UWorld CFA L2 Formulasheet@2024

CFA
Level 2
Quantitative Methods
_
2 = 1 − (
n − k − 1)
n−1
Multiple Regression Adjusted R 2 = R  _
    (1 − R
 2 )
AIC = n ln( _______________ ) + 2(k + 1)

• Multiple Regression Equation Sum of squares error
   n
Multiple regression equation = Y i = b0  + b1  X1i  + b2  X2i  + . . . + b
k  Xki  + ε  i,
BIC = n ln(_______________ ) + ln (n ) (k + 1)
Sum of squares error
i = 1, 2, . . . , n     n
where: • Testing Joint Hypotheses for Coefficients
Yi = the ith observation of the dependent variable Y
Xji = t he ith observation of the independent variable Xj, (Sum of squares error restricted model −
    
 
Sum of squares error unrestricted model)/q
j = 1,2,…, k F = ________________________________________
    
      
b0 = the intercept of the equation Sum of squares error unrestricted model / (n − k − 1)
b1, . . ., bk = the slope coefficients for each of the independent
 Testing for Heteroskedasticity—The Breusch-Pagan (BP) Test
variables
εi = the error term for the ith observation χ2 = nR2 with k degrees of freedom.
n = the number of observations
n = Number of observations
Residual Term R2 = C
oefficient of determination of the second regression
(the regression when the squared residuals of the original
ε  ̂ i = Yi  − Y  ̂ i = Yi  − ( b̂   0 + b̂   1 X1i  + b̂   2 X2i  + . . . + b̂   k Xki  )
regression are regressed on the independent variables)
k = Number of independent variables
• F-statistic
Testing for Serial Correlation–The Durbin-Watson (DW) Test
SSR / k
MSR _____________
F-stat = _
    =       DW ≈ 2(1 − r); where r is the sample correlation between
MSE SSE / [n − (k + 1)]
squared residuals from one period and those from the previous
• Evaluating Regression Model Fit period.
Total variation − Unexplained variation _
SST − SSE _ SSR
R 2 = ____________________________
            =     =    
Total variation SST SST
Value of Durbin-Watson Statistic

(H0: No serial correlation)
Reject H0, Reject H0,

conclude conclude
Positive Serial Do not Reject Negative Serial
Correlation Inconclusive H0 Inconclusive Correlation
0 dl du 4 − du 4 − dl 4
Detecting Multicollinearity
VIFJ = 1/(1− RJ2).
• VIFJ > 5 warrants further investigation of the given independent variable.

• VIFJ > 10 indicates serious multicollinearity requiring correction.
Problems in Linear Regression and Solutions
Problem Effect Solution

Heteroskedasticity Incorrect standard errors Use robust standard errors (corrected for
conditional heteroskedasticity)
Serial correlation Incorrect standard errors (additional Use robust standard errors (corrected for
problems if a lagged value of the dependent serial correlation)
variable is used as an independent variable)
Multicollinearity High R2 and low t-statistics Remove one or more independent variables;
often no solution based in theory
CFA 2024 Level II Formula Sheet.indd 1 27/09/23 11:43 PM

• Influence Analysis • Autoregressive (AR) Time-Series Models
Studentized Residual A first-order autoregressive model is represented as:
e  i * __________ ei  xt  = b0  + b1  xt−1
  + ε  t
ti    * =   _   
se   *  =   √
_________  
MS Ei  (1 − hii  ) 
A pth order autoregressive model is represented as:
In the equivalent formula (on the right) the terms are based on the xt  = b0  + b1  xt−1
  + b2  xt−2
  + … + b
p  xt−p
  + ε  t
initial regression with n observations where:
e  i * is the residual with the i th observation deleted • Detecting Serially Correlated Errors in an AR Model
se* is the standard deviation of the residuals
k is the number of independent variables Residual autocorrelation for lag
t-stat = _____________________________
    
      
MSEi is the mean squared error of the regression with the i th Standard error of residual autocorrelation
observation eliminated
hii is the leverage value for the ith observation where: _
Standard error of residual autocorrelation = 1/√T
• Cook’s Distance T = Number of observations in the time series
k × MSE [ (1 − hii  )2]

e  2i  hii  • Mean Reversion
Di  = _
  _
   
b0 
xt  = _
   
Where: 1−b 1 
e  i * is the residual for observation i
• Multiperiod Forecasts and the Chain Rule of Forecasting
x ̂  t+1 = b̂   0 + b̂   1 xt 

k is the number of independent variables
MSE is the mean squared error of the estimated regression model
hii is the leverage value for observation i
• Random Walks
Practical guidelines for using Cook’s D are the following:
xt  = xt−1
  + ε  t, E( ε  t) = 0, E( ε   2t  ) = σ
2 , E( ε  t ε  s) = 0 if t ≠ s
• If Di is greater than 0.5 the ith observation may be influential and
merits further investigation. The first difference of the random walk equation is given as:
• If Di is greater than 1.0 observation is highly likely to be an
influential data point. yt  = xt  − xt−1
  = xt−1
  + ε  t − xt−1
  = ε  t, E( ε  t) = 0, E( ε   2t  ) = σ2 , E( ε  t ε  s )
_
• If Di  > √
k/n the ith observation is highly likely to be an influential = 0 for t ≠ s
data point.
• Random Walk with a Drift
• Logit Model
xt  = b0  + b1  xt−1
  + ε  t
(1 − p)
p b1  = 1, b
0  ≠ 0, or
ln _
  = b0  + b1  X1  + b2  X2  + b3  X3  + ε
xt  = b0  + xt−1
  + ε  t, E( ε  t ) = 0
• Event Probability
The first-difference of the random walk with a drift equation is
1 given as:
p = ______________________________
  
     
1 + exp [−( b
0  + b1  X1  + b2  X2  + b3  X3  )]
yt  = xt  − xt−1
  , yt  = b0  + ε  t, b0  ≠ 0
Time-Series Analysis • The Unit Root Test of Nonstationarity

• Linear Trend Models xt  = b0  + b1  xt−1
  + ε  t
yt  = b0  + b1  t + ε  t, t = 1, 2, . . . , T xt  − xt−1
  = b0  + b1  xt−1
  − xt−1
  + ε  t
xt  − xt−1
  = b0  + ( b1  − 1) x t−1
  + ε  t
where:
yt = the value of the time series at time t (value of the dependent xt  − xt−1
  = b0  + g1  xt−1
  + ε  t
variable)
b0 = the y-intercept term • The null hypothesis for the Dickey-Fuller test is that g1 = 0
b1 = the slope coefficient/trend coefficient (effectively means that b1 = 1) and that the time series has a unit
t = time, the independent or explanatory variable root, which makes it nonstationary.
εt = a random-error term • The alternative hypothesis for the Dickey-Fuller test is that
g1 < 0, (effectively means that b1 < 1) and that the time series is
• Log-Linear Trend Models covariance stationary (i.e., it does not have a unit root).
A series that grows exponentially can be described using the
• Seasonality
following equation:
xt  = b0  + b1  xt−1
  + b2  xt−n
  + ε  t
yt  = e  b  +b  t
0 1
Where n = number of periods in the seasonal pattern

where:
yt = t he value of the time series at time t (value of the dependent • Moving Average Models
variable)
b0 = the y-intercept term xt  = ε  t + θ ε  t−1, E( ε  t ) = 0, E( ε  2t  ) = σ
2 , E( ε  t ε  s) = 0 for t ≠ s
b1 = the slope coefficient
xt  = ε  t + θ ε  t−1 + … θ  q ε  t−q, E( ε  t ) = 0, E( ε  2t  ) = σ
2 , E( ε  t ε  s) = 0 for t ≠ s
t = time = 1, 2, 3, …, T
We take the natural logarithm of both sides of the equation to • Autoregressive Moving Average (ARMA) Models
arrive at the equation for the log-linear model:
xt  = b0  + b1  xt−1
  + . . . +  b p xt−p
  + ε  t + θ  1 ε  t−1+ . . . +  θ  q ε  t−q
ln yt  = b0  + b1  t + ε  t, t = 1, 2, . . . , T E( ε  t) = 0, E( ε   2t  ) = σ
2 , E( ε  t ε  s) = 0 for t ≠ s

• Autoregressive Conditional Heteroskedasticity Models (ARCH The error in period t+1 can then be predicted using the following
Models) formula:
ε  ̂ 2t  = a
0  + â   1 ε  ̂ 2t−1   + ut  σ̂   2t+1   = â   0 + â   1 ε  ̂ 2t 
Machine Learning
ML Algorithm Type Supervised/Unsupervised When to Use?

