CFA 4.txt

  1. Corp Gov. Best practices (14)
    75% of board independent

    independent board chairman (not CEO)

    qualified directors

    election procedures

    board self-assessment practices

    frequency of separate sessions for independent directors

    audit committee (only independent directors)

    nominating committee (only independent directors)

    compensation committee (link compensation to mostly performance)

    use of independent and expert legal counsel

    statement of governance policies

    disclosure and transparency

    insider or related-party transactions

    responsiveness to shareholder proxy votes
  2. Acquisition
    one company buys a part of another company
  3. Merger
    one company absorbs another company entirely
  4. Statutory merger
    acquiring company obtains all of the target's assets and liabilities; the target company ceases to existr
  5. Subsidiary merger
    the target company becomes a subsidiary of the acquirer; often used when target has strong brand identity
  6. Consolidation
    acquirer and target cease to exist and new company formed
  7. horizontal merger
    two businesses operate in the same or similar industries two clothing stores
  8. vertical merger
    target company is along the supply chain of the acquring company: electronics retailer buying computer manufacturer
  9. conglomerate merger
    two companies form completely separate industries (shoe and food store)
  10. Merger motivations (10)
    synergies: economies of scale/scope

    Achieving more rapid growth: increase rev growth, less risky to acquire growth

    increased market power: market share and price influence, reduce dependence on outside suppliers

    Gaining access to unique capabilities (cost effective way to acquire resources or capabilities)

    diversification: finance theory: unlikely to increase value, stabilize cash flow

    bootstrapping: positive impact on EPS from stock deal

    Personal benefits for managers (higher comp, power, prestige)

    tax benefits: acquirer can use target's tax losses to lower tax liability

    unlocking hidden value: accomplished by improving management, adding resources, or improcing organizational structure

    achieving international business goals: market inefficiences, avoid gov't policies (tariffs), use tech in new markets, product differentiation, provide support to existing clients
  11. Bootstrapping EPS
    Increased EPS that occurs when a high P/E firm acquires low P/E firm

    increase in EPS

    Real economic gains are not necessarily achieved

    due to lower P/E
  12. Pioneer/Development Phase (common mergers)
    uncertain of product acceptance, lower profit margins and large capital requirements

    Merger motivations: access to capital, management talent

    types of mergers: conglomerate and horizontal
  13. Rapid growth phase (common mergers)
    High profit margins, accelerating sales, and earnings, low industry competition

    motivations: access to capital, expand growth capacity

    types: conglomerate and horizontal
  14. Mature growth phase (common mergers)
    reduced profit margins due to competition, but potential still exists

    motivations, efficiency, economies of scale

    types: horizontal and vertical
  15. Stabilization phase (common mergers)
    competition has reduced most of industry's growth potential

    merger motivations: economics of scale, reduce costs, and improve management

    types: horizontal
  16. decline phase (common margins)
    declining margins, overcapacity, and lower demand

    merger motivations: survival, operating efficiencies, new growth opportunties

    types: horizontal, vertical and conglomerate
  17. Forms of acquisition (2)
    stock purchase: target company's stockholders sell their shares directly to the acquiring firm

    asset purchase: acquirer makes payment to target company to acquire assets
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  19. method of payments (2)
    securities offering: target shareholders receive shares of acquirer's common stock

    cash offering: target shareholders receive cash for shares
  20. Friendly merger offers
    acquirer approaches management

    negotiations and due diligence

    definitive merger agreemtn

    public announcement
  21. Hostile merger offers
    acquirer submits proposal to board of directors

    Unsuccessful proposal

    tender offer: offer made to shareholders

    proxy battle: proxy solicitation through votes
  22. poison pill
    shareholders given right to purchase more shares at a discount

    flip-in pill: buy target's shares

    flip-over pill: buy acquirer's shares
  23. poison put
    bondholders can demand immediate repayment in case of a takeover
  24. staggered board
    bidder can only win a minority of the board seats in one year
  25. restricted voting rights
    equity ownership aboce threshold level causes loss of voting rights unless approved by the board
  26. supermajority voting provisons for mergers:
    corporate charter requires shareholder support in excess of 50% (75%)
  27. Fair price amendment
    requires a "fair" price to be offered to shareholders based on independent appraisal
  28. golden parachutes
    managers receive lucrative cash payouts if they leave the target company after a merger
  29. "Just say no" defense
    refuse takeover offer, then convince shareholders to do the same
  30. litigation
    file a lawsuit against the acquirer to consume acquirer's time and money
  31. Greenamail:
    target repurchases shares from the acquirer at a premium: like a payoff to acqurer - think "blackmail", 50% tax on greenmail profits
  32. share repurchase
    target submits a tender offer for its own shares
  33. leveraged recapitalization
    target assumes a large amount of debt to repurchase shares
  34. crown jewel defense
    target sells a major asset to a neutral third party

    risk is that court could declare sale illegal
  35. pac-man defense
    target makes a counteroffer to acquire the acquirer
  36. white knight defense
    friendly 3rd party to acquire firm
  37. white squire defense
    friednly 3rd party buys minority stake in target
  38. HHI Index (def/equ)
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  40. Valuing a target company (3 methods)
    1. discounted cash flow method

    determine FCF and discount (like FCFF)

    2. Comparable company analysis

    use relative value metrics + premium

    Start with minority interest values

    3. comparable transaction analysis

    same, only start with majority prices
  41. Discounted Cash Flows Steps (6)
    Which FCF modle to use (2 or 3 stage)?

