CFA Level 1 Notes

CFA level 1 notes
Contents
Book 1 Ethics and Professional Standards and Quantitative
Methods...........................................................................3
Reading 1...............................................................................3
Standard : Professionalism...................................................3
Standard : Integrity of Capital Markets.................................6
Standard : Duties to Clients..................................................7
Standard : Duties to Employers...........................................10
Standard Investment Analysis, recommendations and actions
............................................................................................12
Standard : Conflicts of Interest...........................................15
Standard : Responsibilities as CFA Institute Member or
Candidate.............................................................................16
Reading 4 Introduction to GIPS..............................................17
Reading 5 The time value of the money..................................20
Reading 6 Discounted Cash Flow Applications........................20
Reading 7 Statistical Concepts and Market Returns................21
Reading 8 Probability Concepts.............................................22
Reading 9 Common Probability Distribution............................23
Reading 10 Sampling and estimates......................................23
Reading 11 Hypothesis Testing..............................................25
Reading 12 Technical Analysis...............................................27
Book 2 Economics............................................................29
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13
14
15
16
17
18
19
20
21
Demand and Supply Analysis: Introduction...........29

Demand and Supply Analysis: Consumer Demand. 33
Demand and Supply Analysis: The firm.................35
The firm and Market Structures............................39
Aggregate Output, Prices, and Economic growth...45
Understanding Business Cycle..............................52
Monetary and Fiscal Policy...................................57
International Trade and Capital Flows...................62
Currency Exchange Rates.....................................66
Book 3 Financial Reporting and Analysis...........................69

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22
23
24
25
26
27
28
29
30
31
32
33
Financial statement analysis: An Introduction.......69

Financing Reporting Mechanics............................70
Financial Reporting Standards.............................71
Understanding Income Statements.......................73
Understanding Balance Sheets.............................76
Understanding Cash Flow Statements..................79
Financial Analysis Techniques..............................81
Inventories.........................................................82
Long-lived Assets................................................84
Income Taxes......................................................87
Non-Current Liabilities.........................................89
Financial Reporting Quality: Red Flags and
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Accounting Warning Signs.....................................................95

Reading 34 Accounting Shenanigans on the Cash Flow
Statement............................................................................97
Reading 35 Financial Statement Analysis: Applications...........98
Book 4 Corporate Finance, Portfolio Management and Equity

Investment...................................................................100
Reading
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36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
Capital Budgeting..............................................100
Cost of Capital...................................................101
Measure of leverage..........................................104
Dividends and share repurchase basics..............104
Working Capital Management.............................105
the Corporate Governance of Listed Companies. .107
Portfolio Management: An Overview...................109
Portfolio risk and return: Part 1..........................111
Portfolio risk and return: Part 2..........................112
Basics of portfolio planning and construction......114
Market organization and structure.....................115
Security Market Indices.....................................120
Market Efficiency...............................................122
Overview of Equity Securities.............................125
Introduction to Industry and Company analysis...128
Equity valuation................................................131
Book 5 Fixed Income, Derivatives, and alternative

investments..................................................................133
Reading 52 Fixed-income securities: Defining Elements........133

Reading 53 Fixed-income Markets: Issuance, Trading, and
Funding..............................................................................136
Reading 54 Introduction to Fixed Income Valuation...............138
Reading 55 Understanding Fixed-Income Risk and Return.....140
Reading 56 Fundamentals of credit analysis.........................142
Reading 57 Derivative Markets and Instruments...................146
Reading 58 Forward Markets and Contracts..........................147
Reading 59 Future Markets and Contracts............................148
Reading 60 Option Markets and Contracts............................149
Reading 61 Swap Markets and Contracts..............................151
Reading 62 Risk Management Applications of Option Strategies
..........................................................................................152
Reading 63 Introduction to Alternative Investments.............152
Book
1
Ethics
and
Professional
Standards and Quantitative Methods
Tips:
Reading 1
CFA institute Professional Conduct Program
Inquiry can be prompted by:
1) Self-disclosure
2) Written complaints
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3) Evidence of misconduct
4) Report by a CFA exam proctor
The designated officer may decide:
1) No disciplinary sanctions are appropriate
2) To issue a cautionary letter
3) To discipline the member or candidate
If the candidate does not accept the proposed sanction, the matter
is referred to a hearing panel composed of hearing panel.
Sanctions may include condemnation by members peers or
suspension of candidates participation in the CFA program
The code of ethics
Six components:
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
Standard : Professionalism
A. Knowledge of the Law
1) Understand and comply with all laws, rules, and regulations

(including Code and Standards) of any government, regulatory
agency, or association governing professional activities
2) Comply with more strict law, rule, and regulation
3) Do not knowingly assist in violation, otherwise dissociate from
activity.
Guidance
1)
2)
3)
4)
5)
6)
Most strict
First, notify supervisor or compliance
May confront wrongdoer directly
Dissociate if necessary
Inaction may be construed as participation ()
No requirement to report violations to governmental authorities, but this may be
appropriate in certain cases
Recommended Procedures
1)
2)
3)
4)
5)
Keep informed, regularly review written compliance procedures, maintain files

Seek compliance/legal advice as needed
Encourage firms to adopt code of ethics
Distribute information internally on applicable laws and regulations
Have written procedures for reporting suspected violations
6) Members strongly encouraged to report violations by other members
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B. Independence and Objectivity

1) Use reasonable care, judgment to achieve and maintain
independence in professional activities
2) Do not offer, solicit, or accept any compensation that could
compromise independence or objectivity
Guidance
1) Modest gifts okay
2) Distinguish between gifts from clients and gifts from entities
trying to influence a member's behavior
3) May accept gift from clients-disclose to employer-get
permission if gift is for future. When possible, prior to
accepting bonuses or gifts from clients, members
should disclose to employers such benefits offered by
clients. If notification is not possible prior to acceptance,
members must disclose to employers benefits previously
accepted from clients.
4) Members responsible for hiring outside managers should not
accept travel, gifts, or entertainment that could impair their
objectivity
5) Investment banking relationships-do not bow to pressure to issue
favorable research
6) For issuer-paid research, flat fee structure is preferred; must
disclose
7) Members working for credit rating firms should avoid influence by
issuing firms
8) Users of credit ratings should be aware of this potential conflict
9) Best practice is for analysts to pay for their own commercial
travel to firms being analyzed or to firm events
1)
2)
3)
4)
5)
Protect integrity of options - reports should reflect unbiased opinion

Create a restricted list
Restrict special cost arrangements
Limit gifts; clear value limits by firm ()
Be careful with IPO share allocations
C. Misrepresentation
Do not make misrepresentations relating to investment analysis,
recommendations, actions, or other professional activities
A mispresentation is any untrue or omission of a fact or any
statement that is otherwise false or misleading.
Guidance
1) Standard covers oral, written, or electronic communications

2) Do not misrepresent qualifications, services of self or firm, or
performance record, characteristics of an investment
3) Do not guarantee a certain return
4) No plagiarism-written, oral, or electronic communications
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1) Firms can assist employees by providing written list of the firm's

available services and a description of the firm's qualifications
2) Maintain records of materials used to prepare research
reports, and quote source, except for "recognized financial
and statistical reporting services". Bloomberg
, US treasury Website.
3) Models and analysis of others at the firm may be used
without attribution ; but the
report written by another analysts employed by the firms
cannot be used as another analysts work.
4) Should encourage firm to establish procedures for verifying
marketing claims of third parties recommended to clients
D. Misconduct (Mummys rule)

Do not engage in any professional conduct involving dishonesty,
fraud, deceit, or commit any act that reflects adversely on
professional reputation, integrity, or competence. Fail to act when
required by ones professional obligations, such as neglecting to
perform due diligence related to investment recommendations,
violates Misconduct.
Guidance
This Standard covers conduct that may not be illegal, but could
adversely affect a member's ability to perform duties
1) Adopt a code of ethics to which every employee must adhere
2) Disseminate a list of potential violations and associated disciplinary sanctions
3) Conduct background checks on potential employees -- look for good character
and eligibility to work in the investment industry
Standard : Integrity of Capital Markets

A. Material Nonpublic Information
Members in possession of nonpublic information that could affect an

investment's value must not act or cause someone else to act on
the information
Guidance
1) "Material" if disclosure of information would affect a security's
price or if an investor would want to know before making an
investment decision
2) If price effect is ambiguous, information may not be considered
material
3) Extends to info such as upcoming rating change, influential
analysis to be released
4) Information is nonpublic until it has been made available to the
marketplace. CFO material nonpublic.
5) Information made available to analysts in the conference call is
considered nonpublic until it is made available to investors in
general
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6) "Act" includes related swaps and options, mutual funds with the
security
7) If you possess material non-public information, act as you
would if you did not know rumor
mosaic theory
8) Mosaic Theoryno violation when an analyst combines nonmaterial non-public information with public information to
reach conclusion
1) Information barrier or "firewall" is recommended to control interdepartmental
communications
2) Information barrier includes use of restricted list
3) Review employee trades
4) Increase review/restrict proprietary trading while firm is in possession of
material nonpublic information
B. Market Manipulation
Do not engage in practices that distort prices or artificially inflate
trading volume with intent to mislead market participants
Guidance
1) Do not engage in transaction-based manipulation-give false
impression of activity/price movement; gain dominant position in

an asset to manipulate price of the asset or a related derivative
2) Do not distribute false, misleading information
Standard : Duties to Clients

A. Loyalty, Prudence, and Care
1) Duty of loyalty to clients-act with reasonable care and exercise prudent judgment
2) Act for benefit of clients and place their interests before employers or own
interests
3) Determine and comply with any applicable fiduciary duty
Guidance
1) Take investment actions in client's best interests
2) Exercise prudence, care, skill, and diligence that a person familiar with such
matters would use
3) Follow applicable fiduciary duty
4) "Client" may be investing public
5) Manage pools of client assets according to terms of governing documents
6) Make investment decisions in context of total portfolio
7) Vote proxies responsibly and disclose proxy voting policies to clients
8) "Soft dollars" must benefit client (brokerage fee is clients money, broker will
give something back, which is called soft dollars)
1)
2)
3)
4)
5)
Follow rules and laws

Establish client investment objectives
Diversify
Deal fairly with clients-investment actions
Disclose all possible conflicts
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6)
7)
8)
9)
Vote proxies in best interest of clients and ultimate beneficiaries

Keep client information confidential
Seek best trading execution for clients
Place client interests first
B. Fair Dealing
Deal fairly and objectively with all clients when:
Providing investment analysis
Making investment recommendations
Taking investment action
Engaging in other professional activities
Guidance
1) No discrimination against any clients when disseminating investment
recommendations or taking investment action
2) Fair does not mean equal
3) Different levels of service are okay as long as disclosed and do not
disadvantage any clients
4) Investment recommendations:
All clients must have fair chance to act on every recommendation
If client is unaware of recommendation change, advise before accepting trade
order
5) Investment actions:
Treat all clients fairly--consider investment objectives and circumstances
Disclose written allocation procedures
Do not disadvantage any clients when distributing "hot" issues new or
old
1) Limit number of people aware of upcoming changes
2) Shorten time frame-decision to dissemination
3) Have pre-dissemination guidelines
4) Simultaneous dissemination
5) Maintain list of clients and their holdings
6) Disclose trade allocation procedures
7) Review accounts regularly to ensure fair client treatment
8) If firm offers different levels of service, disclose this fact to
all clients
9) Deviations from strict pro rata allocation of IPO are
sometimes okay (e.g., minimum block sizes)
Include allocating pro rata on the basis of order size, not account
size. All clients participating in the block trade should receive the
same execution price and be charged the same commission.
buysell selective disclosure
C. Suitability
When in advisory relationship with a client:
1) Make reasonable inquiry as to client's investment experience, risk/return
objectives, financial constraints prior to making any recommendation, or
taking investment action
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2) Update information regularly

3) Ensure investment is suitable to client's situation and consistent with written
objectives before recommending an investment or taking investment action
4) Look at suitability in a portfolio context
5) When responsible for managing a portfolio to a specific mandate, strategy, or
style, only make recommendations or take investment actions that are
consistent with the stated objectives and constraints of the portfolio
Guidance
1)
2)
3)
4)
When in advisory relationship, gather client information at the outset and prepare
IPS (investment policy statement)
Update IPS at least annually
Consider whether leverage (derivatives) is suitable for client
If managing a fund to an index or other mandate, invest according to mandate
1) When formulating IPS for client, know the client's:
Return objectives
Risk tolerance
2) Determine the client's constraints:
Liquidity needs
Expected cash flows, investable funds
Time horizon, tax considerations
Regulatory/legal constraints
Unique circumstances/needs
D. Performance Presentation
1) When communicating investment performance information, make reasonable
efforts to ensure that it is fair, accurate, and complete
2) Can make brief presentation, note limited nature, and make detailed
information available on request
3) Do not require compliance with GIPS, auditing or verification requirements.
Guidance
1)
2)
3)
4)
Do not misstate performance or mislead clients about investment performance

Do not misrepresent past performance
Provide fair and complete performance information
Do not state or imply ability to achieve returns similar to those achieved in the
past
1)
2)
3)
4)
Consider audience sophistication when presenting performance

Use performance of the weighted composite of similar portfolios
Include terminated accounts as part of historical performance
Make all disclosures and maintain records. ,
7 . GIPS, 5 , 10 .
E. Preservation of Confidentiality
Keep current and prospective client information confidential, unless:
Illegal activities are suspected
Disclosure is required by law
Client or prospect allows disclosure of the information
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Guidance
1)
2)
3)
4)
In some cases it may be required by law to report activities to relevant authorities

This standard extends to former clients
Exception: May provide confidential information to CFA Institute for an
investigation under Professional Conduct program
If applicable law requires members to maintain confidentiality, even if the
information concerns illegal activities on the part of the client, members
should not disclose such information.
1) Avoid discussing any information received from a client except to colleagues
working on the same project
2) Follow firm's electronic data storage procedures; recommend adoption of
procedures if none exist
Standard : Duties to Employers

A. Loyalty
On matters related to employment, act for benefit of employer and do not deprive (
) employer of the advantage of skills/abilities, divulge () confidential
information, or otherwise cause harm to employer
Guidance
1) Place client interests first but consider effects on firm integrity and sustainability
2) Members are encouraged to give employer a copy of the Code and standards
3) No incentive or compensation structure that encourages unethical behavior
4) Loyalty-Independent Practice:
4.1) If planning to engage in independent practice, notify
employer of services provided, expected duration,
and compensation. ,
.
4.2) Do not proceed without consent from employer
4.3) Undertaking independent practice means engaging in
competitive business (bad), as opposed to making
preparations to begin such practice (ok).
5) Loyalty-Leaving an Employer:
5.1) Act in best interest of employer until resignation is
effective
5.2) Employer records on any medium (e.g. , cell phone,
PDA, home computer) are property of the firm
5.3) Simple knowledge of names of former clients is okay;
don't solicit prior to leaving
5.4) No prohibition on use of experience or knowledge
gained at former employer
5.5) A departing employee is generally free to make
preparations to go into the competitive business before
terminating their job as long as such preparations do not
breach the employees duty of loyalty. ,
. .
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5.6)
The member must not take records or files to a new

employer without the written permission of the previous
employer.
6) Loyalty-Whistleblowing ():
6.1) Permitted only if it protects client or integrity of capital
markets
6.2) Not permitted for personal gain

Members and candidates are required to disclose any
compensation arrangement to their employers that involves
performing tasks or services that their employers can
charge for. Disclosure is required even if the activities occur during
non-work hours.
B. Additional Compensation Arrangements (

)
Do not accept gifts, benefits, compensation, or consideration that competes with, or
creates a conflict of interest with, employer's interest unless written consent (
) is obtained from all parties involved.
Guidance
1) Compensation and benefits covers direct compensation by the client and other
benefits received from third parties
2) For written consent from "all parties involved", email is acceptable
1) Written report to employer with details of proposed compensation in addition to
normal compensation and benefits
2) Details of incentives verified by offering party
3) Include nature of compensation, amount, and duration of agreement
C. Responsibilities of Supervisors
Make reasonable efforts to detect and prevent violations of applicable laws, rules,
regulations, and Code and Standards by anyone subject to your supervision or
authority.
A supervisor's responsibilities relate to detecting and preventing
violations by anyone subject to their supervision or authority
regarding activities they supervise. Jack had no way of detecting
and/or preventing Tom from cheating during the CFA exam, if in fact
that is what he did, because it was an event he did not attend.
, should decline supervisor responsibilities until

adequate procedures to detect and prevent violations of laws. .
Guidance
1) Supervisors must take steps to prevent employees from violating laws, rules,
regulations, or the Code and Standards
2) Supervisors must make reasonable efforts to detect violations
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3) Should enforce non-investment rules as well (e.g. , mandatory vacations)
1) Adequate compliance procedures should:
1.1) Clear and understandable
1.2) Designate a compliance officer
1.3) Have checks/balances; permitted conduct
1.4) Have procedures for reporting violations
2) Supervisor and compliance officer should:
2.1) Distribute procedures to appropriate personnel and update periodically
2.2) Continually educate staff
2.3) Review employee actions
2.4) Promptly initiate procedures once a violation has occurred
3) Once a violation has occurred, a supervisor should:
3.1) Respond promptly
3.2) Conduct a thorough investigation
3.3) Place appropriate limitations on the wrongdoer until investigation is
complete
Standard Investment Analysis,

recommendations and actions
A. Diligence and Reasonable Basis
1) Exercise diligence, independence, and thoroughness in analyzing investments,
making investment recommendations, and taking investment action
2) Have a reasonable and adequate basis, supported by research, for analysis,
recommendation, or action
Members are in compliance with Diligence and Reasonable Basis if they rely on the
research of another party who exercised diligence and thoroughness. If someone
else's opinion did not agree with the final report, disassociating her from the report is
one way to handle this difference between the analysts.
Guidance
1) Make reasonable efforts to cover all relevant issues when arriving at an
investment recommendation
2) Level of diligence will depend on product or service offered
3) Using secondary or third-party research ():
3.1) Determine soundness of the research-review assumptions, rigor,
timeliness, and independence of analysis
3.2) Encourage firm to adopt policy of periodic review of quality of third-party
research regarding assumptions, timeliness, rigor, objectivity, and
independence
3.3) Members may repackage and distribute third-party research reports as
long as they do not represent themselves as the author of the report.
1) Establish policy that research and recommendations should have reasonable and
adequate basis
2) Review/approve research reports and recommendations prior to external
circulation
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3) Establish due diligence procedures for judging if recommendation has met

reasonable and adequate basis criteria
4) Develop measurable criteria for assessing quality of research
5) Consider scenarios outside recent experience to assess downside risk of
quantitative models
6) Make sure firm has procedures to evaluate external advisers they use or promote,
including how often to review
7) Written procedures of acceptable scenario testing, range of scenarios, cash flow
sensitivity to assumptions and inputs
8) Procedure for evaluating outside information providers including how often
9) No need to dissociate from group research that the member disagrees with
B. Communication with Clients and Prospective Clients

1) Disclose basic format/general principles of investment processes used to analyze
investments, select securities, and construct portfolios
2) Promptly disclose any changes that may affect those processes materially
3) Use reasonable judgment in identifying which factors are important to investment
analyses, recommendations, or actions
4) Include those factors in communications with clients/prospective clients
5) Distinguish between fact and opinion in presentation of investment analysis and
investment recommendations
6) Clearly communicate potential gains and losses on an investment
Guidance
1)
2)
3)
4)
Include basic characteristics of the security

Inform clients of any change in investment processes
Suitability of investment-portfolio context
All communication covered, not just reports
1) The inclusion or exclusion of information depends on a case-by-case review
2) Maintain records
C. Record Retention
1) Develop and maintain appropriate records to support investment analyses,
recommendations, actions, and other investment-related communications with clients
and prospective clients
Guidance
1) Maintain records to support research, and the rationale for conclusions and actions
2) Records are firm's property and cannot be taken when member leaves without
firm's consent
3) If no regulatory requirement, CFA Institute recommends retention period of 7
years
1) Responsibility to maintain records generally falls with the firm
2) However, individuals must retain documents that support investment-related
communications
3) When member changes firm, they must recreate records from
public sources and new firm's information (can't rely on memory or
materials from old firm)
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Standard : Conflicts of Interest

A. Disclosure of Conflicts
1) Make full, fair disclosure of all matters that could reasonably be expected to
impair independence/objectivity, or interfere with duties to clients, prospects, or
employer
2) Ensure disclosures are prominent, delivered in plain language
Guidance
1) Disclose to clients:
1.1) All matters that could impair objectivity-allow clients to judge motives,
biases
1.2) For example, between member or firm and issuer, investment banking
relations, broker/dealer market-making activities, significant stock
ownership, board service
2) Disclose to employers:
2.1) Conflicts of interest-ownership of stock analyzed/recommended, board
participation, financial and other pressures that may influence decisions
2.2) Covers conflicts that could be damaging to employer's business
Disclose to the employer any outside development because this
activity could possibly interfere with her responsibilities at
current employer. In setting up a new firm, she was not acting
for the benefit of her employer. She should have informed the
current employer she wanted to organize the hedge fund and
come to some mutual agreement on how this process would
occur.
disclosure of conflicts.
1) Disclose compensation arrangements with employer that conflict with clients'
interests
2) If firm does not permit disclosure, consider dissociating from the activity
3) Firms are encouraged to include compensation information in promotional
materials
B. Priority of Transactions
1) Investment transactions for clients and employers must have priority over
transactions in which a member or candidate is the beneficial owner
2) Do not use knowledge of pending trades for personal gain
,. Sell buy
.
Guidance
1) "Beneficial owner" has direct/indirect personal interest in the securities
2) Client, employer transactions take priority over personal transactions
(including beneficial ownership)
3) Family member accounts that are client accounts must be treated as other client
accounts (you cannot take advantage or disadvantage of them)
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1) Firm's compliance procedures should:

1.1) Limit participation in equity IPOs
1.2) Restrict purchase of securities through private Placements
2) Establish blackout/restricted periods (to prevent the investment manager from
front running).
3) Establish reporting procedures and prior clearance requirements
4) Disclose policies on personal investing to clients, upon request
C. Referral Fees
Disclose to employer, clients, and prospective clients, as appropriate, any
compensation, consideration, benefit received from, or paid to, others for the
recommendation of products or services.
Guidance
1) Disclosure allows clients and employers to evaluate full cost of service and any
potential biases , disclose to clients
whom he refers disclose to all clients.
2) Disclosure is to be made prior to entering into any formal agreement for services
3) Disclose the nature of the consideration
4) Encourage firm to have clear policy regarding referral compensation
5) Firms that do not prohibit should have clear approval process
6) Members should update referral compensation disclosure to employer at least
quarterly
Standard : Responsibilities as CFA Institute

Member or Candidate
A. Conduct as Members and Candidates in CFA Program
Do not engage in any conduct that compromises the reputation and integrity of CFA
Institute or CFA designation, or the integrity, validity, or security of the CFA
examinations.
Guidance
1) Conduct includes:
1.1) Cheating on the exam
1.2) Disregarding rules and policies or security measures related to exam
administration
1.3) Giving confidential information to candidates or public
1.4) Improper use of CFA designation to obtain personal and professional
objectives
1.5) Misrepresenting the CFA Institute Professional Development program or
the Professional Conduct Statement
1.6) Don't disclose:
1.6.1) Formulas tested or not tested on exam
1.6.2) Specific question information
1.6.3) Topic emphasis on the exam or topics tested
B. Reference to CFA Institute, the CFA Designation, and the CFA Program
When referring to CFA Institute, membership, designation, or candidacy, do not
misrepresent or exaggerate the meaning or implications of membership in CFA
Institute, holding the CFA designation, or candidacy in the CFA program.
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Guidance
1) CFA Institute membership:
1.1) Complete PCS annually
1.2) Pay membership dues annually
2) Failure to comply with above results in an inactive member status
3) Using the CFA designation:
Use the marks "Chartered Financial Analyst" or "CFA" in a manner that does not
misrepresent or exaggerate the meaning or implications of holding the CFA
designation
4) Reference to the CFA program:
4.1) Candidates may reference participation in CFA program, but do not imply
achievement of any type of partial designation
4.2) Okay to say "passed all levels on first attempt" but do not imply superior
ability
5) Improper use of the CFA marks:
The "Chartered Financial Analyst" and "CFA" marks must always be used either
after a charter holders name or as adjectives, not as nouns
1) Make sure that your employer is aware of the proper references to the CFA
designation and CFA candidacy.
Reading 4 Introduction to GIPS

Why were the GIPS created?
Misleading practices included:
1) Representative accounts
2) Survivorship bias
3) Varying time periods
Who can claim compliance? ()
Compliance is a firm-wide process that cannot be achieved on a single product or
composite. compliant
Who benefits from compliance?
Investment management firms and prospective clients
Composites: Construction and Purpose
A composite must include all actual, fee-paying, discretionary portfolios managed
in accordance with the same investment mandate, objective, or strategy.
terminated portfolios
1) Composite-grouping of individual discretionary portfolios with same investment
strategy, objective, or mandate
2) A composite must include all portfolios (current and past) that the firm has
managed in accordance with this particular strategy
3) Groupings must be pre-identified
Purpose of Verification
1) Voluntarily (), a firm may hire an independent third party
to verify its claim of GIPS compliance.
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2) Primary purpose of verification is to provide assurance that

compliance with
GIPS is on a firm-wide basis
3) Requirements:
3.1) Must be performed by a third party, on a firm-wide basis
(SEC )
3.2) Verifier must attest that firm has complied with GIPS
requirements for composite construction, and firm's
processes/procedures
are
established
to
present
performance in accordance with proper calculation
methods, data, and format
GIPS Objectives:
1) Obtain global acceptance of calculation and presentation
standards-fair, comparable format with full disclosure
2) Ensure consistent, accurate performance data -reporting, marketing and presentations
3) Promote fair competition
4) Promote global industry "self-regulation"
GIPS Key Characteristics:
1) To claim compliance, define firm---"distinct" business
entity
2) GIPS-ethical standards for performance presentation-ensure
fair representation
3) Include all actual fee-paying, discretionary portfolios in
composites for 5-year minimum, or since inception
(add performance results up to 10 years)
4) Certain calculation/presentation standards are required, along
with disclosures
5) Input data must be accurate
6) GIPS-required and recommended provisions (encouraged)
7) No partial compliance allowed
8) If GIPS conflicts with local law follow local law, but disclose
conflict
GIPS Firm's Fundamental Responsibilities:
1) Provide compliant presentation to all prospects
2) Provide composite list/description to all prospects that make a
request
3) On client request, provide compliant presentation and composite
description
4) Joint marketing, separate non-compliant firm
Firm Definition and Historical Record
1) To claim compliance, firm defined as the "distinct business entity"
held out to clients and does not include fund sponsors or
consultants.
2) Include all actual fee-paying and non-fee-paying,
Page 16 of 154
discretionary and non-discretionary portfolios in composites

for a minimum of five years or since firm or composite
inception (firm wide)
3) Must add one year of compliant performance history each
year until a 10-year record is presented
4) A reorganization of a firm does not permit any alteration
of historical composite results.
Nine Major Sections of GIPS ()
O) Fundamentals of compliance -- issues for firms to consider when
claiming GIPS compliance, including definition of firm
1) Input data -- must be consistent, for full, fair, comparable
performance presentations
2) Calculation methodology -- certain methodologies are required;
be uniform in Methods
3) Composite construction -- create meaningful, asset-weighted
composites
4) Disclosures -- certain info must be disclosed about
presentation/policies
5) Presentation and reporting -- present investment performance
according to GIPS requirements
6) Real estate -- provisions also apply to real estate investments,
regardless of level of control the firm has over management of the
investment
7) Private equity -- value according to GIPS Private Equity Valuation
Principles, unless open-end or evergreen fund (then follow regular
GIPS)
8 Wrap Fee/Separately Managed Account (SMA) Portfolios - a
supplement to Sections 0-5 with specific reference to those
provisions which don't apply to Wrap Fee/SMA portfolios and some
provisions here that supersede those in Sections 0-5
GIPS
1) Tracking error for a composite
2) Cumulative returns for both composite and benchmark
3) equal-weighted means and median returns
Reading 5 The time value of the money

Required interest rate on a security = risk-free rate
+ Expected inflation rate
+ Default risk premium
+ Liquidity risk premium
+ Maturity risk premium
m
Effective annualrate=(1+ periodic rate) 1
Ordinary annuities ()
Annuities due ()PV FV
The PV annuity function on the calculator set in END mode gives
you the value one period before the annuity begins.
,
Page 17 of 154
Loan amortization schedule:

Ending balance = Beginning balance Principle Component
To draw a time line is a very good way to start.
Reading 6 Discounted Cash Flow Applications

Any discount rate less than the IRR will result in a positive NPV, and
a discount rate greater than the IRR will result in negative NPV.
Mathematically speaking, the NPV method assumes the
reinvestment of a projects cash flows at the opportunity
cost of capital, while the IRR method assumes that the
reinvestment rate is IRR. NPV
Private investor full discretionary control over the timing and
amount of withdrawals and additions to his portfolios Moneyweighted rate of return is an appropriate measure of portfolio
returns. ( IRR,,)
Investment manager clients exercise discretionary control over
the timing and amount of withdrawals and additions to the portfolio
time- weighted rate of return standard in the IM industry. (
)
Ending valuebeginning value+cash flow received
beginning value
D
360
1) Bank discount yield = F
()
t
,1) 2) 3)360
2) Effective annual yield () = (1+ HPY )365/t 1
3) Money market yield (CD equivalent yield, ) =
HPY * (360/t)
EAY and RMM are merely annualized versions of the HPY.
4) Bond equivalent yield refers to 2 * the semiannual discount rate.
(1+BEY/2)2 = 1+EAY
Or BEY = HPY * (365/t) (defined in corporate finance)
The bond equivalent yield for a semi-annual pay bond is equal to
double the semiannual yield to maturity ( effective semiannual
yield) and is lower than the effective annual yield.
Holding period return =
Reading 7 Statistical Concepts and Market

Returns
Types of measurement scales
1) Nominal scales , fund style 1,2,3
(mutual fund investment style)
2) Ordinal scales , (under-, market-, overPage 18 of 154
weight recommendation)
3) Interval scale ,, ( 1 5)
4) Ratio scale ,,,0 (sales in
Euros); , interest rate on T-bills each year for 60 years;
the height of each player on a basketball team.
Descriptive statistics:
Inferential statistics:
The interval with the greatest frequency is referred to as the modal
interval.
distribution , unimodal
, bimodal or trimodal
The formula for the position of the observation at a given percentile,
y, with n data points sorted in ascending order is:
Ly = (n+1) * y/100
standard deviation , Sx sample (
n1), x population
Chebyshevs inequality states that for any set of observations, the
percentage of the observations that lie within k standard deviations
of the mean is at least 1- 1/ k2 for all k>1.
A Positive skew has many outliers in the right tail. It is said to be
skewed right because of its relatively long right tail.
The lognormal distribution is truncated at zero and skewed to the
right.
Negative skew
Skewness affects the mean more than the median and mode,
and the mean is pulled in the direction of the skew.
Leptokurtic ,,,
Platykurtic
Excess kurtosis indicates much more frequent returns at the
extremes, both positive and negative than for a normal distribution.
In general, greater positive kurtosis and more negative skew
in return distributions indicates increased risk.
Regarding means, typically harmonic mean < geometric mean <
arithmetic, unless data are same.

