ETHICAL AND PROFESSIONAL STANDARDS I !(A) [(Bl l(C) l(D) JI ll(A) Il(B) 111 IIl(A) Ill (B) III(C) lll(D) III(£) IV IV(A) IV(B) IV(C) V

Professio nalism Knowledge of the Law. Independence and Objecciviry. Misrepresentation. Misconduct. Integrity of Capital Markets Material Nonpublic Information. Market Manipulation. Duties to Clients Loyalty, Prudence, and Care. Fair Dealing. Suitability. Performance Presencanon. Preservation of Confidentiality. Duties to Employers Loyalty. Additional Compensation ArrangemenL~. Re.sponsibiliries of Supervisors. Investment Analysis, Recommendations, and Actions

V(A) Diligence and Reasonable Basis. V(B) Communicarion with Clicnrs and

Prospective Cliems. V(C) VI VI(A) VI(B) VI(C) VII

Record Rerenrion. Con!I ices oflnterest Disclosure of Conflicrs. Priority ofTransacrions. Referral Fees. Responsibilities as a CFA Instirute Member or CFA Candidate

Vll(A) Conduct as Participants in CFA Institute Programs.

Vll(B) Reference ro CFA Institute, the CFA Designation, and the CFA Program.

G lobal Investment Performance Standards (GIPS®) • Compliance s;a~mmt: "(Insert name of firm] has

prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS)." Compliance must be applied on a firm•wide basis.

• Nine sections: fundamentals of compliance, in put data, calcularion methodology, composite construcnon, disclosures, presentation and reporting, real estate, private equity, and wrap fed separately managed account portfolios.

QUANTITATIVE METHODS Time Value of Money Basics • Furure value (FV): amounr ro which investment

grows after one or more compounding periods. • F1m.re value: FV - PV(l + JIY)N. • Present value (PV): current value of some future

cash Aow PY = FV/(1 + 1/Y)". • Annuities: series of equal cash Rows chat occur ar

evenly spaced intei:vals over time. • Ordinary r.t>muity: cash Bow at end-of-time period. • Annuity due: cash Aow at beginning-of.rime period. • Perpetuiries: annuities with infinite lives.

PY P"'P"""" = PMTl(discoum rate).

Requi.red Rate of Re.turn Cornponencs: I. Real risk-free rate (RFR). 2. Expecred inHadon rare premium ([P). 3. Risk premium.

E(R) = (I +RFR,,.1)(1+ fP)(l + RP) - 1

Approximation fonnula for nominal required rate:

E(R)~RFR + IP + RP

Means Arithmetic mt:r.1n: sum of all observation values in sample/popularion, divided by# of observations. Geometrit mean: used when calculacing investment

recurns over mulriple periods or to measure compound growth rates. Geometric mean return:

R0 = !(1+R,)x ... x(1+R,Jl~ -l

. N harmomcmean - t[ I I

;=I X,

Variance and Standard Deviation Viiriance: average of squased deviations from mean

N

I::<x, - ,,.J2 population variance = o-2

- 1"'="--1 ---­

N

t<x, - xi sample vanance = i=~i-~1~--­

n - l

Standard deviation: square root of variance

Holding Period Return (HPR)

R = P, P, ,+D, or P,-D,_ 1 ' P,_1 P,_1

Coefficient ofVariation Co,fficimt of varialion (CV): expresses how much

dispersion exists relative to mean of a distribucion; allows for direct comparison of dispusion across d ifferent dHa set<. CV i< calculated by dividing

standard deviation of a distribution by the mean or expected value of che discribution:

CV =:b X

Roy's Safety-First Ratio

rp - ria,ga ffiliW 'il,IW;Jl'sllil';l~((i~iM'iX: r1z,!o4!,;it

crp

Expecte<I RecurnlStandard Deviation

Expected return: E(X) = I:P(x, ) xn

E(X) = P(Kt)x1 + P(x2)x2 + ... + P(x 0 )x0

Probabilislic variance:

lT1 (X)= ~P(x;)[x,-E(X)j

2

- P{Ki )[x1 - E(x)]2 + P(x2 )[xi- E(x)j2

+ ... +P(x,)[x. - E(X)j2

Standard deviation: take square root of variance.

Correlation and Covariance Correlation: covariance divided by product of the

cwo standard deviations.

, ) cov(R;,R i) corr(R;,R i = ) ( )

CT( R; a R i

Expected ret11rn, variance of 2-stock portfolio:

E(Rp) = wAE(RA) -. w 8E(R 5 )

var(RP) = w~a2

(RA)+wia2

(Rs)

+2w Aw8a (RA )a(R 8 )p(RA,Ra)

;1;-J;'::lf.tf CFA, FRM\li,.rn.ff':':fl l'l'.!m'il/141/Jl",i>illVX: zyz786468331

Normal Distributions Normal distriburion is complerely described by irs mean and variance. 68% of observacions fall wirhin ± Io. 90% fall within± 1.650.

95% fall within± 1.96o. 99% fall wirhin ± 2.580.

Computing Z-Scores Z-score: ''standardizes• observation from normal distribucion; represents # of standard deviations a given observation is from popularion mean.

