CF0
CF1
CF0
ŵ
holding period return( HPR)=money-weighted return
?>CAJI??>CAJI?
.
IRR
CKGIHKG
time-weighted rate of return (R) are not influenced by the timing of cash flow unlike money-weighted return.
{ŵ-{{ŵ-ŵ{{ŵ-Ŷ{{ŵ-{ bank discount yield (BYD)
ŷźŴ.ŷźŴ
0 .00
holding period yield( HPY)
#.\"-##-#
.ŵ
\"\"
\"
# #
effective annual yield( EAY)
{ŵ-{
%'H.ŵ
money market yield( or CD equivalent yield)
ŷźŴ0.0
33
ŷźŴ.{0.0{
the HPY is the actual return received if the money market instrument is held until maturity the EAY is the annualized HPY on the basis on price of a 365-day year and incorporates the effects of compounding
the money market yield is the annualized yield that is based on the price and 360-day year and does not account for the effects of compounding-it assume the simple interest.
7
Descriptive statistics(
)
inferential statistics(
)
ParameterPopulation
Sample statistic(
)
Construct a frequency distribution
1. Define the interval 2. Tally the observations 3. Count the observations
For any frequency distribution, the interval with the greatest frequency is referred to as the modal interval (
)
Frequency polygon
Population mean(geometric mean(
)
Sample mean
arithmetic mean
)weighted mean
Harmonic mean
˨IJ˭JJ˩I˭˥IJ˧˥J˭˥ˮJ˩IIJ˩ˮ˨˭˥ˮ˩I˭˥IJ median(
)
mode
quantile
quartiles
quintile
decile
percentile
Ascending order
y% of all the observations are below that observation.
Quantiles and measures of central tendency are known collectively as measures of location.
p172
Mean absolute deviation (MAD) P173
ú
ú$
s
$
n
n-1
ú
$
biased estimator.
Chebyshev’s inequality
Relative dispersion
Coefficient of variation (CV)
In an investments setting, the CV is used to measure the risk(variability) per unit of expected return.
.@ 1.
risk-adjusted performance2.
Skewness(
)
Positive skewness
2˭˥ˤ˩IJ2˭Jˤ˥
Negative skewness
˭˥ˤ˩IJ˭Jˤ˥
Kurtosis
leptokurtic
mesokurtic (
)
plarykurtic
Excess kurtosis
8.
Exhaustive (
)
)
Two defining properties of probability(1. 2.
1
1.
Empirical
Priori Subjective
With multiplication rule of probability(
)
Addition rule of probability
Total probability rule (
)
X, Y
P(X | Y) = P(X).
Joint probability function(
)
=1
[P (RA1, RB1) +P (RA1, RB2) +P (RA1, RB3)]RA1+ [P (RA2, RB1) +P (RA2, RB2) +P (RA2, RB3)]RA1+ [P (RA3, RB1) +P (RA3, RB2) +P (RA3, RB3)]RA1=
p214
Bayer’s formula
Factorial(
)
combination(
)
permutation
counting problem
9
probability distribution(random variable
) discrete random variable
continuous
probability density function
cumulative distribution function
discrete uniform random variable
binomial random variable
tracking error is the difference between the total return on a portfolio and the total return on the benchmark against which its performance is measured.
normal distribution
90% 95%99%
1.65s 1.96s 2.58s
2s 4s 6s
68.26% 95.44% 99.74%
univariate distribution(
) multivariate distribution
point estimate
confidential intervals
lognormal distributionnormally distributed.
is generated by the function ˥, where x is
discretely compounded return (
)
==
monte carlo simulation(
)
10
simple random samplingsampling error
sampling distribution sample statistic
unbiasedness, efficiency, and consistency
student distribution
11
critical value(
)
decision rule for rejecting or failing to reject the null hypothesis is based on the distribution of the test statistic. the power of the test
statistical significance does not necessarily imply economic significance .
P value
hypothesis test concerning the equality of the population means of two at least approximately normally distributed populations, based on independent random samples 1. 2.
pooled
p315
The Chi-squared distribution is an asymmetric
distribution
0
F-test is asymmetric distribution
0
p322
Nonparametric tests are not concerned with parameters; they make minimal assumptions about the population from which a sample comes. It is important to distinguish between the test of the difference in the means and the test of the mean of the differences. Also, it is important to understand that parametric tests rely on distributional assumptions, whereas nonparametric tests are not as strict regarding distributional properties.
12
Line charts are the simplest technical analysis charts; they show closing prices for each period as a continuous line
Bar charts add the high and low prices for each trading period and often include the opening price.
Candlestick charts display opening and closing prices.
Point and figure charts are helpful in identifying changes in the direction of price movement.
Relative strength analysis, an analyst calculates the ratios of an asset’s closing price to benchmark values, such as a stock index or comparable asset.
Support level, buying is expected to emerge that prevents further price decreases. Resistance level, selling is expected to emerge that prevents further price increase
.Change in polarity
Reversal patterns occur when a trend approaches a range of prices but fails to continue beyond that range.
head-and-shoulders pattern, double top, triple top.
Bollinger bands are constructed based on the standard deviation of closing prices over the last n periods. Upper Bollinger band may be viewed as indicating an overbought market; lower Bollinger band may be viewed as indicating an oversold market.
Buy in lower Bollinger and sell in upper Bollinger is an example of contrarian strategy
Oscillators are another group of tolls technical analysis use to identify overbought and oversold market.
Rate of change oscillator, an ROC or momentum oscillator is calculated as 100 times the difference between the latest closing price and the closing price n periods earlier.
Relative strength index, an RSI is based o the ratio of total price increases to total price decrease over a selected number of periods.
Moving average convergence/divergence, MACD oscillators are drawn using exponentially smoothed moving averages, which place greater weight on more recent observations.
Stochastic oscillator is calculated from the latest closing price and highest and lowest prices reached in a recent period, such as 14 days.
The %K and %D lines refer to stochastic oscillators. The %K line is calculated based on the highest and lowest prices reached in a selected number of days, and the %D line is a moving average of the %K line. Used as trading signals, crossovers of the %K line above the %D line are buy signals and crossovers below the %D line are sell signals.
Increasing in total margin debt outstanding suggest aggressive buying by bullish margin
investors.
4 year presidential cycles, decennial patterns or 10 years cycles, and 54 year cycles or Kondratieff wave.
Elliott wave theory is based on a belief that financial market prices can be described by an interconnected set of cycles.
Fibonacci ratio use 0.618 and 1.618 usually.
13
price elasticity of demand measures the change in quantity demanded in response to a change in market price.
1. availability and closeness of substitute goods 2. the relative amount of income spent on the good 3. the time has passed since the price change of the good
cross elasticity of demand measures the change in the demand for a good in response to the change in price of a substitute
income elasticity measures the sensitivity of the quantity of a good or service demanded to a change in a consumer’s income.
inferior good normal good(necessities) luxury goods income elasticity Ŵ Ŵŵ 2ŵ
price elasticity of supply measures the responsiveness of the quantity supplied to changes in price.
1. the available substitutes for resources used to produce the good 2. the time that has elapsed since the price change
supply decision time frame includes momentary supply, short-term supply, and long-term supply.
14
allocated method
1. most goods and services are allocated by market price. 2. command system
3. majority rule (taxation) 4. personal characteristics.
efficient allocation of resources, so that the marginal benefit to society equals the marginal cost for the last unit of each good and service produced.
measurement of marginal benefit and cost 1. value to society with additional product 2. opportunity cost of production
the reduction in consumer and producer surplus due to underproduction or over production is called a deadweight loss.
the minimum supply price that producers must receive if they are to produce an additional
unit of output is the opportunity cost of producing that unit, i.e., the marginal cost. The marginal cost curve is the short-run supply curve for the good.
