All CFA Institute members and candidates are

required to comply with the Code and Standards

Basic structure for enforcing
the Code and Standards

The CFA Institute Bylaws

Based on two
primary principles

Rules of Procedure

Fair process to member and candidate

Confidentiality of proceedings

Maintains oversight and responsibility

The CFA Institute
Board of Governors

Structure of the CFA

Institute Professional
Conduct Program

Professional Conduct
program (PCP)
The CFA Designated
Officer

Is responsible for the

enforcement of the
Code and Standards

Through the Disciplinary

Review Committee (DRC)

Directs professional conduct staff

Conducts professional
conduct inquiries

Selfdisclosure
An inquiry can be prompted
by several circumstances

Written complaints
Evidence of misconduct
Report by a CFA exam proctor
Analysis of exam materials and monitoring
of social media by CFA Insitute

a.

The Professional
Conduct staff conducts
an investigation that
may include

Requesting a written explanation

from the member or candidate
The member or candidate
Interviewing

Complaining parties
Third parties

Collecting documents and records in support of its investigation

1. Code Of Ethics And

Standards Of
Professional Conduct

Conclude the inquiry with no disciplinary sanction

Process for the enforcement

of the Code and Standards

When an
inquiry is
initiated

Issue a cautionary letter

If finding that a violation of
the Code and Standards
occurred, the Designated
Officer proposes a
disciplinary sanction

Upon reviewing the

material obtained during
the investigation, the
Designated Officer may
Continue proceedings
to discipline the
member or candidate

Rejected by member

Integrity of investment profession &

interest of clients above personal interest

Six components of
the Code of Ethics

Care & judgment

Practice ethics & encourage others to practice
Integrity & viability of the global capital markets
Professional competence

b,c.

Professionalism
Integrity of Capital markets
Duties of Clients

Seven Standards of
Professional Conduct

Duties to Employers
Investment analysis, Recommendations & Actions
Conflict of interest
Responsibilities as a CFA Institute
member or CFA Candidate

1. Code Of Ethics And Standards Of Professional Conduct - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

The matter is referred to a

hearing by a panel of CFA
Institute members

condemnation by the member's peers

If sanction is imposed

Act with integrity, competence, diligence,

respect and in an ethical manner

Accepted by member

suspension of candidate's continued

participant in the CFA program

Understand and comply with

applicable laws and regulations
Code and Standards vs. Local law

Follow stricter law and regulation

Responsible for violations in which they

knowingly participate or assist
Dissociate from illegal,
unethical activities

Guidance

Leave employers (in extreme case)

Attempt to stop the behavior by bringing it to the attention of
employer through a supervisor or compliance department

Participation or association
with violations by others

May consider directly confronting

the involved individuals

Intermediate steps

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

A. Knowledge
of the law

Not required reporting violations to government, CFAI,

but advisable in some cases or required by laws in others
Stay informed
Review procedures
Members and
candidates

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

Recommended
procedures for
compliance (RPC)

Develop and/or adopt a code of ethics

Firms

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
Maintain independence and
objectivity in professional activities

External
pressures

By benefits

Gifts, Invitations to lavish

functions, Tickets, Favors, Job referrals,
Allocation of shares in oversubscribed IPOs...

May try to pressure sellside analysts

From Buyside clients

From their
own firms
Internal
pressures
How to cope with external and
internal pressures

To issue favorable reports

From public companies

e.g. to issue favorable research reports/

recommendations for certain companies
to issue favorable research on current or
prospective investmentbanking clients

Investmentbanking
relationships

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

Guidance

convey true opinions

-->

Recommendations must

B. Independence
and objectivity

free of bias from pressures

be stated in clear
and unambiguous language

Portfolio managers must respect and

foster honesty of sellside research
Is fraught with conflicts

2.1 Standard I
PROFESSIONALISM

Must engage in thorough,

independent, and unbiased analysis
Must fully disclose potential conflicts,
including the nature of compensation
Issuerpaid research

Must strictly limit the type of compensation

they accept for conducting research

Analysts

Accept only flat fee for their

work prior to writing the report
Best practice

Without regard to conclusions

or recommendations

Protect integrity of opinions

Create a restricted list
Restrict special cost arrangements
Limit gifts

RPC

Equity IPOs

Restrict employee investments

Private placements

Review procedures
Written policies on independence
and objectivity of research
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
qualifications or credentials, services
performance record

Guidance

Must not misrepresent

any aspect of practice, including

Without regard to conclusions or

recommendations
characteristics of an investment
any misrepresentation relating to
member's professional activities

C. Misrepresentation

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
Written list of available services, description of firm's qualification
Designate employees to speak on behalf of firm

