1

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1+1 Rates and Returns

Reading 1+1: Rates and Returns

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Determinants of Interest Rates Price Relatives and Continuously Compounded Returns
Interest rates viewed as a required rate of return for an The price relative is the ending price of a stock divided by
investment can be described as the real risk-free rate plus the beginning price over any time interval. It is
premiums for: St+1

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= 1 + Rt,t+1 ,
St
* inflation,
where
* default risk,
Rt,t+1
* liquidity, and

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* maturity. is the net rate of return from t to t + 1. The continuously
compounded return is calculated as the natural log of the
price relative using the starting and ending prices over the
Time-Weighted Rate of Return holding period.

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The time-weighed rate of return is calculated as a linked
series of individual holding period returns, designed to
ignore cash flows in and out of a portfolio. It is also helpful Calculating Arithmetic Mean Returns
in determining the rate of return an investment manager The arithmetic or mean return is calculated as follows:
actually earns.
re Ri1 + Ri2 + ... + RiT −1 + RiT 1 ∑
T
R̄i = = Rit
T T t=1
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Holding Period Return Formula where R signifies return and T signifies the number of
The holding period return formula gives the rate of return observations in the sample. Mean returns have the primary
on an investment. advantage of being easy to calculate and understand.
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>
Pt − Pt−1 + Dt Comparison and Applicability of Return Measures
HPRt =
Pt−1 Regarding return measures:
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When determining the return, the length of the holding

period must be taken into consideration. * Arithmetic mean returns are simple to calculate but are
biased by variation in investment and high dispersion in
returns around the mean.
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Calculating Geometric Mean Returns * Geometric mean returns correct for dispersion of returns
The geometric mean return is calculated as: around the mean but are still potentially biased by
variation in the level of investment over time.
RG = [(1 + R1 )(1 + R2 )...(1 + RT )]1/T − 1
* Money-weighted returns have the advantage of not being
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biased by variation in investment or dispersion in returns

The geometric mean is a backward-looking measure,
around the mean, but are time consuming to calculate.
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showing the mean return which would have produced the

same result as the return series. Using beginning and
ending values, it is also the discount rate in a TVM
Annualized Return from a Holding Period Return
calculation.
Considering annualized return:
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* When comparing performance of different assets it is

Calculating Harmonic Mean Returns
necessary to ensure the compared returns are realized
The harmonic mean return is calculated by averaging the
over the same horizon.
reciprocals of the returns in a dataset and then taking the
* Convention in the industry is to calculate annualized
reciprocal of the result.
returns as follows, to allow an accurate comparison of
n performance over a common horizon, where c is the
Harmonic Mean = X H = ∑n 1
i=1 Xi number of periods in a year.

This is useful for determining the average price paid for

>
something like shares of stock when investing the same
Rannual = (1 + Rperiod )c − 1
currency amount in multiple periods regardless of the
price, called ”cost averaging.”

© Mindojo, 2023
Reading 1+1: Rates and Returns 2

Gross vs. Net Return

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Regarding gross and net returns: * The money-weighted return jointly accounts for different
levels of investment in different periods and the
* For a performance measure to reflect the return realized compounding effect of sequential returns.

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by the investor, adjustment of the return measures * This contrasts the arithmetic mean return, that holds the
previously considered may be necessary. level of investment constant in each year and the geometric
* Gross and net returns are returns realized before and mean return, that assumes an initial investment only.
after (respectively) management fees and all other costs * The major drawback of the money-weighted return is it is
realized as a direct result of the investment process. complicated and time consuming to calculate.

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* Pre- and post-tax returns are returns realized before and
after the tax liability realized by the investor.
* Nominal and real returns are the returns realized before
and after adjustment for inflation.

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Introduction to Time Value of Money and Discounted
Cash Flows

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Time value of money is a method of valuing any cash flow
in any time in terms of any other time through
compounding and discounting. The language of time value
of money includes present value (PV), future value (FV), and
discount rate (r). The present value of a cash flow is always
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less than some future value of that same cash flow.
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Interpreting Interest Rates in Three Ways
Interest rates can be thought of as discount rates, interest
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rates, and opportunity costs.

* An interest rate is the rate of return that is required for
compensation when making an investment.
* A discount rate is the interest rate that equalizes the
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current value of money to a value of money in the future. It

is used to calculate a present or future value.
* An opportunity cost is the value that investors lose by
choosing a different course of action.
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Leveraged Returns: Using Borrowed Money

Regarding leveraged return:
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* Leveraged positions are investments made partially with

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the investor’s own money and partially with borrowed

money.
* Leveraged positions have the advantage of providing
higher upside potential as a larger amount of money is
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invested in the market but carry greater risk.

The leveraged return is calculated as

RP × (VE + VB ) − (VB × rD )
RL =
VE

where RL is leveraged return, RP is the return on the

investment, VE is the value of the equity provided, VB is
the amount of the borrowed funds, and rD is the interest
rate on the debt.

Money-Weighted Return or Internal Rate of Return

Regarding the money-weighted return or IRR:

© Mindojo, 2023
Reading 1+3: Statistical Measures of Asset Returns 3

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1+3 Statistical Measures of Asset Returns

Reading 1+3: Statistical Measures of Asset Returns

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Measures of Central Tendency: Arithmetic Means between two variables
Arithmetic means are a simple average. The arithmetic
mean is the sum of the value divided by the number of
Defining Dispersion and Range
observations: ∑n

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i=1 Xi Dispersion, as a concept, is variability around the central
X=
n tendency, and provides a means of quantifying risk in a
for a sample, and ∑n financial asset. The range is defined as the maximum value
i=1 Xi
µ= minus the minimum value.
n

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for a population.

Target Semideviation: Calculation and Use

The equation for target semideviation is
Measures of Central Tendency: Median and Mode

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v
The median is the value of the middle observation, or, if u ∑
u (Xi − B)2
there are an even number of observations, then it is the t
f or all Xi ≤B
n−1
midpoint between the two middle observations. The mode re
is a measure of central tendency defined as the most Target semideviation focuses on downside risk—that is,
commonly occurring value in a set of data. A bimodal risk below some chosen target, B.
distribution has two modes.
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Symmetry and Skewness in Return Distributions
Quartiles, Quintiles, Deciles, and Percentiles With consideration to symmetry and skewness in return
Quartiles, quintiles, deciles, and percentiles are measures
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distributions:
of location that:
* A distribution that is not symmetrical is called skewed.
* are more flexible than measures of central tendency * A positively skewed distribution has the long tail on the
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* measure any part of the distribution, not just the center positive side.
of it * For a positively skewed distribution, the mode is less than
the median, which is less than the mean.
Quartiles, quintiles, and deciles, divide data into four, five, * A positive skew in the distribution of asset returns may
and ten pieces, respectively, while percentiles divide data be attractive to an investor.
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into hundredths. Further, measurement of the

y-percentile, divides the data into two pieces according to
the percentage, y, with the position in an array found with Sample Skewness: Calculation and Use
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y For a sample of size n and standard deviation s, sample

Ly = (n + 1) . skewness is approximated (when n is 100 more) as follows:
100
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∑n
1 i=1 (Xi − X)3
Skewness = ×
n s3
With actual financial data, measures of skewness are
Linear Interpolation in Percentiles
normally in the range -0.50, +0.50. The frequency or the
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Linear interpolation is using a weighted average to find the

data may change the value and even the sign of your
appropriate amount between two amounts. When the
skewness statistic.
percentile formula gives a number of the form [Link], the
percentile is between the XX-th and (XX+1)-th observation.
It is the weighted average of the two observations where Sample Excess Kurtosis
the weight on the XX-th observation is [Link] and the weight For a sample of size n and standard deviation s, sample
on the (XX+1)-th observation is ([Link]). excess kurtosis with a sufficiently large sample is calculated
as follows:
∑n
Quantiles in Investment Practice 1 i=1 (Xi − X̄)4
KE = − 3.
In investment practice and analysis, quantiles: n s4
Equity returns are often found to have positive excess
* Frequently serve to rank firms, investments, or portfolios kurtosis, which is to say that they are leptokurtic.
* Can help to analyze data, as they can show a correlation

© Mindojo, 2023
Reading 1+3: Statistical Measures of Asset Returns 4

Weighted Mean: Calculation and Use This provides a scale-free, or unitless, measure of the linear

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The weighted mean is calculated as: relationship between two random variables. rXY ranges
between -1 and +1. Higher absolute values mean stronger
∑
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XW = wi Xi , relationships.

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i=1

where wi are the weights, which must add to 1. This is

Scatter Plots and Spurious Correlations
especially useful in calculating portfolio returns from
Scatter plots show a two-dimensional representation of
various securities or asset classes where certain amounts
two data series, and can illustrate relationships that may
are invested in each.
be missed by correlation alone, such as nonlinear

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relationships. Slope is only connected to correlation by
Mean Absolute Deviation: Calculation and Use sign. Spurious correlations often exist with smaller
The mean absolute deviation for a sample of observations samples, and can be misleading.
X is ∑n

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i=1 |Xi − X̄|
M AD = .
n Working with Outliers in Datasets
Outliers are observations far from the mean, due to error,
rare events, or mixed samples. Correct outliers should

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generally be left alone. Errors are to be eliminated, and
Variance and Standard Deviation
questionable outliers may be deleted for calculation of a
The population variance for a population of size N and
trimmed mean, or changed to some limited boundary
sample variance for a sample of size n are:
∑N ∑n
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value for calculation of a winsorized mean.
i=1 (Xi − µ) i=1 (Xi − X̄)
2 2
σ2 = , and s2 = ,
N n−1
Box and Whisker Plots
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where µ is the population mean, X̄ is the sample mean and
Box and whisker plots show a top and bottom ”whisker”
n-1 represents the degrees of freedom. The standard
each representing the maximum and minimum points of a
deviation is obtained as the square root of the variance in
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distribution. The box represents the top of quartile 3 (Q3)

each case.
to the bottom of quartile 2 (or Q1), with a line running
through at the median. An ”x” represents the mean. It is

Coefficient of Variation as a Measure of Relative also common for an upper and lower fence to be shown
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Dispersion which represents the upper Q3 boundary plus 1.5 times

The coefficient of variation (CV) is a measure of relative the interquartile range of Q3-Q1, and the lower Q2

dispersion. It is the result of dividing the sample standard boundary minus 1.5 times the interquartile range, with

deviation by the sample mean. observations beyond the fences represented as dots that
may be considered outliers.
@

s
CV =
X̄
Making comparisons of the CV across different variables
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and datasets is acceptable.

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Kurtosis in Return Distributions

Kurtosis is a condition of ”fat tails” in a distribution.
Kurtosis of a normal distribution is mesokurtic, a
distribution with excess kurtosis is leptokurtic, and a
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distribution with less kurtosis is platykurtic. This condition

is directly related to the number of extreme values in a
distribution compared with that of a normal distribution.

Correlation and Its Properties

The correlation coefficient between variables is sample
covariance divided by the sample standard deviations:
sXY
rXY =
sX sY

where the sample covariance is calculated as follows:

∑n
i=1 (Xi − X)(Yi − Y )
sXY =
n−1

© Mindojo, 2023
Reading 1+4: Probability Trees and Conditional Expectations 5

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1+4 Probability Trees and Conditional Expectations

Reading 1+4: Probability Trees and Conditional Expectations

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Random Variables and Events Using a Tree Diagram to Solve for Expected Value
A random variable is a quantitative outcome of a process A tree diagram is a useful tool for solving conditional and
or procedure, whose value is uncertain until the process or unconditional expected value problems. This is particularly
procedure is carried out. The value of a random variable important when multiple factors influence a final outcome.

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can change from trial to trial. An event is a subset of
outcomes from a process or procedure. If events are
mutually exclusive, only one event can occur at a time. If at Conditional Variance

least one event from a set of events must occur, the set of The conditional variance and conditional standard

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events are said to be exhaustive. deviation measure risk, conditional upon a certain
situation. They allow for a closer examination of the risk of
an asset or an event by isolating the effect in differing
Expected Value as a Probability-Weighted Average states of the future world. This is the same notion as a

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The expected value of a random sample is a conditional expected value versus an unconditional
probability-weighted average of possible outcomes. The expected value.
expected value for a random variable, X , is denoted as E(X)
and is calculated as follows.

∑
n
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Bayes’ Formula
Bayes’ formula:
E(X) = P (Xi )Xi
i=1
n
* Is used to update a prior probability, using new
information
* Is a variation of the multiplication rule for joint
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Variance and Standard Deviation of a Random Variable probabilities rearranged to calculate a conditional
The variance of a distribution, denoted by either σ 2 (X) or probability—in this case, the probability that an event
Var(X), is the expected value of the squared deviation from occurs given that certain new information is observed
the expected value, which can be written as * Is generally calculated with the following formula
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σ 2 (X) = E{[X − E(X)]2 }. P (Event | New info) =

P (New info | Event)P (Event)

The standard deviation, σ(X), which has the same units as
X, is the square root of the variance. P (New info | Event)P (Event) + P (New info | EventC )P (EventC )
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Conditional Expected Values

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A conditional expected value gives the expected value of a

random variable, conditional on some event occurring. It
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can be calculated as

E(X|S) = P (X1 |S)X1 + P (X2 |S)X2 + ... + P (Xn |S)Xn ,

where X1 , X2 , and so on, are the possible outcome values

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and S is some given event.

Total Probability Rule for Expected Value

The total probability rule for expected value states
unconditional expected values in terms of conditional
expected values and their corresponding probabilities. The
general formula is

E(X) = E(X|S1 )P (S1 )+E(X|S2 )P (S2 )+...+E(X|Sn )P (Sn ),

where S1 , S2 , and so on, are mutually exclusive and

exhaustive outcomes.

© Mindojo, 2023
Reading 1+5: Portfolio Mathematics 6

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1+5 Portfolio Mathematics

Reading 1+5: Portfolio Mathematics

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Calculating a Portfolio’s Expected Return can still be useful when these assumptions are violated.
A portfolio’s expected return can be calculated using the
second property of expected value, letting the weights
represent the proportion of a portfolio invested in each Safety–First Rules, Shortfall Risk, and VaR

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asset. Safety-first rules compare portfolios based on shortfall risk,
which is the probability that their return RP falls below a
E(RP ort ) = w1 E(R1 ) + w2 E(R2 ) + ... + wn E(Rn ) minimum acceptable level RL . Comparison is possible
through the safety-first ratio.

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E[RP ] − RL
SFRatio =
σP
Covariance between Two Random Variables
Value at Risk (VaR) is a risk management technique that
Considering covariance:

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specifies three things: the amount that may be lost on an
investment if things go very poorly, a certain confidence
* It provides a measure of the linear association between
level that the loss will happen, and a specific time period
two random variables.
over which the loss will take place.
* It can be defined as Cov(X,Y)=E{[X-E(X)][Y-E(Y)]}.
* If Cov(X,Y)>0, then X and Y tend to move in the same
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direction.
* If Cov(X,Y)<0, then X and Y tend to move in opposite
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directions.
* If Cov(X,Y)=0, then X and Y are unrelated.
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Covariance Matrix of a Set of Random Variables

Considering covariance matrix:
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* A covariance matrix is a concise way to present the

covariances between a set of random variables.
* The diagonal values in a covariance matrix are variances,
while the off-diagonal values are covariances.
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* Because the matrix reports both variances and

covariances, the matrix is often called a
variance-covariance matrix.
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Calculating Covariance from a Joint Probability

Function
The joint probability function,

P (X, Y ),
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between two random variables, such as the returns from

two assets, can be represented in tabular form. The
tabular form also provides a convenient way to calculate
the covariance between two jointly distributed random
variables.

Mean–Variance Analysis
Mean–variance analysis includes those tools which use
mean or expected returns and variance of returns as a
measure of risk relevant to investors. This assumes
normally distributed returns and investors with quadratic
utility functions, but the tools of mean–variance analysis

© Mindojo, 2023
Reading 1+6: Simulation Methods 7

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1+6 Simulation Methods

Reading 1+6: Simulation Methods

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Lognormal Distribution can be created from a transformation.
A lognormal distribution:

* is a continuous probability distribution of a random Historical Simulation, or Backtesting

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variable whose logarithm is normally distributed. Historical simulation:

* is bound below by zero

* Is otherwise known as ”backtesting” a certain strategy or
model

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Independently and Identically Distributed Returns * Involves using actual data from recent years to test how
Two important assumptions in applications of that strategy would have fared, using the assumption that
compounded rates of return are that rates of return are: this recent past is the best prediction of future events

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* independently distributed—this means each observation
Monte Carlo Simulation—Trial
cannot be foreseen from a previous observation.
A hands-on sample trial of a Monte Carlo simulation can
* identically distributed—this means each observation is
illustrate the process of running repeated trials to look at
”pulled” from the same distribution with the same mean
and standard deviation.
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the distribution of a variable of interest.

* Step 1—Specify the quantities of interest.

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Volatility in Lognormal Distribution * Step 2—Specify a time grid.
Regarding lognormal distributions: * Step 3—Specify distributional assumptions for risk
factors.
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* A lognormal distribution is a continuous probability * Step 4—Use a computer program to generate random
distribution of a random variable whose logarithm is values.
normally distributed. * Step 5—Calculate the underlying values using the
random values.
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* The volatility from continuously compounded returns is

the annualized standard deviation of continuously * Step 6—Compute the quantities of interest.
compounded returns. * Step 7—Go back to Step 4 until a number of trials are
completed.
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The Steps of Monte Carlo Simulation

Monte Carlo simulation is a process of running
computer-generated trials of a model or system with all
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assumptions specified and built into the simulation.

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The steps are as follows:

* Step 1—Specify the quantities of interest.

* Step 2—Specify a time grid.
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* Step 3—Specify distributional assumptions for risk

factors.
* Step 4—Use a computer program to generate random
values.
* Step 5—Calculate the underlying values using the
random values.
* Step 6—Compute the quantities of interest.
* Step 7—Go back to Step 4 until a number of trials are
completed.

Using a Random Number Generator

A random number generator produces a uniformly
distributed variable from 0 to 1. From this, any distribution

© Mindojo, 2023
Reading 1+7: Estimation and Inference 8

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1+7 Estimation and Inference

Reading 1+7: Estimation and Inference

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Simple Random Sampling and a Sampling Plan smaller samples of a larger sample. This method is robust
To pull a simple random sample, each possible sample of a for estimating means, medians, and other measures.
given sample size must have an equal probability of being * Jackknife involves starting with the full sample, then
selected from the population. Sampling error is the cutting one observation at a time for the remaining

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difference between the observed value of a statistic and resamples.
the quantity it is intended to estimate. The sampling
distribution of a statistic is the distribution of all the distinct
possible values that the statistic can assume when Cluster Sampling: One-Stage and Two-Stage

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computed from samples of the same size randomly drawn Cluster sampling involves identifying clusters of

from the same population. observations (for example, people in various areas or
books in certain libraries) and then taking a sample of
some clusters chosen. One-stage cluster sampling includes

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Stratified Random Sampling all observations in the chosen clusters, while two-stage
Stratified random sampling: cluster sampling takes a random sample from each of the
clusters chosen. This method is usually less accurate, but
* divides the population into subpopulations (strata) based also less expensive.
on one or more characteristics or classification criteria,
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* then draws simple random samples from each
subpopulation with sizes proportional to the relative size of
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each subpopulation in the population, and
* may improve the precision of sample statistics.
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The Central Limit Theorem and Standard Error of a

Sample
For a population with mean µ and standard deviation σ
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from a sample of n observations, the sample mean s

follows a sampling distribution with a standard error of:
s
sx = √ .
n
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This leads to the central limit theorem, which states that

regardless of the population distribution, the sampling
distribution of the mean will be normally distributed if the
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sample size is large enough, generally more than 30.

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Non-Probability Sampling: Convenience and

Judgmental
Two main types of non-probability sampling exist:
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* Convenience sampling takes the observations that are

easiest to include; this risks a sample that is not
representative of the population, but is fast and
inexpensive.
* Judgmental sampling relies on the judgment of the
researcher to choose the sample; this risks significant bias,
but can save time if the researcher’s experience can lead to
a solid representative sample.

Resampling Techniques: Bootstrapping and Jackknife

Resampling techniques include:
* Bootstrapping is a powerful statistical method of
inferring properties of a population by taking repeated

© Mindojo, 2023
Reading 1+8: Hypothesis Testing 9

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1+8 Hypothesis Testing

Reading 1+8: Hypothesis Testing

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Formulations of Hypotheses null hypothesis
A hypothesis is a question which can be tested using both
data and statistical tools. Precise formulation of the The choices made in designing the test can cause each
question will allow for the best answer, which at best can error type to become more or less likely.

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offer a probability of confirmation.

Hypothesis Testing: Level of Significance

Steps in Hypothesis Testing Regarding level of significance:

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Steps in hypothesis testing include:
* The level of significance in a hypothesis test is a threshold
* Step 1 — Stating the hypothesis of assurance chosen by the researcher.
* Step 2 — Identifying the appropriate test statistic and its * It is represented by the Greek letter alpha and is also the

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probability distribution probability of a Type I error.
* Step 3 — Specifying the level of significance * A level of significance of 0.05 is common and means the
* Step 4 — Stating the decision rule hypothesis test has a 5% chance of rejecting the null
* Step 5 — Collecting data and calculating the test statistic hypothesis when it is actually true.
* Step 6 — Making the statistical and economic decisions
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Hypothesis Testing: Power of a Test
The power of a test is the probability of correctly rejecting a
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Null and Alternative Hypotheses
Regarding null and alternative hypotheses: false null hypothesis. This is measured numerically as
1 − β, where β is the probability of making a Type II error.
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* Hypotheses are statements about an underlying

population.
Hypothesis Testing: Statistical Significance
* A null hypothesis is the statement to be tested, which will
If a null hypothesis can be rejected, then it can be said the
be rejected or not rejected.
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results are statistically significant. This means the results

* An alternative hypothesis is the statement which is
would be considered to be unusual if the null hypothesis
accepted if the null hypothesis is rejected.
were true, with the threshold for ”unusual” being defined
* Often, the statement ”desired” by a researcher will be
by the chosen significance level. The last step in hypothesis
placed as the alternative hypothesis.
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testing takes economic significance into consideration.

* A null hypothesis can state two things as equal (two-tailed
test) or unequal (one-tailed test).
Hypothesis Testing: Critical Value for the Test Statistic
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The critical value is otherwise called the ”rejection point.” If

Calculating a Test Statistic for a Hypothesis Test
the test statistic lies beyond this value, the null hypothesis
Regarding test statistics:
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is rejected.

* A test statistic is a value calculated and based on sample

data. Hypothesis Testing: p-Values
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* This value is the basis for deciding whether or not to A p-value is one method for testing a null hypothesis. It
reject a null hypothesis. gives the probability of observing the given data (or test
* The test statistic for the common t-test takes the form of statistic), conditioned on the null hypothesis being true.
Sample statistic − Hypothesized population parameter
p-value = P (observe test statistic or more extreme value|H0 is true)
Standard error of the test statistic
If the p-value for a hypothesis test is less than or equal to
the significance level, α, then the null hypothesis is rejected
in favor of the alternative hypothesis. Otherwise, the null
Testing a Null Hypothesis and Type I and Type II Errors
hypothesis is not rejected.
Types of errors when testing a null hypothesis:

* Type I error: when a true null hypothesis will be rejected Hypothesis Tests Concerning the Mean
by the chosen test; probability is alpha Regarding hypothesis tests concerning the mean:
* Type II error: when the researcher fails to reject a false

© Mindojo, 2023
Reading 1+8: Hypothesis Testing 10

* If a random sample is from a normally distributed

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population, then the sampling distribution of the sample * Hypothesis tests about either a single population’s
mean will also be normally distributed. variance or the equality of two populations’ variances
* If the population is not normally distributed, but the require random samples drawn from a population or

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sample size is greater than 30, then the central limit populations that are normally distributed.
theorem can be used to state the sampling distribution of * Unlike tests concerning population means, this
the sample mean is approximately normally distributed. requirement cannot be met by using a larger sample size.
* Having a normal or approximately normally distributed
mean is needed to use a z-test or a t-test to test claims
Hypothesis Tests Concerning a Single Variance

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about a single population’s mean, or the difference
The test statistic used to test a null hypotheses about a
between two populations’ means.
population standard deviation or variance is a chi-square is
(n − 1)s2
Hypothesis Tests Concerning a Single Mean and the χ2 = ,
σ02

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t-Test
where n is the sample size, s is the sample standard
Under the assumption the null hypothesis is true, the test
deviation, and σ02 is the hypothesized value for the
statistic
x̄ − µ0 population variance, as contained in the null hypothesis.

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t= √ ,
sx / n Assuming the null hypothesis is true, the test statistic
follows Student’s t-distribution, with n-1 degrees of follows a chi-square distribution, with n - 1 degrees of
freedom. This distribution looks similar to the standard freedom.
χ2α
normal distribution, but with fatter tails. As the sample size
gets larger, the t-distribution converges toward the normal
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denotes the critical value for a right-tailed test, while
distribution.
χ21− α
2
n
denotes the lower critical value for a two-tailed test and
Hypothesis Tests Concerning Differences between
Means χ2α
so

2
Hypothesis tests can be performed to compare the means
denotes the upper critical value for a two-tailed test.
of two normal populations with equal or unequal unknown
variances based on independent random samples from
these populations.
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One-Tailed and Two-Tailed Tests of Variance

Hypothesis tests concerning the value of a population’s
variance or two population variances can be two tailed:
Hypothesis Tests Concerning Mean Differences
A test of mean differences: H0 : σ 2 = σ02 versus Ha : σ 2 ̸= σ02 ,
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right tailed:
* Compares two related means
* Is done with a t-test where the calculated mean H0 : σ 2 ≤ σ02 versus Ha : σ 2 > σ02 ,
difference is compared with some value (usually zero)
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or left tailed:

H0 : σ 2 ≥ σ02 versus Ha : σ 2 < σ02 ,

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Hypothesis Testing: Test Statistic of Mean Differences

The test statistic for mean differences is calculated by first where σ02 is the value of the population variance, or
creating the difference variable d and then calculating the another variance could be in its place for a two-variance
mean ”d-bar” and the sample standard deviation s of this test. The null and alternative hypotheses can also be
db

difference variable by using written in terms of the population standard deviation, σ.

d − µd0
t= s ,
√d
n Hypothesis Tests of the Equality of Two Variances
The test statistic when testing claims about two
where the value in the numerator
populations’ variances will follow an F-distribution:
µd0
s21
F = ,
is the value against which the mean difference is being s22
tested (usually zero). The expression in the denominator is where s21 is the sample variance from the sample from the
known as the standard error. first population, and s22 is the sample variance from sample
from the second population. The F-statistic is described by
the degrees of freedom for its numerator
Hypothesis Tests Concerning Variance
Regarding hypothesis tests concerning variance: n1 − 1

© Mindojo, 2023
Reading 1+8: Hypothesis Testing 11

and denominator

m
n2 − 1.

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Hypothesis Testing: When a Nonparametric Test is
Appropriate
A nonparametric test is appropriate when:

ch
* working with data that do not meet distributional
assumptions
* there are outliers
* the hypothesis of interest does not concern a parameter

ar
* the data are given in ranks

Multiple Hypothesis Tests: False Discovery Approach

se
The false discovery rate can be thought of as the
probability of a type I error, on average. The multiple
testing problem refers to these false positives as being
more likely when there are many tests and large samples.
One way to address this is with a modification known as
re
the false discovery approach, accepting the significant
results of tests with *p*-values lower than the significance
n
level scaled to the rank of the *p*-value divided by the
number of tests.
so

Hypothesis Testing: Differences in Means with

Independent Samples
To affect a two-sample t-test, calculate the pooled estimate
bo

of the common population variance,

(n1 − 1)s21 + (n2 − 1)s22

s2p = .
n1 + n2 − 2

Then calculate the t-statistic,

@

(X 1 − X 2 ) − (µ1 − µ2 )
t= √( ) ,
s2
p s2
p
n
+n
e

1 2

which follows a t-distribution with

os

n1 + n2 − 2

degrees of freedom.
db

© Mindojo, 2023
Reading 1+9: Parametric and Nonparametric Tests of Independence 12

Parametric and Nonparametric Tests of Indepen-

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1+9
dence
Reading 1+9: Parametric and Nonparametric Tests of Independence

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The Spearman Rank Correlation Coefficient
The Spearman rank correlation coefficient:

* is a common nonparametric test when the assumptions

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underlying parametric tests are inappropriate
* is used for correlations of two series when one or both of
the series are in ranks, or also when the series are
converted to ranks due to some violation of other

ar
underlying assumptions regarding parametric inference

Hypothesis Testing—Summary

se
Some of the more salient points to recall from hypothesis
testing include the following:

* Steps of hypothesis testing and use of the alternative

hypothesis
re
* Test statistics are quantities used in deciding whether to
reject a null
n
* Type I error is rejecting a true null; Type II is failing to
reject a false null
* Level of significance is given by alpha, the chance of a
so

Type I error
* Confidence intervals are ranges where the null is not
rejected
bo

* The t-distribution has fatter tails than the normal and is

good for small samples
* Most tests of variance use the chi-square distribution
* Nonparametric tests can be used for ranked data
@

Hypothesis Tests Concerning Correlation

Strength of a Pearson correlation is tested statistically with
a t-test with n − 2 degrees of freedom:
e

√
r n−2
t= √
os

1 − r2
The null hypothesis of this two-tailed test is that the
correlation is equal to zero.
db

Hypothesis Test of Independence using Contingency

Table Data
Testing independence of values in a i × j contingency table
involves calculating the expected value for each cell as the
product of the row and column totals divided by the overall
total. The squared differences between each cell value and
expected value divided by the expected value are summed
to produce the chi-square test statistic, and this is
compared to the critical value on a chi-square table with

(i − 1)(j − 1)

degrees of freedom.

© Mindojo, 2023
Reading 1+11: Introduction to Big Data Techniques 13

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1+11 Introduction to Big Data Techniques

Reading 1+11: Introduction to Big Data Techniques

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Fintech & Big Data
Fintech is the technological innovation in the design and
delivery of financial services and products. It includes large
datasets, analytical tools, automated trading, automated

ch
advice, and financial record keeping. Big data is the data
generated by industry, governments, individuals, and
electronic devices. Alternative data comes from electronic
devices, social media, sensor networks, and company

ar
exhaust.

Tackling Big Data with Data Science

se
Data science extracts information from big data. It uses
methods such as capture, curation, storage, search, and
transfer to process data. The result is data visualization.
Fintech applies big data through text analytics and natural
language processing, and risk analysis.
n re
Artificial Intelligence and Machine Learning
Artificial intelligence (AI) and machine learning (ML) have
become increasingly influential in finance and investment
so

research. To optimize algorithm performance, it’s crucial to

split datasets into training, validation, and testing subsets,
which helps prevent overfitting. Various learning
techniques, such as supervised learning, unsupervised
bo

learning, and deep learning, offer unique applications and

benefits within the financial sector.
e @
os
db

© Mindojo, 2023
Reading 1+10: Simple Linear Regression 14

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1+10 Simple Linear Regression

Reading 1+10: Simple Linear Regression

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Simple Linear Regression (SLR) Interpreting Regression Coefficients
Simple linear regression employs a single independent Plugging in a value for the independent variable X in a
variable (or ”explanatory variable”) to explain variation in a regression output
dependent variable, based on some theoretical Ŷ = b̂0 + b̂1 X

ch
relationship. The resulting regression line is the one that
provides an estimate for the dependent variable.
minimizes the sum of squares total (SST), or the squared
Regressor values of zero return the intercept, which is
distances from each observation to the calculated best fit
usually a nonsensical value, as estimations are valid over
line.

ar
the area for which observations were provided. The slope
shows what is estimated to happen to the dependent
Estimating the Parameters in SLR variable as the independent variable increases by 1.
A single independent variable is assumed to predict a

se
second dependent variable in SLR, modeled as
Linearity Assumption of SLR
Yi = b0 + b1 Xi + ϵi One basic assumption of simple linear regression is that
the relationship between the variables being tested is
for all observations
re
linear to begin with. This is a common assumption but is
i = 1...n. often not the case. A series changing linearly while the
other changes in levels results in a curved relationship of
This estimates a best-fit line through the data points for
some sort, which may be shown by examining the error
n
prediction, where the estimated parameter
terms more closely.
so

b̂0

Homoskedasticity Assumption of SLR

is the y-intercept, and the estimated parameter
Homoskedasticity is an assumption of linear regression.
b̂1 This means that the residuals have the same variance, or
bo

that the expected squared residual is the same at all

is the slope, and the error terms are represented by ϵ. places. Sometimes this can be seen in a scatter plot. The
presence of heteroskedasticity can cause estimated
parameters to be less precise.
Cross-Sectional vs. Time-Series Regressions
@

Cross-sectional data does not index time. Instead, both the

independent variable(s) and dependent variable are from Independence and Normality Assumptions of SLR
the same time period, and the index value simply Independence is one of the four main assumptions of
e

represents different observations without necessarily linear regression. This assumption is that the residuals are
being in any time order. Time series data is indexed for uncorrelated with each other, which means that any
os

time, and the index values are meaningful time increments. trends, seasonality, or other correlation would serve as a
violation of the independence assumption. Another
assumption is that the residuals are normally distributed.
Estimating a Regression Line
db

A simple linear regression assumes a linear relationship,

and estimates the intercept Analysis of Variance (ANOVA)
Analysis of variance (ANOVA) breaks the sum of squares
b̂0 total (SST) into sum of squares regression and sum of
squares error. The SSR divided by SST is the coefficient of
and slope
determination, or R2 . The test of significance for the R2 is
b̂1 . an F-test with a test statistic of the mean square regression
The slope is found as the covariance of X and Y divided by (MSR) divided by the mean square error (MSE).
the variance of X. The intercept is then found as:

b̂0 = Y − b̂1 X. ANOVA and Standard Error of Estimate in SLR

The standard error of the estimate se is also called the
standard error of the regression, and root mean square
error (RMSE). It is calculated as the square root of the mean

© Mindojo, 2023
Reading 1+10: Simple Linear Regression 15

square error: incremental effect of that condition, leaving the slope in a

m
√∑ simple linear regression to quantify this difference while
√ n
− Ŷi )2
i=1 (Yi
se = M SE = the intercept serves as the average value when the
n−2
condition is not met (or the indicator variable is ”off”).

.co
This is used in evaluating regressions and calculating
prediction intervals.
Hypothesis Testing: Significance and p-Values
The p-value in a regression output is the lowest level of
Hypothesis Testing of Regression Coefficients significance at which the null hypothesis can be rejected.
Hypothesis testing involves checking statistically how close For example, A p-value of 0.008 is less than 0.01, showing

ch
an estimated parameter, that choosing a 1% significance level will allow the null
hypothesis of equality with zero to be rejected.
b̂1 ,

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is to a hypothesized parameter, B1 . This can be done by
Predicted Values and Prediction Intervals
calculating the standard error of the slope coefficient
Predicted values follow from the regression line, but these
sb̂ , estimates are based on the estimated parameters. This
1
added uncertainty causes the estimated standard error of

se
and then using that value in the t-test statistic to compare the forecast to be higher than the standard error of the
against the critical value found with n-k-1 degrees of estimate. √
freedom: 1 (Xf − X)2
sf = se 1+ +
(n − 1)s2x
sb̂ = √∑
1 n
se
and then t =
b̂1 − B1
sb̂
re n
The prediction interval is then found with this estimated
i=1 (Xi − X)2 1
variance of the prediction error and a critical value for the
sample, as
n
Ŷ ± tc × sf .
Hypothesis Testing of Correlation Coefficients
so

A correlation coefficient can be tested as being equal to

zero with a two-tailed t-test with n - 2 degrees of freedom,
using the test statistic Functional Forms for SLR
√ Simple linear regression can be performed on nonlinear
ρ n−2
bo

t= √ . relationships where one or both variables is exponential,

1 − ρ2
by employing the log-lin model
If this test statistic is larger than the critical value found on
the t-table for the chosen level of significance and the (ln Yi = b0 + b1 Xi ),
@

appropriate degrees of freedom, the null hypothesis that

the lin-log model
correlation is equal to zero can be rejected. This provides
the same test statistic as the slope test if the same two (Yi = b0 + b1 ln Xi ),
variables were used in SLR.
e

or the log-log model

os

Hypothesis Testing of the Intercept (ln Yi = b0 + b1 ln Xi ).

Hypothesis testing of an intercept value requires
The nature of the variables and the error terms can both
calculating the standard error of the intercept term:
guide you toward the most appropriate choice when the
v
u relationship is nonlinear.
u1
db

2
X
sb̂ = t + ∑n
i=1 (Xi − X)
0 n 2

This can be plugged directly back into the t-statistic along

with the hypothesized and estimated values of the
intercept:
b̂0 − B0
tintercept =
sb̂
0

Hypothesis Testing of Indicator (Dummy) Variables

An indicator variable or ”dummy” variable takes on a value
of 0 or 1 depending on whether some binary condition is
satisfied. This dummy variable therefore measures the

© Mindojo, 2023
Reading 1+2: Time Value of Money in Finance 16

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1+2 Time Value of Money in Finance

Reading 1+2: Time Value of Money in Finance

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Time Value of Money in Fixed Income and Equity Implied Return and Growth
The time value of money (TVM) demonstrates that The discount bond formula can be algebraically
receiving cash flows earlier is generally more valuable due manipulated to solve for the yield, r :
to the potential to earn positive interest or returns. A ( )1

ch
FV t
fixed-income instrument called a zero-coupon bond can be r= −1
PV
valued as the present value (PV) of a lump sum, using the
discrete calculation for PV: For a coupon bond, the implied yield can be solved for with
TVM keys, but not explicitly with algebra.
FV

ar
PV =
(1 + r/m)tm
Cash Flow Additivity with Financial Instruments
Or for continual compounding:
The cash flow additivity principle stipulates that the

se
FV present value of any future cash flow stream indexed at
P V = rt
e the same point equals the sum of the present values of the
cash flows. This ensures that market prices reflect the
condition of no arbitrage: no possibility exists to earn a
re
riskless profit in the absence of transaction costs.
Discount Bonds under Positive and Negative Interest
Rates
Equity Instruments: Implied Return and Growth
n
Discount bonds are bought and sold at a price lower than
The equity instrument valuation of price being the next
their face value, with the investor receiving the face value
year dividend divided by r-g can be manipulated to solve
so

at maturity. The purchase price is determined by the Yield

for implied return, growth rate, or even current or forward
to Maturity (YTM) which represents the total return an
P/E ratios by adding in earnings from either time t or t+1.
investor would receive if the bond is held until it matures.
Bonds can be issued even with negative YTM, where
bo

investors are essentially paying the issuer to keep their

money.

Time Value of Money with Coupon Instruments

@

The price of a coupon bond is calculated using a market

discount rate, commonly known as the yield to maturity
(YTM), which is adjusted for the frequency of payments. A
e

perpetual bond, which has no stated maturity date,

calculates its present value by dividing the payment by the
os

discount rate.

Time Value of Money with Annuity Instruments

db

A fixed-income instrument structured as an annuity, or a

fixed stream of payments, allows a principal loan to be
repaid over a time period with even, fixed payments. The
payment represents both interest and principal. Each
period, the interest portion decreases while the principal
portion increases.

Equity Instruments and the Time Value of Money

An equity instrument, like common stock, can be valued as
a perpetuity if the dividend is assumed constant. With a
dividend growth rate g, the next period dividend is divided
by r − g rather than just the required return r.

© Mindojo, 2023
Reading 2+2: Understanding Business Cycles 17

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2+2 Understanding Business Cycles

Reading 2+2: Understanding Business Cycles

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The Growth Cycle and Growth Rate Cycle cycles tend to be longer than business cycles, peak just
The growth cycle can be thought of as the classical cycle before some recessions, and be sharper and less smooth
with a long run path of smooth growth (potential output) than business cycles. Recessions tend to be longer and
added, to show each peak and trough as representing deeper when they coincide with a credit cycle downturn.

ch
output gaps. The growth rate cycle is the preceding cycle of
growth rates of economic activity, which peak during the
expansion, and fall to zero at a business cycle peak. Surveys, Big Data, and Nowcasting as Macroeconomic
Indicators

ar
Surveys are used by various entities to develop leading and
The Classical Business Cycle and Its Phases coincident indicators, such as the Purchasing Managers’
Considerations of the classical business cycle: Index (PMI). Big data is used to produce the Chicago Fed
National Activity Index (CFNAI). Nowcasting relies on

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* Economic growth can be volatile; sometimes economic current data like web searches to produce ”nowcasted”
activity can grow rapidly, and other times it can stall or estimates such as ”GDPNow.”
decline.
* Periods of growth are called expansions while periods of
decline are called contractions. The order of the typical
re
business cycle is expansion, slowdown (peak), contraction,
and recovery (trough).
n
Four Phases of the Cycle: Characteristics
so

During a recovery, GDP begins to grow again, equity prices

increase, and consumer spending increases. During the
late phase of an economic expansion, GDP grows, inflation
picks up, and unemployment falls. At the business cycle
bo

peak, the economy overheats and tips over into a

slowdown. In the contraction phase of the business cycle,
consumers reduce their spending but may borrow to
mitigate this. Firms will reduce capital spending, and
@

reduce production; with a lag they lay off workers.

Unemployment increases.
e

Macroeconomic Indicators: Leading, Coincident, and

Lagging
os

Economic indicators are variables whose movements are

correlated with changes in the macroeconomy, which can
be used to gain insight about economic conditions in the
recent past, the present, and the near future.
db

Composite and Leading Macroeconomic Indicators

Economic indicators can be a single value, or a composite
of multiple values used together. Leading economic
indicators tend to move up or down before the economy as
a whole does, and include stock prices, interest rate
spreads, long-term interest rates, manufacturers’ orders
and weekly hours in manufacturing, and initial
unemployment claims.

