1Ethical and Professional Standards Study Session 1 – 2 Weighting 10% 2 Overview of Level II Ethics Code of Ethics Standards of Professional Conduct CFA Institute Research Objectivity Standards Study Session 1 Ethics Cases: - Glenarm Company - Preston Partners - Super Selection Other topics: - Fair dealing & disclosure - Changing investment objectives - Prudence in Perspective Study Session 2 CFA Institute Soft Dollar Standards 3 Overview of the Code and Standards Code of Ethics • Act in an ethical manner Integrity is paramount and clients always come first • Use reasonable care and be independent • Be a credit to the investment profession • Uphold capital market rules and regulations • Be competent Standards of Professional Conduct I: Professionalism A.Knowledge of the Law B.Independence and Objectivity C.Misrepresentation D.Misconduct II: Integrity of Capital Markets A.Material Nonpublic Information B.Market Manipulation III: Duties to Clients A.Loyalty, Prudence, and Care B.Fair Dealing C.Suitability D.Performance Presentation E.Preservation of Confidentiality IV: Duties to Employers A.Loyalty B.Additional Compensation Arrangements C.Responsibilities of Supervisors V: Investment Analysis, Recommendations, and Actions A. Diligence and Reasonable Basis B. Communications with Clients and Prospective Clients C. Record Retention VI: Conflicts of Interest A. Disclosure of Conflicts B. Priority of Transactions C. Referral Fees VII: Responsibilities as a CFA Institute Member or CFA Candidate A. Conduct as Members and Candidates in the CFA Program B. Reference to CFA Institute, the CFA Designation, and the CFA Program 4 Standards of Professional Conduct Standard I: Professionalism I(A): Knowledge of the Law • Understand and comply with all laws, rules, regulations (including Code & Standards) governing professional activities • Comply with more strict law, rule, regulation • Do not knowingly assist in violation, otherwise dissociate from activity Guidance • Most strict • First – notify supervisor or compliance • May confront wrongdoer directly • Dissociate if necessary • Inaction may be construed as participation • No requirement to report violations to governmental authorities, but this may be appropriate in certain cases I(B): Independence and Objectivity • Use reasonable care, judgment to achieve, maintain independence in professional activities • Do not offer, solicit, accept any compensation that could compromise independence, objectivity Guidance • Modest gifts OK • Distinguish between gifts from clients and gifts from entities trying to influence • May accept gift from clients – must disclose to employer – must get permission if gift is for future performance • Investment banking relationships – do not bow to pressure to issue favorable research • For issuer-paid research, flat fee structure is preferred 5 Standards of Professional Conduct Standard I: Professionalism I(C): Misrepresentation • Do not make misrepresentations relating to investment analysis, recommendations, actions or other professional activities Guidance • Standard covers oral, written, or electronic communications • Do not misrepresent qualifications, services of self or firm, or performance record, characteristics of an investment • Do not guarantee a certain return • No plagiarism – written or oral communications I(D): Misconduct • Do not engage in any professional conduct involving dishonesty, fraud, deceit, or commit any act that reflects adversely on professional reputation, integrity, or competence Guidance This Standard covers conduct that may not be illegal, but could adversely affect a member’s ability to perform duties 6 Standards of Professional Conduct Standard II: Integrity of Capital Markets II(A): Material Nonpublic Information • Members in possession of nonpublic information that could affect an investment’s value must not act or cause someone else to act on the information II(B): Market Manipulation • Do not engage in practices that distort prices or artificially inflate trading volume with intent to mislead market participants Guidance • “Material” – if disclosure of information would impact a security’s price or if reasonable investors would want the information before making an investment decision • Information is “nonpublic” until it has been made available to the marketplace • Information made available to “analysts” is considered nonpublic until it is made available to investors in general • Mosaic Theory Guidance • Do not engage in transaction- based manipulation – give false impression of activity / price movement; gain dominant position in an asset to manipulate price of the asset or a related derivative • Do not distribute false, misleading information 7 Standards of Professional Conduct Standard III: Duties to Clients III(A): Loyalty, Prudence, and Care • Act with reasonable care and exercise prudent judgment • Act for benefit of clients and place their interests before employer’s or own interests • Determine and comply with any applicable fiduciary duty III(B): Fair Dealing Deal fairly, objectively with all clients when: • Providing investment analysis • Making investment recommendations • Taking investment action • Engaging in other professional activities Guidance • Take investment actions in client’s best interests • Exercise prudence, care, skill, and diligence • Follow applicable fiduciary duty • Manage pools of client assets according to terms of governing documents • Make investment decisions in context of total portfolio • Vote proxies responsibly and disclose proxy voting policies to clients • “Soft dollars” must benefit client Guidance • Different levels of service okay as long as disclosed, and does not disadvantage any clients • Investment recommendations: all clients must have fair chance to act on every recommendation • Investment actions: treat all clients fairly – consider investment objectives, circumstances 8 Standards of Professional Conduct Standard III: Duties to Clients III(C): Suitability • Know client’s risk and return objectives, and financial constraints • Update information regularly • Make investment recommendations or take investment actions that are consistent with the stated objectives and constraints • Look at suitability in a portfolio context III(D): Performance Presentation • When communicating investment performance information, ensure that information is fair, accurate, and complete Guidance • When in advisory relationship, gather client information at the outset and prepare IPS • Update IPS at least annually • Consider whether leverage (derivatives) is suitable for client • If managing a fund to an index or other mandate, invest according to mandate Guidance • Do not misstate performance or mislead clients about investment performance • Do not state or imply ability to achieve returns similar to those achieved in the past 9 Standards of Professional Conduct Standard III: Duties to Clients III(E): Preservation of Confidentiality Keep current and prospective client information confidential, unless: • Illegal activities are suspected • Disclosure is required by law • Client or prospect allows disclosure of the information Guidance • In some cases it may be required by law to report activities to relevant authorities • This Standard extends to former clients • Exception: May provide confidential information to CFA Institute for an investigation under Professional Conduct Program 10 Standards of Professional Conduct Standard IV: Duties to Employers IV(A): Loyalty • Must act for the benefit of their employer Guidance Loyalty – Independent practice: • If planning to engage in independent practice, notify employer of services provided, expected duration, and compensation • Do not proceed without consent from employer Loyalty – Leaving an employer: • If seeking new employment, act in best interest of employer until resignation is effective • Do not take records or files without permission • Simple knowledge of names of former clients is OK • No prohibition on use of experience or knowledge gained at former employer Loyalty – Whistleblowing: • Permitted only if it protects client or integrity of capital markets • Not permitted for personal gain 11 Standards of Professional Conduct Standard IV: Duties to Employers IV(C): Responsibilities of Supervisors • Must make reasonable efforts to detect and prevent violations IV(B): Additional Compensation Arrangements Do not accept gifts, benefits, compensation, consideration that competes with, or creates a conflict of interest with, employer’s interest unless written consent is obtain from all parties involved Guidance • Compensation and benefits covers direct compensation by the client and other benefits received from third parties • For written consent from “all parties involved,” email is acceptable Guidance • Supervisors must take steps to prevent employees from violating laws, rules, regulations, or the Code and Standards • Supervisors must make reasonable efforts to detect violations 12 Standards of Professional Conduct Standard V: Investment Analysis, Recommendations, and Actions V(A): Diligence and Reasonable Basis • Exercise diligence, independence, and thoroughness • Have a reasonable and adequate basis, supported by appropriate research, for any investment analysis, recommendation, or action. V(B): Communication with Clients and Prospective Clients • Disclose the basic format and general principles of investment processes and promptly disclose any changes that might affect those processes materially • Identify important factors and include them in communications with clients/prospective clients • Distinguish between fact and opinion in the presentation of investment analysis and recommendations Guidance • Make reasonable efforts to cover all relevant issues when arriving at an investment recommendation • Determine soundness when using secondary or third-party research • Group research and decision making: As long as there is reasonable basis for opinion, member does not necessarily have to agree with the opinion Guidance • Distinguish between facts and opinions • Include basic characteristics of the security • Inform clients of any change in investment processes • Suitability of investment – portfolio context • All communication covered, not just reports 13 Standards of Professional Conduct Standard V: Investment Analysis, Recommendations, and Actions V(C): Record Retention • Develop and maintain appropriate records to support their investment analysis, recommendations, actions, and other investment-related communications Guidance • Maintain records to support research, and the rationale for conclusions and actions • Records are firm’s property and cannot be taken when member leaves without firm’s consent • If no regulatory requirement, CFA Institute recommends retention period of 7 years 14 Standards of Professional Conduct Standard VI: Conflicts of Interest VI(A): Disclosure of Conflicts • Must make full and fair disclosure to clients, prospects or employer of all matters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties Guidance Disclose to clients: • All matters that could impair objectivity – allow clients to judge motives, biases • For example, between member or firm and issuer, investment banking relations, broker/dealer market-making activities, significant stock ownership, board service Disclose to employers: • Conflicts of interest – ownership of stock analyzed/recommended, board participation, financial and other pressures that may influence decisions • Also covers conflicts that could be damaging to employer’s business 15 Standards of Professional Conduct Standard VI: Conflicts of Interest VI(C): Referral Fees • Must disclose to employer, clients, and prospective clients VI(B): Priority of Transactions • Investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner Guidance • “Beneficial owner” – has direct / indirect personal interest in the securities • Client, employer transactions take priority over personal transactions (including beneficial ownership) • Family member accounts that are client accounts must be treated as other client accounts Guidance • Disclosure allows clients and employers to evaluate full cost of service and any potential biases • Disclosure is to be made prior to entering into any formal agreement for services • Disclose the nature of the consideration 16 Standards of Professional Conduct Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate VII(A): Conduct as Members and Candidates in the CFA Program • Must not engage in any conduct that compromises the reputation or integrity of CFA Institute or the CFA designation or the integrity, validity, or security of the CFA examinations. Guidance Conduct includes: • Cheating on the exam • Disregarding rules and policies or security measures related to exam administration • Giving confidential information to candidates or public • Improper use of CFA designation to further personal and professional objectives • Misrepresenting the CFA Institute Professional Development Program or the Professional Conduct Statement 17 Standards of Professional Conduct Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program • Must not misrepresent or exaggerate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the CFA program Guidance CFA Institute membership: • Complete PCS annually • Pay membership dues annually Using the CFA designation: • Don’t misrepresent or exaggerate the meaning of holding the CFA designation Reference to the CFA program: • May reference participation but no partial designation • OK to say “passed all levels on first attempt,” but do not imply superior ability Improper use of the CFA marks: • The “Chartered Financial Analyst” and “CFA” marks must always be used either after a charterholder’s name or as adjectives, not as nouns Failure to comply with results in an inactive member status 18 Definitions I. General III. Selection of brokers Soft Dollar Standards II.Relationship with clients VI. Disclosure IV. Evaluation of research CFA Institute Soft Dollar Standards VII. Record keeping Appendix: Permissible research guidance V. Client-directed brokerage General Principles 19 Relationship with clients • Disclose involvement in soft dollar • OK to use brokerage from agency trades to obtain research – client should receive some benefit • OK to use client brokerage obtained from principal trades to benefit other client accounts, as long as disclosed Selection of brokers • Consider trade execution capabilities CFA Institute Soft Dollar Standards General • Soft dollar practices must benefit client, whose interests always come first • Allocation of client brokerage – must not be based on amount of client referrals investment manager receives from broker Two fundamental principles • Client property • Duty to minimize transaction costs, obtain best execution & use client brokerage to benefit clients Soft dollar practices • The use of client brokerage by investment manager to obtain products/services to aid manager in investment decision making process 20 Evaluation of research • Meet definition of Standard • Benefit client • Documentation of basis • Disclosure and consent obtained if benefit other clients • Investment manager pays for research if doesn’t meet criteria • Mixed-use research – allocate Client-directed brokerage • Cannot use brokerage from another client to pay • Manager: Disclose duty of best execution • Disclose to client that client’s selection may adversely affect execution and adequacy of research CFA Institute Soft Dollar Standards34 Disclosure • Disclose types of third-party research received • To comply with Soft Dollar Standards, send client statement of practices annually • On client request, provide description of product / service obtained through client brokerage generated by client’s account • Provide total amount of brokerage paid from all accounts (where manager has discretion) 21 Record keeping Manager must maintain records • Document arrangements obligating manager to generate specific dollar amount of brokerage • Document client arrangements re: client brokerage • Document brokerage arrangements • Document basis for allocations – mixed use brokerage • Show how products / services obtained assist in investment process • Show compliance with CFAI Soft Dollar Standards, responsible party • Include copies of disclosures / authorizations from clients CFA Institute Soft Dollar Standards Permissible research: 3 level analysis • Level I: define the product or service • Level II: determine usage • Level III: mixed-use analysis – investment manager makes proper allocation 22 Objectives Research objectivity policy Reasonable and adequate basis Procedures for compliance Public appearances Relationships with subject companies Investment banking CFAI Research Objectivity Standards Personal investments and trading Timeliness of research reports and recommendations Compliance and enforcement Disclosure Rating system Research analyst compensation 23 Objectives of the Standards • Prepare research, recommendations, investment action – clients always first • Full, fair, meaningful disclosures of conflicts • Promote effective policies/procedures – minimize conflicts affecting independence/objectivity • Support self-regulation – adhere to specific, measurable standards, promoting independence, objectivity • Provide ethical work environment CFAI Research Objectivity Standards Required Compliance Procedures Research objectivity policy • Provide written policy on research independence and objectivity • Have supervisory procedures that ensure compliance • Have a senior officer who attests to the firm’s implementation and adherence Public appearances • Require covered employees to disclose both personal and firm conflicts of interest to the interviewer/host and, if possible, to the audience 24 Required Compliance Procedures Reasonable and adequate basis • Appoint a supervisory analyst or a review committee to evaluate and approve research report recommendations Investment banking • Separate research analysts from the investment banking division • Research analysts are not supervised by or report to the investment banking • Investment banking or corporate finance divisions are unable to modify, review, approve or reject research recommendations and reports Research analyst compensation • Compensation should reflect the quality and accuracy of the recommendations made • Compensation should be not be connected to the analyst’s involvement with investment banking or corporate finance activities Relationships with subject companies Research analysts are not allowed to: • Share research report with a subject company prior to the publication of the research report • Promise a favorable report or a certain price target to a subject company or corporate issuer CFAI Research Objectivity Standards 25 Required Compliance Procedures Personal investments and trading • Firm should have policies to ensure covered employees’ personal investment dealings are properly managed Timeliness of research reports and recommendations • Reports should be issued on a timely and regular basis Compliance and enforcement • Effective compliance procedures should be in place • The compliance procedures should be supervised and audited & maintain internal audit records Disclosure • Firm to provide full disclose of conflicts of interest Rating system • Rating system should be helpful to investors in their decision-making process CFAI Research Objectivity Standards 26 26 Recommended Procedures for Compliance Research objectivity policy • Identify and describe covered employees • Covered employees to be trained regularly and indicate in writing their adherence to the policy annually • Disclose conflict of interest that covered employees face • Identify factors on which research analysts’ compensation is based • Disclose the terms for the purchase of research reports by clients Public appearances • Ensure that the audience of a presentation has enough information to make informed judgments • Be prepared to disclose conflicts of interest • Firm should require research analysts that are participating in public appearances to disclose investment banking relationship with the subject company and whether the analyst has participated in marketing activities for the subject company • Research reports on the companies discussed should be provided to the audience for a reasonable fee CFAI Research Objectivity Standards 27 27 Recommended Procedures for Compliance Reasonable and adequate basis • Develop written guidance for judging what constitutes reasonable and adequate basis • Provide or offer to provide supporting information, and disclose current price of the security Investment banking • Prohibit research analysts from communicating with the investment banking or corporate finance department prior to the publication of a research report • Investment banking or corporate finance personnel may review reports for factual accuracies or to identify possible conflicts • Implement quiet periods for IPOs and secondary offerings • Analysts not be allowed to participate in marketing roadshows for IPOs and secondary offerings Research analyst compensation • Compensation should be based on measurable criteria • Direct link of analysts’ compensation with investment banking and corporate finance activities is not allowed but firm should disclose to what extent analysts’ compensation depends on investment banking revenues CFAI Research Objectivity Standards 28 28 Recommended Procedures for Compliance Relationships with subject companies • Implement policies that govern analysts relationship with subject companies • Implement guidelines that only those sections of the report related to factual information that could be verified by the subject company is shared before publication • Compliance and legal departments get a copy of the draft report before it is shared with the subject company Personal investments and trading • Approval required prior to trading in securities in the industries assigned to the analyst • Should have procedures