CFA LEVEL 1

Investment Banking, Analysis and Portfolio Management Concepts Directory

2009-01-31T00:14:00.000-08:00

I am developing a directory of concepts on knol platform. Prsently I am setting up the framework or structure. I shall create individual knols for each concept over a period of time.

Investment Banking, Analysis and Portfolio Management Concepts Directory (Ua to Uz)
http://knol.google.com/k/narayana-rao-kvss/copy-of-investment-banking-analysis-and/2utb2lsm2k7a/835

Ethical and Professional Standards - The Importance

2008-11-15T09:14:00.000-08:00

The Importance of Ethics

Definitions of Important Terms

The AIMR Code of Ethics

Ethical Responsibilities Required by the Code

Main Prescriptions of the Code

1. Act with integrity
2. Be a credit to the profession
3. Use independent professional judgment

The AIMR code of Professional Conduct - A. Standard I.: Fundamental responsibilities

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1. 1(A) Know and comply with laws, regulations, ethical codes and professional standardsa.

Required conduct
Members must comply with the laws and regulations of their home country when residing and working in foreign countries or in trading foreign securities, as well as with the local laws and regulations ad the AIMR Code of ethics and Standards of Professional conduct. When these laws, regulations, codes and standards are different, the member must comply with the most strict laws, regulations, codes and standards to which he or she is subject.

2. I(B): Do not knowingly Participate or assist others in any violations of applicable regulations or ethical codes

Required conduct
Members are responsible for legal and ethical violations in which they knowingly participate or assist. Although members are presumed to know all applicable laws and regulations, AIMR recognizes that a member may not realize there is a violation because he or she might not be aware of all the facts giving rise to the violation.

B. Standard II: Relationships with and Responsibilities to the Profession

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1. II(A) Use of Professional designation
Required conduct
a. Members of AIMR may reference their membership only in a dignified and judicious manner. An accurate explanation of requirements that have been met to obtain membership may be included.
b. CFA charterholder members may use “Chartered financial Analyst,” or the CFA mark in a dignified and judicious manner. An accurate explanation of requirements tht have been met to obtain the designation may be included.
c. Candidates may reference their participation in the CFA program, as long as it is made clear that they are only a candidate. Only those awarded the CFA charter may use the initials “CFA” after their name. There is no special entitlement or partial designation to someone who has passed one or more CFA examinations, but who has not been awarded a charter.

2. II(B) Do not engage in any act that adversely reflects upon you honesty, trustworthiness, or professional competence

This standard goes beyond acts committed in a professional capacity (which are addressed in Standard I (A)). Standard II (B) concerns personal integrity and behavior that reflect on the entire profession. Violations include:
a. Convictions for a felony or any crime punishable by more than one year in prison, even if not related to professional activities.
b. Conviction or a misdemeanor involving moral turpitude, such as lying, cheating, stealing, and other dishonest conduct.
c. Repeated convictions of misdemeanors, no matter how inconsequential, because a large number of such convictions might suggest a disrespect for the law.
d. An action that reflects negatively on the level of ethical conduct of a CFA.
Required conduct

3. II© Do not plagiarise

Violations of this standard include the following:
a. Using parts of reports or articles prepared by other, either verbatim, or with only a slight change in wording without acknowledgement of the source.
b. Attributing specific quotations to “leading analysts”
or “investment experts,” without specifically referring to them by name.
c. Presenting statistical estimates or forecasts made by others with the source identified, but without any of the caveats that appeared in the source.
d. Using a chart or graph prepared by others without stating the source.

B. Standard II: Relationships with and Responsibilities to the Profession

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C. Standard III: Relationships with and responsibilities to the Employer

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1. III(A) Inform Employers of the code of ethics and standards of professional conduct
Required conduct
Members must inform their immediate supervisor, in writing, that they are required to conform to the Code of Ethics and Standards of Professional Conduct. They are obligated to deliver a copy of the Code and Standards to their supervisor. This procedure is not necessary only if the employer has stated in writing, that the firm’s policies already include AIMR’s Code and Standards.
Compliance Procedures

2. III(B) Duties owed to employers
Required conduct
Do not undertake independent practice in competition with your employer that might result in some compensation or other benefit, unless you have written consent from both your employer and the outside entity (client) to do so.

If a member contemplates performing services for an entity other than his or her employer that could result in compensation, by rendering a service currently available by the employer, a written statement to the employer must be made describing:
a. The types of services offered.
b. The expected duration of the service.
c. The compensation.
No service should be rendered without the current employer’s written approval.
Compliance Procedures

3. III© Disclose conflicts of interest to employer
Required conduct
Members must disclose to employers any material fact that could reasonably be expected to interfere with their duty to the employer, or their ability to act in an unbiased and objective manner. A conflict of interest exists with any situation that would interfere with the member rendering unbiased investment advice, or cause the member not to act in the employer’s best interest. Material ownership of stock, participation in outside boards, and financial or other pressures that may influence a decision should be promptly reported to the employer, so their impact can be assessed and a decision made on how to resolve the conflict.

4. III(D) Disclose additional compensation arrangements
Required conduct
Inform employers in writing of compensation (monetary or other) for services that are in addition to the compensation received from the employer. The employer is entitled to have full knowledge of a member’s compensation arrangements in order to assess the true cost of services, and their likely effects on the employee’s loyalities and objectivity.

Members must make a written disclosure to their employers specifying any compensation they propose to receive, in addition to the compensation received from primary employer.

5. III(E) Responsibility of Supervisors
Required conduct
Members with supervisory responsibility are expected to understand what constitutes an adequate compliance system for their firm and to make reasonable efforts to see that appropriate procedures are established, documented, communicated to subordinates, monitored and enforced. They are expected to have in-depth knowledge of the Code and Standards, and must exercise their responsibility with respect to both persons who hold and do not hold the CFA designation.

D. Standard IV: Relationships with and Responsibilities to Clients and Prospects - Part I

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1. IV(A.1) Recommendations and representations should have a reasonable basis
Required conduct
(1) Be diligent and thorough in investigations, when making recommendations, or when undertaking investment actions for others.
(2) Have a reasonable and adequate basis, supported by appropriate research, for recommendations and investments.
(3) Avoid material misrepresentation in any research report or investment recommendations.
(4) Maintain files and records to support the reasonableness of recommendations and investment decisions.

Members must make reasonable and diligent efforts to ensure any research report is accurate. Members should not use any information from a source he or she has reason to suspect is not accurate.

2. IV(A.2) research Reports

Required conduct
(1) Include all relevant factors in research reports.
(2) Distinguish between facts and opinions in research reports.
(3) Indicate the basic characteristics of the investment for any research reports containing an investment recommendation.
Research report encompasses all means of communicating an investment recommendation. These includes:
(1) Traditional research reports on the market, a class of investments, asset allocation, or a specific secuirity in paper form.
(2) IN-person or telephone recommendations.
(3) Media broadcasts
(4) Computer transmissions (e.g., the Internet)
Capsule recommendations (such as a “buy” or “sell” lists) must be supported by background reports or data that are available to interested members.
(5) A supervisory analyst should check research reports to assure compliance with these standards.

3. IV(A.3) Maintaining Independence 0and Objectivity

Required conduct
Every member should avoid situations that might cause, or be perceived to cause, a loss of independence and objectivity in recommending investments or taking investment action.

Analysts and portfolio managers violate this standard if they:
(1) Take an allocation of shares in oversubscribed IPOs for their personal account.
(2) Accept expensive gifts or entertainment from corporations (corporations that are not clients)
(3) Allow their firm’s business relationships with a company to affect a research review or investment decision.
(4) Allow compensation schedules to affect judgment.

4. IV(B.1) fiduciary Duties

The member has the responsibility to understand and comply with his or her fiduciary duties. This standard relates primarily to those who have discretionary authority in managing clients’ assets, or have other relationships of special trust. It is especially important in cases of managing trust and pension funds.

To satisfy this standard, members have an affirmative obligation to determine what their fiduciary duties are:
a. Required Conduct of Fiduciaries in General
(1) The duties of fiduciaries are to be found in :
(2) The general duties of fiduciaries are:
(a) Loyalty
(b) Care
(c) Prudence
(d) Impartiality
(e) Discretion
(3) Members with control over client assets should
b. Required Conduct of Trustees
(1) the Prudent Man Rule requires that every investment undertaken for a trust, standing alone, must be made prudently, i.e., with the prime directive of preserving the value of the corpus of the trust and secondarily, providing a safe return on the capital invested.

More recently, states have moved towards a Prudent Investor rule.
(a) Under the Prudent Man Rule, certain asset classes might be interpreted to be inherently imprudent (e.g., options), whereas no asset class is considered inherently imprudent under the Prudent Investor Rule. The riskiness of assets must be considered within a portfolio context in P.I.R.
(b) Under the P.M.R., the standard of prudence is applied to each asset held in trust, standing alone. Under the P.I.R. the standard of prudence is applied to the overall portfolio. The prime directive is to achieve a return/risk objective that is reasonable, without exceeding a level of overall portfolio risk that an investment professional would deem suitable to the trust under the prevailing circumstances. Employing overly conservative strategies may be subjected to less criticism under the traditional P.M.R. Under the P.I.R., overly conservative investment strategies may not be justified if they result in generating significantly inferior returns.
(c) The P.I.R. requires that trust investments be reasonably diversified.
(d) Under Traditional P.M.R. trustees were usually not permitted to delegate the authority to make investments. Under P.I.R. trustees may delegate the authority to make investment decisions to qualified investment managers, as long as those managers are selected prudently.
(e) Paying above average commissions for research or other services provided by a broker is permitted if the fiduciary comes to a bona fide conclusion that the services rendered are worth the extra cost.
(f) The modern P.I.R. standards generally impose a professional standard of care and prudence (Prudent Expert Standard).
(g) Other fiduciary duties that must be followed under U.S. law are:
(1) All of the beneficiaries of a trust should be treated equally.
(2) Best efforts must be applied to maximizing after-tax returns.
(3) Legal requirements, such as the filing of periodic financial statements and tax returns required by law, must be known and satisfied.

c. Required conduct for Managing Private Retirement Plans Governed by ERISA

Under ERISA, fiduciaries of retirement plans have the following affirmative duties:
(1) Loyalty: Loyalty, under ERISA, require them to act solely in the interest of the plan participants and beneficiaries with the exclusive purpose of: (a) Providing plan benefits. (b) Defraying reasonable plan expenses.
(2) Care: Care requires them to use all of the skills of a professional in carrying out their responsibilities. Thus ERISA applies a Prudent Expert standard.
(3) Prudence: Prudence requires them to take no risks that are likely to endanger the ability of the plan to provide promised benefits and earn a reasonable return commensurate with the risk taken.
(4) Know and Carry out their Responsibilities as Defined by the Plan’s Trust Documents
(5) ERISA prohibits fiduciaries from
(a) Self-Dealing
(b) Permitting conflicts of interest
(c) Receiving “Kickbacks”
(d) Dealing with Parties in Interest.

d. Legal Rights and Beneficiaries and participants under ERISA
Under ERISA, plan participants and beneficiaries who believe that their retirement trust is not being operated solely for their best interests may bring civil action again the plan fiduciaries. If victorious, they have the right to recover both the losses the court decides they have suffered as a result of breaches of duty by the plan fiduciaries and their attorney(s) fees.

e. Required Conduct for Fiduciaries Associated with Public Pension Plans

f. Required Conduct for Fiduciaries of Charitable Organizations and Endowments

(1) In the U.S. fiduciary duties of fiduciaries of charitable organizations and endowments are primarily contained in the Uniform Management of Institutional Funds Act (UMIFA), which embodies most of the same standards as those found in the Prudent Man and Prudent Investor Standards.

UMIFA does impose some unique affirmative duties on institutional fiduciaries. These are:
(a) Fiduciaries must formulate policies for the investment program of the organization’s assets. Such policies should be based on:
(1) the amount of funds needed on a long- and short term basis, to carry out the work of the institution.
(2) The current and probable future resources of the organization.
(3) The expected return on its assets.
(4) Probable future economic trends.
(b) to follow spending and investment policies adopted by the institution.

g. Required Conduct for Money Managers
(1) Money managers can look to the Investment Advisors Act of 1940 for some behavioral guidance. This act prohibits investment advisors from
(2) Some general principles that should guide a money manager are
(a) be honest and loyal to the client, acting always in the clients best interest.
(b) Use care and independent professional judgment in investment matters.
(c) Have a reasonable basis for investment decisions.
(d) Avoid conflicts of interest or make full disclosure of facts and circumstances that could be construed as a conflict of interest.
(e) Make sure investment actions and advice are suitable for the client.
(f) Obtain the best executions’ on trades for clients. Make sure that commissions and other expenses are reasonable for the service rendered.
(g) Avoid misrepresentations of all kinds, particularly with respect to performance presentations.
h. Required Conduct for Brokers and Dealers
In particular, brokers and dealers:
(1) Should not churn customer accounts.
(2) Should not accept funds when their firms are insolvent
(3) Should not engage in fraudulent, deceptive or manipulative practices.
(4) Should not exploit their customers’ trust or ignorance
(5) Should deal fairly with their clients.

i. Required Conduct for Security Analysts
Research analyst must:
(1) Do the best job they can for their employers and their employers’ clients.
(2) Se independent judgment.
(3) Have an adequate basis for their recommendations
(4) Deal fairly with clients and fellow professionals.
j. Other Issues Regarding the Required Conduct of Fiduciaries
(1) Social Investing: Social investing is permitted under most fiduciary laws and guidelines only if:
(a) The portfolio’s return and risk are not compromised.
(b) Diversification is still adequate
(c) Excessive costs are not incurred.
(2) Relationship Investing
(3) Proxy voting
The U.S. Dept of Labor has set forth specific regulations for proxy voting of shares held by qualified retirement plans governed by ERISA.

(a) The investment manager has the fiduciary responsibility of voting proxies arising form the retirement plans under his or her control, unless the plan documents designate some other person)s) as the responsible Party(s)
(4) Soft Dollars
When an investment manager pays for goods or services that benefit the manager by channeling security transactions through specific brokers who are paid commissions for those transactions, the funds paid are called “soft dollars.” When managers use their own funds to pay for goods and services, such payments are called “hard dollars.”
(a) The primary rule is that brokerage belongs to the client. Fiduciaries must not use client funds for their own benefit. However transactions involving soft dollars are permitted under the following circumstances:
(1) the goods or services purchased help the manager make a better investment decision.
(b) ERISA imposes a sole benefit test of loyalty for the management of pension plans.

5. IV(B.2) Portfolio Investment Recommendations and Actions

a. required conduct
Members shall:
(1) Inquire as to client’s financial situation, investment experience, and investment objectives before any investment recommendations or action are made. Update this information at least once a year.
(2) Before making a recommendation or taking investment action, determine the appropriateness and suitability of the action by considering:
(a) The client’s needs and circumstances
(b) The basic characteristics of the investment
(c) The client’s investment experience and objectives.
(3) Distiniguish between facts and opinions in presenting investment recommendations.
(4) Disclose to clients and prospects the basic format and general principles by which securities are selected and portfolios are constructed. Promptly disclose to clients and prospects any changes that might significantly affect this process.
(5) Obtain written authorization from the client to make changes.

D. Standard IV: Relationships with and Responsibilities to Clients and Prospects - Part II

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6. IV(B.3) Fair Treatment of clients

Required conduct
Deal fairly with clients regarding:
(1) Dissemination of recommendations
(2) Dissemination of changes of prior opinions
(3) Taking investment action.

Every effort should me made to communicate investment ideas to clients, for which the ideas are suitable and who have a known interest in them, as simultaneously as possible within reasonable limits defined by communications technology.

7. IV(b.4)Priority of Transactions
Required conduct
This standard applies to all members and access persons (defined as persons who have advanced knowledge pertaining to upcoming research recommendations, changes in opinions about securities, and/or pending investment actions to be taken either by the firm itself, or on behalf of clients).

There is nothing unethical about access persons investing for their own benefit. The personal investments of access persons and investment professionals must be undertaken within the confines of the following restrictions.
(1) Interests of clients, the employer, and the integrity of the professional must be put ahead of the access person’s or member’s own personal interests.
(2) Care must be taken that personal investments do not create conflicts of interest or impair the investment professional’s ability to be objective and render independent professional judgments about securities.
(3) All applicable laws, regulations, and compliance procedures must be followed.
(4) The investment professional should not receive a personal benefit from investment actions taken on behalf of a client (except for the usual and customary compensation for the service rendered).
Compliance Procedures

8. IV(B.5) Confidentiality
Required conduct
Preserve the confidentiality of client and employer information, unless it concerns illegal activities. The best approach is never to disclose information received from a client or employer, except to authorized persons on a “need to know” basis.

9. IV(B.6) Prohibition against misrepresentations
Required conduct
A member may not misrepresent:
(1) The performance of his or her (or the employer’s) services or investment performance.
(2) Their qualifications or the qualifications of their firm.
(3) Their academic and professional standards.

Members should ensure that misrepresentation does not occur in oral presentations, advertising, electronic communication, or written materials.

No guarantees should be given regarding the outcome or the probable return on an investment.

10. IV (B.7) Disclose conflicts of interest to clients and prospects
Required conduct
Members must disclose to clients and prospects any potential conflict of interest. Disclosure of any matter that could reasonably be expected to impair objectivity allows clients to judge motives and possible biases for themselves.

11. IV(B.8) Disclose referral fees
Required conduct
The existence of referral fees, their nature, and their amount should be disclosed in writing to any prospective client, as soon as the client is referred to a member.

Compliance Procedures

Relationships with and Responsibilities to the Investing Public

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Ethical and Professional Standards

Standard V: Relationships with and Responsibilities to the Investing Public

1. V(A) Do not use material nonpublic information

Members shall not make any investment action (trade the security, or make a recommendation regarding the security), or communicate the information, when in the possession of material nonpublic information related to the value of a security if such action would breach a duty, the information was misappropriated, or if it relates to a tender offer. If such material nonpublic information is received, an effort should be made to get the company about whom the information relates to make a public disclosure of the information, except if the information was received because of a special or confidential relationship with the company (as in the case of “constructive” insider), and the information is to be kept in confidence.

a. Definitions of Material Nonpublic Information
(1) Traditional theory
(a) Information must be material. Information is material if:
(1) It pertains to a tender offer.
(2) It would significantly change the total mix of information about a company, its affairs, or its securities; i.e., a reasonable investor would want to know it before making an investment decision, or, if known it would probably have an impact on the price of a security.
(3) It is a specific fact, rather than an opinion.
(b) The information must be Nonpublic. Information becomes public as soon as the company discloses it in a way calculated to make it available to the general investing public. Corporate disclosure made to a “room full of analysts” does not constitute disclosure under the law.
(c) The source Must be an insider: Someone who knows the information because he or she is in a position to receive confidential information about a company’s affairs and who has a fiduciary duty not to disclose it.