Credit Cycles: Relationship to Business Cycles

Credit cycles are measured by a composite variable. Credit

© Mindojo, 2023
Reading 2+1: Firms and Market Structures 18

m
2+1 Firms and Market Structures

Reading 2+1: Firms and Market Structures

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Total, Average, and Marginal Revenue Introduction to Market Structures
Regarding total, average, and marginal revenue: Market equilibrium and dynamics can change drastically
depending on the type of market structure. The four main
* A perfect competitor can sell more without reducing the types of market structures, in order from the most

ch
price, so total revenue always rises as output increases. competitive environment to the least, are as follows:
* Marginal revenue, the increase in revenue from selling
one more unit, is equal to the price for a perfect * Perfect competition
competitor. * Monopolistic competition

ar
* An imperfect competitor faces a downward-sloping * Oligopoly
demand curve, so must reduce the price to sell more. * Monopoly
* Total revenue may rise or fall as output increases, but
marginal revenue will always be less than the price for an

se
Market Structure: Monopolistic Competition
imperfect competitor.
In monopolistic competition:

Breakeven Point and Shutdown Point * Competition is high and pricing power is low
The supply curve follows the marginal cost curve from the
re
* Many firms compete and each has a similar product
shutdown point upward. The point where the marginal * In order to succeed, firms must set their product apart
cost curve (MC) crosses the average variable cost curve from those offered by competitors
n
(AVC) is the shutdown point. The company will not produce * Firms hope to obtain small gains in both pricing power
anything at a price lower than this. The point where the MC and profits by differentiating their products
crosses the average total cost curve (ATC) is the breakeven
so

point. If price is below this level then the firm loses money;
Market Structure: Oligopoly Markets
above this it earns positive profits.
Oligopoly is a market form characterized by a few large
firms that control the market, vulnerable to attempts at
bo

Profit Maximization under Imperfect Competition collusive behavior and the formation of cartels.
Under imperfect competition, firms face downward-sloping Oligopolistic markets include:
demand and therefore have some ability to affect price
with their output decision. Marginal revenue is below price * Significant barriers to entry
@

for imperfect competitors, and profit maximization occurs * Interdependent pricing

at the production level where MR = MC. * Typically homogeneous products
e

Economies of Scale and Diseconomies of Scale Monopolistic Competition: Optimal Price and Output
Regarding economies and diseconomies of scale: Considerations of optimal price and output in
os

monopolistically competitive markets:

* As the firm increases production, initially average cost
falls, a phenomenon known as economies of scale or * Monopolistically competitive firms determine their
increasing returns to scale. optimal rate of output by finding the point at which
db

* As the firm grows, scarcity of resources and management marginal revenue equals marginal cost (MR = MC).
difficulties drive up the average cost in a region known as * Put more simply, they are likely to produce any unit that
diseconomies of scale, or decreasing returns to scale. increases revenue more than it increases costs.
* Once that rate of output is selected, these firms then
choose price based on demand for their goods.
Minimum Efficient Scale of Production
* Since they choose price in this manner, they are
Companies continually scale the size of their operations up
considered price makers.
and down in search of the optimal level of production. The
minimum efficient scale is the minimum point on the
LRATC curve, it is where the firm has constant returns to Monopolistic Competition: Long-Run Equilibrium
scale, and is where competitive firms end up. These Considerations of long-run equilibrium in monopolistic
changes can occur slowly, as the process of scaling up or competition:
down takes time.
* Competition in a monopolistically competitive industry is

© Mindojo, 2023
Reading 2+1: Firms and Market Structures 19

substantial, and that competition drives prices lower. Oligopoly in the Long Run

m
* However, that process does not typically squeeze out all Considerations of oligopoly in the long run:
profits in the long run, as it does in a perfectly competitive
industry. * Oligopoly profits are maximized by each market

.co
* Economic profits are still sustainable in the long run, participant setting marginal revenue equal to marginal
particularly if firms can successfully differentiate their costs.
products. * For reasons of technological efficiency and competition,
there exist forces to change oligopoly profits in the long
run, which typically decline over time for the market leader.
Oligopoly: Strategic Pricing Structures

ch
* Successful cartels will act like monopolists, although
Oligopolistic firms engage in strategic pricing practices that
these are typically unsustainable over time.
are clearly interdependent. The nature of these strategies
can be categorized into a few distinct theoretical structures:
Identifying Market Structure

ar
* Price wars—firms choose price Identifying a market structure as one the four main market
* Cournot & Stackelberg equilibria—firms choose quantity types—perfect competition, monopolistic competition,
* Nash equilibria—game theory oligopoly, or monopoly—requires knowledge of five

se
characteristics:

Oligopoly: Stackelberg Competition and Equilibrium

* The size of the firm
Stackelberg equilibria are calculated under the
* Product differentiation
assumptions that oligopolists choose quantity, but that
there is a ”leader” that gets to choose quantity first, and a
re
* Pricing power
* Barriers to entry and exit
”follower” that then chooses quantity. The leader firm uses
* Whether or not nonprice competition exists
the reaction function of the follower in the optimization
n
process.
Elasticity and Market Power
so

Regarding elasticity and market power:

Oligopoly: The Kinked Demand Curve
Regarding the kinked demand curve:
* Elasticity measures the sensitivity of quantity changes in
demand to a change in price.
* The demand curve facing a single oligopolist is ”kinked” in
bo

* The elasticity of demand has many applications in

shape at the current price if competitors will match a lower
economics, and is relevant to the concept of market power.
price, but not a higher price.
* A seller with market power will choose a price which
* The combined ”demand up” and ”demand down” curves
resides on the elastic part of the demand curve.
are at different angles because of the difference in
@

consumer response to an increase in price (competitors

won’t match the price, and quantity drops severely) and Concentration Ratio and HHI
response to a decrease in price (competitors will match the The concentration ratio is the sum of sales of N firms
price, and so quantity sold by that firm increases only a divided by the total (or sum of market shares). It is easy to
e

small amount). compute, but doesn’t indicate market power, and is

unaffected by mergers. The HHI was designed to address
os

some concerns and is the sum of squared market shares of

Oligopoly: Game Theory and Nash Equilibrium
the largest N firms.
Game theory is built from the following:
db

* Players—the people, firms, or nations involved Short- and Long-Run Cost Curves
* Strategies—the choices the players can make The fixed-input constraint in the short run together with
* Payoffs—the outcomes from each combination of choices input prices, establish the firm’s short-run average total
cost curve (SRATC). The long-run average total cost curve
Equilibria follow from analysis of these payoffs. This is (LRATC) shows the lowest cost per unit at which output can
useful in analyzing oligopoly market structures as well. be produced over a long period of time when the firm is
able to make technology, plant size, and physical capital
adjustments.
Oligopoly: Supply Analysis and Price Leadership
When an oligopoly has a large price leader in the market,
the other oligopolists will often choose to just follow the Oligopoly: Cournot Competition and Equilibrium
pricing of the leader, rather than to risk a price war. As Cournot equilibria are calculated under the assumption
always, each competitor will produce where MC = MR. that oligopolists choose quantity. This is characterized by
firms with reaction functions that show their best

© Mindojo, 2023
Reading 2+1: Firms and Market Structures 20

responses to quantities chosen, and these are chosen

m
simultaneously.

Factors that Determine Market Structure

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Five factors which collectively determine market structure
include the number and size of firms supplying the product,
the degree of product differentiation, pricing power,
barriers to entry and exit, and non-price competition.

ch
Profit Maximization under Perfect Competition
A perfectly competitive firm is a price taker, and faces a
perfectly elastic demand curve, where price is also

ar
marginal revenue. Profit maximization or cost
minimization occurs by choosing the output level where

M R = M C.

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n re
so
bo
e @
os
db

© Mindojo, 2023
Reading 2+6: International Trade 21

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2+6 International Trade

Reading 2+6: International Trade

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Benefits and Costs of International Trade Considerations of trade restrictions and agreements:
Considerations of international trade:
* Trade restrictions limit the amount of trade between
* International trade has its winners and losers, but most countries, whereas trade agreements tend to do the

ch
would agree the overall impact of trade on a country’s GDP opposite.
and welfare is positive. * Both affect the flows of goods and services, as well as
* Trade allows countries to specialize in their efficient capital, in and out of countries.
industries, benefiting producers and consumers. * Because they regulate international markets by distorting

ar
* While trade is a complex process, its essential free trade, they also impact consumer and producer
characteristics can be explored with a simple model. welfare in both foreign and domestic contexts.
* Export subsidies help out industries in the home country
by making it cheaper to sell abroad than to sell in the

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Tariffs on International Trade: Costs and Benefits
domestic market; however, export subsidies are inefficient,
A tariff is a tax imposed on goods sold domestically and
lowering overall welfare.
produced in other countries. Countries impose tariffs in
order to protect domestic industries from international
competition. However, this causes a loss in consumer (and
re
Costs and Benefits of Regional Trading Blocs,
foreign producer) welfare because taxes distort the price of Challenges, and Implications
imports. Consumers are made slightly better off from the Regional trading blocs are associations of countries within
n
increase in tax revenues caused by the tariff and domestic a region that collaborate for mutual economic benefits,
producers benefit from the price increase. fostering greater interdependence and reducing potential
so

conflicts. While integration offers advantages such as

growth spillovers, it also presents challenges, especially for
Quotas in International Trade: Costs and Benefits
vulnerable sectors and in maintaining independent
Quotas directly restrict total supply from the foreign to the
economic policies. For investors, deep economic
domestic country’s economy. For this reason, domestic
bo

integration means opportunities but also risks, as

producers benefit from quotas, but the overall loss to the
challenges in one member country can affect the entire
consumer through the higher prices (due to reduced
bloc.
supply) outweighs these benefits and leads to a reduction
in social welfare.
@

Regional Trading Blocs and Regional Integration

Trading blocs, such as Free Trade Areas (FTAs) and
e

Customs Unions, are collaborative agreements between

countries to simplify and enhance trade among members
os

while maintaining distinct policies towards non-members.

As integration deepens, blocs like the Common Market
allow for the free movement of not just goods and services,
but also factors of production. Economic and Monetary
db

Unions represent the pinnacle of this integration, with

coordinated economic policies or even a shared currency
among member nations.

Trade Creation and Trade Diversion

Trade creation is the process by which agreements
increase the volume of trade. Trade diversion is when
trade moves from a lower-price to a higher-price nation.
This trade diversion, if significant enough, can more than
offset gains from trade creation.

Trade Restrictions and Agreements

© Mindojo, 2023
Reading 2+7: Capital Flows and the FX Market 22

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2+7 Capital Flows and the FX Market

Reading 2+7: Capital Flows and the FX Market

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Capital Restrictions for Economic Stimulus and purchasing power, which gives rise to the term purchasing
Stability power parity.
Regarding capital restrictions: * In practice, however, economists find prices only loosely
tend toward this purchasing power parity condition

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* Countries restrict inward and outward flows of capital to because goods and services are often not identical and are
further their domestic policy goals. not always traded internationally and because trade
* Capital restrictions allow countries to stimulate their barriers and transaction costs can affect prices.
economy through low interest rates without needing to

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worry about capital flight.
Types of FX Trades and Financial Instruments
* Capital restrictions also allow countries to pursue
Foreign currency transaction types include:
industry-building development goals without having to
worry about the instability of foreign investment capital.

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* The spot market—for immediate delivery
* Forward contracts—customed contracts to buy/sell
Introduction to the Foreign Exchange (FX) Market currency at predetermined exchange rates at a future date
Foreign exchange (FX) markets: * Futures contracts—standardized, traded contracts to
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buy/sell currency at predetermined exchange rates at a
* Involve the exchange of one currency for another future date
* Are incredibly large in terms of daily turnover compared * Swaps—allow a forward to be extended
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to other markets such as equities or fixed income * Options—give the buyer the right, but not the obligation,
to exchange currency at a predetermined exchange rate at
a future date
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Exchange Rates, Appreciation and Depreciation

Regarding exchange rates:
FX Futures and Swaps
* Over time, the value of a currency relative to any other Regarding FX futures and swaps:
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currency can change.

* If more units of domestic currency are needed to buy a * Foreign exchange (FX) futures and swaps are commonly
unit of foreign currency, the foreign currency has used to hedge against exchange rate risk.
appreciated and the domestic currency has depreciated. * Each of these transactions involves a contract to deliver a
@

* If fewer units of domestic currency are needed to buy a currency at an agreed-upon date in the future for an
unit of foreign currency, then the domestic currency has agreed-upon exchange rate at the time of the contract.
appreciated and the foreign currency has depreciated. * While these transactions can be complex, it is worth
understanding them since they comprise about half of all
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foreign exchange transactions.

Nominal and Real Exchange Rates
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Considerations of nominal and real exchange rates:

Spot vs. Forward Exchange Rates
* A nominal exchange rate refers to the price of a specific Considerations of spot and foreign exchange rates:
currency as measured in a second currency.
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* A real exchange rate also considers differences in price * A spot transaction involves the trading of one currency
changes in the underlying nations. for another with an immediate delivery.
* If a nation is experiencing a relatively rapid rate of * A forward contract involves an agreement where a
inflation, the real exchange rate would depreciate quickly currency is exchanged for another currency at some
even if the nominal exchange rate were unchanged. agreed upon point in the future for a rate agreed upon at
the time of the contract.
* These exchanges are often used in conjunction to
Purchasing Power Parity
manage or eliminate exchange rate risk.
Regarding purchasing power parity:

* When countries produce identical goods, and transaction FX Market: Buy-Side and Sell-Side Participants
costs and trade barriers are nonexistent, goods should be The foreign exchange market has both buy-side and
equally priced once adjusting for exchange rates. sell-side participants:
* When true, the currencies are said to have equal

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Reading 2+7: Capital Flows and the FX Market 23

* The buy-side market participants include individuals who In a no separate legal tender regime, a nation gives up the

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travel to other nations and need the local currency there. use of its own currency and enters a monetary union or
* Most of the buying, however, is undertaken by large adopts the currency of another nation. The advantages of
purchasers of currency, including central banks, sovereign this include discipline in monetary policy and often a more

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wealth funds, retail accounts, governments, multinational stable currency. A disadvantage is the loss of independent
corporations, and institutional investors. monetary policy to some degree.
* On the sell side, the largest global banks are the most
important; they account for an increasing share of currency
Exchange Rate Management: Currency Board System
sales given their ability to handle the needs of large
Regarding currency board systems:

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corporations at a lower cost.

* A currency board system is when a government manages

The Ideal Currency Regime and Its Properties its currency by agreeing to exchange domestic currency for
Considerations of the ideal currency regime: a specified foreign currency at a predetermined rate.

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* This system links domestic monetary supply to trade and
* An ideal exchange rate system would include a credibly means the domestic exchange rate will not change.
fixed exchange rate, convertibility of the domestic currency * Seigniorage is possible under this system where the

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to all other currencies, and the ability to pursue domestic country profits by not paying interest on its monetary base
monetary policy. but by receiving interest on its foreign currency reserves.
* In reality, only two of the three can be obtained * This system is best suited for economies with flexible
simultaneously and a nation will need to decide which of prices and wages, where most sectors are traded and the
the three cannot be achieved.
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reserve asset grows at a steady rate.

History of Exchange Rate Regimes Fixed Parity Exchange Rates and Target Zone
n
The history of modern exchange rate regimes can be Regarding fixed parity and target zones:
broken into four broad periods:
so

* A fixed parity exchange rate regime keeps the exchange

* The late 1800s to World War I rate within a 1% range.
* The period from 1914 to 1944 * The monetary authority maintains this rate through
* The end of World War II until 1971-73 either buying or selling currency as needed.
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* From 1973 until today * This process impacts domestic money supply and
inflation.
Each of these had a different approach to the foreign * A target zone regime is the same, except it has a wider
exchange market. range of 2%.
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Taxonomy of Foreign Exchange Regimes Managed Float and Independently Floating Exchange
The purest types of exchange rate regimes are the perfectly Rates
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fixed exchange rate regime on one end and the perfectly Independently floating exchange rates are common
flexible on the other. In reality, many nations have adopted exchange rate systems where the market determines the
os

a regime somewhere between these two, including: exchange rate. Exchange rates in this system change all of
the time and may change by a lot. Some systems use
* Dollarization managed float which is when the country can take action in
* Monetary union the market to change the exchange rate.
db

* Currency boards
* Crawling pegs (active and passive) and bands
Exchange Rate Management: Fixed Parity with
* Managed float
Crawling Bands
Regarding fixed parity with crawling bands:
Exchange Rates and the Trade Balance
International trade and capital flows can both affect * Currency regime choices range from those that are very
exchange rates because they influence the demand and flexible to those that are very inflexible.
supply for a currency. Exchange rates move to maintain an * A currency that has a fixed parity with a crawling band
equilibrium where capital flows exactly offset trade flows. leans toward more flexibility.
* In this system, the monetary authority has announced an
explicit exchange rate but has also signaled the exchange
No Separate Legal Tender Exchange Rate rate may vary increasingly over time.
Regime—Dollarization

© Mindojo, 2023
Reading 2+4: Monetary Policy 24

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2+4 Monetary Policy

Reading 2+4: Monetary Policy

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The Varied Roles of Central Banks inflation at or near a specified level, that is referred to as
A central bank serves many roles in an economy. Most inflation targeting.
often, it is the: * In many cases, target rates are selected to avoid both
price declines but also inflationary shocks.

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* Monopoly supplier of currency and bank notes * Some central banks are given an inflation target from
* Administrator of monetary policy elected officials while other more-independent central
* Lender of last resort banks are able to develop their own.
* Banking system supervisor

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* Banking regulator
Exchange Rate Targeting in Monetary Policy
Exchange rate targeting:
Tools of the Central Bank: Open Market Operations

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Open market operations is one of three primary tools that * Involves the use of monetary policy to maintain a
central banks use to manage the money supply. When a particular exchange rate between the domestic currency
central bank buys government securities such as bonds and one or more other currencies
from a commercial bank or an individual, the money supply * Is useful when an economy routinely experiences high
increases, interest rates fall, and economic activity is
re
rates of inflation as it allows a country to import the
stimulated. The sale of these securities reduces the money inflation experienced in other countries
supply and limits inflationary pressure. * Comes at the expense of using monetary policy for
n
stabilizing domestic economic conditions

Tools of the Central Bank: The Central Bank’s Policy

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Rate Contractionary and Expansionary Monetary Policies

A central bank uses a policy rate to signal the direction of and the Neutral Rate
its monetary policy and to influence interest rates on bank A neutral rate refers to an interest rate that is neither
loans to customers. In the United States, the discount rate expansionary nor contractionary. It can theoretically be
bo

and the target fed funds rate are two important policy determined by summing the long-term real trend growth
rates for the Federal Reserve. rate of an economy and its target inflation rate.
@

Tools of the Central Bank: Required Reserve Ratio Factors Influencing the Mix of Fiscal and Monetary
Central banks have three primary tools that can be used to Policy
manage the money supply, and among them is the Fiscal and monetary policy can either complement or
required reserve ratio. To stimulate economic activity, a counteract one another. The country-specific economic
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central bank can lower the required reserve ratio, thereby situation and country-specific political factors influence the
encouraging banks to lend. That would increase the money mix of fiscal and monetary policies adopted by a country.
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supply and typically cause economic activity to accelerate. Due to policy lags, politics, and Ricardian equivalence,
monetary policy may be favored over fiscal policy.

Transmission Mechanisms of Central Bank Policy Rates

db

The central bank’s policy rate works through the economy Quantitative Easing and Policy Interaction
through any one—and more than likely all—of the When central banks purchase government debt in
following mutually dependent channels: quantitative easing, this monetizes the government debt.
Central banks that do this might not seem to be behaving
* Value changes of crucial asset prices independently.
* Short-term market interest rates
* The exchange rate
Central Bank Independence from Government
* The expectations/confidence of economic agents.
Regarding central banks:

Central Bank Mandates: Inflation Targeting * Elected governments cannot be trusted with monetary
Considerations of inflation targeting: policy.
* Instead, central banks should be independent.
* When a central bank designs its policy actions to hold * Most central banks are operationally independent.

© Mindojo, 2023
Reading 2+4: Monetary Policy 25

* Some are also target independent.

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Importance of Central Bank Credibility
Considerations of independence and credibility of the

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central bank:

* The credibility of a central bank is paramount to its ability

to meet its inflation targets.
* If a central bank is credible, then people will believe the

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actual inflation rate will equal the target inflation rate and
the target will be met, barring unexpected inflation.
* If a central bank lacks credibility, then people will believe
the actual inflation rate will be greater than the target

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inflation rate and the central bank will not hit its target.

Transparency in Central Bank Decision Making

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If the public does not believe in the central bank’s abilities
to meet its targets, it will be more difficult for the central
bank to make those targets. By transparently re
communicating its views, the central bank can establish a
credible reputation.
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Sources of Shock to the Inflation Rate
Considerations of sources of shock to the inflation rate:
so

* How central banks respond to inflationary shocks

depends upon the source of the shock.
* If the inflationary shock is from the demand side, the
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response may be tightening.

* If the inflationary shock is from the supply side, the
appropriate response may be no response.
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Limitations of Monetary Policy

Regarding limitations of monetary policy in implementing
its vision:
e

* Bond vigilantes may act to counter central bank moves.

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* If an economy is in a liquidity trap, the central bank may

be unable to influence interest rates.
* Central banks cannot push interest rates below the zero
lower bound.
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Reading 2+3: Fiscal Policy 26

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2+3 Fiscal Policy

Reading 2+3: Fiscal Policy

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Fiscal Policy and Aggregate Demand investors’ ability to anticipate the usage of future fiscal
Regarding fiscal policy and aggregate demand: policy tools.

* Aggregate demand is the planned expenditures of

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households and firms on consumption and investment in Fiscal Multiplier: How Government Spending affects

the economy as a whole. Aggregate Demand

* Tax cuts and increased government spending may Government spending affects aggregate demand by

increase aggregate demand. stimulating additional spending through a multiplier effect.

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* The relationship between fiscal policy and aggregate This is reduced by taxes and a marginal propensity to save

demand is imperfect. (s), which is one minus the marginal propensity to consume
(c). The calculation of the fiscal multiplier is:

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Government Receipts and Expenditure in Major M ultiplier =
1 − c(1 − t)
Economies
Expansionary fiscal policy expands the government deficit.
Contractionary fiscal policy reduces the government deficit.
re
Balanced Budget Multiplier of One
Increasing government spending and taxes by the same
Government Deficits and the National Debt
amounts allows the maintenance of a balanced budget.
Considerations of deficits and national debt:
n
Still, regardless of the marginal propensity to consume,
taxing and spending a given amount will increase
* The national deficit is the difference between
so

aggregate demand by that same amount in theory due to

government expenditures and revenues in a year.
the fiscal multiplier. Therefore, the balanced budget
* The national debt is the accumulation of these deficits
multiplier is always equal to one.
over time.
* The debt-to-GDP ratio and debt service-to-GDP ratio are
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measures of the size of the national debt.

Government Deficits and the Fiscal Stance
* A large national debt may be cause for concern if it
Looking at a government’s deficit isn’t enough to determine
results in higher taxes, if markets lose confidence in the
the fiscal stance. This is affected by automatic stabilizers,
government’s ability to repay, or if government borrowing
as well as nominal vs. real debt service. A better indicator
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crowds out private investment.

of fiscal stance is the cyclically adjusted budget deficit.

Fiscal Policy Tools and the Macroeconomy

Difficulties in Executing Fiscal Policy
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Government spending includes transfer payments, current

Regarding difficulties in fiscal policy execution:
government spending, and capital expenditures. Taxation
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include direct taxes and Indirect taxes. Economists

* Policymakers may also realize too late that the economy
generally prefer taxes to be fair, efficient, simple, and
is cooling due to data time lags (recognition lag).
sufficient.
* After the policy changes are voted on and passed,
db

implementation may take quite a bit of time (action lag).

Advantages and Disadvantages of Using the Different * And even after implementation, it may be a while before
Tools of Fiscal Policy the economy sees any results from these actions (impact
The fact that changes in indirect taxes can be adjusted lag).
almost immediately after they are announced is an * Other difficulties include the crowding out effect and
advantage as a fiscal policy tool because it can influence excessive debt.
spending behavior immediately. This creates revenue for
the government at low or no cost to the government. The
disadvantages of using a change in direct taxes or capital
spending as fiscal policy tools are primarily due to lags
from the time it takes to create and implement these types
of discretionary policies.

Fiscal policy tools can also lead to outcomes based upon

© Mindojo, 2023
Reading 2+5: Introduction to Geopolitics 27

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2+5 Introduction to Geopolitics

Reading 2+5: Introduction to Geopolitics

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Geopolitics: International Trade Organizations
The World Trade Organization (WTO) has played a crucial
role in policing the international economy’s trade
agreements under the policies of reciprocity. The World

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Bank was formed in 1944 in order to help developing
countries fight poverty and promote economic growth. The
International Monetary Fund (IMF) was established in 1945.
Its designers intended it to play a significant role in

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maintaining international financial stability.

Geopolitics: National Governments and Political

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Cooperation
Geopolitics is the study of how various actors interact.
![](
Geopolitical risks arise from the actions of both state actors re
and non-state actors. Nations fall along a spectrum of
cooperative and non-cooperative in various areas Geopolitics: The Tools of Geopolitics
depending on both economic interests and those of Tools of geopolitics can be generally categorized as
national security. national security, economic, or financial. There are both
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non-cooperative and cooperative tools that can also fall
along a spectrum of nationalism or globalization, with
so

Geopolitics: Resource Endowment, Standardization, some examples as shown:

and Soft Power
Geopolitical resource endowment refers to minerals,
water, and geography that a nation has from its position.
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Standardization refers to cooperative efforts like

containerization and banking agreements that allow for
more speed and consistency in trading. Soft power is
gained from offering various benefits to achieve reciprocity
without coercion or force. The decision maker can
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prioritize cooperative goals or national goals, which are

affected by the length of the political cycle.
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Geopolitics: Non-State Actors and the Forces of

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Globalization
Globalization is the integration of people, countries, and
![](
companies that has accelerated in recent decades while
nationalism is the opposite. Non-state actors pursue FDI
db

and portfolio investment in foreign nations as part of Geopolitics: Types And Assessments of Geopolitical
globalization in pursuit of profits, greater trade, and more Risk
wealth. The downsides often include inequality, Types of geopolitical risk include event risks, thematic risks,
environmental destruction, and weakness of and unpredictable exogenous risks. Financial managers
interdependence. must assess the likelihood of such events, the velocity (or
speed) of how things are affected for short-term and
long-term effects, and the impact on such events. These
Geopolitics: Assessing Geopolitical Actors and Risk
estimations can be used in scenario analysis.
The four archetypes of country behavior are autarky,
hegemony, multilateralism, and bilateralism. Each fall into
a quadrant formed by the spectrum of cooperative vs. Geopolitics: Geopolitical Risk in the Investment
non-cooperative and globalization vs. nationalism as Process
shown: Signposts serve as warning levels of various geopolitical
risks. These can help financial managers determine asset

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Reading 2+5: Introduction to Geopolitics 28

allocation decisions in a top-down approach. The

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Geopolitical Risk Index (GPR) was developed to gather
overall risk levels from varied sources. This could be
included as a factor in a multi-factor model.

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ch
ar
se
n re
so
bo
e @
os
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© Mindojo, 2023
Reading 2+8: Exchange Rate Calculations 29

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2+8 Exchange Rate Calculations

Reading 2+8: Exchange Rate Calculations

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FX Market: Introduction to Exchange Rate Quotations
Foreign exchange quotations are shown as currency pairs.
A quotation of 1.1 ABC/XYZ tells you that it takes 1.1 ABC to
get 1 XYZ, consistent with all other fractional rates.

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FX Market: Cross-Rate Calculations
When you are given two exchange rates involving three

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different currencies, you can find the cross-rate or missing
third currency pair by backing into the rate from the given
quotations.

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FX Forward Discounts and Premiums
Regarding forward discounts and premiums:

* Forward rates are determined by spot exchange rates

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and interest rates.
* If interest rates for investments in the two currencies to
n
be exchanged differ, the forward exchange rate will be
either higher (forward premium) or lower (forward
discount) than the spot exchange rate other things being
so

equal.
* The difference is expressed as an amount of points
(positive or negative) to add to the spot rate.
 [ ]
bo

1 + rf days
360
Ff /d = Sf /d  [ ]
1 + rd days
360
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FX Spot Rates, Forward Rates, and Interest Rates

Contracts for immediate settlement are referred to as spot
contracts. Contracts for later settlement are referred to as
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forward contracts. Interest rates in each country of the

currency pair should cause a no-arbitrage condition:
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( )
1 + rf
Ff /d = Sf /d
1 + rd
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Reading 3+1: Portfolio Risk and Return (Part I) 30

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3+1 Portfolio Risk and Return (Part I)

Reading 3+1: Portfolio Risk and Return (Part I)

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Introduction to Portfolio Risk and Return—Part I negative skew.
Portfolio construction follows the basic process of
considering risk-return characteristics of all available assets
Kurtosis
and possible portfolios, and selecting the most efficient

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Kurtosis is the condition of ”fat tails” in a distribution. This
portfolio that meets the risk and growth preferences of the
condition is seen where the distribution has a number of
target investor. Portfolios are differentiated by the ratio of
extreme values, a factor that has significant implications on
return to risk. Regardless of the expected return, the
models that assume normality.
investor must be comfortable with the risk level of the

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investment, and the risk level must be suitable to the
investor’s investment objectives. Operational Limitation of the Market—Liquidity
Liquidity has significant implications on the desirability of
an asset. It is directly related to transactions costs, and

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Historical Return and Risk
some markets are known to have more liquidity problems
Risk varies across the asset classes based on the certainty
than others.
of future cash payments to each asset class. Future cash
flows to stocks are consider the least certain, followed by
bonds and Treasury Bills. Expected return arises from the
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Risk-Seeking Investor
risk-free rate, expected inflation, and risk premia. Risk seeking is a form of risk aversion which is observed
rarely in certain circumstances, and is defined as the
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preference for a lottery between two values rather than
Returns and Risks of Major Asset Classes those values with certainty.
A look at over 92 years of historical returns for major U.S.
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asset classes shows that large-company stocks have

returned 10.2%, long-term government bonds have Risk-Neutral Investor
returned 6.1%, and T-bills have returned 3.4%, with average Risk neutrality is a form of risk aversion where the value of
inflation of 2.9%. World stocks and bonds have returned an expected outcome must be guaranteed with some
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slightly lower. The real risk-free rate was then about 0.5%, certainty. This is appropriate for fair insurance and
with other returns including inflation and risk premia. situations that are repeated across many trials. It is also
more common for relatively small payoffs.
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Risk-Return Trade-off and the Risk Premium

Risk and return have a direct and positive connection both Risk-Averse Investor
in theory and in practice. The risk premium of each asset Risk-averse preferences are observed when a payoff with
class is closely connected with its level of measured risk. certainty is preferred to a gamble with that same expected
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value. Investors tend to be more risk averse at higher

payoff levels.
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Normal Distribution
The normal distribution has three main characteristics:
Risk Tolerance
Risk tolerance refers to the willingness of an investor to
* The equality of mean and median
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take on risk in order to achieve an investment goal. Risk

* Its definition by mean and variance
tolerance is inversely related to risk aversion and can be
* The proportion of observations contained in varying
difficult to measure.
distances symmetrically around its mean

There are limitations to its applicability to investment Utility Theory and Indifference Curves
returns. Utility theory offers a mathematical way to show equivalent
satisfaction among a set of choices for a given investor.
Depending on the investor’s utility function, this set, called
Skewness
an indifference curve, can be mapped in order to select an
Skewness is a condition where one tail is ”fatter” than the
optimal portfolio.
other, making the distribution asymmetrical. This
measurement is based on the cubed deviation from the
mean and so preserves the direction of the deviation. A fat The Capital Allocation Line (CAL)
right tail shows a positive skew, and a fat left tail shows a Regarding the Capital Allocation Line (CAL):

© Mindojo, 2023
Reading 3+1: Portfolio Risk and Return (Part I) 31

major asset classes to be mindful of; even among the list of

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* The combination of a risk-free asset and a risky asset ”majors,” there are correlations substantially less than 1
shown to be optimal by utility theory is shown graphically which allows investors to take advantage of opportunities
as the capital allocation line. for diversification.

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* Once calibrated, algebra can be used to locate various
points on the capital allocation line.
Diversification with Asset Classes
Of the many avenues to diversification, one of notable
Portfolio Return as a Weighted Average importance is diversification among asset classes. The
The return to a portfolio of assets can be calculated as the imperfect correlations between several asset classes that

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weighted average return to the assets in the portfolio. The tend to be fairly robust and the sheer number of asset
weighting factor on average is the proportion of wealth classes available make this an important dimension to
invested in each asset: consider.

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∑
N
Rp = wi Ri
Diversification with Index Funds
t=1
Of the many avenues to diversification, one popular
where the sum of weights equals 1, method is to use index funds. These are passively

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∑
N managed funds of often many securities, which allow
wi =1. investors to have low-cost access to a diversified portfolio
t=1
without needing to build it from scratch.
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Diversification by Not Owning Company Stock
Relationship Between Portfolio Risk and Return
Of the many avenues to diversification, a key consideration
There is a direct relationship between risk and return;
is an implicit investment in one’s own employer. Investing
n
however, a two-asset portfolio can be used for illustrating
both a career and an investment balance in the same
the fact that, when correlation decreases, risk declines
company is often unwise.
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while expected return remains constant.

Investment Opportunity Set

Portfolio Risk: A Portfolio of Many Risky Assets The first step in identifying efficient portfolios and optimal
bo

Risk in a portfolio of many risky assets is shown as an portfolio analysis is determining the investment
extension of the two-asset portfolio, generalized as a opportunity set (IOS), which is the complete set of all
matrix of all asset weights, variances, and covariances. possible investable portfolios.
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Importance of Correlation in a Portfolio of Many Assets Addition of Asset Classes

Risk in a portfolio of many risky assets is a function of all As additional asset classes of any type are added, the
asset weights, variances, and covariances. As the number investment opportunity set will continue to expand in the
of assets increases, variance becomes less important than northwestern direction, which improves the risk/return
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the correlations between the assets. profile of portfolios available.

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Portfolio Risk: The Power of Diversification Minimum-Variance Portfolios and Frontier

The power of diversification is the ability to obtain a Using the investment set of risky assets, all possible
desirable level of expected return while reducing portfolio combinations of assets in portfolios are constructed to find
db

risk. Harnessing this power requires a precise definition of those portfolios with the lowest variance returns for any
what diversification really is and fair warning about what it given level of expected return. These are
is not. minimum-variance portfolios. The set of all
minimum-variance portfolios is the minimum-variance
frontier.
Historical Risk and Correlation
The connection between past performance and future
expectations is mixed, empirically. This seems to work Global Minimum-Variance Portfolio

better for measures of risk than for return, at least within a The global minimum-variance portfolio is the point of

limited time frame. lowest risk on the minimum-variance frontier. It represents

the portfolio with the lowest possible risk given the set of
available risky assets and separates the efficient and
Historical Correlation Among Asset Classes inefficient regions of the frontier.
There are some intermediate-term correlations between

© Mindojo, 2023
Reading 3+1: Portfolio Risk and Return (Part I) 32

Markowitz Efficient Frontier investor. In contrast, the historical mean return is the

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Using the investment set of risky assets, all possible actual return realized by investors. Differences between
combinations of assets in portfolios are constructed to find the two arise due to unforeseen events not included in
those portfolios with the highest return for any given level investor forecasts. Over the long run, positive and negative

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of risk (measured by standard deviation of returns). The surprises are offsetting such that expected return and
set of these portfolios is the Markowitz efficient frontier. mean realized return are equal.

Capital Allocation Line and Optimal Risky Portfolio Variance and Standard Deviation of a Single Asset
Variance is a measure of risk that captures the volatility of

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Regarding the Capital Allocation Line (CAL) and the optimal
risky portfolio: asset prices. The greater the variance, the larger the
dispersion of returns around the mean. The variance of an
* The line connecting the risk-free asset to the market asset is given by the following equation:
portfolio is known as the capital allocation line (CAL).

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∑
T

* It measures the relationship between risk and expected (Rt − µ)2

t=1
return, when risk is measured by standard deviation. σ2 =
T
* The optimal portfolio for any investor is the point of
where R is the realized return in period t, µ is the mean

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tangency between its unique indifference curve and the
return, and T is the population of returns. The standard
CAL.
deviation is the square root of the variance, and as a
measure of risk it shares common units with the sample
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Two-Fund Separation Theorem mean.

Two funds are all that is needed to create an optimal

portfolio for any investor, according to modern portfolio Concept of Risk Aversion
theory. The two funds needed are the risk-free asset and
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Regarding risk aversion:
the market portfolio.
* Risk-seeking individuals typically choose uncertain
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outcomes with high-potential payoffs and place less weight

Investor Preferences and Optimal Investor Portfolio
on the riskiness of the outcome.
Investors are typically risk-averse, and indifference curves
* Risk-averse individuals prefer a payoff with certainty to
are subsequently convex. These indifference curves will
the same payoff in expected value.
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then touch the capital allocation line at a single point,

* Risk-neutral individuals are ambivalent regarding the
which for each investor’s preferences can be identified as
risky and riskless option and will chose the option with the
that investor’s optimal portfolio.
highest expected payoff.
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Portfolio Risk: Covariance and Correlation

Correlation and Risk Diversification
Regarding covariance and correlation:
Of the many avenues that lead to diversification, all
function effectively only because of their potentials to offer
e

* Covariance is a largely meaningless measure by itself, but

returns that are not perfectly correlated. Every
it is part of the calculation for correlation, which measures
diversification scheme is a derivative of this relationship.
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how closely two variables move together.

* Correlation ranges from -1 to +1.
* A correlation of -1 means two variables move in opposite Diversification Among Countries
directions all of the time. Of the many avenues to diversification, one of notable
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* A correlation of +1 means two variables move in the importance is diversification among countries.
same direction all of the time. Country-specific risks may plague an investor’s portfolio
* A correlation of 0 means two variables are independent. who chooses assets with a home-country bias, and
investing internationally will mitigate these risks.

Application of Utility Theory to Portfolio Selection

Utility theory can be used to demonstrate that a risk averse Diversification by Evaluation of Each Asset Before
investor will optimally choose some combination of a Adding to Portfolio
risk-free asset and a risky asset. This is shown both A risk-return analysis is appropriate when considering the
mathematically and graphically. addition of new assets into an investment portfolio. One
tool to consider is essentially a comparison of the Sharpe
ratio for the portfolio and potential new asset, adjusted for
Historical Mean Return vs. Expected Return correlation.
The expected return is the return demanded by the

© Mindojo, 2023
Reading 3+1: Portfolio Risk and Return (Part I) 33

Buying Insurance for Risky Portfolios

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Insurance produces a negative return but a strong,
negative correlation with the assets it is designed to insure.
A secondary possibility is the purchase of gold, and a third

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is the purchase of put options.

Portfolio Risk: Portfolio of Two Risky Assets

A portfolio of two risky assets has a standard deviation of
returns which can be calculated from the weightings of the

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two assets in the portfolio, the asset variances, and the
correlation between the assets. This formula can provide
some intuition as to the importance of correlation in how
each asset contributes to portfolio risk.

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se
n re
so
bo
e @
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© Mindojo, 2023
Reading 3+2: Portfolio Risk and Return (Part II) 34

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3+2 Portfolio Risk and Return (Part II)

Reading 3+2: Portfolio Risk and Return (Part II)

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Introduction to Portfolio Risk and Return - Part II Considerations of active versus passive portfolios:
Regarding portfolio risk and return:
* Investors can pursue a passive or active portfolio
* Investor or manager perception of risk and return of strategy.

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individual assets and a portfolio formed from those assets * A passive strategy would be investing in a security that
depends on the information available to that investor or would track an index such as the S&P 500.
manager. * The goal in a passive strategy is to match the returns of
* If investors shared a common set of information, they the index.

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would form the same expectations regarding future prices * An active portfolio strategy has a goal to outperform an
and risk. index such as the S&P 500.
* Correspondingly, they would all hold the same optimal
portfolio of risky assets.

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What Is the “Market”?
* More risk averse investors would place a lower weight on
The ”market” in the capital market line is a portfolio of risky
the risky portfolio and a higher weight on the risk-free
asset and anything else of value in the world. In reality, it is
asset to reduce overall position risk.
more practical to use a broad market index as a proxy for
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the market.
Capital Market Theory
Regarding capital market theory:
Leveraged Portfolios
n
Regarding leveraged portfolios:
* The capital market theory is based on the idea that
investors want the highest level of return given their
so

* When an investor holds a portion of a portfolio in the

desired level of risk.
risk-free asset and in the market portfolio, a lending
* It builds on the Markowitz portfolio theory by creating a
portfolio is created.
model for pricing all assets.
* The term ”lending portfolio” is based on the notion that
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* The goal for investors is to find the optimal portfolio

buying the risk-free security is the equivalent of lending
based on return objectives and risk tolerance.
money at the risk-free interest rate.
* An investor that is willing to accept more risk for a
Homogeneity of Expectations possible higher return can borrow money at the risk-free
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Regarding homogeneity of expectations: rate and invest the proceeds in the market portfolio.
* This creates a leveraged position in the optimal risky
* In order to simplify the capital market theory, it is portfolio.
assumed all investors have homogeneity in investor
e

expectations.
Leveraged Portfolio with Different Lending and
* This means every investor has the exact same
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Borrowing Rates
expectations on investment risks and returns.
An investor that is willing to accept more risk for a possible
* The homogeneity of expectations leads to only one
higher return can borrow money at a higher rate than the
optimal portfolio.
risk-free rate and invest the proceeds in the market
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portfolio. This creates a leveraged position in the optimal

Capital Market Line (CML) risky portfolio.
Regarding the CML:

Pricing of Risk and Computation of Expected Return

* The capital market theory revolves around the
Regarding pricing of risk and computation of expected
assumption that you can invest in a risk-free asset and the
return:
optimal risky portfolio.
* The optimal risky portfolio is called the market portfolio.
* By investing in assets with unique risk exposures the
* This combination of assets creates a unique capital
investor reduces portfolio risk.
allocation line (CAL), which is called the capital market line
* This process is termed portfolio diversification.
(CML).
* As more assets with unique risk factors are added to the
portfolio, risk is reduced further but cannot be eliminated.
Passive vs. Active Portfolios * It is impossible to eliminate all risk via diversification as

© Mindojo, 2023
Reading 3+2: Portfolio Risk and Return (Part II) 35

certain risk factors, termed systematic risk factors, are measured by beta, remains.

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common to virtually all assets in the economy.

The Market Model: The Market Index as a Single Factor

The market model is the most common use of the

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Systematic and Nonsystematic Risk
Regarding systematic and nonsystematic risk: single-index model, where the market portfolio is used as
the single factor, the index. The market model allows for
* Systematic risk factors are those that affect virtually all prediction of returns and recognition of abnormal returns.
companies in the economy.
* Nonsystematic or idiosyncratic risk factors are those that

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Estimating Beta through Statistical Regression
affect only one company or the companies in one industry.
One way to calculate beta is an estimation from the market
* Using the variance of returns as a measure of risk—Total
model equation, through statistical regression:
Variance = Systematic Variance + Nonsystematic Variance
Ri = αi + βi RM + ei

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Pricing of Risk
Regarding pricing of risk:

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Beta and Expected Return—Introduction to CAPM
* A simple supply-demand model can be used to illustrate Another name for the single-index model is the capital
when investors are not rewarded for bearing asset pricing model (CAPM), used to estimate returns of
nonsystematic risk. assets using the form:
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* If nonsystematic risk were priced, the rational investor
E[Ri ] = Rf + βi (E[RM ] − Rf )
would purchase high nonsystematic risk investments and
then form a diversified portfolio, eliminating the risk.
* Seeking to realize larger arbitrage profits, more and more
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investors would seek to purchase nonsystematic risk
Capital Asset Pricing Model (CAPM): Assumptions
pushing demand and the price of nonsystematic risk to
so

The capital asset pricing model (CAPM) operates under the

infinity.
following assumptions:
* A price of infinity for nonsystematic risk results in an
expected return of zero for bearing nonsystematic risk.
* Investors are risk averse and rational
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* Investors plan for the same holding period

Return-Generating Models * Investors have homogeneous expectations
Regarding return-generating models: * Investors are price-takers
* Markets are frictionless; no transactions costs or taxes
* A return-generating model is a model that can be used to * All investments are infinitely divisible
@

forecast the return for an asset utilizing predictive factors.

* Factors commonly include economic factors that
Security Market Line (SML)
influence the profitability of the company, or
The security market line (SML) is the graphical
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macroeconomic factors which broadly affect most

representation of the capital asset pricing model (CAPM),
companies in the economy.
connecting the risk-free rate to the market portfolio in the
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* The quality of the return estimate is dependent on the

space of expected return and systematic risk.
quality of the factors used in the return generating model.

Calculating a Portfolio Beta

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Multi-Factor Models The beta of a portfolio is the weighted average of the

Multi-factor models refer to models with multiple securities’ betas that comprise the portfolio:
independent variables chosen to use in statistical
regression in order to explain a dependent variable of βP = w1 β1 + w2 β2 + ... + wn βn
interest. Adding more independent variables makes the
model look like a better fit but may even reduce predictive
power.
Capital Asset Pricing Model (CAPM): Applications
There are a large number of applications for the capital
Decomposition of Total Risk for a Single-Index Model asset pricing model (CAPM), including:
With the use of multiple equations, the total risk found in a
single-index model can be divided into systematic and * Estimation of expected/required rates of return
unsystematic risk. If the portfolio is well-diversified, * Capital budgeting
unsystematic risk can be ignored, and only systematic risk, * Cost of capital estimation

© Mindojo, 2023
Reading 3+2: Portfolio Risk and Return (Part II) 36

* Performance evaluation of the SCL is beta, and the vertical axis intercept is Jensen’s

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alpha.

Capital Asset Pricing Model (CAPM): Calculating

Expected Returns Security Selection

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The most straightforward application of the CAPM is in By relaxing the CAPM assumption of homogeneous
calculating an expected return or required rate of return expectations, investors can now choose securities based
given a level of systematic risk in an asset or project. This on their perceived undervaluation, measured best by
required rate of return becomes a good estimate of the Jensen’s alpha.
discount rate to use in cost of capital calculations.

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Constructing a Portfolio
Portfolio Performance Evaluation Constructing an actual portfolio with the CAPM principles
It is important to be able to evaluate the performance of in mind requires that the market portfolio be substituted

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funds or managers against varying levels of total risk and for something more achievable. Unsystematic risk declines
systematic risk. Popular tools for these evaluations include as a portfolio expands, with most diversification benefits
the Sharpe ratio, Treynor ratio, M-Squared, and Jensen’s achieved at approximately 30 assets.
Alpha.

