All CFA Institute members and candidates are required to comply with the Code and Standards Basic structure for enforcing the Code and Standards
The CFA Institute Bylaws Based on two primary principles
Rules of Procedure
Fair process to member and candidate Confidentiality of proceedings
Maintains oversight and responsibility The CFA Institute Board of Governors
Structure of the CFA Institute Professional Conduct Program
Professional Conduct program (PCP) The CFA Designated Officer
Is responsible for the enforcement of the Code and Standards
Through the Disciplinary Review Committee (DRC)
Directs professional conduct staff
Conducts professional conduct inquiries
Selfdisclosure An inquiry can be prompted by several circumstances
Written complaints Evidence of misconduct Report by a CFA exam proctor Analysis of exam materials and monitoring of social media by CFA Insitute
a.
The Professional Conduct staff conducts an investigation that may include
Requesting a written explanation from the member or candidate The member or candidate Interviewing
Complaining parties Third parties
Collecting documents and records in support of its investigation
1. Code Of Ethics And Standards Of Professional Conduct
Conclude the inquiry with no disciplinary sanction
Process for the enforcement of the Code and Standards
When an inquiry is initiated
Issue a cautionary letter If finding that a violation of the Code and Standards occurred, the Designated Officer proposes a disciplinary sanction
Upon reviewing the material obtained during the investigation, the Designated Officer may Continue proceedings to discipline the member or candidate
Rejected by member
Integrity of investment profession & interest of clients above personal interest
Six components of the Code of Ethics
Care & judgment Practice ethics & encourage others to practice Integrity & viability of the global capital markets Professional competence
b,c.
Professionalism Integrity of Capital markets Duties of Clients
Seven Standards of Professional Conduct
Duties to Employers Investment analysis, Recommendations & Actions Conflict of interest Responsibilities as a CFA Institute member or CFA Candidate
1. Code Of Ethics And Standards Of Professional Conduct - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
The matter is referred to a hearing by a panel of CFA Institute members
condemnation by the member's peers If sanction is imposed
Act with integrity, competence, diligence, respect and in an ethical manner
Accepted by member
suspension of candidate's continued participant in the CFA program
Understand and comply with applicable laws and regulations Code and Standards vs. Local law
Follow stricter law and regulation
Responsible for violations in which they knowingly participate or assist Dissociate from illegal, unethical activities
Guidance
Leave employers (in extreme case) Attempt to stop the behavior by bringing it to the attention of employer through a supervisor or compliance department
Participation or association with violations by others
May consider directly confronting the involved individuals
Intermediate steps
If not successful,--> step away and dissociate from the activity by
Removing their name from written reports Asking for a different assignment
Inaction with continued association may be construed as knowing participation
A. Knowledge of the law
Not required reporting violations to government, CFAI, but advisable in some cases or required by laws in others Stay informed Review procedures Members and candidates
Maintain current files When in doubt, seek advice of compliance personnel or legal counsel When dissociating from violations, --> Document any violations and urge firms to stop them
Recommended procedures for compliance (RPC)
Develop and/or adopt a code of ethics Firms
Make available to employees info that highlights applicable laws and regulations Establish written procedures for reporting suspected violation of laws, regulations or company policies
Application Maintain independence and objectivity in professional activities
External pressures
By benefits
Gifts, Invitations to lavish functions, Tickets, Favors, Job referrals, Allocation of shares in oversubscribed IPOs...
May try to pressure sellside analysts
From Buyside clients From their own firms Internal pressures How to cope with external and internal pressures
To issue favorable reports
From public companies
e.g. to issue favorable research reports/ recommendations for certain companies to issue favorable research on current or prospective investmentbanking clients
Investmentbanking relationships
Conflicts of interest
Modest gifts and entertainment are acceptable but special care must be taken
must disclose to employers
Best practice: reject any offer of gifts, threatening independence and objectivity
Guidance
convey true opinions -->
Recommendations must
B. Independence and objectivity
free of bias from pressures be stated in clear and unambiguous language
Portfolio managers must respect and foster honesty of sellside research Is fraught with conflicts
2.1 Standard I PROFESSIONALISM
Must engage in thorough, independent, and unbiased analysis Must fully disclose potential conflicts, including the nature of compensation Issuerpaid research
Must strictly limit the type of compensation they accept for conducting research
Analysts
Accept only flat fee for their work prior to writing the report Best practice
Without regard to conclusions or recommendations
Protect integrity of opinions Create a restricted list Restrict special cost arrangements Limit gifts
RPC
Equity IPOs
Restrict employee investments
Private placements
Review procedures Written policies on independence and objectivity of research Definition of "Misrepresentation"
any untrue statement or omission of a fact or any false or misleading statement
Must not knowingly make misrepresentation or give false impression in
oral representations, advertising electronic communications written materials qualifications or credentials, services performance record
Guidance
Must not misrepresent any aspect of practice, including
Without regard to conclusions or recommendations characteristics of an investment any misrepresentation relating to member's professional activities
C. Misrepresentation
Must not guarantee clients specific return on investments that are inherently volatile Standard I(C) prohibits plagiarism in preparation of material for distribution to employers, associates, clients, prospects, general publish Written list of available services, description of firm's qualification Designate employees to speak on behalf of firm
RPC
Prepare summary of qualifications and experience, list of services capable of performing Maintain copies To avoid plagiarism
Attribute quotations Attribute summaries
Address conduct related to professional life Any act involving lying, cheating, stealing, other dishonest conduct that reflects adversely on member's professional activities would be violation
Guidance
D. Misconduct
Violations
Conduct damaging trustworthiness or competence (include behaviour may not be illegal but negatively affect a member to perform responsibility such as abusing alcohol during lunch hours) Abuse of the CFA Institute Professional Conduct Program Involved in personal bankruptcy is not automatically assumed to be in violation but bankruptcy involve fraudulent or deceitful business conduct may be a violation
Develop and/or adopt a code of ethics
RPC
Disseminate to all employee a list of potential violations Check references of potential employees
2.1 Standard I PROFESSIONALISM - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
its significant impact to the price of security if it is disclosed
Definition of "Material nonpublic information"
The reliability of the information Non-public until
Guidance
Reasonable investors would like to know for making decision
Material information
disseminated to the market place and effficient time for investors to react
Must be particularly aware of info selectively disclosed by corporations Analysis of Public info + nonmaterial nonpublic info --> Investment conclusion Mosaic Theory
Analysts are free to act on this collection of info without risking violation Analysts should save and document all their research
A. Material non-public information (MNI)
Make reasonable efforts to achieve public dissemination of material info Must communicate the info only to the designated supervisory and compliance personnel within the firm
If public dissemination is not possible,
Must not take investment action on the basis of the info
Must not knowingly engage in conduct inducing insiders to privately disclose MNI
2.2 Standard II INTEGRITY OF CAPITAL MARKETS
adopt compliance procedures preventing misuse of MNI
RPC Encourage firms to
develop & follow disclosure policies to ensure proper dissemination use "firewall"
Prohibition of all proprietary trading while firm is in possession of MNI may be inappropriate
Definition
Distort prices or artificially inflate trading volume with the intent to mislead market participants
transactions that deceive market participants
B. Market manipulation
can be related to dissemination of false or misleading info
Transactions that artificially distort prices or volume Securing a controlling, dominant position in a financial instrument to exploit and manipulate price of a related derivative/or underlying asset including spreading false rumors to induce trading by others
prohibit legitimate trading strategies
Standard II(B) not meant to
prohibit transactions done for tax purposes
The intent of action is critical to determining whether it is a violation of this Standard 2.2 Standard II INTEGRITY OF CAPITAL MARKETS - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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Describe limitations of regression analysis
A sample covariance, a sample correlation coefficient and a scatter plot Describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and calculate and interpret the F-statistic
