CFA® Level II

Formula Sheet – 2024 Syllabus

QUANTITATIVE METHODS - AIC is preferred when the model is used for - Incorrect standard error, test statistics
QUANTITATIVE METHODS
predictive purposes - High Type I errors
- SBC is preferred when the model is used for
BASICSOF
BASICS OFMULTIPLE
MULTIPLEREGRESSION
REGRESSIONAND
AND Testing Conditional Heteroskedasticity
descriptive purposes
UNDERLYING ASSUMPTIONS
UNDERLYING ASSUMPTIONS - Breusch-Pagan test (one-tailed)
Testing Joint Hypotheses for Coefficients - Reject null hypothesis of no conditional
Multiple Linear Regression
t-test for Slope Coefficients heteroskedasticity if nR$ > critical χ$ value
Y: Dependent variable/explained variable
t-statistic for a slope coefficient:
Xi: Independent variable/explanatory variables Correcting for Heteroskedasticity
b! − B!
t= - Compute robust standard error
Y! = b" + b# X#! + b$ X $! + ⋯ + b% X %! + ϵ, s&!
- Generalized least squares method
where b" is the intercept, b% ’s are the partial slope - b' is the estimated value of slope coefficient
coefficients, and ϵ is the error term - B' is the hypothesized value of slope coefficient Serial Correlation
- 𝑠𝑠&" is the standard error of the slope coefficient Errors are correlated across observations
Assumptions of Multiple Linear Regression
F-test for Joint Hypothesis
Model Consequences of Serial Correlation
F-statistic for a one-tailed test:
- Linear relationship between the dependent Is not a
(SSE( − SSE) )/q Is a lagged
variable and the independent variables F= lagged
SSE) /(n − k − 1) Independent value of
- Homoskedasticity (i.e., constant variance of value of
- SSER is the sum of squared errors for the variable… dependent
residuals) dependent
restricted model variable
- Independence of observations (independence of variable
- SSEU is the sum of squared errors for the
errors) Invalid standard
unrestricted model Yes Yes
- Normality of the residuals error estimates
- q is the number of restrictions (omitted
- Independence of independent variables Invalid coefficient
variables) No Yes
estimates
- n is the number of observations
EVALUATING REGRESSION
EVALUATING REGRESSIONMODEL
MODELFIT
FITAND
AND - k is the number of independent variables
- Positive (negative) serial correlation: An error in
INTERPRETING MODEL
INTERPRETING MODELRESULTS
RESULTS General linear F-test:
one direction increases (decreases) the chance of
an error in the same direction in a subsequent
Goodness of Fit Measures F-statistic:
MSR observation
Coefficient of determination: F= - Inflated F-statistic due to underestimated MSE
SSR MSE
R$ = - Inflated t-statistic due to underestimated
SST
standard errors
Adjusted-R2: MISSPECIFICATION
MODEL MISSPECIFICATION
- High Type I errors
n−1 Principles of Model Specification
+$ = 1 − .
R 1 (1 − R$ ) Testing for Serial Correlation
n−k−1 - A regression model should be based on economic
SSE - Durbin-Watson (DW) test (for first-order serial
reasoning
correlation only)
= 1 − 5n − k − 17 - A well-specified model should be parsimonious
SST - Breusch-Godfrey (BG) test
(n − 1) - A model should perform well when applied to
-R+ $ will always be less than R$ because k is greater out-of-sample data Correcting for Serial Correlation
than 0. - The functional form for the variables should be - Adjust coefficients’ standard errors
+$ to be negative.
- It is possible for R appropriate
Multicollinearity
- A high R+ $ does not necessarily mean the - A model should uphold the multiple regression
2+ independent variables are highly correlated
regression is well specified. assumptions
Consequences of Multicollinearity
Analysis of variance (ANOVA) Misspecified Functional Form
- Unreliable regression coefficient estimates
Sum of squares error (SSE): Unexplained variation - Omitted variables
- Inflated standard errors
in Y - Inappropriate form of variables
- Low t-statistics
Sum of squares regression (SSR): Explained - Inappropriate scaling of variables
variation in Y - Inappropriate pooling of data Detecting Multicollinearity
Sum of squares total (SST): Total variation in Y - High R$ , significant F-statistic coupled with
Heteroskedasticity
SST = SSE + SSR insignificant t-statistic for slope coefficients
Variance of error term differs across observations
- High variation inflation factor (VIF)
Measures of Parsimony - Heteroskedasticity is unconditional if error term
1
Akaike’s Information Criterion (AIC): is uncorrelated with independent variables and VIF =
1 − R$*
SSE conditional if variance is correlated
AIC = n × ln . 1 + 2(k + 1) - Conditional heteroskedasticity is more
n Correcting for Multicollinearity
Schwarz’s Bayesian Information Criterion (SBC): problematic than the unconditional version - Exclude one or more of the independent variables
SSE - Increase sample size
SBC = n × ln . 1 + ln(n) × (k + 1) Consequences of Heteroskedasticity
n - Use different proxies for an independent variable
- Lower AIC/SBC is better (more parsimonious) - MSE is biased
- SBC is more conservative - Unreliable F-test and t-test

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EXTENSIONSOF
EXTENSIONS OFMULTIPLE
MULTIPLEREGRESSION
REGRESSION TIME SERIES
TIME ANALYSIS
SERIES ANALYSIS If the time series has a unit root, we can model the
first-differenced series using an autoregressive
Influence Analysis Time Series Challenges
time series.
High-leverage points: Extreme values for - Linear regression assumptions violated
independent variables - Correlated residual errors Moving Average Time-Series Model
Outliers: Extreme values for dependent variables - Mean/variance of time series changes over time MA(q) model
x1 = ε1 + θ# ε10# + θ$ ε10$ + ⋯ + θ/ x104
Leverage measure: Linear Trend Model
- h!! quantifies the distance between the ith value y1 = b" + b# t + ε1 , t = 1, 2, … , T E(ε1 ) = 0, E(ε$1 ) = σ$ , E(ε1 ε2 ) = 0, if t ≠ s
of an independent variable and its mean Seasonality in Time Series
%+# Log-Linear Trend Model
- h!! > 3 K L indicates an influential observation y1 = e&%+&&1 , t = 1, 2, … , T - Regular pattern within a year
,
ln y1 = b" + b# t + ε1 , t = 1, 2, … , T - Significant seasonal autocorrelation of error term
Studentized residuals for the ith observation:
Autoregressive Time-Series Model Autoregressive Moving Average Model
e∗! $! n−k−1
t !∗ = = N A first-order autoregression, AR(1), predicts a An ARMA(p, q) model includes p autoregressive
s.∗ SSE(1 − h!! ) − e$!
variable (x1 ) based on its most recent value (x10# ): parameters and q moving-average parameters
- e∗! : Residuals with the ith observation deleted - An AR(1) model has a “one-period memory” and
x1 = b" + b# x10# + ε1
- n: Number of observations all autocorrelations other than the first will be 0
A model using values for p periods, AR(p), is:
- k: Number of independent variables
x1 = b" + b# x10# + b$ x10$ + ⋯ + b/ x10/ + ε1 Limitations of AR Models
- SSE: Sum of squared errors for the regression
- Highly unstable parameters
model Covariance Stationary Assumption
- h!! : Leverage value for ith observation - Imperfect criteria for deciding p and q
For inferences from AR models to be valid, it is
- s.∗ : Standard deviation of residuals - Should not be used for <80 observations
assumed that the time series’ mean and variance
are constant over time Autoregressive Conditional
Cook’s distance:
e$! Heteroskedasticity Models
h!! Detecting Serial Correlation of Error
D! = P Q ARCH(1) model
k × MSE (1 − h!! )$ Residual autocorrelation
t= ε1 ~ N(0, a" + a# ε$10# )
- Detect both potential high-leverage points and 1⁄√T
If a# = 0, variance of error in every period is a" .
potential outliers T = number of observations in time series
The variance is constant over time and does not
- D! > 0.5: The observation should be investigated
Mean Reversion for an AR(1) Model depend upon past errors
- D! > 1 or D! > 2Uk/n: The observation is likely !! If a# > 0, variance of error in one period depends
influential Mean reverting level =
"#!" on how large the squared error was in the previous
&%
Dummy Variables in a Multiple Linear - xd1+# = x1 when x1 = period. If a large error occurs in one period,
#0&&
Regression &% variance of error in the next period will be larger:
- xd1+# > x1 when x1 <
Dummy variable = 1, if true; 0, if false #0&& εd$1 = a" + a# εd$10# + u1
&%
- xd1+# < x1 when x1 > If a time-series model has ARCH(1) errors, the
To distinguish among n categories, use n – 1 #0&&
variance of error in period t+1 can be predicted in
dummy variable. Root Mean Squared Error (RMSE) period t:
Intercept Dummies - In-sample forecast errors are the residuals from o$1+# = ad" + ad# εd$1
σ
Y = b" + d" D + b# X + ϵ the time period used to estimate the parameters
Slope Dummies Cointegration of Time Series
of the model.
Y = b" + b# X + d# (D × X) + ϵ Two time series are co-integrated when they
- Out-of-sample forecast errors are the residuals
Intercept and Slope Dummies have a financial or economic relationship that
from a time period not used to fit the data.
Y = b" + d" D + b# X + d# (D × X) + ϵ prevents them from diverging without bound in
- The root mean squared error (RMSE) is the square
the long run.
Multiple Linear Regression with Qualitative root of the average squared error. A relatively low
Dependent Variables RMSE for out-of-sample data indicates a good fit. Cointegration Detection
For models with qualitative dependent variables, it Engle-Granger or Dickey-Fuller test
Random Walk and Unit Root
is often preferable to use logit model. x1 = x10# + ε1 Other Issues in Time Series
- p is the probability that an event happens E(ε1 ) = 0, E(ε$1 ) = σ$ , E(ε1 ε2 ) = 0, if t ≠ s - Large forecast uncertainty
/
- The logistic transformation is ln K L - Need to consider uncertainty of error term and
#0/ Random Walk with Drift
-
/
is known as the odds of an event happening estimated parameters
#0/ x1 = b" + x10# + ε1 , E(ε1 ) = 0
- ln K
/
L is the natural logarithm of the odds of an Take first difference before analyzing
#0/
y1 = x1 − x10# MACHINE LEARNING
MACHINE LEARNING
event happening, which is known as log odds or y1 = b " + ε1 , b" ≠ 0
logits Used for client profiling, asset allocation, stock
- Coefficients are estimated using the maximum Unit Root Test of Nonstationarity selection, portfolio construction, trading, etc.
likelihood estimation (MLE) For an AR(1) time series to be covariance Supervised ML: Uses labeled data to infer patterns
- Overall model fit is assessed using a likelihood stationary, the absolute value of b1 must be < 1. between inputs and outputs
ratio (LR) test (score closer to 0 indicates a better Dickey-Fuller Test - Dependent variable (Y) is the target and
fit) x1 = b" + b# x10# + ε1 independent variables (X) are features
x1 − x10# = b" + (b# − 1)x10# + ε1 - Can be used for regression (linear and non-linear)
x1 − x10# = b" + g# x10# + ε1 and classification problems
H" : g# = 0 (has unit root)
H3 : g# < 0 (does not have unit root)