Classification and Supervised Most commonly applied to binary classification or regression.
Regression Tree (CART)
Deep Learning Net Both A form of neural network with three or more ”hidden” layers
Ensemble Learning Supervised The use of a combination of algorithms to describe the data.
Hierarchical Unsupervised A form of clustering data (separating observations into groups) into different and
final levels of clusters based on relationships between clusters.
K-Means Unsupervised A form of clustering data into a predetermined number of groups.
K-Nearest Neighbor (KNN) Supervised Mainly used for classification, by classifying new observations based on existing
data.
LASSO Supervised A type of penalized regression that also eliminates the least important features of
the regression model.
Neural Networks Both Commonly used for regression and classification in which input features (similar to
regression independent variables) are connected to the output (target) variable by
“hidden” layers of relationships.
Penalized Regression Supervised Regression technique to avoid overfitting by penalizing data features that make
insufficient contribution to the regression model.
Principal Components Unsupervised Used to help reduce the features in a data set to a manageable level.
Analysis (PCA)
Random Forest Supervised Type of ensemble learning using collection of decision trees.
Reinforcement Learning Unsupervised An algorithm that uses the experience of millions of trials and errors to maximize
future success.
Support Vector Machine Supervised Used for classification, regression, and outlier detection by finding the optimal
(SVM) boundary between sets of data points.
• LASSO Penalized Regression Constraint • Performance Evaluation
∑  (Yi  − Y ̂  i) + λ ∑  b̂   k | | Accuracy = (TP + TN)/(TP + FP + TN + FN)
n 2 K
i=1 k=1
where: FI score = (2 * P * R)/(P + R)

λ= hyperparameter set by researcher prior to learning
Precision (P) = TP/(TP + FP)
bk  = regression coefficient of kth feature (factor)
Recall (R) = TP/(TP + FN)
Big Data Projects
RMSE = ∑
______________________
n ( Predicted  − Actual  )2
• Normalization    _________________
       n
i
√ i
 
i=1
  − X 
X
Xi  (normalized) = _
i min
   
Xmax
  − Xmin  
• Standardization
Xi  − μ
Xi  (standardized) = _
  σ

Economics
Currency Exchange Rates: Understanding Equilibrium Value The forward premium (discount) on the base currency can be
expressed as a percentage as:
• Currency Cross Rates
F  PC/BC − S  PC/BC
For example, given the USD/EUR and JPY/USD exchange rates, Forward premium (discount) as a % = ___________
  
   
S  PC/BC
we can calculate the cross rate between the JPY and the EUR,
JPY/EUR as follows: The forward premium (discount) on the base currency can be
estimated as:
_ JPY _ JPY _ USD FPC/BC
  − SPC/BC
  FPC/BC
 
    =     ×    
EUR USD EUR ___________
Forward premium (discount) as a % ≈   
    = _    − 1
SPC/BC
  SPC/BC
 
• Cross Rate Calculations with Bid-Ask Spreads ≈ iPC − iBC
USD/EURbid = 1.3802
• Uncovered Interest Rate Parity
• Represents the price of EUR (base currency). Expected future spot exchange rate:
• An investor can sell EUR for USD at this price (as it is the bid
price quoted by the dealer). (1 + iFC  )
 = S  FC/DC × _
S  eFC/DC    
(1 + iDC
  )
USD/EURask = 1.3806
The expected percentage change in the spot exchange rate can
• Represents the price of EUR
be calculated as:
• An investor can buy EUR with USD at this price.
Expected % change in spot exchange rate
Determining the EUR/USDbid cross rate:
 − S  PC/BC
S  ePC/BC
 =  ____________
= %Δ S  ePC/BC     
EUR/USDbid = l/(USD/EURask) S  PC/BC
Determining the EUR/USDask cross rate: The expected percentage change in the spot exchange rate can
be estimated as:
EUR/USDask = 1/(USD/EURbid)
Expected % change in spot exchange rate ≈ %ΔSePC/BC ≈ iPC − iBC
• Forward exchange rates (F)—One-year Horizom
• Purchasing Power Parity (PPP)
(1 + i  )
F  FC/DC = S  FC/DC × _ Law of one price : P
 X  = P  X × S  FC/DC
FC
   
(1 + iDC
  ) FC DC
(1 + iPC  ) Law of one price : P

 X 
PC
= P  X 
BC
× S  PC/BC
F  PC/BC = S  PC/BC × _
   
(1 + iBC
  ) Absolute Purchasing Power Parity (Absolute PPP)
• Forward exchange rates (F)—Any Investment Horizom S  FC/DC = GPL  FC / GPL  DC
1 + ( iFC  × Actual/360) S  PC/BC = GPL  PC / GPL  BC

F  FC/DC = S  FC/DC × ________________
     
1 + ( iDC
  × Actual/360) Relative Purchasing Power Parity (Relative PPP)
1 + ( iPC  × Actual/360)
(1 + π   DC )
T
F  PC/BC = S  PC/BC × ________________
       FC
1+π
1 + ( iBC
  × Actual/360) Relative PPP : E( S  TFC/DC   _
 ) = S0 FC/DC    
• Currencies Trading at a Forward Premium/Discount Where π = inflation rate.
( 1 + ( iDC   × Actual/360) )
  − iDC
( iFC   ) × Actual/360 Ex Ante Version of PPP
F  FC/DC − S  FC/DC = S  FC/DC _________________
      
Ex ante PPP : %ΔS  eFC/DC
 ≈ π   eFC
 − π
  eDC
 
( 1 + ( iBC   × Actual/360) )
  − iBC
( iPC   ) × Actual/360
F  PC/BC − S  PC/BC = S  PC/BC _________________
       Ex ante PPP : %ΔS ePC/BC
 ≈ π   ePC
 − π
  eBC
 
• The Fisher Effect

• Covered Interest Rate Parity
Fisher Effect: i = r + πe
1 + ( i  × Actual/360)
F  PC/BC = S  PC/BC × ________________
PC
     International Fisher Effect: (iFC − iDC ) = (π eFC − π eDC)
1 + ( iBC
  × Actual/360)

Spot Exchange Rates, Forward Exchange Rates, and Interest Rates
Expected change
in
Spot Exchange Rate Forward Rate
Ex Ante PPP %ΔSeFC/DC Parity
Foreign-Domestic Forward Discount

Expected Inflation Uncovered Interest
FFC/DC − SFC/DC
Differential Rate Parity
πeFC − πeDC SFC/DC
International Fisher Covered

Effect Foreign-Domestic Interest Rate
Interest rate Parity
Differential
iFC − iDC
• Balance of Payment • Potential GDP (Labor Productivity Growth Accounting Equation)
Current account + Capital account + Financial account = 0 Growth rate in potential GDP = L
ong-term growth rate of labor
force + Long-term growth rate in
Economic Growth labor productivity
• Relationship between Economic Growth and Stock Prices • Labor Supply
otal number of hours available for work = Labor force × Average

T
P = GDP(_
GDP )( E )
E P
    _
    hours worked per worker
where: • Neoclassical Model (Solow’s Model)

P = Aggregate price or value of earnings.
   = (
[( (1 − α) )
  s ) _
]
_ Y 1 θ
E = Aggregate earnings. _      + δ + n ≡ Ψ
K
This equation can also be expressed in terms of growth rates: where:
ΔP = Δ(GDP ) + Δ(E/GDP ) + Δ(P/E) s = Fraction of income that is saved
θ = Growth rate of TFP
• Production Function α = Elasticity of output with respect to capital
δ = Constant rate of depreciation on physical stock
Y = AKα L1−α
n = Labor supply growth rate
Ψ = Equilibrium output-to-capital ratio
where:
Y = Level of aggregate output in the economy. Savings/Investment Equation:
L = Quantity of labor.
[   (1 − α) ) + δ + n]k
sy = (_
K = Quantity of capital. θ
A=T otal factor productivity. Total factor productivity (TFP)
reflects the general level of productivity or technology in the
• Growth Rates of Output Per Capita and the Capital-Labor Ratio
economy. TFP is a scale factor i.e., an increase in TFP implies a
  y = (
1 − α))
Δy
  + αs(_
    − Ψ)
proportionate increase in output for any combination of inputs. _ θ Y
_
  (
α = Share of GDP paid out to capital. K
1 − α = Share of GDP paid out to labor.
   = (
1 − α)) ( K
    − Ψ)
_ Δk θ Y
_
  (   + s _
k
y = Y/L = A (K/L)α (L/L)1−α = Akα
where: • Production Function in the Endogenous Growth Model

y = Y/L = Output per worker or labor productivity.
y  e = f( k  e ) = ck  e
k = K/L = Capital per worker or capital-labor ratio.
• Cobb-Douglas Production Function (Growth Accounting Equation)

ΔY/Y = ΔA/A + αΔK/K + (1 − α ) ΔL/L

Financial Statement Analysis
Intercorporate Investments
Summary of Accounting Treatment for Investments (US GAAP except where noted)
Business
In Financial Assets In Associates Combinations In Joint Ventures
Influence Not significant Significant Controlling Shared Control
Typical percentage Usually < 20% Usually 20%−50% Usually > 50% Varies
interest
Financial Reporting Classified as Equity method Consolidation IFRS: Equity method
Treatment • Fair value through profit
or loss
• Fair value through other
comprehensive income
• Amortized cost
Types of Business Combination • Balance Sheet Presentation of Defined Benefit Pension Plans
Combination Description Funded status = Fair value of plan assets – Pension obligation
Merger Company A + Company B = Company A Where pension obligation is either pension benefit obligation (US
GAAP) or the present value of the defined benefit obligation (IFRS).
Acquisition Company A + Company B = (Company A +
Company B) • If Pension obligation > Fair value of plan assets:
Consolidation Company A + Company B = Company C Plan is underfunded → Negative funded status →
Net pension liability.
• If Pension obligation < Fair value of plan assets:
Employee Compensation: Post-employment and
Share-based Plan is overfunded → Positive funded status → Net pension
asset.
• Reconciliation of the Pension Obligation:
• Calculating Periodic Pension Cost
Pension obligation at the beginning of the period
+ Current service costs Net periodic pension cost = E
nding net pension liability
+ Interest costs − Beginning net pension liability
+ Past service costs + Employer contributions
+ Actuarial losses
− Actuarial gains Periodic pension cost = C
urrent service costs + Interest costs
− Benefits paid + Past service costs + Actuarial losses
− Actuarial gains − Actual return on plan
Pension obligation at the end of the period
assets
• Reconciliation of the Fair Value of Plan Assets:
Under the corridor method, if the net cumulative amount of
Fair value of plan assets at the beginning of the period unrecognized actuarial gains and losses at the beginning of the
+ Actual return on plan assets reporting period exceeds 10% of the greater of (1) the defined
+ Contributions made by the employer to the plan benefit obligation or (2) the fair value of plan assets, then the
− Benefits paid to employees excess is amortized over the expected average remaining working
Fair value of plan assets at the end of the period lives of the employees participating in the plan and included as a
component of periodic pension expense on the P&L.
Components of a Company’s Defined Benefit Pension Periodic Costs
IFRS Component IFRS Recognition U.S. GAAP Component U.S. GAAP Recognition
Service costs Recognized in P&L. Current service costs Recognized in P&L.
Past service costs. Recognized in OCI and subsequently
amortized to P&L over the service life
of employees.
Net interest income/ Recognized in P&L as the Interest expense on pension Recognized in P&L.
expense following amount: obligation
Net pension liability or asset × Expected return on plan Recognized in P&L as the following
interest rate.(a) assets. amount: Plan assets × expected
return.

