Equity & Fixed Income

Equal Weighting

wᴱᵢ = 1/N wᵢ = fraction of portfolio allocated to security ᵢ or weight of security ᵢ When starting the index, the provider allocates a % of the constiuents to each security. The value allocated to each security is divided by the securities individual share price which determines the number of shares of each security to include in the index Advantage of price weighting is simplicity. Equal weighting has disadvantages though. First, securities that constitute a small fraction of the target market value are over represented. Second, after the index is constructed and the prices of constituent securities change, the index is no longer equally weighted.

Market Capitalization Weighting

wᴹᵢ = QᵢPᵢ/∑QĵPĵ wᵢ = fraction of portfolio allocated to security ᵢ Qᵢ = number of shares outstanding of security ᵢ Pᵢ = share price of security ᵢ N = number of securities in the index

Price Weighted Index

wᴾᵢ = Pᵢ/∑Pᵢ Divide the sum of the secuity values by the number of constituents

Convex Relationship b/t Market Discount Rate and Price of 10 Year

% Price Increase vs. Decrease for Bonds The % price increase is greater in absolute terms than the percentage price decrease. j

Convexity Adjusted Estimate of the % ∆ in a Bond's Full Price

%PV^full = (-AnnModDur * ∆Yield) + [.5 * AnnConvexity * (∆Yield)²] Convexity statistic is used to improve the estimate of the % price ∆ provided by modified duration

Formula to Convert Annual Percentage Rate for m Periods to Annual Percentage Rate for n Periods

(1+APR៳/៳)ᴹ = (1+APRɳ/ɳ)ⁿ

3 Bond Market Sectors

1. Government and government related sector 2. Corporate sector 3. Structured finance sector

Loss Severity

1 - Recovery rate where recovery rate is the percentage of the principal amount recovered in the event of default

Fun Fact

1 USD invested in 1900 would have grown to 834 real dollars with dividend reinvestment, but 8.1 dollars without. Thus, with dividends growth was 6.2% vs 1.9% without.

Covenants

1. Affirmative: what the issuer's management are obligated to do 2. Restrictive: what the issuer's management is limited in doing

Orders 2

1. All or nothing orders (AON): An order that includes the instruction to trade only if the trade fills the entire quantity (size) specified. 2. Display size: The size of an order displayed to public view 3. Iceberg order: display size is less than the orders full size

Callable Bonds: Exercise Styles

1. American-style call, sometimes referred to as continuously callable, for which the issuer has the right to call a bond at any time starting on the first call date. 2. European-style call, for which the issuer has the right to call a bond only once on the call date. 3. Bermuda-style call, for which the issuer has the right to call bonds on specified dates following the call protection period. These dates frequently correspond to coupon payment dates.

US Single Price Auction: 3 Phases

1. Announcement 2. Bidding: all bidders receive the same rate based on the highest accepted bid — competitive bid: if the rate determined in the auction is lower than the competitive bid, the competitive bid gets nothing. — non competitive bid: the bidder agrees to the rate determined at the auction. 3. Issuance

Credit Enhancements: External

1. Bank guarantees and surety bonds: usually a maximum amount guaranteed called the penal sum. The major difference between a bank guarantee and a surety bond is that the former is issued by a bank, whereas the latter is issued by a rated and regulated insurance company. Monoline insurers: insurance companies that specialize in providing financial guarantees. 2. Letter of credit: the financial institution provides the issuer with a credit line to reimburse any cash flow shortfalls from the assets backing the issue. 3. Cash collateral account: Form of external credit enhancement whereby the issuer immediately borrows the credit-enhancement amount and then invests that amount, usually in highly rated short-term commercial paper.

Description of Representative Sectors

1. Basic materials and processing: 2. Consumer discretionary: 3. Consumer staples: 4. Energy: 5. Financial services: 6. Health care: 7. Industrial/producer durables: 8. Technology: 9. Telecommunications: 10. Utilities:

Differences in Yield Measures b/t Money Market & Bond Market

1. Bond yields-to-maturity are annualized and compounded. Yield measures in the money market are annualized but not compounded. Instead, the rate of return on a money market instrument is stated on a simple interest basis. 2. Bond yields-to-maturity can be calculated using standard time-value-of-money analysis and with formulas programmed into a financial calculator. Money market instruments often are quoted using nonstandard interest rates and require different pricing equations than those used for bonds. 3. Bond yields-to-maturity usually are stated for a common periodicity for all times-to-maturity. Money market instruments having different times-to-maturity have different periodicities for the annual rate.

High Yield Analysis is More Detailed

1. Greater focus on issuer liquidity and cash flow 2. Detailed financial projections 3. Detailed understanding and analysis of the debt structure 4. Understanding of an issuer's corporate structure 5. Covenants 6. Equity-like approach to high yield analysis

Public Offerings

1. Book building: lining up subscribers who will buy a security 2. Accelerated book build: when time is pressed, the bank arranges this w/in one to two days 3. Underwritten offering: investment bank guarantees the sale of the issue at an offering price that it negotiates with the issuer. In the case of an IPO the underwriter promises to make the market and to buy whatever securities it cannot sell at the offering price 4. Best effort offering: investment bank acts only as a broker and will not subscribe if issue is undersubscribed.

FI: Summary

1. Brokers, exchanges, and various alternative trading systems match buyers and sellers interested in trading the same instrument at the same place and time. These financial intermediaries specialize in discovering and organizing information about who wants to trade. 2. Dealers and arbitrageurs connect buyers to sellers interested in trading the same instrument but who are not present at the same place and time. Dealers connect buyers to sellers who are present at the same place but at different times whereas arbitrageurs connect buyers to sellers who are present at the same time but in different places. These financial intermediaries trade for their own accounts when providing these services. Dealers buy or sell with one client and hope to do the offsetting transaction later with another client. Arbitrageurs buy from a seller in one market while simultaneously selling to a buyer in another market. 3. Many financial intermediaries create new instruments that depend on the cash flows and associated financial risks of other instruments. The intermediaries provide these services when they securitize assets, manage investment funds, operate banks and other finance corporations that offer investments to investors and loans to borrowers, and operate insurance companies that pool risks. The instruments that they create generally are more attractive to their clients than the instruments on which they are based. The new instruments also may be differentiated to appeal to diverse clienteles. Their efforts connect buyers of one or more instruments to sellers of other instruments, all of which in aggregate provide the same cash flows and risk exposures. Financial intermediaries thus effectively arrange trades among traders who otherwise would not trade with each other. 4. Arbitrageurs who conduct arbitrage among securities and contracts whose values depend on common factors convert risk from one form to another. Their trading connects buyers and sellers who want to trade similar risks expressed in different forms. 5. Banks, clearinghouses, and depositories provide services that ensure traders settle their trades and that the resulting positions are not stolen or pledged more than once as collateral.

Limitation of Business Cycle Classification

1. Business sensitivity is a continuous spectrum rather than an "either/or" issue, so placement of companies on one of the two major groups is somewhat arbitrary. 2. In global investing, different regions generally progress through the stages at different times

Calculate Required Rate of Return

1. CAPM 2. Use est. Rƒ (usually gov't bond) and add a risk premium to the yield on the company's bonds.

Bond Cash Flow Yield Portfolio Limitations

1. CF yield is not commonly calculated for bond portfolios 2. the amount and timing of future coupon and principal payments are uncertain if the portfolio contains callable or putable bonds or floating rate notes. 3. interest rate risk is usually expressed as a changes n the benchmark interest rates, not as a change in the cash flow yield 4. the change in the cash flow yield is not necessarily the same amount as the change in the YTM on the individual bond.

Corp Bond: Contingency Provisions

1. Call 2. Putable: most putable bonds pay fixed interest, but they might have a step-up coupons. 3. Conversion: consists of a long position in an option-free bond and a conversion option that gives the bond holder the rights to convert the bond into specified number of shares of the issuers common shares.

Trading Sessions

1. Call market: trades are only arranged when the market is called at a particular time and place 2. Continuous trading market: trades can be arranged and executed anytime the market is open In a call market, trading only occurs when market is called, but in continuous the trade may occur so long as the market is open

4 C's of Credit Analysis

1. Capacity: ability of borrower to make its debt payments on time 2. Collaterals: refers to the quality of the assets supporting the issuer's indebtedness 3. Covenants: the terms and conditions of lending agreements to which the issuer must comply 4. Character: refers to the quality of management

Credit: Issuer's Liquidity

1. Cash on the balance sheet. Cash holdings provide the greatest assurance of having sufficient liquidity to make promised payments. 2. Net working capital. The big US automakers used to have enormous negative working capital, despite having high levels of cash on the balance sheet. This proved disastrous when the financial crisis hit in 2008 and the economy contracted sharply. Auto sales—and thus revenues—fell, the auto companies cut production, and working capital consumed billions of dollars in cash as accounts payable came due when the companies most needed liquidity. 3. Operating cash flow. Analysts will project this figure out a few years and consider the risk that it may be lower than expected. 4. Committed bank lines. Committed but untapped lines of credit provide contingent liquidity in the event that the company is unable to tap other, potentially cheaper, financing in the public debt markets. 5. Debt coming due and committed capital expenditures in the next one to two years. Analysts will compare the sources of liquidity with the amount of debt coming due as well as with committed capital expenditures to ensure that companies can repay their debt and still invest in the business if the capital markets are somehow not available.

Wholesale Bank Funds

1. Central bank funds 2. Interbank deposits 3. Certificates of deposit

Major Categories of Fixed Income Investors

1. Central banks 2. Institutional investors: includes pension funds, hedge funds, charitable foundations, and endowments, insurance companies, and banks 3. Retail investors

Asset Collateral Backing: Types of Collateral Backing

1. Collateral trust bonds: bonds secured by securities such as common shares, other bonds, or other financial assets. Pledged by an issues and usually held by a trustee 2. Equipment trust certificates: bonds secured by specific types of equipment or physical assets such as aircraft and railroad cars. They are commonly issued to take advantage of the tax benefits of leasing. 3. Covered bonds: a debt instrument backed by a segregated pool of assets called a "cover pool". Covered bonds are like ABS but provide additional protection. A financial institution that sponsors ABS transfers the assets backing the bonds to a special legal entity. If the financial institution defaults, investors who hold bonds in the financial institution have no recourse against the special legal entity and its pool of assets because the special legal entity is a bankruptcy-remote vehicle; the only recourse they have is against the financial institution itself. In contrast, in the case of covered bonds, the pool of assets remains on the financial institution's balance sheet. In the event of default, bondholders have recourse against both the financial institution and the cover pool. Thus, the cover pool serves as collateral. If the assets that are included in the cover pool become non-performing (i.e., the assets are not generating the promised cash flows), the issuer must replace them with performing assets. Therefore, covered bonds usually carry lower credit risks and offer lower yields than otherwise similar ABS.

Swap Contracts

1. Commodity swap 2. Currency swap 3. Equity swap

Important Facts of Asset Based Valuation

1. Companies with assets that do not have easily determinable market (fair) values—such as those with significant property, plant, and equipment—are very difficult to analyze using asset valuation methods. 2. Asset and liability fair values can be very different from the values at which they are carried on the balance sheet of a company. 3. Some assets that are "intangible" are shown on the books of the company. Other intangible assets, such as the value from synergies or the value of a good business reputation, may not be shown on the books. Because asset-based valuation may not consider some intangibles, it can give a "floor" value for a situation involving a significant amount of intangibles. When a company has significant intangibles, the analyst should prefer a forward-looking cash flow valuation. 4. Asset values may be more difficult to estimate in a hyper-inflationary environment.

Credit: Capacity — Company Fundementals

1. Competitive position 2. Track record/operating history 3. Management's strategy and execution 4. Ratios and ratio analysis

Prepayment Risk

1. Contraction risk: risk that interest rates will decline, actual prepayments will be higher than forecasted b/c homeowners will refinance at now-available lower interest rates 2. Extension risk: the risk that when interest rates rise, prepayments will be lower than forecasted because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low.

Foward Contract Limitations

1. Counter party risk 2. Liquidity

Two Offsetting Types of Interest Rate Risk Affect Bond Investor

1. Coupon reinvestment risk 2. Market price risk

Factors Affecting Spreads on Corporate Bonds

1. Credit cycle. As the credit cycle improves, credit spreads will narrow. Conversely, a deteriorating credit cycle will cause credit spreads to widen. Spreads are tightest at or near the top of the credit cycle, when financial markets believe risk is low, whereas they are widest at or near the bottom of the credit cycle, when financial markets believe risk is high. 2. Broader economic conditions. Not surprisingly, weakening economic conditions will push investors to desire a greater risk premium and drive overall credit spreads wider. Conversely, a strengthening economy will cause credit spreads to narrow because investors anticipate credit measures will improve due to rising corporate cash flow, thus reducing the risk of default. 3. Financial market performance overall, including equities. In weak financial markets, credit spreads will widen, whereas in strong markets, credit spreads will narrow. In a steady, low-volatility environment, credit spreads will typically also narrow, as investors tend to "reach for yield." 4. Broker-dealers' willingness to provide sufficient capital for market making. Bonds trade primarily over the counter, so investors need broker-dealers to commit capital for market-making purposes. During the financial crisis in 2008-2009, several large broker-dealer counterparties either failed or were taken over by another. This, combined with financial and regulatory stresses faced by virtually all the other broker-dealers, greatly reduced the total capital available for making markets and the willingness to buy/sell credit-risky bonds. Future regulatory reform may well lead to persistent or even permanent reductions in broker-provided capital. 5. General market supply and demand. In periods of heavy new issue supply, credit spreads will widen if there is insufficient demand. In periods of high demand for bonds, spreads will move tighter.

Risks of Credit Rating Agencies

1. Credit ratings can change over time: the higher the credit rating, the greater the stability 2. Credit ratings tend to lag market's pricing of credit risk 3. Rating agencies make mistakes: examples are subprime mortgage misratings, and Enron, WorldCom, and Parmalat 4. Some risks are difficult to capture in credit ratings: examples are litigation risk, environmental risk and more.

Priority of Claims: Not Always Absolute

1. Creditors with a secured claim have the right to the value of that specific property before any other claim. If the value of the pledged property is less than the amount of the claim, then the difference becomes a senior unsecured claim. 2. Unsecured creditors have a right to be paid in full before holders of equity interests (common and preferred shareholders) receive value on their interests. 3. Senior unsecured creditors take priority over all subordinated creditors. A creditor is senior unsecured unless expressly subordinated.

Reasons for Differences b/t Yields

1. Currency—Bond X could be denominated in a currency with a higher expected rate of inflation than the currency in which Bond Y is denominated. 2. Credit risk—Bond X could have a non-investment-grade rating of BB, and Bond Y could have an investment-grade rating of AA. 3. Liquidity—Bond X could be illiquid, and Bond Y could be actively traded. 4. Tax Status—Interest income on Bond X could be taxable, whereas interest income on Bond Y could be exempt from taxation. 5. Periodicity—Bond X could make a single annual coupon payment, and its yield-to-maturity could be quoted for a periodicity of one. Bond Y could make monthly coupon payments, and its yield-to-maturity could be annualized for a periodicity of 12.

Reasons for High Yield

1. Highly leveraged capital structure 2. Weak or limited operating history 3. Limited or negative free cash flow 4. Highly cyclical business 5. Poor management 6. Risky financial policies 7. Lack of scale and/or competitive advantages 8. Large off-balance-sheet liabilities 9. Declining industry (e.g., newspaper publishing)

Credit: Capacity — Industry Fundementals

1. Cyclical or non-cyclical. This is a crucial assessment because industries that are cyclical—that is, have greater sensitivity to broader economic performance—have more volatile revenues, margins, and cash flows and thus are inherently riskier than non-cyclical industries. Consumer product and health care companies are typically considered non-cyclical, whereas auto and steel companies can be very cyclical. Companies in cyclical industries should carry lower levels of debt relative to their ability to generate cash flow over an economic cycle than companies in less-cyclical or non-cyclical industries. 2. Growth prospects. Although growth is typically a greater focus for equity analysts than for credit analysts, bond investors have an interest in growth as well. Industries that have little or no growth tend to consolidate via mergers and acquisitions. Depending upon how these are financed (e.g., using stock or debt) and the economic benefits (or lack thereof) of the merger, they may or may not be favorable to corporate bond investors. Weaker competitors in slow-growth industries may begin to struggle financially, adversely affecting their creditworthiness. 3. Published industry statistics. Analysts can get an understanding of an industry's fundamentals and performance by researching statistics that are published by and available from a number of different sources, including the rating agencies, investment banks, industry publications, and frequently, government agencies.

Orders 3: Validity

1. Day order: good for day when submitted 2. Good till canceled orders (GTC): stay active for long time 3. Immediate or cancel order (IOC): Immediate or cancel orders (IOC) are good only upon receipt by the broker or exchange. If they cannot be filled in part or in whole, they cancel immediately. In some markets these orders are also known as fill or kill orders. When searching for hidden liquidity, electronic algorithmic trading systems often submit thousands of these IOC orders for every order that they fill. 4. Good on close: can only be filled at the close of trading. These orders often are market orders, so traders call them market-on-close orders. Traders often use on-close orders when they want to trade at the same prices that will be published as the closing prices of the day. Mutual funds often like to trade at such prices because they value their portfolios at closing prices. Many traders also use good-on-open orders.

Credit: Capacity — Ratios & Ratio Analysis: Leverage Ratios

1. Debt/capital. Capital is calculated as total debt plus shareholders equity. This ratio shows the percent of a company's capital base that is financed with debt. A lower percentage of debt indicates lower credit risk. This traditional ratio is generally used for investment-grade corporate issuers. Where goodwill or other intangible assets are significant (and subject to obsolescence, depletion, or impairment), it is often informative to also compute the debt to capital ratio after assuming a write-down of the after-tax value of such assets. 2. Debt/EBITDA. This ratio is a common leverage measure. Analysts use it on a "snapshot" basis, as well as to look at trends over time and at projections and to compare companies in a given industry. Rating agencies often use it as a trigger for rating actions, and banks reference it in loan covenants. A higher ratio indicates more leverage and thus higher credit risk. Note that this ratio can be very volatile for companies with high cash flow variability, such as those in cyclical industries and with high operating leverage (fixed costs). 3. FFO/debt (Funds from operations/Debt) Credit rating agencies often use this leverage ratio. They publish key median and average ratios, such as this one, by rating category so analysts can get a sense of why an issuer is assigned a certain credit rating, as well as where that rating may migrate based on changes to such key ratios as this one. A higher ratio indicates greater ability to pay debt by funds from operations. — FFO = Net Income + Depreciation + Amortization - Gains on Sales of Property. 4. FCF after dividends/debt. A higher ratio indicates that a greater amount of debt can be paid off from free cash flow after dividend payments.

Payout Chronology of Dividends

1. Declaration date is set 2. Ex-dividend date, the first date the share trades w/out the dividend 3. Holder of record date: —Time b/t ex-dividend date and holder of record date is linked to the trade settlement cycle in force. 4. Payment date: day that company mails out dividend to shareholders

Components of Credit Risk

1. Default risk (default probability): the probability that a borrower defaults 2. Loss severity: the portion of a bond's value (including unpaid interest) an investor loses in a default

Two Models Used to Determine an Investor's Required Rate or Return

1. Dividend discount model 2. CAPM`

Assumption of Gordon

1. Dividends are the correct metric to use for valuation purposes. 2. The dividend growth rate is forever: It is perpetual and never changes. 3. The required rate of return is also constant over time. 4. The dividend growth rate is strictly less than the required rate of return.

Preference Shares are Less Risk Than Common b/c

1. Dividends on preference shares are known and fixed, and they account for a large portion of the preference shares' total return. Therefore, there is less uncertainty about future cash flows. 2. Preference shareholders receive dividends and other distributions before common shareholders. 3. The amount preference shareholders will receive if the company is liquidated is known and fixed as the par (or face) value of their shares. However, there is no guarantee that investors will receive that amount if the company experiences financial difficulty.

Credit: Capacity — Ratios & Ratio Analysis: Coverage Ratios

1. EBITDA/interest expense. This measurement of interest coverage is a bit more liberal than the one that uses EBIT because it does not subtract out the impact of (non-cash) depreciation and amortization expense. A higher ratio indicates higher credit quality. 2. EBIT/interest expense. Because EBIT does not include depreciation and amortization, it is considered a more conservative measure of interest coverage. This ratio is now used less frequently than EBITDA/interest expense.

Callable Bonds & Impact of Change in Benchmark Yield

Callable bonds require the use of Effective Duration Ben/c Macaulay and modified yield duration stats are not relevant

Credit: Capacity — Ratios & Ratio Analysis: Profitablity & Cash Flow

1. Earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA is a commonly used measure of cash flow that takes operating income and adds back depreciation and amortization expense because those are non-cash items. This is a somewhat crude measure of cash flow because it excludes certain cash-related expenses of running a business, such as capital expenditures and changes in (non-cash) working capital. Thus, despite its popularity as a cash flow measure, analysts look at other measures in addition to EBITDA. 2. Funds from operations (FFO). Standard & Poor's defines funds from operations as net income from continuing operations plus depreciation, amortization, deferred income taxes, and other non-cash items.24 3. Free cash flow before dividends (FCF before dividends).25 This measures excess cash flow generated by the company (excluding non-recurring items) before payments to shareholders or that could be used to pay down debt or pay dividends. It can be calculated as net income (excluding non-recurring items) plus depreciation and amortization minus increase (plus decrease) in non-cash working capital minus capital expenditures. This is, depending upon the treatment of dividends and interest in the cash flow statement, approximated by the cash flow from operating activities minus capital expenditures. Companies that have negative free cash flow before payments to shareholders will be consuming cash they have or will need to rely on additional financing—from banks, bond investors, or equity investors. This obviously represents higher credit risk. 4. Free cash flow after dividends (FCF after dividends). This measure just takes free cash flow before dividends and subtracts dividend payments. If this number is positive, it represents cash that could be used to pay down debt or build up cash on the balance sheet. Either action may be viewed as deleveraging, which is favorable from a credit risk standpoint. Some credit analysts will calculate net debt by subtracting balance sheet cash from total debt, although they shouldn't assume the cash will be used to pay down debt. Actual debt paid down from free cash flow is a better indicator of deleveraging. Some analysts will also deduct stock buybacks to get the "truest" measure of free cash flow that can be used to de-lever on either a gross or net debt basis; however, others view stock buybacks (share repurchases) as more discretionary and as having less certain timing than dividends, and thus treat those two types of shareholder payments differently when calculating free cash flow.

