Temp
Limitations of correlation analysis
- correlation is a measure of *linear* association. 2 variables can be connected with a nonlinear association but can have a correlation of 0 - correlation may be an unreliable measure when there are *outliers* in one or both of the series - correlation does not imply *causation* - correlations may be *spurious* in that they may highlight relationships that are misleading
Two major objectives of corporate governance
1. Eliminate or reduce *conflicts of interest*, especially those between managers and shareholders, and 2. Ensure that the company's *assets* are used in the best interests of its investors and other stakeholders.
Equity carve‐out
A company separates one of its divisions to create a new legal entity and offers shares in the entity to outsiders. Cash inflow from outsiders.
Spin‐off
A company separates one of its divisions to create a new legal entity but shares are only issued (proportionately) to *current shareholders*.
Leveraged recapitalization
A large amount of debt is issued to finance a substantial share repurchase.
Conflicts for sole proprietorships and partnerships:
Conflicts between the partnership and creditors and suppliers are addressed in the same manner as they are in a proprietorship (i.e., by providing adequate information).
Greenmail
This is an arrangement where the target is allowed to repurchase its shares from the acquirer at a premium to market price. Essentially, it represents a payoff given to the acquirer to terminate a hostile takeover bid. This strategy is not used much now since there is a 50% tax on acquirers on profits realized though greenmail.
9 applications of equity valuation
Valuation Stock selection Reading the market Projecting the value of corporate actions (M&As, MBOs, divestitures) Fairness opinions (eg. for minority shareholders in an M&A) Planning and consulting Communication with analysts and investors Valuation of private business Portfolio management (planning and execution step)
Relative valuation models
Valuation relative to an other asset
consolidation
both the target and acquirer merge (consolidate) into a newly formed company so both their previous legal entities cease to exist
external stakeholders
customers, suppliers, creditors, governments, unions, local communities, and the general public
Poison pills
grant a company the right to issue stock options to existing shareholders enabling them to purchase additional shares of stock at significantly 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 shares of the *acquirer* at a discount. under a *dead‐hand provision* the poison pill can only be redeemed or cancelled by a vote of the continuing directors
acquisition
refers to a company's purchase of another company's assets, identifiable business segments, or subsidiaries.
horizontal merger
the combining companies are in the same line of business (usually as competitors)
p-value
the lowest level of significance at which the null hypothesis can be rejected. a p‐value of 0.007 tells us that we can reject the null hypothesis that the true population parameter equals zero at the 0.7% level of significance (or with a 99.3% level of confidence).
Board members have the responsibility to:
•establish *corporate values and governance structures* for the company to ensure that the business is conducted in an ethical, competent, fair, and professional manner; •ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion; •establish *long-term strategic objectives* for the company with a goal of ensuring that the best interests of shareholders come first and that the company's obligations to others are met in a timely and complete manner; •establish clear lines of *responsibility* and a strong system of *accountability* and performance measurement in all phases of a company's operations; •hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's performance; •ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decisions that are its responsibility, and to be able to adequately monitor and oversee the company's management; •meet frequently enough to adequately perform its duties, and meet in extraordinary session as required by events; and •acquire adequate training so that members are able to adequately perform their duties.
"Crown jewel" defense
The target sells off a valuable asset to make the firm less attractive to the would‐be acquirer.
The Information Ratio
We cannot use active return alone to evaluate the performance of active portfolio manager. Active return must be evaluated in light of the active risk taken by the manager. Numerator: average portfolio return vs benchmark Denominator: standard deviation of *active returns*
The decision to add an investment to an existing portfolio
We need 3 pieces of info: (1) The Sharpe ratio of the new investment (2) The Sharpe ratio of our existing portfolio (3) The correlation between the new investment's return and our existing portfolio's return Sharpe NEW > Sharpe OLD x correlation
How to achieve higher information ratios?
We need to understand the *fundamental law of active management*
Calculate the forward exchange rate:
We use a 365-day basis for foreign currency contracts to calculate T
(1) Agency RMBS are...
mortgage pass-through securities. Each pass-through security represents a claim on the cash flows from a pool of mortgages. Any number of mortgages included in the pool is referred to as a securitized mortgage. WAM and WAC (weighted average maturities and coupons)
Replacement decisions involve...
mutually exclusive projects
The net cost of holding the asset...
net costs = storage costs - convenience yield
dividend coverage ratio
net income / dividends
Periodic Pension Cost Under IFRS and U.S. GAAP
While total periodic pension cost is the same under IFRS and U.S. GAAP, the manner in which total pension cost is divided between the P&L and OCI is different under the two sets of standards.
MM I with taxes:
With taxes, but without costs of financial distress and bankruptcy, use of debt offers immense benefits to the company. Overall company value increases when more debt is issued.
Securitization refers to...
a process by which financial assets (mortgages, AR or auto loans) are purchased by an entity that issues securities that are supported by the cash flows from the financial assets.
An interest rate *floorlet* is similar to...
a put option on interest rates To value a cap (floor), you simply value each caplet (floorlet) and then add them up !!! Caps and floors pay in arrears: the payoff occurs one period after the expiration of the cap or floor.
During the *lockout period*...
no principal is paid to the ABS holders (18 months to 10 years)
Overcollateralization:
occurs when the ABS is issued with a face value less than the value of the underlying collateral. For example, if the liability structure is $100 million and the collateral's value is $105 million, the issue is overcollateralized by $5 million. It enables the issue to absorb some credit losses before ABS investors are affected. Overcollateralization = collateral value - combined value of all tranches
LIFO will ALWAYS...
offer a closer reflection of replacement costs in COGS because it allocates recent costs to COGS.
Alpha (or residual return) is...
a risk-adjusted measure of the active return on a portfolio: - *Ex post* (looking backward) alpha is an average of *realized* residual returns - *Ex ante* (looking forward) alpha is a *forecast* of residual return
An *interest rate collar* is...
a simultaneous position in a floor and cap on the same benchmark rate over the same period with the same settlement dates
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.
A *shifting interest mechanism* is a method for...
addressing a decrease in the level of credit protection provided by junior tranches as prepayments or defaults occur in a senior/subordinated tranche. If prepayments or credit losses decrease the credit enhancement of the senior tranche, the shifting interest mechanism restricts payments to the subordinated tranches for a period of time until the credit enhancement of the senior tranche is restored
The Beneish Model (2)
all formulas are with t/t-1 except for: depreciation, gross margin index (t-1/t)
merger
an acquisition in which a company purchases another company in its entirety.
An *interest rate cap* is...
an agreement in which one party agrees to pay the other at regular intervals over a certain period of time when the benchmark interest rate (LIBOR) exceeds the strike rate specified in the contract. The strike rate is called the *cap rate*.
An *interest rate floor* is...
an agreement in which one party agrees to pay the other at regular intervals over a certain period of time when the benchmark interest rate (LIBOR) falls below the strike rate specified in the contract. The strike rate is called the *floor rate*.
The conditional prepayment rate (CPR) is...
an annualized measure of prepayments
Under the temporal method: The parent's exposure is limited to the subsidiary's net monetary assets (liabilities). If the parent has a net monetary asset (liability) exposure...
an appreciating foreign currency will result in a translation gain (loss) on the income statement. Items Translated at Current Exchange Rate Exposed assets > Exposed liabilities => Net asset balance sheet exposure Exposed assets < Exposed liabilities => Net liability balance sheet exposure
Under the current rate method If the parent has a net asset (liability) exposure...
an appreciating foreign currency will result in a translation gain (loss), which will be reflected in an increasing (decreasing) cumulative translation adjustment on the balance sheet. Items Translated at Current Exchange Rate: Total assets > Total liabilities => Net asset balance sheet exposure
A swaption is...
an option that gives the holder the right to enter into an interest rate swap. The notation is similar to FRAs.
Structural models of credit risk...
are based on the structure of a company's balance sheet and rely on insights provided by option pricing theory
(1) Macroeconomic factor:
assume that return on each asset is correlated with *surprises* in certain factors related to the broader economy. ai: the expected return to stock i FINT=surprise in interest rates
The Public Securities Association (PSA) prepayment benchmark...
assumes that the monthly prepayment rate for a mortgage pool increases as it ages (becomes seasoned) The PSA benchmark is expressed as a monthly series of CPRs. If the prepayment rate (CPR) is of an MBS is expected to be the same as the PSA standard benchmark CPR, we say the PSA is 100 (100% of the benchmark CPR). A pool of mortgages may have prepayment rates that are faster or slower than PSA 100. A PSA of 50 means that prepayments are 50% of the PSA benchmark CPR, and a PSA of 130 means that prepayments are 130% of the PSA benchmark CPR
ABS are most commonly backed by...
automobile loans, credit card receivables, home equity loans, manufactures housing loans, student loans, Small Business Administration loans, corporate loans, corporate bonds, emerging market bonds, structured financial products
(2) Historical betas (unadjusted)
bi is the slope in the market model. It is the increase in the return on asset i if the market return increases by one p.p. ai is the intercept. It represents the predicted return on asset i if the return on the market equals 0
BUT for agricultural, forest and mining products...
both US GAAP and IFRS allow companies to value inventory at NRV even when it exceeds cost.
The CDS pays off not only when the reference entity defaults on the reference obligation...
but also when the reference entity defaults on any other issue that is ranked pari passu (semi rank) or higher
Benefits paid....
by the company to employees decrease the pension obligation.
A cap is actually a portfolio of...
call options on LIBOR called caplets
Non-conforming loans in MBS pools...
can be securitized by private companies for non-agency RMBS
A floating-rate borrower can use a...
cap to limit interest expense during the life of the cap
Capitalized vs expensed interest...
capitalized lowers CFI expensed lowers CFO
Under IFRS....
classification of a lease depends on whether all the *risks and rewards* of ownership are transferred to the lessee.
Constant Dividend Payout Ratio Policy
companies aim to keep a constant dividend payout ratio A constant payout approach means that dividends will vary in proportion with earnings, likely resulting in volatile dividends and a higher risk premium.
Factor portfolios are...
constructed to have a sensitivity of 1 to a specific factor and 0 to all other factors.
A senior/subordinated structure:
contains at least two *tranches* (securities with different claims to the cash flows from the underlying pool of mortgages): a senior tranche and a junior or subordinated tranche. The subordinated tranches absorb the first losses up to their limits. The level of protection for the senior tranches increases with the percentage of subordinated bonds in the structure.
Credit ratings are used for...
corporate debt, ABS and government and quasi-government debt
Credit card receivable-backed securities are ABS backed by pools of...
credit card debt owed to banks, retailers, travel and entertainment companies
The credit quality of a non-agency MBS depends on the...
credit quality of the borrowers as well as the characteristics of the loans, such as their LTV rations
The protection buyer is short...
credit risk
The protection seller is long...
credit risk
Value of futures contract =
current futures price - previous marktomarket price
The translation method that applies to a particular situation...
depends on the entity's functional currency.
Credit card ABS have an...
early amortization provision that provides for earlier amortization of principal when it is necessary to preserve the credit quality of securities
The CAL and the CML only applied to...
efficient *portfolios*, NOT individual assets, nor to inefficient portfolios.
Valuing an FRA prior to maturity
eg. vale a 5.32% 1x4 FRA with a principal of $1 mil. 10 days after initiation if 110-day LIBOR is 5.9% and 20-day LIBOR is 5.7%
The credit rating of the ABS securities may be...
higher than the credit rating of bonds issued by Fred because SPV is a separate legal entity and the buyers of the ABS have no claim on other assets of Fred. A decline in the financial position of Fred does not affect the value of the claims of ABS owners to the cash flows from the trust collateral because it has been sold by Fred, which is now simply the servicer (not the owner) of the loans
Eurodollar futures and T-bills are settled...
in cash
Credit risk is lowest...
in the beginning and toward the end of the swap, since at the end, few payments are left and credit risk is again low
Credit risk is highest...
in the middle of the swap term, because credit quality can have deteriorated and there are significant future payments remaining on the swap
An increase in expected inflation will...
increase WACC
A *credit default swap* is an...
insurance contract
The Minimum-variance portfolio
is one that has the smallest variance among all portfolios with identical expected return
Skill:
is represented by the manager's *information coefficient*, which represents the correlation between her residual return forecasts and subsequent results (actual residual returns)
The optimal portfolio:
is the tangency point of the VA curve and the residual frontier
Channel stuffing...
is when the company inflates current period revenues by pulling future sales into the present A high percentage of accounts receivable to revenues might mean nothing, but it might also mean that channel stuffing has taken place, portending high future returns of inventory or decreased demand for product in the future.
Currency swaps and currency forwards...
it is appropriate to view currency swaps as a series of: currency forwards
Equity swaps and equity forwards...
it is appropriate to view equity swaps as a series of: equity forwards
A long floor is equivalent to a portfolio of...
long call options on fixed-income security prices
Reverse cash and carry arbitrage =>
long forward => borrow asset => sell spot asset => lend money
A long cap is equivalent to a portfolio of...
long put options on fixed-income security prices
Marking to market involves...
making a payment equal to the value of the swap at periodic settlement dates and repricing the swap by resetting the swap rate. This reduces credit risk.
Jensen FCF hypothesis:
managers endowed with free cash flow will invest it in negative net present value (NPV) projects rather than pay it out to shareholders. If a company has enough cash in an environment of fewer profitable growth opportunities, it can tempt Company B's management to overinvest in negative NPV projects. So dividends can mitigate this overinvestment agency issue.
Costs of Asymmetric Information (pecking order theory)
managers prefer modes of financing that offer the *least* information content to company outsiders. Issuance of debt: positive signal Issuance of equity: negative signal Bottom line: Costs of asymmetric information decrease as more debt is issued.