Producer surplus is determined by price and the MSC curve and consumer surplus is determined by price and the MSB curve.
obstacles to the efficient allocation of productive resources
price controls, taxes and trade restrictions, monopoly, external costs, external benefits, public goods and common resources public goods common resources less than the efficient quantity over-used fairness principle utilitarianism (
), symmetry principle (
)
15
in the labor market, the equilibrium price is called wage rate. statutory tax(
)
incidence of taxsubsidies
production quotas (
)
16
economic profit
1. explicit costs
2. implicit costs
normal profit implicit rental rate
economic depreciation forgone interest
constrained profit maximization 1. technological 2. information
3. market constraints technological efficiency(
input
) economic efficiency
1. command system(2. incentive system(
)
)-----principal agent problem
1. ownership 2. incentive pay
3. long-term contracts
proprietorship partnership money resource L M liability H M decision making speed H M tax once once
market concentration
1. four-firm concentration ratio (below 40% above 60%) 2. the Herfindahl-Hirschman index(HHI, 1800)
corporation H L L twice
firm coordination (
)
transaction costs, economies of scale,
economies of cope, economies of team production occur(team
)
17
the short run is defined as a time period for which quantities of some resources are fixed.
in the long run, a firm can adjust its input quantities, production methods, and plant size. marginal product of labor, the additional output from adding one unit of labor.
marginal revenue is the addition to total revenue from selling one more unit of output.
the marginal revenue product(MRP) is the addition to total revenue gained by selling the marginal product( additional output) from employing one more unit of a productive resource. law of diminishing return
diseconomies of scale may result as the increasing bureaucracy of larger firms lead to
inefficiency.
average fixed cost curve,
18
perfect competition 1. identical products
2. large number of independent firms
3. each seller is small relative to size of the total market 4. no barriers to entry or exit P=MR=MC=ATC(
)
2˓ˢ˕
the short-run supply curve for a firm is the MC line above the AVC.
in a situation referred to as external economies of scale, input prices fall because of the greater demand.
external diseconomies of scale,
19
when the average cost of production for a single firm is falling throughout the relevant range of consumer demand, we say that the industry is a natural monopoly.
monopolists are price searchers and have imperfect information regarding market demand
price discrimination(1. 2. 3.
)
one of loss of efficiency results from rent seeking when producers spend time and resources
to try to acquire or establish a monopoly
1. average cost pricing, ATC intersects the market demand curve(
) MC
2. marginal cost pricing, MC curve interests the market demand curve(
ATC
subsidy)
20
monopolistic competition(
,
)
1. a large number of independent sellers 2. differentiated products
3. firms compete on price, quality, and marketing. 4. low barriers
firms in monopolistic competition face downward-sloping demand curves( they are price searcher)
oligopoly
efficiency of monopolistic competition is unclear. consumers definitely benefit from brand name promotion and advertising because they receive information about the nature of a product.
1. product innovation is necessary activity 2. advertising expense are high
3. brand name provide information to consumer by providing them with signals about the
quality of branded products.
kinked demand curve model
kink
collusion
21
the MRP of labor determines the equilibrium wage rate, the highest price a firm will pay to hire an additional unit of labor. so the MRP curve is a firm’s short run demand curve for a productive resource. (
)
The returns to labor are relatively immediate, and can be compared with the overall wage cost
of the labor. The returns from the addition of capital occur over a span of years, so must be discounted back to today and evaluated as present values versus the cost of the capital. Substitution effect ( substitute A for B
A
Bfor
)
Income effect (
)
Collective bargainingMonopsony(
) refer to a situation where the buyer of a good or productive input has
market power.
Similar to the demand for labor, the demand for capital will be a downward-sloping curve derived from its MRP curve.
The quantity of a non-renewable natural resource that has already been discovered is called the known stock.
perfectly inelastic
perfectly elastic
In a price taker market, the MRP of an input is the marginal product of the input multiplied by the price of the output it generates. Economic rent
The difference between a factor of production’s earnings and opportunity cost is called economic rent,
1. 2.
22
Unemployment rate=number of employment/labor force
Labor force=all people who are either employed or actively seeking employment Labor force participation rate=labor/work age population
Work age population=labor +discouraged workers +others
Aggregate hours, the total number of hours worked in a year by all employed people Real wage rate are money wage rates adjusted for changes in the overall price level.
Real wage rate tend to fluctuate with the productivity of labor and are calculated using ratal labor compensation, which includes wages, salaries, and employer-paid benefits
)
Structural
Frictional (
CyclicalOutput
Qualified workers
Full employment
Not qualified
natural level
no cyclical unemployment
Natural rate of unemployment= frictional + structural
Potential GDP when unemployment at natural rate( no cyclical)
Consumer price index(CPI)
The three stages in calculating the CPI are: 1. Select the CPI basket.
2. Conduct a monthly price survey.
3. Calculate the CPI relative to the base period.
CPI
1%
23
Wealth effect
Substitution effect
Intertemporal effect
When interest rates increase, consumers spend less in the current period as they delay purchases until future periods. They substitute purchases later for purchases now (intertemporal substitution).
Marginal benefit is the benefit a consumer receives from consuming an additional unit of a good or service. It is quantified as the maximum price that a consumer is willing to pay for one additional unit of a good or service.
1. Classical economists
AD
AS
2. Keynesian
3. Monetarists
the central bank
should follow a policy of steady and predictable increases in the money supply.
24
1. Medium exchange or means of payment 2. Unit of account 3. Store of value Money supply M1 M2
Currency out of bank, traveler’s check, M1, time deposits, saving deposits, money checking account deposits of individuals and market mutual funds balance firms
The money supply schedule is vertical because it is not affected by changes in the interest rate but is determined by the monetary authorities such as the Federal Reserve System (Fed) in the United States. Depository institutions 1. Commercial banks
2. Thrifts and thrift institutions refer to savings bank, credit unions, and savings and loan
associations(S&Ls)
3. Money market mutual fund (investment bank)
1. Create liquidity
2. Financial intermediaries 3. Monitor risk
4. Pool the default risks
The goals of the U.S Federal Reserve are to manage the money supply 1. Keep low inflation
2. Promote economic froth and full employment
3. Reduce the magnitude of the expansions and recessions that make up business cycles
1.
2. Reserve requirement 3.
The monetary base includes Federal Reserve notes, coins and bank’s reserve deposits at the Fed.
Currency drain(
)
Money multiplier
Equation of exchange
00 0 MV=PY
The quantity theory of money states that an increase in the money supply will cause a proportional increase in prices.
Overall, financial innovation has reduced the demand for money below what it would have been if only the increase in real GDP was at work. The demand for money is determined, for the most part, by interest rates.
Buying bonds would drive bond prices up and interest rates down. Selling bonds would have the opposite effect; driving bond prices down and interest rates up. When interest rates are lower, there is an excess demand for money. The supply of money is determined by the monetary authorities.
25
Inflation is a persistent increase in the price level over time.
expected inflation
Business cycle is characterized by fluctuations in economic activity.
1. Contraction
2. Recessionary trough 3. Expansion 4. Business peak
Cost-push inflation typically results from a significant price increase in a production input that causes a decrease in short-run aggregate supply. Business cycle
1. The mainstream view is those business cycles are caused by the variability of aggregate
demand. Potential real GDP is believed to increase at a fairly stable rate over time.
2. Real business cycle theory emphasizes real economic variables. According to the theory,
due to improvements in technology, workers ‘productivity sometimes grows rapidly and sometimes more slowly, which leads to fluctuations in the growth rate of potential real GDP.
Anticipated inflation will have an adverse effect on an economy. It will decrease potential GDP and slow economic growth by diverting resources from productive activity to inflation avoidance. It increases transactions costs by making money function less well. Inflation has tax effects that distort real after-tax returns on investments. These effects reduce total investment and long-term real GDP growth.
Higher inflation results in increased demand for financial capital and decreased supply of financial capital. Both cause nominal interest rates to increase.
Millidge: Because businesses expect higher prices for their output in the future, they will expect a greater return on their investments and will increase their demand for financial capital, which will drive interest rates higher.
