CFA® Level II

Formula Sheet – 2023 Syllabus

QUANTITATIVE METHODS - AIC is preferred when the model is used for - Incorrect standard error, test statistics
QUANTITATIVE METHODS
predictive purposes - High Type I errors
- SBC is preferred when the model is used for
BASICSOF
BASICS OFMULTIPLE
MULTIPLEREGRESSION
REGRESSIONAND
AND descriptive purposes
Testing Conditional Heteroskedasticity
UNDERLYING ASSUMPTIONS
UNDERLYING ASSUMPTIONS - Breusch-Pagan test (one-tailed)
Testing Joint Hypotheses for Coefficients - Reject null hypothesis of no conditional
Multiple Linear Regression
t-test for Slope Coefficients heteroskedasticity if nR$ > critical χ$ value
Y: Dependent variable/explained variable
t-statistic for a slope coefficient:
Xi: Independent variable/explanatory variables Correcting for Heteroskedasticity
b! − B!
t= - Compute robust standard error
Y! = b" + b# X#! + b$ X $! + ⋯ + b% X %! + ϵ, s&!
- Generalized least squares method
where b" is the intercept, b% ’s are the partial slope - b' is the estimated value of slope coefficient
coefficients, and ϵ is the error term - B' is the hypothesized value of slope coefficient Serial Correlation
- 𝑠𝑠&" is the standard error of the slope coefficient Errors are correlated across observations
Assumptions of Multiple Linear Regression
F-test for Joint Hypothesis
Model Consequences of Serial Correlation
F-statistic for a one-tailed test:
- Linear relationship between the dependent Is not a
(SSE( − SSE) )/q Is a lagged
variable and the independent variables F= lagged
SSE) /(n − k − 1) Independent value of
- Homoskedasticity (i.e., constant variance of value of
- SSER is the sum of squared errors for the variable… dependent
residuals) dependent
restricted model variable
- Independence of observations (independence of variable
- SSEU is the sum of squared errors for the
errors) Invalid standard
unrestricted model Yes Yes
- Normality of the residuals error estimates
- q is the number of restrictions (omitted
- Independence of independent variables Invalid coefficient
variables) No Yes
estimates
- n is the number of observations
EVALUATING REGRESSION
EVALUATING REGRESSIONMODEL
MODELFIT
FITAND
AND - k is the number of independent variables
- Positive (negative) serial correlation: An error in
INTERPRETING MODEL
INTERPRETING MODELRESULTS
RESULTS General linear F-test:
one direction increases (decreases) the chance of
an error in the same direction in a subsequent
Goodness of Fit Measures F-statistic:
MSR observation
Coefficient of determination: F= - Inflated F-statistic due to underestimated MSE
SSR MSE
R$ = - Inflated t-statistic due to underestimated
SST
standard errors
Adjusted-R2: MODEL MISSPECIFICATION
MISSPECIFICATION - High Type I errors
n−1 Principles of Model Specification
+$ = 1 − .
R 1 (1 − R$ ) Testing for Serial Correlation
n−k−1 - A regression model should be based on economic
SSE - Durbin-Watson (DW) test (for first-order serial
reasoning
correlation only)
= 1 − 5n − k − 17 - A well-specified model should be parsimonious
SST - Breusch-Godfrey (BG) test
(n − 1) - A model should perform well when applied to
-R+ $ will always be less than R$ because k is greater out-of-sample data Correcting for Serial Correlation
than 0. - The functional form for the variables should be - Adjust coefficients’ standard errors
+$ to be negative.
- It is possible for R appropriate
Multicollinearity
- A high R+ $ does not necessarily mean the - A model should uphold the multiple regression
2+ independent variables are highly correlated
regression is well specified. assumptions
Consequences of Multicollinearity
Analysis of variance (ANOVA) Misspecified Functional Form
- Unreliable regression coefficient estimates
Sum of squares error (SSE): Unexplained variation - Omitted variables
- Inflated standard errors
in Y - Inappropriate form of variables
- Low t-statistics
Sum of squares regression (SSR): Explained - Inappropriate scaling of variables
variation in Y - Inappropriate pooling of data Detecting Multicollinearity
Sum of squares total (SST): Total variation in Y - High R$ , significant F-statistic coupled with
Heteroskedasticity
SST = SSE + SSR insignificant t-statistic for slope coefficients
Variance of error term differs across observations
- High variation inflation factor (VIF)
Measures of Parsimony - Heteroskedasticity is unconditional if error term
1
Akaike’s Information Criterion (AIC): is uncorrelated with independent variables and VIF =
1 − R$*
SSE conditional if variance is correlated
AIC = n × ln . 1 + 2(k + 1) - Conditional heteroskedasticity is more
n Correcting for Multicollinearity
Schwarz’s Bayesian Information Criterion (SBC): problematic than the unconditional version - Exclude one or more of the independent variables
SSE - Increase sample size
SBC = n × ln . 1 + ln(n) × (k + 1) Consequences of Heteroskedasticity
n - Use different proxies for an independent variable
- Lower AIC/SBC is better (more parsimonious) - MSE is biased
- SBC is more conservative - Unreliable F-test and t-test

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EXTENSIONS
EXTENSIONSOF
OFMULTIPLE
MULTIPLEREGRESSION
REGRESSION TIME SERIES
TIME SERIES ANALYSIS
ANALYSIS If the time series has a unit root, we can model the
first-differenced series using an autoregressive
Influence Analysis Time Series Challenges
time series.
High-leverage points: Extreme values for - Linear regression assumptions violated
independent variables - Correlated residual errors Moving Average Time-Series Model
Outliers: Extreme values for dependent variables - Mean/variance of time series changes over time MA(q) model
x1 = ε1 + θ# ε10# + θ$ ε10$ + ⋯ + θ/ x104
Leverage measure: Linear Trend Model
- h!! quantifies the distance between the ith value y1 = b" + b# t + ε1 , t = 1, 2, … , T E(ε1 ) = 0, E(ε$1 ) = σ$ , E(ε1 ε2 ) = 0, if t ≠ s
of an independent variable and its mean Seasonality in Time Series
%+# Log-Linear Trend Model
- h!! > 3 K L indicates an influential observation y1 = e&%+&&1 , t = 1, 2, … , T - Regular pattern within a year
,
ln y1 = b" + b# t + ε1 , t = 1, 2, … , T - Significant seasonal autocorrelation of error term
Studentized residuals for the ith observation:
Autoregressive Time-Series Model Autoregressive Moving Average Model
e∗! $! n−k−1
t !∗ = = N A first-order autoregression, AR(1), predicts a An ARMA(p, q) model includes p autoregressive
s.∗ SSE(1 − h!! ) − e$!
variable (x1 ) based on its most recent value (x10# ): parameters and q moving-average parameters
- e∗! : Residuals with the ith observation deleted - An AR(1) model has a “one-period memory” and
x1 = b" + b# x10# + ε1
- n: Number of observations all autocorrelations other than the first will be 0
A model using values for p periods, AR(p), is:
- k: Number of independent variables
x1 = b" + b# x10# + b$ x10$ + ⋯ + b/ x10/ + ε1 Limitations of AR Models
- SSE: Sum of squared errors for the regression
- Highly unstable parameters
model Covariance Stationary Assumption
- h!! : Leverage value for ith observation - Imperfect criteria for deciding p and q
For inferences from AR models to be valid, it is
- s.∗ : Standard deviation of residuals - Should not be used for <80 observations
assumed that the time series’ mean and variance
are constant over time Autoregressive Conditional
Cook’s distance:
e$! Heteroskedasticity Models
h!! Detecting Serial Correlation of Error
D! = P Q ARCH(1) model
k × MSE (1 − h!! )$ Residual autocorrelation
t= ε1 ~ N(0, a" + a# ε$10# )
- Detect both potential high-leverage points and 1⁄√T
If a# = 0, variance of error in every period is a" .
potential outliers T = number of observations in time series
The variance is constant over time and does not
- D! > 0.5: The observation should be investigated
Mean Reversion for an AR(1) Model depend upon past errors
- D! > 1 or D! > 2Uk/n: The observation is likely !! If a# > 0, variance of error in one period depends
influential Mean reverting level =
"#!" on how large the squared error was in the previous
&%
Dummy Variables in a Multiple Linear - xd1+# = x1 when x1 = period. If a large error occurs in one period,
#0&&
Regression &% variance of error in the next period will be larger:
- xd1+# > x1 when x1 <
Dummy variable = 1, if true; 0, if false #0&& εd$1 = a" + a# εd$10# + u1
&%
- xd1+# < x1 when x1 > If a time-series model has ARCH(1) errors, the
To distinguish among n categories, use n – 1 #0&&
variance of error in period t+1 can be predicted in
dummy variable. Root Mean Squared Error (RMSE) period t:
Intercept Dummies - In-sample forecast errors are the residuals from o$1+# = ad" + ad# εd$1
σ
Y = b" + d" D + b# X + ϵ the time period used to estimate the parameters
Slope Dummies Cointegration of Time Series
of the model.
Y = b" + b# X + d# (D × X) + ϵ Two time series are co-integrated when they
- Out-of-sample forecast errors are the residuals
Intercept and Slope Dummies have a financial or economic relationship that
from a time period not used to fit the data.
Y = b" + d" D + b# X + d# (D × X) + ϵ prevents them from diverging without bound in
- The root mean squared error (RMSE) is the square
the long run.
Multiple Linear Regression with Qualitative root of the average squared error. A relatively low
Dependent Variables RMSE for out-of-sample data indicates a good fit. Cointegration Detection
For models with qualitative dependent variables, it Engle-Granger or Dickey-Fuller test
Random Walk and Unit Root
is often preferable to use logit model. x1 = x10# + ε1 Other Issues in Time Series
- p is the probability that an event happens E(ε1 ) = 0, E(ε$1 ) = σ$ , E(ε1 ε2 ) = 0, if t ≠ s - Large forecast uncertainty
/
- The logistic transformation is ln K L - Need to consider uncertainty of error term and
#0/ Random Walk with Drift
-
/
is known as the odds of an event happening estimated parameters
#0/ x1 = b" + x10# + ε1 , E(ε1 ) = 0
- ln K
/
L is the natural logarithm of the odds of an Take first difference before analyzing
#0/
y1 = x1 − x10# MACHINE LEARNING
LEARNING
event happening, which is known as log odds or y1 = b " + ε1 , b" ≠ 0
logits Used for client profiling, asset allocation, stock
- Coefficients are estimated using the maximum Unit Root Test of Nonstationarity selection, portfolio construction, trading, etc.
likelihood estimation (MLE) For an AR(1) time series to be covariance Supervised ML: Uses labeled data to infer patterns
- Overall model fit is assessed using a likelihood stationary, the absolute value of b1 must be < 1. between inputs and outputs
ratio (LR) test (score closer to 0 indicates a better Dickey-Fuller Test - Dependent variable (Y) is the target and
fit) x1 = b" + b# x10# + ε1 independent variables (X) are features
x1 − x10# = b" + (b# − 1)x10# + ε1 - Can be used for regression (linear and non-linear)
x1 − x10# = b" + g# x10# + ε1 and classification problems
H" : g# = 0 (has unit root)
H3 : g# < 0 (does not have unit root)

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Unsupervised ML: Finds patterns within unlabeled Text ML Model Building
data; there is no dependent variable Model Variance 1. Text problem formulation
Bias error error
- Can be used for dimension reduction and complexity 2. Text curation
clustering problems Lower 3. Text preparation and wrangling
Low Higher
4. Text exploration
Deep Learning: Sophisticated algorithms for tasks High Lower Higher
such as image classification, face recognition, and Errors Addressed with Data Cleansing
natural language processing Supervised ML Methods Incompleteness error: Data not present
Penalized regression/Regularization: Seeks to Invalidity error: Outside meaningful range
Reinforcement Learning (RL): An algorithm learns
reduce the risk of overfitting by imposing a penalty Inaccuracy error: Not a measure of true value
from the data that it generates
on additional features; Least Absolute Shrinkage Inconsistency error: Conflicts between data points
Neural networks: Highly flexible ML algorithms and Selection Operator (LASSO) uses a Non-uniformity error: Multiple formats used
used for classification, regression, deep learning, hyperparameter, λ, as a penalty Duplication error: Duplicate observations present
and reinforcement learning
Support Vector Machine (SVM): Linear classifier Data Wrangling Methods
ML Methods for Different Types of Variables model used for binary classification, regression, Feature extraction: Creating a new variable from an
Supervised Unsupervised and outlier detection; Soft margin classification is a existing variable to improve analysis
Variables
ML ML non-linear alternative to SVM Aggregation: Combining similar variables
Regression Dimensionality Filtration: Removing irrelevant rows
K-Nearest Neighbor (KNN): Non-parametric
- Linear, Reduction Selection: Removing irrelevant columns
method typically used for classification (e.g., credit
LASSO - PCA Conversion: Making adjustments to increase
rating prediction), but also used for regression
Continuous - Logistic Clustering relevance
- CART - K-Means Classification and Regression Tree (CART):
Addressing Outlier Data
- Random - Hierarchical Produces a tree with a root node, decision nodes,
Trimming: Removing the top/bottom X%
Forest and terminal nodes; Iterative structure is used to
Winsorization: Replacing extreme high/low
Classification Dimensionality find relationships in non-linear data, but it is a
observations with maximum/minimum values
- Logit Reduction black box method
Normalization:
- SVM - PCA X ! − X 7!,
Categorical Ensemble learning: Use multiple models to reduce X ,56738!9.: =
- KNN Clustering X 73; − X 7!,
error rate relative to relying on one model.
- CART - K-Means
Examples include majority-vote classifier, Standardization:
- Hierarchical
bootstrap aggregating, and random forest. X! − µ
Neural Neural X 213,:36:!9.: =
Continuous networks, networks, Unsupervised ML Methods σ
or Deep Deep Learning, Principal Components Analysis (PCA): Features are Text Wrangling Methods
Categorical Learning, RL grouped together to reduce the number of 1. Lowercasing
RL independent variables in a model. It significantly 2. Stop words
reduces model complexity but is a black box 3. Stemming
Training an ML Model: Sampling
method. 4. Lemmatization
Training an ML model requires a dataset to be
divided into three non-overlapping samples: Clustering: K-means clustering, hierarchical Model Performance Evaluation
1. Training sample: In-sample data used to find clustering, and dendrograms are used to organize Actual Actual
relationships observations into groups. training training
2. Validation sample: In-sample data used to label - 1 label - 0
validate relationships found in training sample BIG DATA
DATA PROJECTS
PROJECTS True False
Predicted
3. Test sample: Out-of-sample data used to test the positive positive
4Vs of Big Data result - 1
model’s predictive powers (TP) (FP)
1. Volume
Overfit models explain the training data well but False
2. Variety True
do not generalize to the out-of-sample data. Predicted negative
3. Velocity negative
K-fold cross-validation can be used to prevent result - 0 (FN) (Type
4. Veracity (TN)
overfitting. II Error)
ML Model Building Steps
TP
Training an ML Model: Errors 1. Conceptualization Precision (P) =
Bias error: Does not explain training data well TP + FP
2. Data Collection/Curation
(underfit); more likely for linear functions 3. Data Preparation and Wrangling TP
Recall (R) =
Variance error: Model performs differently with - Data Cleansing TP + FN
out-of-sample data because it has incorporated - Data Preprocessing TP + TN
noise from training data (overfit); more likely for 4. Data Exploration Accuracy (A) =
TP + FP + TN + FN
non-linear functions - Exploratory Data Analysis
2 ×P×R
Base error: Unavoidable errors due to randomness - Feature Selection F1 score =
P+R
The trade-off between bias error and variance - Feature Engineering
5. Model Training FP
error can be shown on a fitting curve False Positive Rate (FPR) =
- Method Selection TN + FP
TP
- Performance Evaluation True Positive Rate (TPR) =
- Tuning TP + FN

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Receiver Operator Characteristic (ROC) technique Low capital mobility Classical model failed because:
plots FPR on x-axis and TPR on y-axis. 1. Population growth slowed as incomes rose
Monetary Policy
2. Diminishing marginal returns to labor input
Root Mean Squared Error (RMSE) is calculated as
Fiscal Policy Expansionary Restrictive were more than offset by technological progress
the square root of the sum of mean squared errors.
Expansionary DC ↓ Ambiguous Neoclassical Model
,
(Predicted! − Actual!)$ - Based on Cobb-Douglas production function
RMSE = st Restrictive Ambiguous DC ↑
n - Both capital (K) and labor (L) are subject to
!<#
Currency Crisis Warning Signs diminishing marginal productivity
A lower RMSE indicates potentially better model - Recent liberalization of capital markets - In the steady state, the output-to-capital ratio is
performance if historical relationships hold. - Large foreign capital inflows, especially s/t funds constant because they grow at the same rate
- Banking crises, either just before or concurrent - In the long run, output per capita is driven by:
- Fixed or partially fixed exchange rates 1. Savings/investment rate
ECONOMICS 2. Rate of technological change
- Sudden, sharp decline in FX reserves
ECONOMICS 3. Population growth
- Recent spike in domestic currency value
CURRENCYEXCHANGE
CURRENCY EXCHANGERATES
RATES - Deteriorating terms of trade ∆y ∆A ∆k ∆k Y
- Money supply growing faster than bank reserves = + α. 1 = s. 1 − δ − n
y A k k K
Factors Influencing Bid/Ask Spreads - Recent high inflation ∆y θ
Currency pair: Wider for less liquid currencies Growth rate of output per capita = =
y 1−α
Time of day: Wider when NY/London closed
ECONOMIC GROWTH
ECONOMIC GROWTH ∆Y θ
Market conditions: Wider when more volatile Growth rate of output = = +n
Y 1−α
Contract term: Wider for longer-term forward Factors Affecting Growth: Developing Countries Implications:
contracts due to lower liquidity and increased - Low rates of savings and investment - Capital accumulation, capital deepening, and an
exposure to credit risk and interest rate risk - Poorly developed financial markets increase in savings rate can only temporarily
- Weak legal systems and failure to enforce laws increase growth, but technological improvements
Covered Interest Rate Parity
- Lack of property rights and political stability can have a permanent impact
Days
1 + i= K L - Poor public education and health services
F=⁄: = S=⁄: u 360 w - Per capita income growth will converge across
Days - Excessive taxes and regulations countries
1 + i: K L
360 - Restrictions on international trade/capital flows
Uncovered Interest Rate Parity Endogenous Growth Theory
Potential Growth and Stock Market Returns - Output per worker is proportional to stock of
%∆S=.⁄: = i= − i: 𝐸𝐸 𝑃𝑃
%∆𝑃𝑃 = %∆𝐺𝐺𝐺𝐺𝐺𝐺 + %∆ + %∆ capital per worker (k . )
Estimated Future Spot Rate 𝐺𝐺𝐺𝐺𝐺𝐺 𝐸𝐸
- c is constant marginal product of capital
F=⁄: − S=⁄: Cobb-Douglas Production Function y. = f(k . ) = ck .
= %∆S=.⁄: = i= − i:
S=⁄: F (K, L) = K ? L#0? ∆y.⁄y. = ∆k . ⁄k . = sc − δ − n
- A higher savings rate can permanently increase
Absolute Version of PPP Capital Deepening vs. Technological Progress
the potential GDP growth rate
P= = S=⁄: × P:
S=⁄: = P= ⁄ P:
ECONOMICS OFREGULATION
ECONOMICS OF REGULATION
Relative Version of PPP
Types of Regulation
%∆S=⁄: ≅ π= − π:
- Statutes enacted by legislatures
Ex-ante Version of PPP - Administrative regulations for agencies
%∆S=.⁄: ≅ π.= − π.: - Judicial laws established by legal rulings

The Fisher Effect and Real Interest Rate Parity Classification of Regulators
i = r + π. Growth Accounting - Independent regulators: Granted the ability to
(i= − i: ) = (r= − r: ) + (π.= − π.: ) ∆Y ∆A ∆K ∆L make regulations by government
= + α . 1 + (1 − α) . 1 - Self-regulatory bodies: Private organizations that
(r= − r: ) = (i= − i: ) − (π.= − π.: ) Y A K L
regulate members, typically industry peers
Real Interest Rate Parity Growth rate in potential GDP
- Self-regulatory organizations: Independent
(r= − r: ) = 0 = L/T growth rate of labor force
industry bodies that have been granted law
+ L/T growth rate in labor productivity
International Fisher Effect enforcement powers
(i= − i: ) = (π.= − π.: ) Labor Supply Inputs - Standard-setting bodies: Establish rules but lack
- Population growth any enforcement powers (e.g., IFRS)
Mundell-Fleming Model
- Labor force participation
High capital mobility Regulatory Interdependencies
- Net migration
- Regulatory capture: Businesses use relationship
Monetary Policy - Average hours worked
with regulators to serve their interest
Restrictive Classical Model - Regulatory competition: Regulators from different
Fiscal Policy Expansionary
- Labor productivity increases population growth jurisdictions compete to attract certain entities
Expansionary Ambiguous DC ↑
- Population growth accelerates as per capita - Regulatory arbitrage: Businesses exploit
Restrictive DC ↓ Ambiguous incomes increase differences between economic substance and
- Diminishing marginal returns to labor input will regulatory interpretation
lead to decline in per capita income

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Regulatory Tools Acquisition Method DB Plan Assumptions
- Price mechanisms (e.g., taxes, subsidies) - The fair value of the consideration given by the - Assuming a higher discount rate reduces the
- Mandates and restrictions acquiring company is used pension liability and service costs
- Provision of public goods - Direct costs of the business combination are - Assuming a higher rate of compensation growth
- Public financing of private projects expensed as incurred increases liability and service costs
- IFRS: Full or partial goodwill - Assuming a higher expected return on assets
Cost-Benefit Analysis of Regulation
US GAAP: Full goodwill only reduces the pension expense under US GAAP but
Regulatory burden: Private costs of regulation, both
Partial goodwill not IFRS and has no impact on the value of assets
direct and indirect
Net burden: Private costs less private benefits = Fair value of consideration given Benefit Calculations
− Acquirer @ s shares of the fair value of A/L - Annual benefit = (Estimated final salary × Benefit
Full goodwill formula) × Years of service
= Fair value of acquired@ s entity - Value at retirement date of estimated future
FINANCIAL STATEMENT ANALYSIS benefits = PV of annual benefit during retirement
FINANCIAL STATEMENT ANALYSIS − Fair value of the entity @ s A/L
- Annual unit credit = Value at retirement
- Non-controlling interest (NCI) is the portion of date/Years of service
INTERCORPORATEINVESTMENTS
INTERCORPORATE INVESTMENTS subsidiary’s equity held by third parties
Classification o Full goodwill: NCI is measured at fair value Cash flows for DB Plan Sponsor
- Financial assets (<20%): Buyer has no significant o Partial goodwill: NCI is based on the The difference between periodic contributions to a
control over the investee proportionate share of net identifiable assets plan and total pension costs of the period can be
- Associates (20% - 50%): Buyer has significant viewed as financing activity
influence but not control - If contributions to a plan are more (less) than the
EMPLOYEE
EMPLOYEECOMPENSATION:
COMPENSATION:POST- total pension costs of the period, the excess is
- Joint venture: Entity is operated by companies EMPLOYMENT AND SHARE-BASED
POST-EMPLOYMENT AND SHARE BASED similar to repaying debt (additional borrowing)
that share control
- Business combinations (>50%): Buyer has control Types of Pension Plan
Share-Based Compensation
Defined benefit (DB): Firm makes periodic
Investments in Financial Assets - Aims to align employees’ interest with owners’
payments to employee after retirement;
- Requires no current-period cash outlays
- Under IFRS 9, all financial assets are initially Employer’s contributions may vary depending on
- Treated as an expense, which reduces earnings
measured at fair value (cost basis at acquisition) assumptions and the performance of plan assets
- Potentially dilutes EPS by increasing shares
- In subsequent periods, financial assets may be Defined contribution (DC): Employer’s obligation is
measured at either amortized cost or fair value Stock Grants
limited to periodic contribution; Future benefits
- To be measured at amortized cost, financial - May be outright, restricted, or contingent
depend on investment performance
assets must meet the following criteria: - Recipients are fully exposed to downside risk,
o Held to collect contractual cash flows Pension Obligation may become risk-averse
o Cash flows may only be principal and interest Present value of estimated future payments to Stock grants’ compensation expense:
- Financial assets that fail to meet both criteria employees for benefits earned to date - Amount based on stock’s fair value on grant date
must be measured at either fair value through - Allocated over the employee’s service period
Net Pension Asset/Liability
profit or loss (FVPL) or fair value through other Overfunded Stock Options
comprehensive income (FVOCI) - Plan assets exceed the pension obligation Must be valued using a pricing model based on key
- Securities are classified as follows: - Sponsor reports net pension asset assumptions such as:
o Debt securities: Carried at amortized cost if Underfunded - Exercise price
held to maturity, but must be carried at fair - Pension obligation exceeds plan assets - Stock price volatility
value if it is possible that they may be sold - Sponsor reports net pension liability - Estimated life of each award
o Equities: Can be held at FVPL or FVOCI - Estimated number of options to be forfeited
Derivatives: Must be carried at FVPL unless Components of Pension Expense (IFRS)
o
- Dividend yield
they are being used as hedging instruments - Current service cost (P&L)
- Risk-free interest rate
- Past service cost (P&L)
Investments in Associates and Joint Ventures
- Net interest expense (P&L)
- Equity method (one-line consolidation): MULTINATIONAL OPERATIONS
OPERATIONS
o Net liability × Interest rate MULTINATIONAL
o Initial investment is recorded at cost on the
- Net return on plan assets (OCI, not amortized) Presentation and Functional Currencies
balance sheet as a non-current asset
o Actual return − (Assets × Interest rate) - Presentation currency: Currency in which the
o Carrying amount is adjusted upward to
- Actuarial losses (OCI, not amortized) company presents its financial statements
reflect a proportionate share of earnings
Components of Pension Expense (US GAAP) - Functional currency: Currency in which the
o Dividends received are treated as a return of
- Current service cost (P&L) company conducts its primary activity
capital and reduce the carrying amount
- Past service cost (OCI, then amortized) - Local currency: Used within the country in which
o If carrying value falls to 0, equity method is
- Interest expense (P&L) the company operates
discontinued and no further losses recorded
o Liability × Interest rate - Often, functional currency of subsidiary ≠
- Profits from transactions with associates cannot
- Expected return (P&L) functional and presentation currency of parent
be realized until the products are sold/used
o Assets × Expected return
Classifying Business Combination
- Net return on plan assets (OCI, then amortized)
- Merger: A + B = A
o Actual return − (Assets × Expected return)
- Acquisition: A+ B = (A + B)
- Actuarial losses (OCI, then amortized)
- Consolidation: A + B = C

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Remeasurement/Translation Methods 2. Current ratio (current assets/current liabilities) Analyzing Property and Casualty Insurers
Current rate method will be different under the two methods Loss and loss adjustment expense ratio:
- Use when the subsidiary’s functional currency is - Inventory is translated at the current Loss expense + Loss adjustment expense
different from the parent’s functional currency exchange rate under the current method, but Net premiums earned
- FX gain/loss reported in shareholders’ equity as at the historical exchange rate under the
Underwriting expense ratio:
part of cumulative translation adjustment (CTA) temporal method
Underwriting expense
- Exposure is net assets (assets minus liabilities) - If the subsidiary’s currency appreciates
Net premiums written
relative to the parent, the current ratio will
Temporal method
be higher under the current rate method than Combined ratio:
- Use when the subsidiary’s functional currency is
the temporal method Loss and loss adjustment expense ratio
the same as the parent’s functional currency
+ Underwriting expense ratio
- Remeasurement gain/loss reported in Subsidiaries in Hyperinflationary Economies
income statement Under IFRS Dividends to policyholders ratio:
- Exposure is net monetary assets (monetary assets - Restate subsidiary’s local currency financial Dividends to policyholders
minus monetary liabilities) statements for local inflation Net premiums earned
- Translate inflation-restated foreign currency
Exchange Rate for Each Line Item Combined ratio after dividends:
financial statements into the parent’s
Combined ratio + Dividends to policyholders ratio
Current presentation currency using the current FX rate
Rate Temporal
Under U.S. GAAP EVALUATINGQUALITY
QUALITYOF
OFFINANCIAL
FINANCIAL REPORTS
Monetary assets Current Current EVALUATING REPORTS
- Use the temporal method to translate the
Monetary subsidiary’s local currency financial statements Quality Spectrum of Financial Reports
Current Current
liabilities - Include the resulting translation adjustment as a 1. GAAP-compliant; decision-useful, high-quality
Nonmonetary gain or loss in determining net income earnings (adequate return/sustainable)
Current Historical
assets 2. GAAP-compliant; decision-useful, low-quality
Nonmonetary earnings (inadequate return/not sustainable)
liabilities
Current Historical ANALYSIS OF
OF FINANCIAL
FINANCIALINSTITUTIONS
INSTITUTIONS 3. GAAP-compliant; not decision-useful
Common stock Historical Historical Key Components of Basel III: 4. GAAP-compliant; earnings management
Revenues/ - Minimum capital requirements: Based on risk- 5. Non-compliant accounting
Average Average weighted assets 6. Fictitious transactions
Expenses
COGS Average Historical - Minimum liquidity: Enough to handle a 30-day
Beneish Model
Depreciation Average Historical liquidity stress scenario
M-scores: Higher values indicate a greater
- Stable funding: To cover needs over a one-year
likelihood of earnings manipulation
Translation Adjustments horizon; based on the length of the deposits and
- Threshold M-scores:
Balance Foreign Currency the type of depositor
o −1.78 (3.8% likelihood of manipulation)
Sheet
Strengthens Weakens Minimum Capital Requirements o −1.49 (6.8% likelihood of manipulation)
Exposure
under Basel III: - Days Sales in Receivables Index (DSRI): Large
Positive Negative
- Common Equity Tier 1 capital ≥ 4.5% increase could mean revenue inflation
Net asset translation translation
- Total Tier 1 capital ≥ 6.0% - Gross Margin Index (GMI): >1 means gross margin
adjustment adjustment
- Tier 1 plus Tier 2 capital ≥ 8.0% has decreased, possible pressure to manipulate
Negative Positive
Net - Asset Quality Index (AQI): Increase could indicate
translation translation The CAMELS Approach
liability excessive capitalization of expenses
adjustment adjustment 1. Capital adequacy
- Sales Growth Index (SGI): Rapid sales growth can
2. Asset quality
Effect of Translation Method on Ratios create pressure to manipulate earnings
3. Management capabilities
- Pure income statement and pure balance sheet - Depreciation Index (DEPI): >1 means depreciation
4. Earnings sufficiency
ratios are unaffected by the current rate method rate has decreased, indicating manipulation
5. Liquidity position
- Under both the current rate and temporal - SG&A Expenses Index (SGAI): >1 means increasing
6. Sensitivity to market risk
methods, ratios using both income statement and SG&A expense, might encourage manipulation
balance sheets figures will be different from the Relevant Factors Not Covered by CAMELS - Accruals: More accruals indicate manipulation
same ratios calculated using local currency Banking-Specific Analytical Considerations - Leverage index (LEVI): >1 shows increasing debt-
statements before translation - Government support to-asset ratio, greater pressure to manipulate
Examples: - Government ownership In the Beneish model, SGAI and LEVI are negatively
1. Receivables turnover (sales/receivables) is the - Mission of banking entity correlated with the M-score; other variables are
same under both current and temporal methods - Corporate culture positively correlated
- Sales are translated at the average exchange Considerations relevant to any company Measures of Earnings Persistence and Accruals
rate under both - Competitive environment - Earnings forecast should not include non-
- Receivables are translated at the current - Off-balance-sheet items recurring items
exchange rate under both - Segment information - Cash components are more persistent than
- Currency exposure accrual components
- Risk factors - Earnings with significant accruals will experience
- Basel III disclosures a faster mean reversion
- A company that consistently performs slightly
better than benchmark should be scrutinized

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- Regulatory enforcement actions and restatements FINANCIAL STATEMENT MODELING
MODELING - Expected volatility of future earnings: Companies
of previous financial statements are red flags with greater earnings volatility are less likely to
Financial Modeling: Overview
Altman model: A lower Z-score indicates a higher increase dividends; Increasing dividends
Income Statement Modeling: Revenue
probability of bankruptcy - Top-down approach increases chances of not maintaining the dividend
- Bottom-up approach - Financial flexibility: Companies seeking more
Cash Flow Quality
- Hybrid approach flexibility are less likely to initiate or increase
- A startup company might be expected to have
dividends
negative operating and investing cash flows,
Income Statement Modeling: Operating Costs - Tax considerations: Investors consider dividends
funded by positive financing cash flows from
Cost analysis should match revenue analysis on an after-tax basis
equity issues or borrowing
- Cost of goods sold (COGS) - Flotation costs: Make using newly issued stock
- For established companies, high-quality
- Selling, general, and administrative expenses more expensive than internally generated funds;
operating cash flow (OCF) should be:
(SG&A) Smaller companies face higher flotation costs
- Positive
- Contractual and legal restrictions: Bond
- Derived from sustainable sources Income Statement Modeling: Non-Operating Costs
indentures, obligations to preferred shareholders,
- Enough for capex, dividends, and debt service Financing expenses are affected by debt level and
rules against capital impairment, etc.
- Stable relative to peers interest rate

Tax rates: Tax System and Dividend Policy

Balance Sheet Quality Indicators
High financial reporting quality requires: - Statutory tax rate - Double Taxation: Corporate earnings are first
- completeness - Effective tax rate taxed at the corporate level and then again at the
- unbiased measurement - Cash tax rate shareholder level when distributed as dividends.
- clear presentation ETR = Corp. tax rate
Balance Sheet and Cash Flow Statement Modeling
A high-quality balance sheet requires: +(1 − Corp. tax rate)(Ind. tax rate)
Return on invested capital (ROIC)
- optimal amount of leverage - Split-rate: Corporate earnings distributed as
Net operating profit less adjusted taxes (NOPLAT)
- adequate liquidity = dividends are taxed at a lower rate than the
Invested capital
- economically successful asset allocation earnings retained. Dividends are taxed as
ordinary income for investors. The effective tax
Sources of Information about Risk
rate on dividends is calculated with the same
- Financial statements, including notes
CORPORATE ISSUERS formula used under a double taxation system, but
- Audit opinion or discretionary change in auditor CORPORATE ISSUERS the lower corporate tax rate is used for dividend
- Management commentary
distributions
- Regulatory disclosures ANALYSIS OF DIVIDENDS
DIVIDENDS AND
AND SHARE
ANALYSIS OF
- Financial press SHARE REPURCHASES ETR = Corp. tax rateF
REPURCHASES
+(1 − Corp. tax rateF )(Ind. tax rate)
Stock Dividends
OF FINANCIAL
INTEGRATION OF FINANCIALSTATEMENT
STATEMENT - Imputation: Corporate earnings distributed as
- In lieu of paying a cash dividend, companies may
ANALYSIS TECHNIQUES
ANALYSIS TECHNIQUES dividends are taxed at the shareholder’s tax rate.
distribute additional shares.
Framework for Analysis - Such a distribution increases the number of Individual shareholders receive a tax credit if
1. Define purpose for analysis shares outstanding without affecting the their marginal tax rate is less than the corporate
2. Collect input data company's total market value. tax rate. If their marginal tax rate is higher, they
3. Process data - The stock dividend does not affect the company’s only pay tax based on the difference between
4. Analyze/interpret processed data balance sheet or income statement, so liquidity their marginal tax rate and the corporate rate.
5. Develop and communicate conclusions and financial leverage ratios are unchanged. Payout Policies
6. Follow up Stable Dividend Policy
Stock Splits
Sources of Earnings and ROE - They have no economic effect on the company D# = D" + (E# × PR G − D" ) × A
Net Income Sales Assets and should not impact shareholders’ wealth. where
ROE = × × E# is expected earnings
Sales Assets Equity - Reverse stock splits reduce the number of shares
outstanding, but they still have no economic PR G is target payout ratio
Net Profit Asset A is an adjustment factor (1/Years to target ratio)
ROE = × × Leverage impact on the company or shareholder.
Margin Turnover
Dividend Theories Constant Dividend Payout
NI EBT EBIT Sales Assets
ROE = × × × × - Dividends are irrelevant: MM Propositions Dividend as a constant share of earnings
EBT EBIT Sales Assets Equity
- Bird-in-the-hand argument: Investors prefer cash Residual Dividend Payout
Accruals and Earnings Quality dividends over unrealized capital gains Pay out earnings remaining after funding all
Balance sheet approach - Signalling: Managers want to increase dividends positive NPV capital projects consistent with its
AccrualsAB = NOA.,: − NOA&.C as a signal of strength to investors target capital structure.
NOA.,: − NOA&.C - Agency cost: Paying dividends to owners limits
Accruals RatioAB = managers’ ability to fund negative NPV projects Capital Equity %
íNOA.,: + NOA&.C ì⁄2 D = max u0, Earnings − × w
Budget in capital
Factors Affecting Dividend Policy structure
Cash flow statement approach
- Investment opportunities: Company with more Share Repurchase Methods
AccrualsDE = NI − CFO − CFI
(less) investment opportunities will pay out less - Buy in the open market
NI − CFO − CFI (more) in dividends - Buy back a fixed number of shares at a fixed price
Accruals RatioDE =
íNOA.,: + NOA&.C ì⁄2 - Dutch auction
- Repurchase by direct negotiation

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Financial Statement Effects of Repurchases - Dual-class shares: Disproportionate voting rights - Misrepresenting a project’s benefits when issuing
Changes in Earnings per Share for certain classes of shares green bonds is known as greenwashing.
- If the net income stays the same, the EPS will
Conflicts with Different Ownership Structures
increase after a share repurchase because there
- Dispersed ownership, dispersed voting power: COST OF
OF CAPITAL:
CAPITAL: ADVANCED
ADVANCED TOPICS
TOPICS
are fewer shares outstanding.
Leads to principal-agent problem where strong
- Share repurchases made with borrowed funds: If Cost of Capital Factors
managers take advantage of relatively weak
the earnings yield is greater (lower) than the Weighted average cost of capital:
shareholders
after-tax cost of the funds, the EPS will increase WACC = w: r:(1 − t) + w/ r/ + w. r.
- Concentrated ownership, concentrated voting
(decrease).
power: Leads to the principal-principal problem Top-down external factors:
- An increase in EPS does not necessarily imply an
where a captive board makes decisions to the - Capital availability
increase in shareholders’ wealth.
detriment of minority owners - Market conditions
Changes in Book Value per Share
- Dispersed ownership, concentrated voting power: - Legal and regulatory considerations
- If the market price per share is greater (less) than
Also leads to the principal-principal problem, but - Tax jurisdiction
its book value per share, a stock repurchase will
for the benefit of large minority owners holding
decrease (increase) the book value per share.
dual-class shares Bottom-up company specific factors:
- Concentrated ownership, dispersed voting power: - Revenue, earnings and cash flow volatility
Valuation Equivalence
Can occur if voting caps are used - Asset nature and liquidity
- Ignoring the tax and information effects, cash
Board Composition - Financial strength, profitability, and financial
dividends and share repurchases should have the
One-tier: Executive and non-executive directors leverage
same effect on shareholder wealth.
Two-tier: Independent supervisory board oversees - Security features
- However, if shares are repurchased at a premium,
management board
wealth will be transferred from remaining Estimating Cost of Debt
CEO duality: The same individual serves as both
shareholders to the seller. - Traded debt
CEO and chair of a one-tier board, raising concerns
- Non-traded debt
Advantages of Share Repurchases vs. Dividends about a lack of independent oversight
- Bank debt
- Potential tax advantages Special voting arrangements: May require directors
- Leases
- Signaling to secure dual majorities among both controlling
- International considerations
- Managerial flexibility and minority shareholders
- Offsets dilution from employee stock options Stewardship codes: Encourage asset managers to Estimating Equity Risk Premium
- Adjusting capital structure increase engagement in corporate governance Historical approach
- Increasing EPS Factors:
Board Policies and Practices - Equity index selection
Analysis of Dividend Safety - Board of Directors Structure - Time period
All else being equal, the risk of a dividend cut or - Board Independence - Mean type
omission increases when we have: - Board Committees - Risk-free rate proxy
- A higher dividend payout ratio (dividends/net - Board Skill and Experience
Limitations:
income) - Board Composition
- Past does not represent the future
- A lower dividend coverage ratio (net - Other Considerations in Board Evaluation
- Index-based ERP can be inflated due to
income/dividends)
Executive Remuneration survivorship bias
FCFE FCFE - Companies may have a say on pay provision that
Forward-looking approach
coverage = allows shareholders to vote or at least provide
Dividends + Share repurchases Survey-based estimates:
ratio feedback on compensation. - Limitations: Sampling bias, recency bias, and
- If the ratio is equal to 1, the company is - A claw-back policy allows companies to regain confirmation bias
distributing all available cash to shareholders. previously paid compensation if mismanagement
or misconduct is subsequently uncovered. Dividend discount model estimates:
- If the ratio is significantly greater than 1, the
- Gordon growth model
company is keeping some earnings to enhance
Shareholder Voting Rights D#
liquidity. V" =
- Under a straight voting share structure, each r. − g
- If the ratio is significantly less than 1, the
share has the same voting rights.
company is borrowing cash to pay dividends, D#
- In a dual-class structure, certain classes of shares r. = + 𝑔𝑔
thereby decreasing liquidity. This is 𝑉𝑉"
have enhanced voting rights, which can create a
unsustainable because the company is paying out D#
conflict of interest between minority ERP = r. − r= = + g − r=
more than it can afford. V"
shareholders and founders/management.

Approaches to Identify ESG Factors Macroeconomic modeling:

ESGCONSIDERATIONS
ESG CONSIDERATIONSINININVESTMENT - Grinold-Kroner model
- Proprietary methods
INVESTMENT ANALYSIS
ANALYSIS 𝐷𝐷#
- Third-party vendors 𝐸𝐸(𝑟𝑟H ) = + Δ𝑃𝑃𝑃𝑃 − Δ𝑆𝑆 + 𝑖𝑖 + 𝑔𝑔
Ownership Structure - Non-profit industry organizations and initiatives 𝑃𝑃"
- Dispersed: Many small minority shareholders Estimating Cost of Equity
Evaluating ESG-related Risks and Opportunities
- Concentrated: One majority shareholder or a few Dividend discount models
- Equity analysts consider both the opportunities
shareholders with large minority positions D#
and risks related to ESG factors, while fixed- r. = + 𝑔𝑔
- Horizontal: Cross-holding share arrangements 𝑉𝑉"
income analysts primarily consider the downside
- Vertical: Controlling interest in two or more
risks associated with ESG issues.
holding companies with their own subsidiaries
- Companies may issue green bonds to raise capital
for projects intended to benefit the environment.

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Bond yield plus risk premium (BYPRP) Investment Actions EQUITY VALUATION
r. = r: + Risk premium Equity investments: EQUITY VALUATION
= r: + (Mean equity index return - The acquirer and the target operate as
− Mean corporate bond index return) independent entities EQUITY VALUATION
EQUITY VALUATION

Joint ventures: Equity Value vs. Market Price

Risk-based models
- Separate entity created by two or more VL – P = (V – P) + (VL – V)
- Capital asset pricing model (CAPM)
companies that contribute assets and other VL : estimate of intrinsic value
r. = r= + β(ERP) resources to pursue common objectives P: market price
= r= + β(r7 − r= )
V: unobservable intrinsic value
Acquisitions:
- Fama-French model (V – P): “true” mispricing
- Target company becomes a subsidiary and its
r! = R E + β# (ERM) + β$ (SMB) + βI (HML) assets, liabilities, and revenues are consolidated Definitions of Value
- Expanded Fama-French model as part of the acquirer's financial statements - Going concern value: Assumes company will
Divestment Actions continue operating for the foreseeable future
r! = R E + β# (ERM) + β$ (SMB) + βI (HML)
+ βJ(RMW) + βK (CMA) Sales: - Liquidation value: Assumes assets must be sold
- The seller transfers a segment or business line to immediately, likely at a discount
Estimating the Cost of Equity for Private - Orderly liquidation value: Higher than if assets
an acquirer, which assumes control of the
Companies must be sold immediately
associated assets and liabilities
Expanded CAPM method - Fair market value: Price negotiated between a
r. = r= + β/..6 (ERP) + SP + IP + SCRP Spin-offs: willing buyer and seller
- The parent company's shareholders receive
Build-up approach - Investment value: Subjective valuation for a
shares in the spun-off company, but the two
r. = r= + ERP + SP + IP + SCRP specific investor
companies issue their own securities and file
International Considerations separate financial reports
Country spread model DISCOUNTED DIVIDEND
DISCOUNTED DIVIDEND VALUATION
VALUATION
Restructuring Actions
ERPLM = ERP for a developed market Single Period Multiple Period
Cost restructuring:
+(λ × Country risk premium) D# + P# ,
- Improve operational efficiency and increase V" = D1 P,
Country risk rating model profit margins through outsourcing and (1 + r)# V" = t +
(1 + r)1 (1 + r),
1<#
Country risk premium offshoring
σL4N!1O
= Sovereign yield spread × Balance sheet restructuring: Gordon Growth Model (GGM)
σA5,:
- Sale leasebacks: Address immediate liquidity D# D" (1 + g)
V" = =
Global CAPM (GCAPM) needs and eliminate the risks associated with r−g r−g
Uses a global market index as a factor and assumes ownership
Value of Fixed-rate Perpetual Preferred Stock
zero correlation between returns across countries - Dividend recapitalization: Debt-financed dividend
D
payment that increases the leverage in a V" =
International CAPM (ICAPM) r
company's capital structure Present Value of Growth Opportunities
r. = r= + βP írC7 − r= ì + βD (rQ − r=)
Reorganization: E#
V" = + PVGO
- Must be approved by a bankruptcy court r
CORPORATE
CORPORATERESTRUCTURING
RESTRUCTURING
Leveraged Buyouts (LBO) Required Rate of Return Using GGM
Corporate Structural Changes D#
- PE firms raise debt to finance acquisition of r= +g
Type of P"
Motivations private companies and aim to operate them more
Change
efficiently under private ownership Two-Stage DDM
- Realize synergies
- The private companies may return to the public ,
- Increase growth potential D" (1 + g B )1 D" (1 + g B ), (1 + g R )
Investment market through IPO V" = t +
- Improve capabilities (1 + r)1 (1 + r), (r − g R )
actions 1<#
- Access new resources Evaluating Corporate Restructurings
- Acquire an undervalued firm Step 1: Initial evaluation H-Model
- Improve operational focus Step 2: Preliminary valuation D! (1 + g " ) + D! H(g # − g " )
V! =
- Improve valuation metrics - Comparable company analysis r − g"
Divestment - Comparable transaction analysis
- Meet liquidity needs Required Return from H-Model
actions - Premium paid analysis
- Address regulatory D"
requirements r = . 1 [(1 + g R ) + H(g B − g R )] + g R
Deal price − Stock price P"
- Improve return on capital Takeover premium =
Stock price
Restructuring markets Sustainable Growth Rate
actions - Avoid/respond to financial Step 3: Modeling and evaluation g = b × ROE
challenges - EBIT/Sales b = retention rate = 1 − dividend payout ratio
Profitability
- EBITDA/Sales
Dividend Growth Rate and ROE Analysis
- Standard deviation of revenues Net Income
Volatility ROE =
- Standard deviation of EBITDA
Shareholder′ equity
Leverage - Debt/EBITDA Net income Sales Assets
=. 1. 1. 1
Collateral - Asset liquidity Sales Assets Equity
Interest - Benchmark reference rates NI − Dividends NI Sales Assets
g=. 1. 1. 1. 1
rates - Credit spreads NI Sales Assets Equity

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FREE CASH
CASHFLOW
FLOWVALUATION
VALUATION Forecasting of FCFF and FCFE Yardeni Model
Assuming fixed debt ratio (DR) in capital structure CEY = CBY − b × LTEG + residual
FCFF Valuation Model
T Net borrowing = DR(FCInv – Dep) + DR(WCInv) - CEY = current earnings yield on the market index
FCFF1
V=!67 t FCFE = NI − (1 − DR)(FCInv − Dep) - CBY = current yield on A-rated corporate bonds
(1 + WACC)1
1<# − (1 − DR)(WCInv) - LTEG = consensus 5-year market EPS growth rate
Constant Growth Model - b = weight the market gives to earnings estimates
FCFF# FCFF" (1 + g) International Application of Single-Stage Model
V=!67 = = Required rate of return (real) P 1
WACC − g WACC − g =
= Country return(real) E (CBY − b × LTEG)
FCFE Valuation Model ± Industry adjustment
T Justified Price Multiples
FCFE1 ± Size adjustment
V.4N!1O = t = V=!67 − MV:.&1 P" ROE − g
(1 + r)1 ± Leverage adjustment Price/Book =
1<# B" r−g
Free Cash Flow Model Variations E"
Constant Growth Model
Sensitivity Analysis of FCFF and FCFE Valuations Price/Sales P" K ¢S" L (1 − b)(1 + g)
=
FCFE# FCFE" (1 + g) Sensitivity analysis can be performed on key S" r−g
V.4N!1O = =
r−g r−g variables such as beta, risk-free rate, equity risk
Price to Cash Flow
premium, FCFE growth rates, and the initial FCFF
Calculating FCFF from Net Income Advantages vs. P/E
or FCFE.
FCFF = Net income to common shareholders - Cash flows are more stable than earnings
Two-Stage Free Cash Flow Models
+ Net non-cash charges - Cash flows are less subject to manipulation
+ Interest expense (1 – tax rate) ,
FCFF1 - Differences between CFs and earnings should be
- Investment in fixed capital V=!67 = t
(1 + WACC)1 eliminated over time
- Investment in working capital 1<#
FCFF,+# 1 Disadvantages vs. P/E
+ P Q
FCFF from NI: Adjustments for Noncash Items WACC − g (1 + WACC), - Cash flows may still be manipulated
Adjustment to Three-Stage Growth Models - FCFE is theoretically better but more volatile than
Noncash Item
NI Three-stage models usually assume one of the FCFF
Depreciation/Amortization Added back following: - Cash flows are different under IFRS vs. US GAAP
Impairment of intangibles Added back - Constant growth rate in all three stages
- Constant growth rate in the first and third stages, Justified Dividend Yield
Restructuring charges Added back
D" r − g
Expense reversals Subtracted with a declining growth rate in stage two =
P" 1 + g
Losses Added back
Gains Subtracted Non-operating Assets and Firm Value Enterprise Value to EBITDA
Amortization of long-term Firm value Enterprise Value
Added back = Value of operating assets
bond discounts = Market Value of Common Equity
Amortization of long-term + Value of non-operating assets + Market Value of Preferred Stock
Subtracted + Market Value of Debt
bond premiums
Added back MARKET-BASED VALUATION: PRICE AND + Minority Interest
Deferred taxes but special ENTERPRISE VALUE
VALUE MULTIPLES
MULTIPLES − Cash and Investment
attention EBITDA = NI + Int + Taxes + Dep & Amort
Trailing (current) P/E
Calculating FCFF from Statement of Cash Flows Current stock price EV/EBITDA vs. P/E
FCFF = CFO + Int(1 − tax) − FCInv Most recent four quarters’ EPS Advantages:
CFO = NI + NCC − WCInv - Controls for differences in leverage
Forward (leading) P/E
FCInv = CapEx − Proceeds from sale of l/t assets - Controls for differences in depreciation
Current stock price
- EBITDA can be used even if earnings are negative
Calculating FCFE from FCFF Next year’s expected EPS
FCFE = FCFF − Int(I − tax) + Net borrowing Disadvantages:
Justified P/E
Finding FCFF/FCFE from EBIT or EBITDA - EBITDA overestimates cash flows if working
P" D#⁄E# 1 − b
FCFF = EBIT(1 − tax) + Dep − FCInv − WCInv Leading = = capital is growing
E# r−g r−g - EBITDA ignores the impact of revenue
NI + Int(1 − tax)
EBIT = P" D" (1 + g)⁄E" (1 − b)(1 + g) recognition policies on CFO
1 − tax Trailing = =
FCFF = EBITDA(1 − tax) + Dep(tax) − FCInv E" r−g r−g
Momentum Indicators
− WCInv P/E to Growth (PEG) Ratio Earnings Surprise / Unexpected Earnings
Uses of FCFF and FCFE - P/E divided by expected earnings growth UE1 = EPS1 − E(EPS1 )
Uses of FCFF = Uses of FCFE = - Stocks with lower PEG are more attractive than Percent earnings surprise = UE/Expected EPS
± Δ Cash balance ± Δ Cash balance stocks with higher PEGs, all else equal
Standardized Unexpected Earnings
+ Interest expense (1-t) + Cash dividends Fed Model EPS1 − E(EPS1 )
+ Debt repayment + Share repurchases - Compares the S&P 500 earnings yield (inverse of SUE1 =
σ[EPS1 − E(EPS1)]
+ Cash dividends P/E) to the 10-year Treasury yield
+ Share repurchases - Market is overvalued if the earnings yield, based
on next 12 months’ expected earnings, is less than
the 10-year Treasury yield

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RESIDUAL
RESIDUAL INCOME
INCOMEVALUATION
VALUATION Excess Earnings Method Yield Curve Risk Based on Key Rate Durations
Residual income × (1 + g) Decomposes changes in yield curve into changes in
Residual Income (RI) V!,13,C!&8.2 =
r−g level (L), steepness (S), and curvature (C):
RI = NI – Equity charge
V&N2!,.22 = WC + FA + Intangibles ∆P
. 1 ≈ −DR ∆xR − DB ∆xB − DD ∆xD
Economic Value Added (EVA) P
EVA = NOPAT − (C% × TC) Valuation Discounts and Premiums
Discounts for lack of control Flattening and Steepening of Yield Curve
NOPAT = EBIT(1 − tax)
1 Bullish steepening: Short-term rates falling faster
C% = Cost of capital DLOC = 1 −
1 + Control premium than long-term rates; observed when central bank
TC = Total capital
loosens monetary policy to stimulate economy
Market Value Added (MVA) Bearish flattening: Short-term rates increasing
= Market value of the company more than long-term rates; occurs when central
− Accounting book value of total capital FIXED INCOME bank raises rates by restricting money supply
FIXED INCOME
Residual Income Model Bullish flattening: Long-term rates falling more
RI1 = E1 − rB10# = (ROE − r)B10# TERM
TERM STRUCTURE AND INTEREST RATE
STRUCTURE AND than short-term rates; observed in the aftermath of
T
RI1 INTEREST
DYNAMICSRATE DYNAMICS market turmoil as investors flock to government
V" = B" + t bonds in a flight to quality
(1 + r)1 Spot Rates
1<#
1
Clean Surplus Relationship DFU =
(1 + ZN )U ARBITRAGE-FREE VALUATION
VALUATION FRAMEWORK
FRAMEWORK
B1 = B10# + E1 − D1
Forward Pricing Model Arbitrage Concepts
Constant Growth B-A Value additivity: Exists if the whole does not equal
ROE − r (1 + zB )B = (1 + zA )A í1 + fA,B-A ì
V" = B" + B sum of parts
1
r−g " F[,A0[ = Dominance: Exists if the present value of a risk-free
A0[
ß1 + f[,A0[ ® payoff is non-zero
Multistage RI Valuation Model
DFA Stripping: Turning coupon bonds into multiple
G
E1 − rB10# PG − BG F[,A0[ =
DF[ zero-coupon bonds
V" = B" + t +
(1 + r)1 (1 + r)G
1<# Relationship between Spot and Forward Rates Reconstitution: Combining zero-coupon bonds to
For an upward-sloping (downward-sloping) replicate a coupon-paying bond
If RI fades over time:
G0# spot curve, the forward curve will be above Binomial Interest Rate Tree
E1 − rB10# EG − rBG0#
V" = B" + t + (below) the spot curve
(1 + r)1 (1 + r − ω)(1 + r)G0#
1<#
- ω = persistence factor; 0 < ω < 1 Swap Rate
G
- ω = 0: RI will fall to zero after forecast horizon sG 1
t + =1
- ω = 1: RI will persist at current level indefinitely (1 + z1 )1 (1 + zG )G
1<#
G
Strengths
t sG DF1 + DFG = 1
- Terminal value does not make up a large portion
1<#
of the total present value as in other models
- RI models use readily available accounting data Spreads
- Can be applied to companies that do not pay - Swap spread = Swap rate − Treasury yield
dividends or positive expected near-term FCF - I-spread = Bond yield − Swap rate i#,\ = i#,R e$]
- Can be used when cash flows are unpredictable - Z-spread: Spread added to each spot rate so
- Appealing focus on economic profitability that PV of bond’s cash flows equals bond’s
market price
Weaknesses
- TED spread = LIBOR rate − T-bill rate
- The models are based on accounting data that can
- LIBOR-OIS spread = LIBOR rate − OIS rate
be subject to manipulation by management
- Accounting data used as inputs may require Term Structure of Interest Rates: Theories
significant adjustments Pure expectations: Forward rates are unbiased
- Additional adjustments are needed when clean predictors of future spot rates
surplus accounting relationships do not hold Local expectations: All bonds are expected to
- The RI model’s use of accounting income assumes generate the risk-free rate over short time periods
that the cost of debt is reflected appropriately by Liquidity preference: Forward rates reflect
interest expense expectations of future spot rates plus liquidity
premiums for longer maturities
Segmented markets: Yield curve shape is
PRIVATE COMPANY
PRIVATE COMPANY VALUATION
VALUATION
determined by preferences of borrowers and
Approaches to Valuation lenders
Income approach Preferred habitat: Investors have preferred
Market approach maturity ranges, but they will shift if yields are
Asset-based approach attractive
Capitalized Cash Flow Method
V=!67 = FCFF# ⁄(WACC − g = )
V.4N!1O = FCFE# ⁄(r − g)

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Binomial Valuation Framework Effects of Interest Rates and Yield Curve Capped or Floored Floating-rate Bonds
- Callable (putable) bond value is inversely Capped floater
Bond value plus coupon (directly) related to interest rate volatility Bond with option that prevents coupon rate from
payment if higher rate
- Value of option-embedded bonds declines as rising above specified maximum
is realized.
upward-sloping yield curve flattens VQ3//.: = V2163!C^1 − V.7&.::.:
=8531.6 =8531.6 Q3/
Bond value
Option Adjusted Spread (OAS)
at any node Floored floater
Constant spread is added to each forward rate in a
Bond value plus coupon Embedded option sets minimum coupon rate:
benchmark binomial interest rate tree to equate PV
payment if lower rate is V=8556.: = V2163!C^1 + V.7&.::.:
of credit risky bond’s cash flow to its market price =8531.6 =8556
realized. =8531.6
- OASQ3883&8. is inversely related to assumed
volatility of benchmark binomial tree rates Convertible Bonds
VH + C VL + C - OAS/N13&8. is directly related to assumed volatility Bondholder has right to convert bond into
Bond value at node = 0.5 . + 1 common shares at conversion ratio:
1+i 1+i of benchmark binomial tree rates
C + 0.5(VH + VL) Conversion Market price Conversion
= Effective Duration of Callable & Putable Bonds = ×
1+i value of stock ratio
(PV0) − (𝑃𝑃𝑉𝑉+ )
Term Structure Models Effective duration =
2 × (∆Curve)(PV" ) Market Market price
Equilibrium Models Conversion
- EffDurQ3883&8. ≤ EffDur2163!C^1 conversion = of convertible´
- Use fundamental economic variables to describe ratio
- EffDur/N13&8. ≤ EffDur2163!C^1 price bond
the term structure
- Require parameters to be specified Market Market
Market conversion
= conversion − price of
- Preferable for dynamic applications premium per share
price stock
- Allow for possibility of multiple different future
interest rate paths Minimum value
Straight Conversion
of convertible = max K , L
Cox-Ingersoll-Ross (CIR) Model: value value
bond
dr1 = k(θ − r1 )dt + σUr1 dZ Callable and putable convertible bond value
= V2163!C^1 + VQ388 5, − VQ388 5, + V/N1 5,
- Drift term: Mean reverting &5,: 215Q% &5,: &5,:
- Volatility: Proportional to the square root of the
short-term rate
- Negative rates: Not possible Convexity Improves Duration-based Estimates

Vasicek Model:

dr1 = k(θ − r1 )dt + σdZ

- Drift term: Mean reverting

- Volatility: Constant
- Negative rates: Possible

Arbitrage-Free Models
- Based on the assumption that bond prices and the
term structure implied by those prices are correct CREDIT ANALYSIS MODELS
MODELS
- Allow parameters to vary deterministically
Measures of Credit Risk
over time (PV0 ) + (𝑃𝑃𝑉𝑉+ ) − [2 × (𝑃𝑃𝑉𝑉" )]
Effective Convexity = - Recovery rate = 100% − Loss severity
Ho-Lee Model: (∆Curve)$ (PV") - Loss given default = Exposure × (100% − RR)
Convexity for Interest Rates - The conditional probability of default in a given
dr1 = θ1 dt + σdZ
and Bond Structure year is the probability of default assuming no
- Drift term: Time-dependent Interest Straight and Callable prior defaults. If this probability of default is a
- Volatility: Constant rates putable bonds bonds constant rate, then the probability of survival to
- Negative rates: Possible year t can be calculated as:
High Positive Positive
(100% − Hazard rate)1
Kalotay-Williams-Fabozzi (KWF) Model:
Low Positive Negative
Measures of Credit Risk (continued)
d ln(r1 ) = θ1 dt + σdZ
PV of Expected Loss
- Drift term: Time-dependent = Discount factor × Expected loss
- Volatility: Constant = Discount factor × Loss given default
- Negative rates: Not possible × Prob. of default
= Discount factor × (Exposure × Loss severity)
BONDSWITH
BONDS WITH EMBEDDED
EMBEDDED OPTIONS
OPTIONS × Prob. of default

