cfa preparation

8/12/2019 CFA Preparation

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Economics

Elasticity

Price elasticity of demand. Refers to the change in the quantity demanded of a good in relation to the change in price.As the price of good increases, the quantity demanded decreases.

An inelastic demand: a large price increase cause a small decrease in quantity demanded

An elastic demand: a small price increase causes a large decrease in the quantity demanded

Demand is elastic when its elasticity is greater than 1.0. When the cross elasticity etween items is positi!e, the itemsre sustitutes.

"he presence of sustitutes will tend to increase demand elasticity. #oods that occupy a relati!ely small proportion of

your udget will tend to e price inelastic.

An inferior good has negati!e income elasticity li$e %argarine.

A normal good has positi!e income elasticity. A lu&ury good is a normal good with an income elasticity of demandgreater than one.

'lasticity of supply has two main determinants:

A!ailale sustitutes for resource inputs used to produce the good. 'lasticity of supply will e lower if the good canonly e produced with rare or unique inputs.

"ime that has elapsed since the price change. %omentary supply is highly inelastic if producers cannot change theoutput of the good quic$ly. (hort)term supply: the supply ecomes more elastic as producers ad*ust their production

processes, for e&ample y changing the amount of laor they hire. +ong)term supply. 'lasticity of supply is mostelastic in the long run, when producers ha!e made all possile ad*ustments, including pro*ects such as uildingfactories and distriution system.

Efficiency and Equity

%arginal enefit is the enefit an indi!idual gets from consuming one more unit of a good or ser!ice. %arginal enefitdecreases as the amount of the good consumed increases. A demand curve is a marginal cost curve. It slopesdownward because of the decreasing marginal benefit principle.

%arginal cost is the cost of producing one more unit of output. "his is also called the opportunity cost ecause itrepresents the !alue of resources in their ne&t)est use other than producing output. When marginal enefit is greater

icolas Pillon -A preparation

Considering a linear demand curve, the elasticity will be different at different points on the curve. At the

point where total revenue (P!" is at a ma#imum, either an increase or decrease in price will decrease

total revenue, demand elasticity is equal to $% and is said to be unitary elastic or to have unitary


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than marginal cost, consumers are willing to py more for the ne&t unit of output than it will cost to produce it. /n there!erse case, !alue is created y producing fewer units of the output and di!erting the resources to produce other,more highly)!alued goods. A supply cur!e is a marginal cost cur!e. /t slopes upward in the short run ecause of theincreasing marginal cost principle.

&otal value created is ma#imal when output level is set where marginal benefit equals marginal cost. &his isthe efficient quantity of output.

Consumer 'urplus and Producer 'urplus

-onsumer surplus is the difference etween what a consumer is willing to pay for a good or ser!ice and hat heactually pays for it. ecause marginal enefit decreases as the amount consumed increases, consumer surplusdecreases with each additional unit consumed. or the unit for which surplus is ero, marginal enefit equals priceand the consumer will not uy any more units if the good.

"he marginal cost, or opportunity cost, of producing an additional unit of a good is the minimum supply price at while aproducer is willing to supply another unit. "he marginal cost cur!e 2ao!e a!erage !ariale cost3 is a producer4ssupply cur!e for the good. Producer surplus is the difference etween the price a producer recei!es for a unit of outputand the minimum supply price for 2opportunity cost of3 that unit.

%arginal (ocial enefit and %arginal (ocial -ost: "he marginal social enefit cur!e is the mar$et demand cur!e for

the good or ser!ice.

%arginal social cost is the sum of all producers4 marginal costs to supply a good or ser!ice. "he marginal social costcur!e is the supply cur!e for the good or ser!ice.

"he equilirium price and quantity for the good or ser!ice occurs where the mar$et demand and mar$et supply cur!esinteract. At this price and quantity, the sum of consumer surplus and producer surplus is at its ma&imum. "hus, theeconomic gains to society are ma&imied when the equilirium quantity of each good or ser!ice is produced.

tilitarianism is the idea that the value of an economy is ma#imi)ed when each individual owns an equalamount of the resources. &his proved to be wrong because transferring wealth from the rich to the poorresults in less being produced overall.

&he symmetry principle implies that when an economy is based on private property and voluntary e#change,individuals get goods and services that are equal in value to their contributions to the economy. &hedistinction here is between a fair*equal economic outcome (utilitarianism" and fair*equal economicopportunity (symmetry".

A minimum Wage is an e&ample of a price floor. When the minimum wage is ao!e the equilirium mar$et wage forlow)s$illed laor.


+bstacles: price controls5 ta&es5 %onopoly5 e&ternal costs5 e&ternal enefits5 Pulic goods and common

resources

A price celling it is an upper limit on the price a seller can charge. /f the ceiling is

ao!e the equilirium price, it has no effect. ut if the ceiling is elow the equiliriumprice, it results in a shortage 6 a larger quantity of good is demanded at that price.

A price -loors is a lower limit on the price that a uyer can offer for a good or ser!ice. /f

the floor is elow the equilirium price, it has no effect. ut if the floor is ao!e the

equilirium price, the result is a surplus6 a larger quantity of the good is supplied than

demanded. Price floors cause inefficiencies as producers can sell enough and

consumers sustitute away from the good toward less e&pensi!e goods.


