Adapt

Prep
ETHICAL
AND PROFESSIONAL STANDARDS
ETHICAL AND PROFESSIONAL STANDARDS
I(A) Knowledge of the Law
Obey strictest law that applies. Do not associate
with law-breakers.
I(B) Independence and Objectivity
Do not offer gifts that might affect someones
independence and objectivity. Refuse gifts or
disclose to appropriate parties.
I(C) Misrepresentation
When using an outside source, cite it. Do not
promise investment returns.
I(D) Misconduct
Do not commit fraud. Personal issues that reflect
poorly on professional image are a violation.
II(A) Material Nonpublic Information
Understand what material and nonpublic
means. Do not act or cause others to act on
material nonpublic information.
II(B) Market Manipulation
Information-based and transaction-based
manipulations are not allowed.
III(A) Loyalty, Prudence, and Care
Clients come first. Treat clients investment like
your own but with higher priority.
III(B) Fair Dealing
Treat all clients fairly. Communicate investment
recommendations and changes simultaneously.
III(C) Suitability
Use a regularly updated IPS during investment
decisions. Choose suitable investments in a
portfolio context.
III(D) Performance Presentation
Do not misrepresent past performance. Do not
promise future performance.
III(E) Preservation of Confidentiality
Keep clients information confidential unless: client
is involved in illegal activity, you are legally
required, or you have client permission.
IV(A) Loyalty
Put employers needs first. Understand
responsibilities when leaving employer. Consult
employer before taking on outside employment.
IV(B) Additional Compensation Arrangements
Obtain employers written permission before
receiving cash or perks. If applicable, obtain other
partys permission.
IV(C) Responsibilities of Supervisors
Supervisors are responsible for reasonably
preventing subordinates violations but are not
responsible for subordinates behavior.
V(A) Diligence and Reasonable Basis
Exercise diligence and thoroughness. Support
actions with research and investigation.

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CFA Level I

Raise Your Odds with Adapt

V(B) Communication with Clients and

Prospective Clients
Make appropriate disclosures. Distinguish between
fact and opinion when presenting investment
analysis and recommendations.
V(C) Record Retention
Develop and maintain records to support work and
communications with clients.
VI(A) Disclosure of Conflicts
Disclose matters that may impair your
independence and objectivity.
VI(B) Priority of Transactions
Execute clients transactions before your own.
VI(C) Referral Fees
Disclose referral fees to clients and employer.
VII(A) Conduct as Participants in
CFA Institute Program
Do not compromise CFA Institutes reputation.
Do not share exam details.
VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program
Do not misrepresent or exaggerate CFA Institute
membership, designation, or candidacy.
QUANTITATIVE METHODS
QUANTITATIVE METHODS
Required Rate of Return
nominal risk-free rate = real risk-free rate
nominal risk-free rate + expected inflation rate
required interest rate = nominal risk-free rate
required interest rate + default risk premium
required interest rate + liquidity premium
required interest rate + maturity risk premium
Effective Annual Rates
EAR = 1 + periodic rate ; 1
EAR = >?@ABCAD@DE 1
Future Value (FV) and Present Value (PV)
FV = PV 1 + r I
Annuities
Ordinary: cash flow at end of time period
Due: cash flow at beginning of time period
Perpetuity: cash flow continues forever
PVJKL = PVM>JNOP>Q 1 + r
FVJKL = FVM>JNOP>Q 1 + r

PVRL>RLSKNSQ =

PMT
r

Use TVM keys on BA II Plus:

- Cash inflows are positive; outflows are negative.
- Set P/Y = 1
- N = number of periods
- I/Y = periodic interest rate in %
- PV = present value
- PMT = level payment amount
- FV = future value
Money-Weighted & Time-Weighted Returns
Money-weighted return: IRR on a portfolio.
Calculate using worksheet and IRR function on
BA II Plus.
Time-weighted return: Product of (1 + holding
period yield) over entire measurement period.
Holding Period Yield
Ending + Interest Received
1
HPY =
Beginning
Effective Annual Yield
\]^

EAY = 1 + HPY S 1
Bank Discount Yield
Dollar discount
360

r_` =
Face value
Days to maturity
Money Market Yield (CD Equivalent Yield)
360
360 r_`
=
rff = HPY
Days to maturity 360 t r_`
Bond Equivalent Yield
BEY = 2 1 + EAY h.^ 1
Type of Measurement Scales
Nominal: Only differentiates between objects
Ordinal: Allows for rank order
Interval: Allows for degree of difference
Ratio: Has meaningful zero value
Means
Arithmetic:
Population mean, =

Sample mean, X =

Geometric:
Xs =

1
n

1
N

Nno

Nno

X N ; N = population size

X N ; n = sample size

Xo X t X O , where X N 0 for i = 1, 2, , n

1 + Rs =

1 + Ro 1 + R t 1 + R O

Harmonic:
N
Xz =
, where X > 0 for i = 1, 2, , n
I 1
Nno X
N
Percentiles
y
Location of y S} percentile, LQ = n + 1
100
If LQ is not an integer, use linear interpolation.
Mean Absolute Deviation
MAD =

O
Nno

XN X

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Expected Value & Variance of Portfolio Return

Variance and Standard Deviation

1
Population variance, t =
N

Sample variance, s t =

1
n1

I
Nno
O
Nno

XN t
XN X t

Standard deviation is square root of variance.

Chebyshevs Inequality
For any distribution with finite variance, the
proportion of observations within k standard
deviations of the arithmetic mean is at least
1 1 k t for all k > 1.
Coefficient of Variation

CV = s X; measures dispersion relative to mean

Sharpe Ratio
mean portfolio return risk-free return

S} =
standard deviation of portfolio returns
Measures excess return per unit of risk.
Skewness
Positive (right) skew:
- Many outliers in right tail
- Mean > Median > Mode
Negative (left) skew:
- Many outliers in left tail
- Mean < Median < Mode
Zero skewness:
- Distribution is symmetrical (e.g. normal)
- Mean = Median = Mode
1 ONno X N X \

Sample skewness
s\
n
Kurtosis
Measure of peakedness of distribution relative
to a normal distribution.
Leptokurtic: More peaked than a normal
Platykurtic: Less peaked than a normal
Mesokurtic: Same kurtosis as a normal
Excess kurtosis: Kurtosis minus 3 (kurtosis of a
normal distribution is 3)
1 ONno X N X

Sample kurtosis
s
n
Probability Rules
P AB = P A B P B = P B A P A
P A or B = P A + P B P AB
P A = P A So P So + + P A SO P SO
Independence
P AB = P A P B
P AB =P A
Expected Value
E X =

Nno

P XN XN

E X = E X So P So + + E X SO P SO
Variance
t X =

Nno

P XN XN E X

Covariance
Cov X, Y =

Nno no

Cov X, X = t X

P X N , YN X N E X

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YN E Y

E RR =

O
Nno
O

t R R =

wN E R N
O

Nno no

wN w Cov R N , R

Market value of investment i

Market value of portfolio
For portfolio with 2 investments:
wN =

E R R = w R + w_ R _

t R R = wt t R + w_t t R _

+ 2w w_ Cov R , R _
where Cov R , R _ = R R _ R , R _
Correlation
N, = Corr R N , R =
1 N, 1

Cov R N , R

RN RN

Bayes Formula
P Info Event P Event
P Event Info =

P Info
Counting Rules
Factorial:
n! = n n 1 n 2 1
Combination:
n!
n
=

O C> =
r
n r ! r!
Counts ways to choose r items from n where order
does not matter, or ways to label n items with 2
different labels.
Permutation:
n!

