must
Firm records or work performed on behalf of firm stored on a home computer should be erased or returned to employer engage in activities conflicting with duty until resignation effective
2.4 Standard IV DUTIES TO EMPLOYERS
Leaving an employer
Must not
contact existing clients/potential clients prior to leaving for soliciting
take records of files to a new employer without written permission Free to make arrangements/preparations provided that not breaching duty of loyalty Applicable non-compete agreement Whistleblowing Nature of employment
Guidance
Obtain written consent from employer before accepting compensation or other benefits from third parties...
B. Additional compensation arrangements
RPC
Should make an immediate written report to their employers
C. Responsibilities of supervisors
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investment philosophy followed The application of Standard V(A) depends on role of member in the investment decision-making process support and resources provided by employer Must make reasonable efforts to cover all pertinent issues when arriving at recommendation Provide or offer to provide supporting info to clients when making recommendations/changing recommendations Using secondary or third-party research -->must make reasonable &diligent efforts to determine whether 2nd/3rd party research is sound
Guidance
A. Diligence and reasonable basis
Group research and decision making
If member does not agree with the independent and objective view of the group
-->Not necessarily have to decline to be identified if believing consensus opinion has reasonable & adequate basis -->Should document member's difference of opinion with group
RPC
Standard V(B) addresses conduct with respect to communicating with clients Communication is not confined to written form but via any means of communication
2.5 Standard V INVESTMENT ANALYSIS, RECOMMENDATIONS & ACTIONS

Guidance
Developing and maintaining clear, frequent, and thorough communication practices is critical distinguish clearly between facts & opinions present basic characteristics of the analyzed security in preparing research report Must adequately illustrate to clients & prospective clients the manner of conducting investment decision-making process keep them informed with respect to changes to the chosen investment process
B. Communication with clients and prospective clients
Brief communications
-->must be supported by background report or data on request
Capsule form recommendations
-->should notify clients that additional info and analyses are available from the producer of the report
Investment advice based on quantitative research and analysis
-->must be supported by readily available reference material -->in a manner consistent with previously applied methodology or with changes highlighted
Should outline known limitations, consider principal risks in investment analysis, report RPC
In hard copy or electric form Fulfilling regulatory requirements may satisfy the requirements of this Standard Must explicitly determine whether it does
Guidance
C. Record retention
Absence of regulatory guidance,
CFAI recommends maintaining records for at least 7 yrs
RPC
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is a critical part of working in investment industry Managing conflicts can take many forms Best practice is to avoid conflicts of interest when possible If not, disclosure is necessary
prominent Disclosures must be made in plain language in a manner to effectively communicate the info to clients between member or their firm and issuer Relationships Guidance investment banking underwriting and financial relationships Broker/dealer market-making activities Material beneficial ownership of stock Investment personnel also serves as a director -->Sell-side members should disclose material beneficial ownership interest in securities/investment recommended All matters may impair objectivity
A. Disclosure of conflicts
Disclosure to clients
Disclosure of conflicts to employers
What?
Same circumstances with clients Any potential conflict situation Enough info
How?
Other requirements
2.6 Standard VI CONFLICTS OF INTEREST
Clients & employers' transactions have priority Co-investment -->personal investment positions or transactions should never adversely affect client investments may occur client is not disadvantaged by the trade Conflicts of interests Guidance -->make sure investment professional does not benefit personally from trades undertaken for clients investment professional complies with applicable regulatory requirements Having knowledge of pending transactions, assess to info during normal preparation of research recommendations May undertake personal transactions after clients & employers have had adequate opportunity to act on recommendation should be treated like other accounts Family accounts (that are client accounts) if member has beneficial ownership -->may still be subject to pre-clearance or reporting requirements -->Must not convey such info
B. Priority of transactions
employer whom client prospective client compensation Inform
C. Referral fees
what
consideration benefit received from, or paid to, others
how
before entry into any formal agreement nature of the consideration or benefit
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Cheating on CFA exam or any exam
Prohibiting any conduct that undermines the integrity of the CFA charter
Not following rules and policies of the CFA program
A. Conduct as members and candidates in the CFA program
Giving confidential info on the CFA Program to candidates or the public
.....
Not precluded from expressing opinion regarding the CFA Program or CFAI
2.7 Standard VII RESPONSIBILITIES AS CFA MEMBER / CANDIDATE

Preventing promotional efforts that make promises or guarantees tied to the CFA designation
Over-promise the competence of an individual
Over-promise future investment results
Applies to any form of communication
B. Reference to CFA Institute, the CFA Designation and the CFA program
To maintain CFAI membership
Remit annually to CFAI a completed Professional Conduct Statement Pay applicable CFAI membership dues on an annual basis
Using the CFA designation (see Curriculum)
Referencing candidacy in the CFA program (see Curriculum)
Proper using of the CFA marks (see Curriculum)
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are voluntary standards for Members Definitions To enable all parties dealing with SD practices to have a common understanding of all of the different aspects of SD To give a clear guidance to investment managers on what products and services are appropriate for a manager to purchase with client brokerage To clarifiy the manager's duty to clearly justify the use of client brokerage to pay a portion of mixed-use product clearly disclose their SD practices give detailed info to each client when requested receive assurances that what investment managers are doing with client brokerage can be supported in an "audit" receive important info on request Client-directed brokerage To clarify the manager's role and fiduciary responsibilities to clients
Research
Mixed-used products
Soft Dollar Standards (SDS)
focus on 6 key areas Disclosure
To obligate investment managers to
Record keeping
To ensure that client can
Investment Manager directs transactions to a Broker, in exchange for which Broker provides brokerage and research services to the Investment Manager
a1. Define "Soft Dollar" Arrangements
include
Proprietary Research Arrangements Third-party Research Arrangements
Not include Client-directed Brokerage Arrangements
Agency trade Principal trade
A transaction involving the pmt of a commission A transaction involving a "discount" or a "spread"
3.1 CFA Institute Soft Dollar Standards
Soft dollar practices
involve the use of client brokerage by an investment manager to obtain products and services to aid the manager in investment decision making process The amount on any trade retained by a broker to be used directly or indirectly as pmt for Servies and/or products provided by a broker, the primary use of which must directly assist the investment manager in its investment decision making process Types Proprietary research Third-party research Investment decision making process Management of the investment firm
Brokerage
a2. Some definitions
Research
Mixed-Use
Services and/or products, provided to an investment manager by a broker through a Bokerage Arrangement used for both
Client-directed brokerage arrangement
An arrangement whereby a client directs that trades for its account be executed through a specific broker
in exchange for which the client receives a benefit in addition to execution services
2 key principles of SDS
1. Brokerage is the property of client obtain best execution 2. Investment managers have a duty to minimize transaction costs use client brokerage to benefit clients
a3. General principles of Soft Dollar Standards
Full and fair disclosure of the investment manager's use of a client's brokerage CFAI SDS are intended to ensure Consistent presentation of info->all parties clearly understand brokerage practices Uniform disclosure and record keeping High standards of ethical practices within the investment industry
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I. General II. Relationships with clients III. Selection of brokers
b. Critique company SD practices and policies
IV. Evaluation of research V. Client-directed brokerage VI. Disclosure VII. Record keeping
Level 1- Define the Product/Service
c. Permissible research guidance
Level 2- Determine Usage Level 3- Mixed Use Analysis
3.2 CFA Institute Soft Dollar Standards (cont.)
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specific, measurable standards
CFAI-ROS are intended to be
for managing and disclosing conflicts of interest
that may impede a research analyst's ability to conduct independent research and make objective recommendations
a a. Objectives of Research Objectivity Standards (ROS) (p.104)

Compliance and legal department Corporate issuer Covered employee Immediate family Investment advisory relationship Investment banking Investment manager Definitions Personal investments and trading Public appearance Quiet period Research analyst Research report Restricted period
Subject company Supervisory analyst 1. Research objective policy 2. Public appearances Requirements and recommended compliance procedures 3. Reasonable and adequate basis 4. Investment banking 5. Research analyst compensation 6. Relationships with subject companies 7. Personal investments and trading 8. Timeliness of research reports and recommendations 9. Compliance and enforcement 10. Disclosure 11. Rating system
4. CFA Institute Research Objectivity Standards
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a Case outline
5. The Glenarm Company
Case results
Case outline
5.6.7 Case Studies
6. Preston Partners
Case results
Case outline
7. Super Selection
Case results
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a. Trade allocation practice critique
8. Trade Allocation: Fair Dealing And Disclosure
b. Appropriate response to inadequate trade allocation practices
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a. Critique disclosure of investment objectives and basic policies
9. Changing Investment Objectives
b. Appropriate response to inadequate disclosure procedures
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Warm-up: The Old Prudent Man Rule
1. Diversification is fundamental to risk minimization 2. Trustees must base an investment's appropriateness on risk/return profile
a. Basic principles of the New Prudent Investor Rule
3. Trustees have a duty to avoid fees, transaction costs, and other expenses that are not justified 4. The fiduciary's duty of impartiality requires a conscious balancing of current income and growth 5. Trustees may have a duty, as well as the authority, to delegate as prudent investors would
Care Skill A trustee must exercise
b. General Fiduciary Standards
Caution Loyalty Impartiality
10. Prudence In Perspective

The Old PMR Use of total return Risk management
c. Differentiate
The New PIR
Evaluation in a portfolio context Security restrictions Delegation of duty
1. Economic conditions 2. Effect of inflation and deflation 3. Impact of investment decisions on the beneficiary's tax liability
d. Key factors should be considered when investing and managing trust assets
4. How each investment contributes to risk/return of the overall trust portfolio 5. Expected total return from income and capital appreciation 6. Other resources of beneficiaries liquidity 7. Needs for regularity of income preservation or appreciation of capital 8. Whether any assets have a special relationship to the requirements of the beneficiary or the trust
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CFALEVEL2
QUANTITAVE ANALYSIS
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EXAMPLE READING 11: (Excel output)

Regression Statistics Multiple R 0.47512 R Square 0.22574 Adjusted R Square 0.12896 Standard Error 15.05668 Observations 10 ANOVA Regression Residual Total df 1 8 9 SS 528.77 1,813.63 2342.4 MS 528.77 226.70 F 2.33 Significance F 0.17
Observation
1 2 3 4 5 6 7 8 9 10
X
12 13 10 9 20 7 4 22 15 23
Y
50 54 48 47 70 20 15 40 35 37
Intercept X
Coefficients Standard Error 25.5586 11.5324 1.1883 0.7780
t Stat 2.2163 1.5272
P-value 0.0575 0.1652
Lower 95% Upper 95% Lower 95.0% Upper 95.0% -1.0351 52.1523 -1.0351 52.1523 -0.6059 2.9824 -0.6059 2.9824
RESIDUAL OUTPUT Observation 1 2 3 4 5 6 7 8 9 10 Predicted Y 39.8176 41.0059 37.4411 36.2529 49.3236 33.8764 30.3116 51.7001 43.3824 52.8884 Residuals Standard Residuals 10.1824 0.7173 12.9941 0.9154 10.5589 0.7438 10.7471 0.7571 20.6764 1.4565 -13.8764 -0.9775 -15.3116 -1.0786 -11.7001 -0.8242 -8.3824 -0.5905 -15.8884 -1.1192
PROBABILITY OUTPUT Percentile 5 15 25 35 45 55 65 75 85 95 Y 15 20 35 37 40 47 48 50 54 70
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Sample covariance
a.
Sample correlation coefficient Scatter plot
Outliers
b. Limitations to Correlation analysis
Spurious correlation Nonlinear relationships
c. Hypothesis testing of correlation coefficient
Dependent (Y)
Explained variable Endogeneous variable Predicted variable
11.1. Correlation And Regression
d. Variables in a linear regression
Independent (X)
Explanatory variable Exogenous variable Predicting variable
linear relationship independent variable uncorrelated with residuals
e1. Assumptions underlying linear regression
expected value of residual term = 0 variance of residual term is constant residual term is independently distributed residual term is normally distributed
e2. Simple linear regression model
Sum of Squared Errors (SSE) Odinary Least Squares (OLS)
e3. Regression coefficients
Slope coefficient Intercept
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f1. SEE (Standard Error of Estimate)
f2. Coefficient of determination (R^2)
f3. Regression coefficient confidence interval
g. Regression coefficient t-test: b1=0
11.2. Correlation And Regression
h. Predicted value of the dependent variable
Y= Confidence intervals
SST (Total Sum of Squares) RSS (Regression Sum of Squares)
i. ANOVA (Analysis Of Variance)
SSE (Sum of Squared Errors) R^2 and SEE F-Statistic Multiple regression Simple regression
Parameter instability
j. Limitations of regression analysis
Limited use if others aware and act the same Invalid assumptions Heteroskedastic Autocorrelation
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Warm-up: Multiple regression basics a

Equation
a. Multiple regression
Interpretation
Intercept term Partial slope coefficients
Hypothesis
b. Regression coefficient testing
Statistical significance Interpreting p-values Other tests of the regression coefficients
c1. Confidence intervals for regression coefficient b
c2. Predicted value for Y
12.1. Multiple Regression & Issues In Regression Analysis
Linear relationship Y -- X Independent variables X Not random No linear relation X -- X
d. Multiple regression assumptions
Expected value = 0 Error term Variance is constant Not correlated with one another Normal distribution
e. F-statistic
R2 vs. Adjusted R2
f. Coefficient of Determination
g. ANOVA tables
Independent variables is binary in nature
h. Dummy variables
To quantify impact of qualitative events Coefficients in a Dummy variable regression
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LOS 12 i,j: Assumption violations