RPC

Prepare summary of qualifications and experience,

list of services capable of performing
Maintain copies
To avoid plagiarism

Attribute quotations
Attribute summaries

Address conduct related to professional life

Any act involving lying, cheating, stealing, other dishonest conduct that
reflects adversely on member's professional activities would be violation

Guidance

D. Misconduct

Violations

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

Develop and/or adopt a code of ethics

RPC

Disseminate to all employee a list of potential violations

Check references of potential employees

2.1 Standard I PROFESSIONALISM - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

its significant impact to the price

of security if it is disclosed

Definition of "Material
nonpublic information"

The reliability of the information

Non-public until

Guidance

Reasonable investors would like

to know for making decision

Material information

disseminated to the market place and

effficient time for investors to react

Must be particularly aware of info

selectively disclosed by corporations
Analysis of Public info + nonmaterial
nonpublic info --> Investment conclusion
Mosaic
Theory

Analysts are free to act on this collection

of info without risking violation
Analysts should save and
document all their research

A. Material non-public
information (MNI)

Make reasonable efforts to achieve

public dissemination of material info
Must communicate the info only to the designated
supervisory and compliance personnel within the firm

If public dissemination
is not possible,

Must not take investment action on the basis of the info

Must not knowingly engage in conduct

inducing insiders to privately disclose MNI

2.2 Standard II
INTEGRITY OF
CAPITAL MARKETS

adopt compliance procedures

preventing misuse of MNI

RPC
Encourage firms to

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

Definition

Distort prices or artificially inflate trading volume

with the intent to mislead market participants

transactions that deceive

market participants

B. Market
manipulation

can be related to
dissemination of false
or misleading info

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
including spreading false rumors
to induce trading by others

prohibit legitimate trading strategies

Standard II(B) not meant to

prohibit transactions done for tax purposes

The intent of action is critical to determining

whether it is a violation of this Standard
2.2 Standard II INTEGRITY OF CAPITAL MARKETS - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

To be continued
For MORE CFA Mind Maps, please go to:

to:[Link]

Describe limitations of regression analysis

A sample covariance, a sample correlation coefficient and a scatter plot

Describe the use of analysis of variance (ANOVA) in regression analysis,
interpret ANOVA results, and calculate and interpret the F-statistic

Limitation to correlation analysis

Calculate and interpret a confidence interval for

the predicted value of the dependent variable

Calculate the predicted value for the dependent variable, given an

estimated regression model and a value for the independent variable

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 and interpret the standard error of

estimate, the coefficient of determination, and a
confidence interval for a regression coefficient

9. Correlation and Regression - An Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Uses of correlation Analysis

9. Correlation and
Regression - An Overview

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

A graph that shows the relationship between the observations for two data series in two dimensions

Scatter Plots

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 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 less than 0 indicates a negative linear association

A sample covariance, a sample

correlation coefficient and a scatter plot

Correlation Analysis

A correlation coefficient can

have a maximum value of 1
and a minimum value of -1

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

The sample covariance of X and Y, for a sample of size n

Calculate the Correlation Coefficient

The expression for the sample variance of X, is

The sample correlation coefficient

9. Correlation and
Regression - Part 1

Correlation may be an
unreliable measure when

Two variables can have a strong nonlinear

relation and still have a very low correlation

Limitation to correlation analysis

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
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

Spurious correlation

correlation between two variables arising not from a direct

relation between them but from their relation to a third variable

In investment decision-making (for example: inflation forecast)

Uses of correlation Analysis

Correlation of stock market tells us how successfully the assets can be combined to diversify risk
Used in a financial statement setting
H0: the correlation in the population is 0 (p = 0)
Ha : the correlation in the population is different from 0 (p # 0)

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

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

9. Correlation and Regression - Part [Link] - 4/28/2016 - Mindjet

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

b0, b1 are the regression coefficients

Y: dependent variable
X: independent variable
b0: the intercept
b1: a slope coefficient

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 regression equation

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
The
X is
and
The

Describe the assumptions

underlying linear regression and
interpret regression coefficient

relationship between the dependent variable, Y, and the independent variable,

linear in the parameter b0 and b1. b0 and b1 are raised to the first power only
that neither b0 nor b1 is multiplied or divided by another (for example, b0/b1).
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

Ensure that linear regression
produces the correct
estimates

The expected value of the error term is 0

Six classic normal linear
regression model assumptions

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.

use the linear regression model to determine

the distribution of the estimated parameters
and and thus test whether those coefficients
have a particular value

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

defined as the percentage of the total variation in the dependent variable explained by the independent variable
The coefficient of determination (R^2)

