FREE CFA LEVEL 2 MIND MAPS - 2016

2. 1. Code Of Ethics And
Standards Of
Professional Conduct
a.
All CFA Institute members and candidates are
required to comply with the Code and Standards
Structure of the CFA
Institute Professional
Conduct Program
Basic structure for enforcing
the Code and Standards
The CFA Institute Bylaws
Rules of Procedure
Based on two
primary principles
Fair process to member and candidate
Confidentiality of proceedings
Professional Conduct
program (PCP)
The CFA Institute
Board of Governors
Maintains oversight and responsibility
Through the Disciplinary
Review Committee (DRC)
Is responsible for the
enforcement of the
Code and Standards
The CFA Designated
Officer Directs professional conduct staff
Conducts professional
conduct inquiries
An inquiry can be prompted
by several circumstances
Selfdisclosure
Written complaints
Evidence of misconduct
Report by a CFA exam proctor
Analysis of exam materials and monitoring
of social media by CFA Insitute
Process for the enforcement
of the Code and Standards
When an
inquiry is
initiated
The Professional
Conduct staff conducts
an investigation that
may include
Requesting a written explanation
from the member or candidate
Interviewing
The member or candidate
Complaining parties
Third parties
Collecting documents and records in support of its investigation
Upon reviewing the
material obtained during
the investigation, the
Designated Officer may
Conclude the inquiry with no disciplinary sanction
Issue a cautionary letter
Continue proceedings
to discipline the
member or candidate
If finding that a violation of
the Code and Standards
occurred, the Designated
Officer proposes a
disciplinary sanction
Accepted by member
Rejected by member
The matter is referred to a
hearing by a panel of CFA
Institute members
If sanction is imposed
condemnation by the member's peers
suspension of candidate's continued
participant in the CFA program
b,c.
Six components of
the Code of Ethics
Act with integrity, competence, diligence,
respect and in an ethical manner
Integrity of investment profession &
interest of clients above personal interest
Care & judgment
Practice ethics & encourage others to practice
Integrity & viability of the global capital markets
Professional competence
Seven Standards of
Professional Conduct
Professionalism
Integrity of Capital markets
Duties of Clients
Duties to Employers
Investment analysis, Recommendations & Actions
Conflict of interest
Responsibilities as a CFA Institute
member or CFA Candidate
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1. Code Of Ethics And Standards Of Professional Conduct - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

3. 2.1 Standard I
PROFESSIONALISM
A. Knowledge
of the law
Guidance
Understand and comply with
applicable laws and regulations
Code and Standards vs. Local law Follow stricter law and regulation
Participation or association
with violations by others
Responsible for violations in which they
knowingly participate or assist
Dissociate from illegal,
unethical activities Leave employers (in extreme case)
Intermediate steps
Attempt to stop the behavior by bringing it to the attention of
employer through a supervisor or compliance department
May consider directly confronting
the involved individuals
If not successful,--> step away and
dissociate from the activity by
Removing their name from written reports
Asking for a different assignment
Inaction with continued association may be construed as knowing participation
Not required reporting violations to government, CFAI,
but advisable in some cases or required by laws in others
Recommended
procedures for
compliance (RPC)
Members and
candidates
Stay informed
Review procedures
Maintain current files
When in doubt, seek advice of
compliance personnel or legal counsel
When dissociating from violations, --> Document
any violations and urge firms to stop them
Firms
Develop and/or adopt a code of ethics
Make available to employees info that
highlights applicable laws and regulations
Establish written procedures for reporting suspected
violation of laws, regulations or company policies
Application
B. Independence
and objectivity
Guidance
Maintain independence and
objectivity in professional activities
How to cope with external and
internal pressures
External
pressures
By benefits
Gifts, Invitations to lavish
functions, Tickets, Favors, Job referrals,
Allocation of shares in oversubscribed IPOs...
From public companies To issue favorable reports
From Buyside clients May try to pressure sellside analysts
Internal
pressures
From their
own firms
e.g. to issue favorable research reports/
recommendations for certain companies
Investmentbanking
relationships
to issue favorable research on current or
prospective investmentbanking clients
Conflicts of interest
-->
Modest gifts and entertainment are
acceptable but special care must be taken must disclose to employers
Best practice: reject any offer of gifts,
threatening independence and objectivity
Recommendations must
convey true opinions
free of bias from pressures
be stated in clear
and unambiguous language
Portfolio managers must respect and
foster honesty of sellside research
Issuerpaid research
Is fraught with conflicts
Analysts
Must engage in thorough,
independent, and unbiased analysis
Must fully disclose potential conflicts,
including the nature of compensation
Must strictly limit the type of compensation
they accept for conducting research
Best practice
Accept only flat fee for their
work prior to writing the report
Without regard to conclusions
or recommendations
RPC
Protect integrity of opinions
Create a restricted list
Restrict special cost arrangements
Limit gifts
Restrict employee investments
Equity IPOs
Private placements
Review procedures
Written policies on independence
and objectivity of research
C. Misrepresentation
Guidance
Definition of
"Misrepresentation"
any untrue statement or omission of a fact
or any false or misleading statement
Must not knowingly make
misrepresentation or give
false impression in
oral representations, advertising
electronic communications
written materials
Must not misrepresent
any aspect of practice, including
qualifications or credentials, services
performance record
Without regard to conclusions or
recommendations
characteristics of an investment
any misrepresentation relating to
member's professional activities
Must not guarantee clients specific return
on investments that are inherently volatile
Standard I(C) prohibits plagiarism in preparation
of material for distribution to employers, associates,
clients, prospects, general publish
RPC
Written list of available services, description of firm's qualification
Designate employees to speak on behalf of firm
Prepare summary of qualifications and experience,
list of services capable of performing
To avoid plagiarism
Maintain copies
Attribute quotations
Attribute summaries
D. Misconduct
Guidance
Address conduct related to professional life
Violations
Any act involving lying, cheating, stealing, other dishonest conduct that
reflects adversely on member's professional activities would be violation
Conduct damaging trustworthiness or competence (include behaviour may
not be illegal but negatively affect a member to perform responsibility such
as abusing alcohol during lunch hours)
Abuse of the CFA Institute Professional Conduct Program
Involved in personal bankruptcy is not automatically assumed to be in violation but
bankruptcy involve fraudulent or deceitful business conduct may be a violation
RPC
Develop and/or adopt a code of ethics
Disseminate to all employee a list of potential violations
Check references of potential employees
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4. 2.2 Standard II
INTEGRITY OF
CAPITAL MARKETS
A. Material non-public
information (MNI)
Guidance
Definition of "Material
nonpublic information"
Material information
its significant impact to the price
of security if it is disclosed
Reasonable investors would like
to know for making decision
The reliability of the information
Non-public until
disseminated to the market place and
effficient time for investors to react
Must be particularly aware of info
selectively disclosed by corporations
Mosaic
Theory
Analysis of Public info + nonmaterial
nonpublic info --> Investment conclusion
Analysts are free to act on this collection
of info without risking violation
Analysts should save and
document all their research
RPC
Make reasonable efforts to achieve
public dissemination of material info
If public dissemination
is not possible,
Must communicate the info only to the designated
supervisory and compliance personnel within the firm
Must not take investment action on the basis of the info
Must not knowingly engage in conduct
inducing insiders to privately disclose MNI
Encourage firms to
adopt compliance procedures
preventing misuse of MNI
develop & follow disclosure policies
to ensure proper dissemination
use "firewall"
Prohibition of all proprietary trading while firm
is in possession of MNI may be inappropriate
B. Market
manipulation
Definition
Distort prices or artificially inflate trading volume
with the intent to mislead market participants
can be related to
transactions that deceive
market participants
Transactions that artificially
distort prices or volume
Securing a controlling, dominant position in a
financial instrument to exploit and manipulate
price of a related derivative/or underlying asset
dissemination of false
or misleading info
including spreading false rumors
to induce trading by others
Standard II(B) not meant to
prohibit legitimate trading strategies
prohibit transactions done for tax purposes
The intent of action is critical to determining
whether it is a violation of this Standard
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5. http://waytofinancesuccess.com
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To be continued…
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6. 9. Correlation and
Regression - An Overview
A sample covariance, a sample correlation coefficient and a scatter plot
Limitation to correlation analysis
Uses of correlation Analysis
Formulate a test of the hypothesis that the population
correlation coefficient equals zero and determine whether
the hypothesis is rejected at a given level of significance
Distinguish between the dependent and
independent variables in a linear regression