OP> =
nr !
Counts ways to choose r items from n where
order does matter.
Multinomial:
n!

no ! nt ! n !
Extension of combination concept; counts ways
to label n items with k labels.
Discrete Uniform Distribution
1
x = xo , x t , , x O
p x = ,
n
Binomial Distribution
n
p x =
p 1 p O , where
x
n = number of trials
p = probability of success
E X = np
t X = np 1 p
Binomial Model
Describes asset price movements. Price either
moves up with probability p or down with
probability 1 p.
Continuous Uniform Distribution
1
f x =
,
a x b
ba
xa
,
a x b
F x =
ba

Normal Distribution
X ~ Normal ,
P < X < + = 0.68
P 2 < X < + 2 = 0.95
P 3 < X < + 3 = 0.99
Observed value Population mean X
Z=
=

standard deviation

E R R shortfall level
Shortfall Ratio =

Lognormal Distribution

- e where X is normally distributed

- Used to model asset prices
- Positively skewed
Continuously compounded return from t to t + 1:
SSo
= ln 1 + R S,So
rS,So = ln
SS
where R S,So is the effective annual rate

Sampling
Simple random sampling: Subset of population is
chosen at random
Systematic sampling: Every kth observation is
chosen until desired sample size is achieved
Stratified sampling: Simple random samples are
drawn from each subpopulation (strata)
Sampling error: Difference between quantity
calculated from sample and its true value
Central Limit Theorem (CLT)
For a sample of size n 30 from a population with
mean and variance t (populations distribution
does not matter), the sample mean x
approximately follows a normal distribution with
mean and variance t n.
Standard Error of Sample Mean
Population variance is known: =

Population variance is not known: s = s n

Confidence Interval
Point estimate Reliability factor Std error
Point estimate: Estimate of population parameter
Reliability factor: Value from distribution of point
estimate, such as normal or t-distribution
Examples: x z t

n; x t t s

Significance
level

Confidence
interval

10%

90%

5%
1%

95%

99%

1.645
1.960
2.575

Biases
Sample selection bias: Excluding subsets of data
because of data availability
Survivorship bias: A type of sample selection
bias where funds or companies that no longer
exist are excluded
Look-ahead bias: Information needed is not
available on the test date
Time-period bias: Data is based on time period
that makes the results time-period specific

Copyright 2016 AdaptPrep. All Rights Reserved. 2

Steps in Hypothesis Testing

1. State hypotheses (null and alternate).
2. Select test statistic.
3. Specify significance level.
4. State decision rule.
5. Collect data; calculate test statistic.
6. Make decision regarding hypothesis.
7. Make economic or business decision.
Test Statistic (General)
Sample statistic Hypothesized value

Standard error of sample statistic
Errors
Decision

Do not reject Hh
Reject Hh

h True

o False

Correct

Type II

Type I

Correct

Power of a test = 1 P Type II error

Hypothesis Test Results
Type

Hypotheses

Reject null if

One-tailed
(upper)

Hh : h
HP : > h

Test statistic >

critical value

Two-tailed

Hh : = h
HP : h

Test statistic <

lower or >
upper critical
value

One-tailed
(lower)

Hh : h
HP : < h

Test statistic <

critical value

Tests Concerning a Single Mean

Population is normal with known variance:
x h

z-statistic =
n
Large sample from any population with unknown
variance (2 choices):
x h
, degrees of freedom = n 1
t-statistic =
s n
x h
z-statistic =

s n
Small sample from normal population with
unknown population variance:
x h
, degrees of freedom = n 1
t-statistic =
s n
Tests Concerning Differences between Means
Normal populations with unknown variances that
are assumed equal:
xo xt o t

t-statistic =
o t
sRt sRt
+
no nt
t
n

1
s
+
nt 1 stt
o
o

sRt =
no 1 + nt 1
Degrees of freedom = no + nt 2
Normal populations with unknown variances that
are assumed unequal:
xo xt o t

t-statistic =
o t
sot stt
+
no nt
t

sot stt
+
no nt
Degrees of freedom = t

t
st n t
so no
+ t t
no
nt
Tests Concerning Mean Differences
Normal populations with unknown variances:
t-statistic =

d Jh
, degrees of freedom = n 1
sJ

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Tests Concerning a Single Variance

Normal population:
t =

n 1 st
,
th

st =

1
n1

O
Nno

xN x t

Degrees of freedom = n 1
Tests Concerning Two Variances
Normal populations:
sot
F= t,
st

st

1
=
n 1

O
Nno

xN x

for j = 1, 2

Degrees of freedom 1 = no 1
Degrees of freedom 2 = nt 1
Technical Analysis: Charts
Bar chart: Shows open, close, low, and high price.
Candlestick chart: Shows open, close, low, and high
price. White body means close > open; dark body
means close < open.
Trends
Support: Low price range where buying is
sufficient to stop further decline
Resistance: High price range where selling is
sufficient to stop further increase
Reversal Patterns
Head and shoulders (H&S): Indicate an upcoming
downtrend following a preceding uptrend
Inverse H&S: Indicate an upcoming uptrend
following a preceding downtrend
Price target = Neckline Head Neckline
Double/Triple tops: When an uptrend reverses
two/three times at about the same high
Double/Triple bottoms: When a downtrend
reverses two/three times at about the same low
Continuation Patterns
Ascending triangle: Highs form horizontal line;
lows form uptrend
Descending triangle: Highs form downtrend;
lows form horizontal line
Symmetrical triangle: Highs form downtrend;
lows form uptrend
Rectangle: Highs and lows form horizontal lines
Flag: Parallel trend lines over short period
Pennant: Converging trend lines over short period
Price-Based Indicators
Moving average: Average closing price over a
specified number of periods
Golden (Dead) cross: When short-term moving
average crosses long-term moving average from
below (above)
Bollinger bands: Lines representing moving
average and moving average +/ set number of
standard deviations from average price
Momentum Oscillators
Rate of Change (ROC) Oscillator:
M = V Vx 100
V = last closing price
Vx = closing price x days ago, typically 10
ROC oscillator crossing 0 in the same direction as
the trend direction is buy/sell signal
Relative Strength Index:
Up changes
100
, RS =

RSI = 100
Down changes
1 + RS

Stochastic Oscillator:
Last closing price Low in past 14
%K = 100

High in past 14 Low in past 14

%D = average of last 3 daily %K values

Moving-average convergence/divergence (MACD)
oscillator: Consists of MACD line and signal line.
MACD line is the difference between two
exponentially smoothed moving averages (12 and
26 days). Signal line is the exponentially smoothed
average of MACD line (9 days)
Sentiment Indicators
Put/call ratio: Volume of put options traded
divided by volume of call options traded
CBOE Volatility Index (VIX): Measures near term
market volatility calculated by the CBOE
Short interest ratio: Number of shares sold short
divided by the average daily trading volume
Flow-of-Funds Indicators
Arms index (or TRIN): Measures relative extent to
which money is moving into and out of rising and
declining stocks
Mutual fund cash position: Percentage of mutual
fund assets held in cash
Cycles
Kondratieff wave: 54-year long economic cycles
Elliott Wave Theory
Market moves in regular, repeated waves.
Wave sizes: grand supercycle, supercycle, cycle,
primary, intermediate, minor, minute, minuette,
and subminuette.
Market waves follow ratios of numbers in
Fibonacci sequence.


ECONOMICS
ECONOMICS
Demand
Demand function: Describes quantity demanded
for a good as a function of own-price, price of
another good, income, and other factors.
Demand curve: Graphs own-price (y-axis) against
quantity demanded (x-axis) for a particular good;
typically downward-sloping.
Movement along demand curve: Quantity
demanded changes as own-price changes.
Change in demand: Changes other than own-price
will cause demand curve to shift left or right.
Supply
Supply function: Describes quantity supplied as a
function of own-price, wage rate paid to labor, and
other factors.
Supply curve: Graphs own-price (y-axis) against
quantity supplied (x-axis) for a particular good;
typically upward-sloping.
Movement along supply curve: Quantity supplied
changes as own-price changes.
Change in supply: Changes other than own-price
will cause supply curve to shift left or right.

