CFA® Level I

Formula Sheet – 2023 Syllabus

QUANTITATIVE METHODS Mean Absolute Deviation Sample Covariance

QUANTITATIVE METHODS 4
E|
MAD = ∑*+34|X + − X ∑*+34(X + − 𝑋𝑋b)(𝑌𝑌H − 𝑌𝑌b)
* s@G =
THE TIME
THE TIME VALUE OF MONEY
MONEY n−1
Variance and Standard Deviation
Required Rate of Return *
Sample Correlation Coefficient
interest rate = real risk-free rate 1 s@G
Sample variance, s < = E)<
F(X + − X r@G =
+ inflation premium n−1 s@ sG
+34
required inter + default risk premium Standard deviation is square root of variance
PROBABILITY CONCEPTS
PROBABILITY CONCEPTS
required inter + liquidity premium
Target Downside Deviation
required inter + maturity premium Odds
∑) *+(@' AB)(
Sample target semideviation, s2$-=%# = X ' P(E)
Future Value (FV) and Present Value (PV) *A4 Odds of E =
1 − P(E)
FV = PV(1 + r)! Coefficient of Variation
Probabilities
Effective Annual Rates CV = s⁄EX; measures dispersion relative to mean
r"#$#%& ' Unconditional: P(A), probability of A
EAR = >1 + ? −1 Skewness Conditional: P(A|B), probability of A given B
m
EAR ()*#+*,)," = 𝑒𝑒 -!"#"$%
−1 Joint: P(AB), probability of A and B
Annuities Probability Rules
Annuity: Finite set of level sequential cash flows, Conditional: P(A|B) = P(AB)/P(B)
valued using calculator’s TVM function Multiplication: P(AB) = P(A|B) × P(B)
Ordinary Annuity: 1st cash flow received in one year Addition: P(A or B) = P(A) + P(B) − P(AB)
Annuity Due: 1st cash flow received immediately
Perpetuity: Ordinary annuity with payments that Total: P(A) = P(A|S4)P(S4) + ⋯ + P(A|S* )P(S* )
012 where S4 , S< ,… S* is an exhaustive set of mutually
continue forever, PV.%-.%#,+#/ =
- exclusive probabilities

ORGANIZING,VISUALIZING,
VISUALIZING,AND DESCRIBING Independence
ORGANIZING,
AND DESCRIBING DATA
DATA If A and B are independent events,
Data Visualization P(AB) = P(A) × P(B)
- Histogram and frequency polygon Expected Value
- Bar chart (and Pareto chart) *

- Tree-map E(X) = F P(X + )X +

+34
- Word cloud/tag cloud
E(X) = E(X|S4)P(S4) + ⋯ + E(X|S* )P(S* )
- Line chart (and bubble line chart)
- Scatter plot (and scatter plot matrix) Variance
- Heat map *

E)D σ< (X) = F P(X + )[X + − E(X)]<

Arithmetic Mean Return 1 ∑*+34(X + − X
Skewness ≈ \ ] +34
* n sD
1 Covariance
Sample mean, E
X = F X + ; n = sample size
n Kurtosis (Excess Kurtosis = Kurtosis – 3) * *
+34
Distribution 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 Peaked Kurtosis Cov(X, Y) = F F P(X + , Y+ )[X + − E(X)][Y+ − E(Y)]
Geometric Mean Return +34 I34
&
Leptokurtic Fatter More >3
R 5 = I∏6734(1 + R # ) − 1 An asset’s covariance with itself is its variance
Mesokurtic Normal Normal 3
Harmonic Mean Return (Cost Averaging)
Platykurtic Thinner Less <3 Expected Value & Variance of Portfolio Return
n
E8 =
X , where X > 0 for i = 1, 2, … , n *
1
∑*+34 EmR . n = F w+ E[R + ]
X+
+34
E9-+#:. > X
If returns are volatile, X E5%). > EX 8$-. * *

Quantiles σ< mR .n = F F w+ wI CovmR + , R I n

y +34 I34
Location of y #: percentile, L/ = (n + 1)
100 Market value of investment i
w+ =
If L/ is not an integer, use linear interpolation. Market value of portfolio
Distributions may be divided into quarters
(Quartiles), fifths (Quintiles), or tenths (Deciles)
E.g., 50th percentile = 2nd quartile = 5th decile 1 ∑*+34(X + − E
X) F
Excess kurtosis, K E ≈ \ ] F
−3
n s

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For portfolio with 2 investments: Lognormal Distribution SAMPLING AND ESTIMATION
ESTIMATION
EmR . n = w9 R 9 + wB R B - e@ where is normally distributed Sampling
- sed to model asset prices i ple rando sa plin : Subset of population is
Cov(R 9 , R B ) = σ(R 9)σ(R B ) (R 9 , R B)
- Positively s ewed chosen at random
σ< mR .n = w9< σ< (R 9 ) + wB< σ< (R B ) ontinuously compounded return from t to t + 1: yste atic sa plin : Every th observation is
S# 4 chosen until desired sample si e is achieved
+ 2w9 wB Cov(R 9 , R B ) r# # 4 = ln \ ] = lnm1 + R # # 4 n
S# trati ied sa plin : Simple random samples are
Correlation where R # # 4 is the effective annual rate drawn from each subpopulation (strata)
CovmR + , R I n Cluster sa plin : Sample set is divided into mini-
+I = CorrmR + , R I n = ; min −1, max 1 Student s t Distribution
σ(R + )σmR I n representations of the population (cluster)
Parameters: degrees of freedom (df)
The ratio below is t-distributed with df = n − 1: Con enience sa plin : Samples are selected based
Bayes Formula
P( nfo|Event) × P(Event) E−
X on accessibility
P(Event| nfo) = t= Jud ental sa plin : Samples are selected based
P( nfo) s/ n
pdates prior probabilities to give posterior on researchers’ nowledge and expertise
probabilities based on new information
Sampling error = Sample mean Population mean
Counting Rules Central Limit Theorem (CLT)
actorial: n = n(n − 1)(n − 2) … 1 For a sample of si e n 30 from a population with
mean and variance σ< , the sample mean XE
Multino ial: approximately follows a normal distribution with
… #
! "
ounts ways to label n items with labels mean and variance σ<⁄n

n %! Standard Error of Sample Mean

Co ination: %C$ = # & = Chi Square Distribution
r (%($)!$! Population ariance is no n: σ = σ⁄ n
Definition: Sum of squares of independent normal
ounts ways to choose r items from n if order does Population ariance is not no n: s = s⁄ n
random variables. It cannot be negative.
OT matter
"! Properties of Estimators
Per utation: "P! = ("%!)! A point estimator is:
ounts ways to choose r items from n if Un iased if its value matches the value of the
order does matter parameter it estimates
icient if it has the lowest variance of all
unbiased estimators
COMMONPROBABILITY
COMMON PROBABILITYDISTRIBUTIONS
DISTRIBUTIONS
Consistent if its value approaches the parameter
Discrete Uniform Distribution
as the sample si e increases
1
p(x) = , x = x4 , x < , … , x * F Distribution
n Confidence Interval
Definition: A ratio of two chi-square random
Continuous Uniform Distribution Point estimate Relia ility factor × Std error
variables (two df’s). It cannot be negative.
1 Point esti ate: Estimate of population parameter
f(x) = ; a x
−a elia ility actor: Value from distribution of point
x−a estimate, such as normal or t-distribution
F(x) = ; a x
−a E z < × σ⁄ n
E.g., X
Binomial Distribution
n Reliability factors for normal distributions
p(x) = > ? p (1 − p)*A , where i ni icance Con idence
x
<
n = num er of Bernoulli trials le el inter al
p = pro a ility of success 10 0 1. 5
E(X) = np Simulation Techniques
5 5 1. 0
σ< (X) = np(1 − p) Monte Carlo si ulation: enerate many random
samples to produce a distribution of outcomes 1 2.5 5
Normal Distribution ( = mean, = SD) istorical si ulation: Sample from a historical
< If the population is not normally distributed
50 of observations are within of record of returns to simulate a process and/or variance is un nown, the t- or -
D
of observations are within of distributions may be used to get reliability factors.
5 of observations are within 2 of ormally Variance Small Large
of observations are within 3 of Distributed nown Sample Sample
es es
O served value − Population mean X − es o t t or
= =
Standard deviation σ o es n/a
o o n/a t or
EmR . n − shortfall level
Shortfall Ratio = Resampling
σ0
ootstrap: eplace each drawn sample with an
identical element for the next draw
Jac ni e: Draw each sample by leaving out one
observation at a time without replacement

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Biases Tests Concerning Differences between Means Assumptions of Simple Linear Regression
Data snoopin ias: Drilling data to find any or al populations it un no n ariances t at Model
statistically significant relationship are assu ed e ual: - Linear relationship between and
a ple selection ias: Excluding unavailable data E4 − E
(X X<) − ( 4 − <) - Homoscedasticity (i.e., constant variance of
t-statistic =
ur i ors ip ias: Excluding the impact of failed s.< s.<
4 < residuals)
\ + ]
funds or companies that no longer exist n4 n< - Independence between and
oo a ead ias: Information needed is not nown (n4 − 1)s4< + (n< − 1)s<< - ormality of the residuals
on the date the observation was recorded s.< =
n4 + n< − 2 Analysis of Variance
Ti e period ias: sing data from an era that df = n4 + n< − 2 u o s uares error : nexplained variation
ma es the results time-period specific
Tests Concerning Mean Differences in
<
or al populations it un no n ariances: SSE = ∑*+34 mY+ − Y+ n
HYPOTHESISTESTING
HYPOTHESIS TESTING
db − & u o s uares re ression : Explained
Steps in Hypothesis Testing t-statistic = , df = n − 1
s& variation in
1. State hypotheses (null and alternative) <
2. Identify test statistic SSR = ∑*+34 mY+ − E
Yn
Tests Concerning a Single Variance
. Specify significance level or al population d n : u o s uares total T : Total variation in
. State decision rule <
* SS = SSE + SSR = ∑*+34 (Y+ − E
Y)<
<
(n − 1)s 1
5. ollect data; calculate test statistic = , s< = F(X + − xb)<
σ< n−1 Coe icient o deter ination:
+34
. Ma e decision regarding hypothesis SSR
Tests Concerning Two Variances R< =
SS
Test Statistic (General)
or al populations: = r < (if there is only one independent varia le)
Sample statistic − ypothesized value *
s4< 1 statistic:
Standard error of sample statistic <
F= , sI< = Fmx+I − xbI n for = 1, 2 MSR SSR/k
s<< nI − 1 F= =
Hypothesis Test Results +34 MSE SSE/(n − [k + 1])
df4 = n4 − 1; df< = n< − 1
e e t ! i test tandard error o re ression:
e ot eses
statisti is Nonparametric Tests <
∑*+34 mY+ − Y+ n
ne taile ! ! Test that is not concerned with parameter and is s% = MSE =
critical alue n−2
upper " ! implemented in situations such as:
ne taile ! ! - Data do not meet distributional assumptions Hypothesis Testing of Linear Regression
critical alue
lo er " ! - Data are sub ect to outliers Coefficients
lo er critical - Data are given in ran s To test a hypothesis about the slope:
T o ! ! - Hypothesis does not concern a parameter −
alue or upper t=
4 4
taile " ! s
critical alue Tests Concerning Correlation
s%
n−2 s =
Hypothesis Testing Decision Errors t-statistic = , df = n − 2 E)<
I∑*+34 (X + − X
1 − r<
Decision is True is alse To test a hypothesis about the intercept:
To use t e pear an ran correlation coe icient
Do not re ect orrect Type II (b) −
su stitute t e ollo in alue into t e t statistic t=
s
e ect Type I (a) orrect calculation:
∑*+34 d<+ 1 E )<
(X
Power of a test = 1 − P( ype error) = 1 b r =1− s = MSE +
n(n< − 1) n ∑*+34 (X + − E
X)<
p alue: smallest value of a at which is re ected