IFRS Component IFRS Recognition U.S. GAAP Component U.S. GAAP Recognition
Remeasurements: Net Recognized in OCI and Actuarial gains and losses Recognized immediately in P&L
return on plan assets not subsequently amortized to including differences or, more commonly, recognized in
and actuarial gains P&L. between the actual and OCI and subsequently amortized
and losses expected returns on plan to P&L using the corridor or faster
assets. recognition method.(b)
• N
et return on plan assets = • Difference between expected
Actual return − (Plan assets and actual return on assets =
× Interest rate). Actual return − (Plan assets ×
Expected return).
• A
ctuarial gains and losses • Actuarial gains and
= Changes in a company’s losses = Changes in a
pension obligation arising company’s pension obligation
from changes in actuarial arising from changes in actuarial
assumptions. assumptions.
(a) The interest rate used is equal to the discount rate used to measure the pension liability (the yield on high-quality corporate bonds.)
(b) If the cumulative amount of unrecognized actuarial gains and losses exceeds 10 percent of the greater of the value of the plan assets or of the present value of the
DB obligation (under U.S. GAAP, the projected benefit obligation), the difference must be amortized over the service lives of the employees.
Impact of Key Assumptions on Net Pension Liability and Periodic Pension Cost
Impact of Assumption on Impact of Assumption on Periodic Pension Cost and

Assumption Net Pension Liability (Asset) Pension Expense
Higher discount rate Lower obligation Pension cost and pension expense will both typically be
lower because of lower opening obligation and lower
service costs.
Higher rate of Higher obligation Higher service and interest costs will increase periodic
compensation increase pension cost and pension expense.
Higher expected return No effect, because fair value of plan Not applicable for IFRS.
on plan assets assets are used on balance sheet No effect on periodic pension cost under U.S. GAAP.
Lower periodic pension expense under U.S. GAAP.
• Multinational Operations
• The presentation currency (PC) is the currency in which the • The functional currency (FC) is the currency of the primary
parent company reports its financial statements. It is typically the business environment in which an entity operates. It is usually
currency of the country where the parent is located. For example, the currency in which the entity primarily generates and expends
U.S. companies are required to present their financial results in cash.
USD, German companies in EUR, Japanese companies in JPY, • The local currency (LC) is the currency of the country where the
and so on. subsidiary operates.
Foreign Currency
Transaction Type of Exposure Strengthens Weakens
Export sale Asset (account receivable) Gain Loss
Import purchase Liability (account payable) Loss Gain
Methods for Translating Foreign Currency Financial Statements of Subsidiaries
Current Rate/ Local Functional Presentation

T CR
Temporal Method Currency Currency Currency
Temporal Local Functional Presentation

T =
Method Currency Currency Currency
Current Rate Local Functional Presentation

= CR
Method Currency Currency Currency
• The current rate is the exchange rate that exists on the balance sheet date.
• The average rate is the average exchange rate over the reporting period.
• The historical rate is the actual exchange rate that existed on the original transaction date.

Rules for Foreign Currency Translation
Current Rate Method FC = LC Temporal Method FC = PC

Income Statement Component Exchange Rate Used
Sales Average rate Average rate
Cost of goods sold Average rate Historical rate
Selling expenses Average rate Average rate
Depreciation expense Average rate Historical rate
Amortization expense Average rate Historical rate
Interest expense Average rate Average rate
Income tax Average rate Average rate
Net income before translation gain (loss) Computed as Rev − Exp
Translation gain (loss) N/A Plug in Number
Net income Computed as Rev − Exp Computed as ΔRE +
Less: Dividends Historical rate Dividends
Change in retained earnings Computed as NI − Dividends Historical rate
Used as input for translated B/S From B/S
Balance Sheet Component Exchange Rate Used

Cash Current rate Current rate
Accounts receivable Current rate Current rate
Monetary assets Current rate Current rate
Inventory Current rate Historical rate
Nonmonetary assets measured at Current rate Current rate
current value
Property, plant and equipment Current rate Historical rate
Less: Accumulated depreciation Current rate Historical rate
Nonmonetary assets measured at Current rate Historical rate
historical cost
Accounts payable Current rate Current rate
Long-term notes payable Current rate Current rate
Monetary liabilities Current rate Current rate
Nonmonetary liabilities:
Measured at current value Current rate Current rate
Measured at historical cost Current rate Historical rate
Capital stock Historical rate Historical rate
Retained earnings From I/S To balance Used as input for
translated I/S
Cumulative translation adjustment Plug in Number N/A
Balance Sheet Exposure
Foreign Currency (FC)
Balance Sheet Exposure Strengthens Weakens
Net asset Positive translation adjustment Negative translation adjustment

Net liability Negative translation adjustment Positive translation adjustment

Effects of Exchange Rate Movements on Financial Statements
Temporal Method,
Net Monetary Liability Temporal Method, Net
Exposure Monetary Asset Exposure Current Rate Method
Foreign currency ↑Revenues ↑Revenues ↑Revenues
strengthens ↑Assets ↑Assets ↑Assets
relative to parent’s ↑Liabilities ↑Liabilities ↑Liabilities
presentation ↓Net income ↑Net income ↑Net income
currency ↓Shareholders’ equity ↑Shareholders’ equity ↑Shareholders’ equity
Translation loss Translation gain Positive translation
adjustment
Foreign currency ↓Revenues ↓Revenues ↓Revenues
weakens relative to ↓Assets ↓Assets ↓Assets
parent’s presentation ↓Liabilities ↓Liabilities ↓Liabilities
currency ↑Net income ↓Net income ↓Net income
↑Shareholders’ equity ↓Shareholders’ equity ↓Shareholders’ equity
Translation gain Translation loss Negative translation
adjustment
Analysis of Financial Institutions Evaluating Quality of Financial Reports

• Basel III Ratios of Banks • The Beneish Model
Minimum Capital Requirement M-score = − 4.84 + 0.920(DSR) + 0.528(GMI) + 0.404(AQI)

+ 0.892(SGI) + 0.115(DEPI) − 0.172(SGAI) + 4.679(Accruals)
Common Equity Tier 1 Capital
______________________ − 0.327(LEVI)
       ≥ 4.5%
RWA
Where
(RWA = Risk-Weighted Assets)
M-score = score indicating probability of earnings manipulation
Total Tier 1 Capital
______________
DSR (days sales receivable index)
  
    ≥ 6.0% = (Receivablest/salest) / (Receivablest-1/salest-1)
RWA
GMI (gross margin index) = Gross margint-1 / Gross margint
Total Capital
___________
  
  ≥ 8.0% 1 − (PPE  t + CA  t) 1 − (PPE  t-1 + CA  t-1)
RWA
AQI(asset quality index) = ____________
       ______________
    
TA t TA t-1
Liquidity Coverage Ratio (LCR)
Highly liquid assets SGI (sales growth index) = salest/salest-1

_________________
  
     ≥ 100%
Expeccted cash outflows
DEPI (depreciation index) = Depreciation ratet-1/Depreciation ratet
Net Stable Funding Ratio (NSFR) Depreciation rate = Depreciation/(PPE + Depreciation)
Available Stable Funding
__________________
   
     ≥ 100% SGAI (SG&A index) = (SGAt/Salest)/(SGAt-1/Salest-1)
Required Stable Funding
• Ratios to Analyze Insurance Companies Accruals = (income before extraordinary items – CFO)/Total assets
Loss and loss adjustment expense ratio LEVI (leverage index) = Leveraget/Leveraget-1
Loss expense + Loss adjustment expense
____________________________ Leverage = debt/assets
    
     
Net Premiums earned
• Altman Model
Underwriting expense ratio
Z-score = 1 .2(Net working capital/Total assets) + 1.4(Retained
Underwriting expense
________________
earnings/Total assets) + 3.3(EBIT/Total assets)
  
     + 0.6(Market value of equity/Book value of liabilities)
Net Premiums written
+ 1.0(Sales/Total assets)
Combined ratio
• Earnings Persistence
Loss expense + Loss adjustment expense ________________
____________________________ Underwriting expense
    
      +        
Net Premiums earned Net Premiums written Earnings  t+1 = α + β
  1 Earnings  t + ε
Dividends to policyholders or shareholders ratio Earnings  t+1 = α + β
  1 Cash flow  t + β  2 Accruals  t + ε
Dividends paid
 ________________
  
  
Net Premiums earned Integration of Financial Statement Analysis Techniques
Combined ratio after dividends • DuPont Analysis
Loss expense + Loss adjustment expense ________________
____________________________ Underwriting expense OE = Tax Burden × Interest burden × EBIT margin × Total asset
R
    
      +        
Net Premiums earned Net Premiums written turnover × Financial leverage
Dividends paid NI _ EBT _ EBIT Revenue Average Asset
+  ________________
  
   ROE = _
    ×     ×     × ___________
      × ___________
  
     
Net Premiums earned EBT EBIT Revenue Average Asset Average Equity

Financial Statement Modeling • Porter’s Five Forces
• Growth Relative to GDP Growth Approach • Threat of substitutes

• Rivalry – Intensity of competition
gS  = β  S,GDP × gGDP
  • Bargaining power of suppliers
A company’s sales growth rate based on sensitivity of its growth • Bargaining power of customers
rate to the country growth rate. • Threat of new entrants – Based on profitability of the market,
barriers to entry, etc.
• Market Growth and Market Share Approach
gS  = (1 + g
M  )(1 + gMS
  ) − 1
A company’s sales growth rate based on market growth and

growth of the company’s share in that market.