Copyright 2016 AdaptPrep. All Rights Reserved. 3

Market Equilibrium
Quantity demanded equals quantity supplied at
equilibrium price.
Equilibrium is stable if price departure will cause
price to converge back to equilibrium.
Equilibrium is unstable if price departure will
cause price to diverge away from equilibrium.
Auctions
Ascending price: Potential buyers openly bid,
starting from a low price. Highest bid wins.
First price sealed bid: Bids are not revealed until
end of auction. Highest bid wins.
Second price sealed bid (Vickery): Like first price
sealed bid but winner pays second-highest bid.
Descending price (Dutch): Price is incrementally
lowered until all units are sold. Each bidder pays
his/her own bid price.
Modified Dutch: Same as the regular Dutch except
all bidders pay the last bid price.
Surpluses
Consumer surplus: Area of triangle above price
and below demand curve.
Producer surplus: Area of triangle below price
and above supply curve
Deadweight loss: Loss of surplus, such as from
price ceiling, price floor, or per-unit tax.
Own-Price Elasticity of Demand
ERJ =

%QJ

%P

ERJ > 1: elastic

ERJ < 1: inelastic

ERJ = : perfectly elastic

ERJ = 0: perfectly inelastic

Income Elasticity of Demand

EJ =

QJ
%QJ
=
%I
I

EJ > 0: normal good

I

QJ

EJ < 0: inferior good

Cross-Price Elasticity of Demand
QJ PQ
%QJ
=

ERJ =
%PQ
PQ QJ
ERJ > 0: substitutes

ERJ < 0: complements

Indifference Curves
- Combinations of two goods with equal utility.
- Slopes downward and convex towards origin.
- Slope at any point is marginal rate of substitution
(MRS), the rate at which consumer will exchange
Good X for Good Y.
- Same consumers curves cannot cross.
Budget Constraint
For 2 goods, X and Y, the budget constraint is
represented by P Q + P Q Income.
Consumer Equilibrium
Point where highest indifference curve is attained
without violating budget constraint, i.e. budget
constraint is tangent to indifference curve.

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Income and Substitution Effects

Price of Good X decreases:
Substitution
effect
Positive
Positive
Positive

Income effect

Consumption
of Good X

Positive

Increase

Negative
(larger than
substitution)

Decrease

Negative
(smaller than
substitution)

Increase

Normal good: Positive income effect

Inferior good: Negative income effect
Giffen good: Negative income effect larger than
positive substitution effect
Veblen good: Higher price increases demand
Profit Measures
Accounting profit = Total revenue
Total accounting costs
Economic profit = Total revenue
Total economic costs
Economic profit = Accounting profit
Total implicit costs
Normal profit = Accounting profit
Economic profit
Revenue Terms
Total revenue (TR): Price times quantity; P Q
Average revenue (AR): TR Q
Marginal revenue (MR): TR Q
Cost Terms
Total fixed cost (TFC): Sum of fixed costs
Total variable cost (TVC): Sum of variable costs
Total costs (TC): TFC + TVC
Average fixed cost (AFC): TFC Q
Average variable cost (AVC): TVC Q
Average total cost (ATC): AFC + AFV or TC Q
Marginal cost (MC): TC Q
Shutdown & Breakeven
Perfect competition:
AR = ATC: Break even
AR ATC: Stay in the market
AVC AR < ATC: Stay in short run; exit in long
AR < AVC: Shut down in short run; exit in long
Imperfect competition:
TR = TC: Break even
TC > TR > TVC: Continue operation in short run;
shutdown in long run
TR < TVC: Shutdown in short and long run
Productivity
Marginal revenue product (MRP) of labor:
Change in TR Change in quantity of labor
Profit maximization:
MRPo
MRPO
==
= 1
Price of input 1
Price of input n

Perfect Competition
- Many firms
- Identical products
- Very low barriers to entry
- Firms have no pricing power
Profit maximization:
- P = MR = MC
- P > ATC implies economic profit
- P < ATC implies economic loss
Monopolistic Competition
- Many firms
- Differentiated products (via advertising)
- Low barriers to entry
- Firms have some pricing power
Profit maximization:
- MR = MC
Oligopoly
- Few firms
- Similar products (close substitutes)
- High barriers to entry
- Firms have substantial pricing power
(price collusion possible)
Profit maximization:
- MR = MC
Monopoly
- One firm
- Highly differentiated product
- No close substitutes for product
- Significant barriers to entry
- Firm has considerable pricing power
(price discrimination)
Profit maximization:
- MR = MC
Market Power Measures
N-firm concentration ratio: Sum of market share
of the N largest firms in the industry
Herfindahl-Hirschman Index (HHI): Sum of squares
of market share of the N largest firms
Gross Domestic Product (GDP)
Nominal GDP: GDP in terms of current prices
Real GDP: GDP in terms of base-year prices
GDP deflator: Nominal GDP Real GDP 100
GDP = C + I + G + X M
C = consumption; I = investment
G = government spending
X = exports; M = imports
National Income
Sum of:
- Employee compensation
- Corporate and government pretax profit
- Interest income
- Unincorporated business net income
- Rent
- Indirect business taxes, less subsidies
Personal Income
= National income Indirect business taxes
Corporate income taxes
Undistributed corporate profits
+ Transfer payments

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Expenditure and Income Equality

GT = SI XM
G T = fiscal balance
S I = savings minus domestic investment
X M = trade balance
IS and LM Curves
IS curve: Negative relationship between real
interest rates and real income (goods market)
LM curve: Positive relationship between real
interest rates and income (money market)
Quantity theory of money: MV = PY
M = real money supply; V = money velocity
P = price level; Y = real GDP
Factors Increasing Aggregate Demand (AD)
- Increased consumer wealth
- Optimistic business expectations
- Expectations of higher consumer income
- High capacity utilization
- Expansionary policies (monetary and fiscal)
- Depreciating exchange rate
- Increased global economic growth
Factors Increasing SR Aggregate Supply (AS)
- Increased labor productivity
- Decreased input prices
- Expectations of higher output prices
- Decrease in business taxes/increase in subsidies
- Appreciating exchange rate
Factors Increasing LR Aggregate Supply (AS)
- Increased supply and quality of labor
- Increased supply of natural resources
- Increased stock of physical capital
Technological improvements
Business Cycle Phases
Trough (lowest point)
Expansion (comes after trough)
Peak (highest point)
Contraction (comes after peak)
Business Cycle Theories
Neoclassical: Free market; invisible hand
Austrian: Neoclassical plus money and government
Keynesian: Advocate government fiscal policy
Monetarist: Maintain steady money supply growth
New classical: Applies microeconomic analysis
to macroeconomics
Unemployment
Unemployed: Jobless people who are seeking jobs
Labor force: People with a job or unemployed
Unemployment rate: Unemployed Labor force

Type

Result of

Frictional

Temporary transitions

Structural
Cyclical

Long-run changes in economy

Changes in economic activity

Inflation
Deflation: Negative inflation rate
Disinflation: Declining inflation rate
Hyperinflation: Extremely high inflation rate
Cost-push: From decrease in aggregate supply
Demand-pull: From increase in aggregate demand
Laspeyres index: Use base consumption basket
Paasche index: Use current consumption basket
Fisher index: Laspeyres Paasche

