Secret Sauce 2
Central bank policy tools
- Changing the policy rate. - Changing the reserve requirement. - Open market operations.
Components of GDP
- Consumption spending - Business investment - Government spending - Net exports
Phases of the business cycle
- Expansion (real GDP increasing) - Peak (real GDP stops increasing) - Contraction/Recession (real GDP decreasing) - Trough (real GDP stops decreasing and begins increasing)
FIFO in deflation
- Higher COGS - Lower gross profit - Lower inventory balances
Arguments for being concerned with the size of fiscal deficit
- Higher future taxes lead to disincentives to work, negatively affecting long-term economic growth. - Fiscal deficits might not be financed by the market when debt levels are high. - A crowding-out effect as government borrowing increases interest rates and decreases private sector investment.
Sources of economic growth
- Increases in the supply of labor. - Increases in human capital. - Increases in the supply of physical capital. - Increases in the availability of natural resources. - Advances in technology.
Contractionary central bank policy
- Increasing the policy rate - Increasing reserve requirements - Making open market sales of securities
Objectives of fiscal policy
- Influencing the level of economic activity. - Redistributing wealth or income. - Allocating resources among industries.
Difference between US GAAP and IFRS on CF
- Interest and dividends received may be classified as either CFO or CFI. - Dividends paid to shareholders and interest paid on debt may be classified as either CFO or CFF. - Income taxes are reported as operating activities unless the expense can be tied to an investing or financing transaction.
Characteristics of a well functioning financial system
- Investors can save for the future at fair rates of return. - Creditworthy borrowers can obtain funds. - Hedgers can manage their risks. - Traders can obtain the currencies, commodities, and other assets they need Operationally efficient = low trading costs Informationally efficient = transparent information Allocationally efficient = if the first two exist then invests will naturally allocate correctly
LIFO in deflation
- Lower COGS - Higher gross profit - Higher inventory balances
Categories of Accrual Accounting
1. Unearned revenue: Cash increases and a liability for the goods or services the firm must provide in the future is recorded in the same amount. 2. Accrued revenue: Revenue is recorded for credit sales, accounts receivable increases, and inventory decreases. 3. Prepaid expenses: Cash decreases and an asset (prepaid expenses) increases. The asset decreases and expenses increase when the expense is actually incurred. 4. Accrued expenses: The firm owes cash for expenses it has incurred but has not paid. A liability for accrued expenses, such as wages payable, increases.
Neoclassical economists
Believe that business cycles are temporary and driven by changes in technology. Rapid adjustments of wages and other input prices cause the economy to move to full-employment equilibrium.
Keynesian economists
Believe that excessive optimism or pessimism among business managers causes business cycles. Contractions can persist because wages are slow to move downward.
Risk of callable bonds
Bondholders have more reinvestment risk as a result, as they must reinvest the proceeds of ____ bonds at lower yields. For this reason, a _____ bond must offer a higher yield (sell at a lower price) than an otherwise identical bond.
Organizational infrastructure for managing stakeholders
A company's corporate governance procedures, including its internal systems and practices that address how it manages its stakeholder relationships.
Current yield for a bond
Annual coupon payments plus the straight-line amortization fo a discount divided by the flat price.
Money market yield
Annualized (without compounding) based on a 360-day year rMM =HPY× (360/t)
Owners' Equity
Balance Sheet Claims that the firm's owners have on it's resources. The residual interest in the assets of an entity that remains after deducting its liabilities.
Liabilities
Balance Sheet The claims that creditors have on the company's resources. Probable future sacrifices of economic benefits. They arise from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events
Held-to-maturity securities recognition
Balance sheet = Amortized cost Income statement 1. Interest 2. Realized G/L
Available-for-sale securities recognition
Balance sheet = Fair value Income statement 1. Dividends 2. Interest 3. Realized G/L
Deferred tax liabilities
Balance sheet amounts that result from an excess of income tax expense over taxes payable and are expected to result in future cash outflows.
Deferred tax assets
Balance sheet amounts that result when taxes payable are greater than income tax expense. This results when revenues are recognized for tax prior to their recording on the financial statements, or when expenses for financial reporting are recorded prior to recognizing them as deductible expenses for tax. Prior losses in excess of those that can be used to offset previous income represent a tax-loss carryforward, which is an asset as it will reduce future taxes.
Giffen good
A good for which a decrease in price decreases its value to some consumers and thus decreases demand
GDP (formula)
C + I + G + (X - M)
Cross price elasticity of demand (Formula)
C × P.other good /Q* C > 0 the goods are substitutes C < 0 the goods are complements
Operating Cash Flow
Cash Flow Statement Includes the cash effects of transactions that involve the normal business of the firm.
Perpetuities
Annuities with indefinite lives PV of perpetuity = periodic payment / periodic interest rate
Cournot model
Assumes that the firms in a two-firm oligopoly have identical cost structures and react only to the price charged by the other firm in the prior period. Each firm will produce half the industry output and charge the same price in equilibrium.
Loan to value ratio (LTV)
Current mortgage amount / current appraised value Measure for the credit rating of CMBS. Lower is better
Planned amortization class tranche (PAC)
This reduced prepayment risk on ABS because support tranches take on more prepayment risk.
Antidilutive securities
Those securities that would increase EPS if exercised and converted to common stock.
Weighted average number of shares outstanding
Each share issue is weighted by the portion of the year it was outstanding. Stock splits and stock dividends are applied retroactively to the beginning of the year, so "old" shares are converted to "new" shares for consistency.
Test statistic for hypothesis test of two population variances
F-statistic
Free cash flow to the firm (FCFF) (formula calculating from operating cash flow)
FCFF = CFO + [interest expense × (1 - tax rate)] - net capital expenditure
International Monetary Fund (IMF)
Facilitates trade by promoting international monetary cooperation and exchange rate stability, assists in setting up international payments systems, and makes resources available to member countries with balance of payments problems.
Labor
Factor of production All levels from unskilled to management
Capital
Factor of production Plants, equipment, physical means of production (not money).
Land
Factor of production Where facilities are located
Assets when using a financing vs operating lease
Finance lease = higher operating lease = lower
CFO when using a financing vs operating lease
Finance lease = higher operating lease = lower
Debt/equity when using a financing vs operating lease
Finance lease = higher operating lease = lower
Liabilities when using a financing vs operating lease
Finance lease = higher operating lease = lower
Asset turnover when using a financing vs operating lease
Finance lease = lower operating lease = higher
Current ratio when using a financing vs operating lease
Finance lease = lower operating lease = higher
Return on assets when using a financing vs operating lease
Finance lease = lower operating lease = higher
Return on equity when using a financing vs operating lease
Finance lease = lower operating lease = higher
Working capital when using a financing vs operating lease
Finance lease = lower operating lease = higher
External credit enhancements
Financial guarantees that support the performance of a given ABS
Tax Expense
Expense Item Payments for taxes
Partially amortizing structure
Fixed income structure where the periodic payments include both interest and principal, but the last payment is a ballon payment to pay off the remaining principal
Sharpe ratio
Measures of Dispersion Widely used to evaluate investment performance and measures excess return per unit of risk. Higher the ratio the better. Sharpe ratio = ( R(portfolio) − R(risk-free) / σ(portfolio)
Computing IRR
The discount rate that makes the NPV equal to zero.
Internal rate of return
The discount rate that makes the present value of the expected future cash flows equal to the initial cost of the project. If the IRR is greater than the project's cost of capital, it should be accepted because it is expected to increase firm value. If the IRR is equal to the project's cost of capital, the NPV is zero.
Fisher price index
The geometric mean of a Laspeyres index and a Paasche index and is termed a chained index.
Null Hypothesis (H0)
The hypothesis the researcher wants to reject
Corporate governance
The internal controls and procedures for managing companies
Recourse Loan
The lender has a claim against the assets of the borrower for any excess of the amount owed above the proceeds from the property after it is repossessed and sold.
Spot exchange rate
The currency exchange rate for immediate delivery.
Real exchange rate
Tells us the dollar cost of purchasing that same unit of goods and services based on the new (current) dollar/euro exchange rate and the relative changes in the price levels of both countries.
Bank discount yield
The annualized percentage discount from face value bank discount yield = r.BD = ($discount/face value) × (360/days)
Governmental infrastructure for managing stakeholders
The regulations to which companies are subject.
Quote-driven markets
Traders transact with dealers (market makers) who post bid and ask prices. Dealers maintain an inventory of securities. Sometimes called dealer markets, price-driven markets, or over- the-counter markets. Most securities other than stocks trade in these and trading often takes place electronically.
Concentration measures for a market
Often used as an indicator of market power instead of elasticity
Sovereign bonds
Fixed income structure issued and backed by a government and it's taxes/ability to print money
Call option on bond
Fixed income structure that gives the bond issues the right to redeem part or all of a bond issue at a specific price.
Floating rate note
Fixed income structure where the coupon rate is based on a reference rate (LIBOR, FED rate, etc). The difference is usually based not he credit worthiness of the issuer
Principal-protected bond
Fixed income structure where the final payment is not less than the original value (liq pref for bonds)
Inverse floating rate note
Fixed income structure where the floating rate note has a moving margin that adjusts based on the opposite of the reference rate
Variable rate note
Fixed income structure where the floating rate note has a moving margin that adjusts based on the reference rate
Fully amortizing structure
Fixed income structure where the periodic payments include both interest and principal and the principal is fully paid off at the last payment
Contingency provision bond
Fixed income structure where the protective provisions that indicate what actions must be taken if a specific action occurs
Bullet structure
Fixed income structure with periodic coupon interest payments are made over the life of the bond and the principle is paid with the final interest payment at maturity
Net Present Value (NPV) of an Investment Project
For a typical investment or capital project, the NPV is simply the present value of the expected future cash flows, minus the initial cost of the investment. The steps in calculating an NPV are: 1. Identify all outflows/inflows associated with the investment. 2. Determine discount rate appropriate for the investment. 3. Find PV of the future cash flows. Inflows are positive and outflows are negative. 4. Compute the sum of all the discounted future cash flows. 5. Subtract the initial cost of the investment or capital project.
Cumulative density function (CDF)
For either a discrete or continuous distribution, gives the probability that a random variable will take on a value less than or equal to a specific value, that is, the probability that the value will be between minus infinity and the specified value.
Percentage-of-completion method
For long-term contracts. Appropriate method when the outcome of the project can be reliably estimated. Revenue, expense, and profit are recognized in proportion to the total cost incurred to date, divided by the total expected cost of the project.
Monte Carlo simulation
Performed by making assumptions about the distributions of prices or risk factors and using a large number of computer-generated random values for the relevant risk factors or prices to generate a distribution of possibly outcomes (e.g., project NPVs, portfolio values). The simulated distributions can only be as accurate as the assumptions about the distributions of and correlations between the input variables assumed in the procedure.
CFA Code of Ethics Rule 2
Place the integrity of the investment profession and the interests of clients above their own personal interests.
Lagging indicators
Have turning points that tend to occur after those of the business cycle. The bank prime lending rate, inventory-to-sales ratio, average duration of unemployment, and the change in unit labor costs are examples of lagging indicators.
Leading indicators
Have turning points that tend to precede those of the business cycle. Weekly hours in manufacturing, the S&P 500 return, private building permits, initial unemployment claims, and the real M2 money supply are examples
Repo margin behavior
Higher the longer the repo term. Lower the higher the quality of the collateral security. Lower the higher the credit quality of the borrower. Lower when the collateral security is in high demand or low supply
Comparative advantage
If a country can product a good where the opportunity cost, in terms of other goods that could be produced instead, is lower than that of another country.
Downtrend in the market
If prices are consistently reaching lower lows and retracing to lower highs. Means supply is increasing relative to demand. A trendline can be drawn that connects the high points in a downtrend.
Financial Liabilities
Liability Things such as short-term notes payable
Production function
Relates economic output to the supply of labor, the supply of capital, and total factor productivity.
Income Statement
Reports on the financial performance of the firm over a period of time. The elements include revenues, expenses, gains, and losses.
Investor overconfidence
Securities will be mispriced if investors overestimate their ability to value securities. However, it appears that this mispricing may be hard to predict, may only be temporary, may not be exploitable for abnormal profits, and may only exist for high-growth firms.
Suppliers
Stakeholder with interest preserving an ongoing relationship with the firm, in the profitability of their trade with the firm, and in the growth and ongoing stability of the firm.
Senior managers
Stakeholder with interests that include continued employment and maximizing the total value of their compensation
Hypothesis.
Statement about a population parameter that is to be tested.
Fisher effect
States that a nominal interest rate is equal to the real interest rate plus the expected inflation rate.
Putable common shares
give the shareholder the right to sell the shares back to the firm at a specific price.
Call option
gives the buyer the right (but not the obligation) to buy an asset.
Put option
gives the buyer the right (but not the obligation) to sell an asset.
Currency swap
involves a loan in one currency for the loan of another currency for a period of time
Cost of equity capital discounted cash flow approach (k.commonstock)
k.commonstock = (D1 / P0) + g.
Cost of equity capital CAPM approach (k.commonstock)
k.commonstock = RFR + b(R.market - RFR)
Cost of preferred stock (k.prefstock)
k.prefstock = D.prefstock / P
Total capital (formula)
long-term debt + short-term debt + common and preferred equity
Non-normal distribution Known variance Small Sample (n < 30)
not available
Non-normal distribution Unknown variance Small Sample (n < 30)
not available
informationally efficient capital market
one in which the current price of a security fully and quickly reflects all available information about that security without bias.
Insurance contract
pays a cash amount if a future event occurs.
Common shares
represent a residual claim (after the claims of debt holders and preferred stockholders) on firm assets.
Normal distribution Unknown variance Small Sample (n < 30)
t-statistic
Depository receipts (DRs)
trade like domestic shares but represent an interest in shares of a foreign firm that are held by a bank in the country in which they trade. When the foreign firm is involved with the issue, they are called sponsored, and investors receive the voting rights for the shares their DRs represent. When the foreign firm is not involved, they are termed unsponsored, face less strict reporting requirements, and the depository bank retains the voting rights on the shares.
project beta
used to determine the appropriate cost of equity capital for evaluating a project. An example is a "pure-play method" that is estimated based on the equity beta of a firm purely engaged in the same business as the project.
One-year holding period (formula)
(D.1 + P.1) / (1 + k.e) Where D.1 is the expected dividend
Return on Equity (DuPont original)
(Net income / revenue) * (Revenue / average total assets) * (Average total assets / equity) ALSO KNOWN AS (Net Profit Margin) * (Asset Turnover) * (Leverage Ratio)
M-squared (formula)
(R.P2 −R.f) x (σ.M/σ.M) − (R.M−R.f)
CFO Inflows
- Cash collected from customers - Interest and dividends received - Sale proceeds from trading securities
Advantage of discounted cash flow model
- Fundamentally based on good finance theory (discounted present value) - widely accepted by analysts
CFF Inflows
- Principal amounts borrowed from others - Proceeds from issuing stock
Central bank roles
- Supplying currency, acting as banker to the government and to other banks. - Regulating and supervising the payments system. - Acting as a lender of last resort. - Holding the nation's gold and foreign currency reserves. - Conducting monetary policy.
U.S. FED Balance of Payments
- The current account, which mainly measures the flows of goods and services - The capital account, which consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets - The financial account, which records investment flows.
