1,905 terms mccauley04
CFA Level 1 Complete
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Private value auctions Value is subjective and different to each bidder
Ascending price (English) auction
Bidders can bid amounts greater than the previous bid, and the bidder that first offers the highest bid wins the item and pays the amount
Sealed bid auction Each bidder submits one bid, which is unknown to the other bidders and the bidder with the highest bid wins the item and pays the price;
The reservation price is the highest price that a bidder is willing to pay;
The optimal bid for the bidder with the highest
reservation price is just slightly above the bidder with the second highest reservation price;
Bids are not necessarily equal to reservation price Second sealed bid
auction (Vickrey auction)
The bidder with the highest bid wins the item but pays the price bid by the second highest bidder;
Descending price (Dutch) auction
Begins with a price greater than what any bidder will pay and the price is reduced until a bidder agrees to pay it; If there are multiple units available, each bidder and specify how many they want to buy;
Can be modified so that winning bidders all pay the same price
Price elasticity How responsive the quantity demanded is to a change in price
Elasticity of demand A measure of how consumers respond to price changes; Perfectly elastic is when the demand curve is horizontal; Perfectly inelastic is when the demand curve is perfectly vertical
Unstable equilibrium When a supply curve intersects a demand curve more than once, the unstable equilibrium is an equilibrium where supply can increase towards another equilibrium that results in a lower price;
Caused by a nonlinear supply function
Statutory incidence Who is legally responsible for paying a tax
Incidence of tax Who ends up bearing the cost of a tax
Substitution effect Always acts to increase the consumption of a good that has fallen in price
Income effect Either increase or decrease a good that has fallen in price;
Typical of normal good to have a positive income effect; Typical of inferior good to have negative substitution effect
Positive substitution, positive income
Consumption increases
Positive substitution, negative income smaller than positive substitution
Consumption increases
Positive substitution, negative income
greater than positive substitution
Causes of demand changes
Income
Increases as prices of substitute goods increase
Decreases as the prices of complement goods increases
Causes of supply changes
Rises if technology increases; Rises if input prices decrease
Giffen good An inferior good for which the income effect outweighs the substitution effect so that the demand curve is positively sloped (higher the price, higher the demand)
Relationship cost curves
AFC slopes downward
Vertical distance between ATC and AVC equals AFC MC initially declines, then rises
MC intersects AVC and ATC at their minimums ATC and AVC are u-shaped
The MC above the AVC is the firm's short-rum supply curve
Average Revenue > AVC
Firm continue production
Average Revenue < AVC
Firm should shut down
Average Revenue > ATC
Firm should stay in business for long-run
Profit maximized Producing up to but not over MR=MC;
Producing quantity where TR-TC is at a maximum
Perfect competition Many firms compete with identical products, low barriers to entry, and the only way to compete is on price;
Perfectly elastic demand curves for each firm;
A firm will continue to expand production until marginal revenue equals marginal cost, which maximizes profit or where MR = MC;
Economic loss occurs when marginal revenue is less than marginal cost;
Firm can't make economic profit in long-run;
An increase/decrease in market demand will
increase/decrease both equilibrium price and quantity; Short-run supply curve is the marginal cost curve above the average variable cost
Monopolistic competition
Many firms that compete with differentiated products; Demand curve is downward sloping and is highly elastic; Quality, Price and Marketing are key differentiators ; Low barriers to entry;
Firms must advertise and innovate;
In short run maximize economic profits by producing where marginal revenue equals marginal cost ; In long run, price equals average total cost and economic profits are 0
Oligopoly Only a few firms compete and each must consider the actions of others when setting price and strategy; High barriers to entry;
Demand is less elastic than monopolistic competition
Monopoly Only one seller in the market and there are no good substitutes;
High barriers to entry; Maximize profit, not price;
Profit maximized when marginal revenue equals marginal cost when demand curve is above ATC
Natural monopoly When the average cost of production is falling over the relevant range of demand and having two or more producers would lead to hire production costs and hurt the consumer
Marginal cost pricing Forces the monopoly to reduce price to the point where the firms marginal cost curve intersects the market demand curve
Oligopoly models -Kinked demand curve -Cournot duopoly -Nash equilibrium -Dominant firm model
Firms assume that demand is more elastic above a certain price than below it;
Firms produce the quantity at the kink, assuming if they increase production, their revenues will be eroded by decreased prices and if they decrease production the price won't go up much;
Model doesn't account for cause of kinks
Cournot duopoly One firm will look at the other's price and production and adjust accordingly until both firms meet at an equilibrium of the same price and quantity
Nash equilibrium When the choice of all firms are such that there is no other choice that makes any firm better off;
Each decision maker will unilaterally choose what's best for himself
Dominant firm model When a firm with the vast majority prices smaller firms out of the market over time by lowering prices to the point where it falls below the average total cost of smaller competitors
Concentration measures
Nth firm indicator
Herfindahl-Hirschman Index
Nth firm indicator How much market share is held by the top N firms in the market;
Isn't affected by two large companies merging
Herfindahl-Hirschman Index
Adds up the sum of the squares of the largest firms in the market
Oligopolists and Collusion Agreements
There is an incentive to cheat and raise your share of the joint profit
Tax Burden Falls on the party with less elastic curve
Discrete Random Variable
Variable where the number of outcomes can be counted and each outcome has a measurable and positive
probability
Continuous Random Variable
Variable where the number of possible outcomes is infinite, even if upper and lower bounds exist
Discrete Uniform Random Variable
Binomial Random Variable
Variable may be defined as the number of successes in a given number of trials where the outcome can be either a success or failure;
Expected value = (probability of success) * (number of trials);
Variance = (expected value) * (1 - probability of success)
Bernoulli Random Variable
Binomial random variable with only one trial
Z-Value of Normal Distribution
The number of standard deviations away a random variable is from the population mean ;
z = (variable - population mean)\(standard deviation)
Roy's Safety First Criterion
The optimal portfolio minimizes the probability that the return of the portfolio falls below A minimum acceptable level;
= (Historical Return - Return Threshold)/(Volatility) Shortfall risk is the probability of being to the left of the minimum return
Lognormal Distribution The function e^x where x is normally distributed; Positively skewed;
Bound to the left by 0
;Price relative is the ending price divided by the starting price
Simple Random Sampling
Completely random, systemic sampling is picking every nth member of a population;
Sampling error is the difference between the sample statistic and the population's statistic
Stratified Random Sampling
When a population is divided up into smaller groups based on distinguishing characteristics;
Proportions of groups in sample same as in population
Longitudinal Data Observations over time of multiple characteristics of the same entity