    Develop pro forma financials

    calculate free cash flows

    discount FCF's back to the present

    Determine terminal value and discount to present (gordan growth model)

    add discounted values for each stage
  42. Comparable Company Analysis
    Uses relative value metrics

    adds a takeover premium to determine fair price to pay

    big point: valuation relative to minoirty prices - does not use transacted firms
  43. Comparable Company Analysis Steps
    Identify set of comparables firms

    calculate relative value measure based on comps market prices

    calc descriptive stats and apply to the target firm

    estimate a takeover premium

    calculate the estimated take over prices (sum of stock value and premium)
  44. Comparable Transaction Analysis Steps
    Identify a set of recent takeover transactions

    calculate various relative value measures based on deal prices

    calculate descriptive statistics for the relative value metrics and apply those measures to the target firm
  45. Post-merger value of an acquirer
    Vat= Va + Vt + S - C

    Vat = Post merger value of combined firm

    Va= pre-merger value of acquirer

    Vt = pre-merger value of target

    S = synergies created by the merger

    C = cash paid to target shareholders
  46. Gains accrued to the target
    Gaint = TP = Pt - Vt

    Gaint = gains accrued to target

    TP = takeover premium

    Pt = price paid for target

    Vt = pre-merger value of target
  47. Gains accrued to the acquirer
    GainA = S - TP

    Adjustment for stock payment

    Pt = (N x Pat)

    n= number of new shares target recieves

    Pat = price per share after merger annouced
  48. Incremental Project Cash Flows (3)
    • 1) initial investment outlay
    • 2) after-tax operating cash flow over project's life (OCF)
    • 3) terminal-year cash flow (TNOCF)
  49. Outlay (Equ)
    Outlay = FCInv + NWCInv

    cost of fixed capital + change in non-cash current assets - change in non-debt current liabilities. Cash outflow if > 0

    non-working capital inventory
  50. after-tax operating cash flow
    CF = (S-C-D)(1-T) +D

    sales - cash operating expenses - depreciation expense , marginal tax rate
  51. terminal year after-tax non-operating cash flows (TNOCF)
    TNOCF = Salt + NWCInv - T(Salt-Bt)

    Sal(t) = pre-tax cash proceeds from sale of fixed capital

    NWSCInv = recovery of NWCInv

    Bt = Book value of fixed capital
  52. Adjustments if capital budgeting for replacement project
    sale of old: reduce intial outlay by the after-tax proceeds from the sale (t=0)

    depreciation: use only the difference between old and new depreciation

    operating CFs: consider only incremental cash flows from new project
  53. Always take higher NPV?
    no, not if they have different life schedules. Use lease common multiple of lives method to equalize life of investment and select higher one

    or use calculator to calc: equivalent annual annuity (EAA)

    PV= -3245, N=6, I = 12 ->PMT = 789

    higher EAA is better
  54. Project Risk Analysis - 3 steps
    1) sensitivity analysis - change single variable and see change in NPV

    2) scenario analysis: uses best-case, worst case, and most likely case scnarios. Calc the mean and standard dev of NPV

    3) monte carlo simulation: forecast probability dist. For key inputs, do random draw, calc npv, repeat
  55. CAPM (equ)
    Rproject = RF +ᵝproject [E(Rmkt) - RF]
  56. Real options (5)
    timing: wait for better info

    abandonment: exit project early if failure

    expansion: invest more $ if successful

    Flexibility: pricing setting: change product price; Production flexibility: overtime, different materials, different variety of product

    fundamental: entire project is an option; payoff depensds on underlying asset
  57. Economic income
    after tax operating cash flow minus economic depreciation

    economic depcreciation is decline in investment's market value
  58. Economic profit (equ def)
    profit in excess of dollar cost of capital invested in project


    NOPAT = EBIT (1-tax rate)

    $WACC = WACC x capital

    market value added (MVA) is NPV based on economic profit
  59. Residual income (alternative valuation models)
    residual income = NI - equity charge

    equity charge = required returin on equity x beginning book value of equity
  60. Claims on valuation approach (alternative valuation models)
    divideds CFs into the claims of deby and equity holders

    Point: debt and equity cash flows valued separately, then added together to estimate value

    CF to debt holders = interest and principal, discounted at cost of deby

    CF to equity holders = dividends and share repurchases, discounted at cost of equity
  61. Capital Structure objective: find optimal capital structure
    determine mix of debt and equity that minimizes the firm's WACC (and maximizes stock price)
  62. WACC (Equ)
  63. WACC = [wd x kd x (1-t)] + (we x ke)
  64. Modigliani and Miller (MM) 3
    Proposition 1: the value of a firm

    Proposition 2: the WACC

    know both with: no taxes and taxes
  65. Concept 1
    value of a firm is unaffected by its capital structure

