Thursday, 17 November 2016

CFA Level 2 - Economics

1) A case study of exchange rate

dealer rate: CHF/EUR 1.0741/1.0746 (bid/offer)

market rate:

CHF/USD = (1/1.0456) / (1/1) = 0.9564  (must take the inverse)
USD/EUR = 1.1241     , so CHF/EUR = 1.0751

CHF/USD = (1/1.0543) / (1/1) = 0.9567
USD/EUR = 1.1243     , so CHF/EUR = 1.0756

arbitrage opportunity, buy 1.0746 from dealer and sell 1.0751 to market

2) Uncovered interest rate parity
Ff/d = Sf/d (1+rf) / (1+rd)

or in another form:

 (1+rd) = (1+rf) Sf/d / Ff/d

3) find mark to market value of forward position
The guy sold 20mil euro forward, USD/EUR = 1.1716

now to calculate mark to market, he needs to buy back euro, so use offer rate (because market sells to him)
  forward point (USD/EUR)   35/36 (bid/offer)

1.1243 + 0.0036 = 1.1279 USD/EUR

20mil * (1.1716-1.1279) = $874,000

PV  874,000 / (1 + 0.0053 (180/360)) = $871,690
   0.0053 is LIBOR (USD)

4) Growth model
Under classical model, Growth in real GDP is temporary- population explosion will occur and stop the growth.

Under neoclassical model, TFP impact the growth rate of output per worker, but capital deepening has no effect on the long term growth of the economy. This can be captured by understanding that in the neoclassical model, there are diminishing returns to capital. Furthermore, changes in savings, labor force growth rate impact only the level of output per worker but do not impact growth rate of output per worker. 

In the endogenous growth model, returns to capital can be constant. Therefore in the endogenous growth theory, as savings increase (savings are closely tied to capital investment), the growth rate can keep increasing.
If question asks: “Under which theory would R&D expenditures have a long term impact on growth” it would be Endogenous. The idea being that this form of capital expenditure can actually have an impact on Total Factor Productivity.

Sunday, 18 September 2016

CFA Level 2 - Derivatives


Pricing and Valuation of Forward Contracts

Generic Forward Contract
  Vt = St - Ft/(1+r)(T-t)

Equity Forward

  Ft = Ste-Dterct
  F(0,T) = S0(1 + r)T - FV(D,0,T)
  F(0,T) = [S0 - PV(D,0,T)](1 + r)T

  Vt = Ste-Dt - Fte-rct
  Vt = St - PV(D,t, T) - Ft/(1+r)(T-t)

Equity forward holders are not entitled to receive dividends

continuously compounded rate and discrete rate conversion:
  rfc = ln(1+rf)

Currency Forward

  Ft = St (1+rd)t / (1 + rf)t

  Vt = St/(1 + rf)(T-t) - Ft/(1+rd)(T-t)

Put Call Parity
  C + PV(x) = P + (S - PV of dividends)

Fixed Income Forward
conversion factor is used when there are a number of eligible bonds to  deliver, the conv factor adjustment is not precise, the seller will select the cheapest to deliver bonds

Future and spot prices must converge at expiration.

Binomial option pricing model

 π = (1 + r - d ) / (u - d)
 p+ = (πp++ + (1 - π) p+- ) /  (1 + r)
 p- = (πp+- + (1 - π) p-- ) /  (1 + r)

High rf => higher call option price, lower put option price

gamma is larger when more uncertainty about whether option will expire in or out of the money

Interest Rate Derivatives
Interest Rate swap is combination of purchase interest rate call option, and sale of interest rate put option

Credit Default Swaps 
A credit derivative is a derivative where the underlying is a measure of borrow's credit quality. CDS, one party makes payment to another party, and receives a promise of compensation if third party defaults.

CDS are similar to put options.

credit events: bankruptcy, failure to pay, involuntary restructuring

CDS pricing: expected loss =  loss given default X probability of default

Trading strategy: company will undergo LBO
  buy the CDS, because of higher prob. of default
  buy the stock, because of stock price rises

Fixed rate swap
Swaption: pay floating, receive fixed - receiver swaption
     receive floating, pay fixed - payer swaption
Currency Swap: exchange of principal amounts in different currencies at swap initiation that is reversed at swap maturity
FX Swap - same as currency swap, but no payment of interim interest

Thursday, 15 September 2016

CFA Level 2 - Alternative Investments

Buyout funds look for companies with stable CF.
Buyout funds invest in companies with low WC requirements, and acquire portfolio companies via auction.

