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CFA LEVEL 1 STUDY SESSION 01
ETHICAL & PROFESSIONAL STANDARDS
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All CFA Institute members and candidates are required to comply with the Code and Standards The CFA Institute Bylaws
Basic structure for enforcing the Code and Standards
Rules of Procedure
Fair process to member and candidate
Based on two primary principles
Confidentiality of proceedings
Maintains oversight and responsibility Structure of the CFA Institute Professional Conduct Program
Professional Conduct program (PCP)
The CFA Institute Board of Governors
The CFA Designated Officer
Through the Disciplinary Review Committee (DRC)
Directs Professional Conduct Staff
Is responsible for the enforcement of the Code and Standards
Conducts professional conduct inquiries
Self-disclosure An inquiry can be prompted by several circumstances
a.
Written complaints Evidence of misconduct Report by a CFA exam proctor
Requesting a written explanation from the member or candidate
1. Code Of Ethics And Standards Of Professional Conduct
Process for the enforcement of the Code and Standards
The Professional Conduct staff conducts an investigation that may include
The member or candidate Interviewing
Complaining parties Third parties
Collecting documents and records in support of its investigation When an inquiry is initiated
Conclude the inquiry with no disciplinary sanction Issue a cautionary letter Upon reviewing the material obtained during the investigation, the Designated Officer may
Continue proceedings to discipline the member or candidate
Act with integrity, competence, diligence, respect and in an ethical manner Six components of the Code of Ethics
Integrity of investment profession & interest of clients above personal interest Care & judgment Practice ethics & encourage others to practice Integrity & rules of capital markets Professional competence
b,c.
Professionalism Integrity of Capital markets Seven Standards of Professional Conduct
Duties of Clients Duties to Employers Investment analysis, Recommendations & Actions Conflict of interest Responsibilities as a CFA Institute member or CFA Candidate
If finding that a violation of the Code and Standards occurred, the Designated Officer proposes a disciplinary sanction
Accepted by member Rejected by member
The matter is referred to a hearing by a panel of CFA Institute members
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Understand and comply with applicable laws and regulations Follow stricter law and regulation
Code and Standards vs. Local law
Responsible for violations in which they
knowingly participate or assist ->Leave employers (in extreme cases)
Dissociate from illegal, unethical activities Guidance
Participation or association with violations by others
a
Attempt to stop the behavior by bringing it to the attention of employer through a supervisor or compliance department Intermediate steps
May consider directly confronting the involved individuals If not successful,-> step away and dissociate from the activity by
A. Knowledge of the law
Removing their name from written reports Asking for a different assignment
Inaction with continued association may be construed as knowing participation Not require reporting violations to government, CFAI, but... Stay informed Review procedures Recommended procedures for compliance (RPC)
Members and candidates
Maintain current files When in doubt,->seek advice of compliance personnel or legal counsel When dissociating from violations,-> Document any violations and urge firms to stop them
Develop and/or adopt a code of ethics Firms
Make available to employees info that highlights applicable laws and regulations Establish written procedures for reporting suspected violation of laws,...
Application
Maintain independence and objectivity in professional activities Gifts, Invitations to lavish functions, Tickets, Favors, Job referrals, Allocation of shares in oversubscribed IPOs...
By benefits External pressures
To issue favorable reports
From public companies From Buy-side clients
May try to pressure sell-side analysts
e.g. to issue favorable research reports/recommendations for certain companies How to cope with external and internal pressures
From their own firms
Internal pressures
Guidance
Investment-banking relationships
to issue favorable research on current or prospective investment-banking clients Conflicts of interest
-->Modest gifts and entertainment are acceptable but special care must be taken
-->must disclose to employers
-->Best practice: reject any offer of gift,..threatening independence and objectivity convey true opinions
--> -->Recommendations must
B. Independence and objectivity
free of bias from pressures be stated in clear and unambiguous language
-->Portfolio managers must respect and foster honesty of sell-side research
2.1 Standard I PROFESSIONALISM
Is fraught with conflicts Must engage in thorough, independent, and unbiased analysis Must fully disclose potential conflicts, including the nature of compensation
Issuer-paid research
-->Analysts
Must strictly limit the type of compensation they accept for conducting research Best practice
Accept only flat fee for their work prior to writing the report Without regard to conclusions or recommendations
Protect integrity of opinions Create a restricted list Restrict special cost arrangements RPC
Limit gifts Restrict employee investments
Equity IPOs Private placements
Review procedures Written policies on independence and objectivity of research
any untrue statement or omission of a fact
Definition of "Misrepresentation"
or any fasle or misleading statement oral representations, advertising
Must not knowingly make misrepresentation or give false impression in Guidance
electronic communications written materials qualifications or credentials, services
Must not misrepresent any aspect of practice, including
performance record characteristics of an investment any misrepresentation relating to member's professional activities
C. Misrepresentation
Must not guarantee clients specific return on investments that are inherently volatile Standard I(C) prohibits plagiarism in preparation of material for distribution to employers, associates, clients, prospects, general publich Written list of available services, description of firm's qualification Designate employees to speak on behalf of firm RPC
Prepare summary of qualifications and experience, list of services capable of performing Maintain copies To avoid plagiarism
Attribute quotations Attribute summaries
Address conduct related to professional life Any act involving lying, cheating, stealing, other dishonest conduct that reflects adversely on member's professional activities would be violation
Guidance Violations
Conduct damaging trustworthiness or competence Abuse of the CFA Institute Professional Conduct Program
D. Misconduct
Develop and/or adopt a code of ethics RPC
Disseminate to all employee a list of potential violations Check references of potential employees
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Definition of "Material nonpublic information" Must be particularly aware of info selectively disclosed by corporations Guidance Analysis of Public info + nonmaterial nonpublic info --> Investment conclusion Mosaic Theory
Analysts are free to act on this collection of info without risking violation Analysts should save and document all their research
Make reasonable efforts to achieve public dissemination of material info
A. Material nonpublic information (MNI)
Must communicate the info only to the designated supervisory and compliance personnel within the firm
If public dissemination is not possible,
RPC
Must not take investment action on the basis of the info
Must not knowingly engage in conduct inducing insiders to privately disclose MNI adopt compliance procedures preventing misuse of MNI Encourage firms to
2.2 Standard II INTEGRITY OF CAPITAL MARKETS
develop & follow disclosure policies to ensure proper dissemination use "firewall"
Prohibition of all proprietary trading while firm is in possession of MNI may be inappropriate
Definition transactions that deceive market participants
Transactions that artificially distort prices or volume Securing a controlling, dominant position in a financial instrument to exploit and manipulate price of a related derivative/or underlying asset
can be related to dissemination of false or misleading info
B. Market manipulation
Standard II(B) not meant to
including spreading false rumors to induce trading by others
prohibit legitimate trading strategies prohibit transactions done for tax purposes
The intent of action is critical to determining whether it is a violation of this Standard
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Prudence require cautions and discretion
act with care, skill, and diligence follow the investment parameters set forth by clients & balancing risk & return
Determine identity of "client" Must be aware of whether they have "custody" or effective control of client assets Manage pool of assets in accordance with terms of governing documents Put their obligation to client first in all dealings Avoid all real or potential conflicts of interest Forgo using opportunities for their own benefit at the expense of client Follow any guidelines set out by client for the management of assets Judge investment decisions in context of total portfolio Vote proxies in an informed & responsible manner Understand & adhere to fiduciary duties
Responsibility to a client includes
Guidance A. Loyalty, prudence, and care
duty of loyalty
"Soft dollars" Submit to clients at least quarterly itemized statements Separate assets Review investments periodically Establish policies & procedures with respect to proxy voting and the use of client brokerage Encourage firms to address some topics (p. )
RPC
Do not discriminate against any clients "Fairly" vs "equally Standard III(B) addresses the manner of disseminating investment recommendations or changes in prior recommendations to clients Ensure fair opportunity to act on Encourage firms to design equitable system to prevent selective, discriminatory disclosure Investment recommendations particularly clients may have acted on Material changes should be communicated to all current clients or been affected by earlier advise
Guidance B. Fair dealing
Clients who don't know changes and therefore place orders contrary to a current recommendation
Investment actions
2.3 Standard III DUTIES TO CLIENTS
should be advised of the changed recommendation before the order is accepted
Treat all clients fairly in light of their investment objectives & circumstances duty of fairness and loyalty to clients can Disclose to clients & never be overridden by client consent to prospects written patently unfair allocation procedures allocation procedures Should not take advantage of their position in the industry to the detriment of clients
RPC (p.
Guidance
)
In investment advisory relationships
Be sure to gather client info in the form of an IPS and make suitability analysis prior to making recommendation/taking investment action Inquiry should be repeated at least annually/prior to material changes -->suitability analysis must be If clients withhold info done based on info provided Risk analysis Fund managers
C. Suitability
In case of unsolicited trade requests unsuitable for client
Be sure investments are consistent with the stated mandate
-->refrain from making trade or seek affirmative statement from client that suitability is not a consideration
Written IPS Investors' objectives and constraints should be maintained and reviewed periodically to reflect any changes in clients' circumstances
RPC
Guidance D. Performance presentation
Standard III(D) prohibits misrepresentations of past performance or reasonably expected performance --> Provide credible performance info -->Should not state or imply that clients will obtain or benefit from rate of return generated in the past --> ensure that their claims are Research analysts promoting the success fair, accurate, and complete of accuracy of their recommendations If the presentation is brief, must make available to clients and prospects the detailed info upon request
RPC
GIPS on the basis of their special ability to conduct a portion of clients' business or personal affairs arising from or is relevant to that portion of clients' business that is the subject of special or confidential relationship Comply with applicable laws When in doubt -->consult with compliance department/ outside counsel before disclosing Standard III(E) is applicable when members receive info
Guidance E. Preservation of confidentiality
Standard III(E) does not prevent cooperating with an investigation by CFAI PCP RPC
a
Pagemust 6 In matters related to their employment, members and candidates not engage in conduct that harms the interests of the employer -->Comply with policies and procedures established by employers that govern employer-employee relationship
Employer-employee relationship
Standard IV(A) does not require to place employer interests ahead of personal interests in all matters The relationship imposes duties and responsibilities on both parties
Independent practice
Abstain from independent competitive activity that could conflict with employer's interests Provide notification to employer, obtain consent from employer in advance
Guidance
A. Loyalty Planning to leave, must continue to act in employer's best interest Must
Leaving an employer
Firm records or work performed on behalf of firm stored on a home computer should be erased or returned to employer engage in activities conflicting with duty until resignation effective
Must not
contact existing clients/potential clients prior to leaving for soliciting take records of files to a new employer without written permission
Free to make arrangements/preparations provided that not breaching duty of loyalty Applicable non-compete agreement Whistle blowing Nature of employment
2.4 Standard IV DUTIES TO EMPLOYERS
Obtain written consent from employer before accepting compensation or other benefits from third parties...