Limitation to correlation analysis
Calculate and interpret a confidence interval for the predicted value of the dependent variable
Calculate the predicted value for the dependent variable, given an estimated regression model and a value for the independent variable
Formulate a null and alternative hypothesis about a population value of a regression coefficient and determine the appropriate test statistic and whether the null hypothesis is rejected at a given level of significance
Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient
9. Correlation and Regression - An Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
Uses of correlation Analysis
9. Correlation and Regression - An Overview
Formulate a test of the hypothesis that the population correlation coefficient equals zero and determine whether the hypothesis is rejected at a given level of significance
Distinguish between the dependent and independent variables in a linear regression
Describe the assumptions underlying linear regression and interpret regression coefficient
A graph that shows the relationship between the observations for two data series in two dimensions
Scatter Plots
Each observation in the scatter plot is represented as a point, and the points are not connected The scatter shows only the actual observation of both data series plotted as pairs Correlation analysis expresses the same relationship (between two data series) using a single number The correlation coefficient measures the direction and extent of linear association between two variables A correlation coefficient less than 0 indicates a negative linear association
A sample covariance, a sample correlation coefficient and a scatter plot
Correlation Analysis
A correlation coefficient can have a maximum value of 1 and a minimum value of -1
A correlation coefficient greater than 0 indicates a positive linear association A scatter plot of two variables with a correlation of 0; they have no linear relation -> the value of A tells us nothing about the value of B
The sample covariance of X and Y, for a sample of size n
Calculate the Correlation Coefficient
The expression for the sample variance of X, is
The sample correlation coefficient
9. Correlation and Regression - Part 1
Correlation may be an unreliable measure when
Two variables can have a strong nonlinear relation and still have a very low correlation
Limitation to correlation analysis
Outliers are present in one or both of the series. Outliers are small numbers of observations at either extreme (small or large) of a sample correlation between two variables that reflects chance relationship in a particular data set correlation induced by a calculation that mixes each of two variables with a third
Spurious correlation
correlation between two variables arising not from a direct relation between them but from their relation to a third variable
In investment decision-making (for example: inflation forecast)
Uses of correlation Analysis
Correlation of stock market tells us how successfully the assets can be combined to diversify risk Used in a financial statement setting H0: the correlation in the population is 0 (p = 0) Ha : the correlation in the population is different from 0 (p # 0)
Formulate a test of the hypothesis that the population correlation coefficient equals zero and determine whether the hypothesis is rejected at a given level of significance
The formula for the t-test
This test statistic has a t-distribution with n-2 degrees of freedom if the null hypothesis is true
Sampling from the same population, a false null hypothesis H0: is more likely to be rejected as we increase sample size. The result whether H0 is rejected also depends on significance level
Distinguish between the dependent and independent variables in a linear regression
9. Correlation and Regression - Part 1.mmap - 4/28/2016 - Mindjet
Linear regression with one independent variable (or simple linear regression) models the relationship between two variables as a straight line Linear regression provides a simple model for forecasting the value of one variable, known as the dependent variable, given the value of the second variable, known as the independent variable
b0, b1 are the regression coefficients
Y: dependent variable X: independent variable b0: the intercept b1: a slope coefficient
Slope coefficient
The estimated slope coefficient is interpreted as the change in the dependent variable for a 1-unit change in the independent variable
The regression equation
The intercept term
The intercept is an estimate of the dependent variable when the independent variable takes on a value of zero
error term (represents the portion of the dependent variable that cannot be explained by the independent variable The X is and The
Describe the assumptions underlying linear regression and interpret regression coefficient
relationship between the dependent variable, Y, and the independent variable, linear in the parameter b0 and b1. b0 and b1 are raised to the first power only that neither b0 nor b1 is multiplied or divided by another (for example, b0/b1). requirement does not exclude X from being raised to a power other than 1
Critical for a valid linear regression. If the relationship between the independent and dependent variables is nonlinear in the parameters, then estimating that relation with a linear regression model will produce invalid results
The independent variable, X, is not random Ensure that linear regression produces the correct estimates
The expected value of the error term is 0 Six classic normal linear regression model assumptions
The variance of the error term is the same for all observations:
The error term is uncorrelated across observations. Consequently, E(ei,j) = 0 for all i not equal to j.
use the linear regression model to determine the distribution of the estimated parameters and and thus test whether those coefficients have a particular value
The error term is normally distributed
Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient
The formula for the standard error of estimate (SEE) for a linear regression model with one independent variable is
The different between the actual and predicted values of the dependent variable is the regression residual
defined as the percentage of the total variation in the dependent variable explained by the independent variable The coefficient of determination (R^2)
R^2 = r^2 for a regression with one independent variable Confidence interval spans the range
Regression coefficient confidence interval A confidence interval is an interval of values that we believe includes the true parameter value, , with a given degree of confidence
the estimated parameter value A hypothesis test using the confidence interval approach if we know
9. Correlation and Regression - Part 2
Formulate a null and alternative hypothesis about a population value of a regression coefficient and determine the appropriate test statistic and whether the null hypothesis is rejected at a given level of significance
the hypothesized value b0 or b1 a confidence interval around the estimated parameter
In practice, the most common way to test a hypothesis using a regression model is with a t-test of significance. To test the hypothesis, we can compute the statistic
This test statistic has a t-distribution with n-2 degrees of freedom. Reject H0 if t> +tcritical or t <-tcritical The appropriate test structure for the null and alternative hypothesis: H0: b1 = 0 versus Ha: b1 # 0
Calculate the predicted value for the dependent variable, given an estimated regression model and a value for the independent variable
If we know
Where sf = standard eror of the forecast
The prediction interval for a regression equation for a particular predicted value of the dependent variable Y
Calculate and interpret a confidence interval for the predicted value of the dependent variable
tc is two-tailed critical t-value at the desired level of significance with df = n-2
variance of the residuals = the square of the standard error of estimate
The formula to calculate sf
variance of the independent variable X
value of the independent variable for which the forecast was made
Analysis of variance (ANOVA) is a statistical procedure for dividing the total variability of a variable into components that can be attributed to different sources Use ANOVA to determine the usefulness of the independent variable or variables in explaining variation in the dependent variable The F-test tests whether all the slope coefficients in a linear regression are equal to 0 The null hypothesis H0: b1 =0 The alternative hypothesis Ha: b1 # 1
SSE (The sum of squared errors or residuals)
Describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and calculate and interpret the F-statistic
Formula for the F-statistic in a regression with one independent variable is
RSS (The regression sum of squares)
TSS = SSE + RSS If there are n observations, the F-test for the null hypothesis that the slope coefficient is equal to 0 is hear denoted
Calculate R^2 and SEE
Describe limitations of regression analysis
Regression relations can change over time-> the issue of parameter instability Public knowledge of regression relationships may negate their future usefulness If the regression assumptions are violated, hypothesis tests and predictions based on linear regression will not be valid
9. Correlation and Regression - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
Introduction
29. Equity Valuation: Applications and Processes An Overview
Value Definition and Valuation Applications
Communicating Valuation Results
The Valuation Process
29. Equity Valuation. Applications and Processes - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
Valuation
The estimation of an asset’s value based on variables perceived to be related to future investment returns, on comparisons with similar assets, or on estimates of immediate liquidation proceeds What is value?