Forrest: Savers expect to pay higher prices for goods and services in the future, so they will be less willing to trade current consumption for future consumption and will therefore supply less financial capital, so interest rates increase.
26
Fiscal policy refers to the federal government’s use of spending and taxation to meet macroeconomic goals. Supply-side effects (Laffer curve
)
Source of financing investment
1. National savings
2. Borrowing from foreigners
3. Government savings
Crowing-out effect (
)
Ricardo-Barro effect refers to the fact that
The burden of these expenditures fill fall on taxpayers in the future. This is a generational imbalance.
Discretionary fiscal policy refers to the spending and taxing decision of a national government that is intended to stabilize the economy. (
Government expenditure multiplier balanced budget multiplier.
)
autonomous tax multiplier
1. Recognition delay
2. Administrative or law-making delay 3. Impact delay Automatic stabilizers (
)
1. Induced tax
2. Needs-tested spending
with given tax rates and expenditure policies, a rise in national income tends to produce a surplus, while a decline tends to result in a deficit.
The real risk-free rate is independent of changes in the growth of the money supply. Structural surplus or deficit would still exist if the economy were at full employment Cyclical surplus or deficit
27
The goal of the Fed is
1. Maximum employment 2. Stable prices
3. Moderate long-term interest rate.
The Fed focus on two things 1. Core inflation
2. The difference between actual and potential economic output ( output gap)
The primary way that the fed conducts monetary policy is through their influence on the federal funds rate
In determining how to adjust the federal funds rate, the Fed must decide between two types of rules
1. Instrument rules(output gap) 2. Targeting rules
taylor ruleis an instrument rule based on the rate of inflation and the
FFR
1. 2. 3. 4. McCallum rule
A rule targeting the rate of growth of money supply A rule targeting the exchange rate Inflation targeting
The primary drawback of targeting the growth rate of the money supply is that fluctuations in demand for money or the velocity of circulation result in interest rate swings and variability in the demand for goods and services.
29
Financial reporting refers to the way companies show their financial performance to
investors, creditors, and other interested parties by preparing and presenting financial statements.
The objective of financial statements, not analysis, is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.
The role of financial statement analysis, not reporting, is to use the information in a company’s financial statements, along with other relevant information, to assess a company’s past performance in order to draw conclusions about the company’s ability to generate cash and profits in the future.
The MD&A portion of the financial disclosure is required to discuss results of operations, capital resources and liquidity and a general business overview based on known trends. A discussion of expected effects of marketplace events may voluntarily be included by a firm, but is not required in the MD&A portion.
Financial statement analysis framework
1. State the objective and context. Determine what questions the analysis is meant to answer, the form in which it needs to be presented, and what resources and how much time are available to perform the analysis.
2. Gather data. Acquire the company’s financial statements and other relevant data on its industry and the economy. Ask questions of the company’s management, suppliers, and customers, and visit company sites.
3. Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios. Prepare exhibits such as graphs and common-size balance sheets.
4. Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports.
5. Report the conclusions or recommendations. Prepare a report and communicate it to its intended audience. Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations.
6. Update the analysis. Repeat these steps periodically and change the conclusions or recommendations when necessary.
30
Expanded accounting equation
31
Reporting standards ensure that the information is “useful to a wide range of users,” including security analysts, by making financial statements comparable to one another and narrowing the range within which management’s estimates can be seen as reasonable. Securities & Exchange Commission Form 8K addresses acquisitions, divestitures, etc. and not reporting standards.
SEC required filings
Form DEF-14A: When a company prepares a proxy statement for its shareholders prior to the annual meeting or other shareholder vote, it also files the statement with the SEC as Form DEF-14A.
Form 8-K: Companies must file this form to disclose material events including significant asset acquisitions and disposals, changes in management or corporate governance, or matters related to its accountants, financial statements, or the markets on which its securities trade.
Form 144: A company can issue securities to certain qualified buyers without registering the securities with the
SEC, but must notify the SEC that it intends to do so.
International Accounting Standard (IAS) No. 1 defines which financial statements are required and how they must be presented. The required financial statements are:
Balance sheet. Income statement. Cash flow statement.
Statement of changes in owners’ equity.
Explanatory notes, including a summary of accounting policies.
Disclosures of material events that affect the company are required by the Securities and
Exchange Commission (Form 8-K) for firms that are publicly traded in the United States.
Qualitative characteristics 1. Understandability 2. Comparability
3. Relevance (to be relevant, information should be timely and sufficiently detailed)
4. Reliability (Reliability refers to information that can be verified (measured accurately)
and has representational faithfulness (they are what they report to be) and neutrality (does not consider the economic impact of the reported information). (Faithful, neutrality, prudence, completeness)
Trade off between reliability and timeliness.
A coherent financial reporting framework is one that fits together logically. 1. Transparency
2. Comprehensiveness 3. Consistency
Barriers to creating a coherent financial reporting frame work 1. Valuation
2. Standard setting.
Companies that prepare financial statements under IFRS or U.S. GAAP must disclose their accounting policies and estimates in the footnotes and Management’s Discussion and Analysis. An analyst should use these disclosures to evaluate what policies are discussed, whether they cover all the relevant data in the financial statements, which policies required management to make estimates, and whether the disclosures have changed since the prior period.
A disclosure that is required for public companies is the likely impact of implementing recently issued accounting standards. Management can discuss the impact of adopting the standard, conclude that the standard does not apply or will not affect the financial statements materially, or state that they are still evaluating the effects of the new standards. Analysts should be aware of the uncertainty that this last statement implies.
32
The installment sales method recognizes sales and COGS in proportion to cash collections.
#
09
X=exercise price
S= spot price of stock
The treasury stock method assumes any funds received by the company from the exercise of the options are used to purchase shares (not sell shares) of the company’s common stock in the market at the average market price.
33
The asset provides future economic benefits as a result of past transactions.
The presentation formats of balance sheets vary by company. A classified balance sheet can be presented in a report format or an account format.
34
Changes in retained earnings are not included in the calculation of financing cash flows.
35
Sensitivity analysis develops a range of possible outcomes as specific inputs are changed one at a time. Sensitivity analysis is also known as “what-if” analysis. Scenario analysis is based on a specific set of outcomes for multiple variables. Computer generated analysis, based on developing probability distributions of key variables, is known as simulation(
) analysis.
36
LIFO allocates the most recent prices to the cost of goods sold and provides a better measure of current income. For balance sheet purposes, inventories based on FIFO are preferable since these values most closely resemble current cost and economic value.
37
IFRS requires firms to use component depreciation, which refers to depreciating the identifiable components of an asset separately. U.S. GAAP permits component depreciation but does not require it.
Capitalized interest costs are reported as CFI on the statement of cash flows, as they are treated as part of the cost of the constructed capital asset.
IFRS provides an alternative, the revaluation model, that permits long-lived assets to be reported at their fair values, as long as active market exist for the assets so their fair value can be reliably estimated.
Any increase in an asset’s value above historical cost is not reported as a gain in the income statement but report as revaluation surplus in shareholder’s equity.
38
Comparability decreases when the comparison period is relatively short (e.g. quarters vs. years), with the presence of volatility in the effective tax rate over the comparison period, and operations in different tax jurisdictions.
Income tax expense will be less than taxes payable because the firm can only recognize warranty expense as they occur. Thus, if the warranty expenses are overestimated on the financial statements income tax expense will be less than taxes payable. income statement
income statement pretax income tax expense
taxable income tax payable
tax base = cost-accumulated depreciation(
)
carrying value=cost-accumulated depreciation
income statement
Under U.S. GAAP, deferred tax assets and liabilities are classified as current or non-current according to the classification of the underlying asset or liability. Under IFRS, deferred tax assets and deferred tax liabilities are all classified as noncurrent, with footnote disclosure about the expected timing of reversals.