Framework for Ethical Decision Making
1. Identify 2. Consider 3. Decide and act 4. Reflect
Horizontal common-size balance sheet
A ________ expresses all balance sheet accounts as a percentage of first year values
Horizontal common-size income sheet
A _________ expresses all income statement items as a percentage of first year values
Basic EPS
A calculation that does not consider the effects of any dilutive securities in the computation of EPS.
Annuity
A stream of equal cash flows that occur at equal intervals over a given period.
Commercial mortgage backed securities (CMBS)
ABS that is backed by income production real estate (apartments, warehouses, shopping centers, office buildings, etc)
Deleveraged inverse floater
An _______ where the reference rate is decreased by some multiple
Components of owners' equity
Assets = liabilities + contributed capital + ending retained earnings
Diseconomies of scale
At larger firm sizes, minimum average total costs begin to increase, indicating this term.
Core inflation
Calculated by excluding food and energy prices from a price index because of their high short-term volatility.
Test Statistic
Calculated from sample data and is compared to a critical value to evaluate H0
Mutually exclusive events
Cannot both happen at same time
Sampling error
Difference between the sample statistic and its corresponding population parameter
Financial Statement Notes
Disclosures that offer further detail about the information summarized in the financial statements. Footnotes allow users to improve their assessments of the amount, timing, and uncertainty of the estimates reported in the financial statements.
Type II error
Failure to reject the null hypothesis when it is actually false.
CFF when using a financing vs operating lease
Finance lease = lower operating lease = higher
95% confidence interval
In a normal distribution, __% of the population will fall between plus/minus 1.96 standard deviation of the mean
98% confidence interval
In a normal distribution, __% of the population will fall between plus/minus 2.58 standard deviation of the mean
Shutdown (long run)
In the long run, a firm should shut down if price is expected to remain less than average total cost.
Long-run average total cost
In the long run, firms can adjust their scale of operations (i.e., capital is variable). The minimum average total cost at each possible scale of operations is shown on this curve
Positive Covariance
Indicates that the variables tend to move together relative to their means
Narrow framing
Investors view events in isolation.
Unearned Revenue
Liability Items that will show up on future income statements as revenues.
Accounts payable and trade payables
Liability Money owed to vendors
Income Taxes Payable
Liability The taxes accrued during the past year but not yet paid.
Tax loss carry forwards
Losses that could not be deducted on the tax return in the current period but may be used to reduce taxable income and taxes payable in future periods.
Enterprise value (formula)
Market value of common stock + market value of debt - cash and short-term investments
Nominal GDP
Measures ____ with goods and services at their current prices.
Real GDP
Measures ______ with current-year output using prices from a base year
Weighted mean
Measures of Central Tendency Mean in which different observations are given different proportional influence on the mean weighted mean = (w1*X1 + w2*X2 +...+ wn*Xn)
Median
Measures of Central Tendency Middle value of a data set, half above and half below. With an even number of observations, median is the average of the two middle observations.
Price index
Measures the total cost of a specific basket of goods and services relative to its cost in a prior (base) period.
Shutdown point
Minimum average variable cost
Survivorship bias
Occurs when only looking at functioning company (ignoring some of the failures). The most common form of sample selection bias.
Call markets
Orders are accumulated and securities trade only at specific times. These are potentially very liquid when in session because all traders are present, but they are obviously illiquid between sessions. All trades, bids, and asks are at prices that are set to equate supply and demand.
Momentum effects
Phenomenon where high short-term returns are followed by continued high returns.
Net profit margin
Profitability Ratio. The ratio of net income to revenue. net income / revenue
Gross profit margin
Profitability Ratio. gross profit / revenue
Demand function
Q.D = 100 - A × P.good + B × Income + C × P.other good at price and quantity P* and Q*
Return on Equity (formula used to determine investment management efficiency)
ROE.t = NI.t / average BV.t ROE.t = NI.t / [(BV.t + BV.t−1 ) / 2]
Outcome
Realization of a random variable
Marginal product
Refers to the fact that as you keep adding labor to a fixed amount of capital (a firm's plan and equipment), you get diminishing incremental returns on that labor.
Business risk
Refers to the risk associated with a firm's operating income and is the result of: - Sales risk (variability of demand). - Operating risk (proportion of total costs that are fixed costs).
Factors of production
Resources a firm uses to generate output. Includes: - Land - Labor - Capital - Materials
Straight-line depreciation (formula)
SL depreciation expense = (cost - residual value)/useful life
Structured financial instruments
Securities designed to change the risk profile of an underlying debt or security, often by combining a debt security with a derivative. Ex: asset-backed security and collateralized debt obligations
Present value of an ordinary annuity
The present value of an annuity is just the sum of the present values of all the payments (TVM calculation for each payment)
Operating breakeven quantity
The quantity of sales a firm must achieve to just cover its fixed operating costs only Q.breakeven = fixed operating costs / (price − variable cost per unit)
Term structure of interest rates
The yield at different maturities for like securities or interest rates
Potentially dilutive securities
These securities include stock options, warrants, convertible debt, and convertible preferred stock
Activity ratios
This category includes several ratios also referred to asset utilization or turnover ratios (e.g., inventory turnover, receivables turnover, and total assets turnover). They often give indications of how well a firm utilizes various assets such as inventory and fixed assets.
Continuous markets
Trades occur at any time the market is open with prices set either by the auction process or by dealer bid-ask quotes
Swap contract
Two parties make payments that are equivalent to one asset or portfolio being traded for another
Financial contracts
based on securities, currencies, commodities, or security indexes (portfolios). They include futures, forwards, options, swaps, and insurance contracts.
Net income (formula)
earnings after taxes but before dividends
Operating profits (formula)
earnings before interest and taxes = EBIT
Gross profits (formula)
net sales - COGS
Valuation allowance
A contra account that reduces a deferred tax asset for the probability that it will not be realized (U.S. GAAP).
Beta (formula)
Covariance of Asset i's return with the market return/variance of market return Cov.im / σ2.m
Contributed capital
Owner's equity the total amount received from the issuance of common and preferred stock.
Total Probability Rule
P(R) = P(R | I) × P(I) + P(R | IC) × P(IC) where: I and IC are mutually exclusive and an exhaustive set of events (i.e., if I occurs, then IC cannot occur and one of the two must occur)
Trigger price (margin purchase formula)
P.0 x [(1 - initial margin %) / (1 - maintenance margin %)]
American depository receipts (ADRs)
Denominated in U.S. dollars and trade in the United States.
One challenge to ethical behavior
Individuals tend to overrate the ethical quality of their behavior and overemphasize the importance of their personal traits in determining the ethical quality of their behavior.
Income elasticity of demand (Formula)
B × (Income/Q*) If B > 0, it's a normal goods If B < 0 it's an inferior goods
Diluted EPS (formula)
[(net income - preferred dividends) + convertible pred. dividends + convertible debt interest x (1 - t)] / [weighted ave. shares + converted shares + stock options]
Cost-push inflation
Results from a decrease in aggregate supply caused by an increase in the real price of an important factor of production, such as labor or energy.
Cost recovery method
Profit is recognized only when, and to the extent that, cash collections exceed estimated total costs.
Return on equity (ROE)
Profitability Ratio. Ratio of net income to average total equity (including preferred stock). net income / average total equity
payback period
capital budgeting method the number of years it takes to recover the initial cost of the project. You must be given a maximum acceptable payback period for a project. This criterion ignores the time value of money and any cash flows beyond the payback period.
Pretax margin
Profitability Ratio. EBT/ revenue
Total capital (alternative formula)
total assets
Herfindahl-Hirschman Index (HHI)
A concentration measure This measure is calculated as the sum of the squares of the market shares of the largest firms in the market. This would account for mergers of market leaders
Normal distribution Unknown variance Large Sample (n > 30)
t-statistic* *The z-statistic is the standard normal, ±1 for 68% confidence, et cetera
Monetarists
Believe that inappropriate changes in the rate of money supply growth cause business cycles. Money supply growth should be maintained at a moderate and predictable rate to support the growth of real GDP.
Supranational bonds
Fixed income structure issued by _______ agencies such as the World Bank, IMF or ADB
Contingent convertible bonds
Fixed income structure that convert from death to common equity automatically if a specific event occurs.
Equity swap
involves the exchange of the return on an equity index or portfolio for the interest payment on a debt instrument.
Standard-setting bodies
Professional organizations of accountants and auditors that establish financial reporting standards.
CFA Code of Ethics Rule 5
Promote the integrity and viability of the global capital markets for the ultimate benefit of society.
Free cash flow to equity (FCFE)
The cash flow that is available for distribution to the common shareholders; that is, after all obligations have been paid.
Total case flow when using a financing vs operating lease
Finance lease = same operating lease = same
Internal credit enhancements
Financial guarantees within the ABS structure. Includes reserve funds (cash or excess spread), overcollateralization (principle is less than that of the underlying security) and senior/subordinated structures (credit risk shifts from senior tranches to subordinate tranches)
Agency bonds or quasi government bonds
Fixed income structure issued by governments for financing small businesses or providing mortgage financing
Nonsovereign government bonds
Fixed income structure issued by states, provinces or counties and used to fund hospitals, airports or other service. Payments on the bonds may be supported by revenues from the project
Convertible bonds
Fixed income structure that give the bondholder the option to exchange the bond for a specific number of common stock. Given the upside of the potential for common stock, these bonds require a lower yield.
Warrants on bonds
Fixed income structure that give the holder the right to buy common shares at a given price until an expiration date
London Interbank Offered Rate (LIBOR)
Most widely used reference rate for the floating rate bond. It's published daily for several currencies and down with various maturities (thus there is never just one rate)
Noncontrolling interest (minority interest)
Owner's equity the minority shareholders' pro- rata share of the net assets (equity) of a consolidated subsidiary that is partially owned by the parent.
Support and resistance levels
Prices at which technical analysts expect supply and demand to equalize. Past highs are viewed as resistance levels Past lows are viewed as support levels. Trendlines are also thought to indicate support and resistance levels.
Installment method
Profit recognized is the proportion of cash collected multiplied by the total expected profit. The installment method is used in limited circumstances, usually involving the sale of real estate.
Return on common equity
Profitability Ratio. (net income - preferred dividends) / average common equity
Operating return on assets
Profitability Ratio. A measure of return on _____ that includes both taxes and interest in the numerator. operating income / average total assets - or - EBIT / average total assets
Return on assets (ROA)
Profitability Ratio. Profitability relative to funds invested in the company by common stockholders, preferred stockholders, and suppliers of debt financing. net income / average total asset
Return on total capital (ROTC)
Profitability Ratio. The ratio of net income before interest and taxes to total capital. EBIT / average total capital
Operating profit margin
Profitability Ratio. The ratio of operating profit (gross profit less selling, general, and administrative expenses) to sales. Operating profit is also referred to as earnings before interest and taxes (EBIT) operating income / revenue -or- EBIT / revenue
Temporary supernormal growth or multi-stage DDM
(D.1) / (1 + k.e) ^ 1 + (D.2) /(1 + k.e) ^ 2 + (D.n) / (1 + k.e) ^ n + (P.n) / (1 + k.e) ^ n Where D.n is the last dividend of the supernormal growth period
Unusual or infrequent items
Recorded for events that are atypical for the business. Examples include: - Gains or losses from the sale of assets or part of a business (that do not qualify as discontinued operations). - Impairments, write-offs, write-downs, and restructuring costs.
Forward rates for bonds
Yields for future periods, such as the rate of interest on a three-year loan that would be made two years from now. 2y3y = begins in 2 years and 3 years is the tenor.
Diversification ratio
_____ of the risk of an equal-weighted portfolio of n securities (standard deviation of returns) to the risk of a single security selected at random from the portfolio
Investment committee
Reviews management proposals for large acquisitions or projects, sale or other disposal of company assets or segments, and the performance of acquired assets and other large capital expenditures. Some companies combine these two functions into one committee.
Market model (formula)
Ri = αi + βiRm + ei where: Ri = Return on Asset i Rm = Market return βi = Slope coefficient αi = Intercept ei = Abnormal return on Asset i
Change in accounting principle
The change from one GAAP or IFRS method to another method. Requires retrospective application so all of the prior period financial statements currently presented are restated to reflect the change.
Constant-yield price trajectory
The change in value as time passes if its yield-to-maturity
Futures contracts
similar to forward contracts except that they are standardized as to amount, asset characteristics, and delivery time, and are traded on an exchange.
profitability index
the present value of a project's future cash flows divided by the initial cash outlay. The decision rule is to accept a project if its profitability index is greater than one, which is the same as the IRR > cost of capital rule and the NPV > 0 rule (since PI = 1 + NPV/Initial Outlay).
Price of annual coupon bond (formula)
(Coupon / (1 + YTM)) + (Coupon / (1 + YTM) ^ 2) + (Coupon + principal / (1 + YTM) ^ N)
Principal-agent conflict
Arises because an management and board of directors are hired to act in the interest of the shareholders, but an management/bod interests may not coincide exactly with those of the shareholders. (ex: lower risk = keep job, but lower returns)
New Keynesians
Believe that input prices other than wages are also slow to move downward.
Disadvantages of price multiple models
- May not be comparable across firms with different price, products and growth - May differ depending on the stage of the business cycle - Depending on the multiple used, the same firm can appear overvalued or undervalued at the same time - impacted by different accounting methods in different geographies
Items that are expenses on a balance sheet
- Start-up and training costs. - Administrative overhead. - Advertising and promotion costs. - Relocation and reorganization costs. - Termination costs.
Monetary policy
A central bank's policy to control the quantity of money supplied.
CFA Code of Ethics Rule 1
Act with integrity, competence, diligence, and respect and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.
Fixed Asset Turnover
Activity Ratio. revenue / average net fixed asset
Infinite period model (formula)
D.1 / (k.e - g.c) Where D.1 could equal D.0 * (1+g.c)
Depreciation and amortization
Expense item Decline in asset value
Negotiable certificates of deposit
Funding alternative for a bank. Has a maturity of a year are are traded in the domestic bond market.
Loss aversion
Refers to the tendency for investors to dislike losses more than they like gains of equal amounts.
Type I error
Rejection of the null hypothesis when it is actually true.
Random variable
Uncertain quantity/number
Hyperinflation
_____ that accelerates out of control Can destroy a country's monetary system and bring about social and political upheavals.
Credit default swaps
a form of insurance that makes a payment if an issuer defaults on its bonds.
Basic EPS (formula)
basic EPS = (net income − preferred dividends) / (weighted average number of common shares outstanding)
Required return on risky country equity securities
k.CE =RFR+b[E(R.MKT)-RFR+CRP]
Income statement equation
revenues - expenses = net income
Price of semiannual coupon bond (formula)
(Coupon / (1 + YTM/2)) + (Coupon / (1 + YTM/2) ^ 2) + (Coupon + principal / (1 + YTM/2) ^ N x 2)
Bond price when using spot rates (Formula)
(Coupon/(1+S.1)) + (Coupon/(1+S.2)^2) + ((Coupon + Principal) / (1+S.N)^N)
Multiple-year holding periods (formula)
(D.1) / (1 + k.e) ^ 1 + (D.2) /(1 + k.e) ^ 2 + (D.n) / (1 + k.e) ^ n + (P.n) / (1 + k.e) ^ n
Return on Equity (DuPont 5-point)
(Net income / EBT) * (EBT / EBIT) * (EBIT / revenue) * (Revenue / average assets) * (Average assets / equity) ALSO KNOWN AS (tax burden) * (interest burden) * (EBIT margin) * (asset turnover) * (financial leverage)
Z-value
"Standardizes" an observation from a normal distribution and represents the number of standard deviations a given observation is from the population mean. z = (observation − population mean) / standard deviation --- or --- z = (x − m) / σ
FIFO in inflation
- Lower COGS - Higher gross profit - Higher inventory balances
Functions of money
- a medium of exchange - a store of value - a unit of account
Primary sources of liquidity
- cash balances - short-term funding - cash flow management of collections and payment
Dominant firm model
Assumes one firm has the lowest cost structure and a significant proportion of the market. In this case, the dominant firm essentially sets the price for the industry, and competitors set their output quantities taking this price as given.