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CAPM — Practical Limitations
Sharpe and Treynor Ratios There are several practical limitations to the CAPM,
The Sharpe ratio is the return premium divided by a including:
measure of total risk:
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Rp − Rf * The lack of a true market portfolio or defensible proxy
Sharpe = * Disagreement in beta estimation
σp
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* The heterogeneity of investors’ expectations
The Treynor ratio is the return premium divided by a
* A poor track record for the CAPM’s predictive power
measure of systematic risk:
so

Rp − Rf
T reynor = Extensions to the CAPM—Theoretical Models
βp
A theoretical model such as arbitrage pricing theory (APT)
is a theoretical advancement beyond the CAPM because it
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allows for several factors to influence asset prices other

M-Squared (M2) and M-Squared Alpha than just market risk. But this model is not typically used in
The M 2 measure requires a weighting to create a practice.
mimicking portfolio with the same total risk as the
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benchmark. Then the weighting is used to find a

Extensions to the CAPM—Practical Models
risk-adjusted return:
Practical models such as the four-factor model have gained
[ ] σm
M 2 = E(RP ) − Rf + Rf popularity because of their ability to better explain asset
e

σP
returns than the CAPM. But the external validity and
From this M 2 measure, the benchmark return is durability of these models are in question.
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subtracted to arrive at the M 2 alpha. A positive M 2 alpha

means that the portfolio outperformed the market and a
negative M 2 alpha means that it underperformed the Capital Allocation Line (CAL)
market, on a risk-adjusted basis. A capital allocation line (CAL) is a linear combination of
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some risky asset and the risk-free rate. This linear set of
possibilities creates feasible portfolios which allows
Jensen’s Alpha investors to obtain points on better indifference curves.
Jensen’s alpha is essentially the vertical distance between
an asset’s performance and the security market line (SML),
in the space of return and systematic risk. This measure is Combining a Risk-Free Asset with Portfolio of Risky

meaningful when used in comparison with both the market Assets

portfolio and other assets. Considerations of combining a risk-free asset with a

portfolio of risky assets:

Security Characteristic Line (SCL) * The investable world is divided between risk-free and
The security characteristic line (SCL) is a graphical risky assets.
representation of the statistical regression of asset premia * A risk-free asset’s return is known and the standard
on market premia which estimates beta directly. The slope deviation of the return is zero.

© Mindojo, 2023
Reading 3+2: Portfolio Risk and Return (Part II) 37

* A risky asset is characterized by having an uncertain

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return. * Covariance and correlation are useful statistics for
* This uncertainty is measured by the standard deviation of evaluating if assets historically move together or inversely.
expected returns. * Covariance measures how two variables—such as stock

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* The standard deviation is the measure of risk for an asset. and bond returns—move in the same or opposite direction.
* Correlation standardizes the degree to movement of
variables with a range of value from -1 to 1.
Interpreting Beta Values * A correlation coefficient of 1 indicates two assets would
Beta is a measure of market risk, with the market as the perfectly move together and a -1 shows perfectly inverse
standard. Therefore, the beta of the risk-free rate is 0, the

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movement.
beta of the market is 1, and positive betas indicate * Covariance and correlation are important factors in
covariance with the market. capital market theory to determine the optimal portfolio.

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Single-Index Model
A single-index model is a return-generating model with a
single factor: an index. A nice application of the
single-index model is in the creation of the capital market

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line (CML).

CAPM — Theoretical Limitations

Regarding theoretical limitations of capital asset pricing
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model (CAPM):
n
* The theoretical assumptions of the CAPM make it easier
to understand and implement.
so

* However, these assumption mean the model may not

accurately reflect reality.
* Specifically, in the CAPM, only systematic risk is priced
when in reality a range of risks influence asset prices, and
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investment occurs in one period when in reality investors

invest for several periods.

Does a Unique Optimal Risky Portfolio Exist?

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regarding a unique optimal risky portfolio:

* One of the underlying assumptions of the capital asset

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pricing model (CAPM) is that all investors possess the same

information set.
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* As investors are evaluating the same information, they

develop common expectations regarding future prices.
* This assumption is referred to as homogeneity of
expectations.
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* Of course in reality, investors do not possess common

information resulting in unique expectations and trading
among investors.

Calculating Beta with Variance and Covariance

Beta is calculated as:
Cov(Ri , RM ) ρi,M σi
βi = 2
=
σM σM

Covariance and Correlation

Regarding covariance and correlation:

© Mindojo, 2023
Reading 4+4: Working Capital and Liquidity 38

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4+4 Working Capital and Liquidity

Reading 4+4: Working Capital and Liquidity

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Sources of Capital: Working Capital Choices
Regarding working capital: Financing choices must ensure that there is adequate
capacity to borrow for additional needs. Cash must always
* Working capital focuses on the short-term aspects of be available for operations, preferably without large

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corporate finance, and attempts to balance the need for disbursement days.
cash to pay obligations with the business goal of investing
assets as productively as possible.
* Working capital managers need to monitor all short-term Working Capital: Relating Liquidity, Capital, and

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asset and credit accounts, while also creating cash Short-Term Funding Needs

forecasts and watching transactions and bank balances. The optimal amount of cash and inventory on hand varies

* The scope of working capital management includes depending on the company. More cash and inventory is

working capital transactions, relations with outside conservative, while less is aggressive. On the financing

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organizations, analysis of working capital strategies, and a side, using short-term debt is aggressive while long-term

focus on liquidity debt and equity is more conservative. The more

conservative choices provide the firm more safety and
flexibility, but lower returns on equity.
Managing Liquidity: Primary and Secondary Sources
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Liquidity management involves developing, implementing,
and maintaining the company’s liquidity policy so the The Cash Conversion Cycle
n
company can obtain cash when needed. Primary sources The cash conversion cycle is calculated as days of inventory
of liquidity include cash balances, short-term funds, and on hand (DOH) plus days sales outstanding (DSO) minus
the days payable outstanding (DPO). The shorter, the
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cash flow management. Secondary sources of liquidity

include negotiating debt contracts, liquidating assets, and better. A common goal is a negative value, if the average
filing for bankruptcy. time to pay suppliers is larger than the average time to sell
and collect.
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Managing Liquidity: Liquidity Ratios

Liquidity ratios include:

* The current ratio: current assets divided by current

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liabilities
* The quick ratio: current assets minus inventory divided
by current liabilities
* The cash ratio: cash and short-term marketable
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securities divided by current liabilities

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Managing Liquidity: Drags and Pulls on Liquidity

Drags on liquidity are situations in which cash comes into a
company more slowly, while pulls on liquidity are situations
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involving cash being paid out too quickly. Both can cause
liquidity problems for a company, and should be avoided
or addressed as soon as possible.

Sources of Capital: Internal Financing

Sources of internal financing include the generation of
additional operating cash flow; slower payments of
accounts payable in use of trade credit; faster collections of
accounts receivable; and the liquidation of current assets,
such as marketable securities and inventory.

Managing Liquidity: Evaluating Short-Term Financing

© Mindojo, 2023
Reading 4+6: Capital Structure 39

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4+6 Capital Structure

Reading 4+6: Capital Structure

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Cost of Capital: Concept, Meaning, and Use estimated market return in the CAPM formula.
Regarding cost of capital:
E[Ri ] = RF + βi (E[RM ] − RF )

* Cost of capital is an opportunity cost against which

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investment projects are compared.
* To add value, a company needs to invest in projects that
Proposition I without Taxes: Capital Structure
produce returns that exceed the cost of its capital.
Irrelevance
* Cost of capital varies with the riskiness of the project and
Franco Modigliani and Merton Miller developed theories on

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it is only an estimate.
the capital structure decision in corporations. MM
Proposition I asserts that the market value of a company is

Choosing WACC Weights: Targets and Market Values not affected by its capital structure. Based on the condition

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Weights for each capital component in calculating a of no taxes and the assumptions described, the value of an

weighted average cost of capital (WACC) should be chosen unlevered firm is equal to the value of a levered firm, or

based on the market value of that capital component, and VU = VL

in the proportions of the target capital structure the firm is
trying to achieve.
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Estimating the Weighted Average Cost of Capital
n
Capital Structure: Startups and Growth Firms
The weighted average cost of capital (WACC) sums the
Capital structure depends in part on the stage of the
weighted individual costs of capital, for an estimated total
company. Start-ups often face high borrowing rates,
so

cost of all capital used by a firm:

leaning more on equity. The use of debt tends to increase
as firms become more mature. W ACC = wD CD + wE CE

where w are the weightings and C are the costs of debt (D)
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and common equity (E).

Cost of Capital: Cost of Common Equity
Regarding common equity:
Capital Structure: Growth and Mature Firms
* The cost of common equity re is calculated as a Growth firms may still not have access to reasonably priced
@

percentage rate. debt financing, and may not want it due to the fixed
* This cost is difficult to estimate. payments required. Mature firms use more debt as it tends
* Approaches to estimation include the capital asset pricing to reduce their costs of capital. The de-leveraging that
model (CAPM), or some other method of estimation. occurs from rising stock prices can be stopped with share
e

buybacks, offering a flexible, tax-efficient way of returning

value to stockholders.
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Cost of Capital: Cost of Debt Estimated by Yield

The estimated cost of debt relates to the yield, at the
margin, for debt issues. Coupons are irrelevant for yield. Proposition II without Taxes: Higher Financial Leverage
Raises the Cost of Equity
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MM Proposition II concludes that as the amount of

Cost of Capital: Cost of Debt after Tax leverage in a firm increases, the cost of equity increases to
The cost of debt is found as Yield(1-T), where T is the tax compensate for the additional risk. In fact, without taxes
rate. This is because of the tax deductibility of debt on the and transaction costs, the increase in the cost of equity
income statement. Since any pre-tax income not paid as exactly offsets the impact in the weighted average cost of
interest expense is subject to tax, only the ”untaxed” capital of the higher amount of debt.
portion of debt remains as a cost for the borrower.

Proposition II with Taxes: Cost of Capital, and Company

Cost of Common Equity: Capital Asset Pricing Model Value
Approach The capital structure decision, under many assumptions,
The capital asset pricing model (CAPM) approach to had no impact on firm value. However, most countries tax
estimating the cost of common equity for firm i requires a corporate income and provide a tax deduction for interest
risk-free rate, the calculated beta of the firm, and an expense of corporate debt. With these conditions, capital

© Mindojo, 2023
Reading 4+6: Capital Structure 40

structure does impact firm value, as the value of a firm taking out short-term loans. The choice of fixed or floating

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increases with increased debt. rates depend on inflation expectations.

Corporations: Life Cycle of the Corporation

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Optimal Capital Structure: The Static Trade-Off Theory
As a firm increases its leverage, firm value increases, but The life cycle of the corporation is generally start-up,
only up to a point. Eventually, the additional agency costs growth, mature, and decline. Some companies in decline
of debt overwhelm the tax shield value of corporate debt, go private again with a leveraged buyout or management
and firm value no longer increases from additional debt. buyout.

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The static trade-off theory states that there is an ”optimal
capital structure” for every company, which maximizes firm
Capital Structure: Internal (Issuer-Specific) Factors
value where the tax shield value from additional corporate
Capital structure is the mix of debt and equity that is
debt exactly offsets the additional agency costs of debt.
targeted for minimizing cost of capital, but changes as

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market values of debt and equity (including retained
Costs of Financial Distress earnings) change. Internal factors that affect capital
The costs of financial distress due to leverage include structure include business model characteristics such as
revenues and earnings variability, operating leverage, the

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explicit costs of legal fees and implicit costs of missed
earnings, lost customers, and time for possible liquidation types of assets owned, and who owns the assets (whether
efforts. The agency costs of debt refer to conflicts between the company is ”capital light”).
managers and debtholders at times near bankruptcy. re
External (Top-Down) Factors Affecting Capital
Structure: Industry and Market Conditions
n
Analysts evaluate a firm’s capital structure based on the
firm’s ability to meet its cash flow obligations, which is
so

dependent on external factors such as capital market

conditions, industry characteristics, and country-specific
factors such as the institutional and legal framework, and
the macroeconomic environment.
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Optimal Capital Structure: Pecking Order Theory and

Information Asymmetries
Information asymmetry is a larger issue in more complex
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companies, and it leads investors to demand higher

returns. Companies may signal information about the
value of securities based on what they are selling in order
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to acquire capital. The pecking order theory suggests that

companies prefer to acquire capital in order of how little
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information is revealed: retained earnings, then debt, then

equity.
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Optimal Capital Structure: Agency Costs of Equity

Agency costs of equity arise from the inherent conflict of
interest between management and shareholders. Higher
leverage in a firm’s capital structure reduces agency costs
of equity through the free cash flow hypothesis.
Information asymmetry raises risk.

Considerations Affecting Financing Choices

Larger firms have greater access to financial markets for all
financing choices while small firms rely more on mortgages
and asset-backed loans. Riskier firms use more equity than
debt, and newer firms must rely on private equity until an
IPO is appropriate. Rollover risk is presented to firms

© Mindojo, 2023
Reading 4+5: Capital Investments and Capital Allocation 41

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4+5 Capital Investments and Capital Allocation

Reading 4+5: Capital Investments and Capital Allocation

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Capital Allocation: The Four-Step Process Projects with very different cash flow patterns or of
Capital allocation is the process of evaluating projects for different sizes can vary in rank according to NPV and IRR
investment. The four steps in this process include rules. When this happens, NPV is preferred. For projects of
generating ideas, investment analysis, capital allocation very different lengths, using the same discount rate might

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planning, and monitoring and post-auditing. More analysis not be appropriate.
is need for new projects and expansion projects than
replacement projects.
Capital to Profits: Return on Invested Capital (ROIC)

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Return on invested capital (ROIC) is a measure of how
Project Evaluation: Internal Rate of Return effectively management is converting capital use into
Regarding internal rate of return (IRR): profits, but suffers from the use of book values.
Management adds value to a company by investing in

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* IRR is the discount rate at which NPV equals zero. positive NPV projects. The profitability of those projects
* IRR is best calculated using a financial calculator. may be higher or lower than investors expected, increasing
* If the IRR for a project is greater than the hurdle rate, or decreasing the share price, and firm value. Real or
accepting the project is the appropriate action, otherwise nominal measures must be used together for consistency,
rejecting the project is preferable.
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and unexpected inflation will reduce profitability.

Project Evaluation: The Multiple IRR Problem Capital Allocation: Terms and Concepts
n
The IRR calculation as a tool for comparison with a hurdle Concepts of capital allocation:
rate may not work as well when cash flows of a project
so

change signs multiple times, possibly creating two or more * Understanding a few important capital allocation
IRRs for a project’s cash flows. concepts will prevent you from making invalid
recommendations.
* Sunk costs should be ignored, while an opportunity cost
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Project Evaluation: The Problem of No IRR

must be considered.
The calculation of IRR as a tool for comparison with a
* If opportunity costs are determined correctly, then
hurdle rate may not work for certain sets of cash flows for
incremental cash flow is an effective way to make a
which there is no IRR at all. This can happen when a
decision.
project’s cash flows are either ”too good” or ”too bad” to
@

* Cash flow patterns, inflows, and outflows must also be

allow the IRR calculation to equate.
considered before selecting decision criteria.
* Various project interactions add challenges to
Project Evaluation: Net Present Value Calculation incremental cash flow analysis; mutually exclusive projects
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Net present value (NPV) is an investment decision criteria must directly compete with each other, while independent
that estimates all cash flows from a project and discounts projects are based solely on their own cash flows.
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those cash flows to present values using the required rate * With project sequencing, decisions are based on the
of return. These PVs are then summed to produce the NPV. financial results of the first project before the second
It is the most appropriate investment decision criteria project is considered (and so on).
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because it considers all cash flows and time value of

money. The decision rule for NPV says to accept projects
The Value of Real Options in Capital Projects
with positive NPV and reject projects with negative NPV.
Real options associated with capital projects include
choices regarding timing, size, flexibility, expansion, and
Project Evaluation: Ranking Conflicts Between NPV and early abandonment of the project. The assumptions built
IRR into a project’s cash flows assume that none of these
Conflicts between NPV and IRR can happen between two options are exercised. Since these options all work in favor
projects with different cash flows or of a different scale. of the company, considering them in forecasting
When this happens, choose NPV for the more conservative unambiguously increases estimated NPV.
reinvestment assumption.

Capital Allocation: Common Pitfalls

Project Evaluation: Conflicts from Differing Cash Flow Common capital allocation pitfalls include:
Patterns * Not incorporating economic responses into analysis

© Mindojo, 2023
Reading 4+5: Capital Investments and Capital Allocation 42

* Pushing pet projects

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* Basing decisions on EPS, ROE, or IRR
* Incorrectly accounting for cash flows or overhead costs
* Failing to consider alternatives, sunk costs, and

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opportunity costs

Capital Allocation: Types of Capital Investments

Capital investments can be categorized as:

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* business maintenance projects, including going concern
projects and regulatory/compliance projects; and
* business growth projects, including expansionary
projects and other.

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se
re
n
so
bo
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© Mindojo, 2023
Reading 4+2: Investors and Other Stakeholders 43

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4+2 Investors and Other Stakeholders

Reading 4+2: Investors and Other Stakeholders

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Overview of Corporate Governance and goal should be to maximize shareholder wealth. The newer
Environmental, Social, and Governance (ESG) Issues stakeholder theory says that the interests of all
Corporate governance includes the internal controls, and stakeholders to the firm should be considered, although
procedures by which a firm is managed, and the rules, clear conflicts of interest exist among stakeholder groups.

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rights, and responsibilities of various parties. There is no
agreement on governance, and there are differences
among countries. Stakeholder theory broadens Stakeholder Interests: Debt vs. Equity Conflict

shareholder theory to include environmental, social, and During distress, debtholders would like to see cash

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governance (ESG) issues. invested by stockholders so that their claim is well
capitalized. But stockholders would like to invest in highly
leveraged firms for turnaround efforts to amplify their
Stakeholder Groups and Their Conflicting Interests potential returns. Bond covenants can provide some

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Stakeholders include shareholders, the Board of Directors, protection to bondholders to ensure that excess leverage
creditors, managers, employees, customers, suppliers, and isn’t used.
even regulators. These stakeholders often have conflicting
interests in the corporation.
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Stakeholder Interests: Other Stakeholders
Interests of other stakeholders include:
Board of Directors: Composition and Responsibilities * Suppliers and customers: ”switching costs” that are larger
Boards of directors vary greatly in size and structure. They
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for customized products
can have a one-tier or two-tier structure. Some are * Employees: both income and savings at risk
staggered in terms of elections. Board members have * Management and directors: well paid, risking
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broad responsibilities including financial statements, entrenchment behavior

operations, risk management, and major firm decisions. * Government and regulators: monitoring labor laws and
Board members are to exercise a duty of care and a duty of operating guidelines
loyalty.
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Characteristics of Debt and Equity

Evaluating ESG-Related Risks and Opportunities From the company’s perspective, debt is riskier than
Environmental, Social, and Governance (ESG) factors can equity. Debt has a priority claim, and cash flows are
@

significantly impact a company’s future cash flows and contractual, legal agreements. Not servicing debt on time
hence its value. Adverse ESG events often hit equity claims leads to bankruptcy. Equity has a residual claim;
harder than debt claims due to the direct relationship stockholders get what is left over after debtholders are
between equity claims and future cash flows. The impact of satisfied, so that makes equity safer for the firm, but also
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ESG-related risks and opportunities can differ based on the more expensive in terms of the cost of capital.
maturity of the debt, with long-term debts usually more
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affected by long-term ESG risks. Lastly, effective handling

of ESG factors can provide a competitive advantage and Debt vs. Equity from the Investors’ Perspective
positively influence a company’s financial performance, For investors, debt is a lot safer than equity. Debtholders
such as reducing operating costs. get a legal promise of payments and priority in liquidation.
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Common equityholders just get residual payments. While

both face limited downside, bondholders also face very
Corporate ESG Considerations: Analysis and limited upside, causing them to favor safer projects. This
Implementation creates a conflict of interest with the shareholders, who
Environmental factors of ESG include physical risks and want higher risk–return payoffs.
transitional risks, including the risk of stranded assets.
Social factors of ESG include impacts on people, including
employees, customers, and communities. Governance
factors of ESG include ownership, voting rights, Board
abilities, and risk management.

Shareholder Theory vs. Stakeholder Theory

Traditional shareholder theory states that a corporation’s

© Mindojo, 2023
Reading 4+3: Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits 44

Corporate Governance: Conflicts, Mechanisms,

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4+3
Risks, and Benefits
Reading 4+3: Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

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Principal–Agent Conflicts and Stakeholder Goals recommends an external auditor, and examines the
Shareholders are the principal, and managers are the auditor’s report before the full board. The governance
agents. Conflicts arise between the goals of profit committee ensures that the code of ethics and other
maximization and executive compensation. Risk tolerance, policies and standards are current, and in line with legal

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debt levels, liquidity goals, etc. all vary depending on the requirements. The compensation committee recommends
stakeholder, and relationships between these stakeholders payment packages for executives and some HR policies.
suffer from conflicts which naturally arise from opposing
goals.

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Corporate Governance: Nominating, Risk, and
Investment Committees
Corporate Governance: Stakeholder Management The nominating committee recommends independent,
Effective stakeholder management includes active potential board members for nomination to keep a desired

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communication. The main tools of voice communication balance. The risk committee decides the risk tolerance of
for shareholders is voting and general meetings. There are the firm and participates in risk monitoring. The
annual general meetings (AGMs) or extraordinary general investment committee focuses on any acquisitions and
meetings (EGMs), depending on the function. Voting is
done in person or by proxy.
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divestitures of the firm which may be brought before the
board.

Corporate Governance: Board of Directors, Audits, and

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Corporate Governance: Shareholder Mechanisms
Transparency
Companies can attempt to communicate well with
The board of directors is elected by shareholders to
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shareholders as part of shareholder engagement.

oversee the hiring of top management and several
Shareholder activism on matters is typically centered on
important functions of firm-wide oversight. This includes
profit maximization, and can include various takeover
the retention of an auditor and the review of the auditor’s
attempts such as proxy contests, tender offers, and hostile
report, reporting and transparency, as well as some
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takeovers.
policies meant to reduce conflicts of interest.

Risks of Poor Governance and Stakeholder

Corporate Governance: Manager Compensation and
Management
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Creditor Mechanisms
Poor governance can lead to undetected fraud from weak
Stock options are popular compensation for managers, but
internal control systems, poor decision making by
this aligns incentives only in the short term. Paying with
managers which are not in the best interests of
stock that has sale restrictions may better solve the
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shareholders, damage to firm reputation, legal problems,

principal-agent problem. Say on pay is shareholder voting
lawsuits, and higher risk of default and bankruptcy.
on executive compensation. Bond indentures use
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covenants and collateral to protect creditor interests.

Benefits of Effective Governance and Stakeholder

Corporate Governance: Laws and Contracts with Management
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Employees, Customers, and Suppliers Benefits of effective governance include operational

Employee rights are ensured mainly by labor law. Human efficiency through clarity of expectations, improved
Resources departments will further develop codes of ethics controls, lower default risk levels leading to lower costs of
and other policies to clarify expectations and work on debt, and an overall improvement in financial performance
retaining good employees. One method of allowing due to these and other lower costs.
employees to become owners is through an employee
stock purchase plan. Laws also extend to consumers,
Corporate Governance: Ownership, Control, and Board
where things like health codes exist to ensure minimum
Representation
product quality.
Dual-class structures of corporate shares can be set up
with class B shares which each have several votes, or that
Corporate Governance: Audit, Governance, and elect a majority of board members. Dual-class structures
Compensation Committees present greater risk to other shareholders. Board
The audit committee looks at the firm’s internal controls, representation is difficult to balance in terms of experience,

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Reading 4+3: Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits 45

expertise, and in avoidance of conflicts of interest.

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Reading 4+1: Organizational Forms, Corporate Issuer Features, and Ownership 46

Organizational Forms, Corporate Issuer Features,

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4+1
and Ownership
Reading 4+1: Organizational Forms, Corporate Issuer Features, and Ownership

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Business Structures: Sole Proprietorships and Corporations: The Varieties of Corporate Owners
Partnerships Corporate ownership is diverse, with shareholders
Sole proprietorships are not legally distinct from their including individuals, other corporations, governments,
single owners, who fully own and operate the business, and non-profits. Governments often establish

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also assuming unlimited liability for the firm. General wholly-owned corporations with structured management
partnerships are similar, but with more owners than just and transparency measures to provide clear insights into
one. Limited partnerships have at least one general the corporation’s performance. Non-profit organizations
partner (GP) that runs the business and faces unlimited can invest in corporations to increase their financial

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liability, while the limited partners (LPs) may contribute resources while fulfilling their societal missions.
some expertise or just passively invest capital, and can only
lose their investment.

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Corporations: Types and Key Features
Corporations can be non-profits, private for-profits, or the
most popular and largest kind, the public for-profits. Public
for-profit corporations are separate legal entities, allowing
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owners (shareholders) to have limited liability, and voting
rights to choose the board of directors who in turn select
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and monitor managers of the company.
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Corporations: Financing and Taxation

Corporations issue securities to get debt capital and equity
capital from a variety of capital providers. Debt capital is
returned per the bond agreement with interest, and equity
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capital provides ownership that can be sold or kept for

dividend income and capital appreciation. Corporate
income is often subject to ”double taxation” where the
corporation pays corporate tax on earnings, and
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stockholders then pay income tax on dividends from those

after-tax earnings.
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Corporations: Public vs. Private

Public corporations with exchange trading provide current
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stock prices, and therefore market capitalizations, found as

the stock price multiplied by the number of shares
outstanding. Private corporations are valued infrequently.
Enterprise value is the market value of debt and equity
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minus cash.

Corporations: Share Issuance and Registration

Requirements
Private equity is generally offered through a private
placement memorandum to accredited investors, and with
relatively little regulation. Public share issuance from going
public with an IPO or a direct listing is more regulated and
requires registration and disclosures. A special purpose
acquisition company (SPAC) is a ”blank check” company
that takes private companies public through a reverse
merger.

© Mindojo, 2023
Reading 4+7: Business Models 47

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4+7 Business Models

Reading 4+7: Business Models

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What is a Business Model?
A business model is a description of a firm and what it
does. This includes the value proposition of what
customers are to receive and how these services are

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priced, and the value chain of what capabilities the firm has
and how it will execute. It illustrates the relationship
between the parts of a firm, including key assets and
suppliers, as well as the business logic.

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Business Models: Types
There is a large variety of business model types and

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variations. Some common traditional types include private
label manufacturers, licensing arrangements, value-added
resellers, and franchises. A common e-commerce business
model type is an aggregator. Businesses can be linear or
rely on network effects, and some use crowdsourcing.
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Business Models: Pricing Decisions
Pricing models can be value-based or cost-based, and
pricing power depends a lot on differentiation. Price
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discrimination can be employed with bulk pricing, tiered

pricing, and auctions. Multiple products can be sold at
once with bundling, razors-and-blades pricing, and optional
product pricing. Rapid growth efforts often use
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penetration pricing, freemium pricing, or hidden revenue

business models. Alternatives to ownership include leases,
licensing, franchises, and subscriptions.
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Business Models: The Who, What, and Where

The ”Who?” of a business model addresses the customers,
including the geography of where they are located, any
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customer segments, and whether the business is B2B or

B2C. The ”What?” includes the offering of products and
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services, including differentiation and customer needs. The

”Where?” identifies distribution channels such as direct
physical sales, the use of intermediaries, and digital
delivery.
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Business Models: Value Propositions

A value proposition includes the target market, the product
features offered, the channels, and pricing strategy. The
value chain is the systems and processes by which this
value is created and delivered.

© Mindojo, 2023
Reading 5+1: Introduction to Financial Statement Analysis 48

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5+1 Introduction to Financial Statement Analysis

Reading 5+1: Introduction to Financial Statement Analysis

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Introduction to Financial Statement Analysis * Audits are performed by qualified, independent auditors.
Financial analysis is the process of examining a company’s * The auditor’s opinion is based on the audit procedures
performance in order to arrive at some sort of decision. It performed that are designed to provide reasonable
gives attention to factors such as industry occurrences and assurance the statements fairly present the results of

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the overall economic environment. Financial analysts operations and financial condition of the company in
examine a company’s financial reports, including audited accordance with applicable accounting standards.
financial statements and disclosures, as well as * Opinions may be unqualified, qualified, adverse, or
management commentary. disclaimed.

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Scope of Financial Statement Analysis Financial Statement Analysis Framework
Financial statements provide information about a A financial statement analysis framework gives guidelines

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company’s position and performance. Analysis based on that are essential for all types of analysts. There are six
financial statements is performed by equity investors phases to the framework:
interested in valuation, lenders interested in liquidity,
suppliers interested in future business, and analysts * Articulate the purpose
working to recommend security purchases, mergers, credit
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* Collect input data
and lending, debt ratings, and forecasting. * Process data
* Analyze/interpret the processed data
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* Develop and communicate conclusions and
Financial Statement Notes and Supplementary
recommendations
Schedules
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* Follow up
The financial notes and supplementary schedules of the
company are a required part of the financial reports and
contain essential information about the company’s Financial Accounting Standards Board (FASB)
accounting policies, methods, and estimates, many of The Financial Accounting Standards Board (FASB) is the
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which are essential for analysis. organization that designs the financial reporting standards
followed by non-governmental entities in the United States.

Financial Reporting: Comparability and Flexibility

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One of the underlying concepts of the reporting framework International Organization of Securities Commissions
is comparability. This means companies in the same (IOSCO)
industry should have financial statements that contain the IOSCO members regulate more than 95% of the world’s
same information and look similar, allowing an analyst to financial capital markets. They aim to protect investors and
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compare the results of different companies in the same present fair, transparent, and efficient financial reports.
industry. However, accounting standards offer the
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flexibility of choosing the accounting policies that fairly

reflect the company’s financial position. Securities and Exchange Commission (SEC)
The Securities and Exchange Commission (SEC), a United
States government agency, has the legal authority to set
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Financial Reporting: Management Discussion and and enforce financial reporting standards.
Analysis
Along with financial statements, a company will often
provide a management discussion and analysis (MD&A) Capital Markets Regulation in Europe
statement as additional information that addresses Though each individual country has jurisdiction over their
favorable and unfavorable trends affecting the company as own capital markets, the European Union-listed companies
well as significant events and uncertainties. The IASB follow European Union-endorsed standards.
proposes a framework of five elements for a
decision-useful management commentary.
Convergence of Conceptual Frameworks and Reporting
Standards
Financial Reporting: Auditors’ Reports Despite some barriers to global convergence to a single set
Concerning auditors’ reports: of accounting standards, convergence efforts have taken
place in the past, and new standards are mostly converged.

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Reading 5+1: Introduction to Financial Statement Analysis 49

Consistent enforcement mechanisms in each country are

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key so that all financial statements can be relied on equally.

Objective of Financial Reports

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Regarding the objective of financial reports:

* The objective of financial reports is to provide useful

financial information to current or potential investors and
creditors.

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* This information is evaluated to make decisions about
lending money to the company, or whether or not to invest
in the particular company.
* The external users will look at the company’s financial

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position, performance, and cash flow.

Comparison of IFRS with Alternative Financial

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Reporting Systems
Differences between IFRS and GAAP accounting standards
include varying treatment of items for inclusion in income re
statements and definitions of assets, among many others.
This can create significant differences between the financial
statements of firms following different sets of standards.
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Accounting for New Products or Types of Transactions
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New products or types of transactions arrive on a regular

basis. They may result from economic events internal or
external to the company, or they may be transactions the
company has entered into. Keeping up to date on new
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products or types of transactions allow for improved

analytical skills. The CFA Institute advocates financial
statements that are timely, consistent, comparable, and
transparent.
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Common Information Sources Used by Analysts

An analyst has many common information sources to use
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to gather information, from the initial registration

statement to the SEC-required 6-K form, 10-K form, and
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proxy statement. Other sources of information include

documents prepared by the company to report
information to its shareholders.
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Reading 5+2: Analyzing Income Statements 50

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5+2 Analyzing Income Statements

Reading 5+2: Analyzing Income Statements

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Connecting Equity: Other Comprehensive Income financial performance. Under U.S. GAAP, material items
To understand how reported shareholders’ equity in one both unusual or infrequent, and that are both as of
period is connected to shareholders’ equity in the next reporting periods beginning after December 15, 2015, are
period, it is important to pay attention to items that are shown as part of continuing operations but are presented

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excluded from the net income calculation. These items, separately.
known as other comprehensive income, represent changes
in equity during a period from transactions other than
Discontinued Operations. Changes in Accounting
those with owners.

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Policies, and Exchange Rates
In financial reporting, the impact of a company disposing of
Income Statements and their Presentation a component of its operations is separately reported as a
The income statement presents information on a ”discontinued operation” under both IFRS and US GAAP.

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company’s revenues and expenses over a period of time. Changes in accounting policies due to new standards are
The difference is earnings, or profit/loss. Both IFRS and US typically applied retrospectively, ensuring that financial
GAAP allow the income statement and statement of statements are comparable over time. Additionally,
comprehensive income to be presented in one section or consolidation due to company acquisition and fluctuations
separately, and both equity and fixed income analysts use
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in exchange rates can complicate the interpretation of
income statement data. financial results, making it harder for investors to compare
performance over different periods. Despite not being a
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requirement, disclosure of the effects of scope and
Revenue Recognition: General Principles
exchange rate changes could greatly aid investors in their
Revenue is recognized when earned, meaning that the
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financial understanding.
service is performed or the good is delivered, as long as
some other conditions are met, such as the expectation of
payment. The timing of that payment is immaterial, Simple vs. Complex Capital Structure and Diluted EPS
however; it can be early, recorded as unearned revenue, or In a complex capital structure, some debt is convertible to
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received late, to satisfy a receivable. new common (or ordinary) shares. This potential dilution
of earnings is accounted for in diluted EPS, which is lower
than basic EPS. A simple capital structure is one without
Expense Recognition: General Principles
convertible debt.
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Expense recognition in financial accounting primarily

follows three models: the matching principle, expensing as
incurred, and capitalization with subsequent depreciation Basic Earnings Per Share (EPS) Calculation
or amortization. The cost of inventory is recognized as an Basic EPS is calculated as net income less preferred
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expense (COGS) when sold, aligning with the matching dividends, all divided by the number of common shares
principle. Operating costs, such as administrative and outstanding. The denominator of this formula is a
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managerial expenses, are typically expensed as incurred. time-weighted average and reflects the impact of share
Interestingly, some employees’ compensation, like factory issuances, share repurchases, stock splits, and stock
workers, is treated as a product cost, included in inventory dividends.
and recognized as COGS when products are sold.
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Diluted EPS with the If-Converted Method

General Accounting Principles: Matching Principle The if-converted method of calculating diluted EPS
The matching principle states that expenses should be assumes that common shares had been exchanged for all
recorded in the same period as the revenue they helped convertible preferred stock at the start of a period. The
generate, thus matching expenses to the revenue. Some diluted EPS value that results from this methodology must
expenses can be directly matched to the revenue they always be equal to, or less than, basic EPS.
generate, like inventory, whereas other expenditures hold
a periodic relationship.
Diluted EPS with the Treasury Stock Method
For a company that has stock options or warrants
Unusual or Infrequent Items: IFRS vs. US GAAP outstanding, diluted EPS is calculated using the treasury
IFRS requires separate disclosure of unusual or infrequent stock method by assuming that they were exercised as
items that would affect understanding of a company’s soon as they were issued, and the company used the

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Reading 5+2: Analyzing Income Statements 51

proceeds to repurchase as many shares of common stock Capitalization allocates expense to current and future

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as possible at the average market price during the period. years, spreading expenses over future periods. This
dampens the upward trend caused by expensing, even
though total expenses and net income futures are
Antidilutive Securities and Changes in EPS

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unchanged. All ratios are affected by consequence.
Considerations with antidilutive securities:

* Potentially convertible securities are considered Capitalization of Interest Costs

antidilutive if their inclusion in the diluted EPS calculation Interest costs for construction of firm PPE can be
would result in an EPS figure higher than the company’s capitalized with the real asset, and then will be included

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basic EPS. with its related depreciation expense over time. Interest
* Such a situation would violate both IFRS and US GAAP costs for inventory production can be capitalized by
accounting standards. inclusion with inventory, and then included in cost of goods
* The effect of antidilutive securities’ conversions must be sold. This also affects the cash flow classification.

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excluded from the calculation of diluted EPS.

Capitalization of Internal Development Costs

Common-Size Analysis of the Income Statement Deciding feasibility requires judgment, and this can lead to

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Common-size analysis of the income statement presents challenges in comparability. Adjusting capitalized costs
the income statement line items as a percentage of sales. back to expenses increases investing cash flow while
This is useful to compare previous years of operations of decreasing operating cash flow, and will also typically
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one company and to compare one company to others. increase the P/E and P/CFO ratios.

Income Statement Ratios: Measuring profitability

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The net profit margin, calculated as net income divided by
revenue, signifies how much profit a company generates
for each dollar of revenue. The gross profit margin,
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calculated as gross profit divided by revenue, can provide

insights into a company’s pricing strategy and product
differentiation. Other profitability ratios, like the operating
profit margin and pretax margin, further contribute to a
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comprehensive view of a company’s financial health.

Capitalizing vs. Expensing: Financial Statement

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Impacts
The decision to capitalize or expense an expenditure
significantly impacts a company’s financial reporting,
influencing profitability, cash flows, and shareholders’
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equity. While capitalizing can enhance current profitability

and increase reported cash flow from operations, it also
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presents potential for financial manipulation. Therefore,

when analyzing a company’s financial performance, it’s
crucial to understand the motivations behind its choice of
accounting methods, compare its practices to industry
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standards, and consider long-term financial trends.

Accounting Standards for Revenue Recognition

According to the newly converged accounting standards,
revenue is recognized as goods and services are
transferred to customers in an amount that reflects the
consideration the seller expects to receive. Adhering to this
core principle involves following five steps, as well as new
rules for modifications and related costs.

Impacts of Capitalization on Financial Statements and

Ratios

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Reading 5+3: Analyzing Balance Sheets 52

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5+3 Analyzing Balance Sheets

Reading 5+3: Analyzing Balance Sheets

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Noncurrent Liabilities: Financial and Deferred Tax and income statements reflect these various treatments.
Noncurrent liabilities refer to all liabilities that are not
classified as current. This can include deferred revenue,
long-term liabilities which are usually held at face value, Common-Size Analysis of the Balance Sheet: Liquidity

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with any premium or discount amortized over time, and and Solvency

deferred tax liabilities arising from companies paying less Common-size analysis (also called vertical analysis) involves

than is expensed in taxes in the current period. stating each balance sheet amount as a percentage of total
assets. This gives insight into the composition of the

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company. This can help identify problems with liquidity
Noncurrent Assets: Intangible Assets (short-term debt) or solvency (long-term debt).
Regarding intangible assets:

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* Intangible assets are identifiable nonmonetary assets Cross-Sectional Common-Size Analysis
with no physical existence. Cross-sectional common-size analysis is a specific
* Trademarks, copyrights, and patents are typical examples application of common-size balance sheet analysis where
of intangible assets. multiple companies are analyzed in regards to their
* Under IFRS, companies recognize identifiable intangible
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composition. This analysis proves useful even if the
assets on their balance sheets if they expect to receive companies are of different sizes.
future economic benefits and can reliably measure the cost
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of the assets.
Balance Sheet Ratios
* Under both IFRS and US GAAP, internally created
Balance sheet ratios can be divided into liquidity ratios,
identifiable intangibles are often not reported on the
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such as the cash ratio, quick ratio, and current ratio, and
balance sheet, but expensed instead. Under IFRS only, the
solvency ratios, such as the debt-to-equity ratio, the total
exception is development phase costs when other
debt ratio, and the financial leverage ratio. They are useful
conditions are met.
because they allow for comparison with other firms and
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with the firm itself over time, although different accounting

Noncurrent Assets: Goodwill practices can make these ratios misleading.
Regarding goodwill:
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* If an acquirer pays more than the fair value of the

identifiable assets and liabilities of a target company, the
excess is recognized on the balance sheet as an asset and
is called goodwill.
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* Goodwill is not amortized like some other intangible

assets.
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* Instead, goodwill is subject to an annual impairment test.

Noncurrent Assets: Financial Assets

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Held to maturity securities as financial assets are measured

at historical cost or amortized cost. Trading securities,
available-for-sale securities, and derivative instruments are
generally measured at fair value. Available-for-sale
securities are no longer included in IFRS (only US GAAP),
and likely won’t exist as a classification in the future.

Accounting for Gains and Losses on Marketable

Securities
Companies record gains and losses on financial assets in
different ways based on the accounting policy that
classifies these assets as held-for-trading, available-for-sale
(under U.S. GAAP only), or held-to-maturity. Balance sheets

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Reading 5+4: Analyzing Statements of Cash Flows I 53

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5+4 Analyzing Statements of Cash Flows I

Reading 5+4: Analyzing Statements of Cash Flows I

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Linkages Among the Financial Statements investing activities.
The cash flow statement is derived from changes in the 3. Consider changes in noncash current assets and
statement of financial position from one year to the next. liabilities.
These changes also include the income statement, as it is

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part of retained earnings.
Conversions of Cash Flows from the Indirect to the
Direct Method
Cash Flows: Cash Received from Customers and Paid to If an analyst wants to review trends in cash receipts and

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Suppliers payments, but the operating activities were prepared using
To calculate cash received from customers, start with the indirect method, a three-step convergence can be
revenues from the income statement. Subtract the done:
increase in accounts receivable, or add the decrease in

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accounts receivable over the year. In order to calculate - Separate the net income into total revenues and total
cash paid to suppliers, first calculate the amount of expenses.
inventory purchased, then determine how much of the - Remove all noncash and nonoperating items and
purchase was paid with cash. separate remaining items into relevant cash flow items.
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- Convert accrual amounts of revenues and expenses to
cash receipts and payments by adjusting for
Cash Flows: Cash Paid for Employees and Interest
increases/decreases in current assets and current
Cash paid to employees is determined by adjusting salary
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liabilities.
and wages expense by the net change in salary and wages
payable. Cash paid for interest adjusts interest expense for
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the change to interest payable. Under US GAAP, cash paid Cash Flows: Investing Activities and Financing
for interest must be classified as an operating activity. Activities
Determining cash flows from investing activities and
financing activities are the second and third steps in
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Cash Flows: Cash Paid for Income Taxes and Other

preparing the cash flow statement. Investing activities
Expenses
impact long-term assets, while financing activities include
Income tax expense needs to be adjusted for the net
long-term liabilities and equity.
change in taxes receivable, deferred taxes, and taxes
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payable to calculate cash paid for income taxes. To

calculate the amount paid for other operating expenses, Differences in Cash Flow Statements Prepared under
the operating expenses must be adjusted by the net US GAAP vs. IFRS
change in prepaid expenses and accrued liabilities. IFRS allows for interest and dividends received to be
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classified as operating or investing cash flows, while US

GAAP requires them to be operating cash flows. IFRS
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Statement of Cash Flows under the Direct Method

allows for interest and dividends paid to be classified as
The statement of cash flows shows how much cash is being
operating or financing cash flows, while US GAAP requires
received or paid for operating, investing, and financing
interest paid to be operating cash flows, and dividends
activities. The direct method determines the amount of
paid to be financing cash flows. Both direct and indirect
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cash received and paid for the day-to-day activities of the

methods of cash flow presentation are allowed under each.
company, shown in the operating section. The overall net
change in cash will be seen on the bottom of the cash flow
statement and on the comparative balance sheet.

Statement of Cash Flows under the Indirect Method

Under the indirect method of preparing the statement of
cash flows, the operating activities section is prepared
differently than in the direct method. Net income is
adjusted in three steps:

1. Add back noncash expenses.

2. Deduct gains and add back losses that result from

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Reading 5+5: Analyzing Statements of Cash Flows II 54

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5+5 Analyzing Statements of Cash Flows II

Reading 5+5: Analyzing Statements of Cash Flows II

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Evaluation of Cash Flow Sources and Uses of Cash companies in the same or in a similar industry.
Evaluating the sources and uses of cash is important in
determining the health of a company. Operating cash flows
indicate whether a company can generate positive cash

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flows from what they are in business to do. Investing cash
flows tell users whether funds are being spent or
generated from capital assets or long-term investments.
Financing cash flows disclose sources or uses of cash from

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long-term debt or from share transactions. Evaluating the
sources and uses of cash in these sections provides
valuable information to an analyst.

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Common-Size Analysis of the Statement of Cash Flows
For the common-size cash flow statement, each line item is
expressed as either a percentage of total cash
inflows/outflows or as a percentage of revenue. The
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common-size format shows trends in cash flow instead of
looking at total amounts.
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Free Cash Flow to the Firm and Free Cash Flow to
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Equity
Cash flow from operations in excess of investing outflows
results in free cash flow. This is cash available to pay for
financing activities, referred to as free cash flow to the firm.
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Cash flow available for distributions to owners is referred

to as free cash flow to equity.
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Cash Flow Ratios: Performance Ratios

There are several performance ratios based on cash flow
from operating activities that allow an analyst to assess the
profitability of a company. These include:
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* The cash flow to revenue ratio

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* The cash return on assets ratio

* The cash return on equity ratio
* The cash to income ratio
* The cash flow per share ratio
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Cash Flow Ratios: Coverage Ratios

A healthy cash flow from operating activities provides
information about the company’s ability to buy property,
plant, and equipment (PPE), to repay debt, and to make
dividend distributions without having to find other sources
of funds.