Guidance
B. Additional compensation arrangements
RPC
Should make an immediate written report to their employers
Must have in-depth knowledge of the Code & Standards Apply knowledge in discharging supervisory responsibilities Delegation of supervisory duties does not relieve members of supervisory responsibility
-->Instruct subordinates methods to prevent and detect violations
Make reasonable efforts to detect violation of laws, rules, regulations, and Code & Standards Must understand what constitutes an adequate compliance system Make reasonable efforts to see that appropriate compliance procedures are established, documented, communicated to covered personnel and followed
Guidance -->Establish and implementing Compliance procedures
C. Responsibilities of supervisors
Bring an inadequate compliance system to senior managers's attention & recommend corrective action If clearly cannot discharge responsibilities 'cos of absence of compliance system, In case of employee's violation,
-->decline in writing to accept responsibilities
promptly initiate investigation take steps to ensure no repetition
Recommend employer to adopt a code of ethics Respond promptly RPC
If there is a violation
Conduct a thorough investigation Increase supervision or place appropriate limitations on the wrongdoer pending the outcome of the investigation
investment philosophy followed The application of Standard V(A) depends on
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role of member in the investment decision-making process support and resources provided by employer
Must make reasonable efforts to cover all pertinent issues when arriving at recommendation Provide or offer to provide supporting info to clients when making recommendations/changing recommendations Guidance -->must make reasonable &diligent efforts to determine whether 2nd/3rd party research is sound
Using secondary or third-party research
A. Diligence and reasonable basis
If member does not agree with the independent and objective view of the group
Group research and decision making
-->Not necessarily have to decline to be identified if believing consensus opinion has reasonable & adequate basis -->Should document member's difference of opinion with group
RPC (p. )
Standard V(B) addresses conduct with respect to communicating with clients Communication is not confined to written form but via any means of communication Developing and maintaining clear, frequent, and thorough communication practices is critical
2.5 Standard V INVESTMENT ANALYSIS, RECOMMENDATIONS & ACTIONS
distinguish clearly between facts & opinions present basic characteristics of the analyzed security in preparing research report Must
adequately illustrate to clients & prospective clients the manner of conducting investment decision-making process keep them informed with respect to changes to the chosen investment process
Guidance
B. Communication with clients and prospective clients
-->must be supported by background report or data on request
Brief communications
-->should notify clients that additional info and analyses are available from the producer of the report
Capsule form recommendations
Investment advice based on quantitative research and analysis
-->must be supported by readily available reference material -->in a manner consistent with previously applied methodology or with changes highlighted
Should outline known limitations, consider principal risks in investment analysis, report RPC
In hard copy or electric form
Guidance
C. Record retention
Fulfilling regulatory requirements may satisfy the requirements of this Standard
Absence of regulatory guidance RPC
Must explicitly determine whether it does
CFAI recommends maintaining records for at least 7 yrs
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is a critical part of working in investment industry Managing conflicts
Best practice is to avoid conflicts of interest when possible
can take many forms
If not, disclosure is necessary
prominent Disclosures must be
made in plain language in a manner to effectively communicate the info to clients between member or their firm and issuer Relationships
investment banking underwriting and financial relationships
Broker/dealer market-making activities Material beneficial ownership of stock between duties to clients and to shareholders of the company
All matters may impair objectivity Investment personnel also serves as a director
Disclosure to clients
Guidance
poses conflicts of interest
may receive option to purchase securities of the company as compensation MNI
-->members providing investment services also serving as directors should be isolated from those making investment decisions
A. Disclosure of conflicts -->Sell-side members
should disclose material beneficial ownership interest in securities/investment recommended
-->Buy-side members
should disclose procedures for reporting requirements for personal transactions
What? Disclosure of conflicts to employers
How?
by firewalls
Same circumstances with clients Any potential conflict situation Enough info Must comply with employer's restrictions regarding conflict of interest
2.6 Standard VI CONFLICTS OF INTEREST
Other requirements
Must take reasonable steps to avoid conflicts If conflicts occur inadvertently, must report them promptly
Should disclose special compensation arrangements with employer that might conflict with client interest RPC
Document request & may consider dissociating from the activity if firm does not permit disclosure of special compensation arrangements Disclose to clients info that fee based on a share of capital gains Disclose as a footnote to research report published if members have outstanding agent options to buy stocks as a part of compensation package
Clients & employers' transactions have priority -->personal investment positions or transactions should never adversely affect client investments
Co-investment
may occur client is not disadvantaged by the trade Conflicts of interests Guidance
-->make sure
investment professional does not benefit personally from trades undertaken for clients investment professional complies with applicable regulatory requirements
B. Priority of transactions
Having knowledge of pending transactions, assess to info during normal preparation of research recommendations
-->Must not convey such info
May undertake personal transactions after clients & employers have had adequate opportunity to act on recommendation Family accounts (that are client accounts)
should be treated like other accounts if member has beneficial ownership
RPC (p. )
employer whom
client prospective client compensation
Inform
C. Referral fees
what
consideration benefit received from, or paid to, others
how
before entry into any formal agreement nature of the consideration or benefit
-->may still be subject to pre clearance or reporting requirements
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Cheating on CFA exam or any exam
A. Conduct as members and candidates in the CFA program
Prohibiting any conduct that undermines the integrity of the CFA charter (p. )
Not following rules and policies of the CFA program Giving confidential info on the CFA Program to candidates or the public .....
Not precluded from expressing opinion regarding the CFA Program or CFAI
a
Preventing promotional efforts that make promises or guarantees tied to the CFA designation
2.7 Standard VII RESPONSIBILITIES AS CFA MEMBER / CANDIDATE
B. Reference to CFA Institute, the CFA Designation and the CFA program
Over-promise the competence of an individual Over-promise future investment results
Applies to any form of communication
To maintain CFAI membership
Remit annually to CFAI a completed Professional Conduct Statement Pay applicable CFAI membership dues on an annual basis
Using the CFA designation (p. Curriculum)
Referencing candidacy in the CFA program (p. Curriculum)
Proper using of the CFA marks (p. Curriculum)
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a1. Why were the GIPS Standards created?
3. Introduction to Global Investment Performance Standards (GIPS)
a2. Who can claim compliance? a3. Who benefit from Compliance? b. Construction & purpose of Composites c. Verification The Structure of the GIPS Standards
GIPS Objectives
4a. Key characteristics of the GIPS standards & fundamentals of compliance
Key characteristics Fundamentals of compliance
Requirements Recommendations
3+4 GIPS Investment firm definition
b. The scope of the GIPS
Historical performance record
c1. How are GIPS standards implemented in countries with existing standards for performance reporting
c2. Appropriate response when the GIPS standards & local regulations conflict
d. Major sections of GIPS standards
a
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CFA LEVEL 1 STUDY SESSION 02&03
QUANTITATIVE ANALYSIS
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Required rate of return
a. Interest rate, considered as
Discount rate Opportunity cost
=
b. Interest rate
c,d. EAR
FV=
PV=
Annuity
e. CF calculations
Ordinary Annuity Annuity Due
PV of a Perpetuity
5. TIME VALUE OF MONEY
Uneven CF
f1. Time index
Find PMT
f2. Loan payment and Amortization
Find N Find I/Y Amortization table
Rate of compound growth
f3. Other applications
Number of periods for specific growth Funding a future obligation
f4. Connection between PV, FV & series of CF
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NPV
a,b. Calculate, Interpret, Decision rule
Problems IRR
Conflict with NPV due to
# Initial costs # timing
c. HPR
Money Weighted
d. Portfolio rate of return Time weighted
6. DISCOUNTED CASH FLOW APPLICATIONS
IRR More appropriate if manager has complete control over cash in/out
Compound growth Geometric mean Not affected by cash in/out Preferred method
Bank discount yield
Holding period yield
e. Yields of T-bills
Effective annual yield
Money market yield
f1. Convert among these yields
f2. Bond equivalent yield
Page 14 Statistical methods
Descriptive statistics Inferential statistics
Population vs. Sample Nominal scales
Types of measurement scales
a.
Ordinal scales Interval scales Ratio scales
Parameter vs. Sample statistic Definition
Frequency distribution
b.
Construction of a frequency distribution
7 steps
Absolute frequency Relative frequency
c.
Cumulative absolute frequency Cumulative relative frequency Histogram
d.
Frequency polygon Population mean vs. Sample mean Arithmetic mean Weighted mean (portfolio return) Mean
Geometric mean (compound growth)
m. Use of arithmetic or geometric mean when determining investment returns
e. Measures of central tendency
Harmonic mean (cost of shares) Harmonic < geometric < arithmetic Median
Odd number of observations Even number of observations No mode
Mode
Unimodal, bimodal, trimodal Model interval
Quartiles (4) Quintile (5) Decile (10)
f. Quantile
Percentile (100)
Ly =(n+1)*y/100
Range MAD
g. Dispersion (measure of risk)
Variance & Standard deviation
Population Sample (use n-1)
1-1/(k^2)
h. Chebyshev's inequality
CV (Coefficient of Variation) = StdDev / Average
i. Relative dispersion
Sharpe Ratio / Reward-to-Variability ratio
Symmetrical
=Excess return/ StdDev
mean=median=mode Calculate: Sample skewness =
j,k. Shape of distribution
Nonsymmetrical (Skewness) (b/c of outliers)
Calculate
l. Kurtosis
Positively skewed (Sk>0) Types
mode
Negatively skewed (Sk<0) --> more risk
Sample kurtosis = Excess kurtosis = sample kurtosis - 3
Compared with normal distribution
Leptokurtic: more peaked, fatter tails (excess kurtosis > 0) --> more risk Platykurtic: less peaked (excess kurtosis < 0) Mesokurtic: identical (excess kurtosis = 0)
mean
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Random variable Outcome
Floating c
Event
a.
Mutually exclusive events Exhaustive events
2 defining properties of probability
0<=P(E)<=1 sum of all P(E) =1, if set of events is mutually exclusive & exhaustive past data
Empirical Determine probabilities
b.
formal reasoning and inspection process
Priori
personal judgment
Subjective
c. Odds for vs. odds against the event Unconditional probabilities
d.
Conditional probabilities
Multiplication rule
e. Probability rules
Addition rule Total probability rule
Joint Probability
8. PROBABILITY CONCEPTS
f. Calculate
Of 2 events Of any number of independent events
Probability of at least one event will occur
g. Dependent events vs. Independent events
h. Total probability rule
i. Use of conditional expectation in investment applications
j. Tree diagram
k. Covariance and Correlation (-1 to 1) Expected return
l. Portfolio
Variance and standard deviation
m. Calculate covariance given a joint probability function
n. Bayes' formula Factorial Labeling
o. Counting methods
Combination Permutation
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Probability distribution Random variables
Discrete Continuous
a,b. Discrete distribution vs. continuous distribution
Probability function p(x)
for discrete variable
PDF- Probability density function f(x)
c,d. Functions
CDF- Cumulative distribution function F(x)=P(X<=x)
Discrete uniform
e,f,g. Discrete random variables
Bernoulli Binomial
h. Tracking error
i. Continuous uniform distribution Normal distribution
9. COMMON PROBABILITY DISTRIBUTIONS
j,k. Normal distribution
Univariate distribution vs. Multivariate distribution (the role of correlation)
1 --> 68%
l. Confidence intervals (for normal distribution)
1.65 --> 90% 1.96 or 2 --> 95% 2.575 --> 99%
m. Standard normal distribution and standardize
z=
Shortfall risk = Probability that (return < threshold)
n. Roy's safety-first criterion
SFRatio = Compare to Sharpe
o. Lognormal distribution Discretely compounded EAR=
p. Compounded rate of return
Continuously compounded
From S: HPR=
Monte Carlo simulation
q,r. Simulation
Historical simulation
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Simple random sampling
a,b. Sampling concepts
Sampling error Sampling distribution
Simple random sampling
c. Sampling methods
Stratified random sampling
Time- series
d. Set of data
Cross- sectional
n>=30
e. Central limit theorem
f. Standard error of the sample mean
Point estimation
h. Estimate a population parameter
Confidence interval estimation
Unbiased
10. SAMPLING & ESTIMATION
g. Desirable properties of an estimator
Efficient Consistent
Small samples (n<30), unknown variance
Used when
Normal (or approximately normal) distribution
i. Student's t-distribution
Symmetrical Properties
Degrees of freedom df=n-1 Less peaked, fatter tails than normal Higher n --> approach z
Non-Normal AND n<30
j. Calculate confidence interval
Not available
Known variance
Other situations
--> z test
Unknown variance --> t test
Sample size n (larger is better), but
Possible mistake: Observations from a different population may be included Higher Cost
Data mining bias
k. Selection of sample size
Sample selection bias Bias
if n >=30 --> t approach z --> both are ok
Survivorship bias Look-ahead bias Time-period bias
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Statement about population parameter Hypothesis
Null hypothesis Alternative hypothesis
One-tailed and two-tailed tests of hypotheses 1. State the hypothesis 2. Identify the test statistic & probability distribution
3. Specifying significance level
May follow t, z,Chi-square, F distribution
b. Significance level and critical value
a. Hypothesis testing steps
=
b. Test statistic
4. State decision rule
Reject ...
c. Decision rule
5. Collect data and calculate test statistic 6. Make statistical decision
Statistical result
d. Distinguish
Economically meaningful result
7. Make economic/investment decision Type I
b. Errors Type II
11. HYPOTHESIS TESTING
(alpha) reject null when it's true
(beta) do not reject null when it's false
=1-beta
c. The power of a test
c. The relation between confidence intervals and hypothesis tests e. How to use p-value f. Mean of a normally distributed population with
Test means
known variance unknown variance
g. The equality of means of 2 normally distributed populations, based on independent random samples with h. The mean difference of 2 normally distributed populations (paired comparisons test)
Single population
i. Test variance
Two independent populations
Parametric test
j.
