Schweser

Schweser's material, especially Practice Exams vol.1 and 2 are really something. I highly recommend to buy them.

http://www.schweser.com/cfa/

Pension Liability Recognized

Pension Liability Recognized (under SFAS(*) No.158)
= Ending pension obligation (PBO) - Ending pension assets without any adjustments for unrecognized amounts

(*)Statements of Financial Accounting Standards (SFAS) - US GAAP

Residual income model: advantage

Which of the following is the most appropriate description for residual income model?

A. The analyst need not adjust the book value of common equity for off-balance sheet items.
B. The analyst need not adjust the book value of common equity for non-recurring items.
C. The interest expense in the residual income model correctly captures the cost of debt capital.


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.

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

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

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

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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.

Economic Growth: three sources

1. Physical capital growth
2. Human capital growth
• (e.g.) Investment in human capital to boost literacy and technical skills.
3. Technological advances
• (e.g.) Discovery of new technologies to increase productivity.

Increasing consumption through population growth, including immigration, does NOT necessarily lead to economic growth.

Active portfolio management: justifications

Why active portfolio management might add value in an efficient market environment?

• Economic argument (logic)
• 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.
• (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
• Some managers have consistently produced excess returns relative to a passive strategy, suggesting skill rather than luck.

Portfolio management process: planning step

Parts of the planning step of the portfolio management process:

1. Identify the investment objectives and constraints.
2. Create an investment policy statement.
3. Form a set of capital market expectations.
4. Determine a strategic asset allocation.

Following parts are NOT in the planning step.

• Evaluation of the performance of the portfolio.
• Selection of assets or managers for the portfolio.

Local currency debt (relative to foreign currency debt)

Criteria established by rating agencies to assess sovereign debt:

Local currency debt (relative to foreign currency debt)

		Local currency debt	Foreign currency debt
Political stability		Yes
Fiscal policy flexibility		Yes
Ability to raise taxes		Yes
Willingness to pay debt (history of defaults)		Yes
Level of external debt			Yes
Level of exchange rate			Yes

High yield issuers

Investments in securities issued by high yield companies.

• Bank loans are an attractive part of the capital structure since they have priority over other bondholders in the firm's assets.
• Bank loans can enhance recovery values because they are senior in the capital structure and generally secured by a lien on the firm's assets, providing priority over other debt holders.
• These companies often have a holding company structure from which it can issue bonds but is reliant on the ability of operating subsidiaries to move cash to the holding company to pay bondholders which may be restricted by covenants, even if they are senior bonds.
• Bonds can be issued out of a holding company but assets and cash flows are typically resident at operating companies which may be restricted by covenants from up streaming funds to the holding company even for the payment of senior bonds.

Affirmative covenant

A covenant calls upon a borrower (debt issuer) to do a certain thing (rather than restrictions on a certain ratio threshold/action).

Free Operating Cash Flow

Free Operating Cash Flow = CFO - NWCInv - FCInv

NWCInv: change in net working capital (net investment in working capital)
FCInv: capital expenditures

The higher the Free Operating Cash Flow, the stronger credit based on cash flow analysis.

Traditional credit analysis

• Current ratio = Current assets/Current liabilities
• Long-term debt to Capitalization = Long-term debt / (Total debt + Total Equity)
• EBIT Interest coverage = EBIT / Interest expense

FCFE: debt paydown

"Although the FCFE declines in the year when debt is paid down, it will increase in subsequent years."

Correct.

FCFE↓ = NI + NCC + Net borrowing↓ - NWCInv - FCInv

In the later years, however, it will increase because of the reduced interest expense(e.g. higher net income); thus, a higher shareholder value.

ROE (Return On Equity)

The lower payout ratio will increase the return on equity.

Incorrect.

g = ROE * (1 - d↓)
Lower payout ratio does not necessary increase the ROE.

Signaling theory

The reduction in dividends is taken as a negative signal by investors therefore dividend reduction almost always results in a reduction in share price.

Capitalization of interest

Capitalization of interest

			Capitalization of interest (to fixed assets)
Net income			↑
CFI			↓
CFO			↑

Generalized least squares model

"First, if ARCH exists, the standard errors for the regression parameters will not be correct. In case ARCH exists, we will need to use generalized least squares..."

OAS

• (Average) OAS is calculated using a:
• binominal model or
• Monte Carlo model (simulation)
• The OAS measures the average spread over a Treasury spot rate curve, and NOT over the Treasury yield.
• It is an average spread since the OAS is found by averaging over the interest rate paths for the possible Treasury spot rate curves.
• The OAS represents compensation for credit risk, liquidity risk, and modeling risk.
• Modeling risk
• The Monte Carlo model uses several critical assumptions and parameters. If those assumptions prove incorrect or if the parameters are misestimated, the prepayment model will not calculate the true level of risk, resulting in modeling risk.
• If the security is issued by a government agency, the credit risk component is not relevant in the OAS.
• If a security is issued by a government agency such as Ginnie Mae, there is no required compensation for credit risk and this will be reflected in the OAS level.

Treynor-Black model

1. The model construct the optimal risky portfolio as a combination of the passive and active portfolios.
2. Each stock's weight in the active portfolio is determined on the basis of its alpha, beta, and σ(e).

External crossing

To achieve best execution in its international investing, the fund emphasizes two aspects related to execution costs:

1. maintaining anonymity
2. minimizing commissions and fees.

[Question]
Which of the following trading techniques is most consistent with the claim above regarding best execution in the firm's international investing?

A. Agency trade
B. Principal trade
C. External crossing

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[Answer]
C

External crossing keeps execution costs very low and anonymity is assured.

Withholding taxes

income gains (dividend) = 1.2 million EUR
capital gains = 2.0 million EUR

withholding tax = 15%

Follow the standard approach with respect to withholdings.


Total amount of withholding taxes the fund will reclaim is:
0.15 * 1.2 = 0.18 million EUR

The standard approach is that withholding is applied to the dividend income only.