The analysis of the effective tax rate typically requires that the analyst, at a minimum, use the information in the management analysis and discussion (MD&A). Furthermore, it is recommended that the analyst seek additional information from the management if needed. Sporadic
items are not repeated and are difficult to predict. Therefore they will
complicate trend analysis and forecasting.
An impaired value write-down reduces net income for accounting purposes, but not for
tax purposes until the asset is sold or disposed of, so taxes payable do not decrease.
Valuation allowance. reduction of deferred tax assets based on the likelihood the assets will not be realized.
Income tax paid. The actual cash flow for income taxes including payments or refunds from other years.
tax loss carry forwards. A current or past loss that can be used to reduce taxable income in the future.
Post employment benefits, warranty expenses, and tax loss carry forwards are typical causes of deferred tax assets.
39
Interest revenues are calculated by multiplying the implicit interest rate by net receivables at the beginning of the period.
The classification of a lease as a finance lease creates an asset, a debt obligation, financing cash flows (amortization of the loan), and operating cash flows (interest expense).
If a firm redeems a bond before maturity for a price that is different from the carrying value of the bond liability, the firm will recognize the difference as a gain or a loss. At maturity, the carrying value of the bond liability is equal to the face value of the bond, therefore the firm does not experience a gain or loss by repaying the face value.
fair value
fair value
Cash payments due under an operating lease must be disclosed in the notes to the
financial statements for each of the following five years and in aggregate. Operating leases are simpler to account for and the often adverse ratio implications of offsetting increases in assets and liabilities are avoided.
A pension is a form of deferred compensation earned over time through employee service.
Defined contribution plan( Defined benefit plan
)
Only a defined benefit plan has a funded status that would appear on the balance sheet as an asset or liability. Employer payments into a defined contribution plan are recognized as expenses in the period incurred.
The present value of future obligation is known as the defined benefit obligation. For DB plan
Dupont equation
40
41
Financing accounts payable(
)
account payable is reclassified to short term debt, the decrease in accounts payable
decreases operating cash flow, and the increase in short-term debt increases financing cash flow. Ultimately, the firm has delayed the outflow of cash.
When receivables are securitized, they are usually transferred to a bankruptcy remote structure known as a special purpose entity (SPE).
When a firm’s stock options are exercised, shares must be issued, the higher the price relative to the exercise price, the more share needed.
The cash received from the exercise of the option and the outflow of cash from the share repurchase are both reported as financing activities in the cash flow statement.
42
Firms that have poor profitability are more likely to be non-dividend paying. Selecting only dividend paying stocks can serve as a check on poor profitability. Using positive ROE to control for poor performance can result in bogus results without additional filters. For
example, if both the numerator (net income) and the denominator (average equity) are negative, ROE will be positive. The higher the assets-to-equity ratio, the higher the leverage. Selecting only stocks with an assets-to-equity ratio below a certain cut-off point will eliminate stocks with high leverage. Debt-to-equity above a certain point would include firms with higher, not lower, financial leverage.
43
44
capital budget process evaluate the project where the cash flow to the firm will be received over a period longer than a year.
1. 2. 3. 4.
idea generation
analyzing project proposals
crate the firm-wide capital budget
monitoring decisions and conducting a post-audit.(post-audit should be used to identify systematic errors in the forecasting process and improve company operations)
1. decisions are based on cash flow
2. cash flows are based on opportunity costs
3. the timing of cash flows is important
4. cash flows are analyzed on the after-tax basis
5. financing costs are reflected in the project’s required rate of return
the drawbacks of the payback period are that it doesn’t take into account either time value of money or cash flows beyond the payback period.
NPV profiles
cost of capital NPV
crossover rate
NPV
IRR
1. NPV
2. IRR measures profitability as percentage, showing the return on each dollars. it also
provide the margin of the safety which NPV does not. 3. IRR
NPV
multiple IRR. IRR) NPV or IRR
American large public high
(unconventional cash flow
location
size of ht company public vs private
management education
IRR
payback period method European countries small private low
45
the wacc is the appropriate discount rate for projects that have approximately the same level of risk as the firm’s existing projects.
approximately the same level of risk WACC
below-average risk
discount rate less than WACC
greater risk
discount rate greater than WACC
project’s beta is a measure of its systematic or market risk
pure-play method begins with the beta of a company or group of companies that are purely engaged in a business similar to that of the project and are therefore comparable to the project. IRR
issuing new equity is more expensive than using retained earnings due to flotation costs, the bottom line is that raising additional capital results in a increase in the WACC. the marginal cost of capitalMCC has upward slope.
Adjusting the cost of equity for flotation costs is incorrect because doing so entails adjusting the present value of cash flows by a fixed percentage over the life of the project. In reality, flotation costs are a cash outflow that occurs at the initiation of a project. Therefore, the correct way to account for flotation costs is to adjust the cash flows in the computation of project NPV, not the cost of equity. The dollar amount of the flotation cost should be considered an additional cash outflow at initiation of the project.
46
Business risk refers to the risk associated with a firm’s operating income and is the result of uncertainty about a firm’s revenue and expenditure.
Firms with high operating leverage experience greater variance in operating income.
Operating leverage is the trade off between fixed and variable costs. Higher operating leverage typically is indicative of a firm with higher levels of risk (greater income variance). Given the positive risk/return relationship, higher operating leverage firms are expected to have a higher rate of return. And, lower operating leverage firms are expected to have a lower rate of return.
1
1
47
cash dividends
regular dividends
special dividends liquidating dividends
ex-dividends date
stock dividends
declaration date
holder of record date two business days later than ex-dividends date
payment date
dividends check mailed out
share repurchasing
1. buy in the open market
2. buy a fixed number of share a fixed price(
)
3. repurchase by direct negotiation
A share repurchase is equivalent to a cash dividend of an equal amount, so total shareholder wealth will be the same.
share repurchase using borrowed funds will increase EPS if the after-tax cost of debt used to buy back shares is less than the earning yield of the shares before the repurchase.
(BVPS(book value per share))
#
4{6{. BVPS=4-44
4
BV=book value
. 4
=
48
primary sources of liquidity secondary sources of liquidity
selling good and services, collecting liquidating short-term or long term assets, receivable, short-term investment negotiating debt agreements, or filing for
bankruptcy and reorganizing the company.
company’s liquidity position are called drags and pulls on liquidity.
the company must always evaluate the trade-off between stricter credit terms and the ability to make sales.
large sound company
short term funding from bank 1. 2. 3.
uncommitted line of credit committed line of credit
a revolving line of credit.(as long as a year) (
company with weaker credit firm export good
non bank short term funding issuing commercial paper
)
finance company
collateral for bank borrowing banker’s acceptance
factoring refers to the actual sale of receivables at a discount from their face value.
49
pro forma balance sheet( 1. 2.
) and pro forma income statement(
)
a%
a%
a%
a%
1. 2.
5
10
GDP
GDP
1. 2. 3.
(
leverage
)
To resolve this financial deficit(asset
equity+liability), the analyst can assume the
company issues new debt or stock or reduce its dividends payout ratio.
a financial surplus in the first iteration of a firm’s pro forma financial statements is most likely the result of an increase in retained earnings greater than the increase in assets.
50
cumulative voting, small group can serve its own interests through cumulative voting confidential voting can encourage unbiased voting
share blocking, a mechanism that prevents investors who wish to vote their shares from trading their shares during a prior to the annual meeting
51
investor individuals DB pensions banks endowments insurance mutual funds
risk tolerance depend on individual high low high low
depend on fund
investment horizon depend on individual long short long
long-life, short-P&C depend on fund
liquidity need depend on individual low high low high high
income needs depend on individual depend on age pay interest spending level low
depends on fund
property and casualty(P&C)
three major steps in portfolio management process
1. planning step. prepare investment policy statement( IPS) which should be updated every
few years and anytime the investor’s objectives or constraints change significantly. 2. execution step. top down analysis(
)
3. feedback step. the portfolio manager must monitor these changes and rebalance the
portfolio periodically in response, adjusting the allocations to various asset class back to their desired percentage.
open-end fund.( no-load funds do not charge additional fees for purchasing shares(up-front fees) or redeeming shares. load funds charge one or both. closed-end fund mutual funds
1. money market funds 2. bond mutual funds
3. stock mutual funds includes index funds( passively managed) and actively managed funds
other pooled investments
1. exchange-traded funds(ETFs) 2. separately managed accounts 3. hedge funds 4. buyout funds(
)
5. venture capital funds typically invest in company in their start-up phase(
)
industry analysis should precede company analysis.
