CFA Mind Maps Level 1

(1)

1. Code Of Ethics And

Standards Of

Professional Conduct

a.

Struc

Structu

ture

re of

of the

the CFA

CFA

Institu

Institute

te Profe

Professiona

ssionall

Conduct Program

Basic

Basic struc

structure

ture for

for enforcing

enforcing

the Code and Standards

The CFA Institute Bylaws

Rules of Procedure

primary

primary principle

principles

s

Based on two

Fair process to member and candidate

Confidentiality of proceedings

Professional Conduct

program (PCP)

The

The CFA

CFA Instit

Institute

ute

Board of Governors

Maintains oversight and responsibility

Throu

Through

gh the

the Discip

Disciplin

linary

ary

Review Committee (DRC)

Is

Is res

respon

ponsi

sibl

ble

e fo

forr the

the

enfor

enforceme

cement

nt of

of the

the

Code and Standards

The

The CFA Desig

CFA Designated

nated

Officer

Directs professional conduct staff

Conducts professional

conduct inquiries

An

An inq

inquir

uiry

y canbe

canbe pro

prompt

mpted

ed

by several circumstances

Selfdisclosure

Written complaints

Evidence of misconduct

Report by a CFA exam proctor

Proce

Process

ss for

for the enfo

the enforcem

rcement

ent

of the Code and Standards

Whe

When

n an

an

inqui

inquiry

ry is

is

initiated

The

The Profession

Professional

al

Condu

Conduct

ct staf

stafff cond

conduct

ucts

s

an

an invest

investigat

igation

ion that

that

may include

Requesting a written explanation

from the

from the member or

member or candidate

candidate

Interviewing

The member or candidate

Complaining parties

Third parties

Collecting documents and records in support of its investigation

Uponreviewin

Uponreviewing

g the

the

mater

material

ial obtain

obtained

ed durin

during

g

the investigation, the

Designated Officer may

Conclude the inquiry with no disciplinary sanction

Issue a cautionary letter

Continue proceedings

to discipline the

member or candidate

If

If fin

findi

ding

ng tha

thatt a

a vio

violat

latio

ion

n of

of

theCode

theCode and

and Stan

Standa

dard

rds

s

occur

occurred

red,, the

the Desig

Designate

nated

d

Offi

Officer

cer prop

propose

oses

s a

a

disciplinary sanction

Accepted by member

Rejected by member

The matter is referred to a

hearing by a panel of CFA

Institute members

b,c.

Six

Six compo

compone

nent

nts

s of

of

the Code of Ethics

Act with integrity, competence

Act with integrity, competence,, diligence,

diligence,

respect and in an ethical manner

Integrity of

Integrity of investment professi

investment profession &

on &

interest of clients a

interest of clients a bove

bove personal interest

personal interest

Care & judgment

Practice ethics & encourage others to practice

Integrity & rules of capital markets

Professional competence

Sev

Seven

en Stan

Standa

dards

rds of

of

Professional Conduct

Professionalism

Integrity of Capital markets

Duties of Clients

Duties to Employers

Investment analysis, Recommendations & Actions

Conflict of interest

Respo

Responsib

nsibili

ilitie

ties

s as

as a

a CFA

CFA Instit

Institute

ute

member

member or CFA Candidate

or CFA Candidate

All

All CFA

CFA Insti

Insti tute members and

tute members and candid

candid

aa

tes are

required to

(2)

A. Knowledge

of the law

Guidance

Understand and comply with

applicable laws and regulations

Code and Standards vs. Local law

Follow stricter law and

Follow stricter law and regulation

regulation

Participation or

Participation or associatio

association

n

with violations by others

Responsible for violations in which they

knowingly participate or assist

Diss

Dissocia

ociate

te fro

from

m illeg

illegal,

al,

unethical activities

Leave employers (in extreme case)

Intermediate steps

Att

Attemp

emptt to stopthe

to stopthe beha

behavio

viorr by

by bri

bringi

ngingit

ngit to

to theatte

theattenti

ntion

on of

of

employer through a supervisor or compliance department

May consider directly confronting

the involved individuals

If

If notsucc

notsuccess

essful

ful,-->

,--> ste

step

p awa

away

y and

and

dissociate from the activity by

Removing their name from written reports

Asking for a different assignment

Inaction with continued association may be construed as knowing participation

Not required reporting viol

Not required reporting violations to

ations to government, CFAI,

government, CFAI,

but advisable in some cases or required by

but advisable in some cases or required by laws in others

laws in others

procedures for

compliance (RPC)

Membe

Members

rs and

and

candidates

Stay informed

Review procedures

Maintain current files

When in doub

When in doub t,

t, seek advice of

seek advice of

compliance personnel or legal counsel

When dissociating from

When dissociating from violations,

violations, --> Document

--> Document

any violations and urge firm

any violations and urge firms to

s to stop them

stop them

Firms

Develop and/or adopt a code of ethics

Make available to employees info that

highlights applicable laws and regulations

Establish written procedures for reporting suspected

violation

violation of

of laws, regula

laws, regulations or compa

tions or company policies

ny policies

Application

B. In

B. In dependenc

dependence

e

and objectivity

Guidance

Maintain independence and

objectivity in professional activities

Howto

Howto co

cope

pe wit

with

h ext

exter

ernaland

naland

internal pressures

External

pressures

By benefits

Gifts, Invitations to lavish

funct

functions,Tickets

ions,Tickets,, Favor

Favors,

s, Job

Job refer

referrals

rals,,

Allocation of shares in

Allocation of shares in oversubscr

oversubscribed IPOs...

ibed IPOs...