Describe the assumptions underlying linear
regression and interpret regression coefficient
Calculate and interpret the standard error of
estimate, the coefficient of determination, and a
confidence interval for a regression coefficient
Formulate a null and alternative hypothesis about a population value of
a regression coefficient and determine the appropriate test statistic and
whether the null hypothesis is rejected at a given level of significance
Calculate the predicted value for the dependent variable, given an
estimated regression model and a value for the independent variable
Calculate and interpret a confidence interval for
the predicted value of the dependent variable
Describe the use of analysis of variance (ANOVA) in regression analysis,
interpret ANOVA results, and calculate and interpret the F-statistic
Describe limitations of regression analysis
9. Correlation and Regression - An Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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7. 9. Correlation and
Regression - Part 1
A sample covariance, a sample
correlation coefficient and a scatter plot
Scatter Plots
A graph that shows the relationship between the observations for two data series in two dimensions
Each observation in the scatter plot is represented as a point, and the points are not connected
The scatter shows only the actual observation of both data series plotted as pairs
Correlation Analysis
Correlation analysis expresses the same relationship (between two data series) using a single number
The correlation coefficient measures the direction and extent of linear association between two variables
A correlation coefficient can
have a maximum value of 1
and a minimum value of -1
A correlation coefficient less than 0 indicates a negative linear association
A correlation coefficient
greater than 0 indicates a
positive linear association
A scatter plot of two variables with a correlation of 0; they have no linear relation -> the value of A tells us nothing about the value of B
Calculate the Correlation Coefficient
The sample covariance of X and Y, for a sample of size n
The expression for the sample variance of X, is
The sample correlation coefficient
Limitation to correlation analysis
Correlation may be an
unreliable measure when
Two variables can have a strong nonlinear
relation and still have a very low correlation
Outliers are present in one or both of the series.
Outliers are small numbers of observations at
either extreme (small or large) of a sample
Spurious correlation
correlation between two variables that reflects chance relationship in a particular data set
correlation induced by a calculation that mixes each of two variables with a third
correlation between two variables arising not from a direct
relation between them but from their relation to a third variable
Uses of correlation Analysis
In investment decision-making (for example: inflation forecast)
Correlation of stock market tells us how successfully the assets can be combined to diversify risk
Used in a financial statement setting
Formulate a test of the hypothesis that the
population correlation coefficient equals zero
and determine whether the hypothesis is
rejected at a given level of significance
H0: the correlation in the population is 0 (p = 0)
Ha : the correlation in the population is different from 0 (p # 0)
The formula for the t-test This test statistic has a t-distribution with n-2
degrees of freedom if the null hypothesis is true
Sampling from the same population, a false null hypothesis H0: is more likely to be rejected as
we increase sample size. The result whether H0 is rejected also depends on significance level
Distinguish between the dependent and
independent variables in a linear regression
Linear regression with one independent variable (or simple linear regression)
models the relationship between two variables as a straight line
Linear regression provides a simple model for forecasting the value of one variable, known as the
dependent variable, given the value of the second variable, known as the independent variable
9. Correlation and Regression - Part 1.mmap - 4/28/2016 - Mindjet

8. Ensure that linear regression
produces the correct
estimates
use the linear regression model to determine
the distribution of the estimated parameters
and and thus test whether those coefficients
have a particular value
9. Correlation and
Regression - Part 2
Describe the assumptions
underlying linear regression and
interpret regression coefficient
The regression equation
Y: dependent variable
X: independent variable
b0: the intercept
b1: a slope coefficient
b0, b1 are the regression coefficients
Slope coefficient The estimated slope coefficient is interpreted as the change
in the dependent variable for a 1-unit change in the
independent variable
The intercept term
The intercept is an estimate of the dependent variable when the independent variable takes on a value of zero
error term (represents the portion of the dependent variable that cannot be explained by the independent variable
Six classic normal linear
regression model assumptions
The relationship between the dependent variable, Y, and the independent variable,
X is linear in the parameter b0 and b1. b0 and b1 are raised to the first power only
and that neither b0 nor b1 is multiplied or divided by another (for example, b0/b1).
The requirement does not exclude X from being raised to a power other than 1
Critical for a valid linear regression. If the relationship
between the independent and dependent variables is
nonlinear in the parameters, then estimating that relation
with a linear regression model will produce invalid results
The independent variable, X, is not random
The expected value of the error term is 0
The variance of the error term is the
same for all observations:
The error term is uncorrelated across observations.
Consequently, E(ei,j) = 0 for all i not equal to j.
The error term is normally distributed
Calculate and interpret the standard
error of estimate, the coefficient of
determination, and a confidence
interval for a regression coefficient
The formula for the standard error of estimate (SEE) for a
linear regression model with one independent variable is
The different between the actual and predicted values
of the dependent variable is the regression residual
The coefficient of determination (R^2)
defined as the percentage of the total variation in the dependent variable explained by the independent variable
R^2 = r^2 for a regression with one independent variable
Regression coefficient confidence interval
Confidence interval spans the range
A confidence interval is an interval of values that we believe includes the true parameter value, , with a given degree of confidence
Formulate a null and alternative hypothesis about a
population value of a regression coefficient and determine
the appropriate test statistic and whether the null
hypothesis is rejected at a given level of significance
A hypothesis test using the confidence interval approach if we know
the estimated parameter value
the hypothesized value b0 or b1
a confidence interval around the estimated parameter
In practice, the most common way to test a hypothesis using a regression model is
with a t-test of significance. To test the hypothesis, we can compute the statistic
This test statistic has a t-distribution with n-2 degrees of freedom. Reject H0 if t> +tcritical or t <-tcritical
The appropriate test structure for the null and alternative hypothesis: H0: b1 = 0 versus Ha: b1 # 0
Calculate the predicted value for the dependent
variable, given an estimated regression model
and a value for the independent variable
If we know
Calculate and interpret a confidence interval for
the predicted value of the dependent variable
The prediction interval for a regression equation for a
particular predicted value of the dependent variable Y
Where sf = standard eror of the forecast
tc is two-tailed critical t-value at the desired level of significance with df = n-2
The formula to calculate sf
variance of the residuals = the square of the standard error of estimate
variance of the independent variable
X value of the independent variable for which the forecast was made
Describe the use of analysis of variance (ANOVA)
in regression analysis, interpret ANOVA results,
and calculate and interpret the F-statistic
Analysis of variance (ANOVA) is a statistical procedure for dividing the total variability of a variable into components that can be attributed to different sources
Use ANOVA to determine the usefulness of the independent variable or variables in explaining variation in the dependent variable
The F-test tests whether all the slope coefficients in a linear regression are equal to 0
The null hypothesis H0: b1 =0
The alternative hypothesis Ha: b1 # 1
Formula for the F-statistic in a regression
with one independent variable is
SSE (The sum of squared errors or residuals)
RSS (The regression sum of squares)
TSS = SSE + RSS
If there are n observations, the
F-test for the null hypothesis that
the slope coefficient is equal to 0
is hear denoted
Calculate R^2 and SEE
Describe limitations of
regression analysis
Regression relations can change over time-> the issue of parameter instability
Public knowledge of regression relationships may negate their future usefulness
If the regression assumptions are violated, hypothesis tests and predictions based on linear regression will not be valid
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9. 29. Equity Valuation:
Applications and Processes -
An Overview
Introduction
Value Definition and
Valuation Applications
Communicating Valuation Results
The Valuation Process
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10. affects a company’s future cash flows -> equity
The requirements are more specific in some situations. For e.g,
regulations governing disclosures of conflicts and potential conflicts
of interest vary across countries, investment recommendations are
affected by policies of the firm employing an analyst
29. Equity Valuation:
Applications and Processes
- Part 1
Introduction
Valuation
The estimation of an asset’s value based on variables perceived to be related to future investment
returns, on comparisons with similar assets, or on estimates of immediate liquidation proceeds
Basic questions
What is value?
