Vault Finance Interview

14. What is a yield curve and how is it constructed?

A yield curve is the plot of current spot yields against maturity.

44. Is beta constant or does it vary over time?

As companies mature, beta should approach one in the limit. Some models of beta (for example, Barra) use a weighted average beta, giving 2/3 weight to the regression beta and weighting the rest at 1 to take this into account

6. What is "junk?"

Called "high-yield" bonds by the investment banks (never call it junk yourself), these bonds are below investment grade, and are generally unsecured debt. Below investment grade means at or below BB (by Standard & Poor's) or Ba (by Moody's). Some less credit worthy companies issue debt at high yields because they have difficulty in securing bank debt or in tapping the equity markets. Sometimes high yield debt starts out investment grade and then "crosses over" to high yield. (Think of K-Mart or the Gap, which had their ratings lowered in 2002.) If a junk bond manages to turn its financial performance around and has its credit rating upgraded, the investor may see a substantial appreciation in the bond's price

51. How can a firm raise cash?

It can go to the capital markets (selling stock through an IPO or secondary offering), it can issue debt, or it can sell off assets.

15. How would you value a non-U.S. company?

LONG WINDED ANSWER comps are fine, but in some cases there is only one type of company in a market, so just make sure to adjust for international differences when using a comp in another country (i.e. lower interest rates affect PE ratios)

26. How do you calculate market capitalization of a company?

Multiply the current stock price by the number of shares outstanding. For example, if MSFT is trading at $52/share and there are 5,415.46 million shares outstanding, the market cap would be calculated as $52/share*5,415.46 million shares = $281,603.9.

On-the-run:

Newly auctioned securities are referred to as "on-the-run" while older, seasoned issues (i.e., those sold in previous auctions) are referred to as "off-the-run."

I was just looking at Bloomberg and noticed that I can earn 3.872% on a one-year bond in the U.K. and can borrow at 2% here in the U.S. Can I make a risk-free profit by doing this?

Not necessarily. The reason for different interest rates across countries is primarily due to different expectations of inflation. High interest rates in the U.K. relative to the U.S. indicate that the currency is expected to depreciate relative to the U.S. dollar

What factors influence the price of a bond?

The main factors are the perceived risk of the bond, its yield and the issuer's cash flows.

4. How do you value a bond?

The value of a bond comes derived from the present value of the expected payments or cash flows from a bond, discounted at an interest rate that reflects the default risk associated with the cash flows.

7. What investment philosophy do you subscribe to and why?

There are several main investment strategies: • "Aggressive growth" investors want to maximize rapid capital appreciation. This implies a readiness for high risk. It may also imply the use of alternative investment vehicles like private equity, venture capital, derivatives and hedge funds. • "Growth" investors seek capital appreciation, but with less risk than "aggressive growth investors." (And thus lower returns.) This still usually means stocks rather than bonds. • "Income" investors concentrate on current and steady income. Such investors usually have a mix of bonds and preferred stocks. They may also have dividend paying stocks and coupon-bearing convertible bonds, usually from "blue chip" companies like IBM or G.E. • "Growth-income" or "balanced" investors seek a mix of "Growth" and "Income." • "Conservative" or "defensive" investors seek capital preservation at all cost. This means investing in only high-grade bonds and the like. There are a few main investment styles, including: • "Value" investing, which emphasizes securities (mainly stocks) that have a market price far below whatever value analysts have computed for the security, whether based on DCF, P/E, or what have you. • "Contrarian" investing, which means investing contrary to the current market direction or beliefs. This is an exaggerated version of value investing, since contrarians seek out-of-favor investments with the potential for large gains through turnarounds. • "Momentum investors" or "market timers" use economic figures or technical analysis to make investment decisions rather than fundamental analysis. The idea is to be invested when prices are rising, and sell just as the market begins falling. This style generally uses technical analysis to time an investment in a particular stock or bond. The goal is to invest at a time when the security's price movement can be anticipated. "Fundamental analysis" means using DCF, P/E, talking with management, examining the income statement and balance sheet or other "fundamental" techniques to value a security. • "Technical analysis" means basing investment decisions by analyzing price charts, trading volume, "resistance levels," and the like. Technical analysts do not care about management, the balance sheet, earnings, or other fundamentals. • "Indexing" or "passive investing" means not picking individual securities but rather mimicking a particular index like the S&P 500 or the Dow Jones Eurostoxx 50. Adherents maintain that, on average, most active portfolio managers and sell-side analysts under perform the broader market. Many studies have supported this theory (often called the "efficient markets theory"). There is no one correct answer to this question at a buy-side interview. You should make sure you know which styles and philosophies the firm employs before the interview and make sure your answer is in line with what the firm espouses. On the sell side, most analysts would consider themselves fundamental analysts, but are agnostic when it comes to growth versus income. Few believe in technical analysis (since it means that what they do is meaningless), though many sell-side firms have technical analysts, so be careful not to downplay any one technique, style or philosophy

27. How do you calculate the market value of a firm?

Total firm value (V) equals the sum of the market value of the firm's debt (D) and equity (E). Or, V = D + E.

17. What is a forward rate?

A forward rate is an interest rate prevailing at some later time that can be locked in today. For example, if we are going to need a one-year loan in one year's time, we could go to the bank today and lock in the rate we will pay. We can get an idea of the market's opinion of where forward rates will be by calculating them from the yield curve

A client expects the market to move significantly and wants to hedge against either direction. What strategy would you recommend? Explain

A straddle. This way, he will profit no matter which way the market moves. Note that if the market does not move, or moves but not by very much, there will be a loss to the strategy. A straddle consists of the purchase of both a call and a put having the same strike price and expiry date. The upfront costs, apart from transaction costs, are the premiums that have to be paid for the call and put.

8. How do you price an option?

Binomial option pricing

What would happen to the price of an option if Iraq invaded Kuwait again?