A common source of value creation in LBO is debt reduction.

IPO - highest exit value
secondary sales - second highest exit value

PE equity funds increase value by taking on high level of debts on favorable terms, they offset borrowing costs by superior reorganization and re-engineering.

The "hurdle rate", is basically a minimum annual return that the limited partners (LPs) are entitled to before the general partners (GPs) may begin receiving carried interest

Carried interest is the GPs' share of the profits of the investments made within a PE fund.

TVPI Total value to  paid in
RVPI Residual value to paid in, residual value is the MV of the remaining equity that LPs have in the fund
DPI Distributions to paid in, distributions is the total amount of cash and stock that have been paid out to LPs

Tag along, drag along rights, strategic decisions to be approved by PE firm, to protect its equity investors.

Monday, 22 August 2016

CFA Level 2 - Equity

Equity Valuation
investment value captures potential synergies of acquisition
fair value is the value between willing buyer and willing seller
intrinsic value is the true value of the company
going concern value : the value given that the company will continue its business activities into the foreseeable future.

Shaping strategy: best in unpredictable environment that a company has the power to change

FCFF = CFO + Interest(1-T) - FCInv
FCFF = NI + NCC - WCInv + Interest(1-T) - FCInt
FCFE = CFO + Net Borrowing- FCInv
FCFF is preferred over FCFE when company is leveraged and capital structure changes

In FCF calculation, WCInv does not include cash, notes payable, and current portion of debt, only include AP and AR.

Cash and marketable securities are NON-operating assets

V0 = FCFF1 / (rwacc -g)
Vequity = V0 - Vdebt

Discounted Dividend Valuation
  i) Gordon growth model: P0 = D1/(r-g)

  ii) H-Model
A variant of the two-stage dividend discount model, growth begins at a high rate and declines linearly throughout the supernormal growth period until it reaches a normal growth rate that holds in perpetuity.

gL - long term dividend growth rate
gS - initial dividend growth rate
N  - years where dividend decline in linear fashion

Free Cash Flow Valuation
  FCFF and FCFE valuation approach

Market based Valuation
  Price multiples, EV multiples

Residual Income Valuation
  Excess earnings methods(EEM)

Private Company Valuation
  Income Approach: FCF method, capitalised cash flow method, residual income method(EEM)
  Market Approach: Guideline public company method (GPCM),  Guideline transaction method (GTM)
  Asset Based Approach: the value of ownership of an enterprise is equivalent to the fair value of its assets - the fair value of its liabilities

discount for lack of control = 1 - 1/(1 + control premium)

EVA = NOPAT – (Cost of capital × Total Capital)  

justified trailing P/E = (1-b)(1+g)/(r-g)
justified forward P/E = (1-b)/(r-g)
restructuring charges and employee stock option grants are included in core earnings

financial leverage does not affect EBITDA
EBITDA overestimates CFO if WC is growing
If EC increase (CA increase more than CL), the firm uses cash to build up the CA, CFO capture changes in WC, EBITDA does not capture changes in WC. So EBITDA overstates CFO when EC is growing

CAPM only incorporates market risk (beta)
FFM model is three factor model, Ri = Rf +  βrmrfFac1 +  βsmbFac2 +  βhmlFac3
smb is small minus big, if βsmb is 1, it is small size company (small cap)
hml is high minus low, book value to market value ratio, if βhml is 1 , it is value stock (high book to market value ratio)

  The Rf is short term gov bill yield(risk free), long term bond has uncertainty
Pastor-Stambaugh model adds liquidity to FFM model

PEG assumes linear relationship between P/E and growth, does not factor in risk

core earnings includes restructuring charges and employee stock option grants

Blume's adjusted beta = (2/3)(unadjusted beta) + (1/3)*(1.0)

Enterprise Value
  EV = D + E - Cash - short term investment + minority interest
D = market value of debt
E =  market value of equity

Comparing firms with differences in international accounting stds:
less subject to accounting stds <------>  most subject to accounting stds
P/FCFE                       EV/EBITDA               P/E

CFA Level 2 - Fixed Income

Spot rate, forward rate, discount factor
calculate bond price from spot rate

d = 1/(1 + r )3
find spot rate from discount factor, find r

(1 + r(3))3 = (1+r(2))2(1+f(2,1))
(1 + r(3))3 = (1+r(2))(1+f(1,2))2
find spot rate from forward rate, find r

Forward rate, is a rate that will make an investor indifferent between two scenarios. For example, 2 year forward rate 3 years from now, is a rate that make investor indifferent between investing in 5 year zero coupon bond or investing in 3 year zero coupon bond and reinvesting  the proceeds for two more years after the 3 year instrument matures.

