CFA I: Quantitative Methods

Quantitative Methods Statistics Sampling Error is the difference between the observed value of a statistic and the quantity it is intended to estimate as a result of using subsets of the population. Standard Error measures how much inaccuracy of a population parameter estimate comes from sampling. Lower the standard error, lower the inaccuracy. Independently Distributed: Returns that are independently distributed do not affect each other. The past return cannot be used to predict a future return. Identically Distributed: The mean and variance of returns are identically distributed if their distributions are identical. Biased Estimator: Biased estimator is one that consistently gives results that are either higher or lower than the true value of the parameter you're trying to estimate. For example, you try to measure the average money people make, but the estimation is biased because it is consistently above or below the actual value. Bias can arise for various reasons, such as the sampling method used, the structure of the estimator formula, or the assumptions made during estimation. Central Limit Theorem: Random Sampling: The samples must be selected randomly from the population. This ensures that the sample is representative of the population and reduces the risk of bias. Finite Variance: The population from which the samples are drawn must have a finite variance. This ensures that the variability of the sample mean decreases as the sample size increases. Independence: The observations in the sample must be independent of each other. This means that the occurrence or value of one observation does not affect the occurrence or value of another. These assumptions allow the CLT to hold, stating that regardless of the shape of the original population distribution, the sampling distribution of the sample mean will tend to be approximately normally distributed as the sample size increases. **Having a normally distributed population is not a requirement for the CLT to hold true. Platykurtic (Thinner Tail): Relatively Flat / Sample Kurtosis < 0 Leptokurtic (Fatter Tail): Relatively Peaked / Sample Kurtosis > 0 Lognormal Distribution of stocks are Right-skewed (Positively Skewed) Lognormal distribution has been found to be a usefully accurate description of the distribution of prices for many financial assets, which includes stocks, which is why we use this lognormal distribution to model stock price. Sampling Systematic Sampling selects some starting point and then selects every kth element in the population. In Cluster Sampling, the population is divided into clusters, each of which is essentially a mini-representation of the entire population. It is useful for conducting a market survey. 𝑁 ∑ 𝐶𝑙𝑢𝑠𝑡𝑒𝑟 < 𝑇𝑜𝑡𝑎𝑙 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑖=1 Stratified Sampling is useful for creating a bond portfolio to mirror the performance of a specified index 𝑁 (Drawn from population). ∑ 𝑠𝑡𝑎𝑟𝑡𝑎 = 𝑇𝑜𝑡𝑎𝑙 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑖=1 A major difference between cluster and stratified random samples is that in Cluster Sampling, a whole cluster is regarded as a sampling unit and only sampled clusters are included. In Stratified Random Sampling, however, all the strata are included and only specific elements within each stratum are then selected as sampling units. Probability Sampling gives every member of the population an equal chance of being selected, creating a sample representative of the population. Therefore, it has a more representative sample than a non-probability sampling based on the sampler's judgment and convenience to access data. Jackknife is a resampling method in which samples are selected by taking the original observed data sample and leaving out one observation at a time, no replacement (Jackknife). As such, the samples are drawn without replacement. For a sample size of n, we need n repeated samples. This method can be used to reduce the bias of an estimator or to estimate the standard error and the confidence interval of an estimator. In the Bootstrap Resampling method, only one sample, not multiple samples, is taken from the population. The subsequent resamples are then taken from the original sample and not directly from the population. A computer simulation is then used to repeatedly draw random samples from the original sample with replacement. The resamples are then used to construct a sampling distribution. The number of repe ated samples to be drawn is at the discretion of the researcher. Furthermore, we can calculate the standard error of the mean. This is done by resampling and calculating the mean of each sample. The following formula is used to estimate the standard error and construct confidence intervals for the statistics of other population parameters, such as the median. The idea behind bootstrap is to mimic the process of performing random sampling from a population. The difference lies in the fact that we have no knowledge of what the population looks like, except for a sample with size n drawn from the population. The randomly drawn sample is treated as if it were the population. Tests Test statistic makes a statistical decision, deciding whether or not to reject the null hypothesis. A sample statistic, estimate a population parameter. Confidence Interval: Point Estimate ± Reliability factor × Standard error The better the fit of the regression model, the smaller the standard error of the estimate (se) and, therefore, the smaller standard error of the forecast. Smaller Standard Error will result in a narrower prediction interval. A larger variation of the independent variable will result in a narrower prediction interval. They will all lead to better fit regression lines. A smaller variation of the independent variable will result in a larger prediction interval. As Reliability Factor such as t-statistics increases, more likely it is to reject the null and the probability that the null hypothesis is true (the p-value) decreases. When the p-value is smaller than a predetermined significance level (often denoted as alpha, e.g., 0.05), we reject the null hypothesis in favor of the alternative hypothesis. Type 1 Error: Rejection null hypothesis actually true Significance Level: Probability of making a Type 1 error. Determine the rejection point (or critical value) Type II Error: Failure to reject the null hypothesis actually false Power of Test: Probability of correctly detecting a false null hypothesis; 1 - Type II Error. When analyzing differences between the variances of two normally distributed populations, the most appropriate test is F-test Non-parametric Tests When the data we use do not meet distributional assumptions (E.G sample too small) When there are outliers When the data are given in ranks or in ordinal scale When the hypothesis we are addressing do not concern a parameter Parametric Test of a correlation test if the two variables are normally distributed, we can test to determine whether the null hypothesis T-statistic (H0: ρ = 0) should be rejected using the sample correlation. In a test of independence based on Contingency Table Data, the nonparametric test statistic to be used is Chi-square distributed. Test the mean difference (paired comparisons test of dependent samples and unknown variance) between two normally distributed populations using dependent samples. If the population variances are unknown are down, the most appropriate hypothesis test is a paired comparisons t-test. Sign Test is most appropriate for testing mean differences (paired comparisons test of dependent samples and unknown variance) in nonparametric data. Wilcoxon signed-rank test is most appropriate for testing the significance of a single mean or mean differences (paired comparisons test of dependent samples and unknown variance) for nonparametric data. T-test with a pooled estimator of the common variance (Differences in Means) is used when it is reasonable to believe that the samples are from populations at least approximately normally distributed and that the samples are also independent of each other Mann–Whitney U-test is most appropriate for tests of differences in means for nonparametric data such as analysts’ rankings. Returns Time-weighted Return calculates multi-period cash flows mirroring a portfolio’s compound growth rate and neutralizes the effect of cash withdrawals or additions to the portfolio. For Money-weighted Return, amounts invested are cash outflows from the investor’s perspective and amounts returned or withdrawn by the investor, or the money that remains at the end of an investment cycle, is a cash inflow for the investor. The Real Risk-free Rate captures the time preference of individuals for current instead of future real consumption. If a Stock’s Continuously Compounded Return is normally distributed, then future stock price is necessarily lognormally distributed. For Target Downside Return, summation applies only to actual returns that are below target return. Roy’s Safety-First Criterion: Evaluate only downside risk; it focuses on shortfall risk, the risk that portfolio value will fall below some minimum acceptable level over some time horizon. Regression Assumptions of linear regression -​ X and Y share linear relationship -​ Independent Variable is (X) unrelated to error term (Residual) -​ Expected Value of Residual is 0 -​ Variance of the residual is constant -​ Residual term is normally distributed SSE: Sum of squared vertical distances between estimated and actual Y-values (Unexplained) SSR: Variation in the dependent variable (Explained) SEE: Standard Deviation of Residuals in the linear regression MSR/MSE (Explained/Unexplained): F-Statistics for ANOVA Table that assesses how well a set of independent variables, as a group, explains the variation in the dependent variable. Null Hypothesis for the F-test in a simple linear regression model; H0: b1 = 0. Ha: b1 ≠ 0; it tests whether the slope of a linear regression is not equal to zero. Prediction Interval: Predicted value of the dependent variable ± Critical t-value × Standard Error of Forecast. The better the fit of the regression model, the smaller the standard error of estimate (SE), and, therefore, the smaller standard error of the forecast. Indicator Variables (X_1,2): either 0 or 1 If independent and dependent variables are non-linear, we can transform one or both of these variables to convert into linear form. Dependent and independent variables do not have to be normally distributed. Other Interquartile Range (IQR) is the difference between the third quartile and the first quartile. Decile/Quintile are 10%/20%. Natural Language Processing (NLP) monitors analyst commentary to aid investment decision making; used to detect, monitor, and tag shifts in sentiment, potentially ahead of an analyst's recommendation change. It may also be employed in compliance functions to review employee voice and electronic communications for adherence to company or regulatory policy, inappropriate conduct, or fraud or for ensuring private or customer information is kept confidential. Text analytics involves the use of computer programs to analyze and derive meaning typically from large, unstructured text- or voice-based datasets. Data Science: Extract, process and visualize data; Capture/Curation/Storage/Search/Transfer Big Data: Volume, Velocity, Variety Robo-advisors are used to implement passive investment strategies with lower cost. Economics Business Cycle The Slowdown Phase is near the peak (decreasing in slope). For example, if the business cycle is in the slow down phase, lagging indicators will be going up. Lagging Indicator Consumer Price Index Inflation (Tends to follow a business cycle, increase as business cycle goes up but with lag) Inventory-Sales Ratio Average Duration of Unemployment Unemployment Rate (Business are slow to hire and fire) Prime Lending Rate Unit Labor Costs Ratio of Consumer Installment Debt to Income Coincident Indicator Industrial Production Index (Industrial Output) Employees on nonagricultural payrolls Manufacturing and Trade Sales Employee Productivity (Output per hours worked) Aggregate Real Personal Income Leading Indicator Stock Market Index Average weekly hours/Average weekly initial claims for unemployment insurance Widening Credit Spread between 10Y and Short Term Bond (Economic Upturn) Rising building Permit Monetary Policy An increase in the policy rates intends to put downward pressure on domestic inflation: 1)​ Discouraging spending and investment and so decreasing the domestic demand. 2)​ Strengthening domestic currency and so decreasing the external demand. Deflation is harder to control by monetary policy than inflation. When the demand for money is perfectly elastic (flatter slope), decreasing the policy rate (increasing the money supply) will not have an effect on the demand for money, resulting in a liquidity trap that is more likely to occur when there is deflation. Goals of the Central Bank are to stabilize price, exchange rates, attain full employment, retain sustainably positive economic growth, and maintain long-term interest rates. Neutral Policy Rate = Real Trend Growth + long-term growth rate that gives rise to stable inflation (Inflation Target) Essential qualities of Monetary Policy are Independence, Credibility, and Transparency. One way of establishing credibility is for a central bank to be transparent in its decision making. They will consider and outline their views on the following subjects, usually in this order: Broad money aggregates and credit conditions. The separation of control of the central bank from political influence refers to the independence quality of an effective central bank as opposed to transparency. The inflation target is associated with the independence of a central bank. Monetary Policy Tools include policy rate, reserves requirements, and Open Market Operations. Limitations of Monetary Policy is that decreasing short-term rate will increase long-term bond yields; the effect of monetary policy on long-term may be small, when money supply growth is seen as inflationary. Quantitative Easing is the targeted use of open market operations in which the central bank buys securities specifically targeted in certain markets, and increases money supplies. When Money neutrality holds, only prices would increase, whereas employment and output would not change. Fiscal Policy Discretionary Fiscal Policy With the objective of raising aggregate demand, the government can use discretionary fiscal policy action to voluntarily change government spending or tax rates, which are actively used to stabilize aggregate demand. The key difference between discretionary fiscal policy and automatic stabilizers is that the first does not automatically respond to the change in output, but to voluntarily increase the aggregate output. Government spending increases have a much bigger effect (six times bigger) on GDP than similar size social transfers because the latter are not considered permanent. Government Spending effect is very great. Automatic Stabilizers They are indeed automatic, not requiring the identification of shocks to which policy makers must consider a response. Unemployment benefits (social benefit through transfer payment) satisfy the definition of automatic stabilizer. For example, as an economy slows and unemployment rises, government spending on unemployment benefits will also automatically rise. Fiscal Spending Tools Government Spending (Capital + Current spending) has much large effect on Aggregate Demand, than on Transfer payments Current Spending: Purchase of goods. Capital Spending: Infrastructure Transfer Payments: Redistribute Wealth Change of government spending on Aggregate Demand equals Fiscal Multipliers times Change in GS **Spending Tools are most effective for affecting Aggregate Demand. Fiscal Revenue Tools Direct Taxes: Levied on income or wealth Indirect Taxes: levied on goods and services Change of Tax on Aggregate Demand equals Fiscal Multipliers X Change in Tax X MPC. **Tax reduction effect depends on the level of wealth, somewhat less effective than spending tools. **Indirect tax shows immediate reaction. Crowding-out Effect is an offset in aggregate demand when expansionary fiscal policy (government deficit such as more debt) raises interest rates and thereby reduces investment spending. Ricardian Equivalence states that a tax cut does not increase aggregate demand even in the short run, because people save money in anticipation of future tax increases. Recognition Lag: Time before government realizes that action is needed Action Lag: Time government takes to take action Impact Lag: Time the policy takes to have an impact. Government Debt is of less concern when most of the debt is owed internally to citizens, that is the government raises money to serve citizens. Under the assumption that wages and prices are rigid, Tight Fiscal Policy and Easy Monetary Policy, together, will stimulate the private sector, while shrinking the public sector. Competitions Market Structure Degree of Product Differentiation Perfect competition Homogeneous/standardized Monopolistic competition Differentiated Oligopoly Homogeneous/standardized Monopoly Unique product Short Run is the period over which some factors of production are fixed. Long run is the period over which all factors of production are variables, which means in the long run, only ATC (total cost) applies Perfect Competition Average Revenue = Average Total Cost; Break-even point Average Revenue < Average Total Cost; LR shutdown Average Revenue < Average Variable Cost; SR Shutdown In the short run, profit = ATC - P. In the long run Profit = AVC - P Firms under a perfect competition (model) have a well-defined supply curve. It has a horizontal demand curve. Profits are driven to the required rate of return paid by the entrepreneur to borrow capital from investors (normal profit or rental cost of capital). In the long-run, Marginal Cost (MC) schedule is the firm’s supply curve and the aggregate market’s equilibrium price dictates the firm’s demand curve. Therefore, the basic rule of profit maximization in the long-run for perfect competition is Aggregate Demand = MC. **The firm's supply curve should measure the quantity the firm is willing to supply at various prices. Imperfect Competition Total Revenue = Total Cost; Break-even point Total Revenue < Total Cost; LR shutdown Total Revenue < Total Variable Cost; SR shutdown Monopolistic Competition Firm’s under a monopolistic competition (model) does not have a well-defined supply curve. The appropriate level of price and output is determined by the information provided by marginal cost and revenue, whereby the optimal output* is at where marginal cost equals marginal revenue. In the short run, the P* and Q* is at MR = MC. Thus Profit = P - ATC. In the long run, profit equals zero, because P* = ATC at MR = MC. Thus, P - ATC = 0; Profit = 0 In the Oligopoly Model each firm faces a demand curve kinked at the currently prevailing price. A firm in an oligopoly market most likely faces a kinked demand curve when competitors match a price reduction and ignore a price increase. Stackelberg Model: Oligopoly model in which one firm sets its output before other firms do. The leader charges a higher price and receives a greater proportion of the market's total profit. Collusion: Joint Agreement to charge a given price. Price of Collusion will be higher than Price of Competition. Dominant Firm Model: A single firm has a significantly large market share due to its larger scale and lower cost structure. And they will produce more quantity of goods due to large market share. Cournot Model According to Cournot assumption, in oligopoly, each firm determines its profit-maximizing production level by assuming that the other firms’ output will not change; there is no need to guess what others will produce. The point at which average cost is minimum on LRAC is the Minimum Efficient Scale Herfindahl-Hirschman Index (HHI) is an index of market concentration found by summing the square of percentage shares of firms in the market. Disadvantages of concentration ratios: It tends to be unaffected by mergers among the top market incumbents. Barriers to entry are not considered. It does not directly quantify the market powers Geopolitics Globalization: The opportunity to generate higher profits may motivate companies to globalize. Through the process of greater economic and financial cooperation Companies may become dependent on other countries’ resources for their supply chains, thus not interdependence. Companies operating in lower-cost countries often operate in the local standards of those countries. Nationalization, the process of transferring an activity or industry from private to state control, is a non-cooperative approach to asserting economic control. Autarky(NG/NC): Describes countries seeking political self-sufficiency with little or no external trade or finance. Bilateralism (Not Global/Cooperative): The conduct of political, economic, financial, or cultural cooperation between two countries. Hegemony (Global/Not Cooperative): Tend to be regional or even global leaders, and they use their political or economic influence on others to control resources. Regionalism (Global/Cooperative): It is between Bilateral and Multilateral; in regionalism, two countries are cooperative and therefore global in some sense. Multilateralism (Global/Cooperative): Describes countries that participate in mutually beneficial trade relationships and extensive rules harmonization. Thematic risks are known risks that evolve and expand over a period of time, such as cyber threats, climate change, migration patterns and the ongoing threat of terrorism. Event risks evolve around set dates, such as elections, new legislation, or other date-driven milestones, such as holidays or political anniversaries; we know when they will occur. Exogenous Risk is a sudden or unanticipated risk such as sudden uprisings, invasions, or the aftermath of natural disaster. Signposts signal that the likelihood of an event increases/decreases, such as volatility indicators in financial markets. Tools of geopolitics are the means by which state actors advance their interests in the world, which include National Security Tools, Economic Tools and Financial Tools. International Trades Reasons for trade restrictions are to protect domestic infant industry and jobs and producers of goods needed for national security. When a country that is a price taker (a small country) imposes a tariff on an imported good, the local producers gain producer surplus, whereas consumers suffer a loss of consumer surplus by an increase in price of goods. The net welfare effect amounts to a deadweight loss. Similarly, Export subsidy for a normal good produced in a small country will increase the price of the good in the domestic market, because it gives incentive for sellers to shift their sales strategy to the international market. However, for a large nation, it may bring down the World Price, increasing welfare for everyone. Voluntary Export Restraint results in DWL equivalent to that for Quota captured by the government. FTA: Reduce or eliminate tariffs, quotas, and other trade barriers on most goods traded among them. Custom Unions: Free movement of goods and services, and common trade policy against non-members Common Market: Free movement of factors of production among members Economic Union: Coordination of economic policies beyond trade and factors of production. Monetary Union: Common Currency and Monetary Policy **Lower Trade Barriers > Trade Policy > Factors of Production > Economic Policy > Monetary Policy Dollarization is a use of the currency of another nation as its medium of exchange. In a Fixed Parity Currency Regime excess private demand for the domestic currency implies a rapidly growing stock of foreign exchange reserves, exerting inflationary pressure on the economy. Deficient demand for the currency depletes foreign exchange reserves and exerts deflationary pressure on the economy. Ideal International Currency Regime -​ Fully convertible -​ Fixed -​ Independent monetary policy If the exchange rate were credibly fixed, then any attempt to decrease default-free interest rates in one country below those in another—that is, to undertake independent, expansionary monetary policy—would result in a potentially unlimited outflow of capital because funds would seek the higher return. The primary determinant of the exchange rate in the short term is capital flows, because they adjust more rapidly than spending, savings, and asset prices. Currency Board Arrangement is an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. In Conventional Fixed Peg Arrangement, a country pegs its currency within margins of ±1% versus another currency or a basket that includes the currencies of its major trading or financial partners. In Crawling Peg, the exchange rate is adjusted periodically. In Managed Floating, the exchange rate is allowed to change (float) but also managed by governments via their buying and selling of particular currencies. In Independently Floating, the exchange rate is market determined. Objectives of capital flow restrictions are to reduce the volatility of domestic asset prices, maintain fixed exchange rates, keep domestic interest rates low, and protect strategic industries. Other Terms Nowcasting involves the use of techniques to estimate the present state. Operational Synchronization is a standard set for containers of uniform size and shape using multi-modal forms of transport. Regulatory Cooperation includes setting up regulatory bodies such as Basel Committee on Banking Supervision (BCBS). Process Standardization Includes establishing processes like Society for Worldwide Interbank financial Telecommunication. Portfolio Management Equity Return and Risks Distribution of Equity Returns is often positively skewed (Right-tailed). Risky stocks with high total risk do not necessarily produce higher return, when total risk consists mostly of unsystematic risk that can be reduced by diversification. The equally weighted portfolio's return is the same as the return on the randomly selected security. However, Equally weighted portfolio’s standard deviation is not equal to average standard deviation of return of randomly selected securities. Equally weighted portfolio offers a lower standard deviation of return than the average of those randomly selected securities due to the correlations between the individual securities. Return Generating Models Models that can provide an estimate of the expected return of a security given certain parameters and estimates of the values of the independent variables in the model. In a Multifactor Models, security returns respond to several systematic factors such as macroeconomic, fundamental, and statistical factors In the Statistical Factor Model, Historical and cross-sectional return data are analyzed to identify factors that explain variance or covariance in observed returns. However, data mining may generate many spurious factors that are devoid of any economic meaning. Fama and French proposed that three factors seem to explain asset returns better than just systematic risk. Those are 1) relative size, 2) relative book-to-market, and 3)the beta of the asset. Mark Carhart’s Four-factor model extended the Fama and French by adding another factor, momentum, defined as relative past stock returns. Fundamental Factors model analyzes and uses relationships between security returns and the company’s underlying fundamentals such as earnings growth, cash flows, and number of patents. Single-index Model is a model of stock allows the decomposition of total variance into systematic and nonsystematic variances Market model is a regression equation that specifies a linear relationship between the return on a security (or portfolio) and the return on a broad market index. Does not use any factor other than the market return Capital Market Theory In the Two-fund Separation Theorem, all investors will hold optimal risky assets and a risk-free asset because the risk-free asset has zero correlation with the risky asset. Capital Allocation Line could include a portfolio that is not fully diversified. In a Lending/Borrowing Portfolio, more burrowed, higher the return and risk in CAL and CML. Markowitz Efficient Frontier contains all portfolios of risky assets that rational, risk-averse investors will choose. For a given efficient frontier, a different risk free rate will result in a different tangent to the frontier, hence a different optimal risky portfolio; CAL(P) is the optimal capital allocation line, and P is the optimal risky portfolio in general. Tangency of Capital allocation line and the investor's Indifference curve indicates Optimal portfolio for that particular investor Portfolio Variance of equally weighted portfolio: As the number of assets in an equally weighted portfolio becomes large, the portfolio variance of returns approaches the average covariance between the individual assets; As N ~ Infinity, Var(P) = Average Covariance between the assets. Capital Market Line (CML) does not apply to all securities or assets, but only to portfolios on the efficient frontier, at which total risk equals systematic risk; therefore, CML consists only of portfolios that are fully diversified. Thus, the Total Risk equals Systematic risk. Capital Asset Pricing Model (CAPM) It is a model describing a relation between the beta (systematic risk) and expected return on a security that varies with respect to its beta. Security Market Line is used to describe such a relation. CAPM assumptions include Risk Aversion, Utility Maximizing, Frictionless Markets, One-period Horizon, Homogeneous Expectations, Divisible Assets, and Competitive Markets (Take price as given). Investors are price takers = Investors cannot affect price Investments are infinitely divisible = Can invest as much as he/she desires Investors plan for the same single holding period = Not unique period Equilibrium Return will depend only on its systematic risk, given that unsystematic risk can be eliminated for free through diversification. Security Characteristic Line (SCL) plots the excess return on security versus the excess return on the market, the intercept of which is Jensen’s alpha. Security Market Line (SML) is a line showing the range of expected return of a security with respect to systematic risk (Beta), where the slope equals market risk premium. SML applies to any/all security, efficient or not. We need to put more weight in the securities with higher Jesen’s Alpha to attain the highest risk-adjusted return. Therefore, the larger the information risk, the more valuable the securities will be. Portfolio Management The CEO and board remain responsible for determining the risk tolerance of the organization as a whole. The CRO, who will be hired by the CEO, will build and manage the risk framework of the organization and participate in strategic decision making for the organization. The Portfolio Approach provides investors with a way to reduce the risk associated with their wealth without necessarily decreasing their expected rate of return. Risk that can be attributed to factor(s) that affect a specific company or industry is best described as unsystematic risk. Compliance Risk consists of Tax risk, Regulatory and Accounting Risk. Portfolio Management Steps include Planning(Objective and Constraint/IPS), Execution (Construct a suitable portfolio based on the IPS) and Feedback. IPS (Example Structure) Introduction: Describes the client. Statement of Purpose: The purpose of the IPS. Statement of Duties and Responsibilities: Details the duties and responsibilities of the client, the custodian of the client’s assets, and the investment managers. Procedures: Explains the steps to take to keep the IPS current and the procedures to follow to respond to various contingencies. Investment Objectives: Explains the client’s objectives in investing. Investment Constraints: Presents the factors that constrain the client in seeking to achieve the investment objectives. Investment Guidelines: Provides information about how policy should be executed (e.g., on the permissible use of leverage and derivatives) and on specific types of assets excluded from investment, if any. Evaluation and Review: This section provides guidance on obtaining feedback on investment results. Appendices: (A) Strategic Asset Allocation and (B) Rebalancing Policy. Many investors specify a strategic asset allocation (SAA), also known as the policy portfolio, which is the baseline allocation of portfolio assets to asset classes in view of the investor’s investment objectives and the investor’s policy with respect to rebalancing asset class weights. This SAA may include a statement of policy concerning hedging risks such as currency risk and interest rate risk. Risk Measures Relative Risk For risk relative to a benchmark, the measure could be Tracking Risk, or tracking error, which is a relative risk measure. Absolute Risk LGD or Loss Severity measures how much we lose on average in such extreme cases as defaults on bonds. Value At Risk (VAR) is a minimum amount of loss at a certain probability. Conditional VAR (CVAR) is also the measurement to calculate the extreme loss. Organizations can modify their risk exposures by diversification, self-insurance, and risk transfers. Risk Shifting is a way to change the distribution of possible outcomes through derivative contracts. Stress testing examines the effects of change in key variables. Scenario analysis is what-if analysis of expected low with changes in multiple inputs. Financial Risks include Credit risk, Liquidity risk (Downward Valuation in Securities), and Market risk. Non-financial risks include Operational risk, Solvency risk, Tail risk, Regulatory risk, Accounting risk, Governmental risk, Legal risk, Model risk and Tax risk. Indifference Curve is a combination of risk and expected returns among which an investor is indifferent; more risk averse people have a flatter indifference curve. A risk-seeking investor would maximize return irrespective of risk; maximum for a given risk is good, but the higher return for a higher risk is better. Risk-neutral investors will look at expected payoff. A risk-averse investor prefers to minimize risks and require even higher return for higher risk. Even for a risk-seeking investor, an investment in a risk-free asset generates utility that is equal to the utility generated for a risk-averse investor. Investment Policy Statement (Planning Step) Risk Tolerance and Constraints Risk Management is a set of decisions that maximizes a company’s value while bearing a tolerable level of risk. Risk Governance is senior management’s determination of the risk tolerance, the elements of its optimal risk exposure strategy, and the framework for oversight of the risk management function. Risk Tolerance should determine what is acceptable and what is not and reflect both an “inside” view and an “outside” view. Risk Budgeting picks up where risk tolerance leaves off, focusing on how that risk is taken. It quantifies and allocates the tolerable risk by specific metrics; four well-known are Standard Deviation, Beta, Value at Risk (VaR), and Scenario Loss. Value at Risk is the minimum loss of X at Y% Investment Guidelines and Selection Criteria The Investment Guidelines section provides information about how policy should be executed (e.g., on the permissible use of leverage and derivatives) and on specific types of assets excluded from investment, if any. Monitoring and Review Procedures This section of IPS delineates the steps to take in order to keep the IPS current and the procedures to follow to respond to various contingencies. Statement of Duties and Responsibilities Details the duties and responsibilities to the clients, the custodian of the client’s assets, and of the investment managers. It covers the investment committee’s approach to appointing and reviewing investment managers for the portfolio, and the discretion that those managers have. Legal and Regulatory Constraints Include, for example, a company director’s restriction on trading the company’s stock shortly before the publication of financial results. Trading with material nonpublic information about a particular security is a legal constraint. In some countries, such institutional investors as pension funds are subject to restrictions on the composition of the portfolio. Pension funds also often face restrictions on the percentage of assets that can be invested in securities issued by the plan sponsor, so called self-investment limits Appendices (Asset Allocation Strategy) By combining a client’s investment objectives and constraints with long-term capital market expectation, the manager can strategically allocate funds to assets. Strategic Asset Allocation is, in other word, the result of a number of important investment principles, which include returns to groups of similar assets (long-term debts) predictably reflect exposures to certain sets of systematic factors (Inflation rates). The risk-return profile of a portfolio’s SAA is determined by expected returns, risks of the individual asset classes, and correlation between those asset classes. Portfolio Rebalancing is a process of restoring the portfolio’s original exposures to systematic risk factors according to rebalancing policy. Tactical Asset Allocation is the decision to deliberately deviate from the policy exposures to systematic risk factors with the intent to add value based on forecasts of the near-term returns of asset classes; Execution Step The next step, the execution step, is for the portfolio manager to construct a suitable portfolio based on the IPS of the client. It consists of first deciding