Tests Concerning a Single Mean

INTRODUCTION TOLINEAR
INTRODUCTION TO LINEARREGRESSION
REGRESSION
Estimated variance of the prediction error for :
Population is nor al it no n ariance: Simple Linear Regression 1 (X − E X) <
E− : Dependent variable/explained variable s < = s%< 1 + +
X n (n − 1)s <
z-statistic = : Independent variable/explanatory variable
σ⁄ n
ar e sa ple ro any population it un no n Y= + 4X + ,
ariance c oices : where is the intercept, is the slope coefficient,
4
E−
X
t-statistic = , df = n − 1 and is the error term
s⁄ n
E−
X The parameters can be estimated by:
z-statistic = Cov[Y, X] ∑*+34 (Y+ − E
Y)(X + − E
X)
σ⁄ n 4 = =
Var[X] ∑+34 (X + − E
*
X)<
all sa ple ro nor al population it
un no n population ariance: =E
Y− 4X
E
E−
X
t-statistic = , df = n − 1 Cov[Y, X]
s⁄ n r=
IVar[Y]IVar[X]

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ECONOMICS ECONOMICS Breakeven Analysis Monopolistic Competition
Economic brea even occurs if a firm’s accounting - Firms: Many
TOPICSIN
INDEMAND
DEMANDAND
ANDSUPPLY
SUPPLYANALYSIS
ANALYSIS profit is enough to cover its implicit opportunity - Products: Differentiated (via advertising)
TOPICS
costs (i.e., normal profit). In the long run, firms
Own Price Elasticity of Demand - Barriers to entry: Low
cannot earn positive economic profits.
& &
P - Pricing power of firms: Some
E.& = = \ ] Shutdown Decision (Short term vs Long term)
P P & Pro it a i i ation: MR = MC
ort Ter on Ter
&
= quantity demanded, P = price per unit T T Stay in Stay in
E.& > 1: elastic TV T T Stay in Exit mar et
E.& 1: inelastic T TV Shut down Exit mar et
E.& = : perfectly elastic
Economies of Scale
E.& = 0: perfectly inelastic Each stage of expansion has its own short-run AT
E.& = −1: unit elastic curve. Mini u e icient scale is the low point on
the long-run average total cost curve.
Income Elasticity of Demand
& &
E& = = \ &
]

where I = consumers’ income

E & > 0: normal good; E & 0: inferior good Oligopoly
- Firms: Few
Cross Price Elasticity of Demand
& &
- Products: Similar (close substitutes)
P/
E.& = = \ &] - Barriers to entry: High
P/ P/
- Pricing power: Some or considerable
where P/ is the price per unit of another good
Pro it a i i ation: MR = MC
E.& > 0: substitutes; E.& 0: complements

Income and Substitution Effects THE

THE FIRM
FIRM AND
AND MARKET
MARKET STRUCTURES
STRUCTURES
Impacts of a reduction in a good’s price:
Perfect Competition
u stitution
Type o ood nco e e ect - Firms: Many
e ect
- Products: Identical
ormal Buy more Buy more - Barriers to entry: Very low
Inferior Buy less Buy more - Pricing power of firms: one

oods with positively sloped demand curves: Pro it a i i ation:

- i en oods: egative income effect is greater - P = MR = MC
than positive substitution effect if good’s price - P > A C economic profit, P A C economic loss
falls
- e len oods: Demand for a status symbol good in ed demand curve: A price increase will impact
falls if its price is reduced sales more than an equivalent price decrease

Revenue Terms Cournot assu ption: ompetitors will maintain

current output levels if one firm changes its price
Total re enue T : Price times quantity; P ×
a e t eory: If one firm changes its prices,
A era e re enue A : R⁄ competitors will ad ust to maximi e their profits,
Mar inal re enue M : R⁄ resulting in a ash equilibrium

Cost Terms Price collusion is more li ely to happen if:

- Few firms or one dominant firm
Total i ed cost T C : Sum of fixed costs
- Products are relatively similar
Total aria le cost T C : Sum of variable costs
- Firms have similar cost structures
Total costs TC : FC + VC
- Orders are frequent and relatively small
A era e i ed cost A C : FC⁄
- redible threat of retaliation for brea ing pact
A era e aria le cost A C : VC⁄
- The threat of external competition is high
A era e total cost ATC : AFC + AFV or C⁄
Mar inal cost MC : C⁄
Profit Measures
Accounting profit = evenue − Accounting costs
Economic costs = Accounting costs + Implicit costs
Economic profit = evenue Economic costs
= Accounting profit−Implicit costs
ormal profit = ero economic profit
Profits maximi ed if M = M and M isn’t falling

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Monopoly Relationship among Saving, Investment, the Shifts in Aggregate Supply (SRAS and LRAS)
- Firm: One Fiscal Balance, and the Trade Balance A A
ncrease in
- Products: nique (no close substitutes) ( − ) = (S − ) − (X − M) it it
- Barriers to entry: Very high − = fiscal balance Labor supply ight ight
- Pricing power of firm: onsiderable (price S − = savings minus domestic investment
atural resources ight ight
discrimination possible) X − M = trade balance
Human capital ight ight
Pro it a i i ation: MR = MC
Aggregate Demand (AD) Physical capital ight ight
The downward slope of the AD curve results from: Productivity/Tech ight ight
- ealt e ect: Price level , real wealth , quantity ominal wages Left one
demanded Input prices Left one
- nterest rate e ect: Price level , interest rate , Price expectations ight one
investment and consumption expenditures
Business taxes Left one
- eal e c an e rate e ect: Price level , real
Business subsidies ight one
exchange rate , exports and imports
Foreign currency
ight one
Aggregate Supply (AS) values

Inflationary Gap

Price discrimination by monopolists:

- 1st degree: Different price for each customer
- 2nd degree: uantity-based menu options
- d degree: Pricing for demographic groups

Market Power Measures

ir concentration ratio: Sum of mar et share
of the largest firms in the industry
er inda l irsc an nde : Sum of squared
mar et share of the largest firms

AGGREGATE OUTPUT,
AGGREGATE OUTPUT,PRICES,
PRICES,AND ECONOMIC ull e ploy ent le el o output: Long-run
AND ECONOMIC
GRO TH GROWTH
equilibrium level of output
Gross Domestic Product (GDP)
o inal DP: DP in terms of current prices Factors Increasing Aggregate Demand (AD)
- Higher household wealth Effect of Combined Changes in AS and AD
eal DP: DP in terms of base-year prices
- Higher business and consumer confidence C an es in
DP de lator: ( ominal DP⁄Real DP) × 100 eal DP Prices
- Higher capacity utili ation A and AD
DP = C + + + (X − M)
C = consumption - Expansionary monetary and fiscal policies AS , AD Increase nclear
= investment - Depreciating domestic currency value AS , AD Decrease nclear
= government spending - Faster global economic growth AS , AD nclear Decrease
X = exports; M = imports AS , AD nclear Increase

D
= et domestic income UNDERSTANDING BUSINESSCYCLES
UNDERSTANDING BUSINESS CYCLES
+ Consumption of fixed capital Business Cycle Phases
+ Statistical discrepancy ecovery
D - cono y: oing through a trough
= Compensation of employees - Acti ity le el: Below potential but start to increase
+ ross operatin surplus + ross mixed income - ploy ent: Layoffs slow, but firms prefer
+ axes (net of su sidies) on production extending overtime to rehiring full-time
+ axes (net of su sidies) on products and imports - n lation: Moderate
- Capital spendin : Low but increasing, with a focus
Personal household income on efficiency rather than capacity
= Compensation of employees Expansion
+ et mixed income from - cono y: En oying an upswing
unincorporated usinesses - Acti ity le el: Above-average growth rates
+ et property income - ploy ent: Full-time rehiring, more overtime
- n lation: Moderate, but increasing
- Capital spendin : Focused on capacity expansion

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Slowdown MONETARY AND FISCAL POLICY
FISCAL POLICY INTRODUCTION TO GEOPOLITICS
INTRODUCTION TO GEOPOLITICS
- cono y: oing through a pea Monetary Policy National Governments and Political
- Acti ity le el: Decelerating Required reserves Cooperation
Required reserve ratio =
- ploy ent: Hiring slows otal deposits tate actors possesses the authority to deploy a
- n lation: Accelerating Money multiplier = 1⁄Reserve requirement country’s national security resources
- Capital spendin : Strong capital spending, but Fisher effect: R *)'+*$ = R -%$ + %
Non State Actors and the Forces of
inventory starts building up as sales growth
Central Bank Roles Globalization
slows on state actors participate in global political,
- Sole currency supplier
ontraction - Lender of last resort economic, or financial affairs but do not control a
- cono y: Wea ens and may go into a recession - Ban for commercial ban s and government country s national security resources
- Acti ity le els: Below potential - egulate and supervise payments system Assessing Geopolitical Actors and Risk
- ploy ent: Hiring free es, then layoffs - old and foreign exchange reserves holder
- n lation: Decelerating, but with a lag - Oversee monetary policy
- Capital spendin : ew orders halted and existing
Monetary Policy Tools
orders canceled, scale bac on maintenance
Expansionary monetary policy measures:
Business Cycle Theories Policy rate: Set policy rate below neutral level
- eoclassical: Invisible hand lets mar ets reach a eser e re uire ent: educe reserves for The Tools of Geopolitics
natural equilibrium; government should not commercial ban s ational security tool: Military force, espionage
intervene Open ar et operations: Buy bonds from cono ic tools: urrency union, nationali ation
- Austrian: Li e eoclassical, focus on loose commercial ban s inancial tools: urrency mar ets, sanctions,
monetary policy causing credit-fueled booms capital controls
Fiscal Policy Spending Tools
- eynesian: ountercyclical fiscal policy should be
Trans er pay ents: edistribution of wealth (e.g., Incorporating Geopolitical Risk into the
used to support aggregate demand
unemployment benefits) Investment Process
- Monetarist: Oppose eynesian fiscal focus, call for Types of geopolitical ris :
Current spendin : Spending on goods and services
steady growth of money - Event ris
Capital spendin : Spending on infrastructure
Unemployment - Exogenous ris
Fiscal Policy Revenue Tools - Thematic ris
- Une ployed: obless people who are see ing obs
Direct ta es: Tax on income (e.g., income taxes,
- a or orce: People with a ob or unemployed Assessing Geopolitical Threats
corporate taxes, capital gains taxes)
- Une ploy ent rate: nemployed⁄La or force To assess geopolitical ris , consider:
ndirect ta es: Tax on goods and services
Type esult o - The li elihood of occurrence
Frictional Temporary transitions Fiscal Multiplier - The velocity (speed) of impact
Structural Long-run changes in economy 1 - The si e and nature of impact
= , where MPC = mar inal
yclical hanges in economic activity 1 − MPC(1 − t)
propensity to consume; t = tax rate INTERNATIONAL
INTERNATIONAL TRADE
TRADE & CAPITAL
AND FLOWS
CAPITAL FLO S
Inflation Difficulties Executing Fiscal Policy Basics of International Trade
De lation: egative inflation rate eco nition la : overnment must see need Ter s o trade: Price of exports/Price of imports
Disin lation: Declining inflation rate Action la : Time needed to choose policy Autar y: o trade with other countries
yperin lation: Extremely high inflation rate A solute ad anta e: Lower total cost of production
pact la : Policies do not have immediate impact
Cost pus : From decrease in aggregate supply Co parati e ad anta e: Lower opportunity cost
De and pull: From increase in aggregate demand
International Trade Models
aspeyres inde : se base consumption bas et
icardian: Labor is the only factor of production,
Paasc e inde : se current consumption bas et
comparative advantage due to labor productivity
is er inde : ILaspeyres × Paasche
ec s er O lin: Both labor and capital are factors,
Economic Indicators income redistribution is possible through trade
eadin : Stoc indexes, building permits Trade Restrictions
Coincident: eal income, industrial production Tari s: Taxes on imported goods
a in : nemployment rate, prime lending rate Quotas: Limits on quantity of imported goods
port su sidies: Payments to exporters
Mini u do estic content re uire ents
oluntary e port restraints: Self-imposed
limitations by foreign producers