Nonparametric test
Chi-square test
F-test
equal assumed variances unequal assumed variances
Fundamentalists
Overview: 3 views
Page 19 Floating Topic
Technicians EMH advocates TA is the study of collective market sentiment
Principles
a. Technical analysis
Prices are determined by the interaction of Supply & Demand
Applications Market price reflects both rational & irrational investor behavior (EMH does not hold) Assumptions
Trends & Patterns exist & tend to repeat, can be used to forecast
Closing prices as a continuous line
Line chart
OHLC chart
Bar chart
12. TECHNICAL ANALYSIS (part 1)
b. Charts
Candlestick chart
Plot only price reversals Point & figure chart
Scale Volume chart Time intervals Relative strength analysis
X: increases O: decreases
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Definition: a trend approaches a range of prices but fails to continue beyond that range
Inverse head & shoulders
Head & Shoulders Head & shoulders
Reversal patterns
Double tops & bottoms Definition: a pause in a trend rather than a reversal
d. Chart patterns
12. TECHNICAL ANALYSIS (part 2)
Floating Topic
Triangles
Continuation patterns
Rectangle
Flags & Pennants
Page 21 Floating Topic
c. Trends breakout vs. breakdown Trend
Support & Resistance lines
Support & Resistance lines Change in polarity (Polarity= phân cực, đối lập) --> to smooth fluctuations
=mean of the last n closing prices (n=20; 250...)
______ (smoother/less smooth) line larger n -->
Moving average lines
--> trends are easier to see
ST average line crosses LT average line
Price-based
if overly long n --> may obscure price trend
(obscure = hide)
above
--> golden cross --> _________ (buy/sell) signal
below
--> dead cross --> _________ (buy/sell) signal
SMA (Simple Moving Average) vs. EMA (Exponential) (place more weigts on recent data)
Bollinger bands
e.g.: bollinger band (20,2) means 2 standard deviations above and below the 20-day moving average line viewed as contrarian indicator: if price at or above upper band --> over___ (bought/sold) market --> we should ____ (buy/sell)
12. TECHNICAL ANALYSIS (part 3)
e. Common TA indicators
closing price today & n days earlier Momentum (đà) oscillator (or Rate of Change oscillator)
today / past day Relative strength index
--> oscillate around 0
(today - past day) x 100 2 formulas
RSI = (1 - 1/ (1 + RS)) x 100
--> oscillate around 100
RS = Total price increases / Total price decreases
between 0 & 100 compare to 30 and 70
Oscillators (dao động)
Moving average convergence/ divergence oscillator
MACD line (e.g.: MACD (26,12): ExpMA(26)-ExpMA(12) Signal line: ExpMA(9) of MACD MACD line crossing above Signal line (or divergence histogram crosses up) --> buy signal Lines
%K line: (latest price - recent low) / (recent high - recent low) %D line: 3-period average of %K line
If %K line crosses up %D line --> buy signal Stochastic oscillator
Fast stochastic oscillator
Slow stochastic oscillator
Fast %K = %K basic calculation Fast %D = 3-period SMA of Fast %K Slow %K = Fast %K smoothed with 3-period SMA Slow %D = 3-period SMA of Slow %K
Opinion polls (survey) =put vol / call vol Put/Call ratio Calculated statistical indices
=volatility of options on S&P 500 CBOE Volatility Index (VIX)
Sentiment indicators
if high --> investors ____ (bearish/bullish) --> we should be______ (bearish/bullish)
if increase --> investors are ________ (bearish/bullish) --> prices are __________ (increasing/decreasing)
Margin debt Short interest ratio Non-price-based indicators
viewed as contrarian indicator: if very high --> __________ (bearish/bullish) investor sentiment --> over_______ (bought/sold) market
=short interest / average daily trading volume
short interest = number of shares that investors have borrowed and sold short
contrarian indicator of follow the smart money indicator? =(number of advancing issues/number of declining issues) / (volume of advancing issues / volume of declining issues) Arms index or TRIN (short-term TRading INdex)
Flow of funds indicators
Margin debt
Compare to 1: Spikes upward = daily ____ (gain/loss) Spikes downward = daily ______ (gain/loss)
if increase --> investors _________ (buy/sell) more
Mutual fund cash position New equity issuance (IPO) and Secondary offerings
= mutual fund cash / total assets viewed as contrarian indicator =market _________ (peak/trough) because Issuers sell new shares when stock prices are thought to be _____ (high/low)
viewed as support or resistance level
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Kondratieff Wave (40 to 60 years)
f. Cycles
12. TECHNICAL ANALYSIS (part 4)
18-year cycle
Decennial (10-year) pattern 4-year Presidential cycle Upward moves: 5 waves (1,3,5=impulses; 2,4=corrective; 2=pullback Downward moves: 3 waves (A,B,C) (A=bulltrap)
Uptrend
g. Elliott Wave Theory
Downtrend: downward moves (5 waves); upward moves (3 waves) Fibonacci numbers Size of waves correspond with Fibonacci ratios
0,1,1,2,3,5,8,13,21... Golden ratio: 1.618 or 0.618
Price target can be 1.618 of the previous high
Different waves
Grand Supercycle (centuries)
Supercycle
Cycle
Primary
Intermediate
Minor
Minute
Minuette
Sub-Minuette (few minutes)
Major asset classes: stocks, bonds, commodities, currencies
h. Intermarket analysis
interrelationships (relative strength ratios) among
Equity sectors/ industries International markets
Floating Topic
Page 23
CFA LEVEL 1 STUDY SESSION 04, 05 & 06
ECONOMICS
Page 24
Markets for factors of production
a. Types of markets
a
Markets for services and finished goods Capital markets
b. Principles of demand and supply Shifts Movement along
c,d. Demand & Supply Curves
d. Process of aggregating Demand and Supply
Stable
e. Equilibria Unstable
Individual and aggregate inverse demand and supply functions
f.g. Calculate and interpret
13. Demand And Supply Analysis: Introduction
Individual and aggregate demand and supply curves Amount of excess demand Amount of excess supply
Types of auctions
h.
Winning price
Consumer surplus
l. Calculate and interpret
Producer surplus Total surplus
i. Causes of demand or supply imbalance
Impact of govt regulation and intervention
j.k.
Effect of introduction and removal of a mkt interference
Price elasticity of demand
m. Elasticity
Income elasticity Cross- price elasticity
Page 25
Consumer choice theory
a
a Consumer utility theory
Indifference curves Use of
Opportunity sets
Budget constraints
b.c.
Calculate and interpret a budget constraint
14. Demand And Supply Analysis: Consumer Demand
d. Consumer's equilibrium bundle of goods
Substitution effects
e. Compare Income effects
normal goods Distinguish inferior goods
f. Giffen goods Explain Veblen goods
Accounting profit
Page 26
Normal profit
a. Concepts
Economic profit
Total revenue Average revenue
b. Revenue
Marginal revenue
a c. Factors of production Total costs
Average costs
Marginal costs
d. Costs
Fixed costs
Variable costs
Breakeven points
e. Shutdown points
15. Demand And Supply Analysis: The Firm
Economies of scale
f. Diseconomies of scale
g. Determine profit-maximizing level of output SR profit maximization
h. Distinguish LR profit maximization
Decreasing-cost industries
i. Distinguish
Constant-cost Industries
Increasing-cost industries
Total
j. Product of labor
Marginal
Average
Diminishing marginal returns
k.l.
Profit-maximizing utilization level of an input
Optimal combination of resources-->Minimize cost
Page 27
PERFECT COMPETITION
a
MONOPOLISTIC COMPETITION
a.b.c.d.e
OLIGOPOLY
16. The Firm And Market Structures
MONOPOLY
Use
f. Concentration measures Limitations
g. Identify type of market structure
Expenditure approach
a. Calculate GDP using
Page 28
Income approach
Sum-of-value-added method
b. Compare Value-of-final-output method
a GDP
Nominal GDP
Compare
Real GDP
c. GDP deflator
GDP National income
d. Compare Personal income Personal disposable income
Saving Investment
e. Fundamental relationship among
Fiscal balance
17. Aggregate Output, Price, And Economic Growth
Trade balance
IS curve
f.
LM curve Aggregate demand curve
Aggregate Demand and Supply
SR
g. Aggregate supply curve in LR
h. Shifts and movements along D & S curves
i. Fluctuations in aggregate D & S --> SR changes in econ & biz cycle Sources
j.
Measurement Sustainability
Economic growth
k. Production function approach
Input growth
l. Components of economic growth
Growth of total factor productivity
Page 29
Biz Cycle
a. Describe Phases of Biz Cycle
Business cycle
b. Economy moving through biz Cycle -->
Inventory levels Labor Physical capital utilization levels
c. Theories of Biz Cycle Types
d. Unemployment
Measures
Inflation
e. Explain
18. Understanding Business Cycles
Disinflation Deflation
f. Indices used to measure inflation Inflation Uses
g. Inflation measures
Limitations
h. Factors --> affect price levels
i. Describe economic indicators
Cost push inflation Demand-pull inflation
Uses Limitations
Economic indicators Past biz cycle
j. Identify
Current biz cycle Expected future biz cycle
a
Page 30
Monetary policy
a. Compare Fiscal policy
Definition, qualities and functions of money
b
Money creation process
Demand for money
c. Theories of Supply of money
d. Fisher effect Roles
e. Central banks
Objectives
f. Implementation of monetary policy Monetary policy
g. Qualities of effective central banks economic growth
h. Relationships between monetary policy and
inflation interest exchange rate
Expansionary monetary policy
19. Monetary And Fiscal Policy
i. Contractionary monetary policy
j. Limitations of monetary policy Roles
k. Describe Objectives
l. Tools of fiscal policy
Fiscal policy
Spending tools Revenue tools
m. Being concerned with Size of a fiscal debt
implementation of fiscal policy
n. Explain difficulties of implementation
Expansionary fiscal policy
o. Contractionary fiscal policy
p. Interaction of monetary and fiscal policy
Arguments for Arguments against
a
Page 31
Warm-Up: International Trade a Benefits
a. International trade
Costs
Comparative advantage
b. Distinguish Absolute advantage
Ricardian
c. Models of trade
Heckscher-Ohlin
Trade restrictions
d. Restrictions Capital restrictions
Trading blocs
20. International Trade And Capital Flows
e. Motivations for and Advantages of
Common markets
Economic unions
Description
f.
Current account Components
Capital account Financial account
Balance of payments Consumers
g. Influenced by
Firms
Govt
World Bank
h. Functions and objectives of international organizations
IMF
WTO
Page 32
Define an exchange rate Nominal exchange rates
a.
