2022 Level I Fact Sheet

Key Facts & Formulas for the CFA®

Quantitative Methods ExamVariance: mean of the squared deviations from the arithmetic
Components of interest rates mean.
Interest rate = real risk-free rate + inflation premium + default risk
Population variance σ2 = ∑N 2
i=0(X i − μ) / N
premium + liquidity premium + maturity premium 2 ∑n ̅
Sample variance s = i=0(Xi − X ) / (n − 1)
2
Nominal interest rate = real risk-free rate + inflation premium

Stated annual rate does not consider the effect of compounding. Standard deviation: square root of variance.
Effective annual rate considers compounding
Coefficient of variation: measures the risk per unit of return;
stated annual rate m 𝑠
With periodic compounding, EAR = (1 + ) −1 lower value is better. CV = ̅
m 𝑋
With continuous compounding, EAR = estated annual rate − 1 ▪ Downside Deviation: A measure of the risk of being below a
Future value: value to which an investment will grow after one or given target.
more compounding periods. FV = PV (1 + I/Y)N
Present value: current value of some future cash flow.
n
PV = FV / (1 + I/Y)N (X i − B)2
STarget = √ ∑
Annuity: series of equal cash flows at regular intervals. n−1
for all Xi ≤B
▪ Ordinary annuity: cash flows occur at the end of time periods.
▪ Annuity due: cash flows occur at the start of time periods.
PMT ▪ Leptokurtic distribution: Fatter tails than a normal distribution
Perpetuity: annuity with never ending cash flows. PV = and an excess kurtosis > 0.
I/Y
Net present value (NPV): present value of a project’s cash inflows ▪ Platykurtic distribution: Thinner tails than a normal distribution
minus the present value of its cash outflows. and an excess kurtosis < 0.
CF1 CF2 CF3 ▪ Mesokurtic distribution: identical to a normal distribution and
NPV = CF0 + [(1+r)1] + [(1+r)2] + [(1+ ] has an excess kurtosis = 0.
r)3

Internal rate of return (IRR): discount rate that makes the NPV Sharpe ratio: measures excess return per unit of risk; higher value
equal to zero. is better. 𝑆𝑝 =
𝑅̅𝑝 − 𝑅̅𝐹
CF1 CF2 CF3 𝑠𝑝
CF0 = [(1+IRR)1] + [(1+IRR)2] + [(1+IRR)3]
Odds for an event = P (E) / [1 – P (E)]
Holding period return: total return for holding an investment Odds against an event = [1 – P (E)] / P(E)
P1 −P0 +I1
over a given time period. HPR =
P0
Money weighted rate of return: the IRR of a project. Multiplication rule: used to determine the joint probability of two
events. P (AB) = P (A│B) P (B)
Time weighted rate of return: compound growth rate at which $1 Addition rule: used to determine the probability that at least one
invested in a portfolio grows over a given measurement period. of the events will occur. P (A or B) = P(A) + P(B) − P(AB)

Arithmetic mean: sum of all the observations divided by the total Total probability rule: used to calculate the unconditional
∑N probability of an event, given conditional probabilities.
i=1 Xi
number of observations. µ = P(A) = P(A|B1)P(B1) + P(A|B2)P(B2) + ... + P(A|Bn)P(Bn)
N
▪ Mode: Most frequently occurring value in a distribution.
▪ Median: Midpoint of a data set that has been sorted into Covariance: measure of how two variables move together.
ascending or descending order. Cov (X,Y) = E[X - E(X)] [Y - E(Y)]

Geometric mean: used to calculate compound growth rate. Correlation: standardized measure of the linear relationship
R G = [(1 + R1) (1 + R2) … … . (1 + Rn)]1/n − 1 between two variables; covariance divided by product of two
standard deviations.
Weighted mean: different observations are given different Corr (X,Y) = Cov (X,Y) / σ (X) σ (Y)
weights as per their proportional influence on the mean. ̅
Xw =
∑ni=1 wi X i Expected value of a random variable: probability-weighted
average of the possible outcomes of the random variable.
Harmonic mean: used to find average purchase price for equal E(X) = X1P(X1) + X2P(X2) + ... + XnP(Xn)
1
periodic investments. XH = n / ∑ni=1 ( )
Xi
Expected returns and the variance of a 2-asset portfolio
E (RP) = w1 E (R1) + w2 E (R2)
Position of a percentile in a data set: Ly = (n+1) y /100
σ2 (RP) = w12σ12 (R1) + w22σ22 (R2) + 2w1w2 ρ (R1, R2) σ (R1) σ (R2)
Range = maximum value – minimum value
Bayes’ formula: used to update the probability of an event based
P(I|E)
Mean absolute deviation (MAD): average of the absolute values on new information. P(E|I) = × P(E)
P(I)
̅|]/n
of deviations from the mean. MAD = [∑ni=1|Xi − X

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Combination Formula: Jackknife: Samples are selected by leaving out one observation at a
n! time from the set (and not replacing it).
n Cr =
(n − r)! r! Sampling distribution: If we draw samples of the same size
several times and calculate the sample statistic. The sample
Permutation Formula: statistic will be different each time. The distribution of values of the
n! sample statistic is called a sampling distribution.
n Pr =
(n − r)!
Null hypothesis (H0): hypothesis that the researcher wants to
Expected value of a binomial variable= np reject. It should always include the ‘equal to’ condition.
Variance of a binomial variable= np(1-p) Alternative hypothesis (Ha): hypothesis that the researcher
wants to prove.
Probabilities for a binomial distribution P(x) = nCx px (1 - p)n – x
One-tailed tests: we are assessing if the value of a population
Probabilities for a continuous uniform distribution parameter is greater than or less than a hypothesized value.
x −x Two-tailed tests: we are assessing if the value of a population
P(x1 ≤ X ≤ x2 ) = 2 1
b−a parameter is different from a hypothesized value.

