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ETHICS
Code of Ethics (Separate from Code of Standards)
Act with integrity competence diligence and respect in an ethical manner with everyone
Place integrity of investment profession and interest of clients above personal interest
Use reasonable care and independent professional judgment wrt investment analysis, action, recommendation
Page 2 of 44
Practice and encourage others to be professional, ethical, which reflects credit on themselves and profession
Promote the integrity and viability of global capital markets for ultimate benefit of society
Maintain and improve professional competence for yourself and others
Ok to compete against employer for additional compensation when working for them if you have written
CONSENT
Notify employer of services rendered, duration of services and compensation for services
Cant solicit current clients to join new firm if you still work at old firm. You can prepare to go into
competitive business before leaving work as long as it doesnt breach employees duty of loyalty
You can solicit current clients of old firm after youve left (unless theres a non-compete clause)
Cant take old work from old employer to new employer without written CONSENT of previous employer
Analyst not prevented from writing research report because of relationship between employer and target
company, DISCLOSURE
Doesnt matter that brokerage firm provides research that is not used by account generating commission if
account isnt paying for it
Best thing to do is to pay for accommodations, accepting not necessarily a violation if it doesnt impede
objectivity
Reward for strong past realized return from clients ok if other clients are treated the same DISCLOSURE
Rewards based on future performance: must receive written permission from employer
Ok to own same investments as clients. Responsibility to clients, then employer, then yourself.
Employees should disseminate public material information if it doesnt breach duty
You must attempt to make everyone (not just direct reports) adhere to laws, rules and regulations
Responsibility of supervisors: are held accountable for their employees actions.
Supervisory duties may be delegated but that doesnt relieve supervisors from responsibility
If block trades occur at different prices they must be allocated pro rata across all accounts with no
preferential treatment.
Acceptable to base a recommendation, in part, on an expectation of future events, even if is uncertain
EX: a politician is fighting for subsidies to an industry and believes that said subsidy will pass
Candidates cant say they received highest score on CFA exams b/c scores are broken in to <50, 50-70,
70< score sections. You dont know your actual score, just if you passed/failed.
CFA logo cant be incorporated into company name or logo. CFA logo used only to identify charterholders not
candidates
Allocate IPOs to suitable clients pro rata directly, not ok to allocate to managers who then have discretion to
allocate to their clients
Oversubscribed issues: forgo sales to yourself and immediate family(unless theyre regular accts), prorate
remaining amongst clients
Present outcomes from models or statistical estimates as opinions not fact and with qualifying statements
and caveats
Plagiarism includes: using experts either verbatim or with slight changes in wording w/o acknowledgement,
specific quotations to vague sources (leading analysts, Investment experts), using charts/graphs without
citing sources, copying spreadsheets or algos without seeking cooperation or authorization of creators.
You can use previous research done by another analyst even if they have left the firm. You cannot reissue
previously released report solely under your name. Firm can issue research if analyst is gone too.
Citing direct source or intermediary source: best obtain complete study from original author and cite author
preferred, or use both intermediary and source and cite both sources.
An influential analyst with the ability to move markets is considered material. But since this analyst is not a
company insider a report written by them is not considered MNPI and dont have to be publicly
disseminated. If you want access you can pay them.
If 10 largest shareholders are told something at a meeting. Analyst cannot use this information because it is
not public, it has not been widely publicly disseminated
Investment decisions made in context of the whole portfolio, consider the investments place in the overall
portfolio
Page 3 of 44
A family members account is a regular fee paying account comparable to all clients. Dont disadvantage
them or any other specific client because of overcorrecting notion of fairness due to this special
relationship
Dissemination should be fair(equal dissemination at same time for everyone too hard), cant discriminate
with selective dissemination
Higher fee paying clients get more service and attention but not to detriment to others
Using Quant Models: dont have to know every technical aspect but you should understand assumptions and
limitations
Developing quant models: understand technical aspects. Thorough testing of model and resulting analysis
should be completed
CFA institute recommends maintaining records for at least 7 years
If you issue a recommendation give ample time for clients to receive message and for them to act before
you or your firm trades in an effort to prevent front running
No need to dissociate yourself from report if you disagree with consensus group opinion if you believe
opinion has reasonable basis.
If market makers are in possession of MNPI, they should be passive market participants. Outright prohibition
of market making might be construed as a tip to outsiders
Exempt from best execution brokerage if client expressly prohibits best execution and is aware of the impact
on their account
MNPI violated if you act or cause other to act on MNPI received a mere outlook (promising,negative)
does not violate this
Diligence and reasonable basis not violated if no formal recommendation is made
All clients participating in a block trade should be given same execution price and pay same commission
Receive trade allocation request (what clients would like to own) notification from clients before receiving
stock from IPO
Whistleblower status granted if you dont have anything to gain personally
If client is trying to set up investment trust for kids, then the kids are the actual clients (trust beneficiaries),
consider kids risks and investment objectives
Suitability isnt an issue when recommending to general clients. Suitability may be issue if recommending
investment for specific client
Cant say date or time frame of receiving charter. Say: CFA charter received when Ive completed required
work experience after passing 3 levels
If influential analyst tells you about recommendation before going on TV it is considered MNPI if you act on
it.
Research Objectivity:
All communication btwn IBD and research should take place through compliance or legal. Draft should be
submitted beforehand. Communication should be only to verify factual info or conflicts of interest.
Page 4 of 44
QUANTITATIVE METHODS
Cov
(x x )( y y )/ ( n1 ) = Cov (x , y ) b = y b^ x plug y x
b^ 1= 2 xy =
1
Var ( x) 0
X
( xx )2 /( n1 )
t stat =
b^ 1b 0
sb
2
1 (xx )
^y t c s f where : s f = s2 1+ +
n ( n1)s x 2
where ^y =b^ 0+ b^ 1 x
Coefficient of
determination
R =
=
=
=
SST
SST ( x^ x )2+ ( x x^ )2
(x x )2
2
+ RSS (explained)
is variation of y explained by x
+ SSE (unexplained)is variation of y NOT explained by x
= SST (total) .is total variation of dependent variable (y)
Correlation Coefficient =
R2
t stat =
r ( n 2)
(1 r )
2
Adjusted R =1
n1
2
(1r )
nk 1
Fstat =
If Fstat > Fcrit then reject. Group of independent variable variation describes dependent variation
Model Misspecification: omitting a variable, variable should be transformed, incorrectly pooling
data, using lagged dependent variable as independent variable, forecasting the past, measuring
independent variables with error.
Page 5 of 44
Effects of misspecification: Regression coefficients are biased and inconsistent, lack of confidence
in hypothesis tests of the coefficients or in the model predictions.
