CFA L2 excl. Ethics

when considering a merger, antitrust action is likely to come from the government of the (acquirer's / target's) country

antitrust action is likely to come from governments of *both* the acquirer and the target

all else equal, a company operating in a country with higher inflation will have a (lower / higher) P/E multiple

higher inflation --> lower P/E multiple

types of algorithms for trading

(1) *execution* algorithms: break down large orders and execute them over a period of time (2) *high-frequency* algorithms: profit seeking vs. cost minimization

an appraiser who wishes to value an unusual property is most likely to use...

the cost approach unless the property architecture cannot be replicated, in which case income approach is used

cash and carry arbitrage

long position in an asset together with a short position in the corresponding futures contract

bull call spread

long call + short call

what types of bonds are used to create the par curve?

on-the-run government paying coupon bonds

earnings yield

-earnings yield = E/P -handles problem of negative earnings. -high earnings yield --> suggests undervalued

Gordon Growth Model

E(R) = D1/P0 + g ERP = E(R) - RFR = Y + g - RFR W = forward-looking estimates change through time; assumes a stable g

annualizing expected return and standard deviation

E(Rp_daily) = E(Rp_annual)/250 sd(Rp_daily) = sd(Rp_annual)/√250

information coefficient

IC = 2 * % of bets that are correct - 1

linear regression assumptions

LR-VUNE

methods to detect presence of and correct for serial correlation

Methods to detect presence: (1) residual plots (2) Durbin-Watson statistic Methods to correct: (1) adjust the coefficient standard errors using the Hansen method (which also corrects for conditional heteroskedasticity) (2) improve specification of the model, typically by incorporating the time-series nature of the data (e.g., including a seasonal term)

OAS

OAS + option cost = Z-spread

central bank intervention on exchange rates

Objectives: - prevent excess appreciation of domestic currency - pursue independent monetary policies - reduce excessive capital inflows Effectiveness of: - intervention in FX markets depends on the size of the central bank reserves relative to trading volume of their currency; usually not effective for developed countries - capital controls depends on the size and persistence of capital controls

ROIC vs. ROCE

ROIC: NOPAT / (operating assets - operating liabilities) ROCE: pre-tax operating earnings / (assets - non-bearing liabilities) or can use (debt + equity) as denominator

active return

R_A,i = Δw_i * (R_x,i - R_B)

TPI

Total paid-in capital = + Distributions of Paid-in Capital + Residual Value of Paid-in Capital

standard for considering an economy to be hyper-inflationary

US GAAP: 3 year cumulative inflation exceeds 100%

geographical differences in perception of dividend changes

US: small changes in dividends --> send a major signal about company's future prospects Japan: large changes in dividends --> less likely to send a signal if at all

an underwriting loss is indicated by...

a combined ratio greater than 1

foreign exchange risks are due to exposure in a company's...

assets liabilities future sales

equity multiplier

assets / equity

According to pecking order theory, which financing choice is most likely to signal management's confidence in future prospects?

debt financing, because commitments to fixed payments may be interpreted as management having confidence in the company's ability to make future payments

poor quality reports tend to...

either overstate or understate results

curation

making adjustments to data to ensure its quality

in investments, objectives chiefly pertain to...

objectives: 1. return 2. risk constraints are separate

delta of at-the-money call option

0.5

where in the P&L are inventory write-downs accounted for?

COGS

CAMELS

Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk

components of periodic pension expense (IFRS, GAAP)

IFRS: +current service cost +past service cost +net interest expense/(income) GAAP: +current service cost +interest cost -expected return on plan assets +amortization of past service costs and actuarial losses/(gains)

balance sheet modeling

Many balance sheet items flow from income statement forecasts. - Inventory = f(COGS) - Acct Rec = f(Sales) = DSO x Sales/365 - Net PPE = beginning balance + capex - acc depreciation - Capex can be based on a relationship with sales or based on company-specific information; can be separated into maintenance or growth

appraisal-based vs. transaction-based indexes

appraisal-based index will have less volatility and will lag a transaction-based index, resulting in less correlation with other asset classes

an (appreciating / depreciating) currency has the largest impact on parent company's financials

appreciating

pension funds and endowment funds (are / are not) taxable

are NOT taxable

restructuring costs (business combinations)

expensed when incurred under both IFRS and GAAP

two-stage FCFE model is suitable for __________

firms with significant barriers to entry

relationship between uncertainty of inflation and term spread

longer-term bonds typically have more inflation uncertainty

credit default swap

form of insurance credit protection buyer (i.e., short the credit risk) pays credit premium spread to credit protection seller (i.e., long the credit risk) standardized rates are 1% for investment-grade, 5% for high-yield, with PV of difference between standardized and actual credit spreads is paid upfront by one of the parties unofficial governing body is ISDA: International Swaps and Derivatives Association single-name: credit event occurs when reference entity defaults on any issue that is ranked pari passu with reference obligation and payoff is based on cheapest-to-deliver index: protection for each issue in the index is equal and total notional amount is reduced by the notional amount attributable to an entity which defaults credit event declared by ISDA by supermajority vote (i.e,. 12+ members)

relative performance of government, investment grade, and high yield bonds when credit spreads are widening

government bonds will outperform investment grade bonds, which will outperform high yield bonds

effective duration represents the sensitivity of a bond's price to parallel shifts in what curve?

government par curve

callable bonds are most common for which type of issuer?

government-entities (e.g., munis) high-yield corporate issuers NOT common for investment grade corporate issuers

growth rate of output

growth rate of output = + growth rate of output per worker + growth rate of labor

typical assumption for healthcare expense growth for other post-retirement benefits

healthcare inflation rate assumed to decline over time to a constant level

firms with aggressive accounting are likely to see (higher / lower) book values and (higher / lower) future earnings

higher book values lower future earnings

relationship between utility of future consumption, expected future income, real rate of return, and intertemporal rate of substitution

higher expected future income --> lower utility of future consumption --> higher real rate of return in order to induce people to save intertemporal rate of substitution = future marginal utility of consumption / current marginal utility of consumption

relationship between agency costs and leverage

higher leverage --> lower agency costs (Jensen's hypothesis) lower agency costs --> lower leverage (e.g., stronger legal systems, presence of analysts and auditors, etc.)

historical scenarios vs. historical simulations

historical *simulation* is based on historical changes in *key factors* during the lookback period historical *scenarios* is based on historical changes in *prices* of individual assets (either observed or model-derived). • historical scenarios should not be used for options or option-embedded securities

stabilized NOI

in the context of real estate, the expected NOI when a renovation is complete

news event

news related to particular instruments or economic indicators

effect of increase in sample size on autoregressive model

increase in sample size can result in better or worse accuracy of forecasts because estimates of coefficients can change substantially across different sample periods

quote event

a new bid or offer in the market for a certain instrument at a certain price level and with a certain available quantity

trade event

a new trade that has taken place at a certain price and certain volume

t-test for correlation of two variables

null hypothesis: zero correlation

primary cause of agency problems is ______________

information asymmetry

relationship between information ratio and active risk

information ratio is inversely proportional to active risk in a constrained portfolio active risk has an opposing effect on the transfer coefficient

types of mergers and integrations

integration: statutory vs. subsidiary vs. consolidation mergers: horizontal vs. vertical vs. conglomerate

factors that affect types of risk measures used by different market participants

1. degree of leverage 2. risk-factor exposure 3. accounting/regulatory requirements

active share

a weight of a security in portfolio less its weight in benchmark a measure of risk for traditional asset managers

adjusted β

adjusted β = ⅔ ⋅ unadjusted β + ⅓ ⋅ 1 where the adjustment accounts for mean reversion of historical values of β

where in the P&L are losses accounted for?

after operating income

direct market access

an arrangement that allows buy side firms (investment companies) to make use of the technology infrastructure and market access of a sell side firm

proxy battle

an attempt by a non-management group to gain control of the management of a firm by soliciting a sufficient number of proxy votes

fundamental theorem of welfare economics

at equilibrium, allocations in competitive markets are Pareto optimal, i.e., can't redistribute to make some agents better off w/o making others worse off 1. constant returns to scale 2. no frictions 3. no externalities

all else equal, higher OAS indicates...

better compensation for risk

quote stuffing

distracting other algorithms by placing a great quantity of fictitious orders and then cancelling them almost immediately

one-sided durations

durations that apply only when interest rates rise (up duration) or fall (down duration)

protective put

long stock + long put motivations: 1. protecting profits:

pecking order theory

managers prefer to make financing choices that are least likely to send signals to investors in decreasing order of preference: -retained earnings -debt -external equity

painting the tape

manipulation by trading with the top of the order book in order to move the market price in one direction, and then placing a larger opposite trade at the new more-favorable price

types of settlement for CDS

Physical - swap buyer receives par value of reference obligation Cash settlement - swap buyer receives difference between par value and market value based on cheapest-to-deliver

return objective takes into account...

return objective takes into account: 1. return requirement 2. stated return desire 3. risk objective

option price vs. risk-free rate

rho

risk/return profile of defined benefit plan

risk: dependent upon the plan's features, the age of the workforce, and the funding status of the plan return: based upon the minimum needed to fund the pension liability while accounting for inflation

sales type vs. direct financing lease

sales type: gain on sale recognized up-front direct: gain on sale recognized over course of lease

option behavior during extreme market movements is best measured by (option sensitivities vs. scenario analysis)

scenario analysis, because sensitivity measures are more accurate measures of risk for smaller market movements

correlation coefficient

square root of R-squared

uses of asset valuation

stock selection, reading the market, projecting the value of corporate actions, issuing fairness opinions, and valuing private businesses

clientele effect

stocks attract particular groups based on dividend yield and the resulting tax effects in a state of equilibrium, a change in dividend policy may have an effect on the mix of shareholders but will not impact share value implication is that companies would tend to maintain dividend policy stability

RVPI

Residual value of paid-in capital = NAV a/f distribution at EoP / Total paid-in capital

cointegration

when two time series are moving with a common pattern due to a connection between the two time series

cash-secured put

writing a put with exercise price X and depositing X amount of cash into a designated account

G-spread

yield spread over a government bond

drivers of short- and long-term interest rate volatility

(1) *short-term* interest rate volatility is primarily driven by uncertainty around *monetary policy* (2) *long-term* interest rate volatility is primarily driven by uncertainty around the *real economy and inflation*

types of arbitrage opportunities

(1) *value additivity* (when the value of whole differs from the sum of the values of parts) (2) *dominance* (when one asset trades at a lower price than another asset with identical characteristics)

uncovered interest parity • definition • when does it hold? • equivalent to? • assumption re: investor attitude toward risk

(1) defn. relationship between expected future spot exchange rate and the two countries' nominal interest rates; when capital flows are restricted or forward currency contracts are not available; assumes that an investor is risk neutral (2) does not hold in short- or medium-term, which gives rise to possibility of profitable carry trades; *does hold in long-term* (3) equivalent to saying that forward rates are an unbiased predictor of expected future spot rates (i.e., *forward rate parity*) (4) equivalent to saying that *both relative PPP and the real interest rate parity hold* (5) assumes that investors are *risk-neutral*

ex-ante version of purchasing power parity

(1) defn. same as relative PPP but with expected inflation (instead of actual inflation)

primary assumption violations encountered in multiple regression analysis

*conditional heteroskedasticity* • coefficients: unbiased & consistent • standard errors: biased, consistent, and too small • t-stat: artificially high *serial correlation* • coefficients: unbiased & consistent • standard errors: biased, consistent, and too small • t-stat: artificially high *multicollinearity* • coefficients: unbiased & consistent • standard errors: biased, consistent, and too large • t-stat: artficially low *misspecification* • coefficients are biased and inconsistent

philosophies underlying business ethics

-Friedman doctrine -utilitarianism -Kantian ethics -rights theories -justice theories

rule for determining whether current rate method or temporal method is used

-if presentation currency is different from subsidiary's functional currency, the current rate method is used -if presentation currency is same as subsidiary's functional currency, the temporal method is used

benefits of financial markets & intermediaries

1. drives efficient allocation of resources to growth generating activities, based on risk-adjusted returns 2. increases liquidity and reduces risk 3. enables pooling of investor savings, allowing financing of otherwise impossible projects

sources of unethical behavior

1. self-dealing 2. information manipulation 3. anti-competitive behavior 4. opportunistic exploitation 5. substandard working conditions 6. environmental degradation 7. corruption

signs that a company can sustain its cash dividend

• low dividend yield • low dividend payout ratio • ability to fund projects and cover capex without issuing debt

Carhart model

• macroeconomic factor model • extension of Fama-French model (i.e., beta, small vs. big, value vs. growth) that adds momentum factor

breakeven inflation rate • description • calculation • components

• market based measure of expected inflation • difference between yield of a nominal bond and yield of an inflation-protected note • BEI = expected inflation + risk premium for uncertainty about inflation

methods of valuing assets at fair value by category

Level 1: quoted prices for identical instruments in active markets Level 2: quoted prices for identical instruments in non-active markets OR similar instruments in active markets Level 3: model-derived prices

methods to determine and correct for heteroskedasticity

Methods to determine: (1) examining scatter plots (2) using the Breusch-Pagan χ² test Methods to correct: (1) using robust-standard errors (i.e., White-corrected standard errors) (2) using generalized least squares

utilitarianism

Morality of action is determined by its consequence -Cost-benefit analysis -Greatest good for most amount of people -Flaws = exploit small group, hard to measure all costs/benefits

the market for corporate bonds is (frictionless / not frictionless)

NOT frictionless - the credit spread includes a premium for liquidity risk in addition to credit risk.

potential GDP growth and rates • impact on consumer behavior • impact on real rates of return

Potential GDP growth (positive) signals consumers believe income will be greater in the future, spend more now, save less now. To spur savings investments need to offer higher real rate of return, therefore higher potential GDP growth = higher real rates and higher real asset returns.

p-value vs. α

p-value: (1) the smallest level of significance at which we can reject the null hypothesis (2) probability of obtaining a test statistic at least as extreme as the observed one, if the null hypothesis is true (3) the smaller the p-value, the more the data "disagrees" with the null hypothesis p-value vs. α observed level of significance vs. chosen level of significance

par rate

rate representing the yield-to-maturity on coupon-paying government bonds that are priced at par

asset quality (bank)

related to the amount of existing and potential credit risk associated with a bank's assets, focusing primarily on financial assets encompasses strength of overall risk management process by which assets are generated and managed

credit scoring is used for...

small businesses and individuals.

absolute purchasing power parity

spot exchange rate is determined by the relative cost of like baskets of goods in two countries

credit spread

the difference between the yield to maturity of a risky zero coupon bond and the yield to maturity of a risk-free zero coupon bond credit spread reflects probability of default, loss given default, and time value of money incl. the adjustment of risk premium

definition of α in economics

α = rK/Y, where rK = the return to providers of capital. The above is the ratio of rK to output, or output per capital provider. In steady state economy, the marginal product of capital (αY/K) = the marginal cost of capital (rental price of capital) αY/K=r and α=rK/Y

comparison of different approaches to evaluating credit risk, with regards to ability to predict probability of default: 1. credit ratings 2. structural form models 3. reduced form models

• credit ratings are least accurate because they tend to lag the market and be relatively stable • reduced form models vs structural models: reduced form models generally do better due to the flexibility of the hazard rate estimation procedures and the ability to incorporate business cycle, without making simplifying assumptions about the balance sheet

benefits of investment in human capital

• debatable • complements growth in physical capital. • investments in education/healthcare show growth • education: developed economies benefit from post-secondary education (innovation), whereas developing economies benefit from primary/secondary education (which allows for application of technical skills)

endogenous growth theory • economic growth is a function of... • technological growth is a result of... • assumptions around return to capital and implications for investment in R&D • implications for convergence

• economic growth is a function of (1) society's *ability to discover new products and methods*, and (2) *real interest rates* • technological growth is a result of investment in physical and human capital (i.e., *endogenous*) and enhances productivity of both capital and labor • constant returns to capital: y = ck, where c = constant marginal product of capital, i.e., no diminishing returns to capital --> more capital investment (i.e., higher savings rates) leads to higher growth rates in long-run • definition of capital is expanded to include *knowledge, R&D, which have large externalities*: if private sector under invests in R&D, direct government spending and/or R&D tax breaks/subsides may help correct • no reason why incomes of developed and developing countries should *converge* (they may or they may not)

short-term relationship between actual and potential GDP • impact on inflation, Fed policy, and fiscal policy

• gives insight to equity/fixed income investors: If actual GDP is higher than potential, prices rise and the gap is forecast inflation pressure - especially useful for fixed income assets and monetary policy. • when actual GDP growth rate is above/below potential GDP growth rate, inflation concerns increase/decrease, and Fed is more likely to follow restrictive/expansionary monetary policy • governments are more likely to run a fiscal deficit if actual GDP rate is < potential GDP rate

benefits of free trade / unrestricted capital flow

• increases efficiency by forcing competition for domestic firms • opens new markets, e.g., foreign demand for domestic products • unrestricted capital flows compensate for potentially insufficient funding from domestic savings • drives foreign direct investment and investment in financial assets

impact of savings & investment

• positively correlated with development • public/private sector investment must provide sufficient level of capital per worker • if country has insufficient domestic savings, it must attract foreign investment to grow

term structure of credit spreads

• relationship of credit spreads to debt maturity • credit spread = yield on zero-coupon risky bond - risk free bond • average credit spread over a specific horizon can be used to estimate the expected percentage loss per year on the risky zero-coupon bond

impact of dividends on call and put options

higher dividends --> lower call option prices and higher put option prices

balance sheet quality (company analysis)

1. Check for completeness (off-balance-sheet finance, operating leases) 2. Unbiased measurement - check for subjective measurements 3. Clear presentation - companies have discretion as to how certain items are presented

proxy fight

an attempt to gain control getting target's stockholders to grant authority to vote shares to replace the current management

forward points quoting convention

10000 * (forward fx rate - current fx rate)

key differences between venture capital and buyout investments (part 2 of 3)

7. *risk assessment*: difficult to estimate vs. able to estimate due to maturity of industry and company 8. *exit*: difficult to forecast (IPO vs. trade sale) vs. predictable 9. *operations*: high cash burn rate vs. low WC requirements 10. *working capital requirement*: increasing requirements vs. low 11. *due diligence*: technological & commercial prospects vs. extensive due diligence incl. financial 12. *goal setting*: milestones in business plan & growth strategy vs. cash flows, strategic & business plan 13. *investment returns*: high returns from a few successful investments vs. low variability in investments with failures being rare

z-scores for 90%, 95%, and 99% confidence intervals

90%: 1.65 95%: 1.960 99%: 2.58

net return on plan assets

= Actual return on Plan Assets - Beginning Assets x Discount Rate (IFRS)

funded status (net pension obligation)

= Pension obligation - Fair Value of Plan Assets

Sharpe ratio

Absolute measure of reward-to-risk

triangular arbitrage

Bring in a third currency to exchange base currency for eventual base currency. - Use cross rates with bid-ask spreads to calculate two paths of exchange rates - Compare to dealer spread for arbitrage opportunities

segmental analysis

Business is reportable if 50% of its revenue from sales external to the firm and at least 10% of a firm's revenue, earnings, or assets Compute: - % of revenue - % of assets - % of operating profit (EBIT) - % of capex - divisional margin (segment EBIT/segment sales) - resource allocation Compare proportional capex to proportional assets.

minimum capital requirements as per Basel III

Capital as % of risk-weighted assets: • Common Equity Tier 1 capital: 4.5% • Total Tier 1 capital: 6.0% • Total capital (Tier 1 + Tier 2): 8.0%

relationship between % of times a manager is correct and the manager's information coefficient

let P = % of times a manager is correct IC = 2 * P - 1

International Valuation Standards

Created by the International Valuation Standards Committee (IVSC). They cover businesses, business interests, real estate, tangible and intangible assets.

economic value added (EVA)

EBIT (1 - t) - WACC x total capital total capital = net working capital + net fixed assets = book value of long-term debt + long-term equity other adjustments: • operating leases treated as capital leases, • deferred taxes eliminated, • add back R&D (and capitalize and amortize) • add back charges on strategic investments that will generate future returns • add LIFO reserve to invested capital and add back change in LIFO reserve to NOPAT • removal of goodwill charges

NAV after Distributions, roll-forward

EoP = BoP + Called-down - Mgmt Fees + Operating Results (i.e., Realized + Unrealized results) = NAV b/f Distributions - Carried Interest (on NAV b/f distributions less threshold or NAV b/f distro less previous year's NAV b/f distro) - Distributions

roll-forward of defined benefit plan assets

EoP = BOP + actual return on plan assets + employer contributions - benefits paid

off-balance-sheet financing

For analytical purposes, treat an operating lease as a finance lease. - Increase assets and liabilities by the present value of remaining lease payments - Remove rent expense from the income statement and replace with depreciation expense and interest expense - Results in higher leverage and lower interest coverage

rights theories

Fundamental rights trump collective good -Shareholders, employees have rights Business managers have moral compass Businesses have right to respect others

share repurchase vs. cash dividend

If tax treatment is the same, then no difference in effect on shareholder wealth Share repurchases: 1. *Tax* advantage to shareholders if tax rate on capital gains < tax rate on dividends 2. *Signal* to shareholders that management believes shares are undervalued 3. Added *flexibility* - repurchase not sticky and can be used whenever there is excess cash 4. Offsetting *dilution* - prevents EPS diluation from exercise of employee stock options 5. Increase *leverage* - repurchase shares to increase financial leverage

liquidation preference (private equity)

places returns of PE firm ahead of those of other investors, including the portfolio company's managers

(P/E or P/CF) is typically more stable

P/CF

target-friendly states in the US for takeovers

PA, OH

corporate investment categories

Passive - <20% ownership; Financial Assets; no significant influence; HTM, AFS, or FV Significant Influence - [20%,50%]; Investments in Associates; Equity Method Business Combinations - >50%; Control; Acquisition Method Joint Venture = Shared control by two or more entities %s are guidelines

fund with zero systematic risk

Sharpe ratio = information ratio for a fund with zero systematic risk

Excess Earnings Method

Start with earnings that should be generated by working capital and fixed assets based on an estimate of the required return Excess earnings = firm earnings - required return on WC and FC Value of intangible assets estimated as the PV of the stream of excess earnings Firm value = WC + FC + PV(excess earnings)

another term for past service costs

plan amendments

equivalent annual annuity

cash flow per period with the same present value as the cost of buying and operating a machine

basis (commodities)

cash price of a commodity - futures price of that commodity

succession event

change in corporate structure of a reference entity for a credit default swap

shaping risk • key factors • relative explanatory power of factors • calculation of price change resulting from change in factors

changes in portfolio value due to changes in the shape of the benchmark yield curve can be identified/managed using sensitivities to *level/steepness/curvature* factors or using *key rate duration* level has most explanatory power for returns on treasury securities. steepness also has high explanatory power, with curvature having the least

core vs. non-core property types

core: retail, multi-family, office, industrial, warehouse non-core: hotel, hospitality

Hansen method

corrects standard errors for both serial correlation and heteroskedasticity

mean reversion of ROE implies that a firm's continuing residual income is assumed to...

decline to zero

direct vs. indirect quote

direct: home currency is price currency indirect: home currency is base currency

an independent board with no business relationships with company or management may actually increase agency conflict between...

directors and managers

Yardeni model

fair earnings ratio is the yield on long-term bonds less a growth factor E_1/P_0 = Y_B - d x LTEG + residual • Y_B: current Moody's A-rate corporate bond yield • d: the weight the market gives to five-year earnings projections • LTEG: consensus 5-year earnings growth rate for the market index does NOT accurately address equity risk premium

natural language processing

focuses on developing computer programs to analyze and interpret human language

comparison of cost of debt and debt capacity for private vs. public firms

for private firms: • cost of debt is higher • debt capacity is lower

liquidity preference theory

forward rates are made up of expected spot rate and liquidity premium • liquidity premium compensates investors for added interest risk when lending long-term • liquidity premium increase with maturity but does not preclude possibility of a downward sloping yield curve

value of a mark-to-market futures contract

futures price at expiration less previous day's futures price

calendar spread (options)

involves two call options on same stock and at same exercise price but with different maturities long calendar spread strategy is short the near-dated call and long the longer-dated call

semi-active investment strategy

involves using indexes as underlying investments whilst trying to add value through active management

scenario limit

limit on estimated loss for a given scenario, which, if exceeded, would require corrective action in portfolio

position limits

limits on market value of any given investment

structure and suitability of log-linear trend model

ln(y) = b0 + b1(t) + et suitable when rate of change is constant over time

straddle

long put + long call (both must have same exercise price)

internal rate of return is what type of weighted return?

money-weighted return

colocation

physically placing trading equipment or algorithms onsite at a trading venue in order to reduce latency

with respect to GDP growth expectations, earnings growth expectations are...

pro-cyclical

what types of dividends are taxable?

taxable: DRIP, cash not taxable: stock dividend

the underlying of a credit default swap is...

the credit quality of the borrower

what is impact of persistence factor on residual income?