Real exchange rates
Distinguish
Spot exchange rates
a
Forward exchange rates
Functions
b. FOREX market
Participants
d. % change in a currency relative to another currency
21. Currency Exchange Rates
e. Currency cross-rates
Forward quotations Forward discount or premium
f.g. h. Calculate and interpret Forward rate consistent with
Countries that do not have their own currency
i. Exchange rate regimes
Countries that have their own currency
International trade
j. Impact of exchange rates on countries'
Capital flows
spot rate and interest rate
Page 33
CFA LEVEL 1 STUDY SESSION 7,8,9,10
FRA
Page 34
Fin position
Role of FiR
of an entity that is useful to a wide range of users in making economic decisions
Fin performance
Provide info about
Changes in fin position
a. Roles of FR and FSA
Use info in a company's Fin Statements Use other relevant info To evaluate past, current, and prospective performance and fin position Invest in securities
Roles of FSA
a
Recommend to investors
To make economic decisions. E.g.:
Whether to extend trade, bank credit Analysts: form opinions about company's ability to earn profits and generate CF
Income Statement (financial performance)
Revenues Expenses Gains and Losses Assets
Balance Sheet (financial position) (A=L+OE)
b. Role of key FS
Liabilities Owners' equity
Operating CF CF statement
Investing CF
Financing CF Statement of changes in Owners' equity
accounting methods, assumptions, estimates
FS notes (footnotes)
Additional items:
acquisitions or disposals legal actions employee benefit plans contingencies and commitments significant customers sales to related parties segments of firm
are audited Supplementary schedules
c. Importance of
not audited operating income or sales by region or business segments reserves for an oil and gas company info about hedging activities and financial instruments
assessment of financial performance and condition of a company from the perspective of its management
22. FSA Introduction
Results from operations, with trends in sales and expenses Publicly held companies in US
Capital resources and liquidity, with trends in CF General business overview
MD&A
discuss accounting policies that require significant judgements by management discuss significant effects of trends, events, uncertainties liquidity and capital resource issues, transactions or events with liquidity implications Discontinued operations, extraordinary items, unusual or infrequent events Extensive disclosures in interim financial statements disclosure of a segment's need for CF or its contribution to revenues or profit
= independent review of an entity's FS objective: auditor's opinion on fairness and reliability of FS, "no material errors" Independent review though FS prepared by mgmt and are its responsibility 3 parts
d. Audits of FS
Standard auditor's opinion
Reasonable assurance of no material errors (follow generally accepted auditing standards) FS prepared in accordance with accepted accounting principles, reasonable accounting principles and estimates, consistency
Explanatory paragraph: when a material loss is probable but amount cannot be reasonably estimated. Uncertainties may relate to the going concern assumption --> signal serious problems and need close examination by analyst (under US GAAP): Opinion on internal controls Unqualified opinion: auditor believes statements are free from material omissions and errors 3 types of Opinions
Qualified opinion: if statements make any exceptions to accounting principles --> explain these exceptions Adverse opinion: if statements are not presented fairly or are materially nonconforming with accounting standards
Interim reports SEC filings
e. Other info sources than annual FS and supplementary info
Quarterly or Semiannual reports (update FS and footnotes, but not audited) from EDGAR to shareholders when there are matters that require a shareholder vote
Proxy statements
Filed with SEC
About election of board members, compensation, management and qualifications and issuance of stock options Corporate reports and press releases Viewed as PR or sales materials
State the objective and context Gather data
f. Steps in FSA framework
Process data Analyze and interpret data Report the conclusions or recommendations Update the analysis
Page 35
Assets Liabilities
a. Fin Statement elements and accounts
5 Elements
a
Owners' equity Revenue Expenses
Basic form
b. Accounting equation
A=L+OW
Extended forms
A=L+CC+Ending Retained Earnings A=L+CC+Beginning RE+R-X-D
Double entry accounting
c. Recording process
Unearned revenue
23. Financial Reporting Mechanics
Accruals
Accrued revenue Prepaid expenses
d. Accruals and other adjustments
Accrued expenses
Other adjustments
Historical vs Current costs --> Valuation adjustments --> income statement or in "other comprehensive income
e. Relationship among IS, BS, CF, OE (p.23)
General Journal (Journal entries) General ledger (sort entries by account)
f. Flow of Info in Accounting system
Initial trial balance-->adjusted trial balance FSs
g. Use of results of accounting process in security analysis
Page 36
Objective of Fin statements
a.
Importance of reporting standards in security analysis and valuation Of standard-setting bodies (establishing standards)
IASB (International Accounting Standards Board) US FASB (Financial Accounting Standards Board)
Of regulatory authorities (enforcing standards)
b. Role
IOSCO (International Organization of Securities Commissions) UK FSA- Financial Services Authority US SEC- Securities and Exchange Commission
Status of global convergence of accounting standards
c.
a
Barriers to developing one universally accepted set of financial reporting standards
standard setting bodies
disagree
regulatory authorities
political pressures from business groups and others Objective of financial statements Understandability consistent among firms and time periods
Comparability Qualitative characteristics
info timely and sufficiently detailed -> influence decision
Relevance
faithful representation substance over form neutrality prudence and conservatism in estimates completeness
Reliability
d. IFRS framework
Required reporting elements
assets, liabilities, equity, income, expenses Historical cost: amount originally paid for the asset Current cost: would have to pay today for the same asset Realizable value: amount for which firm could sell the asset Present value: discounted future cash flows Fair value: 2 parties in an arm's length transaction would exchange the asset
Measurement bases
reliability and relevance (timely) cost Intangible and non-quantifiable info
Constraints
Accrual basis
Assumptions
Going concern Required financial statements
BS, IS, CFS, OE, Explanatory notes (incl. accounting policies)
Fair presentation Principles for PREPARING
Going concern basis Accrual basis Consistency
24. Financial Reporting Standards
e. General requirements for Financial Statements
Materiality Aggregation Principles for PRESENTING
No offsetting Classified balance sheet Minimum information is required Comparative information
IASB requires mgmt to consider the framework if no explicit standard exists
Purpose of framework
IASB same objective
Objectives of financial statements
FASB different objectives for biz and non-biz Assumptions
IASB emphasizes going concern
Qualitative characteristics
FASB: relevance, reliability
Primary characteristics
IASB: comparability, understandability also
IASB: income+expenses
f. IFRS (by IASB) # US GAAP (by FASB)
Performance Financial statement elements
FASB: Revenues, Expenses, Gains, Losses, comprehensive income IASB: resource from which future economic benefit is expected
Asset definition
FASB: future economic benefit IASB: define criteria for recognition
"Probable"
FASB: define assets and liabilities IASB: allow
Values of assets to be adjusted upward
FASB: not allow
Reconciliation statement Characteristics of a coherent financial reporting framework
Transparency Comprehensiveness Consistency Valuation
g.
Barriers to creating a coherent financial reporting framework
Principles-based Standard setting
Rules-based
IFRS relies on broad framework FASB in the past specific guidance how to classify trx FASB moving now
Objectives oriented
blend the other two
Measurement update
h. Importance of monitoring developments in financial reporting standards
www.iasb.org www.fasb.org
In the footnotes & in MD&A (management judgment)
i. Evaluate company disclosures of significant accounting policies & estimates
new accounting standards --> 3 statements
standard does not apply will not affect the FS materially are still evaluating the effects of the new standards
Page 37
Revenues Components
a. IS
a
Expenses Gross profit
Presentation formats
unearned revenue
Accrual accounting
IASB FASB
General principles of
evidence of arrangement btw buyer and seller
Revenue recognition SEC
product delivered or service rendered price is determined or determinable seller reasonably sure of collecting money
Percentage-of-completion method
Long term contracts
b,c. Revenue recognition
Completed-contract method Certain collectibility -> normal method
Installment sales
Not reasonably estimated collectibility -> installment method Highly uncertain collectibility -> cost recovery method
Applications
Round trip transactions
Barter transactions
Gross revenue reporting (vs. net revenue reporting)
primary obligator bear inventory & credit risk ability to choose supplier reasonable latitude to establish prices
Implications for Financial Analysis
Inventories Matching principle
Depreciation Long-lived assets
Depletion Amortization
d. Expense recognition
Bad debt, warranty expenses estimation Period costs
25. Understanding The Income Statement
Admin
Implications for Financial Analysis
Discontinued operations Nonrecurring items
Unusual or infrequent items Extraordinary items
e. Financial reporting treatment and analysis of
Changes in accounting standards
Change in accounting principle Change in accounting estimate Prior-period adjustment
Operating components
f. Distinguish
Nonoperating components
Simple
Capital structure
Complex Basic EPS
Formula: Effect of: Stock dividends and Stock splits
g. EPS Diluted EPS
h.
Dilutive securities Antidilutive securities
Formula: Treasury stock method
i,j. Common size IS & financial ratios FX translation gains and losses Adjustments for minimum pension liability
l. Items excluded from IS but affect OE- other comprehensive income
Unrealized gains and losses from
CF hedging derivatives Available-for-sale securities
k. Comprehensive income: e.g.. on page __
Page 38
Assets Liabilities
a. Elements
Equity
b1. Uses of BS in financial analysis
b2. Limitations of BS in financial analysis Account format
2 common formats
Report format
c. Formats of BS
Classified BS
Current assets Current liabilities
Current vs.non current
Non current assets Non current liabilities
d. Classifying Liquidity-based presentation
Reporting noncontrolling/ minority interest
Historical cost Bases
Fair value Replacement cost PV of future CF Cash and cash equivalent Account receivable
Current assets
lower of cost or net realizable value Inventories
standard costing retail method
26. Understanding The Balance Sheet
Marketable securities Prepaid expenses and others Accounts payable
e. Measurement bases Current liabilities
Note payables Current portion of long term debt Tax payables Accrued liabilities Unearned revenue/income Tangible assets
Non-current assets
Used in operations Not used in operation -> investment assets Identifiable (finite period) -> amortized
Intangible assets
Unidentifiable (infinite) -> not amortized, but tested for impairment at least annually Internally produced -> not recorded, except legal costs
Contributed capital Minority (noncontrolling) interest Retained earnings
f. Components of OE
Treasury stock Accumulated other comprehensive income
BS
g. Analyse
Statement of changes in OE
h. Common-size balance sheet
i. Liquidity & solvency ratios
Goodwill
Page 39
The CF statement
a CFO CFI
a. CFF
affect Net Income affect Long term assets and certain investments affect capital structure
Not reported
b. Noncash investing, financing activities
Disclosed in footnote or supplemental schedule to CF statement
US GAAP: CFF
dividends paid
IFRS: CFF or CFO US GAAP: CFO
interest paid
IFRS: CFO or CFF interest and dividend received
c. IFRS vs. US GAAP
US GAAP: CFO IFRS: CFO or CFI US GAAP: CFO
taxes paid
IFRS: CFO or CFF or CFI
Direct
27. Understanding The CF Statement
d,e, f,g. CF methods
Total currency amounts
Indirect
Major sources and uses of cash CFO CFI CFF
h. Analyse and interpret
Common-size CF statement, divided by
Free cash flow
Revenue Total cash inflow (for inflows) and Total cash outflow (for outflows)
to Firm: FCFF=NI+NCC+Int*(1-t)-FCInv-WCInv=CFO+Int*(1-t)-FCInv
available to
to Equity: FCFE=CFO-FCInv+NetBorrowing CF to revenue
Performance ratios
=CFO/net revenue
Cash return-on-asset
=CFO/average total assets
Cash return-on-equity
=CFO/average total equity
=CFO/Operating income
Cash-to-income Cash flow per share
i. CF ratios
Debt coverage Interest coverage Coverage ratios
=(CFO-preferred dividends)/ Weighted average number of common shares)
=CFO/Total debt =(CFO+Interest paid+taxes paid)/interest paid
Reinvestment ratio
=CFO/cash paid for long term assets
Debt payment ratio
=CFO/cash long term debt repayment
Dividend payment Investing and financing ratio
=CFO/dividends paid =CFO/cash outflows from investing and financing activities
Stockholders Debt holders
Page 40
EXAMPLE: CASH FLOW STATEMENT
Page 41
Page 42
Ratio analysis Common size
a. Analyses
Balance sheet
Vertical
Income statement
Horizontal Charts: stacked column graph, line graph
Receivables management
Receivables T.O = annual sales/average receivables Days of sales outstanding or average collection period = 365/ receivables T.O Inventory T.O = COGS/average inventory
Inventory management
Activity
Days of inventory on hand = 365/inventory T.O Payables T.O = purchases/average trade payables
Trade credit management
Number of days of payables = 365/payables T.O
Total assets management
Total asset T.O = revenue/average total assets
Fixed assets management
Fixed asset T.O = revenue/average net fixed assets
Working capital management
Working capital T.O = revenue/average working capital
Current ratio = current assets/current liabilities Quick ratio = (cash + marketable securities + receivables)/current liabilities
Liquidity
Cash ratio= (cash + marketable securities)/ current liabilities Defensive interval= (cash + marketable securities + receivables)/ average daily expenditures Cash conversion cycle = days sales outstanding + days of inventory on hand - number of days of payables Debt-to-equity = D/E
b,c. Classes of ratios
Debt-to-capital = D/(D+E) Use of debt financing Debt-to-assets = D/A
Solvency
Financial leverage = A/E Interest coverage = EBIT/Interest payments
Ability to repay debt obligations
Fixed charge coverage= (EBIT + lease payments) / (interest payments+lease payments)
Net profit margin= Net income/ Revenue
28. Financial Analysis Techniques
Gross profit margin= (Net sales - COGS)/ Revenue Operating profitability
Operating profit margin = EBIT/ Revenue Pretax margin= EBT/ Revenue
Profitability
ROA Profitability relative to funds
Ratio analysis
Formula 1: ROA= Net income/ Average total assets Formula 2: ROA= (Net income + int exp (1- tax rate))/ Average total assets
Operating ROA = EBIT / Average total assets ROTC (Return on Total Capital) = EBIT/ Average total capital ROE = Net income/ Average total equity Return on common equity = (Net income - preferred dividends)/ Average common equity
Valuation
Sales per share, EPS, P/CF ... (in Equity study section)
Original approach
d. DuPont analysis Extended (5-way) DuPont
Valuation ratios Dividends and Retention Rate Net income per employee and Sales per employee Industry-specific ratios
for service and consulting firms
Growth in same-store sales Sales per square foot
for restaurants and retail industries
for retail industry
Revenue
Equity analysis Business risk
Coefficients of variation of
Operating income Net income
e. Ratios used in Capital adequacy VaR For Banks, Insurance companies, financial firms
Reserve requirements Liquid asset requirement Net interest margin
Credit analysis
Ratios: interest coverage ratios, return on capital, debt-to-assets, CF to total debt ... Altman Z-score Business segment
Segment analysis Geographic segment
f. Model and forecast earnings
Using ratio analysis Using techniques: sensitivity analysis, scenario analysis, simulation
a
Page 43
28. Financial analysis techniques INCOME STATEMENT
VND 3,650
Sales: 1 laptop per day, P=10m Cost of goods sold: Cost=5m SG&A EBIT
(1,825)
-50.0%
(210)
-5.8%
1,615
Interest expense
(15)
EBT
1,600
Income tax
25%
Net income
400 1,200
Dividends
100%
Increase/Decrease in Retained earnings
1,200 -
BALANCE SHEET Cash
105
Account receivable
7 days on credit
70
Inventory
5 days in store
25
Total current assets
200
Net PPE
300
Total assets
500
Account payable
10 days
50
Short-term debt
150
Long-term debt
-
Equity
300
Total liabilities+equity
500
2.9%
8.2%
1.4%
Page 44
Inventory cost flow methods Inventory valuation methods
Inventory accounting
IFRS-> Lower of cost or NRV US GAAP -> LCM=lower of cost or market
ending = beginning + purchases - COGS
a product cost --> capitalized
a. IFRS & GAAP rules for determining Inventory cost
period cost --> expensed
Specification Indication FIFO
b,c. Computing ending inventory and COGS
LIFO Weighted average cost
Periodic
d. Inventory systems
Perpetual
29. Inventories
COGS
e. Effects of different inventory accounting methods on
IFRS
f. Inventory reporting
GAAP
Inventory balances Other FS items: taxes , net income
, working capital , cash flows
Lower of cost or NRV Lower of cost or market No write-up
Exception
Commodity-like products
g. FR presentation & disclosures of inventories
Profitability
h. Effects of different inventory accounting methods on
Liquidity Activity Solvency
a
Page 45
Capitalize a1. Accounting standards
Expense
NI Shareholders' equity
CF
CFO CFI
a2. Effects of capitalizing vs expensing on Financial ratios
Profitability Interest coverage ratio
Implications for analysis
30.1. Long-lived Assets- Part1Capitalization a3. Capitalized interest
Interest incurred during construction --> capitalize
required by both US GAAP & IFRS
i/r on debt related to construction
What interest rate to use?