Developing an investment strategy is based primarily on an analysis of the current and future financial market and economic conditions. Historical analysis serves to help develop an expectation for future conditions.
In the top-down valuation approach, the investor should analyze macroeconomic influences first, then industry influences, and then company influences.
The ratio of a portfolio’s standard deviation of return to the average standard deviation of the securities in the portfolio is known as the diversification ratio.
52
,
,
The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier. The efficient frontier shows the relationship that exists between
expected return and total risk in the absence of a risk-free asset.
When the return on an asset added to a portfolio has a correlation coefficient of less than one with the other portfolio asset returns but has the same risk, adding the asset will decrease the overall portfolio standard deviation. Any time the correlation coefficient is less than one, there are benefits from diversification. The other choices are true.
53
CAPM
1.MARKOWITZ
2.
3. /
4.
5. 6.
7.
8.
Abnormal return = Actual return – expected risk-adjusted return Abnormal return= risk-adjusted return
All portfolios on the capital market line are perfectly positively correlated.
required return SML
expected return
Capital market linemarket portfolio
risk-free
market portfolio
risky assets
market
54
The policy statement should state the performance standards by which the portfolio's performance will be judged and specify the benchmark that represents the investors risk preferences. IPS1. 2. 3.
introduction
IPS
statement of purpose
statement of duties and responsibilities
4. 5. 6.
procedures:
IPS
investment objective
investment constraints
7. 8. 9.
investment guideline
evaluation and review
(appendices)
Risk objective
1. Absolute risk objective
2. Relative risk objective
Security selection refers to deviations from index weights on individual securities within an asset class.
Risk budgeting sets an overall risk limit for the portfolio and budgets. And risk allocation (from tactical asset allocation and security selection.)
55
three main function of financial system
1. save and borrow money, raise equity capital, manage risk, trade assets currently or in the
future and utilizing the information. 2. determine the returns
3. allocate capital to its most efficient users
asset
financial asset real asset securities currencies contracts commodities real asset
securities
fixed income securities- debt securities short-term intermediate-term long-term 1-2 2-5 5- commercial paper(firm) note bond
company bond
commercial paper convertible debt
bank
certificates of deposit
state government
government bond note bills
equity securities includes common stock, preferred stock, warrants
pooled investment vehicles includes mutual fund, exchange-traded funds, asset-backed securities, and hedge funds.
contracts includes forward contracts, futures contracts, swap contract, option contracts, insurance contracts and credit defaults contracts
commodities which can be trade in spot, forward, and futures markets includes metal, industrial metals, agricultural products, energy products, and credits for carbon reduction.
real assets include real estate, equipment, and machinery. brokers block brokers investment banks exchanges alternative trading dealers securitizes depository systems(ATS) institutions insurance companies arbitrageurs clearing house
buy on margin
margin loan
call money rate
initial margin requirement,
maintenance margin
requirement
margin call
bid price
ask or offer price
bid-ask spread
dealer
bid-ask spread
make a market.
take a market
validity instructions execution instructions clearing instructions
market order instructs the broker to execute the trade immediately at the best possible price.
a limit order places a minimum execution price on sell orders and maximum execution price on buy orders.(
)
marketable or aggressively priced
making a new market
standing limit orders
make
market
behind the market
far from the market
hidden orders
display size
iceberg order
validity instructions
most of orders are day orders(immediate or cancel orders good-on-close order (
)
)
market-on-close
stop orders are those that are not executed unless the stop price has been met. stop buy order stop sell order
indications of interest
indications of interest
book building
book runner
accelerated book build underwritten offering
best efforts
private placement self registration
dividend reinvestment
rights offering
call market
continuous market
security market
quote-driven market(
) order-driven market
brokered market
quote drive market
dealer
dealer market, price drive market or OTC market.
order-driven market order matching rules(1. price priority
)
2. secondary precedence rules trading pricing rules1. 2.
uniform pricing rule
discriminatory pricing rule
Pre-trade transparent (get pre-trade information) post-trade transparent
Complete market fulfill
If a market can perform these functions at low costs
Proceeds from the short sale must remain in the brokerage account along with the required margin deposit.
underwriter is a company or other entity that administers the public issuance and distribution of securities from a corporation or other issuing body.
The underwriter provides the following services to the issuer:
1. Origination, which involves the design, planning, and registration of the issue.
2. Risk bearing, which means the underwriter, guarantees the price by purchasing the
securities.
3. Distribution, which is the sale of the issue.
Secondary markets are important because they provide liquidity and continuous information to investors. The liquidity of the secondary markets adds value to both the investor and firm because more investors are willing to buy issues in the primary market, when they know these issues will later become liquid in the secondary market. Therefore, the secondary market makes it easier for firms to raise external capital.
Prevailing market prices are determined by the transactions that take place on the secondary market. This information is used to determine the price of new issues sold on primary markets.
The short seller must pay any dividends on the stock to the owner of the borrowed shares. The short seller must also deposit margin money to guarantee the eventual repurchase of the security.
Continuous markets are markets where trades occur at any time the market is open (i.e. they do not need to be open 24 hours per day). Setting one negotiated price is a method used in major continuous markets to set the opening price.
In call markets, there is only one negotiated price set to clear the market for a given stock.
56
Price weighted index
need adjust for stock splits
The descriptions of value weighted and unweighted indexes are switched. The denominator of a price-weighted index must be adjusted to reflect stock splits and changes in the sample over time. A market value-weighted series assumes you make a proportionate market value investment in each company in the index.
Equal weighted index(simplicity, rebalancing) assume an equal dollar investment is made in each stock in the index.
Market capitalization-weighted index(Market float(Free float
) )
Fundamental weighting uses weights based on firm fundamentals, like earnings,
dividends, or cash flow.
Rebalancing refers to adjusting the weights of securities in a portfolio to their target weight after price changes have affected the weights.
Index reconstitution refers to periodically adding the deleting securities that make up an index
1. 2. 3. 4. 5. 1. 2. 3. 4.
Reflection of market sentiment
Benchmark of manager performance Measure of market return and risk
Measure of beta and risk-adjusted return Model portfolio for index funds
Equity market index Broad market index Multi-market index
Multi-market index with fundamental weighting Sector index
5. Style index(,
,
)
Fixed-income indexes
1. Large universe of securities.
2. Dealer markets and infrequent trading
Illiquidity, transactions costs, and high turnover of constituent securities make it both difficult and expensive for fixed income portfolio managers to replicate a fixed income index.
Other index includes commodity indexes, real estate indexes, and hedge fund indexes.
The most appropriate benchmark for measuring the relative performance of an investment manager is an index that closely matches the manager’s investment approach.
Rebalancing
equal weight index
The Dow Jones World Stock Index, the Russell Index, the S&P 500 Index, and Morgan Stanley Capital International Index are all market-value weighted. Only the Dow Jones Industrial Average and the Nikkei Dow Jones Stock Market Averages are price-weighted. The constituent securities of commodity price indexes are commodity futures contracts.
A price-weighted index needs to be adjusted for stock splits, but a market-cap weighted index does not. Neither type of index considers dividend income unless it is designed as a total return index.
Price weighting produces a downward bias compared to market weighting because firms that split their stocks (which tend to be the more successful firms) decrease in weight within a price-weighted index.
One reason why the creation of a bond index is more difficult than a stock index is due to the fact that the universe of bonds is constantly changing because of numerous new issues, bond maturities, calls, and bond sinking funds.