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Unsupervised ML: Finds patterns within unlabeled Text ML Model Building
data; there is no dependent variable Model Variance 1. Text problem formulation
Bias error error
- Can be used for dimension reduction and complexity 2. Text curation
clustering problems Lower 3. Text preparation and wrangling
Low Higher
4. Text exploration
Deep Learning: Sophisticated algorithms for tasks High Lower Higher
such as image classification, face recognition, and Errors Addressed with Data Cleansing
natural language processing Supervised ML Methods Incompleteness error: Data not present
Penalized regression/Regularization: Seeks to Invalidity error: Outside meaningful range
Reinforcement Learning (RL): An algorithm learns
reduce the risk of overfitting by imposing a penalty Inaccuracy error: Not a measure of true value
from the data that it generates
on additional features; Least Absolute Shrinkage Inconsistency error: Conflicts between data points
Neural networks: Highly flexible ML algorithms and Selection Operator (LASSO) uses a Non-uniformity error: Multiple formats used
used for classification, regression, deep learning, hyperparameter, λ, as a penalty Duplication error: Duplicate observations present
and reinforcement learning
Support Vector Machine (SVM): Linear classifier Data Wrangling Methods
ML Methods for Different Types of Variables model used for binary classification, regression, Feature extraction: Creating a new variable from an
Supervised Unsupervised and outlier detection; Soft margin classification is a existing variable to improve analysis
Variables
ML ML non-linear alternative to SVM Aggregation: Combining similar variables
Regression Dimensionality Filtration: Removing irrelevant rows
K-Nearest Neighbor (KNN): Non-parametric
- Linear, Reduction Selection: Removing irrelevant columns
method typically used for classification (e.g., credit
LASSO - PCA Conversion: Making adjustments to increase
rating prediction), but also used for regression
Continuous - Logistic Clustering relevance
- CART - K-Means Classification and Regression Tree (CART):
Addressing Outlier Data
- Random - Hierarchical Produces a tree with a root node, decision nodes,
Trimming: Removing the top/bottom X%
Forest and terminal nodes; Iterative structure is used to
Winsorization: Replacing extreme high/low
Classification Dimensionality find relationships in non-linear data, but it is a
observations with maximum/minimum values
- Logit Reduction black box method
Normalization:
- SVM - PCA X ! − X 7!,
Categorical Ensemble learning: Use multiple models to reduce X ,56738!9.: =
- KNN Clustering X 73; − X 7!,
error rate relative to relying on one model.
- CART - K-Means
Examples include majority-vote classifier, Standardization:
- Hierarchical
bootstrap aggregating, and random forest. X! − µ
Neural Neural X 213,:36:!9.: =
Continuous networks, networks, Unsupervised ML Methods σ
or Deep Deep Learning, Principal Components Analysis (PCA): Features are Text Wrangling Methods
Categorical Learning, RL grouped together to reduce the number of 1. Lowercasing
RL independent variables in a model. It significantly 2. Stop words
reduces model complexity but is a black box 3. Stemming
Training an ML Model: Sampling
method. 4. Lemmatization
Training an ML model requires a dataset to be
divided into three non-overlapping samples: Clustering: K-means clustering, hierarchical Model Performance Evaluation
1. Training sample: In-sample data used to find clustering, and dendrograms are used to organize Actual Actual
relationships observations into groups. training training
2. Validation sample: In-sample data used to label - 1 label - 0
validate relationships found in training sample DATA PROJECTS
BIG DATA PROJECTS True False
Predicted
3. Test sample: Out-of-sample data used to test the positive positive
4Vs of Big Data result - 1
model’s predictive powers (TP) (FP)
1. Volume
Overfit models explain the training data well but False
2. Variety True
do not generalize to the out-of-sample data. Predicted negative
3. Velocity negative
K-fold cross-validation can be used to prevent result - 0 (FN) (Type
4. Veracity (TN)
overfitting. II Error)
ML Model Building Steps
TP
Training an ML Model: Errors 1. Conceptualization Precision (P) =
Bias error: Does not explain training data well TP + FP
2. Data Collection/Curation
(underfit); more likely for linear functions 3. Data Preparation and Wrangling TP
Recall (R) =
Variance error: Model performs differently with - Data Cleansing TP + FN
out-of-sample data because it has incorporated - Data Preprocessing TP + TN
noise from training data (overfit); more likely for 4. Data Exploration Accuracy (A) =
TP + FP + TN + FN
non-linear functions - Exploratory Data Analysis
2 ×P×R
Base error: Unavoidable errors due to randomness - Feature Selection F1 score =
P+R
The trade-off between bias error and variance - Feature Engineering
5. Model Training FP
error can be shown on a fitting curve False Positive Rate (FPR) =
- Method Selection TN + FP
TP
- Performance Evaluation True Positive Rate (TPR) =
- Tuning TP + FN

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Receiver Operator Characteristic (ROC) technique Low capital mobility Classical model failed because:
plots FPR on x-axis and TPR on y-axis. 1. Population growth slowed as incomes rose
Monetary Policy
2. Diminishing marginal returns to labor input
Root Mean Squared Error (RMSE) is calculated as
Fiscal Policy Expansionary Restrictive were more than offset by technological progress
the square root of the sum of mean squared errors.
Expansionary DC ↓ Ambiguous Neoclassical Model
,
(Predicted! − Actual!)$ - Based on Cobb-Douglas production function
RMSE = st Restrictive Ambiguous DC ↑
n - Both capital (K) and labor (L) are subject to
!<#
Currency Crisis Warning Signs diminishing marginal productivity
A lower RMSE indicates potentially better model - Recent liberalization of capital markets - In the steady state, the output-to-capital ratio is
performance if historical relationships hold. - Large foreign capital inflows, especially s/t funds constant because they grow at the same rate
- Banking crises, either just before or concurrent - In the long run, output per capita is driven by:
- Fixed or partially fixed exchange rates 1. Savings/investment rate
ECONOMICS 2. Rate of technological change
- Sudden, sharp decline in FX reserves
ECONOMICS 3. Population growth
- Recent spike in domestic currency value
CURRENCYEXCHANGE
CURRENCY EXCHANGERATES
RATES - Deteriorating terms of trade ∆y ∆A ∆k ∆k Y
- Money supply growing faster than bank reserves = + α. 1 = s. 1− δ − n
y A k k K
Factors Influencing Bid/Ask Spreads - Recent high inflation ∆y θ
Currency pair: Wider for less liquid currencies Growth rate of output per capita = =
y 1−α
Time of day: Wider when NY/London closed
ECONOMIC
ECONOMICGROWTH
GROWTH ∆Y θ
Market conditions: Wider when more volatile Growth rate of output = = +n
Y 1−α
Contract term: Wider for longer-term forward Factors Affecting Growth: Developing Countries Implications:
contracts due to lower liquidity and increased - Low rates of savings and investment - Capital accumulation, capital deepening, and an
exposure to credit risk and interest rate risk - Poorly developed financial markets increase in savings rate can only temporarily
- Weak legal systems and failure to enforce laws increase growth, but technological improvements
Covered Interest Rate Parity
- Lack of property rights and political stability can have a permanent impact
Days
1 + i= K L - Poor public education and health services
F=⁄: = S=⁄: u 360 w - Per capita income growth will converge across
Days - Excessive taxes and regulations countries
1 + i: K L
360 - Restrictions on international trade/capital flows
Uncovered Interest Rate Parity Endogenous Growth Theory
Potential Growth and Stock Market Returns - Output per worker is proportional to stock of
%∆S=.⁄: = i= − i: 𝐸𝐸 𝑃𝑃
%∆𝑃𝑃 = %∆𝐺𝐺𝐺𝐺𝐺𝐺 + %∆ + %∆ capital per worker (k . )
Estimated Future Spot Rate 𝐺𝐺𝐺𝐺𝐺𝐺 𝐸𝐸
- c is constant marginal product of capital
F=⁄: − S=⁄: Cobb-Douglas Production Function y. = f(k . ) = ck .
= %∆S=.⁄: = i= − i:
S=⁄: F (K, L) = K ? L#0? ∆y.⁄y. = ∆k . ⁄k . = sc − δ − n
- A higher savings rate can permanently increase
Absolute Version of PPP Capital Deepening vs. Technological Progress
the potential GDP growth rate
P= = S=⁄: × P:
S=⁄: = P= ⁄ P:
ECONOMICS OF
ECONOMICS OFREGULATION
REGULATION
Relative Version of PPP
Types of Regulation
%∆S=⁄: ≅ π= − π:
- Statutes enacted by legislatures
Ex-ante Version of PPP - Administrative regulations for agencies
%∆S=.⁄: ≅ π.= − π.: - Judicial laws established by legal rulings

The Fisher Effect and Real Interest Rate Parity Classification of Regulators
i = r + π. Growth Accounting - Independent regulators: Granted the ability to
(i= − i: ) = (r= − r: ) + (π.= − π.: ) ∆Y ∆A ∆K ∆L make regulations by government
= + α . 1 + (1 − α) . 1 - Self-regulatory bodies: Private organizations that
(r= − r: ) = (i= − i: ) − (π.= − π.: ) Y A K L
regulate members, typically industry peers
Real Interest Rate Parity Growth rate in potential GDP
- Self-regulatory organizations: Independent
(r= − r: ) = 0 = L/T growth rate of labor force
industry bodies that have been granted law
+ L/T growth rate in labor productivity
International Fisher Effect enforcement powers
(i= − i: ) = (π.= − π.: ) Labor Supply Inputs - Standard-setting bodies: Establish rules but lack
- Population growth any enforcement powers (e.g., IFRS)
Mundell-Fleming Model
- Labor force participation
High capital mobility Regulatory Interdependencies
- Net migration
- Regulatory capture: Businesses use relationship
Monetary Policy - Average hours worked
with regulators to serve their interest
Restrictive Classical Model - Regulatory competition: Regulators from different
Fiscal Policy Expansionary
- Labor productivity increases population growth jurisdictions compete to attract certain entities
Expansionary Ambiguous DC ↑
- Population growth accelerates as per capita - Regulatory arbitrage: Businesses exploit
Restrictive DC ↓ Ambiguous incomes increase differences between economic substance and
- Diminishing marginal returns to labor input will regulatory interpretation
lead to decline in per capita income

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Regulatory Tools Acquisition Method Share-Based Compensation and Financial
- Price mechanisms (e.g., taxes, subsidies) - The fair value of the consideration given by the Statement Modeling
- Mandates and restrictions acquiring company is used Basic shares outstanding (beginning of period)
- Provision of public goods - Direct costs of the business combination are + RSUs vested during period
- Public financing of private projects expensed as incurred + Options exercised during period
- IFRS: Full or partial goodwill + New shares issued
Cost-Benefit Analysis of Regulation + Share repurchases
US GAAP: Full goodwill only
Regulatory burden: Private costs of regulation, both = Basic shares outstanding (end of period)
direct and indirect Partial goodwill
= Fair value of consideration given Post-Employment Benefits: Disclosures and
Net burden: Private costs less private benefits
Modeling
− Acquirer @ s shares of the fair value of A/L
Defined contribution (DC): Employer’s obligation is
Full goodwill limited to periodic contribution; Future benefits
= Fair value of acquired@ s entity depend on investment performance
FINANCIAL STATEMENT ANALYSIS
FINANCIAL STATEMENT ANALYSIS − Fair value of the entity @ s A/L Defined benefit (DB): Firm makes periodic
- Non-controlling interest (NCI) is the portion of payments to employee after retirement;
INTERCORPORATEINVESTMENTS
INTERCORPORATE INVESTMENTS
subsidiary’s equity held by third parties Employer’s contributions may vary depending on
Classification o Full goodwill: NCI is measured at fair value assumptions and the performance of plan assets
- Financial assets (<20%): Buyer has no significant o Partial goodwill: NCI is based on the DB plan assumptions:
control over the investee proportionate share of net identifiable assets - Assuming a higher discount rate reduces the
- Associates (20% - 50%): Buyer has significant pension liability and service costs
influence but not control EMPLOYEE COMPENSATION: - Assuming a higher rate of compensation growth
COMPENSATION:POST-
- Joint venture: Entity is operated by companies EMPLOYMENT AND SHARE-BASED increases liability and service costs
POST-EMPLOYMENT AND SHARE-BASED
that share control - Assuming a higher expected return on assets
- Business combinations (>50%): Buyer has control Financial Reporting for Share-Based
reduces the pension expense under US GAAP but
Compensation
Investments in Financial Assets not IFRS and has no impact on the value of assets
Restricted stock:
- Under IFRS 9, all financial assets are initially - Total expense is allocated evenly over each year Financial Reporting for DB Plans
measured at fair value (cost basis at acquisition) of vesting period Funded status
- In subsequent periods, financial assets may be - Share-based compensation reserve is recorded as = Fair value of plan assets
measured at either amortized cost or fair value owner’s equity in the balance sheet − PV of defined benefit obligation
- To be measured at amortized cost, financial o Transfers to common equity on settlement Beginning fair value of plan assets
assets must meet the following criteria: date + Actual return on plan assets
o Held to collect contractual cash flows - No impact on statement of cash flows + Employer contributions
o Cash flows may only be principal and interest − Benefits paid
Stock options:
- Financial assets that fail to meet both criteria = Ending fair value of plan assets
- Total expense is allocated evenly over each year
must be measured at either fair value through
of vesting period Beginning pension obligation
profit or loss (FVPL) or fair value through other
- Share-based compensation reserve is recorded as + Current service cost
comprehensive income (FVOCI) + Past service cost
owner’s equity in the balance sheet
- Securities are classified as follows: + Interest expense
o Balance is reduced as the options are exercised
o Debt securities: Carried at amortized cost if + Actuarial losses
- Financing cash inflow upon option exercise
held to maturity, but must be carried at fair − Actuarial gains
value if it is possible that they may be sold Share-Based Compensation Tax and Share − Benefits paid
o Equities: Can be held at FVPL or FVOCI Count Effects, Note Disclosures = Ending pension obligation
o Derivatives: Must be carried at FVPL unless Share price Net pension asset/liability:
Tax US GAAP
they are being used as hedging instruments change after IFRS Overfunded
impact
Investments in Associates and Joint Ventures grant date - Plan assets exceed the pension obligation
- Equity method (one-line consolidation): Reduced - Sponsor reports net pension asset
Gain in income tax
o Initial investment is recorded at cost on the Increase Windfall Underfunded
equity expense
balance sheet as a non-current asset - Pension obligation exceeds plan assets
o Carrying amount is adjusted upward to Higher - Sponsor reports net pension liability
reflect a proportionate share of earnings Loss in income tax
Decrease Shortfall Periodic pension cost
o Dividends received are treated as a return of equity expense = (Ending funded status
capital and reduce the carrying amount
− Beginning funded status)
o If carrying value falls to 0, equity method is Diluted shares outstanding
− Employer contributions
discontinued and no further losses recorded = Basic shares outstanding
- Profits from transactions with associates cannot
+ Shares from conversion or exercise
be realized until the products are sold/used
Assumed proceeds of conversion or exercise
Classifying Business Combination −
Average share price for the reporting period
- Merger: A + B = A
- Acquisition: A+ B = (A + B) = (ITM options) × (Strike price)
- Consolidation: A + B = C + Average unrecognized
share-based compensation expense