if no construction debt outstanding-> based on existing unrelated borrowings
Interest costs in excess of project construction -> expensed
reported in FSs
Unidentifiable: Goodwill
GW=Purchase price -Fair value Not amortized but impairment test
IFRS: R&D anything
b. Intangible assets
R: Expense D: Capitalise
Created internally --> EXPENSED except for Identifiable
US GAAP: R&D software
Software for sale --> similar to IFRS Software for use
Purchased externally --> CAPITALIZED (asset at cost) USGAAP --> expense Obtained in business acquisition IFRS --> not expense
Before technical feasibility: expense After technical feasibility: capitalize Capitalize all
Page 46 Carrying Value (or Book value)
c1. Concepts
Historical cost Economic depreciation
SL (Straight Line) depr=2/n* book value Accelerated depreciation
d. Depreciation methods
DDB (Double Declining Balance)
or final year: depr=book value - salvage
Units-of-production
c2. Effect on net income
c3. Useful lives and Salvage Values
Component depreciation
e,f. Amortization of intangible assets
Cost model
30.2. Long-lived Assets- Part2 Depreciation And Impairment
g. IFRS
Revaluation model (land, buildings...)
Reversal of previous loss --> gain in IS Above historical cost --> revaluation surplus in equity
IFRS
Recoverable amount = max (value in use, fair value - selling cost) If carrying value > recoverable amount --> impair
Step 1: Recoverability test US GAAP
Tangible assets Step 2: Loss measurement
h. Impairment
Intangible assets
Reversing an impairment loss
Asset for sale Asset held for use
Sales --> Gains/ Losses
i. Derecognition of PPE & intangible assets
j. FS presentation & disclosures of PPE & intangible assets
k. Financial reporting of investment property
Abandoned --> no proceeds, loss=carrying value Exchange --> equivalent to sell and buy another
IFRS US GAAP
Value in use = PV of future CF stream
Page 47
Taxable income
TAX RETURN
Taxes payable
current tax expense
Income tax paid
actual cash flow =past or current loss --> create DTA
Tax loss carryforward
Tax base = net amount of asset/liability used for tax reporting purposes Income before tax
Accounting profit
Earnings before tax
Income tax expense
a. Terminology FINANCIAL REPORTING
=Taxes payable + change in DTL - change in DTA
= Income tax expense - Taxes payable
DTL
Cause: depreciation =Taxes payable - income tax expense
DTA
Causes: Warranty expenses, Tax-loss carry forwards
Valuation allowance: contra account to DTA Carrying value = net balance sheet value of asset/liability Permanent difference vs. Temporary difference DTL
Income tax exp. > Current tax exp.
Revenues/Gains recognized in IS before in tax return Expenses/Losses tax deductible before recognized in IS (depreciation) Revenues/Gains taxable before recognized in IS
b.
DTA
Income tax exp. < Current tax exp.
Expenses/Losses recognized in IS before tax deductible (warranty expenses, post-employment benefits) Tax loss carryforwards
Treatment for analytical purpose: DTL not expected to reverse --> equity Definition Assets
31. Income Taxes
Examples
c. Tax base of
Depreciable equipment R&D AR
Definition Liabilities
Examples
Customer advance Warranty liability Note payable
d. Calculation Adjustment to FS
e. Income tax rate changes
=Taxes payable + change in DTL - change in DTA
Impact on FS and ratios Temporary differences
between tax base and carrying value will reverse result in DTA or DTL
f. Differences
Permanent differences
between taxable income and pretax income not reverse makes effective tax rate different from statutory tax rate
effective tax rate = income tax expense / pretax income
>50% probability
g. Valuation allowance for DTA Depreciation --> DTL (if reverse, if not --> equity) Impairments --> DTA Restructuring --> DTA
h. Deferred tax items
LIFO, FIFO Post-employment benefits and deferred compensation --> DTA Unrealized gains/losses on available-for-sale marketable securities
Analyze disclosures relating to
i
deferred tax items effective tax rate reconciliation
How disclosures affect FS and ratios
j. IFRS vs. US GAAP (see table in Schweser)
a
Page 48
Bond terminology a
BS
IS
Par bond a,b. Recognition & measurement
Premium bond
Discount bond (incl. zero-coupon debt)
32.1. Long-term LiabilitiesPart1Financing Liabilities
Amortization methods
IFRS: effective interest rate method US GAAP
b.
Issuance costs
prefers: effective interest rate method allows: straight line depreciation
IFRS: increase liability --> increase effective i/r US GAAP: capitalize as an asset (prepaid exp.)
Fair value reporting option
c. Derecognition of debt
d. Debt covenants
e. Presentation and disclosures
CF
Page 49 Less costly financing Reduced risk of obsolescence
f. Motivations for leasing vs. purchasing
Less restrictive provisions OBS financing Tax reporting advantages
Operating lease Transfer of title US GAAP: If meets one of the criteria
Lessee
Bargain purchase option Lease period >=75% economic life PV(lease pmts)>=90% fair value
g. Types of lease
Finance lease (capital lease)
IFRS: similar to US GAAP but less specific, with 1 additional criterion: leased asset is specialized
US GAAP: like lessee with added conditions:
Lessor
collectability of lease payments is reasonably certain lessor has substantially completed performance
IFRS: like lessee with added condition: substantially all rights & risks of ownership are transferred to lessee
Operating lease
Finance lease
32.2. Long-term LiabilitiesPart2- Leases & Pension Plans
h1. Reporting by Lessee
FS & ratio effects of finance lease compared to operating lease
Balance sheet Income statement Cash flow
Finance lease
Salestype lease Direct financing lease
h2. Reporting by Lessor's Operating lease
i. Disclosures of lease Defined contribution Service cost j. Two types
Interest cost Defined benefit
Pension Plans
Expected return on plan assets Actuarial G/L Prior service costs
k. Presentation & disclosure
l. Leverage & coverage ratios
Page 50
a
Meet earnings expectations overreport earnings
Lending covenants Incentive compensation Trade relief (quotas, tariffs)
underreport earnings
Negotiable favorable terms from creditors
a. Incentives to
Negotiable favorable terms from labor contracts More solvent Manage the BS
Less solvent Enhance performance ratios
Select acceptable accounting --> misrepresent economics of transactions
b. Activities--> Low quality of earnings
Structuring transactions --> achieve desired outcomes Aggressive unrealistic assumptions, estimates Exploit intent of an accounting principle: apply narrow rule to broad range of transactions
=motives Threats to financial stability or profitability Incentives or pressure risk factors
Excessive third-party pressures Personal net worth of mgmt or BOD is threatened Excessive pressure to meet internal financial goals
=weakness in internal control Nature of the firm's industry or operations Opportunity
33. Financial Reporting Quality: Red Flags And Accounting Warning Signs
risk factors
Ineffective mgmt monitoring Complex or unstable organizational structure Deficient internal control
=mindset that fraudulent behavior is justified
c. "Fraud triangle"
Inappropriate ethical standards Excessive participation by nonfinancial mgmt in the selection of accounting standards Known history of violations by mgmt or board members
Attitudes or rationalization
Obsession with increasing firm's stock price or earnings trend risk factors
Commitments to third parties Failing to correct known reportable conditions Inappropriately minimizing earnings for tax purposes Use of materiality as a basis to justify inappropriate or questionable accounting methods Strained relationship between mgmt & auditor
Aggressive revenue recognition CFO growth rate # Earnings growth rate Abnormal sales growth as compared to economy, industry or peers Abnormal inventory growth as compared to sales growth Boosting revenue with nonoperating income and nonrecurring gains Delaying expense recognition
d. Common accounting warning signs & detecting methods
Abnormal use of operating leases by lessees Hiding expenses by classifying them as extraordinary or nonrecurring LIFO liquidations Abnormal gross margin & operating margin as compared to industry peers Extending the useful lives of LT assets Aggressive pension assumptions Year-end surprises Equity method investments & OBS special purpose entities Other OBS financing arrangements including debt guarantees
Page 51
Stretching Accounts Payables
Financing Accounts Payables
Ways to manipulate CFS
Securitizing Accounts Receivables
34. Accounting Shenanigans On The Cash Flow Statement
Repurchasing stock to offset dilution
Page 52
a. Past financial performance of a company
Evaluating
a
Reflecting company's strategy
b. Basic projection of future net income and CF
Character Three C's
Collateral Capacity
35. FSA: Applications
c. FSA in assessing credit quality for DEBT investment
Credit rating agencies use formulas that include
Scale and diversification Operational efficiency Margin stability Leverage
d. FSA in screening for EQUITY investments
e. Adjustments for comparing different companies
Page 53
CFA LEVEL 1 STUDY SESSION 11
CORPORATE FINANCE
Capital budgeting process
Page 54
Step 1: Idea generation Step 2: Analyzing project proposal Step 3: Create firm-wide capital budget Step 4: Monitoring decisions and conducting a post audit To maintain business
Replacement
a.
Project Categories
For cost reduction
Expansion New product/market development Mandatory pet project
Other
high risk (R&D)
Base on incremental CF
# accounting income sunk cost --> exclude ! Cannibalization --> include !
externalities
b. Basic principles
Opportunity cost --> include ! Timing of CF is important After tax basis Financing costs
Exclude ! because Reflected in required rate of return
Independent vs. Mutually exclusive projects Project sequencing
c. Interactions
36. Capital Budgeting
Unlimited funds vs. Capital Rationing
NPV
IRR
d. Methods
Payback period
Discounted payback period
PI
NPV profile Advantage of NPV Advantage of IRR
e. Conflicting project rankings Problems with IRR
Multiple IRR and No IRR problems
Location
Europe: PP more than IRR and NPV
Company Size
f. Which methods are popular?