The convexity of callable bond is negative when near the money. The convexity of putable bond is always positive when near the money.


A bond with less convexity is more affected by interest rates than a bond with more convexity.

Bond A has more convexity than Bond B. When yield increase by large amount, Bond B price decrease more than Bond A.

The effective convexity of a putable bond cannot be less than that of an otherwise identical option free bond-->wrong

Callable Bond, Putable Bond
V(putable bond) = V(normal) + V(put option)
V(callable bond) = V(normal) - V(call option)

yield curve moves to upward sloping, the value of put option embed in bond increase
  V(putable bond) = V(normal) +V(put option), so putable bond value increase

Pure expectation theory assume risk neutrality, investors unaffected by uncertainty, risk premiums do not exist

Monday, 14 March 2016

CFA Finance Ratio

Finance Ratio:

ROE = NI / Equity
ROA = NI / Assets
ROIC = NOPAT / invested capital
  - investment focus
  - invested capital = debt + equity - cash

ROCE = EBIT / Capital Employed
  - pretax, operating focus

Financial Leverage Ratio (Equity Multiplier) =  Avg Total Assets / Avg Total Equity

Asset Turnover = Sales / Assets
Inventory Turnover = COGS / Average Inventory

Interest Coverage Ratio = EBIT/Interest Expense

RI = ((ROIC - WACC) * Assets)
RI = (ROE - r) * BV
RI = NI - r*BV
EVA = NOPAT - WACC * Total Assets

EBIT - Interest Expense = Pretax profit
Pretax profit - tax = NI

Accounting Profit = Normal Profit + Economic Profit

Cash Conversion Cycle
the smaller the number, the better it is

Good Will:


Full Goodwill –> Fair Value - Book Value of Net Identifiable assets (same under IFRS and US GAAP)

And then we allocate the above calculated difference (i.e. the excess purchase price) to subsidiary’s those assets whose fair values exceed their book values. What we get after allocation is the goodwill which is essentially same as the difference between subsidiary’s fair value and parent’s proportionate share of net identifiable assets.


Full Goodwill –> Fair value of entity - Fair Value of Identifiable Net assets (same under IFRS and US GAAP)

Partial Goodwill –> Purchase Price - Proportionate share of Fair Value of Identifiable Net Assets (only under IFRS)

Saturday, 20 February 2016

CFA Level 2 - Financial Reporting and Analysis

LIFO -> FIFO: during time of increasing cost of inventory
  Inv, COGS, NI, equity, cash ratio↓ (because of additional taxes paid)

LIFO reserve:
  the diff. between LIFO inv. carrying amount and amount that would be reported under FIFO

change LIFO to FIFO, impacts cash flow from operating activities only in income taxes paid.

Long-lived Assets
capitalised expenditure: Asset, investing cash outflow

expensed expenditure : NI(NI - expense(1-T)), RE, operating cash outflow expense

interest expenditure:
for own use, capitalised interest as part of long-lived asset, expense over time as depreciation expense
for sale, capitalised interest as part of inv. expense as cost of good sales when asset is sold
expense interest reduce oper. cash flow

research expenditure: expense
in process R&D: capitalised
development expenditure: can be recog. as asset if feasibility is completed

adjust NI from capitalising to expensing:
   expense cost reduce NI in early years
   no amortization increase NI in later years

depreciation: NI, Asset↓, no impact on cash flow, depreciation does have an indirect affect on cash flow, it affects taxable income and tax payable

long lived assets can use historical cost model or revaluation model
historical cost model: long lived assets are at cost less accum. depreciation, adjusted for impartment
revaluation model: long lived assets are at fair value
  fair value less accum. depreciation and impairment loss

 only historical cost model

 carrying amount ↓ -> goes to P/L
 carrying amount ↑ -> goes to OCI, revaluation surplus appears in equity
 carrying amount ↑ -> asset  and shareholder equity ↑ -> financial leverage 
 carrying amount ↓ -> NI and asset goes down, return on asset 

leverage = assets / equity
- if carrying amount > recoverable amount, need to measure impairment loss
- recoverable amount: higher of its fair value less cost to sell, or its value in use (discounted future cash flows)
- impairment loss: the difference of carrying amt over recoverable amt

  Two step process
  1. recoverable amount: if carrying amount > undiscounted future cash flow, then go to step 2
  2. impairment loss is the difference btn fair value and carrying amount