From public companies

To issue favorable reports

From

From Buysi

Buyside

de clien

clients

ts

May

May try

try to

to press

pressure

ure sell

sellside

side anal

analysts

ysts

Internal

pressures

From

From their

their

own firms

e.g. to issue f

e.g. to issue f avorable research

avorable research reports/

reports/

recommendations for certain companies

Investmentbanking

relationships

to

to iss

issue

ue fav

favor

orabl

able

e res

resea

earc

rch

h on

on cur

curre

rent

nt or

or

prospective investmentbanking clients

Conflicts of interest

--> -->

Modest gifts and entertainment are

acceptable but special care must be taken

must disclose to

must disclose to employers

employers

Best practice: reject any offer of gifts,

threatening independence and objectivity

Recommendatio

Recommendations

ns must

must

convey true opinions

free of bias from pressures

be stated in clear

and unambiguous language

(3)

2.2 Standard II

INTEGRITY OF

CAPITAL MARKETS

A. A. Material no

Material no n-public

n-public

information (MNI)

Guidance

Defin

Definiti

ition

on of

of "Mate

"Material

rial

nonpublic information"

Material information

its significant impact to the price

of security if it is

disclosed

Reasona

ble investors would

like

to know for making decision

The reliability of

the information

Non-public until

disseminated to the market place and

effficient time for investors to react

Mus

Mustt be

be par

partic

ticula

ularl

rly

y awa

aware

re of

of inf

info

o

selectively disclosed by corporations

Mosaic

Theory

Analysis of Public info + nonmaterial

nonpub

nonpublic

lic info

info -->

--> Invest

Investment

ment conc

conclusi

lusion

on

Analysts are free to act on this collection

of info without risking violation

Analysts should save and

document all their research

RPC

Mak

Make

e rea

reasona

sonabl

ble

e eff

effort

orts

s to

to achi

achiev

eve

e

public dissemination of material info

If

If publi

public

c disse

disseminat

mination

ion

is not possible,

Must

Must com

communic

municat

ate

e the

the inf

info

o onl

only

y to

to the

the des

designa

ignate

ted

d

supervisory and compliance personnel within the firm

Must not take investment action on the basis of the info

Mus

Mustt not

not know

knowing

ingly

ly eng

engage

age in

in cond

conduct

uct

inducing insiders to privately disclose MNI

Encourage firms to

adopt

adopt complian

compliance

ce proced

procedures

ures

preventing misuse of MNI

dev

develop

elop &

& fol

follow

low dis

disclos

closur

ure

e poli

polici

cies

es

to ensure proper dissemination

use "firewall"

Proh

Prohib

ibit

ition

ion of

of all

all pro

proprie

prietar

tary

y tra

tradi

ding

ng whi

while

le fir

firm

m

is in possession of MNI may

is in possession of MNI may be inappropriate

be inappropriate

B. Market

manipulation

Definition

Distort prices or artificially inflate trading volume

with the intent to mislead market participants

can be related to

transactions

transactions that dec

that deceive

eive

market participants

Transac

Transaction

tions

s that

that artifi

artificia

cially

lly

distort prices or volume

Sec

Securi

uring

ng a

a cont

control

rollin

ling,

g, dom

dominan

inantt pos

positi

ition

on in

in a

a

fin

financ

ancial

ial inst

instrum

rumen

entt to

to ex

exploi

ploitt and

and mani

manipul

pulat

ate

e

price of a related derivative/or underlying asset

dissem

disseminati

ination

on of

of false

false

or misleading info

including

including spre

spreading false rumo

ading false rumors

rs

to induce trading by others

Standard II(B) not meant to

prohibit legitimate trading strategies

prohibit transactions done for tax purposes

Th

The

e in

inte

tent

nt of

of act

actio

ion

n is

is cri

criti

tica

call to

to det

deter

ermi

mini

ning

ng

whether it is a violation of this Standard

(4)

3+4 GIPS

Introdu

Introduction toction to GlobalGlobal Investment Performance Investment Performance Standard

Standards s (GIPS)(GIPS)

a1. Why were the GIPS Standards created? a1. Why were the GIPS Standards created?

The financial markets and The financial markets and investment management industry investment management industry are becoming increasingly global are becoming increasingly global

a2. Who can claim a2. Who can claim compliance?compliance?

