CFA Glossary

CFA Glossary
Tuesday, May 31, 2011
Active portfolio management: justifications
Why active portfolio management might add value in an efficient market environment?
• Economic argument (logic)
o If investors only invested in passively managed portfolios, then actively
managed portfolios would cease to exist. As a consequence, inefficiencies will
arise in securities markets and the resulting profit opportunities will lure active
managers back thus enabling them to outperform passively managed
portfolios.
o (Incorrect description) If active managers were not able to consistently beat a
passive investment strategy, investors would not be willing to pay high fees for
active managers and funds under active management would cease to exist.
Since there are many active managers, economic logic suggests they must be
outperforming passive strategies.
• Empirical evidence
o Some managers have consistently produced excess returns relative to a passive
strategy, suggesting skill rather than luck.
Active portfolio management: justifications
Why active portfolio management might add value in an efficient market environment?
• Economic argument (logic)
o If investors only invested in passively managed portfolios, then actively
managed portfolios would cease to exist. As a consequence, inefficiencies will
arise in securities markets and the resulting profit opportunities will lure active
managers back thus enabling them to outperform passively managed
portfolios.
o (Incorrect description) If active managers were not able to consistently beat a
passive investment strategy, investors would not be willing to pay high fees for
active managers and funds under active management would cease to exist.
Since there are many active managers, economic logic suggests they must be
outperforming passive strategies.

• Empirical evidence
o Some managers have consistently produced excess returns relative to a passive
strategy, suggesting skill rather than luck.
Posted by Spanish Key at 2:17 PM No comments:
Labels: A, CFA Level 2 (June 2011)
Affirmative covenant
A covenant calls upon a borrower (debt issuer) to do a certain thing (rather than restrictions
on a certain ratio threshold/action).
Posted by Spanish Key at 11:57 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Tuesday, May 10, 2011
Accounting income
Accounting income = Net income = Taxable income * (1-Tax rate)
Taxable income = Operating income before tax - Interest expense
Operating income before tax = Sales - Variable cash expenses - Fixed cash expenses -
Depreciation = EBIT
Posted by Spanish Key at 10:03 PM No comments:
Labels: A, CFA Level 2 (June 2011)
Wednesday, May 4, 2011
All-current method and Temporal method
Local currency price: constant
FC: depreciation (vs. DC)
All-current method and Temporal method
method Temporal in DC All-current
Net income (before translation gains and losses) <
D/E <
Gross profit margin
= (Revenue - COGS)/Revenue
(A-H)/A < (A-A)/A
COGS H > A

Posted by Spanish Key at 2:07 PM No comments:
Labels: A, CFA Level 2 (June 2011)
Sunday, April 17, 2011
Acquisition: goodwill, amount reported in the B/S
The pre-acquisition balance sheets
12/31/2007
in $ thousands
Acquirer Target Target
Book value/Fair value BV FV
Assets
Cash 710 100 100
Marketable securities 2,550 - -
Inventory 2,000 400 400
Accounts receivable 3,000 500 500
PP & E 2,450 1,000 1,200
Total assets 10,710 2,000 2,200
Liabilities
Accounts payable 3,310 400 400
Long-term debt 5,000 1,000 1,000
Equity 2,400 600 800
Total liabilities and equity 10,710 2,000 2,200
• On 12/31/2007, Acquirer purchased a 35% ownership interest in a strategic new firm
called Target for $300,000 in cash.
• The remaining useful life of the PP&E is 10 years with no salvage value. Both firms
use the straight-line depreciation method.
• For the year ended 2008, Target reported net income of $250,000 and paid dividends
of $100,000.
• During the first quarter of 2009, Target sold goods to Acquirer and recognized
$15,000 of profit from the sale. At the end of the quarter, half of the goods purchased
from Target remained in Acquirer's inventory.

[Question]
The amount of (partial) goodwill as a result of Acquirer's acquisition of Target is:
300,000 - 35% * 800,000 = 300,000 - 280,000 = $20,000
[Question]
What amount should Acquirer report in its balance sheet as a result of its investment in
Target at the end of 2008?
Under the equity method,
Original amount including goodwill + %ownership * (Net income - Dividends) - %ownership
* Additional depreciation
= 300,000 + 35% * (250,000 - 100,000) - 35% * ((1,200,000 - 1,000,000) - 0)/10
= 300,000 + 52,500 - 7,000
= 345,500
[Question]
Which of the following best describes Acquirer's treatment of the intercompany sales
transaction for the quarter ended 3/31/2009?
Acquirer should reduce its equity income by:
15,000 * 50% * 35% = $2,625
Posted by Spanish Key at 8:47 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Saturday, April 16, 2011
Acquisition method and Pooling of interest method
IFRS
Pooling of interest method Acquisition method
Acquirer Acquirer
Target Assets Book value Fair value
Target Liabilities Book value Fair value
Acquirer goodwill? No Yes
(Question)
Regarding the prior purchase that was accounted for under the pooling of interests method,
had Acquirer reporeted this purchase under the acquisition method:

A. the assets and liabilities of the purchased firm would not be included on Acquirer's
balance sheet
B. balance sheet assets and liabilities of the purchased firm would have been reported at fair
value.
C. reported goodwill could be less depending on the fair value of the identifiable assets and
liabilities compared to their book values.
Answer: B
The assets and liabilities of the purchased firm are included on the balance sheet of the
acquiring firm under either method.
• Under the pooling method, there is no adjustment of balance sheet asset and liability
values to their fair values (i.e. book value).
o There is no goodwill reported under the pooling method; the purchase price is
not reflected on the balance sheet of the acquiring firm.
• Under the acquisition method, assets and liabilities acquired are reported at fair
value at the time of the purchase.
Posted by Spanish Key at 4:58 PM No comments:
Labels: A, CFA Level 2 (June 2011)
Monday, April 11, 2011
Acquisition method: consolidated current asset
Acquirer →(45% ownership stake, $9 million in cash)→ Target
Acquisition method: consolidated current asset
acquisition Prior to Prior to After
in $ millions Acquirer Target Acquirer (consolidated, acquisition method)
Current asset 96 32 96-9+32 = 119
Total equity 80 16
Posted by Spanish Key at 9:51 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Friday, March 11, 2011
Acquisition method, Equity method, and Proportionate consolidation: sample
questions

Acquisition
Acquirer Target
Accounting U.S.GAAP U.S.GAAP
Purchase price - $185 million in cash (20% stake)
Pre-Acquisition Balance Sheets (12/31/2010)
in million $ Acquirer Target
Current assets 13,900 716
PP&E 26,977 108
Total assets 40,877 824
Current liabilities 10,363 220
Other liabilities 11,121 8
Common stock 6,127 108
Retained earnings 13,266 488
Total liabilities and equity 40,877 824
Pro-Forma (i.e. projected) Income Statement (for the year ending 12/31/2011)
in million $ Acquirer Target
Revenue 66,176 2,176
Expenses 63,515 2,068
Net Income 2,661 108
Dividends 1,525 0
(Questions and Answers)
1. Assuming the acquisition goes through at the beginning of 2011, and that Acquirer
will have a significant influence on Target, the total assets after acquisition would be:
o 40,877
o The accounting for an ownership interest of between 20% and 50% in an
associate is handled using the equity method. Acquirer also have a significant
influence (NOT control) on Target.
o Under the equity method, the initial investment is recorded at cost and
reported on the balance sheet as a noncurrent asset.
o Because the acquisition in this case is fully funded by cash, there will be no

change to total assets for Acquirer.
2. The fair value of Target's other assets PP&E is $250 million. The amount allocated to
goodwill would be:
o 37.4
o (Partial) goodwill = Purchase price (cash) - Pro-rata book value of Target -
Amount of excess purchase price allocated to PP&E = 185 - (108+488)*20% -
(250-108)*20% = 37.4
o Full goodwill = 185/20% - (108+488) - (250-108) = 187.0 = 37.4/20%
3. For this question only, assume that as a result of the acquisition, Acquirer must
depreciate an additional $50 million over a 10-year period to zero salvage value.
Target's contribution to Acquirer's EBT for 2011 is projected to:
o 16.6
o Equity income: 108*20% - (50-0)/10 = 16.6
4. For this question only, assume that the acquisition occurs on December 31, 2010, and
that there is no additional depreciation expense as a result of the acquisition.
Compared to its beginning of year investment balance, the balance for Acquirer's
investment in Target on December 31,2011, will be lower, higher, or unchanged?
o Higher
o No calculations are required to solve this problem.
o Acquirer's investment balance = Investment balance at the beginning of
year + equity income - dividend paid (under no additional depreciation
assumption)
o Increase/Decrease to Acquirer's investment balance = Target's equity
income - Target's dividend paid (under no additional depreciation
assumption)
o The equity income is positive Target had positive net income, and there is no
additional depreciation expense to subtract. Additionally, Target is not
expected to make any dividend payments for 2011.
o Based on this, Acquirer's investment balance will increase.
5. "Since Target is profitable and pays no dividends, the equity method will result in

higher net income than proportionate consolidation. Additionally, the equity method
will result in lower return on assets (ROA) than the acquisition method with partial
goodwill." Is this stament correct for both net income and ROA?
o Under the condition above, the equity method, proportionate consolidation,
and the acquisition method all report the same net income.
o ROA is higher under the equity method than under proportionate consolidation
because the equity method does report lower assets than proportionate
consolidation.
6. If an analyst were to follow IFRS instead of U.S. GAAP, the accounting method
predescribed for this type of investment would most likely be (A) the equity method,
(B) the acquisition method, or (C) proportionate consolidation?
o Equity method
o When the investment constitutes 20% to 50% of the associate, and the investor
has significant influence on the associate, IFRS prescribes the equity method
for accounting for the invesment.
Posted by Spanish Key at 8:20 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Monday, February 28, 2011
Autoregressive Conditional Heteroskedasticity (ARCH)
(Question)
Squared Residuals Regression
Coefficient Standard Error p-value
Intercept 3.00 0.577 0.01
Lagged residual squared 0.28 0.185 0.31
From the data provided above, for a 5% level of significance, one should conclude that his or
her AR(1) model exhibits:
A. no autocorrelation.
B. no autoregressive conditional heteroskedasticity (ARCH).
C. no multicollinearity.
Answer: B

Autoregressive conditional heteroskedasticity refers to an autoregressive equation which the
variance of the errors terms is heteroskedastic. (i.e., error variance is not constant.) The
presence of ARCH is tested with the following regression:
e
t
2
= β
1
+ β
2
* e
t-1
2
+ v
t
which serves as a proxy for:
var(e
t
) = β
1
+ β
2
* var(e
t-1
) + v
t
The exhibit above indicates that the slope estimate in the ARCH equation is not significant
(the t-statistic for the slope estimate of the ARCH equation is not significant.) Therefore, the
squared error does not depend on its lagged value (i.e., if the slope value is zero, then the
error variance equals the constant β

1
, which indicates no conditional heteroskedasticity in the
AR model). ARCH is not present.
Posted by Spanish Key at 8:26 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Monday, February 21, 2011
After-tax cash flow for a replacement project
A project would replace a portion of a company's equipment with new machinery expected to
last three years.
Current machinery
item $ amount
Book value 120,000
Market value 195,000
New machinery
item $ amount
Cost 332,000
ΔCurrent assets 190,000
ΔCurrent liabilities 80,000
Δ means the change in the dollar amount.
Tax rate = 40%
Time horizon of the project = 3 years
New machinery
Existing Equipment The project Increment
Annual sales 523,000 708,000 708,000-523,000 = 185,000
Cash operating expenses 352,000 440,000 440,000-352,000 = 88,000
Annual depreciation 40,000 110,667 110,667-40,000 = 70,667
Accounting salvage value 0 0 0
Expected salvage value 90,000 113,000 113,000-90,000 = 23,000
(Question)
Assuming that working capital will be recaptured at the end of the project, what is the final

period after-tax cash flow for the project?
Recaptured working capital at the end of the project = ΔCurrent assets - ΔCurrent liabilities
= 190,000 - 80,000 = 110,000
Because the project is a replacement project, the incremental cash flows must be calculated.
Total cash flow in the final period
= Project cash flows + Return of net working capital + After-tax sale of fixed capital used in
the project
= (185,000-88,000-70,667)*(1-40%) + 70,667
+ 110,000
+ (23,000 - 0)*(1-40%)
= 210,266.8
Posted by Spanish Key at 7:35 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Sunday, January 30, 2011
Auto Loan ABS and Credit Card Receivable ABS
Auto Loan ABS and Credit Card Receivable ABS
Auto Loan ABS Credit Card Receivable ABS
ABS backed by Amortizing assets (auto loan)
Nonamorzing assets (credit card
receivable)
Collateral structure
Generally does NOT change
once the security is issued. (*1)
Change during the lockout
period. ("revolving
structure") (*2)
Call provision (*3) Usually included.
Prepayment rate of the ABS
when interest rates ↑ or ↓
NOT significantly affected (*4)NOT significantly affected (*5)

(*1) The collateral simply gets smaller as the loans are paid off by the borrower.
(*2) During the lockout period, principal payments on the collateral are used to purchase
additional assets.
(*3) A call provision causes cash flows to be directed at principal reduction, rather than
purchasing new collateral assets.
(e.g.) cleanup call : it is triggered by a decline in the value of the collateral.
(*4) Because autoloans are short-term loans and the underlying asset (the automobile) has a
tendency to rapidly depreciate in the early years, there is little incentive for borrowers to
prepay the loan even if interest rates decline. Borrowers who take out an auto loan generally
do not refinance their vehicles as interest rates decline.
(*5) During the lockout period, any principal payments (and prepayments) are used to
purchase additional collateral for the ABS. Thus, any change in prepayment rates induced by
interest rate changes would be offset by additional purchases of collateral. A contraction, or
extension, would be unlikely to occur.
Posted by Spanish Key at 2:50 PM No comments:
Labels: A, CFA Level 2 (June 2011)
Tuesday, January 18, 2011
Acquisition: Form of integration & Type of merger
Acquisition: Form of integration
Form of
integration
Subsidiary
• Maintain the successful target company's brand and operational
structure.
• Most subsidiary mergers occur when the target has a well-known
brand that the acquirer wants to maintain.
Statutory • The target company would cease to exisit as a separte entity.
Acquisition: Type of merger
Type of merger
Horizontal • An acquirer and a target company are in the same industry.

Vertical • An acquirer would be moving up or down the supply chain.
Posted by Spanish Key at 10:02 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Acquisition, Equity, and Proportionate consolidation method
Accounting treatment
method equity proportionate consolidation acquisition
IFRS OK: Allowed OK: Preferred OK
U.S. GAAP OK Generally NOT allowed (*) OK
Net income +share(%) = +share(%) < +100(%)
Total liabilities - < +share(%) < +100(%)
Total assets - < +share(%) < +100(%)
ROA > ?
(*) Proportionate consolidation is not allowed except in very limited situations.
Posted by Spanish Key at 7:46 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Acquisition method and Equity method (U.S. GAAP)
(Case) A U.S. company's 45% ownership stake in another U.S. company:
Accounting treatment (U.S. GAAP)
method equity acquisition
Net income +share(%) < +100(%)
Total asset - < +share(%)
ROA >, <, or =
Posted by Spanish Key at 7:29 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Monday, January 17, 2011
APT and CAPM
The APT is a better approach than the CAPM because even though the factor risk premiums
are difficult to estimate, the CAPM is more problematic because it relies on a single market
risk premium estimate, which in turn leads to greater input uncertainty.
Incorrect.

From a purely theoretical point of view, one cannot say that the APT is better than the CAPM
because the CAPM relies on a single market risk premium. If anything, due to the greater
number of inputs required in APT estimation, input uncertainty is probably a more significant
problem for the APT than it is for the CAPM.
Posted by Spanish Key at 7:53 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Tuesday, January 11, 2011
Amortizing asset and Non-amortizing asset
Amortizing asset and Non-amortizing asset
example
composition of the loans in the asset
pool
Amortizing asset
• auto loan
does NOT change
Non-amortizing
asset • credit card receivable
does change
Posted by Spanish Key at 8:57 PM No comments:
Labels: A, CFA Level 2 (June 2011)
Monday, December 20, 2010
Autocorrelation
Quarterly data = 36 quarters
Model: autoregressive model with a lag one independent variable (which is statistically
different from zero)
Also include lag two and lag four terms, given the magnitude of the autocorrelations of
the residuals shown below?
Significance level: 5%
df: 36-1=35
Critical t-value: 2.03 for a two tail test, 1.69 for a one-tail test

Autocorrelation
Lag Autocorrelation Standard error t-statistic
1 0.0829 0.1690 0.49
2 0.1293 0.1690 0.76
3 0.0227 0.1690 0.13
4 0.1882 0.1690 1.11
n: number of observations = 36 - 1 = 35 → one quarter is lost because we have a lag one
term, so there are 35 observations in the regression.
Standard error = 1/df^0.5 = 1/35^0.5 = 0.1690
t = autocorrelation/standard error
The critical t-value is 2.03 for a two-tail test, so none of the t-statistics indicate that the
autocorrelations are significantly different from zero. Therefore, we do not need to include
additional lag terms.
Posted by Spanish Key at 7:47 PM No comments:
Labels: A, CFA Level 2 (June 2011)
Adjusted R-squared
R-Square (R^2) is the proportion of variation in the dependent variable (Y) that can be
explained by the predictors (X variables) in the regression model.
R
2
= (regression sum of squares)/(total sum of squares)
= (regression sum of squares)/(regression sum of squares + error sum of squares)
As predictors (X variables) are added to the model, each predictor will explain some of the
variance in the dependent variable (Y) simply due to chance. One could continue to add
predictors to the model which would continue to improve the ability of the predictors to
explain the dependent variable, although some of this increase in R-Square would be simply
due to chance variation. The adjusted R-Square attempts to yield a more honest value to
estimate R-Square.
Adjusted R-Square = 1-((1-R^2)*(N-1)/(N-k-1))
N: number of observations

k: number of predictors
When the number of observations (N) is small and the number of predictors (k) is large, there
will be a much greater difference between R-Square and adjusted R-Square (because the ratio
of (N-1)/(N-k-1) will be much less than 1).
By contrast, when the number of observations is very large compared to the number of
predictors, the value of R-Square and adjusted R-Square will be much closer because the
ratio of (N-1)/(N-k-1) will approach 1.
Posted by Spanish Key at 10:24 AM No comments:
Labels: A, CFA Level 2 (June 2011)
Sunday, May 30, 2010
Accrual Tranche (CMO)
(e.g.) Investor's desired investment maturity and cash flow characteristics for CMO.
• investment maturity: long-term investment (average life greater than 5 years)
• cash flow characteristics: does not want to receive any cash flow from it for a number
of years
Which type of CMO tranche would most likely meet this investor's desired investment
maturity and cash flow characteristics?
A. An accrual tranche
B. A sequential-pay tranche.
C. A planned amortization class tranche.
A
Of the three, the accrual tranche typically receives principal only after all sequential-pay
tranche and/or planned amortization class tranches have been paid off, meeting the
investor's need for a long-term security.
Further, until its principal repayment begins, the accrual tranche does not pay interest
but accrues it to principal, meeting the investor's need to not receive any cash flow for a
number of years.
Posted by Spanish Key at 7:18 AM No comments:
Labels: A, CFA Level 2 (June 2010)
Friday, May 28, 2010

Accounting Income (AKA Net Income)
Accounting Income
= (Operating Income Before Tax - Interest Paid) * (1 - Tax Rate)
= (Operating Income Before Tax - Capital Investment(#1) * Interest Rate) * (1 - Tax
Rate)
(#1)(e.g.) Capital investment for an equipment. The equipment is to be financed entirely with
a loan at an interest rate, with interest paid annually for the entire periods and full principal
paid at the end of the year.
See also Net Income.
B
While it is important to adjust income for non-recurring items, these adjustment do not need
to be made to the book value because they are already reflected in the value of the assets.
Posted by Spanish Key at 12:21 PM No comments:
Labels: CFA Level 2 (June 2011), R
CFO: indirect method in the presentation of CFO
Adjustment to Net income related to the pension plan, ignoring income taxes.
CFO = NI + Pension expense - Employer's contributions
Posted by Spanish Key at 12:10 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Compensation expense related to the stock option
Compensation expense related to the stock option (per year)
= Options granted * Option price on the grant date * (1/Service period in year) * Time from
the grant date to fiscal year end
Posted by Spanish Key at 12:08 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Tuesday, May 31, 2011
Growth accounting
The following, according to growth accounting, are helpful in increasing the growth rate of
an economy:
• Stimulate saving

• Stimulate research and development
• Target high-technology industries
• Encourage international trade
• Improve the quality of education
Primary goal: to raise its per capita GDP, which depends on increasing the country's growth
rate of capital per hour of labor. (under New Growth Theory)
Two correct recommendations:
1. provide tax incentives to stimulate savings, and
2. invest in education to raise the population's productivity
(1) Higher savings increase investment in capital.
(2) Increasing investment in education makes labor and machines more productive.
(3) In addition, the New Growth Theory states that knowledge is NOT subject to the laws of
diminishing returns.
Posted by Spanish Key at 3:13 PM No comments:
Labels: CFA Level 2 (June 2011), G
Economic Growth: three sources
1. Physical capital growth
2. Human capital growth
o (e.g.) Investment in human capital to boost literacy and technical skills.
3. Technological advances
o (e.g.) Discovery of new technologies to increase productivity.
Increasing consumption through population growth, including immigration, does NOT
necessarily lead to economic growth.
Posted by Spanish Key at 2:50 PM No comments:
Showing posts with label C. Show all posts
Wednesday, June 1, 2011
CFO: indirect method in the presentation of CFO
Adjustment to Net income related to the pension plan, ignoring income taxes.
CFO = NI + Pension expense - Employer's contributions
Posted by Spanish Key at 12:10 PM No comments:

Labels: C, CFA Level 2 (June 2011)
Compensation expense related to the stock option
Compensation expense related to the stock option (per year)
= Options granted * Option price on the grant date * (1/Service period in year) * Time from
the grant date to fiscal year end
Posted by Spanish Key at 12:08 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Monday, May 30, 2011
Capitalization of interest
Capitalization of interest
Capitalization of interest (to fixed assets)
Net income ↑
CFI ↓
CFO ↑
Posted by Spanish Key at 5:04 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Saturday, April 30, 2011
Convenience Yield
• The convenience yield decreases the futures price. (like dividend yield).
• The price of an index futures contract is reduced by cash flows from the underlying
asset, but the reduction comes from the future value of the cash flows, NOT from an
implied cost for retaining the use of the underlying asset.
Posted by Spanish Key at 10:41 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Cash Flow Yield (CFY)
• dependent on prepayment assumptions
o if prepayment rates differ from the assumption, the CFY will not be realized
• The reinvestment assumption of the CFY is a weakness. The CFY calculation
assumes that interim cash flows are reinvested at the CFY.
Posted by Spanish Key at 10:38 PM No comments:

Labels: C, CFA Level 2 (June 2011)
Friday, April 29, 2011
carrying value of fixed income portfolio
carrying value of fixed income portfolio
bond P V
bond classification held-to-maturity held-for-trading
face value $10 million $7 million
coupon 4%, annual 5%, semi-annual
maturity - 19.5 years
1/2/2009
$9.2 million (yield=5%)
purchase price
7/1/2009
$7 million (par)
purchase price
12/31/2009(current)
$9.6 million
fair value
(*2) $9,260,000
carrying value
(yield = 4%)
fair value
(*1) $7,941,591
carrying value
(*1) Trading securities are reported on the balance sheet at fair value. (carrying value = fair
value)
N = 19.5*2 = 39
I/Y = 4/2 = 2
PMT = 5% * (1/2) * 7,000,000 = 175,000
FV = 7,000,000

CPT PV = -7,941,590.609
(*2) Held-to-maturity securities are reported on the balance sheet at amortized cost.
Carrying value = issue price + discount amortization
= 9,200,000 + (9,200,000*5% - 10,000,000*4%)
= 9,260,000
Thus, at the end of 2009, the investment portfolio is reported at:
9,260,000 + 7,941,591 = 17,201,591
Posted by Spanish Key at 10:41 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Wednesday, April 27, 2011
Capture hypothesis
• The regulatory decisions favor an industry, because:
o the regulatory bodies tend to have members who used to work in the industry.
o the industry has greater economic resources and incentives than consumers.
The industry "captures" the regulators.
Posted by Spanish Key at 11:38 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Saturday, April 23, 2011
Currency Swap
At the inception of the contract (0 day):
USD/MXN
Time USD/MXN
0 day $0.0893
Current term structure
Time USD MXN
360 days 4.0% 5.0%
720 days 4.5% 5.2%
Maturity = 2-year (fixed for fixed)
Payment = annual
Exchange of notional principal: at the beginning and end of the swap term

Notional principal: $100 million
[1] Annual fixed payments in MXN
To calculate the fixed payment in MXN, first use the Mexican term structure to derive the
present value factors:
Z
360(0 day),MXN
= 1/(1+5.0%*360/360) = 0.9524
Z
720(0 day),MXN
= 1/(1+5.2%*720/360) = 0.9058
The annual fixed payment per peso of notional principal would then be:
SF(0,2,360) = (1-0.9058)/(0.9524+0.9058) = 0.0507
The annual fixed payment would be:
0.0507*$100 million*(1MXN/$0.0893) = 56.8 million MXN
Six months have passed (180 days):
USD/MXN
Time USD/MXN
180 day passed (current) $0.0850
Current term structure
Time USD MXN
180 days 4.2% 5.0%
540 days 4.8% 5.2%
[2] Present value of the dollar fixed payments for the two-year currency swap six
months after the initial analysis
Z
360(0 day),USD
= 1/(1+4.0%*360/360) = 0.9615
Z
720(0 day),USD
= 1/(1+4.5%*720/360) = 0.9174

Fixed rate (USD, 0 day) = (1-0.9174)/(0.9615+0.9174) = 0.044
Z
180(180day), USD
= 1/(1+4.2%*180/360) = 0.9794
Z
540(180 day), USD
= 1/(1+4.8%*540/360) = 0.9328
0.044 * 100 * (0.9794+0.9328) + 100 * 0.9328 = $101.69 million
[3] Value of the 2-year currency swap from the perspective of the counterparty paying
dollars six months after the initial analysis
Fixed rate (USD, 0 day) = 0.044
Fixed rate (MXN, 0 day) = 0.0507
Z
180(180 day),MXN
= 1/(1+5.0%*180/360) = 0.9756
Z
540(180 day),MXN
= 1/(1+5.2%*540/360) = 0.9276
The present value of the fixed payments plus the principal is:
0.0507*(0.9756+0.9276)+1*0.9276 = 1.0241 (per MXN)
Apply this to notional principal and convert at current exchange rate:
1.0241 (per MXN) * ($100 million/$0.0893)*$0.085
= 1.0241 * (100/0.0893)*0.085 = $97.48 million
The value of the swap is the difference between this value and the pay dollar fixed present
value derived in the previous question:
$97.48 million - $101.69 million = 97.48 - 101.69 = -$4.21 million
Posted by Spanish Key at 4:43 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Tuesday, April 5, 2011
consolidating SPEs on the balance sheet

consolidating SPEs on the balance sheet
(previously)equity method SPEs consolidated on the balance sheet
Assets ↑
Net income → (no change)
Equity - → (no change)
Posted by Spanish Key at 11:31 AM No comments:
Labels: C, CFA Level 2 (June 2011)
Monday, April 4, 2011
Callable and Putable bond: market price & OAS
• An interest rate lattice is constructed to be arbitrage-free.
• However, when an analyst calculates the price of the callable and putable bond (call
& put price = 100) using the interest rates in the lattice, the analyst gets a value
higher than the market price of the bond.
• The embedded options will be exercised if the option has value(i.e., in-the-money).
The price of the callable and putable bond is likely:
Callable and putable bond
Market price OAS
A. < 100% Zero
B. = 100% Positive
C. > 100% Negative
Answer: B
Market price:
In this case, the bond is callable and putable at the same price(100). Since the embedded
options (the issuer's call option and the holder's put option) will be exercised if the option has
value (i.e., is in-the-money), the value (=market price, in an ideal world) of the bond must be
100 (plus the interest) at all times.
If rates fall and the computed value goes above 100, the company will call the issue at 100.
Conversely, if rates increase and the computed value goes below 100, the bondholder will
"put" the bond back to the issuer for 100.
OAS:

The OAS is a constant spread added to every interest rate in the tree so that the model price
of the bond is equal to the market price of the bond. In this case, using the interest rate lattice,
the model price of the callable and putable bond is greater than the market price. Hence,
a positive spread must be added to every interest rate in the lattice. When a constant spread
is added to all the rates such that the model price is equal to the market price, you have found
the OAS. The OAS will be positive for the callablle and putable bond.
Posted by Spanish Key at 11:17 AM No comments:
Labels: C, CFA Level 2 (June 2011)
Saturday, April 2, 2011
Convenience Yield
"You should note that since we have taken a short position in the futures contract, the price
we will receive for selling the equity index in 240 days will be reduced by the convenience
yield associated with having a long position in the underlying asset. If there were no cash
flows associated with the underlying asset, the price would be higher."
Incorrect
Convenience yield refers to non-monetary benefits from holding an asset in short supply.
A monetary benefit from holding the asset will also decrease the no-arbitrage futures price
because the net cost of holding is reduced.
Posted by Spanish Key at 7:53 AM No comments:
Labels: C, CFA Level 2 (June 2011)
Friday, April 1, 2011
Cash flow duration and Empirical duration
Cash flow duration and Empirical duration
Cash flow duration Empirical duration
Feature Similar to effective duration.
Advantage
It does NOT rely on any theoretical
formulas (theoretical valuation
models)
Weakness

It fails to fully account for changes in
prepayment rates as cash flow yields change.
(Cash flow duration assumes that one
prepayment rate will apply over the life of
an MBS for whatever change in interest rates
is assumed.)
Reliance on historical pricing data
that may not exist for many
mortgage-backed securities. (The
values are based on historical
pricing relationships.)
Posted by Spanish Key at 4:04 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Cash flow yield (CFY)
Cash flow yield (CFY) is one method of valuing mortgage-backed securities.
Cash flow yield (CFY)
description
Advantage
Weakness
• The CFY is dependent on prepayment assumptions; if prepayment rates
differ from the assumption, the CFY will not be realized
• The assumption that interim cash flows will be reinvested at the CFY.
This is rarely true for mortgage-backed securities.
Posted by Spanish Key at 3:37 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Tuesday, March 15, 2011
Carve-out tsansactions and Spin-off transactions
Spin-off transactions and Carve-out tsansactions
Spin-
off

Carve-
out
Creating a new entity out of a company's business line or one of its
subsidiaries
Yes Yes
Granting shares in the new entity to the existing shareholders of the parent
company.
Yes
The shareholders are then free to sell their shares in the spin-off company in
the marketplace.
Yes
Generally viewed as a favorable sign in the market?
Yes
(*1)
Minority of shares is sold to the public while the majority portion of the new
shares are held by the parent company (they are NOT distributed to existing
shareholders).
Yes
(*1) because they often result in greater efficiency for the spin-off company and the parent
company.
Posted by Spanish Key at 9:29 AM No comments:
Labels: C, CFA Level 2 (June 2011)
Sunday, March 13, 2011
Comparable transaction approach (merger and acquisition)
(Question)
To justify the use of the comparable transaction approach to establish a fair acquisition for
Target company, one would like to conclude his report with the most important reason for
choosing this approach. Which of the following rationals would one most likely use?
A. The fair acquisition price developed for Target reflects a market based valuation approach,
an advantage compared to discounted cash flow valuations, which are based on assumptions

that do not incorporate market valuations.
B. The acquisition prices for recently acquired companies provide a reasonable
approximation of their realistic intrinsic values.
C. The fair acquisition price developed for Target is a realistic estimate of potential value to
Acquirer given that forecasts of future performance are unavailable.
Answer: A
This is a key reason to use the comparable value method, particularly when contrasted with
the use of discounted cash flow valuations. Acquisition prices are not necessarily
approximations of intrinsic values. A price developed based on comparable transactions does
not always indicate the potential value of the acquisition to the purchaser.
Posted by Spanish Key at 12:51 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Sunday, March 6, 2011
Cap and Floor
A bank's exposure: $100 million debt obligation next 2 years; quarterly coupon, floating(90D
LIBOR)
Following is an excerpt from a bank manager's memo:
• "Rather than using a cap or floor, the bank can effectively manage its exposure to
interest rates resulting from the 2-year funding requirement by taking long positions
in a series of put options on fixed-income instruments with expiration dates that
coincide with the payment dates on the floating-rate note."
• "As a cheaper alternative, the bank can effectively manage its exposure to interest
rates resulting from the 2-year funding requirement by creating a collar using long
positions in a series of call options on interest rates and long positions in a series of
call options on fixed-income instruments, all of which would have expiration dates
that coincide with the payment dates on the floating-rate note."
Mitigating the interest rate rise risk
approach Underlying Long/short IR↑ IR↓
Interest rate cap Interest rates Long ↑(**)
Cap or floor alternative Put Fixed-income instruments Long ↑

Artificial collar (*)(***) Call Interest rates Long ↑ ↓
Artificial collar (*)(****) Call Fixed-income instruments Long Short ↑ ↓
(*) Long cap & Short floor
(**) It means the value increases when the interest rate rises.
A long cap can be replicated either through (1) long put on fixed-income instruments or (2)
long call on interest rates.
Short floor can be replicated either through (1) short call on fixed-income instruments or
(2) short put on interest rates.
(***)Long cap
(****)Short floor
Posted by Spanish Key at 10:07 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Saturday, March 5, 2011
Capitalization rate (Market Capitalization rate)
Capitalization rate = R
0
= Discount rate - Growth rate = r - g
MV
0
= NOI/(r-g) = NOI/R
0
R
0
= NOI/MV
0
r = R
0
+ g
Capitalization rate
Property type

Net operating
income (NOI)
Growth
rate(g)
Property
value(MV
0
)
Capitalization
rate(R
0
)
Discount
rate(r)
Office
building
$600,000 3% $8,000,000 7.5% (*1)
7.5%+3% =
10.5%
Warehouse $600,000 5% $10,000,000 6% (*2)
6%+5% =
11%
Hotel $900,000 7% $9,000,000 10% (*3)
10%+7% =
17%
(*1) $600,000/$8,000,000 = 7.5%
(*2) $600,000/$10,000,000 = 6%
(*3) $900,000/$9,000,000 = 10%
Posted by Spanish Key at 9:09 AM No comments:
Labels: C, CFA Level 2 (June 2011)

Wednesday, March 2, 2011
Carrying value: held-to-maturity and trading securities
1/1/2009 and 7/1/2009 (MM/DD/YYYY)
bond FV(*1) cost(*1) coupon yield Maturity(yrs)
M held-to-maturity 10 9.2(1/1/2009) 4% annual 5% -
T trading security 7 7(7/1/2009) 5% semiannual - 20
12/31/2009
bond FV(*1) cost(*1) coupon yield Maturity(yrs) CV(*1)(*4)
Fair
value(*1)
M
held-to-
maturity
10 9.2(1/2/2009) 4% annual - - 9.26(*3) 9.6
T
trading
security
7 7(7/1/2009)
5%
semiannual
4% 19.5 Fair value 7.941591(*2)
(*1)$million
(*2)
39 N
2 I/Y
0.175 PMT
7 FV
PV CPT 7.9416
(*3) Held-to-maturity securities are reported on the balance sheet at amortized cost.
issue price + discount amortization

= issue price + (interest expense - coupon payment)
= 9.2 + (9.2*5%-10*4%)
= 9.2 + (0.46-0.40)
(*4) Carrying value is also reported value on the balance sheet.
= 9.26
At the end of 2009, the investment portfolio of bond M and T is reported at:
9.26 + 7.941591 = 17.201591 million USD = 17,201,591 USD
Posted by Spanish Key at 9:15 PM No comments:
Labels: C, CFA Level 2 (June 2011)
Monday, February 28, 2011
Capture Hypotheis
• The regulatory decisions favor the industry (e.g. drug industry); this can be due to the
fact that the regulatory bodies tend to have members who used to work in the
industry.
o (e.g.) Due to the level of scientific knowledge needed, many regulartory
bodies for the pharmaceutical industry are dominated by former drug company
executives and scientists.
• Regulatory decisions will favor industry because the industry has greater economic
resouces and incentives than consumers.
Posted by Spanish Key at 9:08 AM No comments:
Labels: C, CFA Level 2 (June 2011)
Creative Response
In a creative response, the regulated parties conform to the letter(i.e., rule itself), but NOT the
intent of the law.
(e.g.)
When the automobile industry was required to increase the fuel efficiency of passenger
vehicles, it increased the weight of some vehicles so more could be classified as trucks,
instead of passenger vehicles. The trucks were not subject to the regulation, and as a result,
fuel efficiency actually declined in the country due to the heavier weight of trucks.