CDS does NOT provide protection against...
market-wide interest rate risk, only against credit risk
The aim of active management is to...
maximize the *value added* from residual return
Vega...
measures the sensitivity of the option price to changes in the volatility of returns on the underlying asset
The Optimal Capital Structure: The Static Trade‐Off Τheory
After accounting for the costs of financial distress, the value of the leveraged firm can be calculated as: VL = VU + tD - PV(Costs of financial distress)
Agency Costs
Agency costs include: Monitoring costs: These are the costs incurred by shareholders to monitor the actions of management. They include expenses relating to the annual report and the board of directors. Bonding costs: These are the costs incurred by management to assure shareholders that they are working in shareholder interest. These include explicit costs (e.g., costs of insurance to guarantee performance), and implicit costs (e.g., those associated with noncompete employment contracts). Residual loss: These losses refer to costs that are incurred despite adequate monitoring and bonding provisions. These costs arise because monitoring and bonding mechanisms are not perfect. Bottom line: higher debt levels limit opportunities for management to misuse cash.
Costs of Financial Distress
All other factors remaining the same, higher expected costs of financial distress serve as disincentives for companies to take on more debt.
Active factor risk:
Also, active factor risk = (Active sensitivity to the factor)^2 x (factor variance) if the correlation between factors is close to 0
Commercial MBS (CMBS) are backed by income-producing real estate such as
Apartments Warehouses Shopping centers Offices Health care facilities Senior housing Hotel properties
Investments in associates:
Associates are corporate investments over which the investor exercises *significant influence*, but not control (usu. 20-50%). Indicators of significant influence: - Representation on the board of directors - Participation in the policy-making process - Material transactions between the investor and the investee - Interchange of managerial personnel - Technological dependency
Units‐of‐Production:
Based on the actual use of an asset over the period. We subtract salvage value!
Why are American options on futures more valuable than comparable European ones?
Because exercising an in the money option will generate cash from the mark to market. This cash can earn interest, while the futures position will gain or lose from movements in the futures price.
Ending Inventory =
Beginning + purchases - COGS
Share-based compensation:
Both IFRS and U.S. GAAP require companies to measure share‐based compensation expense based on the fair value of the compensation granted.
Fair Value Option
Both U.S. GAAP and IFRS (with certain restrictions) now offer investors the option to account for their equity method investments using fair values. Under both standards, the decision to apply the fair value method must be made at the time of initial recognition and is irrevocable. When the fair value method is applied: Unrealized gains/losses arising from changes in fair value as well as interest and dividends received are included in the investor's income. The investment account on the investor's balance sheet does not reflect the investor's proportionate share in the investee's earnings, dividends, or other distributions. The excess of cost over the fair value of the investee's identifiable net assets is not amortized. Goodwill is not created.
Execution: portfolio construction and revision
optimization techniques
Owning a risky debt with face value of K is equivalent to...
owning a risk-free bond with the same face value and writing a European put option on the A of the company with a strike price of K. If the value of A > face value of debt, the put option will be out of money and not exercised, and the debt holder will simply receive the face value. If the value of A < face value of debt, the put option will be in the money and will be exercised. The debt holder will receive only the value of the A.
Under IFRS...
periodic pension cost is divided into three components. Two of them are recognized in P&L, while one is recognized in OCI. (1) Service costs: Both current and past service costs are recognized as an expense on the P&L under IFRS. (2) Net interest expense/income: Net interest expense/income is also recognized on the P&L under IFRS. This amount is calculated as: Net interest expense (income) = Net pension liability (asset) × Discount rate = (Pension obligation − Fair value of plan assets) × r = Pension obligation × r − Fair value of plan assets × r Note that the discount rate, r, is the rate used to determine the pension obligation (present value of benefits earned). Net interest expense represents the financing cost of deferring payments related to the plan. Net interest income represents the financing income from prepaying amounts related to the plan. (3) Remeasurement: This component of periodic pension cost is recognized in OCI under IFRS. Further, remeasurement amounts are *not subsequently amortized into P&L*. Remeasurement = Actuarial gains (losses) + [Actual return on plan assets - (Fair Value of plan assets x r)]
Payments are netted in...
plain vanilla interest rate swaps but NOT in currency swaps
Tracking portfolios are...
portfolios that have factor sensitivities matched with those of a designated benchmark portfolio
CMOs increase the...
potential market for securitized mortgages because they partition and distribute the cash flows generated by RMBS into different risk packages to better match investor preferences. Each CMO tranche represents a different mixture of contraction and extension risk.
In currency swaps...
principal is exchanged at termination of the swap, so the period of higher credit risk is a little later in the swap's life
An item is *capitalized* if it is expected to...
provide benefits to the company for a period longer than one year
An item is *expensed* if it is expected to...
provide economic benefits in the current period
The buyer of a floor has a position similar to...
put options on LIBOR called floorlets
*Gamma* measures the...
rate of change in delta as the underlying stock price changes Hedges with at-the-money options will have higher gammas, and small changes in stock price will lead large changes in delta and frequent rebalancing. In contrast, hedges with deep in- or deep out-of-the money options will have small gammas and stock price changes will not affect the delta of the hedge significantly. This lowers rebalancing and transaction costs.
Changes in foreign currency....
Both U.S. GAAP and IFRS require that changes in the value of a foreign currency asset/liability resulting from a foreign currency transaction be recognized as gains/losses on the income statement.
Defensive interval ratio
Cash + Marketable securities + Accounts receivable / Daily cash exp.
Disclosures Relating to Foreign Currency Transaction Gains and Losses
IFRS and U.S. GAAP require disclosure of the aggregate amount of foreign currency transaction gains and losses included in net income for the period, but do not require disclosure of whether they are classified as operating or nonoperating income/expenses.
Interest coverage ratio...
EBIT / Interest expense Interest expense should include capitalized AND expensed interest Adjustments: Add to EBIT the depreciation on interest capitalized in previous years Add interest capitalized during the current year to interest expens
B/S:
EI FIFO = EI LIFO + lifo reserve *Cash FIFO = Cash LIFO - (reserve x tax rate)* Equity FIFO = Equity LIFO + (reserve x (1-t)) Deferred taxes FIFO = Deferred taxes LIFO + (reserve x tax rate)
Earnings Persistence and Related Measures of Accruals
Earnings have (1) a cash component and (2) an accruals component. The accruals component arises from accounting requirements to recognize revenues/expenses in the period that they are earned/incurred, not at the time of cash movement. Accruals can roughly be estimated as net income minus operating cash flow. The larger the accruals component of earnings, the lower the level of persistence and, therefore, the lower the quality of earnings.
MM II with taxes:
Overall company value increases when more debt is issued.
In hyperinflationary environments...
IFRS allows adjusting nonmonetary assets and liabilities for inflation, U.S. GAAP does not. Under U.S. GAAP, the functional currency is assumed to be the parent's presentation currency and the *temporal* method is used to translate the subsidiary's financial statements. The translation gain/loss is included in net income.
Upfront premium =
PV of credit spread - PV of fixed coupon
Funded status
PV of estimated future payments (liability) - Fair Value of assets in the pension trust
Upfront payment =
PV of protection leg - PV of premium leg If the result is greater (less) than zero, the protection buyer (seller) pays the seller (buyer)
Payout amount =
Payout ratio x notional
Funded Status =
Pension obligation - Fair value of plan assets
Put-call parity for options on forwards (or futures)
Portfolio 1: A call on the forward A pure-discount bond that pays X-Ft at time T The payoff for this portfolio at expiration will depend on whether the option is in or out of the money. The bond will always pay X-Ft: - If the call is out of the money (S<X), the payoff will be from the bond: *X-Ft* - If the call is in the money (S>X), the payoff is: *(St-X)+(X-Ft) = St-Ft
In that case, the generalized no-arbitrage futures price is...
Positive net costs of holding the asset increase the futures price
Current service costs...
refer to the increase in the pension obligation (PV of promised benefits) as a result of an employee's service in the current period
Past service costs...
refer to the increase in the pension obligation from retroactive benefits given to employees for years of service provided before the date of adoption, amendment or curtailment of the plan.
Forms of Integration
statutory merger subsidiary merger consolidation
Internal stakeholders
stockholders and employees, board members
*Current credit risk* refers to...
the credit risk associated with the counterparty's default on a payment currently due
For an ABS...
the credit risk metric of probability of default should not be applied. The probability of loss should be used instead.
The analysis of CMBS securities focuses on...
the credit risk of the property and NOT the credit risk of the borrower
IC common:
γ: the correlation between the two information sources or managers ICcom: the skill level of the combined sources
When the loans owned by the trust (SPV) are mortgages...
we refer to the securities issued by the trust as *mortgage-backed securities (MBS)*
find the weight w of the tangency portfolio in the investor's portfolio using the expression:
σ (Rp) = wσ (RT)
Philosophical Approaches to Ethics
The Friedman Doctrine Utilitarian Ethics Kantian Ethics (people should be treated as ends and never purely as means to the ends of others) Rights Theories Justice Theories
Calculate the market value of a swap
The MV of a swap *to the fixed-rate payer* is the difference between the value of a floating-rate bond and the value of a fixed-rate bond (PV float - PV fixed)
All in all...
The Minimum Variance Frontier (and therefore, the efficient frontier) is derived using estimates of *expected returns*, *variances* and *covariances* among individual assets. Changes in estimated risk return characteristics of individual assets therefore result in the shape and location of the MVF.
A long position in FRA wins...
when the rate increases
The CAL...
when we add a risk-free asset in our portfolio. The CAL is also called the Sharpe ratio.
A broken PAC is...
when/if the prepayment rate is outside of these bounds so payments to a PAC tranche are either sooner or later than promised
Annual after‐tax operating cash flows (CF) =
where: S = Sales C = Cash operating expenses t = Tax rate D = Depreciation
And more specifically, the hazard rate...
which is the probability that an event will occur given that it has not already occured
Conglomerate discount
The amount by which market value under-represents the sum-of-the-parts valuation
Director-Shareholder Conflicts
The board is entrusted with the responsibility of keeping a check on management and ensuring that shareholder interests are being served. Conflicts arise when directors identify more with management's interests instead of shareholders' interests.
The Credit Curve
The credit spreads for a range of maturities of a company's debt make up its credit curve
Liquidation value
The estimate of what the assets of the firm would bring if sold separately, net of the company's liabilities
Defined-Benefit Pension Plan's Assets
The fair value of assets held in the pension trust (plan) will increase as a result of: A positive actual dollar return earned on plan assets; and Contributions made by the employer to the plan. On the other hand, the fair value of plan assets will decrease as a result of: Benefits paid to employees.
Functional currency
The functional currency (FC) is the currency of the *primary business environment* in which an entity operates. It is usually the currency in which the entity primarily generates and expends cash.
FMCAR
The individual contributions of a portfolio's active factor exposures to active risk squared are measured by computing the Factor's Marginal Contribution to Active Risk (FMCAR)
(6) Departures from GAAP: Fictitious Transactions
The level reflects the lowest quality of financial reports, where actual transactions are omitted and/or fictitious transactions are reported.
Local currency
The local currency (LC) is the currency of the country where the subsidiary operates.
The Residual Frontier:
The manager's information ratio effectively serves as a "budget constraint". She can increase expected residual return only if she accepts a corresponding increase in residual risk: αp = IRp x ωp αp: personal alpha
Null and alternative hypotheses
The null hypothesis is the position the researcher is looking to reject. The alternative hypothesis is the condition whose existence the researcher is trying to validate.
Presentation currency
The presentation currency (PC) is the currency in which the parent company reports its financial statements. It is typically the currency of the country where the parent is located. For example, U.S. companies are required to present their financial results in USD, German companies in EUR, Japanese companies in JPY, and so on.
Fair market value
The price at which a hypothetical, willing, informed and able seller would trade an asset to a willing, informed and able buyer
Rho...
The price of a European call option does not change much if we use different inputs for the risk-free rate, so rho is not a very important sensitivity measure.
Arbitrage with a one-period binomial model
The result is *no. of shares per option*
alternatively: % change in CDS price =
Δspread x Duration
Profit for the buyer of protection = (approx.)
Δspread x Duration x Notional
"Pac Man" defense
The target attempts a hostile takeover of the acquiring company (rare)
Litigation
The target company may take the acquirer to court over alleged violations of antitrust or securities laws.
Under the current rate method, the translation gain/loss over the period is measured as
the change in CTA over the year
vertical merger
the combining companies hail from the same production chain
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.
Pension obligation:
*Pension obligation at the beginning of the period* + Current service costs + Interest costs + Past service costs + Actuarial losses − Actuarial gains − Benefits paid *Pension obligation at the end of the period*
Deep out of the money calls have a delta of...
0
Payout ratio =
1 - Recovery rate (%)
A company's pension obligation will decrease as a result of:
Actuarial gains. Benefits paid.
To summarize, a company's pension obligation will *increase* as a result of:
Current service costs. Interest costs. Past service costs. Actuarial losses.
Calculation of Pension Obligation for an Individual Employee
Final year's salary = Current salary × [(1 + Annual compensation increase)^years until retirement] Estimated annual payment = (Estimated final salary × 1%) × Years of service Annual unit credit (benefit) per service year = Present Value at retirement / Years of service Benefit attributed to prior years = Annual unit credit × No. of years of past service Opening pension obligation = Benefits earned in prior years / [(1 + Discount rate)^years until retirement] Interest cost = Opening pension obligation × Discount rate Current service costs = Annual unit credit / [(1 + Discount rate)^years until retirement] Closing pension obligation = opening pension obligation + interest costs + current service costs
It is very important to understand that the funded status represents the net liability:
If Pension obligation > Fair value of plan assets: Plan is underfunded Positive funded status Net pension liability. If Pension obligation < Fair value of plan assets: Plan is overfunded Negative funded status Net pension asset.