Life Cycle Stage

1. Embryonic 2. Growth 3. Shakeout 4. Mature 5. Declining

Industry Life Cycle Model

1. Embryonic: characteristics of the embryonic stage include slow growth and high prices because customers tend to be unfamiliar with the industry's product and volumes are not yet sufficient to achieve meaningful economies of scale. Increasing product awareness and developing distribution channels are key strategic initiatives of companies during this stage. Substantial investment is generally required, and the risk of failure is high. 2. Growth: a growth industry tends to be characterized by rapidly increasing demand, improving profitability, falling prices, and relativity low competition among companies in the industry. Industry profitability improves as volumes rise and economies of scale are attained. 3. Shakeout: the shakeout stage is usually characterized by slowing growth, intense competition, and declining profitability. During the shakeout stage, demand approaches market saturation levels because few new customers are left to enter the market. Competition is intense as growth becomes increasingly dependent on market share gains. Excess industry capacity begins to develop as the rate at which companies continue to invest exceeds the overall growth of industry demand. In an effort to boost volumes to fill excess capacity, companies often cut prices, so industry profitability begins to decline. During the shakeout stage, companies increasingly focus on reducing their cost structure (restructuring) and building brand loyalty. 4. Mature: characteristics of a mature industry include little or no growth, industry consolidation, and relatively high barriers to entry. Industry growth tends to be limited to replacement demand and population expansion because the market at this stage is completely saturated. As a result of the shakeout, mature industries often consolidate and become oligopolies. The surviving companies tend to have brand loyalty and relatively efficient cost structures, both of which are significant barriers to entry. 5. Decline: during the decline stage, industry growth turns negative, excess capacity develops, and competition increases. Industry demand at this stage may decline for a variety of reasons, including technological substitution (for example, the newspaper industry has been declining for years as more people turn to the internet and 24-hour cable news networks for information), social changes, and global competition (for example, low-cost foreign manufacturers pushing the US textile industry into decline). As demand falls, excess capacity in the industry forms and companies respond by cutting prices, which often leads to price wars. The weaker companies often exit the industry at this point, merge, or redeploy capital into different products and services.

Constructing a Peer Group

1. Examine commercial classification systems, if available to the analyst. These systems often provide a useful starting point for identifying companies operating in the same industry. 2. Review the subject company's annual report for a discussion of the competitive environment. Companies frequently cite specific competitors. 3. Review competitors' annual reports to identify other potential comparable companies. 4. Review industry trade publications to identify comparable companies. 5. Confirm that each comparable company derives a significant portion of its revenue and operating profit from a business activity similar to the primary business of the subject company.

Orders

1. Execution instructions: to to fill 2. Validity instructions: indicate when the order may be filled 3. Clearing instructions: indicate how to arrange the final settlement of trade Bid: prices at which dealers and traders are willing to buy Ask (offer): prices at which dealers and traders are willing to sell Market makers: traders that offer to trade Market takers: traders that trade with them Market bid ask spread: difference b/t best offer and best bid

High Barriers to Entry & Poor Pricing Power Reasons

1. First, price is a large component of the customer's purchase decision when buying from these companies in these industries. In some cases, the reason is that the companies (e.g., refiners) sell a commodity; in some cases, the product is expensive but has easily available substitutes. For example, most airlines choose between purchasing Boeing and Airbus airplanes not on brand but on cost-related considerations: Airlines need to transport people and cargo at the lowest possible cost per mile because the airlines have limited ability to pass along higher costs to customers. That consideration makes price a huge component of their purchase decision. Most airlines purchase whichever plane is the most cost efficient at any point in time. The result is that the Boeing Company and Airbus have limited ability to price their planes at a level that generates good returns on invested capital.9 2. Second, these industries all have high barriers to exit, which means they are prone to overcapacity. A refinery or automobile plant cannot be used for anything other than, respectively, refining oil or producing cars, which makes it hard to redeploy the capital elsewhere and exit the industry if conditions become unprofitable. This barrier gives owners of these types of assets a strong incentive to attempt to keep those loss-making plants operating, which, of course, prolongs conditions of overcapacity.

Uses of Market Index

1. Gauges of sentiment 2. Proxies for measuring and modeling returns, systemic risk, and risk adjusted return 3. Proxies for asset classes in asset allocation models 4. Benchmarks for actively managed portfolios 5. Model portfolios for such investment products as index funds and ETF

2 Categories of Local Government Debt

1. General obligaion (GO): unsecured bonds with the full faith and credit of the issuing non-sovereign government These bonds are supported by the taxing authority of the issuer. 2. Revenue bonds are issued for a specific project. — local governments, with little exception, must maintain a balanced budget.

Commercial Industry Classification Systems

1. Global industry classification standard (GCIS): designed to facilitate global comparisons of industries, and it classifies companies in both developed and developing economies. Each sub-industry belongs to a particular industry; each industry belongs to an industry group; and each group belongs to a sector. 2. Russel global sectors: uses three tier system to classify on the basis of products or services provided. 3. Industry classification benchmark (ICB): uses 4 tiers to divide company based on its source of revenue. Instead of sector, it uses the term industry. ICB also distinguishes b/t consumer goods and consumer services companies.

Factors Leading to Universal Use of Credit Ratings

1. Independent assessment of credit risk 2. Ease of comparison across bond issuers, issues, and market segments 3. Regulatory and statutory reliance and usage12 4. Issuer payment for ratings13 5. Huge growth of debt markets 6. Development and expansion of bond portfolio management and the accompanying bond indexes.

4 Types of ADR

1. L1 sponsored ADR: trade over the counter (OTC) and do not require full registration with the SEC. 2. L2 & L3 sponsored ADR: can trade on NYSE, AMEX, and NASDAQ. These ADRs allow companies to raise capital and make acquisitions but the issuing companies must fulfill all SEC requirements. 4. L4: does not require SEC registration. Instead, foreign companies are able to raise capital by privately placing these depository receipts with qualified institutional investors or to offshore non-US investors

External Influences on Industry Growth, Profitablity, & Risk

1. Macroeconomic 2. Technological 3. Demographic 4. Governmental 5. Social

Use of Forward Rates

1. Make maturity choice decisions 2. Identify artist rage opportunities b/t transactions non the cash market for bonds and derivatives market 3. Forwards are important for the valuation of derivatives, especially interest rate swaps and options

Execution Orders

1. Market order: instructs broker or exchange to obtain the best price immediately available when filling order 2. Limit order: obtain best price immediately available but in no even accept a price higher than a specified limit price when buying or selling 3. Marketable limit order: A buy limit order in which the limit price is placed above the best offer, or a sell limit order in which the limit price is placed below the best bid. Such orders generally will partially or completely fill right away. * buy order set at best bid makes the market. 4. Behind the market: order placed below the best bid 5. Standing limit orders: limit orders waiting to trade.

Driving Factors Behind Spread Changes

1. Modified duration 2. Magnitude of the spread change for example, Price impact ≈ -ModDur * ∆Spread for larger spread changes convexity becomes an issue, Price impact ≈ -(ModDur*∆Spread) + (¹₂*Convexity*(∆Spread)²) In this case, one must be careful to ensure that convexity (denoted by Cvx) is appropriately scaled to be consistent with the way the spread change is expressed. In general, for bonds without embedded options, one can scale convexity so that it has the same order of magnitude as the duration squared and then express the spread change as a decimal. For example, for a bond with duration of 5.0 and reported convexity of 0.235, one would re-scale convexity to 23.5 before applying the formula. For a 1 percent (i.e., 100 bps) increase in spread, the result would be Longer duration of the bond, the greater the price volatility for a given change in interest rates/yields

Key Issues for Sovereign Debt Analysis

1. a government's ability to pay and 2. its willingness to pay. Willingness to pay is important because, due to the principle of sovereign immunity, investors are generally unable to force a sovereign to pay its debts. Sovereign immunity prevents governments from being sued.

Order Driven Markets Rules

1. Order matching rules: — order precedence hierarchy: A. Price priority: highest buy and lowest sale sold first. B. Secondary precedence rules: determine how to rank orders at the same price and generally work on a first come first served basis. Also, displayed orders take precedence. 2. Trade pricing rules: — Order pricing rule: all trades execute at the same price — Discriminatory pricing rule: a pricing rule used in continuous markets in which the limit price of the order or quote that first arrived determines the trade price. Under this rule, the limit price of the order or quote that first arrived—the standing order—determines the trade price. This rule allows a large arriving trader to discriminate among standing limit orders by filling the most aggressively priced orders first at their limit prices and then filling less aggressively priced orders at their less favorable (from the point of view of the arriving trader) limit prices. — Derivative pricing rule: A. Crossing networks: trading systems that match buyers and sellers who are wiling to trade at prices obtained from other markets. B. Derivative pricing rule: the name given to crossing networks b/c the price on one market is derived from another.

3 Major Categories of Equity Valuation Models

1. Present value models (discounted cash flow models): may be in terms of dividend discount models or in terms of free cash flow to equity models (cash flow available to shareholders after meeting CapEx and working capital needs) 2. Multiplier models (market multiple models): based chiefly on share price or enterprise value multiples. — Enterprise value models have the form Eneterprise value/Value of fundemental variable. Two choices for the denominator are EBITDA and total revenue. — Enterprise value: measure of a company's total market value from which cash and short term investments have been subtracted 3. Asset-based valuation models: These models estimate intrinsic value of a common share from the estimated value of the assets of a corporation minus the estimated value of its liabilities and preferred shares. The estimated market value of the assets is often determined by making adjustments to the book value (synonym: carrying value) of assets and liabilities. The theory underlying the asset-based approach is that the value of a business is equal to the sum of the value of the business's assets.

Index Weighting

1. Price weighted 2. Equal weighted 3. Market capt weighted 4. Fundamentally weighted

Credit: Capacity — Ratios & Ratio Analysis

1. Profitablity and cash flow 2. Leverage 3. Coverage

Execution Mechanisms

1. Quote driven market: customers trade with dealers. Almost all bonds and currencies and most spot commodities trade in quote-driven markets. Traders call them quote-driven (or price-driven or dealer) because customers trade at the prices quoted by dealers. 2. Order driven market: an order matching system run by an exchange. Almost all exchanges use order driven trade practices. 3. Brokered markets: brokers arrange trades b/t their customers. More common for transactions of unique instruments- real estate, intellectual properties, or large blocks of securities

Debt Recovery Notes

1. Recovery rates vary widely by industry: companies in secular decline tend to go bankrupt and have less recovery than cyclical industries 2. Recovery rates vary depending on when they occur in the credit cycle. Being in the bottom of the credit cycle will cause less recovery 3. The recovery rates are averages

Funding Alt for Banks: Short Term Wholesale Funds

1. Reserve funds: a fund banks maintain with central banks to support their depositors. — Central bank funds market: The market in which deposit-taking banks that have an excess reserve with their national central bank can loan money to banks that need funds for maturities ranging from overnight to one year. Called the Federal or Fed funds market in the United States. — The most widely followed rate is known as the Fed funds effective rate, which is the volume-weighted average of rates for Fed fund trades arranged throughout the day by the major New York City brokers. Fed funds are traded between banks and other financial institutions globally and may be transacted directly or through money market brokers. 2. Interbank funds: the market of loans and deposits between banks. Term to maturity is overnight to one year. The rate on an interbank loan or deposit can be quoted relative to a reference rate, such as an interbank offered rate or as a fixed interest rate. An interbank deposit is unsecured, so banks placing deposits with another bank need to have an interbank line of credit in place for that institution. Usually, a large bank will make a two-way price, indicating the rate at which it will lend funds and the rate at which it will borrow funds for a specific maturity, on demand. Interest on the deposit is payable at maturity 3. Certificates of deposit

Negative Covenant Examples

1. Restrictions on debt regulate the issue of additional debt. Maximum acceptable debt usage ratios (sometimes called leverage ratios or gearing ratios) and minimum acceptable interest coverage ratios are frequently specified, permitting new debt to be issued only when justified by the issuer's financial condition. 2. Negative pledges prevent the issuance of debt that would be senior to or rank in priority ahead of the existing bondholders' debt. 3. Restrictions on prior claims protect unsecured bondholders by preventing the issuer from using assets that are not collateralized (called unencumbered assets) to become collateralized. 4. Restrictions on distributions to shareholders restrict dividends and other payments to shareholders such as share buy-backs (repurchases). The restriction typically operates by reference to the borrower's profitability; that is, the covenant sets a base date, usually at or near the time of the issue, and permits dividends and share buy-backs only to the extent of a set percentage of earnings or cumulative earnings after that date. 5. Restrictions on asset disposals set a limit on the amount of assets that can be disposed by the issuer during the bond's life. The limit on cumulative disposals is typically set as a percentage of a company's gross assets. The usual intent is to protect bondholder claims by preventing a break-up of the company. 6. Restrictions on investments constrain risky investments by blocking speculative investments. The issuer is essentially forced to devote its capital to its going-concern business. A companion covenant may require the issuer to stay in its present line of business. 7. Restrictions on mergers and acquisitions prevent these actions unless the company is the surviving company or unless the acquirer delivers a supplemental indenture to the trustee expressly assuming the old bonds and terms of the old indenture. These requirements effectively prevent a company from avoiding its obligations to bondholders by selling out to another company.

Implications of the Efficient Market Hypothesis

1. Securities markets are weak-form efficient, and therefore, investors cannot earn abnormal returns by trading on the basis of past trends in price. 2. Securities markets are semi-strong efficient, and therefore, analysts who collect and analyze information must consider whether that information is already reflected in security prices and how any new information affects a security's value.21 3. Securities markets are not strong-form efficient because securities laws are intended to prevent exploitation of private information.

Asset Collateral Backing: Seniority Ranking

1. Seniority ranking — secured bonds: backed by the assets or financial guarantees pledged to ensure debt repayment — unsecured bonds: no collateral and bondholders only have a general claim on the assets and cash flow — senior debt: debt that has a priority claim over subordinated debt or junior debt — debentures: a type of bond that may be secured or unsecured. In many jurisdictions, debentures are unsecured bonds, with no collateral backing assigned to the bondholders. In contrast, bonds known as "debentures" in the United Kingdom and in other Commonwealth countries, such as India, are usually backed by an asset or pool of assets assigned as collateral support for the bond obligations and segregated from the claims of other creditors.

Cross Sectonal Anomalies

1. Size effect: small cap tend to outperform large cap on a risk adjusted basis, but has since not been seen 2. Value effect: a number of global empirical studies have shown that value stocks, which are generally referred to as stocks that have below-average price-to-earnings (P/E) and market-to-book (M/B) ratios, and above-average dividend yields, have consistently outperformed growth stocks over long periods of time.34 If the effect persists, the value stock anomaly contradicts semi-strong market efficiency because all the information used to categorize stocks in this manner is publicly available.

Credit Related Risks

1. Spread risk: yields widen based on two factors — a decline Int eh issuers creditworthiness — an increase in the market liquidity risk 2. Credit migration risk or downgrade risk: risk that an issuer's creditworthiness deteriorates, or migrates lower, leading investors to believe the risk of default i higher and causing the yield spreads on the bonds to widen and the price of bonds to fall 3. Market liquidity risk: risk that prices at which investors can transact are different from the price indicated but the market. Determinants of market liquidity risk are: — size of issuer (amount of publicly traded debt an issuer has outstanding) — credit quality of issuer

Orders 4: Stop Orders

1. Stop order: a trader has specified a stop price condition and order may not be filled until the stop price condition is satisfied. For a sell order, the stop price condition suspends execution of the order until a trade occurs at or below the stop price. After that trade, the stop condition is satisfied and the order becomes valid for execution, subject to all other execution instructions attached to it. If the market price subsequently rises above the sell order's stop price before the order trades, the order remains valid. Similarly, a buy order with a stop condition becomes valid only after a price rises above the specified stop price. 2. Stop loss order:

Call Protection CMBS

1. Structure level: the creation of sequential-pay tranches is an example of call protection at the structure level. 2. Loan level: at the loan level, four mechanisms offer investors call protection: prepayment lockouts, prepayment penalty points, yield maintenance charges, and defeasance.

Credit Enhancements: Internal

1. Subordination (credit trenching): commonly referred to as a waterfall structure. It relies on creating more than one bond class or tranche and ordering the claim priorities for ownership or interest in an asset between the tranches. The cash flows generated by the assets are allocated with different priority to tranches of different seniority. The ordering of the claim priorities is called a senior/subordinated structure, where the tranches of highest seniority are called senior followed by subordinated or junior tranches. The subordinated tranches function as credit protection for the more senior tranches, in the sense that the most senior tranche has the first claim on available cash flows. 2. Overcollateraiztion: A major problem associated with overcollateralization is the valuation of the collateral. 3. Reserve accounts (reserve funds): two types — cash reserve fundL: deposit of cash that may be used to absorb loss — excess spread: involves the allocation into an account of any amounts left over after paying out the interest to bondholders. The excess spread, sometimes called excess interest cash flow, is the difference between the cash flow received from the assets used to secure the bond issue and the interest paid to bondholders. In a process called turboing, the excess spread can be used to retire the principal, with the most senior tranche having the first claim on these funds.

Limitations on Industry Life Cycle Analysis

1. Technological changes: may cause abrupt shift from growth to decline 2. Regulatory changes: 3. Social changes: 4. Demographics;

Bond Price & Bond Characteristics

1. The bond price is inversely related to the market discount rate. When the market discount rate increases, the bond price decreases (the inverse effect). 2. For the same coupon rate and time-to-maturity, the percentage price change is greater (in absolute value, meaning without regard to the sign of the change) when the market discount rate goes down than when it goes up (the convexity effect). 3. For the same time-to-maturity, a lower-coupon bond has a greater percentage price change than a higher-coupon bond when their market discount rates change by the same amount (the coupon effect). 4. Generally, for the same coupon rate, a longer-term bond has a greater percentage price change than a shorter-term bond when their market discount rates change by the same amount (the maturity effect).

3 Important Elements of a Bond

1. The bond's features, including the issuer, maturity, par value, coupon rate and frequency, and currency denomination. These features determine the bond's scheduled cash flows and, therefore, are key determinants of the investor's expected and actual return. 2. The legal, regulatory, and tax considerations that apply to the contractual agreement between the issuer and the bondholders. 3. The contingency provisions that may affect the bond's scheduled cash flows. These contingency provisions are options; they give the issuer or the bondholders certain rights affecting the bond's disposal or redemption.

Convertible Bonds: Key Terms

1. The conversion price is the price per share at which the convertible bond can be converted into shares. 2. The conversion ratio is the number of common shares that each bond can be converted into. The indenture sometimes does not stipulate the conversion ratio but only mentions the conversion price. The conversion ratio is equal to the par value divided by the conversion price. For example, if the par value is 1,000€ and the conversion price is 20€, the conversion ratio is 1,000€ ÷ 20€ = 50:1, or 50 common shares per bond. 3. The conversion value, sometimes called the parity value, is the current share price multiplied by the conversion ratio. For example, if the current share price is 33€ and the conversion ratio is 30:1, the conversion value is 33€ × 30 = 990€. 4. The conversion premium is the difference between the convertible bond's price and its conversion value. For example, if the convertible bond's price is 1,020€ and the conversion value is 990€, the conversion premium is 1,020€ - 990€ = 30€. 5. Conversion parity occurs if the conversion value is equal to the convertible bond's price. Using the previous two examples, if the current share price is 34€ instead of 33€, then both the convertible bond's price and the conversion value are equal to 1,020€ (i.e., a conversion premium equal to 0). This condition is referred to as parity. If the common share is selling for less than 34€, the condition is below parity. In contrast, if the common share is selling for more than 34€, the condition is above parity.

Factors Affecting Repo Rate

1. The risk associated with the collateral. Repo rates are typically lower for highly rated collaterals, such as highly rated sovereign bonds. They increase with the level of credit risk associated with the collateral underlying the transaction. 2. The term of the repurchase agreement. Repo rates generally increase with maturity because long-term rates are typically higher than short-term rates in normal circumstances. 3. The delivery requirement for the collateral. Repo rates are usually lower when delivery to the lender is required. 4. The supply and demand conditions of the collateral. The more scarce a specific piece of collateral, the lower the repo rate against it because the borrower has a security that lenders of cash want for specific reasons, perhaps because the underlying issue is in great demand. The demand for such collateral means that it considered to be "on special." Collateral that is not special is known as "general collateral." The party that has a need for collateral that is on special is typically required to lend funds at a below-market repo rate to obtain the collateral. 5. The interest rates of alternative financing in the money market. Any coupon paid on the security during the repurchase agreement is kept by the seller of the security (borrower of cash)

5 Determinates of the Intensity of Competition in an Industry

1. The threat of entry to the industry, which depends on barriers to entry, or how difficult it would be for new competitors to enter the industry. Industries that are easy to enter will generally be more competitive than industries with high barriers to entry. 2. The power of suppliers, which may be able to raise prices or restrict the supply of key inputs to a company. For example, workers at a heavily unionized company may have greater bargaining power as suppliers of labor than workers at a comparable non-unionized company. Suppliers of scarce or limited parts or elements often possess significant pricing power. 3. The power of buyers, which can affect the intensity of competition by exerting influence on suppliers regarding prices (and possibly other factors such as product quality). For example, auto parts companies generally sell to a small number of auto manufacturers, which allows those customers, the auto manufacturers, to be tough negotiators when it comes to setting prices. 4. The threat of substitutes, which can negatively affect demand if customers choose other ways of satisfying their needs. For example, consumers may trade down from premium beers to discount brands during recessions. Low-priced brands may be close substitutes for premium brands, which, when consumer budgets are constrained, reduces the ability of premium brands to maintain or increase prices. Substitutes do not have to be similar but can satisfy a need with a very different product. 5. The rivalry among existing competitors, which is a function of the industry's competitive structure. Industries that are fragmented among many small competitors, have high fixed costs, provide undifferentiated (commodity-like) products, or have high exit barriers usually experience more intense rivalry than industries without these characteristics.

Main Functions of Financial System

1. achievement of the purposes for which people use the financial system 2. the discovery of the rates of return that equate aggregate savings with aggregate borrowings 3. allocation of capital to the best uses

Fixed Income Indexes: Challenges

1. availability of pricing information 2. number of securities 3. liquidity of the securities

Credit: Capacity — Industry Structure

1. Threat of entry. Threat of entry depends on the extent of barriers to entry and the expected response from incumbents to new entrants. Industries with high entry barriers tend to be more profitable and have lower credit risk than industries with low entry barriers because incumbents do not need to hold down prices or take other steps to deter new entrants. High entry barriers can take many forms, including high capital investment, such as in aerospace; large, established distribution systems, such as in auto dealerships; patent protection, such as in technology or pharmaceutical industries; or a high degree of regulation, such as in utilities. 2. Power of suppliers. An industry that relies on just a few suppliers tends to be less profitable and to have greater credit risk than an industry that has multiple suppliers. Industries and companies with just a few suppliers have limited negotiating power to keep the suppliers from raising prices, whereas industries that have many suppliers can play them off against each other to keep prices in check. 3. Power of buyers/customers. Industries that rely heavily on just a few main customers have greater credit risk because the negotiating power lies with the buyers. For example, a toolmaker that sells 50 percent of its products to one large global retailer has limited negotiating power with its principal customer. 4. Threat of substitutes. Industries (and companies) that offer products and services that provide great value to their customers, and for which there are not good or cost-competitive substitutes, typically have strong pricing power, generate substantial cash flows, and represent less credit risk than other industries or companies. Certain (patent-protected) drugs are an example. Over time, however, disruptive technologies and inventions can increase substitution risk. For example, years ago, airplanes began displacing many trains and steamships. Newspapers were considered to have a nearly unassailable market position until television and then the internet became substitutes for how people received news and information. Over time, recorded music has shifted from records to tapes, to compact discs, to mp3s and other forms of digital media. 5. Rivalry among existing competitors. Industries with strong rivalry—because of numerous competitors, slow industry growth, or high barriers to exit—tend to have less cash flow predictability and, therefore, higher credit risk than industries with less competition. Regulation can affect the extent of rivalry and competition. For example, regulated utilities typically have a monopoly position in a given market, which results in relatively stable and predictable cash flows.