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Monetary Policy

Exchange Rate Calculations

Required reserves

Required reserve ratio =
Total deposits
Money multiplier = 1 Reserve requirement
Fisher effect: R OM;NOP = R >LP + L
Central Bank Roles
- Sole currency supplier
- Bank of banks and government
- Regulate and supervise payments system
- Lender of last resort
- Gold and foreign exchange reserves holder
- Operate monetary policy
Tools to Implement Monetary Policy
Policy rate: Expansionary when less than neutral
interest rate; contractionary otherwise
Reserve requirement: Increase/decrease funds
available for lending and money supply
Open market operations: Buy/sell government
bonds to increase/decrease money supply
Fiscal Policy: Spending Tools
Transfer payments: Redistribution of wealth (e.g.
Social Security and unemployment benefits)
Current spending: Spending on goods and services
Capital spending: Spending on infrastructure
Fiscal Policy: Revenue Tools
Direct taxes: Tax on income (e.g. income taxes,
corporate taxes, capital gains taxes)
Indirect taxes: Tax on goods and services
Fiscal Multiplier
1
, where MPC = marginal
=
1 MPC 1 t
propensity to consume; t = tax rate
Gains from Trade
Absolute advantage: Can produce at lower cost
Comparative advantage: Opportunity cost of
producing good is lower
Trade Restrictions
Tariffs: Taxes on imported goods
Quotas: Limits on quantity of imported goods
Export subsidies: Government payment to
exporting firms
Minimum domestic content: Minimum domestic
product requirement in goods
Voluntary export restraint: Voluntarily limiting
exports, often to avoid tariffs or quota
Regional Trading Blocs
Free trade area (FTA): No barriers to flow of goods
and services among members
Customs union (CU): FTA + common trade policy
among non-members
Common market (CM): CU + free movement of
factors of production among members
Economic union (EU): CM + common economic
institution and coordination of economic policies
Monetary union (MU): EU + common currency
Balance of Payments Components
Current account: Merchandise and services, income
receipts, unilateral transfers
Capital account: Capital transfers, non-financial
assets sales/purchases
Financial account: Government-owned assets
abroad, foreign-owned assets in the country

Real ex. rateJ = Nominal ex. rateJ

Forward exchange rateJ 1 + iJ
=

Spot exchange rateJ
1 + i
Cross rate: S

CPI

CPIJ

= S S _

Forward exchange rates in points:

- Unit of points is last decimal place in spot
exchange rate quote
- Example: If spot exchange rate is quoted in 4
decimal places, each point is 0.0001.
Exchange Rate Regimes
Formal dollarization: No own currency; adopt
another countrys currency
Monetary union: Adopt common currency
Currency board: Commitment to exchange
domestic currency for specified foreign currency at
fixed exchange rate
Fixed peg: Currency is pegged to foreign currency
(or basket of currencies) within 1% margin
Target zone: Fixed peg with wider margin
Crawling peg: Exchange rate is pegged and
adjusted periodically
Crawling bands: Margin increases over time,
usually to transition from fixed peg to floating
Managed floating: Monetary authority intervenes
to manage exchange rate without a target level
Independently floating: Exchange rate is
market determined


FINANCIAL REPORTING AND ANALYSIS
FINANCIAL REPORTING
Accrual Accounting
Cash movement before accounting recognition:
- Unearned revenue: Liability; cash received before
good or service provided
- Prepaid expenses: Asset; cash paid before
expense incurred
Cash movement after accounting recognition:
- Accrued revenue: Asset; cash not yet received
after good or service provided
- Accrued expenses: Liability; cash not yet paid for
expenses incurred
FASB, IASB, and IOSCO
FASB: Sets forth Generally Accepted Accounting
Principles (GAAP) in the U.S.
IASB: Establishes International Financial Reporting
Standards (IFRS) outside the U.S.
FASB-IASB Convergence: In May 2014, FASB and
IASB each issued converged standard for
revenue recognition.
IOSCO: Not a regulatory authority but
members regulate most of the worlds
financial capital markets
Income Statement Components
Gross profit: Revenue less direct costs to produce
good or service
Operating profit: Gross profit less selling, general,
and administrative expenses

Copyright 2016 AdaptPrep. All Rights Reserved. 5

Revenue Recognition Methods

Percentage-of-completion:
- Used under IFRS and U.S. GAAP when outcome of
long-term contract can be reliably measured.
- Revenue, expense, and profit are recognized
based on percentage of completion.
- Percentage of completion is cost incurred to date
divided by total expected cost.
Completed contract:
- Used under U.S. GAAP when outcome of longterm contracts cannot be reliably measured.
- Revenue, expense, and profit are recognized only
when the contract is complete.
- Under IFRS, revenue is recognized to the extent of
contract costs, which means profit is recognized
at completion.
Installment & Cost recovery:
- Under U.S. GAAP, if collectivity is certain, revenue
is recognized at time of sale. Profit is cash
collected multiplied by expected profit as
percentage of revenue
- If collectivity is uncertain, use the cost recovery
method, where profit is only recognized when the
project cost is recovered
Earnings per Share
Net income Preferred dividends

Basic =
Weighted average of shares outstanding
Diluted =

Convertible Convertible
Net
Preferred

+ preferred +
1
debt
income dividends
interest
dividends

Weighted Shares from Shares from Shares issuable
average + preferred + convertible + from stock
options
debt
shares
shares

Only include potentially dilutive security in

calculation after checking that it is dilutive.
Balance Sheet Components
Accounts receivable: Reported at net realizable
value based on bad debt expense. Bad debt
expense increases allowance for doubtful accounts,
which contras accounts receivables.
Inventory:
IFRS LIFO not permitted; inventories reported at
lower of cost or net realizable value.
U.S. GAAP LIFO permitted; inventories reported
at lower of cost or market.
Property, plant, and equipment (PP&E):
IFRS can be reported using cost model or
revaluation model; recoverable amount is greater
of (1) fair value less selling costs, and (2) value in
use (PV of assets future cash flow stream); loss
recoveries are allowed.
U.S. GAAP only cost model is allowed; loss
recoveries not allowed.
Cash Flow Statement Components
U.S. GAAP:
Item

Classification

Dividends paid

Financing

Interest received

Operating

Interest paid

Dividends received
All taxes

Operating
Operating

IFRS:
Item

Classification

Dividends paid

Operating/Financing

Interest received

Operating/Investing

Interest paid

Dividends received
Income taxes

Tax expense from

investing transaction

Tax expense from

financing transaction

Operating/Financing
Operating/Investing
Operating
Investing

Financing

CFO Direct Method

- Convert each accrual-based item in the income
statement to cash inflow/outflow.
- CFO is net of cash inflows and outflows.
CFO Indirect Method
- Start with net income
- Add noncash expenses
- Subtract gains/adding losses from financing or
investing cash flows
- Add/subtract asset and liability adjustments
based on accrual accounting
Free Cash Flow (FCF)
Measures cash available for discretionary purposes
Free cash flow to the firm (FCFF): Cash available to
equity owners and debt holders.
FCFF = NI + NCC + I 1 t FCI WCI
FCFF = CFO + I 1 t FCI
NI = net income
NCC = noncash charges (e.g. depreciation)
I = interest expense
FCI = fixed capital investment
WCI = working capital investment
Free cash flow to equity (FCFE): Cash flow available
to common shareholders
FCFE = CFO FCI + NB
NB = net borrowing = debt issued debt repaid
Common-Size Analysis
Vertical:
- Represent each item on income statement as
percentage of revenue.
- Represent each item on balance sheet as
percentage of total assets.
- Represent each item on cash flow statement as
percentage of total cash inflows/outflows.
Horizontal:
- Express each item relative to its value in a
common base period
Activity Ratios
Annual sales