Residual income models

• One disadvantage(drawback) to the single-stage residual income model is that it assumes the excess ROE above the cost of equity will persist indefinitely.
• In residual income models the terminal value may NOT be a large component of total value because ROE may fade over time toward the cost of equity.

Effective tax rate on dividends

1 - Effective tax rate on dividends = (1 - corporate tax rate on dividends)*(1 - personal tax rate)

Effective tax rate on dividends = 1 - (1 - corporate tax rate on dividends)*(1 - personal tax rate)

Pension Expense

Pension Expense
= Service cost + Interest cost - Expected return on plan assets + Amortization of unrecognized service cost + Amortization of unrecognized loss


See also Economic Pension Expense.

Minimum-variance efficient frontier: instability

The instability of the minimum-variance efficient frontier is attributed to:

• Absence of a short sales constraint
• Historical betas

Total Shareholders' Equity (in a consolidated balance sheet on the date of acquisition)

Total Consolidated Shareholders' Equity
= Shareholders' Equity (Parent) + Noncontrolling interest
= Shareholders' Equity (Parent) + (1 - %Interest of Parent) * Shareholders' Equity (Child)

The noncontrolling interest is now reported in the shareholders' equity section under both U.S. GAAP and IFRS.

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

Stock options and Stock grants

Stock options are affected by higher volatility and would have increased the compensation expense and lowered net income.

Stock grants are based on the fair market value of the stock on the date of the grant and are NOT affected by the stock's volatility.

equity market neutral

[Question]
benchmark: 30-day Treasury bill rate + a spread of 250 bps

The intended benchmark for hedge fund investments would be most appropriate for:

A. distressed securities funds.
B. equity market neutral funds.
C. fixed income arbitrage funds.

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[Answer]
B

Because

• while "application of some universal benchmark, no matter how well constructed, is unlikely to capture the essence of all hedge funds' performances"
• "the hedge fund strategy that comes closer to pure risk-free arbitrage is equity market neutral."

It is reasonable to benchmark risk-free arbitrage against the risk free rate plus a spread to represent return required to compensate for management fees.

roll yield

commodities

roll yield
positive(*)	Futures price > "full carry" price	backwardation	This may occur when prices are low and volatile and commodities producers are concerned that they will fall further, to a level that is unprofitable. Producers will accept less that the "full carry" price in oder to hedge price risk.

(*) If you long a commodity futures and sell at a higher price at roll over date, you will get a positive roll yield.

CFA Institute Research Objectivity Standards: Standard 6, Relationship with Subject Companies

• Sharing any section of a research report that might communicate the analyst's proposed recommendation, rating, or price target, is prohibited by the Standards.
• Factual information is allowed to be shared.

Stock forward: current value of the short position

Financial market information

U.S. three-month (90 day) annualized risk-free rate			6.00%

• Six months ago, you entered into a forward contract to sell the underlying stock at a price of $80.
• The forward contract has three months to expiration now and the stock is currently trading at $75.
• A 360-day year.

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[Question]
What is the current value of the short position in the stock forward contract?

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[Answer]
The value of a long position in a forward contract at any time is:
V_t = S_t - F_(0,T)/(1+r)^(T-t)
(Assumed that there is no dividend.)

V_t = $75 - $80/(1+6.00%)^(90/360) = -$3.84

The value to the short position has the opposite sign and is $3.84.

estimation of the WACC for an emerging country firm

[Question]

1. When estimating the percent of debt and equity in the capital structure, the market value of the firm's debt and equity should be used, not the book value.
2. The beta will be needed to obtain the cost of equity capital in the CAPM. The beta should be estimated for the company by regressing the company's returns against a well diversified global index, not the local market index.

Are both statements correct?

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[Answer]

1. Incorrect. The debt and equity weights from a global industry index should be used, not the weights for the firm. Firms in emerging markets often use debt conservatively and this results in lower leverage ratios than for firms in the same industry in other countries.
2. Incorrect. An industry beta for the firm's industry should be estimated, not an individual firm beta. It is correct however that a well diversified global index, not the local market index, should be used.

Emerging market country risk: adjusting emerging market country risk by the cash flows

[Question]

1. One argument is that companies respond differently to the risk in their country. For example, exporters would benefit from a weaker local currency but importers would be hurt by a depreciating currency. Adjusting the discount rate by the same amount for all companies within a country would misstate the influence of country risk on each company.
2. Additionally, country risk is one-sided and asymmetric in that the country risk to foreign investors is much greater than that to local investors. So if a single discount rate were used to discount cash flows, then the valuations would be inaccurate for either the foreign investors or the local investors.

Are both statements 1 and 2 correct?

---

[Answer]
No, only Statement 1 is correct.

It is correct that emerging market valuations should be adjusted for country risk by adjusting the cash flows and not the discount rate.

1. The argument that companies within an emerging market will be affected differently by country risk is correct.

2. It may be true that country risk for foreign investors is greater than that for local investors. However, it is incorrect in the justification because it incorrectly describes the one-sided nature of country risk in this context. Country risk is asymmetric because many emerging market companies have risk profiles that are one-sided (down only). It is best to adjust for this in the cash flows rather than to adjust the discount rate.

Financial transaction and Strategic transaction

Strategic transaction and Financial transaction

transaction
strategic transaction			A firm is acquired based in part on the synergies it brings to the acquirer.
financial transaction			There are no synergies.

FRA (Forward Rate Agreement)

• A project has eight months until project completion.
• Funding for the project will run out in approximately six months. Need to cover the funding gap.
• Funding = $1,275,000

To mitigate the interest rate uncertainty, you have decided to enter into a FRA based on LIBOR.

LIBOR rates on July 1 (current)

Day			All-current
90			4.28%
180			4.52%
240			5.11%
360			5.92%

LIBOR rates on October 1

Day			All-current
90			5.12%
150			5.96%
210			6.03%
300			6.41%

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[Question 1]

What is the price of the FRA on the date of the contract inception?