If impairment: asset, NI, cash flow no effect

finance lease:
  for lessee:
   balance sheet: leased asset, lease payable
   income statement: interest expense on the lease, depreciation expense
   CF statement: lease interest expense is an operating cash outflow
                 lease principal expense (that reduce lease liability) is an financing cash outflow
  for lessor:
   balance sheet: sale of leased asset, lease receivable
   income statement: interest income on the lease, without  depreciation expense, without lease revenue
   CF statement: increase in lease interest is an operating cash inflow
                 lease payment received (that reduce lease receivable) is an investing cash inflow

operating lease:
  for lessee:
   balance sheet:
   income statement: lease expense
   CF statement: lease expense is an operating cash outflow
  for lessor:
   balance sheet: assets under operating assets classified in PP&E as capital assets
   income statement: lease  revenue

finance lease: higher operating cash flow
operating lease: higher return measures in early years

Intercorporate Investments
1. investment in financial assets
  typical percentage interest < 20%
  4 types:
  •   held to maturity
  •   available for sale
  •   fair value thru P/L
            held for trading
            designated as fair value
  •   loans and receivables

Initially, All investments in financial assets are recognised at fair value, dividends and NI reported in Income statement

held to maturity investment such as debt securities, reported at amortised cost. Any diff, discount or premium, btn fair value and par value is amortised over the life of securities. Amortization affect carrying value of securities.

held for trading, reported at fair value, with unrealised gain/loss reported in P/L

available for sale (AFS), reported at fair value, with unrealised gain or loss reported in OCI. dividends from equities securities are in P/L. For AFS debt securities, under IFRS, foreign exchange gain/loss reported in P/L, remaining portion reported in OCI. Under US GAAP, the total change in fair value reported in OCI.

IFRS generally prohibits reclassification of securities.
held to maturity -> available for sale, if intention change, at time of reclassification, the diff btn amortised cost and fair value reported in OCI

available for sale -> held to maturity, if intention change, fair value become new amortised cost. Any gain/loss is recog. in OCI is amortised to P/L

New standard, IFRS 9, as of December 2012:
2. investment in associates -> equity method
  typical percentage interest, 20% to 50%
  single line item on the income statement, single line item on the balance sheet
  earnings/loss proportion to economic ownership
  dividends also proportion to economic ownership
  asset proportion to economic ownership
  revenue not affected
  EBIT / Interest Expense not affected
On the income statement, share of net income gain/loss as one line item after EBIT, but before taxes. Dividends are included in interest income.

The equity method is carried at cost, plus its share of post acquisition income, less dividends received

If Equity investment > proportionate share of the book value of the investee's net identifiable assets:
  the difference is first allocated to specific assets, then the difference is amortised to the proportionate share of the investee's P/L over the economic life of the assets whose fair value > book value.

Cost of acquisition > proportionate share of the fair value of the net identifiable assets is goodwill. Any remaining diff btn acquisition cost and fair value of net identifiable assets that cannot be allocated to specific assets, is treated as goodwill. Goodwill is not amortised. Goodwill is impaired.

3. business combinations -> acquisition method
  typical percentage interest > 50%
  assets and liabilities of the acquiree measured at fair value at date of acquisition

Measurement of Goodwill:
  IFRS: full goodwill: fair value of entity - fair value of identifiable asset,
           or partial goodwill: fair value of of consideration(purchase price) - proportion of identifiable net asset
  US GAAP: full goodwill only, fair value of entity - fair value of identifiable asset

  allocation of excess purchase price: to diff between fair value and book value of assets, remaining of the amount is goodwill

non-controlling (minority) interest: balance sheet
  IFRS: proportion of acquiree's measured fair value (full goodwill), or proportionate share of acquiree's net identifiable assets (partial goodwill)
 US GAAP : full goodwill only, at proportion of acquiree's measured fair value

Net income is not affected by the accounting method used to account for active investment in other companies --> acquisition method would subtract the minority interest, net effect same as equity method or proportionate method

Employee Compensation
Pensions and Other Post-Employment Benefits
  defined contributions
  defined benefits

defined benefits pension plans:
  pension funded status reported on balance sheet
  periodic pension cost, change in net pension liability/asset adjusted for employer's contribution
  under IFRS
    1. service cost (current service cost, past svc cost)->P/L
    2. net interest expense/income->P/L
    3. remeasurement of net pension liability/asset -> OCI

current service cost: amount of pension obligation increase as employee's service
current service cost = annual pension credit / [(1+r)years until retirement]

Multinational Operations
Translations of Foreign Exchange Financial Stmt:
Current rate method: (All asset/liabilities at current exchange rate)
Temporal  method: (Monetary asset/liabilities at current exchange rate)

Parent currency as the functional currency -> use temporal method
foreign currency as the functional currency -> use current rate method

1. Current rate method:
Asset/liabilities at current exchange rate
stockholder equity at historical rate
revenue/expense  at average rate
translation adjustment shows in stockholder's equity

2. Temporal method:
Monetary asset/liabilities at current exchange rate
Non-monetary asset/liabilities measured at historical cost at historical exchange rate, Non-monetary asset/liabilities measured at current value at date of current rate
stockholder equity at historical rate
revenue/expense  at average rate
revenue/expense of COGS, depreciation at exchange rate of related assets
translation adjustment shows in income statement

temporal method tends to have net liability position (monetary assets - monetary liabilities), because only a few items are monetary assets and many monetary liabilities

monetary assets: cash and AR
non-monetary assets: marketable securities at current rate
non-monetary assets: PPE at historical rate
monetary liabilities: AP, accrued expense, LT debt, deferred income tax

US GAAP defines highly inflationary economy, a cumulative 3 year inflation rate > 100%

Integrated Financial Statement Analysis
compare revenue growth to asset growth to receivables growth

selling receivables to 3rd party, company can boost OCF, and DSO goes down

IFRS                                                                          US GAAP
  interest paid: operating/financing                     operating
  interest received: operating/investing              operating
  dividend received: operating/investing              operating

cash flow from non-trading securities -> investing cash flow
cash flow from trading securities -> operating cash flow

Extended DuPont Analysis
                                   NI    EBT   EBIT
Net profit margin = -----*-------*--------
                                  EBT  EBIT  Sales

             NI    EBT   EBIT          Sales               Total Assets
ROE = -----*-------*-------- *--------------- * ------------------------
            EBT  EBIT  Sales    Total Assets  shareholder equity

Thursday, 18 February 2016

CFA Level 2 - Quantitative Methods

Linear Regression

regression equation : Yi = b0 + b1Xi + εii = 1, …, n 

    means (dependent variable – predicted value of dependent variable)2

Standard Error of Estimates

εi , the residual term in the regression.

∑             i=1n(εi)2

It is the sum of squared residuals

Coefficient of determination

If we call i=1n(YiY)2 the total variation of Y and i=1n(YiYi)2 the unexplained variation from the regression,

then we can measure the explained variation from the regression using the following equation:


Hypothesis testing

We will use a 95 percent confidence interval for our test, or we could say that the test has a significance level of 0.05.

The number of degrees of freedom equals the number of observations minus the number of parameters estimated

t-test of significance:
The b1 is from the null hypothesis (hypothesized population value of the regression coefficient).
The b1bar is the estimated regression coefficient.
The tis critical t-value at the 0.05/0.01 significance level, from the book. The t is calculated. If t is greater than tc, then we can reject the null hypothesis.
s is the standard error of the regression.

For example, the t-statistic is 2.50, and at the 0.05 significance level, tc = 2.00; thus we reject the null hypothesis because t > tc. This statement is equivalent to saying that we are 95 percent confident that the interval for the coefficient does not contain the value b1.

Often, financial analysts report the p-value or probability value for a particular hypothesis. The p-value is the smallest level of significance at which the null hypothesis can be rejected.

For example, if the p-value is 0.005, we can reject the hypothesis that the true parameter is equal to 0 at the 0.5 percent significance level (99.5 percent confidence).

Analysis of Variance (ANOVA)

Total SS = Regression SS + Residual SS

Regression SS:
Total SS:

The F-test for determining whether the slope coefficient equals to 0 is based on an F-statistic.
The F-statistic measures how well the regression equation explains the variation in the dependent variable. 
If the independent variable explains little of the variation in the dependent variable, the value of the F-statistic will be very small.

F statistic: Regression MSS /  Residual MSS
MSS: means sum of squares (SS divided by df)


Confidence Interval of Regression Coefficient (Interval Prediction)
   CI = coeff + tc * SE
tc is from the confidence level. For large number of df:
90% confidence interval will have alpha value of 0.10 (two tail), and tc of 1.645
95% confidence interval will have alpha value of 0.05 (two tail), and tc of 1.96
99% confidence interval will have alpha value of 0.01 (two tail), and tc of 2.576

The end.