    V(L) = V(U)

    levered and unlevered firm have same value

    holds in perfect markets with no taxes, no transaction costs and no costs of financial distress

    "size of pie is same, no matter how you slice it"
  66. Concept 2
    Proposition 2 no taxes

    WACC unchanged by leverage

    in a world with no taxes, capital structure doesn't matter
  67. Concept 3
    Prop 1 WITH taxes

    debt shield increases the size of the pie

    result: VL=Vu + (tax rate x value of debt)

    PV of tax shield

    Big point: optimal capital structure = 100% debt
  68. Concept 4
    as % of debt in capital structure increases, WACC decreases and firm value rises
  69. Costs of Financial distress
    costs incurred when company has trouble paying fixed financing costs (interest)

    direct (lawyer expenses) and indirect (loss of trust)

    Probability of financial distress: higher operating or financial leverage leads to higher probability of financial distress

    better corporate governance lower probability
  70. Agency costs of equity (3 types)
    costs of conflict of interest between managers and owners

    monitoring costs (better corp governance lower agency costs)

    bonding costs (e.g. non-compete agreement)

    residual losses (can't eliminate)

    Point: greater financial leverage reduces agency costs, managers have less FCF to squander
  71. Costs of Asymmetric Info
    Managers know more about firm than owners

    costs higher if complex products or poor financial statements

    stock offering: negative signal (selling overvalued stock)

    debt offering: positive signal (avoid selling undervalued stocK0
  72. Pecking order theory
    management sends signals based on their financing choices

    financing choices are from most favored to least favored (pecking order) based on their info content

    managers are lazy, choose easiest option if possible

    internally generated funds (most favored)


    newly issued equity (lease favored)
  73. Static trade-off theory def + pic
    tax shield plus cost of financial distress

    at some point: value added by tax-shield is exceed by value-reducing costs of financial distress

    this point is the optimal capital structure

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  74. 1) Establish the objectives
    • input
    • analyst's perpective

    needs communicated by client or supervisor

    institutional guidelines

    • output
    • purpose statement and specific questions to be answered

    nature and content of final report

    timetable and budge
  75. 2) Data collection
    • input
    • financial statements

    communication with management, suppliers, customers, and competitors

    • Output
    • organized financial information
  76. 3) Processing data from step 2

    adjusted financial statements

    common-sized statements


  77. 4) analyzing the data from step 2 and 3
    results of analysis
  78. 5) develop and communicate conclusions
    • input
    • results from analysis using report guidelines

    • output
    • recommendations
  79. 6) follow-up
    • input
    • periodically update information

    • output
    • update analysis and recommendations
  80. ROE
    ROE=NI/EBT x EBT/EBIT x EBIT/Revenue x Revenue/Avg Assets x Avg Assets/Avg Equity

    • tax burden
    • interest burden
    • ebit margin
    • asset turnover
    • financial leverage

    net margin
  81. Earning Sources and ROE (things to analyze)
    Assess firm's performance drivers by decomposing ROE using the extended DuPont equation
  82. Asset Base (things to analyze)
    examine composition of the balance sheet assets over time (common-size analysis, acqusiions and goodwill
  83. Capital Structure (things to analyze)
    capital structure must support the management's strategic objectives and allow the firm to honor future obligations (examine long-term debt-to-total capital
  84. capital allocation decisions (things to analyze)
    like marriott hotels. Consolidated statements hide different revenue drivers, disaggregate financial information into segments
  85. Earnings quality (things to analyze)
    persistenet and sustainable earnings are considered "high quality". Look at balance sheet approach, cash flow statement approach. Look at ratio of accruals to average net operating assets: intepretation, lower ratio, higher quality
  86. Cash flow analysis (things to assess):
    earnings confirmed with cash flow? Adjust operating cash flow by adding-back cash interest and cash taxes (if included). Compare to operating income
  87. cash flow return on assets
    Cash basis ratio

    OCF / Avg total assets
  88. Cash flow to reinvestments
    Cash basis ratio

    adjusted OCF/capital expenditures
  89. cash flow interest coverage
    Cash basis ratio

    adjusted ocf/cash interest
  90. market value decomposition (things to analyze)
    determine the implied value of the parent excluding the value of associates

    market capitalization of parent - parent's share of associates' market cap = implied value of parent
  91. Off-balance sheet financing (things to analyze)
    treat an operating lease as a finance (capital) lease

    increase A/L by the PV of remaining lease payments. Remove rent expense from income statement and replace with depreciation expense and interest expense

    RESULT: higher leverage and lower interest coverage
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  96. Compare temporal to current rate
    1) LC appreciating or depreciating

    2) examine numerator-translated at which rate (current, avg, etc.)-will numerator be larger or smaller?

