CFA 4.txt

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

one company buys a part of another company

one company absorbs another company entirely

acquiring company obtains all of the target's assets and liabilities; the target company ceases to existr

the target company becomes a subsidiary of the acquirer; often used when target has strong brand identity

acquirer and target cease to exist and new company formed

two businesses operate in the same or similar industries two clothing stores

target company is along the supply chain of the acquring company: electronics retailer buying computer manufacturer

two companies form completely separate industries (shoe and food store)

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

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

uncertain of product acceptance, lower profit margins and large capital requirements

Merger motivations: access to capital, management talent

types of mergers: conglomerate and horizontal

High profit margins, accelerating sales, and earnings, low industry competition

motivations: access to capital, expand growth capacity

types: conglomerate and horizontal

reduced profit margins due to competition, but potential still exists

motivations, efficiency, economies of scale

types: horizontal and vertical

competition has reduced most of industry's growth potential

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

types: horizontal

declining margins, overcapacity, and lower demand

merger motivations: survival, operating efficiencies, new growth opportunties

types: horizontal, vertical and conglomerate

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

securities offering: target shareholders receive shares of acquirer's common stock

cash offering: target shareholders receive cash for shares

acquirer approaches management

negotiations and due diligence

definitive merger agreemtn

public announcement

acquirer submits proposal to board of directors

Unsuccessful proposal

tender offer: offer made to shareholders

proxy battle: proxy solicitation through votes

shareholders given right to purchase more shares at a discount

flip-in pill: buy target's shares

flip-over pill: buy acquirer's shares

bondholders can demand immediate repayment in case of a takeover

bidder can only win a minority of the board seats in one year

equity ownership aboce threshold level causes loss of voting rights unless approved by the board

corporate charter requires shareholder support in excess of 50% (75%)

requires a "fair" price to be offered to shareholders based on independent appraisal

managers receive lucrative cash payouts if they leave the target company after a merger

refuse takeover offer, then convince shareholders to do the same

file a lawsuit against the acquirer to consume acquirer's time and money

target repurchases shares from the acquirer at a premium: like a payoff to acqurer - think "blackmail", 50% tax on greenmail profits

target submits a tender offer for its own shares

target assumes a large amount of debt to repurchase shares

target sells a major asset to a neutral third party

risk is that court could declare sale illegal

target makes a counteroffer to acquire the acquirer

friendly 3rd party to acquire firm

friednly 3rd party buys minority stake in target

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

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

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

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)

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

V_at= V_a + V_t + 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

Gain_t = TP = P_t - V_t

Gaint = gains accrued to target

TP = takeover premium

Pt = price paid for target

Vt = pre-merger value of target

Gain_A = S - TP

Adjustment for stock payment

P_t = (N x P_at)

n= number of new shares target recieves

P_at = price per share after merger annouced

• 1) initial investment outlay
• 2) after-tax operating cash flow over project's life (OCF)
• 3) terminal-year cash flow (TNOCF)

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

CF = (S-C-D)(1-T) +D

sales - cash operating expenses - depreciation expense , marginal tax rate

TNOCF = Sal_t + NWCInv - T(Sal_t-B_t)

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

NWSCInv = recovery of NWCInv

Bt = Book value of fixed capital

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

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

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

R_project = R_F +ᵝ_project [E(R_mkt) - R_F]

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

after tax operating cash flow minus economic depreciation

economic depcreciation is decline in investment's market value

profit in excess of dollar cost of capital invested in project

EP NOPAT - $WACC

NOPAT = EBIT (1-tax rate)

$WACC = WACC x capital

market value added (MVA) is NPV based on economic profit

residual income = NI - equity charge

equity charge = required returin on equity x beginning book value of equity

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

determine mix of debt and equity that minimizes the firm's WACC (and maximizes stock price)

Proposition 1: the value of a firm

Proposition 2: the WACC

know both with: no taxes and taxes

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"

Proposition 2 no taxes

WACC unchanged by leverage

in a world with no taxes, capital structure doesn't matter

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

as % of debt in capital structure increases, WACC decreases and firm value rises

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

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

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

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)

debt

newly issued equity (lease favored)

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

• 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

• input
• financial statements

communication with management, suppliers, customers, and competitors

• Output
• organized financial information

output





adjusted financial statements

common-sized statements

ratios

forecasts

results of analysis

• input
• results from analysis using report guidelines

• output
• recommendations

• input
• periodically update information

• output
• update analysis and recommendations

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

Assess firm's performance drivers by decomposing ROE using the extended DuPont equation

examine composition of the balance sheet assets over time (common-size analysis, acqusiions and goodwill

capital structure must support the management's strategic objectives and allow the firm to honor future obligations (examine long-term debt-to-total capital

like marriott hotels. Consolidated statements hide different revenue drivers, disaggregate financial information into segments