Multiple Regression Issue
Heteroskedasticity: residual variance
is not constant
Detection
Breusch-Pagan: regress the square of
residuals on original independent
variables and create new Chi-squared
test. REJECT: nR2 > 2 HS exists
(R2 corresponds to 2nd regression:
Regressing 2 (residuals-squared) on
independent variable.
Durbin Watson: DWstat = 2(1-r), where r
is sample correlation between squared
residuals from one period and previous
period.
+ SC
inconclusive
none
inconclusive
- SC
0
4- dL
dL
4
du ~2
Correcting
White corrected SE (robust standard
errors), Generalized least squares (gls),
HS-consistent standard errors (SE)
4- du
Yt = ebo + b1t ln(yt) = b0 + b1X Regress natural log of dependent variables on independent variables
b0
1b1 1
, if b1=1 AR is Unit
Root=non-cov stationary
Var(observations) constant, finite
Cov(Times series) constant, finite
NO unit root (series trends up or down). Correct with first differencing (described in ARCH
section below)
Test with dickey fuller. Unit root exists if b 1 1=0 (it is non-stationary)
AR test for residual correlation for time series models (if times series has
autocorrelation it is not covariance stationary) :
Detect: t-test for auto correlation in residuals:
different from 0.
Page 6 of 44
Fix: Include additional lags for AR(p) model (p increasing) so theres no auto correlation
(t-stat declines to 0)
invalid**
If b1 = 1, then the process has a unit root and is non-covariance-stationary from x t = b0 + b1 xt-1 + et
Test for ARCH is based on a regression of the squared residuals on their lagged values:
1) Square residuals from autoregressive model
2) Regress squared residuals against squared residuals from previous period
3) If coefficient 1 (using t-test) from
conclude regression model exhibits ARCH(1)
4) FIX ARCH error: use generalized least squares
Seasonality
Detecting Seasonality:
Page 7 of 44
lnxt = b0 + b1 (lnxt-1) + et
if residual lag 4
Fixing Seasonality:
lnxt + b0 + b1 (lnxt-1) + b2 (lnxt-4) + et
Add lagged 4th term
Page 8 of 44
tstat =
ECONOMICS
Converting:
PriceCurrency
Base Currency
PriceCurrency
Base Currency
( CA ) =( AB ) x ( CB ) ( CB )
bid
bid
bid
bid
1
C
B
( )
Offer
Triangular Arbitrage
Market:
USD EUR GBP USD
Bid
Ask
strategy
USD/EUR 1.271 1.272
USD 1 EUR
EUR/GBP 1.249 1.250
USD x
x
USD/GBP 1.6 - 1.601
EUR ask GBP
) (
) x ( USD
GBP )
ask
bid
Becomes:
USD x
GBP
USD
x(
x(
( EUR
)
)
USD
EUR
GBP )
bid
$1 x
bid
bid
1
1
( 1.272
) x ( 1.250
) x ( 1.61 )
bid
bid
bid
=$ 1.006289> $ 1
Page 9 of 44
actual
360
actual
1+i d
360
( i f id )
Carry trade for arbitrage opportunities: borrow in lower yielding currency and invest (lend) in
higher yielding one. Then net any profit after borrowing costs and exchange rate movements.
(rd rf) < (Forward Spot) / Borrow Domestic Invest Foreign
Spot
(rd rf) > (Forward Spot) / Borrow Foreign Invest Domestic
Spot
EX: Borrow in USD, translate to Euros, Lend Euros, translate to USD, Repay in USD
Euro
( USD
)
Current
x ( LIBOR Euro ) x
( USD
Euro )
Future
inputs
*FPt, R and days are in terms of the number of days remaining in contract
EX: originally 90-day forward, 60 days have passed (30 days remain). FPt, R and days use 30 day
1+ Actual inflation A
S t =S 0
1+ Actual inflation B
1+ E(inflation A )
S t =S 0
1+ E(inflation B)
Spot
Inflation
Inflation
E( d)
f
E( )=E ( f )
d
Absolute PPP: Given a basket of goods should cost the same in different countries after taking
into consideration exchange rates. Goods and services can be transported at no cost, all
countries use same method to measure price levels
Spot f =
d
Price level f
Price Leveld
Interest Rate Parity: exchange rates change so that risk-adjusted returns on investments in
any currency will be equal. Investors are risk neutral
Page 10 of 44
days
)
360
Forward(F / D)t =
Spot(F / D )t
days
1+r D (
)
360
1+r F (
Forward f spot f
Forward premium ( discount ) as =
spot f
R f R d
Derives no
arbitrage forward rate. Interest rates and exchange rates will
adjust so the
risk adjusted return on assets between any 2 countries and
their
associated currencies will be the same (premiums and
discounts will offset). Real interest rate differentials would result in capital flows to the higher real
interest rate country, equalizing rates over time.
2) Uncovered Interest Rate Parity: Forward is unbiased predictor of expected future spot rates.
Expected spot price is not market traded and thus UIRP does not hold by arbitrage. Expected
appreciation/depreciation offset by int rt differential
Spot
days
)
360
E( (F / D) t)=
Spot ( F / D)t
days
1+r D (
)
360
1+r F (
E(Spot f )spot f
Expected change spot FX rate=
spot f
Rf Rd
Fisher Relation: Countrys nominal interest rates should be similar to expected inflation differences
Rnominal = R real + E(inflation)
R nomA-RnomB = E(InflationA) - E(InflationB)
1+ Rnominal = (1+ R real )[E(inflation)]
Taylor Rule: 1) control inflation 2) maximize employment
R = rn + + ( *) + (y y*)
Central bank policy = Neutral real policy int rate + inflation + diff in target and actual inflation + diff btwn
output and target output
Real FX rateF/D
= equilibrium real exchange rateF/D
+ (real interest rateD - real interest rateF)
+ [(D D*) (F F*)]
(if inflation gap of domestic is greater relative to foreign FX F/D
will rise, D appreciates)
Page 11 of 44
Macroeconomic Balance Approach: estimates how much current exchange rates must adjust to
equalize a countrys expected current account imbalance and sustainable current account
imbalance
External sustainability approach: estimates how much current exchange rates must adjust to
force a countrys
external debt (asset) relative to GDP towards its sustainable level
Reduced form econometric model approach: finds equilibrium path of FX movements based on
patterns in several macroeconomic variables, such as trade balance, net foreign asset/liability
and relative productivity
Mundell Fleming Model: monetary and fiscal policy impact on interest rates and exchange rates
Expansionary Monetary: pump money into economy int rts lower capital moves out
(domestic depreciates)
Expansionary Fiscal: lower taxes/ higher spending more gov borrowing int rts higher
capital moves in
Monetary Models:
Pure Monetary Models: PPP holds, output is constant
- Expansionary monetary/fiscal: prices, value of currency
- Restrictive
monetary/fiscal: prices, value of currency
Dornbush Overshoot Model: prices are inflexible and dont reflect changes in policy immediately *think of
oversteering a car on ice
EX: expansionary monetary: prices, real interest rates depreciation of domestic currency due
to capital outflow
In Short term: depreciation of currency > depreciation implied by PPP. Depreciation is higher than it
should be.