Multifactor models (formula)
E(Ri) - Rf = βi1 × E(Factor 1) + βi2 × E(Factor 2) + ....+ βik × E(Factor k) Where β is the sensitivity of a given factor
Yield-to-call for a bond
Each possible call date and the price
Installment sale
Occurs when a firm finances a sale and payments are expected to be received over an extended period. - If collectability is certain, revenue is recognized at the time of sale. - If collectability cannot be reasonably estimated, the installment method is used. - If collectability is highly uncertain, the cost recovery method is used.
Additional Paid in Capital
Owner's Equity Proceeds from common stock sales above par value.
Accumulated other comprehensive income
Owner's equity includes all changes in stockholders' equity not recognized in the income statement or from issuing stock, reacquiring stock, and paying dividends.
Treasury stock
Owner's equity stock that has been reacquired by the issuing firm but not yet retired. Treasury stock has no voting rights and does not receive dividends.
Retained earnings
Owner's equity the cumulative net income of the firm since inception that has not been paid out as dividends.
Addition Rule for Joint Probability
P(A or B) = P(A) + P(B) - P(AB) Used to calculate the probability that at least one (one or both) of two events will occur.
Investment property
Tangible assets held for capital appreciation or to earn rental income (under IRFS)
Change in accounting estimate
The result of a change in management's judgment, usually due to new information (ex: asset is no longer useful). Does not require retrospective application to prior period financial statements.
Free cash flow to the firm (FCFF) (formula calculating from net income)
FCFF = NI + non-cash charges + [interest expense × (1 - tax rate)] - net capital investment - working capital investment
Net income (early years) when using a financing vs operating lease
Finance lease = lower operating lease = higher
Solvency ratios
Give the analyst information on the firm's financial leverage and ability to meet its longer-term obligations.
Currency cross rate
Given two exchange rates A/B and B/C, you can multiply them together to get A/C
World Trade Organization (WTO)
Has the goal of ensuring that trade flows freely and works smoothly. Their main focus is on instituting, interpreting, and enforcing a number of multilateral trade agreements, which detail global trade policies for a large majority of the world's trading nations.
Unemployment rate
The percentage of people in the labor force who are unemployed
Participation ratio
The percentage of the working-age population who are either employed or actively seeking employment
Simple random sampling
Method of selecting a sample such that each item or person in the population has the same likelihood of being included in the sample
embryonic stage
the industry has just started. The characteristics of this stage are as follows: - Slow growth: customers are unfamiliar with the product. - High prices: the volume necessary for economies of scale has not been reached. - Large investment required: to develop the product. - High risk of failure: most embryonic firms fail.
Nash equilibrium
A situation in which no firm can increase profits by changing its price/output choice.
Leverage Ratio when capitalizing vs expensing
capitalizing = lower expensing = higher
Profitability later years when capitalizing vs expensing
capitalizing = lower expensing = higher
Total cash flows (assuming no tax effects) when capitalizing vs expensing
capitalizing = same expensing = same
Employees
Stakeholder with an interest in their rate of pay, opportunities for career advancement, training, and working conditions.
Benchmark spread
A yield spread relative to a benchmark bond
Interest Expense
Expense Item Payments towards loan interest
Conservatism
Investors react slowly to changes
Dilutive securities
Those securities that would decrease EPS if exercised and converted to common stock.
Non-financial risks
- Operational risk. This is the risk that human error or faulty organizational processes will result in losses. - Solvency risk. This is the risk that the organization will be unable to continue to operate because it has run out of cash. - Regulatory risk. This is the risk that the regulatory environment will change, imposing costs on the firm or restricting its activities. - Governmental or political risk (including tax risk). This is the risk that political actions outside a specific regulatory framework, such as increases in tax rates, will impose significant costs on an organization. - Legal risk. This is the uncertainty about the organization's exposure to future legal action. - Model risk. This is the risk that asset valuations based on the organization's analytical models are incorrect. - Tail risk. This is the risk that extreme events (those in the tails of the distribution of outcomes) are more likely than the organization's analysis indicates, especially from incorrectly concluding that the distribution of outcomes is normal. - Accounting risk. This is the risk that the organization's accounting policies and estimates are judged to be incorrect.
Perfect competition demand characteristics
- Price = marginal revenue = marginal cost (in equilibrium) - Perfectly elastic firm demand curve - Zero economic profit in equilibrium
Monopoly demand characteristics
- Price > marginal revenue = marginal cost (in equilibrium) - Downward sloping firm demand curve - May have positive economic profit in long-run equilibrium - Profits may be zero because of expenditures to preserve monopoly
Oligopoly demand characteristics
- Price > marginal revenue = marginal cost (in equilibrium) - Downward sloping firm demand curve - May have positive economic profit in long-run equilibrium - Tends towards zero economic profit over time
Reasons for changes in the long-run aggregate supply curve
- changes in labor supply and quality - the supply of physical capital - the availability of natural resources - the level of technology
Reasons for changes in the short-run aggregate supply curve
- changes in nominal wages or other input prices - expectations of future prices - business taxes - business subsidies - currency exchange rates - changes in labor supply and quality - the supply of physical capital - the availability of natural resources - the level of technology
Advantage of asset-based models
- good for floor valuation - Easier when _____ are short term or marketable - useful for public firms with more detailed financial reporting
Disadvantage of discounted cash flow model
- inputs must be estimated - output is very sensitive to the input estimates
Secondary sources of liquidity
- liquidating assets - negotiating debt agreements - bankruptcy protection
Advantage of price multiple valuation based on fundamentals
- theoretically sounds valuation multiple - widely accepted valuation metric
Global Investment Performance Standards (GIPS) 9 Major Sections
0. Fundamentals of Compliance. 1. Input Data. 2. Calculation Methodology. 3. Composite Construction. 4. Disclosures. 5. Presentation and Reporting. 6. Real Estate. 7. Private Equity. 8. Wrap Fee/Separately Managed Account (SMA) Portfolios.
General features for preparing financial statements
1. *Fair presentation*, faithfully representing the effects of the entity's transactions and events. 2. *Going concern basis*, assuming that the firm will continue to exist unless its management intends to (or must) liquidate it. 3. *Accrual basis* of accounting is used to prepare the financial statements other than the statement of cash flows. 4. *Consistency* between periods in how items are presented and classified. 5. *Materiality*, meaning the financial statements should be free of misstatements or significant omissions. 6. *Aggregation* of similar items and separation of dissimilar items. 7. *No offsetting* of assets against liabilities or income against expenses unless a specific standard permits or requires it. 8. *Reporting frequency* must be at least annually. 9. *Comparative information* for prior periods should be included unless a specific standard states otherwise.
Coherent financial reporting framework
1. *Transparency* —full disclosure and fair presentation reveal the underlying economics of the company to the financial statement user. 2. *Comprehensiveness* —all types of transactions that have financial implications should be included, including new kinds that emerge. 3. *Consistency* —similar transactions should be accounted for in similar ways across companies, geographic areas, and time periods.
Required financial statements
1. Balance sheet. 2. Statement of comprehensive income. 3. Cash flow statement. 4. Statement of changes in owners' equity. 5. Explanatory notes, including a summary of accounting policies.
Five-step process for recognizing revenue
1. Identify the contract(s) with a customer. 2. Identify the performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation.
Characteristics of markets
1. Number of firms and their relative sizes. 2. Elasticity of the demand curves they face. 3. Ways that they compete with other firms for sales. 4. Ease or difficulty with which firms can enter or exit the market.
Duties of the board of directors
1. Selecting senior management, setting their compensation and bonus structure, evaluating their performance, and replacing them as needed. 2. Setting the strategic direction for the company and making sure that management implements the strategy approved by the board. 3. Approving capital structure changes, significant acquisitions, and large investment expenditures. 4. Reviewing company performance and implementing any necessary corrective steps. 5. Planning for continuity of management and the succession of the CEO and other senior managers. 6. Establishing, monitoring, and overseeing the firm's internal controls and risk management system. 7. Ensuring the quality of the firm's financial reporting and internal audit, as well as oversight of the external auditors.
Complex capital structures
A capital structure that contains potentially dilutive securities such as options, warrants, or convertible securities.
Vertical common-size balance sheet
A ______ expresses all balance sheet accounts as a percentage of total assets _________ ratios = balance sheet account / total assets
Simple capital structure
A capital structure that contains no potentially dilutive securities. This structure contains only common stock, nonconvertible debt, and nonconvertible preferred stock.
Forward exchange rate
A currency exchange rate for an exchange to be done in the future. Are quoted for various dates (e.g., 30 days, 60 days, 90 days, or one year).
Bollinger Bands
A given number of standard deviations above and below a moving average line. Prices are believed to have a higher probability of falling (rising) when they are near the upper (lower) band.
Veblen good
A good for which an increase in price increase its value to some consumers and thus increases demand
Ethics (Definition)
A set of shared beliefs about what behavior is good or acceptable
Discrete random variable
A limited (finite) number of possible outcomes and each has a positive probability. They can be counted (e.g., number of days without rain during a month)
Natural monopoly
A market where the average cost of production is falling over the relevant range of consumer demand. In this case, having two (or more) producers would result in a significantly higher cost of production and be detrimental to consumers.
Finance lease
A purchase of an asset that is financed with debt and must be capitalized. At the inception of a finance lease, the lessee adds a lease asset and an equal lease liability to the balance sheet. Over the term of the lease, the lessee recognizes both depreciation expense on the asset and interest expense on the liability. This treatment is the same as if the asset were purchased with only borrowed funds.
Confidence interval
A range of values around an expected outcome within which we expect the actual outcome to occur some specified percentage of the time
Correlation coefficient
A standardized measure (unlike covariances) of the strength of the linear relationship between two variables r = corr(Ri , Rj) = Cov(Ri , Rj)/ σ(Ri) * σ(Rj)
Income tax expense
A noncash income statement item that includes cash tax expense plus any increase (minus any decrease) in the deferred tax liability minus any increase (plus any decrease) in the deferred tax asset.
Net present value
A normal project is the present value of all the expected future cash flows minus the initial cost of the project, using the project's cost of capital. A project that has a positive net present value should be accepted because it is expected to increase the value of the firm (shareholder wealth).
Inflation
A persistent increase in the price level over time. Erodes the purchasing power of a currency. Favors borrowers at the expense of lenders because when the borrower returns the principal to the lender, it is worth less in terms of goods and services (in real terms) than it was worth when it was borrowed.
Deflation
A persistently decreasing price level (i.e., a negative inflation rate). Commonly associated with deep recessions
GDP deflator
A price index that can be used to convert nominal GDP into real GDP by removing the effects of changes in prices
One-tier board structure
A single board of directors includes both internal and external directors. Internal directors (also called executive directors) are typically senior managers of the firm. External directors (also called non-executive directors) are those who are not company management.
discounted cash flow models (or present value models)
A stock's value is estimated as the present value of cash distributed to shareholders (dividend discount models) or the present value of cash available to shareholders after the firm meets its necessary capital expenditures and working capital expenses (free cash flow to equity models).
Two-tier board structure
A supervisory board that typically excludes executive directors. The supervisory board and the management board (made up of executive directors) operate independently. The management board is typically led by the company's CEO.
Economically meaningful results
A test may indicate a significant statistical relationship (a statistically meaningful result) which is not economically significant
Code of Ethics (definition)
A written set of moral principles that can guide behavior. 1. Having a code of ethics is a way to communicate an organization's the values, principles, and expectations. 2. Some codes of ethics include a set of rules or standards that require some minimum level of ethical behavior. 3. A profession refers to a group of people with specialized skills and knowledge who serve others and agree to behave in accordance with a code of ethics.
Price elasticity of demand (Formula)
A × (P*/Q*) If A < 1, an increase (decrease) in price will increase (decrease) total revenue If A > 1, an increase (decrease) in price will decrease (increase) total revenue
Contractual infrastructure for managing stakeholders
Contracts between the company and its stakeholders that spell out the rights and responsibilities of the company and the stakeholders.
Payables payment period or number of days of payables
Activity Ratio. 365 / payables turnover ratio
Working Capital Turnover
Activity Ratio. revenue / average working capital gives us information about the utilization of working capital in terms of dollars of sales per dollar of working capital
Payables turnover ratio
Activity Ratio. purchases / average trade payables
Total Asset Turnover
Activity Ratio. revenue / average total assets
Receivables turnover
Activity ratio. A measure of _____ turnover. annual sales / average receivable
Inventory turnover
Activity ratio. A measure of the firms efficiency with respect to its processing and inventory management. cost of goods sold / average inventory
Average inventory processing period, number of days of inventory, or days of inventory on hand
Activity ratio. Inverse of receivables turnover. The average number of days ____ is in possession. 365 / inventory turnover
Average collection period, or days of sales outstanding
Activity ratio. Inverse of receivables turnover. The average number of days it takes for the company's customers to pay their bills. 365/receivables turnover
Financial risk
Additional risk common stockholders have to bear because the firm uses fixed cost sources of financing.
Discontinued operation
An __________ that management has decided to dispose of, but either has not yet done so, or disposed of in the current period after the ________ had generated income or losses. Income and losses from __________ are reported separately in the income statement, net of tax, after income from the parent.
Disinflation
An inflation rate that is decreasing over time but remains greater than zero.
Investment in Affiliates
Asset Accounted for using the equity method
Accounts Receivable
Asset Accounts receivable often have an "allowance for bad debt expense" as a contra account.
Inventories
Asset Financial assets such as marketable securities.
Fundamental Accounting Equation
Assets = liabilities + owners' equity
Small cap stocks
Average Annual Return = 11.7% Standard Deviation = 33.0%
Expected return and variance for a portfolio of two assets
E(RP) = wARA + wBRB Var =w2σ2 +w2σ2 +2w w σ σ ρ p AA BB ABABA,B -- or -- Var =w2σ2 +w2σ2 +2w w Cov p AA BB AB A,B
Sensitivity analysis
Based on "what if " questions, such as: What will be the effect on net income if sales increase by 3% rather than the estimated 5%?
Change in polarity principle
Based on a belief that breached support levels become resistance levels, and breached resistance levels become support levels
Kinked demand curve
Based on an assumption that a firm's competitors will not follow a price increase but will cut their prices in response to a price decrease by a competitor. Under this model, each firm faces a demand curve with a ____ at the current market price - more elastic above the current price and less elastic below the current price.