Corporate Issuers
Analysis of Dividends and Share Repurchases t = the marginal tax rate

wp = weight of preferred stock
• Stable Dividend Policy rp = required return on preferred stock
The expected increase in dividends is calculated as: we = weight of common equity
re = required return on common equity
Expected dividend increase = (Expected earnings × Expected
payout ratio − Previous dividend) • Cost of Debt
× Adjustment factor
rd = rf + Credit spread
• EPS Effects of Share Buyback (rf = the risk-free rate)
(Earnings − After-tax cost of funds)
PS after buyback = _________________________
E    
      • CAPM
Shares outstanding after buyback
Re = Rf + (β × ERP)
• Analysis of Dividend Safety
ERP = Equity Risk Premium
Dividend payout ratio = (dividends / net income)
• Expanded CAPM
Dividend coverage ratio = (net income / dividends)
Re = Rf + (βpeer × ERP ) + SP + IP + SCRP
FCFE coverage ratio = FCFE / [Dividends + Share repurchases]
• Dividend Discount Model Estimate for Expected ERP
Cost of Capital: Advanced Topics
( V0  )
D1 
ERP = E _
    + E(g) − r f 
• Weighted Average Cost of Capital (WACC)
WACC = wd rd(1 − t) + wprp + were • Grinold-Kroner Estimate for Expected ERP

(Note: the weights are non-negative and must sum to 1)
ERP = [ DY + Δ(_
  ) + i + g − ΔS] − E( rf  )
P
wd = weight of debt E
rd = required return on debt
In the Grinold-Kroner decomposition of the return on equity:
Factor Symbol Common Proxy

Expected income component DY Broad-based market index dividend yield
Expected growth rate in P/E ∆P/E Analyst adjustment for market overvaluation or undervaluation
Expected inflation i Nominal yield less real yield for securities with similar maturities
Expected growth rate in real earnings per share g
Real GDP growth
Expected change in shares outstanding ∆S Depends on the market and time period
• Risk-Based Models: CAPM where RMW is the average difference in equity returns between
companies with robust and weak profitability and CMA is the
r e  = rf  + β̂ (ERP) average difference in equity returns between companies with
The beta is commonly estimated using the market model. This conservative and aggressive investment portfolios.
model involves performing a linear regression on actual historical • Expanded CAPM
returns for the stock and the market to estimate the beta.
re  = rf  + β  peer + SP + IP + SCRP
( ri,t  − rf,t  ) = b0  + b1  ( rm,t
  − rf,t  ) + ε  r
Where:
• Risk-Based Models: Fama-French Models βpeer = beta of peer group of publicly traded companies
Three factor model: SP = size premium
IP = industry risk premium
re  = rf  + β  1 (ERP ) + β  2 (SMP ) + β  3 (HML) SCRP = specific company risk premium
where SMB is the size premium (the average difference in equity • Build-Up Approach
returns between companies with small and large capitalizations)
and HML is the value premium (the average difference in equity re  = rf  + ERP + SP + SCRP
returns between companies with high and low book-to-market • Country Risk Rating Models
ratios.
The five-factor Fama-French model adds a profitability factor ERP = ERP for a developed market + (λ × CRP)
(RMW) and an investment factor (CMA): Where:
re  = rf  + β  1 (ERP ) + β  2 (SMB ) + β  3 (HML ) + β  4 (RMW ) + β
  3 (CMA) λ = level of exposure of company to the local country
CRP = country risk premium

σ  Equity Corporate Restructuring
Country risk premium = sovereign Yield spread × _
 σ   
Bond • Premium Paid Analysis
• International CAPM (DP − SP)
PRM = _
 
E( re  ) = rf  + β  G (E( rgm
  ) − rf  ) + β  c (E( rc  ) − rf  ) SP
Where: where:
βG = beta relative to global market PRM = takeover premium
βc = beta relative to foreign currency index DP = deal price per share of the target
E(rgm) = expected return of global market SP = unaffected stock price of the target
E(rc) = expected return of foreign currency index

Equity
Equity Valuation: Applications and Processes • The H-Model
• Perceived mispricing: D  0 (1 + g  L ) D  0 H( g  s − g  L )
V  0 = _
  r − g    + _   
  r − g   
L L
Perceived mispricing = True mispricing + Error in the estimate of
intrinsic value. gs = Short-term high growth rate
gL = Long-term sustainable growth rate
V  E− P = (V − P)+ (V  E − V)
r = Required return
VE = Estimate of intrinsic value H = Half-life = 0.5 times the length of the high growth period
P = Market price
The H-model equation can be rearranged to calculate the required
V = True (unobservable) intrinsic value
rate of return as follows:
( P  0 )
Discounted Dividend Valuation D  0
r = _
    [(1 + g  L ) + H( g  s − g  L )] + g  L
• One-Period DDM
D  1 P  1 D  1 + P  1 The Gordon growth formula can be rearranged to calculate the
V  0 = _
    + _
    = _
    required rate of return given the other variables.
(1 + r)1 (1 + r)1 (1 + r)1
V0 = The value of the stock today (t = 0) D  1
r = _
   + g
P1 = Expected price of the stock after one year (t = 1) P  0
D1 = E
xpected dividend for Year 1, assuming it will be paid at the
end of Year 1 (t = 1) • Sustainable Growth Rate (SGR)
r = Required return on the stock g = b × ROE
• Multiple-Period DDM b = Earnings retention rate, calculated as 1 − Dividend payout ratio
D  D  P  • Basic DuPont Analysis
V  0 = _ _ _
1 n n
  1  + … +   n  +   n 
(1 + r) (1 + r) (1 + r)
V  0 = ∑   _

Net income _ Sales _____________________________
Assets
n D  t P  n ROE = ________________
    ×     ×   
     
  + _
 
)t ( 1 + r)n
  Sales Assets Shareholders’ equity
t =1 1 + r
(
= Profit margin × Asset turnover × Financial leverage
• Expression for Calculating Value of a Share of Stock
• PRAT model
  0 = ∑   _
∞ D 
t
V   (   g = b × ROE
t =1 1 + r
)t
Net income − dividends
• Gordon Growth Model = ________________________________
  
       × ROE
Net income
D  0( 1 + g) D  1
V  0 = _
  (r − g) , or V  0 = _
  (r − g)  Net income – Dividends _ Net income _ Sales
g = __________________
   
       ×     ×    
Net income Sales Total assets
• Present Value of Growth Opportunities Total assets
_______________
×   
     
Shareholders’ equity
E  1
V  0 = _
  r + PVGO Free Cash Flow Valuation
• FCFF/FCFE
• P/E Ratio
Firm Value = ∑
∞ FCFF  t
P  0 D  1 / E  1 _ (1 − b)    _
   
Justified leading P/E ratio = _
    =  _   =     (
1 + WACC)t
E  r − g r − g
t =1
1
D1/E1 equals the dividend payout ratio, which can also be MV(Debt)
WACC = __________________
      rd  (1 − Tax Rate )
  
expressed as (1– b). b is the retention ratio. MV(Debt ) + MV(Equity)
MV(Equity)
P  0 D  1 / E  0 _ D  0(1 + g) / E  0 _
(1 − b)(1 + g) + __________________
   
    r
Justified trailing P/E = _
    = _     =   MV(Debt ) + MV(Equity)
E  0 r − g r − g  =   r − g 
Equity Value = Firm Value − Market value of debt
D0/E0 equals the dividend payout ratio, which can also be
Equity Value = ∑   _

expressed as (1 – b). ∞ FCFE 
t
  t 

• Value of Fixed-Rate Perpetual Preferred Stock t =1 (1 + re )
D • Computing FCFF from Net Income

V  0 = _
  r 
FCFF = NI + NCC + Int(1 − Tax Rate ) − FCInv − WCInv
• Two-Stage Dividend Discount Model
Investment in fixed capital (FCInv)
V  0 = ∑    _
n D  (1 + g  )t D  (1 + g  )n (1 + g  )
0 S _______________
0 S L
t  +    
     CInv = Capital exp enditures − Proceeds from sale of long-term
F
t =1 (1 + r)
n
(1 + r) (r − g  L )
assets
gs = Short-term supernormal growth rate
gL = Long-term sustainable growth rate
r = required return
n = Length of the supernormal growth period

Investment in working capital (WCInv) • Constant Growth FCFF Valuation Model
WCInv = Change in working capital over the year FCFF  1 FCFF  0 (1 + g)
Value of the firm = _
    = _
  
   
WACC − g WACC − g
orking capital = Current assets (exc . cash ) − Current liabilities
W
(exc . short-term debt) WACC = Weighted average cost of capital
Noncash Items and FCFF g = Long-term constant growth rate in FCFF
• Constant Growth FCFE Valuation Model