In long term: FX rts gradually increase (appreciate) toward their normal long run PPP implied values.
Growth Economics:
Classical: Growth in real GDP is temporary and is limited by a subsistence level, new technologies result in
larger but not richer population
Neoclassical: Tech (TFP) improvement labor productivity resulting in upward shift of production function
curve.
in K (capital deepening) and L doesnt change growth in output per worker perm only amt of production
(movement on production curve)
Sustainable growth comes from population growth. Labors share of income increases from technological
advancement (treated as exogenous variable). after trade opens up and savings reallocated economies
converge at same growth rate as there is no permanent increase in growth rate. Diminishing marginal
productivity of capital but constant marginal product of capital. Savings and investment have temporary impact
on growth
In steady state, marginal product of capital (MPK) is equal to rental price of capital:
MPK =Y/ K = (capital's share of total output as % x output)/total capital = capital's share of total
output/total capital.
GDP growth rate = (growth rate in total factor productivity / (1-) labor's share of total factor cost) + growth in labor force
Endogenous: Technology leads to better labor productivity, capital deepening, knowledge capital and R&D
leads to social and other technological benefits and externalities for everyone. Saving and investment can
generate selfsustaining growth at a permanently higher rate as the positive externalities associated with R&D
prevent diminishing marginal returns to capital from setting in. Differs from neoclassical because endogenous
says capital investment has constant returns while neoclassical says K investment is diminishing.
GDP growth = TFP(tech) growth + (LT growth rate of capital) + (1- )(LT labor growth)
TFP(tech) growth = Growth in labor productivity Capital deepening
Stock market growth = GDP Growth + Capital growth + P/E multiple growth rates
*In LR stock growth depends only on GDP growth
Stock Market = GDP *(E/GDP)*(P/E) = GDP * corporate share of earnings in GDP * market P/E ratio
Regulations necessary b/c of information frictions (information asymmetry, moral hazard, adverse selection) &
externalities
Page 12 of 44
Regulatory Arbitrage: companies exploit difference between economic substance and interpretation of a
regulation.
Regulatory Capture: regulatory body gets influenced by regulated industry and advance interest of regulated
(eg. banks)
Regulatory Competition: regulators compete to provide best environment
Coase Theorem: When property rights are involved, people will make efficient decisions that are mutually
beneficial
FRA: INVENTORIES
Inventories
AND
LONG-LIVED ASSETS
FIFO inventory
= LIFO inventory + LIFO reserve (writedown charges)
FIFO COGS = LIFO COGS (LREnd - LRBegining) + (writedown charges)
COGS
Avg Inventory
Long-Lived Assets
Capitalize as asset on balance sheet:
1) Initially: noncurrent asset , CFI (similar to investing in asset)
2) Future: noncurrent asset , NI , RE , Equity (all because of
depex)
COMPARISON
NI 1st yr
NI (future) [b/c depex]
T. Assets
Equity
CFO
CFI
Income Variability
D/E Ratio
Capitalizing
Higher
Lower
Higher
Higher
Higher
Lower
Lower
Lower
Expensing
Lower
Higher
Lower
Lower
Lower
Higher
Higher
Higher
Page 13 of 44
CF same b/c impairment is NCC
Asset Revaluation (Upwards):
IFRS 1) Revaluation method:: CV=FairValue Subsequent Accumulated Depreciation & Impairment
2) Cost method
:: CV=HistoricalCost Accumulated Depreciation
*Revaluation recorded in I/S any revaluation exceeding original cost is recorded as revaluation surplus
as OCI equity
GAAP 1) Cost method only. Value can never exceed historical cost
Acct Treatment of Revaluation:
IFRS: G/L in IS any excess gains above original cost is recognized in OCI (equity) as
revaluation surplus
GAAP: not allowed except for long lived assets held for sale.
-Only the cost model may be used as value can never exceed historical costs.
@ inception
During life
No changes
current Liab):
(disc rt x
liabbeginning)
AND
SHARE-BASED COMPENSATION,
Page 14 of 44
Investment in financial assets detail level (amount on parents financial statements proportionate to
FV through profit or loss
- HFT(designated at
FV)
AFS
HTM
I/S: GAAP
I/S: IFRS difference
Interest, Divd
none
Realized/unrealized
G/L
FV:
Interest, Divd
Unrealized FOREX
IFRS: unrealized G/L in OCI
Realized G/L
G/L recognized in IS
GAAP: ALL unrealized G/L in OCI
Realized
Reversed out of OCI in
Reclassification
adj
-Initially recorded @ FV
Interest
including
none
-Subsequently reported at amortized
amort.
cost using effective interest method
Realized G/L
Cost of debt + discount premium
thats been amortized
ownership % [0-20%]):
FV = market value if available
discount
Par > FV (effective interest rate > stated coupon) securities trade at a discount
Par < FV (effective interest rate < stated coupon) securities trade at a premium
CarryingValue1 = CarryingValue0 + FairValue(mkt int rt) Par(Coupon)
*Use market for FV if available
Amortization of the discount/premium results in the carrying value of securities as it converges towards par as time
passes
Comprehensive income (CI=NI +OCI): Change in equity, net assets from non-owner sources.
Other comprehensive income (OCI) : SE, unrealized G/L b/c those items have NOT been settled
Ownership
Amt of control
GAAP
IFRS
20-50%: associates
Significant influence
Equity
same
50% (may vary): joint venture
Shared control
Equity
Equity or Proportionate cons
More than 50%: biz combo
Control
Acquisition (aka consolidation)
same
Equity Method:
ONE-LINE CONSOLIDATION of proportionate share of net assets and net income in B/S and I/S
respectively. Investment is listed at cost. Total value of the investment = Carrying value of investment
+ (earnings - dividends)
Goodwill Treatment:
proportion of net assets owned
goodwill
Goodwill= Investment amount (ownership share%) x [(BV current assets + BV PPE Liab) +
(FV PPE BV PPE)]
If FV of net assets > investment amount
-Excess (negative goodwill) excluded from CV and included as income
Proportionate Consolidation (IFRS joint venture only if theres a stronger implied relationship than
equity method):
Page 15 of 44
All proportionally owned parts of B/S and I/S are included in the parents financial statement line by
line.