Laspeyres price index
Based on the cost of a specific basket of goods and services that represents actual consumption in a base period. New goods, quality improvements, and consumers' substitution of lower-priced goods for higher-priced goods over time cause a ___ to be biased upward.
Brokered markets
Brokers find the counterparty in order to execute a trade. This service is especially valuable when the trader has a security that is unique or illiquid. Examples are large blocks of stock, real estate, and artwork. Dealers typically do not carry an inventory of these assets and there are too few trades for these assets to trade in order-driven markets.
Supplementary Schedules
Contain additional information. Examples of such disclosures are: - Operating income or sales by region or business segment. - Reserves for an oil and gas company. - Information about hedging activities and financial instruments.
Option adjusted yield for callable bond
Calculated by adding the value of the call option to the bond's flat price
Statement of changes in owners' equity
Cash Flow Statement Reports the amounts and sources of changes in equity investors' investment in the firm.
Financing Cash Flows
Cash Flow Statement Those resulting from issuance or retirement of debt and equity securities and dividends paid to stockholders.
Structural unemployment
Caused by long-run changes in the economy that eliminate some jobs while generating other jobs for which unemployed workers are not qualified, so these workers must learn new skills.
Test statistic for hypothesis test of one population variance
Chi-square statistic
Common-size analysis
Common-size statements normalize balance sheets and income statements and allow the analyst to more easily compare performance across firms and for a single firm over time
BOP Financial Account
Comprises of: - Government-owned assets abroad. - Foreign-owned assets in the domestic country.
BOP Current Account
Comprises of: - Merchandise and services. - Income receipts, including foreign income from dividends on stock holdings and interest on debt securities. - Unilateral transfers, which are one-way transfers of assets.
float-adjusted market capitalization-weighted index
Constructed like a market capitalization-weighted index. The weights, however, are based on the proportionate value of each firm's shares that are available to investors to the total market value of the shares of index stocks that are available to investors. Firms with relatively large percentages of their shares held by controlling stockholders will have less weight than they have in an unadjusted market-capitalization index
Ricardian model of trade
Has only one factor of production—labor. The source of comparative advantage in is differences in labor productivity due to differences in technology
Effective annual yield (EAY)
Converts a t-day holding period yield to a compound annual yield based on a 365-day year EAY = ((1 + HPY) ^ (365/t)) - 1
Costs included in inventory on balance sheet
Costs included in inventory on the balance sheet include: - Purchase cost. - Conversion cost. - Allocation of fixed production overhead based on normal capacity levels. - Other costs necessary to bring the inventory to its present location and condition. All of these costs for inventory acquired or produced in the current period are added to beginning inventory value and then allocated either to cost of goods sold for the period or to ending inventory. Period costs, such as unallocated overhead, abnormal waste, most storage costs, administrative costs, and selling costs, are expensed.
Pegged exchange rates within horizontal bands
Exchange rate regime where the permitted fluctuations in currency value relative to another currency or basket of currencies are wider (e.g., ±2 %).
Management of exchange rates within crawling bands
Exchange rate regime where the width of the bands that identify permissible exchange rates is increased over time.
preferred stock value (formula)
D.p/k.p
Double-declining balance method (formula)
DDB depreciation = (2 / useful life) (asset cost − accumulated depreciation)
Degree of financial leverage (DFL)
DFL = % change in EPS / % change in EBIT -- or -- DFL = EBIT / (EBIT − interest expense)
Degree of operating leverage (DOL)
DOL = % change in EBIT / % change in sales -- or -- DOL= Q(P−V) / (Q(P−V)−F)
Degree of total leverage (DTL)
DTL = DOL × DFL -- or -- DTL = (% change in EBIT / % change in sales) (% change in EPS / % change in EBIT) -- or -- DTL = (Q(P−V) / (Q(P−V)−F)) (EBIT / (EBIT − interest expense))
Trading securities
Debt and equity securities acquired with the intent to profit from near-term price fluctuations are reported on the balance sheet at fair value. Unrealized gains and losses are recognized in the income statement. Derivatives are counted as this.
Available-for-sale securities
Debt and equity securities that are not expected to be held to maturity or traded in the near term are reported on the balance sheet at fair value. Unrealized gains and losses are not recognized in the income statement, but are reported in other comprehensive income as a part of stockholders' equity.
Held-to-maturity securities
Debt securities acquired with the intent to be held and are reported on the balance sheet at amortized cost. Amortized cost is equal to the face (par) value less any unamortized discount or plus any unamortized premium, as it is with debt issued by the firm.
Straight-line depreciation (SL)
Deprecation method that allocates an equal amount of depreciation each year over the asset's useful life as follows
Losses
Expense Item Decreases in assets or equity from transactions incidental to the firm's day-to-day activities.
Cost of Goods Sold
Expense item Cost to produce items (may or may not include delivery, finishing)
Selling, general, and administrative expenses
Expense item These include such expenses as advertising, salaries, rent, and utilities.
Common-size income statement
Expresses all items as a percentage of sales. This format is useful for time-series and cross-sectional analysis and facilitates the comparison of firms of different sizes.
Ethical vs. Legal Standards
Ethical principles often set a higher standard of behavior than laws and regulations. In general, ethical decisions require more judgment and consideration of the impact of behavior on many stakeholders compared to legal decisions.
Conventional fixed peg arrangement
Exchange rate regime where a country pegs its currency within margins of ±1% versus another currency.
Formal dollarization
Exchange rate regime where a country uses the currency of another country.
Currency board arrangement
Exchange rate regime where an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.
Moving Average Lines
Frequently used method to smooth the fluctuations in a price chart. A 20-day moving average is the arithmetic mean of the last 20 closing prices. The larger number of periods chosen, the smoother the resulting moving average line will be. Moving average lines can help illustrate trends by smoothing short-term fluctuations, but when the number of periods is large, a moving average line can obscure changes in trend.
Excess reserves
Funding alternative for a bank where they borrow funds from other banks in the central bank funds market. The rates are strongly influenced by the effect of the central bank's open market operations on the money supply
Expenditure approach
GDP is calculated as the total amount spent on goods and services produced in the country during a time period. Can use the sum-of-value-added method or the value-of-final-output method.
Income approach
GDP is calculated as the total income earned by households and businesses in the country during a time period.
Sum-of-value-added
GDP is calculated by summing the additions to value created at each stage of production and distribution.
Holding period yield (HPY)
HPY = (P1 - P0 + D1) / P0 HPY = ((P1 + D1) / P0) - 1
Regulatory authorities
Government agencies that have the legal authority to enforce compliance with financial reporting standards.
Marginal cost pricing
Government regulation may attempt to improve resource allocation by requiring a monopolist to institute __________ (with a subsidy to the firm if MC < ATC). Additionally, regulators often attempt to increase competition and efficiency through efforts to reduce artificial barriers to trade, such as licensing requirements, quotas, and tariffs.
Yield curve for bond
Graph for yield to maturity
Classified balance sheet
Groups together similar items (current assets, current liabilities, current liabilities, noncurrent liabilities) to arrive at significant subtotals.
Odds For and Against Terminology
If the probability of an event is 20%, it will occur, on average, one out of five times. The "odds for" are 1-to-4 and the "odds against" are 4-to-1.
Breakeven (short run)
In the short run, a firm may be selling at less than average total cost (ATC), generating an economic loss. Such a firm should continue to operate in the short run as long as price is greater than average variable cost (AVC). In this case, the losses from shutting down (producing zero output) in the short run would be greater (equal to total fixed costs [TFC]) than the losses from continued operation.
Momentum Oscillators
Include the rate of change oscillator, the Relative Strength Index (RSI), moving average convergence/divergence (MACD) lines, and stochastic oscillators.
Risk committee
Informs the board about appropriate risk policy and risk tolerance of the organization and oversees its risk management processes.
Monetary policy = tight Fiscal policy = easy
Interest rates = higher Output = higher Private sector spending = lower Public sector spending = higher
Monetary policy = tight Fiscal policy = tight
Interest rates = higher Output = lower Private sector spending = lower Public sector spending = lower
Monetary policy = easy Fiscal policy = easy
Interest rates = lower Output = higher Private sector spending = higher Public sector spending = higher
Monetary policy = easy Fiscal policy = tight
Interest rates = lower Output = varies Private sector spending = higher Public sector spending = lower
Periodic inventory system
Inventory values and COGS are determined at the end of the accounting period. No detailed records of inventory are maintained; rather, inventory acquired during the period is reported in a Purchases account. At the end of the period, purchases are added to beginning inventory to arrive at cost of goods available for sale. To calculate COGS, ending inventory is subtracted from goods available for sale.
Perpetual inventory system
Inventory values and COGS are updated continuously. Inventory purchased and sold is recorded directly in inventory when the transactions occur.
Inventory-to-sales ratios behavior
Inventory-to-sales ratios typically increase late in expansions, when sales slow unexpectedly, and decrease near the end of contractions, when sales unexpectedly begin to accelerate.
Representativenes
Investors assume good companies or good markets are good investments.
Mental accounting
Investors classify different investments into separate mental accounts instead of viewing them as a total portfolio.
participating preference shares
Investors receive extra dividends if firm profits exceed a predetermined level and may receive a value greater than the par value of the preferred stock if the firm is liquidated. Non-participating preference shares have a claim equal to par value in the event of liquidation and do not share in firm profits.
Global depository receipts (GDRs)
Issued outside the U.S. and the issuer's home country, are traded primarily on the London and Luxembourg exchanges, are usually denominated in U.S. dollars, and can be sold to U.S. institutional investors.
Creditors
Stakeholder with an interest to supply debt capital to the firm. The interests are protected to varying degrees by covenants in the firm's debt agreements.
CFA Code of Ethics Rule 6
Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.
Fractional reserve system
New money created is a multiple of new excess reserves available for lending by banks.
Repurchase agreement
One party agrees to sell a security to a counterparty with a commitment to buy it back at a later date at a specified higher price. Basically lending a security and then using the security as collateral the higher buyback price is the "interest paid"
perfectly efficient market
One where fees are low and information is efficient. In these markets, investors should use a passive investment strategy (i.e., buying a broad market index of stocks and holding it) because active investment strategies will underperform on average by the amount of transactions costs and management fees.
Continuous uniform distribution
Over the range of 1 to 5 results in a 25% probability [1 / (5 - 1)] that the random variable will take on a value between 1 and 2, 2 and 3, 3 and 4, or 4 and 5, since 1 is one-quarter of the total range of the random variable
Other Comprehensive Income
Owner's Equity Changes in carrying amounts of assets and liabilities.
Profitability ratios
Provide information on how well the company generates operating profits and net profits from its sales.
Nominal exchange rate
Rate of the price currency (numerator) over the base currency (denominator)
Ratio Analysis
Ratios are useful tools for expressing relationships among data that can be used for internal comparisons and comparisons across firms. They are often most useful in identifying questions that need to be answered, rather than answering questions directly.
Governance committee
Responsible for overseeing the company's corporate governance code, implementing the company's code of ethics, and monitoring changes in laws and regulations and ensuring that the company is in compliance.
Student's t-Distribution
Similar in concept to the normal distribution in that it is bell-shaped and symmetrical about its mean. It is appropriate when working with small samples (n < 30) from populations with unknown variance and normal, or approximately normal, distributions. It may also be appropriate to use the t-distribution when the population variance is unknown and the sample size is large enough that the central limit theorem will assure the sampling distribution is approximately normal.
Roy's safety-first ratio (SFRatio)
Similar to the Sharpe ratio. In fact, the Sharpe ratio is a special case of Roy's ratio where the "threshold" level is the risk-free rate of return.
Interest coverage ratio
Solvency Ratio. The remaining risk ratios help determine the firm's ability to repay its debt obligations. earnings before interest and taxes / interest payments
Debt-to-equity
Solvency Ratio. A measure of the firm's use of fixed-cost financing sources. Measures leverage. total debt / total shareholders' equity
Fixed charge coverage
Solvency Ratio. A second ratio that is an indicator of a company's ability to meet its obligations. (earnings before interest and taxes + lease payments) / (interest payments + lease payments)
Yield to maturity (YTM)
The IRR on a bond. For a semiannual coupon bond, YTM is two times semiannual IRR. In other words, it is the discount rate that equates the present value of a bond's cash flows with its market price. We will revisit this topic again in the debt section.
Fair value (balance sheet)
The amount at which an asset could be sold, or a liability transferred, in an orderly transaction between willing parties.
American style callable bond
The bonds can be called anytime after the first call date
Bermuda style callable bond
The bonds can be called on specified date as after the first call date, often on the coupon payment date
Weighted average maturity (WAM)
The mortgage pool is equal to the principal-weighted average of the final maturities of all the mortgages in the pool.
Skewness
The extent to which a distribution is not symmetrical
First-in, first-out (FIFO)
The first item purchased is the first item sold. Appropriate for inventory that has a limited shelf life
Minimum effect of scale
The lowest point on the long-run average total cost curve corresponds to the scale or plant size at which the average total cost of production is at its lowest.
Binomial random variable
The number of "successes" in a given number of trials where the outcome can be either "success" or "failure." p(x) = (nCr) * p ^ x *(1 - p) ^ (n - x)
Non-Recourse loan
The only claim the lender has is to the property, which can be sold and the proceeds up to the amount of the amount owed used to satisfy the loan liability
Roy's safety-first criterion
The optimal portfolio minimizes the probability that the return of the portfolio falls below some minimum acceptable "threshold" level.
Diminishing marginal productivity
The point at which the marginal product declines as you add more labor
Aggregate demand curve
The points at which the IS curve intersects the LM curves for different levels of the real money supply (i.e., for different price levels, holding the nominal money supply constant). Shows the negative relationship between GDP (real output demanded) and the price level (y-axis) when other factors are held constant.
Breakeven point
The quantity of sales a firm must achieve to just cover its fixed and variable costs Q.breakeven = total fixed costs / (price − variable cost per unit)
Consider (Ethical Decision Making)
Understand situational influences, additional guidance, alternative actions.
Liquidity ratios
Understand the to pay short-term obligations as they come due.
Stakeholder theory
The primary focus of a system of corporate governance is broader, considering conflicts among groups such as shareholders, employees, suppliers, and customers.
Discrete uniform probability distribution
The probabilities of the outcomes can be thought of as equal For example, when X = {1, 2, 3, 4, 5}, p(x) = 0.2. Here, the probability for each outcome is equal to 0.2 [i.e., p(1) = p(2) = p(3) = p(4) = p(5) = 0.2].
Z-spread (zero-volatility spread)
The single spread that when added to each spot rate produces a bond that is equal to the current market value of a bond
Heckscher-Ohlin model
The source of comparative advantage (differences in opportunity costs) in this model is differences in the relative amounts of each factor the countries possess. The country that has more capital will specialize in the capital intensive good and trade for the less capital intensive good with the country that has relatively more labor and less capital.
Option adjusted spread (OAS)
The spread to the spot rate curve that the bond would have if it were option-free.
Economies of scale
This is present if there are downward sloping segments in the long-run average total cost. Results from factors such as labor specialization, mass production, and investment in more efficient equipment and technology.
Noncash investing and financing activities
This item is not reported in the cash flow statement but must be disclosed in either a footnote or a supplemental schedule to the cash flow statement.
Disadvantages of fiscal policy
Time lags for implementing changes in direct taxes and time lags for capital spending changes to have an impact. Delays (lags) in realizing the effects of _____ changes limit their usefulness.