Assumption Violation
Heteroskedasticity Phng sai khng ng nht
Serial Correlation (Autocorrelation) T tng quan

(esp. in time series)
Multicolinearity a cng tuyn
Definition
2 types: . Unconditional:
2 types: . Positive:
. Conditional:
. Negative:
Detecting
. Residual plots ( th phn d):
. Residual plots:
. High R2, reject F-test but not any t-tests . Rule of thumb:
. Breusch-Pagan test:
. DW (Durbin-Watson) test:
Effects on regression analysis
. Standard errors: . t-test: . F-test:
. Positive: data cluster standard errors too. t-stat too .. ..
. Negative: data diverge
. F-test: unreliable Correcting . Adjust standard errors: Robust std. errors White-corrected std. errors Heteroskedasticity-consistent std. errors recalculate t-stats . Adjust standard errors: Hansen-White std. errors
(correct both heteroskedasticity & autocorrelation)
. Omit 1 or more variables (not easy, must use stepwise regression)
Serial correlation consistent recalculate t-stats . Improve specification (include seasonal terms)
NOTES:
. Regression analysis tests (t-tests, F-tests):H0: bad model (Reject H0 good model) . Assumption tests:H0: no violation (Fail to reject H0 good model)
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Warm-up: Why multiple regression isn't easy as it looks

Unconditional Conditional
What is it?
i1. Heteroskedasticity
Detecting heteroskedasticity
Correcting heteroskedasticity
What is it?
Positive Negative
Assumption violations
i2. Serial correlation (autocorrelation)
Detecting
Correcting
12.2. Multiple Regression & Issues In Regression Analysis
is
j. Multicollinearity
Detecting
Correcting
Warm-up: Model specification

Subcategory 1: Misspecified functional form Misspecification 1: Omitting a variable Misspecification 2: Variables should be transformed Misspecification 3: Incorrectly pooling data
k. Model misspecification
Subcategory 2: explanatory variables correlated with error term
Misspecification 4: use lagged Y as X Misspecification 5: Forecasting the past Misspecification 6: Measuring independent variables with error
Subcategory 3: misspecifications resulting in nonstationarity
Probit and logit models
l. Models with qualitative dependent variables
Discriminant models
m. Interpreting regression results

a. 2 models
Linear trend model Log-linear trend models
Trend models
b1. Which model is best? b2. Limitations of trend models
Autocorrelation
d. Structure of an AR model of order p
Autoregressive (AR) models
Forecasting with an autoregressive model e. Autocorrelation & Model fit
13.1. TimeSeries Analysis
Definition Detecting Correcting Forecasting with an AR model with a seasonal lag
l. Seasonality
In-sample forecasts
g. In-sample and out-of-sample forecasting
Out-of-sample forecasts Root mean squared error criterion (RMSE)
h. Regression coefficient instability

Constant and finite expected value 3 conditions Constant and finite variance Constant and finite covariance with leading or lagged values Significance of a series not being stationary
c. Covariance stationarity
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Mean reversion
f.
Calculate a mean-reverting level
Random walk
i. Random walks
Random walk with a drift Covariance stationarity
j. Unit roots
13.2. TimeSeries Analysis
First differencing
k,n. Nonstationarity and cointegration
Unit root test for nonstationary Cointegration
m. Autoregressive conditional heteroskedasticity (ARCH)
o. Choosing the correct model
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CFALEVEL2
ECONOMICS
Page 27
Warm-up: Economic growth (EG)
Rule of 70
Estimating EG
Land Capital goods
a1. Sources of EG
Labor Entrepreneurial ability
Markets
a2. Preconditions for E.G.- Incentive system
Property rights Monetary exchange
Labor productivity
=Real GDP per labor hour
Definition of PC
The productivity curve (PC)
2 properties of PC Law of diminishing returns
1. Growth in capital per labor hour --> movement along PC 2. Technological growth --> shift PC upwards
b. The ONE-THIRD Rule
14. Economic Growth

c. Faster economic growth
Increasing the growth of physical capital Three ways Technological advance Investment in human capital Stimulate saving Stimulate R&D -->Suggestions Target high-technology industries Encourage international trade Improve the quality of education
Growth in GDP: not permanent When real GDP per person above subsistence level --> population explosion --> real GDP per person back to subsistence level
Classical GT Figure
d. Growth theories (GT)

Neoclassical GT
Technological change --> increased saving & investment --> capital per labor hour increase --> long term growth in GDP Different from classical GT: population growth Technological growth Independent of econ. growth (or real wage rate or real GDP) But influenced by opportunity cost to women for entering workplace Not influenced by economic growth Occur through trial & error (R&D)
Based on 2 properties of market economies Technological change 2 other key assumptions driven by profit
Discoveries are the result of choices Discoveries lead to profit & competition eliminates profit
New GT
there is ongoing search to discover technologies Discoveries are public capital goods Law of diminishing returns does not apply to knowledge capital --> no mechanism to stop economic growth
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Warm-up: Natural monopolies a
Economic regulation of natural monopolies Rationale for a. Social regulation of nonmonopolistic industries
15. Regulation And Antitrust Policy In A Globalized Economy b. Social regulation
Potential benefits Possible negative side effects Creative response Feedback effect
Conform to the letter (the words), but not to the intent is a typical example of creative response New regulation changes consumers' behavior --> undermine the original intent
Capture hypothesis
regulators are selected from industry experts --> have relationships --> sometimes decisions influenced/controlled by the industry at regulatory hearing: consumers less prepared and less persuasive than industry members
c. Regulators' behavior
Share-the-gains, share-the-pain theory
Legislators Regulators try to satisfy all 3 parties Customers Regulated firms
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Comparative advantage
Concept Law of comparative advantage

Specialize in low-opportunity-cost goods --> export Import high-opportunity-cost goods
a. How countries can gain from international trade
Warm-up: Consumer and producer surplus a Tariffs

--> increase price of imported goods --> reduce imports --> benefit domestic producers tariff=tax --> benefit government
higher price License to import a limited amount --> reduce supply --> lower equilibrium domestic quantity less foreign competition --> benefit domestic producers
Quotas b. Barriers to trade Non-tariff barriers
deadweight loss
firms with import licenses get the gains
Voluntary export restraints (VERs)
are agreements by exporting countries to voluntarily limit the quantity of goods firms with export permits get the gains (different from quotas) Government officials who choose firms may receive some gain.
16. Trading With The World Infant-industry argument
Argument:
infant industries should be protected while they get up to world standards of productivity and quality Benefits not the whole economy but to firms & workers in those industries Tariff or quota is market distorting --> Government subsidy is better
Critiques:
Exporters should be prohibited from selling goods abroad at less than production cost Difficult to estimate production costs
Arguments with some support
Dumping argument
--> Anti-dumping law: Critiques:
price lower than in foreign firms' market is not evidence of dumping drive domestic firms out of business --> still have competition from other countries those domestic firms could re-enter when foreign firms raise prices
c. Critque the arguments for trade restrictions

Argument
Industries associated with national defense should be protected so they will exist domestically in case of war almost all industries contribute or potentially contribute to national defense government should choose strategic industries to subsidize rather than impose trade restrictions
National security argument
Critiques:
Arguments with very little support
Trade barriers protect jobs Trade restrictions create jobs Trade with low-wage countries depresses wages in high-wage countries
Page 30
Direct a. Methods of FX quotations a Indirect
Calculation
b. Spreads
Affected by
Market conditions Bank/dealer's positions Trading volume
c. FX cross rates
d. Triangular arbitrage
Spot markets 17. Currency Exchange Rates e. Distinguish Forward markets
Calculation
Market conditions
f. Spreads in the forward market
Affected by
Bank/dealer's positions Trading volume Maturity/length of contract
g,i. Forward premium/discount
Interest rate parity
interest differential ~ forward differential formula calculating Forward rate from Spot rate:
Covered interest arbitrage
exploits mispricing between spot & forward --> zero-cost but guaranteed profit =money market hedge
a. Exchange rate determination in a floating system
Current account (CA)
b. BOP accounts
Financial (capital) account (FA) Official reserve account
c. How deficit or surplus in CA & FA affects an economy
d. Factors that affect currency movements
Monetary policy on
BOP Exchange rate
e. Effects of
Fiscal policy on
BOP Exchange rate
Fixed
18. Foreign Exchange Parity Relations
f. Other exchange rate systems
Pegged
Absolute PPP
only requires that the law of one price is correct on average Expected spot exchange rate after t years =
g,h. Purchasing power parity (PPP)
Relative PPP
Interest rate differential = Expected inflation differential Assumption: real interest rates stable over time equal across international boundaries Exact formula: Linear approximation:
i,j. International Fisher relation
= combine PPP & international Fisher
k. Uncovered interest rate parity
Formula: expected spot exchange rate after n days=
l,m. Foreign exchange expectation relation
Forward rate = unbiased predictor of expected future spot rate --> no reward for bearing foreign currency exposure (but empirical evidence suggests forward rate is not unbiased predictor) Forward discount/premium = unbiased predictor of expected change in spot e/r
Page 32
a GDP
a. Measures of economic activity
GNI
NNI
Market prices GDP at 19 . Measuring Economic Activity Factor cost b.
Adjustments
Prices c
Current prices Constant prices
GDP deflator
Page 33
CFALEVEL2
FINANCIAL REPORTING ANALYSIS
Page 34
Inflation --> LIFO: ___ COGS; ___NI; ___tax; ___CF; ___Inventory, ___Current asset; ____ profitability; ___solvency, ____liquidity
a. Effect of inflation & deflation of inventory costs e. Effects of different inventory valuation methods
Change in methods --> retrospective Inv.&COGS determined end of accounting period Inv. & COGS continuously updated
Inventory systems
Periodic
Perpetual
LIFO reserve LIFO conformity rule LIFO inventory
b,c. LIFO
c. Adjust FS from LIFO to FIFO
LIFO COGS LIFO equity LIFO tax liability
LIFO liquidation
20. Inventories: Implications For FS & Ratios
IFRS
write down
min(cost, NRV)
NRV=
write up: up to original cost
d. Implications of valuing inventory at NRV
USGAAP
write down
min (cost, market) market=mid(replacement cost, _____, ________
write up: no Except: Commodity-like products
Service Merchandising Raw materials
f. Issues to consider
Manufacturing
3 accounts
WIP Finished goods RM or WIP increased -->
Analysis
FG increased when RM, WIP decreased --> sales g < FG g -->
Page 35
Define asset: Effects of capitalizing Interest cost:
a. Capitalizing vs. Expensing

Intangible assets: developed internally
Normally --> Expensed IFRS Except R&D R: expensed; D: Capitalized Not software: like normal (expense R&D) USGAAP Software for sale: like IFRS (technological feasibility) for use: capitalize R&D affect COGS of SG&A
b. Different depreciation methods for PPE
Straight live Methods DDB (early) Usage-based Change in methods --> Sell --> =(Fair value-Selling cost) Use --> Value in use (=PV of future CFs)
2 options Impairment (write down) IFRS
Recoverable amount= max (2 options) If carrying value > recoverable amount -->
USGAAP
Step 1: Recoverability test Step 2: Loss measurement
c. Impairment & revaluation

Revaluation (write up)
Asset held for sale: up to original cost (both IFRS & USGAAP) Asset held for use USGAAP: no up IFRS: up to original cost (except revaluation model)
21. Long-lived Assets: Implications For FS & Ratios
BS: IS: CF: Notes: Average age= Average depreciable life= Remaining life= 5 motivations for leasing: less costly; less risk of obsolescence; less restrictive provisions; OBS financing; tax advantage
d. Disclosures related to long-lived assets
e. Leasing vs. Purchasing

Transfer of title 4 criteria Bargain purchase option Lease period >= 75% economic life PV(lease pmts) >= 90% fair value of asset Operating lease Reporting by lessee Finance/Capital lease Financial statements & ratios effects Lease disclosures Operating lease Gross profit=PV(lease pmts)-BV Reporting by lessor Sales type lease Finance lease Direct financing lease BS: lease receivable IS: Gross profit for 1st year; Interest revenue each year CF: similar to sales type lease except for gross profit USGAAP: Yr1:..; Yr2:...; Yr3, Yr4,Yr5; Aggregate Yr6 onward IFRS: Yr1:...; Sum Yr2 to Yr 5, Sum Yr6 onward.
f. Finance vs. Operating lease Lessor vs. lessee
Page 36
Held-to-maturity 4 types Held for trading Available for sale Designated at fair value: intention HTM or AFS but treated like HFT Reclassification of investments in financial assets
HTM, AFS ---------------------------------- HFT, DFV AFS----------------------------------------------------HTM impaired if decline in value is not temporary impaired if at least one loss event has occurred & its effect on future CF can be estimated reliably
1. Investments in financial assets (minority passive)
Under US GAAP Impairments of financial assets Under IFRS
Both USGAAP & IFRS require to evaluate each accounting period Reversals of impairment Analysis of investments in financial assets initially Equity method In subsequent periods equity investment is recorded at cost on the investor's BS increases/decreases the investment account on the investor's BS is recognized in the investor's IS --->reduce the investment account Debt Equity
the proportionate share of the investee's earnings/loss
dividends received from the investee
are treated as return of capital
2. Investments in associates
are not recognized in the investor's IS
Excess of purchase price over BV acquired Impairments of Investments in associates
22. Intercorporate Investments
Transactions with the investee Analytical issues for investments in associates Categories Under IFRS Under US GAAP
3. Business combinations
The pooling of interests method Under the acquisition method Under IFRS
4. Joint ventures 5. SPE and VIE
Under US GAAP
Net income Items Equity Assets & Liabilities Sales
c. Effects on financial ratios