Normal distribution: completely described by mean (µ) and Test statistic calculated from sample data and is compared to a
variance (σ2). Has a skewness of 0 and a kurtosis of 3. critical value to decide whether or not we can reject the null
Confidence intervals for a normal distribution are: hypothesis.
▪ 90% of all observations are in the interval x ± 1.65s. ̅ −μ0
X
▪ 95% of all observations are in the interval x ± 1.96s. z − statistic =
σ/√n
▪ 99% of all observations are in the interval x ± 2.58s. t − statistic =
̅ −μ0
X
s/√n
(X− µ)
Computing Z-scores (std normal distribution): Z =
σ Type I error: reject a true null hypothesis.
Type II error: fail to reject a false null hypothesis.
Safety first ratio: used to measure shortfall risk; higher number is
E(RP )−RT
preferred. SFratio = Level of significance (α) = (1 – level of confidence) = P(Type I
σP
error)
Continuously compounded rate of return= Power of a test = 1 – P(Type II error)
rt,t+1 = ln(St+1/St) = ln(1 + Rt,t+1)
Types of test statistics
One population mean: use t-statistic or z-statistic
Value at risk (VaR): Minimum value of losses expected over a
Two population mean: use t-statistic
specified time period.
One population variance: use Chi-square statistic
Two-population variance: use F-statistic
Sampling error: difference between a sample statistic and the
corresponding population parameter.
Regression equation: Y_i=b_0+b_1 X_i+ε_i
Sampling error of the mean = x̅ − μ
Simple linear regression model assumptions:
1. Linearity: The relationship between the dependent variable, Y,
Central limit theorem: if we draw a sample from a population
and the independent variable, X, is linear.
with mean µ and variance σ2, the sampling distribution of the
2. Homoskedasticity: The varian ce of the regression residuals is
sample mean:
the same for all observations.
▪ will be normally distributed.
3. Independence: The observations, pairs of Ys and Xs, are
▪ will have a mean of µ.
independent of one another. This implies the regression
▪ will have a variance of σ2/n.
residuals are uncorrelated across observations.
4. Normality: The regression residuals are normally distributed.
Standard error of the sample mean: standard deviation of the
distribution of the sample means.
σ Slope coefficient:
▪ if population variance is known, σX̅ = 𝐍 ̅ ̅
√n
s ̂ 𝟏 = 𝐂𝐨𝐯𝐚𝐢𝐫𝐚𝐧𝐜𝐞 𝐨𝐟 𝐘𝐚𝐧𝐝 𝐗 = ∑𝐢=𝟏(𝐘
𝐛 𝐢 − 𝐘)(𝐗 𝐢 − 𝐗)
▪ if population variance is unknown, sX̅ = 𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞 𝐨𝐟 𝐗 ∑𝐍 (𝐗 ̅)𝟐
𝐢=𝟏 𝐢− 𝐗
√n
Coefficient of determination:
Explained variation Regression sum of squares (RSS)
Confidence intervals: range of values, within which the actual R2 = =
value of the parameter will lie with a given probability. Total variation Sum of squares total (SST)
▪ if population variance is known, CI = X ̅ ± zα/2 σ
√n
s
▪ if population variance is unknown, CI = ̅ X ± t α/2
√n

Bootstrap: Resampling method that uses computer simulation for

statistical inference by repeatedly drawing samples with
replacement.

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ANOVA table Market structures
Degrees Perfect competition: many firms, very low barriers to entry,
Source of Sum of Mean sum of F-
of homogenous products, no pricing power.
variation squares squares statistic
freedom Monopolistic competition: many firms, low barriers to entry,
differentiated products, some pricing power, heavy advertising.
Regression Oligopoly: few firms, high barriers to entry, products may be
RSS
(explained k RSS MSR = homogeneous or differentiated, significant pricing power.
k
variation) Monopoly: single firm, very high barriers to entry, significant
pricing power, advertising used to compete with substitutes.
Error MSE MSR
F= For all market structures, profit is maximized when MR = MC.
(unexplained n-2 SSE SSE MSE
=
variation) n−k−1
Concentration ratio
Total N-firm: sum of percentage market shares of industry’s N largest
n–1 SST firms.
variation
HHI: sum of squared market shares of industry’s N largest firms.
Standard error of estimate (SEE)= √MSE
Test statistic to test whether an estimated slope coefficient is Gross domestic product (GDP)
statistically significant: Expenditure approach: GDP = (C + G𝐶 ) + (I + G𝐼 ) + (X – M)
̂1 − B1 Estimated value − Hypothesized value
b Income approach: GDP = Gross domestic income (GDI) =
t= = Net domestic income + Consumption of fixed capital (CFC) +
sb̂1 standard error
SEE Statistical discrepancy
where sb̂1 = where:
√∑n ̅ 2
i=1(Xi −X)
Compensation of employees = wages and salaries including direct
Estimated variance of the prediction error: compensation in cash or in kind + employers’ social contributions.
1 (X − X̅)2
sf2 = s2 ∗ [1 + + ] Gross operating surplus represents corporate profits of businesses.
n (n − 1)sx2 Businesses includes private corporations, non-profit corporations,
Steps to determine the confidence interval around the and government corporations.
prediction: Gross mixed income = farm income + non-farm income (excluding
1. Make the prediction. rent) + rental income.
2. Compute the variance of the prediction error. Gross domestic income = Compensation of employees + Gross
3. Determine tc at the chosen significance level α. operating surplus + Gross mixed income + Taxes less subsidies on
4. Compute the (1-α) prediction interval using the formula production + Taxes less subsidies on products and imports
below: Y ̂ ±t_c*s_f
Personal income = Compensation of employees + Net mixed
Log-lin model: The dependent variable is logarithmic but the income from unincorporated businesses + Net property income
independent variable is linear.
Lin-log model: The dependent variable is linear but the Personal Income = National Income - Indirect business taxes -
independent variable is logarithmic. Corporate income taxes - Undistributed corporate profits (retained
Log-log model: Both the dependent and independent variables are earnings) + Transfer payments (ex: unemployment benefits paid
in logarithmic form. by governments to households)

Economics Household disposable income (HDI) = Household primary income -

𝐎𝐰𝐧 𝐩𝐫𝐢𝐜𝐞 𝐞𝐥𝐚𝐬𝐭𝐢𝐜𝐢𝐭𝐲 =
% change in quanitity demanded Net current transfers paid.
% change in own price
Household net saving = HDI - Household final consumption
If |own price elasticity| > 1, then demand is elastic.
expenditures + Net change in pension entitlements.
If |own price elasticity| < 1, then demand is inelastic.
% change in quanitity demanded Nominal GDP includes inflation.
𝐈𝐧𝐜𝐨𝐦𝐞 𝐞𝐥𝐚𝐬𝐭𝐢𝐜𝐢𝐭𝐲 =
% change in income Real GDP removes the impact of inflation.
If income elasticity > 0, then good is a normal good. GDP deflator is a price index that can be used to convert nominal
If income elasticity < 0, then good is an inferior good. GDP into real GDP.
% change in quanitity demanded
Relationship between saving, investment, the fiscal balance,
𝐂𝐫𝐨𝐬𝐬 𝐩𝐫𝐢𝐜𝐞 𝐞𝐥𝐚𝐬𝐭𝐢𝐜𝐢𝐭𝐲 = and the trade balance: (S − I) = (G − T) + (X − M)
% change in price of related good
If cross price elasticity > 0, then related good is a substitute.
If cross price elasticity < 0, then related good is a complement. Quantity theory of money:
money supply ∗ velocity = price ∗ real output
Giffen good: highly inferior good; upward sloping demand curve.
Veblen good: high status good; upward sloping demand curve. Business cycle phases: expansion, peak, contraction, trough.

Breakeven & shutdown points of production Theories of business cycle:

Breakeven quantity is the quantity for which TR = TC. Keynesian: shifts in AD cause business cycles; downward sticky
If TR < TC, then the firm should shut down in the long run. wages prevent recovery; monetary/ fiscal policy should be used to
If TR< TVC, then the firm should shut down in the short run. influence AD.
New Keynesian: in addition to wages, other production factors are
also downward sticky.

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Monetarist: inappropriate changes in money supply cause business Balance of payments accounts
cycle; money supply should be steady and predictable. Current account: represents the flows related to goods and
Austrian: government interventions cause business cycles; markets services.
should be allowed to self-correct. Capital account: represents acquisition and disposal of non-
New classical: changes in technology and external shock cause produced, non-financial assets.
business cycles; no policy action is necessary. Financial account: represents investment flows.