(1+R₂₄₀*240/360) = (1+R₁₈₀*180/360)(1+FRA_6x8*60/360)
FRA_6x8 = ((1+R₂₄₀*240/360)/(1+R₁₈₀*180/360) - 1)*(360/60)
= ((1+5.11%*240/360)/(1+4.52%*180/360) - 1 )*(360/60)
= 0.067279

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[Question 2]

What is the value of the forward rate agreement three months after the inception of the contract (from fixed-payer's perspective)? For this question only, assume that the interest rate at inception was 6.0%.

(1+R₁₅₀*150/360) = (1+R₉₀*90/360)(1+FRA_3x5*60/360)

(1)

FRA_3x5 = ((1+R₁₅₀*150/360)/(1+R₉₀*90/360) - 1)*(360/60)

= ((1+5.96%*150/360)/(1+5.12%*90/360) - 1)*(360/60)

= 0.071288 = 7.13%

or

(2)

FRA_3x5 = ((1+R₁₅₀*150/360)/(1+R₉₀*90/360) - 1)*(360/60)

= ((1+5.96%*150/360)/(1+5.12%*90/360) - 1)*(360/60)

= (1.0248/1.0128 - 1)*(360/60)

= 0.0118*(360/60)

= 0.0708 = 7.08%

(1)

(7.13%-6.0%)*(60/360)*$1,275,000/(1+5.96%*150/360)
= 2343.064

(2)

(7.08%-6.0%)*(60/360)*$1,275,000/(1+5.96%*150/360)

= 2239.389

Weighted Average Cost of Capital (WACC)

WACC = (D+PVOL)/(E+D+PVOL) * r_d * (1-t) + E/(E+D+PVOL) * r_e

D: market value of the firm's debt
PVOL: Present value of operating lease
r_d: (pretax) cost of debt = debt yield = interest rate on operating lease (in this case)
t: corporate tax rate

E: market value of the firm's equity

r_e: cost of equity

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

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.

Cash Flow Yield (CFY)

• dependent on prepayment assumptions
• 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.

ICAPM (International CAPM)

E(R) = R_f,DC + β_WM * WMRP + γ_DC * FCRP

R_f,DC: domestic risk-free rate
β_WM: asset's world market beta
WMRP: world market risk premium
γ_DC: sensitivity of the asset's domestic currency return to a change in the local (foreign) currency
FCRP: foreign currency risk premium

All returns are measured in DC (domestic currency).

ICAPM (International CAPM)

items			value
Rf,DC			2.00%
Rf,FC			8.00%
World market risk premium			6.00%
Foreign country index beta to world market index			1.40
Foreign country's local market risk premium			7.50%
Foreign company's beta to local index			1.30
Foreign currency risk premium			3.00%
Foreign country's sensitivity of LC stock returns to LC			0.70

γ_LC = γ_FC = 0.70

We need to convert this to the sensitivity of the asset's domestic currency returns to the local currency. Using the formula for the sensitivity of the asset's domestic currency return to a change in the local currency.

γ = γ_DC = γ_FC + 1= 0.70 + 1 = 1.70

The ICAPM expected return for the foreign company is:

E(R)
= R_f,DC + β_WM * WMRP + γ_DC * FCRP
= 2.00% + 1.40 * 6.00% + 1.70 * 3.00%
= 15.500%

traditional model

When the FC (foreign currency) changes by 10%, the value of the exporter (a foreign company) stock generally change by 6%. The exporter does not import its inputs but obtains them locally.

[Question]
The sensitivity of the exporter stock returns, measured in DC (domestic currency) to changes in the value of the FC is:

Traditional model

FC			Exporter stock price
↑(appreciation) 10%			-6%
↓(depreciation) -10%			+6%

The exporter's local currency (FC) exposure is thus negative and is -0.60.

Using the formula for the domestic currency exposure, the sensitivity of the exporter stock returns in DC terms to changes in the value of the FC is:

γ = γ(LC) + 1
= (-0.60) + 1 = 0.40

γ: DC sensitivity
γ(LC): LC (local currency) sensitivity


(opposite) money demand model

Foreign Currency Risk Premium (FCRP)

[Question]

The foreign exchange expectation theory and interest rate parity hold between DC (domestic currency/country) and FC (foreign currency/country).

Interest rate: r_DC=2%, r_FC=5%

What is the foreign currency risk premium?

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Answer:

FCRP = Expected exchange rate movement - Interest rate differential between DC and FC
= (E(S₁) - S₀)/S₀ - (r_DC - r_FC)

S₁, S₀: DC/FC

If interest parity holds, the foreign rate, F, reflects the differences between country interest rates.
F = S₀ * (1 + r_DC - r_FC)

FCRP
= (E(S₁) - S₀)/S₀ - S₀*(r_DC - r_FC)/S₀
= (E(S₁) - S₀*(1 + r_DC - r_FC))/S_{0
= (E(S1) - F)/S0}

The foreign exchange expectation relation states that the forward rate is an unbiased predictor of the expected future spot rate:
F = E(S₁)

So, if the foreign exchange expectation relation holds, then the foreign currency risk premium is equal to zero.

FCRP

= (E(S₁) - F)/S₀= 0/S₀= 0

In other words, there is no risk premium for exposure to currency risk.

extended CAPM

Extended CAPM is NOT international CAPM.

[Question]
Statement:

1. To extend the domestic CAPM to international asset pricing using the extended CAPM, one must make two additional assumptions.
1. Global investors have identical consumption baskets.
2. Interest rate parity holds throughout the world.
2. The extended CAPM assumes that exchange rate changes are predictable so that there is no real exchange rate risk.

Are both statements correct?

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Statement:

1.  
1. Correct. In order to use the extended CAPM, one must assume that global investors have identical consumption baskets.
2. Incorrect. We must assume that purchasing power parity holds throughout the world, NOT Interest rate parity.
2. Correct. The extended CAPM assumes that exchange rate changes are predictable so that there is no real exchange rate risk. If exchange rates are consistent with purchasing power parity, exchange rate changes would reflect the inflation differentials between any two countries and real exchange rate risk would be nil.