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Components of pension expense (IFRS): Translation Adjustments Minimum Capital Requirements
- Current service cost (P&L) Balance Foreign Currency under Basel III:
- Past service cost (P&L) Sheet - Common Equity Tier 1 capital ≥ 4.5%
Strengthens Weakens
- Net interest expense (P&L) Exposure - Total Tier 1 capital ≥ 6.0%
o Net liability × Interest rate Positive Negative - Tier 1 plus Tier 2 capital ≥ 8.0%
- Net return on plan assets (OCI, not amortized) Net asset translation translation The CAMELS Approach
o Actual return − (Assets × Interest rate) adjustment adjustment 1. Capital adequacy
- Actuarial losses (OCI, not amortized) Negative Positive 2. Asset quality
Net
Components of pension expense (US GAAP): translation translation 3. Management capabilities
liability
- Current service cost (P&L) adjustment adjustment 4. Earnings sufficiency
- Past service cost (OCI, then amortized) Effect of Translation Method on Ratios 5. Liquidity position
- Interest expense (P&L) - Pure income statement and pure balance sheet 6. Sensitivity to market risk
o Liability × Interest rate ratios are unaffected by the current rate method Relevant Factors Not Covered by CAMELS
- Expected return (P&L) - Under both the current rate and temporal Banking-Specific Analytical Considerations
o Assets × Expected return methods, ratios using both income statement and - Government support
- Net return on plan assets (OCI, then amortized) balance sheets figures will be different from the - Government ownership
o Actual return − (Assets × Expected return) same ratios calculated using local currency - Mission of banking entity
- Actuarial losses (OCI, then amortized) statements before translation - Corporate culture
Examples:
Considerations relevant to any company
MULTINATIONAL OPERATIONS
OPERATIONS 1. Receivables turnover (sales/receivables) is the
same under both current and temporal methods - Competitive environment
Presentation and Functional Currencies - Off-balance-sheet items
- Sales are translated at the average exchange
- Presentation currency: Currency in which the - Segment information
rate under both
company presents its financial statements - Currency exposure
- Receivables are translated at the current
- Functional currency: Currency in which the - Risk factors
exchange rate under both
company conducts its primary activity - Basel III disclosures
2. Current ratio (current assets/current liabilities)
- Local currency: Used within the country in which
will be different under the two methods Analyzing Property and Casualty Insurers
the company operates
- Inventory is translated at the current Loss and loss adjustment expense ratio:
- Often, functional currency of subsidiary ≠
exchange rate under the current method, but Loss expense + Loss adjustment expense
functional and presentation currency of parent
at the historical exchange rate under the Net premiums earned
Remeasurement/Translation Methods temporal method
Current rate method - If the subsidiary’s currency appreciates Underwriting expense ratio:
relative to the parent, the current ratio will Underwriting expense
- Use when the subsidiary’s functional currency is
different from the parent’s functional currency be higher under the current rate method than Net premiums written
- FX gain/loss reported in shareholders’ equity as the temporal method Combined ratio:
part of cumulative translation adjustment (CTA) Loss and loss adjustment expense ratio
Subsidiaries in Hyperinflationary Economies
- Exposure is net assets (assets minus liabilities) + Underwriting expense ratio
Under IFRS
Temporal method - Restate subsidiary’s local currency financial Dividends to policyholders ratio:
- Use when the subsidiary’s functional currency is statements for local inflation Dividends to policyholders
the same as the parent’s functional currency - Translate inflation-restated foreign currency Net premiums earned
- Remeasurement gain/loss reported in financial statements into the parent’s
income statement presentation currency using the current FX rate Combined ratio after dividends:
- Exposure is net monetary assets (monetary assets Combined ratio + Dividends to policyholders ratio
Under U.S. GAAP
minus monetary liabilities)
- Use the temporal method to translate the
EVALUATING
EVALUATINGQUALITY
QUALITYOF
OFFINANCIAL REPORTS
FINANCIAL REPORTS
Exchange Rate for Each Line Item subsidiary’s local currency financial statements
- Include the resulting translation adjustment as a Quality Spectrum of Financial Reports
Current 1. GAAP-compliant; decision-useful, high-quality
gain or loss in determining net income
Rate Temporal earnings (adequate return/sustainable)
Monetary assets Current Current 2. GAAP-compliant; decision-useful, low-quality
ANALYSIS OF
OF FINANCIAL
FINANCIALINSTITUTIONS
INSTITUTIONS
Monetary earnings (inadequate return/not sustainable)
Current Current
liabilities Key Components of Basel III: 3. GAAP-compliant; not decision-useful
Nonmonetary - Minimum capital requirements: Based on risk- 4. GAAP-compliant; earnings management
Current Historical
assets weighted assets 5. Non-compliant accounting
Nonmonetary - Minimum liquidity: Enough to handle a 30-day 6. Fictitious transactions
Current Historical
liabilities liquidity stress scenario
Common stock Historical Historical - Stable funding: To cover needs over a one-year
Revenues/ horizon; based on the length of the deposits and
Average Average the type of depositor
Expenses
COGS Average Historical
Depreciation Average Historical

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Beneish Model Sources of Information about Risk CORPORATE ISSUERS
CORPORATE ISSUERS
M-scores: Higher values indicate a greater - Financial statements, including notes
likelihood of earnings manipulation - Audit opinion or discretionary change in auditor
ANALYSIS
ANALYSIS OF DIVIDENDS AND
OF DIVIDENDS AND SHARE
- Threshold M-scores: - Management commentary
SHARE REPURCHASES
REPURCHASES
o −1.78 (3.8% likelihood of manipulation) - Regulatory disclosures
o −1.49 (6.8% likelihood of manipulation) - Financial press Stock Dividends
- Days Sales in Receivables Index (DSRI): Large - In lieu of paying a cash dividend, companies may
increase could mean revenue inflation INTEGRATION distribute additional shares.
INTEGRATION OF
OF FINANCIAL
FINANCIALSTATEMENT
STATEMENT
- Gross Margin Index (GMI): >1 means gross margin ANALYSIS TECHNIQUES - Such a distribution increases the number of
ANALYSIS TECHNIQUES
has decreased, possible pressure to manipulate shares outstanding without affecting the
- Asset Quality Index (AQI): Increase could indicate Framework for Analysis company's total market value.
excessive capitalization of expenses 1. Define purpose for analysis - The stock dividend does not affect the company’s
- Sales Growth Index (SGI): Rapid sales growth can 2. Collect input data balance sheet or income statement, so liquidity
create pressure to manipulate earnings 3. Process data and financial leverage ratios are unchanged.
- Depreciation Index (DEPI): >1 means depreciation 4. Analyze/interpret processed data
5. Develop and communicate conclusions Stock Splits
rate has decreased, indicating manipulation
6. Follow up - They have no economic effect on the company
- SG&A Expenses Index (SGAI): >1 means increasing
and should not impact shareholders’ wealth.
SG&A expense, might encourage manipulation Sources of Earnings and ROE
- Reverse stock splits reduce the number of shares
- Accruals: More accruals indicate manipulation Net Income Sales Assets
ROE = × × outstanding, but they still have no economic
- Leverage index (LEVI): >1 shows increasing debt- Sales Assets Equity
impact on the company or shareholder.
to-asset ratio, greater pressure to manipulate
In the Beneish model, SGAI and LEVI are negatively Net Profit Asset
ROE = × × Leverage Dividend Theories
Margin Turnover
correlated with the M-score; other variables are - Dividends are irrelevant: MM Propositions
positively correlated NI EBT EBIT Sales Assets - Bird-in-the-hand argument: Investors prefer cash
ROE = × × × ×
EBT EBIT Sales Assets Equity dividends over unrealized capital gains
Measures of Earnings Persistence and Accruals
- Signalling: Managers want to increase dividends
- Earnings forecast should not include non- Accruals and Earnings Quality
as a signal of strength to investors
recurring items Balance sheet approach
- Agency cost: Paying dividends to owners limits
- Cash components are more persistent than AccrualsAB = NOA.,: − NOA&.C
managers’ ability to fund negative NPV projects
accrual components
NOA.,: − NOA&.C
- Earnings with significant accruals will experience Accruals RatioAB = Factors Affecting Dividend Policy
a faster mean reversion ìNOA.,: + NOA&.C î⁄2
- Investment opportunities: Company with more
- A company that consistently performs slightly Cash flow statement approach (less) investment opportunities will pay out less
better than benchmark should be scrutinized AccrualsDE = NI − CFO − CFI (more) in dividends
- Regulatory enforcement actions and restatements - Expected volatility of future earnings: Companies
of previous financial statements are red flags NI − CFO − CFI with greater earnings volatility are less likely to
Accruals RatioDE =
Altman model: A lower Z-score indicates a higher ìNOA.,: + NOA&.C î⁄2 increase dividends; Increasing dividends
probability of bankruptcy increases chances of not maintaining the dividend
FINANCIAL
FINANCIAL STATEMENT
STATEMENT MODELING
MODELING - Financial flexibility: Companies seeking more
Cash Flow Quality
flexibility are less likely to initiate or increase
- A startup company might be expected to have Financial Modeling: Overview
dividends
negative operating and investing cash flows, Income Statement Modeling: Revenue
- Tax considerations: Investors consider dividends
funded by positive financing cash flows from - Top-down approach
on an after-tax basis
equity issues or borrowing - Bottom-up approach
- Flotation costs: Make using newly issued stock
- For established companies, high-quality - Hybrid approach
more expensive than internally generated funds;
operating cash flow (OCF) should be:
Income Statement Modeling: Operating Costs Smaller companies face higher flotation costs
- Positive
Cost analysis should match revenue analysis - Contractual and legal restrictions: Bond
- Derived from sustainable sources
- Cost of goods sold (COGS) indentures, obligations to preferred shareholders,
- Enough for capex, dividends, and debt service
- Selling, general, and administrative expenses rules against capital impairment, etc.
- Stable relative to peers
(SG&A)
Tax System and Dividend Policy
Balance Sheet Quality Indicators
High financial reporting quality requires: Income Statement Modeling: Non-Operating Costs - Double Taxation: Corporate earnings are first
- completeness Financing expenses are affected by debt level and taxed at the corporate level and then again at the
- unbiased measurement interest rate shareholder level when distributed as dividends.
- clear presentation ETR = Corp. tax rate
Tax rates:
A high-quality balance sheet requires: +(1 − Corp. tax rate)(Ind. tax rate)
- Statutory tax rate
- optimal amount of leverage
- Effective tax rate
- adequate liquidity
- Cash tax rate
- economically successful asset allocation
Balance Sheet and Cash Flow Statement Modeling
Return on invested capital (ROIC)
Net operating profit less adjusted taxes (NOPLAT)
=
Invested capital

