I spent the better part of today and yesterday cruising through the CFA books on my weak areas: Alt Investments, Derivatives, Economics, Portfolio Management, Fixed Income, and Equity. I wrote down anything that I wasn’t solid on. I know this is last minute, but it might help someone…? ________________ Mean Variance Assumptions—assuming you know these, remember that kurtosis and skewness do not matter. **** Responses to Mean Variance Instability: 1. Constrain short selling 2. Improve the quality of statistical inputs (covariance, etc…) 3. Use a statistical concept of the efficient frontier (establish a variety of portfolios that are efficient at a given confidence level) *** Remember, 2 assets that have a “0” correlation will have a bigger “bow” on the efficient frontier than 2 assets with a “0.5” correlation. 2 assets with a “-1.0” will extend all the way to the y-axis. A “+1.0” correlation is simply a straight line between the 2 assets. *** Macroeconomic models – intercept is the expected return Fundamental (microeconomic) models – intercept is simply a regression estimate when coefficients are standardized, when they are not standardized the intercept is the riskfree rate. Standardizing a coefficient is simply: (Value – Average Value / Standard Deviation of the Values) Statistical factor model – there are 2: Factor analysis models (factors are portfolios that explain historical return COVARIANCES) and Principal component models (factors are portfolios that explain historical return VARIANCES) *** Active Risk Squared = Active Factor Risk plus Active Specific Risk = variance(Return portfolio – Return benchmark) Factor Marginal Contribution to Active Risk (FMCAR) = Sum of Covariances of the factors / Active Risk Squared *** _______________ *** Fixed Income Particulars… *** CMBS Call Protection: 1. prepayment lockout 2. defeasance (invest prepayments in Treasuries) 3. prepayment penalty points 4. yield maintenance charges (“make lender whole” clause) *** Downgrade Watch – decrease 2 notches Negative outlook – decrease 1 notch Stable outlook – maintain current debt rating Positive outlook – increase 1 notch Upgrade watch – increase 2 notches *** Credit Risk Models 1. Structural – default is driven by the firm’s asset values 2. Reduced Form – model tests the probability of a downgrade *** Modified Duration and convexity – don’t allow for the fact that cashflows from a bond w/ an embedded option may change due to optionality Effective Duration and convesity – do allow for the above *** Non-accelerating Tranche (NAS) 1. receives principal payments according to a schedule 2. average life is STABLE, less contraction risk *** AUTO ABS ISSUERS 1. financial subsidiaries of auto manufacturers 2. commercial banks 3. independent finance companies & small financial institutions *** CDO Debt 1. hi yield corporates 2. emerging market debt 3. structured finance products 4. bank loans 5. special situations and distressed debt *** Excess servicing spread 1. EXAMPLE: The ABS issuer receives 10% on the debt, and pays out 9%, holding back 1% (less the servicing fee) to cover potential defaults or principal loss *** Clean-up Call 1. If the collateral in an ABS (like a credit card ABS) falls below a certain level, instead of using cashflows during lockout period to purchase new, additional collateral, the cashflows will be redirected (yes, even in a lockout period) to pay down principal balances) *** ____________________ *** Private Equity terms 1. Ratchet – determines equity allocation between owners and management, can be increased if firm outperforms… 2. Hurdle Rate – rate the GP must achieve before he gets any carried interest 3. Keyman clause – well isn’t this politically incorrect? Anyhow, if a “key” executive leaves the firm the GP has invested private equity funds in, the GP can’t make any new investments until another “key” executive fills the slot… 4. No-fault divorce – GP may be removed if 75% (supermajority) of LPs vote to remove him 5. Removal for cause – if GP does something illegal, it doesn’t take a supermajority to remove him 6. Co-investing – LPs may invest with GP, often at low or no fees 7. Tag along Drag along – any potential acquirer must offer to buy all owners/managers out if he wants to buy majority position *** ___________________ *** Ethics: Research Objectivity Standards 1. When speaking before a public audience, suitability requires that you inform the audience about the suitability of the specific stock/investment in light of particular, unique, personalized circumstances 2. Firms must use 3-dimensional systems in their research report: (1) recommendation categories (2) time horizon categories and (3) risk categories 3. A firm which has a research dept conducting research on a specific company, and is ALSO working with the company on its investment banking side must disclose in its research report the compensation from the investment banking relationship from the last 12 months AND the expected compensation over the next 3 months… 4 Covered employees should not be allowed to purchase stock in a firm covered by an upcoming research report within 5 calendar days of the date of issuance, and should be prohibited from selling the stock within 60 calendar days of report issuance. You can sell in case of financial hardship. *** __________________ *** EQUITY MISCELLANY *** Adjusting Financial Statements for NOPAT calculations (think Residual Income, Economic Profit, EVA) 1. Capitalise and amortise R&D 2. Capitalise goodwill 3. Only consider cash taxes paid in NOPAT calculation 4. Add increase in LIFO reservce to NOPAT, add LIFO reserve to assets (gets the firm to reflect 5. Capitalise operating leases and adjust nonrecurring items *** Net Borrowing using Debt Ratios: NB = DR(FCinv – D) + DR(WCinv) *** Molodovsky affect: many firms