Who uses equity valuations?
What is the importance of industry knowledge?
How can the analyst effectively
communicate his analysis?
Value Definition and
Valuation Applications
Definition
Intrinsic Value
The value of the asset given a hypothetically complete
understanding of the asset’s investment characteristics
Reflects investor's view of the “true” or “real” value of an asset
Grossman-Stiglitz paradox
Market price and intrinsic
value are identical
Rational efficient
markets formulation
Investors will not rationally incur the expenses of
gathering information unless they expect to be
rewarded by higher gross returns compared with
the free alternative of accepting the market price
Difficult to determine especially
Common stock
Trading costs exist
Further room exists for price to diverge from value
Analysts often view market prices both
with respect and with skepticism
Seek to identify mispricing
A difference between the estimated intrinsic
value and the market price of an asset
Rely on price eventually converging to intrinsic value
Recognize distinctions among the levels
of market efficiency or tiers of markets
Valuation is an inherent part to attempt positive excess
risk adjusted returns (abnormal return or alpha)
Uncertainty is
constantly present
Revaluate by looking for the presence of a
particular market or corporate event ( catalyst)
VE - P = (V - P) + (VE - V)
VE = estimated value
P = market price
V = intrinsic value
(V-P): the true mispricing, the difference between the true but
unobservable intrinsic value V and the observed market price P
Contribute to the abnormal return
(VE-V): the difference between the valuation
estimate and the true but unobservable intrinsic value
The error in the estimate of the intrinsic value
A useful estimate
of intrinsic value
Combine accurate forecasts and
appropriate valuation model
Expectational inputs used in valuation models
Active security selection
Manager’s expectations must differ from
consensus expectations and be correct
Going-Concern Value and Liquidation Value
Going-concern assumption
The assumption that the company will continue
its business activities into the foreseeable future
valuemaximizing using assets
accessing its optimal sources of financing
not appropriate for a company in financial distress
The value added by assets working together and by human capital applied to managing
those assets makes estimated goingconcern value greater than liquidation value
Liquidation value
Different time frame for liquidating causes different assets value of a company
Orderly liquidation value
Fair Market Value and Investment Value
Fair market value
is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller
when the former is not under any compulsion to buy and the latter is not under any compulsion to sell
includes an assumption that both buyer and seller are informed of all material aspects of the underlying investment
often used in valuation related to assessing taxes
Investment value
The concept of value to a specific buyer taking account of potential
synergies and based on the investor’s requirements and expectations
Valuation Applications
Selecting stocks Primary use
Inferring (extracting ) market expectations
evaluate the reasonableness of the expectations
as a benchmark or comparison value of the same characteristic for another company
Evaluating corporate events
A merger the general term for the combination of two companies
An acquisition
a combination of two companies, with one of the companies
identified as the acquirer, the other the acquired
the acquiring company’s own common stock
is often used as currency for the purchase
A divestiture a company sells some major component of its business
A spin-off
the company separates one of its component businesses and transfers
the ownership of the separated business to its shareholders
A leveraged buyout
an acquisition involving significant leverage [i.e., debt], which is
often collateralized by the assets of the company being acquired.)
Rendering fairness opinions
The parties to a merger may be required to seek a fairness opinion on
the terms of the merger from a third party, such as an investment bank
Evaluating business strategies and models
Companies concerned with maximizing shareholder value
evaluate the effect of alternative strategies on share value
Communicating with analysts and shareholders
Appraising private businesses for transactional purposes
E.g acquisitions or buy-sell agreements for the transfer of equity
interests among owners when one of them dies or retires, IPO,...
Sharebased payment (compensation)
Communicating Valuation Results
Contents of a Research Report
Kind of infor. intended readers seek to gain
Sell-side analyst’s report:
investment recommendation
Persuasive supporting
arguments
The intrinsic value
of the security
The key assumptions and
expectations underlying that
estimated intrinsic value
An update on the company’s
financial and operating results
A description of relevant aspects of the
current macroeconomic and industry context
An analysis and forecast for
the industry and company
Detailed historical descriptive statistics
about the industry and company
When a research report states a
target price for a stock, it should
clarify
the basis for computing the target
information on the uncertainty of reaching the target
a time frame for reaching the target
May be accompanied by an explanation of the underlying rationale
Usual contents
Specific forecasts
A description of the valuation model
Key valuation inputs
A discussion of qualitative factors and other considerations that affect valuation
Objectively address the uncertainty associated with investing in the security,
and/or the valuation inputs involving the greatest amount of uncertainty
Contains timely information
is written in clear, incisive language
is objective and well researched, with key assumptions clearly identified
distinguishes clearly between facts and opinions
contains analysis, forecasts, valuation, and a recommendation that are internally consistent
presents sufficient information to allow a reader to critique the valuation
states the key risk factors involved in an investment in the company
discloses any potential conflicts of interests faced by the analyst
Format of a Research Report
Research Reporting Responsibilities
All analysts have an obligation to provide substantive and
meaningful content in a clear and comprehensive report format
Analysts who are CFA Institute members, however, have an additional and overriding responsibility to adhere to
the Code of Ethics and the Standards of Professional Conduct in all activities pertaining to their research reports
The analyst must hold himself accountable to both standards of competence and standards of conduct
An effective research report
29. Equity Valuation. Applications and Processes - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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11. The term “business model” refers
generally to how a company makes
money
Need sensitivity
analysis
29. Equity Valuation:
Applications and Processes -
Part 2: The Valuation Process
Understanding the business
Industry and
Competitive Analysis
is to understand the basic characteristics of the markets served by a company and the economics of the company
Use various
frameworks
Usefulness
give appropriate attention to
the most important economic
drivers of a business
to organize thoughts about an industry and to better understand a company’s
prospects for success in competition with other companies in that industry
to highlight the greatest challenges and opportunities need more sensitivity analysis ?