Traditional Investment Market vs. Alternative Investment Market

1. Traditional: Markets for traditional investments, which include all publicly traded debts and equities and shares in pooled investment vehicles that hold publicly traded debts and/or equities. 2. Alternative: Market for investments other than traditional securities investments (i.e., traditional common and preferred shares and traditional fixed income instruments). The term usually encompasses direct and indirect investment in real estate (including timberland and farmland) and commodities (including precious metals); hedge funds, private equity, and other investments requiring specialized due diligence.

Classification of Fixed Income Markets

1. Type of issuer 2. Bonds credit quality 3. Maturity 4. Currency 5. Type of coupon 6. Where the bond is traded

Uses of Industy Analysis

1. Understanding a company's business and environment 2. Identifying active equity investment opportunities: industry membership has been found to account for at least 20% of the variability of a company's profitability in the US 3. Portfolio performance attribution:

Public Offerings

1. Underwritten offerings (firm commitment offering): the investment bank guarantees the sale of the bond issue at an offering price that is negotiated with the issuer. The investment bank, underwriter, takes the risk associated with the bonds. 2. Best effort offering: investment bank serves only as a broker 3. Auction: bond sales via bidding

Alternatives to Gordon Growth Model

1. Use a more robust DDM that allows for varying patterns of growth. 2. Use a cash flow measure other than dividends for valuation purposes. 3. Use some other approach (such as a multiplier method) to valuation.

3 Main Types of Private Equity

1. Venture capital 2. Leveraged buyouts 3. Private investment in public equity

Forms of Market Efficiency

1. Weak 2. Semi-strong 3. Strong

Questions for Analyzing an Industry

1. What are the barriers to entry? Is it difficult or easy for a new competitor to challenge incumbents? Relatively high (low) barriers to entry imply that the threat of new entrants is relatively low (high). 2. How concentrated is the industry? Do a small number of companies control a relatively large share of the market, or does the industry have many players, each with a small market share? 3. What are capacity levels? That is, based on existing investment, how much of the goods or services can be delivered in a given time frame? Does the industry suffer chronic over- or under-capacity, or do supply and demand tend to come into balance reasonably quickly in the industry? 4. How stable are market shares? Do companies tend to rapidly gain or lose share, or is the industry stable? 5. Where is the industry in its life cycle? Does it have meaningful growth prospects, or is demand stagnant/declining? 6. How important is price to the customer's purchase decision?

Questions Which May Improve a List of Peer Companies

1. What proportion of revenue and operating profit is derived from business activities similar to those of the subject company? In general, a higher percentage results in a more meaningful comparison. 2. Does a potential peer company face a demand environment similar to that of the subject company? For example, a comparison of growth rates, margins, and valuations may be of limited value when comparing companies that are exposed to different stages of the business cycle. (As mentioned, such differences may be the result of conducting business in geographically different markets.) 3. Does a potential company have a finance subsidiary? Some companies operate a finance division to facilitate the sale of their products (e.g., Caterpillar Inc. and John Deere). To make a meaningful comparison of companies, the analyst should make adjustments to the financial statements to lessen the impact that the finance subsidiaries have on the various financial metrics being compared.

Summary of the Relationship b/t Coupon Rate & Market Discount Rate

1. When the coupon rate is less than the market discount rate, the bond is priced at a discount below par value. 2. When the coupon rate is greater than the market discount rate, the bond is priced at a premium above par value. 3. When the coupon rate is equal to the market discount rate, the bond is priced at par value.

General Relationship Among Interest Rate Risk, MacDur, and Investment Horizon

1. When the investment horizon is greater than the Macaulay duration of a bond, coupon reinvestment risk dominates market price risk. The investor's risk is to lower interest rates. 2. When the investment horizon is equal to the Macaulay duration of a bond, coupon reinvestment risk offsets market price risk. 3. When the investment horizon is less than the Macaulay duration of the bond, market price risk dominates coupon reinvestment risk. The investor's risk is to higher interest rates.

Objectives of Market Regulations

1. control fraud; 2. control agency problems; 3. promote fairness; 4. set mutually beneficial standards; 5. prevent undercapitalized financial firms from exploiting their investors by making excessively risky investments; and 6. ensure that long-term liabilities are funded.

3 Major Approaches to Industry Classification

1. products and/or services supplied 2. business cycle sensitivities 3. statistical similarities

Elements that Should be Covered in a Company Analysis

1. provide an overview of the company (corporate profile), including a basic understanding of its businesses, investment activities, corporate governance, and perceived strengths and weaknesses; 2. explain relevant industry characteristics; 3. analyze the demand for the company's products and services; 4. analyze the supply of products and services, which includes an analysis of costs; 5. explain the company's pricing environment; and 6. present and interpret relevant financial ratios, including comparisons over time and comparisons with competitors.

Effective Duration & Credit

Effective Duration Amy be used to determine credit duration - the sensitity of the bond price to a change in the credit spread

Other Behavioral Biases

1. representativeness—investors assess new information and probabilities of outcomes based on similarity to the current state or to a familiar classification; 2. mental accounting—investors keep track of the gains and losses for different investments in separate mental accounts and treat those accounts differently; 3. conservatism—investors tend to be slow to react to new information and continue to maintain their prior views or forecasts; and 4. narrow framing—investors focus on issues in isolation and respond to the issues based on how the issues are posed.

Purpose of Financial System

1. save money for the future 2. borrow money for current use 3. raise equity capital 4. manage risks 5. exchange assets for immediate and future deliveries 6. trade on information

Reasons for Share Repurchase

1. signaling a belief that their shares are undervalued (or, more generally, to support share prices), 2. flexibility in the amount and timing of distributing cash to shareholders, 3. tax efficiency in markets where tax rates on dividends exceed tax rates on capital gains, and 4. the ability to absorb increases in outstanding shares because of the exercise of employee stock options.

Importance of Yield Volatility in Measuring Interest Rate Risk is a Product of 2 Factors

1. the impact per bp ∆ in YTM: first factor is duration or the combination of duration and convexity 2. the # of bp in the ∆YTM: the yield volatility

Fragmented Industry Price Competition

1. the large number of companies makes coordination difficult b/c there are too many competitors for each industry member to monitor 2. each player has such a small piece of the market that even a small gain in the market share can make a meaningful difference to its fortunes, which increases the incentive of each company to undercut prices and steal share. 3. the large number of players lead the industry members to think of themselves individualistically whitich leads to fierce competition.

Careful Areas of Review for Investors

1. the legal identity of the bond issuer and its legal form; 2. the source of repayment proceeds; 3. the asset or collateral backing (if any); 4. the credit enhancements (if any); and 5. the covenants (if any).

Bond Option Pricing Model Inputs

1. the length of the call protection period 2. the schedule of call prices and call dates 3. an assumption about credit spreads over benchmark yields (includes liquidity spread as well) 4. an assumption about the future interest rate volatility 5. the level of market interest rates

Mortgage Design

1. the maturity of the loan 2. how the interest rate is determined 3. how the principal is to be repaid 4. whether the borrower has the option to prepay and whether any prepayment penalties might be imposed 5. the rights of the lender in a foreclosure

US MBS are Dividided into 3 Sectors

1. those guaranteed by a federal agency 2. those guaranteed by a GSE 3. those issued by private entities and that are not guaranteed by a federal agency or a GSE

Questions for Review & Answers

1. which of these represent ownership in corporations? common and preferred stocks 2. which of these are debt instruments? corporate bonds, mortgages, treasury notes, bank deposits, certificates of deposits 3. which of these are created by traders rather than issuers? lumber forward contracts, crude oil futures contracts, interest rate swaps 4. which of these are pooled investment vehicles? ETF, hedge funds, mutual funds 5. which of these are real assets? real estate parcels 6. which of these would a home builder use to hedge construction costs? lumber contracts 7. which of these would a corporation trade when moving cash balances among various countries? currencies,

Classification by Issuer

3 sectors: 1. Government and government related 2. Corporate sector: financial and non financial entities 3. Structured finance sector: includes bonds created by securitization, a process that transforms private transactions b/t borrowers and lenders into securities traded in the public market

CMBS Call Protection

4 mechanisms of call protection in CMBS 1. A prepayment lockout, which is a contractual agreement that prohibits any prepayments during a specified period of time. 2. Prepayment penalty points, which are predetermined penalties that a borrower who wants to refinance must pay to do so—a point is equal to 1% of the outstanding loan balance. 3. A yield maintenance charge, also called a "make-whole charge," which is a penalty paid by the borrower that makes refinancing solely to get a lower mortgage rate uneconomical for the borrower. In its simplest terms, a yield maintenance charge is designed to make the lender indifferent as to the timing of prepayments. 4. Defeasance, for which the borrower provides sufficient funds for the servicer to invest in a portfolio of government securities that replicates the cash flows that would exist in the absence of prepayments. The cash payments that must be met by the borrower are projected on the basis of the terms of the loan. Then, a portfolio of government securities is constructed in such a way that the interest payments and the principal repayments from the portfolio will be sufficient to pay off each obligation when it comes due. When the last obligation is paid off, the value of the portfolio is zero (that is, there are no funds remaining). The cost of assembling such a portfolio is the cost of defeasing the loan that must be repaid by the issuer.

ApproxCon

ApproxCon = (PV_ ) + (PV+) - [2*(PV₀)]/(∆Yield)² * (PV₀) These are full prices.

Annualized Convexity

= periodicity squared.

Floating Rate Notes (FRN/Floaters)

Coupon of a FRN usually contains a reference rate and a spread. Spread is also called a margin and is expressed in basis points (bps). A basis point equals .01%, meaning there are 100 bps in 1%

Step-Up Coupon Bonds

Coupon of a step-up bond, may be fixed or floating, increases by a specified margin at specified dates.

Funding Alt Banks: Repurchase & Reverse Repurchase Agreements

A form of collateralized loan involving the sale of a security with a simultaneous agreement by the seller to buy the same security back from the purchaser at an agreed-on price and future date. The party who sells the security at the inception of the repurchase agreement and buys it back at maturity is borrowing money from the other party, and the security sold and subsequently repurchased represents the collateral.

Funding Alt for Banks: Large Denomination Negotiable Certificates of Deposit (CD)

A CD is an instrument that represents a specified amount of funds on deposit for a specified maturity and interest rate. It may be one of two forms: 1. Negotiable: this allows the depositor (initial or subsequent) to sell the CD prior to its maturity. Two types of negotiable CDs: A. Large denomination: issued at 1M or more and are typically traded among institutional investors. B. Small denomination: 2. Non negotiable: the deposit plus the interest are paid to the depositor at maturity. A withdrawal penalty is imposed if the depositor withdraws early

Global Depository Receipts (GDR)

A GDR is issued outside the company's home country and outside the US. A key advantage of GDRs is that they are not subject to the foreign ownership and capital flow restrictions that may be imposed by the issuing company's home country because they are sold outside of that country.

American Depository Receipts (ADR)

A US dollar-denominated security that trades like a common share on US exchanges. First created in 1927, ADRs are the oldest type of depository receipts and are currently the most commonly traded depository receipts. They enable foreign companies to raise capital from US investors. Note that an ADR is one form of a GDR; however, not all GDRs are ADRs because GDRs cannot be publicly traded in the United States.

Non-Sovereign Bonds

A bond issued by a government below the national level, such as a province, region, state, or city.

Supranational Bonds

A bond issued by a supranational agency such as the World Bank. Typically plain vanilla bonds, although floating rate bonds and callable bonds are sometimes issued.

Quasi-Government Bonds (Agency Bond)

A bond issued by an entity that is either owned or sponsored by a national government. Also called agency bond. Examples in the US include Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Home Loan Bank (FHLB) Quasi bonds are generally rated high and may or may not be backed by collateral.

Plain Vanilla Bond (Conventional Bond)

A bond that pays a fixed interest rate.

Inverse FRN

A bond who's coupon rate has an inverse relationship to the reference rate.

Index Linked Bonds

A bond whose coupon and/or principal payment is liked to a specific index. Index may be any published variable. Inflation linked bonds are an example of index linked bonds. Linkers: inflation linked bonds issued by governments.

Duration Gap

A bond's Macaulay duration minus the investment horizon. The difference b/t the MacDur of a bond and the investment horizon.

Current Yield (Income/Interest Yield)

A bond's annual coupon divided by its price.

Bond Equivalent Yield (BEY)

A calculation of yield that is annualized using the ratio of 365 to the number of days to maturity. Bond equivalent yield allows for the restatement and comparison of securities with different compounding periods. It is a MM yield stated on a 365 AOR basis.

Collateralized Debt Obligation (CDO)

A generic term used to describe a security backed by a diversified pool of one or more debt obligations: CDOs backed by corporate and emerging market bonds are collateralized bond obligations (CBOs); CDOs backed by leveraged bank loans are collateralized loan obligations (CLOs); CDOs backed by ABS, RMBS, CMBS, and other CDOs are structured finance CDOs; CDOs backed by a portfolio of credit default swaps for other structured securities are synthetic CDOs.

Constant Yield Price Trajectory

A graph that illustrates the change in the price of a fixed-income bond over time assuming no change in yield-to-maturity. The trajectory shows the "pull to par" effect on the price of a bond trading at a premium or a discount to par value.

Support Tranche

A class or tranche in a CMO that protects the PAC tranche from prepayment risk. The greater predictability of the cash flows for the PAC tranches occurs because a principal repayment schedule must be satisfied. As long as the prepayment rate is within the specified band, called the PAC band, all prepayment risk is absorbed by the support tranche. If the collateral prepayments are slower than forecasted, the support tranches do not receive any principal repayment until the PAC tranches receive their scheduled principal repayment. This rule reduces the extension risk of the PAC tranches. Similarly, if the collateral prepayments are faster than forecasted, the support tranches absorb any principal repayments in excess of the scheduled principal repayments. This rule reduces the contraction risk of the PAC tranches. Even if the prepayment rate is outside the PAC band, prepayment risk is first absorbed by the support tranche. Thus, the key to the prepayment protection that PAC tranches offer investors is the amount of support tranches outstanding. If the support tranches are paid off quickly because of faster-than-expected prepayments, they no longer provide any protection for the PAC tranches.

Contingency Provision

A clause in a legal document that allows for some action if the event or circumstance does occur. Embedded option: Contingency provisions that provide the issuer or the bondholders the right, but not the obligation, to take action. These options are not part of the security and cannot be traded separately. Types are: 1. Callable 2. Putable 3. Convertible

Closed End Invstment Fund Discounts

A closed-end investment fund issues a fixed number of shares at inception and does not sell any additional shares after the initial offering. Therefore, the fund capitalization is fixed unless a secondary public offering is made. The shares of closed-end funds trade on stock markets like any other shares in the equity market (i.e., their prices are determined by supply and demand).

Global Registered Share (GRS)

A common share that is traded on different stock exchanges around the world in different currencies.

Credit: Collateral & Market Cap

A company who's market cap is below its book value may indicate the company's assets are overvalued.

Effective Convexity

A curve convexity statistic that measures the secondary effect of a change in a benchmark yield curve on a bond's price.

FI: Broker Dealer

A dealer that brokers orders. This can create a conflict of interest and clients should be mindful.

Depository Receipt (DR)

A depository receipt is created when the equity shares of a foreign company are deposited in a bank (i.e., the depository) in the country on whose exchange the shares will trade. The depository then issues receipts that represent the shares that were deposited.

American Depository Shares (ADS)

A depository share is a security that is actually traded in the issuing company's domestic market. That is, while American depository receipts are the certificates that are traded on US markets, American depository shares are the underlying shares on which these receipts are based.

Maturity Structure (Term Structure)

A factor explaining the differences in yields on similar bonds; also called term structure.

Convertible Bonds

A hybrid security with debt and equity features. It gives the bondholder the right to convert into equity and participate in upside while also receiving downside protection. Coupon rate on convertible bond is typically higher than the dividend on the underlying share. From an issuer perspective the advantages of convertibles are: 1. Reduced interest expense 2. Elimination of debt if the conversion option is exercised.

Accounting Return on Equity

A key ratio used to determine management efficiency is the accounting return on equity, ROE. It is the return earned on equity capital. It indicates how efficient a firm is generating profits from every dollar of net assets. ROE = NI/average BV of equity = NI (t) / [(BVE eop + BVE bop)/2]. Directly influenced by accounting methods so not comparable always. An increase in ROE may be the result of net income decreasing at a slower rate than shareholder's equity. Declining net income is concerning The increase in ROE may be the result of debt issuance used to repurchase shares, which increases leverage/risk. Use DuPont analysis to break down what is causing a change in ROE

Bond Indenture (Trusty Deed)

A legal document that specifies both the rights of the bondholders and the duties of the issuing corporation Specifies, 1. Principal value 2. Coupon rate 3. Dates when payments will be made 4. Contingency provisions 5. Funding sources 6. Collateral 7. Credit enhancements or covenants

Mortgage Loan

A loan secured by the collateral of some specific real estate property.

Sequential Pay CMO Structure

A major problem that remains is the considerable variability of the average lives of the tranches. How this problem can be handled is shown in the next section, but at this point, note that some protection against prepayment risk is provided for each tranche. The protection arises because prioritizing the distribution of principal (that is, establishing the payment rule for the principal repayment) effectively protects the shorter-term tranche (A in this structure) against extension risk. This protection must come from somewhere; it actually comes from the longer-term tranches. Similarly, Tranches C and D provide protection against extension risk for Tranches A and B. At the same time, Tranches C and D benefit because they are provided protection against contraction risk; this protection comes from Tranches A and B. Thus, the sequential-pay CMO-01 structure allows investors concerned about extension risk to invest in Tranches A or B and those concerned about contraction risk to invest in Tranches C or D.

Informationally Efficient Market

A market in which asset prices reflect new information quickly and rationally.

Bloomberg Fixed Income Electronic Trading Platform

A marketplace for bond trading.

Key Rate Duration (Partial Duration)

A measure of a bond's sensitivity to a change in the benchmark yield curve at a specific maturity segment. In contrast to effective duration, key rate durations help identify "shaping risk" for a bond—that is, a bond's sensitivity to changes in the shape of the benchmark yield curve (e.g., the yield curve becoming steeper or flatter). For example, this scenario would represent a flattening of the yield curve, given that the yield curve is upward sloping. Using key rate durations, the expected price change would be approximately equal to minus the key rate duration for the short maturity segment times the 0.0025 interest rate shift at that segment. Of course, for parallel shifts in the benchmark yield curve, key rate durations will indicate the same interest rate sensitivity as effective duration.

Weighted Average Life

A measure that gives investors an indication of how long they can expect to hold the MBS before it is paid off; the convention-based average time to receipt of all principal repayments. Also called average life.

Monoline Insurance Company

A monoline Insurance company is an insurance company that only provides guarantees for financial instruments such as ABS.

Interest Only Mortgage

A mortgage that only requires the payment of interest for a stated period of time with the principal due at the end of the term.

Floating Rate Notes

A note on which interest payments are not fixed, but instead vary from period to period depending on the current level of a reference interest rate. Most common method of calculating accrued interest on floater is actual/360 and actual/365

Predictability Based on Prior Information

A number of researchers have indicated that equity returns are related to prior information on such factors as interest rates, inflation rates, stock volatility, and dividend yields.

Collateralized Mortgage Obligation (CMO)

A security created through the securitization of a pool of mortgage-related products (mortgage pass-through securities or pools of loans). The cash flows of mortgage risk are redistributed to various tranches in a CMO. The creation of a CMO cannot eliminate or change prepayment risk, it can only distribute the risk among different bond classes.

Mortgage Pass Through Security (MPTS)

A security created when one or more holders of mortgages form a pool of mortgages and sell shares or participation certificates in the pool.

Spot Curve

A sequence of yields-to-maturity on zero-coupon bonds. Sometimes called zero or strip curve because coupon payments are "stripped" off of the bonds.

Par Curve

A sequence of yields-to-maturity such that each bond is priced at par value. The bonds are assumed to have the same currency, credit risk, liquidity, tax status, and annual yields stated for the same periodicity. Par rate from a sequence of spot rates: 100 = PMT/(1+z₁)¹ + PMT/(1+z₂)² + ... + PMT+100/(1+zɴ)ᴺ

Forward Curve

A series of forward rates each having the same time frame. The forward rate may be interpreted as the marginal return for extending the time to maturity for an additional time period.

Arbitrage

A set of transactions that produces riskless profits. Limits on short selling may impede arbitrage trading, and thereby create inefficiencies in the market.

Sponsored DR vs Unsponsored DR

A sponsored DR is when the foreign company whose shares are held by the depository has a direct involvement in the issuance of the receipts. Investors in sponsored DRs have the same rights as the direct owners of the common shares (e.g., the right to vote and the right to receive dividends). In contrast, with an unsponsored DR, the underlying foreign company has no involvement with the issuance of the receipts. Instead, the depository purchases the foreign company's shares in its domestic market and then issues the receipts through brokerage firms in the depository's local market. In this case, the depository bank, not the investors in the DR, retains the voting rights. Sponsored DRs are generally subject to greater reporting requirements than unsponsored DRs.

Subordination

A type of internal credit enhancement in an ABS, also referred to as credit trenching.

Struct.: Capital Protected Instruments

A type of structured financial instrument that provides investors capital protection. It combines a zero-coupon bond and a call option on some underlying asset. The capital protection is only as good as the issuer and the instrument

Callable Bonds: Make Whole Calls

A typical make-whole call requires the issuer to make a lump-sum payment to the bondholders based on the present value of the future coupon payments and principal repayment not paid because of the bond being redeemed early.

Government Equivalent Yield

A yield that restates a yield-to-maturity based on 30/360 day-count to one based on actual/actual. The government equivalent yield on a bond may be used to calculate the spread over the government yield.

Asset Backed Securities (ABS)

ABS are backed by pools of loans or receivables other than primary mtges. Some ABS are backed by amortizing loans (with scheduled principal payments), and others are backed by non-amortizing loans (with no scheduled principal payments). Created by a process of securitization, which involves moving assets from the owner of the assets into a special legal entity.