Effects of Share Repurchases
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.
Disclosures of Pension and Other Post‐Employment Benefits
Noncomparability of periodic pension expense. Pension expense may not be comparable as IFRS and U.S. GAAP differ with regards to how periodic pension costs can be recognized on the P&L vs. OCI. *Differences* across IFRS and U.S. GAAP regarding the reporting of components of pension expense on the income statement. Recall that under IFRS, companies may report the different components of pension expense within different line items on the income statement. On the other hand, under U.S. GAAP, companies are required to aggregate all components of pension expense and report the net amount within a single line item on the income statement under operating expenses. Differences across IFRS and U.S. GAAP regarding the classification of pension contributions on the cash flow statement. Under IFRS, a portion of contributions may be treated as financing cash flows rather than operating cash flows. Under U.S. GAAP, all contributions are treated as operating cash flows.
Classification of Periodic Pension Costs Recognized in P&L
Only current service costs should be treated as operating expenses. Interest expense should be treated as a nonoperating expense. The return on plan assets should be treated as nonoperating income. Analysts should make the following adjustments to reflect a company's operating performance more accurately on the income statement: 1. Add back the entire amount of pension costs recognized on the P&L (pension expense) to operating income. 2. Subtract service costs before determining operating profit. 3. Add the interest component of pension expense to the company's interest expense. 4. Add the return on plan assets to nonoperating income.
2 approaches to translating foreign currency financial statements:
The *current rate method* (also known as the all‐current method) is used to translate financial statements presented in the functional currency (FC) into amounts expressed in the parent's presentation currency (PC). The *temporal method* (also known as remeasurement) is used to translate financial statements presented in local currency (LC) into amounts expressed in the functional currency (FC).
Translation procedures for the temporal method
The balance sheet is translated first, followed by the income statement and statement of retained earnings. Monetary assets and monetary liabilities are translated at the current rate. ○ Monetary assets include cash and receivables. ○ Monetary liabilities include accounts payable, accrued expenses, long‐term debt, and deferred income taxes. Most liabilities are monetary liabilities. Nonmonetary assets and liabilities measured at historical cost are translated at historical rates. ○ Nonmonetary assets measured at historical cost include inventory measured at cost under the lower of cost or market rule, PP&E, and intangible assets. ○ Nonmonetary liabilities measured at historical cost include deferred revenue. Nonmonetary assets and liabilities measured at current value are translated at the exchange rate that existed when current value was determined. ○ Nonmonetary assets measured at current cost include marketable securities and inventory measured at market under the lower of cost or market rule. Shareholders' equity accounts are translated at historical rates. Revenues and expenses (other than expenses related to nonmonetary assets) are translated at the average rate. Expenses related to nonmonetary assets (e.g., COGS, depreciation, and amortization) are translated at historical rates prevailing at time of purchase of the related nonmonetary assets. The translation gain/loss (also known as remeasurement gain or loss) is reported on the income statement. It is the plug figure that would make net income for the year consistent with ending retained earnings (after accounting for dividends) from the translated balance sheet.
Some terms...
The grant date is the date when options are granted to employees. The vesting date is the date when employees can first exercise the stock options. The service period is the period between the grant date and the vesting date. The exercise date is the date when employees actually exercise the options and convert them to stock. If options go unexercised, they expire at a pre‐determined future date (usually 5 or 10 years from the grant date).
Translation procedures for current rate method
The income statement and statement of retained earnings are translated first, and then the balance sheet is translated. All income statement accounts are translated at the historical rate (which for practical purposes is assumed to equal the average rate). All balance sheet accounts (except common equity) are translated at the current rate. Capital stock is translated at the historical rate that existed on the date of capital contribution. Dividends are translated at the rate that applied when they were declared. The translation gain/loss for the period is the balancing amount. It is included in shareholders' equity under the cumulative translation adjustment (CTA).
Effects of Share Repurchases on Book Value
When the market price is greater than the book value per share, book value per share will decrease after the repurchase. When the market price is lower than the book value per share, book value per share will increase after the repurchase.
Economic Profit
!! $WACC = WACC x NBV of capital
Economic Income (2)
!! Do not include the outlay to find the Market Values
Balance Sheet Effects of Lease Classification
!!Current assets are not affected!
2 primary models for reporting long-lived assets:
(1) *Cost model*: required under GAAP, permitted under IFRS: CV = historical cost - accum. depreciation (2) *Revaluation model*: permitted ONLY under IFRS Long-lived assets reported at *fair value*
4 Quality of earnings issues
(1) Accelerating or premature recognition of income (billing customers before products are shipped or accepted, bill and hold schemes) (2) Reclassifying gains and nonoperating income to operating income (3) Expense recognition and losses (delayed recognition of expenses, capitalizing expenses, operating expenses to nonoperating, leeway on provisions and reserves) (4) Aggressive estimates: long amortization periods, long depreciable lives, asset impairments, high discount rate and low rate of compensation growth for pension liabilities, high expected return on assets for pension (5) Off-balance-sheet issues (SPEs, leases, securitization of receivables)
2 sources of perceived mispricing
(1) Actual mispricing: Market price - Intrinsic Value (2) Valuation error: Analyst's estimate of IV - Actual IV
Residential mortgage-backed securities (RMBS):
(1) Agency RMBS (2) non-agency RMBS Agency are issued by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae securities are backed by the full faith and credit of the US government. Fannie Mae and Freddie Mac also guarantee the MBS they issue but are government-sponsored enterprises (GSE) rather than government agencies. Not backed by the full faith of the US government, but they have very high credit quality,
The 4 assumptions of the mean-variance analysis
(1) All investors are *risk-averse* (they prefer less risk to more risk for the same level of expected return) (2) Expected returns, variances, covariances are *known* for all assets (3) Investors create *optimal portfolios* by relying solely on expected returns, variances, covariances. Returns are often assumed to follow a normal distribution in which skewness and kurtosis can be ignored (4) Investors face *no taxes or transaction costs*
Impact of revaluations:
(1) An increase in the carrying value of depreciable long‐lived assets increases total assets and shareholders' equity. Hence, revaluation of assets can be used to reduce reported leverage (as is the case in Example 3-4). If a company is seeking new capital or approaching leverage limitations set by financial covenants, it may choose to revalue its assets upwards to present more favorable solvency levels. (2) Asset revaluations that decrease the value of an asset also decrease net income in the year of revaluation. In the year of revaluation, return on assets (Net profit/Assets) and return on equity (Net profit/Shareholders' equity) decline. (The percentage change in the numerator is greater than the percentage change in the denominator.) In future years however, the lower values of assets and equity may result in higher ROA and ROE. (3) If the carrying value of the asset is increased in a revaluation, assets and equity increase, and annual depreciation expense also increases. As a result, performance measures such as ROA and ROE may decline in the future. This is ironic given that an upward revaluation is usually associated with an improvement in the operating capacity of the asset and is beneficial for the company. (4) Analysts should also look into who performs asset value appraisals and how often revaluations are recognized. Regular appraisals can be good because the reported value of the asset is representative of its fair value. Appraisals performed by independent external sources are more reliable.
The five inputs to the BSM model:
(1) Asset price (2) Exercise price (3) Asset price volatility (4) Time to expiration (5) Risk-free rate
3 assumptions of APT:
(1) Asset returns are described by a factor model (does not specify the number of factors nor does it offer any guidance) (2) Many assets so that investors can form well-diversified portfolios that have zero asset-specific risk (3) No arbitrage opportunities exist among well-diversified portoflios
3 weaknesses of structural models
(1) Balance sheet cannot be modelled realistically using a single zero coupon bond, meaning that recovery rates and default probabilities may be inaccurate (2) Company assets are not actually traded and their value is not directly observable. Errors in estimating credit measures (3) Estimation procedures do not consider the business cycle
2 types of collars:
(1) Buy cap sell floor If investor has a LIBOR-based *liability*, he can buy a cap on LIBOR at 8% and sell a floor on LIBOR at 4% over the next year. The borrowing costs will stay within the collar (4-8%) (2) Buy floor sell cap If investor has a LIBOR-based *asset*, he can buy a floor on LIBOR at 3% and sell a cap on LIBOR at 7% over the next year. The returns will stay within the collar (3-7%)
2 types of reserve funds:
(1) Cash reserve funds Cash deposits from issuance proceeds. Used to establish a reserve account to pay for any future credit losses (2) Excess servicing spread funds Reserve funds in the form of an excess spread. An excess spread is the extra return on the collateral mortgages above that required to make the promised payments to the RMBS holders and pay for loan servicing and other administrative expenses. Can be used to fund credit losses on the collateral.
3 generic strategies a company may employ to compete and generate profits
(1) Cost leadership (2) Product differentiation (3) Focus (within a particular segment)
2 traditional credit models
(1) Credit scoring models (2) credit rating They both provide ordinal rankings of credit quality. They do NOT provide the degree to which the credit risk differs among different ranks.
2 key ratios to assess this credit risk:
(1) Debt-to-service-coverage ratio (DSC) NOI/Debt service (2) Loan-to-value ratio: current mortgage amount / current appraised value Determines the amount of collateral available above the loan amount to provide a cushion to the lender should the property be foreclosed
2 types of pension plans:
(1) Defined Contribution (2) Defined-Benefit
2 types of share-based compensation:
(1) Equity-settled compensation: stock grants and stock options (2) Cash-settled compensation (stock appreciation rights, phantom stock)
2 types of credit enhancement:
(1) External (2) Internal
3 ways to estimate inputs for mean-variance optimization:
(1) Historical means, variances and correlations (2) Historical betas based on the *market* model (3) Adjusted betas
Differences with macroeconomic models:
(1) In fundamental factor models the factor sensitivities are *standardized*.
Decline in LIFO reserve due to 2 reasons:
(1) LIFO liquidation (when a LIFO firm sells more units than it purchases. As a result, some of the units sold are drawn from beginning inventory which reflects older/cheaper prices) (2) Declining prices
2 methods for finding the NPV of Mutually Exclusive Projects with Unequal Lives:
(1) Least Common Multiple of Lives Approach: find the LCM of the duration of the 2 projects and compare their NPVs
3 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.
3 types of multifactor models
(1) Macroeconomic factor models (2) Fundamental factor models (3) Statistical factor models - Factor analysis models - Principal-components models
5 key characteristics of mortgage loans:
(1) Maturity: 15-30 years in the US, 20-40 in Europe. 100 years in Japan (2) Interest rate: *fixed-rate*, *adjustable-rate*, *index-referenced* (LIBOR or T-bill), *hybrid mortgage* (begins as fixed-rate and then becomes adjustable-rate), *rollover (or renegotiable mortgage) (change of fixed rates), *convertible mortgage* (the interest rate terms can be changed at the option of the borrower) (3) Amortization of principal (fully vs partially amortizing) (4) Prepayment: a partial or full repayment of principal in excess of the scheduled principal repayments required by the mortgage is referred to as *prepayment*. *prepayment penalty*: an additional payment that must be made if principal is prepaid during an initial period after loan origination (5) Foreclosure: *non-recourse* loans means that the lender has no claim against the assets of the borrower except for the collateral property itself. Borrowers sometimes voluntarily return the property to the lender (strategic default)
Feedback:
(1) Monitoring and rebalancing (2) Performance evaluation (measurement, attribution, appraisal) The 3 sources of absolute return: strategic asset allocation, security selection, market timing
2 ways to calculate Periodic Pension Cost:
(1) Net periodic pension cost = Ending - Beginning funded status + Employer contributions (2) Periodic pension cost = Current service costs + Interest costs + Past service costs + Actuarial losses - Actuarial gains - Actual return on plan assets Basically, this formula aggregates all sources of change in a plan's funded status over the year except for employer contributions.
3 types of stock grants:
(1) Outright stock grants: shares are granted to the employee without any conditions (2) Restricted stock grants: the employee should return the share to the company if certain conditions are not met (e.g. if certain performance goals are not met) (3) Performance shares are contingent on meeting performance goals (ROA)
The 3 steps of the portfolio management process:
(1) Planning (2) Execution (3) Feedback
5 measures of credit risk:
(1) Probability of default under the structural models: probability of default = 1 - N (e2) (2) Loss given default: the value a bond investor will lose if the issuer defaults. Varies inversely with the recovery rate (3) Recovery rate: the % of money received upon default of the issuer Loss given default (%) = 100 - recovery rate (4) Expected loss: the probability of default multiplied by the loss given default. Expressed as a monetary value or as a % of a bond's value Under the structural models: expected loss = KN (-e2) - A (5) PV of expected loss: the highest price a hypothetical investor would be willing to pay to an insurer to bear the credit risk of the investment. Makes 2 adjustments to the expected loss measure: a) Time value adjustment: future expected losses are discounted to their PV, reflecting a loss of principal far in the future is less of a concern than a near-term loss b) Risk-neutral probabilities: instead of using the probability of default, we use the risk-neutral probability of default. The diff. between actual probabilities of default and risk-neutral prob. of default is the adjustment for risk. PV of expected loss = Value of credit-risky bond - identical riskfree bond
3 weaknesses of credit ratings
(1) Reduced correlation with default probability (2) Do not adjust with business cycle, even though prob. of default changes (3) Conflicts of interest (issuer-pays model)
2 primary benefits of securitization:
(1) Reduces funding costs for firms selling the financial assets to the securitizing entity and (2) increases the liquidity of the underlying financial assets
3 types of internal credit enhancements:
(1) Reserve funds (2) Overcollateralization (3) Structures that contain senior and subordinated debt
Under GAAP, lessors can classify finance leases in two types:
(1) Sales type leases Gross profit recognized at inception of the lease and interest income is recognized as payments are received over the lease term PV of lease payments = selling price of the asset (2) Direct financing leases PV of lease payments = CV of the asset No gross profit at inception Asset is removed from B/S and lease receivable recognized, interest income recognized in I/S
4 primary CMO structures:
(1) Sequential-pay tranches (2) Planned amortization class tranches (PACs) (3) Support tranches (4) Floating-rate tranches
2 strengths of credit ratings
(1) Simple to understand (2) Relatively stable over time
3 strengths of reduced form models
(1) Since model inputs are observable, historical estimation procedures can be used (2) Credit risk is allowed to fluctuate with the business cycle (3) Reduced form models do not require specification of the company's balance sheet structure
3 types of CDS
(1) Single-name CDS (2) Index CDS (3) Tranche CDS
3 depreciation methods
(1) Straight-line (2) Accelerated methods (3) Units of production
3 differences between APT and multifactor models:
(1) The APT is a *cross-sectional* equilibrium pricing model that explains the variation in returns across assets over the same time period. Multifactor models are based on time series regressions that explain the variation in an asset's return over time (2) The APT is an equilibrium pricing model based on the no-arbitrage argument. Multifactor models are not derived from equilibrium theory. (3) The APT tells us what the value of the intercept term in a multifactor model (expected return) should be in equilibrium.