Adjustment to NI to
Noncash Item Arrive at FCFF FCFE  1 FCFE  0 (1 + g)
Value of equity = _
  r − g  = _
  
  r − g 
Depreciation Added back
Amortization and impairment of Added back r = Required rate of return on equity
intangibles g = Long-term constant growth rate in FCFE
Restructuring charges (expense) Added back • An International Application of the Single-Stage Model
Restructuring charges (income Subtracted FCFE  0 (1 + g  real )
resulting from reversal) Value of equity =  ____________
   r  
  − g   
real real
Losses Added back

• General Expression for the Two-Stage FCFF Model
Gains Subtracted
Firm value = ∑
Amortization of long-term bond Added back
n FCFF  t FCFF  n+1 _ 1
    _ _
t  +        
discounts t =1 (
1 + WACC) (WACC − g) (1 + WACC)n
Amortization of long-term bond Subtracted Firm value = PV of FCFF in Stage 1 + Terminal value × Discount
premiums Factor
Deferred taxes Added back but requires • General Expression for the Two-Stage FCFE Model
special attention
Equity value = ∑
nFCFE  FCFF  n+1 _1
    _tt  +  _      
t =1 (1 + r) (r − g) (1 + r)n
• Computing FCFF from CFO
IFRS versus U.S. GAAP Treatment of lnterest and Dividends Equity value = PV of FCFE in Stage 1 + Terminal value × Discount
Factor
IFRS U.S. GAAP
• Non-operating Assets and Firm Value
Interest received CFO or CFI CFO
alue of the firm = Value of operating assets + Value of non-
V
Interest paid CFO or CFF CFO operating assets
Dividend received CFO or CFI CFO
Market-based Valuation: Price And Enterprise Value
Dividends paid CFO or CFF CFF
Multiples
FCFF = CFO + Int(1 − Tax rate ) − FCInv • Price to Earnings Ratio
Current Stock Price

• Computing FCFF from EBIT Trailing P/E ratio = ______________
  
      
Last year’s EPS
FCFF = EBIT(1 − Tax rate ) + Dep − FCInv − WCInv Current Stock Price
Forward P/E ratio = ______________
  
      
Expected EPS
• Computing FCFF from EBITDA
• Earnings Yield
FCFF = EBITDA(1 − Tax rate ) + Dep(Tax rate ) − FCInv − WCInv
E P
Earnings Yield = _
  = Inverse _
 
• Computing FCFE from FCFF P E
FCFE = FCFF − Int(1 − Tax rate ) + Net borrowing • Price to Book Ratio
• Computing FCFE from Net Income Market price per share

P/B ratio =  ________________
      
Book value per share
FCFE = NI + NCC − FCInv − WCInv + Net Borrowing
Market value of common shareholders’ equity
P/B ratio = ________________________________
    
       
• Computing FCFE from CFO Book value of common shareholders’ equity
FCFE = CFO − FCInv + Net borrowing Book value of equity = Common shareholders’ equity
= Shareholders’ equity − Total value of equity claims that are senior
• Computing FCFE from EBIT to common stock
FCFE = E
BIT(1 − Tax rate ) − Int(1 − Tax rate ) + Dep − FCInv − WCInv Book value of equity = T
otal assets − Total liabilities
+ Net borrowing − Preferred stock
• Computing FCFE from EBITDA • Price to Sales Ratio

FCFE = E
BITDA(1 − Tax rate) − Int(1 − Tax rate) + Dep(Tax rate) Market price per share
− FCInv − WCInv + Net borrowing P/S ratio = ________________
  
      
Sales per share

Relationship between the P/E ratio and the P/S ratio • Terminal price based on fundamentals
P/E × Net profit margin = (P / E) × (E / S) = P/S TV  n= Justified leading P/E × F orecasted earnings n+1
       
TV  n= Justified trailing P/E × Forecasted e arnings n
• Price to Cash Flow Ratio
• Terminal price based on comparables
Market price per share
P/CF ratio = __________________
  
     
Free cash flow per share TV  n= Benchmark leading P/E × F orecasted earnings n+1
       
TV  n= Benchmark trailing P/E × F
orecasted earnings n
• Dividend Yield
Justified trailing dividend yield • Justified P/B Multiple Based on Fundamentals
Trailing dividend yield = Last year’s dividend / Current price per _

P  ROE − g
    = _
0
  r − g 
share B  0
Justified leading dividend yield ROE = Return on equity

r = required return on equity
Leading dividend yield = Next year’s dividend / Current price per
g = Sustainable growth rate
share
• Justified P/S Multiple Based on Fundamentals
• Justified P/E Multiple Based on Fundamentals
Justified leading P/E multiple P 
_
( E  /S  ) (1 − b ) (1 + g)
    =  ________________
0 0 0
   r − g 
S  0
D  1
V  0 = _
   
(r − g) E0/S0 = Net profit margin
P  D  /E 
(1 − b) 1 − b = Payout ratio
Justified leading P/E = _
    =  _   = _
0 1 1
   
E  r − g r − g
1 • Justified P/CF Multiple Based on Fundamentals
(1 − b) is the payout ratio. FCFE  0 (1 + g)
V  0 = _
     
Justified trailing P/E multiple (r − g)
P  0 D  1 /E  0 _ D  0 (1 + g ) / E  0 _
(1 − b ) (1 + g) • Justified Dividend Yield
Justified trailing P/E =  _  = _     =     r − g  =   r − g 
E  0 r − g D  0 r − g
_
    =  _ 
• P/E-to-growth (PEG) ratio P  0 1+g
P/E • EV/EBITDA Multiple

PEG =  _ 
Growth ( % )
Enterprise value = M
arket value of common equity + Market value
• Own historical P/E of preferred stock + Market value of debt
+ Minority interest − Value of cash and short-
Current
Justified   Benchmark
Price  = Historical
   P/E × Earnings
  term investments
Alternative Denominators in Enterprise Value Multiples
Free Cash Net Income plus minus Tax plus plus less less Investment
Flow to the Interest Savings on Depreciation Amortization Investment in in Fixed Capital
Firm = Expense Interest Working Capital
EBITDA = Net Income plus plus plus plus
Interest Taxes Depreciation Amortization
Expense
EBITA = Net Income plus plus plus
Interest Taxes Amortization
Expense
EBIT = Net Income plus plus
Interest Taxes
Expense
• Justified forward P/E after accounting for Inflation • Unexpected earnings (UE)
P  1 UE  t = EPS  t − E( EPS  t )
 _  =  _ 
0
E  1 ρ + (1 − λ ) I
• Standardized unexpected earnings (SUE)
λ = The percentage of inflation in costs that the company can pass
EPS  t − E( EPS  t )
through to revenue. SUE  t = ______________
   
   
ρ = Real rate of return σ[EPS  t − E( EPS  t )]
I = Rate of inflation
EPSt = Actual EPS for time t
E(EPSt ) = Expected EPS for time t
σ[EPSt − E(EPSt )] = Standard deviation of [EPSt − E(EPSt )]

V  0 = B  0 + ∑   ___________
Residual Income Valuation ∞ ( ROE  − r) B 
t t−1
  
   
• Residual Income – Equity Charge Method t =1 (1 + r )t
Residual income = Net income − Equity charge ROE − r

V  0 = B  0 + _
  r − g  B  0
Equity charge = B VCE
  × rCE
 
• Clean Surplus Relation
Where BVCE = Beginning-of-period book value of common equity
and rCE = Required return on common equity Bt  = Bt−1
  + Et  − Dt 
• Residual Income – Capital Charge Method This relationship describes all changes to equity as having gone
through the income statement.
Residual income = EBIT(1 − Tax rate) − Capital charge
Capital charge = (B VCE
  × rCE
  ) + [B VD  × rD  (1 − t )] • Tobin’s q
Where BVCE = Beginning of period book value of debt, rD = Market value of debt and equity
Tobin’s q =  ______________________
   
    
Required return on debt, and t = effective tax rate Replacement cost of total assets
The equity method and capital method yield the same residual
• Multi-Stage Residual Income Valuation
income if 1) after-tax interest expense for net income equals that
V  0 = B  0 + ∑   _

used for the capital charge, and 2) capital charge weights for debt T ( E  − rB  ) P  T − B  T
 
t
t 
t-1
+  _  
and equity are derived from beginning of period book values. t =1 (
1 + r) (1 + r)T
Using WACC based on target values to calculate the capital charge
When residual income fades over time as ROE declines towards
will not yield the same residual income under the capital charge
the required return on equity, the intrinsic value of a stock is
method as under the equity charge method.
calculated using the following formula:
V  0 = B  0 + ∑   _

• Economic Value Added T-1 ( E  − rB  )
t t−1
E  T − rB  T−1
_______________
  t  +   
     
EVA = NOPAT − (C % × TC) t =1 (
1 + r) (1 + r − ω) (1 + r)T−1
NOPAT = Adjusted net operating profit after tax = EBIT (1 − Tax rate) ω = Persistence factor.
C% = Cost of capital (WACC using book value weights)
• Implied Growth Rate
TC = Beginning-of-period adjusted total capital
[ V  0 − B  0 ]

(ROE − r ) × B  0
Both NOPAT and total capital are adjusted to capitalize and g = r − ____________
     
amortize rather than expense R&D, suspend the capital charge on
strategic investments until they yield revenue, add LIFO reserve
back to capital, eliminate deferred taxes, treat operating leases as Private Company Valuation
capital leases, and adjust non-recurring items.
• The Capitalized Cash Flow Method
• Market Value Added
FCFF  1
V  f = _
   