Australian & New Zealand Standard Industrial Classification

ANZSIC was standardized to ISIC. ANZSIC has a structure comprising five levels—namely, divisions (the broadest level), subdivisions, groups, classes, and at the most granular level, subclasses (New Zealand only).

FI: Other Financial Credit Institutions

Acceptance corporations, discount corporations, payday advance corporations, and factors provide credit to borrowers by lending them money secured by such assets as consumer loans, machinery, future paychecks, or accounts receivables. They finance these loans by selling commercial paper, bonds, and shares to investors. These corporations are intermediaries because they connect investors to borrowers Brokers will lend funds to clients that want to buy on margin. Brokers that provide these services to hedge funds are called prime brokers.

Float Adjusted Market Capitalization

Adjust each constituent security's market capitalization by its market float. Market float is the number of shares of the constituent security that are available to the investing public. In addition to excluding shares held by controlling shareholders, most float-adjusted market-capitalization-weighted indexes also exclude shares held by other corporations and governments wᴹᵢ = fᵢQᵢPᵢ/∑fĵQĵPĵ fᵢ = fraction of shares outstanding in the market float wᵢ = fraction of the portfolio that is allocated to security ᵢ or weight of security ᵢ Qᵢ = number of shares outstanding of security ᵢ Pᵢ = share price of security ᵢ N = number of securities in the index Primary advantage is that constinuent securities are held in proportion to their value in the target market. The primary disadvantage is that constituent securities whose prices have risen the most (or fallen the most) have a greater (or lower) weight in the index (i.e., as a security's price rises relative to other securities in the index, its weight increases; and as its price decreases in value relative to other securities in the index, its weight decreases).

International Standard Industrial Classification of all Economic Activities

Adopted by UN in 1948 and categorizes on th basis of principal economic activity. Various categories are: 11 categories, 21 sections, 88 divisions, 233 groups, and more than 400 classes.

Covenants

Affirmative covenants enumerate what issuers are required to do, whereas negative covenants specify what issuers are prohibited from doing. Affirmative covenants are generally administrative in nature. Negative covenants protect bondholders from dilution of their claims, asset withdrawals or substitutions, and suboptimal investments by the issuer and generally constrain a businesses decisions.

FI: Brokers

Agents that fill orders for clients. They help clients by reducing the cost of finding counter parties for trades.

Auto Loan ABS

All have some form of credit enhancement, senior/subordinated structure. Many also have overcollateralization and a reserve account with an excess spread. Certificates: provide credit protection for class B, and class B provides protection for class A.

Enterprise Value (EV)

Alternative to estimating the value of the equity is to measure the value of the enterprise. EV = Market cap + Vale of preferred stock + Market value of debt - Cash & investments (cash equivalents and short term debt) It is viewed as the cost of takeover. It is a most useful measure when comparing companies w/ significant differences in capital structure. EV/EBITDA multiple is useful for valuing companies w/ negative earnings. An alternative to EBITDA is operating income.

Other CMO Structures (FRN CMO)

Although the collateral pays a fixed rate, it is possible to create a tranche with a floating rate. This is done by constructing a floater and an inverse floater combination from any of the fixed-rate tranches in the CMO structure. Because the floating-rate tranche pays a higher rate when interest rates go up and the inverse floater pays a lower rate when interest rates go up, they offset each other. Thus, a fixed-rate tranche can be used to satisfy the demand for a floating-rate tranche.

Macroeconomic Influences

Among the economic variables that usually affect an industry's revenues and profits are the following: 1. gross domestic product or the measure of the value of goods and services produced by an economy, either in current or constant currency (inflation-adjusted) terms; 2. interest rates, which represent the cost of debt to consumers and businesses and are important ingredients in financial institutions' revenues and costs; 3. the availability of credit, which affects business and consumer spending and financial solvency; and 4. inflation, which reflects the changes in prices of goods and services and influences costs, interest rates, and consumer and business confidence.

Credit: Collateral

Analysts do think about the value and quality of a company's assets; however, these are difficult to observe directly. Factors to consider include the nature and amount of intangible assets on the balance sheet. Some assets, such as patents, are clearly valuable and can be sold if necessary to cover liabilities. Goodwill, on the other hand, is not considered a high-quality asset. In fact, sustained weak financial performance most likely implies that a company's goodwill will be written down, reinforcing its poor quality. Another factor to consider is the amount of depreciation an issuer takes relative to its capital expenditures: Low capital expenditures relative to depreciation expense could imply that management is insufficiently investing in its business, which will lead to lower-quality assets, potentially reduced future operating cash flow, and higher loss severity in the event of default.

Information Cascades

An application of behavioral theories to markets and pricing focuses on the role of personal learning in markets. Personal learning is what investors learn by observing outcomes of trades and what they learn from "conversations"—ideas shared among investors about specific assets and the markets. Social interaction and the resultant contagion is important in pricing and may explain such phenomena as price changes without accompanying news and mistakes in valuation. Information cascade: the transmission of information from those participants who act first and whose decisions influence the decisions of others.

Contracts: Underlying

An asset that trades in a market in which buyers and sellers meet, decide on a price, and the seller then delivers the asset to the buyer and receives payment. The underlying is the asset or other derivative on which a particular derivative is based. The market for the underlying is also referred to as the spot market.

Equity Like Approach to Hihh Yield Analysis

An equity market-like approach to analyzing a high-yield issuer can be useful. One approach is to calculate an issuer's enterprise value. Enterprise value (EV) is usually calculated by adding equity market capitalization and total debt and then subtracting excess cash.40,41 Enterprise value is a measure of what a business is worth (before any takeover premium) because an acquirer of the company would have to either pay off or assume the debt and it would receive the acquired company's cash. Bond investors like using EV because it shows the amount of equity "cushion" beneath the debt. It can also give a sense of (1) how much more leverage management might attempt to put on a company in an effort to increase equity returns or (2) how likely—and how expensive—a credit-damaging leveraged buyout might be. Similar to how stock investors look at equity multiples, bond investors may calculate and compare EV/EBITDA and debt/EBITDA across several issuers as part of their analysis. Narrow differences between the EV/EBITDA and debt/EBITDA ratios for a given issuer indicate a small equity cushion and, therefore, potentially higher risk for bond investors.

Basket of Listed Depository Receipts (BLDR)

An exchange-traded fund that represents a portfolio of depository receipts.

Strategic Analysis

Analysis of the competitive environment with an emphasis on the implications of the environment for corporate strategy.

Free Cash Flow to Equity Valuation Model

Analysts believe that FCFE is better b/c it is a measure of dividend paying capacity, and b/c it may be used for non-dividend paying stocks. FCFE = CFO - CapEx + Net borrowing Formula, Eq 4. V₀ = ∑ FCFEԏ/(1+r)ᵗ

Coupon Rate & Frequency

Annual amount of interest payments is a coupon. Mortgage Backed Securities (MBS): often pay interest monthly to match cash flows of mortgages backing the MBS.

FI: Arbitrageurs

Aribitrageurs trad when they can identify opportunities to buy an sell identical or essentially similar instruments at different prices in different markets. Dealers and arbitrageurs both provide liquidity to other traders, they compete with each other. The dealers connect buyers and sellers who arrive in the same market at different times whereas the arbitrageurs connect buyers and sellers who arrive at the same time in different markets. REPLICATION: buying a risk in one form and selling it in another.

Structural Subordination

Arises in a holding company structure when the debt of operating subsidiaries is serviced by the cash flow and assets of the subsidiaries before funds can be passed to the holding company to service debt at the parent level.

Pooled Investment: Asset Backed Securities

Asset-backed securities are securities whose values and income payments are derived from a pool of assets, such as mortgage bonds, credit card debt, or car loans. These securities typically pass interest and principal payments received from the pool of assets through to their holders on a monthly basis. These payments may depend on formulas that give some classes of securities—called tranches—backed by the pool more value than other classes.

Pooled Investment: Hedge Fund

Asset-backed securities are securities whose values and income payments are derived from a pool of assets, such as mortgage bonds, credit card debt, or car loans. These securities typically pass interest and principal payments received from the pool of assets through to their holders on a monthly basis. These payments may depend on formulas that give some classes of securities—called tranches—backed by the pool more value than other classes.

Classification of Assets & Markets

Assets: The most actively traded assets are securities, currencies, contracts, and commodities. In addition, real assets are traded. Securities generally include debt instruments, equities, and shares in pooled investment vehicles. Currencies are monies issued by national monetary authorities. Contracts are agreements to exchange securities, currencies, commodities or other contracts in the future. Commodities include precious metals, energy products, industrial metals, and agricultural products. Real assets are tangible properties such as real estate, airplanes, or machinery. Securities, currencies, and contracts are classified as financial assets whereas commodities and real assets are classified as physical assets.

Accrued Interest (AI)

Assume the coupon period has "T" days b/t payment dates and that "t" days have passed since last payment. The accrued interest is: AI = t/T * PMT t = number of days from last coupon payment to the settlement date T = number of days in the coupon period t/T = fraction of the coupon period that has gone by since the last payment PMT = coupon payment per period Most common convention for counting days: 1. Actual/actual: most common for government bonds 2. 30/360

High Yield: Financial Projections

Because high-yield companies have less room for error, it's important to forecast, or project, future earnings and cash flow out several years, perhaps including several scenarios, to assess whether the issuer's credit profile is stable, improving, or declining and thus whether it needs other sources of liquidity or is at risk of default. Ongoing capital expenditures and working capital changes should be incorporated as well. Special emphasis should be given to realistic "stress" scenarios that could expose a borrower's vulnerabilities.

Matrix Price Interpolated Formula

Avg. first period YTM + [(X period-first period)/(Last period - first period)] * (Avg.YTM last period-Avg. YTM first period)

Statistical Similarities

Based on correlation of past securities return. Cluster analysis: a technique in which companies are separated (on the basis of historical correlations of stock returns) into groups in which correlations are relatively high but between which correlations are relatively low.

Investor's Minimum Required Rate of Return

B/c companies try to raise capital at the lowest possible cost, the company's cost of equity is used as a proxy for the investor's minimum required rate or return.

MM: Add on Rates

Bank certificates of deposit, repos, and indexes such as Libor and Euribor are quoted on an add-on rate basis (bond equivalent yield basis). PV = FV/(1+Day's/Year * AOR) PV = present value FV Days = numenbr of days b/t settlement and maturity Year - Number of days in year AOR = Add on rate, stated as APR AOR = (Year/Days) * (FV-PV/PV)

Putable Bonds

Beneficial for the bondholders by guaranteeing a pre-specified selling price at the redemption dates. The indenture lists the redemption dates and the prices applicable to the sale of the bonds back to the issuer. Selling price is usually the par value of the bond.

Bank Loans & Syndicated Loans

Bilateral loan: a loan from a single lender to a single borrower. Generally these are loans from banks. Syndicated loan: a loan from a group of lenders to a single borrower. A syndicated lona is a hybrid between relational lending and publicly traded debt. These loans are primarily originated by banks. Prime rate: generally driven by the overnight rate at which banks lend to each other.

Bloomberg YAS "risk"

Bloomberg risk is YAS times 100

Global Bond

Bond issued in the Eurobond market simultaneous with the domestic bond market.

Periodicity in Money Market

Bond yields-to-maturity for semiannual compounding are annualized for a periodicity of two. Money market rates are computed using simple interest without compounding. In the money market, the periodicity is the number of days in the year divided by the number of days to maturity. Therefore, money market rates for different times-to-maturity have different periodicities.

Current Yield (Running Yield)

Bond's annual coupon divided by the bonds price. It is analogous to the dividend yield for a common share.

Inflation Linked Bonds

Bonds that contain a provision that adjusts the bond's par value for inflation and thus mitigates inflation risk.

Currency Option Bonds

Bonds that give the bondholder the right to choose the currency in which he or she wants to receive interest payments and principal repayments. They may be viewed as a combination of a single currency bond plus a foreign currency option.

Zero Coupon Bonds

Bonds that pay no annual interest but are sold at a discount below par, thus compensating investors in the form of capital appreciation Sometimes referred to a pure discount bonds.

Perpetual Bonds

Bonds with no stated maturity date.

Fixed Income

Bonds, notes, bills, certificates of deposit, commercial paper, repurchase agreements, loan agreements, and mortgages are examples of promises to repay money in the future.

Implied Forward Rate (Forward Yield)

Breakeven reinvestment Rate linking the return on an investment in a shorter-term zero coupon bond to the return on an investment in a longer term zero coupon bond.

Bullet, Fully Amortized, & Partially Amortized Bonds

Bullet bond: only interest is paid, and entire principal payment made at maturity. Amortizing bond: has a payment schedule that calls for periodic payments of interest and repayments of principal. Ballon payment: only a portion of principal is paid, and thus have outstanding principal amount at maturity.

MPTS: Characteristics

CF of MPTS depend on CF of underlying securities. The monthly cash flows of a mortgage pass-through security are less than the monthly cash flow of the underlying pool of mortgages by an amount equal to the servicing and other administrative fees.

Capital Gains & Bonds

Capital gains occur if the bond is sold above its constant yield trajectory, and a capital loss occurs if the bond is sold below its constant yield price trajectory

Implied Forward Rates

Calculated from spot rates, an implied forward rate is a break-even reinvestment rate that links the return on an investment in a shorter-term zero-coupon bond to the return on an investment in a longer-term zero-coupon bond. The implied forward rate between period A and period B is denoted IFRA,B-A. It is a forward rate on a security that starts in period A and ends in period B. Its tenor is B - A periods. (1+za)^a*(1+IFRa,b-a)^b-a = (1+about)^b

Zero Volatility Spread (Z-Spread)

Calculates a constant yield spread over a government (or interest rate swap) spot curve. May be calculated w/ PV = PMT/(1+z₁+Z)¹ + PMT/(1+z₂+Z)² + ... + PMT+FV/(1+zɴ+Z)ᴺ where the benchmark spot rates, z₁,z₂,..., zɴ are derived from the government yield curve (or from fixed rates on interest rate swaps) Z is the Z-spread per period and is the same for all periods. N is an integer so the calculation is on a coupon date when the AI = 0.

Calculation of Index Values Over Multiple Time Periods: Price Return

Calculation of index values over multiple time periods requires geometrically linking the series of returns. Vprוт = Vpr₀(1+PR៲₁)*(1+PRᵢ₁*...(1+PRוт) Vpr₀ = value of price return index at inception Vprוт = value of price return index at t PRוт = the price return (as a decimal number) on the index over period t, t = 1,2, ..., T

Different Meanings of Cash Markets

Cash markets are also called spot markets, which can be confusing because spot rate can have two meanings. It can mean the "rate on a bond traded in the spot, or cash, market." It can also mean "yield on a zero-coupon bond," which is the meaning of spot rate used in this reading.

Covenants

Clauses that specify the rights of the bondholders and any actions that the issuer is obligated to perform or prohibited from performing

Money Duration (Dollar Duration)

Closely related to modified duration. While modified duration is a measure of the percentage change in price of bond in response to YTM, money duration is the measure of the dollar price change in response to a change in yields. Stated per 100 of par or in terms of actual size of the position. MoneyDur = AnnModDur * PVFull ∆PVFull = -MoneyDur * ∆yield

BF: Herding

Clustered trading that may or may not be based on information.

CDO Structure

Collateral manager: a CDO manager who buys and sells debt obligations for and from the CDO's collateral (that is, the portfolio of assets) to generate sufficient cash flows to meet the obligations to the CDO bondholders. The funds to purchase the collateral assets for a CDO are obtained from the issuance of debt obligations. These debt obligations are bond classes or tranches and include senior bond classes, mezzanine bond classes (that is, bond classes with credit ratings between senior and subordinated bond classes), and subordinated bond classes, often referred to as the residual or equity tranches. The motivation for investors to invest in senior or mezzanine bond classes is to earn a potentially higher yield than that on a comparably rated corporate bond by gaining exposure to debt products that they may not otherwise be able to purchase. Investors in equity tranches have the potential to earn an equity-type return, thereby offsetting the increased risk from investing in the subordinated class. The key to whether or not a CDO is viable is whether a structure can be created that offers a competitive return for the subordinated tranche. The proceeds to make interest and principal payments in a CDO come from interest payments from collateral, maturing of the collateral assets, and sale of the collateral assets

London Interbank Offered Rate (LIBOR)

Collective name for multiple rates at which a select set of banks believe they could borrow unsecured funds from other banks in the London interbank market for different currencies and different borrowing periods ranging from overnight to one year.

Commerical Mortgage Backed Securities (CMBS)

Commercial mortgage-backed securities (CMBS) are backed by a pool of commercial mortgages on income-producing property, such as multifamily properties (e.g., apartment buildings), office buildings, industrial properties (including warehouses), shopping centers, hotels, and health care facilities (e.g., senior housing care facilities).

Commodity Index

Commodity indexes consist of futures contracts on one or more commodities, such as agricultural products (rice, wheat, sugar), livestock (cattle, hogs), precious and common metals (gold, silver, copper), and energy commodities (crude oil, natural gas). The S&P GSCI uses a combination of liquidity measures and world production values in its weighting schem and allocates more weight to commodities that have risen in price. Other indexes have fixed weights that are committee determined. Unlike equity indexes, commodity indexes will have very different risk and return profiles. Commodity index returns reflect the risk free interest rate, changes in future price, and the roll yield.

Equities

Common and preferred stocks.

Underwritten Offerings: 6 Steps

Common for corporate bonds, local government bonds (munis), and MBS. There are 6 steps. 1. Determine funding needs, type of bond offering, and whether the bond should be underwritten. 2. Select underwriter: syndicated offering: lead bank invites others to join to make sale of bond 3. Structure the transaction: issuer and lead underwriter discuss the terms of the bond, coupon rate, and expected offering. Underwriter prepares regulatory filings. A trustee is also assigned to oversee the master bond agreement. — bond issue usually marketed to potential investors. The grey market may help underwriters determine bond issuance price. The grey market is a forward market for bonds about to be issued. 4. Pricing day: last ay when investor can commit to buy the bond issue and the day final terms are agreed. 5. The offering day: the underwriting agreement that includes the bonds final terms is signed. 6. Issuing phase: the underwriter or syndicate purchases the entire bond issue from the issuer, delivers the proceeds, and starts reselling the bonds via its network. Bonds are delivered about 14 days later on the closing day.

Company Analysis: Differentiation Strategy

Companies attempt to establish themselves as the suppliers or producers of products and services that are unique either in quality, type, or means of distribution. Such a strategy puts a premium on creative and inventive people.

Using an Industry Life Cycle Model

Companies in growth industries should be building customer loyalty as they introduce consumers to new products or services, building scale, and reinvesting heavily in their operations to capitalize on increasing demand. Companies in mature industries are likely to be pursuing replacement demand rather than new buyers and are probably focused on extending successful product lines rather than introducing revolutionary new products. They are also probably focusing on cost rationalization and efficiency gains rather than on taking lots of market share. Importantly, these companies have fewer growth opportunities than in the previous stage, and thus more limited avenues for profitably reinvesting capital, but they often have strong cash flows.

Dividends: Background for DDM

Companies undergoing corporate and/or financial restructuring are those that are likely to use extra dividends. Stock dividend (bonus issue of shares): a type of dividend in which a company distributes additional shares of its common stock (typically 2-10% of shares outstanding) instead of cash. The pie is further divided, but the value and ownership ratio remains constant. Stock dividends are not relevant for valuation. Stock splits and reverse stock splits also have no economic effect on the company or shareholders. Share repurchase: when a company uses cash to buyback its own shares.

Company Analysis

Company analysis includes an analysis of the company's financial position, products and/or services, and competitive strategy (its plans for responding to the threats and opportunities presented by the external environment) Two chief competitive strategies: 1. low cost 2. product/service differentiation

General Rule for Periodicity

Compounding more frequently at a lower annual rate corresponds to compounding less frequently at a higher annual rate.

Multi-Market Indexes

Comprised of indexes from different countries, designed to represent multiple security markets. MSCI Barra offers a number of multi market indexes based on level of economic development and geographic region.

Negative Convexity (Concavity)

Concavity is an important feature of callable bonds. Putable bonds always have positive convexity. In summary, when the benchmark yield is high and the value of the embedded call option is low, the callable and the non-callable bonds experience very similar effects from interest rate changes. They both have positive convexity. But as the benchmark yield is reduced, the curves diverge. At some point, the callable bond moves into the range of negative convexity, which indicates that the embedded call option has more value to the issuer and is more likely to be exercised. This situation limits the potential price appreciation of the bond arising from lower interest rates, whether because of a lower benchmark yield or a lower credit spread.

Embedded Option

Contingency provisions that provide the issuer or the bondholders the right, but not the obligation, to take action. These options are not part of the security and cannot be traded separately.

Positions

Contracts have long sides and short sides. The long side of a forward or futures contract is the side that will take physical delivery or its cash equivalent. The short side of such contracts is the side that is liable for the delivery. The long side of a futures contract increases in value when the value of the underlying asset increases in value.

Asset Swap

Converts the periodic fixed coupon of a specific bond to a Libor plus or minus a spread.

Convexity of Zero Coupon Bond

Convexity (zero coupon) = [N-(t/T)] * [N+1-(t/T)]/(1+r)²

Issuer vs. Issue Rating

Corporate family rating (CFR) and corporate credit rating (CCR) or issuer Credit rating and issue credit rating. Issuer credit rating usually applies to the senior unsecured debt. Issue ratings refer to specific financial obligations of an issuer and take into consideration such factors as ranking in the capital structure (e.g., secured or subordinated). Although cross-default provisions, whereby events of default such as non-payment of interest17 on one bond trigger default on all outstanding debt,18 implies the same default probability for all issues, specific issues may be assigned different credit ratings—higher or lower—due to a ratings adjustment methodology known as notching.

Corporate Bonds: Principal Repayment Structure

Corporate notes have either serial or term payment structure. 1. Serial structure: the maturity dates are spread out during a bonds life, and a stated number of bonds mature and are paid off before maturity. 2. Term maturity structure: the bonds notational principal is paid off in a lump sum at maturity and since there is no regular payment of principal during the bonds life, the a term maturity structure carries more credit risk than a serial maturity structure

Floating Rate Notes (FRN)

Coupon rate linked to external reference rate such as LIBOR. Large issuers of FRNs include government sponsored enterprises (GSEs), but it is rare for sovereign governments b/c investors prefer fixed. Variable Rate Note: spread is not fixed. Floor: feature of FRN that prevents the coupon from falling below a specified minimum rate. Cap: prevents the coupon from rising about a specified cap Almost all FRNs have quarterly coupons.

MacDur Coupons & YTM

Coupon rates and yields-to-maturity are both inversely related to the Macaulay duration. In Exhibit 7, for the same time-to-maturity and yield-to-maturity, the Macaulay duration is higher for a zero-coupon bond than for a low-coupon bond trading at a discount. Also, the low-coupon bond trading at a discount has a higher duration than a high-coupon bond trading at a premium. Therefore, all else being equal, a lower-coupon bond has a higher duration and more interest rate risk than a higher-coupon bond. The same pattern holds for the yield-to-maturity. A higher yield-to-maturity reduces the weighted average of the time to receipt of cash flow.