6 assumptions of the reduced form model
(1) The company has zero coupon bond liability that trades in frictionless and arbitrage-free markets. No restriction for other liabilities of the company (2) The risk-free rate is stochastic (varies randomly) (3) The state of the economy is stochastic and depends on nonconstant macroeconomic variables (4) The probability of default depends on the state of the economy and is not constant. This assumption specifically allows for credit risk to vary across the business cycle and also allows for the possibility of systemic default across companies (5) While the probability of default varies with the state of the economy, whether a particular company actually defaults depends only on company-specific considerations (6) The recovery rate (hence, loss given default) is also stochastic and depends on the state of the economy
3 Assumptions of structural model:
(1) The company's A are traded in a frictionless arbitrage-free market with a time T vale that has a lognormal distribution with mean μT and variance σ^2T. The asset return volatility is constant. (2) Risk-free rate is constant over time, implying that there is no interest rate risk, which is illogical in fixed income valuation. (3) The company has a simple balance sheet structure with only one class of simple zero coupon debt.
A lease is classified as capital lease in US GAAP if *any* of the following conditions hold:
(1) The lease *transfers ownership* of the asset to the lessee at the end of the term (2) A bargain purchase *option* exists (3) The lease *term* is grater than 75% of the asset's useful economic life (4) The *PV of lease payments* at inception exceeds 90% of the FV of leased asset
Equity swaps differ in two dimensions from interest rate swaps:
(1) The party making the fixed-rate payment could also have to make a variable payment based on the equity return (2) The payment is not known until the end of the settlement period, at which time the return on the stock is known. In an interest rate swap or currency swap, the floating interest rate is set at the beginning of the period. Therefore, one always knows the amount of the upcoming floating interest payment
6 assumptions of the Black Scholes model
(1) The price of the underlying follows a lognormal distribution (2) The risk-free rate is constant and known (3) The volatility of the underlying is constant and known (4) Markets are frictionless (5) The underlying has no cash flows (6) The options valued are European options
5 elements of industry structure (Michael Porter)
(1) Threat of new entrants in the industry (2) Threat of substitutes (3) Bargaining power of buyers (4) Bargaining power of suppliers (5) Rivalry among existing competitores
5 steps of the equity valuation process
(1) Understand the business (2) Forecast company performance (3) Select appropriate valuation model (4) Convert the forecasts into a valuation (5) Apply the valuation conclusions
1 weakness of reduced form models
(1) Unless the model has been formulated and backtested properly, the hazard rate estimation procedures may not be valid
2 strengths of structural models
(1) Use of option pricing theory to understand a company's probability of default or loss given default (2) The model can be estimated using current market prices
2 legs (sides) of a contract:
(1) protection leg (the contingent payment that the credit protection seller may have to make to the credit protection buyer) (2) premium leg (the series of payments the credit protection buyer promises to make to the seller)
Prepayment rates depend on:
(1) the WAC rate of the loan pool (2) current interest rates (3) prior prepayments of principal
3 assumptions of the market model:
(1) the expected value of the error term is zero (2) the market return is uncorrelated with the error term (3) the error terms are uncorrelated across different assets
3 assumptions of the fundamental law:
(1) the manager has an accurate measure of his or her own skills and exploits information (2) the sources of information are independent (3) the skill level (IC) involved in forecasting each active bet (BR) is the same
2 methods for finding the NPV of Mutually Exclusive Projects with Unequal Lives (2):
(2) Equivalent Annual Annuity Approach (EAA)
Differences with macroeconomic models(2):
(2) The intercept is not interpreted as expected return. When factor sensitivities are standardized, it has no economic interpretation. When factor sensitivities are not standardized, it represents the risk-free rate. (3) Fundamental factor models typically employ a larger number of explanatory variables
Upfront premium = (approx.)
(Credit spread - fixed coupon) x Duration
Changes in actuarial assumptions...
(e.g., discount rate, rate of future compensation increases, life expectancy of employees, etc.) result in changes in the estimated pension obligation. ○ A change in actuarial assumptions that increases the pension obligation gives rise to an actuarial loss. ○ A change in actuarial assumptions that decreases the pension obligation gives rise to an actuarial gain.
The payoff is...
(no present values are involved here)
The payoff is....
(no present values are involved here)
Number of parameters to be estimated using the historical betas method:
*3n + 2*
Investor objectives and constraints (3):
*Constraints*: Liquidity requirements Time horizon Tax concerns Legal and regulatory factors Unique circumstances
Beginning and ending balances of the fair value of plan assets may be reconciled as follows:
*Fair value of plan assets at the beginning of the period* + Actual return on plan assets + Contributions made by the employer to the plan − Benefits paid to employees *Fair value of plan assets at the end of the period*
Investments in debt and equity securities can be categorized as:
*Investments in financial assets*: the investor has no significant influence or control over operations of the investee. No significant influence if the investor holds less than 20% equity interest in the investee.*Investments in associates*, in which the investor can exert significant influence, but not control, over the investee. There is significant influence (but not control) if the investor holds between a 20% and 50% equity interest in the investee. *Business combinations (including investments in subsidiaries)*, in which the investor has control over the investee. Generally speaking, an equity interest exceeding 50% indicates control over the investee. *Joint ventures*, in which control is shared by two or more entities.
Investor objectives and constraints:
*Objectives*: *risk* and *return* Risk: Questions: how should risk be measured (absolute vs relative)? What is the investor's willingness to take risk? What is the investor's ability to take risk? (spending needs, long-term wealth targets, liabilities, financial strength) How much risk is the investor both willing and able to bear? (risk tolerance) What are the specific risk objectives?
Investor objectives and constraints (2):
*Return*: How should return be measured? How much return does the investor desire? How much return does the investor require?
Effects of Changes in Key Assumptions (discount rate)
*The Discount Rate* The assumed discount rate is used to calculate: The present value of DB payments (pension obligation). Current service costs (PV of annual unit credit). Interest expense (under U.S. GAAP) as r × beginning pension obligation. Net interest expense/income (under IFRS) to be recognized on the P&L ○ Net interest expense/income is calculated as (r × pension obligation − r × Fair value of plan assets) Remeasurement (under IFRS) to be recognized in OCI. ○ The second component of remeasurement is calculated as: Actual return on plan assets − r × Fair value of plan assets An increase in discount rate: Decreases the opening pension obligation (as the PV of promised payments decreases). Typically decreases total periodic pension cost. ○ For interest expense (r beginning pension obligation): ■ On one hand, a higher discount rate increases the interest component of pension expense (r). ■ On the other hand, a higher discount rate decreases the beginning pension obligation. ■ The effect of the decrease in the opening obligation usually outweighs the effect of the increase in the discount rate so interest expense typically falls. ○ Current service costs decline as the PV of annual unit credit falls with the increase in the discount rate. Typically decreases the closing pension obligation.
The SML and the CAPM apply to...
*any* security or portfolio, regardless of whether it is efficient.
The CDS payoff is based on the market value of the...
*cheapest-to-deliver* bond that has the same seniority as the reference obligation
The risk that prepayments will be more rapid than expected is called...
*contraction risk*
In order to be of investment grade, most non-agency RMBS include some sort of...
*credit enhancement*
The risk that prepayments will be slower than expected is called...
*extension risk*
The full goodwill method results in higher or lower total assets and equity compared to the partial goodwill method?
*higher*
The party to the forward contract that agrees to buy (short) the financial or physical asset has a...
*long* (short) forward position
Pass-through securities have...
*prepayment risk*, because the mortgage loans used as a collateral have no prepayment penalty
The issuer of the reference obligation is called the...
*reference entity*
Net income to the parent's shareholders will be the same, higher or lower under the full and partial goodwill method?
*the same*
The call option delta is between 0 and 1. If the call option is:
- *Out-of-the-money*, the call delta *moves closer to 0 as time passes, assuming the price of the underlying doesn't change - *In-the-money*, the call delta *moves closer to 1* as time passes, assuming the price of the underlying doesn't change
We will use a fundamental factor model to illustrate the decomposition of *active risk*:
- Active factor risk: the component of active risk squared that can be attributed to differences in factor sensitivities between the portfolio and the benchmark - Active specific risk or asset selection risk: the component of active risk squared that can be attributed to differences in the weights of individual assets between the portfolio and benchmark after accounting for the differences in factor sensitivities between the portfolio and the benchmark
To overcome problems associated with MVF instability
- Add constraints against short sales in the optimization - Improve the statistical quality of inputs to the optimization by employing models that provide better forecasts than historical estimates - Employ models that reflect the fact that inputs to the optimization are random variables than constants - Avoid rebalancing unless there are significant changes in the efficient frontier
3 variations used in the CFA curriculum for the day count and compounding conventions:
- All LIBOR-based contracts (FRA, swaps, caps, floors): 360 days per year and simple interest - Equities, bonds, currencies and stock options: 365 days per year and continuous compounding - Equity indexes: 365 per year and continuous compouning
All else equal, the existence of cash flows on the underlying asset will:
- Decrease the value of a call option - Increase the value of a put option
Equity swaps: who pays what?
- Equity return payer: Pays any positive return on equity Receives fixed rate payment *plus any negative equity return* - Fixed rate payer: Pays fixed rate *plus negative equity return* Receives positive equity return
ABS backed by automobile loans...
- Have maturities from 36 to 72 months - Issuers are the financial subsidiaries of auto manufacturers, commercial banks, credit unions, finance companies and other small financial institutions - The cash flow components include interest payments, scheduled principal payments and prepayments - Prepayments occur: if the car is sold, traded in, stolen or wrecked - They have some sort of credit enhancement to make them attractive to institutionals. Many have a senior-subordinated structure, with a junior tranche that absorbs credit risk
Planning:
- Identify and specify the investor's *objectives* and *constraints* - Create the *IPS*: description of the client, statement of purpose, duties and responsibilities of all parties, investment goals, objectives and constraints, schedule for review of performance as well as the IPS, measures and benchmarks to be used, considerations to be taken into account, strategies and style, guidelines for rebalancing - Form *capital market expectations*: the manager makes long-run forecasts of the risk-return characteristics of different asset classes - Create the *strategic asset allocation*: target asset class weights (passive, active, semi-active)
Revaluations (only in IFRS):
- If revaluation initially increases an asset's carrying amount, it is recognized in *other comprehensive income (equity)* as revaluation surplus. A subsequent decrease in the asset's fair value will first offset the previously recognized revaluation surplus in other comprehensive income, and any remaining decline in value will be recognized on the income statement as a loss. - If revaluation initially decreases an asset's carrying amount, it is recognized in the income statement as a loss (similar to an impairment loss). A subsequent increase in the asset's fair value will first offset the loss previously recognized in the income statement, and any excess will be recognized in other comprehensive income (equity) as revaluation surplus. !!!If an asset is sold or disposed of, any associated revaluation surplus recognized in other comprehensive income is transferred directly to retained earnings.
Fair Value though PnL
- Initially recognized at Fair Value and remeasured at each reporting date to reflect current fair value - Realized and unrealized gains/losses, interest income and dividend income are ALL reported in PnL
HTM Investments:
- Initially recognized on the B/S at fair value (IFRS, GAAP) - Subsequently (at each reporting date) reported at amortized cost: Interest income and realized gains/losses in the I/S Unrealized gains/losses are ignored !!! A firm that sells a HTM security before maturity, is required to carry its remaining HTM securities at market value instead of cost.
Reclassifications under IFRS (*IFRS stricter*)
- Into and out of the "designated at fair value" *prohibited* - Out of the "held-for-trading" category is *restricted* - HTM (debt) securities can be reclassified as AFS: remeasured at FV and any differences between FV and CV (amortized cost) are recognized in OCI - Debt securities under AFS can be reclassified as HTM securities: the FV at time of reclassification becomes their new amortized cost and any unrealized gains/losses in OCI are amortized to I/S over the remaining life
For a fixed-rate payer swap...
- Long interest rate call and - short interest rate put This is a long FRA (pay fixed, received floating) Strike rates equal to the fixed rate on the swap
Straight vs accelerated:
- Lower asset turnover ratio during the early years - Higher operating profit margin in the early years - Higher operating ROA in the early years
Effects of expensing
- Lower taxable income in current period - Greater earnings growth (higher expenses in current year followed by no related expenses in future years)
Futures are different from forwards...