R^2 = r^2 for a regression with one independent variable

Confidence interval spans the range

Regression coefficient confidence interval

A confidence interval is an interval of values that we believe includes the true parameter value, , with a given degree of confidence

the estimated parameter value

A hypothesis test using the confidence interval approach if we know

9. Correlation and
Regression - Part 2

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

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

Where sf = standard eror of the forecast

The prediction interval for a regression equation for a

particular predicted value of the dependent variable Y

Calculate and interpret a confidence interval for

the predicted value of the dependent variable

tc is two-tailed critical t-value at the desired level of significance with df = n-2

variance of the residuals = the square of the standard error of estimate

The formula to calculate sf

variance of the independent variable

X

value of the independent variable for which the forecast was made

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

SSE (The sum of squared errors or residuals)

Describe the use of analysis of variance (ANOVA)

in regression analysis, interpret ANOVA results,
and calculate and interpret the F-statistic

Formula for the F-statistic in a regression

with one independent variable is

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

9. Correlation and Regression - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Introduction

29. Equity Valuation:

Applications and Processes An Overview

Value Definition and

Valuation Applications

Communicating Valuation Results

The Valuation Process

29. Equity Valuation. Applications and Processes - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Valuation

The estimation of an assets value based on variables perceived to be related to future investment
returns, on comparisons with similar assets, or on estimates of immediate liquidation proceeds
What is value?

Introduction

Who uses equity valuations?

Basic questions

What is the importance of industry knowledge?

How can the analyst effectively
communicate his analysis?
The value of the asset given a hypothetically complete
understanding of the assets investment characteristics
Reflects investor's view of the true or real value of an asset
Market price and intrinsic
value are identical
Grossman-Stiglitz paradox

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

Rational efficient
markets formulation
Common stock
Trading costs exist

Difficult to determine especially

Further room exists for price to diverge from value

Seek to identify mispricing

Analysts often view market prices both

with respect and with skepticism

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

Intrinsic Value

Uncertainty is
constantly present

Valuation is an inherent part to attempt positive

excess
risk adjusted returns (abnormal return or alpha)

Revaluate by looking for the presence of a

particular market or corporate event ( catalyst)

The error in the estimate of the intrinsic value

(V E -V): the difference between the valuation

estimate and the true but unobservable intrinsic value

VE = estimated value
V E - P = (V - P) + ( V E - V)

P = market price
V = intrinsic value

Definition

Contribute to the abnormal return

(V-P): the true mispricing, the difference between the true but
unobservable intrinsic value V and the observed market price P

Combine accurate forecasts and

appropriate valuation model

A useful estimate
of intrinsic value

Active security selection

Managers expectations must differ from

consensus expectations and be correct

Expectational inputs used in valuation models

The assumption that the company will continue

its business activities into the foreseeable future

accessing its optimal sources of financing

not appropriate for a company in financial distress

Going-concern assumption
Value Definition and
Valuation Applications

value maximizing using assets

The value added by assets working together and by human capital applied to managing
those assets makes estimated goingconcern value greater than liquidation value

Going-Concern Value and Liquidation Value

Orderly liquidation value

Liquidation value
Different time frame for liquidating causes different assets value of a company
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

Fair market value

often used in valuation related to assessing taxes

Fair Market Value and Investment Value

The concept of value to a specific buyer taking account of potential

synergies and based on the investors requirements and expectations

Investment value
Selecting stocks

Primary use
evaluate the reasonableness of the expectations

Inferring (extracting ) market expectations

A merger

as a benchmark or comparison value of the same characteristic for another company

the general term for the combination of two companies
a combination of two companies, with one of the companies
identified as the acquirer, the other the acquired

An acquisition

29. Equity Valuation:

Applications and Processes
- Part 1

Evaluating corporate events

the company separates one of its component businesses and transfers

the ownership of the separated business to its shareholders

A leveraged buyout

Rendering fairness opinions

affects a companys future cash flows -> equity

a company sells some major component of its business

A divestiture

A spin-off

Valuation Applications

the acquiring companys own common stock

is often used as currency for the purchase

an acquisition involving significant leverage [i.e., debt], which is

often collateralized by the assets of the company being acquired.)

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)

the basis for computing the target
When a research report states a
target price for a stock, it should
clarify

information on the uncertainty of reaching the target

a time frame for reaching the target
An update on the companys
financial and operating results

Kind of infor. intended readers seek to gain

Sell-side analysts report:

investment recommendation

Persuasive supporting
arguments

The intrinsic value

of the security

The key assumptions and

expectations underlying that
estimated intrinsic value

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

May be accompanied by an explanation of the underlying rationale

Specific forecasts
Contents of a Research Report

A description of the valuation model

Usual contents

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

An effective research report

Communicating Valuation Results

distinguishes clearly between facts and opinions

contains analysis, forecasts, valuation, and a recommendation that are internally consistent

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

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

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

Research Reporting Responsibilities

The analyst must hold himself accountable to both standards of competence and standards of conduct

29. Equity Valuation. Applications and Processes - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Sell-side analyst: Analysts

who work at brokerage firms
Investment discipline (security
selection) and quantitative
investment disciplines