Page 19 of 154
Reading 8 Probability Concepts

Objective probabilities: prior probability is determined using a
formal reasoning and inspection process; empirical probability is
established by analyzing past data.
Subjective probability: least formal method of developing
probabilities and involves the use of personal judgment.
Consider an event that has a probability of occurrence of 0.125,
which is one-eighth. The odds that the event will occur are 1/7.
Cov ( Ri , R j ) =E {[ EiE (Ei ) ][ R jE(R j ) ] }
The variance and standard deviation measure the dispersion, or

volatility, of only one variable. Covariance is a measure of how two
assets move together.
Properties of correlation of two random variables:
1) Correlation measures the strength of the linear relationship
between two random variables.
2) Correlation has no units.
3) If correlation is 0, means no linear relationship, but there may
other relationship exists.
,.
B
A
B|
P
P ( AB )
A |
=
P (B)
P
Reading 9 Common Probability Distribution
0 p( x) 1 , p ( x )=1
Cumulative distribution function (CDF) for a random variable, X, may
be expressed as F ( x )=P(X x)
A binomial random (discrete distribution) variable for which the
number of trials is 1 is called a Bernoulli random variable.
Expected value X =E ( X )=np
Variance of X =np ( 1 p )
Multivariate distributions between two discrete random variables are
described using joint probability tables. Correlation is the feature
that distinguishes a multivariate distribution from a univariate
normal distribution. Correlation indicates the strength of the linear
relationship between a pair of random variables.
The 68% confidence level interval for X is
XS
( 1 )
Page 20 of 154

)
)
X 1.65S
X 1.96S
X 2.58S
( 2
( 3
, z ,
Z value represents the number of standard deviation a given
x
observation is from the population mean. Z =
Lognormal has two features: positive skew; the price is bounded

from below by zero.
Safety-first ratio =
E ( R p )Rr
, shortfall probability
p
Reading 10 Sampling and estimates
In stratified random sampling ( ), one divides the

population into subpopulations and randomly samples from within
the subpopulations.
1) Time-series data consists of observations taken over a period of
time at specific and equally spaced time intervals.
2) Cross-sectional data are a sample of observations taken at a
single point in time.
3) Longitudinal data ( ) are observations over time of
multiple characteristics of the same entity, GDP,
inflation rate
4) Panel data () contain observations over time of the same
characteristic for multiple entities, 20 debt/equity
ratio.
Central limit theorem
sample size > 30,
2
,
( )
n
Standard error of the sample mean n
.
Three desirable properties of estimators:
Page 21 of 154
1) un-biasness ()
2) efficiency ()
3) consistency (,)
t
; , ,
.
t .
, t .
An increase in the reliability factor (the degree of
confidence) increases the width of the confidence interval.
Increasing the sample size and increasing the degrees of
freedom both shrink the confidence interval. ( )
x z 2
n
Criteria for selecting the appropriate test statistics
Small sample (n<30)
When sampling from a ( ):
Normal dist with known variance
Z-statistics
Normal dist with unknown variance
t-statistics
Nonnormal dist with known variance
N/A
Nonnormal dist with unknown variance
N/A
Large sample (n>30)

Z-statistics
t-statistics
Z-statistics
t-statistics
unknown variance, t known variance, Z .

, Z test;
, n<30, , t test
, n>30, Z test t test()
The critical z value is
z=
x
/n
1) Data mining bias .

, , bias
2) Sample selection bias , ,
3) Survivorship bias
4) Look-ahead bias , .
, .
5) Time-period bias , ; ,
, .
Reading 11 Hypothesis Testing

The null hypothesis is the hypothesis that the researcher wants to
reject. The null hypothesis always includes the equal to condition.
Page 22 of 154
Test statistics = (sample statistics hypothesized value)/Standard

error of the sample statistics
Type error: (significance level = probability of Type error)
Type error (Power of test = 1 probability of Type error)
.
Usually, P(Type error) increases, then P(Type error) decreases. If
you want them both to decrease, you need to increase the sample
size.
The P-value is the probability of obtaining a test statistics that would
lead to a rejection of the null hypothesis, assuming the null
hypothesis is true.
The P-value is the smallest level of significance at which the null
hypothesis can be rejected. The smaller the p- value the stronger
the evidence against the null hypothesis. P- values close to zero
strongly suggest that the null hypothesis should be rejected. P
0
1) There are two t-tests that are used to test differences between the means of two
populations. (The differences in means test)
1.1) samples are independent; populations are normally
distributed( t test ); population variance is
unknown.
1.2) (N1+N2-2) assume
the population variances are equal, and the sample observations are pooled.
.
2) Paired comparisons (t test): requires the sample data be normally
distributed; samples are dependent. (T statistics is the average
difference in paired observations divided by the standard error of
the differences between observations)
Page 23 of 154
Nonparametric alternatives to parametric tests

Parametric
Test concerning a single mean
t-test, z-test
Tests concerning differences between t-test
means
Test concerning mean differences t-test
(paired comparison tests)
Nonparametric
Wilcoxon signed-rank test
Mann-Whitney U test
Wilcoxon signed-rank test
3) Chi-square test .
( n1 ) s2
2n1=
(S , .
2
2
s1
4) F . F= 2
s2
, . Degree of freedom: n-1
Parametric tests rely on assumptions regarding the distribution of the population and
are specific to population parameters.
Nonparametric tests are only used when the data are not suitable for parametric tests.
Nonparametric tests are primarily concerned with ranks, signs, or
groups, and they are used when numerical parameters are not
known or do not meet assumptions about distributions. Even if the
underlying distribution is unknown, parametric tests can be used on
numerical data if the sample is large.
Examples: small size sample coms from a non-normal distribution; data are
ranks rather than values; runs test, to determine whether data are random.
The spearman rank correlation test can be used when the data are not normally
distributed.
Reading 12 Technical Analysis

A key assumption of technical analysis is that market prices reflect
both rational and irrational investor behavior. This implies that the
efficient market hypothesis does not hold. (It only cares about the
price and volume)
,.
A downtrend line is constructed by drawing a line connecting
the highs of the price chart.
An upward line is constructed by drawing a line connecting the
lows of the price chart.
head-and-shoulders (Volume is important in
interpreting the data in terms of the head and shoulders pattern),
double top, triple top, inverse head-and-shoulders, double bottom
and triple bottom.
Page 24 of 154
Triangles ( suggests buying and selling pressure

have become roughly equal temporarily), Rectangles( Flags and
pennants refer to that appear on short-term charts).
Price-based Indicators:
1) Moving average lines
2) Bollinger bands are constructed based on the standard deviation of closing prices
over the last n periods. (Contrarian strategy)
Oscillators ()
Oscillator charts can be used to identify convergence or divergence of the oscillator
and market prices. Convergence suggests the price trend is likely to continue, while
divergence may indicate a potential change in the price chart.
3) ROC (buy when it changes from negative to positive during an uptrend in prices,
and vice versa).
4) RSI (The relative strength index (RSI) is a momentum oscillator
and provides information on whether or not an asset is overbought
or oversold. An RSI greater than 70 indicates that a stock is
overbought; an RSI lower than 30 suggests that a stock is oversold).
5) MACD (MACD line cross above the signal line is a buy, MACD is the difference
between two exponentially smoothed moving average of the price, and the signal line
is an exponentially smoothed moving average of MACD line)
6) Stochastic oscillator uses two lines that are bounded by 0 and 100; it is used to
identify overbought and oversold markets.
Non-price-based indicators
Put/call ratio (), VIX, Margin debt (), Short interest ratio ()
TRIN=(advanced issues/declining issues)/(Volume of
advancing issues/volume of declining issues) A value below 1 is
bullish as it means more volume is in rising shares than in declining
ones.
Mutual fund cash position ()
IPO ()
Kondratieff wave: 54
Decennial theory: 5 0
US presidential cycle theory: , 4
.
Elliott wave theory (Fibonacci ratio): in a prevailing uptrend, upward
moves in prices consist of 5 waves and downward moves occur in 3
waves. In a prevailing downtrend, downward moves in prices consist
of 5 waves and upward moves occur in 3 waves.
Inter-market analysis: RSI
Page 25 of 154
Book 2 Economics
Reading 13 Demand and Supply Analysis:
Introduction
Types of markets
1) Factors of production (factor markets)
2) Services and finished goods (goods market or product markets)
3) Intermediate goods
An increase in the price of A will decrease demand for B (they are
complements );
An increase in the price of A will increase demand for B (they are
substitutes ).
Qs=55+26 P s+ 1.3 Pa , 1.3, a s
a , s ,.
Law of demand: the fact that quantity demanded typically increases
at lower prices.
Law of supply: the fact that a greater quantity is supplied at higher
prices.
Demand/supply curve: Q, P.
Shifts and movements along demand and supply curve:
1) Changes in price does not result in a shift of the curve
2) Changes in demand or supply will result in a shift of the curve
Partial equilibrium: take the factors that may influence demand as
fixed except for the price
General equilibrium: relationships between the quantity demanded
of the good and factors that may influence demand are taken into
account.
stable equilibrium; unstable.
1) common value auction
Oil lease auctions: The bidder who most overestimates the value of
a lease will be the highest bidder. This is sometimes referred to as
the winners curse.
2) private value auction
Auction of art or collectibles
Page 26 of 154
1) ascending price auction/English auction

2) sealed bid auction
The term reservation price refers to the highest price that a
bidder is willing to pay.
3) second price sealed bid auction/Vickrey auction
There is no reason for a bidder to bid less than his reservation

price. The eventual outcome is much like that of (1).
4) descending price auction/Dutch auction
If first bidder agrees to buy three of ten units at $100,
subsequent bidders will get the remaining units at lower prices.
,.
With US treasury securities, a single price auction is held but bidders
may also submit a noncompetitive bid. Such a bid indicates that
those bidders will accept the amount of treasuries indicated at the
price determined by the auction.
Figure: Consumer/producer Surplus
We assume that the demand curve represents the marginal social

benefit curve; the supply curve represents the marginal social cost
curve.
Producer surplus = revenue variable costs
Deadweight loss: the reduction in consumer and producer surplus
due to underproduction or overproduction.
DWL p q
Obstacles to the efficient allocation of productive resources
1) Price controls
1.1) Price ceiling ( underproduction)
If the ceiling is above the equilibrium, it will have no effect.
If it is below the equilibrium price, please see below.
Page 27 of 154
Producers often respond by reducing the quality of goods.

16-20 producer surplus
price ceiling consumer surplus
1.2) Price floor ( overproduction)

If the floor is below the equilibrium, it will have no effect.
If it is above the equilibrium price, please see below.
2) tax and trade restrictions, such as subsidies( ) and

quotas ()
2.1) Tax
the actual tax incidence ()is independent of whether the
government imposes the tax (statutory incidence ) on
consumers or suppliers.
Tax s d
,,.
Page 28 of 154
As the elasticity of either demand or supply decreases, the DWL

is also reduced. (DWL )
The trade price should be the same whether the tax is imposed
on the buyer or on the seller.
2.2) Subsidies and Quotas
subsidies supply curve .
Producers often seek the imposition of quotas because at
the quota amount, marginal benefit exceeds marginal
cost.
3) external costs ()
4) external benefits()
5) Public goods(,free rider) and common resources. (,
)
1) Price Elasticity of Demand (x)(y)
1.1) ,()
A product's demand is elastic if demand increases by a greater
percentage than the percentage price cut when prices are cut.
1.2) ,()
,
unit elastic ,total revenue ,
1.3)
Other factors affect demand elasticity

1.3.1) Portion of income spent on a good. ,
( ,)
1.3.2) Time
1.4) Calculation >1, elastic; <1, inelastic
Page 29 of 154
Q
(Q +Q )/ 2
Q
1 2
P
P
(P 1+ P2 )/2
2) Income Elasticity of Demand (x)(y)
2.1) Normal goods: an increase in income leads to an increase
in quantity demanded.
2.2) Inferior goods: an increase in income leads to a decrease
in quantity demanded.
3) Cross Price Elasticity of Demand ()
The rate of the percentage change in the quantity demanded of a
good to the percentage change in the price of a related good.
3.1) Substitutes: when an increase in the price of a related good
increases demand for a good, we say the two goods are
substitutes().
3.2) Complements: when an increase in the price of a related
good decreases demand for a good, we say the two goods
are complements().
3.3) Overall, the price elasticity of demand is more positive the
better substitute two good are and more negative the
better complements the two good are.
Q
Q
Q
P Q
(
)
P
P
Q P
P
Reading 14 Demand and Supply Analysis:

Consumer Demand
Utility theory is an important aspect of consumer choice theory,
which related consumers wants and preferences to the goods and
services they actually buy.
Utility theory is consistent with the existence of a Giffen
good.
Utility is an ordinal () measure, rather than a cardinal (
) measure. We can state which one is preferred, but we cannot
state by how much.
Indifference curves plot the combinations of two goods that provide
equal utility to a consumer. Certain rules:
1) Indifference curves for two goods slope downward.
Page 30 of 154
2) Indifference curves are convex towards the origin. The slope of

an indifference curve at any point is referred to as the marginal
rate of substitution. The characteristic convexity of indifference
curves reflects a diminishing marginal rate of substitution.
3) Indifference curves cannot cross. the axiom of transitive
preferences.
Budget constraint ( y/x):
Equilibrium bundle of goods ():
substitution effect:
income effect:
,,
, x .
1) Normal good: positive income effect
2) Inferior good: negative income effect
Giffen good: . A Giffen good is theoretical and
would have an upward-sloping demand curve.
3) Veblen good ( ), a higher price makes the good more desirable. Veblen
Page 31 of 154
good and have an upward-sloping demand curve.
Reading 15 Demand and Supply Analysis: The

firm
1) Accounting profit (cover )= total revenue total
accounting/explicit ()costs
Accounting costs include the interest cost on debt financing but
not any payments to the firms equity owners as a return on
their invested capital.
2) Economic profit/abnormal profit ( cover 0)=
accounting profit implicit ( ) costs = Total revenue total
economic costs
Total economic costs include both implicit and explicit costs
3) normal profit ()= accounting profit that makes economic
profit zero, .
The important thing is that an economic profit of zero (normal
profit) is what we expect in equilibrium.
Overall, earning a positive economic profit will increase the value of
a firms equity, and negative economic profit will decrease the value
of a firms equity.
Economic rent is used to describe a payment to a factor of
production above its opportunity cost.
In a perfectly competitive market, an increase in supply by a single

firm will not affect price.
For a firm in a perfectly competitive market, Average
Revenue=Marginal Revenue=Price
Firms that face downward-sloping demand curves are referred
to as price searchers.
Factors of production:
1) Land 2) Labor 3) Capital or PP&E 4) Materials
Page 32 of 154
Important relationships as shown in figure above:

1) AFC slopes downward.
2) The vertical distance between the ATC and AVC curves is equal to
AFC.
3) MC decreases initially, then increase. At low output
quantities,
efficiencies
are
realized
from
the
specialization of labor. However, as more and more labor
is added, MC increases due to diminishing returns.
4) MC intersects AVC and ATC at their minimum points.
5) ATC and AVC are U-shaped.
6) Minimum point on the ATC curve represents the lowest cost per
unit, but it is not necessarily the profit-maximizing point. It
means the firm is maximizing profit per unit at that point.
7) The MC curve above AVC is the firms short-run supply curve in a
perfectly competitive market.
Determine breakeven and shutdown points
1) Under perfect competition
1.1) if AR ATC, the firm should stay in the market in both the
short and long run;
1.2) If ATC > AR AVC, the firm should stay in the market in
the short run but will exit the market in the long run.
1.3) If AR < AVC, the firm should shut down in the short run and
exit the market in the long run.
2) Under imperfect competition, because price does not equal
average revenue (or MR) for a firm in imperfect competition,
analysis based on total costs and revenues is better suited
for examining breakdown and shutdown points. The conditions
are:
2.1)
TR=TC, breakeven;
2.2)
TC > TR > TVC, firm should continue to operate in the
Page 33 of 154
short run but shutdown in the long run;

2.3)
TR < TVC, firm should shut down in the ST and LT run.
Marginal and average product curves
Determine the profit-maximizing level of output

1) Under perfect competition (price=MR)
1.1) Producing up to the point where MR=MC and not
producing additional units for which MR < MC.
1.2) Producing the quantity for which TR-TC is at a maximum.
For a firm that is operating at MR=MC but is selling at a price
below AVC, shutting down is really the profit-maximizing decision
in the ST and LT run.
2) Under Imperfect Competition (MR<Price)
Produce the quantity of output for which MR=MC, the same
quantity for which TR TC is at its maximum.
In the short run, for a given plant size, producing up to the quantity
where MR = MC will maximize profits as long as price at the output
quantity is greater than AVC.
Some notes for the graph below:
1) Q3=minimum efficient scale
2) Q<Q3: economies of scale, a firm operating with economies of
scale can increase its competitiveness by expanding production and
reducing costs.
3) Q>Q3: diseconomies of scale, A firm operating under
diseconomies of scale will want to decrease output and move back
toward the minimum efficient scale.
4) Constant returns to scale: there may be relatively flat portion at
the bottom of the LRATC curve.
Page 34 of 154
Increasing-cost industry: the long-run supply curve for the

industry is upward sloping (oil is an example)
Decreasing-cost industry: the long-run industry supply curve is
downward sloping (flat-panel television is an example)
Constant-cost industry: the industry demand curve is perfectly
elastic at minimum average cost.
The long-run industry supply curve is perfectly elastic at the ATC for
the minimum efficient scale. This result will hold only if the cost of
the firms input is constant as the industry expands output.
Below point moved from 123
1) For analysis, the usefulness of the total product measure is

limited;
2) Average product is a measure of overall efficiency, not the
efficiency of any one worker.
Page 35 of 154
3) Marginal product ( ) is a better measure of the

productivity of an individual worker and is preferred over average
product or total product. A firm experiencing an increase in the
marginal product of labor employed would most likely to allow an
increased number of workers to specialize and become more adept
at their individual functions.
Increasing the quantity of capital for a given quantity of labor will at
first result in increasing marginal returns to capital, however,
employing additional units of capital will result in smaller increases
in output. This is the point of diminishing marginal returns to
capital.
For a firm with N productive inputs, cost minimization requires
that:
MP 1 MP 2
MP N
=
==
(MP=marginal product, P=price,
P1
P2
PN
, labor, capital)
MP/P (
diminishing marginal productivity)
To maximize profits, it requires that:
MP 1MR output MP 2MR output
MP N MR output
=
==
P1
P2
PN
or
MRP 1 MRP2
MPR N
=
==
=1
P1
P2
PN
MRP = marginal revenue product (), P input price.
Reading 16 The firm and Market Structures

1) perfect competition(price taker)
2) monopolistic competition products are not identical
3) oligopoly market only a few firms competing, such firms
are interdependent, barriers to entry are high
4) Monopoly a single seller of a product with no close
substitutes. High barriers to entry
5) Natural monopoly examples are electric power and
distribution business and other public utilities.
1) Perfect Competition
In short-run, economic profit is maximized at the quantity for which
Page 36 of 154
MR=MC
In long-run equilibrium, each firm is producing the quantify for which
P=MR=MC=ATC, so that all firms earn normal profit (zero
economic profits, and firms can stay in the business in the
long run) and each firm is producing the quantity for which
ATC is a minimum.
(b)
In below graph, a permanent change in demand, D 0D1, the price

increases from P0 to P1, existing firm realize economic profit, which
attracts more firms to enter the industry, then S 0S1, price
decreases back to P0.
2) Monopolistic Competition
Firms in monopolistic competition face downward-sloping demand
curves (price search).
Page 37 of 154
Product innovation is a necessary activity as firms in monopolistic

competition pursue economic profits. Firms that bring new and
innovative products to the market are confronted with less-elastic
demand curves, enabling them to increase price and earn economic
profits.
A firm is considered to be spending the optimal amount on
innovation when the marginal cost of innovation just equals
the marginal revenue of additional innovation.
Advertising expenses are high for firms in monopolistic
competition. Many firms spend a significant portion of their
advertising budget on brand name promotion.
3) Oligopoly
The actions of another firm will directly affect a given firms demand
curve for the product.
3.1) Kinked demand curve model
Based on the assumption that
Qk is the profit maximizing level of output.
Shortcoming: what determines the market price (where the kink
is located) is outside the scope of the model)
3.2) Cournot model, an early version of strategic games

3.3) Nash equilibrium is reached when the choices of all firms are
such that there is no other choice that makes any firm better off.
In general, collusive agreements to increase price in an oligopoly
will be more successful (have less cheating) when (
):
3.3.1)There are fewer firms;
3.3.2)Products are more similar (less differentiated);
3.3.3)Cost structures are more similar;
3.3.4)Purchases are relatively small and frequent;
Page 38 of 154
3.3.5)Retaliation by other firms for cheating is more certain and

more severe;
3.3.6)There is less actual or potential competition from firms
outside the cartel.
3.4) dominant firm model
There is a single firm that has a significant large market share
because of its greater scale and lower cost structure.
A price decrease by one of the competitive firms will lead to a
decrease in price by the dominant firm, and competitive firms will
decrease output and/or exit the industry in the long run. The longrun result of such price decrease by competitors would increase
the market share of the dominant firms.
In the long run, the dominant companys market share tends to
decrease as profits attract entry by other companies.
4) Monopoly ()
Two pricing strategies: single-price, price discrimination
The profit maximizing output for a monopolistic firm is the one for
which MR=MC.
Monopolists are price searches and have imperfect information
regarding market demand.
With price discrimination, the motivation for a monopolist is to
capture more consumer surplus as economic profit than is
possible by charging a single price.
When compared to a perfectly competitive industry, the monopoly
firm will produce less output and charge a higher price.
Monopoly is considered inefficient as it creates a DWL relative to
perfect competition because monopolies produce a quantity that
does not maximize the sum of consumer surplus and producer
surplus. A further loss of efficiency results from rent seeking when
producers spend time and resources to try to acquire or establish a
monopoly.
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With perfect price discrimination, there would be no

consumer surplus. Monopolists would capture it all. A
monopolist would produce the same quantity as under
perfect competition.
A government entity that regulates an authorized monopoly will
most likely base regulated prices on long run average cost.
5) Natural Monopoly
When the average cost of production for a single firm is
falling throughout the relevant range of consumer demand,
we say that the industry is a natural monopoly.
5.1) Average cost pricing is the most common form of
regulation. This will:
5.1.1)Increase output and decrease price
5.1.2)Increase social welfare (allocate efficiency)
5.1.3)Ensure the monopolist a normal profit because
price=ATC
5.2) Marginal cost pricing (efficient regulation) This will:
5.2.1)Increase output and decrease price
5.2.2)Cause the monopolist to incur a loss because price <
ATC.
5.2.3)This solution requires a government subsidy in
order to provide the firm with a normal profit and
prevent it from leaving the market entirely.
5.3) Another way of regulating a monopoly is for the
government to sell the monopoly right to the highest
bidder.
In markets characterized as monopolistic competition, oligopoly, and
monopoly, there is no well-defined supply function.
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In each case, the quantity supplied is determined by the

intersection of MC and MR, and the price charged is
determined by the demand curve.
Pricing strategy under each market structure
1) Perfect competition
MR=MC=P
2) Monopolistic competition
MR=MC<P
3) Monopoly
MR=MC<P
4) Oligopoly
4.1) Kinked demand curve: MR=MC
4.2) Collusion: MR=MC and charge the price from the industry
demand curve at which that quantity can be sold.
4.3) Dominant firm model: MR=MC and charge the price on its
firm demand curve for that quantity. Other firms take the price as
given.
4.4) Game theory
MR=P(1-1/Ep)
Ep is the price elasticity of demand
Concentration measures for a market or industry are very often
used as an indicator of market power.
1) N-firm concentration ratio, relatively insensitive to mergers
of two firms with large market shares.
2) HHI, calculated as the sum of the squares of the market shares of
the largest firms in the market. HHI values below 100 indicate the
market is highly competitive.
barriers to entry are not considered.
Market Structure
Degree
of
Product
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Differentiation
Perfect competition (price taker)
Homogeneous/
standardized
Monopolistic competition (price searcher)
Differentiated
Oligopoly (price maker)
Homogeneous/
standardized
Monopoly (price searcher, downward-sloping demand
Unique product
curve)
Perfect competition, P=MR=AR
Reading 17 Aggregate Output, Prices, and