- Marked to market - Trade on organized exchanges - Highly standardized - Counterparty is the clearinghouse - Regulated
Pension Obligation
- PV of Defined Benefit Obligation (IFRS) - PBO (Projected Benefit Obligation) (US GAAP)
Pros of share repurchases:
- Potential tax advantages - Share price support / signaling that the company considers its shares a good investment - Added managerial flexibility - Offsetting earnings dilution from exercise of employee stock options - Increasing financial leverage Sometimes companies experience upward spikes in cash flows that are not expected to continue in future years. Special cash dividends and share repurchases offer companies means to distribute surplus cash to shareholders without creating an expectation of similar distributions in the future. Generally speaking, share repurchases usually tend to rise when the economy is strong (when companies typically have strong cash flows) and fall during recessions.
Under the new IFRS standards effective 1-1-2015:
- Reclassification of *equity* instruments is NOT permitted - Reclassification of *debt* instruments from FVPL to amortized cost (or vice versa) is only permitted if the objective for holding the assets has changed in a way that significantly affects operations
6 other benefits of securitization:
- Reduces intermediation costs => lower funding costs for borrowers and higher risk-adjusted returns for lenders - The investors' legal claim to the mortgages or other loans is stronger than simply having a general claim against the bank's overall assets - Increases the liquidity of the bank's assets - Banks are able to lend more than they can when they must fund all the loans from bank assets - Financial innovation that allows investors to invest in securities that match their preferred risk, maturity and return characteristics - Diversification and risk reduction compared to purchasing individual loans
Sensitivity, scenario and Monte Carlo analyses (2):
- Scenario Analysis: while sensitivity analysis allows us to evaluate the impact of a change in one input variable on NPV, scenario analysis calculates the NPV of a project in a number of different scenarios where each scenario consists of changes in several input variables. The greater the dispersion in NPV across the given scenarios, the higher the risk of the project.
Sensitivity, scenario and Monte Carlo analyses:
- Sensitivity: sensitivity analysis determines the impact on NPV of changes in one input variable at a time holding all other input variables constant
For a fixed-rate receiver swap...
- Short interest rate call and - long interest rate put Strike rates equal to the fixed rate on the swap
Sensitivity, scenario and Monte Carlo analyses (3):
- Simulation (Monte Carlo) Analysis: In simulation analysis, we estimate a probability distribution of outcomes for a project's NPV and IRR. Instead of using point estimates for input variables (as is the case in sensitivity and scenario analysis) we can define probability distributions for each of them. The simulation can be run thousands of times to come up with a distribution for possible values of NPV and IRR. For Monte Carlo simulations, key inputs are assumed distribution and their mean/standard deviation. Both the curves are skewed to the right (positive skewness). - Statistical output may include correlations between different input variables and NPV (and IRR). These correlations can be interpreted as sensitivity factors. The higher the correlation between an input variable and NPV, the more significant the impact of the variable on NPV.
Effects of impairment:
- The carrying value of the asset decreases. - The impairment charge reduces net income. - Impairment does not affect cash flows because it is a non‐cash charge. - Details regarding impairment losses are usually found in the footnotes to the financial statements and in the MD&A. !!Impairment reversals on assets held for use are prohibited under GAAP!
Under the equity method...
- The investment is initially recognized on the investor's balance sheet at cost (with a single line item) under noncurrent items The investor's proportionate share of investee earnings increases the carrying amount of the investment, while its proportionate share of losses and dividends decreases the carrying value of the investment - The amortization of excess purchase price attributable to plant and equipment is subtracted from the investment AND from the income - The investor's proportionate share of investee earnings is reported within a single line item on its income statement *Dividend payments have no impact on the amount reported on the income statement*
Active return can be broken into:
- The return from factor tilts: active factor sensitivities (factor tilts) x factor returns - The return from asset selection: reflects manager's skills in individual asset selection
Internal Development Costs...
- US GAAP: R&D must be *expensed* when incurred, except for: 1- software development costs after the product's technological feasibility is established, which are capitalized 2- costs related directly to the development of software for internal use - IFRS: expenses on research are *expensed*, but internal development costs are *capitalized*
Support tranches have...
- higher contraction risk - higher extension risk - higher promised interest rate than the PAC tranche
The Clientele Effect
- retired investor prefer high dividends - some institutionals prefer dividend yields above a certain threshold
The effect of inflation on capital budgeting analysis
- use the nominal discount rate to discount nominal cash flows and the real discount rate to discount real cash flows - higher‐than‐expected inflation => *increases* real taxes because it *reduces* the value of the depreciation tax shelter (unless the tax system adjusts depreciation for inflation) and *decreases* real interest expense
Deep in the money puts have a delta of...
-1
Limitations of Regression Analysis
1) *Regression relations can change over time*. For example, a time series regression estimating beta for a stock may come up with a different estimate of beta depending on the time period selected. This problem is referred to as *parameter instability*. 2) Public knowledge of regression relationships (especially in the investment arena) may negate their usefulness going forward as more and more market participants make their investment decisions based on the perceived relationships. 3) If the assumptions of regression analysis do not hold, the predictions based on the model will not be valid. These violations of regression assumptions and their repercussions on the analysis are discussed in the next reading.
Differences between accounting and economic income
1) Accounting depreciation is based on the original cost of an investment, while economic depreciation is based on the market value of the asset. 2) the interest expense that is subtracted from accounting income is not considered when computing economic income because interest expenses are implicit in the required rate of return used to calculate the asset's market value.
2 ways to calculate the R2
1) R^2 = r^2 2) see graph
A Financial Statement Analysis Framework
1. Define the purpose and context of the analysis. 2. Collect input data. 3. Process input data, as required, into analytically useful data. 4. Analyze/interpret the data. 5. Develop and communicate conclusions and recommendations (e.g., with an analysis report). 6. Follow‐up.
General Steps to Evaluate the Quality of Financial Reports
1. Develop an understanding of the company and its industry. Understanding the economic activities of a company provides a basis for understanding why particular accounting principles may be appropriate and why particular financial metrics matter. Understanding the accounting principles used by a company and its competitors provides a basis for understanding what constitutes the norm—and to assess whether a company's treatment is appropriate. 2. Learn about management. Evaluate whether the company's management has any particular incentives to misreport. Review disclosures about compensation and insider transactions, especially insiders' sales of the company's stock. Review the disclosures concerning related‐party transactions. 3. Identify significant accounting areas, especially those in which management judgment or an unusual accounting rule is a significant determinant of reported financial performance. 4. Make comparisons: Compare the company's financial statements and significant disclosures in the current year's report with the financial statements and significant disclosures in the prior year's report. ○ Are there major differences in line items or in key disclosures, such as risk disclosures, segment disclosures, classification of specific expense, or revenue items? ○ Are the reasons for the changes apparent? Compare the company's accounting policies with those of its closest competitors. ○ Are there significant differences? ○ If so, what is the directional effect of the differences? Using ratio analysis, compare the company's performance with that of its closest competitors. 5. Check for warnings signs of possible issues with the quality of the financial reports. For example: Declining receivables turnover could suggest that some revenues are fictitious or recorded prematurely, or that the allowance for doubtful accounts is insufficient. Declining inventory turnover could suggest obsolescence problems that should be recognized. Net income greater than cash provided by operations could suggest that aggressive accrual accounting policies have shifted current expenses to later periods. 6. For firms operating in multiple segments by geography or product—particularly multinational firms—consider whether inventory, sales, and expenses have been shifted to make it appear that a company is positively exposed to a geographic region or product segment that the investment community considers to be a desirable growth area. An analyst may suspect that this shift is occurring if the segment is showing strong performance while the consolidated results remain static or worsen. 7. Use appropriate quantitative tools (discussed in the next section) to assess the likelihood of misreporting.
Assumptions of the Linear Regression Model
1. The relationship between the dependent variable (Y) and the independent variable (X) is linear in the parameters, b1 and b0. This means that b1 and b0 are raised to the first power only and neither of them is multiplied or divided by another regression parameter. 2. The independent variable, X, is not random. 3. The expected value of the error term is zero: E( ) = 0. 4. The variance of the error term is constant for all observations (E( i2 ) = 2 , i 1, , n). This is known as the homoskedasticity assumption. 5. The error term is uncorrelated across observations. 6. The error term is normally distributed.
Price of CDS in currency per 100 par =
100 - Upfront premium %
probability of survival =
100% - hazard rate
Under GAAP
2-step approach: - If the CV of the reporting unit (incl. goodwill) > FV, impair goodwill - Impairment loss = implied FV of goodwill - CV Implied goodwill = FV of unit - FV of net asset of the unit
Eg. a 2-year cap is a...
2-year caplet and a 1-year caplet
CDOs issue...
3 classes of bonds (tranches): - senior bonds - mezzanine bonds - subordinated bonds (equity or residual tranche)
Types and characteristics of residential mortgage loans that are securitized...
A *residential mortgage loan* is a loan for which the collateral that underlies the loan is residential real estate. If the borrower defaults on the loan, the lender, has a legal claim to the collateral property.
(2) Planned Amortization Class (PAC) CMO and (3) support tranches
A PAC tranche is structured to make *predictable* payments regardless of actual prepayments to the underlying MBS. The PAC tranches have reduced contraction and extension risk compared to the underlying MBS. How is this achieved? By increasing the prepayment risk of the CMO's support tranches. If principal repayments are more rapid than expected, the support tranche receives the principal repayments in excess of those specifically allocated to the PAC tranches. Conversely, if actual principal repayments are slower than expected, principal repayments to the support tranche are curtailed so the scheduled PAC payments can be made. The larger the support tranche relative to the PAC tranches, the smaller the probability that the cash flows to the PAC tranches will differ from their scheduled payments.
Interest expense...
A company does not make pension payments to employees until they retire (which is why the pension obligation reflects the present value of promised payments). With the passage of time, interest accrues on these unpaid amounts to increase the pension obligation. This accrued interest, or increase in the value of the obligation due to the passage of time, is classified as interest expense.
Split‐off
A company separates one of its divisions to create a new legal entity and offers current shareholders shares in the newly formed entity in exchange for shares of the parent.
Dynamic hedging:
A delta-neutral portfolio is a risk-free combination of a long stock position and short calls where the number of calls to sell is equal: number of options needed to delta hedge = number of shares hedged / delta of call option
Contingent consideration
A parent may agree to pay additional amounts to the subsidiary's shareholders if the combined entity achieves certain performance targets. This is referred to as contingent consideration. ○Under both IFRS and U.S. GAAP, contingent consideration should initially be measured at fair value and be classified as a financial liability or equity. ○ Subsequent changes in the fair value of these liabilities (and assets in case of U.S. GAAP) are recognized in the consolidated income statement. ○ Contingent consideration classified as equity is not remeasured under both IFRS and U.S. GAAP. Any settlements are accounted for within equity.
Prices of futures versus forwards
A preference for the mark-to-market feature will arise from a positive correlation between interest rates and the price of the contract asset Higher reinvestment rates for gains and lower borrowing costs to fund losses lead to a preference for the mark-to-market feature of futures when interest rates and asset values are correlated
White squire defense
A third party purchases a substantial *minority stake* (large enough to block a hostile takeover) in the target (risk of litigation)
Incorporation in a state with restrictive takeover laws
Certain states in the U.S. (e.g., Pennsylvania and Ohio) are relatively "target‐friendly" as they give companies the most power in defending against takeover attempts.
Residual risk (ω*) as a function of IR and risk aversion (λ)
Check out the level of aggressivenes, moderation in terms of risk
International differences in capital structures
Companies in France, Italy, and Japan tend to use more debt relative to companies in the United States and the United Kingdom. Companies in North America tend to use more long‐term debt compared to Japanese companies. Companies in developed markets tend to use more long‐term debt and usually have higher long‐term debt to total debt ratios compared to companies in emerging markets. Companies in countries with weaker legal systems tend to have higher financial leverage. Use of short‐term debt is more common relative to long‐term debt in countries with weaker legal systems.
Motives for Merger
Creation of synergy Growth Increasing market power Acquiring unique capabilities and resources Diversification (conglomerates) Bootstrapping earnings: The shares of the acquirer trade at a higher P/E ratio than shares of the target; and The acquirer's P/E does not fall after the merger. Managers' personal incentives Tax considerations Unlocking hidden value Cross‐border motivations
European call option price payoff:
Delta is the slope of the prior-to-expiration curve When the call is in=the
The Arbitrage Pricing Theory
Developed in the 1970s as an alternative to the CAPM
Effective tax rates under different tax systems (2):
Dividend Imputation Tax System If an investor's marginal tax rate is lower than the corporate tax rate, she will receive tax credit: corporate profits distributed as dividends are taxed just *once*, at the shareholder's tax rate (Australia, New Zealand, France) If an investor's marginal tax rate is higher than the corporate tax rate, she must pay additional taxes
Effective tax rates under different tax systems:
Double taxation system
Calculate the price of an FRA
Eg. for a 1x4 FRA: 1) Deannualize the rates on the loan (for a 1x4 FRA, deannualize the 30-day and 120-day rates) 2) Calculate the actual rate on a 90-day loan from day 30 to day 120. In the nominator always put the higher rate: price of a 1x4 FRA: (1+R120) / (1+R30) -1 = 0.0.133 3) Annualize this rate: 0.0133 X 360/90 = 5.32% This is the no-arbitrage forward rate - the forward rate that will make the value of the long and the short positions in the FRA both zero at the initiation of the contract
Basic forms of restructuring:
Equity carve‐out Spin‐off Split‐off Liquidation
Put-call parity for options on forwards (or futures) (2)
Equivalent portfolio 2: A put on the forward A long position in the forward The cost of this portfolio is P0, since its costless to enter into a forward The payoff at expiration: - If the put is in the money (S<X): *(X-St) + (St-Ft) = X - Ft* - If the put is out of the money (S>X): *St-Ft* The payoffs of the two positions are identical!