Acquisition Method (biz combo):
BS: assets & liab consolidated on B/S @FV, minority interest is created for portion that parent doesnt
own to balance acct eqn
IS: rev & expenses are added, minority interest is portion that firm doesnt own
Goodwill Treatment in Biz Combos:
IFRS (optional): Full goodwill = FV subsidiary FV identifiable assets
Partial goodwill = purchase price FV parents proportionate share of subsidiarys
identifiable net assets
GAAP (required): Full goodwill = FV subsidiary FV identifiable assets
GOODWILL IMPAIRMENT: recognized separately as line item on consolidated IS
IFRS: CV > recoverable amt (goodwill absorbs 1st hit of impairment, then non-cash assets, then cash units)
GAAP: CV > FV (written down to FV if impaired)
Notes on the 3 methods (assuming they all have 50% (same) ownership) :
1. All 3 have same net income
2. Equity and proportionate consolidation report same equity, ACQUISITION equity is higher
3. Assets, liabilities, sales and expenses: highest in ACQUISTION; PC is in the middle, lowest under equity
PENSION ACCOUNTING
*Funded status shows up in BS
different curriculums denote positive funded status= (PBObeg) x
as
Either net pension liability or asset
(Disc Rt)
Affects actuarial
*A
AL G/L IS PLUG Gains decrease PBO, losses
*If contributions > periodic pension expense,
be viewed as a reduction in PBO
Periodic pension COST: total cost listed in either IS or OCI for GAAP/ IFRS
Periodic pension expense: periodic pension costs
recognized ONLY in IS/P&L (not OCI)
Periodic Pension Cost Treatment
Component
Item
IFRS
Recognition
+ Service Cost
+ Current Service Cost
Actual Events
+ Prior Service Cost
IS (P&L)
+ Amortization of Unrecognized
Prior
Service Costs
CTUARI
increase PBO
remainder can
GAAP Recognition
Service Cost IS
Past Service Cost OCI
Subsequently
Recognized in IS
Page 16 of 44
+ Net Interest
Expense (income)
- Net
Actual/Expected
Plan Asset Returns
Amortization of
Deferred
Actuarial
Assumptions on
PBO
IS
Remeasureme
nt
Recognized
in OCI, not
subsequently
amortized into
P&L
2 Ways:
1) Immediately in IS
2) unamortized amt in OCI
then amortized to IS using
corridor method
(TPPC) (I/S
benefits paid
Multinational Operations
Monetary A/L
Non monetary A/L
Common stock, Divd
Temporal Method
(aka
remeasurement)
Current Rate
Historical Rate
Historical Rate
Mixed * RE PLUG
Average rate
Historical Rate
Historical Rate
Mixed** = Rev Exp
Net monetary
assets
Income Statement
Average Rate
Average Rate = RE +divd
Current Rate
Current Rate
Historical Rate
(capital stock)
Equity
Revenues, Expenses
COGS
Depreciation
Net Income
GAIN
Equity *PLUG
A = L + (E +
CTA
)
if theres a NET
LIABILITY and the foreign currency is appreciating, theres a translation exposure LOSS
Speculative hedges
Purpose
FV hedge (changes in A/L)
CF hedge (offset variable CFs)
Net investment hedge in foreign
subsidiary
I/S
G/L on IS
G/L in equity OCI
G/L in IS once anticipated transaction affects
earnings
G/L w/ translation G/L in SH equity/OCI
B/S
FV
FV
Page 17 of 44
When earnings are relatively free from accruals, mean reversion will occur at a slower rate.
* NOA = A- L (exclude cash equivalent and marketable
securities and debt)
SalesCOGSSG A expenses
Sales
=EBT
N E E R Ta Te.
N S A E.
TIEAF
Beneish model: if (M > -1.78) indicates higher than acceptable probability of earnings manipulation
CORPORATE FINANCE
NPV
WACC reflects inflation & financing charges, CFs should be adjusted to reflect inflation otherwise
NPV will be biased
Depreciation is added b/c it is a non-cash charge that expenses, income. D(1-t)+D = tD which is
the DEPEX tax shield
NWC = NWCInv = non cash current assets nondebt current liabilities
*NWCInv is cumulative NWC during project
NPV =outlay+
CF
TNOCF
+
t
T
(1+ r) ( 1+ r)
S= sales or revenue
C= operating costs
D= depreciation
t=tax rate
Sal0= sale of old asset
SalT= sale of new asset
t(SalT - BT)= tax charge for gain on
asset sale
BT = investment accum.
Depreciation
FCInv = cost of machine
+installation cost
=ending fixed asset - beg fixed
Profitability Index=
Page 18 of 44
Economic Profit
,also=(MV equity+ MV < Debt ) (BV equity + BV < debt)
,
( 1+WACC )t
EIT =
ATCFT
(MVT-1 MVT)
EIT =
EIT =
ATCFT
ATCFT
Economic Income
MV Beginning
M&M Propositions:
MM Proposition
matter)
1 (changes in value)
No tax, transaction costs,
bankruptcy
2
(changes in WACC)
VL = EBIT(1-t)/WACC
VU = EBT(1-t)/WACC
Systematic Risk:
Assets=
D
E
rE
V =
Debt
Equity
Debt
Debt +
Equity Equity = Assets + ( Assets Debt )
Debt + Equity
Debt + Equity
Equity
Institutional framework
D
E
Macro
Page 19 of 44
Debt
Usage
Efficie
nt
Legal
Syste
m
Lower
Comm
on Law
> Civil
law
Lower
info
asymme
try
Favorab
le taxes
on
equity
D/E
Lower
Lower
Lower
ratio
Maturit Longe Longer Longer
N/A
y
r
Dividends
Double taxation:
Effective Tax = CorpTax + (1- CorpTax)(DivdTax)
= 1-(1-CorpTax)(1-DivdTax)
System
Active
bond and
stock
market
Environment
High
High
inflatio GDP
n
growth
Bank
based
financial
system
Large
institution
al
investors
N/A
Higher
Lower
Lower
Lower
Longer
N/A
Longer
Shorte
r
Longer
Imputation tax system: taxes paid out at corporate level, but attributed to shareholder: all taxes are effectively
paid at shareholder rate.