Panel Data Observations of the same characteristic of multiple entities over time
distribution with mean u and a variance equal to the population variance divided by the number of sample observations
Standard Error Dividing the sample variance by the square root of the number of observations since the populations standard deviation is rarely known
Properties of Estimators
Unbiased - Low sampling error Efficient - Small variance
Consistent - Accuracy increases as sample size increases
Point Estimates Single values used to estimate population parameters
Confidence Interval A range of values the population parameter is expected to fall under;
When a distribution has a known population variance, found by:
(sample mean) (+\-) (z-statistic) * (standard error); When distribution population variance is not known, found by:
(sample mean) (+\-) (t-statistic) * (standard error)
T-Distribution A bell shaped distribution symmetrical about its median used to make confidence intervals with small samples (<30) and unknown population variance;
Degrees of freedom = # of Observations - 1
Process for Testing Hypothesis
+State Hypothesis +Select Test Statistic
+Specify Level of Significance
+State Decision Rule Regarding Hypothesis +Calculate Sample Statistics
+Make a Decision about Hypothesis +Make a Decision Based on Test
Null Hypothesis What you are testing
Alternative Hypothesis What is concluded if null is rejected
Type I Error Rejecting the null when it is true;
Significance level is probability of Type I error
Type II Error Not rejecting a false null
Found by subtracting the probability of a Type II error from 1
Z-Test Used to calculate a mean when population is known to be normally distributed
T-Test Used to compare two means when population is known to be normally distributed
Chi-Squared Test Used to test hypothesis about one variance
F-Test Used to compare two variances
Parametric Tests Rely on assumptions regarding the distribution of the population and are specific to population parameters
Nonparametric Tests Do not make any assumptions about the population and are used when parametric tests cannot be
Spearman Rank Correlation Test
Order all of the data and examine its correlation to see if there is any relationship at the extremes ;
Used when data isn't normal
Point and Figure Chart Shows price movement by having price on the vertical axis and the number of changes in direction on the horizontal axis;
X = increase one box size O = decrease one box size
Relative Strength The asset's price charted against the index price
Reversal Pattern When a trend approaches a range of prices but fails to continue beyond that range
Sentiment Indicators Discern the potential views of buyers and sellers
Put/Call Ratio Put volume divided by the call volume;
The higher the ratio, the more negative the sentiment; Sentiment indicator
Volatility Index (VIX) Measures the volatility of options on the S&P 500 index; The higher the level, the more scared the market;
Sentiment indicator
Margin Debt An increase in the number indicates bullish sentiment; Sentiment indicator
volume;
Can indicate a bearish sentiment but also an upcoming spike from shorts closing positions;
Sentiment indicator
Mutual Fund Cash Position
Ratio of a mutual fund's cash to its total positions; Increases in a down market, decreases in an up market
Cycle Theory +Presidential Cycle = 4 years +Decennial Cycle = 10 years +Kondratieff Wave = 54 years
F-Test Statistic Examines two sample variances, with the larger in the denominator and smaller in the numerator
Test's Significance The probability that a true null hypothesis will be rejected by chance
Coefficient of Variation Standard deviation divided by the mean
Contents of Footnotes +The basis of presentation such as the accounting period +Information about the accounting methods used +Additional information about extraordinary events
Contents of Management Discussion and Analysis
+The basis of presentation such as the accounting period +Information about the accounting methods used +Additional information about extraordinary events
Contents of Auditor's Opinion
+Independent view of the firms financial statements +Generally accepted accounting policies were used and judgements were reasonable
+Explanation when accounting policies change from year to year
Auditor's Opinions +Unqualified opinion +A qualified opinion +An adverse opinion +A disclaimer opinion
Unqualified auditor's opinion
Indicates the auditor believes the statements are fine
Qualified auditor's opinion
Adverse auditor's opinion
The statements are not presented fairly or don't conform to standards
Disclaimer auditor's opinion
When the auditor cannot issue an opinion
Steps of Financial Statement Analysis Framework
+State the objective and context +Gather data
+Process data
+Analyze and interpret data
+Report conclusions and recommendations +Update analysis
Accounting Information Flow
1. Journal record every transaction by order of date in the general journal
2. The general ledger sorts the entries in the general journal by account
3. An initial trade balance is prepared at the end of the period to show the balance of each account and adjustments are then made
4. Financial statements are made from the adjusted trial balances
Objectives of International Organization of Securities Commissions
+Protect investors
+Ensure market fairness, efficiency and transparency +Reduce systemic risk
SEC Forms +S-1 +10-K +10-Q +DEF-14A +8-K +144
+Forms 3, 4, 5
Form S-1 Filed before sale of a new security
Form 10-K Annual report
Form 10-Q Quarterly report
Form 8-K Discloses material events
Form 144 Notice to the SEC of a sale of non-registered securities
Forms 3, 4, 5 Notices of insider ownership
Qualities of useful financial statements
Relevance and faithful representation
Enhancements of relevance and faithful representation
+Comparability +Verifiability +Timeliness
+Understandability
Elements of IFRS' Conceptual Framework
+Assets +Liabilities +Equity +Income +Expenses
Going Concern Assumption
The company will remain in operation for the foreseeable future
Required Financial Statements
+Balance sheet +Income statement +Cash flow statement +Owner's equity +Footnotes
Features of preparing financial statements
+Fair presentation +Going concern basis +Accrual basis
+Consistency +Materiality
+Aggregation of only similar items
+No offsetting of assets against liabilities or revenues against expenses unless explicitly stated by a standard +Reporting frequency is annual
Differences between IFRS and GAAP
+IASB lists income and expenses as elements related to performance, GAAP includes revenues, gains, loses and comprehensive income
future economic benefit is probable
+GAAP doesn't allow for the upward valuation of most assets
Characteristics of a coherent financial framework
+Transparency
+Comprehensiveness +Consistency
Barriers to Creating a Coherent Financial Framework
+Valuation
+Standard setting
+Measuring value at a point in time versus it's movement over a period of time
Responsibilities of standard-setting bodies
Professional organizations to establish financial reporting standards
Responsibilities of regulatory authorities
Government agencies with legal authority to enforce compliance with financial reporting standards
Why Firms Support One Set of Reporting Standards
Would reduce the cost and the time spent on reporting
Long Lived Assets: IFRS v. GAAP
Disclosures are more extensive under GAAP
Unrealized
Gains/Losses on Held For Trading Securities
Included in net income
Unrealized Gains/Losses on
Securities Available For Sales
Included in comprehensive income
Bond Indenture The contract that specifies all the rights and obligations of the issuer and the owners of a fixed income security
Zero-Coupon Bonds Do not pay periodic interest;
Sold at a discount and pay par value at maturity
Step-Up Notes Coupon rates increase over time at a specified rate
Deferred-Coupon Bonds
Initial coupon payment is delayed;
Floating-Rate Bonds Coupon payments are based on another rate or index; Reference rate is the underlying rate;
Payment is a specified spread applied to the reference rate;
Indenture lists schedule of rate changes
Cum Coupon When the buyer is entitled to the next couponn