Unemployment types: Real exchange rate = nominal exchange rate x (base currency CPI
Frictional: caused by the time lag necessary to match employees / price currency CPI).
seeking work with employers seeking their skills.
Long-term: People who have been out of work for a long time Forward rate = spot rate (1 + interest rate Price currency) / (1 +
(more than three to four months in many countries) but are still interest rate Base currency)
looking for a job.
Indexes used to measure inflation: Exchange rate regimes
Laspeyres: uses base year consumption basket. Formal dollarization: country uses the currency of another
Paasche: uses current year consumption basket. currency.
Fisher: geometric mean of Laspeyres and Paasche. Monetary union: several countries use a common currency.
Currency board system: an explicit commitment to exchange
Economic indicators: leading, coincident, lagging. domestic currency for a specified foreign currency at a fixed
exchange rate.
𝐌𝐨𝐧𝐞𝐲 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫 =
1 Fixed parity: a country pegs its currency within margins of ± 1% vs.
reserve requirement
another currency or basket of currencies.
Target zone: similar to a fixed parity but with wider bands (± 2%).
Fisher effect: R Nominal = R Real + E[I]
Crawling peg: allows for periodical adjustments in pegged
exchange rate.
Expansionary or contractionary monetary policy
Crawling bands: width of bands used in fixed peg is increased over
Neutral interest rate = real trend rate of economic growth +
time to make the gradual transition from fixed parity to a floating
inflation target
rate.
If policy rate > neutral interest rate → contractionary monetary
Managed float: monetary authority attempts to influence the
policy.
exchange rate but does not set any specific target.
If policy rate < neutral interest rate → expansionary monetary
Independently float: exchange rate is entirely market driven.
policy.

1
𝐅𝐢𝐬𝐜𝐚𝐥 𝐦𝐮𝐥𝐭𝐢𝐩𝐥𝐢𝐞𝐫 = Financial Statement Analysis
1−MPC(1−tax rate)

Expansionary or contractionary fiscal policy Financial statement analysis framework

If budget deficit increases → expansionary fiscal policy. 1. Define the purpose and context of the analysis.
If budget deficit decreases → contractionary fiscal policy. 2. Collect data.
3. Process the data.
Types of trade restrictions 4. Analyze and interpret the data.
Tariffs: taxes imposed on imported goods by the government. 5. Develop and communicate conclusions.
Quotas: restrictions on the amount of imports allowed in a country 6. Follow up.
over some period.
Export subsidies: government incentives to exporting firms which Inventory methods
artificially reduce cost of production. First in first out (FIFO) assumes that the earliest items purchased
Voluntary export restraint: agreements by exporting countries to are sold first.
voluntarily restrict exported amount to avoid tariffs or quotas Last in first out (LIFO) assumes that the most recent items
imposed by trading partners. purchased are sold first.
Minimum domestic content: restrictions imposed to ensure certain Weighted average cost averages total cost over total units available.
portion of the product content is produced in the country. Specific identification identifies each item in the inventory and uses
its historical cost for calculating COGS, when the item is sold.
Types of trading blocs and regional trading agreements
Free-trade area: all barriers to import and export of goods and Non-recurring items
services are removed. Discontinued operations: An operation that the company has
Customs union: free-trade area + all member countries adopt a disposed in the current period or is planning to dispose in future.
common set of trade restrictions with non-members.
Common market: customs union + all barriers to the movement of Unusual or infrequent items: either unusual in nature or infrequent
labor and capital goods are removed. in occurrence, but not both.
Economic union: common market + member countries establish
Net income − Preferred dividends
common institutions and economic policy. 𝐁𝐚𝐬𝐢𝐜 𝐄𝐏𝐒 =
Weighted average number of shares outstanding
Monetary union: economic union + member countries adopt a
single currency. 𝐃𝐢𝐥𝐮𝐭𝐞𝐝 𝐄𝐏𝐒
NI + Conv debt int (1 − t) − Pref div + Conv pref div
=
Weighted average shares + New shares issued

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 Liquidity ratios: measure a company’s ability to meet short-term
Other comprehensive income: includes transactions that are not obligations.
included in net income. Four types of items are: Current ratio = current assets / current liabilities
▪ Unrealized gain/losses from available for sale securities. Quick ratio = (cash + short term marketable investments +
▪ Foreign currency translation adjustments. receivables) / current liabilities
▪ Unrealized gains/losses on derivative contracts used for Cash ratio = (cash + short term marketable investments) / current
hedging. liabilities
▪ Adjustments for minimum pension liability. Defensive interval ratio = (cash + short term marketable
investments + receivables) / daily cash expenditures
Financial assets
Measured at Fair value through profit or loss (FVTPL) under IFRS Solvency ratios: measure a company’s ability to meet long term
or Held-for-Trading under US GAAP: measured at fair value; obligations.
unrealized gains shown on Income Statement. Debt to assets ratio = total debt / total assets
Measured at Fair value through other comprehensive income Debt to equity ratio = total debt / total shareholder’s equity
(FVTOCI) under IFRS or available-for-sale under US GAAP: Financial leverage ratio = average total assets / average total equity
measured at fair value; unrealized gains/losses shown in OCI. Profitability ratios: measure the ability of a company to generate
Measured at Cost or Amortised Cost: measured at cost or profits.
amortized cost; unrealized gains not recorded anywhere. Gross profit margin = gross profit / revenue
Operating profit margin = operating profit / revenue
Direct method of computing CFO: take each item from the Net profit margin = net profit / revenue
income statement and convert to cash equivalent by removing the Return on assets (ROA) = net income / average total assets
impact of accrual accounting. The rules to adjust are: Return on equity (ROE) = net income / average total equity
▪ Increase in assets is use of cash (-ve adjustment). Return on total capital = EBIT/( Average short term and long term
▪ Decrease in asset is source of cash (+ve adjustment).
debt Debt+equity)
▪ Increase in liability is source of cash (+ve adjustment).
▪ Decrease in liability is use of cash (-ve adjustment).
Credit Analysis Ratio:
Indirect method of computing CFO: CFO is obtained from EBITDA interest coverage = EBITDA / interest payments
reported net income through a series of adjustments. FFO (Funds from operations) to debt = FFO / Total debt
▪ Begin with net income. Free operating cash flow to debt = CFO (adjusted) minus capital
▪ Add back all noncash charges to income and subtract all noncash expenditures / Total debt
components of revenue. EBIT margin = EBIT / Total revenue
▪ Subtract any gains that resulted from financing or investing EBITDA margin = EBITDA / Total revenue
cashflows. Debt-to-EBITDA Ratio = Total debt / EBITDA
▪ Add or subtract changes to related balance sheet operating Return on capital = EBIT / Average beginning-of-year and end-of-
accounts. year capital
Valuation ratios: express the relation between the market value of
Free cash flow to the firm (FCFF) a company or its equity.
FCFF = NI + NCC + Int (1 - Tax rate) – FCInv – WCInv P/E = price per share / earnings per share
FCFF = CFO + Int (1 - Tax rate) – FCInv P/CF = price per share / cash flow per share
P/S = price per share / sales per share
Free cash flow to equity (FCFE) P/BV = price per share / book value per share
FCFE = CFO – FCInv + Net borrowing
DuPont analysis decomposes a firm’s ROE to better analyze a
Common size analysis firm’s performance.
▪ Common-size balance sheet expresses each balance sheet net income sales assets
account as a percentage of total assets. ROE = ( )( )( )
sales assets equity
▪ Common-size income statement expresses each item as a ROE = (net profit margin)(asset turnover)(leverage ratio)
percentage of sales.
ROE = ROA x Leverage
▪ Common size cash flow statement expresses each item as a
percentage of total cash inflows/outflows or as a percentage of
sales. LIFO v/s FIFO: When prices are rising, and inventory levels are
stable or increasing, as compared to FIFO, LIFO results in higher
Activity ratios: measure the efficiency of a company’s operations COGS, lower taxes, lower net income, lower ending inventory.
Inventory turnover = COGS / average inventory
Receivables turnover = revenue / average receivables LIFO reserve is the difference between reported LIFO inventory
Payables turnover = purchases / average trade payables and the amount that would have been reported in inventory if the
FIFO method had been used.
Days of inventory on hand = 365 / inventory turnover LIFO liquidation occurs when the number of units in ending
Days of sales outstanding = 365 / receivables turnover inventory is less than the number of units in the beginning
Number of days of payable = 365 / payables turnover inventory.