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Impact of Trade Restrictions Exchange Rate Regimes Income Statement Line Items
Dollari ation: Adopt another country’s currency evenue
Monetary union: Adopt a common currency − ost of goods sold ( O S)
Currency oard: ommitment to exchange ross Profit
domestic currency at fixed exchange rate
− Selling, eneral Admin. (S A)
i ed pe : urrency is pegged to foreign currency
EBITDA
(or bas et of currencies) within 1 margin
− Depreciation and Amorti ation
Tar et one: Fixed peg with wider margin
Cra lin pe : Peg rate is periodically ad usted EBIT (Operating profit)
Cra lin ands: Margin increases over time, − Interest
usually to transition from fixed peg to floating EBT (Earnings before taxes)
Mana ed loatin : Monetary authority intervenes, − Taxes
but no official target exchange rate et Income ( I)
- Price increases from P to P# ndependently loatin : Mar et sets exchange rate
- Domestic production increases from 4 to Separately Reported Items
<
Marshall Lerner Condition - Discontinued operations
- Domestic consumption falls from F to D
urrency devaluation can improve a country’s - nusual or infrequent items ( S AAP only)
- Imports fall from ( F − 4 )to ( D − < )
trade balance if demand elasticities cause export - on-operating items
- Loss of consumer surplus = (A B D)
receipts to increase more than import
- ational welfare loss = (B D) Basic Earnings per Share
expenditures
- Increase in producer surplus = A et income − Preferred dividends
- Tariff revenue/ uota rent = ei hted avera e of shares outstandin
Regional Trading Blocs FINANCIAL STATEMENT
FINANCIAL ANALYSISND
STATEMENT ANALYSIS
ANALYSIS Diluted Earnings per Share
ree trade area TA : Free trade among members
Custo s union CU : FTA + common trade policy ( )
FINANCIAL REPORTINGSTANDARDS
FINANCIAL REPORTING STANDARDS
Co on ar et CM : + free movement of
FASB, IASB, and IOSCO
factors of production within bloc
A : Sets forth S AAP
cono ic union U : M + common economic
A : Establishes IF S
institutions and coordination of economic policies Must be equal to or less than basic EPS
O CO: International body of regulatory authorities
Monetary union MU : E + common currency
C: S capital mar ets regulator
Balance of Payments Components
UNDERSTANDING BALANCESHEETS
UNDERSTANDING BALANCE SHEETS
Fundamental Qualities of Financial Reports
Current account: Merchandise and services, income 1. elevance 2. Faithful epresentation Classified Balance Sheet
receipts, unilateral transfers Enhancing Characteristics Current Assets: To be used within one year
Capital account: apital transfers, non-financial 1. omparability 2. Verifiability - ash and equivalents
assets sales/purchases - Mar etable securities
. Timeliness . nderstandability
inancial account: overnment-owned assets - Accounts receivable, net of bad debt expense
abroad, foreign-owned assets in the country - Inventories
UNDERSTANDING INCOMESTATEMENTS
UNDERSTANDING INCOME STATEMENTS
- Other (e.g., prepaid expenses)
CURRENCYEEXCHANGE RATES Revenue Recognition
CURRENCY CHANGE RATES on Current Assets
evenue must not be recogni ed unless:
Exchange Rate Calculations - Property, Plant, and Equipment (PP E)
- is s of ownership have been transferred
CP - Investment property
Real ex rate& = ominal ex rate& ×\ ] - Amount of revenue can be reliably measured
CP & - Intangible assets
Forward exchan e rate& 1 + i& - ustomer is li ely to pay
= - oodwill
Spot exchan e rate& 1+i - Transaction is unli ely to be reversed
- Financial assets
Cross rate: S9 = S9 × S Service revenue may be recogni ed as earned
B B Current ia ilities: To be settled within one year
or ard e c an e rates in points: Allo ance or dou t ul accounts: ontra-asset
- Accounts payable
- nit of points is last decimal place in the rate account, estimated based on historical experience
- otes payable
quote (e.g., 1.5 01 to 1.5 02 is a 1-point increase) Expense Recognition - Accrued expenses
Ideal Currency Regime Matc in principle: Expenses must be recogni ed - Deferred income ( nearned revenue)
1. Exchange rates are credibly fixed in the same period as associated revenue on ter ia ilities
2. Fully convertible currencies, free capital flows - Long-term debt
. ountries pursue independent monetary policies - Deferred tax liabilities
Such an ideal currency regime is OT possible uity
- ontributed capital
- Preferred shares
- Treasury shares
- etained earnings
- Accumulated other comprehensive income (O I)
- on-controlling (minority) interest

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UNDERSTANDINGCASH
UNDERSTANDING CASHFLO
FLOWSTATEMENTS
STATEMENTS FINANCIAL ANALYSIS
ANALYSIS TECHNIQUES
TECHNIQUES Solvency Ratios
Cash Flow Statement Classifications Common Size Analysis otal de t
De t-to-equity =
FO: ash flows from regular operations ertical: otal shareholders equity
FI: ash flows for buying/selling long-term assets - State income statement items as of revenue otal de t
FF: Financial transactions with capital providers - State balance sheet items as a of total assets De t-to-capital =
otal shareholders
otal de t +
te U AAP - State each cash flow statement item as a of equity
Dividends paid FF FO/ FF total cash inflows/outflows otal de t
ori ontal Trend Analysis: De t-to-assets =
Interest paid FO FO/ FF otal assets
Dividends received FO FO/ FI - State each item relative to its base-year value
Avera e total assets
Interest received Financial levera e =
FO FO/ FI Activity Ratios Avera e total equity
Tax expenses FO FO Annual sales
Receiva les turnover = EB
IF S treat tax expenses for investing or financing Avera e receiva les nterest covera e =
nterest payments
transactions as FI or FF
Days of sales 3 Fixed
= EB + Lease payments
CFO Direct Method outstandin Receiva les turnover char e =
covera e nterest payments + Lease pmts
- onvert each accrual-based item in the income Cost of oods sold
statement to cash inflow/outflow nventory turnover =
Avera e inventory Profitability Ratios
- FO is net of cash inflows and outflows et income
Days of inventory 3 et profit mar in =
= Revenue
CFO Indirect Method on hand nventory turnover
- Start with net income ross profit
Purchases ross profit mar in =
- Add noncash expenses (e.g., Depreciation) Paya les turnover = Revenue
Avera e trade paya les
- Subtract gains/add losses EB
- Add increases in current liabilities um er of days 3 Operatin profit mar in =
= Revenue
- Subtract increases in (non-cash) current assets of paya les Paya les turnover
EB
Revenue Pretax mar in =
Beginning accounts receivable otal asset turnover = Revenue
Avera e total assets
+ evenue et income
Revenue Return on assets (ROA) =
− Ending accounts receivable Avera e total assets
Fixed asset turnover =
Cash collected from customers Avera e net fixed assets
Revenue EB
orkin capital Return on total capital =
= Avera e total capital
ost of goods sold turnover Avera e workin capital
+ Increase in inventory et income
Liquidity Ratios Return on equity (ROE) =
Purchases from suppliers Avera e total equity
Current assets
− Increase in accounts payable Current ratio =
Current lia ilities Valuation Ratios
Cash paid to suppliers
Marketa le Dividends declared
Cash + + Receiva les Dividend payout ratio =
Free Cash Flow (FCF) uick ratio = securities availa le to common
Current lia ilities
ree cas lo to t e ir C : ash available to Retention rate (RR) = 1 − Dividend payout ratio
equity owners and debt holders. Cash + Marketa le securities
Cash ratio = Sustaina le rowth rate ( ) = RR × ROE
FCFF = + CC + × (1 − t) − FC − C Current lia ilities
FCFF = CFO + × (1 − t) − FC Marketa le Price per share
Cash + + Receiva les P/E Ratio =
Defensive securities Earnin s per share
=
ree cas lo to e uity C : ash flow available interval Avera e daily expenditures
to common shareholders DuPont Analysis
Cash Days of Days of um er et income Assets
FCFE = CFO − FC + et Borrowin
conversion = sales + inventory − of days ROE = \ ]\ ]
Assets Book Value of Equity
cycle outstandin on hand paya les
Levera e
= (ROA) > ?
ratio
Revenue Assets
=\ ]\ ]\ ]
Revenue Assets Equity

et profit Asset Levera e

=\ ]> ?> ?
mar in turnover ratio

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INVENTORIES
INVENTORIES Depreciation Methods INCOME TA
TAXES
ES
Inventory Valuation Requirements % Temporary Taxable Differences
trai t line: =
!
IF S: Lower of cost or net reali able value De erred ta assets DTA : reated when taxes
S AAP: Lower of cost or mar et value Dou le declinin alance DD : payable exceeds income tax expense
eversals of inventory write-downs are allowed Book value# De erred ta lia ilities DT : reated when taxes
Depreciation# = \ ]× 2
under IF S, but not under S AAP Deprecia le life payable is less than income tax expense
Units o production: Ta ase o assets: Amount that will be deducted on
Inventory Valuation Methods and Systems
Cost − Salva e the tax return as asset’s benefits are reali ed
U AAP Depreciation# = × Output units#
otal output Ta ase o lia ilities: arrying value of liability
FIFO Allowed Allowed
minus amount that will be deductible
LIFO Allowed /A Intangible Assets
Weighted Allowed Allowed Purc ased: ecord at fair value (purchase price) Asset carrying amount Tax base DTL
average De eloped internally: Asset carrying amount Tax base DTA
IF S Liability carrying amount Tax base DTA
Specific Allowed Allowed
- esearch expenditures are expensed Liability carrying amount Tax base DTL
Identification
- Development expenditures are capitali ed
Impact of Inventory Valuation Method pact o ta rate c an es
S AAP
prices are risin O O If tax rate increases, DTA and DTL will increase
- enerally, both D costs are expensed
Ending Inventory Higher Lower If tax rate decreases, DTA and DTL will decrease
Ac uired in usiness co ination:
ncome tax exp = axes paya le + D L − D A
O S Lower Higher Purchase price is allocated to each asset on fair
et income Higher Lower value basis; excess recorded as goodwill Valuation Allowance
Income Tax Expense Higher Lower ontra account used if it is unli ely that future
Capitalizing vs Expensing
Operating cash flow Lower Higher profits will be sufficient to use DTAs and credits
- apitali ing increases assets on the balance sheet
Perpetual s periodic in entory syste : and investing cash outflows Deferred Tax Charges Directly to Equity
- Periodic system matches total units sold for the - Expensing reduces net income by the after-tax - evaluation of PP E (IF S only)
period with total purchases for the same period expenditure amount in the period it is incurred - Impact of changes in accounting policies
- Perpetual system updates after each transaction - Impact of exchange rate fluctuations
Impairment of PP&E and Intangible Assets
- nder FIFO, ending inventory and O S are the - hanges in fair value of certain investments
S AAP
same for periodic or perpetual - Asset tested for impairment only when firm may
- Weighted average and LIFO will show differences not recover carrying value through future use NON-CURRENT (LONG-TERM)
NON CURRENT (LONG LIABILITIES
TERM) LIABILITIES

LIFO Reserve - Asset is impaired when carrying value exceeds Long Term Liabilities
sed to ad ust LIFO O S and ending inventory asset’s future undiscounted cash flows Pre iu ond: Coupon rate > yield at issuance
(EI) to FIFO-equivalent values - Impaired asset’s value is written down to fair Discount ond: Coupon rate yield at issuance
value and a loss is recogni ed and cannot be ssuance costs:
E =E + L FO Reserve
subsequently reversed S AAP capitali ed as an asset
CO S = CO S − L FO Reserve
ax = ax + L FO Reserve × t IF S IF S reduces initial bond liability
- Assets are tested annually for impairment Dereco nition o de t: If an issuer redeems a bond
LIFO Liquidations
- Impaired if carrying value recoverable amount before maturity, a gain/loss (boo value minus
- Happen when units sold exceed units purchased
- Impaired asset’s value is written down to redemption price) is recogni ed
- May result in higher gross profit than otherwise
recoverable amount and a loss is recogni ed De t co enants: Affirmative borrower promises
- Loss can be reversed if asset value recovers, but
LONG-LIVED ASSETS to do certain things; negative borrower promises
LONG LIVED ASSETS only up to pre-impairment carrying value to refrain from certain things
Long Term Assets
Property plant and e uip ent (PP E): Lessee Accounting
IF S S AAP
- Both cost model and revaluation model allowed inance lease:
- ecoverable amount is greater of: - Lessee purchases the asset, financed by the lessor
(1) fair value less selling costs, and - Lessee s periodic lease payments have separate
(2) value in use (PV of asset’s future cash flows) depreciation and interest components
- Loss recoveries are allowed Operatin lease li e a rental a ree ent :
- Single lease expense, not separated into different
S AAP
components for depreciation and interest
Only cost model is allowed
- The value of an operating lease payment is
Loss recoveries not allowed
calculated as a straight-line allocation of total
payments over the term of the lease