If (Marginal Tax) < (Corp Tax-paid) Investor gets tax credit = franking credit
If (Marginal Tax) > (Corp Tax-paid) Investor pays for gap
Split rate tax system: RE taxed at higher rate than profits it pays out at dividends, encourages
companies to have a lower retention ratio, and pay higher dividends, dividends taxed again @
shareholder level as ordinary income
Expected dividend = (previous dividend) + [(expected increase in EPS) (target payout ratio)
(adjustment factor)]
adjustment factor = 1 / # yrs that adjustment takes place
Private Equity
Bootstrapping: high P/E firm purchases low P/E firm
Current EPS is higher at the expense of lower growth prospects and lower future EPS
Equity carve out: subsidiary created and IPOd parent still retains control. Sale of equity of new co to
outsiders
Spin-off shares of new firm are distributed to parents existing shareholders on pro-rata basis
Split-off: parent and subsidiary exchange (surrender) stock. Parent wishes to draw distinction with
subsidiary.
M&A
GainTarget = Takeover premium = PT - VT
HHI = Sum([Sales company/ T. SalesIndustry x 100]2)
GainAcquirer = S TP = S (PT - VT)
VAT = VA + VT + S C (cash paid to target shareholders)
M&A DCF FCFF using NOPLAT:
Income to all investors
FCFF = NI + Net Interest After Tax + Changes in deferred taxes + NCC INC_NWC FCInv
Unlevered Income
Page 20 of 44
Friedman doctrine: social responsibilities of business is to increase profits within rules of the game
fair competition w/o deception or fraud
Utilitarianism: maximize positive, minimize negative outcomes. Bad: difficult to measure utility, what
may be good for larger group may come at expense of minority (eg: not providing healthcare for few
AIDS patients)
Kantian: People are different than factors of production, they must be treated with dignity and respect
Rights theories: everyone has rights and privileges, greatest good utilitarinism cannot violate the
rights of others
Justice theories (Rawls): rules are fair if you dont know your own particular characteristics.
Differencing principle: unequal division must benefit least advantaged members of society. Everyone
decides if sweatshop is lawful if you dont know if you fall under the category of working in one.
Corporate Governance
- Make sure assets used productively, mitigate conflicts of interest, ensure fairness btwn BOD,
managers, shareholders
- Risks: asset risk, liability risk, financial disclosure risk, strategic policy risk
EQUITY
Return concepts: Estimate required return:
MRP
ERP
Expanded CAPM: Req = RFR + (E(Rmkt) RFR) + Small Co. Premium + Co. Specific Risk
Premium
Fama French: market risk premium, small cap risk premium, value risk premium.
Rmarket RFR
Rsmall - Rbig
Rhigh book to value R low book to value
Pastor-Stambaugh model: adds liquidity factor to FF model
Chen-Ibbottson: ERP = (1+i)(1+REg)(1+PEg)-1+Y-RFR
Terms in order: inflation forecast, growth in real earnings, growth in market PE ratio, yield
on index
Yield on index=dividend and reinvestment income
g real earnings=GDP-inflation
Page 21 of 44
Less Malleable
Less Predictable
Adaptive quick and efficient to change
More Malleable
More Predictable
Classical- Plan for best market
position
Visionary- high risk, disruptive
V 0=
D0 (1+ g s)t
(1+r )t
D0 ( 1+ g s )n (1+ g L )
( 1+r )n (r g L )
The H-Model:
V 0=
D0 (1+ g L ) D0 H (g sg L ) D 0 ( 1+ g L ) + D 0 H (g sg L )
+
=
Growth rate declines linearly
(r g L )
(rg L )
(r g L )
D0
( 1+ g L ) + H ( gs g L ) ] + g L
r
P0 [
( )
forecast
financial
Page 22 of 44
PVGO = Stock price (earnings/required return)
Free Cash Flow
FCF Firm (FCFF) =
EBITDA(1-TaxRT) + Dep(taxRT)
FCInv - WCInv
CFO + Int(1-taxRT) - FCInv
1
Add back: preferred dividends to FCFF
Debt
[ FCinv + NWCinvdep ]
Assets
*easier to remember
deferred indefiniately, no
cash is leaving)
CF
Treatme
nt
Interest
Received
Interest Paid
Dividend
Received
Dividend
Paid
CFO
CFI
CFO
CFF
CFO
CFI
CFO
CFF
or
CFO
or
CFO
or
CFO
or
CFF
EBITDA not good proxy for FCFF and FCFE. EBITDA is looking at debt repayment strength, doesnt
consider WCInv, FCInv. Look at relationships in FCF and EBITDA derivation to see specifics.
Page 23 of 44
Market Comparables
EV = MV eq + MV Debt +minority interest + preferred shares cash & ST investments
(# preferred shares) x (Common Share Price)
Market Ratios
Leading
P 0 P0 1
D1 1 D1 / E1 (1b)
=
=
=
=
E1 1 E1 r g E 1 rg
r g
Trailing
P0 D 0 (1+g) / E 0 (1b)(1+ g)
=
=
E0
rg
r g
( )
D 0 r g
=
P0 1+ g
P
Price
=
BV Book Valueof Equity
Page 24 of 44
RI TO EQUITY HOLDERS
Residual Income = NI Equity charge
Equity charge = Req X BVequity
RI TO ALL CAPITAL HOLDERS
EVA
= [EBIT(1-TaxRate)] (WACC% X Total invested capital)
= NOPAT - $WACC
Residual income = After Tax Operating Profit Capital Charge
= (ROIC - WACC) x Total Capital(Assets)
Capital Charge
= Equity Charge + Debt Charge
= Req x BVequity + Rdebt x Debt Capital x (1-tax)
BVt = BVt-1 + earningst-1 Divdt-1
MVA
V 0=B0 +
Single Stage RI ,V 0 =B 0+
g=r
B 0 x (ROEr )
V 0B0
RI t
E r B t1
( ROEt r )Bt 1
=B0 + t
=B 0+
t
t
(1+r )
(1+r )
(1+ r)t
(ROEr)
B0 RI: residual income
r g
E:earnings
r:req rt
B:bookValue/share
if ROE > required return value > stock price & P/B justified > P/B
Tobins q = Market value of debt and equity / Replacement cost of total assets
Multi-State Residual Income Model
V0 = B0 + (PV of future RI over the short-term) + (PV of continuing RI earnings / re ; perpetuity)
(ROE tr) B t PT BT
V 0=B0 +
+
(1+ r)t
(1+r )T
Persistence factor () :
Strong persistence factor
persists forever
Weak persistence factor
V 0=B0 +
T =1
Et r Bt1
t
(1+r )
E T r BT 1
(1+ r)(1+ r)T 1
RI t
1+r
ROE declines to cost of equity over time due to competitive market, so RI goes to zero
RI appropriate when terminal value is uncertain and when clean surplus relationship holds
Page 25 of 44
Clean surplus relationship:
Ending BV = Beginning BV + net income dividends