Tippees, such as analysts who receive material nonpublic information, may legally use it, unless they are brought into the fold of confidentiality or then know that the information was mis-appropriated or obtained illegally. They are brought into the fold of confidentiality when they are given the information for a legitimate business purpose.

Note that a fiduciary duty exists as a matter of law; it cannot be imposed simply by telling someone to “keep this information confidential.”

(2) Misappropriation Theory

Under the misappropriation theory, individuals commit securities fraud if they obtain material nonpublic information from another to whom they owe a duty of trust and confidence, and then communicate that information or use it as the basis of a trade or recommendation, even if they owe no fiduciary duty to the issuer of the involved issuer. They also commit fraud if they obtain material nonpublic information illegally.

The concept is that material nonpublic information is “property.” If anyone who has access to this information uses it for their own personal benefit, or give it to others, they misappropriate company property. This is a form of theft, which is punishable by criminal and civil actions.

b. The Mosaic theory

Taking several immaterial and/or publicly available stand-alone facts from various sources and putting them together to form a complete and significant picture of a corporate situation is called the mosaic theory. This is the analyst’s job and is completely legal.

c. Required conduct

(1) Members shall not take any investment action or communicate information about a security or company, when in the possession of material nonpublic information related to the value of the security if such action would breach a duty owed to the company, the information was misappropriated, or if it relates to a tender offer.
(2) When acting as a consultant or any other role in which the member becomes a “temporary insider” keep information received confidential and do not use it for investment purposes or communicate it to others.
d. Legal Ramifications of Using or Communicating Inside or Misappropriated Information

Penalties include:
(1) Fines up to $1,000,000 for individuals ($2,500,000 for firms)
(2) Disgorgement of up to three times any illicit profits (or losses avoided) from trading (or recommending) securities based on inside or misappropriated information.
(3) Jail terms of up to 10 years.
(4) Civil suit for damages suffered by the counterparties to any illegal trades.
(5) Sanction by regulating bodies, primarily the SEC.

e. Compliance Procedures

(1) Do not seek out material nonpublic information.

2. V(B) Performance Presentation

Members may not misrepresent their investment performance record, either in terms of the presentation or the measurement of those results. When communicating data about the performance history of accounts or composites (group of accounts), either of the individual investment manager or of a firm, the member must give a fair and complete presentation. It is unethical to misrepresent past investment performance or the investment performance that a client can reasonably expect to obtain in the future.

a. Reasons Why Performance Presentation Standards are Necessary
Historically, investors have faced many difficulties in obtaining fair performance results that were comparable among various investment management firms.

Therefore, AIMR developed the AIMR Performance presentation Standards and Global Investment Performance Standards in the hope that a set of globally accepted common standards will enable performance results among various investment firms to become truly comparable.

b. Required conduct
(1) Members may not misrepresent
(2) When communicating data about the performance history of individual accounts, composites (groups of accounts), an individual investment manager, or an entire firm, the member must give a fair and complete presentation.
c. Compliance Procedures
(1) Compliance with the AIMR Performance Presentation Standards and/or the Global Investment Performance Standards is the best way to comply with this standard.

Ethical and Professional Standards - Corporate Governance

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VI. Corporate Governance

A. Introduction

B. Fiduciaries Responsible for Voting Proxies

C. Proxy Voting Standards for Fiduciaries

D. Recommended elements in a proper Proxy Voting Policy
1. Designate a competent individual or policy making body as being responsible for implementing and monitoring a proxy voting policy. This person or body should:
2. Set up administrative procedures that:

E. Laws and Regulations Regarding the Voting of Proxies by Fiduciaries

Reading 58: Equity: Concepts and Techniques

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LOS

The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.
-----------------

Prescribed reading

“Equity: Concepts and Techniques”
Ch. 6, pp. 256–273, International Investments, 5th edition, Bruno Solnik and Dennis McLeavey (Addison Wesley, 2003)

“Industry Analysis”
Ch. 13, pp. 466–468, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

For points to refresh on Industry analyis based on 7th edition of Reilly and Brown please visit
http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch14-points-to-refresh.html

Reading 59: Company Analysis and Stock Valuation

2008-03-13T21:22:00.000-07:00

Prescribed reading

“Company Analysis and Stock Valuation”
Ch. 14, pp. 513–516 and 533–548, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

Visit for points to refresh of this chapter from 7th edition

http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch15-points-to-refresh.html

Types of Stocks

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59.a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;

Company Analysis and Stock Valuation

By evaluating financial performance variable we can identify good companies. But good companies are not necessarily good investments. For finding a good investment, we have to compare the intrinsic value of a stock to its market value.

Stock of a great company may be overpriced and in such as a case the stock of a growth company may not be growth stock.

Growth Companies

Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings. Financial theorists define in more specific terms a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return. So in the definition of financial theorists growth company has a return on investment that is greater than the required rate of return based on its risk measure.

Growth Stocks

Growth stocks are not necessarily shares in growth companies.

A growth stock has a higher rate of return than other stocks with similar risk. Growth stocks give a higher return in comparison to the risk adjusted return that is expected from stocks with similar risk measure.

Superior risk-adjusted rate of return occurs because in the market they are undervalued at that point of time compared to other stocks

Defensive Companies and Stocks

Defensive companies’ future earnings are more likely to withstand an economic downturn. They have low business risk and not excessive financial risk

Defensive stocks are stocks with low or negative systematic risk (beta values). While defensive companies' stocks can be defensive stocks, they are defensive stocks only when their beta value is significantly less than one. So the analyst have to calculate beta value of a stock before declaring any stock as defensive stock.

Cyclical Companies and Stocks

Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity.

Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return. In this case beta value of stocks are significantly higher than one.

Speculative Companies and Stocks

Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain.

Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return. When markets are at historical peaks or stocks are way above their intrinsic values, many stocks may become speculative.

Value versus Growth Investing

In the debate about growth and value investing, both growth and value stocks are have higher risk adjusted returns compared to other stocks.

IN this context, growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued relative the growth of earnings and dividends expected from them.

Value stocks appear to be undervalued for reasons besides earnings growth potential. The growth potential in earnings and dividends is not spectacular in these stocks, and the undervaluation will be because of apprehension that the sales and earnings may decline relative to average companies.

On the basis of quantitative criteria, value stocks (population or all the companies from value stocks are identified) usually have low P/E ratio or low ratios of price to book value. Growth stocks (population or all the companies from which growth stocks are identified) usually have high P/E ratios and high price to book value ratios.

59-b-apse

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Reading 60: An Introduction to Security Valuation: Part II

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Prescribed reading
“An Introduction to Security Valuation: Part II”
Ch. 11, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

LOS
60a. state the various forms of investment returns;

Visit - for refresher points on this chapter

http://nrao-sapm-handbook.blogspot.com/2007/12/r-b-ch11-points-to-refresh.html

Earnings Multiplier Model from DDM

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c. show how to use the DDM to develop an earnings multiplier model, and explain
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;

DDM model in terms of price (when the market is in equilibrium - each stock's is equal to its value determined by DDM model)
P = D1/k-g

Dividing both sides by E1 (Expected Earnings per share)

P/E1 = (D1/E1)/k-g

so the equilibrium P/E1 ratio is determined by D1/E1, k and g and the DDM model can be used to develop the earnings multiplier model also.

Components of Investor's Required Rate of Return

2008-03-13T09:15:00.000-07:00

d. explain the components of an investor’s required rate of return (i.e., the real riskfree rate, the expected rate of inflation, and a risk premium) and discuss the risk factors to be assessed in determining a country risk premium for use in estimating the required return for foreign securities;

Five risk components determine risk premiums

Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk

Equity risk premiums are to be derived for each country in which assets are to be acquire for a portfolio.

The five risk components differ substantially between countries:

Business risk varies across countries because it is a function of the variations in the economic activity within a country and also of the operating leverage used by firms within a country. For example, for many years the financing of companies in India was done on the basis of a long debt to equity ratio of 2:1. It is only recently that more conservative debt equity ratios became the norm.

(to be continued)

Reading 61: Introduction to Price Multiple

2008-03-13T08:49:00.000-07:00

Prescribed reading:

John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey (AIMR, 2003)

LOS

The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;

b. calculate and interpret P/E, P/BV, P/S, and P/CF.

Price to Cash Flow Valuation Multiple

2008-03-13T08:20:00.000-07:00

The use of this ratio is also becoming popular.

According to Reilly and Brown, the growth in popularity of this relative valuation technique can be traced to concern over the propensity of some firms to manipulate earnings per share. Cash flow values are generally less prone to manipulation.

Discounted cash flow techniques use only cash flow as the basis for valuation.

STUDY SESSION 14 ANALYSIS OF EQUITY INVESTMENTS:

2008-03-12T04:50:00.000-07:00

Industry and Company Analysis

This study session focuses on industry and company analysis and describes the
tools used in forming an opinion about investing in a particular stock or group
of stocks.

This study session begins with the essential tools of equity valuation: the
discounted cash flow technique and the relative valuation approach. These
techniques provide the means to estimate reasonable price for a stock. The
readings on industry analysis are an important element in the valuation process,
providing the top–down context crucial to estimating a company’s potential.
Also addressed is estimating a company’s earnings per share by forecasting
sales and profit margins.

The last reading in this study session focuses on price multiples, one of the
most familiar and widely used tools in estimating the value of a company, and
introduces the application of four commonly used price multiples to valuation.

LEARNING OUTCOMES

Reading 56: An Introduction to Security Valuation: Part I

The candidate should be able to explain the top-down approach, and its
underlying logic, to the security valuation process.

Reading 57: Industry Analysis

The candidate should be able to describe how structural economic changes
(e.g., demographics, technology, politics, and regulation) may affect
industries.

Reading 58: Equity: Concepts and Techniques

The candidate should be able to:
a. classify business cycle stages and identify attractive investment opportunities for
each stage;
b. discuss, with respect to global industry analysis, the key elements related to
return expectations;
c. describe the industry life cycle and identify an industry’s stage in its life cycle;
d. discuss the specific advantages of both the concentration ratio and the
Herfindahl index;
e. discuss, with respect to global industry analysis, the elements related to risk, and
describe the basic forces that determine industry competition.

Reading 59: Company Analysis and Stock Valuation

The candidate should be able to:
a. differentiate between 1) a growth company and a growth stock, 2) a defensive
company and a defensive stock, 3) a cyclical company and a cyclical stock,
4) a speculative company and a speculative stock, and 5) a value stock and a
growth stock;
b. describe and estimate the expected earnings per share (EPS) and earnings
multiplier for a company and use the multiple to make an investment decision
regarding the company.

Reading 60: An Introduction to Security Valuation: Part II

The candidate should be able to:
a. state the various forms of investment returns;
b. calculate and interpret the value both of a preferred stock and a common stock
using the dividend discount model (DDM);
c. show how to use the DDM to develop an earnings multiplier model, and explain
the factors in the DDM that affect a stock’s price-to-earnings (P/E) ratio;
d. explain the components of an investor’s required rate of return (i.e., the real riskfree
rate, the expected rate of inflation, and a risk premium) and discuss the risk
factors to be assessed in determining a country risk premium for use in estimating
the required return for foreign securities;
e. estimate the implied dividend growth rate, given the components of the required
return on equity and incorporating the earnings retention rate and current stock
price;
f. describe a process for developing estimated inputs to be used in the DDM,
including the required rate of return and expected growth rate of dividends.

Reading 61: Introduction to Price Multiples

The candidate should be able to:
a. discuss the rationales for, and the possible drawbacks to, the use of price to
earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash
flow (P/CF) in equity valuation;
b. calculate and interpret P/E, P/BV, P/S, and P/CF.

STUDY SESSION 15 Fixed Income Investments

2008-03-12T02:40:00.000-07:00

STUDY SESSION 15 Fixed Income Investments Basic Concepts

This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.

LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).

Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.
Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);

i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.

Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.

Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.

Yield Curve Risk

2008-03-11T21:35:00.001-07:00

The yield curve risk is how your portfolio will react with different exposures based on how the yield curve shifts.

http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa11.asp

Disadvantages of Callable Securities

2008-03-11T21:32:00.000-07:00

h. explain the disadvantages of a callable or prepayable security to an investor;

Call and prepayment risk is concerned with the holders having their bonds paid off earlier than the maturity date. This is due to decreasing marker rates, which cause the issuer to call the bonds. It can also occur when the borrowers in a MBS or ABS refinance or pay off their debt earlier than the stated maturity date.

http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa9.asp

Reinvestment Risk

2008-03-11T21:30:00.000-07:00

i. identify the factors that affect the reinvestment risk of a security and explain why prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;

Reinvestment risk is the risk that the proceeds from the payment of principal and interest, which have to be reinvested at a lower rate than the original investment.

http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa10.asp

Credit Risk

2008-03-11T21:27:00.000-07:00

j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;

Default risk: the counterparty or the company that issued debt securities is not in a position to pay the coupon on the debt securities.

Credit spread risk: Spread is the difference between the yield on risky bonds and yield on government securities. If it increases, the prices of risky bonds come down.

Downgrade risk: the quality of the bond as assessed by credit rating agencies may come down. Due to which the spread on the bond will increase and its price decreases

http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa12.asp

Liquidity Risk

2008-03-11T21:25:00.000-07:00

k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;

Liquidity risk is concerned with an investor having to sell a bond below its indicated value, the indication having come from a recent transaction.

http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa13.asp

Exchange Rate Risk

2008-03-11T21:23:00.000-07:00

l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;

Exchange-rate risk is the risk of receiving less in domestic currency when investing in a bond that is in a different currency denomination than in the investor's home country.

http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa14.asp

Inflation Risk;

2008-03-11T21:15:00.000-07:00

63.m. explain inflation risk;

Also known as Purchasing Power Risk, this risk arises from the decline in value of securities cash flow due to inflation, which is measured in terms of purchasing power.

http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa16.asp

Reading 65: Understanding Yield Spreads

2008-03-11T09:10:00.001-07:00

LOS
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.Federal Reserve);

What is the federal funds market?
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.

The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the "funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.

What are open market operations?
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.

Suppose the Fed wants the funds rate to fall. To do this, it buys government securities from a bank. The Fed then pays for the securities by increasing that bank's reserves. As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls.

When the Fed wants the funds rate to rise, it does the reverse, that is, it sells government securities. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the funds rate rises.

What is the discount rate?

Banks also can borrow reserves directly from the Federal Reserve Banks at their "discount windows," and the discount rate is the rate that financially sound banks must pay for this "primary credit." The Boards of Directors of the Reserve Banks set these rates, subject to the review and determination of the Federal Reserve Board. ("Secondary credit" is offered at higher interest rates and on more restrictive terms to institutions that do not qualify for primary credit.) Since January 2003, the discount rate has been set 100 basis points above the funds rate target, though the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives. At the same time, the (relatively) easy availability of reserves at this rate effectively places a ceiling on the funds rate.

http://www.frbsf.org/publications/federalreserve/monetary/tools.html

Monetary policy in an environment of global financial markets

2008-03-11T08:47:00.002-07:00

Reading recommended by the institute for this LOS

Professor Otmar Issing, Launching Workshop of the ECB-CFS Research Network on "Capital Markets and Financial Integration in Europe", Frankfurt am Main, 29 April 2002

Let me first say that it is a great pleasure to open the launching workshop for the Research Network "Capital Markets and Financial Integration in Europe ". Understanding global financial linkages is important, not least from the perspective of a central banker. Further integration of European financial markets is one of the expected benefits from monetary unification. By focusing on these issues, the Network will stimulate research on topics we as policymakers can benefit from.

In my remarks today, I would like to focus on the interaction between the central bank and financial markets. Specifically, I will first address the interdependence between monetary policy making and financial market expectations. Linked to this, I will then discuss some of our experiences of the first years of policy making at the ECB. I will conclude by briefly mentioning the recent changes that we have witnessed in the euro area financial landscape, and touch upon some areas where I believe more research is needed and where your contribution will be particularly valuable.

Let me start by elaborating on the issue of how central bank behaviour affects financial markets. In this respect, financial markets can be seen as a transmission channel of monetary policy. The central bank controls the short-term interest rate, but what matters for consumers' and firms' decisions are market interest rates beyond the direct control of the monetary authority. In this regard, the role of private banks in the transmission of monetary policy has traditionally been strong in the euro area and still plays a dominant role. Increases in liquidity are redistributed to end users through the banking system, at interest rates reflecting both current and expected future refinancing costs for the banks. Therefore, not only the actual situation of banks' balance sheets, but also market expectations about the future course of monetary policy and future inflation become important, since these expectations to a large extent determine those interest rates.

In this context, the monetary policy strategy is crucial. By a clear commitment to price stability, the ECB provides the markets with a reference against which new information can be consistently evaluated. If new information indicates risks to price stability, and markets understand the strategy, expectations will adjust in anticipation of the appropriate reaction of monetary policy. This fosters a smooth implementation of policy, where much of the actual work is done by themarket's adjustment of the term structure of interest rates.

We have structured the strategy of the ECB around two pillars, which can be seen as a means of organising information concerning risks to price stability. The first pillar assigns a prominent role to money, and in this context monetary aggregates are carefully monitored to reveal such threats. Under the second pillar, other macroeconomic and financial variables that contain information about future price developments are analysed. Financial markets, by their inherent forward-looking nature, provide the central bank with valuable information about expected economic developments. Two key markets to be monitored in this context are bond markets and equity markets. The former gives an assessment of expected interest rates through the term structure of interest rates. Bond derivatives can provide important information of the prevailing uncertainty about future interest rate developments. Such information is especially useful when deciding on communication issues, should market expectations deviate too far from the central banks own evaluation of the current circumstances. Equity markets can convey information about future economic activity. They also have a direct role in the transmission of economic shocks, in that changes in consumer's wealth can impact consumption. Traditionally, this effect has been stronger in the US than in Europe . However, recent trends point to an increase in equity holdings by Europeans which might make this channel more important. Increasing globalisation and cross-border ownership seems to have resulted in faster transmission of shocks, perhaps also more oriented towards sectors rather than countries. For example, the recent IT bubble both gained momentum and collapsed simultaneously across a number of countries. This has major impact on our economies because the traditional mitigating effects of trade and diversification do not apply when similar events take place everywhere.