Receivables turnover =
Average receivables
365
Days of sales

=
outstanding Receivables turnover
Cost of goods sold

Inventory turnover =
Average inventory
365
Days of inventory
=

Inventory turnover
on hand

Purchases

Average trade payables
365
Number of days
=

of payables
Payables turnover
365
Number of days
=

of payables
Payables turnover
Revenue

Total asset turnover =
Average total assets
Revenue

Fixed asset turnover =
Average net fixed assets
Revenue
Working capital
=

turnover
Average working capital

Payables turnover =

Liquidity Ratios

Current assets

Current liabilities
Marketable
+ Receivables
Cash +
securities

Quick ratio =
Current liabilities
Cash + Marketable securities

Cash ratio =
Current liabilities
Marketable
+ Receivables
Cash +
Defensive
securities
=

interval
Average daily expenditures
Days of
Number
Cash
Days of
conversion =
sales
+ inventory of days
cycle
outstanding
payables
on hand
Solvency Ratios
Total debt
Debt-to-equity =

Total shareholders' equity
Total debt
Debt-to-capital =

Total shareholders'
Total debt +
equity
Total debt
Debt-to-assets =

Total assets
Average total assets
Financial leverage =

Average total equity
EBIT
Interest coverage =

Interest payments
Fixed
EBIT + Lease payments
charge =

Interest payments
+ Lease payments
coverage
Profitability Ratios
Net income

Net profit margin =
Revenue
Gross profit
Gross profit margin =

Revenue
EBIT

Operating profit margin =
Revenue
EBT

Pretax margin =
Revenue
Net income
Return on assets ROA =

Average total assets
EBIT

Return on total capital =
Average total capital
Net income

Return on equity ROE =
Average total equity
Valuation Ratios
Dividends declared

Dividend payout ratio =
NI available to common
Retention rate RR = 1 Dividend payout ratio
Sustainable growth rate g = RR ROE
Price per share

P/E Ratio =
Earnings per share
Current ratio =

Operating

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Copyright 2016 AdaptPrep. All Rights Reserved. 6

DuPont Analysis
Net income Revenue
ROE =

Revenue
Equity
ROE = Net profit margin Equity turnover
Net income Revenue Assets
ROE =

Revenue
Assets
Equity
Net profit
Leverage
Asset

ROE =
margin
turnover
ratio
ROE =

ROE =

NI
EBT

EBT
EBIT

Tax
burden

EBIT
Revenue

Interest
burden

Revenue
Assets

EBIT
margin

Asset
turnover

Assets

Equity

Financial

leverage

Inventory Valuation Methods and Systems

Specific identification:
- Each unit sold is matched with its actual cost.
- Permissible under U.S. GAAP and IFRS.
Weighted average cost:
- Average cost/unit is cost of goods available for
sale divided by quantity available for sale.
- Permissible under U.S. GAAP and IFRS.
First-in, first-out (FIFO):
- Assume first item purchased is first item sold.
- Permissible under U.S. GAAP and IFRS.
Last-in, first-out (LIFO):
- Assume last item purchased is first item sold.
- Permissible under U.S. GAAP but not IFRS.
Perpetual vs. periodic inventory system:
- Perpetual system matches each unit sold with
immediate prior purchases.
- Periodic system matches total units sold for the
period with total purchases for the same period.
Under FIFO, ending inventory and COGS are the
same for periodic or perpetual. Under weighted
average cost and LIFO, they may be different.
LIFO reserve: Must be reported by firms using LIFO
method; used to adjust LIFO COGS and ending
inventory (EI) to FIFO-equivalent values.
EI = EI + LIFO Reserve
COGS = COGS LIFO Reserve
Income tax = Income tax
+ LIFO Reserve t
LIFO liquidations:
- Caused when units sold exceed units purchased
for LIFO company
- May result in higher gross profit than otherwise
Depreciation Methods
Straight-line:
Cost Salvage value

Depreciation =
Depreciable life
Double-declining balance (DDB):
2
Book valueS
DepreciationS =
Depreciable life
Units-of-production:
Cost Salvage
Output unitsS
DepreciationS =
Total output
Intangible Assets
Purchased: Record at fair value (assumed equal to
purchase price)
Developed internally:
IFRS
- Research expenditures are expensed.
- Development expenditures are capitalized.

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U.S. GAAP
- Generally, both research and development costs
are expensed.
Acquired in business combination:
Acquirer allocates purchase price to each
asset acquired on fair value basis; excess
recorded as goodwill
Capitalizing vs. Expensing
- Capitalizing increases assets on the balance sheet
and increases investing cash outflow on the
statement of cash flows.
- Expensing reduces net income by the after-tax
expenditure amount in the period it is incurred.
Impairment of PP&E and Intangible Assets
U.S. GAAP:
- Asset tested for impairment only when firm may
not recover carrying value through future use.
- Asset is impaired when carrying value exceeds
assets future undiscounted cash flows.
- Impaired assets value is written down to fair
value and a loss is recognized.
- Loss recoveries are not permitted.
IFRS:
- Asset tested for impairment annually.
- Asset is impaired when carrying value exceeds
recoverable amount.
- Impaired assets value is written down to
recoverable amount and a loss is recognized.
- Loss can be reversed if asset value recovers, but
only up to carrying value before impairment loss
was recognized.
Income Taxes
Deferred tax assets (DTA): Created when taxes
payable exceeds income tax expense due to
temporary differences. Examples:
- Assets tax base > carrying amount
- Liabilitys carrying amount > tax base
Deferred tax liabilities (DTL): Created when taxes
payable is less than income tax expense due to
temporary differences. Examples:
- Assets carrying amount > tax base
- Liabilitys tax base > carrying amount
Tax base of assets: Amount that will be deducted on
the tax return as assets benefits are realized.
Tax base of liabilities: Carrying value of liability
minus amount that will be deductible on the
tax return.
Impact of tax rate changes:
Income tax = Taxes payable + DTL DTA
Bonds
Premium bond: Coupon rate > yield at issuance
Discount bond: Coupon rate < yield at issuance
Zero-coupon bond: Bond with no coupons
Issuance costs: U.S. GAAP capitalized as an asset;
IFRS reduces initial bond liability
Derecognition of debt: If an issuer redeems a bond
before maturity, a gain/loss (book value minus
redemption price) is recognized.
Debt covenants: Affirmative borrower promises
to do certain things; negative borrower promises
to refrain from certain things.

Leases
Finance (Capital) lease:
- Purchase of asset financed with debt
- Lessee will recognize asset value in balance sheet
and report depreciation expense.
Operating lease:
- Rental arrangement
- Lessee will not recognize asset/liability on
balance sheet but will make periodic lease
payments recognized as rental expense.
Conditions requiring a lease to be a finance lease:
IFRS
- Title transferred to lessee at end of lease.
- Bargain purchase option available to lessee.
- Lease term is majority of assets economic life.
- PV of lease payment is close to fair value.
- Asset is so specialized that only lessee can use
asset without significant modifications.
U.S. GAAP (lease must be treated as finance lease if
any of the following criteria are met)
- Title transferred to lessee at end of lease.
- Bargain purchase option available to lessee.
- Lease period is 75% of assets economic life.
- PV of lease payments is 90% of fair value.
Pension
Defined contribution: Firm periodically contributes
to employees retirement account during
employment. Employer contribution is expensed in
period incurred.
Defined benefit: Firm makes periodic payments to
employee after retirement. Over- (under-) funded
plan recognized as asset (liability).
Financial Reporting Quality Spectrum
1. Compliant with GAAP; decision useful; adequate
and sustainable earnings
2. Compliant with GAAP; decision useful;
inadequate and unsustainable earnings
3. Compliant with GAAP; reporting choices biased;
inadequate and unsustainable earnings
4. Compliant with GAAP; earnings actively
managed (increased/decreased/smoothed)
5. Not compliant with GAAP; numbers presented
based on companys actual economic activities
6. Not compliant with GAAP; numbers fictitious
or fraudulent.
Aggressive vs. Conservative Accounting
Aggressive

Conservative

Costs capitalized

Costs expensed

Straight-line method

Accelerated method

Longer useful life

Higher salvage value

Delayed impairment
recognition

Smaller allowance
for doubtful accounts

Shorter useful life

Lower salvage value

Early impairment
recognition

Larger allowance for

doubtful accounts

Copyright 2016 AdaptPrep. All Rights Reserved. 7

I
Nno

CFN
Outlay
1+r N

Ignore sunk costs.