Valuation judgments to distribute to current and

prospective retail and institutional brokerage clients
is to understand the basic characteristics of the markets served by a company and the economics of the company

Valuation judgments to a portfolio manager or to an

investment committee as input to an investment decision

Buy-side analysts

The purposes and the intended

consumer of the valuation

Both corporate analysts and investment bank analysts may also

identify and value companies that could become acquisition targets

give appropriate attention to

the most important economic
drivers of a business
Usefulness

Applying the Valuation Conclusion:

The Analysts Role and Responsibilities

to organize thoughts about an industry and to better understand a companys

prospects for success in competition with other companies in that industry
to highlight the greatest challenges and opportunities

How attractive are the industries in which

the company operates, in terms of offering
prospects for sustained profitability

Analysts at independent vendors of financial information usually offer

valuation information and opinions in publicly distributed research reports
Help their clients achieve their investment objectives
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

Benefit the suppliers of capital, including shareholders, when

they are effective monitors of managements performance
E.g when assess how a change in assumptions about a companys
future growth or analyze how different competitive responses
would affect the forecasted financials and the estimated valuation

to determine how changes in an assumed

input would affect the outcome

the value of a stock investment

the value of nonpublicly traded stocks

Industry and
Competitive Analysis

How is a useful
framework? Focus
on these questions

Sensitivity analysis

lack of marketability discounts

Two important aspects

Converting Forecasts
to a Valuation

Need sensitivity
analysis

Analysis of Financial Reports

Sources of Information

Historical analysis to have

its insights through time

Looking annual reports

for 10, 5, 2 years prior

importance of qualitative (non-numeric factors)

avoid simply extrapolating past operating
results when forecasting future performance

Financial ratio analysis is useful for established companies

Individual drivers of profitability for merchandising and manufacturing companies
can be evaluated against the companys stated strategic objectives

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
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
Quality of earnings analysis

The fundamental
approach to
equity valuation

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

Present value models

(discounted CF models)

comparison of a companys net

income with its operating cash flow

Poor quality of accounting disclosures, such as segment information, acquisitions,

accounting policies and assumptions, and a lack of discussion of negative factors.

Understanding the business

Absolute Valuation Models

Existence of relatedparty transactions

Greater uncertainty than

the case with bonds due to

Existence of excessive officer, employee, or director loans

29. Equity Valuation:

Applications and Processes Part 2: The Valuation Process

A stream of cash payments specified in

a legal contract (the bond indenture)
Not as uncertain as common stock

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

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

Applied to bond valuation

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.

Values a company on the basis of the market

value of the assets or resources it controls

Can provide an independent estimate of value

Analyzing the companys financial

report to evaluate the company's
strategic objectives' performances
and develop expectations to it

Regulatory requirements concerning disclosures and filings vary internationally

Def. a model that specifies an assets intrinsic value

For common
stock: Dividend
discount models

A discount rate can usually be based on

market interest rates and bond ratings

The term business model refers

generally to how a company makes
money

Analysts can compare the information provided directly

by companies to their own independent research

Analysts frequently
define cash flows at
the company level

Residual income model

need to address other issues, such as

the value of corporate control or the
value of unused assets

Differentiation
Focus

most relevant for evaluating a companys

success in implementing strategic choices

illiquidity discounts

Free cash flow

to equity model

its CFs and discount rate

Cost leadership
Corporate strategies

2 caveats merit mention

The value of an asset to an investor must be related to the

returns that investor expects to receive from holding that asset.

Based on accrual accounting

earnings in excess of the opportunity
cost of generating those earnings

The level and trend of the companys market share indicate

its relative competitive position within an industry

How well has the company

executed its strategy and what are
its prospects for future execution

blockage factor

used to produce an estimate of value that can

be compared with the assets market price

Free cash flow

to the firm

Porter 5 forces

Situational adjustments

an investor wishes to sell an amount of stock that is large relative to that stocks
trading volume (assuming it is not large enough to constitute a controlling ownership)

Defines cash flows before those payments

Use various
frameworks

What is the companys

relative competitive position
within its industry, and what
is its competitive strategy

control premiums

the prices of shares with less depth to their markets

Defines cash flow net of

payments to providers of debt

Try to understand the industry structure

Stay current on facts and news concerning all the industries

Contribute to the efficient functioning of capital markets

The price that would be lower than the

market price for a smaller amount of stock

need more sensitivity analysis ?

