Further notes to exam readings

FIN470-Seminar in Finance
Final exam – cover everything in these 10
readings
Market efficiency
Kaplan SchweserNotes 2023 CFA Prep, Level I
Book 3, Reading 38
Key contents
• Market efficiency and factors affecting market efficiency
• EMH: three forms of market efficiency and tests of each form
• Technical and fundamental analysis
• Active and passive portfolio management
• Market anomalies
Overview of Equity
Securities
Kaplan SchweserNotes 2023 CFA Prep, Level I
Book 3, Reading 39
Key contents
• Different characteristics among different types of equity and equity
classes
• Public vs. Private equity securities
• Types of private equity investments
• Methods of investing in foreign equity securities
• Risk and return characteristics of different types of equity securities
• Market value vs. Book value, cost of equity, ROE, investors’ required
rate of return
Quiz
• Compared to public equity, which of the following is least likely to
characterize private equity?
A. Lower reporting costs.
B. Potentially weaker corporate governance.
C. Lower returns because of its less liquid market.

Answer: C
Private equity has less liquidity because no public market for it
exists. The lower liquidity of private equity would increase
required returns. (LOS 39.c)
Public vs. Private equity securities
Compared to public equity, private equity has the following characteristics:
• Less liquidity
• Share price is negotiated between the firm and its investors
• More limited firm financial disclosure
• Lower reporting costs
• Potentially weaker corporate governance
• Greater ability to focus on long-term prospects
• Potentially greater return for investors once the firm goes public
Quiz
• Global depository receipts are most often denominated in:
A. the currency of the country where they trade and issued outside the United
States.
B. U.S. dollars and issued in the United States.
C. U.S. dollars and issued outside the United States.

Answer: C
Global Depository Receipts are not listed on U.S. exchanges and are most often
denominated in U.S. dollars. They are not issued in the United States. (LOS 39.d)
Direct investing
Obstacles to direct investing in foreign equity securities:
• The investment and return are denominated in a foreign currency.
• The foreign stock exchange may be illiquid.
• The reporting requirements of foreign stock exchanges may be less
strict, impeding analysis.
• Investors must be familiar with the regulations and procedures of
each market in which they invest.
Depository Receipts
• DRs are negotiable certificate issued by a bank
• Represents shares in a foreign company traded on a local stock exchange and
gives investors the opportunity to hold shares in the equity of foreign countries
Depository Receipts

Global DRs American DRs

• GDRs are issued outside the US and • ADRs are issued only by U.S. banks for
the issuer’s home country foreign stocks that are traded on a U.S.
exchange
• Example: A U.S.-based company wants
its stock to be listed on the London • Example: An India-based company’s
Stock Exchange. The U.S.-based syock is typically unavailable to foreign
company enters into a depositary investors. But the company has an
receipt agreement with the London American depositary receipt issued by
depository bank. In turn, the London Deutsche Bank that trades on the NYSE,
bank issues shares in Britain. which most U.S. investors can access.
Equity Valuation: Concepts and
Basic Tools
Kaplan SchweserNotes 2023 CFA Prep, Level I
Book 3, Reading 41
Key contents
• Dividends, splits, and repurchases
• Dividend payment chronology
• Valuation models
• Discounted cash flows: Dividend discount model, FCFE model
• Market multiples: price multiples, enterprise value multiples
• Asset-based models
• Declaration date
• Ex-dividend date
• Holder-of-record date
• Payment date
If you buy the share on or after the ex-dividend date, you will not receive the dividend. On the ex-
dividend date, the share price will decrease from the previous day’s closing price by approximately
the amount of the dividend, in the absence of other factors affecting the stock price
Dividend Discount Model (DDM)
The intrinsic value of stock is the present value of its future dividends.
Free Cash Flow to Equity (FCFE)
• FCFE is the cash remaining after a firm meets all of its debt obligations and
provides for the capital expenditures necessary to maintain existing assets and to
purchase the new assets needed to support the assumed growth of the firm.
Estimating the required return for equity
Estimating the growth rate in dividends
• To estimate the growth rate in dividends, the analyst can use three methods:
1. Use the historical growth in dividends for the firm.
2. Use the median industry dividend growth rate.
3. Estimate the sustainable growth rate.
Multistage dividend discount model.
Price Multiples
• Price-earnings (P/E) ratio: The P/E ratio is a firm’s stock price divided by earnings
per share and is widely used by analysts and cited in the press.
• Price-sales (P/S) ratio: The P/S ratio is a firm’s stock price divided by sales per
share.
• Price-book value (P/B) ratio: The P/B ratio is a firm’s stock price divided by book
value of equity per share.
• Price-cash flow (P/CF) ratio: The P/CF ratio is a firm’s stock price divided by cash
flow per share, where cash flow may be defined as operating cash flow or free
cash
Fundamental (justified) leading P/E ratio