Only i

Only i nvestmenvestment management firmsnt management firms that actually manage assets that actually manage assets

a3. Who benefit from Compliance? a3. Who benefit from Compliance?

Prospect clients and Prospect clients and investmentinvestment management firms management firms

b. Construction & purpose of Composites b. Construction & purpose of Composites

A composite is

A composite is an aggregation of discretionaryan aggregation of discretionary portfolios into a

portfolios into a single group that represents asingle group that represents a particular investment objectives or strategy particular investment objectives or strategy A composite must include all

A composite must include all actual, fee-payingactual, fee-paying discretionary portfolios managed in accordance discretionary portfolios managed in accordance with the same investment objective or strategy with the same investment objective or strategy Composites must include new portfolios on a Composites must include new portfolios on a timely and consistent basis after the portfolio timely and consistent basis after the portfolio comes under management

comes under management

Firms may set minimum asset levels for inclusion in Firms may set minimum asset levels for inclusion in a portfolio, but changes to a composite-specific a portfolio, but changes to a composite-specific minimum asset level are not permitted retroactively. minimum asset level are not permitted retroactively. Terminated portfolios must be included in Terminated portfolios must be included in thethe historical returns of appropriate composites historical returns of appropriate composites

c. Verification c. Verification

increase the level of confidence that a firm claiming increase the level of confidence that a firm claiming GIPS compliance did adhere to GIPS GIPS compliance did adhere to GIPS Improve a firm's internal policies and procedures wi Improve a firm's internal policies and procedures wi thth regard to all aspects of

regard to all aspects of complying with the GIPS standards.complying with the GIPS standards. Firms are

Firms are encouragedencouraged butbut not requirednot required to undertake the verification process to undertake the verification process A single verification report is

A single verification report is issued for the entire firm.issued for the entire firm. Verification cannot be carried out for a single composite Verification cannot be carried out for a single composite

Firms that have been verified are encouraged to add a disclosure to composite presentations or Firms that have been verified are encouraged to add a disclosure to composite presentations or advertisements stating they have been verified:

advertisements stating they have been verified: "[name of firm] has been verified for the periods"[name of firm] has been verified for the periods [insert dates] by [name of verifier]. A

[insert dates] by [name of verifier]. A copy of the verification report is available upon request."copy of the verification report is available upon request."

Key features of the Key features of the GIPS

GIPS stanstandarddardss & & fundamentals fundamentals of of compliance compliance

GIPS Objectives GIPS Objectives

To obtain glo

To obtain glo bal acceptance of calculation and presentationbal acceptance of calculation and presentation standards in a fair, comparable format with full standards in a fair, comparable format with full disclosuredisclosure To ensure co

To ensure co nsistence, accurate investmensistence, accurate investment performance datant performance data To promote fair

To promote fair competition among investment managemcompetition among investment management firmsent firms To promote global "self regulation"

To promote global "self regulation"

Key characteristics Key characteristics

To claim

To claim GIPS, investment managementGIPS, investment management firms must define its "firm" firms must define its "firm" Require Firms to include all

Require Firms to include all actual fee paying,actual fee paying, discretionary

discretionary portfolios in composites definedportfolios in composites defined according to

according to similar strategy/investment objectivessimilar strategy/investment objectives Rely on integrity of input data

Rely on integrity of input data

If an investment firm applies

If an investment firm applies GIPS in a performance situation that isGIPS in a performance situation that is not addressed specifically by GIPS/ is open to inte

not addressed specifically by GIPS/ is open to inte rpretation,rpretation, disclosures other than those required by GIPS may be necessary disclosures other than those required by GIPS may be necessary GIPS

GIPS do notdo not address every aspect of address every aspect of performanceperformance measurement, valuation, attribution or cover all asset classes measurement, valuation, attribution or cover all asset classes

Firms must meet Firms must meet fullfull compliance compliance to claim GIPSto claim GIPS

Compliance cannot be achieved on a Compliance cannot be achieved on a single product, portfolio, or composite single product, portfolio, or composite

Effective date Effective date

The effective date of the revised Standards is 1 The effective date of the revised Standards is 1 Jan 2011.Jan 2011. Presentations that include performance results for periods after 31 Presentations that include performance results for periods after 31 Dec. 2005 must meet

Dec. 2005 must meet all the requirements of the revised GIPS.all the requirements of the revised GIPS. Performanc

Performance presentations that include results through 31 Dec. e presentations that include results through 31 Dec. 20052005 maybe prepared in compliance with the 1999

maybe prepared in compliance with the 1999 version of GIPS.version of GIPS.