    3) examine denominator-same as numerator

    4) Determine impact on ratio
  97. Hyperinflation
    when cumulative inflation rate over 3 years exceeds 3 yearscan't use current rate: lower asset and liability values-use temportal method
  98. EBITDA (proxy for?)
    Used as proxy for operating cash flow but ignores tax, interest, and working capital changes
  99. Operating Income
    Profits from operating activities EBIT
  100. income from continuing operations
    income after unusual or infrequent items and tax, but before extraordinary items and discontinued operations
  101. Net income
    income after all items below and above the line have been included
  102. pro forma income
    the firm's own measure of "operational earnings" - removes what management considers to be transitory items
  103. lesson 2-5
    Read the fine print, incomprehensible footnotes or MDA is warning sign

    Be skeptical, earnings management is warning sign

    Check for cash flow: NI/CFO should be equal to 1 over time

    Undersatnd risks: business risk, interest risk, currency risk, collectability of AR, price risk of inputs, contingneices
  104. lesson 6
    • Using derivatives to hedge risk
    • -Speculatively held derivatives: gains/losses to IS
    • -cash flow hedge: manage CF volatility
    • -Net investment in foreign operation hedges:
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  106. net investment hedge of foreign sub
    Investment in foreign sub

    equity with translation gains/losses
  107. Manipulation Incentives of Earnings
    Remuneration contracts: bonus and stock options

    debt covenants: avoid technical defailts, interest costs tied to financial performance

    Financing: subsequent issuing of debt or equity
  108. Mean Reversion
    earnings at extreme levels revert back to normal over time
  109. Earnings Quality
    Quality = persistence/sustainability
  110. Aggregate Accruals (equ)
    aggregate accruals = accrual based earnings - cash earnings
  111. Net Operating Asssets (NOA)(Equ)
    NOA = (Total assets - cash) - (total liabilities - total debt)

    Balance Sheet Based Accruals
  112. Aggregate accruals (equ)
    Aggregate accruals = NOAt - NOA t-1

    Balance Sheet Based Accruals
  113. Accruals ratio (equ)
    Accruals ratio = aggregate accruals / (NOAt - NOA t-1)/2

    Balance Sheet Based Accruals
  114. Aggregate accruals (Equ)
    aggregate accruals = NI - (CFOt + CFIt)

    cash flow accruals
  115. Accruals ratio (equ)
    Accruals ratio = aggregate accruals / (NOAt - NOA t-1)/2

    Cash Flow Accruals
  116. CFO
    NI+Depreciation+LSD (liability you subtract if it decreases)
  117. Dividends paid (equ)
    Beginning RE + net income - Dividends paid = Ending RE
  118. 2 points on effectiveness of aggregate accruals
    1) companies restating earnings had highest aggregate accruals

    2) aggregate accruals = leading indicator of SEC enforcement actions
  119. Revenue Recognition issues (3)
    • 1) recognition of sale before completion of earnings process
    • 2) recognition of sale without assurance of payment

    Estimates: credit sales, deferred/unearned revenue, warranty provisions, sales returns
  120. Lowering credit standards
    lowering standards and selling to longer pay cycle consumers. Could be sign of accelerating revnue
  121. warning signs: (8)
    • bundled products
    • management vested options
    • pressure to meet earnings forecasts
    • raising additional finance
    • Large AR increase
    • Large decrease in unearned revenue
    • disproporationate revenue in last quarter
  122. Recognizing revenue too early (4)
    • 1) bill and hold sales
    • 2) lessor use of sales type lease
    • 3) recording sales prior to acceptance by customer
    • 4) incorrectly using percent-of-completion method for long-term contracts
  123. increase sales to cash collected from customers equ
    '=sales/(revenue - change in AR + change in deferred revenue)

    Ratio detection of revenue acceleration
  124. days sales outstanding
    365/AR TO or sales / Avg AR

    Ratio detection of revenue acceleration
  125. Expense recognition (3)
    • 1) discretion over depreciation and amortization
    • 2) impairment recognition
    • 3) application of lower cost and fair value rules
  126. 3 signs of deferring expenses
    • 1) increase in net non-current assets
    • 2) consider asset growth in the context of expected sales and margin growth
    • 3) software development costs (discretion) all show the capitalization of operating expenses
  127. 2 signs of misclassification of expenses as nonrecurring or non operating
    • incorrect classification reduces COGS or SG&A
    • 1) company has genuine spectial items that can be piggybacked

    2) changes in operating profit margin or gross margin accompanied by spikes in special items
  128. Big bath provisions (3)
    • Make this bad REALLY bad, to improve future
    • 1) impairments - future IS imrpovements via decrease in depreciation
    • 2) restructuing or impariment changes reversed in subsequent periods

    3) use of high or low bad debt reserves out of line with peers
  129. Off-balance sheet liabilities (3)
    • Assets and Liabilities avoiding recognition
    • 1) operating leases
    • 2) sale of AR with recourse
    • 3) take or pay/through put agreemtns
    • Equity accounted SPVs

    Warning signs: firms following GAAP must report future cash flow obligations of operating leases - analyst should discount to PV and restate BS
  130. CF statement issues: Classification issues: (3)
    • 1) definition of cash and cash equivalents
    • 2) marketable liquid investments may be CFI
    • 3) solution: operatin gcash flows = CFO + CFI
  131. CF Statement Issues: omitted investing and financing activities (2)
    1) non-cash acquisitions-solution: utilize BS based measure of aggregate accruals