• D1 / E1 = expected dividend payout ratio.

• The leading P/E for this stock if it is valued in the market according to the
constant growth DDM.
Enterprise value
• Enterprise value (EV) measures total company value. EV can be viewed as what it
would cost to acquire the firm:
EV = market value of common and preferred stock + market value of debt − cash
and short-term investments
EV/EBITDA
Pros:
- Even out the differences in taxation, capital structure (debt), and asset counting
- Avoid issues with negative earnings
• EXAMPLE: Calculating EV/EBITDA multiples
Daniel, Inc., is a manufacturer of small refrigerators and other appliances. The
following figures are from Daniel’s most recent financial statements except for the
market value of long-term debt, which has been estimated from financial market
data.
• Stock price $40.00
• Shares outstanding 200,000
• Market value of long-term debt $600,000
• Book value of long-term debt $900,000
• Book value of total debt $2,100,000
• Cash and marketable securities $250,000
• EBITDA $1,000,000
Calculate the EV/EBITDA multiple.
EXAMPLE: Calculating EV/EBITDA multiples

• Book value of the firm’s short-term debt and liabilities = book value of
total debt from the book value of long-term debt: $2,100,000 –
$900,000 = $1,200,000  treated as market value
• Add the market value of long-term debt to get the market value of
total debt: $600,000 + $1,200,000 = $1,800,000.
• The market value of equity is the stock price multiplied by the number
of shares: $40 × 200,000 = $8,000,000.
• Enterprise value of the firm is the sum of debt and equity minus cash:
$1,800,000 + $8,000,000 – $250,000 = $9,550,000.
• EV/EBITDA = $9,550,000 / $1,000,000 ≈ 9.6.
Asset-based models
• Equity value is the market or fair value of assets minus the market or
fair value of liabilities.
• Most reliable when the firm has primarily tangible shortterm assets,
assets with ready market values (e.g., financial or natural resource
firms), or when the firm will cease to operate and is being liquidated.
Asset-based models are often used to value private companies
EXAMPLE: Using an asset-based model for a public firm
Williams Optical is a publicly traded firm. An analyst estimates that the market value of net
fixed assets is 120% of book value. Liability and short-term asset market values are assumed
to equal their book values. The firm has 2,000 shares outstanding. Using the selected
financial results in the table, calculate the value of the firm’s net assets on a per-share basis.
• Cash $10,000
• Accounts receivable $20,000
• Inventories $50,000
• Net fixed assets $120,000
• Total assets $200,000
• Accounts payable $5,000
• Notes payable $30,000
• Term loans $45,000
• Common stockholder equity $120,000
• Total liabilities and equity $200,000
EXAMPLE: Using an asset-based model for a public firm

• Estimate the market value of assets, adjusting the fixed assets for the analyst’s
estimates of their market values:
$10,000 + $20,000 + $50,000 + $120,000(1.20) = $224,000
• Determine the market value of liabilities:
$5,000 + 30,000 + $45,000 = $80,000
• Calculate the adjusted equity value:
$224,000 − $80,000 = $144,000
• Calculate the adjusted equity value per share:
$144,000 / 2,000 = $72
Introduction to Fixed Income
Valuation
Kaplan SchweserNotes 2023 CFA Prep, Level I
Book 4, Reading 44
Key contents
• Bond valuation and yield to maturity • Yield curves
• Spot rates and accrued interest • Spot rates vs. Forward rates
• Full price vs flat price • Yield spreads
• Matrix pricing
• G-Spread
• Yield measures • I-spread
• Effective annual yield for semiannual • Zero-volatility spread (Z-spread)
bond
• Current yield, simple yield • OAS
• Yield-to-call, yield-to-worst
• Option-adjusted yield
• Floating-rate note yield
• Money market yield
Annual-coupon vs. Semiannual-coupon
bonds
Full price, Flat price, Accrued interest