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E#plicit costs are the measurale costs of doing usiness that are reflected on a firm4s accounting statement.

Implicit costs include the opportunity costs.

Accounting profit only includes e&plicit cost ut 'conomics profits considers oth the e&plicit and implicit costs. Whenthe firm4s re!enues are *ust equal to its costs 2e&plicit and implicit, including the normal rate of return3, economicprofits are ero and equity capital earns a competiti!e rate of return.

Constraints on Profit a#imi)ation technology constraints: Additional profit from increasing output re!enue islimited y the cost of adopting new technology to do so. /nformation constraints: a firm will e&pend resources toacquire information for decision ma$ing only up to the point where the cost of acquiring is equals the additionalre!enue from using it.

A production is technologically efficient compared to other process if it uses the least amount of specific inputs toproduce a gi!en output. A process is economically efficient if it produces the output at the lowest possile cost. /f aprocess is not technologically efficient, it cannot e economically efficient.

A command system organies production y a managerial chain of command. An incenti!e system organiesproduction y creating a system of rewards to moti!ate wor$ers to perform in the way that ma&imies profits. oth areoften mi&ed in an organiation. /ncenti!e wor$ etter when it is difficult to monitor the employees4 acti!ities.

&he principal$agent problem occurs when the incenti!es of managers and wor$ers are not the same as theincenti!es of the firm4s owners.

&ype of business +rgani)ations

Proprietorship: (ingle owner5 unlimited liaility for firm4s oligations5 firm income is personal income to the owner. utdifficult and e&pensi!e to raise capital.

Partnership: two or more owner, e&posed o ris$

-orporation: owned y stoc$holders5 liaility limited to amount in!ested5 firm pays corporate ta& on its income.

&ypes of economic ar/ets

Perfect competition: all firms in the mar$et produce identical products5 large numer of independent firms, each smallrelati!e to sie of mar$et, no arriers to entry or e&it5 individual firms face perfectly elastic demand.

%onopolistic competition: large numer of competitors with slightly differentiated products5 downward sloping demandfor firms.

7ligopoly

%onopoly: (ingle seller of specific, well)defined product that has no goo sustitutes, high arriers to entry.


A "a& on a good or a ser!ice increases its equilirium price and decreases itsequilirium quantity. A deadweight loss results ecause less than the efficientquantity is produced and consumed. Actually we can see ta&es as a mean to ta$ein account e&ternalities: in a certain way the routes, the schools, and theuni!ersities enale firms to e&ist, e!en though firms don4t pay directly for them."a&es permit to pay for these facilities and to set the true price of the goods andser!ices.


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-oordinating 'conomic Acti!ity: %ar$et coordination means purchasing the !arious components of a final product orser!ice from firms that specialie in producing them, then assemling the final product. 7utsourcing for e&ample. irmcoordination occurs when firms can coordinate acti!ity more efficiently than mar$ets can. irms can often achie!elower transactions costs nd realie economies of scale, scope, and team production.

&ypes of Costs

i&ed cost or sun$ cost, remain unchanged in the short run and are therefore not considered when ma$ing short)runproduction decisions. "hey are related to the passage of time, not the le!el of production.

A!erage fi&ed costs are total fi&ed costs di!ided y output. A!erage fi&ed costs decline as output increases

8ariale costs are incurred when the firm produces output. "hey are related to the le!el of production, not the passageof time. A!erage !ariale cost equals the total !ariale cost di!ided y the numer of units produced.

A!erage total cost

%arginal cost is the additional cost of producing one more unit of output

&he law of diminishing returns states that as more of one input is devoted to a production process, holdingthe quantity of other inputs constant, output increases at a decreasing rate

&o ma#imi)e profits, produce at the quantity where marginal revenue equal marginal cost. "he marginalre!enue cur!e will e horiontal and equal to price for pure competition9 price ta$ers, and downward sloping andelow the demand cur!e for a price searcher.

If price discrimination is possible, where different groups of consumers pay different prices for the product,the firm can earn greater economic profits and will produce a greater quantity of output compared to a single$



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price monopolist. In order to ma/e it wor/, the firm must be able to prevent consumers from reselling theproduct across groups.

-irms under monopolistic competition pursue product innovation because they can earn economic profit inthe short run by being first to mar/et with new or improved product 01 Apple.

2arriers of entry economies of scale5 go!ernment licensing and legal arriers, Patents or e&clusi!e rights, control ofresources.

&raditional +ligopoly odels

3in/ed demand curve model one firm has a significant cost ad!antage and produces such large share of theindustry4s output that it can effecti!ely set the mar$et price, while the other firms in the industry are essentially price

ta$ers.

Prisioners4dilemmais a model used to analye oligopoly output restrictions. /t implies that the est course of actionfor each firm in a collusi!e agreement is to cheat, regardless of whether the other fir honors the agreement or not.

ar/et -actor of Production

A firm will hire additional units of laor until the marginal re!enue product of laor equals its price in order to ma&imie

profits. An increase in the price of the firm4s output will increase its demand for laor. An increase in the price of a

factor of production that is sustitute for laor will increase demand for laor. An increase in the price of a factor of

production that is a complement to laor will decrease demand for laor. Demand for +aor is more elastic in the long

run than in the short run.