Cash conversion cycle = days of inventory on hand + days of sales Conversion from LIFO to FIFO
outstanding – number of days of payables FIFO inventory = LIFO inventory + LIFO reserve
FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO
reserve)

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FIFO NI = LIFO NI + change in LIFO reserve (1 - T) Deferred tax assets are created when income tax payable is
FIFO retained earnings = LIFO retained earnings + LIFO reserve (1 greater than income tax expense. If DTA is not expected to reverse,
– T) increase valuation allowance.

Capitalizing v/s expensing an asset Deferred tax liabilities are created when income tax expense is
As compared to expensing, capitalizing an asset results in higher greater than income tax payable. If DTL is not expected to reverse,
total assets, higher equity, lower income variability, higher CFO, treat it as equity.
lower CFI, lower debt/equity.
Under the effective interest rate method, interest expense = book
Depreciation methods: value of the bond liability at the beginning of the period x market
Straight line depreciation expense = depreciable cost / estimated rate of interest at issuance. The interest expense includes
useful life amortization of any discount or premium at issuance.
DDB depreciation expense = 2 x straight-line rate x beginning book
value Pension plans
Units of production depreciation expense per unit = depreciable Defined contribution plan: cash payment made into the plan is
cost / useful life in units recognized as pension expense on the income statement.
Financial reporting of leases from a lessee’s (entity using the Defined benefits plan: companies must report the difference
asset) perspective: between the defined benefit pension obligations and the pension
Under IFRS: Single accounting model for both finance and assets as an asset or liability on the balance sheet.
operating leases for lessees.
▪ Recognize a lease liability and corresponding right-of-use asset Corporate Issuers
on the balance sheet, both equal to the present value of lease
payments. Corporate governance refers to the system of controls and
▪ The liability is subsequently reduced using the effective interest procedures by which individual companies are managed.
method
▪ The right-of-use asset is amortized, often on a straight-line basis A board of directors is the central pillar of corporate governance.
over the lease term. It is elected by shareholders to act in their interests. A board can
▪ Interest and amortization expenses are shown separately on the have several committees that are responsible for specific functions.
income statement.
For example, audit committee, governance committee,
▪ The principal repayment component is reported as cash outflow
remuneration committee, nomination committee, risk committee,
under financing activities. The interest expense can be reported
under either operating or financing activities. investment committee.
Under US GAAP: Two accounting models for lessees: one for ESG Investment Description
finance leases and another for operating leases. Style
The finance lease accounting model is the same as the lease
accounting model for IFRS. Negative Excluding certain sectors or companies or
The operating lease accounting model is different: screening practices from a fund or portfolio based on
▪ Recognize a lease liability and corresponding right-of-use asset specific ESG criteria.
on the balance sheet, both equal to the present value of lease Positive Including certain sectors, companies, or practices
payments. screening in a fund or portfolio based on specific ESG
▪ The liability is subsequently reduced using the effective interest criteria.
method
▪ But the amortization of the right-of-use asset is the lease ESG integration Refers to the practice of including material ESG
payment less the interest expense. factors in the investment process.
▪ Interest expense and amortization expense are shown together Thematic This strategy picks investments based on a theme
as a single operating expense on the income statement. investing or single factor, such as energy efficiency or
▪ The entire lease payment is reported as cash outflow under climate change.
operating activities.
Financial reporting of leases from a lessor’s perspective. Engagement/ This strategy involves achieving targeted social or
Finance lease lessors (IFRS and US GAAP) active ownership environmental objectives along with measurable
▪ Recognize a lease receivable asset equal to the present value of financial returns by using shareholder power to
future lease payments and de-recognize the leased asset, influence corporate behavior.
simultaneously recognizing any difference as a gain or loss. Impact investing Investments made with the intention to generate
▪ The lease receivable is subsequently reduced by each lease positive, measurable social and environmental
payment using the effective interest method. impact alongside a financial return.
▪ Interest income is reported on the income statement, typically
as revenue.
▪ The entire cash receipt is reported under operating activities on Capital allocation is the process that companies use for decision-
the statement of cash flows. making on capital investments i.e., investments with a life of a year
Operating lease lessors (IFRS and US GAAP) or more. Basic principles of capital allocation are:
▪ The balance sheet is not affected: the lessor continues to 1. Decisions are based on cash flows.
recognize the underlying asset and depreciate it. 2. Cash flows are not accounting net income or operating income.
▪ Lease revenue is recognized on a straight-line basis on the
3. Cash flows are based on opportunity cost
income statement.
4. Cash flows are analyzed on an after-tax basis
▪ The entire cash receipt is reported under operating activities on
the statement of cash flows. 5. Timing of cash flows is vital
6. Financial costs are ignored