Economic, industry, or companyspecific pressures on profitability,

such as loss of market share or declining margins

Asset- based valuation

Management pressure to meet debt covenants or earnings expectations

Underlying idea: similar assets should sell at similar prices

Undervalue

P/E

Relatively undervalue

A history of securities law violations, reporting violations, or persistent late filings

Def. estimate an assets value relative to that of another asset

ratios of stock price to a fundamental

such as cash flow per share

Considerations in Using
Accounting Information

using price multiples

How?

ratios of the total value of common stock and debt net of cash and shortterm investments
to certain of a companys operating assets to a fundamental such as operating earnings

enterprise multiples

The more conservative investing strategies involve overweighting (underweighting)

relatively undervalued (overvalued) assets, with reference to benchmark weights
Pairs trading: buying the relatively undervalued
stock and selling short the relatively overvalued stock

Relative value investing (or relative spread

investing, if using implied discount factors)

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
Breakup value or
private market value

The more aggressive strategies allow short

selling of perceived overvalued assets

The method of comparables is characterized by

a wide range of possible implementation choices

The value derived using a

sum-of-the-parts valuation

Selecting the Appropriate Valuation Model

Relative Valuation Models

Frequently involve a group

of comparison assets

Sums the estimated values of each of the

companys businesses as if each business
were an independent going concern

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

When to use
Sum-of-the-parts
valuation

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

inefficiency of internal capital markets

endogenous factors

Alternative explanation

Valuation of the Total Entity

and Its Components

Conglomerate discount

research measurement errors

A breakup value in excess of a companys unadjusted goingconcern
value may prompt strategic actions such as a divestiture or spin-off
understanding the nature of its assets and
how it uses those assets to create value

having a good understanding

of the business

Forecasting Company Performance

consistent with the characteristics
of the company being valued

appropriate given the availability and quality of data

Approach moves from international and national macroeconomic forecasts

to industry forecasts and then to individual company and asset forecasts

Two perspectives

Bottom-up forecasting

Approach aggregates forecasts at a micro level to larger scale forecasts, under specific assumptions

The companys own operating and financial characteristics

Criteria for model selection are

that the valuation model be

consistent with the purpose of valuation, including the analysts perspective

Top-down forecasting
The economic environment

Issues in Model Selection

and Interpretation

Professionals frequently use multiple valuation

models or factors in common stock selection

29. Equity Valuation. Applications and Processes - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Consider qualitative as well as quantitative factors

To be continued
For MORE CFA Mind Maps, please go to:

to:[Link]

INTRODUCTION

PRIVATE MARKET REAL ESTATE DEBT

REAL ESTATE INVESTMENT: BASIC FORMS

INDICES

VALUATION IN AN INTERNATIONAL CONTEXT

DUE DILIGENCE

39. Private Real

Estate Investments:
An Overview

RECONCILIATION

THE INCOME APPROACH TO VALUATION

39. Private Real Estate Investments - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

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

INTRODUCTION

often included in the portfolios of investors with long-term investment

horizons and with the ability to tolerate relatively lower liquidity

Private equity investment: sometimes

referred to as direct ownership

suitable for investors with short investment horizons and higher liquidity needs

Publicly traded debt investment:

sometimes referred to as indirect lending

The first dimension: whether the investment

is made in the private or public market
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 second dimension: whether the investment

is made in the private or public market

REAL ESTATE INVESTMENT:

BASIC FORMS
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
Heterogeneity and fixed location
High unit value
Management intensive
High transaction costs
Characteristics

Depreciation
Need for debt capital
Illiquidity :
Price determination
Single-family properties may be
owner-occupied or rental properties

REAL ESTATE: CHARACTERISTICS

AND CLASSIFICATIONS

Residential properties: single-family houses

and multi-family properties, properties that
provide housing for individuals or families

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

Classifications

Properties purchased with the

intent to let, lease, or rent

Office

Non-residential properties include commercial properties

other than multifamily properties, farmland, and timberland

Industrial and warehouse

Retail
Hospitality
Other types

Current income
Price appreciation (capital appreciation)
Motivations

Inflation hedge
Diversification
Tax Benefits
Business conditions
Long lead time for new development
Cost and availability of capital
Unexpected inflation
Characteristic sources of risk or risk
factors of real estate investment

Demographics
Lack of liquidity
Environmental

Risk Factors

Availability of information
Management
Leverage

39. Private Real Estate

Investments - Part 1

Other risk factors

PRIVATE MARKET REAL ESTATE

EQUITY INVESTMENTS

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

Real Estate Risk and Return

Relative to Stocks and Bonds

The demand for office depends heavily on employment growth

The average length of an office building lease varies globally

Office

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

Commercial Real Estate

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

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
Retail

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 tenants sales
and the basis for calculating percentage rent once the tenants sales reach a certain level or breakpoint
The demand for multi-family
space depends on

Multi-Family

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 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
Physical deterioration related to the age
of the property because components of the
property wear out over time. Two types
The Cost Approach

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

Types of depreciation

External obsolescence: due to either the location of

the property or economic conditions, results when
the location is not optimal for the property