Economic growth
GDP is the total market value of the goods and services produced in
a country within a certain time period. GDP included only purchase
of newly produced goods and services.
Items those are included in GDP:
1) Goods and services provided by government;
2) The value of owner-occupied housing.
Items those are excluded in GDP:
1) The sale or resale of goods produced in previous periods;
2) Transfer payments made by the government are not economic
output and are not included in the calculation of GDP.
3) The value of labor not sold, such as a homeowners repairs to his
own home, is not included in GDP.
4) By-products of production, such as environment damage, are
not included in GDP.
(domestic),,
(national),,
,.
Expenditure approach: GDP is calculated by summing the amounts
spent on goods and services produced during the period;
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Income approach: GDP is calculated by summing the amounts

earned by households and companies during the period,
including wage income, interest income, and business
profits.
Value-of-final-output method: the calculation of GDP under the
expenditure approach;
Sum-of-value-added method: sum the additions to value created at
each stage of production and distribution.
Nominal GDP: the total value of all goods and services produced by
an economy, valued at current market price.
Real GDP is calculated relative to a base year.
GDP deflator=
nominal GDP Current year priceCurrent year quantity

=
real GDP
prior year priceCurreny year quantity
Per-capital real GDP is defined as real GDP divided by population

and is often used as a measure of the economic well being of a
countrys residents.
Under the expenditure approach, GDP=C+I+G+(X-M) ---------- (1)
Under the income approach,
GDP=national income + capital consumption allowance + statistical
discrepancy
1) CCA measures the depreciation of physical capital from the
production of goods and services over a period.
2) National income is the sum of the income received by all
factors of production that go into the creation of final output.
3) Personal income is a measure of the pretax income received
by households and is one determinant of consumer purchasing
power and consumption.
Personal income = national income
+ Transfer payments to households
- Indirect business taxes
- Corporate income taxes
- Undistributed corporate profits
Personal disposable income (PDI) = personal income personal
tax
Under the income approach, GDP=C+S+T ----------------------------(2)
Combine (1) and (2) (G-T)=(S-I)-(X-M)
(G-T>0)(X-M<0)(S-I>0)
.
If G-T increases, it must be financed by S-I increase or X-M
decrease.
As below, higher rates will decrease the real aggregate income. The
IS curve () plots the combinations of income and real
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interest rates for which aggregate output and income equal

planned expenditure.
Quantity theory of money: MV=PY

The LM curve represents combinations of income and the interest
rate at which the demand for real money balance equals the supply.
The aggregate demand curve shows the relationship between the
quantity of real output demanded (which equals real income) and
the price level.
The aggregate supply curve describes the relationship between the

price level and the quantity of real GDP supplied.
In the long run, wages and other input prices change proportionally
to the price level, so the price level has no long-run effect on
aggregate supply. We refer to this level of output as potential GDP
or full-employment GDP.
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The full employment (the intersect of LRAS and x axis), or

natural, level of output is a level with a modest, stable pool of
unemployed workers (job seekers equal job vacancies) looking
for and transitioning into new jobs.
Shift in the AD curve
Note that a change in the price level is represented, as a movement
along the AD curves, not a shift in the AD curve. Consider GDP=C
+ I + G + net X
1) Increase in consumers wealth (C increases; as the value of
households wealth increases, the proportion of income saved
decreases and spending increases, increasing AD) wealth
effect
2) Business expectation (I increases)
3) Consumer expectations of future income (C increases)
4) High capacity utilization (I increases)
5) Expansionary monetary policy (C and I increase)
6) Expansionary fiscal policy (C increases for tax cut, G increases for
spending increase)
7) exchange rate ()
8) global economic growth (,)
Shifts in short-run aggregate supply curve:
1) Labor productivity
2) Input prices
3) Expectations of future output prices
4) Taxes and government subsidies
5) exchange rate (,,
)
Shifts in long-run aggregate supply curve:
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Factors that affect the real output that an economy can produce at
full employment will shift the LRAS curve.
1) Increase in the supply and quality of labor
2) Increase in the supply of natural resources
3) Increase in the stock of physical capital
4) Technology
With the price level at 115, there is excess supply; this is sometimes
termed a recessionary gap;
With the price level at 105, there is excess demand; this is
sometimes termed as an inflationary gap.
, SRAS , output gap, P1 P*;
P* P1. full-employment GDP
change in AD , which is caused by changes in the money
supply. ,, GDP.
An increase in resources prices that cause SRAS to decrease (shift to

the left)
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A decrease in wages and other input prices increase short-run

aggregate supply (move it down to the right)
Stagflation ( ) refers to an environment of both high

unemployment and increasing inflation.
.
.
An investor anticipating stagflation should:
1) Decrease investment in FID
2) Decrease investment in equities
3) Increase investment related to commodities
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Five sources of economic growth

1) Labor supply
2) Human capital
3) Physical capital stock
4) Technology
5) Natural resources
Growth in potential GDP = growth in labor force + growth in
labor productivity (can be measured directly, output/hour)
The sustainable rate of economic growth is important because longterm equity returns are highly dependent on economic growth over
time.
Labor productivity can be increased by either improving
technology or physical capital per worker. However, because
of diminishing marginal productivity, sustainable long-term
growth cannot necessarily be achieved simply by increasing
physical capital per worker over time, productivity gains and
growth of the labor force are also necessary for long-term
sustainable growth.
Solow model or neoclassical model:
Growth in potential GDP=growth in technology + W L (growth
in labor) + WC (growth in capital) ()
WL and WC are labors percentage share of national income
and capitals percentage share of national income.
An increase in total factor productivity reflects an increase
in output for given inputs.
Reading 18 Understanding Business Cycle

Real GDP and unemployment rate are the key variables used to
determine the current phase of the cycle.
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A common rule of thumb is to consider two consecutive quarters of

growth in real GDP as the beginning of an expansion and two
consecutive quarters of declining real GDP as indicating the
beginning of a contraction.
, private corporations.
Resource use fluctuation
1) When an expansion is approaching its peak, sales growth
begins to slow, and unsold inventories accumulate. This can
be seen in an increase in the inventory-sales ratio above
its normal level.
2) The opposite occurs when a contraction reaches its trough,
inventory-sales ratio decreases below its normal level.
Only when an expansion or contraction appears likely to
persist will they hire or lay off workers.
Housing sector activity
1) Mortgage rates
2) Housing costs relative to income
3) Speculative activity
4) Demographic factors
External trade sector activity
1) Domestic GDP growth
2) GDP growth of trading partners
3) Currency exchange rate
Typical business cycle characteristics:
1) Trough
Moderate or decreasing inflation rate
Spending on consumer durable goods and housing may increase
Increasing use of overtime and temporary workers
2) Expansion
Real GDP is increasing
Inflation rate may increase
Investment increases in producers equipment and home
construction
3) Peak
Real GDP stops increasing and begins decreasing
Unemployment rate decreases but hiring slows
Inflation rate increases
Consumer spending and business investment grow at slower
rates
4) Contraction
GDP growth rate is negative
Unemployment rate increases
Inflation rate decreases with a lag
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Leading indicator
1) Unemployment insurance initial claims
2) ISM new orders
3) Building permits
4) Stock price
5) IR spread
Coincident indicator
1) Non-farm payroll
2) Industrial production
3) Manufacturing and trade sales
Lagging indicator
1) CPI
2) Labor cost
3) Inventory/sale ratio
4) Commercial/industrial loans
Based on typical labor utilization patterns across the business
cycle, productivity (output per hours worked) is mostly likely to be
highest at the bottom of a recession.
1) Neoclassical school
Both aggregate demand and aggregate supply are primarily
driven by changes in technology over time. They conclude that
business cycle is temporary deviations from long-run
equilibrium.
2) Keynesian school (Bernanke) believed that shifts in aggregate
demand due to changes in expectations were the primary cause of
business cycle.
3) Monetarist school , (). They favored
a limited role for government because they argue
government policies operate with a lag.
4) Austrian school believe business cycles are caused by
government intervention in the economy.
5) New classical school introduced real business cycle theory
( ) the policymakers should not try to counteract
business cycles because expansions and contractions are efficient market responses to
real external shocks.
1) Frictional unemployment
2) Structural unemployment
The unemployed workers do not currently have the skills needed to perform the
jobs that are available.
3) Cyclical unemployment is caused by changes in the general level of economic
activity.
1) A person who is not working is considered to be unemployed if he is actively
searching for work. One who has been seeking work unsuccessfully for
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several months is referred to as long-term unemployed.

2) The discouraged workers are those who are available for work but are neither
employed nor actively seeking employment.
3) The unemployment rate is the percentage of people in the labor force who
are unemployed. The labor force includes all people who are either employed
or unemployed.
People who choose not to be in the labor force are said to be voluntarily
unemployed and are not included in the calculation of the unemployment rate.
4) A person who is employed part time but would prefer to work full time or is
employed at a low-paying job despite being qualified for a significant higherpaying one is said to be underemployed.
5) The participation ratio is the percentage of the working-age population
who are either employed or actively seeking employment.
Labor force (employed and unemployed) = working age population *
participation rate
The unemployment rate to lag business cycle because:
1) The movement of discouraged workers out of and back into the labor force
2) Firm tend to be slow in hire or lay off workers at business cycle turning points
1)
2)
3)
4)
Inflation
hyperinflation
Disinflationinflation rate is decreasing but remains greater than 0
deflation () negative inflation rate
CPI
The weights assigned to each good and service reflects the typical consumers
purchasing patterns, which are likely to be significantly different across countries and
regions.
An alternative is the price index for personal consumption expenditure.
PPI (identify trends of CPI)/WPI
Headline inflation: price indexes for all goods.
Core inflation: price indexes that exclude food and energy.
Lapeyres, which uses a constant (last) basket of goods and
services. Three factors cause it to be biased upward as a measure of the cost of
living:
1) New goods
2) Quality changes--use hedonic pricing to adjust for this
3) Substitution--use a chained or chain-weighted price index such as fisher index to
address this. Paasche index also works to reduce substitution bias.
Paasche index uses a constant (present) basket of goods, prices from the base
period, and prices in the current period.
Fisher Index = (IL * IP)0.5
Two types of inflation
1) Cost-push results from a decrease in aggregate supply
New technology will increase the output per hour per worker, which
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will decrease the unit labor cost. As the unit labor cost decreases,
cost-push inflation decreases
1) 2)
Analysts use labor productivity to identity signals of potential wage pressure. Wage
increases are not inflationary as long as they remain in line with gains in productivity.
Non-accelerating inflation rate of unemployment (NAIRU), also called the
natural rate of unemployment (NARU).
full employment
2) Demand-pull inflation results from an increase in the money supply, increased

government spending, or any other change that increases government
spending.
Demand-pull inflation would persist until the central bank reduced the growth rate
of the money supply and allowed the economy to return to full employment
equilibrium at a level of real GDP equal to potential GDP.
Economists often use the capacity utilization rate of industry to indicate the
potential for demand-pull inflation.
Falling unemployment rate puts upward pressure on real wages, which result in a
decrease in SRAS.
The impact on output is the key difference between demand-pull and cost-push
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effects. The demand-pull effect increases GDP above full-employment GDP,

while with cost-push inflation; a decrease in aggregate supply initially
decreases GDP.
Reading 19 Monetary and Fiscal Policy

Money has three primary functions:
1) Medium of exchange/means of payment
2) unit of account
3) Store of value
Narrow money is the amount of notes and coins in circulation in an
economy plus balances in checkable bank deposits.
Broad money included narrow money plus any amount available in
liquid assets, which can be used to make purchases.
1
1+ CD
money multiplier=
=
reserve requirement RR+CD
Money supply * velocity = price * output (MV=PY, Y real GDP)
The belief that output (GDP) and velocity are not affected by
monetary variables (money supply and prices) is referred to as
money neutrality.
Three reasons for holding money:
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1) transaction demand, GDP

2) precautionary demand, GDP
3) Speculative demand, it is inversely related to market returns
and positively related to risks.
The supply of money is determined by the central bank and is
independent of the interest rate,
At Ihigh, there is excess supply of money, firms and households are
holding more real money balances than they desire to. At I low there is
excess demand for real money balances, firms and households will
sell securities to increase their money balance to desired level.
Fisher effect: RNom =R Real+ E[I ]

The real interest rate is relatively stable; this is consistent with
money neutrality
, RNom =R Real+ E [ I ] + RP (RP = risk premium for uncertainty)
Key roles of central banks
1) Sole supplier of currency. Money not backed by any tangible
value is termed fiat money.
2) Banker to the government and other banks
3) Regulator and supervisor of payments system
4) Lender of last resort
5) Holder of gold and foreign exchange reserves
6) Conductor of monetary policy
The primary goal of a central bank is to control inflation. High
inflation leads to menu costs and shoe leather costs.
The pegging country essentially commits to a policy intended to
make its inflation rate equal to the inflation rate of the country to
which they peg their currency.
Costs of unexpected inflation
1) Higher borrowing rates
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2) Information about supply and demand from changes in prices

becomes less reliable
Monetary policy tools
1) Policy rate. The rate at which banks can borrow reserves from the
Fed is termed the discount rate. For the ECB, it is called the
refinancing rate.
BOE policy rate is called the two-week repo (repurchase)
rate.
In US, the federal funds rate is the rate that banks charge each
other on overnight loans of reserves. The Fed sets a target for
this market-determined rate and use open market operations to
move it to the target rate.
2) Reserve requirements. This tool only works well to increase the
money supply if banks are willing to lend and customers are willing
to borrow.
3) Open market operations are buying and selling of securities by
the central bank. Most commonly used and is important in
achieving the federal funds target rate.
Qualities of effective central banks
1) Independence: operational independence (decides to how to
achieve the target) and target independence (sets its own
target).
2) Credibility
3) Transparency
1) Interest rate targeting
2) Inflation targeting (popular)
3) Some developing countries use exchange rate targeting. One
result of this may be greater volatility of the money supply
because domestic monetary policy must adjust money supply
growth rate to the necessity of maintaining a stable foreign
exchange rate.
The net effect of this is that the targeting country will have
the same inflation rate as the targeted currency and the
targeting country will need to follow monetary policy and
accept interest rates that are consistent with this goal, regardless
of domestic economic circumstances.
1) An economys long-term sustainable real growth rate is called
the real trend rate. The trend rate is not directly observable
and must be estimated.
2) The neutral interest rate of an economy is the growth rate of
the money supplies that neither increases nor decreases the
economic growth rate.
Neutral interest rate = real trend rate of economic
growth + inflation target
When the policy rate is above (below) the neutral rate, the
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monetary policy is said to be contractionary (expansionary).

(policy rate neutral rate )
Liquidity trap: A situation in which prevailing interest rates are
low and savings rates are high, making monetary policy
ineffective. In a liquidity trap, consumers choose to keep their funds
in savings because of the prevailing belief that interest rates will
soon increase. (Deflation + expansionary money supply policy)
Compared to inflation, deflation is more difficult for central banks
because they are limited to reducing the nominal policy rate to 0.
Fiscal policy refers to a governments use of spending and taxation
to meet macroeconomic goals.
1) Keynesian economists believe that fiscal policy, through its
effect on aggregate demand, can have a strong effect on
economic growth when the economy is operating at less than
full employment.
2) ,,
Discretionary fiscal policy refers to the spending and taxing

decisions of a national government that are intended to stabilize the
economy. In contrast, automatic stabilizers ( , in a
recession, tax will fall, and government spending on unemployment
insurance will increase, both of these are expansionary) are built-in
fiscal devices triggered by the state of the economy.
Objectives of fiscal policy:
1) Influencing the level of economic activity and aggregate
demand
2) Redistributing wealth and income among segments of the
population.
3) Allocating resources among economic agents and sectors in
the economy.
Fiscal policy tools
1) Spending tools (most efficient in increasing aggregate
demand)
Transfer payments (slow)
Current spending
Capital spending (slow)
2) Revenue tools
2.1) Direct taxes (slow) are levied on income or wealth.
2.2) Indirect taxes (quick) are levied on goods and services.
1) Advantage of fiscal policy:
1.1) Social policies (discouraging tobacco use) can be
implemented very quickly via indirect taxes.
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1.2)
Quick implementation of indirect taxes also means that

government revenues can be increased without
significant additional costs
2) Disadvantages:
2.1) Direct taxes and transfer payments take time to
implement
2.2) Capital spending also takes a long time to implement.
A pay as you go is a neutral policy.
The fiscal multiplier determines the potential increase in aggregate
demand resulting from an increase in government spending:
1
fiscal multiplier=
1MPC (1t )
(MPC = marginal propensity to consumer)
Balanced budget multiplier
= Tax increase * MPC * fiscal multiplier
spending increase
1MPC (1t)
A countrys debt ratio is the ratio of aggregate debt to GDP.

1) Arguments for being concerned with the size of the debt:
1.1) Higher deficits lead to higher future taxes. Higher future
taxes will lead to disincentives to work.
1.2) It may lead to government defaulting.
1.3) Crowding-out effect: government borrowing is taking the
place of private sector borrowing.
2) Arguments against being concerned with the size of fiscal deficit:
2.1) If domestic citizens primarily hold the debt, the scale of
problem is overstated.
2.2) If the debt is used to finance productive capital investment,
future economic gains will be sufficient to repay the debt.
2.3) Fiscal deficits may prompt needed tax reform.
2.4) Deficits would not matter if private sector savings in
anticipation of future tax liabilities just offsets the
government deficit.
Fiscal policy aim to stabilize aggregate demand
:
1) Recognition lag (more frequent reporting)
2) Action lag
3) Impact lag
1)
Misreading economic statistics
2)
Crowding-out effect (caused by deficit budget, also leads
to an increase in interest rate and increase in private
saving)
3)
Supply shortage
4)
limits to deficits
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5)
Multiple targets: fiscal policy cannot address both high

unemployment and high inflation.
An increase (decrease) in surplus (more saving than spending) is

indicative of a contractionary (expansionary) fiscal policy.
Structural (or cyclically adjusted) budget deficit is used to
gauge fiscal policy. This is the deficit that would occur based on
current policies if the economy were at full employment
1) Expansionary fiscal and monetary policy
2) Contractionary fiscal and monetary policy
3) Expansionary fiscal policy + contractionary monetary policy
Aggregate demand will likely be high (due to fiscal policy), while
interest rates will be higher. Government spending as a
proportion of GDP will increase.
Higher government spending may lead to higher interest rate
and lower private sector investing.
4) Contractionary fiscal policy + expansionary monetary policy
Interest rate will fall, government spending as a proportion
of GDP will decrease due to fiscal policy. The private sector
would grow as a result of low interest rate.
Reading 20 International Trade and Capital

Flows
Autarky or closed economy: A country that does not trade with other
countries.
Net exports = exports - imports
Foreign direct investment: ownership of productive resources (land,
factories, natural resources) in a foreign country.
Multinational corporations
The benefits of international trade are greater than the costs for
economies as a whole.
1) A country is said to have an absolute advantage in the
production of a good if it can produce the good at lower cost
in terms of resources than that of another country;
2) A country is said to have a comparative advantage in the
production of a good if its opportunity cost in terms of
other goods that could be produced instead is lower
than that of another country.
If one country has a lower opportunity cost of producing one
good, the other country must have a comparative advantage
in the production of the other good. As long as their
opportunity costs of production differ, two countries can both
benefit from trade.
1) The Ricardian model of trade has only one factor of
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production labor. The source of differences in production

costs in Ricardos model is differences in labor productivity
due to differences in technology. A country captures
more of the gains from trade if the terms of trade are
closer to its partners autarkic prices than to its
autarkic prices.
2) Heckscher and Ohlin presented a model in which there are
two factors of production capital and labor. There is a
redistribution of wealth within each country between labor and
the owners of capital. The good that a country imports will fall
in price (that is why they import it), and the good that a
country exports will rise in price. In other words, the
abundant factor gains relative to the scarce factor in
each country.
1)
1.1) Infant industry
1.2) National security
2)
2.1) Protecting domestic jobs: other jobs will be created, and
prices will be lower.
2.2) Protecting domestic industries: consumers pay higher
price.
Types of trade restrictions
1) tariffs
Domestic producers gain, foreign exporters lose. gained
by tariff revenue.
2) quotas
2.1) if the domestic government collects the full value of the
import licenses, the result is the same as for a tariff.
2.2) If the domestic government does not charge for the
import licenses, this amount is a gain to those foreign
exporters who receive the import license under the quota and
are termed quota rents.
3) Voluntary export restraint: a country voluntarily restricts the
amount of a good that can be exported, often in the hope of
avoiding tariffs or quotas imposed by their trading partners.
VERs is another way of protecting the domestic producers in
the importing country.
Reduce imports; increases price; decrease consumer surplus;

increase domestic quality supplied; increase producer
surplus.
Quotas and tariffs in a large country could increase
national welfare under a specific set of assumptions. In large
country, setting a quota/tariff reduce the world price.
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F = tariff revenue/quota rents

B= producer surplus
E + G = DWL
4) export subsidies
In small country, increase price, reduce consumer surplus,
national welfare loss; in large country, the world price decreases,
the foreign consumers benefits.
5) minimum domestic content
Capital restrictions
Overall, in the long run, it is thought to decrease economic welfare.
However, over short term, they have helped developing countries
avoid the impact of capital flow fluctuations. On Balance, economic
welfare is improved by reducing or eliminating trade restrictions.
Trading blocs/regional trading agreements (in order of their
degrees of integration )
1) free trade areas
2) custom union (all countries adopt a common set of trade
restrictions with non-members)
3) common market (all barriers to the movement of labor
and capital goods among member countries are removed)
4) economic union (member countries establish common
institutions and economic policy for the union)
5) monetary union (member countries adopt a single
currency)
The North American Free Trade Agreement (NAFTA
) is an example of a free trade area, while the European Union
(EU) is an example of a monetary union.
Regional
trading
agreements
are
more
popular
than
large
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multilateral trade agreements are because it has quicker and

easier policy coordination.
The Balance of payments () includes:
1) Current account (flows of goods and services)
1.1) Merchandise consists of all raw materials and
manufactured goods bought, sold, or given away.
1.2) Services include tourism, transportation, and business and
engineering services, as well as fees from patents and
copyrights on new technology.
1.3) Income receipts include foreign income from dividends.
1.4) Unilateral transfers are one-way transfers of assets, such

as money received from those working abroad and direct
foreign aid.
Example of current account:
Bought raw material from Indonesia
Sold food products to France
Received royalty fees from its branch in the United Kingdom
Donated to charitable institution in Africa
Paid legal fees to its German legal consultant company
Received coupon from its investment in Eurobonds issued in
Luxembourg
2) Capital account (capital transfers and the acquisition and
disposal of non-produced, non-financial assets)
2.1) Capital transfer includes debt forgiveness and goods and
financial assets that migrants bring when they come to a
country or take with them when they leave. Capital transfer
also include the transfer of title to fixed assets and of funds
linked to the purchase of sale of fixed assets, gift and
inheritance taxes, death duties, and uninsured damage to
fixed assets.
2.2) Sales and purchases of non-financial assets that are not
produced assets included rights to natural resources
and intangible assets, such as patents, copyrights,
trademarks, franchises, and leases.
3) Financial account (records investment flows)
3.1) government-owned assets abroad () include
gold, foreign currencies, foreign securities, reserve position in the
IMF, credits and other long-terms assets, foreign direct
investments, and claims against foreign banks.
3.2) foreign-owned assets in the country ( ) are
divided into foreign official assets and other foreign assets in the
domestic country.
Example of Financial account:
Borrowed from a bank in Singapore
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A country that has imports valued more than its exporters is said to
have a current account/trade deficit, which must be balanced by
a net surplus in the capital and financial accounts.
X-M=private savings + government savings investment
If a countrys net savings are less than the amount of investment in

domestic capital, foreign borrowing must finance this investment.
Foreign borrowing results in a capital account surplus, which means
there is a trade deficit.
1) IMF
2) World Bank: provide help to developing countries. WB is
made up of two units: the International Bank for
Reconstruction and Development (IBRD) and the International
Development Association (IDA). IBRD aims to reduce
poverty in middle-income, while IDA focuses on the
worlds poorest countries. Together, WB provides lowinterest loans, interest-free credits
3) WTO: only international organization dealing with the global
rules of trade between nations. Its main function is to ensure
that trade flows are smoothly, predictably and freely as
possible. Multilateral trading system
4) General Agreement on Tariffs and Trade (GATT) was the only
multilateral body governing international trade from 1948 to
1995. It operated for almost half a century as a quasiinstitutionalized, provisional system of multilateral treaties
and included several rounds of negotiations.
Reading 21 Currency Exchange Rates

Nominal exchange rate (d/f) = Real exchange rate (d/f) (
CPI d
)
CPI f
A spot exchange rate is the currency exchange rate for immediate
delivery, which for most currencies means the exchange of
currencies take place two days after the trade.
Direct exchange rate: domestic currency / foreign currency
Indirect exchange rate: foreign currency / domestic currency
FX sell-side: large multinational banks
FX buy-side:
1) Corporations
2) Investment accounts
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2.1) Real money accounts: mutual funds, pension funds,

insurance companies, and other institutional accounts that do not
use derivatives
2.2) leveraged accounts: hedge funds
3) Governments and government entities, including sovereign
wealth funds and pension funds.
4) The retail market
Appreciate/depreciate base currency
Cross rates are necessary when there is no active FX market in the
currency pair.
points basis points
For spot and forward rates expressed as domestic/foreign, the
interest rate parity () is:
Forward (1+interest rate domestic )
=
Spot
(1+ interest rateforeign )
The forward discount or forward premium for a currency is
calculated relative to the spot exchange rate.
A forward premium indicates the interest rate is higher in the price
currency than in the base currency.
The trade surplus cannot decline unless the capital account deficit
also declines.
An ideal currency regime would have credibly fixed exchange rates
among all currencies. This would eliminate currency-related
uncertainty with respect to the prices of goods and services as well
as real and financial assets.
Exchange rate regimes
1) Countries that do not have their own currency
1.1) Use
the
currency
of
another
country
(formal
dollarization)
1.2) A member of monetary union (EU)
2. Countries that have their own currency
2.1) Currency board arrangement (does not act as lender
of last resort)
The monetary authority is legally required to hold foreign
exchange reserves backing 100% of its domestic currency
issuance.
2.2) conventional fixed peg arrangement
, allows for a small degree of fluctuation
around the target exchange rate.
2.3) In a system of pegged exchange rates within a target zone
2.4) Crawling peg
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2.5)
2.6)
2.7)
With management of exchange rates within crawling bands

With a system of managed floating exchange rates
Independently floating
The effects of exchange rates on countries international trade and

capital flows:
1) Elasticity approach (): focus on the impact
of import and export.
The conditions under which a depreciation of the domestic
currency will decrease a trade deficit are given in what is called
the generalized Marshall-Lerner condition.
currency depreciation will have a greater effect on the
trade balance when import or export goods are primarily
luxury goods, goods with close substitutes, and goods
that represent a large proportion of overall spending.
The more elastic both import demand and export demand area,
the more likely currency deprecation is to narrow a trade deficit.
J-curve, import and export quantities may be relatively
insensitive to currency depreciation in the short run, which
means currency depreciation may worsen a trade deficit initially.
2) Absorption approach(): focus on capital flows

2.1) When an economy is operating at less than full
employment, the currency depreciation improves the
balance of trade.
2.2) When the economy is operating at full employment, the
currency depreciation initially improves the balance of
trade, but eventually return the economy to its previous
state balance of trade.
Long-term improvements in the trade deficit require either
an improvement in the fiscal deficit or an increase in the
excess of domestic savings over domestic investments.
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Book 3 Financial Reporting and Analysis

Reading 22 Financial statement analysis: An
Introduction
Six steps in financial statement analysis framework:
1) State the objectives and context
2) Gather data
3) Process the data
4) Analyze and interpret the data
5) Report the conclusions or recommendations
6) Update the analysis
The statement of comprehensive income reports all changes in
equity except for shareholder transactions (issuing stocks,
repurchase stocks and paying dividends)
Under IFRS, income statement and other comprehensive income
statement can be combined as comprehensive income;
alternatively, they can be reported separately; Under IFRS, the
statement of comprehensive income (=profit after tax +
OCI) begins with the profit or loss from the income
statement.
Under GAAP, firm can also report comprehensive income in the
statement of shareholders equity. OCI the statement of
shareholders equity
Footnotes: fiscal period, accounting methods, assumptions, and
estimates used by management, business acquisitions or
disposals, legal actions, employee benefit plans, contingencies and
commitments, significant customers, sales to relates parties, and
segments of the firms.
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MD&A: some parts may be unaudited.