"he wage can e seen as the opportunity cost of consuming more leisure. A wage increase, there is a substitution

effect to consume less leisure and an income effect because it causes wor/ers to consume more leisure. &he

effects are in opposite direction and either one can dominate the other.

A monopsony mar$et is one with a single uyer. /t occurs in the laor mar$et when there is only one ma*or employer /

a geographic area.

'conomic rent is the difference etween what a wor$er earns and his opportunity cost. 7pportunitycost of a wor$er is

what he could earn in his ne&t highest paying employment.

"here are three types of unemployment: frictional

unemployment results from constant

changes in the economy5 structural

unemployment is caused y structural

changes in the economy that eliminate some

*os while generating *o openings for which unemployed wor$ers are not qualified5 Cyclical unemployment is

caused by a change in the general level of economic activity. 5hen the economy is operating at less than full

capacity, positive levels of cyclical unemployment will be present.


/f oligopolies could collude perfectly ;, they could set the same price and output as a profit)ma&imisingmonopolist and earn the same profits.


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A factor of overall unemployment that relates to the cyclical trends in growth and production that occur within

the business cycle. 5hen business cycles are at their pea/, cyclical unemployment will be low because total

economic output is being ma#imi)ed. 5hen economic output falls, as measured by the gross domestic

product (67P", the business cycle is low and cyclical unemployment will rise.

Inflation

"he rate of inflation is the rate of change in a price inde& o!er a gi!en period of time:

"he -P/: consumer price inde& is elie!ed to o!erstate inflation y aout 1


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unctions of %oney :

%edium of '&change

@nit of account

(tore of !alue for the future

%1 refers to all currency held at an$s, tra!elers4chec$s and chec$ing account deposits of indi!iduals and firms. %

refers to %1 plus time deposits, sa!ing deposits.

unction of Depository /nstitutions:

-reate liquidity. @se (hort)term deposits to ma$e long)term loans

Act as financial intermediaries. +end at lower cost than orrowers could achie!e y see$ing out indi!idual

lenders.

Pool default ris$s. Bold a portfolio of loans and monitor their ris$s.

ractional Reser!e an$ing (ystem: the required reser!e ratio

7iscount rate the rate at which ban/s can borrow reserves from the -E7. 8ower discount rates tend to

increase the money supply and decrease interest rates9 higher rates tend to decrease the money supply and

increase interest rates.

+pen mar/et operation -E7 buying and selling of &reasury securities. -E7 purchases increase cashavailable, decreasing rates. -E7 sales remove cash, increasing interest rate.

5hat determines the demand for oney

/nterest rates. %ost critical

/nflation

Real #DP growth

8elocity is the a!erage numer of times per year each dollar is used to uy goods and ser!ices.

8elocity?#DP9money

%oney supply C !elocity? price le!el C real output

/mportance of "iming in iscal Policy:

1. Recognition delay: time it ta$es policyma$ers to recognie a policy change is necessary

. Administrati!e or law ma$ing delay. "ime lag etween policy recognition and final passage of law or policychange



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. /mpact delay. "ime lag etween passage of the law or policy and when its impact is felt in the economy



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Ricardo)arro effect:

anagement : Asset ;aluation

/n!estors $now that ris$ dri!es return. "herefore, the practice of in!esting funds and managing portfolios should focusprimarily on managing ris$ rather than on managing returns. Asset allocation is the process of deciding how todistriute an in!estor4s wealth among different countries and asset classes for in!estment purposes. An asset class is

comprised of securities that ha!e similar characteristic.

"he last decades the main impro!ement was the recognition that the creation of an optimum in!estment portfolio isnot simply a matter of comining numerous unique indi!idual securities that ha!e desirale ris$)return characteristics,ut the relationship among the in!estments to uild an optimum portfolio.

"he ris$ means the uncertainty of future outcomes. An alternati!e definition might e the proaility of an ad!erseoutcome.

%ar$owit showed that the !ariance of the rate of return was a meaningful measure of portfolio ris$under a reasonale set of assumptions.

nder these assumptions, a single asset or portfolio of assets is considered to be efficient if there is no other

asset or portfolio of assets offers higher e#pected return with the same ris/ or lower ris/ with the same

e#pected return.



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Covariance is a measure of the degree to which two variables move together relative to their individual mean

value over time. &he magnitude of the covariance depends on the variances of the individual return series, as

well as on the relationship between the series.

Covariance and Correlation. Covariance is affected by the variability of the two individual return inde#es.

&herefore, a number such as the


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In equilibrium all assets and all portfolios of affects should plot on the '8. Any security with an estimatedrate of return that plots above the '8 would be considered underpriced because it implies that you

estimated you would receive a rate of return on the security that is above its required rate based on its

systematic ris/.