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 𝐖𝐀𝐂𝐂 = wd rd (1 − t) + wp rp + we re Q(P − V) S − TVC
DTL = =
CF1 CF2 CF(t) Q(P − V) − F − I S − TVC − F − I
NPV = CF0 + [ ]+ [ ] + ⋯+ [ ]
(1 + r)1 (1 + r)2 (1 + r)t
Breakeven quantity of sales is the quantity of units sold to earn
Decision rule: revenue equal to the fixed and variable costs i.e. for net income to
For independent projects: be 0.
If NPV > 0, accept. Fixed operating costs + fixed financing costs
If NPV < 0, reject. Q(BE) =
Price per unit − variable cost per unit
For mutually exclusive projects: Accept the project with higher and
Operating breakeven quantity of sales ignores the fixed
positive NPV. financing costs i.e. quantity sold for operating income to be 0.
Fixed operating costs
IRR is the discount rate which makes NPV equal to 0. Q(OBE) =
Price per unit − variable cost per unit
Decision rule:
Financing Options Available to a Company
For independent projects:
External
If IRR > required rate of return (usually firms cost of capital
Internal Financial Capital markets Other
adjusted for projects riskiness), accept the project.
intermediaries
If IRR < required rate of return, reject the project.
For mutually exclusive projects: Accept the project with higher IRR ▪ After-tax ▪ Uncommitted ▪ Commercial ▪ Leasing
operating lines of credit paper
(as long as IRR > cost of capital).
cash flows ▪ Committed ▪ Public &
Types of real options include: ▪ Accounts lines of credit private debt
1. Timing options payable ▪ Revolving ▪ Hybrid
2. Sizing options - abandonment options or growth options ▪ Accounts credit securities –
3. Flexibility options - price-setting options or production- receivable ▪ Secured loans preferred
flexibility options ▪ Inventory & ▪ Factoring equity,
4. Fundamental options marketable convertibles
If NPV is positive without considering options, go ahead and make securities ▪ Common
the investment. equity
If NPV is negative without considering options, calculate NPV Primary sources: Cash sources used in day-to-day operations (e.g.,
(based on DCF alone) – Cost of options + Value of options. cash balances, trade credit, lines of credit from bank).
Calculating cost of debt Secondary sources: Impacts the day-to-day operations, alter the
The yield to maturity (YTM) approach: annualized return an financial structure, and may indicate deteriorating financial
investor earns for holding a bond till maturity. condition (e.g., liquidating assets, filing for bankruptcy, negotiating
Debt rating approach: use matrix pricing on comparable bonds. debt agreements).
Drags on liquidity delay cash inflows (e.g., bad debts, obsolete
Cost of preferred stock = preferred dividend / market price of inventory, uncollected receivables).
preferred shares Pulls on liquidity accelerate cash outflows (e.g., earlier payment of
vendor dues).
Calculating cost of equity
Capital asset pricing model: re = RFR + β [E (R m ) − RFR] Equity
Di
Dividend discount model: re = +g
P0
Types of financial intermediaries
Bond yield plus risk premium: re = bond yield + risk premium
1. Brokers, exchanges, and alternative trading systems
2. Securitizers
Pure play method 3. Depository institutions
Derive asset beta for comparable company 4. Insurance companies
1
βasset = βequity ∗ 5. Clearinghouse
(1 − t)D
1+ 6. Depositories or custodians
E
Derive the equity levered beta for the project 7. Arbitrageurs
(1 − t)D
βequity = βasset ∗ (1 + ) 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 𝐫𝐚𝐭𝐢𝐨 =
value of position
E value of equity investment in that position
Degree of operating leverage (DOL) measures operating risk. It
is the ratio of the percentage change in operating income to the 𝐌𝐚𝐫𝐠𝐢𝐧 𝐜𝐚𝐥𝐥 𝐩𝐫𝐢𝐜𝐞 = initial purchase price ×
percentage change in quantity sold. (1 − initial margin)
Q(P − V) S − TVC (1 − maintenance margin)
DOL = = Execution instruction: specifies how the order will be filled.
Q(P − V) − F S − TVC − F
Degree of financial leverage (DFL) measures financial risk. It is Types are: market orders, limit orders, all or nothing orders,
the ratio of percentage change in earnings per share to percentage hidden orders, iceberg orders.
change in operating income. Validity instruction: specifies when the orders may be filled.
Q(P − V) − F EBIT Types are: day orders, good-till-cancelled orders, immediate or
DFL = = cancel orders, good-on-close orders, stop-loss orders.
Q(P − V) − F − I EBIT − interest
Degree of total leverage (DTL) combines DOL and DFL. It is the Clearing instructions convey who is responsible for clearing and
ratio of percentage change in earnings per share to percentage settling the trade.
change in units sold.

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Types of markets Growth: rapidly increasing demand, profitability improves, prices
Quote driven markets: trade takes place at the price quoted by fall, and competition is low.
dealers who maintain an inventory of the security. Shakeout: growth starts slowing down, competition is intense,
Order driven markets: trading rules match buyers to sellers, thus profitability declines.
making them supply liquidity to each other. Mature: little or no growth, industry consolidates, barriers to entry
Brokered markets: brokers arrange trades between counterparties. are high.
Decline: growth is negative, excess capacity, high competition.
Characteristics of a well-functioning financial system External factors that influence an industry include: technology,
Operationally efficient markets where trading costs like demographics, government, social factors and macroeconomic
commissions, bid-ask spreads and price impacts are low, increases influences.
market pricing efficiencies.
Informational efficient markets allow for absorption of timely Dividend discount models: value is estimated as the present
financial disclosures making the prices a close reflection of the value of expected future dividends plus the present value of a
fundamental values. terminal value.
Allocationally efficient markets allow for better utilization of n Dt
V0 = ∑.t=1 (1+r)t + (1+r)n
Pn

capital by allocating it to the most productive use.

A security market index serves as a benchmark that investors can Free cash flow to equity models: value is estimated as the
use to track, measure and compare performance. Index returns can present value of expected future free cash flow to equity.
be calculated using two methods: FCFE = CFO – FCInv + net borrowing
∞ FCFEt
Price return = (index end value – index start value)/ index start V0 = ∑.t=1 ∗ ((1+r)t )
value
Total return = (index end value – index start value + income earned Gordon growth model: assumes that dividends will grow
over the holding period)/ index start value indefinitely at a constant growth rate.
D1
V0 =
Different weighting methods used in index construction r−g
Price weighting: weights are the arithmetic averages of the prices
of constituent securities. Multi-stage dividend discount model: used for companies with
Sum of Stock Prices high growth rate over an initial few number of periods followed by
Price weighted index =
No.of stocks in index adjusted for splits a constant growth rate of dividends forever.
Equal weighted index: weights are the arithmetic averages of the n D0 (1+gs )t Vn
V0 = ∑.t=1 + (1+r)
returns of constituent securities. (1+r)t n
Dn+1
Market capitalization weighted index: weight of each security is Vn =
r−g
determined by dividing its market capitalization with total market
capitalization.
Multiples based on fundamentals: tell us what a multiple should
Fundamental weighing: weights are based on fundamental
be based on some valuation models.
parameters such as earnings, book value, cash flow, revenue, and D1
dividend payout ratio
dividends. Forward P/E = P0 /E1 =
E1
=
r−g r−g
Multiples based on comparables: compares the stock’s price
Forms of market efficiency
multiple to a benchmark value based on an index or with a peer
Weak form: prices reflect only past market data.
group. Commonly used price multiples are P/E, P/CF, P/S, P/BV.
Semi-strong form: prices reflect past market data + public
information.
Enterprise value = market value of debt +market value of equity –
Strong form: prices reflect past market data + public information +
cash and short-term investments.
private information.

Industry classification systems: The three main methods for

Fixed Income
classifying companies are, Basic features of a fixed-income security
▪ Products and/or services offered Issuer: Entity issuing the bond. Bonds can be issued by
▪ Business cycle sensitivities supranational organizations, sovereign governments, non-
• Cyclical: earnings dependent on the stage of the business cycle sovereign governments, quasi-government entities, corporate
• Non-cyclical: earnings relatively stable over the business cycle issuers.
▪ Statistical similarities Maturity date: Date when issuer will pay back principal (redeem
bond)
A peer group is a set of comparable companies engaged in similar ▪ Money market securities: original maturity is one year or less.
business activities. They are influenced by the same set of factors. ▪ Capital market securities: original maturity is more than a year.
Par value: Principal amount that is repaid to bond holders at
Porter’s five forces: the profitability of companies in an industry maturity.
is determined by: (1) threat of new entrants, (2) bargaining power ▪ Premium bond: market price > par value
of suppliers, (3) bargaining power of buyers, (4) threat of ▪ Discount bond: market price < par value
substitutes, (5) intensity of rivalry among existing competitors. ▪ Par bond: market price = par value
Coupon rate: percentage of par value that the issuer agrees to pay
Industry life-cycle phases: to the bondholder annually as interest; coupon rate can be fixed or
Embryonic: slow growth, high prices, requires significant floating; coupon frequency may be annual, semi-annual, quarterly
investment, high risk. or monthly.