Public vs Private
Larger: NPV, IRR Private: PP Public: NPV, IRR
Management education
g. Relationship between NPV, company value and stock price
More educated -> NPV, IRR
a
Page 55
a,b. Formula & tax effects:
c. Weights = Target capital structure (Market values)
If lack information -->
use Current capital structure + Trend or use Industry average
a
Yield to maturity approach
f. Cost of fixed rate debt Debt rating approach
g. Cost of preferred stocks (noncallable, non convertible) WACC Formula: i. Pure-play method to calculate beta of a project CAPM
h. Cost of equity capital --> 3 approaches
37. Cost Of Capital
j. Country equity risk premium CRP =
Dividend Discount Model
pure play Relationship between asset beta & equity beta
Sovereign yield spread x (stddev equity/stddev bond)
g=retention rate * ROE
Bond yield plus risk premium approach
e. Role of MCC in NPV
MCC
k. MCC schedule
Discount rate
=WACC if project same risk level
Assumption: same capital structure over the life of project
Upward sloping with additional capital Breakpoints
d. Optimal capital budget
Incorrect
l. Treatment of Flotation cost
Correct
MCC & Investment opportunity schedule
adjust cost of equity adjust initial project cost
Page 56
Leverage or Gearing
Business risk
a. Define
Sales risk Operating risk <-- operating leverage
a Financial risk <-- financial leverage
DOL
38. Measures Of Leverage
b. Calculate
DFL
DTL
c. Effect of financial leverage on Net income & ROE
d,e. Breakeven quantity
Page 57
Regular dividends Cash dividends
Extra/ Irregular/ Special dividends Liquidating dividends
a. Explain
Stock dividends Stock splits Reverse stock splits
Declaration date Ex-dividend date
b. Dividend payment chronology
Holder-of-record date Payment date
39. Dividends And Share Repurchases: Basics
Buy in the open market
c. Share repurchase methods
Buy a fixed number of shares at a fixed price Repurchase by direct negotiation
when the repurchase is financed with company's excess cash
d. Effects of share repurchase on EPS
when the repurchase is financed with debt
if after-tax borrowing cost > earnings yield if after-tax borrowing cost < earnings yield
e. Effect of share repurchase on BV per share
f. Why share repurchase is equivalent to Cash dividend
a
Page 58 Cash balances (selling goods, collecting receivables, from short term investments) Primary sources
Short term funding (trade credit from vendors, lines of credit from banks) Effective CF management
Sources of liquidity
Liquidating assets (short term or long lived) Renegotiating debt agreements
Secondary sources
a.
Filing for bankruptcy Reorganizing company
Factors that influence company's liquidity position
Drags on liquidity: delay/reduce cash inflows or increase borrowing cost Pulls on liquidity: accelerate cash outflows
Current ratio = CA/CL Quick ratio = (Cash + ST marketable securities + Receivables) / CL Receivables turnover = Credit sales/receivables
Receivables
Number of days of receivables = =365/receivable turnover
b. Liquidity measures
Inventory
Inventory turnover = COGS/average inventory Number of days of inventory = 365/inventory turnover
Payables
Payables turnover ratio = purchases/average trade payable Number of days of payables = 365/payables turnover
Operating cycle
c. Working capital effectiveness
turn raw materials into cash proceeds from sales
Cash conversion cycle or net operating cycle
=days of inventory + days of receivables
turn cash investment in inventory back into cash collected
=Operating cycle - days of payables
US T bills
40. Working Capital Management
Short term federal agency securities
d. Tools to manage net daily cash position (more details in Fixed Income)
Bank CD Banker's acceptances Time deposits Repurchase agreements Commercial paper MM mutual funds Adjustable- rate preferred stock % discount Discount basis yield
e1. Comparable yields (already in Quantitative )
Money market yield Bond equivalent yield Purpose and objective Guidelines
e2. Cash Management Investment Policy
Who does that Responsibilities Steps to make investment Limitations and constraints aging schedule
Receivables weighted average collection period
f. Evaluate performance of
Inventory Accounts payable
2/10 net 60 Trade credit Cost of trade credit Number of days of payables Uncommitted line of credit Lines of credit
Committed (regular) line of credit (overdraft) Revolving line of credit
From banks Short term bank loans, collateralized by
g. Short term funding choices
Fixed assets Inventory Account receivables Blanket lien
Banker's acceptances Factoring Non bank
Nonbank finance companies direct placement Commercial paper through dealers
a
Page 59
Steps to construct sales-drven pro forma FSs
See the example on the next page
average compound growth rate of sales over 5-10 years economic cycles
41. FSA (Pro Forma IS & BS) Estimating sales
regression analysis of GDP growth and sales growth
seasonality new product introductions specific events
changes in regulation competing products
pay down debt entirely reduce L+E pay down debt + buy back common stocks L+E > A --> surplus
Reconcile IS and BS increase A
CAPEX
L+E < A --> deficit
a
Page 60
41. CONSTRUCTING PRO-FORMA FINANCIAL STATEMENTS ($ millions)
Yr 2011
Yr 2012 (1st trial) Yr 2012 (2nd trial) Proportional to sales
INCOME STATEMENT Sales
100% sales projected to increase 100%
500
1,000
Cost of goods sold
(200)
-40.0%
(400)
SG&A
(100)
-20.0%
(200)
Interest expense
10%
(50)
(50)
Nonoperating income
-
Earnings before tax
150
350
-
-
150
350
-
-
150
350
Income tax
0%
Net income Dividends Increase/Decrease in Retained earnings
0%
0.0%
-
BALANCE SHEET Current assets
100
20.0%
Net PPE
900
180.0%
Total assets
1,000
200 (assume full capacity)
1,800 2,000
Current liabilities
100
Long-term debt
500
500
Common stock
100
100
Retained earnings
300
650
1,000
1,450
Total liabilities+equity
20.0%
200
Yr 2012 (final)
Page 61
internal controls Definition
processes procedures
a. Corporate governance
Describe good CG (p.113)
Majority of BOD is independent Meets regularly outside the presence of management otherwise, independent board members should have a primary or leading board member
Chairman of BOD should not be CEO or former CEO
Board members should not be closely aligned with supplier, customer, share-option plan, pension adviser Able to hire external consultants without management approval
b. Independence
firm & subsidiaries, former employees, executives & their families Individuals or groups with a controlling interest no material relationship with
c. Define "independence"
Executive management & their families Firm's advisers, auditors & their families
Effective BOD
Entity with a cross directorship with the firm b. Frequency of Board Elections
annual, not 2-3 years, not staggered (classified)
Skills, experience, qualifications Care & competence d. Experience
Ethical stances Other board experience Regularly attend meetings If served on the board for more than 10 years --> not very independent
c. Resources
Financial information to shareholders
Audit Committee
set executive compensation, commensurate with responsibilities and performance
Remuneration / Compensation Committee
42. Corporate Governance
make sure independence
e. Board committees
link compensation to firm performance and profitability
Nominations Committee
recruit new independent board members
Other Board Committees
f1. Provisions of a strong corporate code of ethics Consultancy contracts Finder's fees for identifying M&A targets
f2. Related party transactions and personal use of company assets --> should discourage:
Other compensation Related party transactions Personal use of company's assets
Confidential voting Voting Rules
Cumulative voting Voting for other corporate changes
Shareowner-sponsored proposals
Shareowner-sponsored board nominations
proxy statement
Shareowner-sponsored resolutions
g. Evaluate policies
Advisory or Binding Shareowner proposals
Common stock classes
dual classes of common stock
Shareowner Legal Rights Golden parachutes Takeover defenses
Poison pills Greenmail
a
Page 62
CFA LEVEL 1 STUDY SESSION 12
PORTFOLIO MANAGEMENT
Page 63
a. Portfolio approach to investing Individual investors
DC pension plans DB pension plans Endowment Foundation
Institutional investors
b. Types of investors
Bank Insurance companies Investment companies/ Mutual funds Sovereign wealth funds
Planning step
c. Steps in PM process
Investment Policy Statement (IPS)
Execution step Feedback step
What is it? 2 categories
43. PM- An Overview
No-load funds
Open-end funds
Load funds
Closed-end funds
d1. Mutual funds
Money market funds Types
Bond mutual funds Stock mutual funds
Index funds Actively managed funds
ETF Separately managed account Long/Short funds Equity market-neutral funds Long bias, Short bias
d2. Other forms of pooled investments
Hedge funds
Strategies
Event-driven funds Fixed income arbitrage funds Convertible bond arbitrage funds Global macro funds
Buyout funds (Private equity funds) Venture capital funds
Page 64
HPR Arithmetic mean return
Geometric mean return Average returns
a. Major return measures
Money weighted rate of return
Gross return Pretax nominal return Other return measures
After tax nominal return Real return Leveraged return
Asset classes with greatest average return also have highest standard deviation Real return much more stable than nominal returns
b. Characteristics of major asset classes considered in Mean-Variance portfolio theory:
44. Portfolio Risk & ReturnPart 1
Returns distributions
are negatively skewed greater kurtosis (fatter tails than normal distribution)
Liquidity is a major concern in emerging markets & thinly-traded securities
Mean Variance
c. Calculate
Covariance Correlation
Risk averse investor
d. Risk aversion
Risk- seeking (risk-loving) Risk neutral
e. Portfolio standard deviation
f. If rho<1 --> Effect on portfolio's risk: Minimum variance frontier of risky assets
g. Interpret
Efficient frontier of risky assets Global minimum variance portfolio
Investor's utility
h. Selection of an optimal portfolio
Capital allocation line (CAL)
Page 65
Return =
a. Risk free asset + Portfolio of risky assets -->
Standard deviation =
CAL (Capital Allocation Line)
b. CML (Capital Market Line)
Systematic
c. Risks Nonsystematic
Macroeconomic Types of Factors
45. Portfolio Risk & ReturnPart 2
Fundamental Statistical
Multifactor models
d. Return generating models
Formula
with k factors Factor sensitivity of Factor loading
Fama & French three-factor model
Firm size, Firm B/P, Rm-Rf
Carhart suggest 4th factor: prior period returns --> to measure price momentum Market model
= covar / variance of market portfolio
e. Calculate Beta
Slope of regression of returns on market index
Equation: Sharpe ratio
f,g,h. CAPM & SML
M-square Treynor measure Jensen's alpha
Page 66
a. Reasons for a written IPS
Description of Client
Circumstances & Situation Investment objectives
Statement of the purpose of the IPS Statement of duties & responsibilities of
Investment manager Custodian of assets Client
Procedures to update IPS & to respond to various possible situations Absolute
Forms
c. Investment objectives
Relative
Risk objectives
(derived from communications with the client)
d. Risk tolerance
Ability Willingness
Return objective
Liquidity
b. Major components of an IPS
e. Investment constraints
Time horizon Tax situation Legal & regulatory Unique circumstances
Investment guidelines (how the policy will be executed, asset types permitted, leverage)
46. Basics Of Portfolio Planning & Construction
Evaluation of performance (e.g..: benchmark)
Definition & Specification
Appendices
Strategic (baseline) asset allocation
Correlations within a class should be very high Correlations between classes should be low Equities
f. Asset classes
Bonds Cash Categories
Real estate Alternative
Hedge funds, PE funds, commodity funds, artwork, intellectual property rights
Tactical asset allocation (deviate from strategic asset allocation) Rebalancing: how & when
Identify investable asset classes Strategic asset allocation Principles of portfolio construction
Risk, Return, Correlation Efficient frontier Identify portfolio which best meets risk & requirement of investor (based on IPS) to take advantage of perceived short term opportunities
Tactical asset allocation
success depends on
g. Security selection Risk budgeting Role of asset allocation
success depends on
manager's ability to identify short term opportunities the existence of such short term opportunities manager's skill opportunities (mispricing or inefficiencies)
Page 67
CFA LEVEL 1 STUDY SESSION 13 & 14
EQUITY
Page 68
Saving Borrowing
a
Issuing equity
Allow entities to
Risk management
a. Main functions of financial system
Exchanging assets Utilizing information Supply & demand determine returns (i/r)
Equilibrium interest rate
Allocate capital to most efficient uses
Financial vs. Real assets Public vs. Private securities Debt vs. Equity vs. Derivative Common stock Equity
Preferred stock Warrants
Fixed income Convertible debt
Securities
b1. Classification of assets
Mutual funds Pooled investment vehicles
c. Asset classes
ETFs and ETNs (depositories) ABS Hedge funds
Currencies Forward, Futures, Swap, Option Contracts
Insurance
Credit default swap
Commodities Real assets
Spot vs. Derivative markets IPO vs. Secondary issues (or seasoned offerings)
47.1. Market Organization & Structure (part 1)
Primary market
i. Primary vs. Secondary markets
Public offerings vs Private placements & other transactions
Secondary market--> importance:
Securities trade after initial offerings provide liquidity
Money vs. Capital markets Traditional investment market (debt, equity) vs. Alternative market (hedge funds, commodities, real estate...) Trades occur at specific times All trades, bids, asks are declared, and then one negotiated price is set to clear the market for the stock
b2. Classification of markets
Call market
Traders/investors indicate their bids and asks NOT a dealer or quote-driven market in smaller markets
j1. Distinguish used
to set opening prices and prices after trading halts on major exchanges Trade occur any time the market is open
Continuous market
Price is set by
auction process dealer bid-ask quote
Quote-driven markets (dealer markets, price-driven markets, OTC markets)
j2. Distinguish
Order-driven markets (rules are used to match buyers & sellers) Brokered markets Pre-trade transparent
j3. Market information
Post-trade transparent
Brokers Brokers, Dealers & Exchanges
Block brokers Investment banks Exchanges Alternative trading systems (ATS) Dealers
d. Financial intermediaries
Securitizers Depository institutions Insurance companies Arbitrageurs Clearinghouses and Custodians
Clearinghouses Custodians
Order matching rules Trade pricing rules
Page 69
Long position
e. Positions
Short position
a
Leveraged position
The investor pays for the stock with some cash and borrow the rest through the broker The broker keeps the stock as collateral Leverage ratio Margin lending rate
f. Margin transaction
The proportion of total transaction value that must be paid in cash
Margin requirement
Initial margin (IM) Maintenance margin (MM)
-->margin call
Margin call price = Po * (1 - IM) / (1 - MM)
Bid-ask Market order Limit order Execution instructions
All-or-nothing order Hidden order Iceberg order Stop order
g,h.