1) Past performance and future outlook
2) For firms in US, SEC requires: trends and significant events
and uncertainties, effect of inflation.
3) Off-balance-sheet obligations, forward-looking expenditures
and divestitures.
4) Significant accounting policies and estimates that
require management judgment. Likely impact of
implementing recently issued accounting standards
Standard auditors opinion
1) Independent
2) No material errors
3) Correct accounting principles
4) Express opinions on internal control (under GAAP)
Auditors opinion:
1) unqualified opinion ,
2) qualified opinion ( ), the statement make any
exceptions to the accounting policies.
3) adverse opinion ( ), statements are not fair or
nonconforming with accounting standards.
4) disclaimer of opinion , in the case of a scope
limitation.
5) An explanatory paragraph when a material loss is probable but
the amount cannot be reasonably estimated.
For a company issuing securities in the United States to meet its obligations under
the
SarbanesOxley Act, it is mandatory that management's Report to Shareholders and
discusses internal financial controls and their effectiveness, as well as the company's
auditor's opinion of these internal controls.
Quarterly or semiannually reports (interim report, to update info
on performance and financial position) are not necessarily
audited.
Form 8-K, M&A and disposals.
Form 10-K, annual report
Form 10-Q, quarterly report
Proxy statements: shareholder vote, election of board
members, compensation, management qualifications, and the
issuance of stock options.
Reading 23 Financing Reporting Mechanics

Prepaid expense, cash, prepaid expense
asset.
Unearned revenue, cash, unearned revenue
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liability.
Accrued expense, net income , liability.

Accrued revenue, net income , asset.
Revenue: Investment income such as interest and dividend income.
Assets=liabilities + contributed capital ( ) +
beginning retained earnings + revenues expenses dividends
Ending Retained earning = Beginning Retained Earning + Net income
Dividends
= Total equity contributed equity
Accrual accounting: revenue is recorded when the firm earns it and
expenses are recorded as the firm incurs them, regardless of
whether cash has actually been paid.
Contra account: accumulated depreciation, allowance for bad debts
( accounts receivable)
:
1) cash Unearned revenue(L) and
prepaid expense(A), cash changes hands first; accrued
revenue(A) and accrued expense(L), the revenue or expense
is recorded first and cash is exchanged later.
2) (revenue)(expense)
Valuation adjustments are to update assets market value.
Information flows through an accounting system:
1) Journal entries ( , show which accounts are changed
and by what amounts) and general journal( , all journal
entries in order of dates)
Adjusting entries are a type of journal entries typically made
at the end of the accounting period to record such items as
accruals that are not yet reflected in the accounting system.
2) General ledger sorts the general journal by account
3) initial trial balance (originating entry)
4) Adjusted trial balance (adjusting entry)
Reading 24 Financial Reporting Standards

Depreciation expense: group by nature of the expense
COGS: group by function
Standard-setting bodies: FABS (US GAAP) and IASB (IFRS)
Regulatory authorities: SEC and FSA (PRA) , established by
national government
Most national authorities (including SEC and FSA) belong to the
International Organization of Securities Commissions (IOSC,
).
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The goal: uniform financial regulations across countries

Three objectives:
1) Protect investors
2) Ensure the fairness, efficiency, and transparency of markets
3) Reduce systematic risk
Form S-1, IPO
Form 10-K, .For Canadian companies in the US market,
form 40-F; other foreign issuers in US market, form 20-F.
Form 10-Q, , disclosure about legal proceedings or
changes in accounting policy.
Form DEF-14A, proxy statement.
Form 8-K, M&A and disposals, change in the management board,
or matters related to its accountants, its financial statements, or the
markets in which its securities trade.
Form 144, , SEC.
Form 3, 4 and 5, .
Two important underlying assumptions of financial statements are
accrual accounting and going concern.
IFRS specifies a number of general features underlying the
preparation of financial statements:
1) Materiality
2) Accrual basis
3) Fair presentation
4) Going concern
5) Consistency
6) Aggregation
7) No offsetting
8) Comparative info
9) Report frequency at least annually
IASBs conceptual framework
Qualitative characteristics
1) Relevance
2) Faithful representation
Four characteristics that enhance above characteristics (CVTU):
1) Comparability: financial statement should be consistent
among firms and across time periods.
2) Verifiability: independent observers, using the same
method, obtain similar results.
3) Timeliness
4) Understandability
Constraints and assumptions:
1) Cost-benefit tradeoff
2) Non-quantifiable information cannot be captured
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Required financial statement under IAS No.1

1) Balance Sheet
2) Statement of comprehensive income
3) Cash flow statement
4) Statement of changes in owners equity
5) Explanatory notes, including a summary of accounting policies
FASB (GAAAP) does not allow the upward valuation of most assets.
Coherent financial reporting framework should be (TCC):
1) Transparent
2) Comprehensive
3) Consistent
Barriers:
1) Valuation
2) Standard setting:
2.1) principles-based (,IFRS)
2.2) rules-based (, GAAP)
2.3) objectives-oriented (,)
3) measurement B/S I/S B/S
Reading 25 Understanding Income

Statements
Net revenue = revenue estimated returns and allowance (
)
Net Income = revenues ordinary expenses + other income other
expense + gains losses
Non-controlling interest (minority interest or minority owners
interest), , net income
If A owns more than 50% of B, then it must include 100% of Bs
revenues.
Interest expense is an operating expense for financial firms and a
financing expense for non-financial firms.
(revenue recognition policies are disclosed in footnotes)
1) According to IASB, revenue is recognized when
1.1) The risk and reward of ownership is transferred
1.2) Revenue can be readily measured
1.3) There is a probable flow of economic benefits
1.4) The cost can be reliably measured
2) According to FASB, revenue is recognized when ()
2.1) Realized or realizable and
2.2) Earned
3) SEC provides additional guidance; revenue is recognized when
3.1) Evidence of an arrangement between the buyer and seller
3.2) Product has been delivered or the service has been
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rendered
3.3) Price is determined
3.4) Seller is sure of collecting money
Long-Term Contracts
1) When the outcome can be reliably estimated:
The percentage-of-completion method is used both under IFRS
and GAAP (more aggressive, more subjective, smoother
earnings).
2) When the outcome cannot be reliably estimated:
2.1) Under IFRS, revenue is same as cost, only recognize
profit in the final period.
2.2) Under GAAP, complete-contract-method is used. All
revenue, expense, and profit are recorded in the final
period.
If a loss is expected, the loss must be recognized immediately under
IFRS and GAAP.
Installment Sales
,,.
Profit = (cash collected/sales) * total expected profit
Cost recovery method
Profit is recognized only when cash collected exceeds costs incurred.
.
Barter transactions
Under GAAP, revenue from a barter transaction can be recognized at
fair value only if the firm has historically received cash
payments for such goods and services and can use this
historical experience to determine fair value. Otherwise, the
revenue is recorded at the carrying value of the asset
surrendered.
Under IFRS, revenue must be based on the fair value of the
revenue from similar non-barter transactions with unrelated parties.
To
1)
2)
3)
4)
use gross reporting of revenue under GAAP, the firm must:

Be the primary obligor under the contract
Bear the inventory risk and credit risk
Be able to choose its supplier
Have reasonable latitude to establish the price
Matching principle: expense follows revenue, except for period

cost, such as administrative costs.
FIFO and average cost are permitted under both GAAP and IFRS.
LIFO is allowed under GAAP but is prohibited under IFRS.
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1) Depreciation (tangible assets)

Straight-line depreciation and Double-declining depreciation
2) Depletion (natural resources)
3) Amortization (intangible assets). Goodwill (indefinite lives)
is not amortized, but they must be tested for impairment at
least annually. If impaired, an expense equal to the
impairment must be recorded in income statement.
4) Bad debt expense () and warranty expense ()
recognition. Recognize the revenue/expense at the time
of the sale and update the expense over the life of the
warranty.
Declining Balance method: apply a constant rate of depreciation to
an assets book value each year.
2
DDB =
* (cost accumulated depreciation)
useful life
Non-Recurring Items
1) Measurement date: the firm develops a formal plan for
disposing of an operation
2) Phase-out period: the time between the measurement period
and the actual disposal date.
discontinuing operations (net of tax, after income from
continuing operations, should be excluded when forecasting
future earnings), restate. On the measurement date,
the company will accrue loss, but any gain (
)cannot be reported until after the sale is completed.
The disposition of a capital asset is reported as a net gain or
loss on the income statement before tax effects.
Unusual or infrequent items (included in income from
continuing operations, reported before tax):
1) Profit/loss from sale of assets
2) Impairments, write-offs, write-downs, and restructuring costs.
Extraordinary items (under GAAP: net of tax, after income from
continuing operations; under IFRS, do not permit
classification of an item as extraordinary.)
1) Losses from an expropriation of assets.
2) Profit/loss from early retirement of debt
3) Uninsured losses from Natural disasters
Changes in accounting standards
1) Change in accounting principles (from LIFO to FIFO) need to
restate.
2) Change from incorrect accounting method or the correction of
an accounting error, called Prior-Period adjustments, need to
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restate and disclosure of the nature of the adjustment

and its effect on net income. Do not affect cash flow.
3) Change in accounting estimate (due to new information), no
restate. Do not affect cash flow, but do affect future
operating results.
EPS refers to
shareholders.
the
per-share
earnings
available
to
common
A simple capital structure: common stock, nonconvertible debt, and

nonconvertible preferred stock. convertible shares, or
convertible debt, or option/warrants, diluted EPS = basic EPS =
preferred
net income
number of shares
preferred dividend,
convertible/nonconvertible
diluted EPS preferred dividend
stock dividend stock split
convertible preferred stock, convertible bonds
stock options, warrants (strike price < average market price)
convertible preferred stock dilute, unconvertible cumulative
Any transaction that affects net income will also affect equity.
Comprehensive income = net income + other comprehensive
income
Other Comprehensive Income
1) FX translation gains and losses.
2) Adjustments for minimum pension liability
3) Unrealized profit/loss from cash flow hedging derivative.
4) Unrealized
profit/loss
from
available-for-sale
securities
(reported as fair value).
Reading 26 Understanding Balance Sheets

Both IFRS and GAAP require firms to separately report
current/noncurrent assets/liabilities (known as classified balance
sheet).
IFRS does not specify the order of presentation of current
and noncurrent assets. Under U.S. GAAP, current assets are
presented before long-term assets and current liabilities
before long-term ones.
Liquidity-based format is often used in the banking industry,
presenting assets and liabilities in the order of liquidity.
Current assetsreveal information about the operating activity
Working capital = current assets current liabilities ()
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Noncurrent assets provide information about the investing

activities
Noncurrent liabilities provide information about long term
financing activities
Accrued liabilities ( ) include income tax payable, interest
payable, wages payable, etc.
All advertising and promotion costs,
placements, are typically expensed.
such
as
media
Non-current asset
1) PPE (property, plant and equipment). Under IFRS, cost model
or revaluation model; under GAAP, only cost model is
allowed.
Cost model: PPE other than land is reported at amortized cost
(historical cost depreciation). Land is not depreciated as it has
indefinite life.
1.1 The cost model (both IFRS and GAAP, but the steps are
slightly different as illustrated here), PPE must be tested for
impairment.
Under IFRS, recoverable amount = max (FV-selling cost,
value in use (PV of cash flow)).
If the carrying value exceeds the recoverable amount, the
asset is impaired and written down to recoverable amount
and loss is recognized in the income statement. Loss
recoveries are allowed under IFRS but not GAAP.
Under GAAP, bad situations ().
Two steps, firstly, recoverability test, carrying value
future undiscounted cash flow. Secondly, loss

measurement, fair value future discounted cash
flow. Loss recovery is not allowed.
1.2 Revaluation model (under IFRS): PPE is reported at FVdepreciation.
Changes
in
FV
are
reflected
in
shareholders equity and may be recognized in the
income statement. To be more specific,
gain, instead, it is reported in revaluation
surplus in shareholders equity. , surplus,
,.,,
reduce fair value.
2) Investment property, under IFRS, a firm can use cost model (
PP&E ) or fair value (if can be estimated reliably) to
value investment property. fair value PP&E revaluation
model .
IFRS investment property, GAAP
3) Intangible assets:
3.1) Identifiable: patents, trademarks, and copyrights.
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Under IFRS, purchased identifiable intangibles can use the cost

model or the revaluation model (only when an active market
exists);
Under GAAP, only cost model is allowed, must be valued
at historic cost.
3.2) Unidentifiable: Goodwill (=purchase price FV of
identifiable net assets), only created in a purchase acquisition.
Internally generated goodwill is expensed as incurred.
Economic goodwill ( ) derives from the expected future
performance of the firm, while accounting goodwill is the result
of past acquisitions.
Intangible assets with finite life, amortized and tested for
impairment, the amortization method and useful life
estimates are reviewed at least annually.
Intangible assets with infinite lives are not amortized, but
tested for impairment at least annually. For example, if
impaired, goodwill is reduced and a loss is recognized. The
impairment loss does not affect cash flow. Trademark ()
, renew, have an indefinite life
and no amortization required.
4) Financial assets
Bonds payable issued by a company are financial liabilities that
are usually measured at amortized cost.
Historical
Amortized cost Fair value (MTM)
Cost
Trading
securities
and
Held-toUnlisted
derivatives, unrealized profit/loss is
maturity
equity
recognized
in
the
income
Securities (
investment
statement
MV Under IFRS/GAAP, Available-forLoans

and unrealized sale security, any unrealized
receivables
profit/loss are reported as OCI
pnl )
as part of shareholders equity.
Dividend and interest income and realized profit/loss
are recognized in the income statement.
Non-current liabilities
1) Long-term financial liability
2) Deferred tax liabilities
Owners equity
1) Contributed capital (issued capital)
Authorized shares ()
Issued shares
Outstanding shares = issued shares treasury stock
(reacquired by the firm)
2) Preferred stock, can be equity (perpetual preferred stock) or debt
3) Non-controlling interest
4) Retained earnings
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5) Treasury stock, reduced stockholders equity, has no voting

rights and does not receive dividends.
6) Accumulated other comprehensive income
6.1) Unrealized pnl from available-for-sale securities
6.2) Cash flow hedging activities
6.3) FX translation
6.4) Minimum pension liability
A vertical common-size income statement: as a percentage of
revenue. This allows for time-series analysis and cross-sectional
analysis.
A vertical common-size balance sheet, expressed as a percentage of
total assets, which allows for time-series analysis and crosssectional analysis.
Current ratio = current assets / current liabilities
The quick ratio is calculated by excluding inventory from current
assets.
Cash ratio excluded both inventory and receivables.
When calculating the solvency ratios, debt is considered to be
any interest-bearing obligation.
When calculating the financial leverage ratio (total debt-toequity=total assets/total equity; long-term debt-to-equity =
long-term debt/total equity) captures both interest bearing
and non-interest bearing.
The issuers report as liabilities any financial instruments
that will require repayment of principal in the future.
Mandatory redeemable preferred shares (which used to be
reported as equity) now must be reported as debt;
dividends on such stock must be reported as interest
expense. (Consistent with the view that the preferred stock
is debt)
Reading 27 Understanding Cash Flow

Statements
CF statement is not used to determine a companys monthly cash
budget.
CFO affects a firms net income.
CFI consists of cash flow resulting from the acquisition or disposal of
long-term assets and certain investments.
CFF affects a firms capital structure.
Noncash investing and financing activities are not reported in the
cash flow statement since they do not result in inflows or outflows of
cash. Noncash transactions must be disclosed in either footnote or
supplemental schedule to the cash flow statement. Some
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examples:
1) The firm acquires real estates with financing provided by the
seller
2) An exchange of debt for equity
3) The exchange of non-monetary assets or issuance of stock as
part of a stock dividend or conversion
4) Exchange stock
5) Write off/impairment of assets
6) Debt retired through issuance of stock
Under US GAAP:
CFF:
CFI:
CFO: trading securities
Items
Dividends paid
Interest paid
Dividends/Interest
received
GAAP (only)
CFF
CFO
IFRS (either)
CFO/CFF
CFO/CFF
CFO
CFO/CFI
CFO unless the

expense
is
associated
with
Income tax paid
CFO
investing
or
financing
activities
Must be disclosed
Report in Cash flow separately in the
Payments for interest and
statement
or cash
flow
tax
disclose in footnote statement under
either method
Both direct and indirect methods are permitted under GAAP and
IFRS ( Direct method). Most firms use indirect method
(because under GAAP, if you use direct, then you need to reconcile
to indirect; same are not required under IFRS).
Direct method provides more information than indirect method.
Advantage of indirect method is that it focuses on the differences in
net income and operating cash flow. This provides a useful link to
the income statement when forecasting future CFO.
Beginning accounts receivable + sales Cash collections = Ending
accounts receivable
Indirect methods
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CFO = Net income + depreciation and amortization profit

sale of assets increase in accounts receivable increase in
inventory + increase in accounts payable + increase in
accrued liabilities
Direct method
1) CFI
Cash paid for new assets (buy assets):
Beginning assets + cash paid for new assets cost of assets sold =
Ending assets
Cash from assets sold (sell assets):
Beginning assets Ending assets + profit/loss on sale = Cash from
assets sold
2) CFF (sum of below two measures)
Cash flow from creditors = net borrowing principal amounts repaid
Cash flow from shareholders = new equity issued share
repurchased cash dividends paid (calculated from dividends
declared and any changes in dividends payable)
Convert cash flows from the indirect to direct method ( sources
or uses of cash )
1) Cash collections from customers (+ ) = sales - increase
in accounts receivable + increase in unearned revenue
2) Cash payments to suppliers (-) = COGS + depreciation
increase in accounts payable + increase in inventory
inventory write-off
3) Cash received from sale of equipment = Book Value +
profit/loss from the sale
Book Value = historic cost depreciation
4) Cash paid for interest = interest expense + decrease in
interest expense
Over the long term, CFO>capital expenditure
CFO can be increased by real earning-related activities or liquidating
inventory / receivables or increasing payables.
Stable CFO/Net income ratio is good.
CFI, CFI
1) FCFF = Net income + depreciation + interest expense * (1-tax
rate) fixed capital investment working capital (net income
depreciation WC, )
2) More importantly,
FCFF = CFO + interest expense * (1-tax rate) Fixed
Capital Investment ( interest CFO , add
back)
Fixed Capital Investment = cash spent on fixed assets
cash received from selling fixed assets
3) FCFE = CFO + net borrowing (debt issued debt
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repaid) fixed capital investment
Reading 28 Financial Analysis Techniques

During the process data phase, an analyst will produce a variety of
reports and documents based on the information collected. These
may include common-size statements, ratios and graphs, forecasts,
adjusted statements, and analytical results.
Assessment of performance includes analysis of profitability and
cash flow generating ability. The relationship between assets and
liabilities is used to assess a company's financial position, not its
performance
Ratio analysis:
1) Common-Size analysis
1.1) Vertical: time-series analysis and cross-sectional analysis
1.2) Horizontal: the divisor is the first-year values
2) Graphical Analysis
2.1) Stacked column graph
2.2) Line graph
3) Regression analysis: used for forecasting
net income EBT
EBIT
revenue
total assets
EBT
EBIT revenue total assets total equity
Above formula shows that more leverage does not always lead
to higher ROE. The second and last item could offset each other.
However, higher taxes will lead to lower levels of ROE.
ROE=
Activity ratio: turnover performance ratio,

efficient
Liquidity ratio: cash defensive interval
Solvency ratio: debt debt/capital, interest coverage
Profitability ratio: such as net profit margin
Defensive interval = (cash + marketable securities +
receivables)/average daily expenditure
Debt-to-capital ratio = total debt / (total debt + total
shareholders equity)
total debt short term and long term debt,
liability
Total capital=total assets
Capital equals to all short-term and long-term debt plus preferred
stock and equity.
Coefficient of variation = standard deviation / mean (
arithmetic mean return geometric mean return)
Z-score: a low score indicates high probability of failure
Reading 29 Inventories
Ending inventory = Beginning inventory + Purchase (in)
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COGS (out)
1) Product costs capitalized in the inventories account(
):
1.1) Purchase cost less trade discounts and rebates.
1.2) Conversion costs including labor and overhead (
).
1.3) Other costs to bring the inventory to the location()
import duties.
2) Period costs are expensed in the period occurred:
2.1) Abnormal waste of materials, labor, or overhead.
2.2) Storage costs (unless required as part of production)
2.3) Administrative overhead
2.4) Selling cost (, shipping to customers)
In a periodic inventory system, inventory values and COGS are
determined at the end of the accounting period.
In a perpetual inventory system, inventory values and COGS are
updated continuously.
Under above two systems, it could produce different values under
LIFO and weighted average cost methods (same under FIFO).
LIFO firms are less likely to recognize inventory write down than
firms using FIFO or weighted average cost. ( ending inventory
cost ,) please see below:
Assume increasing prices and stable or increasing inventory levels.
FIFO
LIFO
COGS
Lower
Higher
Ending
Higher
Lower
Inventory
Gross Profit
Higher
Lower
With rising price, LIFO produces higher COGS and result in lower
earnings. Any profitability measure that includes COGS will be lower
under LIFO, such as gross, operating, and gross profit margins.
Quick ratio is unaffected by the inventory cost flow method
because inventory is excluded from its numerator.
Cost NRV/MV under GAAP/IFRS, report inventory at
NRV (above historic cost) for commodity-like products()
1) Under IFRS, inventories = min (cost, NRV)
NRV= sale price - selling cost
NRV formulas regards to tangible assets are here.
1.1) If NRV is less than the carrying value, the inventory
is written down to NRV and a loss is recognized in
the income statement.
1.2) If there is a recovery of value, it can be written back
up and the gain is recognized in the income
statement by reducing COGS by the amount of the
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recovery. Inventory cannot be written up by more

than the amount it was previously written down
(through valuation allowance account).
, NRV , NRV , write
up
2) Under GAAP, inventories = min (cost, MV)
NRV normal profit margin <MV= replacement value <
NRV
If cost exceeds MV, the inventory is written down to MV
and a loss is recognized in the IS. No write-up is
allowed under GAAP; the firm simply reports higher
profit when the inventory is sold.
,, MV, write down to MV.
Inventory disclosures can be found in footnotes.
disclosures are:
1) LIFO/FIFO method?
2) Carrying value of inventories ()
3) Write-down and any reversals
Required
Under IFRS, change in cash flow method will need to restate priorperiod data
Under GAAP, inventory method LIFO,
restate restate.
Generally, higher inventory turnover is desirable. ,
, inventory write-down.
Higher turnover slower growth .
Higher turnover higher growth .
Higher gross profit margin , with lower inventory
turnover
Reading 30 Long-lived Assets

Purchase, installation and rebuilt costs are capitalized,
Initial training and repair and maintenance costs
expense when incurred.
are
cost residual value

useful life
(costdepreciation)
DDB : Depreciation=
2
useful life
( costresidual value )Unit
Unit of production : Depreciation=
total
SL : D epreciation=
Capitalizing expenditure will result in higher CFO and lower CFI

compared to expensing. Depreciation is a noncash expense and
Page 80 of 154
does not affect CFO (aside from any tax effect).

Capitalized interest ( CFI): the interest rate used to capitalize
interest is based on debt specially related to the construction of the
asset. If no construction debt is outstanding, then it based on
existing unrelated borrowing.
, expense.
Under IFRS, ;
Under GAAP, this is not allowed.
Capitalized interest (CFI) interest expense (CFO) ,
depreciation expense (asset is held for use) or COGS (asset is held
for sale).
Intangible assets
1) Created internally, costs are usually expensed. The only
exception is development cost under IFRS, which may be
capitalized. (under GAAP, R&D costs are expensed as incurred
zero carrying value)
However, software , development costs
.(cost are expensed), (costs are capitalized). The only
exception is when the software is for self-use under GAAP all costs are
capitalized. Details can be found in table below:
IFRS
(cost are expensed)
(costs are capitalized)
(cost are expensed)
GAAP
(cost are expensed)
All capitalized
2) Purchased intangible asset

Recorded on the balance sheet at cost, typically fair value at
acquisition
3) Obtained in a business combination (acquisition method is
used)
Goodwill is said to be an unidentifiable asset that cannot be
separated from the business itself.
Only goodwill created in a business combination is
capitalized on balance sheet. Internally generated
goodwill is expensed.
4) A trademark that may have a specific expiration date, but can be
renewed at minimal cost.
A change in an accounting estimate, such as useful life and
salvage value, is put into effect in the current period and no need
to restate prior periods.
Page 81 of 154
Component depreciation is allowed both under IFRS and GAAP

(seldom used).
PP&E (revaluation model and cost model)
Under GAAP and IFRS, most long-lived assets are reported at
depreciated cost (cost model, ). Revaluation model is
not allowed under GAAP ( cost model).
Revaluation impact on profit/loss recognition (PP&E and investment
property)
Under IFRS, it also allows revaluation model (
, fair value). gain,
instead, it is reported in revaluation surplus in shareholders
equity. , surplus,,.
,, reduce fair value.
For investment property, FV model, revaluation surplus,
revaluation above historic cost is recognized as a gain on
the income statement.
Impairment of tangible and intangible assets with finite lives
that are held for use
1) Under IFRS, tested annually, NRV=max [FV selling costs, value
in use]. The loss can be reversed. Value in use PV of future
CF.
(carrying value = original cost accumulated depreciation
NRV )
2) Under GAAP, bad situations ().
2.1) recoverability test, carrying value future
undiscounted cash flow.
2.2) loss measurement, fair value future discounted
cash flow. Loss recovery is not allowed.
If a firm reclassifies a long-lived asset from held-for-use to held-forsale, the asset is tested for impairment and ceased to depreciate.
For assets that are held for sale, the loss can be reversed
under IFRS and GAAP.
If abandoned or exchanged, then classified as held for use
until disposal and continue to be depreciated.
1)
Sold. Asset is removed and profit/loss is recognized in income
statement.
2)
Abandoned. 1),
3)
Exchanged for another asset. The carrying value of the old
asset is removed and the new asset is recorded at its fair
value. A gain or loss is computed by the two values.
Page 82 of 154
IFRS
PP&E
1) Useful life or depreciation rate
2) Carrying
value
and
accumulated
depreciation
3) Reconcile of carrying value from the
beginning to end period
4) Assets pledged as collateral
5) Agreements to acquire PP&E in the future
6) If revaluation model is used, then the
revaluation date, fair value calculation
and carrying value
Intangibl 1)
e assets 2) Finite/indefinite
3) If impaired, loss and reversals, why and
where they are recognized in income
statement
GAAP
1) 1
2) 2
3)
1)
2) 5
3) if impaired,
(except loss
reversal)
Investment property (cost model and fair value model)

For investment property, firms are required to disclose which
valuation model they use.
If they use fair value model, they must state how they determine
fair value.
If they use cost model, they must also disclose the fair value of
the investment property, along with others that are required for
PP&E.
When transferring into or out of investment property,
If the firm uses the cost model, the propertys carrying amount does
not change;
If the firms uses fair value model,
Transfer from
Transfer to
Owner-occupied
Investment
property
Inventory
Investment
property
Investment
property
Owner-occupied
or inventory
Financial
statement
treatment
Treat
as
revaluation:
recognize gain only if it
reverses
previously
recognized loss
Recognize gain or loss if
fair value is different from
carrying amount
Fair value of asset at date of
transfer will be its cost
under new classification(
)
Page 83 of 154
Reading 31 Income Taxes
Tax return terminology ()

Taxable income, Taxes payable, Income tax paid, Tax loss carryforward (a current or past loss that can be used to reduce taxable
income, can then result in DTA), Tax base (net amount of an asset
or liability used for tax reporting purposes)
Financing reporting terminology
Pretax income (Accounting profit), income tax expense, deferred
tax liabilities, deferred tax assets, valuation allowance, carrying
value (net balance sheet value of an asset or liability), permanent
difference, and temporary difference.
Valuation allowance: ,to record DTA that are not expected to
reverse.
Permanent difference: a difference between taxable income and
pretax income that will not reverse in the future.
Temporary difference: a difference between the tax base and
the carrying value.
DTL: income tax expense > taxes payable (
)
only temporary difference, which means it will reverse in the
future, DTL and DTA.
A temporary difference from an investment will result in a DTA only
if the temporary difference is expected to reverse in the future, and
sufficient taxable profits are expected to exist when the reversal
occurs.
Taxable temporary differences DTL
Deductible temporary differences DTA
Permanent differences do not create DTL or DTA
DTL are expected to reverse and result in future cash outflows.
DTA are expected to provide future tax savings.
DTL occurs when
1) Revenues are recognized in the income statement before they
are included on the tax return due to temporary differences.
2) Expenses are tax deductible before they are recognized in the
income statement.
The most common way that DTL are created is when different
depreciation methods are used on the tax return and the
income statement.
DTA is created when taxes payable are greater than income tax
expense due to temporary differences. ()
DTA occurs when
1) Revenues are taxable before they are recognized in the income
statement.
2) Expenses are recognized in the income statement before they
Page 84 of 154
3)
4)
5)
6)
7)
are tax deductible.