Impairment loss

Impairment loss

	Impairment test (under each inequality, impairment loss is recognized):	Impairment loss	CV after impairment loss
U.S.GAAP	Fair value < Carrying value (including goodwill) or Net book value(CV) > Undiscounted cash flows	(CV - FV)	FV
IFRS	Recoverable amount < Carrying value (including goodwill)	(CV - FV)	FV

The decline is considered to be permanent, the impairment loss is recognized on the income statement.

Full goodwill, partial goodwill, and pooling method: Goodwill, Long-term debt-to-equity ratio

Full goodwill, partial goodwill, and pooling method

in $ millions	Acquirer		Target
	Book value	Fair value	Book value	Fair value
Current assets	9,000	9,000	500	700
Noncurrent assets	7,500	7,800	900	950
	16,500	16,800	1,400	1,650
Current liabilities	3,000	3,000	250	250
Long-term debt	7,700	7,500	400	300
Shareholder's equity	5,800	6,300	750	1,100
	16,500	16,800	1,400	1,650

Acquirer purchased a 60% controlling interest in Target for $900 million (paid with shares of Acquirer's common stock)

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Goodwill

method				Goodwill
Full goodwill				900/60% - 1,100 (identifiable net assets@FV) = 400
Partial goodwill				900 - 1,100 * 60% (pro-rate share of Target's identifiable net assets@FV) = 240
Pooling				0 (*)

(*) Goodwill is not created under the pooling method.

Long-term debt-to-equity ratio

method				Goodwill
Long-term debt				7,700 (Acquirer, BV) + 300 (Target, FV)
Equity				5,800 (Acquirer, BV) + 900 (Acquirer, FV, shares to acquire Target) + 600 (noncontrolling interest) (*)
Long-term debt-to-Equity ratio				8,000/7,300 = 1.0959

(*) Under U.S. GAAP, the noncontrolling interest is based on the full goodwill method.

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

Deregulation

Deregulation

Effect	Scenario	A	B	C
short-term	Prices	Decrease	Increase	Increase
short-term	Quality of goods and services	Improves	Improves	Declines
short-term	Welfare of industry workers	Declines	Improves	Declines
long-term	Prices	Decrease	Increase	Decrease
long-term	Competition	Increase	Decrease	Increase

Which is the most likely scenario resulting from deregulation?

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Answer: C

In the short-run:

• Prices may rise.
• The quality of goods and services may decline.
• Unions become less powerful and employees may be laid off.
• High cost producers may exit the industry due to lower profits.

In the long-run:

• Prices should fall.
• Industries will become more competitive as barriers to entry fall.

Capture hypothesis

• The regulatory decisions favor an industry, because:
• the regulatory bodies tend to have members who used to work in the industry.
• the industry has greater economic resources and incentives than consumers.

The industry "captures" the regulators.

Rate-of-return regulation

(e.g.)
The government is allowing the electricity producer to set their own prices, as long as the prices do not result in excessive returns for the producers.

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

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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

netting agreements, mark-to-market agreements, and off market swap contracts

Because currency swaps almost always include netting agreements and interest rate swaps can be structured to include mark-to-market agreements, we can significantly reduce the credit risk of these swap instruments by negotiating swap contracts that include these respective features. When negotiating these features is not possible, credit risk can be reduced by using off-market swaps that do not require an initial payment from your firm.


[Question]
Evaluate statements above regarding your firm's ability to mitigate the credit risk inherent in currency swaps and interest rate swaps. The statements above are only correct regarding:

A. netting agreements.
B. mark-to-market agreements.
C. off market swap contracts.

---

Answer: B

netting agreements, mark-to-market agreements, and off market swap contracts

Time	interest rate swap	currency swap	equity swap
netting agreements.	OK	- (*)	OK
mark-to-market agreements.	OK	OK
off market swap contracts. (**)

(*) Currency swap payments are generally not netted.
(**) Using off-market swaps is not generally a method to reduce credit risk. If your firm enters into an off-market swap in which they do not owe a payment, then a payment is owed to your firm by the counterparty. This would actually increase credit risk since the counterparty could potentially default on the initial payment.

Two-factor Arbitrage Pricing Model

Macroeconomic multi factor model equations:
R_D = 0.09 + 1.0F_IS + 0.0F_BC
R_E = 0.08 + 0.0F_IS + 1.0F_BC

F_IS: surprise in investor sentiment
F_BC: surprise in the business cycle

Two-factor Arbitrage Pricing Model
E(R) = risk free rate + b_ISRP_IS + b_BCRP_BC

risk free rate = 0.05
b_IS = 1.25
b_BC = 1.10
RP_IS: risk premium associated with risk factor IS
RP_BC: risk premium associated with risk factor BC

According to the multi factor equations, the expected return (intercept) for the investor sentiment factor portfolio (D) = 9% and for the business cycle factor portfolio (E) equals 8%. Risk premiums are defined as the difference between the expected return on the appropriate factor portfolio and the risk-free rate.

Therefore,
RP_IS = 0.09 - 0.05 = 0.04
RP_BC = 0.08 - 0.05 = 0.03

The expected return for Portfolio P equals
0.05 + 1.25 * 0.04 + 1.10 * 0.03 = 0.133

highly inflationary environment: foreign subsidiary's gains and losses in the income statement

Assume the country where a foreign subsidiary is operating has been experiencing 30% annual inflation over the past three years.

---

The temporal method is required if the foreign subsidiary is operating in a highly inflationary environment, defined as cumulative inflation of more than 100% in a 3-year period.