~ = observacion - population mean = x - µ

standard deviation CT

Binomial Models Binomial distribution: assumes a variable can take one of two values (success/failure) o r, in the case of a stock, movements (up/down). A binomial model can describe changes in the value of an asset or portfolio; it can be used to compute its expected value over several periods.

Sampling Distribution Sampling distribution: probability dimibu rion of

all possible sample statistics computed from a set of cqual•size samples randomly drawn from the same population. The sr.1mpling diuribi,tio,i of 1/u mean is

the distribution of estimates of rhe mean.

Central Limit Theorem vn1raL limit thtorem: when selecting simple random samples of size n from population with meanµ and finite variance o1, rhc, sampling distribution of sample mean approaches normal probability distribution wirh mean µ and variance equal to o2/n as rhe sample size becomes large.

Standard Error Standard error of tht: sampu mean is the standard deviarion of disrribution of rhe sample means.

k I . . CT

nown popu anon vartance: ax = ✓n

s unknown population variance: s, = ,fr;

Confidence Intervals Confidence interval: gives range of values the mean

value will be between, with a given probability (say 90% or 95%). With known variance, formula for a confidence interval is:

- CT x±zo/2 fn

z012 = 1.645 for 90% confidence intervals (significance level I 0%. 5% in each tail)

1.0,. = 1.960 for 95% confidence intervals

(significance level 5%, 2.5% in each rail)

z , = 2.5 75 for 99% confidence inrervals "' (significance level I%, 0.5% in each rail)

Null and Alto,rnacive Hypotheses Null hypothesis (H.,): hypothesis chat conrains the equal sign (=, $, ~); 1he hypothesis that is accually tested; the basis for selection of the test statistics. Alten111tive hypothesis (H.): concluded if there is sufficient evidence co reject <he null hypothesis.

Difference Between One- and Two-Tailed Tests One-tailed test: rests whether value is greater than or less than a given number.

Two-railed rest: tests whether value is equal to a given number. • One-railed test: Ho: t• s 0 versus H2 : tt > 0. • Two-railed test: Ho: µ = 0 versus Ha µ ,. 0.

Type I and Type 11 Errors • 7ype I error: rejection of null hypochesis when it is

actually rrue. • 7jpe fl error: failure to reject null hypothesis when

ir is actually false.

Types of Hypothesis Tests Use t-rttttistit- for tests involving the population mean (location of mean, difference in means, paired comparisons). Use chi-square statistic for resrs of a single population variance. Use P-stati.stic for tesrs comparing two population variance,. Use t•sta1is1ic with n - 2 df for rests of corrdation.

ECONOMICS Elasticity

Own price das ticity %.C:. quantity demanded

%.C:. price

If absolute value > I, dem:md is elastic. If absolute value< I, demand is inelastic. On a ,rraight Line demand curve, total revenue is maximized where price elascicicy = -1.

income elasticity %~ quantity demanded % ~ income

If positive, the good is a normal good. If negative, the good is an inferior good.

C . ,__ . . %1', q uantity demanded

ross pnce tu,;twty = - ---'----'----­%.C:. price of related good

If positive, related good is a substitute. If negarive, rela,ed good is a complement.

Breakeven and Shutdown Breakeve:n: total revenue = total cost. Operat:R in 1hort run if rornl revenue is grearer rhan total variable cost but less than total cost. Shut down in short nm if coral revenue is Jc,ss than meal variable cost.

Market Structures Perfect competition: Many lirms wirh no pricing power; very low or no barriers ro entry; homogeneous p,oduct. Monopolistic competition: Many firms; some pricing power; low barriers to entry; differentiated productS; large advertising expense. Oligopoly: Few firms chac may have significanr pricing power; hrgh ba.rriers to entry; products may be homogeneous or differentiated. Monopoly: Single firm with significant pricing power; high barriers to entry; advertising used co

compete with substitute products. In all market structures, profit is maximized at the output quanrity for which marginal revenue= marginal cost.

Gross Domestic Product Real GDP= consumption spending+ investment+ government spending + ner exports.

Savings, Investment, Fiscal Balance, and Trade Balance Fiscal budget deficit (G - T) = excess of saving over domestic investment (S - [) - trade balance (X - M)

Equation of Exchange MV = PY, when~ M = R-al money supply, V = velocity of money in transactions, P = price level, and Y = real G DP.

Business Cycle Phases Expansion: peak: conrraction: trough.

Economic Indicator~ leading:-Turning points occur ahead of pea.k.1 and troughs (stock prices, initial unemployment claims, manufacturing new orders) Coi12cidmt: Turning points coincide with pea.ks and troughs (nonfu-m payrolls, personal income, manufacturing sales) Lagging: Turning points follow peaks and troughs (average duration of unemployment, invtnrory/ sales ratio, prime race)

Factors Affecting Aggregate Demand Consumers' wealth; business expectarions; consumers' income expectations: capacity utilization; monetary and fiscal policy; exchange rares; global economic growth.

Factors Affecting SR Aggregate Supply Input pricts; labor productivity; expectatioru for ourput price~ caxc1. and subsidies; exchange rates;

all factors that affect LR aggregate supply.