Tax loss carry-forwards (in the first year of operations, a firm
produces taxable income of -$10,000) are available to
reduce future taxable income.
Impairments (the write-down are recognized immediately in the
income statement, but the deduction on the tax return is not
allowed until the asset is sold or disposed of.)
Restructuring (same reason as impairments)
Different choices of cash flow method (in US, firms that use LIFO
are required to use LIFO for tax purposes)
Post-employment
benefits
and
compensation,
Warranty
expenses, tax loss carry-forward (), bad debt expense
and customer advance ( ). They are typical causes of
DTA.
Permanent differences occurs when

1) Revenue that is not taxable
2) Expenses that are not deductible
3) Tax credits that result in a direct reduction of taxes
4) Tax exempt bonds (effective tax rate )
Permanent differences will cause the effective tax rate (=income tax
expense/pretax income) to differ from the statutory tax rate (
).
Tipsin general, , asset,
liability.
If Assets, then tax base > carrying value DTA; tax base < carrying
value DTL
If Liabilities, then tax base > carrying value DTL; tax base <
carrying value DTA
Income tax expense = taxes payable + DTL -DTA
If DTL reverses, then it is liability;
If they are not expected to reverse, then they are equity;
If both the timing and amount of tax payments are uncertain, then
they are neither of liabilities nor equities.
Under IFRS, all DTL are non-current assets.
Under GAAP, if more likely that DTA will not be realized, then the
DTA must be reduced by a valuation allowance.
The valuation allowance is a contra account that reduces the net
balance sheet value of the DTA.
1) Increasing the valuation allowance will decrease the net balance
sheet DTA, increasing income tax expense( ) and
decreasing net income/earnings.
2) By decreasing the valuation allowance, the firm is signaling
greater likelihood that future earnings will offset by the DTA (better
Page 85 of 154
future earnings).
Under GAAP, DTA and DTL appear separately on the balance sheet,
and they are not typically netted. DTL
The following deferred tax information is disclosed:
1) DTL, DTA and valuation allowance
2) Any unrecognized DTL for undistributed earnings of subsidiaries
and joint ventures
3) Tax effect of each type of temporary difference
4) Components of income tax expense
5) Reconciliation of reported income tax expense and the tax
expense
6) Tax loss carry-forwards and credits
In analyzing trends in tax rate, it is important to only include
reconciliation items that are continuous (different rates, tax-exempt
income, and non-deductible expenses) in nature rather than those
that are sporadic (large asset sales, tax holiday savings).
Taxing accounting differences, please refer to SCHWESER notes
Book 3 P248
Reading 32 Non-Current Liabilities

Two types of payments are involved in bonds:
1) Periodic interest payments ( CFO) and
2) Repayment of principal at maturity ( CFF)
The balance sheet liability (book value or carrying value) of a bond
is equal to the PV of its remaining future cash flows (coupon
payment and face value), discounted at the market rate of interest
at issuance.
For bonds issued at par, interest expense is equal to coupon
interests; for bonds issued at a premium or discount, they are not
equal because interest expense includes amortization of any
discount or premium.
How to report issuance cost? (Under US GAAP, coupon payments
are CFO)
Interest paid = coupon rate at issue * face value
Interest expense = market rate at issue * carrying value of
bonds
In balance sheet, $1m bond issued for $980,000 with issuance costs
of $5,000.
1) Under GAAP, the firm would increase assets by $980,000
($975,000 cash and $5,000 deferred charge) and increase
liability by $980,000.
GAAP, issuance costs are capitalized as assets.
2) Under IFRS, the bonds issuance costs reduce the bond
Page 86 of 154
liability reported on the balance sheet. Thus, the firm will

increase assets and liabilities by $975,000. In other words,
debt issuance costs are included in the measurement
of the bond liability, increasing the effective interest
rate.
3) In cash flow statement, under both IFRS and GAAP, bond
issuance costs are usually netted against the bond
proceeds and reported on the cash flow statement as CFF.
Interest paid = Coupon rate at issue Issued amount of
bonds
Interest expense = Market rate at issue Carrying (book
value) of bonds
Amortization of discount = Interest expense Interest paid
IFRS and GAAP give firms irrevocable ( ) option to report
debt at fair value. Gains and losses that result from change in
bonds market yield are reported in income statement.
Summary of Financial Statement Effects of Issuing a Bond, please
refer to Book 3 P263
1) When bonds mature, the issuer recognizes no gain or loss. The
principal repayment is reported as CFF.
2) When bonds are redeemed before maturity,
Profit/loss = the book value of the bond liability - redemption
price.
2.1) Under GAAP, any remaining unamortized bond issuance
costs must be written off and included in the gain or loss
calculation.
Any gain or loss from redeeming debt is reported in the
income statement, as a part of continuing operations, and
additional information is disclosed separately.
2.2) Under IFRS, no write-off is necessary as issuance
cost is netted against liability already.
Affirming covenants (,) and negative covenants
(,) borrower. Bond covenants are typically
discussed in the financial statement footnotes.
More details are disclosed about its long-term debt in the footnotes
(as below) or MD&A (both quantitative and qualitative):
1) The nature of the liabilities
2) Maturity dates
3) Stated and effective interest rates
4) Call provisions and conversion privileges
5) Restrictions imposed by creditors
6) Assets pledges as security
7) The amount of debt maturing in each of the next five years
Page 87 of 154
Leasing benefits:
1) Less costly financing
2) Reduced risk of obsolescence
3) Less restrictive provisions
4) Off-balancing-sheet financing (operating lease)
5) Tax reporting advantage
Lessees Perspective
Leases are classified as either finance lease (capital lease) or
operating lease.
1) Finance lease is equal to a purchase of an asset that is
financed with debt (). The lessee will add equal
amount to both assets and liabilities, and recognize
depreciation and interest expense over the term of lease.
The lessor removes the asset and replaces with lease
receivable.
2) Operating lease is a rental arrangement( ). No
asset or liability is reported and the periodic lease payments
are recognized as rental expense in the income statement.
Lessees often prefer operating leases because no
liability is reported. The lessor recognized rental income
and continues to report and depreciate the leased asset on its
balance sheet.
How to classify a finance lease?
1) Under IFRS (same for lessee and lessor)
1.1) Title to the leased asset is transferred to the lessee at the
end of the lease
1.2) The lessee can purchase the leased asset at a much lower
price than the fair value
1.3) The lease term covers a major portion of the assets
economic life.
1.4) The PV of the lease payments is equal to the fair value of
the leased asset
1.5) The leased asset is very specialized that only the lessee
can use the asset.
2) Under GAAP (for lessee, , )
2.1) Title to the leased asset is transferred to the lessee at the
end of the lease
2.2) A bargain purchase option permits the lessee can purchase
the leased asset at a much lower price than the fair value
2.3) The lease period is 75% or more of the assets economic
life.
2.4) The PV of the lease payments is 90% or more of the fair
value of the leased asset
3) Under GAAP (for lessor)
3.1) Above are met
3.2) The collectability of lease payments is reasonably certain
Page 88 of 154
3.3)
The lessor has almost completed performance
Reporting by the Lessee

1) Operating lease: rental expense equal to the lease payment is
reported as CFO
2) Finance lease: interest expense is equal to the lease liability at
the beginning of the period multiplied by the lease interest
rate (the lower of the lessees incremental borrowing rate and
the lessors implicit rate).
In the cash flow statement, the lease payment is separated
into interest and principal components. The principal
portion is equal to the lease payment minus the interest
portion.
Under GAAP, interest paid is CFO, and principal paid is CFF.
Under IFRS, interest paid can be CFO/CFF.
,lease payment , interest expense
, principal payment , beginning value ,
liability, asset,(
)
Beginning liability + interest expense lease payment =
Ending liability
Similar to the calculation of book value of the bond:
Beginning book value + interest expense coupon = Ending
book value
Financial Statement Impact of Finance and Operating lease
Interest expense
1) Balance Sheet
Debt/asset and debt/equity will be higher with finance leases
because of the reported liability.
The principal payment due within next year is reported
current liability, which reduces the lessees current
ratio and working capital.
EBIT will be higher for companies use finance lease
because only the depreciation is treated as expense (
interest portion will be recognized as interest
expense), while the operating lease recognizes entire lease
payment as operating expense.
2) Income Statement
finance lease ,interest expense (liability
), expense , net income will
be lower for a finance lease in its early year and higher
in later years, compared to an operating lease.
3) Cash flow statement
Finance lease ,interest expense CFO, principal
repayment CFF. operating lease , CFO; for
finance lease, CFO is higher and CFF is lower.
Page 89 of 154
For summary of Financing Statement Impact of Lease Accounting,

please refer to Book 3 P272.
In sum, all the ratios are worse when the lease is financed.
The only improvements from finance lease are higher EBIT,
higher CFO and higher net income (in later years).
Reporting by the Lessor
Financing Lease
1) Under GAAP, finance lease is treated as
1.1) sale-type ( , PV of the lease payments >
Carrying value of the asset)
For manufacturers or dealers, Interest portion goes
to CFO and principle goes to CFI.
1.2) direct financing (, PV of the lease payments
= Carrying value of the asset)
The lessor is not manufacturers or dealers, but has
purchased the asset from a third party. Interest portion
goes to CFO and principle goes to CFI.
2) Under IFRS, similar treatment to a sale-type lease is allowed
for finance leases originated by manufacturers or dealers.
Operating Lease
1) In income statement, the income reported from the direct
financing (, ) is higher
than that in the operating lease in the early years.
2) In cash flow statement, :
Operating
Direct Financing
Lease
Year
CFI
CFO
CFO ()
1
3000
17,000
20,000
2
2000
18,000
20,000
3
1000
19,000
20,000
Disclosures in the footnotes relating to finance and operating leases
(both lessees and lessors)
1) General description of the leasing arrangement
2) The timing and amounts to be paid or received in each of the
next 5 years. Lease payments after 5 years can be
aggregated.
3) Amount of lease revenue and expense
4) Amounts receivable and unearned revenues from lease
arrangements
5) Restrictions imposed by lease agreements
Analysts can use the disclosure to estimate the off-balance-sheet
liabilities of operating leases.
1) Defined contribution plan, the firm makes no promise to the
employee regarding the future value of the plan assets.
Page 90 of 154
Pension
expense
is
equal
to
the
employers
contribution.
2) Defined benefit plan, the employer assumes the investment
risk.
Both under IFRS and GAAP,
If fair value > estimated pension obligation, the plan is
overfunded and records a net pension asset;
If fair value < estimated pension obligation, the plan is
underfunded and records a net pension liability;
Under IFRS, re-measurements are not amortized to the income
statement over time.
For manufacturing firm, under IFRS and GAAP, pension expense is
allocated to inventory and COGS for employees who provide direct
labor to production and to salary or administrative expense for other
employees. As a result, pension expense does not appear separately
on the income statement for manufacturing firms.
Leverage ratios
Debt refers to interest-bearing obligations, such as shortterm debt, bonds payable. Non-interest-bearing liabilities,
such as accounts payable, accrued liabilities, and deferred
taxes are not considered debt.
DB plan, pension expense
Under IFRS (SI),
1) Service cost and past service cost
2) Interest expense
Under GAAP (SIE),
1) Service cost
2) Interest expense
3) Expected return on plan assets
Reading 33 Financial Reporting Quality: Red

Flags and Accounting Warning Signs
Firms are motivated to overstate net income to:
1) Meet earnings expectations
2) Remain in compliance with lending covenants
3) Receive higher incentive compensation
Firms are motivated to understate net income to:
1) Obtain trade relief in the form of quotas or protective tariffs
2) Negotiate favorable terms from creditors
3) Negotiate favorable labor union contracts.
Page 91 of 154
CFI CFO.
Low quality earnings are the result of:
1) Selecting acceptable accounting principles that mispresent the
economics of a transaction.
2) Structuring transactions to achieve a desired outcome.
3) Using aggressive or unrealistic estimates and assumptions
4) Exploiting the intent of an accounting principle.
An example of high-quality earning:
Choosing a depreciation method that depreciates the asset at a
higher rate than the economic depreciation (and hence results in
lower earnings) is considered to be a more conservative
depreciation policy, and this choice implies higher earning quality.
Fraud triangle
1) Incentive or pressure
1.1
1.2
1.3
1.4
2) opportunity
2.1
2.2
2.3
2.4
3) attitudes or rationalization
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
Common accounting warning signs and methods for detecting each:
1) Aggressive revenue recognition
2) Different growth rates of operating cash flow and earnings
Cash flow earnings index = operating cash flow/net
income
3) Abnormal sales growth as compared to the economy, industry, or
peers
4) Abnormal inventory growth as compared to sales growth
5) Boosting revenue with non-operating income and
Page 92 of 154
nonrecurring gains.
In effect, move these items up the income statement
6) Delaying expense recognition
7) Abnormal use of operating leases by lessees compare with
industry peers
8) Hiding expenses by classifying them as extraordinary or
nonrecurring.
Move expenses down the income statement and boost income
from continuing operations.
9) LIFO liquidations
LIFO (last-in-first-out) liquidation is when a company sells more
inventory than it purchases over a period of time, assuming the
company is accounting for inventory using the LIFO method.
When companies purchase inventory at different cost levels, they
are required to account for each piece of inventory at that
purchase price. As companies reduce overall inventory levels,
older inventory costs flow to the income statement. Given the
usual inflationary environment (rising prices), these pieces of
older inventory will be sold at current prices (but listed at their
original cost), giving the company a higher margin of profit per
sale, skewing gross profit percentages.
A declining LIFO reserve (the difference between LIFO
inventory and what it would be under FIFO, which must be
disclosed by firms that use LIFO) is an indication of LIFO
liquidation. Firms should disclose the effects of LIFO liquidation
in the financial statement footnotes.
10) Abnormal gross margin and operating margin compared to
industry peers
11) Extending the useful lives of long-term assets
12)
Aggressive pension assumptions
13) Year-end surprise
14) Equity method investments and off-balance-sheet special
purpose entities
15) Other off-balance-sheet financing arrangements including debt
guarantees.
Reading 34 Accounting Shenanigans on the

Cash Flow Statement
Operating cash flow is usually unaffected by estimates and
judgments. However, firms can still create the perception that
sustainable operating cash flow is greater than it actually is.
Four ways to manipulate the cash flow statement
1) Stretching accounts payable
Days sales in accounts payable = (accounts payable / COGS) *
number of days COGS, purchase
2) financing accounts payable (reduce CFO as
payables are reclassified as short term debt)
Page 93 of 154
Such an arrangement allows the firm to manage the timing

of the reported operating cash flow.
3) Securitizing accounts receivable , CFO
The cash received from borrowing against accounts receivables
is CFF.
When receivables are securities, they are usually transferred to a
bankruptcy remote structure known as SPV. By securitizing its
accounts receivable, rather than waiting to collect from the
customer, a firm can accelerate cash flow into the current
period. Securitizing accounts receivable may also affect
earnings. The gain or loss is the result of differences between the
book value and fair value of the receivables at the time of
securitization. GAAP is silent on where the gains should be
reported.
4) Issuance of stock options
option , the issuing firm gets a tax deduction for that year
reflecting the difference between the strike price and the market
price of the option that will decrease cash taxes payable in that
period; operating cash flow is greater than it would have
been if cash compensation was paid instead;
5) Repurchasing stock to offset dilution due to the option exercises
(most buy backs occur in the open market and do not result in
any distortion of cash flows.)
The cash received from the exercise of the option and
cash expended by a company for the buyback of
corporate stock are both reported as CFF.
Consequently, as option exercises grow, so does the boost to
operating cash flows for the tax benefit, but the outflows for
stock buybacks to offset dilution of earnings are recorded in the
CFF.
tax benefits CFO, buy back cash
flow CFF.
For analytical purpose, the cash outflows for share repurchase
should be reclassified from CFF to CFO to better reflect the
substance of the transaction.
Reading 35 Financial Statement Analysis:

Applications
A forecast of future net income and cash flow often begins with a
forecast of future sales.
A typical assumption is non-cash working capital, as a percentage of
sales remain constant.
Credit analysts: Character, Collateral, and Capacity to repay.
Items use by Moody and Fitch:
1) Scale and diversification
2) Operational efficiency
3) Margin stability
Page 94 of 154
4) Leverage
Higher P/E ratio growth company higher MV relative to BV
Low Price-to-book or high dividend screen will likely include an
inordinate proportion of financial services companies.
Several adjustments to improve the comparability of firms financial
statements and ratios:
1) Investments in securities
2) Inventory accounting differences
The LIFO reserve, which all LIFO firms must report, can be used
to adjust LIFO cost of goods and inventory to their FIFOequivalent values.
Example: to adjust assets, add the LIFO reserve to current
assets; to adjust COGS, subtract the increase in the LIFO
reserve from COGS
3) Differences in depreciation methods and estimates
4) Off-balance-sheet financing
Debt ratios should include liabilities for both capital leases and
operating lease. The former is easy to get, but it is not easy to
estimate the PV of operating lease abilities.
5) Goodwill
For the company that has grown through acquisition:
5.1) Tangible assets will be recorded at fair value as the
acquisition date.
5.2) Identifiable intangible assets of the acquired units will
be valued at their acquisition cost.
5.3) Goodwill will be shown on balance sheet.
Two adjustments to goodwill:
5.4) Goodwill should be subtracted from assets when
calculating financial ratios.
5.5) Any income statement expense from impairment of
goodwill in the current period should be revered,
increasing net income.
6) Other tangible assets
Cumulative amount of any such upward revaluations should be
reduced from Equity. (Compare IFRS and GAAP firms)
Price to tangible book value (PTBV) removes both
goodwill and intangible assets from equity to get tangible
book value.
Pre- and post- acquisition financial statement may lack
comparability when the acquisition method is used.
The method combines fair value estimates of identifiable assets
with historical asset costs on the balance sheet and adds the
earnings of the purchased firm with no restatement of prior
results.
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Book 4 Corporate Finance, Portfolio

Management and Equity Investment
Reading 36 Capital Budgeting
The typical steps of capital budgeting:
1) Idea generation
2) Analyzing projects proposals
3) Create the firm-wide capital budget
4) Monitoring decisions and conducting a post-audit
Rescheduling and prioritizing projects is part of the step 3, not
the post-audit. The post-audit's purpose is to explain any
differences between the actual and predicted results of a capital
budgeting project. This process can aid in indicating systematic
errors, improve business operations, and provide concrete
ideas for future investment opportunities.
PI = 1 +
NPV
CF
Categories of Capital Budgeting Projects

1) Replacement projects to maintain the business (made without
detailed analysis)
2) Replacement projects for cost reduction (a fairly detailed
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analysis is necessary in this case)

3) Expansion projects (very detailed analysis)
4) New product or market development (very detailed analysis)
5) Mandatory projects (required by government agency
Insurance Company)
6) Other projects
or
5 key principles in capital budgeting ():

1) Decisions are based on incremental cash flows, not accounting
income. incremental cash flows. Sunk cost
(consulting fee) should not be included in the analysis.
When considering externalities ( ), the full
implication of the new project should be taken into account. The
negative externality is called cannibalization, which occurs when
a new project takes sales from an existing product.
Conventional cash flow pattern if the sign on the cash flows
changes only once; unconventional cash flow pattern has more
than one sign change.
2) Cash flows are based on opportunity costs.
3) The timing of cash flow is important.
4) Cash flows are analyzed on an after-tax basis
5) Do not consider financing costs specific to the project as
they are already reflected in the projects required rate of return. (
interest costs).
Payback period is useless as a measure of profitability, but is a good
measure of project liquidity. Discounted payback period must be
greater than the payback period without discounting; it addresses
one of the drawbacks by discounting the cash flows but still does
not consider any cash flows beyond the payback period, again it is a
measure of liquidity.
NPV rule project ,IRR
IRR IRR., NPV.
IRR project .
NPV reinvestment rate as the discount rate used to
calculate NPV ()
IRR reinvestment rate as IRR ()
NPV profile: the horizontal axis is cost of capital; the point at
which a profile crosses the horizontal axis is described as
IRR; the point at which a profile crosses the vertical axis is
described as the sum of undiscounted cash flows from a
project; the crossover rate is best described as the discount
rate at which two projects have the same NPV.
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cost of capital < crossover rate, NPV rule disagrees IRR

rule.
A positive NPV project should cause a proportionate increase in a
companys stock price.
Reading 37 Cost of Capital

WACC is also referred to as the marginal cost of capital (For a given
company, debt is generally less costly than preferred or common
stock).
, the cost of retained earnings, cost of
equity
WACC=wd k d ( 1t )+ w ps k ps +w ce k ce
The cost of preferred stock is: Kps = Dps / P
(Dps = the preferred stock dividend per share
P = the current preferred stock price per share)
3 Kce (cost of equity is equal to the rate of return required
by stockholders)
1) CAPM model
Rm
Kce = Rf +
- Rf) ( risk free rate Rate of return on
10-year Treasury bonds)

Pure-play method: to estimate project beta, begin with the beta of a
company or group of companies that are purely engaged in a
business similar to that of the project and are therefore comparable
to the project.
(,asset beta does not change with a higher D/E ratio, only
equity beta does)
1.1)
equity (,
index,
);
1.2)
1+(1-t)D/E ()
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asset ;
1.3)
1+(1-t)D/E ()
project ;
2) Kce = D1 / P0 + g (g = ROE * Retention rate)
3) Kce = long-term bond yield + risk premium
Based on priority, we should use:
1) Target capital structure
2) Current capital structure
3) Industry average structure
WACC is an upward line, Investment opportunity schedule (by order)
is a downward line, the intersect point is the optimal capital budget.
The intuition here is that the firm should undertake all those projects
with IRRs greater than the cost of funds.
WACC ,( WACC
) WACC .
Cost of debt is the market interest rate (YTM) on new (marginal)
debt, not the coupon rate on the firms existing debt.
Matrix pricing: if YTM is not available, the analyst may use the rating
and maturity of the firms existing debt to estimate the before-tax
cost of debt. If there is a covenant or seniority, we should make
adjustment; if firms employ floating-rate debt, we should estimate
the long-term cost of the firms debt using the current yield curve
for debt of the appropriate rating category.
CAPM Kce = Rf +
premium]
CRP=sovereign yield
Rm
- Rf) + country risk
spreadannualized stdev of equity index of developing country

annualized stdev of sovereignbond market in terms of thedeveloped market curren
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As a firm raises more and more capital, the costs of different

sources of financing will increase, which means it may be upward
sloping with respect to additional capital. The bottom line is raising
additional capital results in an increase in the WACC. ( capital
raised, WACC)
Break points occur any time the cost of one of the components of
the companys WACC changes.
Flotation costs
The correct way to account for flotation costs is to adjust the initial
project cost. .Floatation cost
WACC , cash outflow , NPV.
flotation cost tax-deductible , cash outflow (
)
Reading 38 Measure of leverage

Business risk is a combination of sales risk and operating risk.
Financial risk refers to the additional risk that the firms common
stockholders must bear when a firm uses fixed cost (debt, or longterm leases/debentures) financing.
DOL (measure operational risk)
Q(PV )
Salestotal variable costs
STVC
EBIT
=
=
=
salestotal variable costs costs

STVCF Q ( PV )F sales
Please note the DOL depends on the level of sales. Sales ,
,leverage .
DFL (measure financial risk)
Q ( PV )F
EBIT
STVC F
EPS
=
=
=
=
EBIT interest STVCFI Q ( PV )FI EBIT
No fixed costs, no operating leverage; no interest costs, no financial
leverage.
EPS
STVC
DTL =DOL * DFL =
=
SALES
STVCFI
The use of financial leverage increases the risk of default but also
increases the potential return for equity holders.
When it comes to breakeven, only consider fixed.
operating costs+ financing costs
Breakeven quantity of sales =
pricevariabe cost per unit
operating costs
Operating breakeven quantity of sales=
pricevariabe cost per u nit
Reading 39 Dividends and share repurchase

basics
Cash dividends (net effect is to transfer cash from the
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company to its shareholders, decrease cash/asset and

shareholders equity)
1) Regular dividends
2) Special dividends / extra dividends / irregular dividends
3) Liquidating dividends
1) Stock dividends are dividends paid out in new shares of stock
rather than cash. A 20% stock dividend means every shareholder
gets 20% more stock.
2) In a 3-for-1 stock split, each old share is split into three new
shares.
Stock dividends and stock splits create more shares but
dont increase shareholder value, they do not affect PE ratio.
3) Reverse stock splits: a company in financial distress whose stock
has fallen dramatically may declare a reverse stock split to increase
the stock price.
Above 3 ways have no effect on a companys leverage ratio
and liquidity ratio
They do not change the assets or equity, they merely change the
number of equity shares.
Declaration date ():
Ex-dividend date (SEC ): the first day a share of stock trades
without the dividends. (
,)
Holder-of-record date (): ,
Payment date
Share repurchase
1) Buy in the open market
2) Buy a fixed number of shares at a fixed price.
,the company may select a tender price or use a Dutch
auction to determine the lowest price at which it can purchase
the number of shares desired.
3) Repurchase by direct negotiation.
If the after-tax cost of debt used to buy back shares < earnings
yield, then EPS increases;
If the after-tax cost of debt used to buy back shares > earnings
yield, then EPS decreases.
If the repurchase price > BVPS (book value per share), then BVPS
decreases;
If the repurchase price < BVPS (book value per share), then BVPS
increases.
Book value = assets - liabilities
Because shares are repurchased using cash, a share repurchase
can be considered an alternative to a cash dividend as a way
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of distributing earnings to shareholders (exclude tax effect).
Reading 40 Working Capital Management

A companys primary sources of liquidity are the sources of cash it
uses in its normal day-to-day operations, such as cash balance,
short-term funds and cash flow management.
Secondary sources of liquidity include liquidating short-term or
long-lived assets, negotiating debt agreements, or filing for
bankruptcy and reorganizing the company.
Drags on liquidity () delay or reduce cash inflows, or increase

borrowing costs, such as bad debt and obsolete inventory.
Pulls on liquidity () accelerate cash outflows.
Operating cycle () days of inventory + days of
receivables
Cash conversion cycle is also called net operating cycle.
, excessive amount of investment in working
capital.
Accruals are paid at a later date, and depreciation is a noncash
expense, so both of them do not affect net daily cash position.
A company extends its trade credit terms by four days to all its
credit customers. The most likely effect of this change to the
company's credit customers is a four-day decrease in the
company's net operating cycle.
Terms of 2/10 net 60 mean that if the invoice is paid within 10
days, the company gets a 2% discount on the invoiced amount and
that if the company does not take advantage of the discount, the
net amount is due 60 days from the date of the invoice. (
10 2%, 60 )
credit sales
average receivables
365
BEY = HPY
t
360
MMY = HPY *
t
receivale=
Cost of trade credit =
1
1D
An extension of days payables may serve as an early warning of

Page 102 of 154
deteriorating short- term liquidity.