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

earnings confirmed with cash flow? Adjust operating cash flow by adding-back cash interest and cash taxes (if included). Compare to operating income

Cash basis ratio

OCF / Avg total assets

Cash basis ratio

adjusted OCF/capital expenditures

Cash basis ratio

adjusted ocf/cash interest

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

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

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

when cumulative inflation rate over 3 years exceeds 3 yearscan't use current rate: lower asset and liability values-use temportal method

Used as proxy for operating cash flow but ignores tax, interest, and working capital changes

Profits from operating activities EBIT

income after unusual or infrequent items and tax, but before extraordinary items and discontinued operations

income after all items below and above the line have been included

the firm's own measure of "operational earnings" - removes what management considers to be transitory items

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

• Using derivatives to hedge risk
• -Speculatively held derivatives: gains/losses to IS
• -cash flow hedge: manage CF volatility
• -Net investment in foreign operation hedges:

Investment in foreign sub

equity with translation gains/losses

Remuneration contracts: bonus and stock options

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

Financing: subsequent issuing of debt or equity

earnings at extreme levels revert back to normal over time

Quality = persistence/sustainability

aggregate accruals = accrual based earnings - cash earnings

NOA = (Total assets - cash) - (total liabilities - total debt)

Balance Sheet Based Accruals

Aggregate accruals = NOA_t - NOA <sub>t-1

Balance Sheet Based Accruals</sub>

Accruals ratio = aggregate accruals / (NOA_t - NOA _t-1)/2

Balance Sheet Based Accruals

aggregate accruals = NI - (CFOt + CFIt)

cash flow accruals

Accruals ratio = aggregate accruals / (NOA_t - NOA _t-1)/2

Cash Flow Accruals

NI+Depreciation+LSD (liability you subtract if it decreases)

Beginning RE + net income - Dividends paid = Ending RE

1) companies restating earnings had highest aggregate accruals

2) aggregate accruals = leading indicator of SEC enforcement actions

• 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

lowering standards and selling to longer pay cycle consumers. Could be sign of accelerating revnue

• 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

• 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

'=sales/(revenue - change in AR + change in deferred revenue)

Ratio detection of revenue acceleration

365/AR TO or sales / Avg AR

Ratio detection of revenue acceleration

• 1) discretion over depreciation and amortization
• 2) impairment recognition
• 3) application of lower cost and fair value rules

• 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

• 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

• 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

• 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

• 1) definition of cash and cash equivalents
• 2) marketable liquid investments may be CFI
• 3) solution: operatin gcash flows = CFO + CFI

1) non-cash acquisitions-solution: utilize BS based measure of aggregate accruals

2) operating leases (solution: capitalize)

• 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

• 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

• 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

• 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

• 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

• misconduct
• -mommy rule: don't embarrass

• -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

-don't distort prices or mislead market participants

• 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

• -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

• -know client before recommendation or investment action
• -update IPS annually

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

• recommended:
• include terminated accounts as port of historical performance

• 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

• -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

-don't accept gifts that conflict interest of employer

-make unreasonable efforts to detect and prevent violations of applicable laws

• recommended
• -have procedures for reporting violations
• -continually educate staff

• -exercise diligence, independence, and thoroughness
• -ensure soundness of 2/3rd party research
• -consider scenarios outside of recent experience (CDO crash)

-disclose basic principles of investment processes

-distinguish between fact and opinion in presentation of investment analysis

• -maintain records
• -clearly communicate potential gains/losses

• 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)

-ensure disclosures are prominent and delivered in plain language

-disclose everything

• -clients transactions over member
• -don't use knowledge of impending trades for personal gain

• disclose to everyone
• Disclose nature of consideration PRIOR to entering formal agreement for services
• update referrel compensation disclosure to employer quarterly

don't make CFA look bad

• don't cheat
• don't disclose tests

• 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)

use of brokerage by investment manager to obtain products/services to aid manager in investment making process

compensation given to broker as payment for trade execution services

includes propietary (generated by broker) and third party (purchased)

research that can be used for both the investment management process and general management

transaction that involves payment of a commission

transaction that involves a discount or a spread

• obtain best execution
• minimize transaction costs
• use client brokerage to benefit clients