Bond prices are quite volatile as measured by the bond’s duration. There is a lack of continuous trade data available for bonds
57
An informationally efficient capital market is one in which the current price of a security fully, quickly, and rationally reflects all available information about that security. In a perfectly efficient market, the passive investment is more useful
index funds
abnormal profits
1. 2. 3. 4. Number of market participants Availability of information Impediments to trading
Transaction and information costs
Intrinsic value(
)
1. Weak-form market ( fully reflect all currently available historical security market data.)
2. Semi-strong form market ( fully reflect all (market or non market)publicly available
information)fundamental analysis
3. Strong-form market (fully reflect all information both public and private sources(market
or non market).)
The weak-form EMH assumes the price of a security reflects all currently available historical information. Thus, the past price and volume of trading has no relationship with the future, hence technical analysis is not useful in achieving superior returns.
The other statements are true. The strong-form EMH states that stock prices reflect all types of information: market, non-public market, and private. No group has monopolistic access to relevant information; thus no group can achieve excess returns. For these assumptions to hold the strong-form assumes perfect markets – information is free and
available to all.
Abnormal profit (or risk-adjusted returns) calculations are often used to test market efficiency. (
abnormal profits)
The limitation of the efficient market is the gains to be earned by information trading can
be less than the transaction costs the trading would entail. Processing new information entails costs and takes at least some time, so security prices are not always immediately affected.
Technical analysis seeks to earn abnormal profits by using historical price and volume data.
Fundamental analysis is based on public information such as earnings, dividends, and various accounting ratios and estimates
An anomaly is something that deviates from the common rule
Market anomaly is something that would lead us to reject the hypothesis of market efficiency.
The weak-form EMH assumes the price of a security reflects all currently available historical information.
The set of assumptions that imply an efficient capital market includes: 1. There exists a large number of profit-maximizing market participants. 2. New information occurs randomly.
3. Market participants adjust their price expectations rapidly (but not necessarily correctly). 4. Return expectations implicitly include risk.
If market prices are efficient there are no returns to the time and effort spent on fundamental analysis. But if no time and effort is spent on fundamental analysis there is no process for making market prices efficient. To resolve this apparent conundrum one can look to the time lag between the release of new value-relevant information and the adjustment of market prices to their new efficient levels. Processing new information entails costs and takes at least some time, which is a limitation of fully efficient markets.
58
Cumulative preference shares(
)
59
Industry rotation, which is overweighting or underweighting industries based on the current phase of the business cycle.
Classify company by firm’s principle business activity.
Classify company by their sensitivity to business cycles( cyclical, non-cyclical firm) Classify company by Statistical method
Pricing power of the firm in a industry is determined by the levels of capacity.
Sector level, industry and sub-industry.
Embryonic, growth, shakeout, mature, decline
Industry analysis provides a framework for an analyst to understand a firm in relation to its competitive environment, which determines how much pricing power a firm has. Competitive strategy and financial performance are aspects of company analysis.
60
Gordon Growth Model also known as the constant growth model.
Price multiple
Enterprise value = Equity value + debt − cash
price-to-sales (P/S)
1. P/S ratios are not as volatile as price-to-earnings (P/E) multiples.
2. Sales figures are not as easy to manipulate or distort as earnings per share (EPS) and book value.
3. P/S ratios do not express differences in cost structures across companies.
The P/S ratio is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for the P/E and P/BV ratios, which can be negative.
In the P/BV ratio book value is an appropriate measure of net asset value for firms that primarily hold liquid assets.(why) PBV ratios can be compared across similar firms if accounting standards are consistent
Analysts use several different definitions of cash flow (CFO, adjusted CFO, FCFE, EBITDA, etc.) to calculate P/CF ratios.
When earnings are negative, the P/E ratio is meaningless. The disadvantages of using PBV ratios are:
1. Book values are affected by accounting standards, which may vary across firms and countries.
2. Book value may not mean much for service firms without significant fixed costs.
3. Book value of equity can be made negative by a series of negative earnings, which limits the usefulness of the variable. P/E ratio
1. Earnings can be negative.
2. Research shows that P/E differences are significantly related to long-run average stock returns.
3. Earnings power is the primary determinant of investment value.
required return on equity
ROE
dividend
ŵ
˫.˞˛˗-
61
The contract specifies all the rights obligations of the issuer and the owners of a fixed income security are called the bond indenture.
Negative covenants (restrictions)
Affirmative covenants (maintenance of certain financial ratios and payment and interest)
Coupon rate structures 1. Zero coupon bonds
2. Set-up notes have coupon rate that increase over time at a specified rate.
3. Deferred-coupon bonds carry coupon, but the initial coupon payments are deferred for
some period.
Floating- rate securities
New coupon rate=reference +-quoted margin
An inverse floater is a floating-rate security with a coupon formula that actually increases the coupon rate when a reference interest rate decreases and vice versa.
Bond rate limit Up limit Cap
Lower limit Floor
Both collar
accrued interest
=full
price( dirty price)=clean price+accrued interest Coupon treasury bond
non-amortizing,
bullet bond or bullet maturity.
Amortizing securities make periodic interest and principal payment over the life of the bond Prepayment option gives the issuer the right to accelerate the principal repayment on a loan Nonrefundable bond
redeemed
refunded
Sinking fund provisions provide for the repayment of principal through a series of payment over the life of the issue
Accelerated sinking fund provision allows the issuer the choice of retiring more than the amount of bonds specified in the sinking fund requirement. Security owner options Issuer option Conversion option, put option, floor Call option, prepayment option, accelerated
sinking fund option, caps
Margin buying involves borrowing funds from a broker or a bank to purchase securities where the securities themselves are the collateral for the margin loan (
)
Repurchase agreement
This statement is accurate. When bonds are redeemed to comply with a sinking fund provision or because of a property sale mandated by government authority, the redemption prices (typically par value) are referred to as \"special redemption prices.\" When bonds are redeemed under the call provisions specified in the bond indenture, these are known as a regular redemptions and the call prices are referred to as \"regular redemption prices.\"
The accrued interest is paid by the new owner of the bond to the seller of the bond. If the buyer must pay the seller accrued interest, the bond is said to be trading cum-coupon. Otherwise, it is trading ex-coupon.61C
62
Call option in bond,
Yield curve risk, the interest rate risk of a portfolio of bonds that is not captured by the duration measure. To estimate the impact of non-parallel shifts, bond portfolio managers calculate key rate durations, which measure the sensitivity of the portfolio’s value to change in yields for specific maturities.
Credit spread
Yield on a risky bond= yield on a default-free bond + credit spread
Event risk (
)
Bonds with larger coupons have a smaller duration, all other things the same. A zero coupon bond has an effective duration equal to its maturity. Duration measures the approximate change in price given a change in interest rates. Therefore, the duration of the bond does not change with the yield to maturity of the bond.
Portfolio managers are very interested in a bond’s sensitivity to changes in interest rates. Bonds can be different in terms of maturity and coupon level, while both characteristics impact the change in the bond’s price given changes in interest rates. Duration is a measure that can assesses the time element of bonds in terms of both coupon and term to maturity.
It enables direct comparisons between bond issues with different levels of risk
Portfolio duration is a measure of a portfolio’s interest rate risk. It measures the
sensitivity of the portfolio’s value to an equal change in yield for all the bonds in the portfolio. It can be calculated as the weighted average of the individual bond durations using the proportions of the total portfolio value represented by each of the bonds. Portfolio duration does not capture the effect of changes in the yield curve (term structure of interest rate).
.
63
Regular cycle auction –single price, regular cycle auction-multiple price, ad hoc auction system, tap system
Treasury security
1. Treasury bills(T-bills) less than one year 2. Treasury notes and treasury bonds
3. Treasury inflation-protected securities( TIPS)
on the run issues and off the run issues(Stripped treasuries or treasury strips
1. Coupon strips 2. Principal strips
)
Strips are taxed by the IRS on their implicit interest.