Stop loss orders
To prevent losses or To protect profits
Stop-buy & Stop-sell orders day order Validity instructions
good-till-cancelled immediate or cancel order (fill or kill order) market-on-close order
good-on-close order
47.2. Market Organization & Structure (part 2)
good-on-open order Clearing instructions
Commissions Operationally efficient
low trading costs
Bid-ask spreads Price impact
Informationally efficient
k. Characteristics of well- functioning financial system
Prices that rapidly adjust to new info The prevailing price is fair since it reflects all available info regarding the asset
Allocationally efficient Allowing entities to achieve their purposes
Investors can save at fair rates of return Creditworthy borrowers can obtain funds Hedgers can manage risks Traders can obtain assets they need
Having financial intermediaries that
Without regulation --> Problems
Fraud & theft Insider trading Costly information Defaults
l. Objectives of market regulation
Consequences
liquidity declines, firms shun risky projects, new ideas go unfunded, economic growth slows
Regulation can be provided by
Governments Industry groups Protect unsophisticated investors --> preserve trust
Market regulation should
Require minimum standards of competency and make it easier for investors to evaluate performance Prevent insiders from exploiting other investors Financial reporting requirements Require minimum levels of capital
Page 70
a. Describe a security market index
Value
b. Calculate for an index
Price return Total return
Which target market Which securities
c. Index construction & management
Weighting Rebalancing frequency Re-examining selection & weighting
48.1. Security Market Indices (part 1)
arithmetic average
Price weighted index
=sum of stock prices / number of stocks adjusted for splits -->Index movements are influenced by the differential prices of the components
A percentage change in a high-priced stock will have a relatively greater effect on the index 30 stocks arithmetic 2 major indexes
limited number of stock
DJIA criticisms
downward bias
Nikkei Dow Jones Stock Average
large growing firms --> splits --> lose weights
225 stocks
arithmetic average return of the index stocks
d,e. Weighting methods
Equal weighted index
equivalent to a portfolio that has equal dollar amounts invested in each stock in the index The Value Line (VL) Composite average
1695 stock returns
Examples Financial Times Ordinary Share Index Market- cap weighted index (or value weighted index)
= Criticism: large company has greater impact Float-adjusted market cap- weighted index
Fundamental weighting (earnings, dividends, cash flow) Example
30 stocks on LSE
Page 71
f. Rebalancing & reconstitution
Reflection of market sentiment Benchmark of manager performance
g. Uses of security market indices
Measure of market return and risk Measure of beta and risk-adjusted return Model portfolio for index funds
Broad market index Multi-market index
h. Types of equity indices
Multi-market index with fundamental weighting Sector index
48.2. Security Market Indices (part 2)
Style index
Characteristics
Large universe of securities Dealer markets and infrequent trading
i. Types of fixed income indices
Sectors, geographic regions, levels of country economic development, type of issuers or collateral, coupon, maturity, default risk, inflation protection Broad market indexes, sector indexes, style indexes & other specialized indexes
Commodity indexes
j. Indices representing alternative investments
Real estate indexes Hedge fund indexes
k. Compare & contrast types of security market indices
Page 72
a. Concepts a
Market value
b. Distinguish
Intrinsic value
Number of market participants Availability of information
c. Factors affecting a market's efficiency
Impediments to trading Transaction and information costs
Weak form
d. Forms of EMH
Semi-strong form Strong-form
Fundamental analysis
e. Implications of each form of EMH for
Technical analysis Choosing between active and passive portfolio management
January effect (or turn-of-the-year effect) Turn-of-the-month effect Anomalies in Time-series data
Calendar anomalies
Day-of-the-week effect Weekend effect Holiday effect
49. Market Efficiency
Overreaction and momentum anomalies
f. Market pricing anomalies
Anomalies in cross-sectional data
Size effect Value effect
Other anomalies
Closed-end investment funds Earnings announcements IPO Economic fundamentals
Implications for investors
Loss aversion Investor overconfidence Representativeness Gambler's fallacy
g. Behavioral finance
Conservatism Disposition effect Narrow framing Information cascades Herding behavior
Page 73 Common shares Callable common shares
a Putable common shares
a. Characteristics of
Preference shares Cumulative preference shares Convertible preference shares
b. Equity classes
Public equity securities Characteristics
c. Distinguish
Private equity securities
Venture capital 3 main types
Leveraged buyouts (LBO) Private investment in public equity (PIPE)
Direct investing
50. Overview Of Equity Securities
Depository receipts (DRs)
d. Methods for investing in non-domestic equity securities
Global depository receipts (GDRs) American depository receipts (ADRs) Global registered shares (GRS) Basket of listed depository receipts (BLDR)
e. Risk and Return characteristics of various types of equity securities
f. Role of equity securities in financing company's assets & creating company value
Market value of equity securities
g. Distinguish
Book value of equity securities
Company's accounting ROE = Company's cost of equity
rate of return required by investors
h. Contrast Investors' required rates of return
depends on estimates of firm's future CF & risk
Page 74
a. Industry analysis
Grouping companies by
Products & services Sensitivity to business cycles Statistical methods (cluster)
different sectors Cyclical Non-cyclical firms with highly correlated returns --> same group Limitations GICS Systems
RGS Industry Classification Benchmark by DJ & FTSE Basic material and processing firms
b. Industry classification
Commercial classifications
Industry classification systems
Consumer discretionary Consumer staples Classification
Energy Financial services Industrial and producer durables Technology Telecommunications
United Nations Government classifications
European Community Australia & New Zealand North America (US, Canada, Mexico)
51.1. Introduction To Industry And Company Analysis (part 1) Firms
Cyclical firms Non-cyclical firms
c. Sensitivity to business cycle
Cyclical sectors Sectors Non-cyclical sectors
d. Peer group
e. Elements of an industry analysis
Macroeconomic factors
f. External influences on industry growth, profitability and risk
Technology Demographic factors Governments Social influence
Defensive (stable) Growth
Page 75
Slow growth Embryonic stage
High prices Large investment required High risk of failure Rapid growth Limited competitive pressures
Growth stage
Falling prices Increasing profitability Growth has slowed Intense competition
g. Product & industry life cycle
Shakeout stage
Increasing industry overcapacity Declining profitability Increased cost cutting Increased failures Slow growth Consolidation
Mature stage
High barriers to entry Stable pricing Superior firms gain market share Negative growth
Decline stage
Declining prices Consolidation
Industry concentration
51.2. Introduction To Industry And Company Analysis (part 2)
h. Effects on return on invested capital and pricing power of
Ease of entry Capacity Market share stability
Rivalry among existing competitors Threat of new entrants
i. Principles of strategic industry analysis- Michael Porter's five forces
Threat of substitute products Bargaining power of buyers Bargaining power of suppliers
j. Example of the candy/confections industry
Financial condition Analyze
k. Elements of a company analysis
Products and services Competitive strategy
Should include
ROE (DuPont)
Defensive vs. Offensive Cost leadership vs. Product differentiation
Firm overview, Industry characteristics, Product demand, Product costs, Pricing environment, Financial ratios, Projected financial statements and firm valuation
Page 76
Size of differences between market price and intrinsic value
a. Factors to consider when exploiting mispricing
Confidence about valuation model Confidence about the inputs Why stock is mispriced If market price will move toward intrinsic value
a
c. Rationale
d. Preferred stock
Dividend discount models
e. Common stock
Types of models
Discounted cash flow models
f. Appropriate for companies that are
Stable & mature Non-cyclical Dividend-paying
Free cash flow to equity models
52. Equity Valuation: Concepts And Basic Tools
Advantages
k. Disadvantages
b. Equity valuation models g. Rationale
h. Stock price / fundamentals Types of models
Multiplier models (or market multiple models)
e. Enterprise value / EBITDA or revenue
Advantages
k. Disadvantages
Explain
j. Assetbased models
Advantages
k. Disadvantages
Page 77
CFA LEVEL 1 STUDY SESSION 15 & 16
FIXED INCOME
Page 78
Rights and obligations Covenants
a. Bond's indenture
a
Negative Affirmative
Basic features of a bond Zero coupon Coupon rate structures
Step-up notes Deferred coupon bonds
b.
Coupon formula Floating-rate securities
Inverse floater Inflation-indexed bonds Caps and floors
Full (dirty) price = Clean Price + Accrued interest
c. Bond trades between coupon dates
Cum coupon vs. Ex-coupon Trading flat
Nonamortizing/ Bullet bond/ Bullet maturity
Amortizing securities
Prepayment options
53. Features Of Debt Securities
Call provisions
d. Provisions for redemption and retirement of bonds
Nonrefundable bonds
Sinking fund provisions
Cash payment Delivery of securities
Accelerated sinking fund provision
Redemption price
Regular Special
Security owner (bondholders) options
Conversion option Put provision Floors
e. Embedded options
Security issuer (borrowers) options
Call provision Prepayment options Accelerated sinking fund provisions Caps
Margin buying
f. Methods to finance the purchase of a security
Repo
Page 79
Interest rate risk Yield curve risk Call risk Prepayment risk Coupon Reinvestment risk
Call feature
i. Factors affecting reinvestment risk
Amortizing Prepayment option
Default risk Credit risk
a,i,j,k,l,m,n,o. Risks
j. Forms
Credit spread risk Downgrade risk
j. Meaning and role of credit rating
Liquidity risk
k. why important even hold to maturity
l. Exchange-rate risk m. Inflation risk n. Volatility risk Disaster o. Event risk
Corporate restructuring Regulatory issues
Sovereign risk
54. Risks Associated With Investing In Bonds
Coupon rate Market yield
b. Relations among
Bond's price relative to par value
Discount Premium Equal to par
Maturity Coupon Embedded options
c. Effect on interest rate risk of
Call Put
Yield
value of option-free bond Value =
minus value of embedded call
d,h. Callable bond
h. Disadvantages of a callable or prepayable security to investors
Less certain CF- call risk/prepayment risk Reinvestment risk Potential price appreciation < option free securities
Interest rate risk
e. Floating rate security
Reasons Price # Par
Cap risk Margin
Duration = Dollar duration =
f,g. Duration g. Duration and Yield curve risk for a portfolio of bonds
a
Page 80
Features
a Credit risk characteristics
a. Government securities (sovereign debt)
Regular cycle auction- single price Distribution methods
Regular cycle auction- multiple price Ad hoc auction system Tap system
T-bills
TREASURIES Instruments
T- notes T- bonds TIPS
b,c. Treasury securities (Treasuries)
Two categories (vintage)
On-the-run Off-the-run
c. Stripped Treasury securities
Coupon strips Principal strips STRIPS
55.1 Overview Of Bond Sectors And Instruments
Federally related institutions (owned by US Gov.)