Violated when currency translation g/l skips I/S go straight to equity
Total invested capital (TIC) = MV debt & equity (incl. cash & ST investments)
Unexpected Earnings Surprise = Actual EPS E(EPS)
Standardized unexpected earnings (SUE) = Earnings surprise (return-predicted)/ earnings surprise
earnings surprise is the scale by measure of the size of the historical errors or surprises
n
1/x i
1
wi /x i
included)
NOIforecast = trailing NOI non-cash rents + adj for full impact of acquisitions + growth in NOI
All risks yield = rent1/Value0 all risks yield is used when tenants are required to pay all expenses (NNN) and when growth in rents and value are
expected from property
( 1+ g )
0 ( 1+ g ST )
r g
Dividend Method=
+
t
( 1+r )
( 1+ r )T
t
of building)
FV = Sales Price Outstanding Loan
N = #yrs
Page 26 of 44
Cost approach for RE:
+ Land
+ Replacement cost of building = (replacement cost + developers profit)
x SqFtComp like Subject
Adj to make
+ Current cost to construct building (to current standards)
Property
- Physical deterioration = (effective age / economic life)
Sales Comp (inverse):
Curable Deterioration
Adj ratio for undesirable target
Incurable physical deterioration (depreciation charge) traits
t.depreciation
= (replacement cost curable deterioration) x (Effective age/t. economic life)
- Functional obsolescence (not intended for current use) = new cost/cap rt
- External obsolescence (locational, economical)
FFO = Accounting Net Earnings + Dep + Deferred Tax Charges + (-) losses (gains) from sales of
property and debt restructuring
*Continuing operating income
NOI
+ MV other assetsMV Liabilities
( A)FFO
Price
Price NAV
Cap Rt
x
multiple =
=
=NAVPS=
Share
Share Share
Shares
( A) FFO
NAV = NOI1/CapRt + Assets Liabilities (*no goodwill, no deferred taxes)
Adj NOI = NOInoncash rents+adj for impact of acquisitions + growth(1+g)
NAVPS = (NOI/CapRt + MV other assets MV Liabilities)
ROEC has more flexibility to invest and retain income
REIT has highest income yields and payout ratios, lower corporate taxes, distributions are divided by:
taxable income, capital gain, return of capital(more favorable)
Venture Capital
Future value of VC investment = (Initial investment) x (1 + IRR rate)Years
VC ownership =
Exit value = Investment cost + earnings growth + inc price multiples + reduction in debt
VC Ownership
( 1%VC
Ownership )
VC shares
foudners shares
founders owned
Page 27 of 44
PIC.
= capital called down
Distributed to PIC (DPI) = distributions / PIC ( LP capital called down) *cash-on-cash return
Residual value to paid in (RVPI) = NAV after distribution / PIC ( LP capital called down) *unrealized
return
Commodities:
F0 = S0 e(RFRc + U - Y )T
t
*continuously compounded
*discrete
FIXED INCOME
Structural models of corporate credit risk: looks at BS and option of A=L+E. Default risk is constant.
Doesnt change for business cycles or changing economic variables. Assumptions: B/S is simple with
only one class of zero-coupon bond, asset is actively traded on frictionless market, RFR is constant.
Reduced forms: impose assumptions on output of structural models. Perform better than structural
models because they impose assumptions on structural models Assumptions: Theres a 0 coupon
liability traded on the market, RFR is stochastic (random, not constant), default risk depends on the
economic conditions which depend on non-constant variables varies w/ business cycle.
Max amt bond holder wants to pay for insurance to remove credit risk = EL = ParDebt[1-e -LGD x (default
intensity) x (time to maturity)
]
Expected Loss = ParDebt x N(-e2) Asset x eE(return on assets) x time to maturity N(-e1)
PV(Expected Loss) = ParDebt x e- RFR x time to maturity N(-d2) Asset x N(-d1)
If PV(EL) > EL then risk premium dominates time value discount
Segmented mkts theory: yields on curve represent supply and demand. So yields dont reflect spot
rates or liquidity premiums.
Page 28 of 44
Preferred habitat: preferred maturities of investors, if premiums for other maturities are large enough
they will invest
Key Rate Calculations
For a given change in the yield curve, each rate is multiplied by the associated key rate duration. The
sum of those products gives the change in the value of the portfolio. If only the 5-year interest rate
changes, then the effect on the portfolio will be the product of that change times the 5-year key rate
duration. *remember when rates go up, Bond value goes down
Z-Spread: Zero volatility-spread is added to every treasury spot rate to make DCF of ABS, MBS equal
to its market price. There are multiple treasury spots, only 1 z-spread. Z-spread considers only 1 path
of interest rates: the current US treasury term structure. Not suitable for bonds with embedded
options b/c zero interest rate volatility options are meaningless
OAS: is added to each & every path in an interest rate tree. OAS is best used for embedded options
that are sensitive to changes in interest rate volatility (like MBS). OAS captures credit and liquidity
risk, removes option risk. You want bigger OAS relative to effective duration because it implies lower
price. OAS & ED should have positive linear relationship (eg. Lower OAS (return) for lower duration
(lower price sensitivity to interest rates) is acceptable trade off).
OAS > 0
OAS = 0
OAS < 0
*Cheap
Treasury Benchmark
Sector Benchmark
Rich if actual OAS < required OAS
Rich if actual OAS < required OAS
Cheap if actual OAS > required OAS
Cheap if actual OAS > required OAS
Rich
Rich
Rich
Rich
means the bond is undervalued, rich means the bond is over valued
Issuer-Specific
Cheap
Fairly Priced
Rich
Page 29 of 44
Effective Duration = (V- V+) / (2V0(y))
Effective Convexity = (V- + V+ 2V0) / (2V0(y)2)
Effective convexity computed using binomial model: the yield curve is shifted upward and downward
in parallel manner and binomial tree calculated each time. Resulting bond values are used to compute
effective convexity.