Increases in volatility are good for option prices, all else being equal, because the more prices jump around, the more likely an option will expire "in the money." Thus, an invasion, in theory, would increase the value of all options.

Do forward rates predict the rates that ultimately prevail in later periods?

No. The expectation is that forward rates are unbiased predictors of future spot rates, but in practice, numerous studies (most notably one by Fama in 1976 and another paper by Fama in 1984) have shown that forward rates have very low predictive power over long time periods. Fama found mixed results over different time intervals: for example, he found one-month forward rates have some predictive power to forecast the spot rate one month ahead. Since the forward rate embeds two elements - the expected future spot rate and the risk premium - he hypothesized that this is due to the failure of models to control for this term premium in the forward rates. Unless this risk premium is controlled for, the best use of forward rates may just be as insight into the market's opinion of future spot rates.

24. What is securitization?

Securitization is the immediate monetizing of future cash flows. The advantage to the seller of the bond is that it receives cash immediately and mitigates any risk of suffering from future defaults by debtors.

35. Why would a firm choose short-term over long-term debt?

Short-term debt is generally cheaper and easier to obtain, but risky because the lender can cut you off at any time, for example, if your credit rating worsens. If you borrow at a floating rate, the risk of short-term debt increases because of having to rollover — the short rate is now a random variable influenced by uncontrollable factors such as inflation. Short-term debt is appropriate only for short time horizons or when assets are liquid.

28. What is the breakup value of a firm?

The breakup value of the firm is determined by analyzing the liquidation value of all tangible assets (A) and liabilities (L). These are netted (i.e., A - L) and the result is the residual value accruing to shareholders

Your client wants to buy one of two banks. One is trading at a 12x P/E, and the other trades at a 16x P/E. Which should your client try to buy? Do you even have enough information to determine this?

There are two ways in which this question is tricky. First, P/E is usually analyzed in relation to expected future growth in earnings. Higher growth companies tend to have higher P/Es, all else being equal. Since we do not know the banks' growth rates, we cannot say for certain. Second, in the answer in an earlier question we stated that price to book is a better measure of relative value for the financial services industry, since the book value of equity is regularly marked to market at banks, brokerages and insurance companies. Therefore, we couldn't make as good a guess as possible even if the growth rates were known. Return on equity is the variable which best matches P/BV. Mathematically this can also be shown as follows:

If a client purchases a 6%, $1,000 bond selling at a yield to maturity of 7%, what is the amount of the semi-annual interest payment?

Yield is unimportant here. What's important is the coupon payment: 6% of $1,000. So each year the payout is $60, or $30 every six months (semiannually). Don't get confused if the interviewer adds extra information to the question.

Basis point:

A basis point is 1/100th of a percentage point. If someone says that the yield on the two-year benchmark treasury rose by 100bp, they mean that the yield increased by 100 (1/100th) percentage points, or a full one percent. Basis points provide us with a convenient means to speak of fractions of percentage points.

Benchmark Treasury

A benchmark Treasury is a reference Treasury having a specific maturity, such as three months, two years and so on. These are securities against which other bonds may be measured, usually in terms of yield comparison. The news media will often say things like, "the benchmark 10-year Treasury closed up 30 basis points.

37. What is a leveraged buyout (LBO)? Why lever-up?

A leveraged buyout is a strategy to buy a company using borrowed funds. The acquiring company can use its own assets as collateral in anticipation that future cash flows from the resulting acquisition will cover the interest payments. LBOs enable shareholders to change the capital structure of the firm. They can buy up all of the stock and retire most of it, leaving the corporation with a structure, for example, of 90 percent debt and 10 percent equity. Benefits may include improved corporate governance: since debt payments have to be made, there are managerial incentives for good performance, thus better aligning managerial and shareholder interest.

What would happen to a company's stock if it announced a large loss due to a write-down of goodwill?

First, what is "goodwill?" When one firm purchases another, the acquiring firm must allocate assets to the new, combined company's balance sheet. Value is assigned to identifiable and tangible assets like land, buildings, and equipment first. Next, value is assigned to identifiable intangible assets like patents, customer lists, or trade names. The remainder is listed on the balance sheet as "goodwill." In short, you can just say goodwill is the difference between the book value of the purchased company and the actual price paid. Let's say General Electric purchases an advertising company like Omnicom and a brand-driven firm like Coca-Cola. The amount of goodwill left on the balance sheet of the combined company would be much greater than if GE bought General Motors.or Equity Office Properties. This is because a relatively larger portion of GM's and Equity Office's value is derived from their ownership of car factories or office buildings. Omnicom derives much of its value from the skills and knowledge of its employees. As much as managers tout "human capital" these days, there is no balance sheet item for the term. Similarly, the majority of Coke's value comes from its brand names and "secret formula" (which is not patented). U.S. GAAP (Generally Accepted Accounting Principles) used to require firms to amortize goodwill much the same way they depreciate tangible assets. This is no longer required: firms must now "write-down" goodwill only when it becomes "impaired." For example, if after GE purchased Coca-Cola, scientists discovered that orange juice causes cancer, the ability of GE to earn money off the Minute Maid brand name would become impaired. Thus some of the NPV of future income that had been projected to come from the Minute Maid division of Coca Cola/GE would have to be subtracted from goodwill on the balance sheet. This subtraction would also be taken from net income as a one-time loss. Consequently, if a company announces a big write-down of goodwill, this means that the company no longer expects to earn as much money as it had hoped from the intangible and unidentifiable assets in question. This would lower net income; in the case of AOL Time Warner in 2002 or Nortel in 2001, it could lower accounting earnings by tens of billions. However, this is considered a noncash charge, since it does not affect actual cash coming into the firm for the quarter the charge is taken. Indeed, it may not affect cash flows for several quarters or even years. If analysts and investors foresee such a charge being taken (which they often do), this massive loss is ignored, and only "operating earnings" are considered. In the case of AOL Time Warner and Nortel, investors had already seen the fortunes of Yahoo!, Lucent, JDS Uniphase, and the like tumble before the announcement of the write-downs. Many dot-coms, technology and telecommunication equipment companies (like JDS Uniphase) had themselves already announced write-downs. The stocks of AOL Time Warner and Nortel were therefore largely unaffected. A firm's stock will only fall if the write-down is completely unexpected, or much larger than expected.