Agency bonds are debt securities issued by various agencies and organizations of the U.S government.
1. Federally related institutions
2. Government sponsored enterprise (GSEs)
Debentures are securities that are not backed by collateral (they are unsecured).
Federally related institutions
Government national mortgage association Tennessee valley authority(TVA)
Government sponsored enterprise Federal farm credit system Federal home loan bank system Federal national mortgage association
Mortgage-backed securities (MBSs) are backed by pools of mortgage loans, which not only provide collateral but also the cash flows to service the debt.
Mortgage passthrough security passes the payments made on the pool of mortgages through proportionally to each security holder.
Collateralized mortgage obligations(CMOs) are create from mortgage passthorugh certificates and referred to as derivative mortgage-backed securities, since theay are derived from a simpler MBS structure. (
)
Stripped mortgage-backed securities are either the principal or interest portions of a mortgage passthrough security.
The motivation for creating CMOs is to redistribute the prepayment risk inherent in mortgage passthourgh securities and/or create securities with various maturity ranges.
Municipal bonds are issued by sates, countries, cities and other political subdivisions. These bonds are often issued as serial bonds, that is, a larger issue is divided into a series of smaller issues, each with its own maturity date and coupon rate. Tax exempt, Taxable
Limited tax GO (general obligation), unlimited GO, double barreled bonds, appropriation-backed obligations.(moral obligation bonds)
Insured bonds carry guarantee of a third party that all principal and interest payments will be make in a timely manner.
Prerefunded bonds are bonds for which treasury securities have been purchased and placed in a special escrow account in an amount sufficient to make all the remaining required bond payments.
Secured debt
unsecured debts
Credit enhancements are guarantees of others that the corporate debt obligation will be paid in a timely manner.
Corporate bond issues 1. Are sold all at once
2. Are sold on a firm-commitment basis whereby an underwriting syndicate guarantees the
sale of the whole issue
3. Consist of bonds with a single coupon rate and maturity.
Medium-term notes (MTNs) are registered under SEC rule 415
Structured note is a debt security created when the issuer combines a typical bond or note with a derivative
Commercial paper includes directly-placed paper(paper.
Certificates of deposit (CDs) customer.
)and dealer-placed
are issued by banks and sold to the
Negotiable CDs permit the owner to sell the CD in the secondary market at any time. Bankers acceptances(
) are essentially guarantees by a bank that a loan
will be repaid. Used especially in international trade.
Asset-backed securities (ABSs)
A special purpose vehicle or special purpose corporation is a separate legal entity to which a corporation transfers the financial assets for an ABS issue.(reduce borrowing cost) External credit enhancement 1. Corporate guarantees, 2. Letter of credit 3. Bond insurance
Collateralized debt obligation (CDO) is a debt instrument where the collateral for the promise to pay is an underlying pool of other debt obligations and even other CDOs
primary market and secondary market
When the investment banker actually purchases the entire issue and resells it, they are said to have “underwritten(
)” the issue. This arrangement is termed a firm commitment
while the deal is termed a bought deal
Another way is
best efforts basis.
Negotiated offering(
) and auction process
When a new issue of debt securities is not registered for sale to the public, it still may be
sold to a small number of investors, this is called a private placement or rule 144A offer. T-notes are coupon-bearing instruments. TIPS pay a fixed coupon rate on a par value that is adjusted for inflation.
While most mortgage-backed securities pay three types of cash flows, only mortgage passthroughs and collateralized mortgage obligations (CMOs) are formed by pooling mortgages. Only CMOs divide investors into tranches with different cash flows and risk profiles. Debentures are securities not backed by collateral.
Yield curve(
maturity
yield)
Term structure of interest (
)
1. Pure expectations theory states that the yield for a particular maturity is an average (not a
simple average) of the short-term rates that are expected in the future.
2. Liquidity preference theory believes that, in addition to expectations about future
short-term rates, investors require a risk premium for holding longer term bonds.
3. The market segmentation theory is based on the idea that investors and borrowers have
preference for different maturity ranges. There is no specific linkage among the yields at different maturities. Yield spread measures 1. Absolute yield spread IIJJˬ˯ˮ˥˳˩˥ˬˤJJJ˥Iˤ
˳˩˥ˬˤJJˮ˨˥˨˩˧˨˥J˳˩˥ˬˤIJJˤ.˳˩˥ˬˤJJˮ˨˥ˬJ˱˥J˳˩˥ˬˤIJJˤ
2. Relative yield spread
IIJJˬ˯ˮ˥˳˩˥ˬˤJJJ˥Iˤ
J˥ˬIˮ˩˰˥˳˩˥ˬˤJJJ˥Iˤ
˳˩˥ˬˤJJˮ˨˥I˥JI˨˭IJ˫IJJˤ
3. Yield ratio
J˯I˪˥IˮIJJˤ˳˩˥ˬˤ
˳˩˥ˬˤJIˮ˩J
I˥JI˨˭IJ˫IJJˤ˳˩˥ˬˤ
Credit (or quality) spread is the difference in yields between two issues that are similar in all respects except for credit rating.
1. Bonds that have less liquidity have higher spreads to treasuries 2. Larger issues normally have greater liquidity
3. Greater size have lower yield spread
I˦ˮ˥JˮI˲˳˩˥ˬˤˮI˲IIˬ˥˳˩˥ˬˤ0{ŵ.˭IJ˧˩JIˬˮI˲JIˮ˥{
ˮI˲˦J˥˥˳˩˥ˬˤ
ˮI˲IIˬ˥˥˯J˩˰Iˬ˥ˮJ˳˩˥ˬˤ
ŵ.˭IJ˧˩JIˬˮI˲JIˮ˥
credit spread
Yield curve
65
With the arbitrage-free valuation approach, we discount each cash flow using a discount rate that is specific to the maturity of each cash flow.
required rate of return is the YTM
For valuing non-Treasury securities, a credit spread is added to each treasury spot yields. The credit spread is a function of default risk and the term to maturity. (
?)
66
relationship
Par IJ˯JJJJIˮ˥I˯JJ˥Jˮ˳˩˥ˬˤ˳˩˥ˬˤˮJ˭Iˮ˯J˩ˮ˳ Discount IJ˯JJJJIˮ˥I˯JJ˥Jˮ˳˩˥ˬˤ˳˩˥ˬˤˮJ˭Iˮ˯J˩ˮ˳ premium IJ˯JJJJIˮ˥2I˯JJ˥Jˮ˳˩˥ˬˤ2˳˩˥ˬˤˮJ˭Iˮ˯J˩ˮ˳ Yield to call, yield to put, yield to worst, yield to refunding.
Cash flow yield (CFY) is used for mortgage-backed securities and other amortizing asset-backed securities that have monthly cash flows.
IJJˤ˥J˯˩˰Iˬ˥Jˮ˳˩˥ˬˤ{{ŵ-˭JJˮ˨ˬ˳˕˘I{.ŵ{0Ŷ
The theoretical treasury spot rate curve by a process called bootstrapping Zero-volatility spread
The zero volatility spread (Z-spread) is the interest rate that is added to each zero-coupon bond spot rate that will cause the present value of the risky bond's cash flows to equal its market value. The nominal spread is the spread that is added to the YTM of a similar maturity Treasury bond that will then equal the YTM of the risky bond. The zero volatility spread (Z-spread) is the spread that results when the cost of the call option in percent is added to the option adjusted spread.
Any complex debt instruments (like callable bonds, putable bonds, and mortgage-backed securities) can be viewed as the sum of the present value of its individual cash flows where each of those cash flows are discounted at the appropriate zero-coupon bond spot rate. It should be noted that while the appropriate spot interest rate can be used to discount each cash flow, determining the actual pattern of cash flows is uncertain due to the possibility of the bond being called away.