Minimum domestic content
Trade restriction Requirement that some percentage of product content must be from the domestic country.
Tariffs
Trade restriction Taxes on imported goods collected by the government.
Elasticities approach
Tor a depreciation of the domestic currency to reduce an existing trade deficit, the elasticities (ε) of export and import demand must meet the Marshall-Lerner condition: W.Exports x ε.Exports + W.Imports (ε.Imports - 1) > 0 where: ε = elasticity W = the proportion of total trade for imports or exports
Export subsidies
Trade restriction Government payments to firms that export goods.
Barter transaction
Two parties exchange goods or services without any cash payment. U.S. GAAP, revenue can be recognized at fair value only if the firm has historically received cash payments for such services and can use this historical experience to determine fair value. IFRS, revenue from barter transactions must be measured based on the fair value of revenue from similar non-barter transactions with unrelated parties.
Bond-equivalent yield
Two times the semiannually compounded yield. This is because U.S. bonds pay interest semiannually rather than annually.
Major components of an IPS
Typically address the following: - Description of Client circumstances, situation, and investment objectives. - Statement of the Purpose of the IPS. - Statement of Duties and Responsibilities of investment manager, custodian of assets, and the client. - Procedures to update IPS and to respond to various possible situations. - Investment Objectives derived from communications with the client. - Investment Constraints that must be considered in the plan. - Investment Guidelines such as how the policy will be executed, asset types permitted, and leverage to be used. - Evaluation of Performance, the benchmark portfolio for evaluating investment performance, and other information on evaluation of investment results. - Appendices containing information on strategic (baseline) asset allocation and permitted deviations from policy portfolio allocations, as well as how and when the portfolio allocations should be rebalanced.
CFA Code of Ethics Rule 3
Use reasonable care and exercise independent, professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.
One-tailed test
Use this type of test when testing a parameter to see if it is above or below a specified value. Assumes a normal distribution, you're looking for something above or below the significance/confidence interval. +-1.645 on one side. 5% on either tail.
Paasche price index
Uses current consumption weights for the basket of goods and services for both periods, thereby reducing substitution bias.
Global Investment Performance Standards (GIPS) Verification Requirements
Verification is voluntary and is not required to be GIPS compliant. Independent verification provides assurance that GIPS have been applied correctly on a firm- wide basis. Firms that have had compliance verified are encouraged to disclose that they have done so, but must include periods for which verification was done.
Weighted average cost of capital (WACC)
WACC = (w.debt)[k.debt(1 - taxrate)] + (w.prefstock)(k.prefstock) + (w.commonstock)(k.commonstock)
Alternative Hypothesis (Ha)
What is concluded if there is sufficient evidence to reject the null hypothesis
Profitability first year when capitalizing vs expensing
capitalizing = higher expensing = lower
Continuously Compounded Returns
When the number of compounding periods (n) for an annual rate of return n goes toward infinity is continuous compounding (e ^ CCR) −1
Income effect
When the price of a singe good changes, this is the points that it intercepts a new indifference curve to reflect spending the left over purchasing power.
G-spread
Yield spread relative to a government bond
I-spread (Interpolated spread)
Yield spread relative to a spot rate
Semiannual bond basis
Yield to maturity for bonds that make semiannual payments
Forward contracts
agreements to buy or sell an asset in the future at a price specified in the contract at its inception and are not typically traded on exchanges or in dealer markets.
Convertible preference shares
can be exchanged for common stock at a conversion ratio determined when the shares are originally issued.
Calculate if a security is dilutive
convertible pfd. dividends / # shares from conversion of pfd. -- or -- (convertible debt interest (1 - tax rate)) /# shares from conversion of debt
Behavioral finance
examines investor behavior, its effect on financial markets, how cognitive biases may result in anomalies, and whether investors are rational.
U.S. FED Balance of Payments (formula)
exports - imports = private savings + government savings - domestic investment
Preference shares (or preferred stock)
have features of both common stock and debt. As with common stock, _________ are not a contractual obligation, the shares usually do not mature, and the shares can have put or call features. Like debt, _______ typically make fixed periodic payments to investors and do not usually have voting rights.
Normal distribution Known variance Large Sample (n > 30)
z-statistic
Normal distribution Known variance Small Sample (n < 30)
z-statistic
Know the law relevant to your position (Definition)
- Comply with the most strict law or Standard that applies to you. - Don't solicit gifts. - Don't compromise your objectivity or independence. - Use reasonable care. - Don't lie, cheat, or steal. - Don't continue association with others who are breaking laws, rules, or regulations. - Don't use others' work or ideas without attribution. - Don't guarantee investment results or say that past results will be certainly repeated. - Don't do things outside of work that reflect poorly on your integrity or professional competence.
Disclose potential conflicts of interest (let others judge the effects of any conflict for themselves) (Definition)
- Disclose referral arrangements. - Client transactions come before employer transactions which come before personal transactions. - Treat clients who are family members just like any client.
Act for the benefit of your employer (Definition)
- Do not harm your employer. - Obtain written permission to compete with your employer or to accept additional compensation from clients contingent on future performance. - Disclose (to employer) any gifts from clients. - Don't take material with you when you leave employment (you can take what is in your brain). - Supervisors must take action to both prevent and detect violations. - Don't take supervisory responsibility if you believe procedures are inadequate.
Long-term Treasury bonds
Average annual return = 5.7% Standard deviation = 9.4%
Consumer price index (CPI)
Price index based on the purchasing patterns of a typical household
Sales
Revenue item Revenue from the firm's day-to-day activities.
Forward rate to spot rate (formula)
(1 + S.2) ^ 2 = (1 + S.1) x (1 + 1y1y)
Price elasticity of demand
The ratio of the percent change in quantity demanded to the percent change in price.
LIFO in inflation
- Higher COGS - Lower gross profit - Lower inventory balances
Leveraged inverse floater
An _______ where the reference rate is increased by some multiple
Effective yield for a bond
Compound return of a bond
Event
Single outcome or a set of outcomes
Austrian-school economists
Believe that business cycles are initiated by government intervention that drives interest rates to artificially low levels.
Debt to service coverage ratio
Net operating income / debt service Measure for the credit rating of a CMBS. Higher is better.
Bonds issued at a premium or discount
*Balance sheet impact*. Bonds sold at a premium will be shown at a premium on the balance sheet. This premium will be amortized toward zero over the life of the bond. Bonds that were originally sold at a discount will always be recorded on the balance sheet at a discount. This discount will be amortized toward zero over the life of the bond. *Interest expense*. Captured with the amortization. *Cash flow*. For premium bonds, the cash coupon is higher than interest expense. Consequently, CFO is lower and CFF is higher, relative to a company that does not have premium bonds in its capital structure. For discount bonds, the cash coupon is lower than interest expense. Consequently, CFO is higher and CFF is lower, relative to a company that does not have discount bonds.
Bonds issued at par
*Balance sheet impact*. The value carried on books throughout a bond's life will be equal to face value. *Interest expense*. This is always equal to the book value of bonds at the beginning of the period multiplied by the market rate of interest at issuance. *Cash flow*. CFO includes a deduction for cash interest expense. CFF is increased by the amount received at issuance and decreased by the payment made when the bonds are redeemed.
Money-Weighted vs. Time-Weighted Return Measures
- *Money-weighted return* is affected by cash flows into and out of an investment account. It is essentially a portfolio IRR. - *Time-weighted return* is preferred as a manager performance measure because it is not affected by cash flows into and out of an investment account. It is calculated as the geometric mean of subperiod returns.
NPV decision rule vs. IRR decision rule
- *NPV decision rule*: For independent projects, adopt all projects with NPV > 0. These projects will increase the value of the firm. - *IRR decision rule*: For independent projects, adopt all projects with IRR > required project return. These projects will also add value to the firm.
CFI Outflows
- Acquisition of fixed assets - Acquisition of debt & equity investments - Loans made to others
Free trade area
- All barriers to import and export of goods and services among member countries are removed.
Customs union
- All barriers to import and export of goods and services among member countries are removed. - All member countries adopt a common set of trade restrictions with non-members.
Common market
- All barriers to import and export of goods and services among member countries are removed. - All member countries adopt a common set of trade restrictions with non-members. - All barriers to the movement of labor and capital goods among member countries are removed.
Economic union
- All barriers to import and export of goods and services among member countries are removed. - All member countries adopt a common set of trade restrictions with non-members. - All barriers to the movement of labor and capital goods among member countries are removed. - Member countries establish common institutions and economic policy.
Monetary union
- All barriers to import and export of goods and services among member countries are removed. - All member countries adopt a common set of trade restrictions with non-members. - All barriers to the movement of labor and capital goods among member countries are removed. - Member countries establish common institutions and economic policy. - Member countries adopt a single currency
Advantages of Technical Analysis
- Based on observable data (price and volume) that are not based on accounting assumptions or restatements. - Can be used for assets that do not produce cash flows, such as commodities. - May be more useful than fundamental analysis when financial statements contain errors or are fraudulent.
CFO Outflows
- Cash paid to employees and suppliers - Cash paid for other expenses - Acquisition of trading securities - Interest paid - Taxes paid
Reasons for changes in the aggregate demand curve
- Changes in household wealth - Business and consumer expectations - Capacity utilization - Fiscal policy - Monetary policy - Currency exchange rates - Global economic growth rates
Financial risks
- Credit risk. This is the uncertainty about whether the counterparty to a transaction will fulfill its contractual obligations. - Liquidity risk. This is the risk of loss when selling an asset at a time when market conditions make the sales price less than the underlying fair value of the asset. - Market risk. This is the uncertainty about market prices of assets (stocks, commodities, and currencies) and interest rates.
Arguments against being concerned with the size of fiscal deficit
- Debt may be financed by domestic citizens. - Deficits for capital spending can boost the productive capacity of the economy. - Fiscal deficits may prompt needed tax reform. - Ricardian equivalence may prevail: private savings rise in anticipation of the need to repay principal on government debt. - When the economy is operating below full employment, deficits do not crowd out private investment.
Expansionary central bank policy
- Decreasing the policy rate - Decreasing reserve requirements - Making open market purchases of securities
Derivatives risks
- Delta. This is the sensitivity of derivatives values to the price of the underlying asset. - Gamma. This is the sensitivity of delta to changes in the price of the underlying asset. - Vega. This is the sensitivity of derivatives values to the volatility of the price of the underlying asset. - Rho. This is the sensitivity of derivatives values to changes in the risk-free rate.
Do not act or cause others to act on material nonpublic information (Definition)
- Do not manipulate market prices or trading volume with the intent to mislead others.
Don't cheat on any exams (or help others to) (Definition)
- Don't reveal CFA exam questions or disclose what topics were tested or not tested. - Don't use your Society position or any CFA Institute position or responsibility to improperly further your personal or professional goals. - Don't use the CFA designation improperly (it is not a noun). - Don't put CFA in bold or bigger font than your name. - Don't put CFA in a pseudonym that conceals your identity, such as a social media account name. - Don't imply or say that holders of the CFA Charter produce better investment results. - Don't claim that passing all exams on the first try makes you a better investment manager than others. - Don't claim CFA candidacy unless registered for the next exam or awaiting results. - There is no such thing as a CFA Level I (or II, or III).
Ratio Analysis Limitations
- Financial ratios are not useful when viewed in isolation. They are only informative when compared to those of other firms or to the company's historical performance. - Comparisons with other companies are made more difficult by different accounting treatments. This is particularly important when comparing U.S. firms to non-U.S. firms. - It is difficult to find comparable industry ratios when analyzing companies that operate in multiple industries. - Conclusions cannot be made by calculating a single ratio. All ratios must be viewed relative to one another. - Determining the target or comparison value for a ratio is difficult, requiring some range of acceptable values.
Thoroughly analyze investments (Definition)
- Have reasonable basis. - Keep records. - Tell clients about investment process, including its risks and limitations. - Distinguish between facts and opinions. - Review the quality of third-party research and the services of external advisers. - In quantitative models, consider what happens when their inputs are outside the normal range.
Traits of an effective central bank
- Independence: The central bank is free from political interference. - Credibility: The central bank follows through on its stated policy intentions. - Transparency: The central bank makes it clear what economic indicators it uses and reports on the state of those indicators.
Reasons monetary policy may not work as intended
- It changes may affect inflation expectations to such an extent that long-term interest rates move opposite to short-term interest rates. - Individuals may be willing to hold greater cash balances without a change in short-term rates so that an expansion of the money supply does not reduce short-term rates (liquidity trap). - Banks may be unwilling to lend greater amounts, even when they have more excess reserves as a result of an increase in the money supply. - Short-term rates cannot be reduced below zero. - Developing economies face unique challenges in utilizing monetary policy due to undeveloped financial markets, rapid financial innovation, and lack of credibility of the monetary authority.
Disadvantages of Technical Analysis
- Less useful for markets that are subject to outside intervention, such as currency markets, and for markets that are illiquid. - Short covering can create positive technical patterns for stocks of bankrupt companies. - Cannot produce positive risk-adjusted returns over time when markets are weak- form efficient.
Disadvantage of asset-based models
- Market values can be difficult to obtain and usually different than the book value - inaccurately when there are a lot of intangible _____ or future cash flows - hard to value when a market is in hyperinflation
Monopolistic competition demand characteristics
- Price > marginal revenue = marginal cost (in equilibrium) - Downward sloping firm demand curve - Zero economic profit in long-run equilibrium
CFF Outflows
- Principal paid on amounts from others - Payments to reacquire stock - Dividends paid to shareholders
Ratio Analysis Benefits
- Project future earnings and cash flow. - Evaluate a firm's flexibility (the ability to grow and meet obligations even when unexpected circumstances arise). - Assess management's performance. - Evaluate changes in the firm and industry over time. - Compare the firm with industry competitors.
Examples of Financial Statement Notes
- Provide information about accounting methods and the assumptions and estimates used by management. - Are audited, whereas other disclosures, such as supplementary schedules, are not audited. - Provide additional information on such items as fixed assets, inventory, income taxes, pensions, debt, contingencies and commitments, marketable securities, significant customers, sales to related parties, and export sales. - Often contain disclosures relating to contingent losses.
Types of fiscal policy lags
- Recognition lag: Policymakers may not immediately recognize when fiscal policy changes are needed. - Action lag: Governments take time to enact needed fiscal policy changes. - Impact lag: Fiscal policy changes take time to affect economic activity.
CFI Inflows
- Sale proceeds from fixed assets - Sale proceeds from debt & equity investments - Principal received from loans made to others
Lognormal Distribution
- The function e^x where x is normally distributed - Positively skewed - Bound to the left by 0 - Price relative is the ending price divided by the starting price
Global Investment Performance Standards (GIPS) Compliance Requirements
- To claim compliance, a firm must present GIPS-compliant results for a minimum of five years or since firm inception. - The firm must be clearly defined as the distinct business entity or subsidiary that is held out to clients in marketing materials. - Performance is presented for "composites" which must include all fee-paying discretionary account portfolios with a similar investment strategy, objective, or mandate. - After reporting five years of compliant data, one year of compliant data must be added each year to a minimum of ten years.
Factors that influence money demand
- Transaction demand, for buying goods and services. - Precautionary demand, to meet unforeseen future needs. - Speculative demand, to take advantage of investment opportunities.