Full price (dirty price): Price buyers pay sellers to

buy the bond 15/6 21/8 15/12

Flat price (quoted price): price is quoted in the

market.
67 126
Accrued interest: the interest the buyers pay the
sellers for holding the bond from the last payment
183 days
(15/6) to the trading day (21/8)

Full price = Flat price + Accrued interest

Full price, Flat price, Accrued interest
Example: YTM =4%. Par value =1000. Semiannual bond
Calculate the full price and flat price of the bond?

15/6 21/8 15/12 Answer

- Calculate the value of the bond on the last payment (15/6)
N=4; PMT=25; FV=1000, I/Y=2 -> PV (15/6) = -1019.04
67 126 - Full price = 1019.04 * (1.02)^ (67/183) = $1026.46
- Accrued interest = 25* (67/183) = $9.15
- Flat price = full price – accrued interest = 1026.46 – 9.15
= $1017.31
183 days
Accrued interest: increases daily between 2 coupon payment. After
coupon payment, accrued interest = 0
Premium bond: Flat price decreases from PV ($1019.04) to FV ($1000)
 Matrix pricing
Matrix pricing: used to estimate the required YTM (or price) of bonds that are currently not traded or
infrequently traded

Example:

A+ rated, 2 year annual pay, YTM = 4.3%

A+ rated, 5 year annual pay, YTM =5.1%
A+ rated, 5 year annual pay, YTM =5.3%
Estimate value of non trade bond 4%
annual pay, A+ rated, 3 year bond.

Answer:

-> X= 4.6%
Bond yields
• The effective annual yield for bond with its YTM as nominal annual
yield and n compounding period per year:

• Current Yield:
Yield-to-call and yield-to-worst
Money market yields
Spot rates and forward rates
Computing spot rates from forward rates
If the current 1-year spot rate is 2%, the 1-year forward rate one year from today (1y1y) is
3%, and the 1-year forward rate two years from today (2y1y) is 4%, what is the 3-year spot
rate?

A. 2.997%
B. 2.562%
C. 3.991%
Bond spreads
Bond spreads
• Option-adjusted spread (OAS) is used for bonds with embedded
options
• OAS is the spread to the government spot rate curve that the bond
would have if it were option-free.
• If a callable bond has an option-adjusted spread (OAS) of 75 basis
points, this most likely suggests:
A) the bond has a zero-volatility spread greater than 75 basis points.
B) the implied cost of the call option is the bond’s nominal spread
minus 75 basis points.
C) the 75 basis points represent the investor’s compensation for credit
risk, liquidity risk, and volatility risk.
Understanding Fixed Income
Risk and Return
Kaplan SchweserNotes 2023 CFA Prep, Level I
Book 4, Reading 46
Key contents
• Bond yields, capital gain/loss
• Market price risk and reinvestment risk, and factors affecting these
risks
• Duration: Macaulay duration, modified duration, approximate
modified duration, effective duration
• Money duration and price value of a basis point
• Convexity: Approximate convexity, Effective convexity
• Calculate change in full bond price, percentage change in bond value,
Duration
• The duration of a bond measures the sensitivity of the bond’s full
price (including accrued interest) to a change in its interest rate.