You have a client that wishes to be invested in a bond portfolio. Would you recommend short- or long-term bonds for this client, and why?

It depends on what you expect the yield curve to do. Is it upward sloping now and expected to flatten? Turn it around on the interviewer (though this can be dangerous as they can then turn it back on you) by asking, "What do you think interest rates are going to do?" But in general, remember that price of a bond moves inversely to yield. Thus if interest rates are expected to rise, the price of a bond should fall. Usually long-term bonds are much more sensitive to interest rate movements than are short-term bonds. So you would tend to stay on the long end of the curve in order to get the maximum profit from rate movements (also, of course, the maximum exposure/potential loss). So, if the client wanted to profit from a rise in interest rates, you might short the long bonds. If rates are expected to decline, you could buy the long bonds

8. What does liquidity allow an investor?

Liquidity allows an investor to move in and out of an asset class quickly, enabling one to capitalize on any upside or quickly get out to avoid downside. All else being equal, one can get a better price for a more liquid asset since there is less risk of not being able to sell it.

What is unique about the U.S. treasury market vs. the rest of the debt market?

The U.S. Federal government's bonds are considered riskless, since the U.S. has never defaulted and is the world's strongest economy. All other bonds trade at and are quoted at a certain percentage or "basis" over treasuries (except in the case of a few other AAA-rated countries like France or the U.K.).

16. What is a spot rate?

The spot rate is the rate at which you could purchase the asset today. There are spot interest rates, spot rates for currencies, spot prices for commodities and so forth.

9. Are you a top-down or bottom-up investor?

Top-down investors evaluate the economy as a whole and find which sectors they believe will outperform the broader market and invest in these. For example, if the economy is entering a recession, such investors may seek "recession-proof" stocks like Kraft or Phillip Morris. If oil prices are expected to rise, they might seek energy sector investments. Bottom-up investors seek investments that are compelling values based on fundamental analysis (DCF, relative valuation or otherwise) regardless of overall economic conditions. Many portfolio managers are a combination of both. If you are interviewing at a buy-side firm, you should research the firm's philosophy and match your answer accordingly

38. How would you value a company with no earnings, such as a start-up?

You can't use the DDM or DCF. You would use multiples such as Price/Sales or comparables. Recall caveats in using comparables: in using comparables analysis, the key is to choose the right comparables. No two companies are exactly alike. Certainly it is necessary to choose companies in the same industry, but also consider the capital structure, size, operating margins and any seasonality effects.

disintermediation

cutting out the middleman in investing to lower costs ex. Before the World Wide Web, local health-care providers often served as a primary resource for individuals with questions or concerns about health issues. Furthermore, a doctor's opinion was accepted with little or no question. The explosion in online information had a significant impact on consumers who were thirsty for healthcare information, spurring them to seek answers about healthcare from various Web sites instead of from local professionals.

2. What is a bulge bracket firm?

"Bulge bracket" is a term that loosely translates into the largest full service brokerages/investment banks as measured by various league table standings. Goldman Sachs, Morgan Stanley, and Merrill Lynch are considered the ultimate examples (sometimes called the "Super Bulge Bracket") Of late, Citigroup/Salomon Smith Barney, CSFB and, increasingly, J.P. Morgan Chase are considered to have joined the U.S. bulge bracket. Globally, J.P. Morgan Chase, Deutsche Bank and UBS Warburg/PaineWebber are typically thrown in with the U.S. top five to form the so-called "Global Bulge Bracket." (Outside of the U.S., Deutsche Bank, J.P. Morgan and UBS frequently outrank Goldman in the league tables, for example.) If you are at a bulge bracket firm, you believe that only the very largest and niche firms will survive over the next few years. If you are applying to a bulge bracket aspirant (DB and UBS for a U.S.-based position; Bank of America, Lehman, Bear, ABN Amro, DKW, or BNP Paribas globally) you want to demonstrate your knowledge of how the firm at which you are interviewing is moving up various league tables and will soon join the ranks of the "Global Bulge Brackets." Or how the firm is essentially already a bulge bracket firm in many areas. Or how you want to be part of a firm with room for growth. If you are interviewing with a boutique or regional firm (Lazard, TWP or Jefferies, at the time of publication), you should emphasize your belief that firms able to carve out a niche and build strong relationships will survive and even thrive.

Your boss uses the discounted free cash flow model to value highgrowth stocks with low earnings. What do you think of this strategy?

It is very dangerous to value high-growth, low-earnings companies by the traditional DCF model. First of all, the distributions of important financial variables such as profit margins, working capital requirements, revenue growth rates, etc., are not distributed as they might be for more stable companies, but rather are bimodally distributed. The return on such a company is usually much better or much worse than expected, so traditional methods that trade off expected return with expected risk do not work. Risk is very high, making it very difficult to determine an appropriate discount rate. This is the same problem faced by venture capitalists, who instead might just use a very high hurdle rate (the minimum return that someone must receive before they'll invest in something) of, say 50% or so. Also, it is very difficult to determine the length of time over which the growth will occur, then diminish to stable growth. The uncertainty in all of these critical variables means that DCF analysis can produce very misleading and inaccurate results.