Introduction
Who uses equity valuations? Basic questions
What is the importance of industry knowledge? How can the analyst effectively communicate his analysis? The value of the asset given a hypothetically complete understanding of the asset’s investment characteristics Reflects investor's view of the “true” or “real” value of an asset Market price and intrinsic value are identical Grossman-Stiglitz paradox
Investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative of accepting the market price
Rational efficient markets formulation Common stock Trading costs exist
Difficult to determine especially
Further room exists for price to diverge from value
Seek to identify mispricing
Analysts often view market prices both with respect and with skepticism
A difference between the estimated intrinsic value and the market price of an asset
Rely on price eventually converging to intrinsic value Recognize distinctions among the levels of market efficiency or tiers of markets
Intrinsic Value
Uncertainty is constantly present
Valuation is an inherent part to attempt positive excess risk adjusted returns (abnormal return or alpha)
Revaluate by looking for the presence of a particular market or corporate event ( catalyst)
The error in the estimate of the intrinsic value
(V E -V): the difference between the valuation estimate and the true but unobservable intrinsic value
VE = estimated value V E - P = (V - P) + ( V E - V)
P = market price V = intrinsic value
Definition
Contribute to the abnormal return
(V-P): the true mispricing, the difference between the true but unobservable intrinsic value V and the observed market price P
Combine accurate forecasts and appropriate valuation model
A useful estimate of intrinsic value
Active security selection
Manager’s expectations must differ from consensus expectations and be correct
Expectational inputs used in valuation models
The assumption that the company will continue its business activities into the foreseeable future
accessing its optimal sources of financing not appropriate for a company in financial distress
Going-concern assumption Value Definition and Valuation Applications
value maximizing using assets
The value added by assets working together and by human capital applied to managing those assets makes estimated goingconcern value greater than liquidation value
Going-Concern Value and Liquidation Value
Orderly liquidation value Liquidation value Different time frame for liquidating causes different assets value of a company is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell includes an assumption that both buyer and seller are informed of all material aspects of the underlying investment
Fair market value
often used in valuation related to assessing taxes
Fair Market Value and Investment Value
The concept of value to a specific buyer taking account of potential synergies and based on the investor’s requirements and expectations
Investment value Selecting stocks
Primary use evaluate the reasonableness of the expectations
Inferring (extracting ) market expectations
A merger
as a benchmark or comparison value of the same characteristic for another company the general term for the combination of two companies a combination of two companies, with one of the companies identified as the acquirer, the other the acquired
An acquisition
29. Equity Valuation: Applications and Processes - Part 1
Evaluating corporate events
the company separates one of its component businesses and transfers the ownership of the separated business to its shareholders
A leveraged buyout
Rendering fairness opinions
affects a company’s future cash flows -> equity
a company sells some major component of its business
A divestiture
A spin-off
Valuation Applications
the acquiring company’s own common stock is often used as currency for the purchase
an acquisition involving significant leverage [i.e., debt], which is often collateralized by the assets of the company being acquired.)
The parties to a merger may be required to seek a fairness opinion on the terms of the merger from a third party, such as an investment bank
Evaluating business strategies and models
Companies concerned with maximizing shareholder value evaluate the effect of alternative strategies on share value
Communicating with analysts and shareholders Appraising private businesses
for transactional purposes
E.g acquisitions or buy-sell agreements for the transfer of equity interests among owners when one of them dies or retires, IPO,...
Sharebased payment (compensation) the basis for computing the target When a research report states a target price for a stock, it should clarify
information on the uncertainty of reaching the target a time frame for reaching the target An update on the company’s financial and operating results
Kind of infor. intended readers seek to gain
Sell-side analyst’s report: investment recommendation
Persuasive supporting arguments
The intrinsic value of the security
The key assumptions and expectations underlying that estimated intrinsic value
A description of relevant aspects of the current macroeconomic and industry context An analysis and forecast for the industry and company Detailed historical descriptive statistics about the industry and company
May be accompanied by an explanation of the underlying rationale Specific forecasts Contents of a Research Report
A description of the valuation model Usual contents
Key valuation inputs A discussion of qualitative factors and other considerations that affect valuation Objectively address the uncertainty associated with investing in the security, and/or the valuation inputs involving the greatest amount of uncertainty Contains timely information is written in clear, incisive language is objective and well researched, with key assumptions clearly identified
An effective research report
Communicating Valuation Results
distinguishes clearly between facts and opinions contains analysis, forecasts, valuation, and a recommendation that are internally consistent
The requirements are more specific in some situations. For e.g, regulations governing disclosures of conflicts and potential conflicts of interest vary across countries, investment recommendations are affected by policies of the firm employing an analyst
presents sufficient information to allow a reader to critique the valuation states the key risk factors involved in an investment in the company discloses any potential conflicts of interests faced by the analyst
Format of a Research Report All analysts have an obligation to provide substantive and meaningful content in a clear and comprehensive report format
Analysts who are CFA Institute members, however, have an additional and overriding responsibility to adhere to the Code of Ethics and the Standards of Professional Conduct in all activities pertaining to their research reports
Research Reporting Responsibilities The analyst must hold himself accountable to both standards of competence and standards of conduct
29. Equity Valuation. Applications and Processes - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
Sell-side analyst: Analysts who work at brokerage firms Investment discipline (security selection) and quantitative investment disciplines
Valuation judgments to distribute to current and prospective retail and institutional brokerage clients is to understand the basic characteristics of the markets served by a company and the economics of the company
Valuation judgments to a portfolio manager or to an investment committee as input to an investment decision
Buy-side analysts
The purposes and the intended consumer of the valuation
Both corporate analysts and investment bank analysts may also identify and value companies that could become acquisition targets
give appropriate attention to the most important economic drivers of a business Usefulness
Applying the Valuation Conclusion: The Analyst’s Role and Responsibilities
to organize thoughts about an industry and to better understand a company’s prospects for success in competition with other companies in that industry to highlight the greatest challenges and opportunities
How attractive are the industries in which the company operates, in terms of offering prospects for sustained profitability
Analysts at independent vendors of financial information usually offer valuation information and opinions in publicly distributed research reports Help their clients achieve their investment objectives Investment analysts play a critical role in collecting, organizing, analyzing, and communicating corporate information, and in some contexts, recommending appropriate investment actions based on sound analysis
Benefit the suppliers of capital, including shareholders, when they are effective monitors of management’s performance E.g when assess how a change in assumptions about a company’s future growth or analyze how different competitive responses would affect the forecasted financials and the estimated valuation
to determine how changes in an assumed input would affect the outcome
the value of a stock investment the value of nonpublicly traded stocks
Industry and Competitive Analysis
How is a useful framework? Focus on these questions
Sensitivity analysis
lack of marketability discounts
Two important aspects
Converting Forecasts to a Valuation
Need sensitivity analysis
Analysis of Financial Reports
Sources of Information
Historical analysis to have its insights through time
Looking annual reports for 10, 5, 2 years prior
importance of qualitative (non-numeric factors) avoid simply extrapolating past operating results when forecasting future performance
Financial ratio analysis is useful for established companies Individual drivers of profitability for merchandising and manufacturing companies can be evaluated against the company’s stated strategic objectives
Be aware when regulations (e.g., Regulation FD in the United States) prohibit companies from disclosing material nonpublic information to analysts without also disseminating that information to the public The scrutiny of all financial statements, including the balance sheet, to evaluate both the sustainability of the companies’ performance and how accurately the reported information reflects economic reality
Also require careful scrutiny of accounting statements, footnotes, and other relevant disclosure
Equity analysts: develop better insights into a company and improve forecast accuracy Quality of earnings analysis
The fundamental approach to equity valuation
Sustainability of performance: identify aspects of reported nonrecurring performance Identify reporting decisions that may result in a level of reported earnings that are unlikely to continue
Present value models (discounted CF models)
comparison of a company’s net income with its operating cash flow
Poor quality of accounting disclosures, such as segment information, acquisitions, accounting policies and assumptions, and a lack of discussion of negative factors.