(1+30%)^3 - 1 = 120%

highly inflationary environment: foreign subsidiary's gains and losses in the income statement

		U.S.GAAP	U.S.GAAP
Accounting		temporal	temporal
Remeasurement gains and losses		I/S	I/S
subsidiary's net monetary asset/liability		liability	asset
foreign currency		depreciating	depreciating
Income statement		gain	loss

Temporal method: depreciation expense

Equipment

Date		Balance (LCU)	LCU/$
beginning of 2006	Purchase equipment	975	1.00/1
2007	Destroyed equipment	-108
end of 2007	Receive an insurance settlement for the loss	92
6/30/2008	Purchase equipment	225	1.25/1

in LCU (local currency unit) millions

---

[Question]
Assuming that the equipment is depreciated using the straight-line method over ten years with no salvage value, calculate the subsidiary's 2008 depreciation expense under the temporal method.

---

Answer:

Temporal method→depreciation: (H) Historical FX rate

((975-108)-0)/10 = 86.7 LCU
86.7 LCU * (1.00USD/1.00LCU) = 86.7 USD million

(225-0)/10 * 0.50 = 11.25 LCU

11.25 LCU * (1.00USD/1.25LCU) = 9 USD million

86.7 + 9 = 95.7 USD million

Economic Equilibrium

To understand the role of technology in the growth of the country A's economy (using neoclassical growth theory assumptions), the following table was developed to show the increased productivity of country A's farmers using disease resistant grains. Assume new disease resistant grain technology was introduced into the country A's farm economy at Point A.

Economic Equilibrium

Point	A	B	C
Target rate of return	10%	12%	12%
Real interest rate	10%	13%	12%

---

[Question]
Based on the neoclassical growth model, indicate at what point the country A's farmers would find economic equilibrium after the introduction of disease resistant grains.

A. Point A.
B. Point B.
C. Point C.

---

Answer: C

Equilibrium in the neoclassical model occurs when the target rate of return equals the real interest rates equal the target interest rates.

Target rate of return = Real interest rates = Target interest rates

• Real interest rates are those rates achieved in the market
• Target interest rates are those rates of return the investor wishes to earn.

Equilibrium occurs at Point A and at Point C. However, as a result of adding disease resistant grain to the country A's farmers, these farmers are operating on a higher productivity curve than the original Point A. At Point B, the real interest rate is higher than the target interest rate, inducting more capital to be invested. At Point C, the target rate of interest is equal to the real rate of interest, creating an equilibrium.

Neoclassical growth theory: Convergence of economic growth rate and income level to that of richer countries

Country A was able to achieve economic growth rates and income levels comparable with many of its neighboring countries during the neoclassical growth period. Country A's scientists, together with the engineering department of a university, provided access to the finest technology in the world. In addition, country A opened up its equity markets to outside investors and allowed its currency to float. Dr. S believes that, given time, these capital market improvements should allow the country A's economy to achieve an economic growth rate and per capita income level comparable to any country in the world.

---

[Question]

Country A has access to the same world class technology and capital markets as its more advanced neighbors. Dr. S expects country A's economic growth rate and income level to converge to that of richer countries over time. Indicate whether convergence with richer countries is likely or unlikely. Convergence is:

A. likely, due to country A's similar access to capital and technology.

B. unlikely, due to differences in savings rates and target rates of return.

C. likely due to differences in savings rates and target rates of return, but not due to similar access to capital and technology.

---

Answer: B

The neoclassical growth theory model does indeed imply that given access to the same technology and capital markets, then growth rates and income levels per person should begin to converge on a global basis.

While some convergence has occurred over time, many countries are just as far away from the rich countries as they have ever been. This lack of convergence in the real world is probably due to the fact that the neoclassical growth model leaves out many of the variables that must grow at the same rate in different countries for convergence to occur.

Obstacles to convergence include differences in:

• population growth rates
• rates of technological change
• (and most importantly) savings rates and target rates of return

In essence, if the countries do not have similar economic and demographic characteristics, then it would be difficult for them to grow at the same rate.

Soft Dollar Standards

1. CFA Institute's soft-dollar rules are not mandatory. In any case, client brokerage can be used to pay for a portion of mixed-use research.
2. Investment firms can use client brokerage to purchase research that does not immediately benefit the client. Commissions generated by outside trades are considered soft dollars, but commissions from internal trading desk are not.

Are these statements on the soft dollar standards correct?

---

1. Correct.
• Statement 1 is true. CFA Institute Soft Dollar Standards are voluntary, though firms that wish to claim compliance with the Standards must follow them completely.
• Client brokerage can be used to pay for mixed-use research with the caveat that the research must be reasonable, justifiable, and documentable, and that the client brokerage is only used to pay for the portion of the research that will be used in the investment decision-making process.
2. Incorrect.
• Commissions from both internal and external brokerage operations are considered soft dollars, so Statement 2 is false.
• While research paid for by client brokerage should directly benefit the client, it does not have to do so immediately.

interest rate floor: valuation

[Question]
If 1-year LIBOR at the end of year 2 is 5.8%, the absolute value of a position (long or short) in the 2-year, 6%, $30 million interest rate floor at the end of year 2 is:

---

Answer:
(6%-5.8%)*$30,000,000/(1+5.8%) = 56,710.78

The floor pays off in arrears, so the $60,000 payoff is made at the end of the third year, and the floor value at maturity is the present value of the $60,000 payoff discounted 1 year at 5.8%.

industry life cycle: four phases

industry life cycle: four phases

	phase		description
1	pioneer		It is not clear that a product will be accepted in the industry.
2	growth		Proper execution of strategy is critical.
3	mature		Participants compete for market share in a stable industry.
4	decline		Changing tastes have an important impact on the industry.