    2) operating leases (solution: capitalize)
  132. 6 aspects of "Code of Ethics"
    • 1) act in an ethical manner
    • 2) integrity is paramount and clients always come first
    • 3) use reasonable care; be independent
    • 4) be a credit to the investment profession
    • 5) uphold capital market rules and regulations
    • 6) be competent, gain knowledge after CFA
  133. 7 Standards of Professional Conduct
    • 1) Professionalism
    • 2) Integrity of Capital Markets
    • 3) Duties to Clients
    • 4) Duties to Employers
    • 5) Investment Analysis, recs, and actions
    • 6) conflicts of interest
    • 7) Responsibilities as a CFA member/candidate
  134. Standard 1: Professionalism

    A) knowledge of the law def and description
    • A) Knowledge of the law:
    • -understand all laws
    • -comply with more strict law
    • -do known knowingly assist in violation
    • -notify supervisor or compliance
    • -may confront wrongdoer directly
    • -dissocociate if necessary
    • -inaction may be participation

    • Recommended
    • -encourage firms to adopt code of ethics
    • -report violations of other members
  135. Standard 1: Professionalism

    B) independenct and objectivity def and description
    • B) independence and objectivity
    • -maintain independence
    • -do not offer, solicit, or accept any compensation that could compromise independence or objectivity
    • -modest gifts okay
    • -distinguish gifts from clients and gifts from entities trying to influence
    • -disclose client gifts to employer, get permission if git is for future performance
    • -Members responsible for hiring outside managers should not accept travel, gifts, or entertainment that could impair objectivity
    • -i-banking relationship do now bow to pressure to issue favorable research

    • recommended:
    • -be careful with IPO share allocations
  136. Standard 1: Professionalism

    C) misrepresentation def and description
    • C) Misrepresentation (lying)
    • -don't misrepresent anything
    • -don't guarantee a certain return

    • recommended
    • -quote sources, except for recognized financial and statistical reporting services
    • -internal work can be used without source
  137. Standard 1: Professionalism

    D) misconduct: def and description
    • misconduct
    • -mommy rule: don't embarrass
  138. Standard 2: Integriy of Capital Markets

    A) material non public information
    • -don't act on nonpublic information
    • -"material" if disclosure of info would affect a security's price or if an investor wold want to know before making an investment decision
    • -until released by press
    • - Mosaic theory - no violation when an analyst combines non-material non-public information

    • recommended:
    • -chinese walls
    • -review employee trades
  139. Standard 2: Integriy of Capital Markets

    B) Market manipulation
    -don't distort prices or mislead market participants
  140. Standard 3: Duties to Clients and Prospective Clients

    A: Loyalty, Prudence, and Care
    • Clients then Firm then Me
    • "Client" may be investing public
    • -vote proxies responsibly and disclose proxy voting to clients
    • - "soft dollars" must benefit clients

    • recommended:
    • -disclose all possible conflicts
    • -diversify
  141. Standard 3: Duties to Clients and Prospective Clients

    B:Fair Dealing
    • -deal fairly with all clients, can't give IPO shares to bigger clients
    • -fair does not mean equal
    • -levels of service are okay as long as disclosed
    • -all clients must have fair chance to act on every recommendation
  142. Standard 3: Duties to Clients and Prospective Clients

    C: Suitability
    • -know client before recommendation or investment action
    • -update IPS annually
  143. Standard 3: Duties to Clients and Prospective Clients

    D: Performance presentation
    • -fair, accurate, and complete
    • -can be brief presentation, not limited nature

    • recommended:
    • include terminated accounts as port of historical performance
  144. Standard 3: Duties to Clients and Prospective Clients

    E: Preservation of confidentiality
    • Keep confidential unless:
    • -illegal activities are suspected
    • -disclosure is required by law
    • -client or proespect allows disclosure
    • -may provide confidential info to CFA institute for an investigation
  145. Standard 4: Duties to Employers

    A: Loyalty
    • -act in best interest of employer until resignation is effective
    • -all records are property of firm
    • -don't solicit PRIOR to leaving
    • -no whistleblowing for personal gain
  146. Standard 4: Duties to Employers

    B: Additional Compensation arrangements
    -don't accept gifts that conflict interest of employer
  147. Standard 5: Duties to Employers

    c: responsibilities of supervisors
    -make unreasonable efforts to detect and prevent violations of applicable laws

    • recommended
    • -have procedures for reporting violations
    • -continually educate staff
  148. Standard 5: Investment analysis, recommendations, and action

    A: Diligence and reasonable basis
    • -exercise diligence, independence, and thoroughness
    • -ensure soundness of 2/3rd party research
    • -consider scenarios outside of recent experience (CDO crash)
  149. Standard 5: Investment analysis, recommendations, and action

    B: Communication with clients and prospective clients
    -disclose basic principles of investment processes

    -distinguish between fact and opinion in presentation of investment analysis

    • -maintain records
    • -clearly communicate potential gains/losses
  150. Standard 5: Investment analysis, recommendations, and action

