KEY CONCEPTS Flashcards

Question

**Credit Default Swaps**

Answer 1

* *Short CDS** (Protection Seller) = Long Credit Risk * *Long CDS** (Protection Buyer) = Short Credit Risk Agreement between 2 parties. The protection seller receives a fee. In return for the fee, the seller is obliged to compensate protection buyer if a credit event occurs. * **Index CDS**: Multiple borrowers, equally weighted * **CDS Spread**: Higher for a higher probability of default and for higher loss given default * **Common credit events** in CDS agreements: Bankruptcy, failure to pay, restructuring (Restructuring is not considered a credit event in some countries; least likely to be a credit event) * **CDS change in value** over their lives as the credit quality of the reference entity changes * When there is a credit event, the swap will be settled in * *cash or by physical delivery** * Note that a CDS does **not entirely eliminate credit risk**; it eliminates the credit risk of the reference entity but substitutes it with the _credit risk of the CDS seller_) The protection buyer is said to be short the reference entity's credit risk and is bearish on the financial condition of the reference entity * A super majority vote of the declarations committee of **ISDA** is needed for a c**redit event to be declared** * CDS fixed payments are customarily set at a **fixed annual rate of 1% for investment-grade debt** or **5% for high-yield debt** * Fixed payments are made by the CDS buyer to the CDS seller. The protection buyer is obligated to make regular payments until maturity of the CDS or until default (whichever occurs first)

Answer 2

**Upfront CDS Payment** = PV(protection leg) - PV(premium leg) (paid by protection buyer) ~ (CDS Spread - CDS Coupon) x Duration x Notional **Change in value after inception** = Change in Spread x Duration x Notional The CDS upfront payment may either be from the protection buyer to the seller, **or vice-versa**. If the credit spread is equal to the coupon rate, the **upfront payment can be zero**. The amount of upfront payment depends on the difference between the credit spread on the reference obligation and the CDS coupon rate, and hence need not be higher for a high-yield bond compared to an investment grade bond.

Answer 3

**Swap Spread** = Swap rate (fixed rate) - Treasury yield **Credit / G-Spread** = YTM Corporate Bond - YTM Government Bond

Answer 4

Exercisable: **European** Option = _Single date_ after lockout (often at expiration) **American** Option = _Continusly_ exercisable **Bermudan** Option = Excercise on _predetermined dates_ (after lockout)

Answer 5

**ED** = (V_- − V₊) / (2V₀(∆y)) **EC** = (V_- + V₊ − 2V₀) / (V₀(∆y)2)

Answer 6

* *Callable Bond** = Low Down Duration * *Putable Bond** = Low Up Duration The “up” and “down” refers to the interest rates, not bond prices. So to say that callable bonds have higher “up” duration means that when interest rates go up, prices fall, and the bond is less likely to be called (and more likely to run through maturity --\> higher duration).

Answer 7

**CAPM** =\> r = Rf + Beta (ERP) **Fama-French**=\> CAPM + Small Cap Return Premium + Value Return Premium **Pastor-Strambaugh Model** =\> r = Fama French + _Liquidty_ Premium _Macro_: * **Ibbptson-Chen ERP** = \> [(Inflation x Growth in real earnings per share x Expected growth in PE ratio) -1] + Income component (e.g. SP500 div yield) - Gov. Yield * **5 Factor BIRR**

Answer 8

Use **DDM** when: * Firm has a dividend history * Dividend policy related to earnings * Minority shareholder perspective Use **FCF** when: * Firm lacks stable dividend policy * Dividend policy not related to earnings * FCF is related to profitability * Controlling shareholder perspective Use **RI** when: * Firm lacks dividend history * Expected FCF is negative

Answer 9

**P₀** = D₁/ (r – g) solve for r **r** = (D₁/ P₀) + g

Answer 10

V₀ = E₁ / r + **PVGO**

Answer 11

Decline in the growth rate is a gradual process (linear)

Answer 12

* FCFF = **Net Income** + Dep + [Interests x (1-t)] - FCInv - WCInv * FCFF = [**EBIT** x (1-t)] + Dep - FCInv - WCInv * FCFF = [**EBITDA** x (1-t)] + [Dep x tax rate)] - FCInv - WCInv * FCFF = **CFO** + [Interests x (1-t)] - FCInv

