CFA Level I FormulaSheet
CFA Level I FormulaSheet
CFA Level I FormulaSheet
Prep
ETHICAL
AND PROFESSIONAL STANDARDS
ETHICAL AND PROFESSIONAL STANDARDS
I(A) Knowledge of the Law
Obey strictest law that applies. Do not associate
with law-breakers.
I(B) Independence and Objectivity
Do not offer gifts that might affect someones
independence and objectivity. Refuse gifts or
disclose to appropriate parties.
I(C) Misrepresentation
When using an outside source, cite it. Do not
promise investment returns.
I(D) Misconduct
Do not commit fraud. Personal issues that reflect
poorly on professional image are a violation.
II(A) Material Nonpublic Information
Understand what material and nonpublic
means. Do not act or cause others to act on
material nonpublic information.
II(B) Market Manipulation
Information-based and transaction-based
manipulations are not allowed.
III(A) Loyalty, Prudence, and Care
Clients come first. Treat clients investment like
your own but with higher priority.
III(B) Fair Dealing
Treat all clients fairly. Communicate investment
recommendations and changes simultaneously.
III(C) Suitability
Use a regularly updated IPS during investment
decisions. Choose suitable investments in a
portfolio context.
III(D) Performance Presentation
Do not misrepresent past performance. Do not
promise future performance.
III(E) Preservation of Confidentiality
Keep clients information confidential unless: client
is involved in illegal activity, you are legally
required, or you have client permission.
IV(A) Loyalty
Put employers needs first. Understand
responsibilities when leaving employer. Consult
employer before taking on outside employment.
IV(B) Additional Compensation Arrangements
Obtain employers written permission before
receiving cash or perks. If applicable, obtain other
partys permission.
IV(C) Responsibilities of Supervisors
Supervisors are responsible for reasonably
preventing subordinates violations but are not
responsible for subordinates behavior.
V(A) Diligence and Reasonable Basis
Exercise diligence and thoroughness. Support
actions with research and investigation.
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CFA Level I
PVRL>RLSKNSQ =
PMT
r
EAY = 1 + HPY S 1
Bank Discount Yield
Dollar discount
360
r_` =
Face value
Days to maturity
Money Market Yield (CD Equivalent Yield)
360
360 r_`
=
rff = HPY
Days to maturity 360 t r_`
Bond Equivalent Yield
BEY = 2 1 + EAY h.^ 1
Type of Measurement Scales
Nominal: Only differentiates between objects
Ordinal: Allows for rank order
Interval: Allows for degree of difference
Ratio: Has meaningful zero value
Means
Arithmetic:
Population mean, =
Sample mean, X =
Geometric:
Xs =
1
n
1
N
Nno
Nno
X N ; N = population size
X N ; n = sample size
Xo X t X O , where X N 0 for i = 1, 2, , n
1 + Rs =
1 + Ro 1 + R t 1 + R O
Harmonic:
N
Xz =
, where X > 0 for i = 1, 2, , n
I 1
Nno X
N
Percentiles
y
Location of y S} percentile, LQ = n + 1
100
If LQ is not an integer, use linear interpolation.
Mean Absolute Deviation
MAD =
O
Nno
XN X
Sample variance, s t =
1
n1
I
Nno
O
Nno
XN t
XN X t
Nno
P XN XN
E X = E X So P So + + E X SO P SO
Variance
t X =
Nno
P XN XN E X
Covariance
Cov X, Y =
Nno no
Cov X, X = t X
P X N , YN X N E X
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YN E Y
E RR =
O
Nno
O
t R R =
wN E R N
O
Nno no
wN w Cov R N , R
E R R = w R + w_ R _
t R R = wt t R + w_t t R _
+ 2w w_ Cov R , R _
where Cov R , R _ = R R _ R , R _
Correlation
N, = Corr R N , R =
1 N, 1
Cov R N , R
RN RN
Bayes Formula
P Info Event P Event
P Event Info =
P Info
Counting Rules
Factorial:
n! = n n 1 n 2 1
Combination:
n!
n
=
O C> =
r
n r ! r!
