TVM & statistical consepts

Interest rate = Real risk-free + Inflation premium + Default risk premium + Liquidity
premium + Maturity premium
Stated annual rate = r
Effective annual rate: EAR = (1 + (r / no of periods)) no of periods – 1
Continuous compounding rate:
 To convert a stated rate to continuously compounded rate use eX function
 To convert an EAR rates to continuously compounded rate use In function

Single cash flow:

Future value: calculator
Present value: calculator
FV = PV (e r x N) Where eX is on financial calculator

Series of cash flows

Future value: FV = Calculator
Present value: PV = Calculator
Perpetuity: PV = PMT / r

NPV & IRR

NPV = calculator
NPV rule & Net IRR rule: positive accept, Negative reject
In conflicts, use NPV with higher positive value

Portfolio return measurements

Holding period yield: HPY = (Face – Price + D) / price
Bank discount yield: RBD = (Face – Price / Face) 360 / days
Money market yield: RMM = HPY (360/days) = RBD (F/P)
Money weighted rate: MWR = IRR of cash flows
Time weighted rate: TWR
1. Break investment horizon into sub-periods
2. Calculate HPR for each sub-period
3. Compound HPRs by taking geometric mean, (1+rN) 1/N – 1
Effective annual yield: EAY = (1+HPY) 365/days (number of periods per year) – 1
Bond yield equivalent = 2 x semiannual effective rate or 4 x quarterly effective rate …….
Measurements of central tendency
Population mean: μ = ∑ X / N
Sample mean: ẍ =∑ X / n

Weighted mean: ẍ w=∑WX

Geometric mean: ẍ G = (X1 X2 X3…X n)1/n

Geometric rate mean: ẍ G-rate = ((1+r1) (1+r2) (1+r3) (1+rN)) 1/N – 1

Harmonic mean: ẍ H = n / ∑ (1/X)
Quantiles, Ly = (n+1) (y/100)

Measurements of dispersion
Range = Maximum value – Minimum value
Mean absolute deviation: MAD = ∑ ∣X − ẍ∣ / n
Variance: σ2 = ∑ (X − μ) 2 / N
Standard deviation: σ = square root of variance

Sample variance: s2 =∑ (X − ẍ) 2 / (n -1)

Sample standard deviation: s = square root of variance
Chebyshev’s inequality, 1 − 1/k2 for all k > 1.

Coefficient of variation: CV = σ / ẍ

Sharp ratio: SH ratio = ẍ R Portfolio –ẍ R Free /σ Portfolio

Skewness: SK = (1 / n) (∑ (X − ẍ) 3 / σ 3)

Kurtosis: KE = {1 / n) {∑ (X − ẍ) 4 / σ 4} – 3

Probability concepts
ODDS:
Odds for is 1 to 7: probability = 1 / 8
Odds against is 15 to 1: probability = 15 / 16
Unconditional probability P (A)
Conditional probability P (A/B)
The probability for independent A and B occurs, P (AB) = P (A) P (B)
The probability for dependent A and B occurs, P (AB) = P (BA) = P (A/B) P (B)
Probability that independent A or B occurs, P (A or B) = P (A) + P (B)
Probability that dependent A or B occurs, P (A or B) = P (A) + P (B) – P (AB)
Total probability: P (A) = P (AS) + P (ASC)
Bayes formula:
P (Event ∣ Information) = {P (Information ∣ Event) / P (Information)} x P (Event)
P (A ∣ B) = {P (B ∣ A) / P (B)} x P (A)
Counting & labelling:
Multiplication rule for counting: n!
General formula: number of ways to label total n with k different ways: n! / n1! n2! … nk!
Combination formula: total n choose r when order does not matter: n C r = n! / ((n−r)! r!)
Permutation formula: total n choose r when order matter: n P r = n! / (n−r)!