Ratios
Leverage Net profit margin ROE ROA
Page 37
a. Types of post-employment benefit plans
Defined-contribution plan Defined-benefit plan Other post-employment benefits
Projected benefit obligation (PBO) 3 measures Accumulated benefit obligation (ABO) Vested benefit obligation (VBO)
b. Measures of a defined benefit pension plan's liability/asset
(+) Beginning PBO (+) Current service cost PBO= (+) Interest cost (+) Plan amendments (+)/(-) Actuarial gains/losses (-) Benefit paid (+) Current service cost (+) Interest cost (-) Expected return on assets (-)/(+) Amortization of deferred gains/losses (+) Amortization of past service cost Discount rate increase PBO_____, ABO_____, VBO_____ Current service cost _____, Interest cost _____, Expected return _____, Pension expense ____ PBO_____, ABO_____, VBO_____ Current service cost _____, Interest cost _____, Expected return _____, Pension expense ____ PBO_____, ABO_____, VBO_____ Current service cost _____, Interest cost _____, Expected return _____, Pension expense ____ Funded status= Under US. GAAP Net pension asset/liability = Funded status Other comprehensive income in Equity Under IFRS Net pension asset/liability = Funded status - Other comprehensive income
c. Net pension expense =
d. Impact of a DBP's assumptions
Rate of compensation growth decrease
Expected rate of return increase
23. Employee Compensation: Post-retirement And Share-based
e. Presentation & footnotes g. Evaluate the underlying economic liability (or asset)
Reasons for netting Employer largely controls plan assets & obligation --> bear risk Decisions regarding funding & accounting are affected by net pension obligation, not gross
Funded pension plan: contributions = CFO-
f. Cash flow information
Unfunded plan: benefits paid = CFOFor analytical purpose: might be CFF-, if contributions largely differ from economic pension expense not "smoothed" actual return instead of expected return
Economic pension expense
h.
Reclassifying for analytical purpose Interest cost & Actual return: should be non-operating
i. Accounting issues
What is share value (esp. if shares are not traded publicly) Expense should be spread over service period Outright stock grants Without conditions Restricted stocks: can't be sold till end of vesting Performance stocks (e.g.. ROA, ROE, IN... --> manipulation) Condition: share price increase over a threshold Payment: cash or equity or both
Stock grant Share-based compensation j.
Stock appreciation rights
Phantom stocks: stock appreciation rights for privately held/ highly illiquid firms --> based on performance of hypothetical stock
Stock options
In the past: intrinsic value method (recognize an expense if market price > exercise price on grant date). Problem: usually no intrinsic value Current: Fair value method (using Black Scholes Merton or binomial models to calculate value of option --> amortize over service period=grant date to vesting date). Problem: very subjective
Page 38
Local currency
a. Distinguish
Functional currency Presentation (reporting) currency
b. Impact of changes in exchange rates on the translated sales of the subsidiary and parent company
24. Multinational Operation
c.
If foreign currency appreciates
All-current method
Net assets exposure --> Net liabilities exposure --> Net monetary assets exposure --> Net monetary liabilities exposure -->
Temporal method
Income before translation G/L Translation G/L
d. Compare 2 methods
Net income Total assets Temporal vs. All current (parent currency depreciated -->)
ROA__; ROE__; TATO___; Invt TO___; A/R TO___ Pure BS or Pure IS ratios Mixed BS/IS ratios (using end-of-period BS) USGAAP: 3-year accumulative infl > 100% (i.e. 26% per year) IFRS: no definition
e. Affecting the parent company's financial ratios
All current vs. Original
Define hyperinflation
USGAAP: Functional = Presentation & use temporal method
f. Subsidiaries operating in hyperinflationary economies
Non-monetary Asset & Liab Treatment IFRS Shareholders' equity
adjust using price index between acquisition date & balance sheet date adjust using price index from date of contribution or from year of beginning, whichever is later no adjustment
Monetary Asset & Liab.
Net purchasing power Gain /Loss --> Income statement
Analyzing foreign currency disclosure : Difficulty: little requirement for disclosure. 1 parent may have many
subsi using diferrent methods --> solution: add delta CTA to Net income (clean surplus accounting)
Page 39
a. Distinguish among various definition of earnings
EBTDA, Operating income, EBT, Income from continuing operations, Income before extraordinary items, Income before effect of changes in accounting principles, net income
Lesson 1: Understand what you are looking at
Lesson 2: Read the fine print
Lesson 3: If it's too good to be true, it may be
25. The Lessons We Learn

Lesson 4: Follow the money
b. Trends in CFO more reliable than trends in earnings
Effective Purpose Fair value hedge To hedge A/L To hedge future CF of trx Foreign subsidiary Unrealized G/L Realized G/L
Not Effective Unrealized G/L
To hedge
CF hedge
c. Lesson 5: Understand the risks
Net investment hedge in foreign subsidiary
To speculate
Realized & Unrealized G/L -->
Page 40
Contrast
Cash-basis Accrual-basis: provide more timely & relevant info. to users
a.
Why accounting discretion with accrual basic?
Revenue recognition, Depreciation estimates, Inventory cost flow, Impairment, GW, Valuation allowances for DTA, pension assumptions, stock option valuation to compute compensation expense
b. Relation between the level of accruals and the persistence of earnings

Opportunities and motivations for management to intervene in the external financial reporting process
Influence capital markets Satisfy contractual provisions (loan covenants, executive compensation)
c.
Mechanisms disciplining mgmt
Independent audit, BoD, Certification by senior mgmt, Class action litigation, Regulators, General market scrutiny
Earnings quality (EQ)
persistent & sustainable
NOA= Balance sheet approach Accruals = Accrual ratio =
d.
Measures of EQ CF statement approach
Accruals = Accrual ratio =
Acquisitions
26. Evaluating Financial Reporting Quality
2 approaches are conceptually equivalent. They still may differ because of
Divestitures Exchange rate G/L Inconsistent treatment
Extreme earnings --> not continue forever but revert back to normal level
e. Mean reversion in earnings
Accruals increase --> mean reversion faster
Misstating revenue Bill-and-hold arrangement Channel stuffing Revenue recognition Accelerating revenue Barter transactions Abnormal sales growth Disproportionate 4th quarter revenues for a non-seasonal firm Misclassifying nonrecurring or nonoperating Large changes in A/R & UR Detection techniques Increased DSO Compare rev & actual cash collected Undestating expense Delaying expense Expense recognition Misclassifying expenses as nonrecurring or nonoperating Large changes in fixed assets & inventory Increased DOH Detection techniques LIFO liquidation Compare depreciation expense to other companies Core operating margin = (sales-COGS-SG&A)/ sales OBS financing BS Goodwill Techniques Capitalize operating leases Look for lack of GW impairment e.g..: "park" cash in LT investment --> CFF e.g..: operating lease
f. Problems with quality of FS & warning signs
Misclassifying CF CFS Ignoring CF Managing CF Techniques
e.g..: lease
Compare growth of operating leases with growth of asset Be alert for a decrease in discretionary spending, esp. near year-end
Page 41
Primary purpose: identify potential outcomes, good or bad, that could affect an investment decision
Figure 1: Framework for Analysis
a.b. Framework for the analysis of FS
Sources of earnings & ROE
Internal or External (remove equity income to reduce bias) Dupont ROE =
27. Integration Of FS Analysis Techniques

Focus on
Asset base Capital structure
Common size BS Divide by total LT capital Working capital ratios Assets, Capex, Rev, EBIT by Business segments Geographic segments
Capital allocation decisions
Earnings quality & CF analysis Mkt value decomposition OBS financing
Accrual ratios & CF/Operating income standalone value of parent, P/E multiple
Anticipating changes in accounting standards
c. Adjustments for differences in accounting rules, methods & assumptions
d. Predict the impact on financial statements and ratios of changes in accounting standards
Eliminate operating lease Eliminate QSPE
BS modifications Earnings normalization
e. Effects of
CF-statement-related modifications
Page 42
FRA examples & exercises Page 1
FRAlevel2examples %PurchasedofSubsidiary Purchasedprice 30% 3

Note:PP=BV
TABLE1:
BSbeforeacquisitionasat1/1/2009 Parent Cash A/R+Inventory InvestmentinS Fixedassets Totalassets Totalliabilities Commonstock Retainedearnings Minority yinterest TotalEquity Totalliab.&equity 20 28 Subsidiary 10 6 Equity Explanation method 17 28 3 32 80 40 28 12 40 80
PaycashtobuyS unchanged PartofS'sequity
BSofParentafteracquisitionasat1/1/2009
Acquisitionmethod (purchasemethod/ consolidationmethod)
Explanation
addupsub&paycash addupsub
Proportionate consolidation method
Explanation
addupPARTOFsub&pay$ addupPARTOFsub
27 34
20 29.8
32 80 40 28 12 40 80
8 24 14 6 4 10 24
unchanged
40 101 54 28 12 7 47 101
addupsub unchanged unchanged Others'share
34.4 84.2 44.2 28 12 40 84.2
addupPARTOFsub
unchanged unchanged unchanged
addupPARTOFsub unchanged unchanged
TABLE2:
ISfortheyearending31/12/2009 Parent Revenues Expenses EquityinincomeofS Minorityinterest Netincome Dividend Retainedearnings 60 40 Subsidiary 20 16 Equity Explanation method 60 40 1.2 21.2
unchanged unchanged P'sshare
ISofParentfortheyearending31/12/2009
Acquisitionmethod (purchasemethod/ consolidationmethod)
Explanation
addupsub addupsub
Explanation
addupPARTOFsub addupPARTOFsub
80 56 2.8 21.2
66 44.8
Deductothers'share
20 0 20
4 1 3
21.2
Page 43
FRAlevel2examples
TABLE3:
"Ifnotacquisition"BSasat31/12/2009
Assumption:allyearendBS itemsofP&Sarethesameas 1/1/09,exceptforcashwhich increasesby(NIDiv)
ConsolidatedBSofParentasat31/12/2009
Equity Explanation method 37.3 28 3.9
+REofP +PartofDivfromS Acquisitionmethod (purchasemethod/ consolidationmethod)
Parent
Subsidiary
Explanation
+REofP+PartofDiv fromS+allREofS
Explanation
+REofP+PartofDiv fromS+partofREofS
Cash A/R+Inventory InvestmentinS Fixedassets Totalassets Totalliabilities Commonstock Retainedearnings Mi it interest Minority i t t TotalEquity Totalliab.&equity
40 28
13 6
50.3 34
41.2 29.8
+PartofNIofS PartofDivfromS
32 100 40 28 32 60 100
8 27 14 6 7 13 27
32 101.2 40 28 33.2 61.2 101.2

+REofP +PartofNIofS
40 124.3 54 28 33.2 9 9.1 1 70.3 124.3

+REofP +PartofNIofS +Other's h ' share h inRE
34.4 105.4 44.2 28 33.2 61.2 105.4

+REofP +PartofNIofS
Page 44
FRAlevel2examples %PurchasedofSubsidiary Purchasedprice 30% 7

FullGW(100%): Note:PP#BV PartialGW30%:
7.33 2.20
FairvalueofS:
23.33
TABLE4:
BSbeforeacquisitionasat1/1/2009 Parent Cash A/R+Inventory InvestmentinS Goodwill Fixedassets Totalassets Totalliabilities Commonstock Retainedearnings Minorityinterest TotalEquity Totalliab.&equity 20 28 Subsidiary 10 6 FairValue ofSubsi. 10 6 Equity method 13 28 4.8 2.2 32 80 40 28 12 40 80
BSofParentafteracquisitionasat1/1/2009
Explanation
PaycashtobuyS Acquisitionmethod PartialGW(IFRS) Acquisitionmethod FullGW(USGAAP& IFRS)
Poolingof interest
Explanation
23 34 2.20
23 34 7.33
30 34
addupBV
PartofS'sfairequity =PPPartofFairV
32 80 40 28 12 40 80
8 24 14 6 4 10 24
14 30 14
46 46 105.2 110.33 54 54 28 28 12 12 11 2 16.33 11.2 16 33 51.2 56.33 105.2 110.33
40 104 54 34 16 50 104
addupBV
addupBV addupBV
16
TABLE5:
ISfortheyearending31/12/2009 Parent Revenues Expenses
ShareinS'sincome Additionaldepr.
ISofParentfortheyearending31/12/2009
Equity method 60 40
1.2 0.6 SLD3years
Subsidiary 60 40 20 16
Explanation
Acquisitionmethod PartialGW(IFRS)
Acquisitionmethod FullGW(USGAAP& IFRS)
80 56 0.6 2.8 20.6
80 56 0.6 2.8 20.6
EquityinincomeofS Minorityinterest Netincome Dividend Retainedearnings
0.6 20 0 20 4 1 3 20.6
Page 45
FRAlevel2examples
TABLE6:
"Ifnotacquisition"BSasat31/12/2009
Assumption:allyearendBS itemsofP&Sarethesameas 1/1/09,exceptforcashwhich increasesby(NIDiv)
ConsolidatedBSofParentasat31/12/2009
Equity method 33.3 28 5.1 2.2
+PartofNIofS AddDepr. PartofDivfromS
Parent
Subsidiary
Explanation
Acquisitionmethod PartialGW(IFRS)
Acquisitionmethod FullGW(USGAAP& IFRS)
Cash A/R+Inventory InvestmentinS Goodwill Fixedassets Totalassets Totalliabilities Commonstock Retainedearnings Minorityinterest TotalEquity Totalliab.&equity
40 28
13 6
32 100 40 28 32 60 100
8 27 14 6 7 13 27
32 100.6 40 28 32.6 60.6 100.6