THE COST AND SALES COMPARISON

APPROACHES TO VALUATION

The Sales Comparison Approach

depreciated replacement cost

curable: fixing the problem will add value that

is at least as great as the cost of the cure

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 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

Appraisals (estimates of value) are critical for such infrequently traded and unique assets as real estate properties
Market value: can be thought of as the most probable sale price. It is what a
Appraisals

Value

There are other definitions of value

that differ from market value

OVERVIEW OF THE VALUATION

OF COMMERCIAL REAL ESTATE

typical investor is willing to pay for the property

Investment value: the value to a particular investor, could be higher or lower than market
value depending on the particular investors motivations and how well the property fits into the
investors portfolio, the investors risk tolerance, the investors tax circumstances, and so on.
Value in use: the value to a particular user

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
Three different approaches
Introduction to
Valuation Approaches

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

39. Private Real Estate Investments - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

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 direct capitalization method

There are two income approaches

applies an explicit growth rate to construct an NOI

stream from which a present value can be derived

the DCF method

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

General Approach and

Net Operating Income

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 cap rate is like a current yield for the property whereas
the discount rate is applied to current and future NOI

The Capitalization Rate and the Discount Rate

Cap rate = Discount rate - Growth rate

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

Cap rate = NOI/Value

Defining the Capitalization Rate

Value = NOI/Cap rate
The Direct Capitalization Method

terminal cap rate is based on expected income for

the year after the anticipated sale of the property
observing what other similar or comparable
properties are selling for to know the cap rate

Cap rate = NOI/Sale price of comparable

ARY: all risks yield

Market value = Rent/ARY

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
Gross income multiplier: the ratio of the sale price to the gross
income expected from the property in the first year after sale

Other Forms of the Income Approach

The Relationship between

Discount Rate and Cap Rate
THE INCOME APPROACH
TO VALUATION

The problem of gross income multipler: not explicitly

consider vacancy rates and operating expenses

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 periods NOI is discounted to arrive at a value of the property
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 Capitalization Rate

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

The Discounted Cash

Flow (DCF) Method

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

Lease structures vary across locales and can have an effect

on the way value is typically estimated in a specific locale

Adapting to Different Lease Structures

The equivalent yield is a single discount rate that could be applied

mathematically to both income streams that would result in the same value

The Equivalent Yield

Project income from existing leases

Make assumptions
about lease renewals

The general s teps to a DCF

analysis are as follows

Assumptions also have to be made about what will happen when a lease
comes up for renewaloften 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)
Advanced DCF:
Lease-by- Lease Analysis

39. Private Real Estate

Investments - Part 2

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

The discount rate does not reflect the risk

Income growth is greater than expense growth
Common Errors

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

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
RECONCILIATION

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
To verify other facts and conditions that might affect the value of the property and that might not have been identified by the appraiser
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.

DUE DILIGENCE
E.g

Have an attorney or appropriate party review the ownership history to be sure there are no issues related
to the sellers 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

Return = {NOI

Appraisal-Based Indices

Disadvantages

Capital expenditures + (Ending market value

Appraisal lag

Beginning market value )}/Beginning market value

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

INDICES

In recent years, indices have been created that are based on actual transactions rather than appraised values
Two main ways
Transaction-Based Indices
Disadvantages

PRIVATE MARKET REAL ESTATE DEBT

A repeat sales index relies on repeat sales of the same property

A hedonic index which requires only one sale
Include random elements in the observations => may be upward or downward movements from quarter to quarter that are somewhat random

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

39. Private Real Estate Investments - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

DSCR = NOI/Debt service

PRICING EURODOLLAR FUTURES, TREASURY BOND

FUTURES, STOCK INDEX AND CURRENCY FUTURES

THE RELATION BETWEEN FUTURES

PRICES AND EXPECTED SPOT PRICES

MONETARY & NONMONETARY BENEFITS AND COSTS

ASSOCIATED WITH HOLDING THE UNDERLYING
ASSET AND THEIR EFFECTS TO FUTURES PRICE

48. Futures Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

FUTURE CONTRACTS

48. Futures Markets and

Contracts: An Overview

FUTURES PRICE & THE VALUE

OF A FUTURES CONTRACT

WHY FORWARD AND

FUTURES PRICES DIFFER

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

Similar to forward
contracts in

Both forwards and futures are priced to have zero value at the time the investor enters into the contract
Futures are marked to market at the end of every trading day. Forward contracts are not marked to market

FUTURE CONTRACTS

Futures contracts trade on organized exchanges. Forwards are private contracts and do not trade on organized exchanges
Different from
forward contracts

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

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.