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- Split-rate: Corporate earnings distributed as - However, if shares are repurchased at a premium, CEO duality: The same individual serves as both
dividends are taxed at a lower rate than the wealth will be transferred from remaining CEO and chair of a one-tier board, raising concerns
earnings retained. Dividends are taxed as shareholders to the seller. about a lack of independent oversight
ordinary income for investors. The effective tax Special voting arrangements: May require directors
Advantages of Share Repurchases vs. Dividends
rate on dividends is calculated with the same to secure dual majorities among both controlling
- Potential tax advantages
formula used under a double taxation system, but and minority shareholders
- Signaling
the lower corporate tax rate is used for dividend Stewardship codes: Encourage asset managers to
- Managerial flexibility
distributions increase engagement in corporate governance
- Offsets dilution from employee stock options
ETR = Corp. tax rateF - Adjusting capital structure Board Policies and Practices
+(1 − Corp. tax rateF )(Ind. tax rate) - Increasing EPS - Board of Directors Structure
- Board Independence
- Imputation: Corporate earnings distributed as Analysis of Dividend Safety
- Board Committees
dividends are taxed at the shareholder’s tax rate. All else being equal, the risk of a dividend cut or
- Board Skill and Experience
Individual shareholders receive a tax credit if omission increases when we have:
- Board Composition
their marginal tax rate is less than the corporate - A higher dividend payout ratio (dividends/net
- Other Considerations in Board Evaluation
tax rate. If their marginal tax rate is higher, they income)
only pay tax based on the difference between - A lower dividend coverage ratio (net Executive Remuneration
their marginal tax rate and the corporate rate. income/dividends) - Companies may have a say on pay provision that
allows shareholders to vote or at least provide
Payout Policies FCFE FCFE feedback on compensation.
Stable Dividend Policy coverage =
Dividends + Share repurchases - A claw-back policy allows companies to regain
ratio
D# = D" + (E# × PR G − D" ) × A previously paid compensation if mismanagement
where - If the ratio is equal to 1, the company is
or misconduct is subsequently uncovered.
E# is expected earnings distributing all available cash to shareholders.
PR G is target payout ratio - If the ratio is significantly greater than 1, the Shareholder Voting Rights
A is an adjustment factor (1/Years to target ratio) company is keeping some earnings to enhance - Under a straight voting share structure, each
liquidity. share has the same voting rights.
Constant Dividend Payout - In a dual-class structure, certain classes of shares
- If the ratio is significantly less than 1, the
Dividend as a constant share of earnings have enhanced voting rights, which can create a
company is borrowing cash to pay dividends,
Residual Dividend Payout thereby decreasing liquidity. This is conflict of interest between minority
Pay out earnings remaining after funding all unsustainable because the company is paying out shareholders and founders/management.
positive NPV capital projects consistent with its more than it can afford. Approaches to Identify ESG Factors
target capital structure. - Proprietary methods
Capital Equity % ESGCONSIDERATIONS
ESG CONSIDERATIONSINININVESTMENT - Third-party vendors
D = max u0, Earnings − × w INVESTMENT ANALYSIS
Budget in capital ANALYSIS - Non-profit industry organizations and initiatives
structure
Ownership Structure Evaluating ESG-related Risks and Opportunities
Share Repurchase Methods - Dispersed: Many small minority shareholders - Equity analysts consider both the opportunities
- Buy in the open market - Concentrated: One majority shareholder or a few and risks related to ESG factors, while fixed-
- Buy back a fixed number of shares at a fixed price shareholders with large minority positions income analysts primarily consider the downside
- Dutch auction - Horizontal: Cross-holding share arrangements risks associated with ESG issues.
- Repurchase by direct negotiation - Vertical: Controlling interest in two or more - Companies may issue green bonds to raise capital
Financial Statement Effects of Repurchases holding companies with their own subsidiaries for projects intended to benefit the environment.
Changes in Earnings per Share - Dual-class shares: Disproportionate voting rights - Misrepresenting a project’s benefits when issuing
- If the net income stays the same, the EPS will for certain classes of shares green bonds is known as greenwashing.
increase after a share repurchase because there Conflicts with Different Ownership Structures
are fewer shares outstanding. - Dispersed ownership, dispersed voting power: COST OF
COST OFCAPITAL:
CAPITAL: ADVANCED
ADVANCEDTOPICS
TOPICS
- Share repurchases made with borrowed funds: If Leads to principal-agent problem where strong
the earnings yield is greater (lower) than the Cost of Capital Factors
managers take advantage of relatively weak
after-tax cost of the funds, the EPS will increase Weighted average cost of capital:
shareholders
(decrease). WACC = w: r:(1 − t) + w/ r/ + w. r.
- Concentrated ownership, concentrated voting
- An increase in EPS does not necessarily imply an power: Leads to the principal-principal problem Top-down external factors:
increase in shareholders’ wealth. where a captive board makes decisions to the - Capital availability
Changes in Book Value per Share detriment of minority owners - Market conditions
- If the market price per share is greater (less) than - Dispersed ownership, concentrated voting power: - Legal and regulatory considerations
its book value per share, a stock repurchase will Also leads to the principal-principal problem, but - Tax jurisdiction
decrease (increase) the book value per share. for the benefit of large minority owners holding
Bottom-up company specific factors:
dual-class shares
Valuation Equivalence - Revenue, earnings and cash flow volatility
- Concentrated ownership, dispersed voting power:
- Ignoring the tax and information effects, cash - Asset nature and liquidity
Can occur if voting caps are used
dividends and share repurchases should have the - Financial strength, profitability, and financial
Board Composition
same effect on shareholder wealth. leverage
One-tier: Executive and non-executive directors
- Security features
Two-tier: Independent supervisory board oversees
management board

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Estimating Cost of Debt International Considerations Balance sheet restructuring:
- Traded debt Country spread model - Sale leasebacks: Address immediate liquidity
- Non-traded debt ERPLM = ERP for a developed market needs and eliminate the risks associated with
- Bank debt +(λ × Country risk premium) ownership
- Leases - Dividend recapitalization: Debt-financed dividend
Country risk rating model
- International considerations Country risk premium payment that increases the leverage in a
σL4N!1O company's capital structure
Estimating Equity Risk Premium = Sovereign yield spread ×
Historical approach σA5,: Reorganization:
Factors: - Must be approved by a bankruptcy court
Global CAPM (GCAPM)
- Equity index selection Uses a global market index as a factor and assumes Leveraged Buyouts (LBO)
- Time period zero correlation between returns across countries - PE firms raise debt to finance acquisition of
- Mean type
private companies and aim to operate them more
- Risk-free rate proxy International CAPM (ICAPM)
efficiently under private ownership
r. = r= + βP ìrC7 − r= î + βD (rQ − r=)
Limitations: - The private companies may return to the public
- Past does not represent the future market through IPO
- Index-based ERP can be inflated due to CORPORATE
CORPORATE RESTRUCTURING
RESTRUCTURING Evaluating Corporate Restructurings
survivorship bias Step 1: Initial evaluation
Corporate Structural Changes
Forward-looking approach Type of Step 2: Preliminary valuation
Survey-based estimates: Motivations - Comparable company analysis
Change
- Limitations: Sampling bias, recency bias, and - Comparable transaction analysis
- Realize synergies
confirmation bias - Premium paid analysis
- Increase growth potential
Investment
Dividend discount model estimates: - Improve capabilities Deal price − Stock price
actions Takeover premium =
- Gordon growth model - Access new resources Stock price
D# - Acquire an undervalued firm
V" = Step 3: Modeling and evaluation
r. − g - Improve operational focus
- EBIT/Sales
- Improve valuation metrics Profitability
D# Divestment - EBITDA/Sales
r. = + 𝑔𝑔 - Meet liquidity needs
𝑉𝑉" actions - Standard deviation of revenues
- Address regulatory Volatility
D# - Standard deviation of EBITDA
ERP = r. − r= = + g − r= requirements
V" - Improve return on capital Leverage - Debt/EBITDA
Macroeconomic modeling: Restructuring markets Collateral - Asset liquidity
- Grinold-Kroner model actions - Avoid/respond to financial
Interest - Benchmark reference rates
𝐷𝐷# challenges
𝐸𝐸(𝑟𝑟H ) = + Δ𝑃𝑃𝑃𝑃 − Δ𝑆𝑆 + 𝑖𝑖 + 𝑔𝑔 rates - Credit spreads
𝑃𝑃"
Investment Actions
Estimating Cost of Equity Equity investments:
Dividend discount models - The acquirer and the target operate as
D# independent entities EQUITY VALUATION
r. = + 𝑔𝑔 EQUITY VALUATION
𝑉𝑉"
Joint ventures:
Bond yield plus risk premium (BYPRP) - Separate entity created by two or more EQUITY VALUATION
VALUATION
r. = r: + Risk premium companies that contribute assets and other
Equity Value vs. Market Price
= r: + (Mean equity index return resources to pursue common objectives
VL – P = (V – P) + (VL – V)
− Mean corporate bond index return) Acquisitions: VL : estimate of intrinsic value
Risk-based models - Target company becomes a subsidiary and its P: market price
- Capital asset pricing model (CAPM) assets, liabilities, and revenues are consolidated V: unobservable intrinsic value
as part of the acquirer's financial statements (V – P): “true” mispricing
r. = r= + β(ERP)
= r= + β(r7 − r= ) Divestment Actions Definitions of Value
Sales: - Going concern value: Assumes company will
- Fama-French model
- The seller transfers a segment or business line to
continue operating for the foreseeable future
r! = R E + β# (ERM) + β$ (SMB) + βI (HML) an acquirer, which assumes control of the
- Liquidation value: Assumes assets must be sold
- Expanded Fama-French model associated assets and liabilities
immediately, likely at a discount
r! = R E + β# (ERM) + β$ (SMB) + βI (HML) Spin-offs: - Orderly liquidation value: Higher than if assets
+ βJ(RMW) + βK (CMA) - The parent company's shareholders receive must be sold immediately
shares in the spun-off company, but the two - Fair market value: Price negotiated between a
Estimating the Cost of Equity for Private
companies issue their own securities and file willing buyer and seller
Companies
separate financial reports - Investment value: Subjective valuation for a
Expanded CAPM method
specific investor
r. = r= + β/..6 (ERP) + SP + IP + SCRP Restructuring Actions
Cost restructuring:
Build-up approach
- Improve operational efficiency and increase
r. = r= + ERP + SP + IP + SCRP
profit margins through outsourcing and
offshoring