+REofP +PartofNIofS AddDepr.
Page 46
Pensionexercise1:
Expectedreturnonplanassetsis80 Amortizationofactuariallossis30 Amortizationofpriorservicecostis10 Calculate Netperiodicbenefitexpense Economicpensionexpense
Page 47
Pensionexercise2:
CalculatePensionexpenseandmakeadjustmentsforanalyticalpurposes.
Page 48
FRA2MultinationaloperationsEg.2
U$/LC Currentex/rate Averageex/rate Historicalex/rate ForCOGS ForDepr.Exp. ForFixedassets Foraccum.Depr. Forend.inventory Forequity 31/12/2008 0.5000 31/12/2009 0.4545 0.4762 0.0000 0.4834 0.4878 0.4881 0.4896 0.4762 0.5000 INCOMESTATEMENT2009 Revenues COGS Grossmargin Otherexpenses Depr.Expenses LC 5,000 3,300 1,700 400 600 Allcurrent method $ 2,381.00 1,571.46 809.54 (190.48) (285.72)
Temporal method $ Explanation 2,381.00 Average 1,595.22 Historical 785.78 (190.48) Average (292.68) Historical
302.62 IncbfremeasureG/L
48.01 RemeasurementG/L
NetIncome
700
333.34
350.63
31/12/2008
BALANCESHEET Cash A/R Inventory CurrentAssets FixedAssets Accum.Depr. Netfixedassets LC 100 500 1,000 1,600 800 100 700 Allcurrent method $ 50.00 250.00 500.00 800.00 400.00 (50.00) 350.00 BALANCESHEET Cash A/R Inventory CurrentAssets FixedAssets Accum.Depr. Netfixedassets LC 100 650 1,200 1,950 1,600 700 900 Allcurrent method
31/12/2009
$ 45.45 295.43 545.40 886.28 727.20 (318.15) 409.05 Temporal method $ Explanation 45.45 Current 295.43 Current 571.44 Historical 912.32 780.96 (342.72) 438.24 Historical Historical
Totalassets
Accountspayable Currentdebt Longtermdebt Totalliabilities Commonstock Retainedearnings Totalequity
2,300
400 100 1,300 1,800 400 100 500
1,150.00
200.00 50.00 650.00 900.00 200.00 50.00 250.00
Totalassets
2,850
500 200 950 1,650 400 800 1,200
1,295.33
227.25 90.90 431.78 749.93 181.80 363.60 545.40
1,350.56
227.25 90.90 431.78 749.93 200.00 400.63 600.63 Current Current Current
Historical Plugnumber
Totalliab.&equity
2,300
1,150.00
Totalliab.&equity
2,850
1,295.33
1,350.56
Page 49
U$/LC Currentex/rate Averageex/rate Historicalex/rate ForCOGS ForDepr.Exp. ForFixedassets Foraccum.Depr. Forend.inventory Forequity 31/12/2008 0.5000 31/12/2009 0.4545 0.4762 0.0000 0.4834 0.4878 0.4881 0.4896 0.4762 0.5000 INCOMESTATEMENT2009 Revenues COGS Grossmargin Otherexpenses Depr.Expenses LC 5,000 3,300 1,700 400 600 Allcurrent method $ 2,381.00 1,571.46 809.54 (190.48) (285.72)
Temporal method $ Explanation 2,381.00 Average 1,595.22 Historical 785.78 (190.48) Average (292.68) Historical
302.62 IncbfremeasureG/L
48.01 RemeasurementG/L
NetIncome
700
333.34
350.63
31/12/2008
BALANCESHEET Cash A/R Inventory CurrentAssets FixedAssets Accum.Depr. Netfixedassets LC 100 500 1 000 1,000 1,600 800 100 700 Allcurrent method $ 50.00 250.00 500 00 500.00 800.00 400.00 (50.00) 350.00 BALANCESHEET Cash A/R Inventory CurrentAssets FixedAssets Accum.Depr. Netfixedassets LC 100 650 1 200 1,200 1,950 1,600 700 900 Allcurrent method
31/12/2009
$ 45.45 295.43 545.40 545 40 886.28 727.20 (318.15) 409.05 Temporal method $ Explanation 45.45 Current 295.43 Current 571.44 571 44 Historical 912.32 780.96 (342.72) 438.24 Historical Historical
Totalassets
2,300
400 100 1,300 1,800 400 100 500
1,150.00
200.00 50.00 650.00 900.00 200.00 50.00 250.00
Totalassets
2,850
500 200 950 1,650 400 800 1,200
1,295.33
227.25 90.90 431.78 749.93 181.80 363.60 545.40
1,350.56
227.25 90.90 431.78 749.93 200.00 400.63 600.63 Current Current Current
Historical Plugnumber
Totalliab.&equity
2,300
1,150.00
Totalliab.&equity
2,850
1,295.33
1,350.56
Page 50
A 1 2 3 Priceindices 4 Dec.31.2009 5 Dec.31.2008 6 Averagefor2009 7 8 9 10 11 B C D E
AdjustmentsforinflationunderIFRS
100 150 125 Adjustment factor 1.20 1.20 Inflation adjusted 18,000 14,400 6,900
INCOMESTATEMENT Revenues Expenses NetpurchasingpowerG/L
2009 15,000 12,000
12 NetIncome 13 BALANCESHEET 14 15 Cash 16 Supplies 17 Totalassets 18 19 Accountspayable 20 Commonstock 21 Retainedearnings 22 Totalliab.&equity 2008 5,000 25,000
3,000
Adjustment factor 1.50
10,500
Inflation adjusted 8,000 37,500
2009 8,000 25,000
30,000
20,000 10,000 0 30,000
33,000
20,000 10,000 3,000 33,000
45,500
20,000 15,000 10,500 45,500
1.50
Page 51
CFALEVEL2
CORPORATE FINANCE
Page 52
Replacement to maintain biz --> no detailed analysis Project categories Replacement for cost reduction --> fairly detailed analysis Expansion --> very detailed New product/ market --> detailed Mandatory (required by Govt. or insurance such as safety or environmental projects) Other (pet projects or high risk like R&D) Incremental CF, not accounting income Timing of CF --> TVM After tax Principles Exclude Notes Include Externalities Opportunity costs Sunk cost Financing costs
Warm-up: Basics
MACRS= Modified Accelerated Cost Recovery System (for tax purpose)
Half-year convention No salvage
Initial investment outlay= Expansion project analysis
After-tax O.CF=
T.NO.CF=
a. Capital budgeting project evaluation

Replacement project analysis
Initial investment outlay=
28.1. Capital Budgeting
After-tax O.CF=
T.NO.CF=
Principle
Nominal CF --> use nominal discount rate Real CF --> use real discount rate
b. Inflation effects (if actual inflation higher than expected)
__________ project profitability __________ tax savings from depreciation __________ value of payments to bondholders Affects Revenues and Costs differently --> CF may be worse or better
Least common multiple of lives approach (replacement chain)
c1. Projects with different lives
Equivalent annual annuity (EAA) approach
Hard rationing: allocated funds cannot be increased
c2. Capital rationing= insufficient capital --> violate market efficiency
Soft rationing: allocated funds can be increased
Sensitivity analysis: Base case, then change ONLY 1 variable up/down
d. Project risk analysis
Scenario analysis: Base case, then change MANY variables --> Worst case, Best case --> Risk analysis Simulation analysis (Monte Carlo): Probability distribution of NPV
CAPM --> WACC
e. Determine discount rate
When risk of project # overall risk --> CANNOT use WACC
Page 53
a
Timing options: option to delay investment Types of real options Abandonment options: abandon if NPVexit > NPVcontinue (=put option) Expansion options: option to have additional investment (=call option) Flexibility options (operational) Price-setting: demand increase --> increase price (oil) Production-flexibility: e.g..: pay overtime, use # inputs, # products...
f. Evaluating projects with real options

Evaluating approaches
Fundamental options: project itself = option (e.g.: copper mine) If NPV without option >0 --> Project will be more valuable with option NPV = NPV without option + option value - option cost Decision tree Option pricing models
Failing to incorporate economic responses: e.g..: profitable but low entry barriers --> competitors Misusing standardized templates, which are not an exact match Pet projects of senior management: less analysis Basing investment decisions on EPS or ROE --> avoid projects with high NPV but low EPS or ROE in the short run (especially when management compensation is tied to EPS or ROE) Using IRR for project decision: for mutually exclusive projects, should use NPV instead
g. Common capital budgeting pitfalls
Poor CF estimation: double count or omit a CF. E.g..: inflation Mis-estimation of overhead costs (e.g..: management time, IT support): difficult to quantify Using the incorrect discount rate: WACC or should adjust?
28.2. Capital Budgeting (cont.)
Politics involved with spending the entire capital budget: e.g.. :management tries to spend all budget to ask for more next year Failure to generate alternative investment ideas: most important step ("good" is the enemy of "better") Improper handling of sunk and opportunity costs
ECONOMIC INCOME
= CASHFLOW minus ECONOMIC DEPRECIATION

Economic Depreciation year t = Beginning market value minus Ending market value for year t Market value year t = sum of PV of all CF left
h. Measures of income and valuation models
ACCOUNTING INCOME
From Income statement # economic income Depreciation based on original cost, not market value Deduct interest expense
ECONOMIC PROFIT (EP)
= NOPAT - WACC in dollars

To bond and equity holders Sum of EP discounted at WACC = MVA (Market Value Added) = NPV
i. Other valuation models
RESIDUAL INCOME
= ACCOUNTING NET INCOME minus EQUITY CHARGE

To equity holders Sum of RI discounted at cost of equity = NPV
Claims valuation
Free cash flows to company (debt and equity holders) --> discount at WACC Free cash flows to equity (shareholders) --> discount at cost of equity
Page 54
Maximize Firm Value
MM Proposition I MM Proposition II
Capital structure objective

Minimize WACC
a1. Capital structure theory
MM Proposition I
No taxes
MM Proposition II MM Proposition I
With taxes
MM Proposition II
Costs of financial distress --> lower Debt Agency costs of equity --> higher Debt
Costs Probability Monitoring costs: supervising, reporting (corporate governance) Bonding costs: insurance premiums, non-compete agreements Residual losses: other costs
a2. Costs and their potential effect on the capital structure
Costs of asymmetric information: (managers vs. creditors and owners)
--> increase required rate of return
MM's propositions with no taxes: Capital structure is irrelevant MM's proposition with taxes: optimal capital structure is 100% debt (highest tax shield, max value, min WACC)
a3. Implications for managerial decision making
Pecking order theory: order of raising funds: Internally generated equity --> Debt --> External Equity Firm value: Static trade-off theory Optimal capital structure achieved when: Marginal Tax Benefit = Marginal Cost of Financial Distress
29. Capital Structure & Leverage
2 reasons for actual capital structure to fluctuate around target capital structure
Opportunities in a financing source Market value fluctuations
E.g.: temporary increase in stock price D, E = market value
b. Target capital structure (optimal)
c. Role of debt ratings
Moody's; S&P's
Changes in capital structure overtime
d. Capital structure policy and valuation
Factors to consider
Competitors with similar business risk Agency costs (corporate governance)
Total debt: Japan, France: more debt than UK, US International differences Debt maturity: US longer than JP Emerging market differences: emerging market less and shorter debt
Strength of legal system: strong --> reduce agency cost--> less and longer debt
e. International differences in leverage

Factors
Institutional and legal factors
Information asymmetry: increase debt (auditors, analysts help reduce info asymmetry --> decrease debt) Taxes: high --> increase debt. Tax on dividend: high --> decrease debt
Financial markets and banking system factors Macroeconomic factors
Liquidity of capital markets (debt market): high --> longer debt Reliance on banking system --> increase debt Institutional investor (shareholders) presence --> decrease information asymmetry --> decrease debt Inflation --> less, shorter debt GDP growth --> longer debt
Page 55
Dividend irrelevance: MM (homemade dividend) Bird in the hand theory (Myron Gordon & John Lintner) Dividend preference
a. Schools of thought on dividends

Tax aversion Clientele
Impact of dividend initiation on stock value and P/E
Higher dividend --> _____ Risk --> _____ Cost of Equity --> _____ P/E Higher dividend --> _____ stock value
Dividend initiations Information conveyed by Dividend increases Unexpected Dividend decreases / omissions
ambiguous: sharing wealth or lack of profitable reinvestment opportunities Strong future Business in trouble or more investment opportunities
b. Signaling effect
Country differences: US # Asia in perception
Double taxation Tax-on-dividend systems Split rate Imputation
d. Factors affecting dividend payout policy
e. Taxation of dividends
Tax considerations
c. Clientele effect c2. Agency issues