Struct: Yield Enhancement Instruments

Credit Linked Note (CLN): Fixed-income security in which the holder of the security has the right to withhold payment of the full amount due at maturity if a credit event occurs. CLNs are examples of yield enhancement instruments. A CLN allows the issuer to transfer the effect of a particular credit event to investors. Thus, the issuer is the protection buyer and the investor is the protection seller. Investors are willing to buy CLNs because these securities offer higher coupons than otherwise similar bonds. In addition, CLNs are usually issued at a discount. Thus, if the specified credit event does not occur, investors will realize a significant capital gain on the purchase of the CLN.

Business Cycle Sensitivity

Cyclical company: one whose profits are strongly correlated with the strength of the overall economy. — Such companies experience wider-than-average fluctuations in demand—high demand during periods of economic expansion and low demand during periods of economic contraction—and/or are subject to greater-than-average profit variability related to high operating leverage (i.e., high fixed costs). — Examples are auto, housing, basic materials, industrials, and technology Non-cyclical: a company whose performance is largely independent of the business cycle. Non-cyclical produce goods and services whose demands are stable throughout the business cycle. — Examples include consumer staples, food, health care, and utilities. Sectors that tend to exhibit a relatively high degree of economic sensitivity include consumer discretionary, energy, financials, industrials, technology, and materials. In contrast, sectors that exhibit relatively less economic sensitivity include consumer staples, health care, telecommunications, and utilities.

Medium Term Note (MTN)

Developed by Walt Disney in 1993. MTN is a corporate bond offered continuously to investors by an agent of the issuer, designed to fill the funding gap between commercial paper and long-term bonds. The market has 3 segments: 1. Short term securities that Cary floating or fixed rates 2. Medium to long term securities that carry a fixed rate 3. Structured notes Life insurance companies, pension funds, and banks are among the largest buyers of MTNs because they can customize the bond issue to their needs and stipulate the amount and characteristics of the securities they want to purchase.

FI: Dealers

Dealers fill their clients orders by trading with them. Dealers provide liquidity. In OTC markets dealers provide liquidity to anyone that wants to trade. Almost all investment banks have large dealer operations.

Corp Bond: Issuance, Trading, & Settlement

Dealers typically do not earn a commission fee or transaction fee but make money through the bid ask spread. New issues take longer than seasoned issues, which are T+2 to T+3 days to settle.

FI: Primary Dealers

Dealers with whom central banks trade when conducting monetary policy. They buy bills, notes, and bonds when the central banks sell them to decrease the money supply. The dealers then sell these instruments to their clients. Similarly, when the central banks want to increase the money supply, the primary dealers buy these instruments from their clients and sell them to the central banks.

Fixed Income: Convertible Bonds

Debt instruments convertible into stock, and if stock price is high, making conversion likely, the debt is treated as stock and vice versa if stock price low.

Covered Bonds

Debt obligations issued by banks and backed (secured) by a segregated pool of assets

Expected Loss

Default probability * Loss severity given default

IPOs

Degree of underpricing: the percentage difference between the issue price and the closing price at the end of the first day of trading. The evidence also suggests that investors buying after the initial offering are not able to earn abnormal profits because prices adjust quickly to the "true" values, which supports semi-strong market efficiency. In fact, the subsequent long-term performance of IPOs is generally found to be below average. Taken together, the IPO underpricing and the subsequent poor performance suggests that the markets are overly optimistic initially (i.e., investors overreact).

Funding Alt. For Banks: Retail Deposits

Demand deposits: accounts available on demand. Depositors have immediate access to the funds and may make immediate transactions. Usually no interest. Savings accounts: do pay interest but are not as transactionally convenient. Money market accounts: offer money market rates of return and depositors may access funds at short to no notice.

Repo Margin

Difference b/t the market value of the security used as collateral and the value of the loan. The level of margin is a function of: 1. The length of the repurchase agreement. The longer the repurchase agreement, the higher the repo margin. 2. The quality of the collateral. The higher the quality of the collateral, the lower the repo margin. 3. The credit quality of the counterparty. The higher the creditworthiness of the counterparty, the lower the repo margin. 4. The supply and demand conditions of the collateral. Repo margins are lower if the collateral is in short supply or if there is a high demand for it.

Private Placement

Difficult to trade in secondary market due to restrictions. Tight liquidity. Unlike in a public offering in which the bonds are often sold to investors on a take-it-or-leave-it basis, investors in a private placement can influence the structure of the bond issue, including such considerations as asset and collateral backing, credit enhancements, and covenants. It is common for privately placed bonds to have more customized and restrictive covenants than publicly issued ones.

Basis Point Value (BPV)

Dollar duration times .0001 (1 bp)

Experience Curve

During stages of the life cycle of a product or industry, its position on the experience curve is analyzed. The experience curve shows the direct cost per unit of good or service produced or delivered as a typically decline in function of cumulative output.

Earnings Surprise

Earnings surprise: portion of earnings that is unanticipated by investors and merits a price adjustment

Economic Profits & Creating & Destroying Value

Economic profit: they are creating value and achieving returns on investment above the opportunity cost of funds

Effective Duration

Eff Dur linearly approximates change in bd price for 100 bp change in yld. Measure of price sensitivity to changes in yld curve. First derivative price/yld function. Effective Duration = [V- - V+] / [2 * V0 * (▲y)^2 ] V- : Bd price if yld decreases V+ : Bd price if yld increases V0: Current Bd Price ▲y : Change in yld (in decimal form) Note: 1% = 0.01 Effective Duration is the preferred measure because it gives a good approximation of interest rate sensitivity for both option-free bonds and bonds with embedded option.

Effective Convexity Formula

EffCon = [(PV_ ) + (PV+)] - [2*(PV₀)]/(∆Curve)²*(PV₀)

Effective Duration Formula

EffDur = (PV_ ) - (PV+)/[2*(∆Curve)*(PV₀)] The difference between approximate modified duration and effective duration is in the denominator. Modified duration is a yield duration statistic in that it measures interest rate risk in terms of a change in the bond's own yield-to-maturity (ΔYield). Effective duration is a curve duration statistic in that it measures interest rate risk in terms of a parallel shift in the benchmark yield curve (ΔCurve).

Dividend Discount Model (DDM)

Eq. 1 V₀ = ∑Dԏ/(1+r)ᵗ V₀ = value of share of stock today, at t = 0 Dԏ = expected dividend in year t, assumed to be paid at the end of the year r = required rate or return on the stock Eq 2. V₀ = ∑Dԏ/(1+r)ᵗ + Pɳ/(1+r)ⁿ

Hedge Fund Indexes

Equally weight the returns of the hedge funds included in the index Instead of index providers determining the constituents, the hedge funds make the determination. Thus, hedge fund indexes are voluntary reporting indexes

Abnormal Return

Equals actual return less expected return

Asset Based Valuation

Estimates the market value of the firm's assets and liabilities; does not reflect the value of the firm as a going concern. It is useful for companies that do not have a lot of intangible or "off the books" assets and that do have a high proportion of current assets and current liabilities.

US Commercial Paper vs Eurocommercial Paper

Eurocommercial paper (ECP): international commercial paper.

Behavioral Finance

Examines investor behavior to understand how people make decisions, individually and collectively. Behavioral finance does not assume that people consider all available information in decision-making and act rationally by maximizing utility within budget constraints and updating expectations consistent with Bayes' formula. The resulting behaviors may affect what is observed in the financial markets.

Pooled Investment Vehicle: ETF & ETN

Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are open-ended funds that investors can trade among themselves in secondary markets. The prices at which ETFs trade rarely differ much from net asset values because a class of investors, known as authorized participants (APs), has the option of trading directly with the ETF. If the market price of an equity ETF is sufficiently below its net asset value, APs will buy shares in the secondary market at market price and redeem shares at net asset value with the fund. Conversely, if the price of an ETF is sufficiently above its net asset value, APs will buy shares from the fund at net asset value and sell shares in the secondary market at market price. As a result, the market price and net asset values of ETFs tend to converge.

Self Regulating Organizations (SROs)

Exchanges, clearinghouses, and dealer trade organizations are examples of self-regulating organizations. In some cases, the members of these organizations voluntarily subject themselves to the SRO's regulations to promote the common good. In other cases, governments delegate regulatory and enforcement authorities to SROs, usually subject to the supervision of a government agency, such as a national securities and exchange authority.

Structured Financial Instruments: 4 Broad Categories

Financial instruments that share the common attribute of repackaging risks. Structured financial instruments include asset-backed securities, collateralized debt obligations, and other structured financial instruments such as capital protected, yield enhancement, participation and leveraged instruments. Includes ABS and CDOs as well as others. 1. Capital protected 2. Yield enhancement 3. Participation 4. Leveraged instruments

Fixed Income: Construction

Fixed income securities number is far greater than equities. As instruments matures, there is turnover in the index. Further challenges is the dealer market structure. This means that firms (dealers) are assigned to specific securities and are responsible for creating liquid markets for those securities by purchasing and selling them from their inventory. In addition, many securities do not trade frequently and, as a result, are relatively illiquid.

Capital Market Securities

Fixed income securities w/ original maturities longer than one year.

Money Market Securities

Fixed income securities with maturities of one year or less. Issuers of such securities include governments and companies. Examples: — Commercial paper and certificates of deposit

Struct: Participation Instruments

Floating rate bonds are a type of instrument. Many participation instruments are linked to an equity index.

Credit: Character

Following ways to judge character: 1. An assessment of the soundness of management's strategy. 2. Management's track record in executing past strategies, particularly if they led to bankruptcy or restructuring. A company run by executives whose prior positions/ventures resulted in significant distress might still be able to borrow in the debt markets, but it would likely have to borrow on a secured basis and/or pay a higher rate of interest. 3. Use of aggressive accounting policies and/or tax strategies. Examples might include using a significant amount of off-balance-sheet financing, capitalizing versus immediately expensing items, recognizing revenue prematurely, and/or frequently changing auditors. These are potential warning flags to other behaviors or actions that may adversely impact an issuer's creditworthiness. 4. Any history of fraud or malfeasance—a major warning flag to credit analysts. 5. Previous poor treatment of bondholders—for example, management actions that resulted in major credit rating downgrades. These actions might include a debt-financed acquisition, a large special dividend to shareholders, or a major debt-financed stock buyback program.

Convexity Adjustment

For a bond, one half of the annual or approximate convexity statistic multiplied by the change in the yield-to-maturity squared.

Annual Rate vs. Periodicity

For a given pair of cash flows, the stated annual rate and the periodicity are inversely related.

Preferred Stock Valuation

For a non-callable, non-convertible, perpetual preferred share paying a level dividend Eq. 6 V₀ = D₀/r Eq. 7, for non-callable non convertible preferred stock with maturity at t V₀ = ∑Dԏ/(1+r)ᵗ + F/(1+r)ⁿ F = par value of preferred When Eq. 7 is used the best approach is to use values for n, r, and D that reflect the payment schedule of the dividends.

Secondary Market Settlement

For government and quasi-government bonds it typically takes place on a cash basis or T+1. Corporate bonds usually settle on a T+2 or T+3 basis, thought settlement may extend to a T+7 basis.

Coupon Effect

For the same time-to-maturity, a lower-coupon bond has a greater percentage price change than a higher-coupon bond when their market discount rates change by the same amount

High Yield: Liquidity Sources

From strongest to weakest 1. Cash on the balance sheet 2. Working capital 3. Operating cash flow 4. Bank credit facilities 5. Equity issuance 6. Asset sales

Forward Market

Future delivery, beyond the settlement time period in the cash market.

Municipal Bonds

Generally refers to US local government debt. For any given rating category, municipal bonds have a lower default rate for the same category.

Price Competition

Industries in which price is a large factor tend to be more competitive than industries in which customers value other attributes more highly. Asset management: fragmented but maintains strong pricing power.

Complete Markets

Informally, markets in which the variety of distinct securities traded is so broad that any desired payoff in a future state-of-the-world is achievable.

Tax Considerations

Generally, the income portion of a bond investment is taxed at the income rate. Bond may also generate a capital gain or loss. Occurs when a bond is sold before maturation. Bonds issued at a discount: additional tax consideration is related to the tax status of the original issue discount. The original issue discount is the difference between the par value and the original issue price. In some countries, such as the United States, a prorated portion of the discount must be included in interest income every tax year. Some jurisdictions also have tax provisions for bonds bought at a premium. They may allow investors to deduct a prorated portion of the amount paid in excess of the bond's par value from their taxable income every tax year until maturity. But the deduction may not be required; the investor may have the choice either to deduct a prorated portion of the premium each year or to deduct nothing and declare a capital loss when the bond is redeemed at maturity.

Callable Common Shares

Give the firm the right to repurchase the stock at a pre-specified price; Benefits the firm because when the market price is greater than the call price, the firm can call shares and reissue them at a higher price; Allows firm to reduce its dividend payments without changing its per-share dividend

Putable Common Shares

Give the shareholder the right to sell back shares to the company at a specific price; Puts a floor on the share price; Shareholders implicitly pay for put option because putable shares sell for more than non-putable; Raise more capital for firm when issued

Primary Bond Markets

Globally bonds are grew at about 4% in 2011.

Ginnie Mae

Government National Mortgage Association. This entity is a federally related institution because it is part of the US Department of Housing and Urban Development. As a result, the RMBS that it guarantees carry the full faith and credit of the US government with respect to timely payment of interest and repayment of principal.

Market Value vs. Intrinsic (Fundemental) Value

Market value is the price at which the asset is being bought and sold and intrinsic value is the value place on the asset if investors had a complete understanding of the asset.

Primary Capital Markets

Markets in which companies and governments raise capital (funds).

Strategic Groups

Groups sharing distinct business models or catering to specific market segments in an industry.

Multistage DDM

Has two growth rates 1. high initial rate 2. lower sustainable rate Eq. 11 V₀ = ∑[D₀*(1+gʂ)ᵗ/(1+r)ᵗ + Vɳ/(1+r)ⁿ gʂ = initial high growth rate Eq. 12 Vת = (Dת+1)/(r-gι) gι = long term growth rate Eq. 13 Dɳ+1 = D₀(1+gʂ)ⁿ * (1+gι) Dɳ+1 = first dividend after high growth stops Vɳ = intrinsic value in year ɳ

Fixed Income Markets Institutional Domination

High informational barriers and high minimum transaction sizes make income hard to enter. Most fixed income securities trade in OTC markets.

Secured Debt

Highest ranked debt in terms of priority of repayment is 1. First mortgage debt: refers to a pledge of specific property 2. First lien debt: refers to a pledge of certain assets that could include buildings but might also include property and equipment, licenses, patents, brands, etc.

Unsecured Debt

Highest ranking unsecured debt is senior unsecured.

Risks Relying on Ratings Agencies

Historically ratings agencies have done a good job of measuring risk.

International Capital Market Association (ICMA)

ICMA is an association of banks and other financial institutions that provides a regulatory framework for international bond markets and that is behind much of the established practices. There are about 35 registered members.

CMBS Structure

If DSC and LTV levels cannot be met, subordination will occur to achieve the desired credit rating. Interest on the principal outstanding is paid to all tranches. Losses arising from loan defaults are charged against the outstanding principal balance of the CMBS tranche with the lowest priority. This tranche may not be rated by credit-rating agencies; in this case, this unrated tranche is called the "first-loss piece," "residual tranche," or "equity tranche." The total loss charged includes the amount previously advanced and the actual loss incurred in the sale of the loan's underlying property.

Portfolio Management & Market Form

If securities markets are weak-form and semi-strong-form efficient, the implication is that active trading, whether attempting to exploit price patterns or public information, is not likely to generate abnormal returns

Corp Bonds: Asset or Collateral Backing

Important for investors is seniority ranking. Equipment trust certificates: secured by specific equipment it is used to finance Collateral trust securities Covered bonds: which are a type of debt obligation that is secured by a segregated pool of assets. Asset-backed securities are also secured forms of debt.

Global Equity Markets to GDP

In 2008 the global value of equity markets was about 55 trillion, which implies an equity market capitalization ratio of about 100%. The long run average is around 50%. The US equity markets, in 2008, contributed about 43% to the global total capitalization despite being only 21% of world GDP.

Technological Influences

New technologies create new or improved products that can radically change an industry and can also change how other industries that use the products conduct their operations.

Company Analysis: Low Cost

In a low-cost strategy, companies strive to become the low-cost producers and to gain market share by offering their products and services at lower prices than their competition while still making a profit margin sufficient to generate a superior rate of return based on the higher revenues achieved. Low-cost strategies may be pursued defensively to protect market positions and returns or offensively to gain market share and increase returns. Pricing also can be defensive (when the competitive environment is one of low rivalry) or aggressive (when rivalry is intense). In the case of intense rivalry, pricing may even become predatory—that is, aimed at rapidly driving competitors out of business at the expense of near-term profitability. Companies seeking to follow low-cost strategies must have tight cost controls, efficient operating and reporting systems, and appropriate managerial incentives. In addition, they must commit themselves to painstaking scrutiny of production systems and their labor forces and to low-cost designs and product distribution. They must be able to invest in productivity-improving capital equipment and to finance that investment at a low cost of capital.

Demand & Supply of Fixed Rate vs Floating Rate Debt

In an effort to limit the volatility of their net worth resulting from interest rate risk, banks that issue floating-rate debt often prefer to make floating-rate loans and invest in floating-rate bonds or in other adjustable-rate assets.

MM: Discount Rates

In general, the interest rate used to calculate a present value. In the money market, however, discount rate is a specific type of quoted rate. In general, the discount rate is the interest rate used to calculate present value. But in the money market the discount rate is a specific type of quoted rate PV = FV * (1 - Day's/Year * DR) PV = present value, or the price of the money market instrument FV = future value paid at maturity, or the face value of the money market instrument Days = number of days b/t settlement and maturity Year = number of days in the year DR = discount rate, stated as an annual percentage rate

Technical Analysis

In other words, by detecting and exploiting patterns in prices, technical analysts assist markets in maintaining weak-form efficiency. Does this mean that technical analysts cannot earn abnormal profits? Not necessarily, because there may be a possibility of earning abnormal profits from a pricing inefficiency. But would it be possible to earn abnormal returns on a consistent basis from exploiting such a pattern? No, because the actions of market participants will arbitrage this opportunity quickly, and the inefficiency will no longer exist.

Industry Concentration

Industries concentrated among a relatively small number of players often experience relatively less price competition. However, there are exceptions. Analysis should begin with market share.

Risks of CDO Transaction

In practice, CDOs are subject to risks that investors should be aware of. For example, in the case of defaults in the collateral, there is a risk that the manager will fail to earn a return sufficient to pay off the investors in the senior and mezzanine tranches, resulting in a loss for these investors. Investors in the equity tranche risk the loss of their entire investment. Even if payments are made to these investors, the return they realize may not be the return expected at the time of purchase. Moreover, after some period, the CDO manager must begin repaying principal to the senior and mezzanine tranches. The interest rate swap must be structured to take this requirement into account because the entire amount of the senior tranche is not outstanding for the life of the collateral.

Government Influence

In setting tax rates and rules for corporations and individuals, governments affect profits and incomes, which in turn, affect corporate and personal spending. Governments are also major purchasers of goods and services from a range of industries. Income trust: A type of equity ownership vehicle established as a trust issuing ownership shares known as units. During a period in the 90's, said trusts could avoid income taxation/double taxation to holders of the units.

FI: Depository Institution

Include commercial banks, savings and loan banks, credit unions, and similar institutions that raise funds from depositors and other investors and lend it to borrowers. d

Ultimate Goal of Management

Increase the book value (shareholder's equity on a company's balance sheet) of the company and maximize the market value of its equity.

Sector Indexes

Indexes that represent and track different economic sectors—such as consumer goods, energy, finance, health care, and technology—on either a national, regional, or global basis.

Constituent Secuities

Individual securities that comprise an index.

Futures Contract

Initial margin: The amount that must be deposited in a clearinghouse account when entering into a futures contract. Maintenance margin: The minimum amount that is required by a futures clearinghouse to maintain a margin account and to protect against default. Participants whose margin balances drop below the required maintenance margin must replenish their accounts. Variation margin: Additional margin that must be deposited in an amount sufficient to bring the balance up to the initial margin requirement.

Largest Group of Fixed Income Investor

Institutional investors, including pension funds, hedge funds, charitable foundations and endowments, insurance companies, and banks

FI: Insurance Companies

Insurers typically provide insurance themselves, but they also broker trades b/t the insured and the insurer. Insurers are financial intermediaries because they connect the buyers of their insurance contracts with investors, creditors, and reinsurers who are willing to bear the insured risk

Credit Card Receivables ABS

Interest is paid to holders of credit card receivable ABS periodically (e.g., monthly, quarterly, or semiannually). As noted earlier, the collateral of credit card receivable ABS is a pool of non-amortizing loans. These loans have lockout periods during which the cash flows that are paid out to security holders are based only on finance charges collected and fees. When the lockout period is over, the principal that is repaid by the cardholders is no longer reinvested but instead is distributed to investors. Some provisions in credit card receivable ABS require early amortization of the principal if specific events occur. Such provisions are referred to as "early amortization" or "rapid amortization" provisions and are included to safeguard the credit quality of the issue. The only way the principal cash flows can be altered is by the triggering of the early amortization provision.

Bond Cash Flow Yield Portfolio

Internal rate of return on a series of cash flows.

Struct: Leveraged Instruments

Inverse floater: move in the opposite direction of the reference rate. General formula: C - (L*R) Where, C= maximum coupon rate R = reference rate L = coupon leverage (the change in the coupon rate for a 100 bp change in the reference rate)

Deleveraged vs Leveraged Inverse Floater

Inverse floaters with a coupon leverage greater than 0 but lower than 1 are called deleveraged inverse floaters Inverse floaters with a coupon leverage greater than one are called leveraged inverse floaters. Floors are included in the inverse floater.

Information Motivated Traders vs. Investors

Investors trade to move wealth from the present to the future whereas information-motivated traders trade to profit from superior information about future values.

Accounting Return on Equity Issues

Is ROE increase always good: NO 1. ROE may increase b/c NI decreases at a slower rate than shareholder's equity 2. ROE may increase b/c the company takes on more debt and buys back shares. Use DuPont formula to determine why ROE is increaseing.

Benchmark Captures vs. Spread Captures

It captures the macroeconomic factors: the expected rate of inflation in the currency in which the bond is denominated, general economic growth and the business cycle, foreign exchange rates, and the impact of monetary and fiscal policy. Benchmark may be further divided into the expected inflation rate and the expected real rate. The spread captures the microeconomic factors specific to the bond issuer and the bond itself: credit risk of the issuer and changes in the quality rating on the bond, liquidity and trading in comparable securities, and the tax status of the bond.