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Currency denomination: bonds can be issued in any currency. Dual Bond pricing
currency bonds pay interest in one currency and principal in Using market discount rate: bond’s price is the present value of its
another currency. future cash flows, discounted at the bond’s market discount rate,
Places where bonds are issued and traded also called YTM.
▪ Bonds issued in a particular country in local currency are Using spot rates:
domestic bonds if they are issued by entities incorporated in the PMT
PV = (1+Z + (1+Z
PMT PMT+FV
+ ⋯ + (1+Z ; where ZN are the spot rates.
1 2 N
country and foreign bonds if they are issued by entities 1) 2) N)

incorporated in another country. Full price or dirty price = flat price + accrued interest
▪ Eurobonds are issued internationally, outside the jurisdiction of t
Accrued interest = ∗ PMT
any single country and are denoted in currency other than that T
of the countries in which they trade.
▪ Global bonds are issued in the Eurobond market and at least one Matrix pricing: method used to value illiquid bonds by using prices
domestic market simultaneously. and yields on comparable securities.

Cash flows of fixed-income securities Stated Annual Rate: The formula for conversion based on
Bullet structure: pays coupon periodically and entire payment of periodicity is
principal occurs at maturity. APR m m APR n n
Fully amortized bond: regular payments include both interest and (1 + ) = (1 + )
m n
principal; outstanding principal amount is reduced to zero by the
Yield measures:
maturity date.
Street convention yield: assumes payments are made on scheduled
Partially amortizing bond: regular payments include both interest
dates, neglecting weekends and holidays for simplicity.
and principal; balloon payment is required at maturity to repay the
True yield: is the yield-to-maturity calculated using an actual
remaining principal as a lump sum.
calendar. Here we consider weekends and holidays.
Sinking fund agreements: issuer is required to retire a portion of
Current yield is the annual coupon payment divided by the flat
the bond issue at specified times during the bond’s life.
price.
Floating rate notes (FRN): coupon is set based on some reference
Simple yield: adjusts the current yield by using straight-line
rate plus a spread.
amortization of the discount or premium.
Yield to call: assumes bond will be called.
Contingency provisions
Yield to worst: lower of YTM and YTC.
Callable bond: gives the issuer the right to redeem the bond prior
Money market yields: are quoted on a discount rate or add-on rate
to maturity at a specified call price; call provision lowers price.
basis.
Putable bond: gives the bondholder the right to sell bonds back to
Bond equivalent yield: is an add-on rate based on a 365-day year.
the issuer prior to maturity at a specified put price; put provision
increases price.
Convertible bond: gives the bondholder the right to convert the Price of a money market instrument quoted on a discount basis
bond into common shares of the issuing company; increases price. days to maturity
PV = FV x (1- x DR)
year

Mechanisms available for issuing bonds Money market discount rate

Underwritten offerings: investment bank buys the entire issue and Year FV−PV
Money market discount rate DR = ( )∗
takes the risk of reselling it to investors or dealers. days to maturity FV
Best effort offerings: investment bank serves only as a broker and
Present value or price of a money market instrument quoted on an
sells the bond issue only if it is able to do so.
add-on basis
Shelf registrations: issuer files a single document with regulators
that allows for additional future issuances. PV =
FV
Days to maturity
Auction: price discovery through bidding. 1+
Year
x AOR

Private placement: entire issue is sold to a qualified investor or to a Add-on rate

group of investors.
Year FV−PV
AOR = ( )∗
Days PV
Relationships among a bond’s price, coupon rate, maturity,
and market discount rate (yield-to-maturity) Relationship between AOR and DR
A bond’s price moves inversely with its YTM.
DR
coupon rate > market discount rate → premium. AOR =
Days to maturity
coupon rate < market discount rate → discount. 1 − ∗ DR
Year
price of a longer-term bond is more volatile than the price of a
shorter-term bond. The factors that affect the repo rate include:
Internal credit enhancements: include ▪ The risk of the collateral
▪ Senior/junior structure ▪ Term of the repurchase agreement
▪ Overcollateralization ▪ Delivery requirement
▪ Excess spread ▪ Supply and demand
▪ Interest rates of alternative financing
External credit enhancements: Relies on a third party called a
A forward rate is a lending or borrowing rate for a short term loan
guarantor, to provide a guarantee. These include
to be made in the future. Implied spot rates can be calculated as
▪ Surety bonds/bank guarantees
▪ Letter of credit geometric averages of forward rates.

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Yield spread Price value of a basis point (PVBP) is an estimate of the change
G-spread: benchmark is yield-to-maturity on government bonds. in the price of a bond given a 1 basis point change in the yield-to-
I-spread: benchmark is a swap rate. maturity. PVBP =
PV− − PV+
2
Z-spread (zero-volatility spread): the constant spread that is added
to each spot rate to make the present value of the bond equal to its
Convexity refers to the curvature of a bond’s price-yield
price. PV− + PV+ − 2∗PV0
Option-adjusted spread (OAS): adjusts Z-spread by the value of the relationship. 𝐴pproximate convexity = (Δyield)2 ∗PV0
embedded option.
Effective convexity, like effective duration, is useful for bonds
Securitization refers to a process in which financial assets such as with embedded options. Effective convexity =
PV− + PV+ − 2∗PV0
(Δcurve)2 ∗PV0
mortgages, loans or receivables are pooled together. Securities are
issued that are backed by this pool, called ABS.
Duration + convexity effect:
1
Credit tranching: focus is on redistribution of credit risk. % Δ PV FULL = (−AnnModDur ∗ Δyield) + [ ∗ AnnConvexity ∗
2
Time tranching: focus is on redistribution of prepayment risk. (Δyield)2 ]

Prepayment risk has two components: Credit risk has two components:
Contraction risk: faster prepayments. Risk of default: probability that the borrower will default.
Extension risk: slower prepayments. Loss severity: if the borrower does default, how severe is the loss.
Expected loss = default probability x loss severity given default
Types of ABS
Agency RMBS: backed by conforming home mortgages. Notching refers to the practice of adjusting an issue credit rating
Non-agency RMBS: backed by nonconforming home mortgages. upward or downward from the issuer credit rating, to reflect the
CMO: backed by RMBS, has multiple tranches. seniority or other provisions in that specific issue.
CMBS: backed by commercial mortgages.
Auto loan ABS: backed by auto loans. Four Cs of traditional credit analysis: capacity, collateral,
Credit card ABS: backed by credit card receivables. covenants, and character.
CDO: backed by a diversified pool of one or more debt obligations.
Derivatives
Covered bonds have lower credit risks and offer lower yields than
otherwise similar ABS. They differ from ABS because of their: dual Exchange-traded derivatives: standardized, highly regulated,
recourse nature, balance sheet impact, dynamic cover pool, and transparent and free of default.
redemption regimes in the event of sponsor default. Over-the-counter derivatives: customized, flexible, less regulated
than exchange-traded derivatives, but are not free of default risk.
Changes in interest rate affects the realized rate of return for any
bond investor in two ways: Forward commitment: obligation to buy or sell an asset or make a
Market price risk: bond price decreases when the interest rate payment in the future.
goes up. Contingent claim: has a future payoff only if some future event
Coupon reinvestment risk: value of reinvested coupons increases takes place.
when the interest rate goes up.
For short term horizon, market price risk dominates. For long term Types of derivatives: forward contracts, future contracts, options,
horizon, coupon reinvestment risk dominates. swaps, credit derivatives.