Ex-Coupon When the buyer does not get the next coupon
Non-Amortizing (Bullet) Bonds
Pays interest until maturity, then principal is repaid
Amortizing Bonds Pay periodic interest and principal payments over the life of a bond;
Payments are equal with the proportion of interest and principal changing with each payment
Non-Refundable Bonds
Can be called but cannot use borrowed money to buy back bonds;
Can be called but not refunded
Sinking Fund Provisions provide the repayment of principal through a series of payments over the life of the issuance;
In a cash payment, the issuer can deposit the required cash amount annually to a trustee, who will randomly call a portion of the issuance back;
In a delivery of securities, the issuer purchases bonds with a total par value equal to the amount that is to be retired in that year in the market and deliver them to the trustee who will retire them;
Accelerated Sinking Fund
Allows the issuer the choice of retiring more than the amount of bonds specified in the sinking fund
requirement
Special Redemption Prices
Redemption prices from a sinking fund or government mandated sale
Repo Agreement An arrangement by which an institution sells a security with a commitment to buy it back at a later date for a higher price
Term Repo Repo lasting longer than a day
+Yield curve risk +Call risk
+Reinvestment risk +Credit risk
+Liquidity risk +Exchange rate risk +Inflation risk +Volatility risk +Event risk +Sovereign risk
Interest Rate Risk The effect of changes in bond rates on bond values
Yield Curve Risk Possibility of a change in the shape of the yield curve
Call Risk As interest rates fall, an issuer is more likely to call its bonds and refinance at a lower rate
Reinvestment Risk Not being able to reinvest money at the same rate of return if interest rates fall and issuers call bonds or prepay loans
Credit Risk Chance the creditworthiness of an issuer will decrease
Liquidity Risk Chance a bond will be sold at less than market price due to a lack of liquidity
Exchange Rate Risk Uncertainty about the value of foreign currency cash flows to an investor in terms of his domestic currency
Inflation Risk Uncertainty of future inflation rates and decreased real return rates
Volatility Risk Chance of increased interest rate volatility causing prepayments
Event Risk Effects from factors outside of financial markets
Sovereign Risk Credit risk of a sovereign bond outside of the investor's home market
Par Bond When the bond's coupon rate equals the market yield; Bonds are typically issued near par value
Discount Bond Bond priced below its par value;
Yield required in the market rises, causing prices to fall
Yield required in the market decreased, causing prices to rise
Duration Bond's interest rate sensitivity;
The ratio of the percent change in price to the percent change in yield;
= (- Percent Change in Bond Price)/Yield Change in Percent;
Longer maturities have longer durations; Lower coupon rates have higher duration; Callable bonds have lower duration; Putable bonds have less duration risk
Reasons Floating Rate Might Reset at Par
*Placing a cap on a floating rate can increase the interest rate risk
*There is time until the next reset
*If the spread in indenture no longer reflects the credit and liquidity risk of the bond
Parallel Shift Shift in the curve is when the entire curve shifts by the same amount
Non-Parallel Shift When not all maturities change by the same amount
Disadvantages of Callable Bonds
+Uncertainty about cash flow stream
+Principal tends to be returned at times when the possibilities for reinvestment are less attractive +Capital appreciation potential is less than an option-free bond
Factors Increasing Reinvestment Risk
+Coupon is higher so interest cash flows are higher +A call feature
+Is amortizing
+Contains prepayment option
Types of Event Risk +Disasters
+Corporate Restructuring +Regulatory Issues
Ways to Issue Sovereign Debt
*Single price, regular auction cycle *Multiple price, regular auction cycle *Ad hoc auction services
Single Price, Regular Auction Cycle
Debt is auctioned periodically according to a cycle and the highest price (lowest yield) at which the entire issue to be auctioned can be sold and is awarded to all bidders
Multiple Price, Regular Auction Cycle
Winning bidders receive bonds at the price each bidder bid
Ad Hoc Auction Services
Method where central government auctions new securities when market conditions are advantageous
Tap System When issuance and auction of bonds identical to the previously issued bonds
Types of Treasury Securities
+Treasury Bills
+Treasury Notes and Bonds +TIPS
Treasury Bills Maturities of less than a year and do not make explicit interest payments;
Sold at a discount to par and pay out par value at maturity;
The implied interest rate is called the implicit interest rate;
Either 28 day (4 week), 91 day (3 month) or 182 day (6 month) maturities;
Sometimes offer cash management bills with very short maturities
Treasury Notes and Bonds
Bonds pay semi-annual coupons at a rate fixed at issuance;
Notes have maturities of 2, 3, 5, and 10 years; Until 1984, were callable every 5 years; Bonds have maturities of 20 or 30 years
Bond Pricing Prices quoted in percent and 32nds of a percent; 102-5 is equal to $102.16 per bond
TIPS Inflation protected 5 and 10 year notes and 20 year bonds;
Make semi-annual coupon payments at a rate fixed at issuance;
for changes to the CPI;
COUPON IS PAID ON ADJUSTED PAR VALUE; Bond holder gets the greater of $1,000 or the final adjusted par value at maturity;
The par value increase is taxed as income in that year
On The Run Issues Most recently auctioned treasury issues; More actively traded than other issuances; Provide best information
Treasury Strips Treasury securities that are sold in bulk to large dealers, who then strip out the coupons from principal,
repackage the cash flows, and sell them separately as zero-coupon bonds;
Coupon strips are strips created from coupon payments stripped from the original security;
Principal strips refer to principal payments with the coupons stripped off;
Taxed on their implicit interest rate
Agency Bonds Securities issued by various agencies and organizations of the Federal government;
Most aren't guaranteed by US Government explicitly, but it is implicit;
Federally related institutions are owned by the US Government and are exempt from SEC rules and are guaranteed by US Gov't;
Government sponsored enterprises are privately owned but publicly chartered organizations and were created by Congress but not guaranteed by US Gov't
Federally Related Institutions Not Guaranteed
+Tennessee Valley Authority
+Private Export Funding Corporation
Mortgage Backed Securities
Backed by pools of mortgage loans that provide both collateral and cash flow;
Self-amortizing and can be paid early;
on a pool of mortgages through proportionally to each security holder;
Collateralized mortgage obligations are derivatives of mortgage passthroughs;
Stripped mortgage-backed securities are either principal or interest portions of a mortgage backed security
Tax Backed (General Obligation) Bonds
Backed by the full faith, credit and taxing power of the issuer
Limited Tax General Obligation Bonds
Subject to a statutory limit on taxes that may be raised to pay off the obligation;
General obligation
Unlimited Tax General Obligation Bonds
Backed by unlimited taxing power of the issuer; General obligation
Double-Barrel Bonds Backed by both taxes but also special charges that are collected outside of the general fund;
General obligation
Appropriations Backed Obligations
When the state isn't the issuer but can act as a back up if the issuer defaults;
General obligation
Debt Supported by Public Credit
Enhancement
An explicit guarantee that the bond is backed up by the state or federal government;
General obligation
Revenue Bonds Supported by revenues from a specific project that is funded by the proceeds of the issuance;
Only required to pay interest and back principal if the project generates a sufficient amount of revenue
Insured Bonds Carry a third-party guarantee that cannot be cancelled and is good for the life of the bond;
Usually raises rating to AAA;
More common for a revenue bond than general obligation
Income and principal from Treasuries must be enough to cover remaining payments until maturity or next call date;
Have little credit risk Firm Specific Credit
Factors
*Past payment history
*Quality of management and their ability to adapt to changing conditions
*Industry outlook and firm strategy *Overall debt level of firm
*Operating cash flow and ability to service debt *Sources of liquidity
*Competitive position, regulatory environment and union history
*Financial management and controls *Susceptibility to event and political risk
Issue Specific Credit Factors
*Priority of claim being rated
*Value/quality of collateral pledged to issuance *Covenants of issuance
*Any third-party guarantees or insurance
Secured Debt Collateral
*Personal property *Real property *Financial assets
Debenture Unsecured bond
Unsecured Debt Credit Enhancements
*Third-party guarantees
*Letters of credit that a bank will advance the issuer for the service of its debt
*Bond insurance
Characteristics of Medium-Term Notes
+Shelf-registered and they do not need to be all sold at once
+Provide a range of maturities and yields the issuer would like to sell
+A best-effort issuance and agent does not buy bonds unsold
+No typical structure or terms
Structured Note Debt security combined with a derivative
Inverse Floater Structured note increase when reference rates decrease and vice versa
Deleveraged Floater Structured note that has coupon rates that equal a fraction of the reference rate plus a constant margin
Dual Index Floater Structured note that has two reference rates
Range Notes Floaters that equal the reference rate if it is within a specific range or zero if it is outside the range
Index Amortizing Notes
Structured Note with fixed coupons but pay back some principal early based on a reference rate
Characteristics of Commercial Paper
+Maturities of 270 days or less +Pure-discount security
+Typically issued by corporations with strong credit ratings
+Directly placed paper is sold to large investors without going through a broker
+Dealer placed paper is sold to purchasers through a commercial paper dealer
Certificates of Deposit Issued by banks and sold to their customers;
A promise by the bank to repay a certain amount plus interest;
Issued in specific denominations and for specified periods of time that can be of any length;
Penalty if funds are withdrawn earlier than the maturity date
Banker's Acceptance Guarantees by a bank that a loan will be repaid; Part of a commercial transaction;
Gives assurance to counterparty that financing is secure for the trade;
Counterparty can sell the acceptance in a secondary market or hold until it is paid;
Credit risks are the borrower does not repay or the acceptance bank does not pay
Collateralized Debt Obligation
Arbitrage CDO Created by a sponsor seeks to profit from the spread between the rate earned on the underlying assets and the rate promised to CDO holders
Balance Sheet CDO Created by a bank to reduce its loan exposure on its balance sheet
Underwritten Issues When a banker purchases the entire issue and resells it; Arrangement is called a firm commitment;
Deal is called a bought deal;
Typically a syndicate of other banks is put together to help sell issue;
Goal is to presell as much of the debt as possible
Best Efforts Sale When the banker agrees to sell as much of the issue as possible;
Not liable for the debt left over
Negotiated Offering When the price is determined between the lead investment bank and the issuer
Auction Process When the issuer determines the size and terms of the issue and several banks bid on the interest rate required to sell it;
Lowest interest rate bid wins the deal
Private Placement When an issue is sold to a small group of investors and is not required to be registered with the SEC;
Issue can be better tailored for the investors' needs; Buyers will require a slightly higher interest rate since issue can not be resold to the public
Interest Rate Tools of the Fed
+Discount rates
+Open market operations +Bank reserve requirements
+Persuading banks to change credit policies
Shapes of Yield Curve +Normal (upward sloping) +Inverted (downward sloping) +Flat
+Humped
Pure Expectations Theory
The yield for a particular maturity is an average of the short term rates that are expected in the future;
If rates are expected to rise, yields on longer maturities will be higher than on shorter maturities
Pure Expectations Theory Yield Curve Ramifications
~Short term rates expected to rise in future = normal curve
~Short term rates expected to fall in future = inverted curve
~Short term rate expected to rise then fall = humped curve
~Short term rate expected to remain constant = flat curve
Liquidity Preference Theory
Both short-term rate expectations and a liquidity premium determine yields;
Consistent with longer maturities having higher yields; Size of liquidity premium will depend on how much additional compensation investors require to take on the greater risk of longer maturity bonds;
Liquidity premium can distort information coming from the yield curve
Market Segmentation Theory
The supply of bonds and demand for bonds determine equilibrium yields for various maturity ranges;
Different investors may have strong preferences for maturity ranges that closely match their liabilities
Arbitrage-Free Treasury Spot Rates
The rates for different time periods that correctly value a Treasury bond;
Discount rates for a zero-coupon bond
Yield Spreads +Absolute yield spread +Relative yield spread +Yield ratio
Absolute Yield Spread The difference between yields on two bonds; = Higher Bond Yield - Lower Bond Yield; Most commonly used;
Relative Yield Spread The absolute yield spread as a percentage of the benchmark bond's yield;
= Absolute Yield Spread/Yield on Benchmark Bond
Yield Ratio The ratio of the yield on the subject bond to the yield on the benchmark bond;
= Subject Bond Yield/Benchmark Bond Yield; = 1 + Relative Yield Spread
Credit Spread The difference in yields between two issues that are similar in all respects except credit rating;
Decline in an expanding economy; Increase during economic contractions
After-Tax Yield = Taxable Yield * (1 - Marginal Tax Rate)
LIBOR The rate paid on negotiable CDs by banks and bank branches located in London;
Most important reference rate for floating-rate debt
Funded Investor Investor who borrows to finance an investment position
Capital Budgeting process
identifying and evaluating capital projects....projects where the cash flow to the firm will be received over a period longer than a year.
Capital Budgeting Steps
1) idea generation
2) analyzing project proposals
3) create the firm-wide capital budget
4) monitoring decisions and conducing a post-audti
Cap Budgeting Principals
1) decisions based on cash flows, not accounting income 2) Cash flows based on opportunity costs & taxes
3) timing of cash flows is important
4) Cash flows are analyzed on a after-tax basis
5) financing costs are reflected in the projects required rate of return
Externalities effects the acceptance of a project may have on other firm cash flows.
Cannibalization when a new project takes sales from an existing product
Conventional Cash Flow Patter
Unconventional Cash flow patter
more than one sign change.
NPV decision rule (independent projects)
accept any project with positive NPV and to reject any project with a negative NPV
Internal rate of return discount rate that makes the PV of the expected
incremental after-tax cash inflows just equal to the initial cost of the project.
PV (inflows) = PV (outflows)
IRR decision rule determine required rate of return for given project. IRR > required rate return, accept
IRR < required rate return, reject
Payback period number of years takes to recover initial cost of investment
Payback period = full years until recover + (unrecovered cost at beginning of last year / cash flow during last year)
Discounted payback period
uses present values of the projects estimated cash flows. Number of years takes a project to recover its initial investment in a PV term and must be greater than the payback period without discounting.
Profitability Index (PI) PV of a projects future cash flows divided by the initial cash outlay
PI = PV of future cash flows / CFo
also
1+ (NPV / CFo)
PI Decision Rule PI > 1, accept project PI < 1, reject project
Crossover rate NPV's are equal
Key advantage of NPV direct measure of the expected increase in the value of the firm. main weakness doesn't take consideration of project size
Disadvantages -
1) possibility of producing rankings of mutuall exclusive projects different from NPV analysis
2) possibility are multiple IRRs or no IRR for project
Weighted Average Cost of Capital
marginal cost of capital (MCC) - discount rate
cost of financing firms assets. View as opportunity cost.
Kd rate at which the firm can issue new debt
Kd (1-t) After-tax cost of debt. t is firms marginal tax rate. The after tax component cost of debt, Kd (1-t) is used to calc WACC
Kps Cost of preferred stock
Kce Cost of common equity. Required rate of return on common stock and is generally difficult to estimate
WACC = (Wd)[Kd(1-t)] + (Wps)(Kps) + (Wce)(Kce)
Wd = % of debt in cap structure
Wps = % preferred stock in cap structure Wce = % C/S in cap structure
Optimal Capital Budget
intersection of investment opportunity schedule with the marginal cost of capital curve identifies amount.
After-tax cost of debt (Kd)
interest rate at which firms can issue new debt net of the tax savings from the tax deductibility of interest.
kd (1-t)
Kps = Dps / P
Preferred dividends / market price preferred
Cost of equity capital required rate of return on the firms common stock.
Capital Asset Pricing Model
1) Estimate RFR. yield on default risk-free debt such as U.S Treasure notes are usually used.
2) Estimate stocks beta, B. Risk measure
Kcs = RFR +B [E(Rm) - RFR] Dividend Discount
Model Kce =
Po = D1 / Kce - g
Kce = (D1 / Po) + g
(D1 / Po) +g
Bond yield + risk premium Kce =
Bond yield + Risk Premium
Pure-play equity beta of a publicly traded firm that is engaged in a business similar to, and with risk similar to, project under consideration.
Beta Asset = Bequity x [ 1 / 1 + ((1-t) D/E) ]
D/E: comparable company's debt-to-equity ratio t : marginal tax rate
Beta Project = Basset [ 1 + ((1-t) D/E) ]
Beta -estimated using historical returns data
-estimate is affected by which index is chosen to represent market return
-revert toward 1 over time, and estimate may need to be adjusted for this tendency
-estimates for small-cap firms may need to be adjusted upward to reflect risk inherent in small firms
Country Risk Premium added to market risk premium when using CAPM
Sovereign yield spread general risk of developing country. Difference in yields between the developing countrys government bonds and T bonds of similar maturity.
Revised Capm with country risk premium
Kce = Rf + B [E (Rmkt) - Rf + CRP]
Country Risk Premium =
Sovereign Yield Spread x (annualized std of equity index of developing country / annualized std of sovereign bond mkt in terms of developed mkt currency)
Capital raises more and more capital, the costs of difference sources of financing will increase. Raising additional capital increases WACC.
Shows WACC for differenc amounts of financing
Break Points occur at any time the cost of one of the components of the company's WACC changes
Break Point = amount of capital at which components cost of capital changes / weight of component in capital structure
Flotation Costs fees charged by investment bankers when a company raises external equity capital.
incorrect treatment increase the WACC by a fixed percentage and will be a factor for the duration of the project because future project cash flows are
discounted at this higher WACC to determine NPV
Flotation costs are a cash outflow that occurs at the initiation of a project and affect the project NPV by increasing the initial cash flow. Correct way to account for flotation costs is to adjust the initial project cost.
Leverage amount of fixed costs a firm has.
ex) operating expenses, building, equipment leases -Greater leverage leads to greater variability of the firms after-tax operating earnings and net income
Business risk risk associated with firms operating income and is result of uncertainty about a firms revenues and expenditures necessary to produce those revenues.
Sales Risk uncertainty about firms sales
Operating Risk additional uncertainty about operating EARNINGS caused by fixed operating costs.
Financial Risk additional risk that a firm's common stockholders must bear when a firm uses fixed cost (debt) financing. LT leases also introduce risk.
DOL = percentage change in EBIT / percentage change in sales
---
S - TVC / S - TVC - F S - sales
DFL = ratio of the percentage change in net income (or EPS) to the percentage change in EBIT
% change in EPS / % Sales
or
EBIT / EBIT - interest
DTL = combines the degree of operating leverage and financial leverage. DTL measures the sensitivity of EPS to change in sales
= DOL x DFL
= (%ΔEBIT/%Δsales) x (%ΔEPS / %ΔEBIT) = (%ΔEPS / %Δsales)
Look back at formulas for DOL and DFL
Convince yourself if no fixed costs, DOL = 1 and if no interest cost DFL = 1. Values of 1 mean no leverage.
Leverage & ROE ROE is higher using leverage than without. Also increases the rate of change for ROE. ROE varies directly with the change in EBIT.
Breakeven quantity of Sales
quantity of sales for which revenues equal total costs, so net income is zero.
Contribution margin difference between price and variable cost per unit, is available to help cover fixed costs.
Qbe (break even quantity) =
(fixed operating costs + Fixed financing costs) / (Price -variable cost per unit)
Operating Breakeven Quantity of Sales
Consider only fixed operating costs and ignore fixed financing costs.
Special Dividends favorable circumstances allow the firm to make a one-time cash payment to shareholders, in addition to any regular dividends the firm pays.
Liquidating dividends when a company goes out of business and distributes the proceeds to shareholders. Treated as a return of capital and amounts over the investors tax basis are taxed as capital gains
Stock Splits divide each existing share into multiple shares, thus creating more shares. No change in wealth
After splits or dividends - trend
- stock prices tend to rise after
- price increases appear because splits are taken as a positive signal from mgmnt about future earnings -If no good earning report, stock prices revert to original levels
-tend to reduce liquidity due to higher percentage brokerage fees on lower-priced stocks
Create more shares but do not increase shareholder value
Reverse Stock Splits opposite of stock splits. Fewer shares outstanding but higher priced stock.
Declaration Date date the board of directors approves payment of the dividend
Ex-dividend date first day a share of stock trades without a dividend. Occurs two business days before the holder-of-record date. If buy a share on or after the ex-dividend date, you will not receive the dividend
Holder-of-record date date on which the shareholders of record are designated to receive the dividend.
Payment Date Date the dividend checks are mailed out - sent electronically
Share repurchase transaction in which a company buys back shares of its own common stock.
prevailing market price. Buy a fixed number of
shares at a fixed price
Company may repurchase stock by making a tendor offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price.
Repurchase by direct negotiation
companies may negotiate directly with large shareholder to buy back a block of shares, usually at a premium to the market price. Will reduce number of shares out, and increase EPS
Share repurchase if after-tax cost of borrowing is less than earnings yield (vice versa)
share repo will increase company's EPS (vice versa)
EPS after buyback = (total earnings - after-tax cost of funds) / shares outstanding after buyback
BVPS BVPS will decrease if the purchase price is greater than the original BVPS and increase if the repo price is less than the original BVPS
Primary source of Liquidity
sources of cash it uses in its normal day-to-day operations.
Secondary sources of liquidity
include liquidating short-term or long-lived assets, negotiating debt agreements or filing for bankruptcy and reorganizing the company.
Drag on liquidity delay reduce cash inflows, or increase borrowing costs -uncollected receivables and bad debts, obsolete inventory
Pulls in liquidity accelerate cash outflows. -paying vendors sooner
Cost of trade credit = (1 + (% discount / 1 - % discount)) ^ (365/days past discount) - 1
# days of payables = Accounts Payable / Average days purchases
Average days purchases =
Uncommitted line of credit
bank extends an offer of credit for certain amount but may refuse to lend if circumstances change
Committed (regular) line of credit
bank offers credit that it "commits to" for some period of time.
Revolving line of credit more reliable source of short-term financing than a committed line. Typically for longer terms than committed, sometimes as long as years.
Bankers acceptances used by firms that export goods. Guarantee from bank of firm that has ordered goods stating that a payment will be made upon receipt of goods
Factoring Actual sale of receivables at a discount from their face values. Size of discount will depend on how long it is until the receivables are due, creditworthiness of firms credit customers, and firms collection history on receivables.
Nonbank finance companies
smaller firms or firms with poor credit use for short-term funding
Commercial paper large creditworthy companies can issue short-term debt securities called commercial paper. Firm sells paper directly to investors (direct placement) or sells through dealers (dealer-placed paper), interest costs slightly less than rate can get from bank
Pro-forma balance sheets / IS
forward-looking financial statements that are
constructed based on specific assumptions about future business conditions and firm performance. (don't
confuse with proforma financial statements)
Constructing Sales Driven Pro Forma Financial
1 - estimate relation tween changes in sales and changes in sales-driven income statement and bal sheet items 2 - Estimate future tax rate, i rate on debt, lease
payments
3 - Forecast sales for period of interest
4 - Estimate fixed operating costs and fixed financial costs
Surplus difference between projected growth in assets and projected growth in liabilities and stockholders equity
Corporate governance set of internal controls, processes, and procedures by which firms are managed.
Net Profit Margin = NI / Sales
= EBT x (1 - t) / Sales
The Compensation Committee should ...
1) Link compensation with LT objectives
How to determine if shr repurchase will cause EPS to increase/decrease
if after-tax cost of debt < earnings yield = EPS increases if after-tax cost of debt > earnings yield = EPS decreases
DBY (discount-basis yield)
(Face - purchase price / Face) x 360 / DTM DTM = days to maturity
Forward Commitment (or Forward Contract)
An agreement between two parties. Buyer agrees to buy an asset from a seller at a future date and price
established at the start. It is a completely customized, OTC, product and includes forwards, futures and swaps.
Contingent Claim Options - Give a buyer the right but not obligation to buy/sell a security at a predetermined price and date. Includes OTC and exchange traded options.
Purpose and Criticism of Derivative Markets
Purposes:
Price discovery - often the contract closest to expiration serves as a proxy for the price of the underlying asset.
Hedging - Companies want to lock-in a certain price for a good they either rely on or produce in order to better forecast their prices/costs.
Criticisms:
Too complex, fail to do their job, legalized gambling
What role does Arbitrage play in
determining prices and
promoting market efficiency?
advantage of until the prices converge - "The Law of One Price"
What is a swap? A forward contract that is equivalent to a series of forwards. Usually, one cash flow is fixed, the other is variable and tied to another rate (exchange rate, stock price, commodity price). They are private transactions.
Explain default risk for both long and short positions in a forward contract
The contract is not settled unless both parties deliver on their side of the contract. Default risk is counter-party risk in this case.
Discuss how forward termination
alternatives prior to expiration can affect credit risk.
To terminate a forward prior to expiration, an off-setting contract must be established. This exposes the investor to credit risk from both parties.
Differentiate between a dealer and an end user of a forward contract
A dealer will take the other side of a forward contract but will attempt to off-set the risk with another contract. An end user is using the forward either to speculate or hedge their exposure to an asset.
Describe the characteristics of equity forward contracts
Equity forward contract: The promise to deliver a certain stock, stock portfolio or stock index at a certain
price+date.
What is LIBOR? The rate of eurodollars, LIBOR (London Interbank Offer Rate) is the rate at which London banks lend USDs to other London banks.
What is a Eurodollar? Describe the
characteristics of the Eurodollar time deposit market, and define Eurobor
Eurodollar: USD time-deposits outside of the US. Banks borrow dollars from other banks by issuing Eurodollar time deposits, which are essentially unsecured loans. The rate of the loans is LIBOR (London Interbank Offer Rate) - the rate at which London banks lend USDs to other London banks.
Euros from another bank. Quotes issued by the ECB (European Central Bank).
How do you calculate the cost of a $10,000, 30 day, 5.25%
Eurodollar deposit?
$10,000 x (1 + .0525(30/360)) = $10,043,750 in 30 days. The convention is to use 360 days. The quoted interest over 360 days is pro-rated and then added to the face value. called "add-on interest."
What is a FRA? Describe the characteristics and calculate the gain/loss of forward rate
agreements (FRAs)
FRA = interest rate forward contract. You calculate the gain/loss by determining the present value of the agreed upon rate and the present value of the market rate at expiration and determine the difference.
calculate and interpret the payoff of an FRA, and explain each of the component terms.
FRA expiring in 90 days on the 180 day LIBOR, quoted at 5.5%. Face value = $10M. Real rate ends up being 6%.
What does 1 X 3 and 12 X 18 mean for an FRA?
10,000,000(((.06-.055)(180/360))/(1.06(180/360))) = $24,272
Long makes money in this case.
Notional principal ((Underlying rate at Exp. - Forward Contract Rate)(Days in underlying
rate/360))/(1+Underlying rate at exp.(Days in underlying rate/360))
FRA notation:
1 X 3 : Contract expires in 1 Month, underlying rate is 60 day LIBOR (3 b/c it is total time, including contract time included)
12 X 18 : Contract expires in 12 months, underlying rate 180 day LIBOR
What is a Currency Forward Contract? Describe the characteristics of currency forward contracts
An agreement to buy/sell a certain amount of a currency at a certain time for a certain rate. Cash or delivery settlement.
What does it mean to be long vs. short in a forward contract?
What are the methods of settlement for a forward contract?
Delivery = Seller delivers the good to the buyer Cash Settlement.= Buyer and Seller exchange the net cash value at the settlement date.
Cash is much more common
What is a non-deliverable forward (NDF)?
An exclusively cash settled forward.
Describe the characteristics of forward contracts on zero-coupon and coupon bonds
Agreement to buy/sell a certain bond for a certain price at a certain date.
differentiate between margin in the securities markets and margin in the futures markets, and explain the role of initial margin,
maintenance margin, variation margin, and settlement in futures trading.
Futures margins vs. Securities margin: For securities, federal regulators set the margin. For Futures, the clearinghouse sets the margin. Margin for futures is expressed in dollar terms instead of as a percent as in the securities market. Futures initial margin is usually much lower than securities market initial margin.
Initial margin - a minimum amount deposited to demonstrate a commitment to pay the full value.
Maintenance margin - an amount lower than the initial margin. If the balance of the margin account drops below the maintenance margin, the account holder is required to deposit enough money to return the account to the initial margin level or close the position and settle the loss.
Settlement price - the avg. of the final few trades of the day.
Variation margin: additional margin posted to meet initial margin after losing more than the maintenance margin.
and the process of marking to market, and calculate and interpret the margin balance, given the previous day's balance and the change in the futures price.
allowed for a specific futures contract. If price hits a limit, the futures contract has made a limit move. Limit up, limit down. If a transaction cannot take place because of a limit, it is called locked limit.
Marking to market: The clearinghouse can mark to market, intraday and collect losses, distribute gains through daily settlement to keep loses from getting out of hand.
describe how a futures contract can be
terminated at or prior to expiration
Via off-setting. If a buyer has purchased a certain future, it offers for sale the same security.
describe the
characteristics of the following types of futures contracts: Treasury bill,
Eurodollar, Treasury Bond, stock index and currency
Treasury bill futures: Not very popular. Calculated as $1,000,000[1-rate(90/360)]
Eurodollar futures: Much more popular. Same calculation as Tbill.
Treasury Bond: Many choices on what bond can be delivered so the exchange declares a hypothetical or standard bond. Thus, if the short delivers a bond with lower interest than the hypothetical bond, they will have to pay additional money and vice versa. Thus, at
settlement, the futures price is multiplied by a
conversion factor which attempts to balance out the value. Since different bonds cost different amounts to buy in the open market and get multiplied by different conversion factors, the seller is still able to deliver the "cheapest to deliver" bond which fulfills their obligation. Thus, it is assume that the cheapest to deliver bond underlies the future.
Currency Futures: A much smaller market than currency forwards. Euro face value * conversion rate = price
Difference between forwards and futures?
1) Futures are not private transactions
2) Futures are traded on a futures exchange 3) Futures are standardized
4) Futures have a secondary market
5) Futures are guaranteed against credit losses resulting from a counter-party's ability to pay.
6) Futures contracts are regulated at the federal level
What types of options exist?
Stock options, index options, bond options (primarily OTC), interest rate options, currency options, options on futures, commodity options, weather options, real
options
Define interest rate caps, floors and collars
Interest rate cap: a series of interest rate calls, expiring on the floating loan reset dates.
Interest rate floor: a series of interest rate puts, expiring on the floating loan reset dates.
Interest rate collar: Long cap, short floor or Short cap, long floor. The short offsets the cost of the long -- a zero cost collar.
Define intrinsic value and time value, explain their relationship.
Intrinsic value is what an option is worth if exercised at expiration in the current conditions.
Time value: the difference between intrinsic value and the market price of the option.
As it gets closer to expiration, time value goes to zero and all that is left is intrinsic value.
explain how option prices are affected by the exercise price and the time to expiration
Higher the exercise price, lower the price of a call, higher the price of a put and vice versa
The greater the time till expiration, the higher the price of the bought option.
characteristics of swap contracts and explain how swaps are
terminated (reading 72)
of future cash flows
-initially, no cash is exchanged
-payment is made at the settlement date through netting unless the swap is initiated in two different currencies -The final payment is made on the termination date -The original time to maturity of the swap is called the tenor of a swap
-Swaps are subject to default risk and can be tricky to untangle. If A misses a payment to B but A's swap (after being discounted to present) is worth more than B's, the value of the swap will be used to settle the existing liability.
*swaps are completely OTC
Swap Termination:
1) Can terminate the swap ahead of time, discount the cash flows and pay the net difference. This can only happen if both parties agree to do so in advance or if both parties agree to at the time.
2) Terminate by setting up an off-setting swap. Exposes you to dual default risk. Most likely, the off-setting swap won't be perfect but at least the floating rate risk is no longer present.
3) Exercise an off-setting swaption -- an option to enz ter into a sway at terms that are established in advance
Chapter 7 versus Chapter 11 bankruptcy protection
Ch. 7 = protection for liquidation Ch. 11 = protection for reorganization
Describe the sources of return and risk for a commodity investment
Sources of return:
1) Collateral yield - the return on the cash used as margin 2) Roll Yield - the return from rolling forward the
maturity
3) Spot price - changes to the price
Contents of Footnotes +The basis of presentation such as the accounting period +Information about the accounting methods used +Additional information about extraordinary events
Contents of Management
Discussion and Analysis
+Additional information about extraordinary events
Contents of Auditor's Opinion
+Independent view of the firms financial statements +Generally accepted accounting policies were used and judgements were reasonable
+Explanation when accounting policies change from year to year
Auditor's Opinions +Unqualified opinion +A qualified opinion +An adverse opinion +A disclaimer opinion
Unqualified auditor's opinion
Indicates the auditor believes the statements are fine
Qualified auditor's opinion
There is an exception to accounting principles
Adverse auditor's opinion
The statements are not presented fairly or don't conform to standards
Disclaimer auditor's opinion
When the auditor cannot issue an opinion
Steps of Financial Statement Analysis Framework
+State the objective and context +Gather data
+Process data
+Analyze and interpret data
+Report conclusions and recommendations +Update analysis
Accrual Accounts +State the objective and context +Gather data
+Process data
+Analyze and interpret data
+Report conclusions and recommendations +Update analysis
Accounting Information Flow
1. Journal record every transaction by order of date in the general journal
3. An initial trade balance is prepared at the end of the period to show the balance of each account and adjustments are then made
4. Financial statements are made from the adjusted trial balances
Objectives of International Organization of Securities Commissions
+Protect investors
+Ensure market fairness, efficiency and transparency +Reduce systemic risk
SEC Forms +S-1 +10-K +10-Q +DEF-14A +8-K +144
+Forms 3, 4, 5
Form S-1 Filed before sale of a new security
Form 10-K Annual report
Form 10-Q Quarterly report
Form DEF-14A Proxy statement
Form 8-K Discloses material events
Form 144 Notice to the SEC of a sale of non-registered securities
Forms 3, 4, 5 Notices of insider ownership
Qualities of useful financial statements
Relevance and faithful representation
Enhancements of relevance and faithful representation
+Comparability +Verifiability +Timeliness
+Understandability
Elements of IFRS' Conceptual Framework
+Income +Expenses Going Concern
Assumption
The company will remain in operation for the foreseeable future
Required Financial Statements
+Balance sheet +Income statement +Cash flow statement +Owner's equity +Footnotes
Features of preparing financial statements
+Fair presentation +Going concern basis +Accrual basis
+Consistency +Materiality
+Aggregation of only similar items
+No offsetting of assets against liabilities or revenues against expenses unless explicitly stated by a standard +Reporting frequency is annual
Differences between IFRS and GAAP
+IASB lists income and expenses as elements related to performance, GAAP includes revenues, gains, loses and comprehensive income
+GAAP defines an asset as having future economic benefit, IASB defines an asset as a resource for which a future economic benefit is probable
+GAAP doesn't allow for the upward valuation of most assets
Characteristics of a coherent financial framework
+Transparency
+Comprehensiveness +Consistency
Barriers to Creating a Coherent Financial Framework
+Valuation
+Standard setting
+Measuring value at a point in time versus it's movement over a period of time
Responsibilities of standard-setting bodies
Responsibilities of regulatory authorities
Government agencies with legal authority to enforce compliance with financial reporting standards
Why Firms Support One Set of Reporting Standards
Would reduce the cost and the time spent on reporting
Long Lived Assets: IFRS v. GAAP
Disclosures are more extensive under GAAP
Unrealized
Gains/Losses on Held For Trading Securities
Included in net income
Unrealized Gains/Losses on
Securities Available For Sales
Included in comprehensive income
Closed End Fund Traded through secondary markets;
Initially sell for a small premium to the value of the underlying assets
Open End Fund Issues and redeems new shares based on that day's closing value;
May charge an upfront sales fee called a load Sometimes there are back-end loads;
Annual fees are charged to cover management fees, administrative expenses, distribution fees
Style Describes the basic characteristics of the underlying assets
Sector Strategy Have its investments concentrate in a specific industry
Index Fund Match returns of a particular index
Global Fund Invests in strategies all over the world
Stable Value Fund Invests in short term government securities or other investments that can provide timely principal payments and a set interest rate
Exchange Traded Fund A fund that invests in a portfolio of stocks and bonds in efforts to mimic an index;
In-Kind Creation and Redemption
When authorized participants ensure an efficient and orderly market;
Can create new shares by depositing with a trustee a portfolio of stocks that track the index;
Can redeem shares with the trustee for underlying portfolio;
Keeps market price close to NAV;
No capital gains to fund, resulting in no tax liability
Advantages of ETFs +Efficient diversification +Traded like a stock
+Better risk management by having options and futures markets
+Investors know the exact composition of the fund throughout the day
+Low expense ratios
+No worry about trading a a premium or discount to NAV
+Dividends can be reinvested immediately +Low capital gains tax liability
Disadvantages of ETFs +Few indices for ETFs to track
+Intraday trading might not matter for long-term investors
+Low volume may result in inefficient markets
+Institutions can get same exposure with lower expenses and tax consequences by investing directly in the index
Risks of ETFs +Exposed to market risk
+Only invest in only a portion of the market, opening up investor to asset class and sector risk
+If market isn't liquid enough, won't stick to NAV
+If doesn't replicate index exactly, there is tracking error risk
+Can be levered and opened to credit risk by using derivatives
+Can be exposed to country or currency risk
Outright Ownership of Real Estate
Holder has full ownership rights for an indefinite time period
Estate Ownership must meet conditions of the loan
Mortgages Receives monthly principal and interest payments paid by a borrower;
If borrower defaults, investor gets ownership
Real Estate
Aggregation Vehicles
Investing in a pool of real estate assets
Ways to Value Real Estate
+Replacement cost +Comparable sales +Income method
+Discounted after-tax cash flow model
Net Operating Income Gross operating income minus estimated vacancy, collections and other operating expenses
Stages of Venture Capital
*Seed stage
*Start-up financing i *First stage financing *Formative stage *Later stage financing *Second stage investing *Third stage investing *Mezzanine financing
Seed Stage Providing capital in the earliest stage of business; Helps fund research and development
Start-Up Financing Funding used for completion of product development and fund initial marketing efforts
First Stage Financing The funding used during the transition to commercial production and sales of products
Formative Stage Financing
Spanning seed stage to first stage financing
Later Stage Financing Financing when marketable goods are in production and sales are underway
Second Stage Financing
Investing in a company producing and selling a product that isn't generating income yet
Mezzanine Financing Financing enables the company the financing to go public
Venture Capital Investment Characteristics
*Illiquidity
*Long-term investment horizon *Difficult to value
*Limited information
*Good entrepreneurs don't always make good managers *Market conditions play a big role in venture capital returns
*Require extensive operations analysis
*Most implant factors are expected payoff at exit, timing of exit, and probability of failure
Long/Short Fund Take long and short stock positions; Largest category;
Not market neutral since they try to profit more from their long positions than their short positions
Market-Neutral Fund A type of long/short fund that attempts to make money despite what the general market is doing;
Long and short positions net themselves out
Global Macro Funds Make bets on the direction of a market, currency, interest rate or some other factor;
HIghly levered through the use of derivatives
Event Driven Funds Strive to capitalize on some unique opportunity in the market
Benefits of Funds of Funds
*Gives access to investors with limited capital resources *Greater diversification
*Fund of fund managers have expertise in picking managers
Drawbacks of Funds of Funds
*Fees are higher than investing in a hedge fund by yourself
*Returns can be lowered by diversification
Ways Hedge Funds Use Leverage
*Borrow through a margin account *Borrow externally
*Utilize derivatives that do not require trading in cash
+Hard to value underlying assets +Counterparty credit risk
+Short squeezes +Margin calls
Self Selection Bias When the only information available for reporting is from managers who had good enough performance to want to report it
Backfilling Bias When past performance of an index is inflated because funds with poor performance in the past is not included
Smoothed Pricing Occurs because there is not daily pricing of hedge fund assets
Hedge Fund Indices Problems
*Self-selection bias *Backfilling bias *Survivorship bias *Smoothed pricing
*Return measures do not account for unlimited downside with limited upside with options
*The incentive fees give the manager reason to take extra risk since they have nothing to lose
Distressed Securities When companies are about to or have filed for bankruptcy;
Company sometimes tries to negotiate a restructuring outside of court;
Debt holders try to get equity stakes; Illiquid with long investment horizons
Reasons to Invest in Commodities
+Exposure to economic growth +Hedge against inflation
+Diversification
Collateralized
Commodities Futures Positions
Require buying a specific futures contract and buying government securities, with a market value equal to the contract value of the futures contract;
Any gains from the futures contract would be used to buy more government securities and cover margin calls by selling them;
Contango When a future price is above the spot price;
Caused by companies wanting to lock in future rates to match future liabilities
Backwardation When a futures price is below the spot price;
Caused by hedgers to insure against price declines in the future;
Some markets are described as having normal backwardation
Sources of Commodity Returns
+Collateral yield +The price return +Roll yield
Indexed Commodity Strategy
An active investment because rolling risk and investing on the futures curve require active management;
Weights of various commodities and blocks can change over time and must be managed;
Collateral must be managed
Common Shares ownership interest. Residual claim (what's left after debt holders and preferred stockholders)
Proxy having someone else vote as they direct them on their behalf
Statutory Voting each share held is assigned one vote in the election of each member of the board of directors.
Cumulative voting shareholders can allocate their votes to one or more candidates as they choose. Benefits shareholders.
Callable common shares
firm the right to repurchase the stock at a pre-specified call price
Putable common shares
shareholder the right to sell the shares back to the firm at a specific price. places a floor under the share value.
Preference Shares no voting rights usually, fixed periodic payments.
Cumulative preferred promised fixed dividends and any dividends that are not paid must be made up before common shareholders can receive dividends.
Non-cumulative preferred