Factors Affecting LR Aggregate Supply Size of labor force; human capital: supply of narural resources; stock of physical capital; level of technology.

Types of Unemployment Frictional: time lag in marching quali6ed workers with job openings. Structural· unemployed workers do nor have the skills to match newly created jobs. Cyclical: economy producing at less than capacity during contraction phase of business cycle.

Policy Mullipliers

money multiplier = ___ ......; ___ _ reseJVe requirement

fiscal multiplier 1- MPC(l-t)

where MPC = marginal propcnsiry to consume, r = cax rate.

Expansionary and Contractionary Policy 1Wo11etdTy policy is expansionary when the policy rare is less than the neutral inrcresr rate (real trend race of economic growth + i nflacion target) and contractionaty when the policy rate is greater than rhe neutral interest rare. Fiscal policy i, expansionary when a hudget deficit is increasing or surplui is decreasing, and conrraccionaty when a budget deficit is dcc«-asing or surplus is incre;ising.

Balance of Payments Current account: merchandise and services; income

receiprs; unilateral uansfers. Capital account: capital transfers; sales/purchases of nonfinancial assets. Financial account: government-owned assets abroad; foreign-owned :issets in the country.

Regional Trading Agreements Frte trade area: Removes ba,riers to goods and services tr<tde among members. Cwtom! union: Members also adopt common rrade policies with non-members. Common market: Members also remove barriers to labor and capital movements among members. Economic i,nion: Members also establish common insriturions and economic policy. 1Wonetnry union; Member, also adopt a common currency.

Foreign Exchange Rates For che exam, FX rares are expressed as price currency I bas, curr,ncy and interpreted as the

number of units of rhe price currency for each unit of che base currency.

Real Exchange Rate

. l FX ( base currency CPI ) nom10a rate X price cu rrenc:y CPI

No-Arbitrage Forward E .. change Rate

forward I + price currency interest rate

spot l + base currency interest rare

Exchange Rate Regimes Formal dollnriz,uion: country adopts foreign currency. Monetary union: members adopt common currency. Fixed peg:± I% margin versus foreign currency or basket of currencies. Targ,t zone: Wider margin than lixed peg. Crawling peg: Pegged exchange rate adjusted periodically. Crawling bands: Width of margin increases over rime. Managed floating: Monernry authority ~cts ro influence exchange rate bur does not sec a carget. lndqmdm1!y floating: Exchange rate is market· determined.

FINANCIAL REPORTING AND ANALYSIS

Revenue Recognition Two rc9uircmcnrs: (I) completion of earnings process and (2) reasonable assurance of payment. Five-step revenue recognition model: l. Identify comracts 2. ldenrify performance obligations 3. Dcrcrminc crdnsaccion price 4. Allocate price to obligations 5. Recognize when (as) obligations are Satisfied

Unusual or Infrequent Items • Gains/losses from disposal of a business segment. • Gains/losses from sale of assets or investmenrs In

subsidiaries. • Provisions for environmental remediarion. • Impairments, ,vrite-offs1 write.downs.,. and

restructuring coses. • lnregrarion expenses associated with businesse,

recently acquired.

Discontinued Operations To be accounrcd for as a discontinued operation, a business-assets, [)p~ratiollS, investing, financing activities-muse be physically/operationally distinct from rest of firm. Income/losses are repon:ed net of tax after net income from continuing operations.

Compute Cash Flows From Operations (CFO) Direct method: start wirh cash collections {cash equi,-alenr of sales); cash inputs (cash equivalent of cost of goods sold); cash operating expenses; cash i nrerest expense; cash taxes. fndirecr muhod: stare with net income, subtracting back gains and adding back losses resulting from financing or investment cash flows, adding back all noncash charges, and adding and subrracring a«et and liability accounts rhat rcsulr from operations.

Free Cash Flow Free rash fiou; (FCF) measur~s cash available for discretionary purposes. Ir is equal to operating cash flow le:.,, nee capital expenditures.

Critical Ratios Common-size finam:ial s1a1emem analysis: • Common-size balance 1heer expresses all balance

sheet accounts as a percen cage of total assets. • Common-size income statement expresses all

income statement items a.s a percentage of sales.

• Common-size cash Aow statement expresses each line icem as a percencage of rocaJ cash inflows (outflows), or as a pcrcenrage of net revenue.