How is a useful
framework? Focus
on these questions
How attractive are the industries in which
the company operates, in terms of offering
prospects for sustained profitability
Try to understand the industry structure
Porter 5 forces
Stay current on facts and news concerning all the industries
What is the company’s
relative competitive position
within its industry, and what
is its competitive strategy
The level and trend of the company’s market share indicate
its relative competitive position within an industry
Corporate strategies
Cost leadership
Differentiation
Focus
How well has the company
executed its strategy and what are
its prospects for future execution
Analyzing the company’s financial
report to evaluate the company's
strategic objectives' performances
and develop expectations to it
Historical analysis to have
its insights through time
Looking annual reports
for 10, 5, 2 years prior
2 caveats merit mention
importance of qualitative (non-numeric factors)
avoid simply extrapolating past operating
results when forecasting future performance
Analysis of Financial Reports
most relevant for evaluating a company’s
success in implementing strategic choices
Financial ratio analysis is useful for established companies
Individual drivers of profitability for merchandising and manufacturing companies
can be evaluated against the company’s stated strategic objectives
Sources of Information
Analysts can compare the information provided directly
by companies to their own independent research
Regulatory requirements concerning disclosures and filings vary internationally
Be aware when regulations (e.g., Regulation FD in the United States) prohibit companies from disclosing
material nonpublic information to analysts without also disseminating that information to the public
Considerations in Using
Accounting Information
Quality of earnings analysis
The scrutiny of all financial statements, including the balance sheet,
to evaluate both the sustainability of the companies’ performance
and how accurately the reported information reflects economic reality
Also require careful scrutiny of
accounting statements, footnotes,
and other relevant disclosure
Equity analysts: develop better insights into a company and improve forecast accuracy
Sustainability of performance: identify aspects of reported nonrecurring performance
Identify reporting decisions that may result in a level
of reported earnings that are unlikely to continue
comparison of a company’s net
income with its operating cash flow
A working selection of risk factors (AICPA 2002) (in case growth in
an asset account at a much faster rate than the growth rate of sales
Poor quality of accounting disclosures, such as segment information, acquisitions,
accounting policies and assumptions, and a lack of discussion of negative factors.
Existence of relatedparty transactions
Existence of excessive officer, employee, or director loans
High management or director turnover
Excessive pressure on company personnel to make revenue or earnings targets,
particularly when combined with a dominant, aggressive management team or individual
Material non-audit services performed by audit firm
Reported (through regulatory filings) disputes with and/or changes in auditors
Management and/or directors’ compensation tied to profitability or stock price
(through ownership or compensation plans). Although such arrangements are
usually desirable, they can be a risk factor for aggressive financial reporting.
Economic, industry, or companyspecific pressures on profitability,
such as loss of market share or declining margins
Management pressure to meet debt covenants or earnings expectations
A history of securities law violations, reporting violations, or persistent late filings
Forecasting Company Performance Two perspectives
The economic environment
Top-down forecasting
Approach moves from international and national macroeconomic forecasts
to industry forecasts and then to individual company and asset forecasts
Bottom-up forecasting Approach aggregates forecasts at a micro level to larger scale forecasts, under specific assumptions
The company’s own operating and financial characteristics Consider qualitative as well as quantitative factors
Selecting the Appropriate Valuation Model
Absolute Valuation Models
Def. a model that specifies an asset’s intrinsic value
used to produce an estimate of value that can
be compared with the asset’s market price
The fundamental
approach to
equity valuation
The value of an asset to an investor must be related to the
returns that investor expects to receive from holding that asset.
For common
stock: Dividend
discount models
Analysts frequently
define cash flows at
the company level
Free cash flow
to equity model
Defines cash flow net of
payments to providers of debt
Free cash flow
to the firmDefines cash flows before those payments
Residual income model
Based on accrual accounting
earnings in excess of the opportunity
cost of generating those earnings
Greater uncertainty than
the case with bonds due to
its CFs and discount rate
need to address other issues, such as
the value of corporate control or the
value of unused assets
Applied to bond valuationNot as uncertain as common stock
A stream of cash payments specified in
a legal contract (the bond indenture)
A discount rate can usually be based on
market interest rates and bond ratings
Asset-based valuation
Values a company on the basis of the market
value of the assets or resources it controlsCan provide an independent estimate of value
Relative Valuation Models
Def. estimate an asset’s value relative to that of another assetUnderlying idea: similar assets should sell at similar prices
How?
using price multiples
ratios of stock price to a fundamental
such as cash flow per share
P/E
Undervalue
Relatively undervalue
enterprise multiples
ratios of the total value of common stock and debt net of cash and shortterm investments
to certain of a company’s operating assets to a fundamental such as operating earnings
The more conservative investing strategies involve overweighting (underweighting)
relatively undervalued (overvalued) assets, with reference to benchmark weights
The more aggressive strategies allow short
selling of perceived overvalued assets
Relative value investing (or relative spread
investing, if using implied discount factors)
Pairs trading: buying the relatively undervalued
stock and selling short the relatively overvalued stock
Frequently involve a group
of comparison assets
The method of comparables is characterized by
a wide range of possible implementation choices
does not specify intrinsic value without making the further
assumption that the comparison asset is fairly valued
being simple, related to market prices, and
grounded in a sound economic principle
Valuation of the Total Entity
and Its Components
Sum-of-the-parts
valuation
Sums the estimated values of each of the
company’s businesses as if each business
were an independent going concern
The value derived using a
sum-of-the-parts valuation
Breakup value or
private market value
When to use
Value a company with segments in different industries
that have different valuation characteristics
evaluate the value that might be unlocked in a restructuring through
a spinoff, splitoff, tracking stock, or equity (IPO) carveout
Conglomerate discount
The market applies a discount to the stock of a company
operating in multiple, unrelated businesses compared to
the stock of companies with narrower focuses
Alternative explanation
inefficiency of internal capital markets
endogenous factors
research measurement errors
A breakup value in excess of a company’s unadjusted goingconcern
value may prompt strategic actions such as a divestiture or spin-off
Issues in Model Selection
and Interpretation
Criteria for model selection are
that the valuation model be
consistent with the characteristics
of the company being valued
having a good understanding
of the business
understanding the nature of its assets and
how it uses those assets to create value
appropriate given the availability and quality of data
consistent with the purpose of valuation, including the analyst’s perspective
Professionals frequently use multiple valuation
models or factors in common stock selection
Converting Forecasts
to a ValuationTwo important aspects
Sensitivity analysis
to determine how changes in an assumed
input would affect the outcome
E.g when assess how a change in assumptions about a company’s
future growth or analyze how different competitive responses
would affect the forecasted financials and the estimated valuation
Situational adjustments
control premiumsthe value of a stock investment
lack of marketability discountsthe value of nonpublicly traded stocks
illiquidity discounts
the prices of shares with less depth to their markets
an investor wishes to sell an amount of stock that is large relative to that stock’s
trading volume (assuming it is not large enough to constitute a controlling ownership)
blockage factor
The price that would be lower than the
market price for a smaller amount of stock
Applying the Valuation Conclusion:
The Analyst’s Role and Responsibilities
The purposes and the intended
consumer of the valuation
Valuation judgments to distribute to current and
prospective retail and institutional brokerage clients
Sell-side analyst: Analysts
who work at brokerage firms
Valuation judgments to a portfolio manager or to an
investment committee as input to an investment decision
Buy-side analysts
Investment discipline (security
selection) and quantitative
investment disciplines
Both corporate analysts and investment bank analysts may also
identify and value companies that could become acquisition targets
Analysts at independent vendors of financial information usually offer
