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?

---

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?

---

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)

---

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?

---

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

---

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.

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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

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(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.

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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

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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

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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.

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"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?

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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.

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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.

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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."

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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."

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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.)