I spread: Risky bond yield swap rate for the same maturity
-represents credit and liquidity risk
TED spread: indicates commercial bank lending risk, perceived credit risk in economy
LIBOR treasury rate
LIBOR-OIS: Liquidity in money market securities
LIBOR(credit risk) OIS (overnight index swapfederal funds rate. Very little credit and
counterparty risk)
Low: high market liquidity
High: unwilling to lend because of concerns over credit and liquidity
Swap rate: liquid, flexible and efficient for hedging
Swap rate determination: EX find swap fixed rate for a three year interest rate swap
1) Spot1, Spot2 Spot3 are given
2) Find CouponRt3 this is the swap rate for 3 yr IRS
Convertible Bonds
CB limit downside risk due to price floor set by straight bond value and reduced upside potential due
to conversion premium of stock. *differentiate between par and market price, conversion ratio stays
the same regardless
Minimum market price of Convertible bond = Max (PV straight bond, Stock x conversion ratio)
CPR=6 x
seasoning PSA
( months
) 100
30 months
SMM = 1 (1 CPR)1/12
CPR = yrly, SMM = monthly. They are prepayments as % available from last month
Monthly servicing fee = (WAC passthrough rate)/ 12
For ABS auto loans:
||
1 [|x|(m1) ]
, WHERE: ABS = absolute prepayment speed (*confusing), m = # months since
SMM Autoloans =
origination
CDO types
Arbitrage driven CDO: take advantage of spread between the return on collateral and funding costs
Cash flow CDO: principal and interest payments can pay tranches
Market value/Balance Sheet CDO is actively managed to generate sufficient cash flows
Term structure:
Pure expectations: forward rates are unbiased predictor of future expected rates
Yield volatility:
Variance=
( x t x )
N 1
, xt =100 ln
yt
, y t = yield
y t 1
( )
OAS: binomial
Z-Spread
None: simple CF
model
Reasoning
Doesnt capture prepayment risk, it
captures inflation and interest rate risk
Bonds can either be put or call so
theres 2 ways a price can go
Interest rate path dependent because
prepayment option affects price (when
interest rates go lower, the bond is more
and more likely to be called)
Only one interest rate path, no
prepayment option. Value is PV of CFs
discounted @ spot rates + z-spread
ABS credit cards arent amortizing
because the pool constantly changes
Binomial Model
Forwards:
Forward price is determined at contract initiation. It is the price that makes the contract value
zero and depends on current interest rates through the cost-of-carry calculation
Forward price is fixed for the life of the contract so the contract may accumulate either a positive or negative value to
long or short as the forward price for new contracts changes over the life of the contract
Forward Contract
St
( )(
e
c ( tr )
Forward
e rc (tr )
(1+ R Dom )T
Forward Price=Spot 0
(1+ R For )T
T
, Spot
(1+ R USD)
T
(1+R EURO)
Value of Long=
Spot t
tr
(1+ R For )
][
Forward
(1+ R Dom )tr
][
Convert to continuously
If you think asset price will enter into a forward contract to buy asset (at lower price)
If you think asset price will enter into a forward contract to sell asset (at higher price)
Dividend and Coupon treatment Example
Time (days)
0 = Inception
Day 30, Divd1= $1.2
Maturity
Day 150
Where g is
the # of
days after
initiation
$ 1.2
$ 1.4
PV =
+
(30g)/ 365
(1+r )
(1+ r)(100 g)/365
FRA:
3 x 9 FRA: 6 (m) month libor rate, 3 (h) months from now
h = expiration in 90 days h+m m =9mo 3 mo = 180-Day LIBOR
0 (Today)
h=expiration
h+m
Buy FRA effectively long loan contract price Sell FRA effectively short loan contract price
IF Floating rate > contract rate
IF Contract rate > floating rate
Long borrows @ below market rt & gets paid Short loans @ below market rt & gets paid
FRA @ Initiation:
FRA=
( h+m
360 )
360
1 (
m )
h
1+ L ( h ) (
360 )
1+ L0 ( h+m )
0
FRA on day g:
Value of long=
1
hg
1+ L g ( hg )
360
( )
][
1+ Forward 0
1+ Lg ( h+mg )
( 360m )
mg
( h+360
)
360
expiry
360
1+[ Libor(date total ) ( of days until FRA expiration+ daysloan term /36
NP
Futures:
The value of a futures contract is zero when the account is marked-to-market and there is no margin call. The price of the
contract is adjusted to the new no-arbitrage value, which is theoretically the same as the settle price at the end of trading, as
long as price change limits have not been reached
Costs increase the price of a futures contract b/c buyer skips out on those costs by buying a
futures contract instead of the underlying asset. Which include: storage costs
Benefits decrease the price of a futures contract b/c the buyer skips out on those benefits by
buying a futures contract instead of the underlying asset. Which include: dividends, cash flows,
convenience yield
Contango: If costs of carry are greater than benefits then futures price are greater than the spot price
Backwardation: If costs of carry are less than benefits then future price is less than spot price
Normal contango: Futures price > Expected Future spot rate
Normal backwardation: Futures Price < Expected Future spot rate
Traders want normal backwardation because they can enter into contract to buy in future @ lower price
Convenience Yield:
If convenience yield> borrowing rate, futures price is below spot price and market is in
backwardation. It means that the value of the convenience of holding the asset is worth more
than the cost of funds to purchase it. The no-arbitrage cost-of-carry model will not apply. This
applies to non-financial futures contracts.
Futures vs forwards
Futures are marked-to-market forwards are not. Futures contracts trade on exchanges, no
counter party risk (margin requirements by clearing house). If mark to market is preferred then
futures price > forward price.
Zero
Negative
No preference
Prefer long in forwards contract to avoid mark to market. Gains from
adjustments are invested in lower level, while losses must be financed at a
higher cost
Value of futures contract = current futures price price when previously marked to market
Contracts marked-to-market, contract=0 @ end of trading day, contract only has value during
trading day.
Greek
AND
CREDIT
Call + [X Forward]/(1+r)T = P
Call Options
Put Options
Delta
( 1+r )d
C
(1+r )
up C
c=
++ down
Value of Call =
down=1 up
2
( down)( up )C C
(1+ r)2
+++( up)( down )C
( up)2 C
Value of 2 period call=
Put Options:
Everything is the same as above except calls replaced with puts for:
Put value up = P+ = Max[0, x- S+]
Put value down = P- = Max[0, x- S-]
+S=
+S=
S
C
+
C
delta call=
, will be positive
DeltaPut= DeltaCall-1
DeltaCall = DeltaPut+1
# options to hedge
shares underlying
Hedged Calls= be hedged
S
S
P
, will be negative
+
P
delta put =
deltacall
shares underlying
Hedged Puts= be hedged
deltaPuts
Option is
overpriced
Option is
underpriced
Portfolio Cost
Portfolio value
intrinsic
Profit
Hedge Ratio = H =
nS-C
Effect on option
intrinsic
N(d1) x S
Value , as stock
as stock
Put price [N(d1) -1] x S
t maturity. Effects
Range
Call
0 to 1
Close to 0
Put
-1 to 0
Close to 0
*the closer the delta is to 0 the more options are
required to hedge
Far In the
money
Close to 1
Close to -1
As price increases
Call Increase from 0 to 1
Put Increase from -1 to 0
Gamma: measures sensitivity of delta to changes in the price of underlying Gamma = delta/price
of underlying
Large (bad) when option is at money and close to expiration (more sensitive). Option value more
sensitive to changes in stock lead to large changes in delta and have frequent rebalancing of
dynamic hedges.