MVA = Market value of the company − Accounting book value of WACC − g  f
total capital
Vf = Value of the firm
Market value of company = Market value of debt + Market value of FCFF1 = Free cash flow to the firm for next twelve months
equity. WACC = Weighted average cost of capital
gf = Sustainable growth rate of free cash flow to the firm
• The Residual Income Model
FCFE  1
RI  t = E  t − (r × B  t−1 ) V =  _ r − g 
RIt = Residual income at time t
V = Value of equity
Et = Earnings at time t
FCFE1 = Free cash flow to the equity for next twelve months
r = Required rate of return on equity r = Required return on equity
Bt–1 = Book value at time t–1 g = Sustainable growth rate of free cash flow to equity
Intrinsic value of a stock: • Discount for Lack of Control (DLOC)
0  = B0  + ∑   _ = B0  + ∑   _

∞ RI  t ∞ E  − r B 
DLOC = 1 − [_______________
     ]
V   t   
t t−1
t 
1
i =1 (
1 + r) i =1 (1 + r) 1 + Control premium
V0 = Intrinsic value of the stock today
• Discount for Lack of Marketability (DLOM)
B0 = Current book value per share of equity
Bt = Expected book value per share of equity at any time t
DLOM = 1 − [ ___________________
1 + Marketability premium ]
1
   
    
r = Required rate of return on equity
Et = Expected EPS for period t
RIt = Expected residual income per share • Combining Discounts
• Residual Income Model (Alternative Approach) V  EI = V  EO(1 − DLOC)(1 − DLOM)
RI  t = EPS  t – (r × B  t−1 ) Where VEI = value of equity indicated after discounts and VEO =
value of equity in operations
RI  t = ( ROE  t – r) B  t−1
NOTE: These calculations must be performed to first recognize
Where ROEt is calculated using net income during period t, and the lack of control in a position and then whether the equity is not
beginning-of-period book value rather than average equity over easily marketable.
the period.

Fixed Income
The Term Structure and Interest Rate Dynamics • Effective Duration
• Discount Factor ( PV  − ) − ( PV  + )

Effective Duration = _______________
  
     
2 × (Δ Curve ) × P V 0
1
D FN  = _
   
(1 + ZN  )N ΔCurve = the magnitude of the parallel shift in the benchmark yield
curve (in decimal).
Where
PV– = Full price of the bond when the benchmark yield curve is
DFN is the discount factor with maturity N shifted down by ΔCurve.
ZN is the spot rate PV+ = Full price of the bond when the benchmark yield curve is
• Forward Rate Model shifted up by ΔCurve.
PV0 = Current full price of the bond (i.e., with no shift).
(1 + z B  )B = ( 1 + zA  )A (1 + fA,B−A
  )B−A

Properties of Effective Durations of Cash and Common Types of
Where fA,B−A
  is the (B-A)-period forward rate at A Bonds
• Relationship between the Spot Rate and One-Period Forward Type of Bond Effective Duration
Rates
Cash 0
[1 + z(T )]T = [1 + z(1)][1 +  1 f1  ][1 +  1 f2  ]...[1 +  1 fT−1
  ] Zero-coupon bond ≈ Maturity
z(T ) = {   ]}⁄ − 1
[1 + z(1)][1 +  1 f1  ][1 +  1 f2  ]...[1 +  1 fT−1 1 T
Fixed-rate bond < Maturity

• Swap Rates Callable bond ≤ Duration of straight bond
∑  _
T
s(T) 1 Putable bond ≤ Duration of straight bond
    + _
   − 1 = 0
( )]t [1 + z(t)]t
[
t =1 1 + zt Floater (Libor flat) ≈ Time (in years) to next reset
∑  _
T
s(T) 1
    + _
   = 1
( )]t [1 + z(t)]t
[
t =1 1 + zt • Effective Convexity
( PV  − ) + ( PV  + ) − 2( PV  0 )
Where the swap rate, s, solves the equation given the spot rate at Effective Convexity = ___________________
    
    
initiation, z(t). (The value of the swap at initiation is 0; therefore, the (Δ Curve)2 × PV  0
floating rate side of the equation always equals 1.)
• Floating-Rate Securities
• Swap Spread
Value of capped floater = V
alue of uncapped floater – Value of
Swap spread = Swap rate − YT  embedded cap.
The swap spread is the difference between the fixed rate side Value of embedded cap = V
alue of uncapped floater – Value of
of a swap and most recently issued government security with capped floater
equivalent maturity. Swap spreads help investors determine the Value of floored floater = V
alue of non-floored floater + Value of
time value, liquidity risk, and credit risk components of a bond’s embedded floor.
yield.
Value of embedded floor = V
alue of floored floater – Value of non-
floored floater
The Arbitrage-Free Valuation Framework
• Arbitrage-Free Value of an Option-Free, Fixed-Rate Coupon Bond • Convertible Bonds
Conversion value = M
arket price of common stock × Conversion
Bn  = 0.50 × [ _
1 + i) ]
VH + C _ VL + C
  (   +   (   ratio
1 + i)
Where Bn = the bond value at any node, n, VH and VL are the high Market price of convertible security
Market conversion price = __________________________
   
       
and low values assumed by the bond corresponding to node n Conversion ratio
based on the high and low forward rates, and C is the fixed-rate
coupon. Market conversion premium per share = M
arket conversion price
− Current market price
• Calibrating the Rates in a Binomial Tree
Market conversion premium ratio
r1,H = r1,L × e2(σ) where σ is the standard deviation (a measure of
Market conversion premium per share
volatility) =  ___________________________
    
     
Market price of common stock
• Valuation and Analysis: Bonds with Embedded Options Market price of convertible bond
Premium over straight value = ________________________
   
      − 1
Value of callable bond = Value of straight bond – Value of embed- Straight value
ded call option
• Valuation of a convertible bond that is not callable or putable:
Value of embedded call option = Value of straight bond – Value of
callable bond Convertible security value = S
traight Value + Value of the call
option on the stock
Value of putable bond = Value of straight bond + Value of embed-
ded put option • Valuation of a convertible bond that is callable but not putable:
Value of embedded put option = Value of putable bond – Value of Convertible callable bond value = S
traight value + Value of the call
straight bond option on the stock − Value of
the call option on the bond

• Valuation of a convertible bond that is callable and putable: • CDS Spreads
Convertible callable and = Straight value CDS Spread ≈ (1 − RR) × POD
putable bond value + Value of the call option on the stock Where RR is the Recovery Rate and POD is the Probability of Default
− Value of the call option on the bond
• Upfront Premium
+ Value of the put option on the bond
Upfront Premium = PV(Protection leg) − PV(Premium leg)
Credit Analysis Models ≈ (Credit spread − Fixed coupon) × Duration
• Change in Bond Price
• CDS Pricing
– Modified duration × (New credit rating credit spread – Original
PCDS
  per 100 par = 100 − Upfront premium %
credit rating credit spread)
≈ 100 − [ (Credit spread − Fixed coupon)
× Duration in years]
Credit Default Swaps
• Settlement Protocols • CDS Profit/(Loss)
Payout amount = Payout ratio × notional Protection buyer’s Π = %Δ P

CDS
  × Notional
= (1 − % recovery rate)× notional = Δ Sbps
  × D × Notional
Where payout ratio is an estimate of the percentage credit loss on The percentage price change in the CDS equals the bp change in
the CDS spread multiplied by duration.

Derivatives
Pricing and Valuation of Forward Commitments • Pricing Fixed-Income Forward and Futures Contracts
• Valuing a Forward Contract at Expiration (t = T) Accrued interest = Accrual period × Periodic coupon amount
Value of long position: AI = (NAD/NTD ) × (C/n)
V  T (T ) = S  T − F  0 (T) where:

NAD = Number of accrued days since the last coupon payment.
Value of short position: NTD = Number of total days during the coupon payment period.
V  T (T ) = F  0 (T ) − S  T C = Stated annual coupon amount.
n = Number of coupon payments per year.
• Valuing a Forward Contract at Initiation (t = 0)
• Accrued Interest
V0(T) = S0 – [F0(T) / (1 + r)T]
S0 = Quoted bond price + Accrued interest = B0 + AI0
• Valuing a Forward Contract During Its Life (T = t)
• Valuing Currency Swaps
Vt(T) = St – [F0(T) / (1 + r)T–t]
Va  = Ba  − S0  Bb 
V  t(T ) = PV of differences in forward prices = PV t,T [F  t (T ) − F  0 (T )] Where the currency a value of the swap equals the difference
between the currency a fixed bond and the currency a value of the
where PVt,T( ) means the present value at time t of an amount paid in
currency b bond.
T – t years (or at time T).
• Valuing Equity Swaps
Value of a Forward Contract
Pay-fixed, receive-return-on-equity
Time Long Position Value Short Position Value
[(1 + Return on equity) * Notional amount] – PV of the remaining
At initiation Zero, as the contract Zero, as the contract fixed-rate payments
is priced to prevent is priced to prevent
arbitrage arbitrage Pay-floating, receive-return-on-equity
S  t − [
1 + r)T – t]
[_
1 + r)T – t]
During life of F  0 (T) F  0 (T) [(1 + Return on equity) * Notional amount] – PV (Next coupon
the contract _
  (     (   − S  t payment + Par value)
At expiration ST – F0(T) F0(T) – ST Pay-return-on-one-equity-instrument, receive-return-on-another-
equity-instrument
• Carry Arbitrage Model when the Underlying has Cash Flows [(1 + Return on Index 2) * Notional amount] – [(1 + Return on Index 1)
F0  = FV[S0  + C C0  − C B0  ] * Notional amount]
Where CC is the carry costs and CB is the carry benefits