Empirical tests of the CAP

A "heory should not e *udged on the asis of its assumptions, ut on how well it e&plains the relationships that e&ist

in the real world. umerous studies ha!e e&amined the staility of eta and generally concluded that the ris$ measure

was not stale for indi!idual stoc$s, ut the staility of the eta of portfolios of stoc$s increased dramatically.

urthermore the etas tended to regress toward the mean 213.

eyond the analysis of return and eta, se!eral authors also ha!e considered the impact of s$ewness on e&pected

returns.

Erauss and +itenerger tested a -AP% with a s$ewness term and confirmed that in!estors are willing to pay for

positi!e s$ewness.

&he ar/et Portfolio &heory versus Practice

&hroughout our presentation of the CAP, we noted that the mar/et portfolio included all the ris/y assets in

the economy. -urther, in equilibrium, the various assets would be included in the portfolio in proportion to

their mar/et value. &herefore, this mar/et portfolio should contain not only .'. stoc/s and bonds but alsoreal estate, options, art, stamps, coins, foreign stoc/s and bonds, and so on, with weights equal to their



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relative mar/et value. Impossible to implement in real life. In fact the vast ma?ority of studies have chosen the

'%P =


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A callable bond (also called redeemable bond" is a type of bond (debt security" that allows the issuer of the

bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity.

In other words, on the call date(s", the issuer has the right, but not the obligation, to buy bac/ the bonds from

the bond holders at a defined call price.

CAPPE7 -8+A&EB A floating$rate note which pays a coupon only up to a specified ma#imum level of the

reference rate. &his is done by embedding a cap in a vanilla note where the investor effectively sells the

issuer a cap. A capped floater protects the debt issuer from large increases in the interest rate environment.

A written agreement between the issuer of a bond and his*her bondholders, usually specifying interest rate,

maturity date, convertibility, and other terms. also called indenture.



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BEI& Beal Estate Investment &rust

Alternative Investment

A closed$end fundis also legally $nown as a Fclosed)end companyF.

/t is an in!estment company that sells a fi&ed numer of shares at a one)time initial pulic offering. (hares are notcontinuously offered for sale5 after the pulic offering, the shares typically can e ought and sold only on a formale&change such as the ew Gor$ (toc$ '&change or the asdaq.

7nce closed)end fund shares egin to trade, their prices are determined y supply and demand and not y net)asset

!alue 2A835 therefore, the mar$et price may e greater or less than the sharesH A8.

7ne of the significant differences etween closed)end funds and mutual funds is that closed)end funds are allowed toin!est in a greater amount of FilliquidF securities. -losed)end funds are regulated under the /n!estment -ompany Actof 1IJ0.

rom this act the (ecurities '&change -ommission 2('-3 was created. "he ('-Hs responsiility is to enforcesecurities laws.

+pen$End -und /n simple terms, an open)end mutual fund is when a company aggregates money from manyin!estors and in!ests the money in stoc$s, onds, short)term money)mar$et instruments or other securities. /n!estorspurchase mutual fund shares directly from the fund itself at a price that is determined y the fundHs per)share net asset!alue 2A83 plus any shareholder fees that the fund imposes at purchase 2such as sales loads3.

utual fund shares are redeemable. +pen$end fund shares cannot be bought or sold in secondary mar/ets,such as the >ew Dor/ 'toc/ E#change or the >asdaq.

owever, it is not useful for evaluating overall fund performance.

&his is because mutual funds are required by law to distribute at least F


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8alue stoc$s are typically found in slower)growing sectors of the economy li$e finance and asic industry ut there areargains to e found e!en in FgrowthF sectors such as technology.

6rowth style managerstypically focus on an issuerHs future earnings potential.

'ector 'trategy +oo$ at a particular industry such as transportation. ecause the holdings of this type of fund are inthe same industry, there is an inherent lac$ of di!ersification associated with these funds.

Inde# 'trategy: "ends to trac$ the inde& it follows y purchasing the same weights and types of securities in thatinde&, such as an (LP fund. /n!esting in an inde& fund is a form of passi!e in!esting.

6lobal 'trategy vs International 'trategy: A gloal strategist uilds a di!ersified portfolio of securities from anycountry throughout the gloe 2ot to e confused with an international strategy, which may include securities frome!ery other country e&cept the fundHs home country.3

'table ;alue 'trategy

K "he stale !alue in!estment style is a conser!ati!e fi&ed income in!estment strategy.

K A stale !alue in!estment manager see$s short)term fi&ed income securities and guaranteed in!estmentcontracts issued y insurance companies.

K "hese funds are attracti!e to in!estors who want high current income and protection from price !olatility

caused y mo!ements in interest rates.

E&-

'&change)traded funds 2'"s3 are in!estment companies that are technically classified as open)end companies2although they are not considered to e or allowed to call themsel!es mutual funds3.

"hey allow in!estors to uy or sell e&posure to an inde& through a single financial instrument.

E&-s can be sold short or margined in the investorGs account.

'"s also differ from traditional open)end companies ecause '" shares trade on a secondary mar$et 2as do

closed)end funds3 and are only redeemale in !ery large loc$s 2M0,000 shares for e&ample3.