To conclude, under the second pillar the financial markets (as well as other markets such as those for labour and goods) provide the central bank with relevant information about risks to price stability. This, together with the monetary analysis under the first pillar, allows two complementary pictures of the threats to price stability to emerge. In turn, this facilitates cross-checking, stimulates internal discussion, and ultimately, I believe, leads to appropriate monetary policy decisions.

Traditionally, bank lending was the main source of financing economic activities in most countries of the euro area and banks were therefore the main "actors" in the monetary transmission process. However, market based financing has become more important during the last few years. An interesting questions for research is how the evolution of financial markets, for example the continuing expansion of corporate bond markets, will impact the transmission of monetary policy.

Let me turn to the issue of predictability of monetary policy. In the environment I have just described, deliberate attempts to surprise markets would be counterproductive. Rather, implementation of policy will be smoother the more predictable it is. Woodford e.g. emphasises [1] that developments in financial markets have increased the possibilities of the central bank to influence markets, to the extent that it may do so by signalling without actually moving interest rates:

"The more sophisticated markets become, the more scope there will be for communication about even subtle aspects of the bank's decision and reasoning, and it will be desirable for central banks to take advantage of this opportunity."

Communicating with sophisticated financial markets is indeed important. At the same time it is a tricky issue, since the central bank needs to ensure that it guides rather than follows the markets. An eloquent quote by Alan Blinder illustrates the danger of failing to do so:[2] "...Following the markets may be a nice way of unsettling financial surprises, which is a legitimate end in itself. But I fear that it may produce rather poor monetary policy for several reasons. One is that speculative markets tend to run in herds and to overreact to almost everything. Central bankers need to be more cautious and prudent. Another is that financial markets seem extremely susceptible to fads and speculative bubbles which sometimes stray far from fundamentals. Central bankers must innoculate themselves against whimsy and keep their eyes on the fundamentals."

It is of utmost importance that the financial markets believe the stated goals of policy and understand the monetary policy strategy. In time, markets can evaluate the track-record of the ECB relative to the goal of price stability. Adherence to the strategy should gradually enhance the credibility in that markets can interpret monetary policy decisions through the strategy. In this respect, communication with markets is essential to foster a proper understanding of the strategy, and to send clear signals about the central banks current assessment of economic conditions.

It is therefore interesting to study actual developments in market-based indicators in order to gain some insight into how market participants have perceived the predictability and credibility of the ECB. Concentrating initially on the issue of predictability, Gaspar et al. (2001) examine the behaviour of overnight interest rates between the start of 1999 and early 2001[3]. They find that the markets during that period did not appear to make systematic errors with respect to monetary policy announcements. Moreover, Hartmann et al. (2001) find that overnight rates on average moved by less than 5 basis points immediately following monetary policy announcements by the ECB. [4] Finally, if we take a look at the behaviour of implied short-term forward rates at the one-month horizon during the entire period since the introduction of the euro, we see that the majority of ECB interest rate moves have been in line with the expectations of financial market participants. In this regard, the track record of the ECB is comparable to that of other major - and substantially older - central banks, such as the US Federal Reserve or the Bank of England. In my view, this performance is not bad for a young central bank like the ECB.

Of course, one could not claim that the money market has perfectly anticipated policy moves on every single occasion. Sometimes, rapidly changing economic conditions or extraordinary events, such as the September 11 terrorist attacks, require swift and decisive policy action that cannot be fully anticipated in advance. Furthermore, at times the monetary authority has access to information that market participants do not have. This information asymmetry may on rare occasions lead to policy moves that are unexpected by markets. This being said, I again repeat that there can be no interest in the monetary authority deliberately aiming to surprise the financial markets. Such a strategy would merely increase uncertainty in the markets and damage the credibility of the monetary authority.

Turning to this very aspect, taking due account of caveats such as liquidity and risk premia considerations, the market for French index- linked government bonds provides a useful measure of the credibility of monetary policy. The ten-year break-even inflation rate obtained from this market has consistently been in line with the ECB's quantitative definition of price stability, indicating a persistently high degree of credibility. Moreover, there is little evidence that monetary policy moves have generated any systematically higher volatility in the break even rate. This would seem to indicate that markets have perceived ECB monetary policy actions as transparent, in the sense that they do not appear to have induced investors to revise their beliefs about the objective of the ECB. Interestingly, in the last few months, the French treasury has issued new index-linked bonds linked to a measure of euro area HICP, which I am convinced will provide us with additional useful information in this respect.

Consistent with the notion that the monetary policy actions of the ECB have not resulted in increased market uncertainty, there is some evidence that bond market volatility has even declined since the introduction of the euro. For example, since 1999 the implied volatility on 10-year German Bund futures has - apart from a brief surge following September 11 - declined to historically low levels. All these indications from prices of financial instruments, determined by market forces which continuously judge the actions of the ECB, lead me to conclude that our monetary policy has been credible and largely transparent to investors.

This being said, it is also clear to me that we still have much to learn about what determines financial asset prices. Moreover, the nature of financial markets, constantly changing and evolving, adds to the need of widening and deepening our understanding of these markets. This is particularly true for financial markets in the euro area, which arguably have seen the most remarkable pace of change among all developed financial markets over the last few years. For example, the euro area money market has undergone a substantial transformation, including the creation of completely new segments, such as the EONIA swap market. Similarly, the bond market has evolved considerably, with very rapid growth of the corporate bond market segment over the last few years and a sizeable expansion of the international issuance of euro-denominated bonds.

No doubt, the introduction of the single currency and a common monetary policy framework acted as a powerful catalyst in bringing about many of the changes to the euro area financial landscape that we have witnessed in recent years. However, we still need to better understand the exact mechanisms which brought about these developments. In addition, as markets evolve and new financial instruments are introduced, this will bring about new ways to extract market information which may be highly relevant for monetary policy purposes. The Research Network can make a very valuable contribution on these topics, and generally with respect to the increasing importance of finance research - both at the macro and at the micro level - for central banks. We should also learn more about international financial linkages as well as the role of global trends and other international factors in determining the evolution of financial markets in Europe. The ongoing financial integration process within the euro area should have beneficial effects for monetary policy, for example by facilitating policy signaling and transmission through enhanced market liquidity. Financial integration and international linkages are the core areas of the Research Network. All these issues which I have mentioned are key for policymakers since we need to correctly interpret the information coming from markets, and also understand how monetary policy is propagated to the real economy through financial markets.

I am convinced that the Research Network will contribute significantly to our understanding of these and other issues. I personally will follow the progress of your work with great interest. I would like to end by wishing you a very productive and fruitful workshop, and all the best in your future research work on these important topics.

--------------------------------------------------------------------------------

[1] Michael Woodford, "Monetary Policy in the Information Economy", in Economic Policy for the Information Economy, Kansas City Fed, 2001.

[2] Alan Blinder, "Central Banking in Theory and Practice", MIT Press, 1998, p. 61.

[3] Gaspar, Perez-Quiros & Sicilia (2001), “ The ECB Monetary Policy Strategy and the Money Market", International Journal of Finance and Economics 6(4).

[4] Hartmann, Manna and Manzanares (2001), “ The microstructure of the euro money market", Journal of International Money and Finance 20

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Source
http://www.ecb.int/press/key/date/2002/html/sp020429_1.en.html

STUDY SESSION 15 Fixed Income Investments

2008-03-11T00:25:00.000-07:00

STUDY SESSION 15 Fixed Income Investments Basic Concepts

This study session presents the foundation for fixed income investments, one of
the largest and fastest growing segments of global financial markets. It begins
with an introduction to the basic features and characteristics of fixed income securities
and the associated risks. The session then builds by describing the primary
issuers, sectors, and types of bonds. Finally, the study session concludes with an
introduction to yields and spreads and the effect of monetary policy on financial
markets. These readings combined are the primary building blocks for mastering
the analysis, valuation, and management of fixed income securities.

LEARNING OUTCOMES
Reading 62: Features of Debt Securities
The candidate should be able to:
a. explain the purposes of a bond’s indenture, and describe affirmative and negative
covenants;
b. describe the basic features of a bond, the various coupon rate structures, and the
structure of floating-rate securities;
c. define accrued interest, full price, and clean price;
d. explain the provisions for redemption and retirement of bonds;
e. identify the common options embedded in a bond issue, explain the importance
of embedded options, and state whether such options benefit the issuer or the
bondholder;
f. describe methods used by institutional investors in the bond market to finance
the purchase of a security (i.e., margin buying and repurchase agreements).

Reading 63: Risks Associated with Investing in Bonds
The candidate should be able to:
a. explain the risks associated with investing in bonds;
b. identify the relations among a bond’s coupon rate, the yield required by the market,
and the bond’s price relative to par value (i.e., discount, premium, or equal
to par);
c. explain how features of a bond (e.g., maturity, coupon, and embedded options)
and the level of a bond’s yield affect the bond’s interest rate risk;
d. identify the relationship among the price of a callable bond, the price of an
option-free bond, and the price of the embedded call option;
e. explain the interest rate risk of a floating-rate security and why such a security’s
price may differ from par value;
f. compute and interpret the duration and dollar duration of a bond;
g. describe yield curve risk and explain why duration does not account for yield
curve risk for a portfolio of bonds;
h. explain the disadvantages of a callable or prepayable security to an investor;
i. identify the factors that affect the reinvestment risk of a security and explain why
prepayable amortizing securities expose investors to greater reinvestment risk
than nonamortizing securities;
j. describe the various forms of credit risk and describe the meaning and role of
credit ratings;
k. explain liquidity risk and why it might be important to investors even if they
expect to hold a security to the maturity date;
l. describe the exchange rate risk an investor faces when a bond makes payments
in a foreign currency;
m. explain inflation risk;
n. explain how yield volatility affects the price of a bond with an embedded
option and how changes in volatility affect the value of a callable bond and a
putable bond;
o. describe the various forms of event risk.

Reading 64: Overview of Bond Sectors and Instruments
The candidate should be able to:
a. describe the features, credit risk characteristics, and distribution methods for
government securities;
b. describe the types of securities issued by the U.S. Department of the Treasury
(e.g., bills, notes, bonds, and inflation protection securities), and differentiate
between on-the-run and off-the-run Treasury securities;
c. describe how stripped Treasury securities are created and distinguish between
coupon strips and principal strips;
d. describe the types and characteristics of securities issued by U.S. federal agencies;
e. describe the types and characteristics of mortgage-backed securities and explain
the cash flow, prepayments, and prepayment risk for each type;
f. state the motivation for creating a collateralized mortgage obligation;
g. describe the types of securities issued by municipalities in the United States, and
distinguish between tax-backed debt and revenue bonds;
h. describe the characteristics and motivation for the various types of debt issued by
corporations (including corporate bonds, medium-term notes, structured notes,
commercial paper, negotiable CDs, and bankers acceptances);

i. define an asset-backed security, describe the role of a special purpose vehicle in
an asset-backed security’s transaction, state the motivation for a corporation to
issue an asset-backed security, and describe the types of external credit enhancements
for asset-backed securities;
j. describe collateralized debt obligations;
k. describe the mechanisms available for placing bonds in the primary market and
differentiate the primary and secondary markets in bonds.

Reading 65: Understanding Yield Spreads
The candidate should be able to:
a. identify the interest rate policy tools available to a central bank (e.g., the U.S.
Federal Reserve);
b. describe a yield curve and the various shapes of the yield curve;
c. explain the basic theories of the term structure of interest rates and describe the
implications of each theory for the shape of the yield curve;
d. define a spot rate;
e. compute, compare, and contrast the various yield spread measures;
f. describe a credit spread and discuss the suggested relation between credit
spreads and the well-being of the economy;
g. identify how embedded options affect yield spreads;
h. explain how the liquidity or issue-size of a bond affects its yield spread relative to
risk-free securities and relative to other securities;
i. compute the after-tax yield of a taxable security and the tax-equivalent yield of a
tax-exempt security;
j. define LIBOR and explain its importance to funded investors who borrow
short term.

Reading 66: Monetary Policy in an Environment
of Global Financial Markets
The candidate should be able to:
a. identify how central bank behavior affects short-term interest rates, systemic liquidity,
and market expectations, thereby affecting financial markets;
b. describe the importance of communication between a central bank and the
financial markets;
c. discuss the problem of information asymmetry and the importance of predictability,
credibility, and transparency of monetary policy.

STUDY SESSION 16 ANALYSIS OF FIXED INCOME

2008-03-11T00:24:00.000-07:00

STUDY SESSION 16

ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation

This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.

LEARNING OUTCOMES

Reading 67: Introduction to the Valuation of Debt Securities

The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.

Reading 68: Yield Measures, Spot Rates, and Forward Rates

The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.
Reading 69: Introduction to the Measurement of Interest Rate Risk

The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.

LOS 67 Introduction to the Valuation of Debt Securities

2008-03-10T21:23:00.000-07:00

LOS 67 Introduction to the Valuation of Debt Securities

a. explain the steps in the bond valuation process;

Steps involved in bond valuation

The fundamental principle of valuation is that the value is equal to the present value of its expected cash flows. The valuation process involves the following three steps:

1. Estimate the expected cash flows.

2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.

3. Calculate the present value of the expected cash flows found in step one by using the interest rate or interest rates determined in step two.

Estimating Expected Cash Flows - Difficulties

2008-03-10T21:18:00.000-07:00

b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;

Bonds With Difficult Expected Cash Flow Estimation
The bonds for which it is difficult to estimate expected cash flows fall into three categories:

1.Bonds for which the issuer or investor has an option or right to change the contract due date for the payment of the principal. These include callable bonds, puttable bonds, MBSs and ABSs.

2.Bonds for which coupon payment rate is reset occasionally based on a formula with values that change, such as reference rates, prices or exchange rates. A floating-rate bond would be an example of this type of category.

3. Bonds for which investor has the option to convert or exchange the security for common stock.

For more See
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa35.asp

The above page has information useful for the next LOS 67.c also.

Computing Value of Bond for a Change in Dicount Rate

2008-03-10T21:16:00.000-07:00

c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;

see
http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp

Price of a Bond near Maturity Date

2008-03-10T21:15:00.001-07:00

d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;

See
www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa36.asp

Arbitrage-free Valuation Approach Bonds

2008-03-10T21:00:00.000-07:00

LOS
67
.f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.

The value of the bond based on the spot rates is the arbitrage-free value.

How Does a Dealer Generate Arbitrage Profits?

A dealer has the ability to strip a security or to take apart the cash flows that make up the bond and create new securites out of them. These Treasury strips can be sold to investors. So if the market price of a Treasury security is less than the value using the arbitrage-free valuation, a dealer will buy the security, strip the bond (break the bond into strips) and then sell the Treasury strips at a higher amount than the purchase price for the whole bond.

See for more

http://www.investopedia.com/study-guide/cfa-exam/level-1/fixed-income/cfa37.asp

LOS 68 Yield Measures, Spot Rates, and Forward Rates

2008-03-10T17:49:00.000-07:00

a. explain the sources of return from investing in a bond;

Interest

Capital appreciation

Reinvestment income
-------------

return of Principal

Traditional Yield Measures for Bonds

2008-03-10T17:46:00.000-07:00

b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;

Current yield

To obtain the current yield, the annual coupon interest is divided by the market price.

Yield to maturity

The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price of the investment.

Yield to call

For bonds that may be called prior to the stated maturity date another yield measure is commonly quoted: it is the yield to call.

To compute the yield to call, the cash flows that occur if the issue is called on its first call date are used.

http://www.paranzasoft.com/help/pages/glBondYieldMeasures.html

Reinvestment Income and Reinvestment Risk

2008-03-10T17:43:00.000-07:00

c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;

Read about it from
The Handbook of Fixed Income Securities By Frank J. Fabozzi

http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA22&lpg=PA22&dq=reinvestment+income+and+reinvestment+risk&source=web&ots=wJORArm5cR&sig=cHzpjvT_6hs_vYEg0Vr397jLIdk&hl=en

Option Adjusted Spread

2008-03-10T17:36:00.000-07:00

f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;

If a bond has embedded options, its Option-adjusted spread (OAS) is the spread at which it presumably would be trading over a benchmark if it had no embedded optionality. More precisely, it is the instrument's current spread over the benchmark minus that component of the spread that is attributable to the cost of the embedded options:

OAS = spread - spread due to option

For more see
http://www.riskglossary.com/link/option_adjusted_spread.htm

OAS - Option Cost Relation

2008-03-10T17:35:00.000-07:00

g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;

LOS 69 Interest Rate Risk Measurement

2008-03-10T09:14:00.000-07:00

a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;

The primary focus of interest rate risk is measuring the impact after an adverse rate change. Two approaches are used to measuring interest rate risk: the full valuation approach and the duration/convexity approach.

The full valuation approach also known as scenario analysis. It examines the value of bonds under a variety of interest rate scenario changes. For example, a portfolio manager might examine the change in a bond with assumed interest rate increases of 50, 100,150 and 200 basis point increases and decreases. This approach is useful when there is a good valuation model and can be used for parallel and nonparallel shifts in the yield curve.

Highly leveraged investors (such as hedge fund investors) often use extreme scenario tests, known as stress testing, to examine the impact of wide interest rate changes. This is fine so long as the manager has a good valuation model to estimate what the price of the bonds will be in each interest rate scenario.

The advantage of the duration/convexity measure is that it is a simpler measure that will show how a portfolio or single bond will change if there is change in a parallel fashion.