Futures price must converge

to the spot price at expiration

Futures margin is a
performance guarantee

Future margins and

marking to market

Arbitrage will force the prices to

be the same at contract expiration

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

FUTURES PRICE & THE 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
Value of a
futures contract

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

The no-arbitrage price of a futures contract

48. Futures Markets

and Contracts - Part 1

FP = futures price
So = spot price at inception of the contract ( t = 0)
R f = annual risk-free rate
T = futures contract term in years

should be the same as that of a forward contract

If investors prefer the mark-to-market feature of futures, futures prices will be higher than forward prices
Cases that causes futures and
forward prices to be different

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

WHY FORWARD AND

FUTURES PRICES DIFFER

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
Borrow money for the term of the contract at market interest rates
At the initiation of the contract
Cash-and-carry arbitrage

Buy the underlying asset at the spot price

Sell (go short) a futures contract at the current futures price

Steps
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

Future arbitrage

The futures contract is overpriced if the actual market price is greater than the no-arbitrage price
When the futures price is too low (which presents a profitable arbitrage opportunity)
Sell the asset short
Reverse cash-and-carry arbitrage

At the initiation of the contract

Buy (go long) the futures contract at the market price

Steps
At contract expiration

48. Futures Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

Lend the short sale proceeds at market interest rates

Collect the loan proceeds

Take delivery of the asset for the futures price and cover the short sale commitment

Any positive costs associated with storing or holding the asset in a cash and carry arbitrage will increase the no-arbitrage futures price
E.g., Financial assets: no storage costs other than the opportunity cost of the funds

A monetary benefit from holding the asset

will decrease the no-arbitrage futures price

Convenience yield: The return from non-monetary benefits which come from holding an asset in short supply
MONETARY AND NONMONETARY
BENEFITS AND COSTS ASSOCIATED WITH
HOLDING THE UNDERLYING ASSET AND
THEIR EFFECTS TO FUTURES PRICE

net costs (NC) = storage costs - convenience yield

The no-arbitrage futures price counting net costs

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

refers to a situation where the futures price is below the spot price
Backwardation
Backwardation and contago

to occur, there must be a significant benefit to holding

the asset, either monetary or non-monetary

refers to a situation where the futures price is above the spot price
Contango

happens when there is no benefits to holding the asset, the futures price will be

The futures price might be temporarily above or below expected future

spot prices, but it would be an unbiased predictor of future spot rates

If both parties to a futures transaction are hedging existing risk,

the futures price may be equal to expected future spot prices
Normal backwardation
Normal contango

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

happens when the futures price is lower than the expected price in the future to compensate the future buyer for accepting asset price risk

happens when the futures price is greater than the expected spot price

The most likely situation in financial markets is normal backwardation

similar to a forward rate agreement to lend US$1,000,000 for three months beginning on the contract settlement date

THE RELATION BETWEEN

FUTURES PRICES AND
EXPECTED SPOT PRICES

Eurodollar

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 %
traded for T-bonds with a maturity of 15 years or more

48. Futures Markets

and Contracts - Part 2

Eurodollar, Treasury Bonds, Stock

Index, and Currency Futures

Treasury Bonds

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
based on the level of an equity index

Stock index futures

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 (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

Treasury Bill Futures Pricing

Eurodollar futures

T-bill futures are priced using the no-arbitrage principle

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

The no-arbitrage futures price for a T-bond contract

Treasury Bond Futures

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)

PRICING EURODOLLAR FUTURES,

TREASURY BOND FUTURES, STOCK
INDEX AND CURRENCY FUTURES

The no-arbitrage futures price adjusted for the future value of

the dividends (FVD) or present value of the dividends (PVD)
Stock futures

Equity Index Futures

The no-arbitrage futures price

The price of currency futures

Currency Futures

In continuous time it is

48. Futures Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

DC = domestic currency
FC = foreign currency

AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS

AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS

PUT-CALL PARITY FOR EUROPEAN OPTIONS

SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK

PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONS

THE HISTORICAL AND IMPLIED

VOLATILITIES OF AN UNDERLYING ASSET

EFFECT OF THE UNDERLYING ASSET'S CASH

FLOWS ON THE PRICE OF AN OPTION

THE DELTA OF AN OPTION AND

ITS USE IN DYNAMIC HEDGING

49. Option Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

49. Option Markets and

Contracts: An Overview

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)

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 fiduciary call

PUT-CALL PARITY FOR EUROPEAN OPTIONS

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

A protective put

That the cost of a fiduciary call must be equal to the cost of a protective up

Put-call parity for European options

+: long position
- : short position
Buying a European put option on the same stock with the same exercise price (X) and the same maturity (T)
Buying the stock

A synthetic European
call option is formed by

Shorting (i.e., borrowing) the present value of X worth of a pure-discount riskless bond
Buying a European call option