Any complex debt instruments (like callable bonds, putable bonds, and mortgage-backed securities) can be viewed as the sum of the present value of its individual cash flows where each of those cash flows are discounted at the appropriate zero-coupon bond spot rate. It should be noted that while the appropriate spot interest rate can be used to discount each cash flow, determining the actual pattern of cash flows is uncertain due to the possibility of the bond being called away.
Spot interest rates are the result of market participant’s tolerance for risk and their collective view regarding the future path of interest rates. If we assume that these results are purely a function of expectations, we can use spot rates to estimate the market’s consensus on forward interest rates.
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Effective duration
Modified duration assumes that the cash flows on the bond will not change (i.e., that we are dealing with non-callable bonds). This greatly differs from effective duration, which considers expected changes in cash flows that may occur for bonds with embedded options. There are three features that determine the magnitude of the bond price volatility: 1. The lower the coupon, the greater the bond price volatility. 2. The longer the term to maturity, the greater the price volatility. 3. The lower the initial yield, the greater the price volatility.
According to these three features the greatest price change will come from the bond with a low coupon and long maturity.
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Exchange-traded derivatives are standardized and backed by a clearinghouse. A dealer market with no central location is referred to as an over the counter market.
A forward commitment is a legally binding promise to promise to perform some action in the future.
A contingent claim is a claim that depends on a particular event. Options are contingent claims that depend on a stock price at some future date. A swap is a series of forward contracts.
Financial derivatives increase the opportunities to either speculate or hedge on the value
of underlying assets. This adds to market completeness by increasing the range of identifiable payoffs that can be used by traders to fulfill their needs. Financial derivatives such as market index futures can also be easier and cheaper than trading in a diversified portfolio, thereby adding to the opportunities available to traders.
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Default risk (or counterparty risk) Cash settlement
Terminating a position prior to expiration 1.
2. Entering the second (offsetting) contract with the same party as the original contract.(
)
Equity forward contracts where the underlying asset is a single stock, a portfolio of stock,
or a stock index, work in much the same manner as other forward contracts. A forward contract on a stock index will be a cash-settlement contract
Dividends are usually not included in equity forward contracts, as the uncertainty about dividend amounts and payments dates is small compared to the uncertainty about future equity prices.
Eurodollar deposit is the term of deposits in large banks outside the United States denominated in U.S dollars. LIBOR is an add-on rate.
Euribor is similar to LIBOR (
)
A forward rate agreement (FRA) can be viewed as a forward contract to borrow/lend money at a certain rate at some future date. In practice, these contracts settle in cash, but no actual loan is made at the settlement date.
The long position in an FRA is the party that would borrow the money Settlement date(
)
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Initial margin is the money that must be deposited in a futures account before any trading
takes place.
Maintenance margin is the amount of margin that must be maintained in a futures account
Variation margin is the funds that must be deposited into the account to bring it back to the initial margin amount
The settlement price is analogous to the closing price for a stock but is not simply the
price of the last trade. (
)
Price limits are exchange-imposed limits on how much the contract price chan change from the previous day’s settlement price.
Limit move, limit up, limit down. Locked limit (so trades can take place and traders are locked into their existing positions
In a cash-settlement contract, delivery is not an option.
You may make a reverse, or offsetting, trade in the futures market.
The short in a Treasury bond futures contracts has the option to deliver any of several bonds that will satisfy the delivery terms of the contract. One particular treasury bond will be the cheapest to deliver bond
Each bond is given a conversion factor, which is used to adjust the long’s payment at delivery so that the more valuable bonds receive a higher payment.
The clearinghouse does not originate trades, it acts as the opposite party to all trades. In
other words, it is the buyer to every seller and the seller to every buyer. This action guarantees that all obligations under the terms of the contract will be fulfilled.
,
.
,
,
.
An exchange-for-physicals involves an agreement between long and short contract holders to settle their respective obligations by delivery and purchase of an asset. It is executed off the floor of the exchange and reported to exchange officials who then cancel both positions.
Most futures positions are closed out by an offsetting trade at some point during life of the contract.
current future price.
.
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Exchange-traded or listed options are regulated, standardize, liquid and backed by the options clearing corporation for Chicago board options exchange transactions. Exchange-listed option
long-term equity anticipatory securities (LEAPS)
OTC options is largely unregulated, consists of custom options, involves counterparty risk, and is facilitated by dealers in much the same way forwards market are.
Financial options include equity options and other options based on stock indices.
Interest rate options are similar to the stock options except that the exercise price is an interest rate and the underlying asset is a reference rate such as LIBOR. An interest rate cap is a series of interest rate call options An interest rate floor is a series of interest rate put options An interest rate collar combines a cap and a floor.
The correct adjustment is to subtract the present value of the expected dividend payments from the current stock price.
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Swaps are agreements to exchange a series of cash flow on periodic settlement dates over a certain time period. The two payments are netted so that only one payment is made. The length of the swap is termed the tenor of the swap and the contract ends on the termination date
Terminate the swap 1. Mutual termination 2. Offsetting contract 3. Resale
4. Swaption, an option to enter into a swap
The plain vanilla interest rate swap involves trading fixed interest rate payment for floating-rate payments.
A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments
In an equity swap, the return on a stock, a portfolio, or a stock index is paid each period by one party in return for a fixed-rate or floating-rate payment.
The futures market uses a standardized contract, which increases the liquidity of the contract. Also, futures exchanges assume the credit risk. However, as the time horizon increases, the liquidity of futures contracts decreases substantially. Therefore, swaps are considered a better method of hedging over long time horizons.
The original notional principal amounts are exchanged at contract termination; there is no adjustment to the amounts for the change in exchange rates over the life of the swap.
In effect, in a currency swap, the two parties make independent borrowings and then exchange the proceeds. This is known as an exchange of borrowings. A swaption is an option on a swap that can be either American or European in form.
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Managers utilize estimates to report the market value and performance of their hedge funds. Using estimates rather than actual market transactions may result in smoothed pricing, thereby reducing reported volatility.
A typical distressed security investment strategy is to invest in the debt of a company, continue to hold the position throughout the bankruptcy negotiations, and ultimately end up with equity in the new, revitalized operation.
Stable value funds seek both timely principal payments and steady interest rates, but tend to invest in short-term securities with regular principal payments. Global funds frequently contain stocks from the investment manager’s home country. Index funds are designed to track a certain index, and fees are typically lower than those of actively managed funds. Because different industry sectors have different growth characteristics, some sector funds’ targets will of necessity diverge from the broader market.
Real estate co-operatives are generally a tool with which multiple owners can purchase shares in a single building or complex.
Commingled funds, limited partnerships and estate investment trusts (REITs) typically allow investors to spread their bets either geographically or through different property types.(real estate)
Appraised Price = net operating income/market cap rate=NOI / CAP
Valuation of venture capital investments is difficult because of the uniqueness of each project in addition to a lack of historical risk and return data. Venture capital investors generally do not know what other competing projects or ideas may hamper their success. Market entrance and exit strategies are critical to the success of a venture capital project. Venture capital investors know upfront they are investing in an illiquid asset with a long time horizon.
Shares of a closed-end investment company are determined in the secondary market and may or may not equal NAV. Share value of an open-end investment company always equals NAV because the investment company stands ready to redeem shares at their net asset value.
The total return on collateralized commodity futures is the sum of the increase in the futures price and the interest on the T-bills used to collateralize the futures position.
Property insurance is not considered a category of real estate investment because the underlying real estate does not revert to the insurer if the property holder allows the policy to lapse.
Mortgages are considered to be a form of real estate investment because if the borrower defaults on the loan, the lender may end up owning the property
The income method does not consider the investment’s income-tax implications. However, it does use a discounted cash flow model based on net operating income. The income method does not account for potential changes in operating income.
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Commodity index strategies require managers to frequently adjust their positions due to the need to roll over expiring commodity contracts, reweight components due to index rebalancing, and roll over collateral debt securities. Managers who correctly time these activities can add additional return.
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