Use worksheet function on BA II Plus:
- Cash inflows are positive; outflows are negative.
- F01, F02, etc. refer to cash flow frequencies.
- CPT + NPV to compute NPV; CPT + IRR for IRR.
NPV decision rules:
- Accept projects with positive NPV.
- Reject projects with negative NPV.
- If only one of multiple mutually exclusive projects
can be accepted, accept project with highest NPV.
Internal Rate of Return (IRR)
IRR is r such that NPV = 0.
IRR decision rules:
- Accept if IRR > required rate of return.
- Reject if IRR < required rate of return.
- Go with NPV decision if IRR decision does not
match NPV decision.
Payback Period
- Number of years required for cumulative cash
flows to equal initial investment.
- Does not take into account time value of money.
Discounted Payback Period
Number of years required for cumulative
discounted cash flows to equal initial investment.
Profitability Index (PI)
NPV
PV of future cash flows
=1+

PI =
CF
CFh
Accept if PI > 1; reject if PI < 1.
Crossover Rate
- Rate at which NPV profile of two projects cross.
- Calculated as IRR of difference in cash flows.
Weighted Average Cost of Capital (WACC)
WACC = wJ k J 1 t + wR k R + wL k L
wJ = percentage of debt in capital structure
wR = percentage of preferred stock

wL = percentage of common stock

t = tax rate
k J = cost of debt
k R = cost of preferred stock = DR P

k L = cost of common stock

k L = Do Ph + g dividend discount model
k L = R + E R ; R CAPM
k L = R + E R ; R + CRP revised CAPM
Pure-Play Method Project Beta
Delevered asset beta for comparable company:
PLS = LKNSQ

1 + 1 t M;RP>PL

DM;RP>PL
EM;RP>PL

Relevered project beta for subject firm:

DKLS
R>MLS = PLS 1 + 1 t KLS

EKLS

Flotation Costs
Correct way to account for flotation costs is to
adjust initial investment, not to increase WACC.

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Cost of debt < Earnings yield

Cost of debt > Earnings yield

EPS increases

EPS decreases

Changes in book value per share (BVPS):

Stock price < BVPS
Stock price > BVPS

BVPS increases

BVPS decreases

Working Capital Management

Primary sources of liquidity: Sources from normal
daily operations (e.g. cash balances, short-term
funding, collections/payments management)
Secondary sources of liquidity: Sources that may
change a companys financial and operating
positions (e.g. asset liquidation, renegotiation of
debt, bankruptcy protection, reorganization)
Drag on liquidity: Delayed cash inflows
Pull on liquidity: Accelerated cash outflows
Cost of trade credit (CTC): Cost of not taking the
discount for early payment
\]^

%discount JPQ RPS JNMKOS

1
CTC = 1 +
1 %discount
Corporate Governance
- Board should be independent of management.
- Audit committee should resolve conflicts
between auditor and management in a way that
favors shareholders.
- Compensation committee should
provide shareholders with executive
compensation information.
- Firms should have strong code of ethics.
- Confidential voting and remote proxy voting
promote shareholder interests.
Takeover defenses (provisions to make
company less attractive to hostile bidder) harm
shareholder interests.

PORTFOLIO MANAGEMENT
PORTFOLIO MANAGEMENT
Portfolio Management Process
Planning: List objectives and constraints in IPS
Execution: Asset allocation, security analysis,
portfolio construction
Feedback: Monitoring and rebalancing,
performance measurement and reporting
Risk Management
Risk management framework:
- Risk governance
- Risk identification and measurement
- Risk infrastructure
- Defined policies and processes
- Risk monitoring, mitigation, and management
- Communications
- Strategic analysis or integration
Risk tolerance: Which risks are acceptable and how
much risk should be taken
Risk budgeting: How the risks should be taken
Financial risks: Arise from financial market
activities (e.g. market, credit, liquidity risk)
Non-financial risks: Arise from within entity or
from external (e.g. operational, legal, regulatory,
political, model, tail risk)
Risk measures: Standard deviation, beta, duration,
delta, gamma, VaR, CVaR, etc.
Risk modification: By prevention and avoidance,
transfer (insurance), or shifting (derivatives)
Indifference Curve
E(Ri)

Expected'Return

NPV =

Measures of Leverage
Degree of operating leverage (DOL):
Q PV
% Operating income
=

DOL =
Q PV F
% Units sold
Degree of financial leverage (DFL):
% Net income
Q PV F
DFL =
=

% Operating income Q P V F C
Degree of total leverage (DTL):
Q PV
% Net income
=

DTL =
Q PV FC
% Units sold
DTL = DOL DFL
Breakeven
F+C

Breakeven: Q _ =
PV
F

Operating breakeven: Q _ =
PV
Q = quantity; P = price; V = variable cost/unit
F = fixed operating cost; C = fixed financial cost
Dividends
- Cash dividends and stock dividends do not affect
shareholder wealth.
- Stock splits are essentially stock dividends.
Payment chronology:
- Declaration date company declares dividend
- Ex-dividend date two days before HOR date
- Holder-of-record (HOR) date shareholders
listed on company records will be deemed to have
ownership of shares to receive dividends
- Payment date company pays dividends
Share Repurchases
Changes in earnings per share (EPS):

Moderate'Risk
Aversion

High'Risk
Aversion

Low'Risk
Aversion

Risk'Neutral

Risk'Seeking

Standard'Deviations

Minimum-Variance Portfolios
E(Rp)

Expected(Return

CORPORATE FINANCE
CORPORATE FINANCE
Net Present Value (NPV)

!i

Markowitz(EfDicient(Frontier

Minimum<Variance
Frontier

Global(
Minimum<
Variance
Portfolio

Portfolio(Standard(Deviations

!p

Capital Allocation Line (CAL)

Line representing possible combinations of riskfree assets and optimal risky asset portfolio.
E RN R
R
E RR = R +
N
Capital Market Line (CML)
CAL with risky portfolio being market portfolio.
E RR = R +

Copyright 2016 AdaptPrep. All Rights Reserved. 8

Ratios

Weighting

Total risk

Borrowing vs. Lending

Sharpe
ratio

Msquared

Systematic
risk

Treynor
ratio

Beta
Systematic risk = Non-diversifiable / market risk
Unsystematic risk = Diversifiable risk
Total risk = Systematic risk + Unsystematic risk
Cov R N , R ;
N,; N
=

N =
t;
;
Capital Asset Pricing Model (CAPM)
Assumptions:
- Investors are risk-averse, utility-maximizing,
rational individuals.
- Markets are frictionless.
- All investors plan for same single holding period.
- Investors have homogeneous expectations.
- Investments are infinitely divisible.
- Investors are price takers.
E R R = R + N E R ; R

Security Market Line (SML)

Graphical representation of CAPM:

SML

E(Rp)

Expected*Return

E(Rm)

Rf

Rm
*=*

pe

Slo

8R i

!i =*!m

!i

1.0
Beta

Identifying Mispriced Stocks

Expected*Return

E(Rp)

SML

Stock Z

Stock X

PR =

Based on the graph above,

- Stock X is underpriced.
- Stock Y is overpriced.
- Stock Z is fairly priced.