Answer 13

* FCFE = **Net Income** + Depreciation - FCInv - WCInv + _Net Borrowing_ * FCFE = **FCFF** - [Interests x (1-t)] + _Net Borrowing_ * FCFE = **CFO** - FCInv + _Net Borrowing_ *Forcasting*: NI - [(1 - DebtRatio) \* (Capex - Depreciation + WCInv)]

Answer 14

* **Leading P/E** = (1-b) / (r-g) * **Trailing P/E** = [(1-b) \* (1+g)] / (r-g)

Answer 15

**D₀ / P₀**= (r - g) / (1 + g) solve for g (D₀ / P₀ = *d*) **g** = (r - d) / (1 + d)

Answer 16

**P₀ / B₀** = (ROE₁ - g) / (r - g)

Answer 17

P₀ / S₀= Net margin \* trailing P/E = [(E₀ / S₀) \* (1 - b) \* (1+g)] / (r - g)

Answer 18

**EV** = MV of Equity + MV of Debt + Nci - Cash & Investments

Answer 19

**EVA** = NOPAT - $WACC *NOPAT = EBIT x (1-t)*

Answer 20

**Residual Income** = Net Income - Equity Charge **RI** = E_t- (r x B_t-1) = (ROE - r) x B_t-1

Answer 21

**g = b x ROE** ROE = NI / Equity or longer: Dupont / PRAT **g = b x Profit Margin x Asset Turnover x Financial Leverage** g = b x NI / Sales x Sales/Total Assets x Total Assets/Equity

Answer 22

B₁ = B₀ + NI DIV (NOt +- OCI = violation) **Violations:** * Cumulative Translation Adjustment * Change in fair value of available for sale investments Don't use RI Model if violated.

Answer 23

1. **ETF share at a discount to NAV**: AP steps in to buy the ETF shares on the open market and simultaneously sells the stocks on the exchange, trading takes place until the pricing discrepancy disappears. The AP may choose to **redeem** ETF shares by exchanging them for the basket of securities with the fund issuer – ETF share redemption 2. **ETF share at a premium to NAV**: AP steps in to sell the ETF shares on the open market and simultaneously buy the stock on the exchange. The AP may choose to **create** additional ETF shares by exchanging the basket of securities for ETF shares with the fund issuer – ETF share creation NAV: Intraday fair value estimate based on its _creation basket for the day_

Answer 24

1. **Portfolio efficiency** * Cash or liquidity management (Minimizing cash drag) * Rebalancing (Maintaining exposure to target weights by asset class or sub-asset class) * Portfolio completion (Using ETFs to plug the gaps if strategic economic exposure by country, sector, industry, themes, factors) * Active manger transition management (Maintain benchmark exposure during manager transition) 2. **Asset class exposure management** 3. **Active and factor investing**

Answer 25

1. A f**actor model describes asset returns.** 2. There are many assets, so investors can form well-diversified portfolios that **eliminate asset-specific risk,** not factor risk. 3. **No arbitrage opportunities** exist among well-diversified portfolios The absence of an arbitrage opportunity indicates a condition of **financial market equilibrium**

Answer 26

1. A minimum loss 2. Over a defined time period 3. With a stated probability

Answer 27

1. **Parametric method** assumes that the distribution of returns on the risk factors is normal, and it is considered to be a straightforward approach. Not suited for options. 2. **Historical Simulation Method** uses past, actual returns. Can be used for options. More weight to recent observations. NOT certain that historical events will re-occur 3. **Monte Carlo** **simulation** method relies on neither a normal distribution nor past returns and, as a result, is able to accommodate bonds that may contain embedded options

Answer 28

1. **Macroeconomic** models, the factors are “_surprises_” (how much higher or lower than what was expected) in macroeconomic variables, not the level or value of macroeconomic variables 2. **Statistical** factor models use factor analysis to produce factors that are portfolios of securities that best explain historical return covariances. Alternatively, they use principal component analysis to derive factors that are portfolios of securities that best explain historical return variances 3. **Fundamental** factor models: the factors are company share attributes, such as price-to-earnings ratio and market capitalization