Macaulay duration: Time horizon at which market price risk Call option payoff, profit at expiration
exactly offsets coupon reinvestment risk. Also interpreted as the ▪ Call buyer payoff: cT = Max(0, ST – X)
weighted average of the time to receipt of coupon interest and ▪ Call seller payoff: –cT = –Max(0, ST – X)
principal payments. ▪ Call buyer profit: Max(0, ST – X) – c0
▪ Call seller profit: Π = –Max(0, ST – X) + c0
Duration gap = Macaulay duration – Investment horizon
Put option payoff, profit at expiration
Modified duration: linear estimate of the percentage price change
▪ Put buyer payoff: pT = Max(0, X – ST)
in a bond for a 100 basis points change in its yield-to-maturity.
▪ Put seller payoff: –pT = –Max(0, X – ST)
Modified duration = macaulay duration / (1 + r) ▪ Put buyer profit: Π = Max(0, X – ST) – p0
(PV− ) − (PV+ )
Approximate modified duration =
2 ∗ ∆ yield ∗ PV0
▪ Put seller profit: Π = –Max(0, X – ST) + p0
Effective duration: linear estimate of the percentage change in a
bond’s price that would result from a 100 basis points change in Arbitrage-free pricing: a derivative must be priced such that no
the benchmark yield curve. Used for bonds with embedded options. arbitrage opportunities exist, and there can only be one price for
(PV− ) − (PV+ ) the derivative that earns the risk-free return.
Effective duration =
2∗∆curve∗PV0 asset + derivative = risk-free asset

Key rate duration is a measure of the price sensitivity of a bond to Price v/s Value
a change in the spot rate for a specific maturity. The price of a forward or futures contract is the forward price that
is specified in the contract.

F0 (T) = (S0 ) × (1 + r)T – (γ − θ) ×(1 + r)T

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The value of a forward or futures contract is zero at initiation. Its is paid only if the fund has crossed the high watermark. High
value may increase or decrease during its life according to changes watermark is the highest value net of fees reported by the fund so
in the spot price. far.
F0 (T)
𝑉𝑡 (T) = St – (γ − θ)(1 + r)t − (1+r)T−t
Private equity categories include leveraged buyouts and venture
Moneyness refers to whether an option is in the money or out of
capital.
the money.
Leveraged buyouts (LBOs) include:
Exercise value of an option is the maximum of zero and the
▪ Management buyouts: existing management team is involved in
amount that the option is in the money. the purchase.
Time value of an option is the amount by which the option ▪ Management buy-ins: external management team replaces the
premium exceeds the exercise value. current management.
Factors that determine the value of an option Stages in venture capital include:
Increase in Value of call Value of put ▪ Formative stage: consists of angel investing, seed and early
Value of Increase Decrease stages.
underlying ▪ Later stage: company is in expansion phase.
Exercise price Decrease Increase ▪ Mezzanine stage: company is preparing for an IPO.
Risk-free rate Increase Decrease
Time to Increase Increase (except for deep in the Exit strategies include:
expiration money European options) ▪ Trade sale: company is sold to a competitor or another strategic
buyer.
Volatility Increase Increase
▪ IPO: company is sold to the public.
Holding costs Increase Decrease ▪ Recapitalization: Increases leverage or introduces it to the
Holding Decrease Increase company. Re-leverages itself when interests are low and pays
benefits itself a dividend.
▪ Secondary sale: company is sold to another private equity firm
The lowest price of the call option is given by: or another investor.
▪ Write off/ liquidation: worst case scenario, company is sold at a
X
c0 > = max (0, S0 – (1+r)T) loss.

The lowest price for a put option is given by: Real estate
Includes private as well as public investments and equity as well as
X
p0 > = max (0, (1+r)T -𝑆0 ) debt investments.

Investment characteristics of real estate are as follows:

Put–call parity for European options ▪ Indivisibility – requires large capital investments
fiduciary call = protective put ▪ Illiquidity
X ▪ Unique characteristics (no two properties are identical).
c0 + (1 = p0 + S0
+ r)T ▪ Fixed location.
▪ Requires professional operational management.
Alternative Investments ▪ Local markets can be very different from national or global
markets.
The three methods of investing in alternative investments are:
▪ Fund investing: The investor contributes capital to a fund, and Natural resources include commodities, farmland, and timberland.
the fund makes investments on the investors’ behalf, e.g., Commodity: Investments take place through derivative
investments in a PE fund. instruments. The return on commodity investment is based mainly
▪ Co-investing: The investor can make investments alongside a on price changes rather than an income stream such as dividends.
fund, e.g., investments in a portfolio company of a fund. Timberland provides an income stream through the sale of trees,
▪ Direct investing: The investor makes a direct investment in a wood, and other timber products. Itis considered a sustainable
company or project without the use of an intermediary, e.g.,
investment that mitigates climate-related risks.
direct investments in infrastructure or real estate assets.
Farmland also provides an income component related to harvest
quantities and agricultural commodity prices. It does not provide
Hedge funds
production flexibility, as farm products must be harvested when
Types
ripe.
Event-driven: includes merger arbitrage, distressed/restructuring,
activist shareholder and special situation.
Infrastructure
Relative value: strategies that seek to profit from pricing
Includes real assets that are planned for public use and to provide
discrepancies.
essential services. They are typically capital intensive and long-
Macro: strategies based on top-down analysis of global economic
lived.
trends.
Equity hedge: strategies based on bottom-up analysis. Includes
market neutral, fundamental growth, fundamental value,
Performance appraisal of alternative investments.
quantitative directional, and short bias.
▪ Traditional risk and return measures (such as the Sharpe ratio)
are not always appropriate for alternative investments.
Hedge fund fees ▪ Many metrics are used to evaluate the performance of
Common fee structure is 2 and 20 which means 2% management alternative investments such as: the Sharpe ratio, Sortino ratio,
fee and 20% incentive fee. Sometimes, the incentive fee is paid only Treynor ratio, Calmar ratio, MAR ratio, batting average, and
if the returns exceed a hurdle rate. In some cases, the incentive fee slugging performance.