Material to be added

2008-03-10T09:00:00.000-07:00

c. describe positive convexity, negative convexity, and their relation to bond price
and yield;

 Convexity is a measure of the curvedness of the price-yield relationship. This curvedness is different for each bond.
 The lower the coupon, the greater the convexity.
 The longer the maturity, the greater the convexity.
 The lower the yield to maturity, the greater the convexity.
 In summary, the change in price of a bond comes from two sources: its modified duration and its convexity.
 The computation of the price change for a bond that is due to the convexity:
Convexity Effect = 1/2 * Price * Convexity * Δyield²

Callable bonds will exhibit negative convexity at certain price-yield combinations. Negative convexity means that as market yields decrease, duration decreases as well.
See

http://www.investopedia.com/university/advancedbond/advancedbond6.asp

Duration Measures

2008-03-10T08:41:00.000-07:00

LOS

69.e. distinguish among the alternative definitions of duration, and explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options;

DURATION MEASURES
 Macaulay Duration: The weighted average time to full recovery of principal and interest payments.

= [ΣC_t*t/(1+i)^t]/[ΣC_t/(1+i)^t]

 Characteristics of Macaulay Duration:
1. The duration of a bond with a coupon is always less than the term to maturity.
2. The larger the coupon, the smaller the duration.
3. There is normally a positive relationship between term to maturity and duration. As term to maturity increases, so does duration, but at a decreasing rate.
4. There is an inverse relationship between the yield to maturity and duration.
5. Sinking funds and call features can reduce the duration significantly.

 Modified duration: an adjusted measure of duration called modified duration can be used to approximate the interest rate sensitivity of a noncallable bond. Modified duration equals Macaulay duration divided by 1 plus the current yield to maturity divided by the no. of payments in a year.

Modified Duration = Macaulay duration[1+(ytm/number of payments per year)]

 The percentage change in the price of a bond for a given change in interest rates can be approximated by:

100*ΔP/P = -D_mod*Δi

ΔP = change in price
Δi = change in interest rate
D_mod = Modified duration

For More
http://www.duke.edu/~charvey/Classes/ba350/bondval/duration.htm

Duration of a bond portfolio

2008-03-10T01:09:00.000-07:00

f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;

duration writeup
http://www.treasurer.ca.gov/cdiac/publications/duration.pdf

Duration, Convexity, and Other Bond Risk Measures By Frank J. Fabozzi
http://books.google.co.in/books?id=7i6ob9SB5jgC&pg=PA6&lpg=PA6&dq=%22duration+of+a+portfolio%22&source=web&ots=ZmSpP6g2Ks&sig=Jgf-3gdgb2O47YENTrQvTtwJ-OI&hl=en

Osborne, Mike J., "A Simple, Accurate Formula for the Duration of a Portfolio of Bonds Under a Non-Parallel Shift of a Non-Flat Yield Curve" (September 5, 2004). Available at SSRN:
http://ssrn.com/abstract=587242

Convexity of a bond

2008-03-10T01:06:00.000-07:00

g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;

Advanced Bond Concepts: Convexity
http://www.investopedia.com/university/advancedbond/advancedbond6.asp

Modified Convexity and Effective Convexity

2008-03-10T01:00:00.000-07:00

h. differentiate between modified convexity and effective convexity;

From Google books
The Handbook of Fixed Income Securities By Frank J. Fabozzi

http://books.google.co.in/books?id=jup2d1pEyWcC&pg=PA116&lpg=PA116&dq=modified+convexity+and+effective+convexity&source=web&ots=wJORAlm2kL&sig=Bv5apvCK-H50KWpySX0uzIRGnrI&hl=en

Price value of a basis point (PVBP) Fixed Income Securities

2008-03-10T00:55:00.000-07:00

LOS

69.i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.

What is basis point value, (BPV)?

BPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or DV01. It is often used to measure the interest rate risk associated with swap trading books, bond trading portfolios and money market books.

It is not new. It has been used for years. In many financial institutions it has been replaced or is used in conjunction with value at risk.

What does it show?

BPV tells you how much money your positions will gain or lose for a 0.01% parallel movement in the yield curve. It therefore quantifies your interest rate risk for small changes in interest rates.

How does it work?

Let's suppose you own a $10m bond that has a price of 100%, a coupon of 5.00% and matures in 5 years time. Over the next 5 years you will receive 5 coupon payments and a principal repayment at maturity. You can value this bond by:

A. Using the current market price from a dealer quote, or

B. Discounting the individual bond cash flows in order to find the sum of the present values

Let's assume you use the second method. You will use current market interest rates and a robust method for calculating accurate discount factors. (Typically swap rates are used with zero coupon methodology).

For the sake of simplicity we will use just one interest rate to discount the bond cash flows. That rate is 5.00%. Discounting the cash flows using this rate will give you a value for the 5 year bond of $10,000,000. (How to do this using a financial calculator is explained on the second page of this document).

We will now repeat the exercise using an interest rate of 5.01%, (rates have increased by 0.01%). The bond now has a value of $9,995,671.72.

There is a difference of $4,328.28.

It shows that the 0.01% increase in interest rates has caused a fall in the value of the bond. If you held that bond you would have lost $4,328.28 on a mark-to-market basis.

This is the BPV of the bond.

For some more details see
http://www.barbicanconsulting.co.uk/quickguides/bpv

STUDY SESSION 16 ANALYSIS OF FIXED INCOME

2008-03-10T00:47:00.000-07:00

STUDY SESSION 16

ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation

This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.

LEARNING OUTCOMES

Reading 67: Introduction to the Valuation of Debt Securities

The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.

Reading 68: Yield Measures, Spot Rates, and Forward Rates

The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.

Reading 69: Introduction to the Measurement of Interest Rate Risk

The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.

Study Session 17 Derivative Investments - LOS

2008-03-10T00:44:00.000-07:00

Study Session 17

Derivative Investments

Derivatives − financial instruments that offer a return based on the return of some underlying asset − have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices and maintaining parity.

This study session builds the conceptual framework for understanding derivative investments (forwards, futures, options, and swaps), derivative markets, and the use of options in risk management.

LOS

Reading 70: Derivative Markets and Instruments

The candidate should be able to:

a. define a derivative and differentiate between exchange-traded and over-thecounter
derivatives;
b. define a forward commitment and a contingent claim, and describe the basic
characteristics of forward contracts, futures contracts, options (calls and puts),
and swaps;
c. discuss the purposes and criticisms of derivative markets;
d. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.

Reading 71: Forward Markets and Contracts

The candidate should be able to:

a. differentiate between the positions held by the long and short parties to a
forward contract in terms of delivery/settlement and default risk;
b. describe the procedures for settling a forward contract at expiration, and discuss
how termination alternatives prior to expiration can affect credit risk;
c. differentiate between a dealer and an end user of a forward contract;

d. describe the characteristics of equity forward contracts and forward contracts on
zero-coupon and coupon bonds;
e. describe the characteristics of the Eurodollar time deposit market, define LIBOR
and Euribor;
f. describe the characteristics of forward rate agreements (FRAs);
g. calculate and interpret the payoff of an FRA and explain each of the component
terms;
h. describe the characteristics of currency forward contracts.
Reading 72: Futures Markets and Contracts
The candidate should be able to:
a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
c. describe price limits and the process of marking to market, and compute and
interpret the margin balance, given the previous day’s balance and the new
change in the futures price;
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
e. describe the characteristics of the following types of futures contracts: Eurodollar,
Treasury bond, stock index, and currency.
Reading 73: Option Markets and Contracts
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
b. identify the types of options in terms of the underlying instruments;
c. compare and contrast interest rate options to forward rate agreements (FRAs);
d. define interest rate caps, floors, and collars;
e. compute and interpret option payoffs, and explain how interest rate option
payoffs differ from the payoffs of other types of options;
f. define intrinsic value and time value, and explain their relationship;
g. determine the minimum and maximum values of European options and
American options;
h. calculate and interpret the lowest prices of European and American calls and
puts based on the rules for minimum values and lower bounds;
i. explain how option prices are affected by the exercise price and the time to
expiration;
j. explain put-call parity for European options, and relate put-call parity to arbitrage
and the construction of synthetic options;
k. contrast American options with European options in terms of the lower bounds
on option prices and the possibility of early exercise;
l. explain how cash flows on the underlying asset affect put-call parity and the
lower bounds of option prices;
m. indicate the directional effect of an interest rate change or volatility change on
an option’s price.

Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.

Reading 75: Risk Management Applications of Option Strategies
The candidate should be able to:
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying and selling calls and puts, and indicate the market outlook
of investors using these strategies;
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
covered call strategy and a protective put strategy, and explain the risk
management application of each strategy.

Specified Readings

"Derivative Markets and Instruments"
Ch. 1, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Forward Markets and Contracts"
Ch. 2, pp. 25-37, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Futures Markets and Contracts"
Ch. 3, pp. 81-103, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Option Markets and Contracts"
Ch. 4, pp. 159-194, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Swap Markets and Contracts"
Ch. 5, pp. 269-285, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Risk Management Applications of Option Strategies"
Ch. 7, pp. 411-429, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)

Characteristics of forward rate agreements

2008-02-27T21:05:00.001-08:00

71
f. describe the characteristics of forward rate agreements (FRAs);

A forward rate agreement or FRA is similar to a forward contract. Its payoff is based on an interest rate.

FRAs are typically based on rates like LIBOR or Euribor, quoted as an annual rate.

The underlying is for a specified term, such as 90 day LIBOR, 180 day Euribor etc.

One peculiarity of the FRA market is that it pays the amount due on the contract on the day of interest rate ascertainment. But the rate quoted in the market is for payment after the period specified with interest.

So, in general an FRA on an m-day interest pays off at expiration but the payoff is discounted for m days at the m-day rate.

Characteristics of Futures Contracts

2008-02-27T20:59:00.000-08:00

a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;

A futures contract - is a type of forward contract with highly standardized and closely specified contract terms.

Distinguishing between a futures and a forward contract.

Differences between Futures contracts and Forward contracts:

Futures contracts always trade on an organized exchange.
Futures contracts are always highly standardized with a specific quantity of a good, with a specific delivery date and delivery mechanism.
Performance on futures contracts is guaranteed by a clearinghouse.
All futures require that traders post margin to trade. Margin is a good faith deposit.
Futures markets are regulated by an identifiable government agency, while forward contracts in general trade in an unregulated market.

Margins in Futures Markets

2008-02-27T20:58:00.000-08:00

LOS 72b
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;

Maintenance margin - When the value of the funds on deposit with a broker reach a certain level where the trader is required to replenish the margin.
Variation margin - The additional amount the trader must deposit to return to the maintenance margin.
Initial margin - The amount a trader must deposit before trading any futures.

Closing Futures Contract

2008-02-22T01:02:00.000-08:00

LOS
72
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
----------------

Delivery and Cash Settlement of futures contracts

All contract eventually expire. Each contract has a delivery month.

The delivery procedures varies among contracts.

Most non-cash settled financial futures contracts permit delivery any business day of the delivery month.

Delivery is three day sequence. Two business days before the intended delivery day, the holder of the a short position intending to deliver notifies the clearing house of his intention to deliver through his clearing member. This is day is termed position day.

On the next business day, termed the notice of intention day, the exchane selects the holder of the oldest long position to receive delivery. On the third day, the delivery day, delivery takes place and the long position holder pay the short position holder who made the delivery.

For many of the financial futures delivery is consummated by wire transfer as the securities are with depositories and money is with banks.

On cash settled financial futures contracts, the settlement price on the last trading day is fixed at the closing spot price of the underlying instrument. All contracts are market to market at this settlement price and cash settlement takes place.

Offsetting: About 90 per cent of all futures contracts are not delivered.Most of the contracts get closed prior to expiration through a process called offsetting. The futures market is not the best route to acquire the underlying asset. Hence long position holders close their position before delivery month.

Exchange for physicals (EFP): Some contracts are actually delivered through this process. This transaction occurs outside the exchange, and is reported to the exchange and exchange accepts it to offset the positions of long and short position holders.

Future Markets and Contracts Part E

2008-02-12T23:33:00.000-08:00

Reading 72

LOS

e. describe the characteristics of the following types of futures contracts: Eurodollar, Treasury bond, stock index, and currency.
---------------

Eurodollar futures contract

Trade Eurodollar Futures at Trade Center, LLC.

Eurodollars are U.S. dollars on deposit in commercial banks located outside of the United States. Eurodollars deposits play a major role in the international capital market, and they have long served as a benchmark interest rate for corporate funding.

The Eurodollar futures contract reflects the London Interbank Offered Rate (LIBOR) for a three-month, $1 million offshore deposit. Eurodollar deposits are direct obligations of the commercial banks accepting the deposits and are not guaranteed by any government. Although they represent low-risk investments, Eurodollar deposits are not risk-free.

CME developed and launched Eurodollar futures in 1981, and since then Eurodollar futures has evolved into one of the world’s most innovative and popular contracts—and is now the most actively traded futures contract in the world with open interest recently surpassed the four million mark.

CME Eurodollar futures are cash-settled, therefore, there is no delivery of a cash instrument upon expiration because cash Eurodollar time deposits are not transferable.

Eurodollar futures contract size has a principal value of $1,000,000 with a three-month maturity. Eurodollar futures move in 1 point increments, or .01, equaling $25.

The Eurodollar tick reflect the dollar value of a 1/100 of one percent change in a $1 million, 90-day deposit, determined by the following equation:
$1,000,000 notional value x .0001 x 90/360 = $25.

Trading can also occur in minimum ticks of .0025, or ¼ ticks, representing $6.25 per contract and in .005, or ½ ticks, representing $12.50 per contract. Eurodollar contracts trade Mar, Jun, Sep, Dec; Forty months in the March quarterly cycle, and the four nearest serial contract months

Since the Eurodollar contract’s inception, it has become one of the most versatile trading vehicles offered on the listed markets, offering numerous opportunities for hedgers and arbitrageurs. The contract’s exceptional growth and its adaptability and versatility continues to evolve due to nonstop enhancements. As a result, today’s Eurodollar contract offers even more trading opportunities.

Besides Eurodollar futures and options on futures, CME also developed the following as part of the Eurodollar contract:

Eurodollar Bundles—allow traders to simultaneously buy or sell a consecutive series of Eurodollar futures in equal proportions beginning with the front quarterly contract.

Eurodollar Packs—simultaneous purchase or sale of an equally weighted, consecutive series of four Eurodollar futures, quoted on an average net change basis from the previous day’s close.

Serial Eurodollars—identical to quarterly Eurodollar futures with the exception of expirations dates. Serial Eurodollars expire in months other than those in the March, June, September and December quarterly cycles.

Contract Specification for Eurodollar Futures

Trade Unit:
Eurodollar Time Deposit having a principal value of $1,000,000 with a three-month maturity.

Point Descriptions:
1 point = .01 = $25.00

Contract Listing:
Mar, Jun, Sep, Dec, Forty months in the March quarterly cycle, and the four nearest serial contract months.

Hours: 7:20 a.m.-2:00 p.m.Holidays LTD(Monday 5:00 a.m.)

Minimum Fluctuation:
Regular 0.01=$25.00
Half Tick 0.005=$12.50
Quarter 0.0025=$6.25 for nearest expiring month.

----------

Treasury Bond Futures

Contract Specification for 30 year T-Bond Futures

Contract Size

U.S. Treasury notes having a face value at maturity of $100,000 or multiple thereof.

Deliverable Grades

U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a maturity of at least 15 years from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent.

Tick Size

Minimum price fluctuations shall be in multiples of one thirty-second (1/32) point per 100 points ($31.25 per contract) except for intermonth spreads, where minimum price fluctuations shall be in multiples of one-fourth of one-thirty-second point per 100 points ($7.8125 per contract). Par shall be on the basis of 100 points. Contracts shall not be made on any other price basis.

Price Quote
Points ($1,000) and thirty-seconds of a point; for example, 80-16 equals 80 16/32

Contract Months
Mar, Jun, Sep, Dec

Last Trading Day
Seventh business day preceding the last business day of the delivery month.

Last Delivery Day
Last business day of the delivery month.

Delivery Method
Federal Reserve book-entry wire-transfer system

Trading Hours
Open Auction: 7:20 am - 2:00 pm, Central Time, Monday - Friday
Electronic: 7:01 pm - 4:00 pm, Central Time, Sunday - Friday
Trading in expiring contracts closes at noon, Central Time, on the last trading day

Daily Price Limit
None
--------
Stock Index Futures Contracts

DJIA Futures ($10 Multiplier)

Contract Size
Ten dollars ($10) times the Dow Jones Industrial Average Index. The DJIA is a price-weighted index of thirty (30) stocks.

Final Settlement Day
The third Friday of the contract month.
Settlement
Cash settlement on the final settlement day. The final settlement price is $10 times a Special Opening quotation of the index.

Tick Size
Minimum price increment is one index point (equal to $10 per contract).

Price Quote
The DJIA Index, quoted in index points.

Contract Months
Mar, Jun, Sep, Dec. Four nearest months in March quarterly cycle and two additional December contracts listed at all times.

Last Trading Day
The trading day preceding the final settlement day.

Trading Platform
Open Auction and Electronic.

Trading Hours
Monday: Thursday 3:30 pm - 4:30 pm and 5:00 pm - 8:15 am next day
Sunday: 5:00 pm - 8:15 am next day
Trading in expiring contracts ceases at 3:15 p.m. Central Time on the last trading day.

Ticker Symbols
Open Auction: DJ
Electronic: ZD

Fungibility

BIG Dow futures ($25 multiplier), mini-sized Dow futures ($5 multiplier), and DJIA futures ($10 multiplier) are fungible contracts

Daily Price Limit
Successive 10%, 20%, and 30% limits. For details, please see CBOT Regulation 1008.01.

Position Limits
The aggregate position limit in BIG Dow futures ($25 multiplier), mini-sized futures and options ($5 multiplier), and DJIA futures and options ($10 multiplier) is 50,000 DJIA futures ($10 multiplier) equivalent contracts, net long or short in all contract months combined.

http://www.cbot.com/cbot/pub/cont_detail/1,3206,1411+14424,00.html
---------------

currecny futures

CME Japanese Yen Futures
Trade Unit 12,500,000 Japanese yen
Point Descriptions 1 point = $.000001 per Japanese yen = $12.50 per contract
Contract Listing Six months in the March Quarterly Cycle, Mar, Jun, Sep. Dec.