Act solely for the benefit of your client and know to whom a fiduciary duty is owed with regard to trust accounts and retirement accounts (Definition)
- Treat clients fairly by attempting simultaneous dissemination of investment recommendations and changes. - Do not personally take shares in oversubscribed IPOs. When in an advisory relationship: - Know your client. - Make suitable recommendations/take suitable investment action (in a total portfolio context). - Preserve confidential client information unless it concerns illegal activity. - Do not try to mislead with performance presentation. - Vote nontrivial proxies in clients' best interests.
Assumptions of Technical Analysis
- Values, and thus prices, are determined by supply and demand. - Supply and demand are driven by both rational and irrational behavior. - Price and volume reflect the collective behavior of buyers and sellers. - While the causes of changes in supply and demand are difficult to determine, the actual shifts in supply and demand can be observed in market price behavior.
Commonly allowed action under the CFA Professional Standards
- You can information from recognized statistical sources without attribution. - You can be wrong (as long as you had a reasonable basis at the time). - You can use several pieces of non-material, nonpublic information to construct your investment recommendations (mosaic theory). - You can do large trades that may affect market prices as long as the intent of the trade is not to mislead market participants. - You can say that Treasury securities are without default risk. - You can always seek the guidance of your supervisor, compliance officer, or outside counsel. - You can get rid of records after seven years. - You can accept gifts from clients and referral fees as long as properly disclosed. - You can call your biggest clients first (after fair distribution of investment recommendation or change). - You can accept compensation from a company to write a research report if you disclose the relationship and nature of compensation. - You can get drunk when not at work and commit misdemeanors that do not involve fraud, theft, or deceit. - You can say you have passed the Level I, II, or III CFA exam (if you really have). - You can accurately describe the nature of the examination process and the requirements to earn the right to use the CFA designation.
Advantages of price multiple models
- widely used by analysts - comp multiples are readily available - can be used as time series or cross sectional
Disadvantage of prince multiple valuation based on fundamentals
- will be very sensitive to inputs (especially the k-g in the denominator)
Circumstances that prompt a Professional Conduct staff to inquire on professional conduct.
1. *Self-disclosure* by members or candidates on their annual Professional Conduct Statements of involvement in civil litigation or a criminal investigation, or that the member or candidate is the subject of a written complaint. 2. *Written complaints* about a member or candidate's professional conduct that are received by the Professional Conduct staff. 3. *Evidence of misconduct* by a member or candidate that the Professional Conduct staff received through public sources, such as a media article or broadcast. 4. *A report by a CFA exam proctor* of a possible violation during the examination. 5. *Analysis of exam scores and materials and monitoring of websites and social*
CFA Code of Ethics
1. Act with integrity, competence, diligence, and respect and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets. 2. Place the integrity of the investment profession and the interests of clients above their own personal interests. 3. Use reasonable care and exercise independent, professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities. 4. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession. 5. Promote the integrity and viability of the global capital markets for the ultimate benefit of society. 6. Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.
Main functions of the financial system
1. Allow entities to save and borrow money, raise equity capital, manage risks, trade assets currently or in the future, and trade based on their estimates of asset values. 2. Determine the returns (i.e., interest rates) that equate the total supply of savings with the total demand for borrowing. 3. Allocate capital to its most efficient uses.
Example conversion payments to suppliers
1. Begin with cost of goods sold (COGS) as reported in the income statement. 2. If depreciation and/or amortization have been included in COGS (they increase COGS), they must be eliminated when computing the cash paid to suppliers. 3. Subtract (add) any increase (decrease) in the accounts payable balance as reported in the indirect method. 4. Add (subtract) any increase (decrease) in the inventory balance as disclosed in the indirect method. 5. Subtract any inventory write-off that occurred during the period.
Converting Indirect CFO to Direct CFO
1. Begin with net income. 2. Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land). 3. Add back all noncash charges to income (such as depreciation and amortization) and subtract all noncash components of revenue. 4. Add or subtract changes to related balance sheet operating accounts as follows: - Increases in the operating asset accounts (uses of cash) are subtracted, while decreases (sources of cash) are added. -Increases in the operating liability accounts (sources of cash) are added, while decreases (uses of cash) are subtracted.
Example conversion cash collections from customers
1. Begin with net sales from the income statement. 2. Subtract (add) any increase (decrease) in the accounts receivable balance as reported in the indirect method. 3. Add (subtract) an increase (decrease) in unearned revenue.
The three Cs of credit analysis
1. Character: Character refers to firm management's professional reputation and the firm's history of debt repayment. 2. Collateral: The ability to pledge specific collateral reduces lender risk. 3. Capacity: The capacity to repay requires close examination of a firm's financial statements and ratios. Since some debt is for periods of 30 years or longer, the credit analyst must take a very long-term view of the firm's prospects.
Characteristics that enhance relevance and faithful representation
1. Comparability. Financial statement presentation should be consistent among firms and across time periods. 2. Verifiability. Independent observers, using the same methods, obtain similar results. 3. Timeliness. Information is available to decision makers before the information is stale. 4. Understandability. Users with basic business knowledge should be able to understand the statements.
Properties of a normal distribution
1. Completely described by mean and variance. 2. Symmetric about the mean (skewness = 0). 3. Kurtosis (a measure of peakedness) = 3. 4. Linear combination of jointly, normally distributed random variables is also normally distributed.
Five Key Principles of Capital Budgeting
1. Decisions are based on incremental cash flows. Sunk costs are not considered. Externalities, including cannibalization of sales of the firm's current products, should be included in the analysis. 2. Cash flows are based on opportunity costs, which are the cash flows the firm will lose by undertaking the project. 3. Timing of the cash flows is important. 4. Cash flows are analyzed on an after-tax basis. 5. Financing costs are reflected in the required rate of return on the project, not in the incremental cash flows.
Actions a Professional Conduct staff may request (in writing) from the subject member or candidate
1. Interview the subject member or candidate. 2. Interview the complainant or other third parties. 3. Collect documents and records relevant to the investigation.
CFA Standards of Professional Conduct
1. Know the law relevant to your position 2. Do not act or cause others to act on material nonpublic information 3. Act solely for the benefit of your client and know to whom a fiduciary duty is owed with regard to trust accounts and retirement accounts 4. Act for the benefit of your employer. 5. Thoroughly analyze investments. 6. Disclose potential conflicts of interest (let others judge the effects of any conflict for themselves). 7. Don't cheat on any exams (or help others to).
Steps in Hypothesis Testing
1. State the hypothesis. 2. Select a test statistic 3. Specify the level of significance. 4. State the decision rule for the hypothesis. 5. Collect the sample and calculate statistics. 6. Make a decision about the hypothesis. 7. Make a decision based on the test results.
Financial Statement Analysis Framework
1. State the objective and context. 2. Gather data. 3. Process the data. 4. Analyze and interpret the data. 5. Report the conclusions or recommendations. 6. Update the analysis.
The Professional Conduct staff may decide after an investigation
1. That no disciplinary sanctions are appropriate. 2. To issue a cautionary letter. 3. To discipline the member or candidate.
Assumptions of financial statement
1. The accrual basis requires that revenue be recognized when earned and expenses recognized when incurred, regardless of when cash is actually paid. 2. The going concern assumption presumes that the company will continue to operate for the foreseeable future.
IASB Requirements for Services Revenue Recognition
1. The amount of revenue can be reliably measured. 2. There is a probable flow of economic benefits. 3. The stage of completion can be measured. 4. The cost incurred and cost of completion can be reliably measured.
IASB Requirements for Revenue Recognition
1. The risk and reward of ownership is transferred. 2. There is no continuing control or management over the goods sold. 3. Revenue can be reliably measured. 4. There is a probable flow of economic benefits. 5. The cost can be reliably measured.
SEC Requirements for Revenue Recognition
1. There is evidence of an arrangement between the buyer and seller. 2. The product has been delivered or the service has been rendered. 3. The price is determined or determinable. 4. The seller is reasonably sure of collecting money.
Barriers to coherent financial reporting framework
1. Valuation—The different measurement bases for valuation involve a trade-off between relevance and reliability. Bases that require little judgment, such as historical cost, tend to be more reliable, but may be less relevant than a base like fair value that requires more judgment. 2. Standard setting—Three approaches to standard setting are a "principles-based" approach that relies on a broad framework, a "rules-based" approach that gives specific guidance about how to classify transactions, and an "objectives-oriented" approach that blends the other two approaches. IFRS is largely a principles-based approach. U.S. GAAP has traditionally been more rules-based, but FASB is moving toward an objectives-oriented approach. 3. Measurement—Another trade-off in financial reporting is between properly valuing the elements at one point in time (as on the balance sheet) and properly valuing the changes between points in time (as on the income statement). An "asset/liability" approach, which standard setters have largely used, focuses on balance sheet valuation. A "revenue/expense" approach would tend to focus on the income statement.
Constraints on financial statement
1. preparation is the need to balance reliability, in the sense of being free of error, with the timeliness that makes the information relevant. 2. Cost is also a constraint; the benefit that users gain from the information should be greater than the cost of presenting it 3. the fact that intangible and non-quantifiable information cannot be captured directly in financial statements.
Impact of increase in growth rate of money supply
1. will decrease nominal and (in the short run) real interest rates, which will increase economic growth. 2. Because lower real interest rates will decrease foreign investment and demand for the domestic currency, it will cause the domestic currency to depreciate relative to those of the country's trading partners. 3. The depreciation of the domestic currency will increase export demand, further increasing economic growth. 4. In the long run, the increase in the money supply will not decrease real interest rates because inflation (and inflation expectations) will increase, offsetting the decrease in nominal interest rates
Impact of decrease in growth rate of money supply
1. will increase nominal and (in the short run) real interest rates, which will decrease economic growth. 2. Because higher real interest rates will increase foreign investment and demand for the domestic currency, it will cause the domestic currency to appreciate relative to those of the country's trading partners. 3. The appreciation of the domestic currency will decrease export demand, further decreasing economic growth. 4. In the long run, the decrease in the money supply will not increase real interest rates because inflation will decrease, offsetting the increase in nominal interest rates
Prior-period adjustment
A change from an incorrect accounting method to one that is acceptable under GAAP or IFRS, or the correction of an accounting error. Requires restating results for all prior period statements presented in the current financial statements.
N-firm concentration ratio
A concentration measure The sum of the percentage market shares of the largest N firms in a market. This has limitations in that it does not reflect mergers of market leaders.
Fiscal policy
A government's use of taxation and spending to influence the economy.
Kurtosis
A measure of the degree to which a distribution is more or less peaked than a normal distribution (normal distribution is 3)
Simulation
A technique in which probability distributions for key variables are selected and a computer generates a distribution of outcomes based on repeated random selection of values for the key variables.
Vertical common-size income statement
A vertical common-size income statement expresses all income statement items as a percentage of sales. _______ income statement ratios = income statement account / sales
Treasury bills
Average Annual Return = 3.7% Standard Deviation = 3.1%
Long-term corporate bonds
Average Annual Return = 5.9% Standard Deviation = 8.4%
Average Cost Method
Allocates the average cost of all inventory to each unit sold, is popular because of its ease of use.
DuPont system of analysis
An approach that can be used to analyze return on equity (ROE). It uses basic algebra to break down ROE into a function of different ratios, so an analyst can see the impact of leverage, profit margins, and turnover on shareholder returns. There are two variants of the DuPont system: The original three-part approach and the extended five-part system.
Audit
An independent review of an entity's financial statement
Indifference curve
An individual's preferred bundles of goods. The farther away (north east) the curve the more preferred the bundles.
Continuous random variable
An infinite number of possible outcomes. The number of inches of rain over a month can take on an infinite number of values, assuming we can measure it with infinite precision. For a continuous random variable, the probability that the random variable will take on any single one (of the infinite number) of the possible values is zero.
Large-cap stocks
Average Annual Return = 9.6% Standard Deviation = 20.9%
Real business cycle theory
Believe that business cycles result from utility-maximizing actions in response to real economic changes, such as external shocks and changes in technology. Policymakers should not intervene in business cycles.
Asset-based valuation models
Appropriate when equity value is the market or fair value of _______. It is difficult a to obtain the values used to calculate this, so you need to adjust for inflation, replacement values, etc. Bad when a lot of the ______ are intangible or off balance sheet. Good when form has tangible short-term ____ or when the firm is being liquidated.
Intangible Assets
Asset Economic resources of the firm that do not have a physical form, such as patents, trademarks, licenses, and goodwill.
Property, Plant, and Equipment
Asset Includes a contra-asset account for accumulated depreciation.
Prepaid Expenses
Asset Items that will show up on future income statements as expenses.
Cash and Cash Equivalents
Asset Risk-free securities with original maturities of 90 days or less.
Inflation
Average Annual Return = 3.0% Standard Deviation = 4.2%
Elliott wave theory
Based on an interconnected set of cycles that range from a few minutes to centuries. According to this theory, in an uptrend the upward moves in prices consist of five waves and the downward moves occur in three waves. If the prevailing trend is down, the downward moves have five waves and the upward moves have three waves. Each of these waves is composed of smaller waves that exhibit the same pattern. The sizes of these waves are thought to correspond with ratios of Fibonacci numbers. Fibonacci numbers are found by starting with 0 and 1, then adding each of the previous two numbers to produce the next (0, 1, 1, 2, 3, 5, 8, 13, 21, and so on). Ratios of consecutive Fibonacci numbers converge to 0.618 and 1.618 as the numbers in the sequence get larger.
Assets
Balance Sheet The firm's economic resources. Probable current and future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
Trading securities recognition
Balance sheet = Fair value Income statement 1. Dividends 2. Interest 3. Realized G/L 4. Unrealized G/L
Scenario analysis
Based on specific scenarios (a specific set of outcomes for key variables) and will also yield a range of values for financial statement items.
Ethical Conduct (definition)
Behavior that follows moral principles and is consistent with society's ethical expectations and also as conduct that improves outcomes for stakeholders, those who are directly or indirectly affected by the conduct
No-arbitrage price of a bond
Bond price calculated with spot rate
country risk premium
CRP = [sovereign bond yield - T-bond yield] × [std. dev. of developing country index / std. dev. of sovereign bonds in U.S. currency]
Investing Cash Flow
Cash Flow Statement Those resulting from acquisition or sale of property, plant, and equipment, of a subsidiary or segment, and purchase or sale of investments in other firms.
Cyclical unemployment
Caused by changes in the general level of economic activity. It is positive when the economy is operating at less than full capacity and negative when an expansion leads to employment temporarily above the full employment level.
Nominations committee proposes qualified candidates for election to the board, manages the search process, and attempts to align the board's composition with the company's corporate governance policies.
Compensation committee or remuneration committee recommends to the board the amounts and types of compensation to be paid to directors and senior managers. This committee may also be responsible for oversight of employee benefit plans and evaluation of senior managers.
BOP Capital Account
Comprises of: - Capital transfers. - Sales and purchases of non-financial assets;
Reflect (Ethical Decision Making)
Consider was the outcome as anticipated? Why or why not?
Standard Auditor's Opinion
Contains three parts, stating that: 1. Whereas the financial statements are prepared by management and are its responsibility, the auditor has performed an independent review. 2. Generally accepted auditing standards were followed, thus providing reasonable assurance that the financial statements contain no material errors. 3. The auditor is satisfied that the statements were prepared in accordance with GAAP and that the accounting principles chosen and estimates made are reasonable.