Documents policies and procedures Documents policies and procedures

Firms must document, in writing, their polices Firms must document, in writing, their polices andand procedures used in establishing and maintaining procedures used in establishing and maintaining compliance with all requirements of compliance with all requirements of GIPSGIPS

Claims of compliance Claims of compliance

Once a firm has meet

Once a firm has meet all the required requirements of GIPSall the required requirements of GIPS , use this, use this statement to declare: "[Insert name of firm] has prepared and presented this statement to declare: "[Insert name of firm] has prepared and presented this report in compliance with the

report in compliance with the Global Investment Performance Standards (GIPS)."Global Investment Performance Standards (GIPS)." If not meet all the

If not meet all the requirements, cannot state:"...in compliance with GIPS except for..."requirements, cannot state:"...in compliance with GIPS except for..." Statements referring to the calculation methodology used in a composite Statements referring to the calculation methodology used in a composite presentation as being "in

presentation as being "in accordance [or compliance] with the Globalaccordance [or compliance] with the Global Investment Performance Standards" are

Investment Performance Standards" are prohibitedprohibited..

Statements referring to the performance of a single, existing client as being Statements referring to the performance of a single, existing client as being "calculated in"calculated in accordanc

accordance with e with the Global Investment the Global Investment PerformanPerformance Standards" arece Standards" are prohibitedprohibited except when aexcept when a GIPS complaint firm reports the performance of an individual account to the existing client GIPS complaint firm reports the performance of an individual account to the existing client

Firm fundamental Firm fundamental responsibilities responsibilities

provide a compliant presentation to all prospect cli provide a compliant presentation to all prospect cli ents, cannotents, cannot choose to whom

choose to whom they want to present compliant performancethey want to present compliant performance

provide a complete list and description of all of the firms' provide a complete list and description of all of the firms' composites to any cli

composites to any cli ent that makes such a requestent that makes such a request

must list discontinued composites on must list discontinued composites on the firms' list of composites for at the firms' list of composites for at least 5 years after discontinuation least 5 years after discontinuation

The scope of the GIPS The scope of the GIPS Investment firm definition

Investment firm definition

Firms from any country may come into compliance with GIPS Firms from any country may come into compliance with GIPS GIPS must be applied on the

GIPS must be applied on the firm-widefirm-wide basis. Firm must be defined basis. Firm must be defined as an investmentas an investment firm, subsidiary, or division held out to clients

firm, subsidiary, or division held out to clients as aas a distinct business entitydistinct business entity Total firm assets must be the aggregate of the

Total firm assets must be the aggregate of the market valuemarket value of of all discretionary and non-discretionary assets under management. all discretionary and non-discretionary assets under management. This includes both fee-paying and non-fee-paying assets This includes both fee-paying and non-fee-paying assets

Historical performance record Historical performance record

Firms must initially show GIPS compliant history for a

Firms must initially show GIPS compliant history for a minimum of 5 years,minimum of 5 years, oror since inception

since inception if the firm has been in existence forif the firm has been in existence for less than 5 years.less than 5 years. After 5-year compliant history has been achieved, firms must After 5-year compliant history has been achieved, firms must add an additional year of

add an additional year of performancperformance each year untile each year until 10-year performance recor

10-year performance record is d is established, at a minimumestablished, at a minimum

A firm may link non-GIPS A firm may link non-GIPS compliant performance to its compliant performance to its compliant history as long as compliant history as long as only GIPS compliant performance is

only GIPS compliant performance is presented for periods after 1 Jan. 2000; presented for periods after 1 Jan. 2000; and

and

Firm discloses non-compliance period Firm discloses non-compliance period and explain how it is and explain how it is not in compliancenot in compliance with GIPS

with GIPS

Firms previously claiming compliance with

Firms previously claiming compliance with an Investment Performancean Investment Performance Council-endorsed Country Version of GIPS are granted reciprocity to Council-endorsed Country Version of GIPS are granted reciprocity to claim compliance with GIPS for historical periods prior to 1 Jan. 2006 claim compliance with GIPS for historical periods prior to 1 Jan. 2006

How

How areare GIPSGIPS stanstandarddardss implem

implemententeded inin councountritrieses withexistin

withexistingg stanstandarddardss for performance reporting for performance reporting If local/country specific law or

If local/country specific law or regulation conflicts with GIPS regulation conflicts with GIPS

Comply with local law or Comply with local law or regulation conflicts with GIPS regulation conflicts with GIPS Make full disclosure of the conflict Make full disclosure of the conflict Note: this differs from Standards of

Note: this differs from Standards of

Professio

Professional Conduct in nal Conduct in which thewhich the

stricter of local laws or Standards of

Professional Conduct prevails

Majo

Majorr sectsectionsof ionsof GIPS standards GIPS standards

Fundamentals and Compliance Fundamentals and Compliance

Input data Input data Consistency of input data is critical to Consistency of input data is critical to effective compliance with GIPS and effective compliance with GIPS and establish a foundation for full, fair and establish a foundation for full, fair and comparable performance presentations comparable performance presentations

Calculation methodology Calculation methodology Uniformity in methods used to

Uniformity in methods used to calculate returns to achieve calculate returns to achieve comparability among firms comparability among firms

Composite construction Composite construction composite return is the

composite return is the asset-weighted asset-weighted average of all theaverage of all the

portfolios' performance results portfolios' performance results

Disclosures Disclosures allow firms to elaborate on the

allow firms to elaborate on the rawraw numbers and give the end user the numbers and give the end user the proper context to understand proper context to understand No "negative assurance" is needed No "negative assurance" is needed for non-applicable disclosures for non-applicable disclosures Presenta