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I
Nno nN PN

D
Price Return over Single Period
PNo PNh
PR N =

PNh

Stock Y

Beta

R R R + R R ; R

!i

Vo Vh
=
Vh

Nno

Nno

PN

I
no P

Market capitalization

wNf =

fN Q N PN

I
no f Q P

Fundamental

1
wN =
N
wN =

FN

I
no F

Behavioral Finance
- Loss aversion: Dislike losses
- Overconfidence: Overconfident in abilities
- Representativeness: Rely too much on current
state when assessing probabilities
- Gamblers fallacy: Estimate future probabilities
based on recent outcomes
- Mental accounting: Keep track of gains and losses
separately for different investments
- Conservatism: Slow to make changes
- Disposition effect: Avoid realizing losses and seek
to realize gains
- Narrow framing: Focus on issues in isolation
Forms of Market Efficiency

Form

Weak

Semi-strong

Market Prices Reflect:

Past market
data

Public
info

Strong

Private
info

Porters Five Forces Framework

- Threat of substitute products
- Bargaining power of customers
- Bargaining power of suppliers
- Threat of new entrants
- Intensity of rivalry
Industry Life Cycle
Embryonic

Slow growth, high prices, high failure risk,

significant investment required
Growth

Rapidly increasing demand, improving

profitability, falling prices, low competition
Shakeout

Slowing growth, intense competition,

declining profitability
Mature

Decline

Negative growth, excess capacity,

high competition

Dividend Discount Model (DDM)

Total Return over Single Period

PNo PNh + IncN
TR N =

PNh
I

wN =

Little or no growth, industry consolidation,

high entry barriers

wN PR N

Vo Vh + Inc
TR =
=
Vh

Price

Equal

RR R

R

Investment Policy Statements (IPS)

Investment objectives: Risk objectives,
return objectives
Constraints: Liquidity, time horizon, tax concerns,
legal and regulatory factors, unique circumstances
Asset Allocation
Strategic asset allocation: Set of exposures to IPSpermissible asset classes expected to achieve the
clients long-term objectives
Tactical asset allocation: Decision to deliberately
deviate from policy exposures to systematic risk
factors intended to add value based on forecasts of
near-term returns of those asset classes.


EQUITY
EQUITY
Positions
Long positions are owned and benefit from
price appreciation.
Short positions are owned and benefit from
price depreciation.
Leveraged Positions
Position

Leverage ratio =
Equity
Maximum initial leverage ratio
1
=

Intial margin requirement
Margin Call Price
Ph 1 Initial margin

1 Maintenance margin
Orders
Execution instruction: How to fill the order
(e.g. market order, limit order)
Validity instruction: When the order may be filled
(e.g. day order, fill or kill)
Clearing instruction: How to settle the trade
Price Return Index
V =

Rf
0

Jensens
alpha

RR R

R
;
RR R
R; R
R

Vh =

wN TR N

Price Return Index over Multiple Periods

V = Vh 1 + PR o 1 + PR t 1 + PR
Total Return Index over Multiple Periods
V = Vh 1 + TR o 1 + TR t 1 + TR

Vh =

Sno
O
Sno

DS

1+r S

DS
PO
+

1+r S
1+r O

Perpetual preferred stock; constant dividend:

Dh
Vh =
r

Copyright 2016 AdaptPrep. All Rights Reserved. 9

Gordon constant growth model:

Vh =

Sno

Dh 1 + g S Dh (1 + g)
Do
=
=

rg
1+r S
rg

g = Earning retention rate ROE

g = 1 Dividend payout ratio ROE
Multistage DDM:
Vh =

Sno

DS
PO
+

1+r S
1+r O

DOo

r g
DOo = Dh 1 + g O 1 + g
Price Multiples
Ph Do /Eo
=

Eo
rg
Price per share
P B=

Book value per share
Price per share

P CF =
Cash flow per share
Price per share
P S=

Net sales per share
Enterprise value EV
= MV Common equity + MV Preferred stock
+ MV Debt Cash + Short term investments


FIXED INCOME FIXED INCOME
Callable Bonds
VPPL MOJ = VNon-callable bond VP
Putable Bonds
VKSPL MOJ = VNon-putable bond + VKS
PO =

Convertible Bonds
Conversion price: Price per share at which bond
can be converted into shares
Conversion ratio: Number of common shares
each bond can be converted into
Conversion value: Current share price
Conversion ratio
Conversion premium: Convertible bonds price
Conversion value
Bond Pricing with Spot Rates
PMT
PMT + FV
PMT
+
+ +

PV =
1 + zo o
1 + zt t
1 + zI I
CR: Coupon Rate; MDR: Market Discount Rate
CR = MDR

CR < MDR
CR > MDR

Price = Par Value

Price < Par Value

Price > Par Value

Par

Discount
Premium

Flat Price, Accrued Interest, and Full Price

PV K = PV PS + AI = PV 1 + r S
AI = t T PMT
Yield Measures
Annual cash coupon payment

Current yield =
Flat price
Amortized
Annual cash
+
coupon payment gain/loss
Simple yield =
Flat price
Yield-to-call (YTC) = IRR assuming the bond is
called early at the stated call price
Yield-to-worse = min YTC, yield-to-maturity
Yield Measures for Money Market Instrument:
Discount Rate (DR) Basis
Days
DR
PV = FV 1
Year

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Yield Measures for Money Market Instrument:

Add-on Rate (AOR) Basis
Days
AOR
PV = FV 1 +
Year
Implied Forward Rate (IFR)
1 + z

1 + IFR ,_

= 1 + z_ _

Yield Spreads over Benchmark Yield Curve

PV =

PMT
1 + zo + Z

PMT
1 + zt + Z

+ +

PMT + FV

1 + zI + Z I

OAS = Z-spread Option value in basis points

Asset-Backed Securities

Securitization Process
- A special purpose vehicle (SPV) buys assets from
the seller firm and issues asset-backed securities
(ABS) against the assets.
- A servicer (could be same entity as seller) collects
funds and performs other related responsibilities.
Residential Mortgage Loans
- Interest: fixed, adjustable, convertible
- Amortization: full, partial, interest-only
- Prepayment: penalty, no penalty
- Foreclosure: non-recourse, recourse
Residential Mortgage-Backed Securities
- Agency RMBS issued by government agencies and
must have conforming loans
- Non-agency RMBS issued by private companies
and may have non-conforming loans
- Pass-through rate: coupon rate on the MBS
- Prepayment risk: contraction (faster-thanexpected prepayments), extension (slower-thanexpected prepayments)
- Prepayment rates are compared to the PSA
benchmark CPR
Collateralized Mortgage Obligations
- Securities backed by pool of RMBS
- Structured with tranches with varying exposures
to prepayment risks
- A sequential-pay CMO has principal and
prepayments paid to the tranches in sequence
- PAC CMO have predictable cash flows and
support tranches with more contraction or
extension risk
Collateralized Debt Obligations
Securities backed by pool of debt obligations, such
as corporate bonds, leveraged bank loans, or credit
default swap on securities
Duration
MacDur

ModDur =
1 +
K
%PV
= AnnModDur Yield
PV PV

ApproxModDur =
2 Yield PVh
ApproxModDur = ApproxMacDur 1 + r
PV PV

EffDur =
2(Curve) PVh
PortfolioDur = wo Do + wt Dt + + wI DI
MoneyDur = AnnModDur PV K