Price to Book Value (Market to Book)

It is a simple to calculate method of determining the value investors are placing on a company

Bid-Ask Spreads

It is also worth noting that bid-ask spreads (in yield terms) translate into higher transaction costs for longer-duration bonds; investors want to be compensated for that as well. For these reasons, spread curves (often called credit curves), like yield curves, are typically upward sloping. That is, longer-maturity bonds of a given issuer typically trade at wider spreads than shorter-maturity bonds to their respective comparable-maturity government bonds.33 Exhibit 18, using the US telecommunications company AT&T as an example, shows the upward-sloping credit curve by plotting the yields of its bonds versus their maturity. (As a large and frequent issuer, AT&T has many bonds outstanding across the yield curve.)

Accounting Return on Equity 2

It is computed as the NI available to ordinary shareholders after dividends are deducted ROEԏ = NIԏ/Average BVEԏ = NIԏ/(BVEԏ - BVEԏ-₁)/2

YTM

It may be approximated as the weighted average of the underlying spot rates

High Yield Covenant Analysis

Key covenants for high yield issuers: 1. Change of control put: in the event of an acquisition (a "change of control"), bondholders have the right to require the issuer to buy back their debt (a "put option"), often at par or at some small premium to par value. This covenant is intended to protect creditors from being exposed to a weaker, more indebted borrower as a result of acquisition. For investment-grade issuers, this covenant typically has a two-pronged test: acquisition of the borrower and a consequent downgrade to a high-yield rating. 2. Restricted payments: bond holders paid first 3. Limitations on liens and additional indebtedness: puts limit on the amout of secured debt 4. Restricted versus unrestricted subsidiaries: with regard to restricted versus unrestricted subsidiaries, issuers may classify certain of their subsidiaries as restricted and others as unrestricted as it pertains to offering guarantees for their holding company debt. These subsidiary guarantees can be very useful to holding company creditors because they put their debt on equal standing (pari passu) with debt at the subsidiaries instead of with structurally subordinated debt. Restricted subsidiaries should be thought of as those that are designated to help service parent-level debt, typically through guarantees. They tend to be an issuer's larger subsidiaries and have significant assets, such as plants and other facilities, and/or cash flow. There may be tax or legal (e.g., country of domicile) reasons why certain subsidiaries are restricted while others are not. Analysts should carefully read the definitions of restricted versus unrestricted subsidiaries in the indenture because sometimes the language is so loosely written that the company can reclassify subsidiaries from one type to another with a simple vote by a board of directors or trustees

FI: Alternative Trading Systems (ATS)

Known as electronic communications networks (ECN) or multilateral trading facilities (MTF) are trading venues that function like exchanges but do not excercise regulator authority over their subscribers except w/ respect to the conduct of their trading in their trading systems. Many ATSs are knows as DARK POOLS b/c they do not display the orders that their clients send.

Eurobonds

Less regulated than domestic and foreign bonds b/c they are issued outside the jurisdiction of any single country. They are usually unsecured and denominated in any currency. Some bonds are bearer bonds, meaning the trustee does not keep records of who owns the bonds., only a clearing system knows who owns the bonds. The opposite are registered bonds.

Rights of Lender in Foreclosure

Loan may be 1. Recourse: lender has claim against the borrower for the shortfall b/t the amount of the outstanding mortgage balance and the proceeds received from the sale of the property 2. Non recourse: lender does to have such a claim and thus can look only to the property to recover the outstanding mortgage balance.

Mortgage Amortization Schedule

Loan w/ a payment schedule that calls for periodic payments of interest and repayments of principal. Two types 1. fully amortizing: in fully amortizing, the sum of all the scheduled principal repayments during the Mortgage' s life is such that when the last mortgage payment is made, the loan is fully repaid 2. partially amortizing: the sum of all the scheduled principal repayments is less than the amount borrowed. The last payment is the unpaid mortgage payment, known as a balloon.

Syndicated Loans

Loans from a group of lenders to a single borrower.

Maturity Effect

Longer-term bonds have more price volatility than shorter-term bonds, other things being equal. Exceptions to the maturity effect are rare in practice. They occur only for low-coupon (but not zero-coupon), long-term bonds trading at a discount. The maturity effect always holds on zero-coupon bonds, as it does for bonds priced at par value or at a premium above par value.

Social Influences

Look at tobacco

MacDur of Consol (Perpetutiy)

MacDur = (1+r)/r as N approaches infinity

Macaulay Duration Calculus Formula

MacDur = {(1+r)/r - (1+r+[N*(c-r)])/c*[(1+r)ᴺ-1]} - (t/T) r = YTM/Discount rate c = coupon rate as decimal

Macaulay Duration & Total Return

MacDur indicates the investment horizon for which coupon reinvestment risk and market price risk offset each other.

Macaulay Duration

Macaulay Duration is an estimate of a bond's interest rate sensitivity based on the time, in years, until promised cash flows will arrive. Not useful measure for bonds with embedded options. MacDur = [((1-t/T)*PMT/(1+r)¹־ᵗᐟᵀ) + ((2-t/T)*PMT/(1+r)²־ᵗᐟᵀ) + ... + (ɴ-t/т)*(PMT+FV)/(1+r)ᴺ-ᵗᐟᵀ]/[(PMT/(1+r)¹־ᵗᐟᵀ) + (PMT/(1+r)²־ᵗᐟᵀ) + ... + (PMT+FV)/(1+r)ᴺ־ᵗᐟᵀ] Where, t = number of days from the last coupon payment to the settlement date T = number of days in the coupon period T/T = fraction of the coupon period that has gone by since last payment PMT = coupon payment per period FV = future value paid at maturity, or par value of the bond r = the yield to maturity, or the market discount rate, per period N = number of evenly spaced periods to maturity as of the beginning of the current period Denominator in Eq 1 is the PV^full

Leveraged Position

Maintainence margin position: generally it is .25 of the current value of the position Margin call: occurs when maintainence margin falls below the margin requirement

Secondary Markets

Major participants in secondary bond markets are large institutional investors and central banks. Speed of trading does not constitute a liquid market. In a liquid market trading occurs quickly at prices close to the security's fair market value.

Dual Currency Bonds

Make coupon payments in one currency but pay the par value in another currency.

In-Kind Redemptions

Many ETFs permit only in-kind deposits and redemptions. Buyers who buy directly from such a fund pay for their shares with a portfolio of securities rather than with cash. Similarly, sellers receive a portfolio of securities. The transaction portfolio generally is very similar—often essentially identical—to the portfolio held by the fund. Practitioners sometimes call such funds "depositories" because they issue depository receipts for the portfolios that traders deposit with them. The traders then trade the receipts in the secondary market. Some warehouses holding industrial materials and precious metals also issue tradable warehouse receipts.

High Yield: Corporate Structure

Many debt-issuing corporations, including high-yield companies, utilize a holding company structure with a parent and several operating subsidiaries. Knowing where an issuer's debt resides (parent versus subsidiaries) and how cash can move from subsidiary to parent ("upstream") and vice versa ("downstream") are critical to the analysis of high-yield issuers. In a holding company structure, the parent owns stock in its subsidiaries. Typically, the parent doesn't generate much of its own earnings or cash flow but instead receives dividends from its subsidiaries. The subsidiaries' dividends are generally paid out of earnings after they satisfy of all their other obligations, such as debt payments. To the extent that their earnings and cash flow are weak, subsidiaries may be limited in their ability to pay dividends to the parent. Moreover, subsidiaries that carry a lot of their own debt may have restrictions or limitations on how much cash they can provide to the parent via dividends or in another way, such as through an intercompany loan. These restrictions and limitations on cash moving between parent and subsidiaries can have a major impact on their respective abilities to meet their debt obligations. The parent's reliance on cash flow from its subsidiaries means the parent's debt is structurally subordinated to the subsidiaries' debt and thus will usually have a lower recovery rating in default.

Leveraged Position

Margin loan: money borrowed from broker to purchase securities Call money rate: the interest rate buyers pay for their margin loan. The call money rate is above the government bill rate and is negotiable. Trader's equity: portion of the security price that the buyer must supply. Initial margin requirement: the minimum fraction fo the purchase price that must be trader's equity. Financial leverage: the relation b/t risk and borrowing. Leverage ratio: ratio of the value of the position to the value of the equity investment in it. It indicates how many times larger a position is than the equity in it. Maximum leverage position financed with minimum margin requirement is one divided by the minimum margin requirement.

Non Mortgage ABS

May be categorized on the basis of the way the collateral repays 1. Amortizing: traditional residential mortgages and auto loans 2. Non amortizing: no schedule of payments, and thus no prepayment risk. Credit card receivable is an example Now, what happens if the collateral of the ABS is 1,000 non-amortizing loans? Some of these loans will be paid off in whole or in part before the maturity of the ABS. When those loans are paid off, what happens depends on whether the loans were paid off during the lockout period or after it. The lockout period or revolving period is the period during which the principal repaid is reinvested to acquire additional loans with a principal equal to the principal repaid. The reinvestment in new loans can result in the collateral including more or less than 1,000 loans, but the loans will still have a total par value of US$100 million. When the lockout period is over, any principal that is repaid will not be used to reinvest in new loans but will instead be distributed to the bond classes.

Real Estate Investment Trust Indexes

May be classified as: 1. Appraisal indexes 2. Repeat sales indexes 3. REIT indexes

Convertible Preference Shares

May be converted to a specified number of common shares. Convertible preference shares have the following advantages: 1. They allow investors to earn a higher dividend than if they invested in the company's common shares. 2. They allow investors the opportunity to share in the profits of the company. 3. They allow investors to benefit from a rise in the price of the common shares through the conversion option. 4. Their price is less volatile than the underlying common shares because the dividend payments are known and more stable.

Commodities

May be used as hedges by information motivated traders and investment managers and most take positions in the futures market due to a lack of storage, futures are more liquid, and quality control. Commodities for which storage and delivery costs are lowest are nonparisable products for which the ratio of value to weight is high and variation in quantity is low.

Term Structure of Credit Spreads

Maybe be created by isolating the credit risk over varying times to maturity

Top-Heavy Capital Structures

Means the company has a lot of secured debt (typically bank debt) relative to unsecured debt and this makes it harder to take on greater debt.

Single Period Index Returns

Measured in two ways: 1. percentage change 2. value of price return

Duration

Measures the sensitive of the bond's full price (including accrued interest) to changes in the bond's YTM or benchmark rate. In duration measurements the time to maturity is unchanged. Duration is useful b/c it represents the approximate amount of time a bond would have to be held for the market discount rate at purchase to be realized if there is a single change in the interest rate. If the bond is held for the duration period, an increase from reinvesting coupons is offset by a decrease in price if interest rates increase and a decrease from reinvesting coupons is offset by an increase in price if interest rates decrease.

Return & Risk of Equities

Methods to measure equity risk and return include: One method uses the equity's average historical return and the standard deviation of this return as proxies for its expected future return and risk. Another method involves estimating a range of future returns over a specified period of time, assigning probabilities to those returns, and then calculating an expected return and a standard deviation of return based on this information.

CMBS: Credit Risk

Non recourse so lender can only use the income producing property backing the loan for interest payments and principal payments. Two key indicator measures of credit performance 1. Loan to value (LTV) 2. Debt service coverage (DSC): annual net operating income (NOI) divided by debt service (annual interest and principal repayments). The NOI is defined as the rental income reduced by cash operating expenses and a non-cash replacement reserve reflecting the depreciation of the property over time

Modified Duration

ModDur = MacDur/(1+r) r= yield per period Annualized modified duration = ModDur from above divided by number of periods per year Can be used to estimate the percentage price change for a bond in response to change in YTM %∆PV^full = -AnnModDur * (∆yield) AnnModDur is the annual modified duration. This formula uses full price, annual modified duration, and annual YTM Negative sign indicates that the bond price and YTM move inversely Modified duration only provides a linear estimate of change in the price of a bond in response to change in yields => good for small changes. This accuracy fades as larger changes in yield because the curvature/convexity becomes more pronounced ApproxModDur = [(PV_ ) - (PV+)]/[2 * ∆ in yield * PV₀] The objective of this formula is to give the slope of the line tangent to the price-yield curve. This will give us the percentage change in the price of a bond in response to a 100bps change in yield (1%). No matter how much you change the interest rate by (5bps for example), the answer is still for a 1% change in yield. All these prices are full prices including accrued interest.

Money Convexity

Money duration measures first order effect on full price of bond in dollar terms for change in YTM, money convexity is the second order effect: ∆PV^full ≈ -(MoneyDur*∆Yield) + [.5 * MoneyCon*(∆Yield)²] MoneyCon = AnnCon * PV

Money Markets vs. Capital Markets

Money: for short-term (less than 1 year) highly liquid debt securities. (New York, London and Tokyo money markets) Capital: for intermediate (1-10 years) or long-term (more than 10 years) debt and corporate stocks (New York stock exchange)

Indexes for Alternative Investments

Most common are 1. Commodities 2. Real estate 3. Hedge funds

Assets & Contracts

Most common assets: financial assets (such as bank deposits, certificates of deposit, loans, mortgages, corporate and government bonds and notes, common and preferred stocks, real estate investment trusts, master limited partnership interests, pooled investment products, and exchange-traded funds), currencies, certain commodities (such as gold and oil), and real assets (such as real estate). Most common contracts: option, futures, forward, swap, and insurance contracts.

Method of Comparables

Most widely used approach for analysts reporting valuation judgments on the basis of price multiples. This method compares relative values estimated using multiples or the relative value of multiples. Choices for the benchmark multiple include the multiple of a closely matched individual stock or the average or median value of the multiple for the stock's industry. The comp company should be similar based on overall size, product lines, and growth rate.

ApproxModDur Becomes ApproxMacDur

Multiply by (1+r) ApproxMacDur = ApproxModDur * (1+r)

Statistical Classification of Economic Activities in the European Community

NACE is the classification of economic activities that correspond to ISIC at the European level. NACE is composed of four levels—namely, sections (identified by alphabetical letters A through U), divisions (identified by two-digit numerical codes 01 through 99), groups (identified by three-digit numerical codes 01.1 through 99.0), and classes (identified by four-digit numerical codes 01.11 through 99.00).

North American Industry Classification System

NACIS replaced SIC in 1997. Businesses are first divided into establishments and then enterprises. Establishment: a single physical location where business is conducted or where services or industrial operations are performed" (e.g., factory, store, hotel, movie theater, farm, office). Enterprise:

Net Leverage vs. Gross Leverage

Net leverage = subtract cash on hand from total debt Gross debt = do not adjust debt for cash on hand

Primary vs. Secondary Market

Primary - when company first offers stock for sale. Secondary - stocks previously bought by other investors now being sold by those investors.

3 Major Sources of Repayment for Non-Sovereign Government Debt

Non-sovereign gov't debt: bonds issued by local governments, such as states and cities. 1. General taxing authority of the issuer 2. Cash flows from the project financed by the bond 3. Special taxes specifically for funding the interest and principal payments

Warrant

Not an embedded option, but an attached options. A warrant entitles the holder to buy the underlying stock of the issuing company at a fixed price until the expiration date.

Semiannual Bond Basis Yield (Semiannual Bond Equivalent Yield)

Note the difference between period and annual yield.

Pari Passu

Of bonds means they are of equal ranking w/in the class, regardless of maturity

Planned Amortization Class Tranch (PAC)

Offers greater protection of CF as long as the prepayment rate is w/in a specified band over the collateral's life. Because PAC tranches have limited (but not complete) protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.

FI: Securitization Cont

Often the financial intermediary avoids placing the assets and liabilities on its balance sheet by placing the securities in a corporation or trust that buys the assets and issues securities. The corporate or trust is called a SPECIAL PURPOSE VEHICLE (SPV) or a SPECIAL PURPOSE ENTITY (SPE).

Mortgage Interest Rate Determination: 4 Basic Ways

On a mortgage the interst rate is known as the mortgage rate, contract rate, or note rate 1. Fixed rate 2. Adjustable or variable rate (ARM): generally an ARM has a maximum interest rate change allowable and a maximum overall rate it may reach — indexed ARM: rate is tied to a reference rate — reviewable ARM: rate is at the lenders discretion 3. Initial period fixed rate: mortgage is fixed for some initial period and then adjusts. — rollover mortgage or renegotiable: the rate adjusts to a fixed rate — hybrid: mortgage starts fixed and then switches at some point. 4. convertible: The mortgage rate is initially either a fixed rate or an adjustable rate. At some point, the borrower has the option to convert the mortgage to a fixed rate or an adjustable rate for the remainder of the mortgage's life.

Bloomberg & Effective Duration

On bloomberg, effective duration is often called the OAS duration.

Term Structure of Credit Spreads

The relationship between the spreads over the "risk-free" (or benchmark) rates and times-to-maturity.

On the Run vs. Off the Run

On the run typically trade at a lower YTM than off the run securities having similar or are times to maturity b/cod differences in demand for the securities, and sometimes differences in the cost of financing in the repo market.

Capital & Projects & Market Efficiency

One of the most important functions of the financial system is to ensure that only the best projects obtain scarce capital funds; the funds available from savers should be allocated to the most productive uses.

Spreadsheet Modeling

One should test the model. Such testing for reasonableness can be done by, first, asking what the few most important changes in income statement items are likely to be from last year to this year and the next year and, second, attempting to quantify the effects of these significant changes or "swing factors" on the bottom line. If an analyst cannot summarize in a few points what factors are realistically expected to change income from year to year and is not convinced that these assumptions are correct, then he or she does not really understand the output of the computer modeling efforts. In general, financial models should be in a format that matches the company's reporting of its financial results or supplementary disclosures or that can be accurately derived from these reports. Otherwise, there will be no natural reality check when the company issues its financial results and the analyst will not be able to compare his or her estimates with actual reported results.

FI: Securitizer

One that buys assets, places them in a pool, and sells securities that represent ownership of the pool is a securitizer. Mortgage backed securities (MBS) are an example. B/c investors value liquidity, they will pay more for securitized mortgages than for individual mortgages. Home owners benefit b/c higher mortgage prices lower home interest rates. The actual mortgages appear on the banks accounts as assets, while the MBS appear as liabilities. Besides mortgages banks securitize car loans, credit card receivables, bank loans, and airplane leases, to name just a few assets. As a class, these securities are called asset-backed securities. ETF is another for of securitization.

Overconfidence

Overconfidence is usually reflected more in higher growth companies. It is the overestimate of ones ability to process and interpret information about a security

Payment in Kind Coupon Bonds (PIK)

PIK allows issuers to pay interest in the form of additional amounts of the bond issue rather than as cash payment. Such bonds are favored by issuers who are concerned the issuer may face potential cash flow problems in the future.

Index Return Formula: Price

PRו = ∑wᵢPRᵢ = ∑wᵢ([Pᵢ₁-Pᵢ₀]/Pᵢ₀) PRו = price of index portfolio Which becomes, PRו = w₁PR₁ + w₂PR₂ + ... + wתPRת ת = number of securities in the index

Formula for Floater

PV = ((Index+QM)*FV/m/(1+Index+DM/m)¹ + ((Index+QM)*FV/m/(1+Index+DM/m)² + ... + ((Index+QM)*FV/m/(1+Index+DM/m)ⁿ PV = present value, or price of FRN Index = reference rate, stated as APR QM = quoted margin, stated as an APR FV = future value paid at maturity, or par value of the bond m = periodicity of the FRN, number of payment periods N = number of evenly spaced periods to maturity

Formula for Bond Price w/ a Series of Spot Rates

PV = PMT/(1+Z₁)¹ + PMT/(1+Z₂)² + ... + PMT+FV/(1+Zɴ)ⁿ Z₁ = Spot rate or zero coupon yield or zero rate for period 1

General Formula of Bond Price w/ MDR

PV = PMT/(1+r)¹ + PMT/(1+r)² + ... + PMT+FV/(1+r)ⁿ

Price Value of a Basis Point (PVBP)

PVBP = [(PV_ ) - (PV+)]/2 A version of money duration, it is an estimate of the change in the full price of a bond given a 1 basis point change in the yield-to-maturity. "PV01" means price value of 1 bp ∆. In the US it is called "DV01"

PV^full & Macaulay Duration

PV^full = PMT/(1+r)¹־ᵗᐟᵀ + PMT/(1+r)²־ᵗᐟᵀ + ... + PMT+FV/(1+r)ᴺ־ᵗᐟᵀ important aspect of the Macaulay duration: Macaulay duration is a weighted average of the time to receipt of the bond's promised payments, where the weights are the shares of the full price that correspond to each of the bond's promised future payments. Eq 3 MacDur = {(1-t/T)*[PMT/(1+r)¹־ᵗᐟᵀ/PV^full)]+ [(2-t/T)*[PMT/(1+r)²־ᵗᐟᵀ/PV^full)] + ... + [(N-t/T)*[PMT/(1+r)ᴺ־ᵗᐟᵀ/PV^full) Weights in MacDur are the present values of CF divided by the full price, and the receipt of CF is measured in terms of time periods 1-t/T ...

Formula for Full Price of Fixed Rate Bond b/t Coupon Payments

PV^full = PMT/(1+r)¹־ᵗᐟᵀ + PMT/(1+r)²־ᵗᐟᵀ + ... + PMT+FV/(1+r)ᴺ־ᵗᐟᵀ which becomes, PV^full = [PMT/(1+r)¹ + PMT/(1+r)² + ... + PMT+FV/(1+r)ⁿ] PV^full = PV * (1+r)ᵗᐟᵀ

Flat Price, Accrued Interest, & Full Price

PV^full = PV^flat + AI Flat price is what is usually quoted by dealers. If trade happens, accrued interest is added to the flat price to obtain the full price paid by the buyer and received by the seller on settlement date Flat price is quoted for transparency. If the full price was quoted, traders would see the bond price rise day after day as the YTM remained constant.

Pooled Investment Vehicle

Pooled investment vehicle shares represent ownership of an undivided interest in an investment portfolio.

Pooled Investment Vehicles

Pooled investment vehicles are mutual funds, trusts, depositories, and hedge funds, that issue securities that represent shared ownership in the assets that these entities hold. The securities created by mutual funds, trusts, depositories, and hedge fund are respectively called shares, units, depository receipts, and limited partnership interests but practitioners often use these terms interchangeably.

Equities: Common and Preferred Stock

Preferred shares are equities that have preferred rights (relative to common shares) to the cash flows and assets of the company. Preferred shareholders generally have the right to receive a specific dividend on a regular basis. If the preferred share is a cumulative preferred equity, the company must pay the preferred shareholders any previously omitted dividends before it can pay dividends to the common shareholders. Preferred shareholders also have higher claims to assets relative to common shareholders in the event of corporate liquidation. For valuation purposes, financial analysts generally treat preferred stocks as fixed-income securities when the issuers will clearly be able to pay their promised dividends in the foreseeable future.