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DISCOUNTEDDIVIDEND
DISCOUNTED DIVIDENDVALUATION
VALUATION Calculating FCFF from Net Income Two-Stage Free Cash Flow Models
FCFF = Net income to common shareholders
Single Period Multiple Period ,
FCFF1
D# + P# , + Net non-cash charges V=!67 = t
V" = D1 P, (1 + WACC)1
(1 + r)# V" = t + + Interest expense (1 – tax rate) 1<#
(1 + r)1 (1 + r), FCFF,+# 1
1<# - Investment in fixed capital
+ P Q
- Investment in working capital WACC − g (1 + WACC),
Gordon Growth Model (GGM)
D# D" (1 + g) FCFF from NI: Adjustments for Noncash Items Three-Stage Growth Models
V" = = Adjustment to Three-stage models usually assume one of the
r−g r−g Noncash Item
NI following:
Value of Fixed-rate Perpetual Preferred Stock Depreciation/Amortization Added back - Constant growth rate in all three stages
D - Constant growth rate in the first and third stages,
V" = Impairment of intangibles Added back
r with a declining growth rate in stage two
Restructuring charges Added back
Present Value of Growth Opportunities
E# Expense reversals Subtracted
V" = + PVGO Losses Added back Non-operating Assets and Firm Value
r
Gains Subtracted Firm value
Required Rate of Return Using GGM = Value of operating assets
Amortization of long-term
D# Added back + Value of non-operating assets
r= +g bond discounts
P"
Amortization of long-term
Subtracted
Two-Stage DDM bond premiums MARKET-BASED VALUATION: PRICE AND
,
D" (1 + g B )1 D" (1 + g B ), (1 + g R ) Added back ENTERPRISE VALUE MULTIPLES
V" = t + Deferred taxes but special
(1 + r)1 (1 + r), (r − g R ) Trailing (current) P/E
1<#
attention Current stock price
H-Model Most recent four quarters’ EPS
Calculating FCFF from Statement of Cash Flows
D! (1 + g " ) + D! H(g # − g " )
V! = FCFF = CFO + Int(1 − tax) − FCInv Forward (leading) P/E
r − g" CFO = NI + NCC − WCInv Current stock price
Required Return from H-Model FCInv = CapEx − Proceeds from sale of l/t assets Next year’s expected EPS
D"
r = . 1 [(1 + g R ) + H(g B − g R )] + g R Calculating FCFE from FCFF Justified P/E
P"
FCFE = FCFF − Int(I − tax) + Net borrowing P" D#⁄E# 1 − b
Sustainable Growth Rate Finding FCFF/FCFE from EBIT or EBITDA Leading = =
E# r−g r−g
g = b × ROE FCFF = EBIT(1 − tax) + Dep − FCInv − WCInv P" D" (1 + g)⁄E" (1 − b)(1 + g)
b = retention rate = 1 − dividend payout ratio NI + Int(1 − tax) Trailing = =
EBIT = E" r−g r−g
1 − tax
Dividend Growth Rate and ROE Analysis FCFF = EBITDA(1 − tax) + Dep(tax) − FCInv P/E to Growth (PEG) Ratio
Net Income
ROE = − WCInv - P/E divided by expected earnings growth
Shareholder′ equity
Uses of FCFF and FCFE - Stocks with lower PEG are more attractive than
Net income Sales Assets
=. 1. 1. 1 stocks with higher PEGs, all else equal
Sales Assets Equity Uses of FCFF = Uses of FCFE =
± Δ Cash balance ± Δ Cash balance Fed Model
NI − Dividends NI Sales Assets
g=. 1. 1. 1. 1 + Interest expense (1-t) + Cash dividends - Compares the S&P 500 earnings yield (inverse of
NI Sales Assets Equity + Debt repayment + Share repurchases P/E) to the 10-year Treasury yield
+ Cash dividends - Market is overvalued if the earnings yield, based
FREE
FREE CASH
CASHFLOW
FLOWVALUATION
VALUATION + Share repurchases on next 12 months’ expected earnings, is less than
FCFF Valuation Model the 10-year Treasury yield
Forecasting of FCFF and FCFE
T
FCFF1 Assuming fixed debt ratio (DR) in capital structure Yardeni Model
V=!67 t
(1 + WACC)1 Net borrowing = DR(FCInv – Dep) + DR(WCInv) CEY = CBY − b × LTEG + residual
1<#
Constant Growth Model FCFE = NI − (1 − DR)(FCInv − Dep) - CEY = current earnings yield on the market index
FCFF# FCFF" (1 + g) − (1 − DR)(WCInv) - CBY = current yield on A-rated corporate bonds
V=!67 = = - LTEG = consensus 5-year market EPS growth rate
WACC − g WACC − g International Application of Single-Stage Model
- b = weight the market gives to earnings estimates
FCFE Valuation Model Required rate of return (real)
T = Country return(real) P 1
FCFE1 =
V.4N!1O = t = V=!67 − MV:.&1 ± Industry adjustment E (CBY − b × LTEG)
(1 + r)1
1<# ± Size adjustment
Justified Price Multiples
Constant Growth Model ± Leverage adjustment
P" ROE − g
Free Cash Flow Model Variations Price/Book =
FCFE# FCFE" (1 + g) B" r−g
V.4N!1O = = Sensitivity Analysis of FCFF and FCFE Valuations
r−g r−g E"
Sensitivity analysis can be performed on key Price/Sales P" K £S" L (1 − b)(1 + g)
=
variables such as beta, risk-free rate, equity risk S" r−g
premium, FCFE growth rates, and the initial FCFF
or FCFE.

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Price to Cash Flow Clean Surplus Relationship Approaches to Valuation
Advantages vs. P/E B1 = B10# + E1 − D1 - Income approach
- Cash flows are more stable than earnings - Market approach
Constant Growth
- Cash flows are less subject to manipulation - Asset-based approach
ROE − r
- Differences between CFs and earnings should be V" = B" + B
r−g " Capitalized Cash Flow Method
eliminated over time
FCFF%+#
Multistage RI Valuation Model Enterprise value% =
Disadvantages vs. P/E G
WACC − g
- Cash flows may still be manipulated E1 − rB10# PG − BG EBIT%+# (1 − t)(1 − RIR)
V" = B" + t + =
- FCFE is theoretically better but more volatile than (1 + r)1 (1 + r)G WACC − g
1<#
FCFF FCFE%+#
If RI fades over time: Equity value% =
- Cash flows are different under IFRS vs. US GAAP G0# r. − g
E1 − rB10# EG − rBG0#
Justified Dividend Yield V" = B" + t +
(1 + r)1 (1 + r − ω)(1 + r)G0# Excess Earnings Method
D" r − g 1<#
= - ω = persistence factor; 0 < ω < 1 Step 1: Calculate required returns on working
P" 1 + g
- ω = 0: RI will fall to zero after forecast horizon capital and fixed assets
Enterprise Value to EBITDA - ω = 1: RI will persist at current level indefinitely Required return on working capital
Enterprise Value = Working capital × rUD
= Market Value of Common Equity Strengths
- Terminal value does not make up a large portion Required return on fixed assets
+ Market Value of Preferred Stock
of the total present value as in other models = Fixed assets × rEV
+ Market Value of Debt
+ Minority Interest - RI models use readily available accounting data Step 2: Calculate residual income
− Cash and Investment - Can be applied to companies that do not pay Normalized income
dividends or positive expected near-term FCF − (Working capital × rUD )
EBITDA = NI + Int + Taxes + Dep & Amort - Can be used when cash flows are unpredictable − (Fixed assets × rEV )
EV/EBITDA vs. P/E - Appealing focus on economic profitability = Residual income
Advantages: Weaknesses Step 3: Capitalize residual income
- Controls for differences in leverage - The models are based on accounting data that can 𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕 𝐨𝐨𝐨𝐨 𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢
- Controls for differences in depreciation be subject to manipulation by management (𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑 𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢)(𝟏𝟏 + 𝐠𝐠)
- EBITDA can be used even if earnings are negative - Accounting data used as inputs may require =
𝐫𝐫𝐑𝐑𝐑𝐑 − 𝐠𝐠
Disadvantages: significant adjustments
- EBITDA overestimates cash flows if working - Additional adjustments are needed when clean Step 4: Calculate enterprise value
capital is growing surplus accounting relationships do not hold Value of intangibles
- EBITDA ignores the impact of revenue - The RI model’s use of accounting income assumes + Fair value of working capital
recognition policies on CFO that the cost of debt is reflected appropriately by + Fair value of fixed assets
interest expense = Total firm enterprise value
Momentum Indicators
Earnings Surprise / Unexpected Earnings Guideline Public Company Method
PRIVATE COMPANY VALUATION
PRIVATE COMPANY VALUATION βR.Y.6.:
UE1 = EPS1 − E(EPS1 ) β),8.Y.6.: =
Percent earnings surprise = UE/Expected EPS Private Company Areas of Focus [1 + (1 − t)(D/E)]
Enterprise value
Standardized Unexpected Earnings ,
𝛃𝛃∗𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋𝐋 = 𝛃𝛃𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔𝐔 [𝟏𝟏 + (𝟏𝟏 − 𝐭𝐭 ∗ )(𝐃𝐃∗ /𝐄𝐄 ∗ )]
EPS1 − E(EPS1 ) FCFF! Terminal Value
SUE1 = =t +
σ[EPS1 − E(EPS1)] (1 + WACC)! (1 + WACC),
!<#

FCFF= EBITDA(1 − t) + Depreciation(t) FIXED INCOME

FIXED INCOME
RESIDUALINCOME
RESIDUAL INCOMEVALUATION
VALUATION −ΔLT Assets − ΔWorking Capital
STRUCTURE AND
TERM STRUCTURE AND INTEREST RATE
Residual Income (RI) Required Rate of Return Models DYNAMICSRATE DYNAMICS
INTEREST
RI = NI – Equity charge Capital asset pricing model (CAPM)
r. = r= + β(r7 − r= ) Spot Rates
Economic Value Added (EVA) 1
EVA = NOPAT − (C% × TC) Expanded CAPM DFb =
(1 + ZN )b
NOPAT = EBIT(1 − tax) r. = r= + β(r7 − r= )
C% = Cost of capital + Small-cap stock premium Forward Pricing Model
B-A
TC = Total capital + Company-specific stock premium (1 + zB )B = (1 + zA )A ì1 + fA,B-A î
1
Market Value Added (MVA) Build-up method FV,A0V = A0V
= Market value of the company r. = r= + (r7 − r=) Ω1 + fV,A0V æ
− Accounting book value of total capital + Small-cap stock premium DFA
FV,A0V =
+ Company-specific stock premium DFV
Residual Income Model
RI1 = E1 − rB10# = (ROE − r)B10# ± Industry premium/discount Relationship between Spot and Forward Rates
T
RI1 Valuation Discounts and Premiums For an upward-sloping (downward-sloping)
V" = B" + t spot curve, the forward curve will be above
(1 + r)1 Discounts for lack of control
1<# (below) the spot curve
1
DLOC = 1 −
1 + Control premium

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Swap Rate Binomial Interest Rate Tree Arbitrage-Free Models
G - Based on the assumption that bond prices and the
sG 1
t + =1 term structure implied by those prices are correct
(1 + z1 )1 (1 + zG )G
1<# - Allow parameters to vary deterministically
G
over time
t sG DF1 + DFG = 1
1<# Ho-Lee Model:
Spreads dr1 = θ1 dt + σdZ
- Swap spread = Swap rate − Treasury yield
- I-spread = Bond yield − Swap rate - Drift term: Time-dependent
- Z-spread: Spread added to each spot rate so - Volatility: Constant
that PV of bond’s cash flows equals bond’s - Negative rates: Possible
i#,h = i#,R e$i
market price Kalotay-Williams-Fabozzi (KWF) Model:
- TED spread = LIBOR rate − T-bill rate
- LIBOR-OIS spread = LIBOR rate − OIS rate d ln(r1) = θ1 dt + σdZ