SYNTHETIC CALL/PUT OPTION,

BOND AND UNDERLYING STOCK

Shorting the stock

A synthetic European
put option is formed by

Buying (i.e., investing in) the discount bond

Buying a European call option

A synthetic stock
position is formed by

Shorting (i.e., writing) a European put option

Buying (i.e., investing in) the discount bond
Buying a European put option

A synthetic pure-discount
riskless bond is created by

Buying the stock

Shorting (i.e., writing) a European call option

Two reasons to create synthetic

positions in the securities

Using put-call parity for arbitrage

To price options by using combinations of other instruments with known prices

To earn arbitrage profits by exploiting relative mispricing among the four securities
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

D =risk-neutral probability of an down-move = 1 -

R f = risk-free rate
U = size of an up-move
D = size of a down-move
Calculating the payoff of the option at maturity
in both the up-move and down-move states

One-Period Binomial Model

Calculate the value of

an option on the stock

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

provides the information required to calculate a hedge ratio

(the fractional share of stock in the arbitrage trade)

Arbitrage with one-period

binomial model

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)

49. Option Markets

and Contracts - Part 1

Calculate three possible option payoffs at the end of two periods

ONE- AND TWO-PERIOD BINOMIAL

MODELS TO CALCULATE AND
INTERPRET PRICES OF INTEREST RATE
OPTIONS AND OPTIONS ON ASSETS

Calculate the expected option values at the end of two

periods (t = 2) using the up-and down-move probabilities

Steps to value
an option

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)

Two-Period Binomial Model

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
is the set of possible interest rate paths that are used to value bonds with a binomial model
Binomial interest
rate trees

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

There are three basic steps to valuing an option

on a fixed-income instrument using a binomial tree
Options on Fixed
Income Securities

the interest rate tree must maintain the interest

rate volatility assumption of the underlying model

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

The value of an interest rate cap or floor is the sum of the values of the individual caplets or floorlets

Options on Interest Rates:

Caps and Floors

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
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
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
Assumptions and Limitations

Markets are "frictionless"

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

Model is less realistic and less useful

The underlying asset generates no cash flows

The options are European

ASSUMPTIONS UNDERLYING THE

BLACK-SCHOLES-MERTION MODEL

The formula for the BSM model

Use put-call parity to calculate the put value

49. Option Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

The BSM model can be easily altered if we relax the

assumption of no cash flows on the underlying asset

The model does not correctly price American options. Binomial option
pricing models are more appropriate for pricing American options

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

A CHANGE IN THE VALUE OF

EACH INPUT AFFECTS THE
OPTION PRICE (UNDER THE
BLACK-SCHOLES-MERTION
MODEL)

Rho measures the sensitivity of the option price to changes in the risk-free rate

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
There is no mark to market on forwards, early exercise does not accelerate the payment of any gains

theta is less than zero: as time passes and the option

approaches the maturity date, its value decreases

American options on futures are more valuable

than comparable European options because

With no reason for early exercise, the value of American

and European options on forwards are the same

Theta measures the sensitivity of the option price to the passage of time

AMERICAN/EUROPEAN OPTIONS
ON FUTURES AND FORWARDS
AND APPROPRIATE PRICING
MODEL FOR EUROPEAN OPTIONS

The Black model can be used to price European options on forwards and futures

= standard deviation of returns on the futures contract

F T = futures price

Put-call parity for options on forwards and futures is as follows

PUT-CALL PARITY FOR

FORWARD/FUTURES OPTIONS

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

49. Option Markets

and Contracts - Part 2

Americans and European options on forward contracts are equivalent because there is no mark to market

Step 1: Convert a time series of N prices to returns

Step 2: Convert the returns to
continuously compounded returns

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

Delta is the change in the price of an option for a one-unit change in the price of the underlying security

The steps in computing historical volatility for use as an

input in the BSM continuous-time options pricing model are

THE HISTORICAL AND

IMPLIED VOLATILITIES OF
AN UNDERLYING ASSET

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

Step 3: Calculate the variance and standard

deviation of the continuously compounded returns

when used in the Black-Scholes formula, it produces the current market price of the option

Implied volatility is the value for standard deviation of continuously compounded

rates of return that is "implied" by the market price of the option

Decrease the value of a call option

Increase the value of a put option

All else equal, the existence of cash flows on the underlying asset will

EFFECT OF THE UNDERLYING

ASSET'S CASH FLOWS ON
THE PRICE OF AN OPTION

Put-call parity for options on underlying assets with cash flows by adjusting S for the present value of the cash flows (PVCF)
A call option delta is between
0 and 1. If the call option is
Interpreting Delta

A put option delta is between

-1 and 0. If the put option is

THE DELTA OF AN OPTION AND

ITS USE IN DYNAMIC HEDGING

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
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

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
Dynamic Hedging

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)

Gamma measures the rate of change in delta as the underlying stock price changes

costly in terms of transaction costs

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

Gama effect

49. Option Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS

To be continued
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