Economic Value Added (EVA) and Market Value Added (MVA)

Balance Sheet (12/31/2008)

Assets			Liabilities
Cash	125,000		Accounts payable	426,000
Accounts payable	975,000		Accrued liabilities	774,000
Inventory	1,215,000		Long-term debt	6,211,000
Fixed assets (net)	9,227,000
			Equity
			Common shares	2,100,000
			Retained earnings	2,081,000
Total assets	11,592,000		Total liabilities and equity	11,592,000

Income Statement (12/31/2008)

Sales				9,423,000
Cost of sales				4,580,000
SG&A				1,230,000
Depreciation				1,745,000
Interest Expense				522,000
Income tax expense				403,800
Net income				942,200

• Tax rate = 30%
• WACC = 11.9%
• Current stock price = $35
• Shares outstanding = 130,000
• Current long-term debt value = 95% of its book value

---

Economic Value Added (EVA)
= NOPAT - $WACC
= EBIT*(1-t) - $WACC

EBIT
= Sales - Cost of sales - SG&A - Depreciation
= 9,423,000 - 4,580,000 - 1,230,000 - 1,745,000
= 1,868,000

Total capital
= Long-term debt + Common shares + Retained earnings
= 6,211,000 + 2,100,000 + 2,081,000
= 10,392,000

Economic Value Added (EVA)

= 1,868,000*(1-30%) - 11.9% * 10,392,000

= 1,307,600 - 1,236,648

= 70,952

---

Market Value Added (MVA)
= Market value (Equity) + Market value (Long-term debt) - Book value (Equity) - Book value (Long-term debt)

Market value (equity) = $35 * 130,000 = $4,550,000
Market value (long-term debt) = 95% * 6,211,000 = $5,900,450

Market Value Added (MVA)
= 4,550,000 + 5,900,450 - (2,100,000 + 2,081,000) - 6,211,000
= 58,450

FCFE: appropriate valuation model with relatively constant proportions of equity and debt financing

[Question]

FCFE > 0

Under the assumption that a company maintains relatively constant proportions of equity and debt financing, the most appropriate valuation model is the:

A. FCFF approach.
B. FCFE approach.
C. residual income approach

---

Answer: B

Since the company's capital structure is reasonably stable and FCFE is positive, FCFE is a simpler approach to valuation than FCFF, EVA, or residual income, and is preferred in this case.

Equity method and Proportionate consolidation

Equity method and Proportionate consolidation

	equity	→	proportionate consolidation
Net income	+share(%)	=	+share(%)
Total equity	(no change)	=	(no change)
COGS	(no change)	<	+share(%)
inclusion of minority interest accounts	(no change)	=	(no change)

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

reclassification: from designated at fair value to available-for-sale

reclassification: from designated at fair value to available-for-sale

	designated at fair value (representing unrealized gains)	→	available-for-sale
Net income			↓
Retained earnings			↓
Other comprehensive income			↑
Total equity			(no change)
Total liabilities			(no change)
Total assets			(no change)
Asset turnover = Revenues / Total assets			(no change)/(no change)
ROA = Net income / Total assets			↓/(no change)
Debt to Equity = D/E			(no change)/(no change)
ROE = Net income / Equity			↓/(no change)
Debt to Total capital = D/(D+E)			(no change)/(no change + no change)

Temporal method: different local currency, functional currency and reporting currency of a subsidiary

[Question]

(1) the operating, financing, and investing decisions related to a foreign subsidiary's operations are typically made by the foreign subsidiary's local management located in the foreign country; and
(2) some of the foreign subsidiary's accounts receivable are denominated in a different foreign currency(DFC).

Which method is the best to use to translate the DFC receivables into the foreign currency (FC), according to U.S. GAAP?

The U.S. dollar is the reporting currency of a parent company.

A. The all-current method.
B. The temporal method.
C. The method will depend on inflation.

---

Answer: B

In this example, the DFC is the local currency, the FC is the functional currency (because the foreign subsidiary is an independent subsidiary), and the U.S. dollar is the reporting currency.

The appropriate application of U.S. GAAP is to first remeasure the DFC receivables from DFC to FC using the temporal method.

Full goodwill and Partial goodwill: IFRS

If Acquirer decides to purchase only 80% of Target, under IFRS they will have the option to:

A. report the acquisition as either a business combination or as an acquisition.
B. value the identifiable assets and liabilities of Target at their current book values or at fair market value.
C. report more or less goodwill depending on the accounting method they choose.

---

Answer: C

• All business combinations (e.g., merger, purchase, or consolidation) are reported under the acquisition method.
• Identifiable assets and liabilities must be reported at fair value at the time of the acquisition.
• Under IFRS, Acquirer has the option of calculating the goodwill for the acquisition under either the full goodwill or partial goodwill methods. Goodwill is less under the partial goodwill method.

Goodwill

(Question)
Regarding the goodwill on the acquisition of Target (from 80% to 100%) being considered by Acquirer, which of the following statements is correct?

A. It is equal to the excess of the purchase price over the fair value of the identifiable assets and liabilities and must be amortized over no longer than 30 years.
B. It will be reported as an asset, not amortized, and must be reviewed for impairment at least annually, with same test for impairment under IFRS and U.S. GAAP.
C. For goodwill that is found to be impaired, the amount of the impairment charge reported is the same under both IFRS and U.S. GAAP.

---

Answer: C

• Goodwill is no longer amortized under IFRS or U.S. GAAP.
• The test for impairment is different under IFRS than under U.S. GAAP.
• For assets that are judged to be impaired, the calculation of the amount of the impairment charge is the same under both IFRS and U.S. GAAP.

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).
• 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.