• Macaulay duration is calculated as the weighted average of the

number of years until each of the bond’s promised cash flows is to be
paid, where the weights are the present values of each cash flow as a
percentage of the bond’s full value.
Macaulay duration

Macaulay duration = 0.0392x1 + 0.0373x2 + 0.9235x3 = 2.884 years

Modified Duration
• Modified duration (ModDur) is calculated as Macaulay duration
(MacDur) divided by one plus the bond’s yield to maturity.
Modified duration = Macaulay duration/( 1+r)

• Modified duration (ModDur) provides an approximate percentage

change in a bond’s price for a 1% change in yield to maturity.

approximate percentage change in bond price = –ModDur × ΔYTM

Example (cont.): ModDur = 2.884 / 1.05 = 2.747

Approximate Modified Duration
• With a given change in YTM, V– is the price of the bond if YTM is decreased by
ΔYTM and V+ is the price of the bond if the YTM is increased by ΔYTM
• V– > V+
• Because of the convexity of the price-yield relationship, the price increase (to V–),
for a given decrease in yield, is larger than the price decrease (to V+)
modified duration is a linear estimate of the relation between a
bond’s price and YTM, whereas the actual relation is convex,
not linear
• Example of approximate Modified Duration: A bond is trading at a
full price of 980. If its yield to maturity increases by 50 basis points, its
price will decrease to 960. If its yield to maturity decreases by 50
basis points, its price will increase to 1,002. Calculate the approximate
modified duration.
Effective Duration
• Bond with embedded options and mortgage back securities do not
have a well defined YTM (future cash flows and their timing are not
known with certainty) yield duration do not apply.
• The effective duration of a bond is the sensitivity of the bond price to
a change in a benchmark yield curve
Factors affect duration
• Duration increases when maturity increases.
• Duration decreases when the coupon rate increases.
• Duration decreases when YTM increases.
Limitation of duration
• Duration calculates a
linear relationship
between price and yield
changes in bonds, in
reality, the relationship
between the changes in
price and yield is convex
 Convexity
Convexity is a measure of the
curvature in the relationship
between bond prices and bond
yields.

Convexity demonstrates how

the duration of a bond changes as the
interest rate changes.
 Convexity and Yield Volatility

Convexity impacted by: time to

The effective convexity of a bond is a curve maturity, coupon rate, yield to
convexity statistic that measures the secondary maturity, dispersion of cash
effect of a change in a benchmark yield curve. It flows.
is used for bonds with embedded options.
56
Factors affect duration
• A longer maturity, a lower coupon rate, or a lower yield to maturity
will all increase convexity, and vice versa.
• For two bonds with equal duration, the one with cash flows that are
more dispersed over time will have greater convexity
Estimate the % price change of a bond for a specified change in
yield, given the bond’s approximate duration and convexity.

change in full bond price = –annual modified duration(ΔYTM) +

½ annual convexity(ΔYTM)2
EXAMPLE: Estimating price changes with duration and convexity
Consider an 8% bond with a full price of $908 and a YTM of 9%. Estimate the percentage
change in the full price of the bond for a 30 basis point increase in YTM assuming the
bond’s duration is 9.42 and its convexity is 68.33.
How changes in credit spread and liquidity affect yield-
to-maturity of a bond and how duration and convexity
can be used to estimate the price effect of the changes.
• With a direct relationship between a bond’s yield spread to the
benchmark yield curve and its YTM, we can estimate the impact on a
bond’s value of a change in spread using the formula introduced
earlier for the price effects of a given change in YTM.
Fundamentals of credit
analysis
Kaplan SchweserNotes 2023 CFA Prep, Level I
Book 4, Reading 47
Key contents
• Credit risks, credit risk components (default risk, loss severity), expected loss, recovery rate
• Yield spread and spread risk
• Seniority ranking of corporate debt and issues in bankruptcy proceedings
• Corporate issuer credit ratings vs. Issue credit ratings
• Notching
• Risks in relying on ratings from credit rating agencies
• Four Cs of traditional credit analysis: capacity, collateral, covenants (affirmative and negative),
character
• Financial ratios used in credit analysis
• Factors affecting yield spreads
• High yield, sovereign, and non-sovereign government bonds
Portfolio Management: An
overview
Kaplan SchweserNotes 2022 CFA Prep, Level I
Book 3, Reading 61
Key contents
• Portfolio approach to investing
• diversification
• Steps in portfolio management process
• Types of investors and their characteristics and needs: individuals, banks,
endowments, insurance companies, investment companies, mutual funds,
sovereign wealth funds
• Defined contribution vs. Defined benefit pension plans
• Aspects and trends of asset management industry
• Mutual funds and types of mutual funds
• Other forms of pooled investments (ETFs, separately managed account, hedge
funds, private equity and venture capital)
Quiz
• A long time horizon and low liquidity requirements best describe the
investment needs of:
A. an endowment.
B. an insurance company.
C. a bank

A An endowment has a long time horizon and low liquidity needs, as an endowment generally
intends to fund its causes perpetually. Both insurance companies and banks require high
liquidity. (LOS 61.
Types of investors
Quiz
• In a defined contribution pension plan:
A. the employee accepts the investment risk.
B. the plan sponsor promises a predetermined retirement income to
participants.
C. the plan manager attempts to match the fund’s assets to its
liabilities.