!foru,ontal common-size financial sratemem analysis: expres~es each Hnc irem relative to ir$ value in a

common base period. Liquidity ratios:

. current assets currt n r rnno = -------

current liabilities

. k . cash + marketable securities + receivables qutc ratio= current liabilities

h . cash + marketable securities

cas rac10 = -----------current liabilities

d r . . I cash+ mkt. sec. + receivables

erenstve mterva = ------------daily cash expenditures

Receivabl.e1. invmtory. payables mrnover, and days' rupply ratios-all of which are used in the cash convenion cycle:

annual sales receivables turnover=------­

average receivables

. cost of ~oods sold inventory turnover = _

average mven[ory

purchases payables turnover ratio =--~-----­

average trade payables

i i'fi.~iC';(c:A FRf-1\lli~~L:n~;t~flfl'~t'.lff,):: .::,•z7UW5~B1 I 365 days of sales ourscanding - ------­

receivables turnover

365 days of inventory on hand = -. ------­

mvenrory rurnover

365 number ot day, of payables= .

payables turnover rauo

. rdays of inventory ·1 cash conversion cycle = • on band

+ldays of s~le~l-1 n umber of days) outstanding of payable1

Total asset, .fi:.:ed-asut, and working capital tumotJt!r ratio!:

total asset turnover - ___ re_v_e_n_u_e __ average 1oral assers

fixed asset turnover = ___ re_v_e_n_u_e __ a vcrage fixed ;,.ssets

working capital turnover = revenue average working capital

Gross, operating, and net profit margins:

. gross pro fo gross profit margin = ~ --­

revenue

, , ope1a1ingprofa EBIT opcrarmg profit margin = ....:..--=-- =

revenue net sales

. nee income net profit margin = ----­

revenue

Remm on asse,s {1-erum on ro,al capiral (ROTC)/:

return on assets EBIT

(total capital) average total capital

Debt to equity ratio arid total debt ratio:

coral debr debt-to-equity ratio= .

rota! equay

. total debt 10Lal-dcbr-rat10 • -----

coral assecs

Jnumt coverage and fixed charge coverage:

. EBIT interest coverage=-. --

1nter~t

EBIT + lease payments fixed charge coverage=-,-----~~--

1ncere,;r + lease payments

Gruiuthrate (g): g = RR x ROE

dividends dedared retention rate = 1------------

operating income after taxes

Liquidity ratios indicate company's abiliry to pay its short-term liabilities.

Operati11g perform,mce mtios indicate how well managemenc ope races the business.

DuPont Analysis Traditional DuPont eqmition:

. I nee income) I sales ll assets l return on cquuy ~ -- --.-sales ,assers,. equ1cy .

You may also see it presented as:

. I net profirll asser ll equity l return one u1 = . . . q cy , margin tlJ mover mu l11plter

Extended DuPont eq..atiQn further decomposes net profit margin:

ROE = l' net incomej' x[ EBT ]xl. EBIT ·1 EBT EBIT r<vcnuc

( revenue ) [ avg. roral assets)

~ avg. total assets >< avg. equity

You may also see ir presented as: ROE= tax burden • interest burden x

EBIT margin x asset turnover >< leverage

Marketable Security Classifications !fdd-for-trading: fur value on balance •hcec; dividends, interest, realized and unrealized G/L recognized on income statement. A1111ilabk-for-1ale: fair value on balance sheer; dividends, interest, realized G/L recognized on income statement; unrealized G/L is other comprehensive income. Held-to-maturity: amortized cost on balance

sheer; incerest, realized G/L recognized on income statement.

Inventory Accounting

In periods of rising prices and scable or increasing inventory quanriries:

LIFO remits in: Higher COGS Lower gross profit Lower inventory balances

Basic and Diluted EPS

FIFO resulrs in: Lower COGS Higher gross profit Higher inventory balances

Basic EPS calculation does 110 1 consider effects of any dilutive securilies in computation ofEPS:

basic EPS = net income- preferred dividends

wed. avg. no. of common sbs. oucstanding

diluced E.PS = adj. income avail. for common shares

wed. avg. common shares plus potential common shares outstanding

Therefore, diluted EPS is:

I fdl convertible lconveniblel

. nee - ~- + preferred + debt (1-t) income iv diviclem.ls incerc::st

[wrdj' l shares from J 1· sh'sfrom l l shares ) avg + conversion of + conversion + issuable from sh• s conv. pfd. sh ' s conv. d~bt stock options

Long-Lived Assecs Capitalizing vs. Expensing Capitalizing: lowers income variability and increases ne2r-term pro/its lncre.a.se :issets, equiry. Expeming: opposite effect.

Depreciation

l cost - residual value

Straight- ine: ---------useful life

Double de.lining balance:

( 2

. j ( cost - accum. depreciation) useful hfe

Units nf pmdi,ction:

cost - salvage value . x output unics

useful life in units

Revaluation of Long-Lived Assets /FRS: revaluation gain recognized in net income only to the extent it reverses previously recognized impairment loss; further gains recognized in equicy

as revaluation surplus. (For inve11ment property, all gains and losses from marking ro fair value are recognized o..s income.)

U.S. GMP: revaluation is not permirterl.

Deferred Taxes • Created when caxable income (on cax return) =

pretax income (on financial statements) due m cemporary differences.

• Deferred rax liabilities are created when taxable income< pretax income. Treat DTL as equity if not expected to reverse.

• Deferred tax assets are created when taxable income > precax income. Muse recognize valuaJion a/lc111ance if more likely than not chat OTA will not be realized.

Long-Tenn Liabilities

• Premium bond: coupon rate > market rate at issuance.

• Di1eoum bond: coupon rate < marker rare ar issuance. !nteresrexpen.se equals book value at the beginning of che year mulciplied by the markec rare of inieresc at the cime the bonds were issued.