Cash Flow Analysis of Comparables

It is important to consider why you are calculating cash
flow ratios and make sure you are using companies whose
results would be comparable. Generally, these are

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Reading 5+6: Analysis of Inventories 55

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5+6 Analysis of Inventories

Reading 5+6: Analysis of Inventories

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Calculation of Cost of Sales, Gross Profit, and Ending
Inventory
When prices are changing, the various inventory methods
will result in different allocations to cost of sales and to

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inventory resulting in differences in:

* Gross profit
* Ending inventory

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* Cost of sales

Measurement of Inventory Value

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US GAAP and IFRS have different measures to account for
the declines and recoveries in value for most inventories:

* US GAAP requires lower of cost or market.

* IFRS requires lower of cost or net realizable value.
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* IFRS allows write-ups of previously written down
inventory.
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* US GAAP prohibits reversals of write-downs.
* Special commodities are accounted for in a similar way
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under both US GAAP and IFRS.

Inventory Valuation: Presentation and Disclosure

under IFRS vs. US GAAP
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IFRS and US GAAP require similar inventory disclosures

when presenting financial statements, with a few
exceptions. Both require disclosures on:
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- Accounting policies for measurement

- Amount and classification of inventory
- Special inventory items carried at net realizable value
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- Cost of sales for the period

- Inventory write-downs for the period and related
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circumstances
- Inventory amounts used as collateral

IFRS additionally requires disclosures on reversal of

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write-downs and the related circumstances.

How Inventory Valuation Affects Financial Ratios

As inventory is a current asset, inventory valuation affects
all ratios using assets or current assets. Profitability ratios
are also affected, since the cost of inventory affects gross
profit and net income. Ratios specific to inventory
management include inventory turnover, days of inventory
on hand, and the gross profit margin.

© Mindojo, 2023
Reading 5+7: Analysis of Long-Term Assets 56

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5+7 Analysis of Long-Term Assets

Reading 5+7: Analysis of Long-Term Assets

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Long-Term Assets: Acquisition of Intangible Assets and Regarding disclosures of impairment losses:
Goodwill
Identifiable intangible assets acquired in a business * Impairment losses occur when the fair value of an asset
combination are recorded at their fair value. Anything is lower than its carrying value.

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extra is goodwill. A purchase of an intangible asset is * Under both IFRS and US GAAP, disclosures are required
similarly recorded at fair value, which should be the concerning the cause of the impairment, the amount of
purchase price. Internally generated intangible assets are loss, and where the loss is reported in the financial
generally expensed, and development costs can only be statements.

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capitalized once technological feasibility is reached. * With IFRS—because it allows reversals of impairment
losses—additional disclosures are required.
* US GAAP does not permit reversals.
Long-Term Assets: Impairment of Assets under IFRS

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and US GAAP
When an asset’s carrying value is greater than its value in Long-Term Assets: Impairment of Intangibles and
the market, both IFRS and US GAAP require the carrying Reversals
value to be written down. This impairment may be later Intangible assets with finite lives are amortized, tested for
reversed under IFRS. Aside from depreciation and
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impairment with significant events. Intangible assets with
amortization, long-lived assets may also suffer from infinite lives are not amortized, but tested at least annually
impairment due to market forces such as obsolescence for impairment. Intangible assets held for sale cease to be
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and loss of product demand. When this occurs, the depreciated or amortized, tested for impairment, and this
carrying value of the asset may need to be reduced. impairment can only be reversed depending upon the
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accounting treatment. Under IFRS, the impairment can be

reversed. Under US GAAP, the impairment can be reversed
Long-Term Assets: Derecognition, Gains, and Losses
only if the asset is held for sale.
When long-term assets no longer provide future economic
benefits for the company, the company will derecognize
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(remove from the books) the long-term asset by selling,

exchanging, or abandoning them. A gain or loss on a sale
of long-lived assets is determined by comparing the selling
price (proceeds) to the book value (carrying value). A
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long-lived asset distributed to owners in a spinoff needs to

be removed from the books.
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Long-Term Assets: Presentation and Disclosures

For every class of long-lived assets, certain information
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must be disclosed and presented in the financial

statements and notes under IFRS. US GAAP also has
required information, but it is not as extensive.
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Long-Term Assets: IFRS vs. US GAAP Disclosures for

Intangible Assets
Although IFRS and US GAAP differ, they both require
enough disclosures about intangible assets to enable an
analyst to assess a company’s:

* Level of investment
* Changes in intangible assets
* Impact on current and future performance

Long-Term Assets: IFRS vs. US GAAP Disclosures of

Impairment Losses

© Mindojo, 2023
Reading 5+8: Topics in Long-Term Liabilities and Equity 57

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5+8 Topics in Long-Term Liabilities and Equity

Reading 5+8: Topics in Long-Term Liabilities and Equity

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Leases and Advantages of Leasing where the company’s obligation ends post-contribution, or
Leases confer substantially all use of a specific asset by defined-benefit, where predictions about future variables
contract. Leases can be an attractive option for both the are necessary. An underfunded pension system, not visible
lessor (the owner of the asset) and the lessee (user of the on a balance sheet, can significantly affect an entity’s

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asset). The lessee may benefit with less cash required up financial health, acting as a hidden debt.
front, better financing terms, and the convenience of lower
risk.
IFRS vs. US GAAP Treatment of Net Pension Asset /

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Liability
Finance Leases vs. Operating Leases Differences in treatment of net pension assets/liabilities
Finance leases transfer substantially all of the rewards and between IFRS and US GAAP:
risks of owning the asset to the lessee, while operating

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leases are essentially rentals. Under both IFRS and US * Accounting for pensions is similar under IFRS and US
GAAP, any one of these five criteria will make the lease a GAAP.
capital lease: * US GAAP amortizes prior service cost while IFRS
1. Ownership of the asset is transferred to the lessee. recognizes it immediately.
2. The lessee has an option to purchase the asset and
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* Actuarial gains and losses and variances between
probably will. expected and actual returns on plan assets are recorded to
3. The lease term is for a major part of the asset’s useful other comprehensive income under both IFRS and US
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life. GAAP.
4. The PV of the lease payments equals or exceeds fair * However, US GAAP amortizes them to expense over time
value.
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while IFRS leaves the amounts in other comprehensive

5. The asset has no alternative use to the lessor. income.
* The net pension asset or liability is recorded on the
balance sheet the same under US GAAP and IFRS.
Accounting and Reporting by the Lessee
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IFRS and US GAAP have similar treatment for capital leases.

The lease liability and the right-of-use (ROU) asset are
Share-Based-Compensation: Stock Grants and Stock
recorded as the PV of lease payments. The lease liability is
Options
amortized with the effective interest method while the ROU
Share-based compensation is a strategic method for
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asset is lowered in a straight-line fashion. US GAAP equates

companies to align the interests of their employees with
these reductions for operating leases. The expense items
those of shareholders, offering them shares or stock
are separated for IFRS but not for US GAAP on the income
options to incentivize performance. This kind of
statement. IFRS treats these as mostly financing cash flows
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compensation can create a common goal of increasing the

while US GAAP treats them as operating cash flows.
company’s value, thus driving productivity and
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commitment. However, share-based compensation can be

Accounting and Reporting by the Lessor influenced by market volatility and may dilute the value of
The accounting and reporting requirements for lessors are existing shares. Therefore, understanding its benefits and
essentially identical under US GAAP and IFRS. For a finance risks is essential for both companies and employees
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lease, the lessor removes the leased asset from the involved.
balance sheet and shows a lease receivable, recognizing
any gain or loss. Lease payments are interest and principal
Accounting for Stock Options and other Share-Based
classified as operating cash flows. For an operating lease,
Compensation
no balance sheet changes; just straight-line lease income.
Stock options are a form of compensation that aligns the
interests of employees and shareholders by offering the
Financial Reporting for Post-Employment and right to purchase company shares at a predetermined
Share-Based Compensation Plans price. The accounting for these options involves
Employee compensation encompasses both immediate recognizing an expense based on the fair value of the
and deferred benefits, often with vesting schedules. option at the grant date, with key dates like grant, vesting,
Deferred benefits often introduces complexities in financial exercise, and expiration playing significant roles. Other
reporting due to variables like future stock prices or forms of share-based compensation include stock
salaries. Pension plans can be either defined-contribution, appreciation rights (SARs) and phantom shares, each

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Reading 5+8: Topics in Long-Term Liabilities and Equity 58

providing unique advantages such as limited downside risk

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with unlimited upside potential, and the ability to motivate
employees in private or non-publicly traded entities
respectively.

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Presentation and Disclosure of Leases
IFRS 16 requires many disclosures for leases. Lessees must
disclose specific amounts such as carrying amounts of
right-of-use assets, total cash outflow for leases, and

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provide a detailed analysis of their leasing activities.
Lessors must disclose information that enables
assessment of the impact of leases on their financial
position, performance, and cash flows, including a maturity

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analysis of lease payments.

Presentation and Disclosure of Postemployment Plans

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and Share-Based Compensation
Defined benefit pension plans, based on a worker’s
earnings history and tenure, require careful disclosures per re
IAS 19, offering transparency on potential risks and
impacts on a company’s future. Share-based
compensations, on the other hand, aim to align employees’
interests with the company’s goals. Disclosures under IFRS
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2 provide insight into these arrangements and their
potential impacts on a company’s financials, promoting
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informed decision-making.
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Reading 6+3: Financial Analysis Techniques 59

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6+3 Financial Analysis Techniques

Reading 6+3: Financial Analysis Techniques

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Common-Size Analysis: Balance Sheets evaluations of a company’s data. Proper evaluation
A vertical common-size balance sheet divides each balance requires comparisons between companies, often of
by total assets for comparability of balance sheet items different size or using different currencies. They can also
across companies, eliminating currency and size require comparisons for different time periods.

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differences. These can also be used to analyze a company’s Comparisons of companies using different accounting
balance sheets over time. A horizontal balance sheet standards also create a need for adjustment.
shows all balances as a percentage of that balance in a
starting year, better showing trends.

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Financial Ratios and Their Interpretation
Regarding financial ratios and interpretation:
Activity Ratios: Overview, Calculation, and Use
Activity ratios measure how efficiently a business handles * The number of different ratios that can be calculated is

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its day-to-day tasks like generating revenues, inventory virtually limitless.
management, receivables, and payables. Many activity * There is no universal list that is common to all analysts.
ratios are a mix of income statement items and balance * There are some that are widely accepted and used, like
sheet items. Balances must be averaged over the time return on assets or return on equity, but others are
period used for the activity.
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industry specific.
* Care must be used so that the specific numbers
used—year end or average, for example—best reflect the
Introduction to Financial Analysis Techniques
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industry being examined.
Financial analysis involves converting data into financial
metrics that aid decision making and allow for in-depth
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analysis on different companies. The information that is Profitability Ratios: Return on Assets (ROA) and Return
required for analysis and the different perspectives for on Equity (ROE)
final reports are important considerations when Return on assets (ROA) is a widely used performance ratio
conducting financial analysis. of net income/average total assets. It can be modified to
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net out interest expense to provide operating ROA. Return

on equity (ROE) is a key profitability ratio which measures
Financial Analysis: Process and Framework the return to the company’s owners—the shareholders.
Because of the variety of reasons for performing financial ROE is net income divided by average total equity, but can
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analysis, it is important the analytic approach be tailored to be adjusted to return on common equity by subtracting
the specific situation. The analyst should clarify the preferred dividends from net income.
purpose and context of his work as well as the level of
detail, data availability, and any limitations before choosing
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the set of techniques to be used. Value, Limitations, and Sources of Ratios

Regarding ratio analysis:
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Financial Analysis: Distinguishing between * Financial ratios can be used to easily compare companies
Computations and Analysis in similar industries, as well as to spot trends in the past of
An effective analysis includes both computations and the same company.
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interpretations. It does more than just present information * Ratios can be used to compare companies that vary in
but integrates it into a meaningful whole. Computations size, but are not useful in comparing companies in
can tell what happened, and analysis can tell why it different industries, due to different products and
happened. Analysts often need to communicate their operating conditions.
findings in a written report. The report should indicate: * Ratios can also be used by potential investors to discover
potential risks.
* How conclusions were reached * Ratios may be calculated using data directly obtained
* How recommendations were made from financial statements.
* The appropriate past period data * Another source are popular databases, such as
* Analytics appropriate to the purpose of the report Bloomberg, that may also include data taken from financial
statements and presented in various forms.

Financial Analysis: Analytical Tools and Techniques

Financial analysis uses tools and techniques to facilitate Common-Size Analysis: Income Statements

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Reading 6+3: Financial Analysis Techniques 60

A vertical common-size income statement divides each low DSO, or days sales outstanding.

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income-statement item by a common denominator, usually * This can indicate either efficiency in credit and collections
total revenue, to create a ratio for each item to the or an overly stringent credit policy.
common base. These ratios can be further decomposed to * Comparison of sales growth relative to the industry can

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create ratios for different lines of business the company help with the determination.
operates. These ratios aid in management decision * A lower turnover can indicate credit management
making. problems.
* Days sales outstanding (DSO) is an activity ratio that
shows how many days it takes a company to collect on
Cross-Sectional and Trend Analysis

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credit sales.
Cross-sectional analysis compares specific metrics for one * The DSO calculation shows creditors and investors the
company with the same metrics for another company or company can collect from their customers efficiently.
group of companies. This allows for comparison of
different-sized businesses or between firms using different

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currencies. Trend analysis can provide important Activity Ratios: Inventory Turnover and Days of
information regarding historical performance and growth. Inventory on Hand (DOH)
Regarding inventory turnover and DOH:

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Use of Graphs and Regression in Analysis * Inventory turnover and days of inventory on hand (DOH)
Considerations in using graphs as analytical tools: both reflect the effectiveness of a company’s inventory
management.
* Graphs allow analysts, investors, and creditors to discern
a company’s health or spot red flags without reading
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* If inventory turnover is high, then DOH would likely be
low, as inventory would be leaving the company quickly.
through volumes of data. * If revenue is growing along with high inventory turnover,
* An analyst can also graph a financial forecast showing the company has effective inventory management.
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expected growth or decline. * If revenues are falling, then the company may be running
* Regression techniques can be used to evaluate whether out of stock.
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relationships exist between items from disparate sources. * Comparing these two ratios with revenue growth allows
for a more complete assessment of inventory
management.
Overview of Common Ratios Used including Categories
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A good way to look at the broad number of available ratios

that can be calculated is to classify them into broad Activity Ratios: Payables Turnover and Number of Days
categories. These are: of Payables
Payables turnover is purchases/average payables in period.
- Activity ratios
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A payables turnover that is high corresponds with a low

- Liquidity ratios days payable. An excessively low turnover could indicate
- Solvency ratios trouble making payments on time or taking advantage of
- Profitability ratios lenient terms. Looking at liquidity ratios can give clues as to
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- Valuation ratios which. The number of days of payables reflects the average
number of days a firm takes to pay its suppliers. The
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These categories are not mutually exclusive. formula is number of days in period/payables turnover.

Interpretation and Context of Financial Ratios Activity Ratios: Turnover Ratios

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Financial ratios: Working capital turnover is revenue divided by average

working capital. This ratio indicates how efficiently a
* Are best interpreted in the context of other information company is using its working capital. Fixed asset turnover
* Can be compared to industry benchmarks or ratios from is revenue divided by average fixed assets. This ratio
major competitors measures how well a company generates revenue from its
* In combination with general economic conditions can fixed assets. Total asset turnover is revenue divided by
also provide context average total assets. It measures the company’s overall
ability to generate revenue from a given level of assets.

Activity Ratios: Receivables Turnover and Days Sales

Outstanding (DSO) Liquidity Ratios: The Defensive Interval Ratio
Regarding receivables turnover and DSO: The defensive interval ratio is the sum of cash, short-term
investments, and receivables divided by daily cash
* A relatively high receivables turnover corresponds with a expenditures. It measures how many days the firm can

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Reading 6+3: Financial Analysis Techniques 61

meet its expenses without receiving any additional cash Profitability Ratios: Overview, Calculation, and Use

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flow. The defensive interval ratio can be examined along Regarding profitability ratios:
with other activity ratios to provide insights about problem
areas. * Profitability ratios, as implied by the name, show the

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profitability of a company.
* In turn this shows how well a company is being managed
Liquidity Ratios: The Cash Conversion Cycle
as well as their position in the market.
The time between the outlay of working capital for
* As an investment analyst, calculating profitability ratios
inventory and the collection of cash from customers from
such as gross profit margin and rate of return on sales can
its sale is the cash conversion cycle. The cash conversion

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help you determine which companies are the best
cycle or net operating cycle is calculated by taking the days
investments.
of inventory on hand (DOH) + days sales outstanding (DSO)
- number of days of payables. Shorter conversion cycles
mean more liquidity. DuPont Analysis and the Decomposition of ROE

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DuPont analysis decomposes ROE into its component
parts. A basic framework is ROE = ROA x leverage. ROA in
Liquidity Ratios: Current, Quick, and Cash Ratios
the formula can be further broken down into ROA = net
The three ratios, current ratio, quick ratio, and cash ratio

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profit margin x total asset turnover. Profit margins can be
indicate a firm’s liquidity.
further broken down into EBIT margin, tax burden, and
interest burden.
* The current ratio includes items that may not be quickly
convertible to cash.
* The quick ratio excludes inventory from the numerator.
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Financial Analysis: Industry-Specific Ratios
* The cash ratio excludes more items from the numerator,
Some ratios are industry specific, such as same-store sales
leaving just cash and marketable securities.
in retail, occupancy rates in hotels, and capitalization ratios
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in banking. Some ratios are designed for specific purposes,
Solvency Ratios: Operating and Financial Leverage such as coefficients of variation in revenue, operating
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Operating leverage, calculated as fixed costs/total costs, income, or net income designed to measure business risk.
arises from the use of fixed costs. A greater use of fixed
costs magnifies the impact that additional sales will have
Financial Analysis: Model Building and Forecasting
on operating income since variable costs will rise with
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Analysts build models that forecast the future financial

volumes and fixed costs won’t. The use of debt constitutes
performance of a company by utilizing multiple techniques,
financial leverage because interest payments are a fixed
including sensitivity analysis, scenario analysis, and
financing cost. Higher leverage increases the proportional
simulation. Analysts also create pro forma financial
returns of earnings to equity holders but also increases the
statements as part of an earnings model. Executives and
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risk of default on obligations.

managers within the company may also create pro forma
statements when considering a change that may have a
Solvency Ratios: Debt to Assets and Debt to Equity financial impact.
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The debt-to-assets ratio is total debt divided by total assets.

The debt-to-capital ratio is total debt divided by the sum of
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total debt and equity. The debt-to-equity ratio is total debt

divided by total shareholders’ equity. These are measures
of financial risk and solvency where lower ratios equal less
risk and greater solvency. The financial leverage ratio
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considers what portion of total assets is supported by

equity.

Solvency Ratios: Interest Coverage And Fixed Charge

Coverage Ratios
The interest coverage ratio or times interest earned ratio
measures the number of times a company’s earnings could
pay the company’s interest costs. Fixed charge coverage is
another coverage ratio, calculated as earnings before
interest, taxes, and lease payments, divided by the
company’s interest and lease payment. This measures how
many times the earnings could cover these fixed payments.

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Reading 6+1: Analysis of Income Taxes 62

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6+1 Analysis of Income Taxes

Reading 6+1: Analysis of Income Taxes

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Differences between Accounting Profit and Taxable they deal with initial recognition. They differ some on:
Income
Differences in accounting guidelines can create differences * The recognition of previously unrecognized tax losses
between accounting profit and taxable income. Also, losses * Uncertain taxes

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from one year may reduce taxable income in later years, as * Subsequent recognition of income tax resolutions
a tax loss carry forward.

IFRS vs. US GAAP—Presentation of Deferred Tax

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Deferred Tax Assets and Deferred Tax Liabilities When presenting tax offsets, US GAAP and IFRS have
Deferred tax assets and liabilities are taxes paid or due that similar guidelines. However, IFRS always classifies deferred
result from a difference between the accounting standards taxes as noncurrent whereas GAAP allows a choice based
and the tax authority standards. When these deferred on the related nontax asset. Reconciliation of actual and

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taxes are self-correcting over time, they are called expected taxes is required via a disclosure by IFRS but
temporary differences. A deferred tax must reverse in GAAP only requires it for publicly traded companies.
some future tax period. re
Corporate Income Tax Rates: Statutory, Effective, and
Required Disclosures Relating to Deferred Tax Items Cash
When temporary differences create deferred taxes, Income taxes payable by a company can be significantly
disclosures must be used to explain:
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influenced by business-specific factors such as R&D tax
credits or accelerated depreciation of fixed assets.
* The reasons for the temporary difference Statutory tax rates are stated. Cash tax rates are what is
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* Any adjustments made paid divided by taxable income. Effective tax rates are tax
* The resolution of the difference expense divided by taxable income. Adjusting for one-time
events and focusing on a tax rate based on normalized
If the deferred tax item affects financial analytics like ratios, operating income can be helpful in forecasting future tax
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then a disclosure must be used for explanation. rates.

IFRS vs. US GAAP—Provisions for Deferred Taxes

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Both IFRS and US GAAP require provisions for deferred

taxes when there is a temporary difference. There are
minor differences in general treatment, as well as
differences in specific applications such as deferred taxes
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from revaluations and currency translation differences

(allowed only under IFRS).
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IFRS vs. US GAAP—Measurement of Deferred Tax

US GAAP and IFRS vary in the way they measure deferred
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taxes.

* IFRS allows tax rates and tax laws that have been enacted
or substantively enacted.
* US GAAP only allows for tax rates and tax laws that have
been fully enacted.
* US GAAP allows for the recognition of deferred tax
through a valuation allowance.
* IFRS does not permit valuation allowances.

IFRS vs. US GAAP—Business Combinations

US GAAP and IFRS deal with acquisitions similarly when it
comes to step-up of assets and liabilities as well as the way

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Reading 6+2: Financial Reporting Quality 63

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6+2 Financial Reporting Quality

Reading 6+2: Financial Reporting Quality

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Financial Reporting Quality: Definition conservative accounting policies may result in bias in the
Financial reporting quality refers to the quality of the reports. Conservatism results in expenses requiring less
information presented in the financial statements, verification for recognition than revenues. There are
including the notes to the financial statements and all several benefits to conservative accounting such as

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related disclosures. High-quality reporting provides protection for contracting parties, reduced potential
information that is relevant and faithfully represents the litigation, and protecting interests of regulators and
activities of the company. High-quality earnings are those politicians. For some transactions, such as the impairment
that the company will be able to continue to sustain in the of long-lived assets, the standards are different between

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future. IFRS and US GAAP.

High-Quality Reporting—Useful Information but Not Financial Reporting Quality: Bias in the Application of

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Sustainable Accounting Standards
The second level of the quality spectrum includes reports Regardless of whether an accounting standard is biased or
that conform to GAAP and are useful for decisions, but may not, judgment is required in the application of standards
indicate that earnings are of a lower quality because they that may result in bias. ”Big bath” accounting and ”cookie
are:
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jar” accounting are conservative techniques that bias
current and future statements. Critical accounting estimate
- Not sustainable in the future disclosures are required by the SEC to help analysis
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- Unable to provide an adequate return on investment understand management’s forecasts.

The difference between the highest level on the quality

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Context for Assessing Financial Reporting Quality

spectrum and the second level is related to the quality of
In assessing the quality of financial reports, it is important
earnings. To remain at or near the top of the spectrum,
to consider motivations for issuing poor-quality reports,
high-quality reporting is necessary.
including hiding poor performance, meeting analyst
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expectations or benchmarks, and fulfilling compensation

Financial Reporting Quality: Biased Accounting Choices arrangements. It is also important to look for conditions
conducive to low-quality reports and mechanisms that
Biased accounting choices are in conformance with GAAP discipline financial reporting.
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but do not accurately portray the company’s economic

position. Earnings smoothing is a management method
Mechanisms That Discipline Financial Reporting
that uses biased accounting choices to increase or
Quality
decreases expenses and revenues in an attempt to report
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The quality of financial reporting is influenced by market

less fluctuation in income from year to year.
regulatory authorities that create and enforce the rules
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related to the financial markets. The International

Financial Reporting Quality: Earnings Management and Organization of Securities Commission (IOSCO) is the
Departures from GAAP global standard setter and has many members worldwide,
Toward the middle of the quality spectrum are earnings including the European Securities and Markets Authority
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that are still within GAAP but include those where earnings (ESMA) and the Securities and Exchange Commission (SEC).
are clearly being managed to create biased reports. The Features of regulatory regimes that influence financial
difference between biased choices and earnings reporting include registration, disclosure, and auditing
management is the intent, which is difficult to identify. requirements, management commentaries and
Near the bottom of the quality spectrum are financial responsibility statements, and regulatory reviews and
reports that contain departures from GAAP. These financial enforcement mechanisms.
reports are of low quality and do not provide adequate
information to assess the quality of earnings.
Auditors and Private Contractors for Financial
Statement Quality
Financial Reporting Quality: Conservatism in Publicly traded companies are typically required to have an
Accounting Standards audit performed by an independent auditor. The auditor
Some accounting policies require a conservative approach. provides an opinion as to whether the financial statements
Although it is often assumed that bias is only upward, have been prepared in conformance with the generally

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Reading 6+2: Financial Reporting Quality 64

accepted accounting principles of the governing body and - Managing working capital accounts

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will often include an opinion on the effectiveness of - Classifying choices between the operating, investing, and
internal controls. Third parties who contract with financing sections
companies also have a vested interest in whether the

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financial statements are of high quality.
Warning Signs in Accounting Choices: Revenue and
Expense Recognition
Detection of Financial Reporting Quality Issues Accounting and reporting choices that result in low-quality
With many choices available in applying accounting reporting can be identified by looking for warning signs.
standards, detection of low-quality financial reporting Warning signs generally fall into one of two ways that

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requires an understanding of the following: management has manipulated earnings:

- Presentation choice - Biased decisions in revenue recognition

- Accounting choices and estimates - Biased decisions in expense recognition

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- Warning signs of low-quality reporting

Warning Signs in Accounting Choices: Depreciation,

Financial Reporting Quality: Presentation Choices Non-operating Income, and Other

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When preparing financial statements for presentation, Other potential warning signs include depreciation
companies have choices as to how to present required methods and estimates that are different from industry
information along with choices about additional norms, fourth quarter surprises, non-operating income
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information the company wishes to present. Common included as revenue, classification of expenses as
presentations may include non-GAAP measurements in non-recurring, related-party transactions, restructuring or
pro forma reports and EBITDA. When companies include impairment charges, and management’s culture and focus
non-GAAP measures in an SEC filing of financial statements, on acquisitions.
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reconciliation between the non-GAAP measure and the
closest GAAP measure must be provided with justification.
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Why Analysts Must Maintain a Healthy Skepticism

When analyzing financial statements, the ability to identify
How Accounting Choices Affect Earnings and Balance low-quality reports and maintaining a healthy skepticism
Sheets are important skills for:
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The choices allowed within US GAAP that impact the

income statement also affect accounts on the balance - Critically reviewing disclosures when preparing an analysis
sheet. The differences may come from choosing different - Developing appropriate adjustments to evaluate past
acceptable methods within US GAAP. Other impacts may performance and future forecasts
relate to the use of estimates based on judgments that are
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required by US GAAP.
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Effects of Depreciation Methods on Reported Earnings

Regarding depreciation methods:
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* Businesses may choose from several different options for

recording depreciation.
* The method of depreciation, estimates of salvage values,
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and estimates of useful lives will all impact the amount of

depreciation recorded.
* These choices and estimates impact the amounts
reported on the income statement and balance sheet.

How Accounting Choices Affect the Cash Flow

Statement
The operating section of the statement of cash flows is
most often used by investors to evaluate the earnings
quality of businesses. Businesses may be motivated to
improve the operating section of the cash flow statement
through:

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Reading 6+4: Introduction to Financial Statement Modeling 65

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6+4 Introduction to Financial Statement Modeling

Reading 6+4: Introduction to Financial Statement Modeling

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Building a Financial Statement Model suppliers can cause costs to increase.
A pro forma income statement is a financial document that
projects a company’s future income and expenses based
on expected sales and operating expenses. These Modeling Inflation and Deflation

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estimates start with operating profits and often follow Industry structure and input costs impact end product

trends from recent years but are complicated by any pricing. Price elasticity, industry structure, and market

market changes. Non-operating items such as interest, tax, dynamics are important in pricing decisions. Companies

and shares outstanding all affect projected EPS. must strategically navigate these factors while considering

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the impact of their pricing strategy on their market
position, ensuring they maintain profitability and a
Pro Forma Statements and Forecasts competitive edge in the market.
A pro forma cash flow statement involves adjusting net

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income for non-cash items and changes in balance sheet
accounts to get operating cash flows. Investing and Cost Projections with Inflation and Deflation
financing cash flows are separately estimated. With a pro Forecasting industry and company costs requires
forma income statement and cash flow statement, the pro understanding purchasing practices, monitoring input
forma balance sheet then follows naturally with any
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price drivers, considering the competitive environment,
updates based on assumptions and trends. and segmenting cost structures. By doing so, businesses
can make strategic decisions to navigate inflation and
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deflation effectively.
Behavioral Finance in Forecasts: Overconfidence,
Illusion of Control, and Conservativism Bias
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In building financial statement models, behavioral biases The Impact Horizon and Long-Term Forecasting
such as overconfidence and illusion of control can arise to The factors influencing the choice of an explicit forecast
make the forecast misused. Overconfidence bias leads to horizon include investment strategy, industry cyclicality,
narrow confidence intervals around estimates. A solution and company-specific factors such as acquisitions and
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is to engage in scenario analysis. The illusion of control restructuring. It is important to use normalized earnings
leads researches to make overly complex models, not and terminal cash flows.
really adding to accuracy. A solution is to restrict the
variables available to the model.
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Behavioral Finance in Forecasts: Representativeness

Bias and Confirmation Bias
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Conservativism bias is the tendency to simply apply old

values or trends onto current numbers, with
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underappreciation of new information. This can be

mitigated with regular updates and incorporation of new
data. Representativeness bias is applying the effects of
past, similar scenarios to a present scenario. This can be
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mitigated by carefully considering differences.

Confirmation bias is the purposeful or accidental overuse
of similar views, without adequate consideration of
opposing views. Exploring both positive and negative
analyst reports can help to reduce the effects of this bias.

The Impact of Competitive Factors: Porter’s Five Forces

Model
Porter’s five forces of threat of new entrants, bargaining
power of customers, bargaining power of suppliers, threat
of substitutes, and rivalry among existing competitors are
all threats for a firm. Most of these threats will serve to put
downward pressure on prices, while bargaining power of

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Reading 7+3: Market Efficiency 66

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7+3 Market Efficiency

Reading 7+3: Market Efficiency

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Introduction to Market Efficiency markets and economies as a whole.
Regarding market efficiency:

Market Value vs. Intrinsic Value

* Market efficiency determines whether prices of securities

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Considerations of market versus intrinsic value:
fully reflect all available information.
* If securities prices are subject to change in response to
* The market value of an asset is the price at which
information that is available to investors, then those
transactions occur.
investors who have the information can profit from the

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* It is the price that satisfies buyer and seller.
change.
* The intrinsic value of the asset is the value that buyers
* An efficient market will not provide consistent
and sellers assess based on their knowledge and
opportunities to profit from delayed response to available
consideration of all available information about the
information.

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benefits, risks, and opportunity costs of holding the asset.
* In efficient markets, market values equal intrinsic values.
Description of Efficient Markets
Regarding degree of efficiency:
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Market Participants
* Market efficiency describes the extent to which new Regarding market participants:
information is incorporated in market prices.
* While the number and diversity of sell-side
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* Financial markets in general are neither completely
efficient nor completely inefficient. foreign-exchange market participants is narrower, there is
* Therefore, understanding the degree of market efficiency a wide variety of buy-side participants.
so

helps investors decide whether to spend money in order to * In some cases, such as tourists seeking foreign currency
achieve excess risk-adjusted returns after costs. to travel abroad, those participants can be very small.
* In other cases, such as those involving hedge funds,
participants can become big and influential, rivaling the
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Passive Investing size of their less numerous sell-side counterparts.

Passive investing is a low-cost investment strategy that
accepts a market return in exchange for market risk
because it is not possible to earn excess returns after Information Availability and Financial Disclosure
@

taking costs into account. Since market efficiency relates market prices to
information, it assumes information enters markets
unimpeded and market participants are able to obtain that
Active Investing information. Relevant information becomes available
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Regarding active investing: through financial disclosure that is subject to accounting

standards and regulation to ensure fairness and accuracy.
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* Active investing is an investment strategy that depends

on inefficient markets to achieve superior (after transaction
and information cost) returns. Limits to Trading
* Active investment managers seek to identify securities Regarding limits to trading:
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that are mispriced based on the information uncovered

through research that is either not known by market * Arbitrage is the ability to earn a riskless profit.
participants, or not incorporated in market prices. * Arbitrage takes advantage of mispricing in the market
through either buying a security or short selling a security.
* Short selling is when an investor borrows a security,
Efficiency in a Financial Market
returns the security later and profits if the security price
Regarding the efficiency of a financial market:
drops.
* These trades help make the market efficient by moving
* Market efficiency is a measure of the extent that prices in
the price toward the intrinsic value.
securities markets reflect all available relevant information
* However, limits to short selling may prevent arbitrage
and whether it is possible to earn excess returns from
and increase mispricing.
dealing in securities that are inaccurately priced.
* The ability of prices to reflect and communicate all
relevant information is critical to the function of capital Transaction Cost

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Reading 7+3: Market Efficiency 67

Regarding transaction cost: * If a market is efficient in the strong form, investors who

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have access to and trade on private or insider information
* Transaction costs are the expenses incurred by investors could not consistently earn above normal returns net of
to trade. cost.

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* As a result of transaction costs, it is best to view market * Prices in strong-form efficient markets reflect all available
efficiency as efficient within the limit of trading costs. relevant past, public, and private information.
* This means that mispricing might occur, but as long as * Since strong-form EMH has not been proven to hold,
the mispricing is less than the trading costs to take trading on insider information is illegal.
advantage of the mispricing, markets are still efficient.

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EMH Implications
Information-Acquisition Cost Regarding implications of EMH:
Regarding information-acquisition cost:
* Empirical evidence from securities market studies has

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* Information-acquisition cost is a factor in determining established trading based on past and public information
market efficiency. will not likely result in consistent excess returns after cost.
* In efficient markets, the cost of research and analysis * And case evidence indicates trading on private

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necessary to identify mispriced assets with the expectation information results in jail time.
of earning a return from changes in asset prices is not * Investment managers should consider this evidence
recoverable. when deciding whether to spend money in pursuit of
* All relevant information that can be uncovered through excess returns.
the research will already have affected asset prices.
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Fundamental Analysis
Forms of Market Efficiency Fundamental analysis is a method of estimating the
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Market efficiency is best represented not as an absolute intrinsic value of a financial asset based on public
law but as a continuum of the degree, in three forms from information and analytical techniques. Analysts evaluate:
so

weak to strong, that market prices reflect relevant

information: * Economic forecasts
* Industry conditions
* Weak form assumes that past price information is * Financial information (disclosed by securities issuers
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reflected in market prices including those of the issuers’ peers)

* Semi-strong form assumes that all public information is
reflected in market prices Fundamental analysis promotes market efficiency in the
* Strong form assumes that all public and private semi-strong form.
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information is reflected in market prices

Technical Analysis
Weak Form EMH Regarding technical analysis:
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Regarding weak-form EMH:

* Technical analysis is widely used by traders to anticipate
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* Weak-form EMH defines ”all available information” to future changes in prices and is based exclusively on
include historical prices, trading volume, or short interest. information obtained from market activity.
* This implies that attempting to profit from analyzing * Technical analysts may look for visible patterns in recent
trends is a waste of time, because the information is widely history of prices and volume or apply statistical analysis to
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available at virtually no cost. prices to predict future prices or trends.

* Technical analysis will occasionally, but not consistently,
produce excess returns.
Semi-strong-Form EMH
Semi-strong-form EMH states markets are so efficient that
all public information enters prices immediately, thereby Market Anomalies
making excess returns that can be earned by analyzing Considerations of market anomalies:
annual reports, economic forecasts, or anything else that is
publicly available. * If market prices differ from their fundamental values
then the market is said to be inefficient and the specific
case of mispricing is called a market anomaly.
Strong Form EMH * Researchers and traders seek to find market anomalies in
Regarding strong-form EMH: order to profit by trading on market anomalies.
* However, data mining—which is searching data for an

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Reading 7+3: Market Efficiency 68

anomaly without any hypothesis—might yield apparent * Research has found the pricing of closed-end funds is an

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anomalies that do not really generate trading profits. anomaly because the funds do not trade at net asset value.
* A closed-end fund issues shares at inception, but not
after.

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Time-Series Anomalies * Because of this, the intrinsic value of closed-end funds is
Market efficiency means prices of securities reflect and the value of the assets held by the fund minus liabilities,
respond to all relevant information. If other factors can also known as net asset value.
affect prices on a sufficiently frequent basis over time, the * Due to trading costs, this anomaly is unlikely to generate
factors are regarded as exceptions or anomalies. There are abnormal profits for traders.
two types of time-series anomalies:

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* Calendar anomalies Earnings Surprise
* Momentum and overreaction anomalies An earnings surprise is the unexpected portion of a firm’s
earnings announcement. If markets are semi-strong form

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efficient, then the price of firms should adjust immediately
Calendar Anomalies to the surprise. However, research has found that while
Regarding calendar anomalies: prices do react to earnings surprises, they are too slow in

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fully reflecting all of the information. This anomaly may
* Calendar anomalies are trading patterns associated with lead to abnormal profits for traders.
months of the year, days of the week, days of the month,
and holidays. re
* If changes in market prices are attributable to predictable Initial Public Offerings (IPOs)
investor behavior at certain times of the year, then those When a company offers equity to the market for the first
changes are exceptions to market efficiency. time, it is known as an initial public offering (IPO).
Historically, IPOs have been underpriced at the time they
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are issued resulting in abnormal profits shortly after
Momentum and Overreaction Anomalies issuance which is interpreted as evidence of market
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Regarding momentum and overreaction anomalies: inefficiency. However, over longer periods IPOs have been
found to underperform.
* Momentum and overreaction are included among the
time-series anomalies identified in market research.
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* When it appears that market prices are influenced by the Predictability of Returns Based on Prior Information
direction and persistence of recent short-term trading Some research has found that stock prices are related to
patterns, or the information that is dominating pricing is changes in firm and economic fundamentals. However, the
not the news, but the traders’ reaction to the news, the relationship between changes in fundamentals and stock
anomaly is called momentum and overreaction. prices has not been stable over time. Additionally,
@

* The ability to trade profitably from this information abnormal profits through trading on these relationships
would contradict the notion of market efficiency; however have not been found, and as a result these relationships do
empirical evidence suggests such profits are possible. not indicate inefficiency.
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Cross-Sectional Anomalies—Size and Value Effects Behavioral Finance

Regarding size and value effects: Considerations of behavioral finance include:

* The two best-known, cross-sectional anomalies are the * Behavioral finance is the study of the decision-making
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size effect and the value effect. process for individuals.

* The size effect describes the observation that small firms * Research focuses on why investors make the choices they
have outperformed large firms historically on a do and whether or not their choices are rational.
risk-adjusted basis. * Behavioral finance has been used to explain some of the
* The value effect describes the observation that value anomalies in finance that indicate market inefficiency.
stocks, as measured by low price/book multiples, have * However, it is commonly argued that even if individuals
outperformed growth stocks historically. are irrational the market remains rational and thus
* The Fama and French model is a three-factor model profiting from market efficiency remains unlikely.
including beta and these two effects.

Loss Aversion
Closed-End Investment Fund Discounts Regarding loss aversion:
Considerations of closed-end funds:
* Risk aversion describes the fact that investors need to be

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Reading 7+3: Market Efficiency 69

compensated for risk because they do not like risk. profits for portfolio managers.

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* Risk is the possibility of unexpected price movements in * If markets are weak-form efficient, then technical analysis
either direction. is unlikely to result in abnormal profits for portfolio
* Loss aversion is a behavioral finance concept that managers.

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suggests investors dislike surprise losses more than they * Research shows portfolio managers are on average not
like surprise gains of the same size. able to beat the market on a risk-adjusted basis.
* Loss aversion is then used to explain observed
overreaction in the market.
Implications for Investment Strategies
When stock market anomalies are detected, investors are

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Overconfidence frequently tempted to take advantage of these anomalies
Overconfidence is: using trading strategies. In practice, implementing these
strategies often fails to deliver the desired results because
* A behavioral bias where investors think they are better at of transaction costs and the fact that some anomalies are

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predicting future financial information than they are the result of faulty statistical methods.
* Has been used to explain observed market inefficiencies

Behavioral Finance and Efficient Markets

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However, whether or not investors can earn abnormal
profits from trading on mispricing due to overconfidence is Behavioral theories are important because they may
not clear. explain anomalies, but there is a lot of debate about
whether or not behavioral theories actually explain
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anomalies. If efficient markets require rational investors,
Other Behavioral Biases then it seems likely that markets are inefficient. If market
Many behavioral biases are related to mispricing: efficiency requires that investors can’t consistently beat the
market, then markets seem to be efficient.
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* Representativeness—making decisions based on the
similarity between future events and current events
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* Gambler’s fallacy—suggests recent outcomes influence

future decisions
* Mental accounting—involves tracking financial activities
in different mental accounts
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* Conservatism—reacting slowly to change

* Disposition effect—avoiding realizing loss
* Narrow framing—the failure to consider the broad
context of a problem
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Information Cascades
Regarding information cascades:
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* Information cascades occur when investors make

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decisions by following the decisions of other investors who

act first.
* Related to this, herding describes when investors cluster
trades.
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* Both types of behavior can cause returns to be correlated

over time and may cause mispricing.
* However, if the direction of the returns is moving prices
to their intrinsic value, then information cascades may
enhance market efficiency.

Implications for Portfolio Management

Regarding portfolio management:

* Stock market efficiency is very relevant to the approach

taken to portfolio management.
* If markets are semi-strong-form efficient, then
fundamental analysis is unlikely to result in abnormal

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Reading 7+4: Overview of Equity Securities 70

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7+4 Overview of Equity Securities

Reading 7+4: Overview of Equity Securities

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Overview of Equity Securities shareholder’s shares are multiplied by the number of
Claims of ownership on a company’s net assets are positions available for election to arrive at the total amount
represented by equity securities. Equity represents a large of votes the shareholder may cast.
portion of investment portfolios. It is an integral part of

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investment portfolio management and investment
Common Cumulative Voting
analysis.
Common cumulative voting:

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Real Returns and Risk of Major Asset Classes * Potentially gives small shareholders greater influence in
Regarding risk and real returns: board elections
* Allows common shareholders to direct all of their voting
* Real returns are nominal or ”face value” returns adjusted rights to specific candidates, as opposed to having to

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for inflation. allocate their voting rights equally among all candidates
* The historical data are generally consistent with a
relationship between risk and return.
Common Share Classes
* Stocks provide the highest historical real returns,
followed by bonds and short-term cash equivalents.
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Regarding common share classes:

* Although most firms have only one common share class,

Types and Characteristics of Equity Securities it is possible for companies to have several share classes.
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There are two main choices for investing in the equity * The most common difference between the multiple share
securities of a firm: classes is in their voting rights.
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* The class with higher voting rights may enable its owners
* Preferred equity—the main advantage is dividends are to control the firm even if they do not own the majority of
paid before common equity and the downside is upside stock market capitalization.
gains are generally limited.
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* Common equity—investors seeking greater upside

Liquidation Rights
potential will likely invest in the common equity of the firm.
Regarding liquidation:
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Voting Rights * Although common shares are created with an infinite

Common shares come with voting rights. These rights maturity date, sometimes firms are liquidated.
permit shareholders to participate in major corporate * Liquidations usually occur due to bankruptcy or because
governance decisions, such as: the board of directors thinks the company is worth more to
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distribute its net assets to shareholders than to operate as

* In the election of members of the board of directors a going concern.
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* Possible mergers and acquisitions * Liquidation rights permit shareholders to share ratably in
* The selection of external auditors any distributions by the firm in the event of a liquidation.
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Common Proxy Voting Preemptive Rights

Regarding common proxy voting: Sometimes companies sell new shares of stock.
Preemptive rights provide existing shareholders the right
* Many common shareholders cannot attend the annual to buy new shares, often at a modestly discounted price.
meeting in person.
* Common proxy voting permits shareholders to designate
Dividends on Preference Shares
another party, such as management or another
The main reason for owning preference shares is for the
shareholder, to vote on their behalf.
dividends expected to be received. Dividends on
* Proxy votes, when voted as a block, may better effectuate
preference shares are paid before dividends on common
corporate change.
equity shares. Dividends on preference shares may be
structured several ways, with the most popular variants
Statutory Voting being:
It is helpful to remember that in statutory voting, a

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Reading 7+4: Overview of Equity Securities 71

* Cumulative for their shares.