Global Investment Performance Standards (GIPS) (Definition)
Created to provide a uniform framework for presenting historical performance results for investment management firms to serve existing and prospective clients. Compliance with GIPS is voluntary, but partial compliance cannot be referenced. There is only one acceptable statement for those firms that claim complete compliance with GIPS.
Amortization
Depreciation of intangible assets. _____ should match the benefits/value used over the period. Goodwill and other intangible assets with indefinite lives are not ______. However, they must be tested for impairment at least annually. If the asset is impaired, an expense is recognized in the income statement.
Money supply
Determined by central banks with the goal of managing inflation and other economic variables.
Sustainable rate of economic growth
Determined by the rate of increase in the labor force and the rate of increase in labor productivity
Strategic asset allocation
Developed which specifies the percentage allocations to the included asset classes. In choosing asset classes for an account, the correlations of returns within an asset class should be relatively high, and the correlations of returns between asset classes should be relatively low in comparison.
Nonparametric tests
Do not consider a particular population parameter or have few assumptions about the sampled population. Runs tests (which examine the pattern of successive increases or decreases in a random variable) and rank correlation tests (which examine the relation between a random variable's relative numerical rank over successive periods) are examples of nonparametric tests.
Investment policy statement (IPS)
Document created after an initial planning process: - Details the investor's investment objectives and constraints. - Specifies an objective benchmark (such as an index return). - Should be updated at least every few years and anytime the investor's objectives or constraints change significantly.
Historical simulation of outcomes
Done by randomly selecting changes in price or risk factors from actual (historical) past changes in these factors and modeling the effects of these changes on the value of a current portfolio. The results of historical simulation have limitations since future changes may not necessarily be distributed as past changes were.
Benefits of reporting standards
Ensure that the information is useful to a wide range of users, including security analysts, the firm's creditors, and current and potential investors, by making financial statements comparable to one another and narrowing the range within which management's estimates can be seen as reasonable.
Operating lease
Essentially a rental arrangement. No asset or liability is recorded on the balance sheet by the lessee, and the periodic lease payments are simply recognized as rental expense in the income statement.
Monetary union
Exchange rate regime where several countries use a common currency.
Crawling peg
Exchange rate regime where the exchange rate is adjusted periodically, typically to adjust for higher inflation versus the currency used in the peg.
Independently floating exchange rate
Exchange rate regime where the exchange rate is market- determined.
Managed floating exchange rates
Exchange rate regime where the monetary authority attempts to influence the exchange rate in response to specific indicators, such as the balance of payments, inflation rates, or employment without any specific target exchange rate.
Common-size balance sheet
Expresses all balance sheet accounts as a percentage of total assets and allows the analyst to evaluate the balance sheet changes over time (time-series analysis) as well as to compare the balance sheets with other firms, industry, and sector data (cross-sectional analysis).
Free cash flow to equity (FCFE) (formula calculating from operating cash flow)
FCFE = CFO - net capital expenditure + net borrowing
Materials
Factor of production Inputs into the production process. Could be raw or intermediate goods
Put option on bond
Fixed income structure that gives the bondholder the right to sell the bond back to the issuing company at a given price, typically par value. With these bonds, the holder sells if the fair value falls below the par value. Given this risk they usually trade at a lower value than normal bonds.
Make-whole bond
Fixed income structure where the call price is not fixed but includes a lump-sum payment based on the present value of the future coupons the bondholder will not receive if the bond is called early. Thus, the issuer is unlikely to call the bond except when corporate circumstances, such as an acquisition or restructuring, require it.
Inflation-linked bond
Fixed income structure where the coupon payments are based in changes to a ________ linked index.
Index-linked bond
Fixed income structure where the coupon payments are based on commodity, equity or some other published ______
Amortizing structure
Fixed income structure where the periodic payments include both interest and some repayment of the principal
Straight or option free bonds
Fixed income structure without protective provisions that indicate what actions must be taken if a specific action occurs
Simple interest rate swap
Floating rate interest payments are exchanged for fixed rate payments over multiple settlement dates.
Coincident indicators
Have turning points that tend to coincide with those of the business cycle and are used to indicate the current phase of the business cycle. Examples are manufacturing activity, personal income, and number of non- agricultural employees.
Value-of-final-output
GDP is calculated by summing the values of all final goods and services produced during the period.
Identify (Ethical Decision Making)
Gather relevant facts, stakeholders and duties owed, ethical principles, conflicts of interest.
Reversal patterns
Head-and-shoulders; double top; triple top; inverse head-and- shoulders; double bottom; triple bottom. These price patterns are thought to indicate that the preceding trend has run its course and a new trend in the opposite direction is likely to emerge.
Repo rate behavior
Higher the longer the term. Lower the higher the credit quality of the security. Lower when the security is actually delivered to the lender. Higher when the interest rates for alternative sources of funding is higher.
Legal infrastructure for managing stakeholders
Identifies the laws relevant to and the legal recourse of stakeholders when their rights are violated.
Labor force
Includes all people who are either employed or unemployed
Absolute advantage
If a country can product a good at a lower cost, in terms of resources, than another country.
Diluted EPS
If a firm has a complex capital structure ______ must be reported. To calculate, treat any ______ securities as if they were converted to common stock from the first of the year (or when issued if issued during the current year).
Uptrend in the market
If prices are consistently reaching higher highs and retracing to higher lows. Indicates that demand is increasing relative to supply. An trendline can be drawn connecting the low points for a stock.
Shutdown (short run)
If selling price is less than average variable cost, the firm will minimize its losses in the short run by ceasing operations
Substitution effect
If you take where slope of the new line and moved parallel back to when it intercepts the first income line, this shows how how the mix of the bundle of goods would change if you replaced X with Y.
Points in forex
In a foreign currency quotation, these are the units of the last digit of the quotation. Can be used to add a small premium on to of a quote.
68% confidence interval
In a normal distribution, __% of the population will fall between plus/minus 1 standard deviation of the mean
Gains and losses
Income Statement Increases (decreases) in equity or net assets from peripheral or incidental transactions.
Revenues
Income Statement Inflows from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.
Expenses
Income Statement Outflows from delivering or producing goods or services that constitute the entity's ongoing major or central operations.
Taxable income
Income subject to tax as reported on the tax return.
Negative Covariance
Indicates that the variables tend to move in opposite directions relative to their means
Advantage of fiscal policy
Indirect taxes (sales, value-added, and excise taxes) can be used to quickly implement social policies and can also be used to quickly raise revenues at a low cost.
Specific identification method
Individual items in inventory, such as a car dealer's cars in inventory, are carried at their individual costs and added to COGS as they are sold.
Shakeout Stage
Industry growth and profitability are slowing due to strong competition. The characteristics of this stage are as follows: - Growth has slowed: demand reaches saturation level with few new customers to be found. - Intense competition: industry growth has slowed, so firm growth must come at the expense of competitors. - Increasing industry overcapacity: firm investment exceeds increases in demand. - Declining profitability: due to overcapacity. - Increased cost cutting: firms restructure to survive and attempt to build brand loyalty. - Increased failures: weaker firms liquidate or are acquired.
decline stage
Industry growth is negative. The characteristics of this stage are as follows: - Negative growth: due to development of substitute products, societal changes, or global competition. - Declining prices: competition is intense and there are price wars due to overcapacity. - Consolidation: failing firms exit or merge.
Growth stage
Industry growth is rapid. The characteristics of this stage are as follows: - Rapid growth: new consumers discover the product. - Limited competitive pressures: The threat of new firms coming into the market peaks during the growth phase, but rapid growth allows firms to grow without competing on price. - Falling prices: economies of scale are reached and distribution channels increase. - Increasing profitability: due to economies of scale.
Excess kurtosis
Kurtosis relative to that of a normal distribution. A distribution with kurtosis of 4 has excess kurtosis of 1. It is said to have positive excess kurtosis (a leptokurtic distribution). A distribution with kurtosis of 2 has excess kurtosis of -1. It is said to have positive excess kurtosis.
LIFO Uses
LIFO is popular because of the income tax benefits. LIFO results in higher cost of goods sold in an inflationary environment. Higher cost of goods sold results in lower taxable income, and thus lower income taxes. LIFO inventory accounting is not permitted under IFRS.
Long-Term Debt
Liability Things such as bonds payable.
Capital restrictions
Limits on the flow of money overseas - Outright prohibition of investment in the domestic country by foreigners. - Prohibition of or taxes on the income earned on foreign investments by domestic citizens. - Prohibition of foreign investment in certain domestic industries. - Restrictions on repatriation of earnings of foreign entities operating in a country.
Quick Ratio
Liquidity Ratio. A more stringent measure of liquidity because it does not include inventories and other assets that might not be very liquid (cash + marketable securities + receivables) / current liabilities
Current Ratio
Liquidity Ratio. Higher the _____ the more likely it is that the company will be able to pay its short-term bills current assets / current liabilities
Defensive Interval Ratio
Liquidity Ratio. Indicates the number of days of average cash expenditures the firm could pay with its current liquid assets. (cash + marketable securities + receivables) / average daily expenditures
Cash Conversion Cycle
Liquidity Ratio. The length of time it takes to turn the firm's cash investment in inventory back into cash, in the form of collections from the sales of that inventory. days sales outstanding + days of inventory on hand − number of days of payables
Cash Ratio
Liquidity Ratio. The most conservative liquidity measure. The higher the ______, the more likely it is that the company will be able to pay its short-term bills. (cash + marketable securities) / current liabilities
Interbank funds
Loans between banks outside of the reserves on deposit with a central bank. Can be lended for a day or even a year.
Intangible assets
Long-term assets that lack physical substance like patents, trademarks, and copyrights. The cost is amortized over its useful life.
Parametric tests
Makes assumptions regarding the distribution of the population from which samples are drawn. Includes the t-test, F-test, and chi-square test
Price to cash flow (p/cf formula)
Market value of equity / cash flow — or — Market price per share / cash flow per share Where: Cash flow = CF, adjusted CFO, FCFE EBITDA
Oligopoly
Market where few firms compete in a variety of ways - Few sellers. - High barriers to entry into or exit from the industry. - Products that may be homogeneous or differentiated by branding and advertising. - Firms that may have significant pricing power.
Perfect competition
Market where many firms produce identical products and competition forces them all to sell at the market price - Many firms, each small relative to the market. - Very low barriers to entry into or exit from the industry. - Homogeneous products that are exact substitutes. - No advertising or branding. - No pricing power.
Monopolistic competition
Market where many sellers product differentiated products - Many firms. - Low barriers to entry into or exit from the industry. - Differentiated products, heavy advertising, and high marketing expenditure. - Firms that have some pricing power.
Monopoly
Market where only one firm is producing the all the products - A single firm that comprises the whole market. - Very high barriers to enter or exit the industry. - Advertising used to compete with substitute products. - Significant pricing power.
M-squared (M2)
Measure that produces the same portfolio rankings as the Sharpe ratio but is stated in percentage terms.
Arithmetic mean
Measures of Central Tendency A population average is called the population mean (denoted μ). The average of a sample (subset of a population) is called the sample mean (denoted x̅). Both the population and sample means are calculated as arithmetic means (simple average). We use the sample mean as a "best guess" approximation of the population mean.
Geometric mean return
Measures of Central Tendency RG = ( ( (1+R1)×(1+R2)×...×(1+Rn) ) ^ (1/n) ) − 1
Geometric mean
Measures of Central Tendency Used to calculate compound growth rates. The greater the variability of returns over time, the greater the difference between arithmetic and geometric mean (arithmetic will always be higher).
Mode
Measures of Central Tendency Value occurring most frequently in a data set. Data set can have more than one of this
Coefficient of variation
Measures of Dispersion Expresses how much dispersion exists relative to the mean of a distribution and allows for direct comparison of the degree of dispersion across different data sets. It measures risk per unit of expected return. The lower the better. CV = standard deviation of returns / mean return
Population variance
Measures of Dispersion The average of the squared deviations from the mean in a population σ^2 = ( (X.1 - Avg)^2 + (X.2 - Avg)^2 + (X.(n-1) - Avg)^2 ) / (n)
Sample variance
Measures of Dispersion The average of the squared deviations from the mean in a sample s^2 = ( (X.1 - Avg)^2 + (X.2 - Avg)^2 + (X.(n-1) - Avg)^2 ) / (n-1)
Range
Measures of Dispersion The difference between the largest and smallest value in a data set and is the simplest measure of dispersion. You can think of the dispersion as measuring the width of the distribution. The narrower the range, the less dispersion.
Standard deviation
Measures of Dispersion The square root of variance. On the exam, if the question is asking for the standard deviation, do not forget to take the square root!
Covariance
Measures the degree to which the two variables tend to move together. It captures the linear relationship between one random variable and another Cov(RX, RY) = [probability case 1 * (returns of X - expected returns of X) * (returns of Y - expected returns of Y) + probability case 2 * (returns of X - expected returns of X) * (returns of Y - expected returns of Y)
Beta
Measures the market risk of equity securities and portfolios of equity securities. This measure considers the risk reduction benefits of diversification and is appropriate for securities held in a well-diversified portfolio, whereas standard deviation is a measure of risk on a stand-alone basis. The sensitivity of an asset's return to the return on the market index in the context of the market model
Double-declining balance method (DDB)
Most common accelerated deprecation method that allocates 200% of the straight-line rate, applied against the declining balance (value net of depreciation)
Multifactor models
Most commonly use macroeconomic factors such as GDP growth, inflation, or consumer confidence, along with fundamental factors such as earnings, earnings growth, firm size, and research expenditures.
Discouraged workers impact on unemployment rate
Movement of ____ out of and back into the labor force causes the _____ to be a lagging indicator of the business cycle. Early in an expansion when hiring prospects begin to improve, the number of _____ who re-enter the labor force is greater than the number hired immediately.
Absorption approach
National income must increase relative to national expenditure in order to decrease a trade deficit. This can also be viewed as a requirement that national saving must increase relative to domestic investment in order to decrease a trade deficit.
Left-skewed distribution
Negative skewness and a mean that is less than the median, which is less than the mode. *Bump is on the right*
Time-period bias
Occurs if the time period over which the data is gathered is either too short or too long.
LIFO liquidation
Occurs when a LIFO firm's inventory quantities decline. In a rising price environment, COGS are based on older, lower unit costs, which makes COGS artificially low. The reduction in COGS from a _____ increases gross and net profits and margins, but these increases are not sustainable
Look-ahead bias
Occurs when a study tests a relationship using sample data that was not available on the test date.
Data-mining bias
Occurs when research is based on the previously reported empirical evidence of others, rather than on the testable predictions of a well-developed economic theory. Also occurs when analysts repeatedly use the same database to search for patterns or trading rules until one that "works" is found.
Sample selection bias
Occurs when some data is systematically excluded from the analysis, usually because of the lack of availability.
Order-driven markets
Orders are executed using trading rules, which are necessary because traders are usually anonymous. Examples include exchanges and automated trading systems
Audit committee
Oversees the financial reporting function and the implementation of accounting policies, monitors the effectiveness of the company's internal controls and internal audit function, recommends an external auditor, and proposes remedies based on its review of internal and external audits.
Retained Earnings
Owner's Equity Cumulative income that has not been distributed as dividends.
Capital (accounting)
Owner's Equity Par value of common stock.