Operating ROA (Return On Asset)

Operating ROA (Return On Asset) = EBIT / Total Assets

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

FRA: current value

LIBOR

Days		original	30 days later
30		3.12%
60		3.32%
90		3.52%
120		3.72%	3.92%
150		3.92%
180		4.12%
2x5 FRA		4.30%	(now 1x4 FRA) 4.14%

The current value of the $10 million FRA to the short position:
(4.30%-4.14%) * $10 million * (90/360) / (1+3.92%*(120/360))
= $3,948.4075

Forward contract on a Treasury bond

Forward contract on a Treasury bond

Days		(underlying) Treasury	Forward
0		Price = $98.25
182		Coupon = 100*5%*(1/2) = $2.50
270			maturity
365		Coupon = 100*5%*(1/2) = $2.50

Forward contract

• Underlying: $1 million Treasury bond (w/ 10 years remaining to maturity)
• Underlying coupon: 5% (just after a coupon payment)
• Effective annual risk-free rate: 4%

No-arbitrage forward price
= (98.25-2.50/1.04^(182/365))*1.04^(270/365)
= 98.25*1.04^(270/365)-2.50*1.04^((270-182)/365)
= $98.6185 = $98.62

---

Forward contract on a Treasury bond

Days		(underlying) Treasury	Forward
60		Price = $98.25 → $98.11
182		Coupon = 100*5%*(1/2) = $2.50
270			maturity
365		Coupon = 100*5%*(1/2) = $2.50

Value of a long position in the 270-day forward contract on a $10 million bond
= (98.11-2.50/1.04^(122/365) - 98.62/1.04^(210/365)) = -0.77696 (per $100)

-0.77696 * $10*10^6 /$100 = -$77,697 (per $10 million)

Value of a short position in the 270-day forward contract on a $10 million bond

= +0.77696 (per $100)

+$77,697 (per $10 million)

Sharpe ratio: market portfolio and risky portfolios

• The market portfolio has the highest Sharpe ratio.
• All other risky portfolios will have a smaller Sharpe ratio than that.
• (even if the funds are mean-variance efficient)

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)

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.

Pecking order theory

Pecking order theory prefers (1) internally generated equity (retained earnings) over new debt and (2) new debt over new equity.

---

"Pecking order theory states that debt financing is preferable to all equity financing."

→Incorrect.

Treynor-Black Model

Treynor-Black Model

Analyst		X	Y
Alpha		4%	7%
Residual risk		30%	40%
Correlation between forecasted and realized alphas		0.85	0.60

Using the Treynor-Black model and alphas adjusted for each analyst's forecast accuracy, what is the optimal allocation of the stock recommended by X to the active portfolio?

---

Answer:

W_X=(4%*0.85^2)/30% / ((4%*0.85^2)/30% + (7%*0.60^2)/40%)
= 0.6046... = 60%

W_Y=1-W_X=40%

Note that as the alphas are adjusted downward, not only does the allocation within the active portfolio change, but the allocation between the active portfolio and the market portfolio changes as well. The allocation to the active portfolio will decline and the allocation to the market portfolio will increase as a result of adjusting for forecast accuracy.

Correlation^2=R^2

Theory of active portfolio management

Active portfolio management: trends in asset pricing over the past several decades

Year			Characterization of capital market valuation
1998-1999			There was a bubble in stock prices.
2000-2001			Stock prices subsequently corrected.
2002-2003			The downward trend in stock prices, due to an overcorrection; that is, prices fell significantly below fundamental values.

Assume that the characterization of capital market valuation above is correct. According to the theory of active portfolio management, in which period(s) of time did large numbers of investors turn their attention to actively managed funds?

A. The period 1998-1999 only.
B. The period 2000-2001 only.
C. The periods 1998-1999 and 2002-2003.

---

Answer: B

According to the theory of active portfolio management, one of the justifications for active management is that market equilibrium results from the activity of active managers who are seeking misvalued securities. That is, the actions of active managers result in fairly valued securities.

Capital markets were corrected from 2000 to 2001. This would result from large numbers of investors turning their attention to actively managed funds.

The misvaluations in the periods 1998-1999 and 2002-2003 would be from not enough assets being deployed to active management.

Expected growth rate in dividends for stocks

If the expected growth rate in dividends for stocks increases by 75 basis points, which of the following would benefit the most? An investor who:

A. is short futures contracts on the equity index.
B. is long futures contracts on the equity index.
C. has a long position in put options on the equity index.

---

Answer: B

An increase in the growth rate in dividends for stocks would increase the spot price of the equity index. As the spot price increases, the futures price for a given maturity also increases (holding interest rates constant). Thus, an investor who is long a futures contract already can enter into a short futures contract at the same maturity for a higher futures price than his long contract. Effectively, the investor can buy the asset in the future for a fixed price and sell the asset for a higher fixed price--a guaranteed profit. Thus, as the spot and futures prices rise, the value of a long index futures position rises as well.

Futures and Forwards

"The risk-free interest rate term structure is flat."

"You should note that if we had entered into a forward contract with the same terms, the contract price would most likely have been lower but we would have increased the credit risk exposure of the portfolio."

---

Incorrect.

• In a flat (constant) interest rate environment, there is no difference in the prices of futures and forward contracts.
• The part of the comment ralating to credit risk is correct.
• Because the forward contracts are not marked to market each day, the value is not reset to zero each day and credit risk is higher because large losses are allowed to accumulate.
• Thus, the credit risk would increase if forwards were used instead of futures.

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.

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.)

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.

NOPLAT

NOPLAT

Year	Real 1	Real 2	Nominal 2
Revenues	100	100 * 1.02 (*1) = 102	102*1.15(*4)
EBITDA	27	27 * 1.02 (*1) = 27.54	27.54*1.15(*4)
Depreciation	12	100 * 1.02 * 12.5% (*2) = 12.75	12.75*1.15(*4)
EBIT	27-12 = 15	27.54 - 12.75 = 14.79	14.79*1.15(*4)
Taxes	6	14.79 * 0.40 (*3) = 5.916	5.916*1.15(*4) = 6.8034
NOPLAT (*5)	15-6 = 9	14.79 * (1-0.40) = 14.79-5.916 = 8.874	(14.79-5.916)*1.15 =10.2051

(*1) Real revenue growth rate (per year) = 2%
(*2) Real depreciation expense = 12.5% of future real revenues
(*3) Tax rate = 40% per year
(*4) Annual inflation rate (per year) = 15%
(*5) NOPLAT = EBIT * (1-t), or (Net operating profit - Adjusted tax) = EBIT - Taxes

High inflation adjustment to the financial statement (of emerging market stocks)

• Inflation (upward) adjustments (e.g. deflating) to reported
• sales
• depreciation

NAV premiums in closed-end country funds

NAV premiums in closed-end country funds

NAV premiums in closed-end country funds:
add to the risk of the fund			Correct
add to the return of the fund			Incorrect (*)
are not steady but quite volatile			Correct

(*1) They tend to decrease as the country liberalizes foreign access to their financial markets.