ω = 0: RI falls to zero immediately ω = 1: RI persists indefinitely ω ∈ (0,1): RI declines to zero over time

IMF approaches for assessing long-term equilibrium real exchange rates

(1) Macroeconomic balance approach: how much will exchange rates adjust to equalize a country's expected current account imbalance and that country's sustainable current account imbalance? (2) External sustainability approach: how much will exchange rates adjust to force a country's external debt relative to GDP toward its sustainable level? (3) Reduced-form econometric approach: how will exchange rates move based on patterns in several key macroeconomic variables (e.g., trade balance, net foreign asset/liability, relative productivity, etc.)

types of traditional credit models

(1) credit scoring models (2) credit rating • ordinal rankings only, not interval or ratio scale (i.e., do not convey relative degree of risk between entities) • do not reflect probability of default

real interest rate parity

(1) defn. real interest rates are expected to converge across markets (driven by capital flowing to country with higher real interest rates, until interest rates are equalized) (2) International Fisher relation (attached image)

credit ratings • used for which entities? • strengths? • weaknesses?

*applications*: -used for corporate debt, ABS, and government and quasi-government debt -incorporate both probability of default and loss given default *strengths*: (1) simple to understand (2) relatively stable over time *weaknesses*: (1) reduced correlation with default probability because of tendency to lag default risk (because of ratings agencies' desire to keep ratings relatively stable over time) (2) do not adjust with business cycle, even though prob. of default changes (3) conflicts of interest (issuer-pays model)

unrealized foreign currency gains/losses due to a foreign currency transaction are recorded on...

the income statement

credit risk

the risk associated with losses stemming from the failure of a borrower to make timely and full payments of interest or principal

defined benefit plan for other post-employment benefits

type of future benefit is defined (e.g., health, dental, prescription) amount of future benefit depends on future contingent events

risk metric relevant for asset backed securities

use probability of loss for ABS - probability of default is NOT relevant because an ABS cannot default

country spread model

-Use developed markets as a benchmark and add a premium for the emerging market -Difference between yield on bonds in emerging market and those on the developed market

GAAP reclassification of investment in financial assets

-allows reclassification between all categories when justified -however, reclassification of a security from HtM could have implications for other HtM securities *HfT --> AfS*: unrealized g/l in P&L *Any --> HfT*: unrealized g/l in P&L *HtM --> AfS (debt)*: unrealized g/l in OCI *AfS --> HtM (debt)*: accumulated g/l in AOCI is amortized over remaining life

conditions when a yield-to-maturity will provide a poor estimate of expected return from holding a bond

(1) volatile interest rates (2) steeply sloped yield curve (3) significant risk of default (4) embedded options

market conversion premium ratio

(market conversion price − stock's market price) / stock's market price

capital rationing

- Allocate fixed capital to maximize shareholder wealth - Choose the combination of projects that has the highest total NPV - Rank projects with the profitability index =(1 + NPV/Outlay)

central tendency

- Arithmetic mean - most affected by outliers - Harmonic mean - less affected by large, more by small, outliers - Weighted harmonic mean - effect of outliers depends on market value weight - Median - least affected by outliers

Serial Correlation in Trend Models

- Regression errors in current period must be uncorrelated with errors from all other periods - Use Durbin Watson to test for serial correlation (null = no autocorrelation) - If linear model exhibits autocorrelation, try log-linear - If log-linear model still exhibits autocorrelation, try autoregression

Evaluation of Specific Regulations (valuation)

- regulation can significantly impact valuation - taxes shrink an industry while subsidies help it to grow - review to include proposed regulations - if regulator captive, regulations may end up benefiting the regulated entities - may introduce inefficiencies in the market (past govt bailouts imply future guarantees) - certain sectors have higher exposure to regulations

distribution waterfall

-Method which profits will flow to the LP and when the GP gets carried interest -Deal by deal method - carried interest distributed after each deal -Disadvantage of this is that one deal could be good and the other bad, but GP will get interest on first deal, even if returns level out -Total return method - Carried interest is calculated on entire portfolio 1. Carried interest can be paid only after all committed capital is returned 2. Carried interest can be paid when value of portfolio exceeds invested cap by some minimum

NSFR

-Net stable funding ratio -Measures liquidity of funding sources relative to liquidity needs of assets over a *one-year* period -Available stable funding / required stable funding -Basel III standards set a minimum recommended level of *greater than* 100%

Porter's 5 Forces

-industry rivalry -threat of new entrants -buyer power -supplier power -availability of substitutes (R-E-B-Su-S)

labor supply factors

1) Demographics -- fertility rates, age matter for potential GDP 2) Labor Force participation -- labor force / working age population, rises with more women 3) Immigration -- offsets declining fertility rates 4) Average hours worked -- trend is downward (wealth effect, high labor income taxes, rise in part-time/temp work)

3 key economic growth theories

1) classical 2) neoclassical 3) endogenous

preconditions for economic growth

1) savings and investments 2) financial markets & intermediaries 3) political stability, rule of law, property rights 4) investment in human capital 5) tax and regulatory systems 6) free trade/unrestricted capital flows

measures of returns when valuing an equity and when are they appropriate

1. *dividends* • dividend paying & stable/clear relationship to earnings • non-control perspective 2. *free cash flow* (to firm or to equity) • not dividend paying • dividend-paying but not inline with FCFE • FCFE aligns with profitability in forecast horizon • control perspective 3. *residual income* • not dividend paying • expected negative FCFE in forecast horizon

momentum indicators

1. *earnings surprise*: EPS_actual - EPS_expected 2. *standardized earnings surprise*: earnings surprise / standard deviation of analyst forecasts 3. *relative strength*: comparison of a stock's performance during a period with (1) its performance during a historical period (price momentum) or (2) performance of a similar group of stocks • belief in patterns of persistence or reversals in returns provides the rationale for valuation using relative strength indicators

Current Rate Method - Application

1. Convert the income statement - average rate 2. Derive closing retained earnings (=REopen + NI - Dividends) 3. Convert the balance sheet - current rate 4. Balance sheet will not balance. Difference is the translation gain/loss (CTA) 5. Force the balance sheet to balance by including the adjustment in shareholders' equity 6. Exchange rate G/L = change in CTA

random walk (w/ and w/o drift)

w/o drift: xt = xt-1 + εt w/ drift: xt = b0 + xt-1 + εt

types of regulators

1. Government Agencies 2. Independent Regulators - SROs, non-SROs 3. Outside Bodies - SROs typically do not receive government funding - SROs without government recognition are *not* regulators - Conflict of interest between members of SRO and regulatory role of SRO inherently exist - Some independent regulators are SROs that are empowered to enforce the law - Independent SROs more common in common-law countries - Independent SROs more effective when properly supervised

rationale for self-regulation

1. Increases overall level of regulatory resources. 2. Uses knowledge and expertise of industry professionals. 3. Enables the regulator to focus on other priorities while relying on the SRO for frontline supervision of members and markets.

incremental project cash flows: replacement project

1. Reflect the sale of the old asset in the calculation of the initial outlay Outlay = FCInv + NWCInv - (Sale - (Sale-Book)(t)) 2. Calculate the incremental operating cash flows as the cash flows from the new asset minus the cash flows from the old asset (dS-dC)(1-t) + Dt 3. Compute the terminal year non-operating cash flow dSalesPrice + NWCInv - (dSale-dBook)(t)

credit curve

A curve showing the relationship between time to maturity and yield spread for an issuer with comparable bonds of various maturities outstanding, usually upward sloping

Black Scholes assumptions

Continuously compounded risk-free rate constant & known European options Volatility of asset returns constant & known, asset prices change smoothly Frictionless markets Lognormally distributed asset prices and returns --> continuously compounded (i.e., log of) returns are normally distributed Yield (continuously-compounded) on asset is constant (asset has no underlying cash flows)

Exposure to Changing Exchange Rates

Current rate translated items are exposed Temporal Method: - Monetary assets and liabilities are exposed to changing rates - (Cash + A/R) - (A/P + current debt + LTD) Current Rate Method: - All assets and liabilities translated at the current rate - Net assets are exposed

justice theories

Fair and equitable distribution of goods and services is just - managers faced with difficult decision and lack all necessary information --> a legitimate way of making ethical decisions as long as all benefit (Rawls' *veil of ignorance*) - maximum basic *liberty* compatible with same liberty for others. - *differencing principle*- Unequal distributions are only justified if they benefit the least advantaged members of society.

NPV and IRR will yield same decision for projects with conventional cash flows and same investment outlays (TRUE / FALSE)

False - a project of a short duration can have higher IRR and lower NPV

determination of voting stock

GAAP determines voting stock only with number of voting shares outstanding IFRS also considers securities with potential voting rights, like warrants

instrumental approach to ethics

It's in the self-interest of an agent to behave in an ethical manner because doing so will ensure the support of stakeholders

variance of dependent variable

SST/(n-1)

law of arbitrage may not be fully enforced in commodities markets (TRUE / FALSE)

TRUE certain parties in certain situations may not be able to take delivery of the underlying, which may result in arbitrage and law of one price not holding

classifying non-operating income as operating income (would be / would NOT be) GAAP compliant

Yes, GAAP compliant but not sustainable

fundamental law of active management

a manager's IR can be estimated using three factors: *skill* (IC), *# of active decisions* (BR), and *degree of constraint on portfolio* (TC)

risk-weighted assets

a measure of a bank's total assets that weights high-risk assets more heavily than low-risk assets

HHI

a measure of market concentration that squares each firm's percentage share of the market, then sums these squares

most common problem with trend models is...

serial correlation

stock split

the division of a single share of stock into more than one share no change in financials; only change in par-value per share and number of outstanding shares

VaR threshold

the portfolio value at which VaR is considered to be breached

primary goal of financial statement analysis

to facilitate an economic decision

relationship between IR and aggressiveness of weights

unconstrained: IR unaffected by aggressiveness of weights constrained: IR decreases with aggressiveness of weights

a firm with higher ROE than its peers will be relatively (overvalued / undervalued) compared to its peers

undervalued

text analytics

use of computer programs to analyze and derive meaning typically from large, unstructured text- or voice-based datasets

types of capital (economics)

*human*: qualitative; spillover effects;, e.g., education *ICT* (infrastructure, computers & telecom capital): offers network externalities, results in capital deepening and technological progress *non-ICT*: capital deepening notes: -strong correlation between investment in physical capital and GDP growth rates -important 2nd-order and multiple-order effects on TFP and economic growth through capital investment (network externalities via IT investments)

stock-specific factors that distinguish private and public companies

(1) liquidity (2) restrictions on marketability (3) concentration of control

products / value chains in energy sector (commodities)

1. crude oil 2. natural gas 3. refined products

Potential GDP

= Upper limit of real growth in an economy The higher the potential GDP growth rate, the higher the real rates (interest and asset returns) - When actual GDP growth > potential GDP growth, inflationary pressure is higher and more likely that monetary/fiscal policy is restrictive - More likely for a government to run a fiscal deficit when actual GDP growth rate is lower than potential growth rate. - Higher potential GDP growth rate reduces expected credit risk of all debt issues.

defined benefit remeasurements: difference between IFRS and GAAP treatment

Consist of: (1) difference between expected return and actual return (2) actuarial gains/losses IFRS: recognized in OCI GAAP: can either be: (a) recognized immediately in P&L, OR (b) recognized in OCI and amortized to P&L using corridor method

IAIS

International Association of Insurance Supervisors

dividend coverage ratio

Net Income / Dividends

option price vs. asset price

delta

comparing portfolios on the amount of exposure to a particular factor (i.e., factor, specific) involves comparing...

particular risk / active risk squared

CDS spread

reflects net % of notional paid by protection buyer

bear put spread

short put + long put

annual unit credit

value at retirement / years of service

impact of degree of leverage on type of risk measures that are useful

• more leverage --> prefer absolute risk measures, et.g., VaR, less leverage --> relative risk measures, e.g., active share, ex-ante tracking error • more leverage --> high confidence intervals, i.e., rare events; less leverage --> low confidence intervals, i.e., more common events

F-test

• null hypothesis is that *all* slopes simultaneously equal zero • always a one-tailed test • two sets of degrees of freedom, that of the numerator and the denominator

commercial real estate

• offices, shopping centers, stores, executive offices, theaters, hotels, parking facilities and other business uses • multi-family properties

consolidation of VIE (accounting)

• reverse sponsor's gain/loss on transactions with VIE from sponsor's NI and equity • add asset and liability

neoclassical theory • what does it seek to estiamte? • when is steady state achieved? • what is steady state growth rate? • what are the key implications?

• Primarily estimates economy's long term steady state *growth rate of output per capita* (equilibrium growth rate) • *Steady state* achieved when output-to-capital ratio is constant, and therefore the capital per worker ratio and output per capita grow at same steady state growth rate, g* = θ / (1-α) • Sustainable growth rate of total output G* = θ / (1-α) + growth of L *** 1. *capital accumulation* affects output level in steady state, not growth rate 2. *deepening vs. technology*: • growth slows as capital is added • growth of output per worker will decrease without increases in TFP 3. *convergence*: • growth rate of developing countries > growth rate of developed countries • per-capita incomes should converge 4. *effect of savings on growth*: • prior to reaching steady-state, a higher savings rate leads to higher growth rate • in steady-state, savings rate does not impact growth rate • countries with higher savings rate will have higher y, k, & TFP (i.e., levels of output)

Ho-Lee model

• first arbitrage-free term structure model • the model is calibrated to market data and uses a binomial lattice approach to generate a distribution of possible future interest rates

cannibalization factor

% of market share taken by a substitute

approximation of change in real exchange rate based on CPI

%Δ real exchange rate (price / base) = + %Δ nominal exchange rate + %Δ CPI base − %Δ CPI price

machine learning terminology for IV and DV

(1) *Independent variable*: called feature (2) *Dependent variable*: called target or tag variable

primary uses of swaptions:

(1) *Lock in fixed rate*: if an investor anticipates a floating-rate exposure at some future date (he will be issuing bonds or getting a loan), a payer swaption would lock in a fixed rate and provide floating-rate payments for the loan (2) *Interest rate speculation*: buy payer swaption if rates expected to rise and vice versa (3) *Swap termination*: a fixed-rate payer on a 5-year swap could buy a 2x5 receiver swaption (at the same fixed rate as the swap). This swaption would give the investor the right to enter into an offsetting 3-year swap at the end of two years, effectively terminating the 5-year swap at the end of the second year.

agency costs of equity

(1) *Monitoring* costs are the costs associated with supervising management and include the expenses associated with making reports to shareholders and paying the board of directors. Note that strong corporate governance systems will reduce monitoring costs. (2) *Bonding* costs are assumed by management to assure shareholders that the managers are working in the shareholders' best interest. Examples of bonding costs include the premiums for insurance to guarantee performance and implicit costs associated with non-compete agreements. (3) *Residual* losses may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee.

factors to consider when doing credit analysis of securitized debt

(1) *collateral pool*: homogeneous + granular + short term --> statistical analysis, but medium-long term --> portfolio analysis. otherwise, individual loan analysis (2) *servicer*: investor exposed to servicer's operational and counterparty risk (3) *structure*: tranching and other management of credit risks, e.g., credit enhancement (internal: tranching of credit risk among classes with different seniority, overcollateralization, excess servicing spread; external: third-party guarantees)

adjusted R squared (can / cannot) be negative

adjusted R-square can be negative for a large number of independent variables that have no explanatory power

factors that affect interbank spread on a currency pair

(1) *currencies* involved (high-volume currency pairs have narrower spreads) (2) *time* of day (most liquid when both London and NY are open) (3) market *volatility* (higher volatility --> wider spreads) (4) *maturity* affects forward (longer maturity contracts are less liquid, have greater counterparty risk, have greater interest rate risk)

economic rationale for regulation

(1) *informational frictions*: when information is not equally available or distributed (2) *externalities*: costs or benefits that affect a party that did not choose to incur that cost or benefit

tools of regulatory intervention

(1) *price mechanisms*: taxes, subsidies (2) *restricting/requiring* certain activities: e.g., restricting use of certain chemicals, requiring filing of certain reports (3) *provision* of public goods or *financing* of private projects: e.g., national defense, small business loans

factors that affect dealers' foreign exchange spread

(1) *spread* in interbank market for the same currency pair (2) *size* of the transaction (larger size --> wider spread) (3) *relationship* between dealer and the client (4) *maturity* affects forward (longer maturity contracts are less liquid, have greater counterparty risk, have greater interest rate risk)

types of asset classes

(1) Capital assets Stock and bonds, real estate when rented out (2) Store of value assets They neither generate income nor can they be consumed (artworks, forex, real estate when the owner is occupying the property) (3) Consumable or transferable (C/T) assets Wheat, oil, cattle. Determined by interaction of supply and demand. Gold can be classified in any of the above types

stakeholder management is an interplay between what three elements?

(1) Corporate performance (2) Corporate governance (3) Business ethics

valuation techniques for M&A

(1) DCF of FCFF, adjusted for synergies (2) Comparable company analysis via multiples of enterprise or equity values (3) Comparable transaction analysis

non-recurring items

(1) Discontinued operations (2) Accounting changes (3) Unusual items (4) Extraordinary items (5) Restructuring charges

metrics used for income-based valuation of a private company

(1) Free cash flow (2-stage) (2) Capitalized cash flow (single stage) (3) Excess earnings: value of intangibles = normalized earnings - earnings required to support rate of return on working capital and fixed assets; rarely used but can be used for small firms with significant intangible assets

stakeholder impact analysis

(1) Identify stakeholders (2) What are their Interests & concerns? (3) What are the most likely claims on the organization? (4) Who is most important? (in order: customers, employees, stockholders) (5) What are the resulting strategic challenges?

investment in associates when fair value of associate's net assets is greater than cost of investment

(1) Investment in associates is recorded as cost of investment adjusted for residual goodwill (the latter of which is a negative number) (2) The difference between fair value of associate's net assets and cost of investment is included as income in the determination of the investor's share of the associate's profit/(loss) in the period in which the investment is acquired

theories of investor preference (dividends)

(1) MM: in a no-tax/no-fees world, dividend policy has no effect on firm value or cost of capital because investors can create their homemade dividend (2) Dividend preference theory (i.e., bird-in-hand theory): dividends prefer certainty of cash today over uncertainty of capital gains tomorrow; implies that firms with high dividends trade at a higher price (i.e., have a lower required return) (3) Tax aversion theory: investors are tax averse and prefer share repurchases if capital gains tax rate is lower than dividend tax rate

uses of residual income models

(1) Measure managerial effectiveness and executive compensation (2) Equity valuation (3) Measure goodwill impairment

a portfolio's active risk is made up what components?

(1) active *factor* risk: results from portfolio's different-from-benchmark exposures to factors; factor sensitivities in the portfolio are different from benchmark (2) active *specific* risk or security selection risk: security weightings in the portfolio different from benchmark

conceptual framework for assessing reporting quality

(1) are the underlying financial reports GAAP compliant and decision-useful? (2) are the earnings of high quality?

factors to consider when evaluating a company's capital structure

(1) changes in the company's capital structure over time (2) capital structure of competitors with similar business risk (3) company-specific factors (e.g., quality of corporate governance, which affects agency costs)

relative purchasing power parity

(1) defn. changes in exchange rates should exactly offset the price effects of any inflation differential between the two countries; does not require absolute PPP to hold (2) seldom holds in the short-term

multicollinearity • definition • effects • methods to detect • methods to correct

(1) defn. the condition when two or more of the independent variables, or linear combinations of the independent variables, in a multiple regression are highly correlated with each other (2) effects: (a) distorts SEE and the coefficient standard errors, which leads to problems when conducting t-tests for statistical significance (b) reduces reliability of slope coefficients (no impact on consistency) (c) standard errors of slope coefficient are artificially inflated, leading to greater probability of type II error (3) methods to detect: -t-test indicate that none of the individual coefficients are significantly different from zero AND the F-test is statistically significant and R² is high -high correlation among independent variables suggests that multicollinearity may be present; low correlation among independent variables does not preclude multicollinearity Methods to correct: -omit one or more independent variables (e.g., via stepwise regression)

analytical considerations that are not addressed by CAMELS analysis

*relevant to all companies*: 1. competitive environment 2. segment information 3. currency exposure 4. risk disclosures 5. off-balance sheet items *banking specific*: 1. government support 2. government ownership 3. mission of banking entity 4. corporate culture

7 things companies/managers can do to ensure adherence to basic ethical principles

(1) favor hiring and promoting people with a well-grounded sense of personal ethics (2) build organizational culture that places a high value on ethical behavior (3) make sure that leaders within the business not only articulate rhetoric of ethical behavior but also act in a manner that's consistent with that rhetoric (4) put decision-making in place that requires people to consider the ethical dimensions of business decisions (5) hire ethics officers (6) put strong governance processes in place (7) act with moral courage

swap spread • how is it determined? • what does it represent?

(1) fixed-rate on a swap less the yield on an on-the-run government bond with the same maturity as the swap (2) represents the compensation for credit and liquidity risk

motivations for M&A

(1) gaining access to unique capabilities (2) diversification (seen as insensible b/c shareholders can diversify on their own; does not add value; can sometimes result in a conglomerate discount) (3) bootstrapping EPS (4) personal benefits for managers (5) tax benefits (i.e., target has tax losses) (6) unlocking hidden value (by improving some aspect of company, e.g., management, organizational structure, etc.) (7) achieving international business goals

approaches to private company valuation

(1) income: PV of expected future income (2) market: price multiples based on prior similar transactions (3) asset-based: assets minus liabilities

factors affecting dividend policy

(1) investment opportunities (2) expected volatility of future earnings (3) financial flexibility (4) shareholder tax considerations (5) flotation costs (i.e., external equity cost > retained earnings cost --> higher flotation costs would imply lower dividends) (6) contractual and legal restrictions (e.g., debt covenants, legal restrictions in certain jurisdictions)

post-offer takeover defense mechanisms

(1) just-say-no (2) litigation (3) greenmail (4) share repurchase (5) leveraged recapitalization (6) crown jewel defense (7) pac-man defense (8) white-knight defense (acquiring enough shares to take control) (9) white-squire defense (acquiring only enough shares to block takeover)

global trends in corporate payout policies

(1) lower % of US firms pay dividends vs. European and Asian small-cap firms (2) % of firms paying cash dividends has trended downward in developed markets (3) % of firms making stock repurchases has increased in the US since 1980s and in the UK/Europe since 1990s (4) payout ratios of dividend paying firms have been increasing over time - 100 largest US firms increased inflation-adjusted dividend by 23% from 1978 to 2000

methods of share buybacks

(1) open market transactions: most flexible, need shareholder approval in Europe but not in US (2) fixed price tender offer: firm buys predetermined # of shares at a fixed price; fastest method, but firm may not get as good a deal (3) dutch auction: company specifies range of prices --> shareholders specify price and amount willing to sell --> work through the book starting at lowest price until desired volume reached --> shares exchanged at maximum price reached in book (4) repurchase by direct negotiation: purchase of shares from a major shareholder; greenmail --> hostile bidder offered a premium to go away

pre-offer takeover defense mechanisms

(1) poison pill (flip-in - existing shareholders of target can purchase target shares at discount, flip-over - existing shareholders of target can purchase acquirer shares at discount) (2) poison put (a covenant that gives bondholder's of target the right to obtain repayment in event of a takeover) (3) restrictive takeover laws (some states in the US have more restrictive takeover laws than others) (4) staggered board (in any particular year, bidder can win only a certain % of board seats) (5) restricted voting rights (equity ownership above certain % triggers loss of voting rights) (6) supermajority voting provision for mergers (i.e., simple majority of 51% not enough) (7) fair price amendment (merger restricted unless fair price offered to shareholders, where fair price is determined by some formula or independent appraisal) (8) golden parachutes (promise to give target management large cash payouts if they leave after a merger)

reasons why PPP may not hold in the short run

(1) product‐mixes and consumption baskets differ across countries (2) there are transaction costs involved in international trade as well as trade restrictions

factors that impact the shape of the credit curve

(1) sector quality (2) market supply/demand (3) company-value models (i.e., structured form models) (4) financial conditions in the economy

challenge for principals

(1) shape behavior of agents so they act in accordance with principals' goals (2) reduce information asymmetry between agents and principals (3) develop mechanism for removing agents who do not act in accordance with the goals of principals

challenges when we estimate discount rate for private companies

(1) size premia (added to the discount rates) (2) availability and cost of debt (3) acquirer versus target (4) projection risk (5) lifecycle stage

types of regulations

(1) statutes: laws made by legislative bodies (2) administrative regulations: rules issued by either government agencies or other bodies authorized by the government (3) judicial law: findings of the court

types of commodity swaps

(1) total return swap: long pays fixed % on notional and receives/(makes) payment based on the underlying commodity's return % - fixed % (2) excess return swap: single payment at initiation in exchange for periodic payments that are a % by which the commodity price exceeds some fixed or benchmark value (no payments made if commodity price is lower than benchmark value) (3) basis swap: variable payment are based on the difference in price between two commodities (4) commodity volatility swap: underlying factor is the volatility of the commodity's price

reasons for private company valuation

(1) transactions: VC, IPO, sale in acquisition, bankruptcy proceedings, performance-based managerial compensation (2) compliance: financial reporting, tax reporting (3) litigation: shareholder suits, damage claims, lost profits claims, divorce settlements

types of transaction-based real estate indexes

*repeat-sales* index: - multiple sale of the same property - needs at least two sales - regression allocates change in value per quarter *hedonic index*: - requires only one sale - regression developed to control for differences in property characteristics such as size, age, location, etc.