PV K MoneyDur Yield
PV PV
Price value of a basis point =

2
Basis point value = MoneyDur 0.0001

Convexity
ApproxCon =

PV + PV 2 PVh

Yield t PVh

%PV K = AnnModDur Yield

1
+ AnnConvexity Yield t
2
PV + PV 2 PVh
EffCon =

Curve t PVh
Duration gap = Macaulay duration
Investment horizon
Credit Analysis
E[Loss] = Pr(Default) Loss severity
Loss severity = 1 Recovery rate
Credit Ratings
Investment grade: Baa3/BBB- and above
Non-investment grade: Ba1/BB+ and below
Four Cs of Credit Analysis
- Capacity
- Collateral
- Covenants
- Character
Yields and Spreads
Yield on a corporate bond is sum of:
- Real risk-free interest rate
- Expected inflation rate
- Maturity premium
- Liquidity premium
- Credit spread
Yield spread = Liquidity premium + Credit spread
Return impact Modified duration Spread
+

1
Convexity Spread t
2

DERIVATIVES DERIVATIVES
Forward Contract
Value of -year forward contract at:
Initiation

Expiration
Time t

Vh T = 0

V T = S Fh (T)

VS T = SS PVS benefit

+ PVS cost Fh (T) 1 + r

Forward price of an asset:

Fh T = Sh 1 + r FV benefit + FV cost
Forwards vs. Futures
Compared to forwards, futures are:
- standardized contracts traded on an exchange
- guaranteed by clearinghouse
- marked-to-market and settled daily
- regulated
Swaps
Two parties exchange a series of cash flows.
Option Styles
- European options can only be exercised at
expiration.
- American options can be exercised at any time
during the life of the option.
Option Values
Exercise/intrinsic value of a
European call = Max 0, S X
Exercise/intrinsic value of a
European put = Max 0, X S

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Option Moneyness
Option Moneyness
In-the-money

At-the-money

Out-of-the-money

Call

Put

SS > X

SS < X

SS = X

SS < X

SS = X

SS > X

Factors Impacting Option Values

Call

Put

Value of underlying

Increase in

Risk-free rate

Exercise price

Time to expiration

Volatility of underlying

Payments on underlying
Cost of carry

*Except for some deep-in-the-money put options

Option Boundaries
European options:
ch Max 0, Sh X 1 + r
ph Max 0, X 1 + r Sh
American options:
Ch ch ; Ph ph
Ch Max 0, Sh X 1 + r
Ph Max 0, X Sh
Put-Call Parity
sh + p h = ch + X 1 + r
Put-Call-Forward Parity
F h T 1 + r + ph = ch + X 1 + r
Option Strategies
Fiduciary call = Long call + Long risk-free bond
Protective put = Long asset + Long put
Covered call = Short call + Long asset
Option Strategies
Profit
Long call
Max 0, S X ch
Short call
Profit(Long call)
Long put
Max 0, X S ph
Short put
Profit(Long put)
Covered call
Profit(Short call) Sh
Protective put
Profit(Long put) Sh


ALTERNATIVE INVESTMENTS
ALTERNATIVE INVESTMENTS
General
Compared to traditional investments, alternative
investments exhibit:
- lower liquidity
- narrow manager specialization
- low correlation with traditional investments
- less regulation and lower transparency
- limited historical risk and return data
- unique legal and tax considerations
Hedge Funds
Strategies:
- Event-driven seek to profit from
short-term events
- Relative value seek to profit from pricing
discrepancies between related securities
- Macro emphasize a top-down approach to
identifying global economic trends
- Equity hedge take positions in equity and equity
derivative securities

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Hedge Fund Fees:

- 2 and 20 2% management fee and 20%
incentive fee
- Hard hurdle rate incentive fee calculated on
returns above the hurdle rate
- Soft hurdle rate incentive fee calculated on
entire return if hurdle rate is cleared
- High water mark incentive fee only applies to
profits after previous losses have been recovered
Private Equity
Leveraged buyouts:
- Going private transactions
- Management buyouts current management
team is involved in the acquisition
- Management buy-ins current management team
is being replaced by the acquiring team
Venture capital:
- Formative-stage financing angel investing,
seed-stage financing, early stage financing
- Later-stage financing after commercial
production and sales have begun but before IPO
- Mezzanine-stage financing prepare to go public
Exit strategies:
Trade sale, IPO, recapitalization, secondary sales,
write-off/liquidation
Real Estate
Examples: Residential property, commercial real
estate, REIT investing, mortgage-backed securities,
timberland, and farmland
Real estate valuation: comparable sales, income,
and cost approaches
Commodities
Contango: Little/no convenience yield; futures
price > spot price
Backwardation: High convenience yield; futures
price < spot price
Roll yield: Spot price Futures price
Futures price: Spot price 1 + + Storage
costs Convenience yield


BA II PLUS CALCULATOR TIPS
BA II PLUS CALCULATOR TIPS
Basic Operations
2ND : Access secondary functions (in yellow)
ENTER : Send value to a variable

2ND + ENTER : Toggle between options

: Navigate between variables/options
STO + 0 - 9 : Store current value into memory

RCL + 0 - 9 : Recall value from memory

Time Value of Money (TVM)
For annuity, loan, and bond calculations
N : Number of periods

I/Y : Effective interest rate per period (in %)

PV : Present value
PMT : Payment/coupon amount

FV : Future value/redemption value

CPT + one of the above : Solve for unknown

2ND + BGN : Toggle between ordinary annuity

and annuity due
2ND + CLR TVM : Clear TVM worksheet

Note:
- Always clear the TVM worksheet before
starting a new calculation.
- For bonds, PMT and FV should have the same
sign, and opposite signs to PV.
Cash Flow Worksheet ( CF , NPV , IRR )
For non-level payments
Input ( CF )
CF0: Initial cash flow
C01: 1st distinct cash flow after initial cash flow
F01: Frequency of CO1.
C0n: nth distinct cash flow.
F0n: Frequency of C0n.
Note:
- Always clear the CF worksheet before starting
a new calculation.
- The use of F0n is optional. You can leave them as
1 and input repeating cash flows multiple times. If
you do so, C01 will be the cash flow at time 1, C02
will be the cash flow at time 2, and so on.
Output ( NPV , IRR )
I: Effective interest rate per period (in %)
NPV + CPT : Solve for net present value
IRR + CPT : Solve for internal rate of return


CFA CANDIDATE CHECKLIST
CFA CANDIDATE CHECKLIST
Source:

http://www.cfainstitute.org/programs/cfaprogram/c
ourseofstudy/Pages/candidate_checklist.aspx

Several Months Before Exam Day

Review testing policies.
Confirm international travel passport is valid.
Ensure you have the necessary travel
documents to get to the test center.
The Month Before Exam Day
Review and print your exam admission ticket on
clean, blank paper.
If the name on your exam admission ticket does
not match the name on your passport exactly,
update your name in your CFA Institute account
as soon as possible. Reprint your ticket after the
name change.
Check directions to the test center and special
instructions for travel and parking.
Plan travel route to the test center.
The Week Before Exam Day
Plan to dress in layers as temperatures at test
centers can vary.
Plan your lunch.
Review instructions for filling out answer sheet.
Review the CFA exam personal belongings
policy (link at end of section).
What to Bring to the Test Center
Valid international travel passport
Exam admission ticket
At least one approved calculator
No. 2 or HB pencils
Eraser
Pencil sharpener
CFA Exam Personal Belongings Policy
http://www.cfainstitute.org/about/governance/p
olicies/Pages/personal_belongings_policy.aspx

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NOTES

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