16. What is operating leverage?

Operating leverage refers to percentage of costs that are fixed versus variable. An airline, manufacturing or hotel company with lots of long-term property leases and unionized employees must make lease and salary payments whether sales rise or fall. On the other extreme, a consulting firm that has many employees working on site with clients or a technology company with high R&D expenditures might have the flexibility to lay-off employees or lower R&D expenses should sales falter, or to increase employees or spending more if sales rise. On the other hand, firms with high degrees of operating leverage generally experience significant increases in operating income as sales increase. A firm's degree of operating leverage is defined as: DOL = 1+(fixed costs/profits) = % change in profits/% change in sales.

Rising U.S. trade deficits are a problem. We need to get our deficit lower. Do you agree?

Rising deficits are not necessarily a problem. After all, Japan had a trade surplus throughout the 1990's while being mired in recession, while the U.S. had the world's strongest economy and high deficits during this time. The trade deficit is defined as follows: Trade Balance = Exports - Imports of Goods = NX. If the balance is negative, we have a trade deficit. You should recall from basic economics that GDP = C + I + G + NX (with C = consumer spending, I = investment, and G = government spending). Lower NX must be offset by higher C, I, or G. In the case of the U.S. during the 90's, C (consumption) and I (investment) were both higher. The total dollars invested in the U.S. economy during this time included massive amounts invested by foreigners. Fast growing economies like the U.S. or the so-called "Asian Tigers" attract foreign investment while having trade deficits. Hence, higher trade deficits are not necessarily a sign of economic weakness but can be a sign of confidence in an economy by global investors (assuming the deficit is financing investment and not consumption or government budget deficits).

12. What is the difference between senior and junior bondholders?

Senior bondholders get paid first (and as a result their bonds pay a lower rate of interest if all else is equal). The order in which debtors get paid in the case of bankruptcy is generally: commercial debts (vendors), mortgage lenders, other bank lenders, senior secured bondholders, subordinated (junior) secured bondholders, debentures (unsecured) holders, preferred stock holders, and finally straight equity (stockholders.)

What do you think the beta of General Motors is? What about a high-tech stock, such as Cisco Systems?

Since beta measures the sensitivity of the stock to the overall market, mature companies such as GM are generally expected to have betas close to 1. This means that they are about as risky as the overall market. A high-tech stock is perceived as more risky than the market and would probably have a beta higher than 1, perhaps closer to 2. Note that the more pronounced the growth orientation of the firm/industry, the higher beta is likely to be. Betas vary significantly between industries

What are some of the defensive tactics that a target firm may employ to block a hostile takeover?

There are a variety of strategies a target firm may employ, many designed to make the takeover economically unattractive to the target. • Changing the bylaws of the corporation — for example, by implementing a staggered board so that only 1/3 of the directors are elected each year and/or requiring a supermajority (for example, 75%) to approve a merger or acquisition. • Poison pill shareholder rights plan — the target company uses this tactic to make its stock less attractive to the potential acquirer. According to the Delaware Supreme Court, "A poison pill is a defensive mechanism adopted by corporations that wish to prevent unwanted takeovers. Upon the occurrence of certain 'triggering' events, such as a would-be acquirer's purchase of a certain percentage of the target corporation's shares, or the announcement of a tender offer, all existing shareholders, except for the would-be acquirer, get the right to purchase debt or stock of the target at a discount. This action dilutes the would-be acquirer's stake in the company and increases the costs of acquisition ...." • Golden parachutes — lucrative benefits, such as stock options, severance pay and so on, given to top management in the event of hostile takeovers. Not only does this increase the cost of the merger, but also results in loss of talented managers and other employees, who may be assets coveted by the acquirer.

Does treasury stock receive dividends? Is it included in market capitalization of a company? What happens to a company's ROE if shares are repurchased?

Treasury stock does not receive dividends. It is not included in market capitalization of a company, since market cap includes only outstanding shares. Retirement of stock through corporate repurchases raises financial variables such as ROE and EPS since the number of outstanding shares, used in the denominator of these variables, decreases.

30. What are some reasons companies carry out mergers?

A merger occurs when two companies agree to combine operations and go forward as a single company. The assets and liabilities of the two companies are combined. They can occur for a variety of reasons. Benefits can include cost reduction, economies of scale or the ability to enter a new market to exploit new opportunities at a lower cost than would be possible without the merger. There are different kinds of mergers as well. • Horizontal merger: a merger that takes place between two competitors (companies in the same line of business), such as one airline purchasing another. The Daimler-Chrysler merger is an example. Horizontal mergers can result in industry consolidation. If industry competition is sufficiently diluted after the horizontal merger, the new company may be able to raise prices and keep them high. For example, the Federal Trade Commission reports that had the merger between Staples (an office supply store) and Office Depot been allowed to go through, Staples would have been the only office supply store in many areas, and would have been able to raise prices 13 percent. • Vertical merger: a merger of non-competing companies, where one makes a component needed by the other. These firms have a buyer-seller relationship. Example: Time-Warner's merger with Turner Broadcasting Systems. Vertical mergers can increase barriers to entry by either refusing to sell needed production inputs to competitors or raising their prices. These types of mergers can also result in lowered prices that competitors cannot match, synergies in product design, and more efficient use of resources. • Conglomerate merger: a combination between companies in unrelated businesses. Goals of conglomerate mergers can include diversification. The theory: the companies are worth more together than separately. Conglomerates have fallen out of favor in recent years; investors today prefer to diversity portfolios, not purchase diversified companies. Divestitures and breakups of huge conglomerates built during the 1960s and 1970s are now common

What is a warrant? Do warrants affect a firm's financial ratios such as ROE?

A warrant is a security similar to a call option on a stock, except a warrant usually has a much longer time to expiry. Warrants may often be attached to issues of preferred stock or bonds in order to make the issue more attractive to investors, as they offer the opportunity for some participation in stock appreciation. When the warrant is exercised, the owner pays the stated strike price in exchange for shares of stock. Thus, warrants result in the issue of new shares of common stock and are dilutive. All other things equal, measures such as ROE and EPS should decrease as the number of shares increases

Why debt, equity, or currency and commodities? Why cash or derivates?