Restrictions on dividend payments
Requirements of institutional investors Individual investor preference
"Impairment of capital" rule Debt covenants Cash flow Industry life cycle
30. Dividends & Dividend Policy
Flotation costs on new issues vs. cost of retained earnings Shareholder preference for current income vs. capital gains
Residual dividend model forecast capital budget for 5 years, Longer-term residual dividend e.g.: Leftover = total net income 5 years minus capital budget for 5 years. Dividend each year = Leftover/5
f. Dividend policy approaches
Dividend stability:
steady dividend payout (taking into account inflation) --> dividend growth rate g = company's long term growth rate
Target payout ratio
Payout ratio = constant Payout ratio moves toward the target
Compare with cash dividend EPS effect Book value effect If Cost of Debt < Earning yield --> EPS_____ If Cost of Debt > Earning yield --> EPS_____ If Price > BVPS --> BVPSnew ______ If Price < BVPS --> BVPSnew ______ Buy in the open market Methods Buy a fixed number of shares at a fixed price: tender offer: P > Pmarket Repurchase by direct negotiation: to avoid price decrease (e.g.: greenmail premium) Capital structure Prevent EPS dilution from employee stock options Rationales Supplement to cash dividend --> residual dividend policy Management is viewing stocks as strong Good future outlook signal
g. Share repurchase
h. Global trends
Net income FCF
i. Dividend coverage ratios based on
j. Symptoms of not being able to sustain cash dividend
Page 56
a
Multiple owners vs managers
Warm-up: conflicts of interest in a corporation
Directors Creditors, Employees, Customers
Definition: system of
Principles & Policies Procedures Responsibilities & Accountabilities
a. Corporate governance (Sarbanes-Oxley)
Objectives
Eliminate or reduce CONFLICTS of interest (esp. mgmt vs. shareholders) Use ASSETS in best interests of investors and other stakeholders RIGHTS of shareholders & stakeholders Oversight RESPONSIBILITIES of managers and directors Fair and equitable TREATMENT Transparent & accurate DISCLOSURES about operations, performance, risk and financial position
Attributes of effective CG
Sole proprietorship Partnerships
no owner vs. manager conflict. Just creditors, suppliers, customers...
no owner vs. manager conflict. Just creditors, suppliers, customers... (US: 20% in number but account for 90% revenue)
b. Business forms
Corporations
Expand firm Manager >< Shareholder
to increase power, security, compensation
Excessive compensation and perquisites (e.g.. lavish jet) Invest in risky ventures (succeed --> benefit from stock options, fail --> not share the loss) Not taking enough risk
c. Conflicts in agency relationships

Director >< Shareholder
Lack of independence Personal relationship btw board - management Board: consulting/ other biz with firm 2 companies Interlinked boards Directors are overcompensated
Responsibilities (check and balance)
31. Corporate Governance
Institute corporate values & CG --> proficient, ethical, fair biz conduction Ensure compliance: with all legal & regulatory requirements Create long-term strategic objectives Determine management's responsibilities (need to be able to measure performance) Hire, compensate, evaluate CEO Require complete and accurate information from management Meet regularly Ensure board members are adequately trained recommend at least 3/4 should be CEO or not
Composition and independence Chairman independent or not Directors qualifications Board election method
skills, experience, strategic planning, risk management, commitment, attitudes, ethics all or staggered? Staggered: keep board continuity but limit shareholders' power & slow down changes annually annually, quarterly
Board self-assessment practices
d,e. Board of Directors

Points to assess Board
Frequency of separate sessions for independent directors Audit committee and audit oversight Nominating committee Compensation committee Use of independent or expert legal counsel
only independent directors, with expertise
all independent
internal counsel --> weak CG Codes of ethics Directors' oversight, monitoring and review responsibilities
Statement of governance policies
f. Statement of CG policies
Management's responsibilities to the board Reports of directors' oversight and review of management Board self assessments Management performance assessments Director training
Disclosure and transparency Insider or related-party transactions Responsiveness to shareholder proxy votes
Strong/effective CG system
--> higher measures of profitability & returns for shareholders incomplete, misleading, materially misstated disclosure
g. Valuation implications of Corporate Governance
Financial disclosure risk Weak/ineffective CG system Asset risk Liability risk
e.g..: too high perks e.g..: OBS obligations e.g..: M&A
Strategic policy risk
Page 57
Bidder/ Acquirer vs. Target company Mergers entire target --> 1 company ceases
Background
Acquisitions part of target e.g..: assets, biz segment
Forms of integration (how physically come together)
statutory merger subsidiary merger consolidation
acquire all A&L --> target not exist e.g.: P&G bought Gillette (good brand) both cease to exist --> new company
a. Categorize M&A
Types of mergers (how activities are related)
horizontal vertical
same industry in the supply chain Forward vs. Backward integration no relation
conglomerate
Synergies More rapid growth More market power Access to unique capabilities Diversification Bootstrapping EPS
c. Bootstrapping
b. Merger motivations
Personal benefits for managers Tax benefits loss carryforwards
32.1. Mergers & Acquisitions
Unlocking hidden value Achieving international business goals, by Taking advantage of market inefficiencies (e.g..: cheap labor force) Working around disadvantageous government policies Use technology in new markets Product differentiation Provide support to existing multinational clients
Pioneer/ development phase Rapid growth
Need capital, management --> H or C
Need capital, management --> H or C Need operational efficiency (from economies of scale) --> H or V Need to cut costs (from economies of scale) --> H
d. Motivations for mergers and industry life cycles
Mature growth Stabilization Decline
H or V or C
Form of acquisition
Stock purchase Asset purchase
Securities offering Methods Method of payment Factors to consider Cash offering Mixed offering Risk & reward for acquirer vs. target
e. Merger transaction characteristics
Relative valuations of companies Changes in capital structure
Mgmt happy --> Friendly merger offers Attitude of target management Tender offer Proxy battle Buy shares from target shareholders Replace BoD
Mgmt unhappy --> Hostile merger offers
Bear hug (propose to BoD)
If Bear hug is unsuccessful -->
Page 58
a
Rights for current SHDs to purchase shares at big discount, triggered with 1 SHD holds > threshold (10%)
Poison pill
Forms
Flip-in pill Flip-over pill
Dead-hand provision: BoD's right to redeem the pill, in a friendly merger offer
Poison put Pre-offer defense mechanisms
Bondholders' right to demand immediate repayment if there is a hostile takeover Ohio & Pennsylvania: most protection
States with restrictive takeover laws Staggered board
e.g.: 3 groups of BoD, each is elected for 3 year-term --> need at least 2 years to gain majority control of the board Ownership > threshold (20%) --> loss of voting rights --> prevent tender offer --> bidder must negotiate with BoD directly e.g..: at least 2/3 or 80%, not 51% as usual
Restricted voting rights
Supermajority voting provision for mergers Fair price amendment Golden parachutes
determined by some formula or independent appraisal lucrative cash payouts to managers if they leave after a merger
f. Takeover defense mechanisms
"Just say no" defense lawsuit (anti-trust or violation of securities law) Litigation Greenmail Post-offer defense mechanisms agreement that allows target to repurchase its shares from acquirer at premium price (rare after 1986: 50% tax)
Share repurchase (target's tender --> acquirer increases bid & leverage --> less attractive offer for its own shares) borrow to buy shares Leveraged recapitalization Crown jewel defense Pac-man defense White knight defense White squire defense (squire = junior knight) sell a major asset/ subsidiary counter offer --> bidding war --> good price --> winner's curse sell a minority stake but big enough to block acquirer
Herfindahl-Hirschman Index
Formula:
< 1000: Merger ok
32.2. Mergers & Acquisitions (cont.)
g. HHI
If post-merger HHI
From 1000 to 1800 > 1800
If increase in HHI <100: merger ok
If increase in HHI >=100: merger NOT ok If increase in HHI <50: merger ok If increase in HHI >=50: merger NOT ok
h,i,j. Methods for valuing a target company
DCF analysis Comparable company analysis Comparable transaction analysis
Post-merger value of an Acquirer
k. Evaluating a merger bid
Gains accrued to the Target Gains accrued to the Acquirer Cash payment versus Stock payment
Price
l. Effects of
Payment method
Cash offer Stock offer
Target gains 30%
m. Distribution of merger benefits
Acquirer lose stock value 1-3% (winner's curse, mgmt hubris) 3 years after merger acquirer return = -4% 60% acquirers lag peer group (fail to capture synergy)
Not fit long term strategy Divestitures (dispose asset)
o. Reasons for divestitures
Lack of profitability Individual parts are worth more than the whole Infusion of cash
n. Downsizing operations through corporate restructuring
Equity carve-outs Spin-offs Split-offs Liquidations
create new, independent company --> issue shares to OUTSIDE SHDs (public)
create new, independent company --> issue shares to EXISTING SHDs exchange shares of parent for shares of division
Page 59
CFALEVEL2
EQUITY
Page 60
Classic works by Graham & Dodd and J.B. Williams
33. A Note On Asset Valuation

Define Valuation Intrinsic value
a.
Possible sources of perceived mispricing
Going concern value
b. Contrast
Liquidation value
Stock selection Reading the market Projecting the value of corporate actions Fairness opinions
34. Equity Valuation: Applications & Process
c. Uses of equity valuation
Planning & consulting Communication with analysts and investors Valuation of private business Portfolio management Planning Executing the investment plan
Threat of new entrants 5 elements of industry structure Threat of substitutes Bargaining power of buyers Bargaining power of suppliers Rivalry among existing competitors
d.
3 generic strategies
Cost leadership Product differentiation Focus
Quality of financial info.
Absolute valuation models
e. Contrast
Relative valuation models
f. Criteria for choosing an approach

HPR Realized and Expected return Required return (RR) Return from convergence of price to intrinsic value Discount rate IRR
a. Concepts
Explain equity risk premium Use in required return determination
b. Equity risk premium
Major methods of estimating equity risk premium
Historical estimation Forward-looking estimation
CAPM Multifactor model Farma-French model Pastor-Stambaugh model Macroeconomic multifactor model
35. Return Concepts
c,e. Methods of estimating the RR on equity investment

Build-up model
Bond-yield plus risk premium model
Public co.
d. Estimating beta for
Thinly traded public co. Nonpublic co.
f. International consideration in RR estimation
Country spread model Country risk rating model
g. WACC
h. Appropriate discount rate

Warm-up
Threat of new entrants
Threat of substitutes
a.b. Porter's five forces. Drivers of industry profitability
Bargaining power of buyers
Bargaining power of suppliers
Rivalry among existing competitors
Industry growth rate
Innovation and technology
36. The Five Competitive Forces That Shape Strategy
c. Common factors that affect the five forces
Govt policies
Complementary products
d. Changes in industry structure and their effects on the industry's profit potential
Altering the firm's existing position Capitalizing on changes in the industries Creating changes in the industry structure
e. Strategic alternatives
Steps in using the forces in an industry analysis
Example: Wal-Mart
Page 63
Industry classification External factor review
a. Components in industry analysis model
Demand analysis Supply analysis Profitability analysis International competition & markets review
b. Life cycle of a typical industry
1. Pioneer 2. Growth 3. Mature 4. Decline
Warm-up: Business cycle
Industry classification
c. Effects of business cycles on industry classification
Growth industry stocks Defensive industry stocks Cyclical industry stocks
37. Industry Analysis

d. External factors
Technology Govt Social changes Demography Foreign influences
e1. Demand analysis
e2. Supply analysis

Product segmentation Industry concentration
f. Profitability analysis
Ease of industry entry Supply input price

Warm-up: Real and nominal valuation
a. Effects of inflation
Income taxes NWC Capital expenditures 1. Operating results- real
CF estimation
b. Calculate nominal and real-term financial projections
2. Operating results- nominal 5-step approach 3. NOPLAT- real 4. Free CF- real & nominal 5. Firm value- real & nominal
38. Valuation In Emerging Markets

Adjust CFs, b/c
Country risks are diversifiable Companies respon differently to country risk Country risk is one-sided risk Identifying CF effects aids in risk management Rather than adjusting r
c. Account for emerging market risks
Rf Ke Beta Market risk premium
d. Estimating cost of capital
Kd (1-t)
Kd t
Capital structure weights
Page 65
Dividends
a. Measures of CF
FCF Residual income
Appropriateness One-period b. Two-period Multi-period Warm-up: General DDM Assumptions Two-stage DDM i,l. Multistage growth models
DDM
Selection of
H-model Three-stage DDM
Spreadsheet modeling
j. Business phases
Initial growth Transition Maturity
k. Terminal value
39. Discounted Dividend Valuation
c. Assumptions d. Implied growth rate f. Justified P/E Justified leading P/E Justified trailing P/E
GGM
Strengths Limitations
h.
e. PVGO
g. Value of preferred stock

GGM
m. Calculate expected return with
H-model Two-stage DDM
n. Sustainable growth rate

To forecast dividends
o. Use of spreedsheet modeling
To value common shares
p. Over/Fairly/Undervalued
Page 66
FCFF
a. Interpret & compare
FCFE
FCFE, FCFF
b,f. Ownership perspective & recognition of value

FCFF
DDM
c,d. Calculate
FCFE
Historical free cash flow
e. Forecasting FCFF and FCFE
Components of free cash flow
Dividends
40. Free Cash Flow Valuation
g. FCFF & FCFE affected by
Share repurchases Share issues Changes in leverage
h. Critique the use of NI and EBITDA as proxies for CF