Minimum Fluctuation
Regular 0.000001=$12.50
Calendar Spread 0.0000005=$6.25
All or None 0.0000005=$6.25

http://www.cme.com/trading/prd/fx/japanese_FCS.html

Options - Part A European Option, American Option

2008-02-12T20:32:00.005-08:00

Reading 73: Option Markets and Contracts

LOS

The candidate should be able to:

a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;

--------
Reference: An INtroduction to Derivatives and Risk Management by Don Chance

An option is a contract between two parties - a buyer and a seller- that gives the buyer the right, but not the obligation to purchase or sell something at a later date at a price agreed upon today.

the option buyer pays the seller the price or premium for the option that he is buying.

There are two types of basic options.

Call option:An option to buy is called a call.

Put option: An option to sell is called a put.

Options now trade in organized exchanges. But the creation of an organized options exchange was done in 1973 only. Prior to that options were bought and sold through dealers as contract between two parties. This type of market, called anover the counter market was actually the first type of options market.

Over the counter market is active now also and is used by corporations and financial institutions to enter into contracts tailor made for their requirements.

While options on OTC can have terms are convenient to the parties involved, exchange traded contract have various features standardized and prescribed by the exchange.

They are assets for which options are traded, contract size, exercise price, expiration date, position abd exercuse limits.

European option and American option,
European Call and American Call

European options can be exercised only on the termination date of the option. The buyer can demand delivery of the underlying asset or choose to allow the option (call) unexercised on the termination date. Till that termination date, he has no interaction with the option writer.

In the case of American option (call), the buyer can exercise the option on any day till the maturity day. The writer of seller of the option has to deliver on the day the buyer makes the demand for delivery.

Moneyness of an option

Moneyness is a relation between the current market price of the asset underlying an option contract.

In case of calls

If the current market price is equal to the exercise price the call is said to be at the money.
If the current market price is higher than the exercise price the call is said to be in the money.

If the current market price is lower than the exercise price the call is said to be out of the money.

Options - Part B

2008-02-12T20:32:00.003-08:00

LOS

b. identify the types of options in terms of the underlying instruments;

Types of options

Stock options

Index options

Currency options

Options on bonds

Interest rate options

Real options - Corporate investment decisions

Options - Part C

2008-02-12T20:32:00.001-08:00

c. compare and contrast interest rate options to forward rate agreements (FRAs);

A forward rate agreement or FRA is similar to any type of forward contract, but the payoff is based on an interest rate, rather than the price of an asset.

Interest rate options are a lot like forward rate agreements. Instead of being a firm commitment, they represent the right to make a fixed interest payment and receive a floating interest payment or to make a floating interest payment and receive a fixed interest payment. Interst rate options have a strike rate or exercise rate instead of price.

Don chance, pages 466, 474, 475

Options - Part D

2008-02-12T20:31:00.006-08:00

d. define interest rate caps, floors, and collars;

A combination of interest rate calls designed to protect a borrower in a floating rate loan against increases in interest rates is called an interest rate cap.

A combination of interest rate puts designed to protect a lender in a floating rate loan against decreases in interest rates is called an interest rate floor.

A combination of long cap and short floor is called an interest rate collar. The collars are most often used by borrowers and consist of long position in a cap, financed by selling a short position in a floor.

Options - Part F

2008-02-12T20:31:00.003-08:00

f. define intrinsic value and time value, and explain their relationship;

in the money options has an intrisic value.

In the case of a call option, current market price - Exercise price, if it is a positive quantity is its intrinsic value. If it is a negative value, then intrinsic value is zero.

Time value of an option is option value or premium at a market price minus the intrinsic value at that market price.

Even if intrinsic value is zero, options have time value.

Options - Part G

2008-02-12T20:31:00.001-08:00

g. determine the minimum and maximum values of European options and
American options;

The maximum value of a call option is the stock price - exercise price

The minimum value of an american call is 0 or intrinsic value. Because one can exercise the get the intrinsic value of the call.

In the case of a european call, the minimum value will be CMP - discounted value of exercise price. (As exercise price is paid only at termination date, its discounted value is taken as the present value of exercise price which the seller will get).

CFA websites - Blogs

2008-02-11T00:20:00.001-08:00

http://vanguardist.blogspot.com/2008/01/testtest.html

http://phdmbacfa.blogspot.com/

http://roadtocfa.blogspot.com/

http://cfathoughts.blogspot.com/

CFA Level 1 Swap Markets and Contracts - Part IA

2008-02-09T03:24:00.000-08:00

Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.

Introduction

Swaps are derivative instruments customized to the requirements of the parties involved. The two parties involved are called counterparties.

IN a swap the two counterparties agree to exchange a stream of future cash for a specified period of time based upon agreed upon parameters in some underlying commodity or market index or currency.

The period of time for which the swap will be in operation is called tenor of the swap.

A swap calls for periodic payments.

swaps are over the counter transactions between two parties.

swap markets have swap facilitators. Swap facilitators help clients find ways via the swap market to alter or avoid unwanted risks.

Swap facilitators act as financial engineers and design swaps to solve client problems.

Swap facilitators act as brokers and bring counterparties together.

Swap facilitators act as dealers who enter into swap agreements with others as principals and carry the swaps on their books.

Swap dealers engage in offsetting swaps., whereby their long positions and short positions net to as close to zero position as possible. Through their understanding of the market for swaps and prices at which various parties are willing to enter into swaps, dealers price their quotes in which they are principals so as to earn a bid-ask spread on their overall book, even if their net exposure were to be zero. Sometimes, dealers may keep some net exposure when they feel the potential returns outweigh the risks.

Keeping a net position means, they will not offset the transaction immediately but wait for sometime to benefit from change in swap prices.

Termination of swaps

Swaps are normally designed with the intention of holding the position till the termination date.

If in case a party changes his mind and wants to get out of the swap, he may go to a dealer and ask for an offsetting swap. It may enter separately into another swaps that offsets the earlier swap and both swaps remain in force but the net effect for a firm is eqaul to terminating the swap. But with both swaps in force, the firm would be facing credit risk. Hence it is better to go in for direct termination of the swap from the origical dealer.

Forward swaps and swaptions also can be used to provide offsetting positions to existing swaps.

Source:
An introduction to Derivatives and Risk Management by Don Chance, Thomson South Western, 2004

CFA Level 1 Swap Markets and Contracts - Part IB

2008-02-09T03:21:00.000-08:00

Reading 74: Swap Markets and Contracts
-------------
LOS 74b
The candidate should be able to:

b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.
-----------------

All the three types of swaps are covered in An introduction to Derivatives and Risk Management by Don Chance, Thomson South Western, 2004.

Plain vanilla interest rate swap:

An interest rate swap is a series of interest payments between two parties to the swap contract. Each set of payments is based on either a fixed or floating rate.

The most common type of interest rate swap is a swap in which one party pay a fixed rate and the other pays a floating rate. This instrument is called a plain vanilla interest rate swap. Sometimes vanilla swap.

Currency swap: Currecy swap is a series of payments between two parties in which the two sets of payments are in different currencies.

The payments are effectively equivalent to interest payments because they are calculated as though interst werebeing paid on a specific notional principal. However, there are two notional principals one in each currency. In a currency swap, the notional principals can be exchanged if the parties desire.

Equity Swaps: In an equity swap at least one of the two streams of cash flow is determined by a stock price, teh value of a stock portfolio, or the level of a stock index. The other stream can be a fixed rate, a floating rate, or it can be determined by the value of another stock, stock portfolio or stock index.

CFA Level 1 Buying Calls

2008-02-07T16:40:00.000-08:00

LOS

a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying calls and indicate the market outlook
of investors using these strategies;
----------

The maximum loss of the strategy of buying a call is the premium or the price paid for buying the call.

The maximum gain of buying a call is unlimited.

The break even point of buying a call is X + c where X is strike price and c is the call premium paid.

The market out look of the investor has to be bullish outlook for the underlying stock

CFA - Selling Calls

2008-02-07T16:39:00.000-08:00

LOS

a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of selling calls and indicate the market outlook
of investors using these strategies;
--------------

The maximum loss is unlimited. the increase in share price has to be born by the call writer.

The maximum gain is limited to the premium received.

The break even point is X + c.

Writer of a call (naked call) requires a moderately bearish outlook for the underlying stock

CFA - Buying a Put

2008-02-07T16:38:00.000-08:00

a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying puts, and indicate the market outlook
of investors using these strategies;

Maximum loss limited to the premium paid.

The maximum gain that it can produce is the exercise price (less the premium paid) as the stock price cannot fall below zero.

Breakeven point = X - p

Buyer of a put (naked put) requires a bearish outlook on the stock underlying the put.

CFA - Selling a Put

2008-02-07T16:36:00.000-08:00

75 a (iv)
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategy of selling puts, and indicate the market outlook
of investors using this strategy.

Maximum loss = X -p

Maximum gain is the premium received

Breakeven point = X - p

Writer of a put requires moderately bullish outlook for the stock underlying the put.

CFA - Derivatives - Risk Management Applications - Options - Covered Call Strategy

2008-02-06T19:12:00.000-08:00

Covered Call Strategy
--------------

b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
a Covered Call Strategy, and explain the risk management application of the strategy.
--------------

IP (Price of the stock when the option contract is initiated) and
TP(terminal price at maturity of the stock)
X Exercise Price

Value of the option strategy at expiration

If TP ≤ X

V = TP - IP + C

If TP ≥ X

V = X - IP + C

Maximum profit occurs when the stock price exceeds the exercise price.

Maximum loss occurs if the stock price at expiration goes to zero.

Breakeven point or breakeven stock price is the stock price where the profit of the option strategy is zero.

This occurs when the stock is price IP - C.

Covered call writing is a very popular strategy among professional traders. This is because it is a low risk strategy of call writing. There are studies that showed that covered call writing is more profitable than buying options.

Many institutional investors also use a covered call writing strategy to earn extra income through call premiums.

CFA Level 1 Derivatives - Risk Management Applications Option

2008-02-04T07:45:00.000-08:00

Risk Management Applications of Option Strategies - Protective put Strategy

LOS
------------------------
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
a protective put strategy, and explain the risk management application of the strategy.
--------------------

A protective put is a put bought to hedge an existing holding of a security. It provides protection against decline in value of the security.

If CP (current price) and TP(terminal price at maturity) on the cash security a profit is realized if TP>CP.

On the put, if TP>CP loss made to the extent of premium.
If TPThe value of the put will be maximum of [0, X-TP].
Profit will be maximum of [0, X-TP] minus the premium paid.

Example: An investor bought a put at strike price $100 for a stock quoting at $100. the premium paid is $5.

If the price remains at $100 at the expiry day, value of the put is zero and the loss of the investment strategy is $5 in comparison to unhedged position.

If the price goes to $98, value of the put is $2 and the loss of the investment strategy is $3 in comparison to unhedged position.

If the price goes to $95 value of the put is $5 and the loss of the investment is strategy is zero compared to unhedged position.

If the price goes up to $105, the investor makes only 100$ because of the premium paid on put. As price at maturity goes higher, investor makes profit.

Thus maximum loss this investment strategy is $5 and upside is available without any cap. So this strategy has a payoff similar to long call.

Study Session 17 Derivative Investments

2008-02-03T05:48:00.000-08:00

Study Session 17

Derivative Investments

Derivatives − financial instruments that offer a return based on the return of some underlying asset − have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices and maintaining parity.

This study session builds the conceptual framework for understanding derivative investments (forwards, futures, options, and swaps), derivative markets, and the use of options in risk management.

LOS

Reading 70: Derivative Markets and Instruments

The candidate should be able to:

a. define a derivative and differentiate between exchange-traded and over-thecounter
derivatives;
b. define a forward commitment and a contingent claim, and describe the basic
characteristics of forward contracts, futures contracts, options (calls and puts),
and swaps;
c. discuss the purposes and criticisms of derivative markets;
d. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.

Reading 71: Forward Markets and Contracts

The candidate should be able to:

a. differentiate between the positions held by the long and short parties to a
forward contract in terms of delivery/settlement and default risk;
b. describe the procedures for settling a forward contract at expiration, and discuss
how termination alternatives prior to expiration can affect credit risk;
c. differentiate between a dealer and an end user of a forward contract;

d. describe the characteristics of equity forward contracts and forward contracts on
zero-coupon and coupon bonds;
e. describe the characteristics of the Eurodollar time deposit market, define LIBOR
and Euribor;
f. describe the characteristics of forward rate agreements (FRAs);
g. calculate and interpret the payoff of an FRA and explain each of the component
terms;
h. describe the characteristics of currency forward contracts.

Reading 72: Futures Markets and Contracts
The candidate should be able to:
a. describe the characteristics of futures contracts, and distinguish between futures
contracts and forward contracts;
b. differentiate between margin in the securities markets and margin in the futures
markets; and define initial margin, maintenance margin, variation margin, and
settlement price;
c. describe price limits and the process of marking to market, and compute and
interpret the margin balance, given the previous day’s balance and the new
change in the futures price;
d. describe how a futures contract can be terminated by a close-out (i.e., offset) at
expiration (or prior to expiration), delivery, an equivalent cash settlement, or an
exchange-for-physicals;
e. describe the characteristics of the following types of futures contracts: Eurodollar,
Treasury bond, stock index, and currency.
Reading 73: Option Markets and Contracts
The candidate should be able to:
a. define European option, American option, and moneyness, and differentiate
between exchange-traded options and over-the-counter options;
b. identify the types of options in terms of the underlying instruments;
c. compare and contrast interest rate options to forward rate agreements (FRAs);
d. define interest rate caps, floors, and collars;
e. compute and interpret option payoffs, and explain how interest rate option
payoffs differ from the payoffs of other types of options;
f. define intrinsic value and time value, and explain their relationship;
g. determine the minimum and maximum values of European options and
American options;
h. calculate and interpret the lowest prices of European and American calls and
puts based on the rules for minimum values and lower bounds;
i. explain how option prices are affected by the exercise price and the time to
expiration;
j. explain put-call parity for European options, and relate put-call parity to arbitrage
and the construction of synthetic options;
k. contrast American options with European options in terms of the lower bounds
on option prices and the possibility of early exercise;
l. explain how cash flows on the underlying asset affect put-call parity and the
lower bounds of option prices;
m. indicate the directional effect of an interest rate change or volatility change on
an option’s price.

Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.

Reading 75: Risk Management Applications of Option Strategies
The candidate should be able to:
a. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of the
strategies of buying and selling calls and puts, and indicate the market outlook
of investors using these strategies;
b. determine the value at expiration, profit, maximum profit, maximum loss,
breakeven underlying price at expiration, and general shape of the graph of a
covered call strategy and a protective put strategy, and explain the risk
management application of each strategy.

Specified Readings

"Derivative Markets and Instruments"
Ch. 1, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Forward Markets and Contracts"
Ch. 2, pp. 25-37, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Futures Markets and Contracts"
Ch. 3, pp. 81-103, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Option Markets and Contracts"
Ch. 4, pp. 159-194, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Swap Markets and Contracts"
Ch. 5, pp. 269-285, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)
"Risk Management Applications of Option Strategies"
Ch. 7, pp. 411-429, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)

CFA Level 1 Alternative Investments

2008-02-03T00:27:00.000-08:00

The institute specified reading for this study session is chapter "Alternative Investments" from International Investments by Bruno Solnik and Dennis McLeavey published by Pearson Addison Wesley.

The chapter covers all learning outcome statements of the syllabus.

I prepared material for each LOS based on this source. Each LOS is covered in a separate post.

CFA Level 1 Alternative Investments - Investment Companies

2008-02-02T23:22:00.000-08:00

a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;

Investment companies are financial intermediaries that pool and invest funds of varius individual and institutional investors, giving the investors rights to a proportional share of the pooled fund performance.

There are managed investment companies and unmanaged investment companies in United States.Unit investment trusts in United States are unmanaged investment companies and they hold a fixed portfolio of investments for the life of the company and they stan ready to redeem the investor's units at market value (net asset value) and also for reselling such shares to new investors.

------------------
Unit Investment Trusts (UITs)

A "unit investment trust," commonly referred to as a "UIT," is one of three basic types of investment company. The other two types are mutual funds and closed-end funds.

Here are some of the traditional and distinguishing characteristics of UITs:

A UIT typically issues redeemable securities (or "units"), like a mutual fund, which means that the UIT will buy back an investor's "units," at the investor's request, at their approximate net asset value (or NAV) . Some exchange-traded funds (ETFs) are structured as UITs. Under SEC exemptive orders, shares of ETFs are only redeemable in very large blocks (blocks of 50,000 shares, for example) and are traded on a secondary market.

A UIT typically will make a one-time "public offering" of only a specific, fixed number of units (like closed-end funds). Many UIT sponsors, however, will maintain a secondary market, which allows owners of UIT units to sell them back to the sponsors and allows other investors to buy UIT units from the sponsors.

A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors.

A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio securities held by the UIT listed in its prospectus.

A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.

Before investing in a UIT, you should carefully read all of the UIT's available information, including its prospectus.

UITs are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, in particular Section 4 and Section 26.

Source:
http://www.sec.gov/answers/uit.htm
------------------------

Managed investment companies are categorised into open-end and closed-end companies

Open-end investment companies are called mutual funds and they stand ready to sell new shares or to redeem existing shares at NAV. Their assets under management expand or contract with each transaction that investors make.

Closed-end investment companies issue shares only once to the public and then those shares are traded in the secondary markets.

NAV calculation of investment companies

NAV is the per-share value of the investment company's assets minus liabilities.

Assets are all the cash and securities that are on its books, accrued dividends &interest payments due to from companies and payments due from stock brokers. Liabilities include payments due to brokers and other parties from whom securities are purchased and will include management fees due to investment managers.

Fees charged by Managers and Management Companies

Investment companies charge fees and also expenses are incurred in transactions and accounting/administration of the fund.

Annual charges comprise management fees, distribution fees and operating expenses.

One time charges at purchase and exit provide commission for sales agent. They do not provide any fee for fund management.

CFA Level Alternative Instruments - Investment Strategies

2008-02-02T23:08:00.000-08:00

b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;

Style stategies: The funds or fund managers focus on some underlying characteristics common to various possible assets or securities of an asset.

In case of equity growth and value are very popular style strategies.

Growth strategies focus on identifying growth companies selling at high P/E ratios, but undervalued according to the analysis of the fund managers. The fund managers has expertise and confidence in his analysis of growth prospects as well as the valuation of those prospects. Growth style managers are willing to consider new companies for investing.