"he fund manager ta$es a small portion of the fundHs annual assets as their fee. An authoried participant, alsoreferred to as a mar$et ma$er or specialist, assemles the appropriate as$et of stoc$s and sends them to a custodialan$. "he custodial an$ is responsile for ensuring that the as$et does, in fact, mirror the requested '". /tforwards the '" shares on to the authoried participant. "he custodial an$ holds the as$et of stoc$s in the fundHsaccount for the fund manager to monitor.

&rading: uy and sell orders for traditional mutual funds are ta$en throughout the trading day ut the transactionsactually occur at the close of the mar$et

7&CC "he Depository "rust -learing -orp.,2D"--, through its susidiaries, pro!ides clearing, settlement andinformation ser!ices for equities, corporate and municipal onds, go!ernment and mortgage)ac$ed securities, money

mar$et instruments and o!er)the)counter deri!ati!es. /n addition, D"-- is a leading processor of mutual funds andinsurance transactions, lin$ing funds and carriers with their distriution networ$s.

D"--Hs depository pro!ides custody and asset ser!icing for .N million securities issues from the @nited (tates and11 other countries and territories, !alued at almost OJ trillion. /n 00I, D"-- settled more than O1.J quadrillion insecurities transactions.3

Bedeeming E&-s"o effect a redemption, an authoried participant uys a large loc$ of '"s on the open mar$etand sends it to the custodial an$. /n return, the participant gets ac$ an equi!alent as$et of indi!idual stoc$s, whichare then sold on the open mar$et or returned to the pension funds that originally owned them

'"s are a fa!orite among ta&)aware in!estors ecause the portfolios that '"s represent are e!en more ta& efficientthan inde& funds. "his arrangement minimies ta& implications for the in!estor e&changing the '"s since the in!estorcan defer most ta&es until the in!estment is sold.

Conclusion &he associated costs are low, and the portfolios are fle#ible and ta# efficient



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Beal Estate Investments

A real estate is a tangile asset and an immo!ale asset. Real estate can e !ery illiquid if the land and uildings arepurchased outright. 7n the other hand, in!estors can en*oy higher liquidity if the same asset 2either land or uildings3is purchased through a fund or some other !ehicle.

1. -ree and Clear Equity) A free and clear equity in!estment confers full ownership for an indefinite period oftime. "he in!estor gets all ownership rights. /t is an outright purchase of the asset with no encumrances. oha!e free and clear equity in an in!estment means that the orrower owns the asset without any loans or liensattached to it. /n other words, if the property was sold free and clear, the owner would recei!e 100 percent ofthe proceeds from the sale and not ha!e to pay off any det at closing.

. 8everage Equity) +e!erage equity has same ownership rights as free and clear equity ut is su*ect to det2promissory note3 or a pledge 2mortgage3 to hand o!er those rights if payments and terms of the det are notmet.

. ortgages) %ortgages are det in!estments in which the mortgage holder recei!es a stream of payments li$ea ondholder 2principal and interest3. %ortgage holders are a type of real estate in!estor ecause they areentitled to ta$e possession of the real estate asset if the mortgagee defaults

J. Aggregation ;ehicles ) Aggregation !ehicles pool in!estorsH funds together, gi!ing them roader and deeper

access to the real estate mar$et.

"hese include:

Real estate limited partnerships allow groups of in!estors to participate in the real estate mar$et with liailitylimited to the amount of their original in!estment.

"he appeal to in!estors is the special ta& deductions they hold for de!elopers and that are passed through to thein!estors. ut it is not !ery liquid.

-ommingled funds are pools of money made up of contriutions from a numer of different pension plans or otherfunds.

A real estate limited partnership is owned y one or more general partners who handle the organiationHsoperations, and y one or more limited partners who participate financially ut ha!e no say in the management andoperation of the partnership.

BEI&s (Beal Estate Investment &rusts": are a well)$nown type of closed end fund that uys, de!elops, manages andsells real estate assets.

R'/"s allow participants to in!est in a professionally)managed portfolio of real estate properties.

K%ost R'/" re!enues come principally from the rental income their properties generate.

K(ince R'/"s are traded on the ma*or e&changes, they are more liquid than limited partnerships and evencompared to traditional private real estate ownership.

K 'quity R'/"( in!est in and own properties 2and are therefore responsile for the equity or !alue of their realestate assets3.

K %ortgage R'/"s deal in in!estment and ownership of property mortgages.



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K Byrid R'/"s comine the in!estment strategies of equity R'/"s and mortgage R'/"s y in!esting in othproperties and mortgages.

;alues real estate based on what would it cost to replace the building in its current form with the value of theland added to itH. 6etting an appraised value for the cost of the e#isting structure can be difficult in somemar/ets.

'ale Comparison Approach

&he Income Approach: "his approach uses a perpetuity discount type of model. "he net income deri!edfrom the property is discounted at a mar$et required rate of return. "he appraisal !alue ? net operating income27/39mar$et cap rate. "he %ar$et cap rate is found y enchmar$ 7/9enchmar$ transaction price.

7iscounted After$&a# Cash -low Approach -alculating the !alue of the discounted cash flows from a realestate in!estment can act as a !alidation or chec$ on other !aluation methods. "his approach ta$es intoaccount the in!estorHs indi!idual ta& rac$et, depreciation and any interest payments. (ee the e&ample elow

Comparable Property >+I %J=,


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ormati!e (tage ) inancing includes seed stage and early stage.

/lliquid ) o easy or short)term path to get out of the in!estment. An in!estor will most li$ely ha!e to wait until thecompany is ale to attract a uy)out or issue an /P7. A liquidity ris$ premium is a characteristic of the initialin!estment.

;intage cycles) "he !olume of usiness start)ups is dependent on the economic climate ) some years offer more

and etter opportunities than others. /t all depends on the mar$et and who and when firms are entering and e&iting the

mar$etplace.

edge -und 2asics

edge fund is a general, non$legal term that was originally used to describe a type of private andunregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in thecorporate equity mar/ets.

In earlier mar/ets, the term hedge fund referred to an asset class employing a strategy to offset its mar/etris/ e#posure by ta/ing an opposing position $ for e#ample, selling short or holding futures. In fact, a perfecthedge is one that totally offsets gains and losses, creating a position that is completely neutral. In todayGsmar/ets, a hedge fund can be ?ust about anything.

Bedge funds are similar to mutual funds in that they oth are pooled in!estment !ehicles that accept in!estorsH moneyand in!est it on a collecti!e asis. Bedge funds differ significantly from mutual funds, howe!er, ecause hedge fundsare not required to register under the federal securities laws.

K7irect edge: "his is accomplished y hedging one asset, such as common stoc$, with another asset that sharessimilar price mo!ements and trades in a similar fashion. An e&ample of this would e hedging a common stoc$position with call options.

KCross edge: "his in!ol!es hedging an instrument with an unli$e instrument. An e&ample of a strategy that failed inthe crash of 1IQ will e&emplify the concept.

"his in!ol!ed uying 2long3 preferred stoc$s and hedging the position with "reasury futures. /nterest rates dri!e"reasury futures, and there are times when these two instruments trac$ one another ) aout M< of the time. /n the

1IQ scenario, the !alue of the preferred stoc$ fell and the "reasury futures rose.

O'tatic edge "his also stri!es to eliminate ris$. #i!en some particular target option, a static hedge is constructed sothat it will not require any further ad*ustment and will e&actly replicate the !alue of the target option. "his is referred toas a static replicating portfolio. /tHs a fi&ed and unchanging hedge that is set until maturity.

K7ynamic edge: /n!ol!es changing the amount of puts in a position o!er time, according to the mar$et en!ironment.

+ne thing all hedge funds have in common is their search for addition alpha or absolute returns.

Bedge fund legal structure is typically in the form of a limited partnership, as a limited liaility corporation in the @.(.,or as an offshore corporation. "hese structures pro!ide the freedom that hedge fund managers need to operatewithout restrictions.

7ften B uy certain stoc$s long and sell other short.

K-or e#ample, a hedge fund manager will go long in the %< biotech stoc/s that should outperform and shortthe %< biotech stoc/s that will underperform. &herefore, what the actual mar/et does wonGt matter (much"because the gains and losses will offset each other.

1. 6lobal macro fund) A hedge fund strategy that ases its holdings primarily on o!erall economic and political!iews of !arious countries 2macroeconomic principles3.

. -utures fund2managed future fund3. "hese funds ta$e direction ets in the positions they hold in a singleasset class such as currencies and interest rates or commodities



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. Emerging$mar/et fund) A mutual fund that in!ests a ma*ority of its assets in the financial mar$ets of ade!eloping country, typically a small mar$et with a short operating history.

"hese mar$ets tend to e less liquid and efficient than de!eloped mar$ets. "hey are fairly !olatile and areinfluenced y economic and political factors.

J. Event 7riven $A hedge fund strategy in which the manager ta$es significant positions in a certain numer ofcompanies in Fspecial situations.F

7istressed securities funds) /n!est in det or equity of companies with se!ere prolems and thatare in or close to an$ruptcy

Ris$ aritrage in mergers and acquisitions ) "he technique ta$es ad!antage of price differences that

usually e&ist etween the current mar$et price of the shares of a company that is eing acquired and

the stoc$ price of the acquiring company. When a companyHs assets are not sufficient to repay all

claims, the stoc$holders 2the last of the sta$eholders to e paid3 are unli$ely to get any of the

proceeds from the liquidation or reorganiation. "herefore, in!estors in distressed securities focus

mostly on acquiring the companyHs onds, an$ det or e!en trade claims.

Although leverage is used in many hedge fund strategies, some do not use it at all.

"he unique ris$s include:

K8iquidity ris/) 7ccurs in !ery thin or illiquid securities. /n e&treme mar$et conditions, liquidity prolems can causethe collapse of the entire fund.

KPricing ris/) (ome of the assets in which a hedge fund in!ests can e !ery complicated, ma$ing it !ery difficult toprice the securities properly.