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Conditions re uirin a lease to e a inance lease: Limited Partnership Principal Agent and Other Relationships
- Ownership of the leased asset is transferred to - Set by partnership agreement Shareholder vs. manager/director
the lessee - Operated by P - ntrenc ent: Managers avoid ustifiable ris s to
- Lessee has the option to purchase the asset and - Business liability is limited by LPs and unlimited avoid losing their positions
will li ely do so for P - pire uildin : Ma ing un ustified acquisitions
- Lease term covers most of asset s useful life - Business profits are shared by partners and taxed to increase company si e and compensation
- The present value of lease payments at inception as personal income - cessi e ris ta in : Ta ing un ustifiable ris s to
is close to the asset’s fair value - Partners are the main source of income maximi e returns on stoc -based compensation
- The leased asset is so speciali ed that only the - Partners’ resources, ris appetite, and P’s - A ency costs reduce the potential for exploitation
lessee can use it without modification competence/integrity limit business growth in an agency relationship

IF S require all leases to be treated in the manner Corporations (Limited Companies) ontrolling shareholder vs. minority shareholder
that is prescribed by S AAP for finance leases. - Legal identity is separated from owners - Dispersed o ners ip: ontrolled by many
- Operated by management team voted by minority shareholders
Lessor Accounting
shareholders Concentrated o ners ip: ontrolled by a single
- For operating leases (under both IF S and S
- Limited business liability for shareholders shareholder
AAP), the lessor retains the leased asset on its
- Financed by equity and debt - Multiple class s are structures: Disproportionate
balance sheet and incurs the associated
- Profits are taxed directly; double taxation occurs voting power to certain shareholder classes
depreciation expense. Lease income from the
when shareholders are taxed on their dividend
lessor is recorded as revenue. Shareholder vs. creditor
income
- For finance leases (under both IF S and S - Equity owners prefer growth and have a higher
AAP), the lessor removes the leased asset from Public and Private Corporations ris tolerance
its balance sheet and creates an asset with a Mar et capitali ation: Product of the current share - reditors prefer stability and limited downside
value equal to the lease receivable and any price and the number of outstanding shares ris
residual value. nterprise alue = MV h s MV t ash
Corporate governance can be described as:
- Lease payments are recogni ed as an operating Pri ate place ent e orandu (PPM) is used by
- A system of internal controls and procedures for
inflow on the lessor’s cash flow statement (for private companies to raise capital in primary
managing organi ational business
both operating leases and finance leases) mar et
- A framewor for defining the rights and
Private companies can go public by:
Pensions responsibilities of individuals and groups within
- Initial public offering (IPO)
De ined ene it (DB): Firm ma es periodic the organi ation
- Direct listing (DL)
payments to employee after retirement. - An arrangement of chec s, balances, and
- Acquisition
Overfunded (underfunded) plan is recogni ed as incentives to minimi e and manage conflicts
an asset (liability). Public companies can go private by: between the interests of insiders and external
- Leveraged buyout (LBO) sta eholders
- Management buyout (MBO)
Stakeholder Mechanisms
CORPORATECORPORATE
ISSUERS ISSUERS
Lenders and Owners Shareholder:
CORPORATESTRUCTURES
STRUCTURESAND ANDOOWNERSHIP is vs return characteristics of equity and debt: - orporate reporting and transparency
CORPORATE NERSHIP
Equity Debt - Shareholder meetings (cumulative voting, proxy
Sole Proprietorship
pside Limited to voting)
- Extension of owner nlimited
potential payments - Shareholder activism
- Operated by owner
Maximum annot be more than the - Derivative lawsuits
- Business liability is retained by owner
loss investment value - orporate ta eovers (proxy contests, tender
- Business profits are owned by owner and taxed
Investment Higher Lower offers, hostile ta eovers)
as personal income
- Owner is the main source of capital ris reditor:
- Owner’s capital and ris appetite limit business Investment Maximi e Timely - Bond indentures, collateral, and trustees
growth interest company repayment - orporate reporting
value - reditor committees
General Partnership
- Set by partnership agreement INTRODUCTION TO CORPORATE
CORPORATEGOVERNANCE
GOVERNANCE Board of director and management:
INTRODUCTION TO
- Operated by partner AND
AND OTHER
OTHER ESG CONSIDERATIONS
ESG CONSIDERATIONS - Audit committee
- Business liability is retained and shared by - overnance committee
Stakeholder Groups
partners - emuneration/ ompensation committee
- Business profits are shared by partners and taxed - omination committee
as personal income - is committee
- Partners are the main source of capital - Investment committee
- Partners’ resources and ris appetite limit
business growth

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Employee: BUSINESS MODELS&&RISKS
BUSINESS MODELS RISKS
Business Models Financial Implications
- Labor laws Value Proposition
External factors:
- ode of ethics and compliance department - Target customers
- Economic conditions
- Whistleblower protections - Product/service offering
- Demographics
- Employee contracts - hannel strategy
- Sector demand
- Pricing strategy
ustomer and supplier: - Industry cost characteristics
- ommercial contracts hannel strategy: - Social and political trends
- Public reputation and social media - Traditional channel
Firm-specific factors:
- Direct sales
overnment: - Firm maturity
- Drop shipping
- Laws and regulations - ompetitive position
- Omnichannel strategy
- orporate governance codes - Business model
- ommon law and civil law systems Pricing model: Business Models Risks
- ost-based Macro ris :
Risks and Benefits of Corporate Governance
- Value-based - Exchange rates
and Stakeholder Management
- Interest rates
Operational ris s of poor sta eholder governance: Price discrimination:
- Political instability
- Wea control systems that do not treat all - Tiered pricing
- Legal and regulatory changes
sta eholders fairly - Dynamic pricing
- ountry-level ris s
- Ineffective decision-ma ing process - Auction/reverse auction models
- Inadequate board scrutiny Business ris :
Pricing for multiple products:
- Diminished operating performance - Industry ris s
- Bundling
- ompany-specific ris s
Financial ris s of poor sta eholder governance: - a ors-and-blades pricing
- Higher default and ban ruptcy ris s - Optional product pricing Financial ris :
- Higher borrowing costs otal levera e = Operatin levera e
Pricing for rapid growth:
- Poor equity returns × Financial levera e
- Penetration pricing
Contri ution mar in EB
Factors Relevant to Corporate Governance and - Freemium pricing = ×
EB EB
Stakeholder Management Analysis - Hidden revenue business model Contri ution mar in
- Economic ownership and voting control =
EB
Alternatives to ownership:
- Board of directors representation
- Subscription pricing
- emuneration and company performance CAPITAL
CAPITAL INVESTMENTS
INVESTMENTS
- Fractionali ation
- Investors in the company Types of Capital Investments
- Leasing
- Strength of shareholders’ rights Business maintenance:
- Licensing
- Management of long-term ris s - oing concern pro ects
- Franchising
- egulatory/compliance pro ects
ESG Considerations for Investors and Analysts
Value Chain
ES investment approaches: Business growth:
alue c ain: Systems and functions within the firm
- esponsible investing - Expansion pro ects
that create value for its customers
- Sustainable investing - Pet pro ects/high-ris investments
upply c ain: Series of steps and processes needed
- Socially responsible investing (S I)
to prepare a product to be sold to the consumer Principles of Capital Budgeting
- Value-based and values-based approaches
ey assumptions of capital allocation:
Profitability and Unit Economics
ES investment styles: - Decisions are based on cash flows instead of
Unit econo ics: The quantitative analysis of a
- egative screening accounting concepts
company s revenues and costs on a per unit basis
- Positive screening - ash flows are not equivalent to accounting
Fixed costs
- ES integration Breakeven point = income or economic income
Contri ution mar in
- Thematic investing Fixed costs - ash flows must account for opportunity costs
- Engagement/active ownership = - Analysis is done on an after-tax basis
nit price − Varia le cost per unit
- Impact investing - Timing of cash flows is important
Business Model Types - Financing costs are ignored
reen inance: se financial instruments to - Private label manufacturers
support economic growth while minimi ing - Licensing arrangements Other important considerations:
environmental impact - Value added resellers - Sun costs are ignored
- Franchises - Opportunity cost is the value of a resource’s next-
- etwor effects best use
- rowdsourcing - Incremental cash flows reflect the cash flows
- Hybrid business models reali ed from a decision
- Externalities (e.g., cannibali ation) may have
E-commerce business models: unexpected negative impact the company
- Affiliate mar eting - onventional cash flow pattern only has
- Mar etplace businesses one sign change
- Aggregators

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Net Present Value (NPV) External Financing Capital Markets COST OF CAPITAL
COST OF CAPITAL –- FOUNDATIONAL TOPIC
FOUNDATIONAL TOPIC
Sum of present values of expected future cash - Short-term commercial paper eighted Average Cost of Capital ( ACC)
inflows, net of initial cash outlay - Long-term debt ACC = w& r&(1 − t) + w. r. + w% r%
*
CF# - ommon equity w& = percentage of debt in capital structure
PV = F − Outlay
(1 + r)# w. = percentage of preferred stoc
#34 Conservative orking Capital Management
Accept a pro ect if PV 0 Advantages: w% = percentage of common stoc
t = tax rate
- Low rollover ris
Internal Rate of Return (IRR) r& = cost of debt
- reater cash flow certainty
I is r such that PV = 0 r. = cost of preferred stoc = D. ⁄P
- Low ris of inventory shortages
Accept a pro ect if its I required return r% = cost of common stock
- Flexibility to adapt to adverse mar et conditions
BA II Plus NPV orksheet Function = R + [E(R ' ) − R ]
Disadvantages: (CAPM)
- ash inflows are positive; outflows are negative
- High borrowing costs = r& + Risk Premium
- F01, F02, etc. refer to cash flow frequencies
- High cost of equity and shareholder dilution (Bond Yield plus Risk Premium)
- PT PV to compute PV; PT I for I
- Less flexibility to borrow on an as-needed basis
Common Capital Budgeting Pitfalls - Longer lead times Costs of the Various Sources of Capital
- Inertia - More covenants ost of debt:
- Source of capital bias - High ris of obsolete inventory - ield-to-maturity approach
- Failing to consider alternatives P = ∑*+34
012"
+
Aggressive orking Capital Management 4 (%
"
4 (%
- Pet pro ects
Advantages:
- Basing decisions on earnings metrics - Debt rating approach (e.g., matrix pricing)
- Low financing costs under an upward-sloping
- Internal forecasting errors
yield curve ost of preferred stoc :
Corporate Usage of Capital Allocation Methods - reat flexibility to borrow only as needed r. = D. ⁄P
eturn on invested capital ( OI ): - Short-term borrowing involves less rigorous
ost of common stoc :
After ax et Profit credit analysis
RO C = - ield-to-maturity approach
Avera e BV of nvested Capital
Disadvantages: r% = r + [r' − r ]
Real Options - is of having to refinance at higher - Multifactor model
Ti in option: Option to delay the investment short-term rates r% = r + 4(Factor4 ) + < (Factor< )
i in option: Option to expand, grow, or abandon - Potential difficulty rolling over short-term debt +⋯+ I mFactorI n
le i ility option: Option to alter operations, with mar et turmoil - Bond yield plus ris premium approach
such as changing prices or substituting inputs - Possible need to rely on expensive trade credit r% = r& + Risk Premium
unda ental option: Option to alter decisions - Tight customer credit terms
based on future events (e.g., drill based on price Estimating Beta
of oil, continue D depending on initial results) Liquidity and Short Term Funding Needs Blume’s beta ad ustment formula:
Pri ary sources o li uidity: 2 1
Analyzing Pro ects with Real Options Ad usted = \ ] ( nad usted ) + \ ] (1 0)
- Free cash flows 3 3
- se the discounted cash flow (D F) analysis - eady cash balances (ban accounts)
Asset beta/unlevered beta for comparable
without considering real options - Short-term funds (lines of credit)
company:
- Ad ust the stand-alone D F analysis by including - ash flow management (centrali ed collection)
the present value of the expected costs and econdary sources o li uidity: 1
= E
benefits options D
- egotiating debt contracts (1 − t)
E+1
- se option pricing models - Liquidating assets Levered pro ect beta for sub ect firm:
- se decision trees - Filing for ban ruptcy D
E = (1 − t) + 1
Dra on li uidity: Delayed cash inflows, such as E
WORKING CAPITAL &
ORKING CAPITAL & LIQUIDITY
LIQUIDITY uncollected receivables and obsolete inventory
Internal Financing Flotation Costs
Pull on li uidity: Accelerated cash outflows, such as
- Increasing after-tax operating cash flows r% ad usted for flotation costs (amount):
settling payables earlier
D4
- Improving wor ing capital efficiency et operating cycle (a. .a. cash conversion cycle) = r% = +
P −F
- onverting liquid assets to cash days of inventory days of receivable days
r% ad usted for flotation costs (percentage):
External Financing Financial Intermediaries of payable D4
r% = +
- ncommitted lines of credit Evaluating Short Term Financing Choices P [1 − f]
- ommitted lines of credit Factors influencing a company’s short-term
- evolving credit agreements borrowing strategy:
- Secured (asset-based) loans - Si e and creditworthiness
- Factoring - Legal and regulatory considerations
- Others (web-based lenders and - Sufficient access
non-ban lenders) - Flexibility of borrowing options