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

• 1) define product/service
• 2) determine usage
• 3) mixed us analysis - make allocation

if pass, done, or go to next

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

must disclose any personal and firm conflicts on interest

• offer to provide supporting data
• disclose current market price of security

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

linke resaerch analyst compensation only to quality of research and recs

no link to corp finance or i-banking

Can't allow subject comapny to see any portion of report before release

• 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

regularly issue reports on subject companies on a timely basis

enforce procedures

disclose conflicts of interests related to covered employees or the firm as a whole

Have rating system that investors find useful for investment decisions

an absolute measure of how closely variables move together

Standard measure of covariance between -1 and +1

only linear correlation (not parabolic)

r_1,2 = Cov_1,2 / [σ₁*σ₂]

linear relationship but no economic explanation (Super bowl wins and S&P 500)

• n - k - 1 degrees of freedom
• t_bi = [estimate - hypothesized] / standard error

• Then test statistical significance:
• =estimate/standard error

independent variable = explains the variation in the dependent variable (mortgage interest rates)

dependent variables: explained variable (housing starts)

• dependent variable: Y
• Intercept: b₀
• Slope coefficient: b₁
• Independent variable: X_i
• Y₁ = b₀ + b₁X_i

point estimate +_ (reliability x variability)

• 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

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

• MSE = SSE / (n-k-1)
• =SSE / n-2 for simple linear regression

• relationships change over time
• difficult to apply
• usefulness limited: all participants can observe relationships

p-value = smallest significance level (α) at which we can reject H₀

• 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

tests whether any independent variable explains variation independent variable

F = MSR / MSE

with k and n-k-1 degrees of freedom

• binary variable
• always use one less dummy variable than states of the world

(e.g. four quarters? use three dummies)

• 1) heteroskedasticity
• 2) serial correlation (autocorrelation)
• 3) multicollinearity

• 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

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 = R_resid² x n (with k df)

• 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

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

• adjust the coefficient standard errors using the Hansen mthod and recalc t-stats
• =also corrects heterosked

• 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

• 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

calculate a probability based on logistic distribution

calculates a probability based on normal distribution

procude a score or ranking used to classify into categories (bankrupt, or not bankrupt)

assumes the dependent financial variable grows at some constant rate:

• ln (y_t) = b₀ + b₁t + ε_t

• 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

the dependent variable is regressed against previous values of itself

x_t =b₀ +b₁x_t-1 + b₂x_t-2+...+ε_t

MRL = b₀ / (1-b₁)

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

• Land, Capital goods, labor, entrepreneurial ability
• Grows when any of the above: grows or becomes more efficient

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)

Labor Productivity = real GDP per labor hour

• · Growth in physical capital
• · Tech change
• Human capital (education)

1/3rd rule: 1% increase in capital results in 1/3% growth, so rest is technological change

• 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

1) Economic: control pricint (think monopoly)

2) Social: social goals (safer drugs)

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

• 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

lowest opportunity cost to produce a product (instead of absolute advantage)

agreements by exporting countries to limit the quantity of goods they will export toan importing country

• Nominal: price of one currency in terms of another
• Real: exchange rate adjusted for inflation differential between two currencies.

• 1) gov'ts like tariff revenue
• 2) domestic producers affected by lower-cost imports use political means to gain protection from foreign competition

• 1) developing industries (protect)
• 2) anti-dumping: prohibit foreign producers for lowering prices
• 3) national defense: steel industry

• · 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

Flexible

fixed

pegged

the same basket of goods should cost the same in different countries

currency appreciation/deprec over time should just offset differences in interest 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

Convention: “BASE CURRENCY:COUNTER CURRENCY” or USD:GBP = 0.554

.5440 Pounds / USD

Efficiency metric (% of ask) = ask – bid / ask = .1573%

• 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

• 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

• Typically, forward spreads > spot spreads
• Remember, spreads are measured as % of ASK

• 1) spread down
• 2) risk up, spread up
• 3) risk up, spread up

Forward premium/discount = [(forward rate - spot rate)/spot rate] * [360 / # of forward contract days]

IRP

Spot x [1+r_{countercurrency} (n/360)] / [1+r_basecurrency (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

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

• 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

depreciation

• · 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

absolute: same basket of goods will cost same everywhere

relative: changes in exchange rates will just offset changes in price levels

S₀ [(1+I_{countercurrency}/(1 + I_basecurrency)]^t = E(S_t)

E(S_t) = expected future spot

REAL interest rates should be the same across countries

Countries with high interest rates should have currency values that fall over time

like covered interest rate parity

S₀ x [1+r_{countercurrency} (n/360)]/[1+r_basecurrency(n/360)] = E(S_n)