exhibit high P/E ratios at the top of the biz cycle, and low P/E ratios at the bottom of the biz cycle….this is why we NORMALIZE earnings… *** In estimating Enterprise Value, if the market value of Debt is not available, use a price matrix estimate before you use book values. *** Justified Price-to-Book multiple can also be calculated as: 1 + Present Value of Excess Earnings/Book Value Note that the numerator is like Market Value Added, which is the PV of Economic Value Added (aka Economic Profit) *** SGR = ROE x B —> this assumes that the capital structure does not change, debt and equity both grow at the SGR, no new equity issuances, and the firm grows only by reinvested earnings… The “dividend displacement of earnings” states that increasing the payout ratio actually DECREASES the future growth rate of dividends because that if a function of the SGR which is a function of the retention rate…this is also a drawback to using Justified Dividend Yield models… *** ____________________ *** Private Company Valuation *** Valuation approaches: 1. Income approach (DCF) 2. Market Approach (price multiples) 3. Asset based approach (good for liquidation) *** Valuation Models 1. FCF Models – use for 2 stage + growth rates 2. Capitalized Cashflow Model – values the firm as a perpetuity: FCFF/WACC-g 3. Excess Earnings Method – IMPORTANT: Estimates the value of intangible assets by capitalizing future earnings in excess of the required return on WORKING CAPITAL and FIXED ASSETS. Add the PV of this estimation to the current WORKING CAPITAL and FIXED ASSETS values and you get total private firm value. *** Guideline Public Co Method – use for minority ownership; estimates firm value using comparable public firm price multiples Guideline Transaction Method – use for controlling ownership, estimates firm value using comparable public price multiples relating to sales of entire companies only Prior Transaction Method – considers prior sales of private firm’s stock *** ____________________ *** Economics *** Asset Market Approach 1. rejects the idea that currency values are determined by trade flows 2. only news about future events will affect the exchange rate 3. long run prices determined by PPP; short run determined by Uncovered IRP *** GDP – all economic activity in one country, regardless who owns the assets GNI – total incomes earned by a country’s residents, regardless where they are located *** Steady State Growth Theory (think about whether capital is subject to diminishing returns or not) – no change in capital per capita, this is linked to Endogenous (New Growth) Theory which says capital is NOT subject to diminishing returns, but Neoclassical Growth Theory says it IS… *** Quantity of US Currency demanded (supplied) relies upon: 1. exchange rate (same) 2. world demand for US exports (world demand for US imports) 3. domestic interest rates compared to other country’s (same) 4. expected future exchange rate (same) *** Exchange rate influences quantity demanded (supplied) for 2 reasons: 1. Exports affect – larger the value of exports, more domestic currency demanded (Imports affect – larger the value of imports, more domestic currency supplied in purchasing them) 2. expected profit affect (same) *** Demand (Supply) for US currency increases if: 1. world demand for US exports increase (world demand for US imports increase) 2. US interest rate differential increases (US interest rate differential decreases) NOTE—In this particular case, when the US interest rate differential increases, the US interest rate is increasing over foreign interest rates—do not get this confused with IRP which states that the country with the higher of the 2 interest rates will experience a currency depreciation… 3. expected future exchange rate increases (expected future exchange rate decrease) *** Factors affecting Bid-Ask Spread 1. Market Volatility/Conditions 2. Trading Volumes ***Dealer/Bank positions do not affect the bid-ask spread, if they have too much of a currency, they will adjust the midpoint downwards so they can buy less and sell more of the subject currency… *** Covered Interest Rate Parity If this formula does not hold, purchase the currency on the side with the lowest number… 1 + DC rate = (1 + FC rate)(Forward) / Spot 1. Purchase the currency on the side with the lowest number (the arbitrage amount is simply the difference between the two numbers, SCALED for the days/360 multiplied by the notional principal). Remember to pay the riskfree rate as interest on the currency purchased. 2. Convert the currency to other currency (FC -> DC or DC -> FC) and invest at the respective risk free rate. Purchase a forward to repatriate the currency back at the end of the contract. Pay off the loan plus interest, and keep arb profits. *** DONE.
Nice.
In estimating Enterprise Value, if the market value of Debt is not available, use a price matrix estimate before you use book values. Whats a price matrix estimate of book value? btw You have an error in New growth theory. Knowledge capital does not have diminishing returns in new growth theory. All monetary capital investment s have diminishing returns
Matrix prices are debt prices estimated from regression models somewhat similar to fundamental factor models. All the major data vendors provide them (e.g. BBG).
Totally helpful for me. I can’t thank you enough. Wish you all the best.
Thank you. You’re very generous for posting this.
sweet, thank!
FYI, Defeasance is #1.
nope text says prepayment lockout is #1
This is awesome! Thanks! BTW what is Factor Marginal Contribution to Active Risk (FMCAR). What page in Schweser is this?!?!
It is in CFAI books. Check the chapter on portfolio concepts twards the end on active factor risk and such crap.
This is why I don’t read Schweser.
Why so much talk of NAS tranches this year?