IMF guidelines for currency intervention

(1) undervalued currency --> no intervention (2) fairly or overvalued currency AND no inflation threat --> unsterilized intervention (i.e., sell currency to push down value of currency) (3) fairly or overvalued currency AND inflation threat --> sterilized inflation (i.e., sell currency + sell domestic securities to the private sector, which reduces excess liquidity created by the exchange rate intervention) (4) if there's a limit to sterilization --> tighten fiscal policy to slow down domestic demand Effectiveness: -Developed economies --> statistically insignificant -Developing economies --> contributes to lower exchange rate volatility but no statistically significant effect on exchange rate level

causes of informational frictions

*Adverse selection*, where some market participants have access to information that is unavailable to others *Moral hazard* occurs in a situation where one party will have a tendency to take risks because the costs that could be incurred will not be felt by the party taking the risk

business combinations: acquisition method • balance sheet • income statement • cash flow statement

*Balance Sheet*: - Eliminate investment account (purchase price) of parent and equity accounts (pre-acquisition) of subsidiary 1. Calculate goodwill: • under US GAAP: full goodwill = total value implied by consideration paid less total fair value of net identifiable assets • partial goodwill (IFRS only) = consideration paid less proportional share of fair value of net identifiable assets 2. Combine 100% of assets and liabilities of both firms (net of intercompany transactions) 3. Calculate minority interest (share of equity not owned): • partial goodwill: proportionate share of total value implied by consideration paid • full goodwill: proportionate share of fair value of net identifiable assets *Income Statement*: • Eliminate subsidiary earnings from parent (dividends) • Subtract minority share of earnings (share of earnings not owned) • Combine revenues and expenses (only post-acquisition) of both firms (Net of intercompany transactions) *Cash Flow Statement* Parent company cashflows exclude those between parent and investee

theories of expected returns on commodities

*CAPM* - not appropriate; only appropriate for capital assets *insurance perspective* - long commodity position earns positive risk premium; speculators earn premium from short hedgers; creates normal backwardation situation; F<E(S) due to risk premium *hedging pressure hypothesis* - shape of curve depends on balance of hedgers in the market *theory of storage* - commodities that are difficult to store should earn a positive convenience yield

Serial Correlation in AR Models

*Cannot* use Durbin Watson to test for serial correlation in AR models. - Use a t-test on residual autocorrelations (t = (rho-0)/s.e.) - If serial correlation exists, model is incomplete - *SOLUTION* - Increase order of model by adding more lagged variables

impairment of investments in financial assets

*Check for impairment*: *GAAP*, HtM & AfS: is decline in FV other than temporary? (for HtM, check at each BS date) *IFRS*: A. HtM / amortized cost: reviewed at end of each reporting period for impairment, i.e., 1+ loss event: 1. issuer experiences financial difficulty 2. default/delinquency in debt service 3. borrower gets concession from lender 4. probable that borrower will enter bankruptcy or other financial reorg Not sufficient to indicate HtM impairment: 1. disappearance of active market 2. downgrade of entity's credit rating 3. decline in FV below cost or amortized cost B. Equity securities: 1. significant technological, market, economic, and/or legal changes 2. significant or prolonged decline below cost *Accounting for impairment* A. *HtM* • IFRS: amount of impairment = carrying value less estimated future cash flows discounted at security's original effective interest rate • GAAP: written down to fair value • recognized in P&L • carrying amount (IFRS) /cost-basis (GAAP) is reduced or allowance account is created (IFRS only) • reversal: only allowed under IFRS - recognized in P&L and BS account is reversed B. *AfS*: • IFRS: accumulated loss is reversed and recognized in P&L; reversal allowed for debt only • GAAP: cost-basis written down to FV and loss recognized in P&L (irreversible, i.e., subsequent increases recorded in OCI)

effects of algorithmic trading

*Positive* effects: 1. increased pricing efficiency 2. narrower bid-ask spreads 3. lower transaction costs 4. greater liquidity Potential *negative* effects: 1. algorithms' potential to speed and amplify market movements 2. greater complexity of achieving regulatory oversight 3. the possibility of algorithms running out-of-control 4. the potential for market abuse through quote stuffing or other manipulation 5. potential negative impact of unequal access to information.

contents of statement of governance policies

*Codes of ethics.* A corporate code of ethics articulates the values, responsibilities, and ethical conduct of an organization. *Directors' oversight, monitoring, and review responsibilities.* These include statements regarding internal controls, risk management, audit and accounting disclosure policies, regulatory compliance, nominations, and compensation. *Management's responsibility to the board.* These include management's responsibility to provide complete and timely information to board members, and to provide directors with direct access to the company's control and compliance functions. *Reports of directors' oversight and review of management.* *Board self assessments.* *Management performance assessments.* *Director training. Includes training that is provided to directors before they join the board as well as ongoing training.

factors when considering method of payment for an acquisition

*Distribution between risk and reward for the acquirer and target shareholders.* • stock offering --> target shareholders share in risk • cash offering --> all borne by acquirer. *Relative valuations of companies involved.* • acquirer's shares overvalued --> acquirer more willing to offer stock. *Changes in capital structure.* • impact on acquiring firm's post-merger leverage, dilution

types of divestitures

*Equity carve-outs* create a new, independent company by giving an equity interest in a subsidiary to outside shareholders. Shares of the subsidiary are issued in a public offering of stock, and the subsidiary becomes a new legal entity whose management team and operations are separate from the parent company. *Spin-offs* are like carve-outs in that they create a new independent company that is distinct from the parent company. The primary difference is that shares are not issued to the public, but are instead distributed proportionately to the parent company's shareholders. This means that the shareholder base of the spin-off will be the same as that of the parent company, but the management team and operations are completely separate. Since shares of the new company are simply distributed to existing shareholders, the parent company does not receive any cash in the transaction. *Split-offs* allow shareholders to receive new shares of a division of the parent company in exchange for a portion of their shares in the parent company. The key here is that shareholders are giving up a portion of their ownership in the parent company to receive the new shares of stock in the division. *Liquidations* break up the firm and sell its asset piece by piece. Most liquidations are associated with bankruptcy.

key stakeholders of a corporation

*External* - Customers - seek stability and product choices and lower prices (lower revenue) - Suppliers & Creditors - seek stability and higher prices (higher expenses) - Unions - seek stability and higher wages and benefits (higher expenses) - Governments - provide rules and regulations - Local communities & general public *Internal* - Stockholders - supply risk capital - Employees - immediate, stable, and growing compensation - Managers - asymmetric information advantage - Board members - monitor and evaluate performance of senior managers

GAAP reclassification of investment in financial assets

*Fair value through profit or loss --> Any*: Income Statement (to extent not recognized) *Held-to-maturity --> Fair value through profit or loss]]*: Income Statement *Held-to-maturity --> Available-for-sale*: OCI *Available-for-sale --> Held-to-maturity*: Amortize out of other comprehensive income over remaining life of security *Available-for-sale --> Fair value through profit or loss*: Transfer out of other comprehensive income Restricted under IFRS: in to / out of FVPL, out of held-for-trading

Valuation and Intrinsic Value

*Intrinsic Value (IV)* = true underlying value of the security given complete understanding *Estimated Value (VE)* = investor estimate of intrinsic value *Market Price (P)* = current price VE - P = (VE - IV) + (IV - P)

equity valuation concepts

*Intrinsic value*: value given a hypothetically complete understanding of asset's investment characteristics *** *Going Concern Value* = value assuming firm will continue its business activities into foreseeable future; primary focus of equity valuation readings *Liquidation Value* = value if firm dissolves and assets sold individually *Orderly Liquidation Value* = Assumes adequate time to realize liquidation value (e.g., required to sell inventory immediately vs. able to sell over time) *** *Fair Market Value* = Price between willing and informed buyer and seller, neither of whom are under any compulsion to buy/sell *Investment Value* = Value to a specific buyer, taking into account synergies and based on investor's requirements and expectations

business combination categories (GAAP)

*Merger*: A+B=A. Net assets transferred from B to A. *Acquisition*: A+B=(A+B). A=parent; b=sub *Consolidation*: A+B=C. A and B cease to exist. *Variable Interest Entity*: Control not based on equity ownership.

private equity economic terms

*Performance* 1. *management fees*: paid by LP to GP, typically a % of committed capital (but can also be NAV) 2. *transaction fees*: charged to portfolio companies; typically split between LP / GP 3. *carried interest*: paid by LP to GP, typically a % of (NAV b/f distributions at EoP less NAV b/f distributions at BoP) 4. *ratchet*: allocation of equity between shareholders and management, allowing management to increase allocation depending on company performance 5. *hurdle rate*: minimum IRR before GP can receive carried interest *Fund overview* 6. *target fund size*: stated total target size of fund 7. *vintage*: year in which fund was started 8. *term of fund*: life of firm; typically 10 years *Other* 9. *administrative costs*: various annual costs including custodian fees, fees to transfer agents, accounting costs 10. *placement fees*: paid by GP to agents for raising funds 11. *trailer fees*: charged annually by GP to LPs

merger motivations by lifecycle

*Pioneer/development* • Unsure of product acceptance • Large capital requirements and low profit margins • Access to capital, sharing mgmt talent • Conglomerate, Horizontal *Rapid growth* • High profit margins, accelerating sales and earnings, low competition • Access to capital, expand capacity to grow • Conglomerate, Horizontal *Mature growth* • Lots of new competition but opportunities for above-average growth • Increase operational efficiencies, achieve economies of scale/synergies • Horizontal, Vertical *Stabilization* • Competition has reduced growth potential, facing capacity constraints • Achieve economies of scale/reduce costs, improve mgmt • Horizontal *Decline* • Consumer tastes have shifted, overcapacity, shrinking profit margins • Survival, operational efficiencies, acquire new growth opportunities • Horizontal, Vertical, Conglomerate

least common multiple of lives method for project valuation

- Assumption is that projects are replaced indefinitely as they wear out. - Create a replacement chain

Beneish Model

*Probit* model that outputs manipulation score (m-score) --> higher m-score indicates higher likelihood of earnings manipulation M-score > -1.78 = possible earnings management Relies on accounting data; may not reflect economic reality. Metrics could be gamed A. variables whose *increase over time* suggests higher likelihood of earnings manipulation: 1. higher non-monetary & non-tangible assets as % of total assets (AQI) 2. higher sales (SGI) 3. higher days sales receivable (DSR) 4. higher accruals B. variables whose *decrease over time* suggests higher likelihood of earnings manipulation: 1. lower depreciation as % of BoP PP&E 2. lower gross margin % C. variables whose increase over time was thought to suggest higher likelihood of earnings manipulation but ended up with a negative regression coefficient: 1. higher SG&A 2. higher leverage

business forms of ownership

*Sole proprietorship* -Business owned and operated by an individual -Easily set up and few legal requirement -Most common -Conflict of interest between creditors and suppliers *Partnership* -Two or more owners/managers -No legal distinction between business and owners -Unlimited liabilities shared among partners -Pool knowledge and capital and share in business risk -Conflict of interest between creditors and suppliers and among partners *Corporation* -Distinct legal entities that are similar to individuals -Top managers act as agents -less than 20% of businesses -Conflict of interest between ownership and control Advantages of corporations -Easier to raise large amounts of capital (common stock) -No need for owners to be industry experts -Ownership stakes are easily transferable -Corp have unlimited lives -Shareholders have limited liability (only lose what they put in)

Proportionate consolidation • accounting • impact on financial statements vs. equity method • when is it allowed?

*accounting* • parent company reports owned % of assets, liabilities, revenue, and expenses; equity is not consolidated *impact on financial statements vs. equity method* • results in higher assets and liabilities, higher revenues and expenses *when is it allowed?* • GAAP allows proportionate consolidation for joint ventures only if the firm is an *unincorporated* venture in a *specialized industry*

contents of IPS

*administrative*: 1. reporting requirements 2. rebalancing guidelines 3. frequency and format of investment communication 4. manager fees 5. client description *strategic*: 1. investment strategy 2. desired investment style 3. evaluation of investor risk preferences 4. (OPTIONAL) strategic asset allocation

advantages of publicly traded real estate securities • all securities • REIT-specific

*advantages of all public real estate securities*: 1. liquidity 2. low minimum investment 3. limited liability 4. access to premium properties 5. active professional management - no investor skill required 6. regulatory protections of publicly traded corporations 7. ability to diversify across property types and geography *REIT-specific advantages*: 1. no corporate taxes 2. predictable earnings (due to rental income fixed by contracts) 3. high yield (due to requirement to pay out most of taxable income as dividends)

VAR advantages & limitations

*advantages*: 1. simple & easily communicated 2. comparable 3. facilitates asset allocation decision 4. can guide performance evaluation 5. reliability can be verified 6. widely accepted by regulators *limitations*: 1. subjective 2. underestimates frequency of extreme events incl. right-tail events 3. doesn't account for liquidity 4. sensitive to correlation risk 5. vulnerable to trending or volatile regimes 6. misunderstanding (e.g., not a worst case scenario) 7. overly simplified

corporate governance best practices

*audit committee* has expertise in financial and accounting matters, has full access to and the cooperation of management, and meets with auditors at least once annually *independent* board members to meet at least annually, preferably quarterly, in separate sessions without management in attendance, 75%+ independent directors, independent chairman boards should evaluate and assess their effectiveness at least *annually*, with a focus son member participation, committee activities, and future needs of the board. compensation/audit/nominating *committees* should consist of only independent directors. annual *elections*, not staggered *qualified* directors who do not serve on more than 2-3 other boards *compensation*: long-term focused, not benchmarked w/ other firms. base salary + performance based perquisites + majority in share-based compensation (options not repriced) *independent legal counsel* (not internal counsel) *statement* of governance policies

investment in associates: equity method (balance sheet, impairment, D&A and upstream & downstream)

*balance sheet* reported at: + cost - potential negative goodwill - % owned * dividends + net income recognized on P&L = + % owned * earnings - D&A from allocation to identifiable assets - % owned * unconfirmed upstream & downstream + bargain purchase note: % owned = owned shares / *common shares*, i.e., preference shares are not considered *Impairment* • entire investment reviewed annually for impairment • reversals not allowed *IFRS*: • one or more loss events that impact future cash flows and can be reliably estimated • recoverable amount < carrying value & not temporary • recognized in P&L and investment written down directly or via allowance account *US GAAP*: • fair value < carrying value AND permanent • asset written down to fair value and impairment loss recognized in income statement. *upstream/downstream sales*: • investor must eliminate its share of upstream profit and unconfirmed downstream profit from its recognized portion of investee equity income

LIBOR-OIS spread • calculation • components

*calculation* • difference between LIBOR (credit risk) and overnight indexed swap (OIS) rate (reflects fed funds rate and has minimal counterparty risk) *interpretation* • useful as a measure of risk and liquidity of *money market securities*

I-spread • calculation • components

*calculation* • difference between yield on a risky bond and swap rate for a given maturity - if swap rate not available, the linearly interpolate *interpretation* • reflects compensation for credit risk and liquidity risk, i.e., no additional time value on top of that reflected in swap rate

appraisal based indices • construction • issues • example

*construction* - investment managers and pension fund sponsors submit appraisal data quarterly. *issues* - tend to lag actual transactions --> results in artificial smoothing of index and lowering of correlation with other asset classes - solution is to unsmooth the index or use a transaction-based index *example* - NCREIF Property Index

current account and impact on exchange rate • description of the three channels

*current account*: sum of all recorded transactions in traded goods, services, income, and net transfer payments for countries with freely floating exchange rate, persistent current account deficits lead to currency depreciation and persistent current account surpluses lead to currency appreciation (1) *flow supply demand channel*: trade deficit --> more supply of currency in international markets --> more downward pressure; amount of adjustment in exchange rate required to restore balance to current accounts depends on: (a) initial gap between X & M (would need more currency depreciation if export demand is less elastic than import demand) (b) response of X & M prices to changes in exchange rate (however empirical results show limited pass through effects) (c) response of X & M demand to change in X & M prices (2) *portfolio balance channel*: foreign nations will only willingly hold a larger amount of domestic bonds if they're compensated by higher expected returns, which can be the result of (a) higher interest rates, and/or (b) depreciation of the domestic currency in order to generate anticipation of future appreciation (3) *debt sustainability channel*: persistent trade deficits will result in more debt owed to foreigners, and if levels become unsustainable in the eyes of investors, the currency will depreciate; implies a limit on current account deficit that is balanced by a depreciation in currency that stabilizes external debt at a sustainable level

private real estate financial ratios

*debt service coverage ratio (DSCR)*: - first-year NOI / debt service - debt service (loan payment) includes interest and principal *loan to value (LTV)*: - loan amount / appraisal value *equity dividend rate*: - first year cash flow / equity - cash return on amount of cash invested - only covers one period

TED spread • definition • indicator

*definition* -TED spread = (3-month LIBOR rate) - (3-month T-bill rate); name comes from combining the T-bill with "ED" (the ticker symbol for Eurodollar futures contract) *indicator* -more accurately reflects the risk in the banking system compared to the swap spread -rising spread = falling liquidity

backward induction method of bond pricing

*definition* process of valuing bond using a binomial interest rate tree by moving backward from last period to time zero *calibration of tree* constructed so as to result in arbitrage-free values for on-the-run benchmark securities or for spot rates that can yield same value as par rates

defn. of, effect of, and approach to manage conditional heteroskedasticity

*definition* strong relationship between the regression error variance and the regression independent variables *effect* understating standard errors of estimated coefficients, which will result in inflated t-statistics Approach to manage is to use robust standard errors

structural model of credit risk • description • assumptions • option analogies • weaknesses

*description* -a company defaults on its debt if the value of its assets falls below the amount of its liabilities - the probability of default has the features of an option -explains "*why*" default occurs (i.e., asset < liabilities) *assumptions* -assets are actively traded -default is treated as an endogenous variable *option analogies* -equity-holders are effectively long a call option on the assets of the company with a strike price of K (face-value of debt), while debt-holders own the assets and are short the call option -alternatively, equity-holders own the assets and are long a put option on the assets with strike price of K, while debt-holders own a risk-free bond of face value K and are short the put-option *weaknesses* -inaccurate if there are off-balance sheet liabilities -relies on information that is best known to a company's managers, bankers, and credit agencies

reduced form model of credit risk • description • assumptions • weaknesses

*description* -statistical model of "*when*" default occurs -key input is *default intensity*, which is the probability of default over the next time increment, which can be measured using regression models based on company-specific variables and macroeconomic variables, thereby allowing the model to consider the current stage of the business cycle -also called intensity-based or stochastic default rate models *assumptions* -default is treated as a random event, i.e., exogenous variable *issues: -default is typically not 100% exogenous as it's preceded by several credit downgrades -relies on information that's widely available in the financial markets

residual value guarantee • description • accounting

*description* a payment made by lessee at termination of lease in the event that *accounting* increase both assets and liabilities by the amount of the residual value guarantee - this approach is used for all off-balance sheet financing

robo advisors

*description* online wealth management services that provide automated, algorithm based portfolio management advice without the use of human financial planners. 1. subject to regulation (e.g., RIA in US so regulated by SEC) 2. most follow passive investment approach 3. can be fully automated or involve a financial advisor

gross income multiplier • description • data source • weaknesses

*description* • alternative method for valuing real estate • ratio of sale price to expected gross income from a property in first year after sale • considered less reliable than using a cap rate *data source* • comparable sales *weaknesses* • assumes vacancy and operating expenses are similar between comparable and subject properties

real options • description • types • calc of project NPV incl. options

*description* • managers have the option to make future decisions that can change the value of projects initiated today • based on real assets rather than financial assets *types* 1. timing - wait for better information 2. abandonment - exit project early if failure 3. expansion - invest more $ if successful; similar to call options 4. flexibility - price setting, production-flexibility, choices of other operational aspects 5. fundamental - entire project is an option; payoff depends on underlying asset (e.g., gold mine under an operating farm) *calc of project NPV incl. options* Project NPV = NPV(no option) - Cost of Option + Value of Option

convenience yield • description • interpretation • role in forward pricing • relationship with supply and prices

*description* • monetary benefit from holding a physical commodity versus being long • holding the commodity gives the option to consume the input at any time. *interpretation* • reflects market's expectations about future availability of a nonrenewable commodity. *role in forward pricing* • F = S + interest cost + storage cost - conv yield *relationship with supply and prices* high supply -> low convenience yield -> higher futures price relative to spot price.

special purpose entity (SPE) / variable interest entity (VIE) • description • accounting • legal forms • examples

*description* • when equity investors don't have decision making rights but have obligations to absorb losses and to receive expected residual returns • IFRS: when control is not based on voting control because equity investors do not have sufficient amount at risk in order to finance the entity, where control is based on whether investor (1) has ability to influence financial & operating policy, and (2) is exposed to variable returns from investee *accounting* • GAAP uses two component consolidation model 1. variable interest component: must be consolidated by the primary beneficiary 2. voting interest (control) • IFRS: SPE must be consolidated by sponsor if substance of relationship indicates control by sponsor *legal forms* • can be a corporation, partnership, joint venture, or trust *examples* • lease residual guarantee, subordinated debt

tracking portfolio • description • construction

*description*: -a portfolio with a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index -active bet on asset selection *construction*: -manager constructs the portfolio to have the same factor exposures as a benchmark, and then selects what they believe are the superior securities, thus outperforming the benchmark without taking on more systematic risk

normalized earnings per share • description • calculation methods

*description*: -estimate of EPS in the middle of the business cycle *calculation methods*: 1. method of *historical average EPS*: average EPS over some recent period (recent business cycle) 2. method of *average returns of equity*: estimated as the average ROE over business cycle * current book value per share; reflects the effect of firm size; preferred method

pension plan, actuarial assumptions

*discount rate* - used to determine PBO, current service cost, gross interest expense *compensation growth rate* - affects PBO and periodic pension cost *expected return on plan assets* - US GAAP only, gross interest income *retirement age, life expectancy* *formula to determine annual benefit per year of service*

regression models with qualitative dependent variable

*discriminant models* generates an overall score/ranking for an observation, which can be used to rank/classify observations (e.g., using financial ratios to determine whether a company is in bankrupt class or not) *probit/logit models*: based on normal/logistic distro; determine probability of an event occurring *how to analyze*: F-test, R-squared, t-tests; watch out for heteroskedasticity, serial correlation, and multicollinearity

due diligence of private real estate investments

*financial*: 1. lease review and rental history 2. examination of bills to confirm operating expenses 3. review of cash flow statements *physical*: 1. environmental reports 2. inspection to identify structural issues 3. survey to confirm the boundaries *legal*: 1. inspection of title and other legal documents 2. compliance with zoning laws, building codes and environmental regulations 3. payment of taxes, insurance, special assessments

types of obsolescence

*functional*: loss in value that results from defects in design that impairs a building's utility (e.g., bad floor plan) *locational*: when the location is no longer optimal (e.g., a prison is built) *economic*: when new construction is not feasible under current economic conditions

acquisition method:

*identifiable assets & liabilities* • acquirer to measure acquiree's identifiable tangible assets, identifiable intangible assets, and liabilities • acquirer to recognize previously unrecognized assets/liabilities (e.g., brand names, patent, tech) *contingent liabilities* • acquirer to recognize if there is a present obligation that arises from past events that can be measured reliably *indemnification assets* • acquirer to recognize if acquiree contractually indemnifies acquirer for outcome of a contingency or uncertainty *financial assets & liabilities* • acquirer to reclassify based on its own accouting/operating policies *goodwill*: • if market price < fair value of net assets, then gain is recognized in P&L • contingent consideration recognized at time of business combination --> subsequent changes in value of CC are recognized in P&L *full goodwill* (GAAP, IFRS): • goodwill = total fair value less net identifiable assets • minority interest = minority share % * total fair value *partial goodwill* (IFRS): • goodwill = consideration - parent's share % of target's net identifiable assets • minority interest = minority share % * FV of target's net identifiable assets net identifiable assets = + identifiable tangible assets + identifiable intangible assets - liabilities - contingent liabilities

incremental VaR vs. marginal VaR

*incremental*: change in VaR from a change in the portfolio allocation to a security *marginal*: similar to incremental VaR but uses formulas derived from calculus; can be thought of as the change in VaR for a $1 or 1% change in position

factors that affect capital structure across countries

*institutional & legal* (a) strength of legal system (weaker --> more debt and shorter maturity), (b) information asymmetry (more asymmetry --> more debt esp. short-term), (c) taxes (tax-shield on interest, are dividends tax advantaged?) *financial market & banking system* (a) liquidity of capital markets (larger & more liquid --> longer maturity debt), (b) reliance on banking system (more reliance on banks, i.e., less on corporate bonds --> more leverage), (c) institutional investor presence (more large institutional investors can affect maturity of debt, e.g., life insurance & pension funds prefer longer maturity; more active institutional investors --> longer maturity and less leverage) *macroeconomic factors* (a) inflation (high inflation --> shorter maturity and less leverage), (b) GDP growth (higher GDP growth --> longer maturity)

disadvantages of publicly traded real estate securities

*investor economics* 1. moderate income growth potential due to high dividend payout rate; can result in undervaluation during times when market highly values fast growth 2. no pass-through of tax losses 3. at whim of stock market, for both stock prices (less stable than appraisal-based) and equity issuance (e.g., if unable to maintain leverage in times of weak credit availability) *principal-agent* 1. limited control 2. structural conflicts and costs due to use of UPREIT and DOWNREIT structures, e.g., conflict of interest between partnership and REIT shareholders 3. costs of maintaining publicly traded corporate structure

valuation after inception of a CDS • key factors • formula

*key factors* • valuation driven by change in credit quality of the reference entity: increase in credit risk benefits protection buyer *formula* • change in spread * duration * notional

due diligence of REITs

*leases* - Remaining lease terms - short remaining lease -> can raise rents in good economy - Inflation protection - scheduled rent increases, inflation-indexed - In-place rents vs. market rents - compare currently-paid leases to market leases - Costs to re-lease space - lost rent, lease incentives, improvements, broker commissions - New competition - amount of new space planned or under construction *tenants* - Tenant concentration - higher concentration = higher risk - Tenants' financial health - failure of largest renters *overall company* - Balance sheet analysis - focus on amount of leverage, cost of debt, and debt's maturity - Quality of management - senior management's performance record, qualifications, and tenure with REIT

market risk vs. credit risk

*market risk*: risk that is due to changes in markets to which an organization has exposure; arises from movements in (1) stock prices, (2) interest rates, (3) exchange rates, and (4) commodity prices *credit risk*: risk of loss from failure of counterparty to make promised payment