valuation information and opinions in publicly distributed research reports
Investment analysts play a critical role in collecting, organizing, analyzing,
and communicating corporate information, and in some contexts,
recommending appropriate investment actions based on sound analysis
Help their clients achieve their investment objectives
Contribute to the efficient functioning of capital markets
Benefit the suppliers of capital, including shareholders, when
they are effective monitors of management’s performance
Present value models
(discounted CF models)
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13. 39. Private Real
Estate Investments:
An Overview
INTRODUCTION
REAL ESTATE INVESTMENT: BASIC FORMS
REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS
PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS
THE COST AND SALES COMPARISON APPROACHES TO VALUATION
OVERVIEW OF THE VALUATION
OF COMMERCIAL REAL ESTATE
THE INCOME APPROACH TO VALUATION
RECONCILIATION
DUE DILIGENCE
VALUATION IN AN INTERNATIONAL CONTEXT
INDICES
PRIVATE MARKET REAL ESTATE DEBT
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14. 39. Private Real Estate
Investments - Part 1
INTRODUCTION
Private equity investment: sometimes
referred to as direct ownership
often included in the portfolios of investors with long-term investment
horizons and with the ability to tolerate relatively lower liquidity
Publicly traded debt investment:
sometimes referred to as indirect lending
suitable for investors with short investment horizons and higher liquidity needs
REAL ESTATE INVESTMENT:
BASIC FORMS
Investment in real estate has been defined from a capital market perspective
in the context of quadrants which are a result of two dimensions of investment
The first dimension: whether the investment
is made in the private or public market
The second dimension: whether the investment
is made in the private or public market
Four quadrants
Private real estate investment, compared with publicly traded real estate investment, typically
involves larger investments because of the indivisibility of real estate property and is more illiquid
Publicly traded real estate investment allows the real estate property to
remain undivided but the ownership or claim on the property to be divided
Equity investors generally expect a higher rate of return than lenders (debt investors) because they take on more risk
Debt investors in real estate, whether through private or public markets, expect to receive their return from
promised cash flows and typically do not participate in any appreciation in value of the underlying real estate
REAL ESTATE: CHARACTERISTICS
AND CLASSIFICATIONS
Characteristics
Heterogeneity and fixed location
High unit value
Management intensive
High transaction costs
Depreciation
Need for debt capital
Illiquidity:
Price determination
Residential properties: single-family houses
and multi-family properties, properties that
provide housing for individuals or families
Single-family properties may be
owner-occupied or rental properties
Multi-family properties are rental properties even if
the owner or manager occupies one of the units
Multifamily housing is usually differentiated
by location and shape of structure
Commercial real estate properties
Properties purchased with the
intent to let, lease, or rent
Office
Industrial and warehouse
Retail
Hospitality
Other types
PRIVATE MARKET REAL ESTATE
EQUITY INVESTMENTS
Motivations
Current income
Price appreciation (capital appreciation)
Inflation hedge
Diversification
Tax Benefits
Risk Factors
Characteristic sources of risk or risk
factors of real estate investment
Business conditions
Long lead time for new development
Cost and availability of capital
Unexpected inflation
Demographics
Lack of liquidity
Environmental
Availability of information
Management
Leverage
Other risk factors
Real Estate Risk and Return
Relative to Stocks and Bonds
Risk and return of equity real estate investments is affected by the characteristics of
real estate and the risk factors, structure of leases between the owner and tenants
Commercial Real Estate
Office
The demand for office depends heavily on employment growth
The average length of an office building lease varies globally
An important consideration in office leases is whether the
owner or tenant incurs the risk of operating expenses
“net lease” requires the tenant to be
responsible for paying operating expenses
“gross lease” requires the owner
to pay the operating expenses
Not all office leases are structured as net or gross leases
There are differences in how leases are structured over time and in different countries
Industrial and Warehouse
The demand for industrial and warehouse space is heavily dependent on the overall strength
of the economy and economic growth and on import and export activity in the economy
Retail
The demand depends heavily on trends in consumer spending. Consumer spending, in turn,
depends on the health of the economy, job growth, population growth, and savings rates
“Percentage lease”: the requirement that the tenants pay additional rent once their sales reach a certain level
The lease will typically specify a “minimum rent” that must be paid regar dless of the tenant’s sales
and the basis for calculating percentage rent once the tenant’s sales reach a certain level or breakpoint
Multi-Family
The demand for multi-family
space depends on
population growth, especially for the age segment most likely to rent apartments
how the cost of renting compares with the cost of
owning-that is, the ratio of home prices to rents
THE COST AND SALES COMPARISON
APPROACHES TO VALUATION
The Cost Approach
Types of depreciation
Physical deterioration related to the age
of the property because components of the
property wear out over time. Two types
curable: fixing the problem will add value that
is at least as great as the cost of the cure
incurable: Fixing a structural problem with the foundation
of the building may cost more to cure than the amount
that it would increase the value of the property if cured
Functional obsolescence: a loss in value due to a design that is different from that of a
new building constructed with an appropriate design for the intended use of the property
External obsolescence: due to either the location of
the property or economic conditions, results when
the location is not optimal for the property
Locational obsolescence results when
the location is not optimal for the property
Economic obsolescence results when new construction
is not feasible under current economic conditions
The Sales Comparison Approach
The sales comparison approach implicitly assumes that the value of a property
depends on what other comparable properties are selling for in the current market
Advantages and Disadvantages of the
Cost and Sales Comparison Approaches
OVERVIEW OF THE VALUATION
OF COMMERCIAL REAL ESTATE
Appraisals
Appraisals (estimates of value) are critical for such infrequently traded and unique assets as real estate properties
Value
Market value: can be thought of as the most probable sale price. It is what a typical investor is willing to pay for the property
There are other definitions of value
that differ from market value
Investment value: the value to a particular investor, could be higher or lower than market
value depending on the particular investor’s motivations and how well the property fits into the
investor’s portfolio, the investor’s risk tolerance, the investor’s tax circumstances, and so on.
Value in use: the value to a particular user
Introduction to
Valuation Approaches
Three different approaches
The income approach considers what price an investor would pay based on an
expected rate of return that is commensurate with the risk of the investment
The cost approach considers what it would cost to buy the land and construct a new property on the site that
has the same utility or functionality as the property being appraised (referred to as the subject property )
The sales comparison approach considers what similar or comparable
properties (comparables) transacted for in the current market
Highest and Best Use Highest and best use: the use that would result in the highest value for the land
The cost approach involves estimating the value of the building(s) based on adjusted replacement cost
The replacement cost is adjusted for different types of depreciation (loss in value) to arrive at a depreciated replacement cost
Non-residential properties include commercial properties
other than multifamily properties, farmland, and timberland
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Classifications

15. 39. Private Real Estate
Investments - Part 2
THE INCOME APPROACH
TO VALUATION
General Approach and
Net Operating Income
There are two income approaches
the direct capitalization method
capitalizes the current NOI using a growth implicit capitalization rate
When the capitalization rate is applied to the forecasted first-year
NOI for the property, the implicit assumption is that the first-year NOI
is representative of first-year NOI would be for similar properties
the DCF method
applies an explicit growth rate to construct an NOI
stream from which a present value can be derived
Income can be projected either for the entire economic life of the property or for a typical
holding period with the assumption that the property will be sold at the end of the holding period
Calculating NOI
Rental income at full occupancy
+ Other income (such as parking)
= Potential gross income (PGI)
– Vacancy and collection loss
= Effective gross income (EGI)
– Operating expenses (OE)
= Net operating income (NOI)
The Capitalization Rate and the Discount Rate
The cap rate is like a current yield for the property whereas
the discount rate is applied to current and future NOI