Valuation of Contingent Claims
• Valuing a Forward Contract When the Underlying Has Carry
• Binomial Option Valuation – No Arbitrage Approach
Benefits/Costs
S+  S− 
V  t(T ) = PV of differences in forward prices = PV t,T [F  t (T ) − F  0 (T )] u = _
  , d =  _
S S
With continuous compounding, the forward price is calculated as:
Where up u and down d describe factors that can be applied to a
F0  = S0  e  (r  +CC−CB)T
C
price to find the new price after an up or down movement.
• Pricing a Forward Rate Agreement c +− c  − p +− p  −

h =  _  > 0, h = _
  +  < 0
S+  − S −  S  − S
− 
⎢ ⎥
⎡ ⎤
1 + L  0(h + m)(_
360 )
h+m
   
________________ Where the hedge ratio h identifies the long position in the
RA(0,h,m)=    
F     − 1
( 360 )
h underlying to be purchased to offset the call or put price
1 + L  (h) _
⎣
    0 ⎦
fluctuations.
where: −  + c  − )

c = hS + PV( −h S
FRA(0,h,m) = The annualized rate on an FRA initiated at Day 0,
p = hS + PV( −h S
+  + p
 + )
expiring on Day h, and based on m-day Libor
h = Number of days until FRA expiration For a two-period binomial model, terminal values for the options
m = Number of days in underlying hypothetical loan are:
h + m = Number of days from FRA initiation until end of term of
underlying hypothetical loan c++ = Max(0,S++ – X) = Max(0,u2S – X),
L0 = (Unannualized) Libor rate today c+– = Max(0,S+– – X) = Max(0,udS – X)
c– – = Max(0,S– – – X) = Max(0,d2S – X)
A generic formula used to compute the settlement payment of an
FRA to the long position is: p++ = Max(0,X – S++) = Max(0,X – u2S),
p+– = Max(0,X – S+–) = Max(0,X – udS)
FRA payoff = NP × [(Market Libor − FRA rate ) × No. of p– – = Max(0,X – S– –) = Max(0,X – d2S)
    
days in the loan term / 360]  
____________________________________________
     
       
= 1 + [Market Libor × (No. of days in the loan And put or call value will be the present value of the terminal value
  for the option. The risk-free rate is used for discounting, and must
term / 360)]
be compounded over two periods.

• Binomial Option Valuation – Expectations Approach The risk-free rate is used for discounting, and must be
compounded over two periods.
E(c 1) = π c   + (1 − π) c −
+
E(p 1) = π p ++ (1 − π) p − • The Black-Scholes-Merton (BSM) Option Valuation Model
π = [FV(1) − d]/( u − d)= (1 + r − d)/( u − d) c = SN( d  1 ) − e−r T XN( d  2 )
Where π is the probability of an up move. p = e−r T XN(−d  2 ) − SN(−d  1 )
r  [E( c1  )]

c = P V where:
p = P Vr  [E( p1  )] ln(S/X)+ (r _ +σ 2 / 2)T

d  1 = _______________
        
σ√ T  
_
Where r is the risk-free rate. d  2 = d  1 − σ √
T 
For a two-period binomial model, expected option payoffs are: σ, = T he annualized standard deviation of the continuously
compounded return on the stock.
E( c2  ) = π2 c +++ 2π(1 − π) c +− + ( 1 − π)2 c −− r = The continuously compounded risk-free rate of return.
E( p2  ) = π2 p +++ 2π(1 − π) p +− + ( 1 − π)2 p −− N(d1) = C umulative normal probability of d1. For example, if d1
is 0.8252, then N(d1) will be 0.7954 (look up the normal
The present value of the payoffs determines the call and put values: distribution table).
c = PV[E( c2  )]
p = PV[E( p2  )]
BSM and Binomial Option Valuation Model Comparison
Call Option Put Option

Option Valuation Model Terms Underlying Financing Underlying Financing
Binomial model hS PV(–hS– + c–) hS PV(–hS– + p–)
BSM model N(d1)S –N(d2)e X
–rT
–N(–d1)S N(–d2)e–rTX
• The carry-benefit-adjusted BSM model is as follows: where:

AP = Accrual period in years
c = Se N( d  1 ) − e XN( d  2 )
−γ T −rT
ln[FRA(0, t  j−1, t  m ) /R  X]+ (σ2 /2) t  j−1
p = e−rT
XN(−d  2 ) − Se−γ T N(−d  1 ) d  1 = ________________________
   
     _ 
σ√ t  j−1 
_
where: d  2 = d  1 − σ √
t  j−1 
ln(S/X)+ (r − γ + σ2 / 2)T
d  1 = __________________
       _ 
σ√ T  • Swaptions
_
d  2 = d  1 − σ √
T
  Payer swaption = (AP) PVA [R FIX N( d  1 ) − R  X N( d  2 )]
• Carry-benefit-adjusted put-call parity: Receiver swaption = (AP) PVA [ R  X N(−d  2 ) − R  FIX N(−d  1 )]
p + Se−γ T= c + e−r T X where:
PVA = P
V of annuity matching the forward swap payment based on
• The Black Model
a notional amount of 1.
Under the Black model, European-style options on futures are AP = Accrual period.
valued as:
ln ( R  FIX /R  X ) + ( σ2 /2 ) T
d  1 = ________________
       _ 
c = e−rT[F  0(T)N(d  1) − XN( d  2 )] σ√ T  
_
p = e−rT[XN(−d  2 ) − F  0(T)N(−d  1 )] d  2 = d  1 − σ √ T  
RFIX = Market swap fixed rate (annualized) at the time of swaption
where: expiration (t = T).
ln[F  0( T)/ X]+ (σ2 / 2)T RX = T he swaption exercise rate starting at Time T, again quoted on
d  1 = ________________
       _ 
an annual basis. As before, we will assume a notional amount
σ√ T
 
_ of 1.
d  2 = d  1 − σ √
T
  σ=V olatility of the forward swap rate. Specifically, it represents the
Futures option put-call parity can be expressed as: annualized standard deviation of continuously compounded
percentage changes in the forward swap rate.
c = e−rT
[F  0(T ) − X] + p
• Option Greeks and Implied Volatility
• Interest Rate Options
Call option delta = e
−δT
N( d  1 )
Under the standard market model, the prices of interest rate call
and put options can be expressed as: Put option delta = − e
−δT N(−d  1 )
c = (AP) e [FRA(0, t  j−1, t  m ) N( d  1 ) − R  X ( d  2 )]
−r(t  j−1+ t  m)
p = (AP) e −r(t  j−1+ t  m)

[R  X N(−d  2 ) − FRA(0, t  j−1, t  m ) N(−d  1 )]

• Estimating Option Value Using Delta • Estimating Option Value Using Delta and Gamma
or calls: ĉ − c ≅ Delta  c (Ŝ − S)

F Gamma  c
elta c (Ŝ − S ) + _
For calls: ĉ − c ≈ D     (Ŝ  − S)2
2
For puts: p̂ − p ≅ Delta  p (Ŝ − S)
Gamma  p
where ĉ , p̂ , and Ŝ denote some new value for the call, put, and elta p (Ŝ − S ) + _
For puts: p̂ − p ≈ D     (Ŝ  − S)2
2
stock, respectively.
e−δT_ where ĉ , p̂ , and Ŝ denote new values for the call, put, and stock,
Gamma  c = Gamma  p = _
    n( d  1 ) . respectively.
Sσ √ T  

Alternative Investments
Real Estate Investments • Adjusted Funds from Operations (AFFO)
• Appraisal-Based Indexes Funds from operations

Less: Non-cash rent
NOI − Capital expenditures + Less: Maintenance-type capital expenditures and leasing costs
    
 
(Ending market value − Beginning market value)
eturn = _____________________________________
R               Adjusted funds from operations
Beginning market value
AFFO is preferred over FFO as it takes into account the capital
VALUATION: NET ASSET VALUE APPROACH expenditures necessary to maintain the economic income of a
• Capitalization Rate property portfolio.
NOI of a comparable property

Capitalization rate = _________________________
   
     
Total value of comparable property
• Net Asset Value per Share
Net Asset Value

NAVPS = ______________
  
     
Shares outstanding
VALUATION: RELATIVE VALUATION (PRICE MULTIPLE) APPROACH

• Funds from Operations (FFO)
Accounting net earnings

Add: Depreciation charges on real estate
Add: Deferred tax charges
Add (Less): Losses (gains) from sales of property and debt
restructuring
Funds from operations

Portfolio Management
Using Multifactor Models Delta
• Arbitrage Pricing Theory and the Factor Model Δc

Delta = _
   
ΔS
E( R  P ) = R  F + λ  1 β  p,1 + … + λ  K β  p,K
Gamma
E(Rp ) = Expected return on the portfolio p
Δdelta
RF = Risk-free rate Γ = gamma =  _  
ΔS
λj = Risk premium for factor j
βp,j = Sensitivity of the portfolio to factor j New call price:
K = Number of factors 1
 c ΔS + _
c + Δc ≈ c + Δ     Γ  c (ΔS)2
2
• Carhart Model
Vega
R  P − R  F = a  p + bp1  RMRF + bp2
  SMB + bp3
  HML + bp4
  WML + ε  p
Δc
Where: Vega ≈ _
   