Again, this should be answered honestly. Debt (or fixed income as it is often called) is viewed as more quantitative than equity. The debt markets are also more attuned to broad macroeconomic trends, such as interest rate changes and GDP figures. Equity is viewed as more "story telling" and as more microeconomic in nature. Derivatives are viewed as very quantitative and many would say that one can make money in derivatives whether or not the markets go up or down. One should be careful when answering this, however. Equity interviewers do not want to hear that you are NOT quantitative, and convertible bond desks are generally part of a firm's equity division but require knowledge of equities, bonds AND derivatives. Similarly, there is an element of "story telling" to areas of fixed income, particularly in high yield and emerging markets sales

0. In 2002 the S&P is trading at a P/E multiple much higher than it was in the 1970s or even during the booming 1980s. Does this mean that stocks as a whole are currently overvalued?

All else being equal, higher growth means higher P/E ratios. All else being equal, lower interest rates mean lower discount rates and thus also higher P/E ratios. One could argue whether corporate earnings were growing faster than in the 1970s and 1980s. Interest rates in 2002 were clearly far lower, however, which allows all stocks to trade at higher multiples.

How would one price the different elements of a convertible bond?

Although this question often popus up in sales and trading interviews, many banks staff convertible bond capital markets/origination employees with bankers, so this question sometimes comes up in corporate finance interviews. In addition, as a banker you may need to discuss potential convertible offerings with a CFO; as an internal corporate finance professional you may help to decide whether your firm should raise money via equity, debt or hybrid securities like convertibles. First, the textbook definition of a convertible bond: A convertible bond is a bond that gives bondholders the option, but not the obligation, to convert into a certain number of shares. This option is usually triggered if the bond issuer's stock hits a certain, higher price in the future. Conversion becomes more likely as the underlying stock price increases. Firms normally use convertibles to lower the interest payments, when all else equal, the right to convert into equity gives the bond more value. From a trading standpoint, a convertible bond behaves at different times like: A bond. When it is "deep out of the money" (the underlying stock price is far below the conversion level) the overwhelming majority of the value comes from the interest payments; An option. Since the option to convert is no different than that of a traditional stock option, traditional option valuation techniques can be used; Straight equity. When the convertible is deep in the money (or the issuer's stock far above the conversion price) it becomes a near certainty that the bondholder will exercise his or her right to exercise. For valuation purposes, a convertible can be broken down into a straight bond and a conversion option. To value the bond component, take the coupon (face value interest) rate on the convertible bond and compare it to the interest rate that the company would have had to pay if it had issued a straight bond. This should be what the company pays on similar outstanding issues. If the company has no bonds outstanding, one can infer from its bond rating what the company might pay. Using the maturity, coupon rate and the market interest rate of the convertible bond, one can estimate the value of the bond as the sum of the present value of the coupons at the market interest rate and the present value of the face value of the bond at the market interest rate. Whatever is leftover is the equity portion. If it were a convertible offering yet to be issued, one would estimate the price of the call options imbedded in the convertible issue (using the option pricing methods discussed in a previous question) and subtract this amount from what the value of an ordinary bond of an equal maturity and face value would be. To determine the interest rate the issuer would then need to pay, one would find the rate, which when plugged into the bond pricing equation, is equal to this new amount (ordinary bond less option value).

31. What is an acquisition?

An acquisition is where one company (the acquiring firm) seeks to gain control over another (the target). An acquisition may be the cheapest way to buy desired assets or gain entry into a particular field. The takeover may be friendly or hostile. In a friendly takeover, the acquiring firm makes an offer to the target firm's management and board of directors to establish either a parent-subsidiary relationship, a merger or a consolidation of the two firms. In a hostile takeover, the acquiring firm proceeds against the wishes of the management/board, normally by accumulating stock and making tender offers directly to the shareholders.

13. What is an option?

An option is a contract between buyer and seller that provides the buyer the right, but not the obligation, to enter into a transaction at some future date, while the seller is obliged to honor the transaction. Options are derivatives that depend on the value of the underlying. For instance, one can buy a call option on a specific stock. The option will be defined by the exercise price (strike price) and the time to expiry. As an example, you buy a June call option on IBM stock with a strike of $80 when IBM is trading at $75. This gives you the option to purchase IBM at a price equal to the strike price,

convexity?

As bond prices rise and fall along with interest rate changes, they do not do so in the linear way assumed by duration. A straight-line approximation is valid for small changes in interest rates. For larger jumps, another measure is needed. Convexity is a second derivative of the price function and measures the actual curvature of the price-yield curve of a bond. Convexity is generally considered desirable in a bond, since the greater the curvature the more prices will increase when yields decrease and fall less when yields increase. Convexity also assumes that as yields rise, the price-bond curve becomes flatter. Convexity is important because it allows one to improve the duration estimation for changes in bond prices.

When should a company raise money via equity? When should a company raise funds using debt?

As you may recall: Cost of Equity = Appropriate Risk Free Rate + Beta (Equity Risk Premium) Only very low Beta companies will have a cost of equity that approaches their cost of debt, but in most cases debt is cheaper than equity from a firm's point of view. (Issuing stock is not "free," since it dilutes the ownership stakes of the firm's existing owners.) However, coupon-bearing debt requires regular payments. Therefore, younger and smaller firms with good growth prospects but more volatile cash flows are better suited for equity, while mature companies or those with steady cash flows tend to use more debt. Even zero-coupon debt, which requires only a balloon payment at maturity, is only appropriate for firms that have fairly certain future large cash flows. Some would argue that a company might want to use equity (such as when making an acquisition) in cases where management believes its own stock to be very highly (or even over) valued; thus AOL used stock to buy Time Warner and many dot-coms sold stock before March 2000 even though they did not need the funds. In other cases, existing bank or debt covenants may require a certain debt/equity ratio or cash balance, in which case a mature company with too much debt may issue stock to keep within its agreements

Why are yields on corporate bonds higher than treasury bonds of the same maturity?