VaR, pros and cons

*parametric*: • pro: simiple & straightforward • con: cannot use for portfolios with options (due to non-normal distribution of payoff) *historical simulation*: • pro & con: based on what actually happened; not constrained by normal distribution but doesn't consider possibility of previously unobserved movements • pro: can handle adjustment of one time horizon to another (e.g., extrapolating annual data based on daily data) • pro: can accurately incorporate effects of positions of options and bonds with embedded options *monte carlo simulation*: • pro: can accommodate more complex distributions • con: can accurately incorporate effects of positions of options and bonds with embedded options

historical methods of accounting for business combinations

*pooling of interests method*: • used pre-2001 under GAAP • combines all assets/liabilities/retained earnings *uniting of interests method*: • used pre-2004 under IFRS • combines all assets/liabilities/retained earnings *purchasing method*: • purchase is viewed as a purchase of net assets (tangible + intangible assets - liabilities), with additional depreciation resulting from increase in value of depreciable assets

key metrics for life & health insurance firm • profitability • underwriting efficiency

*profitability* • RoA, RoE • growth & volatility of capital • book value per share • operating margins • operating RoA, RoE *underwriting efficiency*: both of the following as a % of net premiums written and deposits: • benefits paid • commissions and expenses incurred

risk measures used by insurers

*property & casualty, health*: 1. *sensitivities & exposures* 2. *economic capital and VaR* 3. *scenario analysis*, e.g., stressing market and insurance risks in same scenario *life*: 1. *sensitivities*: exposures of investment portfolio and annuity liability 2. *asset & liability matching* 3. *scenario analysis*: potential stress losses (i.e., both market and non-market sources of cash-flow change) based on differences in invested assets and liabilities driven by insurance contracts

P/B (rationale, calc, drawbacks, adjustments)

*rationale*: -attempts to represent the investment that common shareholders have made in the company -usually positive -more stable than EPS -good for firms with mostly liquid assets (e.g., financial) -useful for distressed firms, liquidation -more meaningful than P/E when EPS is abnormally low/high/variable *calc*: -only common equity -Using the Gordon growth model, P/B = (ROE-g) / (r-g) -(ROE-r) fundamentally affects P/B -larger spread = value creation -firms that earn ROE = r will have a P/B=1 *adjustments*: -tangible book value per share (BV of common equity less intangible assets), e.g., goodwill -accounting adjustments, e.g., LIFO/FIFO -off-balance sheet assets/liabilities *drawbacks*: -does not reflect value of intangible assets (e.g., human capital, reputation, etc.) -misleading when comparing firms with significant differences in (1) asset size/age, (2) accounting conventions -distorted by share repurchases and/or issuance -inflation and technological change can cause big differences between BV and MV

EV/EBITDA Calculation

*rationale*: -controls for leverage, unlike P/E -controls for depreciation/amortization differences -EBITDA is usually positive *calc*: EV = + MV of common + noncontrolling interest + MV of debt + MV preferred - cash - cash equivalents - short-term investments *drawbacks*: -FCFF more closely tied to value than EBITDA (e.g., revenue recognition policies, working capital, capex, etc.)

P/E (rationale, calc, drawbacks)

*rationale*: -earnings power (EPS) key to investment value -focal point for Wall Street -empirical research shows that P/E differences are strongly related to long-run returns -proxy for risk and growth *calculation*: 1. remove nonrecurring items: ---G/L on asset sales ---asset write-downs ---loss provisions ---changes in estimates 2. normalize earnings to remove cyclical component ---historical average EPS ---average ROE x BVPS *drawbacks*: -negative earnings produce a meaningless ratio -volatile, transitory portion of earnings makes interpretation difficult -management discretion can distort earnings -solely using the ratio avoids addressing the fundamentals (growth, risk, cash flows)

PEG

*rationale*: -reflects P/E per percentage-point of growth *calc*: - P/E / g -lower PEG = more attractive -PEG < 1 can be indicator of attractive value level* *drawbacks*: • doesn't account for differences in (1) *risk*, or (2) *duration of growth* • assumes *linear relationship* between P/E and growth (DDM shows that theoretical relationship is non-linear) • not appropriate for firms with low or negative expected dividend growth rate

P/S

*rationale*: -sales always positive -sales more stable and less prone to distortion than EPS over time -useful for (1) distressed firms, (2) mature, cyclical, and zero-income stocks *calc*: Net Income margin % x trailing P/E -control for profit margin, expected growth, risk, accounting data quality *drawbacks*: -high sales *growth may not translate to op profit* -does not capture different *cost structures* or *capital structures* between firms -*revenue recognition methods* can distort reported sales and forecasts

P/CF

*rationale*: -more difficult to manipulate than EPS -more stable than earnings -addresses quality of earnings problem *calc*: -traditional = net income + noncash charges -CFO = from statement -Adjusted CFO = CFO + Int(1-t) -EBITDA -FCFE (theoretically superior) *drawbacks*: -moving toward a better measure of cash flow (i.e., from NI + non-cash charges --> FCFE) results in higher volatility and possibility of negative value

tools to measure risk in an investment • description incl. role in relation to risk adjusted value

*scenario analysis*: appropriate when risk is continuous; can serve as complement to risk-adjusted value *simulation*: appropriate when risk is discrete and non-sequential; can serve as complement or substitute to risk-adjusted value *decision-tree*: appropriate when risk is discrete and sequential; does not accommodate correlated variables; can serve as complement or substitute to risk-adjusted value

probabilistic approach: simulation • steps • common constraints • advantages • weaknesses • appropriate discount rate

*steps* 1. determine probabilistic variables 2. define probability distributions for these variables 3. check for correlations among variables 4. run simulation *common constraints* • book value • market value • earnings, cash flow *advantages* • can be used for continuous risk and both sequential & non-sequential risk • accommodates correlated variables • can allow for higher quality input data assuming proper diligence for key inputs (but risk of GIGO) • provides a distribution of expected value rather than a point estimate • considers full range of possibilities unlike scenario analysis *weaknesses* • garbage-in, garbage-out • real world data doesn't fit statistical distribution • distributions may change over time (i.e., non-stationary) • correlations between input variables may change over time *appropriate discount rate* • cash flows from simulations are *not* risk-adjusted and should not be discounted at the risk-free rate

procedural law vs. substantive law

*substantive law* focuses on the rights and responsibilities of entities and relationships among entities *procedural law* focuses on the protection and enforcement of substantive laws

swap rate curve • swap spread (description and calculation) • construction • advantages over treasury yield curve

*swap spread*: • amount by which fixed-rate payer side of interest rate swap exceeds yield of gov bond with same maturity • positive swap spread --> lower credit risk for government securities swap spread = swap fixed rate - treasury yield *construction of swap rate curve* • based on fixed rate quotes on interest rate swaps at varying maturities (swap rates reflect credit risk) *advantages over treasury yield curve*: • not affected by gov reg --> more comparable across countries • quotes at more maturities

international differences in capital structure

*total debt* - Japan, Italy, and France tend to have more total debt than US and UK *debt maturity* - NA countries use longer maturity debt than Japan *emerging vs. developed* - Developed countries use more total debt and longer maturity debt

properties of an estimator

*unbiased*: the expected value of the statistic equals the value of the parameter it estimates. *efficient*: of all unbiased estimators, it has the smallest sampling error. *consistent*: as the sample size increases, the sampling error decreases.

stock option • what is valuation methodology (incl. key dates)? • how is expense allocated over time? • what is impact on financial statements?

*valuation*: based on the fair value of the options on the grant date based on the number of options that are expected to vest; fair value is based on the observable market price of a similar option available - otherwise, the firm can use Black-Scholes or binomial model *accounting*: compensation expense is allocated in the income statement over the service period, which is the time between the grant date and the vesting date *impact on financial statements*: recognition of compensation expense will decrease net income and retained earnings; however, paid-in capital is increased by an identical amount. This results in no change to total equity

stock grant • valuation • types

*valuation*: based on the fair value of the stock on the grant date and allocated over the employee's service period *types*: 1. normal stock 2. restricted stock (cannot be sold until vested) 3. performance stock (contingent on meeting performance goals, e.g., accounting earnings)

______ tends to outperform ______ investing in the aftermath of a recession

*value* tends to outperform *growth* in the aftermath of a recession *cyclical* tends to outperform *non-cyclical* in the aftermath of a recession *smaller cap* tends to outperform *larger cap* in the aftermath of a recession

calculation of equity risk premium using gordon growth model

+ dividend yield (based on next year's dividend) + consensus long-term earnings growth rate - current long-term government-bond yield

change in net funded status (A-L)

+ employer contributions - pension cost

biased accounting - mechanisms to misstate profitability

- Aggressive revenue recognition, channel stuffing, bill and hold sales, fake sales - Lessor use of finance lease classification - Classification of nonoperating revenues - Classification of operating expenses - Channel gains through NI but losses through OCI

discount rate models for private companies

- CAPM - difficult to estimate beta since non-public - Expanded CAPM - includes additional premiums for size and firm-specific risk - Build-up method - begin with market expected return and add premiums for small size, industry factors, and company specific factors

cash flow quality (company analysis)

- CFO positive and sustainable - CFO > capex + debt service + dividends 1. Review for unusual items 2. Check for revenue quality - outflows due to increased AR; outflows due to inventory increases when fake sales are reversed 3. Provisions for restructuring - cash inflow when created

Forecasting FCF

- Calculate historical free cash flow and apply a growth rate - Growth rate may be different for FCFF and FCFE - Forecast components of FCF - Ties sales forecasts to future capital expenditures, depreciation expenses, and changes in working capital - Target debt-to-asset ratio often maintained; defines net borrowing amount.

Dummy Variables

- Can only take the values of 0 and 1 - Can be used in calendar studies - Always use (n-1) dummy variables to avoid multicollinearity

adjustments to the financial statements before calculating NOPAT and invested capital

- Capitalize and amortize *R&D* charges and add them back to earnings to calculate NOPAT - Add back *charges on strategic investments* that will generate returns in the future - Capitalize (but don't amortize) *goodwill*, add *amortization* expense back to earnings to get NOPAT and add accumulated amortization back to total capital - Eliminate *deferred taxes* and consider only cash taxes as an expense - Treat *operating leases* as capital leases - Add *LIFO* reserve to invested capital and add back change in LIFO reserve to NOPAT

factors to consider when assessing corporate governance

- Codes of ethics - Director's oversight, monitoring, and review possibilities - Management's responsibility to the board - Reports of director's oversight - Board self assessments - Management performance assessments - Director training

Purposes in Regulating Commerce

- Company law, bankruptcy law, competition laws, contract laws, etc. - Regulations essential for business decision making - Regulatory framework may help or hinder commerce

analysis of Earnings Sources and ROE Adjustments

- Consider sources of income and whether the income is generated internally from operations or externally - Remove equity method income and investment asset from the extended DuPont equation

probabilistic approach: scenario analysis

- Defines best, worst, and base case - Better suited for discrete outcomes - Better suited for risks that occur concurrently - Can deal with correlations subjectively by building them into each scenario

Investment in Associates - Analytical Issues

- Equity method results in higher earnings than in passive investments; should consider suitability - Only % investee's equity reported on investor's balance sheet - assets and liabilities not reported; ignoring investee's debt reduces leverage - Investee's earnings may not be distributed as dividends - lower earnings quality

Free Cash Flow Method

- Estimate future cash flows - Discount relative to risk Terminal value determined from constant growth model or a price-multiple approach. Could double count high growth, one in price multiple and once in periodic cash flows

Beta Estimates for Public Companies

- Estimated with regression - Regress the company's returns on the returns of the overall market index - Popular index choices are S&P 500 and NYSE Composite - Can adjust beta for drift toward 1

probabilistic approach: decision tree

- Events considered in phases - Better suited for sequential and discrete risks - Correlated risks difficult to model - Best suited when historical data is available because probabilities have to be estimated at each node

Antitrust Regulation

- Excessive concentration of market share - Anticompetitive behavior - Analysis of announced merger based on probable regulator response

capital budgeting pitfalls

- Fail to incorporate competitor/market response - Misuse standardized templates - Pet projects not analyzed properly - Base investment decision on EPS or ROE - Use IRR for mutually exclusive projects - Poor cash flow estimation - Over/underestimate overhead costs - Use correct discount rate - Internal politics involved with spending entire capital budget vs. returning excess funds - Fail to generate alternative investment ideas - Handle sunk costs and opportunity costs improperly

definitions of private company value

- Fair market value - willing and able buyer/seller, arms-length transaction, well-informed buyer/seller - Fair value for financial reporting - similar to fair market value but no willing buyer/seller - Fair value for litigation - similar to fair value but definition depends on statutes and legal precedents - Market value - used for appraisals of real estate and other real assets - Investment value - value to a particular buyer - Intrinsic value - market value once other investors arrive a the "true" value, independent of any short-term mispricing

pricing a risky bond using credit valuation adjustment

price of an X-year zero coupon risky bond = + price of an X-year zero coupon risk-free bond - CVA

sources of information about risk

- Financial statements - Lack of auditor independence; size of auditor - Notes to financial statements (accounting principles, changes to estimates, disclosures on liability amounts and timing, contingent liability disclosure) - Management discussion and analysis - SEC form NT - Financial press

equivalent annual annuity method for project valuation

- Finds the sequence of equal annual payments with a present value that is equal to the project's NPV. - Take each project's NPV and calculate the annual payment - Select the project with the highest payment

Forecasting SG&A

- Fixed elements set be management and generally only change with the firm's size - Selling and distributions costs related to sales

Forecasting COGS

- Generally estimated as a percentage of revenue - Gross margins need to be evaluated in relation to margins of competitors - Firm's inputs should also be analyzed. Volatility could affect COGS - Firm may have also hedged future COGS

comparative financial analysis, adjustment for pensions

- Gross vs. Net pension assets/liabilities - affects balance sheet ratios (ROA, leverage, etc.) - Differences in assumptions - Difference between IFRS and US GAAP income reports - Differences due to classification in income statement Other adjustments: - Full pension expense is typically included in operating expenses (SG&A) - Only service cost is operating - Remove pension expense from operating expenses and include service cost - Add interest cost to interest expense - Replace expected return on plan assets with actual return and include as non-operating income - Ignore amortization -NOTE: GAAP requires aggregation of periodic pension expense into a single line item and presented as a net item - IFRS has no such requirement Cash flow adjustments: - If contribution > total cost then treat as principal payment (reduces CFF, increases CFO) - Otherwise, treat as borrowing (increases CFF, decreases CFO)

Biased Accounting - Warnings Signed of Misstated Assets/Liabilities

- Inconsistency in model inputs for valuation of assets vs. liabilities - Typical current assets being treated as noncurrent - Allowances and reserves either out of line with peers or fluctuating - Off-balance-sheet liabilities - Fluctuating deferred tax assets/liabilities

effect of removing trade barriers

- Increased investment from foreign savings - Allows focus on industries where the country has a comparative advantage - Increased market for domestic products, resulting in economies of scale - Increased sharing of technology and higher total factor productivity growth - Increased competition leading to failure of inefficient firms and reallocation of their assets to more efficient uses

Biased Accounting - Warning Signs of Overstated CFO

- Increases in payables combined with decreases in inventory and receivables - Capitalized expenditures (CFI, not CFO) - Sale and leas back transactions - Increases in bank overdraft

board responsibilities

- Institute corporate values - Create long-term strategic objectives - Determine management's responsibilities - Ensure complete and accurate information - Meet regularly - Ensure board members are adequately trained

factors affecting dividend payout policy

- Investment *opportunities* - availability keeps cash on hand - Expected *volatility* of future earnings - firms more cautious in changing policy during high volatility - Financial *flexibility* - stock repurchases are less sticky - *Tax* considerations - tax differences between capital gains and dividends - *Flotation costs* - retained earnings have no costs like the issuance of new equity - *Contractual and legal* restrictions - impairment of capital rule, debt covenants

Multinational Operations and Tax

- Issue = transfer pricing - Shift profits from high tax rate to low tax rate countries - Countries have laws to prevent aggressive transfer pricing - Payment of domestic tax on overseas income varies globally - Tax treating prevent double taxation - credit granted for overseas tax (US)

special purpose entity

- Legal structure created to isolate certain assets and obligations of the sponsor - Created to serve specific purpose: purchase assets, fund R&D, lease assets, enhance the balance sheet - Typical motive is to obtain low-cost financing

Stock-Specific Factors (valuation)

- Liquidity - private equity has fewer potential owners and is less liquid - Restrictions on liquidity - private companies often have agreements that prevent shareholders from selling - Concentration of control - few shareholders in private firms

high ω in residual income models is typically associated with...

- Low dividend payouts - Historically high RI persistence in the industry

Biased Accounting - Mechanisms to Overstate CFO

- Managing activities to affect CFO - Misclassifying cash flow into CFO

Forecast Horizon

- May be based on expected holding period - Must include mid-cycle for cyclical firms - For impactful events (acquisitions, mergers, etc.), forecast horizon should be long enough to realize effect - May be dictated by employer

Biased Accounting - Mechanisms to Misstate Assets/Liabilities

- Model choice and model inputs affecting estimated values - Classification from current to noncurrent - Over- or under-stating allowances and reserves - Understating identifiable assets and overstating goodwill in business combinations

types of CDS trades

- Naked CDS - investor with no underlying exposure buys CDS protection - Long/short trade - investor purchases protection on one reference entity while selling protection on another - Curve trade - long/short trade where investor buying and selling protection on same reference entity but with a different maturity (flattening curve => credit spreads reducing => lower prices => sell high, repurchase at lower price - Basis trade - exploit credit spread difference between bond market and CDS market - Synthetic CDO - construct with CDSs, arbitrage opportunity

Forecasting Interest Expense

- Net debt = gross debt less cash, cash equivalents, and short-term securities - Net interest expense = gross interest expense less interest income on cash and short-term debt

Effect on Ratios (translation methods)

- No change from translation using Current Rate method for pure income statement and balance sheet ratios - Mixed ratios are distorted - FX rate change affect consolidated ratios, even when no "real" change occurs

effect of inflation of project valuation

- Nominal vs. Real cash flows - Cash flows must use appropriate discount rate - Profitability based on *expected* inflation. Higher inflation reduces value of cash flows. - Tax savings reduced by inflation - Inflation decreases the value of payments to bondholders - May affect revenues and costs differently

Normalizing earnings for private company valuation

- Nonrecurring and unusual items - Discretionary expenses - Nonmarket compensation levels - may be lower than market which would overstate earnings - Personal expenses - Real estate expenses - separate treatment due to different risk characteristics, growth prospects, cost - Non-market lease rates - Strategic vs. nonstrategic buyers - synergies vs. no synergies; incorporate synergistic revenues and costs

seasonality

- Occurs when a time series shows consistent seasonal patterns - Bring seasonal component into the model to improve forecasting accuracy (incorporate lags)

REOC

- Ordinary companies that own real estate - Not tax-advantaged - Ineligible to organize as REITs because: - may intend to develop and sell real estate rather than generating passive rental income - may be based in a country that does not allow tax-advantaged REITs

Impact of Natural Resources

- Ownership of natural resources is not important as long as there is access (via trade) - Ownership of natural resources may actually hinder growth: 1. Dutch disease -ownership of resources pushes up the value of domestic currency to the detriment of other industries 2. Other industries may be neglected.

roots of Unethical Behavior

- Personal Ethics - Organization Culture - Leadership - Decision-Making Processes - Unrealistic Performance Expectations - Societal Culture P-O-L-D-Up-S

determinants of CDS spread

- Probability of default - likelihood of default in any any given year by the reference entity - Conditional probability of default (hazard rate) - probability of default given than no prior default has occurred - Loss given default - expected amount of loss in the event a default occurs expected loss = hazard rate x loss given default upfront premium % = (CDS spread - CDS coupon) x duration of CDS

Limitations of Regression

- Relationships change over time - Public knowledge of relationships eliminate usefulness to traders - Assumption violations

FCF with Preferred Stock

- Requires the formulas to reflect the payment of preferred dividends and any issuance or repurchase of such shares - Treat preferred stock just like debt, expect preferred dividends are not tax deductible - WACC should also be revised to reflect the percent of total capital raised by preferred stock and the cost of that capital source.

Biased Accounting - Warning Signs of Misstated Profitability

- Revenue growth higher than peers - Receivables growth higher than revenue growth - High rate of returns from customers - Higher Q4 revenues - Unexplained boost to operating margins - CFO lower than earnings - Inconsistent classification of operating/nonoperating items over time - Aggressive accounting assumptions - Executive compensation tied to financial results

Capitalized Cash Flow Method

- Single measure of economic benefit is divided by a capitalization rate (r - g) - If growth is non-constant, should use FCF method instead

factors to consider when estimating discount rate for private company

- Size premiums - more risk for smaller companies - Availability and cost of debt - less access to debt financing; equity costs more - Acquirer versus target - use target's cost of capital - Projection risk - lack of information; lack of experienced managers - Lifecycle stage - CAPM may be inappropriate for firms with high levels of unsystematic risk

incentives of private investment (economics)

- Social returns - external benefits to the economy of investing in R&D projects - Private benefits may be insufficient to cover the required rate of return on some R&D projects - When private benefits and social returns together exceed the required rate of return, government subsidies may provide incentives for investment in R&D

Technological Developments

- Some advances in technology decrease costs of production, which will increase profit margins - Technological advancement may result in improved substitutes (cannibalization) - Cannibalization factor = percentage of the market for the existing product that will be taken by the new substitute

Company-Specific Factors (valuation)

- Stage of life cycle - typically less mature; sometimes mature or near bankruptcy - Size - typically smaller with less access to equity so can be riskier; - Quality/Depth of management - may not be able to attract as many qualified applicants as public firms - Management/Shareholder overlap - less influence from external shareholder - Length of investment horizon - generally longer-term investors in private companies - Quality of information - public firms required to make timely, in-depth financial disclosures - Taxes - private firms may be more concerned due to impact on owners/managers

applications of equity valuation

- Stock selection - Reading the market - Projecting value of corporate actions - Fairness opinions - Planning and consulting - Communication with analysts and brokers - Valuation of private business - Portfolio management

transaction exposure

- Transactions reported at spot rate on date of transaction - Receipt or payment at a later date - Issue = change in spot rates between transaction and settlement date - Record gain or loss at settlement date in income statement - If settlement after B/S date, record unrealized gain/loss at B/S date; further gain/loss recorded in subsequent year at settlement

Long-Term Growth Rate

- Used for terminal value estimation - Look for inflection points (macroeconomic changes, business cycle stage, government regulations, technology)

Guideline Public Company Method for valuing private companies

- Uses price multiples from trade data for public companies - Adjustments included to account for differences between the subject firm and the comparables Control premium (value of control) should be estimated. Equals difference between pro rata value of a controlling interest and the pro rata value of a noncontrolling interest. Use a public transaction to estimate. Issues: - Transaction type - strategic vs. nonstrategic - Industry conditions - high activity may already include control premium - Type of consideration - stock-based may include "bubble" effect - Reasonableness - coordinate with price multiples Control premium adjustments only made to equity portion. Either - use raw multiple to estimate firm value, subtract debt, apply control premium to remainder - adjust control premium by (1-DR)

characteristics of residual income valuation

- Value recognized earlier in RI model. Less sensitive to terminal value estimates. - Can be used to establish market multiples based on ROE and EPS - Most closely related to Tobin's q ratio (MVdebt+MVequity) / Repl cost of total assets

temporal method

- aka, Remeasurement; Monetary/Nonmonetary - Views the overseas operation as an extension of the parent company's activities - Assets and liabilities translated at rates that preserve the measurements bases after translation (don't fluctuate over time) - Monetary A/L remeasured using the current exchange rate - All other A/L considered nonmonetary and remeasured at the historical rate - Common stocks and dividends remeasured at historical rate - Expenses related to nonmonetary assets (COGS, depreciation) remeasured based on historical rates at purchase, using rollforward - Revenues and all other expenses translated at average rates - Remeasurement G/L recognized in the income statement

current rate method - Rules

- aka, Translation - View the overseas operation as an investment - All income statement accounts translated at the average rate - All balance sheet accounts translated at the current rate except for common stock (translated at historical rate that applied when the stock was issued) - Dividends translated at the rate that applied when they were declared - Cumulative translation adjustment (CTA) realized in income statement on disposal

factors to determine functional currency

- currency that influences sales price - currency of the country whose competitive forces and regulations determine sales price - currency in which funds from financing activities are generated - currency in which receipts from operating activities are retained - subsidiary's autonomy - main currency that influences cost of production - financing from parent to service debt remittance of cash flows to parent - transactions with parent