A In a defined contribution pension plan, the employee accepts the investment risk. The plan
sponsor and manager neither promise a specific level of retirement income to participants nor
make investment decisions. These are features of a defined benefit plan. (LOS 61.d)
Defined contribution vs. Defined benefit pension plans

• A defined benefit plan (e.g., a pension) is one where you know what
to expect in terms of a payout when you retire.
• A defined contribution plan (e.g., a 401(k)) is one where you choose
how much to pay in without knowing what the retirement benefit will
be.
Mutual funds, ETFs, Hegde funds
• Compared to exchange-traded funds (ETFs), open-end mutual funds
are typically associated with lower:
A. brokerage costs.
B. minimum investment amounts.
C. management fees
A Open-end mutual funds do not have brokerage costs, as the shares are purchased from and
redeemed with the fund company. Minimum investment amounts and management fees are
typically higher for mutual funds. (LOS 61.f)
Portfolio Management: Part I
Kaplan SchweserNotes 2022 CFA Prep, Level I
Book 3, Reading 62
Key contents
• Return measures and their appropriate uses
• Money-weighted return and Time-weighted return
• Major asset classes characteristics
• Expected return, variance, standard deviation, covariance, and
correlation of asset returns
• Expected return, variance and standard deviation of portfolio return
• Minimum-variance portfolios, minimum-variance frontier, efficient
frontier, global minimum-variance portfolio
• Utility function and indifference curve
Return measures
Money-weighted returns
• The internal rate of return on a portfolio, taking into account all cash inflows and outflows
• EXAMPLE: Money-weighted rate of return
Assume an investor buys a share of stock for $100 at t = 0 and at the end of the year (t =
1), she buys an additional share for $120. At the end of Year 2, the investor sells both
shares for $130 each. At the end of each year in the holding period, the stock paid a $2.00
per share dividend. What is the money-weighted rate of return?

t=0: Cash outflow = -100

t=1: Cash outflow = -120+2 = -118
t=2: Cash inflow = 130*2 + 4 = 264
PV outflows = PV inflows
 r=13.86%
Time-weighted returns
• compound growth, not affected by the timing of cash inflows and outflows.
• find the time-weighted return for the investment above
Standard deviation, variance, covariance and correlation
of returns
Portfolio’s variance and standard deviation
Quiz
• Which of the following statements about correlation is least accurate?
A. Diversification reduces risk when correlation is less than +1.
B. If the correlation coefficient is 0, a zero-variance portfolio can be constructed.
C. The lower the correlation coefficient, the greater the potential benefits from
diversification.
• The variance of returns is 0.09 for Stock A and 0.04 for Stock B. The covariance
between the returns of A and B is 0.006. The correlation of returns between A
and B is:
A. 0.10.
B. 0.20.
C. 0.30.
Risk reduction benefits with different correlations
Efficient frontier
• portfolios that have the greatest expected return for each level of risk
(standard deviation)
Portfolio Management: Part
II
Kaplan SchweserNotes 2022 CFA Prep, Level I
Book 3, Reading 50
Key contents
• Systematic risk vs. Unsystematic risk
• Capital market line, single factor model, market model
• Beta
• CAPM and SML
• Identify mispriced securities
• Sharpe ratio, Treynor ratio, Jensen’s alpha
Introduction to risk analysis
Kaplan SchweserNotes 2022 CFA Prep, Level I
Book 3, Reading 53
Key contents
• Risk management definition and framework
• Risk governance, risk tolerance, risk budgeting
• Types of financial risks and non-financial risks
• Methods for measuring and modifying risk exposures
• Subjective and market-based estimates of risk