Because of the risk involved. Treasury bonds are generally considered to be risk free, "backed by the full faith and credit of the United States Government." Corporate bonds will involve some risk of default, credit downgrades and so on, so investors demand a higher yield (lower price) in order to compensate them for the increased risk of the corporate bond.

9. Tell me what an institutional investor is.

Buyers of stocks, bonds, and other investment instruments are generally governments, corporations, individual investors (either "retail" like buying through Schwab or Merrill Lynch or via a trust or private bank like J.P. Morgan for the very wealthy) and institutional investors. Institutional investors are nongovernmental institutions that manage and invest money for themselves or others. They include mutual funds, which pool and manage money for large groups of retail investors; pension funds, which handle retirement money for a d1 = ln(S/K)+(r-y+ σ2 /2)t σ √t Vault Finance Interviews Practice Guide Sales & Trading 78 © 2002 Vault Inc. C A R E E R L I B R A R Y Customized for: Jason ([email protected]) company's or state's defined benefit retirement plan; insurance companies, which invest either to earn enough to pay out policies in the future or to hedge their liabilities; and endowment funds (like a museum's left-over donation money or a university endowment.) Certain professional investment firms (like Fidelity or the Capital Group) manage money on an outsourced basis for both retail clients through mutual funds as well as for institutions like endowments or for government or corporate clients. These are also commonly referred to as institutional investors. Hedge funds are often lumped in with institutional investors. Some firms break sales coverage (especially in derivatives) into "corporate" (non-pension-related), "insurance", "hedge funds" and "institutional" (everything else save individual investors.)

Tell me three major investment banking industry trends and describe them briefly.

Consolidation: More firms are teaming up. Examples include: Citibank and Travelers/SSB, Morgan Stanley/Dean Witter, Deutsche Banc/Alex. Brown, BNP/Paribas, Dresdner/Wasserstein/Allianz, Credit Suisse/DLJ, UBS/PaineWebber, Merrill Lynch and brokerages in the U.K., Canada, Australia, Japan, Spain, and South Africa, J.P. Morgan and Chase... all driven largely by the need to increase capital base and geographic reach. II. Expansion in Europe: More U.S. firms see the ending of corporate crossholdings, increasing use of capital markets to raise financing along with pension reform as leading to greater growth opportunities for their European-based businesses. III. Technology: Increasingly, firms are using ECN (Electronic Communication Networks, like Archipelago, Island or Instinet) to route and execute trades. Even in traditional forms of trading, technology is lowering costs but simultaneously lowering margins and commoditising many markets. In addition, increasingly sophisticated derivative and risk management products and distribution of information has been made possible due to recent advances in computing and telecommunications technology. IV. Demographic shift: The "baby boomers" in all of the advanced industrial countries are nearing retirement. Simultaneously, the boomers parents and grandparents will leave their estates to their children and grandchildren, leading to the single greatest inter-generational transfer of wealth the world has ever seen. Over the next few decades there should therefore be a sharp rise in the demand for investment services products to support these "Boomers" through retirement years around the world.

24. What is a defensive stock?

Defensive stock is the stock of a company that is not affected much by downturns in the economy. It may be used as a diversification element in a client portfolio. Defensive stocks typically include stocks of corporations that manufacture consumer essentials, such as food, clothing, pharmaceuticals, and so on, which people would still need even during recessions. On the other hand, stocks in sectors such as automotive, heavy construction or steel are highly sensitive to economic conditions.

2. How do derivatives work?

Derivatives are financial instruments that derive their value from other more fundamental variables, such as the price movements stocks, bonds or commodities, interest rates changes, and even the prices of other derivatives. The most common classes of derivative securities are futures, forwards, swaps and options. Futures and forwards are contracts whereby two parties (say a large group of farmers and Unilever or Kellogg's) agree to a future trade at a specific time and price. Common types of futures include oil, cattle and U.S. Treasury bond futures. The main difference between forwards and futures is that futures trade in the open market (like stocks or bonds) whereas forwards are private contracts. Swaps are similar to futures and forwards, but the agreements are for multiple trades in the future. For example, an insurance company might agree to pay the interest on a floating rate security it owns to a hedge fund that agrees to pay a fixed rate in return. This sort of agreement would be struck because the cash flows better match the two parties' risk profile and funding needs. Options are contracts where two parties agree to a possible trade in the future ("possible" because one party has the right but not the obligation to complete the trade). If the buyer has the right, this is a "call." If the seller has the right, it is a "put." Vault Finance Interviews Practice Guide Sales & Trading Visit the Vault Finance Career Channel at http://finance.vault.com — with insider firm profiles, message boards, the Vault Finance Job Board and more. 73 C A R E E R L I B R A R Y Customized for: Jason ([email protected]) Derivatives are used for three main purposes. Despite attention-grabbing headlines that suggest they are always exotic, volatile, and potentially very lucrative financial instruments, they are mainly used to hedge or provide financial insurance. Arbitrageurs also use them, seeking to exploit differences in prices for identical instruments in different markets in an attempt to earn a riskless profit. Finally, speculators looking to make spectacular profits use derivatives (which has led to news stories detailing the spectacular losses suffered by Barrngs, Orange County in California, and elsewhere). In a corporate finance role, you will mainly have to construct, pitch and/or evaluate simple as well as extremely complex derivative instruments for hedging and financial insurance

If Microsoft announces a new issue of 2,000,000 units at $120, with each unit consisting of one share of common, one share of preferred and a warrant for ¼ of a share of common, how many new shares of common will be issued assuming that the offering is successful and all warrants are exercised?