Cap rate = Discount rate - Growth rate
Defining the Capitalization Rate
Cap rate = NOI/Value
going-in cap rate is used to clarify that it is based on the first
year of ownership when the investor is going into the deal
terminal cap rate is based on expected income for
the year after the anticipated sale of the property
Value = NOI/Cap rate
observing what other similar or comparable
properties are selling for to know the cap rate
Cap rate = NOI/Sale price of comparable
Market value = Rent/ARY ARY: all risks yield
Stabilized NOI
If NOI is not representative of the NOI of similar properties because
of a temporary issue, the subject property's NOI should be stabilized
Other Forms of the Income Approach
Gross income multiplier: the ratio of the sale price to the gross
income expected from the property in the first year after sale
The problem of gross income multipler: not explicitly
consider vacancy rates and operating expenses
The Discounted Cash
Flow (DCF) Method
The Relationship between
Discount Rate and Cap Rate
If the growth rate is constant V = NOI/(r – g)
If NOI is not expected to grow at a constant rate, then NOIs are projected into
the future and each period’s NOI is discounted to arrive at a value of the property
The Terminal Capitalization Rate
The cap rate used to estimate the resale price or terminal value
is referred to as a terminal cap rate or residual cap rate
It is a cap rate that is selected at the time of valuation to be applied to the NOI
earned in the first year after the property is expected to be sold to a new buyer
The terminal cap rate could be the same, higher, or
lower than the goingin cap rate depending on expected
discount and growth rates at the time of sale
If interest rates are expected to be higher in the
future => terminal cap rates might be higher
The growth rate is often assumed to be a little
lower => a slightly higher terminal cap rate
Uncertainty about what the NOI will be in the future
may also result in selecting a higher terminal cap rate
Adapting to Different Lease Structures
Lease structures vary across locales and can have an effect
on the way value is typically estimated in a specific locale
The Equivalent Yield
The “equivalent yield” is a single discount rate that could be applied
mathematically to both income streams that would result in the same value
Advanced DCF:
Lease-by-Lease Analysis
The general s teps to a DCF
analysis are as follows
Project income from existing leases
Make assumptions
about lease renewals
Assumptions also have to be made about what will happen when a lease
comes up for renewal—often referred to as market leasing assumptions
Make assumptions about
operating expenses
Operating expenses involve items that must be paid by the owner, such as
property taxes, insurance, maintenance, management, marketing, and utilities
Make assumptions about
capital expenditures such as a new heating and air conditioning system or replacing a roof, etc.,
Make assumptions about absorption of any vacant space
Estimate resale value (reversion) how long the property will be held by the initial investor
Select discount rate to find PV of cash flows
Advantages and Disadvantages
of the Income Approach
Advantage: it captures the cash flows that investors actually care about
Disadvantage is the amount of detailed information that is needed and the need to forecast what will happen in
the future even if it is just forecasting a growth rate for the NOI and not doing a detailed lease-by-lease analysis
Common Errors
The discount rate does not reflect the risk
Income growth is greater than expense growth
The terminal cap rate is not logical compared with the implied going-in cap rate
The terminal cap rate is applied to an income that is not typical
The cyclical nature of real estate markets is not recognized
RECONCILIATION
Three different approaches to valuation: the income, cost, and sales comparison approaches may produce the different answers due to imperfections in the data and inefficiencies in the market
The appraiser needs to reconcile the differences and arrive at a final conclusion about the value
The purpose of reconciliation is to decide which approach or approaches you have the most confidence in and come up with a final estimate of value
In an active market: sales comparison approach is preferred
When there are fewer transactions: income approach is preferred
DUE DILIGENCE
To verify other facts and conditions that might affect the value of the property and that might not have been identified by the appraiser
E.g
Review the leases for the major tenants and review the history of rental payments and any defaults or late payments.
Get copies of bills for operating expenses, such as utility expenses.
Look at cash flow statements of the previous owner for operating expenses and revenues.
Have an environmental inspection to be sure there are no issues, such as a contaminant material on the site.
Have a physical/engineering inspection to be sure there are no structural issues with the property
and to check the condition of the building systems, structures, foundation, and adequacy of utilities.
Have an attorney or appropriate party review the ownership history to be sure there are no issues related
to the seller’s ability to transfer free and clear title that is not subject to any previously unidentified liens.
Review service and maintenance agreements to determine whether there are recurring problems.
Have a property survey to determine whether the physical improvements are in the boundary
lines of the site and to find out if there are any easements that would affect the value.
Verify that the property is compliant with zoning, environmental regulations, parking ratios, and so on.
Verify that property taxes, insurance, special assessments, and so on, have been paid
VALUATION IN AN
INTERNATIONAL CONTEXT
INDICES
Appraisal-Based Indices Disadvantages
Appraisal lag
May not capture the price increase until a quarter or more after it was reflected in transactions
Tend to smooth the index, have lower correlation with others => allocation to real estate would likely overestimated
How to adjust: unsmooth” the appraisalbased or use a transactionbased index when comparing real estate with other asset classes
Transaction-Based Indices
In recent years, indices have been created that are based on actual transactions rather than appraised values
Two main ways
A repeat sales index relies on repeat sales of the same property
A hedonic index which requires only one sale
Disadvantages Include random elements in the observations => may be upward or downward movements from quarter to quarter that are somewhat random
PRIVATE MARKET REAL ESTATE DEBT
The 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) or the debt service coverage ratio (DSCR)
The debt service coverage ratio is the ratio of the firstyear NOI to the loan payment
DSCR = NOI/Debt service
The Direct Capitalization Method
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Return = {NOI Capital expenditures + (Ending market value Beginning market value )}/Beginning market value

16. 48. Futures Markets and
Contracts: An Overview
FUTURE CONTRACTS
FUTURES PRICE & THE VALUE
OF A FUTURES CONTRACT
WHY FORWARD AND
FUTURES PRICES DIFFER
MONETARY & NONMONETARY BENEFITS AND COSTS
ASSOCIATED WITH HOLDING THE UNDERLYING
ASSET AND THEIR EFFECTS TO FUTURES PRICE
THE RELATION BETWEEN FUTURES
PRICES AND EXPECTED SPOT PRICES
PRICING EURODOLLAR FUTURES, TREASURY BOND
FUTURES, STOCK INDEX AND CURRENCY FUTURES
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17. should be the same as that of a forward contract
48. Futures Markets
and Contracts - Part 1
FUTURE CONTRACTS
Similar to forward
contracts in
Deliverable contracts obligate the long to buy and the short to sell a certain quantity of an asset for a certain price on a specified future date
Cash settlement contracts are settled by paying the contract value in cash on the expiration date
Both forwards and futures are priced to have zero value at the time the investor enters into the contract
Different from
forward contracts
Futures are marked to market at the end of every trading day. Forward contracts are not marked to market
Futures contracts trade on organized exchanges. Forwards are private contracts and do not trade on organized exchanges
Futures contracts are highly standardized. Forwards are customized contracts satisfying the needs of the parties involved
Forwards are contracts with the originating counterparty; a specialized entity called a clearinghouse is the counterparty to all futures contracts
Forward contracts are usually not regulated. The government having legal jurisdiction regulates futures markets
FUTURES PRICE & THE VALUE
OF A FUTURES CONTRACT
Futures price must converge
to the spot price at expiration
At expiration, the spot price must equal the futures price because the futures price
has become the price today for delivery today, which is the same as the spot.
Arbitrage will force the prices to
be the same at contract expiration
Future margins and
marking to market
Futures margin is a
performance guarantee
The clearinghouse guarantees that traders in the futures market will honor their
obligations by splitting each trade once it is made and acting as the opposite
side of each position => To safeguard the clearinghouse, both sides of the trade
are required to post margin and settle their accounts on a daily basis
Marking to market is the process of adjusting the margin balance in a futures account each day for
the change in the value of the contract from the previous trading day, based on the settlement price
Value of a
futures contract
Has no value at contract initiation
Does not accumulate value changes over the term of the contract.