Qualitative Dependent Variables

- e.g., binary outcomes. - can't use ordinary least squares Probit Models - estimate probability given values of X based on a specified distribution Logit Models - estimate probability given values of X based on logistic distribution Discriminant Models - produce a score or ranking used to classify into categories

focus of company analysis

- earnings sources and performance - asset base - capital structure - capital allocation decisions - earnings quality and cash flow analysis - market value decomposition - off-balance-sheet financing - anticipating changing accounting standards

residual income

- equivalent to economic profit - net income less opportunity cost of capital - accounting income ignores cost of equity Post-levered = NI - (equity capital x cost of equity) Pre-levered = EBIT(1-t) - (total capital x WACC%)

Hyperinflation

- local currency depreciates rapidly relative to parent's currency - cumulative inflation exceeds 100% over a three-year period US GAAP: temporal method IFRS: 1. Nonmonetary assets and liabilities - restate using a price index from acquisition date to balance sheet date 2. Monetary assets and liabilities are not restated 3. Equity is restated by multiplying the change in the index from the beginning of the period, or date of contribution if later, to the balance sheet date 4. Revenues and expenses are restated by multiplying the change in the index from the transaction date to the balance sheet date 5. A purchasing power gain or loss is recognized in the income statement based on the net monetary asset or liability exposure (asset = loss; liability = gain)

business combination: goodwill impairment

- tested for impairment at least annually - cannot be separated from overall business - recognized in income statement as a part of continuing operations. *IFRS*: - allocated across cash-generating units that will benefit from acquisition - if recoverable amount of CGU < carrying value, recognize difference as impairment - allocate excess to impairment of other non-cash assets *US GAAP*: - allocated across reporting units - impaired if FV < CV - impairment is unit's reported goodwill less current fair value of unit's goodwill - no excess impairment is allocated

REIT

-Earnings are primarily from *rent* generated from owned properties (75%+ from rents or interest, i.e., relatively stable, contractual cash flows) -*Required to distribute* 90% of taxable earnings as dividends -Lower corporate *tax rates* -Cannot pass on *tax losses* to investors -preferred method of valuation is *NAVPS* -Can *raise equity capital* frequently since they are required to distribute a high portion of their taxable income -UPREITs are most common structure in US; diversified REITs (reduced risk, wider opportunities) are more common in Europe and Asia

forward and backward looking measures of risk

-Forward looking measures of risk: VaR, ex-ante tracking error, duration and forward-looking beta, stress tests, scenario analyses -Backward looking measures of risk: standard deviation, ex post tracking error, Sharpe ratio, information ratio, historical beta

contingent liabilities (acquisition method)

-IFRS: included if fair values can be reliably measured -GAAP: included if probable and can be reasonably estimated -IFRS recognizes only liabilities for contingent considerations. -GAAP recognizes liabilities as well as assets. These contingent considerations are recognized at their Fair Values only if they can be reliably measured. Subsequent changes in value are recognized in the Income Statement. For a financial guarantee, after initial recognition, record it at higher of best estimate to settle or amount initially recognized.

reverse cash and carry arbitrage

-Opposite of cash-and-carry arbitrage -At initiation sell the asset short, lend the short sale proceeds at market rate and buy a futures contract -At expiration, collect the loan proceeds, take delivery of asset at future price and cover the short sale

Kantian ethics

-People deserve dignity and respect -People are more than just economic inputs -Incomplete as a moral philosophy (emotions like sympathy or caring)

corridor method (GAAP only)

-corridor method is relevant when cumulative amount of unrecognized gains/losses becomes too large, i.e., when it exceeds the corridor, which is defined as 10% of the greater of PBO and fair value of plan assets -the amount in excess of the corridor is amortized over the expected average remaining working lives of the plan employees

effect of non-covariance stationary variable on estimate of b1 and hypothesis tests

-estimate of b1 will be biased -any hypothesis tests will be invalid

what aspects of a simulation would require us to run more simulations?

-greater number of inputs that have probability distributions -greater variety of distributions across inputs

P&C

-key drivers of profitability: prudence in underwriting, pricing of adequate premiums for bearing risk, and diversification of risk -premium income is highest source of income, followed by investment income (tend to invest conservatively); return requirements of non-life insurers is primarily driven by policy pricing and financial strength -cyclical margins; heighted competition --> soft pricing --> shrinking capital base --> exit --> less competition --> larger margins -major expenses: claims expense and underwriting expense -high combined ratio --> soft market -property insurance covers specific assets, casualty insurance covers legal liabilities -policy period typically short w/ premiums received up front -claims' final cost usually known within a year of insured event occurring -claims are usually more variable and "lumpier" because they stem from unpredictable events, e.g., accidents -liquidity can be assessed by looking at fair value hierarchy reporting (i.e., level 1, 2, & 3) -no global risk-based capital requirements -low risk tolerance

Dickey Fuller Test

-modified t-test for covariance stationary condition in autoregressive models -performed by subtracting a one-period lagged variable from each side of an autoregressive model, testing to see if the new coefficient is different from 0. If not different than 0, coefficient must be a unit root -null hypothesis is that the new coefficient equals zero, i.e., there is a unit root

justified P/E ratios

-not suitable for high-growth companies because it assumes a constant growth rate in perpetuity

L&H

-premium income is highest source of income, followed by investment income (tend to invest conservatively) -key considerations when analyzing: 1. revenue diversification, 2. earnings characteristics (lots of actuarial assumptions), 3. investment returns (longer float period than P&C, low risk tolerance), 4. liquidity (less of a concern than for P&C; e.g., adjusted investment assets / adjusted obligations aka withdrawals), 5. capitalization (no global risk-based requirements) -key ratios: • total benefits paid ÷ net premiums written and deposits • commissions and expenses ÷ net premiums written and deposits

information ratio

-relative measure of reward-to-risk -unaffected by aggressiveness of weights, if portfolio is unconstrained

effect of increase in growth rate of potential GDP

-would allow government to pursue expansionary monetary/fiscal policies because of reduced risk of inflation -credit spreads will narrow because of lower perceived credit risk

a combination of a long call and a short put at the same strike price will have a delta of...

1

expected benefits of removing trade barriers • implications on convergence

1) increased investment from foreign savings 2) increased sharing of tech and higher TFP growth (which drives higher per capita income and growth rate of output) 3) increased markets for domestic products resulting in economies of scale 4) allows focus on industries where the country has competitive advantage 5) increased competition leading to failure of inefficient firms and reallocation of their assets to more efficient uses Both Neoclassical/Endogenous models say open trade leads to faster convergence of states' wealth upwards. Countries not open to global trade grow slower and may not converge.

credit events for a CDS

1. *Bankruptcy* - allows the defaulting party to work with creditors under the supervision of the count so as to avoid full liquidation 2. *Failure to pay* - occurs when the issuer misses a scheduled coupon or principal payment without filing formal bankruptcy 3. *Restructuring* - occurs when the issuer forces the creditors to accept terms that are different than those specified in the original issue. Not considered a credit event in the US, esp. voluntary credit restructuring.

steps of portfolio management process

1. planning: • analyzing objectives and constraints, • developing an IPS, • determining the appropriate investment strategy, • selecting an appropriate asset allocation 2. execution 3. feedback

methodologies to value PE companies

1. *DCF* (requires significant operating history) 2. *relative valuation / market approach* (requires predictable cash flows and significant history) 3. *real option analysis* (applicable for immature companies with flexibility in strategies) 4. *replacement cost* (not applicable to mature companies) 5. *VC* method 6. *LBO* method

key metrics for measuring underwriting efficiency of property & casualty insurance firm

1. *Loss and loss adjustment expense ratio* = (Loss expense + Δ Loss reserve) / Net premiums earned • reflects degree of success estimating insured risks; lower is better 2. *Underwriting expense ratio* = Underwriting expense / Net premiums written • reflects cost efficiency of obtaining new premiums; lower is better 3. *Combined ratio* = Loss and loss adjustment expense ratio + Underwriting expense ratio. • reflects overall underwriting efficiency • combined ratio < 100 is considered efficient *** 4. *Dividends to policyholders (shareholders) ratio* = Dividends to policyholders (shareholders) / Net premiums earned • reflects liquidity via dividend coverage 5. *Combined ratio after dividends* = Combined ratio - Dividends to policyholders (shareholders) ratio • reflects a stricter measure of measure of efficiency

key differences between venture capital and buyout investments (part 1 of 3)

1. *cash-flows*: low vs. high predictability 2. *product market*: new product market & uncertain future vs. strong market position with possible niche position 3. *products*: new technology vs. established products 4. *asset base*: weak vs. strong (can be used as collateral) 5. *mgmt team*: new (but some may have strong entrepreneurial record) vs. experienced 6. *leverage*: low debt use vs. high debt use (senior debt, junior debt, mezzanine)

real estate valuation methods (3 + 1)

1. *cost*: - cost of land purchase and comparable building construction less depreciation - depreciation difficult to measure (more useful for new property) - used when comparable transactions are limited 2. *sales comparison*: - uses sales prices of comparables adjusted for differences 3. *income*: - PV of future income discounted at investor's required return *** *highest and best use of land*: - based on use that produces the highest land value - post-construction value less construction costs

VaR, steps to calculate

1. *decompose* into risk factors 2. *gather data* for each risk factor 3. *estimate* VaR (3 methods) (a) *parametric/analytical/variance-covariance*: based on *expected value* and *standard deviation* (b) *historical simulation*: *reprice* current portfolio using actual historical changes in key factors in lookback period --> estimate VaR based on *percentiles* of historical changes (c) *monte carlo simulation*: develop *own assumptions* about distributions, which are used to *simulate hypothetical* returns to portfolio

reclassification of financial assets (IFRS 9)

1. *equity securities*: initial choice of FVPL vs. FVOCI is irrevocable 2. *debt securities*: permitted only if objective for holding them has changed in a way that significantly affects operations 3. *no restatement* of prior periods 4. earlier recognition of *impairment* for financial assets, financial guarantees, loan commitments, and lease receivables • move from "incurred loss" to "expected loss" model, which takes into account 12 month expected losses for non-performing assets

types of misspecification (regression)

1. *functional form is misspecified*: (a) omitted variables, (b) improperly transformed variables, (c) improperly pooled data 2. *explanatory variables are correlated with error term in time-series models*: (a) using lagged dependent variable as independent variable, (b) forecasting the future (using information from a period to predict something else from that period), (c) measuring variables with error (e.g., want to use real interest rates but forecast nominal interest rates) 3. *other time-series misspecifications that result in nonstationarity*

risk measures used by pension plans

1. *interest rate and curve risk*: exposure of fixed income instruments to changes in their respective countries' interest rate 2. *surplus at risk*: matching assets with pension liabilities; more volatility in assets --> higher surplus at risk; assets with identical cashflows as pension liabilities --> zero surplus-at-risk 3. *glide path*: charts multi-year stages to change portfolio from current state to target state 4. *liability hedging exposures vs. return generating exposures*: separating portfolio into investments matching pension liability vs. investments meant to generate excess return

types of multifactor models

1. *macroeconomic factor models* - driven by surprises in macroeconomic risk factors 2. *fundamental factor models* - driven by multiple firm-specific factors 3. *statistical factor models* - driven by statistical models in which statistical methods are applied to historical returns of a group of securities to extract key factors that can explain observed returns. two major types: • *factor analysis models*: factors are portfolios of securities that best explain historical return *covariance* • *principal component models*: factors are portfolios of securities that best explain historical return *variance*

methods to analyze project risk

1. *sensitivity analysis/what-if analysis* - begin with base case, change one variable and note the change in NPV 2. *scenario analysis* - create probability distribution of different outcomes; create best, worst, most likely cases; calculate mean and sd of NPV 3. *Monte Carlo simulation* - forecast probability distribution of key inputs; random draw, calculate NPV, repeat; generate probability distribuion of NPV • often includes mean reversion when modelling yield curves

examples of bottom-up approaches to modeling revenue

1. *time series*: forecasts based on historical growth rates or time-series analysis 2. *return on capital*: forecasts based on balance sheet accounts, e.g., modeling bank's interest rate revenue as (loans x average interest rate) 3. *capacity-based measure*: forecasts based on same-store sales growth and sales related to new stores

valuation process

1. *understand* business 2. *forecast* firm performance 3. *select* appropriate valuation model 4. *convert* forecasts to a valuation 5. *apply* valuation conclusions (e.g., investment recommendation, opinion about price of a transaction, etc.)

sensitivity risk measures

1. *β*, equity exposure: Cov(i,m) / Var(m) 2. *duration* and *convexity*, fixed income 3a. delta, *Δ*: • sensitivity of option value (i.e., price) to change in price of underlying 3b. gamma, *Γ*: • sensitivity of delta to change in price of underlying • reflects the uncertainty of whether the option will expire in or out of the money 3c. *v*: • sensitivity of option value (i.e., price) to change in volatility of underlying

what are the different approaches to participate in the commodity markets?

1. Buying the good - costs of storage and maintenance may be impractical 2. Commodity stocks - often has low correlation with the price of the underlying commodity 3. Commodity mutual funds - diversified, low transaction costs 4. Commodity futures - convenient, flexible, low cost, flexible; must continuously roll maturing contracts 5. Structured products on commodity futures indices - ETF on a commodity index; commodity index certificate

Porter's elements of competitive strategy

1. Cost leadership - lowest cost producer 2. Differentiation - unique products or services 3. Focus - target segments of industry using either of the above strategies

core attributes of an effective corporate governance system

1. Define shareholder rights 2. Define oversight responsibilities 3. Provide fair and equitable treatment 4. Provide transparency/accuracy in disclosures

tax systems on dividends (3)

1. Double taxation system - effective rate = CorpT + (1-CorpT)(IndT) 2. Split rate system taxes earnings distributed as dividends at a lower rate than earnings that are retained => use CorpT for distributed income 3. Imputation system taxes at the corporate level but are attributed to the shareholder so that all taxes are effectively paid at the shareholder rate. Shareholders deduct their portion of the taxes paid by the corporate from their tax return.

framework for financial analysis

1. Establish the Objectives (output = purpose statement, questions, final report nature, timetable, budget) 2. Collect the Data (organized financial information) 3. Process Data (adjusted statements, ratios, forecasts) 4. Analyze Data (results) 5. Develop and Communicate Conclusions (report answering questions, recommendations) 6. Follow Up (updated analysis and recommendations)

financial reports quality spectrum

1. GAAP compliant and decision-useful, high-quality earnings 2. GAAP compliant and decision-useful, low-quality earnings 3. GAAP compliant but not decision-useful because of biased choices 4. GAAP compliant but earnings management (real or accounting) 5. non-compliant accounting 6. fraudulent accounting

Private company valuation approaches

1. Income - PV of future income; absolute approach 2. Market - price multiples based on recent sales of comparable assets; relative approach 3. Asset-based - firm's assets minus liabilities; absolute approach; assets consist of operating and nonoperating assets Selection of approach depends on firm's operations and lifecycle stage - Early lifecycle favors asset-based - High growth favors income approach - Mature firm favors market approach

incremental project cash flows: expansion project

1. Initial Investment Outlay Outlay = FCInv + NWCInv. NWCInv = Change in non-cash current assets - Change in non-cash(STdebt) current liabilities. Positive number is a cash outflow. 2. After-tax Operating Cash Flows CF = (Sales - OpExpenses)(1-t) + Depreciation(t) Depreciation is non-operating but affects taxes EBIT = S - C - D; EBITDA = S - C 3. Terminal Year After-Tax Non-Operating Cash Flows TNOCF = (SalesPrice of NWC) + NWCInv - (Gain on Sale)(t)

Temporal Method - Application

1. Produce top of Balance Sheet (total assets) 2. Produce Shareholders' Equity and Liabilities (RE = plug to balance balance sheet) 3. Derive net income from reconciliation of retained earnings (include RE plug) 4. Produce the income statement. Net income in I/S different from net income in RE 5. Force the income statement NI to agree to the NI in retained earnings reconciliation by adding a gain or a loss

categories of capital budgeting projects

1. Replacement projects to maintain business - normally made without detailed analysis 2. Replacement projects for cost reduction - detailed analysis necessary 3. Expansion projects - complex decision-making process 4. New product or market - large amount of uncertainty 5. Mandatory projects - involve safety-related or environmental concerns 6. Other - pet projects; high-risk (R&D)

analysis of expense recognition

1. Review cost capitalization disclosures, depreciation disclosures, and compare to peers 2. Evaluate changes in noncurrent assets, margins, depreciation expense/rate, and capex 3. Check for related party transactions

steps of model training (machine learning)

1. Specify the *algorithm* 2. Specify the *hyperparameters* (before the processing begins) 3. Divide data into *training and validation samples*. In the case of cross validation, the training and validation samples are randomly generated every learning cycle. 4. Evaluate the training using a *performance parameter*, P, in the validation sample. 5. *Repeat* the training until adequate level of performance is achieved. In choosing the number of times to repeat, the researcher must use caution to avoid overfitting the model

components of commodity return

1. Spot return - percentage change in commodity's spot price 2. Collateral return - return on posted collateral Rebalancing return - additional return on portfolio of commodity futures 3. Re-balancing return (for indexes) 4. Roll return - income generated as maturing contracts replaced with new contracts Roll returns: - if market is in backwardation, i.e., F < E(S), roll return is positive[(F- - F+) / F-] - nonstorable commodities exhibit positive roll returns (backwardation)

forecasting income tax expense

1. Statutory rate = percentage tax charged in the country where the firm is domiciled 2. Effective tax rate = income tax expense as a percentage of pretax income 3. Cash tax rate = cash taxes paid as a percentage of pretax income Changes in deferred tax items account for the difference between income tax expense and cash taxes due. Multinational countries' effective tax rate will depend on relative earnings growth in high or low tax countries. Analyst should pay special attention to estimates of tax rates for companies that consistently report an effective tax rate that is less than the statutory rate (or consistently less than peer companies) Good starting point: tax rate based on normalized operating income, before results from associates and special items

criticisms of neoclassical model

1. Studies have found that growth in TFP explains a significant portion of economic growth. Under neoclassical theory, TFP is determined outside the model (it is an exogenous variable) so the theory *provides no explanation for the determinants of technological progress or how TFP changes over time*. 2. Economists have found that *savings rates and growth rates are positively related across countries*. Neoclassical theory asserts that the steady state rate of economic growth is unrelated to the rate of saving and investment. Under neoclassical theory, long-run growth is determined by growth in TFP and labor, while higher rates of saving and investment only have a temporary impact on growth.

Black Scholes limitations

1. The assumption of a known and constant risk free rate means the BSM is *not useful for pricing options on bond prices and interest rates*. 2. The assumption of a known and constant asset return volatility makes the BSM *not useful in situations with non-constant volatility*. 3. The assumption of *no taxes and transaction costs* makes the BSM less useful. 4. The BSM is designed to price European options and *not useful for American options*.

private equity contract terms (term sheet)

1. compensation 2. tag-along, drag-along 3. board representation (in event of restructuring, takeover, IPO, bankruptcy or liquidation) 4. non-compete (for company founders) 5. priority in-claims (e.g., preference shares) 6. required approvals 7. earn-outs

factors that affect term structure of credit spreads

1. credit quality 2. financial conditions 3. market demand and supply 4. equity market volatility

reasons for corporate restructuring

1. poor fit 2. change in strategic focus 3. reverse synergy (i.e., division worth more separately) 4. financial or cash-flow needs

steps in industry/company analysis

1. Understand the company, industry, accounting principles, and appropriateness. 2. Understand the management, remuneration packages, insider trades, and related party transactions 3. Identify material accounting areas open to subjectivity and estimation 4. Make cross sectional and time series comparisons of statements and ratios 5. Check for warnings signs 6. Conglomerates: check segmental disclosure for shifting profits 7. Use quantitative tools to evaluate likelihood of earnings management

analysis of revenue recognition

1. Understand the revenue recognition practices 2. Evaluate aging of receivables 3. Evaluate proportion of earnings that are cash-based versus accruals-based 4. Compare financials with physical data provided by the company 5. Compare revenue trends to peers 6. Check for related party transactions

basic elements of a distributed ledger technology network include...

1. a digital ledger 2. a consensus mechanism 3. a participant network

organic sales growth is defined as sales growth excluding the impact of...

1. acquisitions / divestitures 2. fx fluctuations

active factor risk vs. active specific risk

1. active factor risk: risk that results from differences in factor sensitivities relative to benchmark 2. active specific risk: risk that results from differences in individual asset weightings relative to benchmark

cost approach to value real estate

1. add building replacement cost incl. developer profit 2. deduct curable physical deterioration 3. adjust for noncurable deterioration (effective age / effective life * value after deducting curable) 4. deduct functional, locational, and economic obsolescence 5. add market value of land

areas of fintech that are relevant to the investment industry

1. analysis of large datasets 2. analytical tools (e.g., AI) 3. automated trading (e.g., algorithms) 4. automated advice 5. financial record keeping (e.g., DLT)

types of constraints used in simulations

1. book value constraints (regulatory capital, negative book value) 2. earnings & cash-flow constraints 3. market value constraints

routes to convergence

1. capital accumulation & capital deepening 2. imitation/adoption of technology

data processing methods

1. capture 2. curation 3. storage 4. search 5. transfer (from storage to analytical tool)

factors that affect market value of assets

1. changes in forecast of cash-flows 2. risk premium 3. risk-free rate

methods to estimate DLOM

1. comparing price of restricted shares to price of publicly traded shares 2. price of shares pre-IPO vs. post-IPO 3. price of at-the-money put option / stock price

benefits of real estate investment

1. current income (e.g., via leases, rent) 2. price appreciation (i.e., capital appreciation) 3. inflation hedge (rents & prices tend to rise with inflation) 4. diversification (uncorrelated with performance of other asset classes) 5. tax benefits (real estate in US can be depreciated faster than property actually deteriorates; REITs have no corporate income tax)

three most important stakeholders to satisfy are...

1. customers 2. employees 3. stockholders

commodity prices are determined by...

1. discounted forecast of possible futures prices based on supply/demand of the physical item 2. future expected volatility

sources of big data

1. financial markets 2. businesses 3. governments 4. individuals 5. sensors 6. internet of things

issues with simulations

1. garbage in, garbage out 2. real data may not fit distributions 3. non-stationary distributions 4. changing correlation across inputs

calculation of effective duration

1. given a price, calculate OAS to benchmark yield curve at an approriate interest rate volatility 2. shift benchmark yield curve up and down, generating new interest trees for each movement, and revalue bond using OAS from step 1 to find PV+ and PV-

a dividend may be referred to as a liquidating dividend when a company...

1. goes out of business and the net assets are distributed to shareholders 2. sells a portion of its business for cash and the proceeds are distributed to shareholders 3. pays a dividend that exceeds its accumulated retained earnings

ways of describing probabilistic distribution

1. historical data 2. cross-sectional data 3. statistical distribution & parameters

Modigliani and Miller assumptions (w/o taxes)

1. homogeneous expectations 2. perfect capital markets: no distress costs, no transaction costs, no taxes 3. investors can borrow and lend at the risk-free rate 4. no agency costs, i.e., managers always act to maximize shareholder wealth 5. financing and investment decisions are independent of each other, i.e., operating income is unaffected by capital structure

steps of investment planning

1. identify and specify investor's objectives & constraints 2. formulate IPS [TBD]

strategy formulation process

1. identify mission and goals 2. identify core competency and value-creating activities 3. formulate strategies Four styles: A. Adaptive: less malleable, less predictable B. Classical: less malleable, more predictable C. Shaping: more malleable, less predictable D. Visionary: more malleable, more predictable

intercorporate investment categories • key criteria and general guidelines (%) • accounting methods

1. if no significant influence, e.g., <20% ownership • investment in financial assets • GAAP (HtM, FV, AfS) • IAS 39, old (HtM, FV, AfS, L&R) • IFRS 9, new (AC, FVPL, FVOCI) 2. if significant Influence but no control, e.g., ownership of [20%,50%] • investment in associates • equity method 3. if control & significant influence, e.g., ownership of >50%: • acquisition method *** joint venture with exactly 50% ownership => equity method under both GAAP and IFRS

what four things do board members need to do to act in the best interests of the company and its investors?

1. independence 2. TODO - R24 LOSd 3. 4.

factors that influence forecast horizon

1. industry cyclicality 2. employer preference 3. investment strategy 4. company-specific factors

three layers of a neural network

1. input layer 2. hidden layer 3. output layer

contents of a statement of director's oversight, monitoring, and review responsibilities

1. internal controls 2. risk management 3. accounting disclosure 4. compliance 5. nominations 6. compensation awards

equity method, issues for analysts

1. is equity method appropriate? 2. what is impact of one-line consolidation on debt ratios, margins? 3. what is quality of equity method earnings? (any restrictions on dividend cash flows?)

factors that would make a firm's accounting earnings less of a gauge of future economic performance

1. late filings 2. high amount of loans to company insiders 3. short tenure of senior management

investment constraints

1. liquidity 2. time horizon 3. tax 4. legal & regulatory (typically for institutional investors) 5. unique circumstances (e.g., university endowments not wanting to invest in tobacco/alcohol/defense)

risk measures used by banks

1. liquidity gap 2. VaR (HfT) 3. leverage (regulatory + internal) 4. sensitivities (HfS - duration measures; Fx, equity, commodity exposures; option sensitivities) 5. economic capital (blending of market + credit + operational risk) 6. scenario analysis

reasons why countries may fail to converge

1. low rates of *investment* 2. *political instability* 3. a lack of *property rights* 4. poor *education* and *health* 5. *taxes* and *regulations* that discourage working and investing 6. restrictions on *trade*

components of returns in LBO

1. multiple expansion 2. increase in value of interest-bearing preference shares 3. paydown of debt

tracking error ranges of various investing styles

1. passive: <0.1% p.a. 2. low-risk active or enhanced index: ~2% 3. diversified active, large-cap equities: 2-6% 4. aggressive active, equities: 6-10%

key factors driving quality of earnings

1. persistence 2. sustainability

risk measures used by traditional asset managers

1. position limits 2. sensitivities 3. beta sensitivity 4. liquidity 5. scenario analysis 6. active share 7. redemption risk (for open-ended funds) 8. ex-post vs. ex-ante tracking error 9. VaR

types of insurance that are not highly correlated with financial asset markets

1. property & casualty (e.g., home, auto, corporate liability) 2. health

types of returns

1. required rate of return (risk-adjusted) 2. expected return (e.g., due to mispricing) 3. discount rate (for finding PV of a cash flow) 4. internal rate of return (for equating asset price with PV of future cash flows)

factors that affect ability to take on risk

1. required spending needs 2. long-term wealth target 3. financial needs 4. liabilities

evidence of antitrust in addition to HHI

1. responsiveness of consumers to price changes. 2. efficiency of companies in the industry. 3. financial viability of merger candidates. 4. ability of U.S. firms to compete in foreign markets

risk management constraints

1. risk-budgeting 2. position limits 3. scenario limits 4. stop-loss limits 5. capital allocation (e.g., measuring and limiting economic capital) note: not inherently restrictive or unrestrictive - rather, they are limits placed on measures that drive action

risk measures used by hedge funds

1. sensitivities 2. gross exposure (long/short/gross) 3. leverage 4. VaR 5. scenarios 6. drawdown (i.e., peak to trough)

defined benefit plans: where in the P&L are various items reported? and to where should they be adjusted?

1. service cost: 2. interest cost: 3. interest expense:

classification of real estate

1. single-family 2. commercial 3. timberland 4. farmland

factors that can result in correlation that is not meaningful

1. spurious correlation 2. outliers

levels of structure in big data

1. structured: organized in labels 2. semi-structured 3. unstructured, e.g., social media, email, text messages, pictures, blogs, scanners, sensors, etc.

drivers of cross-border mergers

1. taking advantage of market inefficiencies 2. working around disadvantageous government policies 3. using technology in new markets 4. product differentiation 5. provide support to existing multinational clients

main inputs of LBO model

1. target's forecasted cash flows 2. expected returns to providers of financing 3. total amount of financing

conditional vs. unconditional heteroskedasticity

1. unconditional heteroskedasticity: error variance *does not systematically increase or decrease with changes in the value of independent variable* 2. conditional heteroskedasticiy: error variance *changes with the value of independent variable*

choice of an options strategy is dependent on

1. views on stock volatility, relative to implied volatility 2. expectations regarding market direction

BIRR model

T-Bill rate + (sensitivity to confidence risk * confidence risk) + (sensitivity to time horizon risk * time horizon risk) + (sensitivity to inflation risk * inflation risk) + (sensitivity to business cycle risk * business cycle risk) +(sensitivity to market timing risk * market timing risk)

ROE

Tax Burden (NI/EBT) x Interest Burden (EBT/EBIT) x EBIT Margin (EBIT/Revenue) x Asset Turnover (Revenue/Avg Assets) x Financial Leverage (Avg Assets/Avg Equity)

net lease

A lease requiring the tenant to pay not only rent but also costs incurred in maintaining the property, including taxes, insurance, utilities, and repairs

Durbin-Watson statistic

A statistic used to test for first order serial correlation (i.e., are regression errors correlated across observations) in the errors of a time series regression model under the classical linear model assumptions Need a minimum of 15 observations NOt useful for autoregressive models

Types of Multifactor Models

Arbitrage models: - Fama-French - Pastor-Stambaugh - Arbitrage Pricing Model (BIRR version) Ad-hoc models: - Build-up (i.e., bond yield on company's debt plus risk premium, no betas)

growth rate of capital per worker

growth rate of capital per worker = + savings rate * (Y / K) - depreciation rate - population growth rate = output per worker growth rate = growth rate in TFP / labor share of GDP

FFO, AFFO

AFFO (cash funds available for distribution) better but FFO used more in practice. *Net Income* + Depreciation + Amortization + Deferred tax expense - Net gains on sale of property and debt restructuring = *FFO* + Adjustment for straight-lining of rents - Maintenance capex & leasing commissions = *AFFO*

underlying earnings

AKA persistent, continuing or core earnings are earnings that exclude: nonrecurring components, such as: • gains and losses from asset sales • asset write-downs • provisions for future losses and • changes in accounting estimates • goodwill impairment

delta of at the money long put and long call

ATM long put: delta of -0.5 ATM long call: delta of +0.5

Equity Risk Premium

Additional return above the risk-free rate investors require for holding risky equity (Required - RFR) Should correspond to the time horizon for the investment ERP = + one-year dividend yield + long-term EPS growth - long-term risk free rate

Pastor-Stambaugh model

Adds a liquidity premium to the Fama-French model

active risk

Also referred to as tracking error

Investments in Financial Assets - Held for Trading

aka Fair Value through Profit or Loss (IFRS) Debt or equity acquired for purpose of selling in the near future. - Interest and dividend income reported on income statement - Interest includes coupon + amortization - Carried on balance sheet at fair value - Unrealized G/L on income statement

Gordon Growth Model

Assumes that dividends grow at a constant rate (g) forever and that g < r. Compute justified leading and justified training P/E by dividing through by E. Strengths: - Used with broad market indexes - Estimates g, r, and PVGO - Supplement to more complex models Weaknesses: - Value very sensitive to estimates of r and g - Difficult to use with non-dividend-paying stocks - Minority perspective only. Not useful for valuing M&A. Suitability: - Dividend history - Understandable and consistent dividend policy - Minority shareholder takes a non-control perspective - Mature firms, profitable but not fast growth (g>5% is suspect)

Investment in Associates - Goodwill

At acquisition, excess of purchase price over proportionate share of book value is allocated to identifiable assets and liabilities based on fair value. Remainder is goodwill. Proportion of amortization allocated to excess purchase prices reduces income.

Fama-French model

Attempts to account for the high returns generally associated with small-cap stocks. Based on market risk, size risk, and value risk Use short-term risk-free rate

conditional VaR

Average loss conditional on exceeding the VaR cut-off; i.e., how much can I expect to lose if VaR is exceeded? also known as "expected shortfall" best calculated using monte carlo simulation or historical simulation

impact of dividends on conversion price

all else equal, an increase in dividends will lower the conversion price (i.e., the breakeven price)

ABS earn a (higher / lower) premium relative to similarly rated general obligation corporate bonds

higher premium, due to greater complexity of collateralized debt

typical timing of expiry and settlement for: • FRAs • swaps • interest rate options

all expire at start of period • FRAs: advanced set, advanced settle • swaps: advanced set, settled in arrears • interest rate options: advanced set, settled in arrears

order from highest to lowest?: OAS of an option-free bond, a callable bond, and a putable bond which are otherwise identical

all three bonds have identical OAS, since OAS effectively "removes" the option feature

impact of reference bond yields on estimate of equity risk premium

higher reference bond yields --> lower estimate of equity risk premium

investment grade debt has ratings of atleast...

Baa (Moody's) BBB (S&P)

Benefits/Costs of Regulation

Benefits are easy to view but difficult to quantify Costs include: - regulatory burden - direct and indirect cost of regulation - net regulatory burden - regulatory burden minus the private benefits of regulation - costs easier to assess ex-post

agency issues with dividends

Between shareholders and managers: - Dividends reduce free cash flow for managers to invest in empire building Between shareholders and bondholders: - Dividends transfer wealth from bondholders to shareholders

Approaches for Developing Inputs

Bottom up - Forecasts rely on company-specific information Top down - Begins with expectations about a macroeconomic variable Hybrid - Incorporates elements of both

assessing over/undervaluation of portfolios given betas and expected returns

identify linear combinations that imply mispricing

relative VaR (defn., computation)

also called ex-ante tracking error measures the degree to which a portfolio's performance varies from that of its benchmark computed based on portfolio that is the difference between actual holdings and specified benchmark

estimating required return for privately held business

also: discount for lack of control and marketability

economic capital

amount of capital a firm needs to hold in order to survive severe losses from risks in its business

Explain how time-series variables should be analyzed for nonstationarity and/or cointegration before use in a linear regression

Can use linear regression if: (1) both series are covariance stationary (2) neither series is covariance stationary AND series are covariance integrated

effects of balance of payments components on a country's exchange rate

Capital account drives changes in exchange rate over the short to medium term Current account drives changes in exchange rate over the long-term

channel stuffing

an accounting practice in which the manufacturer makes a large shipment to a distributor at the end of a quarter and records the shipment as sales, even though the distributor has not guaranteed sales of the product and has the right to return any unsold merchandise

Measures of Cash Flow - Free Cash Flow

Cash available to pay shareholders. Cash flow distributable to the providers of capital. FCFF = cash flow distributable to all providers of capital FCFE = cash flow distributable to equity holders Advantages: - applicable to many firms regardless of dividend policy or capital structure - better reflects control of the shareholders Disadvantages: - may have negative free cash flow many year into the future due to large capital requirements Appropriate when: - No dividend payment history or payments not related to earnings - FCF corresponds with profitability - Valuation perspective is that of a controlling shareholder

Measures of Cash Flow - Dividends

Cash paid to shareholders Advantages: - Less volatile than other measures - Theoretically justified - what you receive when you buy a stock - Accounts for reinvested earnings to provide a basis for increased future dividends Disadvantages: - Can't be used for non-dividend-paying firms - Dividends artificially small for tax reasons - Dividends may not reflect the control perspective desired by the investor (owner-controlled) Appropriate when: - History exists - Dividend policy is clear and related to the earnings of the firm - The perspective is that of a minority shareholder

commodities: storable, renewable, non-renewable • description • drivers of demand for renewable vs. non-renewable

Commodity is highly storable if if doesn't degrade over time and storage costs are relatively low Renewable commodities can be produced without limit. Spot price is highly influenced by expected cost of future production Nonrenewable commodities have a finite supply. Spot price is highly influenced by demand.

poison put

an anti-takeover provision that allows company's bondholders to redeem bonds at pre-specified price

director vs. shareholder conflicts (description, causes)

Conflict occurs when directors align more with management interests rather than those of shareholders: Can result from: - Lack of independence - Personal relationships - Consulting agreements with the firm - Interlinked boards - Overcompensation

Cobb-Douglas production function • TFP • MPK, MPL • key properties • implications at steady state

Considers aggregate output of economy from perspective of income: income to providers of capital and income to labor *TFP* is exogenous to the model and embodies cumulative effects: • scientific advances • applied R&D • improvements in management methods • ways of organizing Factors of production (i.e., K and L) are paid their marginal product. Profit maximization requires the following two to equate: • MPK = marginal product of capital = real interest rate = alpha*Y/K • MPL = marginal product of labor = real wage rate = (1-alpha)*Y/L *Key properties:* 1. *constant returns to scale*: amount of goods a worker can produce depends on the amount of capital per worker, TFP, and the share of capital in GDP 2. *diminishing marginal productivity*: capital deepening exhibits diminishing returns on output per worker and only while MPK > r; capital deepening is movement along curve (Y/L vs. K/L) whereas increase in TFP is an upward shifted curve • once economy is in steady-state, capital deepening is no longer a source of sustained growth in economy, which can only come from increase in TFP • when MPK > r, capital deepening can raise per-capita • capital deepening has a larger effect when capital-per-worker is lower

analysis of Capital Allocation Decisions

Consolidation can hide individual characteristics of dissimilar subsidiaries - Segment disclosures valuable in identifying revenue and profit by segment, relationship between capital expenditures and returns, segments that should be de-emphasized

WACC, international considerations

Country Spread Model: - Use developed market as a benchmark and add a premium for the emerging market Country Risk Rating Model: - Estimates a regression equation using the equity risk premium for developed countries as the dependent variable and risk ratings as the independent variable

effects of balance of payment accounts on exchange rate

Current Account: - Summarizes whether we are selling more goods and services to the rest of the world than we are buying - Flow Mechanism - deficits increase supply of currency in market which decreases exchange value - Portfolio Composition Mechanism - surplus countries may rebalance portfolios putting downward pressure on investee currencies - Debt Sustainability Mechanism - deficit countries may be borrowing from abroad, level relative to GDP may not be sustainable Capital Account: - Measures flow of funds for debt and equity investment into and out of the country - In the short term, real currency values fluctuate around its long-term PPP-implied equilibrium value - The real value is positively related to real interest rate differential and negatively related to risk premium differential (real ex rate = equil ex rate + (realB - realA) - (riskB - riskA)

delta of covered call / protective put

covered call delta = delta of stock - delta of call option delta of a protective put position = delta of stock + delta of put option

OAS reflects compensation for...

credit and liquidity risk (NOT option risk)

credit spread vs. debit spread

credit spread generates cash inflow at inception debit spread generates cash outflow at inception

fictitious revenue must result in...

fictitious assets

parity conditions

framework for developing a view about future exchange rate movements over a longer-term time period

for accounting purposes, a foreign currency is any currency other than a company's _______________ currency

functional currency

Investments in Financial Assets - Held to Maturity

Debt securities where the company has the intent and ability to hold to maturity - Interest income reported on income statement (coupon + amortization) - Initially reported at cost (US GAAP) or Fair Value (IFRS) - Carried on balance sheet at amortized cost - MV changes not recognized unless impaired - Reclassification or sale prior to maturity may lead to disallowance of HTM classification

Investments in Financial Assets - Available for Sale

Debt or equity - Interest and dividend income reported on income statement - Interest = coupon + amortization - Carried on balance sheet at fair value - For debt security: accumulated gain/loss in OCI is equal to difference between amortized cost and fair market value - Unrealized G/L reported directly in equity - When sold, realized G/L recognized on income statement Impairment on AFS debt can be reversed and the asset can be marked up on the BS, but for AFS equities, the impairment reversal is recognised as a gain on the income statement immediately. The asset stays at the previous impaired value.

Investments in Financial Assets - Available for Sale

Debt or equity neither HTM or HFT. - Interest and dividend income reported on income statement - Interest = coupon + amortization - Carried on balance sheet at fair value Unrealized G/L reported directly in equity When sold, realized G/L recognized on income statement

Investments in Financial Assets - Held to Maturity

Debt securities where the company has the intent and ability to hold to maturity - Interest income reported on income statement (coupon + amortization) - Initially reported at cost (US GAAP) or Fair Value (IFRS) - Carried on balance sheet at amortized cost - MV changes not recognized unless impaired - Reclassification or sale prior to maturity may lead to disallowance of HTM classification Can recognize an impairment by either creating an allowance for doubtful accounts or simply marking the asset down.

principles of capital budgeting

Decisions based on timing of cash flows, not accounting income, and financing costs are reflected in the required return - exclude sunk costs - include externalities are the effects on other cash flows - include taxes (i.e., use tax depreciation method) - include opportunity costs

market value decomposition

Determine the implied value of the parent excluding the value of associates = Market cap of parent - (% share) x Market cap of child Implied P/E = Implied Value of Parent / (Net income - Parent's share of child's earnings)

cash flow analysis

Determine whether earnings are confirmed with cash flow - Adjust CFO by adding back cash interest and cash taxes (if included) - Compare adjusted CFO to operating income Calculate cash basis ratios: - Cash flow return on assets = CFO / average total assets - Operating earnings quality = Adjusted CFO / EBIT - Cash flow to reinvestment = Adjusted CFO / capital expenditures - Cash flow interest coverage = Adjusted CFO / cash interest - Cash flow to total debt = Adjusted CFO / total debt

discretionary vs. non-discretionary accruals

Discretionary accruals arise from transactions or accounting choices outside the normal, which are possibly made with the intent to manage earnings Non‐discretionary accruals arise from normal transactions

DPI

Distribution of paid-in capital: total distributions / total paid-in capital

investment in financial assets, transaction costs

HTM and AFS securities are initially reported with transactions costs included. HFT do not have transaction costs included in their initial reporting.

NOPLAT

EBIT(1-T) + change in deferred taxes

Measures of Cash Flow - Residual Income

Earnings in excess of investors' required return on BOP investment. Economic profit. Focuses on profitability in relation to all opportunity costs faced by the firm. Advantages: - Can be applied to firms with negative free cash flow and to dividend- and non-dividend-paying firms - Can be more difficult because they require in-depth analysis of the firm's accounting accruals. - Susceptible to management discretion, poor quality statements Appropriate when: - No dividend history - Firms with negative FCF for the forseeable future - Firms with transparent financial reporting and high-quality earnings.

commodity index returns reflect changes in ...

future prices and the roll yield contango --> decrease forward looking performance due to negative roll return backwardation --> increased forward looking performance due to positive roll return

roll-forward of defined benefit obligation

EoP = BoP + current service cost + past service cost + interest expense - benefits paid + actuarial losses/(gains)

interest rate cap

Equivalent to being long a series of interest rate call options that have expiration dates that correspond to the reset date on a floating-rate loan; Protect a floating-rate borrower; Long position is paid when rate rises above the cap

interest rate floor

Equivalent to being long a series of interest rate put options that have expiration dates that correspond to the reset date on a floating-rate loan; Protect floating rate lenders; Long position is paid when rate falls below floor

Asset-based approach for valuing private companies

Estimates value of firm equity as the fair value of assets minus fair value of liabilities. Generally not used for going concerns. Usually the lowest valuation. Used for: - troubled firms - finance firms - investment companies - firms with few intangibles - natural resource firms

analysis of asset base

Examine composition of balance sheet assets over time - Common-size analysis is helpful - Useful in identifying acquisitions and goodwill - Recall that goodwill is no longer amortized but subject to impairment

manager vs. shareholder conflicts (examples)

Examples: - Agent unwisely expands size of firm - Excessive compensation and perks - Investing in risky ventures - Not taking enough risk

payer swaption

gives the buyer the right to be the fixed-rate payer at a predetermined rate

Continuing Residual Income

Expected RI beyond the investment horizon Measures by persistence factor (0<w<1). Higher persistence means longer period where ROE>r. Lower w implies a quickly falling continuing residual income => lower firm valuation w=0 => pure competition, no competitive advantage 0<w<1 => declines to 0 over time w=1 => perpetual competitive advantage Could also decline to mature industry level

FCFE coverage ratio

FCFE / (dividends + share repurchases)

Free Cash Flow

FCFF = *pre-levered cash flow* - Cash available to shareholders and bondholders after taxes, capital investment, and WC investment FCFE = *post-levered cash flow* - Cash available to equity holders after payments to and inflows from bondholders

preferred risk measures for portfolios with fair value accounting vs. book value accounting

FV: 1. VaR 2. economic capital 3. duration 4. beta BV: 1. asset/liability gap

FCFF vs. FCFE

Firm Value = FCFF discounted at WACC Equity Value = FCFE discounted at cost of equity = + Firm Value - MV of Debt Use FCFE when capital structure is stable Use FCFF when: • high or volatile debt levels (because WACC is less sensitive to leverage changes) • negative FCFE

hyperinflation (translation)

GAAP: • carried values remain at historical rates and historical exchange rates used to translate IFRS: • non-monetary assets/liabilities, equity accounts, and net income items are restated for price level and translated at current rate • monetary assets/liabilities are not restated • result is a purchasing power gain/(loss) from holding net monetary liabilities/(assets) are recorded in income statement

unethical behaviors generally arise when...

goals are prioritized over rights

participants in commodity markets

Hedgers - have a natural long (farmers) or short (bakers) exposure to commodities; take an offsetting position in futures Speculators - earn a premium by providing liquidity to hedgers and for taking price risk Arbitrageurs - attempt to create risk-free profits from price differences over time, between locations, or from differences between futures and spot prices

Estimating the ERP

Historical - historical mean difference between broad market equity index and T-bill S = objective and simple W = assumes stationary mean and variance; upwardly biased due to survivorship bias; which to use?(geometric, arithmetic, yield curve) Forward - utilizes current market conditions and expectations concerning economic and financial variables S = does not require stationarity W = requires frequent updates; makes lots of assumptions

coefficient of determination (R²)

How much (i.e., what percentage) of the variation in the dependent variable is explained by the independent variable

contingent assets and liabilities (business combinations)

IFRS: • contingent liability measured at HIGHER of amount initially recognized or best estimate of amount to settle • contingent assets not recognized GAAP: • both contractual and non-contractual must be recognized • contingent liability - same as for IFRS • contingent - measured at LOWER of amount initially recognized or best estimate of amount to settle

Business Combination - Goodwill impairment

IFRS: cash-generating units; (1) impairment = recoverable less carrying; can exceed goodwill GAAP: reporting units: (1) is impaired? fair value < carrying value? (2) if yes: new final goodwill = fair value of unit less fair value of unit's net assets; impairment = old goodwill less new goodwill

planning stage of portfolio management: order of steps

IPS + CME --> SAA

gross IRR (PE)

IRR based on cashflows between portfolio companies and fund, i.e., operating results (realized + unrealized gains) and called-down capital

net IRR (PE)

IRR based on cashflows between portfolio companies and investors, i.e., gross cashflows (operating results + called-down capital) less mgmt fees and carried interest

components of discount rate in present value model

I_t,s = yield to maturity on a real default-free investment today (t), which pays one unit of currency s periods in the future θ_t,s = expected inflation rate between t and t + s ρi_t,s = the risk premium required today (t) to pay the investor for taking on risk in the cash flow of asset i, s periods in the future

structure and suitability of log-long model

If y = c(x^m) then log(y) = log[c(x^m)] = log(c) + m log(x) If we let Y = log(y), b = log(c), and X = log(x), then we have: Y = mX + b which is a straight line.

effects of share repurchases on EPS

If borrowed funds are used to finance the repurchase, and the after‐tax cost of borrowing is greater than the company's earnings yield, EPS will fall. If borrowed funds are used to finance the repurchase, and the after‐tax cost of borrowing is lower than the company's earnings yield, EPS will rise.

outside body

not regulators themselves but their product is referenced by regulators, e.g., FASB, IASB, ratings agencies

IOSCO • what does it stand for? • key objectives

International Organization of Security Commissions key objectives: 1) Protect investors 2) Insuring markets are fair, transparent, and efficient 3) Reduce systematic risk

Method of Comparables

Involves using a price based on the average price multiple of the stock of similar companies. Price scaled by a measure of value such as sales, net income, book value, or cash flow

currency types (translation)

Local - currency of the country being referred to Functional - currency of the primary economic environment in which the entity operates Presentation (reporting) - currency in which the parent company prepares its financial statements

intertemporal rate of substitution

MU_tomorrow / MU_today where MU = marginal utility of consumption

Investments in Financial Assets - Designated at Fair Value

Management has option to report at fair value. - Treated just like trading securities, reported on balance sheet at fair value - Unrealized G/L on income statement - Dividends and interest on income statement

economic profit

Measure of profit in excess of the dollar cost of capital invested in a project EP = net operation profit after-tax (EBIT(1-t)) - dollar cost of capital (WACC x invested capital) Then, NPV = market value added = sum(EP / (1+WACC))

potential problems with financial statements

Measurement and Timing Issues: - Affect multiple financial statement elements Classification within a Financial Statement: - Operating vs. Nonoperating - Current vs. Noncurrent

Economic Value Added

Measures value added to shareholders by management = EBIT(1-t) - WACC% x InvestedCap

Mundell-Fleming model

Monetary policy drives changes in exchange rates via interest rates Floating exchange rate: Unrestricted capital flows: GIFE Restricted capital flows: GIDE

analysis of capital structure

Must support management's strategic objectives and allow the firm to honor future obligations - Examine long-term debt-to-total capital - Some liabilities are less onerous than others and may not necessarily require an outflow of cash

public real estate valuation approaches

NAVPS - represents the value of REIT assets to a private market buyer P/FFO - most common multiple used to analyze REITs P/AFFO - AFFO better measure of economic income Discounted cash flow - applied the same way as in other industries

NOPLAT vs. NOPAT

NOPLAT = EBIT ( 1-t) + ΔDTA - ΔDTL NOPAT = EBIT (1- t)

NAVPS • calculation • rationale

Net Asset Value Per Share = + Net Operating Income / cap rate + Assets excl. properties, goodwill, deferred expenses, and DTAs - Liabilities excl. DTLs (incl. measuring debt @ market value) *rationale* • there exist active private markets for real estate assets

FCFE Calculation

Net borrowings include issue repayment of long-term debt, notes payable, and current portion of long-term debt

projected benefit obligation

Present value of all future pension payments earned to date based on expected salary increases over time. Assumes employee works until retirement and firm is a going concern. Based on: - Current service cost - PV of benefits earned by employee during period; change in PBO attributed to employees' efforts during the year. - Interest cost - increase in PBO due to passage of time; equal beginning PBO x discount rate - Past service costs - retroactive benefits awarded to employees when a plan is amended - Actuarial G/L - gains and losses resulting from changes in actuarial assumptions - Benefits paid - payments made from the fund to existing retirees

FCFF Calculation

Noncash charges include depreciation, amortization of intangibles, noncovered restructuring charges, G/L on sale of assets, deferred taxes FCInv = capital expenditures - proceeds from sales of long-term assets; can include intangible items FCInv = ending net PP&E - beginning net PP&E + depreciation WCInv = change in all short-term operating assets and liabilities except for cash and cash equivalents, short-term interest-bearing debt, notes payable, current portion of long-term debt, dividends payable CFO = NI + NCC - WCInv

Economies of Scale

Occurs when the average cost of production decreases as industry sales increase. A company with EOS will have higher operating margins as production volume increases.

earnings quality

Persistent and sustainable earnings considered "high quality" Measure earnings quality using ratio of accruals to net operating assets (lower ratio => higher quality) Balance Sheet Based: Aggregate accruals = NOAend - NOAbeg Cash Flow Based: Aggregate accruals = NI - (CFO + CFI) Accruals ratio = Aggregate Accruals / (NOAend+NOAbeg)/2

FCFE Ownership Perspective

Perspective is that of an acquirer who can change the firm's dividend policy or for minority shareholders of a company that is in play. - Dividend discount model implies that investors have no control over dividend policy

which of the following is considered a credit event? (voluntary restructuring / involuntary restructuring)

a voluntary restructuring is NOT considered a credit event

attributes and best practices of boards

Process: - *Election procedures* (annual elections for all board members) - Board *self-assessment* annually (member participation, activities, future needs) - Frequency of *separate sessions* for independent directors (without management; quarterly) - *Statement* of governance policies - list in shareholder materials - *Disclosure and transparency* - more light is better - Insider or *related-party transactions* - needs approval from the board - Responsiveness to shareholder *proxy votes* Independence and qualifications: - *Qualified* directors - *75%* of directors independent - Independent board *chairman* (i.e., not CEO) - Use of independent or expert *legal counsel* instead of internal counsel Committees: - *Audit committee* - internal audit should report directly to committee; only independent members, 2+ financial experts - *Nominating committee* - establish criteria for board and senior management; only independent directors - *Compensation committee* - base salary and perks are a small % of total compensation; mostly bonuses, stock options based on performance goals

REIT volatility vs. direct investment in properties

REITs tend to be more volatile because prices and returns are determined by the stock market

approach to determining accuracy of AR models in forecasting out-of-sample

RMSE, i.e., root mean square of errors

ROIC

ROIC = NOPLAT / invested capital = net operating profit adjusted for taxes / (operating assets - operating liabilites) - Firms with higher ROIC relative to their peers are likely exploiting some competitive advantage in the production and/or sale of their products - When comparing firms with different capital structure, ROIC is preferred over ROE - Return on capital employed is similar to ROIC but uses pre-tax earnings in numerator

impact of rebalancing frequency on portfolio returns

Rebalancing portfolio weights will decrease returns when prices are trending but increase returns when price changes are choppy and mean-reverting. For this reason, price behavior across rebalancing periods will influence returns. If the prices of a commodity are choppy over short horizons but trending on a longer-term basis, frequent rebalancing may capture gains from mean reversion over the shorter periods but give up some of the gains from the trend of the commodity's price over the longer term.

Regulatory Interdependencies

Regulatory Capture Theory - regulators end up being influenced by regulated industry/entity Regulatory competition - regulators in different jurisdictions compete for business Regulatory arbitrage - business shop for friendly regimes or find loopholes

capital deepening

Related to labor productivity, similar to GDP per capita. Assuming # of workers & α are constant, increases in output can be gained by increasing capital per worker, CAPITAL DEEPENING, or improving tech. TFP HOWEVER since α<1, adding capital has diminishing effect on productivity. Developed markets gain less from capital deepening.

reporting and earnings quality

Reporting Quality: - Decision useful information - Accurate (GAAP compliant) and relevant - Enable assessment Earnings Quality: - Return on equity - Sustainable

types of mortgage backed securities (MBS) • construction • size vs. equity market

Residential (RMBS) or Commercial (CMBS). - Receive cash flows from an underlying pool of mortgage loans - Represent a far larger aggregate market value than equity securities

financial statement quality

Revenue recognition and gains: - early revenue recognition - misclassification of non-operating income Expenses and losses: - Too much or too little reserves - Inappropriate capitalization of expenses Off-Balance Sheet Financing: - understate liabilities Operating Cash Flow: - may be artificially inflated

SST

SST = RSS + SSE

Purposes in Regulating Financial Markets

Security markets: - Disclosure requirements promote investor confidence - Mitigating agency problem inherent with financial intermediaries acting as agents - Protection for small investors and hence lax regulatory environment for hedge funds - who only market to qualified individuals Financial institutions: - prudential supervision to reduce system-wide risks and to protect investors - coherent policy globally to prevent regulatory arbitrage and contagion

residual income valuation: strengths and weaknesses

Strengths: - Terminal value does not dominate intrinsic value estimate - Accounting data usually accessible - Applicable even without dividends or positive cash flow - Applicable even when cash flows are volatile or unpredictable - Focus on economic profitability Weaknesses: - Accounting data can be manipulated by management - Requires many adjustments - Assumes clean surplus relation (B = B + E - D) holds or that its failure to hold has been taken into account

FCF Strengths and Limitations

Strengths: - Used with firms that have no dividends - Functional model for assessing alternative financing policies - Rich framework provides additional detailed insights into company - Other measures (EBIT, EBITDA, and CFO) either double count or omit important cash flows Limitations: - FCF could be negative due to large capital demands - Requires detailed understanding of account and FSA - Information not readily available or published

sustainable growth rate of a firm

Sustainable growth rate in earnings and dividends if we assume: - growth uses internally generated equity - capital structure remains unchanged - several key ratios held constant g = retention rate x ROE

forms of acquisition

Stock purchase: • Payment made directly to shareholders of target in exchange for their shares • Majority shareholder approval required • No corporate taxes • Target shareholders pay capital gains tax • Acquirer assumes liabilities of target Asset purchase: • Payment made directly to target company • No shareholder approval needed unless asset sale is substantial • Target company pays capital gains taxes • No shareholder taxes • Acquirer usually avoids assumption of target's liabilities

Dutch disease

The phenomenon where a country rich in natural resources demanded by global economy sees its currency appreciate markedly, thereby making exports expensive and ultimately leading other (non-extractive, resource) industries to be uncompetitive in global markets

convergence theories

Theories on convergence of GDP per capita 1) Absolute convergence - all countries poor/rich will converge on per capita output 2) Conditional convergence - only countries with similar input factors will converge on per capita output (savings rates, population growth rates and production function) 3) Club convergence - States that are part of 'club' aka same institutions/markets/rights/educational services will grow to match rich peers. Those that dont join 'club' may never achieve higher wealth Note: endogenous growth theory makes no prediction that convergence must occur (it could or it couldn't) Empirical evidence in favor of club convergence

covariance stationarity

To use an autoregressive model, the time series must be *covariance stationary* 1. constant and finite expected value (constant mean, model must attempt to revert to its mean, i.e., slope coefficient < 1) 2. constant and finite variance 3. constant covariance between any two values that are equal distance apart

correlation of zero indicates...

absence of a *linear* relationship, they could have a strong non-linear relationship

REIT structures

Traditional: - REIT holds and operates properties directly UPREIT: - Umbrella partnership - REIT holds controlling interest in partnership - REIT acquires properties with tax-efficiency - Most common structure in the U.S. DOWNREIT: - REIT has ownership of more than one partnership - REIT can own properties both at the partnership level and at the REIT level

Uses of Private Business Valuation

Transactions: - Venture capital financing - development phase companies need external financing - IPO - public sale of equity - Sale in an acquisition - valuations performed by both buyer and seller and subject to negotiation - Bankruptcy proceedings - determine liquidation or reorganization - Performance-based compensation - accurate valuation necessary Compliance: - Financial reporting - goodwill impairment tests, stock-based compensation - Taxes - transfer pricing, property tax, estate gift tax, compensation tax Litigation: - Shareholder suits, damage claims, lost profits, divorces

consolidation of VIE is required if...

Under US GAAP, a VIE must be consolidated if any of: - Insufficient at-risk investment - Shareholders lack decision-making rights - Shareholders do not absorb expected losses - Shareholders do not receive expected residual returns

USPAP

Uniform Standards of Professional Appraisal Practice These standards cover real estate, fixed income and private business valuations. Business appraisers are not required to adhere to the standards

absolute vs. relative valuation

absolute - intrinsic value based on fundamental characteristics (EPS, turnover, leverage, etc.) relative - value derived from relative comparison to similar assets, based on law of one price (P/E, P/B, P/CF, P/S)

contingent consideration (business combinations)

acquirer's obligation to former owners of acquiree, if certain events occur (e.g., performance) IFRS/GAAP: -recognize estimated fair value at acquisition and any other contingent consideration (discount back) -change in FV of liabilities go to I/S -change in FV of equity settled in equity GAAP only: -changes in FV of assets to income statement

equity vs. acquisition methods: impact on financials and key metrics

acquisition: higher sales, expenses, A&L, equity. same NI as equity equity: higher net profit margin (due to lower sales), RoE (due to lower equity), RoA (due to lower assets)

the most diversified portfolio is the one with the lowest...

active specific risk

Guideline Transactions Method for valuing private companies

Use prior acquisition value for entire (public and private) companies. Will already include control premium. Issues: - Transaction type - strategic vs. nonstrategic - Contingent considerations - increases risk to the seller - Type of consideration - stock vs. cash - Availability of data - relevant and accurate data may be limited - Date of data - data may be stale

Durbin-Watson test

Used to test for serial correlation in residuals D ≈ 2(1-r), where r is correlation between subsequent residuals

Prior Transaction Method for valuing private companies

Uses transactions data from the stock of the actual subject company. Most appropriate when valuing minority interests. Ideally, previous transactions would be arms-length, same motivation, recent

intrinsic value (residual income)

Value of current BV + PV of high-growth RI + PV of continuing RI PV cont RI = RI / (1+r+w) For mature industry method, PV of cont RI at T = P - B At T-1; [(P-T) + RI] / (1+r)

Method of Forecasted Fundamentals

Values a stock based on the ratio of its value from a discounted cash flow model to some fundamental variable

discount for lack of marketability

Varies with: - Likelihood of IPO, firm sale, or dividends (higher likelihood increases marketability, decreases discount) - Contractual restrictions on selling stock (more restrictions decrease marketability) - Buyer pool size (larger pool increases marketability) - Asset risk (more risk decreases marketability) Methods: 1. Compare restricted share values to public share values 2. Compare pre-IPO share price to post-IPO share price 3. Price of put option divided by stock price. Time to maturity could be time to IPO. Volatility based on publicly traded stock

type of investment strategy that is most likely to have an absolute return objective

active strategy (passive and semi-active strategies rely on tight tracking errors)

realized alpha

actual holding period return less required return for the period

a CDS on an owned bond (does / does not) eliminate credit risk associated with that bond

a CDS does NOT eliminate credit risk because protection buyer is exposed to credit risk of the protection seller

stock appreciation rights

a bonus given to employees that is based on company's stock appreciating over a predetermined amount unlimited upside and no downside for the employee

sunset provision

a condition of a law that results in automatic removal unless regulator takes further action

mixed-use development

a development that combines different end-users (e.g., storefronts on ground floor + apartments above)

bill-and-hold

a fraudulent financial reporting activity by which a company recognizes a sale even though it does not ship the merchandise to the customer but holds it in its own warehouse

percentage lease

a lease, commonly used for commercial property, whose rental is based on the tenant's gross sales at the premises; it usually stipulates a base monthly rental plus a percentage of any gross sales above a certain amount.

NCREIF property index and calculation

a measure of the historical performance of income properties held by (or for) pension funds and profit sharing plans

pure play method

a method for estimating the beta for a company or project that uses a comparable company's beta adjusted for leverage

(pure) factor portfolio

a portfolio with a factor sensitivity of one to a particular factor in a multi-factor model and zero to all other factors a special case of tracking portfolio

arbitrage portfolio

a portfolio with factor sensitivities of zero to all factors, positive expected net cash flow, and an initial investment of zero

risk neutral probability of default can be thought of as historical probability of default plus

a premium for the uncertainty of the loss given default

stock dividend

a pro rata distribution of stock to existing stockholders recorded by moving amounts from retained earnings to paid-in capital

conversion ratio

a ratio specifying the number of shares of common stock into which a convertible bond can be converted

regulatory capture

a situation in which a regulatory body is influenced or controlled by the industry that is being regulated

child order

a small order that is created by a trading algorithm and placed in the market as a piece of a larger parent order

z-spread

a spread that when added to each spot rate on the Treasury spot curve, makes the present value of a bond's cash flows equal to the bond's market price

a 2x5 swaption is...

a swaption that matures in 2 years and gives the holder the right to enter into a 3-year swap at the end of the second year.

arbitrage pricing theory (APT) • description • assumptions • implication(s)

a theory of risk-return relationships derived from no-arbitrage considerations in large capital markets assumptions: 1. returns can be explained by a factor model 2. no arbitrage opportunities exist 3. there are many assets available to investors implication: • unsystematic risk can be diversified away in a portfolio but systematic risk (i.e., factor risk) cannot

algorithmic trading

a trading strategy that has been automated through the use of a computer

curve trade

a type of long/short trade where the investor is buying and selling protection on the same reference entity but with a different maturity

expanded CAPM

adds to the CAPM a premium for small size and company-specific risk

poison pill

an anti-takeover provision that gives target shareholders the right to purchase shares at discounted prices *flip‐in pill* gives target shareholders the right to buy the *target's* shares at a discount *flip‐over pill* gives target shareholders the right to buy *acquirer's shares* at a discount. *dead‐hand provision* can only be redeemed or cancelled by a vote of the continuing directors

naked CDS

an investor with no underlying protection purchasing protection in CDS market

permissionless networks

an open distributed ledger technology system in which network participants can perform all network functions

stop loss order

an order to sell a particular stock at the next available opportunity after its market price reaches a specified amount

natural breakpoint of a lease

annual base rent / agreed upon overage percentage

Fed model

assumes yield on long term US treasuries should be the same as the expected operating earnings yield on the S&P 500. When the S&P 500 earnings yield is higher (lower) than the Treasury yield, the interpretation is that the index is too low (high) Fed Model: -Does not consider the equity risk premium -Ignores growth in earnings -Compares a real variable (index level) to a nominal variable (Treasury yield)

noblesse oblige

benevolent behavior that is the responsibility of successful enterprises

portfolio duration is impacted by...

bond futures: • buy bond futures --> increase in duration • sell bond futures --> decrease in duration interest rate swaps: • receive fixed, pay floating --> increase duration • pay fixed, receive floating --> decrease duration

retractable bond

bond that may be sold back to the issuer at a prespecified price before maturity

lower credit ratings impact whom?

both debt- and equity-holders

divestiture vs. equity carve-out

both generate cash for parent but equity carve-out takes longer to complete since it involves a public offering process

two series are cointegrated if...

both series have a unit root AND the residuals of a regression of one series on the other are covariance stationary

market conversion price

breakeven price of the stock associated with a convertible bond at which investor is indifferent between converting bond and selling bond

synthetic cash strategy or synthetic risk-free rate strategy

buying a stock and selling it forward

labor productivity growth account formula

growth rate in potential GDP = + long-term growth rate of labor force + long-term growth rate in labor productivity • labor productivity R = reflects both capital deepening and tech progress

value of convertible bond that's callable and putable

callable and putable convertible bond value = + straight value of bond + value of call option on stock − value of call option on bond + value of put option on bond

capital account surplus indicates money flowing (in to / out of) the country

capital account suprlus indicates money flowing *in to* country

economic capital

capital needed for a firm to survive if severe losses are experienced based on the risk the business is exposed to

key rate duration (i.e., partial duration)

captures the *interest rate sensitivity* of a bond to changes in yields (par rates) of specific benchmark maturities used to identify the interest rate risk from changes in the shape of the yield curve computed by measuring price impact that results from shifting one specific par-rate • *effective duration* = sum of key rate durations for a particular bond • *portfolio key rate duration* = weighted average of key rate durations at a given maturity across all bonds in a portfolio (weighted by market value) key observations: (1) for an *option-free bond*, the maturity-matched date is the most important date (and all other key rate durations are zero *if trading at par*) (2) *low coupon* --> possibility of negative key-rate duration for certain maturities (3) *callable* bonds: lower coupon --> less likely to be called --> key rate duration skewed toward maturity-matching date, with a shift toward earlier rates (i.e., time-to-exercise) as coupon increases (4) *putable* bonds: higher coupon --> less likely to be put --> key rate duration skewed toward maturity-matching date, with a shift toward earlier rates (i.e., time-to-exercise) as coupon decreases

when calculating CFO, net working capital excludes...

cash and notes payable

clean surplus relation is violated when...

charges skip the income statement and go directly to equity

collateralized debt obligation

claims against a portfolio of debt securities

zero-cost collar

collar in which call premium = put premium

synthetic CDO

collection of credit default swaps (as opposed to debt securities)

probability of default is (issue-specific vs. company-specific)

company-specific

smart contracts

computer programs that self-execute on the basis of pre-specified terms and conditions agreed to by the parties to a contract

artificial intelligence

computer systems that emulate human thinking

conglomerate discount

concept that the market applies a discount to firms with multiple, unrelated businesses vs. firms with narrower focus

excess purchase price (equity method)

consideration paid less pro-rata share of *book* value

tag-along rights, i.e., co-sale rights

contractual right of a minority investor/shareholder to sell stock (on a pro rata basis) along with and at the same price as the founder or majority shareholder, if either the founder or majority shareholder elects to sell stock to a third party

drag along rights

contractual right to force (or "drag") all other shareholders to agree to a specific action, e.g., sale of company, alongside the initiating investor/shareholder

build-up method for estimating required return on equity (not strictly private companies)

cost of equity = cost of debt + premium

calendar spread (commodities)

cost of near term future less cost of far term future

costs of financial distress

costs arising from bankruptcy or distorted business decisions before bankruptcy e.g., fees associated with bankruptcy, indirect costs such as loss of trust from customers and suppliers, and the probability of financial distress associated with operating and financial leverage

bonding costs

costs borne by management to assure stockholders that management is working in their best interests

relationship between credit spreads and business cycle is...

counter-cyclical

Altman z-score

credit-strength test that indicates likelihood of *bankruptcy* (of a publicly traded manufacturing firm) higher score indicates higher likelihood of bankruptcy based on five financial ratios: 1. working capital as % of assets 2. retained earnings as % of assets 3. EBIT as % of assets 4. market value of equity : total liabilities 5. sales : assets

transfer coefficient

cross-sectional correlation between the forecasted active returns and active weights, adjusted for risk

extendible bond

debt obligation that allows the bondholder to extend the bonds' maturity dates

ARCH • test to check for ARCH • potential usefulness • approach to manage

defn. test for auto-regressive conditional heteroskedasticity heteroskedasticity - when variance of error terms in current period is dependent on variance of error terms in lagged periods test is to perform regression of variance of error terms in in current period over square of residuals in previous period use: estimating variance of error in future periods approach to manage: generalized least squares

net regulatory burden

direct cost of compliance for the regulated entity + indirect cost changes in economic behavior - the private benefits of regulation

estimation of terminal value in RI valuation when assuming that RI declines to long-run level in mature industry

doesn't rely on persistence factor

capital account and impact on exchange rate • why is current account less impactful in short-term?

dominant factor in determining exchange rate movements in the short to medium: *** current account impact is less pronounced in short-term because: (1) prices of real goods and services adjust more slowly than those of financial assets (2) production of real goods and services takes time (demand decisions subject to inertia) (3) current spending/production decisions reflect only purchases/sales of current production vs. ability to immediately rebalance financial portfolio *** meanwhile, expected exchange rate movements can induce very large short term capital flows, therefore actual fx rate can be very sensitive to currency views held by owners/managers of financial assets

term structure of interest rate volatility is typically...

downward sloping, because short-term rates tend to be more volatile

In a macroeconomic factor model of the form: E(Ri) = a_i + b_i1*F_1 + b_i2*F_2 + e_i Asset specific risk is represented by...

e_i (note: a_i represents asset's expected return)

economic income

economic income = + NOPAT + accounting depreciation - economic depreciation where • economic Depreciation= PV of remaining CFs at beginning of year - PV of remaining CFs at end of year (does *not* include current year's CF) • note: uses unlevered cashflows alternatively, economic income = market value @ BoP * economic rate of return

in Solow model, labor force consists of (employed + unemployed / only employed)?

employed + unemployed

reasons why government would support banking system

encourage healthy banking system • facilitating commerce by instilling depositor confidence and providing adequate payment processing • enabling effective transmission of monetary policy

lognormal random walk

ensures non-negative interest rates but results in higher volatility at higher interest rates

accounting method required when each party in a JV owns 50%

equity method required under both GAAP and IFRS

asset specific risk in a multifactor model for portfolio returns is represented by?

error term

ex-post vs. ex-ante tracking error

ex-post tracking error: • looks at historical portfolio variability in historical markets • used to measure manager's skill and identify sources of performance ex-ante tracking error: • looks at exposure of current portfolio to variability in historical markets • used to understand performance relative to benchmark

Dornbusch overshooting model

exchange rates overshoot the long-run PPP values in the short-term

LBO exit value

exit value = + investment cost + earnings growth + increase in price multiple + reduction in debt

target payout adjustment model

expected annual increase in dividends = [(expected earnings × target payout ratio) - previous dividend] / # of years over which adjustment will take place

what interest rate to use when capitalizing operating leases?

expected future borrowing rate

normalized earnings

expected level of *mid-cycle* earnings for a firm that exclude unusual or temporary factors that affect profitability

expected alpha

expected return less required return

basis trade

exploiting credit spread between the bond market and CDS market. buy a bond and credit protection when bond is trading at a 4% credit spread to LIBOR but CDS spread on same bond is 3% buy and sell debt of the same entity based on which the CDS market suggests to be over- or underpriced. buy bond with YTM 6% by borrowing at 1.5% rate, and buy CDS spread at 4%. Cost of protection is 5.5%, but lock in 50bps. buying stock and credit protection in a company which is about to undergo an LBO

threshold dividend

if dividends exceed a preset amount, then conversion price on the bond will be adjusted downward

determining carried interest after hurdle rate

if fund / investment IRR > hurdle rate, then carried interest is calculated on 100% of profits

currency forward pricing

if someone is holds a long position in a forward contract denominated in F/D, then they are committing to buying D in the future

GAAP guidelines for choosing functional currency of subsidiary

if subsidiary is mostly independent from parent --> local currency is functional currency if subsidiary is highly integrated (regardless of local conditions) --> parent's reporting currency is functional currency if subsidiary is experiencing high inflation --> parent's reporting currency is functional currency

J-curve

illustrates the historical tendency of private equity funds to deliver negative returns in early years and investment gains in the outlying years as the portfolios of companies mature

dilution cost

implicit cost of reduced investor value when firms take on additional financing or when stock options are granted (and exercised) by management

private equity exit routes

in order of decreasing exit value: (1) IPO (2) trade sale (i.e., secondary) (3) management buyout (4) liquidation

classical growth theory

increase in GDP per capita above subsistence (e.g., due to increases in capital/technology progress) --> increase in long-term population growth --> decline in marginal returns of labor --> decline in productivity --> reversion of GDP per capita back to subsistence • implies no long-term growth in GDP per capita • not supported by evidence

bootstrapping

increases EPS for the acquiring firm without creating any economic gains method of packaging the combined earnings from two companies after a merger to increase P/E despite no economic gains occurs when a high P/E firm buys a low P/E firm for stock and the latter's earnings are valued at the acquirer's higher P/E post-merger

bootstrapping (increases / decreases) current EPS and (increases / decreases) future EPS

increases current EPS decreases future EPS

index CDS vs. single-name CDS, which is more liquid?

index CDS are typically more liquid with average trading volumes multiple times that of single-name CDS

bank sources of income

interest income service income trading income (most volatile)

indicators of poor quality earnings

internal indicators: • non-recurring earnings • high accruals • mean reversion in earnings • narrowly beating analyst estimates external indicators: • restatement of previous period financials • enforcement actions by regulatory authorities

valuation of inventory vs. payable

inventory is valued at the time it's received payable is valued at the time of payment, with a corresponding gain/loss in P&L

gross lease

lease in which the landlord pays all operating expenses of the property

factors that may cause corporate governance systems to vary across firms

legal environment culture industry

terminology for "long" in a currency forward

long currency is the currency to be received.

collar

long stock + long put + short call

covered call

long stock + short call motivations: 1. *income generation*: S to remain below X 2. *improving upon the market*: S to remain above X; call premium > S - X b/c of time value of money 3. *target price realization*: S very close to X, typically slightly below X

credit valuation adjustment

loss given default x cumulative POD x discount factor = credit valuation adjustment

change of control conversion price

price at which the bondholder can convert the bond if the firm is merged with or acquired by another firm and is unaffected by a cash dividend to shareholders

yield curve characteristics of an economy getting out of a recession

low short-term rates (due to expansionary central bank policy) and higher long term rates (due to prospects of GDP growth and higher expected inflation), leading to an upward sloping yield curve

supervised learning

machine learning technique in which a machine is given labelled input and output data and models the output data based on the input data

Ibbotson-Chen Model

macroeconomic model for equity risk premium S = robust results W = used only with developed countries (1+EINFL)(1+EGREPS)(1+EGPE) − 1.0 + EINC - Expected risk-free return

what approach gives the most reliable estimate of equity risk premium when public equities represent a large share of the economy?

macroeconomic models, i.e., supply side models

relationship between desired limits on active risk and maximum changes in allocation weights

maximum percentage point deviation in weights from benchmark = desired level of risk / annualized active risk

exercising options on futures early

may be worthwhile to exercise puts/calls on futures early to generate cash from immediate mark to market of futures contract

theta

measurement of the option's time decay measures rate at which options lose time value as the expiration date draws nearer typically, less time to expiry --> lower option value, exception is deep in-the-money puts

restricted voting rights

mechanism that prevents new shareholders from exercising their voting rights

execution algorithm

minimizes market impact of large order by chopping into pieces *Volume-Weighted Average Price* Algorithms (VWAP)—chops up order into slices that are proportional to historical trading volume *Implementation Shortfall* Algorithms— minimizes difference between decision price and execution price by taking into account market conditions and balancing minimization of two factors: (1) potential market drift that may happen if order takes a long time to execute (i.e., minimize the opportunity cost of unfilled orders) and (2) negative price impact that will result when an order is executed too quickly. In this way, implementation shortfall algorithms attempt to reduce the difference between the price at which the order actually executes and the price at which the decision was made to buy or sell the security. *Market Participation* Algorithms— chops up order into slices that are proportional to actual trading volume over the allotted period

value at risk (VaR), definition

minimum loss of X magnitude occurring Y% of the time over Z time period, given assumed market conditions made up of three elements: 1. frequency 2. minimum magnitude of loss (currency or percentage) 3. time horizon

convertible bond

minimum value = greater of straight value and conversion value

maturity mismatch

mismatch between maturity of deposits and loans cause banks to have liquidity problems during a bank panic

monetary approach to exchange rates

monetary policy drives changes price level / inflation, which, via purchasing power parity, drives changes in exchange rates

what methods commonly underestimate likelihood of extreme events

monte carlo and parametric/analytic approach frequently underestimate the frequency of extreme events because left tail events are more likely than would be implied by the normal distribution

more volatile GDP growth leads to (lower / higher) interest rates

more volatile GDP growth --> higher interest rates

relationship between price of a default-free bond, discounted expected sale price, and risk premium • multiperiod • single period

multiperiod: attached image • where covariance between expected future price of the bond with the investor's intertemporal rate of substitution is the risk premium which is positive for a risk-averse investor single period: zero covariance b/c there is no uncertainty about the terminal value

# of degrees of freedom of SEE

n - k - 1

number of degrees of freedom for the critical t-value used to calculate a confidence interval around either a parameter estimate or a predicted value in a single linear regression

n-2

relationship between credit spread and benchmark rates is...

negative

net pension asset

net pension asset = minimum of: 1. Plan Assets less PBO or 2. Present value of available refunds and reductions in future contributions

when is an asset backed security considered to have defaulted?

never an ABS only incurs losses until face value is either repaid or eliminated as a result of accumulated losses and/or early loan prepayments

pension footnote disclosure (GAAP, IFRS)

notes must show: periodic pension cost, net funding status on balance sheet and gross amounts of PBO/pension asset in notes companies disclose the following key assumptions in notes: discount rates, expected compensation increases, medical expense inflation - and under US GAAP - expected return on plan assets

hedge ratio

number of shares per option to create a delta-neutral portfolio

Molodovsky effect

observation that P/Es tend to be high on depressed EPS at the bottom of a business cycle and tend to be low on unusually high EPS at the top of a business cycle.

regulatory arbitrage

occurs when businesses shop for a country that allows a specific behavior rather than changing the behavior exploiting the difference between the economic substance and interpretation of a regulation, i.e., loopholes

Friedman doctrine

only social responsibility of business is to *maximize profits* within the rules of the game and through open and fair competition. doctrine *insufficient* when rules are unclear or poorly defined.

net operating assets

operating assets - operating liabilities operating assets = + assets - cash - cash equivalents - marketable securities - other assets held for speculation or investment in other companies - rental assets operating liabilities = + liabilities - interest bearing liabilities

fraudulent reports tend to...

overstate results

equity method at fair value

overview: • allowed by *both* GAAP and IFRS; IFRS only for financial firms (VC, mutual fund, unit trusts, investment-linked insurance funds, etc.) • must occur *at time of initial recognition* • *irrevocable* accounting: • interest, dividends, and unrealised g/l in P&L • excess of cost over net identifiable assets is not recognized; no goodwill is created

types of shifts in yield curve that are empirically found to explain more than 90% of yield changes

parallel shifts

another term for slope coefficients in multiple regression

partial betas

backward induction method assumes that cash-flows are (path dependent / path independent)

path independent

front running

placing personal orders ahead of a customer's large order to profit from the market effects of the trade

credit migration risk

possibility spreads will widen because issuer has become less creditworthy % price change = weighted average of (ending spread - starting spread) x duration expected return = YTM adj. for % price change

calculation of out-of-sample forecast error

predicted value in target year is calculated from predicted value in lagged variables

impact of autocorrelation of error terms in autoregressive model on standard errors and t-statistics

presence of autocorrelation of error terms --> unreliable t-statistics NO effect on standard errors

International Fisher Effect

principle that a difference in nominal interest rates supported by two countries' currencies will cause an equal but opposite change in their spot exchange rates

build-up method

private company valuation method that are used when there are no comparable public companies (i.e., beta not obtainable) required return = risk free rate + equity risk premium + company size premium + company-specific risk premium + industry risk premium (all betas are 1)

convention for quoting debt in private equity vs. public equity

private equity: debt as multiple of EBITDA public equity: debt as multiple of equity

SRO • description • requirement for classification as independent regulator • prevalence by law system

private, self-funded, non-governmental organizations which both represents and regulates its members, e.g., FINRA (recognized by SEC) an SRO that is given authority or enforcement power by the government is classified as an independent regulator not common in civil law countries

dividend safety

probability of dividends continuing at the current rate for a company

risk decomposition

process of converting portfolio holdings into a set of exposures to risk factors

stripping a bond

process of removing coupons from a bond and then selling the separate parts as a zero coupon bond and an interest paying coupon bond

tokenization

process of representing ownership rights to physical assets on a blockchain or distributed ledger

project NPV, assuming options

project NPV = NPV - cost of options + value of options

Coase theorem

proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own

mortgage REITs

publicly traded securities that make loans secured by real estate publicly traded debt investments

layering

quote stuffing strategy intended to use sham orders to trick other market participants into trading with real orders on the other side of the market

appropriate forward exchange rate for an investor from country A investing in country B

quoted in B/A, i.e., A.B

calculation of continuously compounded rate from annually compounded rate

r_c = ln(1 + r_a)

wash trading

rapidly buying and selling the same security to artificially inflate demand for the security

in-process R&D (business combinations)

recognized as a separate intangible asset at fair value under IFRS and GAAP amortized in subsequent periods

a call option on an equity that pays a dividend can be valued using BSM if we...

reduce the current equity price by the present value of the dividend [TBD]

prudential supervision

refers to the monitoring and regulation of financial institutions to reduce system-wide risks and to protect investors

present value of growth opportunities (PVGO) • what does PVGO represent? • formula

reflects value of a company's option to: 1. invest in growth/expansion projects 2. modify current projects V_0 = E_1/r + PVGO where r is required rate of return on equity

regulatory competition

regulators compete to be the most business friendly, e.g., different regulations in different countries

staggered board of directors

• a *portion* of the board is up for election each year, not the entire board. • increases the amount of time an acquirer would need to take control of the board

pull factors

represent a favorable set of developments in the domestic economy that attract capital from foreign countries. These factors include: 1. Better economic management; 2. Expected decline in the inflation rate; 3. A more flexible exchange rate regime; 4. An improving current account balance; 5. A decline in public and private debt burdens; 6. A sovereign credit rating upgrade; 7. An improving fiscal position; and 8. Strong and sustained economic growth.

push factors

represent a favorable set of factors in foreign economies that drive capital flows abroad These factors include: 1. Low interest rates in developed countries (that tend to be the primary sources of internationally mobile capital); 2. Changes in long-run trends in asset allocation such as increasing weights for emerging market assets in global portfolios.

reserved matters (private equity)

requirement that certain strategically important decisions (e.g., acquisitions, divestitures) be approved by the PE firm

stop-loss limit

requires a reduction in size of a portfolio (or its complete liquidation) when a loss of a particular size occurs in a specified period

event study

research methodology designed to measure the impact of an event of interest on stock returns

most appropriate benchmark curve for retail banks? wholesale banks?

retail banks: government spot curve wholesale banks: swap curve

regression model specification

selection of the explanatory (independent) variables to be included in the regression and the transformations, if any, of those explanatory variables

a company's credit rating is calibrated for...

senior unsecured debt

the designated debt entity in a CDS that's the reference entity is typically...

senior unsecured debt, which is often referred to as senior CDS

risk budgeting

sets an overall risk limit for a portfolio or firm and allocates the risk to different asset classes or sub-activities

bear call spread

short call + long call

neutral rate of interest / neutral policy rate

short term interest rate that balances long term savings and borrowings + targeted rate of inflation

short term nominal interest rates are positively correlated with...

short-term real interest rates and short-term inflation expectations

impact of length of time series on stability of regression model

shorter time series --> usually more stable because there is less opportunity for variance in the estimated regression coefficients between the different time periods

dividend signals

signaling results from information asymmetry between managers and investors - Increase - positive signal - Decrease - negative signal - Initiation - positive signal (usually); could indicate lack of NPV opportunities

phantom stock

similar to stock appreciation rights except payoff is based on performance of hypothetical stock

currency rate spread terminology

spread is quoted in units of price currency (i.e., numerator) e.g., given spot exchange rate of CAD/EUR 1.425-1.435, the spread is 0.01 CAD

OAS

spread that when added to the discount rate at each node in a binomial interest tree results in the market price of a bond average spreads over the Treasury spot rate curve

benefits of a strong corporate governance system

strong corporate governance system is essential for companies and financial markets to operate efficiently lack of strong corporate governance system represents a major operational risk that can threaten the very existence of a firm a strong corporate governance system cannot in itself maximize shareholder value, but studies have shown that the lack of effective system certainly reduces shareholder value on average, companies with strong corporate governance systems have higher measures of profitability and generate higher returns for shareholders

real time surveillance vs. real time monitoring

surveillance: detect potential market abuse while it's happening monitoring: detect anomalous market movements and serve as an early warning system to potential market problems and enable rapid response

corporate governance and key objectives

system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts of interest in the corporate form key objectives: (1) eliminate / mitigate conflicts of interest, particularly between management and shareholders (2) ensure assets are used effectively/productively and in the best interests of investors/shareholders

equity pricing models assume which type of risk is priced? systematic vs. unsystematic vs. both

systematic risk

dividend reinvestment plan

the automatic reinvestment of shareholder dividends in more shares of the company's stock open-market: company uses cash dividends to purchase shares off the open market new-issue: company uses dividends to purchase shares from company's treasury stock

costs of financial distress are lower if...

the company has tangible, marketable assets, compared to a company with mostly intangible assets

Jensen's free cash flow hypothesis

the idea that constraining free cash flow to equity may solve agency issues between shareholders and management

static trade-off theory

the optimal level of debt is achieved when the extra cost of financial distress equals the tax benefit of debt

global optimal risky portfolio for all investors is...

the portfolio with the highest Sharpe ratio

residual dividend policy

the practice of paying dividends with only the amount remaining after accepting all positive NPV projects (1) identify optimal capital budget (2) determine amount of equity needed to finance capital budget for a given capital structure (3) meet equity requirement as much as possible using retained earnings (4) pay dividends with "residual" earnings: max(0, net income - equity as % of total capital * capital budget)

when it comes to bonds, risk neutral probability of default is...

the probability of default that is implied by the market price

if a project is to be financed entirely with debt, its appropriate discount rate is...

the project's required rate of return (i.e., no different than if it were financed entirely with equity)

the underlying on an interest rate future is...

the value of a money-market security, e.g., treasury bill or eurodollar

conversion value of a convertible bond

the value of the common stock into which the bond can be converted

there (are / are no) American style putable / callable bonds

there are NO American style putable /callable bonds

earn outs

these are used predominantly in venture capital investments earn outs tie the acquisition price paid by the p/e firm to the portfolio company's future performance over a specified time period

when valuing european swaptions using the Black model, the term t in d1 and d2 corresponds to...

time to expiration of the swaption

what is investors' rationale for trading futures and options on volatility indices

to manage vega

role of Basel III Committee

to provide a framework for analyzing and regulating banks

traditional vs. modern term structure models

traditional: seek to describe shape of yield curve modern: seek to describe how interest rates evolve over time quantitatively

types of machine learning

two types: (1) *regression* - target variable is continuous (2) *classification* - target variable is categorical or ordinal (CART, random forest, neural networks)

high-frequency algorithm

used to analyze real-time market data in search of patterns that can be profitably traded (1) statistical arbitrage (2) liquidity aggregation and smart order routing (3) real-time pricing of securities (4) trading on news (5) genetic tuning

statistical arbitrage algorithms

used to identify securities that have historically moved together but have diverged recently involves buying one security and selling another, with the aim of realizing a profit when their prices converge pairs trading, index arbitrage, basket trading, spread trading (intramarket, intermarket, interexchange, multilegged interexchange - crack, spark, crush), mean reversion, delta neutral

relative sensitivities of short- and long-term CDS to changes in the credit curve

values of longer-term CDS are more sensitive than those of shorter-term CDS

risk factors

variables or characteristics with which individual asset returns are correlated

homoskedastic

variance of error terms is constant

option price vs. volatility

vega

recognizing equity method investment at fair value is allowed for...

venture capital funds or mutual funds

justified price multiple

warranted or intrinsic price multiple

underfitting

when a model is too simple and treats true parameters as noise

non-convergence trap

when developing countries do NOT implement necessary institutional reforms, which results in a stagnant level of GDP-per-capita level (i.e., failing to converge to level of GDP-per-capita of developed countries)

treatment of investment account under equity method when value is reduced to zero

when investment account reaches zero, investor typically discontinues equity method and does not record further losses

busted convertible bond

when price of common stock associated with bond is so low it has little effect on bond's market value

spurious correlation

when two variables are correlated but there is no meaningful, significant relationship

breakeven price on an option strategy

where % change in P = abs(breakeven price - current price) / current price

adjusted breadth

where N = # of bets, r = correlation between bets

expected amount of capital available from debt and equity for project investment

where equity portion of expected earnings available for project investment = + net income - dividends

maximum drawdown

worst-returning month or quarter for portfolio or worst peak-to-trough decline in portfolio's returns

taxes on unrealized gains of investment in financial assets

zero taxes on unrealized gains only realized capital gains are taxable

historical average spread between AAA and BBB debt

~100bps

profit for protection buyer

Δ spread x duration x notional

dividend payout policies (4)

• *stable policy*: flat dividend per share • *target ratio*: previous dividend + (expected increase in EPS)(target payout ratio)(adjustment factor) where AF = 1/years of adjustment • *constant payout ratio* • *residual model*: dividends based on earnings less funds retained to finance equity portion of capital budget 1. Identify optimal capital budget 2. Determine amount of equity needed given (1) 3. Meet equity requirements to extent possible with retained earnings 4. Pay dividends with the residual amount

Black Scholes N(D1) and N(D2)

• D2 is the probability that the option will expire in the money i.e. spot above strike for a call • N(D1) is delta

soft put vs. hard put

• a bond with an embedded *soft put* is redeemable through the issuance of cash, subordinated notes, common stock, or any combination of theses three securities • a bond with a *hard put* is only redeemable using cash

random forest • description • impact on overfitting • impact on signal-to-noise ratio

• a collection of randomly generated classification trees from the same data set, where a randomly selected subset of features is used in creating each tree • since each tree only uses a subset of features, random forests can mitigate the problem of overfitting • because errors across different trees tend to cancel each other out, using random forests can increase the signal-to-noise ratio

LCR

• Liquidity Coverage Ratio • Minimum % of a bank's expected cash outflows that must be held in highly liquid assets • Highly liquid assets / Expected cash outflows (*one-month* liquidity needs in a stress scenario) • Basel III standards set a target minimum of 100%

costs of asymmetric information

• Managers know more about firm prospects than owners. • Costs are higher if products are complex or financial statements are poor • Debt offerings are positive signal - willingness to take risk. Equity offerings are negative signal - overvalued stock.

differences between P&C and L&H insurers

• Only L&H focus on matching A/L • Only L&H use investment income to pay out insurance claims

closet index fund

• a fund that is purported to be actively managed but in reality closely tracks the underlying benchmark index • will have a Sharpe ratio similar to that of the benchmark index, a very low information ratio, and little active risk. After fees, the information ratio of a closet index fund is often negative

factors affecting comparison of multiples across international firms

• accounting methods • cultures • risk • growth opportunities (best to use price to cashflow multiples)

effect of tax & regulatory systems on economic growth

• all else equal, the lower the tax/regulatory burden, the higher the economic growth • lower regulation foster entrepreneurial activity.

growth accounting relation formula

• alpha = elasticity of output with respect to capital, ~0.3 for US (i.e., 1% increase in growth rate of capital --> 0.3% increase in growth rate of output) • 1-alpha = elasticityof output with respect to labor, ~0.7 for US *sources of data*: • Y, L, and K are available from GDP accounts • A (i.e., TFP or tech) is not observable and is estimated as a residual: the ex-post of the actual output - implied output

active risk squared

• an aggressive equity manager would have active risk ranging from 6% to 10%

direct capitalization method

• an income approach to valuing real-estate • net operating income / cap rate • cap rate = discount rate - growth rate

Black model

• applicable to options on underlying instruments that are costless to carry, e.g., futures contracts (e.g., equity index futures), options on futures contracts (e.g., caps, floors, swaptions) • ignores mark-to-market feature of futures contracts

preferred habitat theory

• bond investors prefer have a preferred maturity length and will buy outside their maturity preference only if there is a risk premium for the maturity range is available. • suggests that when all else is equal investors prefer to hold short-term bonds in place of long-term bonds and that the yields on longer term bonds should be higher than shorter term bonds

term structure of credit spreads for distressed debt

• bonds with high likelihood of default tend to *trade at recovery rate* rather than a spread to benchmark rate • longer term bonds may *appear to have a lower credit spread* since there are more years over which loss is attributed, which results in a higher yield (albeit still negative) • resulting inverted yield curve is *non-informative*

PV of residual income w/ persistence factor • formula • key timing assumptions

• calculates PV at time t - 1 and assumes that high-growth period ends in year t

impact of dividend on share price • formula • impact of stock vs. cash dividend

• cash dividend will typically lowers market value, whereas stock dividend has no impact on market value

Breusch-Pagan test • description • what is null hypothesis? • how to conduct? • degrees of freedom?

• chi-squared test for conditional heteroskedasticity in the error term of a regression • null hypothesis is homoskedasticity • nR^2 based on regression of squared residuals on independent variables; uses multiple R-squared (not adjusted R-squared) • k degrees of freedom

optimal capital structure • key condition • how is it used?

• combination of debt and equity financing that minimizes the average cost of capital and maximizes company value • serves as a guide for making decisions about how to raise capital but not necessary to keep it exactly on target; actual capital structure will typically fluctuate around optimal capital structure because book values may be different from market values, etc.

effect of limited political stability, rule of law & property rights

• countries without sufficiently developed property rights (physical & intellectual property) have difficulty attracting capital • political uncertainty due to war, corruption, etc. results in too much risk

Altman model

• discriminant model used to assess likelihood of bankruptcy • single period model using accounting data • *higher value = lower bankruptcy risk* based on five financial ratios: 1. working capital as % of assets 2. retained earnings as % of assets 3. EBIT as % of assets 4. market value of equity : total liabilities 5. sales : assets

claims valuation approach

• divides operating cash flows based on the claims of debt and equityholders that provided capital to the company. • CF to debt holders = interest and principal, discounted at cost of debt • CF to equity holders = dividends and share repurchases, discounted at cost of equity

unbiased expectations theory, i.e., pure expectations theory

• forward rates are unbiased predictor of future spot rates, i.e., shape of interest rate term structure is driven by investor expectations • doesn't hold

liquidity theory of term structure

• forward rates reflect investors' expectations of *future rates plus a liquidity premium*ff to compensate them for exposure to interest rate risk, and this liquidity premium is positively related to maturity (i.e., forward rates are a biased estimate of the market's expectation of future rates, since they include a liquidity premium)

rights theories

• fundamental rights trump the collective good. • managers must have a moral compass and respect these rights.

reverse stress testing

• goal is identifying top risk drivers in a portfolio in terms of exposures and what would make them risky • involves identifying a portfolio's risk factor exposures and determining what would stress those risk factors

common differences in accounting treatments when comparing international firms' multiples

• goodwill • deferred income taxes • foreign exchange adjustments • R&D • pension expense • tangible asset revaluations (best to use price to cashflow multiples)

term structure of credit spreads of high-yield issuers at bottom of recession

• high-yield issuers at bottom of economic cycle typically have downward sloping term structure of credit spreads, because of investor expectations that credit spreads will improve over time

types of estimates of the equity risk premium

• historical estimates • forward-looking (ex-ante) estimates, • macroeconomic model estimates • survey estimates

local expectations theory

• in short-term, expected return from holding any bond is risk-free rate and risk premiums must exist for longer periods, • same as unbiased/pure expectations theory but for short holding periods only • doesn't hold

carry trade

• investing in a currency whose country has higher nominal interest rates by borrowing from the lower yielding currency, in the hopes that the higher yielding currency will not depreciate as much as would be implied by uncovered interest rate parity • carry trade returns typically have negative skewness (i.e., asymmetric tail that extends more toward negative values) and excess kurtosis (i.e., fat tails) • *Crash risk* due to non-normal distribution and excess kurtosis. - if volatility high, then there is risk of adverse movements of exchange rates, which is compounded by flight to quality and leverage - manage risk with volatility filter (close positions over threshold) or valuation filter (overweight currency when value falls below threshold

relative risk of private equity real estate vs. bonds and stocks

• less risky than stocks, more risky than bonds • have a bond-like characteristic because tenant has a legal agreement to make periodic payments to owner • however, uncertainty around lease renewal result in stock-like characteristics

Taylor rule

• links Fed's target for the federal funds rate to economic variables central bank policy rate as per Taylor rule = optimal short-term rate: + neutral real policy rate + current inflation rate = neutral nominal policy rate + 0.5 * (log GDP_current - log GDP_potential) + 0.5 * (π_current - π_target)

segmented markets theory

• markets for different-maturity bonds as completely separated and segmented, because interest rate at a particular maturity is determined by supply and demand of bonds having that maturity

unsupervised learning

• program is provided input that consists of unlabeled data about which no conclusions have been drawn; no tag variable • program seeks out structure or inter-relationships in input data • e.g., clustering, dimension reduction

currency crisis warning signs

• relevant when currency is fixed or partially fixed *exchange rate*: 1) elevated real exchange rate 2) reserves decline sharply *monetary*: 1) high inflation (i.e., CPI increases) 2) M2 rises in 2 years leading to a crisis 3) broad money growth (nominal & real) *economic*: 1) trade deteriorates 2) credit boom 3) equity market boom

gamma

• sensitivity of delta to changes in the asset price • measure of how poorly a dynamic hedge will perform if not rebalanced in response to a change in asset price • a stock's gamma is always 0 because its delta is always 1

implied volatility

• standard deviation of continuously compounded asset returns that is implied by the market price of an option • volatility is the only unobservable input of BSM, with the the other four inputs as follows: 1. time to expiration 2. strike price 3. asset price 4. risk-free rate • no closed form solution

earn-outs

• tie the acquisition price paid by the private equity firm to the portfolio company's future performance over a specified time period • predominantly used in venture capital investments.

bear hug

• unfriendly takeover offer designed to be so attractive that the target firm's management has little choice but to accept it • used by acquirers to circumvent target management's objections to a proposed merger

Sharpe ratio vs. information ratio

• unlike Sharpe ratio, information ratio is affected by cash or leverage • blending active portfolio with benchmark portfolio does not affect information ratio because both numerator and denominator change • investors can select an appropriate amount of active risk by investing a portion of their assets in the active portfolio and the remaining portion in the benchmark

characteristics of big data

• volume: amount of data available • velocity: speed at which data are communicated • variety: degrees of structure in which data exist

differences between commodity indexes

• what commodities are included? • what is weighting of the commodities in the index? • what is method of rolling contracts over as they near expiration? • what is method of rebalancing portfolio weights?

liquidating dividend

• when a company goes out of business and distributes its proceeds to shareholders • treated as a return of capital for tax reasons and not taxed unless it is over the investor's cost basis • use residual income model to value

key drivers of growth in equity values over time (econ)

∆P = ∆GDP + ∆(E/GDP) + ∆(P/E) P=price E=earnings Over LT, growth in earnings relative to GDP is ZERO - labor unwilling to accept decreasing share of GDP. Same for P/E, investors wont pay more for the same earnings forever. -- LT potential GDP growth = aggregate equity valuation