Single stage How many variations are there?
i. Models
Multistage Model assumptions & Firm characteristics
j. Calculate the value of a company
k. Sensitivity analysis
l. Terminal value
FCFF is preferred to FCFE when

Price multiples
Types of valuation indicators
Enterprise value multiples Momentum indicators
Method of comparables
a. Two methods
Method based on forecasted fundamentals
b. Justified price multiple
P/E
Trailing P/E Leading P/E
c,d,g. Price multiples
P/B P/S P/CF
41.1. Market-based Valuation
Trailing D/P
c,d,g. Dividend yield (D/P)
Leading D/P
Exclude nonrecurring components (G/L from asset sales, write-downs...)
e. Underlying earnings (persistent, continuing, core); Normalized EPS
Method of historical average EPS Method of average ROE
f. Earnings yield (E/P)
Justified P/E Justified P/B Justified P/S
h. Calculate
Justified P/CF Justified EV/EBITDA Justified D/P
Page 68
EQUITY LEVEL 2, READING 41

44. c,d,h,n Multiples (LOS c,d) P/E Advantages + Popular + Earnings power (EPS) is the primary determinant of inv. Value + Proved by empirical evidence + Usually BV>0, more stable + Firms that primarily hold liquid assets --> BV~VE + Useful in valuing companies expected to go out of biz. + Proved by empirical evidence Disadvantages Notes Justified (LOS h)
- EPS might be <0 --> P/E is meaningless * Trailing P/E: not useful for - Earnings have 1 portion that is volatile & transitory - forecastin & valuation * Leading P/E: not relevant if > difficult to interpret earnings are too volatile - Earnings can be distorted by mgmt --> lower comparability - Not reflect intangible assets (human capital) - Misleading due to differences in asset size (eg.: outsource vs. not outsource) - Different accounting standards --> affect comparability (eg.: R&D is expensed in US) - BV # MV b/c of inflation or technological change - High sales growth --> not mean high operating profit --> not as meaningful as P/E & P/CF - Not capture cost differences - Can still be distorted (eg.: bill-and-hold) Adjustments to BV: . Exclude intangible assets (GW, patent) . Adjust for OBS . Adjust to reflect fair value . Adjust for # accounting policies (eg.: LIFO vs. FIFO)
P/B
P/S
+ S is always >0, even when E,B<0 --> P/S meaningful for distressed firms + Not as easy to manipulate/ distort + Not as volatile --> estimate is more reliable + Appropriate for start-up companies, mature&cyclical industries, investment mgmt companies + Proved by empirical evidence + CF is harder to manipulate + P/CF is more stable than P/E + Avoid "quality of earning" problem of P/E + Proved by empirical evidence + D/P (with capital gain) contributes to R investment + Div less risky than capital gain
P/CF
- If CF=NI+NCC --> ignore NCRev. & WC - FCFE is preferred to CFO but more volatile
D/P
- Ignores capital appreciation --> incomplete focus - "Div displacement of earnings" concept: trade-off btw div & future earnings (current & future CF)
. Used to value index . Distinguish: Trailing D/P= Leading D/P=
EV/EBITDA + Useful when comparing firms with different (LOS n) leverage and capital intensive (high DA) + EBITDA usually > 0
- When WC increases, EBITDA overstates CFO - Ignore how revenue recognition affects CFO - CAPEX # Depr -> EBITDA not capture CAPEX --> # FCFF --> not linked with valuation theory
Page 69
i. Predicted P/E ratio
j. Evaluate stock by method of comparables
k. PEG ratio
l. Use of price multiples in determining terminal value in a multistage DCF model
m. Alternative definitions of CF used in price multiples
41.2 Market-based Valuation (cont.)
n. EV/EBITDA
o. Sources of differences in cross-border valuation comparisons
p. Momentum indicators
q. Over/Fairly/Undervalued
Arithmetic mean
r. Central tendency of a group of multiples
Harmonic mean Weighted harmonic mean Median
Page 70
RI =
a. Calculate
EVA = MVA =
b. Use of RI models c. FV of RI d. Fundamental determinants of RI

RI valuation
e. Relation between
Justified P/B ratio
f. Single-stage & multistage RI model g. Calculate implied growth rate (g)

is..... Persistent factor RI persists at current level forever RI drops immediately to zero RI declines over time to zero RI declines to LR level in mature industry RI
42. Residual Income Valuation
h. Continuing RI
Assumptions
i. Compare
DDM FCFE Strengths
j. RI models
Weaknesses
k. Justify the selection of RI model

Violations of the clean surplus relationship Variations from fair value
l. Accounting issues
Intangible assets effects on BV Nonrecurring items and other aggressive accounting practices International accounting differences
m. Over/Fairly/Undervalued
Stage of lifecycle Size Quality & depth of mgmt Company-specific factors Mgmt/SHD overlap ST investors Quality of financial & other info. Taxes
a. Private company valuation vs. public

Stock-specific factors
Liquidity Restrictions on marketability Concentration of control
Venture capital financing Transaction- related valuations IPO Sale in an acquisition Bankruptcy proceedings Performance-based managerial compensations
b. Uses of private business valuation
Compliance- related valuations
Financial reporting Tax purposes
43.1 Private Company Valuation
Liquidation- related valuations
Fair market value Fair value for financial reporting Fair value for litigation
c. Definitions of value
Market value Investment value Intrinsic value
f. Income approach
Free CF method Capitalzed CF method Excess earnings method
d. Valuation approaches
Market approach Asset-based approach

Normalized earnings
e. Estimate
CF
Size premiums Availability and cost of debt
g. Elements of discount rate
Acquirer vs. target Projection risk Lifecycle stage
CAPM Expanded CAPM Build-up method
h. Estimate ke
43.2 Private Company Valuation (cont.)

i. Market approaches
GPCM (Guideline public company method)
GTM (Guideline transactions method)
PTM (Prior transaction method)
j. Asset- based approach
Discount for lack of control
k. Use of discounts & premiums
Discount for lack of marketability
l. Role of valuation standards
Page 73
CFALEVEL2
ALTERNATIVE INVESTMENTS
Page 74
a. RE Investment characteristics
44. Investment Analysis
CFAT
= NOI - debt service - taxes payable
c. Calculate
EART = selling price - selling costs - mortgage balance - taxes on sale
Valuing real estate investments
b. Evaluate a real estate investment using NPV, IRR d. Potential problems with IRR
Multiple IRRs Ranking conflicts
Page 75
a. Capitalization rate vs. discount rate
Market-extraction method
b. Determine cap rate by
band- ofinvestment method
45. Income Property Analysis And Appraisal

Direct capitalization approach
built-up method
c.
Gross income multiplier technique
Limitations of the direct capitalization approach
Selecting the appropriate cap rate Application to income-producing property
Discontinuous pricing
d. Contrast
Limitations of the gross income multiplier approach
Lack of information Gross rent vs. NOI Distorted selling prices Unique or non-income producing properties
Page 76
Background: Private equity (PE) a

1. Re-engineering 2. Favorable debt financing 3. Superior alignment of interests (also see los b)
a. Sources of value creation in PE
Incentives
Compensation Tag-along, drag-along clauses
b. Aligning managerial and ownership interests in PE firms
Effective structuring of investment terms
Board representation Noncompete clauses Priority in claims Required approvals Earn-outs
Venture Capital
c. Characteristics of
Buyout Investments
46.1. Private Equity Valuation
d. Valuation issues
IPO Secondary market sale
e. Exit routes in PE
MBO Liquidation
Risks
Specific risks General risks
g. Investing in PE firms
Costs
Page 77
Company limited by shares Limited partnership (Most) Structures Most are closed-end 2 businesses raising fund managing PE investments Management fees Transaction fees Carried interest Economic terms Ratchet Hurdle rate Target fund size Vintage Should focus on aligning the interests of GP & LPs Terms of the fund Key man clause Performance disclosure & confidentiality Clawback Corporate governance terms Distribution waterfall Tag-along, drag-along clauses Removal for cause No-fault divorce Investment restrictions LPs GP
Terms
f. PE Fund
46.2. Private Equity Valuation (cont)
Co-investment Only vailable for "qualified" investors Fund prospectus 1. At cost, adjusting for subsequent financing and devaluation 2. The minimum of cost or market value Ways to determine NAV 3. By revaluing a portfolio company anytime there is new financing 4. At cost with no adjustment until exit 5. By discounting for restricted securities 6. Less frequently, marked to market by reference to a peer group of public companies, applying illiquidity discounts to public comparables Stale NAV No definitive method Issues in calculating NAV Undrawn LP capital Comparison between PE funds GP usually values -->Now, more and more independent parties value
Valuation
NAV
Due diligence of PE fund investments
PE funds tend to exbihit a strong persistence of returns over time The performance range between funds is extremely large Liquidity in PE is typically very limited and thus LPs are locked for the long term
Page 78
Gross IRR IRR Net IRR PIC
a
DPI Multiples RVPI Quantitative measures TVPI management fees carried interest NAV PIC
h. Evaluation of PE fund performance
i. Calculating performance measures

Multiples
DPI RVPI TVPI
46.3. Private Equity Valuation (cont.)
Other analyses Benchmarks
Earning growths
Components of performance from an LBO
Increase in price multiples Debt reduction Exit value = investment cost + earnings growth + increase in price multiple + reduction in debt
1.1. Valuation for a single financing round
1.2. Valuation for multiple financing rounds (11 steps)
j. VC method
2. IRR methodology
k. Accounting for risk when valuing VC
Adjusting the discount rate (r*) Adjusting the Terminal Value using scenario analysis
= (1 + r)/(1 - q) - 1
Page 79
Leverage Use of derivatives
a. Hedge fund vs. Mutual fund
Disclosure requirements and practices Lockup periods Fee structures
Arbitrage-based Convertible bond arbitrage Equity market neutral Event driven Risk arbitrage, merger arbitrage Fixed-income arbitrage
47.1. Investing In Hedge Funds: A Survey
b. Hedge funds strategies
Medium volatility Global macro Long-short equity Managed futures (Commodity trading advisers - CTAs) Multi-strategy Directional hedge Dedicated short bias Emerging market
Variety of databases exist Hedge fund database No database is complete Own methodology
c. Hedge fund databases and performance biases
Reporting to databases is voluntary
Performance biases
Selection bias (backfill bias) Survivor bias
Page 80
Alpha (manager skill) and beta (market exposure)
d. Factor models for hedge fund returns
Regression model Use a multitude of traditional market factors
Sources
e. Non-normality of HF returns
Implications for performance appraisal
Simple to manage therefore offered to investors at low fees
f. Motivations for HG replication strategies
Simplest form vs. complex form Separate HF beta from HF replication
47.2. Investing In Hedge Funds: A Survey

g. Difficulties in applying traditional portfolio analysis to HG
Developing exp. return assumption: survivor, selection, stale pricing, backfill biases inherent in HF databases. Correlation, volatility and beta exposures can change significantly over time Warning about the use of mean-variance optimization and Share ratios: Because standard deviation is not a complete measure of risk for HF Individual HF typically have a higher standard deviation than their style index
Reduce the standard deviation of a HF portfolio (diversify) High quality managers: significant investment skill, manager relationship, and research cost
h. Funds of funds vs. single manager HF
Average performance Take less factor risk than a broad HF index Longer lives and larger asset inflows
CFALEVEL2
FIXED INCOME
Page 82
=Borrower not pay Default risk Credit rating Sources of info from rating agencies Rating watch Rating outlook Credit spread risk Downgrade risk
a. Components of credit risk
Character b. Components- 4 Cs Covenants Collateral Capacity to pay c,d. Key financial ratios Profitability: ROE --> DuPont Short-term solvency Capitalization (financial leverage) Coverage ratios # CF, # FCFF, #FCFE
Corporate Credit Analysis
S&P uses: e. Cash Flow analysis CF ratios Funds from operations / Total debt 4 traditional coverage ratios Funds from operations / capital spending requirements (Free operating CF + Interest) / Interest Debt service coverage = (Free OCF + interest) / (Interest + annual principal repayment) Leverage ratio = Debt payback period = Total debt / Discretionary CF f. Analysis of High-Yield Issuers Debt structure Analysis Corporate structure Analysis Covenants Analysis Equity Analysis approach
48. General Principles Of Credit Analysis
Collateral credit quality
g. Analysis of Asset-Backed securities
Seller/Servicer quality Cash Flow stress and Payment Structure Legal structure
Issuer's debt structure Tax-backed debt Budgetary policy Local tax & Intergovernmental revenue availability Issuer's socioeconomic environment
h. Analysis of Municipal bond

Revenue bonds
Limits of the Basic Security Flow of funds structure Rate, or User-Charge, Covenants Priority-of-Revenue Claims Additional-Bonds test
Economic and Income structure Prospects for economic growth Degree of fiscal flexibility Key considerations Economic risk (ability) Public debt burden Monetary policy and Price stability BOP flexibility External debt and liquidity Political risk (willingness) 2 ratings Local currency debt rating Foreign currency debt rating
i. Analysis of Sovereign Bonds
Corporate bonds vs. ABS
j. Contrast credit analysis
Corporate bonds vs. Municipal securities Corporate bonds vs. Sovereign debt
Page 83
Warm-up: Yield curve shapes