Absolute valuation models
Estimates an asset's IV without regard to the value of other firms Absolute approaches: Free cash flow Dividend discount Residual income Asset-based models (useful for firms that own natural resources: oil fields, coal deposits)
Stable Dividend Policy
Expected dividend increase = $Increase in earnings x Target payout ratio x Adjustment factor Adjustment factor = 1/N N: Number of years over which the adjustment is expected to occur Expected dividend = Last dividend + (Exp. increase in earnings x target payout ratio x adjustment factor) !!With a stable dividend policy, companies seek to increase their dividend each year at a constant rate.
(2) Fundamental factor models:
Expressed using the same equation as for a macroeconomic factor model.
FCFE coverage ratio
FCFE / [Dividends Share repurchases]
*Expansion projects* Initial investment outlay for a new investment =
FCInv + NWCInv - NWCInv = Δ Noncash current assets - Δ Nondebt current liabilities
Goodwill and Noncontrolling interests...
FULL US GAAP requires the use of the *full goodwill* method, in which: Goodwill = Total FV of the subsidiary - FV of its identifiable net assets PARTIAL IFRS permits both the full goodwill and the *partial goodwill* method Under the partial goodwill: Goodwill = purchase price - FV of the parent's proportionate share of the subsidiary's identifiable net assets NONCONTROLLING under FULL If the full goodwill is used, the noncontrolling interest is measured based on its proportionate share of the subsidiary's *fair value* NONCONTROLLING under PARTIAL If the partial goodwill is used, the noncontrolling interest is measured based on its proportionate share of the fair value of the subsidiary's *identifiable net assets*
4 criteria to consider for the model to use
Fits the characteristics of the company? Does it pay dividends? Does it have significant intangible assets? Is appropriate based on the quality and availability of input data Is suitable given the purpose of the analysis (minority vs majority purchase)
Equivalence of a swap with a portfolio of FRAs
Fixed-rate payments are known today in both cases. The complex average of the FRA rates must equal the swap fixed rate. A difference is that with a swap, the next payment is always known one period ahead, when the floating rate for the next period becomes known. This is not true for an FRA, because its payment is made at expiration, based on the 1-period rate for the next period.
NPV vs IRR
For independent projects, the NPV and IRR criteria for acceptance lead to the same result: Accept the project if NPV is greater than zero. Accept the project if IRR is greater than the cost of capital. For mutually exclusive projects, NPV and IRR may offer *different* recommendations. In such a situation, a company should select the project with the higher NPV. NPV is a better criterion because of its more realistic reinvestment rate assumption. IRR assumes that interim cash flows received during the project are reinvested at the IRR. This assumption is sometimes rather inappropriate, especially for projects with high IRRs. NPV makes a more realistic assumption that interim cash flows are reinvested at the required rate of return.
Reporting the Periodic Pension Cost
For pension costs that are not capitalized (e.g., certain costs recorded in inventory as mentioned earlier): IFRS only differentiates between components included in P&L and in OCI. It does not specify where exactly the various components of pension cost must be presented. U.S. GAAP also differentiates between components included in P&L and in OCI. Further, it requires all components of pension expense recognized in P&L to be aggregated and presented within one net line item on the income statement. Note that both IFRS and U.S. GAAP require total periodic pension cost to be disclosed in the notes to the financial statements.
Equity swaps as combinations of equities...
For the fixed rate payer: Borrow at a fixed rate, invest in a stock or an index For the valuation of the swap that receives the index return, we don't discount anything
Swaps as combinations of bonds...
For the fixed rate payer: Issue a fixed coupon bond and invest proceeds in a floating-rate bond with the same maturity and payment dates
We should note that...
Foreign currency transaction risk only arises when the payment and settlement dates are different.
Reclassifications under US GAAP:
Generally allows reclassifications of securities between all categories when justified, with fair values being determined at the transfer date. !!anything into or out of trading securities - all gains / losses needs to be moved to the Income statement From AFS to HTM: Availableforsale securities transferred to heldtomaturity are transferred at: fair market value, and any unrealized gains or losses remain in equity but are subsequently amortized over the remaining life of the security.
Dividend Policy Does Not Matter − Dividend Irrelevance Theory
Homemade dividends Both companies and individuals incur transaction costs ○ Companies incur flotation costs (e.g., underwriters' fees, legal costs, registration expenses, etc.) when issuing new shares, but no such costs are incurred if internally generated equity is used to finance a capital project. ○ Shareholders incur transaction costs when buying and selling shares. Volatile stock prices can make it problematic to create homemade dividends. For example, if there is a decline in share prices, shareholders would have to sell more shares in order to create the desired dividend stream.
Defining a High-Inflation Economy
IFRS provides no specific definition of high inflation, but does indicate that a cumulative three‐year inflation rate approaching or exceeding 100% indicates high inflation. U.S. GAAP defines a highly inflationary economy as one where the cumulative three‐year inflation rate exceeds 100%, which equates to an average of approximately 26% per year.
The option analogy...
If a company has A financed with E and zero coupon D: the value of the A = E + D. Due to the limited liability nature of corporate equity, *the shareholders have a call option on the company's assets* with a strike price equal to the face value of debt. If at the maturity of the debt, the value of A > D, the shareholders will exercise their call option to acquire the A (and then pay off the debt and keep the residual). But if the value of the company's A < debt, the shareholders will let the option expire worthless, leaving the A to the debt holders.
Excess of Purchase Price over Book Value and Amortization of Excess Purchase Price
If the amount paid by the investor to purchase shares in the investee is greater than the book value of those shares (i.e., the value of the investor's proportionate share in the investee's net identifiable tangible and intangible assets): The investor first allocates the excess amount to its proportionate share in specific assets whose fair value exceeds book value. ○ Amounts allocated to inventory are expensed. ○ Amounts allocated to depreciable or amortizable assets are capitalized and subsequently expensed (depreciated or amortized) over an appropriate period of time. ○ Amounts allocated to land and other assets or liabilities that are not amortized continue to be reported at fair value as of the date of investment. Any remaining excess (after being allocated to specific identifiable assets) is treated as goodwill, which is not amortized but reviewed periodically for impairment. The investor continues to recognize goodwill as part of the carrying amount of the investment.
Effects of Changes in Key Assumptions (compensation growth rate)
If the pension formula is based on the final year's salary, an increase in the assumed rate of growth in compensation: Increases the pension obligation. Increases periodic pension cost. A higher compensation growth rate increases the total value of payments owed to employees after retirement (benefits earned). This increases annual unit credit, which results in an increase in the pension obligation, service costs and interest costs.
Effects of Changes in Key Assumptions (Expected Life Expectancy)
If, under the terms of the plan, the sponsoring company must make pension payments to employees until their death, an increase in assumed life expectancy will result in an increase in the annual unit credit and the pension obligation. Further, service costs and interest costs will also increase so periodic pension cost will rise.
Under IFRS
Impair goodwill if CV (incl. goodwill) > recoverable amount of the cash-generating unit Impairment loss = CV - recoverable amount of the unit
Under IFRS...
Impaired asset when: CV > recoverable amount recoverable amount = higher of "FV-costs to sell" and "value in use (DCF)" Impairment = CV - recoverable amount
Under US GAAP...
Impaired asset when: CV > total value of undiscounted expected future cash flows Impairment = CV - FV (or the sum of DCF)
Dividend Policy Matters: The Tax Argument
In countries that impose a higher tax rate on dividends than on capital gains, taxable investors should prefer companies that pay relatively low cash dividends and reinvest their earnings in profitable growth opportunities.
Summary
In theory, all three of the different valuation approaches should lead to the same result, despite the economic profit method using the WACC, the residual income method using the cost of equity, and the claims valuation approach separately using the cost of debt and cost of equity as discount rates
3 explanations for conglomerate discounts
Internal capital inefficiency Endogenous factors Research measurement factors
The Black Model can be used to price European options on forwards and futures:
It is just the BSM model with e^RfxT x Ft substituted for S0
Justice theory
Justice theories assert that there should be a just (i.e., fair and equitable) distribution of economic goods and services. Once equal basic liberty is ensured, inequality in basic social goods (income, wealth, and opportunities) is acceptable only if it benefits the least advantaged person (differencing principle).
Valuing an FRA at maturity
Let's say that the 90-day rate has increased to 6% (which is above the contract rate of 5.32%) - The interest savings at the end of the loan term will be: (0.06 x 90/360) - (0.0532 x 90/360) x 1 mil. = $1700 - Find the PV of this amount at the FRA settlement date (90 days prior to the end of the loan term) discounted at the *current market rate* of 6%: 1700/ 1+(0.06 x 90/360) = $1674.88
Conforming loans in MBS pools...
Loans that meet certain criteria: minimum % down payment, maximum LTV ratio, max. size, min. documentation.
Effects of capitalization
Makes it easier for a company to achieve earnings targets for a particular period. Capitalization allows companies to report higher CFO.
2 types of conflicts in agency relationships:
Manager-Shareholder Conflicts Director-Shareholder Conflicts
Estimate delta using BSM:
N(d1) is the delta from the BSM model
The net benefit of holding the asset...
NB = yield on the asset + convenience yield
The market for corporate bonds is...
NOT frictionless. The credit spread includes a premium for liquidity risk in addition to credit risk.
(1) Historical means, variances and correlations:
Problems: - Quantity of estimates required - Quality of historical estimates of inputs n parameters for expected returns to the assets, n parameters for variances of asset returns and n(n-1)/2 parameters for pair-wise covariances between assets In total: n^2/2 + 3n/2
Quality Spectrum of Financial Reports
Quality from highest to lowest: (1) GAAP, Decision‐Useful, Sustainable, and Adequate Returns (2) GAAP, Decision‐Useful, but Sustainable? (3) Within GAAP, but Biased Accounting Choices (4) Within GAAP, but "Earnings Management" (5) Departures from GAAP: Non‐Compliant Accounting (6) Departures from GAAP: Fictitious Transactions
Impairment of Goodwill
Reversal of an impairment loss is not allowed under IFRS or U.S. GAAP.
Active return:
Rp: return on portfolio Rb: benchmark return
Transactions with associates
Sales from investee to investor are known as upstream sales. Sales from investor to investee are known as downstream sales.
(1) Sequential-pay CMO
Separates the CFs into tranches that are retired sequentially (create a sequential pay CMO). Let's consider a simple CMO with 2 tranches: both tranches receive interest payments but all principal payments (scheduled and prepayments) are paid to Tranche 1 (the short tranche) until its principal is paid off. Principal payments then flow to Tranche 2 until its principal is paid off. The short tranche which matures first has lower extension risk. The other tranche has lower contraction risk.
Under GAAP...
Service costs are recognized in P&L. However, past service costs are reported in OCI in the period during which the change that gave rise to the costs occurred. In subsequent years, these past service costs are amortized to P&L over the average service lives of affected employees. Recall that under IFRS, past service costs were also recognized on the P&L as pension expense for the period. Periodic pension expense includes interest expense on pension obligations (which increases pension cost) and returns on plan assets (which decrease pension cost). However, unlike IFRS: ○ These two components are not presented in a single net amount. Recall that the second component of pension cost under IFRS (i.e., net interest expense/income), represented a single net amount. ○ The return on plan assets is calculated based on an assumed expected return on plan assets. The difference between the actual return and the expected return on plan assets is another source (in addition to changes in assumptions that determine the value of the pension obligation—e.g., discount rate and life expectancy) of actuarial gains and losses under U.S. GAAP. All actuarial gains and losses can be reported either in P&L or in OCI. Typically, companies report actuarial gains and losses in OCI and recognize gains and losses in P&L by applying the corridor method. Recall that under IFRS, actuarial gains and losses are a part of the remeasurement component, which is never amortized into P&L from OCI.
Impairment of goodwill:
Since goodwill is an intangible asset with an indefinite life, it is not amortized. However, goodwill must be tested for impairment at least annually or more frequently if events and circumstances indicate that it may be impaired. Once an impairment charge has been made against goodwill, it cannot subsequently be reversed.
Capital Market Line:
Since the CML is a straight line, all portfolios that lie on the CML are perfectly positively correlated
Non-mortgage asset-backed securities...
Small business loans Accounts receivable Credit card receivables Automobile loans Home equity loans Manufactured housing loans
Effective tax rates under different tax systems (3):
Split‐Rate Tax System Under this system earnings that are distributed as dividends by the company are taxed at a lower rate than earnings that are retained by the company. Dividends are then taxed again at the shareholder level as ordinary income. Note that earnings that are distributed as dividends are still taxed twice, but the lower tax rate on earnings that are distributed mitigates the penalty.