Multiplication Rule for Joint Probability
P(AB) = P(A | B) × P(B) = P(B | A) × P(A) The probability that A and B will both (jointly) occur is the probability of A given that B occurs, multiplied by the (unconditional) probability that B will occur.
Tangible assets
Plant, equipment, and natural resources, which are reported at historical cost less accumulated depreciation or depletion. Land, which is reported at historical cost and is not depreciated.
Right-skewed distribution
Positive skew (or skewness) and a mean that is greater than the median, which is greater than the mode. *Bump is on the left*
CFA Code of Ethics Rule 4
Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.
Management's Discussion and Snalysis (MD&A)
Provides an assessment of the financial performance and condition of a company from the perspective of its management. For publicly held companies in the United States, the MD&A is required to discuss: - Trends, significant events, and uncertainties that affect the firm. - Effects of inflation and changing prices, if material. - Impact of off-blance-sheet and contractual obligations. - Accounting policies that require significant judgment by management. - Forward-looking expenditures and divestitures.
World Bank
Provides low-interest loans, interest-free credits, and grants to developing countries for many specific purposes. It also provides resources and knowledge and helps form private/public partnerships with the overall goal of fighting poverty.
Cash Flow Statement
Reports the company's cash receipts and outflows. They include Operating Cash Flow, Investing Cash Flor and Financing Cash Flow
Balance Sheet
Reports the firm's financial position at a point in time. Consists of Assets, Liabilities and Owner's Equity.
Budget line
Represents all the combinations of two goods that will just exhaust a consumer's income. This bounds an area representing all affordable combinations of two goods at current prices. The y-intercept of this is income/price of Good Y The x-intercept of this is income/price of Good X.
Long-run aggregate supply curve
Represents potential GDP, the full-employment level of economic output. Perfectly inelastic (vertical)
Total factor productivity
Represents that part of economic growth not accounted for by increases in the supply of either labor or capital. Increases in ____ can be attributed to advances in technology.
Non-accelerating inflation rate of unemployment (NAIRU)
Represents the unemployment rate below which upward pressure on wages is likely to develop.
Accrual Accounting
Requires that revenue is recorded when the firm earns it, and expenses are recorded when the firm incurs them, regardless of whether cash has actually been paid.
Demand-pull inflation
Results from persistent increases in aggregate demand that increase the price level and temporarily increase economic output above its potential or full-employment level.
Frictional unemployment
Results from the time lag necessary to match employees seeking work with employers seeking their skills and is always present as employers expand or contract their businesses and as workers move, are fired, or quit to seek other opportunities.
market capitalization-weighted index (value-weighted index)
Returns are weights based on the ________ of each index stock as a proportion of the total ____________ of all the stocks in the index. Does not need to be adjusted when a stock splits or pays a stock dividend.
Gains
Revenue item Increases in assets or equity from transactions incidental to the firm's day-to-day activities.
Investment Income
Revenue item Interest and dividend income.
Valuation ratios
Sales per share, earnings per share, and price to cash flow per share are examples of ratios used in comparing the relative _________ of companies.
Collateralized mortgage obligations (CMO)
Securities that are collateralized by RMBS
Stratified random sampling
Separate the population into groups based on one or more characteristics. Take a random sample from each class based on the group size. In constructing bond index portfolios, we may first divide the bonds by maturity, rating, call feature, etc., and then pick bonds from each group of bonds in proportion to the number of index bonds in that group. This insures that our "random" sample has similar maturity, rating, and call characteristics to the index
Exhaustive set of events
Set that includes all possible outcomes
Discouraged workers
Short-term fluctuations in the participation ratio can occur because those who are available for work but are neither employed nor actively seeking employment.
Commercial paper
Shorter term debt securities issued by corporations with lower funding costs than traditional debt. Only for larger, creditworthy corporations.
IS curve
Shows the negative relationship between the real interest rate (y-axis) and equilibrium value of aggregate income (which must equal planned expenditures) consistent with each real interest rate
Short-run aggregate supply curve
Shows the positive relationship between real GDP supplied and the price level when other factors are held constant.
LM curve
Shows the positive relationship between the real interest rate (y-axis) and the level of aggregate income at which demand for and supply of real money balances are equal.
Debt-to-assets
Solvency Ratio. A slightly different way of analyzing debt utilization total debt / total assets
Debt-to-capital
Solvency Ratio. Capital equals all short-term and long-term debt plus preferred stock and equity. Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing. total debt / (total debt + total shareholders' equity)
Financial leverage ratio (leverage ratio)
Solvency Ratio. Greater use of debt financing increases _______ and, typically, risk to equity holders and bondholders alike. average total assets / average total equity
Underemployed
Someone who is employed part time but would prefer to work full time, or is employed at a low-paying job despite being qualified for a significantly higher-paying one
Unemployed person
Someone who is not working and actively searching for work
Present and Future Value of an Annuity Due on Calculator
Something to be careful of, when calculating the PV or FV of annuity, you need to adjust the PV of FV by (1 + period rate) depending on if the calculator is in BGN or END mode.
Fiscal policy tools
Spending tools - transfer payments - current spending (goods and services used by government) - capital spending (investment projects funded by government) Revenue tools - direct taxation - indirect taxation
Board of directors
Stakeholder with a responsibility to protect the interests of shareholders.
Shareholders
Stakeholder with an interest in the ongoing profitability and growth of the firm, both of which can increase the value of their ownership shares.
Two-fund separation theorem
States that all investors' optimum portfolios will be made up of some combination of an optimal portfolio of risky assets and the risk-free asset.
Central limit theorem of statistics
States that in selecting simple random samples of size n from a population with a mean μ and a finite variance σ^2, the sampling distribution of the sample mean approaches a normal probability distribution with mean μ and a variance equal to σ^2/n as the sample size becomes large. Specific inferences about the population mean can be made from the sample mean, regardless of the population's distribution, as long as the sample size is sufficiently large.
European style callable bond
The bonds can only be called on the call date specified
Participation instrument
Structured financial instrument that has payments based on the value of an underlying interest rate, asset return or index return. A floating-rate note based on a reference such as LIBOR.
Credit-linked note (CLN)
Structured financial instrument that has regular coupon payments, but its redemption value depends on whether a specific credit event occurs (downgrade or something like that). If it doesn't happen, the _____ will be redeemed at par value. If it does happen, the ____ will be redeemed at a discount. The yield on a _____ is higher than a normal bond to account for the risk.
Capital protected instrument
Structured financial instrument that offers a guarantee of a minimum value at maturity as well some potential upside gain. Something like a zero-coupon bond with a call option to convert to equity.
Inverse floater
Structured financial instrument weigh coupon payments that most oppositely to a reference interest rate
Free cash flow to the firm (FCFF)
The cash available to all investors, including stockholders and debt holders. ______ can be calculated using net income or operating cash flow as a starting point.
National income
The ______ received by all factors of production used in the creation of final output.
Income tax paid
The actual cash outflow for taxes paid during the current period.
LIFO reserve
The amount by which LIFO inventory is less than FIFO inventory. Analysts must: 1. Add the LIFO reserve to LIFO inventory. 2. Increase retained earnings by the LIFO reserve.
Deferred income tax expense
The excess of income tax expense over taxes payable.
Last-in, first-out (LIFO)
The last item purchased is the first item sold. Appropriate for inventory that does not deteriorate with age.
Options in a case where the Professional Conduct staff finds a violation has occurred and proposes a disciplinary sanction
The member or candidate may accept or reject the sanction. If the member or candidate chooses to reject the sanction, the matter will be referred to a panel of CFA Institute members for a hearing. Sanctions imposed may include condemnation by the member's peers or suspension of the candidate's continued participation in the CFA Program.
Weighted average coupon (WAC)
The mortgage pool is the principal-weighted average of the interest rates of all the mortgages in the pool
Inflation rate
The percentage increase in the price level, typically compared to the prior year
Shareholder theory
The primary focus of a system of corporate governance is the interests of the firm's shareholders, which are taken to be the maximization of the market value of the firm's common equity
Significance level (α)
The probability of making a Type I error (rejecting the null when it is true) and is designated by the Greek letter alpha (α). You can think of this as the probability that the test statistic will exceed or fall below the critical values by chance even though the null hypothesis is true. α of 5% means there is a 5% chance of rejecting a true null hypothesis.
Shortfall risk
The probability that a portfolio's return or value will be below a specified (target) return or value over a specified period.
Production Function
The quantity of output that a firm can produce can be thought of as a function of the amounts of capital and labor employed. For a given amount of capital (a firm's plant and equipment), we can examine the increase in _________ that will result as we increase the amount of labor employed.
Income elasticity of demand
The ratio of the percent change in quantity demanded to the percent change in income. For a normal good, this is positive so that an increase in income increases demand for the good. For an inferior good, this is negative so that an increase in income decreases demand for the good (e.g., bus travel).
Cross price elasticity of demand
The ratio of the percent change in quantity demanded to the percent change in the price of a related good. It is positive for a good that is a substitute in consumption (e.g., cars and bus travel) It is negative for a good that is a complement in consumption (e.g., cars and gasoline)
Standard error of the sample mean
The standard deviation of the means of samples of size n σ/(n ^ (1/2))
Simple yield for a bond
The sum of the coupon payments plus the straight-line amortized share of the gain or loss, divided by the flat price.
Taxes payable
The tax liability based on taxable income, as shown on the tax return
Gross national product (GNP)
The total value of goods and services produced by the labor and capital of a country's citizens
Historical cost (balance sheet)
The value that was exchanged at the acquisition date. It is objective (highly reliable), but its relevance to an analyst declines as values change.
mature stage
There is little industry growth and firms begin to consolidate. The characteristics of this stage are as follows: - Slow growth: market is saturated and demand is only for replacement. - Consolidation: market evolves to an oligopoly - High barriers to entry: surviving firms have brand loyalty and low cost structures. - Stable pricing: firms try to avoid price wars, although periodic price wars may occur during recessions. - Superior firms gain market share: the firms with better products may grow faster than the industry average.
Credit enhancements
Tools that are used when constructing an ABS to attract institutional lenders
Voluntary export restraint
Trade restriction A country voluntarily restricts the amount of a good that can be exported, often in the hope of avoiding tariffs or quotas imposed by their trading partners.
Quotas
Trade restriction Limits on the amount of imports allowed over some period.
Items excluded from Income Statement that Affect Owners' Equity
Transactions with owners: 1. Issuing or reacquiring stock. 2. Dividends paid. Transactions included in other comprehensive income: 1. Foreign currency translation gains and losses. 2. Adjustments for minimum pension liability. 3. Unrealized gains and losses from cash flow hedging derivatives. 4. Unrealized gains and losses from available-for-sale securities.
Continuation patterns
Triangles; rectangles; flags; pennants. These indicate temporary pauses in a trend which is expected to continue (in the same direction).
Two-tailed test
Use this type of test when testing a parameter to see if it is different from a specified value. Assumes a normal distribution, you're looking for something in between the significance/confidence intervals. +-1.96 on either side. 2.5% on either tail.
Return generating models
Used to estimate the expected _____ on risky securities based on specific factors. For each security, we must estimate the sensitivity of its _______ to each factor included in the ____. Factors that explain security returns can be classified as macroeconomic, fundamental, and statistical factors.
Completed Contract Method (US GAAP)
Used when the outcome of a project cannot be reliably measured or the project is short-term. Revenue, expense, and profit are only recognized when the contract is complete.
fundamental weighting index
Uses weights based on firm performance, such as earnings, dividends, or cash flow. An advantage is that it avoids the bias of market capitalization- weighted indexes toward the performance of the shares of overvalued firms and away from the performance of the shares of undervalued firms
Effective Annual Rate
With m compounding periods per year and a stated annual rate of i, the effective annual rate is calculated by compounding the periodic rate (i/m) over m periods (the number of periods in one year). EAR = (1 + (i/m))^m - 1
Basket of listed depository receipts (BLDR)
an exchange-traded fund (ETF) that is a collection of DRs. ETF shares trade in markets just like common stocks.
equal-weighted index
calculated as the arithmetic average of the returns of index stocks and would be matched by the returns on a portfolio that had equal dollar amounts invested in each index stock. When stock prices change, however, portfolio weights change and the portfolio must be rebalanced periodically to restore equal weights to each index security. Compared to a price-weighted index, more is spent on low-priced stocks Compared to a market capitalization-weighted index, more is spent on returns of stocks with small market capitalizations.
discounted payback period
capital budgeting method the number of years it takes to recover the initial investment in present value terms. The discount rate used is the project's cost of capital. This method incorporates the time value of money but ignores any cash flows beyond the discounted payback period.
CFO when capitalizing vs expensing
capitalizing = higher expensing = lower
Net Income first year when capitalizing vs expensing
capitalizing = higher expensing = lower
CFI when capitalizing vs expensing
capitalizing = lower expensing = higher
Income variability when capitalizing vs expensing
capitalizing = lower expensing = higher
Net Income later years when capitalizing vs expensing
capitalizing = lower expensing = higher
Callable common shares
give the firm the right to repurchase the stock at a pre- specified call price.
Cost of equity capital bond yield plus risk premium approach (k.commonstock)
k.commonstock = current market yield on the firm's long-term debt + risk premium
Real exchange rate (formula)
real exchange rate = nominal exchange rate × (base currency CPI / price currency CPI)
Cumulative preference shares
require that current period dividends and any dividends that were not paid must be made up before common shareholders can receive dividends. The dividends of non-cumulative preference shares do not accumulate over time when they are not paid, but dividends for the current period must be paid before common shareholders can receive dividends.
Portfolio perspective
refers to evaluating individual investments by their contribution to the risk and return of an investor's overall ______. The alternative is to examine the risk and return of each security in isolation
size effect
refers to evidence that small-cap stocks outperform large-cap stocks. This effect could not be confirmed in later studies, suggesting that either investors had traded on, and thereby eliminated, this anomaly or that the initial finding was simply a random result for the time period examined.
value effect
refers to the finding that value stocks have outperformed growth stocks. Some researchers attribute this to greater risk of value stocks that is not captured in the risk adjustment procedure used in the studies
Characteristics that financial information useful
relevance - Financial statements are relevant if they contain information that can influence economic decisions or affect evaluations of past events or forecasts of future events. faithful representation - Information that is faithfully representative is complete, neutral (absence of bias), and free from error.
Asset-backed securities
represent a claim to a portion of the cash flows from a pool of financial assets such as mortgages, car loans, or credit card debt.
Price-weighted index (formula)
sum of stock prices / number of stocks in index
Total Risk (formula)
systematic risk + unsystematic risk
Test statistic for hypothesis test of two population means
t-statistic
Test statistic for hypothesis test of one population mean
t-statistic or Z-statistic
Non-normal distribution Unknown variance Large Sample (n > 30)
t-statistic* *The z-statistic is theoretically acceptable here, but use of the t-statistic is more conservative.
January effect (or turn-of-the-year effect)
the finding that during the first five days of January, stock returns, especially for small firms, are significantly higher than they are the rest of the year.
overreaction effect
the finding that firms with poor stock returns over the previous three or five years (losers) have better subsequent returns than firms that had high stock returns over the prior period
Global registered shares (GRS)
traded in different currencies on stock exchanges around the world.
Non-normal distribution Known variance Large Sample (n > 30)
z-statistic