Understanding the business
Absolute Valuation Models
Existence of relatedparty transactions
Greater uncertainty than the case with bonds due to
Existence of excessive officer, employee, or director loans
29. Equity Valuation: Applications and Processes Part 2: The Valuation Process
A stream of cash payments specified in a legal contract (the bond indenture) Not as uncertain as common stock
High management or director turnover Excessive pressure on company personnel to make revenue or earnings targets, particularly when combined with a dominant, aggressive management team or individual
A working selection of risk factors (AICPA 2002) (in case growth in an asset account at a much faster rate than the growth rate of sales
Applied to bond valuation
Material non-audit services performed by audit firm Reported (through regulatory filings) disputes with and/or changes in auditors Management and/or directors’ compensation tied to profitability or stock price (through ownership or compensation plans). Although such arrangements are usually desirable, they can be a risk factor for aggressive financial reporting.
Values a company on the basis of the market value of the assets or resources it controls
Can provide an independent estimate of value
Analyzing the company’s financial report to evaluate the company's strategic objectives' performances and develop expectations to it
Regulatory requirements concerning disclosures and filings vary internationally
Def. a model that specifies an asset’s intrinsic value
For common stock: Dividend discount models
A discount rate can usually be based on market interest rates and bond ratings
The term “business model” refers generally to how a company makes money
Analysts can compare the information provided directly by companies to their own independent research
Analysts frequently define cash flows at the company level
Residual income model
need to address other issues, such as the value of corporate control or the value of unused assets
Differentiation Focus
most relevant for evaluating a company’s success in implementing strategic choices
illiquidity discounts
Free cash flow to equity model
its CFs and discount rate
Cost leadership Corporate strategies
2 caveats merit mention
The value of an asset to an investor must be related to the returns that investor expects to receive from holding that asset.
Based on accrual accounting earnings in excess of the opportunity cost of generating those earnings
The level and trend of the company’s market share indicate its relative competitive position within an industry
How well has the company executed its strategy and what are its prospects for future execution
blockage factor
used to produce an estimate of value that can be compared with the asset’s market price
Free cash flow to the firm
Porter 5 forces
Situational adjustments
an investor wishes to sell an amount of stock that is large relative to that stock’s trading volume (assuming it is not large enough to constitute a controlling ownership)
Defines cash flows before those payments
Use various frameworks
What is the company’s relative competitive position within its industry, and what is its competitive strategy
control premiums
the prices of shares with less depth to their markets
Defines cash flow net of payments to providers of debt
Try to understand the industry structure Stay current on facts and news concerning all the industries
Contribute to the efficient functioning of capital markets
The price that would be lower than the market price for a smaller amount of stock
need more sensitivity analysis ?
Economic, industry, or companyspecific pressures on profitability, such as loss of market share or declining margins
Asset- based valuation
Management pressure to meet debt covenants or earnings expectations
Underlying idea: similar assets should sell at similar prices Undervalue
P/E
Relatively undervalue
A history of securities law violations, reporting violations, or persistent late filings
Def. estimate an asset’s value relative to that of another asset
ratios of stock price to a fundamental such as cash flow per share
Considerations in Using Accounting Information
using price multiples How?
ratios of the total value of common stock and debt net of cash and shortterm investments to certain of a company’s operating assets to a fundamental such as operating earnings
enterprise multiples
The more conservative investing strategies involve overweighting (underweighting) relatively undervalued (overvalued) assets, with reference to benchmark weights Pairs trading: buying the relatively undervalued stock and selling short the relatively overvalued stock
Relative value investing (or relative spread investing, if using implied discount factors)
does not specify intrinsic value without making the further assumption that the comparison asset is fairly valued
being simple, related to market prices, and grounded in a sound economic principle Breakup value or private market value
The more aggressive strategies allow short selling of perceived overvalued assets
The method of comparables is characterized by a wide range of possible implementation choices
The value derived using a sum-of-the-parts valuation
Selecting the Appropriate Valuation Model Relative Valuation Models
Frequently involve a group of comparison assets
Sums the estimated values of each of the company’s businesses as if each business were an independent going concern
Value a company with segments in different industries that have different valuation characteristics evaluate the value that might be unlocked in a restructuring through a spinoff, splitoff, tracking stock, or equity (IPO) carveout
When to use Sum-of-the-parts valuation
The market applies a discount to the stock of a company operating in multiple, unrelated businesses compared to the stock of companies with narrower focuses
inefficiency of internal capital markets endogenous factors
Alternative explanation
Valuation of the Total Entity and Its Components
Conglomerate discount
research measurement errors A breakup value in excess of a company’s unadjusted goingconcern value may prompt strategic actions such as a divestiture or spin-off understanding the nature of its assets and how it uses those assets to create value
having a good understanding of the business
Forecasting Company Performance consistent with the characteristics of the company being valued
appropriate given the availability and quality of data
Approach moves from international and national macroeconomic forecasts to industry forecasts and then to individual company and asset forecasts
Two perspectives
Bottom-up forecasting
Approach aggregates forecasts at a micro level to larger scale forecasts, under specific assumptions
The company’s own operating and financial characteristics
Criteria for model selection are that the valuation model be
consistent with the purpose of valuation, including the analyst’s perspective
Top-down forecasting The economic environment
Issues in Model Selection and Interpretation
Professionals frequently use multiple valuation models or factors in common stock selection
29. Equity Valuation. Applications and Processes - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
Consider qualitative as well as quantitative factors
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INTRODUCTION
PRIVATE MARKET REAL ESTATE DEBT
REAL ESTATE INVESTMENT: BASIC FORMS
INDICES
VALUATION IN AN INTERNATIONAL CONTEXT
DUE DILIGENCE
39. Private Real Estate Investments: An Overview
RECONCILIATION
THE INCOME APPROACH TO VALUATION
39. Private Real Estate Investments - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS
PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS
THE COST AND SALES COMPARISON APPROACHES TO VALUATION
OVERVIEW OF THE VALUATION OF COMMERCIAL REAL ESTATE
INTRODUCTION
often included in the portfolios of investors with long-term investment horizons and with the ability to tolerate relatively lower liquidity
Private equity investment: sometimes referred to as direct ownership
suitable for investors with short investment horizons and higher liquidity needs
Publicly traded debt investment: sometimes referred to as indirect lending
The first dimension: whether the investment is made in the private or public market Investment in real estate has been defined from a capital market perspective in the context of quadrants which are a result of two dimensions of investment
The second dimension: whether the investment is made in the private or public market