Leases IFRS: Lessee reports asser and liability on balance sheer. Principal portion of payment reduces

liability; depreciation and interest expense recognized on income statement. Lessor classifies lease as finance or operating. U.S. GAAP: Lessee reporrs as finance lease (same rreatment as TFRS) or operating lease (on balan~e sheer, but lease payments on incomestatemenr). Lessor classifies lease as sales-cype or direct

financing (asser off balance sheer), or operaring (asser stays on balance sheer).

Pensions

Defi.md contribution: employer conrribucion expensed in period incurred. Deftmd b~neftt: overfunded pbn recognized o.s asser, underfunded plan recognized as liability.

CORPORATE FINANCE Weighted Average Cosl of Capital

WACC = (wd)[k10-l\l + (w p,Hk,,.) + (w «l(k,)

Cose of Preferred Srock

k - Dps p- p Cost of Equity Capital

D k =.......!. + g

< Po

Cost of Equity Using CAPM

k, = RFR + .6(Rmk, - RFR )

Capital Budgeting

Npv _ CF. CEI CF1 CF0 +---+---+ ... +---0 (l + k)1 (l+k)2 (l+k)"

/RR, discoum race chat makes NPY equal co zero.

Pure-Play Method Project Beta Delevered asser bern for comparable company:

I

Rclcvercd project beta for subject firm:

~proj«r; f3,_,m + 1-((1 - t} ~ JI Measures of Leverage Total leverage: percent change in net income

from a given percent change in sales. Operating leve,age: percent change in EBIT from a given percent change in sale~. Financial leverage: percent change in net income from a given percenr change in EBIT.

breakeven quamiry of sales =

fixed operating & financing cosrs price - variable costs per unit

operating brcakeven quantity of sales=

fixed operating costs price- variable com per unit

Working Capital Management Primary sources of liquidiJy. cash balances, short-term funding, cash Aow management of collections and payment. Secondary sources of liquidity. liquidating asset5, negotiating debt agreements, bankruptc)' protection.

Cose of trade credit:

[ % discount l 4ar• P1'' dikt11,1t11

1 + 1-o/o discoum -l

Corporate Governance

One-tier board· Includes internal and exrernal directors. Two-tier board: Supervisory board of external directors, management board of internal directors. Board comminees: Audir: Financial reporting. Governance: Legal and ethics compliance. Nominatitms: Find board candidates. Remuneration: Compens~tion for senior managers. Risk: Firm risk rnlerance aml risk management. lnvertment: Review large capital projects, asset purchasei;, asset sales.

ESG in Investment Analysis Negative screening: Exclude companies with poor ESG records. Positive ureening: Invest in companies with good ESG records. Thematic investing: Invest co promote a specific ESG goal. Active ownership: Use share vocing, access to

managers to promote ESG go.ls.

PORTFOLIO MANAGEMENT lnvcslmcnt Policy Statement Investment objectives: • Return objeccive5. • Risk tolerance. Constraints: • Liqujdity needs. • Time horizon. • Tax concerns. • Legal and regulatory factors. • Unique cira.tmstances.

Combining Preferences wilh lhe Optimal Set of Ponfolios Markowitz efficient frontier is the ser of portfolios thar have highest return for given level of risk.

~ -~-.z Ri~I· ht.r-S< /.,. .,.,,. ' ' Efficient Froa1icr

l 11 tu1 / .,..,.,

X~' ;>' / ,.,.

I I

'------------------- 11 a

Security Marke1 Line (SML) Investors should only be compensated for risk relacive to marker. Unsystmzatic risk is diversified away; invescors are compensated for sysumaric risk. The equation of the SML is the CAPM, which is a return/syscemaric risk equilibrium relationship.

total risk = systematic + unsystematic risk

Ill

/ Effid~nr Frontier

RFR

[ R.

Sr1..uriw X.farkct J me

7 /

_______ ..,.,_ Marke,

/ : J>onfolio

' RfR

01trillLmll = cf mb Syit~rn.mc Risk ( Cuv-

The SML and Equilibrium Identifying mispriced stocks: Consider three stocks (A, B, C) and SML. Esrimored s,ock returns should plot on SML. • A return plor over the line is u11d(rpriced. • A return plot under the line is overpriced.

B

RFR

; ~\Ml

. /2 i / ' . :

' ' ' ' ' ' ' ' ' ' ' ' ' ..._ ___ __._ __ .....,_ ___ ..._ __ p ri,k

0.8 1.2

Risk-Adjusted Returns Sharpe ratio and ,\1-squared measure excess return per unit of wtal risk. Trtynor measure and Jnue-n} alpha measure excess return per uni, of systematic risk.

;::(RJ ,lop, - In:ynor measure f.,r l'onfolio I'

I< mm\ alpha

~------------P ~p

Technical Analysis Reverr11I pan,ms: head and shoulder<, inverse H &S. double/triple cop or borcom. Cominuatior1 pacrerns: triangles, rectangles, pennancs, Rags. Price-based mdicators: moving averages, Bollinger brnds. momentum oscillators (rate of change. RSI. stochastic, MACD). Smtimt:nt indicutar>: opinion polls, puc/call rnrio, VIX, margin debt, short interest ratio. Flow of farul.s indicators: TRIN, margin debt, murual fund cash posirion, new eq11iry issuance, secondary offerings.