The value after the margin deposit has been adjusted for the day's gains and losses in contract value is always zero
The futures price at any point in time is the price that makes the value of a new contract equal to zero
The value of a futures contract strays from zero only during the trading periods between the times at which the account is marked to market
Value of futures contract = current futures price - previous mark-to-market price
If the futures price increases, the value of the long position increases
WHY FORWARD AND
FUTURES PRICES DIFFER
The no-arbitrage price of a futures contract
FP = futures price
So = spot price at inception of the contract ( t = 0)
Rf = annual risk-free rate
T = futures contract term in years
Cases that causes futures and
forward prices to be different
If investors prefer the mark-to-market feature of futures, futures prices will be higher than forward prices
If investors would rather hold a forward contract to avoid the marking to market
of a futures contract, the forward price would be higher than the futures price
Future arbitrage
Cash-and-carry arbitrage
A cash-and-carry arbitrage consists of buying the asset, storing/holding the
asset, and selling the asset at the futures price when the contract expires
Steps
At the initiation of the contract
Borrow money for the term of the contract at market interest rates
Buy the underlying asset at the spot price
Sell (go short) a futures contract at the current futures price
At contract expiration
Deliver the asset and receive the futures contract price
Repay the loan plus interest
If the futures contract is overpriced => generate a riskless profit
The futures contract is overpriced if the actual market price is greater than the no-arbitrage price
Reverse cash-and-carry arbitrage
When the futures price is too low (which presents a profitable arbitrage opportunity)
Steps
At the initiation of the contract
Sell the asset short
Lend the short sale proceeds at market interest rates
Buy (go long) the futures contract at the market price
At contract expiration
Collect the loan proceeds
Take delivery of the asset for the futures price and cover the short sale commitment
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18. 48. Futures Markets
and Contracts - Part 2
MONETARY AND NONMONETARY
BENEFITS AND COSTS ASSOCIATED WITH
HOLDING THE UNDERLYING ASSET AND
THEIR EFFECTS TO FUTURES PRICE
Any positive costs associated with storing or holding the asset in a cash and carry arbitrage will increase the no-arbitrage futures price
A monetary benefit from holding the asset
will decrease the no-arbitrage futures price
E.g., Financial assets: no storage costs other than the opportunity cost of the funds
Convenience yield: The return from non-monetary benefits which come from holding an asset in short supply
The no-arbitrage futures price counting net costs
net costs (NC) = storage costs - convenience yield
FV (NC)= future value, at contract expiration, of the net costs of holding the asset
The no-arbitrage futures price counting net benefits
NB = yield on the asset + convenience yield
FV (NB) = future value, at contract expiration, of the net benefits of holding the asset
THE RELATION BETWEEN
FUTURES PRICES AND
EXPECTED SPOT PRICES
Backwardation and contago
Backwardation
refers to a situation where the futures price is below the spot price
to occur, there must be a significant benefit to holding
the asset, either monetary or non-monetary
E.g., benefits to holding the asset that offset the opportunity cost of
holding the asset (the risk-free rate) and additional net holding costs
Contango
refers to a situation where the futures price is above the spot price
happens when there is no benefits to holding the asset, the futures price will be
If both parties to a futures transaction are hedging existing risk,
the futures price may be equal to expected future spot prices
The futures price might be temporarily above or below expected future
spot prices, but it would be an unbiased predictor of future spot rates
Normal backwardation
happens when the futures price is lower than the expected price in the future to compensate the future buyer for accepting asset price risk
Normal contango
happens when the futures price is greater than the expected spot price
The most likely situation in financial markets is normal backwardation
Eurodollar, Treasury Bonds, Stock
Index, and Currency Futures
Eurodollar
similar to a forward rate agreement to lend US$1,000,000 for three months beginning on the contract settlement date
based on 90-day LIBOR, which is an add-on yield
the price quotes are calculated as (100 - annualized LIBOR in percent)
the minimum price change is one "tick," which is a price change of 0.0001 = 0.01 %
Treasury Bonds
traded for T-bonds with a maturity of 15 years or more
the contract is deliverable with a face value of $100,000
T-bond futures are quoted as a percent and fractions of 1 % (measured in 1/32nds) of face value
each bond is given a conversion factor (multiplier) that is used to adjust the long's payment at delivery
Stock index futures
based on the level of an equity index
most popular stock index future is the S&P 500
settlement is in cash and is based on a multiplier of 250
Currency Futures In the United States, currency contracts trade on the euro, Mexican peso, and yen, among others
Treasury Bill Futures Pricing
Treasury bill (T-bill) futures contracts are based on a $1 million face value 90-day (13-week) T-bill, and they settle in cash
The price quotes are 100 minus the annualized discount in percent on the T-bills
T-bill futures are priced using the no-arbitrage principle
PRICING EURODOLLAR FUTURES,
TREASURY BOND FUTURES, STOCK
INDEX AND CURRENCY FUTURES
Eurodollar futures
Eurodollar futures are priced as a discount yield, and LIBOR-based deposits are priced as an add-on yield
=> The result is that the deposit value is not perfectly hedged by the Eurodollar contract
=> Eurodollar futures can't be priced using the standard no-arbitrage framework
Treasury Bond Futures
The no-arbitrage futures price for a T-bond contract
FVC: the future value of the coupon payments
The futures price that insures a cash-and-carry arbitrage would provide no profit is lower than
without the cash flows Because the cost to hold the asset is reduced by the asset cash flows
T-bond futures prices must be adjusted to conform to the price for
the bond that is cheapest to deliver, using its conversion factor (CF)
Stock futures
The no-arbitrage futures price adjusted for the future value of
the dividends (FVD) or present value of the dividends (PVD)
Equity Index Futures
The no-arbitrage futures price
Currency Futures
The price of currency futures DC = domestic currency
FC = foreign currency
In continuous time it is
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19. 49. Option Markets and
Contracts: An Overview
PUT-CALL PARITY FOR EUROPEAN OPTIONS
SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK
ONE- AND TWO-PERIOD BINOMIAL MODELS TO
CALCULATE AND INTERPRET PRICES OF INTEREST
RATE OPTIONS AND OPTIONS ON ASSETS
ASSUMPTIONS UNDERLYING THE
BLACK-SCHOLES-MERTION MODEL
A CHANGE IN THE VALUE OF EACH INPUT AFFECTS THE OPTION
PRICE (UNDER THE BLACK-SCHOLES-MERTION MODEL)
THE DELTA OF AN OPTION AND
ITS USE IN DYNAMIC HEDGING
EFFECT OF THE UNDERLYING ASSET'S CASH
FLOWS ON THE PRICE OF AN OPTION
THE HISTORICAL AND IMPLIED
VOLATILITIES OF AN UNDERLYING ASSET
PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONS
AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS
AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS
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20. 49. Option Markets
and Contracts - Part 1
PUT-CALL PARITY FOR EUROPEAN OPTIONS
A fiduciary call
A long position in a European call option with an exercise price of X that matures in T years on a stock (with a price at time t of S t)
A long position in a pure-discount riskless bond that pays X in T years
A protective put
A long position in a European put option with an exercise price of X that matures in T years
A long position in the underlying stock
SYNTHETIC CALL/PUT OPTION,
BOND AND UNDERLYING STOCK
That the cost of a fiduciary call must be equal to the cost of a protective up
+: long position
- : short position
A synthetic European
call option is formed by
Buying a European put option on the same stock with the same exercise price (X) and the same maturity (T)
Buying the stock
Shorting (i.e., borrowing) the present value of X worth of a pure-discount riskless bond
A synthetic European
put option is formed by
Buying a European call option
Shorting the stock
Buying (i.e., investing in) the discount bond
A synthetic stock
position is formed by
Buying a European call option
Shorting (i.e., writing) a European put option
Buying (i.e., investing in) the discount bond
A synthetic pure-discount
riskless bond is created by
Buying a European put option
Buying the stock
Shorting (i.e., writing) a European call option
Two reasons to create synthetic
positions in the securities
To price options by using combinations of other instruments with known prices
To earn arbitrage profits by exploiting relative mispricing among the four securities
Using put-call parity for arbitrage
If put-call parity doesn't hold (if the cost of a fiduciary call does not equal the cost of a protective
put), buy (go long in) the underpriced position and sell (go short) in the overpriced position
ONE- AND TWO-PERIOD BINOMIAL
MODELS TO CALCULATE AND