Sources of short term funding from banks
1) lines of credit ()
1.1 uncommitted line of credit ()
1.2 committed (regular) line of credit (,
overdraft lines of credit)
1.3 revolving line of credit ()
The bank may also have a Blanket Lien, which gives it a claim
to all current and future firm assets as collateral in case the
primary collateral is insufficient and the borrowing firm defaults.
2) Bankers acceptance (
), BA
3) Factoring ()
Smaller companies use collateralized loans, factoring, or loans
from non-bank companies as their sources of short-term
financing, .
Larger companies can take advantage of commercial paper
(interest rate lower than banks), banker's acceptances and
lines of credit.
It is often worth having slightly higher overall short-term funding
costs in order to have flexibility and redundant sources of financing.
purchase ,
Purchase = COGS + Ending Inventory Beginning inventory
Reading 41 the Corporate Governance of

Listed Companies
Corporate governance is the set of internal controls,
process, and procedures by which firms are managed.
The duty of the board is to act in the shareholders long-term
interests. A truly independent board will have the ability to hire
external consultants without management approval.
1) A majority of the board of directors is comprised of

independent members (not management)
2) The board meets regularly outside the presence of management
3) The chairman of the board is also the CEO or a former

CEO of the firm. This may impair the ability and willing ness of
independent board members to express opinions contrary to those
of management.
4) Board members are closely aligned with a firm supplier (,
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)
5) Independent board members have a primary or leading board
member in case where the chairman is not independent.
6) A board member of firm B who is a partner in an accounting firm
that competes with the firms auditor. ()
It is not clear whether it is better to have all members elected
annually (more flexibility to meet changes in the marketplace) or
whether it is better to have staggered board terms (better
continuity of board expertise, but make it more difficult for
shareholders to change the board of directors).
1) board
2) board member
3) the board investor
4) board
To be considered independent, a board member must not have any
material business or other relationship with:
1) The firm and its subsidiaries, including former employees,
executives, and their families.
2) Any entity which has a cross directorship with the firm.
3) Executive management and their families
4) The firms advisers and auditors
When evaluating the qualifications of board members, consider
whether board members:
1) Can make informed decisions about the firms future
2) Can act with care and competence as a result of their experience
3) Have other board experience
4) Regularly attend meetings
5) Have significant stock positions?
6) Have necessary experience and qualifications
7) Have served on the board for more than 10 years. ,
Audit committee, investor must determine whether (

):
1) The external auditor is free from management influence.
2) The audit committee has authority to approve or reject any
proposed non-audit engagements with the external audit firm.
3) All board members serving on the audit committee are
independent.
4) The audit committee controls the audit budget
Compensation committee, investor must determine whether:
1) The firm has provided loans or the use of company property to
board members
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2) Terms and conditions of options granted are reasonable.

3) Senior executives from other firms have cross-directorship links
with the firm or committee members. Watch for situation where
individuals may benefit from reciprocal decisions on board
compensation.
Nominations committee, investor must determine whether:
1) Criteria for selecting new board members
2) The process for finding new members
3) Succession plans for executive management
The ability to vote proxies is a fundamental shareholder right.
Investors should consider whether the firm:
1) Limit the ability to vote shares by requiring attendance at the
annual meeting
2) Groups its meetings to be hold the same day as other companies
in the same region and requires attendance to cast votes
3) Allows proxy voting by some remote mechanism
4) Is allowed to use share blocking (
)
Confidential voting ( minority group )
Cumulative voting is generally viewed as favorable for shareholders.
It enhances the likelihood that shareowners interests are
represented on the board. Information on possible cumulative voting
rights will be contained in the articles of organization and bylaws,
the prospectus, or Form 8-A.
Voting for other corporate change
Watch for changes to: poison pill provisions (
)
Investors should be able to review issues such as:
1) Share buy-back programs that may be used to fund share-based
compensation grants.
2) Amendments or other changes to a firms charity and bylaws.
3) Issuance of new capital stock.
Shareowner-sponsored Board Nominations
board member ( proxy
statement)
Shareowner-sponsored resolutions
Advisory or Binding shareowner proposals

board
Different classes of common equity (information can be found in
the proxy)
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Firms that separate voting rights from economic rights have

historically had more trouble raising equity capital for fixed
investment and product development than firms that combine those
rights.
Shareowner legal rights
Takeover defenses ()
1) Golden parachutes (senior management resigns)
2) poison pills ()
3) Greenmail ()
All above have probable effect --- decrease share values.
Reading 42 Portfolio Management: An

Overview
Portfolios reduce risk more than they increase returns. In other
words, they affect risk more than returns.
1) Individual investors
Below two have long investment horizons ( , ),
high risk tolerance, and little need for additional liquidity.
Endowment
Foundation
2) Banks keep risk low and need adequate liquidity to meet
investor withdrawals as they occur.
3) Life insurance companies have a relatively long-term
investment horizon, while property and casualty insurers have a
shorter investment horizon because claims are expected to arise
sooner than for life insurers.
4) Investment companies manage the pooled funds of many
investors.
5) Sovereign wealth funds refer to pools of assets owned by a
government.
Defined contribution pension plan: decisions are left to
employees, who assume all of the investment risks.
Defined benefit pension plan: the employer assumes the
investment risk. Although DB plans have a need for income, the
need for liquidity is low.
Steps in the portfolio management process:
Step 1 planning step: ,,,,benchmark.
IPS should be updated at least every few years and any time the
investors objectives or constraints changes significantly.
Step 2 Execution step: , top-down analysis;
, bottom-up analysis.
Step 3 Feedback step: rebalance
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Mutual funds are one form of pooled investments.

1) With an open-end fund (do not have brokerage fees), all
mutual funds charge a fee for the ongoing management of the
portfolio assets; no-load funds do not charge up-front fees or
redemption fees; load-funds charge either, or both.
2) With a closed-end fund, the shares of a closed-end fund trade
like equity shares. ,(actively managed).
Types of mutual funds
1) Money market funds
2) Bond mutual funds
3) Index funds
4) Actively managed funds have higher turnover portfolio securities,
which lead to greater tax liabilities compared to index funds.
Other forms of pooled investment (parallel to Mutual Funds)
1) ETFs track benchmark, special redemption provisions are
designed to keep their market prices very close to their NAVs.
ETF ,
ETF ;
ETF ,
ETF may produce less capital gains liability compared to
.
NAV , (NAV could differ
significantly due to imbalances between investor supply and
demand) ETF can trade at a premium or a discount.
2) A separately managed account
3) Hedge funds
3.1) Long/short funds
3.2) Equity market-neutral funds
3.3) Event-driven funds
3.4) Fixed-income arbitrage funds
3.5) Convertible bond arbitrage funds
3.6) Global macro funds
4) Buyout funds (private equity funds) buy entire public company
and take them private. Only make a few large investments,
increase cash flow ,pay down its debt, increase the value of its
equity, and then sell in IPO over 3 to 5 years.
5) Venture capital (do not typically restructure companies)
funds invest in companies in their start-up phase; invest in many
small companies, with the expectation that only a few will go to
IPO.
Both buyout funds and venture capital funds are very involved in the
management of their portfolio companies and often have expertise
in the industries on which they focus.
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Reading 43 Portfolio risk and return: Part 1

Gross return ,net return
Real return is nominal return adjusted for inflation. Because annual

inflation fluctuated greatly over the period, real return has been
much more stable than nominal returns.
A leveraged return refers to a return that is a multiple of the return
on the underlying asset.
The negative skew reflects a tendency towards large downsize
deviations, while the positive excess kurtosis reflects frequent
extreme deviations on both the upside and downside.
A risk-averse investor is simply one that dislikes risk (i.e., prefer less
risk to more risk). ,.
A risk-seeking investor prefers more risk to less. ,
.
A risk-neutral investor has no preference regarding risk and would
be indifferent between two such investments.
.
The lower the correlation of asset returns, the greater the risk
reduction benefit of combining assets in a portfolio. The desire to
reduce risk is what drives investors to invest in not just domestic
stocks, but also bonds, foreign stocks, real estate, and other assets.
1
U=E ( r ) A 2
2
Based on the function, a risk-free asset will generate a numerical
utility that is the same for all individuals. ,,
.
Utility function
A more risk-averse investor will have steeper indifference curves.

Combining s risky portfolio with a risk-free asset is the process that
supports the two-fund separation theorem. The line representing
these possible combinations of risk-free assets and the optimal risky
asset portfolio is referred to as the CAL.
CAL ,,CAL IC
.( total risk expected return)
annualized return ,
Real rate of return =
1+Geometric return
1+inflation rate
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Reading 44 Portfolio risk and return: Part 2

,each investor will have a different optimal risky asset
portfolio and a different CAL
,investors have homogeneous expectations and have the
same optimal risky portfolio and CAL. CAL CML.
total risk, efficient portfolio CML ; theoretically,
any point above the CML is not achievable and any point
below the CML is dominated by and inferior to any point on
the CML.
Unsystematic/unique/diversifiable/firm-specific risk
Systematic risk/non-diversifiable/market risk
Total risk = systematic risk + unsystematic risk
The riskiest stock, with risk measuring as standard deviation of
returns, does not necessarily have the greatest expected return.
, zero ,
.
Return generating models are used to estimate the expected returns
on risky securities based on specific factors.
Multifactor model: FAMA and French, estimated sensitivity of
security returns to three factors: firm size; firm book value to market
value ratio, and the market excess return.
Market model: Ri= i + i Rm + ei
i=
Cov (i . m)
2
m
i
m
SML , systematic risk --- Cov(i. m) , expected

2
return; m , i , CAPM (the relationship
between beta and expected return).
In CAPM world, all properly priced securities and portfolios of
securities will plot on the SML.
Remember, all stocks should plot on the SML ( CAPM
return SML ); any stock not plotting on the SML is
mispriced. If the estimated return plots over the SML, it is undervalued; if it plots under the SML, it is over-valued.
E ( Rm ) Rf
]
E ( Ri )=R f + i
The security market line is a graphical representation of the CAPM
with beta on the x-axis and expected return on the y -axis. The
slope of the line is given by the market risk premium.
Formally, the CAPM is stated as:
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The assumptions of CAPM are:

1) Risk aversion
2) Utility maximizing investors
3) Frictionless markets
4) One-period horizon
5) Homogeneous expectations
6) Divisible assets
7) Competitive markets
8) Security prices are not affected by investor trades
9) An investor can invest as much as he or she desires in any asset.
Based on total risk (based on CML):

1) The sharp ratio is its excess returns per unit of total portfolio risk.
Note sharp ratio is only useful when compared with the SR of
another portfolio.
2) The M-squared measure produces the same portfolio ranking as
the sharp ratio but is stated in percentage terms.
Based on beta (based on SML):
Treynor measure ( sharp ratio) and Jensens alpha ( Msquared)
If a single manager is used, then the total risk is relevant; if multiple
managers were used, then systematic risk would be more relevant.
Reading 45 Basics of portfolio planning and

construction
A written investment policy statement will typically begin with the
investors goals in terms of risk and return.
The major components of an IPS( 1, 7, 8 ):
1) Description of client circumstances and situation
2) Statement of the purpose of the IPS
3) Statement of duties and responsibilities of investment manager,
custodian of assets and the client
4) Procedures to update IPS
5) Investment objectives
6) Investment constraints
7) Investment guidelines, such as asset type permitted and
leverage to be used
8) Evaluation of performance, the benchmark
9) Appendices, strategic asset allocation, how and when the
portfolio allocations should be rebalanced
Absolute risk objective: a return of 3% more than the annual
inflation rate each year.
Relative risk objectives: no greater than a 5% probability of returns
more than 4% below the return on the MSCI World Index over any
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12-month period.
If the investors willingness to take on investment risk is high but
the investors ability to take on risk is low, the low ability to take on
investment risk will prevail in the advisers assessment.
,,.,
.
A written IPS is best seen as a communication instrument allowing
clients and portfolio managers to mutually establish investment
objectives and constraints.
Investment objectives:
1) Return requirements
2) Risk tolerance
Investment guidelines:
1) policies regarding permitted asset types and the leverage.
Investment constraints (RRTTLLU):
1) Risk
2) Return
3) Time horizon: the longer, the more risk and less liquidity
4) Tax situation: investors subject to higher tax rates may prefer
tax-free bonds to table bonds or prefer equities that are expected
to produce capital gains, which are often taxed at lower rate than
other types of income.
5) Liquidity: illiquid investments in hedge funds and private equity
funds are not suitable for an investor who needs access to the
funds.
6) Legal restrictions: corporate officers and directors face legal
restrictions on trading in the securities of the firms.
7) The unique constraints of a specific investor
Alternative investment asset class includes hedge funds of various
type, private equity funds, managed or passively constructed
commodity funds, artworks, and intellectual property rights.
1) Strategic asset allocation
2) Tactical asset allocation ( ,underweight or overweight)
tactical asset allocation allows actual asset allocation to
deviate from that of the strategic asset allocation of the
IPS. Tactical asset allocation attempts to take advantage of
temporary dislocations from the market conditions and
assumptions that drove the policy portfolio decision.
3) Security selection
Risk budgeting sets an overall limit for the portfolio and allocates a
portion of the permitted risk to the systematic risk of the strategic
asset allocation, the risk from tactical asset allocation, and the risk
from security selection.
Page 111 of 154
Core-satellite approach: ,
Reading 46 Market organization and

structure
The main function of the financial system:
1) Allow entities to save and borrow money, raise equity capital;
manage risks.
2) Determine the returns
3) Allocate capital
,,
.The shares of a closed-end fund trade at a premium or
discount to NAV.
Money markets refer to markets for debt securities with maturities
of one year or less.
Capital markets refer to markets for longer-term debt securities
and equity securities that have no specific maturity date.
1) Traditional investment markets refer to those for debt and
equity.
2) Alternative markets refer to those for hedge funds,
commodities, real estate, collectibles, gemstones,
leases, and equipment. Alternative assets are often more
difficult to value, illiquid, require investor due diligence, and
therefore often sell at a discount.
Debt securities are promises to repay borrowed funds.
Equity securities represent ownership positions.
Private securities are often illiquid and not subject to
regulation.
Bonds are generally long term; notes are intermediate term.
Commercial paper refers to short-term debt issued by the firm.
Government Issue bills and banks issue CDs.
Equity securities:
1) Common stock: common stock dividends are paid only after
interest is paid to debt holders and dividends are paid to
preferred stockholders.
2) Preferred stock is an equity security with scheduled dividends
that typically do not change over the securitys life.
3) Warrants.
Pooled investment vehicles
1) Mutual funds
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2) ETF, these funds are sometimes referred to as depositories, with

their shares referred to as depository receipts.
3) Asset-backed securities
4) Hedge funds are organized as limited partnership, with the
investors as the limited partners () and the fund
manager as the general partner ().
Currencies
Reserve currency: USD, EURO, GBP, JPY and CHF.
Real assets:
An investor may choose to invest through REIT (real estate
investment trust) or MLP (master limited partnership), or they can
buy the stock of firms that have large ownership of real assets.
Real assets are characterized by illiquidity. The heterogeneity (
) of real assets, their illiquidity, and the substantial costs of
managing them are all factors that complicate the valuation of real
assets.
Market maker:
1) Act as a broker to match buy/sell orders (stop buy/sell)
2) act as a dealer to provide liquidity
Broker ,.
Block brokers help with the placement of large trades, and they help
conceal their clients intentions so that the market does not move
against them.
Exchange provides a venue where traders can meet.
Alternative
trading
systems/electronic
communication
networks/multilateral trading facilities
ATFs that do not reveal current client orders are known as dark pool.
Dealers provide liquidity in the market and profit from the bid/ask
spread. Some dealers also act as brokers. As brokers, they should
seek the best prices for clients, but as dealers, their goal is
to profit through spreads.
Securitizations
The primary benefit of securitization is to decrease funding costs for
the assets in the pool.
Depository institutions
The equity owners of banks and brokers absorb any loan losses
before depositors and other lenders. The more equity capital an
intermediary has, the less risk for depositors.
Insurance company provides a benefit to investors by managing the
risks inherent in insurance: moral hazard, adverse selection,
and fraud.
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Arbitrageurs
More commonly, arbitrageurs try to exploit pricing differences for
similar instruments.
Clearinghouses and custodians
Clearinghouses limit counterparty risk. Custodians improve market
integrity by holding client securities and preventing their loss due to
fraud.
As a rule of thumb, hedgers must do in the futures market what
they must do in the future.
The repayment of the borrowed security or other asset is referred to
as covering the short position.
The short seller must pay all dividends or interests that the
lender would have received from the security that has been
loaned to the short seller. These payments are called
payments-in-lieu of dividend or interest.
Margin call price=P 0 (
1initial margin
)
1maintenance margin
In terms of bid/ask price, just remember the price you get will be the
one that is worse for you.
Execution instructions
1) Market order
2) Limit buy/sell
2.1) A limit buy order above the best ask or a limit sell order
below the best bid are said to be marketable or
aggressively priced;
2.2) If the limit price is between the best bid and the best ask, a
limit order is said to be making a new market;
2.3) A buy order with a limit price below the best bid is said to
be behind the market.
2.4) If a limit-buy order at the best bid, it is said to make the
market.
2.5) If a limit-sell order at the best bid, it is said to take the
market.
3) All-or-nothing orders execute only if the whole order can be filled.
4) Hidden orders are those for which only the broker or exchange
knows the trade size.
5) Iceberg orders, similar to hidden order but traders can also
specify display size.
Validity instructions
1) Day orders
2) Good-till-cancelled orders last until they are filled.
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3) Immediate-or-cancel (fill-or-kill) orders are cancelled unless they

can be filled immediately.
4) Good-on-close orders are only filled at the end of the trading day.
If they are market orders, they are referred to as market-on-close
orders. (Used by mutual funds as their portfolios are valued using
closing prices)
5) Stop loss order
Stop buy always buy at a price higher than market price, either
cover short or wait for confirmation.
Stop-sell orders execute when market prices are falling, while
stop-buy orders execute when the market is rising.
Clearing instructions
One important clearing instruction is whether a sell order is a short
sale or long sale.
1) Primary capital markets
1.1) seasoned offerings or secondary issues
1.2) IPO
2) Secondary financial market
Secondary markets are important because they provide liquidity and
price/value information.
Gathering indications of interest in bond issue is referred to as the
book runner.
Underwritten offering: the IB agrees to purchase the entire issue at
a price that is negotiated between the issuer and bank. If the issue
is undersubscribed, the IB must buy the unsold portion.
Best efforts basis: If the issue is undersubscribed, the IB is not
obliged to buy the unsold portion.
1) In a private placement, securities are sold directly to qualified
investors.
2) Shelf registration: a firm makes its public disclosures as in a
regular offering but then issues over time when it needs
capital and when the markets are favorable.
3) Dividend reinvestment plan allows existing shareholders to
use their dividends to buy new shares at a slight discount
4) Rights offering: existing shareholders are given the right to
buy new shares at a discount.
Call market: one single negotiated price is set that clears the
market for the stock. It is used in smaller markets but is also used to
set opening prices and prices after trading halts on major
exchanges.
Continuous markets: stock can trade any time the market is
open.
Market structure
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1) Quote-driven market/dealer markets/price-driven market/OTC

market
Most securities other than stocks trade in quote-driven
markets. Trading often takes place electronically.
2) Order-driven market
Exchanged and automated trading systems are examples of orderdriven markets. Two sets of rules in these markets ():
1.1 Firstly, order matching rules
,, give priority
to non-hidden orders and earliest arriving orders.
1.2 Secondly, trade pricing rules
Under the uniform pricing rule, under
the discriminatory pricing rule uses the limit price of the
order that arrived first as the trade price.
3) Brokered markets
Large block of stocks
Market information
Pre-trade transparent: investors can obtain pre-trade information
regarding quotes and orders;
Post-trade transparent: investors can obtain post-trade information
regarding completed trade prices and sizes.
Buy-side traders value transparency; dealers prefer opaque market
because transaction costs and bid-ask spread are larger in opaque
markets.
A well-functioning financial market fulfill the following:
1) Investors can save for the future at fair rates of return
2) Creditworthy borrowers can obtain funds
3) Hedgers can manage their risks
4) Traders can obtain the assets they need.
If markets can perform these functions at low trading costs, it is said
to be operationally efficient;
If security prices reflect all the information associated with
fundamental value in a timely fashion, it is said to be
informationally efficient.
Short sale 100 shares @42 (good-till-cancelled, stop 50, limit 55
buy), and then the maximum loss is 1300.
Reading 47 Security Market Indices
Price index price return

Return index total return (also includes dividends or interest
payments)
1) price-weighted index (DJIA Nikki 225)
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The return is just calculated from the change in average price

number of shares are same
for each underlying; split repurchase
adjust
Please see example below:
2) equal-weighted index (value line composite average Financial

Times Ordinary Share Index), which is the main situation when
it needs rebalancing
dollar amount . rebalance.
,.
The return of the equal-weighted index over a given period is
often calculated as a simple average of the returns of the index
stocks.
3) Market capitalization-weighted index (S&P 500)
split adjust
return market cap
4) Float-adjusted market capitalization index ,
total values of the shares that are actually available to the
investing public.
the relative impact of a stocks return
on the index increases as its price rises and decreases as
its price falls.
Most security market indexes are market capitalization-weighted
and often adjusted for the float (securities actually available for
purchase).
5) Fundamental weighting, these weights are unaffected by the
share prices of the index stocks. A fundamental-weighted index
will actually have a value tilt, overweighting firms with high
value-based metrics such as book-to-market ratios or
earnings yields. Portfolio weights will shift away from
securities that have increased in relative value.
Contrarian effect: (value-based matrix )
When a security is added to an index, its price tends to rise as

portfolio managers seeking to track that index in a portfolio buy the
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security.
Security market indexes have several uses:
1) Reflection of market sentiment
2) Benchmark of manager performance
3) Measure of market return and risk ( proxy)
4) Measure of beta and risk-adjusted return
5) Model portfolio for index funds
Equity indexes can be classified as follows:
1) Broad market index
2) Multi-market index (MSCI World Index)
3) Multi-market index with fundamental weighting
4) Sector index (provides a means to determine whether an active
investment manager is more successful at stock selection or
sector allocation, serving as the benchmark)
5) Style index (according to market capitalization, value,
growth), typically have high turnover of constituent firms than
broad market indexes
Market float represents shares available to the investing publics and
excluded shares held by controlling shareholders;
Free float is a narrower measure that also excluded shares that are
not available to foreign investors.
Fixed income indices
1) Large universe of securities. Unlike equities, bonds mature and
must be replaced in fixed income indexes. As a result, turnover is
high in fixed income indexes.
2) Dealer market and infrequent trading. Dealers primarily trade
fixed income securities, so index providers must depend on
dealers for recent prices, or they must estimate the prices of
constituent securities using the prices of traded fixed-income
securities with similar characteristics.
Illiquidity, transaction costs, and high turnover of constituent
securities make it both difficult and expensive for fixed income
portfolio managers to replicate a fixed income index.
Three of the most widely held alternative assets are commodities,
real estate, and hedge funds.
The issues in commodity indexes are:
1) Weighting method.
2) Futures vs. actual. Commodity indexes are based on the prices of
commodity futures contracts, not the spot prices of
commodities. Commodity futures contracts reflect the risk free
rate, changes in futures prices, and the roll yield.
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Real estate indexes (appraisal index, repeat sales index)

While real properties are quite illiquid, REIT shares trade like
common shares and offer very good liquidity.
Most hedge fund indexes equally weight the returns of the hedge
funds included in the index. A unique feature of hedge fund
indices is it is constituents of the index they determine them,
rather than index providers determining the constituents.
Reading 48 Market Efficiency

An informationally efficient capital market is one in which the
current price of a security fully, quickly, and rationally reflects all
available information about that security.
In a perfectly efficient market, investors should use a passive
investment strategy because active investment strategies will
underperform due to transaction costs and management fees.
The market value of an asset is its current price. The intrinsic value
or fundamental value of an asset is the value that a rational investor
with full knowledge about the assets characteristics would willingly
pay. ,
.
Factors that affect a markets efficiency
1) Number of market participants
2) Availability of information
3) Impediments to trading
4) Transaction and information costs
Technical analysis expects stock price to move in trends that
persist for long periods of time;
Fundamental analysis expect the price adjustments to be
more abrupt.
EMH (the stronger, the harder)
1) Weak formreflect past data information cant profit from
technical analysis
In the weak-form efficient market hypothesis, security prices fully
reflect all past market data including transactions by exchange
specialists.
Which of the following market anomalies is inconsistent with
weak-form market efficiency?
2) semi-strong form reflect public information cant profit from
fundamental analysis (,
)
Fundamental analysis facilitates a semi-strong efficient market
by disseminating value-relevant information. Fundamental
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analysis can be profitable in terms of generating abnormal

returns if the analyst creates a comparative advantage with
respect to this information. Such an advantage can be achieved
by doing a superior job of estimating the relevant
variables and predicting earnings surprises.
3) Strong formreflect both public and private informationcant
make any profit
Abnormal profit calculations are often used to test market efficiency.
An event study is one method of testing the semi-strong form. The
evidence in DM indicates that markets are generally semi-strong
form efficient. However, there is evidence of semi-strong form
inefficiency in some EM countries. Even if markets are semi-strong,
portfolio managers can add value by establishing and implementing
portfolio risk and return objectives and by assisting clients with
portfolio diversification, asset allocation, and tax management.
weak form, semi-strong form, strong
form.
Investigating data until a statistically significant relation is found is
referred to as data mining or data snooping. To avoid it,
1) Check if an economic basis exists
2) Run with out-of-sample data
3) Run in various sub-periods
1) Anomalies in Time-Series Data
1.1) calendar anomalies, , , tax-loss
selling, window dressing;
1.2) Overreaction and momentum anomalies
They violate the weak form because they provide evidence of
a profitable strategy based only on market data.
2) Anomalies in Cross-Sectional data
2.1) Size effect
2.2) Value effect. Value stocks (those with lower PE, lower
market-to-book, and higher dividend yields) have
outperformed growth stocks. This violates the semi-strong
form.
3) Other Anomalies
3.1) Closed-end investment funds
NAV , transaction costs.
3.2) Earnings announcements
The anomaly is that the adjustment process does not occur
entirely on the announcement day.
3.3) IPO
3.4) Economic fundamentals
: the majority of the evidence suggests that reported anomalies
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are not violations of market efficiency but are due to the

methodologies used in the tests of market efficiency.
The bottom line is investment management based solely on
anomalies has no sound economic basis.
Behavioral finance:
1) Loss aversion: investors dislike losses more than they like gains
of an equal amount. (, overreaction)
2) Investor overconfidence
3) Representativeness
Investors assume good companies or good markets are good
investments.
An investor assessing probabilities of outcomes depending on
how similar they are to the current state is called
representativeness.
4) Gamblers fallacy ()
Recent results affect investor estimates of future probabilities.
5) Mental accounting
Investors classify different investments into separate mental
accounts instead of viewing them as a total portfolio.
6) Conservatism (slow adjustments of security prices to new
information, information cascades (herding behavior, consistent
with investor rationality and improve market efficiency),
somewhat similar to investor herding behavior, a term to
describe trading that occurs in clusters and is not necessarily
driven by information)
7) Disposition effect
Investors are willing to realize gains but unwilling to realize
losses.
8) Narrow framing
Investors view events in isolation.
9) Confirmation bias
Looking for information that supports prior opinions and
decisions, which leads to a tendency to misvalue the stocks of
popular companies.
10)Escalation bias
Investors tend to invest more in money-losing investments for
which they feel responsible than they invest in an ongoing
successful investment.
11)Prospect theory
500 500
500
100
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The efficient market hypothesis only requires that the market is

rational (not the investor)
Reading 49 Overview of Equity Securities

Common shares:
1) Firms are under no obligation to pay dividends on common
equity.
2) Shareholders can vote by proxy.
A shareholder has 100 shares, and three directors will be elected.
Under statutory voting, the shareholder can vote 100 shares for his
director choice in each election;
Under cumulative voting, he has 300 votes, which can be cast for a
single candidate or spread across multiple candidates.
To conclude, cumulative voting makes it possible for a minority
shareholder to have more proportional representation on the board.
Callable common shares
Give the firm the right to repurchase the stock at a pre-specified call
price. Allow the firm to reduce its dividend payments without
changing its per-share dividend.
Putable common shares
Give the shareholder the right to sell the shares back to the firm at a
specific price.
Preferred stock
Preferred shares typically make fixed periodic payments to
investors and do not usually have voting rights.
Preferred stock is less risky than common stock because preferred
stock pays a known, fixed dividend to investors that are a large part
of the return.
1) Cumulative preference shares
Promised fixed dividends, and any dividends that are not paid
must be made up before common shareholders can receive
dividends.
2) Non-cumulative preference shares do not accumulate over
time when they are not paid, but dividends for any period
must be paid before common shareholders can receive
dividends.
3) Participating preference shares
3.1) Receive extra dividends if firm profits exceed
some certain level.
3.2) May receive a value greater than the par value of
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the preferred stock if the firm is liquidated.