Multiplier Models: Price Multiple

Price multiple refers to a ratio that compares the share price w/ some sort of monetary flow or value to allow evaluation of the relative worth of a company's stock. Some practitioners use price multiple as a screening tool. 1. Price to earnings (P/E) 2. Price to book (P/B): inverse relationship b/t price to book and future rates of return 3. Prices to sales (P/S): ratio of stock price to sales per share. Low P/S multiples are the most useful for predicting future returns. 4. Price to cash flow ratio (P/CF): measures include free cash flow and operating cash flow

Premium Bond

Price of bond is above par.

Discount Bond

Price of bond is below par value

Price Return vs Total Return Index

Price return index reflects only the prices of the constituent securities Total return index: reflects both price and reinvestment of received income.

Semi Strong Form

Prices reflect all publicly available information. Publicly available information includes financial statement data (such as earnings, dividends, corporate investments, changes in management, etc.) and financial market data (such as closing prices, shares traded, etc.). Event test may be used to test the concept of semi strong form. Compare the expected return (CAPM, simple market model, market index return) to the difference between the actual return and expected return.

Credit Quality of Commercial Paper

Prime paper: commercial paper rated adequate or above and is considered investment grade Rolling over the paper: paying maturing commercial paper with new commercial paper. This does create rollover risk. Backup lines of credit: required by the credit rating agencies to limit rollover risk. Most commercial paper issuers maintain 100% backing. Yield on commercial paper is typically higher than the yield on short term sovereign bonds for two reasons: 1. Commercial paper is exposed to credit risks unlike sovereign bonds 2. Commercial paper markets are generally less liquid than sovereign bond markets. 3. In the US the yield is also higher than short term municipal bonds for tax reasons.

Par Value

Principal amount, principal value, or simply principal is the amount that the issuer agrees to repay the bondholders on the maturity date. This amount is also known as par value.

Private Placement

Private placement: corporations issue their securities directly to a small group of qualified investors Self registration: when corporations sell new issues of seasoned securities directly to the public on a piecemeal basis Corporations also issue shares via dividend reinvestment plans (DRPs or DRIPs) that allow their shareholders to reinvest their dividends in newly issued shares of the corporation Rights offerings: the issuance of new stock by corporations to existing shareholders in proportion to their holdings.

Matrix Pricing

Process of estimating the market discount rate and price of a bond based on the quoted or flat prices of more frequently traded comparable bonds. These bonds will have similar times to maturity, coupon rates, and credit quality.

FI: Investment Banks

Provide advice to their mostly corporate clients and helps them arrange transactions such as initial and seasoned securities offerings.

FI: Block Broker

Provide brokerage service to large traders and manage exposure of the trades

FI: Exchanges

Provide place where traders may meet and arrange trades. Exchanges are easily distinguesed from brokers by their regulatory operations. Most exchanges regulate their members behavior when trading on the exchange, and sometimes away from the exchange. Many securities exchanges require timely financial disclosure. Some exchanges also prohibit the formation of capital structures that limit the rights of other investors.

Broad Market Index

Provides a measure of a market's overall performance and usually contains more than 90% of the market's total value The Wilshire 5000 Total Market Index is a market-capitalization-weighted index that includes more than 6,000 equity securities and is designed to represent the entire US equity market.3 The Russell 3000, consisting of the largest 3,000 stocks by market capitalization, represents 99 percent of the US equity market.

Credit Enhancements

Provisions that may be used to reduce the credit risk of a bond issue.

Credit Enhancements

Provisions that may be used to reduce the credit risk of a bond issue. They include 1. internal credit enhancements, such as subordination, overcollateralization and reserve accounts, and 2. external credit enhancements, such as financial guarantees by banks or insurance companies, letters of credit, and cash collateral accounts.

Auctions

Public auction in the US is a single price auction in which all the winning bidders pay the same price and receive the same coupon rate for the bonds.

When P₀ = V₀, Gordon Growth Becomes

P₀ = D₁/(r-g) Substitue P₀/E₁ P₀/E₁ = D₁/E₁/(r-g) = p/(r-g) p = payout Thus, P/E is inversely related to the required rate of return and positively related to growth. However, a higher payout ratio, (1-b), may imply slower growth rate as a result of the company retaining a lower proportion of earnings for reinvestment. The P/E and payout ratio are positively related.

Fannie Mae & Freddie Mac

RMBS issued by GSEs do not carry the full faith and credit of the US government.8 Agency RMBS issued by GSEs differ from non-agency RMBS in two ways. First, the credit risk of the RMBS issued by Fannie Mae and Freddie Mac is reduced by the guarantee of the GSE itself, which charges a fee for insuring the issue. In contrast, non-agency RMBS use credit enhancements to reduce credit risk, which is further discussed in Section 5.3. The second way in which RMBS issued by GSEs differ from non-agency RMBS is with regard to the pool of securitized loans. For a loan to be included in a pool of loans backing an agency RMBS, it must meet specific underwriting standards established by various government agencies

Non-Agency MBS

RMBS issued by any other entity are non-agency RMBS. Entities that issue non-agency RMBS are typically thrift institutions, commercial banks, and private conduits. Private conduits may purchase non-conforming mortgages, pool them, and then sell mortgage pass-through securities whose collateral is the underlying pool of non-conforming mortgages. Because they are not guaranteed by the government or by a GSE, credit risk is an important consideration when investing in non-agency RMBS. Shifting mechanism may be included if the credit enhancement for senior tranches deteriorates b/cod poor performance of the collateral.

ROE & DuPont

ROE = (Net profit margin: NI/Net sales) * (Asset turnover: Net Sales/Average total assets) * (Financial leverage: Average Total Assets/Average common equity)

Preference Shares

Rank above common stock with respect to dividends and the distribution of the company's net assets upon liquidation. However, preference shareholders generally do not share in the operating performance of the company and do not have any voting rights unless explicitly allowed for at issuance. Preference shares may be callable or putable, may or may not pay dividends, and are perpetual. Dividends may be cumulative, non cumulative, participating, non-participating, or a combination. Participating preference shares entitle the shareholders to receive the standard preferred dividend plus the opportunity to receive an additional dividend if the company's profits exceed a pre-specified level. Participating preference shares also contain provisions that entitle shareholders to an additional distribution of the company's assets upon liquidation, above the par (or face) value of the preference shares.

Equilibrium Interest Rate

Rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded.

Notching

Ratings adjustment methodology where specific issues from the same borrower may be assigned different credit ratings.

Real Assets

Real assets include such tangible properties as real estate, airplanes, machinery, or lumber stands. These assets normally are held by operating companies, such as real estate developers, airplane leasing companies, manufacturers, or loggers. Real assets may have low correlation with other investments managers hold, and the tax advantages they may have. Real assets tend to trade in highly illiquid markets and have high managing costs. These disadvantages are also the reasons they become mispriced and information motivated traders may identify them. Many financial intermediaries create entities, such as real estate investment trusts (REITs) and master limited partnerships (MPLPs), to securitize real assets and facilitate indirect investment in real assets.

Index Reconstruction

Reconstitution is the process of changing the constituent securities in an index. It is similar to a portfolio manager deciding to change the securities in his or her portfolio. Reconstitution is part of the rebalancing cycle. The reconstitution date is the date on which index providers review the constituent securities, re-apply the initial criteria for inclusion in the index, and select which securities to retain, remove, or add. Constituent securities that no longer meet the criteria are replaced with securities that do meet the criteria. Once the revised list of constituent securities is determined, the weighting method is re-applied. Indexes are reconstituted to reflect changes in the target market (bankruptcies, de-listings, mergers, acquisitions, etc.) and/or to reflect the judgment of the selection committee.

Term Structure of Yield Volatility

The relationship between the volatility of bond yields-to-maturity and times-to-maturity

Index Rebalancing

Refers to adjusting the weights of the constituent securities in the index. Price-weighted indexes are not rebalanced because the weight of each constituent security is determined by its price. For market-capitalization-weighted indexes, rebalancing is less of a concern because the indexes largely rebalance themselves. In our market-capitalization index, for example, the weight of Security C automatically declined from 10.96 percent to 6.91 percent, reflecting the 36 percent decline in its market price. Market-capitalization weights are only adjusted to reflect mergers, acquisitions, liquidations, and other corporate actions between rebalancing dates.

Interest on Interest

Reinvested interest from bond will affect the Realized Rate of Return.

Funding Alt Banks: Structure of Repurchase & Reverse Repurchase Agreements

Repo rate: the interest rate on a repurchase agreement. Repurchase price: the price at which the dealer repurchases the item. Repurchase date: date the item is repurchased.

Common Shares

Represent an ownership interest, a residual claim on the firm's assets in liquidation, and govern through voting rights; No obligation for firm to pay a dividend; Can proxy their votes to others;

Matrix Pricing & Required Yield Spread

Required yield spread: the difference between the yield-to-maturity on a new bond and the benchmark rate; additional compensation required by investors for the difference in risk and tax status of a bond relative to a government bond. Sometimes called the spread over the benchmark. Benchmark rate: typically the yield-to-maturity on a government bond having the same, or close to the same, time-to-maturity.

Active Returns

Returns earned by strategies that do not. assume that all information is fully reflected in the market prices

Revenue Bonds

Revenue bonds, which are issued to finance a specific project, have a higher degree of risk than GO bonds because they are dependent on a single source of revenue. The analysis of these bonds is a combination of an analysis of the project and the finances around the particular project. The project analysis focuses on the need and projected utilization of the project, as well as on the economic base supporting the project. The financial analysis has some similarities to the analysis of a corporate bond in that it is focused on operating results, cash flow, liquidity, capital structure, and the ability to service and repay the debt. A key credit measure for revenue-backed non-sovereign government bonds is the debt-service-coverage (DSC) ratio, which measures how much revenue is available to cover debt payments (principal and interest) after operating expenses. Many revenue bonds have a minimum DSC ratio covenant; the higher the DSC ratio, the stronger the creditworthiness.

BF: Risk Aversion

Risk aversion refers to the tendency of people to dislike risk and to require higher expected returns to compensate for exposure to additional risk Loss aversion: the tendency for people to dislike losses more than they like gains.

Concentrated yet Competitive Pricing

Said industries are highly capital intensive and sell commodity like products

Operationally Efficient

Said of a market, a financial system, or an economy that has relatively low transaction costs.

Discount Margin

Same as a required margin and is the yield spread over or under the reference rate such that an FRN is priced at par on a rate reset date.

Savers vs. Equity Issuers & Borrowers

Savers move money from the present to the future, while equity issuers and borrowers move money from the future to the present

Primary Security Markets (PSM)

Seasoned offering (secondary offering) is the sale of additional suits of a previously issued security

Products & Services Supplied

Sector: group of related industries Principal business activity: the source from which a company derives a majority of their revenues.

Strong Form

Security prices fully reflect both private and public information. Researchers test strong form efficiency by testing if traders can capitalize on private information.

Weak Form Efficient

Security prices reflect all past market data, which refers to historical price and trading volume information. In weak form, past trading prices are already reflected in current prices and investors cannot predict future price changes by extrapolating prices or patterns of prices from the past. Look for serial correlation which could indicate a predictable pattern.

Short Positions

Short sellers creat short positions in contracts by selling contracts that they do not own. They borrow scurities from security lenders who are the longs. The shorts then sell the borrowed securities to other traders. They close their positions by repurchasing the securities and returning them. Security lenders own promises made by the short sellers to return the securities. These promises are memorialized in security lending agreements. These agreements specify that the short sellers will pay the long sellers all dividends or interest that they otherwise would have received had they not lent their securities. These payments are called payments-in-lieu of dividends (or of interest), and they may have different tax treatments than actual dividends and interest. The security lending agreements also protect the lenders in the event of a stock split. To secure the security loans, lenders require that the short seller leave the proceeds of the short sale on deposit with them as collateral for the stock loan. They invest the collateral in short-term securities, and they rebate the interest to the short sellers at rates called short rebate rates. The short rebate rates are determined in the market and generally are available only to institutional short-sellers and some large retail traders. If a security is hard to borrow, the rebate rate may be very small or even negative. Such securities are said to be on special. Otherwise, the rebate rate is usually 10 basis points less than the overnight rate in the interbank funds market. Most security lending agreements require various margin payments to keep the credit risk among the parties from growing when prices change.

Commercial Paper

Short-term unsecured debt issued by large corporations.

Yield Curve

Shows the relationship between the interest rate earned on a bond (measured on the vertical axis) and the length of time until the bond's maturity date (shown on the horizontal axis).

Types of Fixed Income Indexes

Similar to equities, fixed-income securities can be categorized according to the issuer's economic sector, the issuer's geographic region, or the economic development of the issuer's geographic region. Fixed-income securities can also be classified along the following dimensions: 1. type of issuer (government, government agency, corporation); 2. type of financing (general obligation, collateralized); 3. currency of payments; 4. maturity; 5. credit quality (investment grade, high yield, credit agency ratings); and 6. absence or presence of inflation protection. Fixed-income indexes are based on these various dimensions and can be categorized as follows: aggregate or broad market indexes; market sector indexes; style indexes; economic sector indexes; and specialized indexes such as high-yield, inflation-linked, and emerging market indexes.

Value/Growth Classification

Some indexes represent categories of stocks based on their classifications as either value or growth stocks. Different index providers use different factors and valuation ratios (low price-to-book ratios, low price-to-earnings ratios, high dividend yields, etc.) to distinguish between value and growth equities.

Legal Identity of Bond Issuer & Its Legal Form

Sometimes bonds are issued by a holding company, which is the parent legal entity for a group of companies, rather than an operating company in the group. Investors must be aware of the assets of the holding company that are acting as collateral for the bond. For ABS, the legal obligation to repay the bondholders often lies with the special legal entity that was created by the financial institution in charge of the securitization process. The financial institution is known as the sponsor or originator. It is often referred to as a SPE in the US and a SPV in the UK. One of the key reasons for forming a special legal entity is bankruptcy remoteness. The transfer of assets by the sponsor is considered a legal sale; once the assets have been securitized, the sponsor no longer has ownership rights. Any party making claims following the bankruptcy of the sponsor would be unable to recover the assets or their proceeds. As a result, the special legal entity's ability to pay interest and repay the principal should remain intact even if the sponsor were to fail—hence the reason why the special legal entity is also called a bankruptcy-remote vehicle.

Characteristics of Commercial Paper

Source of funding for working capital and seasonal cash needs. It is also a source of bridge financing: interim financing until permanent financing may be arranged. Maturity is b/t overnight and one year, but the average is 3 months.

Sovereign Bonds Secondary Market

Sovereign bonds traded in the secondary market are called on the run. These are the most recently issued and most recently traded sovereign bonds. Benchmark issue: the latest sovereign bond issue for a given maturity.

Pricing w/ Spot Rates (zero rates)

Spot rates: yields to maturity on zero coupon bonds maturing at the date of each cash flow.

Market Share Stability

Stable market shares indicate less competitive industries Unstable market shares often indicate highly competitve industries with little pricing power Market shares are affected by barriers to entry (high => stable market share), new products (frequent new products => unstable market share), product differentiation (more differentiation => increase market share) Low switching costs plus a relatively high benefit from switching caused market shares to change quickly in the stent market. High switching costs for orthopedic devices coupled with slow innovation resulted in a lower benefit from switching, which led to greater market share stability in orthopedic devices.

Common Shares Voting & Classes

Statutory voting: regular shareholder voting in which each share represents one vote. Cumulative voting: may be used to better serve the interest of small shareholders. Cumulative voting allows shareholders to direct their total voting rights to specific candidates, as opposed to having to allocate their voting rights evenly among all candidates For example, under cumulative voting, if four board directors are to be elected, a shareholder who owns 100 shares is entitled to 400 votes and can either cast all 400 votes in favor of a single candidate or spread them across the candidates in any proportion. In contrast, under statutory voting, a shareholder would be able to cast only a maximum of 100 votes for each candidate.

Style Indexes

Style indexes represent groups of securities classified according to market capitalization, value, growth, or a combination of these characteristics. They are intended to reflect the investing styles of certain investors, such as the growth investor, value investor, and small-cap investor.

Callable Bonds

Such a bond gives the right to the issuer to redeem all or part of the bond before the maturity date. The primary reason why issuers choose to issue callable bonds rather than non-callable bonds is to protect themselves against a decline in interest rates. Details of the call provision are in the indenture: details call price, call premium (amount over par paid by the issuer if the bond is called), the call schedule (some have a lockout period, cushion, or deferment period)

Deferred Coupon Bonds (Split Coupon Bond)

Such a bond pays no coupon for the first few years but pays a higher coupon for the remainder of its life. Common for low quality issuers and for issuers who are financing assets that will not generate income immediately. Investors are interested b/c of the bonds steep discounts and occasional tax advantages. A zero coupon bond may be thought of as an extreme deferred coupon bond.

Index Return Formula: Total Return 2

TRᵢ = [P₁ᵢ-P₀ᵢ+Iתᥴᵢ]/P₀ᵢ TRᵢ = total return of security ᵢ etc. which can become a weighted average or securities, TRᵢ = ∑wᵢTRᵢ = ∑wᵢ([P₁ᵢ-P₀ᵢ+Iתᥴ]/P₀ᵢ) which becomes, TRᵢ = w₁TR₁ + w₂TR₂ + ... + wתTRת where,

Total Return of Equities

TRₑPrice appreciation and dividends TR = Rߪ = (Pߪ-Pԏ-₁ +Dԏ)/Pԏ-₁ There may be foreign exchange gains or losses for foreign investors.

Orders 5: Clearing Instructions

Tells brokers and exchanges how to arrange final settlement of trades. An important clearing instruction that must appear on security sale orders is an indication of whether the sale is a long sale or a short sale. In either case, the broker representing the sell order must ensure that the trader can deliver securities for settlement. For a long sale, the broker must confirm that the securities held are available for delivery. For a short sale, the broker must either borrow the security on behalf of the client or confirm that the client can borrow the security.

Option Adjusted Yield

The required market discount rate whereby the price is adjusted for the value of the embedded option.

FRN Above PAR

The FRN will be at a premium if the quoted margin is greater than the discount margin

Z-Spread & Option Adjusted Spread (OAS)

The OAS, like the option-adjusted yield, is based on an option-pricing model and an assumption about future interest rate volatility. Then, the value of the embedded call option, which is stated in basis points per year, is subtracted from the yield spread. In particular, it is subtracted from the Z-spread: OAS = Z-spread - Option value (in basis points per year)

Industry Analysis

The analysis of a specific branch of manufacturing, service, or trade.

Company Analysis

The analysis of the competitive position of a company within an industry.

Periodicity of Annual Rate

The assumed number of periods in the year, typically matches the frequency of coupon payments.

Depositor Bank

The bank that holds the shares, and acts as custodian and as a registrar. This entails handling dividend payments, other taxable events, stock splits, and serving as the transfer agent for the foreign company whose securities the DR represents.

Benchmark vs. Spread

The benchmark for a fixed income security w/ a given time to maturity is the base rate, often a government yield. The spread is the difference b/c the YTM and the benchmark.

Limit Order Book

The book or list of limit orders to buy and sell that pertains to a security.

Carrying Value

The carrying value is the purchase price plus the amortized amount of the discount if the bond is purchased at a price below par value. If the bond is purchased at a price above par value, the carrying value is the purchase price minus the amortized amount of the premium.

Capital Structure

The composition and distribution across operating units of a company's debt and equity - including bank debt, bonds of all seniority rankings, preferred stock, and common equity

Transaction Costs & Information Acquiaition Costs

The costs incurred by traders in identifying and exploiting possible market inefficiencies affect the interpretation of market efficiency. 1. Transaction costs: transaction costs are incurred in trading to exploit any perceived market inefficiency. Thus, "efficient" should be viewed as efficient within the bounds of transaction costs. 2. Information acquisition costs: expenses associated with gathering and analyzing information. New information is incorporated in transaction prices by traders placing trades based on their analysis information. The modern perspective views a market as inefficient if, after deducting such costs, active investing can earn superior returns. Gross of expenses, a return should accrue to information acquisition in an efficient market.

Credit Linked Coupon Bonds

The coupon changes when the bonds credit rating changes.

MPTS: Pass Through Rate

The coupon rate on a MPTS. The pass through rate received by the investor is said to be net interest or net coupon. Weighted average coupon rate (WAC): WAC is calculated by weighting the mortgage rate of each mortgage in the pool by the percentage of the outstanding mortgage balance relative to the outstanding amount of all the mortgages in the pool Weighted average maturity (WAM): the WAM is calculated by weighting the remaining number of months to maturity of each mortgage in the pool by the outstanding mortgage balance relative to the outstanding amount of all the mortgages in the pool.

Time Tranching

The creation of classes or tranches in an ABS/MBS that possess different (expected) maturities.

MacDur Fixed Rate Coupon Discount Bonds

The curious result displayed in Exhibit 7 is in the pattern for discount bonds. Generally, the Macaulay duration increases for a longer time-to-maturity. But at some point when the time-to-maturity is high enough, the Macaulay duration exceeds (1 + r)/r, reaches a maximum, and then approaches the threshold from above. In Equation 4, such a pattern develops when the number of periods (N) is large and the coupon rate (c) is below the yield-to-maturity (r). Then the numerator of the second expression within the braces can become negative. The implication is that on long-term discount bonds, the interest rate risk can actually be less than on a shorter-term bond, which explains why the word "generally" is needed in describing the maturity effect for the relationship between bond prices and yields-to-maturity. Generally, for the same coupon rate, a longer-term bond has a greater percentage price change than a shorter-term bond when their yields-to-maturity change by the same amount. The exception is when the longer-term bond actually has a lower duration statistic.

Classification by Currency Denomination

The currency denomination of the bonds cash flows influences which interest rates affect bonds.

Experience Curve Declines b/c

The curve declines 1. because as the utilization of capital equipment increases, fixed costs (administration, overhead, advertising, etc.) are spread over a larger number of units of production, 2. because of improvements in labor efficiency and management of facilities, and 3. because of advances in production methods and product design. The experience curve is especially important in industries with high fixed overhead costs and/or repetitive production operations, such as electronics and appliance, automobile, and aircraft manufacturing.

General Obligation Bonds (GO)

The economic analysis of non-sovereign government GO bonds, including US municipal bonds, focuses on employment, per capita income (and changes in it over time), per capita debt (and changes in it over time), the tax base (depth, breadth, diversification, stability, etc.), demographics, and net population growth, as well as an analysis of whether the area represented by the non-sovereign government has the infrastructure and location to attract and support new jobs. Analysis should look at the volatility and variability of revenues during times of both economic strength and weakness. An overreliance on one or two types of tax revenue—particularly a volatile one, such as capital gains taxes or sales taxes—can signal increased credit risk. Pensions and other post-retirement obligations may not show up directly on the non-sovereign government's balance sheet, and many of these entities have underfunded pensions that need to be addressed. Adding the unfunded pension and post-retirement obligations to the debt reveals a more realistic picture of the issuer's debt and longer-term obligations. The relative ease or difficulty in managing the annual budgeting process and the government's ability to operate consistently within its budget are also important credit analysis considerations.