Emerging country/market investments

Emerging country/market investments

		Closed-end country funds	Direct investing
Immediate diversification within the subject country		Yes	No
More volatile?		Yes (*1)	No
Strongly correlated to the U.S. stock market?		Yes	No

(*1) more volatile than their underlying assets due to the added volatility induced by the fund premium to net asset value

Buying country funds is NOT always a better choice than direct investment for most emerging markets. (e.g. higher volatility by fund premium)

Initial growth phase and Terminal value in the 3-stage dividend growth model

Analysts discuss the characteristics of firms in various stages of growth, where firms experience an initial growth phase, a transitonal phase, and a maturity phase in their life.

An analyst also makes the following statements.

1. For firms in the initial growth phase, earnings are rapidly increasing, there are little or no dividends, and there is heavy reinvestment. The return on equity is, however, higher than the required return on the stock, the free cash flows to equity are positive, and the profit margin is high.
2. When estimating the terminal value in the 3-stage dividend growth model, it can be estimated using the Gordon Growth Model or a price-multiple approach.

Are these statements correct?

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1. Answer: Incorrect.
• All of the description of the initial growth phase is correct except that, in this stage, the free cash flows to equity (FCFE) are actually negative.
• This is due to the heavy capital investment.
2. Answer: Correct.
• The terminal value in the three-stage dividend growth model can be estimated using either approach, i.e.
• Gordon Growth Model or
• price-multiple approach

Percentage of a leading P/E related to PVGO

P₀ = E₁/r + PVGO

Leading P/E = P₀/E₁ = 1/r + PVGO/E₁

Percentage of a leading P/E related to PVGO
= (PVGO/E₁)/Leading P/E = (PVGO/E₁)/(P₀/E₁)

Value impact, Strategic policy risk, Accounting risk

A group of shareholders, upset about the board's plan, submit a formal objection to the Company's board as well as to the SEC. In the objection, the shareholders state that the independence of the board has been compromised to the detriment of rhe company and its shareholders. The objection also states that:

• The value of the Company's common stock has been impaired as a result of the poor corporate governance system.
• The liability strategic policy risk of the Company has increased due to the increased possibility of future transactions that benefit the Company's directors, without regard to the long-term interests of shareholders.
• The asset accounting risk of the Company increased due to the inability of investors to trust the Spin-off company financial disclosures necessary to value the division.

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.

Static trade-off capital structure theory

The optimal level of debt is achieved when the extra cost of financial distress equals the tax benefit of debt.

It states that all firms have an optimal level of debt.

Pecking order theory

Pecking order theory prefers internally generated equity (retained earnings) over new debt and new debt over new equity.

More preferable← →Less preferable
Internally generated equity (retained earnings) > new debt > new equity

It does NOT state that debt financing is preferable to all equity financing.

Miller and Modigliani Proposition II (without taxes)

The cost of equity is linear function of a company's debt/equity ratio.

It does NOT state that cost of equity is not affected by capital structure changes.

Net agency costs of equity and Static trade-off capital structure theory

"In selecting a refinancing plan, we must not push our leverage ratio too high. An overly aggressive leverage ratio will likely cause debt rating agencies to downgrade our debt rating from its current rating, causing our cost of debt to rise dramatically."

• This effect is explained using the static trade-off capital structure theory, which states that if our debt usage becomes high enough, the marginal increase in the interest shield will be more than the marginal increase in the costs of financial distress.
• However, using some additional leverage will benefit the company by reducing the net agency costs of equity required to align the interests of the company's management with its shareholders.

Are these staments correct?

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Answer: Only correct with respect to the net agency cost of equity.


Static trade-off capital structure theory
A company should lever up to the point at which the additional increase in the costs of financial distress exceeds the additional increase in the tax shield from interest rate payments. Once this point is reached, adding more leverage to the company will decrease its value.

So, the correct statement should be "if our debt usage becomes high enough, the marginal increase in the interest shield will be less than the marginal increase in the costs of financial distress."


Net agency cost of equity
Agency costs include equity holders' cost to monitor the firm's executives, management's bonding costs to assure owners that their best interests are guiding the company's actions, and residual losses that result even when sufficient monitoring and bonding exists. Adding additional debt reduces the agency costs to equity holders because less of their capital is at risk. The leverage effectively shifts some agency costs to bondholders. Additionally, managers have less cash to squander when higher leverage is employed because higher interest costs will restrict discretionary free cash flow.

Optimal capital structure

Optimal capital structure

plan		A	B	C	D
Debt/equity		2.33	1.86	1.22	0.82
Kd(after-tax)		8.5%	6.2%	4.4%	3.9%
Ke		16.0%	13.5%	11.2%	10.9%
Expected EPS		$6.00	$6.33	$5.47	$4.89
wd		(2.33/(2.33+1))	(1.86/(1.86+1))	(1.22/(1.22+1))	(0.82/(0.82+1))
we		(1/(2.33+1))	(1/(1.86+1))	(1/(1.22+1))	(1/(0.82+1))
WACC		10.75% (*1)	8.75% (*2)	7.46% (*3)	7.75% (*4)

(*1) (2.33/(2.33+1))*8.5% + (1/(2.33+1))*16.0% = 10.75%
(*2) (1.86/(1.86+1))*6.2% + (1/(1.86+1))*13.5% = 8.75%
(*3) (1.22/(1.22+1))*4.4% + (1/(1.22+1))*11.2% = 7.46%
(*4) (0.82/(0.82+1))*3.9% + (1/(0.82+1))*10.9% = 7.75%

The plan with the lowest WACC maximizes the firm's stock price and thus reflects the optimal capital structure.