on a target asset allocation, which determines the weighting of asset classes to be included in the portfolio. Risk management is an important part of the portfolio construction process. This step is followed by the analysis, selection, and purchase of individual investment securities. When defining Asset Classes, an asset class should contain relatively homogenous assets and thus paired correlations of assets within an asset class should be relatively high. Security Selection is an attempt to generate higher returns than the asset class benchmark. Smart Beta Strategies (active) features somewhat higher management fees and higher portfolio turnover relative to passive market-cap weighted strategies Feedback Step Performance Evaluation is analysis of the risk and return of the portfolio. Attribution Analysis compares the portfolio return with benchmark return like S&P 500. ESG Consideration Negative screening is the practice of excluding certain sectors or excluding companies that deviate from accepted standards or norms. Positive Screening is investing in companies that have positive ESG practices. Thematic investing focuses on investment in objectives, themes, and trends that relate positively to ESG issues. In Impact Investing, an investment is selected primarily on its expected social or environmental benefits with measurable investment returns. Shareholder engagement/active ownership is the practice of entering into a dialogue with companies (including with respect to ESG issues). With shareholder engagement, clients and investment managers have to be clear with each other about the exercise of voting rights, filing shareholder proposals or entering into conversations with company management. Alternatively, the client may instruct some proxy agent to vote on its behalf and according to its own stewardship policies. Stranded asset risk refers to carbon-intensive assets that are at risk of no longer being economically viable because of changes in regulation or investor sentiment and would most likely apply to the energy sector. Benefits Plans In a Defined Contribution Plan, employers make periodic contributions each period to employees’ accounts. Defined Benefit Pension Plan, the firm promises to make periodic payments after retirements. University endowment funds: high tolerance for risk Defined benefit pension plans: high tolerance for risk Property and casualty insurance companies: lowest tolerance for risk Funds Mutual Funds is a form of pooled investment, in which each investor owns shares representing ownership, NAV. ETF: Structured as open-end. Lower minimum requirement than Open-end Mutual Funds. Prices are determined interday and can be settled at a price different from the NAV. Dividends are paid out to the shareholders Open-end Mutual Funds: Accept new investment. Higher fund requirement than ETFs. Prices are determined once a day and must be adjusted to the NAV. Open-Ends funds have more pressure to liquidate assets than closed-end funds because they have to manage more cash inflows and outflows. Closed-end Mutual Funds: Received no new investment. Do not have to redeem once initial investors are redeemed with NAV. Cognitive Errors Belief Perseverance is an irrational reluctance to change prior conclusions and decisions. Market participants fail to change an initially held view even when new information becomes available due to Conservatism Bias Confirmation Bias refers to the tendency to look for and notice what confirms prior beliefs and to ignore or undervalue whatever contradicts them. Refer to analyzing an individual member of the population without adequately considering the characteristic of a population due to Representative Bias - Base-rate Neglect and make a classification based on a small data sample due to Representative Bias - Sample-size neglect. Believe they can control or affect outcomes when they cannot due to Illusion of Control. Hindsight bias refers to believing past events as having been predictable and reasonable to expect. People tend to remember their own predictions of the future as more accurate than they actually were because they are biased by the knowledge of what actually occurred. Processing error occurs when information analysis is flawed. Base expectations on a prior number and overweight its importance due to Anchoring and Adjustment. View money in different accounts due to Mental Accounting. The way a question is phrased can influence the answer given is a Framing Bias. Emotional Bias Feel more pain from a loss than pleasure from an equal gain due to Loss-aversion. Overestimate their abilities due to Overconfidence. Individuals lack self-discipline and favor short-term satisfaction due to lack of Self-control. Feel comfort with an existing situation causes an individual to be resistant to change due to preference with Status Quo. Assets feel more special, because they are Endowed. Do nothing out of fear that actions could be wrong and will Regret the choice. Market Anomalies Anomalies in returns are results that do not fit the prevailing model of securities risk and return. Market Inefficiencies are anomalies that present opportunities to earn positive risk-adjusted returns. Possible explanations for the cause of “market bubbles” are Overconfidence/Self-attribution/Confirmation Bias/Anchoring/Fear of Regret. The Halo effect is a type of representative bias, in which a company's fast growth and rising prices leads to the conclusion that it’s a good stock to own. Corporate Issuer Corporate Structure Corporation is a legal entity separated from its owners and managers; Articles of Incorporation identify the characteristics of a corporation. Similar to Limited Liability Partnership (LLP), owners in a Corporation (and US LLC) have limited liability, and do not share all risk and business liability. The separation between ownership and management allows corporations to access capital more easily than other business structures. In Limited Liability Partnership (LLP), a General Partner is not required, and all the partners are Limited Partners. In a Limited Partnership (LP), general partners (GP) operate the business, having unlimited liability, while limited partners (LPs) have no control over business operation and thus limited liability (Hedge Funds and PE). Shares of Public Corporations are sold publicly, while shares of Private Limited Company have limited number of shareholders and restrictions on transfer of shares. General Partnerships have a small number of partners who establish the business by contributing equal amounts of capital. A key feature of general partnerships is that partners share all risk and business liability. Board of directors are responsible for hiring the senior managers who operate the company. Coroporate’s CEO is hired by the board and responsible for implementing the strategy under the oversight of the board of directors. Staggered boards provided continuous implementation of strategy and oversight without constantly being reassessed by new board members. In a one-tier structure, both inside and independent directors serve on a single board, whereas in Two-tier structure, independent directors serve on supervisory boards that oversee a management board comprising inside directors. Contract Manufacturers produce goods to be marketed by others. Licensing arrangement includes manufacturing and selling a product using other brand names, paying loyalty. In the Franchise Model, a subsidiary (franchisee) has a tightly defined and exclusive relationship with the parent company. Supply Chain includes all the steps involved in producing and delivering a physical product to the end customer. Value Proposition refers to the product or service attributes valued by a firm’s target customer that lead those customers to prefer a firm’s offering over those of its competitors, given relative pricing. Value propositions vary greatly and relate to pricing relative to competitors. Value Chain is the systems and processes within a firm that create value for its customers. It provides a link between the firm’s value proposition for customers and its profitability. It involves identifying the specific activities carried out by the firm. Shareholder activists may pursue additional tactics, such as shareholder derivative lawsuits, which are legal proceedings initiated by one or more shareholders against board directors, management, and/or controlling shareholders of the company. In a Proxy Contest, shareholders are persuaded to vote for a group seeking a controlling position on a company’s board of directors Hostile Takeover is an attempt by one entity to acquire a company without the consent of the company’s management. Anti-takeover measures, such as. a shareholder rights plan (also known as a poison pill), reduces the likelihood of an unwanted takeover. Conflict of Interest Stakeholder Management - Managing those around the company​ Corporate Governance is a system of internal controls and procedures to manage a company. Agency costs arise from conflicts of interests. The relationship between shareholders and directors is an example of Principal-agent relationship, whereby shareholders are principals who elect directors (agents) who are expected to protect shareholders’ interests by appointing senior managers to run the company. Cost of asymmetric information arises from the fact that managers know more than analysts do. Level of Information Asymmetry: Bank > Private Debt Holders > Public Debtholders The Free Cash Flow hypothesis suggests that less free cash flow, and more debt financing reduce agency costs, because managers cannot use free cash flow for their own benefits. If the Executive Remuneration Plan only includes cash, executives may not align their interests with those of shareholders. Entrenchment: Tenure too long leading to create conflict of interest; less conflict of interest Empire building: when director and management compensation are high and tied to the size of the business, leading to aggressive M&A Excessive Risk Taking: Motivate risk-taking behavior by management, since option holders participate only in upside share price moves Pecking Order Theory suggests Internally Generated Capital > Debt > External Equity are preferred by the management in this order. From the perspective of a corporate issuer, debt is riskier than equity, because issuers have to pay debt holders before they pay shareholders. Equity is riskier than debt as debt investors have priority claims on a firm's assets and cash flows to shareholders. Shareholders have claims to net assets of the corporation after all liabilities have been settled. While shareholders have the right to receive dividends, the corporation is not required to pay dividends. Whereas, a corporation must pay its interest payment to the debt holders. Common Shareholders have the same right as preferred shareholders to be redeemed when a company is liquidated. So Debtholders care more about the company's ability to pay back while the shareholders prefer that company takes more risks. Managers may want to take less risk than do shareholders, because managers’ compensation depends on the company's performance while investors can easily diversify risks. Corporate Capital Structure Working Capital Management seeks to maximize firm profits while ensuring liquidity. Conservative Approach is to hold higher short-term assets, and finance the working capital with long-term debt. Aggressive approach is to hold longer-term assets, and finance working capital with short-term debt. Highly capital-intensive businesses are capable of using the greatest amount of leverage (more debt) in their capital structures, because their assets can be bought and sold fairly easily. When the firm’s Interest Coverage Ratio increases, the firm’s ability to raise debt capital increases. Firm’s Operating Leverage is another measure of firm’s leverage. Internal Business Character and External Factors affect capital structure; more predictable profit, owning more tangible assets as collateral, and lower current level of debt affect ability to issue debt. Primary Source of Liquidity includes selling goods and services and increasing lines of credit. Secondary Source of Liquidity includes cash by suspending dividend, selling assets, issuing additional equities, extending debt maturity, renegotiating debt contracts, and filing for bankruptcy protection and reorganization. The main difference between the primary and the secondary is that using a primary source is not likely to affect the normal operation of the firm, whereas using the secondary may result in a change in the financial and operating positions. Pull on liquidity occurs when outflows are paid too quickly by the company or when trade credit availability is limited, requiring companies to expend funds before they receive funds from sales that could cover the liability. Drag on liquidity occurs when money is received later than expected due to uncollected receivables. EAR of Supplier Financing implies that forgoing the discounts for prompt payment amounts to borrowing money from suppliers for (c-b) days. Given Modigliani and Miller's assumptions of perfect capital markets—in which there are no taxes, transaction costs, or bankruptcy costs, and in which all investors have equal (“symmetric”) information—capital structure does not affect the value of the company. Under MM Proposition with Tax, from the perspective of a corporate issuer, debt is cheaper than equity, because the returns to lenders are capped and the cost of debt is lower than the cost of equity. Marginal cost of debt is cost of debt times (1 - Tax Rate), because interest payment is deducted from taxability. A company's interest payments are fully tax deductible. So when tax rates increase, the company's cost of debt decreases and therefore, the cost of capital can benefit from a tax shield and 100% debt maximizes the firm’s value. Static Tradeoff Theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. 𝑉𝐿 = 𝑉𝑈 + 𝑡𝐷 − 𝑃𝑉(𝐶𝑜𝑠𝑡 𝑜𝑓 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑖𝑠𝑡𝑟𝑒𝑠𝑠) As the cost of financial distress increases, we can offset the cost of financial distress by using more debt, that is receiving tax shield benefits. Therefore, the value of a levered company will increase when we are using debt. Optimal Capital Structure is attained when the combination of debt and equity minimizes WACC, and maximizes profit. Target Capital Structure is a structure firm seeks to achieve on average over time to maximize its value. Double Taxation: Company pays its tax on profit, and shareholders will have to pay tax on dividend (income distribution) paid from the company. Corporate Capital Investment Projects Capital Allocation Processes include idea generation, analyzing project proposals (Cash Flow Forecast), Capital budget (Prioritize Profitable Projects), and monitor/post-audit. In this process, managers must consider tax, incremental cash flow (cash flow that a company acquires when it takes on a new project), negative effects, and time value of money in the decision-making process and ignore sunk costs (Consulting Fees), Common Capital Allocation Pitfalls Cognitive Errors in Capital Allocation -​ Internal forecasting errors -​ Ignoring costs of internal financing -​ Inconsistent treatment of, or ignoring, inflation -​ Ignoring the responses of competitors into the analysis. -​ Not ignoring sunk cost Behavioral Biases in Capital Allocation -​ Inertia -​ Basing investment decisions on accounting measures, such as EPS -​ Pet project bias -​ Failure to consider investment alternatives or alternative scenarios Going Concern Projects maintain the business or reduce costs. Regulatory Projects involve safety-related or environmental concerns. Expansion Projects expand business. There are Options to projects such as timing option (more preferable timing to implement the project), sizing options (abandonment and expansion options), flexibility option (price/production), and fundamental options. Internal Rate of Return is the required rate of return at which NPV = 0 When the actual Discount Rate > IRR, NPV < 0 When the actual Discount Rate < IRR, NPV > 0 **Discount rate is almost always greater than zero When a company chooses between the mutually exclusive projects with higher NPV and the project with higher Internal Rate of Return, the NPV criteria is strongly preferred. Hurdle Rate is the minimum IRR above which a project will be accepted. Corporate Pricing Structure Tiered Pricing is charging different prices to different buyers, based on volume purchased and product features. Dynamic pricing is charging different prices at different times and for different types of customers depending on variables such as available supply levels and demand. Valued Based Pricing is setting prices based on the values received by the customer. Corporate Profit Structure “Economic” profit is the profit in excess of what they could have earned elsewhere on different investments. Financial Statement Analysis Financial Statement Notes on the Financial Statement should disclose information about the accounting policies, methods, and estimates used to prepare the financial statements. Interim reports are also provided by the company either semi-annually or quarterly, depending on the applicable regulatory requirements. They generally present the four basic financial statements and condensed notes but are not audited. Management Commentary [MD&A] discusses trends and identifies significant events and uncertainties that affect the firm’s liquidity Effects of inflation Impact of off-balance-sheet obligations Accounting Policies Forward Looking Expenditures Net Operating Cycle indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash. In a Fragmented Consumer Base, the consumers have less bargaining power making it easier for companies to pass on higher costs to the consumers. Discussion and presentation of inherent risks in an investment is appropriate in the develop and communicate conclusions/recommendations step. Financial Reporting Quality The monitoring role of lenders is most likely to insure high-quality financial reports because the lenders inspect financial reports carefully to be sure they are not manipulated. Biased Reporting includes combining the results from two segments as a single entity, leading to lower financial reporting quality and Aggressive - more earning /Conservative - less earning Accounting. Including gains from foreign exchange rate in its cost of goods sold will result in lower reporting quality, because these changes may not recur and thus will blur the investors’ decision. Biased Reporting is better than Earning Management in that the latter represents deliberate actions to influence reported earnings and their interpretation. The distinction between them is subtle, and primarily a matter of intent. Internal Control is the process by which the company ensures