Presentation and tion and reportingreporting Real estate Real estate

Private equity Private equity Refers to investments in non-public

Refers to investments in non-public companies that are in various stages of companies that are in various stages of development and venture investing, development and venture investing, buyout investing and mezzanie financing buyout investing and mezzanie financing

Wrap Fee/

Wrap Fee/ Separately ManagedSeparately Managed Account (SMA) portfolios. Account (SMA) portfolios. Wrap fees are a type of bundle fee

Wrap fees are a type of bundle fee and areand are specific to a particular investment specific to a particular investment productproduct is charged by a wrap fee sponsor for investment is charged by a wrap fee sponsor for investment management services and included trading management services and included trading expenses that cannot be separately identified expenses that cannot be separately identified can be all-inclusive, asset-based fees and may include can be all-inclusive, asset-based fees and may include a combination of investment management fees, a combination of investment management fees, tradingtrading expenses, custody fees and/or administration fees expenses, custody fees and/or administration fees A wrap fee portfolio is sometimes A wrap fee portfolio is sometimes referred to as a "separately managed referred to as a "separately managed account (SMA) or "managed account" account (SMA) or "managed account"

Note:

Note: GIPS standards are printed in theirGIPS standards are printed in their

entirety in the readings, but the Level I

candidate is required only to know the

material through the end of Section II.0

"Fundamental of Compliance."

(5)

5. TIME VALUE

OF MONEY

a. Interest rate,

considered as

Required rate of return Required rate of return

equilibrium interest rate for a equilibrium interest rate for a particular

particular investmeninvestmentt

Discount rate Discount rate

for calculating the present value of for calculating the present value of future cash flows

future cash flows

Opportunit Opportunity y costcost

b. Interest rate

Nominal risk-free rate = real risk-free rate Nominal risk-free rate = real risk-free rate + expected inflation rate

+ expected inflation rate

real risk-fr

real risk-free rate ee rate isis a theora theoreticaletical rate on a single-period loan when rate on a single-period loan when there is no expectation of inflation. there is no expectation of inflation.

Several risks of securities Several risks of securities

default risk default risk

a borrower will not make the a borrower will not make the promisedpromised payments in timely manner payments in timely manner

liquidity risk liquidity risk

receiving less than fair value if receiving less than fair value if anan investment must be sold for cash quickly investment must be sold for cash quickly

maturity risk maturity risk

Longer-term

Longer-term bonds have more riskbonds have more risk than

than shorter-termshorter-term bondsbonds

-->The required rate of return on a security = real risk-free rate + expected inflation rate -->The required rate of return on a security = real risk-free rate + expected inflation rate + default risk premium + liquidity premium + maturity risk premium

+ default risk premium + liquidity premium + maturity risk premium

c,d. EAR

represents the annual rate of return actually being earned represents the annual rate of return actually being earned after after adjustments have been made for different compounding periods adjustments have been made for different compounding periods

Where: Where:

Periodic rate = stated annual rate/m Periodic rate = stated annual rate/m m

m = = the the number number of of compounding compounding periods periods per per yearyear

Non-annual time value of Non-annual time value of money problems money problems

divide the stated annual interest rate by the number of compounding divide the stated annual interest rate by the number of compounding periods per year,

periods per year, m,m, and multiply the number of years by the numberand multiply the number of years by the number of compounding periods per year

of compounding periods per year

e. CF calculations

Future value Future value Present value Present value Annuity Annuity

a series of equal cash flo a series of equal cash flo ws that occursws that occurs at evenly spaced intervals over time. at evenly spaced intervals over time.

Ordinary Annuity Ordinary Annuity occur at t

occur at the end ofeachhe end ofeach timtimee periperiod.od.

Annuity Due Annuity Due occur atthe beginnin

occur atthe beginning of g of eachtimeeachtime periperiod.od. FV of Annuity Due = FV of Ordinary

FV of Annuity Due = FV of Ordinary Annuity x (1+ I/Y)

Annuity x (1+ I/Y)

PV of Annuity Due = PV of Ordinary PV of Annuity Due = PV of Ordinary Annuity x (1+ I/Y) Annuity x (1+ I/Y) PV of a Perpetuity PV of a Perpetuity Uneven CF Uneven CF

Discount each individual cash flows Discount each individual cash flows Use CF function in Calculator Use CF function in Calculator

f1. Use time line

to solve many types of time to solve many types of time value of money problems value of money problems

Loan payment Loan payment and Amortization and Amortization Find PMT Find PMT Find N Find N Find I/Y Find I/Y Amortization table Amortization table Other applications Other applications Rate of compound growth

Rate of compound growth Number of periods for specific growth Number of periods for specific growth Funding a future obligation Funding a future obligation