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* Noncumulative
* Participating
* Nonparticipating Convertible Preference Shares

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Regarding convertible preference shares:

Preference Shares: Description and Types * Convertible preference shares are a type of preferred
Regarding preference shares: stock.
* They entitle preference shareholders to convert their
* Preference shares are hybrid securities with

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shares into common shares through a set conversion price.
characteristics of both debt and common equity. * Once shares are converted to common shares, they are
* The most common types of preference shares are unable to be converted back to preference shares.
cumulative, noncumulative, participating, nonparticipating,
and convertible.

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* Each type offers a unique risk-return opportunity. Private vs. Public Equity Securities
Equity securities are issued and traded in private equity
markets. There are three private equity investment types:
Cumulative Preference Shares

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Regarding cumulative preference shares:
* Venture capital (VC)
* Leveraged buyouts (LBO)
* Preference shares are also known as preferred stock.
* Private investment in public equity (PIPE)
* The primary reason for purchasing preference shares is
for its dividends.
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Start-up companies can go public through an initial public
* Cumulative preference shares require firms to make up
offering (IPO) on the stock market. A management buyout
any previously missed preference dividend payments
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transaction (MBO) exists when acquisition is by the
before any dividend can be paid to common shareholders.
company’s management.
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Noncumulative Preference Shares

Investing in Non-Domestic Equity Securities
Regarding noncumulative preference shares:
Considerations of investing in non-domestic equity
securities:
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* Preference shares are preferred stocks.

* Preference shares are purchased for fixed dividends.
* Global financial markets have grown as a result of
* Noncumulative preference shares do not require
technological innovations such as the Internet.
companies to make up missed dividend payments but
* Some countries continue to impose foreign restrictions to
when payments resume, noncumulative preference
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limit others from investing in their local companies,

shareholders are paid before common shareholders.
although more countries are allowing increasing foreign
ownership levels.
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Participating Preference Shares

Regarding preference shares:
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Direct Investing
* Participating preference shares are a type of preferred Investors can invest directly in foreign markets by buying
stock. and selling in markets outside of their local market.
* Shareholders have rights to receive fixed-scheduled Investors need to be concerned about currency conversion
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dividends and an opportunity to obtain additional and unfamiliar market practices.

dividends if profits exceed a predetermined level.

Depository Receipts
Nonparticipating Preference Shares Regarding depository receipts:
Regarding nonparticipating preference shares:
* Depository receipt (DR) securities represent foreign
* Nonparticipating preference shares are a type of economic interests and trades on a domestic exchange.
preferred stock. * The depository bank issues DRs and acts as a guardian
* Shareholders have rights to receive fixed scheduled and record keeper.
dividends but do not have any opportunity to obtain * With sponsored DRs the underlying foreign company has
additional dividends if company profits exceed a direct involvement in receipt issues.
predetermined level. * Unsponsored DRs have no issuance involvements.
* In the event of liquidation, shareholders receive par value

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Reading 7+4: Overview of Equity Securities 72

American Depository Receipts The Cost of Equity and Investors’ Required Rates of

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An American depository receipt (ADR) is one type of global Return
depository receipt (GDR) security. It is a DR that is issued Regarding cost of equity:
by an American bank. American depository shares (ADS)

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are securities that are traded in the US market. There are * To maximize shareholder wealth, companies try to
four different types of ADRs. minimize costs in raising capital.
* Investors require a return on the investments they make.
* The cost of equity is the minimum expected return that
Global Depository Receipts companies offer its investors.

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Regarding GDRs: * It is part of the capital allocation process and used to
estimate the weighted average cost of capital.
* A global depository receipt (GDR) is a type of security that
is issued both outside of the United States and outside the
Equity Securities and Company Value

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foreign company’s home country.
* GDRs allow investors to invest in foreign companies The goal of the firm in most capitalistic societies is to
without experiencing foreign laws, rules, and trading maximize the market value of equity. Market values may
practices. differ dramatically from book values since the former is

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largely forward-looking and determined by investors, while
the latter is backward or present-looking and determined
Basket of Listed Depository Receipts by management using GAAP.
A basket of listed depository receipts (BLDR) is a type of
exchange-traded fund. It contains a portfolio of depository
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Risk of Equity Securities
receipts (DR).
Regarding risk of equity securities:
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* There is a priority rule for cash flows generated by the
Risk and Return Characteristics of Equity Securities
firm.
The return of equities includes capital gains and possibly
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* Bondholders are paid first in full, then preferred

dividends. Investments in foreign equities may also include
stockholders, then common stockholders.
foreign exchange gains or losses. The main risk of investing
* Security holders paid first have the lowest risk and lowest
in equities, and most other securities, is the uncertainty of
expected returns, while those paid last have the highest
future cash flows.
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risk and highest expected returns.

Return Characteristics of Equity Securities

Equity Securities in Global Financial Markets
Total return on equity is normally provided by two sources:
Equity securities represent an important asset class for
@

global investors because of their large size and unique

* Capital gains arise from changes in a company’s stock
risk-return characteristics. A common metric for measuring
price.
the size of the global equity markets is market
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* Dividend income may be issued and may compound if

capitalization to GDP. US equities have a disproportionate
dividends are reinvested.
influence on global equity markets.
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Foreign exchange gains/losses are a third source when

investors directly purchase foreign shares or purchase
depository receipts (DRs).
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Accounting Return on Equity

Regarding ROE:

* Return on equity (ROE) is the profitability ratio that

investors use to measure whether or not management
effectively uses equity financing to fund operations.
* Equity book value reflects historical information.
* Market value reflects historical information and expected
future cash flows.
* ROE and book value are limited ways to find intrinsic
value.

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Reading 7+8: Equity Valuation: Concepts and Basic Tools 73

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7+8 Equity Valuation: Concepts and Basic Tools

Reading 7+8: Equity Valuation: Concepts and Basic Tools

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Equity Valuation Concepts and Basic Tools Retractable Term Preferred Shares
Equity valuation is used to determine if a stock is Preferred stock that has a maturity can be valued using the
undervalued, overvalued, or fairly valued. This is done by formula:
∑
n
Dt F
generating an estimate of value and comparing to the V0 = +

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(1 + r)t (1 + r)n
market price. There are three major types of equity t=1

valuation models: In addition to having a maturity, some preferred stock is

callable, which means the issuer can buy back the
* Present-value models preferred stock, making it less valuable to the owner of the

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* Multiplier models shares. Additionally, some preferred stock is retractable,
* Asset-based valuation models which means the owner of the shares can sell them back to
the issuer, making these shares more valuable.

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Intrinsic Value or Fundamental Value
Regarding intrinsic value: Gordon Growth Model
Considerations of the Gordon growth model:
* Intrinsic value or fundamental value is the estimated
value of a firm based on analysis and projections.
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* The Gordon growth model is a common dividend
* If intrinsic value is more than the current market price for discount model.
an asset, the difference is potential value for the investor * It allows you to value a firm using a simple formula that
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and represents a good buy. accounts for all future dividends paid by the firm.
* This assumes the market price may not always match the * The key assumption is the dividends grow at a constant
rate.
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intrinsic value.
* The Gordon growth formula is:
D1
V0 =
Estimated Value and Market Price r−g
When an analyst compares the market price of an asset to
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the estimated or intrinsic value, there are three

possibilities:
Multistage Dividend Discount Models
The Gordon growth model is not appropriate in situations
* The asset could be overvalued, so market price is greater
@

where dividend growth is going to be unsustainably high.

than the intrinsic value.
When growth is high, it is best to use multistage models
* The asset could be undervalued, so market price is less
which value the high growth dividends separately and then
than the intrinsic value.
add the present value of the constant growth period for
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* The asset could be fairly valued, so market price is the

the firm.
same as the intrinsic value.
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Two-Stage Models
Present Value Models: Discounted Cash Flows
A two-stage dividend model has a period of high growth
Present value models or discounted cash flow models are
followed by a period of stable growth. A two-stage firm can
one of three major equity valuation models in the CFA®
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be valued by finding the present value of each of the

curriculum.
dividends from the high growth period and adding that
value to the present value of the constant growth period
Non-Callable, Non-Convertible Perpetual Preferred using this formula:
Shares ∑n
D0 (1 + gs )t Vn
V0 = +
Preferred stock is a type of equity that takes precedence t=1
(1 + r)t (1 + r)n
over common equity in both dividends and liquidation
events. The value of preferred stock that is noncallable,
nonconvertible, and perpetual is the same as the formula
Multiplier Models
to value a perpetuity:
D Regarding multiplier models:
V0 =
r
* Multiplier models are one of the three major equity
valuation models.

© Mindojo, 2023
Reading 7+8: Equity Valuation: Concepts and Basic Tools 74

* Multiplier models use a ratio that usually includes some fundamentals such as growth and price multiples in order

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measure of value like price or enterprise value in the to find out if firms are mispriced or not.
numerator and some driver of performance like earnings
in the denominator.
Method of Comparables

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Considerations of method of comparables:
P/E Ratio Models
Regarding P/E ratio models: * The method of comparables is the most commonly used
technique for finding a firm’s value based on price
* The price-to-earnings (P/E) ratio is the most commonly multiples.

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used price model. * The method is based on finding firms that are
* It is calculated by taking a company’s stock price and comparable to the firm being valued in terms of
dividing by earnings per share. fundamentals.
* The P/E ratio can then be interpreted as how much the * The average of price multiples for the comparable firms

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market is currently paying for every $1 in earnings per is then used to find an estimate of value for the firm.
share for the firm.
* This can be compared to a firm’s own past history to
Illustration of a Valuation Based on Price Multiples

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other firms in the industry.
Considerations of valuation based on price multiples:

* One of the advantages of price multiples is it is easy to

P/B Ratio Models
compare a firm’s value to other similar firms at a given
Regarding P/B ratio models:
re
point in time as well as to its own value over time.
* One drawback of price multiples is comparisons to other
* The P/B ratio is found by dividing a stock’s current price
firms may give you a different valuation conclusion than
by the book value per share.
n
comparisons of multiples across time.
* The P/B ratio is interpreted as the amount the market is
* Another drawback of price multiples is that inputs into
paying for $1 in book value per share for the company.
so

the multiples may not be standard across firms, which

* All else equal, a lower P/B means a lower valued company
makes comparison difficult.
that is relatively more likely to be a bargain.

Enterprise Value
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P/S Ratio Models

Regarding enterprise value:
Regarding P/S ratio models:

* Some valuation techniques are based on enterprise value

* The price-to-sales (P/S) ratio is the ratio of a stock’s
instead of price.
current price to its sales per share.
@

* Enterprise value is the market capitalization of a stock

* The P/S is often useful because sales, unlike earnings,
plus the market value of preferred stock and the market
must be positive.
value of debt less cash and cash equivalents.
* P/S is interpreted as how much the market is currently
* Enterprise value is a better option when firms have
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paying for every $1 in sales per share.

differing capital structures because it directly includes debt.
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P/CF Ratio Models Asset-Based Valuation

Regarding P/CF ratio models: Regarding asset-based valuation:
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* The price-to-cash-flow (P/CF) ratio is a price multiple that * Asset-based valuation is based on estimates of a firm’s
scales a firm’s current stock price by cash flow per share. assets and liabilities.
* The cash flow measure used in this ratio is usually either * This method works well in cases where most of a firm’s
free cash flow or operating cash flow. value is tangible and is commonly used to value privately
* The interpretation of the P/CF ratio is how much the held firms.
market will pay for $1 of free cash flow per share for a * Finding value using this method involves estimating the
given company. value of assets and subtracting the estimate of the value of
liabilities.
* The interpretation of this valuation is often as the
Relationships Among Price Multiples, Present Value
baseline or worst case scenario for value.
Models, and Fundamentals
Firms often have different price multiples and this does not
necessarily mean that either is mispriced. It is important Equity Analysis: Valuation Ratios using Share Price
for analysts to understand the relationship between firm Regarding valuation ratios:

© Mindojo, 2023
Reading 7+8: Equity Valuation: Concepts and Basic Tools 75

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* Price to earnings, price to cash flow, price to sales, and
price to book value are valuation ratios that have share
price in the numerator and divide by performance metrics

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in the denominator.
* Price to earnings ratio: share price/earnings per share.
* Price to cash flow: share price/cash flow per share.
* Price to sales: share price/sales per share.
* Price to book value: share price/book value per share.

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The Dividend Discount Model (DDM)
The dividend discount model (DDM) equates the estimated
future dividends to the current price by discounting each in

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a geometric series, which can be solved explicitly for the
return of equity:
D1
re = +g
P0

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where D is the current market index dividend level, P is the
price of the index, and g is the assumed sustainable growth
rate of dividends. This sustainable growth rate can be re
estimated with the payout ratio and the firm’s return on
equity: ( )
D
g= 1− ROE
EP S
n
so

Free Cash Flow to Equity (FCFE) Model

Regarding the FCFE model:

* Free cash flow to equity (FCFE) models use the capacity to

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pay dividends, rather than actual dividends, to value a

stock.
* FCFE is calculated by first finding cash flow from
operations (CFO), where CFO is net income plus noncash
@

expenses minus increases in net working capital.

* FCFE is CFO minus fixed capital investment, plus net
borrowing.
* The value of a company is the discounted expected
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future FCFE.
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Justified Forward P/E Estimates

Considering justified P/E estimates:
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* In order to determine if differences in price multiples

between firms indicate mispricing or differences in
fundamentals, justified price multiples are often used.
* The justified price-to-earnings (P/E) ratio shows P/E is
inversely related to required rate of return and positively
related to growth.
* Differences between firms in either required rate of
return or growth may explain differences in P/E.

© Mindojo, 2023
Reading 7+6: Industry and Competitive Analysis 76

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7+6 Industry and Competitive Analysis

Reading 7+6: Industry and Competitive Analysis

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Industry Analysis Step 1: Defining the Industry Porter’s model is used to derive the level of competition
Industry classification is used to group companies with and profitability of an industry based on:
similar traits together. Frequently used approaches to
industry classification include grouping companies * The threat of substitute products

ch
together that have similar products, provide similar * The threat of new entrants
services based on how sensitive they are to the * Bargaining power of customers
business-cycle, or possess similar statistical properties. * Bargaining power of suppliers
Commonly used market classification systems, such as * The intensity of rivalry between current companies in the

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Global Classification Standards (GICS), the Industry industry
Classification Benchmark (ICB), and The Refinitiv Business
Classification (TRBC) group companies together that
provide similar services or sell similar products. Porter’s Five Forces Model: Barriers to Entry

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The threat of new companies entering an industry is
determined by the barriers to entry. An industry with high
Identifying Similar Companies by Business Cycle barriers to entry leads to a less competitive environment.
Sensitivities
Regarding business cycle sensitivities:
re
The following are all examples of barriers to entry:

* Economies of scale
* Companies and industries can be grouped by their * Patents
n
sensitivity to a business cycle. * Government regulation
* Cyclical companies’ revenues are strongly correlated with
the greater economy, and tend to increase during
so

expansionary economic times and decline during Porter’s Five Forces Model: Price Competition
recessions. Industries in which price is a large factor in customer
* Non-cyclical company revenues are independent of purchase decisions are typically more competitive than
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economic conditions. industries in which customers value other product

* One limitation of business-cycle sensitivity classifications attributes more highly. Companies that are able to
is geographic diversification of revenues. differentiate their products based on unique qualities,
instead of on price, are likely to have strong pricing power.
@

Identifying Similar Companies by Statistical Similarities

External Influences on Industry: Economic Influences

A statistical approach to grouping companies together is
Macroeconomic trends can greatly influence the demand
usually based on analyzing correlations of historical
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for an industry’s products and services. These trends can

returns. The composition of companies tends to vary
be either cyclical or structural in nature, depending on
greatly based on the time periods used and countries
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whether they are the product of the business cycle or are

analyzed.
expected to be long lasting changes for the industry.

Industry Classification Systems and their Limitations

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Industry classification schemes like GICS, ICB, and TRBC are External Influences on Industry: Technological
fundamental tools in finance, offering a structure for Influences
categorizing companies globally based on their products or New technologies can often create new or improved
services. However, they have limitations, such as struggling products and have a profound impact on an industry. They
with multi-industry companies and potentially can also change how businesses in other industries use the
misclassifying businesses with significantly different products in their operations.
models under the same category. Moreover, these
schemes are dynamic, reflecting the ever-evolving global
External Influences on Industry: Governmental
business landscape.
Influences
Governments exert considerable influence on industries’
Industry Analysis Step 3: Industry Structure revenues and profits. In setting tax rates and rules for
Porter’s five forces model provides analysts with a companies and individuals, governments affect profits and
systematic approach to conduct strategic industry analysis. incomes, which impact both corporate and personal

© Mindojo, 2023
Reading 7+6: Industry and Competitive Analysis 77

spending levels. Industry Analysis Step 2: Industry Survey

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In industry analysis, the size is determined by relevant
segment sales, not all company sales. Characterizing
External Influences on Industry: Social Influences growth industries involves understanding if they’ll reach

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Societal changes related to the way people work, spend market saturation, and in assessing industry profitability,
their incomes, and engage in other activities can have a when data aren’t available, assumptions based on publicly
marked impact on the sales and growth prospects of many traded companies can be made. While increased market
industries. concentration can lead to higher profitability, it can also
raise regulatory concerns.

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Industry Analysis Step 4: External Influences on
Industry Industry Analysis Step 5: Competitive Analysis
Understanding the growth and market dynamics of Companies need to adopt intentional strategies, which
involve careful planning and execution, to effectively

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industries requires considering external factors,
encapsulated in the PESTLE framework: political, economic, navigate competitive landscapes. Such strategies should
social, technological, legal, and environmental influences. be evaluated considering a company’s defense against
Legal influences, which entail changes in laws and industry forces, its alignment with external influences, and

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regulations, significantly impact industries like tobacco and its resources to execute the strategy. Failing to adhere to
cannabis. Environmental influences present risks and clear competitive strategies, such as cost leadership,
opportunities related to the transition to a lower-carbon differentiation, or focus, can leave a company ”stuck in the
economy, especially for sectors involved in the production middle” and undifferentiated, potentially harming its
or consumption of fossil fuels.
n re
success.

Introduction to Industry Analysis and Competitive

Analysis
Industry analysis centers around analyzing a particular
so

area of manufacturing, service, or trade, and provides an

important foundation for the analysis of individual
companies. Competitive analysis begins with a review of
the external environment’s dynamic factors that can affect
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the company’s growth prospects and competitive strategy,

including technological and social influences, and whether
a company’s strategy is one of low-cost leadership or
product/service differentiation.
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Porter’s Five Forces Model: Industry Concentration

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Industry concentration is a reasonably good indicator that

an industry has pricing power and rational competition,
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although certain other factors may mitigate the importance

of that concentration. Industry fragmentation is a strong
signal that an industry is competitive with limited pricing
power.
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Uses of Industry Analysis: Why Analyze an Industry?

Understanding the dynamics of business models and
market competition is crucial for effective industry analysis,
as it influences a company’s competitive positioning and
profitability. Broader perspectives that incorporate
competitive forces and external influences can enhance
forecasting accuracy and reveal compelling investment
opportunities. However, it’s essential to remember that
while competition often aligns a company’s profitability
with the industry average, company-specific factors can
cause significant variance.

© Mindojo, 2023
Reading 7+1: Market Organization and Structure 78

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7+1 Market Organization and Structure

Reading 7+1: Market Organization and Structure

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Functions of the Financial System Raising equity capital is an alternative to raising capital via
The functions of the financial system include: debt markets. The financial system facilitates raising equity
capital by:
* To trade assets for immediate or future use

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* Enable growth in saving for future use * Aggregating buyers and sellers to create a liquid,
* Raise capital via equity issuance competitive, and centralized market for determination of
* Trade on information equity instrument value
* Borrow money for current use * Facilitating information sharing between firms and

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* Risk management investors

In a properly functioning financial system, transaction costs

Managing Risks
are low, participants are able to accurately estimate asset

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Regarding managing risk:
value and expected returns, and capital is allocated to its
best use.
* Financial risks arise due to fluctuations in market prices
beyond the control of the firm.
Helping People Achieve Their Purposes in Using the
re
* Examples include interest rates, exchange rates, and raw
Financial System material prices.
The financial system has six main purposes. These * The financial system aggregates parties who seek to
n
purposes need not be mutually exclusive, and one reduce risk, facilitating trading in instruments that hedge
transaction can serve multiple purposes. risk.
* By aggregating traders, the financial system creates a
so

liquid market for risk management instruments that

Capital Markets: Motivations of Saving
minimizes transaction costs.
Saving
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* Moves money from the present to the future Exchanging Assets For Immediate Delivery (Spot
* Can be accomplished by buying a range of assets such as Market Trading)
stocks, bonds, or investment funds Regarding spot market trading:
* Is dependent on investors being able to realize a fair
@

return for bearing risk, easily sell the asset in the future, * Virtually every day most people participate in the spot
and buy and sell the asset with low-transaction costs. market—the market where assets are traded for
immediate delivery.
* The financial system aggregates spot buyers and sellers
e

Capital Markets: Connecting Lending and Borrowing

ensuring a competitive market where assets are priced
Regarding borrowing:
fairly.
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* By aggregating buyers and sellers, the financial system

* The debt market—which is part of the financial
eases the process of finding a counterparty for both buyers
system—functions to aggregate lenders and borrowers.
and sellers and facilitates economies of scale for sellers,
* Lenders and borrowers interact to determine prices for
which minimizes transaction costs.
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debt contracts, resulting in a fair cost of debt for borrowers

and a fair return on investment given repayment risk for
lenders. Information-Motivated Trading
* Repayment risk can be lowered by offering collateral and Regarding information-motivated trading:
communicating the risk and viability of the project planned
with borrowed funds. * Information-motivated traders rely on information to
* Repayment risk is lower for borrowers with a strong forecast a financial instrument’s future price movements.
credit rating who have a history of repaying loans and have * They hope their information will enable them to identify
predictable cash flows to repay the loan, such as consistent attractive trading opportunities that produce returns in
salary income for individuals and positive net income for excess of those other market participants without this
firms. information can expect.

Raising Equity Capital Determining Rates of Return: Transfer of Capital

© Mindojo, 2023
Reading 7+1: Market Organization and Structure 79

through Time * Common equity holders elect boards of directors and

m
Regarding rates of return: indirectly choose who manages the company.
* Preferred stockholders are entitled to receive dividends
* Money is constantly moving between the present and the that have been specified in advance.

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future.
* Investors who buy bonds and stocks are essentially
transferring capital to the future, while borrowers and Pooled Investments
equity issuers are moving funds from the future to use Investors can obtain indirect exposure to securities via a
them today. pooled investment, that sells ownership stakes in its
portfolio of assets. Pooled investments are sometimes

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* The amount of money invested or consumed depends on
the expected rate of return on the funds, with lower rates called:
stimulating consumption and higher rates prompting
increased capital flows from investors. * Units
* Limited partnership interests

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* Depository receipts
Capital Markets: Allocation Efficiency
Regarding capital allocation efficiency: Pooled investments can include:

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* Companies and governments obtain funds in the primary * Mutual funds
capital markets. * Hedge funds
* Funds are allocated efficiently if they are being used for * Asset-backed securities
the most productive projects available.
re
* Exchange-traded funds
* Given that investment capital is limited, investors must
choose what to fund and what not to fund, and they do this
through direct or indirect means. Contracts
n
Regarding contracts:
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Classifications of Assets and Markets * A contract is an agreement between two parties to do

Regarding classification of assets and markets: something at a point in time.
* A contract’s value is linked to an underlying asset, and
* Assets and markets can be classified based on their settlement can occur physically, through the delivery of a
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shared characteristics, allowing parties to understand the financial instrument, or for cash.
nature of financial instruments.
* Assets can be classified based on how they are traded or
their unique features. Forward Contracts
Forward contracts are:
@

* Markets can be distinguished based on aspects such as

the duration of an instrument and how easily it is valued.
* Agreements to trade an underlying asset at a point in the
future, at a price that is agreed upon today
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Fixed Income Financial Instruments * Are often used to reduce risk, although counterparty risk
Considerations of fixed-income financial instruments: and liquidity concerns are important factors for all parties
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to consider
* Fixed-income financial instruments generally call for an
individual or entity to borrow funds and repay these funds
over time. Futures Contracts
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* Companies and governments are frequent issuers of Regarding futures contracts:

fixed-income instruments.
* However, other arrangements can be created that * Futures contracts are standardized forward contracts for
include payment schedules that are characteristic of which a clearinghouse guarantees all traders’ performance.
fixed-income instruments. * The clearinghouse acts as a buyer for each seller and a
seller for each buyer, ensuring traders are not impacted by
other traders’ nonperformance.
Equities * Futures contracts allow parties to take offsetting
Regarding equities: positions to eliminate their obligations.

* Common equity and preferred equity are forms of

ownership. Swap Contracts
* Owners of these types of securities face unique risks and Regarding swap contracts:
have different claims against a company’s assets.

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Reading 7+1: Market Organization and Structure 80

* Swap contracts are agreements for the periodic exchange * Brokers and exchanges

m
of cash flows between parties, based on future changes in * Insurance companies
asset prices or interest rates.
* Several types of swap contracts are in use.

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* The cash flows for these contracts are initially uncertain Brokers, Exchanges, and Alternative Trading Systems
when they are created. Financial intermediaries include:

* Brokers who fill orders for clients but do not trade with
Option Contracts them
Regarding option contracts: * Block brokers who service large traders

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* Investment banks that provide transactional services to
* An option contract allows a purchaser to buy or sell an corporations
underlying asset at a predefined price at, or before, a date * Exchanges where traders meet to execute trades
in the future.

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* Option writers, or sellers, assume the other side of an Alternative trading systems are similar to exchanges but
option trade. exercise limited regulatory authority over their subscribers.
* Traders compare the strike price with the asset’s value to

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determine if an exercise is justified.
Dealers
Regarding dealers:
Commodities re
Commodities include: * Dealers fill their clients’ orders by trading directly with
them.
* Agricultural products * They buy securities or contracts when a client wants to
* Energy products sell, and they sell when the client is looking to buy.
n
* Industrial metals * By acting in this manner, dealers provide liquidity in the
* Precious metals market, helping to keep transaction costs low.
so

* Dealers can also function as brokers, acting on their

Commodities can be traded in the spot market or the clients’ behalf and not for their own account.
futures market. Participants’ choice of market(s) will
depend on whether they have the ability to take or make
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delivery and store the physical products. Securitizers

Regarding securitizers:

Real Assets * Securitizers purchase assets, place them into a pool, and
Real assets are tangible and include: sell securities that represent ownership stakes in the pool.
@

* Mortgage-backed securities are an example of a

* Real estate securitization that improves market liquidity by allowing
* Machinery investors to buy assets they would otherwise not buy.
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* Other items that can provide income and tax benefits * The classes of securities created by securitizers often
have different cash flow characteristics.
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Investment in real assets—no two of which are

identical—can occur directly or indirectly and offers
investors another opportunity for their portfolios. Depository Institutions and Other Financial
Corporations
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Regarding other financial corporations:

Financial Intermediaries
Financial intermediaries: * Depository institutions, such as banks, raise funds from
depositors and investors and lend to borrowers.
* Help their clients address problems efficiently * Financial corporations, such as payday advance
* Connect buyers and sellers companies, offer credit services and obtain their funds
* Facilitate the transfer of capital and risk within the from outside investors.
financial system * Brokers also serve as financial intermediaries, providing
funds to clients buying securities on margin.
These intermediaries include:

* Banks Insurance Companies

* Credit unions Insurance companies are financial intermediaries that
* Credit card firms enable individuals and companies to reduce or eliminate

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Reading 7+1: Market Organization and Structure 81

their risk exposures by transferring these risks to other

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entities. Insurance contracts can be created for a variety of Some traders will lose money on their positions while
purposes, including for: others will gain.

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* Auto
* Fire Short Positions
* Life Regarding short positions:
* Liability
* Medical * A short position is created when a trader sells a contract
they do not own.

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* Theft
* Natural disaster risks * The security is borrowed from a lender and must be
repurchased at some point in the future.
* The potential loss on a short position is limitless, while
Arbitrageurs the maximum gain is the entire value of the security.

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Regarding arbitrageurs:

* Arbitrageurs trade when they are able to identify buying Leveraged Positions
Regarding leveraged positions:

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and selling opportunities for identical or similar
instruments that are priced differently in the markets.
* Arbitrageurs link buyers in one market with sellers in * Traders are able to borrow money to finance a portion of
another market and, as such, can be thought of as financial their securities purchases.
re
intermediaries. * The borrowed money—called a margin loan—has a
significant impact on the potential gains and losses from a
trade.
Settlement and Custodial Services * Leverage ratios are calculated to determine the riskiness
n
Regarding settlement and custodial services: of a position relative to an unleveraged position.
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* Financial intermediaries do more than just connect

buyers and sellers. Computing Total Return on a Leveraged Stock
* As clearinghouses, they settle trades on behalf of their Purchase
members, imposing certain performance requirements The total return on a leveraged stock purchase is calculated
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that impact nonmember entities as well. using:

* As custodians, intermediaries hold securities to prevent
their potential loss. * The change in the price of the stock
* Factors in the dividends received
* The interest due on the margin loan
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Summary—Financial Intermediaries * Any commissions paid to purchase and sell the stock
Financial intermediaries are essential to maintaining
successful financial systems and include: A leveraged position will magnify the potential gains and
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losses relative to an unleveraged position.

* Brokers
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* Exchanges
* Dealers Computing the Margin Call Price
* Arbitrageurs Regarding margin call price:
* Securitizers
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* Insurance companies * Traders who use margin loans to establish their positions
* Custodians in financial instruments must maintain a maintenance
margin—or minimum amount of equity—for their trades.
They facilitate trading and are like the oil that keeps the * If the traders’ equity balance falls below this amount, they
markets’ gears in operating condition. will get a margin call to contribute more equity.

Positions Orders
Positions are: Buyers and sellers of financial instruments convey their
trading desires by submitting orders that denote:
* The quantities of a financial instrument that an entity
owns or is liable for * The type of instrument they want to trade
* Can be long or short, suggesting different expectations * The amount they want to trade
exist for the value of the underlying asset or contract * Whether they intend to buy or sell

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Reading 7+1: Market Organization and Structure 82

for a longer period of time.

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The spread between the best buy and sell orders can reveal * The instructions a trader gives can reflect the nature of
important information about the market for a security. the trade and the time frame for the investor’s profit
opportunity.

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Execution Instructions
Considerations of execution instructions: Stop Orders
Regarding stop orders:
* Traders can have unique strategies when they seek to
have their orders executed.

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* Traders can submit stop orders if they want to specify a
* They include execution instructions to the brokers or price condition that must be met before the order can be
exchanges handling their trades that can have a significant executed.
impact on the price at which the order is ultimately filled. * The stop price instruction on a sell order prevents it from

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being filled until another trade takes place at or below this
price.
Market Orders
* Buy orders with stop requirements cannot be completed
Regarding market orders:
until other trades take place at or above the stop price.

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* Traders often call these types of instructions stop-loss
* Traders who place market orders are looking to secure
orders.
the best price immediately available in the market when
completing an order. re
* These orders are usually filled quickly if other traders are
Clearing Instructions
available to take the other side of a trade.
Regarding clearing instructions:
* However, if other traders need to be incentivized to take
part in a trade, a price concession may be necessary.
n
* Clearing instructions are provided to brokers and
exchanges indicating how trades are to be settled.
* For trades settled on behalf of retail customers,
so

Limit Orders
settlement is handled by the customer’s broker.
Limit orders:
* For institutional customers, different brokers can be used
to execute trades and to settle trades, allowing the entity to
* Have specific instructions regarding the price a trader is
obtain unique services from each broker.
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willing to accept for a given order

* Are to be filled immediately at the best price available,
subject to the constraints of the limit price—for buy orders,
Primary Security Markets
the execution price must be at or below the limit price, and
Considerations of primary security markets:
for sell orders, it must be at or above the limit price
@

* Pricing is compared to market prices to determine their

* When companies and governments want to sell their
likelihood of being filled
securities to investors, they turn to the primary markets.
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* Once an initial offering has taken place, investors trade

Hidden Orders these securities with each other in the secondary markets.
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Regarding hidden orders: * Issuers need to pay close attention to both markets, since
their capital raising fortunes are influenced by the strength
* Not all traders want their intentions disclosed to the of both.
marketplace.
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* Hidden orders can be used to completely or partially

obscure the size of a trade, and the details will only be Public Offerings
shared with the trader’s broker and the exchange. Investment banks, or underwriters, arrange for investors to
* Hidden orders generally do not become known to other participate in a public offering through a process called
market participants until they can be filled. book building. Issuing entities are required to disclose
certain key pieces of information before an issuance can
occur, including:
Validity Instructions
Regarding validity instructions: * The nature of the business
* Its risk factors
* Validity instructions can be included with trading orders * How the money raised in the offering will be used
to indicate when an order should be filled.
* Some instructions can result in orders being executed the Investment banks can use different techniques for bringing
same day, while others allow for orders to remain unfilled the issue to the market and each one has implications for

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Reading 7+1: Market Organization and Structure 83

the bank and the issuer.

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* An order-driven market is one type of market structure.
* The market uses order-matching rules to match buyers to
Private Placements and Other Primary Market sellers and trade-pricing rules to control prices for trades.

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Transactions * Almost all exchanges use order-driven trading systems.
Companies can issue securities through a variety of
transactions, including:
Secondary Security Markets: Order-Matching Rules
* Private placements Considerations of order-matching rules:
* Dividend reinvestment plans

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* Rights offerings * In an order-driven market, an order-matching system
* Shelf registrations uses rules to arrange trading.
* The order of precedence hierarchy controls how orders
Each of these capital raising methods can be appealing, but will be sequenced.

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certain drawbacks need to be considered to ensure they * Price priority supports the highest-priced buy orders and
are the optimal transaction for the issuer. lowest-priced sell orders first.
* Secondary preference rules establish the arrangement of

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same-priced orders.
Secondary Security Markets: Call Market vs.
Continuous Trading Market
Considerations of call versus continuous trading markets: Secondary Security Markets: Trade Pricing Rules
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Regarding trade pricing rules:
* Financial markets can be call markets or continuous
trading markets, depending on when trades can occur. * In order-driven markets, trade pricing rules govern prices
* Trades in call markets only take place when the market is that match the price at which trades transact.
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called at a specific time and place, and no trading occurs in * Uniform pricing rules are used in single-price auctions.
between sessions. * Discriminatory pricing rules determine pricing in
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* In a continuous trading market, trades can occur continuous markets.

whenever the market is open. * Crossing networks follow derivative pricing rules.
* Buyers and sellers are always present in call markets but
may not be so in continuous trading markets.
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Secondary Security Markets: Brokered Markets

Regarding brokered markets:
Secondary Security Markets: Trading Sessions
Regarding trading sessions: * A brokered market is a type of market structure.
* Brokers arrange trading between their clients.
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* Markets have different trading structures depending on * They organize markets when finding trading partners
when the market participants are allowed to trade. may be difficult because of the type of instruments desired
* A call market is a marketplace where trading occurs at a or offered for purchase or sale.
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particular time interval and place.

* A continuous market is a marketplace where trading is
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planned and executed throughout the trading session. Secondary Security Markets: Market Information
Systems
Considerations of market information systems:
Secondary Security Markets: Quote-Driven Markets
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Quote-driven markets are a type of exchange where * Markets vary in the type and quantity of data they
market participants trade at prices that are quoted by disseminate to the public.
dealers. Quote-driven markets are referred to as * Markets may be pre-trade or post-trade transparent
over-the-counter (OTC) markets. Traded in quote-driven depending on the timing for when data are published
markets are: about trading details.

* Bonds
* Currencies Characteristics of Well-Functioning Financial Systems
* Certain equity securities Considerations of well-functioning financial systems:
* Commodities
* Financial systems must meet certain criteria to be
considered well functioning.
Secondary Security Markets: Order-Driven Markets * Investors must be able to move funds from the present
Regarding order-driven markets: to the future, and borrowers need to be able to obtain

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Reading 7+1: Market Organization and Structure 84

these funds to finance their personal or business needs.

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* In addition, traders must be able to offset the risks they
are unwilling to maintain and trade in the assets or
contracts they need.

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Financial Market Regulation: Purpose and Practice
Regarding market regulation:

* Financial markets are regulated so all parties can be

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treated fairly when trading securities and obtaining or
providing capital.
* Market regulations are developed to prevent
sophisticated or knowledgeable parties from taking

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advantage of others.
* Regulatory agencies can establish rules of conduct for
agents and can designate certain activities illegal, like

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insider trading.
* Certain entities can also regulate themselves in order to
instill confidence in those with which they come in contact.

Currencies: Use and Exchange

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Regarding currencies:
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* Currencies, the monies that are issued by national
monetary authorities, are an essential element of global
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commerce and frequent currency exchanges are a part of

modern life.
* Currencies can be exchanged in large-quantity
institutional transactions or smaller retail trades.
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Making a Market vs. Taking a Market

Considerations of ”making” versus ”taking” a market:
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* Buyers and sellers of securities can influence market

prices based on the types of orders they place.
* Traders are ”making the market” if they place standing
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limit orders and are ”taking the market” if they place

market orders or marketable limit orders.
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Other Contracts
Regarding other contracts:
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* There are several other types of contracts that can be

used to hedge existing investment risks or to speculate.
* Insurance contracts can be used to compensate for
losses and credit default swaps, a form of insurance, can
provide a payment in the event of a default.

© Mindojo, 2023
Reading 7+2: Security Market Indexes 85

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7+2 Security Market Indexes

Reading 7+2: Security Market Indexes

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Security Market Index Returns modeled to track indexes.
Price return of an index is simply the percentage change in
the prices of constituent securities. Total return includes
Equity Indexes
income. Weights are used along with constituent returns to

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Broad market equity indexes represent a specific market,
calculate the total return of an index.
such as the United States or Shanghai. These indexes
represent over 90% of securities in each given market.
Index Weighting: Price vs. Equal Multi-market indexes are constructed of equities from

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Price weighting an index is simply weighting the shares multiple countries. Additionally, some multi-market
based on price. In a price-weighted index, stock splits will indexes have fundamental weighting, which strategically
change the weighting for all constituent securities. To keep weights each country, or market, within the portfolio.
the value of the index unchanged, an adjustment is made

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to the divisor. In an equally-weighted index, all securities in
the index are weighted in equal amounts; while this is Sector and Style Indexes
simple, price changes cause the index to be unequal very Sector indexes are measurements of an economic industry,
quickly. such as health care or energy. Within each sector, there are
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national, regional, and global indexes. Style indexes are
comprised of categorized securities. These categories are
Market-Capitalization Weighting derived from market capitalization and value/growth
Regarding market-capitalization weighting: classification.
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* Market capitalization weighting is calculated by dividing
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the market capitalization for a firm by the total market Fixed-Income Indexes
capitalization for all firms in the index to obtain the firm’s A benchmark for a short-term investment portfolio is
weight. fixed-income indexes, varying by region, country, market
* The market capitalization for a security is its price times type, or grade. Constructing a fixed-income index is more
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the number of shares outstanding. difficult than building an index of common equities. Special
* The float-adjusted market-capitalization weighting problems created when constructing fixed-income indexes
adjusts the market capitalization for each security to reflect can include:
only the number of shares available to the investing public.
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* The large volume of securities to choose from

* The maturity issue where fixed-income debt must be
Fundamental Weighting replaced in the index
Fundamental weighting uses measures besides price and * The fact that many debt issues are not actively traded by
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market capitalization to weight constituent securities. individual investors

These measures include:
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* Dividend yield Indexes for Alternative Investments

* Earnings yield Investors can lower risk or increase performance by
* Book value investing in alternative investments. The most popular
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* Revenue categories of indexes for alternative investments are:

The measures used in fundamental weighting will often * Real estate

give a different weighting than market-capitalization * Commodities
methods will. * Hedge funds

Uses of Market Indexes Index Management—Rebalancing and Reconstitution

According to investors’ portfolios and their investment Regarding rebalancing and reconstitution:
goals, investors choose market indexes to follow and
analyze. Investors become familiarized with the * Rebalancing refers to the need to readjust the weights of
appropriate indexes and can gauge information based off the constituent securities in an index.
index performance. The three main aspects of using * Price changes cause the weights to be no longer
market indexes are return, risk, and performance. ETFs are consistent with the index-weighting method.

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Reading 7+2: Security Market Indexes 86

* Reconstitution is the process of changing the constituent

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securities in an index.

Calculation of Index Values Over Multiple Time Periods

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Calculating an index return over multiple periods involves
geometric linking of returns. For a price index, the ending
value is calculated as the product of the starting index
value and gross price returns:

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VP RIT = VP RI0 × (1 + PRI1 ) × (1 + PRI2 ) × ... × (1 + PRIT )

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Reading 7+5: Company Analysis: Past and Present 87

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7+5 Company Analysis: Past and Present

Reading 7+5: Company Analysis: Past and Present

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Degree of Financial Leverage (DFL) * Pricing environment; and
Financial risk refers to the risk of meeting financial * Relevant financial ratios and comparisons.
obligations related to debt. Increasing the debt also means
the shareholders bear more of the risk and magnifies ROE. Financial ratios include ROE and decomposition analysis,

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This risk can be quantified by calculating the degree of which is best handled through careful spreadsheet
financial leverage (DFL): analysis.

%∆ Net income
DF L =
%∆ Operating income

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Introduction to Company Analysis: Company Research
Report
Financial statement models are valuable tools for analysts,

Degree of Operating Leverage (DOL) serving as quantitative expressions of forward-looking

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Regarding degree of operating leverage (DOL): views rather than definitive answers to problems.
Company research reports, informed by these models and

* The DOL is the measure of the risk arising from relatively comprehensive company analysis, provide investors with
detailed insights that aid in their investment decisions. The
higher fixed costs than variable costs.
* The DOL is the ratio of the percentage change in
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nature and structure of these reports vary based on the

operating income to the percentage change in units sold. audience and the context, with initiating coverage reports

* If the DOL is greater than 1, then the company is utilizing offering a comprehensive introduction to a new security,
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operating leverage and will have magnified operating and subsequent reports providing concise updates. While

income gains and losses with changes in sales. these reports are crucial for informed decision-making,
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they don’t guarantee investment success due to the

inherent unpredictability of markets.
Degree of Total Leverage (DTL)
Regarding DTL:
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Determining the Business Model

* In the case of operating leverage, the greater the fixed Understanding a company’s business model is a critical
costs relative to variable costs, the more sensitive first step in financial analysis, as it illuminates key drivers of
operating income is to changes in sales. financial results and sets the direction for further
* In the case of financial leverage, the more debt used, the investigation. The core questions an analyst needs to ask
@

more sensitive net income is to changes in operating remain the same across industries and companies, even
income. though their answers may vary. Information for analysis
* Degree of total leverage combines both to analyze the can be drawn from a range of sources, with regulatory
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sensitivity of net income to changes in units sold. filings providing a reliable and objective start. An analyst’s
ability to utilize these resources, ask the right questions,
DT L = DOL × DF L
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and discern unique aspects of business models can provide

invaluable insights into potential risks and opportunities.
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Revenue Analysis: Revenue Drivers

Introduction to Measures of Leverage
Revenue drivers are key to understanding a company’s
The leverage, or high level of fixed costs, means that small
financial performance and can be identified through a
changes in revenue lead to large changes in profits. This
combination of top-down and bottom-up approaches.
magnified outcome means that highly leveraged
Pricing power, a company’s ability to adjust prices without
companies have more risk. The cost of borrowing generally
significantly impacting sales volumes, varies across
increases and the discount rate is higher.
markets and can greatly influence revenues. In highly
competitive markets, companies often become price
Company Analysis: Elements takers, whereas in less competitive markets with features
Elements of a company analysis include: like product differentiation and high customer loyalty,
* Overview of the company; companies can often set their own prices. If a company’s
* Relevant industry characteristics; costs are rising faster than its prices, it may indicate weak
* Demand for the company’s products and services; pricing power, impacting its profitability over time.
* Supply of products and services;

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Reading 7+5: Company Analysis: Past and Present 88

Natural and Functional Operating Cost Classifications

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and Measures of Operating Profitability
Classifying operating costs functionally, as suggested by
IFRS and US GAAP, allows for more structured and

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comparable income statements. Key profitability measures
such as gross profit, EBITDA, and EBIT capture different
aspects of these costs, with gross profit offering an
approximation of the contribution margin. Operating costs
are often expressed as a percentage of revenue, reflecting

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their relationship to output. Understanding the
implications of economies of scale and scope, which
respectively refer to declining costs per unit with growing
output and cost efficiencies from a broader range of

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business lines, is crucial for informed financial
decision-making.