SECURITIES MARKETS & EQUITY INVESTMENTS

Well-Functioning Security Markets • Operational efficiency (lowest possible

transactions costs). • I nformat1onal efficiency (prices rapidly adjust co

new information).

Margin Purchases For margin Lransaccions: • Leverage factor = I /margin percentage. • Levered return = HPR x leverage factor.

Margin Call Price P0 (1-initial margin%)

I - maintenance margin %

Computing Index Prices

Estock prices Price-weighted Index=-='---.:....- ­

adjusted divisor

V:ilue-weighted lndex

= E(amcnc priccs)(#sharcs) X base value Dbase year prices)(# base year shares)

Types of O rders Ex«utton instrucnons: how co trade; e.g., marker orders, limit orders Validity instructions: when co execute; e.g., stop orders, day orders, fill-or-kill orders. Clearing imtructions: how to clear and settle; for sell orders, specif)• shon sale or sale of owned security.

Market Structures Quote-driven markm: investors rrade wirh dealers. Order-driven mnrk,ts: buyer, and sellers malchcd

by rules. Brokered markm: brokers find counterparcies.

Forms ofEMH • M-ak form. Current stock prices fully rrjkct

availabk smmty mar/let info. Volume information/pasc price do not relate 10 fucure direction of security prices. Investor cannot achieve cxa:ss returns using tech analysis.

• Semi-strongform. Security prices inscamly adjust 10 new public mfarmation. Investor c111111ot achieve excess recurns using fundamcncal analysis.

• Strongfarm. Stock prices fully reflect all ,nfon1111tion .from public 1111d pritAU so11rcn.

Assumes perfect markets in which all information is cost free dnd available LO everyone at the same time. Even with inside info, investor cannot achieve excess returns.

EQUITY INVESTMENTS Industry Life Cycle Stage~ Embryonic: slow growth, high prices, large invounem ncx<lc<l, high rbk of failure. Growth: rapid growth, falling prices, limited competition, increasing profitability. Shakeout: slo,.cr growrh. inrrn~e competition, ded ining profi1abil1cy. cosr curring, weaker firms fail or merge. Mature: slow growth, consolidarion, stable pnces, high barriers to cnrry. Dedi,u: neganve growth. declining prices. consolidation.

Five Competitive forces I . Rivalry among existing compe1i1ors. 2. Threat of encry. 3. Threat of substitutes. 4. Powerofbuycrs. 5. Power of suppliers.

O ne-Period Valuation Model

v. = _0_1_ + _ P_1_ 0 (l+k.) (I+k.)

Be sure ro use rxpeaed dividend DI in calculation.

Infinite Pe riod Dividend Discount Model~ S11pernonnal f!OWth model (multi-stage) DDM:

0 1 00

P0

Yo = (I + k,) - ...... + ( I + k.)" + (I + k, )"

D.+1 where: P, - -( - -)

k. -g.

Constant gro1vrh model:

Yo= Do(I +gel=~ k. -g, k, -g.

Critical relationship between k and g: • As difference becween k, and g, widms. value or

nockfo//.r. • ~ difference 11arrows, value of stock rises. • Small changes in difference berween k, and g,

cause large changes in stock's value. Crirical assumptions of infinite pcnod DOM.

Stock pays dividends; constant growth rate. • Con.rant growth rate, g._, never changes. • k mu.st be grea1er than g (or 1T1Ath will noc work).

Ear~ings Multiplier Mod~l o,

P0 = __§_ = payout ratio

E1 k -g k - g

Price Multiples pric, per share

la.ding P/E • ----'----'----­forecast .EPS next I 2 mo

. . PIE price per share t ra t!mg " El'S . 12 ptCVIOUS mo.

price per share P/B = _,__,_ _ _ _ book value per share

PIS = prioe p,r share sales ptr share

price per share PICF = ~-~---,-­

cash flow per share

FIXED INCOME Basic Fearures of Bonds /ssutr. Household, nonfinancial corporations, governments, financial instiruriom. Mamrir:y. Muney marker {one year or lrs.s); apical market (greater than one year). />ar value. Bond's principal value (face value). roupon Annual percem of par; fixed or Aoari ng. Divide by pmodicity 10 get periodic rare. Currcn<J, Single:, dual, currcm .. y option. Indenture. Affirmative and negative covenants.

Price, Yield, Coupon Relationships Bond prices and yields are iaYcc<ei)' re)ated. Increase in yield decreases price; decrease in yield increases price. Coupon < yield: Discount to par value. Coupon > yield: Premium ro par value. Consrant-yield priet rrajutory. Price approaches par as bond nean marurity from amomzarion of discounts and premiums. CapiraJ gains and losses arc calculated rc:la1i ve ro th is trajectory.

Cash Flow Structures 8,./[et; All prmc.ipal repaid a1 ma1uriry. Fully amorti:ring: Equal periodic p.iymam include both inreresr and principal. PartiallJ amortizing: Periodic payments include interest and principal, balloon paymem ac macuriry repays remaining principal. S111ki11gfimd. Schedule for early redemption. Floattng-rare: Coupon payments based on reference

rare plus margin.