Each warrant entitles the owner to redeem it for ¼ shares, so since there were 2,000,000 warrants issued, there will be 2,000,000 (¼) = 500,000 new shares of common, in addition to the 2,000,000 new shares of common issued with the units, for a total of 2,500,000 new shares.

what is duration of a bond

It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices.

. Tell me how you would go about valuing a privately held construction company?

LONG WINDED (GOOD) ANSWER There are differences in the details when it comes to valuing a private company in any industry, however. These differences arise mainly when it comes to DCF valuation. When it comes to relative valuation, one would follow the same steps as outlined in the answer to the valuing a stock question. For a construction company, using the P/E multiples of publicly traded peers is probably the best choice. Real option valuation might be appropriate if the company has the exclusive right to build potentially valuable properties. If so, the only difference between a public and a private company using real options lies in the determination of the weighted average cost of capital (WACC). For a DCF valuation, the determination of the cost of equity (COE) or the WACC will also differ. Remember, the WACC is based partly on the COE. The cost of equity estimation usually depends on either a historical regression beta (found on Bloomberg among other data sources) or a bottom-up beta estimation. Since no historical regression betas are available (private companies do not trade), one must perform a bottom-up beta estimation using an average of the regression betas of similarly sized publicly traded peers as a proxy. In this case, one would look at similar-sized construction companies (as we did in the earlier question)

Who is Alan Greenspan and why is he followed so closely by the press? How will the stock market be affected if he announces an increase in interest rates?

One of these tools is the ability to alter the interest rate charged between banks for overnight loans. This discount rate is widely used as a benchmark against which other rates are compared. The effect of a rise in interest rates depends on whether the announced increase was anticipated or not. If the markets anticipate a rate increase of 50bp (50 basis points, or half a percent) and if Greenspan announces a rate increase of 50bp, there should be no change in stock prices, since the stocks would already have been priced according to this expectation. On the other hand, if rates rise higher than expected, stock prices must change to reflect the new reality and the overall market indices could be expected to fall. (Although, for example, stocks of financial corporations such as banks and other lenders may rise if a significant part of their revenues come from interest payments.)

34. Why is a firm's credit rating important?

The credit ratings are assigned by the major ratings agencies (Moody's, S&P, Fitch). Firms can raise cash by going to the equity markets (IPO, secondary offering, etc.) or through the debt markets (commercial paper, bonds, etc.). The credit rating directly affects the firm's cost of debt. The lower the rating, the higher the borrowing cost. If the rating is low enough, the firm may be rated non-investment grade, at which point many institutional investors will be prohibited from owning it. There are times when a firm will not be actively engaged in the capital markets. If a firm is rated AA, for example, it can pretty much raise cash whenever it wants by borrowing.

18. What are some ways to determine if a company might be a credit risk?

The easiest method, of course, is to look at what the rating agencies (S&P, Moody's, and/or Fitch) say about a company; it is their job to analyze such risk. These ratings may be unavailable, however, or you may wish to do further due diligence. There are several potential sources of risk any company faces. When analyzing the credit risk of a potential recipient of financing, one should examine all of these from a subjective standpoint. There are international-related risks (host government changes in law, political unrest, currency risk); domestic risks (recession, inflation or deflation, interest rate risk, demographic shifts, political and regulatory risk); industry risk (technological change, increased competition, increasing supply costs, unionization); and company-specific risk (management (in)competence, strategic outlook, legal action). Additionally, one must objectively look for signs that any subjectively determined risk scenarios will affect the finances of a company. Short-term liquidity risk can be analyzed by looking at some of the following accounting equations:

If you believe that there is a 40% chance of earning a 10% return on a stock, a 50% change of losing 5% and a 10% chance of losing 20%, what is the expected gain/(loss) on the stock?

The expected return is the weighted average of the probabilities of the returns times the returns,

49. Why would a firm try to optimize its capital structure?

The idea here, due to MM (Modigliani-Miller), is that there is an optimal capital structure for a firm. The capital structure is the mix between debt and equity. If the capital structure is optimized, the return on equity (ROE) should also be optimized, because the firm possesses the optimal amount of equity to produce its income. According to MM, firms should rely almost exclusively on debt to finance their operations. They don't do this, in practice, for a variety of reasons, including reduced liquidity, increased risk of financial distress, agency costs, etc.

16. What are the important factors affecting the value of an option?

The important factors include: • The "moneyness" of an option — how close the underlying is to the strike price. • Time to expiration — the longer the time to expiry, the higher the probability that the option will finish in the money. • Volatility — this increases the value of the option for the same reason as above. Other factors include risk-free rate and dividends paid (or foreign interest rate received if valuing currency option).

29. How can a company raise its stock price?

There are many ways in which a company could do this. These include: • Initiation of a large public stock repurchase. This sends a signal to the market that the company feels that its stock is undervalued. This means that the company can't find better investment alternatives than its own stock. Financial ratios such as earnings per share and return on earnings should increase since there are fewer outstanding shares (corporate share repurchases go into the treasury stock account, which is not included in the number of shares outstanding). • Announcement of planned changes to organizational structure, such as mounting major cost cutting campaign, consolidation or refocusing of product lines, making management changes and so on. • Structural changes, including mergers, acquisitions and divestitures. • Announcing an increase in dividends. Since the share price should be valued as the DCF of future expected cash flows, if cash flows increase, the share price should increase.

Stocks historically outperform bonds over the long term. If I am a long-term investor, I don't need any bonds in my portfolio. True or false?