Term Structure of Interest Rates: Theories - Drift term: Time-dependent

Pure expectations: Forward rates are unbiased - Volatility: Constant
predictors of future spot rates - Negative rates: Not possible
Local expectations: All bonds are expected to
generate the risk-free rate over short time periods BONDS WITH EMBEDDED OPTIONS
BONDS WITH OPTIONS
Liquidity preference: Forward rates reflect
Valuation of Callable and Putable Bonds
expectations of future spot rates plus liquidity Binomial Valuation Framework
VQ3883&8. = V2163!Cj1 − VQ388
premiums for longer maturities
Bond value plus coupon V/N13&8. = V2163!Cj1 + V/N1
Segmented markets: Yield curve shape is
determined by preferences of borrowers and payment if higher rate
Effects of Interest Rates and Yield Curve
is realized.
lenders - Callable (putable) bond value is inversely
Preferred habitat: Investors have preferred Bond value (directly) related to interest rate volatility
maturity ranges, but they will shift if yields are at any node - Value of option-embedded bonds declines as
attractive Bond value plus coupon upward-sloping yield curve flattens
payment if lower rate is
Yield Curve Risk Based on Key Rate Durations Option Adjusted Spread (OAS)
realized.
Decomposes changes in yield curve into changes in Constant spread is added to each forward rate in a
level (L), steepness (S), and curvature (C): benchmark binomial interest rate tree to equate PV
∆P VH + C VL + C of credit risky bond’s cash flow to its market price
. 1 ≈ −DR ∆xR − DB ∆xB − DD ∆xD Bond value at node = 0.5 . + 1
P 1+i 1+i - OASQ3883&8. is inversely related to assumed
C + 0.5(VH + VL) volatility of benchmark binomial tree rates
Flattening and Steepening of Yield Curve =
1+i - OAS/N13&8. is directly related to assumed volatility
Bullish steepening: Short-term rates falling faster
than long-term rates; observed when central bank Term Structure Models of benchmark binomial tree rates
loosens monetary policy to stimulate economy Equilibrium Models
Effective Duration of Callable & Putable Bonds
Bearish flattening: Short-term rates increasing - Use fundamental economic variables to describe
(PV0) − (𝑃𝑃𝑉𝑉+ )
more than long-term rates; occurs when central the term structure Effective duration =
2 × (∆Curve)(PV" )
bank raises rates by restricting money supply - Require parameters to be specified
- EffDurQ3883&8. ≤ EffDur2163!Cj1
- Preferable for dynamic applications
Bullish flattening: Long-term rates falling more - EffDur/N13&8. ≤ EffDur2163!Cj1
- Allow for possibility of multiple different future
than short-term rates; observed in the aftermath of
interest rate paths
market turmoil as investors flock to government
bonds in a flight to quality Cox-Ingersoll-Ross (CIR) Model:

dr1 = k(θ − r1 )dt + σUr1 dZ

ARBITRAGE-FREE VALUATION FRAMEWORK
ARBITRAGE-FREE VALUATION FRAMEWORK
- Drift term: Mean reverting
Arbitrage Concepts - Volatility: Proportional to the square root of the
Value additivity: Exists if the whole does not equal short-term rate
sum of parts - Negative rates: Not possible
Dominance: Exists if the present value of a risk-free
payoff is non-zero Vasicek Model:
Stripping: Turning coupon bonds into multiple dr1 = k(θ − r1 )dt + σdZ
zero-coupon bonds
Reconstitution: Combining zero-coupon bonds to - Drift term: Mean reverting
replicate a coupon-paying bond - Volatility: Constant
- Negative rates: Possible

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Convexity Improves Duration-based Estimates Factors for the Term Structure of Credit
Spreads
- Credit quality
- Financial conditions
- Market supply and demand
- Company-value model

Factors for the Credit Analysis on Securitized

Debt
- Homogeneity
- Granularity
- Underlying collateral
CREDIT ANALYSIS
CREDIT ANALYSIS MODELS
MODELS
(PV0 ) + (𝑃𝑃𝑉𝑉+ ) − [2 × (𝑃𝑃𝑉𝑉" )] - Structure of the secured debt transaction
Effective Convexity = Measures of Credit Risk
(∆Curve)$ (PV")
- Recovery rate = 100% − Loss severity
Convexity for Interest Rates and Bond - Loss given default = Exposure × (100% − RR) CREDIT
CREDIT DEFAULT
DEFAULT SWAPS
SWAPS
Structure - The conditional probability of default in a given Settlement Protocol
Interest Straight and Callable year is the probability of default assuming no - Loss given default (LGD) = 1 − Recovery rate (%)
rates putable bonds bonds prior defaults. If this probability of default is a - Payout amount = LGD × Notional amount
High Positive Positive constant rate, then the probability of survival to
year t can be calculated as: CDS Pricing Conventions
Low Positive Negative PV of credit spread = Upfront premium
(100% − Hazard rate)1
+ PV of fixed coupon
Measures of Credit Risk (continued) Upfront Credit Fixed
≈. − 1 × CDS Duration
PV of Expected Loss premium spread coupon
= Discount factor × Expected loss
CDS price per 100 par = 100 − Upfront premium %
= Discount factor × Loss given default
× Prob. of default Valuation Changes during CDS Term
= Discount factor × (Exposure × Loss severity) % Change in CDS price
× Prob. of default = Change in spread (bps) × Duration

where Prob. of default = POSAl × Hazard rate1 Applications of CDS

- Naked credit default swap: Purchase of credit
Credit Valuation Adjustment (CVA)
, protection without holding the reference
CVA = t PV of expected loss1 obligation
Capped or Floored Floating-rate Bonds 1<# - Long/short trade: Long position in one CDS
Capped floater Structural and Reduced Form Credit Models and short position in another
Bond with option that prevents coupon rate from Structural credit models can interpret debt and - Curve trade: Buy a CDS of one maturity and
rising above specified maximum equity values with option terminology. Debt and sell a CDS with a different maturity for the
VQ3//.: = V2163!Cj1 − V.7&.::.: equity are also random values because they are same reference entity
Q3/
=8531.6 =8531.6
functions of the asset random values. At time T, the - Basis trade: Exploit differences in credit
Floored floater balance sheet can be represented with: spreads offered by the CDS market and
Embedded option sets minimum coupon rate: A(T) = D(T) + E(T) the bond market
V=8556.: = V2163!Cj1 + V.7&.::.: Assuming the maturity value at time T of the debt
=8531.6 =8531.6 =8556
is K, a default will occur if the asset value at time T
Convertible Bonds is less than K. The value of the equity and debt at DERIVATIVES
Bondholder has right to convert bond into time T are: DERIVATIVES
common shares at conversion ratio: - E(T) = max[A(T) − K, 0]

Market price
- D(T) = A(T) − max[A(T) − K, 0] PRICING AND VALUATION OF
Conversion Conversion
= × FORWARD COMMITMENTS
value of stock ratio
This implies that:
Principles of Arbitrage-Free Pricing
- Equity is a call option on the assets with a strike
Market Market price To implement the no-arbitrage argument, the
Conversion price equal to the face value of the debt
conversion = of convertible¡ following simplifying assumptions are made:
ratio - Debtholders have written the call option to the
price bond - Replicating instruments are available.
equity holders
Market Market - Market frictions are absent.
Market conversion
= conversion − price of The value of the equity and debt at time T can also - Short selling is allowed.
premium per share
price stock be expressed as follows using put-call parity: - Investors can borrow and lend at the
Minimum value - E(T) = A(T) − K + max[K − A(T),0] risk-free rate.
Straight Conversion - D(T) = K − max[K − A(T),0]
of convertible = max K , L
value value Pricing and Valuation of Forwards and Futures
bond This implies that: Forward Price
Callable and putable convertible bond value - Equity can also be viewed as a long position in F" (T) = FV",G (S" + CC" − CB" )
= V2163!Cj1 + VQ388 5, − VQ388 5, + V/N1 5, the assets, long put option, and short bond
&5,: 215Q% &5,: &5,:
- Carry benefits could include dividends and bond
- Debt can be interpreted as a long bond and a
coupon payments. They reduce the forward price.
short put option

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- Carry costs could include waste, storage, and - S" is the full bond price (including accrued Futures
insurance. They increase the forward price. interest). c = F" (T)e06G N(d# ) − e06G XN(d$ )
- If interest rates, carry benefits, and carry costs - There are no carry costs, so CC" = 0. p = e06G XN(−d$ ) − F" (T)e06G N(−d# )
are continuously compounded, then: - The carry benefits are the coupon interest
ln(F" (T)e06G ⁄X) + [r + (σ$ ⁄2)]T
F" (T) = S" e(6'+DD0DA)G payments, so CB" = PVCI",G . d# =
- If there is no carry benefit, then set CB = 0. σ√T
If accrued interest is not included in the bond d$ = d# − σ√T
- If there is no carry cost, then set CC = 0.
price quote, then:
Valuing Forward Contracts Interest Rate Options
F" = FV",G ΩB" + AI" − PVCI",G æ
V1 (T) = PV1,G[F1 (T) − F" (t)] for long - An interest rate cap is a portfolio of call options
= FV",G [B" + AI" ] − AIG − FVCI",G
V1 (T) = PV1,G[F" (t) − F1 (T)] for short on interest rates (a.k.a. caplets), each with the
Often, the delivery of more than one bond is
VG(T) = SG − F"(t) for long same exercise rate and with sequential
permitted. Then, the actual futures price is:
VG(T) = F" (t) − SG for short maturities.
F" = Q " × CF
- An interest rate floor is a portfolio of put
Futures Contract Valuing Fixed-Income Forwards and Futures options on interest rates (a.k.a. floorlets),
- Right before marking to market: - The value of a bond futures contract is the price each with the same exercise rate and with
v1 (T) = f1 (T) − f10(T) for long change since the previous day’s settlement. sequential maturities.
v1 (T) = f10 (T) − f1(T) for short - The value of a bond forward contract at a later
- The value after the daily marking to market is 0. Swaptions
date is the present value of the current forward
A swaption is an option on a swap. It gives the
Interest Rate Forward and Futures price less the original forward price.
holder the right to enter into a swap with
Forward Rate Agreement specified terms, including the fixed rate.
Pricing and Valuing Swap Contracts
- The two FRA counterparties are the fixed-rate - A payer swaption is an option on a swap to
Swap pricing equation
receiver (short party) and the floating-rate pay a fixed rate and receive a floating rate.
1.0 − PV",1( (1)
receiver (long party). rE'o = , - A receiver swaption is an option on a swap
∑*<# PV",1! (1)
- FRAs are identified in an “X × Y” format. to pay a floating rate and receive a fixed rate.
A 3 × 9 FRA will expire in three months with a
payoff based on the six-month Libor when the Option Greeks
VALUATION CONTINGENT CLAIMS
VALUATION OF CONTINGENT CLAIMS
FRA expires. Delta
Binomial Option Valuation Model - Delta is the change in an instrument's value
- FRAs typically use the advanced set, advanced
Exercise values for calls and puts for a given change in the underlying value.
settled approach. This means interest rate is set
cG = Max(0, SG − X) - The delta of a long stock is 1.
and the FRA settlement is made at time h, when
pG = Max(0, X − SG ) - Using the BSM model:
the FRA expires.
Hedge ratio DeltaQ = e0pG N(d# ); 0 ≤ DeltaQ ≤ e0pG
- The settlement amount for the floating receiver
c+ − c0 Delta/ = −e0pG N(−d# ); −e0pG ≤ Delta/ ≤ 0
(long position) is: h= + ≥ 0 for call
S − S0 - As the stock price increases:
NA[L7 − FRA" ]t 7 + 0
p −p
1 + D7 t 7 h= + ≤ 0 for put DeltaQ → 1
S − S0
Delta/ → 0
- The FRA fixed rate is the forward m-day rate in h - A long call is equivalent to buying stocks with
borrowed funds. - Delta hedging is used to offset the exposure of
days:
- A long put is equivalent to selling stocks short and the portfolio to changes in the underlying.
1 + LG t G 1
FRA" = P − 1Q . 1 Portfolio Delta
1 + Lj t j t7 lending the proceeds. Nh = −
Deltah
- The value of an existing long FRA (floating Expectations approach If Nh < 0, short the hedging instrument.
receiver) can be calculated using an offsetting c = PV[πc + + (1 − π)c 0 ] If Nh > 0, long the hedging instrument.
transaction at the new rate applicable when the p = PV[πp+ + (1 − π)p0 ] - Delta approximation:
#+60:
FRA expires: π= «prıce ≈ option price + DeltaìS» − Sî
Optıon
N0:
ΩFRAC − FRA" æt 7 American-Style Options
VC = Gamma
1 + DG0C t G0C Solve for the values from right to left. At each node,
- Gamma measures the change in an instrument’s
the value is the greater of the calculated value or
Fixed-Income Forward and Futures delta for a small change in the underlying stock.
the immediate exercise value.
Accrued interest - The gamma for a stock position is 0.
Accrued interest = Accrual period The Black-Scholes-Merton Formula - GammaQ = Gamma/
× Periodic coupon amount Stock - Gamma is always non-negative.
NAD C For nondividend-paying stock: - The largest value occurs when the option
AI = . 1×. 1
NTD n c = SN(d# ) − e06G XN(d$ ) is near the money.
where: p = e06G XN(−d$ ) − SN(−d#) - Delta-plus-gamma approximation:
- NAD is the number of days since the last coupon ln(S⁄X) + [r + (σ$ ⁄2)]T
d# = «prıce ≈ option price + DeltaìS» − Sî
Optıon
payment σ√T Gamma $
- NTD is the total days during a coupon payment d$ = d# − σ√T + ìS» − Sî
2
period - N(d$ ) represents the probability the call option
- n is the number of coupon payments per year expires in the money. Theta
- C is the annual coupon amount - 1 − N(d$ ) represents the probability the put - Theta is the change in an instrument's value for a
option expires in the money. small change in calendar time.
If accrued interest is included in the bond price
- Stock theta is zero.
quote, then F" = FV",G (S" + CC" − CB" ).