3.3) Participating preference shares do NOT entitle the
shareholders to participate in corporate decisions
through voting rights.
4) Non-participating preference shares have a claim equal to par
value in the event of liquidation and do not share in firm
profits.
5) Convertible preference shares can be exchanged for common
stock at a conversion ratio determined when the shares are
originally issued. It has the following advantages (often used
to finance risky venture capital and private equity firms):
5.1) The preferred dividend is higher than a common
dividend
5.2) Convertible
5.3) The dividend is stable and they have priority over
common stock in receiving dividends and in the event of
liquidation of the firm.
5.4) Less price volatility than the underlying common shares
Information on the ownership and voting rights of different classes
of equity shares can be found in the companys filings with SEC.
Private equity ( ) is usually issued to institutional
investors via private placements.
Private equity has the following characteristics:
1) Less liquidity
2) Share price is negotiated between the firm and its investors
3) More limited firm financial disclosure
4) Lower reporting costs
5) Potentially weaker corporate governance
6) Focus on long-term prospects
7) Potential greater return for investors once the firm goes public
Three main types of private investments are venture capital,
leverages buyouts, and private investments in public equity.
1) Venture capital financing at various stages of a firms
development is referred to as seed or start-up, early stage, or
mezzanine financing ().
2) Leveraged buyout: if the buyers are the firms current
management, the LBO is referred to as a MBO.
3) Private investment in public equity (PIPE, ), a
public firm that needs capital quickly sells private equity to
investors. The investors can often buy the stock at a sizeable
discount to its market price.
Direct financing in the securities of foreign companies refers to
buying a foreign firms securities in foreign markets. Other methods
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are:
1) GDRs and ADRs, both are denominated in USD, but GDRs trade
outside of US while ADRs trade in the US. GDRs are not subject to
the capital flow restrictions.
2) GRSs traded in different currencies around the world (global
registered).
GRSs are identical shares of the same issuer that trade on
multiple global exchanges in the local currency.
3) BLDRs (basket of listed depository receipts) are an ETF that is a
collection of DRs.
DRs (depository receipts, ) represent ownership in a foreign
firm and are traded in the foreign markets in local currencies. Values
of DRs are affected by exchange rate change, firm fundamentals,
economic events and so on.
1) Sponsored DR: the firm is involved with the issue, provides the
investors the voting rights and is usually subject to greater
disclosure requirements.
2) Unsponsored DR: the firm is not involved with the issue. The
depository bank retains the voting rights.
Dividends on callable shares > non-callable shares > put-able
shares
The primary goal of firm management is to increase the book value
(retained earnings) of the firms equity and thereby increase the
market value of its equity, which reflects the expectations of
investors about the firms future performance.
ROE= (net income preferred dividends)/average book value
of common equity
A firm can issue debt to repurchase equity, thereby decreasing the
book value of equity and increase ROE.
Cost of equity: (very difficult to estimate, use CAPM model) can be
interpreted as the minimum rate of return required by investors to
compensate them for the risk of firms equity shares.
Reading 50 Introduction to Industry and

Company analysis
Industry rotation
In an active management strategy, investors engage in overweight
or underweight industries based on the current phase of the
business cycle.
Portfolio performance attribution, which addresses the sources of a
portfolios returns, usually in relation to the portfolios benchmark,
includes industry or sector selection. Industry classification schemes
Page 124 of 154
play a role in such performance attribution.

Firm Classification
1) A sector is a group of similar industries. Systems that are grouped
by products and services use a firms principal business activity
(the largest source of sales or earnings) to classify firms.
2) Firm can also be classified by their sensitivity to business cycles:
cyclical and non-cyclical firms.
Cyclical firms have high earnings volatility and high operating
leverage. ,,,,.
Non-cyclical firms include health care, utilities, telecommunications,
and consumer staples. defensive industries growth
industries. Defensive industries may not always be safe
investments.
3) Statistical method, groups firms that have had highly correlated
returns. The groups formed will have lower returns correlations
between groups.
Industry classification systems
Commercial classifications:
GICS (S&P and MSCI), Russell Global
Classification Benchmark (Dow Jones/FTSE)
Sectors
and
Industry
The broadest category is generally the sector level, then industry

and sub-industry level.
1) Consumer discretionary firms: automotive, apparel ( ),
hotels and restaurants
2) Consumer staples firms: food, beverage, tobacco and personal
care products.
3) Technology firms: software, consulting and services.
Government classifications
The main systems are:
1) International standard industrial classification of all economic
activities (ISIC)
2) Statistical classification of economic activities
3) Australian and New Zealand industrial classification
4) North American industry classification system (NAICS, updated
every 5 years)
Most governments do not identify individual firms in a group, so we
cannot know the groups exact composition.
Commercial providers identify the constituent firms.
Governments do not distinguish between small and large firms,
for-profit and not-for-profit organizations, or private and public firms.
Commercial providers only include for-profit and public firms.
A peer group is a set of similar companies an analyst will use for
valuation comparisons.
Page 125 of 154
Companies in the same peer group

1) Derive the revenue and earnings from similar business activities
2) Can have different valuations depending on structure and
competitiveness.
Steps to form a peer group:
1) Use commercial classification
2) Examine firms annual reports to see if they identify key
competitors
3) Examine competitors annual reports to see if other competitors
are named
4) Use industry trade publications to identify competitors
5) Confirm that comparable firms have similar sources of sales and
earnings
6) Adjust financial statements of non-financial companies for any
financing subsidiary data they include
Strategic analysis ()
1) Rivalry among existing competitors
2) Threat of new entrants
3) Threat of substitute products
4) Bargaining power of buyers
5) Bargaining power of suppliers
1) Barriers to entry: If the same firms dominate the industry today
as 10 years ago, entry is probably difficult. , firms have
little pricing power; , firms have greater pricing
power.
2) Industry concentration
3) Industry Capacity: higher unused capacity results in less
pricing power.
4) Market share stability: more stable markets indicate greater
pricing power.
High barriers to entry do not necessarily mean that firm pricing
power is high.
High industry concentration does not guarantee pricing power.
Pricing power is guaranteed by higher relative market share and
product differentiation.
5 phases of the industry life cycle
1) Embryonic stage: slow growth, higher prices, large
investment required, high risk of failure.
2) Growth stage: rapid growth, limited competitive pressure,
falling price and increasing profitability
3) Shakeout stage: growth has slowed, intense competition,
increasing industry overcapacity, declining profitability,
increased cost cutting, increased failures
4) Mature stage: Slow growth, high barriers to entry, stable
pricing, consolidation, superior firms gain market shares
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5) Decline
stage:
Negative
growth,
declining
prices,
consolidation
Test: An industry with high barriers to entry and weak pricing power
most likely has high barriers to exit.
A list of factors to be considered in industry analysis
1) Major firms
2) Barriers to entry and success
3) Industry concentration
4) Influence of industry capacity on pricing
5) Industry stability
6) Life cycle
7) Competition
8) Demographic influences (age distribution and population size)
9) Government influence (taxes and regulation)
10)Social influence (how people work, play, spend their money, and
conduct their lives)
11)Technological influence
12)Business cycle sensitivity
External factors on industry growth
1) Macroeconomic factors: education level
2) Technology
3) Demographic: age distribution, population size
4) Government: tax regulation
5) Social influence
Company competitive strategy:
1) Low-cost strategy (be able to finance the investment at a low
cost of capital.
Such as predatory pricing, the firm hopes to drive out
competitors and later increase prices.
2) Product/service differentiation strategy
Successful differentiators will have outstanding marketing
research teams and creative personnel
Which of the following has the lowest barriers to entry? A
A. Oil services
B. confections and candy
C. branded
pharmaceuticals
Reading 51 Equity valuation

An analyst will use more than one model with several different sets
of inputs to determine a range of possible stock values.
1) Discounted cash flow models
1.1) Dividend discount models (DDM)
Gordon growth model valuation (most suitable for valuing stable
D1
and mature, non-cyclical, dividend-paying firms): V 0=
K e gc
gc = (1-div payout ratio) * ROE
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Multistage Dividend Growth model: div n ,

n-2 , n-3 div , n-2
price value, n-1 dividend ( ,
ke)
1.2) Free cash flow to equity models (FCFE, in any case where
future dividends cannot be estimated with much confidence,
valuation based on FCFE is appropriate as long as growth rates of
earnings can be estimated)
FCFE = CFO Fixed Capital investment + net borrowing
2) Multiplier models
2.1) The ratio of stock price to fundamentals (P/E, use forward
earnings to calculate forward PE ratio)
Price multiples used for valuation include:
2.1.1) PE ratio
2.1.2) Price-sales ratio
2.1.3) Price-book value ratio (appropriate for firms that hold
primarily liquid assets, such as banks)
2.1.4) Price-cash flow ratio, where cash flow may be CFO or
free cash flow
Multiples based on comparable are grounded in the law of
one price and take into account historical multiple
values. ,P/E multiples based on fundamentals can be
based on the Gordon growth model, which takes into
account future expected dividends.
2.2) The ratio of enterprise value to EBITDA or revenue. (EBITDA
revenue , non-cash
revenues and expenses operating income may be used
instead of EBITDA)
EV can be viewed as what it would cost to acquire the firm:
EV=market value of common and preferred stock +
market value of debt - cash and short-term investments
( book value )
3) Asset based model
the MV of assetsthe MV of liabilities
Equity value =
shares
Discounted CF
Multiples based
on Comparable
Advantage
Widely accepted
1) Used in time series and
cross-sectional
comparisons
2) EV/EBITDA
are
independent of capital
structure
or
when
earnings are negative
Disadvantage
1) Inputs are estimated
2) Value
estimates
are
sensitive to input values
1) Lagging price multiples
reflect the past
2) Not comparable when
firms have different size
or products
3) Different
accounting
methods
Page 128 of 154
Multiples based
on
fundamentals
1)
2)
Asset-based
models (
1)
2)
3)
They
are
based
on
theoretically
sound
valuation models
They correspond to widely
accepted value metrics
intangible
asset (hard to
value ),
tangible assets,
when the firm cease to
operate
and
is
being
liquidated
value private
companies;
They are increasing useful
for valuing public firms that
report fair values
Very sensitive to the inputs

(especially
the
k-g
denominator)
1) MV are usually different
than book values
2) Assets can be difficult to
value during periods of
hyperinflation
Book 5 Fixed Income, Derivatives, and

alternative investments
Reading 52 Fixed-income securities: Defining
Elements
Bonds that have no maturity date are called perpetual bonds. They
make periodic interest payments but do not promise to repay the
principal amount.
1) Money market securities (US treasury bills, CP, CD, etc.)
Bonds with original maturities of one year or less
2) Capital market securities.
Bonds with original maturities of more than one year are referred
to as
A bond with a fixed coupon rate is called a plain vanilla bond or a
conventional bond.
Some bonds pay no interest prior to maturity and are called zerocoupon bonds or pure discount bonds.
A dual-currency bond makes coupon interest payment in one
currency and the principal repayment at maturity in another
currency.
A currency option bond gives bondholders a choice of which of two
currencies they would like to receive their payments in.
Pure-discount bond: the increase in the bonds value is treated as
interest income.
The provisions in the bond indenture (trust deed, ) are known
as covenants (only one element of bonds indenture) include:
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1) Negative covenants (prohibitions on the borrower to prevent the

issuer from taking actions that could reduce its ability to make
interest and principal payments; )
1.1) Restrictions on asset sales
1.2) Negative pledge of collateral
1.3) Restrictions on additional borrowing
1.4) Prohibit the issuer from investing in risky projects
2) Affirmative covenants (actions the borrower promises to perform;
)
2.1) Make timely interest and principal payments to
bondholders
2.2) Ensure and maintain assets
2.3) Comply with applicable laws and regulations
2.4) What the issuer intends to do with the proceeds from the
bond issue
1) , foreign bonds (
registered bond),
1.1) panda bonds
1.2) Yankee bonds
2) Eurobonds (Eurodollar bonds, Euro yen bonds):
(Eurobond) . Eurobond,
(Euro) ,, (
) (Eurobond).
(Bearer Bond),
,.Eurobonds are
typically subject to lower regulation than domestic and foreign
bonds.
3) Global bonds: A global bond is a bond that is issued in several
countries at the same time. A large multinational corporation
or sovereign entity with a high credit rating typically issues it. By
offering the bond to a large number of investors, a global
issuance can reduce borrowing cost.
Issuing entities: the credit quality can differ among related entities.
SPVs (bankruptcy remote vehicles, a separated legal entity, in
the case of bankruptcy, the SPV is unaffected because it is
not a subsidiary of the corporation and SPV can have a
rating as high as AAA): bonds issued by these entities (at a lower
interest rate than bonds issued by the originating corporation) are
called securitized bonds.
Covered bonds ( ): They offer better protection than
securitized bonds.
seniority, secured bonds ( ) > senior unsecured bonds
() > subordinated debt ()
Page 130 of 154
Debentures refer to unsecured debt in US and elsewhere, in UK

and other countries the term refers to bonds collateralized by
specific assets.
Traditional MBS had a couple of problems, the biggest of which was
their uncertain maturity, caused by the prepayment of principal. The
CMO was developed as a way to remedy this problem by setting up
tranches to sequentially retire the debt and redirect early principal
repayments to certain classes of investors.
Collateralized mortgage obligations (CMOs) are structured using
tranches that redistribute prepayment risk. Certain tranches are
protected from receiving early principal repayments.
Credit enhancement
1) Internal:
1.1) Overcollateralization
1.2) Excess spread
1.3) Divide a bond issue into tranches (waterfall structure)
2) External:
2.1) surety bonds (guarantee received from a third
party)
2.2) Bank guarantees
2.3) Letters of credit
Profits/losses from bond sales are considered capital gains
income, taxed at a lower rate than ordinary income.
Pure-discount bonds and other bonds sold at significant discount to
par when issued are termed original issue discount (OID) bonds. A
portion of the discount from par at issuance is treated as
taxable income each year. It also allows that the tax basis of the
OID bonds increased each year by the amount of interest income
recognized, so there is no additional capital gains tax liability
at maturity.
A typical bond has a bullet structure.
When the final payment includes a lump sum in addition to the final
periods interest, it is referred to as a balloon payment.
A loan structure in which the periodic payments include both
interest and some repayment of principal is called an amortizing
loan.
Sinking fund provisions provide for the repayment of principal
through a series of payments over the life of the issue. less
credit risk, ,,.
Several coupon structures besides a fixed-coupon structure
1) Floating-rate notes (FRN/ floaters)
The market rate of interest is called the reference rate. FRN may
have a cap (benefits the issuer) and floor (benefits the floor). An
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inverse floater (favored by investors who expect decline in

interest rate) has a coupon rate that increases when the
reference rate decreases and vice versa.
2) Step-up coupon bonds
The coupon rate increases over time according to a
predetermined schedule (protect against increase in market
interest rate). Have a call feature that allows the firm to redeem
the bond issue at a set price at each step-up date.
3) Credit-linked coupon bond
The coupon rate will go up by a certain amount if the credit
rating of the issue falls and vice versa.
4) Payment-in-kind (PIK) bond
Pay bond interest with more bonds. Typically they have higher
yields.
5) Deferred coupon bond (split coupon bond)
6) Index-linked bond
Coupon payments and/or a principal value are based on a
commodity index, an equity index.
7) Inflation-linked bonds (linkers)
7.1) Indexed-annuity bonds
7.2) Indexed zero-coupon bonds
7.3) Interest-indexed bonds
7.4) Capital-indexed bonds (TIPS, coupon rate remains
constant, but coupon payment changes with par value,
which
is
increased/decreased
by
the
rate
of
inflation/deflation)
7.5) Equity-linked notes (ETN)
8) Principal protected bonds: will not pay less than their original par
value at maturity
If market yields decreases, then the issuer will call the bond and
issue new bond at a lower yield. Three types of exercise fir callable
bonds:
1) American style can be called anytime
2) European style can only be called on the call date specified
3) Bermuda style can be called often on coupon payment dates
Contingency provisions in bond indentures are referred to as
embedded options.
Issuers introduce bonds with make-whole call provisions, which
actually penalize the issuer for calling the bond. (
), yield callable bond .
Convertible bonds: downside protection of a bond, but at a
reduced yield, and the upside opportunity of equity shares. Often
referred to as a hybrid security, part debt and part equity. Many
convertible bonds have a call provision, and then the issuers can
force bondholders to exercise their conversion option when the
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conversion value is significantly above the par value of the bonds.

(Par value < call price < conversion value)
Warrants give the holders the right to buy the common shares at a
given price over a given period of time. For a young firm, including
warrants makes the debt more attractive to investors.
Contingent convertible bonds (CoCos): Bonds convert from
bond to common equity automatically if a specific event occurs.
European banks issue CoCos to maintain specific levels of equity
financing, so if the banks equity capital falls below a given level,
they are automatically converted to common stock.
Reading 53 Fixed-income Markets: Issuance,

Trading, and Funding
Ratings above BBB or Baa3 (include BBB) are considered
investment grade bonds.
Municipal bonds are tax exempt and are sold with lower yields.
US treasury securities are sold through single price auctions with the
majority of purchases made by primary dealers.
The majority of bond trading in the secondary market is made in
OTC market.
Settlement occurs on
T+0 for some money market securities
T+1 for government bonds
T+3 for corporate bonds
Sovereign bonds are unsecured obligations of the national
government issuing the bonds; they are not backed by collateral,
but by the taxing authority of the national government.
Spot rates are market discount rates for a single payment to
be received in the future. The discount rates for zero-coupon
bonds are spot rates.
Agency or quasi-government bonds are issued by entities created by
national governments for specific purposes such as financing small
business or providing mortgage financing. In the US, bonds are
issued by government-sponsored enterprises (GSEs), such as
.
World Bank, IMF, and
supranational bonds.
the
Asian
Development
Bank
issue
Types of debt issued by corporations

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1) Bank debt
When the loan involves only one bank, it is referred to as a
bilateral loan; when several banks fund the loan; it is referred to
as a syndicated loan.
2) Commercial paper (short term, unsecured debt)
2.1) Interest is less than bank debt. Prices are quoted as a
percentage discount from face value (pure discount security),
while Euro Commercial Paper rates are quoted as an add-on
yield.
2.2) CP or ECP are negotiable, which means investors can buy or
sell on secondary market ( large institutional investors and
central banks).
2.3) ECP can be denominated in any currency, has maturity up to
1 year.
2.4) CPs are a source of funding working capital and also as a
source of interim financing for long-term projects until permanent
financing can be arranged. CP, has a maturity up
to 270 days, often maintains backup lines of credit with banks.
2.5) In order to get an acceptable credit rating, corporations
maintain backup lines of credit with banks. These are
referred to as liquidity enhancement or backup liquidity lines.
Bridge financing: debt that is temporary until permanent
financing can be secured.
3) Corporate bonds
An alternative to a sinking fund provision is to issue a serial bond
issue. The difference is that with a serial bond issue, investors
know at issuance when specific bonds will be redeemed.
For corporate bonds, maturities <5 y is short term; 5y-12y is
medium term; >12y is long term.
4) Medium-term notes (MTNs), can have fixed or floating coupons.
To combine the derivatives and notes is called a structured
security.
Short term funding for banks
1) Retail deposits:
1.1) Customer deposits, money market mutual funds and
savings accounts
2) Wholesale funds:
2.1) Nonnegotiable CDs cannot be sold and withdrawal of
funds often incurs a significant penalty.
2.2) Negotiable CDs can be sold, maturities < 1 year, large
denominations (>$1m)
2.3) Central bank funds markets
2.4) Interbank funds, unsecured
Repos
The interest cost of a repo is customarily less than the rate on bank
loans or other short-term borrowing.
The percentage difference between the market value and the
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amount loaned is called the repo margin/haircut. The repo margin is

lower when the collateral security is in high demand or low supply
(some lenders want to own specific bond or type of bond as
collateral.
3Y2Y: 2-year forward rate three years from now.
0y1y spot rate
(1+S 3 )3 =(1+0 y 1 y )(1+1 y 1 y)(1+2 y 1 y )
Reading 54 Introduction to Fixed Income

Valuation
Spot rates are the market discount rates for a single payment to be
received in the future.
Full price (dirty price) = flat price (clean price) + accrued interest
full price = PV * (1+coupon)days/360
coupondays
accrued interest
360
flat price = full price accrued interest
Bond dealers most often quote the flat/clean price, full price
.
In some situations, the maturity effect may not hold for a lowcoupon bond that is trading below par.
When calculating accrued interest (does not discount to its present
value), actual/actual method is used most often with government
bonds. The 30/360 methods are most often used for corporate
bonds. When calculating spreads between government bond yields
and the yield on a corporate bond, the corporate bond yield is often
restated to its yield on actual/actual basis.
Matrix pricing is a method of estimating the required YTM of the
bonds that are currently not traded or infrequently traded. The
benchmark rate is the YTM on a government bond with the
same, or similar time to maturity.
Street convention stated coupon dates
True yield actual coupon payment dates
Current yield =
annualcash coupon payment

bond price
The option-adjusted yield YTM , bond current flat

price + call option value.
Floating-rate note yield
1) Credit risk increases, quoted margin < required margin, the FRN
will sell at a discount to its par value
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2) Credit risk decreases, quoted margin > required margin, the FRN
will sell at a premium to its par value
3) Credit risk unchanged, quoted margin = required margin, the
FRN returns to its par at each reset date
required margin ,quoted margin coupon
Coupon rate = Libor + quoted margin
Appropriate discount rate = Libor + discount margin
Note that both Libor and the margins are quoted on an annual basis,
so if the bonds pay semiannually, they coupon rate should be
divided by 2.
Yields for Money market instruments
LIBOR and bank CD rates are quoted as add-on yields.
US T-bill is quotes as annualized discounts from face value based on
a 360-day year.
BEY is annualized add-on yield (365 days), the first step is always
calculate add-on yield = discount value / present value, then add-on
yield *365/360
The spot rate yield curve for US T-bill is also referred to as the zero
curve or strip curve. Yields on zero-coupon government bonds are
spot rates.
All bonds used to derive the par curve are assumed to have the
same credit risk, periodicity, currency, and liquidity, tax status and
annual yields. It can be viewed as the YTM of a par bond at each
maturity date.
Forward rates are yields for future periods. 3y2y is the 2-year
forward rate three years from now
1) A yield curve constructed from a sequence of yields-tomaturity on zero-coupon bonds is the spot curve.
2) A par bond yield curve is constructed from the spot curve. The
par curve is a sequence of yields-to-maturity such that each
bond is priced at par value.
3) The forward curve is constructed using a series of forward
rates, each having the same timeframe.
1) A yield spread relative to a benchmark bond is known as a
benchmark spread.
2) A yield spread over a government bond is known as a Gspread.
3) Yield spreads to swap rates are known as interpolated spreads
or I-spreads. I-spreads are frequently stated for bonds
denominated in euros.
G-spread I-spread spot yield curve is flat
. zero-volatility spread and option-adjusted
spread (used for bonds with embedded options)
4) The Z-spread is the constant yield spread over the benchmark
spot curve.
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5) OAS = z-spread option value (takes the option yield

component out of z-spread measure)
If it is a callable bond (option value is positive), then OAS is less
than z-spread
If it is a putable bond (or the option value is negative), then OAS
is larger than z-spread
Reading 55 Understanding Fixed-Income Risk

and Return
Short investment horizon: market price risk > reinvestment risk
Long investment horizon: market price risk < reinvestment risk
A bond held to maturity has no capital gain or loss. The
increase in value of a zero-coupon over its life is interest
income. For floating-rate security, if IR increases by 1%, the
change will be related to the securitys reset frequency.
Between coupon dates, the Macaulay duration of a coupon bond
decreases with the passage of time and then goes back up
significantly at each coupon payment date. Macaulay duration is a
weighted average of the times to the receipt of cash flow.
1) Approximate
modified duration (measure of yield duration)=
V 1V 2
2V 0 YTM
2) Effective
duration
(measure
of
curve
duration)=
V 1V 2
2V 0 curve
3) Modified Duration = Macaulay duration / (1 + YTM)
V 1 V 2
4) PVBP =
2
The price value of a basis point is the money change in the full
price of a bond when its YTM changes by 0.01%.
The pricing of bonds with embedded put, call or prepayment options
begins with the benchmark yield curve. The appropriate measure of
interest rate sensitivity of these bonds is effective duration.
Effective duration reflects only the sensitivity of the bonds value to
changes in the benchmark yield curve. Changes in the credit spread
are addressed with a separate credit duration measure.
An increase in a bonds YTM will decrease its interest rate
risk.
Adding either a put or a call provision will decrease a straight bonds
interest rate risk as measured by effective duration.
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Take a weighted average (by market value) of the durations of the

individual bonds in the portfolio duration. One limitation of this
method is that for portfolio duration to make sense the YTM of
every bond in the portfolio must change by the same amount.
Money duration = annual modified duration * full price of bond
position
Money duration per 100 units of par value = annual modified
duration * full bond price per 100 of par value
Convexity is a measure of the curvature of the price-yield relation.
V 1 +V 22 V 0
1) Approximate convexity =
2
V 0( YTM )
2) Effective convexity, like effective duration, must be used for
bonds with embedded options.
A bonds convexity is increased or decreased by the same bond
characteristics that affect duration. For two bonds with equal
duration, the one with cash flows that are more dispersed over time
will have the greater convexity.
Callable bond has negative convexity at a low yield;
Putable bond has less convexity at a higher yield.
The term structure of yield volatility refers to the relation between
the volatility of bond yields and their times to maturity.
1) When the investment horizon just matched the Macaulay
duration, the effect of a change in YTM on the sale price of a
bond and on reinvestment income just offset each other.
,market price risk and reinvestment risk offset each other.
Buy and hold: no capital gain (The redemption of principal
does not expose the investor to interest rate risk).
2) The difference between a bonds Macaulay duration and the
bondholders investment horizon is referred to as a duration
gap.
2.1) A positive duration gap (Macaulay duration >
investment horizon) exposes the investor to market
price risk;
2.2) A negative duration gap (Macaulay duration <
investment
horizon)
exposes
the
investor
to
reinvestment risk.
Bonds spread to the benchmark curve has two components:
1) A premium for credit risk (the risk to a bonds principal and
interests)
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2) A premium for lack of liquidity relative to the benchmark

If the bonds are sold prior to maturity, the capital gain or loss is
measured by comparing the price at which the bond is sold to the
carrying value (the original price plus the amortized amount of
discount or minus the amortized amount of the premium.
Tips:
1) capital gain/loss ,
2) five-year horizon yield annualized yield
Reading 56 Fundamentals of credit analysis

Credit risk: default risk + loss given default
1) Spread risk is the possibility that a bonds spread will widen
due to one or both of these factors. Bond prices are inversely
related to spreads; a wider spread implies a lower bond price
and a narrower spread imply a higher price.
2) Credit migration risk/downgrade risk
3) Market liquidity risk: greater for the bonds of smaller issuers
with relatively little publicly traded debt.
A bonds priority of claims to the issuers assets and cash flows is
referred to as its seniority ranking.
Generally the rankings are:
1) First lien or first mortgage
2) Senior secured debt
3) Junior secured debt
4) Senior unsecured debt
5) Senior subordinated debt
6) Subordinated debt
7) Junior subordinated debt
All debt within the same category is said to rank pari passu, or have
same priority of claims.
Senior lenders have claims on the assets before junior lenders and
equity lenders. However, by vote or by order of the bankruptcy
court, the final plan may differ from absolute priority.
Rating agencies rate both the issuer and the debt issues. Issue
credit ratings are called corporate family ratings, while issue-specific
ratings are called corporate credit ratings. The issuers are rated on
their senior unsecured debt.
S&P and Fitch rated default bond as D (C by Moodys). When a
company defaults on one of its several bonds, provisions in bond
indentures may trigger default on the remaining issues as well. Such
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a provision is called a cross default provision.