    C: Record retention
    • maintain records to support research
    • records are firm's property
    • recommends retention of 7 years

    when member changes firm, must recreate records from public sources and new firm's inforamtion (can't rely on memory or materials from old firm)
  151. Standard 6: Conflicts of interest

    A: disclosure of conflicts
    -ensure disclosures are prominent and delivered in plain language

    -disclose everything
  152. Standard 6: Conflicts of interest

    B: Priority of Transactions
    • -clients transactions over member
    • -don't use knowledge of impending trades for personal gain
  153. Standard 6: Conflicts of interest

    C: Referral fees
    • disclose to everyone
    • Disclose nature of consideration PRIOR to entering formal agreement for services
    • update referrel compensation disclosure to employer quarterly
  154. Standard 7: Responsibilities as CFA institute member

    A: conduct
    don't make CFA look bad

    • don't cheat
    • don't disclose tests
  155. Standard 7: responsibilities as CFA

    B: Reference to CFA
    • don't misrepresent or exaggerate meaning
    • complete PCS annually
    • pay dues

    okay to say "passed all levels on first attempt"

    don't not us as noun (become a CFA)
  156. soft dollar practices
    use of brokerage by investment manager to obtain products/services to aid manager in investment making process
  157. brokerage
    compensation given to broker as payment for trade execution services
  158. research
    includes propietary (generated by broker) and third party (purchased)
  159. mixed use reseach
    research that can be used for both the investment management process and general management
  160. agency trade
    transaction that involves payment of a commission
  161. principal trade
    transaction that involves a discount or a spread
  162. Soft dollar: investment manager duty (3)
    • obtain best execution
    • minimize transaction costs
    • use client brokerage to benefit clients
  163. Soft dollar rules (5)
    1) disclose to client that manager may participate in soft dollar arrangements prior to doing so

    2)consider trade execution capabilities

    3) mixed use research: make reasonable allocation of cost based on expected usuage

    4) no commitment of portion of brokerage to single broker

    5) document aragements
  164. 3-level analysis to determine whether product/service is "research"
    • 1) define product/service
    • 2) determine usage
    • 3) mixed us analysis - make allocation

    if pass, done, or go to next
  165. CFA Research objectivity standards:

    1. Research objectivity policy
    • Ffirm must have:
    • -formal written independence and objectivity of research policy
    • -supervisory procedures in place
    • -senior officer to attest annually to compliance
  166. CFA Research objectivity standards:

    2. Public appearances
    must disclose any personal and firm conflicts on interest
  167. CFA Research objectivity standards:

    3. Reasonable and adequate basis
    • offer to provide supporting data
    • disclose current market price of security
  168. CFA Research objectivity standards:

    4. i-banking
    firms must separate research from i-banking operations

    ensure that analysts do not report to i-banking

    prevent i-banking from becoming involved with research/recs
  169. CFA Research objectivity standards:

    5: research analyst compensation
    linke resaerch analyst compensation only to quality of research and recs

    no link to corp finance or i-banking
  170. CFA Research objectivity standards:

    6.0 relationships with subject companies
    Can't allow subject comapny to see any portion of report before release
  171. CFA Research objectivity standards:

    7: personal investments and trading
    • firm's policies/procedures must:
    • -address employee personal trading
    • -no front-running client trades
    • -ensure employees and immediate familty members not trade contrary to firm's recs (exception: severe financial hardship)
    • -no IPO shares
  172. CFA Research objectivity standards:

    8: timeliness of research reports and recs
    regularly issue reports on subject companies on a timely basis
  173. CFA Research objectivity standards:

    9: compliance and enforcement
    enforce procedures
  174. CFA Research objectivity standards:

    10: disclosure

    11: rating system
    disclose conflicts of interests related to covered employees or the firm as a whole

    Have rating system that investors find useful for investment decisions
  175. covariance
    an absolute measure of how closely variables move together
  176. correlation
    Standard measure of covariance between -1 and +1

    only linear correlation (not parabolic)
  177. covariance equ
    Image Upload 17
  178. correlation (r) equ
    r1,2 = Cov1,2 / [σ12]
  179. spurious correlation
    linear relationship but no economic explanation (Super bowl wins and S&P 500)
  180. t-test
    • n - k - 1 degrees of freedom
    • tbi = [estimate - hypothesized] / standard error

    • Then test statistical significance:
    • =estimate/standard error
  181. dependent variable vs. independent variable
    independent variable = explains the variation in the dependent variable (mortgage interest rates)

    dependent variables: explained variable (housing starts)
  182. Slope coefficient and intercept (equ)
    • dependent variable: Y
    • Intercept: b0
    • Slope coefficient: b1
    • Independent variable: Xi
    • Y1 = b0 + b1Xi
  183. confidence intervals
    point estimate +_ (reliability x variability)
  184. Total variation in Y variable (equ)
    • Total variation in Y variable (SST) =
    • Variation explained by X variable (RSS)
    • + Unexplained variation (SSE)

    • k=# of independent variables
    • = 1 for simple linear regression

    n=sample size
  185. Regression mean square (MSR)

    Mean squared error (MSE)