Answer 29

There are three main drivers behind the expected active return of a portfolio (value added). 1. **Breadth** (BR) is defined as the number of independent forecasts of exceptional return we make per year 2. **Information coefficient** (IC) is a measure of the investor’s skill and considers the correlation of each forecasted active return with realized active returns. This tells us if the investor was just lucky or whether there was some process behind the strategy 3. **Transfer Coefficient** (TC) represents the degree to which the investor’s forecasts are translated into active weights. You can be the best forecaster of active returns in the world but to create value added, the portfolio must be properly constructed to incorporate these forecasts **Limitations**: Key assumption (and problem) is that the forecasts should be (decision) **independent** i.e. forecast 2 should not be based on information that is correlated with the sources used for forecast 1. Fixed Income: Duration risk, credit risk, and optionality, so their returns are highly correlated

Answer 30

1. **Act with integrity, competence, diligence, respect, and in an ethical manner** with the _public, clients, prospective clients, employers, employees, colleagues_ in the investment profession, and other participants in the global capital markets 2. **Place the integrity of the investment profession and the interests of clients above their own** personal interests 3. **Use reasonable care and exercise independent professional judgment** when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities 4. **Practice and encourage others to practice in a professional and ethical manner** that will reflect credit on themselves and the profession 5. **Promote the integrity and viability of the global capital markets** 6. **Maintain and improve their professional competence** and strive to maintain and improve the competence **of other investment professionals**

Answer 31

1. **Professionalism** * Knowledge of the Law * Independence and Objectivity * Misrepresentation * Misconduct 2. **Integrity of capital markets** * Material Non-public Information * Market Manipulation 3. **Duties to clients** * Loyalty, Prudence, and Care * Fair Dealing * Suitability * Performance Presentation * Preservation of Confidentiality 4. **Duties to employers** * Loyalty * Additional Compensation Arrangements * Responsibilities of Supervisors 5. **Investment analysis, recommendations, and actions** * Diligence and Reasonable Basis * Communication with Clients and Prospective Clients * Record Retention 6. **Conflict of interest** * Disclosure of Conflicts * Priority of Transactions * Referral Fees 7. **Responsibilities as a CFA Institute member or CFA® Program candidate** * Conduct as Participants in CFA Institute Programs * Reference to CFA Institute, the CFA Designation, and the CFA Program

Answer 32

**EPS after buyback** = (Total earnings - after-tax cost of funds) / shares outstanding after buyback Change in EPS is **positive** if earnings yield **exceeds** after-tax cost of debt.

Answer 33

* **Post-merger value** = Pre-bid value of both + Synergies - Cash paid * **Takeover Premium** = Price - Pre-bid value * **Acquirer’s gain** = Synergies - Premium

Answer 34

***p*xy** = (sign of b1) x (R)^1/2 Higher -\> Better Fit

Answer 35

1. **Linear relationship** – might need transformation to make linear 2. **Independent variable is not random** – assume expected values of independent variable are correct 3. Expected value of **error term is zero** 4. **Variance of error term is same across all observations** (homoskedasticity) 5. **Error terms uncorrelated** (no serial correlation) across observations 6. Error terms normally distributed

Answer 36

* Model should be **grounded in sensible economic reasoning** - E.g. avoid data mining * Functional f**orm of variables should be appropriate** - E.g. use logs of inputs if appropriate * Model should be **parsimonious** i.e. achieving a lot with a little * Model should be **examined for violations** of regression assumptions before being accepted * Model should be **tested ‘out of sample’**, i.e. use new sample data before being accepted The model could fail because: One or more important variables are omitted; One or more of the regression variables may need to be transformed - E.g. using natural logs for exponential data: Data from different samples is pooled, e.g. using data from different stages of a company’s growth

Answer 37

* The **regression coefficient** is _significant_ * The **Autocorrelations** of the residual are _not significant._

Answer 38

1. Prior to the crisis, **capital markets are liberalized to allow free movement of capital** 2. **Large inflows of foreign capital** (relative to GDP). If these investment/loans are in the form of short-term, foreign currency denominated loans then will cause problems if the currency weakens 3. Currency crisis often **follow a banking crisis** 4. Countries that adopt a **fixed or partially fixed exchange rate are more likely to experience a currency crisis** 5. **Inflation significantly higher pre crisis** 6. Ratio of **M2** (broad money) to bank reserves **rises in years leading up to crisis and plummets immediately after** 7. **Foreign exchange reserves tend to decline rapidly** as the currency crisis approaches 8. The terms of trade (ratio of exports to imports) worsen ahead of the crisis 9. Preceding the crisis, the currency trades higher than its long-run average

***KEY CONCEPTS*** Flashcards

KEY CONCEPTS Flashcards