Small (good) when option is deep in or out the money (not sensitive) b/c changes in stock dont
affect . Dynamic hedge will perform well
Long
Periodic
Payment
cap
market
rate strike .
max
floor index
strike
rate.
max
Caplet Value
Floorlet Value
When interest
rates
Decrease
Increase
Increase
Decrease
Increase
Decrease
Decrease
Increase
of call on LIBOR
of call on bond
Increases
Decreases
of put on LIBOR
of put on bond
Decreases
Increases
Increases
Decreases
1
Fixed rate
c=
1Z n
=
Z 1 + Z2 + Z n
1
1+ R1
1
1+ R 4
[ ])
360
360
[ ] ) ( [ ] ) ( [ ]) ( [ ] )
+
90
360
1+ R2
180
360
1+ R3
270
360
1+ R 4
360
360
90 x period
1
z (n)=
1+ raten ( 360 )
Fixed Rate
Receiver
Profit
Mkt Rts
Loses
Mkt Rts
Floating Rate
Receiver
Mkt Rts
Mkt Rts
Equivalence
Long Interest Rate
Puts
Short interest rate
calls
Short Interest Rate
Puts
Long Interest Rate
Calls
Swap Value
Fixed payment amount = (fixed rate from above) x (360/period length) x (notional)
PV(fixed rate) = Z1(days until pymt 1) x (fixed pymt) + Z2(days until pymt 2)[fixed pymt +
notional]
*Uses new term structure
EX: originally pymts made annually, now 180 days have passed
PV ( rate ) =
1+ R180
180
360
( )
x [ payment ] +
1
1+ R1 80
540
360
( )
x [ payment +notional ]
PV(floating) uses only 1st floating payment and notional for calculation
= Z1(days until pymt 1) x [(Rate pymt 1)*(period length/360)*(notional) + notional]
Use new term structure for PV factor Use initiation original old term structure for floating pymt
EX : PV ( floating rate )=
1
1+ R 180
( 180
360 )
) [(
R0 ( 360 ) x
x notional )+notional
( 360
]
360 )
Equity Swaps:
Pay fixed, receive float: (1+ROE) x NP PV(remaining fixed rt payments)
Pay float, receive fixed: (1+ROE) x NP PV(coupon + par)
Swaption:
Payer swaption gives holder right to enter into a swap in the future as a fixed-rate payer
If swap fixed rates increase (as interest rates increase), the right to enter the pay-fixed
side of the swap (a payer swaption) becomes more valuable, when interest rates
increase bond prices fall and put options on the bond becomes more valuable.
Receiver Swaption gives holder the right to pay floating and receive fixed.
CDS:
Payout amount = (payout ratio) x (notional)
Payout ratio = 1 recovery rate
Bond spread = yield investors cost of fundingcompare w/ CDS spread
CDS asset swap spread = coupon interest rate on swap fixed
CDS spread < asset swap spread
CDS spreads are negatively related to probability of survival and recovery rate, and positively related
to probability of default and loss.
Cheapest to deliver same seniority (pari passu):
single name payoff = protection notional (par %) x (notional)
index payoff = proportional weighted notional (% of par after default) x (weighted notional)
new notional = total notional default payoff
physical settlement
Cash settlement
- Discounted/defaulted reference obligation
- Par-market value in cash
- Par value
CDS price (per $100 notional) = 100 upfront premium
Value protection leg
= credit risk, contingent payment that may be made from CDS seller to CDS
buyer in case of default
= value of RFR bond E(payoff risky bond)
Upfront payment = PV(protection leg) pv(premium leg)
If this is positive it means protection buyer must make payment to buyer b/c premiums are
artificially low
Upfront premium = [CDS spread CDS coupon] x duration
(paid by buyer)
Credit spread= upfront premium/duration + fixed coupon
Valuation after inception of CDS:
Profit for protection buyer (chance in spread %) x (duration)
CDS spread may differ from fixed coupon on CDS, so difference is paid PV(coupon-spread), Seller pays
buyer if +
Hazard rate = P(default|given it hasnt already occured)
Probability of survival =
(hazard rtt)
PORTFOLIO MANAGEMENT
Variance for 2 asset portfolio
Minimum
Variance Portfolio:
Correlation = = Cov(1,2)/1 2
Equally Weighted Portfolio Variance:
Portfolio STD of return
1
+
n
2p =Cov
Intercept and slope of CAL depend on varied investor expectations for future.
CAL EQN
Based on Graph
Borrow money at RFR and invest in risky
assets. Move on line A from bottom to top
(same risk, more return)
Lend money at RFR, earn same return but less
risk. Move on line B from right to left (same
return, less risk)
Similar
CML EQN ( CAL ) : E ( R A )=RFR +
E ( R M )RFR
A
M
Slope = market price of risk/reward
CML VS CAPM:
If markets are in equilibrium risk & return will lie on SML, not CML. Risk & return combos for
individual securities will lie below CML b/c their include unsystematic risk which can be diversified
away
SML
CML
Measure of
Uses (systematic, market, nonUses =stand alone risk = systematic +
risk
diversifiable)
unsystematic
Application
Determine benchmark appropriate
Asset allocation btwn RF asset and risky
returns
portfolio
Definition
Graph CAPM
Graph efficient frontier
ADJUSTED
Slope
Market risk premium
Market portfolio
sharpe BETA
ratio for stability, as
it tends to gravitate towards 1
Assets systematic risk:
Adj i= 0+ ii
OR adj 1=
1/3
+
2/3
i
where i = stock, M = market
is
historical.
Not necessarily
Market Model: estimate beta
good @ predicting future.
Called instability
Ri=i+iRM+i
Market Model:
1. E(Ri)= i+i(RM)
2. i2 = i 22Mi + 2
3. Covij= i j M2
4.
Cov ij
i j
bij =
*p is portfolio, b is benchmark
( RP RB )2
n1
Active Weight
( pb)(Residual risk asseti )2
Active Specific Risk=
Factors marginal contribution to active risk squared (FMCAR):
k
b j b i COV (F j , F i)
FMCAR j=
Exposure Factor**
R pR b
Active return
=
active risk
s(R p Rb )
indicates pure stock selection ability and manager performance, independent of aggressiveness
(aggressiveness included in residual risk)
add stocks with highest IR
Residual Risk:
Information ratio=
Residual return
(vs benchmark ) trade off between active return & active risk
residual risk
IR IC x Breadth
Optimal amount of residual risk= =
=
2
2
Nc
picks correct
1=2
1
N
total picks
( )
Residual return
(vs benchmark)
residualrisk
Risk Aversion Aversion
Information ratio=
IR IR IC x breadth
=
=
2
4
4
IC Combined =IC
2
(1+r =correlation)