Connection between Connection between PV, FV & series of CF PV, FV & series of CF

the sum of the present values of the

the sum of the present values of the cash Rows is the present value of thecash Rows is the present value of the series. The sum of the future values (at some future time = n) of a series of series. The sum of the future values (at some future time = n) of a series of cash flows

cash flows is the future value of that series of cash flowsis the future value of that series of cash flows.. The

Thec a s h f l o w a d d i t i v i t y c a s h f l o w a d d i t i v i t y principle refers to the fact that present principle refers to the fact that present value of anyvalue of any stream of cash flows equals the sum of the present values of the cash flows stream of cash flows equals the sum of the present values of the cash flows

(6)

6. DISCOUNTED

CASH FLOW

APPLICATIONS

Calculate,

Interpret,

Decision rule

NPV

the PV of the cash flows

the PV of the cash flows less the initial (time = 0) outlay

less the initial (time = 0) outlay

where: where:

CFt = the expected net cash flow at time CFt = the expected net cash flow at time t t

N = t

N = t he estimated life of the he estimated life of the investmentinvestment r = the discount rare (opportunity cosr of capital) r = the discount rare (opportunity cosr of capital)

Decision rules

Accept

Accept projects wi

projects with

th a positive NP

a positive NPV

V

Reject projects with a negative NPV

Two mutually exclusive projects:

accept higher positive NPV

IRR

is the discount rate that make the

NPV of a project equal to zero

Problems

Conflict with

NPV due to

Different project size: the smaller projects may have

higher IRR but their contribution to the firm value

may be smaller compared to the larger projects

Differen timing of cash flows

Multiple IRR or No IRR

When CFA pattern is unconventional

Unrealistic assumptions

IRR method: project cash flows are IRR method: project cash flows are assumed to reinvest at IRR while with NPV assumed to reinvest at IRR while with NPV it is assumed to reinvest at market rate it is assumed to reinvest at market rate

--> at the bottom lines: use NPV

Decision rules

Accept projects with an IRR > the firm's

(investor's) required rate of return.

Reject projects with an IRR

Reject projects with an IRR < the firm's

< the firm's

(investor's) required rate of return.

For single project, IRR and NPV

lead to exactly the same decision

HPR

is the percentage change in an

investment over the period of holding

Portfolio

rate of return

Money Weighted

defined as the IRR

More appropriate if manager has

complete control over cash in/out

Time weighted

(chain-link)

measures compound growth

Not affected by cash in/out

Preferred method

3 steps

Value the investment immediately after Value the investment immediately after any withdrawals or deposits, divide the any withdrawals or deposits, divide the overall investment horizon into subperiods overall investment horizon into subperiods Calculate HPR for each subpediod Calculate HPR for each subpediod Compute

Compute the geometric mthe geometric meanean

Yields of T-bills

Bank discount yield

Not much

Not much meaningful

meaningful

1. Based on face value, not price

2. Use 360-day

3. Use simple interest, ignore

reinvestment of interest

Where:

rr

BDBD

= the annualized yield on a bank discount basis

D

D = the dollar discount, which

= the dollar discount, which is equal to the diff

is equal to the difference

erence

between the face value of the bill and the purchase price

F

F = the face

= the face value (par va

value (par value) of the

lue) of the bill

bill

t

= number

= number of days

of days remaining

remaining until

until maturity

maturity

360 = bank convention of number of days in a year

Holding period yield

Where:

Po = initial price of the the instrument

P

11

= price received for instrument at maturity

D

11

= interest payment (distribution)

Effective annual yield

Money market yield

rr

MMMM

= HPY x (360/t)

Bond equivalent yield

BEY = 2 x

semi annual discount rate

Convert among these yields

(7)

7. Statistical Concepts

and Market Returns

a. a.

Statistical methods Statistical methods

Statistics is used to refer to Statistics is used to refer to data and to the methods we data and to the methods we use to analyze date use to analyze date Descriptive statistics Descriptive statistics

to summarized the important to summarized the important characteristi characteristics of cs of large data setslarge data sets

Inferentia Inferential l statisticsstatistics

pertain to the procedures used to pertain to the procedures used to make forecasts, estimates, or make forecasts, estimates, or judgement ab judgement about a large set of dout a large set of dataata

Population vs. Sample Population vs. Sample

A population is defined as the set of all A population is defined as the set of all possible member

possible members of s of a stated groupa stated group Population parametersPopulation parameters

A sample is defined as a subset o A sample is defined as a subset o f f the populations of interest the populations of interest

Sample statistics Sample statistics

The most The most frequently concernedfrequently concerned

mean (measures of central tendency) mean (measures of central tendency) which addresses return which addresses return Var (measures of variation around Var (measures of variation around center) which addresses risk center) which addresses risk

Types of measurement scales Types of measurement scales

Nominal scales Nominal scales

Classify or count observations with no Classify or count observations with no particular or ranking particular or ranking

Ordinal scales Ordinal scales

Specified characteristics are used to Specified characteristics are used to categorize observations band involve ranking categorize observations band involve ranking no information on the difference among categories no information on the difference among categories

Interval scales Interval scales

Like ordinal scales + the differences Like ordinal scales + the differences between scale values are between scale values are equal -> scaleequal -> scale values can be added values can be added and subtractedand subtracted No true zero point

No true zero point cannot build meaningful ratioscannot build meaningful ratios

Ratio scales Ratio scales

Provide ranking, equal differences Provide ranking, equal differences between scale values and true zero point between scale values and true zero point

b. b.