KCounterparty ris/) Bedge funds tend to deal with ro$er9dealers. As such, there is always the ris$ that a particularro$er9dealer may fail or simply cut off the hedge fund. /n these situations, the downside ris$ for the hedge fund andall its participants is e&tremely serious.

K'ettlement ris/) ailure to deli!er the securities y one or more parties to the transaction.

K'hort 'quee)e ris/) A short squeee occurs when you ha!e to purchase the securities you sold short efore youwant to. "his can occur ecause the in!estors from whom you orrowed the security need it earlier than anticipated.

K-inancial squee)e) 7ccurs when companies find themsel!es unale to orrow or unale to orrow at acceptalerates. 7!ere&tended credit lines, defaults and other det issues can cause a financial squeee. %argin calls and mar$to mar$et positions may also result in financial issues.

edge -und Performance

"hey tend to ha!e a net return that is higher than equity and ond mar$ets.

"hey tend to ha!e lower ris$s than equities when measured y the !olatility of their returns.

(harpe ratios tend to e higher than those of equities and onds. "he (harpe ratio is the reward to ris$

-orrelation of hedge funds with con!entional in!estment is generally low ut still positi!e.

'urvivorship biasis an important issue that needs to e addressed when analying past performance of funds.

-und of -unds Investing

Any fund that pools capital and uses two or more sub managers to invest that capital $ whether it is debt,equity, commodities, derivatives, or currencies, is a fund of funds. ay be able to allow investors into funds

that are already closed to new investors if the fund of fund already has cash placed with a particular manager.



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Due Diligence Process )"his process is !ery time consuming and highly specialied. A fund of funds manager shoulde e&ceptionally e&perienced and well equipped to perform this process.

und of funds are not without disad!antages, howe!er, and we would e remiss not to discuss them: fees, rely onpast performances of the funds

Alternative ;aluation ethods for Closely eld Companies

1. Cost Approach) "he cost approach determines what it would cost to replace all the companyHs assets intheir present form and condition.

. Comparables Approach ) %ar$et !alues are estimated !ia some enchmar$. "he enchmar$ may e asimilar corporation that is pulicly)traded or has recently sold. "he enchmar$ needs to e constantlyupdatedto reflect mar$et changes.

. Income Approach) @ses a discounted income or cash flow model. Any anticipated future economic incomeflows are discounted at an appropriate rate. After !aluing the firm, a numer of discounts or premiums areapplied to the preliminary !alue. Discounts usually are ta$en for the illiquidity. (ince the stoc$ of closely)heldor pri!ate corporations does not trade on pulic mar$ets and may e difficult to sell, a significant discount isapplied. A discount may also apply if one is only acquiring a minority interest and will ha!e little influence inhow the usiness is run. Alternatively, a premium may be paid for acquiring controlling interest.

Equity ;aluation

Intrinsic value: "he actual !alue of a company or an asset ased on an underlying perception of its true !alue

including all aspects of the usiness, in terms of oth tangile and intangile factors.



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-o)opetition is a usiness strategy ased on a comination of cooperation and competition, deri!ed from an

understanding that usiness competitors can enefit when they wor$ together.

Calculation of Price* Earning Batio



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/magine that there are ma*or changes in the firm policy or in the industry en!ironment the P9' ratio may change.

'trategy

"he e&perience cur!e: the cost per unit of produced declines as a company produces more output and gainsmore e&perience.

'conomies of scale: the a!erage cost declines as a company e&pands.

'conomies of scope: as a company produces related products, e&perience and reputation with one product

may spill o!er to another product.

etwor$ e&ternalities: some products and ser!ices gain !alue as more consumers use them so that they are

ale to share something popular.

Concentration ratiois the comined mar$et share of the largest firms in the industry. /f there are three firms that

ha!e a comined mar$et share of L


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5ACC

+ptimal Capital 2udget +ptimal capital structure, the cpital structure at which the value of the company isma#imi)ed

&his ratio is interesting in a sense that it is a relative value, so it introduces a /ind of budget constraint.

Accounting rate of return measures the average net income divided by average boo/ value of the pro?ect and

does not use Cash -low, the average investment is the boo/ value of asset and the profit number is operating

profit. It doesn4t ta/e in account for time value of money.

&he two most common types of accelerated depreciation are sum of the years digits and double declining

balance. ere is (briefly" how each wor/s

K@nder doule declining alance, the asset is depreciated twice as fast as under straight line. @sing the e&ample

ao!e, 10< of the cost is depreciated each year using straight line. Douling the rate would mean that 0< would e

depreciated each year, so the asset would e fully depreciated in M years, rather than 10.

K@nder sum)of)the)years)digits, the asset is depreciated faster than straight line ut not as fast as declining alance.

As an e&ample of how this method wor$s, letHs say an assetHs useful life is M years. Adding up the digits would e



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MSJSSS1 or a total of 1M. "he first year, M91M is e&pensed5 the ne&t year J91M is e&pensed, and so on. (o if the

assetHs cost is O1000, M91M, or O.J would e e&pensed the first year, ONN.NQ the second year, and so on.

(o than$s to this methods that permit to ha!e igger depreciations for the first years, we ha!e a igger P8 of

depreciation ta& shield.