to prevent employees from trading ahead of investing client trades Restricted period of at least 30 days prior and 5 days after a report is issued • Analysts permitted to sell contrary to their recommendation when in extreme financial hardship • Covered employees to provide a list of personal investments • Establish policies to prevent short-term trading of securities CFAI Research Objectivity Standards 29 29 Recommended Procedures for Compliance Timeliness of research reports and recommendations • Reports and recommendations should be issued at least quarterly • If the coverage of a firm is discontinued, a “final” research report should be issued Compliance and enforcement • Distribute a list of activities that constitute violations and the disciplinary sanctions Disclosure • Disclose investment banking or other corporate finance relationships & conflicts of interests • Provide information on their recommendations and ratings • Disclose the valuation methods used to determine price targets, including risk factors Rating system • Rating systems should include recommendation and rating categories, time horizon categories, and risk categories • Absolute or relative recommendations are allowed • Employees should be prohibited from communicating a recommendation contrary to the current published one CFAI Research Objectivity Standards 30 Study Session 2 topics The Glenarm Company Applications of Standards Preston Partners Super Selection Case Studies Trade Allocation: Fair Dealing and Disclosure Changing Investment Objectives Prudence in Perspective Ethics and Professional Standards 31 Quantitative Methods Study Session 3 Weighting 5 – 10% 32 Study Session 3 Time-Series Analysis Multiple Regression Correlation and Linear Regression Overview of Level II Quant 33 Covariance & Correlation Covariance • may range from +ve to –ve infinity • units are squared hence less meaningful ( )( ) = ÷ ÷ = ÷ ¯ n t,1 1 t,2 2 t 1 1,2 R R R R cov n 1 Correlation • standardised measure of relationship • bounded by -1 and +1 • the closer to absolute 1, the stronger the relationship o o = 1,2 1,2 1 2 Cov r Significance of correlation coefficient H 0 : ²= 0 H a : ²Į0 Two-tailed test Degrees of freedom are n – 2 Limitations to correlation analysis •outliers affect the coefficient •spurious correlation: linear relationship but no economic explanation •a nonlinear relationship exists which cannot be captured by correlation 2 r n 2 t = 1 r ÷ ÷ 34 Linear Regression x x x x x x x x x x x x x x x x x x x Y, dependent variable X i c i error term or residual i i X b b Y 1 0 ˆ ˆ ˆ + = X, independent variable Y i i Y ˆ Basic idea: a linear relationship between two variables, X and Y. Note that the standard error of estimate (SEE) is in the same units as ‘Y’ and hence should be viewed relative to ‘Y’. Mean of c i values = 0 Standard deviation of c i = standard error of the estimate (SEE) Least squares regression finds the straight line that minimises the SEE by minimising: SSE) errors, squared the of sum ( ݈ 2 i = ¯ 35 Significance of coefficients Hypothesis Tests on a Regression Coefficient To test statistical significance: H 0 : b i = 0 H a : b i Į 0 Other tests are possible, for example: H 0 : b i ı 1 H a : b i < 1 Confidence interval for the population value of a regression coefficient Predictions for the dependent variable Given the estimated regression coefficients and an assumed value for the independent variable(s) we can predict the value of the dependent value using: Degrees of freedom = n – (k + 1) i i i i s b b ˆ t , statistic Test ÷ = i i b ˆ of error standard s : Where = ( ) i i s value t critical b ˆ × ± 1 1 0 i X ˆ b ˆ b ˆ Y ˆ + = Confidence interval for the prediction of Y n – 2 degrees of freedom ( ) f s value - t critical Y ˆ × ± ÷ ÷ + + = 2 2 2 2 ) 1 ( ) ˆ ( 1 1 x f s n X X n SEE s 36 i 1 0 i X b ˆ b ˆ Y ˆ + = ( ) SSE Y ˆ - Y 2 i i ÷ ( ) SSR Y - Y ˆ 2 i ÷ ( ) SST Y - Y 2 i ÷ i Y 0 b ˆ Y X Y Components of Variation Total variation = sum of squared totals (SST) = actual - expected Explained variation = sum of squared regressions (SSR) = predicted – expected Unexplained variation = sum of squared errors (SSE) = actual – predicted 37 Analysis of Variance Table Coefficient of determination R 2 = explained variation in y total variation in y R 2 is the proportion of the total variation in y that is explained by the variation in x’s R 2 = r 2 for linear regression Interpretation When correlation is strong (weak, i.e. near to zero) •R 2 is high (low) •Standard error of the estimate is low (high) Standard Error of Estimate Source of Variation Degrees of Freedom Sum of Squares Mean Square Regression (explained) 1 = k Regression sum of squares (RSS) Mean sum of squares (MSR) = RSS/k Error (unexplained) n – (k + 1) = n - 2 Sum of squared errors (SSE) Mean squared error (MSE) = SSE/(n – 2) Total n - 1 Sum of squares total (SST) SST RSS = ( ) ( ) MSE 1 k n SSE 1 k n ݈ SEE n 1 i i = + ÷ = + ÷ = ¯ = ANOVA, SEE and R-squared 38 General form of model: Predicting the dependent variable i k k 2 2 1 1 0 i X b .... X b X b b Y c + + + + + = Independent variables Dependent variable Partial slope coefficients Y-intercept Error term, residual s t variable independen the of values assumed the are X ˆ ..... , X ˆ , X ˆ b .... , b , b parameters regression for the estimates are b ˆ ...., , b ˆ , b ˆ : where k 2 1 k 1 0 k 1 0 k k 2 2 1 1 0 i X ˆ b ˆ .... X ˆ b ˆ X ˆ b ˆ b ˆ Y ˆ + + + + = Multiple Regression 39 Hypothesis tests on individual regression coefficients To identify which independent variables are individually important in a multiple regression we perform a t-test on each slope coefficient with b i = 0. (seen earlier) Degrees of freedom = n – (k + 1) Determining the collective significance of the independent variables Perform an F-test: H 0 : None of the independent variables significantly explain the dependent variable. b 1 = b 2 = b 3 = ……= b k = 0 H a : At least one of the independent variables significantly explains the dependent variable. At least one b i Į0 Reject H 0 if computed F > F-critical Test statistic: i i i i s b b ˆ t , statistic Test ÷ = i i b ˆ of error standard s : Where = ( )) 1 k - (n errors squared of Sum k squares of sum Regression F + = table) ANOVA from (data MSE MSR error squared Mean squares of sum regression Mean = = Looking up the critical F- value Use table corresponding to the significance level of test (o) i.e. (one-tailed!!!!) Numerator dof = k Denominator dof = n – (k + 1) Significance of coefficients 40 Other Issues in Multiple Regression Adjusted R 2 • As you incorporate more variables R 2 can only go up, even if some of the new variables are statistically insignificant • Hence in multiple regression we use adjusted R 2 . This measure of fit does not automatically increase when another variable is added. No calculations are required Qualitative independent factors • These are variables that attain discrete states, rather than taking values from a range. • We use Dummy Variables for these factors. • To distinguish between n categories, we need n-1 dummy variables. ( ) ( ) ( ) ÷ ÷ ÷ ÷ = 1 - k n 1 n R 1 1 R 2 2 Qualitative dependent variables with binary outcomes • Logit models - estimate the probability that the event will occur based on logistic distribution • Probit models - as with logit, except based on normal distribution • Discriminant models - based on regression analysis, but producing a score which can then be used to assess likelihood of event (e.g. credit scoring) Interpreting p-values • A p-value is the smallest significance level (ө) at which we can reject H 0 41 Assumptions of a multiple regression model 1. The relationship between the dependent variable, Y, and the independent variable, X, is linear 2. Expected value of the error term is 0 3. The variance of the error term is the same for all observations (homoskedasticity) 4. The error term is normally distributed 5. The error term is uncorrelated across observations (i.e. no serial correlation) 6. No linear relationship exists between two or more independent variables (i.e. no multicollinearity) Limitations of regression analysis 1. Regression relations change over time (non-stationarity) 2. If assumptions are not valid, the interpretation and tests of hypothesis are not valid Violations of regression assumptions 1. Heteroskedasticity – error term has non-constant variance 2. Serial correlation – error terms are correlated with each other 3. Multicollinearity – linear relationship between independent variables Assumptions, Limitations, Violations 42 Description • Variance of the error term is non- constant. • Unconditional: Not related to independent variables Æcauses no major problems. • Conditional: related to independent variable Æthis is a problem. Correction • Compute robust standard errors (aka White-corrected standard errors) used to recalculate the t statistics Effect on statistical inference • Estimated standard errors of the regression coeffs. are likely to be wrong. • With financial data they are likely to be too small, hence actual t-stats too high, so coefficients might appear significant when they are not (Type I error). Detection •Scatter diagrams (plot residual against each independent variable and against time). •Breusch-Pagan test: regress the residuals 2 against the independent variables, then test the significance of the resulting R 2 using a one- tailed chi-square test. A significant value is evidence of heteroskedasticity. Heteroskedasticity 43 Serial Correlation Description • Autocorrelation (serial correlation) arises when the residuals are correlated with one another • Usually arises with time series data • Autocorrelation may be positive or negative Correction • Adjust the coefficient standard errors, e.g. using the Hansen method (which also corrects for conditional heteroskedasticity) • Improve the specification of the model. Effect on statistical inference • Positive autocorrelation can lead to too low estimates of coefficient standard errors, hence too large t-stats, causing Type I errors. • Negative autocorrelation can cause the standard errors to be overstated, causing Type II errors. Detection (if not autoregressive model) •Scatter plot of residual errors •Calculate the Durbin-Watson Statistic, DW Ĭ2(1 - r) . Where r = sample correlation coefficient between consecutive residuals 0 2 4 d L d U 4-d L 4-d U Evidence of positive autocorrelation Evidence of negative autocorrelation No evidence of autocorrelation T e s t i s a m b i g u o u s T e s t i s a m b i g u o u s 44 Multicollinearity Description Two or more independent variables are mutually correlated, making the interpretation of the regression output problematic. Correction Remove one or more of the offending independent variables Alternatively perform a more advanced technique such as stepwise regression Detection • Conflicting t- and F-tests: significant F-statistic combined with insignificant individual t-statistics • High correlation coefficient between two independent variables (rule of thumb: > 0.7 but works only if no more than two independent variables are present) • When dealing with more than two independent variables, low pair correlations could still lead to multicollinearity • Signs on the coefficients that are opposite to what is expected Effect on statistical inference • Inflates SEE and coefficient standard errors leading to lower computed t-stats • As a result, the null is rejected less frequently leading to Type II errors 45 Model Specification Issues biased and inconsistent regression coefficients Leading to: Unreliable hypothesis testing and inaccurate predictions Examples of misspecification: • Omitting a variable • Failing to transform a variable [e.g. using market cap as an independent variable instead of ln(market cap)] • Incorrectly pooling data [e.g. using data spanning two distinct monetary policy regimes when building a model to predict inflation] • Using the lagged value of the dependent variable as an independent variable • Forecasting the past [using variables measured at the end of a period to predict a value in the period] • Errors in the measurement of the independent variables Model Misspecification causes: 46 Trend Models Variable is a function of time Moving-Average (MA) models Variable is a function of weighted average of previous error terms Autoregressive (AR) models Variable is a function of earlier value(s) of itself Autoregressive Moving- Average (ARMA) models A hybrid approach Autoregressive Conditional Heteroskedasticity (ARCH) models Used when variance of the error term is dependent on the size of earlier errors Types of Time-Series Models 47 Trend Models Linear trend model Value of time series in period t, y t = b 0 + b 1 t + c t Average change in y is constant in absolute terms = b 1 Log-linear trend model The natural log of the value of time series in period t, ln(y t ) = b 0 + b 1 t + c t Exponential trend: average rate of change in y is constant = e b 1 – 1 Might be a better model to use if a linear trend model produces serially correlated errors. Limitations of trend model • The one independent variable may be insufficient to explain changes in the dependent variable. • Model errors are often serially correlated (use DW to detect) and hence assumption violated. data series straight line of best fit y t t y Observation Trend 48 Exists if time series data is well-behaved, so process can be represented with a relatively simple model (e.g. AR) Covariance stationarity E.g. AR(p): x t = b 0 + b 1 x t-1 + b 2 x t-2 + … + b p x t-p + e t Series has: • constant mean • constant variance • constant covariance with itself over time If not covariance stationary then regression results, both statistically & financially, are meaningless Mean reversion Time series has tendency to converge to its mean: Necessary condition for parameters to be estimated by AR regression methods No finite mean- reverting level ¬not covariance stationary First differencing might help a time series achieve covariance stationarity ( ) 1 0 b 1 b : AR(1) For ÷ Autoregressive Models 49 Chain rule of forecasting Inputs used in multi-period forecasts are themselves forecasts x t = b 0 + b 1 x t-1 + b 2 x t-2 + … + b p x t-p + ¦ t Random walks Value in one period is equal to the value in previous period plus a random error: x t = b 0 + x t-1 + ¦ t If b 0 Į0 then random walk with drift This is an AR(1) model with b 1 = 1 Known as a unit root hence the mean reverting level is undefined Serial correlation • Serial correlation within an AR model causes estimates of the regression coefficients to be inconsistent ÷big problem. • Cannot test for it using the DW statistic. • Instead use a t-test to see whether any of the residual lag autocorrelations differ significantly from zero. • If some are significant then the model is incorrectly specified. • Increase the order of the model by incorporating the offending lags. • In case of seasonality, add x t-4 for quarterly data, and x t-12 for monthly data No finite mean- reverting level ¬not covariance stationary Autoregressive Models cont. 50 Q th order moving average model, MA(q) x t = c t + u 1 c t-1 + u 2 c t-2 + … + u q c t-q • A time series will be well represented by a MA(q) model if the first q autocorrelations of that time series are significantly different from 0, while subsequent autocorrelations equal 0 (the autocorrelations drop suddenly to 0 after the first q) • With most AR time series the autocorrelations start large and decline gradually as the lags increase. ARMA models Combines both autoregressive lags of the dependent variable and moving-average errors. Problems: • Parameters can be very unstable - slight changes in data sample or initial guesses of parameters can give very different final estimates • Choosing the right model is more art than science • Model may not forecast well - in most cases a much simpler AR model will do as good a job • Require large amounts of data (at least 80 observations) Moving Average Models 51 Description of heteroskedasticity • Variance of the error term is non- constant. • Unconditional: Not related to independent variables Æcauses no major problems. • Conditional: Is related to independent variable Æthis is a problem. Correction • Compute robust/corrected standard errors (aka White-corrected standard errors) or • Use an ARCH model to forecast the variance of the error term Autoregressive Conditional Heteroskedasticity • Variance of error terms in one time period is dependent on the variance of the error terms in another period. • SEs of the regression coefficients in models will be incorrect and hypothesis tests will be invalid. • ARCH(1) detected by performing following regression: (u t is an error term) • If a 1 is statistically different from zero then the series is ARCH(1). • Can then use ARCH model to predict variance of errors with the following equation: t u a a + + = 2 1 - t 1 0 2 t ˆ ˆ c c ARCH Models 2 t 1 0 2 1 t ˆ ˆ c o a a + = + 52 In-sample vs Out-of-sample forecast errors • In-sample forecasts are for values within the estimation period. Can use the SEE to compare the in-sample errors of competing models. • Out-of-sample forecast errors represent the differences between actual and predicted values of the time series outside of the period used to construct the model. • Can use the RMSE (Root Mean Squared Error, i.e. the square root of the average squared forecast error) to judge which model is most accurate. The Dickey-Fuller (DF) Test for a Unit Root • Test is based on a transformed version of the AR(1) model x t = b 0 + b 1 x t-1 + c t • Subtracting x t-1 from both sides produces: x t - x t-1 = b 0 + (b 1 – 1)x t-1 + c t or x t - x t-1 = b 0 + g 1 x t-1 + c t where g 1 = (b 1 – 1) • If there is a unit root in the AR(1) model, then g 1 will be 0 in a regression where the dependent variable is the first difference of the time series and the independent variable is the first lag of the time series. • DF test: H 0 : g 1 = 0, time series has a unit root and is nonstationary H a : g 1 Ћ0, time series does not have a unit root • Test is conducted by calculating a t-statistic for g 1 and using a revised set of critical values computed by DF. Other Issues in Time Series 53 Cointegration • Two time series are cointegrated if a long-term financial or economic relationship exists between them such that they do not diverge from each other without bound in the long run (e.g. they share a common trend) With a simple regression the following scenarios are possible: 1. Neither time series has a unit root Can safely use linear regression 2. One or other time series has a unit root Error term in the regression will not be covariance stationary ÷one or more regression assumptions violated ÷ regression coefficients might appear significant when not 3. A) Both time series have a unit root but are not cointegrated As with 2. above 3. B) Both time series have a unit root but are cointegrated Error term in the linear regression will be covariance stationary but we should be very cautious in interpreting the regression results. The regression estimates the long-term relation between the two series but may not be the best model of the short-term relation. Multiple Time Series 54 S t a r t Time Series - Summary 55 Economics Study Session 4 Weighting 5 – 10% 56 Study Session 4 Economic Growth Regulation and Antitrust Policy In a Globalized Economy Trading with the World Currency Exchange Rates Foreign Exchange Parity Relations Measuring Economic Activity Overview of Level II Economics 57 Economic Growth Real GDP = measure of inflation-adjusted income and output Standard of living = level of real GDP per labor hour = level of labor productivity Economic growth = % change in real GDP per labor hour = growth in labor productivity = improvement in standard of living Rule of 70: a country’s economic activity will double every (70/growth rate) years 58 Economic Growth PRECONDITIONS FOR ECONOMIC GROWTH Theories of Economic Growth • Markets • Property rights • Monetary exchange New Growth Theory Neoclassical Growth Theory • Saving and investment in new capital • Investment in human capital • Discovery of new technologies For economic growth to continue Classical Growth Theory GDP growth will be driven back to the subsistence level LT GDP growth requires technological change Discovery of new products and techniques is down to luck At a given level of technology, on average, a 1% increase in capital per labor hour results in a one third of 1% increase in real GDP per labor hour PRODUCTIVITY One Third Rule Methods for Increasing Economic Growth • Encourage savings • Encourage basic R&D • Stimulate international trade • Improve the quality of education 59 Regulation and Antitrust Policy Government regulation Social regulation Economic regulation Based upon Product quality Product safety Employee safety Natural Monopolies Cost-of-service regulation Rate-of-return regulation Negative Side Effects Creative response Feedback effect Regulator Behavior Theory Capture Theory Industry controls regulator Share-the-gains, Share the Pains Theory Legislators Customers Regulated firms 60 Trading with the World Comparative advantage refers to the lowest opportunity cost to produce a product. Law of comparative advantage: trading partners can be made better off if they specialize in producing goods for which they are the low-opportunity-cost producer and trade for the goods for which they are the high-opportunity-cost producer Restrictions on Trade Tariff is a tax imposed on imported goods Quota is a limitation on the quantity of goods imported Voluntary export restraints (VERs) are agreements by exporting countries to limit the quantity of goods they will export to an importing country Two primary forces underlying trade restrictions: ¾ Governments like tariff revenue ¾ Domestic producers affected by lower-cost imports use political means to gain protection from foreign competition 61 Currency Exchange Rates Foreign Exchange Quotations Direct Quotes • DC/FC • Usual method of quoting currencies Indirect Quotes • FC/DC Triangular Arbitrage Profit is calculated by “going around the triangle”. Choose the way > 1 Always sell the base currency and by the quoted! USD CHF GBP 1 . 5 6 0 0 U S D / G B P 2.3182 CHF/GBP 1 . 4 8 6 0 C H F / U S D USD ėGBP ėCHF ėUSD or USD ėCHF ėGBP ėUSD £/$ x CHF/£ x $/£ or CHF/$ x £/CHF x $/£ £:$ £ base $ quoted £/$ $ base £ quoted 62 Triangular Arbitrage Bid and Ask $ € “BID” means turning € into $ “ASK” means turning $ into € CHF GBP 1 . 3 5 0 0 U S D / G B P Ask rate = ?.???? CHF/GBP 1 . 5 0 0 0 C H F / U S D 1 . 5 0 1 0 C H F / U S D Bid Rate = ?.???? CHF/GBP 1 . 3 5 1 0 U S D / G B P 63 Currency Exchange Rates Bid – Ask Spread Factors affecting spread: • Volume • Volatility • Dealers long/short position • Term (forward contracts only) Triangular Arbitrage 1. Choose a direction and formulate equations: £/$ x CHF/£ x $/CHF 2. Check examiner has given the quotes for the right base and quoted combinations. If not you will need to take reciprocals noting that the bid and ask swap when you do 3. Using the bids move round the triangle selling the base and buying the quoted currency 4. Did you get > 1? If not take the reciprocal of the ask quotes to move the opposite direction. USD CHF GBP £/$ 0.7113 – 0.7116 Bid (lower) Bank sells £ Bank buys $ Ask (higher) Bank sells $ Bank buys £ Forward Contracts Premium – base currency buys more future quoted Discount – base currency buys less future quoted Fwd – Spot Spot x 360 Contract Days Fwd Pm or Disc = 64 Factors That Cause a Currency to Appreciate/Depreciate Differences in income growth: Country with rapid income growth has more demand for imports and foreign currency, domestic currency depreciates Differences in inflation rates: Higher inflation means exports more expensive, imports cheaper, domestic currency depreciates Differences in real interest rates: Country with higher real rates will attract foreign investment, increased demand for domestic currency so it appreciates A fixed rate system has a set rate of exchange to another currency A currency board creates domestic currency only in exchange for the other currency, held in bonds and other liquid assets. The currency board promises to redeem the domestic currency at the fixed exchange rate into dollars A pegged exchange rate system is based on a commitment to use monetary policy to keep exchange rates within a band Other Exchange Rate Regimes Foreign Exchange Parity Relations 65 Fiscal Policy and Exchange Rates Expansionary monetary policy leads to: Rapid economic growth (increases imports) Higher inflation (decreases exports) Lower real interest rates (increase investment to abroad) All three cause the domestic currency to depreciate Monetary Policy and Exchange Rates Unanticipated restrictive fiscal policy leads to: Slower growth (decreases imports) appreciation Lower inflation (increases exports) appreciation Lower real interest rates (increases investment abroad) depreciation Financial capital is more mobile, so third effect dominates in short run Expansionary policy ėShort run appreciation Foreign Exchange Parity Relations 66 Purchasing Power Parity Based on the “Law of One Price” Absolute PPP: Same basket of goods will cost the same everywhere, after adjusting for exchange rates Relative PPP: Changes in exchange rates will just offset changes in price levels (i.e., differences in inflation) Uncovered Interest Rate Parity • Countries with high interest rates (and high inflation rates) should have currency values that fall over time • Assumes PPP and Fisher hold • Assumes constant real exchange rate International Fisher Relation • Inflation differentials between countries are the prime drivers of interest rate differentials • Key = real interest rates the same in every country! Foreign Exchange Parity Relations Covered Interest Rate Parity • Forward rates are arbitrage free rates set using interest rate differentials. 67 Foreign Exchange Parity Relations International Fisher Effect Spot Forward Interest Rate Parity Purchasing Power Parity The forward rate is the best unbiased predictor of the future spot rate U n c o v e r e d I n t e r e s t R a t e P a r i t y B Q INT 1 INT 1 + + 0 t Spot Future Spot ) REAL 1 )( INF 1 ( ) REAL 1 )( INF 1 ( B Q + + + + 68 Purchasing Power Parity Interest Rate Parity (covered) Parity Relationships International Fisher Effect Exact Methodology: 1+r = (1+real r)(1+E(i)) Linear Approximation: r = real r + E(i) Where: r = nominal interest rate real r = real interest rate E(i) = expected inflation Uncovered Interest Rate Parity Foreign Exchange Parity Relations Foreign Exchange Expectation Relation E(S) = F E(%S) = F - S o S o E(S T ) = So x (1+I quoted ) T (1+I base ) T Fwd = So x (1+R quoted ) (1+R base ) E(S T ) = So x (1+R quoted ) (1+R base ) 69 Measures of Economic Activity Gross Domestic Product (GDP) Total market value of all final goods and services provided in a country over a stated period of time (1yr) Gross National Income (GNI) Total goods and services produced by the citizens of a country Net National Income (NNI) GNI less depreciation. Amount of resources utilized or worn out by the production process Value of production - cost of inputs GDP Output Consumption + Investment Total domestic expenditure + Exports of goods and services Total final expenditure - Imports of goods and services GDP Expenditure Wages and salaries + Self-employment income + Company trading profits + Government and enterprise trading surpluses + Rental income GDP Income GDP + net property income from abroad GNI - Depreciation NNI Can be expressed in current or constant prices GDP at market prices – indirect taxes + subsidies = GDP at factor prices 70 Financial Reporting & Analysis Study Sessions 5, 6 & 7 Weighting 15 – 25% 71 Overview of Level II FSA34 Inventories Intercorporate Investments Study Session 5 Multinational Operations Study Session 6 Employee Compensation Long-Lived Assets Integration of Financial Statement Analysis Techniques Study Session 7 The Lessons We Learn Financial Reporting Quality 72 Inventories With inflation and LIFO, COGS is higher and end. inv. is lower. With deflation and LIFO, COGS is lower and end. inv. is higher. Weighted average cost is in between FIFO and LIFO. Inventory methods Perpetual vs. Periodic Systems Perpetual: updates inv. after each purchase/sale. Periodic: records purchase/sale in "Purchases" account , inv./COGS determined at period end. LIFO reserve will increase with rising prices and stable/increasing inv. inv FIFO = inv LIFO + LIFO reserve . COGS FIFO = COGS LIFO – LIFO reserve. NI = LIFO reserve h (1-t). LIFO reserve Under LIFO, inv. purchased last is treated as if it’s sold first. LIFO liquidation occurs when a company appears to sell the inventory it purchased first. LIFO liquidation Under IFRS: Lower of cost or NRV, NRV = sales price - selling cost Under US. GAAP: Lower of cost or market (replacement cost), NRV < Market < NRV – Normal profit margin Inventory valuation 73 Long-lived assets IFRS: Annually, CV vs. recoverable amount (FV-selling cost), can be reversed US. GAAP: Tested, two steps: recoverability test, then measuring the loss, loss recoveries are prohibited Impairment Long-lived assets disclosure Fixed asset useful life, Fixed asset SV, Depreciation method, Useful calculations regarding a firm’s FA: average age, average depreciable life, remaining useful life In the year of impairment: NI lower, ROA & ROE will decrease In subsequent year: lower depreciation, NI higher, ROA & ROE will increase Impact of Impairment US GAAP: upward revaluation is prohibited, except for long lived assets held for sale IFRS : permitted Upward revaluation: A & E increase, D/E decrease, subsequent periods: Higher depreciation, Lower ROA and ROE Revaluation to FV 74 Leases transfer title bargain purchase option 75% of the asset’s economic life 90% of the fair value of the leased asset Capital lease criteria Capital lease: Sales-type lease: Manufacturer, dealer, PV of the lease payments is greater than carrying value of the leased asset (COGS) Direct financing lease Lessor: capital vs. operating lease Relative to operating leases, capital leases will make assets higher, liabilities higher, net income (early years) lower, CFO higher, CFF lower, total cash flow the same, EBIT higher Lessee: capital vs. operating lease 75 Intercorporate Investments shares are a genuine small investment for dividend/capital gains purposes <20% votes shares are to ensure a significant influence is exerted over the other company (but NOT outright control) “Affiliate/Associate” Equity Account 20 – 50% votes shares are to take over and control the company “Subsidiary” Consolidate (Purchase method) Pooling (Merger method) > 50% votes Secondary market? No Held-to-maturity securities Available-for- sale securities Trading securities Yes Debt securities which the company intends to hold to maturity Securities are carried at amortized cost May be sold to satisfy company needs Debt or equity Current or non-current Carried in the balance sheet at market value Income statement same as cost method Acquired for the purpose of selling in the near term Carried in the balance sheet as current assets at market value Income statement includes dividends, realised & unrealised gains/losses B/S Historic Cost I/S Dividends/Int 76 Equity Accounting Equity Accounting: Significant Influence “One line consolidation” Initially recorded at purchase price (cost) Subsequent periods: B/S: Cost + earnings pickup – dividends A B/S = %Share x A Retained earnings I/S: Earnings pickup (% share of NI) Purchase Price > Book Value Investment initially recorded at cost However within cost: % Net Assets Acquired %FMV adjustments Goodwill Cost paid $m X X X X FMV adjustments impact future earnings Adjust earnings for up/down stream inter group unearned profits Impairments Carrying value > Fair value Decline considered permanent No reversal (US GAAP) Reversal allowed (IAS) Upstream Profits recognized in investee I/S Unconfirmed profits – eliminate pro-rata share Downstream Profits recognized in investor I/S Unconfirmed profits – eliminate pro-rata share Fiscal years beginning post Nov 2007 IFRS 159 Can elect to hold investment at fair value with changes in fair value taken to the I/S Convergence with IAS 28/39 77 Joint Ventures Joint Ventures •Equity account: Required US GAAP Permitted IAS “one line consolidation” •Proportional consolidation recommended by IAS “line by line proportional consolidation • Report pro-rata share of all accounts, net out intercompany transfers • Make both sides of intercompany adjustments in joint venture accounts • No minority interest (consolidated on the basis of ownership not control) • The rest is as per a normal consolidation • Interest cover - overstated • Return on assets - overstated • Debt ratios skewed Stockholders equity, Net Assets and NI same under both methods Total asset and total liabilities differ Big impact on ratios 78 Consolidation (Purchase Method) Steps 1. Record any finance raised in parent company’s balance sheet 2. Record investment in subsidiary in parent’s balance sheet. (Investment recorded at purchase price) 3. Adjust subsidiary identifiable net assets to fair market value (IAS 100% of FMV adjustments, US GAAP parents share of FMV adjustments) 4. Calculate goodwill on acquisition Proceeds % Identifiable Net Assets Goodwill 5. Eliminate inter-company transactions 6. Add together assets and liabilities 100% regardless of ownership 7. Eliminate investment in parent company’s books 8. Include Common Stock and Additional Paid in capital of parent only 9. Include parents reserves and % share of any post acquisition retained earnings in the subsidiary (unlikely) 10. Calculate Minority Interest Minorities % share of Net Worth of sub (at FMV IAS, at book value US GAAP) 11. Total Balance Sheet X (X) X •Control of subsidiaries decisions: Operating/Financing/Investing •Share ownership > 50% •Reflect control not ownership 79 Goodwill Business Combination – with Less 100% Interests Allowed in both US GAAP and IFRS = consideration / % of interests acquired – fair value of net assets MI is stated (% of MI shareholders own) h(consideration / % of interests acquired) Full goodwill Only allowed under IFRS = consideration – fair value of net assets X % of interests acquired MI is stated (% of MI shareholders own) X FV of net assets Partial goodwill 80 Business Combinations Purchase Method Pooling of Interests Method US: no longer permitted (since 2001) IAS: no longer permitted (since 2003) US: required under SFAS 141 – Business Combinations IAS: required under IFRS 3 – Business Combinations Treats transaction as acquisition of target by buyer Treats transaction as merger of equals Still studied, as move from pooling to purchase has been prospective, not retrospective No goodwill No minority interest No fair value adjustment Restate prior periods Post and pre acquisition earnings pooled Combine equity Goodwill on consolidation Purchase consideration 10 % FMV (assets – liabilities) (8) Goodwill 2 Goodwill Minority Interests Fair value adjustments Post acquisition earnings 81 Impact on Accounts Cost vs.. Equity If sub earnings > 0 and sub dividend payout < 100%, parent results are more favorable under equity method: Parent earnings larger Parent cash flows the same Interest coverage and return on investment ratios higher Capital ratios lower Cost method preferred if sub is not profitable Assets and liabilities are different, but equity is the same Revenues and expenses are different (operating income), but net income is the same Reported cash flows are different Equity method includes only capital flows between parent and sub Consolidation method includes all cash flows except between parent and sub Financial ratios different Consolidation vs. Equity Proportionate Consolidation vs. Equity Method Equity, net income and ROE are the same under both methods Most other accounts and ratios change Equity method overstates ROA Equity method hides liabilities Equity method hides footnote info 82 Purchase vs.. Proportionate vs. Equity A/C Current Ratio Consolidated > Proportionate > Equity Assuming investee ratio > parents Leverage Consolidated > Proportionate > Equity Net Profit Margin Equity > Proportionate > Consolidated Gross Margin Consolidated > Proportionate > Equity Assuming investee ratio > parents Return on Assets ROA Equity > Proportionate > Consolidated Impact on Accounts Purchase vs. Pooling Assets Purchase > Pooling Equity Purchase > Pooling Assuming purchase is funded by issuing equity Net Income Purchase < Pooling Profit Margins Purchase < Pooling ROA and ROE Purchase < Pooling 83 Impairment of goodwill Identification: Measurement: Group Accounting Carrying value of reporting unit + goodwill Fair value of reporting unit > Carrying value of goodwill Implied fair value of goodwill > Fair value of reporting unit – fair value of identifiable net assets Bargain Purchase (-ve goodwill) Price < % FMV of identifiable net assets Reassess FMV of identifiable net assets US GAAP- reduce non current assets - take remainder to I/S as an extraordinary gain IAS - take as gain to I/S US GAAP & IFRS Differences In-process R&D Contingent liabilities Contingent consideration Convergence Project FMV adjustments for 100% of net assets not just purchased element Minority interest calculated using FMV In-process R&D capitalized Contingent consideration recognized at acquisition date Minority interests in equity Remaining Differences: US GAAP full goodwill IFRS full or partial goodwill 84 Special Purpose Entities A separate legal entity established by asset transfer to carry out some specific purpose Uses Access capital or manage risk Characteri -stics Issue Securitized loans, synthetic leases, sale of accounts receivable, R&D costs Thinly capitalized, lack of independent management, servicing agreements Prior to Fin 46R consolidation was based on voting rights not risk and reward of ownership Purpose VIE Criteria Fin 46R 1. Equity interest less than 10% of total assets 2. Equity investor lacks: • Decision making ability • Obligation to absorb losses • Right to receive residual returns A VIE must be consolidated in a company’s accounts if the company is the primary beneficiary (Previously only if controlled via voting rights) Variable Interests: Guarantees of debt Subordinated debt instruments Lease residual interest guarantees Participation rights Asset purchase options Qualifying SPEs US GAAP only Not consolidated if SPE: •Independent and legal separate from sponsor •Has total control over asset •May only hold financial assets •Sponsor must have limited financial risk 85 Pension Plans Employee directs investment policy Employer will appoint an investment manager Asset manageme nt Employee owns assets, employer acts as agent Employer owns assets Asset ownership Employee carries the risk Employer carries the risk Risk Defined Contribution Defined Benefit Income Statement = Employer Contribution Balance Sheet - Asset/Liability = excess or shortfall in payments relative to specified contribution level No major analyst issues Income Statement = Pension expense Balance Sheet - Asset/Liability = Cumulative payments into plan less cumulative pension expense SFAS 87 & IAS19 Post 2006 SFAS 158 Asset/Liability = Funded status Major issue for analysts PBO (Projected Benefit Obligation) Present value of all future pension payments earned to date based on expected salary increases over time. Assumes employee works until retirement. Estimate of liability on a going concern basis ABO = Accumulated Benefit Obligation VBO = Vested Benefit Obligation 86 Pensions Service cost Interest cost Actuarial gains or losses Prior service cost Benefits paid ENDING PBO -/+ -/+ + + = BEGINNING PBO X - Reconciliation disclosed in foot notes (SFAS 132) Benefits paid to retirees Fair value of plan assets at end of year Fair value of plan assets at start of year Actual return on plan assets Employer contributions Plan participant contributions Expenses X + + + - = - Reconciliation disclosed in foot notes (SFAS 132) 87 Pensions Actual Events Service Cost Interest Cost Smoothed Events (SFAS 87) Expected Return on Plan Assets Amortisation of gains/losses Amortisation of prior service costs Amortisation of transition asset or liability + + - +/- +/- +/- Reported Pension Cost X Other Events Curtailment/Settlements/ Termination +/- Pension Expense FV of Plan Assets – PBO = Funded Status FV > PBO = Overfunded FV < PBO = Underfunded Funded Status = Economic Position of Plan Funded Status ĮB/S Asset/Liability SFAS 158 Funded Status Actuarial (Gain)/Loss Prior Service Cost Net Transition Asset Balance Sheet (Liability)/Asset +/- +/- +/- +/- +/- 88 Actuarial Assumptions Lower Lower Lower Pension Expense No change No change Lower ABO No change Lower Lower PBO Higher Expected Return on Assets Lower wage rate increases Higher discount rate Actuarial Assumptions 3 main delayed events Actuarial gains & losses Prior service adjustments Transition assets & liabilities Net of: Plan Assets Actual vs.. Expected return Plan Liabilities ¨ PBO due to ¨ actuarial assumptions Amortised if net gain or loss > 10% of opening PBO or Market related plan assets value Delayed Events 89 Post 2006 SFAS 158 SFAS 158 Impact on Financial Statements Income Statement same as SFAS 87 Balance Sheet = Funded Status Adjust balance sheet asset/liability to funded status Adjust deferred tax asset Adjust comprehensive income (equity) Assuming net actuarial losses the new standard will increase the pension liability and reduce equity 90 Income Statement: Adjusted pension expense = service cost + interest cost – actual return on plan assets Alternatively = ¨ funded status + employer contribution Improvement in funded position reduced economic expense Worsening of funded position increases economic expense Required for both SFAS 87 and 158 Analyzing Pension Disclosures Balance Sheet: Replace accounting asset/liability with funded status take any change to equity NB only required for SFAS 87 not 158 Cash Flow Statement Cash flow = employer contribution into fund (ĘCFO) Contribution > Economic Expense = Principal repayment ĘCFF ĖCFO Contribution < Economic Expense = Source of funding ĖCFF ĘCFO Analyst should adjust CFO and CFF for after tax amounts Analyst Adjustment 91 Employee Compensation Employee compensation: Salary Bonus Share based compensation Managerial compensation disclosure: US GAAP - Proxy statement to SEC IAS – Accounting disclosure Share based compensation Advantages: Reduces agency problem No cash outlay Disadvantages: Dilution of EPS Employees limited influence over share price Ėownership Ėrisk aversion Stock options Ėrisk taking Dilution of existing shareholders Stock Based Appreciation Rights Payments linked to share value performance No shares held Advantages: Avoids dilution Avoids Ėrisk aversion Disadvantages: Cash outflows Expense spread over service life 92 Stock Compensation Plans Stock Options Prior to June 2005 Account APB 25 Footnote Disclosure SFAS 123 Post June 2005 Account SFAS 123 APB 25 Intrinsic value at grant date SFAS 123 Fair value at grant date (similar to IFRS 2) Disclosure Nature and extent of arrangement Method of determining fair value Impact on periods income Fair value Market premium of similar option or valuation model: BSM Binomial Monte Carlo Stock Purchase Plans Enable employees to purchase stock at a discount to market value Recognize expense over life of option if compensatory (5% rule) Service Based Awards Compensation linked to length of service Recognize expense over vesting period Performance Based Awards Non price related and price related Recognize over estimated time to meet criteria Can lead to accounting manipulation All models require 6 inputs: 1. Exercise price 2. Stock price at grant date 3. Volatility 4. Risk free rate 5. Expected term (time to expiry) 6. Dividends 93 Foreign Currency Translation Functional currency Reporting currency Local currency The currency of the primary economic environment in which the firm generates and expends cash flows. The currency in which the multi-national firm prepares its final, consolidated financial statements. For exam purposes, most likely to be the US$ The currency of the country in which the foreign subsidiary is located Temporal method of translation aka “Remeasurement” Current Rate method of translation aka “Translation” SFAS 52 Hyperinflation = cumulative 3 year inflation rate > 100% Use temporal method – prevents book value of PP&E falling Net asset position and depreciating local currency - reduces $ value of net assets ¬negative translation adjustment under current rate method Temporal method if amount of liabilities exposed to current rate exceeds exposed assets – (net liability position) a depreciating currency makes this liability smaller 94 Temporal/Remeasurement Liabilities (current) Common Stock (historic) Retained earnings (ß) Liabilities + Equity X X X X Temporal 1. Produce top of Balance Sheet (Total Assets) 2. Produce Shareholders Funds and Liabilities (retained earnings = plug figure to ensure that the balance sheet balances) 3. Produce reconciliation of retained earnings 4. Net Income in the Income Statement will be different from NI in retained earnings. The difference is the exchange gain/(loss) which is taken to the income statement Opening retained earnings Net income (ß) Dividends Closing Retained earnings X X (X) X SFAS 52 Hyperinflation = use Temporal IAS 21 Hyperinflation = use indexing Monetary assets/liabilities = current rates (cash, AR, AP, STD,LTD) Non monetary assets/liabilities = historic rates 95 Current/Translation All Current Approach 1. Produce Income Statement – translating at average rate 2. Derive closing retained earnings 3. Compute Balance Sheet 4. Top and bottom of the balance sheet will not balance. The difference is the translation gain/(loss) 5. Force the balance sheet to balance by including the adjustment on the balance sheet in the equity section Opening retained earnings NI (from income statement) Dividends Closing Retained earnings X X (X) X All assets/liabilities = current rates 96 Impact on Ratios Translation/All Current (Compared to LC) No change from translation using all- current method for pure income statement and balance sheet ratios Mixed ratios are distorted FX rate changes affect consolidated ratios, even when no “real” change occurs Comparing Temporal and All Current Process: Step 1: LC appreciating or depreciating? Step 2: Examine numerator Translated at which rate? (current, avg, historic, etc.) Will numerator be larger or smaller? Step 3: Examine denominator Same as numerator Step 4: Determine impact on ratio Remeasurement/Temporal (Compared to LC) Even pure ratios may be distorted due to mix of current and historic in B/S or average and historic in I/S Mixed ratios now a blend of current, average and historic! 97 IAS & Transaction Risk IAS 21 Similar to SFAS 52 Exceptions Integral subsidiaries – temporal method Foreign entities – all current Revaluations – historic rate at time of revaluation Hyperinflation – indexing Goodwill – current or historic rate Losses resulting from the acquisition of an asset invoiced in an overseas currency can be expensed (SFAS 52) or added to capitalized cost Transaction Gains/(Losses) Transaction recorded at spot rate Receipt or payment at a later date Issue = movements in spot rate between entering and settling a contract Gains and losses reported in income statement (no guidance to where) • Within SGA • Non-operating income/expense reduces comparability 98 The Lessons & Derivatives The lessons we learn 1. Read all info including MDA and Footnotes 2. Be sceptical – persistently higher than average growth rates 3. Understand what you are looking at: pro-forma information 4. Follow the money (cash flow and earnings divergence) 5. Understand the risks (business & financial) Derivative Accounting B/S fair value Speculatively held – gains/losses I/S Hedging purposes – location per SFAS 133 Fair Value Hedge Hedging asset/liability value Gains and losses I/S Cash flow hedge Hedging the future cash flows of a transaction Unrealized gains/losses to comprehensive income Accumulated gains/losses released to I/S when the transaction affects earnings Hedging foreign currency exposure All current – gains/losses to comprehensive income Temporal - gains/losses to I/S 99 Financial Reporting Quality Accrual vs.. Cash Accounting Cash: Transaction recorded on payment/receipt Advantages: No subjectivity/Easy to verify Accrual: Revenue/Expense triggered by earnings process Advantages: Timely and relevant information/Indication of value creating activities Disadvantages: Subjective measurement/earnings management 1. Revenue Recognition: • % completion method • Earnings activities complete • Assurance of receipt • Bill and hold • Unearned income 2. Depreciation Choices: • Method (S/L vs accel’) • UEL • Salvage value 3. Inventory Choices • FIFO/LIFO/AVCO • Normal cost • LOCOM rules 4. Goodwill • Fair value measurement • Impairments 5. Deferred Tax • Valuation allowance 6. Pension Accounting • Discount rate • Expected returns • Salary growth 7. Assets held at FMV 8. Stock Options 9. Provisions 100 Financial Reporting Quality Manipulation Incentives: Analyst Expectations Remuneration (Bonus/Stock Option) Debt Covenants Financing (raising further funds) Disciplining Mechanisms: External Auditors Internal Audit/Committee Management Certification Class Action Law Suits Regulators Market Scrutiny Earnings: Quality = persistence/sustainability Mean reversion Cash flow and accruals elements Accruals element – not sustainable Accruals – naturally self correct Richardson, Tuna, Wu – companies restating earnings have highest accruals Calculations: Aggregate Accruals Accrual based earnings NI Cash based earnings = - Net Operating Assets NOA Total assets - cash Total liabilities – total debt = - Aggregate Accruals NOA t NOA t-1 = - Aggregate Accruals NI – (CFO t + CFI t ) = - B/S based aggregate accruals Cash flow based aggregate accruals 101 Earnings Management Revenue Recognition Problems: Range of problems: Recognition of sale before completion of earnings process Recognition of sale without assurance of receipt Estimates: Credit sales Deferred/Unearned revenue Warranty provisions Sales returns Warning Signs: Large ĖAR Large ĘUnearned Revenue Lower future cash-flows and accounting rates of return Accelerating Revenue Recognition Range of problems: Recognition of sale before completion of earnings process (assessing the completion date) Lowering credit standards Cut off issues (moving sales between periods) Warning signs: Bundled products Management vested options ITM Pressure to meet earnings forecasts Raising additional finance Large ĖAR Large ĘUnearned Revenue Disproportionate revenue in last ¼ Recognizing revenue to early: Bill-and-hold sales Lessor use of sales type vs.. direct financing leases Recording sales prior to acceptance by customer (sales of equipment prior to installation) Incorrectly using % completion method for long term contracts 102 Earnings Management Classification of non operating earnings as operating: Range of problems: 1.Investment income 2.Divestiture of non current assets NB. No accrual or deferral reversal in later periods Warning signs: Temporary inconsistency of items included within definition of operating income Expense Recognition: Range of problems: Discretion over depreciation and amortization Impairment recognition Application of lower of cost and fair value rules Warning signs: of methods or lives – depreciation (disclosed in footnotes) Conference calls – additional information LIFO liquidations Inventory obsolescence Deferring Expenses: Range of problems: Capitalization of operating expenses Warning signs: ĖNet non current assets (B/S broad measure accruals) Consider asset growth in the context of expected sales and margin growth Software development costs - discretion Classification of operating expenses as non operating Range of problems: Incorrect classification reduces COGS or SG&A Warning signs: Company’s with genuine special items that can be piggy backed Changes in operating profit margin or gross margin accompanied by spikes in special items 103 Earnings Management Big Bath Provisions Range of problems: 1. Impairments – future I/S improvements via Ędepreciation 2. Restructuring or impairment charges reversed in subsequent periods 3. Use of high or low bad debt reserves out of line with peers Off Balance Sheet Items Range of problems: 1.Assets and liabilities avoiding recognition: Operating leases Sale of AR with recourse Take or pay/through put agreements Equity accounted SPVs Warning signs: SEC obligations to report future cash flow obligations of operating leases – analyst may discount to PV and restate Goodwill: Range of problems FMV adjustments on acquisition Future impairments Warning signs: Goodwill reported and not impaired for companies where market cap < book value IASB & FASB move to fair value accounting Issues: Some assets have readily identified fair values e.g. listed equity Some assets don’t have readily identified fair values (assets with no actively traded secondary markets) e.g. unlisted equity e.g. specialized equipment Valuation models = discretionary inputs 104 Modifying the Balance Sheet Unrecorded Items Special Purpose Entities Operating Leases Guarantees Contingent liabilities Recorded Items Marketable securities Accounts receivable Inventory Proportional vs.. equity a/c Property Plant and Equipment Capitalized interest Goodwill Intangibles (R&D) Redeemable Pref/Convertible Debt Long term debt Pension Liabilities (SFAS 87!) Stock Option plans (Pre SFAS 123R) Deferred Income Taxes Comprehensive Income Net Income Pension adjustments Unrealised gains and losses on available for sale securities Cumulative foreign currency translation adjustments Comprehensive Income $ X X X X X U S G A A P COGS LIFO – FIFO Capitalization of operating leases Reversal of deferred tax assets/liabilities Mark to market LTD Adjustments (not required by US GAAP) Capitalized interest reversal Off Balance sheet items Funded status of pension plan 105 Adjust COGs to LIFO Litigation or gov’t actions Discontinued ops LIFO liquidations Capitalize Op leases Capitalized interest Economic cost of pension plan Temporal gains/(losses) Normalized Earnings Normalizing Operating Earnings Discretionary accounting changes Regulated accounting changes Realised capital gains/losses Gains/losses on repurchase of debt Catastrophes Insurance settlements Strikes Impairment or restructuring Inter-firm comparisons (adjustments) Inventory methods Depreciation assumptions/methods Pension plan/Stock option assumptions Capital/operating leases Cyclical Firms Remove the impact for valuation: 1. Averages over the business cycle 2. Average ratios applies to current sales or equity 3. Regression model approach International comparisons LIFO prohibitions Extraordinary items Capitalized R&D Accelerate Dep n Asset revaluation Acquisition a/c 106 Corporate Finance Study Sessions 8 – 9 Weighting 5% – 15% 107 Overview of Level II Corp Fin Capital Budgeting Study Session 8 Capital Structure and Leverage Corporate Governance Study Session 9 Mergers and Acquisitions Dividends and Dividends Policy 108 Capital Budgeting (1) Expansion vs. replacement (see next slide) Expansion – investment to increase the business Replacement – replacement of existing equipment with newer alternatives Inflation and capital budgeting Real (or nominal) CF discounted using real discount rate (or nominal) Inflation increases company’s real taxes Higher than anticipated inflation decreases the worth of interest payments to bondholders Inflation does not affect sales and expenses equally Use cash not accounting profit Incremental cash flows only – Ignore sunk costs – Use opportunity costs –Include net working capital increases/decreases Cash flows based on opportunity costs Cash flow timing is important (time value of money) Analyze after-tax cash flows Financing costs reflected in required return Depreciation methods and cash flows Accelerated methods provide higher tax savings and hence better cash flows in the earlier years compared to straight line methods Example of accelerated method – MACRS Comparing projects with unequal lives Least common multiple of lives approach – look at NPVs over a common life Equivalent Annual Annuity – find the annuity (PMT) that equates the NPVs at the cost of capital 109 Expansion vs. replacement projects Expansion Projects – investment to increase the business 1. Initial cash outflow = FCInv + NWCInv 2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax rate) + Depn 3. Terminal year non-operating cash flow = Cash proceeds from sale of FCInv + NWCInv – tax rate x (Cash proceeds – BV of FCInv Termination) Replacement projects – replacement of existing equipment with newer alternatives 1. Initial cash outflow = FCInv + NWCInv – Cash proceeds of old asset + tax rate x (Cash proceeds – book value of old asset) 2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax rate) + Depn 3. Terminal year non-operating cash flow = (Cash proceeds from sale of FCInv + NWCInv – tax rate x (Cash proceeds – BV of FCInv Termination) 110 Stand-alone – the project’s individual risk Sensitivity to e.g. assumed sales Best/worst scenario analysis Monte Carlo simulation – random lots of scenarios – generate probability distribution for NPV and IRR Capital rationing Management constraint on the size of the capital budget Optimal choice is to select investments that maximize the overall NPV within the capital budget Using SML in Capital budgeting (Based on £) K project required return = K RF + (K mkt – K RF ) £ project K project required return = discount rate to discount project cash flow Use of project beta to calculate required return when project risk is different from the company Real Options Real options are options that allow managers to make decisions at a later date where these decisions are dependent upon future events or information Examples: Timing options; sizing options; flexibility options and fundamental options Real option analysis Work out the NPV without including the real options. If the NPV is positive, accept the project. There is no need to consider the real options if these options enhance the project value. Work out the NPV based on estimated future cash flows. Then add the value of the real options. This approach is useful when the NPV is negative. Capital Budgeting (2) 111 Capital Budgeting (3) Economic versus accounting income Economic income = cash flow + change in market value NB: Change in MV = Ending MV – Beginning MV or Economic income = cash flow – economic depreciation Accounting income differs from economic income in the following ways: Accounting depreciation is based on initial cost of the investment and reflects the decline in the book value. Economic depreciation reflects the decline in the market value of the investment. Interest expense is included in accounting income but ignored in economic income. Other valuation models Economic profit (EP) = NOPAT - $WACC = EBIT(1 – t) – [WACC x Capital] NPV = MVA = sum of PV of all future EPs discounted at WACC Residual income: RI t = NI t – r e B t-1 NPV = sum of PV of all future RIs discounted at cost of equity Claims valuation – looks at the cash flows to debt holders and equity holders. The sum of the PV of these cash flows equal project NPV 112 Capital structure Objective of capital structure decision is to maximise firm value and minimises the WACC Taxes and its impact on value of the firm & re Interest are tax deductible, debt capital provides a tax shield that increases the value of a company. Proposition I (with taxes): value is maximised at 100% debt Value of a leveraged firm = value of an ungeared firm + value of the tax shield Proposition II (with taxes): WACC is minimised at 100% debt With tax, WACC is Cost of equity is ( ) e d a r V E t 1 r V D r | . | \ | + ÷ | . | \ | = ( ) t 1 E D r r r r d a a e ÷ | . | \ | ÷ + = ) ( MM Proposition without taxes Proposition I: Capital structure decision does not affect the company’s market value MM assumed no taxes and no cost of bankruptcy Value of ungeared firm = value of a leveraged firm Proposition II: The cost of equity is linearly related to the firm’s debt to equity ratio Without taxes, WACC is Cost of equity is As D/E increases, cost of equity would increase e d a r V E r V D r | . | \ | + | . | \ | = | . | \ | ÷ + = E D r r r r d a a e ) ( D/E C o s t o f c a p i t a l r d WACC r e MM no tax D/E C o s t o f c a p i t a l r d WACC r e MM with taxes 113 Debt financing: other issues (1) In reality, the value of a leveraged firm is affected by factors other than the interest on the debt. These factors are: Agency costs Agency costs of equity – conflicts between equity owners and managers who managed the company. The net agency costs of equity include: Monitoring cost – incurred by shareholders to supervise the managers. Bonding costs – incurred by management to assure shareholders that they are working for shareholders’ interests. Residual loss – incurred even though there is monitoring and bonding systems in place as these systems are not flawless Theory says that if a firm uses more debt, it would reduce the net agency costs of equity. Financial distress costs Costs of financial distress and bankruptcy can be direct or indirect costs. Probability of bankruptcy Higher operating or financial leverage leads to higher probability of financial distress Cost of asymmetric information Managers of the firm have better information compared to outsiders. Valuation implications: Stock offering ¬ negative signal Debt offering ¬positive signal Pecking order theory says that mangers choose financing methods that are the least observable signals to the most apparent signals. Manager prefers to use internally generated funds, then debt and finally equity. 114 Static trade-off theory Under the static trade-off theory, as higher proportion of debt is being used, there exist a point where the benefit arising from the use of debt (i.e. tax shield) is offset by the costs of financial distress. An optimal capital structure exists where the value of the firm is maximized. The optimal capital structure is a function of many factors V ungeared V Leveraged Max firm value M V o f f i r m Debt ratio Optimal Debt ratio PV tax shields Cost of financial distress C o s t o f c a p i t a l Optimal D/E ratio D/E ratio r d WACC r e Between 0% and 100% Implications for managers’ decisions MM I (No Taxes): Capital structure irrelevant MM I (With Taxes): 100% debt maximizes value Pecking order theory: Capital structure is by-product of individual financing choices Static trade-off theory: Trade off cheaper debt financing with costs of financial distress; optimal capital structure between 0% and 100% 115 Debt financing: other issues (2) Target Capital Structure Used when making decisions on raising new finance For managers maximizing firm value target = optimal capital structure Practice – fluctuation around target: Exploitation of opportunities in a specific financing source Fluctuating debt/equity markets affecting weightings Capital Structure and Valuation Analyst considerations: Changes in capital structure over time Capital structure of competitors with similar business risk Factors effecting agency cost – corporate governance International Difference in Leverage Japan/France more debt than US/UK Debt maturity – longer in US than Japan Developed markets have more total debt and longer maturity than emerging markets Institutional/Legal Factors • Strength of legal system • Information asymmetry • Taxes Financial Markets/Banking System • Liquidity • Reliance on banking system • Institutional Investor presence Macroeconomic Factors • Inflation • GDP growth Debt Rating Agencies Cost of capital tied to debt ratings Goals for achieving certain ratings may effect capital structure 116 Dividends and dividend policy (1) Factors affecting dividend payout policy Taxation of dividends Flotation costs of a new issue Restrictions on dividend payments Signalling effects Clientele effects Taxation of dividends: Double taxation and split rate systems: Effective tax rate = corporate tax + (1 – corp tax) x individual tax Split tax rate – use corporate tax rate for distributed income Imputation system – div taxed only at shareholders’ rate Signalling effect: • Dividend initiation – mixed view • Unanticipated dividend increase – signal strong future prospects • Unanticipated dividend decrease – negative signal Residual dividend model Dividend = actual earnings minus the equity portion of firm’s capital budget Advantages: simple to use; investment opportunities considered independent of the dividend Disadvantages: unstable dividend payments; uncertainty as to dividend increases investors assessment of risk 117 Dividends and dividend policy (2) Pay a specific % of total earnings over long- term Focus on steady $ payout – even though earnings may be volatile In practice this increases with the long term rate of growth of the company Longer term forecast of capital budget is determined – excess earnings over this period are then spread more evenly each year Easy to use BUT Investors may prefer stable dividends Target payout ratio Dividend stability Longer-term residual dividend Residual Dividend Dividend using the target payout approach: | | | | | | | | | | × × | | | | \ . \ . \ . \ . expected target previous adjustment expected dividend = + increase payout dividend factor in EPS ratio 118 Dividends and dividend policy (3) Investors will prefer NOT to receive dividends due to their higher tax rates. Low dividend payout policy will be rewarded. Evidence shows K s decreases as payout ratio increases – investors are rewarding the certainty of near term dividends with a lower level of risk. Higher dividend payout policy will be rewarded. Dividends can be manufactured – sell a little bit of stock to get the cash you want. Theory requires a number of assumptions. Policy has NO effect on value. The tax aversion theory The bird-in-the-hand theory Dividend irrelevance theory Rationales for stock repurchases Signal that future outlook is good Share dilution due to exercise of stock options Distribute cash Company views its own stock as good investment Change the capital structure Dividend initiation Based on dividend preference theory Dividend initiation Lower risk Lower cost of equity Higher PE ratio 119 Corporate governance (1) Definition: The system of principles, policies, procedures and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts inherent in the corporate form” (McEnally and Kim) Objectives: Eliminate or reduce conflicts of interest Use the company’s assets properly An effective system will: Define the rights of shareholders (and other important stakeholders) Define and communicate to stakeholders the oversight responsibilities of managers and directors Provide fair and equitable treatment in all dealings between managers, directors and shareholders Have complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position 120 Corporate governance (2) Corporate shareholders have no input in the day to day mgmt of the firm – this lack of control can create conflict between managers and shareholders Similar to sole proprietors – conflicts between partners are dealt with by implementing a partnership agreement Since owners and managers are one in the same no conflict exists here. Conflicts mainly involve creditors and suppliers Distinct legal entities – managers act as agents of co. Two or more owner managers Owned and operated by a single individual Corporations Partnership Sole Proprietorship Managers and shareholders Management may act in their best interests not those of the shareholders Using funds to expand the size of the firm Granting excessive compensation and perquisites Investing in risky ventures Not taking enough risk Directors and shareholders Directors may align more closely with managers than shareholders Lack of independence Board members with personal relationships with managers Board members having consulting or other business agreements with the firm Interlinked boards Directors are over compensated Agency Relationships Conflicts of Interest 121 Corporate governance (3) Determining the effectiveness of the Board Composition of board: 75% of directors independent Independent chairman on board (not CEO) Qualifications of directors How board elected (annual elections) Board self-assessment practices Frequency of separate sessions for independent directors (annually) Audit committee and audit oversight (only independent directors) Nominating committee (only independent directors) Compensation committee and management compensation (mostly performance-based) Use of independent and expert legal counsel Statement of governance policies Disclosure and transparency (more disclosure is better) Insider or related-party transactions (board approval for related-party transactions) Responsiveness to shareholder proxy votes 122 Corporate governance (4) Board Of Directors The board of directors have a responsibility to: Institute corporate values Ensure firm complies with all legal and regulatory requirements Create long term strategic objectives Determine management’s responsibilities Evaluate the performance of the CEO Require management to supply the board with complete and accurate information Meet regularly Ensure board members are adequately trained Investors and analysts should assess the following policies of corporate governance: Codes of ethics Directors’ oversight, monitoring and review responsibilities Management’s responsibility to the board Reports of directors’ oversight and review of management Board self-assessments Management performance assessments Directors’ training Corporate Governance and Company Value Firms with strong/effective governance systems exhibit: Higher measures of profitability Higher returns for shareholders Weak/ineffective governance system: Increased risk to investors Reduced value Extreme cases: bankruptcy 123 Mergers and acquisitions Acquisition: One company buys only part of another company Merger: One company absorbs another company entirely Forms of integration Statutory merger: target company ceases to exist Subsidiary merger: target company becomes a subsidiary of the acquirer Consolidation: acquirer and target form a completely new company Types of Merger Acquirer Forward integration Horizontal Conglomerate Brewery Another Brewery Pubs Training Hops Farms Merger motivations Synergies Achieving more rapid growth Increased market power Gaining access to unique capabilities Diversification Bootstrapping Personal benefits for managers Tax benefits Unlocking hidden values Achieving international business goals Bootstrapping EPS A way of packaging earnings from two companies after a merger Increase in earnings per share Real economic gains are not necessarily achieved Occurs when a firm with a high P/E ratio acquires a firm with a low P/E ratio Backward integration 124 Industry life cycle and common mergers Mature growth phase: ~ Industry characteristics: reduced profit margins due to new competition, but potential still exists for above average growth ~ Merger motivation: efficiency, economies of scale/synergies ~ Horizontal and vertical Stabilization phase: ~ Industry characteristics: competition has reduced most of industry’s growth potential ~ Merger motivation: economies of scale, reduced costs, improve management ~ Horizontal Decline phase: ~ Industry characteristics: declining profit margins, overcapacity, and lower demand due to shifts in consumer tastes ~ Merger motivation: survival, operating efficiencies, new growth opportunities ~ Horizontal, vertical, and conglomerate Pioneer/development phase: ~ Industry characteristics: uncertain of product acceptance, low profit margins, and large capital requirements ~ Merger motivation: access to capital, management talent ~ conglomerate and horizontal Rapid growth phase: ~ Industry characteristics: high profit margins, accelerating sales, and earnings, but still low industry competition ~ Merger motivation: access to capital, expand growth capacity ~ conglomerate and horizontal 125 Mergers transaction characteristics Comparing Forms of Acquisition Friendly merger offers Acquirer approaches management Negotiations and due diligence Definitive merger agreement Public announcement and shareholders vote Attitude of target management Usually avoids assuming Acquirer assumes Liabilities None S/H pay CG S/H taxes Target pays CG None Corporate taxes None for “small” Shareholders Approval To target To shareholder Payment Asset Purchase Stock Purchase Hostile merger offers Acquirer submits proposal to board of directors Successful Unsuccessful Tender offer Proxy battle Offer made to shareholders Proxy solicitation 126 Takeover defense & HHI Pre-offer defense mechanisms Poison pill: flip-in pill and flip-over pill Poison put States with restrictive takeover laws Staggered board Restricted voting rights Supermajority voting provision for mergers Fair price amendment Golden parachutes Post-offer defense mechanisms “Just say no” defense Litigation Greenmail Share repurchase Leveraged recapitalization Crown jewel defense Pac-man defense White knight defense White squire defense Virtually certain 50 or more High > 1800 Possible 100 or more Moderate Between 1000 & 1800 No action Any amount Not concentrated < 1000 Antitrust Action Change in HHI Industry Concentration Post merger HHI Herfindahl- Hirschman Index Key measure of market power for determining anti-trust violations n 2 i i=1 HHI = (MS ? 100) ¯ 127 Valuing a target company (1) Discounted cash flow method Similar to FCFF approach in SS 12 Determine free cash flows available to investors after necessary expenditures Choose appropriate discount rate (target company WACC adjusted for merger effects) Discount cash flows back to the present Determine terminal value – constant growth or market multiple Comparable transaction analysis Also uses relative value metrics for comparables Comparables are recent takeover transactions, not just comparable firms! No need to calculate separate takeover premium 3 methods to evaluate a target company Comparable company analysis Uses relative value metrics from similar firms Adds a takeover premium to determine fair price to pay 128 Valuing a target company (2) Discounted cash flow method Advantages Easy to model changes in cash flow from synergies Using forecasts avoids biases that may exist in current market data Model is easy to customize Disadvantages Model is difficult to apply when free cash flows are negative (rapid growth firm) Estimation error – terminal value Changing discount rates can have large impact on estimate Comparable transaction analysis Advantages No need to estimate a takeover premium Estimates of value are derived directly from recent deal prices Disadvantages Assumes past M&A transactions were accurately valued May not be enough comparable transactions available Difficult to incorporate synergies or changing capital structures into analysis 3 methods to evaluate a target company Comparable company analysis Advantages Easy access to data Estimates of value are derived from the market (reduces estimation error) Disadvantages Assumes market is valuing comparable firms correctly Must determine takeover premium separately Difficult to incorporate synergies or changing capital structures Historical data used to estimate a takeover premium may not be timely 129 Evaluating a merger bid Post-merger value of an acquirer: V AT = V A + V T + S – C Gains accrued to the target: Gain T = TP = P T – V T Gains accrued to the acquirer: Gain A = S – TP = S – (P T – V T ) Adjustment for stock payment: P T = (N hP AT ) where: N = number of new shares target receives P AT = price per share after merger announced Effect of Payment Cash offer Acquirer assumes the risk and receives the potential reward Gain for target shareholders is limited If synergies more than expected, takeover premium for target is fixed, so acquirer wins If synergies less than expected, acquirer loses Stock offer Some of the risks and potential rewards shift to the target firm Target shareholders will own part of acquiring firm Confident synergies will be realized Acquirer wants to pay cash; target wants stock to participate in upside Lack of confidence in synergy estimates Acquirer wants to pay in stock to share risk; target wants cash to lock in any gains 130 Mergers benefits & restructuring Distribution of merger benefits Short-term effect on stock price Targets gain approximately 30% Acquirer’s lose between 1% and 3% Long-term effect on stock price Acquirers tend to underperform Failure to capture promised synergies Corporate restructuring Divestitures: Selling, liquidating, or spinning off a division or subsidiary Equity carve-outs: creates a new, independent company; sell shares to outside stockholders through a public offering Spin-offs: create a new, independent company; distribute shares to parent company shareholders – no cash for parent Split-offs: existing shareholders must exchange shares for shares of new division Liquidations: break up the firm and sell its assets piece by piece Reasons for divestitures Division no longer fits into management’s long-term strategy Lack of profitability Reverse synergy – individual parts are worth more than the whole Infusion of cash 131 Equity Investments Study Sessions 10,11 &12 Weighting 20 -30% 132 Equity Investments - Overview Valuation process Residual Income Valuation Market-Based Valuation: Price Multiples Free Cash Flow Valuation Valuation in Emerging Markets Return concepts Industry Analysis Five competitive forces Discounted Dividend Valuation Private Company Valuation A note on asset valuation 133 Graham and Dodd 1934 – 1962 Value should be independent of price Financial statement analysis, earnings power, growth prospects Relative valuation methods “Blocking and tackling” A Note on Asset Valuation John Burr Williams (1938) Value is the present value of cash flows at an “opportunity cost of capital” Discount rate was not clearly defined DDM and FCF models Forward-looking Modern Portfolio Theory (1959) Harry Markowitz (Portfolio Selection): Value includes growth and risk, efficient frontier dominates other portfolios, covariance is key, diversification is a free lunch William Sharpe: Cost of capital is function of systematic, non-diversifiable risk Unsystematic risk can be diversified away Developed CAPM Modern Valuation Techniques Fixed income: PV of coupons and par value discounted by YTM Common stock: PV of future cash flows discounted by the required return DDM: PV of expected dividends FCFF: discounted at WACC FCFE: required return on equity Relative value: earnings ͪ multiplier Residual income: current book value + PV of expected economic profit 134 Uses: • Stock selection • Reading the market • Projecting the value of corporate actions • Fairness opinions • Planning and consulting • Communications with analysts and investors • Valuation of private business • Portfolio construction and management Valuation = the estimation of an asset’s value Absolute – based on variables perceived to be related to future investment returns Relative – based on comparisons with similar assets Inputs – should be qualitative as well as quantitative Valuation Process - Overview 1. Understand the business 2. Forecast business performance 3. Select the relevant valuation model(s) 4. Convert forecasts to a valuation 5. Make the recommendation or investment decision Critical step that involves financial statement analysis (including quality of earnings analysis) combined with an evaluation of industry prospects, competitive position and corporate strategies. Valuation Process 135 Industry Competitive Analysis Five Elements of Industry structure: Threat of new entrants, Threat of substitutes, Bargaining power of Buyers, Bargaining power of Suppliers, Rivalry among Existing Competition Three Generic Strategies: Cost Leadership, Product Differentiation, Focus Valuation Process Importance of F/S Footnotes Footnotes reveal management’s discretion in choices of accounting methods and estimates Analyst’s ability to accurately forecast result derived from quality inputs Greater transparency in earnings results in higher stock price—management’s ultimate goal Accounting Shenanigans Accelerating or Premature Recognition of Income Reclassifying gains and non-operating income Expense recognition and losses Amortization, depreciation, and discount rates Off-balance sheet issues Considerations in Valuation Fits the Characteristics of the Company (Does it pay dividends? Is earnings growth estimable? Does it has significant intangible assets) Is appropriate based on the quality and availability of input data Is suitable given the purpose of the analysis Considering only one model is not good 136 Perceived mispricing • = any difference between the analyst’s estimate of intrinsic value and the market price • reflected in the abnormal return, alpha, the analyst expects to earn. Ex ante alpha = expected holding-period return – required return Ex post alpha is used to assess the success of the analyst’s strategy = actual holding-period return - contemporaneous required return Model selected must be: • consistent with the characteristics of the company being valued; • appropriate given the availability and quality of data; • consistent with the purpose of valuation, including the analyst’s ownership perspective (i.e. extent of the investor’s influence over the company). Valuation Process Ownership Perspective Marketable publicly traded minority interest—DDM approach is the benchmark value Premiums for control—FCFE approach Discounts for lack of marketability for non-publicly traded stocks Discounts for lack of liquidity for publicly traded stocks 137 Different Returns/Rates • Holding Period Return, Realized Return, Expected Return, Required Return, Return from Price Convergence, Discount Rate, Internal Rate of Return Return Concepts Ways of Measuring the Required Return • Multifactor Models Req’d Return=(factor sensitivity) i *(factor risk premium) i + …. + (factor sensitivity) n *(factor risk premium) n CAPM: ( ) ( ) f m f r r E ȕ r E(r) ÷ × + = “equity risk premium” 138 Return Concepts Ways of Measuring the Required Return Fama – French Model Req’d return on stock j = R f + b mkt ,*(R mkt – R f ) + b SMB,j *(R SMALL -R BIG ) + b HML,j *(R HBM -R LBM ) R mkt – R f = return on a value weighted market index minus risk free rate R SMALL -R BIG =small cap return premium R HBM -R LBM =value return premium Pastor-Stambaugh Model Builds on the Fama French Model by adding a liquidity factor Macroeconomic Multifactor Models e.g. Burmeister, Roll and Ross Model Uses economic variables believed to affect cash flows as factors within the model. 139 Return Concepts Ways of Measuring the Required Return Build-Up Method Req’d return =R f + Equity risk premium + size premiuim + specific company premium Bond Yield Plus Risk Premium Req’d return =YTM on long term debt + risk premium Country Spread Model and Country Risk Rating Model Calculates the premium to be added to the req’d return when investing in emerging mkts 140 Return Concepts Estimating Beta Public Companies Use regression of company stock returns against the market Adjust for beta drift by using adjusted beta Adjusted beta=(2/3)*regression beta + (1/3)*1 Thinly traded/non public companies Estimated beta for ABC=unlevered beta of similar quoted company * (1+(debt of ABC/equity of ABC)) Unlevered beta of similar quoted company = Beta of similar co.* 1/[1+(debt of similar co/equity of similar co)] 141 Return Concepts Estimating Equity Risk Premium using….. Historical estimates Strengths: •Objective. Simple, unbiased if investors rational Weaknesses: •Assumes mean and variance are stationary •Different ways of calculating mean return (geometric, arithmetic) •Different ways of estimating risk free rate (can use long or short term bonds) 142 Return Concepts Estimating Equity Risk Premium using….. Forward looking / Ex Ante estimates Strengths: •Doesn’t depend on assumption of stationarity 3 Types….. Gordons Growth Model Strengths Assumptions used are reasonable and inputs to the model can easily be sourced Weaknesses • This estimate will change over time and needs updating, assumes stable growth Supply Side Estimates Strengths: • Uses proven models and current information Weaknesses: • Only appropriate for developed countries Survey Estimates Strengths: • Uses expert opinions and more likely to be reliable Weaknesses • There maybe large differences of opinion 143 Porter’s 5 forces Top-down forecasting 1. Macroeconomic 2. Industry 3. Company Understanding the business • How attractive are the industries in which the company operates, in terms of offering prospects for sustained profitability? • What is the company’s relative competitive position within its industry? • What is the company’s competitive strategy? 3. 2. 1. FIRM RIVALRY SUPPLIERS BUYERS SUBSTITUTES Bargaining power Threat of substitute products or services Threat of new entrants Bargaining power POTENTIAL ENTRANTS Industry and Company Analysis 144 Risks of each generic strategy Cost Leadership • New entrant enters market with lower cost base and/or technological breakthrough reduces rivals production cost Differentiator • Consumers cease to value differentiating factor and/or rival company does it better Niche • Interest in niche from big players and/or smaller players target sub-sectors of niche Cost Leadership Differentiation Narrow Target Broad Target Focus Competitive Advantage Low costs in all market segments • economies of scale • proprietary technology • pref. access to raw materials Satisfy particular consumer needs • product/delivery/marketing • premium pricing A focuser will be an above average performer if it can achieve product differentiation in its chosen sub-sector A focuser will be an above average performer if it can achieve cost leadership in its chosen sub-sector Competitive Strategies 145 Industry life cycle Industry life cycle phases Pioneer - Acceptance of the product or service uncertain, implementation of business strategy is unclear. Period of high risk with many failures. Growth – Acceptance of the product or service established. Accelerating sales and earnings. Industry growth faster than the general economy. Profit margins above average. Mature – Industry growth corresponds to the growth of the general economy. Participants compete for share in stable industry. Decline – Demand for the industry’s product steadily decreases due to shifting tastes or technologies. Profit margins are diminished. Classification by business cycle reaction • Growth Industry Stocks - experience accelerating sales and high profit margins during all phases of the business cycle • Defensive Industry Stocks - product demand independent of the business cycle, therefore less cyclical than the overall market • Cyclical Industry Stocks - product demand tends to vary directly with the business cycle S a l e s Time Growth Maturity Decline Pioneer Business and Industry Life Cycles 146 Industry External Factors • Technology • Government • Social changes • Demographics • Foreign influences Supply analysis • In the long term, demand will equate to supply • In the short term, there could be shortfalls in supply due to long lead times etc Demand analysis An analyst is in a position to assess future demand for the industry’s output by developing • A macroeconomic forecast • An industry classification • An external factor review Two additional sources of information • A study of the firm’s customers • A study of the industry’s inputs and outputs Factors influencing pricing practices and hence profitability • Product segmentation - Firm’s ability to differentiate its product over various market segments. • Concentration – The greater the concentration, the greater the likelihood of collusion. • Ease of industry entry – Greater ease of entry ÷prices toward the marginal cost. • Supply input price – Changes in resource prices will have major implications of profitability. Industry Analysis 147 Dealing with inflation in emerging market valuation Country Risk Premium •No satisfactory method for estimation •Premium is often overstated Real valuation approach Nominal valuation approach Incorporating EM risks Adjust the required return by adding a country risk premium Adjust the cash flows in a scenario analysis (preferred) Valuation in Emerging Markets 148 Generic DCF model return of rate required r t time at flow cash expected CF 0) (t today asset the of value V where t 0 = = = = ( ) ¯ · = + = 1 t t t 0 r 1 CF V Consider using dividends for CF when: • there is a dividend record to analyze; • the dividend policy established by the board bears an understandable and consistent relationship to the company’s profitability; • the investor takes a non-control perspective. DCF 149 Generic DDM equity on return required r t time at dividend expected D 0) (t today share the of value V where t 0 = = = = ( ) ¯ · = + = 1 t t t 0 r 1 D V No growth model r E) (or D V 0 = Holding period of n years Single Holding Period ( ) 1 1 1 0 r 1 P D V + + = t time at price share P where t = Expected HPR 0 1 0 1 P D P P r + ÷ = ( ) ( ) ( ) n n n 2 2 1 1 0 r 1 P D ... r 1 D r 1 D V + + + + + + + = Present value of growth opportunities = market value of share - no growth value per share Gordon growth model ( ) g r D g r g 1 D V 1 0 0 ÷ = ÷ + = Two-stage DDM ( ) ( ) n n n 1 t t t 0 r 1 V r 1 D V + + + = ¯ = H-model H = half the number of years for anticipated decline in growth ( ) ( ) L L S 0 L L 0 g r g g H D g r g 1 D ÷ ÷ × + ÷ + Dividend Discount Models 150 Gordon growth model Strengths: • Suitable for stable, mature, dividend paying firms • Easily applied to indices • Easily communicated & explained • Can be used to determine growth rates, rates of return and PVGO • Supplements other methods Limitations: • Very sensitive to inputs • Not easily applied to non- dividend paying stocks • Unpredictable growth patterns makes using the model difficult Problem with two-stage model with constant growth in both stages Assumption that a firm’s high growth rate will suddenly drop to a lower level overnight is highly unrealistic. Improvement built into H-model Over a set time the high initial growth will decline in a linear fashion to the sustainable long-term growth rate Rationale for three-stage model • With a good product, some companies may sustain a high growth rate in the short-term • The business is most likely to go through a growth phase, transitional phase, then mature phase Spreadsheet approach Used when even the three-stage DVM is too simple for a real-life application DCF Commentary 151 Multi-stage models Strengths: • Flexibility • Can calculate implied growth rates or required returns • Can incorporate the impact of different assumptions into the model • Relatively easy to construct using spreadsheet software Limitations: • Estimates are only as good as the inputs used • Model must be fully understood to arrive at accurate estimates • Estimates are very sensitive to assumptions regarding growth and the required return • Formula and data input can lead to errors that are difficult to identify Sustainable growth rate Rate at which earnings (and dividends) can continue to grow indefinitely, assuming that the firm’s leverage is unchanged and no new equity finance is raised. Estimating return on equity (ROE) Equity Assets x Assets Sales x Sales EBIT EBIT EBT EBT Income Net Equity Income Net ROE × × = = Further Aspects g = b x ROE Where: b = retention rate ROE = expected return on equity 152 • FCFs are not published but need to be computed from published financial statements • Free means after fulfilling all obligations and without impacting on the future growth plans of the company Free Cash Flows to Equity (FCFE) = net income f non-cash items in income statement - investment in working capital - investment in fixed assets + net increase in debt or = CFO* - investment in fixed assets + net increase in debt * Assuming interest received and paid and dividends received have been classified as an operating cash flow as required under US GAAP Free Cash Flows to the Firm (FCFF) = net income f non-cash items in income statement + interest expense x (1 – tax rate) - investment in working capital - investment in fixed assets or = CFO + interest expense x (1 – tax rate) - investment in fixed assets or = FCFE + interest expense x (1 - tax rate) – net increase in debt NB: May be given EBIT or EBITDA as starting point for FCFE or FCFF calculations FCF Models 153 Calculation of WACC is covered in Corporate Finance ( ) ¯ · = + = 1 t t t r 1 FCFE value Equity ( ) ¯ · = + = 1 t t t WACC 1 FCFF value Firm Equity Debt capital. the providing is whom of regardless operations s firm' the of value total the represents This value". enterprise " as to referred Often Constant growth models: ( ) ( ) g WACC g 1 FCFF value Firm g r g 1 FCFE value Equity 0 0 ÷ + = ÷ + = Generic 2-stage model: ( ) ( ) n 1 n n 1 t t t 0 r 1 1 g r FCF r 1 FCF V + ÷ + + = + = ¯ Forecasting FCF - Apply a growth rate to most recent reported free cash flow or forecast each component separately. Sensitivity Analysis – Often utilized to assess the impact of uncertain assumptions. FCF Models 154 Preferred to DDM when: • Firm pays no dividends. • Firm is paying dividends but dividends differ significantly from the firm’s capacity to pay dividends – i.e. dividends imperfectly signal the firm’s long-run profitability. • Free cash flows appear to be better aligned with profitability over the analyst’s forecast period. • Investor takes a control perspective since the firm is being analyzed as a takeover target FCFE v FCFF models For firms with relatively stable leverage, FCFE is more direct and easier to use. Situations where the FCFF approach is more useful include: • proposed purchase of entire firm (i.e. equity and debt capital) with a subsequent reorganization of the capital structure. • firms where FCFE is negative. • firms with history of leverage changes – FCFF may be more meaningful than an ever-changing growth pattern in FCFE. Free cash flow proxies Both net income and EBITDA are regarded as fairly poor proxies since: • both ignore the important distinction between profit and cash flow • both ignore the reinvestment of earnings needed for growth • EBITDA ignores the tax that the firm needs to pay before any distribution to investors FCF Further Aspects 155 Overview • Price multiples are ratios of a stock’s market price to some measure of value per share. • Method of comparables involves comparing a stock’s price multiple to a benchmark multiple to determine whether or not the stock is appropriately valued. • Method based on forecasted fundamentals relates multiples to company fundamentals using a discounted cash flow model. • A justified price multiple is a multiple justified by an analyst based on either of the above methods. P/E multiple • Earnings may not exist or be negative • Need to adjust “book” earnings to sustainable or recurring earnings • Management discretion with accounting practices distort earnings and affect comparability of P/Es across companies • Earnings power is the primary driver of investment value • P/E ratio is a popular measure with investors • Empirical research shows that P/Es may be related to differences in long- run average stock returns Drawbacks of using P/E: Rationales for using P/E: Price Multiples 156 P/E ratio based on fundamentals g r b 1 g r E D E P P/E Leading 1 1 1 0 ÷ ÷ = ÷ = = ( )( ) g r g 1 b 1 g r E g) (1 D E P P/E Trailing 1 1 0 0 ÷ + ÷ = ÷ + = = Methods used to find normalized earnings for cyclical businesses: • Method of historical average EPS – use the average EPS over the most recent full cycle • Method of average return on equity – use the average ROE (based on the most recent full cycle) multiplied by the current book value per share Value = earnings x P/E ratio P/E multiple increases if: • growth rate increases • firm’s risk level decreases causing the required return to decrease • interest rates decrease causing the required return to decrease • payout ratio increases (although g will also be negatively affected) Determining earnings Analyst may adjust for: • company specific transitory, nonrecurring components* • transitory components due to business or industry cyclicality • accounting method differences* • potential dilution (e.g. due to options and convertibles) Valuation using P/E 157 Steps for valuation using comparables 1. Select and calculate the price multiple that will be used in the comparison. 2. Select the comparison asset or assets. 3. Calculate the benchmark value of the multiple, i.e. the mean or median value of the multiple for the comparison assets. 4. Compare the stock’s actual multiple with the benchmark value. 5. If possible, assess whether differences in the fundamental determinants of the price multiple explain any of the difference in 4 and modify conclusions accordingly. P/E to growth ratio • Step 5 above could involve calculating the P/E-to-g (PEG) ratio. • A high P/E should be justified by high growth – so this ratio should be roughly constant for all firms in a sector. • A high ratio may indicate an overpriced share, a low ratio an under priced share. PEG Ratio 158 Value = book value x P/B ratio • relies on consistent application of accounting standards • not good for firms with off Balance Sheet human capital • depreciated historical cost of assets may be different across similar firms due to the age of the assets • book value more stable than EPS • works with zero or negative earnings • for some firms, book values of assets may approximate market values • empirical evidence suggests differences in P/Bs may be related to differences in long-run average returns Drawbacks of using P/B: Rationales for using P/B: Fundamental P/B g r g ROE B P 0 0 ÷ ÷ = P/B multiple increases if: • growth rate increases • firm’s risk level decreases causing the required return to decrease • interest rates decrease causing the required return to decrease • ROE increases Book value of equity is: • net assets; or • shareholders’ funds P/B Ratios 159 Value = sales x P/S ratio • fails to highlight cost control issues within a firm • does not reflect differences in cost structures among different companies • meaningful even if EPS is negative • sales figures less subject to manipulation • less volatile than P/E • viewed as appropriate for valuing the stock of mature, cyclical and zero-income companies • research suggests that differences in P/Ss may be related to differences in long-run average returns Drawbacks of using P/S: Rationales for using P/S: Fundamental P/S E/S = profit margin P/S multiple increases if: • growth rate increases • payout rate increases, but …. • profit margin increases • firm’s risk level decreases causing the required return to decrease • interest rates decrease causing the required return to decrease ( )( ) g r g 1 b 1 S E S P 0 0 0 0 ÷ + ÷ | . | \ | = P/S Ratios 160 Value = cash flow x P/CF ratio • certain cash flows are ignored if proxies are used such as EPS plus non-cash charges • FCFE is superior for valuation but introduces volatility problems and may also be negative at certain times • addresses the issue of differences in accounting conservatism between companies (quality of earnings) • cash flows less subject to manipulation than earnings • less volatile than P/E since CF tends to be more stable than earnings • research suggests that differences in P/CFs may be related to differences in long-run average returns Drawbacks of using P/CF: Rationales for using P/CF: Fundamental P/CF Measures of cash flows that may be used: CFO = cash flow from operations FCFE = free cash flow to equity CF = earnings plus non fcash charges or income EBITDA = earnings before interest, tax, depreciation and amortization measure flow cash Chosen model FCFE from equity of Value CF P 0 0 = P/CF Ratios 161 • focus on D/P is incomplete as it ignores capital appreciation • dividends now would displace future earnings, which implies a trade-off between current and future cash flows Drawbacks of D/P approach: • dividend yield is a component of total return • dividends are not as risky as the capital appreciation component of total return Rationales for using dividend yield: Dividend yield model Value = annualized dividend / dividend yield Enterprise Value/EBITDA • EV = MV of all equity and debt less cash & liquid investments = NPV of firm’s earning activities • EV should be a predictable multiple of EBITDA Rationales for using EV/EBITDA: • Useful in comparing firms with different financial leverage • Eliminates accounting manipulation in depreciation & amortization • EBITDA more stable than other earnings measures, and normally positive Drawback of using EV/EBITDA: • EBITDA ignores required capital and working capital investments price Market quarters four next over dividends Forecasted D/P Leading price Market 4 dividend quaterly recent Most D/P Trailing = × = Other Models 162 Overview • Residual Income = accounting profit - charge for equity capital employed • Residual income represents returns in excess of shareholder expectations, or “economic income” Forecasting residual income • This might use internal management forecasts for the next few years. Problem = bias. • Could use fundamental forecasts of earnings growth and dividend policy. The general model where: V 0 = value of share today B 0 = current per-share BV of equity B t = expected per-share BV at time t r = required rate of return on equity E t = expected EPS for period t RI t = expected per-share RI ( ) ( ) ¯ ¯ · = ÷ · = + ÷ + = + + = 1 t t 1 t t 0 1 t t t 0 0 r 1 rB E B r 1 RI B V Relationship with other models • RI, DDM and FCF models = DCF models but recognition of value is different in the RI model. • The total PV produced by all models should be consistent, in theory, so long as each uses fully consistent assumptions. Residual Income Models 163 Drivers of RI and link to P/B Assuming a constant growth rate in earnings, g, and a constant ROE and dividend payout, the residual income valuation model simplifies to: This formula is linked to: Multi-stage RI model – Continuing RI • Continuing residual income is residual income after the forecast horizon. • It is likely that residual income will decline in the long run until the firm is making a “normal” return (i.e. ROE = r ÷RI = 0). • Possible continuing RI assumptions are: • RI continues indefinitely at a positive level • RI is 0 from the terminal year forward • RI declines to 0 as ROE reverts to r over time • RI reflects reversion of ROE to some mean Applicable RI model when RI fades over time from time T w (fade rate) takes values between 0 and 1: w = 0 ÷no expectation of any future RI w = 1 ÷same level of RI continuing forever 0 0 0 B g r r ROE B V ÷ ÷ + = g r r ROE 1 g r g ROE B P 0 0 ÷ ÷ + = ÷ ÷ = ( ) ( ) ( )( ) 1 T 1 T T 1 T 1 t t 1 t t 0 0 r 1 r 1 rB E r 1 rB E B V ÷ ÷ ÷ = ÷ + ÷ + ÷ + + ÷ + = ¯ e Terminal value of RI Residual Income Models 164 Implied Growth Rate Can be calculated given the P/B ratio and the required rate of return on equity by rearranging the single- stage RI formula: Justifying Continuing RI Persistence Factors suggesting high ¹: • Low dividend payout ratios • High historical industry persistence Factors suggesting low ¹: • Very high rates of return (ROE) • Large special items e.g. non-recurring items • Large accounting accruals Problems Applying RI Models • violations of clean surplus: currency translation adjustments, minimum liability adjustment, unrealised gains/losses on available-for-sale securities • off-balance sheet items: operating leases, LIFO inventory, goodwill, assets/liabilities not at FMV • non-recurring items: extraordinary items, discontinued operations, accounting changes • Differing international standards RI Models – Further Aspects 165 • Easily manipulated by changing accounting assumptions • Ignore changes in reserves other than income and dividends • Many adjustments may need to be made to accounting data to get comparable figures • Terminal value doesn’t dominate estimate • Uses available accounting data • Useful even if firm doesn’t pay dividend, and not distorted by irregular dividends • Can be used with unpredictable cash flows • Models focus on economic profitability, not just accounting profitability Weaknesses of RI models: Strengths of RI models: When to use a RI model: RI model is most appropriate when: • company does not pay dividends, or its dividend are not predictable • company’s expected FCFs are negative within the analyst’s forecast horizon • great uncertainty exists in forecasting TVs using an alternative PV approach RI model is least appropriate when: • there are significant departures from “clean surplus accounting” • determinants of RI are not predictable RI Models Commentary 166 Alternative measures RI (see earlier slide) EVA® = NOPAT – (WACC x IC) MVA = Market value of firm – IC Accounting vs Economic Profitability Economic profitability reflects the dollar cost of debt and equity capital used to generate cash flow. Accounting profitability (ROE) only includes an accounting accrual related to interest expense. One way of assessing relative economic profitability is to compute an EVA spread: EVA spread = ROC – WACC where ROC = NOPAT/Invested Capital Methods of Increasing EVA® • Increase Revenues • Reduce operating expenses • Use less Invested Capital • Take advantage of positive NPV projects • Reduce WACC Value-Based Metrics 167 Private Company Valuation Private Company Specific Factors • Stage of lifecycle, size, Taxes • Quality and Depth of Management • Management/Shareholder overlap • Quality of financial and information • Liquidity, Marketability, Control Private Company Valuation Approaches • Income Approach ÎPV of expected future income ÎHigh Growth Phase Companies • Market Approach ÎRecent Transaction Price Multiples ÎMature Phase Companies • Asset-based Approach ÎFirm’s assets’ value minus liabilities ÎEarly Stage Companies Liquidity and Marketability • Minority referred to Liquidity • Difficult to be sold referred to Marketability DLOC = 1-[1/(1+control Premium)] Total discount = 1-[(1-DLOC)(1-DLOM)] Scenario Comparable Data Subject Valuation Adj. to Comp. data for control 1 Controlling Interests Controlling Interests None 2 Controlling Interests Noncontrolling Interests DLOC 3 Noncontrolling Interests Controlling Interests Control Premium 4 Noncontrolling Interests Noncontrolling Interests None 168 Alternative Investments Study Sessions 13 Weighting 5 – 15% 169 SS13 Overview Alternative Asset Valuation Private Equity Investment Analysis Income Property Hedge Funds 170 Real Estate Investments Type Main Value Determinants Investment Characteristics Principal Risks Likely Investor Raw Land Supply/demand Location Passive, illiquid, limited leverage, no tax depreciation, CGT, low current income Alligator! Uncertain appreciation Speculators, developers, long-term investors Apartments No of households, incomes, location, population growth Active management, both current income and capital gains, high liquidity and leverage, inflation hedge Startup risks due to uncertain demand, need of professional management Well capitalised in need of tax shelter Office buildings Business conditions, location, tenant mix Active management, income and capital gain, moderate liquidity and leverage Startup risk, obsolescence, quality of management , competing properties High net worth companies and individuals in need of tax shelter 171 Real Estate Investments cont. Type Main Value Determinants Investment Characteristics Principal Risks Likely Investor Warehouses Commercial and industrial activity, flexibility of design, easy access and convenience Passive, moderate liquidity and leverage, mostly income Oversupply (cheap) and obsolescence Investors seeking high cash flow, minimal management and tax shelter Shopping centres Population, income level, location, tenant mix, lease terms Active management, low liquidity, moderate leverage, both income and capital gain, tax advantages The right tenant mix, obsolescence, competition, maintaining quality management, high vacancy rates Well capitalised seeking tax shelter Hotels and Motels Level of business and tourist activity, location Active management, limited liquidity, and leverage, tax depreciation Economies of scale, quality management, competing facilities Wealthy investors or REITS 172 Valuing Real Estate Generally use NPV or IRR analysis CFAT = cash flow after taxes ERAT = equity revision after tax EI = initial equity investment Steps in Calculating CFAT Step 1: Compute taxes payable Taxes payable = (NOI – depreciation – interest) htax rate Step 2: Compute cash flows after tax (CFAT) CFAT = NOI – debt service – taxes payable Step 3: Compute equity reversion after taxes ERAT = selling price – selling costs – mortgage balance – taxes on sale IRR Problems • Multiple or no IRR are the result of cash flow changing signs more than once - common with property renovations • Misleading IRR decisions due to size and timing of cash flows • Conflicting IRR and NPV decisions for mutually exclusive projects • Solution - use the NPV methodology and select projects with positive NPV Evaluating Real Estate • If NPV > 0, or NPV = 0, then purchase the property. A positive NPV means that the present worth of the property is greater than the equity cost of the investment. A zero NPV means the investors equity cost is unaffected • If NPV < 0, don’t invest in the property as it destroys value Valuing Real Estate EI IRR ERAT IRR CFAT IRR CFAT NPV n n n ÷ + + + + + + = ) 1 ( ) 1 ( ... ) 1 ( 1 1 173 Cap Rate and Discount Rate •Discount rate (r) - the required rate of return on a real estate investment given the risk and uncertainty of cash flows •Cap rate (r – g) - the required return less the expected growth of net operating income (NOI) Methods to Estimate Cap Rate Market Extraction Method – considered the most accurate but depends on appraisal data and comparable properties Band-of-Investment Method – useful for properties that utilise both debt and equity financing; uses a sinking fund factor to calculate the cap rate as a WACC figure; depends on comparable property data Built-up Method - Useful when comparables not available Property Analysis and Appraisal 1 1 0 0 0 NOI NOI MV r g R Where R = market capitalization rate = = ÷ 0 NOI R (ME) = MV × × 0 R (BOI) = (mtg weight mtg cost) + (equity weight equity cost) 0 R (BU) = pure rate + liquidity premium + recapture premium + risk premium Limitations of Direct Income Capitalisation •Selecting the correct cap rate may be difficult due to lack of available market data, or low- quality data •Approach is limited to income-generating properties, not owner-occupied properties with non-monetary benefits •Properties that provide little or no income or benefits cannot use this method 174 Value Creation Reengineer firm Obtain lower cost financing Goal alignment Exit Routes IPO Secondary Market MBO Liquidation VC v Buyout Characteristics Cash flow Product Asset base Management team entrepreneurial record Leverage Risk assessment Exit strategy Operations Capital required in growth phase Returns Activity in public capital markets Future funding Carried interest Private Equity Risks Liquidity Competition Agency Capital Regulatory Tax Valuation Diversification Market Structure and Terms Structure – LP Terms Management fees Carried interest Ratchet Hurdle Rate Target fund size Vintage Valuation Due Diligence Costs Transaction Placement fee Fund set up Performance fee Administrative Management fee Audit 175 Private Equity Control Mechanisms in PE Transactions Compensation & Tag-along, drag-along clauses Board representation & Non-compete clauses Priority in claims, Required approvals, & Earn-outs Corporate Governance terms Key man clause & performance disclosure and confidentiality Claw-back & distribution waterfall Tag-along, drag-along clause & Remove for cause No-fault divorce & Investment restrictions Co-investment Valuation Methodologies DCF Relative value or Market approach Real option analysis Replacement cost VC method & leverage buyout method Calculating Payoff Multiples and IRRs Calculating the exit value Calculating the claimant’s payoffs: Debt, Preference shares, PE firms, Management Calculating the total investment and total payoff, using these two can get the Payoff Multiples for PE firms Calculating the IRRs for PE investors and management equity 176 Private Equity Performance Measurement Multiples: Popular, simple, easy to use and differentiates between realized and unrealized returns, specified by GIPS Paid in Capital (PIC) – % of capital used by GP Distributed to PIC (DPI) – measures GP realized return, cash on cash return Residual Value to PIC (RVPI) – measures LP’s unrealized return Total value to PIC – measures LP’s realized and unrealized return, sum of DPI, and RVPI Valuation Issue Buyout Venture Capital Use of DCF Frequently used Uncertain cash flow Relative Value Validates DCF No comps Use of Debt High Low, more equity Key return drivers EPS growth, P/E expansion, debt reduction Pre-money valuation, future dilution Other Valuation VC – Single / Multiple financing rounds LBO - Target IRR - Cash flow 177 Private Equity For a Single Financing Round Step 1: Post-Money Valuation POST = FV /(1+r) N Step 2: Pre-Money Valuation PRE = POST-INV Step 3: Ownership Fraction f = INV/POST Step 4: No. of the shares to be held by the PE firm S pe = S e [f/(1-f)] Step 5: Price per share P = INV/ S pe For Multiple Financing Rounds Step 1: the compound discount rate Step 2: Post-Money Valuation (round 2) POST 2 = FV/ (1+ r 2 ) Step 3: Pre-Money Valuation (round 2) PRE 2 = POST 2 – INV 2 Step 4: Post-Money Valuation (round 1) POST 1 = PRE 2 / (1+ r 1 ) Step 5: Pre-Money Valuation (round 1) PRE 1 = POST 1 – INV 1 Step 6: Ownership Fraction (round 2) f 2 = INV 2 / POST 2 Step 7: Ownership Fraction (round 1) f 1 = INV 1 / POST 1 Step 8: No. of the shares to be held by the PE firm Spe1 = S e [f 1 /(1- f 1 )] Step 9: Price per share after financing (round 1) P 1 = INV 1 / S pe1 Step 10&11: Price per share after financing (round 2) S pe2 = (S e + S pe1 ) [f 2 /(1- f 2 )] P 2 = INV 2 / S pe2 178 Private Equity IRR Method Ownership Fraction Step 1: Investor’s expected future wealth W = INV h(1+r) N Step 2: Ownership Fraction f = W/FV Price per share Step 3: No. of the shares to be held by the PE firm S pe = S e [f/(1-f)] Step 4: Price per share P = INV/ S pe Post-Money & Pre-Money Valuation Step 5: Post-Money valuation POST = INV/f or POST = P h(S pe + S e ) Step 6: Pre-Money valuation PRE = POST - INV or PRE = P hS e Adjusting the Discount Rate r* = [(1+r)/(1-q)] – 1 r* = discount rate adjusted for probability of failure r = discount rate unadjusted for probability of failure q = probability of failure in a year Target IRR Method Target IRR must meet or exceed: The cost of the LBO debt financing The cost of equity capital for a similar unlevered firm The return that the fund managers market to client investors Equity Cash Flow Method Discount the future value of equity back to the present using an expected return on equity for each period that reflects the then capital structure The beta for equity that accounts for the financial leverage: N terminal equity value PVof equityinvestment = (1+target IRR) Asset Equity E D E þ þ = + Equity Equity Market ( ) [ ( ) ] f f E R R E R R þ = + ÷ 179 179 Fee Structures •Paid on quarterly or annual basis •High-water mark provision Hedge Fund Returns •Factor models •Alpha: manager skill •Beta: market exposure •Hedge fund returns are often not normally distributedǂSharpe ratio or other classical ratios may be useless Hedge Funds Performance biases •Voluntary report to databases •Selection bias •Backfill bias •Survivor bias Funds of funds (FOF) •Retailing (exposure to a large number of hedge funds) •Access to funds closed to individuals •Diversification •Expertise •Due Diligence Process Hedge Fund Strategies •Arbitrage-based funds •Convertible bond arbitrage strategies •Equity market neutral funds •Event driven funds •Risk arbitrage (merger arbitrage) •Fixed-income arbitrage •Medium volatility arbitrage •Global macro funds •Long-short equity funds •Managed futures funds •Multi-strategy funds •Directional hedge fund strategies •Dedicated short bias funds •Emerging market hedge funds 180 180 Market risks •Can be limited by understanding the beta exposures of individual hedge funds and increase the allocation to funds with lower market risks •Alternatively, allocate to managers with the highest alpha and hedge away the common factors at the FOF level Hedge Fund Risk Event risks •Event driven funds, such as those following mergers and distressed or special situation investments •Event driven funds have a lower correlation with market indices, but their returns can change dramatically with event risk •Events may affect broader market risks Operational risks •Include inadequate resources, unauthorized trading and style drift, the theft of investor assets, and misrepresentation of investments and performance •Can be minimized by a strict delineation of duties Counterparty risk •Arises when owed money on a swaps or options contract and the seller of the contract fails to deliver the gains Leverage •Can magnify market risk and counterparty risk •Can be gained through derivatives 181 Fixed Income Investments Study Sessions 14 & 15 Weighting 5 – 15% 182 Overview of Level II Fixed Income General Principles of Credit Analysis Term Structure and Volatility of Interest Rates Valuing Bonds with Embedded Options Study Session 14: Valuation Issues Mortgage-backed Sector of the Bond Market Asset-backed Sector of the Bond Market Valuing MBS/ABS Study Session 15: Structured Securities 183 Credit Analysis Key ratios • Profitability • Short-term solvency • Capitalization/Leverage • Coverage Credit Risk Default Risk Credit Spread Risk Downgrade Risk High yield issuer – Debt structure (bank loans), corporate structure, covenants Asset Backed Securities - Quality of underlying collateral Municipal Securities – Tax/revenue- generating ability of the issuer Sovereign Debt - Economic and political risk – 2 ratings (local & foreign currency debt) Key Considerations The 4 Cs • Character • Capacity • Collateral • Covenants 184 Credit Analysis S&P Framework Net income + Depreciation +/ũ Other noncash items Funds from operations ũIncrease in NWC Operating cash flow ũCapital expenditures Free operating cash flow – Cash dividends Discretionary cash flow –Acquisitions +Asset disposals +Other sources (uses) Prefinancing cash flow Cash flow ratios Coverage ratios Funds from operations Total debt Funds from operations Capex Free operating CF + interest Interest Debt service coverage Free operating CF + interest Annual interest + principal Debt payback period Total debt Discretionary CF 185 Term Structure Parallel shifts Yield Curve Shifts Twists Butterfly shifts Yield curve construction: 4 bond universes • on-the-run Treasuries • on-the-run + some off-the-run Treasuries • all Treasuries • Treasury strips Alternative: swap rate (LIBOR) curve Shape of yield curve Defined by “term structure” of interest rates Three theories: - pure expectations (shape shows expected implied forward rates) - liquidity theory (long-term bonds give higher yield to compensate for higher IR risk) - preferred habitat (investors must be compensated for investing in less- preferred habitat) Yield Maturity Yield Maturity New steepened curve Original curve Yield Maturity Positive butterfly shift Original curve Yield Maturity Original curve Megative butterfly shift 186 Volatility of Interest Rates Impact of non-parallel shifts on price measured by Key Rate Duration Approximate percentage change in value in response to a 100 basis point change in a key rate, holding all other rates constant Historical yield volatility Implied volatility Yield volatility and measurement Forecasting yield volatility Volatility derived from option pricing models ( ) ( ) | | t day on yield the y y y ln 100 X Where 1 T X X Variance t 1 t t t T 1 t 2 t = = ÷ ÷ = ÷ = ¯ ¯ = ÷ = T 1 t 2 t 1 T X iance var Best estimate of average X is zero. Hence: Maturity Spot rate key rate Effective Portfolio Duration = Sum of Key Rate Duration 187 Bonds with Embedded Options Binomial Model ( ) o = 2 L , 1 U , 1 e i i Callable: call price is effective cap at each node Putable: put price is effective floor at each node Backward induction 1. Populate interest rate tree with rates 2. Discount from end 3. At each node take average price, consider call/put and add cash flow Spread measures Nominal spread = YTM corp – YTM Treas (ignores shape of yield curve) Zero-volatility/Z/Static spread - spread added to spot rates to get theoretical bond price = actual bond price Option-Adjusted Spread - spread added to the interest rate tree to get theoretical bond price = actual bond price Treasury term structure z-spread: credit, liquidity and option risks OAS: credit and liquidity risks only “option cost” ( ) y y 0 y y 0 2 0 BV BV ED 2 BV y BV BV 2 BV EC 2 BV y ÷A +A ÷A +A ÷ = × × A + ÷ × = × × A 188 Relative Value Analysis Overvalued Overvalued Overvalued Actual OAS < 0 Fairly priced Overvalued Overvalued Actual OAS = 0 Undervalued Undervalued if actual OAS > required OAS* Undervalued if actual OAS > required OAS* Actual OAS > 0 Issuer Benchmark Sector Benchmark Treasury Benchmark *Relative to same benchmark 189 Convertible Bonds ( )( ) 1 Premium . 7 interest . 6 Premium 5. . 4 . 3 . 2 . 1 ÷ = ÷ = = = ÷ = ÷ = × = value straight bond of price Market value straight over ratio conversion share per dividends ratio conversion coupon share per al differenti income Favourable share per difference income favourable share per premium conversion market period payback stock common of price market share per premium conversion market ratio premium conversion Market price market price conversion premium conversion Market ratio conversion CB of price market price conversion Market ratio conversion stock the of price market value Conversion Convertible bond value = Straight value + equity call option – bond call option + bond put option “Common stock equivalent” (conversion value > straight value) vs.. “Fixed income equivalent” (conversion value < straight value) 190 Mortgage-Backed Securities US Mortgage market – key features Home loans in the form of fixed-rate level-payment fully amortized mortgages Mortgage Passthrough Securities Only one class of bond investor Cash flows: net interest, principal payments, curtailments Mostly issued by agencies: Ginnie Mae, Fannie Mae, Freddie Mac principal outstanding t Non-agency MBS Collateral can be individual loans (vs.. passthrough securities for agency MBS) No government guarantee Normally have max LTV, payment-to-income and size criteria Pool Mortgage 1 Mortgage 2 Mortgage N … Investor 1 Investor 2 Investor N … Pass-through securities backed by the pool are issued to investors 191 Mortgage-Backed Securities Prepayment Rates PSA Benchmark Assumes the monthly prepayment rate increases as it seasons CPR Conditional prepayment rate (CPR) is the expected annual prepayment rate. Can be converted to SMM (single-monthly mortality rate): ( ) 12 / 1 CPR 1 1 SMM ÷ ÷ = Contraction Risk: IR | hence prepayments | hence expected life | Extension Risk: IR | hence prepayments | hence expected life | Factors affecting prepayment behaviour 1.Prevailing mortgage rates 2.Housing turnover 3.Characteristics of the underlying mortgage loans Annual CPR Age in months 30 100 PSA 50 PSA 125 PSA 6% 3% 7.5% 192 Mortgage-Backed Securities Mortgage Paythrough Securities Several classes of investors Collateralized Mortgage Obligations Securities issued against passthrough securities for which the cash flows have been reallocated to different bond classes known as tranches Planned Amortization Class Tranches Amortized based on a sinking fund schedule established within a range of prepayment speeds Support tranche absorbs any excess Stripped MBS Principal and interest payments are paid to different security holders: Interest Only (IO) Strips Positively related to mortgage rates: as IR | there is more prepayment of principal leading to less cash flow for the IO strip Principal Only (PO) Strips Very sensitive to prepayment rates Prices rise as IR | Sequential Pay Tranches Each class of bond retired sequentially Tranche A – Most Contraction Risk Tranche Z – Most Extension Risk 193 Commercial MBS • CMBS are backed by a pool of commercial mortgage loans on income producing property • CMBS differ from residential MBS in that they are non- recourse loans. Hence each property must be assessed in isolation rather than as a pool • Call Protection at the Loan Level – Prepayment lockout – Defeasance – Prepayment penalty points – Yield maintenance charge • Call Protection from the actual CMBS structure: as the CMBS is sequential paying (by credit rating), the AA rated tranche cannot be repaid before the AAA rated tranche • Debt-to-service coverage (DSC) ratio = ratio of net operating income to debt service. • Need DSC need > 1, but also check average & dispersion. • Loan to Value (LTV) ratio • The lower the LTV, the greater the protection afforded to the lender • Note value estimates may vary considerably Balloon Risk Risk of default at end of loan, when most of repayment is due 194 Asset-Backed Securities ABS: Key Features Credit Enhancements Types credit card receivables auto loans home equity loans manufactured housing loans Small Business Admin loans corporate loans bonds other credit-sensitive receivables Amortizing (e.g. auto loans) vs.. Non-amortizing (e.g. credit card loans) vs. Prepayment (sequential pay ABS, tranches having differing prepayment/extension risks) vs. Senior-subordinate structure (senior tranche protected against default by subordinate) a.k.a. credit tranching Internal credit enhancements: 1. Reserve funds 2. Overcollateralization 3. Senior/subordinated structure External credit enhancements: 1. Corporate guarantee by seller 2. Bank letter of credit 3. Bond insurance 195 Types of Asset-Backed Security Credit Card Receivables • Non-amortizing, with cash flows = interest, fees, principal • 3 amortization structures: passthrough, controlled amortization, bullet payment • Prepayment measured by “monthly payment rate” Home equity loans • Often closed-ended HELs, fixed or floating rate • Cash flows similar to MBS • Can be split into tranches: NAS vs. PAC • Prepayments are modelled on issuer- specific prospectus prepayment curve (PPC) Manufactured housing loans • Amortizing over 15-20 yrs • Lower prepayments than MBS because (1) small loans, (2) depreciating collateral, (3) low credit quality of borrowers • Prepayment model: CPR with PPC Student loans • Floating rate, with deferment, grace & repayment periods • Prepayments from defaults or loan consolidations SBA loans • Variable rate, 5-25 years • Prepayments measured via CPR Auto Loans • Prepaid if sold, traded in, repossessed, destroyed (insurance proceeds), early repayment or refinanced – but… • Refinancing uncommon since collateral value depreciates rapidly and new car loans often below market rates • Prepayments: CPR & SMM 196 ABSs: Other issues Collateralized Debt Obligations CDO = ABS backed by pool of bonds, loans, MBSs or ABSs Arbitrage transaction (motivation: earn the spread) vs. Balance sheet transaction (motivation: remove debt from B/S) Cash CDO (underlying = cash debt instruments) vs. Synthetic CDO (credit derivatives create economic equivalence to cash instruments) 197 Valuing MBS/ABS Techniques for valuing MBSs and ABSs Cash flow yield analysis Discount rate that makes the present value of the future cash flows equal to the current price. Prepayment assumption required. Can calculate bond equiv yield: ] 1 ) i 1 [( x 2 BEY 6 M ÷ + = Spread measures Nominal spread: hides prepayment risk Z-spread: same problem, but considers y.c. shape OAS: best measure Monte Carlo and spreads The rates in the Monte Carlo model can be “tweaked” so that model’s resultant price of MBS/ABS = market price. Level of “tweak” is the OAS, since the model incorporates the prepayment option. Hence for investing: biggest OAS = cheapest investment Best spread measure for valuations no option (or option exercise unlikely): use Z-spread embedded option, not IR path dependent: OAS with binomial embedded option, IR path dependent: OAS with Monte Carlo Monte Carlo vs. binomial Monte Carlo incorporates IR path, so can use prepayment model to produce value. Binomial model does not have ability to value securities that are IR path dependent, since backward induction starts at end of timescale. 198 Duration Measures MBS/ABS MBS Duration Measures Effective Duration From Monte Carlo model. Shock yield by +/-Ay, reapply the model then plug results into duration formula. Cash Flow Duration Estimate CF and hence CF yield, shock yield by +/-Ay, re-estimate CFs and hence new prices, then plug results into duration formula. Coupon Curve Duration Calculate duration by changing coupon instead of yield. Empirical Duration Use linear regression to identify how price changes with yields. 0 2 P P Duration P y ÷ + ÷ = A 199 Derivative Investments Study Sessions 16 & 17 Weighting 5 -15% 200 Overview of Level II Derivatives Forward Market and Contracts Future Market and Contracts Study Session 16: Derivatives Investments: Forwards and Futures Options Market and Contracts Interest Rate Derivatives Instruments Credit Derivatives Study Session 17: Derivatives Investments: Options, Swap and Interest Rate Swap Market and Contracts 201 Forward Contracts Obligation to: buy (long) sell (short) an asset at an agreed price on an agreed forward date Value & Price – Value = PV of net advantage to long from having contract at forward price (FP) – Price = FP set when contract initiated, for no-arbitrage must = cash asset price + net cost of carry Credit risk Party with the positive value faces credit risk in that amount 202 Forward Contract Prices & Values PV of difference between interest at FRA rate and at the current forward rate for the FRA period Calculate the forward interest rate. E.g. 4ͪ7 FRA, use fwd rate from time 4 to 7 FRA Currency Forwards Equity Index Forwards (S o - PVD) x (1+R f ) T Equity Forwards VALUE (to the long at time t) = (spot price – PV benefits) – PV of forward price FORWARD PRICE = spot price + net costs of carry TYPE ( ) ( ) | | . | \ | + ÷ ÷ ÷t T f t R 1 FP PVD S ( )T į R 0 e S ÷ ( ) ( ) | . | \ | ÷ | . | \ | ÷ ÷ t T R t T į t e FP e S T base f, T quoted f, 0 ) R (1 ) R (1 S + + × ( ) ( ) | | . | \ | + ÷ | | . | \ | + t - T quoted t - T base t ) R (1 F ) R (1 S 203 Futures Contracts Like forwards, but standardised, exchange traded and subject to margining Basis = spot price – futures price Contango = negative basis. Most likely scenario. Backwardation = positive basis. It will occur if benefits holding assets large enough Convergence ШAs maturity approaches, basis converges to zero (due to arbitrage) | | . | \ | ÷ | | . | \ | = market to mark last of time at futures of price price futures current contract futures of Value Futures price v. Forward price – In principle same no- arbitrage price applies to both – But investors preference for mark-to-market feature (cash flow effect) could make futures more (/less) valuable than forwards – Effect of mark-to-market ignored on following slides 204 Futures pricing Futures arbitrage – Futures price (like forward) determined by arbitrage If futures trades above theoretical FP then: Cash and carry arbitrage – Buy cash asset with borrowed money and sell future If futures trades below theoretical FP then: Reverse cash and carry arbitrage – Short sell cash asset, invest proceeds, and buy future Generic futures pricing formula: FP = S 0 ͪ (1 + R f ) T +FV(NC)-FVD NC=Storage Cost-Convenience Yield FVD=Future Value of Cash Flow Convenience Yield: Non- monetary benefits from holding asset, e.g., holding asset in short supply with seasonal/highly risky production process Eurodollar deposits vs T-bills •Eurodollar deposits are US$ denominated deposits outside the US priced off the LIBOR curve using 360 day convention •While T-bills are discount instruments, Eurodollar deposits are add-on instruments Difficulty in pricing Eurodollar futures •Eurodollar futures cannot be priced easily as LIBOR is an add-on interest and arbitrage transaction cannot be constructed perfectly as is the case with T-bill futures 205 Pricing Financial Futures FP = [(S o x (1+R f ) T ) – FV(Coupons)]/CF S 0 ,CF = Price, Conversion Factor of CTD bond (Cheapest To Deliver bond gives highest implied repo rate) T-Bond Exactly the same as for forwards Equity & Currency Price Type of Future Normal Backwardation • Hedgers (shorts) are rejecting price risk • Speculators (longs) will require compensation to accept risk •Result: Futures price < expected spot price Normal Contango • Hedgers (longs) are rejecting price risk • Speculators (shorts) will require compensation to accept risk •Result: Futures price >expected spot price 206 Options basics (refresher) call payoff = max(0, S T – X) call profit = max(0, S T – X) – C 0 put payoff = max(0, X – S T ) put profit = max(0, X – S T ) – P 0 Long Long Short Short Call Put B/E = strike + prem B/E = strike - prem Max loss = premium Max profit = premium Max profit = unlimited Max loss = unlimited Max loss = B/E Max profit = B/E 207 Options Jargon (refresher) Call Put In the money S – X = +ve; S – X = –ve Out of the money S – X = –ve; S – X = +ve At the money S – X = 0; S – X = 0 – Moneyness – Strike/exercise price (X) – Underlying price (S) – expiration – European/American – Intrinsic value – Time value Intrinsic value – Call: Max (S-X,0) – Put: Max (X-S,0) Time value – Premium minus Intrinsic value 208 Caps, floors, collars Collar – (long) collar = long cap + short floor – zero cost if cap premium = floor premium Cap – series of interest rate caplets, calls with identical strikes & equally-spaced expiries – bought by borrower Floor – series of interest rate floorlets, puts with identical strikes & equally-spaced expiries – bought by lender 209 Put-call parity Synthetics – c 0 = p 0 + S 0 - X/(1+r) T (synthetic call = long put + long underlying + short bond) – p 0 = c 0 - S 0 + X/(1+r) T (synthetic put = long call + short underlying + long bond) – S 0 = c 0 - p 0 + X/(1+r) T (synthetic underlying = long call + short put + long bond) – X/(1+r) T = p 0 - c 0 + S 0 (synthetic bond = long put + short call + long underlying) Arbitrage – If Put-call parity doesn’t hold then any of the equations below tells you how to get a profit e.g. if c 0 > p 0 + S 0 - X/(1+r) T then sell call and buy synthetic call (buy put & U/L & sell bond [=borrow]) for options on futures: c 0 + [X - f 0 (T)]/(1+r) T = p 0 Cost of fiduciary call (long call + Zero Coupon Bond): c 0 + X/(1+r) T must equal cost of protective put (long put + stock): p 0 + S 0 210 Option pricing models Discrete time – underlying asset is assumed to move only at discrete points in time Continuous time – underlying asset can move at any point in time e.g. Binomial e.g. Black-Scholes-Merton limit of discrete time model as period length Ш0 211 Binomial option pricing Symbols S = stock price at start of period S+ = upper potential end-of-period stock price = S ͪ u S- = lower potential end-of-period stock price = S ͪ d (if d is not given, then assume d = 1/u) c+ = call value at expiry if stock rises = Max(0,S+ - X) c- = call value at expiry if stock falls = Max(0,S- - X) r = risk-free rate per period Hedge ratio (delta) – a risk-free portfolio requires n units of stock per call, where n (hedge ratio) = ÷ + ÷ + ÷ ÷ S S c c Option value – for no arbitrage, call price at start of a period: where: r 1 )c (1 c c + ÷ + = ÷ + d u d r 1 ÷ ÷ + = Valuing American options At each point, substitute intrinsic value if larger than ‘roll-back’ value Given call value can estimate put from put-call parity 212 2-period Binomial example (1) Stock price = $100 Each period stock either rises 25% or falls 20% (so u = 1.25, d = 0.8) European call option expires at end of two periods, strike = $97.5 Risk free rate = 7% per period Stock = $100 Call = ? Stock = $125 Stock = $80 e it h e r o r Stock = $156.25 Call = $58.75 Stock = $100 Call = $2.50 e it h e r o r Stock = $64 Call = $0 e it h e r o r A B C 213 2-period Binomial example (2) At all three points (because r, u, and d are the same each period): 6 . 0 8 . 0 25 . 1 8 . 0 07 . 0 1 d u d r 1 ʌ = ÷ ÷ + = ÷ ÷ + = Point B (i.e. at end of first period, assuming stock price rose): | | | | $33.88 1.07 $2.5 ) 6 . 0 (1 75 . 58 $ 0.6 r 1 ʌ)c (1 ʌc c B = × ÷ + × = + ÷ + = ÷ + Point C (i.e. at end of first period, assuming stock price fell): | | | | $1.40 1.07 $0 ) 6 . 0 (1 5 . 2 $ 0.6 r 1 ʌ)c (1 ʌc c C = × ÷ + × = + ÷ + = ÷ + Point A (now, using c B as c + and c C as c - ): | | | | $19.52 = × ÷ + × = + ÷ + = 1.07 $1.40 ) 6 . 0 (1 88 . 33 $ 6 0. r 1 ʌ)c (1 ʌc c C B A 214 Valuing interest rate options Valuing an option on a bond - work backwards to value the bond at each point in the tree - value option on bond using conventional binomial approach Valuing a cap or a floor - use rates in tree to evaluate payoff for each caplet/floorlet - use rates in tree to discount p- weighted payoffs back to a PV interest rates in tree will be provided, and assume p = 0.5 Binomial Model ( ) o = 2 L , 1 U , 1 e i i 215 Black-Scholes-Merton model Assumptions of BSM – Underlying asset price follows a geometric lognormal diffusion process – Risk-free rate and volatility of asset known and constant over option life – No cash flows (e.g. dividends) on the underlying – No transaction costs or taxes – European style options ) N(d Xe ) N(d S c 2 T r 1 0 c ÷ ÷ = ( ) ( ) ( ) T ı T /2 ı r ln d 2 c X S 1 0 + + = T ı d d 1 2 ÷ = As per binomial, given call value can estimate put from put-call parity 216 Extensions of BSM ) N(d Xe ) N(d e S c 2 T r 1 įT 0 c ÷ ÷ ÷ = BSM Model with dividends ( ) ( ) ( ) ( ) T ı T /2 ı r ln d 2 c X e S 1 T -į 0 + + = | | ) XN(d ) (T)N(d f e c 2 1 0 T r c ÷ = ÷ Black’s model (options on futures) ( ) ( ) T ı T /2 ı ln d 2 X (T) f 1 0 + = Application to interest rate options – replace f 0 (T) with forward interest rate from the date of expiration of option to end of period of underlying interest rate in the option T ı d d 1 2 ÷ = 217 The Greeks Positive Positive Vega Volatility Interest rate Passage of time Underlying price Factor Negative Positive Rho Negative Negative Theta Negative Positive Delta Relationship between change in factor and change in premium Put Call Factor sensitivity price asset ue option val A A expiry to time ue option val A A rate interest ǻ ue option val ǻ y volatilit price ue option val A A price asset Delta A A = Gamma Estimating volatility: Historical (std. devn. of past log returns) Implied (by pricing model & current premium) 218 Delta hedging 0 2 4 6 8 10 12 14 16 1 2 1 4 1 6 1 8 2 0 2 2 2 4 2 6 2 8 3 0 3 2 3 4 3 6 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Intrinsic value Total value delta (right axis) Delta is the slope of the premium versus asset price line. Call deltas vary between 0 and +1 (since the line moves from being flat to a 45 0 slope) Gamma is the slope of this line, it measures how fast delta changes as the underlying price moves. It is positive, and greatest for ATM options A long position in a stock with a short position in call options so value of portfolio does not change with the value of the stock. Number of calls required = (but beware of gamma) delta call shares of number 219 Swaps and swaptions Plain Vanilla Interest Rate Swap • An agreement to exchange fixed rate payments for floating rate payments • Based on a notional principal. • Payments are netted off • Equivalent to issuing a fixed-coupon bond and using proceeds to buy a floating-rate bond • Equivalent to a series of off-market FRAs • Equivalent to a series of interest rate calls and puts Currency Swap • An agreement to exchange payments denominated in one currency with payments in another currency. • Principal amounts are exchanged at the start and end of the swap. • Interest payments not netted off as they are in different currencies • Equivalent to issuing a fixed- or floating- rate bond in currency A, converting proceeds to currency B and buying a fixed- or floating-rate bond in the latter currency Equity Swap • An agreement to swap fixed payments for a return on a stock or stock index • If the equity returns are negative, the fixed rate payer must also pay the percentage decline • Equivalent to buying/ selling equity A and selling/buying the bond/equity B Swaptions Payer Swaption An option to enter into a pay fixed swap As interest rates increase, the option becomes more valuable Receiver Swaption An option to enter into a receive fixed swap. As interest rates decrease, the option becomes more valuable 220 Pricing and valuing swaps Pricing (setting the fixed rate) Interest rate swap pricing Use the premise that an interest rate swap is equivalent to issuing a fixed rate bond and investing in a floating rate bond. The fixed rate must be set so that the values of the 2 bonds are the same at initiation. At issue, the floating rate bond has a value equal to its face value. Therefore, the value of the fixed rate must be: ( ) ( ) ¯ = flow i for DF flow last for DF - 1 F th Valuation - Difference between PVs of the two flows - Discount fixed cash flows at the new LIBOR rates - use fact that PV of FRN at coupon date = par to simplify floating rate PV - NB LIBOR at the start of each coupon period determines the coupon paid at the end of the period 221 Swaption Value of Payoff for a Payer Swaption) PV of the difference between payments based on higher existing (market) swap rate and payments based on strike rate Discount CFs based on “spread” between contract and market Payer swaption Right to enter swap as fixed- rate payer (wins if rates increase) Receiver swaption Right to enter swap as fixed- rate receiver (wins if rates fall) Uses Hedge anticipated floating rate exposure in the future Speculate on IR changes Terminate an existing swap (i.e., buy the right to enter into an offsetting position) 222 Interest rate options Interest rate call payoff: Notional principal ͪ Max(0,underlying rate at expiry – exercise rate) ͪ (days in underlying rate/360) Interest rate put payoff: Notional principal ͪ Max(0,exercise rate - underlying rate at expiry) ͪ (days in underlying rate/360) For both types: • payoff is at end of underlying notional loan period, rather than at expiry (for other options payoff is at expiry) • compare with FRAs • Cap = series of interest rate calls • Floor = series of interest rate puts 223 Credit Default Swap Strategies Basis trade Credit curve flattener Credit curve steepener Index trade Options trade Capital structure trade Correlation trade Characteristics Insurance contract on “reference obligation” (a specific bond or loan) Buyer pays seller default swap premium (default swap spread) Protects buyer from losses due to default Swap seller is long the credit risk only 224 Portfolio Management Study Session 18 Weighting 5 – 15% 225 PORTFOLIO MANAGEMENT Portfolio Concepts A Note on “Market Efficiency” Portfolio Management Process & the Investment Policy Statement The Theory of Active Management International Asset Pricing Overview of Portfolio Management 226 Mean and standard deviation 2 , 1 2 1 2 2 2 2 2 1 2 1 2 : assets 2 for e.g. Cov w w w w port + + = o o o Cov i,j = E[(R i -E(R i ))㬍(R j -E(R j ))] Variance (for standard deviation take square root) Expected return For a portfolio For an individual investment j i for 1 1 1 2 2 2 = = = = ¯ ¯¯ + = n i n i n j ij j i i i port Cov w w w o o ¯ | | . | \ | × = return potential y probabilit ) (R E ) ( ) ( 1 i n i i port R E w R E ¯ = = ¯ | | . | \ | | | . | \ | ÷ × = 2 2 ) (R E return potential prob o j i ij Cov r o o = ij n, Correlatio If estimating an investment’s E(R) & s from time series data then use these formulae, but use actual return for each period in place of potential, and set all probs equal Most important factor when adding an investment to a portfolio that contains a number of other investments is average covariance with all the other investments 227 Mean Variance Analysis . . . A B C . D o E(R) . . . A B C . D o E(R) BCD is the efficient frontier opportunity set of available portfolios ABCD is the minimum variance frontier Assumptions: • Investors are risk-averse • Investors know expected returns, variances, and covariances for all assets • Investors use Markowitz framework • Frictionless markets: no taxes or transactions costs Minimum Variance Frontier--Smallest variance among all portfolios with the same expected return Construction: 1. Estimation: Forecast expected return, E(R), and variance, Ӻ 2 , for each individual asset 2. Optimization: Solve for weights that minimize the portfolio Ӻ 2 given target return and portfolio weights that sum to one 3. Calculation: Calculate E(R) and Ӻ 2 for all the minimum variance portfolios from Step 2 228 Correlation and Diversification Lower correlation ¬higher bow ¬greater diversification This is for a two-asset portfolio E(r) 30% 20% 10% 0% 0% 10% 20% Total Risk = –1 = –0.3 = +0.3 = +1 Variance for an equal-weighted portfolio: 2 2 P i 1 n 1 ı = ı + Cov n n ÷ 229 Adding in a risk-free asset Combinations of a risk portfolio and a risk-free asset will lie on a straight line: Standard deviation E x p e c t e d R e t u r n . . P R F Lending at R F Borrowing at R F . . P R F . M C M L E(R) o Hence, given assumptions on next slide: CML (Capital Market Line) M is the market portfolio (optimal risky portfolio) All investors want to be on CML 230 CML vs. CAL Security Market Line CML Risk measure Systematic Total Application Required return for securities Asset allocation for R f and M Definition Graph of CAPM Graph of efficient frontier Slope Market risk premium Sharpe ratio • The Capital Market Line assumes homogeneous expectations • CML Equation • The Capital Allocation Line assumes heterogeneous expectations • CAL Equation C o o + = M F M F C R - ) E(R R ) E(R C o o + = T F T F C R - ) E(R R ) E(R 231 Total Risk Market Risk Total Risk = Unsystematic Risk + Systematic Risk Unsystematic Risk Systematic Risk Number of Stocks in the Portfolio Systematic vs. Unsystematic Risk 232 Using the SML . R F . M R M þ i E(R i ) þ M =1 S M L . R F . M R M þ i E(R i ) þ M =1 S M L SML shows expected return (per CAPM) Compare this to anticipated (forecast) return • A stock that is overpriced will plot below the SML • A stock that is underpriced will plot above the SML • A stock that is correctly priced will plot on the SML E(R i ) = RF + þ i (E(R M )- R F ) 㱍= Expected Return – Required Return ƽ 233 CAPM in The Real World Two key assumptions… 1. Investors can borrow/lend at risk-free rate 2. Unlimited short-selling and access to short proceeds …yields two implications… 1. Market portfolio lies on the efficient frontier (market portfolio is efficient) 2. Linear relationship between expected return and beta If the 2 key assumptions are violated… 1. Market portfolio might lie below the efficient frontier (might be inefficient) 2. Relationship between expected return and its beta might not be linear 234 The Market Model LOS 71.a: discuss how the Index Model simplifies CAPM • Regression of an asset’s returns against an observable index’s returns: • Expected return: • Variance: • Covariance: E(Ri) =oi +þiE(RM) Ri = oi +þiRM +ci oi 2 = þi 2 oM 2 + oc 2 Cov ij = þiþjoM 2 Beta Instability Problem Historical beta not necessarily a good predictor of future relationships…. Adjusted beta Mean-reverting level of beta = 1 Adjust beta to reflect this mean-reverting level Ӫ i,t = ө 0 + ө 1 Ӫ i,t–1 , where 㱍 0 + 㱍 1 = 1 Most popular values: 㱍 0 = 1/3 and 㱍 1 = 2/3 Adjustment moves beta towards 1 Adjusted beta moves toward 1 more quickly for larger values of 㱍 0 235 Active Risk and Return • Active return is the difference between the portfolio return (P) and its benchmark (B): R P – R B • Active risk (“tracking risk”) is the standard deviation of the active return • Source of active risk can be active factor risk and active specific risk • Factor portfolio vs. tracking portfolio Information Ratio Active return per unit of active risk Measures manager’s consistency in generating active returns P B P B (r r ) IR= s(r r ) ÷ ÷ 236 Multifactor models/APT E(R i ) = R f + b 1 ì 1 + b 2 ì 2 + b 3 ì 3 + ಹಹ.+ b k ì k APT (Arbitrage Pricing Theory) b k = sensitivity of the actual return from security i to changes in an index representing risk factor k ì k = the difference between the expected return for a one- unit exposure to factor k and the risk-free return APT assumptions: • Security returns can be described by a factor model • Sufficient securities to diversify away the unsystematic risk • No arbitrage opportunity CAPM assumptions: • Competitive capital market • Markowitz investors • Unlimited risk-free lending/borrowing • Homogenous expectations • One-period investment horizons • Frictionless markets Multifactor models • analyst chooses number and the identity of the factors - enough so model adequately predicts security returns (but not too many) • Macroeconomic models use underlying economic influences (e.g. real GDP growth, unexpected inflation) • Fundamental factor models use specific aspects of the securities (e.g. P/E ratio, firm size) 237 International Asset Pricing Real Exchange Rate Risk The possibility of exchange rate changes that are not explained by inflation differentials Real exchange rate = spot rate x foreign price level domestic price level (dc/fc) %A real spot = %A nominal spot rate – (inflation Q – inflation B ) (dc/fc) 238 ICAPM Form of ICAPM: E(R) = R f + b G MRP G + ¸ 1 FCRP 1…… + ¸ k FCRP k where E( R) = expected return required on investment x R f = risk free rate in investor’s home country (domestic) b G = the world beta of stock x (sensitivity to changes in global portfolio value) MRP G = the world risk premium ¸ k = sensitivity of stock* x to changes in real exchange levels FCRP k = foreign currency risk premium Foreign Currency Risk Premium OR Domestic Currency Sensitivity Exporter ¸ LC < 0 Importer ¸ LC > 0 ¸ = domestic currency sensitivity ¸ LC = local currency sensitivity ¸ = ¸ LC + 1 *in domestic currency returns ( ) base quoted r - r S S - ) E(S = FCRP 0 0 1 ÷ FCRP = E(S1) - F S0 239 Equity & Bond Exposures Currency Exposures of National Economies Equity Markets Bond Markets Increased long-run economic activity Currency depreciation Higher equity prices causes causes Negative currency exposure Traditional Model Increased long-run economic activity Currency appreciation Higher equity prices causes causes Positive currency exposure Money Demand Model Increase in real interest rates Currency appreciation Lower bond prices causes causes Negative currency exposure Free Markets Theory Government to decrease real rates Currency appreciation Higher bond prices causes causes Positive currency exposure Government Intervention Theory 240 Active Management Treynor-Black Model: • Only a limited number of securities are analyzed. The rest are assumed to be fairly priced. • The market index portfolio (M) is the baseline portfolio. The expected return and the variance of M are known. • To create the active portfolio: • Estimate the beta of each security to find mispricings. Those with non-zero alphas will be put into the active portfolio with the following weights: (+ alpha ¬+ weight, - alpha ¬- weight) • The cost of less-than-full diversification comes from the non-systematic risks of the mispriced stocks, Ӻ 2 (e), which offsets the benefit of the alphas. • Estimates of ө, Ӫand Ӻ 2 (e) are used to determine security’s weights (+ or -) in the active portfolio n A i i i=1 ȕ = wȕ ¯ n 2 2 2 A i i i=1 ı(İ )= wı(İ) ¯ Active management and market equilibrium: • empirical evidence: • abnormal returns produced by some managers • some anomalies in realized returns have persisted over prolonged periods • if no one can beat the passive strategy, money will flow away from active managers and their expensive analysis - prices will no longer reflect sophisticated forecasts - subsequent profit opportunity lures back active managers who once again become successful n j i i 2 2 j=1 i j Į Į w = ı (İ) ı (İ ) ¯ n A i i i=1 Į = wĮ ¯ 241 Active Management Treynor-Black Model (cont’d): • The expected return and the standard deviation of the Active portfolio (A): E(R A ) = 㱍 A + 㱎 A {E(R M ) – R F } • Combine the active portfolio and M to create the optimal portfolio which will maximize the Sharpe’s ratio • When short positions are prohibited, simply discard stocks with negative alphas. • We should adjust the alpha estimated by an analyst by his past accuracy. Therefore if a manager has consistently overestimated alpha on a stock in the past, we have to “discount” his analysis . That will give a smaller weight to the stock 2 2 2 A A M A ı = ȕ ı +ı (İ ) 242 The portfolio management process Steps: 1. Planning • Specify investor’s objectives and constraints • Create the investment policy statement (IPS) – formal document governing all investment decision making, with a central role in the whole portfolio management process • Formalize capital market expectations • Create the strategic asset allocation 2. Execution step • Construct a portfolio with the appropriate asset allocation 3. The feedback step • Monitor objectives and constraints and capital market conditions, rebalance portfolio as needed Objectives: • Return • Risk tolerance (ability & willingness) Constraints: • Time horizon(s) • Liquidity needs • Taxes • Legal & Regulatory needs • Unique circumstances Typical IPS elements: • Client description • Purpose of the IPS • Identification of duties and responsibilities • Formal statement of objectives and constraints • Calendar schedule for portfolio performance and IPS review • Performance measures and benchmarks • Considerations for developing the strategic asset allocation • Investment strategies and investment styles • Guidelines for portfolio adjustments and rebalancing Time horizon directly affects ability to take risk Importance of ethical conduct (managers are in a position of trust)