REAL ESTATE INVESTMENT: BASIC FORMS Four quadrants Private real estate investment, compared with publicly traded real estate investment, typically involves larger investments because of the indivisibility of real estate property and is more illiquid Publicly traded real estate investment allows the real estate property to remain undivided but the ownership or claim on the property to be divided Equity investors generally expect a higher rate of return than lenders (debt investors) because they take on more risk Debt investors in real estate, whether through private or public markets, expect to receive their return from promised cash flows and typically do not participate in any appreciation in value of the underlying real estate Heterogeneity and fixed location High unit value Management intensive High transaction costs Characteristics
Depreciation Need for debt capital Illiquidity : Price determination Single-family properties may be owner-occupied or rental properties
REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS
Residential properties: single-family houses and multi-family properties, properties that provide housing for individuals or families
Multi-family properties are rental properties even if the owner or manager occupies one of the units Multifamily housing is usually differentiated by location and shape of structure Commercial real estate properties
Classifications
Properties purchased with the intent to let, lease, or rent
Office
Non-residential properties include commercial properties other than multifamily properties, farmland, and timberland
Industrial and warehouse Retail Hospitality Other types
Current income Price appreciation (capital appreciation) Motivations
Inflation hedge Diversification Tax Benefits Business conditions Long lead time for new development Cost and availability of capital Unexpected inflation Characteristic sources of risk or risk factors of real estate investment
Demographics Lack of liquidity Environmental
Risk Factors
Availability of information Management Leverage
39. Private Real Estate Investments - Part 1
Other risk factors
PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS
Risk and return of equity real estate investments is affected by the characteristics of real estate and the risk factors, structure of leases between the owner and tenants
Real Estate Risk and Return Relative to Stocks and Bonds
The demand for office depends heavily on employment growth The average length of an office building lease varies globally
Office
An important consideration in office leases is whether the owner or tenant incurs the risk of operating expenses
“net lease” requires the tenant to be responsible for paying operating expenses “gross lease” requires the owner to pay the operating expenses
Not all office leases are structured as net or gross leases There are differences in how leases are structured over time and in different countries
Commercial Real Estate
Industrial and Warehouse
The demand for industrial and warehouse space is heavily dependent on the overall strength of the economy and economic growth and on import and export activity in the economy
The demand depends heavily on trends in consumer spending. Consumer spending, in turn, depends on the health of the economy, job growth, population growth, and savings rates Retail
“Percentage lease”: the requirement that the tenants pay additional rent once their sales reach a certain level The lease will typically specify a “minimum rent” that must be paid regar dless of the tenant’s sales and the basis for calculating percentage rent once the tenant’s sales reach a certain level or breakpoint The demand for multi-family space depends on
Multi-Family
population growth, especially for the age segment most likely to rent apartments how the cost of renting compares with the cost of owning-that is, the ratio of home prices to rents
The cost approach involves estimating the value of the building(s) based on adjusted replacement cost The replacement cost is adjusted for different types of depreciation (loss in value) to arrive at a Physical deterioration related to the age of the property because components of the property wear out over time. Two types The Cost Approach
incurable: Fixing a structural problem with the foundation of the building may cost more to cure than the amount that it would increase the value of the property if cured
Functional obsolescence: a loss in value due to a design that is different from that of a new building constructed with an appropriate design for the intended use of the property
Types of depreciation
External obsolescence: due to either the location of the property or economic conditions, results when the location is not optimal for the property
THE COST AND SALES COMPARISON APPROACHES TO VALUATION
The Sales Comparison Approach
depreciated replacement cost
curable: fixing the problem will add value that is at least as great as the cost of the cure
Locational obsolescence results when the location is not optimal for the property Economic obsolescence results when new construction is not feasible under current economic conditions
The sales comparison approach implicitly assumes that the value of a property depends on what other comparable properties are selling for in the current market
Advantages and Disadvantages of the Cost and Sales Comparison Approaches
Appraisals (estimates of value) are critical for such infrequently traded and unique assets as real estate properties Market value: can be thought of as the most probable sale price. It is what a Appraisals
Value
There are other definitions of value that differ from market value
OVERVIEW OF THE VALUATION OF COMMERCIAL REAL ESTATE
typical investor is willing to pay for the property
Investment value: the value to a particular investor, could be higher or lower than market value depending on the particular investor’s motivations and how well the property fits into the investor’s portfolio, the investor’s risk tolerance, the investor’s tax circumstances, and so on. Value in use: the value to a particular user
The income approach considers what price an investor would pay based on an expected rate of return that is commensurate with the risk of the investment Three different approaches Introduction to Valuation Approaches
The cost approach considers what it would cost to buy the land and construct a new property on the site that has the same utility or functionality as the property being appraised (referred to as the subject property ) The sales comparison approach considers what similar or comparable properties (comparables) transacted for in the current market
Highest and Best Use
Highest and best use: the use that would result in the highest value for the land
39. Private Real Estate Investments - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
capitalizes the current NOI using a growth implicit capitalization rate When the capitalization rate is applied to the forecasted first-year NOI for the property, the implicit assumption is that the first-year NOI is representative of first-year NOI would be for similar properties
the direct capitalization method There are two income approaches
applies an explicit growth rate to construct an NOI stream from which a present value can be derived
the DCF method
Income can be projected either for the entire economic life of the property or for a typical holding period with the assumption that the property will be sold at the end of the holding period
General Approach and Net Operating Income
Calculating NOI
Rental income at full occupancy + Other income (such as parking) = Potential gross income (PGI) – Vacancy and collection loss = Effective gross income (EGI) – Operating expenses (OE) = Net operating income (NOI) The cap rate is like a current yield for the property whereas the discount rate is applied to current and future NOI
The Capitalization Rate and the Discount Rate
Cap rate = Discount rate - Growth rate going-in cap rate is used to clarify that it is based on the first year of ownership when the investor is going into the deal
Cap rate = NOI/Value
Defining the Capitalization Rate Value = NOI/Cap rate The Direct Capitalization Method
terminal cap rate is based on expected income for the year after the anticipated sale of the property observing what other similar or comparable properties are selling for to know the cap rate
Cap rate = NOI/Sale price of comparable ARY: all risks yield