Notching is the practice by rating agencies of assigning different
ratings to bond of the same issuer. One of the factors they consider
is structural subordination (subsidiary is safer than the parent
company). A subsidiarys debt covenants may restrict the transfer of
cash or assets upstream to the parent company before the
subsidiarys debt is serviced.
For lower-rated issuers, higher default risk leads to significant
differences between recovery rates of debt with different seniority,
leading to more notching.
Risks in relying on ratings from credit rating agencies
1) Credit ratings are dynamic
2) Rating agencies are not perfect
3) Event risk is difficult to assess.
4) Credit ratings lag market pricing.
Market price reflects expected losses, while credit ratings only
assess default risk.
Components of 4Cs
1) Capacity (ability to repay)
1.1) Industry structure
1.2) Industry fundamentals
1.3) Company fundamentals
2) Collateral
2.1) Intangible assets, Patents are considered high-quality
intangible assets. Goodwill is considered a low-quality
intangible asset and is usually written down when company
performance is poor.
2.2) Depreciation
2.3) Equity market capitalization
2.4) Human capital and intellectual capital
3) Covenants
3.1) Affirmative covenants: pay interest, principal, and taxes;
carrying insurance on pledged assets; and maintaining
certain financial ratios within prescribed limits.
3.2) Negative covenants: restrict the borrower from incurring
additional debt or directing cash flows to shareholders in
the form of dividends and stock repurchases.
4) Character
Managements business qualifications and operating record
4.1) Soundness of strategy
4.2) Track record
4.3) Accounting policies and tax strategies
4.4) Fraud and malfeasance record
4.5) Prior treatment of bondholders
Page 140 of 154
Ratio analysis (part of capacity analysis)

1) Profit and cash flows
1.1) EBITDA
1.2) Funds from operations, similar to CFO except that FFO
exclude changes in working capital.
1.3) Free cash flows before dividend.
1.4) Free cash flows after dividend.
2) Leverage ratios
2.1) Debt/capital (capital = total debt + shareholders equity)
2.2) Debt/EBITDA
2.3) FFO/debt
3) Coverage ratio
3.1) EBITDA/interest expense. This is more often used than the
EBIT/interest expense ratio. This ratio will be higher than
EBIT/interest expense ratio
3.2) EBIT/interest expense (interest coverage ratio, also Times
interest earned ratio)
Yield spreads on corporate bonds are affected primarily by five
interrelated factors:
1) Credit cycle
2) Economic conditions
3) Financial market performance
4) Broker-dealer capital
5) General market demand and supply
Credit curves or spread curves show the relationship between
spread and maturity. Because longer maturity bonds tend to have
wider spreads, credit curves typically upward sloping.
Special considerations for high yield bonds:
1) Liquidity. Liquidity is critical for high yield issuers.
2) Financial projections
3) Debt structure
High yield companies for which secured bank debt is a high
proportion of the capital structure are said to be top heavy and
have less capacity to borrow from banks in financially stressful
periods. Companies that have top-heavy capital structures are
more likely to default and have lower recovery rates for
unsecured debt issues.
4) Corporate structure
5) Covenants
5.1) Change of control put. This covenant gives debt holders the
right to require the issuer to buy back debt in the event of
an acquisition.
5.2) Restricted payments. Limit the amount of cash that may be
paid to equity holders.
5.3) Limitations on liens
The covenant limits the amount of secured debt that a
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borrower can carry.

5.4) Restricted versus unrestricted subsidiaries. Restricted
subsidiaries cash flows and assets can be used to
service the debt of the parent holding company. This
benefits creditors of holding companies because their debt
is pari passu with the debt of restricted subsidiaries, rather
than structurally subordinated. Restricted subsidiaries are
typically the holding companys larger subsidiaries that
have significant assets.
Sovereign debt
Bondholders usually have no legal recourse if a national
government refuses to pay its debts.
Basic framework for evaluating sovereign credit rating:
1) Institutional effectiveness
2) Economic prospects
3) International investment position
4) Fiscal flexibility
5) Monetary flexibility
Credit rating agencies assign each national government two ratings:
1) A local currency debt rating
2) A foreign currency debt rating
Municipal Debt
Classified as general obligation bonds or revenue bonds
1) GO bonds are unsecured bonds backed by the full faith credit
of the issuing government entity, which is to say they are
supported by its taxing power.
2) Revenue bonds finance specific projects. Revenue bonds often
have higher credit risk than GO bonds because the project is
the sole source of funds to service the debt. A key metric for
revenue bonds is the debt service coverage ratio (DSCR)
Net Revenue( project)
DSCR=
required interest principal payments
Reading 57 Derivative Markets and

Instruments
A dealer market with no central location is referred to as an OTC
market. Some options trade in the OTC market, notably bond
options.
Forward commitments include forward contracts, futures contracts,
and swaps.
Forward contracts provide the obligation to do
something.
A contingent claim (options, credit derivatives) is a claim that
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depends on a particular event. It takes two options to replicate

a future or forward. Option sellers have an obligation to do
something while option buyers have the right to do something.
Main differences with forwards are futures are traded in an active
secondary market, are regulated, backed by the clearinghouse, and
require a daily settlement of gains and losses.
The option premium represents the value of the option, whereas
futures and forwards have a value of zero at the initiation of the
contract.
A swap is a series of forward contracts.
Credit spread option, typically a call option that is based on a bonds
yield spread against a benchmark. If its yield spread increases then
the bondholder will collect a payoff on the option.
Derivative market has greater liquidity than the underlying
market. Derivatives also have lower transaction costs and lower
capital requirements than the underlying.
Benefits of derivatives:
1) Provide price information
2) Allow risk to be managed and shifted among market participants
3) Reduce transaction costs
Arbitrage opportunities arise when assets are mispriced.
1) Law of one price
2) Two securities with uncertain returns can be combined in a
portfolio that will have a certain payoff.
Reading 58 Forward Markets and Contracts

At any point in time, including the settlement date, only one party to
the forward contract will owe money.
Deliverable forward contract
Cash settlement
A party to a forward contract can terminate the position prior to
expiration by entering into an opposite forward contract with an
expiration date equal to the time remaining on the original contract.
You can enter into the second (offsetting) contract with the same
party as the original contract.
The end user of a forward contract is typically a corporation,
government unit, or non-profit institution.
Dealers are often banks. Bid/ask spread is the dealers
compensation for administrative costs as well as bearing default risk
Page 143 of 154
and any asset price risk from un-hedged positions.

A forward contract on a stock index is similar except that the
contract will be based on a notional amount and will very likely be a
cash-settlement contract.
Equity forward contracts do not have a maturity date, while bonds
do, and forward bond contract must settle before the bond matures.
The price specified in forward contracts on coupon-bearing bonds is
typically stated as YTM as of the settlement date, exclusive of
accrued interest.
Eurodollar deposits are the term for deposits in large banks
outside the Untied States denominated in US dollars. The
lending rate on dollar-denominated loans between banks is
called LIBOR. It is quoted as an annualized rate based on a 360day year. In contrast to T-bill discount yields, LIBOR is an add-on
rate.
Euribor, established in Frankfurt, is published by the ECB.
A Forward rate agreement can be viewed as a forward contract to
borrow/lend money at a certain rate at some future date.
2x5 FRA means the contract will expire in 2 months and
using 3month LIBOR.
( notional principal )( floatingforward )(

payment the longat settlement=
1+ floating(
days
)
360
days
)
360
Days= number of days in the loan term (same as the number in

front of LIBOR)
FRAs for non-standard period (45-day FRA on 132-day LIBOR) are
termed off-the-run FRAs.
Reading 59 Future Markets and Contracts

The maximum price limits expand during periods of high volatility
and are not in effect during the delivery month. The exchange also
sets the trading times for each contract.
Uniformity promotes market liquidity.
Clearinghouse allows either side of the trade to reverse positions at
a future date without having to contact the other side of the
initial trade.
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In the futures market, both the long and the short investors deposit
margins.
1) Initial margin: performance bond ensuring fulfilling of
the obligation
2) In the futures contract account, maintenance margin requires
investors to bring the margin balance back up to the initial
margin requirements;
In the equity account, maintenance margin requires investors
only to bring the margin up to the maintenance level.
3) Variation margin. , maintenance
requirement ,.
In future contract, the short holds the right to make
decisions about when/where to deliver. The short initiate the
delivery process, and actual delivery typically can occur on
any business day of the delivery month.
The Fed sets initial and minimum margins in securities accounts;
The clearinghouse sets those in the futures markets.
The mechanism by which supply and demand determine this
equilibrium is open outcry at a particular location on the exchange
floor called a pit.
Marking-to-market is the process of adjusting the margin balance in
a futures account each day for the change in the value of the
contract assets from the previous trading day, based on the new
settlement price.
Four ways to terminate a futures contract:
1) Delivery (very rare), initiated by the short and the delivery can
take place any business day during the delivery month.
2) Cash-settlement contract
3) Make a reverse, or offsetting.
4) Exchange for physicals. The traders actually exchange the goods,
the contract is not closed on the floor of the exchange, and the
two traders privately negotiate the terms of the transaction.
Regular delivery involves only one traders and the clearinghouse.
You must then contact the clearinghouse and tell them what
happened.
Delivery options in futures contracts
These options can be of significant value to the holder of the short
position in a futures contract.
1) Treasury bill futures ( ) contracts are
based on a $1m face value 90-day T-bill and settle in cash.
The price quotes are 100 minus the annualized discount in
percent on the T-bills. If you short position and the T-bill price
increase then you make a loss (as normal).
Page 145 of 154
2) Eurodollar futures are based on 90-day LIBOR, which is an

add-on yield. The minimum price change is one tick, which is
0.01%. Long positions gain when interest rate decreases (as
normal).
The IMM index price for a Eurodollar future is 95.23, then the
annualized LIBOR rate is 4.77%, then the actual price is
$1m*[1-0.0477*(90/360)] = $988,075 (1 basis point = $25)
3) Treasury bond futures contracts are traded with maturities
greater than 15 years. Have a face value of $100,000, and
are quoted as a percent and fractions of 1% of face value.
Each bond is given a conversion factor (multiplied by the
future price to determine the delivery price).
4) Treasury notes coupon. Commercial paper
.
Stock index future -- Settlement is in cash and is based on a
multiplier of 250.
Currency futures-- Contracts are set in units of the foreign currency,
and the price is stated in USD/unit.
Reading 60 Option Markets and Contracts

After issuance, stock option contracts are adjusted for stock
splits but not cash dividends.
Most exchange-traded options have expiration dates within two or
four months of the current date. Exchanges also list long-term
equity anticipatory securities (LEAPS), which are equity options
with expiration dates longer than one year.
Most interest rate options are European options. If the rate is for less
than one year, the payoff is adjusted.
A long interest rate call combined with a short interest rate put can
have the same payoff as a long position in an FRA.
1) An interest rate cap is a series of interest rate call options,
having expiration dates that correspond to the reset dates on
a floating-rate loan. Caps are often used to protect a
floating-rate borrower from an increase in interest
rates. Caps pay when rates rise above the cap rate. A cap can
be viewed as a series of interest rate call options with strike
rates equal to the cap rate. Each option in a cap is called a
caplet.
2) An interest rate floor on a loan operate has just the opposite
effect of a cap. Each option in a floor is called floorlet.
3) An interest rate collar combines a cap and a floor. The issuer
of a collar long a cap and short a floor. The note issuer
receives a payment when rates are above the cap, and
makes an additional payment when rates are below the
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floor.
The payoff of a forward rate agreement is paid immediately when
the contract expires.
The payoff on interest rate options, the payment is made not at
option expiration, but at future date corresponding to the term of
the reference rate. For example, an option based on 90-day
LIBOR will make a payment 90 days after the expiration date
of the option.
An options intrinsic value is the amount by which the option is in
the money. Options are a zero-sum game.
Option value = intrinsic value( strike and stock price) +
time value
Option
Minimum value
Maximum
value
St
X
European
Ct max [ 0, S t
]
call
( 1+ RFR )T t
X
American
St
Ct max [ 0, S t
]
T
t
call
( 1+ RFR )
X
X
European
Pt max [0,
S t ]
T
t
put
(1+ RFR )
( 1+ RFR )T t
Ct max [ 0, XSt ]
American
X
put
S=underlying price
X=strike price
minimum ,maximum
365 .
Call prices are inversely related to exercise price
Put prices are directly related to exercise price
X
=S + P
( 1+ RFR )T
(This formula can be used to determine the effect of interest rate
change on an options price)
The options must be European-style and the puts and calls must
have the same exercise price for these relations to hold.
A fiduciary call is a combination of a pure-discount, riskless bond
that pays X at maturity and a call with exercise price X.
A protective put is a share of stock together with a put option on the
stock.
Put-call parity:
C+
For assets with positive cash flows over the term of the option, we
can substitute this (lower) net cost, S-PVCF.
Page 147 of 154
Reading 61 Swap Markets and Contracts

Swaps are agreements to exchange a series of cash flows on
periodic settlement dates over a certain time period. A swap has
zero value at the start of the contract.
The length of the swap is termed the tenor of the swap. A swap
can be decomposed into a series of forward contracts (FRAs) that
expire on the settlement dates.
Four ways to terminate a swap:
1) Mutual termination
2) Offsetting contract
3) Resale. This would be unusual as there is not a functioning
secondary market.
4) Swaption
1) Currency swaps
These settlement payments are both made. They are not netted
as they are in a single currency interest rate swap.
Steps (fixed-for-fixed currency swap):
1.1) Notional principal is swapped at initiation.
1.2) Full interest payments are exchanged at each
settlement date, each in a different currency.
1.3) Notional principal is swapped again at the termination of
the agreement.
2) Interest rate swaps
The plain vanilla interest rate swap involves trading fixed interest
rate payments for floating-rate payments. A basis swap involved
trading one set of floating rate payments for another.
Notional principal is generally not swapped in single interest rate
swaps.
Net interest is paid by the one who owes it.
At the conclusion of the swap, there is no transfer of funds.
Swaps are a zero-sum game.
3) Equity swaps
The return can be the capital appreciation or the total return
including dividends on the stock, portfolios, or index.
Equity swap payments can be floating on both sides and the
payments are not known until the end of the quarter. With
interest rate swaps, both the fixed and floating payments are
known as the beginning of period for which they will be paid.
Reading 62 Risk Management Applications of

Option Strategies
Write a covered call (long stock, sell call)
You feel the stock price will not go up any time soon, and you want
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to increase your income by collecting the call option premium. The

call writer is trading the stocks upside potential for the call
premium.
Protective put (long stock, long put)
A protective put is an investment manager technique designed to
protect a stock from a decline in value. It is constructed by buying a
stock and put option on that stock.
Reading 63 Introduction to Alternative

Investments
Alternative investments as a group have had low returns
correlations with traditional investments. Compared to traditional
investments, alternative investments exhibit:
1) Less liquidity of assets hold
2) More specialization by investment managers
3) Less regulation and transparency
4) More problematic and less available historical return and
volatility data
5) Different legal issues and tax treatments
Alternative investments
1) Hedge fund, they do not necessarily hedge risks as the name
imply.
2) Private Equity funds
3) Real Estate includes residential or commercial properties as
well as real estate backed debt.
4) Commodities
5) Other
Survivorship bias refers to the upward bias of returns if data only
for currently existing firms is included.
Backfill bias refers to bias introduced by including the previous
performance data for firms recently added to a benchmark index.
Hedge funds
Like Private Equity fund, hedge funds are typically set up as limited
partnership, with the investors as the limited partners. The
management firm is the general partner and typically receives
both a management fee based on the value of assets managed and
an incentive fee based on fund returns.
Restrictions on redemptions may include a lockup period and a
notice period. A lockup period is a time after initial investment
during which withdrawals are not allowed. A notice period, typically
30 to 90 days, is the amount of time a fund has after receiving a
redemption request to fulfill the request. Additional fees may be
charged at redemption.
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Fund of funds managers (provide more due diligence and

better redemption terms) charge an additional layer of fees
beyond the fees charged by the individual hedge funds in the
portfolio.
Strategy
1) Event-driven strategies
1.1) Merger arbitrage
1.2) Distressed/restructuring
1.3) Activist shareholders
1.4) Special situation
2. Relative value strategies
2.1) Convertible arbitrage
2.2) Asset-backed fixed income (exploit pricing discrepancies
among various MBS or ABS.
2.3) General fixed income
2.4) Volatility (exploit differences between returns volatility
implied by options prices and manager expectations of
future volatility).
2.5) Multi-strategy
3. Macro strategies
4. Equity hedge fund strategies
4.1) Market neutral (select undervalued/overvalued equities)
4.2) Fundamental growth (use fundamental analysis to find
high-growth companies).
4.3) Fundamental value (use fundamental analysis to find
undervalued companies)
4.4) Quantitative directional (use technical analysis)
4.5) Short bias
Hedge fund valuation
Hedge fund values are based on market values for traded securities
in their portfolios, but must use model values for non-traded
securities. Some funds calculate a trading NAV using such
adjustments for illiquidity. Trading NAV is different from the
calculated NAV required by accounting standards, which is
based on either market or model prices.
Private Equity
The majority of private equity invests either in private companies or
public companies they tend to take private, or in early stage
companies. Two smaller categories are distressed investment
funds and developmental capital funds.
Strategies
Leveraged buyouts, which means primarily bank debt, high-yield
bonds, or mezzanine financing funds the purchase of the portfolio
company.
Two types of LBOs (firms with high cash flow, low leverage and
Page 150 of 154
large amount of physical assets are attractive LBO candidates)

1) MBOs, in which the existing management team is involved in the
purchase
2) Management buy-ins (MBIs), in which an external management
team will replace the existing management team.
Venture capital funds invest in companies in the early stages of their
development. VC fund managers often sit on their boards or
filling key management roles.
Different company stages:
1) Formative stage
1.1) Angel investing, often the idea stage, the funds are used
for business plans and assessing market potential. The
funding source is usually individuals rather than VC funds.
1.2) Seed stage refers to the investments made for product
development, marketing and market research (
). This is typically the stage during which VC
funds make initial investments, through ordinary or
convertible preferred shares.
1.3) Early stage refers to investments made to fund initial
commercial production and sales ( ).
2) Later stage. Funds are used for expansion of production or
sales.
3) Mezzanine financing refers to capital provided to prepare the firm
for an IPO. Mezzanine financing refers to debt or preferred
shares that are subordinate to the high-yield bonds issued and
carry warrant or conversion features that give investors
participation in equity value increase.
Other strategies
1) Developmental capital / minority equity investing/ PIPE
2) Distressed investing
3) Investors often take an active role in the turnaround by working
with management.
Private Equity Structure and Fees
Private Equities are structured as limited partnership.
Management fees are typically 1% to 3% of committed
capital, rather than invested capital. This is in contrast to
hedge funds, for which the management fee is based on
invested capital. Incentive fees are typically 20% of profits, but
the fees are not earned until after the fund has returned
investors initial capital.
Private Equity exit strategies
The average holding period for companies in PE portfolio is 5 years.
1) Trade sale (sell to a competitor)
2) IPO
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3) Recapitalization
4) Secondary sale (sell to another PE firm)
5) Write-off/liquidation
PE portfolio company valuation
1) Market/comparable approach
2) Discounted cash flow approach
3) Asset-based approach
Real Estate
1) Residential property single family homes
2) Commercial property produces income
3) Mortgage loans
Forms of Real Estate investment
1) Residential property is a direct investment in real estate. Property
purchased with a mortgage is referred to a leveraged investment
and the owners equity is the property value minus the
outstanding loan amount.
2) Commercial real estate
Long time horizons, illiquidity, the large size of investment
needed, and the complexity of the investments make commercial
real estate inappropriate for many investors.
3) Real estate investment trusts
4) Timberland
5) Farmland
Three types of indices measure real estate performance:
1) An appraisal index ( , lowest standard deviation),
prepared by National Council of Real Estate Investment
Fiduciaries (NCREIF).
2) Repeat sales index (an example of sample selection bias)
3) REIT indices ()
3.1) Mortgage REIT does not invest in real estate directly. They
make real estate loans.
3.2) Equity REIT, invest directly in properties.
REIT index returns and global equity returns have had a relatively
strong correlation. The correlation between global bond returns
and REIT returns has been very low historically.
Real estate valuation
1) Comparable sales approach
2) Income approach
net operating income
( interesttax required rate of return )
capitalization rate
3) Cost approach
Commodities
Futures, forwards, options, and swaps; other methods of exposures
Page 152 of 154
to commodities include:
1) ETF
2) Equities that are linked to a commodity, one potential drawback
are the price movement of a stock and the commodity may not
be perfectly correlated.
3) Managed future funds
4) Individual managed accounts
5) Specialized funds in specific commodity sectors
Returns and sharp ratio for commodities has been lower than stocks
or bonds. Holding commodities can act as a hedge of inflation risk.
Spot prices for commodities are a function of supply and
demand.
Commodity futures price
= Spot price (1+RFR) + storage costs convenience yield
Convenience yield is the value of having the physical commodity for
use over the period of the future contract. (
)
Three sources of commodities futures returns are (no convenience
yield):
1) Roll yield, positive for a market in backwardation and negative for
a market in contango.
2) Collateral yield
3) Change in spot prices
Changes in the underlying commoditys price least likely to be
directly reflected in the returns of commodity index.
Other alternative investments
Rare wines, art, rare coins and stamps, valuable jewelry and
watches, and sports memorabilia
Hedge fund fees (2 and 20)
1) Management fee is based on invested capital, rather than
committed capital.
2) Incentive fee
A hard hurdle rate means incentive fees are earned only on
returns in excess of the benchmark.
A soft hurdle rate means that incentive fees are paid on all
profits, but only if the hurdle rate is met.
A high water mark
The incentive fee is not paid on gains just offset prior losses, thus
incentive fees are only paid to the extent that the current value is
above the highest value preciously recorded.
Investors in funds of funds incur additional fees from the managers
of the funds of funds. A 1% management fee and a 10% incentive
fee are charged in addition to any fees charged by the individual
Page 153 of 154
hedge funds within the fund-of-funds structure.

Key items for Due diligence for alternative investments
1) Organization
2) Portfolio management
3) Operations and controls
4) Risk management
5) Legal review
6) Fund terms
A+B , the most important factor is the average
covariance of C with the returns of A+B.
VaR and the Sortino ratio are measures of downside risk.
Page 154 of 154

CFA Level 1 Notes

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CFA Level 1 Notes

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CFA level 1 notes

Demand and Supply Analysis: Introduction...........29

Book 3 Financial Reporting and Analysis...........................69

Financial statement analysis: An Introduction.......69

Accounting Warning Signs.....................................................95

Book 4 Corporate Finance, Portfolio Management and Equity

Book 5 Fixed Income, Derivatives, and alternative

Reading 52 Fixed-income securities: Defining Elements........133

1) Understand and comply with all laws, rules, and regulations

Keep informed, regularly review written compliance procedures, maintain files

B. Independence and Objectivity

Protect integrity of options - reports should reflect unbiased opinion

1) Standard covers oral, written, or electronic communications

1) Firms can assist employees by providing written list of the firm's

D. Misconduct (Mummys rule)

Standard : Integrity of Capital Markets

Members in possession of nonpublic information that could affect an

impression of activity/price movement; gain dominant position in

Standard : Duties to Clients

Follow rules and laws

Vote proxies in best interest of clients and ultimate beneficiaries

2) Update information regularly

Do not misstate performance or mislead clients about investment performance

Consider audience sophistication when presenting performance

In some cases it may be required by law to report activities to relevant authorities

Standard : Duties to Employers

The member must not take records or files to a new

6.2) Not permitted for personal gain

B. Additional Compensation Arrangements (

, should decline supervisor responsibilities until

3) Should enforce non-investment rules as well (e.g. , mandatory vacations)

Standard Investment Analysis,

3) Establish due diligence procedures for judging if recommendation has met

B. Communication with Clients and Prospective Clients

Include basic characteristics of the security

Standard : Conflicts of Interest

1) Firm's compliance procedures should:

Standard : Responsibilities as CFA Institute

Reading 4 Introduction to GIPS

2) Primary purpose of verification is to provide assurance that

discretionary and non-discretionary portfolios in composites

Reading 5 The time value of the money

Loan amortization schedule:

Reading 6 Discounted Cash Flow Applications

Reading 7 Statistical Concepts and Market

Reading 8 Probability Concepts

The variance and standard deviation measure the dispersion, or

Reading 9 Common Probability Distribution

The 90% confidence level interval for X is

Lognormal has two features: positive skew; the price is bounded

Reading 10 Sampling and estimates

In stratified random sampling ( ), one divides the

Large sample (n>30)

unknown variance, t known variance, Z .

1) Data mining bias .

2) Sample selection bias , ,

Reading 11 Hypothesis Testing

Test statistics = (sample statistics hypothesized value)/Standard

Nonparametric alternatives to parametric tests

Reading 12 Technical Analysis

Triangles ( suggests buying and selling pressure

1) ascending price auction/English auction

There is no reason for a bidder to bid less than his reservation

We assume that the demand curve represents the marginal social

Producers often respond by reducing the quality of goods.

1.2) Price floor ( overproduction)

2) tax and trade restrictions, such as subsidies( ) and

As the elasticity of either demand or supply decreases, the DWL

Other factors affect demand elasticity

Reading 14 Demand and Supply Analysis:

2) Indifference curves are convex towards the origin. The slope of

Equilibrium bundle of goods ():

good and have an upward-sloping demand curve.

Reading 15 Demand and Supply Analysis: The

In a perfectly competitive market, an increase in supply by a single

Important relationships as shown in figure above: