ECONOMICS

 Neoclassical model→ convergence → quickly if economies are open, free

trade and international borrowing and lending.
 Profits/GDP cannot rise forever
 Population growth can increase the growth rate of the overall economy but
does not affect the rate of increase in per capita GDP.
 In the long run, GDP growth rate is most important driver of stock market
performance. Thus, drivers of potential GDP are drivers of stock market.
 Broad measures of money (M2)---> Rises just before a crisis.
 Regulatory arbitrage regulation used to exploit differences in economic
substance and regulatory interpretation or regulatory regimes to the entity’s
benefit.
 Independent regulator has the power to enforce regulations by government
statute, yet it is not funded by the government
 Inflation —> significantly higher in pre-crisis periods
 The leverage magnifies the effect of losses and gains relative to the investors’
equity base.
 The interbank FX markets are most liquid when the major FX trading centers
are all open. The two largest, London and New York overlap from
approximately 8:00–11:00 a.m. NY time. 
 Establishing legal standards for contracts and employers’ rights &
responsibilities are objectives (intended consequences) of some regulation.
 In fixed-income investments, higher rates of potential GDP growth translate
into higher real interest rates and higher expected real asset returns.
 Requirement of capital deepening as a source of economic growth can be
measured by difference between labor productivity and total factor
productivity. 
Larger the difference → more important capital deepening is as a source of
economic growth.
 The carry trade strategy is dependent on fact that uncovered interest rate
parity does not hold in the short or medium term. 
FX carry traders go long (i.e., buy) high-yield currencies and fund their
position by shorting—that is, borrowing in—low-yield currencies.
Unfortunately, crashes in currency values can occur which create financial
crises as traders unwind their positions.
 When both covered and uncovered interest rate parity conditions are in effect
future spot exchange rates are most likely to be forecast by forward
exchange rates. 
Corporate Issuers:

 When no taxes, no tax differences between dividends and capital gains. 

All other things being equal, the effect on shareholder wealth of a dividend
and a share repurchase should be same.
 Only authorized open market share repurchase plan allows the company the
flexibility to time share repurchases to coincide with share price declines in
company whose objective is to support its stock price in the event of a market
downturn
 Expected dividend = Previous dividend + (Expected earnings × Target payout
ratio − Previous dividend) × Adjustment factor
 A stock dividend will decrease the price per share
 A stock split will reduce the price and earnings per share proportionately,
leaving the price-to-earnings ratio the same. 
 The trade-off of the tax savings of debt versus the value of financial distress
cost is an example of the static trade-off theory of capital structure.
 Proposition II is about the cost of equity and not firm value.
  Proposition I states that a firm’s leverage does not affect its value, which
leads to Proposition II—debt is less expensive than equity because of
seniority (ignoring distress costs)
 Reduction in net agency costs of equity→ increase in the use of debt vs
equity
 Pecking order theory observes that manager behavior is closely scrutinized
by investors and that managers prefer to avoid or sidestep this scrutiny by
seeking out low information content sources of financing, such as internally
generated funds, first.

Advantages of green bonds:

 Green bonds can command a premium over comparable conventional
bonds
 Lower cost of capital due to green bond premium
Disadvantages of green bond:
 Additional costs related to the monitoring and reporting of the use of the
bond’s proceeds
 Lack of liquidity of green bonds when purchased and held by buy-and-hold
investors
 
 A primary challenge when integrating ESG factors into investment analysis is
identifying and obtaining information that is relevant and useful.
 ESG-related adjustments to a company’s balance sheet often reflect an
analyst’s estimate of impaired assets.
 Financing costs are not subtracted from the cash flows for either the NPV or
the IRR. The effects of financing costs are captured in the discount rate used.
 The correct discount rate is the project-required rate of return
 In a consolidation, the acquiring company and target company cease to exist
and form a new company.
 The terminal year non-operating cash flow includes the after-tax salvage
value and the recovery of net working capital, (Note: Terminal year recovery
 of net working capital `investment = Decrease in current assets − Decrease in
current liabilities)
 An equity carve-out involves sale of equity in a new legal entity to outsiders
and would thus result in a cash inflow
 A stock dividend is accounted for as a transfer of retained earnings to
contributed capital.
 A spin-off or a split-off - no cash flow for the firm
 The combination of concentrated ownership and concentrated voting power is
generally associated with controlling shareholders maintaining a position of
power over both managers and minority shareholders, known as a principal–
principal problem.
 A mixed-ownership model tends to have lower market scrutiny of
management than that of corporate ownership models.
 ESG data providers would be independent organizations, such as MSCI or
Sustainalytics, from whom the private equity fund would purchase information.
 GRI (Global Reporting Initiative) and SASB (Sustainable Accounting
Standards Board) are examples of not-for-profit organizations working to
develop sustainability reporting standards. The private equity firm is not
relying on those sources.
 CF = (S − C − D)(1 − t) + D
 The private equity fund uses proprietary methods to identify and assess
ESG investments. Proprietary methods include analysts using their own
judgment based on information available from corporate reports, industry
organizations, news reports, and environmental groups
 A stock proposal to board of directors instead of management team, is a
“bear hug” strategy.
 A project should be abandoned in the future only when its abandonment value
is more than the discounted value of the remaining cash flows.
 “If the cost of a real option is less than its value, this will increase the NPV of
the investment project in which the real option is embedded.”
 For a project if accelerated depreciation (for both book and tax accounting)
instead of straight-line depreciation is used, 
NPV —> increase 
total net cash flow in the terminal year —> Decrease
 If there were a pre-announcement run-up in target company price because of
speculation, the takeover premium should be based on price before the run-
up
 Comparable transaction approach is based on the acquisition price, the
takeover premium is implicitly recognized in this approach
 
 
 
 

Alternative Investments :
 A common source of value creation in leveraged buyouts is debt reduction.
 Most buyout transactions are auctions, which involve multiple potential
acquirers.
 Buyout funds seek out companies with stable cash flows. They generally
invest in companies with low working capital requirements and acquire
portfolio companies via auction.
 Tag-along, drag-along rights ensure that any potential future acquirer of the
company may not acquire control without extending an acquisition offer to all
shareholders, including the management of the company, thus protecting the
interests of managers
 Net asset value ÷number of shares = NAVPS often used as a fundamental
benchmark for the value of a REIT and REOC.
 Capitalization rate = Discount rate – Growth rate
 Cap rate = NOI/Value
 The terminal value using the income approach is NOI/terminal cap rate
 DSCR = NOI/Debt service
 A hedonic index is a transaction-based real estate index, which relies on a
single sale of a property as opposed to repeating sales of the same property
 Venture capital funds typically invest in companies with significant cash
burn rates.
 VC investments tend to be characterized as having exits that are difficult to
anticipate.
 Members of both the firm being bought out and the venture capital investment
usually have strong individual management track records
 Total return = Price return + Roll return + Collateral return
 Private equity funds increase value by taking on high levels of debt on
favorable terms. They can offset their borrowing costs through superior
reorganization and re-engineering capabilities.
 The contractual term enabling management of the private equity–controlled
company to be rewarded with increased equity ownership as a result of
meeting performance targets is called a ratchet.
 The total return swap involves a monthly cash settlement (reset) based on
the performance of the underlying reference asset
 Theory of storage focuses on the level of commodity inventories and the
state of supply and demand. 
 A storage REIT, this investment faces competitive pressures because the
ease of entry into the field of self-storage properties can lead to periods of
overbuilding.
 Physical assets have to be stored, and storage incurs costs (rent, insurance,
inspections, spoilage, etc.). According to the theory of storage, a commodity
that is consumed along a value chain that allows for just-in-time delivery and
use (i.e., minimal inventories and storage) can avoid these costs
 Expected future cash flows affect the valuation of financial assets, such as
stocks and bonds, but not affect valuation of commodities .
 Commodity arbitrage involves an ability to inventory physical commodities
and the attempt to capitalize on mispricing between the commodity
 REITs are tax-advantaged entities, whereas REOC securities are not
typically tax-advantaged entities
 A private real estate equity investor or direct owner of real estate has
responsibility for the management of the real estate, which  increases the
investor’s control in the decision-making process
 According to the hedging pressure hypothesis, hedging pressure occurs
when producers and consumers seek to protect themselves from commodity
market price volatility by entering into price hedges to stabilize their projected
profits and cash flows. If consumers hedge more than producers, futures
price > spot price.
 The insurance theory predicts that the futures price has to be lower than the
current spot price as a form of payment or remuneration to the speculator who
takes on the price risk and provides price insurance to the commodity seller.
 The life cycle of livestock does vary widely by product. Grains have uniform,
well-defined seasons and growth cycles specific to geographic regions
 Indexes that (perhaps inadvertently) contain contracts that more commonly
trade in backwardation may improve forward-looking performance
because this generates a positive roll return.
 Maximum amount of debt that an investor can obtain on commercial real
estate is usually limited by either the ratio of the loan to the appraised value of
the property (loan-to-value, or LTV, ratio) or the debt service coverage ratio
(DSCR), depending on which measure results in the lowest loan amount
 The due diligence process includes a review of leases for major tenants,
which would include the grocery anchor tenant. The lease term for the
anchor tenant is typically longer than the usual 3 to 5 year term for smaller
tenants
 Price of gold, which historically has acted as a store of value, similar to
currencies, and its price is less likely to be influenced by weather, GDP
growth, or the level of emerging market wealth.
 DPI → fund’s realized return, RVPI —-> fund’s unrealized return
 Adjusted funds from operations, is a refinement of FFO that is designed to be
a more accurate measure of current economic income.
 An appraisal-based index is most likely to result in over-allocation as it
tends to “smooth” the index, meaning that it has less volatility.
 Warehouse is most likely affected by import and export activity in the
economy.
 A direct capitalization method would not be appropriate for valuation in
presence of multiple growth rates
 Capitalization rates are used as an input to calculate net operating income
when calculating net worth, or net asset value, which is not a market-based
approach

 REITs are typically exempt from the double taxation of income that comes
from taxes being due at the corporate level and again when dividends or
distributions are made to shareholders in some jurisdictions, such as the
United States.
 Risk factors of private equity real estate investments include business
conditions, demographics, the cost of debt and equity capital, and financial
leverage.
 The lease term for the anchor tenant is typically longer than the usual three-
to five-year term for smaller tenants.
 A positive calendar spread is associated with futures markets that are in
backwardation, whereas a negative calendar spread is associated with
futures markets that are in contango
  The valuation of equities is based on the estimation of future profitability and
cash flows, while valuation of commodities is based on a discounted forecast
of future possible prices based on such factors as supply and demand of a
physical item or the expected volatility of future prices.
 Value of Property  = Land value + (Replacement building cost + Developer’s
profit) – Deterioration – Functional obsolescence – Locational obsolescence –
Economic obsolescence
 A percentage lease is a unique aspect of many retail leases, which requires
the tenant to pay additional rent once its sales reach a certain level.
 A shopping center would most likely require more active management than a
single-tenant office or a warehouse

ETHICS:
 The Code of Ethics and Standards of Professional Conduct applies only to
members of CFA Institute and CFA candidates
 All accounts participating in a block trade should receive the same
execution price and pay the same commission rate. “Orders will be
executed on a first-in, first-out basis, with consideration given to bundling
orders for efficiency,” are consistent with the CFA Institute
 If the regulator finds the systems and processes of supervision are insufficient
at the adviser’s firm, they have the responsibility to appoint an independent
compliance officer until such time the firm has implemented corrective action
to prevent and detect ethical and legal violations in the future
 if a member or candidate determines that information is material, the member
should make reasonable efforts to achieve public dissemination.”
 Recommended procedures to implement Standard VI(C): Referral Fees are
to notify clients at least quarterly, not semiannually.
 Standard III(B): Fair Dealing. A Member’s or Candidate’s duty of fairness and
loyalty to clients can never be overridden by client consent to patently unfair
allocation procedures.
 Fair Dealing states that members must deal fairly and objectively with all
clients regardless of whether they are discretionary or non-discretionary
accounts.
 Once a violation is discovered increase supervision or place appropriate
limitations on the wrongdoer pending the outcome of the investigation.
 Standard I, Professionalism, specifically, Standard I(B), Independence and
Objectivity, which states that CFA Institute members and CFA candidates
must not offer, solicit, or accept any gift, benefit, compensation, or
consideration that reasonably could be expected to compromise their own or
another’s 
 “Firms should require prior approval for employees participating in initial public
offerings and Firms should implement effective supervisory and review
procedures to ensure compliance with personal investment policies.
 CFA Standards recommend that firms allocate IPOs on a pro-rata basis to
clients, not to portfolio managers
  Regularly reviewing employee and proprietary trading is one
recommendation to assess whether trades are being done based on
nonpublic material information.
 Employees to attend an annual refresher course in how to identify and handle
material nonpublic information is a recommendation that helps to increase
awareness of insider information issues which decreases the likelihood of a
violation 
 With a senior professional leaving the firm, the organizational structure
should be updated before submitting an RFP for a potential client’s
consideration
 Adoption of the CFA Code and Standards does not necessarily imply that they
currently have in place proper policies and procedures to ensure compliance
with the Code and Standards and local legal and regulatory requirements.

Portfolio Management :
 Hypothetical scenario analysis allows the risk manager to estimate the
likely effect of the scenario on a range of portfolio risk factors.
 The Monte Carlo method allows the user to develop her forward-looking
assumptions about the portfolio’s risk and return characteristics
 Stress tests and scenario analysis can be used to evaluate the effect of
outlier events on each line of business.
 VaR approaches that can accommodate a non-normal distribution are critical
to understanding relative risk across lines of business.
 If some assets in a portfolio are relatively illiquid, VaR could be
understated, even under normal market conditions. Conditional VaR
measures tail risk
 Stress tests and scenario analysis subject current portfolio holdings to
historical or hypothetical stress events.
 Duration is a measure of interest rate risk. To reduce risk in anticipation of
an increase in interest rates, Montes would seek to shorten the portfolio’s
duration.
 Tracking error is a synonym for tracking risk or active risk.
 Passive investment strategy —> lowest amount of tracking error, Aggressive
active equity manager —> highest tracking error.
 Fundamental factor model because it considers such factors as return on
equity, capital investment, and equity returns
 Macroeconomic factors (e.g., interest rates, inflation risk, business cycle
risk, or credit spreads) and statistical factors (e.g., historical
covariances) are not mentioned.
 When constructing a portfolio, securities with expected returns higher than the
benchmark would be included
 The assumptions under the APT are as follows:
1. A factor model describes asset returns.
2. There are many assets, so investors can form well-diversified portfolios
that eliminate asset-specific risk, not factor risk.
3. No arbitrage opportunities exist among well-diversified portfolios.
4. APT makes fewer strong assumptions than CAPM.
 VaR has emerged as one of the most popular risk measures because global
banking regulators require or encourage the use of it
 Surplus at risk is an application of VaR; it estimates how much the assets
might underperform the liabilities with a given confidence level, usually over a
year.
 Historical yields drive the pricing of bonds more than the price history or
the current duration
 A limitation of VaR —> vulnerability to different volatility regimes. A
portfolio might remain under its VaR limit every day but lose an amount
approaching this limit each day. If market volatility during the last year is lower
than in the lookback period, the portfolio could accumulate a substantial loss
without technically breaching the VaR constraint.
 ETF authorized participants to create and redeem ETF shares in the
primary market.
 Market beta equity risk factors, such as dividend yield, size, value, and
momentum, enable investors to implement an active view while continuing to
track a designated benchmark.
 ETFs can be used to fill a temporary gap in exposure to an asset class.
Gaps may arise whenever an active manager transitions a portfolio away from
a desired market exposure
 An advantage of statistical factor models is that they make minimal
assumptions. However, the interpretation of statistical factors is generally
more difficult than the interpretation of macroeconomic and fundamental
factor models
 Factor sensitivities are generally determined first in fundamental factor
models, whereas the factor sensitivities are estimated last in macroeconomic
factor models.
 Multifactor models can be useful in both active and passive management.
 When using a macroeconomic factor, the expected return is the intercept
(when all model factors take on a value of zero).
 Many ETF portfolio managers lend a portion of their portfolio holdings to short
sellers.
 ETF secondary market trades are transactions between buyers and sellers of
existing ETF shares. No new ETF shares are created by trades in secondary
market.
 Interest rate swaps are used by the managers of smart beta fixed-income
ETFs to minimize interest rate risk, enabling the ETFs’ return to be generated
by taking credit risk.
 The information ratio is unaffected by rebalancing the active portfolio and the
benchmark portfolio. In this case, the active return and active risk are both
reduced and the information ratio will be unchanged.
 The IC measures an investment manager’s ability to forecast returns.
 The transfer coefficient measures how well the anticipated (ex-ante), risk-
adjusted returns correlate with the risk-adjusted active weights
 The Sharpe ratio is unaffected by the addition of cash or leverage in a
portfolio
 The information ratio for an unconstrained portfolio is unaffected by the
aggressiveness of the active weights.
 The active weights are the differences between the managed portfolio’s
weights and the benchmark’s weights.
 Active return is not the same as alpha.
 If investors demand high equity risk premiums, they are likely expecting
their future consumption and equity returns to be positively correlated
 During an economic downturn, the spreads of corporate bonds can be
expected to widen
 When spreads widen, the spreads on bonds issued by corporations with a low
credit rating and that are part of the cyclical sector will tend to widen the most.
 The sensitivity of a corporate bond’s spread to changes in the business cycle
and the level of cyclicality tend to be positively correlated
 During times when corporate bond spreads are narrowing relative to
government bonds and the spreads between higher- and lower-rated bond
categories are also narrowing, corporate bonds will generally outperform
government bonds and lower-rated corporate bonds will tend to outperform
higher-rated corporate bonds.
 One interpretation of an upward-sloping yield curve is that returns to short-
dated bonds are more negatively correlated with bad times than returns to
long-dated bonds
 Positive output gaps are usually associated with high and/or rising inflation,
while high levels of unemployment usually accompany negative output gaps.
 The covariance of the inter-temporal rate of substitution with asset price is
expected to be negative for risk-averse investors.
 Changes in the expected volatility of economic growth would likely lead to
changes in default-free real interest rates, which in turn would affect the prices
of real, default-free government bonds.
 The issuers with a good credit rating (such as Aaa rated Bond A) tend to
outperform those with lower ratings (such as B3 rated Bond C) as the spread
between low- and higher-quality issuers widen
 The slope of the yield curve will likely become upward sloping during the
recession
 Real short-term interest rates are positively related to both real GDP growth
and the volatility of real GDP growth.
 The breakeven inflation rate incorporates both premiums for expectations
about inflation and the uncertainty of the future inflation environment.
 Establishing new constraints of caps on the over-and underweight of sectors
reduces the correlation of optimal active weights with the actual active
weights, which results in a decreased TC and thus a decrease in the IR
 The IR measures the consistency of active return generation. A higher ratio
generally indicates better managerial skill at achieving active returns on a risk-
adjusted basis.
 Bluffing involves submitting orders and arranging trades to influence other
traders’ perceptions of value. Bluffers often prey on momentum traders,
who buy when prices are rising and sell when prices are falling.
 Wash trading consists of trades arranged among commonly controlled
accounts to create the impression of market activity at a particular price. The
purpose of wash trading is to fool investors into believing that a market is
more liquid than it truly is 
 Flickering quotes are exposed limit orders that electronic traders submit and
then cancel shortly thereafter, often within a second
 Effective spread = 2 × (Trade price − Midpoint of market at time of order entry)
 Electronic front runners trade in front of traders who demand liquidity. They
identify when large traders or many small traders are trying to fill orders on the
same side of the market. The order anticipation strategies of electronic front
runners try to identify predictable patterns in order submission.
 Liquidity aggregation and smart order routing, help traders manage the
challenges and opportunities presented by fragmentation.
 With increasing market fragmentation, traders filling large orders adapt their
trading strategies to search for liquidity across multiple venues and across
time to control the market impacts of their trades.
 Many trading problems are ideally suited for machine learning analyses
because the problems repeat regularly and often. For such problems,
machine-based learning systems can be extraordinarily powerful
 Market impact, or price impact, is the effect of trade on transaction prices
 The ICs are found by calculating the correlations between each manager’s
forecasts and the realized risk-weighted returns.
 The information ratio for a portfolio of risky assets will generally shrink if
cash is added to the portfolio.
 Low-latency traders include news traders who subscribe to high-speed
electronic news feeds reporting news releases made by corporations,
governments, and other aggregators of information. They can quickly analyze
these releases to determine whether the information will move markets and
can profit when they can execute against stale orders that do not yet reflect
the new information.
 Changes in dealers’ bid and ask prices do belong in the category of implicit
costs.
 Quote matchers are parasitic traders who base their predictions about
future prices on information they obtain about orders that other traders intend
to fill.
 Breadth is equal to the number of independent decisions made per year by
the investor in constructing the portfolio.
 The model can measure both ex-ante and ex-post value-added
 While toward the end of a recession (and sometimes while the recession is
still in place) sharp increases in corporate profit growth tend to occur as
expenses have been cut and profits quickly respond to any increase in
revenue
 Most investors overestimate their forecasting abilities, so actual
information ratios are substantially lower, not higher, than predicted.
 Once built, electronic systems are indeed cheaper to operate than floor-based
trading systems.
 The amount of ongoing order flow in the ETF is negatively related to the bid-
ask spread (more flow means lower spreads).
 The actual costs and risks for the liquidity provider are positively related to
spreads (more costs and risks mean higher spreads)
 Amount of competition among market makers for that ETF is negatively
related to the bid-ask spread (more competition means lower spreads).
 Compared with a full replication approach, ETF portfolios managed using a
representative sampling/optimization approach are likely to have greater
tracking error.
 ETF sponsors that engage in securities lending can generate additional
portfolio income to help offset fund expenses, thereby lowering tracking error.
 When the share price of an ETF is trading at a premium to its intraday NAV
and arbitrage costs are minimal, APs will step in and take advantage of the
arbitrage by creating new ETF shares.
 A significant advantage of the ETF creation/redemption process is that the AP
absorbs all costs of transacting the securities for the fund’s portfolio. APs
pass these costs to investors in the ETF’s bid-ask spread
 Each day, ETF managers publicly disclose a list of securities that they want to
own, which is referred to as the creation basket
 An ETF’s tracking error is typically reported as the annualized standard
deviation of the daily differential returns of the ETF and its benchmark.
 A rolling return assessment referred to in the ETF industry as the “tracking
difference,” provides a more informative picture of the investment outcome for
an investor in an ETF. 
 Return-of-capital distributions are amounts paid out more than an ETF’s
earnings and serve to reduce an investor’s cost basis by amount of
distribution. These distributions are generally not taxable.
 Fund-closure risk is the risk that an ETF may shut down. The reasons that
lead to an ETF closing down often have to do with changes in regulations,
increased competition, and corporate activity
 Expectation-related risk where ETF investors may not fully understand how
more complex ETFs will perform because of a lack of understanding of
sophisticated assets classes and strategies
  ETF bid-ask spreads are generally less than or equal to the combination of
the following:

± Creation/redemption fees and other direct costs, such as brokerage and

exchange fees
+ Bid-ask spread of the underlying securities held by the ETF
+ Compensation for the risk of hedging or carrying positions by liquidity
providers (market makers) for the remainder of the trading day
+ Market maker’s desired profit spread
− Discount related to the likelihood of receiving an offsetting ETF order in a
short time frame
For very liquid and high-volume ETFs, buyers and sellers are active
throughout the trading day. Therefore ETF trades are matched extremely
quickly. So, creation/redemption fees and other direct costs are not likely to
have much influence on these ETFs’ bid-ask spreads.

 ETFs tend to distribute far less in capital gains relative to mutual funds.
 ETFs that trade infrequently may have large premiums or discounts on NAV
 NAV is often a poor fair value indicator for ETFs holding foreign securities
because of differences in exchange closing times between the underlying
(e.g., foreign stocks, bonds, or commodities) and the exchange where the
ETF trades.
 Transition management refers to the process of hiring and firing managers
— or making changes to allocations with existing managers.
 Factor (Smart beta) strategies of ETFs are usually benchmarked to an index
created with predefined rules which are considered longer-term, buy-and-
hold investment options rather than tactical trading instruments. Investors
seek outperformance versus a benchmark and modification of portfolio risk
 Position limits are limits on the market value of any given investment; they
are excellent controls on overconcentration. Position limits can be expressed
in currency units or as a percentage of net assets
 A traditional asset manager uses ex-post tracking error when analyzing
backward-looking returns.
 VaR is an estimate of the loss that is expected to be exceeded with a given
level of probability over a specified time period
 The parametric method typically assumes that the return distributions for the
risk factors in portfolio are normal. It then uses the expected return and
standard deviation of return for each risk factor and correlations to estimate
VaR
 Duration is the primary sensitivity exposure measure for fixed-income
investments.
 Market Maker: ETFs trade in the secondary market throughout the day at the
then-current market price. Like any other stock buyers and sellers are
matched by market makers
 Authorized participant (AP): There is a primary market for ETFs in which
there is a creation and redemption process for shares. Here, the arbitrage
gap is reduced to a narrow band by AP 
  ETF sponsor: ETF shares are being created, an intermediary receives the
basket of in-kind securities at settlement.
 Synthetic ETFs, such as swap-based funds that use OTC derivatives to gain
exposure and are subject to both counterparty and settlement risk.
 Leveraged and inverse funds might not deliver the expected performance
over the desired time horizon that was expected based on the underlying
exposures.
  Exchange-traded notes ETNs do not hold underlying securities but rather
are unsecured obligations of the institutions that issue them and therefore are
subject to counterparty risk
 Active share is the measure of the percentage of the portfolio that differs
from the benchmark and would not be an appropriate measure of firm-wide
risk. Active share is more frequently used for traditional asset managers who
have explicit benchmarks, compared with hedge funds
 Gross exposure measures the combination of long and short exposures and
can be an important metric in the management of hedge fund exposure.
 Relative VaR is a measure of the degree to which the performance of the
portfolio might deviate from its benchmark. Relative VaR is also referred to as
“ex-ante tracking error.”
 Ex-ante tracking error correctly compares the current portfolio with its
benchmark in attempting to measure future potential performance.
 Risk measures for banks are typically focused on liquidity, solvency, and
capital sufficiency, whereas risk measures for traditional asset managers are
typically focused on investment performance.
 The rate of return is calculated as Portfolio return/Economic capital. Higher
the better. 
 When returns are correlated, it is necessary to specify a multivariate
distribution rather than modeling each factor or asset on a standalone basis.
 The excess kurtosis implies that strategies are likely to generate surprises,
meaning extreme returns (-ve or +ve), whereas the negative skewness
suggests those surprises are more likely to be negative (than positive).
 Random sampling with replacement, also known as bootstrapping, is
often used in historical simulations because the number of simulations
needed is larger than the size of the historical dataset. 
 Sensitivity analysis can be implemented to help managers understand how
the target variable (portfolio returns) and risk profiles are affected by changes
in input variables
 The reliability of VaR can be easily verified through a process known as
backtesting. 
 VaR doesn't account liquidity
 VaR underestimates risk during periods of extreme market stress as it is
sensitive to rising correlations eroding the diversification benefits that exist
during normal conditions.
  Risk considerations of institutions:
Bank: Include liquidity gap, VaR, leverage, key rate duration, operational
risk capital, and scenario analysis
Hedge Fund: Not focus on tracking error or active shares, which are more
traditional asset manager metrics, Instead would be focused on categories
such as sensitivities, scenario analysis, gross exposure, and drawdown
Pension Plan: Include VaR (surplus at risk), interest rate and curve risk,
glide path, and liability hedging exposures instead of return-generating
exposures.

 Inverse transformation is a method of random observation generation,

often used in simulation.
 In order to simulate impact of latest financial crisis on the current bond
portfolio holdings, valuation model for bonds should use historical yields of
bonds with similar maturity. 
 Surplus at risk is an application of VaR; it estimates how much the assets
might underperform the liabilities with a given confidence level, usually over
a year.
 ETNs do not hold underlying securities but rather are unsecured obligations of
the institutions that issue them and therefore are subject to counterparty
risk.
 Forward-looking beta is a current risk measure of a current portfolio and
measures an equity portfolio’s sensitivity to the broad equity market.
 Both VaR and maximum drawdown are downside risk measures, lower the
better
 Conditional VaR is defined as the weighted average of all loss outcomes in
the return distribution that exceed the VaR loss. Thus, CVaR is a more
comprehensive measure of tail loss than VaR. 
 A rolling return assessment referred to in the ETF industry as the “tracking
difference,” provides a more informative picture of the investment outcome for
an investor in an ETF
 Resulting tracking error by index changes will not be large as the tracking
error caused by representative sampling or by fees and expenses incurred by
the ETF.
 The optimal amount of active risk is
σA = (IR/SRB ) *σB
 Quote matchers, parasitic traders who base their predictions about prices on
information they obtain about orders that other traders intend to fill. 
 Buy-side trader and their brokers are aware of the efforts quote matchers
make to detect and front run their orders. Accordingly, they submit orders at
random times and in various sizes in order to make detection more difficult.
 To reduce systemic risks associated with fast trading, some exchanges
have adopted trade halts when prices move too quickly. 
 Wash trading consists of trades arranged among commonly controlled
accounts to create the impression of market activity at a particular price.
 Establishing new constraints of caps on the over- and underweight of
sectors, reduces correlation of optimal active weights with the actual active
weights, which decreases TC and thus a decreases IR. 
 Expected increases in GDP volatility would put upward pressure on short-
term TIPS rates
 Break-even rate of inflation (BEI), which is composed of the expected rate
of inflation plus a risk premium for the uncertainty of future inflation. 
 Economy with positive output gap—actual GDP exceeds potential GDP—
producing beyond its sustainable capacity. 
 The information ratio for an unconstrained portfolio is unaffected by the
aggressiveness of the active weights.
 The transfer coefficient measures how well the anticipated (ex ante), risk-
adjusted returns correlate with the risk-adjusted active weights. This is also
expressed in the equation for the transfer coefficient: TC = ρ(μ i/σi,Δwiσi).
 The information ratio is unaffected by rebalancing the active portfolio and
the benchmark portfolio

 FSA:

(1)

 Expense for the year = Options granted × Option price on grant

date/Expected life of options (* .5, if for half year)
 Country with higher sustainable sales growth→ management control growth in
sales from greater volume or higher prices excluding growth from currency
fluctuations
 Other Comprehensive Income (OCI) loss consists of actuarial gains and
losses and the net return on plan assets. It will not affect P&L
 Net income is same in accounting method used to account for active
investments in other companies
 Compared to the tangible assets of non-financial companies, financial assets
create direct exposure to a different set of risks, including credit risks, liquidity
risks, market risks, and interest rate risks.
 Basel III ‘specifies min percentage of risk-weighted assets that a bank must
fund with equity capital. This minimum funding requirement prevents a bank
from assuming so much financial leverage that it is unable to withstand loan
losses or asset write-downs.
 Fair value of the net assets (€ thousands) = Share capital + Retained
earnings
 Total shareholders’ equity consists of share capital, retained earnings, and the
cumulative foreign exchange gain or loss since acquisition. 
 When the domestic currency strengthens, a net liability position results in a 

positive translation adjustment (gain).--- temporal method on the I/S

negative translation adjustment —- Current method in stockholders’ equity.

 Under IFRS 9, FVPL and FVOCI securities are carried at market value,
whereas amortized cost securities are carried at historical cost
 The coupon payment - interest income whether securities are amortized cost
or FVPL. No adjustment is required for amortization since the bonds were
bought at par.
 Under IFRS,
Periodic pension costs like service cost and net interest expense
 reported in P&L
service costs = current service and past service costs
net interest expense = ( PBO + Past service cost - Planned asset at beg.) *    
discount rate at beg.
The component of periodic pension in OCI is remeasurements (Actuarial
gains and losses on the pension obligation and net return on plan assets)
 Lower volatility reduces the fair value of an option and thus the reported
expense.
 For either inventory choice, the current rate method will give higher gross
profit to the parent company if the subsidiary’s currency is depreciating. 
 Under the pooling of interest method, assets and liabilities at historical
book value leading lower equity in comparison to fair value, no affect on
revenue.
 The choice of equity method or proportionate consolidation for joint
venture does not affect reported shareholders’ equity - same.
 Under US GAAP, any past service costs will be reported in other
comprehensive income and are amortized on the profit and loss statement
over the average service lives of the employees. 
Under IFRS, the past service costs are recognized as an expense in the
income statement and are used to calculate the pension liability or asset that
is reported on the balance sheet.
  The vesting period is the time required for employees to be eligible for
benefits earned from prior years of service. A shorter vesting period →
workers’ benefits - increases pension obligation and give rise to an
actuarial loss.
 The yield on high-quality corporate bonds - discount rate to calculate the PV of the future
benefits because it represents the rate at which the defined-benefit obligation could be
effectively settled.
 Conceptually speaking, only the current service cost component is considered an
operating expense. Both the interest expense and asset returns components of pension
expense are non-operating.
 According to IFRS, under the partial goodwill method, 
value of the minority interest = non-controlling % * subsidiary’s identifiable net assets.
 Net trading income more volatile than net interest income or net fee
income. 
trading income has decreased —> earnings composition less volatile
net interest income & net fee income have increased—> earnings
composition more sustainable.
  Risk-weighted asset stratification - process of assessing a bank’s capital
adequacy.
 Banks borrow money on shorter terms than the terms for lending to
customers, they create value by lending at higher rates than their short-term
funding costs. This is called maturity transformation.
 Common Equity Tier 1 Capital includes common stock, capital surplus,
retained earnings, and other comprehensive income
 CAMELS - capital adequacy, asset quality, management, earnings, liquidity,
and sensitivity
 The current rate method appropriate when operating with high degree of
autonomy. In Current rate method, all currency gains and losses are
recorded as a cumulative translation adjustment to shareholder equity.
 Under proportionate consolidation, Add assets and liab. = % acquired * A/L
values
 In acquisition all assets and liab are added and in equity no asset and liab are
added
 Downward trend in the two VaR measures indicate reduction in its exposure,
to market risk
 Reduced-form credit model involves regression analysis using information
of financial markets, such as the measures as the debt ratio and returns on
assets, and macroeconomic variables, such as the rate of inflation and the
unemployment rate.
 Structural models require “inside” information known to company
management, whereas reduced-form models can use publicly available
data on the firm.
 Acquisition method→consolidated financial statements→control. 
 Proportionate consolidation→joint ventures
 Equity method→ some joint ventures & when significant influence not
control.
 The full & partial goodwill method will have same amount of debt; 
however, shareholders’ equity→ higher under full goodwill→ debt to equity
ratio lower
 Assumed long-term rate of return on plan assets is not a component that is
used in calculating the pension obligation
 Altman scores in excess of 3.0 indicate low probability of bankruptcy; those
below 1.81 indicate a high probability of bankruptcy.
 The discretionary accruals are possibly made with the intent to distort
reported earnings, particularly outlier discretionary accruals indicator of
possible manipulation—and thus low quality earnings(referred to as abnormal
accruals).
 The combination of increases in accounts payable with substantial
decreases in accounts receivable and inventory is an accounting warning
sign that management may be overstating cash flow from operations
 Cash-flow-based accruals ratio = [NI − (CFO + CFI)] / (Average NOA)
 The quality of earnings, directly related to level of sustainable sources of
income. 
           Trading income is volatile and not sustainable. 
Higher-quality income→net interest income and fee-based service income. 
Lower the trading revenue, higher the quality of earnings 
 If the yield curve unexpectedly inverts, the short-term funding costs will
increase and the net interest margin will decrease
 A decrease in dividend yield increases the estimated value of a call option
when using the Black–Scholes model and hence would increase the related
compensation expense.
 The actual return on plan assets has no effect on the periodic pension cost
reported in P&L.
 The difference between historical cost and par value must be amortized under
the effective interest method. 
If initial cost > par value (stated interest rate>effective rate), the interest
income -lower 
 The choice of equity method or proportionate consolidation does not affect
reported shareholders’ equity- (same)
 Carrying Value = Purchase price + net income - dividend - amortization of
dep.
 Tier 1 capital = Common shares + preference shares + retained earnings
 Cost of borrowing through SPE is less, because SPE is bankruptcy remote
from company, and the lenders have direct claim on the receivables, thus
allowing the SPE to borrow at preferred rates.
 
 When financial assets are reclassified there is no restatement of prior periods
at the reclassification date.
 The temporal method ignores unrealized gains and losses on non-
monetary assets and liabilities, but the current rate method does not.
 Bal. sheet exposure = tot assets − tot liabilities OR common stock + retained
earnings
 Current service cost = PV of annual unit credit earned in the current period.
Annual unit credit (benefit) per service year = Value at retirement / Years of
service.
 Accruals from normal transactions → non-discretionary
Accruals from trans or accounting choices outside the normal → discretionary
accruals)
 The ratios (Operating cash flow before interest and taxes to operating income)
over 1.0 and stable upward trend indicate that earnings are supported by cash
flow.
 
 
 
 
 
 

Equity:
(1)

 A going-concern assumption generally increases the value placed on a

company’s inventory relative to not making that assumption.
 Usually, inventory that can be sold in the company’s regular distribution
channels would realize higher amounts than inventory that must be sold
immediately because a company is being liquidated.
 PEG assumes a linear relationship between P/E and growth, does not factor
in differences in risk, and does not account for differences in the duration of
growth.
 The required return reflects the magnitude of the historical equity risk
premium, which is generally higher when based on a short-term interest rate
(as a result of the normal upward-sloping yield curve),
 The backfilling of index returns using companies that have survived to the
index construction date is expected to introduce a positive survivorship bias
into returns.
 Unobservable intrinsic value and the observed market price contributes to the
abnormal return or alpha, which is the aim of active investment managers.
 A control premium may be reflected in the value of a stock investment that
would give an investor a controlling position.

(2)

 The H-model is appropriate to use when transition from a higher rate of

growth to a lower one is linear over time but does not provide a very close
approximation for a long extraordinary growth period or a large difference in
growth rates.
 Dividend discount model (DDM) → non-control perspective because he
cannot meaningfully influence the timing or magnitude of a company’s cash
flows and relies on dividend policy.
 Spreadsheet allows any assumed dividend pattern. Therefore, a spreadsheet
model would be best suited for anticipated special dividends.
 Intuitively, a higher dividend growth rate is associated with a higher expected
return if all the other inputs (such as the assumed required rate of return) are
held constant.
 Residual income of the most recent year = Net income – Equity charge
 For individual securities, idiosyncratic risk can overwhelm market risk and,
in that case, beta may be a poor predictor of future average return. Thus
analyst needs multiple tools.
 A “normalized” growth rate is an average growth rate based on an entire
business cycle
 ROIC is an after-tax measure and will increase with earnings growth if
additional capital is not contributed
 If the future growth or profitability of a company is likely to be lower than the
historical average (in this case, because of potential technological
development), then the target multiple should reflect a discount to the
historical multiple to reflect this difference in growth and/or profitability.
 Revenue growth = (1 + Price increase for revenue) × (1 + Volume growth) − 1
 COGS increase = (1 + Price increase for COGS) × (1 + Volume growth) − 1
 Forecasted revenue = Base revenue × Revenue growth increase
  The return on capital employed (ROCE) is a pre-tax return measure that
can be useful in the peer comparison of companies in countries with
different tax structures.
  PVGO/E captures the growth component of the P/E.
1

 Option values are simply the present value of the expected terminal option
payoffs (based on risk-neutral probabilities) discounted at the estimated risk-
free interest rate, rather than the risk-adjusted periodic rate
 Gordon growth model can accurately value companies that are repurchasing
shares when the analyst can appropriately adjust the dividend growth rate for
the impact of share repurchases.
 Industry cyclicality can influence the analyst’s choice of timeframe because
the forecast period should be long enough to allow business to reach
expected mid-cycle level of sales and profitability.
 The residual income approach uses the book value of equity and it
requires that the clean surplus relation holds
 Sustainable growth rate through Dupont or PRAT Model:
g= (Net income−Dividends)/Net income   × Net income/Sales × Sales/Total assets  × Total assets/Shareholders'
equity
 
 If the future growth or profitability of a company is likely to be lower than the
historical average (maybe because of a potential technological development),
then the target multiple should reflect a discount to the historical multiple
( Like P/E Multiple )to reflect this difference in growth and/or profitability
 Customer bargaining power is the Porter five force least likely affected by
using futures contracts. 
 

(3)

 The insurance industry have no global regulatory standards like Basel III, but 

NAIC (National Association of Insurance Commissioners) has established

minimum capital adequacy standards. Also in US, insurance companies
prepare financial reports according to statutory accounting rules, which differ
from US GAAP and IFRS

 Under the equity method goodwill is included in the value of the investment
and not separately. Impairment losses exceeding goodwill are allocated pro-
rata to the unit’s non-cash assets when the investor has control over the
investee, not under equity method.

Both IFRS and US GAAP prohibit the reversal of impairment losses

recognized using the equity method, even if the fair value later increases. 

 When financial assets are reclassified, restatement of prior periods is not

required.  Reclassification of debt instruments is only permitted if the business
model for the financial assets has changed significantly.
 Net profit margin is highest using the equity method.
 The remeasurement component of periodic pension cost includes both
actuarial gains and losses on the pension obligation and net return on plan
assets. 
 Under IFRS, the component of periodic pension cost (remeasurments) is
shown in OCI rather than P&L.
 Balance sheet exposure in current method = net assets (total assets − total
liabilities) = Common stock + Retained earnings
 PVDBO = Funded status (Net pension liability) + Plan assets
 When periodic contribution to a plan < total pension cost of the period, it is
source of financing. 
To reflect this event, the deficit amount is adjusted by the effective tax rate
and should be reclassified from an operating cash flow to a financing cash
flow
 The Fed model considers the equity market to be undervalued when,
market’s current earnings yield>10-year Treasury bond yield. 
 While calculating the free cash flow to the firm (FCFF), If we begin with cash
flow from operations (CFO), we do not have to make adjustments for working
capital items
 FCFE = Net income – {(1 – DR) × (FCInv – Depreciation)} – {(1 – DR) ×
(WCInv)}
 CAPM only incorporates single risk premium for market risk (beta); it does
not incorporate company-specific (idiosyncratic) risk.
 Fama–French model (FFM) expands on the CAPM model with two additional
risk factors: Current short-term govt bill yield +
(1) SMB (small minus big), a size (market capitalization) factor, and 
(2) HML (high minus low), a value return premium factor.
 Bond yield + risk premium cost of equity = Yield to maturity on company’s
long-term debt + Risk premium
 PEG does not factor in differences in the duration of growth, differences in
risk, an important determinant of P/E, and assumes a linear relationship
between P/E and growth. 
 P /B = (ROE – g)/(r – g)
0 0

 EVA = NOPAT – (C% × TC), 

Where EVA = Economic value added, NOPAT is the net operating profit after
taxes, C% is the cost of capital, and TC is the total capital employed. 
 
 The Yardeni model incorporates the consensus five-year earnings growth
rate forecast for the market index, a variable missing in the Fed model.
 Standardized unexpected earnings (SUE) is unexpected earnings scaled
by the standard deviation in past unexpected earnings 
 Residual income model is preferred to other approaches as The analyst
need not adjust the book value of common equity for non-recurring items
as they are already reflected in the value of the assets.
 RI model assumes that cost of debt is appropriately reflected by interest
expense. Residual income model is appropriate when a company does not
pay dividends or when its dividends are not predictable
 Less of an impact arises from the uncertainty in forecasting terminal value in
RI MODEL.
 Intrinsic value=BVPS+ PV of expected future income per-share residual
income
  Normalized EPS is the level of earnings per share that the company could
currently achieve under mid-cyclical conditions.
 Residual income = (ROE − r) × BV
 Using the single-stage RI model, the intrinsic value of TTCI is calculated as
           V0= B0+(ROE−r/ r−g)B0    {If Intrinsic value of an equity is asked}
Justified P/B=1+(ROE−r /r−g)
         Justified P/B = P /B = (ROE – g)/(r – g) 
0 0

          ROE = Net income/Book value of equity

 EV = Market value of common equity + Market value of preferred stock +
Market value of debt – Cash, cash equivalents, and short-term investments +
minority interest 
 Normalized EPS = Average ROE × BVPS
 GGM equity risk premium estimate = Dividend yield on the index based on
year-ahead aggregate forecasted dividends and aggregate market value +
Consensus long-term earnings growth rate – Current long-term government
bond yield
 Equity risk premium according to the macroeconomic model:
[(1 + EINFL)(1 + EGREPS)(1 + EGPE) – 1] + EINC – Expected risk-free rate
Where
EINFL = expected inflation

EGREPS = expected growth in real earnings per share

EGP E = expected growth in P/E 

EINC = expected income component

 Survivorship bias in equity market data series arises when poorly performing 
companies are removed, only relative winners remain. Survivorship bias
tends to inflate historical estimates of the equity risk premium, historical risk
premium estimate should be adjusted downward.
 Significant amounts of other comprehensive income will affect book value per
share
 Example : A persistence factor of 0.10 indicates that a company’s residual
income is forecasted to decline at an average rate of 90% per year.
 Persistence factor of 0.10 is quite low. Companies with extreme accounting
rates of return typically have low persistence factors. 
 Companies with strong market leadership positions and low dividend payouts
are likely to have high persistence factors.
 Excess earnings method (EEM) is useful as it allows valuing working
capital, fixed assets, and intangibles using different discount rates.
 Guideline transactions method (GTM) uses a multiple that specifically
relates to the sale of entire companies, and SFAS No. 157 also presents a
fair value hierarchy that gives the highest priority to market-based
evidence
 Reversal of a restructuring charge would increase net income and thus must
be subtracted in arriving at FCFE.
 The comparable transactions method uses details from recent takeover
transactions for comparable companies to make estimates of the target
company’s takeover value. It is not necessary, to separately estimate a
takeover premium because this is already included in the multiples
determined from the comparable transactions.
  Transactions between the company and its shareholders (through cash
dividends, share repurchases, and share issuances) do not affect free cash
flow
 Market value of firm = Market value of debt + Market value of equity
 Market value added = Market value of company – Book value of total capital
 Residual income model, 
intrinsic value of stock = BVPS + PV of expected per share residual income
If intrinsic value > book value per share, PV of expected per share residual
income is positive.
 Market-based method: Yields a market-estimated stock price for the target
company by additionally estimating a fair takeover premium and use that
information to adjust the estimated stock price.
 Real required rate of return = Country return ± Industry adjustment ± Size
adjustment ± Leverage adjustment
 Equity risk premium = Dividend yield on the index based on forecasts +
consensus LT earnings growth rate - current LT government bond yield
 Assuming all else is equal,
company in a country with high inflation will have lower justified P/E multiples
than a company in a country with lower rates of inflation.
 In Working Capital Investment of FCFE, FCFF Calculation; Cash & Cash
eq. And notes patyables should not be considered
 Changes in notes payable need to be considered in net borrowing
 Sustainable growth rate model assumes that the growth will be financed
with the issuance of debt and internally generated equity will be used to
maintain target capital structure. No additional common equity will be
issued. 
ROE → constant during this period.
 In the ordinary course of business, non-domestic currency transactions with
customers and suppliers (resulting from import purchase or export sale) are
accounted for on both the income statement and balance sheet at fair value,
and hence they do not violate clean surplus accounting. 
 sustainable dividend growth rate (g) = r (cost of equity) - D1/P0
 When the company being analyzed has significant noncash charges other
than depreciation expense, this sales-based methodology will result in a less
accurate estimate of FCFE than one obtained by forecasting all the individual
components of FCFE.
 Company’s forward P/E > harmonic mean of peer,shares of Company
overvalued.

Fixed Income:
(1)

 Two methods to estimate potential interest rate volatility in a binomial interest

rate tree, First method bases estimates on historical interest rate volatility,
second method uses observed market prices of interest rate derivatives.
 Increasing the number of paths using the Monte Carlo method does increase
the estimate’s statistical accuracy, however, Doesn't provide value that is
closer to the bond’s true fundamental value.
 The interest rate tree performs two functions in the valuation process:
(1) generating the cash flows that are interest rate dependent and 
(2) supplying the interest rates used to determine the present value of the
cash flows.

 Two assumptions must be made to create a binomial tree. First is an interest

rate model such as a lognormal model of interest rates, second is volatility of
interest rates.
 The binomial tree is based on the spot rate curve and a no-arbitrage
condition, therefore any option-free bond should have the same value whether
using spot rate curve or binomial tree.
 Using a Monte Carlo simulation, the model will produce benchmark bond
values equal to the market prices only by chance. A constant is added to all
interest rates on all paths such that the average present value for each
benchmark bond equals its market value (If they are not equal)
 When the spot curve is upward sloping and shape is expected to remain
constant over horizon, buying bonds with a maturity longer than the
investment horizon (i.e., riding the yield curve) will provide a total return
greater than the return on a maturity-matching strategy.
 Equilibrium term structure models are factor models that seek to describe the
dynamics of the term structure by using fundamental economic variables that
are assumed to affect interest rates
 Arbitrage-free term structure models use observed market prices of a
reference set of financial instruments, assumed to be correctly priced, to
model the market yield curve
1. equilibrium term structure models require fewer parameters to be
estimated relative to arbitrage-free models, 
2. arbitrage-free models allow for time-varying parameters. 
3. arbitrage-free models can model the market yield curve more
precisely than equilibrium models.
 Calibrating a binomial interest rate tree to match a specific term structure is
important because we can use the known valuation of a benchmark bond,
Once its accuracy is confirmed, the interest rate tree can then be used to
value bonds with embedded options.
 Calibration of the interest rate tree is dependent on a volatility assumption, an
interest rate model, and the observed market value of the benchmark bond
 To find the value of a bond at a particular node in a binomial tree, the
backward induction methodology is used
 Bootstrapping entails forward substitution, however, using par yields to solve
for zero-coupon rates one by one, in order from earliest to latest maturities.
 In a positively sloped yield curve, the discount rate for each successive cash
flow will be higher than the last, whereas with a flat yield curve, the same
discount rate would be applied to all cash flows. 
 If the yield curve remains flat during the holding period, the realized rate of
return on a bond will be the same as the expected rate of return.
 Z-spread is directly affected by the general creditworthiness of individual debt
issuers. It represents the constant basis point spread that is added to the
implied spot yield curve to measure the price of credit risky bonds
 Libor–OIS represents the difference between Libor and the overnight index
swap rate. Libor–OIS spread is affected by bank’s lending rates for unsecured
overnight loans, which is a measure of risk in the money markets.
 TED spread represents the difference between the yield on treasury bills and
Libor for specific maturity date. Since the TED spread is affected by banks’
analysis of default of interbank loans, the TED spread is a measure of
counterparty risk. It is an indicator of perceived credit and liquidity risk.
 The secured overnight financing rate (SOFR), or overnight cash borrowing
rate collateralized by US Treasuries, is a barometer of the US Treasury
repurchase (or repo) market. SOFR is a volume-weighted index of all
qualified repo market transactions on a given day and is influenced by supply
and demand conditions in secured funding markets.
 The local expectations theory asserts that the total return over a one-month
horizon for a five-year zero-coupon bond would be the same as for a two-year
zero-coupon bond.
 In segmented market theory, bond market participants are limited to
purchase maturities that match the timing of their liabilities.

In the preferred habitat theory, participants have a preferred maturity for

asset purchases, but they may deviate from it if they feel returns in other
maturities offer sufficient compensation for leaving their preferred maturity
segment.

 Key rate durations can address shaping risk, but effective duration cannot.
 The expected % price change = modified duration(NEW - OLD credit spread) 
 The observed spread over the yield on a risk-free bond in practice includes
liquidity and tax considerations, in addition to credit risk.
 Effective duration of callable bond decreases when interest rates fall (-ve
convexity).
  The swap rate is the interest rate for the fixed-rate leg of an interest rate
swap
 During economic expansions, monetary authorities raise benchmark rates to
help control inflation. This action is most often consistent with bearish
flattening.
 When government budget deficits fall, fiscal supply-side effects are most likely
to result in lower bond yields.
 A flight to quality is most often associated with bullish flattening, in which
the yield curve flattens as long-term rates fall by more than short-term rates.
 Ho–Lee model is arbitrage-free and can be calibrated to closely match the
observed term structure.
 The KWF model describes the log of the dynamics of the short rate, while
the Ho–Lee model does not.
 Interest rate tree performs two functions in valuation process: (1) generating
the cash flows that are interest rate dependent and (2) supplying the interest
rates used to determine the present value of the cash flows.
 Two assumptions must be made to create a binomial tree. The first is an
interest rate model such as a lognormal model of interest rates. The second is
a volatility of interest rates.
  Volatility can be measured relative to the current level of rates. By using
lognormal distribution, interest rate movements are proportional to the level
of rates and are bounded at the low end by zero.
 Using Monte Carlo simulation, the model will produce benchmark bond
values equal to the market prices only by chance. A constant is added to all
interest rates on all paths such that the average present value for each
benchmark bond equals its market value.
 Calibrating binomial interest rate tree to match a specific term structure is
important because we can use the known valuation of a benchmark bond
from the spot rate pricing to verify the accuracy of the rates shown in the
binomial interest rate tree which can then be used to value bonds with
embedded options.
 Yield-to-maturity is a poor estimate of expected return because it does not
capture the effect of reinvesting coupons at new rates due to changes in the
shape of the yield curve. 
 Kalotay–Williams–Fabozzi equilibrium term structure model is similar to the
Ho–Lee model in that it assumes constant drift, no mean reversion, and
constant volatility, but the KWF model describes the log of the dynamics of
the short rate, while the Ho–Lee model does not

(2)

 Probability of default reflects risk-neutral probabilities of default

 statistical-based approach—> short-term with granular, homogeneous
assets
 portfolio-based approach—> medium-term granular and homogeneous oblig.
 loan-by-loan approach—> discrete or non-granular heterogeneous portfolios,
such as CMBS
 If cash dividend > threshold dividend, result: reduction in conversion price,
which increases the conversion ratio
 Many convertible bonds contain a call option that can be exercised if the
common stock price rises to more than the conversion price, resulting in a
forced conversion
 The embedded call option is so far out of the money that a small change in
the price of common stock will have a min. impact on value of convertible
bonds. Therefore, bonds will resemble option-free bonds, also known as
busted convertibles.
 Convertible bonds are more difficult to value than callable bonds because the
analyst must consider the impact of all of the economic conditions that affect
value of the issuer's common stock.
 The conversion price =  par value/ conversion ratio
 Market conversion price= convertible bond price / conversion ratio
 A fall in the stock price will result in a fall in the convertible bond price. 
However, the change in the convertible bond price is less than the change in
the stock price because the convertible bond has a floor. 
 The effective convexity of a callable bond can be negative in some
circumstances, but the effective convexity of a putable bond is always
positive.
 A convertible bond most closely resembles a hybrid when the issuer’s share
price is close to the bond’s conversion price, bond’s value can change
substantially from a change in the issuer’s share price, a change in market
interest rate, or a change in the issuer’s credit rating.
 nonconvertible bond when the issuer’s share price is substantially below the
conversion price.
 Probabilities for rating changes are skewed more toward a downgrade than
toward an upgrade, and the increase in the credit spread for downgrades is
much larger than the decrease in spreads for upgrades.
 Parties to CDS contracts generally agree that their contracts will conform to
ISDA specifications by signing an ISDA master agreement
 Downward-sloping curves are less common and often are the result of
severe near-term stress in the financial markets.
 Upfront premium = (Credit spread – Fixed coupon rate) × Duration of the
CDS. 
 In Option-free bond, one-sided up-duration and one-sided down-duration will
be about equal
 Value of callable putable convertible bond = Value of straight bond + Value
of call option on the issuer’s stock  + Value of investor put option – Value of
issuer call option on bond
 The value of a put option decreases as the yield curve moves from being
upward sloping to flat to downward sloping, call option’s value increases
as the yield curve flattens and increases further if the yield curve inverts. 
 The market price of callable with no protection period cannot exceed 100
 Option-adjusted spread (OAS) is constant spread added to all the one-
period forward rates that make the arbitrage-free value of a risky bond equal
to its market price. 
 If two bonds have the same characteristics and credit quality, they should
have the same OAS. Bond with the largest OAS is likely to be underpriced,
relative to the bond with the smallest OAS 
 The effective duration of a floating-rate bond is close to the time of next reset.
If the reset for Bond is annual, the effective duration of this bond is close to 1
 As interest rates rise, a call option moves out of the money, which increases
the value of the callable bond and lengthens its effective duration. In Put
option & option-free bond with increase in interest effective duration shortens. 
 The minimum value of a convertible bond is equal to the greater conversion
value of the convertible bond and the current value of the straight bond 
 Credit valuation adjustment for each bond is the present value of expected
loss over its term to maturity and reflects the probability of default and
recovery rate.
 For a callable bond upside potential is capped because the issuer is more
likely to call the bond. In contrast, the upside potential for a putable bond is
uncapped.
 The value of a straight (option-free) bond doesn’t change when interest rate
volatility changes. When interest rate volatility decreases, so the value of the
callable bond will increase and the value of the putable bond will decrease.
 Convertible bonds typically set a threshold amount and a cash dividend below
the threshold would have no impact on the conversion price.
  Issuers typically would call a convertible bond when the underlying share
price exceeds the conversion price to “force” the investor to convert and
thereby would avoid paying further coupon payments.
 The typical term structure of credit spreads is upward slowing because
investors typically want more compensation for future credit uncertainty.
 If the yield curve became inverted, the value of the embedded option in
putable would decrease and the value of the embedded option in callable
would increase.
 Credit term structure can be inverted: 

—-> high-yield issuers in cyclical industries at the bottom of a cycle where

investors are looking past the bottom of the cycle 
—-> Bonds that have a very high likelihood of default where a primary pricing
mechanism is based on the recovery amount in default.

 Issuance of debt will most likely cause a company’s credit fundamentals to

deteriorate, thus buying the company’s CDS is likely profitable
 CDS index (e.g., CDX and iTraxx) would allow the Fund to simultaneously
fully hedge multiple fixed-income exposures.
 Approximate profit = Change in credit spread (in bps) × Duration × Notional
amount.
 Downward-sloping credit curve implies a greater probability of default in
the earlier years than in the later years
 The changing probability of default will not affect the binomial tree, BUT it will
CVA
 The expected exposure is the projected amount of money that an investor
could lose if an event of default occurs, i.e, coupon + par value
 Actual default probabilities do not include the default risk premium
associated with the uncertainty in the timing of the possible default loss.
 In Option-free bond, one-sided up-duration and one-sided down-duration will
be about equal for option-free bonds.
 Value of convertible bond= value of option-free bond + value of a call
option 

Derivatives:
 A stock position always has a delta of +1 & it does’nt change, so Gamma = 0
 Gamma of a call = gamma of a similar put, proven using put–call parity
 Put gamma is always non-negative
 Risk-neutral probabilities are based on the paths that interest rates take,
which are determined by the market and not the details of a particular option
contract.
 A higher exercise price does lower the exercise value (payoff)
 To create a leveraged position in a stock, the correct components are to
purchase N(d ) shares by borrowing an amount e rTXN(d ).
1
–
2

 The term e rTXN(–d ) represents the amount lent when purchasing a put
–
2

option.
 Vega - high when near or at the money.Vega low when “out of the money.”
 To be fully hedged against a small change in the stock price, the proper
strategy to construct the hedge is to use call option delta and add the call
option gamma to arrive at the number of shares required. 
 Implied volatility is a measure of future estimated volatility, which varies
across both exercise price and time to expiration for various options.
 Expectations approach of options valuation, option values are present value
of the expected terminal option payoffs (based on risk-neutral probabilities)
discounted at the estimated risk-free interest rate, rather than the risk-
adjusted periodic rate.
 Payer swaption —> hedge against rising interest rates. According to the Black
model, the value of a payer swaption = swap component - the bond
component.
 Under no-arbitrage approach and the expectations approach, expected
options payoffs are a function of a risk-neutral probability, investor’s outlook
—> Irrelevant.
The investor’s outlook with respect to the future course- relevant under
discounted cash flow approach to securities valuation.
 The underlying deliverable bond in a US Treasury futures contract consists of
a basket of bonds from which the short position can deliver the cheapest
bond.
 The put is priced by the BSM model using the historical volatility input
 Risk-neutral probabilities are based on paths that interest rates take
determined by market and not the details of particular option contract.
 To be fully hedged against a small change in stock price, construct the
hedge to use call option delta and add the call option gamma to arrive at the
number of shares required. 
 Volatility skew tends to steepen whenever the market price of hedging is
rising, which causes its shape to be different from the volatility smile.
 In the forward market, the initial value = zero.