Ginnie Mae (Government National Mortgage Association) TVA (Tennessee Valley Authority)
d. Types of US Fed agencies
GSEs (Government Sponsored Enterprises) (privately owned, publicly chartered) (commonly issue debentures)
Federal Farm Credit System Federal home Loan Bank System Federal National Mortgage Association (Fannie Mae) Federal Home Loan Bank Corporation (Freddie Mac) Student Loan Marketing Association (Sallie Mae)
Debentures (unsecured, not backed by collateral) Characteristics Periodic interest CF
AGENCY BONDS
Scheduled repayments of principal Principal repayments in excess of scheduled principal payments
Instruments
Mortgage passthrough security
e,f. MBS (Mortgagebacked securities)
Tranche I 3 tranches Types
CMOs (Collateralized mortgage obligations)
Tranche II Tranche III
f. Motivation for creating CMO Stripped mortgage-backed securities
Tax
Page 81
Tax exempt Taxable
Limited tax GO debt
g. MUNIS (Municipal securities)
Tax- backed bonds or GO (General Obligation) bonds
Unlimited tax GO debt Double-barreled bonds Appropriation-backed obligations (or Moral obligation bonds)
Instruments Revenue bonds Insured bonds Prerefunded bonds
Rating agencies and Credit ratings
Secured vs. Unsecured Debt
Credit enhancements
Shelf registration (sold over time)
Medium term notes
55.2 Overview Of Bond Sectors And Instruments (cont.)
Maturity ranges Best effort underwriting
= typical bond + derivative Purpose: get around restrictions Step-up notes Inverse floaters
Structured notes
Structured medium term notes
Deleveraged floaters Dual-indexed floaters Range notes Index amortizing notes
h,i,j,k. CORPORATE ISSUES
Instruments
Commercial paper
Directly placed Dealer placed
Negotiable CDs Bankers Acceptances Role of a SPV i. Asset-backed securities
Motivation External credit enhancements
Corporate guarantees LC Bond insurance
j. CDO (Collateralized debt obligation)
k. Bonds
Primary market Secondary market
Mechanism for placing bonds
a
Page 82 Discount rate OMO
Banks borrow reserves from Fed
Buy/Sell Treasuries by Fed Most commonly used
a. Interest rate policy tools
Bank reserve requirement
% of deposits banks must retain
Persuading banks to tighten/loosen credit policies
Normal / Upward Inverted / Downward
b. Yield curve / Term structure of interest rate
Flat Humped
Pure expectation
c. Basic theories of term structure of interest rate
Liquidity preference Market segmentation theory
d. Define a spot rate
56. Understanding Yield Spread
Absolute yield spread =
e. Measures
Relative yield spread = Yield ratio =
= yield difference b/c of credit rating
f. Credit (quality) spread
Relation with the well-being of the economy
Yield spread g. Effect of embedded options
Issue size
h. Liquidity spread
Maturity spread
After tax yield of a taxable security
i. Tax
j. LIBOR
Tax equivalent yield of a tax-exempt security
a
Page 83
1. Estimate CFs
a. Steps in bond valuation process
Coupons Principal
2. Determine appropriate discount rate 3. Calculate present value
Defaults and potential credit problems Embedded options -> uncertain principal repayment
b. Difficulties in estimating CFs
Floating rate securities -> uncertain coupons Convertible or Exchangeable bonds
57. Introduction To The Valuation Of Debt Securities
Compute value of bonds
c.
Value of zero coupon bonds
d. Time and value of bond
Price-yield profile
e. Yield and value of bond
f. Arbitrage free valuation approach
a
Page 84
Coupons
a. Sources of return from investing in bond
Principal + Capital gain/loss
a
Reinvestment income
Current yield
d. Calculate BEY and EAY Assumptions
CF will be reinvested at YTM Bond will be held till maturity Reinvestment income
YTM Limitations
b,c,d. Traditional yield measures
58. Yield Measures, Spot Rates And Forward Rates
c. Reinvestment
Reinvestment risk increases with
Realized yield can be different from YTM
BEY
Yield to call
Yield to worst
Yield to refunding
YTP
CFY
e. Theoretical Treasury spot rate curveBOOTSTRAPPING Nominal spread
Zero-volatility spread (Z-spread)
f. Spreads Option-adjusted spread (OAS)
g. Spot rates, Forward rates, Value of bonds
OAS = Z spread - Option cost
Higher coupons Longer maturities
Page 85
Full valuation approach (scenario analysis)
a. Measuring interest rate
Duration/ convexity approach
a
Option-free bonds
Callable bonds
b. Price volatility characteristics for
Prepayable bonds
Putable bonds
d,e. Effective duration d,e. Types of duration
Macaulay duration
Modified duration
59. Introduction To The Measurement Of Interest Rate Risk
Duration
f. Interpreting duration =
g. Portfolio duration Limitations
=
j. PVBP Relationship to duration
What is it?
Can be
Positive Negative
c,h,i. Convexity
Relation to bond price and yield h. Calculation
i. Types
Modified convexity Effective convexity
k. Impact of yield volatility on i/r risk of bonds
Page 86
CFA LEVEL 1 STUDY SESSION 17
DERIVATIVES
Page 87
Derivative
a.
a
Exchange- traded vs. OTC
Forward contracts Forward commitment
Futures contracts Swaps
b. Calls Contingent claim
Options Puts Convertible, callable bonds
60. Derivatives Markets And Instruments
Criticisms
-
c. Derivative markets
Purposes
-
Law of one price
2 securities/portfolios with identical cash flows
d. Arbitrage 2 securities with uncertain returns combined in a portfolio
a
Page 88 Long position
a. Positions Short position
a
Deliverable forward contracts
Settling
Cash settlement
b. Settling Terminating a position prior to expiration
Basics
with same party (offsetting) with other party
Banks/Financial institutions
Dealer
Bid-ask prices
c. Parties Corporations End user
Gov. units Non-profit
Single stocks
1. Equity forward (LOS d)
Portfolio of stocks Stock index With or without dividends
Settled before bonds mature Quote: annualized % discount from FACE
Zero-coupon bonds (T-bills)
61. Forward
2. Bond Forward (LOS d)
Quote: yield to maturity
Types Coupon bonds
Exclusive of accrued interest Include provisions for default, embedded options Can be on individual or portfolio of bonds
Large banks outside of US Denominated in U$ Published daily by British Banker's Association Eurodollar time deposit
Compiled from quotes from large banks E.g..: LIBOR
e. Rates
Annualized 360-day/year Add-on rate (# T-bill) = reference/benchmark rate
Euribor
3. Loan forward (FRA)
Euro lending rate, established in Frankfurt, published by ECB
Settle in cash
f. Features
No actual loan Long=borrower
Formula:
g. Payoff of an FRA
Term of FRA # Term of loan Quote
4. Currency Forward (LOS h)
E.g.: 2x5 FRA Off-the-run FRA
Page 89
Deliverable or cash settlement
Similar to forward
Zero value at beginning Differ from forward
Futures : exchange- traded >< Forwards are private, do NOT trade Futures are highly standardized >< Forwards are customized Futures: clearinghouse as counterparty --> reduce credit risk
a,b. Characteristics of futures (vs. Forward)
Futures market regulated by government Quality, Quantity, Delivery time, manner, minimum price fluctuation
Standardization
Uniformity promotes market liquidity Long vs. Short Hedger vs. Speculator
# margins in securities markets Initial margin Types of margins
c. Margins
Maintenance margin Variation margin
Settlement price How a futures trade takes place
Price limits
Limit move
Limit up Limit down
Locked limit
62. Futures d. Marking to market
adjust margin balance on daily basis (or more frequent in chaotic situations)
Delivery 4 ways
Cash settlement Reverse/ Offsetting/ Closing out
e. Terminate a futures
Ex-pit transactions
Delivery options in futures contracts
For short position What (T-bonds), where (gold, corn), when to deliver
T-bill futures
Eurodollar futures
f.
T-bond futures
Stock Index futures
Currency futures
a
Page 90
Definition Call vs. Put
a. Options characteristics
Long vs. Short Option premium
a
b. American vs. European options
In-the-money
c. Moneyness
Out-of-the-money At-the-money
d. Exchange-traded vs. OTC options
63.1. Option (part 1) Equity Financial options
Stock indices
Bond Interest rate
e. Underlying instruments
Currencies Options on futures Commodity options
interest rate options f. Compare
FRAs
Cap
g. Interest rate ...
Floor Collar
contract multiplier
Page 91
a for a stock option
h. Option payoffs
for interest rate options
Intrinsic value
i. Option value =
+ Time value
European call European put
j,k. Rules for minimum values and lower bounds
American call American put
63.2. Option (part 2)
Exercise price Time to expiration
l,o. Option price affected by
Interest rate Volatility
m. Put- Call parity
Put-Call parity
n. CF on the underlying asset affect
Lower bounds
Page 92
Characteristics
a Mutual termination
a.
How swaps are terminated
Offsetting contract Resale Swaption
64. Swap Currency swaps
b.
Plain vanilla interest rate swaps
Equity swaps
a
Page 93
a Value at expiration Profit Maximum profit/loss
a. Simple Call & Put
Breakeven underlying price General shape of the graph Market outlook of investors
b1. Covered call
b2. Protective put
a
Page 94
CFA LEVEL 1 STUDY SESSION 18
ALTERNATIVE INVESTMENTS
Page 95
Open- end vs. Closed- end NAV
a. Managed investment companies (mutual funds)
Investment company fees
one-time fees ongoing annual fees
Style Sector
b. Strategies
Index Global Stable Value
Definition
mimic an index
In-kind process
Advantages
price tax
Diversification
66.1. Alternative InvestmentsPart 1
Exchange traded Better risk management Advantages
Composition is known Operating expense ratio No trading at a discount or premium Tax Dividend
b,c,d. ETF
Few indices Disadvantages
Intraday trade Inefficient markets Larger investors
Market risk Asset class/ sector risk Risks
Trading prices # NAV (depth and liquidity) Tracking errors Derivative risks --> credit risk Currency and country risks
a
Page 96
Outright ownership
a Types
Leveraged equity position Mortgages Aggregation vehicles
Characteristics
e,f,g. Real Estate Investment
Cost method
f,g. Approaches to the valuation of real estate
Sales comparison method
Income method
Discounted after tax cash flow model
Seed stage
66.2. Alternative InvestmentsPart 2
R&D
Start-up financing
Formative stage
Initial marketing
Early stage
Stages
First stage financing
Balanced stage
Later stage
Expansion stage financing
Second stage investing
Third stage financing
Mezzanine (bridge financing)
h,i. Venture capital investing Illiquidity Long term horizon
Difficulty in valuation Limited data Characteristics
Entrepreneurial / Management mismatches Fund Manager incentive mistakes Timing in the business cycle Requirement for extensive operations analysis
i. NPV of a venture capital project
IPO
Commercial production
Producing and selling products Not yet generating income
Major expansion
Page 97
Absolute return
a
Limited partnership Forms
Limited liability corporation Offshore corporation Long/short funds
Classifications
Market-neutral funds Global macro funds Event- driven funds
Leverage Illiquidity Potential for mispricing
j. Hedge fund
l.
Counterparty credit risk
Unique risks
Settlement errors Short covering Margin calls
Performance Self-selection bias Backfilling bias
m.
Biases
Survivorship bias Smoothed pricing Option-like strategies Fee structures and gaming
Effect of survivorship bias
66.3. Alternative InvestmentsPart 3
Fund to invest in hedge funds
k. Fund of funds investing
Benefits Drawbacks
n. How legal issues affect valuation
n,o. Closely held companies
o. Valuation methods
Cost approach Comparable approach Income approach
describe
p. Distressed securities investing
compare with VC
Commodities Motivation for investing in
Commodities derivatives Commodity-linked securities
q,r Commodities
Sources of return on Collateralized commodity futures position
Page 98
a. Relationship between spot prices and expected future prices
67. Investing In Commodities
Contango
a
Backwardation
Sources of return b. Commodity investment
Risk Effect on portfolio
c. Commodity index strategy
Active investment