that it presents accurate financial statements. Poor Internal Controls provide opportunities for errors or fraud to be incorporated in financial reporting without being detected. Motivation results from personal pressures or corporate pressures to report on a low-quality basis. Rationalization takes place after the low-quality reporting act has taken place. Accounting Standard Under the Retrospective Application, changes are applied to both prior-period and future financial statements. Accounting Errors should follow retrospective application. Changes in accounting policies are reported through retrospective application unless it is impractical to do so. Changes in accounting estimates, however, such as changes in the estimated residual value of long-lived assets are handled prospectively. Under the Modified Retrospective approach, companies are not required to revise previously reported statements. Instead, they adjust opening balances of retained earnings and other applicable accounts for the cumulative impact of the new standard. Financial Statement Analysis (CFA) An analyst should conduct additional analysis when finding the exclusion of recurring items from non-GAAP financial measures. If a company uses non-GAAP measures in its SEC filings, it must display the comparable GAAP measure with equal prominence, and provide reconciliation between the two. LIFO reporting provides sufficient information in the Notes to convert from LIFO to FIFO so that a change in inventory measure standard shouldn’t alter an ananlyst’s opinion. Defensive Interval Ratio measures how long the company can continue to pay its expenses from its existing liquid assets without receiving any additional cash inflow. Audit Unqualified/Qualified/Adverse/Disclaimer Cash Flow Statements Provides information for a reporting period beyond information available from the income statement. Direct Methods Add Source of Cash; Subtract Use of Cash; ​ Opposite is true for calculating cash paid to others (Expense) Indirect Method Adjust for non-cash items, for non-operating items, and for the net changes in operating accruals NI + NCC - Net Working Capital Common-size Cash Flow Statements Express each line item of cash inflow as a percentage of inflows and outflow as a percentage of outflow. Or Express each line item as a percentage of revenue. Cash Flow Per Share (IFRS) = (CFO + Total Dividend if reported in the operating cash flow - Preferred Dividends ) / Number of common shares outstanding Cash Flow Per Share (US GAAP) = (CFO – Preferred Dividends) / Number of common shares outstanding. Note that if the company reports under IFRS and includes total dividends paid as a use of cash in the operating section, total dividends should be added back to CFO as reported and then preferred dividends should be subtracted. Operating Cash Flow Inflow Cash Collected From Customers Interest Received (CFI) Dividend Received (CFI) Sales Proceeds from Trading Securities Outllow Cash Paid to Employees Cash Paid to Suppliers Cash Paid for Other Expenses Acquisition of Trading Securities (CFI) Interest Paid on Debt or Leases (CFF) Taxes Paid on Debt or Leases (CFF) Taxes Paid (CFF, CFI) Dividend Paid to Shareholders (IFRS, CFI) Investing Cash Flow (Long-term Assets and Investments) Inflows Sales Proceeds from PP&E Sales Proceeds from Intangible Assets Sales Proceeds from Debt and Equity Investment Principal Received From Loans Made to Others Outflows Acquisition of PP&E Acquisition of Intangibles Acquisition of debt and equity Investments Loans made to others Financing Cash Flow (Firm’s Capital Structure - Debt/Equity) Inflow Principal Amounts of Debt Issued Bank overdrafts (GAAP) Proceeds from Issuing Stock Outflow Principal Paid on Debt or Leases Payments to Reacquire Stock (Share Repurchase) Dividends Paid to Shareholders Cost and Revenue Recognition Central Principle to revenue recognition is that a firm should recognize revenue when it has transferred a good or service to clients and when it is not likely to reverse. Collectibility must be probable for a contract to exist. Matching Principle: Expenses to generate revenue are recognized in the same period as the revenue. Capitalization Standard: Expense that is expected to provide future economic benefits will be capitalized. Subsequent related expenditures can also be capitalized. Capitalization will decrease expense, thus increasing net income (Aggressive Accounting). Period Costs are not tied to revenue generation, expensed in the period incurred. Long-term Contracts: Revenue is recognized when a performance obligation is fulfilled. And when revenue is recognized and the cash payment is made, a Contract Asset is presented on the balance sheet. It is only at the point when all performance obligations have been met except for payment that a Receivable appears on the seller’s balance sheet. Output method/Input Method Input Method = (Cost Incurred/Total Cost)*Total Contract Value Output Method = (Unit Produced/Total Promised Unit)*Total Contract Value Income Statement Items Impairment Loss [IFRS]: Carry amount of equipment – Max(Fair Value - Cost to sell, Present Value of Expected Cash Flows (Value in Use)) Depreciation Expense: Tangible assets Depletion Expense: Natural Resources Amortization Expense: Intangible Assets Impairment Charge for Intangible Assets: Year 2 End Value +/- Exchange movements Y2 +/Amortization Y2 +/- Net additions in Year 2 - Year 1 End Value Costs from Creating Intangible Assets: Start-up and training costs/Administrative Overhead/Termination Costs/ Advertising Costs/Relocation and Reorganization costs Gain from Acquisition = Purchase Price - Fair Value ; Purchase Price > Fair Value Warranty Expense (Bad Debt): Goods or Services sold on credit Income from Continuing Operation (Unusual and Infrequent Item): G/L from sales of assets, Impairments, Write-offs/downs, Restructuring Costs. Reported Separately Discontinued Operation: G/L from disposing part of business Balance Sheet Items Vertical Common-size balance sheet is represented as total assets Total Asset (Total Capital) = Total Shareholder Equity + Total Liability (Debt) Therefore, The creation of an asset results in a comparable increase in stockholder’s equity. Cash Dividend: Cash Paid-to Common Shareholders do not decrease Net Income But decrease retained earning and thus equity = Paid-in Capital + Retained Earning Inventory Measure (IFRS): Min[Cost, NRV] Carrying value of the equipment (IFRS) after impairment loss: Max(Fair Value - Cost to sell, Value in Use [PV of expected cash flows]). Book Value of Equipment Sold (Carrying Amount): Historical Cost of Equipment Sold - Accumulated Depreciation on the equipment sold Accounts Receivable: Asset is created when sale of goods delivered successfully to clients is made on credit. Revenue is recognized at the time of sale. Unearned Revenue: Liability is created when cash is received before the delivery of product/service to customers. As product/service is delivered, liability decreases, recognizing income. Accounting Goodwill (Intangible/Indefinite) arising from acquisition is capitalized. It is not amortized but tested for impairment annually; Fair Value of Assets of the acquired - Purchase Price [Fair Value > Purchase Price] Capitalized Assets: Costs are initially capitalized as assets. Capitalized Interest: Cost of Capital from construction of asset Unusual and Infrequent Items Under US GAAP, material income items that are unusual and infrequent are shown as part of continuing operations and presented separately. Intangible Assets Intangible Assets like licenses that have Indefinite Life are not amortized but tested for impairment once a year. Those that have Finite Useful Lives are amortized over their useful lives. Identifiable can be acquired separately or patented and copyrighted. Unidentifiable cannot be acquired separately and may have an unlimited life [good will]. An acquirer with a high current tax rate would theoretically be willing to pay more than an acquirer with a lower tax rate. Inventory Methods IFRS states that inventories shall be measured (and carried on the balance sheet) at the Min(Cost, NRV), Inventory Write-down reduces both carrying amount of inventory on balance sheet and profit (by increasing COGs), and thus has a negative effect on profitability, liquidity and solvency ratios. Increasing Valuation Allowance (Same effect as Inventory Write down) > Inventory Decreases -​ Under IFRS, we frequently increase valuation allowance instead of writing down inventory. Reversal of Inventory Write-down [IFRS] will decrease the cost of sales. IFRS Balance Sheet i) Min(Cost, NRV) NRV = Expected Sales - Estimated Selling Costs - Completion Costs ii) NRV < Balance Sheet Value of Inventory Inventory value is "written down" to NRV iii) If recovered later, "written up" Income Statement ii) Written-down, either 1) Separate Item 2) Increasing COGs (Recognizing Expense) iii) Written-up, either 1) Separate Item 2) Reducing COGs US GAAP Balance Sheet i-2) Min(Cost, NRV) for FIFO/Weighted-Average Methods i-1) Min(Cost, Market) for LIFO ii) Market Value of Inventory < Cost, Inventory value is "written down" to Market or NRV Income Statement ii) If written-down, either 1) Increasing COGs [For a relatively small changes] 2) Separate Item [For a relatively large changes] FIFO Ending Inventory: Higher Gross Profit: Higher COGs: Lower LIFO Ending Inventory: Lower Gross Profit: Lower GOGs: Higher The inventory carrying amounts under the LIFO methods are already conservatively (lower inventory) presented at the oldest and lowest costs. Thus, it is far less likely that inventory write-downs will occur. Companies that use specific identification, weighted average cost or, FIFO, all of which are with higher inventories are more likely to incur inventory write-downs. In an environment of steadily increasing prices and quantities, reported ending inventory reflects current replacement value under the FIFO using a periodic inventory system. It’s because FIFO assumes that the oldest items are sold first, leaving the most recently purchased items in the balance sheet. LIFO liquidation occurs when LIFO firm's inventory quantities decline, leading to higher profit margins (inventory turned into cash) and higher income taxes. Management could use it for artificial inflation of profit margin. Impairments Unanticipated decline in an asset’s value, falling below the carrying value IFRS When the carrying value is greater than the recoverable amount, the carrying value is written down to a recoverable amount, Max(Fair Value - Cost to sell, Value in Use [PV of expected cash flows]). And Impairment Loss is incurred in income statement [IFRS]: Carry amount of equipment – Max(Fair Value Cost to sell, Value in Use [PV of expected cash flows]). US GAAP When the Net Book Value (Carrying Value) is greater than the asset's undiscounted future cash flows, the asset is written down to its Fair Value. And the loss is recognized in the Income Statement. Earning per share (EPS) Share Repurchases decrease the number of shares outstanding, increasing EPS. Stock-split applies retrospectively. Assumed exercise of the stock options would not change net income for the year (or preferred dividends). For calculating EPS, therefore, no change is made to the numerator. However, the denominator would be increased by the incremental number of shares issued as a result of the stock option being exercised. A convertible security which, if converted, would result in the EPS lower, therefore dilutive, than the basic EPS. Otherwise, a particular convertible security is not dilutive. When the Dilutive EPS is antidilutive, then we report Dilutive EPS equal to Basic EPS (Dilutive EPS = Basic EPS). Long-Lived Assets (PP&E) When long-lived assets (equipment/PP&E) are sold, G/L is recognized in the income statement. When long-lived assets are abandoned, the carrying value is removed from the balance sheet and the loss is recognized in the income statement by the same amount. When long-lived assets are exchanged, G/L is recognized by the difference between Carrying Value of Old Asset and Fair Value of Old Asset/New Asset. Revaluation Revaluation Surplus If a revaluation initially increases the carrying amount of the asset class, it bypasses income statement and goes to equity and is recognized as initial surplus in OCI. Any subsequent decrease in asset’s value first decreases the revaluation surplus in Other Comprehensive Income and then goes to the income statement. If a revaluation initially decreases the carrying value of the asset, the decrease is recognized in the profit or loss. Later, if the carrying amount of the asset class increases, the increase is recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset class previously recognised in profit or loss. Any increase in excess of the reversal amount will not be recognised in the income statement but will be recorded directly to equity in a revaluation surplus account. Effect of Revaluation Asset revaluations that increase the carrying amount of an asset initially increase depreciation expense, which will decrease the net income; revenue (sales) doesn’t change. Average Asset and Average Equity increases by the same amount. And for an equal increase, Leverage Ratio will decrease. Financial Instruments US GAAP Available-for-sale Securities: Fair value without its unrealized g/l recognized in the income statement Trading Securities: Fair value with unrealized g/l recognized in the income statement IFRS Amortized cost Debt securities with the intent to hold to maturity Loans and notes receivable Unlisted equity Other Comprehensive Income (Separate Section) Debt securities with intent to collect interest payments but sell before maturity Equity securities (not in GAAP) only if this treatment is chosen Measured at fair value through profit and loss (unrealized G/L in Income Statement) Debt securities with intent to sell in near term Equity securities (unless chosen to be reported in OCI) Derivatives Any security not assigned above (OCI, Amortized) Any security for which this treatment is chosen at acquisition Tax Deferred Tax Liability arises when you pay less tax than you actually have to 1)​ Income Tax Expense > Taxes Payable 2)​ Carrying Value of an asset > Tax Base of an asset 3)​ Carrying Value of a liability < Tax Base of a liability Under IFRS, if a deferred tax asset/liability resulted in the past, but the criteria of economic benefits is not met on the current balance sheet date, an existing deferred tax asset/liability will be reversed Tax Return: Taxes Payable Tax Base of Asset/Tax Base of Liability Income Statement: Income Tax Expense = Tax Payable + ∆DTL - ∆DTA ** Decrease in the DTA by Increasing Valuation allowance will increase Income Tax expense, thereby decreasing Net Income Balance Sheet: Carrying Value of an Asset/Carrying Value of a Liability Deferred Tax Liability/Deferred Tax Asset Under IFRS, reverse the deferred tax asset, when it will not be realized Valuation Allowance (GAAP): Increasing the valuation allowance will reduce DTA based on the likelihood that assets will not be realized. Permanent Difference: Difference between taxable income - pretax income that will not reverse in the future Temporary Difference: Difference between the tax base and the carrying value of an asset or liability that will result in either taxable amounts or deductible amounts in the future Lease Leases can provide less costly financing Operating Lease Benefits and the risks of ownership are not substantially transferred to the lessee. Lessee recognizes a single lease expense in the income statement and no depreciation expense. Finance Lease Benefits and risks of ownerships are substantially transferred from the lessor to lessee. 1.​ Ownership Transfer 2.​ Option to buy an asset 3.​ The lease is for the asset’s useful life 4.​ PV of lease payment is greater than Fair Value. 5.​ Lessor has no other use for the asset Finance Lease creates Right-of-use Asset [ROUs] in the balance sheet. ROUs [IFRS] is amortized by different methods, while ROUs [US GAAP] is amortized by the amount of principal payment. Lessee recognizes Depreciation Expense in the income statement. At the same time, Finance Lease creates Lease Liability in the balance sheet, which decreases with each period of principal payment. For the lessor of Finance Lease, lease receivable that amounts to the value of expected lease payments is created in the balance sheet. The G/L from the lease payment is immediately recognized in the income statement. If the lessor is a financing company, G/L is not recognized at initiation. G/L is deferred and is recognized over the life as interest income or an expense. If the lessor is doing a sale-type lease, the lessor reports a profit on the sale of the leased asset on the income statement in the case of a sales-type lease. Exception If the lease is less than a year or for a “low value asset,” up to $5,000 in sales price (IFRS only), then the lessee can elect to simply expense the lease payments on a straight-line basis. This doesn’t apply to the lessors. Under IFRS, long-term lease for a customized piece of equipment is classified as a finance lease. Defined Benefit Plan IFRS Balance Sheet: Net Pension Asset or Net Pension Liability Income Statement: Service Cost - Additional Benefits and Net Interest Expense or Income OCI: Re-measurements - Actuarial gains and Losses between actual and expected returns on plans assets. US GAAP Balance Sheet: Net Pension Asset/Net Pension Liability Income Statement: Service Cost for the current period/Interest Expense or Income/Expected Return on plan assets Other Comprehensive Income: Past Service Costs/Actuarial Gains and Losses Share Based Compensation Designed to align the manager and stockholders interest and reduce agency cost. Issuing Stock Options will diluted EPS; they only have value when the stock prices are above the exercise price. Stock-based appreciation rights (SARs) generate cash for the holders, linked to stock performance, a cash compensation based on the company's stock price. Balance Sheet: Fair Value of Stock Grants Income Statement: Expense over vesting period Equity: Common Stock and Additional Paid-in Capital (APIC) increase by the amount expensed over the vesting period **At the end of the service period, any amount remaining in an equity reserve will be recycled into common stock and APIC. Disclosures Requirements for PP&E [IFRS] A reconciliation of carrying amount at the beginning and end of the period. The date of revaluation under the revaluation model. These, however, are not required for US GAAP. Revaluation IFRS Not required disclosure of the original date of acquisition How the fair value was obtained. The Carrying amount under the cost model. Both IFRS and GAAP A company must disclose for each class of long-lived assets the amounts of impairment losses recognized in the period and where those losses are recognized on the financial statements under: Smoothing Free-on-board (FOB): FOB at shipping point will mean that revenue is recognized earlier compared to FOB at the destination. Channel Stuffing: Overloading a distribution channel with more goods than would normally be sold during a period. Bill-and-hold transaction: The customer buys the goods and receives an invoice but requests that the firm keep the goods at their location for a period of time. Pro-Forma Financial Statements Provide estimates of financial statement items for one or more future periods Sensitivity analysis Scenario analysis Simulation Equity Investment Financial System Main Functions of Financial Systems 1.