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CAPITAL STRUCTURE
CAPITAL STRUCTURE Breakeven
Internal Factors Affecting Capital Structure F+C
rea e en: BE =
usiness odel c aracteristics: P−V
F
- evenue, earnings, and cash flow sensitivity Operatin rea e en: BE =
P−V
- Asset type
= quantity; P = price; V = varia le cost/unit
- Asset ownership
F = fixed operatin cost; C = fixed financial cost
istin le era e:
- Liquidity
- Profitability
EQUITY EQUITY
- Interest coverage
- Leverage To estimate a company’s target capital structure:
MARKET
MARKET ORGANIZATION AND STRUCTURE
ORGANIZATION AND STRUCTURE
Corporate ta rate: The higher the tax rate, the - Assume the company will main its current capital
structure Functions of the Financial System
more benefit of using debt
- Infer target weights the company is moving - Saving
Capital structure policies uidelines: Firm-specific
toward - Borrowing
policies and debt covenants
- se the industrial average - aising Equity apital
Co pany li e sta e:
Pec in order t eory: Since managers have an - Managing is s
asymmetric information advantage, they prefer - Exchanging Assets
capital sources that reveal the least amount of - Information-Motivated Trading
information: Securities Markets
1. Internally generated earnings (best option) - pot s or ard Mar ets: Spot mar et trades are
2. ew debt settled within days.
. ew equity (least attractive for managers) - Pri ary s econdary Mar ets: Primary mar et
Stakeholder Interests transactions are done directly with the issuer,
Agency costs arise from conflicts between while secondary mar et trades ta e place on
managers and owners. The interests of managers, organi ed exchanges.
External Factors Affecting Capital Structure - Capital s Money Mar ets: Money mar ets are
shareholders, and bondholders are not always
- Mar et conditions/business cycles used for securities with maturities of less than
aligned.
- egulatory constraints one year, while longer-dated securities are traded
- Industry/peer firm leverage MEASURES OFLEVERAGE
LEVERAGE in capital mar ets.
MEASURES OF
Modigliani and Miller Propositions Leverage Positions
MM Proposition A firm s capital structure would on positions: Benefit from price appreciation
have no effect on its value, assuming: ort positions: Benefit from price depreciation
1. Investors have homogeneous expectations
Leveraged Positions
2. o mar et frictions (e.g., transaction costs, taxes,
Position
or costs of financial distress) Levera e ratio =
Equity
. o agency costs
1
. Investors can borrow and lend at ris -free rate Maximum initial levera e ratio =
ntial mar in
5. Investing/financing decisions are independent
Maintenance ar in: minimum amount of equity
MM Proposition ost of equity increases with the
required
debt-to-equity ratio.
Mar in call is triggered if the equity falls below the
Business Risk
Without Taxes maintenance margin. Additional equity will be
Two components of business ris are:
Firm value V =V requested to bring the account balance bac to the
- Sales ris : determined by the elasticity of demand
D initial margin.
ost of Equity r% = r + (r − r& ) \ ] for products and services
E - Operating ris : determined by the share of fixed Execution Instructions (How to fill)
With Taxes costs as a share of total operating costs - Mar et: Fill immediately at mar et price
Firm value V = V + tD - i it: Buy below maximum price or sell above
Measures of Leverage
minimum price specified in order
ost of Equity ! !
Degree of operating leverage (DOL):
- All or not in : ancel order if not fully filled
Operatin income (P − V)
DOL = = - idden: Visible to bro ers and exchanges, but
! nits sold (P − V) − F
invisible to other traders
Optimal and Target Capital Structure Degree of financial leverage (DFL): - ce er : Only a fraction of order amount is visible
Static trade-off theory balances costs of financial et income (P − V) − F
DFL = = Validity Instructions ( hen to fill)
distress with tax shield benefits from using debt: Operatin income (P − V) − F − C
- Day orders: ancelled if unfilled at end of day
V = V + tD − PV(costs of financial distress) Degree of total leverage (DTL): - ood till cancelled: o set expiry date
et income (P − V) - ood on close: Filled at end of day
D L= =
nits sold (P − V) − F − C
- top loss: Sell if prices fall below specified level
D L = DOL × DFL

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Clearing Instructions Price eighted Indexes Implications of EMH
Settlement/clearing typically done by bro ers for P+ - If wea form holds, investors will not earn
w+0 = !
retail trades; bro ers or custodians for ∑I34 PI abnormal profits from technical analysis
institutional trades - Li e buying one share of each stoc - If mar ets are semi-strong efficient, investors
- Advantage is simplicity must have a comparative advantage to earn
Primary Market Transactions
- nitial Pu lic O erin s (IPOs) - Disadvantage is arbitrary weights abnormal profits from fundamental analysis
- Pri ate place ents - A stoc ’s weight is halved due to a stoc split,
Market Anomalies
- el re istrations: Part of issue is held bac to be requiring an ad ustment to the divisor
hanges in a security’s price that are not
sold directly to secondary mar et investors later Equally eighted Indexes attributable to nown information
- Di idend rein est ent plans (D IPs): Investors 1
can roll over dividend payments to purchase new w+E = Selected Behavioral Biases
shares, possibly at a discount - Li e investing the same amount in each stoc - oss a ersion: Disli ing losses more than li ing
- i ts o erin s: urrent shareholders gain right - Advantage is simplicity equivalent gains
to purchase additional shares at below-mar et - Disadvantages are that the impact of large - n or ation Cascades: Those who act first will
price; dilutes value of existing shares companies is underrepresented and frequent convey information that influences others
rebalancing is required - epresentati eness: ely too much on current
Market Structure state when assessing probabilities
Quote dri en: Investors trade with dealers Capitalization eighted Indexes - Mental accountin : eep trac of gains and losses
Order dri en: Exchanges use order matching rules + P+
w+1 = ! separately for different investments/goals
ro ered: Trades arranged by bro ers ∑I34 I PI
- Conser atis : Failing to incorporate new
Call ar ets: onduct periodic single price - Li e holding all stoc s in proportion to their information in a timely manner
auctions, otherwise completely illiquid mar et values - arro ra in : Focusing on certain issues in
Continuous Tradin ar ets: Allow trades - Float ad ustment may be used to reflect the isolation
whenever mar et is open, may use call mar et number of shares that may be actively traded
auction at beginning and/or end of each day - Advantage is that the asset classes’ performance OVERVIEW
OVERVIE OF
OF EQUITY
EQUITY SECURITIES
SECURITIES
is well-represented Common Share Voting Methods
Trade Pricing Rules
Uni or pricin rules: sed by call mar ets, all - Disadvantage is that returns are heavily driven by tatutory: One vote per share
trades executed at the price that maximi es total large-cap (possibly overvalued) firms Cu ulati e: Votes can be bundled
quantity traded Fundamentally eighted Indexes Example: 10 board positions
Discri inatory pricin rules: sed by continuous - Built li e price-weighted indexes, but using a Statutory: 1 share votes for 10 different candidates
mar ets, fills most aggressively priced orders first fundamental measure such as sales or cash flows umulative: 10 votes may go to 1 candidate
Deri ati e pricin rules: sed by crossing networ s - ontrarian effect of rebalancing by selling off top umulative method advantages small shareholder
to trade at midpoint of quotes from other mar ets performers and buying underperforming stoc s Preference Shares
Complete Markets produces a value tilt - Cu ulati e: Accrue dividends if payments missed
- Facilitate savings/investment - on cu ulati e: Missed dividends do not accrue,
Types of Equity Market Indexes
- Facilitate lending to creditworthy borrowers but no common dividends allowed if preferred
- road ar et inde es: overs one equity mar et
- Allow ris exposures to be hedged shareholders do not receive their dividend
- Multi ar et inde es: overs equity mar ets in
- Facilitate exchange of currencies/commodities - Participatin : May receive additional dividend if
multiple countries
An ideal financial system is co plete (see above), firm is profitable or in the event of liquidation
- ector inde es: Important for assessing a
operationally e icient (low transaction costs), and - on participatin : o compensation beyond
manager’s performance (selection vs. allocation)
in or ationally e icient (prices reflect all info.) dividends and face value in a liquidation
- tyle inde es: Large/small cap; Value/growth

SECURITY MARKET
MARKET INDE
INDEXES Private Equity Securities
SECURITY ES MARKET
MARKET EFFICIENCY
EFFICIENCY - enture capital (V ): Start-up, early-state, or
Price Return over Single Period
Forms of Efficient Market Hypothesis (EMH) me anine financing with IPO as exit strategy
!
P+4 − P+ Mar et Prices eflect: - e era ed uyouts (LBO): Debt-financed deals to
PR + = PR = F w+ PR +
P+ Past
+34 ta e undervalued listed companies private
Public Private
Form mar et - Pri ate in est ent in pu lic e uity (PIPE):
Total Return over Single Period info info
!
data ompanies can raise new capital quic ly,
P+4 − P+ + nc+ Wea ✔ investors can negotiate discounts
R+ = R = F w+ R +
P+
+34 Semi-
Price Return Index over Multiple Periods ✔ ✔
strong
V0 2 = V0 (1 + PR 4 )(1 + PR < ) … (1 + PR 2) Strong ✔ ✔ ✔
Total Return Index over Multiple Periods
V2 2 = V2 (1 + R 4 )(1 + R < ) … (1 + R 2 )

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Depository Receipts (DRs) Multista e DDM: Credit Enhancements
*
ponsored D s: Issued directly by foreign D# P* nternal: Subordination, over-collaterali ation,
company; Investors receive same voting rights and V =F + reserve accounts
(1 + r)# (1 + r)*
#34
dividends as other common shareholders D* ternal: Surety bonds, letters of credit, guarantees
4
P* = from financial institutions
Unsponsored D s: Foreign company not involved; r−
Depository ban purchases shares, issues D s, and D* 4 = D (1 + )* (1 + ) Bonds with Contingency Provisions
retains voting rights Price Multiples Calla le onds
P D4 /E4 May be recalled by issuer if rates fall
lo al D s: Issued outside company’s home =
E4 r− V $ $ % )*& = VNon-callable bond − V $
country to avoid limits on capital flows; May be
denominated in any currency, but SD is common; P⁄B = Price per share⁄Book value per share Puta le onds
P⁄CF = Price per share⁄Cash flow per share May be sold bac to issuer if rates rise
annot be listed on S exchanges, but S investors
P⁄S = Price per share⁄Sales per share V0,#$ % )*& = VNon-putable bond + V0,#
can purchase them via private placements
Asset Based Valuation Models
A erican D s: SD-denominated D s that can be Convertible Bonds
seful for companies with natural resource or a
traded on S exchanges; nderlying securities, large share of current assets/liabilities; ot useful Con ersion price: Price per share at which bond
American depository shares, trade in issuer’s if company has a large share of PP E/intangibles can be converted into shares
domestic mar et Enterprise Value (EV) Con ersion ratio: umber of common shares
= MV(Common equity) + MV(Preferred stock) each bond can be converted into
lo al e istered ares: Traded on multiple
+ MV(De t) − (Cash + Short term investments) Con ersion alue:
exchanges, including issuer’s domestic mar et;
urrent share price × onversion ratio
Denominated in multiple local currencies; nli e
Con ersion pre iu :
D s, S represent an actual ownership interest
FI ED INCOME FIXED INCOME onvertible bond’s price − onversion value
arrants: Options to buy equity, lowers debt costs
INTRODUCTIONTO
INTRODUCTION TOINDUSTRY
INDUSTRY&AND
COMPANY
COMPANY ANALYSIS
ANALYSIS FIXED-INCOME SECURITIES:DEFINING
FI ED INCOME SECURITIES Convertible Contingent Bonds (CoCos)
Porter s Five Forces Framework DEFINING
ELEMENTSELEMENTS - Automatically convert to equity if a condition is
- Threat of substitute products Types of Bonds met (e.g., capitali ation ratio falls)
- Bargaining power of customers - Collateral Trust onds: Bac ed by financial assets - Lender does not control if option is exercised
- Bargaining power of suppliers - uip ent Trust onds: Bac ed by physical assets - Primarily issued by financial institutions
- Threat of new entrants - Co ered onds: Bac ed by a segregated pool of
- Intensity of rivalry loans that are replaced if they stop performing FIXED-INCOME MARKETS: ISSUANCE,
FI ED INCOME MARKETS ISSUANCE,TRADING,
Principal Repayment Structures TRADING, AND FUNDING
AND FUNDING
Industry Life Cycle Stages
- ullet onds: Full principal repaid at maturity Bond Markets
- ryonic: Slow growth, high prices, high failure
- ully A orti in : Equal annuity-li e payments - Pri ary ond ar ets: Mar ets in which issuers
ris , significant investment required
contain a mix of interest and principal initially sell bonds to investors to raise capital
- ro t : apidly increasing demand, improving
- Partially A orti in : Some principal is amorti ed, - econdary ond ar ets: Mar ets in which bonds
profitability, falling prices, low competition
remainder repaid as a lump sum at maturity are subsequently traded among investors; Most
- a eout: Slowing growth, intense competition,
- in in unds: ertain percentage of principal trading is OT rather than on organi ed
declining profitability
retired each year exchanges
- Mature: Little or no growth, industry
- rey ar et: Informal forward mar et to gauge
consolidation, high entry barriers Coupon Structures
interest in upcoming bond issues and set prices
- Decline: egative growth, excess capacity, - i ed rate onds: Set percentage of principal
for the primary mar et
high competition - loatin rate (F s): eference rate spread
- tep up: oupon rate increases on schedule Sovereign Debt
Key Competitive Strategies
- Credit in ed: oupon rate is increased if issuer is - Issued by national governments, ero default ris
- o cost leaders ip: To hold/gain mar et share
downgraded, reduced if upgraded - Bills mature 1 year; Bonds mature 1 year
- Product di erentiation: To charge premium prices
- Pay ent in ind: oupons may be paid with more - On-the-run: Most recent issues of a given
bonds rather than cash maturity; more liquid than off-the-run issues
EQUITY VALUATION
EQUITY VALUATION: CONCEPTS ANDBASIC
CONCEPTS AND
BASIC TOOLS - De erred plit Coupon: o coupons in early Non Sovereign Debt
TOOLS
years, high coupons in later years - Municipal bonds (sub-national issuers)
Dividend Discount Model (DDM)
*
Inflation Indexed Bonds - uasi-government bonds (gov’t-bac ed agencies)
D# D# P*
V =F =F + - Supranational bonds (i.e., IMF, World Ban )
(1 + r)# (1 + r)# (1 + r)* - ero coupon: Principal amount is ad usted
#34 #34
- nterest inde ed: oupons are ad usted Corporate Debt
Perpetual pre erred stoc constant di idend:
- Capital inde ed: Fixed rate, ad usted principal - ommercial paper ( P) used for 1 year, but
D
V = - nde ed annuity: Amorti ing bonds with annuity carries rollover ris
r
ordon constant ro t odel ( M): payments ad usted for inflation - Long-term bonds 12 years
- Bilateral/syndicated ban loans are also used
D (1 + )# D (1 + ) D4
V =F = =
(1 + r)# r− r−
#34
= (Retention rate) × ROE = (1 − D⁄E) × ROE

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Medium Term Notes (MTNs) Yield Measures Securitization Example
- sed to bridge gap between P and L/T bonds Annual cash coupon payment - Firm sells equipment on credit
Current yield =
- Offered to investors through an agent in a range Flat price - Firm creates ban ruptcy-remote SPV
of maturities Annual cash Amortized - SPV issues debt to purchase loans from firm
+
coupon payment ain/loss
- Lower registration/underwriting costs than Simple yield = - SPV creates securities bac ed by loans
Flat price
bonds, but relatively illiquid - Investors purchase securities from SPV
ield-to-call ( T ) = I assuming bond is called
- SPV collects loan payments from firm’s customers
USCP vs Eurocommercial Paper ield-to-worse = min[ T , Y M]
- SPV distributes cash flows to investors
S P E P
Yield Measures for FRNs Residential Mortgage Loans
urrency S dollar Any currency
uoted margin ( M): Spread paid by F - Interest: fixed, ad ustable, convertible
Maturity Overnight Overnight to
Discount margin (DM): Spread required by mar et - Amorti ation: full, partial, interest-only
to 2 0 days days
If M DM, F will trade above par - Prepayment: penalty, no penalty
Interest Discount Interest-
F pricing formula: - Foreclosure: non-recourse, recourse
calculation basis bearing or
(Ref + M)(FV) (Ref + M)(FV)
discount + FV
= m …+ m Residential Mortgage Backed Securities
basis (Ref + DM) 4 (Ref + DM) ! - A ency M : Issued by government agencies;
\1 + ] \1 + ]
Settlement T 0 T 2 m m
must have conforming loans
egotiable an be sold an be sold Yield Measures for Money Market Instrument - on a ency M : Issued by private companies
Discount ate D asis and may have non-conforming loans
Structured Financial Instruments
- uarantee certi icate: ero-coupon bond with a Days - Pass t rou rate: MBS coupon rate
PV = FV × \1 − × DR]
call option on the issuer’s equity Year - Prepay ent ris : ontraction (faster-than-
- Credit lin ed note: Seller earns a premium for expected); extension (slower-than-expected)
Add on ate AO asis
providing credit protection on underlying bond Days - Prepayment rates are relative to PSA benchmar
PV = FV \1 + × AOR] Collateralized Mortgage Obligations (CMO)
- Participation nstru ents: oupon payments Year
based on underlying rate (e.g., F s) - nli e pass-through securities, MOs have
Implied Forward Rate (IFR)
- e era ed nstru ents: Modify returns tranches to redistribute cash flows and ris s
BA9
(1 + z9 )9 × m1 + FR 9 BA9n = (1 + zB )B - e uential pay CMOs have principal and
Leveraged floater: 2 × (Reference rate)
Deleveraged floater: 0 × (Reference rate) prepayments paid to the tranches sequentially
Leveraged inverse floater: Max coupon − 2 × (RR) - Planned a orti ation class PAC CMOs have
support tranches to absorb prepayment ris
Factors Increasing Repurchase (Repo) Rates
- Higher ollateral ris Non Mortgage ABS
Yield Spreads over Benchmark Yield Curve
- A orti in : E.g., auto loan ABS
- Longer term -spread= Y M − overnment ond yield
- on a orti in : E.g., credit card receivable ABS
- Delivery requirement I-spread= Y M − Swap rate
- Low quality collateral Collateralized Debt Obligations (CDO)
spread Securities bac ed by pool of debt obligations, such
- Higher rates for alternative sources of funds
( ) ( ) ( ) as corporate bonds, leveraged ban loans, or credit
INTRODUCTIONTO
INTRODUCTION TOFI
FIXED-INCOME VALUATION
ED INCOME VALUATION ( an only be calculated by trial-and-error) default swap on securities

Bond Pricing with Spot Rates Option ad usted spread OA Covered Bonds
PM PM PM + FV OAS = -spread − Option value (in asis points) - Dual recourse against the issuing financial
PV = + + ⋯+
(1 + z4 )4 (1 + z< )< (1 + z! )! institution and the cover pool
CR Coupon Rate; MD : Mar et Discount ate - One bond class per cover pool
INTRODUCTION TOASSET BACKED
INTRODUCTION TO
Par ASSET-BACKED SECURITIES - Issuer must replace non-performing asset with
SECURITIES
iscount performing asset
Parties to a Securitization
Premium - eller Depositor: Originates loans (assets)
- ssuer: Special purpose vehicle (SPV) established
Bond Pricing Relationships
to create asset-bac ed securities (ABS)
- n erse e ect: Price moves opposite to yield
- er icer: ollects payments on underlying loans
- Con e ity e ect: Falling yield has greater price
impact than equivalent increase in yield ABS Tranching
- Coupon e ect: ield changes have greater impact - Credit tranc in : ertain tranches absorb credit
on lower coupon bonds losses before others
- Maturity e ect: ield changes have greater impact - A solute priority rule: Senior claims outran
on longer-term bonds (may not apply to low- subordinated claims in the event of a liquidation
coupon bonds trading at very deep discounts) - Ti e tranc in : ertain tranches are exposed to
prepayment ris
Flat Price, Accrued Interest, and Full Price
PV , = PV $# + A = (PV)(1 + r)# 2
A = (t⁄ ) × PM

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UNDERSTANDINGFI
UNDERSTANDING FIXED-INCOME
ED INCOME RISK AND Convexity DERIVATIVES DERIVATIVES
RISK AND RETURNS
RETURNS (PVA ) + (PV ) − [2 × (PV )]
ApproxCon =
Constant Yield Price Tra ectory ( Yield)< (PV ) DERIVATIVE
DERIVATIVEINSTRUMENT
INSTRUMENTAND
ANDDERIVATIVE
DERIVATIVE
1 MARKET
MARKET FEATURES
FEATURES
PV , = −D1)& × Y M + (Conv)( Y M)<
2 Derivative Underlyings
(PVA ) + (PV ) − 2(PV )
EffConv = - Equities
( Curve)<(PV )
- Fixed-income instruments and interest rates
- urrencies
- ommodities
- redit
- Other (e.g., weather, crypto, longevity ris )

Derivatives Markets
OT ETD
Mar et Mar et
Liquidity Lower Higher
Yield Duration vs Curve Duration
Trading costs Higher Lower
ield duration: Sensitivity to TM
Transparency Less reater
Measures: Macaulay duration, modified duration,
Standardi ation Lower Higher
money duration, price value of basis point (PVBP)
Cur e duration: Sensitivity to benchmar yields Duration Gap Flexibility/
Higher Lower
(e.g., effective duration); for bonds with options Duration ap = D1$( − nvestment horizon customi ation
- If positive: Price ris einvestment ris ounterparty
Macaulay Duration Higher Lower
- If negative: einvestment ris Price ris credit ris
1+r 1 + r + (c − r) t
D1$( = \ − ]−
r c[(1 + r)! − 1] + r
FUNDAMENTALS OFCREDIT
FUNDAMENTALS OF CREDITANALYSIS
ANALYSIS FORWARD
FOR ARD COMMITMENT
COMMITMENT AND
AND CONTINGENT
CONTINGENT
r: TM
CLAIM
CLAIM FEATURES AND INSTRUMENTS
FEATURES AND INSTRUMENTS
c: oupon rate Credit Risk
- Default ris : Probability of default Types of Derivatives
: umber of periods to maturity
- Loss severity: Loss given default or ard co it ents: Obligation to trade on a
t: umber of days since last coupon payment
E[Loss] = Pr(Default) × Loss severity specified date at a previously agreed price
T: umber of days in each coupon period
Loss severity = 1 − Recovery rate Contin ent clai s: Trade may or may not occur
depending on mar et conditions
Spread Risk
- redit migration ris : Possibility of downgrade or ard
Contin ent Clai s
- Mar et liquidity ris : eed to sell at a discount Co it ents
Seniority Ranking Forward contract Options
- First Lien Loan Senior Secured Futures contracts redit derivatives
- Second Lien Loan Secured Swaps
- Senior nsecured
- Senior Subordinated DERIVATIVE
DERIVATIVEBENEFITS,
BENEFITS, RISKS, ISSUER
RISKS, AND ISSUER
- Subordinated AND
AND INVESTOR USES
INVESTOR USES
Modified Duration Derivative Benefits and Risks
D1$( - unior Subordinated
ModDur = Pari passu: All creditors in the same ran ing, Benefits:
1+r
PV , = −AnnModDur × Yield regardless of maturity, have the same priority - is allocation, transfer, and management
(PVA ) − (PV ) - Information discovery
ApproxModDur = Credit Ratings - Operational advantages
2( Yield)(PV )
n est ent rade: Baa /BBB- and above - Mar et efficiency
Money Duration and PVBP on in est ent rade: Ba1/BB and below
, is s:
MoneyDur = AnnModDur × PV Four C s of Credit Analysis
, - Potential for speculative use
PV ≈ −MoneyDur × Yield - apacity - Lac of transparency
(PVA ) − (PV ) - ollateral
Price value of a asis point = - Basis ris
2 - ovenants
Basis point value = D1)& × 0 0001 - Liquidity ris
- haracter - ounterparty credit ris
Effective Duration - Destabili ation and systemic ris
Corporate Bond Yield Components
(PVA ) − (PV )
EffDur = - eal ris -free interest rate Derivative Benefits and Risks
2( Curve)(PV )
- Expected inflation rate
Issuers use derivatives to perform:
- Maturity premium
- ash flow hedge
- Liquidity premium
ield spread - Fair value hedge
- redit spread
- et investment hedge