Bond Pricing There are cwo equivalem ways 10 price a bond: • Constant discount rare applied ro all cash Aows

(YTM) co find PV. This is a bond's flat priu (does not include ~ccrued interest).

• Discount each cash Row using appropriate spo1 rare for a ch. This is a bond'; no-arbirrnge priee

Full prire indudes accrued interest. Government bonds use actual day counts; corporate bonds use 30/360 merhod.

full price = [>V a1 lase coupon dace K (I + YTM)''T accrued intercn & coupon payment >< (tff) where: c = days from mosc recent coupon payment co

trade scrclcment T = days in coupon payment period

M4trix pricing: For illiquid bonds, use yields of bonds with same credit quality co estimate yield; adjust for matuncy differences wich linear interpolation.

Bond Market.~ National bond marlut includes domestic bonds and foreign bonds. • Domesrie bondt. Domestic issuer and currency • Fortign bpnds. Foreign issuer, domescic currency. Eurl)bnnd marktt is outside any one country. wirh bonds denominated in currencies other rhan those of ~oumries in which bonru arc ,old. Global bonds trade in borh a national bond market and rhe eurobond market.

Bond Issu:incc Underwritten offtring: lnve5tment banks buy entire issue, sell to public. &st efforts offermg: Investment ba.nks act as brokers. Shelf regisrrarion: Regisrer entire issue wirh resula,ors bur sell over a period of rime.

Embedded Options CallnbfL: Issuer may repay principal early. Increases yield and decreas~s duration. P11tt1bk: Bondholder may sell bond back ro issuer. Dec.re.so yield and Jurauon. Canvertible: Bondholder may exchange bond for issuer's common stock. Embedded warrants: Bandho!der may buy issuer's common stock at exercise price.

Yield Measures E(/tcriue yield depends on periodicity. YTM =

effective yield for annual-pay bonds. S,miannual bond basis: YTM • 2 >< semiannual

discount rate. Cu"ent yield= annual coupon I price. Simple yield= current yield :1: amorriz.ation. Yield to call is based on call dace and call price. Yield to wom is lowest of :1 bond's YTCs or YTM. Monty marktt yields may be on a discount or add­on basis and may use a 360- or 365-day year. Bond-,quivalem Jield is an annualized add-on yidd based on a 365-day year.

Forward and Spot Rates Forward rdte is a rare for a loan rha1 begins ar a future date .. "I y3y" = 3-yeas forward rate I year from coday. Example of spot-forward relationship:

( I +S2)2-(l , S,)(l + lyly)

Yield Spreads G-spre.id: Basis pointS above gov,rnmenr yield. I-spread: Basis point< obove swap rote. Z-spre,u/: Accounrs for 5hape of yield curve. Oprion-adjwred spw1d: Adjusts 2-spread for cffecrs or embedded options.

Interest Rate Risk Interest race risk I~s 1wo components: mn=tmcm riJJc and market prsce risk from YTM changes. These risks have opposing eArcts on an investor's horizon yield. • Bond investors with shorr horiwns are more

concerned with market price risk. • Bond investors with long horitons ~re more

concerned witn reinvestment risk. • I 'he horiwn ac which market price risk and

reinvestment risk just offset is a bond's Maea11lay durario11. This is the weighted average of times until a bond's cash Rows are scheduled ro be paid.

Modified duration is r.he approximare change in a bond's price given a 1 % change in its YTM:

Macaulaydurarion (V_)- (v,) = ( I+ r) ~ 2V0 (6y)

Effective d1tratic11 is required if a bond has embedded options:

(V_)- (Y+) 2Vo (~curve)

Price change estimates based on duration only are improved by adjusring for convexiry:

o/ob.price = -duration (b.y) + .!.convexity (b.y )2

2

Asset-Backed Securities ~sidentia/ MBS: home morrgages are collateral. Agency RMBS include only conforming loans; nonag_eocr RMBS may include nonconforming loans and need credir enhancement. Prepayment risk conrraction risk from faster prepaymenrs; e;,crension risk from slower prepaymenrs. CMOs: pass-through MBS are collateral. May have sequential-pay or PAC/support scrucrure. Commercial MBS: non-recourse mortgages on commercial properties are collateral. Auto ABS: auto loans are collareraL Credit card ABS: credir card receivables are collo.reral. CDOs: Bonds, bank loans, MBS, ABS, or other C:DOs arc collateral.

Collateral and Credit Enhancement Secured bonds are backed by specific collateral and ,cnior 10 unsecured bonds. Unsecured bonds are general claims co issuer's cash flows and assets. internal m:dir enhancement: Excess spread, overcollaceralizuion, waterfall srrucmre. External credit mham:ement: Surety bonds, lc,rcrs of credir, bank guarantees.