​ Save and borrow money, raise equity capital, and trade assets 2.​ Determine returns that equate the supply of savings with demand for burrowing. 3.​ Allocate capital to its most efficient uses Equilibrium Interest rate is the rate at which the supply of savings equals demand for burrowing. Brokers help their clients buy and sell securities by finding counterparties to trades in a cost efficient manner (help make large trade). Dealers provide liquidity to the market by trading with buyers and sellers; they profit from bid and ask (offer) spread. Clearinghouse acts as an intermediary between buyers and sellers, providing escrow services, guarantees of contract completion, assurance that margin traders have adequate capital and limits on the aggregate net order quantity (Buy minus Sell orders) of members, and thus reducing counterparty risk. Custodians improve market integrity by holding client securities and preventing their loss due to fraud. Ex-dividend date is normally determined by the security exchange on which the shares are listed. The corporation determines the holder-of-record date and declaration date. Market Structure Objectives of Market Regulation 1) Control Fraud 2) Control Agency Problems 3) Promote Fairness, ensuring that long-term liabilities are funded In the informationally efficient market, fundamental values of equities nearly equal the market price In the operationally efficient market, the market is liquid so that the trading cost is low. In the allocationally efficient market, the resources are allocated for their best use. Execution Instructions Market Order instructs the broker to execute the trade immediately at the best possible price (at or above for buy and at or below for sell) Limit Buy Order will be executed to buy stocks whenever the current market price is at or below the limit price specified. Limit Sell Order will be executed to sell stocks whenever the current market price is at or above the limit price specified. Standing Limit Order are limit orders waiting to execute. All-or-nothing Orders execute only if the whole order can be filled. Validity Instruction (When) Day Orders expire if unfilled by the end of the trading day. Good till canceled orders last until they are canceled. Immediate-or-cancel (fill-or-kill) orders are canceled unless they can be filled immediately. Good-on-close order is only filled at the end of the trading day Market-on-close order is Good-on-close order used by mutual funds. Stop Buy Orders will be executed to buy stocks at prevailing price, thus better than limit orders Stop Sell Orders will be executed to sell stocks at prevailing price, thus better than limit orders Clearing Instruction (How to Settle) Clearing Instructions tell the trader how to clear and settle a trade. IPO Book Building: Investment bank finds investors who agree to buy part of the issue (Indication of interest) Underwritten Offering: The investment bank agrees to purchase the entire issue at a price that is negotiated between the issuer and bank. An investment bank also agrees to distribute shares of an IPO on a Best Efforts Basis, rather than agreeing to purchase the whole issue. In a Shelf Registration, a firm makes its public disclosures as in a regular offering; issues registered securities over time when it needs capital and when the markets are favorable. In a Private Placement, securities are sold directly to qualified investors with the assistance of an investment bank. Dividend Reinvestment Plan allows existing shareholders to use their dividends to buy new shares from the firm at a slight discount. In a Rights Offering existing shareholders are given the right to buy new shares at a discount. In Brokered Markets, brokers set up buyers and sellers to trade, but don’t trade with them. Large block trades are done. In Quote-driven Markets, traders transact with dealers who post bids and ask prices. Dealers maintain an inventory of securities. Buyers and sellers trade only with dealers. In an Order-driven markets, orders are executed using trading rules (exchanges); necessary because traders are usually anonymous. Order Matching Rules match buy order to a sell order; the priority is for best (highest) bid, and best (lowest) ask. Best Bid and Best Ask Price lower than best bid (highest buy) is behind the market Price higher than best ask/offer (lowest sell) is behind the market Pricing Rules Under the Uniform Pricing Rule all trades execute at the same price. The market chooses the price that maximizes the total quantity traded. Under the Derivative Pricing Rule, the price is derived from another market, typically at the midpoint of the best bid and ask quotes published by the exchange at which the security primarily trades. Under the Discriminatory Pricing Rule, the limit price of the order or quote that first arrived—the standing order—determines the trade price. Trading/Investment Strategy Long and Short If you benefit from the increase in value, you are in a long position If you benefit from the decrease in value, you are in a short position Short Sale Potential gain is maximum 100% of the security value on short sale, while the loss is unbonded. Short Seller must pay all dividends/interests of lenders, Payments-in-lieu. The lender of securities earn Interest Earned on Proceeds form short sale less Short Rebate paid to brokers. Buy on Margin Use leverage to buy securities by burrowing from brokers. Market Efficiency In efficient markets and over long periods of time, large company stocks are expected to have lower returns and lower risk than small company stocks. Efficient Market Investors react only to the unexpected information like earning surprise, not to expected information. The current price of a security fully, quickly, and rationally reflects all available information about that security. More number of participants, more information, more short selling, less impediments to trading, and less transaction and information cost will improve market efficiency. Weak Form: Prices reflect Past Data - Volume and Price Semi-Strong Form: Prices reflect All new and current Public Information. If markets are semi-form efficient, an active investment strategy cannot outperform. Strong Form: Prices reflect both Public and Private and all insider information. Market Anomaly Overreaction Effect: Underperforming stocks are doing better in the next years (Time-series) Momentum Effect: High short-term increase with subsequent long-term increase (Time-series) Size Effects: Small Cap outperforms the large cap (Cross-sectional) Value Effect: Companies with low PE and high dividends outperform growth stocks (Cross-sectional) Earning Announcements IPOs Economic Fundamentals Calendar Anomalies Equity From the perspective of an investor, the risk in order is Callable equity > Equity > Puttable Equity. Callable equity is most risky for the investor because the issuer has the right to redeem the shares at a predetermined Price. Putable Equity is less risky than callable and regular equity, because if the price falls, the holders can redeem at a prespecified price. For this reason, holders of putable equity receive the lowest dividend (Similarly, Putable Bond is more attractive for the bondholders). Investors of Common Stocks share in the operating performance of the company, participate in the governance process through voting rights, and have a claim on the company’s net assets in the case of liquidation. Equity cannot be categorized by currency of payment and degree of inflation protection, whereas fixed-incomes can be categorized by currency of payment and degree of inflation protection, For the Statutory Voting, each share represents one vote. For someone who has 100 shares can only cast a maximum of 100 shares. It allows shareholders to allocate their votes evenly among candidates and are ​regular shareholder voting. Cumulative Voting allows shareholders to direct their total voting rights to specific candidates. Convertible preference share is a popular option in venture capital, where the issuer resumes a higher risk. Equity Analysis Fundamental Analysis is based on public information such as earnings, and dividends. Determination of business model is a company analysis An analysis of the competitive positioning such as Porter's five forces is typically included in the initial company research report. Competitive and Industry Analysis Industry Level Forces driving industry competitions are 1) Threat of new entrants 2) Substitution threats 3) Customer bargaining force 4) Supplier bargaining force 5) The competitive forces in the industry (rivalry) 6) life-cycle issues 7) business-cycle considerations. 8)and PESTLE (External Effect) Economic influences are most important for cyclical sectors such as crude oil, natural gas, freight transportation, semiconductor, fintech, and digital advertising. Utilities, Pharmaceuticals and Consumer Defensives are defensive industries The Refinitiv Business Classification (TRBC) covers private companies, non-profits, and government entities, while GICS and ICB only cover public companies Event Study examines abnormal returns before and after the release of new information that affects a firm’s intrinsic value. Forecast Scenario Analysis - Investors compare them with other analysts’ (e.g., sell-side analysts) forecasts for a company, as well as forecasts implied by current valuations, to make investment decisions. Rather than a point estimate, analysts generate multiple scenarios for the forecast to be made. Revenue Disclosure from the issuer is more detailed than Operating Cost Disclosure. Equity Valuation Intrinsic Value is a value that a rational investor with full knowledge about the asset’s characteristics would willingly pay. Asset-based Valuation The companies that do not have easily determinable market (fair) values—such as those with significant property, plant, and equipment (PP&E)—are very difficult to analyze using asset-based valuation methods. It works well for companies that have a high proportion of current assets and current liabilities and less intangible assets. Price Multiples Valuation EBITDA can be a proxy for Operating Cash Flow because it excludes Depreciation/Amortization. Price Multiples like P/E can be used for relative comparison between Time-series and Cross-sectional. Security Market Index The usage of Index are: 1.​ Reflection of market sentiment 2.​ Benchmark of manager performance 3.​ Measure of market return and risk 4.​ Measure of beta and risk-adjusted return 5.​ Model portfolio for index funds Fundamentally Weighted Index will have a contrarian ‘effect’ in that the portfolio weights will shift away from securities that have increased in relative value toward those that have fallen in value. Fundamental indexes use a single measure, such as total dividends, to weight the constituent securities. All shares are included in a fundamental weighted index. Rebalancing is not needed in the Price-weighted indexes; it is automatic. Regular rebalancing is needed in an Equal-weighted index because weights of the constituents change as their market prices change. The values of the price and total return versions of an index are equal. As time passes, however, the value of the total return index that includes the dividend should be greater than the value of the price return index. As time passes by, value of total return > Price return because of dividend Fixed-income Security Bond Structure Bond Indenture Affirmative Covenants specify requirements the issuer must fulfill Cross-default: if the issuer defaults on any other debt obligation, the issuer will also be considered in default on this bond. Pari Passu: Bond will have the same priority of claims as the issuer's other senior debt issues Negative Covenant place restrictions on the issuer such as: Entering into asset sales and leaseback agreements Pledges of collateral (cannot use the same collateral) Issuance of debt ranks more senior than existing debt Additional borrowing, share repurchases, or dividend payments Bullet Structure: Principal is paid back in a single payment at maturity. In an Amortizing Loan, principal is paid partially along with PMT. In a Balloon Payment, principal is paid back more in the earlier period. Sinking fund provisions provide for the early repayment of principal. Waterfall structures establish principal repayments to holders of ABSs and MBSs, providing tranches of varying seniority. Bonds with seniority are paid back first. Step-up Coupon Bonds: coupon rate increases at a predetermined schedule. Leveraged Loan is a loan to a burrower of lower credit quality For a Credit-linked note, coupon rate increases if the credit rating decreases. Payment-in-kind (PIK) bonds allow the issuer to pay bond interest by issuing more bonds. Index-linked bonds have coupon payments or principal value based on index. Bond Market In the Primary Market, the newly issued bonds are sold In the Underwritten Offering, bonds issue prices are promised by intermediary In the Shelf Registration, tell securities regulators all the details, and sell them. In the Secondary Markets, existing bonds trade primarily in the Dealer/OTC market. OTC Markets, which can be customized to meet the desired risk exposure, offer more flexibility than ETDs. Bond Market Securities (Except ABS/RMBS/CMBS) Eurobonds, Domestic, and Foreign Bonds are now registered bonds for which ownership is recorded by either name or serial number. Bonds issued by entities that are incorporated in another country are called Foreign Bonds. Therefore, the bonds issued by a South Korean company in South Korea in the United States are known as foreign bonds. Eurobonds are bonds issued internationally, outside the jurisdiction of any single country (doesn’t belong to any country) to bypass the legal, regulatory, and tax constraints imposed on bond issuers and investors. The bonds registered with the SEC are not classified as Eurobonds. The Eurobond market was created primarily to bypass the legal, regulatory, and tax constraints imposed on bond issuers and investors, particularly in the United States and thus are less regulated. Global Bonds are Eurobonds that also trade in the domestic market. Foreign Bonds, Global Bonds, and Eurobonds are collectively called International Bonds. The price of a bond issued by a US-based company and denominated in British Pounds will be affected by British Interest Rates. Original Issue Discount (OID) Bonds are Zero-Coupon Bonds sold at a significant discount. But discounts are taxed as interest income over the period. In a Covered Bond, the pool of assets remain in the balance sheet of the financial institution. In the case of default, the bondholder has a recourse against financial institutions and the cover pool (assets). Issuers can default on Hard-bullet Covered Bond, if they fail to make a scheduled payment. However, in a Soft-bullet Covered Bond, they may postpone the maturity date and corresponding principal payment as late as a year. Covered bonds usually consist of one bond class per cover pool. Cover pool sponsors must replace any prepaid or non-performing assets (i.e., assets that do not generate the promised cash flows) in the cover pool to ensure sufficient cash flows until the maturity of the covered bond. Covered bonds, therefore, do not expose investors to prepayment risk. Government Bonds Main types of non-sovereign government issuers include agencies, public banks, supranationals, and regional governments. Regional government issuers include provincial, state, and local governments, referred to as municipal bonds in the US and most often as local authority bonds elsewhere, within a specific sovereign jurisdiction. Agency Bonds are issued by agency governments created for specific purposes. Local and regional governments issue General Obligation Bonds for general public spending. Revenue Bond is issued for a specific project, in which the source of repayment is directly from the project (use of infrastructure). Supranational bonds are issued by international organizations like the World Bank. Sovereign Issuance takes place on auction. On-the-run Bonds are most actively traded and recently issued bonds whose prices are informative. US Treasury Inflation-Protected Securities (TIPS) issue at maturity is most likely max (inflation-adjusted principal, initial par value.) Bonds with Option Callable Bond gives the issuer the right to redeem the principal to bondholders at a prespecified price. When the interest rate falls, and the bond price rises, issuers will redeem bonds to reissue at lower coupon rates. Due to such call risks, bondholders will demand a higher yield, and so lower bond price. For the Contingent Convertible Bond (CoCos), the optionality also lies within the issuer. For this reason, it must offer higher yield and lower price than otherwise similar bonds or those with put or regular convertible options. Putable Bond gives the bondholder the right to sell the bond at a prespecified price. When the interest rate rises, and the bond prices fall, bondholders will sell the bonds at the prespecified price, and reinvest in bonds at higher rates. For this reason, they are sold at higher prices and lower Yield Convertible Bond gives the bondholder the right to convert bond into shares. For this reason, they are sold at higher prices. Warrants (those that are attached to mezzanine debt) give bondholders the right to buy shares at prespecified price. Convertibility Option that provides benefits to bondholders will accept a lower yield on the convertible bond [puttable option] compared with the option-free bond, Callable and CoCos. Money Market Securities US Commercial Paper has maturities up to 270 days and requires burrowers (issuers) to have back up lines of credit. Money Market Yields are stated on a simple interest basis. Certificates of deposit (CDs): Small-denomination CDs are mostly traded by retail clients, while large-denomination CDs are traded by institutional investors. Only negotiable CDs can be sold in the open market prior to maturity. If the CD is non-negotiable, the deposit plus the interest are paid to the initial depositor at maturity. Like other money market securities, CDs are available in domestic bond markets as well as in the Eurobond market and they are traded like ordinary shares on the investors' local exchanges. Repurchase Agreement is an agreement in which one party sells security to another party with promise to buy back in a short-term. Repo is the implied annualized rate stemming from price difference. Initial Margin posed is to secure the lender's position only. Bond Characters Seniority (Priority of Claim to Issuer’s Assets) 1. First lien/mortgage 2. Senior secured (second lien) 3. Junior secured 4. Senior unsecured 5. Senior subordinated 6. Subordinated 7. Junior subordinated Asset Backed Securities (ABS) Securitization Process 1.