[Link] Copyright © 2021 Salt Solutions. All Rights Reserved. 17

Investors use derivatives to hedge their ris PRICING
PRICING AND
AND VALUATION
VALUATIONOF
OF FUTURES Factors Impacting Option Values
exposures and ta e speculative positions FUTURE CONTRACTS
CONTRACTS ncrease in Call Put
Pricing of Futures and Forward Contracts Value of underlying
ARBITRAGE,
ARBITRAGE, REPLICATION,
REPLICATION, AND
AND THE COSTOF
THE COST OF Price of interest rate futures contract: Exercise price
CARRY
CARRY IN
IN PRICING
PRICING DERIVATIVES
DERIVATIVES f9 BA9 = 100 − m100 × MRR 9 BA9 n Time to expiration
No Arbitrage Forward Price with
is -free rate
Benefits Income and Costs
Volatility of underlying
Annual compounding:
Payments on underlying
F ( ) = [S + PV (C) − PV ( )](1 + r)2
ontinuous compounding: ost of carry

F ( ) = S e(- (A+)6 Except for some deep-in-the-money put options

No Arbitrage Currency Forward Price Gains from Gains from OPTION

OPTION REPLICATION
REPLICATION USING PUT-CALL
USING PUT PARITY
CALL PARITY
Type
F & ( ) = S & e(- A-%)6 Rising MRR Falling MRR Put Call Parity
Interest rate Short futures Long futures c + X⁄(1 + r)2 = s + p
PRICING
PRICING AND VALUATION
VALUATION OF
OF FOR ARD futures contract contract Fiduciary call = Protective put
FORWARD
CONTRACTSCONTRACTS Long F A: Short F A:
Forward rate Put Call Forward Parity
Pricing and Valuation of Forward Fixed-rate Floating-rate
agreement c + X⁄(1 + r)2 = F ( )⁄(1 + r)2 + p
Commitments payer payer
Fiduciary call = Protective put w. forward contract
Valuation at initiation:
Futures Contract Value
F ( ) = S (1 + r)2 MRR Put Call Parity Applications Firm Value
= otional Principal × 1 + \ ] V + p = c + PV(D)
Valuation at maturity: M
- Long party: Futures Contract BPV
V2( ) = S2 − F ( )
VALUING
VALUINGAADERIVATIVE
DERIVATIVEUSING
USINGAAONE-PERIOD
ONE PERIOD
= otional Principal × 0 0001 × Period
BINOMIAL
BINOMIALMODEL
MODEL
- Short party:
Forward Price vs Futures Price Binomial Valuation
V2( ) = −[S2 − F ( )]
The relationship between forward prices and Hedging portfolio:
Valuation during the life of the contract: futures prices depends on the correlation between V = hS − c
V# ( ) = S# − F ( )(1 + r)A(2A#) futures prices and interest rates:
Hedge ratio:
Correlation elations ip
Pricing and Valuation of Currency Forward c4, − c4&
one Futures price = Forward price h=
Contracts S4, − S4&
Valuation at initiation: Positive Futures price Forward price
F & ( ) = S & e(- A-%)6 egative Futures price Forward price Risk Neutrality
is -neutral probabilities:
Valuation during the life of the contract: 1+r−d
PRICING
PRICING AND
AND VALUATION
VALUATIONOF
OF INTEREST
INTEREST RATES =
V# ( ) = S# & − F & ( )eA(- A-%)(2A#) u−d
AND
ANDOTHER
OTHERSWAPS
S APS
Pricing and Valuation of Interest Rate Forward Swap Values and Prices is -neutral probability-weighted call price:
Contracts Periodic settlements: c4, + (1 − )c4&
c =
Implied forward rate: Periodic Settlement Value 1+r
4 (BA9)
(1 + zB )B = otional Principal × 0 0001 × Period
FR 9 BA9 = −1
(1 + z9 )9
PRICING
PRICING AND
AND VALUATION
VALUATIONOF
OF OPTIONS
OPTIONS ALTERNATIVE INVESTMENTS
ALTERNATIVE INVESTMENTS
Forward rate agreements: Option Moneyness
Option Moneyness Call Put CATEGORIES,
CATEGORIES, CHARACTERISTICS, AND
CHARACTERISTICS, AND
COMPENSATION
COMPENSATION STRUCTURES OF
STRUCTURES OF
In-the-money S# > X S# X
ALTERNATIVE
ALTERNATIVEINVESTMENTS
INVESTMENTS
At-the-money S# = X S# = X
Qualities of Alternatives vs Traditional Assets
Out-of-the-money S# X S# > X - arrow manager speciali ation
Option Values - Low correlation with traditional investments
c2 = max[0, S2 − X] - Less regulation and lower transparency
p2 = max[0, X − S2] - Limited historical ris and return data
- nique legal and tax considerations
c# = max[0, S# − X⁄(1 + r)2A# ] + ime value
- High fees
p# = max[0, X⁄(1 + r)2A# − S# ] + ime value
- High use of leverage
et payment received by the F A buyer:
Arbitrage and Replication for Options - estrictions on redemptions
(MRR − Fixed FR) × otional principal × Period
all option:
Investment Methods
- Lower ound (c# ) = max[0, S# − X/(1 + r)2A# ]
- und n estin : Indirect investing
- pper ound (c# ) = S#
- Co n estin : Hybrid between direct investing and
Put option: indirect investing
- Lower ound (p# ) = max[0, X/(1 + r)2A# − - Direct in estin : Without the use of intermediary
7]
- pper ound (c# ) = X

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Compensation Structures PRIVATE CAPITAL,
PRIVATE CAPITAL, REAL
REAL ESTATE,
ESTATE, PORTFOLIO MANAGEMENT
PORTFOLIO MANAGEMENT
- o t urdle rate: Incentive fee applies to entire INFRASTRUCTURE,NATURAL
INFRASTRUCTURE, NATURALRESOURCES,
RESOURCES,
AND
return if hurdle rate is cleared AND HEDGE
HEDGE FUNDSFUNDS
PORTFOLIOMANAGEMENT
MANAGEMENT:AN
ANOVERVIE
OVERVIEW
PORTFOLIO
- ard urdle rate: Incentive fee is only paid on Private Equity Leveraged Buyouts
Portfolio Management Process
return in excess of hurdle rate - Mana e ent uyouts: urrent management team
Plannin : List ob ectives and constraints in IPS
is involved in the acquisition
Common Clauses and Provisions ecution: Asset allocation, security analysis,
- Mana e ent uy ins: urrent management team
- Catc up clause: Allows the P to receive 100 of is being replaced by the acquiring team portfolio construction
the return in excess of the hurdle rate until the P eed ac : Monitoring and rebalancing,
catches up with their cumulative performance fee Private Equity Venture capital performance measurement and reporting
- i ater ar clause: eflects the highest - or ati e sta e inancin : Angel investing,
value used to calculate an incentive fee seed-stage financing, early-stage financing Institutional Investor Clients
- ater all: Distribution method that defines the - ater sta e inancin : After commercial - D pension plans: ounger beneficiaries increase
order of allocations to the LPs and Ps production and sales have begun but before IPO time hori on and ris tolerance
- Cla ac pro ision: Allows the LPs to get bac - Me anine sta e inancin : Prepare to go public - ndo ents oundations: enerally longer time
incentive fees that have been paid if gains are it strate ies: Trade sale (best price), IPO, hori on, low liquidity needs, high ris tolerance
subsequently reversed recapitali ation, secondary sale, liquidation - an s: Short time hori on, high liquidity need,
Private Debt very low ris tolerance
PERFORMANCECALCULATION
PERFORMANCE CALCULATIONAND
ANDAPPRAISAL - Direct lendin : Direct capital in the form of senior - nsurers: Short time hori on (longer for Life than
APPRAISAL
OF OF ALTERNATIVE
ALTERNATIVE INVESTMENTS
INVESTMENTS and secured loans P ), high liquidity needs, low ris tolerance
Common Approaches and Application - Me anine de t: Debt subordinated to senior - n est ent co panies: Time hori on and ris
Challenges secured debt but senior to equity tolerance vary by mandate, liquidity needs are
r. − r - enture de t: To complement existing equity usually high due to potential redemptions
Sharpe ratio =
financing of start-up or early-stage companies - o erei n ealt unds: Vary by mandate
- Easy to calculate - Distressed de t: Funding provided to mature
Robo Advisors
- Fails to capture tail-ris and treat volatility companies facing financial distress
- ater to underserviced segments, mass affluent
equally
Forms of Real Estate Investing - Lower fees compared to traditional managers
r. − r Debt Equity - elatively low barriers to entry
Sortino ratio =
Mortgages, Direct ownership, Mutual Funds
- Does not penali e upside volatility Private onstruction eal estate funds,
- More difficult to calculate than Sharpe ratio, but is lending Private EITs - Open end: Accept new investors after launch
more appropriate with non-normal returns MBS, MOs, Shares in E corps., - Closed end: o new shares created after launch,
Public Mortgage EITs may trade at a premium/discount to AV
Avera e compounded annual EITs - o oad: o investing/redemption fees, funds
return (since inception)
MAR ratio = Infrastructure Investments charge a percentage of AV
Max drawdown (since inception)
- ew (greenfield) or existing (brownfield) assets Exchange Traded Funds (ETFs)
Avera e compounded annual - Economic (roads) or social (healthcare facilities) - Mutual funds only trade at the end of each day,
return (period) - Direct ownership or indirect (via LP or ETF)
Calmar ratio = ETFs can be traded at any time during the day
Max drawdown (period)
- Private vehicles or public securities (uncommon) - Investors can sell ETFs short or buy on margin
- Appropriate for assets with long left-tail
distributions Commodities - ETFs do not trade at discount/premium to AV
utures price: - ETFs distribute dividends to investors, mutual
Performance Evaluation Private Equity and funds reinvest dividends
S (1 + r) + Storage costs onvenience yield
Real Estate - ETFs have lower minimum investment levels
- Internal rate of return (I ) Contan o ac ardation
- Multiple of invested capital (MOI ) Price curve PORTFOLIORISK
RISKAND
ANDRETURN
RETURN:PART
PARTI I
pward Downward PORTFOLIO
Realized value nrealized value slope
+ onvenience Money eighted Return (M R)
= of investment of investment Low High
otal amount of investment yield - I derived from all cash inflows and returns
- an be s ewed by timing/value of cash flows
- uartile ran ing Timberland and Farmland
- Appropriate if manager controls timing of Fs
- ap rate Sources of return:
- Biological growth Time eighted Return (T R)
Performance Evaluation Hedge Funds
- Prices of timber/crops - eometric mean of sub-period returns
- Leverage
- Land price changes - ompound growth for an initial 1 investment
- Illiquidity and asset valuations
- naffected by timing/value of cash flows
- Potential redemption pressures (notice periods, Hedge Fund Strategies
loc up periods, liquidity gates) - uity ed e: Long and short positions in equity
and equity derivative securities; Bottom-up
- ent dri en: See to profit from
short-term events (e.g., Mergers); Bottom-up
- elati e alue: See to profit from pricing
discrepancies between related securities
- Macro: Emphasi e top-down approach to
identifying global economic trends

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Risk Aversion PORTFOLIORISK
PORTFOLIO RISKAND
ANDRETURN
RETURN:PART
PARTIIII Identifying Mispriced Stocks
ombination of ability and willingness to ta e ris Capital Market Line (CML) Stoc s that plot above the SML are underpriced;
is a erse: equires a premium to ta e more ris stoc s that plot below the SML are overpriced
AL with ris y portfolio being mar et portfolio
is neutral: Only concerned with expected return, E[R ' ] − R Ratios
E R. = R + σ.
indifferent to level of ris σ' Sharpe R. − R
is see in : Will pay a premium to ta e more ris σ.