Parameter vs. Sample statistic Parameter vs. Sample statistic

A parameter is a measure used to A parameter is a measure used to describe a characteristic of a population describe a characteristic of a population A sample statistic is used to A sample statistic is used to measure a characteristic of a sample measure a characteristic of a sample

Frequency distribution Frequency distribution

Definition Definition

A tabular presentation of st A tabular presentation of st atistical dataatistical data that aids the analysis of large data that aids the analysis of large data setssets

Construction of a Construction of a frequency distribution frequency distribution 3 steps3 steps

1. Define interval 1. Define interval 2. Tally the observations 2. Tally the observations 3. Count the observations and then calculate 3. Count the observations and then calculate

c. c. Absolute frequency Absolute frequency Relative frequency Relative frequency

calculated by dividing the absolute calculated by dividing the absolute frequency of each return interval by frequency of each return interval by the total number of observations. the total number of observations.

Cumulative absolute Cumulative absolute frequency frequency

summing the absolute frequencie summing the absolute frequencies starting at s starting at thethe lowest interval and progressing through the highest. lowest interval and progressing through the highest.

Cumulative relative frequency Cumulative relative frequency

summing the relative frequenci summing the relative frequencies starting at es starting at thethe lowest interval and progressing through the highest. lowest interval and progressing through the highest.

d. d. HistogramHistogram

bar chart bar chart

Frequency polygon Frequency polygon line chartline chart

e. Measures of e. Measures of central tendency central tendency Mean Mean Population mean Population mean Sample mean Sample mean Arithmetic mean Arithmetic mean

the measure of central tendency the measure of central tendency for which the sum of the deviations for which the sum of the deviations from the mean is zero from the mean is zero

Weighted mean Weighted mean (portfolio return) (portfolio return) Geometric mean

Geometric mean (compound growth)(compound growth) (return data set) (return data set)

Use of arithmetic or geometric mean Use of arithmetic or geometric mean when determining investment returns when determining investment returns

Harmonic mean Harmonic mean (cost of shares) (cost of shares) Harmonic < geometric < arithmetic Harmonic < geometric < arithmetic

Median Median

value of middle item in a set of value of middle item in a set of sorted itemssorted items not affected by extreme value but not affected by extreme value but more difficul more difficult to t to find outfind out

Mode Mode

No mode No mode Unimodal, bimodal, trimodal Unimodal, bimodal, trimodal --> the only measure can be --> the only measure can be used with nominal scale used with nominal scale Model interval --> Model interval --> for continuous distribution for continuous distribution

f. Quantile f. Quantile

value at or below which a portion o

value at or below which a portion o f the data distribution liesf the data distribution lies Quartiles

Quartiles into quartersinto quarters Quintile Quintile into fifthsinto fifths Decile Decile into tenthsinto tenths Percentile (100) Percentile (100) Ly =(n+1)Ly =(n+1) x xyy /100 /100 g. Dispersion g. Dispersion (measure of risk) (measure of risk)

Range = Max - Min Range = Max - Min Easy to compute

Easy to compute affected by extreme value affected by extreme value no info on how data is distributed no info on how data is distributed

better than range better than range less sophisticated than Var and Sd less sophisticated than Var and Sd

Variance & Variance & Standard dStandard deviationeviation Population Population Sample Sample Semivariance and Semivariance and semideviation semideviation h. Chebyshev's inequality h. Chebyshev's inequality

For any distribution with For any distribution with finite variance, thefinite variance, the percentage of observations lie within k percentage of observations lie within k standardstandard deviation of the mean is at deviation of the mean is at least 1-1/(k^2)least 1-1/(k^2)

36%: +/-1.25k 36%: +/-1.25k 56%: +/-1.50k 56%: +/-1.50k 75%: +/-2k 75%: +/-2k 89%: +/-3k 89%: +/-3k 94%: +/-4k 94%: +/-4k i. Relative i. Relative dispersiondispersion

CV (Coefficient of Variation) CV (Coefficient of Variation)

Sharpe Ratio / Reward-to-Variability ratio Sharpe Ratio / Reward-to-Variability ratio Limitations

Limitations

Negative Sharpe ratio Negative Sharpe ratio Not suitable with asymmetric return distribution Not suitable with asymmetric return distribution

j,k. Shape j,k. Shape of distributionof distribution

Symmetrical Symmetrical mean=median=mode mean=median=mode the frequency of the frequency of experienciexperiencingng losses and gains are the losses and gains are the samesame