Expected value
Expected value of random variable: E(x) = ∑ P(x) X
Variance of random variable: σ2(x) = ∑ P(x) (X−E(x)) 2
Standard deviation of random variable: σ = square root of variance

Portfolio expected return and variance

Portfolio expected return: E (RP) = ∑ w n E (Rn)
Portfolio expected variance: σ2 (RP) = w12 σ12 + w22 σ22 + 2 w1 w2 COV (R1, R2)
Covariance: COV (R1, R2) = ρ (R1, R2) σ1 σ2
Portfolio standard deviation: σ = square root of variance

Common probability distribution

Discrete uniform: equal probability for all outcomes
Continuous uniform distribution: is defined over a range a & b
P (any outcome) = 0
P (x1 interval x2) = (x1 – x2) / (b - a)
Continuous mean = (a + b) / 2
Binomial distribution: The probability of x successes in n trials is given by
Binomial probability of success = (n! / (n−x)! x!) p x (1− p) n-x
Binomial mean = n P
Standardization: Z value = (X – μ) / σ
Safety first ratio: SF Ratio = [E (RP) – RL] / σ P, choose portfolio with highest SF Ratio
Sampling
Standard error of sample mean: sẍ = σ / n1/2, when we know σ

Standard error of sample mean: sẍ = s / n1/2, when we do not know σ

Confidence interval = 100 (1 − α) %

Confidence interval structure = ẍ ± (z-statistic) σ

Popular confidence intervals:
 90% confidence interval is ẍ ± 1.65 standard error
 95% confidence interval is ẍ ± 1.96 standard error
 99% confidence interval is ẍ ± 2.58 standard error

Statistic for Small Sample Statistic for Large Sample

Sampling from:
Size Size
Normal distribution with known variance Z Z
Non-normal distribution with known
not available Z
variance
Normal distribution with unknown
T T (Z is alternative)
variance
Non-normal distribution with unknown
not available T (Z I alternative)
variance
Hypothesis tests
Single mean: T α/2, n−1 = ẍ RP − μ0 / sẍ,
Differences of 2 means: Tα/2, n−1 = d’ − μd0 / sd’
Single variance: χ2α/2, n−1 = (n−1) σ 2 / σ02
Equality of 2 variances: Fn1-1, n2-1 = s12 / s22

Corporate finance
Capital budgeting
NPV: calculator
IRR: calculator
Payback period: number of years to recover original project cost from original cash flows
Discounted payback period: number of years to recover original project cost from discounted
cash flows
Average Accounting Rate of return = Average net income / Average book value
Profitability Index = (CF0 + NPV) / CF0
Cross over rate = IRR of difference between cash inflows & outflows
Estimated increase in stock price = company’s value + NPV / shares outstanding
Where company’s value = price x shares outstanding
Cost of capital
WACC = W debt R debt (1− t) + W preferred R preferred + W equity R equity
R debt: yield to maturity approach
R preferred = Dividend / current preferred stock price
R equity
1- CAPM: R equity = Risk free + beta (risk premium)
Risk premium:
 Risk premium = average return of market – average return of free risk
 Risk premium = dividend rate + dividend growth rate – risk free rate
 Risk premium = survey approach
Beta:

 unlevered: βAsset = βEquity, comparable [1 + ((1 – t comparable) (D comparable / E comparable)] -1

 Lever it: βEquity, project = βAsset [1 + ((1 – t project) D project / E project)]
 2- DDM: R equity = (next dividend / price) + growth rate
 Growth rate = retention rate x ROE
 Retention rate = (1 – payout ratio)
 Payout ratio = Dividend / EPS
3- Bond yield approach: R equity = R Debt + risk premium
MCC break point = capital at cost of capital changes / weights of new target structure
Country risk premium = Sovereign yield spread X standard deviation of equity index of
developing country / Annualized standard deviation of the sovereign bond market in
developed market
Where Sovereign yield spread = Treasury bond yield in a developed country - government
bond yield in developing country
Leverage
DOL = % Δ operating income / % Δ Sales
DOL = [Q (P – V)] / [(Q (P – V)) – F]
DFL = % Δ net income / % Δ operating income
= EBIT / EBIT – interest
DFL = [(Q (P – V)) – F] / [(Q (P – V)) – F – C]
DTL = DOL x DFL
DTL = % Δ net income / % Δ units sold
DTL = [Q (P – V)] / [(Q (P – V)) – F – C]
Breakeven point: Q (P – V) = F + C
Operation breakeven point: Q (P – V) = F
Stock repurchase
1- Stock dividends & splits
Price new = original price (number of shares / number of new shares)
EPS new = original EPS (number of shares / number of new shares)
Dividend new = original dividends (number of shares / number of new shares)
2- Stock repurchase
EPS new = new net income / new number of shares
 After tax borrowing rate > Earning yield, EPS declines
 After tax borrowing rate < Earning yield, EPS increase
BVPS new = (original BV – purchase value) / (original shares outstanding – purchased shares)
 Current price > original book value, Book value per share will decrease
 Current price < original book value, Book value per share will increase
Working capital
Operating cycle = days of inventory + Days of receivables
Cash conversion cycle = Days of inventory + Days of receivables – Days of payables
Cost of trade credit = 1 + (Discount / 1 − Discount) (365 / remaining days) − 1
Credit with commitment fee: Cost = Interest + Commitment fee / Loan amount

All-inclusive with any other fee:

Cost = Interest + Dealer's commission + Backup costs / Net proceeds

Markets
Margin call price = initial price {(1 – initial margin) / (1 – maintenance margin)}
Returns calculation after one period
Price return of an index = END value − BGN value / BGN value
Total return of an index = END value + income − BGN value / BGN value
Value of index = ∑ W P
Value of index after T periods = BGN value (1+PR1) (1+PR2)… (1+PRT)
Weighting:
Price weighting W = P / ∑ P
Equal weighting W = 1 / N
Market capitalization weighting W = P x shares outstanding / ∑ P x shares outstanding
Float adjusted market capitalization weighting W = P x public shares / ∑ P x public shares
Fundamental weighting W = Fundamental value / ∑ Fundamental values

Equity
ROE ratio = Net income / Average Book value of equity
Price to book value ratio = Price / book value per share
Present value models
For common stock:
1- DDM:
Estimated price = PV of cash Dividends

2- FCFE:
Estimated price = PV of FCFEs
 FCFE = CFO – Fixed Capital investments + net borrowing
 CFO = net income + depreciation – increase in working capital
  Net Borrowing = new debt issues – debt principle repayments

3- Gordon growth model:

Estimated price = next dividend / R – G
 G = retention rate x ROE
 Retention rate = 1 – payout ratio
 Payout ratio = D / price

4- Multi stage dividend growth model:

Estimated present value = Value stage 1 + Value stage 2
 Value stage 1 = PV of Dividends
 Value stage 2 = Dividend (1+g) / r – g

For preferred stocks:

Infinite life: Estimated price = Dividends / rate
Finite life: Estimated price = PV of Dividends

Multiplier models
1- price multiples:
 Price to earnings per share ratio = P/E
 Price to book value per share ratio = P/B
 Price to sales per share ratio = P/S
 Price to cash flow per share ratio = P/CF
Fundamental: Low multiples associated with higher future returns

Enterprise multiples:
EV = market value of common & preferred shares & debt – cash & short term investments
Enterprise value to EBITDA ratio = EV / EBITDA
Comparable: Ratios below benchmark are undervalued, above benchmark are overvalued

Asset-based models
Equity value = market or fair value of assets – market or fair value of liabilities & preferred
shares / outstanding common shares
Fixed income
YTM (Yield to maturity rate) = IRR of cash inflows & outflows
Market discount rate approach:
Present value approach:
Estimated price = PV of cash inflows
 Coupon rate < market discount rate, bond priced at a discount.
 Coupon rate > market discount rate, bond priced at a premium.
 Coupon rate = market discount rate, bond priced at par.
When market discount rate changes it has the following effects:
 Inverse effect: Bond price is inversely related to market discount rate
 % Δ bond price is greater when
1- market discount rates goes down, convexity effect
2- for lower coupon, coupon effect
3- longer maturity bond, maturity effect
Spot rate approach:
Estimated price = sum of PV of each payment using its spot rate
= PMT / (1+S1) + PMT / (1+S2)2 + ⋯ + PMT+FV (1+SN) N
Full price between payments:
Full bond price = Estimated price x (1 + r) t/T
Full bond price = Flat price + Accrued interest
Accrued interest = PMT x (t / T)
Where (t / T) can be calculated by actual/actual or 30/360
Yield measures for fixed yield bond:
Effective annual yield = {(1+ periodic YTM) n} - 1
Current yield = annual PMT / bond price
Yield to call can be calculated for each possible call date and price
Yield to worst is the lowest of yield to call & yield to maturity
Option adjusted price = flat price + value of embedded option
Value of embedded option = price as it was option-free bond – price of an option price
Yield measures for FRNs (floating-rate notes):
Coupon rate = reference rate + quoted margin
Bond price = PV of cash inflows using reference rate + required margin
Yields to money market instruments:
Money market at discount rate: PV = FV {1 – (Discount yield (days / year)}
Money market at add on rate: PV = FV / {1 + Add-On yield (days / year)}
Bond equivalent rate = add on rate based on 365 days
To convert: Add on yield / Discount yield = 365/360
(1 + Spot 4)4 = (1+spot 1) (1+1Y1Y) (1+2Y1Y) x (1+3Y1Y)
= (1+spot 2)2 (1+2Y1Y) x (1+3Y1Y)
= (1+spot 3)3 (1+3Y1Y)
Off-record:
Approximate spot rate by: r1 + r2 + r3 / 3
Approximate forward rate by: 2Y1Y = 3 x r3 – 2 x r2

Horizon yield (Realized rate of total return):

To calculate horizon yield:
 Future sale price: PV at date of selling using face value and the missing coupons
 FV of reinvested coupons
 Total return by summing the above
 Calculate annualized holding period rate using PV & FV calculations

Duration:
Macaulay Duration calculations:
  PV of PMT: Calculate discounted value of each payment
 Weight of PV of PMT: Calculate weight of each discounted payment
 MacDur = ∑ Weight x term of maturity of each payment
ModDur = MacDur / (1 + YTM)
Approx. ModDur = (PV−) − (PV+) / 2 × (ΔYTM) × (PV0)
EffDur = (PV−) − (PV+) / 2 × (ΔCurve) × (PV0)
MonDur per par value = ModDur x Full price of the bond
MonDur = ModDur x Full price of the bond x quantity
PVBP (price value of 1 basis point) = (PV−) − (PV+) / 2
%Δ bond price ≈ – ModDur × Δ Yield
%Δ bond price ≈ – MoneyDur x Δ Yield
Bond duration of a portfolio:
(1) The weighted average of time to receipt of the aggregate cash flows
(2) The weighted average of the individual bond durations that comprise the portfolio.
Portfolio duration = W1D1 + W2D2 + ……. + WNDN
 W = market value of bond / ∑ market values of N bonds
 D = duration of each bond
 N = number of bonds
Convexity:
Approx. Con = ((PV−) + (PV+) – (2 × PV0)) / (ΔYield2 × PV0)
EffCon = ((PV−) + (PV+)] – (2×PV0)) / (ΔCurve)2 × (PV0)
%Δ bond price ≈ (− ModDur × Δ YTM) + (1/2 × Convexity × Δ YTM2)
%Δ bond price: %Δ bond price ≈ (− Duration × Δ spread) + (1/2 × Convexity × Δ Spread2)

Derivatives
PV of an asset:
S0 = PV of expected ST + PV of net cost of carry
Net cost of carry = PV of benefits – PV of costs
No arbitrage value:
S0 = F0 (PV of FT)
FT = ST (FV of S0)
At initiation: Value = S0 – PV of FT = 0
During its life N: Value = SN – PV of FT-N
At expiration: Value = ST – FT
No arbitrage value with costs and benefits:
At initiation: Value = S0 + PV of costs – PV of benefits – PV of FT = 0
During its life N: Value = SN + PVT- N Costs – PVT- N benefits – PV of FT-N
At expiration: Value = ST – FT
Arbitrage value:
If FT > ST, Arbitrager buy asset now, short position forward and gain the difference at T
If FT < ST, Arbitrager sell asset now, long position forward and gain the difference at T
For a call option
 In the money: price > exercise price
 Out of money: price < exercise price
 At the money: price = exercise price

For a put option

 In the money: exercise price > price
 Out of money: exercise price < price
 At the money: exercise price = price

European option:
 Call option value at T = Max (0, Price − exercise)
 Put option value at T = Max (0, Exercise − price)
Relationships:
 As price of underlying increases: call value increases, put value decreases
 As exercise price increases: call value decreases, put value increases
 As time increase: increase volatility, call value increase, put value increase except for
some cases in European put option
 As RF rate increase, call value increase, put value decrease
 As volatility of the underlying increase: increase both call & put values
 As benefits incur: call value decrease, put value increase
  As costs incur: call value increase, put value decrease
Put-call parity:
Current position = Spot price of asset + Premium for money at risk
Invested funds = Call cost + PV of exercise price
Spot price of asset + Premium for money at risk = Call cost + PV of exercise price
General equation: Long call + Long bond = long put + long asset
Covered call: long asset + write a call
Breakeven = current price – premium
Maximum gain = Strike price + premium – current price
Maximum loss = Current price – premium
Protective put: long asset + long put
Breakeven point: current price + premium
Maximum gain: unlimited
Maximum loss: premium
Binomial valuation:
Up = S+1 / S0, Down = S−1 / S0
C0 = π C+ + (1−π) C− / (1 + r)
P0 = π P+ + (1−π) P− / (1 + r)
Where π = 1 + R – down / Up − Down