Market value = Rent/ARY
Stabilized NOI
If NOI is not representative of the NOI of similar properties because of a temporary issue, the subject property's NOI should be stabilized Gross income multiplier: the ratio of the sale price to the gross income expected from the property in the first year after sale
Other Forms of the Income Approach
The Relationship between Discount Rate and Cap Rate THE INCOME APPROACH TO VALUATION
The problem of gross income multipler: not explicitly consider vacancy rates and operating expenses
If the growth rate is constant
V = NOI/(r – g)
If NOI is not expected to grow at a constant rate, then NOIs are projected into the future and each period’s NOI is discounted to arrive at a value of the property The cap rate used to estimate the resale price or terminal value is referred to as a terminal cap rate or residual cap rate It is a cap rate that is selected at the time of valuation to be applied to the NOI earned in the first year after the property is expected to be sold to a new buyer
The Terminal Capitalization Rate
The terminal cap rate could be the same, higher, or lower than the goingin cap rate depending on expected discount and growth rates at the time of sale
The Discounted Cash Flow (DCF) Method
If interest rates are expected to be higher in the future => terminal cap rates might be higher The growth rate is often assumed to be a little lower => a slightly higher terminal cap rate Uncertainty about what the NOI will be in the future may also result in selecting a higher terminal cap rate
Lease structures vary across locales and can have an effect on the way value is typically estimated in a specific locale
Adapting to Different Lease Structures
The “equivalent yield” is a single discount rate that could be applied mathematically to both income streams that would result in the same value
The Equivalent Yield
Project income from existing leases Make assumptions about lease renewals
The general s teps to a DCF analysis are as follows
Assumptions also have to be made about what will happen when a lease comes up for renewal—often referred to as market leasing assumptions
Make assumptions about operating expenses
Operating expenses involve items that must be paid by the owner, such as property taxes, insurance, maintenance, management, marketing, and utilities
Make assumptions about capital expenditures
such as a new heating and air conditioning system or replacing a roof, etc.,
Make assumptions about absorption of any vacant space Estimate resale value (reversion) Advanced DCF: Lease-by- Lease Analysis
39. Private Real Estate Investments - Part 2
how long the property will be held by the initial investor
Select discount rate to find PV of cash flows Advantages and Disadvantages of the Income Approach
Advantage: it captures the cash flows that investors actually care about Disadvantage is the amount of detailed information that is needed and the need to forecast what will happen in the future even if it is just forecasting a growth rate for the NOI and not doing a detailed lease-by-lease analysis
The discount rate does not reflect the risk Income growth is greater than expense growth Common Errors
The terminal cap rate is not logical compared with the implied going-in cap rate The terminal cap rate is applied to an income that is not typical The cyclical nature of real estate markets is not recognized
Three different approaches to valuation: the income, cost, and sales comparison approaches may produce the different answers due to imperfections in the data and inefficiencies in the market The appraiser needs to reconcile the differences and arrive at a final conclusion about the value RECONCILIATION
The purpose of reconciliation is to decide which approach or approaches you have the most confidence in and come up with a final estimate of value In an active market: sales comparison approach is preferred When there are fewer transactions: income approach is preferred To verify other facts and conditions that might affect the value of the property and that might not have been identified by the appraiser Review the leases for the major tenants and review the history of rental payments and any defaults or late payments. Get copies of bills for operating expenses, such as utility expenses. Look at cash flow statements of the previous owner for operating expenses and revenues. Have an environmental inspection to be sure there are no issues, such as a contaminant material on the site. Have a physical/engineering inspection to be sure there are no structural issues with the property and to check the condition of the building systems, structures, foundation, and adequacy of utilities.
DUE DILIGENCE E.g
Have an attorney or appropriate party review the ownership history to be sure there are no issues related to the seller’s ability to transfer free and clear title that is not subject to any previously unidentified liens. Review service and maintenance agreements to determine whether there are recurring problems. Have a property survey to determine whether the physical improvements are in the boundary lines of the site and to find out if there are any easements that would affect the value. Verify that the property is compliant with zoning, environmental regulations, parking ratios, and so on. Verify that property taxes, insurance, special assessments, and so on, have been paid
VALUATION IN AN INTERNATIONAL CONTEXT
Return = {NOI
Appraisal-Based Indices
Disadvantages
Capital expenditures + (Ending market value
Appraisal lag
Beginning market value )}/Beginning market value
May not capture the price increase until a quarter or more after it was reflected in transactions Tend to smooth the index, have lower correlation with others => allocation to real estate would likely overestimated
How to adjust: unsmooth” the appraisalbased or use a transactionbased index when comparing real estate with other asset classes
INDICES
In recent years, indices have been created that are based on actual transactions rather than appraised values Two main ways Transaction-Based Indices Disadvantages
PRIVATE MARKET REAL ESTATE DEBT
A repeat sales index relies on repeat sales of the same property A hedonic index which requires only one sale Include random elements in the observations => may be upward or downward movements from quarter to quarter that are somewhat random
The maximum amount of debt that an investor can obtain on commercial real estate is usually limited by either the ratio of the loan to the appraised value of the property (loan to value or LTV) or the debt service coverage ratio (DSCR) The debt service coverage ratio is the ratio of the firstyear NOI to the loan payment
39. Private Real Estate Investments - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
DSCR = NOI/Debt service
PRICING EURODOLLAR FUTURES, TREASURY BOND FUTURES, STOCK INDEX AND CURRENCY FUTURES
THE RELATION BETWEEN FUTURES PRICES AND EXPECTED SPOT PRICES
MONETARY & NONMONETARY BENEFITS AND COSTS ASSOCIATED WITH HOLDING THE UNDERLYING ASSET AND THEIR EFFECTS TO FUTURES PRICE
48. Futures Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
FUTURE CONTRACTS
48. Futures Markets and Contracts: An Overview
FUTURES PRICE & THE VALUE OF A FUTURES CONTRACT
WHY FORWARD AND FUTURES PRICES DIFFER
Deliverable contracts obligate the long to buy and the short to sell a certain quantity of an asset for a certain price on a specified future date Cash settlement contracts are settled by paying the contract value in cash on the expiration date
Similar to forward contracts in
Both forwards and futures are priced to have zero value at the time the investor enters into the contract Futures are marked to market at the end of every trading day. Forward contracts are not marked to market
FUTURE CONTRACTS
Futures contracts trade on organized exchanges. Forwards are private contracts and do not trade on organized exchanges Different from forward contracts
Futures contracts are highly standardized. Forwards are customized contracts satisfying the needs of the parties involved Forwards are contracts with the originating counterparty; a specialized entity called a clearinghouse is the counterparty to all futures contracts Forward contracts are usually not regulated. The government having legal jurisdiction regulates futures markets
At expiration, the spot price must equal the futures price because the futures price has become the price today for delivery today, which is the same as the spot.