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Reading 7+7: Company Analysis: Forecasting 89

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7+7 Company Analysis: Forecasting

Reading 7+7: Company Analysis: Forecasting

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Company Analysis: Forecast Objects and Forecasting and bottom-up drivers (like stores and sales per store) can
Principles significantly enhance the accuracy of revenue forecasts.
Financial forecasting is a critical task that requires careful
selection of forecast objects based on their regular

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disclosures and the clarity of their drivers. Analysts should Forecasting Cost of Sales and Gross Margins

prioritize significant factors that largely impact a company’s Operating costs and revenue forecasts should be coherent,

financial outlook, using their professional judgment to meaning an anticipated growth in low-margin product

aggregate and simplify where discrete forecasting doesn’t sales should lead to a forecast of overall profit margin

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add substantial value. The quality of forecasts, rather than deterioration. Gross margins can be influenced by factors

the quantity, shapes strategic investment decisions, making such as market share shifts and product differentiation,

financial forecasting an art of discernment and judgment. while sudden shocks in input costs can significantly affect
operating profit. Business model differences, hedging

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strategies, and price elasticity of demand are critical factors
Company Analysis: Forecast Approaches to consider in financial analysis and forecasting.
Forecasting methods include four main approaches: re
Forecasting Selling, General, and Administrative
* Historical results, assuming the past is a precedent, well
Expenses
suited for stable industries
Selling, General, and Administrative (SG&A) expenses,
* Historical base rates and convergence, for
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which include costs not directly linked to the production of
well-established industries with public trading
goods or services, are a significant component of a
* Management guidance, which tends to be more
company’s operating costs and can influence its
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forward-looking than other approaches

profitability. These expenses, which can be variable or
* Analyst’s discretionary forecast, suitable for companies
fixed, should be accurately incorporated in financial
undergoing fundamental change
forecasting models to provide comprehensive insights into
future performance. Additionally, when cost breakdowns
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The choice of forecast time horizon is influenced by factors

are not provided at the segment level, analysts may rely on
like industry cyclicality and significant company events,
summary measures for constructing forecasts,
such as acquisitions.
emphasizing the role of critical thinking in financial analysis.
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Forecasting Revenues: Forecast Objects for Revenues

Forecasting Working Capital Elements
Forecasting revenues can be done with top-down and
Working capital forecasts, driven by efficiency ratios, are
bottom-up approaches, considering macroeconomic
crucial for maintaining a company’s financial stability by
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factors like GDP growth and company-specific details like

accurately predicting short-term liquidity needs. These
product prices and volumes. It’s crucial to separate
forecasts are often based on historical data, but the
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non-recurring events, such as an unexpected surge in

relevance of past performance can change significantly in
sales, from recurring revenue for accurate forecasting.
the face of new developments, such as a tech startup
Furthermore, understanding a company’s position in its
launching a new product.
product market, its market share, and the relationship of
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that market with larger economic indicators can

significantly refine revenue predictions. Forecasting Capital Investments and Capital Structure
Projecting long-term assets necessitates an understanding
of a company’s cash flow and income statements to predict
Forecasting Revenues: Forecast Approaches for
changes effectively. Capital expenditure forecasts, crucial
Revenues
for a company’s growth and maintenance, rely on historical
Forecasting revenue involves several tools and
depreciation data and management’s expansion plans.
methodologies, including historical data, management
Moreover, scenario analysis, which considers key risk
guidance, and scenario analysis, selected based on the
factors like changes in technology and competition, is
analyst’s judgment and the company’s business model. Key
integral for creating robust and comprehensive financial
risk factors, such as competition, business cycle changes,
forecasts.
inflation and deflation, and technological developments,
should be incorporated into forecasts. Understanding and
applying both top-down drivers (like market size and share)

© Mindojo, 2023
Reading 8+1: Fixed-Income Instrument Features 90

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8+1 Fixed-Income Instrument Features

Reading 8+1: Fixed-Income Instrument Features

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Overview of a Fixed-Income Security down to the last detail. This goes beyond just the features
Fixed-income securities are synonymous with debt of the bond and includes:
securities and bonds. They represent a set of defined cash
flows owed from an issuer to an investor. The main * Any information about collateral

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features of a bond include: * Covenants
* Credit enhancements
* Issuer * Any other contingency provisions, rights, or obligations of
* Maturity the issuer or investor

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* Par value
* Coupon rate and frequency
* Currency Fixed-Income Features: Collateral Backing and
Seniority Ranking

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Collateral is an important assurance to bond investors,
Fixed-Income Features: Types of Issuers who will want to know what rank they have in obtaining the
Bond issuers include: collateral in case of default, and also the quality of that
collateral. Secured bonds are backed by collateral, while
* Companies
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debentures are not. For seniority, senior debt has priority,
* Governments and quasi-government entities and then the subordinated debt or junior debt follows.
* Supranational organizations
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The rating of investment grade allows some issuers access Fixed-Income Features: Bond Covenants
Covenants are legally binding agreements in a bond
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to a more liquid bond market than others.

indenture. Affirmative covenants state what is required of
the issuer, and negative covenants state what the issuer is
Fixed-Income Features: Maturity and Par Value prohibited from doing.
The maturity of a bond is the date when the final payment
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is repaid from the issuer to the investor. This is an

important variable in defining the total cash flows of a Fixed-Income Features: Contingency Provisions
bond. The par value of a bond is the amount the issuer Bond issuers often place contingency provisions within the
pays to the investor on the maturity date. Any periodic bond contracts. There are three types:
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bond payments and the quoted price of the bond are

typically based on this value. * Call—gives issuers the ability to call the bond, retiring
debt before maturity
* Put—gives bondholders the right to put the bond, selling
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Fixed-Income Features: Coupon Rate and Frequency it back issuer before maturity
A bond’s coupon defines the size and timing of any cash * Conversion—allows bondholders to exchange the bonds
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flows prior to and including the maturity date. These can for shares of the underlying stock
be thought of as interest payments, although they are
generally fixed in conventional bonds. Floating rate notes
(FRNs) use a spread over a market reference rate (MRR). Fixed-Income Features: Bond Cash Flow Diagram
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Zero-coupon bonds offer a single cash flow at maturity. Bond cash-flow diagrams are helpful in visualizing the cash
flows of various bond types such as conventional bonds of
various coupon frequencies and zero-coupon bonds,
Fixed-Income Features: Yield Measures where the cash outflow is the investment, and the cash
Two main bond yield measures include: inflows are the contractual bond payments.

* The current yield—the coupon divided by the current

market price
* The yield to maturity—the internal rate of return (IRR) for
the bond from the current date

Fixed-Income Features: Bond Indenture

A bond indenture is the legal contract that defines a bond

© Mindojo, 2023
Reading 8+5: Fixed-Income Markets for Government Issuers 91

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8+5 Fixed-Income Markets for Government Issuers

Reading 8+5: Fixed-Income Markets for Government Issuers

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Legal Identity and Form of Issuer Sovereign bonds vary in type. National governments issue
The bond indenture identifies the legal name of the issuer. for fixed-rate and floating-rate bonds, inflation-linked
This could be a government or government agency, bonds, and others.
corporation, subsidiary, holding company, or, in the case of

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securitized bonds, a special purpose vehicle (SPV). Each of
Sovereign Fixed-Rate Bonds
these may have a different credit rating and risk.
Fixed rate bonds are the most common type of sovereign
bond issued. There are two types:

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Sovereign Debt Issuance: Public Auctions
US Treasuries are sold through a single-price auction, * Discount bonds
which means all orders are filled at the same winning price * Coupon bonds
and coupon rate. This process includes three steps:

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announcement, bidding, and issuance. With competitive Treasury bills are issued as discount bonds, also known as
bids, a bidder specifies the rate (yield) that is desired. The zero coupon bonds. Treasury notes and bonds are issued
lowest rate wins. Noncompetitive bids are guaranteed to as fixed coupon bonds.
be filled at the rate set through the competitive process.
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Sovereign Floating-Rate Bonds
Sovereign Bonds Changes in interest rates and bond prices move in opposite
Regarding sovereign bonds: directions from each other. Regarding floating-rate bonds:
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* Sovereign bonds are bonds issued by national * Floating-rate bonds perform well in increasing-rate
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governments environments.
* Sovereign bonds are issued primarily to fund budgetary * Japan, the United Kingdom, and the United States have
shortfalls when tax revenues are insufficient for desired not issued these bonds due to low and consistently stable
spending levels environments.
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* Floaters lose money in decreasing rate, or deflationary,

economies.
Characteristics of Sovereign Bonds
Sovereign bonds have different names in different
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countries. Names may also vary depending on maturity Non-Sovereign Bonds

such as bills, notes, and bonds. Non-sovereign bonds are debt issues by government
entities below the national level. These issuers include
* On-the-run securities are the most recent and most liquid cities, states, and provinces. Non-sovereign issuers
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treasury issue. typically have a lower credit rating than the nation and this
* A benchmark issue is the latest sovereign bond issue causes non-sovereign debt to have higher yields than
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used to compare similar bonds by another type of issuer. similar sovereign issues.
* T-bills are issued at a discount, whereas notes and bonds
are coupon-bearing.
Quasi-Government Bonds
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Regarding GSEs:
Credit Quality of Sovereign Bonds
Considerations of sovereign bond credit quality: * Governments sponsored entities (GSEs) are created by
national governments to fulfill needs of the citizens.
* Sovereign bonds are unsecured obligations backed by * GSEs can issue bonds, known as agency bonds or
the full faith and credit of the national government. quasi-government bonds.
* Governments can print money or tax citizens to repay * They have low default rates, but still have to pay a slightly
debt, but taxes can only go so far before it is an economic higher yield than sovereign bonds since they typically are
burden. not backed by the full faith and credit of the government.
* Sovereign bonds in a country’s own currency are rated
higher than those issued in a foreign currency.
Supranational Bonds
Supranational bonds are bonds issued by supranational
Types of Sovereign Bonds agencies, such as the World Bank and the International

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Reading 8+5: Fixed-Income Markets for Government Issuers 92

Monetary Fund. They issue callable bonds, floating, and

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fixed. These are usually very low risk bonds.

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Reading 8+18: Asset-Backed Security (ABS) Instrument and Market Features 93

Asset-Backed Security (ABS) Instrument and Market

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8+18
Features
Reading 8+18: Asset-Backed Security (ABS) Instrument and Market Features

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Internal and External Credit Enhancements structured in tranches with varying levels of risk and yield.
Internal credit enhancements are measures taken by the CLOs come in several forms including Cash Flow CLOs,
firm to create issues more safe than average using Market Value CLOs, and Synthetic CLOs, each with unique
structure of collateral or priority ranking. These measures strategies for managing and distributing cash flows. The

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include subordination, overcollateralization, and excess performance of a CLO is also subject to various coverage
spread. External credit enhancements use a third party, and performance tests, such as the overcollateralization
and include letters of credit and bank guarantees. test.

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Non-Mortgage Asset-Backed Securities
Non-mortgage type asset-backed securities (ABS) can
contain components which consist of amortizing and

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non-amortizing loans. Automobile loans and lease
receivables are securitized into ABS. All automobile loan
ABS are structured with credit enhancements. Credit card
receivables are used as collateral for issued credit card
receivable-backed securities, which are nonamortizing.
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Solar ABS are backed by home solar energy systems.
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Collateralized Debt Obligations (CDOs)
A collateralized debt obligation (CDO):
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* is a type of asset backed security (ABS) that is backed by a

pool of various fixed income assets.
* may include a mixture of mortgages, corporate debt,
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credit card debt, and/or automobile loans.

* structure includes senior and subordinated bond classes.
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Covered Bonds
Covered bonds give investors dual recourse to the
underlying assets and a ”cover pool” provided by the
issuing institution, making them less risky than traditional
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ABS, and without a need for tranches. In the case of

default, hard-bullet covered bonds immediately trigger
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default and payments, soft-bullet covered bonds wait up to

a year for this, and conditional pass-through covered
bonds convert to pass-through securities once the maturity
date passes without full repayment.
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Introduction to Asset-Backed Security (ABS)

Instruments and Features
Structured financial instruments tend to combine a bond
and a derivative, such as asset-backed securities (ABS), and
collateralized debt obligations (CDOs). A unifying feature of
ABS is subordination, or credit tranching, that allows for
more target risk and return profile securities for investors.

Generic Collateralized Loan Obligation (CLO) Structure

Collateralized Loan Obligations (CLOs) are composed of
different types of debt, primarily corporate loans, and are

© Mindojo, 2023
Reading 8+2: Fixed-Income Cash Flows and Types 94

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8+2 Fixed-Income Cash Flows and Types

Reading 8+2: Fixed-Income Cash Flows and Types

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Fixed-Income Types: Domestic and Foreign Bonds Floating-Rate Notes
Considerations of domestic and foreign bonds: A floating-rate note (FRN) allows the coupon payment to
change with a reference interest rate, to which a spread is
* Domestic bonds are issued by an entity from that country added. This reduces interest rate risk, but can increase

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and in that country’s currency. credit risk.
* Foreign bonds are issued in a country using the local
currency but by an entity domiciled outside the country.
Fixed-Income Types: Step-Up Bonds
* Eurobonds are issued outside of any country’s

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Step-up bonds may be fixed or floating, but they offer a
jurisdiction and are denominated in any currency.
significant coupon increase at some point in the bond’s
* While domestic and foreign bonds are typically registered
tenor. This offers some protection to investors, but bonds
bonds, Eurobonds are typically bearer bonds.
are typically redeemed by the step-up date. If not, it is

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often seen as a bad signal of credit risk.
Fixed-Income Types: Tax Considerations
The tax treatment of bonds varies widely among
Fixed-Income Types: Credit-Linked, PIK, and Deferred
jurisdictions, so an appreciation of the variables is
important to keep in mind. These include:
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Coupon Bonds
Credit-linked notes have a provision in the bond indenture
which increases the coupon in the case of issuer credit
* Whether interest income of an issue is taxable as current
downgrades, and decreases the coupon in the case of
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income
issuer credit upgrades. Payment-in-kind bonds offer the
* The capital gain/loss rate
issuer either a choice or a trigger event upon which either
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* Whether long-term gains/losses are treated differently

additional bond issue or common stock can be paid to
than short-term gains/losses
investors in lieu of a cash coupon. Deferred coupon bonds
* Any proration of a bond’s discount
pay no coupons in the early years of the bond’s tenor, but
then pay a higher coupon than they otherwise would once
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Fixed-Income Types: Structure of a Bond’s Cash Flows the coupons begin.

The payment structure of a conventional bond is quite
popular, but there are many other payment structures by
Fixed-Income Types: Index-Linked Bonds
which bonds can be classified. These include:
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An index-linked bond links either coupon payments,

principal payments, or both to some published index. The
* Accelerated principal payments to some degree
most popular subset is inflation-linked bonds. These are
* Variations on the size and timing
often issued by governments, although some financial
* Linkages of coupon payments
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institutions issue them as well. The most common types

are interest-indexed bonds and capital-indexed bonds.
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Fixed-Income Types: Bullet, Fully Amortized, and

Partially Amortized Bonds
Fixed-Income Types: Callable Bonds
Bullet bonds include the conventional bond structure of a
Regarding callable bonds:
single principal payment at maturity. Fully amortized
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bonds pay the bond’s principal over the bond’s entire tenor
* The most common embedded option to have in a bond is
with equal cash flow payments. Partially amortized bonds
a call option, giving the issuer the right to call the bond and
are a hybrid of these two.
pay off the principal.
* The rights of the issuer to do this are specified by the call
Fixed-Income Types: Sinking Funds price, call date, and other variables.
A sinking fund is principal set aside in advance of maturity
to pay the principal of an issue. It is usually forwarded to a
Fixed-Income Types: Putable Bonds, Convertible Bonds,
trustee to redeem portions of a bond issue late in the
and Warrants
bond’s tenor, reducing risk for all bondholders, but also
The embedded option called a put option gives the
potentially increasing reinvestment risk.
bondholder the right to put the bond back onto the issuer,
requiring payment of the principal and termination of the
Fixed-Income Types: Variable Interest Debt, bond. These allow for lower yields. A convertible bond is

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Reading 8+2: Fixed-Income Cash Flows and Types 95

convertible to common stock. This makes the bond more

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of a debt and equity hybrid. The conversion will include a
conversion price. Warrants are attached call options that
allow the bondholder the right to purchase shares at a

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fixed price for a period of time.

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Reading 8+3: Fixed-Income Issuance and Trading 96

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8+3 Fixed-Income Issuance and Trading

Reading 8+3: Fixed-Income Issuance and Trading

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Fixed-Income Global Markets: Classification Credit ratings serve as critical indicators of an issuer’s
Fixed income markets are several times larger than equity creditworthiness, influencing investment decisions.
markets, with a great variety of debt instruments. Some Sovereign government issuers typically have the lowest
common criteria used to classify fixed-income markets credit risk due to their authority to tax and control

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include: economic policies. Expected returns for investors vary, with
high-yield bond investors expecting higher returns due to
* The type of issuer the increased risk they take on, while investment-grade
* Credit quality bond investors anticipate more stable cash flows.

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* Maturity
* Currency denomination
* Type of coupon Fixed-Income Aggregate Indexes
Fixed-income indexes serve a vital role akin to equity

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indexes, but they possess unique characteristics such as
Secondary Bond Market Details having more constituents due to single issuers having
Regarding secondary markets: many individual securities, higher turnover due to frequent
new issuance, and weighting based on the market value of
* Secondary markets are where existing securities are
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debt outstanding. Monthly rebalancing of these indexes
bought and sold among investors. accommodates the high turnover, allowing for the
* Bonds are sold over-the-counter (OTC), which means buy inclusion of new issues and removal of those falling below
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and sell orders are initiated from various locations and a minimum maturity. Bond funds use a representative
matched through a communications network. sample of constituent securities to match index returns,
* The bid price is the price at which dealers will buy from a
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given the complexity and size of bond indexes.

customer, and the ask price (or offer price) is the price at
which the dealer will sell. The difference between these
two prices is the bid–ask spread. Fixed-Income Markets: Primary vs. Secondary
Bonds, whether issued in primary or secondary markets,
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* Higher spreads indicate a less liquid bond.

represent key financial instruments for entities seeking to
raise capital. The liquidity, risk, and pricing accuracy of
Processes of Issuance, Trading, and Settlement bonds can vary greatly, influenced by factors such as
The processes of issuing and settling bonds are virtually whether the issuer is making a debut or repeat issuance,
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the same across the globe. Corporate bonds are primarily the bond’s market (public offering versus private
sold in the secondary market. Dealers are connected placement), and the bond’s status (e.g., recently issued
electronically through an over-the-counter (OTC) network. sovereign bonds, distressed bonds, or illiquid bonds).
Dealers make the markets for corporate bonds and are
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paid a bid-ask spread between the price the dealer bought

the security and the price the dealer sells the security. Less Fixed-Income Narrowly Defined Indexes
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liquid issues have larger spreads, quoted in basis points. Narrowly defined indexes offer varying degrees of
Post-trade settlement typically is bridged from local specificity and risk, catering to different investment needs.
platforms to Euroclear and Clearstream and settled in T+3 Indexes like the J.P. Morgan EMBI+ Index target higher
days for most corporate issues. returns by incorporating riskier assets and have unique
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return calculation methods, such as using bid side prices

for a conservative estimate. Moreover, factors such as ESG
Fixed-Income Segments, Issuers, and Investors
considerations can impact an index’s composition and
Companies issue various types of fixed-income instruments
potential performance.
in multiple currencies to cater to diverse investor needs
and hedge against currency risks. These instruments,
influenced by factors such as issuer type, credit quality, and
maturity, offer different levels of risk and reward, attracting
different types of investors. Successful investment in these
markets requires a thorough understanding of the
underlying principles and careful risk evaluation.

Fixed-Income Credit Ratings: S&P System

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Reading 8+4: Fixed-Income Markets for Corporate Issuers 97

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8+4 Fixed-Income Markets for Corporate Issuers

Reading 8+4: Fixed-Income Markets for Corporate Issuers

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Repurchase and Reverse Repurchase Agreements instruments such as uncommitted and committed bank
Regarding repurchase agreements: lines of credit, and revolving credit agreements or
revolvers. The choice between these instruments, and
* A repurchase agreement, or repo, is the sale of a security between secured and unsecured credit, depends on the

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along with the seller’s commitment to buy back the same company’s financial strength, business situation, and
security from the purchaser at a price and future date potential risk factors. Selling accounts receivable (factoring)
which is agreed to by both. to generate immediate cash flow and leveraging syndicates
* A reverse repo is the other side of a repo for larger borrowings are other strategic options that

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transaction—the lender buys the securities and sells them corporations use based on their specific needs and
back later at an agreed-upon price. conditions.
* The price at which the dealer repurchases the collateral is
known as the repurchase price.

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Short-Term Funding Alternatives: Security-Based
* The date of repurchase is called the repurchase date.
Financing
* A ”repo to maturity” is a repurchase agreement which
Commercial paper (CP) is a cost-efficient, short-term debt
lasts until the final maturity date.
instrument often preferred by large financial institutions,
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which contributes significantly to its issuance. Rollover risk,
Structure of Repurchase and Reverse Repurchase inherent in the use of commercial paper, is mitigated
Agreements through a committed backup line of credit from banks.
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Companies use repurchase agreements to raise short-term Asset-backed commercial paper (ABCP) allows for
cash for operations. The collateral used affects the repo off-balance-sheet financing beneficial to both issuers and
rate that is negotiated between the parties. Some of the investors.
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factors that affect the rate negotiated are:

Short-Term Funding Alternatives: Deposits, CDs, and

* The term of the agreement
the Interbank Market
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* The demand for the collateral in general

Financial institutions, especially banks, rely on deposits
* Interest rates of alternative financing
from households and firms as a primary source of
short-term funding. These include checking accounts,
Risks Associated with Repurchase Agreements savings accounts, and certificates of deposit (CDs). The
@

Credit risk is associated with repurchase agreements for interbank market allows banks to lend to and borrow from
both parties. A repo margin, or haircut, is put in place to each other to balance reserve requirements and maintain
reduce credit risk for the reverse repo party. This haircut is liquidity, and the central bank serves as a lender of last
determined by the length of the repo, the quality of the resort. Efficient management of short-term liquidity is
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collateral, and the credit quality of the repo party. crucial for banks to meet daily withdrawal requests and
sustain depositor trust.
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Building a Yield Curve

Yield curves plot the relationship between bonds with Long-Term Corporate Debt: Investment Grade (IG) and
different maturity dates and their yields. There are High-Yield (HY)
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multiple types of yield curves based on different bond In the context of long-term corporate debt, credit quality
characteristics. When building a yield curve it is important significantly impacts a corporate issuer’s ability to meet
that the bonds possess the same: future obligations, with higher credit quality indicating a
stronger capacity. Both investors and issuers must
* Credit risk carefully weigh the relative risks associated with debt
* Tax status maturity choices against yield-to-maturity, considering
* Coupon payment periodicity factors such as price risk, reinvestment risk, and rollover
* Currency risk. High-yield issuers face a larger risk-versus-return
* Liquidity trade-off due to higher spreads, compared to
investment-grade issuers.

Short-Term Funding Alternatives: External Loan

Financing Long-Term Corporate Debt: Differences between IG
Corporations often rely on various short-term financing and HY Issuance

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Reading 8+4: Fixed-Income Markets for Corporate Issuers 98

In the realm of corporate bonds, investment-grade (IG) and

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high-yield (HY) bonds offer distinct cash flow characteristics
and risks. IG bonds present bond-like cash flows, offering
predictable returns, while HY bonds provide equity-like

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cash flows, posing a greater default risk and consequently,
potential losses. Analyzing these bonds necessitates
different approaches, from focusing on credit ratings and
financial ratios for IG bonds to examining default likelihood
and potential loss for HY bonds.

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Reading 8+6: Fixed-Income Bond Valuation: Prices and Yields 99

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8+6 Fixed-Income Bond Valuation: Prices and Yields

Reading 8+6: Fixed-Income Bond Valuation: Prices and Yields

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Introduction to Fixed-Income Valuation * The convexity effect reflects a greater percentage price
Considerations of fixed-income valuation: change when the market rate goes down compared to
when it goes up for bonds that have the same coupon and
* An option-free bond is a series of cash flows, which come maturity date.

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in the form of coupon payments and a principal repayment * The coupon effect reveals a greater percentage price
(par) at maturity. change on a lower coupon bond for bonds that have the
* Discounted cash flow analysis is utilized to find a bond’s same maturity date.
price using the market discount rate. * The maturity effect indicates a greater percentage price

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* When a bond’s coupon rate does not equal the market for a longer-term bond than for bonds with the same
discount rate, the bond’s price will vary from par. coupon rate.
* Bonds possess an inverse relationship between price and
yield.

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Flat Price, Accrued Interest, and the Full Price
A bond that trades between coupon payments must
Bond Pricing with a Market Discount Rate compensate the seller for the interest that has accrued
Bond pricing is purely an exercise in time value of money since the last payment. Bonds are quoted on a flat (clean)
calculations. Each cash flow in the payment schedule of a
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price and trade at the full (dirty) price, which includes
conventional bond can be discounted by the same market accrued interest.
discount rate, arriving at a summed present value of cash
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flows which is the bond’s price.
Calculating Accrued Interest on a Coupon Bond
Accrued interest is the proportional share of the coupon
so

Fixed-Income Valuation: Trading at Par Value that has been earned since the last coupon payment. It is
For a bond to trade at par value, the bond’s cash flows calculated using the formula
must be discounted at exactly the coupon rate. Days since last payment
Accrued Interest = Payment per Period ×
Days in the period
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Fixed-Income Valuation: Trading at a Premium or

Discount
A bond will trade at a premium when its coupon rate is Calculating the Flat Price, Accrued Interest, and the
Full Price
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higher than the market rate of interest demanded for the

bond. A bond will trade at a discount when its coupon rate The present value full price of a bond equals the present
is lower than the market rate of interest demanded for the value of the flat price of the bond plus the accrued interest.
bond. The following formula is used to calculate the PV full price
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of a bond.
P VFull Price =
[ ]
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Fixed-Income Valuation: Yield-to-Maturity P MT P MT P M T + P AR days since last payment

+ + ... + ×(1+r) days in period
Regarding yield-to-maturity: (1 + r)1 (1 + r)2 (1 + r)n

After calculating the PV full price, the accrued interest can

* Where bond pricing calculates the price based on cash be subtracted to solve for the PV flat price. Accrued
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flows and a discount rate, the yield-to-maturity of a bond is interest is calculated without consideration of the time
the calculated discount rate that equates the current price value of money.
of the bond and the remaining cash flows through time.
* It is the internal rate of return for the bond if purchased
The Matrix Pricing Method of Fixed Income Valuation
and held to maturity, and reinvestment at that rate is
Regarding matrix pricing:
assumed.

* Matrix pricing can be used to value a bond that rarely

Relationships Between the Bond Price and Bond trades and does not have a market price or yield.
Features * Comparable bonds with similar credit ratings prices are
Regarding characteristics and pricing of bonds: presented in a matrix based on maturity dates and coupon
rates.
* Bond prices are inversely related to market discount * Yields can then be calculated for the comparable bonds,
rates. and linear interpolation is used to estimate the yield for the

© Mindojo, 2023
Reading 8+6: Fixed-Income Bond Valuation: Prices and Yields 100

target bond.

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Use of Matrix Pricing in Calculating Spread Over
Benchmark

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Matrix pricing analyzes comparable bonds with similar
credit ratings, maturities, and coupon rates to determine
the required yield spread over a benchmark rate for a new
bond issuance. The yield spread is stated in basis points
and represents the credit spread for the bond to be issued.

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Reading 8+9: The Term Structure of Interest Rates: Spot, Par, and Forward Curves 101

The Term Structure of Interest Rates: Spot, Par, and

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8+9
Forward Curves
Reading 8+9: The Term Structure of Interest Rates: Spot, Par, and Forward Curves

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Bond Pricing Using Spot Rates computed using spot interest rates. They are important to
Regarding pricing bonds with spot rates: bondholders because they provide an indication of future
interest rate movements, and are considered to be the
* For bonds with multiple coupon payments yet to be breakeven rate on extending an investment by some

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made, using spot rates to discount cash flows is a more period. The IFR is calculated from spot rates zA and zB :
appropriate way to calculate a bond’s price than using one
(1 + zA )A × (1 + IF RA ,B−A )B−A = (1 + zB )B
market discount rate.
* A spot rate is the yield-to-maturity on a zero-coupon

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bond for a given maturity.
* Using spot rates to discount cash flows values a bond to a
no-arbitrage price. Definition of a Forward Curve
Regarding a forward curve:

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Maturity Structure of Interest Rates and Spot Rates
* The forward curve is a series of forward rates along the
Regarding maturity of interest rates:
term structure that can be used for a variety of purposes
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by analysts in pricing both fixed income securities and
* Bonds have different yields to maturities for many
derivatives.
reasons, including currency denomination, credit risk, and
* Each forward rate is a breakeven return for extending a
differences in liquidity.
fixed income security by one period.
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* The time to maturity is another factor, which is analyzed
* Forward curves will be upward sloping when the spot is
with the spot curve, yield curves, and par yield curves,
upward sloping and will lie above it, but the forward curve
which are built while attempting to hold other factors
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will be downward sloping when the spot curve is

constant.
downward sloping and will lie below it.

Par Rate and Deriving the Par Curve from the Spot
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Spot, Par, and Forward Yield Curves and their

Curve
Relationships
Regarding the par curve:
Understanding the relationships between spot, par, and
forward rates is crucial in finance. The shape of the spot
* Each point along the par curve is a yield to maturity on a
curve - whether upward sloping, flat, or downward sloping
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coupon paying bond that is priced at par.

- influences the positioning of par and forward curves. An
* In other words, the yield to maturity is equal to the
upward sloping spot curve typically results in a par curve
bond’s coupon rate.
that sits slightly below and a forward curve that exceeds
* All the bonds used in the construction of a par curve
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the spot curve, while a flat spot curve aligns all three
must have the same credit risk, tax status, coupon
curves, and a downward sloping spot curve leads to a
payment periodicity, currency, and liquidity.
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forward curve that falls below the spot curve due to the
* Spot rates are used to derive the par curve.
mathematics of forward rate calculation.

Forward Rates from Spot Rates: Definition and

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Notations
Regarding forward rate:

* An agreed trade of a bond that will be delivered and paid

for in the future is trading in the forward market.
* The interest rate on the bond trading in the forward
market is called a forward rate.
* In forward rate notation, the first number corresponds to
the length of the forward period time frame and the
second number is the tenor of the bond.

Forward Rates: Implied Forward Rate Calculation

Implied forward rates are interest rates on future loans

© Mindojo, 2023
Reading 8+7: Yield and Yield Spread Measures for Fixed-Rate Bonds 102

Yield and Yield Spread Measures for Fixed-Rate

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8+7
Bonds
Reading 8+7: Yield and Yield Spread Measures for Fixed-Rate Bonds

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Yield Measures: Periodicity and Annualized Yields * The yield-to-worst is the lowest yield of those
Yield measures for fixed-rate bonds are typically yields-to-call possible. For example, a callable bond with
annualized, and the rate stated as the annualized rate five possible call dates will have five possible yields for
depends on the periodicity used in calculating the those five different cash flow schedules, and the

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annualized rate. yield-to-worst is the lowest of those five yields.

Yield Measures: Effective Annual Rate Yield Measures: Option-Adjusted Yield

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Regarding effective annual rate: For a bond with an embedded option, an option pricing
model can be used to measure the option-adjusted price,
* An effective annual rate is a bond yield measure with a which can then be used in estimation of the
periodicity of one. option-adjusted yield. This will provide a yield that is based

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* This assumes a single compounding period each year. on expectation rather than a worst-case scenario.
* A bond yield with a periodicity other than one can be
converted to an effective annual rate, and the stated rate is
Definition of Spot Curve
inversely related to the periodicity used to calculate that
stated rate.
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Regarding the spot curve:

* Spot rates are hypothetical rates on zero-coupon

Yield Measures: Semiannual Bond Basis Yield government bonds that can be used to estimate any bond’s
n
The semiannual bond basis yield is the stated bond yield price.
with a periodicity of two. This is the most common * The spot curve is a series of spot rates along the term
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measure for US bonds since most US coupon bonds pay a structure that reflect the market’s expectations about
semiannual coupon. future interest rates.
* The most common shape of the curve is upward sloping,
since investors generally believe the economy will expand.
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Yield Measures: Street Convention, True, and

Government Equivalent Yields
* The street convention yield ignores weekends and Yield Spreads Over Benchmark Rates
holidays, and assumes bond payments are made on their The yield spread is the difference between the yield on a
specific bond issue and a benchmark security. It’s is an
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specified dates.
* The true yield takes these delays into account, adjusting important tool for analysts to use when comparing fixed
to the actual dates of payment. income securities. Several important spreads to remember
* Since the only adjustment for a true yield is a later include the following:
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payment date, the true yield is never greater than the

street convention yield, and the difference is very small. * The benchmark spread—the bond’s spread over a
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* The government equivalent yield is the actual/actual yield, specific benchmark

found by scaling the 30/360 yield by the fraction 365/360. * The G-spread—the bond’s spread over an actual or
interpolated government bond
* The I-spread—the bond’s spread over the swap rate
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Yield Measures: Current Yield and Simple Yield

The current yield is the sum of the coupon payments paid Analysts can locate mispriced securities when using spread
in the period of a year on a bond divided by the current analysis properly.
price of the bond. This is a quick yield measure to calculate,
but it is also fairly inaccurate. The simple yield is the sum of
Yield Spreads Over the Benchmark Yield Curve
the coupon payments plus the straight-line amortized
There are two yield spreads over the benchmark yield curve
share of the gain or loss, divided by the flat price.
that financial analysts use to price risk and compare bonds:

Yield Measures: Yield-to-Call and Yield-to-Worst * The Z-spread—a constant premium added to the
Regarding yield-to-call and yield-to-worst: benchmark spot curve that forces the present value of the
bond’s cash flows to be equal to the market price of the
* The yield-to-call is the yield calculated to some call date bond
with that call price. * The option-adjusted spread (OAS)—subtracts the option

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Reading 8+7: Yield and Yield Spread Measures for Fixed-Rate Bonds 103

value, in basis points, from the Z-spread

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Reading 8+8: Yield and Yield Spread Measures for Floating-Rate Instruments 104

8+8 Yield and Yield Spread Measures for Floating-Rate

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Instruments
Reading 8+8: Yield and Yield Spread Measures for Floating-Rate Instruments

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Yield and Yield Spread Measures for Floating-Rate discount rate in time value of money calculations. Money
Notes markets use simple interest, and the discount rate is found
Considerations of yield for FRNs: as: ( )
Days
PV = FV 1− × DR ,

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Y ear
* Floating-rate notes (FRNs) have coupon payments that
where PV is present value, FV is future value, and DR is the
adjust to a reference rate throughout the bond’s tenor.
discount rate.
* This flexibility in allowing variance in the coupons allows
the bond’s price to be much more stable than that of a

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fixed-rate bond. Yield Measures: Bond Equivalent Yield
* An FRN has a quoted margin over the reference rate to The bond equivalent yield is essentially the add-on rate
be paid, and the required margin is the value needed for using a 365-day year. This is then a larger yield measure,
the bond to be priced at par.

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but also the most accurate. A discount rate can be
converted to an add-on rate with a FV/PV factor, and a rate
based on a 360-day year can be converted with the factor
Floating-Rate Note (FRN) Pricing
365/360.
Regarding pricing of FRNs:
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* Pricing a floating-rate note (FRN) requires a model that
discounts the expected coupon payments by an expected
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discount rate, as with any other bond.
* But for an FRN, the coupon is unknown, and the discount
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rate is comprised of the reference rate and a discount

margin.

Floating-Rate Note (FRN) Discount Margin Calculation

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From the simplified model for pricing a floating-rate note,

the discount margin is an important measure of the
market’s evaluation of an issue’s risk, and can be isolated
with a little algebra, and careful treatment of the bond’s
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periodicity. This involves solving for an appropriate

discount rate, and then isolating the discount margin from
that discount rate.
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Yield Measures for Money Market Instruments: Add-On

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Rate (AOR)
Money market instruments represent very short-term
debt. Yields for money market instruments differ from
those of bonds as they are based on simple interest, use
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some nonstandard measures, and have nonstandard

periodicities. One common yield measure is an add-on
rate, found as follows, where PV is present value, FV is
future value, and AOR is the add-on rate.
FV
PV = Days
(1 + Y ear
× AOR)

The bond equivalent yield is the AOR assuming a 365-day

year.

Yield Measures: Discount Rate for Money Market

Instruments
A discount rate in money markets is very different from a

© Mindojo, 2023
Reading 8+17: Fixed-Income Securitization 105

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8+17 Fixed-Income Securitization

Reading 8+17: Fixed-Income Securitization

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Introduction to Securitization and Asset-Backed
Securities
Regarding asset-backed securities:

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* Fixed-income instruments are made through the
securitization process, increasing liquidity.
* Securities backed by asset pools are asset-backed
securities (ABS).

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* Assets such as loans and credit card debt used to create
asset-backed bonds are securitized assets.
* Mortgage-backed securities (MBS) are ABS backed by
high-quality real estate mortgages

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* Subordination allows for creation of multiple tranches for
better offerings to investors

The Securitization Process

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Regarding securitization:
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* During securitization, there are legal and regulatory
conditions that must be satisfied as fixed income assets are
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moved from an owner, pooled, and then sold to investors.

* The special purpose vehicle (SPV) is established to
facilitate the process.
* The structure adopted in a securitization is called the
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waterfall.
* Parties to the securitization process include the
originator (or seller), the SPV, and the servicer.
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The Parties to a Securitization

Securitization is a complex financial process involving
several key parties: the seller of the collateral, the Special
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Purpose Entity (SPE) which issues the Asset-Backed

Security (ABS), and the servicer of the loans. The SPE plays
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a crucial role, offering protection to the originator and

investors, and maintaining the ability to make payments to
security holders even if the originating company goes
bankrupt. Legal documents, particularly the prospectus,
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are critical, outlining payment structures and credit

enhancements, while investors must also navigate varying
legal frameworks across different jurisdictions.

© Mindojo, 2023
Reading 8+19: Mortgage-Backed Security (MBS) Instrument and Market Features 106

Mortgage-Backed Security (MBS) Instrument and

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8+19
Market Features
Reading 8+19: Mortgage-Backed Security (MBS) Instrument and Market Features

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Residential Mortgage Loans the pool, each security is assigned a Weighted Average
Considerations of residential mortgage loans: Coupon rate (WAC) and a Weighted Average Maturity
(WAM), calculated by weighting each mortgage’s rate and
* Residential mortgage loans are popular asset backed maturity by its proportion in the total outstanding balance.

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securities used for real estate purchases.
* The lender minimizes risk exposure through a low loan-to
value ratio transaction. Collateralized Mortgage Obligations (CMOs)

* If a borrower defaults, the lender may foreclose and take Regarding CMOs:

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possession of property to satisfy remaining debt.
* Collateralized mortgage obligations (CMOs) are securities
that result from when mortgage-related product cash flows
Mortgage Contingency Features are redistributed to different tranches.

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Mortgage loans amortize according to a planned schedule * The mortgage-related products are collateral.
over the loan’s duration. The lender may impose a * CMOs distribute prepayment risk across bondholder
prepayment penalty in its mortgage contract in order to classes and are created to satisfy institutional investors’
minimize prepayment risk costs. Mortgages can be financial needs.
recourse loans or non-recourse loans.
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* Sequential-pay collateralized mortgage obligations
(CMOs) are structured so that each tranche (bond class)
retires in sequence.
Residential Mortgage-Backed Securities (RMBS)
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Bonds backed by residential mortgage loans are residential
mortgage-backed securities (RMBS). These are held Other CMO Structures
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together by the value of the assets that the mortgages are Tranches of mortgage-backed securities can include the
applied against. Agency RMBS are guaranteed by a federal following:
agency or a government formed agency (i.e., Fannie Mae).
Non-agency RMBS are not guaranteed as they are issued * Z-Tranches - delay their payouts to free up cash for other
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by private entities. Mortgage pass-through securities are tranches

made when a mortgage pool is formed and shares or * Principal-Only (PO) securities - segregate principal
certificates are sold. payments
* Interest-Only (IO) securities - segregate interest payments
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* Floating-Rate tranches: carry variable interest rates tied

Mortgage-Backed Securities (MBS): Time Tranching
to an index or market reference rate
Prepayment risk, a crucial factor in evaluating Asset-Backed
* Residual tranches - higher risk cash flows after all other
Securities (ABS) and Mortgage-Backed Securities (MBS),
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obligations have been met

represents the uncertainty of cash flows due to borrowers
* Planned Amortization Class (PAC) tranches - offer more
potentially deviating from the scheduled payment plan.
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stability but are reliant on the prepayment rates being

This risk manifests as contraction risk, where borrowers
within a specified range, using a support tranche
pay earlier in a declining interest rate environment, and
extension risk, where repayments get stretched out as
interest rates rise. Through securitization structures,
Commercial Mortgage-Backed Securities (CMBS)
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specifically time tranching, these risks can be effectively

Regarding CMBS:
managed and distributed among different bond classes
with varied expected maturities.
* Commercial mortgage-backed securities (CMBS) are a
type of ABS backed by a pool of commercial mortgages on
MBS Cash Flow Construction: Pass-Through Rate, WAC, commercial properties.
and WAM * They are associated with commercial loans that refinance
Mortgage pass-through securities are complex financial prior commercial mortgages or finance new ones, and are
instruments where pooled mortgages are securitized, with typically non-recourse loans.
investors receiving a flow of cash from principal * CMBS structures often include call protection and balloon
repayments, interest, and prepayments. The security’s maturity provisions.
coupon rate, or pass-through rate, is lower than the * CMBS provide investors with call protection, which is
average rate of the mortgage pool due to administrative made at the structure level or loan level.
charges. To manage the diversity of the mortgages within

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Reading 8+10: Interest Rate Risk and Return 107

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8+10 Interest Rate Risk and Return

Reading 8+10: Interest Rate Risk and Return

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Introduction to Fixed-Income Risk and Return cash flows, a change in interest rates affects the value of
Considerations of fixed-income risk and return: those cash flows. The two most common measures of
interest rate risk are duration and convexity.
* The fixed income markets are very large and represent

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an important investment class.
* The most common type of fixed-income investment is the Introduction to Duration of a Bond

fixed-rate bond. Duration is an estimate of the change in a bond’s price for

* Understanding the risk and return analysis of fixed-rate a given change in yields, assuming nothing else changes. It

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bonds is important as it applies to individual bonds. can also be thought of as the period of time a bond must

* It is also important because other assets have similar cash be held in order to obtain the market yield on a particular

flows to bonds and can be analyzed in the same manner. bond.

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Sources of Return for Fixed Income Macaulay Duration
The return on fixed-rate bonds comes from three sources: Macaulay duration is the oldest measure of duration. It is
computed by taking the present value of each cash flow,
* The coupon on the bond
re
dividing that by the bond price, and multiplying the result
* Price changes of the bond by the time period. The sum of that calculation over all the
* Reinvestment of the periodic coupons time periods is equal to the duration.
n
CF
∑
n
(1+r)t
Since prices changes and reinvestment of the coupons are MacDur = (t)
t=1
P
both affected by changes in interest rates, they are the
so

most important sources of return. Because of the way it is calculated, it is commonly thought
of as the weighted average time to receive back the original
investment.
Horizon Yield of a Fixed-Rate Bond
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Regarding horizon yield:

Investment Horizon, Macaulay Duration, and Interest
* Horizon yield is a return measure for a fixed-rate bond Rate Risk
that is sold prior to the maturity date. The relationship between investment horizon and
@

* It is affected by the sales price of the bonds and the Macaulay duration is important. Investors have the most
actual investment rate over the holding period. risk when investment horizon is different than Macaulay
* It represents the internal rate of return between the duration. The difference between the two is called duration
purchase price of the bond and the future value of all cash gap.
e

flows, including the sale price of the bond.