Parallel shift
a. Yield curve shifts
Nonparallel shift
Yield curve twist Butterfly shifts
Changes in the level of rates (parallel shifts)
b. Factors affecting Treasury returns
Changes in the slope (twists) Changes in the curvature (butterfly)
Warm-up: Spot curves and bootstrapping

All on-the-run Treasury securities All on-the-run and some off-the-run Treasury securities All Treasury coupon securities and Bills Treasury strips What is it?
c. Treasury spot rate curve
49. Term Structure & Volatility Of Interest Rates
d. Swap rate curve (LIBOR curve)
As a benchmark --> reasons:
Pure (Unbiased) expectations theory
e. Term structure theories
Liquidity theory Preferred habitat theory
Warm-up: Calculating key rate duration

Barbell portfolios
f. Yield curve risk
Ladder portfolios Bullet portfolios Historical yield volatility
g1. Yield volatility
Implied yield volatility
g2. Forecasting yield volatility

Binomial interest rate trees Constructing an arbitrage-free tree Valuing an option-free bond with the binomial model Spread measures The nominal spread The Z-spread OAS Treasury securities
Warm-up: Binomial model
b. Benchmark interest rates to calculate spreads
A bond sector Specific issuer
c. Backward induction methodology d. Callable bond valuation

Vcall =
e. Relations
Vput=
50. Valuing Bonds With Embedded Options
f. Effect of volatility on arbitrage-free value of an option Warm-up: How OAS is calculated

Treasury benchmark
a,g. Relative value analysis
Bond sector benchmark Issuer-specific benchmark
h. Effective duration and convexity i. Putable bond valuation

Conversion ratio Conversion value Straight value Component values Minimum value of a convertible bond Market conversion price Market conversion premium per share Premium payback period Valuing convertible bonds using an option-based valuation approach
j. Convertible bonds
k. Convertible bonds vs. Common stock

Fixed income examples Page 1
LOAN AMORTIZATION SCHEDULE

Loan amount Mortgage rate (per month) Number of months Scheduled total pmt Column 1 Column 2 Period 1 2 3 4 5 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 358 359 360 Beginning Principal 500,000 499,857 499,712 499,567 499,419 433,500 432,692 431,876 431,051 430,219 429,378 428,529 427,671 426,804 425,929 425,046 424,153 423,252 422,341 421,421 420,492 419,554 418,607 417,650 416,683 415,707 414,721 413,725 412,719 411,703 410,677 15,126 10,134 5,092 Column 3 Scheduled total pmt 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 500,000 1% 360 $5,143.06 Column 4 Interest pmt 5,000 4,999 4,997 4,996 4,994 4,335 4,327 4,319 4,311 4,302 4,294 4,285 4,277 4,268 4,259 4,250 4,242 4,233 4,223 4,214 4,205 4,196 4,186 4,176 4,167 4,157 4,147 4,137 4,127 4,117 4,107 151 101 51 Column 5 Scheduled principal pmt 143 144 146 147 149 808 816 824 833 841 849 858 866 875 884 893 902 911 920 929 938 948 957 967 976 986 996 1,006 1,016 1,026 1,036 4,992 5,042 5,092 Column 6 Beg. Pr less scheduled pr. Pmt 499,857 499,712 499,567 499,419 499,270 432,692 431,876 431,051 430,219 429,378 428,529 427,671 426,804 425,929 425,046 424,153 423,252 422,341 421,421 420,492 419,554 418,607 417,650 416,683 415,707 414,721 413,725 412,719 411,703 410,677 409,641 10,134 5,092 0
Page 86

Loan amount Mortgage rate (per mth) Number of months Scheduled total pmt Col 1 Col 2 Col 3 500,000 1% 360 $5,143.06 Col 4 Col 5 Col 6 Col 7 Col 8 Col 9 Col 10 average life: 86.82 Col 11 Col 12 Life 0.0005 0.0012 0.0024 0.0039 0.0057 0.5945 0.6048 0.6152 0.6257 0.6363 0.6470 0.6578 0.6686 0.6795 0.6906 0.7017 0.7129 0.7242 0.7356 0.7470 0.7586 0.7703 0.7821 0.7939 0.8059 1.3871 1.4038 1.4205 1.4374 1.4544 1.4715 1.0915 PSA m=1 to 30: m=31 or more 100 0.2% 6%
Beginning Scheduled Interest Period Principal total pmt pmt 1 2 3 4 5 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 140 141 142 143 144 145 146 500,000 499,774 499,461 499,063 498,576 291,518 287,802 284,069 280,317 276,548 272,760 268,954 265,130 261,288 257,427 253,547 249,649 245,732 241,796 237,842 233,868 229,875 225,863 221,832 217,782 33,822 28,868 23,890 18,888 13,862 8,812 3,738 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 3,775 5,000 4,998 4,995 4,991 4,986 2,915 2,878 2,841 2,803 2,765 2,728 2,690 2,651 2,613 2,574 2,535 2,496 2,457 2,418 2,378 2,339 2,299 2,259 2,218 2,178 338 289 239 189 139 88 37
Weights Scheduled Beg. Pr less Ending for principal scheduled CPR SMM Prepmt principal Macaulay pmt pr. Pmt Duration 143 499,857 0.20% 0.0167% 83 499,774 0.0005 145 499,628 0.40% 0.0334% 167 499,461 0.0006 148 499,313 0.60% 0.0501% 250 499,063 0.0008 152 498,910 0.80% 0.0669% 334 498,576 0.0010 157 498,419 1.00% 0.0837% 417 498,002 0.0011 2,228 289,290 6.00% 0.5143% 1,488 287,802 0.0074 2,265 285,537 6.00% 0.5143% 1,469 284,069 0.0075 2,302 281,766 6.00% 0.5143% 1,449 280,317 0.0075 2,340 277,977 6.00% 0.5143% 1,430 276,548 0.0075 2,378 274,170 6.00% 0.5143% 1,410 272,760 0.0076 2,415 270,345 6.00% 0.5143% 1,390 268,954 0.0076 2,454 266,501 6.00% 0.5143% 1,371 265,130 0.0076 2,492 262,638 6.00% 0.5143% 1,351 261,288 0.0077 2,530 258,757 6.00% 0.5143% 1,331 257,427 0.0077 2,569 254,858 6.00% 0.5143% 1,311 253,547 0.0078 2,608 250,940 6.00% 0.5143% 1,291 249,649 0.0078 2,647 247,002 6.00% 0.5143% 1,270 245,732 0.0078 2,686 243,046 6.00% 0.5143% 1,250 241,796 0.0079 2,725 239,071 6.00% 0.5143% 1,230 237,842 0.0079 2,765 235,077 6.00% 0.5143% 1,209 233,868 0.0079 2,804 231,064 6.00% 0.5143% 1,188 229,875 0.0080 2,844 227,031 6.00% 0.5143% 1,168 225,863 0.0080 2,884 222,979 6.00% 0.5143% 1,147 221,832 0.0081 2,925 218,907 6.00% 0.5143% 1,126 217,782 0.0081 2,965 214,816 6.00% 0.5143% 1,105 213,712 0.0081 29,017 6.00% 0.5143% 149 28,868 0.0099 4,805 4,854 24,013 6.00% 0.5143% 124 23,890 0.0100 4,904 18,986 6.00% 0.5143% 98 18,888 0.0100 4,954 13,934 6.00% 0.5143% 72 13,862 0.0101 5,004 8,858 6.00% 0.5143% 46 8,812 0.0101 5,055 3,757 6.00% 0.5143% 19 3,738 0.0101 3,738 0.00% 0.0000% 0.0075
Page 87

Loan amount Mortgage rate (per month) Number of months Scheduled total pmt Column 1 Column 2 Period 1 2 3 4 5 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 140 141 142 143 144 145 146 147 148 149 150 151 152 Beginning Principal 500,000 499,782 499,487 499,113 498,661 307,999 304,524 301,030 297,518 293,987 290,437 286,868 283,280 279,673 276,047 272,401 268,736 265,051 261,347 257,623 253,879 250,115 246,331 242,527 238,702 62,994 58,211 53,403 48,569 43,709 38,823 33,910 28,972 24,008 19,016 13,999 8,954 3,882 Column 3 Scheduled total pmt 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 3,921 500,000 1% 360 $5,143.06 Column 4 Column 5 Scheduled Interest principal pmt pmt 5,000 143 4,998 145 4,995 148 4,991 152 4,987 156 3,080 2,063 3,045 2,098 3,010 2,133 2,975 2,168 2,940 2,203 2,904 2,239 2,869 2,274 2,833 2,310 2,797 2,346 2,760 2,383 2,724 2,419 2,687 2,456 2,651 2,493 2,613 2,530 2,576 2,567 2,539 2,604 2,501 2,642 2,463 2,680 2,425 2,718 2,387 2,756 630 4,513 582 4,561 4,609 534 486 4,657 437 4,706 388 4,755 339 4,804 290 4,853 240 4,903 190 4,953 140 5,003 90 5,054 39 3,882 Column 6 Column 7 Beg. Pr less scheduled pr. CPR Pmt 499,857 0.18% 499,637 0.36% 499,338 0.54% 498,961 0.72% 498,504 0.90% 305,936 5.40% 302,426 5.40% 298,897 5.40% 295,350 5.40% 291,784 5.40% 288,198 5.40% 284,594 5.40% 280,970 5.40% 277,327 5.40% 273,664 5.40% 269,982 5.40% 266,280 5.40% 262,559 5.40% 258,817 5.40% 255,056 5.40% 251,275 5.40% 247,473 5.40% 243,651 5.40% 239,809 5.40% 235,946 5.40% 58,481 5.40% 53,650 5.40% 48,794 5.40% 43,911 5.40% 39,003 5.40% 34,068 5.40% 29,107 5.40% 24,119 5.40% 19,105 5.40% 14,063 5.40% 8,995 5.40% 3,900 5.40% 0.00% Column 8 Column 9 Column 10 SMM 0.0150% 0.0300% 0.0451% 0.0602% 0.0753% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.4615% 0.0000% Prepmt 75 150 225 300 375 1,412 1,396 1,380 1,363 1,347 1,330 1,314 1,297 1,280 1,263 1,246 1,229 1,212 1,195 1,177 1,160 1,142 1,125 1,107 1,089 270 248 225 203 180 157 134 111 88 65 42 18 Ending principal 499,782 499,487 499,113 498,661 498,129 304,524 301,030 297,518 293,987 290,437 286,868 283,280 279,673 276,047 272,401 268,736 265,051 261,347 257,623 253,879 250,115 246,331 242,527 238,702 234,857 58,211 53,403 48,569 43,709 38,823 33,910 28,972 24,008 19,016 13,999 8,954 3,882 PSA m=1 to 30: m=31 or more 90 0.2% 6%
Page 88

500,000 Loan amount 1% Mortgage rate (per month Number of months 360 Scheduled total pmt Col 1 Period 1 2 3 4 5 6 7 8 9 10 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 88 89 90 91 Col 2 Col 3 $5,143.06 Col 4
Col 5 Scheduled principal pmt 143 147 153 163 174 189 206 225 248 273 3,382 3,444 3,506 3,567 3,628 3,689 3,749 3,809 3,868 3,927 3,986 4,044 4,102 4,159 4,216 4,273 4,329 4,385 4,441 4,496 4,976 5,028 5,080 1,255
PSA m=1 to 30: m=31 or more
300 0.2% 6%
Col 6
Col 7
Col 8
Col 9 Prepmt 251 502 754 1,007 1,259 1,511 1,762 2,011 2,258 2,503 2,833 2,730 2,627 2,526 2,425 2,325 2,225 2,126 2,028 1,930 1,833 1,737 1,641 1,546 1,451 1,357 1,264 1,172 1,079 988 192 106 21 -
Col 10 Ending principal 499,606 498,957 498,049 496,880 495,446 493,747 491,780 489,543 487,038 484,261 169,878 163,704 157,570 151,477 145,424 139,410 133,436 127,502 121,606 115,749 109,930 104,149 98,407 92,702 87,035 81,405 75,811 70,255 64,735 59,251 11,490 6,356 1,255 90-300 PSA90 PAC tranche 75 150 225 300 375 450 525 600 674 749 1719 1704 1689 1675 1660 1645 1630 1615 1600 1585 1569 1554 1539 1523 1507 1492 1476 1460 1444 1428 1280 1263 1246 1229 75 150 225 300 375 450 525 600 674 749 1,719 1,704 1,689 1,675 1,660 1,645 1,630 1,615 1,600 1,585 1,569 1,554 1,539 1,523 1,451 1,357 1,264 1,172 1,079 988 192 106 21 -
Beginning Scheduled Interest Principal total pmt pmt 500,000 499,606 498,957 498,049 496,880 495,446 493,747 491,780 489,543 487,038 176,093 169,878 163,704 157,570 151,477 145,424 139,410 133,436 127,502 121,606 115,749 109,930 104,149 98,407 92,702 87,035 81,405 75,811 70,255 64,735 16,658 11,490 6,356 1,255 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 5,143 1,268 5,000 4,996 4,990 4,980 4,969 4,954 4,937 4,918 4,895 4,870 1,761 1,699 1,637 1,576 1,515 1,454 1,394 1,334 1,275 1,216 1,157 1,099 1,041 984 927 870 814 758 703 647 167 115 64 13
Beg. Pr less scheduled CPR pr. Pmt 499,857 499,459 498,804 497,887 496,705 495,258 493,541 491,554 489,296 486,765 172,711 166,434 160,198 154,003 147,849 141,735 135,661 129,628 123,633 117,679 111,763 105,886 100,048 94,248 88,486 82,762 77,076 71,426 65,814 60,239 11,681 6,462 1,276 0.60% 1.20% 1.80% 2.40% 3.00% 3.60% 4.20% 4.80% 5.40% 6.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 18.00% 0.00%
SMM
0.0501% 0.1006% 0.1513% 0.2022% 0.2535% 0.3051% 0.3569% 0.4091% 0.4615% 0.5143% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 1.6402% 0.0000%
Page 89
a. Mortgage loans b. Mortgage passthrough securities