Valuation of Callable and Putable Bonds where Prob. of default = POSA` × Hazard rate1
VQ3883&8. = V2163!C^1 − VQ388 Credit Valuation Adjustment (CVA)
V/N13&8. = V2163!C^1 + V/N1 ,

CVA = t PV of expected loss1

1<#

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Structural and Reduced Form Credit Models Applications of CDS
Structural credit models can interpret debt and - Naked credit default swap: Purchase of credit - FRAs typically use the advanced set, advanced
equity values with option terminology. Debt and protection without holding the reference settled approach. This means interest rate is set
equity are also random values because they are obligation and the FRA settlement is made at time h, when
functions of the asset random values. At time T, the - Long/short trade: Long position in one CDS the FRA expires.
balance sheet can be represented with: and short position in another - The settlement amount for the floating receiver
A(T) = D(T) + E(T) - Curve trade: Buy a CDS of one maturity and (long position) is:
Assuming the maturity value at time T of the debt sell a CDS with a different maturity for the NA[L7 − FRA" ]t 7
is K, a default will occur if the asset value at time T same reference entity 1 + D7 t 7
is less than K. The value of the equity and debt at - Basis trade: Exploit differences in credit
- The FRA fixed rate is the forward m-day rate in h
time T are: spreads offered by the CDS market and
days:
- E(T) = max[A(T) − K, 0] the bond market
1 + LG t G 1
- D(T) = A(T) − max[A(T) − K, 0] FRA" = P − 1Q . 1
1 + L^ t ^ t7
This implies that: - The value of an existing long FRA (floating
DERIVATIVES
- Equity is a call option on the assets with a strike DERIVATIVES receiver) can be calculated using an offsetting
price equal to the face value of the debt transaction at the new rate applicable when the
- Debtholders have written the call option to the PRICING AND
AND VALUATION
VALUATION OF
OF FRA expires:
equity holders FORWARD COMMITMENTS ßFRAC − FRA" ®t 7
VC =
The value of the equity and debt at time T can also 1 + DG0C t G0C
Principles of Arbitrage-Free Pricing
be expressed as follows using put-call parity: To implement the no-arbitrage argument, the Fixed-Income Forward and Futures
- E(T) = A(T) − K + max[K − A(T),0] following simplifying assumptions are made: Accrued interest
- D(T) = K − max[K − A(T),0] - Replicating instruments are available. Accrued interest = Accrual period
This implies that: - Market frictions are absent. × Periodic coupon amount
- Equity can also be viewed as a long position in - Short selling is allowed. NAD C
- Investors can borrow and lend at the AI = . 1×. 1
the assets, long put option, and short bond NTD n
- Debt can be interpreted as a long bond and a risk-free rate. where:
short put option - NAD is the number of days since the last coupon
Pricing and Valuation of Forwards and Futures
payment
Forward Price
Factors for the Term Structure of Credit - NTD is the total days during a coupon payment
F" (T) = FV",G (S" + CC" − CB" )
Spreads period
- Carry benefits could include dividends and bond
- Credit quality - n is the number of coupon payments per year
coupon payments. They reduce the forward price.
- Financial conditions - C is the annual coupon amount
- Carry costs could include waste, storage, and
- Market supply and demand
insurance. They increase the forward price. If accrued interest is included in the bond price
- Company-value model
- If interest rates, carry benefits, and carry costs quote, then F" = FV",G (S" + CC" − CB" ).
are continuously compounded, then: - S" is the full bond price (including accrued
Factors for the Credit Analysis on Securitized
F" (T) = S" e(6'+DD0DA)G interest).
Debt - There are no carry costs, so CC" = 0.
- If there is no carry benefit, then set CB = 0.
- Homogeneity - The carry benefits are the coupon interest
- If there is no carry cost, then set CC = 0.
- Granularity payments, so CB" = PVCI",G .
- Underlying collateral Valuing Forward Contracts
- Structure of the secured debt transaction V1 (T) = PV1,G[F1 (T) − F" (t)] for long If accrued interest is not included in the bond
V1 (T) = PV1,G[F" (t) − F1 (T)] for short price quote, then:
VG(T) = SG − F"(t) for long F" = FV",G ßB" + AI" − PVCI",G ®
CREDIT DEFAULT SWAPS VG(T) = F" (t) − SG for short = FV",G [B" + AI" ] − AIG − FVCI",G
Settlement Protocol Futures Contract Often, the delivery of more than one bond is
- Loss given default (LGD) = 1 − Recovery rate (%) - Right before marking to market: permitted. Then, the actual futures price is:
- Payout amount = LGD × Notional amount v1 (T) = f1 (T) − f10(T) for long F" = Q " × CF

CDS Pricing Conventions v1 (T) = f10 (T) − f1(T) for short Valuing Fixed-Income Forwards and Futures
PV of credit spread = Upfront premium - The value after the daily marking to market is 0. - The value of a bond futures contract is the price
+ PV of fixed coupon Interest Rate Forward and Futures change since the previous day’s settlement.
Upfront Credit Fixed Forward Rate Agreement - The value of a bond forward contract at a later
≈. − 1 × CDS Duration
premium spread coupon date is the present value of the current forward
- The two FRA counterparties are the fixed-rate
CDS price per 100 par = 100 − Upfront premium % receiver (short party) and the floating-rate price less the original forward price.
receiver (long party).
Valuation Changes during CDS Term Pricing and Valuing Swap Contracts
- FRAs are identified in an “X × Y” format.
% Change in CDS price Swap pricing equation
A 3 × 9 FRA will expire in three months with a
= Change in spread (bps) × Duration 1.0 − PV",1( (1)
payoff based on the six-month Libor when the rE'c = ,
∑*<# PV",1! (1)
FRA expires.

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VALUATION OF CONTINGENT
VALUATION OF CONTINGENTCLAIMS
CLAIMS Option Greeks ALTERNATIVE INVESTMENTS
Delta ALTERNATIVE INVESTMENTS
Binomial Option Valuation Model
- Delta is the change in an instrument's value
Exercise values for calls and puts OVERVIEW OF
OF TYPES OF
for a given change in the underlying value. OVERVIEW OF REAL
REAL ESTATE
cG = Max(0, SG − X)
- The delta of a long stock is 1. INVESTMENT
ESTATE INVESTMENTS
pG = Max(0, X − SG )
Hedge ratio - Using the BSM model: Public Private
c+ − c0 DeltaQ = e0dG N(d# ); 0 ≤ DeltaQ ≤ e0dG
h= + ≥ 0 for call REOC shares
S − S0 Delta/ = −e0dG N(−d# ); −e0dG ≤ Delta/ ≤ 0 Direct
Equity REIT shares
+
p −p 0 - As the stock price increases: Indirect
h= + ≤ 0 for put ETFs/Index funds
S − S0 DeltaQ → 1
Mortgage REITs Mortgages
- A long call is equivalent to buying stocks with Delta/ → 0
Debt MBSs Private debt
borrowed funds. - Delta hedging is used to offset the exposure of Unsecured REIT debt Bank debt
- A long put is equivalent to selling stocks short and the portfolio to changes in the underlying.
lending the proceeds. Portfolio Delta Real Estate Characteristics
N\ = −
Delta\ - Heterogeneity and fixed location
Expectations approach
c = PV[πc + + (1 − π)c 0 ] If N\ < 0, short the hedging instrument. - High unit value
p = PV[πp+ + (1 − π)p0 ] If N\ > 0, long the hedging instrument. - Management intensive
#+60: - Delta approximation: - High transaction costs
π=
N0: ±prıce ≈ option price + DeltaíS≤ − Sì
optıon - Depreciation
American-Style Options - Need for debt capital
Gamma
Solve for the values from right to left. At each node, - Illiquidity
- Gamma measures the change in an instrument’s
the value is the greater of the calculated value or - Price determination
delta for a small change in the underlying stock.
the immediate exercise value.
- The gamma for a stock position is 0. Risk Factors of Real Estate Investment
The Black-Scholes-Merton Formula - GammaQ = Gamma/ Property demand and supply:
Stock - Gamma is always non-negative. - Business conditions
For nondividend-paying stock: - The largest value occurs when the option - Demographics
c = SN(d# ) − e06G XN(d$ ) is near the money. - Excess supply
p = e06G XN(−d$ ) − SN(−d#) - Delta-plus-gamma approximation:
ln(S⁄X) + [r + (σ$ ⁄2)]T Valuation:
d# = ≥prıce ≈ option price + DeltaíS≤ − Sì
Optıon - Cost and availability of capital
σ√T Gamma
+ íS≤ − Sì
$ - Availability of information
d$ = d# − σ√T 2 - Lack of liquidity
- N(d$ ) represents the probability the call option
Theta - Rising interest rates
expires in the money.
- 1 − N(d$ ) represents the probability the put - Theta is the change in an instrument's value for a Property operations:
option expires in the money. small change in calendar time. - Management
Futures - Stock theta is zero. - Lease provisions
c = F" (T)e06G N(d# ) − e06G XN(d$ ) - Option theta is negative and more pronounced - Leverage
p = e06G XN(−d$ ) − F" (T)e06G N(−d# ) the closer the option is to expiration. - Environmental
Vega - Obsolescence
ln(F" (T)e06G ⁄X) + [r + (σ$ ⁄2)]T
d# = - Vega is the change in an instrument's value for a - Recent and ongoing market disruption
σ√T small change in volatility.
d$ = d# − σ√T Benefits of Real Estate Investment
- VegaQ = Vega/
- Current income
Interest Rate Options - Positive for both call and put
- Price appreciation
- An interest rate cap is a portfolio of call options Rho - Inflation hedge
on interest rates (a.k.a. caplets), each with the - Rho is the change in an instrument's value for a - Diversification
same exercise rate and with sequential small change in the risk-free interest rate. - Tax benefits
maturities. - Positive for calls, negative for put
- An interest rate floor is a portfolio of put Types of Leases
options on interest rates (a.k.a. floorlets), Implied Volatility Gross lease: The owner pays all operating expenses
each with the same exercise rate and with - The implied volatility measure provides Net lease: The tenant covers certain operating
sequential maturities. information about the market consensus on price expenses
uncertainty and demand for options. Triple-net lease: The tenant pays their share of
Swaptions - The volatility smile is a plot of the implied common area maintenance costs, property taxes,
A swaption is an option on a swap. It gives the volatility with respect to the exercise price. and building insurance
holder the right to enter into a swap with - The volatility surface is a plot of the implied Sale-leaseback: The owner sells its property and
specified terms, including the fixed rate. volatility with respect to various combinations of leases it back from the new owner
- A payer swaption is an option on a swap to time to expiration and exercise prices.
pay a fixed rate and receive a floating rate. Appraisal-Based Index
- A receiver swaption is an option on a swap Relevant appraisal data in the U.S. are provided by
to pay a floating rate and receive a fixed rate. the NCREIF Property Index (NPI).
Holding period return:
NOI − Capex + (End. MV − Beg. MV)
HPR =
Beginning MV