* As such, it can be thought of as a holding period return.
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* The only time horizon yield is equal to the original yield

on a bond is if the reinvestment rate is at the original yield
and the sales price is also at the original yield.
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Carrying Value of a Bond

Regarding carrying value:

* Carrying value is the adjusted value of a bond over time.

* It begins at the purchase price, whether at par, a
discount, or premium, and moves toward par value of the
bonds at maturity.
* If the bonds are sold for more or less than the carrying
value, a tax event occurs.

Interest Rate Risk on Fixed-Rate Bonds

Since fixed-rate bonds consist of a series of fixed expected

© Mindojo, 2023
Reading 8+11: Yield-Based Bond Duration Measures and Properties 108

Yield-Based Bond Duration Measures and Proper-

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Reading 8+11: Yield-Based Bond Duration Measures and Properties

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Yield Duration Statistics: Modified Duration point and then decrease slightly as maturity is increased.
Modified duration is an adjusted version of Macaulay
duration. It represents a linear estimate of the expected
changes in a bond’s price for a given change in yields. Yield Duration Statistics: Money Duration

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Regarding money duration:
MacDur
ModDur =
(1 + r)
* Modified duration can be used to estimate the
percentage change in a bond price.

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* If modified duration is multiplied by the price of the
bond, the result is money duration.
Approximate Modified Duration
* Money duration can be used to estimate the actual price
Modified duration can be estimated. Approximate
change for a bond.

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modified duration is a way of estimating price changes
without starting with a duration measure. Actual upward
and downward prices are used to compute an estimate of Yield Duration Statistics: Price Value of a Basis Point
a bond’s change. Approximate modified duration is (PVBP)
re
calculated as follows: The price value of a basis point is the estimated change in
(P V− ) − (P V+ ) the value of a bond or bond portfolio for a one basis point
ApproxModDur =
2 × (∆Yield) × (P V0 ) change in yields. It is useful for comparing the relative risk
n
of bonds or bond portfolios.
The result is generally very close to the actual modified
duration computation.
It is computed as
so

(P V− ) − (P V+ )
Properties of Bond Duration P V BP = .
2
A bond’s duration is affected by several variables, including:
bo

* Coupon rate
* Yield Yield Duration vs. Curve Duration for Fixed Income
* Time to maturity Yield duration is an estimate of the change in a bond’s price
* The portion of the interest payment period that remains given a change in the yield on the bond. The most common
@

measures of duration are measures of yield duration.

If one variable is changed while holding the others Curve duration is an estimate of the change in a bond’s
constant, it allows identification of the characteristics of price given a change in yields on a benchmark curve, such
e

duration that apply to that variable. as a government bond yield curve.

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Duration Limit for Perpetual Bonds Duration of Floating-Rate Notes and Loans
A perpetual bond has no maturity. It is an endless series of Floating-rate instruments offer variable interest, which
coupon payments. For noncallable perpetual bonds, aligns with a market reference rate and a specified margin,
Macaulay duration is simply
db

presenting an interest rate risk between reset dates. The

(1 + r) Macaulay duration for these instruments, calculated as the
MacDur = . fraction of a period remaining until the next reset date, is
r
typically low due to their short coupon periods, making
them ideal for reducing duration and consequently interest
rate risk in fixed-income portfolios.
Determinants of Duration
Regarding duration determinants:

* Macaulay and modified duration are determined by the

coupon, the yield, and the maturity of the bonds.
* Higher coupons and yields lead to lower durations.
* Longer maturities generally lead to higher durations.
* The special case is discount bonds that increase to a

© Mindojo, 2023
Reading 8+13: Curve-Based and Empirical Fixed-Income Risk Measures 109

8+13 Curve-Based and Empirical Fixed-Income Risk Mea-

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sures
Reading 8+13: Curve-Based and Empirical Fixed-Income Risk Measures

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Effective Duration
Effective duration:

* Is a measure of curve duration

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* Estimates the sensitivity of a bond’s price to changes in a
benchmark or index
* Is computed much like approximate modified duration
except it is based on a change in a benchmark instead of a

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bond yield

Key Rate Duration

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Key rate duration is a measure of sensitivity to a bond’s
price given a change in a single rate, all else being equal.
Key rate durations show ”shaping risk” of a bond. The sum
of key rate durations is the bond’s effective duration.

1 ∆P V
re
KeyRateDurk = − ×
PV ∆rk
n
so

Effective Convexity
Like effective duration, effective convexity is a way to
measure interest rate risk for unique fixed-income
securities. Effective convexity is a curve convexity statistic.
bo

It is an appropriate measure for callable bonds which

exhibit negative convexity.

Analytical Duration vs. Empirical Duration

@

Analytical duration is the calculated duration measures

based on the bond’s cash flows, which are used to estimate
price changes. Empirical duration is found statistically
e

using historical data to uncover actual price movements

that have taken place. Empirical duration often differs from
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analytical duration due to changing correlations between

benchmark yields and credit spreads.
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Reading 8+12: Yield-Based Bond Convexity and Portfolio Properties 110

Yield-Based Bond Convexity and Portfolio Proper-

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Duration and Convexity of a Bond Portfolio Yield Volatility: Duration and Convexity as
The duration of a bond portfolio can be calculated in two Approximated Price Change
ways: When comparing several bonds, it is important to consider
the yield volatility of each. Yield volatility:

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1. The weighted average of the modified durations of the
individual bonds * Refers to the expected change in yields for a particular
2. The weighted average time to maturity of the aggregate bond or maturity on the yield curve
cash flows in the portfolio. Note that this second method * Is determined by market factors and characteristics of a

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requires the internal rate of return for the portfolio. particular investment.

Convexity of a bond portfolio can also be calculated as a

weighted average of the individual bonds’ convexity

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statistics.

Parallel Shifts in the Yield Curve

If all maturities in the yield curve change by the same
re
amount, it is referred to as a parallel shift in the yield curve.
Some measures of duration assume that this is the case.
n
Since yields tend to change by different amounts at each
maturity, this is generally not a realistic assumption.
so

Bond Convexity and Money Convexity

The price/yield line for a bond is not linear, but convex.
Duration estimates linear changes in a bond price. The
bo

difference between duration estimates and actual bond

price changes is due to convexity. Money convexity is the
annual convexity multiplied by the bond’s full price.
@

Convexity Adjustments
The estimated change in a bond price consists of two parts.
The first is the estimated change due to duration which is
e

based on modified duration. The second is a convexity

adjustment added to the duration estimate. The full price
os

adjustment is computed as follows.

[ ]
1
%∆P V F ull ≈ −(AnnModDur×∆Yield)+ × AnnConvexity × (∆Yield)2
2
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Approximate Convexity
An approximation exists for convexity that is very accurate.
Like modified duration, convexity can be approximated
with a relatively simple equation, and the inputs are the
same. The convexity approximation is unique, however,
because it uses the sum of the expected price changes and
the yield change is squared. Approximate convexity is
calculated as:
(P V− ) + (P V+ ) − [2 × P V0 ]
ApproxCon =
(∆Yield)2 × (P V0 )

© Mindojo, 2023
Reading 8+14: Credit Risk 111

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8+14 Credit Risk

Reading 8+14: Credit Risk

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Fundamentals of Credit Analysis—Introduction Credit Rating Considerations: Lags, Complexities, and
Credit analysis serves the vital function of measuring risk, Miscalculations
and pricing it accurately. This includes the topics of: Agency ratings are not always correct; they were
significantly misleading in 2008 prior to the financial crisis.

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* Credit risk They can also be very dynamic, changing multiple levels
* Issuers over a short period of time. They do not capture specific
* Seniority ranking risks that are unforeseen, and they tend to lag the market.
* Ratings agencies

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* Credit ratings
* Yields Evaluating Creditworthiness: the Cs of Credit Analysis
* Spreads The Cs of credit analysis include:
* Other things

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* Capacity: Borrower’s ability to make timely debt
The bond market is enormous, so appropriate credit payments.
analysis is crucial. * Capital: Other resources reducing borrower’s reliance on
debt.
re
* Collateral: Quality and value of borrower’s guarantee
Sources of Credit Risk: Default Risk and Loss Severity assets.
Credit risk is the risk the bondholder will not receive all of * Covenants: Legal terms of debt that borrower must
n
the promised cash flows on the agreed time frame. This follow.
includes two main components: default risk and loss * Character: Management’s quality and their willingness to
severity. Risk measures related to credit risk include
so

repay.
spread risk, downgrade risk, and liquidity risk. * Conditions: Economic and business environment
affecting repayment.
* Country: Geopolitical and legal environment impacting
Special Considerations of High-Yield Debt
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debt payment.
High yield debt carries a rating lower than Baa3/BBB-, for
* Currency: Impact of exchange rate changes on
various reasons including high leverage, weak operations
repayment.
or cash flow, and large off-balance sheet activities. Six
sources of liquidity for high-yield issuers from strongest to
@

weakest are cash, working capital, operating cash flow,

Credit Spread Risk: Macroeconomic, Market, and
bank credit facilities, equity issuance, and asset sales.
Issuer-Specific Factors
Debt instruments like corporate bonds trade at a yield
e

Ratings Agencies, Credit Ratings, and Their Role in the premium or spread over ”default-risk free” bonds due to
Debt Markets the increased risk associated with the issuing corporation’s
os

The big three ratings agencies are Moody’s, S&P, and Fitch, financial health, market conditions, and macroeconomic
which provide issuer-paid ratings on all types of debt, and factors. The spread is influenced by factors like the
have a dominant role in the credit markets as investors business cycle, with spreads narrowing when business
require these ratings for purchase. The ratings are by conditions improve and widening during downturns. The
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independent analysts who have access to material, yields and prices of bonds are impacted by changes in real
nonpublic information. interest rates, expected inflation, and credit and liquidity
risks, while issuer-specific factors, like the amount of
publicly traded debt and the issuer’s credit quality,
Credit Rating Agencies: Moody’s, S&P, and Fitch influence market liquidity risk.
The ”big 3” ratings agencies of Moody’s, S&P, and Fitch all
provide simple, comparable ratings from high-quality
grade to medium grade, low grade, and default. These Credit Risk vs. Return: Yields and Spreads
range from: Risk and return are directly related. In bond markets, credit
spread risk is represented by a lower issuer credit rating is
* Aaa to C—for Moody accompanied by higher yields, and higher spreads over
* AAA to D—for S&P that of comparable risk-free bonds. These higher yields
* AAA to D—for Fitch and spreads are also more volatile.

© Mindojo, 2023
Reading 8+14: Credit Risk 112

Bond Yield and Yield Spread Decomposition

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A corporate bond yield can be decomposed as the sum of
the real risk-free rate, an expected inflation rate, a maturity
premium, a liquidity premium, and a credit spread. The

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yield spread is just the liquidity premium and credit spread
over and above that of a risk-free bond. These components
are not directly observable.

The Price Impact of a Spread Changes in a Risky Bond

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A spread change in a risky bond will lead to a price impact.
The measurement of that impact can be closely
approximated as the negative product of the spread
change and the annual modified duration of the bond, and

ar
even more closely approximated by adding a small
convexity measure.

se
n re
so
bo
e @
os
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Reading 8+16: Credit Analysis for Corporate Issuers 113

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8+16 Credit Analysis for Corporate Issuers

Reading 8+16: Credit Analysis for Corporate Issuers

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Capital Structure and Seniority Ranking * Operations
Capital structure refers to the bank debt, bonds, preferred * Fundamentals
stock, and common equity that make up a firm’s balance * Liquidity
sheet. Various forms of these categories will have different * Financial ratios

ch
seniority rankings, or priority of payments, over those of
others, from secured debt of first lien or second lien, to
Fundamentals and Ratios in Corporate Credit Analysis
unsecured debt from senior to subordinated.
Alongside industry structure and fundamentals, company

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fundamentals are an integral part of the capacity
Recovery Rates component of credit analysis. This includes profitability
Regarding recovery rates: and cash flow measures, leverage ratios, coverage ratios,
and firm liquidity measures. Liquidity analysis includes the

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* A recovery rate is the percentage of invested assets cash balance, net working capital, operating cash flow,
returned to investors following bankruptcy and liquidation. committed bank lines, and near-term cash commitments.
* The provision pari passu places all bondholders of a
common seniority on equal footing for recovering assets
during a liquidation.
re
Key Leverage Ratios for Corporate Creditworthiness
Leverage ratios include:
* Data on average recovery rates show that the average
recovery rates correspond directly to seniority levels.
* Debt to EBITDA
n
* RCF to net debt
Priority of Claims
so

The seniority ranking of debt securities provides a clear These provide information about how heavy an issuer’s
structure of the priority of claims during a liquidation of a debt load is, which directly impacts the capacity of the firm
firm following default. However, in practice this is not to successfully service its debt.
always strictly followed, as collective bondholder
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agreements sometimes provide for claims by junior debt

Key Coverage Ratios for Corporate Creditworthiness
while senior debt is less than 100% satisfied.
Coverage ratios include:
@

Issuer and Issue Ratings * EBIT to interest expense

Issuer ratings are ratings on the ability of the issuer to * EBITDA to interest expense
service senior unsecured debt. Issue ratings are ratings on
specific issues which are ”notched” higher or lower based These provide rough information about how many times
e

on differences in loss severity or structural subordination. the interest expense of an issuer is covered by cash from
operations, which directly impacts the capacity of the firm
os

to successfully service its debt.

Introduction to Traditional Corporate Credit Analysis
Corporate credit analysis is the assessment of a firm to
fulfill its debt obligations, and includes analysis of the firm’s The Cs of Corporate Credit: Collateral
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fundamentals, operations, assets, and sustainability. There Regarding collateral:

are similarities to equity analysis, but there is a marked
difference in the spectrum of growth vs. stability. The four * Collateral refers to the assets of a company which may be
Cs of credit analysis include the issuer’s capacity to repay, sold to satisfy debtholders in the event of a default.
covenants in the bond indenture, character of * A low-default risk makes this part of credit analysis less
management, and collateral available should the issuer important.
default. * Intangible assets are difficult to value, and the market
may signal asset quality with the market value to book
value ratio.
The Cs of Corporate Credit: Capacity
Capacity refers to the issuer’s ability to service and repay its
debt. Capacity includes the firm’s: The Cs of Corporate Credit: Covenants
Regarding covenants:
* Competitive position

© Mindojo, 2023
Reading 8+16: Credit Analysis for Corporate Issuers 114

* Covenants are clauses in a bond indenture that protect

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bondholders.
* Affirmative covenants are promises that the issuer will
fulfill, and negative covenants are things the issuer

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promises not to do.

The Cs of Corporate Credit: Character

In credit analysis, character refers to the consistency,
conservatism, and strategy of management, as well as any

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past issues of fraud or investor mistreatment.

Assessing Corporate Creditworthiness: Qualitative

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Factors
Creditworthiness determines an entity’s capacity to handle
its debt obligations, relying heavily on both qualitative
factors like business model and industry risks, and

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quantitative aspects. The nature of the debt, whether
secured by tangible assets or not, can impact the likelihood
of repayment. Additionally, consistent changes in a re
company’s management, especially in financial roles, can
be a red flag indicating potential financial issues or
disagreements.
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Assessing Corporate Creditworthiness: Quantitative
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Factors
Financial forecasting requires a deep understanding of a
company’s fundamental business drivers and an
assessment of future risks. Two primary approaches to this
bo

are top-down, which starts with macroeconomic factors,

and bottom-up, which focuses on company-specific details.
Key metrics in credit analysis, such as profitability,
leverage, and liquidity, provide insights into a company’s
ability to uphold its debt commitments, and hidden factors
@

like off-balance sheet pension deficits should be treated as

significant future obligations.
e
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Reading 8+15: Credit Analysis for Government Issuers 115

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8+15 Credit Analysis for Government Issuers

Reading 8+15: Credit Analysis for Government Issuers

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Credit Analysis for Government Issuers - Introduction mandates.
Sovereign debt is analyzed by the government’s ability and
willingness to pay. Many traditional credit tools are used,
as part of a larger framework that includes the country’s

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institutional and economic profile, liquidity and
international investment position, and effectiveness of
monetary policy.

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Regional Government Issuers: Municipal Bonds
Municipal bonds are typically issued by a city, state, or
county. There are two main types:

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* General obligations (GOs)—unsecured bonds, backed
only by the full faith and credit of the issuing government re
* Revenue bonds—issued for a specific project and are
more risky due to the fact their success relies on the
revenue stream of one project
n
Sovereign Credit Analysis: Qualitative Factors
so

Sovereign creditworthiness hinges on five key qualitative

factors: the stability and transparency of government
institutions and policies, a nation’s fiscal flexibility in
economic challenges, the effectiveness of its monetary
bo

policies, the diversification of its economy, and its external

reputation in the global community. Together, these
factors offer a comprehensive view of a country’s economic
stability and potential.
@

Sovereign Credit Analysis: Quantitative Factors

Quantitative credit analysis for sovereign nations differs
e

from corporate assessments, as it relies heavily on

government economic data and employs a macroeconomic
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approach. Key financial ratios, like debt to GDP and interest

to revenue, offer insights into a government’s solvency and
fiscal discipline. Additionally, measures of economic
growth, external stability, and potential hidden liabilities,
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such as underfunded pension systems, are crucial for a

comprehensive evaluation of a nation’s creditworthiness.

Non-Sovereign Credit Risk

Agencies, public banks, and supranationals are
non-sovereign government debt issuers closely tied to
sovereign entities. While agencies and public banks often
share a credit risk profile similar to their respective
sovereign governments due to implicit or explicit backing,
supranationals have unique credit risks influenced by the
collective strength and commitment of their member
nations. Evaluating their creditworthiness requires
understanding their operations, backing, and individual

© Mindojo, 2023
Reading 9+4: Forward Commitment Pricing and Valuation 116

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9+4 Forward Commitment Pricing and Valuation

Reading 9+4: Forward Commitment Pricing and Valuation

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Pricing and Valuation of Forward Contracts at Derivatives: Replication
Expiration Regarding replication:
A forward contract provides for a buyer to purchase an
asset from a seller, on the expiration date and at a price * Replication is the process of replicating the payoff of an

ch
designated at the start of the contract. The value of a asset using a combination of other assets.
forward contract at expiration is the spot price of the asset * Replication is useful as it allows the investor to execute
minus the forward price, and the value will be positive or arbitrage strategies in the event of mispricing.
negative, depending on whether prices have moved for or * Even in the absence of mispricing, replication is useful for

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against each party. determining the value of a derivative which by the law of
one price must be equal to the value of the portfolio of
assets that replicate its payoff.
Pricing and Valuation of Forwards vs. Futures

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A futures contract’s value needs to take into account the
previous day’s settlement, as they are marked to market Pricing vs. Valuation of Forward Contracts
every day. Futures and forwards could have the same Regarding pricing versus valuation:
prices if interest rates were constant, but the marking to
market (MTM) process for futures makes this very unlikely.
re
* In most cases asset value and price are synonymous, with
a common definition of value being the market price.
* This is true for some derivatives where the premium to
Derivatives: Storage Cost of the Underlying
n
enter the contract is synonymous with its price; for forward
Regarding storage:
contracts, there is no cost to enter the contract.
* Over time as prices vary, the forward contract may have
so

* A natural way to hedge a derivative position is to

value to either the long or short party.
purchase the underlying and hold it for future delivery.
* Therefore, for some derivatives, price and value need not
* In the setting of an exchange which is free of
be synonymous.
counterparty risk, the expected return for entering such a
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position is the risk-free rate of return as there is no default

risk associated with the position. Pricing and Valuation of Forward Contracts at
* The capital costs of entering this hedge position vary with Initiation Date
the underlying and include all costs and benefits realized When a forward contract is initiated, it has no value to the
@

by the holder. buyer or the seller of the underlying asset. But the price at
* For example, storage, insurance, or transportation costs which the asset will ultimately change hands, the forward
increase capital requirements whereas dividend payments price, can be determined by compounding the asset’s spot
or interest payments in the form of coupons decrease price by the risk-free interest rate. If there are any benefits
e

capital requirements. or costs associated with holding the asset, these variables
need to be included when calculating the forward price.
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Derivatives: Introduction to Pricing and Valuation

Buyers and sellers of derivatives need to understand how Pricing and Valuation of Forward Contracts During the
to price financial products to make good investment Life of the Contract
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decisions. Derivatives have characteristics that are The value of a forward contract can be calculated at any
complex, but they also help to simplify as it isn’t necessary point in time after initiation and prior to expiration. This
to take an investor’s risk aversion into account. value is the underlying asset’s spot price minus the present
value of the agreed-upon forward price. If there are any
benefits or costs that accrue to the asset holder, these
Derivatives: Benefits and Costs of Holding an Asset
variables are included in the valuation formula as well.
Monetary and nonmonetary benefits and costs are present
when holding an asset. Dividends and interest payments
are potential benefits, and a convenience yield is a Pricing and Valuation of Interest Rate Forward
nonmonetary benefit. There are opportunity costs of Contracts
money being tied up in investments. Costs and benefits are Forward rate agreements, or FRAs, are like other types of
accounted for by finding the stock’s value at the end of the forward contracts, except that the underlying asset really is
holding period. not an asset at all. It is an interest rate that is typically
quoted based on the level of the London Interbank Offered

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Reading 9+4: Forward Commitment Pricing and Valuation 117

Rate, or LIBOR. FRAs can be used by market participants to the same throughout the marketplace.

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address their exposure to fluctuating interest rates. * Financial markets are generally considered to be efficient
and arbitrage-free, to find the value of derivative contracts.
* By constructing a portfolio that consists of the derivative
Derivatives: Swap Values and Prices

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and the underlying where the payoff in the future is known,
Swap values are zero at initiation, with the next periodic the portfolio is risk free and the derivative price is the one
payment typically determined one period ahead. If the that ensures the portfolio earns the risk-free rate of return.
market reference rate (MRR) matches the implied forward
rates (IFRs) forecast to calculate the swap rate, the swap
will continue to have zero value. But at any period, the

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value of the swap is the present value of all future cash
flows, and can change.

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Derivatives: Comparing Swaps and Forwards
A swap can be thought of as a series of forward contracts.
A common type of swap exchanges implied forward rate
(IFR) payments to a single, constant par swap rate by

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discounting the IFRs and the single swap rate at the same
set of spot rates.

Pricing of Futures Contracts at Inception

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At inception, a futures contract has zero value. No cash is
exchanged, and neither the buyer nor the seller has an
n
asset or liability. The spot price is reduced from the
expected future spot price by the risk-free rate, while also
so

affected by any benefits or income ( I ) or costs of carry ( C

).
f0 (T ) = [S0 − P V0 (I) + P V0 (C)](1 + r)T
bo

Interest Rate Futures vs. Forward Contracts

Interest rate futures contracts are quoted on a price basis.
@

Long interest rate futures contracts benefit from a falling

MRR, while the short side gains from a rising MRR. The
basis point value of a contract is the notional value times
0.01% times the period, which gives the per-basis point
e

settlement change of the contract for each bp change in

the MRR.
os

Forward and Futures Price Differences and OTC Central

Clearing
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A positive futures/interest rates correlation causes futures

to offer a slightly better return than forwards, a negative
correlation is best for forwards, and zero correlation (or
constant interest rates) makes them equal. A convexity
bias exists for forwards, as their settlements are PV
calculations, rather than the linear settlements for futures.

Derivatives: The Arbitrage-Free Framework

Regarding arbitrage:

* The law of one price requires that in a market with low

transaction costs and common information between
market participants, the price of the same product must be

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Reading 9+8: Option Pricing and Valuation 118

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9+8 Option Pricing and Valuation

Reading 9+8: Option Pricing and Valuation

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Option Pricing: Put-Call Parity the greater potential for a large payoff can be offset as a
Put-call parity is useful in determining whether the price of result of discounting the future exercise proceeds back to
a call or put option is appropriate in light of certain the present over a longer period of time.
interdependent characteristics of the options and their

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underlying assets. Put-call parity assumes an investor can
Option Prices: Effect of the Risk-Free Rate of Interest
enter into a protective put and a fiduciary call, and if either
Movements in the risk-free interest rate can have a marked
position is mispriced relative to the other, an arbitrage
impact on the value of European options. Higher rates
opportunity will arise for the investor.

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drive higher valuations for call options, but prompt lower
valuations for put options. For options that are not
Risk Neutrality and Arbitrage-Free Pricing expected to be exercised, interest-rate changes have no
Pricing on spot markets is driven by risk averse investors effect.

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seeking incremental reward for holding higher risk assets.
Derivative pricing is not dependent on risk aversion as the
law of one price, which defines derivative prices, holds for Option Prices: Effect of Volatility of the Underlying

both risk neutral and risk averse investors. The volatility of the asset underlying an option contract can
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have a significant impact on the value of European call and
put options. Volatility represents the range of prices that
Binomial Valuation of Options can be reasonably expected for the asset, and a greater
The binomial option pricing model determines appropriate dispersion of prices will increase the chances of an option
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call and put prices based on assumed price paths for an expiring with a payoff.
underlying asset. The model takes the expected payoff
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based on risk-neutral probabilities and discounts this

figure back to the present to arrive at a justified price. Option Prices: Effect of Payments on the Underlying

Variations between this theoretical value and market prices and the Cost of Carry

can produce arbitrage opportunities. Option pricing is influenced by the dividend payments a
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company makes to its stockholders and the interest

payments it makes to its bondholders. The financing costs
Value of an Option at Expiration incurred by the owners of the assets that underlie option
The exercise value of an option contract at expiration contracts also play a role in option valuation. Call and put
@

depends on the price of the underlying asset relative to the option holders will be impacted quite differently by these
exercise price. For call options, this value is the greater of factors.
zero or the asset’s price less the exercise price. For put
options, the value is the greater of zero or the exercise
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price less the asset’s price. Option Pricing: Put-Call Forward Parity
Put-call forward parity is used to determine whether the
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price of a call or put option is appropriate in light of certain

Option Prices: Effect of the Exercise Price and the pricing relationships between the options, their underlying
Underlying asset, and a forward contract. Put-call forward parity
The exercise price and underlying price for a European assumes an investor can enter into a synthetic protective
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option determines its moneyness. The exercise price is the put and a fiduciary call, and if either position is mispriced
point at which an option holder breaks even with its payoff. relative to the other, the investor can potentially make
For call options, lower exercise prices and higher money from an arbitrage opportunity.
underlying prices increase the chances that the options will
expire in-the-money, and for put options, higher exercise
prices and lower underlying prices make it more likely that Option Arbitrage and Replication
the options will expire in-the-money. The no-arbitrage conditions for option contracts requires
lower and upper bounds for both put options and call
options. For call options, these bounds are:
Option Prices: Effect of Time to Expiration ( )
The value of an option is impacted by the time remaining M ax 0, St − X(1 + r)−(T −t) < ct ≤ St .

until it expires. For call options, the longer the time prior to For put options, these bounds are:
expiration, the better are the chances of the position ( )
paying off. The same is typically true for put options, but M ax 0, X(1 + r)−(T −t) − St < pt ≤ X.

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Reading 9+8: Option Pricing and Valuation 119

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Reading 9+1: Derivative Markets and Instruments 120

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9+1 Derivative Markets and Instruments

Reading 9+1: Derivative Markets and Instruments

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Characteristics of Forward Commitments * Credit default swaps (CDS) are the most common credit
Regarding forward commitments: derivative where the protection buyer (short CDS) pays the
protection seller (long CDS), and stands to receive a
* A forward commitment is a binding agreement between payment if there is a credit event.

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two parties to transact in a specified amount of an
underlying asset at a specified price, future time, and
Derivatives Underlyings: Debt, Equity, and
location.
Commodities
* The payoff to the party in the long position is the

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Commodities are physical assets, classified as ”hard” or
difference between the spot price of the underlying at
”soft.” Commodity derivatives allow users to speculate on
maturity and the forward price.
and hedge commodity prices. Interest rates for lending or
* The counterparty in the short position realizes the
borrowing can be essentially locked in place with interest
opposite payoff, the difference between the forward price,

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rate derivatives. Equity derivatives are issued with both an
and the spot price at maturity.
individual stock and indexes as the underlying.
Corporations may use options instead of salary to give
Characteristics of Swap Contracts managers incentives to monitor stock prices and better
Considerations of swap contracts:
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align the incentives of managers and shareholders.

* A swap can be thought of as a contract that binds

Purposes and Benefits of Derivatives
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together a series of forward contracts.
Considering the purpose of derivatives:
* In a forward contract, the two parties transact once at the
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maturity of the contract.

* Derivative markets are necessary as they provide features
* In a swap, the two parties transact multiple times.
either not available or costly to obtain via the spot market.
* The forward price used at each settlement need not be
* The most significant of these features is the ease of
the same under the terms of a swap agreement.
entering a short position, enabling the sharing of downside
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risk.
* Derivatives also enable investors to enter a highly levered
Characteristics of Contingent Claims
position not easily attained by trading in equity or debt
Regarding contingent claims:
markets.
@

* An option (contingent claim) contract gives the buyer of

the contract the right, but not the obligation, to transact in Operational Advantages and Market Functions of
the underlying asset at a set price, time, and location. Derivatives
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* To obtain the right to decide whether to transact or not, Derivative markets have a number of operational
the buyer pays a premium to the seller of the option advantages over spot markets, including lower transaction
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contract at inception. costs, greater liquidity, ease of entry into short positions,
* A call option gives the buyer of the option contract the and allowing a highly leveraged position. Derivatives allow
right, but not the obligation, to buy the underlying asset investors to much more effectively manage risk within their
from the seller of the contract. portfolios. A primary contribution comes in the form of
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* A put option gives the buyer of the option contract the information discovery. Derivative markets also contribute
right, but not the obligation, to sell the underlying asset to to improved market efficiency via lower transaction costs,
the seller of the contract. greater liquidity, and lower capital costs to enter positions.

Credit Derivatives: Credit Default Swaps (CDS) Derivative Risks: Destabilization and Systemic Risk
Regarding credit derivatives: Considerations of destabilization and systemic risk:

* Credit derivatives are a class of contracts that protect the * Opponents of derivatives often argue derivatives enable
buyer against losses from default of their counterparty in a speculators to take highly leveraged positions that can lead
loan. to widespread defaults by speculators and their creditors.
* The buyer typically makes periodic payments to the seller. * It is argued that default waves can result as the creditor
* In return, in the event of default or a significant credit of the creditors then default, resulting in the spread of
event, the seller compensates the buyer for realized losses. instability throughout the market.

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Reading 9+1: Derivative Markets and Instruments 121

* Proponents of derivatives note many financial crises

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predate the modern era of derivative use. * Participants bear higher transaction costs
* Derivatives are but one of many methods to achieve a * The cost of identifying a counterparty
highly levered position which could have equally negative * Counterparty risk

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effects.

Forward Commitments: Futures Contracts

Introduction to Derivative Markets and Instruments Regarding futures:
Derivatives are financial instruments, the value of which is
related to the performance of an underlying asset. Many * A futures contract is a binding contract between two

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derivative contracts are similar to insurance policies. In the parties to transact in an underlying in a specified amount
absence of a triggering event, such as a fire, there is no at a specified future price and location.
payout. After the triggering event has occurred, the size of * Futures and forwards are contractually identical,
the payout increases as the trigger point is increasingly however, futures trade on derivative exchanges, whereas

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surpassed. forwards trade over-the-counter.

Derivatives: Definitions and Uses Calculating Option Payoffs

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A derivative is a financial instrument, the value of which is Regarding option payoffs:
based on the value of the underlying asset. There are two
basic types of derivatives: * In contrast to forward contracts for which the payoff to
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either party is linearly increasing or decreasing with the
* Forward commitments obligate two parties to transact in price of the underlying, option payoffs to both parties are
the underlying asset in the future at a set price non-linear.
* Contingent claims are similar, but only the party that sold * The non-linearity in option payoffs arises because the
n
the contract is obligated to transact in the future losses are capped for the buyer of the contact who will
transact only if it is in his/her favor to do so.
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* An option contract is referred to as ”in the money” if it is

Basic Characteristics of Derivatives in the best interest for the buyer to exercise the contract.
Derivatives can be used to enter positions not possible * If it is not in the best interest of the long party to exercise
using the underlying alone. The exposures realized via the option, the contract is referred to as ”out of the money.”
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derivatives and the highly leveraged nature of the

exposure facilitate risk transfer. The process by which a
company or individual identifies financial risk and adjusts Derivatives Underlyings: Currencies, Credit, and Other
those risks to target levels is referred to as risk The exchange rate between currencies becomes a major
management, and includes hedging. profit factor over which the company has no control, and
@

derivative contracts with a currency or exchange rate as the

underlying can offset this risk. Credit is an underlying used
Exchange-Traded Derivatives Markets in derivatives for risk management and trading purposes.
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There are three key distinctions that differentiate exchange Credit derivatives are created for both single and multiple
traded derivatives (ETD) trading from OTC trading: entities. Collateralized debt obligations (CDOs) are credit
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derivatives on a portfolio of credit risks. Derivatives may

- The contracts on exchanges are standardized to common have other underlyings such as elections or weather.
maturities and sizes for commonly traded underlyings.
- On exchanges, trading is facilitated by the market maker
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and the clearinghouse guarantees payment by the parties Derivatives Usage by Issuers and Investors
in the contract. Hedge accounting allows a derivative holder not to mark to
- Trading on the exchange is more transparent with current market if the derivative is hedging a balance sheet item. A
price, trading volume, and limit order depth commonly and cash flow hedge is some derivative position to nullify the
publicly reported by the exchange. value changes from cash flows. A fair value hedge is some
derivative used to offset changes in the fair value of an
asset or liability. A net investment hedge is when
Over-the-Counter Derivatives Markets something like an FX swap or forward offsets the exchange
Derivatives trade on both exchange and over-the-counter rate risk of a foreign operation.
(OTC) markets. The primary advantage of OTC trading is
contract flexibility and customization. Traders seeking to
purchase unique derivatives for uncommon underlyings,
with custom maturities or sizes by necessity trade on OTC
markets. The flexibility of the OTC market comes at a cost:

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Reading 10+1: Alternative Investment Features, Methods, and Structures 122

10+1 Alternative Investment Features, Methods, and

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Structures
Reading 10+1: Alternative Investment Features, Methods, and Structures

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Introduction to Alternative Investments and Features Disadvantages include high management fees.
Alternative investments have grown in popularity in recent * Co-investing is owning specific investments in a group.
years, and tend to be more illiquid and require manager Advantages include some control and decision making with
specialization over traditional long-only stock and bond lower management fees. Disadvantages include facing

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portfolios. Alternative investments have low correlations adverse selection bias and time commitment.
with traditional investments, are less regulated, have less * Direct investing is purchasing sole properties outright.
reliable return data, and often present unique tax Advantages include full control and no fees. Disadvantages
considerations. include high capital requirements, no diversification, and

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significant time and expertise required.

Alternative Investments: Categories

There are no hard and fast rules to assigning categories for Alternative Investments: Due Diligence for Investing

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alternative investments, but generally they fall into the A due diligence process for fund investing includes scrutiny
following groups: of the organization and manager, including experience and
track record, the investment process, operations and
* Private capital (Private equity, venture capital, private controls, risk management, legal review, and fund terms.
debt)
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Direct investment requires substantial due diligence of the
* Real assets (Real estate, infrastructure, natural resources) target investment, including the management team with
* Hedge funds similar considerations. Co-investment requires some due
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* Others such as wine and art diligence of both.
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Alternative Investments: Common Clauses and

Provisions
A catch-up clause helps the GP get a full performance fee
without the hurdle rate deduction once the hurdle rate is
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achieved. The high-water mark protects limited partners by

requiring that performance fees are paid based on the
highest prior fund value. A deal-by-deal waterfall allocates
profits to GPs first, and the clawback provision allows the
@

limited partners to get some of this back if it ends up being

too much. A whole-of-funds waterfall provides profits to
the limited partners first.
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Alternative Investment Structures: Management and

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Compensation
Partnerships are the most common structure for
alternative investment management, with the fund as the
general partner and the investors as limited partners.
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These are generally structured as limited liability

companies under a limited partnership agreement (LPA) to
reduce the individual partner’s overall risk. The fee
structure for managing a fund usually consists of a base
management fee of 1%-2% and a performance fee of
typically 20% of excess returns beyond an 8% hurdle rate.

Alternative Investments Methods

Methods of investing in alternative investments include:

* Fund investing is buying a homogenous piece of an

investment pool. Advantages include lack of time and
expertise required and diversification benefits.

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Reading 10+6: Hedge Funds 123

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10+6 Hedge Funds

Reading 10+6: Hedge Funds

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Hedge Funds: Event-Driven Strategies market movements, have evolved into versatile private
Event-driven strategies form one set of equity strategies investment pools, investing in a range of products from
that hedge funds use. They include: equities to real assets. Their approach to these
investments, rather than the actual assets, distinguishes

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* Merger arbitrage them from other investment vehicles like mutual funds.
* Distressed/Restructuring While they employ strategies that might seem to amplify
* Activist risks, such as leverage and short selling, these methods are
* Special situations often used to enhance risk-adjusted returns.

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Each strategy has specific goals, benefits, and risks to the
Hedge Funds: Direct Investment Forms
stakeholder.
Hedge funds are private investment partnerships that can

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be set up onshore or in tax-advantaged offshore locations,
Hedge Funds: Relative Value and Opportunistic with their offerings typically limited to select investors.
Strategies They often employ a ”two and twenty” fee structure,
Relative value strategies are used by hedge funds looking though this is evolving due to investor pressures. Larger
for price distortions or anomalies in the market. There are
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investors might opt for separately managed accounts
five main types: (SMAs) for more control and customization, but these
structures also come with challenges, including potential
n
* Fixed income convertible arbitrage misalignment of manager incentives.
* Fixed income general
* Fixed income asset backed
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Hedge Funds: Indirect Investment Forms

* Volatility
Indirect hedge fund investments, like fund-of-hedge-funds,
* Multi-strategy
have risen in popularity due to their ability to diversify
portfolios and offer reduced management costs, increased
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Opportunistic strategies include:

transparency, and enhanced liquidity. However, they come
with additional fee layers, which can reduce an investor’s
* Macro strategies, which look to profit from the
initial returns. Exchange-traded products, such as ETFs,
overarching conditions * Managed futures funds, also
seek to replicate hedge fund strategies but often deliver
called commodity trading advisers (CTAs).
@

lower returns due to heavier regulations and limitations on

leverage.
Hedge Funds: Equity Strategies
Equity hedge fund strategies focus on savvy stock investing
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Hedge Funds: Sources of Returns, and Biases

that incorporates long, short, and market-neutral
Hedge funds aim to limit market exposure and focus on
strategies. Derivatives can also be used. Subtypes include:
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generating idiosyncratic returns, or alpha, by leveraging

market inefficiencies and manager skill. Their performance
* Fundamental growth
is derived from market beta, strategy beta, and alpha, with
* Fundamental value
strategy beta being tied to the unique investment
* Short bias
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approach of the fund. However, various biases, higher

* Market neutral
fees, and off-balance sheet obligations like underfunded
pensions can influence the true returns and risk profile of
Hedge Funds: Distinguishing Characteristics these funds.
Leverage is another consideration for hedge funds,
because it magnifies both gains and losses. Buying call
Hedge Funds: Investment Risks and Returns
options, selling put options, taking long futures positions,
Hedge funds, with their unique investment strategies, offer
or buying on margin are ways that hedge funds use
a diverse range of risk and return profiles that can differ
derivatives for leverage. Losses cause drawdown that can
significantly from traditional equity and fixed income
lead to investor redemptions.
benchmarks. Their performance metrics are often
influenced by survivorship bias due to self-reporting. The
Hedge Funds: Investment Features coefficient of variation provides a meaningful measure for
Hedge funds, originally designed to hedge against stock these funds, offering insights into the relative return

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Reading 10+6: Hedge Funds 124

adjusted for risk.

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Hedge Funds: Diversification Benefits of Hedge Fund
Investments

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Hedge funds initially aimed to neutralize market exposure
by holding both long and short positions, ensuring
profitability irrespective of market direction. Over the
years, their strategies have diversified, making them
attractive for their risk-mitigating and market

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outperforming properties. However, with their evolution,
thorough due diligence has become crucial for investors,
given the funds’ somewhat low correlation with traditional
asset classes.

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Reading 10+3: Investments in Private Capital: Equity and Debt 125

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10+3 Investments in Private Capital: Equity and Debt

Reading 10+3: Investments in Private Capital: Equity and Debt

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Private Capital: Characteristics and Categories a traditional stock and bond portfolio due to a less than
Private capital investors generally invest in privately owned perfect correlation with these traditional asset classes.
companies or in public companies with the purpose of
making them private, either through debt or equity. Based

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on strategy and goals, private capital investments can be Private Capital: Private Debt

categorized as: Private debt can be broadly subdivided into four categories:
* Direct lending—loans to private businesses, sometimes

* Leveraged buyouts leveraged

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* Venture capital * Mezzanine debt—junior, unsecured debt senior to only

* Growth capital equity for higher returns

* Private Debt (direct, mezzanine, venture, distressed) * Venture debt—lending as part of venture capital activity
to avoid dilution

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* Distressed debt—purchasing low-value bonds with plans
Private Capital: Leveraged Buyouts to help turn around the firm
Leveraged buyouts or LBOs generally have the goal of
taking public companies and making them private or
maintaining an established private company as private
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under new management. Some LBO transactions keep the
current management, called management buyouts (MBOs),
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or they can replace the current management, called
management buy-ins (MBIs). Debt is a central
characteristic of LBO financing.
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Private Capital: Venture Capital

Venture capital involves financing private companies at
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various stages of growth, with investors requiring higher

returns for early-stage ventures due to increased risk. As
companies mature, the type of financing evolves, from
pre-seed and seed capital for initial development, to early
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and later-stage financing for operational growth, and finally

to mezzanine-stage financing in preparation for an IPO.
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Private Capital: Exit Strategies

The goal of private equity investing is to add value to the
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company and exit with a high valuation, making the exit

strategy very important. The most common exit strategies
can be categorized as:
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* Trade sale
* IPO or SPAC
* Recapitalization
* Secondary sales
* Write-off/liquidation

Private Capital: Diversification Benefits

Private capital investments may provide higher return
opportunities than investments in traditional stocks and
bonds through their ability to invest in private companies,
influence the strategy and management of these
companies, and finance these transactions with leverage.
Private capital investments may also add to the diversity of

© Mindojo, 2023
Reading 10+4: Real Estate and Infrastructure 126

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10+4 Real Estate and Infrastructure

Reading 10+4: Real Estate and Infrastructure

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Real Estate: Features and Characteristics classes, making it a valuable tool in investment portfolios.
Regarding real estate:

* Real estate investing can include ownership of real Infrastructure Investments: Overview

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property as well as lending against real property for which Infrastructure is real, long-lived assets, and private

the property usually serves as collateral. investment has dramatically grown in partnership with

* Real estate investment may be commercial (rentals, governments. Infrastructure assets are categorized as

office, or retail) or residential. economic, such as transportation and utilities, and social,

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* Real property generally has returns from both rental such as education and healthcare facilities. Infrastructure

income and capital gains, the former serving as an inflation is also categorized as greenfield (new development) or

hedge and risk alleviator from changes in the economy. brownfield (existing development).

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Infrastructure Investments: Forms, Risks, and Returns
Real Estate: Forms and Styles of Investment
Direct infrastructure investment is unpopular due to the
The basic forms of real estate investments are either:
size of investment and management required. Indirect

* private, which can be sole ownership or some

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investments include private equity funds, ETFs, listed and
unlisted funds, and publicly traded funds like master
commingled fund where the investor has managing input;
limited partnerships (MLPs). There are significant
* public, which may be through a corporation or trust
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regulatory risks. Index returns have averaged
where the investor owns shares in the portfolio;
approximately 10% in recent years, with resilience to
* equity, which will have some form of real property; and
market crashes and low correlations with stocks and
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* debt, which utilizes the financing of real property as the

bonds.
investment vehicle.
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Real Estate: Investment Categories

The two primary categories of real estate investments are
commercial and residential. The difference between them
is in classifying real estate as either income generating or
owner occupied without an income source. Commercial
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real estate usually requires active and experienced,

professional management.
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Real Estate: REIT and MBS Investing

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Equity investment REITs rely on a predictable income

stream from rents for their return, thus maximum
occupancy is important for these REITs. In most countries,
REITs are obligated to distribute most of their income to
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shareholders. Investment banks package these mortgages

into mortgage backed securities (MBS). These securities are
then sold to retail and institutional investors.

Real Estate: Performance and Diversification Benefits

Real estate investments offer a unique blend of steady
returns, similar to bonds, and the opportunity for capital
appreciation akin to stocks. Over half of the returns from
commercial real estate come from consistent income
sources like rents, while the remainder arises from
long-term property value appreciation. Diversification
through real estate, including vehicles like REITs, provides
benefits due to its low correlation with traditional asset

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Reading 10+5: Natural Resources 127

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10+5 Natural Resources

Reading 10+5: Natural Resources

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Natural Resources: Raw Land, Timberland, and * Other specialty commodity funds or separately managed
Farmland accounts (SMAs)
Natural resources, encompassing soft and hard * Real estate investment trusts (REITs) for land
commodities, are foundational to the economy and daily

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life, with significant investments made directly through
assets like farmland and timberland. While both land Natural Resources: Risks and Returns
investments and real estate are unique and Commodities can provide a hedge for inflation and provide
location-specific, they differ in their valuation focus; land diversification to a portfolio. However, commodities such

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investments emphasize soil quality and climate, while real as energy and food can be volatile, and offer relatively low
estate prioritizes potential land improvements. Investing in returns. A large bet on a single commodity, such as oil or
timberland and similar assets requires specialized gas, using leverage could lead to spectacular losses.
knowledge, often leading investors to rely on expert Farmland and timberland often provide better returns than

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organizations such as TIMOs. These investments are many commodities.
typically less liquid due to the niche expertise needed for
transactions.
Natural Resources: Pricing of Commodity Futures
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Contracts
Commodity futures contracts are exchange traded. As
Natural Resources: Commodity Features and
such, they require the posting of collateral and are marked
Characteristics
n
to market on a daily basis. The price of a commodity
Regarding natural resources:
futures contract at time T can be calculated by using the
spot price (S), risk-free rate (r), storage costs (c), and
so

* Commodities are physical products that offer a return

convenience yield (i):
based on their change in price.
* Commodity prices are dependent on demand and the
F0 (T ) = S0 e(r+c−i)T
supply chain.
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* Because trading a physical commodity can be impractical, Or approximated for a one-year contract as:
investors trade commodity derivatives that generally have
a high correlation to inflation and a low correlation to other F0 (T ) ≈ S0 × (1 + r) + c − i
investments.
* Other natural resources include timberland and
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farmland.
Natural Resources: Forward Curves in Contango or
Backwardation
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Natural Resources: Commodity Derivatives and

An upward sloping commodity forward curve suggests that
Indexes
futures prices are higher than the spot price, and
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Commodity derivatives (such as futures contracts) and

commodity prices are referred to as being in contango. A
indexes are utilized in replacement of trading actual
downward sloping commodity forward curve suggests that
commodities and represent an agreement or contract to
commodity prices are in backwardation.
purchase a specific amount of commodities at a specific
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time in the future.

Natural Resources: Diversification Benefits
Commodities have a high correlation with the price level,
Natural Resources: Commodity Exposure by Other producing superior returns in high inflationary
Means environments and losses in low inflationary environments.
Most of the trading in commodities takes place with Commodity return correlations with stocks and bonds is
futures contracts rather than physical commodities. Other low, providing diversification to a traditional portfolio.
commodity investment vehicles include: Timberland and farmland have a near zero correlation with
traditional investments, and can also satisfy ESG
* Exchange-traded funds (ETFs) and exchange-traded notes requirements.
(ETNs)
* Common stock in commodity-oriented firms
* Managed futures funds called commodity trading Natural Resources: Features and Forms of Farmland
advisers (CTAs) and Timberland Investment

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Reading 10+5: Natural Resources 128

Farmland and timberland investments offer stability and

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returns due to the consistent demand for food and shelter,
and their resilience during economic volatility. While
farmlands are often family-owned and driven by

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agricultural product prices, timberland investments
provide flexibility by allowing harvest timing based on
market conditions. Additionally, these lands serve as
environmental assets, acting as carbon sinks and playing a
role in carbon offsetting and water rights.

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Reading 10+7: Introduction to Digital Assets 129

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10+7 Introduction to Digital Assets

Reading 10+7: Introduction to Digital Assets

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Distributed Ledger Technology Investible Digital Assets
DLT is based on a distributed ledger, a type of database Investible digital assets encompass cryptocurrencies,
shared among a network of participants. Each participant altcoins, stablecoins, and meme coins, each with unique
has a copy of the immutable digital database, ensuring a characteristics. Bitcoin is the most popular cryptocurrency,

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verified record of all transactions. A distributed ledger while Ether is a prominent altcoin that enables
network has all participants (nodes) connected to each programmable blockchain applications. Stablecoins are
other, each with a copy of the distributed ledger. The designed to maintain a stable value by being linked to
consensus mechanism is at the center, where nodes agree other assets, and asset-backed tokens are a special subset.

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on new transactions and ledger updates. Meme coins are often inspired by jokes.

Proof of Work vs. Proof of Stake Digital Asset Investment Forms

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There are two main consensus protocols in blockchains: Digital asset investments can be made through direct and
Proof of Work (PoW) and Proof of Stake (PoS). PoW relies indirect methods, each with its own advantages and risks.
on solving complex cryptographic problems and requires Direct investments involve buying cryptocurrencies on
substantial computing power, while PoS involves validators centralized or decentralized exchanges, while indirect
pledging capital to vouch for a block’s validity. Both
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investments include vehicles like cryptocurrency coin
protocols involve mining as a reward system, where trusts, futures contracts, and exchange-traded funds.
validators earn new digital assets. PoS is generally more Asset-backed tokens represent a digital form of investment
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energy-efficient compared to PoW. for non-digital assets, offering increased liquidity and
reduced transaction costs.
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Permissioned and Permissionless Networks

Permissionless networks are open, fully decentralized, and Digital Asset Investment Risk, Return, and
utilize a consensus mechanism, but are therefore slower Diversification
and more costly. Permissioned networks offer restricted Digital asset investments, such as cryptocurrencies, exhibit
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access and only partly decentralized governance, and are high volatility and unique risks but offer potential
therefore faster and more cost effective. diversification benefits due to their low correlations with
traditional asset classes. Factors driving cryptocurrency
prices include market demand, limited supply, market
Types of Digital Assets
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adoption, and technological advancement. Regulatory

Digital assets, such as cryptocurrencies and tokens, are
uncertainty and varying legal protection across countries
revolutionizing the financial industry with the help of
add to the complexity of investing in digital assets.
distributed ledger technology (DLT). Cryptocurrencies
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enable near-real-time transactions without intermediaries,

while tokenization streamlines ownership verification for
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various assets. Various types of tokens, including security

tokens, utility tokens, and governance tokens serve
different purposes in the digital landscape.
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Digital Asset Investment Features

Digital assets, such as cryptocurrencies, are becoming
increasingly important in the financial services industry and
offer potential diversification benefits for investors. They
have unique characteristics, such as deriving their value
from anticipated asset appreciation and using
decentralized digital ledgers for transaction validation.
However, digital assets face challenges like limited
acceptance in the mainstream financial system and an
unclear legal and regulatory framework, which investors
must consider when incorporating them into their
portfolios.

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Reading 10+2: Alternative Investment Performance and Returns 130

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10+2 Alternative Investment Performance and Returns

Reading 10+2: Alternative Investment Performance and Returns

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Performance Evaluation: Multiple of Invested Capital
(MOIC)
Private equity and real estate managers have a long-term
focus, and both risk and return measures must be long

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term as well. For returns, IRR and multiple of invested
capital (MOIC) are popular places to start. The MOIC is
simple, but ignores timing of cash flows.

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Fees and Returns of Alternative Investments
A ”2 and 20” fee structure may vary due to investors’ asset
size, liquidity terms, acceptance of founder’s shares, or

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”either/or” agreements. Incentive fees can be calculated
based on an American ”deal-by-deal” waterfall or a
European ”whole-of-fund” waterfall. Calculating
management fees includes the investment amount gross of
return, and incentive fee may be calculated independently,
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net of management fee, and with a hurdle rate.
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Alternative Investment Performance
Alternative investments differ significantly from traditional
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asset classes, with unique features like staggered capital

commitments, reduced liquidity, and complex fee
structures. Appraising their performance requires an
in-depth understanding of factors like the life cycle phase,
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borrowed funds, and asset valuation. While traditional

assets have standardized benchmarks, alternative
investments demand meticulous analysis, like discerning
the value of a unique piece of art.
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The Alternative Investment Life Cycle

Alternative investments undergo a unique life cycle
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consisting of the capital commitment, deployment, and

distribution phases, each with its distinct financial
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dynamics. The initial stages typically see negative returns

due to upfront costs and fees, while returns accelerate
upon successful implementation in the distribution phase.
To account for the unpredictable cash flows of these
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investments, the internal rate of return (IRR) is essential,

emphasizing the importance of timing in investment
decisions.

Alternative Investments: Leverage, Illiquidity, and

Redemption
Traditional performance measures may appear better than
they really are due to returns being amplified by leverage,
prices being overstated by illiquidity, understated risk from
prices being smoothed due to infrequent trading, and
understated risk due to the possibility of investor
redemptions.

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Reading 11+1: Portfolio Management: An Overview 131

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11+1 Portfolio Management: An Overview

Reading 11+1: Portfolio Management: An Overview

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Active vs. Passive Management assets in portfolios, but also understand how these assets
Active management is employing various strategies to are correlated to one another.
search for relatively undervalued securities and assets. * This understanding focuses on the benefits of
This represents about 80% of the USD 79 trillion asset diversification, which is a crucial concept for the

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management market. Passive management takes broad development of MPT.
exposures without such attempts, and is therefore much
less expensive for investors.
Individual Investors

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Regarding individual investors:
Traditional vs. Alternative Asset Managers
Traditional asset managers are humans that take long * Individual investors will have different goals and
exposures in traditional assets. But alternative asset constraints, which will dictate how they invest, and many

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managers focus on private equity, hedge funds, or other invest through an employer’s pension plan.
alternative asset classes. Some alternative asset managers * These are broadly defined benefit (DB) plans, where the
aren’t even human, but are robo-advisors programmed to employer is responsible for meeting the employees’
serve the needs of many smaller investors in a low-cost retirement income, or a defined contribution (DC) plan,
fashion.
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where the employee has the exposure to any investment
shortfalls to meet his or her retirement income
expectations.
Reducing Risk in Portfolios
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Regarding risk in portfolios:
Institutional Investors
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* The combination of assets, also known as a portfolio, Institutional investors can take many forms. The most
impacts risk more than it impacts returns. common are:
* This is the essence of diversification.
* The less correlated the assets in one portfolio are, the * Defined benefit pension plans
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more diversified that portfolio will be. * University endowments

* This can reduce the portfolio’s risk (volatility). * Banks
* Charitable foundations
* Insurance companies
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Risk-Return Tradeoff * Investment companies

Regarding risk-return tradeoff: * Sovereign wealth funds (SWFs)

* Every investment comes with its own expectations of risk

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and return. Steps in the Portfolio Management Process

* Picking the best combination of assets will maximize your The portfolio management process:
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return and minimize your risk.

* This is called the tradeoff between risk and return. * In order to invest on behalf of a client, one has to
* Combining assets with different correlations and different understand the client’s needs.
weights will not only impact the return expectations, but * Once there is a clarity of the constraints and objectives
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also the standard deviation (risk) of the portfolio. intended by the client, it is possible to develop an
investment policy statement (IPS).
* Following the planning step, there is the execution step
Portfolios: Not Necessarily Downside Protection where the investments as per the IPS are selected.
Diversification provides risk reduction, not necessarily * Lastly, once the portfolio has been created, there is the
downside protection. It does not eliminate risk. Also, monitoring of the portfolio, which is part of the feedback
diversification benefits may vary depending on economic step.
and market cycles.

Portfolio Management Process Step One—Planning

Portfolios: The Emergence of Modern Portfolio Theory Regarding planning:
Regarding Modern Portfolio Theory (MPT):
* The first step in the portfolio management process is the
* The main idea of MPT is investors should not just group planning step.

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Reading 11+1: Portfolio Management: An Overview 132

* This is where the client’s needs—defined by objectives

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and constraints—are understood and defined. * In the feedback step is where the portfolio manager will
* Once there is clarity in the client’s requirements, the monitor and rebalance the portfolio, as well as evaluate
development of the investment policy statement (IPS) takes and report on its performance.

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place. * As markets and a client’s circumstances change, the
* Any changes in the client’s circumstances need to also be portfolio manager needs to monitor and rebalance the
addressed in the IPS. portfolio for any deviations from the intended risk and
return levels, as well as accurately evaluate and report on
the portfolio’s performance.
Portfolio Management Process Step Two—Execution

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The execution step can be broken down into three parts:
Portfolio Monitoring and Rebalancing
* Asset allocation—defines the asset classes (equity, bonds, Portfolio monitoring and rebalancing is an integral part of
cash, commodities) good portfolio management, where the portfolio manager

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* Security analysis—defines which bonds (bond X) and needs to monitor and review the client’s portfolio
which equity to buy (share Y) composition to ensure it does not deviate from the levels
* Portfolio construction—when the portfolio becomes a of risk and return agreed upon in the investment policy

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reality statement (IPS). If the client’s circumstances or market
expectations change, the IPS might need to be revisited.
This is also part of portfolio monitoring and rebalancing.
Asset Allocation
Regarding asset allocation:
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Performance Evaluation and Reporting
* Asset allocation bases its optimal distribution on Ensuring that a client’s needs are being met is a
economic and capital market expectations as defined by fundamental part of the portfolio management process
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the analyst writing the investment policy statement (IPS). that takes place in the feedback step. Whenever the
* The analysis will help assess the most appropriate asset portfolio deviates from the desired levels of risk and
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class distribution that satisfies the risk and return profile return, that might require the portfolio manager reassess
defined in the planning step of the IPS. the IPS and the portfolio itself.

Security Analysis Mutual Funds

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Regarding security analysis: Mutual funds can be broken down into:

* In the security analysis, one can combine the top-down * Open-end funds—new money and same NAV for buyers
overview with the bottom-up insights of security analysts. and sellers
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* This combination aims to identify attractive investments * Closed-end funds—no new money and NAV will vary
by using their detailed knowledge of the companies and depending on supply and demand
industries to project expected opportunities and risks that
each security offers. On top of any annual ongoing fees, funds can be load
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funds (additional fees to buy, sell, and hold shares) or

no-load funds (no fees).
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Execution: Portfolio Construction

Regarding portfolio construction:
Private Equity and Venture Capital Funds
* In the execution step, following the asset allocation and Private equity and venture capital funds are unique, as
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security analysis, comes the portfolio construction. both hold equity in private companies rather than those
* One key focus of this stage is diversification. listed in a public stock exchange. The end goal is to turn
* As seen before, the portfolio manager will avoid putting these companies around quickly and efficiently for a
all the eggs in one basket. significantly higher price than the original cost. These are
* By now, the weighting for each asset class and sector, as often formed as limited partnerships, and carry high costs
well as the weighting to each individual security, has been for the investors (limited partners).
set.
* In this part, the portfolio manager places the order to
Introduction to Portfolio Management
execute and trade on what was decided in the previous
The approach to managing a portfolio is crucial for all types
steps.
of investors in achieving their financial goals. The financial
needs of different types of individual and institutional
Portfolio Management Process Step Three—Feedback investors vary. The portfolio management process has
Regarding feedback: several steps and there are various types of investment

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Reading 11+1: Portfolio Management: An Overview 133

management products that are available to investors.

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Portfolio Diversification: Avoiding Disaster
Regarding diversification:

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* Diversification implies you are spreading away risks
through different investments, as any rational investor is
concerned with the risk-return tradeoff of their investment.
* The portfolio approach provides the framework to

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address risk without losing focus on the expected rate of
return.

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Types of Mutual Funds
Mutual funds can be broken down into several major types:

* Money markets

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* Bond mutual funds
* Stock mutual funds
* Hybrid or balanced funds re
Each type of fund has its own characteristics, such as the
main underlying asset class, the investment time horizon,
and the tax considerations.
n
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Other Investment Products

Other investment products include:

* Exchange-traded funds (ETFs)—typically index funds, also

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known as passive funds

* Separately managed account (SMA)—an exclusively
managed investment portfolio for the benefit of an
individual or institution
* Hedge funds—normally involve a considerable amount of
@

risk, derived from their complexity and extensive use of

leverage
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Reading 11+2: Basics of Portfolio Planning and Construction 134

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11+2 Basics of Portfolio Planning and Construction

Reading 11+2: Basics of Portfolio Planning and Construction

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ESG Considerations in Portfolio Planning take risk.
Environmental, Government, and Social (ESG) concerns can * Quantitative risk objectives can be absolute or relative or
limit the investment universe, but could also possibly a mix of the two.
enhance portfolio performance by reducing business risks

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that arise from poor governance. Thematic investing
Absolute vs. Relative Risk Objectives
requires a specialized manager, and some common
Absolute versus relative risk objectives:
exclusionary screened benchmarks exists for performance
measurement.

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* Absolute risk objectives state the maximum loss
acceptable in any time period.
Introduction to Basics of Portfolio Construction * Variance or standard deviation of returns and value at
Regarding portfolio planning and construction: risk are typical measures for absolute risk.

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* Relative risk objectives relate risk relative to benchmarks
* An investment adviser should first prepare the that characterize appropriate risk standards.
investment policy statement based on an individualized * Tracking risk and tracking error are typical measures for
understanding of the client’s investment objectives, relative risk.
resources, circumstances and constraints.
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* The adviser should then proceed with the portfolio
construction process, including the first step of formulating Return Objectives
Considerations of return objectives:
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a strategic asset allocation for the client consistent with the
investment policy statement.
* Return objectives specify the client’s desired return.
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* If the client wants to achieve a certain level of return, an

Investment Policy Statement (IPS) absolute return objective is used.
An investment policy statement (IPS): * Other clients may prefer relative return objectives, given
with respect to a benchmark.
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* Is written to facilitate portfolio planning in order to

achieve investment success
* Includes the client’s investment objectives (risk tolerance, Absolute vs. Relative Return Objectives
return requirements) and the constraints (liquidity, time Absolute return objectives state the minimum level of
@

horizon, regulatory requirements, legal factors, tax status, return acceptable in a given time period. Percentage rate
unique needs) that apply to the client’s portfolio of return is a typical measure of absolute return. Relative
return objectives relate return relative to benchmarks or
peer groups. Outperforming the benchmark or peer group
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Major Components of an IPS by a certain percentage return is a typical relative return

Investment policy statements (IPSs) come in different objective.
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formats. The following are major components of a typical

IPS:
Factors to Consider in Setting Return Objectives
* Risk objectives that reflect risk tolerance Regarding factors of setting return objectives:
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* Return objectives
* Potential liquidity needs * There are important factors to consider when setting
* Investment time horizon return objectives.
* Tax concerns * Returns can be nominal or real.
* Legal and regulatory restrictions * The return objective should state clearly whether the
* Unique circumstances desired return is before or after fees.
* A portfolio manager should have a conversation with the
client to make sure the return objective is realistic and
Risk Objectives
consistent with risk objectives.
Regarding risk objectives:

* Risk objectives are specifications for portfolio risk that Liquidity

reflect a client’s risk tolerance, which is a function of the Considerations of liquidity:
client’s ability to bear risk and willingness to

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Reading 11+2: Basics of Portfolio Planning and Construction 135

* Liquidity refers to the likelihood the client will need to Using Client Information to Construct an IPS Outline

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withdraw cash from the portfolio some time during the An investment policy statement (IPS) should contain an
investment time horizon. investor’s risk and return objectives, as well as liquidity,
* Such a need will require the portfolio manager to allocate time horizon, taxes, legal issues, regulatory requirements,

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some of the funds in the portfolio in liquid assets. and unique circumstances such as investment constraints.
* These assets not only have low risk, but also can be Following information gathering, an IPS outline may be
converted into cash easily. constructed.

Time Horizon

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Strategic Asset Allocation (SAA)
The investment time horizon:
Strategic asset allocation (SAA) is an integral part of
investment-portfolio construction. It is accomplished by
* Should be stated clearly in the investment policy
using the information obtained through the investment
statement

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policy statement (IPS) and capital-market expectations and
* May refer to the time period before the client will need to
choosing a mix of asset classes that expect to achieve an
take out any assets
investor’s long-term goals. The primary objective of SAA is
* May also refer to the period of time before the
to develop a mix of financial assets over the long-term that

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circumstances of the client change
can provide investors with a balance of their risk and
return.
In either case, the nature of investments in the portfolio
depends on the client’s time horizon. re
Correlation Within an Asset Class and Between Asset
Tax Concerns Classes
Taxes are a type of constraint on portfolio selection. Tax Diversifying portfolios includes correlating assets between
n
concerns and considerations differ among investors. An classes as well as within them. Correlation is the
investment portfolio should accurately reflect an investor’s relationship between two securities and how their returns
move versus one another. The coefficient, or degree of
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tax position.
relationship, ranges from +1.0 when securities are perfectly
synchronized to -1.0 when they move in opposite
Legal and Regulatory Factors directions.
The investment policy statement (IPS) incorporates legal
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and regulatory restrictions on portfolio investments.

Self-investment limits are investment level restrictions Expected Utility Maximization and SAA
imposed on some pension funds. Trading limitations may Part of the process needed to develop a strategic asset
arise from investors who may have internal company allocation (SAA) includes quantifying and summarizing
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information. investor tradeoffs between risk and return. Objectives can

be described as a utility function, where utility increases
with lower risk and higher expected returns. The allocation
Portfolio Construction
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providing the highest utility is ideal for the investor.

Regarding portfolio construction:
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* Portfolio construction may begin after the IPS is prepared.

Additional Portfolio Organizing Principles
* An asset class is an asset group with similar attributes.
There are other portfolio organization models that fully
* Strategic asset allocation is the process of weighting a
utilize active portfolio managers. With the core satellite
portfolio with class percentages acceptable by the IPS to
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model, most of the portfolio is invested in passive

achieve long-term goals.
investments. The rest is invested in a small satellite with
* Systematic risk is economic risk that cannot be diversified
aggressive management. This approach targets higher
away through portfolio management.
returns while stabilizing risk.

Capital Market Expectations

An investor’s capital market expectations (CME) are Unique Circumstances
outlooks on risk and return for each of the asset classes The IPS must include any specific restrictions or desires of
within a portfolio. These are quantified through: the client, which often arise from religious or ethical
concerns. Negative screening removes securities of firms
* Asset-class expected returns with objectionable activities. A best-in-class approach,
* Their standard deviation thematic investing, or impact investing can focus on firms
* Correlations among pairs of asset classes with positive ESG efforts.

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Reading 11+2: Basics of Portfolio Planning and Construction 136

Gathering Client Information

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Regarding the gathering of client information:

* Getting to know your client requires gathering a good

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deal of personal information.
* This information should be gathered at the beginning of a
client-investor relationship, and good record keeping of
this information is essential.

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Portfolio Construction and the Role of Asset Allocation
Taking investment plans to the construction of an actual
portfolio involves strategic asset allocation, tactical asset
allocation, and security selection with either active or

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passive management. Rebalancing is the process of
returning the portfolio back to its original risk/return
design.

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New Developments in Portfolio Management
Portfolio construction and management has changed due re
to many recent developments, including the proliferation
of ETFs, the adoption of robo-advice, and a greater desire
for shareholder engagement efforts by some investors.
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e @
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Reading 11+4: Introduction to Risk Management 137

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11+4 Introduction to Risk Management

Reading 11+4: Introduction to Risk Management

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Risk Management: Defining Risk and Managing Risk avoidance represents an opportunity cost, and risk
Exposure acceptance represents a real cost. Self-insurance and
Risk management 1) defines the risk and risk exposure for diversification are two means of mitigating risk.
maximizing utility for both the individual and the

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enterprise, and 2) manages that exposure toward goals
and objectives. The risk management framework includes Risk Transfer and Shifting

the following: Risk transfer moves risk to another party, and risk shifting
changes the distribution of risk for a party. Risk transfer is

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* Risk governance achieved through insurance, while risk shifting is achieved

* Risk identification and measurement through hedging with derivatives and contingent claims.

* Risk infrastructure
* Policies and procedures

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Choosing Methods of Modifying Risk
* Risk monitoring, mitigation, and management
The approach to risk and choice of management method
* Communications
depends on many factors and characteristics of the
* Strategic analysis or integration
enterprise or individual.
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Risk Governance: Aligning Risk Management with
Goals
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Risk governance is a top-down activity designed to align
risk management with enterprise or individual goals. Risk
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governance activities include assessing risk tolerance and

risk budgeting as risk allocation.

Identification of Risks: Financial, Nonfinancial,

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Individual, and Interactions

It is important to recognize and identify the sources of risk
in order to manage them. These include:
@

* financial risks (market, credit, and liquidity risk),

* non-financial risks (operational risk and solvency risk),
* individuals’ risks, and
* risk interaction and dependence.
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Drivers of Risk and Metrics for Measuring Risk

Common factors drive risk within a region, country,
economy, industry, company, or individual. Common
metrics are used to measure risks, including:
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* probability distributions,
* beta, delta, gamma, vega, rho,
* duration,
* value at risk (VaR), and
* credit and operational risk.

Risk Modification
Risk modification explores methods of reducing or
rebalancing risk to align with risk tolerance and goals.

Risk Acceptance and Avoidance

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Reading 11+3: The Behavioral Biases of Individuals 138

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11+3 The Behavioral Biases of Individuals

Reading 11+3: The Behavioral Biases of Individuals

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Categorizations of Behavioral Biases Framing bias is an information-processing bias where
Cognitive errors result from faulty logic and reasoning but investors answer questions differently based upon how the
can be corrected (and potentially eliminated) through question was posed. It can lead to inefficient portfolios,
better information, education, and advice. Emotional poor investment selection, and a focus on short-term

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biases result from reasoning influenced by feelings and results. The best way to overcome framing bias is to
emotions, so these biases can only be adapted to and remain neutral and focus on future gain or loss together.
adjusted for.

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Loss Aversion Bias
Conservatism Bias Loss aversion bias occurs when investors strongly prefer
Conservatism bias is a cognitive error in which people avoiding losses rather than achieving gains. Myopic loss
continue to believe a view or forecast in spite of new aversion occurs when investors choose to avoid short-term

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information. This leads to overweighting old forecasts and losses by taking less risk (typically bonds) than the optimal
underweighting new information, so forecasts are portfolio (stocks and bonds). Fundamental analysis and
maintained or slowly updated. Investors often avoid probability distributions can help investors treat loss
updating beliefs given the mental stress of complex data. aversion.
To address conservatism bias, investors should ask how
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new information changes the forecast and work to
Overconfidence Bias
acknowledge any biases revealed.
Overconfidence bias occurs when investors incorrectly
n
believe in their own intuitive reasoning, judgments, and/or
Representativeness Bias cognitive abilities. The consequences of overconfidence
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Representativeness bias occurs when people interpret new include underestimating risks, overestimating expected
information based on previous experiences or returns, holding undiversified portfolios, trading
classification. It can be broken down into base-rate neglect frequently, and lower returns. To moderate
and sample-size neglect. To overcome representativeness overconfidence, investors should perform a detailed
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bias, investors need to ask how new information impacts review of trading activity, including winners and losers.
the reality of the investment decision and ask key
questions regarding how mutual funds are selected.
Status Quo and Endowment Biases
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Status quo bias is an emotional bias where investors do

Illusion of Control Bias nothing, which can lead to maintaining risky portfolios and
An illusion of control bias occurs when investors believe failing to explore other investment opportunities. It can be
that they can control the outcome of a decision, when moderated through education, although it is difficult to
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actually, they cannot. Signs of this bias include frequently overcome. Endowment bias is an emotional bias where
trading and a lack of diversification in portfolios. The best investors give more value to the assets they hold. It’s best
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process to overcome the illusion of control bias is to moderated through questioning, education, and starting
recognize that markets are a probability game, to seek with small decisions.
contradictory viewpoints, and to retain information that led
to the decision for studying purposes.
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How Behavioral Finance Influences Market Behavior

Anomalies are abnormal returns that are somewhat
Anchoring and Adjustment Bias predictable. These don’t persist once they are identified,
Anchoring and adjustment bias is an but can regularly exist either due to sampling issues or
information-processing bias that occurs when individuals short-term equilibria that have not yet been identified.
use a psychological heuristic influence to estimate Momentum effects have been noted as one of the most
probabilities. This leads to a biased decision-making persistent anomalies in markets, likely due to availability,
process that enables investors to stick to their original hindsight, and loss aversion biases.
forecast. To overcome this, investors should ask questions
that can reveal the bias and remember that the future
Bubbles and Crashes from a Behavioral Perspective
determines the securities price.
Asset bubbles and subsequent crashes have occurred for
hundreds of years, and will continue to do so. Participants
Framing Bias don’t want to miss out on price appreciation, and also

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Reading 11+3: The Behavioral Biases of Individuals 139

suffer from confirmation bias and self-attribution bias as commission and error of omission. The signs of

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bubbles continue to inflate. Value stocks have been shown regret-aversion bias are herding and conservative
to outperform growth stocks in certain times, and investors investments given the circumstances. To moderate
may be drawn to value due to the halo effect and the home regret-aversion bias, education can be used to explain

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bias. diversification and asset allocation to reduce risk and
achieve return.

Confirmation Bias
Confirmation bias is a cognitive error where people tend to

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look for and notice what confirms their beliefs and ignore
new information that doesn’t confirm their beliefs. To
overcome confirmation bias, investors should seek out
information that challenges beliefs and find supporting
evidence for a thesis.

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Hindsight Bias

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Hindsight bias occurs when investors see past events as
predictable and reasonable with a selective ability to
perceive and retain information from the events. This
means that investors can have a false sense of confidence re
and hold asset managers to a higher level of accountability
than called for. To overcome hindsight bias, investors
should take an honest assessment of mistakes.
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Mental Accounting Bias
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Mental accounting bias occurs when investors treat equally

sized sums of money differently. Typically, this occurs
through the source or use of funds and can lead to
investors having a highly correlated portfolio or a focus on
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separate types of returns. The best way to overcome

mental accounting bias is to list all assets as a whole and
analyze assets based on total return.
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Availability Bias
Availability bias is an information-processing bias where
investors use a mental shortcut to process a probability
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outcome. In order to address availability bias, investors

should focus on appropriate strategy, research, and
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decision-making, and identify where ideas come from.

Self-Control Bias
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Self-control bias is an emotional bias that occurs when

investors fail to act in their best long-term interest and
prioritize short-term pleasure because of a lack of
discipline. This can lead to insufficient saving for the future,
and a portfolio that takes too much risk or has asset
allocation imbalances. The best approach to moderate
self-control bias is to have a written financial plan and
budget.

Regret-Aversion Bias
Regret-aversion bias is an emotional bias where investors
avoid making decisions out of fear that the decision is
wrong. The bias can be broken down into error of

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Reading 12+4: Introduction to the Global Investment Performance Standards (GIPS) 140

12+4 Introduction to the Global Investment Performance

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Standards (GIPS)
Reading 12+4: Introduction to the Global Investment Performance Standards (GIPS)

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GIPS: Why Were the GIPS Created? - Inclusion of all actual, discretionary, fee-paying portfolios
Global Investment Performance Standards (GIPS) are a in a minimum of one composite defined by investment
practitioner-driven set of ethical principles that establish a mandate, objective, or strategy to prevent choosing only
standardized, industry-wide approach for investment firms those with high performance

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to follow in calculating and presenting their historical - Reliance on the integrity of data through accurate inputs
investment results to prospective clients. GIPS were using specific calculation methods and required disclosures
created to avoid misleading practices that would make - Compliance with all GIPS, in addition to updates, guidance
comparability difficult and provide relevant information to statements, interpretations, Q&As, and clarifications

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prospective clients.

GIPS: Objectives
GIPS: Who Can Claim Compliance? Objectives of GIPS include creating an industry-wide

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Compliance with GIPS is not typically mandatory. standard for consistent investment performance, global
Investment management firms may voluntarily choose to acceptance of this standard, encouraging fair, healthy
comply with the Standards. Firms have two choices: competition, and industry self-regulation.
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- Comply with all requirements and claim compliance
through the use of the GIPS Compliance Statement GIPS: Historical Performance Record
- Not comply with all requirements, and not make any The Global Investment and Performance Standards require
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reference to the GIPS that historical performance is presented for a minimum of
five years, or for the number of years since inception if
so

fewer than five. Reporting will continue to expand for each

GIPS: Who Benefits From Compliance?
year and may include non-GIPS-compliant performance for
GIPS are beneficial to both the investment management
periods before January 1, 2000, if properly disclosed. The
firms who are meeting all requirements and claiming
GIPS are evolving, and as new provisions become effective,
compliance, and the prospective clients of these firms.
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firms must follow them.

GIPS: Use of Composites

GIPS: Standard 1. Fundamentals of Compliance
A composite is an aggregation of one or more portfolios
Fundamentals of Compliance includes adherence to the
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managed according to a similar investment mandate,

law, documentation of compliance, no claims of partial
objective, or strategy. GIPS require the use of composites.
compliance without full, firm-wide compliance on all
portfolios.
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GIPS: Verification Tests

Firms are responsible for ensuring they are maintaining
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and meeting compliance with GIPS. Firms may wish to have GIPS: Standard 2. Input Data Provisions
verification of their compliance and must hire an Input Data provisions of GIPS after 2010 include monthly
independent third party to perform a verification. The valuation at year end, and on large cash flows. Firms must
verification tests: use trade date accounting and accrual accounting. After 1
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January 2011, portfolio valuation changed from market

- Whether the investment firm has complied with all the value to fair value. After 1 January 2020, firm assets can’t
composite construction requirements of the GIPS on a include uncalled committed capital, and overlay exposure
firm-wide basis standards apply.
- Whether the firm’s policies and procedures are designed
to calculate and present performance in compliance with
GIPS: Standard 2. Calculation Methodology
the GIPS
Composite construction provisions of the GIPS Standards
requires the use of total returns, and time-weighted return
GIPS: Key Features rates that adjust for daily-weighted external cash flows,
The key features of GIPS include: using actual trading expenses. Composite returns must be
calculated by asset-weighted portfolio returns at least
- Ethical standards for investment performance to ensure monthly.
fair representation and full disclosure

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Reading 12+4: Introduction to the Global Investment Performance Standards (GIPS) 141

GIPS: Standard 3. Composite and Pooled Fund are remarkably similar to those of the composite

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Maintenance time-weighted return report. There is nothing about
Composite construction provisions of the GIPS Standards constituent portfolios since it’s a pooled fund, and there’s
require that all fee-paying, discretionary portfolios be nothing about carve-outs since that also isn’t relevant for a

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included in at least one composite, while non-discretionary pooled fund.
and simulated portfolios are excluded. Terminated
portfolios and new portfolios are included in each full
period of management, and carve-outs are excluded GIPS: Standard 7. Pooled Money-Weighted Return

unless managed separately. Report

GIPS guidelines on pooled money-weighted return reports

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are remarkably similar to those of the composite
GIPS: Disclosure money-weighted return report. There is nothing about
Disclosure in GIPS Standards allows firms to elaborate on constituent portfolios since it’s a pooled fund, and there’s
data provided, and give readers the proper context to nothing about carve-outs since that also isn’t relevant for a

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understand. Some disclosures are required for all firms pooled fund.
while other disclosures are required only in specific
circumstances. An essential disclosure is the claim of

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compliance, which can include disclosure of whether or not
the firm has been verified.

GIPS: Real Estate provisions

Various real estate provisions of GIPS exist in 2020
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Standards 2, 4, 5, 6, and 7. They include requirements of
using fair value, valuations each 12 months (or 36 months
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if approved by the client) by a professional external
appraiser, calculation of capital returns, along with an
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appropriate benchmark.

GIPS: Standard 4. Composite Time-Weighted Return

Report
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A composite time-weighted return report should show 5

years of annual data or since inception, adding years until it
reaches 10. Information on dispersion, benchmarks,
carve-outs, committed capital, gross or net of fees choice,
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and many other details are required, aside from the many
recommendations listed in the GIPS Standards.
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GIPS: Standard 8. Advertising Guidelines

GIPS advertising guidelines offer compliant ways to
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advertise performance to prospective clients, as long as

various required elements are included in any print or
electronic advertisements, and these elements get at least
the same prominence as other elements included in the
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advertisement.

GIPS: Standard 5. Composite Money-Weighted Return

Report
A composite money-weighted return report should show
annual return data since inception. Most other GIPS
requirements are similar to those for composite
time-weighed return reports, except the lack of wrap fee
language.

GIPS: Standard 6. Pooled Time-Weighted Return Report

GIPS guidelines on pooled time-weighted return reports

© Mindojo, 2023
Reading 12+5: Code of Ethics and Standards of Professional Conduct 142

12+5 Code of Ethics and Standards of Professional Con-

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duct
Reading 12+5: Code of Ethics and Standards of Professional Conduct

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Introduction to CFA Institute Code of Conduct Program pose (or be perceived to pose) a conflict of interest or
CFA Institute places a strong emphasis on ethical principles impair judgment.
surrounding the financial markets. Current CFA®
candidates and CFA® charterholders are required to

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I(C): Misrepresentation
comply with the Code of Ethics and Standards of
Misrepresentation—Guidance:
Professional Conduct.

* Members and candidates must not make any

If a candidate or member is found in violation of the Code

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misrepresentations in their professional activities, this
and Standards, the penalties can be severe, such as being
includes performance reporting, investment analysis,
prohibited from continuing to pursue the CFA® charter or
recommendations, and social media.
revocation of the CFA® charter.
* Members and candidates must not knowingly

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misrepresent, omit, or falsify information.
Code and Standards
The Code of Ethics and Standards of Professional Conduct
I(D): Misconduct
are not just outstanding moral principles that positively
impact the global financial markets; CFA® candidates and
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Misconduct—Guidance:

CFA Institute members are required to uphold the Code

* Members and candidates must not commit fraud, be
and Standards.
dishonest, deceitful, or engage in any activity that has a
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negative impact on their professional character.
The Standards of Professional Conduct are comprised of
* The standard on misconduct focuses on professional
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seven main topics:

conduct and not on members or candidates’ personal lives.

* Professionalism
* Integrity of Capital Markets II(B): Market Manipulation
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* Duties to Clients Members and candidates cannot do anything to distort

* Duties to Employers pricing or artificially influence trading volume with the
* Investment Analysis, Recommendations, and Actions intent to mislead the market participants. Market
* Conflicts of Interest manipulation includes:
* Responsibilities as a CFA Institute member or CFA®
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candidate * Disseminating incorrect or misleading information

* Engaging in transactions that distort security prices
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I(A): Knowledge of Law

Knowledge of Law—Guidance: III(B): Fair Dealing
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Clients must be dealt with fairly, objectively, and impartially

* Members and candidates are required to understand and when members and candidates:
abide by the Code and Standards, laws, rules, and
regulations governing their professional work. * Provide analysis
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* The more strict rule applies, meaning if a candidate or * Make recommendations

member works in multiple countries, the strictest law or * Take investment action
CFA Institute standard applies.
* Members and candidates should not knowingly
participate in a violation of any law, rule, or III(C): Suitability
regulation—they should dissociate if necessary. Regarding suitability, members and candidates must:

* Make a reasonable inquiry as to the client’s risk and

I(B): Independence and Objectivity return objectives
The Independence and Objectivity standard states that * Have a signed investment policy statement (IPS) in place
members and candidates have a responsibility to act with before making any recommendations or taking investment
good judgment while maintaining independence and action
objectivity relating to all professional endeavors, with a * Ensure investments are suitable to the client’s situation
focus on not accepting gifts or compensation that could and be looked at in the context of the entire portfolio

© Mindojo, 2023
Reading 12+5: Code of Ethics and Standards of Professional Conduct 143

appropriate records supporting their work. Standard V(C):

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Further, if managing a portfolio to a particular mandate, Record Retention describes the kinds of records that
strategy, or style, this must be followed. should be kept, how long they should be kept, and who
owns them.

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III(D): Performance Presentation
Members must make sure performance results are VI(A): Disclosure of Conflicts
presented in a fair, accurate, and complete manner. These Members and candidates must disclose to clients,
results should be presented in such a way that avoids prospects, and their employers anything that would impair
misrepresentation, and provides no assurance that past independence and objectivity.

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results are a guarantee of future performance.

VI(B): Priority of Transactions

III(E): Preservation of Confidentiality Investment transactions for clients always come ahead of

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Client information must be kept confidential unless illegal both employer transactions and personal transactions.
or it is required by law to disclose it.

VI(C): Referral Fees

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IV(A): Loyalty
Members and candidates must disclose referral fees
Members and candidates must always act for the benefit of
and/or benefits received to employers. clients, and
their current employer. However, if an employer were to
prospects. This includes noncash benefits like free services
ask a member or candidate to do something illegal or in
or referrals as well.
violation of the Code and Standards, then the law and/or
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Code and Standards would take precedence.
VII(A): Conduct as Participants in CFA Institute
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Programs
IV(B): Additional Compensation Arrangements
Members and candidates cannot engage in conduct that
Members and candidates are not allowed to accept any
compromises the integrity or dignity of the CFA® Exam
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gifts or benefits without written permission from their

itself, CFA Institute, or its programs.
employer. This is to avoid any conflict of interest with the
employer.
VII(B): Reference to CFA Institute, the CFA®
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Designation, and the CFA® Program

IV(C): Responsibilities of Supervisors
Members and candidates may not misrepresent or
Supervisors must make reasonable efforts to ensure their
exaggerate their membership in CFA Institute or their
employees comply with applicable laws, rules, regulations,
participation in the CFA® program.
as well as the Code and Standards.
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II(A): Material Nonpublic Information

V(A): Diligence and Reasonable Basis
Material Nonpublic Information—Guidance:
Members and candidates must be diligent, independent,
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and thorough in analysis, while making recommendations,

* Members and candidates must not act upon or cause
and when taking investment action. They must have a
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others to act upon information that has not been

reasonable and adequate basis for all of the above.
distributed publicly and could have an impact on the price
of a security.
V(B): Communication with Clients and Prospective * This standard works to uphold the integrity of the capital
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Clients markets.
Members and candidates, in communicating with clients
and prospects, must:
III(A): Loyalty, Prudence, and Care
* Disclose the basic format and principles of their The Standards of Professional Conduct regarding loyalty,
investment processes prudence, and care require members and candidates:
* Disclose any significant limitations and risks
* Use reasonable adjustment as to what are important * Always act in their clients’ best interests
investment factors * Place their clients’ interests before their own and their
* Distinguish between fact and opinion in their analysis employers’
* Provide clients with as much care, judgment, and caution
in investment decisions as they would for themselves
V(C): Record Retention
Members and candidates must develop and maintain

© Mindojo, 2023
Reading 12+1: Ethics and Trust in the Investment Profession 144

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12+1 Ethics and Trust in the Investment Profession

Reading 12+1: Ethics and Trust in the Investment Profession

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Ethics and Ethical Conflicts in the Investment
Profession
CFA Institute requires that members, candidates, and
charterholders adhere to the Code of Ethics and Standards

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of Behavior (the Code and Standards). Ethical conflicts
arise when stakeholders’ interests (including the
charterholders’) may conflict. The Code and Standards
provides guidance on ethical decision-making to

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investment professionals in the interests of the profession
and the integrity of the markets.

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Professionalism and Ethical Challenges
The investment profession works with client relationships
that rely on trust and, in turn, ethical behavior.
Overconfidence and situational influences can be
challenges to adherence to a code of ethics.
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Importance of Ethical Conduct
Ethical behavior in financial markets is especially critical
because the financial markets are inherently risky, and
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because investment professionals naturally have

informational advantages. Those factors must be
overcome with a higher level of trust in the
client-professional relationship.
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Ethical vs. Legal Standards

Laws and regulation may overlap but do not replace a
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professional code of ethical behavior.

Ethical Decision-Making Frameworks

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An effective code of ethics needs to be accompanied by a

framework for applying it to ethical decisions. An effective
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framework includes:

- identifying relevant facts and stakeholders and your

duties to them,
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- identifying situational influences and alternative sources

of guidance,
- making a decision and taking action, and
- reflecting on the consequences of your decision.

© Mindojo, 2023