Δ σ  S
Rp = Return on the portfolio
RF = Risk-free rate New call price:
bp = Sensitivity of the return on the portfolio to the given factor 1
 c ΔS + _
c + Δc ≈ c + Δ     Γ  c (ΔS)2 + vegaΔ σ
  S
RMRF = R eturn on a value-weighted equity index in excess of the 2
T-bill rate
Economics and Investment Markets
• Standardized Sensitivities for Fundamental Factor Models
• Taylor Rule
Value of attribute k for asset i − Average value of attribute k
bik    = ___________________________________________
      
         p rt  = Lt  + ι  t + 0.5( ι  t − ι  t * ) + 0.5( Yt  − Y   t * )
σ(Values of attribute k)
= Lt  + 1.5 ι  t − 0.5 ι  t * + 0.5( Yt  − Y   t * )
• Active Return
where:
Active return = Rp − RB
p rt  = Policy rate at time t
Active return = Return from factor tilts + Return from asset selection Lt  = L evel of real short-term interest rates that balance long-term
savings and borrowing in the economy
• Active Risk ι  t= Rate of inflation
ι  t*  = Target rate of inflation
TE = S(Rp − RB)
Yt  = Logarithmic level of actual real GDP
Where TE = tracking error Y   t*  = Logarithmic level of potential real GDP
Active risk squared = S2(Rp − RB)
Analysis of Active Portfolio Management
Active risk squared = Active factor risk + Active specific risk
Active specific risk = ∑   w  ai  σ  2ε    
n Sharpe Ratio
i=1
i
RP  − Rf 
Where: S RP  = _
   
w  ai  = The ith asset’s active weight in the portfolio (i.e., the difference STD ( RP  )
between the asset’s weight in the portfolio and its weight in the
• Information Ratio
benchmark)
σ  2ε    = The residual risk of the ith asset (i.e., the variance of the ith Active return _ R  A R  P − R  B
i
asset’s returns that is not explained by the factors) IR = ___________

  
    =     = _
   
Active risk σ( R  A ) σ ( R  P − R  B )
Active factor risk = Active risk squared − Active specific risk • Optimal Level of Risk
• The Information Ratio IR

σ* ( RA  ) = _
    σ( RB  )
SR  B
R̅   p − R̅   B
IR =  _ 
s(R  p − R  B ) where:
σ(RA) = Optimal amount of active risk
Measuring and Managing Market Risk IR = Information ratio of the actively managed portfolio
SRB = Sharpe ratio of the benchmark
• Estimating VaR—Parametric Method σ(RB) = Standard deviation of the benchmark return
R−μ • Optimal Sharpe Ratio
z = _
  σ
SR  2P  = SR  2B   + IR2
• Equity Exposure—CAPM
E( r  a ) = rf + β [ E( r  M ) − r  f]

• Fixed Income Exposure
First- and second-order yield effects on bond price:
ΔB Δy _ 1 (Δy)2
 _ = − D _
    +     C _
   
B 1 + y 2 (1 + y)2

The Correlation Triangle
Forecasted
Active Returns
μi
Portfolio Construction: Signal Quality:

Transfer Coefficient Information Coefficient
Realized
Active Weights Active Returns
wi R Ai
Value Added
Mean-Variance-Optimal Active Security Weights

μ  i σ  A
Δw  i * = _
  2  _   _ 
σ  i  IC√BR
where:
Δ w  i * = Active security weight
μi = Active return forecast
σA = Active portfolio risk
σi = Forecasted volatility of the active return on security i
IC = Information coefficient
BR = Breadth
• Ex-Ante (Expected) Risk-Weighted Correlation
IC = COR(_ σ    )

RAi  μ  i
  σ   ,  _
i i
TC = COR(µi /σi, ∆wiσi)
• The Basic Fundamental Law

_
E(R  A )* = IC √BR σ  A
• The Full Fundamental Law

_
E(RA  ) = TC IC √
BR σ  A
• Ex-Post (Realized) Risk-Weighted Correlation

_
E( R  A |IC  R) = (TC ) ( IC  R ) √
BR  σ  A Passing the CFA – It’s in Our DNA
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CFA

​AIC = n ln​(​ _______________ ​)​ + 2(k + 1)​

Value of Durbin-Watson Statistic

Reject H0, Reject H0,

VIFJ = 1/(1− RJ2).

• VIFJ > 5 warrants further investigation of the given independent variable.

Problems in Linear Regression and Solutions

Problem Effect Solution

CFA 2024 Level II Formula Sheet.indd 1 27/09/23 11:43 PM

k × MSE [ ​(1 − ​hii​ ​​ )​​2​]

​​​x ̂​​ t+1​​ = ​​b̂ ​​ 0​​ + ​​b̂ ​​ 1​​ ​xt​ ​​​

Time-Series Analysis • The Unit Root Test of Nonstationarity

Where n = number of periods in the seasonal pattern

CFA 2024 Level II Formula Sheet.indd 2 27/09/23 11:43 PM

ML Algorithm Type Supervised/Unsupervised When to Use?

• LASSO Penalized Regression Constraint • Performance Evaluation

where: ​FI score = (2 * P * R)/(P + R)​

CFA 2024 Level II Formula Sheet.indd 3 27/09/23 11:43 PM

(1 + ​iPC​ ​​ ) Law of one price : P

1 + ( ​iFC​ ​​ × Actual/360) ​S​ PC/BC​​ = ​GPL​ PC​​ / ​GPL​ BC​​​

• Currencies Trading at a Forward Premium/Discount Where π = inflation rate.

• The Fisher Effect

CFA 2024 Level II Formula Sheet.indd 4 27/09/23 11:43 PM

Foreign-Domestic Forward Discount

International Fisher Covered

• Balance of Payment • Potential GDP (Labor Productivity Growth Accounting Equation)

• Relationship between Economic Growth and Stock Prices • Labor Supply

​ otal number of hours available for work = Labor force × Average

where: • Neoclassical Model (Solow’s Model)

where: • Production Function in the Endogenous Growth Model

• Cobb-Douglas Production Function (Growth Accounting Equation)

CFA 2024 Level II Formula Sheet.indd 5 27/09/23 11:43 PM

Components of a Company’s Defined Benefit Pension Periodic Costs

CFA 2024 Level II Formula Sheet.indd 6 27/09/23 11:43 PM

Impact of Assumption on Impact of Assumption on Periodic Pension Cost and

Methods for Translating Foreign Currency Financial Statements of Subsidiaries

Current Rate/ Local Functional Presentation

Temporal Local Functional Presentation

Current Rate Local Functional Presentation

CFA 2024 Level II Formula Sheet.indd 7 27/09/23 11:44 PM

Current Rate Method FC = LC Temporal Method FC = PC

Balance Sheet Component Exchange Rate Used

Balance Sheet Exposure

Foreign Currency (FC)

Balance Sheet Exposure Strengthens Weakens

Net asset Positive translation adjustment Negative translation adjustment

CFA 2024 Level II Formula Sheet.indd 8 27/09/23 11:44 PM

Analysis of Financial Institutions Evaluating Quality of Financial Reports

Minimum Capital Requirement ​M​-​score = − 4.84 + 0.920(DSR) + 0.528(GMI) + 0.404(AQI)

Highly liquid assets SGI (sales growth index) = salest/salest-1

CFA 2024 Level II Formula Sheet.indd 9 27/09/23 11:44 PM

• Growth Relative to GDP Growth Approach • Threat of substitutes

A company’s sales growth rate based on market growth and

CFA 2024 Level II Formula Sheet.indd 10 27/09/23 11:44 PM

Analysis of Dividends and Share Repurchases t = the marginal tax rate

WACC = wd rd(1 − t) + wprp + were • Grinold-Kroner Estimate for Expected ERP

In the Grinold-Kroner decomposition of the return on equity:

Factor Symbol Common Proxy

CFA 2024 Level II Formula Sheet.indd 11 27/09/23 11:44 PM

CFA 2024 Level II Formula Sheet.indd 12 27/09/23 11:44 PM

AIC = n ln( _______________ ) + 2(k + 1)

k × MSE [ (1 − hii  )2]

x ̂  t+1 = b̂   0 + b̂   1 xt 

where: FI score = (2 * P * R)/(P + R)

(1 + iPC  ) Law of one price : P

1 + ( iFC  × Actual/360) S  PC/BC = GPL  PC / GPL  BC

otal number of hours available for work = Labor force × Average

Minimum Capital Requirement M-score = − 4.84 + 0.920(DSR) + 0.528(GMI) + 0.404(AQI)

V  0 = ∑   _

Equity Value = ∑   _

FCFF = CFO + Int(1 − Tax rate ) − FCInv • Price to Earnings Ratio

Trailing dividend yield = Last year’s dividend / Current price per _

Residual income = Net income − Equity charge ROE − r

V  0 = B  0 + ∑   _

V  0 = B  0 + ∑   _

[ V  0 − B  0 ]

0  = B0  + ∑   _ = B0  + ∑   _

• Discount Factor ( PV  − ) − ( PV  + )

Payout amount = Payout ratio × notional Protection buyer’s Π = %Δ P

V  T (T ) = S  T − F  0 (T) where:

• Pricing a Forward Rate Agreement c +− c  − p +− p  −

where: −  + c  − )

Where π is the probability of an up move. p = e−r T XN(−d  2 ) − SN(−d  1 )

r  [E( c1  )]

p = P Vr  [E( p1  )] ln(S/X)+ (r _ +σ 2 / 2)T

p = (AP) e −r(t  j−1+ t  m)

or calls: ĉ − c ≅ Delta  c (Ŝ − S)

asset’s returns that is not explained by the factors) IR = ___________

E( r  a ) = rf + β [ E( r  M ) − r  f]

IC = COR(_ σ    )