Futures price must converge to the spot price at expiration
Futures margin is a performance guarantee
Future margins and marking to market
Arbitrage will force the prices to be the same at contract expiration
The clearinghouse guarantees that traders in the futures market will honor their obligations by splitting each trade once it is made and acting as the opposite side of each position => To safeguard the clearinghouse, both sides of the trade are required to post margin and settle their accounts on a daily basis
Marking to market is the process of adjusting the margin balance in a futures account each day for the change in the value of the contract from the previous trading day, based on the settlement price
FUTURES PRICE & THE VALUE OF A FUTURES CONTRACT
Has no value at contract initiation Does not accumulate value changes over the term of the contract. The value after the margin deposit has been adjusted for the day's gains and losses in contract value is always zero Value of a futures contract
The futures price at any point in time is the price that makes the value of a new contract equal to zero The value of a futures contract strays from zero only during the trading periods between the times at which the account is marked to market Value of futures contract = current futures price - previous mark-to-market price If the futures price increases, the value of the long position increases
The no-arbitrage price of a futures contract
48. Futures Markets and Contracts - Part 1
FP = futures price So = spot price at inception of the contract ( t = 0) R f = annual risk-free rate T = futures contract term in years
should be the same as that of a forward contract
If investors prefer the mark-to-market feature of futures, futures prices will be higher than forward prices Cases that causes futures and forward prices to be different
If investors would rather hold a forward contract to avoid the marking to market of a futures contract, the forward price would be higher than the futures price
WHY FORWARD AND FUTURES PRICES DIFFER
A cash-and-carry arbitrage consists of buying the asset, storing/holding the asset, and selling the asset at the futures price when the contract expires Borrow money for the term of the contract at market interest rates At the initiation of the contract Cash-and-carry arbitrage
Buy the underlying asset at the spot price Sell (go short) a futures contract at the current futures price
Steps At contract expiration
Deliver the asset and receive the futures contract price Repay the loan plus interest
If the futures contract is overpriced => generate a riskless profit Future arbitrage
The futures contract is overpriced if the actual market price is greater than the no-arbitrage price When the futures price is too low (which presents a profitable arbitrage opportunity) Sell the asset short Reverse cash-and-carry arbitrage
At the initiation of the contract
Buy (go long) the futures contract at the market price
Steps At contract expiration
48. Futures Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
Lend the short sale proceeds at market interest rates
Collect the loan proceeds Take delivery of the asset for the futures price and cover the short sale commitment
Any positive costs associated with storing or holding the asset in a cash and carry arbitrage will increase the no-arbitrage futures price E.g., Financial assets: no storage costs other than the opportunity cost of the funds
A monetary benefit from holding the asset will decrease the no-arbitrage futures price
Convenience yield: The return from non-monetary benefits which come from holding an asset in short supply MONETARY AND NONMONETARY BENEFITS AND COSTS ASSOCIATED WITH HOLDING THE UNDERLYING ASSET AND THEIR EFFECTS TO FUTURES PRICE
net costs (NC) = storage costs - convenience yield
The no-arbitrage futures price counting net costs
FV (NC)= future value, at contract expiration, of the net costs of holding the asset
The no-arbitrage futures price counting net benefits
NB = yield on the asset + convenience yield FV (NB) = future value, at contract expiration, of the net benefits of holding the asset
refers to a situation where the futures price is below the spot price Backwardation Backwardation and contago
to occur, there must be a significant benefit to holding the asset, either monetary or non-monetary
refers to a situation where the futures price is above the spot price Contango
happens when there is no benefits to holding the asset, the futures price will be
The futures price might be temporarily above or below expected future spot prices, but it would be an unbiased predictor of future spot rates
If both parties to a futures transaction are hedging existing risk, the futures price may be equal to expected future spot prices Normal backwardation Normal contango
E.g., benefits to holding the asset that offset the opportunity cost of holding the asset (the risk-free rate) and additional net holding costs
happens when the futures price is lower than the expected price in the future to compensate the future buyer for accepting asset price risk
happens when the futures price is greater than the expected spot price
The most likely situation in financial markets is normal backwardation similar to a forward rate agreement to lend US$1,000,000 for three months beginning on the contract settlement date
THE RELATION BETWEEN FUTURES PRICES AND EXPECTED SPOT PRICES
Eurodollar
based on 90-day LIBOR, which is an add-on yield the price quotes are calculated as (100 - annualized LIBOR in percent) the minimum price change is one "tick," which is a price change of 0.0001 = 0.01 % traded for T-bonds with a maturity of 15 years or more
48. Futures Markets and Contracts - Part 2
Eurodollar, Treasury Bonds, Stock Index, and Currency Futures
Treasury Bonds
the contract is deliverable with a face value of $100,000 T-bond futures are quoted as a percent and fractions of 1 % (measured in 1/32nds) of face value each bond is given a conversion factor (multiplier) that is used to adjust the long's payment at delivery based on the level of an equity index
Stock index futures
most popular stock index future is the S&P 500 settlement is in cash and is based on a multiplier of 250
Currency Futures
In the United States, currency contracts trade on the euro, Mexican peso, and yen, among others
Treasury bill (T-bill) futures contracts are based on a $1 million face value 90-day (13-week) T-bill, and they settle in cash The price quotes are 100 minus the annualized discount in percent on the T-bills
Treasury Bill Futures Pricing
Eurodollar futures
T-bill futures are priced using the no-arbitrage principle Eurodollar futures are priced as a discount yield, and LIBOR-based deposits are priced as an add-on yield => The result is that the deposit value is not perfectly hedged by the Eurodollar contract => Eurodollar futures can't be priced using the standard no-arbitrage framework
The no-arbitrage futures price for a T-bond contract
Treasury Bond Futures
FVC: the future value of the coupon payments
The futures price that insures a cash-and-carry arbitrage would provide no profit is lower than without the cash flows Because the cost to hold the asset is reduced by the asset cash flows T-bond futures prices must be adjusted to conform to the price for the bond that is cheapest to deliver, using its conversion factor (CF)
PRICING EURODOLLAR FUTURES, TREASURY BOND FUTURES, STOCK INDEX AND CURRENCY FUTURES
The no-arbitrage futures price adjusted for the future value of the dividends (FVD) or present value of the dividends (PVD) Stock futures
Equity Index Futures
The no-arbitrage futures price
The price of currency futures Currency Futures
In continuous time it is
48. Futures Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
DC = domestic currency FC = foreign currency
AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS
PUT-CALL PARITY FOR EUROPEAN OPTIONS
SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK
PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONS
THE HISTORICAL AND IMPLIED VOLATILITIES OF AN UNDERLYING ASSET
EFFECT OF THE UNDERLYING ASSET'S CASH FLOWS ON THE PRICE OF AN OPTION
THE DELTA OF AN OPTION AND ITS USE IN DYNAMIC HEDGING
49. Option Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
49. Option Markets and Contracts: An Overview
ONE- AND TWO-PERIOD BINOMIAL MODELS TO CALCULATE AND INTERPRET PRICES OF INTEREST RATE OPTIONS AND OPTIONS ON ASSETS
ASSUMPTIONS UNDERLYING THE BLACK-SCHOLES-MERTION MODEL
A CHANGE IN THE VALUE OF EACH INPUT AFFECTS THE OPTION PRICE (UNDER THE BLACK-SCHOLES-MERTION MODEL)
A long position in a European call option with an exercise price of X that matures in T years on a stock (with a price at time t of S
t)
A long position in a pure-discount riskless bond that pays X in T years
A fiduciary call
PUT-CALL PARITY FOR EUROPEAN OPTIONS
A long position in a European put option with an exercise price of X that matures in T years A long position in the underlying stock
A protective put
That the cost of a fiduciary call must be equal to the cost of a protective up
Put-call parity for European options
+: long position - : short position Buying a European put option on the same stock with the same exercise price (X) and the same maturity (T) Buying the stock
A synthetic European call option is formed by
Shorting (i.e., borrowing) the present value of X worth of a pure-discount riskless bond Buying a European call option
SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK
Shorting the stock
A synthetic European put option is formed by
Buying (i.e., investing in) the discount bond Buying a European call option
A synthetic stock position is formed by
Shorting (i.e., writing) a European put option Buying (i.e., investing in) the discount bond Buying a European put option
A synthetic pure-discount riskless bond is created by
Buying the stock Shorting (i.e., writing) a European call option
Two reasons to create synthetic positions in the securities