This is false. It is true that measured both arithmetically and geometrically, stocks in the U.S. (as measured by the S&P or Dow Jones Industrial indexes) have outperformed the various key bond categories since at least 1926. However, when the broader stock market rises, bonds tend to go down, and vice versa, and there is not perfect covariance. You should be familiar with the phrase "No risk, no reward." Higher returning assets tend to be riskier than lower returning assets. By having a certain amount of bonds in a portfolio, one can exploit the lack of perfect covariance in order to earn the same return with lower risk. Let's take the simple example of a two-security portfolio to illustrate: First, let's assume that these securities have a single period investment horizon, that returns are independent between periods, that there are no transactions costs, and that the assets' returns follow a normal distribution. This notion can be expanded to include a portfolio with dozens, hundreds, or even thousands of securities. Therefore, in theory at least, if one can find the appropriate uncorrelated assets (of technology stocks and grocery store stocks, or of stocks in general and bonds, or of bonds and gold, etc.), a portfolio manager can use bonds to lower the risk in his or her portfolio without lowering returns.

How does the yield curve work? What does it mean when it is upward sloping?

This is more likely to come up in a fixed income research or sales and trading interview, but do not be surprised of it is asked in a banking interview (just to test your knowledge). The "yield curve" generally refers to points on a price/time to maturity graph of various U.S. Treasury securities. While yields to maturity on bonds of different maturities are often similar, yields generally do differ. Shorter maturity bonds tend to offer lower yields to maturity while longer-term bonds tend to offer higher ones. This is shown graphically as the yield curve, which sometimes called "the term structure of interest rates." There are a few reasons why yields may differ as maturities change. One theory is the "expectations theory," which states that the slope of the yield curve is determined by expectations of changes in short-term rates. Higher yields on longer-term bonds reflect a belief that rates while increase in the future. If the curve is downward sloping, this theory holds that rates will fall (probably because the economy is slowing, easing fears of inflation and raising the expectation that rates will fall in tandem). If the curve falls then rises again, it may signal that rates will go down temporarily then rise again (perhaps because of monetary easing by the Fed due to an economic slowdown). If the yield is upward sloping, the economy is expected to do well in the future. A sharply rising curve suggests a boom. Another supposition is the "liquidity preference theory." This theory states that since shorter-term bonds tend to be more liquid than longer-term ones, investors are more willing to hold shorter-term bonds even though they do not pay relatively high yields. A third hypothesis is the "market segmentation" or "preferred habitat" theory, which states that long- and short-term bonds trade The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped). A normal yield curve (pictured here) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates differently because different types of investors seek to purchase each an ongoing basis. It is likely that all of these theories are true and work in tandem.

Suppose you have an investment earning 1% per month. How do you convert this to an annual rate?

This question is simple, but on an interview, where you may be nervous, these simple questions can really trip you up. One should not assume that you won't be asked questions of this type just because they appear trivial. It is a good idea to talk through your thought process out loud and make use of a pad and paper if available. This "talk" might go something like the following: Assuming that the client will earn a flat rate of r for each month over the year, then, if r is the monthly rate, this means that an investment of $P will be worth $P + interest on $P, or $P(1+r) after one month. This amount is invested at the beginning of the second month, so you will have ($P(1+r))*(1+r) at the end of the month. This process continues so that by the end of the year, you have a total of $P(1+r)12. The annualized interest earned is then (1+r)12.

What do you think about index funds? Do you subscribe to the "Random Walk" theory?

Those who tout index funds (funds that do not pick stocks but rather mimic a particular index like the S&P 500 or the Dow Jones Eurostoxx 50) and the author of A Random Walk Down Wall Street (Burton Gordon Malkiel) maintain that on average, most active portfolio managers and sell-side analysts underperform the broader stock market. Many studies have supported this theory (often called the "efficient markets theory"). Supporters of this view maintain that investors should not pay the extra fees that active mutual fund managers and stockbrokers charge, but should simply buy index funds. You do believe in investors diversifying their holdings, but unless you are interviewing at Vanguard or another index fund/firm, you do NOT believe in what the author of Random Walk says or that investors should use index funds. You believe that a good stock (or bond) picker can find mispriced securities and/or exploit the market's occasional inefficiencies. Just think about it: if everyone believed in the efficient markets theory, no one would buy mutual funds, invest in hedge funds, or use the advice of sell-side analysts. Your interviewers would all be out of work. Do not fall into this trap during an interview, no matter what your finance professor told you in class.

11. What kinds of things make a stock extremely volatile in the short term?

Uncertainty about the economy or the sector that a stock is in; varying news from competitors (for example, if Ford says business is weak but GM says it is strong, Daimler Chrysler's stock may move about wildly until it discusses its outlook); the firm may be in a highly cyclical sector (like semiconductors or oil); lots of momentum players in the stock (these are investors who bet that the direction of a stock will continue rather than those who perform fundamental analysis); the company may be in a newer, less proven and/or high growth industry (like biotech); and legislative uncertainty (will the government raise or lower tariffs for steel makers?).

Why might a technology company be more highly valued in the market in terms of P/E than a steel company stock?

You may recall from the question on how to value a stock that relative P/E is affected by the growth rate in earnings. Generally speaking, higher growth companies (and industries) have higher P/E ratios than lower growth ones. Mathematically this can be shown by breaking down the components of the ratio into their equity DCF components: Using the DDM model: P = Dividends per Share/(r-g). Dividing both sides by EPS: P/E = (Payout Ratio)(1+g)/(r-g) Using the FCFE method of valuation: P = FCFE/(r-g), and P/E = (FCFE/Earnings)(1+g)/(r-g) All else being equal, higher growth ("g" in the equation) means higher P/E ratios. One can safely assume that technology companies (even in the down market of 2002) will grow faster than steel companies.

10. Why do we care about housing starts?

housing start is defined as beginning the foundation of the home itself. The housing industry accounts for over 25% of investment spending in the U.S. and approximately 5% of U.S. GDP. The housing starts figure is considered a leading indicator. Housing starts rise before an economic up-tick, and decline before a slow down