Nonsymmetrical (Skewness) Nonsymmetrical (Skewness) (because of outliers) (because of outliers) Types Types Positively skewed (Sk>0) Positively skewed (Sk>0) Negatively skewed (Sk<0) Negatively skewed (Sk<0) --> more risk --> more risk l. Kurtosis l. Kurtosis Calculate Calculate Excess kurtosis = sample kurtosis - 3 Excess kurtosis = sample kurtosis - 3

Compared with Compared with normal distribution normal distribution Leptokurtic: more peaked, fatter tails

Leptokurtic: more peaked, fatter tails (excess kurtosis > 0) --> more risk (excess kurtosis > 0) --> more risk Platykurtic: less peaked (excess kurtosis < 0) Platykurtic: less peaked (excess kurtosis < 0)

Mesokurtic: identic

(8)

Useful to a wide range of users in

making economic decisions

> To evaluate past, current, and prospective

performanc

performance &

e & fin position

fin position

> To make economic decisions

Roles of FR & FSA

FR

Element

F.Stm

Additional disclosures required by

Additional disclosures required by regulatory

regulatory

Any commentary by management

Role of FR

Financial position

Firm's performance

Changes in financial position

Roles of FSA

Use info i

Use info i n a company's Fin Statements

n a company's Fin Statements

Use other relevant info

Role of key FS

Income Statement

Revenues

Expenses

Gains and Losses

Balance Sheet (A=L+OE)

Assets

Liabilities

Owners' equity

CF statement

CFO

CFI

CFF

Statement of changes in Owners' equity

FS notes (footnotes)

disclose the basis of preparation for FS

(e.g: accounting methods, assumptions,...)

Additional items:

acquisitions or disposals

legal actions

employee benefit plans

contingencies and

contingencies and commitments

commitments

significant customers

sales to related parties

segments of firm

are audited

Supplement

Supplementary

ary schedules

schedules

not audited

operating income or sales by region

or business

or business segments

segments

reserves for an oil and

reserves for an oil and gas company

gas company

info about hedging activities and

financial i

(9)

23. Financial reporting

mechanics

Classification

Operating activity:

Operating activity: activities that are part of the day-to-day business function of an entity

activities that are part of the day-to-day business function of an entity

Investing activity:

Investing activity: activities associated with acquisition & disposal of long-term asset

activities associated with acquisition & disposal of long-term asset

Financing activity:

Financing activity: activities related to obtaining or repaying capital from shareholders or creditors

activities related to obtaining or repaying capital from shareholders or creditors

Account & financial

statement

FS elements

& accounts

Elements

Assets

Liabilities

Equity

Revenue

Expense

Accounts

Chart of accounts

Chart of accounts : set forth the actual accounts used in a company's accounting system

: set forth the actual accounts used in a company's accounting system

Contra account:

Contra account: offset or deducted from other accounts

offset or deducted from other accounts

Accounting equation

Assets

Liabilities

Owners' equity

Contributed capital

Retained earning

Expanding:

Expanding: A = L + Contributed capital + BGN Retained earnings + Rev - Exp - Dividend

A = L + Contributed capital + BGN Retained earnings + Rev - Exp - Dividend

Accruals & Valuation

adjustment

Accruals

Cash moveme

Cash movement prior

nt prior to Acct. recognition

to Acct. recognition

Unearned (Deffered) revenue

Prepaid expense

Cash movement after Acct. recognition

Unbilled (Accrued) revenue

(when billing, Un.Rev decrease & Receivables increase)

Accrued expense

Valuation adjustment:

Valuation adjustment: made to company's A or L so that account records current market value (not

made to company's A or L so that account records current market value (not

Historical cost)

Accounting system

Flow of information

1. Journal entries & Adjusting entries

1. Journal entries & Adjusting entries (record=time)

(record=time)

2. General ledger & T-accounts

(record=order)

3. Trial balance

(list account balances at a particular point in time)

4. Fin.

4. Fin. statem

statement

ent

Debit & Credit

Using fin. statement

in security analysis

Analyst uses FS to judge the fin. health of the company

Analyst can use his understanding to detect misrepresentation

(10)

Enhancing

Understandability

Verifiability

Comparability

(

consistent among firms and time periods)

Timeliness

Overview FRS

Objective of FR:

Objective of FR: provide fin. info about the reporting entity

provide fin. info about the reporting entity

Importance of reporting standards in security analysis and valuation

Standard setting &

Regulatory bodies

Standard-setting bodies

(establishing standards)

IASB (International Accounting Standards Board)

US FASB (Financial Accounting Standards Board)

Regulatory authorities

(enforcing standards)

IOSCO (international):

not a regulatory, but its members regulate significant portio

not a regulatory,

but its members regulate significant portion

n

FSA (in UK)

SEC (in USA)

1. Protect investors

2. Ensure: market is fair, efficient, transparent

3. Reduce systematic risk

c.

Status of global convergence of accounting

Status of global convergence of accounting standards

standards

Barriers to developing one universally accepted set of financial reporting standards