    • MSR = RSS / k
    • = RSS for simple linear regression

    • MSE = SSE / (n-k-1)
    • =SSE / n-2 for simple linear regression
  186. ANOVA table
    Image Upload 18
  187. 3 limits of regression
    • relationships change over time
    • difficult to apply
    • usefulness limited: all participants can observe relationships
  188. P-values
    p-value = smallest significance level (α) at which we can reject H0

  189. assumptions of mulitple regression (6)
    • 1) linear relationship between Y and X's
    • 2) no exact linear relationship among X's
    • 3) expected value of error term = 0
    • 4) variace of error term is constant
    • 5) errors not serially correlated
    • 6) error term not normally distributed
  190. f-statistic (def and equ)
    tests whether any independent variable explains variation independent variable

    F = MSR / MSE

    with k and n-k-1 degrees of freedom
  191. dummy variable
    • binary variable
    • always use one less dummy variable than states of the world

    (e.g. four quarters? use three dummies)
  192. Regression assumption -> condition if violated

    1) error term has constant variance
    2) error terms are not correlated with each other
    3) no exact linear relationship among "X" variables
    • 1) heteroskedasticity
    • 2) serial correlation (autocorrelation)
    • 3) multicollinearity
  193. Durbin-Watson statistic

    equ and 3 cases
    • DW = 2(1-r)
    • r=correlation of residuals from one observation to the next

    • 3 cases:
    • 1) no autocarrelation DW = 2
    • 2) positive serial correlation: DW =0
    • 3) negative serial correlation: DW = 4
  194. Conditional Heteroskedasticity

    def and test
    t-stats are artificially high

    standard error too low = t-stat too high = false significance

    • Breusch-Pagan test:
    • H0=no heteroskedacsticity
    • Chi-square test: BP = Rresid2 x n (with k df)
  195. correcting for heteroskedasticity
    • Use robust standard errors
    • called White-corrected standard errors
    • -uses robust standard erros to recalc t-stats
    • Result: standard errors higher, t-stats lower and more accurate
  196. serial correlation def and detecting
    Positive autocorrelation: each error term tends in same direction as previous term

    t-stats are too high (same as heterosk)

    detecting: scatter plot and Durbin-Watson statistic
  197. correcting for serial correlation
    • adjust the coefficient standard errors using the Hansen mthod and recalc t-stats
    • =also corrects heterosked
  198. multicollinearity def and detecting and correction
    • two or more X variables are correlated with each other
    • -Inflactes SEs, reduces t-stats
    • -so variables falsely look unimportant

    • no formal test
    • tell-tale signs from regression data
    • 1) significant f-stat overall, but insignificant t-stats
    • 2) high correlation between x variables

    correction: omit one ore more of the x variables
  199. 3 types of model misspecification
    • 1) functional form:
    • -important variables omitted
    • -variables not transformed properly
    • -data pooled improperly
    • 2) correlation between error and X variables
    • -x variable is lagged Y variable
    • -forecast the past
    • -measurement error
    • 3) other time series problems
  200. Logit models
    calculate a probability based on logistic distribution
  201. probit models
    calculates a probability based on normal distribution
  202. discriminant models
    procude a score or ranking used to classify into categories (bankrupt, or not bankrupt)
  203. log-linear trend model
    assumes the dependent financial variable grows at some constant rate:

    • ln (yt) = b0 + b1t + εt
  204. covariance stationary
    • a time series must be covariance stationary:
    • -constant and finite expected value
    • -constant and finite variance

    a nonstationary times series will produce meaningless regression results
  205. autoregressive models
    main idea and equ
    the dependent variable is regressed against previous values of itself

    xt =b0 +b1xt-1 + b2xt-2+...+εt
  206. Mean reverting level (equ)
    MRL = b0 / (1-b1)
  207. cointegration
    two time series are related to the same macro variables or follow the same trend

    • -if cointegrated, go ahead use the model,
    • if not, throw out the model
  208. economic factors (4)
    • Land, Capital goods, labor, entrepreneurial ability
    • Grows when any of the above: grows or becomes more efficient
  209. Preconditions for economic growth
    Incentive system: most important factor

    • Necessary social institutions
    • § Markets: facilitates the exchange of info
    • § Property rights: guarantees private ownership(more efficient markets)Monetary exchange: provides for efficient exchange of goods/services (more efficient markets)
  210. Labor Productivity equ
    Labor Productivity = real GDP per labor hour
  211. 3 sources of economic growth
    • · Growth in physical capital
    • · Tech change
    • Human capital (education)
  212. 1/3rd rule
    1/3rd rule: 1% increase in capital results in 1/3% growth, so rest is technological change
  213. 3 growth theories
    • 1. Classical: (sad) in long run, we are all at the subsistence level (y-axis)
    • 2. Neoclassical : (medium) Economic growth results for “lucky” discoveries of new tech. Growth is no long-term, but there is a permanently higher living standard. Real return = target return. If Real R is > target R, more competitions, returns fall back down and economic growth stops if no new tech comes.
    • 3. New Growth Theory: (happy/American): economic growth gives incentives to create
    • a. Real Return > target R = big profits
    • b. Big profits attract entryDeclining returns motivate search for new tech
  214. 2 types of regulation
    1) Economic: control pricint (think monopoly)