INTERPRET PRICES OF INTEREST RATE
OPTIONS AND OPTIONS ON ASSETS
One-Period Binomial Model
D=risk-neutral probability of an down-move = 1 - U
Rf = risk-free rate
U = size of an up-move
D = size of a down-move
Calculate the value of
an option on the stock
Calculating the payoff of the option at maturity
in both the up-move and down-move states
Calculating the expected value of the option in one year as
the probability-weighted average of the payoffs in each state
Discounting the expected value back to today at the risk-free rate
Arbitrage with one-period
binomial model
provides the information required to calculate a hedge ratio
(the fractional share of stock in the arbitrage trade)
Two-Period Binomial Model
Steps to value
an option
Calculate the stock values at the end of two periods (there are three possible outcomes
because an up-then-down move gets you to the same place as a down-then-up move)
Calculate three possible option payoffs at the end of two periods
Calculate the expected option values at the end of two
periods (t = 2) using the up-and down-move probabilities
Discount the expected option values (t = 2) back one period at the risk-free
rate to find the option values at the end of the first period (t = 1)
Calculate the expected option value at the end of one
period (t = 1) using up-and down-move probabilities
Discount the expected option value at the end of one period (t = 1)
back one period at the risk-free rate to find the option value today
Binomial interest
rate trees
is the set of possible interest rate paths that are used to value bonds with a binomial model
the underlying rule governing the
construction of an interest rate tree
the values for on-the-run issues
generated using an interest rate tree
should prohibit arbitrage opportunities
the interest rate tree must maintain the interest
rate volatility assumption of the underlying model
Options on Fixed
Income Securities
There are three basic steps to valuing an option
on a fixed-income instrument using a binomial tree
price the bond at each node using projected interest rates
calculate the intrinsic value of the option at each node at maturity of the option, and
calculate the value of the option today
Options on Interest Rates:
Caps and Floors
The value of an interest rate cap or floor is the sum of the values of the individual caplets or floorlets
Expiration value of caplet
Expiration value of floorlet
As the period covered by a binomial model is divided into arbitrarily small, discrete time periods, the model results converge to those of the continuous-time model
ASSUMPTIONS UNDERLYING THE
BLACK-SCHOLES-MERTION MODEL
The Black-Scholes-Merton (BSM) model values options in continuous time and is derived from the same no-arbitrage assumption used to value options with the binomial model
To derive the BSM model, an "instantaneously" riskless portfolio is used to solve for the option price based on the same logic
Assumptions and Limitations
The price of the underlying asset follows a lognormal distribution
The (continuous) risk-free
rate is constant and known Limitation: The BSM model is not useful for pricing options on bond prices and interest rates
The volatility of the underlying
asset is constant and known
In practice, the volatility is not known and must be estimated. The bigger problem is that
volatility is often not constant over time and the BSM model is not useful in these situations
Markets are "frictionless" Model is less realistic and less useful
The underlying asset generates no cash flows
The BSM model can be easily altered if we relax the
assumption of no cash flows on the underlying asset
The options are European
The model does not correctly price American options. Binomial option
pricing models are more appropriate for pricing American options
The formula for the BSM model
Use put-call parity to calculate the put value
Put-call parity for European options
49. Option Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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21. 49. Option Markets
and Contracts - Part 2
A CHANGE IN THE VALUE OF
EACH INPUT AFFECTS THE
OPTION PRICE (UNDER THE
BLACK-SCHOLES-MERTION
MODEL)
A Greek is a sensitivity factor that captures the relationship between each input (asset
price, asset price volatility, time to expiration, and the risk-free rate) the option price
Delta describes the relationship between asset price and option price
Vega measures the sensitivity of the option price to changes
in the volatility of returns on the underlying asset
Rho measures the sensitivity of the option price to changes in the risk-free rate
Theta measures the sensitivity of the option price to the passage of time
theta is less than zero: as time passes and the option
approaches the maturity date, its value decreases
THE DELTA OF AN OPTION AND
ITS USE IN DYNAMIC HEDGING
Delta is the change in the price of an option for a one-unit change in the price of the underlying security C = change in the price of the call over a short time interval
S = change in the price of the underlying stock over a short time interval
Use BSM model to estimate the change in the value of the call
given the change in the value of the stock and the option's delta
C N(d1) x S
P (change in put price) [N(d1) - 1] x S
Interpreting Delta
A call option delta is between
0 and 1. If the call option is
Out-of-the-money (stock price is less than exercise price), the call delta moves
closer to 0 as time passes, assuming the underlying stock price doesn't change
In-the-money (stock price is greater than exercise price), the call delta moves
closer to 1 as time passes, assuming the underlying stock price doesn't change
A put option delta is between
-1 and 0. If the put option is
Out-of-the-money (stock price is greater than exercise price), the put delta moves
closer to O as time passes, assuming the underlying stock price doesn't change
In-the-money (stock price is less than exercise price), the put delta moves
closer to -1 as time passes, assuming the underlying stock price doesn't change
Dynamic Hedging
The goal of a delta-neutral portfolio (or delta-neutral hedge) is to combine a long position in a stock with a short
position in a call option so that the value of the portfolio does not change when the value of the stock changes
Number of call options needed to delta hedge = number of shares hedged/delta of call option
Number of put options needed to delta hedge = number of shares/delta of the put option
The delta-neutral position only holds for very small changes in the value of the underlying stock
=> must be continually rebalanced to maintain the hedge (a dynamic hedge)
costly in terms of transaction costs
Gama effect
Gamma measures the rate of change in delta as the underlying stock price changes
can be viewed as a measure of how poorly a dynamic hedge will perform
when it is not rebalanced in response to a change in the asset price
Call and put options on the same underlying asset with the same exercise price and time to maturity will have equal gammas
Long positions in calls and puts have positive gammas
Gamma is largest when a call or put option is at-the-money and close to expiration
EFFECT OF THE UNDERLYING
ASSET'S CASH FLOWS ON
THE PRICE OF AN OPTION
All else equal, the existence of cash flows on the underlying asset will
Decrease the value of a call option
Increase the value of a put option
Put-call parity for options on underlying assets with cash flows by adjusting S for the present value of the cash flows (PVCF)
THE HISTORICAL AND
IMPLIED VOLATILITIES OF
AN UNDERLYING ASSET
The steps in computing historical volatility for use as an
input in the BSM continuous-time options pricing model are
Step 1: Convert a time series of N prices to returns
Step 2: Convert the returns to
continuously compounded returns
Step 3: Calculate the variance and standard
deviation of the continuously compounded returns
Implied volatility is the value for standard deviation of continuously compounded
rates of return that is "implied" by the market price of the option
when used in the Black-Scholes formula, it produces the current market price of the option
PUT-CALL PARITY FOR
FORWARD/FUTURES OPTIONSPut-call parity for options on forwards and futures is as follows
American options on futures are more valuable than European options because early exercise provides mark to market funds on the futures, which can earn interest
Americans and European options on forward contracts are equivalent because there is no mark to market
AMERICAN/EUROPEAN OPTIONS
ON FUTURES AND FORWARDS
AND APPROPRIATE PRICING
MODEL FOR EUROPEAN OPTIONS
There is a benefit to early exercise of options on futures when they are deep in the money
Exercising the option (either a put or call) early will generate cash from the mark to market => cash can earn
interest, while the futures position will gain or lose from movements in the futures price => these price
movements between early exercise and option expiration will mirror those of the deep in the money option
With no reason for early exercise, the value of American
and European options on forwards are the same
There is no mark to market on forwards, early exercise does not accelerate the payment of any gains
The Black model can be used to price European options on forwards and futures
= standard deviation of returns on the futures contract
FT = futures price
American options on futures are more valuable
than comparable European options because
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