Value fund managers, rely on past performance to derive a value estimate, and find undervalued companies based on their valuation and then analyze whether there are serious weaknesses that disturb historical record. Value style managersl limit their analysis to companies with having a minimum number of years of existence to get historical data to analyse.

Sector investment funds focus on stocks of particular industry. ex: Pharmaceuticals, Financial industry

An index fund attempts to track an index.

An international fund invests only in foreign assets.

A global fund invests in foreign assets as well as domestic assets.

CFA ETFs

2008-02-02T20:59:00.000-08:00

Exchange traded funds are index based investment products that allow nvestors to buy or sell exposure to an index on the stock exchange through a single financial instrument.

ETFs are shares of funds that trade on a stock market like shares of any individual companies.

CFa Level 1 Advantages and Risks of ETFs

2008-02-02T20:54:00.002-08:00

c. explain the advantages and risks of ETFs

-----------------

Applications

Implementing asset allocation
Diversifying sector/industry exposure
Gaining exposure to international markets
Equitizing cash
Managing cash flows
Completinng overall investment strategy
Bridging transitions in fund management
Managing portfolio risk

Risks

Market risk
Asset class/sector risk
Trading risk
Tracking error risk
Derivatives risk
Currency risk and country risk

CFA Level 1 Alt. Inv. Venture Capital

2008-02-02T20:39:00.000-08:00

g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;

---------------------

Private equity investments are equity investments that are not traded on exchanges. private equity definition is now extended to making equity investment through bulk deals involving negotiated prices.

Venture capital falls under private equity definition. Venture capital investments are investments in business ventures from idea stage through expansion of an unlisted company already producing and selling a product. The exit from the investment is made through a buyout or an initial public offering.

Investments in private equity are done through limited partnerhships. Limited partnerships allow participation in funds with limited liability (the initial investment) and management of the fund by general partners who are private equity experts.

Funds of funds are available in private equity funds.

CFA L1 Alt. Inv. Venture Capital Investing

2008-02-02T20:33:00.000-08:00

g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;

Stages of Venture Capital Investing

Seed-stage

Early-stage

Formative-stage

Later-stage

Expansion-stage

Venture capital investment characteristic

Illiquidity
Long-term commitment
Difficulty in determining current market values
Limited historical risk and return data
Limited information
Entrepreneurial management mismatches
Fundmanager incentive mismatches
Lack of knowledge of competitors
Vintage cycles
Extensive operations analysis and advice

types of liquidation

Exits

divestment by trade sale
divestment by IPO/Floatation
Sale of quoted equity
Divestment by writeoff

CFA Level 1 Alternative Investments - NPV VC Project

2008-02-02T00:42:00.000-08:00

---------

h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
----------

NPV calculation of the venture capital project is done first by calculating NPV in the normal manner as is done for projects of existing companies. The estimates mostly likely cashflows for each year of the project life are made and the cash flows are discounted to present value to determine NPV.

The risk of the venture is explicitly modelled in VC projects. For illustration let use take the following data regarding the probability of failure of a venture.

Year ----Failure probability

1---------------0.30
2.--------------0.25
3.--------------0.20
4.--------------0.15
5.--------------0.15
6.--------------0.10
7.--------------0.10

Becasue probablity of failure is given, probability of success is 1 minus probability of failure. For the first year 0.70 is the probability of success.

The seven years the probability of success is
(0.70)(0.75)(0.80)(0.85)(0.85)(0.90)(0.90) = 0.246

So the probability of venture surviving for seven year is .246.

If the estimate is that the investment outlay required is $2 million and it will give an exit value of 30 million at the end of seven years. The required return is 20%.

The present value of 30 million received at the end of 7 years is 30/(1.20^7) which comes out as 8.372 million.

If project fails at any during seven years the NPV(failure) is -$2 million and if its succeeds NPV(success) is $6.372 million.

The expected NPV of the venture = .754(-$2 mil) + .246($6.372) = $0.06 million

Based on the NPV the venture project can be accepted.

CFA Level 1 Alternative Investments - Hedge Funds - 1

2008-01-31T00:33:00.000-08:00

Hedge fund
Objectives,
legal structure,
fee structure, and
classifications of hedge funds;

CFA LOS

i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;

Reference/Reading: International Investments, by Bruno Solnik and Dennis McLeavey

Solnik and McLeavey say the original concept of a hedge fund was to offer plays against markets, using short selling, futures and other derivative products.

Today the common denominator of hedge funds is not their investment strategy but the search for absolute returns.

Professional money management has progressively moved toward relative performance, performance relative to a bench mark. A fund manager's performance is evaluated relative to some market index which is assigned as a benchmark in his mandate or investment policy document.

The development of hedge funds can be seen as a reaction against this trend and hedge funds try to achieve absolute returns. This means that hedge funds may be termed more appropriately as isolation funds, funds isolated from market trends..

Legal structure: In USA, there are typically set up as a limited partnership, or as limited liability company or as an offshore corporation. These legal structures provide the flexibility to the fund managers to take short positions in any asset, use all kinds of derivatives, and to leverage without restrictions of regulators. In contrast mutual funds are allowed only long positions.

Hedge funds based in United States most often take the form of a limited partnership organized under section 3(c)(1) of the Investment Company Act, thereby gaining exemption from most U.S. Securites and Exchange Commission (SEC) regulations. The fund is limited to no more than 1,009 partners, who must be accredited investors

-----------------
Section 3(c)(1) of the Investment Company Act

c. Further exemptions. Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title:

1. Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:

A. Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstanding voting securities of the issuer, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company's outstanding securities (other than short-term paper).

B. Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.

------------
Some hedge funds in US are organized under section 3(C)(7) of the Investment Company Act. This form also provide exemption from most SEC regulations. In this case, the fund is limited to no more than 500 investors, who have to be qualified purchasers. The fund is prohibited from advertising.

-------------
Section 3(C)(7) of the Investment Company Act.

7.
A. Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

B. Notwithstanding subparagraph (A), an issuer is within the exception provided by this paragraph if--

i. in addition to qualified purchasers, outstanding securities of that issuer are beneficially owned by not more than 100 persons who are not qualified purchasers, if--

I. such persons acquired any portion of the securities of such issuer on or before September 1, 1996; and

II. at the time at which such persons initially acquired the securities of such issuer, the issuer was excepted by paragraph (1); and

ii. prior to availing itself of the exception provided by this paragraph--

I. such issuer has disclosed to each beneficial owner, as determined under paragraph (1), that future investors will be limited to qualified purchasers, and that ownership in such issuer is no longer limited to not more than 100 persons; and

II. concurrently with or after such disclosure, such issuer has provided each beneficial owner, as determined under paragraph (1), with a reasonable opportunity to redeem any part or all of their interests in the issuer, notwithstanding any agreement to the contrary between the issuer and such persons, for that person's proportionate share of the issuer's net assets.

C. Each person that elects to redeem under subparagraph (B)(ii)(II) shall receive an amount in cash equal to that person's proportionate share of the issuer's net assets, unless the issuer elects to provide such person with the option of receiving, and such person agrees to receive, all or a portion of such person's share in assets of the issuer. If the issuer elects to provide such persons with such an opportunity, disclosure concerning such opportunity shall be made in the disclosure required by subparagraph (B)(ii)(I).

D. An issuer that is excepted under this paragraph shall nonetheless be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] relating to the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer.

E. For purposes of determining compliance with this paragraph and paragraph (1), an issuer that is otherwise excepted under this paragraph and an issuer that is otherwise excepted under paragraph (1) shall not be treated by the Commission as being a single issuer for purposes of determining whether the outstanding securities of the issuer excepted under paragraph (1) are beneficially owned by not more than 100 persons or whether the outstanding securities of the issuer excepted under this paragraph are owned by persons that are not qualified purchasers. Nothing in this subparagraph shall be construed to establish that a person is a bona fide qualified purchaser for purposes of this paragraph or a bona fide beneficial owner for purposes of paragraph (1).

----------------

As the number of partners is limited, the minimum investment is typically more than $200,000.

Institutional investors can also become partners.

For U.S. hedgefund, Delaware is a fund-friendly state and funds prefer fund friendly states for registration.

Offshore funds also have attractive legal structures and U.S. investors are investing in such funds. Offshore funds are incorporated in British Virgin Islands, Cayman Islands, Bermuda, or such locations that offer fiscal and legal benefits.

Fee Structure

The manager is compensated through a base management fee based on the assets under management (AUM) now typically about 1 percent fo the asset base plus an incentive fee - a percentage of the realized profits (ranging from 15% to 30%, the typical value being 20%). In some agreement, the incentive fee is applied to profits in excess of a specified risk-free-rate. In some agreement, a condition is there that if in some years, the fund declines in value, the fund would first have to recover the decline before realized profit is recognized and incentive fee is paid.

Classification:

Solnik and Mcleavey provide the following classificastion

Long/short funds

Market-neutral funds

Global macro funds

Futures funds

Emerging-market funds

Even driven funds

Distressed securities funds

Risk arbitrage in mergers and acquisitions

Hedge funds - 2

2008-01-31T00:31:00.000-08:00

Fund of funds investing;

----------------------
LOS
j. explain the benefits and drawbacks to fund of funds investing;
-----------------------

Fund of funds have been created in hedge funds.

A fund of funds collects money from small investors and in turn invests in various hedge funds.

It provides investors with the following benefits.

Retailing
As noted earlier, hedge funds requier minimum $200,000 per investor. In the case of fund of funds for the same amount, the investor can get exposure to a large number of hedge funds.

Access

FOF managers can invest in highly successful hedge fund which are closed for subscription as old (existing) investors. Because of their relationships, they can buy partnership or shares of investors leaving the hedgefunds.

Diversification
This benefit is similar to the retailing benefit. In the case of retailing even person with minimum amount gets the benefit of diversification. But in this case benefits of diversification are emphasized for even big investors.

Expertise
The fund managers of FOFs have and develop expertise in finding good quality hedgefunds. Information about hedge funds is limited as they do not advertise. FOF managers buy databases and develop more intimate knowledge of strategies, and their advantages and potential pit falls.

Due Diligence process
There is a due diligence process which needs to be done. Individual investors will find it difficult to do. Even institutional investors may find it cumbersome. An FOF can have better staff resources, procedures and systems to perform the due diligenc process compared to typical institutional investors.

Drawbacks

Fee: Additional fee to FOF managers.
While each hedge fund in which FOF invests charges its fee, FOF charges an additional fee on the AUM. So investors in FOF have to pay an additional fee.

Performance: Past performance based selection is generally done by FOFs. There is little scientific evidence of persistence of performance delivered by FOFs.

Diversification - a two edged sword: Due to diversification FOFs may invest in some high performing funds and some not so high performance funds. So the realized return can be lower than the return of high performance funds.

CFA Level 1 Alternative Investments - Hedge Funds - 3

2008-01-31T00:29:00.000-08:00

Leverage and unique risks of hedge funds
------------------
LOS
k. discuss the leverage and unique risks of hedge funds;
------------------

Leverage in hedge funds often runs fron 2:1 to 10:1 and can run higher than 100:1.

It is interesting to note that at one point in time, a well known hedge fund that got into problems LTCM, had leverage over 500:1 (Lhabitant, Hedge Funds: Myths and Limits, Jon Wiley, 2002).

Unique risks:

Liquidity risk
The liquidity risk is common to all investors who trade in securities. The risk is much more in the case of trading in illiquid or thin markets. Many hedgefund strategies rely on the presence of liquidity in markets. Because of this, lack of liquidity in extreme market conditions can cause irreversible damage to hedge funds. The failure of the hedge fund Longterm Capital Management (LTCM) was attributed to the unexpected disappearnce of liquidity in the market.

Pricing risk
Hedge funds invest in over the counter traded products. Pricing of those securities or products is a difficult task. In periods of high volatility, broker dealers adopt an extremely conservative policy of pricing them and demand margin based on those prices. This can create severe cash needs for hedge funds to maintain their positions. Pricing risk is more when liquidity is a problem and so they appear together.

Counterparty credit risk
As hedge funds deal in over the counter products, counterparty credit risk arises.

Settlement risk
This is the risk that the counterparty fails to deliver the securities or money involved in a transaction on the settlement day. If the hedge fund planned to utilise the securities or money in turn to settle its other trades, there will be a problem because of settlement failures.

Short squeeze risk
This risk comes into appearance when short sold stock has to be bought at rising prices. This could come about because the lenders of the stock want their stock back. Because some hedge funds use short positions, this can be a risk.

Financing squeeze
If the hedge fund has reached its borrowing limits, and still needs cash to maintain positions by paying margin calls, there is a problem. To tide over the problem, the fund has to square up some its positions under adverse circumstances. This risk is termed financing squeeze risk.

CFA Level 1 Alternative Investments - Hedge Funds - 4

2008-01-31T00:25:00.000-08:00

------------------------
LOS

l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;
------------------------

Performance of hedge funds

Various indexes of hedge funds are available from consultants and fund managers.

Some of them are:

CISDM
Zurich Capital Management and MAR
CSFB/Tremont
VAN
Henesse
EACM 100
HFR
Carr/Barclays for CTAs

Based on the indices Solnik and Mcleavey conclude that there is a strong case for investing in hedge funds.

Hedge funds tend to have a net return (after fees) higher than equity markets and bond markets.

Hedge funds tend to have lower risk(measured by standard deviation of past returns) than traditional equity investments.

Higher Sharpe ratio indicates higher return for a unit of risk. For hedgefunds, data providers do calculate Sharpe ratio and was found to be higher than that for equity investments for the period 1996-2002. But Solnik and Mcleavey raise the caution that Sharpe ration may not be an appropriate measure for hedge funds as they have option like characteristics.

The correlation of hedge fund returns with conventional bonds and equities is positive but low.

Attraction for talent: The fee structure and flexibility of investment options is attracting talented fund managers. When both and long positions and short positions can be taken research insights can be used either way. Also leverage can be employed to magnify the benefit from an insight.

Caveats or cuations:

Investors need to exercise caution in using the available historical performance data on hedgefunds. The hedge fund industry does not adhere to rigorous performance presentation standards as it is not a regulated activity with uniform reporting formats. While past winners may not repeat, certain known biases can make it difficult to interpret the hedgefund performance data. The biases identified are:

Self selection bias

Instant history bias

Survivorship bias

Smoothed pricing - Infrequently traded assets

Option like investment strategies

Fee structure and gaming

There is a very large pool of capital chasing after what is likely to be a limited supply of pricing inefficiencies. Any successful trading strategy will quickly be imitated by many other fund managers, thereby reducing the profitability of the strategy. Investors need to exercise great caution in interpreting and extrapolating the reported performance of hedge funds; there is possibility of underestimating risk.

CFA Level 1 Alternative Investments - Closely Held Companies - 1

2008-01-31T00:24:00.001-08:00

CFA Level 1 Alternative Investments - Closely Held Companies

2008-01-30T19:51:00.000-08:00

Closely held companies

LOS

m. explain how the legal environment affects the valuation of closely held companies;

n. describe alternative valuation methods for closely held companies and distinguish among the bases for the discounts and premiums for these companies;

Reference/Reading" Solnik and McLeavey

Closely held companies are those that are not publicly traded. Inactive traded securities are securities that are infrequently traded; Normally, they are securities traded on minor stock exchanges.

Limited information availability is an issue for analysis of such companies. Illiquidity is an obvious issue. In the valuation of such securites minority ownership issue needs to be brought in.

So the analysis of these securities require evaluation of legal, financial, ownership and illiquidty issues.

Legal Issues:

Closely held companies may be organized in a variety of ways. The options include: special tax advantaged corporations (subchapter S corporations in US), regular coprorations, general partnerships, limited partnerships, and sole proprietorships.

Case law defines terms such as intrinsic value, fundamental value an fair value. Valuation of closely held and inactively traded securities requires extensive knowledge of concerned law and the purposes of valuation.

[Reference: Pratt, s.P., Reilly, R.F., and Schweihs, R.P. Valuing a Business, 3rd ed., Chicago; Irwin, 1996]

Alternative Valuation Methods Applicable

The cost approach: Determining what it would cost to replace the assets of the firm or company in their present form and state.

The comparables approach: This approach involves developing a bench mark value based on the market price of similar but actively traded company, or the average or median value of the market prices of similar companies, in transactions made in the period close to the time of appraisal.

To derive the value of the firm or security or company concerned, the benchmark price/value needs to be adjusted for market conditions (there is a possibility that tbere is mispricing either on the lower side or higher side) and the unique features of the firm that differ from benchmark.

The income approach: Methods that Estimate any anticipated future economic income stream and discount them to find the value fall under this approach.

CFA Alternative Investment - Distressed Securities

2008-01-30T16:25:00.001-08:00

Reference/Reading: Solnik and McLeavey

Distressed securities are the securities of companies that have filed or are close to filing for bankruptcy court protection, or that are seeking out-of-court debt restructuring to avoid bankruptcy.

Valuation of distressed securities requires legal, operational, and financial analysis.

Readings CFA Level I

2008-01-30T02:20:00.000-08:00

“Code of Ethics and Standards of Professional Conduct”
Standards of Practice Handbook, 9th edition (CFA Institute, 2005)

“Guidance” for Standards I – VII
Standards of Practice Handbook, 9th edition (CFA Institute, 2005)

Introduction to the Global Investment Performance Standards

Global Investment Performance Standards
(CFA Institute, 2005)

"The Time Value of Money"
Ch. 1, Quantitative Investment Analysis, 2nd edition, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, David E. Runkle, and Mark J.P. Anson (Wiley, 2007)

"Discounted Cash Flow Applications"
Ch. 2, Quantitative Investment Analysis, 2nd edition, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, David E. Runkle, and Mark J.P. Anson (Wiley, 2007)

"Statistical Concepts and Market Returns"
Ch. 3, Quantitative Investment Analysis, 2nd edition, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, David E. Runkle, and Mark J.P. Anson (Wiley, 2007)

"Probability Concepts"
Ch. 4, Quantitative Investment Analysis, 2nd edition, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, David E. Runkle, and Mark J.P. Anson (Wiley, 2007)

“Common Probability Distributions”
Ch. 5, Quantitative Investment Analysis, 2nd edition, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, David E. Runkle, and Mark J.P. Anson (Wiley, 2007)

“Sampling and Estimation”
Ch. 6, Quantitative Investment Analysis, 2nd edition, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, David E. Runkle, and Mark J.P. Anson (Wiley, 2007)

"Hypothesis Testing"
Ch. 7, Quantitative Investment Analysis, 2nd edition, Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto, David E. Runkle, and Mark J.P. Anson (Wiley, 2007)

“Technical Analysis”
Ch. 15, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“Elasticity”
Ch. 4, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Efficiency and Equity”
Ch. 5, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Markets in Action”
Ch. 6, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Organizing Production”
Ch. 9, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Output and Costs”
Ch. 10, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Perfect Competition”
Ch. 11, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Monopoly”
Ch. 12, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Monopolistic Competition and Oligopoly”
Ch. 13, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Demand and Supply in Factor Markets”
Ch. 17, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Monitoring Cycles, Jobs, and the Price Level”
Ch. 22, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Aggregate Supply and Aggregate Demand”
Ch. 23, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Money, Banks, and the Federal Reserve”
Ch. 26, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Money, Interest, Real GDP, and the Price Level”
Ch. 27, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Inflation”
Ch. 28, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Fiscal Policy”
Ch. 31, pp. 740 – 758, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

“Monetary Policy”
Ch. 32, Economics, 7th edition, Michael Parkin (Pearson Addison-Wesley, South-Western, 2005)

"Financial Statement Analysis: An Introduction"
Thomas R. Robinson, Hennie van Greuning, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

"Financial Reporting Mechanics"
Thomas R. Robinson, Hennie van Greuning, Karen O'Connor Rubsam, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

"Financial Reporting Standards"
Thomas R. Robinson, Hennie van Greuning, Karen O'Connor Rubsam, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

"Understanding the Income Statement"
Thomas R. Robinson, Hennie van Greuning, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

"Understanding the Balance Sheet"
Thomas R. Robinson, Hennie van Greuning, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

"Understanding the Cash Flow Statement"
Thomas R. Robinson, Hennie van Greuning, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

“Analysis of Inventories”
Ch. 6, pp. 192-215 and pp. 219-220, The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003)

“Analysis of Long-Lived Assets: Part I – The Capitalization Decision”
Ch. 7, pp. 227-240, including Box 7-1, and pp. 242-244, The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003)

“Analysis of Long-Lived Assets: Part II – Analysis of Depreciation and Impairment”
Ch. 8, pp. 257-278 and pp. 280-282, The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003)

“Analysis of Income Taxes”
Ch. 9, pp. 290-314, including Boxes 9-1 and 9-2, The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003)

“Analysis of Financing Liabilities”
Ch. 10, pp. 322-332 and pp. 337-352, The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003)

“Leases and Off-Balance-Sheet Debt”
Ch. 11, pp. 363-383, including Box 11-1, and pp. 386-393, The Analysis and Use of Financial Statements, 3rd edition, Gerald I. White, Ashwinpaul C. Sondhi, and Dov Fried (Wiley, 2003)

"Financial Analysis Techniques"
Thomas R. Robinson, Hennie van Greuning, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

"Financial Statement Analysis: Applications"
Thomas R. Robinson, Hennie van Greuning, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

"International Standards Convergence"
Thomas R. Robinson, Hennie van Greuning, Elaine Henry, and Michael A. Broihahn (CFA Institute, 2007)

“Capital Budgeting”
Ch. 2, pp. 1-22, John Stowe and Jacques R. Gagne, Corporate Finance for the CFA Program (CFA Institute, forthcoming)

“Cost of Capital"
Ch. 3, pp. 1-20, Yves Courtois, Gene C. Lai and Pamela P. Peterson, Corporate Finance for the CFA Program (CFA Institute, forthcoming)
Member download (PDF)

"Working Capital Management"
Edgar A. Norton, Jr., Kenneth L. Parkinson, and Pamela P. Peterson (CFA Institute, 2006)

"Financial Statement Analysis"
Pamela P. Peterson (CFA Institute, 2006)
“The Corporate Governance of Listed Companies: A Manual for Investors”
(CFA Institute, 2005)

“The Asset Allocation Decision”
Ch. 2, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“An Introduction to Portfolio Management”
Ch. 7, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“An Introduction to Asset Pricing Models”
Ch. 8, pp. 229-252, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“Organization and Functioning of Securities Markets”
Ch. 4, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“Security-Market Indexes”
Ch. 5, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“Efficient Capital Markets”
Ch. 6, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“Market Efficiency and Anomalies”
Ch. 1, Beyond The Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing, Vijay Singal (Oxford University Press, 2004)

“An Introduction to Security Valuation: Part I”
Ch. 11, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“Industry Analysis”
Ch. 13, pp. 466–468, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“Equity: Concepts and Techniques”
Ch. 6, pp. 256–273, International Investments, 5th edition, Bruno Solnik and Dennis McLeavey (Addison Wesley, 2003)

“Company Analysis and Stock Valuation”
Ch. 14, pp. 513–516 and 533–548, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“An Introduction to Security Valuation: Part II”
Ch. 11, Investment Analysis and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South-Western, 2006)

“Introduction to Price Multiples”
John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey (AIMR, 2003)

“Features of Debt Securities”
Ch. 1, Fixed Income Analysis, 2nd edition, Frank J. Fabozzi (Wiley, 2007)

“Risks Associated with Investing in Bonds”
Ch. 2, Fixed Income Analysis, 2nd edition, Frank J. Fabozzi (Wiley, 2007)

“Overview of Bond Sectors and Instruments”
Ch. 3, Fixed Income Analysis, 2nd edition, Frank J. Fabozzi (Wiley, 2007)

“Understanding Yield Spreads”
Ch. 4, Fixed Income Analysis, 2nd edition, Frank J. Fabozzi (Wiley, 2007)

“Monetary Policy in an Environment of Global Financial Markets”
European Central Bank, Press Division, Otmar Issing, Capital Markets and Financial Integration in Europe, 2002

“Introduction to the Valuation of Debt Securities”
Ch. 5, Fixed Income Analysis, 2nd edition, Frank J. Fabozzi (Wiley, 2007)

“Yield Measures, Spot Rates, and Forward Rates”
Ch. 6, Fixed Income Analysis, 2nd edition, Frank J. Fabozzi (Wiley, 2007)

“Introduction to the Measurement of Interest Rate Risk”
Ch. 7, Fixed Income Analysis, 2nd edition, Frank J. Fabozzi (Wiley, 2007)

"Derivative Markets and Instruments"
Ch. 1, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)

"Forward Markets and Contracts"
Ch. 2, pp. 25-37, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)

"Futures Markets and Contracts"
Ch. 3, pp. 81-103, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)

"Option Markets and Contracts"
Ch. 4, pp. 159-194, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)

"Swap Markets and Contracts"
Ch. 5, pp. 269-285, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)

"Risk Management Applications of Option Strategies"
Ch. 7, pp. 411-429, Analysis of Derivatives for the CFA® Program, Don Chance (AIMR, 2003)

"Alternative Investments"
Ch. 8, International Investments, 5th edition, Bruno Solnik and Dennis McLeavey (Addison Wesley, 2004)

CFA Level 1 Topic details

2008-01-30T01:58:00.000-08:00

Study Session 1

Ethical and Professional Standards

The readings in this study session present a framework for ethical conduct in the investment profession by focusing on the CFA Institute Code of Ethics and Standards of Professional Conduct as well as the Global Investment Performance Standards (GIPS).

The principles and guidance presented in the CFA Institute Standards of Practice Handbook (SOPH) form the basis for the CFA Institute self-regulatory program to maintain the highest professional standards among investment practitioners. “Guidance” in the SOPH addresses the practical application of the Code of Ethics and Standards of Professional Conduct. The guidance reviews the purpose and scope of each standard, presents recommended procedures for compliance, and provides examples of the standard in practice.

The Global Investment Performance Standards (GIPS) facilitate efficient comparison of investment performance across investment managers and country borders by prescribing methodology and standards that are consistent with a clear and honest presentation of returns. Having a global standard for reporting investment performance minimizes the potential for ambiguous or misleading presentations.

The readings in this study session present a framework for ethical conduct in the investment profession by focusing on the CFA Institute Code of Ethics and Standards of Professional Conduct as well as the Global Investment Performance Standards (GIPS).

The principles and guidance presented in the CFA Institute Standards of Practice Handbook (SOPH) form the basis for the CFA Institute self-regulatory program to maintain the highest professional standards among investment practitioners. “Guidance” in the SOPH addresses the practical application of the Code of Ethics and Standards of Professional Conduct. The guidance reviews the purpose and scope of each standard, presents recommended procedures for compliance, and provides examples of the standard in practice.

The Global Investment Performance Standards (GIPS) facilitate efficient comparison of investment performance across investment managers and country borders by prescribing methodology and standards that are consistent with a clear and honest presentation of returns. Having a global standard for reporting investment performance minimizes the potential for ambiguous or misleading presentations.

Study Session 2

Quantitative Methods: Basic Concepts

This introductory study session presents the fundamentals of those quantitative techniques that are essential in almost any type of financial analysis, and which will be used throughout the remainder of the CFA curriculum. This session introduces two main building blocks of the quantitative analytical tool kit: (1) the time value of money and (2) statistics and probability theory.

The time value of money concept is one of the main principles of financial valuation. The calculations based on this principle (e.g., present value, future value, and internal rate of return) are the basic tools used to support corporate finance decisions and estimate the fair value of fixed income, equity, or any other type of security or investment.

Similarly, the basic concepts of statistics and probability theory constitute the essential tools used in describing the main statistical properties of a population and understanding and applying various probability concepts in practice.

Study Session 3

Quantitative Methods: Application

This study session introduces the discrete and continuous probability distributions that are most commonly used to describe the behavior of random variables. Probability theory and calculations are widely applied in finance, for example, in the field of investment and project valuation and in financial risk management.

Furthermore, this session teaches how to estimate different parameters (e.g., mean and standard deviation) of a population if only a sample, rather than the whole population, can be observed. Hypothesis testing is a closely related topic. This session presents the techniques that can be applied to accept or reject the assumed hypothesis (null hypothesis) about various parameters of the population. Finally, you will also learn about the fundamentals of technical analysis. It is important that analysts properly understand the assumptions and limitations when applying these tools as mis-specified models or improperly used tools can result in misleading conclusions.

Study Session 4

Microeconomic Analysis

This study session focuses on microeconomic concepts and how firms are affected by these concepts. One of the main concepts related to the equilibrium between demand and supply is elasticity, which measures the dependency between demand and supply and the impact of changes in either on the equilibrium price level. A second key concept is efficiency, which is measure of the firm's "optimal" output given its cost and revenue functions. Understanding these concepts enables analysts to differentiate among various companies on an individual level, and to determine their attractiveness for an investor.

Study Session 5

Market Structure and Macroeconomic Analysis

This study session first compares and contrasts the different market structures in which firms operate. The market environment influences the price a firm can demand for its goods or services. Among the most important of these market forms are monopoly and perfect competition, although monopolistic competition and oligopoly are also covered.

The study session then introduces the macroeconomic concepts that have an impact on all firms in the same environment, be it a country, a group of related countries, or a particular industry. The readings explain the business cycle, and how to forecast changes in the business cycle and the impact on, among other things, price levels and profitability. The study session concludes by describing how an economy’s aggregate supply and aggregate demand are determined.

Study Session 6

Monetary and Fiscal Economics

This study session focuses on the monetary sector of an economy. It examines the functions of money and how it is created, highlighting the special role of the central bank within an economy. Supply and demand for resources, such as labor and capital, and goods are strongly interrelated, and this study session describes circumstances when this may lead to inflation and the transmission mechanisms between the monetary sector and the real part of the economy. Finally, the goals and implications of fiscal and monetary policy are explored by examining some of the main models of macroeconomic theory (Keynesian, classical, and monetarist).

Study Session 7

Financial Statement Analysis: An Introduction

The readings in this study session discuss the general principles of the financial reporting system, underscoring the critical role of the analysis of financial reports in investment decision making.

The first reading introduces the range of information that an analyst may use in analyzing the financial performance of a company, including the principal financial statements (the income statement, balance sheet, cash flow statement, and statement of changes in owners’ equity), notes to those statements, and management discussion and analysis of results. A general framework for addressing most financial statement analysis tasks is also presented.

A company’s financial statements are the end-products of a process for recording the business transactions of the company. The second reading illustrates this process, introducing such basic concepts as the accounting equation and accounting accruals.

The presentation of financial information to the public by a company must conform to the governing set of financial reporting standards applying in the jurisdiction in which the information is released. The final reading in this study explores the role of financial reporting standard-setting bodies worldwide and the International Financial Reporting Standards framework promulgated by one key body, the International Accounting Standards Board. The movement towards worldwide convergence of financial reporting standards is also introduced.

Study Session 8

Financial Statement Analysis: The Income Statement, Balance Sheet, and Cash Flow Statement

Each reading in this study session focuses on one of the three major financial statements: the balance sheet, the income statement, and the statement of cash flows. For each financial statement, the chapter details its purpose, construction, pertinent ratios, and common-size analysis. Understanding these concepts allows a financial analyst to evaluate trends in performance over several measurement periods and to compare the performance of different companies over the same period(s). Additional analyst tools such as the earnings per share calculation are also described.

The readings in this study session discuss and illustrate the earnings analysis of financial statements and the critical role that financial ratio analysis plays in making investment or credit decisions through the measurement of financial performance and risk.

Financial ratios may be used to compare the risk and return of a company with that of other companies of different sizes. A significant hurdle in applying ratio analysis is the difficulty of comparing companies that use alternative accounting policies and estimates. To achieve appropriate comparability, the accounting differences must be identified and then the financial statement balances adjusted for those differences.

Basic and diluted earnings per share are important and widely used performance statistics for publicly traded companies. Unlike other ratios presented in this study session, the measurement and calculation of the earnings per share ratio is strictly determined by the regulatory requirements of U.S. GAAP.

Study Session 9

Financial Statement Analysis: Inventories, Long-Term Assets, Deferred Taxes, and On- and Off-Balance-Sheet Debt
The readings in this study session examine specific categories of assets and liabilities that are particularly susceptible to the impact of alternative accounting policies and estimates. Analysts must understand the effects of alternative policies on financial statements and ratios, and be able to execute appropriate adjustments to enhance comparability between companies. In addition, analysts must be alert to differences between a company's reported financial statements and economic reality.

The description and measurement of inventories require careful attention because the investment in inventories is frequently the largest current asset for merchandizing and manufacturing companies. For these companies, the measurement of inventory cost (i.e., cost of goods sold) is a critical factor in determining gross profit and other measures of company profitability. Long-term operating assets are often the largest category of assets on a company's balance sheet. The analyst needs to scrutinize management's choices with respect to recognizing expenses associated with the operating assets because of the potentially large impact such choices can have on reported earnings.

A company's accounting policies (such as depreciation choices) can cause differences in taxes reported in financial statements and taxes reported on tax returns. The reading “Analysis of Income Taxes” discusses several issues that arise relating to deferred taxes.

Both on- and off-balance-sheet debt affect a company's liquidity and solvency, and have consequences for its long-term growth and viability. The notes of the financial statements must be carefully reviewed to ensure that all potential liabilities (e.g., leasing arrangements and other contractual commitments) are appropriately evaluated for their conformity to economic reality. Adjustments to the financial statements may be required to achieve comparability when evaluating several companies, and may also be required to improve credit and investment decision-making.

Study Session 10

Financial Statement Analysis: Techniques, Applications, and International Standards Convergence

The readings in this study session discuss financial analysis techniques, financial statement analysis applications, and the international convergence of accounting standards.

The first reading presents the most frequently used tools and techniques used to evaluate companies, including common size analysis, cross-sectional analysis, trend analysis, and ratio analysis. The second reading then shows the application of financial analysis techniques to major analyst tasks including the evaluation of past and future financial performance, credit risk, and the screening of potential equity investments. The reading also discusses analyst adjustments to reported financials. Such adjustments are often needed to put companies’ reported results on a comparable basis.

This study session concludes with a reading on convergence of international and U.S. accounting standards. Although there has been much progress in harmonizing accounting standards globally, as this reading discusses, there are still significant variations between generally accepted accounting principles from one country to another.

Study Session 11

Corporate Finance

This study session covers the principles that corporations use to make their investing and financing decisions. Capital budgeting is the process of making decisions about which long-term projects the corporation should accept for investment, and which it should reject. Both the expected return of a project and the financing cost should be taken into account. The cost of capital, or the rate of return required for a project, must be developed using economically sound methods.

Corporate managers are concerned with liquidity and solvency, and use financial statements to evaluate performance as well as to develop and communicate future plans. The final reading in this study session is on corporate governance practices, which can expose the firm to a heightened risk of ethical lapses.

Although these practices may not be inherently unethical, they create the potential for conflicts of interest to develop between shareholders and managers, and the extent of that conflict affects the firm’s valuation.

Study Session 12

Portfolio Management

As the first discussion within the CFA curriculum on portfolio management, this study session provides the critical framework and context for subsequent Level I study sessions covering equities, fixed income, derivatives, and alternative investments. Furthermore, this study session provides the underlying theories and tools for portfolio management at Levels II and III.

The first reading discusses the asset allocation decision and the portfolio management process—they are an integrated set of steps undertaken in a consistent manner to create and maintain an appropriate portfolio (combination of assets) to meet clients’ stated goals. The last two readings focus on the design of a portfolio and introduces the capital asset pricing model (CAPM), a centerpiece of modern financial economics that relates the risk of an asset to its expected return.

Study Session 13

Securities Markets

This study session addresses how securities are bought and sold and what constitutes a well-functioning securities market. The reading on market indexes gives an understanding of how indexes are constructed and calculated and the biases inherent in each of the weighting schemes used.

Some of the most interesting and important work in the investment field during the past several decades revolves around the efficient market hypothesis(EMH) and its implications for active versus passive equity portfolio management. The readings on this subject provide an understanding of the EMH and the seemingly persistent anomalies to the theory, an understanding that is necessary to judge the value of fundamental or technical security analysis.

Study Session 14

Industry and Company Analysis

This study session focuses on industry and company analysis and describes the tools used in forming an opinion about investing in a particular stock or group of stocks.

This study session begins with the essential tools of equity valuation: the discounted cash flow technique and the relative valuation approach. These techniques provide the means to estimate reasonable price for a stock. The readings on industry analysis are an important element in the valuation process,providing the top–down context crucial to estimating a company’s potential. Also addressed is estimating a company’s earnings per share by forecasting sales and profit margins.