"here are three ways to estimate the a!erage age of a companyHs fi&ed assets:

1. Average age? accumulated depreciation 9 current depreciation e&pense ? T years

. Belative age? accumulated depreciation 9 ending gross in!estment ? < of age

. Average depreciable life? ending gross in!estment 9 depreciation e&pense

J. Bemaining seful 8ife? ending net in!estment9 annual depreciation

"he a!erage useful life of the assets can e estimated y di!iding historical cost y annual depreciation e&pense. "his

estimate wor$s etter for companies that use straight line depreciation.

Besidual ;alue ow much a fi#ed asset is worth at the end of its lease, or at the end of its useful life.

salvage value 0 what you can sell it for now (as is"

residual value 0 purchase price depreciation



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Beturn on Q means Income divided by Q

5hereas

&urnover on Q means 'ales divided byQ

&a/e$or$pay agreement A ta/e$or$pay contract is a rule structuring negotiations between companies and

their suppliers. 5ith this /ind of contract, the company either ta/es the product from the supplier or pays the

supplier a penalty. -or any product the company ta/es, they agree to pay the supplier a certain price, say =umber of 7ays in InventoryU >umber of 7ays in A*B (from sales to collection$

>umber of day payable

CC

C

0 days between disbursing cash and collecting cash in connection with underta/ing a discrete unit ofoperations.

0 Inventory conversion U Beceivables conversion Payables conversion period


-inancing


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period period

0Avg. Inventory

C+6'* JM=U

Avg.Accounts Beceivable

Credit 'ales * JM=

Avg. Accounts Payable(money that you haveto pay"

Purchases * JM=

!uantitative Analysis

1. >ominal 'cale$wea$est le!el of measurement, categorie ut does not ran$5

. +rdinal 'cale$ne&t strong measurement, sorts data into categories of some characteristic5

. Interval 'cale$creates ran/ingAD assurance of difference etween scale !alues are equal where y

!alues can e added and9or sutracted5

J. Batio 'cale$strongest le!el of measurement, all characteristics of inter!al measurement as well as a true

Uero point of origin.V

armonic ean)"he !alue y summing the reciprocals of oser!ations 19T, then a!eraging this sum y the numerof oser!ations, and then ta$ing the reciprocal of the a!erage5 the weight is in!ersely proportional to its magnitude

http://en.wikipedia.org/wiki/Cost_of_goods_soldhttp://en.wikipedia.org/wiki/Cost_of_goods_soldhttp://en.wikipedia.org/wiki/Receivableshttp://en.wikipedia.org/wiki/Receivableshttp://en.wikipedia.org/wiki/Accounts_Payablehttp://en.wikipedia.org/wiki/Receivableshttp://en.wikipedia.org/wiki/Accounts_Payablehttp://en.wikipedia.org/wiki/Cost_of_goods_sold


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istogram

Attention 'harpe ratio 01 'tandard deviation.

&he 3urtosis of a normal distribution is equal to J.

Corporate -inance

-apital udgeting is the process of analying which pro*ect should e underta$en.

Planning in!ol!es considering the timing of pro*ects and prioritiing pro*ects depending on their importance and

resource a!ailaility.

-ategories of pro*ects:



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&he basic assumptions of capital budgeting are the C2 uses C- rather than accounting net income. &his C-

are incrementale9 after ta#es9 before financing costs.

Incremental cash flow are determined as cash flow with the pro?ect minus cash flow without the

pro?ect.

An e#ternality is the effect of a pro?ect on other cash flows.

Conventional C- occurs when a pro?ect has an initial investment and then a flow of C-.

5e must ta/e in account the interactions between pro?ects (mutually e#clusive pro?ect compete directly with

each other". 'ome pro?ects can lead to the option to invest in future pro?ects (Pro?ect 'equencing".

E&+7 +- 'E8EC&I+>



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&he paybac/ period is simple to calculate and easy to e#plain. In ddition, it is a good indicator of a pro?ect

liquidity. &he shorter the paybac/ period, the better, the liquidity.

2ut paybac/ ignore time value of money and the pro?ect4s ris/



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%ethod:

In many cases, a pro?ect with a negative >P; will not have a paybac/ period because the initial investment is

never recoverd.



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&he PI indicates the value of the pro?ect returns for each dollar of investment. &he disadvantage of the PI

method is that it can mislead in ran/ing mutually e#clusive pro?ects of different si)es because smaller >P;

pro?ect could have a larger PI than a larger >P; pro?ect. 8arger >P; pro?ects add more shareholder wealth

than smaller >P; pro?ects, so the PI decision would fail to ma#imi)e shareholder wealth.

7E+>'&BA&I+>



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H

H

flotation0 emission



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7E+>'&BA&I+>

V



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5hen a ban/ lends money against a promissory note it collects the interest charges in advance by deducting

them from the full value or face of the note. &his is called discounting the note. &he amount thus deducted is

called the discount. &he remainder left when the discount has been deducted from the face of the note is

called the net proceeds and is what the borrower receives. 5hen the note falls due at maturity, the borrowerpays bac/ to the ban/ it is full face value.

cfa preparation

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