CPR PSA
d. Measuring prepayment speeds
c. Calculate prepayment amount for a month

Factors affecting prepayments Prevailing mortgage rates Housing turnover Characteristics of the underlying mortgages
f.
Types of prepayment risk
Contraction risk Extension risk
e. Average life of an MBS
51. MortgagedBacked Sector Of The Bond Market

CMOs
g. Creation and Matching of assets and liabilities

Sequential Pay Accrual tranche
h. Tranches
Planned Amortization Class (PAC) Support Tranche
i. Risks and Performance of each type of CMO tranche j. Stripped MBS

Agency
k. MBS
Nonagency
Warm-up: Commercial MBS l. CMBS vs Residential MBS m. CMBS: Structure and Call protection
Structural features
a. Securitization transaction
Seller Parties Issuer/Trust Servicer Prepayment tranching
b. Tranching
Credit tranching Amortizing assets
c. Securitization backed by
Non-amortizing assets Corporate guarantees External Letter of credit Bond insurance
d1. Credit enhancements
Reserve funds Internal
Cash reserve funds Excess servicing spread funds
Overcollateralization Senior/Subordinated structure
52. AssetBacked Sector Of The Bond Market
d2. Shifting interest mechanism

Home equity loans
Manufactured housing backed loans
e. Cash flow and prepayment charateristics for securities backed by
Auto loans ABS
Student loan-backed securities
SBA loan-backed securities
Credit card receivable-backed securities What is it? Ramp up phase Cash flow CDO Types Market value CDO Reinvestment phase Pay down phase
f. CDO
Synthetic CDO
g. Primary motivations for CDO
Arbitrage-driven Balance sheet- driven

Page 91
Cash flow yield
a. MBS/ABS spread measures
Nominal spread Zero- volatility spread
Step 1: Step 2:
b. Monte Carlo simulation model
Step 3: Step 4: Step 5:
c. Path dependency
d. OAS from a Monte Carlo model
e. OAS analysis
53. Valuing MBS And ABS

f. Why effective durations reported by various dealers & vendors may differ
g. Analysing interest rate risk with effective duration and convexity
Cash flow duration
h. Other MBS duration measures
Coupon curve duration Empirical duration
Nominal spread
i. Spread analysis of fixed-income securities
Zero-volatility spread OAS
Page 92
CFALEVEL2
DERIVATIVES
Page 93
Warm-up: Forward contracts
The no-arbitrage principle
Warm-up: Forward contract price determination
A simple version of the Cost-of-Carry model Cash and Carry arbitrage when the forward contract is overpriced Reverse cash and carry arbitrage when the forward contract is underpriced
At initiation
a. Forward contract value
During the life At expiration
54. Forward Markets And Contracts
b. Price and Value of Forward on EQUITY
With discrete dividends With continuous dividends
c1. Price & Value of Forward on FIXED INCOME
c2. Price & Value of FRA
c3. Price & Value of Forward on CURRENCY
d. Credit risk
Page 94
Warm-up: Futures contracts a. Futures/Spot convergence Warm-up: Futures margins and marking to market b. Futures contract value c. Futures vs Forward prices
Monetary costs Non-monetary costs
Costs
d. Holding the underlying asset

Benefits
Monetary benefits Non-monetary benefits
55. Futures Markets And Contracts
e. Backwardation vs. Contango f. Normal backwardation & Normal contango

Eurodollar futures Treasury bond futures
Warm-up:
Stock index futures Currency futures
Warm-up: T-Bill futures pricing g. Difficulties in pricing Eurodollar futures & creating a pure arbitrage opportunity
Treasury bond futures Stock futures
h. Calculate price of
Stock index futures Currency futures

Fiduciary call
Warm-up: Put-call parity for European options
Protective put Call option
a1. Using put-call parity to create synthetic
Put option Bond Underlying stock
a2. Why synthetic?
Pricing options Earning arbitrage profit
b. Binomial option-pricing model
One-period Two-period
Options on Fixed Income Securities
Warm-up: Binomial interest rate trees
Options on Interest rates: Caps and Floors Assumptions: Lognormal, Rf & sigma: constant & known, Frictionless market, No CF, European options.
c. BSM model
Limitations Delta
e. Interpreting
DELTA
56. Option Markets And Contracts
e. Use in dynamic hedging
Interpreting Option's price GAMMA
f. Effect on d. The Greeks
Delta Delta hedge
Interpreting VEGA Historical volatility
h. Estimate
Implied volatility RHO THETA
g. Effect of the underlying asset's cash flows on option price i. Put-call parity for options on forwards (or futures) j. American vs European options on forwards and futures
pricing
a. Swap
valuation
I/r swap = FRAs
b. Swaps =
= 1 call + 1 put
c. Pricing & Valuing a Plain Vanilla swap
Plain vanilla swaps as combinations of bonds Floating rate bond reprices to par at each settlement date
d. Valuing a Currency swap
57. Swap Markets And Contracts
e. Equity swaps
f. Characteristics and uses
Swaptions
g. Payoffs and cash flows
h. Value of i/r swaption
i. Swap credit risk
j. Swap spread
Page 97
on i/r
a. Cap and floor
on fixed-income instruments
58. Interest Rate Derivative Instruments
b1. Payoff for a cap and a floor
b2. A collar
Page 98
a. Credit default swaps (CDS) vs. Corporate bonds
Risk management Short positions
b. Advantages over other credit instruments
Liquidity Flexibility Confidentiality
Commercial banks
59. Using Credit Derivatives To Enhance Return And Manage Risk
c1. The use of credit derivatives by
Investment banks Hedge funds Life Insurance, Property & casualty insurance, Reinsurers & monoline companies
c2. Structured credit products
Basis trade
Curve trade
Index trade
d. Credit derivative strategies
Options trade
Capital structure trade
Correlation trade
CFALEVEL2
PORTFOLIO MANAGEMENT
Page 100
Assumptions
Risk averse investors, parameters are known and used, no taxes or transaction costs
a. MeanVariance analysis b. Frontiers c. Diversification
Portfolio expected return Standard deviation Minimum variance frontier Efficient frontier Effect of correlation on diversification Effect of number of assets on diversification Equally-weighted portfolio risk (variance)
d. CAL and CML
CAL CML Inputs needed: E(R), s, cov. Homogeneous expectation Borrow and lend at risk free rate Unlimited short-selling No trx cost, no tax Perfect competitive market
4 assumptions
e. CAPM
Market risk premium Beta Financial market equilibrium Risk measure CML # SML Application Definition Slope 2 sources of risks E(error)=0 3 assumptions covar (Rm, error)=0 uncorrelated unsystematic risk across assets Expected returns Predict Variances Covariances
f. SML
60. Portfolio Concepts
g. Market model (single factor model)
h. Adjusted betas
Reliability Statistical inputs are forecast Forecast from historical sample--> change over time Small changes cause large change
i. Instability in the minimum variance frontier
Reasons
Time instability Overfitting problem
Macroeconomic factor models
k. Portfolio expected return
j. Multifactor models
Fundamental factor models Statistical factor models Assumptions
l. Arbitrage Pricing Model
APT equation APT # Multifactor Active return (tracking error) Active risk (tracking risk)
Active factor risk Active specific risk
m. Active return and risk
Information ratio Uses of factor and tracking portfolios
n. CAPM # APT
CAPM assumptions
Borrow and Lend at risk free
Unlimited short selling
a. CAPM
Market portfolio on efficient frontier CAPM implications
Linear relationship between return and beta
61. A Note On Harry M. Markowitz's "Market Efficiency: A Theoretical Distinction And So What?"
borrowing at risk free rate b. Consequences of restrictions on
short selling
Page 102
Integration vs. Segmentation Impediments to international flow of capital Psychological barriers Legal restrictions Transaction costs Discriminatory taxation Political risks Foreign currency risk Many private and institutional investors who are internationally active Essentially all major corporations have multinational operations Corporations and Governments borrow and lend on an international scale
a,b. International market integration

b. Factors that favor international market integration
2 basic results
Separation theorem Risk-pricing relationship
Standard CAPM
c. Assumptions of domestic CAPM
Risk-averse investors Homogeneous expectations Investors concerned with nominal returns in home currency Risk free security available for lending and borrowing No taxes, no transaction costs
Elements
Risk-free rate = Investor's domestic risk free rate Market portfolio = All risky assets in the world
d. Extended CAPM
Additional assumptions (unreasonable)
Investors have identical consumption baskets PPP holds exactly
Warm-up: domestic and foreign currency returns
62. International Asset Pricing
e. Real e/r and domestic currency returns Expected exchange rate Domestic-currency HPR on a foreign bond
f. Calculate
g. Calculate
End-of-period real e/r Domestic currency ex-post return on a foreign bond
h. Calculate foreign currency risk premium Investor's domestic risk free rate
ICAPM
i. ICAPM Formula
World market risk premium Sensitivity of asset to changes in all foreign currencies
j. Effect of market segmentation on ICAPM k. Currency exposure l. Exchange rate exposure J-curve effect: Trade balance - Currency Equity exposure
m,n
E/R and domestic economy/ equity
Traditional model Money demand model
E/R and bonds (i.e. E/R and I/R)
Free markets theory Government intervention theory
Page 103
a. Justify ACTIVE PM
b1. TreynorBlack modelsteps
Stock alphas
63. Theory Of Active Portfolio Management

b2. TreynorBlack Calculations
Weightings
Alpha Expected return Standard deviation forecast
Portfolio A
Covariance A and Market index M
b3. Treynor-Black: Efficient market periods vs. Inefficient market periods
c. Measure accuracy in forecasting alphas a
Page 104
Evaluating investor and market characteristics Developing an investment policy statement
Warm-up: elements of PM
Determining an asset allocation strategy Measuring and evaluating performance Monitoring dynamic investor objectives and capital market conditions
a. Importance of the PORTFOLIO perspective

c1. Objectives
Risk objectives Return objectives
Liquidity
64. PM Process And Investment Policy Statement
f. Time horizon c2. Constraints f. Legal and regulatory concerns f. Tax considerations f. Unique circumstances
PM process Step 1: Planning

d. IPS
Role of IPS Elements of IPS
Passive e. Strategic Asset allocation: 3 common approaches Active Semi-active, risk-controlled active or enhanced index strategies
PM process Step 2: Execution
PM process Step 3: Feedback
g. Ethical conduct in managing investment portfolios


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ChangesinCFAlevel2curriculum2012

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright

ETHICAL & PROFESSIONAL STANDARDS

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The CFA Institute Board of Governors

The CFA Designated Officer An inquiry can be prompted by several circumstances

1. Code Of Ethics And Standards Of Professional Conduct

Continue proceedings to discipline the member or candidate

Six components of the Code of Ethics

Seven Standards of Professional Conduct

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A. Knowledge of the law

Recommended procedures for compliance (RPC) Application

From Buy-side clients

B. Independence and objectivity

2.1 Standard I PROFESSIONALISM

Must not knowingly make misrepresentation or give false impression in

Must not misrepresent any aspect of practice, including

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A. Material nonpublic information (MNI)

If public dissemination is not possible,

2.2 Standard II INTEGRITY OF CAPITAL MARKET

dissemination of false or misleading info

Standard II(B) not meant to

The intent of action is critical to determining whether it is a violation of this Standard

duty to exercise reasonable care

Prudence require cautions and discretion

A. Loyalty, prudence, and care

2.3 Standard III DUTIES TO CLIENTS

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Planning to leave, must continue to act in employer's best interest

2.4 Standard IV DUTIES TO EMPLOYERS

contact existing clients/potential clients prior to leaving for soliciting

B. Additional compensation arrangements

Should make an immediate written report to their employers

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright

A. Diligence and reasonable basis

Group research and decision making

2.5 Standard V INVESTMENT ANALYSIS, RECOMMENDATIONS & ACTIONS

B. Communication with clients and prospective clients

-->must be supported by background report or data on request

Capsule form recommendations

Investment advice based on quantitative research and analysis

CFAI recommends maintaining records for at least 7 yrs

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Disclosure of conflicts to employers

2.6 Standard VI CONFLICTS OF INTEREST

employer whom client prospective client compensation Inform

consideration benefit received from, or paid to, others

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright

Cheating on CFA exam or any exam

Not following rules and policies of the CFA program

A. Conduct as members and candidates in the CFA program

Giving confidential info on the CFA Program to candidates or the public

2.7 Standard VII RESPONSIBILITIES AS CFA MEMBER / CANDIDATE

Over-promise the competence of an individual

Over-promise future investment results

Applies to any form of communication

To maintain CFAI membership

Using the CFA designation (see Curriculum)

Referencing candidacy in the CFA program (see Curriculum)

Proper using of the CFA marks (see Curriculum)

CFA MINDMAPS 2012- LEVEL 2- AFTC copyright

Soft Dollar Standards (SDS)