Counts ways to choose r items from n where order
does not matter, or ways to label n items with 2
different labels.
Permutation:
n!
OP> =
nr !
Counts ways to choose r items from n where
order does matter.
Multinomial:
n!
no ! nt ! n !
Extension of combination concept; counts ways
to label n items with k labels.
Discrete Uniform Distribution
1
x = xo , x t , , x O
p x = ,
n
Binomial Distribution
n
p x =
p 1 p O , where
x
n = number of trials
p = probability of success
E X = np
t X = np 1 p
Binomial Model
Describes asset price movements. Price either
moves up with probability p or down with
probability 1 p.
Continuous Uniform Distribution
1
f x =
,
a x b
ba
xa
,
a x b
F x =
ba
Normal Distribution
X ~ Normal ,
P < X < + = 0.68
P 2 < X < + 2 = 0.95
P 3 < X < + 3 = 0.99
Observed value Population mean X
Z=
=
standard deviation
E R R shortfall level
Shortfall Ratio =
Lognormal Distribution
Sampling
Simple random sampling: Subset of population is
chosen at random
Systematic sampling: Every kth observation is
chosen until desired sample size is achieved
Stratified sampling: Simple random samples are
drawn from each subpopulation (strata)
Sampling error: Difference between quantity
calculated from sample and its true value
Central Limit Theorem (CLT)
For a sample of size n 30 from a population with
mean and variance t (populations distribution
does not matter), the sample mean x
approximately follows a normal distribution with
mean and variance t n.
Standard Error of Sample Mean
Population variance is known: =
n; x t t s
Significance
level
Confidence
interval
10%
90%
5%
1%
95%
99%
1.645
1.960
2.575
Biases
Sample selection bias: Excluding subsets of data
because of data availability
Survivorship bias: A type of sample selection
bias where funds or companies that no longer
exist are excluded
Look-ahead bias: Information needed is not
available on the test date
Time-period bias: Data is based on time period
that makes the results time-period specific
Do not reject Hh
Reject Hh
h True
o False
Correct
Type II
Type I
Correct
Hypotheses
Reject null if
One-tailed
(upper)
Hh : h
HP : > h
Two-tailed
Hh : = h
HP : h
One-tailed
(lower)
Hh : h
HP : < h
1
s
+
nt 1 stt
o
o
sRt =
no 1 + nt 1
Degrees of freedom = no + nt 2
Normal populations with unknown variances that
are assumed unequal:
xo xt o t
t-statistic =
o t
sot stt
+
no nt
t
sot stt
+
no nt
Degrees of freedom = t
t
st n t
so no
+ t t
no
nt
Tests Concerning Mean Differences
Normal populations with unknown variances:
t-statistic =
d Jh
, degrees of freedom = n 1
sJ
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n 1 st
,
th
st =
1
n1
O
Nno
xN x t
Degrees of freedom = n 1
Tests Concerning Two Variances
Normal populations:
sot
F= t,
st
st
1
=
n 1
O
Nno
xN x
for j = 1, 2
Degrees of freedom 1 = no 1
Degrees of freedom 2 = nt 1
Technical Analysis: Charts
Bar chart: Shows open, close, low, and high price.
Candlestick chart: Shows open, close, low, and high
price. White body means close > open; dark body
means close < open.
Trends
Support: Low price range where buying is
sufficient to stop further decline
Resistance: High price range where selling is
sufficient to stop further increase
Reversal Patterns
Head and shoulders (H&S): Indicate an upcoming
downtrend following a preceding uptrend
Inverse H&S: Indicate an upcoming uptrend
following a preceding downtrend
Price target = Neckline Head Neckline
Double/Triple tops: When an uptrend reverses
two/three times at about the same high
Double/Triple bottoms: When a downtrend
reverses two/three times at about the same low
Continuation Patterns
Ascending triangle: Highs form horizontal line;
lows form uptrend
Descending triangle: Highs form downtrend;
lows form horizontal line
Symmetrical triangle: Highs form downtrend;
lows form uptrend
Rectangle: Highs and lows form horizontal lines
Flag: Parallel trend lines over short period
Pennant: Converging trend lines over short period
Price-Based Indicators
Moving average: Average closing price over a
specified number of periods
Golden (Dead) cross: When short-term moving
average crosses long-term moving average from
below (above)
Bollinger bands: Lines representing moving
average and moving average +/ set number of
standard deviations from average price
Momentum Oscillators
Rate of Change (ROC) Oscillator:
M = V Vx 100
V = last closing price
Vx = closing price x days ago, typically 10
ROC oscillator crossing 0 in the same direction as
the trend direction is buy/sell signal
Relative Strength Index:
Up changes
100
, RS =
RSI = 100
Down changes
1 + RS
Stochastic Oscillator:
Last closing price Low in past 14
%K = 100
High in past 14 Low in past 14
Market Equilibrium
Quantity demanded equals quantity supplied at
equilibrium price.
Equilibrium is stable if price departure will cause
price to converge back to equilibrium.
Equilibrium is unstable if price departure will
cause price to diverge away from equilibrium.
Auctions
Ascending price: Potential buyers openly bid,
starting from a low price. Highest bid wins.
First price sealed bid: Bids are not revealed until
end of auction. Highest bid wins.
Second price sealed bid (Vickery): Like first price
sealed bid but winner pays second-highest bid.
Descending price (Dutch): Price is incrementally
lowered until all units are sold. Each bidder pays
his/her own bid price.
Modified Dutch: Same as the regular Dutch except
all bidders pay the last bid price.
Surpluses
Consumer surplus: Area of triangle above price
and below demand curve.
Producer surplus: Area of triangle below price
and above supply curve
Deadweight loss: Loss of surplus, such as from
price ceiling, price floor, or per-unit tax.
Own-Price Elasticity of Demand
ERJ =
%QJ
%P
QJ
%QJ
=
%I
I
I
QJ
Indifference Curves
- Combinations of two goods with equal utility.
- Slopes downward and convex towards origin.
- Slope at any point is marginal rate of substitution
(MRS), the rate at which consumer will exchange
Good X for Good Y.
- Same consumers curves cannot cross.
Budget Constraint
For 2 goods, X and Y, the budget constraint is
represented by P Q + P Q Income.
Consumer Equilibrium
Point where highest indifference curve is attained
without violating budget constraint, i.e. budget
constraint is tangent to indifference curve.
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Income effect
Consumption
of Good X
Positive
Increase
Negative
(larger than
substitution)
Decrease
Negative
(smaller than
substitution)
Increase
Perfect Competition
- Many firms
- Identical products
- Very low barriers to entry
- Firms have no pricing power
Profit maximization:
- P = MR = MC
- P > ATC implies economic profit
- P < ATC implies economic loss
Monopolistic Competition
- Many firms
- Differentiated products (via advertising)
- Low barriers to entry
- Firms have some pricing power
Profit maximization:
- MR = MC
Oligopoly
- Few firms
- Similar products (close substitutes)
- High barriers to entry
- Firms have substantial pricing power
(price collusion possible)
Profit maximization:
- MR = MC
Monopoly
- One firm
- Highly differentiated product
- No close substitutes for product
- Significant barriers to entry
- Firm has considerable pricing power
(price discrimination)
Profit maximization:
- MR = MC
Market Power Measures
N-firm concentration ratio: Sum of market share
of the N largest firms in the industry
Herfindahl-Hirschman Index (HHI): Sum of squares
of market share of the N largest firms
Gross Domestic Product (GDP)
Nominal GDP: GDP in terms of current prices
Real GDP: GDP in terms of base-year prices
GDP deflator: Nominal GDP Real GDP 100
GDP = C + I + G + X M
C = consumption; I = investment
G = government spending
X = exports; M = imports
National Income
Sum of:
- Employee compensation
- Corporate and government pretax profit
- Interest income
- Unincorporated business net income
- Rent
- Indirect business taxes, less subsidies
Personal Income
= National income Indirect business taxes
Corporate income taxes
Undistributed corporate profits
+ Transfer payments
Type
Result of
Frictional
Temporary transitions
Structural
Cyclical
Inflation
Deflation: Negative inflation rate
Disinflation: Declining inflation rate
Hyperinflation: Extremely high inflation rate
Cost-push: From decrease in aggregate supply
Demand-pull: From increase in aggregate demand
Laspeyres index: Use base consumption basket
Paasche index: Use current consumption basket
Fisher index: Laspeyres Paasche
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Monetary Policy
Required reserves
Required reserve ratio =
Total deposits
Money multiplier = 1 Reserve requirement
Fisher effect: R OM;NOP = R >LP + L
Central Bank Roles
- Sole currency supplier
- Bank of banks and government
- Regulate and supervise payments system
- Lender of last resort
- Gold and foreign exchange reserves holder
- Operate monetary policy
Tools to Implement Monetary Policy
Policy rate: Expansionary when less than neutral
interest rate; contractionary otherwise
Reserve requirement: Increase/decrease funds
available for lending and money supply
Open market operations: Buy/sell government
bonds to increase/decrease money supply
Fiscal Policy: Spending Tools
Transfer payments: Redistribution of wealth (e.g.
Social Security and unemployment benefits)
Current spending: Spending on goods and services
Capital spending: Spending on infrastructure
Fiscal Policy: Revenue Tools
Direct taxes: Tax on income (e.g. income taxes,
corporate taxes, capital gains taxes)
Indirect taxes: Tax on goods and services
Fiscal Multiplier
1
, where MPC = marginal
=
1 MPC 1 t
propensity to consume; t = tax rate
Gains from Trade
Absolute advantage: Can produce at lower cost
Comparative advantage: Opportunity cost of
producing good is lower
Trade Restrictions
Tariffs: Taxes on imported goods
Quotas: Limits on quantity of imported goods
Export subsidies: Government payment to
exporting firms
Minimum domestic content: Minimum domestic
product requirement in goods
Voluntary export restraint: Voluntarily limiting
exports, often to avoid tariffs or quota
Regional Trading Blocs
Free trade area (FTA): No barriers to flow of goods
and services among members
Customs union (CU): FTA + common trade policy
among non-members
Common market (CM): CU + free movement of
factors of production among members
Economic union (EU): CM + common economic
institution and coordination of economic policies
Monetary union (MU): EU + common currency
Balance of Payments Components
Current account: Merchandise and services, income
receipts, unilateral transfers
Capital account: Capital transfers, non-financial
assets sales/purchases
Financial account: Government-owned assets
abroad, foreign-owned assets in the country
CPI
CPIJ
= S S _
Convertible Convertible
Net
Preferred
+ preferred +
1
debt
income dividends
interest
dividends
Weighted Shares from Shares from Shares issuable
average + preferred + convertible + from stock
options
debt
shares
shares
Classification
Dividends paid
Financing
Interest received
Operating
Interest paid
Dividends received
All taxes
Operating
Operating
IFRS:
Item
Classification
Dividends paid
Operating/Financing
Interest received
Operating/Investing
Interest paid
Dividends received
Income taxes
Operating/Financing
Operating/Investing
Operating
Investing
Financing
Purchases
Average trade payables
365
Number of days
=
of payables
Payables turnover
365
Number of days
=
of payables
Payables turnover
Revenue
Total asset turnover =
Average total assets
Revenue
Fixed asset turnover =
Average net fixed assets
Revenue
Working capital
=
turnover
Average working capital
Payables turnover =
Liquidity Ratios
Current assets
Current liabilities
Marketable
+ Receivables
Cash +
securities
Quick ratio =
Current liabilities
Cash + Marketable securities
Cash ratio =
Current liabilities
Marketable
+ Receivables
Cash +
Defensive
securities
=
interval
Average daily expenditures
Days of
Number
Cash
Days of
conversion =
sales
+ inventory of days
cycle
outstanding
payables
on hand
Solvency Ratios
Total debt
Debt-to-equity =
Total shareholders' equity
Total debt
Debt-to-capital =
Total shareholders'
Total debt +
equity
Total debt
Debt-to-assets =
Total assets
Average total assets
Financial leverage =
Average total equity
EBIT
Interest coverage =
Interest payments
Fixed
EBIT + Lease payments
charge =
Interest payments
+ Lease payments
coverage
Profitability Ratios
Net income
Net profit margin =
Revenue
Gross profit
Gross profit margin =
Revenue
EBIT
Operating profit margin =
Revenue
EBT
Pretax margin =
Revenue
Net income
Return on assets ROA =
Average total assets
EBIT
Return on total capital =
Average total capital
Net income
Return on equity ROE =
Average total equity
Valuation Ratios
Dividends declared
Dividend payout ratio =
NI available to common
Retention rate RR = 1 Dividend payout ratio
Sustainable growth rate g = RR ROE
Price per share
P/E Ratio =
Earnings per share
Current ratio =
Operating
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DuPont Analysis
Net income Revenue
ROE =
Revenue
Equity
ROE = Net profit margin Equity turnover
Net income Revenue Assets
ROE =
Revenue
Assets
Equity
Net profit
Leverage
Asset
ROE =
margin
turnover
ratio
ROE =
ROE =
NI
EBT
EBT
EBIT
Tax
burden
EBIT
Revenue
Interest
burden
Revenue
Assets
EBIT
margin
Asset
turnover
Assets
Equity
Financial
leverage
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U.S. GAAP
- Generally, both research and development costs
are expensed.
Acquired in business combination:
Acquirer allocates purchase price to each
asset acquired on fair value basis; excess
recorded as goodwill
Capitalizing vs. Expensing
- Capitalizing increases assets on the balance sheet
and increases investing cash outflow on the
statement of cash flows.
- Expensing reduces net income by the after-tax
expenditure amount in the period it is incurred.
Impairment of PP&E and Intangible Assets
U.S. GAAP:
- Asset tested for impairment only when firm may
not recover carrying value through future use.
- Asset is impaired when carrying value exceeds
assets future undiscounted cash flows.
- Impaired assets value is written down to fair
value and a loss is recognized.
- Loss recoveries are not permitted.
IFRS:
- Asset tested for impairment annually.
- Asset is impaired when carrying value exceeds
recoverable amount.
- Impaired assets value is written down to
recoverable amount and a loss is recognized.
- Loss can be reversed if asset value recovers, but
only up to carrying value before impairment loss
was recognized.
Income Taxes
Deferred tax assets (DTA): Created when taxes
payable exceeds income tax expense due to
temporary differences. Examples:
- Assets tax base > carrying amount
- Liabilitys carrying amount > tax base
Deferred tax liabilities (DTL): Created when taxes
payable is less than income tax expense due to
temporary differences. Examples:
- Assets carrying amount > tax base
- Liabilitys tax base > carrying amount
Tax base of assets: Amount that will be deducted on
the tax return as assets benefits are realized.
Tax base of liabilities: Carrying value of liability
minus amount that will be deductible on the
tax return.
Impact of tax rate changes:
Income tax = Taxes payable + DTL DTA
Bonds
Premium bond: Coupon rate > yield at issuance
Discount bond: Coupon rate < yield at issuance
Zero-coupon bond: Bond with no coupons
Issuance costs: U.S. GAAP capitalized as an asset;
IFRS reduces initial bond liability
Derecognition of debt: If an issuer redeems a bond
before maturity, a gain/loss (book value minus
redemption price) is recognized.
Debt covenants: Affirmative borrower promises
to do certain things; negative borrower promises
to refrain from certain things.
Leases
Finance (Capital) lease:
- Purchase of asset financed with debt
- Lessee will recognize asset value in balance sheet
and report depreciation expense.
Operating lease:
- Rental arrangement
- Lessee will not recognize asset/liability on
balance sheet but will make periodic lease
payments recognized as rental expense.
Conditions requiring a lease to be a finance lease:
IFRS
- Title transferred to lessee at end of lease.
- Bargain purchase option available to lessee.
- Lease term is majority of assets economic life.
- PV of lease payment is close to fair value.
- Asset is so specialized that only lessee can use
asset without significant modifications.
U.S. GAAP (lease must be treated as finance lease if
any of the following criteria are met)
- Title transferred to lessee at end of lease.
- Bargain purchase option available to lessee.
- Lease period is 75% of assets economic life.
- PV of lease payments is 90% of fair value.
Pension
Defined contribution: Firm periodically contributes
to employees retirement account during
employment. Employer contribution is expensed in
period incurred.
Defined benefit: Firm makes periodic payments to
employee after retirement. Over- (under-) funded
plan recognized as asset (liability).
Financial Reporting Quality Spectrum
1. Compliant with GAAP; decision useful; adequate
and sustainable earnings
2. Compliant with GAAP; decision useful;
inadequate and unsustainable earnings
3. Compliant with GAAP; reporting choices biased;
inadequate and unsustainable earnings
4. Compliant with GAAP; earnings actively
managed (increased/decreased/smoothed)
5. Not compliant with GAAP; numbers presented
based on companys actual economic activities
6. Not compliant with GAAP; numbers fictitious
or fraudulent.
Aggressive vs. Conservative Accounting
Aggressive
Conservative
Costs capitalized
Costs expensed
Straight-line method
Accelerated method
Smaller allowance
for doubtful accounts
I
Nno
CFN
Outlay
1+r N
1 + 1 t M;RP>PL
DM;RP>PL
EM;RP>PL
Flotation Costs
Correct way to account for flotation costs is to
adjust initial investment, not to increase WACC.
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EPS increases
EPS decreases
BVPS increases
BVPS decreases
PORTFOLIO MANAGEMENT
PORTFOLIO MANAGEMENT
Portfolio Management Process
Planning: List objectives and constraints in IPS
Execution: Asset allocation, security analysis,
portfolio construction
Feedback: Monitoring and rebalancing,
performance measurement and reporting
Risk Management
Risk management framework:
- Risk governance
- Risk identification and measurement
- Risk infrastructure
- Defined policies and processes
- Risk monitoring, mitigation, and management
- Communications
- Strategic analysis or integration
Risk tolerance: Which risks are acceptable and how
much risk should be taken
Risk budgeting: How the risks should be taken
Financial risks: Arise from financial market
activities (e.g. market, credit, liquidity risk)
Non-financial risks: Arise from within entity or
from external (e.g. operational, legal, regulatory,
political, model, tail risk)
Risk measures: Standard deviation, beta, duration,
delta, gamma, VaR, CVaR, etc.
Risk modification: By prevention and avoidance,
transfer (insurance), or shifting (derivatives)
Indifference Curve
E(Ri)
Expected'Return
NPV =
Measures of Leverage
Degree of operating leverage (DOL):
Q PV
% Operating income
=
DOL =
Q PV F
% Units sold
Degree of financial leverage (DFL):
% Net income
Q PV F
DFL =
=
% Operating income Q P V F C
Degree of total leverage (DTL):
Q PV
% Net income
=
DTL =
Q PV FC
% Units sold
DTL = DOL DFL
Breakeven
F+C
Breakeven: Q _ =
PV
F
Operating breakeven: Q _ =
PV
Q = quantity; P = price; V = variable cost/unit
F = fixed operating cost; C = fixed financial cost
Dividends
- Cash dividends and stock dividends do not affect
shareholder wealth.
- Stock splits are essentially stock dividends.
Payment chronology:
- Declaration date company declares dividend
- Ex-dividend date two days before HOR date
- Holder-of-record (HOR) date shareholders
listed on company records will be deemed to have
ownership of shares to receive dividends
- Payment date company pays dividends
Share Repurchases
Changes in earnings per share (EPS):
Moderate'Risk
Aversion
High'Risk
Aversion
Low'Risk
Aversion
Risk'Neutral
Risk'Seeking
Standard'Deviations
Minimum-Variance Portfolios
E(Rp)
Expected(Return
CORPORATE FINANCE
CORPORATE FINANCE
Net Present Value (NPV)
!i
Markowitz(EfDicient(Frontier
Minimum<Variance
Frontier
Global(
Minimum<
Variance
Portfolio
Portfolio(Standard(Deviations
!p
Ratios
Weighting
Total risk
Sharpe
ratio
Msquared
Systematic
risk
Treynor
ratio
Beta
Systematic risk = Non-diversifiable / market risk
Unsystematic risk = Diversifiable risk
Total risk = Systematic risk + Unsystematic risk
Cov R N , R ;
N,; N
=
N =
t;
;
Capital Asset Pricing Model (CAPM)
Assumptions:
- Investors are risk-averse, utility-maximizing,
rational individuals.
- Markets are frictionless.
- All investors plan for same single holding period.
- Investors have homogeneous expectations.
- Investments are infinitely divisible.
- Investors are price takers.
E R R = R + N E R ; R
SML
E(Rp)
Expected*Return
E(Rm)
Rf
Rm
*=*
pe
Slo
8R i
!i =*!m
!i
1.0
Beta
Expected*Return
E(Rp)
SML
Stock Z
Stock X
PR =
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I
Nno nN PN
D
Price Return over Single Period
PNo PNh
PR N =
PNh
Stock Y
Beta
R R R + R R ; R
!i
Vo Vh
=
Vh
Nno
Nno
PN
I
no P
Market capitalization
wNf =
fN Q N PN
I
no f Q P
Fundamental
1
wN =
N
wN =
FN
I
no F
Behavioral Finance
- Loss aversion: Dislike losses
- Overconfidence: Overconfident in abilities
- Representativeness: Rely too much on current
state when assessing probabilities
- Gamblers fallacy: Estimate future probabilities
based on recent outcomes
- Mental accounting: Keep track of gains and losses
separately for different investments
- Conservatism: Slow to make changes
- Disposition effect: Avoid realizing losses and seek
to realize gains
- Narrow framing: Focus on issues in isolation
Forms of Market Efficiency
Form
Weak
Semi-strong
Past market
data
Public
info
Strong
Private
info
Decline
wN =
wN PR N
Vo Vh + Inc
TR =
=
Vh
Price
Equal
RR R
R
Rf
0
Jensens
alpha
RR R
R
;
RR R
R; R
R
Vh =
wN TR N
Vh =
Sno
O
Sno
DS
1+r S
DS
PO
+
1+r S
1+r O
Sno
Dh 1 + g S Dh (1 + g)
Do
=
=
rg
1+r S
rg
Sno
DS
PO
+
1+r S
1+r O
DOo
r g
DOo = Dh 1 + g O 1 + g
Price Multiples
Ph Do /Eo
=
Eo
rg
Price per share
P B=
Book value per share
Price per share
P CF =
Cash flow per share
Price per share
P S=
Net sales per share
Enterprise value EV
= MV Common equity + MV Preferred stock
+ MV Debt Cash + Short term investments
FIXED INCOME FIXED INCOME
Callable Bonds
VPPL MOJ = VNon-callable bond VP
Putable Bonds
VKSPL MOJ = VNon-putable bond + VKS
PO =
Convertible Bonds
Conversion price: Price per share at which bond
can be converted into shares
Conversion ratio: Number of common shares
each bond can be converted into
Conversion value: Current share price
Conversion ratio
Conversion premium: Convertible bonds price
Conversion value
Bond Pricing with Spot Rates
PMT
PMT + FV
PMT
+
+ +
PV =
1 + zo o
1 + zt t
1 + zI I
CR: Coupon Rate; MDR: Market Discount Rate
CR = MDR
CR < MDR
CR > MDR
Par
Discount
Premium
PV K = PV PS + AI = PV 1 + r S
AI = t T PMT
Yield Measures
Annual cash coupon payment
Current yield =
Flat price
Amortized
Annual cash
+
coupon payment gain/loss
Simple yield =
Flat price
Yield-to-call (YTC) = IRR assuming the bond is
called early at the stated call price
Yield-to-worse = min YTC, yield-to-maturity
Yield Measures for Money Market Instrument:
Discount Rate (DR) Basis
Days
DR
PV = FV 1
Year
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1 + IFR ,_
= 1 + z_ _
PMT
1 + zo + Z
PMT
1 + zt + Z
+ +
PMT + FV
1 + zI + Z I
Securitization Process
- A special purpose vehicle (SPV) buys assets from
the seller firm and issues asset-backed securities
(ABS) against the assets.
- A servicer (could be same entity as seller) collects
funds and performs other related responsibilities.
Residential Mortgage Loans
- Interest: fixed, adjustable, convertible
- Amortization: full, partial, interest-only
- Prepayment: penalty, no penalty
- Foreclosure: non-recourse, recourse
Residential Mortgage-Backed Securities
- Agency RMBS issued by government agencies and
must have conforming loans
- Non-agency RMBS issued by private companies
and may have non-conforming loans
- Pass-through rate: coupon rate on the MBS
- Prepayment risk: contraction (faster-thanexpected prepayments), extension (slower-thanexpected prepayments)
- Prepayment rates are compared to the PSA
benchmark CPR
Collateralized Mortgage Obligations
- Securities backed by pool of RMBS
- Structured with tranches with varying exposures
to prepayment risks
- A sequential-pay CMO has principal and
prepayments paid to the tranches in sequence
- PAC CMO have predictable cash flows and
support tranches with more contraction or
extension risk
Collateralized Debt Obligations
Securities backed by pool of debt obligations, such
as corporate bonds, leveraged bank loans, or credit
default swap on securities
Duration
MacDur
ModDur =
1 +
K
%PV
= AnnModDur Yield
PV PV
ApproxModDur =
2 Yield PVh
ApproxModDur = ApproxMacDur 1 + r
PV PV
EffDur =
2(Curve) PVh
PortfolioDur = wo Do + wt Dt + + wI DI
MoneyDur = AnnModDur PV K
PV K MoneyDur Yield
PV PV
Price value of a basis point =
2
Basis point value = MoneyDur 0.0001
Convexity
ApproxCon =
PV + PV 2 PVh
Yield t PVh
1
Convexity Spread t
2
DERIVATIVES DERIVATIVES
Forward Contract
Value of -year forward contract at:
Initiation
Expiration
Time t
Vh T = 0
V T = S Fh (T)
VS T = SS PVS benefit
Option Moneyness
Option Moneyness
In-the-money
At-the-money
Out-of-the-money
Call
Put
SS > X
SS < X
SS = X
SS < X
SS = X
SS > X
Put
Value of underlying
Increase in
Risk-free rate
Exercise price
Time to expiration
Volatility of underlying
Payments on underlying
Cost of carry
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Note:
- Always clear the TVM worksheet before
starting a new calculation.
- For bonds, PMT and FV should have the same
sign, and opposite signs to PV.
Cash Flow Worksheet ( CF , NPV , IRR )
For non-level payments
Input ( CF )
CF0: Initial cash flow
C01: 1st distinct cash flow after initial cash flow
F01: Frequency of CO1.
C0n: nth distinct cash flow.
F0n: Frequency of C0n.
Note:
- Always clear the CF worksheet before starting
a new calculation.
- The use of F0n is optional. You can leave them as
1 and input repeating cash flows multiple times. If
you do so, C01 will be the cash flow at time 1, C02
will be the cash flow at time 2, and so on.
Output ( NPV , IRR )
I: Effective interest rate per period (in %)
NPV + CPT : Solve for net present value
IRR + CPT : Solve for internal rate of return
CFA CANDIDATE CHECKLIST
CFA CANDIDATE CHECKLIST
Source:
http://www.cfainstitute.org/programs/cfaprogram/c
ourseofstudy/Pages/candidate_checklist.aspx
NOTES
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