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- Option theta is negative and more pronounced Real Estate Characteristics Transaction-Based Index
the closer the option is to expiration. - Heterogeneity and fixed location Repeat sales index uses repeat sales of the same
- High unit value property.
Vega
- Vega is the change in an instrument's value for a - Management intensive Hedonic index performs regression based on
small change in volatility. - High transaction costs properties that are sold.
- VegaQ = Vega/ - Depreciation Disadvantages:
- Need for debt capital - Market trends contain random noises
- Positive for both call and put
- Illiquidity -
Rho - Price determination INVESTMENTS IN
INVESTMENTS IN REAL
REALESTATE
ESTATE THROUGH
THROUGH
- Rho is the change in an instrument's value for a PUBLICLY TRADED
PUBLICLY TRADED SECURITIES
SECURITIES
small change in the risk-free interest rate. Risk Factors of Real Estate Investment
Property demand and supply: Publicly Traded Real Estate Securities
- Positive for calls, negative for put
- Business conditions Real estate investment trusts (REITs)
Implied Volatility - Demographics - Tax-advantaged entities
- The implied volatility measure provides - Excess supply Real estate operating companies (REOCs):
information about the market consensus on price - Ordinary taxable entities
uncertainty and demand for options. Valuation:
Mortgage-backed securities (MBS):
- The volatility smile is a plot of the implied - Cost and availability of capital
- Asset-backed securitized debt obligations
volatility with respect to the exercise price. - Availability of information
- The volatility surface is a plot of the implied - Lack of liquidity Advantages and Disadvantages of REITs
volatility with respect to various combinations of - Rising interest rates Advantages:
time to expiration and exercise prices. - Liquidity
Property operations:
- Transparency
- Management
- Diversification
- Lease provisions
- High-quality portfolios
- Leverage
- Active professional management
ALTERNATIVE INVESTMENTS - Environmental
ALTERNATIVE INVESTMENTS - High, stable income
- Obsolescence
- Tax efficiency
- Recent and ongoing market disruption
INTRODUCTION
INTRODUCTIONTO
TOCOMMODITIES
COMMODITIESAND
AND Disadvantage:
COMMODITY DERIVATIVES
COMMODITY DERIVATIES Benefits of Real Estate Investment
- Lack of retained earnings
- Current income
Commodities Overview - Regulatory costs
- Price appreciation
- Energy (crude oil, natural gas, and refined - Reduced portfolio diversification benefits
- Inflation hedge
products) - Limitations on types of assets owned
- Diversification
- Grains
- Tax benefits Net Asset Value Per Share (NAVPS)
- Industrial (base) metals NAV
- Livestock Types of Leases NAVPS =
Shares outstanding
- Precious metals Gross lease: The owner pays all operating expenses MV of assets − MV of liabilities
- Softs Net lease: The tenant covers certain operating =
Shares outstanding
expenses
Spot and Futures Pricing
Triple-net lease: The tenant pays their share of Funds from Operations (FFO)
Basis: Spot price − Futures price = Accounting net earnings
common area maintenance costs, property taxes,
- Spot price > Futures price: Backwardation + Depreciation charges on real estate
and building insurance
- Spot price < Futures price: Contango Sale-leaseback: The owner sells its property and + Deferred tax charges
Calendar spread + Loss from property sales & debt restructuring
leases it back from the new owner
= Futures contract with an earlier expiration − Gain from property sales & debt restructuring
−Futures contract with a later expiration Appraisal-Based Index
Adjusted Funds from Operations (AFFO)
Relevant appraisal data in the U.S. are provided by
Components of Futures Returns = FFO − Non-cash rent − Maintenance-type capital
the NCREIF Property Index (NPI).
- Price return expenditures and leasing costs
Holding period return:
- Roll return NOI − Capex + (End. MV − Beg. MV) Advantages of Using P/FFO and P/AFFO
- Collateral return HPR =
Beginning MV - Widely accepted in global stock markets
- Rebalance return - Valuations of REITs and REOCs are easily
Disadvantages:
compared to other investment alternatives
- Appraisal lag occurs
TYPESOF
OVERVIEW OF TYPES OFREAL
REALESTATE - FFO estimates are readily available
- Volatility and correlations with other assets are
ESTATE INVESTMENTS
INVESTMENT - Multiples can be used with expected growth and
understated
leverage levels to deepen understanding
Public Private - Index requires complicated unsmoothing
techniques Disadvantages of Using P/FFO and P/AFFO
REOC shares
Direct - FFO or AFFO may not capture all intrinsic value
Equity REIT shares
Indirect (like land parcels)
ETFs/Index funds
- Does not adjust for the right recurring capex
Mortgage REITs Mortgages
- Income statement rules have changed, so P/FFO
Debt MBSs Private debt
and P/AFFO are difficult to calculate
Unsecured REIT debt Bank debt

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HEDGE
HEDGEFUND
FUNDSTRATEGIES
STRATEGIES Specialist Strategies ETF Bid-Ask Spreads
- Volatility Trading: Relative value volatility ETF spreads are typically less than or equal to the
Classification of Hedge Funds and Strategies arbitrageurs can take advantage of differences sum of the factors listed below:
Hedge Fund Characteristics in implied volatility for the same product across - Direct trading costs, such as brokerage and
- Legal/ Regulatory Overview time zones (time-zone arbitrage) or markets exchange fees, as well as creation/redemption
- Flexible Mandates (cross-asset volatility trading). fees paid to the sponsor
- Large Investment Universe - Reinsurance/Life Settlements: The sale of a life - Bid-ask spreads for the underlying securities
- Aggressive Investment Styles insurance policy to a party other than its - Compensation for the market maker’s risk of
- High Leverage originator is called a life settlement. Third-party carrying positions
- Liquidity Constraints brokers will then package the individual policies - The market maker’s desired profit spread
- High Fees that they have acquired into pools to be resold
to hedge funds. Premiums and Discounts
Equity Strategies Sources of ETF premiums and discounts
- Long/Short Equity: Buy undervalued stocks and Multi-Manager Strategies to NAV include:
sell overvalued stocks short. - Fund-of-Funds: The FoF manager will make - Timing differences
- Dedicated Short-Selling and Short-Biased: Take allocations to a diverse group of funds. - Stale pricing
short-only positions in equities but may vary the - Multi-Strategy Hedge Funds: Multiple
short positions by holding cash. teams pursuing distinct strategies within Total Costs of ETF Ownership
- Equity Market-Neutral: Use offsetting long the same organization. The main components of ETF cost are:
and short positions to establish an overall - Management fees
Multi-Manager Strategies - Trading costs (e.g., commissions, bid-ask spreads,
portfolio with near zero net exposure to equity - A conditional risk-factor model goes a step
market risk (beta). premiums/discounts)
further to account for the possibility that
- Taxes
Event-Driven Strategies factor exposures can change under different
- Tracking error
- Merger Arbitrage: Take positions based on market conditions.
- Portfolio turnover
their expectations about merger activity. - Using the example of a managed futures with
- Security lending
- Distressed Securities: Focus on firms that are exposure to equity and commodity risks, the
either already in the bankruptcy process or conditional factor model is: Trading costs are more significant for active
that are currently experiencing financial distress 𝑟𝑟qr = 𝛼𝛼 + 𝛽𝛽s 𝑅𝑅s + 𝛽𝛽t 𝑅𝑅t + 𝐷𝐷𝛽𝛽s 𝑅𝑅s + 𝐷𝐷𝛽𝛽t 𝑅𝑅t shorter-term investors.
and are expected to file for bankruptcy in the where Ongoing costs have an increasing impact on
near future. o 𝐷𝐷: Dummy variable with a value of 0 under returns for longer-term investors.
normal market conditions and 1 during crises
Relative Value Strategies o 𝐷𝐷𝛽𝛽s 𝑅𝑅s : Incremental exposure to equity risk Risks
- Fixed-Income Arbitrage: Seek to profit from during periods of market stress - Exchange-traded notes (ETNs) carry
relative mispricing. counterparty risks of default.
o Yield curve trades involve taking long and - Any fund that uses OTC derivatives will carry
short positions based on expected changes settlement risk because mark-to-market gains are
in the shape of the yield curve in response PORTFOLIO MANAGEMENT subject to default.
PORTFOLIO MANAGEMENT
to macroeconomic conditions. - ETFs often lend securities to short-sellers for
o Carry trades are executed by shorting additional income to investors, creating the risk
low-yielding bonds and purchasing
EXCHANGE-TRADED FUNDS:
EXCHANGE-TRADED FUNDS:MECHANICS AND
of counterparty default.
higher-yielding bonds.
MECHANICS AND APPLICATIONS
APPLICATIONS
- The closing of an ETF fund can trigger unexpected
- Convertible Bond Arbitrage: Seek to take The Creation/Redemption Process of ETFs tax liabilities and force investors to find another
advantage of discrepancies between the prices - ETF shares are created or redeemed continuously fund.
of an issuer’s convertible bonds and their to match supply and demand.
straight bonds. Portfolio Uses of ETF
- The primary market is over-the-counter (OTC)
- Efficient Portfolio Management
with trades between authorized participants
Opportunistic Strategies - Asset Class Exposure Management
(APs), which are large broker/dealers, and the
- Global Macro Strategies: Generally hold views - Active and Factor Investing
ETF manager (a.k.a. ETF sponsor or ETF issuer).
on macro-level economic activity based on
APs are the only investors who can create or
top-down analysis and express views by USING MULTIFACTOR
redeem new shares of an ETF. USING MULTIFACTOR MODELS
MODELS
taking positions in a variety of asset
Arbitrage Pricing Theory (APT)
classes and instruments. Tracking Error
The APT is an equilibrium pricing model, but it
- Managed Futures: A highly technical and - Tracking error is the standard deviation of return
makes these weaker assumptions:
systematic strategy that is executed using differentials between an ETF and its index.
- A factor model describes the asset returns.
primarily futures and options on futures. - Sources of ETF tracking error include:
- A well-diversified portfolio can be created to
- Fees and expenses
eliminate asset-specific risk.
- Representative sampling/optimization
- No arbitrage opportunities exist in well-
- Depository receipts and ETFs
diversified portfolios.
- Index changes
- Fund accounting practices EìR / î = R E + λ# β/,# + ⋯ + λ% β/,%
- Regulatory and tax requirements
Carhart Model
- Asset manager operations
EΩR / æ = R E + β/,# RMRF + β/,$ SMB + β/,I HML
+ β/,J WML