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▪ The IRR calculation is frequently used to evaluate private equity Unlike time-weighted rate of return, money-weighted rate of
investments. return is impacted by the timing and amount of cash flows.
▪ The cap rate is frequently used to evaluate real estate
investments. If the portfolio manager does not control the timing and amount of
▪ Leverage, illiquidity, and redemption pressure pose special investment, then the time-weighted return should be used.
challenges while evaluating hedge funds’ performance.
Beta is a standardized measure of covariance of an asset’s return
Portfolio Management
with the market returns.
Cov(i,M) ρiM ∗σi ∗ σM ρiM ∗σi
Portfolio management process has three phases: βi = = =
σ2M σ2M σM
1. Planning
SML plots returns versus systematic risk i.e. beta on the x-axis. The
2. Execution
equation of the line is given by CAPM.
3. Feedback
▪ Securities on the SML line (CAPM) → fairly valued.
▪ Securities above the SML line → undervalued.
Asset managers are usually referred to as a buy-side firm since it ▪ Securities below the SML line → overvalued.
uses (buys) the services of sell-side firms.
Rm −Rf
The three key trends in the asset management industry include CML: Rp = Rf +( )* 𝜎p
σm
growth of passive investing, “Big Data” in the investment process,
and robo-advisers (use of automation and investment algorithms) re = Rf + β[E(Rmkt ) − Rf ]
in the wealth management industry.
Slope of the CML is the Sharpe ratio
The portfolio having the least risk (variance) among all the
portfolios of risky assets is called the global minimum-variance Slope of the SML is the market risk premium
portfolio. The four measures commonly used in performance evaluation are:

The part of minimum-variance frontier above the global minimum- portfolio excess returns Rp −Rf
variance portfolio is called the efficient frontier. Sharpe ratio = =
portfolio total risk σp
Drawing a line tangent from the risk free asset to the efficient (Rp −Rf )σm
M2 = − (R m − R f )
frontier will give the capital allocation line (CAL). σp
Rp −Rf
The point where this line intersects the efficient frontier is called Treynor measure =
Portfolio risk premium
=
beta risk (systematic risk) βp
the optimal risky portfolio.
The optimal investor portfolio is the point at which the investor’s Jenson′ s alpha = Actual portfolio return − SML expected return =
indifference curve is tangential to the CAL line. R p − [R f + β(R m − R f )]
Investment policy statement (IPS)
Investment objectives
▪ Return objectives
▪ Risk tolerance
Investment constraints (LLTTU)
▪ Liquidity requirements
▪ Legal and regulatory
▪ Time horizon
▪ Tax
▪ Unique circumstances

IPS may also include policy regarding sustainable investing which

takes into account environmental, social, and governance (ESG)
Under homogeneity of expectations, all investors have the same factors.
efficient frontier. Thus, all investors have the same optimal risky The ESG implementation approaches may have a negative impact
portfolio and CAL. This optimal CAL, using homogenous on expected risk and return of a portfolio as it may limit the
expectations, is the capital market line (CML). The optimal risky manager’s investment universe and the manner in which
portfolio is called the market portfolio. investment management firms operate.
Risk management is the process by which an organization or
Total risk (standard deviation) = systematic risk (non- individual defines the level of risk to be taken (i.e. risk tolerance),
diversifiable) + unsystematic risk (diversifiable) measures the level of risk being taken (i.e. risk exposure), and
modifies the risk exposure to match the risk tolerance.
Money-weighted return is the internal rate of return on money
invested that considers all the cash inflows and cash outflows. It is Methods to estimate target capital structure weights.
similar to the internal rate of return (IRR). 1. Assume the current capital structure at market value weights
for the components.
Time-weighted rate of return is the compound growth rate at 2. Examine trends in the capital structure or statements by
which $1 invested in a portfolio grows over a given measurement management regarding capital structure policy.
period. 3. Use averages of comparable companies’ capital structures.

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Modigliani–Miller propositions regarding capital structure. management, ensure investments are consistent with stated
mandate.
Without Taxes With Taxes III(D) Performance presentation: do not misstate performance;
make detailed information available on request.
Proposition VL = VU VL = VU + tD
III(E) Preservation of confidentiality: maintain confidentiality of
I
clients; unless disclosure is required by law, information concerns
Proposition re = r0 + (r0 − rd ) D⁄E re = r0 + (r0 − rd )(1 − t) D⁄E illegal activities, client permits the disclosure.
II IV(A) Loyalty: do not harm your employer; obtain written consent
before starting an independent practice; do not take confidential
Technical Analysis information when leaving.
Charts: line, bar, candlestick, volume. IV(B) Additional compensation arrangements: do not accept
Reversal patterns: head & shoulders, inverse head & shoulders, compensation arrangements that will create a conflict of interest
double/triple tops & bottoms. with your employer; but you may accept if written consent is
Continuation patterns: triangles, rectangles, flags, pennants. obtained from all parties involved.
IV(C) Responsibilities of supervisors: prevent employees under
Price based indicators: moving averages, Bollinger bands.
your supervision from violating laws.
Momentum oscillators: ROC, RSI, Stochastic, MACD.
V(A) Diligence and reasonable basis: have a reasonable and
Sentiment indicators: put/call ratio, VIX, margin debt, short adequate basis for any analysis, recommendation or action.
interest. V(B) Communication with clients and prospective clients:
distinguish between fact and opinion; make appropriate
Head and shoulders pattern: price target = neckline – (head – disclosures.
neckline) V(C) Record retention: maintain records to support your analysis.
𝐒𝐡𝐨𝐫𝐭 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐢𝐨 =
short interest VI(A) Disclosure of conflicts: disclose conflict of interest in plain
average daily trading volume language.
VI(B) Priority of transactions: client transactions come before
Uptrend: If prices are reaching higher highs and higher lows. An employer transactions which come before personal transactions.
upward trendline can be drawn by connecting the increasing low VI(C) Referral fees: disclose referral arrangements to clients and
points with a straight line. employers.
Downtrend: If prices are reaching lower highs and lower lows. A VII(A) Conduct as participants in CFA Institute programs: don’t
downward trendline can be drawn by connecting the decreasing cheat on the exams; keep exam information confidential.
high points with a straight line. VII(B) Reference to CFA Institute, the CFA designation, and the
Support: Price level at which there is sufficient buying pressure to CFA program: don’t brag, references to partial designation not
stop a further price decline. allowed.
Resistance: Price level at which there is sufficient selling pressure GIPS
to stop the further price hike. ▪ The GIPS standards were created to avoid misrepresentation of
Major fintech applications include: performance.
▪ Text analytics and natural language processing ▪ A composite is an aggregation of one or more portfolios
▪ Robo-advisory services managed according to a similar investment mandate, objective,
▪ Risk analysis or strategy.
▪ Algorithmic trading ▪ Verification is performed by an independent third party with
respect to an entire firm. It is not done on composites, or
Major DLT applications include: individual departments.
▪ Cryptocurrencies
▪ Tokenization
▪ Post-trade clearing and settlement
▪ Compliance

Ethical and Professional Standards

I(A) Knowledge of the law: comply with the strictest law;

disassociate from violations.
I(B) Independence and objectivity: do not offer, solicit or accept
gifts; but small token gifts are ok.
I(C) Misrepresentation: do not guarantee performance; avoid
plagiarism.
I(D) Misconduct: do not behave in a manner that affects your
professional reputation or integrity.
II(A) Material nonpublic information: do not act or help others
to act on this information; but mosaic theory is not a violation.
II(B) Market manipulation: do not manipulate prices/trading
volumes to mislead others; do not spread false rumors.
III(A) Loyalty, prudence, and care: place client’s interest before
employer’s or your interests.
III(B) Fair dealing: treat all client’s fairly; disseminate investment
recommendations and changes simultaneously.
III(C) Suitability: in advisory relationships, understand client’s
risk profile, develop and update an IPS periodically; in fund/index

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