Total ris
ratio
Borrowing vs Lending
M- σ'
Utility Function mR . − R n +R
squared σ.
1
= E(r) − Aσ<
2 Treynor R. − R

Systematic
A is the degree of ris aversion, it is 0 for ris - ratio .
averse, 0 for ris -neutral, and 0 for ris -see ing

ris
ensen’s
R. − R + . (R ' −R )
Indifference Curves alpha

BASICSOF
BASICS OFPORTFOLIO
PORTFOLIOPLANNING
PLANNINGAND
AND CONSTRUCTION
CONSTRUCTION
Investment Policy Statements (IPS)
n est ent o ecti es: is /return ob ectives
Constraints: Liquidity, time hori on, tax concerns,
legal and regulatory factors, unique circumstances

Asset Allocation
trate ic asset allocation: Set of exposures to IPS-
Beta permissible asset classes in weights that are
Cov(R + , R ' ) + ' σ+ consistent with the client’s long-term ob ectives
+ = =
Minimum Variance Portfolios σ<' σ' Tactical asset allocation: Deliberate deviations
Systematic ris = on-diversifiable (mar et) ris from policy weights based on forecasts of asset
onsystematic ris = Diversifiable ris class returns over the near term
Total ris = Systematic ris + onsystematic ris

Capital Asset Pricing Model (CAPM) THE BEHAVIORAL

THE BEHAVIORAL BIASES
BIASESOF
OFINDIVIDUALS
INDIVIDUALS
Assu ptions: Cognitive Errors
- Investors are ris -averse, utility-maximi ing, - Conser atis ias: People fail to incorporate new
rational individuals information that conflicts with their opinions
- Mar ets are frictionless - Con ir ation ias: People see evidence that
- All investors plan for same single holding period confirms their prior beliefs
- Investors have homogeneous expectations - epresentati eness ias: People inappropriately
- Investments are infinitely divisible classify new information based on past similar
- Investors are price ta ers situations
Capital Allocation Line (CAL)
E R. = R + + [E[R ' ] −R ] - llusion o control ias: People overestimate their
Line representing possible combinations of ris -
ability to control or predict events
free assets and optimal ris y asset portfolio i itations:
- indsi t ias: People believe past events would
E[R + ] − R - Single-factor: Only accounts for systematic ris
E R. = R + σ. have been predictable
σ+ - Single-period: Does not consider multiple periods
- Anc orin and ad ust ent ias: People rely too
- Inclusion of assets that are not investable, such as
Investor s Optimal Portfolio much on initial information in their estimation
human capital and assets in closed economies
- Mental accountin ias: People put money in
Security Market Line (SML) separate mental buc ets
rap ical representation o CAPM: - ra in ias: People answer the same question
differently based on how it is framed
- A aila ility ias: People assume outcomes that
are easier to remember are more li ely

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Emotional Biases ar c art Trian le y etrical
- oss a ersion ias: People strongly prefer arrowing = bullish; Widening = bearish
avoiding losses more than achieving gains
- O ercon idence ias: People overestimate their
own abilities
- el control ias: People lac self-discipline to
ma e decisions based on their long-term goals
- tatus uo ias: People are more inclined to do
nothing rather than ma e changes
- ndo ent ias: People value an asset more
Candlestic c art
when they hold the rights to it
White body: close > open; Dar body: close open
- e ret a ersion ias: People avoid ma ing ectan les ullis and earis
decisions that could potentially turn out badly

Market Anomalies
Factors that cause anomalies misclassifications:
- Inappropriate asset pricing model
- Statistical issues due to small samples
- Temporary disequilibria

Trends
ANINTRODUCTION
AN INTRODUCTIONTO
TORISK
RISKMANAGEMENT
MANAGEMENT
Uptrend: Price reaches higher highs/lows
Risk Management
Do ntrend: Price reaches lower highs/lows
is ana e ent ra e or : la : Parallel trend lines over short period
upport: Buying is sufficient to stop further decline
- is governance Pennant: onverging trend lines over short period
esistance: Selling pressure stops further increase
- is identification and measurement Price Based Indicators
- is infrastructure Reversal Patterns
Mo in a era e (MA): Average closing price over a
- Defined policies and processes ead and s oulders : Indicate an upcoming
specified number of periods (e.g., -day, 0-day)
- is monitoring, mitigation, and management downtrend following a preceding uptrend
olden cross: Short-term MA crosses long-term MA
- ommunications n erse : Indicate an upcoming uptrend
from below; bullish indicator
- Strategic analysis or integration following a preceding downtrend
Dead cross: Short-term MA crosses long-term MA
is tolerance: Which ris s are acceptable and how from above; bearish indicator
much ris should be ta en ollin er ands: Lines representing MA +/ −
is ud etin : How the ris s should be ta en standard deviations; Bullish if MA reaches lower
inancial ris s: Arise from financial mar et bound, bearish if MA reaches upper bound
activities (e.g., mar et, credit, liquidity ris )
on inancial ris s: Arise from within entity or
from external (e.g., operational, legal, regulatory,
political, model, tail ris )
is easures: Standard deviation, beta, duration,
delta, gamma, Va , Va , etc.
is odi ication: By prevention and avoidance, Price tar et = eckline − ( ead − eckline)
transfer (insurance), or shifting (derivatives) Dou le tops: When an uptrend reverses twice at
about the same high
TECHNICALANALYSIS
TECHNICAL ANALYSIS
Price tar et = Valley − ( op − Valley)
Technical Analysis Principles
Dou le otto s: When a downtrend reverses twice
- The mar et discounts everything
at about the same low
- Prices move in trends and countertrends
Price tar et = op + ( op − Valley)
- Price action is repetitive with reoccurring
patterns Triple Tops otto s: More significant indicators
than double tops/bottoms
Technical Analysis Charts
ine c art: A plot of price data, typically closing Continuation Patterns
prices, with a line connecting the points Trian les Ascendin and Descendin

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Momentum Oscillators loc c ain: Digital ledger for bloc s of lin ed IV(A) Loyalty
ate o C an e OC Oscillator: transactions validated through user consensus et permission before ta ing outside wor (even
M = (V − Vx) × 100 Per issionless net or s: o centrali ed authority unpaid) that competes with employer. Abide by
V = last closin price needed to validate transactions non-compete agreement (if applicable) and do not
Vx = closin price x days a o, typically 10 Per issioned net or s: Members are restricted ta e employer’s property.
O oscillator crossing 0 in the same direction as from participating in certain activities IV(B) Additional Compensation Arrangements
the trend direction is buy/sell signal Obtain written permission from all parties before
Uses of DTL in Investment Management
elati e tren t nde : receiving any compensation for outside wor .
Cryptocurrencies: Allow transactions without
100 ( p chan es)
RS = 100 − , RS = intermediaries, such as ban s
1 + RS (|Down chan es|)
To eni ation: epresents ownership of physical IV(C) Responsibilities of Supervisors
toc astic Oscillator:
assets on a bloc chain or distributed ledger Supervisors must adequately train and monitor
Last closin price − Low in past 1
K = 100 \ ] Clearin ettle ent: DTL allows near real-time subordinates. esponsibilities may be delegated.
i h in past 1 − Low in past 1
D = avera e of last 3 daily K values trade verification and reconciliation V(A) Diligence and Reasonable Basis
MA con er ence di er ence MACD oscillator: Co pliance: Allows regulators to conduct near Exercise diligence and thoroughness. Support
onsists of MA D line and signal line: MA D line is real-time review of all transactions actions with research and investigation.
the difference between two exponentially V(B) Communication with Clients and
smoothed moving averages (12 and 2 days); Prospective Clients
Signal line is the exponentially smoothed average ETHICAL
ETHICALAND
ANDPROFESSIONAL
PROFESSIONALSTANDARDS
STANDARDS Ma e appropriate disclosures. Distinguish between
of MA D line ( days) fact and opinion in analysis and recommendations.
I(A) Knowledge of the Law
Sentiment Indicators Obey strictest applicable law. Disassociate V(C) Record Retention
Put call ratio: Volume of put options traded immediately from any illegal or unethical activity. Maintain records to support recommendations and
divided by volume of call options traded decisions. -year retention period recommended.
I(B) Independence and Ob ectivity
C O olatility nde : Measures near-term
Do not offer or accept gifts that might impair VI(A) Disclosure of Conflicts
mar et volatility calculated by the BOE
independence and ob ectivity. ifts from clients Disclose any matters that may impair
Intermarket Analysis may be permissible. independence and ob ectivity, prominently
The combined analysis of ma or categories of and in plain language.
I(C) Misrepresentation
securities (equities, bonds, etc.) to identify
ite sources. Do not plagiari e or omit important VI(B) Priority of Transactions
patterns and inflection points
information. Act quic ly to correct any errors. Execute clients’ transactions before accounts
- Top do n approac : Focus on global equity
mar ets, then narrow down to specific companies I(D) Misconduct in which you have a beneficial interest.
- otto up approac : Select stoc s based on Does not apply to personal behavior unless it VI(C) Referral Fees
a set of predefined criteria regardless of reflects poorly on the investment profession. Disclose referral fees to clients and employer,
economy and sector II(A) Material Nonpublic Information including non-monetary arrangements.
Do not act or cause others to act on material
FINTECHIN
ININVESTMENT
INVESTMENTMANAGEMENT
MANAGEMENT VII(A) Conduct as Participants in
FINTECH nonpublic information. See public dissemination.
CFA Institute Program
Machine Learning II(B) Market Manipulation Do not share confidential exam details. Expressing
uper ised learnin : Algorithm finds relationships Do not ta e any actions that distort prices or opinions about FAI policies is permissible.
among labeled training data trading volume. Mar et ma ing and legitimate
Unsuper ised learnin : Algorithm wor s with VII(B) Reference to CFA Institute, the CFA
trading strategies are allowed.
unlabeled data to create clusters/groupings Designation, and the CFA Program
III(A) Loyalty, Prudence, and Care Do not misrepresent the meaning of FA Institute
Data Processing Methods Place clients’ interest above yours. Disclose membership, designation, or candidacy.
Data capture: ollecting data, transforming into policies on proxy voting and soft commissions.
usable format
III(B) Fair Dealing
Data curation: leaning data to ensure high quality
Treat all clients fairly. Treat non-immediate family
Data stora e: ecording, archiving, accessing data
li e other clients. ommunicate investment
earc : Finding specific information in datasets
recommendations and changes simultaneously.
Trans er: Moving data from source or storage
location to the analytical tool III(C) Suitability
se a regularly updated IPS during investment
Uses of Fintech in Investment Management
decisions. Evaluate decisions in a portfolio context.
Text Analytics: Analysis of unstructured data
atural Language Processing: Interpreting human III(D) Performance Presentation
language (e.g., speech recognition) Performance data should be fair, accurate, and
complete. Do not promise returns for ris y assets.
Distributed Ledger Technology (DTL)
III(E) Preservation of Confidentiality
Ownership of assets is created and exchanged on a
eep all client information confidential unless:
peer-to-peer networ
client is involved in illegal activity, you are legally
art contracts: Programmed to execute if
required, or you have the client’s permission.
specified conditions are met

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BA II PLUS
BA CALCULATOR TIPS
II PLUS CALCULATOR TIPS

Basic Operations
2 D : Access secondary functions (in yellow)
E TE : Send value to a variable
2 D E TE : Toggle between options
: avigate between variables/options
STO 0- : Store current value into memory
L 0- : ecall value from memory

Time Value of Money (TVM)

or annuity loan and ond calculations
: umber of periods
I/ : Effective interest rate per period (in )
PV : Present value
PMT : Payment/coupon amount
FV : Future value/redemption value
PT one of the above : Solve for un nown
2 D B : Toggle between ordinary annuity
and annuity due
2 D L TVM : lear TVM wor sheet
ote:
- Always clear the TVM wor sheet before
starting a new calculation
- For bonds, PMT and FV should have the same
sign, and opposite signs to PV
Cash Flow orksheet ( CF , NPV , IRR )
or non le el pay ents
Input ( F )
F0: Initial cash flow
01: 1st distinct cash flow after initial cash flow
F01: Frequency of O1
0n: nth distinct cash flow
F0n: Frequency of 0n
ote:
- Always clear the F wor sheet before starting
a new calculation
- The use of F0n is optional. ou can leave them as
1 and input repeating cash flows multiple times. If
you do so, 01 will be the cash flow at time 1, 02
will be the cash flow at time 2, and so on.
Output ( PV , I )
I: Effective interest rate per period (in )
PV PT : Solve for net present value
I PT : Solve for internal rate of return

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