​ Depositors create a pool of debt-based assets 2.​ Depositors sell Pool of Securitized Assets (Collateral) to SPE 3.​ SPE issues Asset Backed Security (ABS) supported by Collateral Benefits of Securitization Issuers can remove assets from the balance sheet and borrow more from lenders Investors can have tailored risk and return according to Tranches. ABSs are more liquid, which decreases liquidity risks. Overall, ABSs reduce costs and improve market efficiency. ABS Risks Cash Flows may be uncertain. Credit Risk on Collateral may transfer to ABS holders. Credit Enhancements Structures in Securitization Credit Tranching in ABS is a way to enhance the credit by dividing them into tranches, each of which has different priority of claims to Collaterals (Waterfall Structure). Overcollateralization Excess Spread: Income on Collateral is greater than coupon for ABS. Using these methods, ABS ratings > the Corporate (Issuer) rating. A trustee (Trustee Agent) is typically a financial institution with trust powers that safeguards (hold) the assets after they have been sold to the SPE, holds the funds due to the ABS holders until they are paid, and provides periodic information to the ABS holders. Purchase Agreement, an important legal document between the seller of the collateral and SPE, sets forth the representations and warranties that the seller makes about assets (assures qualities) to investors. Credit Card Receivable ABS is an example of ABS backed by non-amortizing loans, whereby lockout periods only pay fees to ABS holders, after which repays principal from cardholders to ABS holders. Collateralized Debt Obligations (CDOs) It is a structured security issued by SPE, whose Collateral is a pool of Debt Obligation. It includes Collateralized Loan Obligation (CLOs), and Collateralized Bond Obligation (CBOs). Creation of a collateralized mortgage obligation cannot eliminate or change prepayment risk; it can only distribute the various forms of this risk among different bond classes. Mortgage pass-through security cash flows are uncertain because they depend on actual prepayments. Structured Finance CDOs are backed by ABS, RMBS, CMBS, and other CDOs Mortgage-backed Securities (MBS) One of its crucial aspects is Prepayment, the principal prepayment in excess of the promised principal payment by the burrowers. Extension Risk arises when prepayments are made later than expected. Contraction Risk arises when they are made earlier than expected. Lower interest rates will speed up the prepayment. One way to reduce this risk is to utilize Time Tranching. Prepayment Risk RMBS > CMBS (Call Protection) Residential Mortgage Backed Securities (RBMS) The coupon of a RMBS is pass-through rate which is equal to mortgage rate on the underlying pool of mortgages, less servicing and other administration fees. They are pools of loans that are securitized and offered to the financial markets providing indirect debt investment opportunities in residential property. It is exposed to considerable prepayment risk. They impose prepayment penalties and have recourse/non recourse loans. Commercial Mortgage Backed Securities (CMBS) Protects against early prepayments available to investors with Call Protection which is equivalent to prepayment protection (restriction on the early return of principal through prepayments). Loan-level call protection -​ -​ -​ Prepayment lockout Prepayment penalty points Defeasance Collateralized Mortgage Obligations (CMOs) They have multiple CMO Tranches that have different exposures to prepayment risk. Total prepayment risk is not reduced, but redistributed among Tranches. Planned Amortization Class (PAC) Tranche is structured to make predictable payments to investors as long as prepayment is within the expected range, which reduces both contraction and extension risks. Z-Tranche receives no interest payments during a specified accrual period, during which the tranche occurs interest as extra principal. Residual Tranches rank junior to all other tranches. Price-Yield Curve Price increases Yield decreases (Inverse Relation) (dp/dy) is greater with lower coupon, higher maturity, and “decrease in YTM than for increase in YTM” YTM falls, price increases > YTM increases, price falls Yield-Maturity Curve When we are using YTM as a return measure, we assume that investors must reinvest its coupon at YTM as well. Par Curve and Spot Curve Spot Curve shows a different YTM of risk-free bonds with different maturities. Par Curve shows a different YTM of a hypothetical bond with different maturities, which can be created from a spot curve. All of the bonds on the Par Curve are priced at Par such that YTM = Coupon Forward and Spot Rates Implied Forward Rate is a break-even reinvestment rate, which links the return on an investment in a shorter-term zero-coupon bond to that on a longer-term. When Current Market Price equals “no-arbitrage value’ Discounting the cash flows by either spot rates or yield to maturity arrives at the same price. PV1 = [PMT1 / (1 + S1)]+ ... [PMTn + Principal / (1 + Sn)^n] PV2 = [PMT1 / (1 + YTM)] + ... [PMTn + Principal / (1 + YTM)^n] PV1 = PV2 if the current market price equals the 'no-arbitrage value (price)' Interest Rates Risks Bond Selling at Premium and thus giving higher coupon rate, face higher reinvestment risk Long-term investors of bonds face coupon reinvestment risk and market price risk if the bond needs to be sold prior to maturity. But it is likely that reinvestment risk is greater than price risk. For long-term investors intending to hold bonds to maturity, they only face reinvestment risks, which is greater for a callable option than for putable and convertible bonds. All else being equal, overall interest rate risk is higher for lower coupon bond than for higher coupon bond. Duration and Convexity Macaulay duration, a weighted average of the time to receipt of the bond’s promised payments. Macaulay Duration of zero-coupon bond is its time-to-maturity. Duration gap equals to the bond’s Macaulay Duration less the Investment Horizon. When the investment horizon is shorter than the Macaulay duration of the bond, market price risk dominates coupon reinvestment risk. The investor is vulnerable to higher interest rates and drop in bond price. When the Investment horizon is longer than the Macaulay duration, coupon reinvestment risk dominates market price risk. Assuming an interest rate increase, the gain from reinvesting coupon payments at a higher rate will outweigh any loss incurred from a drop in bond price. When calculating the duration of a portfolio, we calculate the weight of each security using the market value (not par). Macaulay and modified duration statistics for a fixed-rate bond depend primarily on the coupon rate, yield-to-maturity, and time-to-maturity: 1) Higher the coupon rate, shorter the duration, 2) Higher the YTM, shorter the duration, 3) Lower the time-to-maturity, shorter the duration. Effective Duration curve duration statistic in that it measures interest rate risk of a complex bond (Embedded call option and Mortgage-backed bond) in terms of a parallel shift in the benchmark yield curve. We use a benchmark yield curve, because the future cash flow of the complex bond is contingent on future interest rate and so uncertain. Key Rate Duration (or partial duration) is a measure of a bond’s sensitivity to a change in the benchmark yield curve at a specific maturity segment, which measures the effect of nonparallel shifts (first derivative). Analytical Duration uses mathematical formulas to create the curve. For Analytical Duration, the government bond yield and the yield spread are uncorrelated. Empirical Duration uses actual (observed) data to create the curve. For Empirical Duration, however, the bond yield and the yield spread are correlated In case of market stress, the high yield bond’s credit spread will widen due to increased probability of default. Increased credit spread will offset the increase in duration for the bond due to decreased yield, resulting in lower Empirical Duration than Analytical Duration. For the bond portfolio consisting only of government bonds, the benchmark yields are the primary determinant of the bond yields. Thus, the outcomes of analytical duration and empirical duration may be equivalent. Price Value of a Basis Point (PVBP) shows change in price for a basis point change in YTM. The modified duration and effective duration of an option-free bond are identical only in the rare circumstance of an absolutely flat yield curve. 1)​ 2)​ 3)​ 4)​ 5)​ 6)​ 7)​ 8)​ All else equal, lower the coupon, higher duration All else equal, lower the YTM, higher duration All else equal, higher the maturity, higher duration All else, equal, interest rate falls, price increases > interest rate rises, price decreases (Convexity Effect) Lower coupon, priced at par or premium, and high maturity show increase in the duration But lower coupon, priced at discount, and high maturity may show reduction in the duration All else equal, embedded call option has a value to the issuer (Decreased Optionality), lower duration All else equal, embedded put option and convertible bond has a value to the investor (Increased Optionality), higher duration than callable Callable Bonds can have a negative convexity when yield is low. Other bonds have only positive convexity Yield Realized Horizon Yield equals Original YTM if Reinvestment Rate equals Original YTM and the bond is sold at a price on the constant-yield price trajectory. If Reinvestment rate is smaller than horizon yield, the horizon yield held-to-maturity will also be smaller than Original YTM. For the constant yield trajectory, the carrying value of a bond includes the amortization of the discount or premium if the bond is purchased at a price below or above par value. The carrying value is any point on the constant yield trajectory, the initial value of a bond less amortization of premium or plus amortization of discount, which will follow the constant yield trajectory. Therefore, Capital gains and losses from selling bonds are measured from the carrying value of the bond. Yield Spread Yield spread widen when: (1) a decline in an issuer’s creditworthiness (Increase in yield on the corporate bond). (2) an increase in market liquidity risk (Increase in liquidity risk may increase the required yield on bond). (3) In period of less demand for bond (Price of a bond will decrease, higher yield) Yield Spread = Liquidity Risk + Credit Risk Decrease in Trading Frequency will increase market liquidity risk Issuer size decrease will increase market liquidity risk Issuer size increases will decrease market liquidity risk Moody’s [1 > 2 > 3] BAA1 BAA2 BAA3 S&P AAA AA+ AA AAA+ A ACredit Analysis and Rating Notching depends on the rating of the issuer’s Senior Unsecured Debt, which is usually equal to corporate rating. Nothing Adjustment made is smaller for higher corporate’s issuer rating. Key factor in the credit analysis of revenue-backed non-sovereign governments bonds is Debt-Service-Coverage Ratio (DSCR) of the project, because revenue bonds are issued for specific project financing. Floating Rate Notes The coupon rate of a floating rate bond is typically expressed as a reference rate plus a spread or margin. The spread is usually set when the bond is issued and remains constant until maturity. The reference rate, however, resets periodically. Coupon Rate = Market Reference Rate + Fixed Spread Margin; Fixed Margin = QM = DM, initially Fixed Margin doesn’t change according to the change in the issuer's credit quality. DM > QM; Coupon is sold at discount, because investors demand higher yield DM < QM; Coupon is sold at premium, because investors demand lower yield Risks Credit Risk is the risk related to the default from the bond issuers. Key Drivers of Credit Risks are: Bottom-up: Capacity/Capital/Collateral/Covenants/Character Top-down: Condition/Currency/Country Credit Spread can be approximated by probability of default and loss severity. Credit Spread Risk arises from a fall in bond price due to increased yield spread. Liquidity Risk: Refers to the transaction costs associated with selling a bond. More specifically, market liquidity risk refers to the risk that the price at which investors can actually transact may differ from the price indicated in the market. Solvency Risks: Organization does not survive or succeed because it runs out of cash, even though it might otherwise be solvent. Operational Risks: the risk that arises from inadequate or failed people, systems, and internal policies, procedures, and processes, as well as from external events that are beyond the control of the organization but that affect its operations. Wrong-way Risk: Investor's expected payoff is lower as a result of facing a credit risk that is compounded by market risk. Prepayment Risk - Covered Bonds do not have prepayment risk! [CDOs/ABS] Extension Risk: RMBS > CMBS with Balloon Payment > Short Term Tranche CMO; PAC Tranche CMO Derivatives Derivative Benefits, Risks, and Issuer and Investor Uses Derivative -​ Low transaction costs. -​ Low capital requirements. -​ Ease of short selling to hedgers and speculators Issuers predominantly use derivatives to offset or hedge market-based underlying exposures incidental to their commercial operations and financing activities. In contrast, investors use derivatives to replicate a cash market strategy, hedge a fund’s value against adverse movements in underlyings, or modify or add exposures using derivatives, which in some cases are unavailable in cash markets. Net Investment Hedge offset the exchange rate risk of the equity of a foreign operation by using derivatives. Cash Flow Hedge absorbs the variable cash flow of a floating rate asset or liability. Fair Value Hedge offset the fluctuation in the fair value of an asset or liability. Forward, Futures, and Swap have Symmetric Payoffs, meaning value at initiation is zero and hence no money is exchanged upfront, while Options have Asymmetric Payoffs, meaning value at initial is not zero and money is exchanged upfront. Basis Risk is the potential divergence between the expected value of a derivative instrument versus an underlying or hedged transaction. Liquidity Risk is described as potential divergence between the cash flow timing of a derivative instrument versus an underlying or hedged transaction. Cost of Carry for commodity equals Opportunity Cost + Other Cost of ownership - Benefit of Ownership Replication (Hedge Portfolio) In replicating a portfolio to earn a risk-free rate under arbitrage opportunity, if the call option is underpriced, investors should buy call, and do the opposite of call, selling short the underlying and investing the proceeds at the risk-free rate. Interest Rate Swap of floating rate receivers can be replicated by long floating rate bonds and short fixed rate bonds. Derivatives pricing makes use of the fact that arbitrage opportunities guarantee that a risk-free portfolio that combines the underlying with a derivative must earn the risk-free rate. For a riskless arbitrage to exist, assets must be capable of being sold short and liquid. Forward, Futures, and Swap OTC Contracts can be customized to match an investor's desired risk exposure profile. One end is the dealer while the other end is the investor. Embedded Derivative is a derivative within an underlying, examples of which are callable/putable bonds. Forward Rate Agreement Different Fixed Rates usually exist for different time-to-maturities. It has a single settlement, which occurs at the beginning of an interest period. It requires no cash flow upfront unlike option contracts. As MRR rises over the initial fixed rate, an investor in the long position will gain receiving MRR - Initial Fixed Rate. The discounting feature of the Forward Rate Agreement, which is not present in the futures contract, leads to a convexity bias that is greater for longer discounting periods. Standard Interest Rate Swap and other swap Interest rate swaps are a type of firm commitment (It is not contingent - only option is contingent). For example, an investment manager can use interest rate swaps to increase or reduce portfolio duration without trading bonds. The price of a pay-fixed receive-floating interest rate swap is the fixed rate that results when the market value of the swap is zero at initiation. It has a constant Fixed Rates over its life, regardless of time-to-maturity. It has periodic settlements, which occur at the end of each respective period. It requires no cash flow upfront unlike option contracts. Each forward contract will be created at the fixed price that corresponds to the fixed price of a swap of the same maturity with payments made at the same dates as the series of forward contracts. That means that some of the forward contracts would have positive values and some would have negative values, but their combined values would equal zero. The replacement of existing trades on a swap execution facility by the central counterparty is best described as novation Credit default swap is a derivatives contract between a credit protection buyer and a credit protection seller in which the seller receives a series of cash payments from the buyer in return for a promise of compensation for credit losses resulting from a third party’s default. Interest Rates Futures Interest Rates Future Prices equals 100 - (100 X MRR_A, B-A). As MRR increases, the price of the underlying bond decreases, thereby futures price decreases. Therefore, investors in the long position in the Interest Rate Futures will lose money, when the Market Reference rate increases such that the price of underlying bond decreases. Futures Investors taking short positions in the future is one of the ways to hedge long underlying assets. Daily Settlement Mechanism reset the MTM daily by exchanging Variation Margin, thereby reducing the counterparty credit risk. In futures markets, contract performance is often secured by clearinghouses.. Future and Forward Comparison All else being equal, the Future is more attractive than Forward when price is in direct relation with interest rate, because daily cash settlement from future contracts can be reinvested over the period of contract. Therefore, the price differential between an equal future and forward contract is primarily due to rising interest rate with price and volatility of interest rate. When futures price and interest rates are uncorrelated, futures and forward prices equal. When future price and interest rates are negatively correlated, the forward price is greater than the future price. While futures are standardized and traded in the exchanges, Forward Contracts are traded in OTC. Forward Pricing and Value F = (S + PV(C) - PV(B))*(1+r)^T RCC(F) = S*e^(r-b+c)*T V(T) = [S + PV(C) - PV(B)] - PV(F) Option Option requires a payment to be made at the initiation contract; its value at initiation may not equal 0, whereas the values of futures, forwards and swaps at initiation must equal zero. Option Payoff is different from Option profit in that Call Option profit is Max[0, S - X] - Call Price, whereas Option payoff is Max[0, S - X]. Option Premium (Market Price of an Option) equals Intrinsic Value (Exercise Value) + Time Value, such that Time Value equals Option Premium - Intrinsic Value; we can use this relation to calculate the underlying values. But in the question, we may use Option Premium (Market Price of an Option) as an Option unless the time value is explicitly given. Non-linear Payoff of Options requires that the replicating transaction be adjusted as probability of exercise changes. Furthermore, for Call Option, the non-linear payoff requires adjustment over time based on the probability of exercise. Option Pricing by Binomial Model depends on risk free-rate; Derivative value established by binomial model is the risk-neutral pricing with no-arbitrage. All else being equal, if the up gross return increases in a one-period binomial model, the risk-neutral probability of upward move will decrease; indirect relationship. But the value of the option is independent of the probability of up/down movement. Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives Replication is the process of creating an asset or portfolio from another asset, portfolio, and/or derivative. It is used to exploit pricing differentials (Arbitrage). A hedge portfolio consists of underlying assets and derivatives on those underlying assets. In the absence of arbitrage, the portfolio is expected to earn Risk-free Rate. Hedge Portfolio = Derivative + Underlying Asset Under no-arbitrage condition, the return of the hedge portfolio is Risk-free Rate. Alternative Investments Traditional investments include all publicly traded debts and equities and shares in pooled investment vehicles (ETF) that hold publicly traded debts and/or equities. Alternative investments include hedge funds, private equities (including venture capital), commodities, real estate securities and real estate properties, securitized debts, operating leases, machinery, collectibles, and precious gems. Unlike ETF, and Open-end funds that are issued and sold at NAV, Closed-end funds can be sold at discount or premium to NAV. Digital Assets They do not have an inherent value based on underlying assets or on potential cash flow. Commodities Hard: Mined, such as copper, or extracted such as oil Soft: Those grown over time, such as livestock, grains, and cash crops such as coffee. Timberland is in the large institutional investor’s portfolio because it’s sustainable while Farmland is not. Commodity Forward Curve is upward sloping when future price is greater than spot price (contango), which means return (yield) increases with respect to time. Commodity Index returns differ from actual commodities because it is based on the futures price that depends on risk-free rate and so change in future prices. Infrastructures Divided into economic and social infrastructures. Investments in infrastructure may add an income stream, increase portfolio diversification by adding an asset class with typically low correlation with existing investments, and offer some protection against inflation. Low exposure to short-term GDP growth issues may also be a factor. In infrastructure investment, take-or-pay arrangements, where payments are based upon the availability rather than the use of an asset are used to mitigate demand/volume risk. Social infrastructure investments are directed toward human activities and include such assets as educational, health care, social housing, and correctional facilities, with the focus on providing, operating, and maintaining the asset infrastructure. Utility investments encompass environmentally sustainable development, with an increasing focus on renewable technologies, including solar, wind, and waste-to-energy power generation. Greenfield investors typically invest alongside strategic investors or developers who specialize in developing the underlying assets. Investing in correctional facilities to be constructed and sold to the government is best described as greenfield investment. Brownfield investments expand existing facilities and may involve privatization of public assets or a sale leaseback of completed greenfield projects. Real Estate Joint Ventures are a partnership structure common in real estate direct investing. Value-add Real Estate Investments Strategy may require modest redevelopment or upgrades, the leasing of vacant space, or repositioning the underlying properties to earn a high return. Investors seeking higher returns than core strategies may also accept development, redevelopment, repositioning, and leasing risk. Opportunistic investments accept much higher risks than value-add or core strategies. The main appeal of the REIT structure is the avoidance of corporate income taxation Private Equity Private Equity is a Limited Partnership where GP takes all the responsibility and unlimited liability. Investment Strategy Growth Capital Strategy with Minority Equity Investing: the firm takes a less-than-controlling interest in more mature companies that are looking for capital to expand or restructure operations, enter new markets, or finance major acquisitions. Development Capital Strategy is not a minority equity investment, but still aims to fund expansion, and restructure for proven companies. Management Buy Out - Not replacing Management Management Buy in - Replacing Management Have large amounts of undervalued assets (which can be sold to reduce debt) and generate high levels of cash flows (which are used to make interest and principal payments on the debt). Venture Capital -​ -​ -​ Pre-seed Stage:Transformation of an idea into a business plan. Seed-stage financing, or seed capital: Generally supports product development and marketing efforts, including market research. This is the first stage at which VC funds usually invest. Early-stage financing (early-stage VC), or start-up stage financing: Goes to companies moving toward operation but prior to commercial production or sales, in both of which early-stage financing may be injected to initiate. Exit Strategy SPAC: Extended time for public disclosure on company prospects to build investor interest, fixed valuation with lower volatility of share pricing, flexibility of transaction structure to best suit the company’s context, and association with potentially high-profile and seasoned sponsors and their extensive investor network. Also Include IPO, and Recapitalization Trade Sale: A private equity firm sells a portfolio company to a buyer that is active in the same industry as the portfolio company. Return Structure Committed Capital > Invested Capital > Assets under management Fee Structure Management fees for private equity funds are most likely based on committed capital Private Debt Direct Lending Distressed Debt A leverage loan is itself levered. Private Debt firms that invest in leveraged loans first borrow money to finance the debt and then extend it to another borrower. By using leverage, a private debt firm can enhance the return on its loan portfolio. Mezzanine Debt often comes with additional features such as warrants or conversion rights, which provide equity participation to lenders/investors. Venture Debt may carry additional features that could grant the lender rights to purchase equity in the borrowing company under certain circumstances. Seniority Ranking Infrastructure (Senior Secured) > Unitranche (Blend of Senior Secured and Subordinated) > Mezzanine (Subordinated) Risk Order Mezzanine > Unitranche > Infrastructure Hedge Fund Hedge Funds have a longer lockout period than regular mutual funds. Asset Pricing Levels Level 1: Assets have an exchange-traded, publicly traded price available Level 2: Asset values use outside quotes from brokers when publicly traded (Level 1) prices are not available Level 3: Asset values are computed using only internal models when outsider broker (Level 2) quotes are not available or not reliable. Fees Incentive Fee (Hard Hurdle) = (End Value - Beginning Value - Hard Hurdle - Management Fee) X Fee Rate; Hard Hurdle = Beginning Value X Hard Hurdle Rate Incentive Fee (Soft Hurdle) = (End Value - Beginning Value - Management Fee) X Fee Rate Management Fee = End Value X Management Fee Rate Return = (End - Beginning) / (Beginning) - 1 Gross Return = (End - Beginning - Incentive Fee - Management Fee) / (Beginning) - 1 High-water Mark The incentive fee is based on the performance relative to the previous high-water mark after fees. Clawback Provision: The incentive fee of 5 was accrued (not paid) in the first year from 20% of total profit of 25. But then, the next year, the fund lost 10. Now, due to Clawback provision, the General Partner is only entitled to the incentive fee of 20% for 15 which equals 3. This means GP has to return 2 of 5 initial incentive fees to the investors. Without Catch-up Clause, 80/20 split will just result in incentive fee net of hard hurdles. Hedge Fund Strategy Event Driven: Tends to be long-biased, with merger and acquisition least biased. Relative Value Strategy: includes a multi-strategy which seeks to profit from a pricing discrepancy, an unusually short-term relationship between related securities. A more conservative and accurate approach for a hedge fund to hedge its position is to use bid prices for long positions and ask prices for short positions because these are more realistic prices at which the positions could be closed. However, some managers use a simplifying approach whereby they take the average of the bid and the ask; this approach is not as accurate and could be misleading. Other Clauses Funds sometimes impose a gate, which limits or restricts redemptions for a period of time. A gate is imposed by the hedge fund manager independent of any lockup period that may apply. A gate therefore applies to all investors for a finite period of time while a lockup period applies to new investors only. Lockup period that only applies to new investors is the time periods when new investors cannot withdraw their capital—provide the hedge fund manager the required time to implement and potentially realize a strategy’s expected results. The redemption fee increases the value of investors by increasing the value of the hedge fund by a fee amount. A redemption fee may be charged, typically payable to the fund itself (rather than the manager). This is to protect remaining investors in the fund, particularly in circumstances where the redemption takes place during the lockup period. This characteristic is called a soft lockup, and it offers a path (albeit an expensive one) to redeem early. Ethical and Professional Standards Ethics Most societies acknowledge the ethical principles of honesty, fairness or justice, diligence, and respect for the rights of others. Duplicity or deception would be in violation of most ethical principles. Advocacy efforts of CFA Institute aim to build market integrity by calling for regulations that align the interests of firms and clients. The Code of Ethics (CFA) 1. Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients; employers, employees, colleagues in the investment profession, and other participants in the global capital markets. 2. Place the integrity of the investment profession and the interests of clients above their own personal interests. 3. Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities. 4. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession. 5. Promote the integrity and viability of the global capital markets for the ultimate benefit of society. 6. Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals **Stand-alone Codes of Ethics should be written in plain language as such and should address general fiduciary concepts. Mingling compliance procedures in the firm’s code of ethics goes against the goal of reinforcing the ethical obligations of employees. Professional Conduct Statement Members and candidates must self-disclose all matters that question their professional conduct, such as involvement in civil litigation or a criminal investigation or being the subject of a written complaint. GIPS Standards 1.​ The objective of the GIPS Standard is to obtain worldwide acceptance of a single standard for calculating and presenting performance and to promote investor interests and instill investor confidence. 2.​ GIPS, a voluntary, not mandatory, standards are ethical standards for investment performance presentation to ensure fair representation and full disclosure of investment performance. The main objective is to promote fair, global competition among investment firms and industry self-regulation on a global basis. 3.​ Firms must update GIPS reports provided to prospective clients to include information through the most recent annual period within 12 months of that annual period end. 4.​ It is a requirement to present a minimum of five years of annual investment performance compliant with GIPS standards. 5.​ A claim of compliance requires that all fee-paying discretionary accounts managed by the firm be included in at least one composite. Fee-paying Non-discretionary portfolios must not be included in a firm’s composites. 6.​ If documented client-imposed restrictions interfere with the implementation of the intended strategy to the extent that the portfolio is no longer representative of the strategy, the firm may determine that the portfolio is non-discretionary. 7.​ A composite is an aggregation of one or more portfolios managed according to a similar investment mandate, objective, or strategy. The firm must include terminated composites on this list for at least five years after the composite termination date. The requirement to create, use and maintain composites is designed to prevent firms from cherry-picking—using the best-performing accounts to represent the performance of an investment strategy. 8.​ The determination of which portfolios to include in the composite should be done according to pre-established criteria, not after the fact. 9.​ Rely on the integrity of input data, the quality of which is critical to creating accurate performance presentations, requiring firms to adhere to certain calculation methodologies to allow for comparability across firms. 10.​ Firms claiming compliance with the GIPS standards are responsible for their claim of compliance and for maintaining that compliance — that is, firms self-regulate their claim of compliance. Compliance with GIPS Standards Firms have two options with compliance with GIPS Standard: 1) fully comply with all requirements of the GIPS standards and claim compliance through the use of the GIPS Compliance Statement; 2) or not comply with all requirements or the GIPS standards and not claim compliance with, or make any reference to, the GIPS standards. Companies competing for businesses and asset owners may comply with GIPS, if not conflicted with local laws and regulations. For cases in which laws/regulations conflict with the GIPS standards, firms are required to comply with the laws and regulations before the GIPS Standard and make full disclosure of the conflict in the GIPS Report. Compliance enables the GIPS-compliant firm to participate in competitive bids against other compliant firms throughout the world. Even when compliance is verified by an independent third party, the firm is always responsible for maintaining that compliance and only those managing assets can claim compliance. GIPS Verification According to GIPS, verification is a process by which an independent verification firm (verifier) conducts testing of a firm on a firm-wide basis (not on a single compositie) in accordance with the required verification procedures of the GIPS standards. It provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. The Standards of Professional Conduct (CFA) I. Professionalism A. Knowledge of the Law Understand and comply with all applicable laws, rules, and regulations. Must not knowingly violate laws and rules. If a member or candidate has reasonable grounds to believe that imminent or ongoing client or employer activities are illegal or unethical, the member or candidate must disassociate, or separate from the activity. Firms might provide written protocols for reporting suspected violations of laws, regulations, or company policies. In the event of conflict between the Code and Standards and local laws, Standard I(A) requires members or candidates to comply with the stricter law, rule, or regulation. If clearly stated in the law not to release the confidential information of the client, a member should not disclose the information even when requested to support CFA investigation. B. Independence and Objectivity Use reasonable care and judgment to achieve and maintain independence and objectivity. If the firm is unwilling to permit dissemination of adverse opinions about a corporate client, members should encourage the firm to remove the controversial company from the research universe and put it on a restricted list so that the firm disseminates only factual information about the company. Members should encourage their investment firms to develop formal policies related to employee purchases of equity or equity-related IPOs. Firms should require prior approval for employee participation in IPOs, with prompt disclosure of investment actions taken following the offering. A member is prohibited from accepting benefits from corporate issuers in the form of allocation of shares in oversubscribed IPOs that are suitable for the firm's clients. Strict limits should be imposed on investment personnel acquiring securities in private placements. Adhere to strict standards of conduct that govern how issuer-paid research is conducted. Members must not offer, solicit, or accept any gift that compromises one's independence and objectivity, required to disclose their compensation. No corporate issuer should reimburse members or candidates for air transportation. It is recommended (not required) that members pay for commercial transportation and hotel charges, not meals, when attending meetings at an issuer's headquarters. Receiving a gift, benefit, or consideration from a client can be distinguished from gifts given by entities seeking