The last reading in this study session focuses on price multiples, one of the most familiar and widely used tools in estimating the value of a company, and introduces the application of four commonly used price multiples to valuation.

Study Session 15

Fixed Income Investments: Basic Concepts

This study session presents the foundation for fixed income investments, one of the largest and fastest growing segments of global financial markets. It begins with an introduction to the basic features and characteristics of fixed income securities and the associated risks. The session then builds by describing the primary issuers, sectors, and types of bonds. Finally, the study session concludes with an introduction to yields and spreads and the effect of monetary policy on financial markets. These readings combined are the primary building blocks for mastering the analysis, valuation, and management of fixed income securities.

Study Session 16

Fixed Income Investments: Analysis and Evaluation

This study session illustrates the primary tools for valuation and analysis of fixed income securities and markets. It begins with a study of basic valuation theory and techniques for bonds and concludes with a more in-depth explanation of the primary tools for fixed income investment valuation, specifically, interest rate and yield valuation and interest rate risk measurement and analysis.

Study Session 17

Derivative Investments

Derivatives − financial instruments that offer a return based on the return of some underlying asset − have become increasingly important and fundamental in effectively managing financial risk and creating synthetic exposures to asset classes. As in other security markets, arbitrage and market efficiency play a critical role in establishing prices and maintaining parity.

This study session builds the conceptual framework for understanding derivative investments (forwards, futures, options, and swaps), derivative markets, and the use of options in risk management.

Study Session 18

Alternative Investments

Due to diversification benefits and higher expectations of investment returns, investors are increasingly turning to alternative investments. This study session describes the common types of alternative investments, methods for their valuation, unique risks and opportunities associated with them, and the relation between alternative investments and traditional investments.

Although finding a single definition of an “alternative” investment is difficult, certain features (e.g., limited liquidity, infrequent valuations, and unique legal structures) are typically associated with alternative investments. This study session discusses these features and how to evaluate their impact on expected returns and investment decisions in more detail. The reading provides an overview of the major categories of alternative investments, including real estate, private equity, venture capital, hedge funds, closely held companies, distressed securities, and commodities.

Each one of these categories has several unique characteristics, and the readings discuss valuation methods for illiquid assets (such as direct real estate or closely held companies), performance measures for private equity and venture capital investments, differences between various hedge fund strategies, and implementation vehicles for investments in alternative assets.

CAF level 1 Alternative Investments - Commodities - 1

2008-01-30T01:51:00.000-08:00

CFA Learning outcome statements

Commodities

p. discuss the role of commodities as a vehicle for investing in production and
consumption;

q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;

r. discuss the sources of return on a collateralized commodity futures position.

Commodities are raw materials that are sold in bulk, such as oil, wheat, silver, gold, oranges and cocoa. They are generally raw materials that are eventually used to produce other goods such as oil for gasoline, cocoa for chocolate, wheat for bread, etc. There is trade in commodities within a country as well as across countries. Most large manufacturers buy the commodities they need on the "spot market," where the full cash price is usually paid on the spot. Speculators typically buy and sell commodities with options and futures contracts.As such, they give an investor/speculator the opportunity to invest in the materials that a country produces and in the materials it consumes.

CFA Level 1 Alternative Investments - Commodities - 2

2008-01-30T01:49:00.000-08:00

Commodities are raw materials that are sold in bulk, such as oil, wheat, silver, gold, pork bellies, oranges and cocoa. They are generally raw materials that are eventually used to produce other goods such as oil for gasoline, cocoa for chocolate, wheat for bread, etc. As such, they give an investor the opportunity to invest in the materials that a country (or corporation) produces as well as those that it consumes. Most larger manufacturers buy the commodities they need on the "spot market," where the full cash price is usually paid on the spot. Speculators typically buy and sell commodities with options and futures contracts.

Types of Commodity Investments
A commodity-linked security refers to a security whose return is dependent to a certain extent on the price level of a commodity, such as crude oil, gold, or silver, at maturity. For example, the principal of a commodity-linked bond is indexed to movements of a commodity index such as precious metal or oil.

Commodity derivatives include both exchange-traded and over-the-counter commodity derivatives such as swaps, futures and forwards. They are used to hedge risk and to take advantage of arbitrage opportunities.

Collateralized Commodity Futurespositions involve taking a long position in the futures contract of your choice and then purchasing the amount equal to your futures position in T-bills. The source of return comes from the interest you earn on your T-bill position and the movement of the futures price.

Motivations for Investing in Commodities, Commodity Derivatives, and Commodity-linked Securities
Commodities offer investors a number of benefits:

Hedge Against Inflation: Commodity cash prices may benefit from periods of unexpected inflation, whereas stocks and bonds may suffer. Commodities are "real assets", unlike stocks and bonds, which are "financial assets". Commodities, therefore, tend to react to changing economic fundamentals in ways that are different from traditional financial assets, particularly with respect to inflation. Commodity prices usually rise when inflation is accelerating, so investing in commodities can give portfolios a hedge against inflation. Conversely, stocks and bonds tend to perform better when the rate of inflation is stable or slowing. Faster inflation lowers the value of future cash flows paid by stocks and bonds because those future dollars will be able to buy fewer goods and services than they would today.

However, this inflation advantage is captured more efficiently by direct investment in commodities than, for example, investment in commodity-related equities whose prices also reflect the financial prospects of the issuer or actively managed commodity futures accounts, which tend to reflect the manager's skills at selecting the right commodities.

Performance/Return: Investor interest in commodities has soared in recent years as the asset class has outperformed traditional assets such as stocks and bonds. Over the five-year period ended March 31, 2006, the Dow Jones AIG Commodity Index has returned 10.6%, versus 2.6% for the S&P 500. Part of this superior performance is attributable to a rise in commodity prices driven by increased demand from China and other emerging countries.

Enhanced Diversification: Portfolio diversification is the primary benefit of holding commodities. The reason for that is the commodity investor is exposed to commodity futures prices. Changes in those prices reflect changing expectations about future supply and demand for commodities. Factors that change expectations - such as a weather event in the Midwest or a strike in a copper mine in Chile - typically don't have anything to do with stock and bond markets.

Forms of Commodity Investing
Investing in commodities comes in two forms: passive and active:

Passive investing is a strategy used by investors who are using commodities as a risk diversification tool. For example, when inflation picks up, it tends to hurt fixed income securities and equities to some extent. However, prices of commodities tend to rise during these periods. This helps diversify your portfolio. Commodity investing has long had a reputation for exceptional volatility and risk but there is now a small but growing number of excellent, high-quality index-based commodity funds available that provide a relatively conservative way to invest in commodities. The management attempts to minimize price fluctuations and provide overall risk management in several ways. The selection and weighting of assets in a portfolio are typically reviewed annually or when there is a major change in an industry or even a drastic change in usage of any given commodity. This provides some overall risk reduction in commodity index funds and makes them suitable for investment by investors with limited commodity backgrounds.

Index funds usually consist of long positions on the contracts. Short positions are usually not taken.

Active investing or actively managing a position in the commodities market can provide good performance results. In periods of economic growth, commodities are in strong demand to satisfy production needs. Because commodity or raw material prices tend to move more quickly in reaction to economic fluctuations than do the prices of the related finished goods, an active approach could lead to economic gains if trading activities are closely monitored and managed by the investor.

CFA LEVEL 1 STUDY SESSION 18 ALTERNATIVE INVESTMENTS

2008-01-30T00:46:00.000-08:00

STUDY SESSION 18
ALTERNATIVE INVESTMENTS

Due to diversification benefits and higher expectations of investment returns,
investors are increasingly turning to alternative investments. This study
session describes the common types of alternative investments, methods for their
valuation, unique risks and opportunities associated with them, and the relation
between alternative investments and traditional investments.
Although finding a single definition of an “alternative” investment is difficult,
certain features (e.g., limited liquidity, infrequent valuations, and unique
legal structures) are typically associated with alternative investments. This study
session discusses these features and how to evaluate their impact on expected
returns and investment decisions in more detail. The reading provides an
overview of the major categories of alternative investments, including real estate,
private equity, venture capital, hedge funds, closely held companies, distressed
securities, and commodities.
Each one of these categories has several unique characteristics, and the
readings discuss valuation methods for illiquid assets (such as direct real estate or
closely held companies), performance measures for private equity and venture
capital investments, differences between various hedge fund strategies, and
implementation vehicles for investments in alternative assets.

LEARNING OUTCOMES
Reading 76: Alternative Investments

The candidate should be able to:
a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;

b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;

c. explain the advantages and risks of ETFs;

d. describe the forms of real estate investment and explain their characteristics as
an investable asset class;

e. describe the various approaches to the valuation of real estate;

f. calculate the net operating income (NOI) from a real estate investment, the value
of a property using the sales comparison and income approaches, and the
after-tax cash flows, net present value, and yield of a real estate investment;

g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;

h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;

i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;

j. explain the benefits and drawbacks to fund of funds investing;

k. discuss the leverage and unique risks of hedge funds;

l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;

m. explain how the legal environment affects the valuation of closely held
companies;

n. describe alternative valuation methods for closely held companies and distinguish
among the bases for the discounts and premiums for these companies;

o. discuss distressed securities investing and compare venture capital investing with
distressed securities investing;

p. discuss the role of commodities as a vehicle for investing in production and
consumption;

q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;

r. discuss the sources of return on a collateralized commodity futures position.

Grouped contents

Mutual fund

a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;

b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;

ETFs

c. explain the advantages and risks of ETFs;

Real estae

d. describe the forms of real estate investment and explain their characteristics as
an investable asset class;

e. describe the various approaches to the valuation of real estate;

f. calculate the net operating income (NOI) from a real estate investment, the value
of a property using the sales comparison and income approaches, and the
after-tax cash flows, net present value, and yield of a real estate investment;

venute capital

g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;

h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;

Hedge fund

i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;

j. explain the benefits and drawbacks to fund of funds investing;

k. discuss the leverage and unique risks of hedge funds;

l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;

closely held companies

m. explain how the legal environment affects the valuation of closely held
companies;

n. describe alternative valuation methods for closely held companies and distinguish
among the bases for the discounts and premiums for these companies;

distressed

o. discuss distressed securities investing and compare venture capital investing with
distressed securities investing;

Commodities

p. discuss the role of commodities as a vehicle for investing in production and
consumption;

q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;

r. discuss the sources of return on a collateralized commodity futures position.

Study Session 2 syllabus

2008-01-29T22:18:00.000-08:00

STUDY SESSION 2
QUANTITATIVE METHODS:
Basic Concepts

This introductory study session presents the fundamentals of those quantitative
techniques that are essential in almost any type of financial analysis, and which
will be used throughout the remainder of the CFA curriculum. This session introduces
two main building blocks of the quantitative analytical tool kit: (1) the time
value of money and (2) statistics and probability theory.
The time value of money concept is one of the main principles of financial valuation.
The calculations based on this principle (e.g., present value, future value,
and internal rate of return) are the basic tools used to support corporate finance
decisions and estimate the fair value of fixed income, equity, or any other type of
security or investment.
Similarly, the basic concepts of statistics and probability theory constitute the
essential tools used in describing the main statistical properties of a population
and understanding and applying various probability concepts in practice.

LEARNING OUTCOMES
Reading 5: The Time Value of Money
The candidate should be able to:
a. interpret interest rates as required rate of return, discount rate, or opportunity
cost;
b. explain an interest rate as the sum of a real risk-free rate, expected inflation, and
premiums that compensate investors for distinct types of risk;
c. calculate and interpret the effective annual rate, given the stated annual interest
rate and the frequency of compounding, and solve time value of money problems
when compounding periods are other than annual;
d. calculate and interpret the future value (FV) and present value (PV) of a single
sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a
series of unequal cash flows;
e. draw a time line, specify a time index, and solve time value of money applications

Reading 6: Discounted Cash Flow Applications
The candidate should be able to:
a. calculate and interpret the net present value (NPV) and the internal rate of return
(IRR) of an investment, contrast the NPV rule to the IRR rule, and identify problems
associated with the IRR rule;
b. define, calculate, and interpret a holding period return (total return);
c. calculate, interpret, and distinguish between the money-weighted and timeweighted
rates of return of a portfolio and appraise the performance of portfolios
based on these measures;
d. calculate and interpret the bank discount yield, holding period yield, effective
annual yield, and money market yield for a U.S. Treasury bill; and convert among
holding period yields, money market yields, effective annual yields, and bond
equivalent yields.
Reading 7: Statistical Concepts and Market Returns
The candidate should be able to:
a. differentiate between descriptive statistics and inferential statistics, between a
population and a sample, and among the types of measurement scales;
b. explain a parameter, a sample statistic, and a frequency distribution;
c. calculate and interpret relative frequencies and cumulative relative frequencies,
given a frequency distribution, and describe the properties of a dataset presented
as a histogram or a frequency polygon;
d. define, calculate, and interpret measures of central tendency, including the population
mean, sample mean, arithmetic mean, weighted average or mean (including
a portfolio return viewed as a weighted mean), geometric mean, harmonic
mean, median, and mode;
e. describe, calculate, and interpret quartiles, quintiles, deciles, and percentiles;
f. define, calculate, and interpret 1) a range and a mean absolute deviation, and 2 )
the variance and standard deviation of a population and of a sample;
g. calculate and interpret the proportion of observations falling within a specified
number of standard deviations of the mean, using Chebyshev’s inequality;
h. define, calculate, and interpret the coefficient of variation and the Sharpe ratio;
i. define and interpret skewness, explain the meaning of a positively or negatively
skewed return distribution, and describe the relative locations of the mean,
median, and mode for a nonsymmetrical distribution;
j. define and interpret measures of sample skewness and kurtosis.
Reading 8: Probability Concepts
The candidate should be able to:
a. define a random variable, an outcome, an event, mutually exclusive events, and
exhaustive events;
b. explain the two defining properties of probability, and distinguish among
empirical, subjective, and a priori probabilities;
c. state the probability of an event in terms of odds for or against the event;
Study Session 2 169
www.cfainstitute.org/toolkit—Your online preparation resource
d. distinguish between unconditional and conditional probabilities;
e. calculate and interpret 1) the joint probability of two events, 2) the probability
that at least one of two events will occur, given the probability of each and the
joint probability of the two events, and 3) a joint probability of any number of
independent events;
f. distinguish between dependent and independent events;
g. calculate and interpret, using the total probability rule, an unconditional probability;
h. explain the use of conditional expectation in investment applications;
i. diagram an investment problem, using a tree diagram;
j. calculate and interpret covariance and correlation;
k. calculate and interpret the expected value, variance, and standard deviation of a
random variable and of returns on a portfolio;
l. calculate and interpret covariance given a joint probability function;
m. calculate and interpret an updated probability, using Bayes’ formula;
n. identify the most appropriate method to solve a particular counting problem,
and solve counting problems using the factorial, combination, and permutation
notations.

STUDY SESSION 1

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ETHICAL AND PROFESSIONAL
STANDARDS

The readings in this study session present a framework for ethical conduct in
the investment profession by focusing on the CFA Institute Code of Ethics and
Standards of Professional Conduct as well as the Global Investment Performance
Standards (GIPS®).

The principles and guidance presented in the CFA Institute Standards of
Practice Handbook (SOPH) form the basis for the CFA Institute self-regulatory
program to maintain the highest professional standards among investment
practitioners. “Guidance” in the SOPH addresses the practical application of the
Code of Ethics and Standards of Professional Conduct. The guidance reviews
the purpose and scope of each standard, presents recommended procedures for
compliance, and provides examples of the standard in practice.

The Global Investment Performance Standards (GIPS) facilitate efficient comparison
of investment performance across investment managers and country borders
by prescribing methodology and standards that are consistent with a clear and
honest presentation of returns. Having a global standard for reporting investment
performance minimizes the potential for ambiguous or misleading presentations.

LEARNING OUTCOMES

Reading 1: Code of Ethics and Standards of Professional Conduct
The candidate should be able to:
a. describe the structure of the CFA Institute Professional Conduct Program and the
process for the enforcement of the Code and Standards;
b. state the six components of the Code of Ethics and the seven Standards of
Professional Conduct;
c. explain the ethical responsibilities required by the Code and Standards, including
the multiple subsections of each Standard.

Reading 2: “Guidance” for Standards I–VII
The candidate should be able to:
a. demonstrate a thorough knowledge of the Code of Ethics and Standards of
Professional Conduct by applying the Code and Standards to specific situations
presenting multiple issues of questionable professional conduct;
b. distinguish between conduct that conforms to the Code and Standards and conduct
that violates the Code and Standards;
c. recommend practices and procedures designed to prevent violations of the Code
of Ethics and Standards of Professional Conduct.

Reading 3: Introduction to the Global Investment Performance
Standards (GIPS)
The candidate should be able to:
a. explain why the GIPS standards were created, what parties the GIPS standards
apply to, and who is served by the standards;
b. explain the construction and purpose of composites in performance reporting;
c. explain the requirements for verification of compliance with GIPS standards.

Reading 4: Global Investment Performance Standards (GIPS)
The candidate should be able to:
a. describe the key characteristics of the GIPS standards and the fundamentals of
compliance;
b. describe the scope of the GIPS standards with respect to an investment firm’s
definition and historical performance record;
c. explain how the GIPS standards are implemented in countries with existing standards
for performance reporting and describe the appropriate response when the
GIPS standards and local regulations conflict;
d. characterize the eight major sections of the GIPS standards.

CFA Level 1 Study Sessions

2008-01-29T21:39:00.000-08:00

Ethical and Professional Standards Study Session 1, 2

Quantitative Analysis Study Session 3,4

Economics Study Session 5-8

Financial Statement Analysis Study Session 9,10

Corporate Finance Study Session 11
Portfolio Management Portfolio Management Study Session 12,13
Equity Study Session 14,15

Fixed Income Study Session 16

Derivatives Study Session 17
Alternative Investments Study Session 18

http://cfainstitute.org/cfaprog/resources/l1_outline.html

Beginning of the Blog

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I studied the full material of the CFA level 1, 2 and 3. I started the study in 2001-02. With some experience of writing blogs accumulated so far, I am initiating this blog. I shall slowly try to develop material that will be of use to CFA aspirants