Using put-call parity for arbitrage
To price options by using combinations of other instruments with known prices To earn arbitrage profits by exploiting relative mispricing among the four securities If put-call parity doesn't hold (if the cost of a fiduciary call does not equal the cost of a protective put), buy (go long in) the underpriced position and sell (go short) in the overpriced position
D =risk-neutral probability of an down-move = 1 -
U
R f = risk-free rate U = size of an up-move D = size of a down-move Calculating the payoff of the option at maturity in both the up-move and down-move states
One-Period Binomial Model
Calculate the value of an option on the stock
Calculating the expected value of the option in one year as the probability-weighted average of the payoffs in each state Discounting the expected value back to today at the risk-free rate
provides the information required to calculate a hedge ratio (the fractional share of stock in the arbitrage trade)
Arbitrage with one-period binomial model
Calculate the stock values at the end of two periods (there are three possible outcomes because an up-then-down move gets you to the same place as a down-then-up move)
49. Option Markets and Contracts - Part 1
Calculate three possible option payoffs at the end of two periods
ONE- AND TWO-PERIOD BINOMIAL MODELS TO CALCULATE AND INTERPRET PRICES OF INTEREST RATE OPTIONS AND OPTIONS ON ASSETS
Calculate the expected option values at the end of two periods (t = 2) using the up-and down-move probabilities
Steps to value an option
Discount the expected option values (t = 2) back one period at the risk-free rate to find the option values at the end of the first period (t = 1)
Two-Period Binomial Model
Calculate the expected option value at the end of one period (t = 1) using up-and down-move probabilities Discount the expected option value at the end of one period (t = 1) back one period at the risk-free rate to find the option value today is the set of possible interest rate paths that are used to value bonds with a binomial model Binomial interest rate trees
the underlying rule governing the construction of an interest rate tree
the values for on-the-run issues generated using an interest rate tree should prohibit arbitrage opportunities
There are three basic steps to valuing an option on a fixed-income instrument using a binomial tree Options on Fixed Income Securities
the interest rate tree must maintain the interest rate volatility assumption of the underlying model
price the bond at each node using projected interest rates calculate the intrinsic value of the option at each node at maturity of the option, and calculate the value of the option today
The value of an interest rate cap or floor is the sum of the values of the individual caplets or floorlets
Options on Interest Rates: Caps and Floors
Expiration value of caplet
Expiration value of floorlet As the period covered by a binomial model is divided into arbitrarily small, discrete time periods, the model results converge to those of the continuous-time model The Black-Scholes-Merton (BSM) model values options in continuous time and is derived from the same no-arbitrage assumption used to value options with the binomial model To derive the BSM model, an "instantaneously" riskless portfolio is used to solve for the option price based on the same logic The price of the underlying asset follows a lognormal distribution The (continuous) risk-free rate is constant and known
Limitation: The BSM model is not useful for pricing options on bond prices and interest rates
The volatility of the underlying asset is constant and known Assumptions and Limitations
Markets are "frictionless"
In practice, the volatility is not known and must be estimated. The bigger problem is that volatility is often not constant over time and the BSM model is not useful in these situations
Model is less realistic and less useful
The underlying asset generates no cash flows
The options are European
ASSUMPTIONS UNDERLYING THE BLACK-SCHOLES-MERTION MODEL
The formula for the BSM model
Use put-call parity to calculate the put value
49. Option Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
The BSM model can be easily altered if we relax the assumption of no cash flows on the underlying asset
The model does not correctly price American options. Binomial option pricing models are more appropriate for pricing American options
A Greek is a sensitivity factor that captures the relationship between each input (asset price, asset price volatility, time to expiration, and the risk-free rate) the option price
Delta describes the relationship between asset price and option price
Vega measures the sensitivity of the option price to changes in the volatility of returns on the underlying asset
A CHANGE IN THE VALUE OF EACH INPUT AFFECTS THE OPTION PRICE (UNDER THE BLACK-SCHOLES-MERTION MODEL)
Rho measures the sensitivity of the option price to changes in the risk-free rate
There is a benefit to early exercise of options on futures when they are deep in the money Exercising the option (either a put or call) early will generate cash from the mark to market => cash can earn interest, while the futures position will gain or lose from movements in the futures price => these price movements between early exercise and option expiration will mirror those of the deep in the money option There is no mark to market on forwards, early exercise does not accelerate the payment of any gains
theta is less than zero: as time passes and the option approaches the maturity date, its value decreases
American options on futures are more valuable than comparable European options because
With no reason for early exercise, the value of American and European options on forwards are the same
Theta measures the sensitivity of the option price to the passage of time
AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS
The Black model can be used to price European options on forwards and futures
= standard deviation of returns on the futures contract F T = futures price
Put-call parity for options on forwards and futures is as follows
PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONS
American options on futures are more valuable than European options because early exercise provides mark to market funds on the futures, which can earn interest
49. Option Markets and Contracts - Part 2
Americans and European options on forward contracts are equivalent because there is no mark to market
Step 1: Convert a time series of N prices to returns Step 2: Convert the returns to continuously compounded returns
C = change in the price of the call over a short time interval S = change in the price of the underlying stock over a short time interval
Delta is the change in the price of an option for a one-unit change in the price of the underlying security
The steps in computing historical volatility for use as an input in the BSM continuous-time options pricing model are
THE HISTORICAL AND IMPLIED VOLATILITIES OF AN UNDERLYING ASSET
Use BSM model to estimate the change in the value of the call given the change in the value of the stock and the option's delta
C N(d1) x S P (change in put price)
[N(d1) - 1] x
S
Step 3: Calculate the variance and standard deviation of the continuously compounded returns
when used in the Black-Scholes formula, it produces the current market price of the option
Implied volatility is the value for standard deviation of continuously compounded rates of return that is "implied" by the market price of the option
Decrease the value of a call option Increase the value of a put option
All else equal, the existence of cash flows on the underlying asset will
EFFECT OF THE UNDERLYING ASSET'S CASH FLOWS ON THE PRICE OF AN OPTION
Put-call parity for options on underlying assets with cash flows by adjusting S for the present value of the cash flows (PVCF) A call option delta is between 0 and 1. If the call option is Interpreting Delta
A put option delta is between -1 and 0. If the put option is
THE DELTA OF AN OPTION AND ITS USE IN DYNAMIC HEDGING
Out-of-the-money (stock price is less than exercise price), the call delta moves closer to 0 as time passes, assuming the underlying stock price doesn't change In-the-money (stock price is greater than exercise price), the call delta moves closer to 1 as time passes, assuming the underlying stock price doesn't change Out-of-the-money (stock price is greater than exercise price), the put delta moves closer to O as time passes, assuming the underlying stock price doesn't change In-the-money (stock price is less than exercise price), the put delta moves closer to -1 as time passes, assuming the underlying stock price doesn't change
The goal of a delta-neutral portfolio (or delta-neutral hedge) is to combine a long position in a stock with a short position in a call option so that the value of the portfolio does not change when the value of the stock changes Number of call options needed to delta hedge = number of shares hedged/delta of call option Dynamic Hedging
Number of put options needed to delta hedge = number of shares/delta of the put option The delta-neutral position only holds for very small changes in the value of the underlying stock => must be continually rebalanced to maintain the hedge (a dynamic hedge)
Gamma measures the rate of change in delta as the underlying stock price changes
costly in terms of transaction costs
can be viewed as a measure of how poorly a dynamic hedge will perform when it is not rebalanced in response to a change in the asset price
Call and put options on the same underlying asset with the same exercise price and time to maturity will have equal gammas Long positions in calls and puts have positive gammas Gamma is largest when a call or put option is at-the-money and close to expiration
Gama effect
49. Option Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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