Credit Analysis lnve,rmem grnd,: Bo.a3/BBB- or :tbove Non-investment grade: Bal/BB+ or below Corporate fan1ily raring (CFR): issuer rating. Corporare credit rating (CCR): securiry raring. "Four Cs": capacity, colla1eral, covenants, characrer.

default risk~ probability of default loss severiry = percent of value lose if borrower

defaults expected loss ~ default risk x loss sevcriry recovery rate = I - expected loss percentage

DERIVATIVES Arbitrage and Replication • law of one price: two assets with idemical cash

flows in the future, regardless of furure evenlS, should have the same price.

• Two assets wich uncertain returns can be combined in a porrfolio that will have a certain payoff. If a portfolio has a certain payoff, rhe portfolio should yield the risk-free rate. For thjs reason, derivatives values are based on risk-neutral pricing.

Derivatives Values vs. Prices The price of a forward, furures, or swap concracr is the forward price srared in the concracr :tnd is set such chat the contract has a value of zero at initiation. Valut may change during the lormacc's life with opposite gains/losses to the long and shorr.

Forward Conrract Value Ar rimer-.

E (T) V,(T) = S, + PV, (cost) - PV, (benefit) - o T

(I + Rf) -,

At expiration (tim, t = T):

payoff to long= S, - F0(T) Futures vs. Forwards

Fbrwards Futures

Private contracts Exchange-traded Unique conmccs Standardized contracts Default risk Guar3nteed by clearinghouse Little or no regulation Regulated

Forward Rate Agreemenrs (FRA) Can be viewed as• forward contract ro borrow/ lend money at a certain rate ac some future dare.

Interest Rate Swaps Moy be replicated by a series of off-market FRA, with present values at swap iniriac,on char sum co L.efO.

Options • Buyer of a call oprion-long asser exposure. • Writer (seller) of a call option-short asset

exposure. • Buyer of a put oprion- short asser exposure. • Writer (seller) of a put option-long asset

exposure. intrinsic value of a call option - Max[O, S - X) intrinsic value of a put option= Max[O, X- SJ

American vs. European Options Am~rirn,1 option., allow rhe owner- to ~~rci~~ rhc

option any time before or ar expirarion. European opri(),u can be exercised only at expiration. Yalu~ of American option will equal or exceed value of European option. They will have identical values excepr for: ( 1) call options on dividend paying stocks and (2) in-the-money pur oprions.

Factors that Affect Option Values

Increase in: C,,/l, Pu.ss

Asset price Increase Dtcreast

Exercise price Decrease Increase

Risk- free race Increase Docrease

Volacilicy Increase Increase

Time to Increase Increase· expiranon

Holding coses Increase Decrease

Holding Decrease Increase b•nefics

•Except some deep-in-the-money European puts.

Put-Call Parity The pur-call pariry rclarionship for European options at rime r-.

X c, + -( l_+_R_f_),,...T = S, + p,

ISBN: 978- 1-4754-9508-9

9 781475 495089

©2019 Kaplan, Inc. All Rights Reserved.

Each securiry in che puc-call parity relarionship can be expressed as:

S = c+ X p (l+Rf)T

c = S+p X

X S+p-c

Put-Call-Forward Parity The present value of the forward price of die underlying asser, F 0(T) I (l + Rf) 1, can be subsrirured for S0 in any of the pur-call pariry relarionsrups at rime 0.

ALTERNATIVE INVESTMENTS Hedge Funds Evem-drivm strategies: merger arbitrage; disrressed/ restructuring; activist shareholder; special situations. Relative value strafegiw convcrriblc arbitrage; asscr-backed fixed income; general fixed income; volatility; muJci-srraregy. Equiry strategies: market neurral; fundamental growth; fundamental value; quantitative direcrional; short bias. Macro straregies: based on global economic rrends. Hedge fund fees: • "2 and 20": 2% management fee plus 20%

incenrivc fee. • Hard hurdle rare: incentive fee only on return

above hurdle rate. • Soft hurdle race: incenrive fee on whole return,

bur only paid if return is greater rhaa hurdle rare. • High warer mark: no incentive fee until value

exceeds previous high.

Private Equity leveraged buyouts: managemenr buyouts (exisring managers), management buy-ins (new managers) Ven1t1re capital stages of development:

Formative stage: angel invc.sci ng, seed stage, early stage.

• Later stage: expand producrion, increase sales. • Mezzanine stage: prepare for !PO. Portfolio company valuation methods: market/ comparables; discounted cash Row; asset-based. Exit strategies: trade sale; !PO; recapiralizarion; secondary sale; wme-off.

Real Estate Includes residential property; commercial property; real esrare investment crusts (Rf.lTs); farmland/ timberland; whole loans; consrrucrion loans. Property valuation method.: comparable sales; income approach; cost approach.

Commodities Cont1mgll: futtJre~ price > spQt price, Backwardation: futures price ,:; spor price. Sources ofinvestmem return: • Collateral y iekl: return on T-bills posted as margin. • Price retum: due to change in spot price. • Roll yuk/: positive for backwudanoa, negative for

concango. futures price ::::: spot price( l + R,.) + srnrage costs - convenience yield

l nfrastrucru re Long-lived assets for public use, including tra1uportatlo11, uLility, c oni111unications. :wcial. Brownfield:. Existing infrastrucrnre. Greenfield: lnframuaure to he builr.