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Disadvantages: Disadvantage: Exit Routes
- Appraisal lag occurs - Lack of retained earnings Initial public offering (IPO): Often a higher
- Volatility and correlations with other assets are - Regulatory costs valuation and more liquidity, but expensive,
understated - Reduced portfolio diversification benefits cumbersome, and less flexible option
- Index requires complicated unsmoothing - Limitations on types of assets owned Secondary market: Sale to another financial or
techniques strategic investor
Net Asset Value Per Share (NAVPS)
Management buyout: Significant leverage
Transaction-Based Index NAV
NAVPS = Liquidation: Applies if company is no longer viable
Repeat sales index uses repeat sales of the same Shares outstanding
property. MV of assets − MV of liabilities Corporate Governance Terms
=
Hedonic index performs regression based on Shares outstanding Key man clause: Future investment is limited if key
properties that are sold. people leave
Funds from Operations (FFO)
Disadvantages: Clawback provision: GP returns some capital to LP
= Accounting net earnings
- Market trends contain random noises + Depreciation charges on real estate if early exits are very profitable and later ones are
+ Deferred tax charges not as profitable
+ Loss from property sales & debt restructuring Distribution waterfall: Provides an order of
INVESTMENTSIN
INVESTMENTS INREAL
REALESTATE
ESTATETHROUGH
THROUGH
− Gain from property sales & debt restructuring distributions between LPs and GPs
PRIVATE VEHICLES
PRIVATE VEHICLES
- Deal-by-deal allows earlier distribution of
Valuation Approaches Adjusted Funds from Operations (AFFO) carried interest to GP after the deal
- Income approach = FFO − Non-cash rent − Maintenance-type capital
- In total return, GP may not get any carried
- Cost approach expenditures and leasing costs
interest until LPs get back all committed capital
- Sales comparison approach Advantages of Using P/FFO and P/AFFO Tag-along, drag along: Future acquirer can’t get
Net Operating Income (NOI) - Widely accepted in global stock markets control without making an offer to all shareholders
Rental income at full occupancy - Valuations of REITs and REOCs are easily No-fault divorce: LPs can remove GP with super
+ Other income compared to other investment alternatives majority vote (~75%)
= Potential gross income - FFO estimates are readily available Removal for cause: If GP commits gross negligence
− Vacancy and collection loss - Multiples can be used with expected growth and Investment restrictions: Set a minimum level of
= Effective gross income leverage levels to deepen understanding diversification or limits on borrowing
− Operating expenses Co-investment: LPs can invest alongside the GP
Disadvantages of Using P/FFO and P/AFFO
= Net operating income - FFO or AFFO may not capture all intrinsic value Performance Evaluation Multiples
Direct Capitalization Method (like land parcels) PIC (paid in capital)
Cap rate = Discount rate − Growth rate - Does not adjust for the right recurring capex Paid in capital / committed capital
NOI - Income statement rules have changed, so P/FFO DPI (distributed to paid in)
= and P/AFFO are difficult to calculate Cumulative distributions/cumulative invested
Value
Rent capital
ARY =
Sale price of comparables RVPI (residual value to paid in)
PRIVATEEQUITY
PRIVATE EQUITY INVESTMENT
INVESTMENT
LP’s shareholding / cumulative invested capital
DCF Method Contrasting Valuation in Venture TVPI (total value to paid in)
NOI Capital and Buyout Settings
V= Distributed and undistributed value / cumulative
r−g Buyout investments invested capital
Debt Service Coverage Ratio (DSCR) - Predictable cash flow
DSCR = NOI⁄Debt service - Strong, experienced management team
INTRODUCTION TO COMMODITIES
INTRODUCTION TO COMMODITIESAND
AND
- Extensive leverage
COMMODITY DERIVATIES
DERIVATIVES
- Low need for working capital
INVESTMENTSIN
INVESTMENTS INREAL
REALESTATE
ESTATETHROUGH
THROUGH
- Established products Commodities Overview
PUBLICLY TRADED
PUBLICLY TRADED SECURITIES
SECURITIES
- Predictable exit - Energy (crude oil, natural gas, and refined
Publicly Traded Real Estate Securities Venture capital investments products)
Real estate investment trusts (REITs) - Unpredictable cash flow - Grains
- Tax-advantaged entities - New management team with strong track records - Industrial (base) metals
Real estate operating companies (REOCs): - Primarily equity funded and weak asset base - Livestock
- Ordinary taxable entities - Significant cash burn rate - Precious metals
Mortgage-backed securities (MBS): - Unpredictable exit - Softs
- Asset-backed securitized debt obligations
VC Methods for Valuation of Venture Capital Spot and Futures Pricing
Advantages and Disadvantages of REITs Transactions Basis: Spot price − Futures price
Advantages: Post-money valuation: - Spot price > Futures price: Backwardation
- Liquidity POST = PRE + Investment - Spot price < Futures price: Contango
- Transparency Exit Value Calendar spread
=
- Diversification ROI = Futures contract with an earlier expiration
- High-quality portfolios Required rate of return:
−Futures contract with a later expiration
- Active professional management Exit Value
(1 + IRR)1 = ROI =
- High, stable income POST
- Tax efficiency New Share Creation
S,
=F
S. + S,

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Components of Futures Returns Risks MEASURING AND
MEASURING AND MANAGING
MANAGINGMARKET
MARKETRISK
RISK
- Price return - Exchange-traded notes (ETNs) carry
Understanding Value at Risk
- Roll return counterparty risks of default.
- Value at Risk (VaR) is the minimum loss expected
- Collateral return - Any fund that uses OTC derivatives will carry a certain percentage of time over a certain period
- Rebalance return settlement risk because mark-to-market gains are of time.
subject to default. - It can be measured in currency units or as a
- ETFs often lend securities to short-sellers for percentage of the portfolio value.
PORTFOLIO MANAGEMENT additional income to investors, creating the risk
PORTFOLIO MANAGEMENT
of counterparty default. Estimating VaR
- The closing of an ETF fund can trigger unexpected Parametric Method
EXCHANGE-TRADED
EXCHANGE-TRADEDFUNDS:
FUNDS:MECHANICS AND
tax liabilities and force investors to find another - This method (a.k.a. the analytical method or the
APPLICATIONS
MECHANICS AND APPLICATIONS
fund. variance-covariance method) typically estimates
The Creation/Redemption Process of ETFs
Portfolio Uses of ETF VaR by assuming normally-distributed returns
- ETF shares are created or redeemed continuously
- Efficient Portfolio Management - Advantage: Simplicity; Works best when the
to match supply and demand.
- Asset Class Exposure Management normal distribution assumption is reasonable and
- The primary market is over-the-counter (OTC)
- Active and Factor Investing the parameter estimates are reliable
with trades between authorized participants
- Disadvantage: Does not work well for portfolios
(APs), which are large broker/dealers, and the
USING MULTIFACTOR MODELS
USING MULTIFACTOR MODELS that contain options because the returns on
ETF manager (a.k.a. ETF sponsor or ETF issuer).
options are not normally distributed
APs are the only investors who can create or Arbitrage Pricing Theory (APT)
redeem new shares of an ETF. The APT is an equilibrium pricing model, but it Historical Simulation Method
makes these weaker assumptions: - This method analyzes the return of the current
Tracking Error
- A factor model describes the asset returns. portfolio composition over a historical period.
- Tracking error is the standard deviation of return
- A well-diversified portfolio can be created to The VaR is then calculated by sorting the returns
differentials between an ETF and its index.
eliminate asset-specific risk. from the largest loss to the largest gain and
- Sources of ETF tracking error include:
- No arbitrage opportunities exist in well- choosing the one based on the desired confidence
- Fees and expenses
diversified portfolios. interval.
- Representative sampling/optimization
- Advantage: Can incorporate events that actually
- Depository receipts and ETFs EíR / ì = R E + λ# β/,# + ⋯ + λ% β/,%
happened and it does not require specification of
- Index changes
Carhart Model a distribution or the estimation of parameters;
- Fund accounting practices
EßR / ® = R E + β/,# RMRF + β/,$ SMB + β/,I HML can also handle options
- Regulatory and tax requirements
+ β/,J WML - Disadvantage: Only useful if the historical period
- Asset manager operations
is representative of the future
ETF Bid-Ask Spreads Fundamental Factor Models
Monte Carlo Simulation Method
ETF spreads are typically less than or equal to the R ! = a! + b!# F# + b!$ F$ + ⋯ + b!e Fe + ε!
- This method allows the analyst to develop
sum of the factors listed below: Factors are stated as returns rather than return
assumptions about the statistical
- Direct trading costs, such as brokerage and surprises in relation to predicted values
characteristics of the distribution, then
exchange fees, as well as creation/redemption Macroeconomic Factor Models use them to generate random outcomes.
fees paid to the sponsor R ! = a! + b!# F# + b!$ F$ + ⋯ + b!e Fe + ε! - Advantage: Very flexible; Works well
- Bid-ask spreads for the underlying securities Asset returns are correlated with the surprises in with a portfolio that has many assets
- Compensation for the market maker’s risk of certain factors and not constrained by the normal
carrying positions Surprise = Predicted value − Expected value distribution assumption
- The market maker’s desired profit spread
- Disadvantage: Can be complex and
Factor Models in Return Attribution
Premiums and Discounts time-consuming to use
Active return = R f − R A
Sources of ETF premiums and discounts e
Active Portfolio Benchmark Advantages and Limitations of VaR
to NAV include: = t P. 1 −. 1 Q
return sensitivity % sensitivity % Advantages of VaR include:
- Timing differences e<#
- Simple concept
- Stale pricing Factor
× K L - Easily communicated concept
return %
Total Costs of ETF Ownership + Security selection - Basis for risk comparison
The main components of ETF cost are: - Facilitates capital allocation decisions
- Management fees Factor Models in Risk Attribution - Can be used for performance evaluation
- Trading costs (e.g., commissions, bid-ask spreads, Active risk = Tracking error = s(R f − R A ) - Reliability can be verified
premiums/discounts) Active risk square - Widely accepted by regulators
- Taxes = s $ (R f − R A ) Limitations of VaR include:
- Tracking error = Active factor risk + Active specific risk - Subjectivity
- Portfolio turnover ,
- Underestimating the frequency of extreme events
- Security lending Active specific risk = t(w!3)$ σ$g!
- Failure to consider liquidity
!<#
Trading costs are more significant for active - Sensitivity to correlation risk
shorter-term investors. Information Ratio - Vulnerability to volatility regimes
R +A
+f − R - Misunderstanding of its meaning
Ongoing costs have an increasing impact on IR =
s(R f − R A ) - Oversimplification
returns for longer-term investors.
- Disregard of right-tail events

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Extensions of VaR o It is difficult to establish limits based on Credit Premiums and Business Cycle
- Conditional VaR (CVaR), a.k.a. expected shortfall scenario analysis. U
µ 1+2
E1 ßCF !
®
or expected tail loss, measures the expected loss if o Extreme hypothetical scenarios are not likely P1! = t 2
B<#
í1 + l1,2 + θ1,2 + π1,2 + γ!1,2ì
VaR is exceeded. to be taken seriously by management.
- Incremental VaR (IVaR) measures the impact of However, using only plausible scenarios could γ!1,2 : credit premium
changing a position's size within a portfolio. be too limiting. Equities and the Equity Risk Premium
- Marginal VaR (MVaR) is similar to incremental Using Constraints in Market Risk Management
U
µ 1+2
!
E1 ßCF ®
VaR in that it measures the change in VaR for a - Risk budgeting first sets limits for the entire firm, P1! = t 2
small change in a position, but it uses formulas B<#
í1 + l1,2 + θ1,2 + π1,2 + γ!1,2 + κ!1,2 ì
then allocates the firm's overall risk budget
derived from calculus. κ!1,2 : equity premium relative to credit risky bonds
among sub-activities. The risk will generally be
- Relative VaR, a.k.a. ex ante tracking error,
based on ex ante tracking error or VaR. Commercial Real Estate
indicates the amount that a portfolio may deviate
- Position limits are effective controls against U
µ 1+2
E1ßCF !
®
from its benchmark. P1! = t
overconcentration. They may be specified in 2
í1 + l1,2 + θ1,2 + π1,2 + γ!1,2 + κ!1,2 + ϕ!1,2 ì
Sensitivity Risk Measures terms of the market value of securities or the B<#

notional principal of derivatives. ϕ!1,2 : liquidity risk premium

Equity Exposure Measures - Beta
E(R ! ) = R E + β![E(R M ) − R E ] - Scenario limits place limits on the loss in a given
scenario. This can be used to address ANALYSIS OF
ANALYSIS OF ACTIVE
ACTIVE PORTFOLIO
PORTFOLIO
Fixed-Income Exposure Measures – Duration, MANAGEMENT
MANAGEMENT
shortcomings in VaR. If results are not within the
Convexity
limits, corrective action should be taken. Measuring Value Added
∆A ∆O # ∆O)
≈ −D + C - Stop-loss limits require changes if losses over a R[ = Rf − RA
A #+O $ (#+O))
given magnitude occur in a specified period. This where:
Option Risk Measures – Delta, Gamma, Vega can catch trending losses that are staying just U
D^3,C. !, i38N. 5= 5/1!5,
∆(delta) ≈ below the VaR daily limits. R A = t wA,! R !
D^3,C. !, i38N. 5= N,:.68O!,C
- Capital allocation aligns risks and rewards by !<#
D^3,C. !, :.813
Г(gamma) ≈ placing limits on capital assigned to each of the U
D^3,C. !, i38N. 5= N,:.68O!,C
firm's activities. R f = t wf,! R !
#
c + ∆c ≈ c + ∆Q ∆S + ГQ (∆S)$ !<#
$