    2) Social: social goals (safer drugs)
  215. Negative side effects of regulation: (2)
    1) Creative response: compliance with the letter of the law, but not the spirit

    2) Feedback effect: change in consumers’ behavior in response to regulation
  216. Regulator Behavior: (4)
    • Theoretical: regulators are unbiased
    • Pathological:
    • 1) The capture hypothesis: regulators eventually controlled by industry
    • 2) Share the gains, share the pains: regulators serve 3 people:
    • a. Regulated Industry
    • b. Public
    • c. Law makers
  217. Comparative Advantage
    lowest opportunity cost to produce a product (instead of absolute advantage)
  218. voluntary export restraints
    agreements by exporting countries to limit the quantity of goods they will export toan importing country
  219. nominal vs. real
    • Nominal: price of one currency in terms of another
    • Real: exchange rate adjusted for inflation differential between two currencies.
  220. 2 reasons for trade restrictions
    • 1) gov'ts like tariff revenue
    • 2) domestic producers affected by lower-cost imports use political means to gain protection from foreign competition
  221. 3 suport arguments for trade restrictions (3)
    • 1) developing industries (protect)
    • 2) anti-dumping: prohibit foreign producers for lowering prices
    • 3) national defense: steel industry
  222. 3 factors that affect demand of FX demand:
    • · Interest rates: high real rates should increase the demand for a currency for a country’s currency
    • · Expected future exchange rates

    Demand for impots/exports
  223. Exchange rate policies:


  224. purchasing power parity
    the same basket of goods should cost the same in different countries
  225. inerest rate parity
    currency appreciation/deprec over time should just offset differences in interest rates
  226. 3 factors affecting FX rates
    1) interst rates: high real rates should increase the demand for a country's currency

    • 2) expected future FX rates
    • 3) demand for imports/exports
  227. currency convetion: base and counter currency

    .5440 Pounds / USD
  228. Efficiency metric (% of ask)
    Efficiency metric (% of ask) = ask – bid / ask = .1573%
  229. The triangle (5)
    • Process:
    • · Start with fixed amount of Currency A
    • · Convert to currency B
    • · Convert to Currency C
    • · Finally, convert back into Currency A
    • IF you make money, you went the right way, if you lose: wrong way or no arbitrage
  230. how do you know whether the bid or the as is the appropriate rate?

    • up-the-bid
    • down-the-ask

    • $/Euros
    • bid means turning Euro to dollar
    • ask means turning dollar to euro

    ask is always higher than the bid
  231. (Bid-ask) spread is calculated just as for spot rates: (2)
    • Typically, forward spreads > spot spreads
    • Remember, spreads are measured as % of ASK
  232. 3 things afecting spot and/or forward rates

    1) trading volume increases
    2) currency volatility increases
    3) term of the contract increases (just forward)
    • 1) spread down
    • 2) risk up, spread up
    • 3) risk up, spread up
  233. forward premium or discount equ
    Forward premium/discount = [(forward rate - spot rate)/spot rate] * [360 / # of forward contract days]
  234. Interest Rate Parity (IRP) equ + 2 points

    Spot x [1+rcountercurrency (n/360)] / [1+rbasecurrency (n/360)] = Forward

    if not equal, arbitrage exists

    • Point 1: currency with higher nominal interest rate will depreciate
    • Point 2: when IRP holds, an investor will make the same return holding either currency
  235. Balance of Payment Accounts
    Current Account + Capital Account + Official Reserve Account = 0

    Current Account: net exchange of goods/services

    Capital account: net flow of funds

    Official Reserve account: funds held by gov’t in foreign currencies and loans to foreign governments

    Running a current account is not a good measure of its economic health
  236. 3 Factors that Cause a currency fluctuation
    • 1) Differences in income growth
    • a. Rapit income growth = high demand for imports, so domestic currency depreciates
    • 2) Differences in inflation rates
    • a. High inflation = expensive exports
    • b. Domestic currency depreciates
    • 3) Differences in real interest rates
    • a. Domestic currency depreciates
    • b. High real rates attracts foreign investments
  237. monetary expansion leads to
  238. Expansionary Fiscal policy (3)
    • · Higher growth: increases imports; currency depreciates
    • · Higher inflation: decreases exports; currency depreciates
    • · Higher real interest rates: more demand for loans
    • o Increases investment abroad; appreciation
  239. absolute PPP
    Relative PPP
    absolute: same basket of goods will cost same everywhere

    relative: changes in exchange rates will just offset changes in price levels
  240. relative PPP equ
    S0 [(1+Icountercurrency/(1 + Ibasecurrency)]t = E(St)

    E(St) = expected future spot
  241. international fisher relation
    REAL interest rates should be the same across countries

    Countries with high interest rates should have currency values that fall over time
  242. uncovered interest rate parity equ
    like covered interest rate parity

    S0 x [1+rcountercurrency (n/360)]/[1+rbasecurrency(n/360)] = E(Sn)
Card Set
CFA 4.txt