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Fundamental Factor Models Scenario Risk Measures
Monte Carlo Simulation Method
R ! = a! + b!# F# + b!$ F$ + ⋯ + b!u Fu + ε! - Historical scenarios are scenarios that measure
- This method allows the analyst to develop
Factors are stated as returns rather than return the portfolio return if historical markets repeat
assumptions about the statistical
surprises in relation to predicted values themselves.
characteristics of the distribution, then
- Hypothetical scenarios model the impact of
Macroeconomic Factor Models use them to generate random outcomes.
extreme movements and co-movements in
R ! = a! + b!# F# + b!$ F$ + ⋯ + b!u Fu + ε! - Advantage: Very flexible; Works well
different markets that have not previously
Asset returns are correlated with the surprises in with a portfolio that has many assets
happened.
certain factors and not constrained by the normal
- Reverse stress testing is the process of targeting
Surprise = Predicted value − Expected value distribution assumption
and stressing the portfolio’s material exposures.
- Disadvantage: Can be complex and
Factor Models in Return Attribution - Sensitivity and scenario risk measures
time-consuming to use
Active return = R v − R A complement VaR in the following ways:
u Advantages and Limitations of VaR o Sensitivity measures address some of the
Active Portfolio Benchmark
= t P. 1 −. 1 Q Advantages of VaR include: shortcomings of position size measures.
return sensitivity % sensitivity %
u<# - Simple concept o They do not have to rely on historical
Factor
× K L - Easily communicated concept volatility and correlation data, so their
return %
+ Security selection - Basis for risk comparison utility is not limited by the parameters of
- Facilitates capital allocation decisions the lookback period.
Factor Models in Risk Attribution - Can be used for performance evaluation o Normal distributions do not have
Active risk = Tracking error = s(R v − R A ) - Reliability can be verified to be assumed.
Active risk square - Widely accepted by regulators o Scenarios can target key exposures of the
= s $ (R v − R A ) portfolio, such as concentrated positions.
Limitations of VaR include:
= Active factor risk + Active specific risk - One limitation of sensitivity risk measures is they
- Subjectivity
, often do not distinguish by volatility.
- Underestimating the frequency of extreme events
Active specific risk = t(w!3)$ σ$w! - The limitations of scenario measures include:
- Failure to consider liquidity
!<# o Hypothetical scenarios are necessary to fill in
- Sensitivity to correlation risk
the gaps of historical scenarios.
Information Ratio - Vulnerability to volatility regimes
+A
+v − R o Hypothetical scenarios may incorrectly specify
R - Misunderstanding of its meaning
IR = the correlation between assets or fail to adjust
s(R v − R A ) - Oversimplification
correctly for factors such as liquidity or
- Disregard of right-tail events
concentrated positions.
MEASURING
MEASURINGAND
ANDMANAGING
MANAGINGMARKET
MARKETRISK
RISK Extensions of VaR o Hypothetical scenarios are difficult to
Understanding Value at Risk - Conditional VaR (CVaR), a.k.a. expected shortfall maintain. There is no certainty the range of
- Value at Risk (VaR) is the minimum loss expected or expected tail loss, measures the expected loss if scenarios tested is adequate.
a certain percentage of time over a certain period VaR is exceeded. o It is difficult to establish limits based on
of time. - Incremental VaR (IVaR) measures the impact of scenario analysis.
- It can be measured in currency units or as a changing a position's size within a portfolio. o Extreme hypothetical scenarios are not likely
percentage of the portfolio value. - Marginal VaR (MVaR) is similar to incremental to be taken seriously by management.
VaR in that it measures the change in VaR for a However, using only plausible scenarios could
Estimating VaR small change in a position, but it uses formulas be too limiting.
Parametric Method derived from calculus. Using Constraints in Market Risk Management
- This method (a.k.a. the analytical method or the - Relative VaR, a.k.a. ex ante tracking error, - Risk budgeting first sets limits for the entire firm,
variance-covariance method) typically estimates indicates the amount that a portfolio may deviate
then allocates the firm's overall risk budget
VaR by assuming normally-distributed returns from its benchmark.
among sub-activities. The risk will generally be
- Advantage: Simplicity; Works best when the based on ex ante tracking error or VaR.
Sensitivity Risk Measures
normal distribution assumption is reasonable and - Position limits are effective controls against
Equity Exposure Measures - Beta
the parameter estimates are reliable overconcentration. They may be specified in
E(R ! ) = R E + β![E(R M ) − R E ]
- Disadvantage: Does not work well for portfolios terms of the market value of securities or the
that contain options because the returns on Fixed-Income Exposure Measures – Duration,
notional principal of derivatives.
options are not normally distributed Convexity
- Scenario limits place limits on the loss in a given
∆A ∆O # ∆O)
Historical Simulation Method ≈ −D + C scenario. This can be used to address
A #+O $ (#+O))
- This method analyzes the return of the current shortcomings in VaR. If results are not within the
Option Risk Measures – Delta, Gamma, Vega limits, corrective action should be taken.
portfolio composition over a historical period. Dj3,C. !, Y38N. 5= 5/1!5,
The VaR is then calculated by sorting the returns ∆(delta) ≈
Dj3,C. !, Y38N. 5= N,:.68O!,C
- Stop-loss limits require changes if losses over a
from the largest loss to the largest gain and given magnitude occur in a specified period. This
Dj3,C. !, :.813
choosing the one based on the desired confidence Г(gamma) ≈ can catch trending losses that are staying just
Dj3,C. !, Y38N. 5= N,:.68O!,C
interval. below the VaR daily limits.
#
- Advantage: Can incorporate events that actually c + ∆c ≈ c + ∆Q ∆S + ГQ (∆S)$ - Capital allocation aligns risks and rewards by
$
happened and it does not require specification of placing limits on capital assigned to each of the
Dj3,C. !, Y38N. 5= 5/1!5,
a distribution or the estimation of parameters; Vega ≈ firm's activities.
Dj3,C. !, Y5831!8!1O 5= N,:.68O!,C
can also handle options
- Disadvantage: Only useful if the historical period
is representative of the future

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BACKTESTING
BACKTESTING AND SIMULATION
SIMULATION b
ETHICAL AND PROFESSIONAL STANDARDS
R V = t Δw! R ! ; Δw! = wv.! − wA,! ETHICAL AND PROFESSIONAL STANDARDS
Backtesting Process
!<#
1. Strategy design b I(A) Knowledge of the Law
2. Historical investment simulation R V = t Δw! R V! ; R V! = R ! − R A Obey strictest applicable law. Disassociate
3. Analysis of backtesting output !<# immediately from any illegal or unethical activity.
Backtesting Multifactor Models Decomposition of Value Added I(B) Independence and Objectivity
- Give equal weight to each parameter M M Do not offer or accept gifts that might impair
- Use a risk-based weighting scheme R V = t Δw* R A,* + t wv,* R V,* independence and objectivity. Gifts from clients
*<# *<#
Common Problems in Backtesting may be permissible.
- Survivorship bias: This can be combated using a Sharpe Ratio I(C) Misrepresentation
point-in-time approach Rv − RE
SR v = Cite sources. Do not plagiarize or omit important
- Look-ahead bias: This includes reporting lags, STD(R v )
information. Act quickly to correct any errors.
data revisions, and addition of new companies to
Information Ratio
indexes/databases I(D) Misconduct
Rv − RA
- Data snooping: To combat this practice, analysts IR = Does not apply to personal behavior unless it
STD(R v − R A )
may use a higher statistical t-value, perform reflects poorly on the investment profession.
cross-validation, or test theories on different data Constructing Optimal Portfolios
SR$v = SR$A + IR$ II(A) Material Nonpublic Information
Simulation Analysis Do not act or cause others to act on material
IR
Historical simulation: A non-deterministic form of STD(R V ) = STD(R A )
SR A nonpublic information. Seek public dissemination.
rolling window backtesting
Monte Carlo simulation: A model that specifies a Active Security Returns II(B) Market Manipulation
statistical distribution for the underlying data µ! = ICσ! S! Do not take any actions that distort prices or
Mean-variance active return weights trading volume. Market making and legitimate
ECONOMICS AND µ! σV
ECONOMICS ANDINVESTMENT
INVESTMENTMARKETS
MARKETS Δw!∗ = $ trading strategies are allowed.
σ! IC√BR
Pricing a default-free nominal coupon
III(A) Loyalty, Prudence, and Care
paying bond Basic Fundamental Law
Place clients’ interest above yours. Disclose
b
!
CF1+2 Expected active portfolio return
P1! = t policies on proxy voting and soft commissions.
2 E(R V)∗ = IC√BRσV
B<#
ì1 + l1,2 + θ1,2 + π1,2 î
III(B) Fair Dealing
l1,2 : yield to maturity on a real default-free Full Fundamental Law
Treat all clients fairly. Treat non-immediate family
investment today E(R V) = (TC)(IC)√BRσV
like other clients. Communicate investment
θ1,2 : expected inflation rate
Ex Post Performance Measurement recommendations and changes simultaneously.
π1,2 : compensation for uncertainty in inflation
E(R V |IC( ) = (TC)(IC( )√BRσV
III(C) Suitability
Credit Premiums and Business Cycle R V = E(R V |IC( ) + Noise
b
The portfolio’s active return variance can be Use a regularly updated IPS during investment
Õ 1+2
E1 ΩCF !
æ
P1! = t 2 divided into two parts: decisions. Evaluate decisions in a portfolio context.
B<#
ì1 + l1,2 + θ1,2 + π1,2 + γ!1,2î
- Variation due to the realized information III(D) Performance Presentation
γ!1,2 : credit premium coefficient, TC $ Performance data should be fair, accurate, and
Equities and the Equity Risk Premium - Variation due to constraint-induced noise,
complete. Do not promise returns for risky assets.
b
Õ 1+2
! 1 − TC $
E1 ΩCF æ
P1! = t 2 III(E) Preservation of Confidentiality
ì1 + l1,2 + θ1,2 + π1,2 + γ!1,2 + κ!1,2 î Ex Ante Measurement of Skill
B<# Keep all client information confidential unless:
κ!1,2 : equity premium relative to credit risky bonds σV = σ'D √Nσ(M
IC client is involved in illegal activity, you are legally
Commercial Real Estate E(R V) = σ required, or you have the client’s permission.
σ'D V
b
Õ 1+2
E1ΩCF !
æ IV(A) Loyalty
P1! = t Practical Measure of Breadth
2
ì1 + l1,2 + θ1,2 + π1,2 + γ!1,2 + κ!1,2 + ϕ!1,2 î N Get permission before taking outside work (even
B<#
BR =
ϕ!1,2 : liquidity risk premium 1 + (N − 1)ρ unpaid) that competes with employer. Abide by
non-compete agreement (if applicable) and do not
ANALYSIS
ANALYSIS OF
OF ACTIVE PORTFOLIO take employer’s property.
MANAGEMENT
MANAGEMENT
IV(B) Additional Compensation Arrangements
Measuring Value Added Obtain written permission from all parties before
RV = Rv − RA receiving any compensation for outside work.
where:
b IV(C) Responsibilities of Supervisors
R A = t wA,! R ! Supervisors must adequately train and monitor
!<#
subordinates. Responsibilities may be delegated.
b

R v = t wv,! R !
!<#

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V(A) Diligence and Reasonable Basis BA II PLUS
BACALCULATOR TIPS
II PLUS CALCULATOR TIPS
Exercise diligence and thoroughness. Support
actions with research and investigation. Basic Operations
V(B) Communication with Clients and 2ND : Access secondary functions (in yellow)
Prospective Clients ENTER : Send value to a variable
Make appropriate disclosures. Distinguish between
2ND + ENTER : Toggle between options
fact and opinion in analysis and recommendations.
↑ ↓ : Navigate between variables/options
V(C) Record Retention STO + 0 - 9 : Store current value into memory
Maintain records to support recommendations and RCL + 0 - 9 : Recall value from memory
decisions. 7-year retention period recommended.
Time Value of Money (TVM)
VI(A) Disclosure of Conflicts For annuity, loan, and bond calculations
Disclose any matters that may impair
N : Number of periods
independence and objectivity, prominently and in
I/Y : Effective interest rate per period (in %)
plain language
PV : Present value
VI(B) Priority of Transactions PMT : Payment/coupon amount
Execute clients’ transactions before accounts in FV : Future value/redemption value
which you have a beneficial interest.
CPT + one of the above : Solve for unknown
VI(C) Referral Fees 2ND + BGN : Toggle between ordinary annuity
Disclose referral fees to clients and employer, and annuity due
including non-monetary arrangements. 2ND + CLR TVM : Clear TVM worksheet
Note:
VII(A) Conduct as Participants in
- Always clear the TVM worksheet before starting
CFA Institute Program
a new calculation.
Do not share confidential exam details. Expressing
- For bonds, PMT and FV should have the same
opinions about CFAI policies is permissible.
sign, and opposite signs for PV.
VII(B) Reference to CFA Institute, the CFA
Designation, and the CFA Program Cash Flow Worksheet ( CF , NPV , IRR )
Do not misrepresent the meaning of CFA Institute For non-level payments
membership, designation, or candidacy. Input ( CF )
CF0: Initial cash flow
C01: 1st distinct cash flow after initial cash flow
F01: Frequency of CO1
C0n: nth distinct cash flow
F0n: Frequency of C0n
Note:
- Always clear the CF worksheet before starting a
new calculation.
- The use of F0n is optional. You can leave them as
1 and input repeating cash flows multiple times. If
you do so, C01 will be the cash flow at time 1, C02
will be the cash flow at time 2, and so on.
Output ( NPV , IRR )
I: Effective interest rate per period (in %)
NPV + CPT : Solve for net present value
IRR + CPT : Solve for internal rate of return

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