D^3,C. !, i38N. 5= 5/1!5, BACKTESTING AND

BACKTESTING ANDSIMULATION
SIMULATION U
Vega ≈
D^3,C. !, i5831!8!1O 5= N,:.68O!,C R [ = t Δw! R ! ; Δw! = wf.! − wA,!
Backtesting Process
!<#
Scenario Risk Measures 1. Strategy design U
- Historical scenarios are scenarios that measure 2. Historical investment simulation R [ = t Δw! R [! ; R [! = R ! − R A
the portfolio return if historical markets repeat 3. Analysis of backtesting output !<#
themselves.
Backtesting Multifactor Models Decomposition of Value Added
- Hypothetical scenarios model the impact of
- Give equal weight to each parameter M M
extreme movements and co-movements in
- Use a risk-based weighting scheme R [ = t Δw* R A,* + t wf,* R [,*
different markets that have not previously
*<# *<#
happened. Common Problems in Backtesting
- Reverse stress testing is the process of targeting - Survivorship bias: This can be combated using a Sharpe Ratio
and stressing the portfolio’s material exposures. point-in-time approach Rf − RE
SR f =
- Sensitivity and scenario risk measures - Look-ahead bias: This includes reporting lags, STD(R f )
complement VaR in the following ways: data revisions, and addition of new companies to
o Sensitivity measures address some of the Information Ratio
indexes/databases
Rf − RA
shortcomings of position size measures. - Data snooping: To combat this practice, analysts IR =
STD(R f − R A )
o They do not have to rely on historical may use a higher statistical t-value, perform
volatility and correlation data, so their cross-validation, or test theories on different data Constructing Optimal Portfolios
utility is not limited by the parameters of SR$f = SR$A + IR$
Simulation Analysis
the lookback period. IR
Historical simulation: A non-deterministic form of STD(R [ ) = STD(R A )
o Normal distributions do not have SR A
rolling window backtesting
to be assumed.
Monte Carlo simulation: A model that specifies a Active Security Returns
o Scenarios can target key exposures of the
statistical distribution for the underlying data µ! = ICσ! S!
portfolio, such as concentrated positions.
Mean-variance active return weights
- One limitation of sensitivity risk measures is they µ! σ[
ECONOMICS AND
ECONOMICS ANDINVESTMENT
INVESTMENTMARKETS
MARKETS Δw!∗ = $
often do not distinguish by volatility.
σ! IC√BR
- The limitations of scenario measures include: Pricing a default-free nominal coupon
o Hypothetical scenarios are necessary to fill in paying bond Basic Fundamental Law
U Expected active portfolio return
the gaps of historical scenarios. !
CF1+2
o Hypothetical scenarios may incorrectly specify P1! = t 2 E(R [)∗ = IC√BRσ[
B<#
í1 + l1,2 + θ1,2 + π1,2 ì
the correlation between assets or fail to adjust
l1,2 : yield to maturity on a real default-free Full Fundamental Law
correctly for factors such as liquidity or
concentrated positions.
investment today E(R [) = (TC)(IC)√BRσ[
θ1,2 : expected inflation rate
o Hypothetical scenarios are difficult to
maintain. There is no certainty the range of π1,2 : compensation for uncertainty in inflation
scenarios tested is adequate.

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Ex Post Performance Measurement - News traders need to quickly collect and process Abusive Trading Practices
E(R [ |IC( ) = (TC)(IC)√BRσ[ information in order to take positions based on - Market manipulation strategies usually involve
R [ = E(R [ |IC( ) + Noise predicted directional movement. They hope to one or more of these improper market activities:
The portfolio’s active return variance can be profit from stale orders that are not updated to o Trading for market impact deliberately raises
divided into two parts: reflect the latest news. or lowers prices to influence others’
- Variation due to the realized information - Parasitic traders include front runners perceptions. Traders may pay significant
coefficient, TC $ and quote matches. transaction costs to do this.
- Variation due to constraint-induced noise, - Front runners use artificial intelligence to detect o Rumor mongering spreads false information
1 − TC $ trading patterns and predict orders. that affects a stock’s fundamental value.
- Quote matchers seek to exploit the option value o Wash trading is trading between accounts
Ex Ante Measurement of Skill
of standing orders. controlled by the same entity to create the
σ[ = σ'D √Nσ(M - Buy-side traders fill orders for investment and impression that liquidity is greater than
IC risk managers who use the markets to establish actually exists.
E(R [) = σ
σ'D [ positions from which they derive profit- o Spoofing, a.k.a. layering, is a practice of
Practical Measure of Breadth motivated benefits. placing exposed standing limit orders to
N - Electronic brokers serve both proprietary and give the false impression of liquidity or a
BR = buy-side traders. misleading valuation.
1 + (N − 1)ρ
- Electronic dealers hope to profit by trading at - Market manipulation strategies include
positive net spreads. They take liquidity to reduce the following:
TRADING
TRADING COSTS AND ELECTRONIC
COSTS AND ELECTRONICMARKETS
MARKETS
exposure if prices move against inventory o Bluffing involves submitting orders or making
Costs of Trading positions, and they generally avoid holding large trades to influence other traders’ perceptions
- Explicit costs are direct costs of trading, such as inventories of actively traded stocks. of value. Momentum traders are usually
brokerage commissions, transaction taxes, - Electronic arbitrageurs seek to buy undervalued targeted because they buy when prices are
stamp duties, and exchange fees. securities and sell overvalued securities. They try rising and sell when prices are falling.
- Implicit costs are indirect costs caused by the to construct an arbitrage portfolio at minimum o “Pump-and-dump” is an example of a bluffing
market impact of trading. These include: cost and risk. tactic that tries to raise prices.
o Bid-ask spread = Ask price – Bid price o Gunning the market attempts to force traders
Traders seeking quick completion of orders Systemic Risks of Electronic Trading into a disadvantageous trade.
may accept less attractive prices - Runaway algorithms result in unintended errors o Squeezing and cornering is a practice of
o Market impact (or price impact) is the due to programming mistakes. manipulators to control the resources
negative effect of large order sizes - Fat finger errors occur when a manual trader necessary to settle trading contracts.
o Delay (slippage) costs occur when prices submits the wrong order size. This is not unique Then the manipulator takes the resources
move before trades can be fully executed to electronic trading, but the consequences can be off the market, forcing some to default on
o Opportunity costs (unrealized profit/loss) far more severe. their contract or buy the resources at very
result from partially filled orders - Overlarge orders demand too much liquidity from high prices.
- Effective spread: the market. This may result in severely disrupted
o For buy orders: (Trade price – Midquote) x 2 prices and even a temporary halt to trading.
o For sell orders: (Midquote – Trade price) x 2 - Malevolent order streams are created deliberately
- Implementation shortfall: Difference between to disrupt markets. This may be done by
the value of a hypothetical portfolio based on disgruntled employees or even terrorists.
the assumption that an order was executed at
the decision price and the actual portfolio value Solutions to Systemic Risks
- VWAP transaction cost: - Test software thoroughly before using it in live
o For buy orders: VWAPG63:. − VWAPA.,Q^736% trading operations.
o For sell orders: VWAPA.,Q^736% − VWAPG63:. - Exchanges must ensure that order matching
systems only accept orders from approved
Types of Electronic Traders parties (market access controls).
- Proprietary traders include dealers, arbitrageurs, - Adopt controls to ensure that algorithms can only
and front runners. Broker/dealers send orders be changed by authorized parties.
directly to exchanges; other proprietary traders - Shut off trading immediately if the order flow is
send orders to outside brokers to be forwarded to observed to be abnormal.
exchanges. Brokers may provide sponsored - Ensure broker oversight by not allowing broker’s
access to clients. clients to enter orders directly (sponsored naked
- High-frequency traders (HFT) make round-trip access).
trades (buy/sell) within milliseconds. - Use price limits and trade halts to stop trading
- Low-latency traders speculate based on when prices move too quickly or there is
predictions about future prices and order activity excessive demand for liquidity.
using analysis of market data. They are willing to
hold positions for a day or more, unlike high-
frequency traders. They include news traders and
some parasitic traders.

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ETHICAL AND PROFESSIONAL STANDARDS IV(A) Loyalty BA II PLUS CALCULATOR TIPS
ETHICAL AND PROFESSIONAL STANDARDS BA II PLUS CALCULATOR TIPS
Get permission before taking outside work (even
I(A) Knowledge of the Law unpaid) that competes with employer. Abide by Basic Operations
Obey strictest applicable law. Disassociate non-compete agreement (if applicable) and do not 2ND : Access secondary functions (in yellow)
immediately from any illegal or unethical activity. take employer’s property. ENTER : Send value to a variable
I(B) Independence and Objectivity IV(B) Additional Compensation Arrangements 2ND + ENTER : Toggle between options
Do not offer or accept gifts that might impair Obtain written permission from all parties before ↑ ↓ : Navigate between variables/options
independence and objectivity. Gifts from clients receiving any compensation for outside work. STO + 0 - 9 : Store current value into memory
may be permissible. IV(C) Responsibilities of Supervisors RCL + 0 - 9 : Recall value from memory
I(C) Misrepresentation Supervisors must adequately train and monitor Time Value of Money (TVM)
Cite sources. Do not plagiarize or omit important subordinates. Responsibilities may be delegated. For annuity, loan, and bond calculations
information. Act quickly to correct any errors. N : Number of periods
V(A) Diligence and Reasonable Basis
I(D) Misconduct Exercise diligence and thoroughness. Support I/Y : Effective interest rate per period (in %)
Does not apply to personal behavior unless it actions with research and investigation. PV : Present value
reflects poorly on the investment profession. PMT : Payment/coupon amount
V(B) Communication with Clients and
II(A) Material Nonpublic Information Prospective Clients FV : Future value/redemption value
Do not act or cause others to act on material Make appropriate disclosures. Distinguish between CPT + one of the above : Solve for unknown
nonpublic information. Seek public dissemination. fact and opinion in analysis and recommendations. 2ND + BGN : Toggle between ordinary annuity
II(B) Market Manipulation V(C) Record Retention and annuity due
Do not take any actions that distort prices or Maintain records to support recommendations and 2ND + CLR TVM : Clear TVM worksheet
trading volume. Market making and legitimate decisions. 7-year retention period recommended. Note:
trading strategies are allowed. - Always clear the TVM worksheet before starting
VI(A) Disclosure of Conflicts
a new calculation.
III(A) Loyalty, Prudence, and Care Disclose any matters that may impair
- For bonds, PMT and FV should have the same
Place clients’ interest above yours. Disclose independence and objectivity, prominently and in
sign, and opposite signs for PV.
policies on proxy voting and soft commissions. plain language
Cash Flow Worksheet ( CF , NPV , IRR )
III(B) Fair Dealing VI(B) Priority of Transactions
Treat all clients fairly. Treat non-immediate family For non-level payments
Execute clients’ transactions before accounts in
like other clients. Communicate investment Input ( CF )
which you have a beneficial interest.
recommendations and changes simultaneously. CF0: Initial cash flow
VI(C) Referral Fees C01: 1st distinct cash flow after initial cash flow
III(C) Suitability
Disclose referral fees to clients and employer, F01: Frequency of CO1
Use a regularly updated IPS during investment
including non-monetary arrangements. C0n: nth distinct cash flow
decisions. Evaluate decisions in a portfolio context.
F0n: Frequency of C0n
VII(A) Conduct as Participants in
III(D) Performance Presentation Note:
CFA Institute Program
Performance data should be fair, accurate, and - Always clear the CF worksheet before starting a
Do not share confidential exam details. Expressing
complete. Do not promise returns for risky assets. new calculation.
opinions about CFAI policies is permissible.
III(E) Preservation of Confidentiality - The use of F0n is optional. You can leave them as
Keep all client information confidential unless: VII(B) Reference to CFA Institute, the CFA 1 and input repeating cash flows multiple times. If
client is involved in illegal activity, you are legally Designation, and the CFA Program you do so, C01 will be the cash flow at time 1, C02
required, or you have the client’s permission. Do not misrepresent the meaning of CFA Institute will be the cash flow at time 2, and so on.
membership, designation, or candidacy. Output ( NPV , IRR )
I: Effective interest rate per period (in %)
NPV + CPT : Solve for net present value
IRR + CPT : Solve for internal rate of return

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