Fundemental Analysis

The examination of publicly available information and the formulation of forecasts to estimate the intrinsic value of assets. Fundamental analysis involves the estimation of an asset's value using company data, such as earnings and sales forecasts, and risk estimates as well as industry and economic data, such as economic growth, inflation, and interest rates. Fundamental analysis is necessary in a well-functioning market because this analysis helps the market participants understand the value implications of information. In other words, fundamental analysis facilitates a semi-strong efficient market by disseminating value-relevant information.

Terminal Stock Value (Terminal Value)

The expected value of a share at the end of the investment horizon

PAC Tranche & Support Tranche

The full PAC tranche, P-A, is paid off, then the support tranche, then P-B, then

Bond Indenture

The governing legal credit agreement, typically incorporated by reference in the prospectus. Also called trust deed.

FI: Settlement & Custodial Service

The hierarchical system of responsibility generally ensures that traders settle their trades. The brokers and dealers guarantee settlement of the trades they arrange for their retail and institutional customers. The clearinghouse members guarantee settlement of the trades that their customers present to them, and clearinghouses guarantee settlement of all trades presented to them by their members. If a clearinghouse member fails to settle a trade, the clearinghouse settles the trade using its own capital or capital drafted from the other members. Depositories or custodians hold securities on behalf of their clients. These services, which are often offered by banks, help prevent the loss of securities through fraud, oversight, or natural disaster. Broker-dealers also often hold securities on behalf of their customers so that the customers do not have to hold the securities in certificate form. To avoid problems with lost certificates, securities increasingly are issued only in electronic form.

Position: Swap

The identification of the long side in a swap contract is often arbitrary because swap contracts call for the exchange of contractually determined cash flows rather than for the purchase (or the cash equivalent) of some underlying instrument. In general, the side that benefits from an increase in the quoted price is the long side.

Position: Options

The identification of the two sides can be confusing for option contracts. The long side of an option contract is the side that holds the right to exercise the option. The short side is the side that must satisfy the obligation. Practitioners say that that the long side holds the option and the short side writes the option, so the long side is the holder and the short side is the writer. The put contracts are the source of the potential confusion. The put contract holder has the right to sell the underlying to the writer. The holder will benefit if the price of the underlying falls, in which case the price of the put contract will rise. The holder is long the put contract and has an indirect short position in the underlying instrument. Analysts call the indirect short position short exposure to the underlying. The put contract holders have long exposure to their option contract and short exposure to the underlying instrument.

Effective Annual Rate (EAR)

The interest rate expressed as if it were compounded once per year.

Horizon Yield

The internal rate of return between the total return (the sum of reinvested coupon payments and the sale price or redemption amount) and the purchase price of the bond. Horizon yield on a bond investment is the annualized holding period rate of return

True Yield

The internal rate of return on cash flows using the actual calendar including weekends and bank holidays.

Calculation of Index Values Over Multiple Time Periods: Total Return

Vтו = Vт₀(1+TR₁)*(1+TR₂)...(1+TRוт) where, Vтו = value of index at inception Vтו = total return index at time t TRוт = Total Return as a decimal number

Different Methods for Linking Cash Flows of Index Linked Bond to Specified Indexes

The link may be via interest payments, principal payments, or both. 1. Zero-coupon-indexed bonds pay no coupon, so the inflation adjustment is made via the principal repayment only: The principal amount to be repaid at maturity increases in line with increases in the price index during the bond's life. This type of bond has been issued in Sweden. 2. Interest-indexed bonds pay a fixed nominal principal amount at maturity but an index-linked coupon during the bond's life. Thus, the inflation adjustment applies to the interest payments only. This type of bond was briefly issued by the Australian government in the late 1980s, but it never became a significant part of the inflation-linked bond market. 3. Capital-indexed bonds pay a fixed coupon rate but it is applied to a principal amount that increases in line with increases in the index during the bond's life. Thus, both the interest payments and the principal repayment are adjusted for inflation. Such bonds have been issued by governments in Australia, Canada, New Zealand, the United Kingdom, and the United States. 4. Indexed-annuity bonds are fully amortized bonds, in contrast to interest-indexed and capital-indexed bonds that are non-amortizing coupon bonds. The annuity payment, which includes both payment of interest and repayment of the principal, increases in line with inflation during the bond's life. Indexed-annuity bonds linked to a price index have been issued by local governments in Australia, but not by the national government.

Yield to Worst

The lowest of the sequence of yields to call and YTM.

Unsecured Debt: Subordinated Debt & Junior Subordinated Debt

The lowest rank of debt and generally has no claim in the event of default.

Internal vs. External Credit Enhancements of Non-Agency RMBS and Non-Mortgage ABS

The most common forms of internal credit enhancement are senior/subordinated structures, reserve funds, and overcollateralization. In external credit enhancement, credit support in the case of defaults resulting in losses in the pool of loans is provided in the form of a financial guarantee by a third party to the transaction.

Index Return Formula: Total Return

Total return is the price appreciation plus interest, dividends, or other distruibutions TRו = [Vpr₁ - Vpr₀ + Iתᥴ៲]/Vpr₀ Vpr₁ = value of the price return index at the end of the period Vpr₀ = value of the price return index at the beginning of the period Iתᥴ = total income (dividends and interest) from all securities in the index over the holding period

Securitized Assets

The pool of securitized assets from which the ABS's cash flows are generated. These assets are typically loans and receivables and include, among others, residential mortgage loans (mortgages), commercial mortgages, automobile (auto) loans, student loans, bank loans, accounts receivables, and credit card receivables.

Securitization

The process of transforming loans or other financial assets into securities. Transfer ownership of assets from original owners into a special legal entity.

Open Market Operations

The purchase or sale of bonds by the national central bank to implement monetary policy. The bonds traded are usually sovereign bonds issued by the national government.

Market Discount Rate

The rate of return required by investors given the risk of the investment in a bond; also called the required yield or the required rate of return. Also called required yield or required rate or return.

CMBS Balloon Maturity Provision

The risk that a borrower will not be able to make the balloon payment because either the borrower cannot arrange for refinancing or cannot sell the property to generate sufficient funds to pay off the outstanding principal balance is called "balloon risk." Because the life of the loan is extended by the lender during the workout period, balloon risk is a type of extension risk.

Curve Duration

The sensitivity of the bond price (or the market value of a financial asset or liability) with respect to a benchmark yield curve. A curve duration statistic often used is effective duration.

Yield Duration

The sensitivity of the bond price with respect to the bond's own yield-to-maturity. Yield duration statistics used in fixed-income analysis include Macaulay duration, modified duration, money duration, and the price value of a basis point (PVBP)

Quoated Margin on FRN

The specified yield spread over the reference rate, used to compensate an investor for the difference in the credit risk of the issuer and that implied by the reference rate. For example, a company with strong credit may be able to borrow at a negative LIBOR

Information Motivated Traders

Traders that trade to profit from information that they believe allows them to predict future prices.

Simple Yield

The sum of the coupon payments plus the straight-line amortized share of the gain or loss, divided by the flat price. This is used most commonly to quote Japanese government bonds, "JGBs".

Parties to Securitization

The three main parties to a securitization are: 1. the seller of the collateral, sometimes called the depositor (Mediquip in our example); 2. the SPE that purchases the loans or receivables and uses them as collateral to issue the ABS—MET in our example. (The SPE is often referred to as the issuer in the prospectus because it is the entity that issues the securities; it may also be called the trust if the SPE is set up as a trust); and 3. the servicer of the loans (Mediquip in our example).

Aggregate Supply of Funds & ROR

The total money saved must equal the total money borrowed and received in exchange for equity, the expected return depends on the aggregate supply of funds through savings and the aggregate demand for funds. If the rate is too high, savers will move more money to the future than both borrowers and equity issuers will want to move it to the present. Opposite if it is too low.

Convexity & Return

The two bonds in Exhibit 12 are assumed to have the same price, yield-to-maturity, and modified duration. Therefore, they share the same line tangent to their price-yield curves. The benefit of greater convexity occurs when their yields-to-maturity change. For the same decrease in yield-to-maturity, the more convex bond appreciates more in price. And for the same increase in yield-to-maturity, the more convex bond depreciates less in price. The conclusion is that the more convex bond outperforms the less convex bond in both bull (rising price) and bear (falling price) markets. This conclusion assumes, however, that this positive attribute is not "priced into" the bond. To the extent that it is included, the more convex bond would have a higher price (and lower yield-to-maturity). That does not diminish the value of convexity. It only suggests that the investor has to pay for it. As economists say, "There is no such thing as a free lunch."

Prepayment Risk

The uncertainty that the timing of the actual cash flows will be different front eh scheduled cash flows as set forth in the loan agreement due to the borrowers' ability to alter payments, usually to take advantage of interest rate movements.

Option Adjusted Price

The value of the embedded option plus the flat price of the bond.

G-Spread

The yield spread in basis points of a fixed rate bond over a government bond. Euro bonds are priced over a EUR interest rate swap benchmark

I-Spread (Interpolated Spread)

The yield spread of a specific bond over the standard swap rate in that currency of the same tenor.

Required Margin

The yield spread over, or under, the reference rate such that the FRN is priced at par value on a rate reset date. At the reset date, any change in Libor is included in the interest payment for the next period.

Industry Capacity

Tight, or limited, capacity gives participants more pricing power as demand for the product or service exceeds supply, whereas overcapacity leads to price cutting and a very competitive environment as excess supply chases demand. An analyst should think about not only current capacity conditions but future changes in capacity levels.

Tenor

Time remaining until bonds maturity date.

Tenor

Time to maturity of underlying bond or contract.

Time Tranching

Time tranching is the process in which a set of bond classes or tranches is created that allow investors a choice in the type of prepayment risk, extension or contraction, that they prefer to bear.

Contingent Convertible Bond (CoCos)

These are bonds with contingent write down provisions. Two main features distinguish bonds with contingent write-down provisions from the traditional convertible bonds just described. A traditional convertible bond is convertible at the option of the bondholder, and conversion occurs on the upside—that is, if the issuer's share price increases. In contrast, bonds with contingent write-down provisions are convertible on the downside. In the case of CoCos, conversion is automatic if a specified event occurs—for example, if the bank's core Tier 1 capital ratio (a measure of the bank's proportion of core equity capital available to absorb losses) falls below the minimum requirement set by the regulators. Thus, in the event that the bank experiences losses that reduce its equity capital below the minimum requirement, CoCos are a way to reduce the bank's likelihood of default and, therefore, systemic risk—that is, the risk of failure of the financial system. When the bank's core Tier 1 capital falls below the minimum requirement, the CoCos immediately convert into equity, automatically recapitalizing the bank, lightening the debt burden, and reducing the risk of default. Because the conversion is not at the option of the bondholders but automatic, CoCos force bondholders to take losses. For this reason, CoCos must offer a higher yield than otherwise similar bonds.

Bullet Mortgage, Interest Only Lifetime Mortgage

These are interst only mortgages in which no principal payment is made during the life of the loan.

Financial Intermdiaries (FI)

These intermediaries include commercial, mortgage, and investment banks; credit unions, credit card companies, and various other finance corporations; brokers and exchanges; dealers and arbitrageurs; clearinghouses and depositories; mutual funds and hedge funds; and insurance companies. There job is to connect buyers to sellers.

Spot Curve Gov't Bonds

These make the perfect maturity structure b/c other than maturity all else is equal. Plus there is no reinvestment. Analysts usually use only the most recently issued and actively traded government bonds to build a yield curve. These bonds have similar liquidity, and because they are priced closer to par value, they have fewer tax effects.

Yield to Maturity (Redemption Yield/Yield to redemption): 3 Critical Assumption

This is the internal rate of return on the cash flows. 1. The investor holds the bond to maturity. 2. The issuer makes all of the coupon and principal payments in the full amount on the scheduled dates. Therefore, the yield-to-maturity is the promised yield—the yield assuming the issuer does not default on any of the payments. 3. The investor is able to reinvest coupon payments at that same yield. This is a characteristic of an internal rate of return.

Gordon Growth Model

This model assumes dividends grow indefinitely at a constant rate A history of stable dividend growth Eq. 8 V₀ = ∑[D₀(1+g)ᵗ]/(1+r)ᵗ if the required return, r, is assumed to be strictly greater than the growth rate, g, then the square bracketed term is an infinite geometric series and sums to [(1+g)/(1+r)] which may substitue into Eq. 8, Eq. 9 V₀ = [D₀(1+g)]/(r-g) => D₁/(r-g) Note denominator is D₁, not D₀

Private Investment in Public Equity (PIPE)

This type of investment is generally sought by a public company that is in need of additional capital quickly and is willing to sell a sizeable ownership position to a private investor or investor group.

Prepayment Rate Measures

Two important rate measures are 1. Single monthly mortality rate (SMM) 2. Conditional prepayment rate (CPR) SMM = prepayment for the month/(beginning outstanding mortgage balance for the month - scheduled principal repayment for the month) Public Securities Association (PSA) prepayment benchmark, which is produced by the Securities Industry & Financial Markets Association (SIFMA), describes the prepayment rates in terms of a prepayment pattern or benchmark over the life of the mortgage pool. What is important to remember is that the standard for the PSA model is 100 PSA; that is, at 100 PSA, investors can expect prepayments to follow the PSA prepayment benchmark—for example, an increase of prepayment rates of 0.20% for the first 30 months until they peak at 6% in Month 30. A PSA assumption greater than 100 PSA means that prepayments are assumed to be faster than the standard model. In contrast, a PSA assumption lower than 100 PSA means that prepayments are assumed to be slower than the standard model.

Time Series Anomalies

Two major ones are 1. Calendar anomalies: January effect or turn of the year effect and is most frequently observed for the returns of small market cap stocks. —Tax loss harvesting may account for a portion of the abnormal returns, but not all of it. — Portfolio managers reduce risk in December before they publish their portfolios, and then rebuy the securities. The evidence for this is limited. — Recent studies of bonds and equites seem to show the January effect does not really exist. 2. Momentum and overreaction anomalies: stock prices will be inflated (depressed) for those companies releasing good (bad) information. This anomaly has become known as the overreaction effect.

Fixed Rate Sovereign Bonds

Two types 1. Zero coupon: does not pay interest but instead is issued at a discount to par and redeemed at maturity 2. Coupon bonds: issued at a stated interest rate and make interest payments periodically.

Duration of Bond Portolio

Two ways to calculate 1. Weighted average time to receipt of the aggregate cash flows: theoretically correct approach but diffficult 2. the weighted average of the individual bond durations that comprise the portfolio: not as exact but more common

Shelf Registration

Type of public offering that allows the issuer to file a single, all-encompassing offering circular that covers a series of bond issues. This master prospectus may be in place for years before it is replaced or updated. These are only an option for well established issuers that have convinced the regulatory authorities of their financial strength.

High Yield: Debt Structure

Types of debt typically on a high yield issuer's balance sheet: 1. (Secured) Bank debt 2. Second lien debt 3. Senior unsecured debt 4. Subordinated debt, which may include convertible bonds 5. Preferred stock For a high yield issuer with several layers of debt with different expected recovery rates, high-yield analysts should calculate leverage at each level of the debt structure.

MacDur Fixed Rate Coupon Premium

Typical fixed-rate coupon bonds with a stated maturity date are portrayed in Exhibit 7 as the premium and discount bonds. The usual pattern is that longer times-to-maturity correspond to higher Macaulay duration statistics. This pattern always holds for bonds trading at par value or at a premium above par. In Equation 4, the second expression within the braces is a positive number for premium and par bonds. The numerator is positive because the coupon rate (c) is greater than or equal to the yield-to-maturity (r), whereas the denominator is always positive. Therefore, the Macaulay duration is always less than (1 + r)/r, and it approaches that threshold from below as the time-to-maturity increases.

Trustee

Typically a financial institution that acts in a fiduciary capacity w/ the bondholders The trustee's role is to monitor that the issuer complies with the obligations specified in the indenture and to take action on behalf of the bondholders when necessary. The trustee's duties tend to be administrative and usually include maintaining required documentation and records; holding beneficial title to, safeguarding, and appraising collateral (if any); invoicing the issuer for interest payments and principal repayments; and holding funds until they are paid, although the actual mechanics of cash flow movements from the issuers to the trustee are typically handled by the principal paying agent. In the event of default, the discretionary powers of the trustee increase considerably. The trustee is responsible for calling meetings of bondholders to discuss the actions to take. The trustee can also bring legal action against the issuer on behalf of the bondholders.

Parallel Shift

Typically a shift in the yield curve is not parallel. Thus, the rates will not all change as one. The estimation of MacDur and ModDur can be incorrect b/c of different rate changes.

Convertible Bond Maturities

Typically are 5-10 years, but younger issuers are able to issue at around 3 years.

Strength & Weakness of Current System

Unlike commercial systems, the government classification systems do not disclose information about a specific business or company, so an analyst cannot know all the constituents of a particular category. Government systems do not generally distinguish b/t small and large businesses. Another limitation of the current systems is that the narrowest classification unit assigned to a company cannon be assumes to be its peer group for the purposes of detailed fundemental comparisons or valuation. A peer group is a group of companies whose economics and valuation are influenced by closely related factors.

Sinking Fund Arrangements

Used to periodically retire a bond's principal outstanding. Originally, a sinking fund was a specified cash reserve that was segregated from the rest of the issuer's business for the purpose of repaying the principal. More generally today, a sinking fund arrangement specifies the portion of the bond's principal outstanding, perhaps 5%, that must be repaid each year throughout the bond's life or after a specified date. This repayment occurs whether or not an actual segregated cash reserve has been created. May include a call provision allowing the issuer to repurchase the bond at market price, par, or a specified sinking fund price. Bonds to retire are selected at random based on serial number. Risk to investors: 1. Reinvestment risk: risk of reinvesting the funds at a rate lower than the bond 2. Issuer may repurchase bonds below market price.

Forward Rates & Spot Rates

Using a geometric series, spot rates may be made from a series of forward rates.

Credit Quality of Sovereign Bonds

Usually the bonds are unsecured obligations of the issuer, backed only by the taxing authority of the government. The national government of a country that has a strong domestic savings base has the luxury of being able to issue bonds in its local currency and sell them to domestic investors.

Floating Rate Sovereign Bonds

Usually the rate is based on changes in a reference rate such as LIBOR.

Formula of Price Return index

V(pri) = ∑nᵢPᵢ/D V(pri) = value of price return index nᵢ = number of units of constituent security ᵢ held in the index N = number of constituent securities in the index Pᵢ = unit price of constituent security i D = value of the divisor Divisor is initially chosen at inception and generally 1000. This may change as the index changes and old constiuents are replaced with new constituents. This is done to keep the index consistent.

Equity: Warrant

Warrants are securities issued by a corporation that allow the warrant holders to buy a security issued by that corporation, if they so desire, usually at any time before the warrants expire or, if not, upon expiration. The security that warrant holders can buy usually is the issuer's common stock, in which case the warrants are considered equities because the warrant holders can obtain equity in the company by exercising their warrants. The warrant exercise price is the price that the warrant holder must pay to buy the security.

Fixed Income Indexes

Weighting may be based on price or value (market capitalization) Bloomberg Barclays Global Aggregate Bond Index: represents a broad based measure of global investment grade fixed rate bonds JP Morgan Emerging Bond Index (EMBI): emerging market bond index FTSE Global Bond Index Series: established to provide coverage of different classes of securities related to government and corporate bond markets.

Leveraged Buyout (LBO)

When a group of investors uses a large amount of debt to purchase all of th outstanding common share of a publicly traded company. Management buyout (MBO): the group of investors mostly consists of the company's exiting management. Companies that are candidates for these types of transactions generally have large amounts of undervalued assets (which can be sold to reduce debt) and generate high levels of cash flows (which are used to make interest and principal payments on the debt). The ultimate objective of a buyout (LBO or MBO) is to restructure the acquired company and later take it "public" again by issuing new shares to the public in the primary market.

Stock Split & Price Index

When a stock splits it will affect the weights on all securities in the index, and to prevent this the index provider must adjust the value of the divisor Main advantage of price weighting is simplicity, but the drawback is the arbitrary weighting. Divisor is changed by dividing the sum of the constituent prices before the split by the value of the index before the split.

FI: Securitization & Tranches

When financial intermediaries securitize assets, they often create several classes of securities, called tranches, that have different rights to the cash flows from the asset pool. The tranches are structured so that some produce more predictable cash flows than do others. The senior tranches have first rights to the cash flow from the asset pool. Because the overall risk of a given asset pool cannot be changed, the more junior tranches bear a disproportionate share of the risk of the pool. Practitioners often call the most junior tranche toxic waste because it is so risky. The complexity associated with slicing asset pools into tranches can make the resulting securities difficult to value.

Yield to Maturity (YTM/Redemption Yield)

YTM is an internal rate of return on the bonds expected cash flows — that is the discount rate that equates the present value of the bond's expected cash flows until maturity to the bond's price. YTM may be considered an estimate of the bonds expected return; it reflects the annual return an investor will earn on a bond if the investor purchases the bond today and holds it until maturity.

Spot Rate

YTM on zero coupon bond.

Street Convention

Yield measure that neglects weekends and holidays; the internal rate of return on cash flows assuming payments are made on the scheduled dates, even when the scheduled date falls on a weekend or holiday.

Yield on Corporate Bond & Yield Spread

Yield on corporate bond = Real risk free interest rate + Expected inflation + Maturity premium + Liquidity premium + Credit spread Yield spread = Liquidity premium + Credit spread

Benchmark Rates

Yields to maturity on government bonds or fixed rates on interest rate swaps. The

Leveraged Position: Margin Call Formula

[Equity/Share]/[Price/Share] = [Eauity + Sт -P₀]/P₀

Estimating Growth, g, in Gordon Growth Model

g = b * ROE where, g = dividend growth rate b = earnings retention rate = (1-dividend payout ratio) ROE = return on equity`

Forward Rate

the interest rate on a bond or money market instrument traded in a forward market.

Fundemental Weighting

wᶠᵢ = Fᵢ/∑Fĵ F = fundemental size measure of company ᵢ This attempts to address the disadvantage of market capitalization weighting by using measures of a company's size that are independent of its security price to determine the weight on each constituent security. Measures include book value, cash flow, revenues, earnings, dividends, and number of employees. Relative to a market-capitalization-weighted index, a fundamental index with weights based on such an item as earnings will result in greater weights on constituent securities with earnings yields (earnings divided by price) that are higher than the earnings yield of the overall market-weighted portfolio. Fundementally weighted index's have a value tilt. In contrast to the momentum "effect" of market-capitalization-weighted indexes, fundamentally weighted indexes generally will have a contrarian "effect" in that the portfolio weights will shift away from securities that have increased in relative value and toward securities that have fallen in relative value whenever the portfolio is rebalanced.