to influence a member or candidate to the detriment of other clients; a gift from a client could be considered supplementary compensation. C. Misrepresentation Members must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities. Prohibits members and candidates from guaranteeing clients any specific return on volatile investments. Firms can also help prevent misrepresentation by specifically designating which employees are authorized to speak on behalf of the firm. Members may use research conducted or models developed by others within the same firm without committing a violation. The most common example relates to the situation in which one (or more) of the original analysts is no longer with the firm. Does not prohibit members and candidates from providing clients with information on investment products that have guarantees built into the structure of the products themselves or for which an institution has agreed to cover any losses. Performance presentation is not always required to provide a benchmark. D. Misconduct Must not engage in conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity or competence. Members should encourage their firms to develop/adopt a Code of Ethics to which every employee must subscribe. Disseminate to all employees a list of potential violations and associated disciplinary sanctions. Misconduct is not meant to cover legal transgressions resulting from acts of civil disobedience in support of personal beliefs. Misconduct in Private lives are not included in (I)D. II. Integrity of Capital Markets A. Material Nonpublic Information Those who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information. Review employee trading on material nonpublic information through the maintenance of watchlists. Material Nonpublic Information includes not only company information but also a financial model for valuation of stocks. Sharing financial models with a friend in another firm, who acts on the information by buying a call option is a violation of Standard II(A). B. Market Manipulation Must not engage in practices that distort prices and volumes, including securing a controlling, dominant position in a financial instrument to exploit the price of the underlying asset. The intent of the action is critical to determining whether it is a violation of this standard. Market Manipulation is not intended to restrict transactions undertaken on legitimate trading strategies based on perceived market inefficiencies. Issuing an overly optimistic projection of a security's value to induce trading by other market participants, if based on the correct information, may not be the violation of the Standard II(B). Information-based manipulation includes spreading false rumors to induce trading by other III. Duties to clients A. Loyalty, Prudence, and Care Must act for the benefit of their clients and place their clients' interests before their employer's or their own. Should not engage in trades for a client, particularly high-risk investments, before updating the client's risk and return objectives, financial constraints, and financial positions. Must follow any guidelines set by their clients for the management of clients’ assets. Members with control of client assets should submit to each client, at least quarterly, an itemized statement showing the funds and securities in the custody or possession of the member or candidate plus all debits, credits, and transactions that occurred during the period. Should make their clients aware of all forms of manager compensation. Proxies have economic value to a client, and members must ensure that they properly safeguard and maximize this value. If members are employed by trust, members are entitled to the beneficiaries of funds. B. Fair Dealing Must deal fairly and objectively with all clients when providing investment analysis, recommendations and actions; make every effort to treat all individual and institutional clients in a fair and impartial manner. Establish procedures for the timing of dissemination of investment recommendations so that all clients are treated fairly—that is, are informed at approximately the same time. Once this distribution has occurred, the members may follow up separately with individual clients, but members should not give favored clients advance information when such advance notification may disadvantage other clients. If the issue is oversubscribed, then the issue should be allocated to all subscribers. Asset allocation procedures should include processing and executing orders on a first-in, first-out basis with consideration of bundling orders for efficiency as appropriate for the asset class or the security. If the investment professional’s family-member accounts are managed similarly to the accounts of other clients of the firm, the family-member accounts should not be excluded from buying such shares. C. Suitability Make a reasonable inquiry into a client's investment experience, risk and return objectives and financial constraints. Determine that an investment is suitable to the client's financial situation and consistent with objectives, mandates, and constraints before making recommendation or actions. Judge the suitability of investments in the context of the client's total portfolio. According to Standard III(C), Suitability, when an advisory relationship exists, members and candidates must gather client information at the inception of the relationship. Such information includes the client’s financial circumstances, personal data (such as age and occupation) that are relevant to investment decisions, attitudes toward risk, and objectives in investing. In cases of Unsolicited Trade Requests that a member or candidate knows are unsuitable for a client, a member should refrain from taking investment action without telling the client of unsuitability. Should the client accept the fact that the unsolicited investment is material to the portfolio, the member should update IPS before taking action. Some members do not manage money for individuals but are responsible for managing a fund to an index or an expected mandate. The responsibility of these members is to invest in a manner only consistent with the stated mandate. An investor's objectives and constraints should be reviewed annually unless there is a reason that dictates more frequent review. A member advising investments to clients should take into consideration performance benchmarks in formulating an investment policy statement. After formulating long-term capital market expectations, members can assist in developing an appropriate Strategic Asset Allocation and Investment Program for the client, whether these are presented in separate documents or incorporated in the IPS or in appendices to the IPS. D. Performance Presentation Must make reasonable efforts to ensure that the investment performance information is fair, accurate and complete. Include disclosures that fully explain the performance results being reported. If the performance presentation is brief, the member must make available to clients and prospective clients, on request, the detailed information supporting that communication. Members should not state or imply that clients will obtain or benefit from a rate of return generated in the past. E. Preservation of Confidentiality Members and candidates preserve the confidentiality of information communicated to them by their clients, prospective clients, and former client When there is no law requiring the maintenance of confidentiality, members must keep information about current, former, and prospective clients confidential unless the information concerns illegal activities, disclosure is required by law, the client permits the disclosure of information, and information received from a client will improve service to the client, which may be disclosed only to authorized fellow employees who are also working for the clients. When there is a law requiring the maintenance of confidentiality, members should not disclose such information unless the client permits the disclosure of the information. The unsolicited stock order from the client is confidential so that members must obtain the original client's authorization before recommending the stock to other clients. Members should convey to clients that not all firm-sponsored resources may be suitable for transmitting confidential information. IV. Duties to Employers A. Loyalty Must act for the benefit of their employer and not divulge confidential information, and cause harm to the employer. A departing employee is generally free to make arrangements or preparations to go into a competitive business before terminating the relationship with his or her employer as long as such preparations do not breach the employee’s duty of loyalty. Members who plan to engage in independent practice for compensation must notify their employer and describe the types of services they will render to prospective independent clients, the expected duration of the services, and the compensation for the services. Members should not render services until they receive consent from their employer to all of the terms of the arrangement. Working on weekends and doing tasks that do not compete with her investment role employer does not violate this Standard. Members are free to use public information after departing to contact former clients without violating Standard IV(A) as long as there is no specific agreement not to do so. Non-solicitation agreement is a contract in which an employee agrees not to solicit a company's clients or customers, for his or her own benefit. Note that Standard IV(A) is not meant to be a blanket requirement to place employer interests ahead of personal interests in all matters. B. Additional Compensation Arrangements Must not accept gifts and compensations that may or will create conflicts of interest with the employer, unless written consent from all parties involved. Compensation and benefits include direct compensation by the client and any indirect compensation or other benefits received from third parties. C. Responsibilities of Supervisors Must make reasonable efforts to ensure that anyone subject to member's supervision complies with laws, rules, regulations, and the Code and Standard. If the member clearly cannot execute supervisory responsibilities because of the absence of a compliance system or because of an inadequate compliance system, the member or candidate should decline in writing to accept supervisory responsibility until the firm adopts reasonable procedures to allow adequate exercise of supervisory responsibility. Members are encouraged to recommend [not require] that their employers adopt a code of ethics. Members should also encourage their employers to provide their codes to clients, which will be effective in conveying that the firm is committed to conducting business in an ethical manner and in the best interests of the clients. V. Investment Analysis, Recommendations, and Actions A. Diligence and Reasonable Basis Exercise diligence, independence, and thoroughness in analyzing investments and have a reasonable and adequate basis, supported by appropriate research and investigation. The firm can issue a report that is different from the original report of an analyst as long as there is a reasonable and adequate basis for its conclusions. A member can write his/her name in the report even if he/she disagrees with the conclusion. A member may rely on others in the firm to determine whether secondary or third-party research is sound. Members who are directly involved with the use of external advisers need to ensure that their firms have standardized criteria for reviewing these selected external advisers and managers. Such criteria would include, but would not be limited to reviewing the adviser's established code of ethics, investment process and adherence to its stated strategy, understanding the adviser's compliance and internal control procedures, and assessing the quality of the published return information. When a member has reason to suspect that either secondary or third-party research or information comes from a source that lacks a sound basis, the member must not rely on that information as required by Standard V(A), Diligence and Reasonable Basis. Preparing only for one hour before convincing the investment is good is a violation of Standard V(A). Pro forma analysis may be standard industry practice, Earning Estimate is not required by the Standards. Earnings estimates are opinions and must be clearly identified as such. B. Communication with Clients and Prospective Clients Disclose to clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios; promptly disclose any changes. Disclose limitations and risks associated with the investment process. Use reasonable judgment in identifying which factors are important to their investments and communicate with clients. Distinguish between fact and opinion in the presentation of investment analysis and recommendation. If recommendations are contained in capsule form (such as a recommended stock list) members should notify clients that additional information and analyses are available from the producer of the report. Communication of such information is not confined to a written report; presentation of information can be made via any means of communication, including in-person recommendation or description and telephone conversation. A report writer who has done adequate investigation may emphasize certain areas, touch briefly on others, and omit certain aspects deemed unimportant. C. Record Retention Develop and maintain records to support their investment; the responsibility to maintain records that support investment action generally lies with the firm, rather than individuals. The length of record retention should be consistent with the firm's standard before the CFA standard of 7 years. The member cannot use historical recommendations or research reports created at the previous firm because the supporting documentation is unavailable. For future use, the member must re-create the supporting records at the new firm with information gathered through public sources or directly from the covered company and not from memory or sources obtained at the previous employer. VI. Conflicts of Interest A. Disclosure of Conflicts Disclose all conflicts of interests, if aware, that could impair member's independence and objectivity or interfere with duties to clients and employer. Must disclose conflicts of interests if finding out that there are conflicts of interests between the client and the member. Disclose arrangements in which the firm benefits directly from investment recommendations. Conflicts could arise from rebates from mutual fund charges to investors. Members should ensure that their firms disclose such relationships so clients can fully understand the costs of their investments and the benefits received. Members beneficially own securities or other investments if they have a direct or indirect pecuniary interest in the securities, have the power to vote for, and to dispose of securities. Buy-side members should disclose their procedures for reporting requirements for personal transactions. Members should disclose special compensation arrangements with the employer that might conflict with client interests. If the member’s firm does not permit such disclosure, the member should document the request and may consider dissociating from the activity. There is no requirement to report the matter to the CFA Institute. Member’s firms are encouraged to include information on compensation packages in firms’ promotional literature; has outstanding agent options to buy stock as part of the compensation package for corporate financing activities, the amount and expiration date of these options should be disclosed as a footnote to any research report published by the member’s or candidate’s firm. For members, accepting the board position is acceptable with disclosure. B. Priority of Transactions Investment transactions for clients must have priority over investment transactions of the member. Establish blackout periods prior to trades for clients so that managers cannot take advantage of their knowl­edge of client activity by front-running client trades. If a member has beneficial ownership in the account, he/she may be subject to preclearance or reporting requirements of the employer or applicable law. Preclear their participation in IPOs, even in situations without any conflict of interest between a member and candidate. Investment personnel should be required to direct their brokers to supply to firms duplicate copies or confirmations of all their personal securities transactions and copies of periodic statements for all securities accounts. C. Referral Fees Members and candidates must disclose to their employer, clients, and prospective clients, as appropriate, any compensation, consideration, or benefit received from or paid to others for the recommendation of products or services. Such disclosures allow clients or employers to evaluate (1) any partiality shown in any recommendation of services and (2) the full cost of the services. Must disclose to employer and current/prospective clients any benefits including both the nature and the estimated dollar value received for referrals. Even if the referral fees are not in forms of cash payment, any benefits received like referring to each other should be disclosed. VII. Responsibilities as a CFA institute member or CFA candidate A. Conduct as Participants in CFA Institute Programs Must not engage in any conduct that compromises the reputation of CFA. Should not reveal exam questions/details. Conduct covered includes but is not limited to improperly using an association with CFA Institute to further personal or professional goals. It does not cover expressing general negative opinions regarding CFA Institute, like “CFA Exam was outrageously difficult.” Conduct as Participants in CFA Institute Programs, examples of information that cannot be disclosed by candidates sitting for an exam include but are not limited to broad topical areas and formulas tested or not tested on the exam. B. Reference to CFA Institute, the CFA Designation, and the CFA Program Must not misrepresent or exaggerate the meaning or implications of CFA. When individuals anonymously express their opinions, pseudonyms or online profile names created to hide a member’s identity should not be tagged with the CFA designation. A person is a candidate in the CFA Program if the registered person has sat for a specified examination but exam results have not yet been received. General Read Question Carefully Read Answer Choices Carefully Process of Elimination Answer questions only by the context given. Things are not implied. Questions you do not know how to answer should follow the most logical sense. Even if you can’t recall the equation, try to use the given numbers in the question.