Value of long position at maturity:
St - FP At expiration, we do not need to discount the forward price because the time left on the contract is zero
3 Payout policies
Stable Dividend Policy Constant Dividend Payout Ratio Policy Residual Dividend Policy
Value of long position during life:
T-t: number of years remaining until expiration The long position will pay the forward price (FP) at maturity (time T) and receive the spot price (St). The value of the long at maturity is what he will receive less what he will pay: St - FP Think that: long position is spot price minus PV of forward price
I/S:
Taxes FIFO = Taxes LIFO + (Δ in reserve x tax rate) COGS FIFO = COGS LIFO - (Δ in reserve) NI FIFO = NI LIFO + (Δ in reserve x (1-t))
MVF and GMVP
The *minimum variance frontier* reduces the investment opportunity set to a curve that contains only those portfolios that entail the lowest level of risk for each level of expected return. The *global minimum variance portfolio* is the portfolio of risky assets that entails the lowest level of risk among all portfolios on the minimum variance frontier. ALL portfolios above and to the right of the GMVP dominate those that lie below and to the right of the GMVP The section of the MVF that lies above and to the right of the GMVP is referred to as the Markowitz efficient frontier
Comparison of different approaches
The 3 models for evaluating credit risk (credit ratings, structural models and reduced form models) have been tested to evaluate their ability to predict the probability with which debt will default. Of the three, credit ratings have been found to be the least accurate credit risk evaluation approach because they tend to be relatively stable and lag the market. Reduced form models vs structural models: reduced form models win due to the flexibility of the hazard rate estimation procedures that reduced form models use. These models are able to incorporate the business cycle, thus, not being required to make simplifying assumptions about the balance sheet structure
Lessor's perspective under US GAAP:
The 4 previous criteria plus: - Collectibility of the lease payment is predictable - No significant uncertainties regarding the amount of costs still to be incurred by the lessor under the provisions of the lease agreement Leases not meeting these criteria must be classified as operating leases because the earnings process is not complete. When the lease is classified as a finance/capital lease, the lessor removes the longlived asset from its balance sheet, and instead records a *receivable* in its books. The lessee records the longlived asset on its balance sheet and depreciates it.
APT formula:
The CAPM can be considered a special case of the APT with only one risk factor, the ERP The intercept term in the APT is the risk-free rate
Spurious correlation
The term spurious correlation is used to refer to relationships where: ○ Correlation reflects chance relationships in a data set. ○ Correlation is induced by a calculation that mixes the two variables with a third. ○ Correlation between two variables arises from both the variables being directly related to a third variable.
Intrinsic value
The valuation of an asset by someone who has complete understanding of the characteristics of the asset.
(1) GAAP, Decision‐Useful, Sustainable, and Adequate Returns
These are high‐quality reports that provide useful information about high‐quality earnings. High‐quality financial reports: Conform to the accounting standards acceptable in the company's jurisdiction. Embody the fundamental characteristics of useful information (i.e., relevance and faithful representation). High‐quality earnings: Indicate an adequate return on investments. Are primarily derived from activities that the company will likely be able to sustain in the future.
(3) Within GAAP, but Biased Accounting Choices
This level refers to a situation where high‐quality reporting provides useful information, but biased choices result in financial reports that do not faithfully represent the company's true economic situation. Management can make *aggressive or conservative* accounting choices, both of which go against the concept of neutrality, as unbiased financial reporting is the ideal. ○ Aggressive choices increase a company's reported financial performance and financial position in the current period. ■ Note that aggressive accounting choices in the current period may lead to depressed reported financial performance and financial position in later periods, thereby creating a sustainability issue. ○ Conservative choices decrease a company's reported financial performance and financial position in the current period. ■ Note that conservative accounting choices in the current period may lead to improved reported financial performance and financial position in later periods. Therefore, they do not give rise to a sustainability issue. Aside from biases in determining reported amounts, biases can also creep into the way information is presented. A company may choose to present information in a manner that obscures unfavorable information and/or highlights favorable information.
(2) GAAP, Decision‐Useful, but Sustainable?
This level refers to a situation where high‐quality reporting provides useful information, but the *economic reality* being depicted is not of high quality (i.e., earnings do not provide an adequate rate of return or they are not expected to recur).
(4) Within GAAP, but "Earnings Management"
This level refers to a situation where high‐quality reporting provides useful information, but where earnings are "managed." Earnings management can be defined as "making intentional choices or taking deliberate action to influence reported earnings and their interpretation." There are two ways that earnings can be managed: (1) By taking real actions. ○ For example, a company may defer R&D expenses until the next year to improve reported performance in the current year. (2) Through accounting choices. ○ For example, a company may change certain accounting estimates such as estimated product returns, bad debts expense, or asset impairment to manipulate reported performance.
(5) Departures from GAAP: Non‐Compliant Accounting
This level reflects financial information that deviates from GAAP. Such financial information cannot be used to assess earnings quality, as comparisons with other entities or earlier periods cannot be made.
Reduced form models of corporate credit risk:
This model does not impose assumptions on the company's balance sheet, instead it imposes assumption on the output of a structural model. It allows flexibility to incorporate real world conditions in the model.
The optimal VA:
This says that no matter how high or low our risk aversion level is, we would choose the investment manager with the highest information ratio. Investors will only differ with respect to how aggressively they implement the manager's strategy.
Contingent assets (*IFRS stricter*)
UNDER IFRS Contingent assets are NOT recognized Congtingent liabilities are recognized (given that their FVs can be measured reliably) UNDER GAAP Contingent assets AND liabilities are recognized at their FVs at the time of acquisition
Underfunded vs Overfunded
UNDERFUNDED If the pension obligation is greater than the fair value of plan assets, the plan is said to be underfunded, and a net pension liability equal to the positive difference is recognized on the B/S. OVERFUNDED If the pension obligation is less than the fair value of plan assets, the plan is said to be overfunded, and a net pension asset equal to the negative difference is recognized on the balance sheet. ○ *Note that the amount of net pension asset reported is subject to a ceiling equal to the present value of future economic benefits, such as refunds from the plan or reductions of future contributions.*
From 2014 onward...
US companies are required to switch to the FIFO or weighted-average cost inventory methods for financial and tax reporting purposes.
Available-for-sale Investments
Under *IFRS*: - Initially recognized at FV - ALL unrealized gains/losses (except for gains/losses on AFS *debt* securities arising from exchange rate movements) are recognized (net of taxes) in *equity* under OCI. When sold, these (now realized) gains/losses are reversed out of OCI and reported in Pn as a reclassification adjustment - Unrealized gains/losses on AFS debt securities arising from exchange rate movements are recognized on the I/S - Realized gains/losses, interest income, dividend income are recognized on the I/S Under *US GAAP*: - The same except that *ALL* unrealized gains/losses (including those on AFS debt securities caused by exchange rate movements) are reported in OCI
Effects of Changes in Key Assumptions (Expected Return on Plan Assets)
Under U.S. GAAP, the expected return on plan assets reduces the periodic pension expense. An increase in the assumed expected return on plan assets: Has no impact on a company's net pension liability (funded status) reported on the balance sheet. The funded status is calculated based on the actual fair value of plan assets, which is not influenced by the expected rate of return assumption. Decreases the company's pension expense (under U.S. GAAP). Note that total periodic pension cost is not affected by a change in the expected return on plan assets. An increase in the expected return reduces pension expense on the P&L, but this is offset by a higher pension cost recognized in OCI (as an actuarial loss).
Defined Contribution
Under a defined contribution (DC) pension plan, the employer contributes specific (agreed-upon) amounts to an employee's pension plan. Once the employer has made the agreed-upon contribution (generally in the same period during which the employee provides the service) *it has no obligation to make payments beyond the specified amount*.
Defined-Benefit
Under a defined-benefit (DB) pension plan, the employer promises to pay a defined amount of pension *in the future*.
In-process R&D
Under both IFRS and U.S. GAAP, in‐process research and development (R&D) acquired in a business combination is recognized as a separate intangible asset at fair value. In subsequent periods, IPR&D is amortized.
Restructuring costs
Under both IFRS and U.S. GAAP, restructuring costs associated with a business combination are expensed in the period in which they are incurred (they are not included in the acquisition price).
Acquisition Method for Business Combinations
Under the acquisition method: All the assets, liabilities, revenues, and expenses of the acquiree are combined with those of the parent. ○ *All identifiable tangible and intangible assets and liabilities of the acquired entity are measured at fair value.* ○ The acquirer must also recognize any assets and liabilities that the acquiree has not recognized on its financial statements. For example, identifiable intangible assets such as brand names and patents that the acquiree had developed internally would now be recognized by the acquirer. The acquirer must recognize any contingent liability assumed in the acquisition if (1) it is a present obligation that arises from past events, and (2) it can be measured reliably. Costs that the acquirer expects (but is not obliged) to incur, however, are not recognized as liabilities, but are expensed in future periods as they are incurred. The acquirer must recognize an indemnification asset if the acquiree contractually indemnifies the acquirer for (1) the outcome of a contingency, (2) an uncertainty related to a specific asset or liability of the acquiree, or (3) against losses above a specified amount on a liability arising from a particular contingency. If the purchase price is less than the fair value of the subsidiary's net assets, it is referred to as a bargain acquisition. Both IFRS and U.S. GAAP require the difference between the fair value of the acquired net assets and the purchase price to be recognized immediately as a gain in profit or loss. Transactions between the acquirer and acquiree are eliminated. The acquiree's shareholders' equity accounts are ignored.
Corridor method of Amortizing Actuarial Gains and Losses:
Under the corridor method, if the net cumulative amount of unrecognized actuarial gains and losses at the beginning of the reporting period exceeds 10% of the greater of (1) the defined benefit obligation or (2) the fair value of plan assets, then the excess is amortized over the expected average remaining working lives of the employees participating in the plan and included as a component of periodic pension expense on the P&L.
Pooling-of-Interests Method (U.S. GAAP) / Uniting-of-Interests Method (IFRS)
Under this method, the two firms are combined using their historical book values, and their operating results are restated as if they had always operated as a single entity. Further, ownership interests are continued and former accounting bases are maintained. Fair values are not used in accounting for a business combination under this method, and the actual price paid for the acquisition is not evident on the financial statements.
post‐merger value of the combined company (VA*)
VA* = VA + VT + S − C VA: pre‐merger value of the acquirer VT: pre‐merger value of the target
MM I without taxes: capital structure irrelevance
VL = VU Assumptions: 1. Investors have homogeneous expectations regarding the cash flows from an investment in bonds or stocks. 2. Capital markets are perfect (i.e., there are no taxes, no transaction costs, and no bankruptcy costs). Further, all market participants have the same information so investments with identical cash flow streams and risk must trade at the same price. 3. Investors can borrow and lend at the risk‐free rate. 4. There are no agency costs—i.e., managers always act in the best interests of shareholders (aim to maximize shareholder wealth). 5. The financing and investment decisions are independent of each other. Therefore, operating income remains unaffected by changes in capital structure.
LIFO reserve:
Value of Inventory under FIFO - value under LIFO
Weighted average price:
Value of goods available for sale / Number of units available for sale
Periodic pension cost:
Various components of this total cost can be recognized on the profit and loss (P&L) or in other comprehensive income (OCI) under IFRS and U.S. GAAP.
Discount factors for swaps:
Zn = 1/(1+unannualized LIBOR) !! C is a quarterly rate! Annualize it to find the fixed rate!
Staggered board of directors
a *portion* of the board is up for election each year, not the entire board. A staggered board increases the amount of time an acquirer would need to take control of the board. For example, consider a 12‐person board with a 3-year term, with only 4 seats coming up for election each year. With the staggered board, it would take an acquirer at least two years to take control of the board.
An interest rate *caplet* is similar to...
a call option on interest rates
Residual Dividend Policy
a company first utilizes internally generated funds to finance investments in positive NPV projects consistent with its target capital structure. Remaining funds (if any) are distributed in their entire amount as dividends to shareholders Dividends = Net Income − equity portion of capital budget
A 2x3 FRA is...
a contract that expires in 2 months and the underlying loan is settled in 3 months. The underlying rate is 1-month LIBOR on a 30-day loan in 60 days.
Swaps and options...
a fixed rate payer or receiver can be replicated with a series of put/call positions with expiration dates on the payment dates of the swap
The key is that...
a floating-rate bond will always be worth its par value at every settlement date
The *fundamental law of active management*:
a manager's IR can be estimated using two attributes of her strategy: *skill* and *breadth*
Golden parachutes
executives receive lucrative payouts if they leave the company following a change in corporate control. While they do not serve as deterrents to acquirers (since the value of compensation given to management is insignificant compared to the amount paid to acquire the target), *they do pacify management concerns regarding job loss*.
The cash flow to a pool of credit card receivables includes...
finance charges annual fees and principal repayments
External credit enhancement:
financial guarantees from third parties that support the performance of the bond. They are used to supplement other forms of credit enhancements. Often the party that provides the guarantee is a monoline insurance company
calculate the value of an interest rate swaption at expiration:
find the net cash flow to the investor at each payment date and discount it...
A floating-rate investor can use a...
floor to limit reductions in interest income during the life of the floor
FIFO will ALWAYS...
give a better reflection of the current economic value of inventory because the units currently in stock are valued at the most recent prices
Poison puts
give target company *bondholders* the right to sell their bonds back to the target at a pre‐specified redemption price (typically par value or above) in the event of a takeover. This means that if the acquirer takes over the target, it would need to raise a substantial amount of cash to refinance the target's debt.
Non-agency RMBS are not guaranteed by...
government or a GSE so credit risk is an important consideration
Without netting, credit risk is...
greater.
The temporal method is first used to convert local currency into functional, then the current rate method is used to convert functional into presentation...
if local currency, functional currency and presentation currency are different
The current rate method is used to translate foreign currency financial statements into the parent's presentation currency...
if the local currency is deemed to be the *functional currency* (LC = FC not PC) Such instances usu. arise when the subsidiary is independent and its operating, investing and financing activities are decentralized from the parent.
The temporal method is used to translate foreign currency financial statements into the parent's presentation currency...
if the presentation currency is deemed to be the *functional currency* (LC not equal to FC = PC) Such instances usually arise when the subsidiary and parent are well‐integrated.
Periodic pension expense:
refers to the components of periodic pension cost that are recognized on the P&L (not OCI).
Collateralized mortgage obligations (CMO) are...
securities that are collateralized by RMBS. Each CMO has multiple bond classes (CMO tranches) that have different exposures to prepayment risk. The total prepayment risk of the underlying RMBS is *NOT* changed. It is simply reapportioned among the various CMO tranches.
Dividend Policy Matters: The Bird in the Hand Argument
shareholders prefer current dividends over an equivalent amount of potential capital gains from reinvesting earnings because there is uncertainty associated with the capital gain, which makes it more risky.
Cash and carry arbitrage=>
short forward => borrow money => long spot asset Hints: (1) Always buy underpriced assets and sell overpriced (2) take opposite positions in the spot and forward markets
Credit scoring is used for...
small businesses and individuals.
A collateralized debt obligation (CDO) is a...
structured security issued by an SPV for which the collateral is a pool of debt obligations. CDOs do not rely on interest payments from the collateral pool. CDOs have a collateral manager who buys and sells securities in the collateral pool to generate cash to make the promised payments to investors.
the Herfindahl‐Hirschman Index (HHI)
sum the squared market shares of each firm and then decide:
The Coefficient of Determination (R2)
tells us how well the independent variable explains the variation in the dependent variable
the F‐test
tests whether *all* the slope coefficients in the regression are equal to zero.
A gamma of 0.04 means...
that a $1.00 increase in the price of the underlying stock will cause a call option's delta to increase by 0.04, making the call option more sensitive to changes in the stock price it is largest when a call or put option is at-the-money and close to expiration
The buyer of a cap has a position similar to...
that of a buyer of a call on LIBOR (benefit when rates rise)
Under both IFRS and GAAP, investments in associates are accounted for using...
the *equity method*
In the case of single-name CDS,
the *reference obligation* is the fixed-income security on which the swap is written.
The protection buyer pays the seller a premium called...
the CDS spread
Under US GAAP, inventory must be stated at...
the LCM (lower of cost or market). Market is the replacement cost. It is constrained by two amounts: from NRV - normal profit margin to NRV. If market > NRV, it must be brought down to NRV If market < NRV - normal profit margin, it must be brought up to NRV - normal profit margin
This notional is...
the amount of protection being purchased
The sum of squared errors or residuals (SSE)
the amount of variation in the dependent variable that cannot be explained by the independent variable. It equals the sum of the squared deviations of actual values of the dependent variable from their predicted values (based on the regression equation).
The regression sum of squares (RSS)
the amount of variation in the dependent variable that is explained by the independent variable. It equals the sum of the squared deviations of predicted values of the dependent variable (based on the regression equation) from the mean value of the dependent variable.
Because of prepayments...
the average life of an MBS will be less than its weighted average maturity.
In order for the bill-and-hold treatment to be legal...
the buyer must (1) request such treatment, (2) have a genuine business purpose for the request, and (3) accept ownership risks. These requirements were not met, so Sunbeam should not have recognized the associated revenue.
The Minimum-variance frontier is...
the curve that represents the minimum portfolio variance that can be achieved for each level of expected return The Global Minimum Variance portfolio: is the portfolio which has the lowest level of risk among all portfolio possibilities on the minimum variance frontier The Efficient Frontier is the portion of the Minimum variance frontier that lies above and to the right of the global minimum variance portfolio. It encompasses the set of portfolios that maximize expected return for each level of risk.
The cheapest-to-deliver obligation is...
the debt instrument that can be purchased and delivered at the *lowest* cost but has the *same* seniority as the reference obligation
For mutually exclusive projects...
the decision rule is to pick the project that has the highest *positive* net present value. If it's negative, don't pick anything.
Credit spread is...
the difference between the yield to maturity of a credit-risky zero coupon bond and the yield to maturity of a risk-free zero coupon bond Credit spread includes measures of probability of default, loss given default and time value of money incl. the adjustment of risk premium
*Potential credit risk* reflects...
the future credit risk over the remaining term of the swap
The Security Market Line is...
the graph of the CAPM equation. Its y-intercept equals the risk-free rate and its slope equals the market risk premium.
Given his investment opportunity set (which is determined by the ex ante alpha)...
the investment manager will try to invest in the portfolio that has the highest value added
statutory merger
the legal identity of the target *ceases to exist* following the amalgamation of all its assets and liabilities into the acquirer.
Under IFRS, inventory must be stated at...
the lower of *cost* or *net realizable value*. NRV = selling price - selling costs If NRV falls below cost recorded on the B/S, inventory must be written down and a *loss* must be recognized as part of COGS or separately on the I/S. A subsequent increase in NRV would require a reversal of the previous write-down, which would reduce COGS in the period that the increase in value occurs. However, the increase in value that can be recognized is limited to the total write-down that had previously been recorded. Effectively, inventory value can *never* exceed the amount originally recognized
Investors in mortgage pass-through securities receive...
the monthly cash flows generated by the underlying pool of mortgages, less any servicing and guarantee/insurance fees
Convenience yield is...
the non-monetary benefit from holding an asset in short supply
The contract is written on a face value called...
the notional principal
Breadth:
the number of independent forecasts of exceptional return that a manager makes *per year*
For a less than 100% acquisition...
the parent must create a *non-controlling* interest account on the consolidated B/S and I/S to reflect the proportionate share in the net assets and net income of the subsidiary that belongs to minority shareholders Non-controlling interests on the consolidated B/S presented in the *equity* section reflects minority shareholders' proportionate share in the net assets of the subsidiary Non-controlling interests on the I/S are deducted from consolidated net income and reflect minority shareholders' proportionate share in the net income of the subsidiary
If the underlying credit card holders make principal payments during the lockout period...
the payments are used to purchase additional credit card receivables, keeping the overall value of the receivables pool relatively constant. Once the lockout period ends, principal payments are passed through to security holders.
The single monthly mortality rate (SMM) is...
the percentage by which prepayments reduced the month-end principal balance, compared to what it would have been with only scheduled principal payments (with no prepayments)
The price of the forward is...
the price that makes the values of both long and short positions zero at contract initiation forward price = price that would not permit profitable riskless arbitrage in frictionless markets
The price of the forward is NOT...
the price to purchase the contract because the parties to a forward contract typically pay nothing to enter into the contract at its inception. Price refers to the contract price of the underlying asset under the terms of the forward contract.
The sum-of-the-parts valuation is also called...
the private market value or the breakup value
The most important element of CDS pricing is...
the probability of default
*Credit risk* in a swap reflects...
the probability that a counterparty will default on the required payments
Marking to market is...
the process of adjusting the margin balance in a futures account each day for the change in the value of the contract from the previous trading day, based on the settlement price
During periods of falling interest rates...
the refinancing of mortgage loans will accelerate prepayments and reduced the average life of an MBS
The *term structure of credit spreads* represents...
the relationship of credit spreads to debt maturity. Credit spread = yield on zero-coupon credit risky bond - yield on zero-coupon risk free bond The average credit spread over a specific horizon can be used to estimate the expected percentage loss per year on the risky zero-coupon bond
A payer swaption is...
the right to enter into a specific swap at some date in the future as the fixed-rate payer at a rate specified in the swaption. If swap fixed rates increase, the right to enter the pay-fixed side of a swap becomes more valuable
A receiver swaption is...
the right to enter into a specific swap at some date in the future as the fixed-rate receiver (i.e. the floating-rate payer) at a rate specified in the swaption. If swap fixed rates decrease, the right to enter the receive-fixed side of a swap becomes more valuable
*Credit risk* is...
the risk associated with losses stemming from the failure of a borrower to make timely and full payments of interest or principal
Contango refers to...
the situation where the futures price is above the spot price. If there are no benefits to holding the asset (dividends, coupons), the futures price will be FP = S0 (1+Rf)^T + FV (NC) and contango will occure
Backwardation refers to...
the situation where the futures price is below the spot price. For this to happen, there must be a significant benefit to holding the asset, either monetary or non-monetary. Benefits of holding the asset that offset the opportunity cost of holding the asset and additional net holding costs.
Normal contango refers to...
the situation where the futures price is greater than the expected spot
Normal backwardation refers to...
the situation where the futures price is lower than the expected spot
The *swap spread* is...
the spread between the swap rate and the comparable maturity T-notes.
*Active risk* (or tracking error, TE, or tracking risk) is...
the standard deviation of active returns
Under IFRS...
the subsidiary's foreign currency accounts are restated for inflation and then translated into the parent's presentation currency using the *current* exchange rate. - Nonmonetary assets and liabilities are restated for changes in the general purchasing power of the local currency. - Monetary assets and liabilities (e.g., cash, receivables, and payables) are not restated for inflation. - Shareholders' equity accounts are restated for inflation by multiplying their values by the change in the general price index from the beginning of the period, or from the date of contribution (if later), till the balance sheet date. - Income statement items are restated for inflation by multiplying their values by the change in the general price index from the dates when the items were originally recorded till the balance sheet date. - All items are then translated into the parent's presentation currency using the current exchange rate. - The gain/loss in purchasing power is recorded on the income statement.
Corporate governance
the system of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome the conflicts of interest inherent in the corporate form.
subsidiary merger
the target becomes a *subsidiary* of the acquirer
The initial PAC collar is...
the upper and lower bound on the actual prepayment rates for which the support tranches are sufficient to either provide or absorb actual prepayments in order to keep the PAC principal repayments on schedule
With currency swaps...
there are 2 yield curves and 2 swap rates, one for each currency
The difficulties in pricing Eurodollar futures...
these futures are priced as a discount yield and LIBOR is subtracted from 100 to get the quote. Every basis point move in annualized 90-day LIBOR represents a $25 gain or loss on the contract, just as with the t-bill contract. LIBOR is an add-on yield, the rate you would earn on the face amount of a deposit. An add-on yield account for 167 days that pays $1 at maturity can be valued at expiration (77 days later) using 90-day LIBOR 77 days from now (L90 t=77) as $1 / (1+ L90 t=77)
When the collateral securities are supported by corporate and emerging market debt...
they are called collateralized bond obligations (CBO)
When the collateral securities are supported by leveraged bank loans...
they are called collateralized loan obligations (CLO)
Structured finance CDOs are...
those where the collateral is ABS, RMBS, other CDOs and CMBS
Synthetic CDOs are...
those where the collateral is a portfolio of CDS on structured securities
Value of risky debt =
value of risk-free debt - value of a put option on a company's assets
Factors Affecting Choice of Payment
○ The more strongly the acquirer believes that the merger will create value, the more it is likely to push a cash offering. ○ The more strongly target shareholders believe that the merger will create value, the more they will push for a stock offering.
An effective corporate governance system (attributes):
Clearly describes the rights of shareholders and other important stakeholders. Defines the responsibilities of managers and directors to stakeholders. Identifies measurable accountabilities for the performance of responsibilities. Ensures *fairness and equitable treatment* in all dealings between managers, directors, and shareholders. Ensures transparency and accuracy in disclosures regarding operations, performance, risk, and financial position.
stakeholder impact analysis (SIA)
Identify stakeholders. Identify stakeholders' interests and concerns. Identify what claims stakeholders are likely to make on the organization. Identify the stakeholders who are most important from the organization's perspective. Identify the resulting strategic challenges.
Uses of Correlation Analysis
Investment analysis (e.g., evaluating the accuracy of inflation forecasts in order to apply the forecasts in predicting asset prices). Identifying appropriate benchmarks in the evaluation of portfolio manager performance. Identifying appropriate avenues for effective diversification of investment portfolios. Evaluating the appropriateness of using other measures (e.g., net income) as proxies for cash flow in financial statement analysis.
Additional evidence beyond the HHI
Responsiveness of consumers to price changes. Efficiency of companies in the industry. Financial viability of merger candidates. Ability of U.S. companies to compete in foreign markets.
F-stat
!! The F‐test is a one‐tailed test. The decision rule for the test is that we reject H0 if F‐stat > Fcrit If the regression model does a good job of explaining the variation in the dependent variable, explained variation should be relatively high, so MSR should be high relative to MSE, and the value of the F‐stat should be higher.
Post‐Offer Takeover Defense Mechanisms
"Just say no" defense Litigation Greenmail Share repurchase Leveraged recapitalization "Crown jewel" defense "Pac Man" defense White knight defense White squire defense
Pre‐Offer Takeover Defense Mechanisms
Poison pills Poison puts Incorporation in a state with restrictive takeover laws Staggered board of directors Restricted voting rights Supermajority voting provisions Fair price amendments Golden parachutes
Acquirer's gain
Synergies - Premium S − (PT − VT) or VA* − VA
Target shareholders' gain
Takeover premium = PT − VT PT = Price paid for target VT = Pre‐merger value of target
Supermajority voting provisions
Target companies can change their charter and bylaws to require a higher percentage approval by shareholders for mergers (e.g., 80% of outstanding shares as opposed to a simple 51% majority for other items requiring shareholder approval).
Restricted voting rights
Target companies may adopt a mechanism that precludes shareholders who have recently purchased a large block of shares from exercising their voting rights. The possibility of owning target company shares but not being able to vote deters acquirers from making a hostile move for the target.
White knight defense
The target encourages a third firm (that is more acceptable to target company management) to acquire the target company
Share repurchase
The target may repurchase its shares from shareholders. This can increase the cost of a takeover for the acquirer by increasing the stock's price, or by causing the acquirer to increase its bid in order to remain competitive with the target's offer for its own shares.
Investment value
The value of a stock to a particular buyer. Depends on: - the buyer's specific needs ad expectations - perceived synergies with existing buyer assets For acquisitions, investment value may be more appropriate.
Fair price amendments
These are changes to the corporate charter that only allow mergers if the offer price is above a certain threshold (e.g., the highest price attained by the stock over the year). Not only do these amendments protect target shareholders from temporary declines in the target's stock price, but they also provide protection against two‐tiered tender offers.